Performance Management (PM)

Course Notes
For exams in September 2018,
December 2018, March 2019 and June
2019

ISBN: 1781472713016

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Performance Management (PM)
Study Programme
Taught Phase Study Programme
Page
Introduction to the exam and the course ................................................................................................................. 4
1 Assumed Knowledge: Variance analysis...................................................................................................... 11
2a Activity based costing................................................................................................................................... 25
2b Target costing............................................................................................................................................... 35
2c Life cycle costing .......................................................................................................................................... 43
2d Throughput accounting................................................................................................................................. 49
2e Environmental management accounting ...................................................................................................... 61
3 Cost volume profit analysis........................................................................................................................... 67
4 Limiting factor analysis ................................................................................................................................ 81
5 Pricing decisions .......................................................................................................................................... 93
6 Short-term decisions................................................................................................................................... 105
7 Quantitative analysis in budgeting.............................................................................................................. 123
8a Risk preferences ........................................................................................................................................ 133
8b Risk and uncertainty in decision making .................................................................................................... 143
9 Budgetary systems..................................................................................................................................... 153
10 Budgeting and standard costing ................................................................................................................. 167
11 Mix and yield variance analysis ................................................................................................................ 177
12 Planning and operational variance analysis .............................................................................................. 185
13 Performance management information systems ........................................................................................ 193
14 Sources of management information and management reports ................................................................ 201
15 Performance management......................................................................................................................... 207
16 Divisional performance measures .............................................................................................................. 229
17 Further performance management............................................................................................................. 249

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INTRODUCTION

Introduction to PM Performance Management

Overall aim of the syllabus

To develop knowledge and skills in the application of management accounting techniques to quantitative and
qualitative information for planning, decision-making, performance evaluation, and control.

The syllabus
The broad syllabus headings are:

A Specialist cost and management accounting techniques

B Decision-making techniques
C Budgeting and control
D Performance measurement and control

Main capabilities
On successful completion of this exam, candidates should be able to:
 Explain and apply cost accounting techniques
 Select and appropriately apply decision-making techniques to facilitate business decisions and promote
efficient and effective use of scarce business resources, appreciating the risks and uncertainty inherent in
business and controlling those risks
 Identify and apply appropriate budgeting techniques and methods for planning and control
 Identify and discuss performance management information systems and assess the performance of a
business from both a financial and non-financial viewpoint, appreciating the problems of controlling
divisionalised businesses and the importance of allowing for external aspects.
 Use standard costing systems to measure and control business performance and to identify remedial action

Advanced
Performance
Management (APM)

Performance
Management (PM)

Management
Accounting (MA)

PM is the middle exam in the management accounting section of the qualification structure. It builds upon the
knowledge acquired in MA and prepares those candidates who choose to study APM at the Professional level.
PM requires you to be able to apply techniques and think about their impact on the organisation. It seeks to
examine candidates' understanding of how to manage the performance of a business.

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 INTRODUCTION

Taught Phase Aims

Achieving ACCA's Study Guide Outcomes

A Specialist cost and management accounting techniques

A1 Activity based costing Chapter 2a
A2 Target costing Chapter 2b
A3 Life cycle costing Chapter 2c
A4 Throughput accounting Chapter 2d
A5 Environmental accounting Chapter 2e

B Decision-making techniques
B1 Relevant cost analysis Chapter 6
B2 Cost volume analysis Chapter 3
B3 Limiting factors Chapter 4
B4 Pricing decisions Chapter 5
B5 Make-or-buy and other short-term decisions Chapter 6
B6 Dealing with risk and uncertainty in decision-making Chapter 8

C Budgeting and control

C1 Budgetary systems Chapter 9
C2 Types of budget Chapter 9
C3 Quantitative analysis in budgeting Chapter 7
C4 Standard costing Chapter 11
C5 Material mix and yield variances Chapter 12
C6 Sales mix and quantity variances Chapter 12
C7 Planning and operational variances Chapter 12
C8 Performance analysis and behavioural aspects Chapter 11

D Performance measurement and control

D1 Performance management information systems Chapter 13
D2 Sources of management information Chapter 14
D3 Management reports Chapter 14
D4 Performance analysis in private sector organisations Chapter 15
D5 Divisional performance and transfer pricing Chapter 16
D6 Performance analysis in not-for-profit organisations and the public sector Chapter 17
D7 External considerations and behavioural aspects Chapter 17

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INTRODUCTION

The Examination
The examination lasts for 3 hours and 15 minutes and consists of three sections.

40% Numerical 60% Discussion

40% Knowledge 60% Application

Computer-based exams
ACCA have commenced the launch of computer-based exams (CBEs) for PM–FM. They have been piloting
computer-based exams in limited markets since September 2016 with the aim of rolling out into all markets
internationally over a five-year period. Paper-based examinations will be run in parallel while the CBEs are
phased in and BPP materials have been designed to support you, whichever exam option you choose.
Exam duration
The Skills module examinations PM–FM contain a mix of objective and longer type questions with a duration of 3
hours for 100 marks. For paper-based exams there are an extra 15 minutes to reflect the manual effort required.
As ACCA increase their offering of PM–FM session CBEs, they will be introducing seeded content to guarantee
all exams are equivalent and fair. When the seeded content is introduced, students will be given more time to
complete the exams – increasing to 3 hours and 20 minutes to take into account the inclusion of additional
seeded content.
For more information on these changes and when they will be implemented, please visit the ACCA website.
www.accaglobal.com/uk/en/student/changes-to-exams/f5-f9-session-cbe.html
Format of the exam
The exam will be available in paper and computer based exam modes of delivery. The exam format is the same
irrespective of the mode of delivery and will comprise 3 exam sections

Section Style of question type Description Proportion of exam, %

A Objective test (OT) 15 questions  2 marks 30
B Objective test (OT) case 3 questions  10 marks 30
Each question will contain 5
subparts each worth 2 marks
C Constructed Response 2 questions  20 marks 40
(Long questions)
Total 100

Section A and B questions will be selected from the entire syllabus. The paper version of these objective test
questions contain multiple choice only and the computer based versions will contain a variety. The responses to
each question or subpart in the case of OT cases are marked automatically as either correct or incorrect by
computer.
Section C questions will mainly focus on the following syllabus areas but a minority of marks can be drawn from
any other area of the syllabus
 Decision-making techniques (syllabus area B)
 Budgeting and control (syllabus area C)
 Performance management and control (syllabus area D)
The responses to these questions are human marked.

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 INTRODUCTION

Key to icons
The following icons appear in this set of study notes

Section reference in the Study Text

You could further consolidate your knowledge in this area with additional reading from the
Study Text.

Formula to learn

Formula given in exam

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INTRODUCTION

Key skills required to pass

Our analysis of the examining team's comments on past exams, together with our experience of preparing
students for this type of exam, suggests that to pass PM you will need to develop a number of key skills.

1 Effective reading
and planning at the
5 Good knowledge of start of the exam
the whole syllabus

B C
2 Tackling
4 Tackling constructed objective test
response questions questions Specific
Good technique is skills are needed in
essential in section C section A of the exam
A ...... ……
3 Tackling objective B ...... ……
C ...... ……
test case questions D ...... ……

Good technique is
essential in section B

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 INTRODUCTION

Skill 1 – Effective reading and planning time at the start of

the exam
We recommend that you spend time at the beginning of your exam to carefully read your exam, specifically
looking through the requirements in sections B and C. Once you feel familiar with your exam we then
recommend that you attempt Section C, ensuring that you spend adequate time reading and planning before you
begin to write up your answer. Comments from examining teams across all exams regularly suggest that
students appear less time-pressured if they do larger section C style questions first.
Focus on the requirement first, underlining key verbs such as prepare, comment, explain, discuss etc to
ensure you answer the question properly. You should make good use of the time you have to read the rest of
the question, underlining and annotating important and relevant information, and making notes of any
relevant technical information you think you will need. Answer plans for written questions can help
consolidate your thoughts before you start writing.
However our recommendations are not inflexible. If you would prefer to start on section A or B questions, then do
those first, but DON'T run over time on them. Advice on tackling each of the question types is given below.
A ...... ……
B ...... ……

Skill 2 – Tackling multiple choice questions

C ...... ……
D ...... ……

Section A of the exam will include fifteen 2 mark multiple choice questions. Time allocation is important here
to ensure you tackle all of the questions in the allotted time. There is no negative marking on multiple choice
questions, so if you are unsure you should make sure that you guess rather than leaving the question out!
Having a selection of answers to choose from does not make section A easier. The wrong options will often be
very plausible. You need to think carefully before selecting an option and ensure you practice lots of questions so
that you can spot red-herrings and potential pitfalls.

Skill 3 – Tackling objective test case questions

Read through the whole case first and then skim the five questions. Identify the easier or less time consuming
questions quickly as these should be attempted first. The questions are independent of each meaning they can
be answered in any order.

B C Skill 4 – Tackling constructed response questions

Approach is very important in section C. Professional presentation of answers is an area that students often don't
do well. It is vital that you do not throw marks away purely because the exam marker cannot follow what you
have done.
Numbers should be well referenced and written neatly and in discussion questions you need to avoid waffle. It is
important that you make and explain your point fully without going overboard.
You also need to ensure that you stick to the requirements in the question. This may sound obvious but many
candidates appear to get side tracked in the exam and therefore waste precious time on answers that don't score
any marks.
Candidates are required to not just make a point but need to apply it to the scenario given. Whenever you think
you have finished your answer always go back and re-read that requirement before moving on.

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INTRODUCTION

Skill 5 – Knowledge of the syllabus

You need to have a good, broad knowledge of all of the PM syllabus. The examining team can and will test all
areas of the syllabus.
Practising Section A questions is a really effective way of testing you knowledge of technical numerical content.
For written content, you can also use a variety of memory techniques. Creating mind maps can be helpful as the
human brain is better at remembering patterns than lists. Pictures are another excellent memory technique too
as often a simple picture can act as aid in recalling information. Another effective memory technique is to create
mnemonics as often it is easier to recall sounds and rhymes than simple lists.

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Variance analysis

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Example past exam questions
Revise the calculation and interpretation of basic
variances, which are examined in MA.
These concepts will be built upon in PM.

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1: VARIANCE ANALYSIS

Overview

Calculation

Basic variance
analysis

Interpretation

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 1: VARIANCE ANALYSIS

1 Calculation of basic variances

1.1 Variance analysis reconciles actual to budgeted costs, revenue or profit. It is a way of
explaining the difference between actual and budgeted results. They can either be
favourable (F), ie better than expected, or adverse (A), worse than expected.

1.2 These variances have been examined in MA. They could also be examined in PM along
with a discussion as to what the variances are showing or preparation of an operating
statement. Basic variances are assumed knowledge and not specifically mentioned in the
PM syllabus. It is vital that you are happy with them before studying the additional variances
in PM.

2 Operating statement proforma

Operating Statement $
(under marginal costing)
Budgeted contribution
Sales volume contribution variance
Sales price variance

Cost variances: $(F) $(A)

Materials Price
Usage

Labour Rate
Efficiency
Idle

Variable o/h Expenditure

Efficiency

Actual contribution
Fixed overheads
Budgeted
Expenditure variance
Actual
Actual profit

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1: VARIANCE ANALYSIS

3 Variance proformas
3.1 Material variances
$
Price
'Should' Actual purchases should cost X
'Did' Actual purchases did cost (X)
X

Usage Kg
'Should' Actual production should use X
'Did' Actual production did use (X)
Difference valued at standard cost X
$X

3.2 Labour variances

$
Rate
'Should' Actual hours paid should cost X
'Did' Actual hours paid did cost (X)
X

Efficiency Hrs
'Should' Actual production should take X
'Did' Actual production did take (X)
Difference valued at standard rate per hour X
$X

Idle time Hrs

'Should' Hours worked X
'Did' Hours paid (X)
Difference valued at standard rate per hour $X
3.3 Variable overhead variances
$
Expenditure
'Should' Actual hours worked should cost X
'Did' Actual hours worked did cost (X)
X

Efficiency Hrs
'Should' Actual production should take X
'Did' Actual production did take (X)
Difference valued at standard rate per hour X
$X
Note. This assumes variable overheads are incurred per labour hour.

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 1: VARIANCE ANALYSIS

3.4 Fixed overhead variances

Under marginal costing, the fixed overhead variance is just the difference between
budgeted and actual fixed overhead costs, ie fixed overhead expenditure variance.
Under absorption costing, the fixed overhead variance can be further subdivided as
follows:
Total variance (over/under absorption)

Expenditure variance Volume variance

$ Units
'Should' Budget expenditure X 'Should' Budgeted units X
'Did' Actual expenditure (X) 'Did' Actual units (X)
X X
Difference value at OAR
per unit $X

Efficiency Capacity

Hours Hours
'Should' 'Should'
Actual production should take X Budgeted hours worked X
'Did' 'Did'
Actual production did take (X) Actual hours worked (X)
X
Difference valued at OAR per hour $X Difference valued at X
OAR per hour $X

3.5 Sales variances

Price $
'Should' Actual units sold should sell for X
'Did' Actual units sold did sell for (X)
X

Volume Units
'Should' Budgeted sales units X
'Did' Actual sales units (X)
X
Difference valued at standard contribution/unit $X
Under absorption costing this variance will be valued at standard profit/unit.

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1: VARIANCE ANALYSIS

Lecture example 1 Preparation question

Brenda and Eddie run The Italian Restaurant selling a variety of pasta dishes each using similar
ingredients and taking the same amount of time to prepare.
To try to control costs they instigate a standard costing system, deriving the following standard
cost per meal.
$/meal
Ingredients (average value) 400 g @ $1.50/kg = 0.60
Labour 30 mins @ $4/hour = 2.00
Variable overheads 30 mins @ $1/hour = 0.50
Fixed overheads 30 mins @ $2.50/hour = 1.25
4.35
Standard profit 2.60
Selling price 6.95
The overheads are absorbed on the assumption that Brenda and Eddie normally sell 100 pasta
meals per day over the year during which they are open for 300 days.
During one six-day week, the following results are obtained:
Meals sold 630 Total revenue = $4,500
Ingredients bought: 260 kg for $380
used: 240 kg
Hours paid: 300 hrs costing $1,350
Time lost due to late delivery of ingredients = 10 hours
Variable overheads $325
Fixed overheads $750
Required
(a) Reconcile the budgeted contribution to the actual profit (for one week) using
MARGINAL costing.
(b) Prove the actual profit.
(c) Suggest possible causes for the variances identified.

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 1: VARIANCE ANALYSIS

Solution

$
Operating Statement
(under marginal costing)
Budgeted contribution
Sales volume contribution variance
Sales price variance

Cost variances: $(F) $(A)

Materials Price
Usage

Labour Rate
Efficiency
Idle

Variable o/h Expenditure

Efficiency

Actual contribution
Fixed overheads
Budgeted
Expenditure variance
Actual
Actual profit

Workings

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1: VARIANCE ANALYSIS

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 1: VARIANCE ANALYSIS

Differences between absorption costing and marginal costing

3.6 Variances calculated using absorption costing are the same as under marginal costing
except:
(a) Fixed overheads – fixed overhead volume variance is calculated in addition to the
fixed overhead expenditure variance.
(b) Sales volume profit variance:
variance in units is valued at standard profit/unit, not contribution/unit.
(c) Operating statement will usually reconcile budgeted profit to actual profit.

4 Fixed overheads
Absorption costing
4.1 When using absorption costing, the over/(under) absorption in a period is calculated as:
Overheads absorbed (OAR  actual activity) x
Actual overheads (x)
Over/(under) absorption x/(x)

4.2 The over/(under) absorption of fixed overheads can be split further as follows:

Fixed overhead volume variance Fixed overhead expenditure variance

Budgeted production volume X Budgeted expenditure $X
Actual production volume X Actual expenditure $X
X $X
Value at OAR/Unit $X

4.3 When overheads are absorbed on a labour hour or machine hour basis the volume variance
can be split further into:

Volume efficiency variance Volume capacity variance

Based on actual production  Budgeted hours of work
 How long did it take?  Actual hours of work
 How long should it have taken? Value at standard OAR/hour
Value at standard OAR/hour

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1: VARIANCE ANALYSIS

Lecture example 2 Preparation question

Required
Using the information in Lecture Example 1, analyse the fixed overhead variances in detail
and prepare an operating statement using ABSORPTION COSTING principles.

Solution

$
Operating Statement
(under absorption costing)
Budgeted profit
Sales volume profit variance
Sales price variance

Cost variances: $(F) $(A)

Materials Price
Usage
Labour Rate
Efficiency
Idle
Variable o/h Expenditure
Efficiency
Fixed o/h Expenditure
Efficiency
Capacity

Actual profit
Workings

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 1: VARIANCE ANALYSIS

5 Interpretation of variances
Causes of variances
5.1 Obviously the cause of the variance must be determined before appropriate action can be
taken. An employee should only be judged on what they have control over.
(a) Different controllable expenditure
(b) Different uncontrollable expenditure
(c) Inaccurate standard due to:
 Poor planning
 Use of unrealistic standard
(d) Inaccurate measurement

Interdependence of variances
5.2 In order to interpret variances effectively any interdependence between variances must be
identified, ie it is not always possible to look at individual variances in isolation.

5.3 For example, a decision to purchase better quality, higher price materials may result in an
adverse price variance but a favourable usage variance.

5.4 The following table may help you to think about some of the operational causes of
variances.

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1: VARIANCE ANALYSIS

Variance Favourable Adverse

Material price Unforeseen discounts received Price increase
Greater care in purchasing Careless purchasing
Change in material standard Change in material standard
Material Material used of higher quality Defective material
usage than standard Excessive waste or theft
More efficient use of material Stricter quality control
Errors in allocating material to Errors in allocating material to jobs
jobs
Labour rate Use of workers at a rate of pay Wage rate increase
lower than standard
Idle time The idle time variance is always Machine breakdown
adverse Illness or injury to worker
Labour Output produced more quickly Lost time in excess of standard
efficiency than expected because of worker Output lower than standard set
motivation, better quality materials because of lack of training,
etc sub-standard materials etc
Errors in allocating time to jobs Errors in allocating time to jobs
Fixed Savings in costs incurred Increase in cost of services used
overhead More economical use of services Excessive use of services
expenditure
Change in type of service used
Overhead expenditure variances ought to be traced to the individual cost centres where the
variances occurred.
Fixed Production or level of activity Production or level of activity less
overhead greater than budgeted than budgeted
volume
Efficiency Reasons for this tie in exactly to Reasons for this tie in exactly to
labour efficiency labour efficiency
Capacity Labour worked for more hours Maybe a result of lower production
than budgeted; maybe due to volumes or higher absenteeism eg
more production than expected holidays/sickness
Sales price Unplanned price increase Anticipated increase in selling price
Fewer discounts given than did not happen
expected More discounts allowed than
expected
Sales volume Additional demand experienced Fall in demand
Lower output

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 1: VARIANCE ANALYSIS

Lecture example 3 Idea Generation

Required
Discuss instances when a favourable variance may not be good news and when adverse
variances may be good for a business.

Solution

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1: VARIANCE ANALYSIS

6 Chapter summary
Section Topic Summary
1 Calculation of basic Variance analysis is a performance evaluation tool that is
variances often used especially as a part of cost control. You must
be able to calculate variances under both marginal costing
and absorption costing principles.
5 Interpretation of Interpretation of variances is as important as the
variances calculations themselves.

END OF CHAPTER
CHPATER
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Activity based costing

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Example past exam questions
Identify appropriate cost drivers under ABC
Calculate costs per driver and per unit using ABC Q1 Section A – specimen exam
Q15 Section A – September 2016
Q11 Section A – December 2016
Compare ABC and traditional methods of
overhead absorption based on production units,
labour hours or machine hours

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 2a: ACTIVITY BASED COSTING

Overview

Activity based
costing

Calculation of cost/unit Comparison with absorption Implications of ABC

costing

Cost pools Benefits

Cost drivers Criticisms
Implications

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 2a: ACTIVITY BASED COSTING

1 Activity based costing (ABC)

Introduction
1.1 In this chapter we will be looking at an alternative method of cost accumulation, activity
based costing (ABC). ABC is an alternative to absorption costing which attempts to
overcome the problems of costing in a modern manufacturing environment.
Reasons for
development
Traditional absorption costing
1.2 Traditional absorption costing uses a single basis for absorbing all overheads into cost
units for a particular production department cost centre.
A business will choose the basis that best reflects the way in which overheads are being
incurred, eg in an automated business much of the overhead cost will be related to
maintenance and repair of the machinery. It is likely that this will vary to some extent with
machine hours worked so we would have used a machine hour absorption rate.

PRODUCTION SET-UP COSTS

MACHINE OIL PRODUCTION OAR =

DEPARTMENT MACHINE
A HOURS
SUPERVISOR SALARY

MACHINE REPAIRS

ABC
1.3 Production overheads are by no means all volume-related and hence a single basis for
absorption, eg labour hours, would not adequately reflect the complexity of producing
certain products/cost units as opposed to others.
1.4 ABC is an extension of absorption costing specifically considering what causes each type of
overhead category to occur, ie what the cost drivers are. Each type of overhead is absorbed
using a different basis depending on the cost driver.
Overheads Cost drivers

PRODUCTION NUMBER OF
SET-UP COSTS PRODUCTION SET UPS

MACHINE OIL AND TOTAL

MACHINE REPAIRS MACHINE HOURS

SUPERVISOR TOTAL
SALARY LABOUR HOURS

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2a: ACTIVITY BASED COSTING

Steps in ABC
1.5 (a) Group overheads into activities, according to how they are driven. These are known
as cost pools.
(b) Identify the cost drivers for each activity, ie what causes the activity cost to be
incurred.
(c) Calculate a cost per unit of cost driver.
(d) Absorb activity costs into production based on usage of cost drivers.

2 Traditional absorption costing vs activity based

costing
2.1 Overhead absorption rates using ABC should be more closely linked to the causes of
overhead costs.
The modern business environment has much wider product ranges than seen before,
complex production processes and decreasing product life cycles. ABC recognises these
factors by using multiple cost drivers when absorbing overheads.

Lecture example 1 Technique demonstration

Dodo Ltd manufactures three products, A, B and C. Data for the period just ended is as follows:

A B C
Output (units) 20,000 25,000 2,000

Sales price $ 20 20 20
Direct material cost $ 5 10 10
Labour hours/unit 2 1 1
Wages paid at $5/hr
Total production overheads for Dodo Ltd amount to $190,000.
Required
(a) Calculate the profit per unit obtained on each product if production overheads are
absorbed on the basis of labour hours (Traditional Absorption Costing).

