Performance Management
Performance Management
Performance Management
PERFORMANCE MANAGEMENT
PM
STUDY NOTES - 2019
Contents
CHAPTER 1: MANAGING INFORMATION ................................................................................................ 4
CHAPTER 2: SOURCES OF INFORMATION ............................................................................................. 11
CHAPTER 3: INFORMATION SYSTEMS AND DATA ANALYTICS .............................................................. 14
CHAPTER 4: TRADITIONAL COSTING ..................................................................................................... 24
CHAPTER 5: ACTIVITY BASED COSTING (ABC) ....................................................................................... 29
CHAPTER 6: TARGET COSTING .............................................................................................................. 35
CHAPTER 7: LIFECYCLE COSTING........................................................................................................... 41
CHAPTER 8: THROUGHPUT ACCOUNTING ............................................................................................ 47
CHAPTER 9: ENVIRONMENTAL ACCOUNTING ...................................................................................... 56
CHAPTER 10: COST VOLUME PROFIT (CVP) ANALYSIS .......................................................................... 61
CHAPTER 11: LIMITING FACTOR ANALYSIS ........................................................................................... 70
CHAPTER 12: PRICING DECISIONS ......................................................................................................... 83
CHAPTER 13: SHORT TERM DECISIONS ................................................................................................. 97
CHAPTER 14: RISK AND UNCERTAINTY ............................................................................................... 106
CHAPTER 15: BUDGETARY SYSTEMS ................................................................................................... 120
CHAPTER 16: QUANTITATIVE ANALYSIS.............................................................................................. 131
CHAPTER 17: STANDARD COSTING AND VARIANCE ANALYSIS ........................................................... 138
CHAPTER 18: MIX AND YIELD VARIANCES .......................................................................................... 158
CHAPTER 19: PLANNING AND OPERATIONAL VARIANCES ................................................................. 166
CHAPTER 20: PERFORMANCE ANALYSIS ............................................................................................. 172
CHAPTER 21: PERFORMANCE ANALYSIS – PRIVATE SECTOR .............................................................. 177
CHAPTER 22: DIVISIONAL PERFORMANCE AND TRANSFER PRICING ................................................. 197
CHAPTER 23: PERFORMANCE ANALYSIS – NOT FOR PROFIT SECTOR ................................................ 226
PM STUDY NOTES
Syllabus Area A
INFORMATION, TECHNOLOGIES AND SYSTEMS FOR
ORGANISATION PERFORMANCE
PM STUDY NOTES
Introduction
Businesses thrive on data – so all businesses; big or small, need systems and procedures
that help them collect, process, store and share data.
In today’s digital world, instead of maintaining paper based records, the collection,
processing, storing and sharing of data is also automated.
Businesses invest in Information systems in order to have data easily accessible in the
form required for decision making. When used correctly, information system’s can
positively impact an organization's overall performance and revenue.
Information System
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Normally organisations predict the benefits of an information system expected over its
lifetime and estimate the costs of initial development and ongoing operations to
compare and identify the worth of the system to the business.
Some generic benefits and costs associated with the implementation of an Information
System are discussed below:
Benefits:
Academic studies have proven that Information Systems support operational
benefits such as cost reduction and increase competitive capability of businesses.
Provided there are no challenges in the data collection phase, the information
generated by the systems normally has less chances of ‘human error’.
Since information systems rely on software – this can be modified or re-
programmed to meet the changing needs of the users. With the advancement in the
field of programming, this does not necessarily imply a disruption in all functions of
the organisation, when a particular part is being re-programmed.
Costs:
Normally the major cost associated with a custom Information system is the labour
cost – which covers the salaries of the system analysts and programmers.
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In such a scenario, another cost impact is the time of the employees with whom the
programmers need to work in close collaboration in order to develop software that
fulfils the maximum user needs.
An alternate to a customised Information System are the ‘off-the-shelf’ software that
although cheap may cost the company in terms of unfulfilled information needs,
since these are not designed according to the specific business requirements.
Regardless of what information system is finalised, there are costs related to the
hardware and telecommunications network associated with its use.
Additionally businesses have to bear the cost of training employees in the use of the
information systems.
The business also needs to budget for repairs and maintenance expenses of the
system implemented – also taking into account the rapidly changing environment.
Although not a tangible cost with immediate impact, a risk associated with
automated information systems is that of its security – physical or in the form of
virus or malware.
These technologies include optical fiber, wired, wireless or electronics circuitry. The
internet carries huge amounts of data available on World Wide Web.
Uses:
E-mails – the most common way of communicating the written word across the
globe
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Ease of research into factors affecting the business and expanding the business
network
E-meetings help do away the need for travelling for work
Sharing files, images, videos etc.
The Intranet is a network of devices which is private and not available to the public. In
an intranet, the networked computers or devices are available only to a group of
authorized users.
Businesses can set up security policies specific to the user, group or device. The users
within intranet can connect to the internet, a public network through firewalls.
Uses:
The major uses of intranet include faster sharing of information within an
organization. This helps streamline activities.
Improved internal communication leads to enhanced collaboration and promotion
of corporate culture.
Businesses are able to centralise and organise company data into a single database.
The main differences between the internet and intranet can be summarised as follows:
INTERNET INTRANET
Available to all across the globe Only the employees of organization can
access it
Data traveling across the internet or the Intranet is more secure due to presence of
web is Less Secure robust security systems
No login credentials are required to A user account is must to access the
access the information from internet devices of intranet
Any number of users can access the There is a limit to the number of users that
internet services and documents. can access internet resources
No rules or policies are defined to access There are certain policies and regulations
internet resources which you have to comply within the
intranet.
Wireless communications can be available all of the time, almost anywhere. They have
several advantages including:
Communication has enhanced to convey the information quickly to the consumers.
Working professionals can work and access Internet anywhere and anytime without
carrying cables or wires wherever they go. This also helps to complete the work
anywhere on time and improves the productivity.
Urgent situation can be alerted through wireless communication.
Wireless networks are cheaper to install and maintain.
Wireless networks are computer networks that are not connected by cables of any
kind.
The use of a wireless network enables enterprises to avoid the costly process of
introducing cables into buildings or as a connection between different equipment
locations.
The basis of wireless systems are radio waves, an implementation that takes place at the
physical level of network structure.
PM STUDY NOTES
When generating information, even if for internal use, as well as when distributing it,
businesses should ensure that there are certain controls in place. These can vary based
on whether the information being generated is routine information or ad-hoc.
Distributing Information:
A procedures manual should be in place. This would indicate what reports are to be
prepared and issued to whom.
Confidential information should be highlighted as such and users guided on how to
deal with sensitive information.
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E-mail policy should be established specifying the do’s and donts’ for on-line
communication.
Physical computer security
Internal security should be established. Senior management should specify
which user can have access to which assets and information.
External security through firewalls should be established, as they can be used to
protect data and databases from being accessed by unauthorised people.
Security and confidential information
A number of procedures can be used to ensure the security of highly confidential
information that is not for external consumption. Measures such as passwords,
firewalls, database controls, data encryption can be implemented.
Additionally businesses can ensure that the security of the information stored is
maintained by entrusting limited people with its access.
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Types of Data
External Sources:
Legal/ Tax expert
Research & Development and Marketing departments
Directories & other published sources
Associations and Government agencies
Information from customers
Information from suppliers (product details, pricing etc.)
Internet & online databases
Database information
Data warehouses
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Cost of Information
The following are some examples of costs that are incurred in gathering, recording and
storing data:
Management costs:
Recording, processing and dissemination of external information
Infrastructure costs:
Installation and maintenance of systems – communication, internet etc. to
facilitate flow of information.
Time theft:
Wasted time caused by abuse of internet and email access facilities
Information overload
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Strategic Planning: These are long term planning decisions that define the objectives of
the organisation.
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This is also known as Tactical Planning and managers at this level are required to
ensure that their decision making reflects the following:
Efficiency in the use of resources means that optimum output is achieved from
the input resources used.
Effectiveness in the use of resources means that the outputs obtained are
according to set objectives or targets.
The time horizon involved in management control will be shorter than at the strategic
decisions level and these are considered short-term non-strategic activities.
PM STUDY NOTES
This includes scheduling of unexpected or 'ad hoc' work as this must be done at
short notice.
Operation control decisions are termed as short-term non-strategic activities.
Information requirements for decisions taken at this level include:
Transaction data which is needed for the conduct of day-to-day implementation
of plans.
Detail of information provided depends upon the purpose, it is required for.
Operational information, although quantitative, is expressed in terms of units,
hours, quantities of material, and so on.
Transaction Processing Systems (TPS) collect, store, modify and retrieve the
transactions of an organisation.
PM STUDY NOTES
Management information systems (MIS) convert data from mainly internal sources
into information, which enables managers to make timely and effective decisions for
planning and controlling the activities.
Executive information systems (EIS) provides a quick and efficient computing and
communication environment for senior managers to support strategic decisions.
Executive information systems draw data from the MIS and allow communication with
external sources of information.
Executive resource planning systems (ERP systems) are modular software packages
designed to integrate the key processes in an orgnanisation so that a single system can
serve the information needs of all functional areas.
ERP systems have the principal benefit that the same data can easily be shared between
different departments. ERP systems work in real time.
Benefits of ERP
Easy access to shared real time information to support decision making.
A lot of inefficiencies in the way things are done can be removed; as the company
restructures its processes so that multiple departments can work together.
Standardising Information and work practices so that the terminology used is
similar.
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Big Data
There are many definitions of the term ‘big data’ but most suggest something like the
following:
'Extremely large collections of data (data sets) that may be analysed to reveal patterns,
trends, and associations, especially relating to human behaviour and interactions.'
Big data is about much larger, more complex data sets in all forms being available to
businesses, from structured and semi structured to completely unstructured data. It
comes from a variety of new and existing sources and these are increasing as more and
more people carry out most of their activities on electronic devices where the data is
recorded. Data therefore has a great deal of potential value.
Data which is not used or analysed has no value, but value can be added to data if it is
cleaned, processed, transformed and analysed. Therefore data collected can be
considered to be the raw material as in a manufacturing process.
The cleaning and transformation of the data into a suitable form for analysis is really
where the value is being added, so that the data can become the finished product –
which is useful information which needs to be delivered or communicated to the user.
Today, big data has become an important form of organisational capital. For some of the
world’s biggest tech companies such as Facebook, a large part of the value they offer
comes from their data, which they are constantly analysing to produce and develop new
revenue streams.
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These characteristics, and sometimes additional ones, have been generally adopted as
the essential qualities of big data.
Volume
The amount of data matters greatly and the more that can be accessed the better. Most
of this may have no value, but no one will know until they try and structure it and use it.
This data can come from a wide range of sources, but could include social media data,
hits on a website, or results from surveys or approval ratings given by consumers. For
some organisations the sheer amount of this data will be difficult to manage unless the
organisation has the right capabilities, including adequate storage and processing
capacity.
The main thing about the volume of big data is the additional reliability it gives the data
analyst. As any statistician knows, the more data you have, the more reliable your
analysis becomes and the more confident you can be about using the results you obtain
to inform decision-making
Velocity
Velocity is the rate at which data is received and used. In the modern world,
transactions are conducted and recorded in real time. As people increasingly shop with
debit and credit cards and use their phone apps, these transactions are updated
immediately.
Stores themselves know exactly how much inventory they have and the sales they are
generating on a transaction by transaction basis and because customers transact with
them electronically, they also know a lot more about their customers and their buying
patterns. The banks too, immediately know that funds have gone out of customers‘, and
into their suppliers’ accounts in real time.
Variety
Variety refers to the many types and sources of data which are available. Traditional
data types were more structured. With the rise of big data, data comes in new
PM STUDY NOTES
unstructured types. This also comes in a variety of forms. These include numerical data,
text, audio, pictures and videos.
All these require additional processing to transform them into meaningful and useful
information which can be used to support decision-making, but being able to access
them and use them provides richer information for the business leader which can make
the information obtained from the data analysis more relevant and significant than
larger amounts of data from more structured sources.
The processing of big data is generally known as big data analytics and includes:
Data mining: analysing data to identify patterns and establish relationships such as
associations (where several events are connected), sequences (where one event leads to
another) and correlations.
Predictive analytics: a type of data mining which aims to predict future events. For
example, the chance of someone being persuaded to upgrade a flight.
Text analytics: scanning text such as emails and word processing documents to extract
useful information. It could simply be looking for key-words that indicate an interest in
a product or place.
PM STUDY NOTES
Some real world examples of the use of big data are as follows:
Netflix: this company began as a DVD mailing service and developed algorithms to help
it to predict viewers’ preferences and habits. Now it delivers films over the internet and
can easily collect information about when movies are watched, how often films might be
stopped and restarted, where they might be abandoned, and how users rate films. This
allows Netflix to predict which films will be popular with which customers. It is also
being used by Netflix to produce its own TV series, with much greater assurance that
these will be hits.
Amazon: the world’s leading e-retailer collects huge amounts of information about
customers’ preferences and habits which allow it to market very accurately to each
customer. For example, it routinely makes recommendations to customers based on
books or DVDs previously purchased.
Airlines: they know where you’ve flown, preferred seats, cabin class, when you fly, how
often you search for a flight before booking, how susceptible you are to price reductions,
probably which airline you might book with instead, whether you are returning with
them but didn’t fly out with them, whether car hire was purchased last time, what class
of hotel you might book through their site, which routes are growing in popularity,
seasonality of routes. They also know the profitability of each customer so that, for
example, if a flight is cancelled they can help the most valuable customers first.
PM STUDY NOTES
This information allows airlines to design new routes and timings, match routes to
planes and also to make individualised offers to each potential passenger.
The cases above have shown how detailed analysis of data can be used in a number of
different ways to improve the performance of an organisation. Big data can be used to
understand customers and trends better, to provide insights into costs, and to make it
easier for customers to find what they want on the website. Companies are likely to
continue to identify innovative uses of the increasing volumes of data available to them,
and analysis of Big Data is likely to grow in importance as an important strategic tool for
many businesses.
PM STUDY NOTES
Syllabus Area B
SPECIALIST COST AND MANAGEMENT ACCOUNTING
TECHNIQUES
PM STUDY NOTES
Direct Cost: A cost that can be traced back in full to a product, service or department.
Indirect Production Cost: Also known as Overheads. It is a cost that cannot be directly
linked in full to the actual production of goods/ provision of services. Example: Rent of
factory where five different products are manufactured. How will the rent be split
between the five products? It cannot be traced back in full to any one or all of the
products.
Absorption Costing: a form of costing in which the costs of products are calculated by
adding an amount for indirect production costs (overheads) to the direct costs of
production.
Marginal Costing: a form of costing where only the direct costs are considered relevant
for the cost of a product. Fixed costs are treated as Period Costs.
PM STUDY NOTES
$ $
Sales xx Sales xx
Less : Full production cost of sale Less : Variable production cost
(Full production cost per unit x (Variable production cost per unit x
number of units) (x) units sold) (x)
Less/Add: Under/Over absorbed Gross contribution xx
(Step 6) Production overheads (x)/x Less : Variable non production cost (x)
Gross Profit xx Contribution xx
Less : Fixed non-production overhead (x) Less : Fixed non-production
Less : Variable non production cost (x) overhead (x)
Profit xx Less : Fixed production overhead (x)
Profit xx
Used for financial reporting purposes to comply with the Accounting standards
and inventory valuations.
Helpful in cases where companies attempt to set selling prices based on the full
cost of production or sales of each product.
Best practice in case of a company selling multiple products, to determine
profitability of each product.
Worked Example:
Harp Plc manufactures and sells a single product .The following budgeted/ actual
information is provided in relation to the production of this product:
$
Selling price per unit 50.00
Direct material per unit 8.00
Direct labour per unit 5.00
Variable production overheads per unit 3.00
Actual production and sales for the month of April, 2017 were 500 units.
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Fixed production overheads are budgeted at $6,000 per month and the budgeted level
of production is 600 units.
Profit Statement $ $
Sales (500 x $50) 25,000
Less: Cost of Sales (500 x $26) (13,000)
Less under-absorbed/ Add over-absorbed overheads
Absorbed production overheads (500 x $10) 5,000
Actual overheads (budgeted are assumed to be actual) 6,000
Under-absorbed production overheads (1,000)
Gross Profit 11,000
Less: Expenses
Variable sales commission (10% of $25,000) 2,500
Fixed selling 1,700
Fixed administration 2,300
(6,500)
Net Profit 4,500
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Profit Statement $ $
Sales (500 x $50) 25,000
Less: Variable Cost of Sales (500 x $16) (8,000)
Gross Contribution 17,000
Less: Variable sales commission (10% of $25,000) (2,500)
Contribution 14,500
Less: Expenses
Fixed production overheads 6,000
Fixed selling 1,700
Fixed administration 2,300
(10,000)
Net Profit 4,500
Note: When there are no changes in the level of inventory due to opening and closing
balances, the profit under both absorption and marginal costing approach will be the
same.
PM STUDY NOTES
Introduction:
The simplest method of dealing with the fixed production costs is to assume that all of
the production overheads can be treated together and a single overhead absorption rate
per labour hour, or cost per machine hour, can be derived.
With production processes becoming highly automated the conventional way of treating
fixed overheads, using an over-simplified base is not good enough, especially for
organisations manufacturing multiple products. Companies need to know the cause of
overhead expenses and they need to try to assign costs to products or services on the
basis of the resources they consume.
To get a more accurate estimate of what it costs to produce each unit; it is necessary to
examine the activities that are necessary to produce each unit, because activities usually
have a cost attached. This is the logic of Activity Based Costing (ABC).
4. Charge the overheads cost to each product, by identifying how much of the cost
driver was utilised by that particular product. This can then be converted into a per
unit product overhead charge.
