MALec Batch 3

University of London
Management Accounting
Lecture Notes
Lecture 12
Topics Covered
Decision making and uncertainty
Readings: Subject Guide Chapter 9. This lecture not covered in

Horngren.
Lecture 12
This lecture deals with methods of reducing risk in decision making

and has only recently introduced in the MA2097 syllabus. The
techniques involved can be tested mainly in section A of the exam.
207
Risk and Uncertainty in decision making
Investors are risk averse that is, they do not like risk and can only be induced
to accept higher risk if they are offered a higher return.
Aggressive Investor
High Risk High Return
Low Risk Low Return
Conservative Investor
Techniques to reduce uncertainty
Expected values (probability analysis)
Expected values: An expected value is the weighted average of the outcomes

with the probability of each outcome serving as a weight.
Expected value = Σ n X p
Where n = number of items or event

P = probability of the outcome or event.
Lecture Illustration
Suppose that a project has the following profile
Sales Volume(n) Profit(Loss)$000(n) Probability(P)

600 210 0.1
400 90 0.3
300 30 0.4
100 (90) 0.2
1.0
Required: Calculate the expected profit and sales volume given the
probabilities
Expected Profit
=
Expected sales volume

=
208
A company had developed a new product and management is trying to

formulate a budget for this product whose demand is uncertain.
The following information has been collected:
Demand Probability
(units)
Worst possible outcome 10,000 0·3
Most likely outcome 22,000 0·5
Best possible outcome 35,000 0·2
The selling price per unit is $25. The variable cost per unit is $8 for any
production level up to 25,000 units. If the production level is higher than
25,000 units, then the variable cost per unit will decrease by 10% and this
reduction will apply to all the units produced at that level.
Total fixed costs are estimated to be $75,000.
Required:
Calculate the expected budgeted contribution of the product?
Contribution per unit
(Up to 25,000 Units) =
Above to 25,000 Units =
(n) (p)
Demand Contribution Total Expected
Unit per Unit Contribution X Prob. Contribution
$ $ $
10,000
22,000
35,000
Total Expected Contribution 362,600
209
Decision rule using Maximax, Maximin and Regret criteria
In situations where uncertainty exists and its not possible to assign

meaningful estimates of probability to possible outcomes, managers can use
maximax, maximin and regret criteria to make decisions.
Maximax - Choose the alternative with the maximum benefit in the best
situation.
Maximax criteria looks at the best possible results.
This approach used by an aggressive investor. Optimistic outlook
Maximin - Choose the alternative with the maximum benefit in the worst
situation.
Maximin criteria looks at the worst possible results. Pessimistic outlook
This approach used by a conservative investor.

Note that we always want the
maximum benefit, but the situation
Lecture Illustration the company is facing is not
controllable by it.
A company is considering three mutually exclusive projects to undertake.
The following profit table has been drawn up:
Net profit in $000s if outcome turns out to be
Worst Most Likely Best
Project
A 50 85 130
B 70 75 140
C 90 100 110
Determine which project should be selected using the:

1. Maximax Rule
2. Maximin Rule
1) Maximax Rule
Select Project
2) Maximin Rule
Select Project
210
Nobody likes to regret and hence
Regret Criterion we want to minimise regret
Minimax regret rule aims to minimize the regret from making the wrong
decision. Regret is the opportunity loss through making the wrong decision.
Regret = Profit from best action taken Less Profit from action actually taken
The regret criterion is that option selected which minimizes the maximum
potential regret for any possible outcomes.
A manager is trying to decide which of three mutually exclusive projects to

undertake. Each of the projects could lead to varying net costs which the
manager calls outcomes 1,2 and 3. The following payoff table has been
constructed:
Net profit in $000s if outcome turns out to be

Worst Most Likely Best
Project 1 2 3
A 50 85 130
B 70 75 140
C 90 100 110
Determine which project should be undertaken using the regret criterion rule.
Regret Table $’000

Outcome
$000 Maximum
Project (1) (2) (3) Regret
$ $ $ $
A
C
Decision: Select Project as minimum regret is
211
OR
Project
Outcome A B C
$ $ $
1
Maximum Regret
Decision: Select Project B.
The budgeted demand for product X will be 11,500 units if the price is $10.
8,500 units if the price is $12 and 5,000 units if the price is $14. Variable cost
are estimated at either $4,$5 or $6 per unit. A decision needs to be made on
the price to be charged.
Required;
Construct the contribution table showing the budgeted contribution for each of
the nine possible outcomes and determine the price to be charged for the
following decision rules:
a. Maximax
b. Maximin
c. Regret criterion
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Per Unit Answer
Variable Contribution Total
Unit Price Cost Per Unit Contribution
$ $ $ $
11,500 10
11,500 10
11,500 10
8,500 12
8,500 12
8,500 12
5,000 14
5,000 14
5,000 14
(a) Maximax
Maximum Total Contribution in the best situation when Variable cost

per unit lowest @ $4 per unit
Price Total Contribution (V. Cost $4 per unit)

$ $
10
12
14
Decision: Choose low price of $10m maximum total contribution of
$
213
(b) Maximin
Maximise Total Contribution in the worst situation (Highest variable

Cost of $6 per unit)
Price Total Contribution (V. Cost $6 per unit)

$ $
10
12
14
Decision: Choose price of $12.

Maximum Total Contribution of $
C. Regret Table
Variable Cost
Maximum
Price $4 $5 $6 Regret
$ $ $ $ $
10
12
14
Decision: Select Price of $12 minimum regret of $1,000.
214
Your company is about to launch a new product onto the market.
A decision is to be made as to whether to launch the product at a price of

$30 or $35 per unit. The following information has been obtained from
market research:
Price per unit $30 Price per unit $35
Probability Sales volume Probability Sales volume
0·4 120,000 0·3 108,000
0·5 110,000 0·3 100,000
0·1 140,000 0·4 94,000
Notes:
1 Variable production costs would be $12 per unit for production volumes
up to and including 100,000 units each year. However, if production
exceeds 100,000 units each year, the variable production cost per unit
would fall to $11 for all units produced.
2 Advertising costs would be $900,000 per annum at a selling price of $30

and $970,000 per annum at a price of $35.
3 Fixed production costs would be $450,000 per annum.
Required: For each of the six possible profit outcomes which could arise
for in the coming year.
a) Calculate the expected value of profit for each of the two price options and
recommend, on this basis, which option should be chosen.
b) Identify which price should be chosen if the maximin rule is used.
(a) Contribution per unit

Price
$30 $35
Up to 100,000 Units
Above 100,000 Units
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Price of $30
Prodn (n)
Volume Contribution Total Fixed Fixed Total
Unit per Unit Contribution Cost Advertising Profit
$ $’000 $’000 $’000 $’000
120,000 19
110,000 19
140,000 19
Expected Profit = Σn X p
Price of $35
(970 + 450) (n)
Volume Contribution Total Total Total
Unit per Unit Contribution Fixed Cost Profit
$ $’000 $’000 $’000
108,000
100,000
94,000
Expected Profit
Decision:
b) Maximin
Maximum Total Profit in Worst situation (Lowest Profit)
Price Lowest Profit
$ $
Decision: Select price of
216
Exam Tip
Decision Trees Decision tress fairly popular for section B of exam
A Decision Tree is an analytical tool to assist in decision making. It ensures

that all possible choices and outcome are taken into consideration.
Decision tree analysis is particularly useful when there is a sequence of

possible uncertain events, rather than one only.
Decision Trees
Circle represent outcome
Square represents
Decision point
Rules of drawing a decision tree:
Start from left to right
Every decision tree starts from a decision point with the decision options or
choices are shown as branches on the tree.
All possible outcome of each option/choice are shown as subsidiary branches

of the tree.
Squares represents decision points and circles represents outcomes.
In the exam, remember to draw the decision tree neatly, using a pen and
ruler. Remember to label the decision points and branches as clearly as
possible.
217
A company is about to launch a new product with the following information:
Sales Units Probability Unit Costs $ Probability

10,000 0.8 6 0.7
15,000 0.2 8 0.3
Required:
Draw a decision tree.
Exam Tip: Draw diagram neatly in
exam, using a ruler to draw
straight lines. Its pays to be neat
and professional in the exam.
Decision
218
A company is considering the launch of a new product. It can now either test
the product or abandon it.
If it test,the product, it will cost $100,000 and the market response will either
be positive or negative with probabilities of 0.6 and 0.4 respectively. If the
response is positive, the company could either abandon the product or market
it full scale.
If it markets the product, the demand might be low, medium or high and the
probability of this is 0.2, 0.5, 0.3 respectively with profits of ($200,000),
$200,000, or $1000,000.
If the result of the test market is negative and the company goes ahead and
markets the product, estimated losses would be $600,000. At any point if the
company abandon the product, there would be a net gain of $50,000 from the
sale of scrap.
Required:
Draw a decision tree.
Decsion Tree
219
At Point E
Expected profit if result positive and market product
C Decision:
Market =
Abandon =
Decision:
D Decision: If result negative
Market =
Abandon =
Decision:
B Expected Profit If Test
A If Test
Expected Profit =
Abandon =
Decision:
Conclusion:
1) Test Product
2) If Result
Action
Positive:
Negative:
The End – Lecture 12
220
University of London
Lecture Notes
Lecture 13
Topics Covered
Linear Programming, Theory of Constraints
Readings : Hongren Chapter 10 appendix.