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 2a: ACTIVITY BASED COSTING

Solution

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2a: ACTIVITY BASED COSTING

Lecture example 1 cont'd

The following data is now also available:
$

Machining 55,000
Quality control and set-up costs 90,000 These are known
Receiving 30,000 as cost pools
Packing 15,000
190,000

A B C
Output (units) 20,000 25,000 2,000
Cost driver data
Labour hours/unit 2 1 1
Machine hours/unit 2 2 2
No. of production runs 10 13 2
No. of component receipts 10 10 2
No. of customer orders 20 20 20
Required
(b) Using ABC, show the cost and gross profit per unit for each product during the
period and contrast this with the profit calculated using absorption costing.
(c) What factors should be considered when comparing the results?

Solution

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 2a: ACTIVITY BASED COSTING

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 2a: ACTIVITY BASED COSTING

Cost driver analysis

2.2 Today's complex business environment means that costs are incurred because cost drivers
occur at different levels.
2.3 There are four key categories for activities and their related costs.
Categories Type of cost Cost driver
Unit Direct Units produced
Batch Set ups Batches produced
Inspection
Product R&D Products produced
Marketing
Facility sustaining Depreciation None
Rent
The difference between unit costs under traditional absorption costing and ABC depends
upon the proportion of overheads in each category.
If most overheads are unit level or facility sustaining the costs will be similar.
If overheads are batch or product sustaining costs, the resulting unit costs will be very
different.

3 Implications of ABC
When ABC should be used
3.1 (a) When production overheads are high relative to prime costs (eg service sector)
(b) When there is a whole diversity of product range
(c) When there are considerable differences in the use of resources by products
Merits &
criticisms of ABC (d) Where consumption of resources is not driven by volume

Benefits of ABC
3.2 The use of ABC provides opportunities for:
(a) Cost control and reduction by the efficient management of cost drivers
(b) Better costing information used to assist pricing decisions
(c) Re-analysis of production and output/product mix decisions
(d) Profitability analysis (by customer, product line etc)
(e) A more realistic estimate of costs and profits which can be used in performance
appraisal

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 2a: ACTIVITY BASED COSTING

Criticisms of ABC
3.3 (a) It is time consuming and expensive
(b) Will be of limited benefit if overhead costs are primarily volume related
(c) Reduced benefit if the company is producing only one product or a range of products
with similar costs
(d) Complex situations may have multiple cost drivers
(e) Some arbitrary apportionment may still exist

Lecture example 2 Exam standard Section A (All Exams) – 2 marks

The following statements have been made about activity based costing.

(1) Implementation of ABC is unlikely to be cost effective when variable production costs are a
low proportion of total production costs.
(2) The cost driver for materials handling and despatch costs is likely to be the number of
orders.
Which of the above statements is/are true?
A 1 only
B 2 only
C Neither 1 nor 2
D Both 1 and 2

4 Chapter summary
Section Topic Summary
1 Activity based  Activity based costing groups overheads into
costing activities. These are referred to as cost pools.
 The item that causes the costs to be incurred is the
cost driver.
 Overheads are absorbed into products using the cost
drivers.
2 Absorption costing Overhead absorption rates under ABC should be more
vs ABC closely linked to the causes of overhead costs.
3 Implications of ABC ABC results in a more meaningful product cost when
overheads are high and there is a wide diversity of product
range.

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2a: ACTIVITY BASED COSTING

END OF CHAPTER
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Target costing

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Example past exam questions
Derive a target cost in manufacturing and service Q2 section A – specimen exam
industries Q27 Section B – September 2016
Explain the difficulties of using target costing in Q7 Section A – September 2016
service industries Q30 Section B – September 2016
Suggest how a target cost gap might be closed Q28 & 29 Section B – September 2016

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 2b: TARGET COSTING

Overview

Target
costing

Deriving a Closing a target Implications Target costing in

target cost cost gap service industries

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1 Target costing
Introduction
1.1 In a modern environment with shortening product life cycles, organisations have to
continually redesign their products. It is essential that they try to achieve a target cost during
the product's development.

Cost plus pricing

1.2 Under traditional approaches to pricing, businesses calculate the cost of manufacturing and
selling a product, and then add mark up, to give the profit element. These methods are
known as 'cost plus pricing'.

1.3 A major criticism of cost plus pricing techniques is that they do not consider any external
factors (eg demand for product, no. of competitors). They are therefore unlikely to maximise
the profits that a business will generate.

Target costing
1.4 As product life cycles have become much shorter, the planning, development and design
stage of a product is critical to an organisation's cost management process. Cost reduction
must be considered at this stage of a product's life cycle, rather than during the production
process.

1.5 Target costing involves setting a selling price for your product by reference to the market.
From this your desired profit margin is deducted leaving you with a target cost.

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2 Deriving a target cost

Traditionally:

mark up
(2nd)

selling price
(3rd)
cost
(1st)

Target costing:

margin
(2nd)

selling price
target (1st)
cost
(3rd)

Implementing target costing

2.1 (a) Define product specification and estimate anticipated sales volume.
(b) Set a target selling price at which the company will be able to achieve the desired
market share.
(c) Required profit is estimated based on profit margins or return on investment.
(d) Target cost is calculated as:
$
Target selling price X
Less target profit (X)
Target cost X
(e) The estimated cost of the product is calculated based on the product specification
and current cost levels.
(f) Estimated product cost – target cost = cost gap
(g) Efforts are made to close the cost gap. Aim to 'design out' costs before production
starts.

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Lecture example 1 Exam standard Section B (All Exams) – 6 marks

'House it' produces rabbit hutches. It is about to launch a new top of the range hutch which it
believes can be sold for $125. House it demands a margin of 25% on sales.
Cost information for the new hutch is as follows:
Timber – Good quality timber is essential – the hutch needs 10 m of good quality planed timber.
Sam can acquire this at a cost of $48.
Felt roofing material – 2 m2 are required. Roofing material costs $17.50 / m2.
Wire – 1 m of wire is needed at a cost of $1.50 per metre.
Labour – The hutch will take 2 hours to construct – labour is paid at a rate of $7 / hour.
Variable overhead – These will be incurred at a rate of $1.50 per labour hour.
1. What is the target cost of the rabbit hutch?
A $75
B $93.75
C $100
D $125
2. What is the expected cost to make the hutch?
A $93
B $98.50
C $101.50
D $125
3. Which of the following options would not be an appropriate strategy for 'House it' to
close the cost gap?
A Make the hutch smaller
B Raise the selling price
C Make the window bigger – increasing the proportion of wire and reducing the
proportion of wood
D Use lower skilled labour for the unskilled elements of production
4. What is the target cost of the rabbit hutch?
$
5. What is the expected cost to make the hutch?
 $93
 $98.50
 $101.50
 $125

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2b: TARGET COSTING

6. Which TWO of the following options would be the most appropriate strategies for
'House it' to close the cost gap?
 Make the hutch smaller
 Raise the selling price
 Make the window bigger – increasing the proportion of wire and reducing the
proportion of wood
 Use lower skilled labour for all elements of production
 Use lower quality timber to make the hutch

Solution

3 Implications
3.1 Target costing turns the traditional cost plus approach to pricing on its head, meaning
pricing is the first consideration. Cost control is considered right up front as part of the
development of the product, not merely as an activity which happens alongside production.

3.2 Performance management will therefore focus on ensuring sales targets are met and ways
of improving processes/development to drive down costs to at least the level of the target
cost.

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4 Implications of target costing in service industries

4.1 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.

4.2 Unlike manufacturing, service industries have the following characteristics which make cost
and performance measurement more difficult:
Simultaneity – created at time consumed
Heterogeneity – quality/consistency varies
Intangibility – of what is provided
Perishability – cannot make in advance and store up

4.3 In addition to these problems, service organisations will require more qualitative information
to arrive at a price and evaluate performance eg:
 Quality of service
 Repeat customers

Lecture example 2 Exam standard Section A (All Exams) – 2 marks

The following statements have been made about target costing.

1. It is more difficult to implement target costing in service industries rather than manufacturing
because of the lack of a tangible product.
2. Target costing makes the business look at what competitors are offering at an early stage in
the new product development process.
Which of the above statements is/are true?
A 1 only
B 2 only
C Neither 1 nor 2
D Both 1 and 2

Solution

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2b: TARGET COSTING

5 Chapter summary
Section Topic Summary
1 Target costing Target costing is an approach that sets the selling price
of a product or service with reference to the
marketplace.
2 Deriving a target Selling price less desired margin = target cost
cost
Any cost gap should be closed via the design and
development of the product.
3 Implications Cost control is considered up front during the development
stage.
4 Implications of Target costing can be applied to service industries but the
target costing in measurement of cost is more difficult.
service industries

END OF CHAPTER
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Life cycle costing

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Example past exam questions
Identify the costs involved at different stages of Q12 Section A – specimen exam
the life cycle.
Derive a life cycle cost or profit in manufacturing Q1 Section A – September 2016
and service industries. Q7 Section A – December 2016
Identify the benefits of lifecycle costing. Q26 Section B – September 2016

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 2c: LIFE CYCLE COSTING

Overview

Life cycle
costing

Costs at the different stages Deriving a life cycle cost Benefits of life cycle costing
of the life cycle

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 2c: LIFE CYCLE COSTING

1 Life cycle costing

Introduction
1.1 Life cycle costing aims to cost a product, service, customer or project over its entire life
cycle with the aim of maximising the return over the total life while minimising costs.

1.2 Traditionally the costs and revenues of a product are assessed on a financial year or period
by period basis.

1.3 Product life cycle costing considers all the costs that will be incurred from design to
abandonment of a new product and compares these to the revenues that can be generated
from selling this product at different target prices throughout the product's life.

2 Product life cycle

2.1 The product life cycle (PLC) can be divided into five stages.

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2.2 Characteristics of the PLC

Stage Sales volume Costs

Development None Research & development
Introduction Very low levels Very high fixed costs (eg fixed
(non-current) assets, advertising)
Growth Rapid increase Increase in variable costs
Some fixed costs increase
(eg increased number of fixed (non-
current) assets)
Maturity Stable Primarily variable costs
High volume
Decline Falling demand Primarily variable costs
(now decreasing)
Some fixed costs
(eg decommissioning costs)

Impact of PLC in the modern environment

2.3 (a) Shorter product life cycles.
(b) Clearer strategic planning required.
(c) 90% of costs to be incurred throughout its life cycle will have been determined before
a product reaches the market.

Maximising return over the product life cycle

2.4 There are a number of ways that return can be increased over the life cycle.
(a) Design costs out of products
Approximately 70%–90% of a product's life cycle costs are determined by decisions
made early in the life cycle at the design and development stage. Thus design and
production teams must work together to ensure costs are minimised.
(b) Minimise the time to market
This is the time from the conception of the product to its launch. If a company can get
a product to the marketplace very quickly, it will give the product as long a span as
possible without competitors' rival products in the marketplace. This should mean that
market share is increased in the long run.
(c) Minimise breakeven time
Pricing strategies will affect both contribution and volumes generated. A short
breakeven time is very important for liquidity purposes.
(d) Extend the length of the life cycle itself
For example, product development, finding other uses for a product or staggering the
launch of the product in different markets.
2.5 Collected data are compared with budgeted costs to check whether expected savings have
been realised.
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3 Implications
3.1 Given that there will be different levels of demand for a product over its expected life, it
would not be appropriate to set one price for the product's entire life.
3.2 An understanding of the stages a product goes through enables you to price accordingly to
either manipulate demand (low price, demand will rise and the intro stage is shortened) or to
maximise profit.
3.3 All costs relating to a product including R&D are associated with the product. This enables
true assessment of a product's profitability.
3.4 Having looked at a product's PLC it is clear that initially the product will make a loss.
Viewing profitability on a periodic basis can put unnecessary pressure on management due
to the visibility of the loss and could lead to wrong decisions being taken.

Advantages
3.5 (a) Considers external factors throughout a product's expected life
(b) Considers all costs incurred on a product, and therefore leads to cost reduction
(c) Very useful in the modern competitive environment, in which products often have a
short life cycle and when a large portion of costs will be committed prior to production
commencing

Lecture example 1 Exam standard Section A (All Exams) – 2 marks

Co X is in a high tech industry and is often first to market with new technological advances. It has
recently spent $500,000 designing and developing a new product. The new product is expected to
have a life of four years.
The anticipated performance of this product is as follows:
Year 1 Year 2 Year 3 Year 4
Sales volume (units) 4,000 9,000 30,000 10,000
$ $ $ $
Marketing costs 1.2 million 0.4 million 0.1 million 0.1 million
Variable production cost per unit 249 249 199 149
Customer service cost per unit 100 100 60 75
Disposal costs 0.2 million
What is the expected life cycle cost per unit?
A $196.95
B $205.39
C $249.00
D $321.64
What is the expected life cycle cost per unit?

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Solution

4 Chapter summary
Section Topic Summary
1 Life cycle costing Life cycle costing considers all costs and revenues of a
product throughout its life rather than on a periodic
basis.
2 Product life cycle The product life cycle is divided into five stages:
 Development
 Introduction
 Growth
 Maturity
 Decline
3 Implications Understanding the product life cycle enables you to price
accordingly to either manipulate demand or maximise
profit.

END OF CHAPTER
CHPATER
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Throughput accounting

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Example past exam questions
Calculate and interpret a throughput accounting Q13 Section A – Specimen exam
ratio (TPAR) Q16 – Q20 Section B – Specimen exam
Q26 Section B – December 2016
Suggest how a TPAR could be improved Q11 Section A – September 2016
Q3 Section A – December 2016
Q28 – Q30 Section B – December 2016
Apply throughput accounting to a multi-product Q27 Section B – December 2016
decision-making problem

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 2d: THROUGHPUT ACCOUNTING

Overview

Theory of constraints Goldratt's 5 steps Throughput accounting

Throughput
accounting

Throughput accounting ratios Throughput accounting and

decision making

Return/hour Products
Cost/hour Divisions
TPAR Limiting factor scenarios

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 2d: THROUGHPUT ACCOUNTING

1 Throughput accounting (TA) and theory of constraints

(TOC)
Theory of constraints (TOC)
1.1 The theory of constraints is a production system where the key financial concept is the
maximisation of throughput while keeping conversion and investment costs to a minimum.

1.2 Throughput = Sales revenue – Material cost

1.3 TOC focuses on bottlenecks in the production process which act as a barrier to throughput
maximisation.

Bottlenecks

raw materials component final assembly

materials sales
preparation preparation

100 units 50 units 100 units

per hour per hour per hour
One process will inevitably act as a bottleneck, known as a binding constraint.

1.4 Goldratt's 5 steps for dealing with a bottleneck activity were:

Step 1 – Identify the binding constraint

Step 2 – Exploit. The highest possible output must be achieved from the binding constraint.
This output must never be delayed and as such a buffer inventory should be held
immediately before the constraint.

Step 3 – Subordinate. Operations prior to the binding constraint should operate at the same
speed as it so that WIP does not build up.

Step 4 – Elevate the system's bottleneck. Steps should be taken to increase resources or
improve its efficiency.

Step 5 – Return to Step 1. The removal of one bottleneck will create another elsewhere in
the system.

Throughput accounting (TA)

1.5 TA is an accounting system based on the theory of constraints. It is very similar to the
marginal costing technique, key factor analysis, but uses a different definition of contribution.
It is most appropriate to use in a just-in-time (JIT) environment because of the emphasis on
throughput and inventory minimisation.

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1.6 TA emphasises throughput, inventory minimisation and cost control.

Three concepts:
(a) All factory costs are fixed in the short run, with the exception of material cost.
(b) In a JIT environment, producing for inventory is bad. Ideally inventory would be zero.
Products should not be made unless there is a customer for them. This means
accepting some idle time in non-bottleneck operations. WIP should be valued at
material cost only, so that no value is added to profit until a sale is made.
(c) Profit is determined by the rate at which throughput can be generated, ie how quickly
raw materials can be turned into sales to generate cash. Producing just to increase
inventory creates no profit and so should not be encouraged.

Traditional costing Throughput accounting

Labour costs and variable overheads All costs other than materials are seen as
are treated as variable costs. fixed in the short term.
Inventory is valued at total production Inventory is valued at material cost only.
cost.
Value is added when an item is Value is added when an item is sold.
produced.
Product profitability can be Profitability is determined by the rate at
determined by deducting a product which money is earned.
cost from selling price.

2 Ratios
2.1 (a) Total factory costs (TFC) = Fixed production costs, including labour
Sales revenue  material purchases
(b) Return per factory hour =
Time on key resource
Total factory costs
(c) Cost per factory hour =
Time on key resource
Return per factory hour
(d) TPA ratio =
Cost per factory hour

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Lecture example 1 Exam standard Section B (All Exams) – 4 marks

MN Co manufactures automated industrial trolleys. Each trolley sells for $2,000 and the material
cost per unit is $600. Labour and variable overhead are $5,500 and $8,000 per week respectively.
Fixed production costs are $450,000 per annum and marketing and administrative costs are
$265,000 per annum.
The trolleys are made on three different machines. Machine X makes the four frame panels
required for each trolley. Its maximum output is 180 frame panels per week. Machine X is old and
unreliable and it breaks down from time to time. It is estimated that 20 hours of production are lost
per month. Machine Y can manufacture parts for 52 trolleys per week and machine Z, which is old
but reasonably reliable, can process and assemble 30 trolleys per week.
The company has recently introduced a just-in-time (JIT) system and it is company policy to hold
little work in progress and no finished goods inventory from week to week. The company operates
a 40-hour week, 48 weeks a year.
1. Which is the bottleneck machine?
A Machine X
B Machine Y
C Machine Z
D All of the machines
2. The throughput accounting ratio (TPAR) is:
A 1.84
B 3.11
C 6.67
D 7.03

Solution

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Lecture example 2 Exam standard Section A (All Exams) – 2 marks

In the theory of constraints and throughput accounting, which of the following actions may
be used to improve a throughput accounting ratio?
(1) Increase selling price
(2) Buy cheaper materials
A (1) only
B (2) only
C Both (1) and (2)
D Neither (1) nor (2)

In the theory of constraints and throughput accounting, which THREE of the following
actions may be used to improve a throughput accounting ratio?
Increase selling price
Decrease selling price
Buy cheaper materials
Reduce time spent on the bottleneck machine
Increase time spent on the bottleneck machine

Solution

3 Throughput accounting and decision making

Ranking production
3.1 Products/divisions are ranked by TPA ratio.

3.2 If two or more products are made in the same factory, they can be ranked on return per
factory hour, not TPA ratio, since their costs will be identical.

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Target for decision making

3.3 The TPA ratio should be greater than one if a product is to be viable. Return/hour enables
businesses to make short-term decisions when there is a scarce resource.
Priority must be given to products generating the best ratios.

Use in performance management

3.4 A division of a company is not discouraged from inventory building if reported profit is used
as a principal performance measure.
Is it good or bad?
3.5 This is at odds with the JIT philosophy where purchase and production costs should only be
incurred if there is to be an immediate return generated.
Use of TPAR instead of (or in addition to) profit should resolve this problem.
3

Lecture example 3 Exam standard Section B (All Exams) – 8 marks

Teeth Co is a private cosmetic dental surgery offering two types of teeth whitening procedures
known as A and B.
Both procedures are carried out by one of three dentists. The surgery also has two receptionists
and three dental nurses.
Every patient is first seen by the receptionist, who books them in and completes the paperwork;
next by the dentist who applies the treatment; then finally a dental nurse who rinses the treatment
off. The average length of time spent with each member of staff is as follows:

Treatment A Treatment B
Hours Hours
Receptionist 0.15 0.25
Dentist 1.25 2.4
Dental nurse 0.5 0.5
The surgery is open for eight hours each day for five days per week. It closes for two weeks each
year. Staff salaries per employee are as follows:
Receptionist $25,000
Dentist $70,000
Dental nurse $30,000
The cost of the products used for procedure A is $40 and $74 for procedure B. Other surgery costs
amount to $200,000 each year.
Teeth Co charges $270 for procedure A and $365 for procedure B.
The dentists' time has been correctly identified as the bottleneck activity.

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1. What is the capacity of the bottleneck activity?

Treatment A Treatment B
A 1,600 833
B 1,600 2,500
C 4,800 2,500
D 4,800 4,800
2. The surgery has calculated the cost per hour to be $91.67.
What is the throughput accounting ratio (TPAR) for both treatments?
Treatment A Treatment B
A 2.01 1.32
B 2.01 3.98
C 2.95 1.32
D 2.95 3.98
3. Which of the following activities could the surgery use to improve the TPAR?
(1) Increase the time spent by the bottleneck activity on each treatment
(2) Identify ways to reduce the material costs for the treatments
(3) Increase the level of inventory to prevent stock-outs
(4) Increase the productivity of the receptionists
(5) Improve the control of the surgery's total operating expenses
(6) Apply an increase to the selling price of the services
A (1), (2) and (4)
B (2), (3) and (5)
C (2), (5) and (6)
D (1), (4) and (6)
4. What would be the effect on the bottleneck if the surgery employed another dentist?
A The dentists' time would be the bottleneck for treatment A only.
B The dentists' time would be the bottleneck for treatment B only.
C The dentists' time will remain the bottleneck for both treatments.
D There will no longer be a bottleneck.

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Solution

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4 Chapter summary
Section Topic Summary
1 Throughput Throughput accounting focuses on maximising throughput.
accounting and the Throughput = sales – materials
theory of constraints
All labour and variable overheads are seen as fixed in
the short term.
2 Ratios Return per factory hour =
Sales revenue  material purchases
Time on key resource
Total factory costs
Cost per factory hour =
Time on key resource
Return per factory hour
TPA ratio =
Cost per factory hour
3 Throughput Decisions are made with reference to the TPAR.
accounting and
decision making

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END OF CHAPTER
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Environmental
management accounting

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Example past exam questions
Discuss the issues businesses face in the Q4 Section A – Specimen exam
management of environmental costs.
Describe the different methods a business may Q5 Section A – September 2016
use to account for its environmental costs. Q13 Section A – December 2016

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 2e: ENVIRONMENTAL MANAGEMENT ACCOUNTING

Overview

Environmental management
accounting

Principles Methods to account for

environmental costs

Managing environmental Defining environmental costs

costs

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 2e: ENVIRONMENTAL MANAGEMENT ACCOUNTING

1 Principles of environmental costing

1.1 Increasingly, management accountants need to be aware of the environmental costs
associated with business activities.

1.2 In the past, environmental costs such as energy costs were treated as production overheads
and effectively hidden from management scrutiny.

1.3 Society has become more environmentally aware with 'carbon footprint' becoming a
recognised term. A carbon footprint measures the total greenhouse gas emissions caused
directly and indirectly by a person, organisation, event or product.

