PM Lecture Support Notes 2

2022
ACCA
PERFORMANCE
MANAGEMENT (PM)
Lecture Support Notes

PRINCE FRANCIS
Contents
Information, Technologies and System for Organisational Performance-----------1
Costing Basics-------------------------------------------------------------------------------------6
Activity Based Costing-------------------------------------------------------------------------- 10
Target Costing-------------------------------------------------------------------------------------15
Lifecycle Costing----------------------------------------------------------------------------------18
Throughput Accounting------------------------------------------------------------------------ 21
Environmental Accounting---------------------------------------------------------------------27
Relevant Costing----------------------------------------------------------------------------------30
Cost Volume Profit (CVP) Analysis------------------------------------------------------------33
Limiting Factors-----------------------------------------------------------------------------------39
Pricing Decisions--------------------------------------------------------------------------------- 45
Make-or-buy and Other Short-term Decisions--------------------------------------------52
Dealing with Risk and Uncertainty in Decision-making---------------------------------60
Budgetary Systems and Types of Budget---------------------------------------------------67
Quantitative Analysis in Budgeting----------------------------------------------------------73
Standard Costing---------------------------------------------------------------------------------78
Variance Analysis---------------------------------------------------------------------------------80
Material Mix and Yield Variances------------------------------------------------------------ 88
Sales Mix and Quantity Variances------------------------------------------------------------92
Planning and Operational Variances---------------------------------------------------------94
Performance Analysis in Private Sector Organisations----------------------------------98
Divisional Performance and Transfer Pricing----------------------------------------------106

Performance Analysis in Private Non-profit Organisation------------------------------111
Performance Management Information, Technologies and System for Organisational Performance 1
Information, Technologies and System for Organisational

Performance
Information Systems
An information system is a combination of hardware, software and communications capability, where
information is collected, processed and stored.
The Role of Information Systems

− Support operations through the processing and storing of transactions.
− Support managerial activities such as a decision making, planning, performance measurement,
and control.
Requirements of Information for Organisations

Use of Information
− Record transaction
− Make decisions
− Planning purpose
− Performance management
− Control
Communication of Information
1. Networks
− Intranets
A cluster of computers can be networked together to form an organisation-wide network.
This is known as an intranet and is used to share information internally. Intranets are
effectively private networks.
− Extranets
An extranet is an intranet that is accessible to authorised outsiders, using a valid username
and password. The username will have access rights attached, determining which parts of
the extranet can be viewed.
− Internet
The internet is a global network connecting millions of computers.
Security of Confidential Information

A number of procedures can be used to ensure the security of highly confidential information.
− Logical access systems: performs three operations when access is requested;
(1) Identification of user
(2) Authentication of user identity
(3) Check on user identity
− Passwords
− Database controls
− Firewall
(1) A combination of hardware and software located between the company’s intranet (private
network) and the public network.
(2) A set of control procedures will be established to allow public access to some parts of the
organisation’s computer system.
+91 79077 65651 Prince Francis

− Personnel security planning

− Anti-virus and anti-spyware software
Cost Example
Direct data capture – Use of bar coding and scanners (e.g., in retailing and
manufacturing)
– Newspaper subscriptions
Processing – Payroll department time spent processing and
analysing personnel costs
Indirect – Information collected but not needed
– Wasted time finding useful information
– Duplication of information
Types of Information Systems

1. Transaction Processing Systems
Transaction processing systems (TPS) collect, store, modify and retrieve the transactions of an
organisation.
Features
− Controlled processing
− Inflexibility
− Rapid response
− Rapid response
Properties of a TPS
− The components of a TPS include hardware, software and people.
− People in the TPS can be divided into three categories – users, participants and people
from the environment.
− The users are employees of the company who own the TPS. The users will not alter data
themselves, but will use the TPS to provide inputs for other information systems such as
inventory control.
− Participants are direct users of the system. They are the people who enter the data.
Participants include data entry operators, customer service staff and people working at
checkouts.
− People from the environment are people who sometimes require the services of a TPS as
they enter transaction and validate data, such as customers withdrawing money from an
ATM.
Types of TPS
− Batch Transaction Processing (BTP)
Collects transaction data as a group and processes it later, after a time delay, as batches
of identical data.
− Real Time Transaction Processing (RTTP)
It is the immediate processing of data.
2. Management Information Systems (MIS)

Convert data from mainly internal sources into information (e.g., summary reports, exception
reports).
This information enables managers to make timely and effective decision for planning, directing
and controlling the activities for which they are responsible.

3. Executive Information Systems (EIS)

Executive information systems (EIS) draw data from the MIS and allow communication with
external sources of information. EIS are designed to facilitate senior managers' access to
information quickly and effectively.
4. Enterprise Resource Planning Systems (ERP systems)

Enterprise resource planning systems (ERP systems) are modular software packages designed
to integrate the key processes in an organisation so that a single system can serve the
information needs of all functional areas.
5. Decision Support Systems (DSS)

Computer based systems which enable managers to confront ill-structured problems by direct
interaction with data and problem-solving programs.
6. Expert systems
Can be used at all levels of management.
Uses a knowledge base that consists of facts, concepts and the relationships between them and
uses pattern-matching techniques to solve problems.
Operations
Controls inventory throughout the supply
chain from procurement to distribution
Finance Accounting
ERP Software
Reports customer’s Records sales and
Manages information flow
credit rating and payments and tracks
among all database applications
current selling business performance
Marketing Human Resource

Co-ordinates sales activities and Recruits, trains, evaluates and
handles customer relationship compensates employees
7. Customer Relationship Management Systems (CRM systems)

Customer relationship management systems (CRM systems) are software applications which
specialise in providing information concerning an organisation's products, services and
customers.
Most CRM systems are based on a database which stores data about customers such as their
order history and personal information such as address, age and any marketing feedback they
have provided.
CRM systems are often used by customer-facing staff who handle customer enquiries, orders or
complaints.
8. Closed and Open Systems

An open system interacts with its environment.

A closed system has no contact with its environment. Information is not received from or
provided to the environment.
Benefits of Information System

− Enhanced efficiency and capacity
− Better quality of information
− Better access to information
− Improved sharing of information
− Improved communication
− Better decision making and customer service
Sources of Management Information

1. Internal Sources
Internal sources of information may be taken from a variety of areas such as the sales ledger
(e.g., volume of sales), payroll system (e.g., number of employees) or the fixed asset system
(e.g., depreciation method and rate).
2. External Sources
In addition to internal information sources, there is much information to be obtained from
external sources such as suppliers (e.g., product prices), customers (e.g., price sensitivity) and
the government inflation rate.
3. Big Data
Big Data refers to the mass of data that society creates each year, extending far beyond the
traditional financial and enterprise data created by companies. Sources of Big Data include
social networking sites, internet search engines, and mobile devices. These extremely large
collections of data that may be analysed to reveal patterns, trends and associations.
The 3 Vs
Big Data is characterised by the 3 Vs:
− Volume
− Variety
− Velocity
Processing Big Data
The processing of Big Data is known as Big Data analytics. For example, Google Analytics tracks
many features of website traffic.
The Uses of Big Data
Big Data has implications across all business departments. It involves the collection and analysis
of large amounts of data to find trends, understand customer needs and help organisations to
focus resources more effectively and to make better decisions.
Risks Associated with Big Data
1) Security and data protection – To store and protect vast amounts of personal
information is difficult and comes with great risk.
2) Privacy – Have customers consented to data about them being captured and stored?
3) Information – There may be technical difficulties involved when integrating new Big
Data systems with existing technology. Also, valuable time could be wasted collecting
data that has no value to the organisation. Just because information can be collected
does not mean it has to be collected.

Multiple Choice Questions

1. Which THREE of the following are the three 'V's associated with Big Data?
A. Volume
B. Visibility
C. Verification
D. Variability
E. Velocity
F. Variety
2. The following statements have been made about data and information.
1. Automated systems for data capture are generally more reliable than data capture
requiring input by individuals.
2. As a general rule, secondary information is more expensive to collect than primary data.
Which of the above statements is/are true?
A. 1 only
B. 2 only
C. Neither 1 nor 2
D. Both 1 and 2
3. The following statements have been made about management information and management
information system.
1. Management information is often produced from transaction processing systems.
2. The data used in management information systems comes mainly from sources within the
organisation and its operations.
A. 1 only
A. 2 only
B. Neither 1 nor 2
C. Both 1 and 2

Performance Management Costing Basics 6
Costing Basics
Costing
Costing is the process of determining the costs of products, services or activities.
Cost Classification
Cost classification
By nature By behaviour By traceability

Material Variable cost Direct cost
Labour Fixed cost Indirect cost
Expenses Semi variable cost
Step cost
1. By Nature
− Material: Costs of any materials we use in the production of goods.
− Labour: Labour costs consists of the salary and wages paid employees in the pursuit of
manufacturing products.
− Expense: All other expenses associated with making and selling the goods or services.
2. By Behaviour
− Variable cost: Costs which change in direct proportion to the level of production. Example
– Cost of material.
− Fixed cost: Those costs which do not change with the level of activity. Example – Rent.
− Semi variable: Mixture of fixed and variable costs. Costs are fixed for a set level of
production and become variable after this production level exceeded. Example –
Telephone charges.
− Step cost: Constant at a certain activity level but increase or decrease when an activity
threshold is met crossed. Example – Supervision cost.
3. By Traceability
− Direct cost: A cost that can be directly identifiable with a specific cost unit is called direct
cost. Example – Materials used in production, worker paid for making units.
− Indirect cost: A cost that cannot be directly identifiable with a specific cost unit is called
indirect cost. Example: Rent, salary.
Some Basic Terms

− Prime Cost: Sum of all direct costs is called prime cost.
Prime Cost = Direct Material + Direct Labour + Direct Expense
− Conversion Cost: Manufacturing or production costs necessary to convert raw materials into
products.
Conversion Cost = Direct Labour + Production Overheads

Traditional Costing Techniques

Marginal Costing
Marginal costing is a costing technique wherein the marginal cost, i.e., variable cost is charged to units.
It is the accounting system in which variable production costs are charged to cost units and fixed costs
of the period are written off in full against the aggregate contribution.
Product Cost under Marginal Costing

The variable production cost per unit of an item usually consists of the following:
− Direct material
− Direct labour
− Direct expense
− Variable production overheads
Contribution
Contribution is the difference between sales and variable cost. Contribution is more useful for
decision-making.
Contribution = Total Sales Revenue – Total Variable Cost
Arguments in Favour of Absorption Costing

− Fixed production costs are incurred in order to make output, it is therefore fair to charge all
outputs with a share of these costs.
− Closing stock values, by including a share of fixed production overhead, will be valued on
the principle of IAS 2, as required by financial accounting purpose.
Arguments in Favour of Marginal Costing

− It is simple to operate as we do not have to determine fixed overhead absorption rate.
− Fixed costs are irrelevant cost for decision-making, thus highlighting contribution in
profit statement provides better information for decision making purposes.
− Profit will not be distorted through fluctuation in inventory level and production level
as the contribution calculated is based on sales volume.
Example 1
Details of a product are as follows:
Variable cost per unit $20 per unit
Selling price $60
Total fixed cost $25,000
Total sales units 12,000 units
Required:
Calculate the total profit.

Absorption Costing
The aim of traditional absorption costing is to determine the full production cost per unit. This is a
method of calculating the cost of a product or enterprise by taking into account indirect expenses
(overheads) as well as direct costs.
In absorption costing product cost Includes fixed and variable elements.
Full Cost per unit = Variable cost per unit + Fixed Cost per unit
Overheads are absorbed into products using an appropriate absorption rate based on budgeted costs
and budgeted cost and budgeted activity levels.
𝐁𝐮𝐝𝐠𝐞𝐭𝐞𝐝 𝐭𝐨𝐭𝐚𝐥 𝐨𝐯𝐞𝐫𝐡𝐞𝐚𝐝
Overhead Absorption Rate (OAR) =
𝐁𝐮𝐝𝐠𝐞𝐭𝐞𝐝 𝐭𝐨𝐭𝐚𝐥 𝐚𝐜𝐭𝐢𝐯𝐢𝐭𝐲
Possible Bases of Absorption (Activity Level)

− A rate per direct labour hour
− A rate per machine hour
− A rate per unit
− A percentage of direct materials cost
− A percentage of direct labour cost
− A percentage of direct prime cost
Example 2
Direct material cost per unit $6
Direct labour cost per unit $4
Total production overhead $2,000
Total units 1,000 units
Required:
Calculate full production cost per unit.
Example 3
Material usage per unit 5 Kg
Material price per kg $10 per Kg
Labour hours per unit 3 Hours
Labour cost per hour $2 per hour
Estimated overheads $6,000
Estimated total labour hours 3,000 hours
Required:

Example 4
A company makes two products, the A and B.
A B
Labour hours per unit 2 5
Total production units 10,000 6,000
Total overhead $100,000
Total direct labour hours 50,000
Required:
What is the overhead cost per unit for A and B respectively if overheads are absorbed on
the basis of labour hours?
Example 5
Company produces two products, A and B.
A B
Material usage per unit ($) 5 10
Material price per kg ($) 2 2
Labour hours per unit 3 6
Labour cost per hour ($) 4 4
Budgeted production units 1,000 500
Estimated total overhead ($) 12,000
Required:

1. Budgeted overheads $690,480
Budgeted machine hours 15,344
Actual machine hours 14,128
Actual overheads $679,550
Based on the data above, what is the machine hour absorption rate (to the nearest $)?
A. 44 per machine hour
B. 45 per machine hour
C. 48 per machine hour
D. 49 per machine hour
2. Under absorption costing, the total cost of a product will include:
A. Direct costs only
B. Variable costs only
C. All direct and indirect costs excluding a share of fixed overhead
D. All direct and indirect costs

Performance Management Activity Based Costing 10
taditionally it was labour intensive an the indirect cost was relative lower thus a rough estmeiate of these overhead was enough ,but in the modern era it is now machine
intensive thus the indirect costs are relatively higher thus the use of accurate calculation introduced the activity based costing
Activity Based Costing (ABC)
Activity based costing is an extension of absorption costing specifically considering what causes each
type of overhead category to occur, i.e., what the ‘cost drivers’ are. Each type of overhead is
absorbed using a different basis depending on the cost driver.
Absorption Costing
Traditional absorption costing uses a single basis for absorbing all overheads into cost units.
Traditional absorption costing systems:
− under-allocates overhead costs to low-volume products; over-allocates overheads
to higher-volume products
− under-allocates overhead costs to smaller products; over-allocates overheads
to larger products.
Example 1
Products A B
Production units 1,000 units 2,000 units
Total ordering cost $9,000
Number of orders 700 200
Required:
Calculate the total cost of both products using absorption costing and activity based costing (ABC)
Stages in Developing Activity Based Costing System

1. Group production overheads into activities (cost pool).
2. Identify factor causing change in the cost of these activities (cost driver).
3. Calculate absorption rate per cost driver for each activity (OAR = Cost pool / Cost driver).
4. Charge overhead cost to products on the basis of usage of these activities.
5. Calculate the full production cost.
Cost Driver
− Any factor, reason or base which generates overheads cost.
− Reason which increases or decreases overheads.
Cost Pool
− The costs that accumulate for each activity.
Overhead costs and possible cost drivers – Examples

Cost pool Possible cost driver
Ordering costs Number of orders
Materials handling costs Number of production units runs
Machine set-up costs Number of machine set-ups
Machine operating costs Number of machine hours
Production scheduling costs Number of production runs
Despatching costs Number of orders despatched
no.of machine set up cost =no.of production runs

Note:
− Costs that relate to production volume should be traced to products using production
volume-related cost drivers (direct labour hours or machine hours).
− For costs that do not seem to relate to production volume, a different cost driver is
identified.
Example 2
TR Co manufactures four products, W, X, Y and Z. Output and cost data for the period just ended are
as follows:
Product Total units Material cost Labour hours Labour cost Production
per unit per unit per unit runs in the
period
W 10 20 1 5 2
X 10 80 3 15 2
Y 100 20 1 5 5
Z 100 80 3 15 5
Overhead costs $
Set-up costs 10,920
Materials handling costs 7,700
Required:
Prepare unit costs for each product using:
a) Conventional absorption costing (overheads are absorbed using direct labour hours)
b) Activity based costing
Advantages of Activity Based Costing

− Accurate cost calculation (fair distribution of overheads).
− Accurate selling price. overhead cost can be controlled by managing cost drivers
− ABC recognises the complexity of modern manufacturing by the use of multiple cost drivers.
− ABC can be applied to both production and non-production overheads.
− Better cost control. an insight to control which cost driver is to be controlled .
- can be used in product costing and service costing -it can be used to find relative cost in complex environment
Disadvantages of Activity Based Costing

− Time consuming and expensive.
− Selection of cost driver may not be easy. there is a chance of multiple cost drivers
− ABC does not eliminate the need for cost apportionment. Some arbitrary apportionment
not a fair apporttionment
may still exist. in some cases fair cost driver may not exist thus an unfair apportionment in takenplace.
− The cost of implementing and maintaining an ABC system can exceed the benefits.
(Implementation of ABC is likely to be cost effective when overheads costs are a high
proportion of total costs.)
− ABC is a form of absorption costing; an ABC cost is not a variable cost and therefore not a
relevant cost for decision. -marginal costing
− ABC will be of limited benefit if the overhead costs are primarily volume related or if the
overhead is a small proportion of the overall cost.
that is overhead costing is suitable when the overhead is a huge amount


1. Which of the following statements about activity based costing is true?
A. The cost driver for quality inspection is likely to be batch size.
B. The cost driver for materials handling and despatch costs is likely to be the number
of orders handled.
C. In the short run, all the overhead costs for an activity vary with the amount of the
cost driver for the activity.
D. A cost driver is an activity based cost.
2. The following statements have been made about traditional absorption costing and activity
based costing (ABC):
(1) Traditional absorption costing may be used to set prices for products, but activity
based costing cannot.
(2) Traditional absorption costing tends to allocate too many overhead costs to low-
volume products and not enough overheads to high-volume products.
(3) Implementing ABC is expensive and time consuming.

A. 1 only
B. 2 only
C. 3 only
D. 1 and 2
3. ABC is felt to give a more useful product cost than classic absorption costing (with overheads
absorbed on labour hours) if which of the following TWO apply?
A. Labour costs are relatively minor proportion of total costs.
B. Overheads vary with many different measures of activity.
C. Overheads are difficult to predict.
D. Cost drivers are difficult to identify.
4. Which TWO of the following statements about activity based costing (ABC) are true?
A. ABC recognises the complexity of modern manufacturing by the use of multiple cost
drivers.
B. ABC establishes separate cost pools for support activities.
C. ABC reapportions support activity costs.
D. ABC is an appropriate costing system when overheads vary with time spent on
production.

Constructed Response Questions

Brick by Brick (BBB) (Specimen December 2014)

Gadget Co (December 2010)

Performance Management Target Costing 15
Target Costing
When a new product is launched, traditionally profit was added to cost that is cost plus pricing
considering internal factors to get to the selling price. But target costing involves setting a target cost
by subtracting a desired profit margin from a target selling price.
Aim of Target Costing

When a product is first planned, its estimated cost will often be higher than its target cost.
The aim of target costing is then to find ways of closing this target cost gap, and producing and
selling the product at the target cost.
Cost reduction must be considered at the design stage of a product’s life cycle, rather than during
the production process.
Process of Target Costing

1. Determine a product and adequate sales volume.
2. Decide a target selling price.
3. Estimate the required profit.
4. Calculate target cost.
Target cost = Target selling price – Target profit
5. Prepare an estimated cost for the product, based on the initial design specification and
current cost levels.
6. Calculate target cost gap.
Target cost gap = Estimated cost – Target cost
7. Make efforts to close the gap.
Closing a Target Cost Gap

Possible ways to close a cost gap:
− Value analysis can be used to determine which features are adding value to the product
and which will not affect it at all.
− Reducing the number of components.
− Using cheap labour/staff.
− Using standard components wherever possible.
− Acquiring new more efficient technology.
− Training staff.
− Using different materials.
A risk with target costing is that cost reductions may affect the perceived value of the product.
Example 1
A car manufacturer wants to calculate a target cost for a new car, the price of which will be set at
$17,950. The company requires an 8% profit margin on sales.
Required:
Find the target cost.

Target Costing in Service Industries

The target costing approach is a sensible basis for estimating/driving down costs regardless of the
type of business. However, due to the nature of service industries this process is more difficult in
these businesses.
Characteristics of Service Industries

Service industries have the following characteristics which make cost and performance
measurement more difficult:
1. Simultaneity
2. Variability/Heterogeneity
3. Intangibility
4. Perishability
5. No transfer of ownership.
Note:
From the above ‘Intangibility and Variability/Heterogeneity’ make it difficult to use target costing in
service industry.
Advantages of Target Costing

− Target costing encourages the management to continually improve processes and innovate
to gain a competitive cost advantage.
− New market opportunities can be converted into real savings to achieve the best value for
money rather than to simply realize the lowest cost.
− The product is created from the expectation of the customer (i.e., cost approach is more
customer-centric) and, hence, the cost is also based on similar lines. Thus, the customer
feels more value is delivered.
− The company’s approach to designing and manufacturing products becomes market-driven.
− Helps in creating economies of scale.
Disadvantages of Target Costing

− The development process can be very lengthy as the product has to go through several
alterations to meet the target cost.
− Cost reduction process may affect employee morale.