Lecture 13
Linear programming is a popular section A question in the exam.
It’s a good one to focus on as there is not many ways the examiner can
vary the question as the approach to the solution is very structured so
pay attention to the technique taught in this lecture.
The parts on bottleneck operation and the theory of constraints are

good section B potential questions.
221
Linear programming is an optimization technique used to maximize total
contribution (the objective function) given multiple constraints.
Features of Linear Programming:
There is a single objective which is to maximise total contribution. (not total profit)
There are several constraints, often scarce resources in short supply.
Techniques:
In linear programming in management accounting, only a two product situation can

be tested because we only use a two axis graph.
Exam tip- Memorise the 4 steps
Steps in solving a Linear programming problem
Step1 - Define the two products. Normally using 2 alphabets for example A, B.
Step 2 - Determine the objective function which is to maximise total contribution Not
maximise
Step 3 – Specify the constraints profit
A constraint is a mathematical inequality that must be
satisfied by the variables.
Step 4 – Draw the graph and compute the optimal solution.(required in exam)
Note:
1) In the short-term, total fixed cost is constant, hence as
long as total contribution is maximised, total profit will also
be maximized.
2)Mathematical inequality used are (step 3)

a) ≤ Lesser than or equal to.
b) ≥ Greater than or equal to.
3)Drawing the graph is required in the exam to derive the

solution.
222
Lecture Illustration 1
RAB consulting specialises in two types of consulting project.
Each type of project A requires twenty hours of work from qualified researchers
and eight hours of work from junior researchers.
Each type of Project B requires twelve hours of work from qualified researchers
and fifteen hours of work from junior researchers.
Researchers are paid on a hourly basis at the following rates:
Qualified researchers $30 per hour Hourly labour should be

Junior researchers $14 per hour considered a variable cost
Other data relating to the projects:
Project type:
A B
$ $
Revenue per project 1,700 1,500
Direct project expenses 408 310
Administration 280 270
Administration cost are attributed to projects using a rate per project hour. Total
administration cost are $28,000 per four week period. Judge: Administration is a _____ cost.
During the four-week period ending 30 June of the current year, owing to holidays
and other staffing difficulties, the number of working hours available are:
Qualified researchers 1,344 These are the

Junior researchers 1,120 constraints
An agreement has already been made for twenty type A projects with XYZ group.
RAB consulting must start and complete these projects in the four week period
ending 30 June.
A maximum of 60 type B projects may be undertaken during the four-week period

ending 30 June.
RAB consulting is preparing its detailed budget for the four-week period ending 30
June and need to identify the most profitable use of the resources it has available.
223
Required:
Calculate the mix of projects that will maximise profit for RAB consulting for the
four-week period ending 30 June. (Note: projects are not divisible)
Step 1 – Define the 2 products
Let A = A number of projects that can be undertaken in the 4 week period.

Let B = B number of projects that can be undertaken in the 4 week period.
Step 2 – Objective function

Maximise total contribution
Contribution per project Project
A B
$ $
Selling Price
Less: Variable cost
Direct project expense
Labour
Qualified researchers(QR)
A
B
Junior researchers(JR)
A
B
Total contribution
Objective function:
Since A = no. of A project
undertaken, B= no. of B projects
Maximise undertaken, this equation
represents the total contribution
Step 3 -State the constraint
Labour constraint
QR
JR
Demand constraints
A
B
Note that the non-negativity constraint must
Non negativity constraints always be stated in business linear
programming (LP) as the number of units sold
cannot be negative.
In engineering LP, variables such as
temperature can be negative, example -5%
celcius.
224
Exam tip: Graph paper will be provided in the
exam for LP questions
Step 4 – Draw graph
Before drawing the graph, always determine the size of the co-ordinates so
that the graph can be drawn to scale on the graph paper.
QR: 20A + 12B = 1,344 Exam tip:

A=0 B= You want to draw a neat and
nice graph, not too big and
B=0 A= not too small.
JR: 8A + 15B = 1,120

A=0 B=
B=0 A=
Plan: Each square of the graph equal to projects undertaken.
Optimal solution:
Optimal solution will be derived at the extreme of the feasible region at
Points A, B,C, D and E in the graph.
There are 2 methods to derive the optimal solution:

Method 1 – Draw the OF line and shift it to the extreme of the graph without
changing the slops of the OF line.
OR
Method 2 – Compute the total contribution at the extreme points of the
feasible region, A,B,C,D and E.
Exam Tip:
Choose only 1 method to use in the exam, as both methods will derive the
same solution.
The feasible region in the graph should be marked out by highlighting or by

shading it.
The feasible region represents all combination of projects that can be done
that will satisfy all the constraints.
For example, doing 40 project A and 20 project B is in the feasible region and
hence these number of projects will meet all constraints but will not give the
maximum total contribution as the maximum total resources will not be used
for this solution.
To derive the highest total contribution and hence the highest total profit, the
solution must be derived at the extreme point of the feasible region to the right
of the graph as this is where the maximum resources available will be utilised.
225
GRAPH
226
Exam tip:
Deriving the optimal solution Method 1- Use need a long ruler to do this method
Method 1 - Draw the OF line and shift it to the extreme point of the feasible
region, without changing the slope of the OF line.
OF: Maximise 580A + 620B
Step 1
Using trial and error, set the first point of the OF line. The OF line should be
clearly visible on the graph and on the left side of the graph.
Step 2
For example, select co-ordinate A = 40, B= 0 (x axis point)
OF = (580 X 40) + 0 = 23,200 (This is now a fixed total, don’t change it)
Step 3 This method uses trial and error and

Next, get a Y axis point hence any point on the graph can be
used.
580A + 620B = 23,200 You can start from the X axis or from
the Y axis first, it does not matter.
A=0 B=?
But choose a convenient, visible point
620B = 23,200, therefore B = 23,200/620 = 37.4
Steps 1 to 4 involves drawing the OF
Therefore, Y axis point: A=0, B = 37.4. line so no need to explain in the exam,
but show the mathematical working as
Step 4 – Draw the OF line on the graph. to how you derive the line
Only explain the step 5 in the exam.
Step 5 – Derive the solution
Optimal solution is derived by shifting the OF line to the extreme of the feasible
region, keeping the slope of the OF line constant all the time.
Hence, the optimal solution is at point C, the intersection of the JR and the QR
line.
Mathematical optimal solution:

20A + 12B = 1,344
8A + 15B = 1,120
Optimal solution: A = 32.9, B = 57.1

Hence undertake 33A and 57B.
Maximum total contribution = (580 X 33) + (620 X 57) = $54,480

Less: Administration fixed cost = $28,000
Maximum Total profit = $26,480
227
Method 2
Step 1 -Compute the total contribution at the extreme point of feasible region
ABCDE.
Step 2 – Select the point where total contribution is maximised.
Point Co-ordinates Total contribution

A
Optimal solution is at the Point _________, with total contribution of

$__________.
Note:
Method 1 and 2 derive the same solution, so use only 1 method.
228
Slack, Binding Constraint
A constraint is said to be binding when the maximum availability of the resources

is used at the optimal solution.
When the maximum availability of the resources is not used up at the optimal
solution, the resource is said to be slack.
Refer to the previous Illustration 1 and identify the binding constraint and the
slack.
Optimal solution: Undertake 33A and 57B projects
Total QR hours used at optimal solution
Total JR hours used at optimal solution
Maximum available JR hours used at the optimal solution, hence JR hours

is a ___________________ constraint.
Actually you don’t have to do the computation above to conclude that

both the QR and the JR hours are binding constraint.
This fact could be determined from inspecting the point c in graph. Both
resources are binding, because the optimal solution is on the JR and
the QR line, hence the maximum resources are used at this point.
229
Limiting factors and shadow prices
A shadow price or dual price of a limiting factor is the increase in benfit (total
contribution) which would be created by having one additional unit of the limiting
factor at the original cost.
The shadow price is the increase in total contribution(benefit) created by the

availability of an extra unit of limited resource at its original cost.
A shadow price is only computed for a binding constraint.
Steps in computing a shadow price
Step 1 – Confirm that the resource is a binding constraint.
Step 2 – At the optimal solution, increase the resource by 1 unit.
Step 3 – Compute the revised optimal solution.
Step 4 - Compute the revised contribution at the revised optimal solution.
Step 5 – Compute the incremental contribution
Incremental Contribution = Original contribution Less Revised Contribution
Incremental Contribution = Shadow Price
Why do we have to compute the shadow price?
This is because the binding constraint limits your ability to maximise

the total contribution.
So, if additional resources can be located, for example if the workers

can do overtime more output can be produced.
Hence, we need to determine the benefit of each additional hour to

compare to the cost of the additional hour so that the right decision
can be made to hire additional hours. Hence, it is about benefit versus
cost again.
230
The Rosemary Kerridge Orthopaedic Hospital is a national centre of excellence

treating a range of patients with orthopaedic problems or who have been
seriously injured in accidents. The hospital includes a unit specialising in the
treatment of patients with arthritic knees. There is an extensive national waiting
list of patients suffering from this condition and many (some of whom are
wheelchair bound) wait for well over a year for treatment.
Traditionally treatment has been of two types:
• A “blow out” in which loose fragments of broken cartilage are removed

from the knee. This must be done in the sterile conditions of an operating
theatre and takes 1.5 hours, but could be performed in a local hospital as
a ‘day case’ procedure only.
• A total knee replacement operation. This is a major operation which takes

three hours of theatre time and requires an extensive recuperation period.
Recently, however, a new treatment has been successfully introduced. This is:
• A partial knee replacement requiring one and a half hours of theatre time
and a shorter recuperation period. However, this procedure is only
suitable for younger, more active patients.
The hospital is paid for each treatment based on a national tariff, calculated using
absorption cost.
Facilities are limited. The team has use of an operating theatre for two six-hour
sessions per week (and for 50 weeks per year) and a small dedicated ward of
eight beds (also for 50 weeks per year).
Relevant details of these procedures are as follows.