Managing environmental costs

1.4 Many benefits accrue from a clear understanding and effective management of the
environment-related costs of business activities.
(a) Environmental costs are becoming huge for some companies. Once identified,
environmental costs can be controlled and reduced.
(b) There is increasing worldwide regulation and a need for regulatory reporting of
environmental costs.
(c) Ethical issues – businesses should be aware of how their production methods will
affect the environment (eg carbon emissions).
(d) Improved brand image – 'green' ways of doing business can be a selling point.
(e) Associating environmental costs with individual products will lead to more accurate
pricing and improved profitability.

Lecture example 1 Exam standard Section A (All Exams) – 2 marks

Raxo plc is a multinational organisation, manufacturing chemicals for use in the agricultural
industry.
Which of the following environmental costs should NOT be included in an environmental
cost budget?
A Cost of disposal of unused raw materials
B Cost of fines for environmental contamination
C Cost of disposal of chemical packaging
D Cost of using pollution-prevention methods and technology

Solution

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2e: ENVIRONMENTAL MANAGEMENT ACCOUNTING

2 Defining environmental costs

2.1 Definitions of environmental costs vary widely. This can make it difficult to identify the costs
involved and therefore control them. They may be hidden inside 'general overheads'.

2.2 Hansen and Mendoza (1999) suggested that environmental costs could be classified as:
(a) Environmental prevention costs: the costs of activities undertaken to prevent the
production of waste eg environmental training.
(b) Environmental detection costs: costs incurred to ensure that the organisation
complies with regulations and voluntary standards eg record keeping and recording.
(c) Environmental internal failure costs: costs incurred from performing activities that
have produced contaminants and waste that have not been discharged into the
environment eg waste disposal costs.
(d) Environmental external failure costs: costs incurred on activities performed after
discharging waste into the environment.

2.3 Much business activity takes place at the cost of the environment, and some of these costs
are felt by society as a whole. Externalised costs are those for which wider society has to
'pay' at least an element – eg global warming.

3 Accounting for environmental costs

3.1 The PM syllabus is concerned with information for internal decision making only. It is not
concerned with how environmental information is reported externally.

3.2 There are a range of management accounting techniques for the identification and allocation
of environmental costs. The United Nations Division for Sustainable Development (UNDSD)
identified four techniques.

Input/output flow analysis

3.3 The idea of this analysis is that what comes in, must go out. Material inflows are recorded
and balanced with outflows. This forces the business to account for the difference and
therefore focus on environmental costs.

Flow cost accounting

3.4 Material flows through an organisation are divided into three categories.
 Material
 System and delivery
 Disposal
The value and cost of each material flow is then calculated. The aim is to reduce the
quantity of materials which should reduce the business's total costs in the long term and
have a positive effect on the environment.

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Activity based costing

3.5 In order to fully integrate environmental costs into their management accounting,
organisations can apply activity based costing principles to environmental costs.

3.6 Environmental costs would be grouped together into environmental cost pools, and each
pool would be associated with an environmental cost driver.

3.7 Individual products that passed through the most polluting processes would therefore
absorb more environmental costs than cleaner or more 'green' products.

3.8 As for ABC in general, this will lead to:

(a) Increased awareness of how environmental costs behave
(b) Better product pricing
(c) Better production decisions

Life cycle costing

3.9 Environmental costs are considered from the design stage of a new product right up to the
end of life costs such as decommissioning and removal.
The consideration of future disposal or remediation costs at the design stage may influence
the design of the product itself, saving on future costs.

4 Chapter summary
Section Topic Summary
1 Principles of Environmental costs need to be clearly
environmental costing understood by management, and not 'hidden'
in with production overheads.
2 Defining environmental Costs can be classified as 'internalised' in that
costs the impacts are contained within the
organisation.
Externalised costs are those which affect
society as a whole.
3 Accounting for There are four management accounting
environmental costs techniques for the identification and allocation
of environmental costs: input/output analysis,
flow cost accounting, activity based costing
and life cycle costing.

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END OF CHAPTER
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Cost volume profit
analysis

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Example past exam questions
Explain the nature of CVP analysis.
Calculate and interpret breakeven point and Q3 Section A – specimen exam
margin of safety. Q3 Section A – December 2016
Q16 Section B – December 2016
Calculate the contribution to sales ratio, in single
and multi-product situations, and demonstrate an
understanding of its use.
Calculate target profit or revenue in single and Q2 Section A – September 2016
multi-product situations, and demonstrate an Q17 – 19 Section B – December 2016
understanding of its use.
Prepare breakeven charts and profit volume
charts and interpret the information contained
within each, including multi-product situations.
Discuss the limitations of CVP analysis for Q20 Section B – December 2016
planning and decision making.

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3: COST VOLUME PROFIT ANALYSIS

Overview

CVP analysis

Single product Multi-product

Breakeven point
Margin of safety
C/S ratio
Target profit
Breakeven chart
Profit volume
chart
Limitations

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 3: COST VOLUME PROFIT ANALYSIS

1 Cost volume profit analysis (CVP analysis)

Introduction
1.1 CVP analysis looks at the effects of differing levels of activity on the financial results of a
business by examining the relationship between sales volume and profit.

1.2 Most businesses need to at least break even when setting prices and output levels. The
breakeven point for a company is the sales volume which will give the company a profit of
$nil. If sales exceed the breakeven point the company will make a profit.

Assumptions
1.3 Constant:
(a) Selling price per unit
(b) Variable cost per unit
(c) Total fixed costs

1.4 These lead to linear relationships for volume and sales revenue.

2 Single product breakeven analysis

Fixed costs
2.1 Breakeven point =
Unit contribution

2.2 The ratio of contribution to sales is an alternative method of finding the breakeven point.
It gives the amount of contribution earned per dollar of sales. It can be measured as a
fraction or a percentage.
It is also known as the profit-volume (P/V) ratio and can be used to determine breakeven
revenue.
Contribution/unit
Contribution/Sales ratio =
Selling price/unit
Fixed costs
Breakeven revenue = or Breakeven point  selling price/unit
C/S ratio

2.3 The margin of safety is a measure of the amount by which sales must fall before we start
making a loss. A loss is made if sales volume is less than the BEP.
Margin of safety = Budgeted sales – Breakeven sales
Budgeted sales  Breakeven sales
Margin of safety (%) =
Budgeted sales

2.4 The approach used to find an expression for the breakeven sales volumes can be extended
to find the volume needed to attain a required profit level.
The required profit is like an additional fixed cost which must be covered before the
company 'breaks even'.
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Fixed costs + target profit

Output required for target profit =
Unit contribution

Lecture example 1 Preparation Question

A company has fixed costs of $5,700 and variable costs per unit of $6.50.
Required
(a) If the selling price is $8/unit at all levels, what is the breakeven point (in units)?
(b) What is the breakeven revenue?
(c) What is the C/S ratio?
(d) If budgeted sales are 5,000 units, what is the margin of safety in units?
What is the margin of safety as a %? What does this mean?
(e) What is the sales volume (in units) required to make a profit of $10,000?

Solution

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Breakeven chart
2.5 The breakeven point can also be determined graphically using a breakeven chart.
This diagrammatically shows the relationship between revenue, costs and sales volume.

Lecture example 2 Technique demonstration

The breakeven chart for the data in Lecture Example 1 has been sketched.
Match the following labels to the letters on the graph:
Total cost line
Margin of safety
Breakeven point
Total revenue line

Sales
& Costs $

40,000 C
38,200 D

5,700

3,800 5,000 units

B

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2.6 We can also draw a contribution graph which shows that the gap between the total revenue
line and the variable cost line is the contribution:
$

40,000 Sales revenue Profit

Total costs
Contribution
Fixed costs
30,400
Variable cost

Fixed MoS
costs

3,800 5,000

Profit volume chart

2.7 The profit volume chart is an alternative to the breakeven chart as it illustrates the
relationship between profits and sales. It emphasises the impact of changes in volume on
profit.

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Lecture example 3 Section A (All Papers) – 2 marks

Below is a sketch of the profit volume chart for Lecture Example 1.

What does the letter Z represent?
A Breakeven point
B Fixed costs
C Profit
D Contribution

1,800

Volume
Z (Unit)

–5,700

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Lecture example 4 Preparation Question

(a) Indicate the following points on the chart in Lecture Example 3:

(i) Breakeven point
(ii) Fixed costs
(iii) Margin of safety
(b) How would the line differ if the fixed costs increased to $6,500?
(c) Describe the impact on the breakeven point if the selling price increased to $10.

Solution

Limitations of breakeven analysis

2.7 Breakeven analysis is a useful technique for managers as it can provide simple and quick
estimates. It is a form of sensitivity analysis and is therefore useful for assessing risk
surrounding the estimate of sales volume.
It does, however, have a number of limitations as it assumes that:
(a) All costs can be split into fixed and variable elements
(b) Fixed costs are constant
(c) Variable cost per unit is constant
(d) Selling price is constant
(e) Inventory levels are constant (Sales = Production)

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3 Multi-product breakeven analysis

Introduction
3.1 Breakeven analysis can be expanded for a 'single' mix of products using a weighted
average contribution figure. A constant product sales mix must be assumed.

Formulae
Fixed costs
3.2 Breakeven point =
Weighted average unit contribution
Fixed costs
Breakeven revenue =
Weighted average C/S ratio

Lecture example 5 Exam standard Section C (All Exams) – 4 marks

United Trading sells three products as follows.

Product Footballs Baseballs Rugby balls
$ $ $
Selling price 7 6 9
Variable costs 3 4.50 5
Budgeted sales (units) 2,000 4,000 3,000
Assume that the sales mix is 'fixed' in these proportions.
Fixed costs are $20,000.
Required
(a) What is the breakeven sales volume?
(b) What is the breakeven sales revenue?

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Solution

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Graphs
3.3 Graphs can also be used in multi-product situations to indicate the relationships between
cost, revenue and volume.

3.4 Multi-product P/V charts can also be produced which plot each of the products individually,
so allowing their profitability to be compared.

3.5 Products are plotted in the order of their contribution/sales ratio.

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Lecture example 6 Section A (All Exams) – 2 marks

Below is a sketch of a multi-product P/V chart for Lecture Example 5.

Required
What do the points Y and Z represent?
Point Y Point Z
A Breakeven point if most profitable Multi-product breakeven point
product made first
B Multi-product breakeven revenue Breakeven revenue if most profitable product
made first
C Multi-product breakeven point Breakeven point if most profitable product made
first
D Breakeven revenue if most profitable Multi-product breakeven revenue
product made first
Multi-product P/V chart
Profit/
loss

6,000 X

0 XY
XZ
14,000 41,000 50,000 65,000
Revenue
£

12,000 X

20,000 X

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Solution

3.6 It can be observed from the graph that when the company sells its most profitable product
first, it breaks even earlier than when it sells products in a constant mix.

4 Chapter summary
Section Topic Summary
1 CVP analysis Constant selling price, variable costs and fixed costs
assumptions
2 Single product Fixed costs
Breakeven point =
breakeven analysis contribution/unit
3 Multi-product Multi-product breakeven analysis can only be performed if
breakeven analysis a constant product sales mix is assumed.
Fixed costs
Breakeven point =
Weighted average contribution/unit
On a P/V chart, products should be plotted individually in
order of the size of their C/S ratio.

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END OF CHAPTER
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Limiting factor analysis

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Example past exam questions
Identify limiting factors in a scarce resource
situation and select an appropriate technique.
Determine the optimal production plan where an Q8 Section A – Specimen exam
organisation is restricted by a single limiting Q32 (a) Section C – September 2016
factor, including within the context of 'make' or
'buy' decisions.
Formulate and solve a multiple scarce resource
problem both graphically and using simultaneous
equations as appropriate.
Explain and calculate shadow prices (dual prices)
and discuss their implications on decision-making
and performance management.
Calculate slack and explain the implications of Q9 Section A – September 2016
the existence of slack for decision-making and Q32 (c) Section C – September 2016
performance management.

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Overview

Limiting factor
Shadow prices Slack
analysis

Single limiting factors Multiple limiting factors

Linear programming
 Graphical
 Simultaneous equations

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1 Introduction
1.1 The production and sales plans of a business may be limited by a limiting factor/scarce
resource (the 'principal budget factor').
This could be:
 Demand
 Materials
 Labour
 Machine hours
 Money
The plans of the business must be built around this factor.

2 Single constraint
2.1 If the business makes more than one product, it will want to find the product mix which will
maximise profit given the limiting factor by ranking products in terms of greatest
contribution per unit of limiting factor.

3 Shadow prices
3.1 A shadow price or (dual price) is:
 The additional contribution generated from one additional unit of limiting factor
 The opportunity cost of not having the use of one extra unit
 The maximum extra amount that should be paid for one additional unit of scarce
resource

Lecture example 1 Preparation Question

Jam & Sponge has just changed its cake mix and is struggling to cope with increased demand for
its cakes. Machine time available is 300 hours per week.

Fairy Butterfly Pixie

Information per batch: $ $ $
Sales price 150 120 100
Variable cost 100 80 70
Fixed cost 20 20 20
Profit 30 20 10
Machine time per batch 5 hrs 2 hrs 1 hr
Demand per week 50 50 50
Required
(a) What is the optimal production plan?
(b) What would happen if five extra machine hours were made available?
(c) What is the shadow price of one machine hour?

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Solution

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4 Limiting factors and throughput accounting

4.1 In a throughput environment the approach when a single limiting factor exists is the same as
under marginal costing except that we maximise return/unit of limiting factor.

Lecture example 2 Exam standard Section C (All Exams) – 6 marks

PH plc produces three different products and has adopted throughput accounting for its short-term
decisions.
The employees are guaranteed a weekly salary that is equivalent to their normal working hours
paid at their normal hourly rate of $7 per hour.
Costs and selling prices per batch are as follows:
Product Adam James Luke
$/batch $/batch $/batch
Selling price 340 450 270
Material K ($5/kg) 150 120 90
Material L ($10/kg) 70 90 40
Material M ($15/kg) 30 75 45
Labour ($7/hour) 21 28 42
Factory costs absorbed 20 80 40
PH plc is preparing its production plans and has estimated the maximum demand from its
customers to be as follows:
Batches
Adam 500
James 400
Luke 350
However, these demand maximums do not include a contract for the delivery of 50 batches of
each product to an important customer. If this minimum contract is not satisfied then PH plc will
have to pay a substantial financial penalty for non-delivery.
Material L is in short supply and the maximum amount available is 7,000 kg.
Required
Prepare calculations to determine the production mix that will maximise the profit of PH plc.

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Solution

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5 More than one constraint – graphical linear

programming
5.1 When there is more than one limiting factor, the above method cannot be used. Instead
linear programming using graphical analysis and simultaneous equations needs to be used.

Steps
5.2 Formulating the model
(a) Define variables
(b) Establish constraints – generally in the form: amount of resource used  amount
available
(c) Formulate objective function
Solving the problem using graphs (only if two variables):
(d) Plot constraints on a graph
(e) Identify the feasible region ie those combinations of variables which are possible
within the resource constraints
(f) Plot the slope of the objective function (iso-contribution/profit line) and slide to optimal
point (away from the origin for a maximum, towards the origin for a minimum)
(g) Calculate the value of the objective function at the optimal point

Lecture example 3 Technique demonstration

KG Ltd makes two products, the Purse and the Handbag. Each purse earns $5 contribution and
each handbag earns $6. Inputs are as follows:
Purse Handbag
Leather 1½ m2 2 m2
Cotton 1 m2 1 m2
Skilled labour 45 min 30 min
There are 6 skilled labourers each working a 35-hour week and it is not possible to recruit any
additional skilled labour in the short term. Delivery contracts limit the amount of leather available to
600 m2 and the amount of cotton, for the product linings, to 375 m2 each week.
Sales forecasts have revealed that the maximum demand for purses during the period is 250.
Leather costs $8 per m2, cotton costs $1.50 per m2 and wages are paid at $4.20 per hour.
Required
Using graphical linear programming determine the optimal production plan for KG Ltd and
calculate accurately the contribution that can be achieved using whichever equations you
need.

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Solution
(a) Identify variables

(b) State constraints as linear relationships

(c) Formulate objective function

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(d) Plot a graph

Workings

(e) Determine optimal point

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(f) Plot the objective function

(g) Calculate the value of the objective function (using simultaneous equations)

6 Available resources
6.1 Slack occurs when the maximum availability of a resource is not used.
6.2 If the entire resource available is required for the optimal solution, then the company will be
willing to pay a premium (shadow price) to obtain additional resources.

Lecture example 4 Exam standard Section A (All Exams) – 2 marks

What are the shadow prices for leather, cotton and labour for KG?
Leather Labour Cotton
A $2.65 $1.35 $0
B $10.65 $1.35 $1.50
C $2.65 $5.55 $1.50
D $10.65 $5.55 $0
What is the shadow price of leather?

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Solution

7 Using linear programming

7.1 Assumptions made in linear programming techniques include:
(a) Fixed costs are unchanged by decision
(b) Unit variable cost is constant
(c) Estimates of demand and resource requirements are known with certainty
(d) Units of output are divisible
(e) Total amount of each scarce resource is known with certainty
(f) No interdependence between demand for products

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7.2 Linear programming can be useful in the following situations:

(a) Budgeting
(b) Calculation of relevant costs
(c) Production decisions
(d) Payment for scarce resources
(e) Control
(f) Capital budgeting

8 Chapter summary
Section Topic Summary
1 Introduction Plans of the business are built around the limiting factor.
2 Single constraint Single limiting factor problems can be solved by
maximising contribution/limiting factor or return per
limiting factor if with throughput accounting.
3 Shadow prices A shadow price is the additional contribution
generated from one more unit of limiting factor.
4 Limiting factors and Rank products on the basis of their throughput
throughput contribution.
accounting
5 Multiple constraints Multiple limiting factor problems are solved via linear
programming. First formulate the model. Secondly solve
the problem using graphs or simultaneous equations.
6 Slack Slack occurs when not all of a resource has been
used.

END OF CHAPTER
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Pricing decisions

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Example past exam questions
Explain the factors that influence the pricing of a
product or service.
Explain the price elasticity of demand.
Derive and manipulate a straight line demand Q31 Section C – September/December 2017
equation. Derive an equation for the total cost
function (including volume-based discounts).
Calculate the optimum selling price and quantity Q31 Section C – September/December 2017
for an organisation equating marginal cost and
marginal revenue.
Evaluate a decision to increase production and
sales levels, considering incremental costs,
incremental revenues and other factors.
Determine prices and output levels for profit Q31 Section C – September/December 2017
maximisation using the demand based approach
to pricing (both tabular and algebraic methods).
Explain different pricing strategies. Q24 Section B – Specimen exam
Q14 Section A – December 2016
Q31 Section C – September/December 2017
Calculate a price from a given strategy using
cost-plus and relevant costing.

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Overview

Pricing
decisions

Demand

Total cost function Pricing strategies

Y = a + bx
 Cost plus
– Full cost
– Marginal cost
– Relevant cost
Price elasticity Demand function Optimal pricing – Standard cost
% Q P = a – bQ  Market penetration
MR = MC
 Market skimming
% P
 Premium pricing
 Price discrimination
 Product bundling
 Psychological pricing
 Product line pricing
 Complementary
products
 Loss leaders
 Controlled pricing
 Volume discounting

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1 Introduction
1.1 Historically the cost of a product would have had a large influence on the selling price set for
that product. Today there are many factors that will influence that price.
These factors include:
(a) Demand
(b) Quality
(c) Competitors
(d) Substitutes
(e) Inflation
(f) Age of product
(g) Disposable incomes

2 Demand
2.1 Economic theory is that the higher the price charged the less demand there will be for
Variables which
normal goods.
influence demand
Price elasticity
2.2 Price elasticity of demand (PED) is a measure of the responsiveness of demand to changes
in price. Some products are more responsive than others.

% Q % change in Q
2.3 PED is calculated =
% P % change in P
When PED > 1:
The product is described as having elastic demand. This means that a small change in
price will cause a proportionately greater change in quantity demanded.
When PED < 1:
The opposite applies. The product has inelastic demand and prices can be changed
greatly without creating large changes in demand.

2.4 An awareness of the PED of a product will assist companies when setting price.

Demand and the 2.5 Where demand is inelastic prices can be raised.
individual firm
2.6 If demand is elastic a decrease in price will result in an increase in volume.

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Lecture example 1 Technique demonstration

A football club charges $12 per ticket for home games. Average attendance at these regular
games is 16,000.
When prices were increased by $1 per ticket, attendance fell by 2,500.
Determine the PED if ticket price increases from $12 to $13.

Solution

Demand function
2.7 Price will affect the quantity demanded for a product. Output considerations will alter the
price to be charged. If the demand function is known, and the desired output has been
calculated, the appropriate price can be determined for the product.
2.8 Demand functions are usually downward sloping – demand falls when price rises and vice
versa.
($) P

Q (units)
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2.9 If a downward sloping demand curve becomes steeper demand is becoming more inelastic.
If it becomes shallower it is more elastic.

2.10 The demand function will be in the form P = a – bQ.

P = Selling price
Q = Quantity demanded at that price
a = Theoretical maximum price. If price is set at 'a' or above, demand will be zero
change in price Gradient of line. Represents the change in price required
b =
change in quantity to change demand by 1 unit

Lecture example 2 Exam standard Section A (All Exams) – 2 marks

A football club charges $12 per ticket for home games. Average attendance at these regular
games is 16,000.
When prices were increased by $1 per ticket, attendance fell by 2,500.
Assume attendance to be purely price dependent.
What should be the ticket price to ensure a full house with capacity being 25,000?
A $6.40
B $8.40
C $13
D $18.40

Solution

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3 Optimal pricing
3.1 The desired level of output can be determined graphically by plotting total cost and total
revenue lines. This is another breakeven chart, as used by economists.

$ TC
MR

Profit TR

MC

Optimal output X

3.2 The gradient of the total revenue line is known as the marginal revenue (MR). It is the
increase in total revenue from selling one more unit.
3.3 The marginal revenue will be MR = a – 2bQ.

3.4 The gradient of the total cost line is known as the marginal cost (MC). It is the increase in
total cost from producing one more unit.

3.5 This analysis can be used to ensure the company reaches its objective.

3.6 Profit is maximised where the gradients are equal, ie where marginal revenue = marginal
cost.

Optimal pricing approach

Step 1 – Determine the demand function.
Step 2 – Make the MR equation given equal to the value of MC.
Step 3 – Substitute the values found for a and b in Step 1 into the MR formulae and solve.
Step 4 – Take the quantity found in Step 3 and put this into the demand function to find the
price that should be charged.

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Lecture example 3 Exam standard Section A (All Exams) – 2 marks

A firm charges $18 per unit for its product. At this price it sells 17,000 units.
Research has shown that when prices were changed by $1 per unit sales changed by 2,000 units.
The product has a constant variable cost per unit of $5.
The demand function is given by P = a – bQ. The marginal revenue will be MR = a – 2bQ.
Determine the price to be charged to maximise profit.
A $8.50
B $15.75
C $21.50
D $26.50

Solution

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Tabular approach
3.7 One approach to determining the profit maximising production plan is to calculate the extra
(marginal) costs and revenues at different combinations of output and selling price.