1. Which of the following statements about target costing is NOT true?
A. Target costing is better suited to assembly orientated industries than service
industries that have a large fixed cost base.
B. Costs may be reduced in target costing by removing product features that do not
add value.
C. A target cost gap is the difference between the target cost for a product and its
projected cost.
D. Products should be discontinued if there is a target cost gap.

2. VC Co is a firm of opticians. It provides a range of services to the public, such as eye tests and
contact lens consultations, and has a separate dispensary selling glasses and contact lenses.
Patients book appointments with an optician in advance.
A standard appointment is 30 minutes long, during which an optician will assess the
patient's specific requirements and provide them with the eye care services they need.
After the appointment, patients are offered the chance to buy contact lenses or glasses from
the dispensary.
Which of the following describes a characteristic of the services provided by an optician at
VC Co during a standard appointment?
A. Tangible
B. Homogeneous
C. Non-perishable
D. Simultaneous
3. Are the following statements about target costing true or false?
A risk with target costing is that cost reductions may affect the TRUE FALSE
perceived value of the product.
An effective way of reducing the projected cost of a new product is TRUE FALSE
to simplify the design.
The value of target costing depends on having reliable estimates of TRUE FALSE
sales demand.
Target costing may be applied to services that are provided free of TRUE FALSE
charge to customers, such as costs of call centre handling.
4. The selling price of Product X is set at $550 for each unit and sales for the coming year are
expected to be 800 units.
A return of 30% on the investment of $500,000 in Product X will be required in the coming
year.
What is the target cost for each unit of Product X (to two decimal places)?

Performance Management Lifecycle Costing 18
Lifecycle Costing
Traditionally the costs and revenues of a product are assessed on a financial year or period by period
basis.
A product's life cycle costs are incurred from its design stage through development to market
launch, production and sales, and finally to its eventual decline and withdrawal from the market.
Aim of Lifecycle Costing

Lifecycle costing aims to cost a product, service, customer or project over its entire lifecycle with the
aim of maximising the return over the total life while minimising costs.
Lifecycle Cost – Examples

− Research and development costs
− Training costs
− Production costs
− Distribution costs
− Marketing costs
− Inventory costs
− Retirement and disposal costs
Calculating Lifecycle Cost per unit

Total lifecycle costs
Average Lifecycle Cost per unit =
Total lifecycle units

Example 1
Year 1 Year 2 Year 3 Year 4
Units manufactured and sold 2,000 15,000 20,000 5,000
$ $ $ $
R&D costs 1,900,000 100,000 - -
Marketing costs 100,000 75,000 50,000 10,000
Production cost per unit 500 450 400 450
Customer service cost per unit 50 40 40 40
Disposal of specialist equipment 300,000
Required:
Calculate lifecycle cost per unit.
Maximising Return Over the Product’s Lifecycle

− Careful design of product (can save design and manufacturing costs).
− Take the product to market as soon as possible (minimise the time to market).
− Minimize breakeven time.
− Maximize the length of the life span.
− Minor changes in technology.
Advantages of Lifecycle Costing

− It helps management to assess profitability over the full life of a product, which in turn helps
the management to decide whether to develop the product, or to continue making the
product.
− It encourages longer-term thinking and forward planning.
− The lifecycle concept results in earlier actions to generate more revenue or to lower costs.
− Life cycle costing encourages management to find a suitable balance between investment
costs and operating expenses.
Disadvantages of Lifecycle Costing

− It is a time-consuming process.
− Collecting data for analysis is a tedious job.

1. In which of the following ways might financial returns be improved over the life cycle of a
product?
(1) Maximising the breakeven time
(2) Minimising the time to market
(3) Minimising the length of the life cycle
A. 1 and 2
B. 1 and 3
C. 2 only
D. 2 and 3
2. The following costs have arisen in relation to the production of a product:
(1) Planning and concept design costs

(2) Testing costs

(3) Production costs
(4) Distribution and customer service costs
In calculating the life cycle costs of a product, which of the above items would be included?
A. 3 only
B. 1, 2 and 3
C. 1, 2 and 4
D. All of the above
3. The following information relates to the expected cost of a new product over its expected
three-year life.

Units made and sold 25,000 100,000 75,000
R&D costs $850,000 $90,000
Production costs
Variable per unit $30 $25 $20
Fixed costs $500,000 $500,000 $500,000
Selling and distribution costs
Fixed costs $700,000 $500,000 $300,000
Customer service costs
What is the expected average life cycle cost per unit?

A. $35.95
B. $46.25
C. $48.00
D. $50.95
4. Which TWO of the following statements about life cycle costing are true?
A. A product is usually most profitable during the growth phase of its life cycle.
B. Life cycle costing is useful for deciding the selling price for a product.
C. An important use of life cycle costing is to decide whether to go ahead with the
development of a new product.
D. Life cycle costing encourages management to find a suitable balance between
investment costs and operating expenses.
5. The following estimates have been produced for a new product with an expected life of four
years.
Units made and sold 5,000 10,000 25,000 10,000
$ $ $ $
R&D costs 0.9 million 0.3 million - -
Marketing costs 0.3 million 0.3 million 0.1 million 0.1 million
Production cost per unit 80 40 30 30
Customer service cost per unit 20 15 10 5
Disposal costs - - - 0.2 million
What is the expected life cycle cost per unit (to two decimal places)?

Performance Management Throughput Accounting 21
Throughput Accounting
The throughput accounting system aims to maximise the throughput contribution 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 (or binding constraint), a resource that slows down the production process.
inventory management technique
pull system
Just in Time (JIT) Environment production as per order only
It originally referred to the production of goods to meet customer demand exactly, in time, quality
and quantity. Products should not be made unless there is a customer for them. This means that
goods are only produced when they are needed, eliminating large stocks of materials and finished reduce inventory levels
quality products
goods. pratically some buffer inventoery is stored perfect situation
speedy production
In a JIT environment, inventory is not desired. Ideally, inventory would be zero. but not practical reduce wastage
reduce holding cost
In short-term, ONLY material cost is variable. ALL other factory costs are fixed (both direct labour
all other factors than raw material should be ready for production thus it is
costs and overhead costs are assumed to be 'fixed' costs). fixed
suitable for luxury products,not suitable for necessities
Throughput contribution = Sales revenue – Material cost
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.
Operational expenses, also known as factory expenses, are all the other costs of operations. They
include what in traditional costing would be both direct labour costs and overhead costs.
Work-in-progress should be valued at material cost only, so that no value is added to profit until a
sale is made. fadhil can also be a
jeo bottleneck resource
Bottleneck Resource or Binding Constraint
Bottleneck resource or binding constraint is an activity which has a lower capacity than other
activities.
Bottleneck resources may be:
− Labour hours
− Machine hours
Production is limited to the capacity of the bottleneck resource but this capacity must be fully
utilised. This may result in some idle time in non-bottleneck resources.
Aim of Throughput Accounting

As mentioned earlier, the throughput accounting system aims to maximise the throughput
contribution of the production process (i.e., to make the best use of a scarce resource (bottleneck) in
a JIT environment).
Throughput accounting is an approach to production management which aims to maximise
throughput, while reducing inventory and operational expenses. It is based on the Theory of
Constraints, which focuses on maximising throughput while keeping the organisation’s bottleneck
resources in view, and trying to minimise the operational costs.
how to increase production and manage bottle neck resources

Theory of Constraints (TOC)
Theory of Constraints focuses on bottlenecks in the production process which act as a barrier to
throughput maximisation. The theory of constraints is applied within an organisation by following
‘the five focusing steps.’

if our production is restricted then there will be always a bottle neck resource
Five steps for dealing with a bottleneck activity

1. IDENTIFY: the bottleneck resource. bottle neck=total required -total available
2. EXPLOIT: the highest possible output must be achieved from bottleneck resource. The
output must never be delayed and as such a buffer inventory should be held immediately
safety inventory-to keep the input of bottle neck
before bottleneck resource. resources not be blocked.
3. SUBORDINATE: operations prior to the binding constraint should operate at the same speed
as it so that WIP does not build up.
4. ELEVATE
increase
the bottleneck: steps should be taken to increase resources or improve its
efficiency.
5. RETURN TO STEP 1: the removal of one bottleneck will create another elsewhere in the
system. buffer inventory-inventory to be used in an emergency situation.
Maximising Throughput and Multiple Products

Optimum Production Plan or profitability plan
− Determine the bottleneck resource.

− Calculate the throughput per unit for each product.
− Calculate the bottleneck resource per unit. Example: labour hours per unit or machine hours
per unit.
− Calculate throughput per unit of bottleneck resource (return per hour).
− Rank products
− Allocate resources to arrive at optimum production plan.
Example 1
Product A Product B Product C
Sales price 2.80 1.60 2.40
Materials cost 1.20 0.60 1.20
Machine hours per unit 0.5 hours 0.2 hours 0.3 hours
Weekly sales demand 4,000 units 4,000 units 5,000 units
Machine time is a bottleneck resource and maximum capacity is 4,000 machine hours per week.
Operating costs including direct labour costs are $10,880 per week.
Required:
Determine the optimum production plan for WR Co and calculate the weekly profit that would
arise from the plan.
Throughput Accounting Ratio (TPAR)

It is the ratio of the throughput per unit of bottleneck resource to the factory cost per unit of
bottleneck resource.
𝐑𝐞𝐭𝐮𝐫𝐧 𝐩𝐞𝐫 𝐟𝐚𝐜𝐭𝐨𝐫𝐲 𝐡𝐨𝐮𝐫
Throughput accounting ratio =
𝐂𝐨𝐬𝐭 𝐩𝐞𝐫 𝐟𝐚𝐜𝐭𝐨𝐫𝐲 𝐡𝐨𝐮𝐫
𝐓𝐡𝐫𝐨𝐮𝐠𝐡𝐩𝐮𝐭 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭
Return per factory hour = 𝐏𝐫𝐨𝐝𝐮𝐜𝐭𝐢𝐨𝐧 𝐭𝐢𝐦𝐞 𝐨𝐧 𝐛𝐨𝐭𝐭𝐥𝐞𝐧𝐞𝐜𝐤 𝐫𝐞𝐬𝐨𝐮𝐫𝐜𝐞
(Throughput generated from one unit of bottleneck resource.)

𝐓𝐨𝐭𝐚𝐥 𝐟𝐚𝐜𝐭𝐨𝐫𝐲 𝐜𝐨𝐬𝐭𝐬

Cost per factory hour =
𝐓𝐨𝐭𝐚𝐥 𝐭𝐢𝐦𝐞 𝐚𝐯𝐚𝐢𝐥𝐚𝐛𝐥𝐞 𝐨𝐧 𝐛𝐨𝐭𝐭𝐥𝐞𝐧𝐞𝐜𝐤 𝐫𝐞𝐬𝐨𝐮𝐫𝐜𝐞
(The total factory cost is the operational expense [labour plus overhead] of the organisation.)
In any organisation, you would expect the throughput accounting ratio to be 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.
Interpretation of TPAR
− TPAR > 1 – throughput exceeds operating costs so the product should make a profit.
− TPAR < 1 – throughput is insufficient to cover operating costs, resulting in a loss.
Criticisms of TPAR
− It concentrates on the short-term.
− It is more difficult to apply throughput accounting concepts to the longer-term, when all
costs are variable, and vary with the volume of production and sales or another cost driver.
− In the longer-term an ABC approach might be more appropriate for measuring and
controlling performance.
Example 2
Product A Product B Product C
Sales price 2.80 1.60 2.40
Materials cost 1.20 0.60 1.20
Machine hours per unit 0.5 hours 0.2 hours 0.3 hours
Weekly sales demand 4,000 units 4,000 units 5,000 units
Machine time is a bottleneck resource and maximum capacity is 4,000 machine hours per week.
Operating costs including direct labour costs are $10,880 per week.
Required:
Calculate the Throughput Accounting Ratio for all the products.
Improving Throughput Accounting Ratio

− Increase the sales price.
− Reduce the material cost.
− Reduce total operating expenses, to reduce the cost per hour.
− Improve productivity, reducing the time required to make each unit of product.
− Elevate the bottleneck.

1. One of the products manufactured by a company is product X, which sells for $40 per unit
and a material cost of $10 per unit and a direct labour cost of $7 per unit. The total direct
labour budget for the year is 50,000 hours of labour time at a cost of $12 per hour. Factory
overheads are $2,920,000 per year.
The company is considering the introduction of a system of throughput accounting. It has
identified that machine time is the bottleneck in production. Product X needs 0.01 hours of

machine time per unit produced. The maximum capacity for machine time is 4,000 hours per
year. What is the throughput accounting ratio for product X (to 2 decimal places)?
2. The following data refers to a soft drinks manufacturing company that passes its product
through four processes and is currently operating at optimal capacity.
Process Washing Filing Capping Labelling
Time per dozen unit 6 mins 3 mins 1.5 mins 2 mins
Machine hours available 1,200 700 250 450
Product data $ per unit
Selling price 0.60
Direct material 0.18
Direct labour 0.02
Factory fixed cost $4,120
Which process is the bottleneck?
A. Washing
B. Filing
C. Capping
D. Labelling
3. The following statements have been made about throughput accounting.

1) Inventory has no value and should be valued at $0.
2) Efficiency is maximised by utilising direct labour time and machine time to full
capacity.
A. 1 only
B. 2 only
C. Neither 1 nor 2
D. Both 1 and 2
4. Budget information relating to a company that manufactures four products is as follows.

Product Maximum sales Machine Maximum machine Sales price Material cost
demand units hours per unit hours required per unit ($) per unit ($)
A 1,000 0.1 100 15 6
B 500 0.2 100 21 10
C 2,000 0.3 600 18 9
D 1,000 0.2 200 25 16
1,000
Only 750 machine hours are available during the period.

Applying principles of throughput accounting how many units of product B should be made
if the company produces output to maximise throughput and profit?
5. Which TWO of the following statement about through put accounting and theory of
constraints are true?
A. A principle of throughput accounting is that buffer inventory should be built up for
output from the bottleneck resource.
B. Unless output capacity is greater than sales demand, there will always be binding
constraint.

C. The production capacity of a bottleneck resource should determine the production

schedule for the organisation as a whole.
D. Idle time should be avoided in areas of production that are not a bottleneck
resource.
6. The following statements have been made about throughput accounting.

1) Direct labour should always be treated as a factory cost when measuring
throughput.
2) If machine time is the bottleneck resource, there is no value in taking measures to
improve direct labour efficiency.
Which of the above statements is/ are true?
A. 1 only
B. 2 only
C. Neither 1 nor 2
D. Both 1 and 2
7. A company manufactures Product Q, which sells for $50 per unit and has material cost of
$14 per unit and direct labour cost of $10 per unit. The direct labour budget for the year is
18,000 hours of labour time at a cost of $10 per hour. Factory overheads are $1,620,000 per
year. The company has identified machine time as the bottleneck in production. Product Q
needs 0.05 hours of machine time per unit produced. The maximum capacity for machine
time is 6,000 hours per year.
What is the throughput accounting ratio for the product Q (to one decimal place)?
Constructed Response Question

Solar System Co
Solar Systems Co (S Co) makes two types of solar panels at its manufacturing plant: large panels for
commercial customers and small panels for domestic customers. All panels are produced using the
same materials, machinery and a skilled labour force. Production takes place for five days per week,
from 7 am until 8 pm (13 hours), 50 weeks of the year. Each panel has to be cut, moulded and then
assembled using a cutting machine (Machine C), a moulding machine (Machine M) and an assembly
machine (Machine A). As part of a government scheme to increase renewable energy sources, S Co
has guaranteed not to increase the price of small or large panels for the next three years. It has also
agreed to supply a minimum of 1,000 small panels each year to domestic customers for this three-
year period.
Due to poor productivity levels, late orders and declining profits over recent years, the finance
director has suggested the introduction of throughput accounting within the organisation, together
with a ‘Just in Time’ system of production.
Material costs and selling prices for each type of panel are shown below.
Large panels Small panels
Selling price per unit 12,600 3,800
Material costs per unit 4,300 1,160
Total factory costs, which include the cost of labour and all factory overheads, are $12 million each
year at the plant.
Out of the 13 hours available for production each day, workers take a one-hour lunch break. For the
remaining 12 hours, Machine C is utilised 85% of the time and Machines M and A are utilised 90% of
the time. The unproductive time arises either as a result of routine maintenance or because of staff

absenteeism, as each needs to be manned by skilled workers in order for the machine to run. The
skilled workers are currently only trained to work on one type of machine each. Maintenance work is
carried out by external contractors who provide a round the clock service (that is, they are available
24 hours a day, seven days a week), should it be required.
The following information is available for Machine M, which has been identified as the bottleneck
resource:
Large panels Small panels
hours per unit hours per unit
Machine M 1.4 0.6
There is currently plenty of spare capacity on Machines C and A. Maximum annual demand for large
panels and small panels is 1,800 units and 1,700 units respectively.
Required:
a) Calculate the throughput accounting ratio for large panels and for small panels and explain
what they indicate to S Co about production of large and small panels.
(9 marks)
Assume that your calculations in part (a) have shown that large panels have a higher throughput
accounting ratio than small panels.
Required:
b) Using throughput accounting, prepare calculations to determine the optimum production
mix and maximum profit of S Co for the next year.
(5 marks)
c) Suggest and discuss THREE ways in which S Co could try to increase its production capacity
and hence increase throughput in the next year without making any additional investment
in machinery.
(6 marks)
(20 marks)

Performance Management Environmental Accounting 27
Environmental Accounting
Environmental management accounting is the generation and analysis of both financial and non-
financial information in order to support environment management process.
Importance of Environmental Costs

− Society as a whole has become more environmentally aware and companies can increase
their appeal to customers by portraying themselves as environmentally responsible.
− Environmental costs are becoming huge for some companies.
− Regulation is increasing worldwide, with penalties for non-compliance also increasing
accordingly.
− Identifying environmental costs associated with individual products and services can
assist with pricing decisions.
Environmental Costs – Examples

− Consumable and raw materials
− Transport and travel
− Waste disposal
− Water consumption
− Energy
Internal Environmental Costs

These are costs that directly impact on the income statement of a company.
For example:
− Waste disposal costs
− Regulatory costs such as taxes
External Environmental Costs

These are costs that are imposed on society at large, but not borne by the company that generates
the cost in the first instance.
For example:
− Carbon emissions
− Usage of energy and water
− Forest degradation
Classification of Environmental Costs

1. Environmental prevention costs
The costs of activities undertaken to prevent the production of waste.
For example:
− The costs of the design and operation of processes to reduce waste.
− Obtaining certification relating to meeting the requirements of national and
international standards.

2. Environmental detection costs

Costs incurred to ensure that the organisation complies with regulations and voluntary
standards.
For example:
− Performing pollution tests.
− Inspecting products to ensure regulatory compliance.
3. Environmental internal failure costs
Costs incurred from performing activities that have produced contaminants and waste that
have not been discharged into the environment.
For example:
− Recycling scrap.
− Disposing of toxic materials.
4. Environmental external failure costs
Costs incurred on activities performed after discharging waste into the environment.
For example:
− Costs of cleaning up contaminated soil, or restoring land to its natural state.
Methods of Environmental Accounting

1. Input/Output Analysis
Input/output analysis operates on the principle that what comes in must go out. Process
flow charts can help to trace inputs and outputs, particularly waste.
− Any difference between the amount input and the eventual output is 'residual',
which is called 'waste'.
− Input and output quantities are measured and these can be given a cost.
2. Flow Cost Accounting
Flow cost accounting is a development from input/output analysis.
It divides the material flows into three categories:
− Material
− System and delivery
− Disposal
The values and costs of each of these three flows are then calculated.
3. Activity Based Costing
Environmental activity-based costing combined elements of environmental costing with an
activity-based costing system. ABC allocates internal costs to cost centres and cost drivers on
the basis of the activities that give rise to the costs.
4. Lifecycle Costing
Within the context of environmental accounting, lifecycle costing is a technique which
requires the full environmental costs, arising from production of a product to be taken
account across its whole lifecycle. Under this method of environmental cost accounting,
environmental costs for a product are considered from the design stage of the product right
up to the end-of-life costs, such as decommissioning and removal.
Advantages of Environmental Costing

− Better environmental cost control.
− Facilitates the quantification of cost savings from "environmentally-friendly" measures.

− Reduces the potential for cross-subsidisation of environmentally damaging products.