Blow out Total knee Partial knee
operations Replacement replacement
operations Operations
National tariff £400 £9,000 £4,100
Drugs & £100 £3,000 £1,500
Prostheses
Operating theatre
time 0.5 hours 3.0 hours 1.5 hours
Ward length of - 16 days 4 days
stay
Follow-up Home
visits - 10 5
Variable Operating Theatre Costs are £1000 per hour.
231
Direct Variable Costs in the wards are £60 per patient per day.
Follow-up home visits are charged by the local community trust at £40 per visit.
Ward Fixed Expenses are £160,000 per annum.
General Hospital Overheads allocated to the knees unit are £130,000 per
annum.
Required:
(a) Calculate the contribution per unit of each procedure for each of the limiting
factors.(6 marks)
(b) Are there good financial reasons for dropping one of these procedures? If
so, which? (2 marks)
(c) Calculate the maximum number of each procedure that can be undertaken
given the constraints on operating theatre time and bed-days available.
(4 marks)
Part d is a LP solution
(d) Calculate the maximum contribution that can be earned given the as there are 2
constraints on theatre time and bed-days. (6 marks) constaints.
(e) If the hospital management could be persuaded to make more theatre time
and/or bed-days available, calculate the direct (shadow prices) for a bed day.
(2 marks)
UOL Adapted 2011 Zone A Question 3
(a) Contribution per procedure
Blow Out Total Replace Partly Replace

£ £ £
National Tariff
Less: Variable Cost
Drugs
Theatre Time
Ward Stay
Home Visit
Contribution
232
We never produce/sell
products with negative
contribution.
(b) Drop Blow out as negative contribution of £200.
(c) T. Time available per year

= 12 hours per week X 50 weeks
= 600 hours per week
Bed Days per year

= 8 Beds per day X 7 Days X 50 weeks
= 2,800 Beds per year
Note: In order to do the maximum number of each procedure, you have to

use all the constraint resources on that particular procedure only and hence
assume that you do zero units of the other procedure. Since there are 2
constraints acting together at the same time you need to apply the 2
constraints together.
Total replace Partial replace
T. Time
B. Days
Maximum:
Total Replace = procedures p.a. assume zero partial done.
Partial = procedures p.a. assume zero total Replace Done.
When you apply both the constraints, you need to select the lower
number of procedures.
Total replace, the ______________________ was more constraining.
Partial replace, ________________________ was more constraining.
233
( d) Linear Programming
Step 1 - Define Variable
Let T = Total Replace procedures done per year
Let P = Partial Replace procedures done per year
Step 2 = OF - Maximise Total Contribution
Maximise
Step 3 - Constraints
OT Time =
Bed Days =
Non Negativity Constraint
T, P ≥ 0
Graph: Planning
T. Time = 3T + 1.5P ≤ 600
T = 0 P =
Co-ordinates
P = 0 T =
Bed Days = 16T + 4P ≤ 2,800
Maximum
T = 0 P =
Co-ordinates
P = 0 T =
Planning
X Axis = T Y Axis = P
For example:
X = 50 procedures per square
Y = 100 procedures per square
234
Solution:
Method: Draw and Shift of OF Line (Method 1)
OF = 1,640T + 660P
(Trial + Error)
If T = 0, P = 200
(1,640 X 0) (660 X 200) = 132,000 (Fixed - Don’t change)
If P = 0, T = 81
1,640T + (660 X 0) = 132,000
T = 132,000 = 80.49
1,640
OF Line = T = 81, P = 200
Optimal Solution:
1) Optimal solution is derived by shifting the OF Line to
the extreme point of the feasible region ABCO, without changing the
slope of the line.
2) Optimal solution is at point B intersection of bed days and T.

Time line
16T + 4P = 2,800 Bed Days

3T + 1.5P = 600 T. Time
Optimal Solution:
Do T = 150, P = 100 Procedure
Max Contribution:
(1,640 X 150T) + (660 X 100P)

= £312,000
235
OR Method 2
Optimal Solution
Points Co-ordinates Total Contribution
Optimal Solution at point B, where total contribution maximum of £312,000.
236
e)
Steps in computing a shadow price
Step 1 – Confirm that the resource is a binding constraint.
Answer: Yes, as the optimal solution is on the bed day line
Step 2 – At the optimal solution, increase the resource by 1 unit.

Increase by 1 bed day.
Answer: 3T + 1.5P = 600

16T+ 4P =
Step 3 – Compute the revised optimal solution.
Answer: P = 99.75 procedures, T = 150.125 procedures
Step 4 - Compute the revised contribution at the revised optimal solution.
Answer: Revised total contribution

( 1640 X ______ ) + (660 X ______ ) = _________
Step 5 – Compute the incremental contribution
Answer: £312,040 Less___________ = £__________________
Incremental Contribution = Revised contribution Less original contribution
Incremental Contribution = Shadow Price = £_____per bed day
Question: What is the maximum price to pay for 1 bed day?

________________________________________________
________________________________________________
________________________________________________
Exam tip:
All this work for 2 marks, may not be worth it!
237
GRAPH
238
This part for section
B of exam only.
Bottleneck Operations & the Theory of Constraints (TOC)
The theory of Constraints is an approach to production management. It focuses

on factors such as bottlenecks which acts as constraints to the maximization of
contribution.
Bottleneck Operations is an operation where the work required to be performed

approaches or exceeds the available capacity.
The theory of constraints (TOC) describes methods to maximise operating profits

when faced with some bottleneck and non-bottleneck operations.
Throughput contribution equals:
Throughput contribution: Sales revenue less direct material cost only.
All other cost (including direct labour) are fixed in the short run and that the only
truly variable cost is material cost only.
The TOC concept aims to increase throughput contribution and reduce inventory
and operating expense.
However, operational expenses are considered fixed and a certain level of

inventory also has to be maintained
Therefore, there is little scope to reduce inventory and fixed cost.
Hence in TOC, increasing throughput is the first priority, reducing inventory

second and reducing operation expenses the last priority.
Steps to Manage Bottleneck Operations:

A five-step approach to managing production bottlenecks is useful. The steps
are:
1. Identify the system’s bottlenecks.
2. Decide how to exploit the bottleneck.
3. Subordinate everything else to the decision in step 2.
4. Elevate the bottleneck (in other words, solve the problem, for example, by
replacing the machine if it is faulty or using a subcontractor).
5. Repeat steps 1–4 for the next bottleneck.
239
Example: Bottleneck operations
Process 1 Process 2
Maximum Capacity Maximum Capacity
=100,000 units =80,000 units
Demand in
unlimited, can sell
all production
units
Steps
1) Identify the system’s bottlenecks.
_Answer
2) Decide how to exploit the bottleneck.
Example:
a. Slow down process 2 to 80,000 units, eliminating the long que at
process 2.
b. Shift resources (labour and machines), from process 1(Non BO) to

process 2(BO) to increase capacity of process 2 to 90,000 units.
c. Increase throughput contribution for additional 10,000 units.
3) Subordinate everything else to the decision in step 2.
4) Elevate the bottleneck (in other words, solve the problem, for example, by
replacing the machine if it is faulty or using a subcontractor).
5) Repeat steps 1–4 for the next bottleneck.
240
Situations in which it may be more appropriate to use linear programming
approaches as a decision tool rather than “Theory of Constraints”
Linear programming is most relevant where there are several limited resources
and shared by several products. The approach assumes that it is possible to
identify, all variable costs (not only materials), revenues and resource use for all
products involved. The method can respond quickly to changes in prices and
variable costs.
It tends to be used in highly structured environments e.g. mix of products to be

made from crude oil.
The technique requires good information relating to all the costs, revenues and
constraints. As a powerful mathematical model it can also calculate shadow
prices for all the limited resources.
The throughput contribution approach is used in situations where a more

pragmatic solution is required and many factors are difficult to identify with
accuracy. It therefore focuses on the areas which are easy to identify, product
prices, material prices and one bottleneck.
It is more appropriate where a company makes a large number of diverse

products for which the estimates of demand are difficult and different products
use the resources in different ways. In today’s environment it is not an
unreasonable assumption that direct materials are the only easily measurable
variable cost.
Summary
Linear Programming Theory of Constraints

1) Objective Function Maximise(normal) Maximise throughput
contribution. contribution.
Assumes that all other Only variable cost can be
variable cost can be identified accurately is
identified, not just direct direct materials.
materials
1) Constraints Multiple constraints 1 constraint(Bottleneck)
241
Lecture 13- Homework Questions
Short answer questions
Q1
Given the following graph, at which the following point will the total profit be maximized?
y
B
C
D
242
Q2
The following graph has been established for a given set of constraints:
The objective function (OF) for the company has also been plotted on the graph
and the feasible region is bounded by the area ABCD.
300
200
A
100 D
0 100 200 300

x Units
OF
Required:
At which point on the graph will profits be maximised?
243
Q3
The following graph relates to a linear programming problem:
(1)
(2)
(3)
The objective is to maximise contribution and the dotted line on the graph
depicts this function. There are three constraints which are all of the ‘less
than or equal to’ type which are depicted on the graph by the three solid
lines labelled (1), (2) and (3).
Required:
At which of the following intersections is contribution maximised?
Q4
Briefly describe what is the shadow price of a resource in linear programming ?
244
Question 1
AZ Ltd makes three products H, Y and C. All three products must be offered for
sale each month in order to be able to provide a complete market service. The
products are fragile and their quality deteriorates rapidly once they are
manufactured.
The products are produced on two types of machine and worked on by a single
grade of direct labour. Five direct employees are paid $8 per hour for a guaranteed
minimum of 160 hours each per month.
All of the products are first moulded on a machine type 1 and then finished and
sealed on a machine type 2.
The machine hour requirements for each of the products are as follows.
Product H Product Y Product C

Hours per unit Hours per unit Hours per unit
Machine type 1 1.5 4.5 3.0
Machine type 2 1.0 2.5 2.0
The capacity of the available machines type 1 and 2 are 600 hours and 500 hours
per month respectively.
Details of the selling prices, units costs and monthly demand for the three product
are as follows.
Product H Product Y Product C

$ per unit $ per unit $ per unit
Selling price 91 174 140
Component cost 22 19 16
Other direct material cost 23 11 14
Direct labour cost $8/hr 6 48 36
Overheads 24 62 52
Profit 16 34 22
Maximum monthly
demand (units) 120 70 60
Although ABC uses marginal costing and contribution analysis as the basis for its
decision making activities, profits are reported in the monthly management
accounts using the absorption costing basis. Finished goods inventories are
valued in the monthly management accounts at full absorption cost.
245
Required
a)Calculate the machine utilisation rate for each machine each month and explain
which of the machines is bottleneck/limiting factor.
b)Using the current system of marginal costing and contribution analysis,

calculate the profit maximising monthly output of the three products.
c)Explain why throughput accounting might provide more relevant information on

ABC’s circumstances.
Question 2
Toymaker Ltd makes and sells three products. The forecast costs, use of
production facilities and demand figures are as follows:
Product Princess Doll Action Robot

