ACCA

PERFORMANCE
MANAGEMENT
Student’s Name ……………………………………………..

Batch Name ……………………………………………….

Subject……………………………………………………..

Address ……………………………………………………

…………………………………………………………….

…………………………………………………………….

Contact Number …………………………………………...

PERFORMANCE
MANAGEMENT
 Chapter Index
Part I – Decision Making (Part C)
Chapter Chapter / Topic Name Page No.
No.
a CVP Analysis 1-3
b Limiting Factor 4-7
c Make or Buy, Make or Buy with Limiting Factor 8 - 10
d Short Term Decision 11 - 16
e Pricing Decision 17 - 26

Part II – Specific Cost Management Techniques (PART B)

Chapter Chapter Name Page No.
No.
a Target Costing 27 - 30
b 31 - 35
Life Cycle Costing
c Activity Based Costing 36 - 37
d Theory of Constraints 38 - 40
e Environmental Management Accounting 41 - 49

Part III – Budget & Control (PART D)

Chapter Chapter Name Page No.
No.
a (a) Budgetary Controls 50 - 54
b (b) Learning Curve 55 - 58
c (c) Variance 59 - 79

Part IV – Performance Measurement (PART E)

 Chapter Chapter Name Page No.
No.
a Divisional Performance 80 - 82
b 83 - 96
Transfer Pricing
c Balanced Score card 97 - 112
d BBM 113 - 118

Part V – SECTION A
Chapter Chapter Name Page No.
No.
Section A – Managing Information 119 - 130
 I – DECISION MAKING (PART C)
(a) CVP ANALYSIS
Cost volume profit (CVP)/breakeven analysis is the study of the
interrelationships between costs, volume and profit at various levels of activity.

Remember the Examples we have done in class

It states relationship between VC, SP, Contribution, connection between
Volume – Contribution, Fixed Cost and Profit.
 Contribution per unit = unit selling price – unit variable costs
 Profit = (sales volume × contribution per unit) – fixed costs
 Breakeven point = activity level at which there is neither profit nor loss
= total fixed costs contribution required to breakeven /
contribution per unit
 Contribution/sales (C/S) ratio = profit/volume (P/V) ratio
= (contribution/sales) × 100%
 Sales revenue at breakeven point = fixed costs / C/S ratio
 Margin of safety (in units) = budgeted sales units –
breakeven sales units
Or
Profit / Contribution per unit

 Margin of safety (as %) = (budgeted sales – breakeven sales) / budgeted

sales × 100%
 Sales volume to achieve a target profit (Units) = (fixed cost + target
profit)/contribution per unit
 Sales volume to achieve a target profit (Value)
(fixed cost + target profit)/contribution Sales Ratio

MULTIPLE PRODUCTS

 BEP (Units): Fixed Cost / Weighted Average Contribution Per unit

Weighted Average CPU = Total Contribution for MIX / No. of Units in MIX

 BEP (Value) = Fixed Cost / Weighted Average CS Ratio

Weighted Average CSR = Total Contribution for the MIX /

Total Sale Value of MIX

1
Before studying the computation & Analysis part, we have to understand
following assumptions of the CVP

1. CVP analysis can apply to one product only, or to more than one product
only if they are sold in a fixed sales mix (fixed proportions).

2. Fixed costs per period are same in total, and unit variable costs are a
constant amount at all levels of output and sales.

3. Sales prices are constant at all levels of activity.

4. Production volume = sales volume.

Preparation of PV Chart:
Another form of breakeven chart is the profit–volume chart. This chart plots a
single line depicting the profit or loss at each level of activity. The breakeven
point is where this line cuts the horizontal axis.
The vertical axis shows profits and losses and the horizontal axis is drawn at
zero profit or loss.
The profit–volume graph is also called a profit graph or a contribution– volume
graph.
Refer Page No. 83 of Kaplan or Page No. 131 of BPP Study Text

For Multiple PV Chart : Follow the steps mentioned

1. Rank the products on the basis of CSR
2. Compute Total Sales and Contribution of each product in a cumulative
Manner
3. Plot profit of each product’s Contribution and Sales
4. Draw Line from Zero Output Line (Point at which Line touches on X
Axis is known as BEP

Limitations of CVP Analysis

1. It is assumed that fixed costs are the same in total and variable costs are the
same per unit at all levels of output. This assumption is a great
simplification.
a. Fixed costs will change if output falls or increases substantially.
b. The variable cost per unit will decrease where economies of scale are
made at higher output volumes, but the variable cost per unit will also
eventually rise when diseconomies of scale.
c. begin to appear at even higher volumes of output (for example the extra
cost of labour in overtime working).

2
2. It is assumed that sales prices will be constant at all levels of activity. This
may not be true, especially at higher volumes of output, where the price may
have to be reduced to win the extra sales. (In case of Competition also,
Prices may be changed)

3. Production and sales are assumed to be the same, so that the consequences
of any increase in inventory levels or of 'de-stocking' are ignored. (Same
stock concepts is not at all possible in practice)

4. Uncertainty in the estimates of fixed costs and unit variable costs is often
ignored.

Questions Relevant for the topics

1. BPP Text Book Examples: 1.1.3 – 4.1 PL – Alpha - 7.2 – 8.1.1
2. Kaplan KIT: 83 to 96, 252 (HARE) -253 (CARDIO)

3
 (b) LIMITING FACTOR

A limiting factor is any factor that is in scarce supply and that stops the
organisation from expanding its activities further, so that there is a maximum
level of activity at which the organisation can operate.