Lecture example 4 Exam standard Section A (All Exams) – 2 marks

Total Selling Total

Output cost MC price revenue MR Profit
(Units) $ $ $ $ $ $
10 10 10 5.00 50 50 40

20 25 15 4.50 90 40 65

30 45 20 4.00 120

40 70 25 3.50

50 100 3.00

60 135 2.50

Complete the table above to determine the output level and selling price that will maximise
profit.
A $20
B $30
C $40
D $60

Solution

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3.8 A tabular approach assumes that only discrete variables exist, ie that either 30 or 40 units
can be sold, not, say, 35. The use of equations can solve this problem.

4 Pricing strategies
Cost plus
4.1 The price of the product is calculated by adding an appropriate profit mark up to the
Cost plus pricing
examples product's cost. This cost could be:
 Absorption/full cost (including ABC)
 Marginal cost
 Relevant cost (Chapter 6)
 Standard cost

Advantages
4.2 (a) Readily understood/easy to apply
(b) Readily determined
(c) Doesn't require/assume a linear and stable price/quantity relationship

Disadvantages
4.3 (a) Because it ignores the impact that the price will have on quantity demanded, it will not
maximise profit.
(b) If the basis of absorbing overheads changes, the price of the product will change.
Thus absorption costing methods require accurate overhead and activity levels.
(c) Price may need to be adjusted to reflect market conditions.

Market penetration
4.4 A policy of low prices when the product is first launched to obtain sales volume and market
share.

4.5 Useful if:

(a) The firm wants to discourage new entrants into the market
(b) The firm wishes to shorten the initial period of the product's life cycle
(c) There are significant economies of scale to be achieved

Market skimming
4.6 Involves charging high prices when a product is first launched and spending heavily on
advertising and sales promotion to obtain sales. As the product moves into the later stages
of its life cycle (growth, maturity and decline) progressively lower prices will be charged. The
aim of market skimming is to gain high unit profits early in the product's life.

4.7 Useful if:

(a) The product is new and different, so that customers are prepared to pay high prices to
be 'one up' on people who do not own it
(b) The product has a short life cycle and needs to recover development costs and make
a profit quickly
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Premium pricing
4.8 Making a product appear 'different' so as to justify a premium price. The product may be
different in terms of quality, reliability, durability, after-sales service or extended warranties.
Heavy advertising can establish brand loyalty which can help to sustain a premium.

Price discrimination
4.9 When a company can sell into two or more separate markets, it might be able to charge a
different price in each market. To be successful the company must prevent the transfer of
goods from the cheap market to the more expensive one.

Product bundling
4.10 Selling a number of products or services as a package at a price lower than the aggregate
of their individual prices.

Psychological pricing
4.11 Psychological pricing strategies include pricing a product at £19.99 instead of £20.

4.12 Another example would be withdrawing an unsuccessful product from the market and then
relaunching it at a higher price, the customer having equated the lower price with lower
quality (which was not the seller's intention).

Product–line pricing
4.13 Most organisations sell not just one product but a range of products. Focus is placed on the
profit from the whole range rather than the profit on each single product.

Complementary product pricing

4.14 These products are sold separately but are used together. One product would tend to be
priced competitively which attracts demand for the complementary product.

Loss leaders
4.15 Particularly useful in retailing, a very low price is charged for one product, which is intended
to make consumers buy additional products in the range that carry higher profit margins.

Controlled pricing
4.16 Monopolies have the potential power to charge very high prices for their goods/services as
demand is inelastic. Frequently monopolies are regulated to ensure customers receive value
for money.

Volume discounts
4.17 These are given in order to increase sales volume without reducing prices permanently.
They also allow differentiation between customers ie wholesale v retail.

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5 Other considerations
5.1 Bear in mind decisions should not just be based on financial factors. Non-financial
considerations should also be made.
These might include:
 Company objectives – profit, sales, revenue, market share, long term or short term
 Competition and markets – competing products and reaction of competitors
 Production capacity – demand may exceed supply
 Product life cycle – introduction, growth, maturity, decline
 Superior innovation, technology or quality – may set higher prices
 Customer's buying power
 Other products in range – displacing or supplementary
 Availability of resources
 Impact on staff
 Impact on customers
 Competitors' reactions
 Opportunity costs
 Impact on other products

6 Chapter summary
Section Topic Summary
2 Demand PED measures the responsiveness of demand to a
change in price. PED > 1 = elastic demand. PED < 1 =
inelastic demand.
Price can be determined using the demand function:
P = a – bQ
3 Optimal pricing The output level to maximise profit is found when
MR = MC.
The output level to maximise revenue is where MR = 0.
Prices at these output levels can then be determined
from the demand function.
4 Pricing strategies There are several strategies that can be applied to a
product. These strategies may be changed depending
upon the stage in the product life cycle.
5 Other The pricing strategy should be chosen bearing in mind
considerations both financial and non-financial factors.

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END OF CHAPTER
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Short-term decisions

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Example past exam questions
Explain the concept of relevant costing.
Identify and calculate relevant costs for a specific Q26 – 30 Section B – Specimen exam
decision from given data.
Explain and apply the concept of opportunity
costs.
Explain the issues surrounding make vs. buy and
outsourcing decisions.
Calculate and compare 'make' costs with 'buy-in'
costs.
Compare in-house costs and outsource costs of
completing tasks and consider other issues
surrounding this decision.
Apply relevant costing principles in situations Q32 Section C (part c) – September 2016
involving shut down, one-off contracts and the Q6 Section A – December 2016
further processing of joint products.

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 6: SHORT-TERM DECISIONS

Overview

Short-term
decisions

Relevant costs Decisions

 Future  Accept or reject
 Cash flow  Make or buy
 Specific to decision  Outsourcing
 Opportunity costs  Shut down
 Minimum price
 Further processing

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1 Decision-making scenarios
1.1 (a) Accept or reject
(b) Make or buy
(c) Outsource
(d) Shutdown
(e) Minimum price of an order/job/contract
(f) Further processing decisions

2 Relevant costs
The relevant cost concept is fundamental in decision making.

2.1 In order for a cost to be a relevant cost it must be:

(a) Future
(b) Cash flow
(c) Incremental (specific to the decision)

2.2 Relevant costs may also be:

(a) Opportunity costs – the value of a benefit sacrificed when one course of action is
chosen in preference to an alternative. The opportunity cost is represented by the
potential benefit forgone.
(b) Avoidable costs – the specific costs of an activity or sector of a business which
would be avoided if that activity or sector did not exist.
Avoidable costs are usually associated with shutdown decisions. Fixed costs may be
avoided if they are specific to a department or product. Allocated fixed costs are
unlikely to change.

2.3 The following are not relevant costs.

Sunk costs – costs that have already been incurred.
Committed costs – these might include the cost of materials under a long-term contract.
Notional costs – non-cash items such as depreciation or the apportionment of general
overheads.

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Relevant cost of materials

2.4

In inventory

Not in stock
In continual
No other use Scarce
use

If take from If take from If take from

Have to buy it inventory will be inventory won't inventory can't
replaced be replaced replace it

Relevant cost is ...

Current Current Current

Opportunity
replacement replacement resale
cost
cost cost value

Lecture example 1 Exam standard Section A (All Exams) – 2 marks

A contract requires 400 kg of X and 200 kg of Y.

The following data is available:
Current
Historic purchase Scrap
In inventory cost price value
X 300 kg $2/kg $3/kg $2.20/kg
Y 300 kg 50c/kg $2/kg $1.50/kg
X is no longer used by the company; Y is regularly used for other products/purposes within the
business.
What is the relevant cost of X and Y to be included in the contract cost?
A $1,000
B $1,300
C $1,360
D $1,660

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Solution

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Relevant cost of labour

2.5

Current labour force

Spare Full
capacity capacity

Additional Additional
work can be work cannot be
undertaken undertaken

Hire more Cannot hire

staff more staff

Relevant cost is ...

Variable
Current
Nil cost & lost
rate of pay
contribution

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Lecture example 2 Exam standard Section A (All Exams) – 2 marks

A plc is deciding whether to undertake a new contract.

15 hours of labour are required for the contract. Labour is currently at full capacity producing X.

Cost card for X $/unit

Direct materials (10 kg @ $2) 20
Direct labour (5 hrs @ $6) 30
50
Selling price 75
Contribution 25
What is the cost of using 15 hours of labour for the contract?
A $6
B $75
C $90
D $165
What is the cost of using 15 hours of labour for the contract?

Solution

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3 Accept or reject decisions

Lecture example 3 Exam standard Section B (All Exams) – 10 marks

Make Co makes a range of different products. It has been approached by a new customer to
manufacture 12,000 units of T over 12 months at a selling price of $3 per unit. This would be in
addition to normal budgeted production.
The following statement has been prepared:
$ $
Sales revenue 36,000
Costs: Material X at historical cost 5,000
Material Z at contract price 9,000
Skilled manufacturing labour 10,000
Semi-skilled manufacturing labour 2,000
Depreciation of machine 4,000
Variable overheads @ 30c per unit 3,600
Fixed overheads
(absorbed @ 60% of skilled manufacturing labour) 6,000
(39,600)
(3,600)
A quotation now needs to be prepared on a relevant cost basis so that Make Co can decide
whether to accept the proposal.
1. Material X cannot be used or sold for any other product. It would cost $200 to dispose of the
existing inventories.
Each unit of new production uses two kilos of material Z. The company has entered into a
long-term contract to buy 24,000 kilos at an average price of 37.5c per kilo. The current
price is 17.5c per kilo. This material is regularly used in the manufacture of the company's
other products.
What is the cost of the two materials which should be included in the quotation?
Material X Material Z
A $200 $9,000
B $5,000 $4,200
C ($200) $9,000
D ($200) $4,200

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2. The new product requires the use of skilled labour, which is scarce. If product T were not
made this labour could be used on other activities, which would yield a contribution of
$1,000. Semi-skilled labour currently has spare capacity to undertake the additional work.
What cost should be included in the quotation for skilled labour and semi-skilled
labour?
Skilled labour Semi-skilled labour
A $1,000 $2,000
B $10,000 $2,000
C $10,000 $0
D $11,000 $0
3. The machine which would be used to manufacture T was bought new 3 years ago for
$22,000. It had an estimated life of 5 years with a scrap value of $2,000.
If the new product is not manufactured the machine could be sold immediately for $7,000. If
it is used for one year it is estimated that it could then be sold for $4,000.
What is the cost which should be included in the quotation for machine costs?
Machine
A $4,000
B $7,000
C $3,000
D $0
4. Which statement correctly describes the treatment of the general fixed overheads
when preparing the quotation?
A The overheads should be included because they relate to production costs.
B The overheads should be included because all expenses should be recovered.
C The overheads should be excluded because they are a sunk cost.
D The overheads should be excluded because they are not an incremental cost.
5. Which statement correctly describes the decision Make Co should reach regarding
the proposal?
A Reject because the relevant costs exceed the relevant benefits
B Reject because it will decrease the company's profits for the year
C Accept because the relevant benefits exceed the relevant costs
D Accept because it will increase the company's profits for the year

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Solution

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4 Make or buy decisions

Lecture example 4 Exam standard Section C (All Exams) – 10 marks

Mars Co makes units Pluto & Jupiter, for which costs in the forthcoming year are expected to be as
follows.
P J
Production (units) 1,000 1,500
$ $
Direct materials 3 5
Direct labour 6 9
Variable production overheads 2 3
11 17
Directly attributable fixed costs per annum and committed fixed costs:
$
Incurred as a direct consequence of making P 1,500
Incurred as a direct consequence of making J 3,000
Other fixed costs (committed) 10,000
14,500
A sub-contractor has offered to supply units of P for $12 and J for $21.
Required
(a) Should Mars make or buy the components?
(b) What other factors should be considered before making a decision?

Solution

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4.1 Remember decisions should not be purely based on financial factors.

4.2 Making the product gives the company more control whereas buying the product gives them
access to an organisation with specific expertise.
4.3 They will also need to consider what the impact will be on:
(a) The workforce
(b) Customers
(c) Competitors

5 Outsourcing decisions
Outsourcing
5.1 Outsourcing scenarios are very similar to make or buy decisions and therefore you should
approach these in exactly the same way.

5.2 Consideration of non-financial factors is particularly important here.

Advantages Disadvantages
Cost savings Loss of control
Access to expertise Impact on quality
Releases capital How flexible, reliable is supplier
Frees up capacity Potential loss of confidential information
Loss of in-house skill
Impact on employees’ morale

6 Shutdown decisions
6.1 These decisions may involve the closure of:
(a) A division
(b) A product
(c) A department
of a business that appears to be loss making.

6.2 Shutdown decisions should not be made on the basis of profitability under absorption
costing as this fails to consider the relevance of fixed overheads.

6.3 Shutdown decisions should focus on:

(a) Variable costs
(b) Avoidable costs (what constitutes an avoidable cost may be different depending upon
the timing of the decision)
(c) Directly attributable costs (and revenues) if the closure is made
(d) Timing

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Lecture example 5 Exam standard Section C (All Exams) – 8 marks

Lewis Ltd manufactures three products, K, L and G. Forecasted income statements for next year
are as follows:
K L G Total
$'000 $'000 $'000 $'000
Sales 600 300 200 1,100
Cost of production
Materials (200) (60) (30)
Labour (95) (20) (10)
Variable overhead (75) (10) (5)
Fixed overhead (210) (50) (80)
Gross margin 20 160 75 255
Selling costs (30) (20) (15) (65)
Net margin (10) 140 60 190
The directors are considering the closure of the K product line, due to the losses incurred. You
obtain the following information:
(1) Fixed production overheads consist of an apportionment of general factory overheads,
based on 80% of direct materials cost. The remaining overheads are specific to the product
concerned.
(2) Selling costs are based on commission paid to sales staff.
Required
(a) Determine if the K product line should be closed down.
(b) Suggest other factors that should be considered prior to a final decision.

Solution

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7 Minimum price
7.1 Minimum price scenarios are dealt with in exactly the same way as the other examples we
have seen so far.

7.2 The minimum price quoted must be the relevant cost. Never be tempted to add on an
amount for general overheads that the question may tell you is allocated to each job or a
profit mark up. These items are not relevant.

8 The further processing decision

Processes
8.1 In certain circumstances more than one product may be produced from a single process.
These products may sell in their current state or may need further, separate processing
before they can be sold. The decision whether or not to process further is based on relevant
Joint products costs and benefits.

Joint costs
8.2 The costs of the process will need to be apportioned between the products created by the
process in order to:
(a) Value inventory
(b) Prepare financial accounts

8.3 These costs are not relevant when deciding whether to process any product further
because they are:
(a) Sunk
(b) Arbitrarily apportioned

8.4 The total joint cost may be relevant for decisions regarding the viability of the process as a
whole.

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Lecture example 6 Exam standard Section A (All Exams) – 2 marks

Product Selling price Post

Selling price after further separation
Output at separation processing costs
X 2,500 3 5 10,000
Y 1,500 5 10 8,000
Z 2,000 8 15 12,000
Joint processing costs are $20,000.
Which products should be processed further?
A X, Y and Z
B X and Y
C X only
D Z only

Solution

9 Qualitative factors
Assumptions in relevant costing
9.1 (a) Cost behaviour patterns are known with certainty.
(b) Costs, prices and volumes are known with certainty.
(c) Objective is to maximise profit/contribution.
(d) Information is complete and reliable.

9.2 Note. State all assumptions made in relevant costing questions.

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Other factors to consider

9.3 Exam questions may require a discussion of other factors, aside from the financial
calculation, that should be taken into account in making any decision.

9.4 Timescale can also be relevant. Many fixed costs can be varied, but only in the long term.

10 Chapter summary
Section Topic Summary
1–8 Relevant costs Decisions should be made on the basis of relevant costs.
Relevant costs must be future, cash flows and specific
to the decision. They may also be opportunity costs.
9 Qualitative factors Non-financial considerations should also be taken into
account before making a final decision.

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END OF CHAPTER
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Quantitative analysis in
budgeting

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Example past exam questions
Analyse fixed and variable cost elements from
total cost date using high/low method.
Estimate the learning rate and learning effect. Q21 Chair Co section B – specimen exam
Apply the learning curve to a budgetary problem, Q22 – 23 Chair Co section B – specimen exam
including calculations on the steady state.
Discuss the reservations with the learning curve.

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Overview

High-low method
Total cost
Y = a + bx
function

Quantitative analysis
in budgeting

Theory
As cumulative output
doubles the average time Learning curves Formula
to produce a unit falls Y = axb
by a given rate

Conditions Steady state Experience effect

and
problems

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1 Introduction
1.1 In order to prepare budgets, forecasts of costs and revenues will need to be undertaken.
You will have seen in your earlier studies the use of the high-low method and linear
regression to analyse total costs into their fixed and variable elements.

2 High-low method
Example
Units 10,000 12,000 14,000
Labour ($) 27,000 31,000 35,000
Required
Calculate the variable cost per unit and the fixed labour cost.

Solution
Step 1 – Take the highest and lowest output levels

Output Cost
Highest 14,000 35,000
Lowest 10,000 27,000

Step 2 – Find the difference 4,000 8,000

Step 3 – Calculate the variable cost/unit
... VC/unit = $8,000/4,000 = $2
Step 4 – Calculate the fixed cost
By substitution into high output:
Total costs 35,000
Variable cost (28,000)
 fixed cost 7,000

3 Total cost function

3.1 When determining price and output levels we need to bear in mind the cost and revenue
behaviours. These can be expressed as equations and graphed (as you will have seen in
your earlier studies on cost behaviours).

3.2 Most simply the costs of producing an item are expressed as y = a + bx

y = total cost
a = fixed cost (the intercept on the y axis)
b = variable cost per unit (the gradient of the line)
x = output

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y
Total cost TC
b

a FC

x
Output

3.3 This assumes fixed costs remain unchanged and variable costs per unit are constant.
However, this will not always be the case.

3.4 In the short term we may be able to assume that fixed costs stay the same but variable
costs could change due to bulk buying or learning curves.

4 Learning curve theory

Introduction
4.1 When new working practices or products are introduced, the theory is that as a workforce
gains experience in a task, it will come to perform that task quicker.
This means that labour costs and variable overheads (if labour hour driven) will be lower in
later periods of production than when the new product or production technique is introduced.

Theory
4.2 The theory of learning curves will only hold if the following conditions apply:
(a) There is a significant manual element in the task being considered.
(b) The task must be repetitive.
(c) Production must be at an early stage so that there is room for improvement.
(d) There must be consistency in the workforce.
(e) There must not be extensive breaks in production, or workers will 'forget' the skill.
(f) Workforce is motivated.

Rule
4.3 As cumulative output doubles, the cumulative average time per unit falls to a given
percentage of the previous cumulative average time per unit.
Cumulative average time is the average time for all units produced so far.

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Learning effect Y = axb

Cumulative
average time
per unit

Steady state

Cumulative output

Lecture example 1 Exam standard – Section A (All Exams) – 2 marks

A firm's workforce experiences a 75% learning rate.

The budgeted time for the first batch is 100 hours.
What is the total time to produce eight batches in total?
A 42.19 hours
B 337.5 hours
C 600 hours
D 800 hours

Solution

Output Total time Cumulative average time

(batches) (hours) (hours)
1 100 100

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Formula
4.4 Y= aXb
where Y is the cumulative average time per unit taken to produce X units
a is the time taken to produce the first unit
X is the cumulative number of units
b is the index of learning (log LR/log 2)
LR = the learning rate as a decimal

Lecture example 2 Technique demonstration

A firm's workforce experiences a 75% learning rate.

The budgeted time for the first batch is 100 hours.
Using the formula Y= aXb, calculate the time to produce:
(a) The first 10 batches in total
(b) The 10th batch only

Solution

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Steady state
4.5 Eventually, the time per unit will reach a steady state where no further improvement can be
made.

Cessation of learning effect

4.6 Practical reasons for the learning effect to cease are:
(a) When machine efficiency restricts any further improvement.
(b) The workforce reach their physical limits.
(c) There is a 'go-slow' agreement among the workforce.

Lecture example 3 Exam standard Section B (All Exams) – 6 marks

Flogel Co has just produced the first full batch of a new product taking 200 hours.
Flogel has predicted a learning curve effect of 85%. b = –0.2345
1. How long will it take to produce the next 15 batches?
A 1,470 hours
B 1,590 hours
C 1,670 hours
D 3,000 hours
2. Flogel expects that after the 30th batch has been produced, the learning effect will cease.
From the 31st batch onwards, each batch will take the same time as the 30th batch.
What is the long-run steady state time per unit?
A 30 hours
B 31 hours
C 69 hours
D 90 hours
3. The first 8 units have now been produced. The first unit took 200 hours to make and the
total time for the first 8 units was 819.2.
What was the actual rate of learning which occurred?
A 85%
B 80%
C 72%
D 50%

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Solution

Uses of learning curve theory

4.7 The learning curve theory can be used in the business for:
 Forecasting labour hours required
 Cash forecasting
 Standard setting
 Cost calculation
 Price setting

Problems with learning curve theory

4.8 Although it seems a useful and easy to apply technique, learning curve theory is not without
problems:
 How do we calculate the rate?
 How do we know when the production will reach steady state?
 Is the rate really constant?

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5 Experience effect
5.1 The 'learning curve' is a term usually applied to the time taken by the skilled labour element
in production.

5.2 The 'experience curve' covers all costs that may reduce due to technological and
managerial learning effects, following an increase in production volumes:
 Material costs may decrease with quantity discounts.
 Variable overheads follow the pattern of direct labour.
 Fixed overheads per unit will decrease as production volumes rise.

5.3 The experience curve is exploited through:

 Growth
 Market share
 Mass production

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6 Chapter summary
Section Topic Summary
2 High-low Method This can be used to determine the amount of fixed and
variable cost which can then be used to forecast for
different levels of output.
3 Total cost function Total costs can be represented as a straight line equation
y = a + bx.
4 Learning curve The amount of time needed for production may reduce
theory when the product is new, repetitive and has a significant
manual element.
Learning curve theory states that as cumulative output
doubles, the cumulative average time per unit falls to
a given percentage of the previous cumulative
average time per unit.
The time/cost for production of units can be calculated if
the rate of learning is known using the formula Y= aXb.
Eventually a consistent time to produce a unit will be
reached from which it is not possible to improve any
further. This is known as steady state.
5 Experience effect This refers to the other costs (besides labour) that may
reduce as production volumes increase.