Man
Selling price per £40 £60 £80
unit
Anticipated annual 40,000 units 30,000 50,000 units
sales units units
Variable costs per £12 £40 £56
unit
Use of machine 1 hour 2 hours 1 hour
time per unit
Assembly time per 1 hour 1.5 hours 2 hours
unit
Annual Company Fixed costs are forecast to total £680,000.
For the forthcoming year the total machine time available will be 120,000 hours
and because of a lack of skilled workers, a total of 140,000 hours of assembly
time is available.
Required:
(a) Determine whether the company can meet the total demand from the
machine and assembly time available. (3 marks)
(b) One of the three products has the highest contribution per limiting factor for
both machining and assembly so the company wishes to make sufficient of this
product to meet market demand. Identify this product and indicate the number of
hours remaining in machining and assembly to make the two remaining products.
(4 marks)
246
(c) Incorporating the production and market constraints calculate the optimal
production schedule for the two remaining products. (8 marks)
(d) Calculate the maximum profit which the company would make given the
constraints.
(2 marks)
(e) Calculate the dual (shadow price) for each of the production constraints and
explain how this information would be used by the company. (8 marks)
UOL adapted
Question 3
(a) i. Meeting customers’ expectations is vital for profitability. Explain the term
“customer response time” and describe, with examples, two reasons why delays
in meeting customer expectations occur. (5 marks)
ii. Describe how customer response time could be improved in a student canteen
and how the costs and benefits could be quantified. (4 marks)
b i. Explain the “Theory of Constraints” and define the following:

• Throughput contribution;
• Investments;
• Operating costs. (4 marks)
ii. Describe the process of managing bottlenecks. (6 marks)
iii. Discuss the situations in which it may be more appropriate to use linear
programming approaches as a decision tool rather than “Theory of
Constraints”. (6 marks)
(UOL adapted 2010 Zone B Q7 25 marks)
247
Question 4
Superskis Ltd makes and sells three products. The forecast costs, use of
production facilities and demand figures are as follows:
Product Learner Ski Professional Snow board

Ski
Selling price per unit £200 £300 £400
Anticipated annual sales 50,000 units 30,000 units 40,000 units
units
Variable costs per unit £70 £200 £260
Use of machine time per unit 1 hour 2 hours 1 hour
Assembly time per unit 2 hours 1.5 hours 1 hour
Annual Company Fixed costs are forecast to total £3,400,000.
For the forthcoming year the total machine time available will be 120,000 hours
and because of a lack of skilled workers, a total of 144,000 hours of assembly
time is available.
Required:
(a) Determine whether the company can meet the total demand from the
machine and assembly time available. (3 marks)
(b) One of the three products has the highest contribution per limiting factor for
both machining and assembly so the company wishes to make sufficient of this
product to meet market demand. Identify this product and indicate the number of
hours remaining in machining and assembly to make the two remaining products.
(4 marks)
(c) Incorporating the production and market constraints calculate the optimal
production schedule for the two remaining products. (8 marks)
(d) Calculate the maximum profit which the company would make given the
constraints. (2 marks)
(e) Calculate the dual (shadow price) for each of the production constraints and
explain how this information would be used by the company. (8 marks)
(UOL adapted 2009 Zone A Question1, 25 Marks)

The End Lecture 13
248
UOL- Management Accounting
Lecture Notes
Lecture 14
Topic: Capital Investment Decisions and Life cycle costing
Reading : Capital Budgeting :Horngren Chapter 13, pages 387 to 402 only.
Life cycle costing : Horngren Chapter 12, pages 366 to 369 only
Lecture 14
The first part of this lecture is based on long run decision making
involving capital expenditure where the benefits are received over
many years. This part is very frequently tested in Section A of the
exam.
The second part deals with life cycle costing which is also quite often
tested in Section A of the exam.
249
Capital Budgeting
Capital budgeting involves decisions regarding capital investments involving large

sums of money and a long-time frame to recover the initial investment.
Because of the long-time frame of recovery, the time value of money must be
considered.
Examples of capital investment decisions are purchase of non-current assets

(useful life more than 1 year) by a business.
The methods essentially are used to determine if the benefit received from the
non-current asset is greater than the cost of the asset.
When the benefit is greater than cost of the asset, the non-current asset should
be acquired.
When the benefit is less than cost of the asset, the non-current asset should not
be acquired.
The methods here differ in how the benefit received is measured.
Techniques of Appraisal:
1) Accrual Accounting Rate of return
2) Payback Method
3) Net Present Value - NPV
250
Accounting Rate Of Return (ARR )
This the measure which is used when the objective is to maximise reported profits.
The Project’s ARR is defined as ratio of average profit to capital invested. Don’t forget to
deduct
Accounting Rate of Return = Average Profit X 100% depreciation to
==================== derive profit
Average Capital invested
Average Profit = Total Profit

===============
Useful Life
(Cost of the equipment). + (Net book value at end)

Average Capital = Initial investment at start + scrap value of equipment
======================================
2
The decision rule is to accept the investment whose ARR exceeds a given target
rate or the highest ARR if a choice exists between mutually exclusive projects.
The higher the ARR
the better.
251
Your company plans to buy a new machine to meet expected demand for a new
product, Product T. This machine will cost $250,000 and last for four years, at the
end of which time it will be sold for $5,000. The expected demand for Product T to
be as follows:
When given the selling
price and variable cost,
Year 1 2 3 4 compute contribution per
Demand (units) 40,000 45,000 50,000 25,000 unit as this is faster.
The selling price for Product T is expected to be $12.00 per unit and the variable
cost of production is expected to be $7.80 per unit in year 1. Incremental annual
fixed production overheads of $25,000 per year will be incurred. Both the selling
price and variable cost are expected to increase at a rate of 5% per annum.
Your company has a target return on capital employed of 20%. Depreciation is

charged on a straight-line basis over the life of an asset.
Required:
Calculate the Accounting Rate of Return based on the average investment and
comment on your findings.
252
Average Capital invested =
Average Profit
Year
1 2 3 4
X units 40,0000 45,0000 50,000 25,000
Total Contribution 168,000 198,450 231,500 121,500
$
Total Contribution 719,450
Total Incremental Fixed Cost
Total Depreciation
Total Profit
Average Profit =
ARR =
Decision:
Advantages of Accounting Rate of Return:
1) Calculations are relatively simple.
2) Managers are very familiar with the ARR as it is often used by them for
performance measurement and hence will be comfortable to use it.
253
Disadvantages
1) Ignores time value of money.
2) Uses accounting profit instead of cash flows. Accounting profit is subjective
For example, the use of different accounting policies may result in different
amount of profit reported.
3) No universal method of calculating ARR, hence no consistency.
4) It is difficult and subjective to set a target rate.
254
For the other methods such as payback
and NPV, use cash flows instead of profit
2. Payback Method
Payback period refers to the number of years it takes to recover the initial
investment.
The decision rule is to accept the project with the shortest payback. The shorter
the period the better.
Steps in the calculation of Payback:
Step 1
To calculate the payback period of a project, set up the following table:
Cash Flow
Cash Inflow Cumulative Cash
Year Description (Cash Outflow) Flow
0 Initial Investment (initial investment) (initial investment)
1 Cash Inflow Cash Inflow
2 Cash Inflow Cash Inflow
Step 2
Fill in the cash inflows for the project life until the balance in the cumulative
column (column 4) changes from negative to positive.
Step 3
Determine the Payback Period as = A . a/b years
Step 4
Select the project with the shortest payback.
255
When dealing with the information provided in capital budgeting, it is
important to understand the timing of the cash flows.
1) Cash flows are always assume to occur at the end of the year
concerned, hence all cash flows are one year apart.
2) For example, the cash flows associated with asset A will look as follows
on a time line assume the asset was purchased on 1st January 2020.
(Yr = Year)
Asset A
Year Cash Flows $

0 (3,000)
1 500
2 700
3 800
4 900
5 950
Asset A- Time line
12 months 12 months 12 months 12 months 12 months

Yr0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
1/1/20 1/1/21 1/1/22 1/1/23 1/1/24 1/1/25
($3,000) $500 $700 $800 900 950
Note that Year 0 is not a year in itself, it simply represent the start of the
investment.
256
Advantage of Payback Method
1) Simple to use.
2) More objective as it uses cash flow instead of accounting profit. Better than ARR
3) Favours projects with a short payback. This will produce faster growth and
ensure more liquidity especially for smaller companies.
3) Choosing projects with the shortest payback will minimise risk.
Disadvantage
1) Ignores cash flows after the payback period.
2) Ignores the time value of money. Same As ARR
Net Present Value (NPV) Method
Central to the use of the NPV method is the principle that a dollar received today
is worth more than a dollar received in the future. (This is termed the “time value
of money)
This method involves discounting all future cash in-flows and out-flows to present
day and compare this to the initial investment at present. The net result is the
NPV of the project.
Decision Criteria:
1) PV of cash inflow (benefit) greater PV of cash outflow (Cost) = NPV positive.

Accept investment as shareholder’s wealth will increase if accept.
2) PV of cash inflow(benefit) less than PV of cash outflow (Cost) = NPV negative

Reject investment as accepting it will decrease shareholder’s wealth.
The discount rate to be used is the cost of capital and this refers to the cost of
funds raised that are used in the investment, for example to pay for the initial
investment.
If you are asked to select between two projects, select the project with the
highest NPV.
When computing the NPV, only relevant cash flows are considered.
Irrelevant cash flows such as sunk-cost, depreciation expense are ignored.
257
Assume you invest $100 today in the bank and earn 10% interest. You reinvest
the interest earned at the end of year 1
Today Yr 1 Yr 2
$100 $110 $121
Present Future Future
Value(PV) Value(FV) Value
FV at year 2 = !" $ (1 + ()! = $100 X (1 + 0.1)" = $121
Where: r = interest rate, n = number of years on investment

# "
Hence, PV = FV X PV = $121 X ("$%.")! = $100
(#%&)!
#
(#%&)!
= Present Value factor (PVF) which is provided in the exam.
Present Value = FV X PVF
Discounting cash flows refer to the process of deriving the present value for a
given future value.
Note that the difference between future value and present value is the interest.
258
Review of POA
When considering the time value of money, we cannot add future value to present value because
their values is not the same.
For example, would you add the following dollars?