Example:
 You want to play Soccer after studying PM, but you have no time: LF is
Time.
 You want to invest in Fixed Deposit – 10,00,000 and Stock Market
15,00,000: But you have only 50,000 – LF is Money.
 Demand for the product is 7,000, each product require 2KG of input, but
total available stock of R/M is 10,000 KG - LF is R/M.

In Broad Sense,
Examples of limiting factors include sales demand and production constraints.

– Labour. The limit may be either in terms of total quantity of labour or a limit
to the availability of employees with particular skills.
– Materials. There may be insufficient available materials to produce enough
units to satisfy sales demand.
– Machine capacity. There may not be sufficient machine capacity for the
production required to meet sales demand.

If a resource is the limiting factor, contribution will be maximized by earning

the biggest possible contribution per unit of the limiting factor.

Note 1: Where there is just one limiting factor, products should be ranked
in order of priority (for production and sale) in order of the contribution
they earn per unit of the limiting factor.

Steps in Product Mix Decision

1. Calculate Contribution per Unit for each product
2. Calculate CPLF
3. Rank the Product based on CPLF
4. Allocate Scarce Resource on the basis of Ranking

Note 2: If there is only 1 product and more than 1 Limiting Factor, Contribution
as per Binding Constraint should selected and produced.

Note 3: If there is two product, and More than 1 Limiting Factor, we will use
Graphical Method of LPP to solve the Problem

4
GRAPHICAL METHOD OF LPP

The graphical method of linear programming can be used when there are just
two products (or services). The steps involved are as follows.

1. Define the problem:

A. Define variables : Name Finished Goods as X or Y or A or B or
Suttrumees of Kuttrumees based on your idea.
B. Establish constraints: Equation :P like 2X+ 3Y<=2400 etc.
C. Construct objective function
Maximize Contribution is the Agenda for our syllabus, but under LPP it
can be Minimization of cost

2. Draw the constraints on a graph: Drawing Graph will not be asked, but
understanding it is very important, hope we have done it well (y).

3. Establish the feasible region for the optimal solution (Like OABCD, normal
naming given in the questions).

4. Determine the optimal solution: Simultaneous Equations.

Questions:
1. A company manufactures two products A and B, involving three
departments - Machining, Fabrication and Assembly. The process time,
profit/unit and total capacity of each department is given in the following
table.

Machining Fabrication Assembly Profit (`)

(hours) (hours) (hours)
A 1 5 3 80
B 2 4 1 100
Capacity 720 1,800 900

Set up Linear Programming problem to maximize profits. What will be

the product-mix at maximum profit level? What will be the profit? (Solve
by using graphic method).

5
 Answer:
Let x and y denote the number of units produced for the product A & B
respectively. The linear programming model for the given problem is

Maximize Z = 80x + 100y

Subject to the Constraints:
x + 2y ≤ 720 (Machining Time)
5x + 4y ≤ 1,800 (Fabrication Time)
3x + y ≤ 900 (Assembly Time)
X, y >0

The shaded portion in the diagram represents the feasible region. Value of the
objective function at the feasible points is calculated below:

Point Co-Ordinates of the corner points Value of the objective

of the feasible region function
(value of x and y) Z = 80x + 100y
P (300,0) 24,000
Q (257,129) 33,460
R (120,300) 39,600
S (0,360) 36,000
T (0,0) 0
Since at Point R company makes maximum profit hence product mix at Point R
i.e. 120 units of Product A and 300 units of product B should be produced.

6
Slack and surplus
Slack occurs when maximum availability of a resource is not used: slack is the
amount of the unused resource or other constraint, where the constraint is a 'less
than or equal to' constraint.

Surplus occurs when more than a minimum requirement is used: surplus is the
excess over the minimum amount of constraint, where the constraint is a 'more
than or equal to' constraint.
Slack occurs when maximum availability of a resource or other constraining
factor is not used.
If, at the optimal solution, the amount of the resource used equals the amount of
the resource available, there is no spare capacity of a resource and so there is
no slack.

If, at the optimal solution, the amount of the resource used is less than the
amount of the resource available, there is spare capacity for the resource and so
there is slack.

Shadow prices
The shadow price or dual price of a limiting factor is the increase in value
which would be created by having one additional unit of the limiting factor at its
original cost.

The shadow price or dual price of a constraint factor is the amount of change in
the value of the objective function (for example, the increase in contribution)
created by the availability of one extra unit of the limited resource at its original
cost.

Note the following points.

(a) The shadow price therefore represents the maximum premium above the
basic rate that an organisation should be willing to pay for one extra unit of
a resource.

(b) Since shadow prices indicate the effect of a one unit change in a constraint,
they provide a measure of the sensitivity of the result.