END OF CHAPTER
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Risk preferences

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Example past exam questions
Suggest research techniques to reduce
uncertainty eg focus groups, market research.
Apply the techniques of maximax, maximin and Q16 – 18 Section B – September 2016
minimax regret to decision-making problems
including the production of profit tables.
Calculate the value of perfect and imperfect Q14 Section A – December 2016
information. Q19 Section B – September 2016

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Overview

Risk preference
Risk vs uncertainty
 Risk seeker
 Risk averse
 Risk neutral

Risk preferences

Expected values
 px

Value of perfect
information

Decision methods
 Maximax
 Maximin
 Minimax regret

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1 Introduction
1.1 Decision making involves making decisions now which will affect future outcomes and it is
unlikely that future cash flows will be known with certainty.

Risk
1.2 Risk exists where a decision maker has knowledge that several possible future outcomes
are possible, usually due to past experience. This past experience enables a decision
maker to estimate the probability of the likely occurrence of each potential future outcome.
Risk can be quantified.

Uncertainty
1.3 Uncertainty exists when the future is unknown and the decision maker has no past
experience on which to base predictions.
Uncertainty cannot be quantified but techniques can be adopted to reduce uncertainty.
These might include:
 Market research
Allowing for  Focus groups
uncertainty

2 Risk preference
2.1 (a) Risk seeker – An optimist. A decision maker who is interested in the best outcomes
no matter how small a chance that they may occur.
(b) Risk neutral – A decision maker who is concerned with the most likely outcome.
(c) Risk averse – A pessimist. A decision maker who acts on the assumption that the
worst outcome might occur.

Lecture example 1 Preparation question

Investment A B
Expected outcome $10,000 $10,000
Highest possible $25,000 $11,000
Lowest possible $(10,000) $9,000
Which investment would be chosen by a decision maker who is:
(a) Risk seeking?
(b) Risk neutral?
(c) Risk averse?

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Solution

3 Data tables
3.1 If there is one decision and one uncertain variable it is often easiest to display all options on
a data table, which may be generated easily by a spreadsheet.

Lecture example 2 Exam standard Section C (All Exams) – 8 marks

Clothing Co must decide how best to use a monthly factory capacity of 1,200 units. Demand from
regular customers is risky and could be either 300, 500 or 700 units per month.

Regular customers generate contribution of $5 per unit. Clothing Co has the opportunity to enter a
special contract which will generate contribution of only $3 per unit. For the special contract they
must enter a binding agreement now at a level of 900, 700 or 500 units.
Required
Display all possible contributions in a data table.

Solution
Workings
Special contract (units)
Demand 900 700 500
(units)
300

500

700

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4 Making decisions
4.1 Calculating expected values
When the final outcome is unknown and a range of possible future outcomes has been
quantified (for example, best, worst and most likely) probabilities can be assigned to these
outcomes and a weighted average (expected value) of those outcomes calculated.
EV = px
where p is the probability of the outcome occurring and x is the value of the outcome (profit
or cost).

When faced with a number of alternative decisions, the one with the highest expected
value (EV) should be chosen.
Limitations of expected values (EVs)
(a) EV is a long-term average, so that the EV will not be reached in the short term and
is therefore not suitable for one-off decisions.
(b) The results are dependent on the accuracy of the probability distribution. In particular,
it uses discrete variables rather than continuous variables (ie variables are point
estimates rather than a continuous range). This may not accurately model the real
situation.
(c) EV takes no account of the risk associated with a decision.
(d) The EV itself may not represent a single possible outcome.

4.2 Maximin decisions

Maximise the minimum return of each decision.
Risk averse decision maker.
Limitations of maximin
 Doesn't consider the probability of each outcome occurring
 Is conservative (doesn't try to maximise profit)

4.3 Maximax decisions

Aim for the best possible return.
Risk seeking decision maker.
Limitations of maximax
 Doesn't consider the probability of each outcome occurring
 Is overly optimistic

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Lecture example 3 Exam standard Section B (All Exams) – 6 marks

Clothing Co must decide how best to use a monthly factory capacity of 1,200 units. Demand from
regular customers is risky and as follows.
Monthly demand
(units) Probability
300 0.2
500 0.6
700 0.2
1.0
Regular customers generate contribution of $5 per unit. Clothing Co has the opportunity to enter a
special contract which will generate contribution of only $3 per unit. For the special contract they
must enter a binding agreement now at a level of 900, 700 or 500 units.
Pay off table:
Special contract (units)
Demand (units) P 900 700 500
300 0.2 4,200 3,600 3,000
500 0.6 4,200 4,600 4,000
700 0.2 4,200 4,600 5,000
1. Using the profit table, what is the optimal level of special contract to commit to every
month, using expected values?
A 300 units
B 500 units
C 700 units
D 900 units
2. Using the profit table, what is the optimal level of special contract to commit to every
month, assuming a totally risk averse attitude to decision making?
A 300 units
B 500 units
C 700 units
D 900 units
3. Using the profit table, what is the optimal level of special contract to commit to every
month, assuming a risk seeking attitude to decision making?
A 300 units
B 500 units
C 700 units
D 900 units

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Solution

4.4 Minimax regret decision rule

'Regret' means opportunity cost from making the wrong decision.
The decision rule chooses the option which minimises the maximum opportunity cost from
making the wrong decision.

Lecture example 4 Exam standard Section A (All Exams) – 2 marks

Required
Using the minimax regret rule, what decision would be taken using the data table in Lecture
Example 3?

Solution
Special contract (units)
Demand 900 700 500
(units)
300 4,200 3,600 3,000

500 4,200 4,600 4,000

700 4,200 4,600 5,000

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Opportunity cost table

Special contract (units)
Demand 900 700 500
(units)
300

500

700

Maximum
regret

5 Perfect information
5.1 Information may be available about uncertain variables eg market research.
5.2 If this information is guaranteed to predict the future with certainty it is defined as perfect
information.
5.3 Perfect information removes risk. It is therefore valuable.

5.4 Value of perfect information (VOPI)

EV (with perfect information) X

EV (without perfect information) (X)
VOPI X

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Lecture example 5 Exam standard Section A (All Exams) – 2 marks

Clothing Co has been contacted by a market research company, which guarantees that the results
of its survey will be 100% correct.
These results will enable Clothing Co to ascertain the demand from his regular customers every
month, in advance of accepting the special order.
Without this information the company would choose to order the special contract of 700 units
which, based on their expected value calculations, will give an average profit of $4,400.
Required
What is the maximum amount that Clothing Co should pay for the survey?
Special contract (units)
Demand P 900 700 500
(units)
300 0.2 4,200 3,600 3,000
500 0.6 4,200 4,600 4,000
700 0.2 4,200 4,600 5,000

A $0
B $200
C $400
D Impossible to know

Solution

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7 Chapter summary
Section Topic Summary
1 Risk and uncertainty Risk is where a decision maker has past experience.
With uncertainty there is no past experience.
2 Risk preference There are three types of risk preference
 Risk seeker – optimist
 Risk averse – pessimist
 Risk neutral – uses EVs
3 Data tables Data tables are used to display all the possible outcomes
when there is one decision and one uncertain variable.
4 Expected values EVs are calculated as  px.
5 Decision methods Maximin – maximise the minimum return
Maximax – maximise the maximum return
Minimax regret – minimise the opportunity cost from
making the wrong decision
6 Perfect information Perfect information is guaranteed to predict the future
with 100% accuracy. Imperfect information is valuable
even though it may incorrectly predict future events.
The value of perfect information is calculated as:
$
EV with perfect information X
EV without perfect information (X)
Value of information X

END OF CHAPTER
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Risk and uncertainty in
decision making

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Example past exam questions
Explain the use of simulation, expected values
and sensitivity.
Apply expected values and sensitivity to Q20 Section B – September 2016
decision-making problems.
Draw a decision tree and use it to solve a Q7 Section A – Specimen exam
multi-stage decision problem

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 8b: RISK AND UNCERTAINTY IN DECISION MAKING

Overview

Risk and uncertainty in

decision making

Techniques
 Data tables
Expected values
 Joint probabilities
 px  Decision trees

 Sensitivity analysis
 Simulation

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 8b: RISK AND UNCERTAINTY IN DECISION MAKING

1 Joint probability tables

1.1 If there are two variables that are uncertain or risky it may be helpful to record the range of
possible outcomes in a joint probability table.

1.2 Analysis could take the form of expected values (EVs) or the data table could be used to
give management an overview of the decision it is facing.

Lecture example 1 Exam standard Section C (All Exams) – 15 marks

Brown Co has developed a new product.

The company is confident that demand for the product will be 30,000 units at a selling price of $25,
but both the variable cost per unit and the specific fixed costs associated with this product are
uncertain.
Brown Co believes that the following circumstances could occur.
VC Prob FC Prob
$ $
12 0.2 100,000 0.4
13 0.35 110,000 0.5
14 0.45 120,000 0.1
Required
(a) Construct a two-way data table for profit generated.
Fixed costs
$100,000 $110,000 $120,000

$12
VC
$13

$14

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(b) Using the joint probabilities for each combination of fixed cost and variable cost,
calculate the expected value of Brown Co's profit.
Joint probability table
Fixed costs
$100,000 $110,000 $120,000
Prob 0.4 0.5 0.1
$12 0.2
VC
$13 0.35

$14 0.45
Expected value of profit
Fixed costs
$100,000 $110,000 $120,000
$12
VC
$13

$14

Solution

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2 Decision trees
2.1 A decision tree is a pictorial method of showing a sequence of interrelated decisions and
their expected outcomes. Decision trees can incorporate both the probabilities of, and value
of, expected outcomes, and are used in decision making.

2.2 Decision trees are most useful when there are several decisions and ranges of outcome.

Constructing a decision tree

2.3 Constructing a tree requires all the choices and outcomes to be drawn and the numbers
(probabilities, outcomes and EVs) to be entered.
The steps involved are:
(a) Plan the tree diagram and tick off all information given in the question as you use it in
the plan.
(b) Draw the tree from left to right, using a ruler, giving yourself as much space as
possible.
(c) Show a key in the answer detailing the different symbols for decisions and
outcomes

Evaluating a decision tree

2.4 Once drawn the optimal decision can be calculated using rollback analysis.
(a) Evaluate the tree from right to left.
 Calculate expected values at outcome points
 Take highest benefit at decision points
(b) Keep your workings on a different page.
(c) State clearly the initial decision to be made.

Lecture example 2 Exam standard Section C (All Exams) – 6 marks

Captain Co runs its business through a number of centres. One of its centres is suffering from
declining sales and management has a range of options:
(a) To shut down the site and sell it for $5 million
(b) To undertake a major refurbishment
(c) To undertake a cheaper refurbishment
In the past 2/3 of such refurbishments have achieved good results, the other 1/3 being less
successful, achieving poor results.
The major refurbishment will cost $4,000,000 now. Estimates of the outcomes are as follows.
(1) Good results PV = $13,500,000
(2) Poor results PV = $6,500,000

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The cheaper refurbishment, costing $2,000,000 now, would have the following outcomes:
(1) Good results PV = $8,500,000
(2) Poor results PV = $4,000,000
Required
(a) Construct a decision tree for Captain Co to show all possible decisions and
outcomes.
(b) Evaluate the decision tree and recommend what action should be taken.

Solution
Workings

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Lecture example 3 Exam standard Section C (All Exams) – 14 marks

Captain Co now has the opportunity to commission a market research survey prior to deciding
what action to take regarding its centre.
There is a 69% chance of receiving positive feedback and a 31% chance of receiving negative
feedback. However, the survey is not 100% reliable. The probability of a good outcome after
positive feedback is 91%, whereas the probability of a poor outcome after negative feedback is
87%.
If feedback from the survey is positive, Captain Co would consider either the major or cheaper
refurbishment. If the feedback is negative they would only consider the cheaper refurbishment or
closure.
Required
(a) Construct a decision tree to show the outcomes and decisions that can now occur.
(b) Calculate the value of obtaining the survey.

Solution
Workings

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3 Sensitivity analysis
3.1 Assessing probabilities of a range of variables may be difficult with certainty. Sensitivity
analysis permits an alternative way of assessing risk.
Decisions are assessed for their response to a change in a variable.

3.2 Approaches to sensitivity analysis are:

(a) Calculating the maximum percentage change in a variable before the decision would
change
(b) Assessing if the decision would change if a variable changed by x% of estimate
(c) Estimating by how much costs/revenues would need to change before the decision
maker would be indifferent between two options

3.3 Limitations of sensitivity analysis

 Only one variable can be tested at a time.
 There is no decision rule.
 It does not quantify the probability of the variable changing.

Lecture example 4 Exam standard Section B (All Exams) – 4 marks

Company P is considering the launch of a new product.

Details are as follows:
$
Sales 10,000 units @ $10 100,000
Material costs $2 per unit 20,000
Labour cost $3 per unit
30,000
(50,000)
Fixed overheads (30,000)
Profit 20,000
Required
1. What is the sensitivity of the product to a change in the material cost?
A 0
B 20%
C 50%
D 100%
2. What is the sensitivity of the product to a change in the units sold?
A 20%
B 40%
C 60%
D 100%

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Solution

4 Simulation
Simulation 4.1 Simulation models can be used to deal with decisions where there are a number of
models uncertain variables.

4.2 Simulation models can be created using computers and random numbers. These numbers
are linked to probability distributions so that the number chosen occurs with the same
probability that the real life event would occur.

4.3 Simulation can be used for estimating queues in shops as this depends on two
uncertainties: arrival of customers at the shop and service time. Two sets of probabilities
and random numbers will be required.

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5 Chapter summary
Section Topic Summary
1 Joint probability A joint probability table can be prepared if there are two
tables unknown variables.
2 Decision trees Decision trees can be used to illustrate the choices and
possible outcomes of a decision.
The value of imperfect information may be needed too.
3 Sensitivity analysis An alternative way of assessing risk. Variables are
assessed in isolation.
4 Simulation A method of assessing risk where there are several
uncertain variables.

END OF CHAPTER
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Budgetary systems

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Example past exam questions
Explain how budgetary systems fit within the
performance hierarchy.
Identify the factors which influence behaviour.
Discuss the issues surrounding setting the difficulty
level for a budget.
Explain the benefits and difficulties of the participation
of employees in the negotiation of targets.
Select and explain appropriate budgetary systems for Q6 Section A – Specimen exam
an organisation, including rolling, zero-based, activity-
Q2 Section A – December 2016
based and incremental.
Describe the information used in budget systems and
the sources of the information needed.
Explain how budget systems can deal with uncertainty
in the environment.
Indicate the usefulness and problems with different Q31 (b) Section C – December 2016
budget types (zero-based, activity-based, incremental,
master, functional and flexible).
Explain the difficulties of changing the type of budget Q31 (c) Section C – December 2016
used.
Prepare flexed budgets, rolling budgets and activity Q21 – 22 Section B – September 2016
based budgets.
Q31 (a) Section C – December 2016
Explain and illustrate the importance of flexing Q23 – 24 Section B – September 2016
budgets in performance management.
Apply expected values and explain the problems and
benefits.
Explain the benefits and dangers inherent in using Q25 Section B – September 2016
spreadsheets in budgeting.

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 9: BUDGETARY SYSTEMS

Overview

Planning and control cycle Budgetary control

Budgetary
Changing budgetary systems Behavioural aspects
systems

Types Spreadsheets

Fixed, flexible, Incremental ZBB ABB Rolling

flexed

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 9: BUDGETARY SYSTEMS

1 Introduction
1.1 Long-term strategic plans are broken down into short-term plans and targets. This is
generally done in the form of a budget or forecast.
A budget is a financial and/or quantitative plan of operations for a forthcoming period.

2 Planning and control

Planning & 2.1 Budgeting is part of the overall process of planning and control. A budget is a plan which will
control in the assist in achieving objectives.
performance
hierarchy
2.2 Purpose of budgetary control:
P – Planning
R – Responsibility
I – Integration and co-ordination
M – Motivation
E – Evaluation and control

3 Budget systems

Traditional
Fixed budgets
budgetary 3.1 A fixed budget is one that is not adjusted regardless of the level of activity attained in a
systems
period. The fixed budget is the master budget prepared before the beginning of the budget
period.
It is based on budgeted volumes and costs/revenues and as such is often unrealistic as the
actual level of activity will be almost certainly different from the level of activity originally
planned.

Flexible budgets
3.2 The flexible budget is a budget which is designed to change as volume of activity changes.
This can be done by recognising the behaviour of different costs (fixed, variable, semi-
variable etc).
Useful at the planning stage to show different results from various possible activity levels
(what-if analysis) allowing better planning for uncertainty in the future.

Flexed budgets
3.3 Used at the control stage budgets need to be flexed to reflect the actual activity level
achieved in a given period before the budget can meaningfully be compared with actual
results and variance analysis performed.

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Purpose of flexible/flexed budgets

3.4 (a) Designed to cope with different activity levels to keep the budget meaningful and
hence preserve the relevance of variances for effective control.
(b) Useful at planning stage to show different results from possible activity levels.
(c) Necessary as control device because we can meaningfully compare actual results
with relevant flexible budget, ie budgetary control.

Lecture example 1 Exam standard Section A (All Exams) – 2 marks

Chateau Larnaque has a bottling plant for its wine and has prepared flexible budgets:

Flexible budgets
Bottles: 10,000 12,000 14,000
Production costs: $ $ $
Materials 30,000 36,000 42,000
Labour 27,000 31,000 35,000
Overhead 20,000 20,000 20,000
If actual production was 12,350 bottles and the production costs incurred totalled $90,000.
What is the meaningful total variance for performance evaluation purposes?
A $0
B $350 Adverse
C $1,250 Adverse
D $1,650 Adverse

Solution

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 9: BUDGETARY SYSTEMS

Incremental budgeting
3.5 Incremental budgeting is where the budget is based on the current year's budget (or results)
plus an extra amount for estimated growth or inflation.
3.6 Incremental budgeting may be appropriate for certain costs. For example in a stable
environment it may be sufficient to budget salary costs by taking current year plus wage
inflation.
However, if the headcount was larger than necessary this approach would keep building in
unnecessary cost which would never get stripped out.
3.7 Traditionally this type of budgeting would have been very evident in the public sector. This
would often result in departments becoming locked in to public expenditure.
Advantage
(a) Easy
Disadvantages
(a) Unnecessary spending
(b) Budgeting slack
(c) No business scrutiny

Zero based budgeting (ZBB)

3.8 Zero based budgeting (ZBB) is a technique used to allocate resources more efficiently thus
reducing waste and increasing efficiency.
3.9 The process of ZBB starts from the basic premise that next year's budget is zero; every
process or item of expenditure, or intended activity (referred to as a 'decision package'),
must be justified in its entirety before it can be included in the budget.
3.10 The three-step approach to ZBB is as follows:
Implementing
ZBB (a) Define decision packages
(b) Evaluate and rank packages
(c) Allocate resources
3.11 ZBB is not particularly suitable for direct manufacturing costs but lends itself very well to
support expenses or discretionary costs.
3.12 ZBB is particularly useful in public sector organisations where funding (income) is set and
the best possible service for the available budget needs to be achieved.

Advantages of ZBB
3.13 (a) Can identify and remove inefficient or obsolete operations
(b) Necessitates close examination of organisation's operations
(c) Results in a more efficient allocation of resources

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Disadvantages of ZBB
3.14 (a) May emphasise short-term benefits to detriment of longer-term goals
(b) May need skills not available in organisation
(c) Resistance from employees
(d) Time and effort required
(e) Ranking activities is very difficult

Rolling budgets
3.15 Rolling budgets are also called continuous budgets. They are particularly useful when an
organisation is facing a period of uncertainty making it difficult to prepare accurate forecasts.
For example, it may be difficult to estimate the level of inflation for the forthcoming period.
3.16 Rolling budgets are an attempt to prepare targets and plans which are more realistic and
certain, particularly with a regard to price levels, by shortening the period between preparing
budgets.
3.17 Instead of preparing a periodic budget annually for the full budget period, budgets would
be prepared, say, every 1, 2 or 3 months (4, 6, or even 12 budgets each year). Each of
these budgets would plan for the next 12 months so that the current budget is extended by
an extra period as the current period ends: hence the name rolling budgets. Cash budgets
are usually prepared on a rolling basis.

3.18 Advantages of rolling budgets

(a) They reduce the element of uncertainty.
(b) Managers have to regularly reassess the budget.
(c) Planning and control will be based on a more recent plan.
(d) The budget always extends for some time into the future.

3.19 Disadvantages of rolling budgets

(a) Effort and expense required to continuously update the budget
(b) May demotivate managers

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Lecture example 2 Exam standard Section A (All Exams) – 2 marks

Bay Ltd uses a system of rolling budgets. The sales budget for the year to 31 December 20X3 is
as follows:
Q1 Q2 Q3 Q4 Total
$ $ $ $ $
Sales 122,000 131,760 142,301 153,685 549,746
Actual sales for Q1 were 117,879. The adverse variance is explained by growth being lower than
anticipated and the market being more competitive than predicted.
Senior management has proposed that the revised assumption for sales growth should be 5% per
quarter.
Applying the principles of rolling budgets, what would the forecast for Q4's sales be?
A $123,773
B $129,962
C $136,460
D $143,283

Solution

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9: BUDGETARY SYSTEMS

Activity-based budgeting (ABB)

3.20 Activity-based budgeting (ABB) involves defining the activities that underlie the financial
figures in each function and using the level of activity to decide how much resource should
be allocated, how well it is being managed and to explain variances from budget.

3.21 ABB recognises that:

(a) Activities drive costs
(b) The causes (drivers) of cost should be controlled rather than the cost themselves
(c) Not all activities are value adding
(d) Demand and decisions beyond the control of a department's manager drive many
departmental activities
(e) Traditional financial measures of performance are unable to fulfil the objective of
continuous improvement
3.22 Advantages of ABB
(a) Focuses on whole of activity therefore more likely to be right
(b) Critical success factors are identified – allows performance measurement
(c) Takes company strategy into account

4 Changing budgetary systems

4.1 Whilst the business environment may dictate that a change in budgetary system is
necessary, the change is not without its problems. The following need to be borne in mind:
 Employee resistance
 Cost of change
 Learning curve
 Loss of control
 Training
 Lack of accounting systems

5 Budgeting and uncertainty

5.1 Preparing a budget involves forecasting which is open to risk and uncertainty.
Some of the tools we have seen will help to deal with this. Examples include:
 Flexible budgeting
 Rolling budgets
 Probabilistic budgeting
 Sensitivity analysis

Probabilistic budgeting
5.2 You have already come across expected values when dealing with risk and uncertainty.
Budgets are subject to risk and uncertainty and as such expected values may be
incorporated into the budget.