Foreign
Currency
$100 USD
$100 Sing
$100 HK
Hence the same should be for the following below! They cannot be
added.
Time
Currency
$100 Yr 1
$100 Yr 2
$100 Yr 3
Hence, to add future values they have to be discounted to a

common time currency termed present value, just like you would do
to add the foreign currency above together.
259
Duo Co needs to increase production capacity to meet increasing demand for an
existing product, the annex.
A new machine, with a useful life of four years and a maximum output of 600,000
kg of annex per year, could be bought for $500,000, payable immediately. A
feasibility study to determine the viability of the machine was carried out three
months ago costing $10,000 and this amount will be paid for next month.
The scrap value of the machine after four years would be $30,000. Forecast
demand and production of annex over the next four years is as follows:
Year 1 2 3 4
Demand (kg) 1·4 million 1·5 million 1·6 million 1·7 million
Existing production capacity for annex is limited to one million kilograms per year
and the new machine would only be used for demand additional to this.
The current selling price of annex is $8·00 per kilogram and the variable cost of
materials is $5·00 per kilogram. Other current variable costs of production are
$1·90 per kilogram. All revenue and cost are expected to increase at a rate of 4%
per annum.
Fixed costs of production associated with the new machine would be $240,000 in
the first year of production, increasing by $20,000 per year in each subsequent
year of operation.
Exam Tip- Always follow instructions
Duo Co cost of capital is 10% per annum. in the exam
Required:
(a) Calculate the net present value of buying the new machine and advise on the
acceptability of the proposed purchase (work to the nearest $1,000).
(b) Calculate the payback period for the new machine.

Discount rates
Year Factor
1 0.909
2 0.826 Exam Tip:
3 0.751 The relevant discount factors will be
4 0.683 provided in the exam just below the
5 0.621 capital budgeting question in section A,
6 0.564 no table will be provided for Acct 2097.
7 0.513
8 0.467
9 0.424
10 0.386
260
Steps in answering an NPV question
1) Read the requirement
2) Read the question and determine the life of the project
3) Highlight all relevant cash flows
4) Prepare the NPV table, taking into consideration the life of the project
5) Insert all relevant cash flows in the respective years
6) Add the total cash flows for each year to get net cash flow
7) Multiply the total cash flows by the discount rate to derive the present value for each
year.
8) Add the total present values
9) Derive the NPV = Total present value of cash inflows – present value initial investment
10) Make the decision: NPV+ = Accept, NPV - = Reject
Note:
For the payback period in part b, use the net cash flow from step 6 above to
compute the payback period, not the present values of the cash flows.
261
(a) NPV
Relevant Cash Flows only

Years $‘000
Description 1 2 3 4
Scrap Value
Total Contribution (W1)
Incremental Fixed Cost
Net Cash flows 216 335 464 504

X Discount rate 0.909 0.826 0.751 0.683
Present Value
Total Present Value = $

$’000
Total Present value
Less: PV of Initial Investment
NPV
Decision:
(b) Payback Period
Year Description Undiscounted Cumulative

Cash Flow Cash Flow
$’000 $’000
Start Initial Investment
1 Cash Inflow
2 Cash Inflow
Payback period = A . a/b
262
Working
Current Contribution per unit (Today) =
Years
1 2 3 4
X Sale Units
Total Contribution (W1)
Note: Feasibity study cost of $10,000 ignored because it is a sunk cost.
263
Advantage of the NPV
¨ Accounts for the time value of money.
¨ It takes into account all expected cash flow from the project, unlike the
payback method.
¨ It takes into account the size of the investment
¨ It is an absolute measure, so it shows the increase in the wealth of the

shareholders.
¨ It is consistent with the objective of shareholder wealth maximisation
¨ It assumes that any cash inflow during the life of the project can be reinvested
at the cost of capital. This is a reasonable assumption.
Disadvantage of the NPV
¨ There is a need to estimate the cost of capital, which is very subjective.
¨ The NPV concept is not easily understood.
264
Life Cycle Costing
Product life cycle spans from Research & Development activity until the decline
of the product.
Life cycle costing focuses on revenues and cost for each product over the entire
life cycle so that the total profitability of the product can be determined over the life
cycle, not just over one year.
The traditional accounting systems do not accumulate the cost over a product life
cycle, but instead records the cost over a twelve months in line with the financial
year.
Hence, it may be difficult to assess the product profitability over its entire life, if we
depend on the traditional accounting system.
Life cycle costing is the accumulation of cost over the product’s entire life cycle so
that the right decision can be made to launch only profitable products.
Hence, life cycle costing applies mainly to potential new products.
The product Life cycle

A product life cycle can be divided into five phases:
• Development
• Introduction
• Growth
• Maturity
• Decline
Assume the following forecast of a new product:
Year 1 Year 2 Year 3

$000 $000 $000
Sales 3,000 4,000 4,000
Expenses (1,000) (2,000) (9,000
Profit (Loss) 2,000 2,000 (5,000)
Would you recommend the launch of this new product?

__________________________________________
__________________________________________
__________________________________________
__________________________________________
265
Every product goes through a life cycle.
(a) Development. The product has a research and development stage where
costs are incurred but no revenue is generated.
(b) Introduction. The product is introduced to the market. Potential

customers will be unaware of the product or service, and the organization
may have to spend further on advertising to bring the product or service to
the attention of the market.
(c) Growth. The product gains a bigger market as demand builds up. Sales
revenues increase and the product begins to make a profit.
(d) Maturity. Eventually, the growth in demand for the product will slow down
and it will enter a period of relative maturity. It will continue to be profitable.
The product may be modified or improved, as a means of sustaining its
demand.
(e) Decline. At some stage, the market will have bought enough of the product
and it will therefore reach “saturation point’. Demand will start to fall.
The usefulness of life cycle costing
With life cycle costing, non-production costs such as research and development
are traced to individual products over complete life cycles.
The total of these costs for each individual product can therefore be reported and
compared with revenues generated over the entire life cycle to determine the
product profitability over the entire life cycle.
The visibility of such costs and revenue is increased. The full set of revenues and
costs for each product become visible, particularly research and development,
marketing and customer service and disposal costs.
Individual product profitability can better be understood by attributing all costs to

products over the entire life cycle.
As a consequence, more accurate feedback information is available to assist

companies to make better decisions as to which products to launch.
266
Companies that can benefit from using life cycle costing
Life cycle costing is of benefit in companies whose products:
1) Have definable lifecycles which can be forecasted with some accuracy.
2) Have very short lifecycles e.g. mobile phones, cosmetics. The maximum life
cycle should be no more than three years as it becomes very difficult to forecast
cost and revenue beyond three years.
3) Have large expenditure on research and development or decommissioning

costs for example pharmaceutical companies. Such companies must ensure they
recover the expensive research and development expenditure.
DataExclusive Ltd has been trading for a few years as a software company,
developing high quality software products for industrial applications. Each
product has an estimated life of two years.
The company has noticed that their annual profits are erratic and have decided to
investigate, in detail, the profitability and cost structures of three of their products
which have just completed their economic lives. The details are shown below:
Package Inventory Distribution Quality

(IM) Logistics Measurement
(DL) (QM)
Year 1 Year 2 Year 1 Year 2 Year 1 Year 2
Estimated
demand 2,500 10,000 2,000 3,000 4,000 3,500
Selling
price £1,800 £1,600 £3,000 £3,000 £2,500 £2,200
Cost £000 £000 £000 £000 £000 £000
Research
& Product
design 6,500 12 5,100 100 2,400 910
Production 750 2,800 900 1,200 1,500 1,400
Marketing 1,400 2,600 1,200 800 2,400 1,700
Distribution 150 600 240 360 600 360
Customer
call out
and
support 500 1,250 450 850 2,200 3,080
For Product QM, in an effort to reduce costs, the research and product design
was kept to a minimum.
Never a good idea to compromise the quality of the
product
267
Required
(a)Calculate the product life cycle income statement for each software
package.(10 marks)
(b)Comment on the profitability and differences in cost structure of the three

products and advise the company on strategies for improved profitability.
(6 marks)
UOL Adapted
Zone A 2009 Question 4
How would you analyse which of these 2 companies has been better able
to control cost?
Co 1 Co 2
$ Million $ million
Sales 12 106
Expenses (3) (15)
Profit 9 91
Company 2, sales high, hence expenses also high

Company 1, sales low, hence expenses also low.
Hence, we cannot judge the efficiency of cost control by analysing the

actual cost in $.
Solution: Use percentages(proportions) such as______________.

Co 1 Co 2
Profit Margin
Cost structure
268
Product Life cycle Income Statement
Product IM DL QM
£000
Description Yr 1 Yr 2 Total Yr 1 Yr 2 Total Yr 1 Yr 2 Total
Sales 20,500 15,000 17,700
Less: Cost
Research 6,512 5,200 3,310
Production 3,550 2,100 2,900
Marketing 4,000 2,000 4,100
Distribution 750 600 960
Customer
Support 1,750 1,300 5,280
Profit(Loss) 3,938 3,800 1,150
Profit Margin
(b)
Product QM
1)Product QM is the product with the lowest profit margin(7%) and the highest
cost structure.( 93%)
2) Low profit in year 2 was due to the high customer support cost incurred due to
the poor design.
3) To improve profitability, more effort put into research and design.
Product DL
1)Product DL has the highest profit margin(25%) and hence lowest cost structure.
2)Lowest cost structure due to adequate research undertaken.
269
Product IM
1)Product IM is the product with the highest sales growth in year 2 and also the
highest total profit.
2) Highest sales growth in Year 2 due to the higher marketing cost and adequate
attention to research and design.
Exam Tip
Life cycle costing questions quite popular in Section A of exam.
Its actually easy to do this question as long as you structure the answer well as all
you are actually doing is “cut and paste” for an easy 10 marks.
Life-cycle budgeting
Life-cycle budgeting is the process in which managers estimate revenues and
business function costs of the entire value chain.
These factors make life-cycle budgeting important:
1) The development period for R&D is long and costly. These costs must be
recovered over the life span of the product.
2) Many costs are locked in at the R&D and design stages. Poorly designed
products require higher marketing and customer service costs.
270
Homework Questions- Lecture 14
Question 1
Trecor Co plans to buy a new machine to meet expected demand for a new
product, Product T. This machine will cost $250,000 and last for four years, at the
end of which time it will be sold for $5,000. Trecor Co expects demand for
Product T to be as follows:
Year 1 2 3 4
Demand (units) 35,000 40,000 50,000 25,000
The selling price for Product T is expected to be $12.00 per unit and the variable
cost of production is expected to be $7.80 per unit. Incremental annual fixed
production overheads of $25,000 per year will be incurred. Selling price and costs
are all in current price terms.
Selling price and costs are expected to increase as follows:
Increase
Selling price of Product T: 3% per year
Variable cost of production: 4% per year
Fixed production overheads: 6% per year
Trecor Co has a target return on capital employed of 20%. Depreciation is charged

on a straight-line basis over the life of an asset.
Required:
Calculate the Accounting rate of return based on the average investment and
comment on your findings.
271
Question 2
PV Co is evaluating an investment proposal to manufacture Product W33, which
has performed well in test marketing trials conducted recently by the company’s
research and development division. The following information relating to this
investment proposal has now been prepared.
Initial investment $2 million