(c) The shadow price of a constraint that is not binding at the optimal solution is
zero.

Relevant Questions for Shadow Price: Cut and Stitch, BEFT Co, COSMETICS
Co, CARA Co, CSC Co.

7
 (c) MAKE OR BUY - SHORT TERM DECISION
Outsourcing decision is often called a ‘make or buy’ decision. It involves a
decision of whether to continue 'making' a product versus ‘buying’ it from an
external firm. Outsourcing enables a firm to

 reduce costs or
 benefit from supplier efficiencies

Outsourcing Decisions- Accept or Reject?

 If incremental cost savings + opportunity costs < incremental costs, reject

the outsourcing, unless qualitative factors fiercely impact the decision.
 If incremental cost savings + opportunity costs > incremental costs,
accept the outsourcing unless qualitative factors fiercely impact the
decision.
 If incremental cost savings + opportunity costs are = incremental costs,
focus primarily on qualitative factors to evaluate the decision.

Qualitative Factors: While considering the decision to Outsourcing the

management should consider qualitative aspects like quality of goods, reliability
of suppliers, impact on the customers and suppliers etc.

A firm generally decides to outsource:

 If it costs less rather than to manufacture it internally;
 If the return on the necessary investment to be made to manufacture is not
attractive enough;
 If the company does not have the requisite skilled manpower to make;
 If the concern feels that manufacturing internally will mean additional
labour problem;
 If adequate managerial manpower is not available to take charge of the
extra work of manufacturing;
 If the component shows much seasonal demand resulting in a
considerable risk of maintaining inventories;
 If transport and other infrastructure facilities are adequately available;
 If the process of making is confidential or patented;
 If there is risk of technological obsolescence for the component such that
it does not encourage capital investment in the component.

8
Practical Questions:
X is a multiple product manufacturer. One product line consists of motors and
the company produces three different models. X is currently considering a
proposal from a supplier who wants to sell the company blades for the motors
line.

The company currently produces all the blades it requires. In order to meet
customer's needs, X currently produces three different blades for each motor
model (nine different blades).

The supplier would charge ₹ 25 per blade, regardless of blade type. For the next
year X has projected the costs of its own blade production as follows (based on
projected volume of 10,000 units): Direct materials ₹ 75,000.
Direct labour... ₹ 65,000
Variable overhead ₹ 55,000
Fixed overhead
Factory supervision ₹ 35,000
Other fixed cost... ₹ 65,000.
Total production costs... ₹ 2,95,000

Assume
(1) the equipment utilized to produce the blades has no alternative use and no
market value,
(2) the space occupied by blade production will remain idle if the company
purchases rather than makes the blades, and
(3) factory supervision costs reflect the salary of a production supervisor who
would be dismissed from the firm if blade production ceased.

(i) Determine the net profit or loss of purchasing (rather than manufacturing),
the blades required for motor production in the next year.
(ii) Determine the level of motor production where X would be indifferent
between buying and producing the blades. If the future volume level were
predicted to decrease, would that influence the decision?
(iii)For this part only, assume that the space presently occupied by blade
production could be leased to another firm for ₹ 45,000 per year. How
would this affect the make or buy decision?

Other Question Relevant for the topic:

Robber Co - Pixie Chemicals

9
Limiting Factor and Make or Buy
In a situation where a company is able to subcontract work to make up a
shortfall in its own in-house production capabilities, its total costs will be
minimised if those units bought from the subcontractor have the lowest
extra variable cost per unit of scarce resource saved by buying. Extra
variable cost is the difference between the variable cost of in-house
production and the cost of buying from the subcontractor.

Steps:
1. Compute Extra variable cost per unit of subcontracting
2. Compute cost per machine hour of extra buying
3. Rank the product based on the basis of lowest per limiting factor to
higher (Least per unit of limiting factor is preferable for buying and
so on)
4. Allocate the resources based on Ranking

Questions:
MM manufactures three components, S, A and T, using the same machines for
each. The budget for the next year calls for the production and assembly of
4,000 of each component. The variable production
cost per unit of the final product is as follows.

Machine hours Variable cost

1 unit of S 3 $
1 unit of A 2 20
1 unit of T 4 36
Assembly 24
20
100

Only 24,000 hours of machine time will be available during the year, and a
subcontractor has quoted the following unit prices for supplying components:
S $29; A $40; T $34.
Required
Advise MM.

Refer Questions – Robber Co – 164 BPP

10
 (d) SHORT TERM DECISIONS
RELEVANT COSTING (Minimum Pricing
Decision)
Relevant costs are future cash flows arising as a direct consequence of a
decision.
 Relevant costs are future costs.
 Relevant costs are cash flows.
 Relevant costs are incremental costs, arising as a direct consequence of
the decision.

1. It must be a cost that will occur in the future. Any cost that has already been
incurred in the past cannot be a relevant cost.
2. It must be a cost (or benefit) that results in cash flow. Depreciation charges
and overhead absorption costs cannot be relevant costs.
3. It must arise as a direct consequence of the decision. Any costs (or benefits)
that will happen anyway, regardless of the decision, cannot be a relevant
cost.

