CHAPTER 1
ABSORPTION COSTING AND MARGINAL COSTING
1
ABSORPTION COSTING IN OUTLINE
 In absorption costing, the cost of a product or service is
established by adding a share of fixed production overheads to
direct costs. It is consistent with the requirements for stock
valuation in financial reporting. It is usual to absorb production
overheads only into product costs. Other overheads are written
off as an expense when they arise.
 Production overhead costs are first allocated, then apportioned
and finally absorbed into production costs (or service costs).
–
Overhead allocation. Indirect production costs are
allocated to cost centres or codes. Allocation is the process
of charging a cost directly to the source of the expenditure.
–
Overhead apportionment. The overhead costs that have
been allocated to cost centres and codes other than direct
production departments are then apportioned to direct
production departments. Apportionment is the process of
sharing on a fair basis.
–
Overhead absorption. An absorption rate is calculated for
each production department as follows:
Total overhead costs (allocated and apportioned)
Production volume
 Where the department produces a single product, production
volume can be measured as the number of units produced, and
the absorption rate would be a rate per unit produced.
FTC FOULKS L YNCH
1
CHAPTER 1
ABSORPTION COSTING AND MARGINAL COSTING
 Where organisations produce different products or carry out
non-standard jobs for customers production volume may then
be measured as one of the following:
–
direct labour hours worked – the absorption rate is a rate
per direct labour hour worked
–
machine hours worked – the absorption rate is a rate per
machine hour operated
–
the cost of direct labour – the absorption rate is a
percentage of direct labour cost.
 It is possible to calculate absorption rates using actual overhead
costs and actual production volume but the normal practice is
to absorb based on budgeted overhead expenditure and
budgeted production volume.
 An absorption costing system might distinguish between fixed
and variable overheads.
–
Variable overhead costs – where the total expenditure is
expected to rise in direct proportion to the volume of
output.
–
Fixed overhead costs – where total expenditure is a
constant amount in a given period, regardless of the output
volume.
 In absorption costing, inventories of work-in-progress and
finished goods are valued at their full production cost.
2
MARGINAL COSTING IN OUTLINE
 Marginal costing is another method of costing products or
services and measuring profitability. Products or services are
valued at their marginal cost (variable cost) only. Inventories of
work-in-progress and finished goods are valued at their variable
production cost. All fixed costs are treated as period costs and
charged against profit in the period to which they relate.
2
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ABSORPTION COSTING AND MARGINAL COSTING
CHAPTER 1
 Contribution is the difference between sales and the variable
cost of sales:
Contribution = Sales – Variable cost of sales
Contribution is short for ‘contribution to fixed costs and profits’.
 In a marginal costing system, the measure of product
profitability is the total contribution earned by each product,
without charging any fixed costs to the product. In absorption
costing, product profitability is measured as sales income from
each product minus the full absorption costs of the product.
 Changes in the volume of sales, or in sales prices, or in variable
costs will all affect profit by altering the total contribution.
Marginal costing techniques can be used to help management to
assess the likely effect on profits of higher or lower sales
volume, or the likely consequences of reducing the sales price
of a product in order to increase demand, and so on.
 Example
A company sells a single product for £9. Its variable cost is £4.
Fixed costs are currently £70,000 per annum and annual sales are
20,000 units. There is a proposal to make a change to the product
design that would increase the variable cost to £4.50, but it would
also be possible to increase the selling price to £10 for the redesigned model. It is expected that annual sales at this higher
price would be 19,000 units, and fixed costs should fall by
£1,000.
How would the re-design of the product affect annual profit?
Solution
Sales
Variable costs
Contribution
Fixed costs
Profit
FTC FOULKS LYNCH
Before
After
£
(20,000 × £9) 180,000
(20,000 × £4) 80,000
100,000
70,000
30,000
£
(19,000 × £10) 190,000
(19,000 × £4.50) 85,500
104,500
69,000
35,500
3
CHAPTER 1
3
ABSORPTION COSTING AND MARGINAL COSTING
INCOME STATEMENTS FOR ABSORPTION AND MARGINAL
COSTING
 Absorption costing is used to provide inventory valuations for
financial statements. Either marginal or absorption costing can
be useful for internal management reporting.
 Example
Hound produces a single product and has the following budget:
Budget per unit
Selling price
Direct materials
Direct wages
Variable overhead
$
10
3
2
1
Fixed production overhead is $10,000 per month; production
volume is 5,000 units per month.
Required:
Show income statements for the month if sales are 4,800 units and
production is 5,000 units under:
(a) absorption costing
(b) marginal costing.
Solution
(a) Absorption costing
The fixed overhead cost per unit is $2 (= $10,000/5,000
units).
The full cost per unit produced is therefore $8 (3 + 2 + 1 +
2).
4
FTC FOULKS LYNCH
ABSORPTION COSTING AND MARGINAL COSTING
CHAPTER 1
Income statement: absorption costing
$
Sales (4,800 at $10)
Opening inventory
Costs of production (5,000 × $8)
Less: Closing inventory (200 × $8)
Cost of sales
Profit
$
48,000
40,000
40,000
1,600
(38,400)
9,600
(b) Marginal costing
If marginal costing is used, units of closing inventory are
valued at $6 (3 + 2 + 1)
Income statement: marginal costing
$
Sales (4,800 at $10)
Opening inventory
Variable costs of production (5,000 × $6)
Less: Closing inventory (200 × $6)
Variable cost of sales
$
48,000
30,000
30,000
1,200
Contribution
Fixed costs
Profit
(28,800
)
19,200
10,000
9,200
The two profit figures can be reconciled as follows:
Absorption costing profit
Add: fixed costs included in opening inventory
Less: fixed costs included in the closing
inventory (200  $2)
Marginal costing profit
FTC FOULKS LYNCH
$
9,600
0
(400)
9,200
5
CHAPTER 1
ABSORPTION COSTING AND MARGINAL COSTING
 The basic rule
The basic rules for reconciling absorption costing profit to
marginal costing profit are (AC = absorption costing, MC =
marginal costing):
–
If closing inventory is more than opening inventory, AC
profit > MC profit.
–
If closing inventory is less than opening inventory, AC
profit < MC profit.
–
If opening and closing inventory are the same, AC profit =
MC profit.
 Under- or over-absorbed overhead
–
Under- and over-absorption of fixed overheads occur in
absorption costing, and are reported in the income
statement.
–
It occurs because the absorption rate is a predetermined
rate.
–
The amount of under- or over-absorbed overhead is:
Production overhead absorbed into product costs
Actual production overhead expenditure
Under- or over-absorbed overhead
6
$
X
Y
(X – Y)
–
When the overhead absorbed (X) is more than the overhead
expenditure incurred, there is over-absorption.
–
When the overhead absorbed (X) is less than the overhead
expenditure incurred, there is under-absorption.
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ABSORPTION COSTING AND MARGINAL COSTING
CHAPTER 1
 Proforma income statements
Absorption costing
$
Sales
Opening inventory (full production
cost)
Production costs:
Direct materials
Direct labour
Production overheads absorbed
$
$
X
X
X
X
X
X
X
(X)
Less closing inventory (full production
cost)
Production cost of sales:
(X)
X
Production overhead absorbed
Production overhead incurred
Over-absorbed/(under-absorbed)
overheads
X
X
Administration overheads incurred
Selling and distribution costs incurred
X
X
X or (X)
X
(X)
X
Profit
Marginal costing
$
Sales
Opening inventory (marginal production
cost)
Variable production cost incurred:
Direct materials
Direct labour
Variable production overheads
$
$
X
X
X
X
X
X
X
FTC FOULKS LYNCH
7
CHAPTER 1
ABSORPTION COSTING AND MARGINAL COSTING
Less closing inventory (marginal
production cost)
Variable production cost of sales
Variable selling and distribution costs
Total variable cost of sales
CONTRIBUTION
Fixed costs (period costs)
Fixed production costs
Fixed administration costs
Fixed selling and distribution costs
Total fixed costs
Profit
4
(X)
X
X
(X)
X
X
X
X
(X)
X
BATCH COSTING AND JOB COSTING
 In batch costing, production costs are recorded for each batch of
items produced. Direct materials costs and direct labour costs
are recorded for the batch as a whole, and in absorption costing,
fixed overheads are then absorbed into the cost of the batch at
the predetermined rate. A cost per unit of output is then
calculated by dividing the full production cost of the batch by
the number of output units in the batch.
 In job costing, each job carried out for a customer is costed
separately. A job cost card is used to record the direct materials
and direct labour costs of the job as it progresses, and there
might also be some direct expenses chargeable. In absorption
costing, production overheads are added to the cost of the job at
the predetermined rate.
 When marginal costing is used, there is no absorption of fixed
overheads into the cost of batches or jobs, and only the variable
production costs are recorded.
8
FTC FOULKS LYNCH
ABSORPTION COSTING AND MARGINAL COSTING
5
CHAPTER 1
MARGINAL AND ABSORPTION COSTING COMPARED
Advantages of absorption costing
 Fixed production costs can be a large proportion of the total
production costs incurred. Unless production overheads are
absorbed into product costs, a large proportion of cost would be
excluded from the measurement of product costs.
 Absorption costing follows the matching concept (accruals
concept) by carrying forward a proportion of the production
cost in the inventory valuation to be matched against the sales
value when the items are sold.
 It is necessary to include fixed production overhead in
inventory values for financial statements; absorption costing
achieves this.
 In job costing, absorption costing can help to decide on the
price to quote to a customer for a job. The job cost estimate
includes a share of overhead cost, and the price can be decided
by adding a profit margin to this estimated cost. This method of
‘cost plus pricing’ can help to ensure that sales income is
sufficient to cover all costs, fixed as well as variable.
 Analysis of under-/over-absorbed overhead may be useful for
identifying inefficient utilisation of production resources.
 There is an argument that in the longer term, all costs are
variable, and it is appropriate to try to identify overhead costs
with the products or services that cause them. This argument is
used as a reason for activity-based costing (ABC).
Disadvantages of absorption costing
 The apportionment and absorption of overhead costs is
arbitrary.
FTC FOULKS LYNCH
9
CHAPTER 1
ABSORPTION COSTING AND MARGINAL COSTING
 Profits vary with changes in production volume.
For example, by increasing output, more fixed overhead is
absorbed into production costs, and if the extra output is not sold,
the fixed overhead costs are carried forward in the closing
inventory value.
Advantages and disadvantages of marginal costing
 Marginal costing has several advantages:
–
Simpler costing system, there is no requirement to
apportion and absorb overhead costs.
–
Variable production cost is a more realistic estimate of
inventory value than full production cost.
–
Marginal costing reflects the behaviour of costs in relation
to activity, i.e. when sales increase, the cost of sales rise
only by the additional variable costs
 However, marginal costing has weaknesses:
–
When fixed costs are high relative to variable costs, and
when overheads are high relative to direct costs, the
marginal cost of production and sales is only a small
proportion of total costs. A costing system that focuses on
marginal cost and contribution might therefore provide
insufficient and inadequate information about costs and
product profitability. Marginal costing is useful for shortterm decision-making but not over the longer term.
–
The treatment of direct costs as a variable cost item is often
unrealistic. When direct labour employees are paid a fixed
wage or salary, their cost is fixed, not variable.
 Since both absorption costing and marginal costing have
advantages and weaknesses as methods of measuring the costs
and profitability of products and services, neither can be
regarded as superior to the other.
In view of the recognised weaknesses in both costing methods,
new approaches to costing have been devised.
10
FTC FOULKS LYNCH
CHAPTER 2
COST LEDGER ACCOUNTING
1
THE COST LEDGER
 In financial accounting, the nominal or general ledger contains
accounts for assets, liabilities, income, expenses and capital
used for recording financial transactions.
 Some organisations also have a cost ledger.
 The financial accounting ledger and cost accounting ledger can
be integrated into a single ledger. When they are separate, the
two systems must reconcile with each other, and the system is
referred to as an ‘interlocking’ accounting system.
 There are different types of cost accounting system.
–
For manufacturing businesses, the costing system could be
for a batch production system, for a production system
based on doing non-standard jobs to customer
specifications, and for a continuous process manufacturing
system.
–
The costing system might use absorption costing or
marginal costing.
–
The costing system might use actual costs or standard
costs.
 Within a cost ledger for a manufacturing business, there should
be accounts for recording transactions relating to:
–
inventory (a stores ledger control account)
–
labour costs (a wages and salaries control account)
–
production costs (a work in progress control account)
–
overhead costs
–
unsold completed production (a finished goods account)
–
the cost of sales
–
sales.
FTC FOULKS LYNCH
11
CHAPTER 2
COST LEDGER ACCOUNTING
 There are three accounts that record opening and closing
inventory: the stores ledger control account (raw materials), the
work-in-progress control account (unfinished production) and
the finished goods account (unsold completed production).
 In an absorption costing system, there could be an account for
recording the under- or over-absorbed production
overheads.
 There is an account for calculating the profit or loss for the
period. In an interlocking accounts system, the cost accounting
profit might differ from the profit in the financial accounting
system, for example because inventory values might differ
between the systems. The account in the cost ledger will be
referred to as the costing income statement, although a
different name might be given.
 In an interlocking accounts system, the cost ledger does not
have accounts for non-current assets, bank, receivables,
payables, long-term liabilities, capital or depreciation. The cost
accounts also exclude financial transactions such as investment
income, interest costs, and dividends to shareholders.
 Transactions in the cost ledger are recorded using double entry
book-keeping. In an interlocking accounting system, when the
corresponding credit or debit entry would be to an account that
does not exist in the cost ledger, the credit or debit is recorded
in a financial ledger control account in order to maintain the
integrity of the double entry accounting system.
2
THE DOUBLE ENTRY SYSTEM IN COST ACCOUNTING
 The following rules apply for an interlocking accounts system
and absorption costing.
12
–
Additions to cost are recorded as a debit entry in the
appropriate account.
–
Costs of indirect materials and indirect labour are recorded
as a debit entry in the appropriate overhead account. The
FTC FOULKS LYNCH
COST LEDGER ACCOUNTING
CHAPTER 2
debit side of the overhead control accounts is therefore
used to build up the total cost of overheads actually
incurred.
–
The cost of production is recorded by means of debit
entries in the work-in-progress control account.
(i) The cost of direct materials is recorded as a debit entry
in work-in-progress, and the credit entry is in the stores
ledger control account.
(ii) The cost of direct labour is recorded as a debit entry in
work-in-progress, and the credit entry is in the wages
and salaries control account.
(iii) In an absorption costing system, production overheads
absorbed in the cost of production are recorded as a
debit entry in work-in-progress, and the credit entry is in
the production overhead control account.
 The work-in-progress control account is a total account
representing the accumulated production costs recorded within
the costing system for products, jobs or batches produced.
 Completed production is recorded as a credit entry in the
work in progress control account and as a debit entry in either
the finished goods account or the cost of sales account.
 In the work-in-progress control account, the debit side
therefore records the cost of items going through production,
and the credit side records the cost of the completed output.
 Transfers of inventory are recorded as a credit entry in the
inventory account from which the transfer is made and the
debit entry is to the account representing the cost or value of
where the inventory was transferred to.
(i) Transfers of raw materials from stores are recorded as a
credit entry in the stores ledger control account and as a debit
entry in the work-in-progress control account (direct
materials) or the appropriate overhead control account
(indirect materials).
FTC FOULKS LYNCH
13
CHAPTER 2
COST LEDGER ACCOUNTING
(ii) Transfers of finished output from work-in-progress is
recorded as a credit entry in the work-in-progress account,
with the debit entry in either the finished goods account or
cost of sale account.
(iii) Transfers of finished goods, when they are sold to
customers, are recorded by a credit entry in the finished
goods account, with the debit entry in the cost of sales
account.
 The cost of sales is recorded by means of debit entries in the
cost of sales account.
(i) The production cost of goods sold is recorded as a debit in
cost of sales, and the credit entry is in either the work-inprogress control account or the finished goods account.
(ii) The cost of administration overhead and sales and
distribution overhead is debited to cost of sales, with the
credit to the appropriate overhead account.
 Sales are recorded as a credit in the sales account and the
debit entry is in the financial ledger control account (since there
is no account in the cost ledger for receivables or cash/bank).
 Under- or over-absorbed overhead. The production
overhead control account records overhead costs incurred on
the debit side and overhead costs absorbed into production cost
on the credit side. The difference between the total costs
debited and absorbed costs credited is the under- or overabsorbed overhead.
 Costing profit or loss. A costing profit and loss account is used
to calculate the profit or loss for a period.
(i) Sales are credited in this account, with the debit entry in the
sales account.
(ii) The cost of sales is debited in this account, with the credit
entry in the cost of sales account.
14
FTC FOULKS LYNCH
COST LEDGER ACCOUNTING
CHAPTER 2
(iii) Under-absorbed overhead is debited in the account, with
the matching credit in either the under/over-absorbed
overhead account or the production overhead control
account.
(iv) Over-absorbed overhead is credited in the account, with the
matching debit in either the under/over-absorbed overhead
account or the production overhead control account.
 Opening and closing inventories. The value of opening
inventory is a debit balance brought forward. The value of
closing inventory is shown on the credit side of the account, as
a closing balance carried forward.
The double entry system in T account format
 FLCA stands for financial ledger control account. WIP stands
for the work-in-progress control account. The figures are to
illustrate only.
Stores ledger control account
$
$
Opening balance
4,000 (2) Direct materials used
b/f
(1) Purchases 50,000
– WIP
40,000
FLCA
(3) Indirect materials
used
– production
9,000
overhead
– admin overhead
1,000
– sales overhead
1,000
Closing balance c/f
3,000
54,000
54,000
Opening balance
3,000
b/f
FTC FOULKS LYNCH
15
CHAPTER 2
COST LEDGER ACCOUNTING
Work in progress control account
$
Opening balance
8,000 (6) Finished output
b/f
(2) Direct materials
40,000
– Finished goods a/c
used – stores
ledger control
(4) Direct labour cost 25,000
– wages and
salaries control
(5) Production
25,000
Closing balance c/f
overhead
absorbed –
prod’n overhead
account
98,000
Opening balance
5,000
b/f
Finished goods account
$
Opening balance
4,000 (7) Finished goods sold
b/f
(6) Completed
93,000
– Cost of sales a/c
production
(unsold) –WIP
Closing balance c/f
97,000
Opening balance 11,000
b/f
16
$
93,000
5,000
98,000
$
86,000
11,000
97,000
FTC FOULKS LYNCH
COST LEDGER ACCOUNTING
CHAPTER 2
Wages and salaries control account
$
(8) Total cost of
82,000 (4) Cost of direct labour
wages and
- WIP
salaries - FLCA
Indirect labour cost:
(9) Production overh’d
(9) Admin overh’d
(9) Sales and dist’n
oh’d
82,000
Production overhead control account
$
(3) Cost of indirect 9,000 (5) Absorbed overhead
materials –
– WIP
stores ledger
control
(9) Cost of indirect 7,000 (11) Balance: underproduction
absorbed overhead
labour – wages
and salaries
(10) Indirect
11,000
production
expenses –
FLCA
27,000
FTC FOULKS LYNCH
$
25,000
7,000
20,000
30,000
82,000
$
25,000
2,000
27,000
17
CHAPTER 2
COST LEDGER ACCOUNTING
Administration overhead control account
$
(3) Cost of indirect
1,000 (12) Cost of sales
materials –
stores ledger
control
(9) Cost of indirect 20,000
labour – wages
and salaries
(10) Indirect
5,000
administration
expenses - FLCA
26,000
$
26,000
26,000
Sales and distribution overhead control account
$
$
(3) Cost of indirect
1,000 (13) Cost of sales
43,000
materials –
stores ledger
control
(9) Cost of indirect
30,000
labour – wages
and salaries
(10) Indirect
12,000
sales/distn.
expenses FLCA
43,000
43,000
18
FTC FOULKS LYNCH
COST LEDGER ACCOUNTING
CHAPTER 2
Cost of sales account
$
$
(7) Production cost 86,000 (14) Costing profit and 155,000
of sales –
loss account
finished goods
(12) Administration 26,000
overhead
(13) Sales/distributio 43,000
n overhead
155,000
155,000
(17) Costing profit
and loss
account
Sales account
$
180,000 (16) Sales – FLCA
$
180,000
180,000
180,000
Under/over-absorbed overhead account
$
(11) Under-absorbed
2,000 (15) Costing profit and
overhead –
loss account
production
overhead
account
2,000
Costing profit and loss account
$
(14) Cost of sales
155,000 (17) Sales
(15) Under-absorbed
2,000
overhead
(18) Profit – FLCA
23,000
(balancing
figure)
180,000
FTC FOULKS LYNCH
$
2,000
2,000
$
180,000
180,000
19
CHAPTER 2
COST LEDGER ACCOUNTING
Financial ledger control account
$
(16) Sales
180,000
Opening balance
b/f
(1) Stores ledger
control account
(8) Wages and
salaries control
(10) Production
overhead control
(10) Admin overhead
(10) Sales/distribution
overhead
Closing balance 19,000 (18) Profit – costing
c/f
profit and loss
199,000
Opening balance
b/f
$
16,000
50,000
82,000
11,000
5,000
12,000
23,000
199,000
19,000
 The opening credit balance of $16,000 on the financial ledger
control account matches the total of the opening debit balances
on the three inventory accounts:
Stores ledger control
Work-in-progress control
Finished goods
$
4,000
8,000
4,000
16,000
 Similarly, the closing credit balance of $19,000 on the financial
ledger control account matches the total of the closing balances
on the three inventory accounts:
Stores ledger control
Work-in-progress control
Finished goods
20
$
3,000
5,000
11,000
16,000
FTC FOULKS LYNCH
COST LEDGER ACCOUNTING
3
CHAPTER 2
MARGINAL COSTING AND THE COST LEDGER
 The entries in the cost ledger for a marginal costing system are
different from those shown above.
–
Fixed production overheads are charged directly to the cost
of sales:
Debit
Cost of sales
Credit Production overhead account (fixed production
overheads)
–
If there are any variable production overhead costs, these
must be added to the cost of production in the WIP
account.
Debit
Work in progress
Credit Production overhead account (variable production
overheads).
 In marginal costing, there is no under- or over-absorbed
overhead, and so this account does not appear in a cost ledger
for marginal costing.
4
THE WORK IN PROGRESS CONTROL ACCOUNT
 The work in progress control account is an account for
recording the total cost of all items produced.
–
In batch costing, the WIP control account is the sum of all
the recorded entries in the cost accounts for the individual
batches produced.
–
In job costing, it is the sum of all the recorded entries in the
cost accounts for the individual jobs produced.
FTC FOULKS LYNCH
21
CHAPTER 2
22
COST LEDGER ACCOUNTING
FTC FOULKS LYNCH
CHAPTER 3
PROCESS COSTING
1
THE CHARACTERISTICS AND APPLICATION OF PROCESS
COSTING
 Process costing is a method of product costing for continuous
processing manufacture. The distinctive features are:
–
losses during processing
–
continuous processing. Process manufacturing does not
come to an end, there is always some opening and closing
work in process
–
in some industries, more than one product is output from
the same process and there could be joint products or a
by-product.
 Costs cannot be attributed to individual jobs or batches. Instead,
costs are attributed to individual processes. In process costing,
there is a work-in-process (work-in-progress) account for
each individual process, and:
–
in absorption costing, costs are recorded by charging direct
materials, direct labour and absorbed fixed production
overhead costs to each process
–
in marginal costing, costs are recorded by charging direct
materials, direct labour and variable production overhead
costs to each process
–
in a continuous processing system, there might be several
sequential processes.
 In a simple process account, where there are no losses in
production and no opening or closing work-in-process, costing
is straightforward. The total cost of the process is divided by
the number of units produced to calculate a cost per unit
produced.
FTC FOULKS LYNCH
23
CHAPTER 3
2
PROCESS COSTING
LOSS IN PROCESS
 Losses are measured as the difference between:
–
input units of materials, and
–
units of output and closing inventory.
 A distinction is made between the expected and the unexpected
loss. Expected loss is called normal loss. Any unexpected loss
(= loss in excess of the expected loss) is called abnormal loss.
 Normal loss, where loss has no scrap value
The costs of production are shared between the expected units of
output. The reason that normal loss is given a zero cost is that
since the loss is expected, it should be allowed for in product
costing.
 Normal loss, where loss has a scrap value
The scrap value of the normal loss is treated as a deduction from
the cost of processing. In ledger accounting, this is done by:
Debit
Scrap account, with the scrap value of the normal loss
Credit
Process account
The cost per unit of output is calculated as:
Total process costs minus scrap value of normal loss
Expected units of output
 Abnormal loss: loss has no scrap value
24
–
When actual loss exceeds normal loss, the difference is
abnormal loss.
–
When loss has no scrap value, the full cost of the
abnormal loss is written off as a cost in the income
statement for the period.
–
The cost per unit of output and the cost per unit of
abnormal loss are calculated as the total process cost
divided by the expected number of units of output.
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PROCESS COSTING
CHAPTER 3
 Abnormal loss, where loss has a scrap value
If loss has a scrap value, the cost to the business of abnormal loss
is reduced by its scrap value. However, this adjustment is made in
the scrap and abnormal loss accounts.
3
–
The process account is credited with the scrap value of the
normal loss only.
–
A cost per expected unit of output is calculated for output
units and abnormal loss units, in the same way as described
previously.
–
In the abnormal loss account and scrap account, the scrap
value of the abnormal loss is recorded by:
Debit
Scrap account
Credit
Abnormal loss account
–
The balance on the abnormal loss account is written off as
a charge to the income statement for the period.
–
The balance on the scrap account is matched by a debit
entry in the cash/bank account (where integrated
accounting is used) or the financial ledger control account
(where interlocking accounts are used).
ABNORMAL GAIN
 Sometimes, the actual loss in a process will be less than the
expected or normal loss. When this happens the difference is
called an abnormal gain. This is treated in the same manner as
an abnormal loss however the gain is a benefit rather than a
charge to the income statement.
4
WORK-IN-PROCESS AND EQUIVALENT UNITS
 In process manufacturing, there is usually some unfinished
work-in-process at the beginning and end of each period.
–
FTC FOULKS LYNCH
Closing work-in-process is given a value that is carried
forward.
25
CHAPTER 3
–
PROCESS COSTING
Opening work-in-process is completed during the period,
and transferred either to the next process or to finished
goods.
 There needs to be a method in process costing for:
–
putting a value to closing work-in-process, and
–
calculating the cost of completed units when some units are
partly finished at the beginning of the period.
 The method used is to estimate the equivalent number of units
of finished output represented by closing and opening
inventory. An equivalent unit is an amount equal to one
completed unit of output.
 Inventory, output and losses are valued in process costing by
first of all calculating a cost per equivalent unit.
Rules to remember
1
One full unit of production equals one equivalent unit.
2
If loss is assumed to occur at the end of processing, one unit
of abnormal loss or abnormal gain equals one equivalent
unit.
Normal loss = 0 equivalent units.
Abnormal loss equivalent units are added to the total of
equivalent units.
Abnormal gain equivalent units are subtracted from the
total of equivalent units.
3
Labour costs and overhead costs are usually treated together
as conversion costs.
4
Closing stock has to be converted from actual units to
equivalent units.
 If there are two or more direct materials in the process,
and one material is added in full at the start of the
process and the other is added gradually throughout the
processing, it is necessary to calculate an equivalent
units figure for each direct material.
26
FTC FOULKS LYNCH
PROCESS COSTING
5
6
7
CHAPTER 3
If loss has a scrap value, it is usual to subtract the scrap
value of normal loss from the total cost of direct materials.
The cost per equivalent unit of conversion cost =
Total conversion costs/Total equivalent units of conversion
cost
The costs per equivalent unit are used to value finished
output, abnormal loss or abnormal gain and closing work-inprocess.
 Example
A manufacturer starts processing on 1 April. During April, the
following costs were incurred in Process 1:
$
Direct materials (20,000 litres)
78,000
Direct labour
43,000
Production overhead absorbed
86,000
207,000
Normal loss is 5% of input materials and loss has a scrap value of
$2 per litre.
There was no work-in-process at the beginning of April. During
April, output to Process 2 totalled 15,800 litres. Closing work-inprocess at the end of April was 2,400 litres, which were 100%
complete for direct materials but only 25% complete for
conversion costs.
Required:
(a) Calculate the cost of finished output during April.
(b) Calculate the value of closing work-in-process.
Solution
1 Calculate the amount of abnormal loss or gain.
2
Calculate the number of equivalent units of output.
3
Calculate a cost per equivalent unit for materials and
conversion costs. Remember that the scrap value of normal
loss, if there is any, is deducted from the total cost of the
direct materials before calculating a cost per equivalent unit.
FTC FOULKS LYNCH
27
CHAPTER 3
4
PROCESS COSTING
Use the costs per equivalent unit to put a value to finished
output, closing work-in-process and abnormal loss/abnormal
gain.
Abnormal loss/abnormal gain
litres
15,800
1,000
2,400
19,200
20,000
800
Finished output
Normal loss (5% of 20,000)
Closing WIP
Input materials
Difference = abnormal loss
Number of equivalent units
Total units
Finished output
Normal loss
Abnormal loss
Closing WIP
Equivalent units
Direct
Conversion
materials
costs
15,800
15,800
15,800
1,000
0
0
800
800
800
2,400 (100%)
2,400 (25%)
600
20,000
19,000
17,200
Total cost
Cost
Less scrap value of normal loss
Cost per equivalent unit
$
78,000
(2,000)
76,000
$
129,000
129,000
$4.00
$7.50
Evaluation
Direct materials
Conversion costs
Equivalent Cost Equivalent Cost
units
$
units
$
Finished output
15,800
63,200
15,800 118,500
Abnormal loss
800
3,200
800
6,000
Closing WIP
2,400
9,600
600
4,500
19,000
76,000
17,200 129,000
28
Total
cost
$
181,700
9,200
14,100
205,000
FTC FOULKS LYNCH
PROCESS COSTING
CHAPTER 3
(Note: The cost of finished output could be calculated more
quickly as:
15,800 equivalent units × ($4 + $7.50) = $181,700.
Similarly, the cost of abnormal loss = 800 equivalent units × ($4
+ $7.50) = $9,200.)
5
THE AVCO METHOD
 When there is opening work-in-process at the start of a period,
the inventory has a brought forward value from the previous
period, there is a cost to completion during the current period.
There are several methods of calculating the value of completed
opening work-in-process including:
–
the weighted average cost method or AVCO method
–
first in, first out method (FIFO)
–
standard cost.
 Using the AVCO method, it is assumed that all production units
during a period have the same unit cost. A unit of partcompleted opening WIP, on completion, has the same cost as a
unit of output started and finished in the current period.
Rules to remember
1
2
Every unit of finished output during a period counts as one
full equivalent unit of production.
Total costs for direct materials are:
(a) direct materials value of opening WIP, plus
(b) direct materials costs incurred in the current period,
minus
(c) scrap value of normal loss.
3
Total conversion costs are:
(a) conversion cost value of opening WIP, plus
(b) conversion costs incurred in the current period.
FTC FOULKS LYNCH
29
CHAPTER 3
PROCESS COSTING
 The total equivalent units are calculated and a cost per
equivalent unit. This is then used to put a value to finished
output, abnormal loss or abnormal gain and closing WIP.
6
THE FIFO METHOD
 The FIFO method is based on the assumption that the first units
of materials input to a process are the first items to be
completed.
 The rules for the FIFO method are:
1
The equivalent units of opening WIP are the equivalent units
of work to complete production.
2
Units started and finished in the current period are one
equivalent unit each.
3
The cost per equivalent unit is the total costs incurred in the
current period divided by the total equivalent units for the
current period.
4
If normal loss has a scrap value, this is usually deducted from
the cost of the materials input to the process during the
period.
5
The cost of finished output is calculated in two parts.
(a) Opening WIP, completed during the current period. The
cost of this output is the value of the equivalent units in
the current period plus the value of the opening WIP.
(b) Other units started and completed during the current
period.
30
FTC FOULKS LYNCH
PROCESS COSTING
7
CHAPTER 3
BY-PRODUCTS
 The output from a process might include a by-product in
addition to the main product. A by-product is manufactured as
an unavoidable result of the process. Although it has some sales
value, its value is small in comparison.
 There is no information value in calculating a cost for a byproduct or measuring its profitability. The accounting treatment
of a by-product in process costing is similar to the treatment of
normal loss.
8
JOINT PRODUCTS
 Joint products are two or more separate products output from
a common process, each having a sales value large enough to
justify the treatment of the product as a main product.
 The cost of each joint product is a share of the common
processing costs up to split-off point. Split-off point is the
point during processing where the separate joint products are
produced.
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31
CHAPTER 3
PROCESS COSTING
The apportionment of common costs between joint products
 There are four broad methods of apportioning:
–
on the basis of units of each joint product
–
on the basis of the market values at the split-off point
–
on the basis of the eventual market value after deducting
further processing costs on the separate joint product after
the split-off point
–
on the basis of a technical estimate of the relative ‘usage’
of common processing resources
 Example
The output from a process consists of two joint products, JP1 and
JP2, and a by-product BP. The following data relates to
November:
Opening WIP (1,500 units)
Materials input (20,000 units): cost
Conversion costs
Normal loss (1,000 units): scrap value
Abnormal loss: (500 units)
Output:
By-product BP (2,000 units): sales value
Joint-product JP1: 10,000 units
Joint-product JP2: 5,000 units
Closing WIP (3,000 units): value
$16,000
$151,000
$89,500
$500
$7,000
$6,000
$33,000
The units of JP1 output from the process have a sales value of
$220,000. The units of JP2 output from the process have a sales
value of $250,000 after further processing costs of $50,000 are
incurred.
Required:
Calculate the output value of each joint product assuming that
common processing costs are shared on the basis of:
(i) units produced
(ii) sales value at split-off point/ eventual sales value less further
processing costs.
32
FTC FOULKS LYNCH
PROCESS COSTING
CHAPTER 3
Solution
Opening WIP
Direct materials
Conversion costs
Scrap value of normal loss
By-product sales income
Abnormal loss
Closing WIP
Cost of finished output
(i) Units produced
Cost per unit
($210,000/15,000)
Apportionment of
common costs
(ii) Sales value
Less further processing
costs
Net sales value
Cost per $1 net value
($210,000/$420,000)
Apportionment of
common costs
FTC FOULKS LYNCH
Units
1,500
20,000
21,500
1,000
2,000
500
3,000
6,500
15,000
$
$
16,000
151,000
89,500
256,500
500
6,000
7,000
33,000
46,500
210,000
JP1
10,000
$14
JP2
5,000
$14
Total
15,000
$140,000
$70,000
$210,000
220,000
-
250,000
(50,000)
220,000
$0.50
200,000
$0.50
420,000
$110,000
$100,000
$210,000
33
CHAPTER 3
34
PROCESS COSTING
FTC FOULKS LYNCH
CHAPTER 4
THROUGHPUT ACCOUNTING
1
THE ORIGINS OF THROUGHPUT ACCOUNTING AND
DEFINITIONS
 Throughput accounting emerged in the 1980s and 1990s. It is
associated with the work of Dr Eli Goldratt, who developed the
Theory of Constraints (TOC).
 Dr Goldratt described the approach of traditional accounting
systems as ‘Cost World’, in which product cost is the main way
to understand value. Costs are categorised as fixed and variable
costs, and in absorption costing overheads are charged to labour
time or to products using many arbitrary assumptions that have
no commercial relevance. Even in marginal costing, it is
assumed that direct labour costs vary with the activity level, and
that fixed costs are the same for a given time period, regardless
of the activity level.
 Throughput accounting challenges these assumptions.
–
Direct labour costs are not wholly variable. Skilled workers
are paid fixed salaries, and so their cost does not vary
directly with output volume.
–
Fixed costs are ‘less fixed’ than they might have been in
the past.
–
The only totally variable cost is the purchase cost of raw
materials and components that are bought from external
suppliers.
–
According to the throughput accounting approach, a
business makes its money by selling goods (or services).
Until it makes the sale, there is no added value.
FTC FOULKS LYNCH
35
CHAPTER 4
THROUGHPUT ACCOUNTING
Throughput
 Throughput is ‘the rate of production of a defined process over
a stated period of time. Rates may be expressed in terms of
units of products, batches produced, turnover or other
meaningful measurements’.
 Value is created from throughput. In money terms, throughput
can therefore be defined as the extra money that is made for an
organisation from selling its products:
THROUGHPUT = REVENUE – TOTALLY VARIABLE
COSTS
 Throughput brings fresh money into the business from outside.
 Since totally variable costs are normally just raw materials and
bought-in components, it is often convenient to define
throughput as:
REVENUE – RAW MATERIAL COSTS
Inventory (or investment)
 This is defined as all the money the business invests to buy the
things that it intends to sell, or all the money tied up in assets so
that the business can make the throughput. Inventory therefore
includes unused raw materials, work-in-progress and unsold
finished goods.
Operating expenses
 Operating expenses are defined as all the money a business
spends to produce the throughput It is not correct to think of
operating expenses as fixed costs. They are costs that are not
totally variable.
36
FTC FOULKS LYNCH
THROUGHPUT ACCOUNTING
2
CHAPTER 4
MEASURING PROFIT AND INVENTORY VALUE IN
THROUGHPUT ACCOUNTING
Net profit
 Since a business makes its money from throughput,
management accounting systems should focus on the value of
throughput created. Profit should therefore be reported as
follows:
$
Revenue
Raw materials costs (totally variable costs)
Throughput
Operating expenses
Net profit
750,000
200,000
550,000
400,000
150,000
 Throughput accounting has been described as a form of ‘supervariable costing’ because the concept of throughput has
similarities to the concept of contribution. In throughput
accounting, the concept of product cost is rejected. The
throughput earned by individual products is calculated, but no
attempt is made to charge operating expenses to products.
The value of inventory
 Inventory should be valued at the purchase cost of its raw
materials and bought-in parts.
 It should not include any other costs, not even labour costs. No
value is added by the production process, not even by labour,
until the item is sold.
FTC FOULKS LYNCH
37
CHAPTER 4
3
THROUGHPUT ACCOUNTING
THE THEORY OF CONSTRAINTS
 The theory of constraints is a development of system theory and
applies to all types of system.
–
Every system has inputs.
–
The inputs are brought together within the system and are
processed to produce outputs.
–
Within a system, there are many different processes or subsystems that react with each other and that are
interdependent.
–
A system can also be affected by external factors in its
environment.
Inputs
System
Outputs
 Outputs are affected by:
–
the design of the system
–
controls within the system
–
external constraints on the system.
System goals
 Every system must have a clear goal such as to maximise profit.
Complexity of systems
 All complex systems are just a number of simple systems
interacting with each other.
Problems and constraints
 Problems can occur within systems, and every system has one
or more core problems or constraints. The existence of
constraints within a system is self-evident. If there were no
38
FTC FOULKS LYNCH
THROUGHPUT ACCOUNTING
CHAPTER 4
constraints, the output from the system would be either zero or
it would continue to grow indefinitely.
 Constraints could be caused by:
–
weaknesses in the system’s design and the way in which its
different parts link together
–
weaknesses in the controls within the system
–
external factors such as a limit to the volume of customer
demand.
 In physical systems, such as manufacturing processes,
constraints can be identified as bottlenecks in the system. A
bottleneck is something that sets a limit to throughput through
the system.
 The approach recommended by the theory of constraints is to
concentrate effort on the key constraint that limits the
performance of the system as a whole.
–
Every system has a weakest link, which is its core
constraint.
–
Strengthening any link in the chain that is not the weakest
link does nothing to improve the performance of the
system as a whole.
–
Physical constraints are the easiest to identify but there
can also be policy constraints. A policy constraint might
be caused by a hidden conflict, and to resolve the problem,
it is necessary to identify the assumptions underlying the
conflict and to challenge at least one of them.
 In a manufacturing business, constraints on throughput could
be:
–
selling prices that are too high, limiting the volume of sales
demand
–
selling prices that are too low, limiting total sales revenue
FTC FOULKS LYNCH
39
CHAPTER 4
THROUGHPUT ACCOUNTING
–
unreliable product quality, which causes losses due to
wastage and scrapped items, or items returned by
dissatisfied customers
–
unreliable supplies of key raw materials, so that production
cannot be scheduled in a reliable way
–
a shortage of a key production resource, which creates a
bottleneck in the production process.
 Goldratt’s five steps to dealing with constraints
Step 1 Identify the key system constraints.
Step 2 Decide how to exploit the system constraint or relieve
the bottleneck. . Until the constraint can be overcome,
every effort should be made to make the most efficient
use possible of the constraining resource.
Step 3 Make everything else subordinate to the requirement to
exploit the system constraint or relieve the bottleneck.
The work rate for all non-constrained resources must
be tied to the rate at which the constraining resource
operates. This is to avoid a wasteful build up of
unnecessary work in progress.
Step 4 Elevate the system constraints. The constraint should
be removed.
Step 5 If the constraint is now broken, go back to Step 1. In
other words, when the original constraint is no longer a
bottleneck, start the procedure again by finding the
new bottleneck.
4
THE THEORY OF CONSTRAINTS AND THROUGHPUT
ACCOUNTING
 Goldratt and others used the theory of constraints to suggest
throughput accounting as an alternative to cost accounting
systems.
40
FTC FOULKS LYNCH
THROUGHPUT ACCOUNTING
CHAPTER 4
Throughput accounting and cost accounting
 Cost accounting systems are based on the idea that costs should
be attributed to products.
 Throughput accounting is different, because costs are not
attributed to products and there are no measurements of product
profitability. Product profit does not exist. ‘Products are not
profitable or unprofitable, businesses are’ (Waldron).
 Different decisions might be taken by management when
throughput accounting is used as a basis rather than cost
accounting. This is because in throughput accounting, we look
at the system as a whole and how to maximise output from the
global system. In contrast, cost accounting encourages
management to look at ways of optimising local sub-systems.
5
DECISION-MAKING WITH THROUGHPUT ACCOUNTING
 Using throughput accounting, the aim should be to maximise
throughput, on the assumption that operating expenses are a
fixed amount in each period.
–
If the business has more capacity than there is customer
demand, it should produce to meet the demand in full.
–
If the business has a constraint that prevents it from
meeting customer demand in full, it should make the most
profitable use that it can of the constraining resource. This
means giving priority to those products earning the highest
throughput for each unit of the constraining resource that it
requires.
 Example
A business makes four products, W, X, Y and Z. Information
relating to these products is as follows:
FTC FOULKS LYNCH
41
CHAPTER 4
THROUGHPUT ACCOUNTING
Sales price/unit
Materials required/unit
Labour hours/unit
Monthly sales demand
(units)
W
€20
€10
4
500
X
€25
€15
5
800
Y
€18
€11
2
1,000
Z
€40
€22
6
400
There is a limit to the availability of labour, and only 8,000 hours
are available each month.
Required:
What products should the business produce?
Solution
The business should seek to maximise total throughput.
Sales price/unit
Materials required/unit
Throughput/unit
Labour hours/unit
Throughput/labour hour
Priority
W
€
20
10
10
4
€2.5
3rd
X
€
25
15
10
5
€2.0
4th
Y
€
18
11
7
2
€3.5
1st
Z
€
40
22
18
6
€3.0
2nd
The production volumes that will maximise throughput and net
profit are:
Product
Units
Labour hours
Y
Z
W
1,000
400
500
2,000
2,400
2,000
6,400
1,600
8,000
X (balance)
42
320
Throughput
€
7,000
7,200
5,000
3,200
22,400
FTC FOULKS LYNCH
THROUGHPUT ACCOUNTING
6
CHAPTER 4
PERFORMANCE MEASUREMENT WITH THROUGHPUT
ACCOUNTING
 Performance measurement with throughput accounting should
relate to:
– throughput, operating expenses and net profit, and
– inventory/investment.
Profit reporting
 Throughput may be reported for each product. However,
operating expenses should not be attributed to individual
products unless they are entirely attributable to the product.
 However, for control purposes, local operating expenses should
be attributed to the operating unit that has full control over the
cost. Managers of those units should be made accountable for
the actual operating expenses incurred by the unit.
Return on investment
 The return on investment can be measured as:
Return on investment 
(Throughput  Operating expenses)
Inventory
Other performance measures
 Inventory turns
This is the ratio of throughput in a period to the average
investment in inventory. An increase in the inventory turns ratio
should result in a higher return on investment.
Inventory turns 
Throughput in the period
Inventory
 Productivity
Productivity can be measured as the ratio of throughput to
operating expenses.
Productivity 
FTC FOULKS LYNCH
Throughput in the period
Operating expenses in the period
43
CHAPTER 4
THROUGHPUT ACCOUNTING
Throughput accounting ratio
 When there is a bottleneck resource, performance can be
measured in terms of throughput for each unit of bottleneck
resource consumed.
 There are three inter-related ratios:
–
throughput per unit of the bottleneck resource
–
operating expense per unit of the bottleneck resource
–
throughput accounting ratio. This is the ratio of throughput
per unit of bottleneck resource to operating expenses per
unit of bottleneck resource.
 Units of bottleneck resource are typically measured in hours
(labour hours or machine hours), therefore:
Throughout accounting ratio 
7
Throughput per hour of bottleneck resource
Operating expenses per hour of bottleneck resource
A CRITICISM OF THROUGHPUT ACCOUNTING
 A criticism of throughput accounting is that it concentrates on
the short term, when a business has a fixed supply of resources
and operating expenses are largely fixed.
 This criticism suggests that although throughput accounting
could be a suitable method of measuring profit and performance
in the short term, an alternative management accounting
method, such as activity based costing, might be more
appropriate for measuring and controlling performance from a
longer-term perspective.
44
FTC FOULKS LYNCH
CHAPTER 5
ACTIVITY-BASED COSTING
1
WEAKNESSES OF TRADITIONAL ABSORPTION COSTING
AND MARGINAL COSTING
Problems with absorption costing
 The assumption underlying this method is that overhead
expenditure is connected to the volume of production activity.
– This assumption was valid years ago, when production
systems were based on labour-intensive or machineintensive mass production of fairly standard items.
Overhead costs were also fairly small relative to direct
materials and direct labour costs.
– The assumption is not valid in a complex manufacturing
environment, where production is based on smaller
customised batches of products, indirect costs are high in
relation to direct costs, and a high proportion of overhead
activities are not related to production volume.
 The criticism of absorption costing is that it cannot calculate a
‘true’ product cost. Overheads are charged to departments and
products in an arbitrary way, and the assumption that overhead
expenditure is related to direct labour hours or machine hours in
the production departments is no longer realistic.
Problems with marginal costing
 The main criticisms of marginal costing as a method are:
–
–
variable costs might be small in relation to fixed costs
‘fixed’ costs might be fixed in relation to production
volume, but they might vary with other activities that are
not production-related.
 In many manufacturing and service environments, it is therefore
inappropriate to treat overhead costs as fixed period costs, and
indirect costs should be charged to products or services in a
more meaningful way.
FTC FOULKS LYNCH
45
CHAPTER 5
2
ACTIVITY-BASED COSTING
CONCEPTS AND ASSUMPTIONS IN ACTIVITY-BASED
COSTING
 Activity-based costing (ABC) is an alternative approach. It is a
form of absorption costing, but its approach is to link overhead
costs to the products or services that cause them by absorbing
overhead costs on the basis of activities that ‘drive’ costs (cost
drivers) rather than on the basis of production volume.
 The concepts or assumptions underlying ABC are:
–
In the long run, all overhead costs are variable. Some
overheads are variable in the short run. However, overhead
costs do not necessarily vary with production volume or
service level.
–
Products, services and other cost objects consume
activities.
–
Activities consume resources.
–
The consumption of resources drives cost.
 Products incur overhead costs because of the activities that go
into providing the products or services, and these activities are
not necessarily related to the volumes of the product that are
manufactured. Direct labour hours and machine hours are not
the drivers of cost.
When is ABC relevant?
 Activity-based costing could provide much more meaningful
information about product costs and profits when:
46
–
indirect costs are high relative to direct costs
–
products or services are complex
–
products or services are tailored to customer specifications
–
some products or services are sold in large numbers but
others are sold in small numbers.
FTC FOU LKS LYNCH
ACTIVITY-BASED COSTING
3
CHAPTER 5
THE STEPS IN ACTIVITY-BASED COSTING
 There are five basic steps:
Step 1 Identify activities that consume resources and incur
overhead costs.
Step 2 Allocate overhead costs to the activities that incur
them.
Step 3 Determine the cost driver for each activity or cost pool.
Step 4 Collect data about actual activity for the cost driver in
each cost pool.
Step 5 Calculate the overhead cost of products or services.
This is done by calculating on overhead cost per unit
of the cost driver. Overhead costs are then charged to
products or services on the basis of activities used for
each product or service.
Definitions
 A cost pool is an activity that consumes resources and for
which overhead costs are identified and allocated. For each cost
pool, there should be a cost driver.
 A cost driver is a unit of activity that consumes resources or
‘any factor which causes a change in the cost of an activity’.
4
COMPARING ABC WITH TRADITIONAL ABSORPTION
COSTING
 It is important to recognise that with ABC, the total amount of
overheads charged to products or services can be significantly
different from the overhead costs that would be calculated with
traditional absorption costing.
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47
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ACTIVITY-BASED COSTING
 Example
A company manufactures two products, P and Q. Monthly data
relating to production and sales are as follows:
Direct material cost per unit
Direct labour hours per unit
Direct labour cost per unit
Sales demand
Product P
$15
1 hour
$20
100 units
Product Q
$20
2 hours
$40
950 units
Production overheads are $200,000 each month and are absorbed
on a direct labour hour basis. The overhead absorption rate is
$100 per direct labour hour.
Other monthly information:
Activity
Setting up
Machining
Order
handling
Quality
control
Engineering
Total
Cost driver
cost
$
20,000 Number of
set-ups
80,000 Machine
hours
20,000 Number of
orders
20,000 Number of
inspections
60,000 Engineering
hours
200,000
Total Product
number
P
Product
Q
4
1
3
2,000
100
1,900
4
1
3
5
1
4
1,000
500
500
Required:
Calculate the costs, in total and per unit, for Product P and
Product Q, using:
(a) traditional absorption costing
(b) activity-based costing.
48
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ACTIVITY-BASED COSTING
CHAPTER 5
Solution
(a) Traditional absorption costing
Direct material cost/unit
Direct labour cost/unit
Overhead (at $100 per hour)
Total cost /unit
Number of units
Total cost
Cost per unit
Product P
$
15
20
100
135
Product Q
$
20
40
200
260
100
$13,500
$135
950
$247,000
$260
(b) Activity-based costing
Activity
Setting up
Machining
Order
handling
Quality
control
Engineering
Total Cost driver
Product Product
cost
P
Q
$
$
$
$
20,000 Cost per
5,000
5,000
15,000
set-up
80,000 Cost per
40 4,000
76,000
machine
hour
20,000 Cost per
5,000 5,000
15,000
order
20,000 Cost per
4,000 4,000
16,000
inspection
Cost per
60,000 engineering
60 30,000
30,000
hour
200,000
48,000 152,000
Direct materials
Direct labour
Overheads
Total cost
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Product P
$
1,500
2,000
48,000
51,500
Product Q
$
19,000
38,000
152,000
209,000
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ACTIVITY-BASED COSTING
Number of units
Cost per unit
Product P
$
100
$515
Product Q
$
950
$220
With activity-based costing, the unit cost of Product P is much
higher, because the overhead cost reflects its comparatively high
activity levels for set-up, order handling, quality control and
engineering for each unit produced and sold.
It could be argued that:
5
–
the product costs provided by ABC are much more realistic
than those calculated with traditional absorption costing
–
ABC gives management better insights into how products
should be priced
–
ABC also gives management better insights into how
overhead costs might be controlled. For example, the unit
costs of Product P might be reduced, at least in the longer
term, by focussing on how to reduce the engineering hours
or the number of inspections each month.
IDENTIFYING ACTIVITIES AND COST DRIVERS
 A business must identify the key activities that consume
resources and the cost driver for each of those activities.
50
–
There might be a large number of different activities, but in
an accounting system it is usually necessary to simplify and
select a fairly small number of activities.
–
There might be just one cost driver or several different cost
drivers. Where there are several cost drivers, it might be
appropriate to select just one for the purpose of ABC
analysis.
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ACTIVITY-BASED COSTING
CHAPTER 5
 A useful approach to identifying suitable activities within a
business is to consider four different categories of activity or
transaction:
–
Logistical transactions. These are activities or
transactions concerned with moving materials or people,
and with tracking the progress of materials or work through
the system.
–
Balancing transactions. These are concerned with
ensuring that the resources required for an operation are
available.
–
Quality transactions. These are concerned with ensuring
that output or service levels meet quality requirements and
customer expectations.
–
Change transactions. These are activities required to
respond to changes in customer demand, a change in
design specifications, a scheduling change or a change in
production or delivery methods.
 For each selected activity, there should be a cost driver. The
chosen cost driver must be:
–
relevant
–
easy to measure.
 Often, the cost driver is the number of transactions relating to
the activity. For example:
–
the cost of setting up machinery for a production run might
be driven by the number of set-ups (jobs or batches
produced)
–
the costs of purchasing might be related to the number of
purchase orders made
–
the costs of quality control might be related to the number
of inspections carried out, or to the incidence of rejected
items.
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ACTIVITY-BASED COSTING
 In selecting the appropriate cost driver for an activity, it might
be necessary to relate consumption of resources to the
appropriate level of activity. There may be a hierarchy of
activity levels, and the appropriate level should be selected. For
manufacturing businesses, four levels of activity can be
identified:
Activity level
Unit
Batch
Product
Facility
The consumption of resources
and costs depend on
Production or sales volume
The number of batches
produced
The number of different
products sold
The business being in existence
Examples
Machine running
costs
Set-up costs
Product design and
re-design costs
Factory rental
 Many overhead costs are incurred at the batch or product level,
rather than at the unit level.
6
ADVANTAGES AND CRITICISMS OF ABC
ABC has a number of advantages.
 ABC gives management a much better insight into what drives
overhead costs.
 ABC recognises that overhead costs are not all related to
production and sales volume, but they are nevertheless variable
and controllable, at least over the longer term.
 In many businesses, overhead costs are a significant proportion
of total costs, and management needs to understand the drivers
of overhead costs.
 It can be applied to derive realistic costs in a complex business
environment.
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 ABC can be applied to all overhead costs, not just production
overheads.
 ABC can be used just as easily in service costing as in product
costing.
 Product costs and product profitability are measured more
realistically. This helps management to identify which products
are most profitable and which are unprofitable.
 ABC can be used by management to identify ways of reducing
overhead costs in the longer-term. This is because ABC
shows the nature of resource-consuming activities, the costs
incurred by each activity and the cost drivers for those
activities.
 ABC analysis can also be used to identify activities and costs
that do not add value.
 ABC can also be used to analyse the profitability of individual
customers or categories of customer.
 If products or jobs are priced on a cost-plus basis, ABC can
help management to make sensible pricing decisions.
 ABC can be used as a basis for budgeting and longer-term
forward planning of overhead costs.
There are some criticisms of ABC.
 It is impossible to allocate all overhead costs to specific
activities, because some costs are incurred at a facility level,
such as factory rental costs. These have to be charged to
products on an arbitrary basis.
 The selection of just a few activities and one cost driver for
each activity means that ABC costs are based on assumptions
and simplifications.
 The benefits obtained from ABC might not justify the costs.
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53
CHAPTER 5
54
ACTIVITY-BASED COSTING
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CHAPTER 6
PRODUCTION SYSTEMS AND ENVIRONMENTS
1
MRP I: MATERIALS REQUIREMENTS PLANNING
 Many manufacturing organisations use computerised systems to
help with production planning and scheduling, and production
control.
 A manufactured product might consist of many components or
sub-parts, and each sub-part might consist of many components
and inventory items. Components and sub-parts take differing
amounts of time (‘lead times’) to produce, and they might need
to be available in a specific sequence in order to assemble the
end product.
 Materials Requirements Planning, now known as MRP I, is a
computer system for production planning, purchasing and
inventory control, for use in complex manufacturing systems. It
is particularly appropriate for batch manufacturing systems.
Three important elements
 Master production schedule – a plan summarising the volume
and timing of end-products required.
‘The master production schedule (MPS) is the most important
planning and control schedule in a business, and forms the main
input to materials requirements planning…. In manufacturing, the
MPS contains a statement of the volume and timing of the end
products to be made; this schedule drives the whole operation in
terms of what is assembled, what is manufactured and what is
bought. It is the basis of planning the utilisation of labour and
equipment and it determines the provisioning of materials and
cash’ (Operations Management, Slack, Chambers and Johnston).
 Bills of materials – lists in detail the parts that make up the
product and their production lead time. It also shows the
relationship between the parts in the end-product.
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PRODUCTION SYSTEMS AND ENVIRONMENTS
Using the bills of materials for each product, the master
production schedule is ‘exploded’ to work out:
–
the number of sub-assemblies that are needed, and the
quantities of raw materials and parts
–
the time by which they are needed, and therefore
–
the time by which their manufacture must begin or the
purchase orders must be placed.
The scheduling is based on an assumption that lead times for
purchasing and manufacture are constant and predictable.
 Inventory records – which relate to all raw material items,
components and sub-assemblies as well as finished goods
items.
MRP I and capacity planning
 An MRP I system does not provide for capacity planning.
 A closed loop MRP I system does have a capacity planning
feature. The system makes checks against available capacity to
establish whether the production plan is feasible, and where
there is insufficient capacity at certain times, it will re-schedule
production.
Output from an MRP I system
 The output from an MRP I system is an overall production
schedule, and in addition it produces purchase orders and works
orders.
 A significant benefit of MRP systems is that if any change is
necessary to the manufacturing schedule a new production
schedule can be prepared in a very short time, together with
new purchase orders and works orders.
 It should reduce inventory levels. Through reliable scheduling
of production requirements, it should be possible to avoid
producing items that are not required in the foreseeable future.
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CHAPTER 6
MRP I and accounting
 An MRP I system is not integrated with other related systems
within the organisation. It cannot produce a production cost
budget or a materials purchases budget.
 However, the system does provide information that can be used
by accountants.
2
–
The master production schedule provides the basis for
drawing up a production cost budget.
–
The schedule of materials purchase requirements can be
used to prepare a materials purchases budget, by applying
expected purchase prices to the quantities of purchases
required.
–
A bill of materials for each product can be used to
construct a standard cost or budgeted cost for products.
MRP II: MANUFACTURING RESOURCE PLANNING
 Manufacturing Resource Planning, or MRP II, is an extension
of MRP I to other areas of the business.
MRP II and accounting
 MRP II systems offer integration between the production
planning, inventory control and purchasing systems and the
accounting system.
 It is possible for the system to produce:
–
a production cost budget from the master production
schedule
–
a materials purchases budget
–
elements of a cash budget
–
a standard cost for each unit produced.
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57
CHAPTER 6
3
PRODUCTION SYSTEMS AND ENVIRONMENTS
ERP: ENTERPRISE RESOURCE PLANNING
 An enterprise resource system is a powerful system that
integrates information from all parts of the organisation. It is an
extension of the MRP philosophy, but provides more
integration between different parts of the organisation.
 An ERP system is expensive to acquire and install. It includes
modules for:
4
–
manufacturing: production planning and control,
materials purchasing, plant maintenance, quality
management
–
sales and distribution: sales order management, customer
management, distribution, transportation and shipping
–
accounting: accounts receivable, accounts payable,
budgeting, standard costing
–
human resources: recruitment and workforce scheduling,
payroll, training and development.
JUST IN TIME (JIT) MANAGEMENT
 Just-in-time is an approach to operations management based on
the idea that goods and services should be produced only when
they are needed.
–
It can be described as a ‘pull through’ system responding to
customer demand.
–
This contrasts with a ‘push’ system, in which items are
produced, and if there is no immediate demand, inventories
build up.
 The JIT philosophy sees inventory as a cost burden, and the
ideal inventory level is zero.
 At the same time, products (or services) must be delivered to
the customer at the time the customer wants them (‘just in
time’). To be able to do this with no inventory, the production
58
FTC FOU LKS LYNCH
PRODUCTION SYSTEMS AND ENVIRONMENTS
CHAPTER 6
cycle must be short, and there can be no hold-ups in production
due to defective items, bottlenecks or inefficiency.
–
‘Just-in-time production is a production system that is
driven by demand for finished products, whereby each
component on a production line is produced only when
needed for the next stage.’
–
‘Just-in-time purchasing is a purchasing system in which
material purchases are contracted so that the receipt and
usage of material, to the maximum extent, coincide.’
Requirements of JIT
 The operational requirements for the successful implementation
of JIT production are as follows:
–
high quality
–
speed
–
flexibility
–
lower costs.
 The most suitable conditions for applying JIT management are
where:
–
there are short set-up times and low set-up costs
–
there are short lead times and low ordering costs for buying
raw materials from suppliers
–
work flow is fairly constant over time, and customer
demand is not uneven and unpredictable
–
production throughput time is very short
–
there are no downtimes due to poor quality or stock-outs.
The JIT philosophy
 The JIT philosophy is based on:
–
continuous improvement (‘kaizen’)
–
the elimination of waste.
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PRODUCTION SYSTEMS AND ENVIRONMENTS
 Waste is defined as any activity that does not add value.
Examples of waste are:
–
overproduction
–
waiting time
–
unnecessary movement of materials or people
–
waste in the process
–
inventory is wasteful
–
complexity in work processes
–
defective goods
–
inspection time.
 A JIT production system is usually operated with a Kanban
system for stock replenishment. ‘Kanban’ is a Japanese word
for ‘signal’ and the system uses printed cards containing
specific information such as part name and description.
 The cards are used to signal a requirement to re-order inventory
or production units, and the system works on the basis that
replacement inventory or units will be delivered in a specified
short period .
5
TOTAL QUALITY MANAGEMENT (TQM)
 Total Quality Management (TQM), is a customer-focussed
approach to management that focuses on achieving high
standards of performance through quality.
 There are several inter-related aspects to TQM.
60
–
Customer focus. The aim should be to meet the needs and
expectations of customers.
–
Internal customers and internal suppliers. A TQM
approach uses the concept of the internal customers and
internal suppliers at each stage of the process chain from
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PRODUCTION SYSTEMS AND ENVIRONMENTS
CHAPTER 6
raw materials procurement to providing the end product or
service to the customer.
–
Getting things right first time.
–
Continuous improvement.
Quality costs
 Quality costs are incurred because the quality of production or a
service is not perfect. The aim of TQM is to minimise quality
costs. There are four categories of quality costs.
–
Prevention cost – incurred in advance to prevent substandard quality and defects.
–
Inspection cost – incurred after a product has been made,
to check that the output meets the required quality standard
and to identify defects.
–
Internal failure cost – arising from inadequate quality,
where the problem is identified before the product or
service is delivered to the customer.
–
External failure cost – arising from inadequate quality,
where the problem is identified after the customer has
received the product or service.
 A ‘traditional’ approach to quality management is that a
balance can be reached between the benefits of achieving a
certain quality standard and the costs of reaching this standard.
 The TQM approach in contrast is that the target should be zero
defects. The TQM view is that:
–
Prevention costs and inspection costs are controllable items
of expense, and subject to management discretion. It is
better to spend money on prevention, before failures occur,
than on inspection to detect failures.
–
Internal and external failure costs are the consequences of
management efforts to control quality through prevention
and appraisal. Giving more attention to prevention will
reduce internal failure costs.
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CHAPTER 6
–
6
PRODUCTION SYSTEMS AND ENVIRONMENTS
The TQM philosophy is also based on establishing quality
systems, which should be thoroughly documented. For
example, the ISO 9000 quality system is a set of standards
for quality management systems.
BACKFLUSH ACCOUNTING
 Backflush accounting can be applied in mature JIT systems
where:
–
the speed of throughput (or ‘velocity’ of throughput) is
high, and
–
inventories of raw materials, work-in-progress and unsold
finished goods are very low.
In these conditions, it is doubtful whether the traditional approach
to product costing is worthwhile.
 Backflush accounting offers a simplified approach to costing by
getting rid of ‘unnecessary’ costing records. Instead of building
up product costs sequentially from start to finish of production,
backflush accounting calculates product costs retrospectively, at
the end of each accounting period.
 A backflush accounting system differs from traditional cost
accounts in several ways.
62
–
There is a combined account for production materials and
work in progress called the Raw Materials and InProgress account (or RIP account).
–
All costs of production labour and overhead are therefore
combined as conversion costs.
–
The backflush costing system might use a conversion costs
account to record these costs. Alternatively, conversion
costs are charged in full as they are incurred as an expense
in the Cost of Goods Sold account.
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PRODUCTION SYSTEMS AND ENVIRONMENTS
CHAPTER 6
 During an accounting period, production costs are recorded
simply by:
– recording the cost of raw materials purchased in the RIP
account, and
– recording conversion costs incurred as a cost of goods sold.
 At the end of the accounting period, there is a physical stock
count of inventories which should be low.
 A value is then estimated for the inventory and ‘backflushed’
from the cost of goods sold account to the RIP account. Any
finished goods inventory is backflushed from the cost of goods
sold account to a finished goods account.
 This produces a figure for the actual production cost of goods
sold and for closing inventory levels.
 The advantages of using backflush accounting are:
–
–
–
It is a simple costing system.
It avoids the need to record production costs sequentially as
items move through step-by-step operations in the
production process.
When inventory levels are low or constant, it yields the
same results as traditional costing methods would.
 It is therefore appropriate in a mature JIT environment where
there is a short production cycle and low inventories.
 The disadvantages of backflush accounting are:
–
–
–
FTC FOULKS LYNCH
It is not appropriate for manufacturing environments where
inventory levels are high, due to the problems of counting
and valuing the inventory.
It is inappropriate for production systems with a long
production cycle. It is preferable to record the production
costs as the work passes sequentially through each stage of
the production system.
It provides less detailed management information than
traditional costing systems.
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CHAPTER 6
64
PRODUCTION SYSTEMS AND ENVIRONMENTS
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CHAPTER 7
STANDARD COSTS
1
DEFINITIONS
 Whenever identical operations are performed or identical
products are manufactured many times over, it should be
possible to decide in advance not merely what they are expected
to cost, but also what they ought to cost.
–
A standard is ‘a benchmark measurement of resource
usage, set in defined conditions’ (CIMA Official
Terminology).
–
A standard cost for a product or service is a
predetermined (planned) unit cost, based on a standard
specification of the resources needed to supply it and the
costs of those resources.
–
A standard price for a product or service is the expected
price for selling the standard product or service. When
there is a standard sales price and a standard cost per unit,
there is also a standard profit per unit (absorption
costing) or standard contribution per unit (marginal
costing).
 Standard costs can be prepared using either absorption costing
or standard marginal costing. A simplified standard cost card
(standard cost specification) using absorption costing for a
manufactured product might be as follows:
$
Direct materials:
Material A
Material B
FTC FOULKS LYNCH
2 litres at $3 per litre
1.5 kilos at $4 per
kilo
$
6.00
6.00
65
CHAPTER 7
STANDARD COSTS
$
Direct labour:
Grade I
Grade II
Variable production
overhead
Fixed production
overhead
Full standard
production cost
0.75 hours at $10
per hour
1.5 hours at $8 per
hour
2.25 hours at $1 per
hour
2.25 hours at $12
per hour
$
12.00
7.50
12.00
19.50
2.25
27.00
60.75
 An important concept in standard-setting and standard costing
is the standard hour. A standard hour represents the amount of
work that is achievable, at standard levels of efficiency, in one
hour.
2
THE PURPOSE OF STANDARDS AND STANDARD COSTING
 They are used to set standards of performance, which can be
used as targets for achievement. Setting standards provides a
platform for finding ways of improving efficiency and
minimising waste.
 They are used in planning. Having established the targets for
performance, these can be used to prepare plans and schedules
of resource requirements.
 They are used for monitoring actual performance. Actual
performance is compared against the standards, and differences
are reported as favourable or adverse variances. By comparing
actual performance against standard and investigating the
reason for variances, management can exercise control over
operations.
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 Standard costs can be used to set selling prices. Prices can be
decided by adding a profit margin or contribution margin to the
standard cost.
 Standard costs are also used in the costing system to measure
inventory values.