Selling price (current price terms) $20 per unit
Expected selling price inflation 3% per year
Variable operating costs (current price terms) $8 per unit
Fixed operating costs (current price terms) $170,000 per year
Expected operating cost inflation 4% per year
The research and development division has prepared the following demand
forecast as a result of its test marketing trials. The forecast reflects expected
technological change and its effect on the anticipated life-cycle of Product W33.
Year 1 2 3 4
Demand (units) 60,000 70,000 120,000 45,000
It is expected that all units of Product W33 produced will be sold, in line with the
company’s policy of keeping no inventory of finished goods. No terminal value or
machinery scrap value is expected at the end of four years, when production of
Product W33 is planned to end.
For investment appraisal purposes, PV Co uses a cost of capital of 10% per year
and a target return on capital employed of 15% per year. Ignore taxation.
Discount factors for 10% are as follows:
Year Discount
Factor
0 1.000
1 0.909
2 0.826
3 0.751
4 0.683
Required:
Calculate the following values for the investment proposal:
(i) Net present value;
(ii) Accounting rate of return based on average investment.
Comment on your findings.
272
Question 3
East Bromwich Council is an English Local Authority responsible for providing a
range of services to its resident population of 300,000. One such service is
refuse collection. For the past ten years this has been ‘contracted out’ to a
private sector company. However, several councillors feel that this has become
increasingly expensive and there have been numerous complaints regarding the
standard of service provided. The present contract expires in just over a year’s
time.
Accordingly the Council has set up a small working party to investigate the
feasibility of taking the service back ‘in house’. This would involve the purchase
of a fleet of refuse collection vehicles at an initial cost of £3 million and
recruitment and training appropriate staff (costing £0.5m) before the service can
be run ‘in house’. The predicted running costs of the ‘in house’ service are as
shown in the table below. It is estimated that the vehicles would have working
lives of five years and a combined residual value of £0.6 million. The residual
value of the equipment would be realised in the year after the final year of use.
There would be vehicle refurbishment costs in Year 3 of £0.03 million. This
amount is already included in ‘Other Costs’ for Year 3.
The Council would, save the cost of payments to the private contractor which are
estimated to be £4.75 million in the first year, increasing by 3% per annum
thereafter.
Predicted Running Costs of ‘in house’ Service

Year of ‘in house’ Staff Costs Fuel £000 Other Costs*
service £000 £000
st 3,000 468 1,000
1
2nd 3,045 477 1,008
3rd 3,091 487 1,046
4th 3,137 497 1,024
5th 3,184 507 1,033
* The ‘Other costs’ shown above include depreciation of the vehicles and
amortisation of the initial recruitment and training both calculated using the
straight line method.
273
The Council’s cost of capital is 5% per annum. Discount factors for 5% are as
follows:
Year Discount
Factor
0 1.000
1 0.952
2 0.907
3 0.864
4 0.823
5 0.784
6 0.746
Required:
(a) Prepare a table showing the cash savings to be made by the Council
during the working life of the refuse collection project. (5 marks)
(b) Calculate the following for the refuse collection project:

i. Payback period.
ii. Accounting rate of return (based on average capital invested).
iii. Net present value. (12 marks)
(c) A similar situation exists within the Council in respect of computing facilities
where a similar sized scheme has been evaluated. The computing facilities
scheme has the following projected results:
Payback = 3 years
Accounting rate of return = 25%
Net present value = £1,150,000
However, the Council’s Director of Finance feels that capital funds are limited
and therefore the two projects are mutually exclusive.
Write a short report to the Council outlining whether investment should be

committed to the refuse collection project or the alternative project outlined.
Clearly state the reasons for your decision. Include in your answer discussion of
the relative merits of the three investment appraisal methods.
(8 marks)
UOL adapted
274
Question 4
The East Mercia Ambulance Trust serves a resident population of 2 million. It
provides emergency ambulances and patient transport services to elderly and
disabled patients from their homes to hospital and clinic appointments at National
Health Service and Local Authority locations. For the past ten years these patient
transport services have been ‘contracted out’ to a private sector company. The
Trust Board now feel that this has become increasingly expensive. There have
been numerous complaints regarding the standard of service provided. The
present contract expires in just over a year’s time.
Accordingly the Trust has set up a small working party to investigate the
feasibility of taking the service back ‘in house’. This would involve the purchase
of a fleet of patient transport vehicles at an initial cost of £6 million and the
recruitment and training of appropriate staff (costing £1m) before the service can
be run ‘in house’.
The predicted annual running costs of the ‘in house’ service are shown in the
table below. It is estimated that the vehicles would have working lives of five
years and a combined residual value of £0.8 million. The residual value of the
equipment would be realised in the year after the final year of use. There would
be an upgrade of the ambulances in Year 3 of £0.04 million. This amount is
already included in the ‘Other Costs’ shown below.
The Trust would, of course, save the cost of payments to the private contractor,
which are estimated to be £9.5 million in the first year, increasing by 3% per
annum thereafter.
Predicted Running Costs of ‘in house’ Service

Year of ‘in Staff Costs £000 Fuel £000 Other Costs*
house’ service £000
st 6,000 936 2,000
1
nd 6,090 954 2,016
2
rd 6,182 974 2,072
3
th 6,274 994 2,048
4
th 6,368 1,014 2,066
5
* The ‘Other Costs’ shown above include depreciation of the vehicles and
amortisation of the initial recruitment and training calculated using a straight line
basis.
The Trust’s cost of capital is 5% per annum. Discount factors for 5% are as
follows:
275
Year Discount
Factor
0 1.000
1 0.952
2 0.907
3 0.864
4 0.823
5 0.784
6 0.746
Required:
(a) Prepare a table showing the net cash savings to be made by the Trust during
the working life of the patient transport project. (5 marks)
(b) Calculate the following for the patient transport project:
i. Payback period.
ii. Accounting rate of return (based on average capital invested).
iii. Net present value. (12 marks)
(c) A similar situation exists within the Trust in respect of computing facilities and
a similarly sized scheme has been evaluated. The computer scheme has the
following projected results:
Payback = 3.75 years

Accounting rate of return = 21%
Net present value = £2,900,000
However, the Trust’s Director of Finance feels that capital funds are limited and
therefore the two projects are mutually exclusive.
Write a short report to the Trust outlining whether investment should be

committed to the patient transport or the alternative project outlined. Clearly state
the reasons for your decision. Include in your answer discussion of the relative
merits of the three investment appraisal methods. (8 marks)
(UOL adapted 2009 Zone A Question 2)
Question 5
List & briefly describe the five stages in capital budgeting.
276
Question 6
Digital Gadgets, a division of a large group, is developing a new product with a
predicted four year life. To produce this product more building space will be
needed. To provide this space, Digital Gadgets can lease a derelict site for four
years, after which time the site must be cleared. Digital Gadgets plans to hire
prefabricated buildings to be used on the site, so that the buildings can be easily
removed after four years. Maximum production capacity available will be 100,000
units per year.
The estimated costs and revenues are:
Digital Gadgets estimates that the price will be £50 per unit from month 5 to
month 24. In month 25 there will be a re-launch of the product with new features.
At this stage, the price will be increased to £55 until month 48. The manager
wishes to see the total impact on profits of this plan.
Required:
(a) Prepare a lifecycle costing statement for this product (ignore the time value of
money). (7 marks)
(b) The manager is disappointed with the sales forecast for the final year (months
37-48) and explores possibilities of reducing the price to £52 and increasing
marketing and promotion by £200,000. Demand forecasts indicate:
277
50% probability that sales units will not increase as the gadget is losing
popularity,
40% probability that sales will increase to 80,000 units,
10% probability that sales will increase to 110,000 units.
Provide calculations and comment on whether the manager’s idea should be

adopted. (5 marks)
(c) Show the profits that would be reported each year. Assume that product
development costs and site dismantling costs are expenses in the income
statement the year they are incurred; the cost of installation of buildings and the
equipment costs are depreciated using the straight line method with no residual
value. (6 marks)
(d) Explain how your forecasts in (a) to (c) would be used by the divisional
manager. (4 marks)
(e) The group operates a divisional managers’ bonus scheme, based on annual
profits. Briefly discuss the effect this may have on the manager’s decision to
adopt this project. (3 marks)
(UOL adapted 2010 Zone B Q3, 25 marks)
278
Question 7- (note this question was partially done in class)
Data Exclusive Ltd has been trading for a few years as a software company,
developing high quality software products for industrial applications. Each
product has an estimated life of two years.
The company has noticed that their annual profits are erratic and have decided to
investigate, in detail, the profitability and cost structures of three of their products
which have just completed their economic lives. The details are shown below:
Package Inventory Distribution Quality

movement (IM) logistics (DL) measurement (QM)
Year 1 Year 2 Year 1 Year 2 Year 1 Year 2
Estimated demand 2,500 10,000 2,000 3,000 4,000 3,500
(units)
Selling price £1,800 £1,600 £3,000 £3,000 £2,500 £2,200
Costs £000 £000 £000 £000 £000 £000