It follows from this definition that:

(a) Sunk costs cannot be relevant costs. Sunk costs are costs that have already
been incurred.

(b) Committed costs cannot be relevant costs. These are costs that will be
incurred in the future, but they cannot be avoided because they have already
been committed by a previous decision.

Opportunity cost is the benefit sacrificed by choosing one opportunity rather

than the next best alternative. You will often encounter opportunity costs when
there are several possible uses for a scarce resource.

Try Question
BPP: Ennerdale , T Co, BELTON PARK RESORT
Kaplan: SIP Co, Choice of Contracts

11
Note: If there modification to older stock (in stock R/M) is there, it is
considered as Relevant Cost.

1. ABC Ltd has been approached by a customer who would like a special job
to be done for him, and he is willing to pay 22,000 for the work. Job
requires the following materials.

Material Total required Units in Book value Realizable Replacement

units stock in stock value cost
A 1,000 -- -- -- 6
B 1,000 600 2 2.5 5
C 1,000 700 3 2.5 4
D 200 200 4 6 9

 Material B is used regularly by co. and if units of B are required for the
job, it need to be replaced.
 Material C and D are In stock as the result of previous over buying and
restricted to use. No other use for C, but D can be used in another job as
substitute of 300 unit of Material E, which cost 5 per unit (No stock of E
in hand)
Compute relevant cost and decide whether to accept the offer or not?

12
**Committed Payment (Salary), If Skilled labor paid hourly, then Opportunity
cost + Hourly rate is relevant cost.

Note: If there is delay in delivery of a contract or project due to undertaking of

the new project (for which we are considering the Relevant cost) - Relevant cost
of labor include Penalty for delay in delivery of other contract / project.

Question on Material and Labor (Disposal Cost Question)

XL Polymers, located in Sahibabad Industrial Area, manufactures high quality
industrial products. AT Industries has asked XL Polymers for a special job that
must be completed within one week.

Raw material R1 (highly toxic) will be needed to complete the AT Industries’

special job. XL Polymers purchased the R1 two weeks ago for ₹ 7,500 for a job
‘A’ that recently was completed. The R1 currently in stock is the excess from
that job and XL Polymers had been planning to dispose of it. XL Polymers
estimates that it would cost them ₹ 1,250 to dispose of the R1. Current
replacement cost of R1 is ₹ 6,000.

Special job will require 250 hours of labour G1 and 100 hours of labour G2. XL
Polymers pays their G1 and G2 employees `630 and `336 respectively for 42
hours of work per week. XL Polymers anticipates having excess capacity of 150
[G1] and 200 [G2] labour hours in the coming week. XL Polymers can also hire
additional G1 and G2 labour on an hourly basis; these part-time employees are
paid an hourly wage based on the wages paid to current employees.

Suppose that material and labour comprise XL Polymers’s only costs for
completing the special job.

Calculate the ‘Minimum Price’ that XL Polymers should bid on this job?
Q. Compute Relevant cost of Labor and Material:

13
4 types of material will be needed:
Material Quantity in unit Price per unit
Required In stock Purchase Current Resale
price in Purchase price
stock price
Z 1100 100 7 10 8
Y 150 200 40 44 38
X 600 300 35 33 25
W 200 400 20 21 10

 Z & Y are in regular use. Neither X or W is currently used. X has no

foreseeable use in business; but W could be used on other job in place of
material currently costing @16/unit.
 The contract will last for 6 months and requires 2 craftmen; whose annual
wage cost 16000 each. To complete the contract in time, it will also be
necessary to pay them a bonus of 700 each. Without the contract, they
would be retained at their normal pay rate, doing work, which will
otherwise be done by temporary workers, engaged for the contract period
@ a total cost of 11,800.
3 casual laborers would be employed specifically for that contract at 4000
each.

Concept Illustration on relevant costing:

B ltd, a co. that builds houses presents the following facts relating to a certain
housing contracts that it wishes to undertake –
 The CEO’s and marketing manager’s food and hotel expenses of 3750
were incurred for a meeting with a prospective customer.
 1200 Kgs of material Z will be required for the house. Current stock
available 550 KG. It was purchased at 580 oer KG. it is used Co. in other
projects, and current market price of Z is 650.
 The house require 90 hours of engineer’s time. Engineer’s are paid a
fixed monthly salary of 47500 per engineer who can work 150 hours a
month. Spare time is not available now and the engineer has to be hired
for one month.
 B ltd will use a special earthquake – proof foundation material developed
by co. at a cost of 30,000 for some other project ad had to be abandoned.
If it does not use for this project, it can be use for some other project and
client will charged amount of 50,000. You are required to classify the
costs in to relevant and irrelevant?

14
Shutdown Decision
A shutdown decision is whether to close down an operation or stop making and
selling a particular product or service.

Exam Perspective: Identify the Incremental Cost Savings and Cost, Compute
net incremental cost / benefit.