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Production overheads
Allocated/apportioned to
Production overheads
Allocated/apportioned to
Worked Example:
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Under the traditional Absorption costing method, Fixed Overheads cost for Product A
will be:
$34,000 x 20 labour hours = $6,800
100 labour hours
Based on the information made available, the following types of decision making
processes will be supported:
1. Accurate cost calculation(Fair distribution of Overheads)
2. Accurate selling price(Better costing information)
3. Better cost control
4. Better decision making for the continuation/discontinuation of products if incurring
losses
5. Better planning- activity based budgeting
6. Better performance measurement
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a) When production overheads are high relative to prime costs (e.g. service sector)
b) When there is a whole diversity of product range
c) When there are considerable differences in the use of resources by products
d) Where consumption of resources is not driven by volume
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Example:
A company manufactures two products, C and D, for which the following information is
available:
Product C Product D Total
Budgeted production (units) 1,000 4,000 5,000
Labour hours per unit/in total 8 10 48,000
Number of production runs required 13 15 28
Number of inspections during production 5 3 8
Total production set up costs $140,000
Total inspection costs $80,000
Other overhead costs $96,000
Other overhead costs are absorbed on the basis of labour hours per unit. Using activity-
based costing, what is the budgeted overhead cost per unit of product D?
a) $43·84
b) $46·25
c) $131·00
d) $140·64
Solution:
Correct option is B
Set-up costs per production run = $140,000/28 = $5,000
Cost per inspection = $80,000/8 = $10,000
Other overhead costs per labour hour = $96,000/48,000 = $2
Overheads costs of product D:
$
Set-up costs (15 x $5,000) 75,000
Inspection costs (3 x $10,000) 30,000
Other overheads (40,000 x $2) 80,000
––––––––
185,000
Overhead cost per unit = 185,000/4,000 = $46·2
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Example:
A company makes two products using the same type of materials and skilled workers.
The following information is available:
Product A Product B
Budgeted volume (units) 1,000 2,000
Material per unit ($) 10 20
Labour per unit ($) 5 20
Fixed costs relating to material handling amount to $100,000. The cost driver for these
costs is the volume of material purchased.
General fixed costs, absorbed on the basis of labour hours, amount to $180,000.
Solution:
The correct option is B
Total material budget ((1,000 units x $10) + (2,000 units x $20)) = $50,000
Fixed costs related to material handling = $100,000
OAR = $2/$ of material
Product B = $2 x $20 = $40
Total labour budget ((1,000 units x $5) + (2,000 units x $20) = $45,000
General fixed costs = $180,000
OAR = $4/$ of labour
Product B = $4 x $20 = $80
Total fixed overhead cost per unit of Product B ($40 + $80) = $120
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Introduction:
Target Costing:
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Helot Co develops and sells computer games. It is well known for launching innovative
and interactive role-playing games and its new releases are always eagerly anticipated
by the gaming community. Customers value the technical excellence of the games and
the durability of the product and packaging.
Helot Co has previously used a traditional absorption costing system and full cost plus
pricing to cost and price its products.It has recently recruited a new finance director
who believes the company would benefit from using target costing. He is keen to try this
method on a new game concept called Spartan, which has been recently approved.
After discussion with the board, the finance director undertook some market research
to find out customers’ opinions on the new game concept and to assess potential new
games offered by competitors. The results were used to establish a target selling price
of $45 for Spartan and an estimated total sales volume of 350,000 units. Helot Co wants
to achieve a target profit margin of 35%.
The finance director has also begun collecting cost data for the new game and has
projected the following:
Production costs per unit $
Direct material 3.00
Direct labour 2.50
Direct machining 5.05
Set-up 0.45
Inspection and testing 4.30
PM STUDY NOTES
W1: Production cost per unit = $3.00 + 2.50 +5.05 + 0.45 +4.30 = $15.30
Non-production cost per unit = ($2,500,000 + 1,700,000 + 1,400,000) / 350,000 units =
$16
Actual cost = $15.30 + $16 = $31.30
Emphasis will be placed on the planning and design stage to ensure that the design
is not needlessly expensive to make. Some decisions that can be made at the design
stage, which can affect the cost of a product are:
Reducing components
Arranging cheaper labour/ training existing staff
Acquiring new and efficient technology etc.
The total target cost can be split into broad cost categories based on functions to
ensure better control over costs. The product has to be developed using Value
Engineering Techniques.
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There are five major characteristics of services that distinguish it from manufacturing.
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Challenges:
Example:
Solution:
The correct option is C
A target cost is arrived at by identifying the market price of a product and then
subtracting a desired profit margin from it
Example:
PM STUDY NOTES
Solution:
The correct option is B
Variance analysis is not relevant to target costing as it is a technique used for cost
control at the production phase of the product life cycle. It is a feedback control tool by
nature and target costing is feed forward.
Value analysis can be used to identify where small cost reductions can be applied to
close a cost gap once production commences.
Functional analysis can be used at the product design stage. It ensures that a cost gap is
reached or to ensure that the product design is one which includes only features which
customers want.
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Introduction:
Under traditional costing methods, only the current costs, comprising of marginal
costs plus a share of fixed costs, are considered and other costs, without which the
goods could not have been made, such as Research & Development costs, are
ignored.
The true profitability of a product should be assessed by comparing the total
revenue arising over the lifetime of the product with its total costs; regardless of
whether these costs are incurred before, during or after the product is produced.
This is addressed by lifecycle costing.
Lifecycle Costing:
PM STUDY NOTES
The company’s total fixed production overheads are budgeted to be $72 million each
year and total machine hours are budgeted to be 96 million hours. The company
absorbs overheads on a machine hour basis.
OAR for fixed production overheads ($72 million/96 million hours) = $0·75 per hour
Total manufacturing costs (300,000 units x $20) = $6,000,000
Total design, depreciation and decommissioning costs = $1,320,000
Total fixed production overheads (300,000 units x 4 hours x $0·75) = $900,000
Total life-cycle costs = $8,220,000
Life-cycle cost per unit ($8,220,000/300,000 units) = $27·40
Development stage The product has a research and development stage where costs
are incurred but no revenue is generated.
Examples: R&D costs; Capital Expenditure decisions
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Growth stage At this stage, the product becomes well-known in the market.
Due to increase in demand, it captures a bigger market and
starts to make a profit. At this stage, cost of the initial
investment is progressively recovered.
Examples: Costs of increasing capacity; Maybe learning effect
and economies of scale; Increased costs of working capital
Maturity stage At this stage, demand for the product stabilises or the rate of
growth slows down. It continues to be profitable. Expenses for
marketing and distribution can be minimised at this stage. In
order to sustain the demand, the product may be differentiated
/ modified.
Decline / saturation A point comes where large / adequate quantities of the product
stage have been sold in the market and the product, therefore,
reaches a saturation point. At this stage the demand for the
product starts to fall and marketing costs are cut down. The
product may start making loss at this stage. The organisation
may decide to discontinue the production and to develop a new
product.
Examples: Asset decommissioning costs; Possible
restructuring costs; Remaining warranties to be supported
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A summarised analysis of the revenue and costs involved at the different stages is:
Stages Cost Demand Revenue Profit
R&D
Development Testing cost
Nil Nil Loss
stage Training cost
Sampling cost
Manufacturing cost
Distribution cost
Introduction Low Revenue Loss
High Marketing cost
Inventory
Manufacturing cost
Distribution cost
Growth Growing Growing Profit
Marketing cost
Inventory
Manufacturing cost
Distribution cost
High High High
Maturity Inventory
(Maximum) (maximum) profits
Marketing cost if long
life cycle product.
Manufacturing cost
Distribution cost
Low
Decline Marketing cost Decreasing Decreasing
profits
Inventory
Disposal
PM STUDY NOTES
Cost reduction at the planning, design and development stage of a product's life cycle,
rather than during the production process, is one of the most important ways of
reducing product cost.
Support to Management:
An understanding of the product life cycle can also assist management with decisions
about:
Pricing: As a product moves from one stage in its lifecycle to the next, a change in
pricing strategy might be necessary to maintain the market share and recover the
costs incurred over the lifecycle.
PM STUDY NOTES
In Service lifecycles, the R & D stages do not exist in the same way and will not have the
same impact on subsequent costs. However consideration should be given in advance
about how to carry out the services and arrange them so as to minimise cost.
Products that take years to produce are usually called projects, and discounted cash
flow calculations are invariably used to cost them over their life cycle in advance. They
are monitored very carefully over their life to make sure that they remain on schedule
and that cost overruns are not being incurred.
Customers also have life cycles, and an organisation will wish to maximise the return
from a customer over their life cycle. The aim is to extend the life cycle of a particular
customer by encouraging customer loyalty.
The initial cost is high but once customers get used to a supplier they tend to use them
more frequently, bringing in the benefit to the company.
The projected cash flows over the full lives of customers or customer segments can be
analysed to highlight the worth of customers and the importance of customer retention.
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Introduction
The throughput accounting system aims to maximise the throughput (sales revenue less
material costs) of the production process. It supports the Just in Time system to reduce
inventory costs as well as works on reducing the operational costs.
It works on the principle that sooner or later, an organisation will face a bottleneck
resource, a resource that slows down the production process.
A bottleneck resource is one which slows down the product or service delivery process
of an organisation. For example, an organisation has market demand of 50,000 units for
a product that goes through three processes: cutting, heating and assembly. The total
time required in each process for each product and the total hours available are:
The total time required to make 50,000 units of the product can be calculated and
compared to the time available in order to identify the bottleneck.
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It is clear that the heating process is the bottleneck. The organisation will in fact only be
able to produce 40,000 units (120,000/3) as things stand.
This involves making sure that the bottleneck resource is actively being used as much as
possible and is producing as many units as possible. So, ‘productivity’ and ‘utilisation’
are the key words.
The main objective is that production capacity of the bottleneck resource should
determine the production schedule for the organisation as a whole.
Idle time is unavoidable and needs to be accepted. To push more work into the system
than the constraint can deal with results in excess work-in-progress, extended lead
times, and the appearance of what looks like new bottlenecks, as the whole system
becomes clogged up. By definition, the system does not require the non-bottleneck
resources to be used to their full capacity and therefore they must sit idle for some of
the time.
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Step 5: If a new constraint is broken in Step 4, go back to Step 1, but do not let
inertia become the system’s new bottleneck
When a bottleneck has been elevated, a new bottleneck will eventually appear. This
could be in the form of another machine that can now process less units than the
elevated bottleneck. Eventually, however, the ultimate constraint on the system is likely
to be market demand. The system should be one of ongoing improvement because
nothing ever stands still for long.
Throughput Accounting
It is very similar to marginal costing but can be used for longer-term decision making
about production capacity. It is an alternative system of cost and management
accounting in a JIT environment.
a) In short term ONLY material cost is variable. ALL other factory costs are fixed.
d) WIP should be valued at material cost only, so that no value is added to profit
until a sale is made.
e) Profit is determined by the rate at which throughput can be generated, i-e how
quickly raw materials can be turned into sales to generate cash. Producing just to
increase inventory creates no profit and so should not be encouraged.
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Throughput contribution
Throughput is the rate at which a firm generates money by spending an hour of a
bottleneck resource.
Throughput contribution = Sales price – Material cost per unit
Example
Coco Company manufactures and sells a single product. The company has recorded a
contribution of $553,000 during a year. The contribution / sales ratio and material cost
of the sales for the year were 70% and 10% respectively.
Working
Sales revenue= Contribution
C/S ratio
= $553,000/70% = $790,000
Given that most businesses are producing more than one type of product (or supplying
more than one type of service), this means that part of the exploitation step involves
working out what the optimum production plan is.
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In key factor analysis, the contribution per unit is first calculated for each product, then
a contribution per unit of scarce resource is calculated by working out how much of the
scarce resource each unit requires in its production.
Example
Beta Co produces 3 products, E, F and G, details of which are shown below:
E F G
$ $ $
There are 320,000 bottleneck hours available each month. Calculate the optimum
product mix each month.
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E F G
$ $ $
Ranking 2 3 1
Before the time taken on the bottleneck resource was taken into account, product E
appeared to be the most profitable because it generated the highest throughput per
unit. However, applying the theory of constraints, the system’s bottleneck must be
exploited by using it to produce the products that maximise throughput per hour first.
This means that product G should be produced in priority to E.
$4,100,00
In this example, there were enough hours to produce the full quota for G and E.
However, for F out of the 320,000 hours available, 270,000 had been used up (120,000
+ 150,000), leaving only 50,000 hours to spare.
Therefore, the number of units of F that could be produced was a balancing figure i.e.
50,000 hours divided by the four hours each unit requires – ie 12,500 units.
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Performance Measures
There are three main ratios that are calculated in throughput accounting:
The ‘total factory cost’ is simply the ‘operational expense’ of the organisation. If the
organisation was a service organisation, it would simply be called ‘total operational
expense’ or something similar. The cost per factory hour is across the whole factory and
therefore only needs to be calculated once.
In any organisation, it is expected that the throughput accounting ratio is greater than 1.
This means that the rate at which the organisation is generating cash from sales of this
product is greater than the rate at which it is incurring costs. It follows on, then, that if
the ratio is less than 1, this is not the case, and changes need to be made quickly.
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Important:
Products and/or divisions can be ranked according to TPAR. The TPAR should be
greater than one for a product to be viable. Priority should be given to the products
generating the highest TPARs.
Alternatively the products generating highest TP contribution per unit of constraint
should be given priority.
Example:
X Co uses a throughput accounting system. Details of product A, per unit, are as follows:
Selling price $320
Material costs $80
Conversion costs $60
Time on bottleneck resource 6 minutes
What is the return per hour for product A?
a) $40
b) $2,400
c) $30
d) $1,800
Solution:
Example
A company manufactures a product which requires four hours per unit of machine time.
Machine time is a bottleneck resource as there are only ten machines which are
available for 12 hours per day, five days per week. The product has a selling price of
$130 per unit, direct material costs of $50 per unit, labour costs of $40 per unit and
factory overhead costs of $20 per unit. These costs are based on weekly production and
sales of 150 units.
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a) 1·33
b) 2·00
c) 0·75
d) 0·31
Solution:
The correct option is A
Return per factory hour = ($130 – $50)/4 hours = $20
Factory costs per hour = ($20 + $40)/4 = $15
TPAR = $20/$15 = 1·33
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Introduction:
Environmental accounting is becoming increasingly topical in the modern business
environment due to increased regulation and media coverage.
This is the generation and analysis of both financial and non-financial information in
order to support environmental management processes.
Limitations of EMA
2. Second, having defined them, some of the costs are difficult to separate out and
identify.
3. Third, the costs can need to be controlled but this can only be done if they have been
correctly identified in the first place.
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The majority of environmental costs are already captured within accounting systems. It
is often difficult to pinpoint and allocate them to a particular service
1. Input/output analysis
This method operates on the principal that what comes in must go out. Output is split
across sold and stored goods and waste.
Measuring these categories in physical quantities and monetary terms, forces a business
to focus on environmental costs.
Flow diagrams are often used to illustrate how the input is split across different output
such as stored goods and waste.
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Examples of environmental cost drivers include volume of emissions and the cost of
complying with environmental.
Material
System and delivery
Disposal
The values and costs of each flow are calculated. This method focuses on reducing costs
by questioning them and having a positive effect on the environment.
4. Life-cycle costing
Environmental costs are considered from the design stage right up to the last stage
costs such as decommissioning and waste removal etc.
This may influence the design of the product itself, saving on future costs.
Example
Which of the following statements regarding environmental cost accounting are true?
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4 Environmental life-cycle costing enables environmental costs from the design stage
of the product right through to decommissioning at the end of its life to be
considered
Solution:
Most organizations do collect data about environmental costs but find it difficult to
split them out and categories them effectively.
Life-cycle costing does allow the organisation to collect information about a
product’s environmental costs throughout its life cycle.
The technique which divides material flows into three categories is material flow
cost accounting, not input/output analysis.
ABC does categorise some costs as environment-driven costs, however, these are
costs which are normally hidden within total overheads in a conventional costing
system. It is environment-related costs which can be allocated directly to a cost
centre.
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Syllabus Area C
DECISION MAKING TECHNIQUES
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CVP analysis stands for 'cost-volume-profit analysis'. It is used to show how costs and
profits change with changes in the volume of activity. CVP analysis is an application of
marginal costing concepts.
1) Costs are either fixed or variable. The variable cost per unit is the same at all levels
of activity (output and sales). Total fixed costs are a constant amount in each period.
2) Fixed costs are normally assumed to remain unchanged at all levels of output.
3) The contribution per unit is constant for each unit sold (of the same product).
4) The sales price per unit is constant for every unit of product sold; therefore the
contribution to sales ratio is also a constant value at all levels of sales.
5) If sales price per unit, variable cost per unit and fixed costs are not affected by
volume of activity sales and profits are maximised by maximising total contribution.
6) Production = sale
Contribution
Total contribution = Contribution per unit x Number of units sold. Profit is measured
as contribution minus fixed costs.
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$
Sales (Units sold x sales price per unit) S
Variable costs (Units sold x variable cost price per unit) (V)
Contribution C
Fixed costs (F)
Profit Profit
Many problems solved using CVP analysis use either contribution per unit (CPU) or the
CS (Contribution/Sales) ratio.
Break-even analysis
Break-even point is the volume of sales required in a period (such as the financial
year) to 'break even' and make neither a profit nor a loss. At the break-even point, profit
is zero.
Management might want to know what the break-even point is in order to:
Identify the minimum volume of sales that must be achieved in order to avoid a loss,
or
Assess the amount of risk in the budget, by comparing the budgeted volume of sales
with the break-even volume.
At the break-even point, the profit is $0. If the profit is $0, total contribution is exactly
equal to total fixed costs.
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Margin of safety
It is the maximum amount by which actual sales can be lower than budgeted sales
without incurring a loss for the period. A high margin of safety indicates a low risk of
making a loss.
Target profit
Management might want to know what the volume of sales must be in order to achieve
a target profit. CVP analysis can be used to calculate the volume of sales required.