3
Standard costing has been defined as ‘a control technique that
compares standard costs and revenues with actual results to
obtain variances that are used to stimulate improved
performance’ (CIMA Official Terminology).
SETTING STANDARD COSTS IN MANUFACTURING
 Standard costs are derived by establishing a standard quantity
of materials or labour for each unit of product and a standard
price or rate for each unit of the resource.
Standards for direct materials usage and direct labour time
 Standards for direct material usage are established from
product specifications. These should be detailed; for example,
the usage standards might be specified within the bill of
materials for each product within a MRPI or MRPII system.
Whenever product specifications are altered, the standard
materials usage within the standard cost should also be
changed.
 When there is loss or wastage in production, the standard
material usage should make allowance for the expected or
normal loss.
 Example
In a process manufacturing system, normal loss is 5% of input
direct materials. To produce one unit of good output will require
1.0526 units of input (1/0.95 units), and the standard materials
usage should therefore be 1.0526 units.
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STANDARD COSTS
 Standards for direct labour time (labour efficiency) can be
established by work study. The standard time per unit which is
an average expected time, might have to allow for periodic
activities such as machine-setting, clearing up and on-line
quality inspections.
 Standards for material prices and labour rates
In setting material price standards, it will often be found that a
particular item of material is purchased from more than one
supplier, and at slightly different prices. When there are several
different suppliers for an item of material, a standard price can be
derived in any of three ways:
–
use the price charged by the major supplier
–
use the lowest of the prices charged by any of the suppliers
–
use an estimated weighted average price.
 Standard labour rates should be based on official rates of pay.
 Standard costs for overheads
In traditional standard product costing, it is assumed that
production overhead costs are related to direct labour time.
1
When variable production overhead costs are measured, it is
assumed that these costs vary in direct proportion to active
direct labour time.
2
In standard absorption costing, the standard production
overhead cost per unit is usually calculated as the standard
direct labour hours per unit multiplied by a predetermined
absorption rate per direct labour hour.
Different types of standard
 Standards are used to set targets for performance and monitor
actual results by comparing them with the standard. A problem
with setting standard costs is to decide how demanding or
challenging the standards should be.
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STANDARD COSTS
CHAPTER 7
 Any of four different approaches can be taken to standardsetting, and there are four different types of standard.
4
Basic standard
A basic standard is a standard that is
established for use over a long period of
time.
Ideal standard
An ideal standard is one that is set at an
ideal level of performance, that makes
no allowance for normal losses or
expected wastage rates and machine
down-time.
Attainable standard
‘Standards may be set at attainable
levels which assume efficient levels of
operation, but which include allowances
for normal loss, waste and machine
downtime (CIMA Official
Terminology).
Current standard
A current standard is the standard of
performance that is currently being
achieved.
CRITICISMS OF STANDARD PRODUCT COSTING
 Standard product costs are associated with traditional
manufacturing systems producing large quantities of standard
items. Standard costing in manufacturing has often been
criticised, for reasons largely connected to the fact that this type
of manufacturing environment is not as common today as it has
been in the past.
–
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Standard product costs apply to manufacturing
environments in which quantities of an identical product
are output from the production process. They are not
suitable for manufacturing environments where products
are non-standard or are customised to customer
specifications.
69
CHAPTER 7
STANDARD COSTS
–
It is doubtful whether standard costing is of much value for
performance setting and control in automated
manufacturing environments.
–
The significance of variances for management control
purposes depends on the type of standard cost used. For
example, adverse variances with an ideal standard have a
different meaning from adverse variances calculated with a
current standard.
–
Standard costing is inconsistent with the concept of
continuous improvement, which is applied within Total
Quality Management and JIT environments.
–
When standard costing was first devised, the main elements
of product costs were direct materials and direct labour. In
modern manufacturing, production overheads costs are
often a high proportion of total production costs.
5
STANDARD COSTS FOR SERVICES
 Although standard costing was originally devised for
manufacturing and product costs, it also has applications in
service industries.
 Efficiency improvements are typically achieved:
–
by replacing labour with machinery as much as possible,
and
–
by standardising the service for all customers, with no
customisation.
 This approach to service provision is well illustrated by the
concept of McDonaldization. This comes from the successes
of the fast food company. The term was defined by George
Ritzer (1996) as ‘the process by which the principles of the fastfood restaurant are coming to dominate more and more sectors
of American society, as well as the rest of the world.’
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CHAPTER 7
 Ritzer identified four dimensions to McDonaldization which are
critical to the success of the model.
–
Efficiency. This means choosing the optimum means to
achieve a given end.
–
Calculability. This means the ability to produce and obtain
large quantities of something very quickly.
–
Control. There should be effective controls over both
employees and customers.
–
Predictability. Customers (and employees) should know
exactly what they are going to get at any service point
anywhere in the world.
 Other principles on which McDonaldization is based are that:
–
When goods and services are more uniform in quality,
quality will be better.
–
Standardisation of services is less expensive than
customisation.
–
Customers like familiarity, and feel that it is safer to do
things within a controlled regime.
–
People like to be treated in the same way as everyone else.
 This approach has made McDonalds successful, and generated
huge profits.
 The relevance of standard costing to services of this nature
should be apparent. Management should be able to set accurate
standards for what is takes, in terms of materials and time, to
provide standard items to customers. This in turn means that
costs are both minimised and predictable, and with predictable
costs, it becomes possible to set prices that customers see as fair
(or even better) and still make a large profit.
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STANDARD COSTS
 Diagnostic related groups are another application of standards
in a service industry. The concept was developed in US
healthcare in the early 1980s as a means of controlling the costs
of the Medicare health service. In broad terms, patients are
placed into one of several standard categories of condition and
treatment, and the amount that Medicare will pay the hospitals
providing the treatment is based on a standard price for that
category.
 A diagnostic related group (DRG) is a category of disease or
medical condition for which diagnosis and treatment are
similar. For each DRG, a standard cost is calculated for
diagnosis and treatmentbased on estimates of the standard
consumption of hospital resources required and the expected
length of stay in hospital. This uniform cost for each DRG is
then used by Medicare and other medical insurers as the basis
for payments to the hospitals.
 Since the system sets a maximum amount that will be paid for
the care of Medicare patients, it provides an incentive to
hospital management to meet the standards and keep their costs
down.
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VARIANCE ANALYSIS
1
STANDARD COSTING VARIANCES
 Where standard costing is used, variance analysis can be an
important aspect of performance measurement and control.
 Variance reports comparing actual results with the standards or
budget are produced regularly, perhaps monthly.
Cost variances
 A hierarchy of cost variances is shown below.
Total cost variances
Direct
material
cost
variance
Price
Direct
labour cost
variance
Usage
Mix
Yield
Rate
Variable
overhead
cost variance
Efficiency
Mix
Fixed
overhead
cost
variance
Expenditure Efficiency Expenditure Volume
Yield
Notes
 This table of variances is for a standard absorption costing
system. In a standard marginal costing system, there is no fixed
overhead volume variance.