1. Rabi Ltd. is considering the discontinuance of Division C. The following

information is given:

Particulars Divisions Division C Total

A&B
Sales (Maximum achievable) 41,40,000 5,17,500 46,57,500
(₹)
Less: Variable cost (₹) 20,70,000 2,76,000 23,46,000
Contribution (₹) 20,70,000 2,41,500 23,11,500
Less: Specific avoidable fixed 14,49,000 4,14,000 18,63,000
cost (₹)
Divisional Income (₹) 6,21,000 (1,72,500) 4,48,500

The rates of variable costs are 90% of the normal rates due to the current
volume of operation. There is adequate market demand. For any lower
volume of operation, the rates would go back to the normal rates. Facilities
released by discontinuing Division C cannot be used for any other purpose.

COMMENT on the decision to discontinue Division C using relevant cost

approach?.

Further processing decisions

A further processing decision often involves joint products from a common

manufacturing process. The decision is whether to sell the products at the
split-off point, as soon as they emerge from the common process, or whether
they should be processed further before selling them.

A joint product should be processed further past the split-off point if the
additional sales revenue exceeds the relevant post-separation (further
processing) costs.

If Incremental Revenue is greater than Incremental Cost of Further

Processing – Recommend to Further Process and Vice versa

15
 Note: Incremental Cost include both specific fixed cost for further
processing and Variable cost of processing further.

BPP Study Text Questions: 4.2 and Page No. 174 – Revision Kit – Q95

Other Questions:
1. A process industry unit manufactures three joint products: A, B and C. C
has no realizable value unless it undergoes further processing after the point
of separation. The cost details of C are as follows:

Upto point of separation

Marginal cost 30
Fixed Cost 20
After point of separation
Marginal cost 15
Fixed cost 5
Total Cost 70

C can be sold at ₹37 per unit and no more.

(i) Would you recommend production of C?
(ii) Would your recommendation be different if A, B and C are not joint
products?

2. A company processes different products from a certain raw material. The

raw material is processed in process I (where normal loss is 10% of input) to
give products A and B in the ratio 3 : 2. B is sold directly. A is processed
further in process II (where normal loss is 12.5% of output) to give products
C and D in the ratio 5:3. At this point C and D have sale values ₹ 55 and
₹ 40 per kg respectively. C can be processed further in process III with
processing cost ₹ 3,95,600 and normal wastage 5% of input and then be sold
at ₹ 66 per kg. D can be processed further in process IV with processing
cost ₹ 3,82,500 and normal wastage 12.5% of output and then be sold at
₹ 55 per kg. The normal wastage of each process has no realizable value.
During the production period, 2,00,000 kgs of raw material is to be
introduced into Process I.

Using incremental cost-revenue approach, advise whether sale at split off or

further processing is better for each of the products C and D.

16
 (e) PRICING DECISION
“A pricing decision is one of the most crucial & difficult decision that a
firm has to make. Such a decision affects the long- term survival of any
profit oriented enterprise.”

The basic approach in most of the micro-economic theory (theory of the

individual firm and its relation to other firms) defines the term optimum
price as that price which yields the maximum profits (excess of total
revenues over total costs).

Profit Maximization Model:

As per Economic theory of pricing, profit is maximum at a level of output
where marginal revenue is equal to marginal cost (MR=MC)

Basic Price equation to determine the price at which profit is maximum

= P = a – bQ
P = Price
b= Slope of the demand curve b = Change in price/ change in quantity
Q = Quantity of demand
A = price at which profit is Zero

Marginal Revenue equation = MR = a – 2bQ

Concepts Questions:
1. The current price of a product is $12. At this price the company sells 60
items a month. One month the company decides to raise the price to $15, but
only 45 items are sold at this price. Determine the demand equation, which
is assumed to be a straight line equation.

2. The current price of a product is $30 and its producers sell 100 items a week
at this price. One week the price is dropped by $3 as a special offer and the
producers sell 150 items. Find an expression for the demand curve,
assuming that this is a linear equation.

3. AB has used market research to determine that if a price of $250 is charged

for product G, demand will be 12,000 units. It has also been established that
demand will rise or fall by 5 units for every $1 fall/rise in the selling price.
The marginal cost of product G is $80.
If marginal revenue = a – 2bQ when the selling price (P) = a – bQ, calculate
the profit- maximizing selling price for product G.

17
Determination of Prices under different market situations:
Market type Description Price Fixation
Perfect - large numbers of - firm has no pricing
Competition sellers selling a policy of its own as
homogeneous product the sellers are price
- Free entry and Exit takers
- Perfect knowledge of - Since each firm
customers and sellers produces and sells
on prices & qty a homogeneous
product, it cannot
increase its price
beyond the market
price
Monopoly - where there is only (1) - Under the monopoly,
one supplier or a firm is a price setter
producer of a i.e. it can fix any
homogeneous product price
for which there is no but here also the
close substitute (No pricing is done taking
competition) but has elasticity of demand
many buyers for the product into
consideration
Monopolistic - There are large (1) Short run optimal
Competition number of firms price: MR= MC
producing similar but (2) Long run optimal
not identical products. price: Average
Revenue = Average
cost and MC=MR
Oligopoly - There are few firms 1. Going rate pricing:
producing or selling
homogenous or
identical product.
- Firms are aware of the
mutual
interdependence of
investment,
production process,
advertising
and sales plan of its
rival firm.