− Better/fairer product costs.
− Improved pricing – so that products that have the biggest environmental impact reflect this
by having higher selling prices.
Disadvantages of Environmental Costing

− Time consuming and expensive.
− Determining accurate costs and appropriate costs drivers is difficult.
− External costs not experienced by the company (e.g., carbon footprint) may still be ignored/
unmeasured.
− Some internal environmental costs are intangible (e.g., impact on employee health) and
these are still ignored.

1. In environmental costing, the future cost of cleaning up operations for a product or activity
may be classified as which of the following?
A. Carbon footprint
B. Contingent cost
C. Hidden cost
D. Relationship cost
2. Are the following statements about environmental cost accounting true or false?
The majority of environmental costs are already captured within a typical TRUE FALSE
organisation's accounting system. The difficulty lies in identifying them.
Input/output analysis divides material flows within an organisation into three TRUE FALSE
categories: material flows; system flows; and delivery and disposal flows.
3. In material flow cost accounting (MFCA), which of the following is NOT a category used?
A. Output flows
B. Material flows
C. Delivery and disposal flows
D. System flows
4. Which of the following should be categorised as environmental failure costs by an airline
company?
(1) Compensation payments to residents living close to airports for noise pollution
caused by their aircraft
(2) Air pollution due to the airline's carbon emissions from their aircraft engines
(3) Penalties paid by the airline to the government for breaching environmental
regulations
A. 2 only
B. 1, 2 and 3
C. 1 and 3
D. 2 and 3

Performance Management Relevant Costing 30
Relevant Costing
Relevant costs are future cash flows arising as a direct consequence of a decision.
A relevant cost is:
Future
− It must be a cost that will occur in the future.
− Any cost that has already been incurred in the past cannot be a relevant cost.
− Sunk costs cannot be relevant costs. Sunk costs are costs that have already been incurred.
Incremental
− It must arise as a direct consequence of the decision.
− Any costs (or benefits) that will happen anyway, regardless of the decision, cannot be a relevant
cost.
− Committed costs cannot be relevant costs. These are costs that will be incurred in the future,
but they cannot be avoided because they have already been committed by a previous decision.
− Opportunity costs should be included – look at the next best alternative use of a resource.
Cash flow
− It must be a cost (or benefit) that results in cash flow.
− Depreciation charges and overhead absorption costs cannot be relevant costs.
There are two basic types of decision where relevant costs are used.
a) Decisions about whether to do something or whether not to do it
b) Decisions that involve selecting between two or more different options about what to do
Relevant Costs
− Generally Variable Costs
− Incremental Fixed Costs
− Opportunity Costs
Opportunity Costs
An opportunity cost is the benefit foregone by choosing one opportunity instead of the next best
alternative.
Example 1
A new project requires the use of an existing machine that would otherwise be sold.
Information concerning the machine is as follows:
Original purchase price = $20,000
Current net book value (NBV) = $5,000
Estimated current sales value = $4,000
Required:
What is the relevant cost (if any) if using the machine in the project?
Example 2
A company which manufactures and sells one single product is currently operating at 85% of full
capacity, producing, 102,000 units per month. The current total monthly costs of production amount to
$330,000, of which $75,000 are fixed and are expected to remain unchanged for all levels of activity up
to full capacity. A new potential customer has expressed interest in taking regular monthly delivery of
12,000 units at a price $2.80 per unit. All existing production is sold each month at a price of $3.25 per

unit. If the new business is accepted, existing sales are expected to fall by 2 units for every 15 units sold
to the new customer.
Required:
What is the overall increase in monthly profit which would result from accepting the new business?
Irrelevant Costs
− General Fixed Costs
− Uncontrollable Costs
Relevant Cost of Material

Is required material available in
stock?
If NO, purchase price will be relevant

If YES, is it regularly used?
(current market value)
If YES, relevant cost will be the If NO, relevant cost will be higher of:
replacement cost (current market a) scrap value
value) b) alternative use
Relevant Cost of Labour
Labour
Spare capacity Full capacity (No spare capacity)
Relevant cost = nil

Work overtime or hire
Divert from other jobs
extra staff
Relevant cost = extra cost Relevant cost =

of labour opportunity cost (lost
contribution and
extralabour cost)

Relevant cost of Non-Current Assets

− If NCA is specially purchased/ hired (relevant cost is cost of purchase)
− If the existing NCA is used for the new project (irrelevant cost because depreciation is non-cash)
− Net Book Value is always irrelevant cost
− Depreciation is always irrelevant cost
− Historic Purchase Cost is irrelevant cost
− Scrap Value of machine is relevant cost

Performance Management Cost Volume Profit Analysis 33
Cost Volume Profit (CVP) Analysis

Cost-volume-profit analysis looks primarily at the effects of differing levels of activity on the financial
results of a business.
Breakeven Point
The breakeven point is when total revenue equals total costs.
At breakeven point contribution is equal to fixed costs as there is no profit or loss made.
𝐓𝐨𝐭𝐚𝐥 𝐟𝐢𝐱𝐞𝐝 𝐜𝐨𝐬𝐭
𝐁𝐫𝐞𝐚𝐤𝐞𝐯𝐞𝐧 𝐮𝐧𝐢𝐭𝐬 =
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭
𝐁𝐫𝐞𝐚𝐤𝐞𝐯𝐞𝐧 𝐬𝐚𝐥𝐞𝐬 𝐫𝐞𝐯𝐞𝐧𝐮𝐞 = 𝐁𝐫𝐞𝐚𝐤𝐞𝐯𝐞𝐧 𝐮𝐧𝐢𝐭𝐬 ∗ 𝐒𝐞𝐥𝐥𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭 = 𝐒𝐞𝐥𝐥𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞 − 𝐕𝐚𝐫𝐢𝐚𝐛𝐥𝐞 𝐜𝐨𝐬𝐭 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭
Single Product Analysis

Example 1
Selling price per unit = $15
Variable cost per unit = $12
Total fixed cost = $36,000
Required:
Calculate break-even point.
Target Profit
𝐅𝐢𝐱𝐞𝐝 𝐜𝐨𝐬𝐭 + 𝐓𝐚𝐫𝐠𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭
𝐒𝐚𝐥𝐞𝐬 𝐯𝐨𝐥𝐮𝐦𝐞 𝐫𝐞𝐪𝐮𝐢𝐫𝐞𝐝 𝐭𝐨 𝐚𝐜𝐡𝐢𝐞𝐯𝐞 𝐚 𝐭𝐚𝐫𝐠𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭 =
Example 2
Targeted Profit = $21,000
Required:
Calculate the sales volume required to achieve the target profit.
Margin of Safety
Margin of safety is the measure of sensitivity or riskiness of the budget.
It is the excess of budgeted sales over the breakeven sales.
𝐌𝐚𝐫𝐠𝐢𝐧 𝐨𝐟 𝐬𝐚𝐟𝐞𝐭𝐲 (𝐮𝐧𝐢𝐭𝐬) = 𝐁𝐮𝐝𝐠𝐞𝐭𝐞𝐝 𝐮𝐧𝐢𝐭𝐬 − 𝐁𝐫𝐞𝐚𝐤𝐞𝐯𝐞𝐧 𝐮𝐧𝐢𝐭𝐬
𝐁𝐮𝐝𝐠𝐞𝐭𝐞𝐝 𝐮𝐧𝐢𝐭𝐬 − 𝐁𝐫𝐞𝐚𝐤𝐞𝐯𝐞𝐧 𝐮𝐧𝐢𝐭𝐬
𝐌𝐚𝐫𝐠𝐢𝐧 𝐨𝐟 𝐬𝐚𝐟𝐞𝐭𝐲 (𝐮𝐧𝐢𝐭𝐬 %) = ∗ 𝟏𝟎𝟎
𝐁𝐮𝐝𝐠𝐞𝐭𝐞𝐝 𝐮𝐧𝐢𝐭𝐬

𝐌𝐚𝐫𝐠𝐢𝐧 𝐨𝐟 𝐬𝐚𝐟𝐞𝐭𝐲 (𝐬𝐚𝐥𝐞𝐬) = 𝐁𝐮𝐝𝐠𝐞𝐭𝐞𝐝 𝐬𝐚𝐥𝐞𝐬 𝐫𝐞𝐯𝐞𝐧𝐮𝐞 − 𝐁𝐫𝐞𝐚𝐤𝐞𝐯𝐞𝐧 𝐬𝐚𝐥𝐞𝐬 𝐫𝐞𝐯𝐞𝐧𝐮𝐞
𝐁𝐮𝐝𝐠𝐞𝐭𝐞𝐝 𝐬𝐚𝐥𝐞𝐬 𝐫𝐞𝐯𝐞𝐧𝐮𝐞 − 𝐁𝐫𝐞𝐚𝐤𝐞𝐯𝐞𝐧 𝐬𝐚𝐥𝐞𝐬 𝐫𝐞𝐯𝐞𝐧𝐮𝐞

𝐌𝐚𝐫𝐠𝐢𝐧 𝐨𝐟 𝐬𝐚𝐟𝐞𝐭𝐲 (𝐬𝐚𝐥𝐞𝐬 %) = ∗ 𝟏𝟎𝟎
𝐁𝐮𝐝𝐠𝐞𝐭𝐞𝐝 𝐬𝐚𝐥𝐞𝐬 𝐫𝐞𝐯𝐞𝐧𝐮𝐞
Example 3
Total budgeted units = 2,000 units
Required:
Calculate margin of safety.
Contribution to Sales Ratio

𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭
𝐂𝐒 𝐑𝐚𝐭𝐢𝐨 = ∗ 𝟏𝟎𝟎 𝐎𝐑 ∗ 𝟏𝟎𝟎
𝐒𝐚𝐥𝐞𝐬 𝐒𝐞𝐥𝐥𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
Calculations Using CS Ratio

𝐁𝐫𝐞𝐚𝐤𝐞𝐯𝐞𝐧 𝐬𝐚𝐥𝐞𝐬 𝐫𝐞𝐯𝐞𝐧𝐮𝐞 =
𝐂𝐒 𝐫𝐚𝐭𝐢𝐨
𝐓𝐨𝐭𝐚𝐥 𝐟𝐢𝐱𝐞𝐝 𝐜𝐨𝐬𝐭 + 𝐏𝐫𝐨𝐟𝐢𝐭
𝐒𝐚𝐥𝐞𝐬 𝐫𝐞𝐯𝐞𝐧𝐮𝐞 𝐫𝐞𝐪𝐮𝐢𝐫𝐞𝐝 𝐭𝐨 𝐚𝐜𝐡𝐢𝐞𝐯𝐞 𝐚 𝐭𝐚𝐫𝐠𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭 =
𝐂𝐒 𝐫𝐚𝐭𝐢𝐨
Graphs – Single Product Analysis

Traditional Breakeven Chart
Total Revenue
$ Total Cost
Total Variable Cost

break even point
Fixed Cost
Units

Contribution Breakeven Chart
Total Revenue
$ Total Cost
Breakeven Point Contribution

Total Variable Cost
Fixed Cost
Units
Profit Volume Chart
$’000s
P/V line
fixed cost +profit=contribution
Breakeven Point Profit
0 Contribution
Level of Activity
loss
Fixed volume of production
Cost
total loss=total fixed cost
Multi Product Environment

𝐁𝐫𝐞𝐚𝐤𝐞𝐯𝐞𝐧 𝐮𝐧𝐢𝐭𝐬 =
𝐖𝐞𝐢𝐠𝐡𝐭𝐞𝐝 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 𝐜𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭

𝐒𝐚𝐥𝐞𝐬 𝐯𝐨𝐥𝐮𝐦𝐞 𝐫𝐞𝐪𝐮𝐢𝐫𝐞𝐝 𝐭𝐨 𝐚𝐜𝐡𝐢𝐞𝐯𝐞 𝐚 𝐭𝐚𝐫𝐠𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭 =
𝐖𝐞𝐢𝐠𝐡𝐭𝐞𝐝 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 𝐜𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭

Calculations Using CS Ratio

𝐁𝐫𝐞𝐚𝐤𝐞𝐯𝐞𝐧 𝐬𝐚𝐥𝐞𝐬 𝐫𝐞𝐯𝐞𝐧𝐮𝐞 =
𝐖𝐞𝐢𝐠𝐡𝐭𝐞𝐝 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 𝐂𝐒 𝐫𝐚𝐭𝐢𝐨
𝐒𝐚𝐥𝐞𝐬 𝐫𝐞𝐯𝐞𝐧𝐮𝐞 𝐫𝐞𝐪𝐮𝐢𝐫𝐞𝐝 𝐭𝐨 𝐚𝐜𝐡𝐢𝐞𝐯𝐞 𝐚 𝐭𝐚𝐫𝐠𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭 =
𝐖𝐞𝐢𝐠𝐡𝐭𝐞𝐝 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 𝐂𝐒 𝐫𝐚𝐭𝐢𝐨
Example 4
PL produces and sells two products, M and N. Product M sells for $7 per unit and has a total variable
cost of $2.94 per unit, while Product N sells for $15 per unit and has a total variable cost of $4.40 per
unit. The marketing department has estimated that, for every five units of M sold, one unit of N will
be sold. The organization’s fixed costs per period total $123,600.
Required:
Calculate the breakeven point for PL.
Example 5
TIM produces and sells two products, the MK and the KL. The organization expects to sell 1 MK for
every 2 KLs and have monthly sales revenue of $150,000. The MK has a C/S ratio of 20% whereas the
KL has a C/S ratio of 40%. Budgeted monthly fixed costs are $30,000.
Required:
What is the breakeven sales revenue?
Graph – Multi Product Analysis

Multi Product Profit Volume Chart
200
150 first method

Product L
100
Product M
50 Product
since k has highest cs ratio J second method
Profit/(Loss) $’000
300 untis is enough to be sold

to reach break even point
0
100 200 300 400 500 600 700 800 900 1,000
(50) Revenue ($’000)
(150)
Breakeven Point
(200) Product K
(250)

Limitations/Assumptions of Cost-Volume-Profit Analysis

− Either a single product is being sold or, if there are multiple products, these are sold in a
constant mix.
− Fixed costs remain constant over the 'relevant range'.
− Selling price per unit and variable cost per unit constant.
− Contribution per unit constant at all levels of activity.
− CS ratio remain constant at all levels of activity.
− The total cost and total revenue functions are linear.

1. A company produces and sells a single product. Budgeted sales are $2.4m, budgeted fixed
costs $360,000 and the margin of safety is $400,000. What are budgeted variable costs?
A. $1.640m
B. $1.728m
C. $1.968m
D. $2.040m
2. A company has fixed costs of $1.3m. variable costs are 55% of sales up to a sale level of
$1.5m, but at higher volume of production and sales, the variable cost for incremental
production unit falls to 52% of sales.
What is the breakeven point in sales revenue, to the nearest $1,000?
A. $1,977,000
B. $2,027,000
C. $2,708,000
D. $2,802,000
3. A company budgets to sells its three products A, B and C in the ratio 2:3:5 respectively,
measured in units of sales. Unit sales prices and variable costs are as follows:
Product A B C
$ per unit $ per unit $ per unit
Sales price 20 18 24
Variable cost 11 12 18
Budgeted fixed costs are $1.2m.
What sales will be needed to achieve target profit of $400,000 for the period?
(Give answer in millions, to 3 decimal points.)
4. A company makes and sells three products. The budget for the next period is as follows:
Product A B C
$ per unit $ per unit $ per unit
Sales price 12 18 20
Variable cost 3 6 11
9 12 9
Fixed cost 6 9 6
Profit 3 3 3
Number of units 30,000 40,000 10,000

What is the breakeven point in sales, to the nearest $1,000?
Constructed Response Question

Cardio Co
Cardio Co manufactures three types of fitness equipment: treadmills (T), cross trainers (C) and
rowing machines(R). The budgeted sales prices and volumes for the next year are as follows:
T C R
Selling price $1,600 $1,800 $1,400
Units 420 400 380
The standard cost card for each product is shown below:
T C R
$ $ $
Material 430 500 360
Labour 220 240 190
Variable overheads 110 120 95
Labour costs are 60% fixed and 40% variable. General fixed overheads excluding any fixed labour
costs are expected to be $55,000 for the next year.
Required:
a) Calculate the weighted average contribution to sales ratio for Cardio Co.
(4 marks)
b) Calculate the margin of safety in $ revenue for Cardio Co.
(3 marks)

Performance Management Limiting Factors 39
Limiting Factors
Limiting Factor Analysis
Limiting factor is that resource which is in short supply and which limits the output of the business.
Examples of limiting factors – a factor which limit further expansion
Short term restriction on one of the following:
− Materials
− Labour hours
− Machine hours
Single Limiting Factor

Looks at situations where there is only one factor limiting the company’s activities.
In the long-term, the business could rectify this by;
− Sourcing from different suppliers
− Recruiting new workers
− Purchasing new machinery, etc.
In the short-term we aim to maximise contribution by choosing production combinations of products
which make the ‘best use’ of the scarce resource (we assume that fixed costs in total will not change as
a result of our decision).
Example 1
Product A Product B
Selling price $14 $11
Variable cost per unit $8 $7
Labour hours per unit 2 hours 1 hour
Maximum sales demand 3,000 units 5,000 units
During July the available direct labour is limited to 8,000 hours.
Total fixed costs per month are $20,000.
Required:
Determine the profit maximising production budget.
Steps to Determine Optimal Production Plan

1. Calculate the contribution per unit of each product.
2. Calculate limiting factor per unit for each product.
Example:
− Material usage per unit
− Labour hours per unit
− Machine hours per unit
3. Calculate the contribution per limiting factor (contribution generated from one unit of limiting
factor).
Contribution = 𝐋𝐢𝐦𝐢𝐭𝐢𝐧𝐠 𝐟𝐚𝐜𝐭𝐨𝐫 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭
4. Rank products on the basis of contribution per limiting factor.
5. Allocate the resource in order of the ranking (optimal production plan).

Multi–Limiting Factor
The Linear Programming
If there are multiple limiting factors, Linear programming approach is used. The graphical method of
linear programming can be used when there are just two products (or services).
The steps involved are as follows:
1. Define variables.
2. Establish constraints.
3. Construct objective function.
4. Draw the constraints on a graph.
5. Establish the feasible region for the optimal solution.
6. Determine the optimal solution.
Example 2
WX Co manufactures two products, A and B. Both products are produced using the same machines and
same type of labour.
The organisation's objective is to maximise contribution.
Product A Product B
Selling price per unit $1.5 $2
Variable cost per unit $1.3 $1.7
Machine hours per unit 0.06 0.08
Labour hours per unit 0.04 0.12
Maximum sales demand Unlimited 13,000
Total available machine hours = 2,400 hours
Total available labour hours = 2,400 hours
Required:
Determine the optimal production plan.
Solution –
1. Define the variables.
Let x = number of units of product A produced and sold
Let y = number of units of product B produced and sold
2. Establish the constraints.
The constraints are as follows:
0.06x + 0.08y ≤ 2,400 (machine hours)
0.04x + 0.12y ≤ 2,400 (labour hours)
y ≤ 13,000 (demand for product B)
x, y ≥ 0 (non-negativity)
3. Construct the objective function.
Product A yields a contribution of $0.20 per unit (1.50 – 1.30)
Product B yields a contribution of $0.30 per unit (2.00 – 1.70)
Maximise contribution (C): 0.2 x + 0.3 y

4. Graphing the problem.
Y
30,000
0.06x + 0.08y = 2,400
20,000
y = 13,000
10,000
0.04x + 0.12y = 2,400
O 10,000 20,000 30,000 40,000 50,000 60,000 X
5. Establishing the feasible region.
Y
30,000
0.06x + 0.08y = 2,400
20,000
y = 13,000
10,000
Feasible Region 0.04x + 0.12y = 2,400
O 10,000 20,000 30,000 40,000 50,000 60,000 X
Finding the Optimum Production Plan

Using Simultaneous Equation –
Y
30,000
0.06x + 0.08y = 2,400
20,000
P y = 13,000
A
B C
10,000
0.04x + 0.12y = 2,400
D
O 10,000 20,000 30,000 40,000 50,000 60,000 X
Point A
x=0
y = 13,000
Contribution = 0.2 * 0 + 0.3 * 13,000 = $3,900

Point B
Y = 13,000 ------------------- (1)
0.04x + 0.12y = 2,400 ------ (2)
Substitute (1) into (2) ---- 0.04x + 0.12 * 13,000 = 2,400
0.04x + 1,560 = 2,400
0.04x = 840
X = 21,000
Total contribution = (21,000 × 0.2) + (13,000 × 0.3)
Total contribution = $4,200 + $3,900
Total contribution = $8,100
Point C
0.06x + 0.08y = 2,400
0.04x + 0.12y = 2,400
Multiply (1) by 2 ------------ 0.12x + 0.16y = 4,800
Multiply (2) by 3 ------------ 0.12x + 0.36y = 7,200
Subtract (3) from (4) ---------- 0 + 0.20y = 2,400
Y = 12,000
Substitute in (1) 0.06x + 0.08 * 12,000 = 2,400
0.06x = 1,440
X = 24,000
When x = 24,000 and y = 12,000,
Total contribution = (24,000 × 0.2) + (12,000 × 0.3)
Total contribution = $4,800 + $3,600
X = 40,000 and y = 0
Total contribution = 40,000 × $0.20
Comparing Points B, C and D, we can see that contribution is maximised at C, by making 24,000 units of
product A; 12,000 units of product B; to earn a contribution of $8,400.
Binding Constraint
− Resource which is fully utilised under the optimal solution.
− Maximum capacity is utilised.
− The constraint is a 'less than or equal to' constraint.
Example 3
Continuation from Example 2;
Machine hours: 0.06 x + 0.08 y
Total machine hours required to meet optimal production = 0.06*24,000 + 0.08*12,000
Total machine hours required to meet optimal production = 2,400 hours
Total available hours = 24,00 hours
Here maximum capacity is utilized.
So, machine hours is binding.
Shadow (or Dual) Prices

− The amount of contribution generated by having one extra unit of the binding constraint.
− It’s the maximum premium the company could pay for one extra unit of the binding constraint.
− The shadow price of a constraint that is not binding at the optimal solution, is zero.