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Lecture example 3 Exam standard Section A (All Exams) – 2 marks

Orchard has made the following predictions for the profitability of its product the Russet for the
upcoming financial year.
Profit/(loss) Probability
$'000
Best 400 0.3
Most likely 200 0.5
Worst (150) 0.2
Calculate the expected value that would be included in the budget.
A $0
B $190
C $200
D $450

Solution

Obviously the problems discussed earlier about expected values still hold ie:
(a) The results are dependent on the accuracy of the probability distribution.
(b) EV takes no account of the risk associated with a decision.
(c) The EV itself may not represent a single possible outcome.

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6 Spreadsheets in budgeting
6.1 Spreadsheet packages can be used to build business models and to assist the forecasting
and planning process. They are particularly useful for 'what-if analysis'.
Spreadsheets and
what-if analysis

7 Budgetary control
7.1 A system must be controlled to keep it steady or enable it to change safely.
Control is required because unpredictable disturbances arise and enter the system, so that
actual results/(outputs) deviate from expected results.
Examples of disturbances from the environment which would impact on a business system
would be as follows:
 Rise in the cost of raw materials
 Changes in demand levels
 Price war
A control system must ensure that the business is capable of surviving the disturbances.
7.2 The components of a controlled system are:
 A meaningful target or standard
 A method of gathering information from a system (sensor)
 A method of comparing information to a standard (comparator)
 The means to initiate control action (effector)
7.3 This flow of information through a system is known as the 'feedback loop'.
A 'single feedback' loop is confined to information coming from within the organisation and
refers to a fixed budget. For example, if sales targets are not reached, control action will be
taken to ensure that targets will be reached soon.
This can be compared to a 'double feedback' loop, in which the external environment is
monitored and action may be taken to modify the control system itself (for example, the
budget may be amended to reflect an expected downturn in sales).

Controllable vs uncontrollable costs

7.4 A controllable cost is a cost which can be influenced by the budget holder.
There may well be costs which cannot be changed by the budget holder or by management
within a given time period. These are uncontrollable costs.
Responsibility accounting associates costs and revenues with the managers that can control
them. It therefore distinguishes between controllable and uncontrollable costs.

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Feedback control
7.5 A feedback system operates by comparing actual (historical) results against a standard or
plan, and taking control action where differences between actual and plan have occurred.
Events in the past are used to take corrective action for the future.
Positive feedback indicates that results were better than planned. Control action may be
taken to encourage the deviation from what was originally expected.
Negative feedback indicates worse results than planned. Control action aims to get back to
the original plan.

Feedforward control
7.6 A feedforward system operates by comparing planned results against a current (revised)
forecast of what results will be (unless corrective measures are taken). Control action is
triggered by differences between anticipated and planned results.

Planned
results
$

Control action

Forecast

Current date

8 Behavioural aspects of budgeting

General considerations
8.1 Accountants must consider the impact of their budgeting systems on human behaviour.
(a) Budget pressure unites employees against management.
(b) Pressure may lead to negative results.
(c) Workers form into protective groups.
(d) Accounting personnel equate success with finding fault in workers.
(e) Workers feel victimised – loss of confidence and motivation results.
(f) Supervisors use budgets as an expression of their position of superiority.
A good system of control must influence employees in the direction of the company's best
interests.

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Motivation and budget setting

8.2 Best performance is usually achieved when a budget is perceived as challenging but
achievable.
Hofstede's analysis suggested targets should be set at 'almost achievable' levels for
maximum motivation and performance.

8.3 It is vital that the goals of management are in line with the goals of the organisation as a
whole. This is known as goal congruence.
Poor attitudes
when setting Management accountants should therefore try to ensure that management and employees
budgets have positive attitudes towards setting and implementing budgets, and feedback of results.

Participation in budgeting
8.4 In a top-down system, budgets are imposed on individuals by their managers.
In a bottom-up system, the budget holder is invited to have input at the budget setting
stage.
In between these two extremes is negotiated budgeting. Regardless of the initial approach
taken the final budget is likely to be arrived at after much negotiation between senior and
junior management and so in reality budgeting is actually a bargaining process.

8.5 Advantages of top-down (imposed) budgeting systems include:

(a) Likely to be quicker
(b) Avoid budgetary slack and budget bias
(c) Utilise senior management awareness of total resource availability

8.6 Advantages of bottom-up budgeting systems include:

(a) More detailed information used in budget setting processes
(b) Morale and motivation is improved
(c) Increased likelihood of achievement

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9 Chapter summary
Section Topic Summary
1 Introduction Budgeting is part of the planning and control process.
2 Planning and control Purpose of budgetary control is:
P – Planning
R – Responsibility
I – Integration and co-ordination
M – Motivation
E – Evaluation
3 Budget systems  Flexible budgets are ideal for planning
 Flexed budgets are the best budget for control as
they allow you to compare like for like
 Incremental budgets tend to build in slack and
inefficiency
 ZBB results in efficient resource allocation and is
suitable for discretionary spend
 Rolling budgets are useful in times of uncertainty
 ABB ensures the causes of cost are managed
4 Changing budgetary Changes to the budgetary system will meet with resistance
systems due to the learning curve, loss of control, cost and training
required.
5 Budgeting and Probabilistic budgeting incorporates expected values.
uncertainty Flexible and rolling budgets can also be used.
6 Spreadsheets in Useful for 'what-if analysis'.
budgeting
7 Budgetary control Managers should only be assessed on those items within
their control.
Control can be feedback or feedforward – comparison of
past results or forecast results to plan.
8 Behavioural aspects The budget set and the participation in the process can
of budgeting have a large impact on motivation.

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END OF CHAPTER
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Budgeting and standard
costing

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Example past exam questions
Explain the use of standard costs. Q1 Section A – Specimen exam
Outline the methods used to derive standard
costs and discuss the different types of cost
possible.
Explain and apply the principle of controllability in
the performance management system.
Discuss the dysfunctional nature of some
variances in the modern environments of JIT and
TQM.
Discuss the behavioural problems resulting from
using standard costs in rapidly changing
environments.
Discuss the effect that variances have on staff
motivation and action.

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 10: BUDGETING AND STANDARD COSTING

Overview

Purpose of standards Calculation of standards Bases of standards

Budgeting and standard Behavioural impacts of

costing standard costing

Controllability Standards and Waste and idle Criticisms of TQM

budgets time standard costing

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1 Standards
1.1 A standard is prepared by management in advance, and details their expectations of the
future.

1.2 Standards are not just for items of production in manufacturing businesses. They exist in
many different spheres. Standard times for repairing cars, standard punctualities for train
companies and standard response times for ambulances are just some of the many
examples encountered.

1.3 A standard cost is an estimated unit cost.

1.4 You will have come across standard costs before as part of costing. When trying to establish
the cost of a unit, be it under absorption or marginal costing, the cost card was derived using
standard costs.
As a reminder:

Example of a standard cost card for a cost unit

1.5
$/unit
Direct costs:
Direct materials (5 kg @ $3/kg) 15.00
Direct labour (3 hrs @ $6/hr) 18.00
33.00
Indirect costs:
Variable overheads 2.00
Fixed overheads 3.00
Full product cost 38.00
The costs in the cost card are built up using, for example, the expected amount of material
at the expected price of the material.

2 Purposes of standards
2.1 The uses of standard costing are as follows:
(a) Prediction of costs and times for decision making, eg for allocating resources.
(b) Standard costing is used in setting budgets – an accurate standard will increase the
accuracy of the budget.
(c) Variance analysis is a control technique which compares actual with standard costs
and revenues.
(d) Performance evaluation systems make use of standards as motivators and also as
a basis for assessment.
(e) Inventory valuation – this is often less time consuming than alternative valuation
methods such as FIFO or weighted average.

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3 Bases
3.1 (a) Ideal standard – assumes an optimum level of efficiency.
(b) Attainable standard – makes an allowance for normal inefficiencies but also includes
hoped-for improvements.
(c) Current standard – based on current efficiency levels and achievements.
(d) Basic standard/historic standard – not updated regularly, used to show changes
over the long term.

Lecture example 1 Exam standard Section A (All Exams) – 2 marks

The following statements have been made about different types of standards in standard costing
systems:
(1) Current standards provide the best basis for budgeting because they represent an
achievable level of productivity.
(2) Ideal standards provide a useful short-term target for standard setting, because they lead to
improvement in performance.
Which of the above statements is/are true?
A (1) only
B (2) only
C Neither (1) nor (2)
D Both (1) and (2)

Solution

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4 Deriving standards
4.1 The standard cost of materials will be estimated by the purchasing department.

Lecture example 2 Exam standard Section A (All Exams) – 2 marks

The following statements have been made about factors that the purchasing department will need
to consider when establishing the standard cost of materials needed to make a new product.
(1) The forecast sales levels
(2) The amount of wastage expected
Which of the above statements is/are true?
A (1) only
B (2) only
C Neither (1) nor (2)
D Both (1) and (2)

Solution

4.2 Setting standards for other elements on the cost card will undergo a similar process.

Setting standards
for overheads

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5 Standards and budgets

5.1 Similarities:
Budgets and
standards  Are very similar in terms of their motivation impacts on employees
compared  Standards generally form the basis for the budget
 Both used for control

5.2 Differences:

Standards Budgets
By unit In total
For areas of repetition All areas
Financial and non-financial targets Financial targets

6 Criticisms of standard costing

6.1 Standard costing has some disadvantages and, arguably, is less relevant in the modern
environment than previously.
(a) Standard costing works best in a stable environment; the modern business
environment is very fast changing.
The role in (b) Regular revisions to the standard are required. This process is expensive and time
modern business consuming.
of standards and
variances (c) Meeting the standard should not necessarily be accepted as satisfactory if further
improvements could be made.
(d) Techniques associated with standard costing (such as variance analysis) are less
useful in a modern environment of customised products.

Revision of standards
6.2 Standards should be reviewed regularly, and revised when there is a change in the basis
upon which they were set. This ensures that they remain useful as a performance measure.

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7 Behavioural impacts of standard costing in the

modern environment
7.1 Standard costing is often perceived as being at odds with the modern business
environment.

Traditional Modern environment Impacts of standard

manufacturing costing
High labour cost, low Low labour cost, high Overhead variances do not
overhead overhead have enough detail to aid
performance measurement.
Stable environment/ Rapidly changing Regular revision of standards
products environment/products can be demotivating for
employees as the goal posts
keep moving.
Standard product Customised product Differences between products
make developing a standard
difficult. Resulting variances
may not be meaningful and
certain employees may be
unfairly penalised.
Focus on cost Focus on quality Variance analysis encourages
cost control. Desired quality
may drive adverse price
variances.
Raw material and finished JIT philosophy Inventory may be built up in an
goods inventory is effort to improve efficiency
important variances.

7.2 Despite the criticisms and impacts, many businesses still operate with standard costing as it
does aid planning and control. Other non-financial measures should be used alongside it
such as on time deliveries, customer satisfaction measures and so on.

8 Total quality management (TQM)

Total quality management (TQM) is a business philosophy aimed at improving quality.

Get it right, first time

8.1 The cost of preventing mistakes is less than the cost of correcting them if they occur.

Continuous improvement
8.2 Never be satisfied with current achievement. It is always possible to improve performance.

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Goals of TQM
8.3 (a) To gain competitive advantage via continuously improved quality
(b) To continuously reduce the cost of providing enhanced quality
(c) Innovation
(d) Provide first class customer service
(e) To involve all employees

Design for quality

8.4 Design quality into an organisation's products and operations from the outset.
(a) Reduce the number of parts in a product
(b) Use components common to other products in the organisation
(c) Improve physical characteristics to meet customers' needs

Performance measurement
Can standard 8.5 Traditional variance analysis is not appropriate in a TQM environment, due to the focus on:
costing and TQM
co-exist?  Continuous improvement
 Quality as opposed to cost

8.6 Alternative measures of performance, therefore, include:

(a) Measuring incoming supplies
(b) Monitoring work as it proceeds
(c) Measuring customer satisfaction

Lecture example 3 Exam standard Section A (All Exams) – 2 marks

The following statements have been made about the use of a TQM approach.
(1) Standard costing systems are not compatible with a TQM approach to operations.
(2) TQM can only be used in industries which operate in a rapidly changing environment.
Which of the above statements is/are true?
A (1) only
B (2) only
C Neither (1) nor (2)
D Both (1) and (2)

Solution

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9 Chapter summary
Section Topic Summary
1 Standards A standard is prepared in advance based upon
expectations of the future.
2 Purposes of Standard costs have many uses in performance
standards management. These include:
 Performance evaluation
 Control
 Decision making
 Budgeting
 Inventory valuation
3 Bases The four bases are:
 Ideal
 Attainable
 Current
 Basic
Standards should be set at an attainable level to drive the
best performance.
4 Deriving standards Standards are prepared taking into account future price
rise, efficiencies etc.
5 Standards and Standards are set for a unit, whereas budgets
budgets encompass the whole business.
6 Criticisms of The changes occurring in today's business environment
standard costing result in standard costing being criticised.
 Requires a stable environment
 Regularly updating the standard is time consuming
and costly
 Meeting a standard is the goal rather than improving
upon it
Less appropriate with customised products

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Section Topic Summary

7 Behavioural Standard costing is often still used as it still aids planning,
impacts of control and decision making.
standard costing in Care must be taken when using it for control as modern
the modern business philosophies such as TQM and JIT will often
environment drive adverse price or efficiency variances.
Other mechanisms reflecting today's key indicators must
be used in performance management.
8 Total quality Business philosophy aimed at improving quality.
management Two key aims are:
 Get it right first time
 Continuous improvement
Traditional variance analysis is not appropriate as focus
is on quality and continuous improvement rather than
cost.

END OF CHAPTER
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Mix and yield
variance analysis

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Example past exam questions
Calculate, identify the cause of and explain Q5 Section A – Specimen exam
material mix and yield variances. Q3 Section A – December 2016
Q21 – 23 Section B – December 2016
Explain the wider issues involved in changing mix
eg cost, quality and performance measurement
issues.
Identify and explain the relationship of the
material usage variance with the material mix and
yield variances.
Suggest and justify alternative methods of
controlling production processes.
Calculate, identify the cause of, and explain sales Q24 – 25 Section B – December 2016
mix and quantity variances.
Identify and explain the relationship of the sales
volume variances with the sales mix and quantity
variances.

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11: MIX AND YIELD VARIANCE ANALYSIS

Overview

Mix and yield variance analysis

Material mix and yield Sales mix and quantity

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 11: MIX AND YIELD VARIANCE ANALYSIS

1 Mix and yield variances

Materials and labour inputs
1.1 Where inputs can be substituted for one another, the efficiency/usage variance can be
subdivided.
The materials and labour variances can both be split into mix and yield (or output)
components.

1.2 The mix variance represents the financial impact of using a different proportion of raw
materials.
1.3 The yield variance represents the financial impact of the input yielding a different level of
output to the standard.

Lecture example 1 Exam standard Section A (All Exams) – 2 marks

Brenda and Eddie are analysing the main ingredients to their basic pasta sauce.
The standard ingredients for one batch of tomato pasta sauce are:
$
Onions 5 kg @ $2/kg 10
Tomatoes 5 kg @ $4/kg 20
30
During June, 100 batches of sauce were prepared, using the following ingredients:
Onions 600 kg
Tomatoes 900 kg
For the materials mix and materials yield variance, was there a favourable or adverse result
in June?
A The total mix was adverse and the total yield was favourable
B The total mix was favourable and the total yield was adverse
C Both variances were adverse
D Both variances were favourable

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What is the material yield variance? ▼

Adverse
Favourable

Solution

Lecture example 2 Exam standard Section A (All Exams) – 2 marks

The following statements have been made about the implications of changing the mix of materials
used in the production of soup:
Issues involved in (1) Using proportionally more of the cheaper ingredients will always lead to lower yields.
changing the mix
(2) Altering the mix could affect the taste and therefore the number of units sold.
Which of the above statements are true?
A (1) only
B (2) only
C Neither (1) nor (2)
D Both (1) and (2)

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Solution

1.4 Mix and yield with losses

Lecture example 3 Exam standard Section A (All Exams) – 2 marks

A company manufactures a fruit flavoured drink by mixing two liquids (A & J). The standard cost for
ten litres of the drink is shown below:
$
5 litres of liquid A at $16 per litre 80
6 litres of liquid J at $25 per litre 150
230
During August the company produced 4,800 litres of the drink. This was 200 litres below budgeted
production. The company purchased and used 2,200 litres of A for $18 per litre and 2,750 litres of
J for $21 per litre.
What is the material yield variance for August?
A $450 A
B $450 F
C $6,900 F
D $6,900 A

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Solution

2 Sales mix and quantity variances

2.1 The sales volume profit variance can be analysed further into a sales mix variance and a
sales quantity variance.
Total sales
variance

Sales price Sales volume

variance variance

Sales mix Sales quantity

variance variance

2.2 The sales mix variance occurs when the proportions of the various products sold are
different from those in the budget.

2.3 The sales quantity variance shows the difference in contribution/profit because of a
change in sales volume from the budgeted volume of sales.

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Lecture example 4 Exam standard Section B (All Exams) – 6 marks

Puddingsrus makes and sells two products, Sticky Toffee and Chocolate Goo. The budgeted sales
and profit are as follows.
Sales Revenue Costs Profit Profit per unit
Units $ $ $ $
Sticky Toffee 800 5,600 2,400 3,200 4
Chocolate Goo 900 4,500 2,700 1,800 2

Actual sales in November were 600 units of Sticky Toffee and 1,200 units of Chocolate Goo. The
company management is able to control the relative sales of each product through the allocation of
sales effort, advertising and sales promotion expenses.
1. What is the sales volume profit variance for Puddingsrus?
A $800 Adverse
B $800 Favourable
C $200 Adverse
D $200 Favourable
2. What is the sales mix variance for Puddingsrus?
A $494 Adverse
B $494 Favourable
C $247 Adverse
D $247 Favourable
3. What is the sales quantity variance for Puddingsrus?
A $294 Adverse
B $294 Favourable
C $200 Adverse
D $800 Favourable

Solution

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3 Chapter summary
Section Topic Summary
1 Material mix and A mix variance is the result of a different mix of materials
yield variance to the standard being used.
A yield variance occurs when a different quantity from
standard is input in order to achieve the desired output.
2 Sales mix and A sales mix variance is the result of selling a different
quantity variance proportion of products to the standard.
A sales quantity variance occurs when a different volume
of units is sold.

END OF CHAPTER
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 Planning and operational
variance analysis

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Example past exam questions
Calculate a revised budget.
Identify and explain those factors that could and
could not be allowed to revise an original budget.
Calculate, identify and explain planning and Q31 Section C – Specimen exam
operational variances for sales, including market Q12 Section A – September 2016
size and market share, materials and labour,
Q8 Section A – December 2016
including the effect of the learning curve.
Q31 Section C – March/June 2017
Explain and discuss the manipulation issues Q31 Section C – Specimen exam
involved in revising budgets.

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12: PLANNING AND OPERATIONAL VARIANCE ANALYSIS

Overview

Planning and operational

Planning and operational

variances

Budget revisions

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1 Planning and operational variances

1.1 The variance analysis you have studied so far has compared actual results with a budget
which was set at the beginning of the year. This might not always be the best approach.

Approach to planning and operational variances

1.2
Total material price variance

$
(1) Actual materials should cost X
(3) Actual materials did cost X
X

Material price Material price

planning variance operational variance

$ $
(1) Actual materials should cost X (2) Actual materials should now cost X
(2) Actual materials should now cost X (3) Actual materials did cost X
X X

1.3 The traditional variances we have seen so far can be investigated further to look at the
elements driven by a wrong standard (planning variances) and the elements that were
within the manager's control (operational variances).

Lecture example 1 Exam standard Section C (All Exams) – 20 marks

Mason Co makes plastic patio furniture for sale to garden centres. One of its most popular
products is the recliner chair. The standard amount of plastic per chair is 4 kg and the standard
cost per kg is $9. Budgeted production in June was 15,000 units. Actual production in June was
only 14,000 units, which used 54,000 kg of plastic at a cost of $9.50 per kg.
At the end of May it was agreed that in order to boost sales the quality of the chairs needed to be
improved. This meant purchasing better quality plastic at a standard cost of $9.30 per kg, whilst
reducing the standard kg per chair to 3.8 kg due to less waste.
Required
(a) Calculate the following variances for Mason Co:
(i) Material price planning variance
(ii) Material price operational variance
(iii) Material usage planning variance
(iv) Material usage operational variance
(b) Assess the performance of the production manager for the month of June.

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Solution

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Lecture example 2 Exam standard Section A (All Exams) – 2 marks

A sales volume variance can be analysed into a market size variance and a market share
variance.
The following statements have been made about these variances.
(1) In a competitive market, the market share variance is controllable by the sales management.
(2) In a competitive market, a market size variance is controllable by sales management.
Which of the above statements is/are true?
A (1) only
B (2) only
C Neither (1) nor (2)
D Both (1) and (2)

Solution

Lecture example 3 Exam standard Section A (All Exams) – 2 marks

Chianti Limited manufactures and sells a single product. The company uses a standard costing
system, and the standard cost per unit is $7.40 and the budgeted selling price is $16.00 per unit.
Budgeted production and sales for 20X8 were 5,000 units. The budgeted fixed overhead was
$20,000.
Actual production in 20X8 was 5,200 units, and 5,100 units were sold for $81,000.
You have discovered that industry sales of Chiantis were 10% lower than forecast.
For the sales volume planning variance and the sales volume operational variance was
there a favourable or adverse result in 20X8?
A The sales volume planning variance was adverse and the sales volume operational variance
was favourable
B The sales volume planning variance was favourable and the sales volume operational
variance was adverse
C Both variances were adverse
D Both variances were favourable

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Solution

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Advantages of revising the budget

1.4 (a) Highlights those variances which are controllable and those which aren't
(b) Ensures that operational performance is appraised by reference to realistic targets
(c) Should ensure that future budgets are more realistic

Disadvantages of revising the budget

1.5 (a) Determination of revised budget:
 May be biased
 May need external information
(b) Use of revised budget may undermine original budget as a target and as a motivator.
(c) Employees may use this system to their advantage by excusing operating problems
as poor planning if this method is used.

1.6 A budget should only be revised for items that are beyond the control of the organisation.
Such changes would render the original budget inappropriate as a performance
management tool.

1.7 Budgets should not be revised for operational issues.

2 Chapter summary
Section Topic Summary
1 Planning and Planning variances represent the difference between the
operational original and revised budget.
variances Operational variances are those items which were within
a manager's control. They are the difference between the
revised budget and the actual.