18
Pricing Methods:

Cost-based pricing methods

1. Cost plus pricing:
“Estimated cost plus a profit margin”
It assures guaranteed contribution/profit to the firm, reduces risk and
uncertainties – simple to compute – full recovery of all cost.
It ignores competition/ opportunity cost – price volume relationship
2. ROCE Pricing:
Cost plus (required rate of return on Capital employed per unit)
3. Variable cost pricing:
To earn contribution, selling price is fixed above variable cost. (In several
circumstances, it may price the goods at lower of variable cost)
4. Conversion Cost pricing:
Price = Conversion cost + Profit Mark up on Conversion cost +
Material cost

Competitive Pricing
When a company sets its price mainly on the consideration of what its
competitors are charging, its pricing policy under such a situation is called
competitive pricing or competition-oriented pricing.

1. Going Rate Pricing:

A firm tries to keep its price at the average level charged by the industry.
Going Rate pricing in Perfect Competition Market: Under highly competitive
conditions in a homogeneous product market (such as food, raw materials and
textiles) the concern really has no pricing decision to make. The major
challenge before such a concern is good cost control. Since promotion and
personnel selling are not in the picture, the major marketing costs arise in
physical distribution.

Going Rate pricing in oligopoly Market: where a few large concerns dominate
the industry, the concern also tends to charge the same price as is being charged
by its competitors. Since there are only a few concerns, each firm is quite aware
of other’s prices, and so are the buyers.

2. Sealed Bid Pricing:

It is a type of competitive pricing is prevalent when firms compete for jobs
based on bids, while quoting for specific assignment or jobs e.g Govt. grants,
specialized work contracts etc.

19
Value- Based Pricing Method
There is an increasing trend to price the product based on customer’s perception
of its value. This method helps the firm in reducing the threat of price wars.
Marketing research is important
for this method. It is based on:

Objective Value or True Economic Value (TEV)

This is a measure of benefits that a product is intended to deliver to the
consumers relative to the
other products without giving any regard whether the consumer can recognize
these benefits or
not.
TEV = Cost of the Next Best Alternative (cost of comparable product by other
firm) + Value of Performance Differential (value of additional features
provided by the seller firm).

Perceived Value
This is the value that consumer understands the product deliver to it. It is the
price of a product that a consumer is willing to spend to have that product.

New product Pricing

A new product can be either
(1) Revolutionary - when it is new for the market and has the potential to
create its own value. This type of product has revolutionary impact on the
market and consumer behavior.

(2) Evolutionary - A product introduces upgraded version with few additional

characteristics of the product is known as evolutionary product.

(3) me - too Product - when its emergence is a result of the success of a

revolutionary product. These types of products are very similar (in ordinary
language imitation) to revolutionary and/ or evolutionary products of other
firms.
While deciding to enter with the new product, the management should decide
whether to adopt skimming or penetration price policy:-

20
 Skimming Price Policy Penetration Price Policy
- Policy of higher prices during early Pricing suitable for penetrating mass
period of a product existence. market as quickly as possible through
- The demand is likely to be lower price offers. This method is also
inelastic. used for pricing a new product. In
- High initial capital outlays needed order to popularize a new product,
for manufacture, results in high cost penetrating pricing policy is used
of production. Added to this, the initially.
manufacturer has to incur huge
promotional activities resulting in The company may not earn profit by
increased costs. High initial prices resorting to this policy during the
will be able to finance the cost of initial stage. Later on, the price may be
production particularly when increased as and when the demand
uncertainties block the usual picks up.
sources of capital

Price Adjustment Polices –

(i) Distributor’s Discounts – It means price deductions that systematically make
the net Price vary according to buyer’s position in the chain of distribution.

(ii) Quantity discounts are price reductions related to the quantities purchased.

(iii)Cash discounts are price reductions based on promptness of payment.

(iv)Price Discrimination – charging different prices and it takes various forms

according to whether the basis is customer, product, place or time.

(v) Geographic Pricing – Pricing policies may be established whereby the buyer
pays all the freight expense, the seller bears the entire cost, or the seller and
buyer share this expense. The strategy chosen can influence the geographic
limits of a firm’s market, locations of its production facilities, sources of its
raw materials, and its competitive strength in various geographic markets.

Concept Questions:
State most suitable pricing policy for the following situations:
1. The co. makes original equipment and does defense contract work. There
are other companies, which also undertake such projects.

2. The product made by a company is new to the market. It is expected to

enjoy long term demand, competition is expected very soon, since the
product will be desirable to most customers

21
3. Stock pf processed ready to eat product’s, whose shelf life will soon be over
in the next 2 months

4. The co. sells a homogeneous product in highly competitive Market

5. D, is a perishable item, with more 80% shelf life over

6. Modern Pattern Drug entering to the market

7. A new product is to be launched, it has had high promotional expenditure

and its demand in the market is unknown

8. A new product is to be launched, it has to be mass manufactured.

Practical Problems
SECTION 1: COST PLUS PRICING / MARK UP PRICING
1. Technocraft has just completed repair work on Car No. DL 7CL 2001 of
Mr. ‘M’. The parts used to repair the vehicle cost `250. The company’s 20%
mark up rate on parts covers parts–related overhead costs. Labour involved
5 hours of time from a Technocraft service engineer whose wages are `80
per hour. The current overhead work up rate on labour is 80%.
Compute how much Mr. ‘M’ will be billed for his car repairs?