Calculating Shadow Prices

1. Take the equations of the straight lines that intersect at the optimal point. Add one unit to the
constraint concerned, while leaving the other critical constraint unchanged.
2. Use simultaneous equations to derive a new optimal solution.
3. Calculate the revised optimal contribution and compare to the original contribution calculated.
The increase is the shadow price.
Example 4
Continuation from Example 2;
Using the following data, calculate the shadow price for labour hour.
Optimal Point = C
X = 24,000
Y = 12,000
Current Contribution = $8,400
Implications of Shadow Prices

− Management can use shadow prices as a measure of the maximum premium that they would
be willing to pay for one more unit of the scarce resource.
− However, the shadow price should be considered carefully.
− If more of the critical constraint is obtained, the constraint line will move outwards altering the
shape of the altering the shape of the feasible region. After a certain point there will be little
point in buying more of the scarce resource since any non-critical constraints will become
critical.
Slack
− If a resource is not binding at the optimal point, it will have slack.
− Maximum capacity is not utilised.
− The constraint is a 'less than or equal to' constraint.
Implication of Shadow Prices

− High slack: it is an indication of inefficient use of particular resource. If possible, the resource
should be reallocated to another part of the business.
− Low slack: management should be alert to the risk that this resource could become a binding
constraint.
Surplus
− Surplus is the excess over the minimum amount of constraint.
− Constraint is a 'more than or equal to' constraint.

1. A company uses linear programming to decide on the production and sales budget that will
maximise total contribution and profit for a financial period. The optimal solution involves
using all available direct labour hours for which the shadow price is $4.50 per hour, and
machine hours, for which the shadow price is $3 per machine hour. Direct labour is paid $8 per
hour.
If the objective of the company is to maximise total contribution and profit in each period, how
much should the company be willing to pay per hour to obtain additional direct labour hours of
production capacity?

A. Up to but not including $4.50

B. Up to but not including $9.50
C. Up to but not including $12.50
D. Up to but not including $15.50
2. A company makes two products, X and Y, using the same type of direct labour. Production
capacity per period is restricted to 60,000 direct labour hours. The contribution per unit is $8
for Product X and $6 for Product Y. The following constraints apply to production and sales:
X ≤ 10,000 (Sales demand for product X)
Y ≤ 12,000 (Sales demand for product Y)
5X + 4Y ≤ 60,000 (Direct labour hours)
The contribution-maximising output is to produce and sell 10,000 units of Product X and 2,500
units of Product Y.
What is the shadow price per direct labour hour and for how many additional hours of labour
does this shadow price per hour apply?
A. $1.50 per hour for the next 38,000 direct labour hour
B. $1.50 per hour for the next 47,500 direct labour hours
C. $1.60 per hour for the next 38,000 direct labour hours
D. $1.60 per hour for the next 47,500 direct labour
3. In a linear programming problem to determine the contribution-maximising production and
sales volumes for two products, X and Y, the following information is available.
Product X per unit Product Y per unit Total available per
period
Direct labour hours 2 hours 4 hours 10,000 hours
Material L 4 kg 2 kg 14,000 kg
Contribution per unit $12 $18
The profit-maximising level of output and sales is 3,000 units of Product X and 1,000 units
of Product Y.
What is the shadow price of a direct labour hour?
A. $1.00
B. $2.40
C. $4.00
D. $4.50

Performance Management Pricing Decisions 45
Pricing Decisions
Factors Affecting Price
− Inflation
− Newness new prdouct
− Incomes of customers
− Product range tata has zudio and westside high price product and low price products ,so price is set accordingly considering the profitability
− Ethics some companies consider their ethics while charging an unfair price
− Product lifecycle
− Organizational goals
− Quality of the product
− Competitor’s pricing strategy
− Suppliers rawmaterial cost high sp also high
− Intermediaries low intermediaries low selling price
Types of Market
Types of market
Monopoly Perfect competition Oligopoly Monopolistic

competition
Monopoly eg:microsoft
− Only one seller who dominates many buyers, so price can be set as high as possible.
Perfect competition every buyer and seller is a price taker homogenuous products,zero entry and exit
− Selling the same product and there are a lot of sellers and buyers as well. barriers and perfect information
Oligopoly
− Oligopoly is a market in which a small number of firms have the large majority of market share.
Monopolistic competition airtel,bsnl,vodafone -small firms had the majority share of telephone
industry
− A large number of firms offer similar but not identical products.
soap instead of body wash
Demand-based Pricing Strategy

Economic theory argues that the higher the price of a good, the lower will be the quantity demanded.
($) P
Q (units)

b is always negative becuase of the inverse relationship between price and quantity,but ignore the
Demand Function minus sign
Demand Equation P = a – bQ
where;
constant
P = the price
Q = the quantity demanded
a = the price at which the demand would be nil
change in price
b=
change in quantity
Example 1
The current price of a product is $12. At this price the company sells 60 items a month. One month the
company decides to raise the price to $15, but only 45 items are sold at this price.
Required:
Determine the demand equation, which is assumed to be a straight-line equation.
Price Elasticity of Demand

Price elasticity of demand (PED) is a measure of the responsiveness of demand to changes in price.
% 𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐐𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐨𝐫 𝐃𝐞𝐦𝐚𝐧𝐝 (𝐐)

PED =
% 𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐏𝐫𝐢𝐜𝐞 (𝐏)
− If the PED is greater than 1 – Elastic: Demand is responsive to a change in price.

− If the PED is less than 1 – Inelastic: Demand is not very responsive to changes in price.
− If the PED is equal to 1: The percentage change in quantity demanded is equal to the
percentage change in price.
− If the PED is equal to zero – Perfectly Inelastic: A change in price will have no influence on
quantity. 0/1-even if the price changes quantity has no change
here we can increase the price since it will not affect the demand
PED = 0, perfectly inelastic
P - Price
Q - Quantity demanded

− If the PED is equal to infinity – Perfectly Elastic: Customers will buy an infinite amount but only
up to a particular price. Any price increase above this level will reduce demand to zero.
any n0./0-infifnity
P - Price PED = ∞, perfectly elastic
eg; mineral water

price is constant
Q - Quantity demanded
Example 2
The price of a good is $1.20 per unit and annual demand is 800,000 units. Market research indicates
that an increase in prices of 10 cents per unit will result in a fall in annual demand of 75,000 units.
Required:
What is the price elasticity of demand?
Profit-Maximizing Price and Quantity optimal price and quantity
The Algebraic Approach if you want to sell more units we should reduce the selling price there by our reveune per
unit is reducing
If price decreases, the quantity of units sold will increase.
A company wishes to select the option that will maximise the total profits earned.
$
more units more discounts which reduce marginal revenue
Marginal revenue
it is the point with sale is stopped Marginal cost

profit maximising point
fixed cost is irrelevant here Point 1 Q – Quantity demanded
Profits are maximised using marginalist theory when,

Marginal Cost (MC) = Marginal Revenue (MR)
In the graph above, point 1 therefore represents the profit-maximising quantity.
Marginal revenue is the additional revenue earned from selling one more unit. MR = a - 2bQ
Marginal cost is the additional cost incurred from making one extra unit (variable cost per unit).
Steps to Calculate Profit Maximising Quantity and Price

− Establish the demand function (find the values for ‘a’ and ‘b’).

− Obtain a value for MR from the demand curve. MR = a - 2bQ

− Establish the Marginal Cost (MC).
− To maximise profit, equate MC and MR to find Q (the optimum quantity).
− Substitute Q into the demand function and solve to find P (the optimum price).
Example 3
AB has used market research to determine that if a price of $250 is charged for product G, demand will
be 12,000 units. It has also been established that demand will rise or fall by 5 units for every 1 fall/rise
in the selling price. The marginal cost of product G is $80.
Required:
Calculate the profit-maximising selling price for product G.
Tabular Method
Example 4
Total output units Selling price per unit Average cost per unit
1 504 720
2 471 402
3 439 288
4 407 231
5 377 201
6 346 189
7 317 182
8 288 180
Required:
Calculate the profit-maximising selling price.
Equation for Total Cost Function

Cost equations are derived from historical cost data.
y = a + bx
− ‘x’ is the activity level (the independent variable).
− ‘y’ is the total cost = fixed cost + variable cost (the dependent variable).
− ‘a’ is the fixed cost per period (the intercept).
− ‘b’ is the variable cost per unit (the gradient).
Decision to Increase Production and Sales

Consider incremental costs, incremental revenues and other factors.
Incremental costs and revenues are the difference between costs and revenues for the corresponding
items under each alternative being considered.
Different Pricing Strategies

Cost plus pricing
− Full cost-plus pricing fc+vc+profit
Adding profit margin/mark-up to full cost.

− Marginal cost-plus pricing vc+profit

Adding profit margin/mark-up to marginal (variable) costs.
− Relevant cost (Minimum pricing)
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.
Market Skimming Pricing

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.
This is an appropriate approach: eg:iphone
− When the product is new and different. if the price changes there will be no much change in
− When its demand elasticity is unknown or inelastic demand.demand-thus here high price is charged
− When a company is trying to resolve liquidity issues.
− When a product has a short lifecycle and its costs are to be recovered as soon as possible.
Market Penetration Pricing

Introducing a product at low costs to establish its stronghold in the market.
This is an appropriate approach: new comeptitor
− When company is trying to discourage new entrants in the market. popuralise quickly
− When a company wishes to push a product to its growth and maturity stage quickly.
− When a company can enjoy great economies of scale. achieving maximum effeciency by increasing production and
lowering cost
− Product demand is highly elastic.
Complementary Products Pricing eg:shoes and socks,brush and paste
− Setting a pricing policy for goods that are complementary i.e., are normally bought together.
− The main product is sold at a low margin but the accessories or after- sales service required, is
sold subsequently at a higher margin.
product line-group of related products all marketed under a single brand name
eg:milma-milk,ghee ,peda,etc
Product Line Pricing
Setting a consistent pricing policy for a group of products.
Example: same policy for shampoos, skin care products etc., of the same brand.
Volume Discounting
Volume discounting means offering customers a lower price per unit if they purchase a particular
quantity of a product.
Price Discrimination
Charging different prices to different groups of buyers for the same product.
eg;bus charge to students have concession and others have normal rate

1. The following statements have been made about cost plus pricing
1) A price in excess of full cost per unit will ensure that a company will cover all its costs and
make a profit.
2) Cost plus pricing is an appropriate pricing strategy when jobs are carried out to customer
specifications.


A. 1 only
B. Neither 1 nor 2
C. 2 only
D. Both 1 and 2
2. If the price elasticity of demand is zero, which TWO of the following figures are true?
A. Demand is 'perfectly inelastic'.
B. There is no change in price regardless of the quantity demanded.
C. The demand curve is a horizontal straight line.
D. There is no change in the quantity demanded, regardless of any change in price.
3. The price elasticity of demand for a product at its current price level is inelastic. What will
happen to the total revenue and the profit if the price of the products is reduced?
Increase Fall
Total revenue . - -
. Profit - -
4. The following statements have been made about price elasticity of demand.
1) When sales demand is inelastic, a company can increase profits by raising the selling price
of its product.
2) Price elasticity of demand is measured as the amount of change in sales price (measured
as a percentage of the current sale price) divided by the amount of change in quantity
demanded measured as a percentage of the current sales volume.
A. 1 only
B. 2 only
C. Neither 1 nor 2
D. Both 1 and 2
5. Which method of pricing is most easily applied when two or more markets for the product or
service can be kept entirely separate from each other?
A. Price discrimination
B. Product line pricing
C. Skimming
D. Volume discounting
6. The demand for a product at its current price has a price elasticity greater than 1.0 (ignoring
the minus sign).
Which of the following statements must be correct?
1. A reduction in the sales price will increase total revenue.
2. A reduction in the sales price by x% will result in a percentage increase in sales
demand which is greater than X%
3. An increase in the selling price will increase total profit.
A. Statements 1 and 2
B. Statements 1 and 3
C. Statements 2 and 3
D. Statements 1, 2 and 3

7. Market research into demand for a product indicates that when the selling price per unit is
$145, demand in each period will be 5,000 units, if the price $ 120, demand will be 11,250
units. It is assumed that the demand function for this product is linear. The variable cost per
unit is $27.
What selling price should be charged in order to maximise the monthly profit?

Performance Management Make-or-buy and Other Short-term Decisions 52
Make-or-buy and Other Short-term Decisions

Short-term Decisions
− Further processing decisions
− Make-or-buy decisions
− Shut-down decisions
− One-off contract decisions
Further Processing Decisions

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.
− The point at which joint products become separately identifiable is known as the split-off point
or separation point.
− Costs incurred prior to split-off point are common or joint costs.
A further processing decision often involves joint products from a common manufacturing process. The
decision is whether to sell the products at the split-off point or whether they should be processed further
before selling them.
Rule:
If incremental revenue is GREATER than incremental cost then; decision: further process.
Note:
Joint (pre-separation) costs are incurred regardless of the decision and they are therefore irrelevant to
the further processing decision.
Example 1
The Chemical company produces two joint products, A and B from the same process. Joint processing
costs of $150,000 are incurred up to the split-off point, when 100,000 units of A and 50,000 units of B are
produced. The selling prices at the split-off point are $1.25 per unit for A and $2.00 per unit for B.
The units of A could be processed further to produce 60,000 units of a new chemical, A plus but at an
extra fixed cost of $20,000 and variable cost of 30c per unit of input. The selling price of A plus would be
$3.25 per unit.
Required:
Should the company sell A or A plus?
Make-or-buy Decision
The suggested approach is to compare between the relevant costs of make or buy a component. If it is
cheaper to make, the company should manufacture internally and if it is cheaper to buy then the
company should buy from the external supplier.
Example 2
Shellfish Co makes four components, W, X, Y and Z, for which costs in the forthcoming year are expected
to be as follows:
W X Y Z
Production (units) 1,000 2,000 4,000 3,000
Unit marginal costs ($) 14 17 7 12
Directly attributable fixed costs per annum and $

committed fixed costs:
Incurred as a direct consequence of making W 1,000

Incurred as a direct consequence of making X 5,000

Incurred as a direct consequence of making Y 6,000
Incurred as a direct consequence of making Z 8,000
Other fixed costs (committed) 30,000
Directly attributable fixed costs are all items of cash expenditure that are incurred as a direct
consequence of making the product in-house.
A subcontractor has offered to supply units of W, X, Y and Z for $12, $21, $10 and $14 respectively.
Required:
Should Shellfish make or buy the components?
Make-or-buy: Other Factors to Consider

− Reliability of external supplier: can the outside company be relied upon to meet the requirements
in terms of:
− Quantity required
− Delivering on time
− Price stability
− Specialist skills: the external supplier may possess some specialist skills that are not available in-
house.
− Alternative use of resource: outsourcing will free up resources which may be used in another part
of the business
− Social: will outsourcing result in a reduction of the workforce? Redundancy costs should be
considered
− Legal: will outsourcing affect contractual obligations with suppliers or employees?
− Confidentiality: is there a risk of loss of confidentiality, especially if the external supplier performs
similar work.
− Customer reaction: do customers attach importance to the products being made in-house?
Make-or-buy Decisions With a Limiting Factor

A manufacturing organisation may want to produce items in-house but does not have sufficient capacity
to produce everything that it needs, due to a limiting factor on production.
In this situation, the decision is not whether to make internally or purchase externally. The decision is
about which items to make internally and which to purchase externally. The optimal decision, based on
financial considerations alone, is to arrange internal production and external purchasing in a way that
minimises total costs.
Steps:
1. Calculate the savings per unit of each component by making the product internally.
Savings = Purchases price – VC to make
2. Calculate limiting factor per unit.
3. Calculate the savings per unit of the limiting factor.
4. Rank products.
5. Allocate resources.
6. Any component with unsatisfied demand can be satisfied by buying from the external source.
Example 3
MM manufactures three components, S, A and T, using the same machines for each. The budget for the
next year calls for the production and assembly of 4,000 of each component. The variable production cost
per unit is as follows:

Machine hours per unit Variable cost per unit

S 3 20
A 2 36
T 4 24
Assembly - 20
Only 24,000 hours of machine time will be available during the year, and a subcontractor has quoted the
following unit prices for supplying components:
S-$29; A-$40; T-$34.
Required:
Prepare production plan and purchase plan.
Shut Down Decision

A shutdown decision is whether to close down an operation or stop making and selling a particular
product or service.
Costs and Benefits of Closure
− The lost contribution from the area that is being closed (=relevant cost of closure).
− Penalties and other costs resulting from the closure, e.g., redundancy, compensation to
customers (=relevant cost of closure).
− Reorganisation costs (=relevant cost of closure).
− Savings in specific fixed costs from closure (=relevant benefit of closure)
− Additional contribution from the alternative use for resources released (=relevant benefit of
closure).
Example 4
A company manufactures three products, A, B and C. The present net annual income from these is as
follows:
A B C
$ $ $
Sales 50,000 40,000 60,000
Variable costs 30,000 25,000 35,000
Contribution 20,000 15,000 25,000
Fixed costs 17,000 18,000 20,000
Profit/loss 3,000 (3,000) 5,000
The company is concerned about its poor profit performance, and is considering whether or not to cease
selling B. $5,000 of the fixed costs of product B are direct fixed costs which would be saved if production
ceased. All other fixed costs, it is considered, would remain the same.
Required:
Comment on the shutdown decision.
Timing of Shutdown
An organisation may also need to consider the most appropriate timing for a shutdown. Some costs may
be avoidable in the long run but not in the short run. For example, office space may have been rented
and three months' notice is required to terminate the rental agreement. This cost during the three-month
notice period is therefore unavoidable for the three months.

Other Factors to Consider

− The other product sales might be affected.
− Competitors can take advantage of the situation.
− Shutting down a department can adversely affect the rest of employees.
− Redundancy can lead to legal and reputation issues.
− Over capacity of labour and machine.
− Adverse effect on suppliers causing loss of goodwill.
− Bulk purchase of discount might be lost.
One-off Contract and Minimum Pricing

When a business is presented with a one-off contract, it should apply relevant costing principles to
establish the cash flows associated with the project in order to help set a price.
The minimum contract price = the total net relevant cash flow associated with the contract.
The minimum price is effectively a break-even price, so will give the firm no gain or loss.
− If the contract price does not cover these cash flows then it should be rejected as the company
will have less cash if it accepts the contract.
− Any price higher than the minimum will mean that the company is better-off accepting the
contract than rejecting it.

1. A manufacturing company makes two joint products, CP1 and CP2, in a common process. These
products can be sold at the split-off point in an external market, or processed further in separate
processes to produce products FP1 and FP2. Details of these processes are shown in the diagram.
CP1 Further process FP1

5,500 Kg
Input 10,000 Kg Common process Loss 10% of input
Loss 5% of input Further process

CP2
4,000 Kg Loss of 5% input FP2
CP1 has a market price of $6 per kg and CP2 has a market price of $5 per kg. Relevant further
processing costs are $2 per input kg in the process to make FP1 and $3 per input kg in the process
to make FP2. Both FP1 and FP2 sell for $9 per kg.
For each 10,000 kg input to the common process, how much additional profit is obtained by
further processing each of the joint products instead of selling them at the split-off point?
A. $2,750
B. $4,450
C. $8,750
D. $9,500
2. A company is making product P with the following cost card:

$ $
Selling price 100
Marginal 25
Labour 30
Variable overheads 20
Fixed overhead 10

(85)
Profit 15
Each unit of P takes one hour to make and the available labour and machinery are fully used in its
current production of P. The company is considering making a new product, Q, but would have to
divert labour and machine use from product P.
What is the relevant total cost per hour for labour and variable overheads which should be
included in the cost of product Q?
3. A benefit sacrificed by taking one course of action instead of the most profitable alternative
course of action is known as which of the following?
A. Opportunity cost
B. Incremental cost
C. Relevant cost
D. Sunk cost
4. Which TWO pieces of information are required when deciding, purely on financial grounds,
whether or not process a joint product further?
A. The final sales value of the joint product
B. The further processing cost of the joint product
C. The value of the common process costs
D. The method of apportioning the common costs between the joint products
5. A company makes and sells four products. Direct labour hours are a scarce resource, but the
company is able to sub-contract production of any products to external suppliers. The following
information is relevant:
Product W X Y Z
$ per unit $ per unit $ per unit $ per unit
Sales price 10 8 12 14
Variable cost 8 5 8 12
Cost of external purchase 9 7.1 10 13
Direct labour hours/unit 0.1 0.3 0.25 0.2
Match the products to the order of priority in which the company should make them in-house,
rather than purchase them externally.
Ranking
1st
2nd
3rd
4th
6. A special job for a customer will require 8 tonnes of a Material M. The company no longer uses
this material regularly although it holds 3 tonnes in inventory. These originally cost $44 per
tonne, and could be resold to a supplier for $35 per tonne. Alternatively, these materials could be
used to complete another job instead of using other materials that would cost $126 to purchase.
The current market price of Material M is $50 per tonne. The company must decide whether to
agree to the customer's request for the work, and to set a price.
What would be the relevant cost of Material M for this job?