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Performance
management information
systems

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Exam past exam questions

Identify the accounting information requirements

and describe the different types of information
systems used for strategic planning,
management control and operational control and
decision making
Define and identify the main characteristics of Q10 Section A – specimen exam
transaction processing systems; management Q4 Section A – September 2016
information systems; executive information
systems; and enterprise resource planning
systems
Define and discuss the merits of, and potential Q4 Section A – December 2016
problems with, open and closed systems with
regard to the needs of performance management

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 13: PERFORMANCE MANAGEMENT INFORMATION SYSTEMS

Overview

Performance management
information systems

Information Systems Management

levels information
systems

 TPS
Open Closed
Strategic Operational  MIS
 EIS
 ERP
Tactical

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1 Information levels
1.1 Performance management information systems provide the information which enables
performance measurement to take place.
1.2 Tactical information is also important to facilitate management planning and control for
shorter time periods (eg one year ahead); and those responsible for day to day
management will also need operational information to facilitate day to day decision
making.

Long term

Strategic

Medium term
Tactical

Day to day
Operational

Lecture example 1 Exam standard Section A (All Exams) – 2 marks

Hydra is a bicycle retailer which has a significant presence in the South of England. Each location
has a manager who is responsible for day to day operations and is supported by an administrative
assistant. All other staff at each location are involved in retailing operations.
How would information concerning the development of new services such as the provision
of car parts be classified?
A Strategic information
B Tactical information
C Operational information
D None of the above

Solution

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13: PERFORMANCE MANAGEMENT INFORMATION SYSTEMS

2 Strategic management accounting

2.1 Definition: a form of management accounting in which emphasis is placed on information
about factors which are external to the organisation, as well as non-financial and internally
generated information.
2.2 It differs from traditional management accounting because it has an external and future
orientation.
2.3 Examples of information provided:
 Product profitability
 Customer profitability
 Value of market share
 Capacity expansion
 Brand values
 Shareholder wealth
 Cash flow
 Competitors' costs
 Financial effect of competitor response
 Effect of acquisitions and mergers

3 Management information systems

You should be aware of the main characteristics of the following four systems.
3.1 Transaction processing systems (TPS)
TPS collect, store, modify and retrieve the transactions of an organisation. There are two
main types: batch transaction processing which collects data as a group and processes it
later and real time transaction processing, which involves immediate processing of data.

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Characteristics of TPS:
 Controlled processing
 Inflexibility
 Rapid response
 Reliability
3.2 Management information systems (MIS)
MIS generate information for monitoring performance (eg productivity) and maintaining
co-ordination (eg between purchasing and accounts payable). Information is extracted from
TPS and summarised to provide periodic reports for management.
Characteristics of MIS:
 Support structured decisions
 Report on existing operations
 Analytical capability
 Internal focus
3.3 Executive information systems (EIS)
EIS draw data from MIS and allow communication with external sources of information,
providing a generalised computing and communication environment to senior managers to
support strategic decisions.
EIS typically involves lots of data analysis and modelling tools such as what-if analysis to
help strategic decision making.
3.4 Enterprise resource planning systems (ERP systems)
ERP systems are modular software packages which aim to integrate the key process in an
organisation so that a single system can serve the information needs of all functional areas.
The real time operation of ERP systems ensures that the exact status of everything is
always available.
3.5 There is a different need for volume of data at each level of the organisation. For example,
the CEO is not going to be concerned about the detail of every sale (which would be
represented in the TPS) but is going to require strategic information including external data
(represented in the EIS) so that he can set strategy for the business. The volume of data
decreases the higher you go in the organisation.

Lecture example 2 Exam standard Section C (All Exams) – 6 marks

Fix It is a chain of garages with eight branches in the South-West of England and one warehouse
which supplies spare parts to the garages. Mechanics are assigned to a particular garage but can
work in different locations. As well as repairs the company also carries out MOTs for which
specialist testing equipment is required.
Fix It has decided to implement an ERP system.
Required
What benefits could management hope to see following the implementation of the system?

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Solution

4 Open and closed systems

4.1 An open system is connected to and interacts with the environment and is influenced by it.

4.2 All social systems, including business organisations, are open systems. For example
businesses are influenced by and have an influence on suppliers, customers, employees,
competitors and society as a whole.

4.3 Advantages of an open system:

 Strong communication
 Adapts to changing environment
 Highlights inter-dependencies of operations and processes
 Focus on external factors

4.4 Closed systems are isolated and shut off from the environment. Information is not received
from or provided to the environment; this makes them less useful for strategic management
accounting.
4.5 Reasons for a closed system include:
 Business critical information
 Confidential information
However, these are impossible to achieve in reality.

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5 Chapter summary
Section Topic Summary
1 Information levels Management accounting information can be used at
strategic, tactical and operating levels. Managers
need information according to their responsibilities.
2 Information aimed at long-term decisions, which will
Strategic management
often be external to the organisation and with a future
accounting
orientation.
3 Management Provide information at different levels and for different
information systems purposes:
 TPS
 MIS
 EIS
 ERP
4 Open and closed Systems can be open or closed. Open systems are
systems capable of responding to changes in the environment.

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Sources of
management
information and
management reports

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Exam past exam questions
Identify the principal internal and external sources
of management accounting information.
Demonstrate how these principal sources of
management information might be used for
control purposes.
Identify and discuss the direct data capture and Q8 Section A – September 2016
process costs of management accounting
information.
Identify and discuss the indirect costs of Q11 Section A – Specimen exam
producing information.
Discuss the limitations of using externally
generated information.
Discuss the principal controls required in
generating and distributing internal information.
Discuss the procedures that may be necessary to Q10 Section A – December 2016
ensure security of highly confidential information
that is not for external consumption.

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Overview

Sources of management
information and management
reports

Internal/external Control

Costs Uses

Sources

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 14: SOURCES OF MANAGEMENT INFORMATION AND MANAGEMENT REPORTS

1 Internal sources of information

1.1 Internal information includes:

Formal Informal
Accounting records Meeting minutes
Payroll records Questionnaires
Capacity
Timesheets

1.2 Internal information is usually operational in nature, but can include information on
customers and suppliers.

2 External sources of information

2.1 External information is more relevant than internal information to strategic decisions.

2.2 Capturing external information is potentially expensive as it has so many sources.

Information technology is helping to reduce the cost of data collection.

2.3 Sources of external information include:

(a) Directories
(b) Associations
(c) Government agencies
(d) Customers
(e) Suppliers
(f) Internet
(g) Databases/data warehouses

2.4 External information can be out of date by the time it has been collated.

3 Primary and secondary data

3.1 Data can be either primary or secondary. Primary data is collected by the organisation.
Secondary data is not collected by, or for, the user.

3.2 Primary data can be expensive to obtain. It can be achieved by:

(a) Desk research
(b) Interviews and questionnaires
(c) Market research

3.3 Secondary data is cheaper than primary data. This is because it is less relevant.

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4 Controls over information

Reports
4.1 Before any report is created the following controls should be adopted:
(a) Cost/benefit analysis
(b) Prototype
(c) Check that the report is not duplicated

Distribution
4.2 To ensure efficiency and security of data the following controls should be created:
(a) Procedures manual
(b) Format
(c) Distribution list
(d) Disposal (especially if confidential)

Security and confidential information

4.3 IT systems are particularly vulnerable to unauthorised access, or use, from both internal and
external parties unless they are protected.

Lecture example 1 Exam standard Section A (All Exams) – 2 marks

The following statements have been made about IT systems:

(1) Employees should have the ability to make changes to customer records if they notice an
error or omission.
(2) Transmitted data should usually be encrypted to prevent hackers gaining access to it.
Which of the above statements is/are true?
A (1) only
B (2) only
C Neither (1) nor (2)
D Both (1) and (2)

Solution

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5 Chapter summary
Section Topic Summary
1–2 Internal and external Information can be internal to organisations or
sources of information available in the external environment.
Data can be:
 Out of date
 Expensive
 Biased
3 Primary and secondary Data can be collected by an organisation or bought
data from third parties. This is the difference between
primary and secondary data.
4 Controls over Controls are required over access to, and use of,
information information hardware and software. This is important
both when information is available to external parties
and when it is only available internally.

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Performance
management

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Example past exam questions
Describe, calculate and interpret financial Q32 Section C – Specimen exam
performance indicators for profitability, liquidity Q31 Section C – September 2016
and risk in both manufacturing and service Q32 Section C – March/June 2017
businesses. Suggest methods to improve these
measures.
Describe, calculate and interpret non-financial
performance indicators (NFPIs) and suggest
methods to improve the performance indicated.
Explain the causes and problems created by
short-termism and financial manipulation of
results and suggest methods to encourage a
long-term view.
Explain and interpret the Balanced Scorecard, Q15 Section A – Specimen exam
and the Building Block model proposed by Q32 Section C – March/June 2017
Fitzgerald and Moon.
Discuss the difficulties of target setting in
qualitative areas.

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Overview

Financial performance
indicators
Non-financial performance
 Profitability
 Liquidity indicators
 Gearing

Performance
management

Short-termism Balanced scorecard Performance measurement in

service businesses

Building block model

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1 Performance measurement
Financial performance indicators
1.1 Analysis and interpretation of a company's accounts will give an indication of the company's
performance.
The aims would be to:
 Assess the company's performance and financial position (in comparison with other
companies in the same industry)
 Try to assess the potential future performance or identify weakness

Company performance assessment

1.2 This would usually involve:
(a) Ratio analysis
(b) Review of the accounts to highlight issues not disclosed by ratio analysis (eg
contingent liabilities)
(c) Review of the benefits/wealth from the point of view of the other stakeholders
(d) Analysis of other financial and non-financial information from external sources

Areas for analysis

1.3 (a) Profitability – how well a company performs, given its asset base
(b) Liquidity – short-term financial position
(c) Gearing – measure of risk
These areas can all be assessed using ratios but when presented with a set of accounts,
you should start by looking at obvious trends or changes in figures (you will normally be
given figures with some sort of comparative data).
Details of these ratios are provided in the additional notes section of this chapter. You must
ensure that you learn these; however the focus for PM is application.

Basis for comparison

1.4 (a) Over time
(b) With other companies
(c) With industry averages
(d) With other performance measures

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Lecture example 1 Exam standard Section C (All Exams) – 5 marks

Preston Financial Services is an accounting practice. The business specialises in providing

accounting and taxation work for dentists and doctors. In the main the clients are wealthy,
self-employed and have an average age of 52.
The business was founded by and is wholly owned by Richard Preston, a dominant and
aggressive sole practitioner. He feels that promotion of new products to his clients would be likely
to upset the conservative nature of his dentists and doctors and, as a result, the business has
been managed with similar products year on year.
You have been provided with financial information relating to the practice.
Financial information
Current year Previous year
Turnover ($'000) 945 900
Net profit ($'000) 187 180
Average cash balances ($'000) 21 20
Average debtor/trade receivables days (industry average 30 days) 18 days 22 days
Inflation rate (%) 3 3
Required
Using the financial information above only, comment on the financial performance of the
business (briefly consider growth, profitability, liquidity and credit management).

Solution

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2 Limitations and strengths of ratios

2.1 Limitations:
(a) Not useful on their own – need to be compared to yardstick
(b) Must be carefully defined
(c) Inflation needs to be adjusted for – often forgotten
(d) Different basis of calculating between companies
(e) Based on historical costs – accurate reflection of future?

2.2 Strengths:
(a) Easier to understand than absolute measures
(b) Easier to look at changes over time
(c) Puts performance into context
(d) Can be used as targets
(e) Summarise results

Other problems with financial performance indicators

2.3 (a) Focus only on variables which can be expressed in monetary terms ignoring other
important variables which cannot be expressed in monetary terms
(b) Focus on past
(c) Do not convey the full picture of a company's performance in a modern business
environment eg quality, customer satisfaction
(d) Focus on the short term

3 Non-financial performance indicators (NFPIs)

Definition
3.1 Non-financial performance indicators (NFPIs) are measures of performance based on non-
financial information which operating departments use to monitor and control their activities.

Examples
3.2 Examples of NFPIs are summarised in the table below.

Area assessed Performance measures

Service quality Number of complaints
Proportion of repeat bookings
On-time deliveries
Customer waiting time
Personnel Staff turnover
Days lost through absenteeism
Days lost through accidents/sickness
Training time per employee

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Different industries will place a different weighting on each area depending on those most
critical to their success.

Value of NFPIs
3.3 (a) Information can be provided quickly for managers (eg per shift, daily or hourly)
unlike traditional financial performance reports.
(b) Anything can be measured/compared if it is meaningful to do so.
(c) Easy to calculate and easier for non-financial managers to understand and use
effectively.
(d) Less likely to be manipulated than traditional profit related measures.
(e) Can be quantitative or qualitative.
(f) Provide information about key areas such as quality, customer satisfaction etc.
(g) Better indicator of future prospects than financial indicators which focus on the
short term.

Problems with NFPIs

3.4 (a) Too many measures can lead to information overload for managers, providing
information which is not truly useful.
(b) May lead managers to pursue detailed operational goals at the expense of overall
corporate strategy.
(c) Need to be linked with financial measures.
(d) Need to be developed and refined over time to ensure remain relevant.

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4 The balanced scorecard

4.1 A popular approach in current management thinking to performance measurement (for
service and non-service organisations) is the use of what is called a 'balanced scorecard',
consisting of a variety of indicators, both financial and non-financial.
4.2 The balanced scorecard focuses on four different perspectives and aims to establish goals
for each together with measures which can be used to evaluate whether these goals have
been achieved.
How do we create value for our shareholders?
Financial perspective

Goals Measures

How do What
customers must we
see us? excel at?
Customer perspective Internal business
perspective

Goals Measures Goals Measures

Innovation and
learning perspective
Goals Measures

Can we continue to improve

and create value?

Features
4.3 (a) Traditional measures are mainly inward looking and narrow in focus with over
emphasis on financial measures and short-term goals.
(b) The balanced scorecard focuses on both internal and external factors and links
performance measures to key elements of a company's strategy.
(c) It requires a balanced consideration of both financial and non-financial measures and
goals to prevent improvements being made in one area at the expense of another.
(d) It attempts to identify the needs and concerns of customers to identify new products
and markets and focuses on comparison with competitors to establish best practice.
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Lecture example 2 Exam standard Section A (All Exams) – 2 marks

The following statements have been made about the use of the balanced scorecard:
(1) Percentage of customers ordering a dessert could be used as a measure of customer
satisfaction for a restaurant.
(2) Percentage of revenue from meals sold from the specials board could be used as a
measure of innovation for a restaurant.
Which of the above statements is/are true?
A (1) only
B (2) only
C Neither (1) nor (2)
D Both (1) and (2)

Solution

Lecture example 3 Exam standard Section C (All Exams) – 10 marks

Preston Financial Services is an accounting practice. The business specialises in providing

accounting and taxation work for dentists and doctors. In the main the clients are wealthy,
self-employed and have an average age of 52.
The business was founded by and is wholly owned by Richard Preston, a dominant and
aggressive sole practitioner. He feels that promotion of new products to his clients would be likely
to upset the conservative nature of his dentists and doctors and, as a result, the business has
been managed with similar products year on year.
You have been provided with financial information relating to the practice.
Financial information
Current year Previous year
Turnover ($'000) 945 900
Net profit ($'000) 187 180
Average cash balances ($'000) 21 20
Average debtor/trade receivables days (industry average 30 days) 18 days 22 days
Inflation rate (%) 3 3
You have also been provided with non-financial information which is based on the balanced
scorecard format.
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Balanced scorecard (extract)

Internal Business Processes
Current year Previous year
Error rates in jobs done 16% 10%
Average job completion time 7 weeks 10 weeks
Customer Knowledge
Current year Previous year
Number of customers 1,220 1,500
Average fee levels ($) 775 600
Market share 14% 20%
Learning and Growth
Current year Previous year
Percentage of revenue from non-core work 4% 5%
Industry average of the proportion of revenue from non-core work in
accounting practices 30% 25%
Employee retention rate 60% 80%
Notes
1 Error rates measure the number of jobs with mistakes made by staff as a proportion of the
number of clients serviced.
2 Core work is defined as being accountancy and taxation. Non-core work is defined primarily
as pension advice and business consultancy. Non-core work is traditionally high margin.

Required
Using the data given in the balanced scorecard extract comment on the performance of the
business. Include comments on internal business processes, customer knowledge and
learning/growth, separately, and provide a concluding comment on the overall performance
of the business.

Solution

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5 Chapter summary
Section Topic Summary
1 Performance Performance of a business can be evaluated by financial
measurement indicators.
Financial indicators focus on the past and are short-term
measures; as such, non-financial indicators also need to
be used. A balance is needed between both.
2 Limitations and Whilst ratios are very helpful as a target and a means of
strengths of ratios assessing performance, they should not be used on their
own. They only focus on the past and monetary measures
and are very often short term.
3 Non-financial These measures when used in conjunction with financial
performance measures enable the whole picture to be seen. They can
indicators be quantitative or qualitative. Anything that is important
to the business can be measured and these ratios are not
easily manipulated.
4 The balanced Tools such as the balanced scorecard help to evaluate a
scorecard business by looking at all key areas using a variety of
financial and non-financial indicators.
The four key areas are:
 Customer
 Financial
 Internal
 Innovation and learning

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Additional Notes

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6 Profitability ratios
Profit before interest and tax
6.1 ROCE = %
Capital employed
Capital employed = total assets less current liabilities
ROCE = PBIT  Sales
Sales Capital employed

Net profit Asset

margin turnover
ROCE states profit as a percentage of capital employed and shows how well the business
utilises the funds invested in it.
There are three comparisons that can be made:
(a) The change in ROCE from year to year
(b) Comparison to other similar businesses
(c) Comparison to the market borrowing rate
Note. ROCE should be increasing. If it is static or reducing it is important to determine
whether this is due to a reduced profit margin or asset turnover. If both profit margin and
asset turnover are deteriorating then the company has a profitability problem.

6.2 Net profit margin

Net profit
 100 %
Sales
A high profit margin indicates that either sales prices are high or total costs are being kept
well under control.

6.3 Gross profit margin

(Sales  COS)
 100 %
Sales
A high gross profit margin indicates that either sales prices are high or production costs are
being kept well under control.

6.4 Asset turnover

The ratio of sales turnover to the amount of capital employed
Sales
(Total assets – current liabilities)
This shows the turnover that is generated from each $1 worth of assets employed.

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7 Liquidity/working capital ratios

7.1 The current ratio can be calculated by dividing the most liquid assets in the business
Liquidity and (receivables, inventories and cash) by the business's payables.
working capital
ratios Current assets
Current ratio =
Current liabilitie s
7.2 The current ratio can be amended by excluding the inventory from the current assets. This
gives the quick ratio or acid test.
Current assets  inventories
Quick ratio =
Current liabilities

1 Receivables period Average receivables  365 = days

Credit sales
2 Inventory period Average finished goods  365 = days
Cost of sales
3 Payables period Average payables  365 = days
Credit purchases
Note. If average data is not available year-end values should be used.
7.3 Improving the ratios
Inventory
(a) Reducing the raw material inventory holding period
 Introduce just-in-time (JIT) inventory management systems
 Reduce the variety of parts and components used and, consequently, the
variety of inventory to hold
(b) Reducing the production time
 Redesign of the factory layout to facilitate a smoother flow through the
production process
 Introduction of Total Quality Management (TQM) philosophy. This should
reduce or eliminate the level of rejects and costly rectification work
 Provide relevant staff training and development focused on continuously
seeking improvements in performance and efficient practices
 Invest in the ongoing review of product and process design to ensure only
value-adding activities are undertaken in the manufacturing or service
processes
 Introduction of automated processes where appropriate
(c) Reduce finished goods inventory holding periods
 If possible, operate a JIT philosophy of only manufacturing to order thus
reducing finished goods inventory levels to zero
 Regular review of inventory turnover by finished inventory item with a view to
eliminating slow or obsolete inventory line

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8 Gearing ratios
Long-term debt
8.1 Gearing ratio =
Long-term debt + equity (shareholders' funds)
Gearing measures the financial risk of a company.
8.2 Business risk refers to the variability in earnings which is due to the business activities of the
organisation. This can result from the organisation's products, customers, suppliers or cost
structure.

8.3 Operating gearing is a ratio which is calculated to quantify business risk. It looks
specifically at the operating cost structure of the organisation.
Contribution
Profit before interest and tax (PBIT)

8.4 If operating gearing is high this indicates that a large proportion of the organisation's
operating costs are fixed. Fixed costs make profit more volatile as PBIT becomes more
vulnerable to downturns in business volume.

9 Short-termism
9.1 Short-termism – is when managers focus on their performance in the short term often at
the expense of long-term performance.

9.2 If a manager's performance is measured on a short-term basis or a company is under

pressure to report positive growth short-termism may occur.

Lecture example 4 Exam standard Section A (All Exams) – 2 marks

The following are all decisions a manager could make:

(i) Postpone repairs/maintenance expenditure until the following year
(ii) Reduce R&D expenditure
(iii) Postpone recruitment of new staff
(iv) Train staff to complete work faster
Which of the above decisions are consequences of a bonus based on short-term profits?
A (i) and (ii)
B (i) and (iii)
C (i), (ii) and (iii)
D All of the above

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Solution

Lecture example 5 Exam standard Section A (All Exams) – 2 marks

Which of the following could be used to encourage managers to take decisions in the
long-term interests of the company?
(1) Link bonus to share price
(2) Link bonus to profit
(3) Award bonus in shares rather than cash
A (1) and (2)
B (1) and (3)
C (2) and (3)
D (1)

Solution

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Lecture example 6
ARH has the following results for the last two years of trading.
ARH INCOME STATEMENT FOR THE YEAR ENDED
31.12.X4 31.12.X5
$'000 $'000
Sales 14,400 17,000
Less cost of sales 11,800 12,600
Gross profit 2,600 4,400
Less expenses 1,200 2,000
Net profit for the year 1,400 2,400
Dividends paid 520 780

ARH STATEMENT OF FINANCIAL POSITION

31 December 20X4 31 December 20X5
$'000 $'000 $'000 $'000
Non-current assets 2,500 4,000
Current assets
Inventories 1,300 2,000
Receivables 2,000 1,600
Bank balances 2,400 820
5,700 4,420
8,200 8,420
Financed by:
2.4 million ordinary shares of $1 each 2,400 2,400
Revaluation reserves 500 500
Retained profits 1,200 2,820
4,100 5,720
Long-term liabilities
10% bonds 2,600 –
Current liabilities
Payables 1,500 2,700
8,200 8,420
Required
Calculate for both years:
(a) The gross profit margin
(b) The net profit margin
(c) The return on capital employed
(d) The asset turnover
(e) The acid test ratio
(f) The inventory turnover period in days
(g) The gearing ratio
Discuss what each ratio is telling you.

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Solution

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10 Performance measurement in service businesses

10.1 In Chapter 2b the characteristics which make cost and performance measurement difficult in
service industries were discussed.