2. A Japanese soft drink company is planning to establish a subsidiary

company in India to produce mineral water. Based on the estimated annual
sales of 40,000 bottles of the mineral water, cost studies produced the
following estimates for the Indian subsidiary:

Total Annual Costs Percentage of Total

Annual Cost which is
Variable
Material 2,10,000 100%
Labour 1,50,000 80%
Factory Overheads 92,000 60%
Administrative Overheads 40,000 35%

The Indian production will be sold by manufacturer's representatives who

will receive a commission of 8% of the sale price. No portion of the
Japanese office expenses is to be allocated to the Indian subsidiary
(i) Compute the sale price per bottle to enable the management to realise an
estimated 10% profit on sale proceeds in India?
(ii) Calculate the break-even point in Rupee sales and also in number of
bottles for the Indian subsidiary on the assumption that the sale price is
₹ 14 per bottle?
22
3. A manufacturing company has an installed capacity of 1,20,000 units per
annum. The cost structure of the product manufactured is as under:
Variable cost per unit-
a. Materials... ₹ 8
b. Labour (subject to a minimum of ₹ 56,000 per month) ₹8
c. Overheads... ₹ 3
d. Fixed overheads... ₹ 1,68,750 per annum
e. Semi-variable overheads ₹ 48,000 per annum at 60% capacity, which
increase by ₹ 6,000 per annum for increase of every 10% of the capacity
utilisation or any part thereof for the year as a whole.
The capacity utilisation for the next year is estimated at 60% for two
months, 75% for six months and 80% for remaining part of the year.

If the company is planning to have a profit of 25% on the selling price,

calculate the selling price per unit. Assume that there are no opening and
closing stocks.

A. TR Co is a pharmaceutical company which researches, develops and

manufactures a wide range of drugs. One of these drugs, ‘Parapain’, is a
pain relief drug used for the treatment of headaches and until last month
TR Co had a patent on Parapain which prevented other companies from
manufacturing it. The patent has now expired and several competitors
have already entered the market with similar versions of Parapain, which
are made using the same active ingredients.

TR Co is reviewing its pricing policy in light of the changing market. It

has carried out some market research in an attempt to establish an
optimum price for Parapain. The research has established that for every
$2 decrease in price, demand would be expected to increase by 5,000
batches, with maximum demand for Parapain being one million batches.

Each batch of Parapain is currently made using the following materials:

Material Z: 500 grams at $0·10 per gram
Material Y: 300 grams at $0·50 per gram

Each batch of Parapain requires 20 minutes of machine time to make

and the variable running costs for machine time are $6 per hour. The
fixed production overhead cost is expected to be $2 per batch for the
period, based on a budgeted production level of 250,000 batches.

23
 The skilled workers who have been working on Parapain until now are
being moved onto the production of TR Co’s new and unique anti-
malaria drug which cost millions of dollars to develop. TR Co has
obtained a patent for this revolutionary drug and it is expected to save
millions of lives. No other similar drug exists and, whilst demand levels
are unknown, the launch of the drug is eagerly anticipated all over the
world.

Agency staff, who are completely new to the production of Parapain and
cost $18 per hour, will be brought in to produce Parapain for the
foreseeable future. Experience has shown there will be a significant
learning curve involved in making Parapain as it is extremely difficult to
handle. The first batch of Parapain made using one of the agency
workers took 5 hours to make. However, it is believed that an 80%
learning curve exists, in relation to production of the drug, and this will
continue until the first 1,000 batches have been completed. TR Co’s
management has said that any pricing decisions about Parapain should
be based on the time it takes to make the 1,000th batch of the drug.

Note: The learning co-efficient, b = –0·321928

Required:
(a) Calculate the optimum (profit-maximising) selling price for Parapain
and the resulting annual profit which TR Co will make from
charging this price.
Note: If P = a – bQ, then MR = a – 2bQ

(b) Discuss and recommend whether market penetration or market

skimming would be the most suitable pricing strategy for TR Co
when launching the new anti-malaria drug.

B. Just over two years ago, RB Co was the first company to produce a
specific 'off-the-shelf' accounting software package. The pricing
strategy, decided on by the managing director, for the packages was to
add a 50% mark-up to the budgeted full cost of the packages. The
company achieved and maintained a significant market share and high
profits for the first two years.

Budgeted information for the current year (Year 3) was as follows.

Production and sales 15,000 packages
Full cost $400 per package

24
At a recent board meeting, the finance director reported that although costs were
in line with the budget for the current year, profits were declining. He explained
that the full cost included $80 for fixed overheads. This figure had been
calculated by using an overhead absorption rate based on labour hours and the
budgeted level of production of 15,000 packages. He pointed out that this was
much lower than the current capacity of 25,000 packages.