With the graphical method, the total costs and total revenue lines are plotted on a
graph; $ is shown on the y axis and units are shown on the x axis. The point where the
total cost and revenue lines intersect is the break-even point. The amount of profit or
loss at different output levels is represented by the distance between the total cost and
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total revenue lines. Figure 1 shows a typical break-even chart for a company. The gap
between the fixed costs and the total costs line represents variable costs.
Hence, it is the difference between the variable cost line and the total cost line that
represents fixed costs. The advantage of this is that it emphasises contribution as it is
represented by the gap between the total revenue and the variable cost lines. This is
shown in Figure 2.
Figure 1
Figure 2
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This weighted average C/S ratio can then be used to find CVP information such as
break-even point, margin of safety etc.
Worked Example:
Company A manufactures two products. The following information is available for both
products:
Product x Product y
The weighted average C/S ratio can be calculated by dividing the total expected
contribution by the total expected sales:
The C/S ratio is useful in its own right as it tells us what percentage each $ of sales
revenue contributes towards fixed costs; it is also invaluable in calculating the break-
even point in $ sales revenue, or the sales revenue required to generate a target profit.
The break-even point can now be calculated this way for Company A:
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Such calculations provide only estimated information because they assume that
products x and y are sold in a constant mix of 2x to 1y.
In order to draw the graph, it is therefore necessary to work out the C/S ratio of each
product being sold before ranking the products in order of profitability. It is easy here
for Company A, since only two products are being produced, and so it is useful to draw a
quick table in order to ascertain each of the points that need to be plotted on the graph
in order to show the profit/loss lines.
Product x Product y
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Product x Product y
The graph can then be drawn (Figure 3), showing cumulative sales on the x axis and
cumulative profit/loss on the y axis. It can be observed from the graph that, when the
company sells its most profitable product first (x) it breaks even earlier than when it
sells products in a constant mix. The break-even point is the point where each line cuts
the x axis.
Figure 3
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Example
A company makes and sells product X and product Y. Twice as many units of product Y
are made and sold as that of product X. Each unit of product X makes a contribution of
$10 and each unit of product Y makes a contribution of $4. Fixed costs are $90,000.
What is the total number of units which must be made and sold to make a profit of
$45,000?
A. 7,500
B. 22,500
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C. 15,000
D. 16,875
Solution:
The correct option is B
Two units of Y and one unit of X would give total contribution of $18.
Weighted average contribution per unit = $18/3 units = $6
Sales units to achieve target profit = ($90,000 + $45,000)/$6 = 22,500
Example
The following information is available for a manufacturing company which produces
multiple products:
(i) The product mix ratio
(ii) Contribution to sales ratio for each product
(iii) General fixed costs
(iv) Method of apportioning general fixed costs
Which of the above are required in order to calculate the break-even sales
revenue for the company?
Solution:
The method of apportioning general fixed costs is not required to calculate the break-
even sales revenue.
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Introduction
A limiting factor is any factor that is in scarce supply and that stops the organisation
from expanding its activities further, that is, it limits the organisation’s activities.
It is assumed in limiting factor analysis that management would make a product mix
decision or service mix decision based on the option that would maximise profit and
that profit is maximized when contribution is maximised (given no change in fixed cost
expenditure incurred).
Worked Example
Hopper Ltd makes two products, the Bunny and the Babbit. Unit variable costs are as
follows.
Bunny Babbit
$ $
Direct materials 1 3
Direct labour ($3 per hour) 6 3
Variable overhead 1 1
8 7
The sales price per unit is $14 per Bunny and $11 per Babbit. During July the available
direct labour is limited to 8,000 hours.
Sales demand in July is expected to be 3,000 units of Bunny and 5,000 units of Rabbit.
Fixed costs are normally $20,000 and the company does not maintain any inventory.
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Therefore now the contribution per labour hour for each product will be determined to
make the optimal production decision:
Bunny Babbit
$ $
Sales price 14 11
Variable cost 8 7
Unit contribution 6 4
Labour hours per unit 2 hrs 1 hr
Contribution per labour hour (= per unit of limiting factor) $3 $4
Although Bunny has a higher unit contribution than Babbit, two units of Babbit can be
made in the time it takes to make one unit of Bunny. Because labour is in short supply it
is more profitable to make Babbit than Bunny.
Sufficient volume of Babbit will be made to meet the full sales demand, and the
remaining labour hours available will then be used to make Bunny.
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Hours Contribution
Product Units Needed per unit Total
$ $
Babbit 5,000 5,000 4 20,000
Bunny (balance) 1,500 3,000 6 9,000
8,000 8,000
Less fixed costs 20,000
Profit 9,000
Conclusion
(a) Unit contribution is not the correct way to decide priorities.
(b) Labour hours are the scarce resource, therefore contribution per labour hour is
the correct way to decide priorities.
(c) The Babbit earns $4 contribution per labour hour, and the Bunny earns $3
contribution per labour hour. Babbit therefore make more profitable use of the
scarce resource, and should be manufactured first.
Example
CAW manufactures two products, the L and the L1, using the same material for each.
Annual demand for the L is 9,000 units, while demand for the L1 is 12,000 units. The
variable production cost per unit of the L is $10, that of the L1 $15.
The L requires 3.5 kgs of raw material per unit, the L1 requires 8 kgs of raw material
per unit. Supply of raw material will be limited to 87,500 kgs during the year.
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A sub-contractor has quoted prices of $17 per unit for the L and $25 per unit for the L1
to supply the product.
L L1
$ per unit $ per unit
Variable cost of making 10 15
Variable cost of buying 17 25
Extra variable cost of buying 7 10
Raw material saved by buying 3.5 kgs 8 kgs
Extra variable cost of buying per kg saved $2 $1.25
Priority for internal manufacture 1 2
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Worked Example:
Suppose a profit-seeking firm has two constraints: labour, limited to 16,000 hours, and
materials, limited to 15,000kg. The firm manufactures and sells two products, X and Y.
To make X, the firm uses 3kg of material and 4 hours of labour, whereas to make Y, the
firm uses 5kg of material and 4 hours of labour. The contributions made by each
product are $30 for X and $40 for Y. The cost of materials is normally $8 per kg, and the
labour rate is $10 per hour.
The first step in any linear programming problem is to produce the equations for
constraints and the contribution function, which should not be difficult at this level.
The materials constraint will be 3X + 5Y ≤ 15,000, and the labour constraint will be
4X + 4Y ≤ 16,000.
The non-negativity constraint of X,Y ≥ 0.
The contribution function is 30X + 40Y = C
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Plotting the resulting graph (Figure 1, the optimal production plan) will show that by
pushing out the contribution function, the optimal solution will be at point B – the
intersection of materials and labour constraints.
The optimal point is X = 2,500 and Y = 1,500, which generates $135,000 in contribution
(Working 1). The ability to solve simultaneous equations is assumed in this article.
The point of this calculation is to provide management with a target production plan in
order to maximise contribution and therefore profit. However, things can change and, in
particular, constraints can relax or tighten. Management needs to know the financial
implications of such changes. For example, if new materials are offered, how much
should be paid for them? And how much should be bought? These dynamics are
important.
Working 1:
The optimal point is at point B, which is at the intersection of:
3X + 5Y = 15,000 and
4X + 4Y = 16,000
Multiplying the first equation by four and the second by three we get:
12X + 20Y = 60,000
12X + 12Y = 48,000
Substituting Y = 1,500 in any of the above equations will give us the X value:
3X + 5 (1,500) = 15,000
3X = 7,500
X = 2,500
As more material is bought, the constraint relaxes and so its line on the graph moves
outwards and away from the origin. Eventually, the materials line will be totally outside
the labour line on the graph and the point at which this happens is the point at which
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the business will cease to find buying more materials attractive (point D on the graph).
Labour would then become the only constraint.
It is important to determine how many materials are needed at point D on the graph,
the point at which 4,000 units of Y are produced. To make 4,000 units of Y, 20,000kg of
materials is needed. Consequently, the maximum amount of extra material required is
5,000kg (20,000 – 15,000).
Important Definitions:
1. Shadow price: the amount of contribution generated by having one extra unit of the
binding constraint- it’s the maximum premium the company could pay by having
one extra unit of the limited resource at optimal point
2. Slack: the best utilization of resource is not the full utilization of resource; if a
resource is not binding at the optimal point it will have slack
3. Surplus: when the resource use is more than the minimum required, it is said to
have surplus
Suppose the shadow price of materials is $5 per kg (Working 2). This means that If
management is offered more materials it should be prepared to pay no more than $5
per kg over the normal price. Paying less than $13 ($5 + $8) per kg to obtain more
materials will make the firm better off financially. Paying more than $13 per kg would
render it worse off in terms of contribution gained.
There may, of course, be a good reason to buy ‘expensive’ extra materials (those costing
more than $13 per kg). It might enable the business to satisfy the demands of an
important customer who might, in turn, buy more products later. The firm might have
to meet a contractual obligation, and so paying ‘too much’ for more materials might be
justifiable if it will prevent a penalty on the contract. Equally, it might be that ‘cheap’
material, priced at under $13 per kg, is not attractive. Quality is a factor, as is reliability
of supply.
PM STUDY NOTES
To find this we relax the material constraint by 1kg and resolve as follows:
3X + 5Y = 15,001 and
4X + 4Y = 16,000
Again, multiplying by four for the first equation and by three for the second produces:
12X + 20Y = 60,004
12X + 12Y = 48,000
8Y = 12,004
Y = 1,500.5
The new level of contribution is: (2,499.5 x 30) + (1,500.5 x 40) = $135,005
The increase in contribution from the original optimal is the shadow price:
135,005 – 135,000 = $5 per kg.
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Worked Example 2:
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Influences on Price: Price of a product is decided after taking into account many
factors apart from Cost.
Price If customers of the product can pass on the burden of the cost to
Sensitivity someone else, they will not be price sensitive. E.g. A customer will
travel business class if his/ her company is bearing the expenses but
will reconsider if he/ she has to spend own money.
Price E.g. if the price of sugar is increased and the customer perceives that
Perception the price will further increase, they will stock-up on the product.
Quality Customers may consider high prices to be a reflection of the high
quality of the product
Competitors Some companies show unified increase in price (e.g. petrol) but in
others a change in price, may start a price war (e.g. mobile network
services).
Suppliers If a company increases the price of its products, the suppliers may
start providing the raw material at a higher price too.
Inflation Prices have to reflect the increase in material and labour cost.
Newness Pricing will depend upon reference points and in the case of new
products’ a company may have to look at other markets where the
product/ similar product has been launched.
Incomes If customers have more income, their focus is quality and accessibility
of product but if income decreases, focus is on price.
Product Range Price can be spread over a complete product range to maintain
profitability. E.g. sell ink pens cheaper but make up for profit in the
price of ink.
Ethics Does the company want to exploit the market by increasing prices
when there is a short term shortage of the product in the market?
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Market: Price is determined by the type of market, the company operates in:
Perfect
Monopoly
Competition
Monopolistic
Oligopoly
Competition
Competition: If competitors cut prices, a company can react in the following possible
ways:
Demand:
Economic theory argues that the higher the price of a good, the lower will be the
quantity demanded.
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A company is able to sell a fixed quantity (Q) A company is able to sell limitless
of the product, regardless of any price (P). quantity (Q) of the product at a set
This is termed as completely inelastic price (P). This is termed as
demand as change in price does not affect the completely elastic demand as change
quantity demanded. in price will substantially affect the
quantity demanded.
Price Elasticity of Demand: It is a measure of the change in sales demand that would
occur for a given change in the selling price.
PED > 1 than demand is elastic: impact on quantity demanded is greater due to change
in price
PED< 1 than demand is inelastic: impact on quantity demanded due to change in price is
nominal
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Demand Influencers:
Price of other goods Substitutes: Increase in price of one product will lead to
customers moving towards the substitute available.
Tastes or fashion A change in tastes or fashion will alter the demand for a good,
or a particular variety of a good.
Expectations Stock up may occur if customers expect the prices to rise and
this will lead to more demand.
Obsolescence Many products and services have to be replaced periodically
because of obsolescence.
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Product Life Cycle: Demand varies over the life cycle of a product.
Introduction Phase: The price has no impact on demand at the initial
stage, when there is little or no competition in the market.
Growth: Prices will have to be reduced as competition increases, to
maintain demand.
Maturity: Prices can be stabilised unless the competitors reduce their
prices.
Decline: Prices may fall due to lower demand or prices can be increased if
the competition withdraws from the market and you are the only one
offering the product.
Quality: If the product is of good quality, the demand may be high regardless of
price.
Marketing: The 4 P’s of marketing are demand influencers:
Price
Product
Place: of purchase. If goods are not easily accessible, customers will turn
to substitutes.
Promotion: developing a brand name and using a variety of promotional
tools will lead to increased demand for the product.
Demand Equation:
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Example:
The current price of a product is $18. At this price the company sells 100 items a month.
One month the company decides to raise the price to $22, but only 75 items are sold at
this price.
Solution
Assuming demand is linear, each increase of $4 in the price would result in a fall in
demand of 25 units. For demand to be nil, the price needs to rise from its current level
by as many times as there are 25 units in 100 units (100/25 = 4) ie to $18 + (4 x $4) =
$34.
Using the formula above, this can be shown as a = $18 + ((100/25) x $4) = $34
Step 2: Calculate b
Step 3: Substitute the known value for ‘b’ into the demand function to find ‘a’
P = a - (0.05Q)
18 = a - (0.05 x 100)
18 =a-5
a = 23
The demand equation is therefore P = 23 – 0.05Q
18 = 23 – (0.05Q)
0.05Q = 23 – 18
0.05Q = 5
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Q = 5 = 100
0.05
Total Cost (TC) = Fixed Cost (FC) + [Variable Cost (VC) x Quantity sold (Q)]
Assume that fixed costs remain constant when in reality there is a concept of
Step Fixed Costs
Assume that Variable Cost per unit remains constant when in reality they change
due to economies/ diseconomies of scale or Volume Based Discounts (discounts
given for bulk transactions)
Profits are maximized when marginal cost (MC) = marginal revenue (MR).
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Profit Maximisation is the process by which a firm determines the price and output level
that returns the greatest profit. There are two common approaches to this problem.
The Total revenue (TR) – Total cost (TC) method is based on the fact that profit
equals revenue minus cost.
The Marginal revenue (MR) – Marginal cost (MC) method is based on the fact
that total profit in a perfect market reaches its maximum point where marginal
revenue equals marginal cost.
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The optimal selling price can be determined using equations (ie when MC = MR).
Example:
It has been determined based on research that if a price of $400 is charged for product
G, demand will be 12,000 units. Demand will rise or fall by 20 units for every $1 fall/rise
in the selling price. The marginal cost of product G is $120. Calculate the profit-
maximising selling price for product G.
Solution:
The following step-by-step approach can be applied to most questions involving algebra
and pricing.
Step 1: Establish the demand function (find the values for ‘a’ and ‘b’)
b = change in price = $1 = 0.05
change in quantity 20
a = $400 + [(12,000 /20) x $1] = $1,000
Step 2: Establish MC (the marginal cost). This will simply be the variable cost per unit
MC = $120 (given)
Step 3: State MR, assuming MR = a – 2bQ
MR = $1,000 – (2 x 0.05) Q = $1,000 – 0.1Q
Step 4: To maximise profit, equate MC and MR to find Q
$120 = $1,000 – 0.1Q
Q = ($1,000 - $120) x (10/1) = 8,800 is profit maximising demand
Step 5: Substitute Q into the demand function and solve to find P (the optimum price)
P = a – bQ = $1,000 – (0.05 x 8,800) = $560
PM STUDY NOTES
Price Strategies
Full cost plus pricing:
Calculate full cost of product and add desired profit to determine selling price.
Example:
Mark-Up Margin
% $ % $
Advantages:
Quick, simple and cheap method to set product price.
As profit % is added to full cost, all the expenses are easily recovered.
Disadvantages:
Ignores profit maximisation combination of price and demand.
In reality the price has to be adjusted to market and demand conditions.
Relies on budgeted output volume to determine appropriate absorption
rate for overheads.
Suitable basis for overhead absorption rate has to be selected.
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A mark-up or profit margin is added to the marginal cost in order to obtain a selling
price.
The method of calculating sales price is similar to full-cost pricing, except that marginal
cost is used instead of full cost.
Advantages:
Simple and easy to calculate.
Mark up % can be varied to reflect demand conditions.
Focuses attention on the contribution of the product, which is a key factor
in decision making.
Useful in industries where the Variable cost per unit is easily available.
Disadvantages:
Apart from demand, other relevant market factors, like prices set by
competitors etc. are ignored.
Ignores fixed overheads in pricing decisions.
Charging a high price when the product is introduced in the market for the first time,
with the hope of skimming the market for profits. The price of the product is adjusted at
a later date.
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Setting a single pricing policy for goods that are complementary i.e. are normally bought
together. E.g. Computer games console and computer games.
Loss Leader: is when a company sells a low price for one product to attract customers
and ends up selling complementary products with high profit margins. This is also
termed as ‘Captive Product Pricing’.
Setting a consistent pricing policy for a group of products that are related to each other.
E.g. same policy for shampoos, skin care products etc. of the same brand.
Charging different prices to different groups of buyers for the same product.
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Calculating a minimum price of the product/ order, at which the company will neither
be better off, nor worse off. If sold at more than the minimum price, the company will
enjoy a profit.
The minimum price calculated must take into account the following:
To earn a profit, the company needs to sell the product/ order at a price higher than the
minimum price.
Example
A company wants to introduce a new product. The non-current assets required for the
production will cost $7,000,000 and working capital is $1,500,000 required.
The sales estimated for the year is 75,000 units. Variable production cost is $55 per
unit. Fixed production costs will be $820,000 per year and annual fixed non-production
costs will be $280,000.
Required:
Calculate the selling price using
(i) full cost plus 18% and
(ii) on marginal cost plus 30%.