Process Co
Process Co has two divisions, A and B. Division A produces three types of chemicals: products L, M and S,
using a common process. Each of the products can either be sold by Division A to the external market at
split-off point (after the common process is complete) or can be transferred to Division B for individual
further processing into products LX, MX and SX.
In November 2013, which is a typical month, Division A’s output was as follows:
Product Kg
L 1,200
M 1,400
S 1,800
The market selling prices per kg for the products, both at split-off point and after further processing, are
as follows:
$ $
L 5·60 LX 6·70
M 6·50 MX 7·90
S 6·10 SX 6·80
The specific costs for each of the individual further processes are
$
Variable cost of $0·50 per kg of LX
Variable cost of $0·70 per kg of MX
Variable cost of $0·80 per kg of SX
Further processing leads to a normal loss of 5% at the beginning of the process for each of the products
being processed.
Required:
(a) Calculate and conclude whether any of the products should be further processed in Division B
in order to optimise the profit for the company as a whole.
(10 marks)
(b) It has been suggested that Division A should transfer products L and M to Division B for further
processing, in order to optimise the profit of the company as a whole. Divisions A and B are both
investment centres and all transfers from Division A to Division B would be made using the actual
marginal cost. As a result, if Division A were to make the transfers as suggested, their divisional
profits would be much lower than if it were to sell both products externally at split-off point.
Division B’s profits, however, would be much higher.
Required:
Discuss the issues arising from this suggested approach to transfer pricing.
(5 marks)
Robber Co
Robber Co manufactures control panels for burglar alarms, a very profitable product. Every product
comes with a one-year warranty offering free repairs if any faults arise in this period.
It currently produces and sells 80,000 units per annum, with production of them being restricted by the
short supply of labour. Each control panel includes two main components – one key pad and one display
screen. At present, Robber Co manufactures both of these components in-house. However, the company
is currently considering outsourcing the production of keypads and/or display screens.
A newly established company based in Burgistan is keen to secure a place in the market, and has offered
to supply the keypads for the equivalent of $4·10 per unit and the display screens for the equivalent of
$4·30 per unit. This price has been guaranteed for two years.
The current total annual costs of producing the keypads and the display screens are:

Keypads Display screens

Production 80,000 units 80,000 units
$’000 $’000
Direct materials 160 116
Direct labour 40 60
Heat and power costs 64 88
Machine costs 26 30
Depreciation and insurance costs 84 96
Total annual production costs 374 390
Notes:
1. Materials costs for keypads are expected to increase by 5% in six months’ time; materials costs
for display screens are only expected to increase by 2%, but with immediate effect.
2. Direct labour costs are purely variable and not expected to change over the next year.
3. Heat and power costs include an apportionment of the general factory overhead for heat and
power as well as the costs of heat and power directly used for the production of keypads and
display screens. The general apportionment included is calculated using 50% of the direct labour
cost for each component and would be incurred irrespective of whether the components are
manufactured in-house or not.
4. Machine costs are semi-variable; the variable element relates to set up costs, which are based
upon the number of batches made. The keypads’ machine has fixed costs of $4,000 per annum
and the display screens’ machine has fixed costs of $6,000 per annum. Whilst both components
are currently made in batches of 500, this would need to change, with immediate effect, to
batches of 400.
5. 60% of depreciation and insurance costs relate to an apportionment of the general factory
depreciation and insurance costs; the remaining 40% is specific to the manufacture of keypads
and display screens.
Required:
(a) Advise Robber Co whether it should continue to manufacture the keypads and display screens
in-house or whether it should outsource their manufacture to the supplier in Burgistan,
assuming it continues to adopt a policy to limit manufacture and sales to 80,000 control panels
in the coming year.
(8 marks)
(b) Robber Co takes 0·5 labour hours to produce a keypad and 0·75 labour hours to produce a display
screen. Labour hours are restricted to 100,000 hours and labour is paid at $1 per hour. Robber Co
wishes to increase its supply to 100,000 control panels (i.e., 100,000 each of keypads and display
screens).
Advise Robber Co as to how many units of keypads and display panels they should either
manufacture and/or outsource in order to minimise their costs.
(7 marks)
(c) Discuss the non-financial factors that Robber Co should consider when making a decision about
outsourcing the manufacture of keypads and display screens.
(5 marks)
(20 marks)
Hi Life Co (HL Co)

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:

Note $
Direct materials:
Fabric 200 m2 at $17 per m2 1 3,400
Wood 50 m at $8·20 per m2 2 410
Direct labour:
Skilled 200 hours at $16 per hour 3 3,200
Semi-skilled 300 hours at $12 per hour 4 3,600
Factory Overheads 500 hours at $3 per hour 5 1,500
Total production cost 12,110
Administration overheads at 10% of total production cost 61,211
Total cost 13,321
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 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 cost. 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.
Required:
Prepare, on a relevant cost basis, the lowest cost estimate which could be used as the basis for the
quotation. Explain briefly your reasons for including or excluding each of the costs in your estimate.
(10 marks)

Performance Management Dealing with Risk and Uncertainty in Decision-making 60
Dealing with Risk and Uncertainty in Decision-making

Risk and Uncertainty
Risk:
− there are a number of possible outcomes and the probability of each outcome is known.
Uncertainty:
− there are a number of possible outcomes but the probability of each outcome is not known.
Methods to Reduce Uncertainty

− Questionnaires and interviews – potential customers could be asked questions in details about
their likely future buying requirements and needs.
− Test marketing – prototype products are tried in small markets.
− Focus groups – a group of individuals who may meet to discuss the attributes and features of a
new product.
Attitudes Towards Risk

1. Risk Seeker
A risk seeker is a decision- maker who is interested in the best outcomes, no matter how small
the chance that at they may occur. Focuses on maximum profit and ignore other factors.
2. Risk Neutral
A decision-maker is risk neutral if they are prepared to make a decision that balances risk and
return. They are willing take on more risk, but only if the expected profit or return is higher.
They will also accept lower return for lower risk.
3. Risk-Averse
A risk-averse decision-maker acts on the assumption that the worst outcome might occur and
will make a decision that limits or minimizes the risk.
Pay-off Tables
A profit table (pay-off table) can be a useful way to represent and analyse a scenario where there is a
range of possible outcomes and a variety of possible responses. Pay-off tables identify and record all
possible outcomes in situations where there are two or more decision options and the outcome from
each decision depends on the eventual circumstances.
It has 2 variables:
1. Options (decision choices)
2. Outcomes
Example 1
A Company is trying to set the sales price for one of its products. Three prices are under consideration,
and expected sales volumes and costs are as follows:
Pricing choices Sales demand (units)
$4 Best possible 16,000
Most likely 14,000
Worst possible 10,000

$4.30 Best possible 14,000

Most likely 12,500
$4.40 Best possible 12,500

Most likely 12,000
Variable costs are $2 per unit.
Required:
Prepare a pay-off table for the different possible outcomes for each decision option.
Decision Making Techniques

1. Maximax
The Maximax criterion looks at the best possible results. Maximax means 'maximize the
maximum profit'.
The decision with this rule is to choose the option that could provide the maximum possible
profit. This criterion is based upon a risk-seeking approach.
2. Maximin
This would mean choosing the alternative that maximises the minimum profits.
This approach would be appropriate for a risk-averse who seeks to achieve the best results
if the worst happens.
3. Expected Values
An expected value is a weighted average value of the different possible outcomes from a
decision.
Expected values indicate what an outcome is likely to be in the long term, if the decision can be
repeated many times over.
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.
The formula for the expected value is EV = Σpx
The expected value (EV) decision rule is that the decision option with the highest EV of benefit
or the lowest EV of cost should be selected.
Example 2
Option A Option B
Probability Profit Probability Profit
$ $
0.8 5,000 0.1 (2,000)
0.2 6,000 0.2 5,000
0.6 7,000
0.1 8,000
Required:
Calculate expected value of these two options.

Limitations of Expected Values

− An expected value is a weighted average outcome that will occur in the long run if events occur
many times over. It is a long-run average.
− The expected value of a decision may be a value that will never occur.
− Because an EV is an average value, it ignores the extreme outcomes.
− The probabilities used are usually very subjective.
4. Minimax Regret
− The minimax regret rule aims to minimize the regret from making the wrong decision. Regret is
the opportunity lost through making the wrong decision.
− It is useful for a risk-averse decision maker.
Decision Trees
A decision tree is a diagrammatic representation of a problem and on it we show all possible courses of
action and all possible outcomes for each possible course of action. It is particularly useful where there
are a series of decisions to be made and several outcomes arising at each stage of the decision-making
process.
There are two stages to making decisions using decision trees:
1. The first stage is the construction stage, where the decision tree is drawn from left to right and
all of the probabilities and financial outcome values are put on the tree.
A square is used to represent a decision point (i.e., where a choice between different
courses of action must be taken).
A circle is used to represent an outcome point. The branches coming away from a circle
will be different outcomes and have probabilities attached to them.
Label the tree and relevant cash inflows/outflows and probabilities associated with outcomes.
2. The second stage is Rollback analysis. It is the evaluation and recommendation stage.
Evaluate the tree from right to left carrying out these two actions:
(a) Calculate an EV at each outcome point.
(b) Choose the best option at each decision point.
Finally, a course of action is recommended for management.
Example 3
Beethoven Co has a new wonder product, the violin, of which it expects great things. At the moment
the company has two courses of action open to it, to test market the product or abandon it. If the
company test markets it, the cost will be $100,000 and the market response could be positive or
negative with probabilities of 0.60 and 0.40.
If it markets the violin full scale, the outcome might be low, medium or high demand, and the
respective net gains(losses) would be ($200,000), $200,000 or $1,000,000. These outcomes have
probabilities of 0.20, 0.50 and 0.30 respectively.
If the result of the test marketing is negative and the company goes ahead and markets the product,
estimated losses would be $600,000.
If, at any point, the company abandons the product, there would be a net gain of $50,000 from the sale
of scrap.
All the financial values have been discounted to the present.
Required:
Draw a decision tree.

The Value of Perfect and Imperfect Information

The value of information is the difference between the expected value of profit with information
and the expected value of profit without information.
− Perfect information is said to be available when a 100% accurate prediction can be made
about the future.
− Imperfect information is not 100% accurate but provides more knowledge than no information.
The value of information (either perfect or imperfect):
Expected value WITH the information – Expected value WITHOUT the information
Example 4: The value of perfect information

The management of Ivor Ore must choose whether to go ahead with either of two mutually exclusive
projects A and B. The expected profits are as follows:
Demand Probability Profit
Project A Project B
Strong 0.2 $4,000 $1,500
Moderate 0.3 $1,200 $1,000
Weak 0.5 ($1,000) $500
Required:
Calculate the value of perfect information about demand.
Example 5: The value of imperfect information

Suppose that a company want to make a decision between two mutually exclusive options, Option A
and Option B.
The profits from each option will depend on the state of the economy in the next 12 months. Current
estimates are that there is a 60% probability that the economy will be weak and a 40% probability that
the economy will be strong.
The profitability with each decision option would be as follows:
Demand Probability Profit
Project A Project B
Weak 0.6 $50,000 $20,000
Strong 0.4 $60,000 $100,000
Research could be carried out into the state of the economy in the next 12 months. It has been
estimated that if the true state of the economy will be weak, there is an 80% probability that the
research would predict this correctly.
It is also estimated that if the true state of the economy will be strong, there is a 90% probability that
the research would predict this correctly.
Required:
What is the value of this imperfect information?
Sensitivity Analysis
Sensitivity analysis is a method of analysing the uncertainty in a situation or decision.
Sensitivity analysis takes each uncertain factor in turn, and calculates the change that would be
necessary in that factor before the original decision is reversed. Typically, it involves posing 'what-if'
questions.
By using this technique, it is possible to establish which estimates (variables) are more critical than
others in affecting a decision.

Example 6
Company has estimated the following sales and profits for a new product which it may launch on to the
market.
Sales (2,000 units) $4,000

Variable costs:
Material $2,000
Labour $1,000
Contribution $1,000
Less incremental fixed costs ($800)
Profit $200
Required:
Analyse the sensitivity of the project to changes in key variables.
Simulation Models
Simulation models can be used to deal with decision problems when there are a large number of
uncertain variables in the situation. Random numbers are used to assign values to the variables.

1. A decision tree is a way of representing decision choices in the form of a diagram. It is usual for
decision trees to include probabilities of different outcomes.
The following statements have been made about decision trees:
(1) Each possible outcome from a decision is given an expected value.
(2) Each possible outcome is shown as a branch on a decision tree.
A. 1 only
B. 2 only
C. Neither 1 or 2
D. Both 1 and 2
2. Analysing the range of different possible outcomes from a particular situation, with a computer
model that uses random numbers, is known as which of the following?
A. Probability analysis
B. Sensitivity analysis
C. Simulation modelling
D. Stress testing
3. What method of uncertainty or risk analysis is also called 'What if?' analysis?
A. Decision tree analysis
B. Sensitivity analysis
C. Simulation modelling
D. Stress testing
4. A company wishes to go ahead with one of three mutually exclusive projects, but the profit
outcome from each project will depend on the strength of sales demand, as follows:
Profit/loss ($)
Strong demand Moderate demand Weak demand
Project 1 70,000 10,000 (7,000)
Project 2 25,000 12,000 5,000

Project 3 50,000 20,000 (6,000)

Probability of demand 0.1 0.4 0.5
What is the value to the company of obtaining this perfect market research information,
ignoring the cost of obtaining the information?
A. $3,000
B. $5,500
C. $6,000
D. $7,500
5. A company wishes to decide on a selling price for a new product. Weekly sales of each product
will depend on the price charged and also on customers' response to the new product. The
following pay-off table has been prepared.
Probability Price P1 Price P2 Price P3 Price P4
$ $ $ $
Price 5.00 5.50 6.00 6.50
Unit contribution 3.00 3.50 4.00 4.50
Weekly demand Units Units Units Units
Best possible 0.3 10,000 9,000 8,000 7,000
Most likely 0.5 8,000 7,500 7,000 6,000
Worst possible 0.2 6,000 5,000 4,000 3,000
If the choice of selling price is based on a maximin decision rule, which price
would be selected?
6. A company wishes to decide on a selling price for a new product. Weekly sales of each product
will depend on the price charged and also on customers' response to the new product. The
following pay-off table has been prepared.
Probability Price P1 Price P2 Price P3 Price P4
$ $ $ $
Price 5.00 5.50 6.00 6.50
Unit contribution 3.00 3.50 4.00 4.50
Weekly demand Units Units Units Units
Best possible 0.3 10,000 9,000 8,000 7,000
Most likely 0.5 8,000 7,500 7,000 6,000
Worst possible 0.2 6,000 5,000 4,000 3,000
If the choice of selling price is based on a minimax regret decision rule, which price
would be selected?

Cement Co
Cement Co is a company specialising in the manufacture of cement, a product used in the building
industry. The company has found that when weather conditions are good, the demand for cement
increases since more building work is able to take place. Last year, the weather was so good, and the
demand for cement was so great, that Cement co was unable to meet demand. Cement Co is now
trying to work out the level of cement production for the coming year in order to maximise profits. The
company doesn’t want to miss out on the opportunity to earn large profit by running out of cement
again. However, it doesn’t want to be left with large quantities of the product unsold at the end of the
year, since it deteriorates quickly and then has to be disposed of.
The company has received the following estimates about the probable weather conditions and
corresponding demand levels for the coming year:

Weather Probability Demand

Good 25% 350,000 bags
Average 45% 280,000 bags
Poor 30% 200,000 bags
Each bag of cement sells for $9 and costs $4 to make. If cement is unsold at the end of the year, it has
to be disposed of at a cost of $0·50 per bag.
Cement Co has decided to produce at one of the three levels of production to match forecast demand.
It now has to decide which level of cement production to select.
Required:
a. Construct a pay-off table to show all the possible profit outcomes.
(8 marks)
b. Decide the level of cement production the company should choose, based on the following
decision rules:
(i) Maximin
(1 mark)
(ii) Maximax
(1 mark)
(iii) Expected value
(4 marks)
You must justify your decision under each rule, showing all necessary calculations.
c. Describe the ‘maximin’ and ‘expected value’ decision rules, explaining when they might be
used and the attitudes of the decision makers who might use them.
(6 marks)
(20 marks)

Performance Management Budgetary Systems and Types of Budgets 67
Budgetary Systems and Types of Budgets

Budget
A budget is a quantified plan of action for a forthcoming accounting period.
Objectives of Budgeting
− Ensure the achievement of the organisation’s objectives
− Helps in planning
− Co-ordinate activities
− Provides a system of control
− Authorising and delegating
− Evaluation of performance (provide a framework for responsibility accounting)
− Communicating of ideas and plans
− Motivate employees to improve their performance (budgets are targets)
The Planning and Control Cycle
Identify objectives Step 1
Identify alternative course of action

(strategies) which might contribute Step 2
towards achieving the objectives
Evaluate each
Evaluate each strategy
strategy Step 3
Planning process Choose alternative course of action Step 4
Implement
Implementthe the
long-term planplan
long-term in the Step 5
inform of the
the form ofannual budget
the annual budget
Measure actual
Measure results
actual andand
results compare
compare Step 6
with
withthethe
plan
plan
Control process
Respond to divergences
Respond fromfrom
to divergences planplan Step 7
deviations

Feedback Control
Feedback is information produced as output from operations; it is used to compare actual results with
planned results for control purposes.
1. Negative feedback: Indicates that results or activities must be brought back on course, as they are
deviating from the plan.
2. Positive feedback: Means that results are going according to the plan and that no corrective
action is necessary.
3. Feedforward control: Control based on forecast results: in other words, if the forecast is bad,
control action is taken well in advance of actual results.
There are two types of feedback controls:
1. Single Loop Feedback Control: The plan/target itself is not changed even though the resources
needed to achieve might have to be reviewed.
2. Double Loop Feedback Control: Information used to change the plan/target itself (revision of
budgets).
Budget Preparation Methods (Based on Participation)

Top-Down Approach
A non-participatory approach to budgeting is where junior management do not participate in the
budgeting process. Senior management prepares the budget and distributes the final budget to the
relevant departments. This will usually only be appropriate in smaller organisations or if junior
management lack the skill to prepare budgets.
Bottom-Up Approach
A participatory approach to management is where junior management prepare the budget for their area
of responsibility and submit to senior management for approval.
Note: Top-down budgeting takes much less time and planning effort than bottom-up budgeting and
senior management can use top-down budgets to impose their views. Bottom-up budgeting is much
more time consuming and draft budgets may have to be revised many times until they are properly co-
ordinated.
Types of Budgeting Techniques

Incremental Budgeting
Incremental budgeting is the traditional budgeting method whereby the budget is prepared by taking the
current period's budget or actual performance as a base, with incremental amounts then being added for
the new budget period. These incremental amounts will include adjustments for things such as inflation,
sales growth or decline or planned increases in sales prices and costs.
− Suitable for organisations that operate in a stable environment.
− Incremental budgeting encourages slack and wasteful spending.
Zero Based Budgeting
− With Zero-Based budgeting, the budgeting process starts from a base of zero, with no reference
being made to the prior period's budget or actual performance. All of the budget headings start
with a balance zero.
− Zero-Based Budgeting tries to achieve an optimal allocation of resources to the parts of the
business where they are most needed. It does this by forcing managers to justify every in their
department, until do this, the budget for their department is zero.