Mix and yield variances are only calculated when there is more
than one direct material in the product or more than one grade
or type of labour.
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2
VARIANCE ANALYSIS
DIRECT MATERIALS COST VARIANCES
Direct materials total cost variance
 The total cost variance for direct materials is the difference
between the actual and standard direct materials costs of the
output. It is calculated as follows:
Direct materials cost:
Actual quantity of output
$
should cost (standard)
did cost
X
Y
X–Y
Total cost variance
Direct materials price variance
 A direct materials price variance is the difference between:
–
the actual price of the direct materials purchased or used,
and
–
their standard price.
 It is calculated as follows:
Direct materials price
variance:
Quantity of materials
purchased/used
Direct material price
variance
$
should cost (standard
price)
did cost (actual
purchase cost)
X
Y
X–Y
Direct materials usage variance
 A direct materials usage variance is the difference between:
74
–
the actual quantity of direct materials used to produce the
actual output in the period, and
–
the standard quantity that should have been used to produce
the actual output.
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 It is calculated as follows:
Direct materials usage variance:
Actual output produced
should use (standard
quantity)
did use (actual quantity)
(in material quantity)
Direct material usage
variance
× Standard price per unit of material
Direct material usage
variance
3
Material
quantity
(units)
X
Y
X–Y
$P
$P × (X – Y)
DIRECT LABOUR COST VARIANCES
Direct labour total cost variance
 The total cost variance for direct labour is the difference
between the actual and standard direct labour costs of the
output produced.
 It is calculated as follows:
Direct labour cost:
Actual quantity of output
$
should cost (standard)
did cost
Total cost variance
X
Y
X–Y
This variance is favourable (F) if the actual cost is less than the
standard cost, and adverse (A) or unfavourable (U) if the actual
cost is higher than the standard cost.
Direct labour rate variance
 A direct labour rate variance is the difference between:
–
the standard rate for the hours actually worked, and
–
the actual cost of the labour.
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 It is calculated as follows:
Direct labour rate
variance:
Number of hours worked
$
should cost (standard rate)
did cost (actual cost)
X
Y
X–Y
Direct labour rate variance
Direct labour efficiency variance
 A direct labour efficiency variance is the difference between:
–
the actual direct labour hours to produce the actual output
in the period, and
–
the standard number of hours to produce the actual output.
This difference is measured first of all in labour hours and is then
converted into a money value at the standard rate per direct
labour hour.
 It is calculated as follows:
Direct labour efficiency variance:
Actual output produced
should take (standard
hours)
did use (actual hours)
Direct labour efficiency
variance
(in hours)
× Standard rate per hour
Direct labour efficiency
variance
Hours
X
Y
X–Y
$R
$R × (X – Y)
Idle time and idle time variances
 The purpose of an efficiency variance should be to measure the
efficiency of the work force in the time they are actively
engaged in making products or delivering a service. During a
period, there might be idle time.
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 When this occurs, and if it is recorded, the efficiency variance
should be separated into two parts:
–
an idle time variance
–
an efficiency variance during active working hours.
 An idle time variance is always adverse, because it represents
money ‘wasted’.
4
VARIABLE OVERHEAD COST VARIANCES
 In standard product costing, a variable production overhead
total cost variance can be calculated, and this can be analysed
into an expenditure or rate variance and an efficiency variance.
 With service costing, a variable overhead total cost variance
can be calculated, but this might not be analysed any further.
Variable production overhead total cost variance
 The total cost variance for variable production overhead is the
difference between the actual and standard direct variable
overhead costs of the output produced.
 A variable production overhead total cost variance is calculated
as follows:
Variable production overhead cost:
Actual quantity of output
should cost (standard)
did cost
Total cost variance
$
X
Y
X–Y
Variable production overhead expenditure variance
 A variable production overhead expenditure variance is the
difference between:
–
the standard variable overhead cost for the hours worked,
and
–
the actual variable overhead cost.
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 A variable production overhead expenditure variance is
calculated as follows:
Variable production overhead expenditure variance:
Number of hours worked
should cost (standard
rate)
did cost (actual cost)
$
X
Y
X–Y
Variable production overhead expenditure variance
Variable production overhead efficiency variance
 A variable production overhead efficiency variance is the
difference between:
–
the actual direct labour hours to produce the actual output
in the period, and
–
the standard number of hours to produce the actual output.
 This difference is measured first of all in labour hours and is
then converted into a money value at the standard variable
overhead rate per direct labour hour.
 A variable production overhead efficiency variance is
calculated as follows:
Variable production overhead efficiency variance:
Actual output produced
should take (standard
hours)
did use (actual hours)
Efficiency variance
Hours
X
Y
X–Y
(in hours)
× Standard variable overhead rate per hour
Variable production overhead efficiency variance
$R
$R × (X – Y)
Idle time variances and variable production overhead
 The analysis of variable production overhead variances is
affected by the existence of idle time.
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CHAPTER 8
 The variable production overhead efficiency variance is
calculated in the same way that the direct labour efficiency
variance is calculated when there is idle time.
 The variable production overhead expenditure variance, when
there is idle time, is the difference between:
5
–
the standard variable overhead cost of the active hours
worked, and
–
the actual variable overhead cost.
FIXED OVERHEAD COST VARIANCES: ABSORPTION
COSTING
Fixed production overhead: total cost variance
 The total cost variance for fixed production overhead variances
is the amount of over-absorbed or under-absorbed overhead.
The amount of overhead absorbed for each unit of output is the
standard fixed overhead cost per unit. The total cost variance is
therefore calculated as follows:
Fixed production overhead total cost variance:
Overheads absorbed
(actual output × standard
fixed cost per unit)
Actual fixed overhead incurred
Fixed production overhead total cost variance
$
X
Y
X–Y
 The fixed overhead cost per unit is based on estimates of the
budgeted fixed overhead expenditure for the period and the
volume of production. The fixed production overhead total cost
variance can be analysed into two subsidiary variances:
–
a fixed overhead expenditure variance, and
–
a fixed overhead volume variance.
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Fixed overhead expenditure variance
 A fixed overhead expenditure variance is the difference
between the budgeted fixed overhead expenditure and the
actual fixed overhead expenditure.
Fixed overhead expenditure variance:
Budgeted fixed overhead
Actual fixed overhead incurred
$
X
Y
X–Y
Fixed overhead expenditure variance
 A similar variance can be calculated (if required) for other fixed
overhead costs:
–
a fixed administration overhead expenditure variance
–
a fixed sales and distribution overhead expenditure
variance.
Fixed production overhead volume variance
 A fixed production overhead volume variance represents the
amount of fixed overhead that has been under- or over-absorbed
due to the fact that actual production volume differed from the
budgeted production volume.
Fixed production overhead volume variance:
Actual output produced
Budgeted output
Volume variance
(in units)
× Standard fixed overhead rate per unit
Fixed production overhead volume
variance
6
Units
X
Y
X–Y
$F
$F × (X – Y)
FIXED OVERHEAD VARIANCES: MARGINAL COSTING
 In marginal costing, fixed overheads are not absorbed into the
cost of production. For this reason, there is no fixed overhead
volume variance.
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 The only fixed overhead variance reported in standard marginal
costing is a fixed overhead expenditure variance. This is the
difference between actual and budgeted fixed overhead
expenditure, as described above for absorption costing.
7
SALES VARIANCES
 Sales variances explain the effect of differences between:
–
actual and standard sales prices, and
–
budgeted and actual sales volumes.
Sales price variance
 A sales price variance shows the effect on profit of the
difference between the standard sales prices for the items sold
in a period and the actual sales revenue achieved.
 It is calculated as follows:
Sales price variance
Units sold should have
sold for
Budgeted output
$
(units sold × standard sales
price per unit)
Sales price variance
X
Y
X–Y
Sales volume variance
 The sales volume variance is the difference between actual and
budgeted sales volumes. It can be measured in any of the
following ways:
–
if there is only a single product or service, as the difference
between actual and budgeted units of sale
–
as the difference in standard sales revenue between actual
and budgeted units of sale: (standard sales revenue = units
sold at their standard sales price, not their actual sales
price)
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VARIANCE ANALYSIS
–
as the difference in standard profit between actual and
budgeted sales volumes
–
as the difference in standard contribution between actual
and budgeted sales volumes.
 A sales volume variance measured either in units or standard
sales revenue has to be calculated first.
Sales volume variance
Budgeted sales volume
Actual sales volume
Sales volume variance
Units of
sale
units
X
Y
X–Y
Units of sale ×
standard sales price
$ revenue
S×X
S×Y
S × (X – Y)
(where S is the standard sales price per unit)
 A sales volume variance expressed in terms of standard profit
or standard contribution is called a sales volume margin
variance.
Sales volume profit variance (standard absorption costing)
Units of sale ×
Units of sale
standard sales price
units
$ revenue
Budgeted sales
X
S×X
volume
Actual sales volume
Y
S×Y
Sales volume
X–Y
S × (X – Y)
variance
× Standard profit
× Standard
× Standard profit/sales
profit per unit
ratio
= Sales volume profit margin variance
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CHAPTER 8
Sales volume profit variance (standard marginal costing)
Units of sale ×
Units of sale
standard sales price
Units
$ revenue
Budgeted sales
X
S×X
volume
Actual sales volume
Y
S×Y
Sales volume
X–Y
S × (X – Y)
variance
× Standard
contribution
× Standard
contribution
per unit
× Standard
contribution /sales ratio
= Sales volume contribution margin variance
8
STANDARD COSTING IN COSTING SYSTEMS
 Standard costing can be applied within cost ledger systems.
 Only cost variances are recorded in the cost ledger.
 Variances are recorded within the double entry system using
either a single cost variances account, or a separate variance
account for each type of cost variance.
 In the variance account, an adverse variance is a debit entry and
a favourable variance is a credit entry.
 The double entry is recorded as follows:
(i) materials price variance: in the stores ledger control account
(materials account)
(ii) direct labour rate variance: in the wages and salaries control
account
(iii) materials usage variance and direct labour efficiency
variance: in the WIP control account
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VARIANCE ANALYSIS
(iv) production overhead variances: in the production overhead
account.
 At the end of an accounting period, the balances on the cost
variance accounts are transferred to the income statement.
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CHAPTER 9
MIX AND YIELD VARIANCES
1
THE NATURE OF MIX AND YIELD VARIANCES
 Mix variances might be calculated when there is a mix of two
or more items, and the mix is regarded as controllable by
management.
Materials
usage
Materials
mix
Labour
efficiency
Materials
yield
Labour
mix
Labour
yield
 If the mix cannot be controlled, it is inappropriate to calculate a
mix and yield variance. Instead, a usage variance should be
calculated for each individual material or an efficiency variance
should be calculated for each individual type or grade of labour.
In other words, if the mix cannot be controlled, the usage or
efficiency variance should not be analysed into a mix and yield
variance.
The nature of a mix variance
 Measures whether the actual mix that occurred was more or less
expensive than the standard mix.
The nature of the yield variance
 Assumes that the mix of materials or labour can be controlled.
 The material usage should therefore be assessed for all the
materials combined, not for each item of material separately.
 Similarly, the labour efficiency variance should be assessed for
the labour team as a whole, not for each grade of labour
separately.
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MIX AND YIELD VARIANCES
 A yield variance is therefore an overall usage variance or
efficiency variance for all the items in the mix.
2
MATERIALS MIX AND YIELD VARIANCES
 A materials yield variance is similar to a materials usage
variance. However, instead of calculating a usage variance for
each material separately, a single yield variance is calculated
for all the materials as a whole. The yield variance is calculated
first of all in terms of units of material, and is converted into a
money value at the weighted average standard price per unit of
material.
Units of
material
Actual output produced should use (in total, for all
materials)
It did use (in total, for all materials)
Yield variance in units of material
× Weighted average standard price per unit of
material
Yield variance =
X
Y
X–Y
P
P (X – Y)
 As with the usage variance, the yield variance is favourable if
the actual quantity of materials used is less than standard, and
adverse if actual usage is more than standard.
Materials mix variance: individual basis of valuation method
 There are two ways of calculating the mix variance:
–
an individual basis of valuation method
–
an average valuation basis method.
 Both methods produce exactly the same total figure for the mix
variance. Both methods compare the actual mix of materials
with the standard mix.
–
86
The actual mix = the actual quantities of materials used (for
each material individually and in total).
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MIX AND YIELD VARIANCES
CHAPTER 9
–
The standard mix = the actual total quantity of materials
used, with the total divided between the individual
materials in the standard proportions.
–
The mix variance in units of material is the difference
between the actual mix and the standard mix. A mix
variance is calculated for each individual material in the
mix.
 Using the individual basis of valuation method:
–
a mix variance is adverse if the actual quantity of materials
used is more than the quantity in the standard mix
–
a mix variance is favourable if the actual quantity of
materials used is less than the quantity in the standard mix
–
the total of the mix variances for all the materials, in units
of material, is always 0.
 For each material individually, a mix variance is calculated at
the standard price for the material. The total mix variance is the
sum of the mix variances for the individual materials.
Material 1
Material 2
Material 3
Total mix
variance
Actual
material
usage
Standard
mix
Mix
variance
Units of
material
A
B
C
Units of
material
D
E
F
Units of
material
(A – D)
(B – E)
(C – F)
X
X
Standard
price per
unit of
material
Mix
variance
$
P1
P2
P3
P1 (A – D)
P2 (B – E)
P3 (C – F)
0
Y
Notes
(1) The total actual usage of materials and the total of the
standard mix are the same.
(2) Using the individual basis of valuation method, the total mix
variance in units of material is always 0.
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Materials mix variance: average valuation basis method
 The average valuation basis method of calculating a mix
variance reaches exactly the same total figure for the mix
variance, but using a different method.
 Using this method:
Material 1
Material 2
Material 3
–
A mix variance for an individual material is adverse if
the actual proportion of the material in the mix indicates
that the actual mix will be more expensive than the
standard mix. This means that if there is less of a cheaper
material in the actual mix than in the standard mix, the mix
variance for that material is adverse.
–
Similarly, a mix variance for an individual material is
favourable if the actual proportion of the material in the
mix indicates that the actual mix will be less expensive
than the standard mix. This means that if there is more of a
cheaper material in the actual mix than in the standard mix,
the mix variance for that material is favourable.
–
The mix variance is converted from units of material to a
money value at the difference between the standard price
for the individual material and the weighted average
standard price for all the materials in the mix.
Actual Standard
Mix
Rate
material
mix
variance
usage
Units of Units of Units of
$
material material material
A
D
(A – D) P1 – AP
B
E
(B – E) P2 – AP
C
F
(C – F) P3 – AP
X
X
Mix variance
$
(P1 – AP) (A – D)
(P2 – AP) (B – E)
(P3 – AP) (C – F)
Y
AP = the weighted average standard price of the materials in the
standard mix.
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CHAPTER 9
Mix variance is:
Rules for the mix variance in units