Solution
$
(i) Fixed cost 820,000
Annual non-production cost 280,000
Total fixed cost 1,100,000
Per unit fixed cost ($1,100,000/75,000) 14.67
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Variable cost 55
Mark-up = 30% on variable cost 16.50
Selling price 71.50
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Relevant Costs: Are incremental future cash flows, arising as a direct consequence of a
decision.
Sunk costs, Committed costs and non-cash expenses like depreciation are irrelevant
costs.
If labour is re-assigned tasks to take up new project or product, the variable cost
of labour, variable overheads and the contribution foregone are relevant for
decision making.
PM STUDY NOTES
Opportunity Costs
The value of a benefit given up, in order to avail the benefit from an alternative.
For example, if a material is in short supply, it may be transferred from the production
of one product to that of another product. The opportunity cost is the contribution lost
from ceasing production of the original product.
The Hi Life Co (HL Co) makes sofas. It has recently received a request from a customer
to provide a one-off order of sofas, in excess of normal budgeted production. The order
would need to be completed within two weeks. The following cost estimate has already
been prepared:
Notes
1. The fabric is regularly used by HL Co. There are currently 300 m2 in inventory,
which cost $17 per m2. The current purchase price of the fabric is $17·50 per
m2.
2. This type of wood is regularly used by HL Co and usually costs $8·20 per m2.
However, the company’s current supplier’s earliest delivery time for the wood is
in three weeks’ time. An alternative supplier could deliver immediately but they
would charge $8·50 per m2. HL Co already has 500 m2 in inventory but 480 m2
of this is needed to complete other existing orders in the next two weeks. The
remaining 20 m2 is not going to be needed until four weeks’ time.
3. The skilled labour force is employed under permanent contracts of employment
under which they must be paid for 40 hours’ per week’s labour, even if their time
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is idle due to absence of orders. Their rate of pay is $16 per hour, although any
overtime is paid at time and a half. In the next two weeks, there is spare capacity
of 150 labour hours.
4. There is no spare capacity for semi-skilled workers. They are currently paid $12
per hour or time and a half for overtime. However, a local agency can provide
additional semi-skilled workers for $14 per hour.
5. The $3 absorption rate is HL Co’s standard factory overhead absorption rate;
$1·50 per hour reflects the cost of the factory supervisor’s salary and the other
$1·50 per hour reflects general factory costs. The supervisor is paid an annual
salary and is also paid $15 per hour for any overtime he works. He will need to
work 20 hours’ overtime if this order is accepted.
6. This is an apportionment of the general administration overheads incurred by
HL Co.
Solution:
1. Since the material is in regular use by HL Co, it is replacement cost which is the
relevant cost for the contract.
2. 30 m will have to be ordered from the alternative supplier for immediate
delivery but the remaining 20 m can be used from inventory and replaced by an
order from the usual supplier at a cost of $8·20 per m.
3. There is no cost for the first 150 hours of labour because there is spare capacity.
The remaining 50 hours will be paid at time and a half, which is $16 x 1·5, i.e. $24
per hour.
4. HL Co will choose to use the agency workers, who will cost $14 per hour, since
this is cheaper than paying existing semi-skilled workers at $18 per hour ($12 x
1·5) to work overtime.
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5. None of the general factory costs are incremental, so they have all been excluded.
However, the supervisor’s overtime pay is incremental, so has been included.
The supervisor’s normal salary, on the other hand, has been excluded because it
is not incremental.
6. These are general overheads and are not incremental, so no value should be
included for them.
Worked Example
A company makes two components F and P, for which costs in the forthcoming year are
expected to be as follows.
F P
Production (units) 1,000 2,000
Unit marginal costs $ $
Direct materials 4 5
Direct Labour 8 9
Variable production overheads 2 3
Directly attributable fixed costs per annum and committed fixed costs:
Incurred as a direct consequence of making F $1,000
Incurred as a direct consequence of making P $5,000
A sub-contractor has offered to supply units of F & P for $12 and $21 respectively.
PM STUDY NOTES
Outsourcing:
This is the use of external suppliers for finished products, components or services.
This is also known as contract manufacturing or sub-contracting.
Reasons for Outsourcing:
Hiring specialists ensures the quality of the end product and efficiency.
Outsourcing leads to spare resources that can be effectively utilised in other core
areas.
Company’s offering outsourcing services have the capacity and flexibility to meet
ad-hoc variations in the demand.
There isn’t enough work to justify the recruitment of resources for a specific
function.
Companies rely on outsourcing facilities for administrative and maintenance tasks.
The performance of ‘outsourcers’ has to be monitored and measured to make sure
quality and targets are not compromised upon.
PM STUDY NOTES
Joint Products:
Joint products are two or more products which are output from the same processing
operation, but which are indistinguishable from each other up to their point of
separation. Each product post separation has a substantial sales value.
A joint product is regarded as an important saleable item, and so it should be
separately costed. The profitability of each joint product should be assessed in the
cost accounts.
The point at which joint products become separately identifiable is known as the
split-off point or separation point.
Costs incurred prior to this point of separation are common or joint costs, and these
need to be allocated (apportioned) in some manner to each of the joint products.
Problems in accounting for joint products are basically of two different sorts.
How common costs should be apportioned between products, in order to put a
value to closing inventory and to the cost of sale (and profit) for each product.
Whether it is more profitable to sell a joint product at one stage of processing, or
to process the product further and sell it at a later stage.
Worked Example
A Company produces two joint products, S and T from the same process.
Joint processing costs of $150,000 are incurred up to split-off point, when 100,000 units
of S and 50,000 units of T are produced.
The selling prices at split-off point are $1.25 per unit for S and $2.00 per unit for T.
The units of S could be processed further to produce 60,000 units of a new chemical, S+,
but at an extra fixed cost of $20,000 and variable cost of 30c per unit of input.
PM STUDY NOTES
S S+
Selling price per unit $1.25 $3.25
$ $ $
Total sales 125,000 195,000
Post-separation processing costs ___ Fixed 20,000
___ Variable 30,000 50,000
Sales minus post-separation 125,000 145,000
(further processing) costs
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Worked Example
Company V makes four products, P, Q, R and S. The budget for next year is as follows:
P Q R S Total
$000 $000 $000 $000 $000
Direct materials 300 500 400 700 1,900
Direct labour 400 800 600 400 2,200
Variable overheads 100 200 100 100 500
800 1,500 1,100 1,200 4,600
Sales 1,800 1,650 2,200 1,550 7,200
Contribution 1,000 150 1,100 350 2,600
Directly attributable fixed (400) (250) (300) (300) (1,250)
costs
Share of general fixed costs (200) (200) (300) (400) (1,100)
Profit/(loss) 400 (300) 500 (350) 250
'Directly attributable fixed costs' are cash expenditures that are directly attributable to
each individual product. These costs would be saved if operations to make and sell the
product were shut down.
Required: State with reasons whether any of the products should be withdrawn
from the market.
From a financial viewpoint, a product should be withdrawn from the market if the
savings from closure exceed the benefits of continuing to make and sell the product. If a
product is withdrawn from the market, the company will lose the contribution, but -will
save the directly attributable fixed costs.
Product P and product R both make a profit even after charging a share of general fixed
costs.
On the other hand, product Q and product S both show a loss after charging general
fixed costs, and we should therefore consider whether it might be appropriate to stop
making and selling either or both of these products, in order to eliminate the losses.
PM STUDY NOTES
Effect of shutdown P Q R S
$000 $000 $000 $000
Contribution forgone (1,000) (150) (1,100) (350)
Directly attributable fixed costs saved 400 250 300 300
Increase/(reduction) in annual cash flows (600) 100 (800) (50)
Although product S makes a loss, shutdown would reduce annual cash flows because
the contribution lost would be greater than the savings in directly attributable fixed
costs.
However, withdrawal of product Q from the market would improve annual cash flows
by $100,000, and withdrawal is therefore recommended on the basis of this financial
analysis.
Decision recommended: Stop making and selling product Q but carry on making and
selling product S.
PM STUDY NOTES
Introduction
The basic definition of risk is that the final outcome of a decision, such as an investment,
may differ from that which was expected when the decision was taken. Risk and
uncertainty are distinguished in terms of the availability of probabilities.
Risk is when the probabilities of the possible outcomes are known (such as when
tossing a coin or throwing a dice); uncertainty is where the randomness of outcomes
cannot be expressed in terms of specific probabilities.
Attitudes to risk
Risk seeker: A decision maker interested in the best outcomes no matter how small the
chance that they may occur.
Risk neutral: A decision maker concerned with what will be the most likely outcome.
Risk Averse: A decision maker whose acts are based on the assumption that the worst
outcome might occur.
Probability
The term ‘probability’ refers to the likelihood or chance that a certain event will occur,
with potential values ranging from 0 (the event will not occur) to 1 (the event will
definitely occur). The total of all the probabilities from all the possible outcomes must
equal 1, ie some outcome must occur.
A real world example could be that of a company forecasting potential future sales from
the introduction of a new product in year one, as depicted in the following table:
PM STUDY NOTES
From Table 1, it is clear that the most likely outcome is that the new product generates
sales of £1,000,000, as that value has the highest probability.
Using the information regarding the potential outcomes and their associated
probabilities, the expected value of the outcome can be calculated simply by multiplying
the value associated with each potential outcome by its probability. Referring back to
Table 1, regarding the sales forecast, then the expected value of the sales for year one is
given by:
Expected value
= ($500,000)(0.1) + ($700,000)(0.2) + ($1,000,000)(0.4) + ($1,250,000)(0.2) +
($1,500,000)(0.1)
= $50,000 + $140,000 + $400,000 + $250,000 + $150,000
= $990,000
In this example, the expected value is very close to the most likely outcome, but this is
not necessarily always the case. Moreover, it is likely that the expected value does not
correspond to any of the individual potential outcomes.
A further point regarding the use of expected values is that the probabilities are based
upon the event occurring repeatedly, whereas, in reality, most events only occur once.
Decision-making criteria
The decision outcome resulting from the same information may vary from manager to
manager as a result of their individual attitude to risk. Individuals can be distinguished
between who are risk averse (dislike risk) and individuals who are risk seeking
PM STUDY NOTES
(content with risk). Similarly, the appropriate decision-making criteria used to make
decisions are often determined by the individual’s attitude to risk.
An ice cream seller, when deciding how much ice cream to order (a small, medium, or
large order), takes into consideration the weather forecast (cold, warm, or hot). There
are nine possible combinations of order size and weather, and the payoffs for each are
shown in the table below:
Decision-making combinations
The highest payoffs for each order size occur when the order size is most appropriate
for the weather, ie small order/cold weather, medium order/warm weather, large
order/hot weather. Otherwise, profits are lost from either unsold ice cream or lost
potential sales.
1 Maximin
This criteria is based upon a risk-averse (cautious) approach and bases the order
decision upon maximising the minimum payoff. The ice cream seller will therefore
decide upon a medium order, as the lowest payoff is £200, whereas the lowest payoffs
for the small and large orders are £150 and $100 respectively.
PM STUDY NOTES
2 Maximax
This criteria is based upon a risk-seeking (optimistic) approach and bases the order
decision upon maximising the maximum payoff. The ice cream seller will therefore
decide upon a large order, as the highest payoff is $750, whereas the highest payoffs for
the small and medium orders are $250 and $500 respectively.
3 Minimax regret
This approach attempts to minimise the regret from making the wrong decision and is
based upon first identifying the optimal decision for each of the weather outcomes. If
the weather is cold, then the small order yields the highest payoff, and the regret from
the medium and large orders is $50 and $150 respectively. The same calculations are
then performed for warm and hot weather and a table of regrets constructed, as below:
Table of regrets
The decision is then made on the basis of the lowest regret, which in this case is the
large order with the maximum regret of $200, as opposed to $600 and $450 for the
small and medium orders.
Decision Trees
PM STUDY NOTES
Decision trees provide a useful method of breaking down a complex problem into
smaller, more manageable pieces.
The first stage is the construction stage, where the decision tree is drawn and all of the
probabilities and financial outcome values are put on the tree. The principles of relevant
costing are applied throughout – ie only relevant costs and revenues are considered.
The second stage is the evaluation and recommendation stage. Here, the decision is
‘rolled back’ by calculating all the expected values at each of the outcome points and
using these to make decisions while working back across the decision tree. A course of
action is then recommended for management.
A decision tree is always drawn starting on the left hand side of the page and moving
across to the right. Decision points represent the alternative courses of action that are
available. These are within control – it is the organisation’s choice. It can either take one
course of action or take another. Outcomes, on the other hand, are not within the
organisation’s control. They are dependent on the external environment – for example,
customers, suppliers and the economy.
Both decision points and outcome points on a decision tree are always followed by
branches. If there are two possible courses of action – for example, there will be two
branches coming off the decision point; and if there are two possible outcomes – for
example, one good and one bad, there will be two branches coming off the outcome
point. It makes sense to say that, given that decision trees facilitate the evaluation of
different courses of actions, all decision trees must start with a decision.
A simple decision tree is shown below. It can be seen from the tree that there are two
choices available to the decision maker since there are two branches coming off the
decision point. The outcome for one of these choices, shown by the top branch off the
decision point, is clearly known with certainty, since there is no outcome point further
along this top branch. The lower branch, however, has an outcome point on it, showing
PM STUDY NOTES
that there are two possible outcomes if this choice is made. Then, since each of the
subsidiary branches off this outcome point also has a further outcome point on with two
branches coming off it, there are clearly two more sets of outcomes for each of these
initial outcomes. It could be, for example, that the first two outcomes were showing
different income levels if some kind of investment is undertaken and the second set of
outcomes are different sets of possible variable costs for each different income level.
Once the basic tree has been drawn, like above, the probabilities and expected values
must be written on it. Remember, the probabilities shown on the branches coming off
the outcome points must always add up to 100%, otherwise there must be an outcome
missing or a mistake with the numbers being used. As well as showing the probabilities
on the branches of the tree, the relevant cash inflows/outflows must also be written on
there too.
Once the decision tree has been drawn, the decision must then be evaluated.
When a decision tree is evaluated, the evaluation starts on the right-hand side of the
page and moves across to the left – ie in the opposite direction to when the tree was
drawn. The steps to be followed are as follows:
PM STUDY NOTES
1. Label all of the decision and outcome points – ie all the squares and circles. Start
with the ones closest to the right-hand side of the page, labelling the top and then
the bottom ones, and then move left again to the next closest ones.
2. Then, moving from right to left across the page, at each outcome point, calculate
the expected value of the cashflows by applying the probabilities to the
cashflows.
Finally, the recommendation is made to management, based on the option that gives the
highest expected value.
Limitations:
Expected values give a long run average of the outcome that would be expected if a
decision was to be repeated many times. So, if a one-off decision is being made, the
actual outcome may not be very close to the expected value calculated and the
technique is therefore not very accurate. Also, estimating accurate probabilities is
difficult because the exact situation that is being considered may not well have arisen
before.
The expected value criterion for decision making is useful where the attitude of the
investor is risk neutral. They are neither a risk seeker nor a risk avoider. If the decision
maker’s attitude to risk is not known, it difficult to say whether the expected value
criterion is a good one to use.
Worked Example
A company is deciding whether to develop and launch a new product.
Research and development costs are expected to be $400,000 and there is a 70% chance
that the product launch will be successful, and a 30% chance that it will fail.
If it is successful, the levels of expected profits and the probability of each occurring
have been estimated as follows, depending on whether the product’s popularity is high,
medium or low:
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Probability Profits
If it is a failure, there is a 0.6 probability that the research and development work can be
sold for $50,000 and a 0.4 probability that it will be worth nothing at all.
The basic structure of the decision tree must be drawn, as shown below:
Next, the probabilities and the profit figures must be put on, not forgetting that the
profits from a successful launch last for two years, so they must be doubled.
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Now, the decision points and outcome points must be labeled, starting from the right-
hand side and moving across to the left.
Now, calculate the expected values at each of the outcome points, by applying the
probabilities to the profit figures. An expected value will be calculated for outcome
point A and another one will be calculated for outcome point B. Once these have been
calculated, a third expected value will need to be calculated at outcome point C. This will
be done by applying the probabilities for the two branches off C to the two expected
values that have already been calculated for A and B.
These expected values can then be put on the tree if there is enough room.
PM STUDY NOTES
Once this has been done, the decision maker can then move left again to decision point
D. At D, the decision maker compares the value of the top branch of the decision tree
(which, given there were no outcome points, had a certain outcome and therefore needs
no probabilities to be applied to it) to the expected value of the bottom branch. Costs
will then need to be deducted. So, at decision point D compare the EV of not developing
the product, which is $0, with the EV of developing the product once the costs of
$400,000 have been taken off – ie $155,000.
Finally, the recommendation can be made to management. Develop the product because
the expected value of the profits is $155,000.
Perfect information
The value of perfect information is the difference between the expected value of profit
with perfect information and the expected value of profit without perfect information.
For example, an agency can provide information on whether the launch is going to be
successful and produce high, medium or low profits or whether it is simply going to fail.
The expected value with perfect information can be calculated using a small table.
Profit less
Demand EV of
Probability development Proceed
level info
cost
$380,000
PM STUDY NOTES
Expected value $0
The value of the information can then be calculated by deducting the expected value of
the decision without perfect information from the expected value of the decision with
perfect information – ie $266,000 – $155,000 = $111,000. This would represent the
absolute maximum that should be paid to obtain such information.
Imperfect information
In reality, information obtained is rarely perfect and is merely likely to give more
information about the likelihood of different outcomes rather than perfect information
about them. The value of imperfect information will always be less than the value of
perfect information unless both are zero. This would occur when the additional
information would not change the decision. Note that the principles that are applied for
calculating the value of imperfect information are the same as those applied for
calculating the value of perfect information.
Sensitivity analysis
The essence of sensitivity analysis is to carry out calculations with one set of values
for the variables and then substitute other possible values for the variables to see
how this effects the overall outcome.
This technique can be used in any situation where relationships between key
variables can be identified.
Sensitivity analysis is one form of ‘what-if? Analysis.