It is suitable for:
− Allocating resources in areas were spend is discretionary, i.e., non-essential. For example,
research and development, advertising and training.
− Public sector organisations such as local authorities.
Stages in Zero-Based Budgeting
1. Activities are identified by managers. Managers are then forced to consider different ways of
performing the activities. These activities are called a 'decision package’
There are two types of decision package:
1) Mutually exclusive packages: These are alternative methods of getting the same job
done. The best option among the packages must be selected by comparing costs and
benefits.
2) Incremental packages: These divide an aspect of operations into different levels of
activity
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.
Advantages of Zero-Based Budgeting
− It is possible to identify and remove inefficient or obsolete operations.
− It can increase motivation of staff by promoting a culture of efficiency.
− It responds to changes in the business environment.
Disadvantages of Zero-Based Budgeting
− Short-term benefits might be emphasised to the detriment of long-term benefits.
− Managers may have to be trained in ZBB techniques.
− The ranking process can be difficult.
Activity Based Budgeting
− At its simplest, activity-based budgeting (ABB) is merely the use of activity based costing methods
as a basis for preparing budgets.
− Activity based budgeting differs from traditional budgeting in the way that budgets are prepared
for overhead costs. Overhead costs are budgeted on the basis of activities, rather than on a
departmental basis.
− The advantages of ABB are similar to those provided by activity based costing (ABC).
Rolling Budgets
− Rolling budgets (also called continuous budgets) are budgets which are continuously updated
throughout a financial year, by adding a further period (a month or a quarter) and removing the
corresponding period that has just ended.
− As a result, a number of rolling budgets are prepared each year and each rolling budget covers
the next 12-month period.
Example 1
A company uses a system of rolling budgets. The sales budget is displayed below.
Jan – Mar Apr – Jun Jul – Sep Oct – Dec Total
Sales $78,480 $86,120 $91,800 $97,462 $353,862
Actual sales for January – March were $74,640
The adverse variance is explained by growth being lower than anticipated and the market being more
competitive than predicted. Senior management has proposed that the revised assumption for sales
growth should be 2.5% per quarter.

Required:
Update the budget as appropriate.
Advantages of Rolling Budgets
− They reduce the element of uncertainty in budgeting.
− They force managers to reassess the budget regularly, and to produce budgets which are up to
date.
− Realistic budgets are likely to have a better motivational influence on managers.
− There is always a budget which extends for several months ahead.
Disadvantages of Rolling Budgets
− They involve more time, effort and money in budget preparation.
− Frequent budgeting might have an off-putting effect on managers who doubt the value of
preparing one budget after another at regular intervals.
− The benefits of rolling budgets are limited and therefore not worth the extra cost when the rate
of change in the business environment is not rapid and continual.
Continuous Budgets (or Updated Annual Budgets)
If the expected changes are not likely to be continuous then the routine updating of the budget is
unnecessary. An updated annual budget, prepared in response to a significant change in circumstances,
may simply be called a revised budget.
Beyond Budgeting
− Beyond Budgeting is a budgeting model which proposes that traditional budgeting should be
abandoned. Adaptive management processes should be used rather than fixed annual budgets.
Traditional annual plans tie managers to predetermined actions which are not responsive to
current situations.
− Performance is monitored against world-class benchmarks and competitors.
Benefits
− Motivation: Rewards are team based which encourages cooperation and helps achieve corporate
goals.
− Faster response to threats and opportunities.
− Shift of focus: The use of external benchmarks can lead to management focus on competitive
success.
Challenges
− Resistance to change
− Resource constraints
Setting the Difficulty Level of a Budget

− Expectations budget: Budget set at current achievable levels. This is unlikely to motivate
managers to improve but may give more accurate forecasts for resource planning, control and
performance evaluation.
− Aspirations budget: Budget set at a level which exceeds the level currently achieved. This may
motivate managers to improve if it seen as attainable but may also result in an adverse variance if
it is too difficult to achieve.
Changing Budgetary Systems

An organisation which decides to change its type of budget used, or budgetary system, will face a number
of difficulties.
− Resistance by employees

− Costs of implementation
− Training
− Lack of accounting information
− Management time
Budget Systems and Uncertainty

Causes of uncertainty in the budgeting process include:
− Customers
− Inflation
− Competitors
− Employees
− Unrest or disaster
− Machine breakdown
− Technological advances
− Materials
Information for Budgeting

− Previous year’s actual results
− Internal sources such as manager’s knowledge concerning state of repair of fixed assets, training
needs of staff
− Estimates of costs of new products
− Statistical techniques may help to forecast sales
− Models, such as the EOQ model
− External sources of information may include suppliers' price lists and estimates of inflation

1. Are the following statements about Zero-Based Budgeting true or false?
Employees will focus on eliminating wasteful expenditure TRUE FALSE
Short-term benefits could be emphasized overlong-term benefits TRUE FALSE
2. A co-operates in export and import markets, and its operational cash flows are affected by
movements in exchange rates, which are highly volatile. As a result, the company has great
difficulty in establishing a budgeting system that is reliable for more than three months ahead.
Which of the following approaches to budgeting would be most appropriate for this company’s
situation?
A. Flexible budget
B. Incremental budget
C. Rolling budget
D. Zero based budget
3. A budget that is continuously updated by adding a further accounting period (a month or quarter)
when the earlier accounting period has expired is known as which of the following?
A. Flexible budget
B. Periodic budget
C. Rolling budget
D. Zero based budget

4. Which of the following best describes a top-down budget?

A. A budget which has been set by scaling down individual expenditure items until the total
budgeted expenditure can be met from available resources.
B. A budget which is set by delegating authority from top management, allowing budget
holders to participate in setting their own budgets.
C. A budget which is set without permitting the ultimate budget holder to participate in the
budgeting process.
D. A budget which is set within the framework of strategic plans determined by top
management.

Performance Management Quantitative Analysis in Budgeting 73
Quantitative Analysis in Budgeting

Quantitative Analysis
High/Low analysis Learning curve model
High/Low Method
− High low method is used to determine fixed and variable elements of mixed (semi variable) cost.
− It can also be used for estimating the total cost for a particular activity level.
− It relies on the assumption that mixed costs are linear.
Total Cost Function

Total cost is a type of mixed cost.
Total cost = Fixed cost + Variable cost/unit * Units
TC = FC + VC/U * U
This is in the form of y = a + bx
− Y is the dependent variable that is the total cost for the period at the activity level of x
− X is the independent variable that is the activity level
− a is the constant that is the total fixed cost for the period
− b is also a constant that is the variable cost per unit of activity
Steps:
1. Identify two different levels of activities: the highest and the lowest level of activities and the
corresponding costs.
2. Find the variable cost per unit.
3. Compare the variable cost with the total costs at either the lowest activity level or highest
activity level to compute the total fixed cost.
4. Calculate total cost.
Example 1
Company has recorded the following total costs during the last five years.
Year Output volume (units) Total cost ($)
20X0 65,000 145,000
20X1 80,000 162,000
20X2 90,000 170,000
20X3 60,000 140,000
20X4 75,000 160,000
Required:
Calculate the total cost that should be expected in 20X5 if output is 85,000 units.
High Low Method – with Stepped Fixed Costs

Example 2
The following data relate to the total cost at two activity levels:
Units produced Total cost
12,750 $73,950
15,100 $83,585
When more than 14,000 units are produced there will be a step up in fixed cost of $4,700

Required:
Calculate the estimated total cost for 14,500 units.
Learning Curves
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. As the process is repeated 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.
Average time per unit
LC
x
Cumulative volume of production
Application of Learning Curve Theory

Labour time should be expected to get shorter, with experience, in the production of items which exhibit
any or all of the following:
− When product is made largely by labour effort.
− It is necessary for the process to be a repetitive one.
− There needs to be a continuity of workers and they mustn’t be taking prolonged breaks during
the production process.
− Brand new product.
− Short life products (will have more effect of learning curve).
− Complex products made in small quantities for special orders.
− Applied on homogenous products.
The Learning Rate

Where a learning curve applies, there is a learning rate. The learning rate is expressed as a percentage
value, such as an 80% learning curve or a 70% learning curve.
Learning Curve – Methods

1. Tabular approach
2. Algebraic approach

Tabular Approach
The tabular approach is quicker and easier when it can be used, but it can be used only for a limited type
of problem. The tabular approach can only be used to calculate average times when cumulative output
doubles. The specific learning curve effect is that the cumulative average time per unit decreased by a
fixed percentage each time cumulative output doubled.
Example 3
Time to make first unit = 50 hours
Learning rate = 90%
Cumulative Cumulative Total time Incremental total Average Hours/unit
output (units) average (hours) time
time/unit
1 50 50
2 45 90 40 40(40/1)
4 40.50 162 72 36(72/2)
8 36.45 291.6 129.6 32.4(129.6/4)
Time taken for the first unit = 50 hours
Cumulative average time per unit for the first 2 units = 45 hours
Total time for the first 2 units = 90 hours
Time taken for the 2nd unit = 40 hours
Time required to produce 2nd unit = Total time for 2 units – Total time for 1 unit
So, time required to produce 3rd unit is = Total time for 3 units – Total time for 2 units
Total time for 3 units = Cumulative average time per unit for 3 units * 3
Example 4
Company has designed a new type of sailing boat, for which the cost of the first boat to be produced has
been estimated as follows:
$
Materials 5,000
Labour (800 hrs * $5 per hr) 4,000
Overhead (150% of labour cost) 6,000
Total cost 15,000
Profit mark-up (20%) 3,000
Sales Price 18,000
It is planned to sell all the units at full cost plus 20%. An 80% learning curve is expected to apply to the
production work. The management accountant has been asked to provide cost information so that
decisions can be made on what price to charge.
Required:
1. What is the selling price of second unit?
2. What would be the total cost for the first 4 units?
Derivation of the Learning Rate

Example 5
BL is planning to manufacture a new product, product A. The labour hours for the first unit are estimated
to be 720, while the total labour hours for producing first four units will be 1620.
Required:
Calculate the rate of learning.

Algebraic Approach
Y = ax^b
Where,
Y = Cumulative average time per unit to produce x units
a = The time taken for the first unit of output
x = The cumulative number of units produced
b = The index of learning (log LR/log2)
LR = The learning rate as a decimal
Example 6
Suppose that an 80% learning curve applies to production of a new product item ABC. The time to make
the very first unit of ABC was 120 hours. The labour cost is $10 per hour.
Required:
Calculate the time required to make the 31st unit.
Cessation of Learning
As long as a learning curve effect applies, the time taken to produce each additional unit is less than the
time for the previous unit.
A time will be reached when the learning effect no longer applies and steady state of production will
reach for a product. When a steady state point is reached a standard time and labour cost for the
product can be established.
For example, if learning ceases at 30 units, the time it takes to make 30th unit will be time required to
make rest of the units.
Limitations of Learning Curve

− It is only applicable in labour intensive operations which are repetitive and reasonably skilled.
− It assumes that employees are motivated to learn.
− It assumes that there is a stable labour mix with a negligible turnover.
− Difficulty in determining the learning curve effect accurately.
− Difficulty in determining the level of production where the curve will be flat and no further
learning takes place.
− Breaks between production runs must be short or learning will be forgotten.

1. Tech World is a company which manufactures mobile phone handsets. From its past experience,
Tech World has realised that whenever a new design engineer is employed, there is a learning
curve with a 75% learning rate which exists for the first 15 jobs. A new design engineer has just
completed their first job in five hours.
Note: At the learning rate of 75%, the learning factor (b) is equal to – 0.415.
How long would it take the design engineer to compete the sixth job?
A. 2.377 hours
B. 1.442 hours
C. 2.564 hours
D. 5 hours
2. The first item of a new product took 2,000 hours to manufacture (at a labour cost of $15 per
hour). A 90% learning curve was expected to apply, and it was decided to establish a standard

time as the time required to manufacture the 50th item of the product, rounded to the nearest
hour. The 50th item actually took 980 hours.
Select value to indicate the labour efficiency variance for the 50th unit produced and whether it is
favourable or adverse.
Value ($) Sign
A. 645 Favourable
B. 43 Adverse
C. 1,860
D. 1,905

Big Cheese Chair
Big Cheese Chairs (BCC) manufactures and sells executive leather chairs. They are considering a new
design of massaging chair to launch into the competitive market in which they operate.
They have carried out an investigation in the market and using a target costing system have targeted a
competitive selling price of $120 for the chair. BCC wants a margin on selling price of 20% (ignoring any
overheads).
The frame and massage mechanism will be bought in for $51 per chair and BCC will upholster it in leather
and assemble it ready for despatch. Leather costs $10 per metre and two metres are needed for a
complete chair although 20% of all leather is wasted in the upholstery process. The upholstery and
assembly process will be subject to a learning effect as the workers get used to the new design.
BCC estimates that the first chair will take two hours to prepare but this will be subject to a learning rate
(LR) of 95%. The learning improvement will stop once 128 chairs have been made and the time for the
128th chair will be the time for all subsequent chairs. The cost of labour is $15 per hour.
The learning formula is shown on the formula sheet and at the 95% learning rate the value of b is –
0·074000581.
Required:
a. Calculate the average cost for the first 128 chairs made and identify any cost gap that may be
present at that stage.
(8 marks)
b. Assuming that a cost gap for the chair exists suggest four ways in which it could be closed.
(6 marks)
The production manager denies any claims that a cost gap exists and has stated that the cost of
the 128th chair will be low enough to yield the required margin.
c. Calculate the cost of the 128th chair made and state whether the target cost is being achieved
on the 128th chair.
(6 marks)
(20 marks)

Performance Management Standard Costing 78
Standard Costing
Standard costing is a system based on pre-determined costs and revenue per unit which are used to
compare actual performance and therefore provide useful feedback information to management.
Standard Cost
A standard cost is an estimated/budgeted unit cost.
Deriving Standards
The responsibility for deriving standards costs should be shared between managers who provide the
necessary information about levels of expected efficiency, prices and overheads costs.
Allowance for idle time/wastage should be built in to standards.
Types of Standards
Ideal Standard
− Standard which is based on perfect operating conditions. Ex: 100% efficiency.
− Could form the basis for long-term aims.
− Demotivation for employees.
Attainable Standard
− Based on efficient operating conditions.
− It is motivating for employees.
Current Standard
− Based on current working conditions.
− Current wastage.
− Current inefficiencies.
Basic Standard
− Kept unaltered over long period of time.
− May be out of date.
− Least useful and least common type.
Standard Cost Card

A standard cost card shows full details of the standard cost of each product.
Standard Cost Card under Absorption Costing

Per unit
Material cost 2 Kg @ $3/kg $6
Labour cost 4 Hrs @ $2/hr $8
Variable overhead 4 Hrs @ $3/hr $12
Fixed overhead 4 Hrs @ $5/hr $20
Standard cost per unit $46

Standard profit per unit $14
Standard selling price $60

Performance Management Standard Costing 79
Standard Cost Card under Marginal Costing

Per unit
Material cost 2 Kg @ $3/kg $6
Labour cost 4 Hrs @ $2/hr $8
Variable overhead 4 Hrs @ $3/hr $12
Standard variable cost per unit $26

Standard contribution per unit $34
Standard selling price $60
Uses of Standard Costing

− For performance measurement.
− For budgetary control, reporting deviations from plan (reporting by exception).
− Use in variance analysis.
− Motivating staff by using standards as targets.
− For budget preparation/business planning.
− As a basis for pricing decisions i.e., cost plus pricing.

Performance Management Variance Analysis 80
Variance Analysis
The process by which the total difference between standard and actual results is analysed is known as
variance analysis.
Variance is the difference between an actual amount and a budgeted, planned or past amount.
Variance ($)
Favourable (F) Adverse (A)

actual results are better actual results are worse
t than expected results than expected results
Forms of Variance
− Sales volume
− Selling price
− Direct material cost
− Direct labour cost
− Variable overhead
− Fixed overhead
Example 1
Budget Actual Difference (variance)
Units 2,000 1,000
Profit per unit $5 per unit $4 per unit
Total profit $10,000 $4,000
Required:
Calculate variances.
Material Variances
Direct Material Cost Variance
The materials total variance is the difference between the actual cost of direct material and the standard
material cost of actual production (flexed budget).
Material cost total variance includes:
− Material price variance
− Material usage variance

Material cost total

variance
SQ * SP - AQ*AP
Material price variance Material usage variance

(SP - AP) * AQ (SQ - AQ) * SP
SP *AQ - AP * AQ SQ * SP - AQ * SP
Where,
SQ – Standard quantity for actual production (Expected material usage for actual units)
SQ = Actual production units * Standard material usage per unit
SP – Standard price per unit of material (Standard price/kg)
AQ – Actual quantity used for production (Actual material kg used)
AP – Actual price per unit of material (Actual price/kg)
AQ*AP = Actual total material cost
Note:
If material purchase quantity and used quantity is different then; material price variance calculated by
using
− Purchase quantity: If closing stock valued at standard cost
− Use quantity: If closing stock valued at actual cost like (FIFO, LIFO, AVCO)
Example 2
Product X has a standard direct material cost as follows:
10 kilograms of material at $5 per kilogram = $50 per unit
During a period 1000 units of X were manufactured, using 11,700 kilograms of material Y which cost
$48,600
Required:
Calculate the following variances.
a) The direct material total variance
b) The direct material price variance
c) The direct material usage variance
Example 3
A company manufactures a single product L, for which the standard material cost is as follows:
$ per unit
Material 14 kg @ $3 42
During July, 800 units of L were manufactured, 12,000 kg of material were purchased for $33,600 of
which 11,500 kg were issued to production.
SM Co values all inventory at standard cost.
Required:
What are the material price and usage variances for July?
Direct Labour Cost Variance

The labour cost total variance is the difference between the actual direct labour cost and the standard
labour cost of the actual production (flexed budget).

labour cost total variances

SH * SR - AH * AR
Labour Rate Variance Labour Efficiency Variance

(SR - AR) * AH (SH - AH) * SR
SR * AH - AR * AH SH * SR - AH * SR
Where,
SH – Standard hours for actual production (Expected hours for actual units)
SH = Actual production units * standard labour hours per unit
SR – Standard rate per hour
AH – Actual hours
AR – Actual rate per hour
AH*AR – Actual total labour cost
In case of idle time;
Labour Rate Variance – Calculate by using total hours
Labour Efficiency Variance – Calculate by using productive hours
Idle Time Variance – Calculate by using non-productive hours
Example 4
The standard direct labour cost of product X is as follows:
2 hours of labour at $5 per hour = $10 per unit of product X
During the period, 1,000 units of product X were made, and the direct labour cost of labour was $8,900
for 2,300 hours of work.
Required:
a) The direct labour total variance
b) The direct labour rate variance
c) The direct labour efficiency (productivity) variance
Example 5
A company expected to produce 200 units of its product in 20X3. In fact, 260 units were produced.
The standard labour cost per unit was $70 (10 hours at a rate of $7 per hour). The actual labour cost was
$18,600 and the labour force worked 2,200 hours although they were paid for 2,300 hours.
Required:
a) What is the direct labour rate variance for the company in 20X3?
b) What is the direct labour efficiency variance for the company in 20X3?
Sales Variance
Sales variance is the difference between actual sales and budget sales.
Sales Variance = Actual sales revenue – Budgeted sales revenue

1. Sales Price Variance

Sales price variance is the measure of change in sales revenue as a result of variance between actual and
standard selling price.
Sales Price Variance = (AP – SP) AU
2. Sales Volume Profit Variance
Sales volume profit variance is the measure of change in profit as a result of the difference between
actual and budgeted sales quantity.
Sales Volume Profit Variance = (AU – BU) Standard Profit/Unit
Where,
AP – Actual Selling Price per unit
SP – Standard (Budgeted) Selling Price per unit
AU – Actual sales units
BU – Budgeted sales units
AU * AP – Actual total sales revenue
Example 6
Suppose that a company budgets to sell 8,000 units of product J for $12 per unit. The standard full cost
per unit is $7. Actual sales were 7,700 units, at $12.50 per unit.
Required:
Calculate sales price and sales volume variances.
Variable Overhead Variance

This is the difference between standard variable overheads for actual production and the actual variable
overheads.
Variable Overhead Cost Total Variances

SH * SR - AH * AR
VOH Expenditure Variance VOH Efficiency Variance

(SR - AR) * AH (SH - AH) * SR
SR * AH - AR * AH SH * SR - AH * SR
Where,
SH – Standard hours for actual production
SH = Actual production units * Standard hours per unit
SR – Standard variable overhead rate per hour
AH – Actual hours (Actual operating hours)
AR – Actual variable overhead rate per hour
AH * AR – Actual variable overhead cost
Example 7
The standard variable overhead cost of product X is as follows:
2 hours at $5 per hour = $10 per unit of product X
During the period, 1,000 units of product X were made, and the total variable overhead cost was $8,900
for 2,300 hours of work.