Actual usage more than standard mix
Adverse
usage, for a material costing more than
the weighted average cost

Actual usage less than standard mix
Favourable
usage, for a material costing more than
the weighted average cost

Actual usage more than standard mix
Favourable
usage, for a material costing less than
the weighted average cost

Actual usage less than standard mix
Adverse
usage, for a material costing less than
the weighted average cost
As a result, the total mix variance in units does not necessarily add
up to 0.
3
LABOUR MIX AND YIELD VARIANCES
 Labour mix and yield variances are calculated in the same way
as materials mix and yield variances.
 The labour mix might be controllable where a job is done by a
team of individuals with differing skills or experience.
–
The budgeted cost for the job might be based on a standard
mix of the different types of labour.
–
Management might control the composition of the team by
using a greater or lesser proportion of cheaper labour to do
the work.
–
The actual mix of labour used to do the work might
therefore differ from the standard or budgeted mix.
 A labour yield variance is sometimes called a team
productivity variance. It measures the efficiency of the team
as a whole, rather than the efficiency of each grade of labour
separately.
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 A labour mix variance is sometimes called a team
composition variance. It measures whether the actual
composition of the labour team was more or less expensive than
the standard mix.
 Example
An audit team consists of senior auditors, junior qualified auditors
and unqualified student accountants. The fee for audit work is
agreed in advance with the client, and is based on the expected
labour cost of the audit team.
The expected time required to carry out an audit for client AB
was as follows:
Grade
Senior auditor
Junior qualified
Students
Expected
hours
16
160
64
240
Rate/cost
per hour
£
280
120
50
Total cost
£
4,480
19,200
3,200
26,880
The actual time spent on the audit work was:
Grade
Senior auditor
Junior qualified
Students
Actual hours
30
190
50
270
Required:
(a) Calculate the labour yield variance.
(b) Calculate the labour mix variance, using both the individual
basis of valuation method and the average valuation basis
method.
(c) Show that the labour yield and mix variances add up to the
labour efficiency variance.
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Solution
(a) The weighted average labour rate per hour is £26,880/240
hours = £112 per hour.
Expected time, in total
Actual total time
Yield variance in hours
Hours
240
270
30
(A)
× Weighted average standard rate per hour
Labour yield variance =
£112
£3,360
(A)
(b) Labour mix variance: individual basis of valuation
method
Grade
Senior
auditor
Junior
qualified
Student
Actual
hours
hours
30
Standard mix
Mix
Standard
Mix
variance rate per
variance
hour
hours hours
£
(6.7%) 18
12 (A)
£280
3,360 (A)
190
(66.7%) 180
10 (A)
£120
1,200
(A)
50
270
(26.7%)
22 (F)
0
£50
1,100
3,460
(F)
(A)
72
270
Labour mix variance: average valuation basis method
Senior
Junior
Student
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Actual Standard
Mix
Rate
hours
mix
variance
hours
hours
hours
30
18
12 (A) £(280 – 112)
190
180
10 (A) £(120 – 112)
50
72
22 (A) £(50 – 112)
270
270
Mix variance
$
2,016
80
1,364
3,460
(A)
(A)
(A)
(A)
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MIX AND YIELD VARIANCES
(c) Reconciliation to the labour efficiency variance
Senior
hours
16
30
14 (A)
Junior
hours
160
190
30 (A)
Student
hours
64
50
14 (F)
× Rate per hour
£280
Efficiency variance = £3,920 (A)
£120
£3,600 (A)
£50
£700 (F)
Expected time
Actual time
Efficiency variance
Total labour efficiency variance = £6,820 (A). This equals the
sum of the labour yield variance (£3,360 (A)) and the labour mix
variance (£3,460 (A)).
In this type of situation, management might find the information
on mix and yield more useful for control purposes than the
efficiency variances for each grade of labour separately.
4
LIMITATIONS OF MIX VARIANCES
 Mix and yield variances can provide useful control information,
but only where the mix of materials or labour is
controllable, and where the information about total yield is
more useful than usage/efficiency variances for the individual
materials or labour grades separately.
 Using mix variances also has some other limitations.
–
It is often found that the mix and yield variances are
interdependent, and one variance cannot be assessed
without also considering the other.
–
If management is able to achieve a cheaper mix of
materials or labour, without affecting yield, the standard
becomes obsolete. The cheaper mix should become the
new standard mix.
 Control measures to improve the mix by making it cheaper are
likely to affect the quality of the output or the work done.
Analysing mix and yield variances for control purposes does
not take quality issues into consideration.
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CHAPTER 10
VARIANCE REPORTING AND BENCHMARKING
1
OPERATING STATEMENTS
 Variances should be reported to management as soon as
possible at the end of each control period. There might be a
hierarchy of control reports:
–
a top level report reconciling budgeted and actual profit
–
variance reports prepared for managers with responsible
for a particular aspect of operations.
 An operating statement is a top-level variance report,
reconciling the budgeted and actual profit for the period. A
suggested format for an operating statement is:
Operating statement (absorption costing)
for (month)
$
$
$
Budgeted profit
35,000
Sales variances
(F)
(A)
Sales price variance
1,000
Sales volume (profit) variance
2,000
3,000
Actual sales less the standard
32,000
cost of sales
Cost variances
Direct materials price
900
Direct materials usage
8,200
Direct labour rate
4,600
Direct labour efficiency
8,000
Variable production overhead
1,200
expenditure
Variable production overhead
1,500
efficiency
Fixed production overhead
2,700
expenditure
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(A)
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CHAPTER 10
VARIANCE REPORTING AND BENCHMARKING
$
Fixed production overhead
volume
Administration overhead
expenditure
Sales and distribution overh’d
expenditure
Actual profit
$
1,000
$
4,500
_____
3,000
14,300
21,300
7,000
25,000
Operating statement (marginal costing) for (month)
$
$
$
35,000
Budgeted profit
Budgeted fixed costs
80,000
115,000
Budgeted contribution
Sales variances
(F)
(A)
Sales price variance
1,000
Sales volume (contribution)
3,000
variance
4,000
Actual sales less the standard
111,000
cost of sales
Cost variances
Direct materials price
900
Direct materials usage
8,200
Direct labour rate
4,600
Direct labour efficiency
8,000
Variable production overhead
1,200
expenditure
Variable production overhead
1,500
_____
efficiency
11,600
12,800
1,200
94
(A)
(A)
(A)
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VARIANCE REPORTING AND BENCHMARKING
Actual contribution
Budgeted fixed costs
Fixed cost expenditure
variances
Fixed production overhead
expenditure
Administration overhead
expenditure
Sales and distribution overh’d
expenditure
109,800
80,000
2,700
4,500
____
3,000
2,700
7,500
Actual profit
2
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4,800
25,000
(A)
INTERPRETATION OF VARIANCES
 For control purposes, management might need to establish why
a particular variance has occurred:
–
to prevent an adverse variance continuing in the future, or
–
to repeat a favourable variance in the future, or
–
to bring actual results back on course to achieve the
budgeted targets.
 If the budget or standard is reasonable, possible operational
causes of variances are as follows:
Variance
Material price
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Possible cause

Using a different supplier, who is
either cheaper or more expensive.