10.2 Current thinking is that if something is difficult to measure it is because it has not been
defined clearly enough.

Fitzgerald and Moon's building blocks

10.3 Fitzgerald and Moon (1996) focused on performance measurement in service businesses.
The diagram below shows their building blocks for dimensions, standards and rewards.
This framework is also known as the results and determinants framework.

10.4 Performance of the organisation is viewed over six dimensions, the first two listed on the
diagram – Profit and Competitiveness being the results of the other four determinants:
(a) Quality – being reliability, courtesy, competence and availability
(b) Flexibility – the ability to deliver at the right time, response to customer requirements
and changes in demand
(c) Resource utilisation – best use of inputs to create outputs. This is usually measured
in terms of productivity
(d) Innovation – ability to develop new products or services, move into new markets and
continuous improvement

10.5 Underlying the achievement of results via the determinants are the standards:
Ownership – Employees need to participate in the creation of standards to take
ownership of them but this can sometimes lead to the inclusion of
some budgetary slack
Achievement – The standards set must be challenging but achievable
Equity – Each division or department must have appropriate standards set for
it in order to ensure fairness in measurement

10.6 And the rewards:

Clarity – The objectives of the organisation need to be clearly understood
Motivation – Individuals need to be motivated to achieve the objectives
Controllability – Managers should not be held responsible for costs over which they
have no control

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Lecture example 7 Exam standard Section A (All Exams) – 2 marks

The following statements have been made about performance measurements:

(1) Non-financial performance measures are important because they can provide a good
indication of future financial prospects.
(2) A problem with using multiple measures of performance is that the organisation may lose
sight of its overall aim.
Which of the above statements is/are true?
A (1) only
B (2) only
C Neither (1) nor (2)
D Both (1) and (2)

Solution

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END OF CHAPTER

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Divisional performance
measures

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Example past exam questions
Explain and illustrate the basis for setting a Q14 Section A – Specimen exam
transfer price using variable cost, full cost and the Q5 Section A – December 2016
principles behind allowing for intermediate
markets.
Explain how transfer prices can distort the
performance assessment of divisions and
decisions made.
Explain the meaning of, and calculate, Return on Q10 Section A – September 2016
Investment (ROI) and Residual Income (RI), and Q32 Section C – December 2016
discuss their shortcomings.
Q32 Section C – September/December 2017
Compare divisional performance and recognise Q13 Section A – September 2016
the problems of doing so. Q15 Section A – December 2016

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 16: DIVISIONAL PERFORMANCE MEASURES

Overview

Divisional performance
measures

Responsibility accounting Investment centre Transfer pricing

performance appraisal
methods

ROI – Return On Investment

RI – Residual Income

Approaches
 Market based
 Cost based
 Opportunity cost
Aims

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1 Responsibility accounting
1.1 Generally a company with several divisions will be a decentralised organisation. In such
organisations divisional managers tend be responsible for making their own decisions
concerning the operation of the division.

1.2 Advantages of decentralisation include:

(a) Decisions taken more quickly
(b) Increased motivation of management
(c) Increased quality of decisions due to local knowledge
(d) Reduced head office bureaucracy
(e) Provides better training for all levels of management

1.3 Disadvantages of decentralisation include:

(a) Potential for dysfunctional decision making ie not in the interests of the whole
organisation
(b) Duplication amongst divisions leading to greater cost
(c) Senior management loss of control
Appropriate performance evaluation methods are therefore needed.

Conditions for a good performance measure

1.4 A good performance measure should:
(a) Provide incentive to the divisional manager to make decisions which are in the best
interests of the overall company (goal congruence)
(b) Only include factors for which the manager (division) can be held accountable
(c) Recognise the long-term objectives as well as short-term objectives of the
organisation

Responsibility accounting
1.5 Responsibility accounting is used to measure performance of decentralised units.

1.6
Responsibility Manager's area of Typical financial
structure responsibility performance measure
Cost centre Decisions over costs Standard costing variances
Revenue centre Revenues only Revenues
Profit centre Decisions over costs and Controllable profit
revenues
Investment centre Decisions over costs, Return on investment and
revenues, and assets residual income
So far we have seen many of the performance measures dealing with the first three of these
responsibility centres.
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Lecture example 1 Exam standard Section A (All Exams) – 2 marks

The following are some of the areas which require control within a division:
(i) Generation of revenues
(ii) Investment in non-current assets
(iii) Apportioned head office costs
(iv) Salary costs
Which of the above does the manager have control of in an investment centre?
A All of the above
B (i) and (ii)
C (ii) and (iv)
D (i), (ii) and (iv)

Solution

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2 Investment centres
2.1 Within an investment centre, managers also have responsibility over investments and
assets. To measure their performance purely on say profit would be only focusing on part of
the picture. To overcome this we use two methods which measure the assets and the profit
they generate.

Return on investment (ROI)

Divisional Profit
2.2 ROI =  100
Divisional Investment

2.3 Profit should be before interest and tax (PBIT). It may also be helpful in measuring
performance to calculate ROI based on controllable profit.
For the investment, use opening book value of total assets less current liabilities.
Alternatively an average book value may be used.

2.4 ROI enables performance in different divisions to be compared.

Similarly, new investments can also be appraised using ROI.

2.5 Decision rule

Only projects which increase the existing ROI should be undertaken.

2.6 Problems with ROI

 Dysfunctional behaviour – only projects which increase ROI will be accepted; this
could be at the expense of growth in corporate profits
 The ratio will be distorted by the age of the assets
 Profit can be manipulated

Residual income
2.7 Traditionally the main alternative to ROI, it provides a hurdle figure for profit based on the
company's minimum required percentage return from a division.
$
PBIT (or controllable profit) X
Less 'imputed interest' (= Divisional Investment  Cost of Capital) (X)
Residual income X
The result is an absolute figure.

Advantages of residual income

2.8  Avoids dysfunctional behaviour
 Different costs of capital can be used to reflect risk

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ROI vs RI
2.9 In practice, however, ROI is used more frequently than RI, for the following reasons:
(a) Dysfunctional behaviour is not material
(b) ROI is consistent with corporate assessment (ROCE)
(c) Percentages are more easily understood
(d) RI requires a cost of capital

Lecture example 2 Exam standard Section A (All Exams) – 2 marks

Brenda and Eddie have two franchises in different parts of town and want to monitor the
performance of the two managers who have full control over investments.
Forecast results for the year are:
Vittorio's Dugaldo's
$ $
Profits 90,000 135,000
Investment 500,000 750,000
Which explanation would explain why profit or ROI would be more equitable for comparing
Vittorio's and Dugaldo's forecast performance?

A Profit because this relates to shareholder wealth

B Profit because maximising profit is the overriding objective of all companies
C ROI because it takes into consideration the fact that Dugaldo has more investment than
Vittorio
D ROI because it is based on prior results which are historical information

Lecture example 3 Exam standard Section B (All Exams) – 12 marks

Brenda and Eddie have two franchises in different parts of town and want to monitor the
performance of the two managers who have full control over investments.
Forecast results for the year are:
Vittorio's Dugaldo's
$ $
Profits 90,000 135,000
Investment 500,000 750,000
Vittorio is considering investing in a labour-saving piece of equipment which will cost $8,000. This
will generate an increase in net profit of $1,200 each year for 10 years, after which time the
equipment is expected to have no resale value. Vittorio uses straight-line depreciation.
Dugaldo has been offered a replacement oven for one of his existing ones. The existing one is
written down in the books to an NBV of $2,000 and is very inefficient. Total costs are $25,000,
including maintenance and depreciation.
The replacement will cost $75,000, will have no downtime and negligible maintenance costs in its
early years. Depreciation will be 20% p.a. straight-line.

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Each oven is estimated to generate $60,000 p.a. before these costs are considered.
The Directors demand a minimum return on capital employed of 12%.
1. What is the current ROI of each division?
Vittorio Dugaldo
A 18% 8%
B 18% 18%
C 15% 8%
D 15% 18%
2. What is the ROI of the new labour-saving equipment Vittorio is considering?
A 18.00%
B 17.95%
C 15.00%
D 5.00%
3. What decision would the manager and the company reach regarding the new
equipment?
Manager Company
A Accept Reject
B Accept Accept
C Reject Accept
D Reject Reject
4. What is the ROI of the new oven?
A 1750%
B 60%
C 18%
D 15%
5. What decision would the manager and the company reach regarding the new oven?
Manager Company
A Accept Reject
B Accept Accept
C Reject Accept
D Reject Reject
6. What is the RI of each investment?
Vittorio Dugaldo
A $240 $1,000
B $960 $9,000
C $240 $9,000
D $960 $1,000

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Solution

3 Transfer pricing
3.1 Within a decentralised organisation there may be a division which makes units that are then
transferred to another division. It will usually be necessary to charge the receiving division
for the goods that it has received in order for performance to be measured equitably.
A transfer price is the price at which goods are transferred internally.
The transfer pricing policy will have a significant impact on responsibility accounting and
performance measurement.

3.2 It is vital that the transfer price is carefully selected to ensure all parties act in the best
interest of the company. The overriding question should be:
'Whether the transfer is in the company's best interest'
If so, the price charged should ensure that the transfer satisfies the company, the supplying
division and the receiving division.
Company

Supplying division Receiving division

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3.3 The goals of a transfer pricing system are:

(a) Goal congruence
(b) Equitable performance measurement
(c) Retain divisional autonomy
(d) Motivate divisional managers
(e) Optimum resource allocation
External sale of intermediate
product by Supply

Costs WHOLE COMPANY

incurred by
Supply Division Division Revenue
Supply Receive earned by
Transfer? Receive

Alternative suppliers to Receive

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Lecture example 4 Exam standard Section C (All Exams) – 14 marks

The Fruity Bakers specialise in making delicious cakes. Their trademark fruit cake is made in
Division A (the supplying division) and sold to external customers for them to decorate, or it can be
enjoyed plain. It is also transferred to Division B (the receiving division) where it is iced and
decorated to be sold as a luxury wedding cake. Fruity Bakers are currently trying to decide what
the optimum price to sell the cakes from Division A to B should be in order to motivate the
managers of both divisions. The following data shows the costs incurred by Division A to make a
fruit cake and by Division B to ice and decorate the wedding cake.
$/unit
Division A Variable costs 20.00
Fixed overhead 8.00
28.00

Division B Variable costs 40.00

Fixed overhead 5.00
45.00
Notes
1 Plain fruit cakes can be sold and purchased externally for $30.
2 Wedding cakes can be sold for $100.
Required
(a) Should the company make the fruit cakes internally or buy them in?
(b) What non-financial factors should also be taken into consideration?
(c) What would be the implication of using the following transfer pricing policies?
(i) Full cost plus 10%
(ii) Variable cost plus 55%
(iii) Variable cost only
(iv) The external market price

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Solution

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Lecture example 5 Exam standard Section C (All Exams) – 8 marks

It has now been identified that Division A also makes excellent sponge cakes. These are sold
externally only. The bakers can make either 100 fruit cakes per month or 800 sponge cakes or any
combination of the two. The following information is available:
Fruit cake Sponge cake
$/Unit $/Unit
Selling price 30 10
Variable costs (20) (6)
Fixed overheads (8) (2)
Profit 2 2
Labour hours per cake 2 0.25
Required
Using the above information, provide advice on the determination of an appropriate transfer
price and provide a reasoned recommendation of a policy The Fruity Bakers should adopt
for the transfer of fruit cakes from Division A to Division B in the following conditions:
(a) When Division A has spare capacity and limited external demand for sponge cakes
(b) When Division A is operating at full capacity with unsatisfied external demand for
sponge cakes

Solution

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Lecture example 6 Exam standard Section A (All Exams) – 2 marks

Division X produces three products, A, B and C. Each product has an external market, but B can
also be transferred to Division Y.
After incurring extra costs of $60, Division Y then sells the unit for $300.
The maximum quantity that might be required for transfer is 150 units of B.
Information on the products is as follows.
A B C
External market price per unit $150 $200 $140
Variable production cost per unit $86 $95 $83
Labour hours required per unit 4 6 3
Maximum external sales, in units 2,000 1,250 2,400
In the current period, labour hours in the profit centre are limited to 20,000, and this is insufficient
to satisfy maximum external demand.
Therefore, using limiting factor analysis, the optimal production plan has been calculated as:
A B C
Contribution per unit $64 $105 $57
Labour hours required 4 6 3
 Contribution per hour $16 $17.50 $19
Ranking 3rd 2nd 1st

 Optimal Production Plan

Product Units Hours/unit Hours
C 2,400 3 7,200
B 1,250 6 7,500
A (balance) 1,325 4 5,300
20,000
Given that Division X is operating at full capacity, what are the minimum and maximum
transfer prices that could be used for Product B?
Minimum Maximum
A $191 $200
B $105 $200
C $191 $210
D $105 $210

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Solution
Minimum transfer price

Maximum transfer price

Checklist of things to look out for in exam questions:

 Impact on both divisions and the company as a whole
 Capacity issues
 Opportunity costs
 Remember the current situation does not always result in goal congruent behaviour!

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4 Summary of all of the different approaches to

transfer pricing
Method Impact on selling Impact on buying Impact on company
division division
Market based  Earns same profit  Happy to accept Goal congruent
as external sales transfer (can't buy behaviour should arise
 Equitable cheaper
performance elsewhere)
management  Equitable
performance
management
Full cost  No incentive to  Happy to accept (if May lead to
transfer unless less than market dysfunctional
spare capacity price) behaviour
Variable cost  No incentive to  Happy to accept May lead to
transfer dysfunctional
behaviour
Full cost plus %  Covers all costs and  May not accept as May lead to
makes a price could be dysfunctional
contribution to profit higher than market behaviour
so happy to sell price
Variable cost plus %  May not cover all  Will accept if lower May lead to
fixed costs than market price dysfunctional
behaviour
Head office  Lack of autonomy  Lack of autonomy Goal congruent
intervention so demotivating so demotivating behaviour should arise

4.1 An opportunity cost based approach is the optimum approach to setting transfer prices.

Minimum transfer price Maximum transfer price

Variable cost Lower of: External market price
+ or
Opportunity cost Divisional net revenue

4.2 Where the supplying division has spare capacity, the opportunity cost of transferring units
internally is nil.
Where the supplying division is at full capacity, the opportunity cost will be the lost
contribution from the other sales (the shadow price).

4.3 Opportunity cost based approaches should always result in goal congruent behaviour with
both buyer and seller happy to transfer when it is in the group's best interest to do so.

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5 Chapter summary
Section Topic Summary
1 Responsibility A good performance measure should be one that drives
accounting goal congruence, measures managers only on those
items that they can control and recognises long-term as
well as short-term objectives.
2 Investment centres Performance measures need to reflect not just profit but
also the investment made to generate that profit.
ROI is the most commonly used measure within a
decentralised business but can result in dysfunctional
behaviour.
Using RI will ensure all decisions result in goal congruent
behaviour.
3 Transfer pricing Within a decentralised business it may be necessary to set
transfer prices when goods are transferred between
divisions. Transfer prices can be set on the basis of cost,
market price or opportunity cost.
Cost based transfer prices are most likely to result in
dysfunctional behaviour.
4 Summary of Transfer prices can be set on the basis of cost, market
different approaches price or opportunity cost.
Cost based transfer prices are most likely to result in
dysfunctional behaviour.

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Additional Notes

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6 Transfer pricing in practice

Market based approaches
6.1 If an external market exists for transferred goods (and there is unsatisfied demand
externally), the transfer price can be set as the external market price.

6.2
Seller Buyer

Earns the same level of profit on internal Happy to accept transfer (cannot buy
sales as external sales cheaper elsewhere)
Equitable performance measurement Equitable performance measurement

The managers of both divisions will behave in a goal congruent way.

6.3 If savings are made by selling internally then this may be reflected in the transfer price, eg
by offering a discount equivalent to saved transport costs.

Cost based approaches

6.4 The idea behind these approaches are similar to those involved in manufacturing accounts.
The supplying division has its costs of manufacturing refunded and may also be given a
mark up to encourage the transfer.

Actual cost v standard cost

6.5 Use of actual costs would result in:
(a) All inefficiencies passed on to buying division
(b) No encouragement for cost control in selling division
(c) Buying division does not know in advance what price it will be paying
(d) Performance measurement is therefore difficult
(e) Seller will want to transfer, buying division will not want to transfer
Using standard costs overcomes all these problems.

Full cost v variable cost

6.6 Full cost

Seller Buyer

Doesn't receive any profit on transfers Happy to accept transfer (assuming full
cost is below market price)
May not transfer unless it has spare capacity

This approach may lead to dysfunctional behaviour.

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6.7 Variable cost

Seller Buyer

Doesn't receive any contribution towards fixed

costs or profit
Happy to accept transfer
Will not want to transfer unless it has spare
capacity
This approach may lead to dysfunctional behaviour.

Standard full cost plus percentage

6.8
Seller Buyer

Covers all costs and makes a contribution Price may be higher than market price
towards profit
Will want to transfer May not wish to accept transfer

This approach may often lead to dysfunctional behaviour.

Standard variable cost plus percentage

6.9
Seller Buyer

May not cover all fixed costs

Likely to be happy to accept transfer
(assuming percentage is not so large that
May not wish to transfer if percentage final price exceeds market price)
does not provide enough contribution
towards fixed costs

This approach could potentially lead to dysfunctional behaviour.

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END OF CHAPTER
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Further performance
management

How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Example past exam questions
Comment on the problems of having
non-quantifiable objectives in performance
management.
Explain how performance could be measured in Q6 Section A – September 2016
this sector (NFPOs and the public sector). Q12 Section A – December 2016
Comment on the problems of having multiple
objectives in this sector.
Outline Value for Money (VFM) as a public sector Q9 Section A – Specimen exam
objective.
Explain the need to allow for external
considerations in performance management,
including stakeholders, market conditions and
allowance for competitors.
Suggest ways in which external considerations
could be allowed for in performance
management.
Interpret performance in the light of external
considerations.
Identify and explain the behaviour aspects of
performance management.
Describe, calculate and interpret non-financial
performance indicators (NFPIs) and suggest
methods to improve the performance indicated.
Explain the causes and problems created by
short-termism and financial manipulation of
results and suggest methods to encourage a long
term view.
Discuss the difficulties of target setting in
qualitative areas.

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Syllabus learning outcomes Example past exam questions

Analyse past performance and suggest ways for
improving financial and non-financial
performance.

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Overview

Objectives Evaluation of performance

Further performance
management

External factors Behavioural aspects

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1 Objectives
1.1 Profit seeking organisations
Primary objective:
 Maximise the wealth of the owners of the business – (equity)
Secondary objectives might be:
 Ensure survival
 Provide a quality product/service (customer satisfaction)
 Be a good corporate citizen (health and safety/environment)
 Create wealth/benefits for management/employees
 Secure competitive advantage and grow market share
The objective of profit or wealth maximisation is thus modified to meet the needs of different
interest groups (stakeholders).

1.2 Public sector organisations

Primary objective might be:
 Provision of a quality product/service within a value for money framework
Secondary objectives might be:
 Be a good corporate citizen (health and safety/environment)
 Adopt an ethical social stance in decision making
 Create wealth/benefit for management/employees
 Earn sufficient profits to provide for future capital investment and perhaps provide a
surplus for the exchequer

1.3 Not for profit organisations (NFPOs)

Primary objective might be:
 Provision of a social or community service for the wellbeing of society
Secondary objectives might be:
 Be a good corporate citizen (health and safety/environment)
 Adopt an ethical social stance in decision making
 Increase wealth/benefit for management/employees

2 Evaluation of performance
2.1 NFPOs and public sector organisations will not have wealth maximisation as a primary
objective. However, they will still have strategic objectives (albeit non-financial) and
stakeholders (clients, members etc), who will wish to measure their performance.

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2.2 Problems of performance measurement in NFPOs

 Multiple objectives
 How to measure output
Solutions
 Lack of financial/profit measure
 Difficult to define a unit

Lecture example 1 Exam standard Section A (All Exams) – 2 marks

The following performance targets have been suggested for ensuring that a hospital is achieving
its objectives:
(1) Incidents of abuse against staff
(2) Death rates
(3) Readmission rates
(4) Use of agency staff
Which of the above would be suitable performance measures?
A All of the them
B (2) only
C (2), (3) and (4)
D (2) and (3)

Solution

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Possible performance measurement methods

2.3  The 3 Es
 Comparisons – eg comparison of results/benchmarking between different public
sector organisations
 Efficiency measurement – ie cost/patient/day
 Judgement – some measurement will be subjective

2.4 The '3 Es' measures performance in value for money terms
Economy – Sourcing inputs at minimum cost while maintaining standards of quality
Efficiency – Achieving better productivity (output) from resources input/consumed
Effectiveness – Success in achieving objectives

Lecture example 2 Exam standard Section A (All Exams) – 2 marks

The following performance measures have been suggested for a public sector higher education
college:
(i) Teaching hours per student
(ii) Sourcing lecturers of appropriate quality at an acceptable cost
(iii) Percentage of graduates employed within 12 months of the course ending
(iv) Percentage of students achieving target pass rates
Which would be appropriate for measuring effectiveness?
A All of the above
B (ii), (iii) and (iv)
C (iii) and (iv)
D (iv) only

Solution

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3 Performance measurement and external factors

3.1 When devising performance measures for any organisation, consideration needs to be given
to three key external factors:
 Stakeholders
 Economic environment
 Competition

3.2 A stakeholder is anyone who has a legitimate interest in the organisation.

Stakeholders can be broken down into three key groups.
 Internal – such as employees
 Connected – shareholders, customers, suppliers
 External – community and the Government
3.3 There will often be a conflict between the stakeholder objectives. For example, shareholders
want larger returns whereas employees want pay rises. Performance measures need to be
considered carefully. A suitable measure in this case might be performance related pay.

4 Performance management and behaviour aspects

4.1 You have already come across some of the behavioural aspects of performance
measurement when looking at setting standards and budgets.
These are some of the aspects to bear in mind:
 Targets should be set which support the company objectives.
 Managers should only be assessed on those items that they can control.
 Targets should incorporate long-term as well as short-term objectives.
 Targets should be set that motivate.
 Targets should encompass the big picture and may include financial and non-financial
aspects.

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5 Chapter summary
Section Topic Summary
1 Objectives Performance measurement in public sector or NFP
organisations can be difficult as they often have multiple
objectives and these are often hard to quantify and
measure.
2 Evaluation of Performance is often evaluated using the 3 Es:
performance  Economy
 Effective
 Efficiency
3 Performance Performance measures need to be developed bearing in
measurement and mind three external factors:
external factors  Stakeholders (which can be internal, external or
connected)
 Economic environment
 Competition
4 Performance Issues here are the same issues that occur with
measurement and performance measurement in a profit making organisation.
behaviour aspects

END OF CHAPTER
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