Required:
a) Variable overhead total variance
b) Variable overhead expenditure variance
c) Variable overhead efficiency variance
Example 8
Suppose that the variable production overhead cost of product X is as follows:
2 hours at $1.50 = $3 per unit
During period 6, 1,000 units of product X were made. The labour force worked 2,020 hours, of which 60
hours were recorded as idle time. The variable overhead cost was $3,075.
Required:
a) The variable overhead total variance
b) The variable production overhead expenditure variance
c) The variable production overhead efficiency variance
Fixed Overhead Variance

Fixed overhead total variance is the difference between absorbed fixed production overheads and actual
fixed production overheads (under or over absorbed overhead).
Fixed Overhead Cost Total Variance

Absorbed Fixed OH - Actual Fixed OH
FOH Volume Variance

FOH Expenditure Variance Absorbed FOH-Budgeted FOH
Budgeted FOH - Actual FOH (Actual units - Budgeted units) * OAR
per unit
FOH Volume Variance

Absorbed FOH - Budgeted FOH
FOH Capacity Variance FOH Efficiency Variance

(Actual Hrs - Budgeted Hrs) * OAR per Hr (Standard Hrs - Actual hours) * OAR per hour
(AH - BH) * OAR (SH - AH) * OAR

Example 9
Suppose that a company plans to produce 1,000 units of product E during August 20X3. The expected
time to produce a unit of E is five hours, and the budgeted fixed overhead is $20,000. The standard fixed
overhead cost per unit of product E will therefore be as follows:
5 hours at $4 per hour = $20 per unit
Actual fixed overhead expenditure in August 20X3 turns out to be $20,450. The labour force manage to
produce 1,100 units of product E in 5,400 hours of work.
Required:
(a) The fixed overhead total variance
(b) The fixed overhead expenditure variance
(c) The fixed overhead volume variance
(d) The fixed overhead volume efficiency variance
(e) The fixed overhead volume capacity variance
Fixed Overhead Variances under Marginal and Absorption Costing

System
Marginal Costing System
− No overheads are absorbed, the amount spent is simply written off to the income statements.
− Fixed overhead variance is the difference between what was budgeted to be spent and what was
actually spent.
− There is only fixed overhead expenditure variance.
Absorption Costing System
− It uses an absorption rate to absorb overheads.
− We calculate fixed overhead expenditure variance and the fixed overhead volume variance.
Fixed OH volume variance = Fixed OH efficiency variance + Fixed OH capacity variance
Operating Statements
Differences between actual results and the budget or standard are reported in monetary terms as
variances, and variances can be used to reconcile budgeted profit and actual profit in an operating
statement.
Operating statement under Absorption Costing

$ $
Budgeted profit x
Sales volume profit variance x
Standard profit from actual sales x
Variances F A
Sales price x (x)
Material price x (x)
Material usage x (x)
Labour rate x (x)
Labour efficiency x (x)
Variable overhead expenditure x (x)
Variable overhead efficiency x (x)
x/(x)

Fixed overhead expenditure x/(x)

Fixed overhead volume x (x)
Actual profit x
Operating statement under Marginal Costing

$
Budgeted contribution x
Sales volume contribution variance x
Standard contribution from actual sales x
Variable cost variances F A
Sales price x (x)

Material price x (x)
Material usage x (x)
Labour rate x (x)
Labour efficiency x (x)
Variable overhead expenditure x (x)
Variable overhead efficiency x (x)
x/(x)
Actual contribution x
Budgeted fixed cost x
Fixed costs expenditure variance x/(x)
Actual profit x
Example 10
A company uses a standard absorption costing system. The following figures are available for the last
accounting period in which budgeted profit was $270,000
$
Sales volume profit variance 15,000 adverse
Sales price variance 12,500 favourable
Total variable cost variance 17,500 adverse
Fixed cost expenditure variance 7,500 favourable
Fixed cost volume variance 5,000 adverse
Required:
What was the actual profit in the last accounting period?
Interdependence Between Variances

Sometimes a variance in one area will be related to a variance in another.
− If Material price variance: Adverse; Usage variance – Favourable
− If Labour rate variance: Adverse; Efficiency variance – Favourable
− If Material price: Adverse; Labour efficiency – Favourable
− If Labour rate variance: Adverse; Usage variance – Favourable
− If Sales price variance: Adverse; Sales volume variance – Favourable

Further Investigation of Variance

Factors to consider:
− Materiality
− Trend
− Controllability
− The type of standard being used
− Interdependence between variances
− Costs of investigation
Further Aspects of Variance Analysis

Application of standard costing (and variance analysis) in the modern environment
Standard costing and variance analysis may be inappropriate in a production environment based on Just
in Time (JIT) methods or a Total Quality Management (TQM).
− Standard product costs apply to manufacturing environments in which quantities of an identical
product are output from production process. They are not suitable for manufacturing
environments where products are non-standard or are customised to customer specifications.
− Another element of the TQM culture is the idea of trying to achieve continuous improvement.
Traditional variance analysis does not really accommodate this.
− Traditional variance analysis focuses on quantity rather than quality. This could mean, for
example, using lower quality material to save money. This would contrary to the TQM and JIT
culture.
Multiple Choice Question

1. The following statements have been made about the application of standard costing systems.
1) Standard costing systems are compatible with a Total Quality Management approach to
operations.
2) Standard costing systems are less commonly used in an industry that operates in a rapidly
changing environment.
A. 1 only
B. 2 only
C. Neither1 or 2
D. Both 1 and 2

Performance Management Material Mix and Yield Variances 88
Material Mix and Yield Variances

Example 1
A company produces and sells a product and the standard cost for one unit being as follows:
$/unit
Direct material A: 10 kilograms at $20 per kg 200
Direct material B: 5 litres at $6 per litre 30
During April the actual results were as follows:
Production 800 units
Material 7,800 kg used, costing $159,900
Material B 4,300 litres used, costing $23,650
Required:
Calculate price and usage variances for each material.
Example 2
The standard cost for one unit of a product is as follows
$/unit
Direct material A: 1 kg at $2 per kg 2
Direct material B: 2 kg at $5 per kg 10
Actual results were as follows:
Production 1 unit
Material A 1.5 kg used
Material B 1.5 kg used
Required:
Calculate material usage variance.
Example 3
The standard cost for one unit of a product is as follows:
$/unit
Direct material A: 1 kg at $2 per kg 2
Direct material B: 2 kg at $5 per kg 10
Actual results were as follows:
Production 1 unit
Material A 2 kg used
Material B 4 kg used
Required:
Calculate material usage variance.
Material Mix and Yield Variances

The materials usage variance can be subdivided into a materials mix variance and a materials yield
variance when more than one material is used in the product and the management is in a position to
control the mix of materials used in a production.
The materials mix variance indicates the cost of a change in the mix of materials and the yield variance
indicates the productivity of manufacturing process.

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.
Favourable mix variance means the actual mix is cheaper 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.
Note
A favourable mix variance may lead to an adverse yield variance because that item is of a lower quality.
Material Usage Variance

(SQ – AQ) * SP
Material Mix Variance Material Yield Variance

(AQ in SM – AQ) * SP (SQ – AQ in SM) * SP
Where,
SQ – Standard quantity for actual production (Expected material usage for actual units)
AQ – Actual quantity used for production (Actual material kg used)
SP – Standard price per unit of material (Standard price/kg)
AQ in SM – Actual quantity in standard mix
Example 4
A company manufactures a chemical using two compounds A and B. The standard materials usage and
cost of one unit are as follows:
$
A: 5 kg at $2 per kg 10
B: 10 kg at $3 per kg 30
40
In a particular period, 80 units were produced from 600 kg of A and 750 kg of B.
Required:
Calculate the materials usage, mix and yield variances.
Alternative Methods of Controlling Production Processes

In a modern manufacturing environment with an emphasis on quality management, using mix and yield
variances for control purposes may not be possible or may be inadequate. Other control methods could
be more useful.
− Rates of wastage
− Percentage of deliveries on time
− Customer satisfaction ratings
− Average cost of input calculations
− Average cost of outputs
− Detailed timesheets
− Average prices achieved for finished products

− Yield percentage calculations or output to input conversion rates
Interpretation of Material Mix and Yield Variances

Mix – a favourable total mix variance would suggest that a higher proportion of a cheaper material is
being used hence reducing the overall average cost per unit.
Yield – an adverse total yield variance would suggest that less output has been achieved for a given
input, i.e., that the total input in volume is more than expected for the output achieved.
Changing the Mix – the Wider Issues

It can impact on:
− Cost
− Quality
− Performance measurement

1. The following information is given about standard and actual material costs during one month
for a production process:
Material Standard cost Actual cost Standard mix Actual mix
per kg per kg
P 3.00 3.50 10% 8.20
Q 2.50 2.75 20% 1,740
R 4.00 3.50 30% 2,300
S 5.25 5.00 40% 2,640
7,500
What was the favourable materials mix variance?

2. Vibrant paints Co manufactures and sells paints. Business Unit A of the company makes a paint
called Micra. Micra is made using three key materials: R, S and T.
At the end of period 1, a total material cost variance of $4,900 adverse was correctly recorded
for Micra. The following information relates to Micra for period 1:
Material Standard cost Actual cost Actual usage
per litre ($) per litre ($) (litres)
R 63 62 1,900
S 50 51 2,800
T 45 48 1,300
The standard ratio of mixing material R, material S and material T is 30:50:20.

The material price variance for Micra has been correctly calculated as $4,800 adverse.
What is the total material yield variance for Micra for period 1?
A. $700 Favourable
B. $800 Adverse
C. $800 Favourable
D. $900 Adverse

3. The following statements have been made about standard mix and yield variances:
1. Mix variances should be calculated whenever a standard product contains two or more
direct materials.
2. When a favourable mix variance is achieved, there may be a counterbalancing adverse yield
variance.
A. 1 only
B. 2 only
C. Neither nor 2
D. Both 1 and 2

Organic Bread Co
The Organic Bread Company (OBC) makes a range of breads for sale direct to the public. The production
process begins with workers weighing out ingredients on electronic scales and then placing them in a
machine for mixing.
A worker then manually removes the mix from the machine and shapes it into loaves by hand, after
which the bread is then placed into the oven for baking. All baked loaves are then inspected by OBC’s
quality inspector before they are packaged up and made ready for sale. Any loaves which fail the
inspection are donated to a local food bank.
The standard cost card for OBC’s ‘Mixed Bloomer’, one of its most popular loaves, is as follows:
$
White flour 450 grams at $1·80 per kg 0·81
Wholegrain flour 150 grams at $2·20 per kg 0·33
Yeast 10 grams at $20 per kg 0·20
Total 610 grams 1·34
Budgeted production of Mixed Bloomers was 1,000 units for the quarter, although actual production
was only 950 units. The total actual quantities used and their actual costs were:
Kg $ per kg
White flour 408·5 1·90
Wholegrain flour 152·0 2·10
Yeast 10·0 20·00
Total 570·5
Required:
(a) Calculate the total material mix variance and the total material yield variance for OBC for
the last quarter
(7 marks)
(b) Using the information in the question, suggest THREE possible reasons why an ADVERSE
MATERIAL YIELD variance could arise at OBC.
(3 marks)
(10 marks)

Performance Management Sales Mix and Quantity Variances 92
Sales Mix and Quantity Variances

The sales volume variance can be analysed further into a sales mix variance and a sales quantity
variance. This may be useful where management is in a position to control the sales mix.
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

Shows the difference in contribution/profit because of a change in sales volume from the budgeted
volume of sales.
Sales Volume Profit Variance

(AU – BU) * Standard profit/unit
Sales Mix Variance Sales Quantity Variance

(AU – AU in SM) * Standard profit/unit (AU in SM – BU) * Standard profit/unit
Where,
AU in SM – Actual units in standard mix
Example 1
Company makes and sells two products A and B
The budgeted sales and profit are as follows:
Product Budgeted sales unit Budgeted profit per unit
A 2 $3
B 4 $7
Actual sales were
A: 3
B: 3
Required:
Calculate the sales volume variance.
Example 2
Company makes and sells two products, C and S.
The budgeted sales and profit are as follows:
Units Sales Revenue ($) Costs ($) Profit ($) Profit per unit ($)
C 400 8,000 6,000 2,000
S 300 12,000 11,100 900
2,900
Actual sales were 280 units of C and 630 units of S.
Required:
Calculate the sales volume variance, the sales mix variance and the sales quantity variance.

Performance Management Sales Mix and Quantity Variances 93
Practice Questions
1. A company makes and sells three products. Budgeted and actual results for the period just
ended were as follows:
Product Budgeted sales Budgeted profit Actual sales Actual profit
units per units units per unit
X 800 10 700 8
Y 1,000 6 1,200 6
Z 600 12 350 16
2,400 2,250
Required:
What was the adverse sales quantity variances?
2. A company makes and sells three products. Budgeted and actual results for the period just
ended were as follows:
Product Budgeted sales Budgeted profit Actual sales Actual profit
units per units units per unit
X 800 10 700 8
Y 1,000 6 1,200 6
Z 600 12 350 16
2,400 2,250
Required:
What was the adverse sales mix variance?

Performance Management Planning and Operational Variances 94
Planning and Operational Variances

Revision of Budgets or Standards
It may be appropriate to revise a budget or standard cost. When this happens, variances should be
reported in a way that distinguishes between variances caused by the revision to the budget and
variances that are the responsibility of operational management.
A budget revision should be allowed if something has happened which is beyond the control of the
organisation or individual manager and which makes the original budget unsuitable for use in
performance management.
Planning and Operational Variances

A planning and operational approach to variance analysis divides the total variance into those variances
which have arisen because of inaccurate planning or faulty standards (planning variances) and those
variances which have been caused by operational performance, compared with a standard which has
been revised in hindsight (operational variances).
− Planning variances are calculated by comparing the original budget/standard cost with the
revised budget/ standard cost.
− Operational variances are calculated by comparing actual results and the revised
budget/standard cost.
Causes of Planning and Operational Variances

− Unexpected market changes related to sales demand, material cost, availability of labour etc.
− Unexpected changes in the product specification etc.
Planning and operational variances can be calculated for
1. Material price variance
2. Material usage variance
3. Labour rate variance
4. Labour efficiency variance
5. Sales price variance
6. Sales volume variance
Material Price Variance

(SP – AP) * AQ
Planning Variance Operational Variance

(SP – Rs P) * AQ (Rs P – AP) * AQ
Material Usage Variance

(SQ – AQ) * SP

(SQ – Rs Q) * SP (Rs Q – AQ) * SP

Where,
SP – Standard price per unit of material (standard price/kg)
AP – Actual price per unit of material (actual price/kg)
Rs P – Revised standard price
SQ – Standard quantity for actual production (expected material usage for actual units)
AQ – Actual quantity used for production (actual material kg used)
Rs Q – Revised standard quantity for actual production
Labour Rate Variance

(SR – AR) * AH

(SR – Rs R) * AH (Rs R – AR) * AH
Labour Efficiency Variance

(SH – AH) * SR

(SH – Rs H) * SR (Rs H – AH) * SR
Where,
SH – Standard hours for actual production (Expected hours for actual units)
AH – Actual hours
Rs H – Revised standard hours for actual production
AR – Actual rate per hour
SR – Standard rate per hour
Rs R – Revised standard rate per hour
Sales Price Variance

(AP – BP) * AU

(Rs P – BP) * AU (AP – Rs P) * AU

Sales Volume Profit Variance

(AU – BU) * standard profit/unit

(Market Size Variance) (Market Share Variance)
(Rs U – BU) * Standard profit/unit (AU – Rs U) * Standard profit/unit
Where,
BP – Budgeted selling price
AP – Actual selling price per unit
Rs P – Revised selling price
Rs U – Revised sales units
Example 1
KSO budgeted to sell 10,000 units of a new product during 20X0. The budgeted sales price was $10 per
unit, and the variable cost $3 per unit. Actual sales in 20X0 were 12,000 units and variable costs of sales
were $30,000, but sales were only $5 per unit. With the benefit of hindsight, it is realised that the
budgeted sales price of $10 was hopelessly optimistic, and a price of $4.50 per unit would have been
much more realistic.
Required:
Calculate planning and operational variances for sales price.
Example 2
PG budgeted sales for 20X8 were 5,000 units. The standard contribution is $9.60 per unit. A recession in
20X8 means that the market for PG's products declined by 5%. Actual sales were 4,500 units.
Required:
Calculate planning and operational variances for sales volume.
Example 3
Product X had a standard direct material cost in the budget of: 4 kg of Material M at $5 per kg = $20 per
unit. Due to disruption of supply of materials to the market, the average market price for Material M
during the period was $5.50 per kg, and it was decided to revise the material standard cost to allow for
this. During the period, 6,000 units of Product X were manufactured. They required 26,300 kg of Material
M, which cost $139,390.
Required:
Calculate;
a) The material price planning variance
b) The material price operational variance
c) The material usage (operational) variance

Example 4
The standard hours per unit of production for a product is 5 hours. Actual production for the period was
250 units and actual hours worked were 1,450 hours. The standard rate per hour was $10. Because of a
shortage of skilled labour, it has been necessary to use unskilled labour and it is estimated that this will
increase the time taken by 20%
Required:
Calculate the planning and operational efficiency variances.
Advantages of Planning and Operational Variances – Calculations

− The analysis highlights those variances which are controllable (operational variances) and those
which are non-controllable (planning variances).
− The planning and standard-setting processes should improve; standards should be more
accurate, relevant and appropriate.
− Operational variances will provide a more realistic and 'fair' reflection of actual performance.
Disadvantages of Planning and Operational Variances – Calculations

− 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.
− It is difficult to decide in hindsight what the realistic standard should have been.
Revising Budgets: Manipulation Issues

Revision to the budget or standard cost may be manipulated in such a way as to make operating results
seem much better than is really the case.
Revision to the budget or standard cost should ideally be based on independence evidence (verifiable
evidence) that operational managers are not in a position to manipulate.

1. For which of the following variances should a production manager usually be held responsible?
A. Material price planning variance
B. Material price operational variance
C. Material usage planning variance
D. Material usage operational variance
2. A standard product uses 3 kg of direct material costing $4 per kg. During the most recent month,
120 units of the product were manufactured. These required 410 kg of material costing $4.50 per
kg. It is decided in retrospect that the standard usage quantity of the material should have been
3.5 kg, not 3 kg
What is the favourable materials operational usage variance, if it is chosen to use planning and
operational variances for reporting performance?

Performance Management Performance Analysis in Private Sector Organisations 98
Performance Analysis in Private Sector Organisations

Financial Measures
− Profitability ratios
− Liquidity ratios
− Gearing ratios
Profitability Ratios
1. Gross profit margin
Gross Profit
∗ 100
Sales Revenue
2. Net profit margin
Net Profit
∗ 100
Sales Revenue
3. Asset turnover
Sales Revenue
∗ 100
Capital Employed
Capital Employed = Equity + Long term liability
Net Assets = Total assets – Current liabilities
4. Cost to sales ratio

Cost
∗ 100
Sales Revenue
5. Earnings Per Share (EPS)

Earnings attributable to ordinary shareholders
Total number of ordinary shares
6. Return on Capital Employed
Net Profit (PBIT)
∗ 100
Capital Employed
Net profit margin * Asset turnover
Net Profit Sales Revenue
∗
Sales Revenue Capital Employed
7. Sales growth
Current year sales − Previous year sales
∗ 100
Previous year sales
Liquidity Ratios
1. Current ratio
Current assets
Current liabilities
Current assets = Cash + Receivables + Inventory + Short term investments
Current liabilities = Payables + Overdraft + Short-term loans
2. Quick ratio
Current assets − Inventory
Current liabilities

Working Capital Ratios

1. Inventory days
Inventory
∗ 365
Cost of sales
2. Receivable days
Trade receivables
∗ 365
Credit sales
3. Payable days
Trade Payables
∗ 365
Credit purchase or Cost of sales
Gearing Ratios
1. Financial gearing or Capital gearing
Debt Debt
or
Debt + Equity Equity
2. Interest cover
PBIT
Interest charge
Issues Surrounding the Use of Financial Performance Indicators to

Monitor Performance
1. Short-termism
Short-termism is when there is a bias towards short-term rather than long-term performance to
maximise the remuneration and bonuses.
2. Manipulation of results
− Accelerating revenue
− Delaying cost
− Understating a provision or accrual
− Manipulation of accounting policies
3. Do not convey the full picture
It does not convey the full picture regarding the factors that will drive long-term profitability,
e.g., customer satisfaction, quality.
Decisions Which Involve the Sacrifice of Longer-term Objectives

− Postponing or abandoning capital expenditure projects
− Cutting R&D expenditure
− Reducing quality control
− Cutting training costs or recruitment
Methods to Encourage Long-term View

− Making short term targets realistic (so no manipulation is required)
− Link manager’s rewards to share price (long term incentive)
− Set quality based and multiple targets
− Providing sufficient management information
− Evaluating manager’s performance in terms of contribution to long term objectives

Improving Performance
Objectives
− Identify aspects of performance that may be a cause for concern.
− Explain differences between actual performance and the plan or expectation, or deteriorating
performance overtime.
− Consider ways of taking control measures to improve performance.
Analyse Performance
− Comparing actual results with a target or with performance in previous time periods.
− Purpose is to identify whether there are any aspects of performance that are worse than the
target or worse than the previous year, where there may be some cause for concern.
Identifying Reasons for Unexpected Performance or Poor Performance

For example;
Aspects of Performance Possible Reasons
Increase in frequency of machine breakdowns Reduction in amount of routine maintenance
work
Customer dissatisfaction with online sales service Poor website design
Declining labour productivity Increase in complexity of the work
Improving Performance
Methods of improving performance should be linked to the possible reason for the poor performance.
Aspects of Performance Possible Reasons Measures to Improve
Performance
Increase in frequency of Reduction in amount of routine Increase routine maintenance of
machine breakdown maintenance work machines
Customer dissatisfaction with Poor website design Redesign the website
online sales service
Declining labour productivity Increase in complexity of the work Give complex task to specialists
Non-financial Performance Measures

1. Quality
2. Speed
3. Innovation
4. Pollution
5. Risk
6. Flexibility
7. Capability
8. Customer satisfaction
The Balanced Scorecard

The balanced scorecard approach to performance measurement focuses on four different perspectives of
performance, and uses both financial and non-financial indicators to set performance targets and monitor
performance.