An unexpected increase in the prices
charged by a supplier.

Unexpected buying costs.

Efficient or inefficient buying
procedures.

A change in material quality.
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Material usage
VARIANCE REPORTING AND BENCHMARKING



Labour rate




Labour efficiency





Overhead
variances


Sales price



96
A higher-than-expected or lower-thanexpected rate of scrap or wastage.
Better quality control.
More efficient work procedures,
resulting in better material usage rates.
Changing the materials mix.
An unexpected increase in basic rates
of pay.
Payments of bonuses, where these are
recorded as direct labour costs.
A change in the composition of the
work force, and so a change in
average rates of pay.
Taking more or less time than
expected to complete work.
Improved working methods.
Industrial action by the work force
Poor supervision.
Unexpected lost time due to
production bottlenecks and resource
shortages.
Fixed overhead expenditure adverse
variances are caused by spending in
excess of the budget.
Variable production overhead
efficiency variances: the causes are
similar to those for a direct labour
efficiency variance.
Higher-than-expected discounts
offered to customers to persuade them
to buy, or due to purchasing in bulk.
The effect of low-price offers during a
marketing campaign.
Unexpected price increases.
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VARIANCE REPORTING AND BENCHMARKING
Sales volume




CHAPTER 10
Successful or unsuccessful direct
selling efforts.
Successful or unsuccessful marketing
efforts (for example, the effects of an
advertising campaign).
Unexpected changes in customer
needs and buying habits.
Higher demand due to a cut in selling
prices, or lower demand due to an
increase in sales prices.
Possible interdependence between variances
 In many cases variances are inter-related.
 Some examples of interdependence between variances are:
–
Using cheaper materials will result in a favourable material
price variance, but using the cheaper material in production
might increase the wastage rate (adverse material usage)
and cause a fall in labour productivity (adverse labour and
variable overhead efficiency).
–
A more expensive mix of materials (adverse mix variance)
might result in higher output yields (favourable yield
variance).
–
Using more experienced labour to do the work will result
in an adverse labour rate variance, but productivity might
be higher as a result (favourable labour and variable
overhead efficiency).
–
Changing the composition of a team might result in a
cheaper labour mix (favourable mix variance) but lower
productivity (adverse yield variance).
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3
VARIANCE REPORTING AND BENCHMARKING
THE CONTROLLABILITY PRINCIPLE IN VARIANCE
REPORTING
 Controllability means the extent to which a specific manager
can control costs or revenues. This means that variances should
be reported to the managers who are in a position to control the
costs or revenues to which the variances relate.
Composite variances
 Sometimes a variance might be caused by a combination of two
factors – a composite variance. To apply the controllability
principle, the variance should be reported to each of the
managers who is in a position to control one of the factors.
4
THE SIGNIFICANCE OF VARIANCES
 In order to interpret a variance, management must carry out
some investigations, which will cost time and money.
 Variances should only be investigated if they seem to be
significant, so that it is worth trying to establish their cause with
a view to taking control action.
–
Reporting by exception – particular attention is given to
the aspects of performance that appear to be exceptionally
good or bad.
–
Cumulative variances and control charts – a method of
identifying significant variances only if the cumulative
total for the variance over several control periods exceeds a
certain limit.
 The reason for this approach is that variances each month might
fluctuate, with adverse variances in some months and
favourable variances in the next. Provided that over time, actual
results remain close to the standard, monthly variances might
be acceptable.
98
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CHAPTER 10
Control chart
Cumulative
variances
$
Favourable
Control
Limit
MONTHS
0
Control Limit
Adverse
Month
Cumulative
£2,000 (A)
£2,000 (A)
£3,000 (F)
£1,000 (F)
£5,000 (A)
£4,000 (A)
£1,000 (F)
£3,000 (A)
£6,000 (A)
£9,000 (A)
 In this example, the cause or causes of this variance will not be
investigated until the cumulative total of variances exceeds the
control limit of £8,000 adverse.
(This type of control chart might be called a cusum chart.
‘Cusum’ stands for ‘cumulative sum of the variances’.)
5
BEHAVIOURAL IMPLICATIONS OF SETTING STANDARD
COSTS
 The aims of setting standards include:
–
setting a target for performance
–
motivating the managers responsible to achieve those
targets
–
holding these managers accountable for actual performance
–
perhaps rewarding managers for good performance and
criticising them for poor performance.
 Managers and employees might respond in different ways to
standard setting.
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Standards as a target for achievement
 Individuals might respond to standards in different ways,
according to the difficulty of achieving the standard level of
performance.
–
When a standard level of performance is high, for example
an ideal standard, employees and their managers will
recognise that they cannot achieve it. Since the target is not
achievable, they might not even try to get near it.
–
When the standard of performance is not challenging (for
example, a current standard), employees and their
managers might be content simply to achieve the standard
without trying to improve their performance.
–
An attainable standard might be set that challenges
employees and their managers to improve their
performance. If this attainable standard is realistic, it might
provide a target that they try to achieve.
Standard costs and motivation
 An argument in favour of setting attainable standards is that
they can be used to motivate employees and their managers to
improve performance.
100
–
If the standard is too difficult, it could have the opposite
effect and de-motivate individuals.
–
Even if the standard is attainable, individuals will not
necessarily be motivated to achieve it. It might be
necessary to provide motivation in the form of a bonus or
other type of reward for achieving the standard.
–
Individuals might prefer standards to be set at a low level
of performance, in order to avoid the need to work harder.
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VARIANCE REPORTING AND BENCHMARKING
CHAPTER 10
Participation in standard setting
 It has been suggested that if managers and employees can
participate in the standard setting process, their motivation will
improve.
 Arguments in favour of
Arguments against participation
participation
It could motivate employees to
set higher standards for
achievement.
Senior management might be
reluctant to share
responsibilities for budgeting.
Staff are more likely to accept
standards that they have been
involved in setting.
The standard-setting process
could be time-consuming.
Morale and actual performance
levels might be improved.
Staff might want to set
standards that they are likely to
achieve, rather than more
challenging targets. They might
try to build some ‘slack’ into the
budget.
Staff will understand more
clearly what is expected of
them.
The standard setting process
could result in conflicts rather
than co-operation and
collaboration.
Staff might feel that their
suggestions have been ignored.
Pay as a motivator
 If standards are used as a way of encouraging employees to
improve their performance, motivation could be provided in the
form of higher pay (or other rewards) if targets are reached or
exceeded.
 However, if employees are offered a bonus for achieving
standard costs, this could increase their incentive to set low
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VARIANCE REPORTING AND BENCHMARKING
standards of performance, and include ‘slack’ in the standard
cost.
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Behavioural aspects of adverse variances
 It should also be remembered that individual managers might
respond in different ways to performance reports that contain
adverse variances.
 If there is a culture of ‘blame’ when adverse variances occur,
managers might try to disguise their poor results.
 The response to adverse variances needs to be more positive.
The aim of reporting adverse variances is to indicate problems
that might have occurred, and encourage managers to take
action to deal with their cause.
6
BENCHMARKING
 In addition to monitoring performance through variance
analysis, or as an alternative to variance reporting,
organisations might use benchmarking to:
–
monitor their performance, and
–
set targets for improved performance.
 Benchmarking was pioneered by Xerox Business Systems in
the late 1970s as a tactical planning tool, in response to the
challenge from rival Japanese producers of photocopier
machines.
 The reasons for benchmarking might be summarised as:
–
to receive an alarm call about the need for change
–
learning from others in order to improve performance
–
gaining a competitive edge (in the private sector)
–
improving services (in the public sector).
Different types of benchmarking
 Internal benchmarking – against other units in the
department.
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VARIANCE REPORTING AND BENCHMARKING
 Competitive benchmarking – the most successful competitors
are used as the benchmark.
 Functional benchmarking – comparisons are made with a
similar function in other organisations that are not direct
competitors.
 Strategic benchmarking – a form of competitive
benchmarking aimed at reaching decisions for strategic action
and organisational change.
 Companies in the same industry might agree to join a
collaborative benchmarking process, managed by an
independent third party such as a trade organisation.
The benchmarking process
 Identify gaps in performance through comparisons with other
organisations.
 Seek a fresh approach to achieve an improvement in
performance where significant gaps are found. This does not
necessarily mean copying what the other organisation does.




Implement the improvements.
Monitor progress.
Repeat the process.
Benchmarking should be a continual process, not a ‘one-off’
exercise.
Performance measures
 Gaps in performance are identified by comparing an
organisation’s own performance with the performance of the
organisation acting as the benchmark.
 Several measures of performance will be used. Each measure
should be a key performance measure, critical to the success of
the organisation.
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CHAPTER 10
 Performance measures can be financial or non-financial.
 Ideally performance should be quantifiable and measurable,
although qualitative assessments and comparisons might be
necessary.
 The information available for comparison will depend on
whether it has been provided voluntarily by the benchmark. Cooperative benchmarking should provide more extensive
information.
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PLANNING AND OPERATIONAL VARIANCES
1
EX ANTE AND EX POST STANDARDS
 Planning and operational variances are a method of reporting
variances where a fault in the standard or budget has been
identified retrospectively, and the original budget or standard
is considered to be inappropriate.
–
The ex ante standard (or budget) is the original standard
(or budget).
–
The ex post standard (or budget) is a realistic standard (or
budget) that is established retrospectively, as something
that should realistically have been achievable.
 Variances can then be reported using these two standards that
separate the effects on performance of:
–
getting the original standard or budget wrong (a planning
variance), and
–
variances due to operational factors (operational variances).
 Example
A business might estimate that it should take 2 hours of direct
labour to make one unit of product T33 at a rate of $8 per hour.
The standard direct labour cost is therefore $16 per unit of T33.
During the course of the accounting period, it might be recognised
that due to a change in working methods, it should require only
1.5 hours of direct labour to make one unit, and that a realistic
direct labour cost should be $12 per unit, not $16. Management
might therefore decide that variances for the period should be
reported as planning and operational variances.
–
The ex ante direct labour standard cost is 2 hours × $8 =
$16 per unit.
–
The ex post direct labour standard cost is 1.5 hours × $8 =
$12 per unit.
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CHAPTER 11
 There must be a good reason for deciding that the original
standard cost is unrealistic. Deciding in retrospect that
expected costs should be different from the standard should not
be an arbitrary decision, aimed perhaps at shifting the blame for
poor results from poor operational management to poor cost
estimation. A good reason for a change might be:
2
–
a change in one of the materials used to make a product
–
an unexpected increase in the price of materials due to a
rapid increase in world market prices
–
a change in working methods and procedures that alters the
expected direct labour time for a product or service
–
an unexpected change in the rate of pay to the work force.
OPERATIONAL VARIANCES
 Operational variances are variances that are assumed to have
occurred due to operational factors. These are materials price
and usage variances, labour rate and efficiency variances,
variable overhead efficiency variances, overhead expenditure
variances, and sales variances.
 Operational variances are calculated with the ‘realistic’ ex post
standard.
3
PLANNING VARIANCES
 A planning variance measures the difference between the
budgeted and actual profit that has been caused by errors in the
original standard cost. It is the difference between the ex ante
and the ex post standards.
 A planning variance is favourable when the ex post standard
cost is lower than the original ex ante standard cost.
 A planning variance is adverse when the ex post standard cost
is higher than the original ex ante standard cost.
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 For example, when the ex ante direct labour standard cost is 2
hours per unit and the ex post standard is 1.5 hours, the effect of
the change is to make the standard cost lower, since the
production time is shorter. The planning variance would
therefore be favourable, and actual profit should be higher than
the budgeted profit as a consequence.
 Example
The ex ante standard marginal cost of product T33 is as follows:
$
14
16
30
Direct materials: 2 kilos at $7 per kilo
Direct labour: 2 hours at $8 per hour
The standard sales price per unit is $70, giving a standard
contribution per unit of $40. Budgeted production and sales were
1,000 units.
It was subsequently recognised that due to a change in operating
procedures, the standard time to produce a unit of T33 should
have been 1.5 hours.
Actual production and sales were 1,100 units, and other actual
results were:
$
Sales revenue at $70 per unit
Direct materials: 2,200 kilos at $7.50 per kilo
Direct labour: 1,800 hours at $8 per hour
Total variable costs
Actual contribution
$
77,000
16,500
14,400
30,900
46,100
Required:
Calculate the planning and operational variances for the period.
108
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CHAPTER 11
Solution
Operational variances
These are calculated using the realistic ex post standard. The only
operational variances in this example are for materials price and
labour efficiency, since actual materials usage (2 kilos per unit)
and the actual labour rate ($8 per hour) and sales price per unit
($70) were the same as the ex post standard.
However, there is also a sales volume contribution margin
variance, and this is calculated using the original (ex ante)
standard contribution of $40 per unit.
2,200 kilos should cost (× $7)
They did cost
Materials price variance
$
15,400
16,500
1,100
1,100 units of T33 should take (× 1.5 hours)
They did take
Direct labour efficiency variance (in hours)
Standard rate per hour
Direct labour efficiency variance
Hours
1,650
1,800
150
$8
$1,200
Budgeted sales of T33
Actual sales of T33
Sales volume variance (in units)
Ex ante standard contribution per unit
Sales volume contribution variance
Units
1,000
1,100
100
$40
$4,000
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(A)
(A)
(A)
(F)
(F)
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CHAPTER 11
PLANNING AND OPERATIONAL VARIANCES
Planning variance
The planning variance is based on actual units produced.
Ex ante standard per unit
Ex post standard per unit
Planning variance per unit
Per unit
hours
2.0
1.5
0.5
(F)
Units produced
Standard rate per hour
Total planning variance
× 1,100
× $8
$4,400
(F)
The planning and operational variances together explain the difference
between the budgeted and actual contribution.
Operating statement
Budgeted contribution (1,000 units × $40)
Sales volume variance
Planning variance
Actual sales volume at ex post standard
contribution (1,100 units × $44)
Operational variances
Material price
Labour efficiency
Actual contribution
4
$
40,000
4,000
44,000
4,400
48,400
1,100
1,200
46,100
(F)
(F)
(A)
(A)
MORE THAN ONE DIFFERENCE BETWEEN THE EX ANTE AND
EX POST STANDARDS
 In these circumstances, the rules for calculating planning and
operational variances are as follows:
110
–
Operational variances are calculated using the ex post
standard.
–
The planning variance is the difference between the ex ante
and the ex post standard cost per unit, multiplied by the
number of units.
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PLANNING AND OPERATIONAL VARIANCES
–
CHAPTER 11
It might be possible to analyse the planning variance into
the amount of planning variance caused by each of the
differences between the ex post and ex ante standard.
 Example
A company budgeted to make and sell 2,000 units of its only
product, for which the standard marginal cost is:
$
8
18
26
Direct materials: 4 kilos at $2 per kilo
Direct labour: 3 hours at $6 per hour
The standard sales price is $50 per unit and the standard
contribution $24 per unit. Budgeted fixed costs were $30,000,
giving a budgeted profit of $18,000.
Due to severe material shortages, the company had to switch to a
less efficient and more expensive material, and it was decided in
retrospect that the realistic (ex post) standard direct material cost
should have been 5 kilos at $3 per kilo = $15 per unit.
Actual results were as follows:
Actual production and sales: 2,400 units
$
Sales revenue
Direct materials: 12,300 kilos at $3 per kilo
Direct labour: 7,500 hours at $6.10 per hour
Total variable costs
Actual contribution
Actual fixed costs
Actual profit
$
115,000
36,900
45,750
82,650
32,350
32,000
350
Required:
Prepare an operating statement with planning and operational
variances that reconciles the budgeted and actual profit figures.
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Solution
Operational variances
12,300 kilos should cost (× $3)
They did cost
Materials price variance
$
36,900
36,900
0
2,400 units of product should use (×5 kilos)
They did use
Direct materials usage variance (in kilos)
Kilos
12,000
12,300
300
(A)
$3
$900
(A)
$
45,000
45,750
750
(A)
Standard price per kilo (ex post)
Direct materials usage variance
7,500 hours should cost (× $6)
They did cost
Direct labour rate variance
2,400 units of product should take (× 3
hours)
They did take
Direct labour efficiency variance (in hours)
112
Hours
7,200
7,500
300
(A)
Standard rate per hour
Direct labour efficiency variance
$6
$1,800
(A)
2,400 units should sell for (× $50)
They did sell for
Sales price variance
$
120,000
115,000
5,000
(A)
Budgeted fixed costs
Actual fixed costs
Fixed cost expenditure variance
$
30,000
32,000
2,000
(A)
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CHAPTER 11
Budgeted sales
Actual sales
Sales volume variance (in units)
Units
2,000
2,400
400
(F)
Ex ante standard contribution per unit
Sales volume contribution variance
$24
$9,600
(F)
Planning variance
Material costs
Ex ante standard per unit (4 kilos × $2)
Ex post standard per unit (5 kilos × $3)
Planning variance per unit
Per unit
$
8.0
15.0
7.0
Units produced
Total planning variance
× 2,400
$16,800
(A)
(A)
The planning variance is due to changes in the standard for both the
material usage per unit of product and the material price per kilo. This
could be analysed as follows:
Planning variance due to:
Change in material usage:
1 kilo per unit × $2 per kilo × 2,400 units
Change in material price:
$1 per kilo × 4 kilos per unit × 2,400 units
Composite variance:
$1 per kilo × 1 kilo per unit × 2,400 units
Total planning variance
$
4,800
(A)
9,600
(A)
2,400
16,800
(A)
(A)
In this example, since the change in both the material usage and
material price are inter-related, the total planning variance only is
reported in the operating statement below.
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$
Budgeted profit
Budgeted fixed costs
Budgeted contribution
Sales volume contribution variance
Planning variance
Operational variances
Sales price
Materials usage
Direct labour rate
Direct labour efficiency
Actual contribution
Budgeted fixed costs
Fixed cost expenditure variance
Actual fixed costs
Actual profit
5
$
18,000
30,000
48,000
9,600
57,600
16,800
40,800
5,000
900
750
1,800
32,350
(F)
(A)
(A)
(A)
(A)
(A)
30,000
2,000 (A)
32,000
350
PLANNING AND OPERATIONAL VARIANCES AND LEDGER
ACCOUNTING
 When an organisation has cost ledger accounts with standard
costs, it will continue to use the original ex ante standard cost in
the ledger accounts. Planning and operational variances are
used for reporting and control purposes, not in the ledger
accounts.
 However, if a change in the standard cost is likely to be
permanent rather than temporary, the organisation might decide
to revise its standard cost.
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CHAPTER 11
Using planning and operational variances
 Planning and operational variances analyse the difference
between budgeted and actual results that appear to be due to:
–
planning mistakes or unforeseen changes, and
–
operational factors.
 The aim of variance reporting should be to:
–
identify responsibilities for performance, and
–
attempt to put a realistic value to the costs or benefits
arising from that performance.
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CHAPTER 12
THE BUDGETING FRAMEWORK
1
REASONS FOR FORECASTING AND PLANNING BY
ORGANISATIONS
 A forecast is an estimate of what is expected to happen in the
future.
–
It can be either qualitative or quantitative.
–
It could be either financial or non-financial in nature, or a
combination.
–
Forecasts can be short-term, medium-term or long-term.
Forecasts over the short term should be more reliable than
longer-term predictions.
 Organisations need to prepare forecasts in order to:
–
look to the future, and
–
assess what they must do to meet the future challenges or
opportunities they face.
If any problems are foreseen, they can take measures in advance
to deal with them.
Forecasts provide a basis for planning.
The reasons for planning
 A plan is a chosen course of action, decided in advance.
–
A plan might be based on forecasts for the future.
–
The purpose of a plan should be to achieve an objective or
several objectives.
–
As a result of the action plan, the forecasts might be
changed.
 When a plan is decided, the current forecasts and the planned
outcome should be the same. Subsequently, however, forecasts
might be revised and differ from the planned outcome.
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CHAPTER 12
 Planning is a formalised process, and the main reasons why
organisations plan are to:
2
–
establish objectives
–
set targets for meeting these objectives over time
–
communicate the objectives and targets
–
establish how the targets should be achieved
–
co-ordinate the efforts of everyone in the organisation, to
work towards the common objectives, over the short,
medium and long term
–
assess what resources will be required to achieve the
targets and ensure that these should be available
–
give authority to managers within the organisation to take
certain actions
–
monitor progress towards objectives, by comparing actual
results against the plan
–
measure performance standards, by comparing them with
the plan.
BUDGETING AND THE PURPOSES OF BUDGETING
 A budget can be defined as a written statement of
management plans for a specified time period, expressed in
financial terms. The budget period is typically the financial
year of the organisation. (Longer-term budgets are prepared for
capital expenditure, but are usually reviewed and revised
annually.)
 The purposes of budgets are:
–
FTC FOULKS LYNCH
Planning. A budget is a medium-term plan, setting targets
for achievement over the financial period. Management use
budgets to quantify the amount of resources that will be
needed and check that they expect the resources to be
available.
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CHAPTER 12
3
THE BUDGETING FRAMEWORK
–
Communication. A budget is a formal written document
that can be communicated to everyone involved in putting
the plan into practice. Individual managers are told what is
expected of them and how much they are able to spend to
meet their targets.
–
Co-ordination. A budget provides a means of coordinating the efforts of everyone within the organisation,
because individual targets are set within the framework of
the plan for the organisation as a whole.
–
Motivation. It could be argued that budgeting can motivate
individuals, by setting challenging targets and offering the
prospect of rewards for achieving them.
–
Authorisation. When a budget is agreed, the managers of
responsibility centres should be authorised to spend the
money and obtain the resources permitted by the budget.
–
Control. A budget can be used for control purposes.
–
Evaluation. Budgets can be used to measure and evaluate
performance, by comparing actual results with the budget
targets.
FUNCTIONAL BUDGETS AND THE MASTER BUDGET
 A master budget for the entire organisation brings together the
departmental or activity budgets for all the departments or
responsibility centres within the organisation.
 Most start with:
118
–
Sales budget – future sales, expressed in revenue terms
and possibly also in units of sale.
–
Production budget – follows on from the sales budget,
since production quantities are determined by sales
volume. The production volume will differ from sales
volume by the amount of any planned increase or decrease
in inventory.
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THE BUDGETING FRAMEWORK
CHAPTER 12
 In order to express the production budget in financial terms
(production cost), subsidiary budgets must be prepared for
materials, labour and production overheads.
 These stages in budgeting are illustrated in the following
diagram.
Budget preparation
SALES BUDGET
Step 1
Step 2
Step 3
PRODUCTION BUDGET
RAW MATERIALS
LABOUR
FACTORY OVERHEAD
COST OF GOODS SOLD
BUDGET
Step 4
SELLING AND
DISTRIBUTION EXPENSES
BUDGET
GENERAL AND
ADMINISTRATION
EXPENSES BUDGET
MASTER
BUDGET
Step 5
BUDGETED INCOME
STATEMENT
Step 6
CASH BUDGET
Step 7
BUDGETED BALANCE
SHEET
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CAPTIAL EXPENDITURE
BUDGET
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Principal budget factor
 It is usually assumed in budgeting that sales demand will be the
key factor setting a limit to what the organisation can expect to
achieve in the budget period. H however, there might be a
shortage of a key resource, such as cash, raw material supplies,
skilled labour or equipment. If a resource is in restricted supply,
and the shortage cannot be overcome, the budget for the period
should be determined by how to make the best use of this key
budget resource.
 When a key resource is in short supply and affects the planning
decisions, it is known as the principal budget factor or
limiting budget factor.
Other budgets
 The budgets illustrated above relate to profitability and the
balance sheet. Other budgets are:
4
–
A cash budget is a plan of cash flows during the budget
period. Cash management is a critical area of financial
management.
–
A capital expenditure budget is a plan for spending on
capital items over a planning horizon of several years, and
which is reviewed and updated annually.
RESPONSIBILITY ACCOUNTING
 A master budget is built up from the budgets of different
departments or operating groups within the organisation. For
example:
120
–
a total sales budget brings together the sales budget for
each sales area or region, or for each product or service
–
a total production budget brings together the production
budget for each production centre or department, as well as
for each product
–
overhead budgets bring together the planned spending
budgets for many different departments or activities.
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THE BUDGETING FRAMEWORK
CHAPTER 12
Budget centres and responsibility accounting
 It is usual in budgeting to apply the principles of responsibility
accounting where a manager is given the responsibility for a
particular aspect of the budget, and within the budgetary control
system and is then made accountable for actual performance.
 The area of operations for which a manager is responsible
might be called a responsibility centre. Within an
organisation, there could be a hierarchy of responsibility
centres.
–
If a manager is responsible for a particular aspect of
operating costs, the responsibility centre is a cost centre.
–
If a manager is responsible for revenue as well as costs, the
responsibility centre is a profit centre.
 There could be several cost centres within a profit centre, with
the cost centre managers responsible for the costs of their
particular area of operations, and the profit centre manager
responsible for the profitability of the entire operation.
–
If a manager is responsible for investment decisions as well
as for revenues and costs, the responsibility centre is an
investment centre. There could be several profit centres
within an investment centre.
 Each cost centre, profit centre and investment centre should
have its own budget, and its manager should receive regular
budgetary control information relating to the centre, for control
and performance measurement purposes.
Responsibility accounting and controllable costs
 If the principle of controllability is applied, a manager should
be made responsible and accountable only for the costs (and
revenues) that he or she is in a position to control. A
controllable cost is a cost ‘which can be influenced by its
budget holder’. Controllable costs are generally assumed to be:
–
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variable costs, and
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CHAPTER 12
–
THE BUDGETING FRAMEWORK
directly attributable fixed costs. These are fixed costs that
can be allocated in full as a cost of the centre.
 It is important to make managers responsible and accountable
for costs they can control. Without accountability, managers do
not have the incentive to control costs and manage their
resources efficiently and effectively.
The controllability of costs
 A common assumption in management accounting is that
controllable costs consist of variable costs and directly
attributable fixed costs. Uncontrollable costs are costs that
cannot be influenced up or down by management action.
 This assumption should be used with caution.
–
Some items treated as variable costs cannot be influenced
or controlled in the short term. Direct labour costs are
treated as a variable cost, but in reality, the direct labour
work force is usually paid a fixed wage for a minimum
number of working hours each week. Without making
some employees redundant the direct labour cost cannot be
reduced in the short term because it is really a fixed cost
item.
–
An item that is uncontrollable for one manager could be
controllable by another.
–
In the long term, all costs are controllable. At senior
management level, control should be exercised over longterm costs as well as costs in the short term.
 A useful distinction can be made between:
122
–
committed fixed costs, which are costs that are
uncontrollable in the short term, but are controllable over
the longer term, and
–
discretionary fixed costs, which are costs treated as fixed
cost items that can nevertheless be controlled in the short
term, because spending is subject to management
discretion.
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THE BUDGETING FRAMEWORK
5
CHAPTER 12
KEY METRICS IN THE BUDGET
 An organisation should have certain targets for achievement.
Targets can be expressed in terms of key metrics. A budget
should not be approved by senior management unless budgeted
performance is satisfactory, as measured by the key metrics.
Actual performance should then be assessed in comparison with
the targets.
 The term ‘key performance indicators’ might be used.
 Key areas of financial performance are:
–
profitability
–
liquidity
–
asset turnover.
 A key metric for profitability might be:
–
the profit/sales ratio (profit margin), or
–
contribution/sales ratio (contribution margin).
Liquidity
 A key metric for liquidity might therefore be:
–
the current ratio (which is the ratio of current assets to
current liabilities), or
–
the quick ratio or acid test ratio (which is the ratio of
current assets excluding inventories to current liabilities).
 A low liquidity ratio could indicate poor liquidity and a risk of
cash flow difficulties. The appropriate minimum value for a
liquidity ratio varies from one industry to another, because the
characteristics of cash flows vary between different industries.
 On the other hand, a business can have excessive liquidity, with
too much capital tied up in working capital.
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Asset turnover
 Asset turnover is a measure of productivity in the use of assets.
When asset turnover is fast, a business is making efficient use
of its assets. Turnover can be measured in relation to any
category of assets, such as:
Non-current asset turnover, which is measured as:
Sales revenue in the period
Non-current assets
Total asset turnover, which is measured as:
Sales in the period
Net assets
Net assets = Net non-current assets + (Current assets – Current
liabilities)
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THE BUDGETING FRAMEWORK
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CHAPTER 12
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ALTERNATIVE APPROACHES TO BUDGETING
1
INCREMENTAL BUDGETING
 Incremental budgeting is a method of budgeting that starts with
the current year’s budget and ‘builds’ on this to produce the
budget for next year.
 Fairly small changes are made to the current year’s budget.
 A check is then made to ensure that the budget produced in this
way meets the performance targets of the organisation.
 There a several criticisms of incremental budgeting.
–
The main disadvantage is that it assumes that all current
activities should be continued at the current level of
operations and with the same allocation of resources.
–
It is backward-looking in nature, since next year’s budget
is based on what has been expected in the past. In a
dynamic and rapidly-changing business environment, this
approach to planning is inappropriate.
–
It is often seen as a desk-bound planning process, driven by
the accounts department.
–
The performance targets in the budget are often
unchallenging, based on past performance.
–
When there are excessive costs in the budget for the current
year, these will be continued in the future.
 There are some advantages of incremental budgeting.
–
It is a simple, low-cost budgeting system.
–
If the business is fairly stable, the budgets produced by this
method might be sufficient for management needs.
–
There are some items of cost where an incremental
budgeting approach is probably the most practical, for
example telephone expenses.
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CHAPTER 13
2
ALTERNATIVE APPROACHES TO BUDGETING
ZERO-BASED BUDGETING (ZBB)
 In ZBB, all activities and costs are budgeted from scratch (a
zero base).
 The starting point for preparing a zero-based budget is to
develop a decision package for each activity.
 A decision package is a document that:
–
analyses the cost of the activity (costs may be built up from
a zero base, but costing information can be obtained from
historical records or last year’s budget)
–
states the purpose of the activity
–
identifies alternative methods of achieving the same
purpose
–
assesses the consequence of not doing the activity at all, or
performing the activity at a different level
–
establishes measures of performance for the activity.
 In this way, each decision package can be evaluated. They
should then be ranked in order of priority, based on the costbenefit analysis.
–
Individual managers of responsibility centres must rank the
activities for which they are responsible.
–
Senior managers will then rank the activities of the various
responsibility centre managers reporting to them.
 The final stage in ZBB is to decide which activities should be
approved for the budget, and resources should be allocated
accordingly. The decision is based on the priorities that have
been established for the decision packages.
Benefits of ZBB
 It helps to create an organisational environment where change
is accepted.
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CHAPTER 13
 It helps management to focus on company objectives and goals.
It moves budgeting away from number-crunching, towards
analysis and decision-making.
 It focuses on the future rather than on the past.
 It helps to identify inefficient operations and wasteful spending,
which can be eliminated.
 Establishing priorities for activities provides a framework for
the optimum utilisation of resources.
 It establishes a measure of performance for each decision
package.
 It involves managers in the budgeting process.
Disadvantages of ZBB
 It is a time-consuming exercise. It is unlikely that an
organisation will have the time to carry out a ZBB exercise
every year.
 There is a temptation to concentrate on short-term cost savings
at the expense of longer-term benefits.
 It might not be useful for budgeting for production activities or
service provision, where costs and efficiency levels should be
well-controlled, so that budgets can be prepared from forecasts
of activity volume and unit costs.
 It might require skills from management that the management
team does not possess.
 The ranking process can be difficult, since widely-differing
activities cannot be compared on quantitative measures alone
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3
ALTERNATIVE APPROACHES TO BUDGETING
ACTIVITY-BASED BUDGETING (ABB)
 ABB is defined as: ‘a method of budgeting based on an activity
framework and utilising cost driver data in the budget-setting
and variance feedback processes’ (CIMA Official
Terminology).
 The key elements to this definition are:
–
budgets are for activities rather than departments
–
budgeted costs for each activity are estimated using the
cost driver or cost drivers for that activity
–
actual results are monitored
–
by comparing the actual and budgeted costs for each
activity.
 Whereas ZBB is based on budgets (decision packages) prepared
by responsibility centre managers, ABB is based on budgeting
for activities.
 The basic approach of ABB is to budget the costs for each cost
pool or activity.
(1) The cost driver for each activity is identified. A forecast is
made of the number of units of the cost driver that will
occur in the budget period.
(2) Given the estimate of the activity level for the cost driver,
the activity cost is estimated. Where appropriate, a cost per
unit of activity is calculated.
ABB activity matrix
 An activity-based budget can be constructed by preparing an
activity matrix. This identifies the activities in each column,
and the resources required to carry out the activities in each
row.
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CHAPTER 13
Advantages of activity-based budgeting
 The advantages of ABB are similar to those provided by
activity-based costing.
 It draws attention to the costs of ‘overhead activities’. This can
be important where overhead costs are a large proportion of
total operating costs.
 It provides information for the control of activity costs, by
assuming that they are variable, at least in the longer term.
 It provides a useful basis for monitoring and controlling
overhead costs.
 It also provides useful control information by emphasising that
activity costs might be controllable if the activity volume can
be controlled.
 ABB can provide useful information for a total quality
management programme, by relating the cost of an activity to
the level of service provided.
4
ROLLING BUDGETS (CONTINUOUS BUDGETS)
 A rolling budget is ‘a budget continuously updated by adding a
further accounting period (month or quarter) when the earliest
accounting period has expired’ (CIMA Official Terminology).
Rolling budgets are also called continuous budgets.
 Rolling budgets are for a fixed period, but this need not be a
full financial year.
 The reason for preparing rolling budgets is to deal with the
problem of uncertainty in the budget, when greater accuracy
and reliability are required.
 A common example is cash budgeting.
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ALTERNATIVE APPROACHES TO BUDGETING
Advantages and disadvantages of rolling budgets
5
Advantages
Disadvantages