PM STUDY NOTES
Example
The Mobile Sandwich Co prepares sandwiches which it delivers and sells to
employees at local businesses each day.
Demand varies between 325 a nd 400 s andw i che s each day. As the day progresses,
the price of the sandwiches is reduced and, at the end of the day, any sandwiches
not sold are thrown away. The company has prepared a regret table to show the
amount of profit which would be foregone each day at each supply level, given the
varying daily levels of demand.
Regret table
Daily supply of sandwiches ( units)
Daily demand 325 350 375 400
325 $0 $21 $82 $120
for sandwiches
350 $36 $0 $44 $78
(units) 375 $82 $40 $0 $34
400 $142 $90 $52 $0
Applying the decision criterion of minimax regret, how many sandwiches should
the company decide to supply each day?
A 325
B 350
C 375
D 400
Solution
The correct option is C
The maximum regret at each supply level is as follows:
A At 325: $142
B At 350: $90
C At 375: $82
D At 400: $120
PM STUDY NOTES
Example
Berraq runs a cafeteria in an accountancy college and is now considering investing in a
specialty coffee. She has estimated the following daily results for the new machine:
$
Sales (650 units) 1,300
Variable costs (845)
Contribution 455
Incremental fixed costs (70)
Profit 385
Which of the following statements is/ are true regarding the sensitivity of this
investment?
1. The investment is more sensitive to a change in sales volume than selling price
2. If variable costs increase by 44% the investment will make a loss
3. The investment’s sensitivity to incremental fixed costs is 550%
4. The margin of safety is 84·6%
A. 1, 2 and 3
B. 2 and 4
C. 1, 3 and 4
D. 3 and 4 only
Solution:
The correct option is D
The investment’s sensitivity to fixed costs is 550% ((385/70) x 100), so
Statement 3 is correct.
The margin of safety is 84·6%. Budgeted sales are 650 units and BEP sales
are 100 units (70/0·7), therefore the margin of safety is 550 units which
equates to 84·6% of the budgeted sales, so Statement 4 is therefore correct.
The investment is more sensitive to a change in sales price of 29·6%, so
Statement 1 is incorrect.
If variable costs increased by 44%, it would still make a very small profit, so
Statement 2 is incorrect
PM STUDY NOTES
Syllabus Area D
BUDGETING AND CONTROL
PM STUDY NOTES
A budget can be set from the top down (imposed budget) or from the bottom up
(participatory budget).
In top-down budgeting, senior management level sets the budgetary targets for
the organisation. This approach is a time saving technique.
With bottom-up budgeting, managers are required to draft a budget for their
area of operations. These are submitted to their superior, eventually becoming
part of the budget for the whole organisation. This is much more time
consuming, however it reflects views of managers actually dealing with
operations and encourages motivation through participation.
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Feedback: This is important aspect of control once the plan is being implemented.
Single Loop Feedback: Feedback is used to take corrective action to ensure original
plan is met.
Double Loop Feedback: Feedback is used to revise the original plan.
Types of feedback:
a) Negative feedback indicates that results or activities must be brought back on
course, as they are deviating from the plan.
b) Positive feedback results in control action continuing the current course.
c) Feedforward control is based on forecasts. Action can be taken well in advance if
issues identified.
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There are several possible reasons why behavioural factors in budgeting can be
damaging for the entity.
Misunderstanding and worries about cost-cutting.
Opposition to unfair targets set by senior management
Sub-optimisation
Lack of goal congruence
Budget slack or budget bias
When senior managers use the budgeting process to set unrealistic and unfair
performance targets for the year, their subordinates may unite in opposition to what
the senior managers are trying to achieve.
Sub-optimisation
There may be a risk that the planning targets for individual managers are not in the best
interests of the organisation as a whole. For example, a production manager might try
to budget for production targets that fully utilise production capacity. However,
working at full capacity is not in the best interests of the company as a whole if sales
demand is lower.
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The behavioural problems with budgeting arise because the corporate aims of an
organisation are usually not the same as the aspirations of the individuals who work for
it. This is known as lack of goal congruence and leads to dysfunctional behaviour.
Budget slack has been defined as 'the intentional overestimation of expenses and/or
underestimation of revenue in the budgeting process' (CIMA Official Terminology).
Managers -who prepare budgets may try to over-estimate costs so that it will be much
easier to keep actual spending within the budget limit.
Advantages:
Quick and easy method of budgeting
Suitable for organisations that operate in a stable environment
Disadvantages:
Previous problems and inefficiencies are automatically included in the upcoming
year’s budget.
Managers may overspend in order to be able to claim the same or more budget for
the next year.
Fixed Budget: is a budget which remains unchanged throughout the budget period,
regardless of differences between the actual and the original planned volume of output
or sales. E.g. Master Budget.
PM STUDY NOTES
Flexible Budget: is a budget which is changed as the volume of output and sales
changes by using the cost behaviour patterns.
These can be created at the planning stage, as the organisation may prepare budgets
for different levels of expected activities.
These can also be created retrospectively to reflect the actual level of activity
achieved. For example, if actual activity was of 10,000 units produced, then a flexible
budget for 10,000 units is created. This supports the control element as
management will be able to compare the actual performance with a budget of a
corresponding level of activity.
Worked Example:
The following monthly budgeted cost values have been taken from the budget working
papers of Yum Limited for the year ended 30 October 20X7.
During October 20X7, actual activity was 39,000 units and actual costs were:
$
Direct material 117,000
Direct labour 169,650
Production overhead 79,250
PM STUDY NOTES
Solution:
Flexed Budget Actual Variance
39,000 units 39,000 units
$ $ $
Direct material (W1) 97,500 117,000 -19,500 A
Direct labour (W2) 204,750 169,650 35,100 F
Production overhead (W3) 69,500 79,250 -9,759 A
Selling overhead (W4) 115,600 115,150 459 F
Administration overhead 33,500 37,800 -4,300 A
520,850 518,850 572,750
Workings:
W1: ($50,000 / 20,000 units) x 39,000 = $97,500
W3: Apply hi-low formula to work out variable cost per unit
($72,500 - $60,000)/(45,000 units – 20,000 units) = 0.5 per unit
Work out fixed cost element
$72,500 – (45,000 units x $0.5 per unit) = $50,000
For 39,000 units = $50,000 + (39,000 x $0.5 per unit) = $69,500
W4: Apply hi-low formula to work out variable cost per unit
($118,000 - $108,000)/(45,000 units – 20,000 units) = 0.4 per unit
Work out fixed cost element
$118,000 – (45,000 units x $0.4 per unit) = $100,000
For 39,000 units = $100,000 + (39,000 x $0.4 per unit) = $115,600
PM STUDY NOTES
Zero Based Budgeting: involves preparing a budget for each cost centre or activity
from a zero base. Every item of expenditure has then to be justified in its entirety in
order to be included in the next year's budget.
Implementation: ZBB is particularly useful for budgeting for discretionary costs and for
rationalisation purposes, in areas of operations where efficiency standards are not
properly established, such as administration work.
1. Define items or activities for which costs should be budgeted, and spending
decisions should be planned: these are 'decision packages'.
2. Evaluate and rank the packages in order of priority: eliminate packages whose
costs exceed their value.
3. Allocate resources to the decision packages according to their ranking. Where
resources such as money are in short supply, they are allocated to the most
valuable activities.
Advantages:
PM STUDY NOTES
Disadvantages:
Extra volume of paperwork created and the extra time required to prepare the
budget.
Short-term benefits might be emphasised to the detriment of long-term benefits.
It might give the impression that all decisions have to be made in the budget and
discourage innovative ideas.
Managers may have to be trained in ZBB techniques.
The organisation's information systems may not be capable of providing suitable
information.
The ranking process can be difficult.
Activity Based Budgeting: This involves defining the activities that underlie the
financial figures in each function and using the level of activity to decide how much
resource should be allocated and how well it is being managed and to explain variances
from budget.
Principles:
Activities drive costs and the aim is to plan and control the causes (drivers) of
costs rather than the costs themselves.
Non value adding activities should be removed.
Most departmental activities are driven by demands and decisions beyond the
immediate control of the manager responsible for the department's budget.
Additional measures apart from traditional financial measures are needed to
ensure continuous improvement.
PM STUDY NOTES
Advantages:
Advantages:
Disadvantages:
PM STUDY NOTES
Criticisms of Budgeting:
Use adaptive management processes for making decisions. Managers should plan
on a more adaptive, rolling basis but with the focus on cash forecasting rather
than purely on cost control. Performance is monitored against world-class
benchmarks, competitors and previous periods.
The emphasis is on encouraging a culture of personal responsibility by
delegating decision-making and performance accountability to line managers.
PM STUDY NOTES
Benefits:
Challenges:
PM STUDY NOTES
The learning rate and learning effect – extract from ACCA Technical Article
In practice, it is often found that the resources required to make a product decrease as
production volumes increase. It costs more to produce the first unit of a product than it
does to produce the one hundredth unit.
In part, this is due to economies of scale since costs usually fall when products are made
on a larger scale. This may be due to bulk quantity discounts received from suppliers,
for example.
The learning curve, effect, however, is not about this; it is not about cost reduction. It is
a human phenomenon that occurs because of the fact that people get quicker at
performing repetitive tasks once they have been doing them for a while. The first time a
new process is performed, the workers are unfamiliar with it since the process is
untried. As the process is repeated, however, the workers become more familiar with it
and better at performing it. This means that it takes them less time to complete it.
The learning process starts as soon as the first unit or batch comes off the production
line. Since a doubling of cumulative production is required in order for the cumulative
average time per unit to decrease, it is clearly the case that the effect of the learning rate
on labour time will become much less significant as production increases. Eventually,
the learning effect will come to an end altogether. See Figure 1 below.
When output is low, the learning curve is really steep but the curve becomes flatter as
cumulative output increases, with the curve eventually becoming a straight line when
the learning effect ends.
PM STUDY NOTES
Figure 1
The learning curve effect will not always apply, of course. It flourishes where certain
conditions are present.
Learning curve models enable users to predict how long it will take to complete a future
task. Management accountants must therefore be sure to take into account any learning
rate when they are carrying out planning, control and decision-making. If they fail to do
this, serious consequences will result.
attractive as possible to customers but still wants to make a profit, so it prices it based
on the full absorption cost plus a small 5% mark-up for profit.
The first unit of that product may take one hour to make. If the labour cost is $15 per
hour, then the price of the product will be based on the inclusion of that cost of $15 per
hour. Other costs may total $45. The product is therefore released onto the market at a
price of $63.
Subsequently, it becomes apparent that the learning effect has been ignored and the
correct labour time per unit should is actually 0.5 hours. Without crunching through the
numbers again, it is obvious that the product will have been launched onto the market
at a price which is far too high. This may mean that initial sales are much lower than
they otherwise would have been and the product launch may fail. Worse still, the
company may have decided not to launch it in the first place as it believed it could not
offer a competitive price.
Finally, it is worth noting that the use of learning curve is not restricted to the assembly
industries it is traditionally associated with. It is also used in other less traditional
sectors such as professional practice, financial services, publishing and travel. In fact,
research has shown that just under half of users are in the service sector.
This is a fairly common exam requirement which tests candidates’ understanding of the
difference between cumulative and incremental time taken to produce a product and
the application of the learning curve formula. It is worth mentioning at this point that
learning curve calculations should never be rounded to less than three decimal places.
PM STUDY NOTES
The learning curve formula is always given on the formula sheet in the exam: Y = axb
Worked Example:
Learning curve 90%
Units produced till date 500 units.
LaboUr cost = $10/ hour
Time to make first unit 100 hours
Calculate the cumulative average time and cost to produce 500 units.
Solution:
𝑦 = 𝑎𝑥
.
𝑦= 100 (500)
𝑦= 38.88 / unit
Example
P Co operates a standard costing system. The standard labour time per batch for its
newest product was estimated to be 200 hours, and resource allocation and cost data
were prepared on this basis.
The actual number of batches produced during the first six months and the actual time
taken to produce them is shown below:
PM STUDY NOTES
June 1 200
July 1 152
August 2 267.52
September 4 470.8
October 8 1,090.32
November 16 2,180.64
Required
(a) Calculate the monthly learning rate that arose during the period.
(b) Identify when the learning period ended and briefly discuss the implications
of this for P Co.
Cumulative
Incremental Cumulative
Incremental Cumulative average
Month number of number of
total hours total hours hours per
batches batches
batch
Learning rate:
176/200 = 88%
154.88/176 = 88%
136.29/154.88 = 88%
PM STUDY NOTES
The learning period ended at the end of September. This meant that from October
onwards the time taken to produce each batch of the product was constant. Therefore,
in future, when P Co makes decisions about allocating its resources and costing the
product, it should base these decisions on the time taken to produce the eighth batch,
which was the last batch produced before the learning period came to an end. The
resource allocations and cost data prepared for the last six months will have been
inaccurate since they were based on a standard time per batch of 200 hours.
P Co could try and improve its production process so that the learning period could be
extended. It may be able to do this by increasing the level of staff training
provided. Alternatively, it could try to incentivise staff to work harder through payment
of bonuses, although the quality of production would need to be maintained.
Example
The first batch of a new product took six hours to make and the total time for the first
16 units was 42.8 hours, at which point the learning effect came to an end.
Using algebra:
Step 2: Divide each side by 16 in order to get rid of the ’16 x’ on the right hand side of
the equation: 2.675 = (6 x r4)
PM STUDY NOTES
Step 3: Divide each side by 6 in order to get rid of the ‘6 x’ on the right hand side of the
equation: 0.4458333 = r4
Step 4: take the fourth root of each side in order to get rid of the r 4 on the right hand
side of the equation. This can be done using the button on the calculator that says r4 or
x1/y. Either of these can be used to find the fourth root (or any root, in fact) of a number.
r = 0.8171
PM STUDY NOTES
$
Direct Materials:
Material A: 2 litres at $4.50 per litre 9
Material B: 3 kilos at $4 per Kilo 12
Direct Labour:
Grade 1 labour: 0.5 hours at $20 per hour 10
Grade 2 labour: 0.75 hours at $16 per hour 12
Variable production overheads: 1.25 hours at $4 per hour 5
Fixed production overheads: 1.25 hours at $40 per hour 50
Standard ( production) cost per unit 95
Used to prepare budgets When standard costs are established for products,
they can be used to prepare the budget.
PM STUDY NOTES
Types of Standards:
Ideal Standards The ideal standard cost is the cost that would be achievable if
operating conditions and operating performance were perfect. In
practice, the ideal standard is not achievable. Will demotivate
employees if enforced.
Attainable standard These assume efficient but not perfect operating conditions. An
allowance is made for waste and inefficiency. However the
attainable standard is set at a higher level of efficiency than the
current performance standard, and some improvements will
therefore be necessary in order to achieve the standard level of
performance. This can be a basis of motivating employees.
Current standards These are based on current working conditions and what the
entity is capable of achieving at the moment. Current standards do
not provide any incentive to make significant improvements in
performance, which may cause employee performance to slack.
Basic Standards These are standards which remain unchanged over a long period
of time. Cause employees to lose interest.
PM STUDY NOTES
So if an organisation had originally budgeted for an activity level of 5,000 units but
ended up producing/ selling 7,000 units, the following steps will have to be carried out
to carry out an effective variance analysis:
Step 1: Use the standard cost card to determine flexible budget for 7,000 units. If the
cost card is not available, information from the fixed budget of 5,000 units can be picked
up to create a budget for the 7,000 units. This will depend on following knowledge
points:
Total Budgeted Fixed Costs (unless Step Fixed) will not change regardless of
level of activity
Budgeted Variable Cost Per Unit will not change regardless of level of activity
Step 2: Compare the actual revenue and costs of 7,000 units with the flexed budget
created in Step 1.
Step 3: Identify the differences between the actual and budget as positive (Favourable)
or negative (Adverse).
Step 4: Carry out an investigation to determine causes of the variances (if material).
Remember both favourable and adverse variances may require investigation.
Example:
A company has prepared the following standard cost card:
$ per unit
Materials (4 kg at $4.50 per kg) 18
Labour (5 hrs at $5 per hr) 25
Variable overheads (5 hrs at $2 per hr) 10
Fixed overheads (5 hrs at $3 per hr) 15
68
Budgeted selling price $75 per unit.
Budgeted production was 8,700 units
Budgeted sales were 8,000 units
There is no opening inventory
PM STUDY NOTES
Solution:
Original Flexed Actual Variances
Fixed Budget Budget $
$ $
Sales (units) 8,000 8,400 8,400
Production (units) 8,700 8,900 8,900
PM STUDY NOTES
Variance Analysis
Example: A unit of product P123 has a standard cost of five liters of material A at $3 per
liter. The standard direct material cost per unit of product 123 is therefore $15.
In a particular month, 2,000 units of product 123 were manufactured. These used
10,400 liters of material A, which cost $33,600.
$
2,000 units of product P123 should cost 30,000
(x$15)
2,000 units of product P123 did cost 33,600
Total direct materials cost variance (3,600) (A)
PM STUDY NOTES
The total direct materials cost variance is adverse, because actual costs were higher
than the standard cost.
Example: A unit of product p123 has a standard cost of five liters of material A at $3per
liter. The standard direct material cost per unit of product 123 is therefore $15. In a
particular month, 2,000 units of product 123 were manufactured. These used 10,400
liters of Material A, which cost $33,600.
The total direst material cost variance is $3,600 (A), as calculated earlier, in the
previous example.
$
10,400 liters of materials should cost (x$3) 31,200
10,400 liters of materials did cost 33,600
Material price variance 2,400 (A)
The price variance is adverse because the materials cost more to purchase than they
should have.
Example: Using the same example above that was used to illustrate the material price
variance; the usage variance should be calculated as follows:
kilos
2,000 units of Product P123 should use (x 5 kilos) 10,000
2,000 units of Product P123 did use 10,400
Material usage variance in kilos 400 (A)
Standard price per kilo of Material A $3
Material usage variance in $ $1,200 (A)
The usage variance is adverse because more materials were used than expected, and
this has added to costs.