Research & Product 6,500 12 5,100 100 2,400 910
Design
Production 750 2,800 900 1,200 1,500 1,400
Marketing 1,400 2,600 1,200 800 2,400 1,700
Distribution 150 600 240 360 600 360
Customer call out 500 1,250 450 850 2,200 3,080
and support
For Product QM, in an effort to reduce costs, the research and product design
was kept to a minimum.
Required
(a) Calculate the company’s income for Years 1 and 2 and briefly comment on
the profit trend. (5 marks)
(b) Calculate the product life cycle income statement for each software package.
(10 marks)
(c) Comment on the profitability and differences in cost structure of the three
products and advise the company on strategies for improved profitability.
(6 marks)
(d) Briefly discuss the usefulness of life cycle costing. (4 marks)

(UOL adapted 2009 Zone A Question 4)
The End –Lecture 14
279
University Of London
Lecture Notes
Lecture 15
Topics Covered
Budgeting 1
Readings : Horngren Chapter 14
Lecture 15
This lecture is on the preparation of the master(planning) budget.
The discursive elements in this lecture frequently tested in Section

B of the exam and hence good to focus on for the essay question in
section B.
The question on master budget preparation for Section A of exam,

for example on cash budget are also fairly easy so also good focus
areas.
280
The Planning & Control Cycle
Planning – Involves making choices between alternatives and is primarily a

decision making activity.
Control- involves measuring and correcting actual performance to ensure that the
strategy that are chosen and the plans for implementing them are carried out.
Planning:
This involves establishing objectives and selecting appropriate strategies to

achieve those objectives.
Planning involves:
Long term planning
This is corporate planning. Long term planning involves selecting appropriate

strategies to prepare a long-term plan.
Short –term planning
This involves converting the long-term plans into a series of short-term plans,
usually covering one year, relating to specific functions or departments.
Examples of short plans are the sales budget and production budget.
281
The main purposes and benefits of budgeting are:
Purpose:
Define goals and set targets.
Management are forced to plan for the future and set targets.
Benefits
1) Communication and coordination.
Preparation of budgets encourages coordination and communication between
different parts of the organisation. For example, the production department needs
to know how much the sales department is planning to sell in order to set its
target for production.
2) Motivation
Budgets provide targets and, as such, can motivate staff to achieve them,
especially if staff are rewarded on the basis of meeting budget.
Budgets give managers the authorisation to
spend and responsibility to achieve targets
3) Authorisation and responsibility
Managers know that budgeted expenditure has been authorised and can act
accordingly. Setting individual budget for particular business activities or
departments can be used to assign responsibility to individual managers for
meeting those budgets. Actual performance judged
against budgets
4)Performance evaluation and cost control.
Budgets provide plans against which subsequent performance can be
judged. Management performance can also be assessed and rewarded on
this basis.
Forces management to
plan for the future, define
goals
Enhance Set targets,

coordination assign
responsibility
Enhance ADVANTAGES OF Performance

communication BUDGETING evaluation
ENHANCE Cost Control

MOTIVATION
282
Developing the (fixed) operating budget
Budgets typically cover a set time period including a full business cycle which is
usually 1 year, in line with the financial year.
The master budget expresses management’s operating and financial plans for a
specified period (usually a fiscal year). The master budget is actually a series of
budgets including a set of budgeted financial statements.
The budgeting process includes both operating budgets and financial

budgets.
Operating budgets include budgets reflecting the planned operational aspects

of the business, including revenues, production, manufacturing costs, and other
expenses for the period. It culminates in a budgeted income statement.
Financial budgets consist of a capital expenditures budget, a cash budget, a

budgeted balance sheet, and a budgeted statement of cash flows
283
The Master (Fixed) Budget Preparation Process
Sales Budget
Note the sequence of
budget preparation, start
Ending Stock
from the sales budget,
Budget then to the other budgets
as we only produce in
Production Budget accordance to demand.
DM Budget DL Budget Overhead Budget
Operating
Budget
COST OF GOODS SOLD BUDGET
R & D, MARKETING& DISTRIBUTION

COST BUDGETS
BUDGETED INCOME STATEMENT
CAPITAL EXPENDITURE BUDGET

Financial Budget CASH BUDGET
BUDGETED STATEMENT OF FINANCIAL POSITION
BUDGETED STATEMENT OF CASH FLOW
NOTE: DM refers to Direct Materials ,DL refers to Direct Labour
284
These budgets are similar to the budgets done
in POA.
Formats
a) Sales Budget
Description Budgeted Units Selling Price Total Sales
Per Unit $
b) Production Budget (Units)

Units
Budgeted Sales
Add: Target Ending Stocks
Total Requirements
Less: Opening Stocks
UNITS TO PRODUCED
c) Direct Material Usage & Purchase Budget
Units
Units to Produce
X Direct Material Usage Per Unit
Total Budgeted Usage
Add: target Ending Stock
Total KG Required
Less: Opening Stocks
KG to be purchased
Purchase Price Per KG
Total Purchases $
d) Direct Labour Budget
Units to Produce
Direct Labour Hours per Unit
Total Budgeted Hours
X Cost Per Hour $
Total Direct Labour Cost $
285
Cash Budget
A detailed budget which shows all cash inflows & outflows incorporating both
revenue & capital items.
Objective : To determine periods of cash deficiency and surplus so that

appropriate action can be taken. The period will be
Memorise the structure of the specified in the question,
Format of the cash budget: cash budget for example, monthly or
quarterly
The typical cash budget has the general format shown below:
Period 1 Period 2
+OPENING CASH BALANCE
CASH RECEIPTS
+ Receipts from Debtors
+ Sales of capital items
+Any Loans Receipts
+ Proceeds from share issue
+ Any other Cash Receipts
E.G. Taxation Refund
GST Refund
+TOTAL CASH RECEIPTS
= TOTAL CASH AVAILABLE
CASH DISBURSEMENTS
- Payment to creditors
- Cash Purchases
- Wages & Salaries
- Loan Repayments
-Capital Expenditures
-Dividends paid
-taxation paid
-Any other cash disbursements
-TOTAL CASH DISBURSEMENTS

ENDING CASH BALANCE FOR PERIOD
Notes of preparing a cash budget:
1) Only include cash flows , therefore exclude depreciation expense as it’s a

non-cash expense.
2) Include all cash flows in the actual period received or paid.
3) Timing of the cash flows is important.
286
Boris Bikes PLC is a U.K. company manufacturing motor scooters. It has
recently decided to build a factory in Singapore, to serve both the Singaporean
and other markets in the Far East. After the initial period of capital investment,
you have been appointed Financial Director of the Singaporean subsidiary.
The new factory is due to open in January 2015. You are aware that the first four
months of operations will be critical to its long term survival and you wish to
prepare budgets for that period. After consultation with the Boris Head Office you
discover that:
Expected sales are $2.0 million in January, $3.0 million in February, $4.0
million in March and $5.0 million in April.
Monthly fixed expenses are expected to be:
Production overheads $2,000,000

Selling overheads $250,000
Administration overheads $250,000
The budget for variable operating expenses is expected to be:
Direct Materials 20% of sales revenue

Direct Wages 10% of sales revenue
Production Overhead 5% of sales revenue
Selling Overhead 2% of sales revenue
Required:
Prepare in columnar form, an operating budget for the months of January to April
showing projected income, operating expenses, and the budgeted operating Income is
income. (6 marks)
another word
for profit
You also establish that on 1st January 2015 Head Office will provide you with
an opening cash balance of $1.5million at, and you are concerned as to
whether this will be sufficient. On researching the timing of receipts and
payments relating to the operating budget you discover the following:
Sales Revenue will be 50% within Singapore and 50% from exports.
Singaporean customers will pay in the month following the sale, export
customers two months after the sale.
Direct Materials will be paid for in the month after their usage.
Direct Wages and Variable Production Overheads will be paid for in the month to
which they relate.
287
Fixed Production Overheads relate largely to the manufacturing plant which is
highly automated. They therefore include a monthly depreciation charge of $1.0
million. They also include an annual insurance premium of $2.8 million which
must be paid in January, and property taxes of $1.6 million must be paid twice a
year in March and September (a yearly total of $3.2million). The remaining
costs are due for payment in even monthly amounts throughout the year.
Variable Selling Overheads are payable in the month following the month to
which they relate.
Fixed Selling Overheads and Administration Overheads are spread evenly

throughout the year, and are payable in the month to which they relate.
A payment of $4 million is outstanding on the capital cost of the automated

plant and – providing that the plant is working satisfactorily – will be paid in
April.
In setting up the Singaporean subsidiary Boris purchased more land than was
needed. A site of 2 hectares is now being sold for its cost price, of $3 million
which will be received in March.
You have established good relations with the local branch of a major bank,
and are aware that short term overdraft facilities are available. Interest will be
paid at 1% per month on the balance outstanding at the previous month end.
Required:
Prepare a cash budget for Boris Bikes (Singapore) for the months of January to
April. (14 marks)
Exam Tip:
Not bad for 14 marks, compared to other topic
UOL Adapted Zone A 2014 Question 3 questions.
Cash budget, lots of easy marks available as

long as you structure your answer quickly and
“cut and paste” the easy cash flows in the
respective years.
Good choice question especially for students

who are not good with their MA concepts.
288
Exam Tip
Important to structure the answer asap
after you read the question
Operating budget £‘000
Description Jan Feb Mar Apr
Sales
Less: Expense
D. Material
D. Wages
Production Overheads
Variable
Fixed
Selling Overheads
Variable
Fixed
Fixed Admin Overheads
Operating Profits (1,240) (610) 20 650
289
Cash Sales Working(W1)
£‘000
Jan Feb Mar Apr
Accrual Sales 2,000 3,000 4,000 5,000
Singapore (50%) 1,000 1,500 2,000
Export (50%) 1,000 1,500
Cash Sales (W1) 1,000 2,500 3,500
$
Monthly Fixed Prodn Overheads
Less: Monthly Depreciation Expense
Less: Monthly Insurance & Property
Cash Monthly Fixed Prod Overheads
290
Cash Budget
$000
Description Jan Feb Mar Apr
Opening Cash Balance
Cash Receipt
Cash form Sales (W1)
Land Sales
Total Cash Available 1,500 (1,600) 1,984 1,589
Cash Payment
D. Material
D. Wages
Variable Prodn Overheads
Variable Selling
Fixed Selling
Admin Overheads
Plant Cost
Prodn Overheads Cash Fixed
Insurance
Property Tax
Cash Payment (4,100) (1,890) (3,860) (6,630)
Cash Bal b/f OD interest