They reduce uncertainty in
budgeting.

Preparing new budgets
regularly is timeconsuming.

They can be used for cash
management.

It can be difficult to
communicate frequent
budget changes.

They force managers to look
ahead continuously.

When conditions are subject
to change, comparing actual
results with a rolling budget
is more realistic than
comparing actual results
with a fixed annual budget.
‘WHAT IF’ SCENARIOS
 A budget is based on a large number of assumptions about what
is likely to happen in the future. For example:
–
Sales budgets might be based on forecasts of sales,
assuming favourable market conditions, no significant
activity by competitors, no significant change in customer
demand and given a budgeted amount of spending on
advertising and marketing.
 ‘What if’ analysis looks at what the budgeted results would be
if certain assumptions or values in the budget were different.
Risk and risk analysis
 Risk refers to the probability that actual results might turn out
different from expected results, for reasons outside
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ALTERNATIVE APPROACHES TO BUDGETING
CHAPTER 13
management control. Risk can be assessed and evaluated in
terms of:
–
what is the probability of a particular ‘outcome’, and
–
what will be the effect on profitability and cash flow if the
outcome does occur.
 Risk can be assessed and evaluated within the budgeting
process, using computer modelling such as spreadsheets for
preparing the budget.
Budgeting for different outcomes
 One approach to the problem of risk and uncertainty is to
prepare several budgets, each based on a different set of
assumptions about future conditions.
 One scenario is selected as the master budget, but if conditions
turn out different from those assumed in the budget,
management can switch to using one of the other scenario
models as its revised budget.
 Scenario planning also helps management to evaluate risk when
the budgets are being prepared, and consider what might be
done to keep the risk within acceptable limits.
Sensitivity analysis
 Another approach to ‘what if’ budgeting, using a computer
model, is to alter one or more of the assumptions or ‘variables’
in the budget, and prepare a revised budget on the basis of the
new assumptions. This is sensitivity analysis, which can be
described as an analysis of the effect on output results of
changes in one or more key variables.
 With a spreadsheet model or other budget model, each ‘what if’
question can be evaluated easily and quickly, simply by altering
the value of the relevant variable in the model.
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ALTERNATIVE APPROACHES TO BUDGETING
 Example
A company makes and sells two products, X and Y, for which the
budgeted sales price and variable costs per unit are:
Variable cost
Sales price
Product X
$2
$5
Product Y
$4
$8
Budgeted fixed costs are $140,000. Budgeted sales are 30,000
units of Product X and 15,000 units of Product Y.
Required:
(a) Calculate the budgeted profit.
(b) Calculate how profit would be affected in each of the
following separate circumstances:
(i) if the variable cost of Product Y were 25% higher than
expected
(ii) if sales of Product X were 10% less than budgeted
(iii) if sales of Product X were 5% less than budgeted and
unit variable costs of X were 10% higher than
budgeted
(iv) if total sales revenue is the same as in the original
budget, but the sales mix (by revenue) is 50% of
Product X and 50% of Product Y.
Solution
The original budget and ‘what if’ budgets can be constructed
quickly using a marginal costing approach.
Budgeted sales
Variable costs
Contribution
Fixed costs
Budgeted profit
134
Product X
$
150,000
60,000
90,000
Product Y
$
120,000
60,000
60,000
Total
$
270,000
120,000
150,000
140,000
10,000
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ALTERNATIVE APPROACHES TO BUDGETING
CHAPTER 13
(b) (i)
Budgeted sales
Variable costs
Contribution
Fixed costs
Budgeted loss
Product
X
$
150,000
60,000
90,000
(+ 25%)
Product
Y
$
120,000
75,000
45,000
Total
$
270,000
135,000
135,000
140,000
(5,000)
(ii)
Budgeted sales
Variable costs
Contribution
Fixed costs
Budgeted profit
(- 10%)
(- 10%)
Product
X
$
135,000
54,000
81,000
Product
Y
$
120,000
60,000
60,000
Product
X
28,500
$
142,500
62,700
79,800
Product
Y
15,000
$
120,000
60,000
60,000
Total
$
255,000
114,000
141,000
140,000
1,000
(iii)
Sales units
Budgeted sales
Variable costs
Contribution
Fixed costs
Budgeted loss
FTC FOULKS LYNCH
(at $5)
(at $2.20)
Total
$
262,500
122,700
139,800
140,000
(200)
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ALTERNATIVE APPROACHES TO BUDGETING
(iv)
Sales units
Budgeted sales
Variable costs
Contribution
Fixed costs
Budgeted profit
136
Product
Product Total
X
Y
(135,000/5) 27,000 (135,000/8) 16,875
$
$
$
(50%) 135,000
(50%) 135,000 270,000
(at $2)
54,000
(at $4)
67,500 121,500
81,000
67,500 148,500
140,000
8,500
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CHAPTER 14
BUDGETARY CONTROL
1
BUDGETS FOR CONTROL
 Defined as ‘the establishment of budgets relating the
responsibilities of executives to the requirements of a policy,
and the continuous comparison of actual with budgeted results,
either to secure by individual action the objectives of that
policy or to provide a basis for its revision’ (CIMA Official
Terminology).
 In other words, budgetary control involves:
–
setting targets or performance standards for individuals
(budget holders)
–
comparing actual performance against the budget
–
expecting the budget holder to use this information to take
action where necessary to make sure that the budget is
achieved
–
where necessary, changing the budget targets or
performance standards.
 Budgetary control is based on a feedback control system.
2
FEEDBACK CONTROL
 Feedback control is defined as ‘the measurement of differences
between planned outputs and actual outputs achieved, and the
modification of subsequent action and/or plans to achieve
future required results’ (CIMA Official Terminology).
 Within the context of a business:
–
the business is a system
–
the system receives inputs (resources, such as cash, labour,
materials and equipment)
–
the system uses the inputs to produce outputs (products,
services)
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CHAPTER 14
BUDGETARY CONTROL
–
some of the outputs of the system are measured (costs,
revenues, and so on)
–
this measured information is reported back to management
as feedback
–
management use the information, by comparing it with a
plan or objective to decide whether control action is
required
–
where control action is appropriate, management alter the
inputs to the system, to affect the future outputs.
 A feedback control system is illustrated in the following
diagram:
Plan/budget
Controller
Inputs
Feedback
System
Outputs
 Corrective action that brings actual performance closer to the
target or plan is called negative feedback.
 Corrective action that increases the difference between actual
performance and the target or plan is called positive feedback.
3
FEED-FORWARD CONTROL
 Feed-forward control information is an alternative approach to
control using feedback.
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BUDGETARY CONTROL
CHAPTER 14
 Whereas feedback is based on a comparison of historical actual
results with the budget for the period to date, feed-forward
looks ahead and compares:
–
the target or objectives for the period, and
–
what actual results are now forecast.
 Feed-forward control is defined as ‘the forecasting of
differences between actual and planned outcomes and the
implementation of actions before the event, to prevent such
differences’ (CIMA Official Terminology).
4
FIXED AND FLEXIBLE BUDGETS
 A fixed budget is a budget prepared for a planned level of
activity. The master budget of an organisation could be
described as a fixed budget, based on a given level of activity
and sales.
 A flexible budget is a budget that can be adjusted to allow for
changes in the volume of activity. Within a flexible budget, a
distinction is made between fixed and variable costs.
Flexible budgets and variance analysis
 Budgetary control using flexed budgets is a form of feedback
control system.
–
In many respects, it is similar to standard costing variance
reporting, although the level of detail in variance reports
might be less with flexible budgets.
–
Actual results should be compared with a flexible budget
based on the same volume of activity and sales.
–
Although it is possible to prepare flexible budgets based on
absorption costing, it is more sensible to produce flexible
budgets using marginal costing principles.
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BUDGETARY CONTROL
 Example
A software company has the following annual budget:
$
Sales
Materials
Labour costs
Other expenses
Budgeted profit
$
480,000
48,000
200,000
180,000
428,000
52,000
–
Sales are expected to be a constant amount each month.
–
Material costs vary with sales.
–
30% of labour costs are variable with sales, and the rest are
fixed costs.
–
Other expenses are part-fixed and part-variable. Variable
expenses are 10% of sales.
At the end of month 6, the following report is prepared for the six
months to date:
Budgeted and actual results for the first six months
Original
Actual
Difference
budget
results
$
$
$
Sales
240,000
200,000
40,000
Materials
24,000
16,000
8,000
Labour costs
100,000
94,000
6,000
Other expenses
90,000
89,000
1,000
214,000
199,000
15,000
Profit
26,000
1,000
25,000
(A)
(F)
(F)
(F)
(F)
(A)
This comparison of actual results with a fixed budget does not
provide useful control information. A more useful control report
would be prepared by comparing actual results with a flexible
budget.
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BUDGETARY CONTROL
Sales
Materials
Labour costs
(see W1)
Other expenses
(see W2)
Profit
CHAPTER 14
Original
budget
$
240,000
Flexible
budget
$
200,000
24,000
100,000
20,000
95,000
16,000
94,000
4,000(F)
1,000(F)
90,000
86,000
89,000
3,000(A)
201,000 199,000
(1,000)
1,000
2,000(F)
214,000
26,000
Actual Difference
results
$
$
200,000
Workings for the flexible budget:
(W1) Labour costs:
Budgeted labour costs, original budget
Budgeted variable costs (30%)
Budgeted fixed costs
Fixed cost budget for the first six months (× 6/12)
Flexible budget variable costs (60,000/480,000 ×
$200,000)
Total labour costs in the flexed budget
$
200,000
60,000
140,000
$
70,000
25,000
95,000
(W2) Other expenses
Budgeted other expenses, original budget
Budgeted variable costs (10% of $480,000)
Budgeted fixed costs
Fixed cost budget for the first six months (× 6/12)
Flexible budget variable costs (10% × $200,000)
Total labour costs in the flexed budget
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$
180,000
48,000
132,000
$
66,000
20,000
86,000
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BUDGETARY CONTROL
Reconciling budgeted and actual profit: sales variance
 In order to reconcile the budgeted profit for a period with the
actual profit or loss, a sales volume margin variance has to be
calculated. If the flexible budget is prepared using marginal
costing, the sales volume variance should be a contribution
margin variance.
 In the example above, the budgeted contribution margin should
be calculated as a budgeted contribution/sales ratio:
$
$
Sales
480,000
Materials (all variable)
48,000
Variable labour costs
60,000
Variable other expenses
48,000
Budgeted variable costs
156,000
Budgeted contribution
324,000
Budgeted contribution/sales ratio = (324,000/480,000) = 0.675 or
67.5%.
The sales volume contribution margin variance is calculated in
the same way as a sales volume margin variance in standard
costing:
$
Budgeted sales for the 6 months
240,000
Actual sales for the 6 months
200,000
Sales volume variance (revenue)
40,000 (A)
Budgeted contribution/sales ratio
67.5%
Sales volume contribution variance
$27,000
(A)
There is no sales price variance, because there is no standard sales
price.
Reconciling budgeted and actual profit: operating statement
 An operating statement can be used to present the reconciliation
of budgeted and actual profit. This is similar to an operating
statement with standard costing variances, although the
variances might be presented as total cost variances, rather than
calculated in further detail.
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CHAPTER 14
 For the example above, the operating statement might be:
Budgeted profit for the 6 months
Variances
Sales volume contribution
Materials costs
Labour costs
Other expenses costs
Actual profit
$
26,000
(F)
$
4,000
1,000
____
5,000
(A)
$
27,000
3,000
30,000
25,000 (A)
1,000
Comparing variance analysis with flexible budgets and standard
costs
 There are similarities between variance analysis with flexible
budgets and standard costs. Both approaches to variance
analysis compare the actual costs for a given volume of activity
with the expected costs for that volume of activity. The
differences are cost variances.
 The differences between the two approaches are as follows.
–
With standard costing, all products (or all services) are
valued at standard cost. With flexible output is costed using
normal costing methods.
–
With standard costing, all products or services have a
standard sales price. With flexible budgeting, standard
selling prices are unlikely to be used. Unless there are
standard sales prices, there can be no sales price variance.
–
With standard costing, there is a standard profit or standard
cost for every unit of product or service. With flexible
budgeting, a sales volume margin variance is calculated by
assuming that all sales should earn the same
contribution/sales ratio (or profit/sales ratio). The sales
volume margin variance is therefore the difference between
budgeted and actual sales, multiplied by the budgeted
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BUDGETARY CONTROL
contribution/sales ratio (or profit/sales ratio, if absorption
costing is used for the flexible budget).
–
5
With standard costing, variable costs are analysed into
material usage quantity and price per material unit, or
labour hours and cost per labour hour. With flexible
budgeting, there is unlikely to be an analysis of costs in
such detail. Reported cost variances are therefore likely to
be total cost variances.
OVERHEAD COST VARIANCES AND FLEXIBLE BUDGETS
 When a budget is prepared, overhead costs might be analysed
into fixed overheads and variable overheads. However, when
actual costs are recorded, it might be impossible to separate
actual fixed overhead costs from actual variable overhead costs.
 A total overhead cost variance can be calculated by comparing:
–
total actual overhead costs, with
–
a flexible budget consisting of budgeted fixed overheads
and the expected variable overheads for the actual volume
of activity.
Overhead costs and the high-low method of cost estimation
 There are various techniques for estimating fixed and variable
overhead costs for a flexible budget. You will be expected to
know the high-low method, and how it might be used for
variance analysis with flexible budgeting.
 The high-low method is a technique for analysing a total cost
into its fixed cost and variable cost components.
 The analysis is based on historical cost records, for total costs
in different time periods and the volume of activity associated
with those costs.
144
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CHAPTER 14
 The high-low analysis takes just two of these historical cost
records: the highest volume of activity in any of the periods and
its associated cost, and the lowest volume of activity in any of
the periods and its associated cost.
 The variable cost per unit of activity is found by taking the
difference between the high activity and the low activity. Since
fixed costs are the same at both volumes of activity, the
difference between the two costs must consist of variable costs
only.
 Taking the difference between the high and the low therefore
gives a variable cost for a given number of units of activity
(high volume units minus low volume units), from which a
variable cost per unit is calculated.
The value of performance evaluation with fixed and flexed budget
reports
 Provided that an estimate can be made of fixed and variable
costs, it is possible to compare actual results for a period with
expected results (a flexible budget) and to reconcile the original
expected profit with the actual profit or loss.
 This can provide useful information for control purposes, but
the quality of the control information is lower than for standard
costing variances:
–
The cost variances are usually total cost variances for
materials, labour and other costs, without a further analysis
into price and usage variances or rate and efficiency
variances. Total cost variances do not give any indication
of the reason for the variance.
–
Estimates of expected fixed and variable costs for flexible
budgeting are probably subject to a greater estimation error
than with standard costing (where expected costs are
prepared in greater detail).
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CHAPTER 15
BUDGETING: BEHAVIOURAL ASPECTS AND
CRITICISMS
1
INTRODUCTION: BUDGETS AND HUMAN BEHAVIOUR
 The aims of budgeting are to:
–
set objectives and targets for the business
–
communicate these objectives and targets
–
co-ordinate the activities of different parts of the
organisation
–
plan for the future
–
motivate individuals to set challenging targets and then
achieve them
–
allocate resources and authorise spending
–
provide a system for control
–
measure and evaluate performance.
 Individuals react to the demands of budgeting and budgetary
control in different ways, and their behaviour can damage the
budgeting process.
2
PROBLEMS WITH BUDGET OBJECTIVES AND TARGETS
 A criticism of budgeting is that the objectives and targets that
are set for the organisation:
–
are short-term in outlook and ignore the longer term
–
focus on financial targets to the exclusion of non-financial
issues.
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3
BUDGETING: BEHAVIOURAL ASPECTS AND CRITICISMS
TOP-DOWN AND BOTTOM-UP BUDGETING
 Budgeting is a planning system for the entire organisation, and
the management style within the organisation will be evident in
the way the budget is prepared. Two extreme styles of
budgeting are top-down and bottom-up.
–
Top-down budgeting is ‘a budget allowance which is set
without permitting the ultimate budget holder to have the
opportunity to participate in the budgeting process’ (CIMA
Official Terminology).
–
Bottom-up budgeting is ‘a budgeting system in which all
budget holders are given the opportunity to participate in
setting their own budgets’ (CIMA Official Terminology).
 Between these two extremes is the negotiated budget.
Advantages of bottom-up
budgeting
 Budgets should be
realistic. They are
formulated by budget
holders who are familiar
with the area of
operations.