PM STUDY NOTES
PM STUDY NOTES
Example: Product P123 has a standard direct labour cost per unit of: 1.5 hours x $12
per direct labour hour = $18 per unit.
During a particular month, 2,000 units of Product 123 were manufactured. These took
2,780 hours to make and the direct labour cost was $35,700.
$
2,000 units of product P123 should cost (x 36,000
$18)
2,000 units of product P123 did cost 35,700
Total direct labour cost variance 300 F
PM STUDY NOTES
The variance is favourable, because actual costs were less than the standard cost.
The direct labour total cost variance can be analysed into a rate variance and an
efficiency variance. The calculations are similar to the calculations for the materials
price and usage variances.
Example: Using the same example that was used previously to calculate the total labour
cost variance, calculate the direct labour rate variance.
$
2,730 hours should cost (x $12) 33,360
2,730 hours did cost 35,700
Direct labour rate variance 2,340 (A)
The rate variance is adverse because the labour hours worked cost more than they
should have.
Example: Using the same example above that was used to illustrate the total direct
labour cost variance and the direct labour rate variance; the efficiency variance should
be calculated as follows:
hours
2,000 units of Product P123 should take (x 1.5 hours) 3,000
2,000 units of Product P123 did take 2,780
Efficiency variance in hours 220 F
Standard direct labour rate per hour $12
Direct labour efficiency variance in $ $2,640 F
The efficiency variance is favourable because production took less time than expected,
which has reduced costs.
PM STUDY NOTES
PM STUDY NOTES
Example: Product P123 has a standard variable production overhead cost per unit of
1.5hours x $2 per direct labour hour= $3 per unit. During a particular month, 2,000 unit
of a product 123 were manufactured. These took 2,780 hours to make and the variable
production overhead cost was 46,550.
Required: Calculate for the month the total variable production overhead cost variance.
(Note: this same example will be used to illustrate the variable overhead expenditure
and efficiency variances.)
$
2,000 units of output should cost (x$3) 6,000
2,000 units of output did cost 6,550
Total variable production overhead cost variance 550 (A)
The variance is adverse, because actual costs were more than a standard cost.
Example: Using the same example that was used previously to calculate the total
variable production overhead cost variance, calculate the variable production overhead
expenditure variance.
$
2,780 hours should cost (x$2) 5,560
2,789 hours did cost 6,550
Variable production overhead variance 990 (A)
hours
2,000 units of Product P123 should take (x 1.5 hours) 3,000
2,000 units of Product P123 did take 2,780
Efficiency variance in hours 220 F
Standard variable production overhead rate per hour $2
Variable production overhead efficiency variance in $ $440 F
PM STUDY NOTES
The efficiency variance is favourable because production took less time than expected,
which has reduced costs.
The causes of variable overhead efficiency variances are the same as the causes
of labour efficiency variances, when variable overhead expenditure is assumed
to vary with the number of direct labour hours worked.
The causes of variable overhead expenditure variances maybe:
Efficient or inefficient spending on overhead items of cost
Inaccurate estimates of the variable overhead expenditure rate per hour.
PM STUDY NOTES
Example: A company budgeted to make 5,000 units of a single standard product in Year
1. Budgeted direct labour hours are 10,000 hours. Budgeted fixed production overhead
is $40,000. Actual production in Year 1 was 5,200 units and fixed production overhead
was $40,500.
Standard fixed overhead cost per unit = $8 (2 hours per unit x $4 per hour).
The variance is favourable, because fixed overhead costs have been over-absorbed.
PM STUDY NOTES
This variance is adverse because actual expenditure exceeds the budgeted expenditure.
This variance is favourable because actual production volume exceeded the budgeted
volume.
Summary $
Fixed overhead expenditure variance 500 (A)
Fixed overhead volume variance 1,600 F
Fixed overhead total cost variance 1,100 F
Example: A company budgeted to make 5,000 units of a single standard product in Year
1. Budgeted direct labour hours are 10,000 hours. Budgeted fixed production overhead
is $40,000. Actual production in Year 1 was 5,200 units in 10,250 hours of work, and
fixed production overhead was $40,500.
PM STUDY NOTES
The capacity variance is favourable because actual hours worked exceeded the
budgeted hours (therefore more units should have been produced).
Summary $
Sales Variances
PM STUDY NOTES
Example: A company budgets to sell 7,000 units of Product P456. The standard sales
price of Product P456 is $50 per unit and the standard cost per unit is $42.
Actual sales were 7,200 units, which sold for $351,400. The sales price variance and
sales volume variance would be calculated as follows:
The sales price variance is adverse because actual sales revenue from the units sold was
less than expected.
The sales volume variance is favourable because actual sales exceeded budgeted sales.
PM STUDY NOTES
Operating Statements:
Fav Adv
£000 £000 £000
Budgeted profit xxx
Sales margin
variances
Price xxx (xxx)
Volume xxx (xxx)
xxx/(xxx)
XXX
Cost variances
Materials Price xxx (xxx)
Usage xxx (xxx)
Labour Rate xxx (xxx)
Idle time (xxx)
Efficiency xxx (xxx)
Variable Overhead Expenditure xxx (xxx)
Efficiency xxx (xxx)
Fixed Overhead Expenditure xxx (xxx)
Capacity xxx (xxx)
Efficiency xxx (xxx)
xxx (xxx)
xxx/(xxx)
Actual profit XXX
PM STUDY NOTES
When a company uses standard marginal costing rather than standard absorption
costing: finished goods inventory is valued at the standard variable production cost, not
the standard full production cost variances are calculated and presented in the same
way as for standard absorption costing, but with two important differences:
PM STUDY NOTES
Investigating Variances
Factor Description
Size of the variance. As a general rule, the larger the variance, the greater the
potential benefit from investigation and control
measures.
Probability that the cause Whether or not to investigate the cause of a variance -will
of the variance will be also depend on the expectation of management that the
controllable. cause of the variance will be controllable.
Reliability of budgets and Management might have a view about whether the
measurement systems. variance is caused by poor planning and poor
measurement systems, rather than by operational factors.
If so, investigating the variance would be a waste of time
and would be unlikely to lead to any cost savings.
PM STUDY NOTES
Mix Variance: A mix variance occurs when the materials are not mixed or blended in
standard proportions and it is a measure of whether the actual mix is cheaper or more
expensive than the standard mix.
Yield Variance: A yield variance arises because there is a difference between what the
input should have been for the output achieved and the actual input.
When standard costing is used for products which contain two or more items of direct
material, the total materials usage variance can be calculated by calculating the
individual usage variances in the usual way and adding them up (netting them off).
Example: Product N is produced front three direct materials, A, B and C that are mixed
together in a process. The following information relates to the budget and output for
the month of January
PM STUDY NOTES
The materials mix variance measures how much of the total usage variance is
attributable to the fact that the actual combination or mixture of materials that was
used was more expensive or less expensive than the standard mixture for the materials.
The mix component of the usage variance therefore indicates the effect on costs of
changing the combination (or mix or proportions) of material inputs in the production
process. The materials mix variance is calculated as follows (making reference to the
example above):
Step 1: Take the total quantity of all the materials used and divide this into a standard
mix for the materials used.
Step 2: The difference between the quantity of material used and the quantity hat
should have been used according to the standard mix; is the mix variance.
Material Actual Standard Mix variance Std. cost per Mix variance
mix mix (kgs) kg (Standard)
The materials yield variance is the difference between the actual yield from a given
input and the yield that the actual input should have given in standard terms. It
indicates the effect on costs of the total materials inputs yielding more or less output
than expected.
The standard cost of each unit (kg) of input = $90/10kg = $9 per kilo
PM STUDY NOTES
Method 1: This compares the actual yield to the expected yield from the material used.
The difference is then valued at the standard cost of output.
The difference between this figure and the actual output is the yield variance as a
number of units. This is then multiplied by the expected cost of a unit of output.
Units
2,100 kgs of input should yield (@10 kg per unit) 210
did yield 200
Yield variance in units 10 (A)
Standard cost of output $90
Materials yield variance $900 (A)
Method 2: This compares the actual usage to achieve the yield to the expected usage to
achieve the actual yield. The difference is then valued at the standard cost of input.
In the above example 1 unit should use 10 kg of input, therefore, 200 units should use
2,000 kg of input.
The difference between this figure and the actual output is the yield variance as a
number of units. This is then multiplied by the expected cost of a unit of output.
kg
200 units of product N should use (x 10 kilos) 2,000
did use 2,100
Yield variance in quantities 100 (A)
Standard cost of input $9/kg
Yield variance in money = $900 (A)
value
PM STUDY NOTES
Summary
$
Mix variance 1,180 (F)
Yield variance 900 (A)
Usage variance (= mix + yield variances) 280 (F)
Analysis of the material usage variance into the mix and yield components is
worthwhile if management have control of the proportion of each material used.
Management will seek to find the optimum mix for the product and ensure that the
process operates as near to this optimum as possible.
PM STUDY NOTES
It is calculated as the difference between actual sales units and budgeted sales units,
multiplied by the standard profit per unit.
If a company sells more than one product, it is possible to analyse the overall sales
volume variance into a sales mix variance and a sales quantity variance.
Sales mix variance: The sales mix variance occurs when the proportions of the various
products sold are different from those in the budget.
Sales quantity variance: The sales quantity variance shows the difference in
contribution/profit because of a change in sales volume from the budgeted volume of
sales.
The sales mix variance is calculated as the difference between the actual quantity sold in
the standard mix and the actual quantity sold in the actual mix, valued at standard
margin per unit.
The sales quantity variance is calculated as the difference between the actual sales
volume in the budgeted proportions and the budgeted sales volumes, multiplied by the
standard margin.
Example:
The following information relates to the sales budget and actual sales volume results for
X Inc for the month of March.
Product X Y Z Total
Budgeted sales (units) 2,400 1,400 1,200 5,000
Unit contribution $5 $7 $6
PM STUDY NOTES
The sales quantity variance indicates the effect on profits of the total quantity of sales
being different front that budgeted, assuming that they are sold in the budgeted sales
mix.
If this was the case the average standard contribution per unit would be the same as
budgeted at: $29,000/ 5,000 units = $5.80 per units
Units
of sale
Budgeted sales in total 5,000
Actual sales in total 6,000
Sales quantity variance in units 1,000 (F)
Weighted average standard contribution per unit $5.80
Sales quantity variance in $ of standard $5,800 (F)
contribution
PM STUDY NOTES
The sales mix variance is calculated as follows (making reference to the example
above):
Sum up the budgeted sales of each individual product and calculate the percentage that
each bears to the total (Product X: 2,400/5,ooo = 48%; Product Y: 1,400/5,000 = 28%; Product
Z: 1,200/5,000 = 24%).
Apply the percentages to the actual total sales to give the actual number of each that
would have been sold if the actual sales were made in the standard mix. (For product X
this figure is 48% of 6,000 = 2,880 units).
The mix variance (in units) for each product is the difference between this number and
the actual sales of that product. (For product X this is 2,400 - 2,880 = 480 units. Thus the
company has sold 480 units of X less than it would have if the actual sales were made in
the standard mix)
The variance for each product expressed as units is multiplied by the standard
contribution per unit of that product to give the impact on contribution.
In this illustration the total mix variance is favourable because the company has sold
more high contribution items and less low contribution items.
PM STUDY NOTES
Summary
$
Mix variance 1,400 (F)
Quantity variance 5,800 (F)
Volume variance 7,200 (F)
Example
Product GX consists of a mix of three materials, J, K and L. The standard material cost of
a unit of GX is as follows:
$
Material J 5 kg at $4 per kg 20
Material K 2 kg at $12 per kg 24
Material L 3 kg at $8 per kg 24
During March, 3,000 units of GX were produced, and actual usage was:
Material J 13,200 kg
Material K 6,500 kg
Material L 9,300 kg
Solution:
The correct option is A
3,000 units should use 10 kg each (3,000 x 10) = 30,000 kg
3,000 units did use = 29,000 kg
Difference = 1,000 kg favourable
Valued at $6·80 per kg ($68/10 kg)
Variance = $6,800 favourable
PM STUDY NOTES
Introduction:
Sometimes based on circumstances the budget and the standard cost established by an
organisation turns out to be inaccurate and this contributes towards the variances.
Under the circumstances, the budgets/ standard costs should be revised based on the
new information available and the variances should be split into Planning or
Operational variances.
Revising Budgets:
Budgets should be revised when it is confirmed beyond reasonable doubt that
the original budget is redundant or ineffective under the circumstances.
The changes have to be approved by the senior management.
However care needs to be taken as there is a possibility of management
manipulating the budget revision so that the end result is favourable variances.
PM STUDY NOTES
MATERIAL
Material Price Operational Variance Revised standard cost for material actually used
Less: Actual cost for material actually used .
Price Operational Variance ($) .
PM STUDY NOTES
LABOUR
Labour Rate Operational Variance Revised standard rate for hours actually worked
Less: Actual rate for hours actually worked .
Rate Operational Variance ($) .
PM STUDY NOTES
SALES
Sales Price Operational Variance Revised budgeted sales price for units actually
sold
Less: Actual sales price for units actually sold
Price Operational Variance ($) .
PM STUDY NOTES
Advantages
They identify variances due to poor planning and put a realistic value to
variances resulting from operations.
Planning variances can be used to update standard costs and revise budgets.
The performance of managers is assessed on 'realistic' variance calculations.
Disadvantages
It takes time and effort to revise budgets and prepare revised standard costs.
Managers might try to blame poor results on poor planning and not on their
operational performance.
Manipulation issues in revising budgets
Example
PlasBas Co uses recycled plastic to manufacture shopping baskets for local retailers. The
standard price of the recycled plastic is $0·50 per kg and standard usage of recycled
plastic is 0·2 kg for each basket. The budgeted production was 80,000 baskets.Due to
recent government incentives to encourage recycling, the standard price of recycled
plastic was expected to reduce to $0·40 per kg. The actual price paid by the company
was $0·42 per kg and 100,000 baskets were manufactured using 20,000 kg of recycled
plastic.
Solution:
The correct option is C
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Example
Caf Co budgeted to sell 10,000 units of a new product in the period at a budgeted
selling price of $5 per unit. Actual sales volumes in the period were as budgeted but
the actual sales price achieved was only $4 per unit. This w as because a competitor
launched a similar product at the same time. Caf Co had been unaware that this was
going to happen when it prepared its budget and, had it known this, it would have
revised its expected selling price to $3·80 per unit, which was the price of the
competitor’s product.
Solution:
The correct option is A
Planning variance = ($3·80 – $5) x 10,000 = $12,000 A
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Just in time (JIT) management involves purchasing raw materials and producing
output 'just in time' for when they are needed.
In principle, in a JIT environment there will be no inventory of raw materials or
finished goods, (in practice the aim is to keep these inventories as low as possible).
This approach to management may possibly be inconsistent with some variance
reporting, especially if a system of absorption standard costing is used.
PM STUDY NOTES
Standard costs may be incompatible with rapid change, for similar reasons to those
of TQM.
In a rapidly-changing environment, it should be expected that the original standard
or budget may get out of date, and action to try to eliminate an adverse variance may
in fact be inappropriate because operating conditions have now changed.
Many companies produce nonstandard products and try to customise their products
according to needs of particular customers. Even where companies do not customise
products for individual customers, there is extensive fragmentation of markets into
segments or niches, with different product designs manufactured for each separate
segment. It is extremely difficult to establish a standard in such an environment.
Variance analysis concentrates on only a narrow range of costs, and does not give
sufficient attention to issues such as quality and customer satisfaction.
Standard costing places too much emphasis on direct labour costs. Direct labour is
only a small proportion of costs in the modern manufacturing environment and so
this emphasis is not appropriate.
Many of the variances in a standard costing system focus on the control of short-
term variable costs. But in most organisations the majority of costs, including direct
labour costs, tend to be fixed in the short run.
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The use of standard costing relies on the existence of repetitive operations and
relatively homogeneous output. Nowadays many organisations are forced
continually to respond to customers’ changing requirements, with the result that
output and operations are not so repetitive.
Most standard costing systems produce control statements weekly or monthly. The
modern manager needs much more prompt control information in order to function
efficiently in a dynamic business environment
PM STUDY NOTES
Syllabus Area E
PERFORMANCE MEASUREMENT AND CONTROL
PM STUDY NOTES
Performance Measurement
Performance measurement is a vital part of control and aims to establish how well
something or somebody is doing in relation to a planned activity.
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Performance measurement should cover the long-term, medium-term and short- term.
Long-term performance: Measures should be linked to the long-term objectives and the
strategies of the organisation. The most significant long-term objectives might be called
critical success factors or CSFs. in order to achieve its long-term and strategic
objectives, the critical success factors must be achieved.
For each critical success factor, there should be a way of measuring performance, in
order to check whether the CSF targets are being met. Performance measurements for
CSFs might be called key performance indicators (KPIs) or possibly key risk indicators
(KRIs).
PM STUDY NOTES
Financial performance indicators are the tools used by financial analysts for
making decisions regarding credit and investments. This method utilises the data
found in financial statements to determine a company’s standing.
Analysts will compare the company’s ratios to its past performance, as well as to
industry statistics to determine risks, trends and to identify any peculiarities.
This analytical tool facilitates inter-company as well as intra company
comparisons.
Percentage annual growth in sales = (Current Year Sales / Previous Year Sales) x 100%
If a company wishes to increase its annual profits, it will probably want to increase its
annual sales revenue. Sales growth is usually necessary for achieving a sustained
growth in profits over time.
Sales growth (or a decline in sales) can usually be attributed to two causes: Sales prices
and sales volume.
Profitability Indicators
Profitability ratios are good indicators of the operating efficiency of an organisation. The
management of an organisation is usually keen to measure its operating efficiency.
Again, the owners/ shareholders invest their funds in the expectation of reasonable
returns. The operating efficiency of a firm and its ability to ensure ample returns to its
owners/ shareholders depends basically on the profits earned by it.