OD Interest
Ending Cash Bal
291
Exam Tip
Budgeting Systems This part popular for Section B of the exam
Four systems are identified here:
1) Incremental budgeting systems
2) Zero based budgeting systems
3) Rolling budgets
4) Activity Based Budgets
Incremental budgeting systems
This involves adding certain percentage to last year’s budget to allow for growth
and inflation. The starting point is either previous period budget or the previous
period’s actual results.
Appropriate for use if the current operations are very efficient.
Appropriate for budgeting for certain cost such as staff salaries which are based
on an estimate of current salaries plus an increment for inflation.
Advantage:
Quick & easy to prepare as only the size of the increase required needs to be
justified.
Disadvantages:
1) Encourages non-value added activities to continue.
2) It encourages organisation to spend the maximum allowed in the knowledge

that if they don’t do this then future budget allocation will be reduced.
3) Determining the amount of the increment may be difficult as it is subjective.
2) Why would the manager spend the maximum amount and what’s wrong
with that?
Because of you don’t spend the maximum amount allocated to your

department, it means you need less funds in the future and hence managers
fear that less funding will be available in the future.
Problem here is that the manager will just spend for the sake of spending and
use up the existing budget now and hence end up spending inefficiently.-
WRONG BEHAVIOUR!
292
Zero based Budgeting Systems (ZBB)
ZBB treats the preparation of the budget for each new period as an independent
planning exercise.
The initial budget is zero (unlike incremental budgeting) and every item of
expenditure has to be justified to its entirety in order to be included.
ZBB involves a questioning attitude by all those involved in the budgetary process.
Existing activities must be challenged and questions asked about each and every
expenditure, hence non-value added activities can be identified and eliminated.
ZBB involves prioritizing expenditure. In order to do this spending proposals have

to be prepared by each department and this spending proposal is termed a
decision package
A decision package is a comprehensive description of a specific organisation

activity which management can use to evaluate the activity and rank it in order of
priority against other activities.
Exam tip
Memorise the three steps here as
A ZBB approach has 3 steps: commonly tested
Step 1 – Define the various decision packages
Step 2 – Evaluate and rank packages
Each activity is evaluated and ranked on the basis of its benefit to the
organisation. The ranking process requires managers to allocate scarce
resources between activities.
Step 3 – Allocate Resources
Resources in the budget are then allocated according to the funds available
and the evaluation and ranking of the competing packages.
Advantages of ZBB:
a) Identifies and removes inefficient or obsolete operations.
b) Forces employees to avoid wasteful expenditure.
c) Forces managers to challenge the status quo
d) Leads to more efficient allocation of resources
293
Disadvantages of ZBB:
a) Time consuming and requires a lot of paperwork
b) Ranking of packages can prove difficult as managers may regard each

package as being equally vital.
c) Certain activity becomes difficult to quantify and rank as their benefits are
more qualitative than quantitative. For example, spending on employee
welfare and improving working conditions.
One way to overcome that most serious drawback of ZBB is to apply it selectively
on a rolling basis throughout the organisation. For example, apply ZBB to different
departments every year.
Rolling budgets
Rolling budgets (continuous budgets) are budgets which are continuously updated
by adding a further period (month or quarter) and deducting the earliest period.
Rolling budgets are useful for companies facing changing, dynamic conditions in
its operating environment for example new technology, competitors actions.
Changes in the operating environment may make the original budget assumptions
inappropriate or unrealistic and hence changes required.
Advantages
a) Up to date budgets are always prepared
b) Planning and control are based on recent plans
c) Budgets are more realistic. The element of uncertainty is reduced. This

becomes more motivational to employees.
Disadvantages:
a) More time consuming, simpler to update the budget manual once or twice every
year.
b) Frequent budgeting may have a “off-putting effect” on managers. Managers

may doubt the value of preparing one budget after another.
294
Example of rolling budgets, assuming rolling monthly.
1st budget prepared for the financial year ending 31/12/20
1/1/20 31/12/20
At end of January 2020, the budget revised to include the next following
month, January 2021 and January 2020 is excluded.
1/2/20 31/1/21
At end of February 2020, the budget revised again to include the next
following month, February 2021 and February 2020 is excluded.
1/3/20 28/2/21
The process is repeated again for the next months.
Main advantage is that when the budgets are revised, changes in
assumptions can be incorporated and new information can be reflected
in the revised budget and the budget reflects the current environment.
This is part of Activity Based

Activity Based Budgeting (ABB) Management (ABM)
This is a method of budgeting in line with the ABC system.
ABB is based on the following principles:
• Activities are the cost drivers of cost.
• If activities can be controlled, then cost can be controlled.
• ABB focus on activities and not department cost. Hence, easier to see if
the activities are adding value in the value chain.
• Non value-added activities should be eliminated.

1.
Hence, ABB leads to a better understanding of the determinants of cost and will
result in improved budgeting resource allocation decision
295
Participative budgeting
Human Aspects of Budgeting Advantages: Gain commitment, realistic budget and
motivational.
Disadvantages: Time consuming, leads to budgetary slack
1)Participation is crucial
A budget is more effective when the lower-level managers actively engage in the
budget process. This participation adds credibility to the budgeting process and
creates greater commitment toward the budget.
Self Interest preservation, if managers allowed to
2) Budgetary Slack participate in setting targets.
Managers frequently play games with budgets and build in budgetary slack.
This is the practice of underestimating revenues, overestimating costs in order to
make the budget targets more easily achievable. This will dilute the targets set
and hence distort the objectives of budgeting.
Challenges in budgeting
1) Time consuming and managers may resent spending the extra time
It is a time-consuming process that involves all levels of management.
2) Needs the support of all levels of management

Management at all levels should understand and support the budget
3) Flexibility required
Budgets should not be administered rigidly. Changing conditions may call for
changes in plans. Hence, flexibility in the interpretation of the results as well
the need to make changes to the budgets is important.
Summary: Good budgeting system must: Remember, budgets are target and target
1) Allow Participation meant to be motivational.
2) Fair and Well communicated targets This will only be when the targets are fair,
3) Budgets are realistic, yet challenging realistic and challenging.
4) Flexible in changing plans and interpretation of results
5) Get support of all levels of management
What is budgetary slack?
Managers “game” the budget in order to achieve favourable variances and hence
enhance their performance.
The sales manager if allowed to participate in setting the sales budget will understate
the sales budget so that its easier to achieve.
The production manager will overstate the production cost budget so that its easier to
achieve. 296
Remember, in the real world managers tend to act in “self interest”.
Homework Question Lecture 15
Question 1
For many organisations in both the private and public sectors the annual budget
is the basis of much internal management information.
Required:
a)Briefly discuss four purposes of budgets.
b) Explain the behavioural factors which should be borne in mind and the
difficulties of applying them in the process of budgeting and budgetary control.
Question 2
Explain the purpose of Responsibility Accounting and the behavioural problems

which can arise in companies where managerial performance appraisal is largely
related to meeting budgetary targets.(15 marks)
(UOL adapted Zone A 2008 Question 6b)
Question 3
Management accounting information may be improved by the use of probability

analysis (including decision trees)
Explain the operation of the method, describe one management accounting

situation in which it might be used and explain the factors which should be
considered in order to use the technique most effectively. (You are not required
to provide a numerical example). (UOL adapted 2008 Zone A Question 7).
Question 4
Companies need to forecast in order to make both long-term and short-term

decisions. Discuss the role that management accounting plays in forecasting in
large organisations.
(UOL adapted 2010 Zone A Question 5, 25 marks).
Question 5
Explain the relationship between strategy, plans and budgeting.
Question 6
Briefly explain the four steps(elements) of the budgeting cycle.
The End –Lecture 15
297

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University of London

Decision making and uncertainty

Readings: Subject Guide Chapter 9. This lecture not covered in

This lecture deals with methods of reducing risk in decision making

High Risk High Return

Low Risk Low Return

Techniques to reduce uncertainty

Expected values (probability analysis)

Expected values: An expected value is the weighted average of the outcomes

Where n = number of items or event

Sales Volume(n) Profit(Loss)$000(n) Probability(P)

Expected sales volume

A company had developed a new product and management is trying to

The following information has been collected:

Total fixed costs are estimated to be $75,000.

Contribution per unit

(Up to 25,000 Units) =

Above to 25,000 Units =

Total Expected Contribution 362,600

In situations where uncertainty exists and its not possible to assign

Maximax criteria looks at the best possible results.

This approach used by an aggressive investor. Optimistic outlook

Maximin criteria looks at the worst possible results. Pessimistic outlook

This approach used by a conservative investor.

Determine which project should be selected using the:

A manager is trying to decide which of three mutually exclusive projects to

Net profit in $000s if outcome turns out to be

Regret Table $’000

Decision: Select Project B.

Maximum Total Contribution in the best situation when Variable cost

Price Total Contribution (V. Cost $4 per unit)

Maximise Total Contribution in the worst situation (Highest variable

Price Total Contribution (V. Cost $6 per unit)

Decision: Choose price of $12.

Decision: Select Price of $12 minimum regret of $1,000.

Your company is about to launch a new product onto the market.

A decision is to be made as to whether to launch the product at a price of

2 Advertising costs would be $900,000 per annum at a selling price of $30

3 Fixed production costs would be $450,000 per annum.

b) Identify which price should be chosen if the maximin rule is used.

(a) Contribution per unit

Above 100,000 Units

Decision: Select price of

A Decision Tree is an analytical tool to assist in decision making. It ensures

Decision tree analysis is particularly useful when there is a sequence of

Circle represent outcome

Rules of drawing a decision tree:

Start from left to right

All possible outcome of each option/choice are shown as subsidiary branches

Squares represents decision points and circles represents outcomes.

A company is about to launch a new product with the following information:

Sales Units Probability Unit Costs $ Probability

Expected profit if result positive and market product

D Decision: If result negative

B Expected Profit If Test

The End – Lecture 12

Linear Programming, Theory of Constraints

Readings : Hongren Chapter 10 appendix.

Linear programming is a popular section A question in the exam.