148
Participation in setting
budgets should motivate
budget holders and
encourage them to raise
targets.
They should increase the
acceptance and
commitment of budget
holders to the
organisation’s objectives.
Disadvantages of bottom-up
budgeting
 There could be problems
with co-ordinating the
planning process. Budget
holders might be concerned
about their particular area of
responsibility, rather than
about the objectives of the
organisation.
 The concerns of budget
holders might differ from
those of senior
management.

Senior management is
responsible for setting and
achieving targets for the
organisation.
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




4
CHAPTER 15
The knowledge that is
spread across the
management of the
organisation can be
brought together in the
planning process.
The communication
between managers within
the organisation should
improve as they discuss
the budget.
Budget holders should be
motivated to achieve
targets that they have
helped to set.

Bottom-up planning is more
time-consuming than topdown planning.

Changes to the budget
decided by senior
management might cause
resentment.

Participation in budgeting
helps to avoid a split
between senior and junior
management.
Participation in decisionmaking leads to greater
job satisfaction and a
lessening of job-related
tensions and stress.

Unless budget holders are
motivated to improve
performance, they might
build ‘slack’ into their
budget allowance.
Many budget holders might
be poor at budgeting,
especially if they lack
financial knowledge.
Some individuals react
better to an imposed budget.

MANAGEMENT POLITICS AND BUDGETING
 Top-down budgeting can give senior management an
opportunity to impose their ideas.
 With top-down budgeting, senior management can impose
targets for achievement on budget holders/responsibility centre
managers.
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 Budget holders might see the budgeting process as a
competition with other budget holders to obtain a share of the
spending budget. Budgeting is therefore:
–
an opportunity for ‘empire-building’ and trying to obtain a
larger share of the money and resources in the budget, or
–
trying to avoid cuts in authorised spending.
 Budget holders might take a ‘use it or lose it’ approach to
spending.
Goal congruence
 Barriers to goal congruence are:
5
–
The managers of responsibility centres will focus on
achieving a good performance for their particular area of
responsibility.
–
Sometimes, improving performance in one area can result
in poor performance somewhere else.
–
This behavioural problem in budgeting and budgetary
control is probably unavoidable. Individual managers will
focus on their own performance and results.
BUDGET SLACK
 Budget slack is a deliberate over-estimation of expenditure
and/or under-estimation of revenues in the budgeting process.
 The following are possible reasons for the creation of budget
slack:
150
–
Where budget holders are rewarded for keeping spending
within the budget limit, or achieving budgeted sales targets,
slack in the budget can help them to achieve their target
and earn their rewards.
–
Slack in the budget provides some ‘insurance’ against the
risk of results not going according to plan.
–
Slack in the budget takes away the pressure to ‘perform’.
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6
CHAPTER 15
BUDGETS AND PERFORMANCE EVALUATION
 The extent to which managers are judged on their success in
meeting financial targets in the budget might affect their
attitudes and behaviour.
 Research was carried out by Hopwood (1973) into the
manufacturing division of a US steelworks. Hopwood identified
three distinct styles of using budgetary information to evaluate
management performance.
–
Budget constrained style – Here, the main emphasis in
performance evaluation is the manager’s success in
meeting budget targets in the short term, with no
consideration for other aspects of performance that are not
targeted in the budget.
–
Profit conscious style – The performance of a manager is
measured in terms of his ability to increase the overall
effectiveness of his area of responsibility, in relation to
meeting the longer term objectives of the organisation.
–
Non-accounting style – With this style, performance
evaluation is not based on budgetary information, and
accounting information plays a relatively unimportant role.
 Hopwood’s research suggested that each style of performance
evaluation had the following behavioural effects.
–
With the budget constrained style, much attention was
given to costs and there was a high degree of job-related
pressure and tension. This often led to the manipulation of
data in accounting reports.
–
With the profit-conscious style, there was still a high
involvement with costs but less job-related pressure.
Consequently, there was less manipulation of accounting
data. Relationships between managers and their colleagues
and superiors were also better than with a budgetconstrained style.
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CHAPTER 15
–
BUDGETING: BEHAVIOURAL ASPECTS AND CRITICISMS
With the non-accounting style, the results were very
similar to the profit conscious style, except for a much
lower concern with cost information.
 Hopwood found some evidence that better managerial
performance was achieved where a profit conscious or nonaccounting style was in use.
 Subsequent studies by Otley (1978) involving profit centre
managers in the UK coal mining industry contradicted
Hopwood's findings showing a closer link between the budgetconstrained style and good performance. The manager
evaluated on a rather tight budget-constrained basis tended to
meet the budget more closely than if it was evaluated in a less
rigid way.
7
NON-FINANCIAL PERFORMANCE INDICATORS (NFPIS)
 If a company focuses entirely on the aim of maximising shortterm (budgeted) profits, it will probably damage its longer-term
prospects for:
–
sustained profit growth, and
–
shareholder wealth maximisation.
 The longer-term objective of a company should be shareholder
wealth maximisation, but in order to achieve this financial
objective, management should give attention to a range of nonfinancial issues as well as to profitability.
 If a business is to thrive, it must produce the goods or services
that customers want, at a price they are willing to pay, to a
quality standard they expect and on time. Factors such as
innovation, efficiency and customer satisfaction are nonfinancial issues that have to be recognised as essential
ingredients of longer-term success.
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CHAPTER 15
 Tom Peters, the American management guru, recommended
that targets should be set and monitored for a wide range of
non-financial performance indicators, such as:
–
–
–
–
–
–
–
the percentage number of customer orders processed on the
same day the order is received
the percentage number of customer orders processed
without error
the number of new products launched per period
the number of ideas taken from competitors in each period
the number of customer complaints
the number of product defects
suppliers’ product quality.
 Non-financial factors are the causes of success.
 Profit is the consequence or effect of success.
 For example, customer satisfaction is a major cause of success,
whereas profits simply measure the effects of the success that
has been achieved.
8
THE BALANCED SCORECARD
 In the 1990s, Kaplan and Norton recommended a balanced
scorecard approach to setting performance targets, using both
non-financial as well as financial targets.
 The approach focuses on four different aspects of performance,
and management must address a key question for each.
Aspect of performance
Key question
Customer perspective
What do customers want
from us?
Internal business perspective
What processes must we
excel at to achieve our
objectives?
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Innovation and learning perspective How can we learn and
improve and create value?
Financial perspective
How do we create value for
our shareholders?
 The main monthly performance report should then be a
balanced scorecard report, not a traditional budgetary control
report.
 The targets for each perspective in the balanced scorecard
should be quantifiable and measurable, so that actual
performance can be compared with the target.
 Examples of possible targets are as follows:
Financial perspective
Customer perspective
Internal business
perspective
Innovation and
learning perspective
Economic value added (EVA)
Profit target
Operating cash flow target
Cost reduction target
Target for new customers
Percentage of orders met within x days
Market share target
Percentage of tenders accepted by
customers
Percentage of items produced that have to
be re-worked
Production cycle time
Number of new products launched
Target for employee productivity
Percentage of total revenue coming from
new products
Possible problem with a balanced scorecard approach
 Kaplan and Norton argued in favour of a balanced scorecard
approach over traditional budgeting that:
–
154
accounting figures are unreliable and are easily
manipulated
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BUDGETING: BEHAVIOURAL ASPECTS AND CRITICISMS
–
CHAPTER 15
changes in the business and market environment do not
show up in the financial results of a company until much
later.
 There is a risk, however, that when performance targets are
selected for each of the four perspectives:
–
The targets for the different perspectives could be
contradictory and inconsistent with each other.
–
Non-financial performance targets could become an end in
themselves, rather than a means towards the overall
financial objective of maximising shareholder wealth.
–
Setting targets and measures are a guide to achieving the
key financial objective, and are not themselves the main
objective.
–
A problem with the balanced scorecard approach in
practice is that the targets for each item on the balanced
scorecard might be seen as key objectives in their own
right.
 Instead of supporting the main financial objective, balanced
scorecard targets can become a part of a political process for
promoting the competing interests of each stakeholder group.
9
BEYOND BUDGETING
 The argument for abolishing budgets, referred to as ‘beyond
budgeting’, was put forward by Hope and Fraser (Management
Accounting December 1997). The basis of their argument was
as follows.
–
To compete in the information age, companies must go
beyond budgeting.
–
Many companies have most of their value in intellectual
assets, such as ‘know-how’. Maximising the value of these
assets will do more for shareholder value than maximising
the value of tangible assets.
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BUDGETING: BEHAVIOURAL ASPECTS AND CRITICISMS
–
In the information age, the business environment is
constantly changing. Front-line managers are expected to
act like entrepreneurs, strategists and decision-makers.
–
The budgeting system is too rigid. It acts as a barrier to
change because managers are expected to conform to
budget.
–
Planning should be based on maximising value, using
techniques and philosophies such as Total Quality
Management, Business Process Re-engineering,
decentralisation, empowerment of employees and a
balanced scorecard.
 Their criticisms of budgeting are:
–
Budgets are a commitment. They therefore act as a
constraint on doing anything different.
–
Traditional budgets are seen as a mechanism for topdown control by senior management.
–
Traditional budgets restrict flexibility because individuals
feel they are expected to achieve the budget targets. This is
a deterrent to continual improvement .
–
Budgeting reinforces the barriers between departments,
instead of encouraging a sharing of knowledge across the
organisation.
–
Budgets are bureaucratic, internally-focused and timeconsuming.
Planning and control ‘beyond budgeting’
 Hope and Fraser referred to examples of companies in
Scandinavia that had successfully gone ‘beyond budgeting’.
The features of an appropriate system of planning and control
might be as follows.
–
156
Managers should prepare rolling plans. However, the
purpose of these plans should be for cash forecasting, not
cost control.
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CHAPTER 15
–
These forecasts should be revised more frequently if
necessary.
–
Performance measures to senior management should
not be based on actual versus budget, but on:
(1) achieving strategic milestones, and
(2) using relative measures of performance, for example
by comparing actual results against a benchmark.
(3) The emphasis should be on adding value, rather than
managing costs down.
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CHAPTER 16
FORECASTING TECHNIQUES: TIME SERIES AND
LINEAR REGRESSION
1
FORECASTS IN BUDGETING
 Budgets are based on forecasts. Forecasts might be prepared
for:
–
the volume of output and sales
–
sales revenue (sales volume and sales prices)
–
costs
using a number of forecasting models, methods or techniques.
2
TIME SERIES ANALYSIS
 A time series is a set of observations or measures taken at
equal time intervals.
 Examples of time series might include the following:
–
annual overhead costs over a number of years
–
daily production output over a month.
 A time series can be drawn as a graph, with the horizontal axis
representing time.
 A graph of a time series showing quarterly production figures is
shown below.
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REGRESSION
Production
Production
(Tonnes)
130
120
110
100
90
1
2
20X2
3
4
1
2
20X3
3
4
1
2
20X4
3
4
1
2
3
4 Quarter/Year
20X5
Forecasting with time series analysis
 Time series analysis is a term used to describe techniques for
analysing a time series, in order to:
160
–
identify whether there is any underlying historical trend
and if there is, measure it
–
use this analysis of the historical trend to forecast the trend
into the future
–
identify whether there are any seasonal variations around
the trend, and if there is measure them
–
apply estimated seasonal variations to a trend line forecast
in order to prepare a forecast season by season.
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FORECASTING TECHNIQUES: TIME SERIES AND LINEAR
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CHAPTER 16
Additive model
 Using time series analysis and an additive model, the value of
the item being measured can therefore be stated as:
Time series value = Trend line value +/- Seasonal variation +/Random variation.
 For forecasting purposes, the random variations are ignored.
Forecast value = Trend line value +/- Seasonal variation
Multiplicative model
 Using time series analysis and a multiplicative model, the
value of the item being measured can therefore be stated as:
Time series value = Trend line value × Seasonal variation ×
Random variation.
 For forecasting purposes, the random variations are ignored.
Forecast value = Trend line value × Seasonal variation
3
MEASURING THE TREND LINE: MOVING AVERAGES
 A trend line can be estimated from a historical time series and
used to prepare a forecast. The underlying assumptions are:
–
there has been a trend in the past
–
this trend is identifiable and measurable, and
–
the trend will continue at the same rate into the future over
the full planning period.
 There are several methods of measuring a trend line from a time
series. These include:
–
moving averages, and
–
linear regression analysis.
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The moving average time period
 Where there is a regular cycle of time periods, it would make
sense to calculate the moving averages over a full cycle.
4
MEASURING SEASONAL VARIATIONS
 The technique for measuring seasonal variations differs
between an additive model and a multiplicative model. The
additive model method is described here.
 Seasonal variations can be estimated by comparing an actual
time series with the trend line values calculated from the time
series.
 For each ‘season’ the seasonal variation is the difference
between the trend line value and the actual historical value for
the same period.
 A seasonal variation can be calculated for each period in the
trend line.
 An average variation for each season is calculated.
 The sum of the seasonal variations has to be 0 in the additive
model. If they do not add up to zero, the seasonal variations
should be adjusted so that they do add up to zero.
 The seasonal variations calculated in this way can be used in
forecasting, by adding the seasonal variation to the trend line
forecast if the seasonal variation is positive, or subtracting it
from the trend line if it is negative.
Seasonal variations: multiplicative model
 When a multiplicative model is used to estimate seasonal
variations, the seasonal variation for each period is calculated
by expressing the actual sales for the period as a percentage
value of the moving average figure for the same period.
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CHAPTER 16
 In time series analysis with seasonal variations:
5
–
the trend line value might be referred to as the deseasonalised value
–
the forecast is therefore the de-seasonalised value adjusted
to allow for the seasonal variation.
STRENGTHS AND WEAKNESSES OF FORECASTING WITH
TIME SERIES ANALYSIS
 The advantages of forecasting using time series analysis are
that:
–
forecasts are based on clearly-understood assumptions
–
trend lines can be reviewed after each successive time
period, when the most recent historical data is added to the
analysis
–
forecasting accuracy can possibly be improved with
experience.
 The disadvantages of forecasting with time series analysis are
that:
–
there is an assumption that what has happened in the past is
a reliable guide to the future
–
there is an assumption that a straight-line trend exists
–
there is an assumption that seasonal variations are constant,
either in actual values using the additive model or as a
proportion of the trend line value using the multiplicative
model.
 None of these assumptions might be valid.
 However, the reliability of a forecasting method can be
established over time.
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6
FORECASTING TECHNIQUES: TIME SERIES AND LINEAR
REGRESSION
LINEAR REGRESSION ANALYSIS
 Linear regression analysis is a statistical technique for
identifying a ‘line of best fit’ from a set of data.
 If it is assumed that there is a linear relationship between two
‘variables’, the technique can be used to quantify this
relationship using historical data. The relationship is expressed
in the form:
y = a + bx
where
y is the value of the dependent variable
x is the value of the independent variable
a and b are values obtained from a statistical analysis of historical
data for values of x and y.
 This is the equation for a straight line, which can be shown in
graphical form as follows. This is a graph for y = a + bx.
y
7
6
5
4
3
2
1
x
0
164
1
2
3
4
5
6
7
8
9
10
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CHAPTER 16
Examples of linear relationships for budgeting
 Linear regression analysis can be used to make forecasts or
estimates whenever a linear relationship is assumed between
two variables, and historical data is available for analysis.
 Two such relationships are:
–
–
A time series and trend line. Linear regression analysis is
an alternative to calculating moving averages to establish a
trend line from a time series.

The independent variable (x) in a time series is time.

The dependent variable (y) is sales, production volume
or cost, etc.
Total costs, where costs consist of a combination of
fixed costs and variable costs. Linear regression analysis
is an alternative to using the high-low method of cost
behaviour analysis. It should be more accurate than the
high-low method, because it is based on more items of
historical data.

The independent variable (x) in total cost analysis is
the volume of activity.

The dependent variable (y) is total cost.