It is wrong to conclude, without further analysis, that a high profit margin means 'good
performance' and a low profit margin means 'bad performance'. To assess performance
by looking at profit margins, it is necessary to look at the circumstances in which the
profit margin has been achieved.
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Some companies operate in an industry or market where profit margins are high,
although sales volume may be low. Other companies may operate in a market where
profit margins are low but sales volumes are much higher.
Any change in profit margin front one year to the next will be caused by: changes in
selling prices, or changes in costs as a percentage of sales, or a combination of both.
Cost/sales ratios
Performance may be assessed by looking at changes in these ratios over time. A large
increase or reduction in any of these ratios would have a significant effect on profit
margin.
This ratio indicates the efficiency with which company is able to use all its (net) assets
to gearing $1 sales. Generally, the higher a company’s total net asset turnover, the more
efficiently its assets have been used.
PM STUDY NOTES
EPS is a figure based on past data, and it is easily manipulated by changes in accounting
policies and by mergers or acquisitions. The use of the measure in calculating
management bonuses makes it particularly liable to manipulation.
Return on capital employed (ROCE) = (Capital Employed / Profit Before Interest & Tax)
x 100%
Capital employed = Shareholders' funds plus 'payables: amounts falling due after more
than one year' plus any long-term provisions for liabilities = Total assets less current
liabilities.
The change in ROCE from one year to the next
The ROCE being earned by other companies, if this information is available
A comparison of the ROCE with current market borrowing rates
We may analyse the ROCE, to find out why it is high or low, or better or worse than last
year. There are two factors that contribute towards a return on capital employed, both
related to turnover.
Profit margin. A company might make a high or a low profit margin on its sales.
Asset turnover. Asset turnover is a measure of how well the assets of a business are
being used to generate sales.
Profit margin and asset turnover together explain the ROCE, and if the ROCE is the
primary profitability ratio, these other two are the secondary ratios. The relationship
between the three ratios is as follows
Profit Margin x Asset Turnover = ROCE
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Financial Risk
Financial risk is the risk to a business entity that arises for reasons related to its
financial structure or financial arrangements.
There are several major sources of financial risk, such as credit risk (= the risk of bad
debts because customers who are given credit will fail to pay what they owe) and
foreign exchange for companies that import or export goods or services (= the risk of an
adverse movement in an important currency exchange rate).
The risk is that if an entity borrows very large amounts of money, it might fail to
generate enough cash front its business operations to pay the interest or repay the debt
principal.
Debt ratios
Debt ratios can be used to assess whether the total debts of the entity are within control
and are not excessive.
Gearing ratio (leverage) = (Long term debt/ Share capital and reserves) x 100%
Or (Long term debt/ Share capital and reserves plus long term debts) x 100%
When there are preference shares, it is usual to include the preference shares within
long-term debt, not share capital.
A company is said to be low-geared when the amount of its debt capital is less than its
share capital and reserves. This means that a company is low-geared when the gearing
ratio is less than either 50% or 100%, depending on which method is used to calculate
the ratio.
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The gearing ratio can be used to monitor changes in the amount of debt of a company
over time. It can also be used to make comparisons with the gearing levels of other,
similar companies, to judge whether the company has too much debt, or perhaps too
little, in its capital structure.
Interest cover ratio = Profit before interest and tax / Interest charges in the year
Interest cover measures the ability of the company to meet its obligations to pay
interest.
An interest cover ratio of less than 3.0 times is considered very low, suggesting that the
company could be at risk from too much debt in relation to the amount of profits it is
earning.
The risk is that a significant fall in profitability could mean that profits are insufficient to
cover interest charges, and the entity will therefore be at risk from any legal action or
other action that lenders might take.
Financial risk, as we have seen, can be measured by financial gearing. Business risk
refers to the risk of making only low profits, or even losses, due to the nature of the
business that the company is involved in. One way of measuring business risk is by
calculating a company's operating gearing or 'operational gearing'.
Liquidity Ratios
Liquidity for a business entity means having enough cash, or having ready access to
additional cash, to meet liabilities when they fall due for payment. The most important
sources of liquidity for non-bank companies are:
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Cash may also come front other sources, such as the sale of a valuable non-current asset
(such as land and buildings), although obtaining cash front these sources may need
some time.
Liquidity is important for a business entity because without it, the entity- may become
insolvent even though it is operating at a profit. If the entity is unable to settle its
liabilities when they fall due, there is a risk that a creditor will take legal action and this
action could lead on to insolvency proceedings.
On the other hand a business entity may have too much liquidity, when it is holding
much more cash than it needs, so that the cash is 'idle', earning little or no interest.
Managing liquidity is often a matter of ensuring that there is sufficient liquidity, but
without having too much.
It is sometimes suggested that there is an 'ideal' current ratio of 2.0 times (2:1).
However, this is not necessarily true and in some industries, much lower current ratios
are normal. It is important to assess a current ratio by considering:
changes in the ratio over time
the liquidity ratios of other companies in the same industry.
The quick ratio or acid test ratio is the ratio of 'current assets excluding inventory' to
current liabilities. Inventory is excluded from current assets on the assumption that it is
not a very liquid item.
PM STUDY NOTES
It is sometimes suggested that there is an 'ideal' quick ratio of 1.0 times (1:1). However,
this is not necessarily true and in some industries, much lower quick ratios are normal.
As indicated earlier, it is important to assess liquidity- by looking at changes in the ratio
over time and comparisons with other companies and the industry norm.
Accounts Receivable Payment Period: (Trade Receivables/ Credit Sales Turnover) x 365
This is a rough measure of the average length of time it takes for a company's accounts
receivable to pay what they owe.
This indicates the average number of days that items of inventory are held for. As with
the average accounts receivable collection period, this is only an approximate figure, but
one which should be reliable enough for finding changes over time.
The accounts payable payment period often helps to assess a company's liquidity; an
increase in accounts payable days is often a sign of lack of long-term finance or poor
management of current assets, resulting in the use of extended credit from suppliers,
increased bank overdraft and so on.
PM STUDY NOTES
Non Financial Performance indicators are adequately covered through different models
– covered later.
Analysing NFPIs
You need to explain the significance of the ratio - What does it mean? Does it indicate
good or bad performance, and why?
Look at the background information given in the exam question and try- to identify a
possible cause or reason for the good or bad performance.
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Performance measures - both financial and non-financial - are needed for service
industries, but the key measures that are best suited to service industries are often very
different from the key NFPIs in manufacturing.
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In many cases the measures used will be non-financial ones. They may be divided into
three types.
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Balanced Scorecard
Customer satisfaction
Financial performance
The justifications of balanced scorecard over the traditional measures are that:
Accounting figures are easily manipulated and as such unreliable changes in the
business and market environment do not show in the financial results of a
company until much later.
Factors other than financial performance must therefore be targeted.
Customer perspective
This focuses on the analysis of different types of customers, their degree of satisfaction
and the processes used to deliver products and services to customers.
Customer service.
New products.
New markets.
Customer retention.
Customer satisfaction.
Quality performance.
Quality.
Motivated workforce.
Product diversification.
% sales from new products.
Amount of training.
Number of employee suggestions.
Extent of employee empowerment.
Financial perspective
Market share.
Profit ratio.
Return on investment.
Economic value added.
Return on capital employed.
Cash flow.
Share price.
PM STUDY NOTES
Criticism
The targets for each of the four perspectives might often conflict with each other. When
this happens, there might be disagreement about what the priorities should be.
This problem should not be serious, however, if it is remembered that the financial is
the most important of the four perspectives for a commercial business entity. The term
'balanced' scorecard indicates that some compromises have to be made between the
different perspectives.
PM STUDY NOTES
dimensions
standards, and
rewards.
These are shown in the following diagram, which is known as the 'building block model'.
Dimensions of Performance
Research by Fitzgerald and others (1993) and by Fitzgerald and Moon (1996)
concluded that there are six aspects to performance measurement that link
performance to corporate strategy. These are:
PM STUDY NOTES
flexibility
innovation.
Performance measures should be established for each of these six dimensions. Some
performance measures that might be used for each dimension are set out in the
following table.
Standards of performance
To what extent do individuals feel that they own the standards that will be used
to assess their performance? Do they accept the standards as their own, or do
they feel that the standard shave been imposed on them by senior management?
Do the individuals held responsible for achieving the standards of performance
consider that these standards are achievable, or not?
Are the standards fair ('equitable') for all managers in all business units of the
entity?
It is recognised that individuals should 'own' the standards that will be used to assess
their performance, and managers are more likely to own the standards when they have
been involved in the process of setting the standards.
It has also been argued that if an individual accepts or 'owns' the standards of
performance, better performance will be achieved when the standard is more
demanding and difficult to achieve than when the standard is easy to achieve.
This means that the standards of performance that are likely to motivate individuals the
most are standards that will not be achieved successfully all the time. Budget targets
should therefore be challenging, but not impossible to achieve.
Finding a balance between standards that the company thinks are achievable and
standards that the individual thinks are achievable can be a source of conflict between
senior management and their subordinates.
The third aspect of the performance measurement framework of Fitzgerald and Moon is
rewards. This refers to the structure of the re-wards system, and how individuals will
PM STUDY NOTES
One of the main roles of a performance measurement system should be to ensure that
strategic objectives are achieved successfully, by linking operational performance with
strategic objectives.
According to Fitzgerald, there are three aspects to consider in the reward system.
Example
The following ratios have been calculated for a company:
Gross profit margin 42%
Operating profit margin 28%
Gearing (debt/equity) 40%
Asset turnover 65%
PM STUDY NOTES
A 27·3%
B 18·2%
C 11·2%
D 16·8%
Solution:
The correct option is B
ROCE can be calculated by multiplying the operating profit margin and the asset
turnover i.e. 28% x 65% = 18·2%
Example
A company’s sales and cost of sales figures have remained unchanged for the last two
years. The following information has been noted:
Year ended 31 May 2015 31 May 2014
Inventory turnover period 45 days 38 days
Payables payment period 40 days 35 days
Receivables payment 60 days 68 days
Current ratio 1·3 1·4
Quick ratio 1·1 1·3
The following statements have been made about the company’s performance for the
most recent year:
(i) Customers are taking longer to pay and this may have contributed to the
decline in the company’s current ratio
(ii) Inventory levels have decreased and this may have contributed to the decline
in the company’s quick ratio
Which of the above statements is/are true?
A (i) only
B (ii) only
C Both (i) and (ii)
D Neither (i) nor (ii)
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Decentralisation of authority
Benefits of decentralisation
PM STUDY NOTES
Disadvantages of decentralisation
The divisional managers might put the interests of their division before the
interests of the organisation as a whole. Taking decisions that benefit a division
might have adverse consequences for the organisation as a whole. When this
happens, there is a lack of 'goal congruence'.
Top management may lose control over the organisation if they allow
decentralisation without accountability. It may be necessary to monitor
divisional performance closely. The cost of such a monitoring system might be
high.
It is difficult to find a satisfactory measure of historical performance for an
investment centre that will motivate divisional managers to take the best
decisions. For example, measuring divisional performance by Return 011
Investment (ROI) might encourage managers to make inappropriate long-term
investment decisions. This problem is explained in more detail later.
Economies of scale might be lost. For example, a company might operate with
cute finance director. If it divides itself into three investment centres, there might
be a need for four finance directors - one at head office and one in each of the
investment centres. Similarly there might be a duplication of other systems, such
as accounting system and other IT systems.
Controllable profit is used to assess the manager and is therefore sometimes called the
managerial evaluation.
Traceable profit is used to assess the performance of the division and is sometimes
called the economic evaluation.
costs that are controllable by the manager of the division, and also
costs that are traceable to the division. These are controllable costs plus other
costs directly attributable to the division over which the manager does not have
control.
PM STUDY NOTES
There may also be an allocation of general overheads, such as a share of head office
costs.
In a divisionalised system, profit centres and investment centres often trade with each
other, buying and selling goods and services. These are internal sales, priced at an
internal selling price (a 'transfer price'). Reporting systems should identify external
sales of the division and internal sales as two elements of the total revenue of the
division.
Responsibility Accounting
With a system of responsibility accounting there are five types of responsibility centre:
cost centre; revenue centre; profit centre; contribution centre; investment centre.
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Transfer Pricing
When a company has a divisionalised structure, some of the divisions might supply
goods or services to other divisions in the same company.
One division sells the goods or services. This -will be referred to as the 'selling
division'.
Another division buys the goods or services. This will be referred to as the 'buying
division'.
For accounting purposes, these internal transfers of goods or services are given a value.
Transfers could be recorded at cost. However, when the selling division is a profit
centre or investment centre, it will expect to make some profit on the sale.
A transfer price is the price at which goods or services are sold by one division within a
company to another division in the same company. Internal sales are referred to as
transfers, so the internal selling and buying price is the transfer price.
When goods are sold or transferred by one division to another, the sale for one division
is matched by a purchase by the other division, and total profit of the company as a
whole is unaffected. It is an internal transaction within the company, and a company
cannot make a profit from internal transfers.
A decision has to be made about what the transfer price should be. A transfer price
maybe:
the cost of the item (to the selling division), or
a price that is higher than the cost to the selling division, which may be cost plus a
profit margin or related to the external market price of the item transferred.
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Transfers at cost
The transfer price may be the cost of making the item (goods) or cost of provision
(services) to the selling division. A transfer at cost maybe at either:
marginal cost (variable cost), or
full cost.
Example
An entity has to divisions, Division A and Division B, Division A makes a component X
which is transferred to Division B. Division B uses component X to make end-product Y.
Details of budgeted annual sales and costs in each division are as follows:
Division A Division
B
Units produced/sold 10,000 10,000
$ $
Sales of final product - 350,000
Costs of production
Variable costs 70,000 30,000
Fixed costs 80,000 90,000
Total costs 150,000 120,000
Required
What would be the budgeted annual profit for each division if the units of component X
are transferred from Division A to Division B:
a) at marginal cost
b) at full cost?
How would the reported profit differ if actual sales prices, actual variables costs per unit
and total fixed costs were as budgeted, but units sold are 10% more than budget?
PM STUDY NOTES
Answer
Transfers at marginal cost: budgeted performance:
By transferring goods at variable cost, the transferring division earns revenue equal to
its variable cost of production. It therefore bears the full cost of its fixed costs, and its
records a loss (or a net cost) equal to its fixed costs.
On the other hand, the buying division (Division B) reports a profit. Because te fixed
costs of Division A are not included in the transfer price, the profit of Division B exceeds
the total profit of the company as a whole.
The same situation occurs if actual output and sales differ from budget. If production
and sales are 11,000 units, the profits of Division B will increase, but Division A still
makes a loss equal to its fixed costs. The total company profits increase by the same
amount as the increase in the profits of Division B.
PM STUDY NOTES
In this example, the full cost per unit produced in Division A is $15, with an absorption
rate for fixed overheads of $S per unit produced and transferred
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Since the transfer price includes the fixed costs of the selling division, Division A is able
to cover all its costs, but it reports neither a profit nor a loss. It covers its costs exactly.
The buying division (Division B) has to pay for the fixed costs of division A in the
transfer price. It still reports a profit, but this profit is now equal to the profit earned by
the company as a whole.
A similar situation occurs if actual output and sales differ from budget. If production
and sales are 11,000 units, the profits of Division B will increase. However, Division A
will make some 'profit', but this is simply the amount by which its fixed overhead costs
are over-absorbed.
These examples should illustrate that if transfers are at cost, the selling division has no
real incentive, because it will earn little or no profit from the transactions, in effect, the
selling division is a cost centre rather than a profit centre or investment centre.
PM STUDY NOTES
One way of arranging for each division to make a profit on transfers is to set the
transfer price at an amount above cost, to provide the selling division with a profit
margin. However the transfer price should not be so high that the buying division
makes a loss on the items it obtains from the selling division.
It would be more realistic to set the transfer price at or close to a market price for the
item transferred, but this is only possible if an external market exists for the item.
PM STUDY NOTES
Divisional autonomy
A system of transfer pricing should allow the divisional managers the freedom to make
their own decisions, without having to be told by head office what they must do. At the
same time, the system should not encourage divisional managers to take decisions that
do harm to the company.
PM STUDY NOTES
The main problems arise when there is an external market for the goods (or services)
that one division transfers to another. When an external market exists for goods or
services that are also transferred internally, the market might be called an external
intermediate market.
The selling division can sell its goods into this market, instead of transferring them
internally.
Similarly the buying division can buy its goods from other suppliers in this market,
instead of buying them internally from another division.
Divisional managers will put the interests of their division before the interests of the
company. When there is an external intermediate market, divisional managers will
decide between internal transfers and using the external market in a way that
maximises the profits of their division.
Market-based and cost-based transfer prices, and transfer prices based on opportunity
cost
As a general rule:
when an external intermediate market does not exist for transferred goods, the
transfer price will be based on cost
when an external intermediate market does exist for transferred goods, the transfer
price will be based on the external market price.
However, the situation is more complicated when:
there is a limit to production capacity in the selling division, or
there is a limit to sales demand in the external intermediate market.
In these circumstances, we need to consider the opportunity costs for the selling
division of transferring goods internally instead of selling them externally.
PM STUDY NOTES
The selling division and the buying division have opportunity costs of transferring
goods internally when there is an intermediate external market.
For the selling division, the opportunity cost of transferring goods internally to
another division might include a loss of contribution and profit from not being able
to sell goods externally in the intermediate market.
For the buying division, the opportunity cost of buying internally from another
division is the price that it would have to pay for purchasing the items from external
suppliers in the intermediate market.
The ideal transfer price is a price at which both the selling division and the buying
division -will want to do what is in the best interests of the company as a whole,
because it is also in the best interests of their divisions.
Ideal transfer prices must therefore take opportunity costs into consideration.
The following rides should help you to identify the ideal transfer price in any situation:
Step 1. Begin by identifying the arrangement for transferring goods internally that
would maximise the profits of the company as a whole, in other words, what
solution is best for the company?