Perspective Basics Question Identifying Performance Targets

Financial How do we create value for our Covers traditional measures such as growth,
shareholders? profitability.
Customer What do customers value Give rise to target that matter to customer: cost,
from us? Quality, delivery, inspection and so on.
Innovation Can we continue to improve and Considers the business's capacity to maintain its
and learning create future value? competitive position through the acquisition of
new skills and the development of new products.
Internal What processes must we excel at Aims to improve internal processes and
to achieve our financial and decision-making.
customer objectives?
Goals and Measures

Goals (CSF) Measures (KPI)
FINANCIAL
Increase profit margin Profit margins or percentage increase in profit
margin.
Increase sales revenue or sales growth Sales growth (percentage increase in sales
revenue).
Decrease cost Cost to sales ratios, percentage decrease in costs.
CUSTOMER
Increase customer satisfaction Customer satisfaction ratings, number of repeat
business, customer complaints.
Reduce customer complaints Customer complaints.
Increase the number of new and returning Percentage increase in customer number.
customers
INNOVATION AND LEARNING (GROWTH)
Develop new products Number of new products.
Increase the sales revenue from new products Sales revenue from new products as a percentage
of total sales revenue.
Provide more trainings No. of trainings per employee, no. of training hours
per employee.
INTERNAL (PROCESS EFFICIENCY)
Improve process efficiency Efficiency ratio.
Reduce the time required for a specific task Time taken for the specific task.
Reduce employee turnover Employee turnover rate.
The Building Block Model

Fitzgerald and Moon’s Building Block Model is an evolution of the Balanced Scorecard, developed to meet
the needs of service organizations.
1. Dimensions of performance
− Profit
− Competitiveness
− Quality
− Resource allocation
− Flexibility
− Innovation

2. Standards
− Ownership
− Achievability
− Equity
3. Rewards
− Clarity
− Motivation
− Controllability
Dimensions
Dimensions are the goals for the business and suitable measures must be developed to measure each
performance dimension.
Dimensions of performance Possible measure of performance
Profit growth
Financial performance Gross profit margin
Net profit margin
Growth in sales
Competitiveness
Success rate in converting enquiries into sales
Number of complaints
Service quality
Customer satisfaction
Number of new services offered within the
Innovation
previous year or two
Mix of different types of work done by employees
Flexibility
Speed in responding to customer requests
Efficiency/productivity measures
Resource utilisation
Capacity utilisation rates
Standards
− Individuals need to feel that they 'own' the standards and targets for which they will be made
responsible.
− Individuals also need to feel that the targets or standards are realistic and achievable.
− The standards and targets should be seen as 'fair' and equitable for all the managers in the
organisation.
Rewards
− The system of setting targets and rewarding individuals for achieving the targets should be clear.
Clarity will improve the motivation to achieve the targets.
− Achievement of performance targets should be suitably rewarded.
− Individuals should be made responsible only for aspects of performance that they are in a
position to control.
Difficulties of Target Setting in Qualitative Areas

− Difficulty in selecting suitable measure of performance.
− Qualitative data is not quantified so it is difficult to target and monitor.
− Lack of reliable and comprehensive system for collecting data about qualitative aspects of
performance.

External Considerations
− Stakeholders (including Government and competitors)
− Economic environment
− Inflation
− Interest rates
− Exchange rates

1. Organisations may need to develop performance measures to ensure that the needs of
stakeholders are met.
Which TWO of the following measures are geared towards customer needs?
A. Morale index
B. Percentage of repeat customers
C. Number of warranty claims
D. Dividend yield
2. A company has a call centre to handle queries and complaints from customers. The company is
concerned about the average length of calls and the time that it takes to deal with customers. As
part of its Balanced Scorecard, it has set a target for reducing the average time per customer call.
A target for reducing the average time per call would relate to which of the four Balanced
Scorecard perspectives?
A. Customer
B. Financial
C. Innovation and learning
D. Internal business
3. In a balanced scorecard system of performance measurement, which of the following is most
likely to be used as a measure of performance from the customer perspective?
A. Increase in size of product range
B. Percentage of customers making repeat orders
C. Number of orders won per sales representative
D. Speed of processing an order
4. Which of the following is a dimension of performance in a service business, as identified by
Fitzgerald and Moon?
A. Controllability
B. Innovation
C. Rewards
D. Standards
5. Classify the following into qualitative and quantitative aspects of non-financial performance.
− Volume of customer complaints
− Employee revenue
− Defective products per batch
− Customer needs
− Brand recognition
− Employee morale
− Customer satisfaction
− Repeat business

6. A typical Balanced Scorecard measures performance from four different perspectives. Which
perspective is concerned with measuring 'What must we excel at’?
A. Customer satisfaction perspective
B. Financial success perspective
C. Growth perspective
D. Process efficiency perspective
7. Which one of the following performance indicators is a financial performance measure?
A. Quality rating
B. Number of customer complaints
C. Cash flow
D. System (machine) down time
8. The following summarised statement of financial position is available for L Co.
$'000 $'000
Non-current assets 31,250
Current assets
Inventory 35,000
Receivables 40,000
Cash 1,250
107,500
EQUITY AND LIABILITIES
Capital and reserves 47,500
Current liabilities (payables only) 60,000
107,500
What is the value of the acid test ratio?
A. 0.6875
B. 0.7093
C. 1.2708
D. 2.000
9. What is short-termism?
A. It is when non-financial performance indicators are used for measurement
B. It is when organisations sacrifice short term objectives
C. It is when there is a bias towards short term rather than long term performance
D. It is when managers' performance is measured on long term results
10. Which of the following performance measures is most likely to be recorded because of
government regulations?
A. Sales growth
B. Customer numbers
C. CO2 emissions
D. Return on investment
11. A company has current assets of $1.8m, including inventory of $0.5m, and current liabilities of
$1.0m. What would be the effect on the value of the current and acid test ratios if the company
bought more raw material inventory on three months' credit?
Current ratio Acid test
A. Increase Increase
B. Decrease Increase
C. Increase Decrease
D. Decrease Decrease

12. Balance Co is looking to introduce a Balanced Scorecard and is finalising the measures to use for
the 'Innovation and Learning' perspective. Which one of the following is not really suitable for
this perspective?
A. Number of ideas from staff
B. Percentage of sales from new products
C. Number of new products introduced
D. Level of refunds given

Ties Only
Ties Only is a new business, selling high quality imported men’s ties via the internet. The managers, who
also own the company, are young and inexperienced but they are prepared to take risks. They are
confident that importing quality ties and selling via a website will be successful and that the business will
grow quickly. This is despite the well-recognised fact that selling clothing is a very competitive business.
They were prepared for a loss-making start and decided to pay themselves modest salaries (included in
administration expenses in table 1 below) and pay no dividends for the foreseeable future.
The owners are so convinced that growth will quickly follow that they have invested enough money in
website server development to ensure that the server can handle the very high levels of predicted
growth. All website development costs were written off as incurred in the internal management accounts
that are shown below in Table 1.
Significant expenditure on marketing was incurred in the first two quarters to launch both the website
and new products. It is not expected that marketing expenditure will continue to be as high in the future.
Customers can buy a variety of styles, patterns and colours of ties at different prices.
The business’s trading results for the first two quarters of trade are shown below in Table 1.
Table 1
Quarter 1 Quarter 2
$ $ $ $
Sales 420,000 680,000
Less: Cost of sales (201,600) (340,680)
Gross Profit 218,400 339,320
Less: Expenses
Website development 120,000 90,000
Administration 100,500 150,640
Distribution 20,763 33,320
Launch marketing 60,000 40,800
Other variable expenses 50,000 80,000
Total expenses (351,263) (394,760)
Loss for the quarter (132,863) (55,440)
Required:
a) Assess the financial performance of the business during its first two quarters using only the
data in table 1 above.
(12 marks)
b) Briefly consider whether the losses made by the business in the first two quarters are a true
reflection of the current and likely future performance of the business.
(4 marks)

Performance Management Divisional Performance and Transfer Pricing 106
Divisional Performance and Transfer Pricing

Divisionalisation
Divisionalisation is the division of an organisation into divisions. Each divisional manager is responsible
for the performance of the division.
Advantages of Divisionalisation
− Decisions should be taken more quickly because information does not have to pass along the
chain of command to and from top management.
− The authority to act to improve performance should motivate divisional managers.
− Divisional organisation frees top management from detailed involvement in day-to-day
operations and allows them to devote more time to strategic planning.
− Divisions provide valuable training grounds for future members of top management.
Disadvantages of Divisionalisation
− Decisions might be taken by a divisional manager in the best interests of their own part of the
business, but against the best interest of other divisions.
− A task of head office is therefore to try to prevent dysfunctional decision-making by individual
divisional managers.
− Top management, by delegating decision-making to divisional managers, may lose control since
they are not aware of what is going on in the organisation as a whole.
Responsibility Centres
Type of responsibility Manager has control over Principal
centre performance
measures
Cost centre Controllable costs Variance analysis
Efficiency measures
Revenue centre Revenues only Revenues
Profit centre Controllable costs, sale prices (including TP) Profit
Contribution centre As for profit centre except that expenditure is Contribution
reported on a marginal cost basis
Investment centre Controllable costs, sales prices (including Return on investment
transfer prices) and investment in non-current Residual income
assets and working capital
Return on Investment (ROI)

Return on investment (ROI) shows how much profit has been made in relation to the amount of capital
invested.
Controllable (traceable) profit
*100
Controllable traceable investment
Example 1
If investment centre A currently has assets of $1,000,000 and expects to earn a profit of $400,000, how
would the centre's manager view a new capital investment which would cost $250,000 and yield a profit
of $75,000 p.a.?
Required:
Calculate ROI.

Residual Income (RI)

Residual Income is a measure of the centre's profits after deducting a notional or imputed interest cost.
Residual Income = Controllable (traceable) profit – Imputed interest charge on controllable
(traceable) investment.
Imputed interest = Controllable (traceable) investment * Cost of capital %
Example 2
A division with capital employed of $400,000 currently earns an ROI of 22%. It can make an additional
investment of $50,000. The average net profit from this investment would be $12,000 after depreciation.
The division's cost of capital is 14%.
Required:
What are the Residual Incomes before and after the investment?
The Advantages of RI Compared with ROI

− Residual Income will increase when investments earning above the cost of capital are
undertaken and investments earning below the cost of capital are eliminated.
− Residual Income is more flexible since a different cost of capital can be applied to investments
with different risk characteristics.
Transfer Pricing
A transfer price is the price at which goods or services are transferred from one department to another,
or from one member of a group to another.
Transfer Price Calculation

Where there is no external market
Transfer price is based on cost:
− Variable cost
− Full cost
− Variable cost plus
− Full cost plus
Example 3
An entity 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.
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

Where there is an external market for the component

The limits within which transfer prices should fall are as follows:
Maximum Transfer Price
The maximum price that the buying division will want to pay is the market price for the product – i.e.,
whatever they would have to pay an external supplier for it.
Minimum Transfer Price (for selling division)
The sum of the supplying division's marginal cost and opportunity cost of the item transferred, less any
internal cost savings in packaging and delivery.
1. Spare Capacity
If there is spare capacity, then, for any transfers that are made by using that spare capacity, the
opportunity cost is zero.
Example 4
Details of selling division A
Total production capacity = 6,000 units
Total external demand = 3,000 units
Total internal demand = 2,000 units
Variable cost per unit of the component = $12
External selling price = $20
Required:
Calculate the minimum transfer price for 2,000 units.
2. No Spare Capacity
If the seller doesn’t have any spare capacity, opportunity cost represents contribution foregone.
So minimum price will be equal to variable cost-plus opportunity cost that is the external selling price
less any internal cost savings in packaging and delivery.
Example 5
Details of selling division A
Total production capacity = 3,000 units
Total external demand = 3,000 units
Total internal demand = 2,000 units
Variable cost per unit of the component = $12
External selling price = $20
Required:
Calculate the minimum transfer price for 2,000 units.
Dual Pricing
In some situations, two divisions may not be able to agree a transfer price. But 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.
Comparing Divisional Performance

ROI and RI are common methods but other methods could be used.
− Variance analysis

− Ratio analysis – measures such as sales per employee or square foot as well as industry specific
ratios such as transport costs per mile, brewing costs per barrel, overheads per chargeable hour.
− Other information – such as staff turnover, market share.
Problems of Comparing Divisions

− Divisions may operate in different environments.
− The transfer pricing policy may distort divisional performance.
− Divisions may have assets of different ages.
− There may be difficulties comparing divisions with different accounting policies
− Evaluating performance on the basis of a few indicators may lead to manipulation of data.

1. The following statements have been made about a transfer pricing system where Division A
transfers output to Division B.
1. Internal transfers should be preferred when there is an external market for the transferred
item because there will be more control over quality and delivery.
.
2. The transfer price will determine how profits will be shared between the two divisions.
A. 1 only
B. 2 only
C. Neither 1 nor 2
D. Both 1 and 2
2. In a company with a divisionalised structure, Division A transfers its output to Division B. Division
A produces just one item, component X. Division B makes and sells an end product that requires
one unit of Component X.
$ per unit of X
Marginal cost of production in Division A 8
Fixed overhead cost of production 3
Cost of selling in the external market 1
Market price in the external market 16
Division B contribution from further processing
Component X, before deducting the transfer cost 25
Division A is working at full capacity.
What should be the minimum transfer price per unit of Component X in this situation?
3. Which of the following figures would be the most suitable for divisional profit for the purpose of
performance measurement?
A. Gross profit
B. Profit before interest and tax
C. Profit before tax
D. Profit after tax
4. In a company with a divisionalised structure, Division A transfers its output to Division B. Division
A produces just one item, Component X. Division B makes and sells an end product that requires
one unit of Component X.
$ per unit of X
Marginal cost of production in Division A 8
Fixed overhead cost of production 3
Market price in the external market 16
Division B contribution from further processing

Component X, before deducting the transfer cost 25

.
Division A is not working at full capacity, and can meet in full the external market demand and
the demand from Division B for internal transfers.
What should be the minimum transfer price per unit and the maximum transfer price per unit
for Component X in this situation?
5. At the beginning of 20X2, a division has capital employed, consisting of non-current assets of
$2 million (at net book value) and working capital of $0.2 million. These are expected to earn a
profit in 20X2 of $0.5 million, after depreciation of $0.4 million. A new machine will be installed
at the beginning of 20X2. It will cost $0.8 million and will require an additional $0.1 million in
working capital. It will add $0.35 million to million to divisional profits before deducting
depreciation. This machine will have a four-year life and no residual value: depreciation is by the
straight-line method. When calculating ROI, capital employed is taken at its mid-year value.
What is the expected ROI of the division in 20X2?
A. 21.7%
B. 23.2%
C. 24.1%
D. 26.0%
6. A company has two Divisions, A and B. Division A manufactures a component which is
transferred to Division B. Division B uses two units of the component from Division A in every
item of finished product that it makes and sells. The transfer price is $43 per unit of the
component.
$ per unit
Selling price of finished product made in Division B 154
Variable production costs in Division B, excluding the
cost of transfers from Division A 32
Variable selling costs, chargeable to the division 1
33
Fixed costs $160,000
External sales in units 7,000
Investment in the division $500,000
The company uses 16% as its cost of capital.
What is the residual income of Division B for the period?
7. Which of the following is NOT usually a consequence of divisionalisation?
A. Duplication of some activities and costs
B. Goal congruence in decision making
C. Faster decision making at operational level
D. Reduction in head office control over operations
8. An investment centre earns a return on investment of 18% and a residual income of $300,000.
The cost of capital is 15%. A new project offers a return on capital employed of 17%.
If the new project were adopted, what would happen to the investment centre's Return on
Investment and Residual Income?
Return on investment Residual income
A. Increase Decrease
B. Increase Increase
C. Increase Decrease
D. Decrease Decrease

Performance Management Performance Analysis in Non-profit Organisation 111
Performance Analysis in Non-profit Organisation

Performance Analysis in Not-for-Profit and Public Sector Organisations
Problems with Performance Measurement
− Multiple objectives
− Measuring outputs
− Lack of profit measure
− Nature of service provided
− Financial constraints
− Political, social and legal considerations
Solutions
− Inputs
− Judgement
− Comparisons
− Quantitative measures
Value for Money

Value for money means providing a service in a way which is economical, efficient and effective.
− Economy
Economy is concerned with the cost of inputs, and it is achieved by obtaining those inputs at
the lowest acceptable cost.
*Inputs – Resources (labour, materials, machines, money)
− Efficiency
Efficiency means maximise the outputs from minimum inputs. It measures the relationship
between inputs and outputs.
− Effectiveness
Effectiveness means ensuring that the outputs of a service or programme have the desired
impacts; that is finding out whether they succeed in achieving objectives and, if so, to what
extent.
*Outputs – Results of an activity

1. The following statements have been made about performance measurements in not-for-profit
organisations
1. Not-for-profit organisations do not have financial objectives.
2. The outputs produced by not-for-profit organisations are easier to measure than output of
commercial companies.
A. 1 only
B. 2 only
C. Neither 1 nor 2
D. Both 1 and 2
2. Which of the following measures of performance for public sector services is a measure of
efficiency?
A. Number of patients treated per $1 spent on the state hospital service.
B. Percentage reduction in the spending budget of a government department compared with
the previous year.
C. Proportion of reported crimes that are solved by the police service.

Performance Management Performance Analysis in Non-profit Organisation 112
D. Proportion of students in a state-owned college achieving good pass grades in their

examinations.
3. The 3Es are often used to assess performance in non-profit making organisations, especially in
relation to value for money.
Which THREE of the following Es are used?
o Efficiency
o Effectiveness
o Economy
o Enterprise
o Efficacy
o Expediency
o Endurance
4. In not-for-profit businesses and state-run entities, a value-for-money audit can be used to

measure performance. It covers three key areas: economy, efficiency and effectiveness. Which of
the following could be used to describe effectiveness in this context?
A. Avoiding waste of inputs
B. Achieving agreed targets
C. Achieving a given level of profit
D. Obtaining suitable quality inputs at the lowest price

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Lecture Support Notes

Activity Based Costing-------------------------------------------------------------------------- 10

Cost Volume Profit (CVP) Analysis------------------------------------------------------------33

Make-or-buy and Other Short-term Decisions--------------------------------------------52

Dealing with Risk and Uncertainty in Decision-making---------------------------------60

Budgetary Systems and Types of Budget---------------------------------------------------67

Quantitative Analysis in Budgeting----------------------------------------------------------73

Material Mix and Yield Variances------------------------------------------------------------ 88

Sales Mix and Quantity Variances------------------------------------------------------------92

Planning and Operational Variances---------------------------------------------------------94

Performance Analysis in Private Sector Organisations----------------------------------98

Divisional Performance and Transfer Pricing----------------------------------------------106

Information, Technologies and System for Organisational

The Role of Information Systems

Requirements of Information for Organisations

Security of Confidential Information

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− Personnel security planning

Types of Information Systems

2. Management Information Systems (MIS)

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3. Executive Information Systems (EIS)

4. Enterprise Resource Planning Systems (ERP systems)

5. Decision Support Systems (DSS)

Marketing Human Resource

7. Customer Relationship Management Systems (CRM systems)

8. Closed and Open Systems

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Benefits of Information System

Sources of Management Information

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Multiple Choice Questions

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By nature By behaviour By traceability

Some Basic Terms

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Traditional Costing Techniques

Product Cost under Marginal Costing

Arguments in Favour of Absorption Costing

Arguments in Favour of Marginal Costing

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Possible Bases of Absorption (Activity Level)

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Multiple Choice Questions

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Activity Based Costing (ABC)

Stages in Developing Activity Based Costing System

Overhead costs and possible cost drivers – Examples

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Advantages of Activity Based Costing

Disadvantages of Activity Based Costing

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Multiple Choice Questions

Which of the above statements is/are true?

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Constructed Response Questions

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Gadget Co (December 2010)

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