The value of a is the amount of fixed costs

The value of b is the variable cost per unit of activity.
 When a linear relationship is identified and quantified using
linear regression analysis, values for a and b are obtained, and
these can be used to make a forecast for the budget.
Least squares linear regression
 To calculate the line of best fit, the following formulae may be
used. These will be provided on a formula sheet in your
examination. You do not need to know how the formulae are
derived, only how to apply them to historical data.
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FORECASTING TECHNIQUES: TIME SERIES AND LINEAR
REGRESSION
=
y  bx
y bx

n
n
=
n  xy -  x  y
b
=
n  x 2 ( x) 2
 Example
The management accountant of Artful has obtained the following
historical data of monthly costs of order processing. Total costs
are assumed to vary with the number of orders processed.
Month
Orders processed
March
April
May
June
100
120
140
July
110
70
Total costs
$000
144
163
176
157
115
Required:
Use least squares regression analysis to estimate the fixed and
variable costs of order processing.
Solution
The first step in a solution is to obtain all the values needed to
calculate the value of b.
A table should be prepared with columns containing the historical
data for orders processed (x values) and associated costs (y
values).
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Additional columns should be included, one for  x² and one for
xy.
Orders
processed
X
100
120
140
110
70
540
Total costs
$000
y
144
163
176
157
x²
10,000
14,400
19,600
12,100
xy
14,400
19,560
24,640
17,270
115
755
4,900
61,000
8,050
83,920
These working give the values needed to calculate b.
–
n is 5, the number of pairs of data used
–
x is the sum of the values in the x column, which is 540.
–
y is the sum of the values in the y column, which is 755.
–
x² is the sum of the values in the x² column, which is
61,000.
–
xy is the sum of the values in the xy column, which is
83,920.
Putting these values into the formula for b:
b=
=
B=
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5 (83,920) – (540)(755)
5 (61,000) – (540)²
419,600 – 407,700
305,000 – 291,600
11,900/13,400 = 0.888.
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REGRESSION
This value for b can now be used to calculate the value of a.
y = the average of the values for y
x = the average of the values for x
a=
–
755
5
0.888 ×
540
5
a = 151 – 0.888 (108)
= 151 – 95.9
= 55.1
The line of best fit is:
y (in $000) = 55.1 + 0.888x
y = 55,100 + 888x.
 The alternative formula for calculating b is:
b=
Covariance (xy)
Variance (x)
To find these values, we need to:
–
Calculate x and y , i.e. the average values for x and y in
the data.
–
Calculate the difference between each value for x in the
data and x , to obtain (x – x ), and calculate the difference
between each value for y in the data and y , to obtain (y –
y ).
–
168
Variance (x) is found by squaring the values for (x – x ),
and finding the total of these values.
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–
CHAPTER 16
Covariance (xy) is found by multiplying each value for (x –
x with the corresponding value for (y – y ), and finding the
total.
7
STRENGTHS AND WEAKNESSES OF LINEAR REGRESSION
ANALYSIS
 Linear regression analysis is a technique for establishing a line
of best fit, using available historical data. It is based on
assumptions.
–
There is a linear relationship between the two variables
represented by x and y.
–
This relationship in the future can be predicted from the
relationship in the past.
Interpolation and extrapolation
 A line of best fit might be calculated using regression analysis,
and this might then be used to predict a value between the two
extreme values (the high and the low values) that were used to
calculate the line. This is known as interpolation.
 As a general rule, forecasts based on interpolation are more
reliable than extrapolations.
Adjusting forecasts for inflation
 The accuracy of forecasting is affected by the need to adjust
historical data and future forecasts to allow for price or cost
inflation.
Correlation
 An advantage of linear regression analysis is that it is possible
to calculate the strength of the connection (or correlation)
between the two variables. The stronger the connection, the
more reliable the line of best fit should be for forecasting.
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 The strength of the connection can be measured by a
correlation coefficient, r.
r=
n  xy -  x  y
2
(n  x  ( x) 2 )(n  y 2  ( y) 2 )
 You might be expected to understand correlation and the
significance of the correlation coefficient r.
 The value of r must lie between –1 and + 1.
 The closer the value of r to + 1 or – 1, the greater is the
correlation and the more reliable the line of best fit.
Coefficient of determination, r²
 The degree of correlation between x and y can be measured in
even more detail using the coefficient of determination r²,
which is the correlation coefficient squared.
 The value of r² indicates the proportion of the variations in the
value of the dependent variable y that can be ‘explained by’
variations in the value of the independent variable x.
8
EXPECTED VALUES
 Forecasts might have to consider risk and uncertainty.
170
–
Risk arises out of the situation that is being forecast. Future
events might not be certain. However, it might be possible
to predict the likelihood that each possible outcome will
occur.
–
Uncertainty arises from a lack of reliable information. The
future cannot be predicted because there is not enough
information to make a confident forecast.
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 When a forecast or budget is prepared under conditions of risk
or uncertainty, the forecaster might use probability estimates
of different possible outcomes.
 An expected value is a weighted average value of expected
outcomes.
Strengths and weaknesses of forecasting with expected values
 The main advantage of forecasting with expected values is
that it is a useful method of deriving an expected average. If
the probability estimates are reliable, the expected value should
be a reliable average measure of future outcomes.
 The potential disadvantages of forecasting with expected
values are that:
–
the probability estimates might be unreliable, especially
when they are determined by judgement rather than an
objective mathematical analysis
–
an expected value does not have a practical meaning when
it is used to forecast a ‘one-off’ outcome.
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CHAPTER 17
COST CENTRES, PROFIT CENTRES AND INVESTMENT
CENTRES
1
RESPONSIBILITY CENTRES AND ORGANISATION
STRUCTURE
 A cost centre is a unit of an organisation where the manager
responsible for the centre is made accountable for the costs of
the centre.
 A revenue centre is a unit of the organisation where the
manager responsible for the centre is accountable for the sales
revenue earned by the centre.
 A profit centre is a unit of the organisation where the manager
responsible for the centre is made accountable for the
profitability of the centre’s operations.
 An investment centre is a unit of the organisation where the
manager responsible for the centre is responsible for both the
profit of the centre and its profitability in relation to the capital
invested.
 Responsibility centres provide a system for:
–
measuring performance
–
motivating centre managers to improve performance
–
control over performance by comparing actual results
against budget or targets.
Measures of performance for responsibility centres
 The main measures of performance are:
–
cost control for cost centres
–
total revenue for revenue centres
–
profit for profit centres, and
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–
COST CENTRES, PROFIT CENTRES AND INVESTMENT
CENTRES
return on capital employed or something similar for
investment centres.
Responsibility centres and the effect of decentralisation
 Decentralisation has both advantages and disadvantages.
2
–
The main benefit of decentralisation is that it gives the
management of responsibility centres the authority to use
their initiative and make their own decisions.
–
The main problem with decentralisation is that ‘local’
managers will inevitably give priority to the performance
of their own centre, even if an improvement in their own
performance causes a worse performance in another centre.
The interests of the organisation as a whole are
subordinated to the interests of the responsibility centre.
COST CENTRE REPORTING
 For cost centres performance reporting should recognise both
the variability of costs and the controllability of costs.
 Variability of costs. Costs should be analysed into their fixed
and variable cost elements, and the expected costs for a period
should be based on a flexed budget.
 Controllability of costs. Cost centres might be charged with an
apportioned share of central overhead costs, but for control
purposes, a distinction should be kept between costs that the
centre manager should be in a position to influence and costs
that the manager cannot influence.
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 A cost centre report might therefore be presented as follows:
Variable costs:
Materials
Other costs
Controllable fixed
costs:
Labour
Other
Apportioned central
costs
Total costs
3
Expected
costs
(flexed
budget)
$
Actual
costs
Variance
$
$
50,000
15,000
65,000
54,600
12,600
67,200
4,600
2,400
2,200
(A)
(F)
(A)
64,000
45,000
109,000
60,000
53,000
113,000
4,000
8,000
4,000
(F)
(A)
(A)
35,000
34,000
1,000
(F)
209,000
214,200
5,200
(A)
PROFIT CENTRE REPORTING
 The profitability of profit centres and investment centres should
be reported in a way that identifies the ‘contribution’ to profit
from the centre in each reporting period. The principles of
marginal costing should be applied to derive a figure for
contribution. Controllable fixed costs or attributable fixed costs
should then be deducted from contribution to obtain a figure for
profit attributable to the profit centre.
 A share of central overhead costs might then be charged to the
centre, to obtain a net profit figure.
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COST CENTRES, PROFIT CENTRES AND INVESTMENT
CENTRES
 Actual profit might be reported as follows.
$
Sales
Variable costs:
Materials
Other variable costs
Total variable costs
Contribution
Controllable fixed costs:
Labour
Other fixed costs
Controllable profit
Apportioned central costs
Net profit
4
$
250,000
54,600
12,600
67,200
182,800
60,000
53,000
113,000
69,800
34,000
35,800
PERFORMANCE MEASURES FOR INVESTMENT CENTRES
 The profitability of investment centres should be measured in
the same way as for profit centres. However, the overall
performance of an investment centre, where the centre manager
has responsibility for capital expenditure decisions should take
into consideration both profits and the amount of capital
employed.
 A range of performance measures have been developed for
investment centres:
176
–
return on investment (ROI)
–
residual income, and
–
economic value added or EVA®.
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5
CHAPTER 17
RETURN ON INVESTMENT (ROI)
 The return on investment (ROI) for an investment centre is
similar to the return on capital employed (ROCE) for an
organisation as a whole. It is calculated for a particular period
as follows:
ROI
=
P rofitbeforeinterestand tax
 100
Operationsmanagementcapitalemployed
 Profit before interest and tax is the reported profit of the
investment centre. However, the distinction between
controllable profit and net profit might be applied, and return on
investment could be measured using either or both controllable
profit and net profit before interest.
 Operations management capital employed is the capital
employed for which the centre manager is responsible and
accountable.

Non-current assets might be valued at cost, net
replacement cost or net book value.

The value of assets employed could be either an average
value for the period as whole or a value as at the end of
the period. An average value for the period is preferable.
Secondary performance ratios
 ROI, like ROCE, can be analysed further into the secondary
ratios: profit margin and asset turnover.
ROI
=
Divisional profit
Divisional sales
×
Divisional sales
Divisional capital
employed
ROI
=
Profit margin
×
Asset turnover
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COST CENTRES, PROFIT CENTRES AND INVESTMENT
CENTRES
Advantages of using ROI
 It is an easily-understood measure that focuses on both profit
and capital employed.
 It can be used to compare the performance of two investment
centres of different sizes.
 It provides an incentive to management to increase profits and
also to reduce or keep under control the amount of capital
employed.
Disadvantages of using ROI
 When assets are valued at net book value, reported performance
improves with time.
 Since ROI improves as non-current assets get older, there is a
disincentive to invest in new assets.
 If an investment centre manager takes investment decisions on
the basis of short-term ROI, he will be reluctant to make any
new capital investment where the first-year ROI is lower than
the current annual ROI for the rest of the investment centre.
 It is difficult to assess the significance of ROI.
 With ROI, there is scope to manipulate the value of profit and
capital employed.
6
RESIDUAL INCOME
 The biggest criticism of ROI as a measure of divisional
performance is that it discourages new investment. Residual
income (RI) is an alternative measure of investment centre
performance.
 Residual income is a measure of the profitability of an
investment centre after deducting a notional interest cost for the
cost of the capital invested in the division.
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Residual income = Accounting profit – Notional interest on
capital
Advantages of residual income
 Compared to using ROI as a measure of performance, residual
income has several advantages.
 It encourages investment centre managers to make new
investments if they add to residual income. A new investment
might add to residual income but reduce ROI. In such a
situation, measuring performance by residual income would
persuade an investment centre manager to invest, when using
ROI would make him reluctant to invest. Residual income can
therefore help to reduce the potential problem of underinvesting.
 Making a specific charge for interest helps to make investment
centre managers more aware of the cost of the assets under their
control.
 The notional interest charge might be a reasonably good
measure of the economic cost of the capital employed in the
investment centre.
Disadvantages of residual income
 As a measure of investment centre performance, residual
income shares many of the weaknesses of ROI.
 It is based on accounting measures of profit and capital
employed.
 New investments should not be evaluated using accounting
measures of performance, because they are unreliable.
 It encourages investment centre managers to think in the short-
term, about how to increase next year’s residual income for the
investment centre.
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7
COST CENTRES, PROFIT CENTRES AND INVESTMENT
CENTRES
ECONOMIC VALUE ADDED (EVA®)
 The basic concept of EVA is that the performance of a
company as a whole, or of investment centres within a
company, should be measured in terms of the value that has
been added to the business during the period.
 EVA attempts to measure the true economic profit that has been
earned.
 It is a measure of performance that is directly linked to the
creation of shareholder wealth.
 The measurement of EVA is simple – to add to its economic
value, a business must make an economic profit in excess of the
cost of the capital that has been invested to earn that profit.
 Economic profit is defined as NOPAT – the net operating profit
after tax.

The cost of the capital employed is the economic value of the
business assets multiplied by the business cost of capital = (cost
of funding, both debt capital and share capital).
EVA = NOPAT minus Capital charge
Capital charge = Economic value of business assets × Cost of
capital (%).
Comparing EVA and residual income
 The major difference between EVA and residual income is that:
180

residual income is calculated using accounting profit and
an accounting value for capital employed

EVA is calculated using an estimated value for economic
profit and an estimated economic value of capital
employed.
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CHAPTER 17
 Economic profit and economic value of capital employed are
estimated by making adjustments to accounting profit and
accounting capital employed.
The principle underlying EVA
 The principle underlying EVA can be stated as follows.

The objective of a company is to maximise shareholder
wealth.
 The value of a company depends on the extent to which
shareholders expect future economic profits to exceed the
cost of the capital invested.
 A share price therefore depends on expectations of EVA.
 Current performance (EVA) is reflected in the current
share price, so in order to increase the share price a
company must achieve a sustained increase in EVA.
Measuring EVA
 The difficulties in applying EVA in practice arise from the
problem of establishing the economic profit in a period, and the
economic value of capital employed.
Adjustments to calculate NOPAT
 To calculate NOPAT from accounting profit, the following
adjustments might be made:
Accounting profit after depreciation and amortisation
+ Adjustment for economic depreciation
+ Any goodwill amortised
+ Any increase ( – any decrease) in the provision for doubtful
debts
+ Any increase in net capitalised development costs
+ Implied interest expense on operating leases
– Cash payments for tax on operating profits
= NOPAT
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COST CENTRES, PROFIT CENTRES AND INVESTMENT
CENTRES
Adjustments to calculate the economic value of capital employed
 To calculate the economic value of capital employed from the
accounting value of capital employed, the following
adjustments might be made:
Total assets (non-current assets + current assets) in the
balance sheet
– Non-interest-bearing liabilities, such as trade payables and
tax payable
+ Adjustments to allow for the net replacement cost of
tangible non-current assets
+ Cumulative amortised goodwill
+ Economic value (= net book value) of capitalised
development costs
+ Economic value (= net book value) of capitalised operating
leases
+ Provision for doubtful debts
= Capital invested
Cost of capital
 The cost of capital used in the EVA computation should reflect
the weighted average cost of the company’s share capital and
debt capital, including short-term interest-bearing debt such as
bank overdrafts.
Using EVA
 Economic value added can be used to:
182

set targets for performance for investment centres
(divisions) and the company as a whole

measure actual performance

plan and make decisions on the basis of how the decision
will affect EVA.
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CHAPTER 17
 When EVA is used to measure performance divisional
managers should be:

given training to understand the principles of
EVAinformed about the interest cost that will be applied
for the capital charge

taught how to calculate EVA for decision-making purposes

given a pay incentive based on a bonus for achieving or
exceeding a target EVA.
 EVA can also be used for control purposes, by encouraging
managers to:

identify products and services that provide the greatest
EVA, and concentrate resources on them

identify customers who provide the greatest EVA, and give
priority to serving them

identify and eliminate activities that do not add to EVA

identify capital that is not providing a sufficient return to
cover its capital cost and seek to reduce the capital
investment.
Advantages of EVA
 It is a performance measure that attempts to put a figure to the
increase (or decrease) that should have arisen during a period
from the operations of a company or individual divisions within
a company.
 Like accounting return and residual income, it can be measured
for each financial reporting period.
 It is easily understood by non-accountants.
 It is based on economic profit and economic values of assets,
not accounting profits and asset values.
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8
COST CENTRES, PROFIT CENTRES AND INVESTMENT
CENTRES
OTHER PERFORMANCE INDICATORS
 The main measures of performance for cost centres, revenue
centres, profit centres and investment centres are financial
measures, relating to costs, revenues, profits or returns on
capital.
 However, performance might also be measured in other ways,
using non-financial indicators or monetary measures related to
efficiency.
 The basic principles for establishing non-financial
performance indicators are that:
184

there should be key targets for achievement

the performance metric should be suitable for assessing the
success or failure in achieving the key target

the metric selected should be easily measurable, so that
actual performance can be compared against target.
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CHAPTER 18
TRANSFER PRICING
1
DECENTRALISATION AND PROFIT CENTRES AND
INVESTMENT CENTRES
 The purposes of decentralisation are to:

give autonomy to local centre managers in decision-making

to motivate centre managers to improve performance

through performance enhancement at a profit centre level,
to achieve better results for the organisation as a whole.
 Decentralisation can create tension between local centre
managers and head office management.

The performance of the managers of profit centres and
investment centres will be assessed, and the managers
themselves will be rewarded, on the basis of the results of
their particular centre. Profit centre managers will therefore
be motivated to optimise the results of their own division,
regardless of other profit centres and regardless of the
organisation as a whole.

When head office management believe that a profit centre
manager is taking decisions that improve the profit centre
performance, but are damaging for the interests of the
organisation as a whole, they might want to step in and
either:
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
alter the decisions that have been made at profit centre
level, or

make new decisions for the profit centre.
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2
TRANSFER PRICING
INTER-DIVISIONAL TRADING AND TRANSFER PRICING
 In an organisation with profit centres and investment centres,
there will almost certainly be some inter-connection between
them. Some profit centres will supply goods and services to
others.
 Inter-divisional transfers must therefore be priced.
3

The price of the transfer is the transfer price.

The transfer is treated as an internal sale and an internal
purchase within the organisation.

The sales income of one division is offset by the purchase
cost of the other division. The transfer therefore affects the
profits of the two divisions individually, but has no effect
on the profit of the organisation as a whole.
SETTING A TRANSFER PRICE: INTER-DIVISIONAL TRADING
POLICY
 The transfer price for inter-divisional transactions is significant
because:

it determines how the total profit is shared between the two
divisions, and

in some circumstances, it could affect decisions by the
divisional managers about whether they are willing to sell
to or buy from the other division.
 Both divisions must benefit from the transaction if interdivisional sales are to take place.
 Transfer prices have to be established and agreed.
186

They could be imposed by head office.

Alternatively, they could be decided by commercial
negotiation between the profit centre managers.
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TRANSFER PRICING
CHAPTER 18
 Inter-divisional trading should take place within a broad
company policy, that:

for a ‘selling division’, given the choice between making a
sale to an external customer or supplying goods or services
to another division within the group, the preference should
be to sell internally

for a ‘buying division’, given the choice between
purchasing from an external supplier or from another
division within the company, the preference should be to
purchase internally.
 However, a division should be allowed to sell externally
rather than transfer internally, or buy externally rather than
internally, if it has a good commercial reason. Good
commercial reasons would include:

an external customer offering a higher price, or

an external supplier offering a lower price.
 The following guidelines should always be considered.

The transfer price should be a price that will ensure that
the profits of the company as a whole are maximised.
One profit centre should not make profits at the expense of
another profit centre.

Goal congruence is achieved when all profit centres
maximise their profits by operating at levels of output and
prices that ensure the maximisation of profit for the
company as a whole.

The transfer price should provide for a fair division of the
total profit between the selling and the buying division,
and so should provide a fair basis for measuring profit
centre performance.

The transfer price should motivate the profit centre
managers to trade with each other so as to maximise the
profits of the company as a whole.
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CHAPTER 18

4
TRANSFER PRICING
Transfer pricing decisions should ideally be set at the
‘local’ level, in negotiations between the profit centres,
rather than imposed by head office.
THE BASES FOR SETTING TRANSFER PRICES
 In broad terms, there are three bases for setting a transfer price:
5

market-based prices

cost-based prices

negotiated prices.

A market-based transfer price might be agreed when there
is an intermediate market for the transferred item. An
intermediate market is a term to describe an external
market for the goods or services of the selling division.
THE INTERMEDIATE MARKET
 The intermediate market for the products or services of a selling
division could be perfect or imperfect.
A perfect intermediate market
 Where all suppliers to the market are able to sell all their output
at the prevailing market price. There are no restrictions on sales
demand at that price, and no individual supplier dominates
market supply.
An imperfect intermediate market
 Where the selling division is unable to sell all its output
externally at the same market price. This can happen when the
division is a dominant influence in the market, and monopoly or
oligopoly conditions apply.
 The rule of market prices is that the total market demand for an
item varies with the sales price. If the relationship between
188
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TRANSFER PRICING
CHAPTER 18
sales price and sales demand is linear, a demand curve could
be expressed by the formula:
P = a – bQ
where
P is the sales price
Q is the quantity
Values can be established for a and b. When the price is a, Q
should be 0.
 Marginal revenue is the extra revenue that will be earned by
selling one additional unit in the market. In a perfect market,
the marginal revenue for a company is always the market price
of the item.
When the market is imperfect, marginal revenue is always lower
than the market price.
The demand curve gives a value for P: P = a – bQ.
Total revenue = P × Q
Substituting, we get: total revenue = (a – bQ) × Q
Total revenue = aQ – bQ²
Marginal revenue is found by differentiating aQ – bQ².
Without going into the details of the arithmetic:
Marginal revenue (MR) = a – 2bQ.
 In an imperfect market, profits are maximised by selling
output up to a volume where marginal revenue = marginal cost.
When there is no external market for the products or services of a
profit centre, all the output of the centre is sold to one or more
divisions within the company or group.
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TRANSFER PRICING
FINDING THE IDEAL TRANSFER PRICE
 The ideal transfer price is a price for inter-divisional sales that
will:

maximise the profits of both the selling and the buying
division, and

maximise the profit of the company as a whole.
 The technique for identifying the ideal transfer price (or range
of transfer prices) is as follows.

Start by identifying the profit-maximising output for the
firm as a whole. Then take the buying and the selling
division in turn.

Identify a transfer price that will motivate the division
manager to produce and sell this profit-maximising
quantity. This transfer price must ensure that the division
will maximise its own profit.
 Ideal transfer price = Marginal cost + Opportunity cost
where:
7

Marginal cost is the marginal cost for the selling division to
make and sell the product item or provide the service

Opportunity cost is the benefit forgone by the selling
division if it transfers internally rather than sells externally.
THE IDEAL TRANSFER PRICE: PERFECT INTERMEDIATE
MARKET
 When there is a perfect intermediate market for the output of
the selling division, the ideal transfer price is a market-based
transfer price.
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Perfect intermediate market and no variable selling costs
 If there are no variable selling costs or buying costs in the
intermediate market ) the ideal transfer price is the market
price.
Perfect intermediate market, but with variable selling costs
 If there are variable selling costs or buying costs in the
intermediate market:

it will cost the selling division more to sell externally than
to transfer internally, or

it will cost the buying division more to purchase from an
external supplier than to buy internally.
 It is therefore cheaper and more profitable to transfer internally
than to sell or buy externally. The cost savings can be reflected
in an adjustment to the transfer price, so that both divisions
share the benefit.
8
THE IDEAL TRANSFER PRICE: NON-EXISTENT
INTERMEDIATE MARKET
 When there is no intermediate market for a transferred product
or service, the transfer price will be based on cost.
9
THE IDEAL TRANSFER PRICE: IMPERFECT INTERMEDIATE
MARKET
 The features of an imperfect intermediate market might vary,
but the procedures to apply in order to identify an ideal transfer
price, or range of transfer prices, are:

begin by identifying what output volumes and sales prices
will maximise total company profit

next, taking each profit centre in turn identify a transfer
price or range of transfer prices at which the centre’s own
profit would be maximised at this same output level
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
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TRANSFER PRICING
finally, compare the transfer prices for each division, and
identify a price or range of prices at which the profits of
both centres as well as the total company profit will be
maximised.
TRANSFER PRICES WHEN THE SELLING DIVISION HAS
SPARE CAPACITY
 A situation might arise where a profit centre has an
intermediate market for its output, and also sells internally, but:

there is a limit to the amount that it can sell externally, and

it has spare capacity.
 In such a situation, the opportunity cost of transferring units
internally would be nil, and the ideal transfer price would be
based on cost, not the external market price.
 The opportunity cost of transferring units internally is nil
because the selling division can meet external demand in full,
and still have excess capacity for making inter-divisional sales.
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NEGOTIATED TRANSFER PRICES
 On occasions, a transfer price might be negotiated. With
decentralisation of authority to profit centres, centre managers
will negotiate transfer prices for inter-divisional sales, but the
price will usually be based on external market price or cost.
When the intermediate market is imperfect, the transfer price
might be based on an analysis of marginal costs and revenues,
and this would require careful analysis and negotiation.
 Other examples of negotiated transfer price are:
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
a two-part tariff

dual price where the difference is subsidised by headoffice.
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Difficulties with negotiated transfer prices
 There are two main difficulties with negotiated transfer prices.
12

Identifying a suitable transfer price is not always
straightforward, and a price might have to be imposed on
the profit centres by head office.

If the divisional managers are given the authority to
negotiate their transfer prices, there is a risk that the
negotiations could turn into a power struggle between the
divisional managers.
INTERNATIONAL TRANSFER PRICING
 Transfers within an international group will often be crossborder, between divisions in different countries. Other factors
need to be considered.
Different tax rates
 A multinational company will seek to minimise the group’s
total tax liability. One way of doing this might be use transfer
pricing to:

reduce the profitability of its subsidiaries in high-tax
countries, and

increase the profitability of its subsidiaries in low-tax
countries.
 Changes in the transfer price can redistribute the pre-tax profit
between subsidiaries, but the total pre-tax profit will be the
same. However, if more pre-tax profit is earned in low-tax
countries and less profit is earned in high-tax countries, the total
tax bill will be reduced.
Government action on transfer prices
 Governments are aware of the effect of transfer pricing on
profits, and in many countries, multinationals are required to
justify the transfer prices that they charge. Multinationals could
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be required to apply ‘arm’s length’ prices to transfer prices: in
other words, they might be required under tax law to use
market-based transfer prices, to remove the opportunities for
tax avoidance.
 It is also possible that some countries wishing to attract
business might have tax laws that are very favourable to
business. A country with the status of a ‘tax haven’ might offer:
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
a low rate of tax on profits

a low withholding tax on dividends paid to foreign holding
companies

tax treaties with other countries

no exchange controls

a stable economy

good communications with the rest of the world

a well-developed legal framework, within which company
rights are protected.
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