Step 2. Having identified the plan that is in the best interests of the company as a
whole, identify the transfer price, or range of transfer prices, that will make the
manager of the buying division want to work towards this plan. The transfer price
must ensure that, given this transfer price, the profits of the division will be
maximised by doing what is in the best interests of the company as a whole.
Step 3. In the same way, having identified the plan that is in the best interests of the
company as a whole, identify the transfer price, or range of transfer prices, that will
make the manager of the selling division want to work towards the same plan.
Again, the transfer price must ensure that, given the transfer price, the profits of the
division will be maximised by doing what is in the best interests of the company as a
whole.
PM STUDY NOTES
When there is no external intermediate market, the ideal transfer price is either:
cost or
cost plus a contribution margin or profit margin for the selling division.
Transfers at cost do not provide any profit for the selling division; therefore transfer
prices at cost are inappropriate for a divisional structure where the selling division is a
profit centre or an investment centre, with responsibility for making profits.
Transfers at cost are appropriate only if the selling division is treated as a cost centre,
with responsibility for controlling its costs but not for making profit.
If the selling division is a profit centre or an investment centre, and there is 110 external
intermediate market for the transferred item, transfers should therefore be at a
negotiated 'cost plus' price, to provide some profit to the selling division.
Example
A company has two divisions, Division A and Division B. Division A makes a component
X which is transferred to Division B.
Division B uses component X to make end-product Y. Both divisions are profit centres
within the company.
Division A $
Cost of component X
Variable cost 10
Fixed cost 8
Total cost 18
PM STUDY NOTES
Division B
Further processing costs
Variable cost 4
Fixed cost 7
11
The further processing costs of Division B do not include the cost of buying component
X from Division A. One unit of component X goes into the production of one unit of
Product Y. Fixed costs in both divisions will be the same, regardless of the volume of
production and sales.
Required: What is the ideal transfer price, or what is a range of prices that would be
ideal for the transfer price?
Step 2: What will motivate the buying division to buy as many units of component X as
possible?
Division B will want to buy more units of component X provided that the division earns
additional contribution from every unit of the component that it buys.
Division B $
Selling price of Product Y, per unit 40
Variable further processing costs in 4
Division B
36
PM STUDY NOTES
The opportunity cost of not buying units of component X, ignoring the transfer price, is
$36 per unit. Division B should therefore be willing to pay up to $36 per unit for
component X. Any transfer price below $36 but above $4 per unit -will increase its
contribution and profit
Step 3: What will motivate the selling division to make and transfer as many units of
component X as possible?
Division A will want to make and sell more units of component X provided that the
division earns additional contribution from every unit of the component that it sells.
The marginal cost of making and transferring a unit of component X is $10. Division A
should therefore be willing to transfer as many units of component X as it can make (or
Division B has the capacity to buy) if the transfer price is at least $10.
Finding the ideal transfer price: An external intermediate market and no production
limitations
When there is an external intermediate market for the transferred item, a different
situation applies. If there are no production limitations in the selling division, the ideal
transfer price is usually the external market price.
Example
A company has two divisions P and Q. Division P makes a component X which it either
transfers to Division Q or sells in an external market. The costs of making one unit of
component X are:
Component X $
Variable cost 60
Fixed cost 30
Total cost 90
PM STUDY NOTES
Division Q uses one unit of component X to make one unit of product Y, which it sells
for $200 after incurring variable further processing costs of $25 per unit.
Required What is the ideal transfer price or range of transfer prices, if the price of
component X in the external intermediate market is:
$140
$58?
Step 2: What will motivate the buying division (Division Q) to buy as many units of
component X as possible from Division P?
Division Q will be prepared to buy component X from Division P as long as it is not
more expensive than buying in the external market from another supplier. Division Q
will be willing to buy internally if the transfer price is:
a) not more than $140 when the external market price is $140
b) not more than $58 when the external market price is $58.
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If the external market price and transfer price are both $140, Division Q will make an
incremental contribution of $35 ($200 - $140 - $25) from each unit of component X that
it buys and uses to make and sell a unit of product Y.
If the external market price and transfer price are both $58, Division Q will make an
incremental contribution of $117 ($200 - $58 - $25) from each unit of component X that
it buys and uses to make and sell a unit of product Y.
It the transfer price is higher than the external market price, Division Q will choose to
buy component X in the external market, which would not be in the best interests of the
company as a whole.
Step 3: What will motivate the selling division to make and transfer to Division Q as
many units of component X as possible?
Division P should be prepared to transfer as many units of component X as possible to
Division Q provided that its profit is no less than it would be if it sold component X
externally.
Units transferred to division Q are lost sales to the external market; therefore there is
an opportunity cost of transfer that Division P will wish to include in the transfer price.
component X externally. It would also be cheaper for the entity as a whole to buy the
component externally for $58 rather than make internally for a marginal cost of $60.
Division P should consider ending its operations to produce component X.
Finding the ideal transfer price: An external intermediate market and production
limitations
When there is an external intermediate market for the transferred item, and the selling
division has a limitation on the number of units it can produce, the ideal transfer price
should allow for the opportunity cost of the selling division. Every unit transferred
means one less external sale.
Example
A company consists of two divisions, Division A and Division B. Division A is working at
full capacity on its machines, and can make either Product Y or Product Z, up to its
capacity limitation. Both of these products have an external market.
The costs and selling prices of Product Y and Product Z are:
Product Y Product Z
$ $
Selling price 15 17
The variable cost of sale is incurred on external sales of the division's products. This
selling cost is not incurred for internal sales/transfers from Division A to Division B.
To make one unit of Product Y takes exactly the same machine time as one unit of
Product Z.
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Step 2: What would motivate the buying division to buy as many units of Product Y as
possible from Division A?
Division B will be prepared to buy Product Y from Division A as long as it is not more
expensive than buying in the external market from another supplier.
Division B will be willing to buy Product Y internally if the transfer price is $15 or less.
Step 3: What would motivate the selling division to make and transfer as many units of
Product Y as possible?
The selling division will only be willing to make Product Y instead of Product Z if it
earns at least as much contribution as it would front making Z and selling it externally,
(in this situation, the division can make as many units of Z as it can make of Y, and
Product Z earns a higher contribution).
Product Y $
Variable cost of making Product Y (the variable cost of sale
is not relevant for internal transfers) 10
Opportunity cost of lost external sale of Product Z (17 - 7 - 8
2)
Total cost = minimum transfer price 18
PM STUDY NOTES
Transfer prices might be decided by head office and imposed on each division.
Alternatively, the managers of each division might have the autonomy to negotiate
transfer prices with each other.
In practice, transfer prices may be agreed and expressed in one of the following ways.
A transfer price may be the external selling/buying price for the item in an external
intermediate market. This price is only possible when an external market exists.
If the selling division would incur some extra costs if it sold its output externally rather
than transferred it internally to another division, the transfer price may be reduced
below market price, to allow for the variable costs that would be saved by the selling
division. This is very common as the selling division may save costs of packaging and
warranties or guarantees. Distribution costs may also be cheaper and there will be no
need for advertising.
Market price is the ideal transfer price when there is an external market. A transfer
price below this amount will make the manager of the selling division want to sell
externally, and a price above this amount will make the manager of the buying division
want to buy externally.
PM STUDY NOTES
Transferring at market price also encourages efficiency in the supplying division, which
must compete with the external competition.
It may also be difficult to identify exactly what the external market price is. Products
from rival companies may be different in quality, availability may not be so certain and
there may be different levels of service back-up.
A transfer price may be the full cost of production plus a margin for profit for the selling
division.
Standard full costs should be used, not actual full costs. This will prevent the selling
division from increasing its profit by incurring higher costs per unit.
Full cost plus might be suitable when there is no external intermediate market.
However, there are disadvantages in using full cost rather than variable cost to decide a
transfer price.
The fixed costs of the selling division become variable costs in the transfer price of
the buying division. This might lead to decisions by the buying division manager
that are against the best interests of the company as a whole. This is because a
higher variable cost may lead to the buying division choosing to set price at a higher
level which would lose sales volume.
PM STUDY NOTES
A transfer price might be expressed as the variable cost of production plus a margin for
profit for the selling division.
Standard variable costs should be used, not actual variable costs. This will prevent the
selling division from increasing its profit by incurring higher variable costs per unit.
Variable cost plus might be suitable when there is no external intermediate market. It is
probably more suitable in these circumstances than full cost plus, because variable cost
is a better measure of opportunity cost. However, as stated earlier, when transfers are
at cot, the transferring division should be a cost centre, and not a profit centre.
With two-part transfer prices, the selling division charges the buying division for units
transferred in two ways:
a standard variable cost per unit transferred, plus
a fixed charge in each period.
The fixed charge is a lump stun charge at the end of each period. The fixed charge would
represent a share of the contribution front selling the end product, which the
selling/transferring division has helped to earn. Alternatively, the charge could be seen
as a charge to the buying division for a share of the fixed costs of the selling division in
the period.
PM STUDY NOTES
The fixed charge could be set at an amount that provides a 'fair' profit for each division,
although it is an arbitrary amount.
Dual pricing
In some situations, two divisions may not be able to agree a transfer price, because
there is no transfer price at which the selling division will want to transfer internally or
the buying division will want to buy internally. However, the profits of the entity as a
whole would be increased if transfers did occur.
These situations are rare. However, when they occur, head office might find a solution
to the problem by agreeing to dual transfer prices.
the selling division sells at one transfer price, and
the buying division buys at a lower transfer price.
There are two different transfer prices. The transfer price for the selling division should
be high enough to motivate the divisional manager to transfer more units to the buying
division. Similarly, the transfer price for the buying division should be low enough to
motivate the divisional manager to buy more units from the selling division.
In the accounts of the company, the transferred goods are:
sold by the selling division to head office and
bought by the buying division from head office.
The loss from the dual pricing is a cost for head office, and treated as a head office
overhead expense.
However, dual pricing can be complicated and confusing. It also requires the
intervention of head office and therefore detracts from divisional autonomy.
A negotiated transfer price is a price that is negotiated between the managers of the
profit centres.
PM STUDY NOTES
The divisional managers are given the autonomy to agree on transfer prices.
Negotiation might be a method of identifying the ideal transfer price in situations where
an external intermediate market does not exist.
An advantage of negotiation is that if the negotiations are honest and fair, the divisions
should be willing to trade with each other on the basis of the transfer price they have
agreed.
These profit measures can be used with variance analysis, ratio analysis, return on
investment, residual income and non-financial performance measurements to evaluate
performance.
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Profit is not a suitable measure of performance for an investment centre. It does not
make the manager accountable for his or her use of the net assets employed (the
investment in the investment centre).
Measuring ROI
Performance measurement systems could use ROI to evaluate the performance of both
the manager and the division. ROI is the profit of the division as a percentage of capital
employed.
Profit
ROI =
Capital employed (size of investment)
Profit. This should be the annual accounting profit of the division, without any charge
for interest on capital employed. This means that the profit is after deduction of any
depreciation charges on non-current assets.
Capital employed/investment.
This should be the stun of the non-current assets used by the division plus the working
capital that it uses. Working capital = current assets minus current liabilities, which for
a division will normally consist of inventory plus trade receivables minus trade
payables.
PM STUDY NOTES
PM STUDY NOTES
Imputed interest (notional interest) and the cost of capital: The interest charge is
calculated by applying a cost of capital to the division's net investment (net assets).
Imputed interest (notional interest) is the division's capital employed, multiplied by:
One reason for using residual income instead of ROI to measure a division's financial
performance is that residual income has a monetary value, whereas ROI is a percentage
value.
PM STUDY NOTES
Example
At the end of 20X1, an investment centre has net assets of $1m and annual operating
profits of $190,000. However,the bookkeeper forgot to account for the following:
A machine with a net book value of $40,000 was sold at the start of the year for $50,000
and replaced with a machine costing $250,000. Both the purchase and sale are cash
transactions. No depreciation is charged in the year of purchase or disposal. The
investment centre calculates return on investment (ROI) based on closing net assets.
Solution:
The correct option is B
Revised annual profit = $190,000 + $10,000 profit on the sale of the asset = $200,000
Revised net assets = $1,000,000 – $40,000 NBV + $50,000 cash – $250,000 cash +
$250,000 asset = $1,010,000
ROI = ($200,000/$1,010,000) x 100 = 19·8%
Example
A division is considering investing in capital equipment costing $2·7m. The useful
economic life of the equipment is expected to be 50 years, with no resale value at the
end of the period. The forecast return on the initial investment is 15% per annum
before depreciation. The division’s cost of capital is 7%.
What is the expected annual residual income of the initial investment?
A $0
B ($270,000)
C $162,000
D $216,000
PM STUDY NOTES
Solution:
The correct option is C
Divisional profit before depreciation = $2·7m x 15% = $405,000 per annum.
Less depreciation = $2·7m x 1/50 = $54,000 per annum. Divisional profit after
depreciation = $351,000
Imputed interest = $2·7m x 7% = $189,000
Residual income = $162,000.
PM STUDY NOTES
The public sector refers to the sector of the economy that is owned or controlled by
the government in the interests of the general public.
Not-for-profit organisations are entities that are not government-owned or in the
public sector, but which are not in existence to make a profit. They include
charitable organisations and professional bodies.
A common feature of public sector organisations and not-for-profit organisations is
that their main objective is not financial.
A not-for-profit organisation will nevertheless have some financial objectives:
State-owned organisations must operate within their spending budget.
Charitable organisations may have an objective of keeping running costs within a
certain limit, and of raising as much funding as possible for their charity work.
Although the main objective of not-for-profit and public sector organisations is not
financial, they need good management, and their performance should be measured and
monitored as the directors or senior managers of public sector bodies are accountable
to the public. In practice, this usually means accountability to the government, which in
turn should be accountable to the public.
The leaders of not-for-profit organisations outside the public sector should also be
accountable to the people who provide the finance to keep them in existence.
Client satisfaction maximisation (the police generating the support of the public)
Performance measurement should be related to achieving targets that will help the
organisation to achieve its objectives, whatever these may be.
The selection of appropriate targets will vary according to the nature and purpose of the
organisation. The broad principle, however, is that any not-for-profit organisation
should have:
To identify suitable performance targets for Not for Profit organisations and Public
sector organisations, focus on:
However, there are several reasons why the problems with performance measurement
in the public sector are greater than those in commercial business organisations.
PM STUDY NOTES
Economy means spending within limits, and avoiding wasteful spending. It also
means achieving the same purpose at a lower expense.
Efficiency means getting more output from available resources. Applied to
employees, efficiency is often called 'productivity'.
Effectiveness refers to success in achieving end results or success in achieving
objectives. Whereas efficiency is concerned with getting more outputs from
PM STUDY NOTES
available resources, effectiveness is concerned with achieving outputs that meet the
required aims and objectives.
Value for money audits may be carried out to establish how much value is being
achieved within a particular department and whether there have been improvements to
value for money.
Value for money is an objective that can be applied to any organisation whose main
objective is non-financial but which has restrictions on the amount of finance
available for spending. It could therefore be appropriate for all organisations within
the public sector.
The objective of economy focuses on the need to avoid wasteful expenditure on
items, and to keep spending within limits. It also helps to ensure that the limited
finance available is spent sensibly. Targets could be set for the prices paid for
various items from external suppliers. Audits by the government's auditors into
departmental spending may be used to identify:
any significant failures to control prices, and
unnecessary expense.
Efficiency relates the quantity of resources to the quantity of output. This can be
measured in a variety of ways
PM STUDY NOTES
External considerations are factors that arise or exist outside an organisation, and
within its external environment, that could have an impact on the objectives that the
organisation should try to achieve and the targets that it sets for those objectives, or its
actual performance.
The external factors that affect an organisation vary according to the type of
organisation and the environment in which it operates. Broad categories of external
factors include:
Political and legal developments: new laws may affect what a company is
allowed to do or is not permitted to do, and this change could affect its
performance
Economic conditions and economic developments
Changes in public attitudes and behaviour
Technological changes
Competition in the market.
Stakeholders:
PM STUDY NOTES
company to take risks that could threaten its ability to make the interest
payments and repay the lending at maturity.
Major suppliers to a company may depend on the company for a large
proportion of their profits. They will expect honest and fair dealing from the
company, and they will expect to be paid on time.
Customers of a company expect to receive value for the money they pay to buy
the goods or services that the company provides. If they think they are receiving
poor value, they are likely to switch to buying the products of competitors, or to
finding an alternative product.
Employees are stakeholders in a company because the company provides them
with a job and possibly also career opportunities. They also have an interest in
working conditions.
The government and the general public. Some large companies can have a major
influence on the national economy. They provide work for large numbers of
people, and they produce the goods or services that many people buy and rely
on. In addition, companies are major users of natural resources, and are a cause
of much pollution in the environment. Public expectations of what particular
companies should or should not be doing may become quite strong, and in some
cases a company may come under severe criticism from protest groups.
For each company, some stakeholders are likely to be more influential than others.
However, when there are several influential stakeholder groups the company may
need to take their conflicting interests into consideration, and set their objectives
and performance targets accordingly.
Market conditions
Market conditions are any factors that influence the state of the market or markets in
which a company operates. These include:
Companies will usually hope to achieve growth in sales and profits, and economic
conditions may be either favourable or adverse.
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Other financial conditions may affect a company's performance, such as changes in rates
of taxation, interest rates or foreign exchange rates.
The targets that a company sets, and the performance that it achieves, are also affected
the by nature of competition in the market. When the size of a market is fixed, and
competition is strong, the rival firms will compete for market share.
Example
A government is trying to assess schools by using a range of financial and non-financial
factors. One of the chosen methods is the percentage of students passing five exams or
more.
Which of the three Es in the value for money framework is being measured here?
A Economy
B Efficiency
C Effectiveness
D Expertise
Solution:
The correct option is C
Exam success will be a given objective of a school, so it is a measure of effectiveness
PM STUDY NOTES