The marketing director stated that competitors were beginning to increase their
market share. He also reported the results of a recent competitor analysis which
showed that when RB Co announced its prices for the current year, the
competitors responded by undercutting them by 15%. Consequently, he
commissioned an investigation of the market. He informed the board that the
market research showed that at a price of $750 there would be no demand for
the packages but for every $10 reduction in price the demand would increase by
1,000 packages. The managing director appeared to be unconcerned about the
loss of market share and argued that profits could be restored to their former
level by increasing the mark-up.
(a) Discuss the managing director's pricing strategy in the circumstances
described above. (5 marks)
(b) Suggest and explain two alternative strategies that could have been
implemented at the launch of the packages. (4 marks)
(c) Based on the data supplied by the market research, derive a straight line
demand equation for the packages. (3 marks)
(d) RB's total costs (TC) can be modelled by the equation TC = 1,200,000 +
320Q. Explain the meaning of this equation. (3 marks)
(e) Explain what is meant by price elasticity of demand and explain the
implications of elasticity for RB's pricing strategy. (PM-BPP-131)

Question:
Amber Ltd. is a leading company in the Footwear Industry. The company has
four factories in different locations with state of the art equipments. Due to
competition in the market, company is continually reviewing its product range
and enhancing its existing products by developing new models to satisfy the
demands of its customers.
The company currently has a production facility which has a capacity of 3,500
standard hours per week.
Product 'Comfort' was introduced to the market six months ago and is now
about to enter the maturity stage of its life cycle.
However, research by the marketing department indicates that demand of the
product 'Comfort' in the market is price sensitive. The likely market responses
are as follows:

25
Selling price per unit (₹) 1,750 1,600 1,525 1,450 1,300
Sales demand per week (units) 550 725 1,000 1,150 1,200

The variable cost per unit of manufacturing 'Comfort' is ₹ 750. Standard hours
used to manufacture one unit is 2 hours.

Product 'Sports' was introduced to the market two months ago using a
penetration pricing policy and is now about to enter its growth stage. Each unit
has a variable cost of ₹ 545 and takes 2.50 standard hours to produce. Market
research has indicated that there is a linear relationship between its selling price
and the number of units demanded, of the form P = a - bx. At a selling price of
₹ 1,000 per unit demand is expected to be 1,000 units per week. For every ₹ 100
increase in selling price the weekly demand will reduce by 200 units and for
every ₹ 100 decrease in selling price the weekly demand will increase by 200
units.

Product 'Ethnic' is currently being developed and which is about to be launched

in the market. This is a highly innovative designer product which the company
believes that it will have a revolutionary impact on the market and consumer
behaviour. The company has decided to use a market skimming approach to
pricing this product during its introduction stage.

Required

(a) (i) ADVISE which of the above five selling prices should be charged for
product 'Comfort', in order to maximize its contribution during its
maturity stage. (3 marks)
(ii) CALCULATE the number of units to be produced of product 'Sports' in
order to utilize all of the spare capacity from your answer to (i) above
and the selling price per unit of product 'Sports' during its growth stage.
(2 + 3 = 5 marks)

(b) COMPARE penetration and skimming pricing strategies during the

introduction stage, using product 'Ethnic' to illustrate your answer.
(4 marks)

(c) EXPLAIN with reasons, for each of the stages of 'Ethnic's product life
cycle, the changes that would be expected in the
(i) average unit production cost
(ii) unit selling price (4 + 4 = 8 marks)

26
 II. SPECIFIC COST MANAGEMENT
TECHNIQUES (PART B)
(a) TARGET COSTING

Target costing has been described as a process that occurs in a competitive

environment, in which cost minimization is an important component of
profitability.

It is termed as “a structured approach to determining the cost at which a

proposed product with specified functionality and quality must be produced, to
generate a desired level of profitability at its anticipated selling price.

Steps in Target Cost:

1. Identify Market requirement as regards quality, utility need, Quantity,
product specification etc.
2. Set Target selling price at which the organisation will be able to sell the
product successfully and achieve a desired market share.
3. Set Profit Margin / Required profit
4. Set Target Cost
5. Determine Current Cost / Estimated Cost of production
6. Set reduction target – Cost Gap = Estimated Cost – Target Cost
7. Make efforts to close the gap. Analyze cost and identify cost reduction
opportunities by using VA/ VE and ABC
Target cost is broken down into various components, and each component is
studied and opportunities for cost reduction are found out. These activities are
referred as Value Analysis (VA) and Value Engineering (VE)
Value Analysis (VA) is a planned, scientific approach to cost reduction which
reviews the material composition of a product and production design so that
modifications and improvements can be made which do not reduce the value of
the product to the customer or to the user.
Generally, it is associated with Existing Products.

Closing a target cost gap:

 Reducing the number of components
 Using cheaper staff
 Using standard components wherever possible
 Acquiring new, more efficient technology
 Training staff in more efficient techniques
 Cutting out non value added activities
 Using different materials (identified using activity analysis etc)
27
Target costing in service industries
Unlike manufacturing companies, services are characterised by intangibility,
inseparability, variability, perishability and no transfer of ownership.

Some of the characteristics of services make it difficult to use target costing,

and identify a target cost for a service having established a target selling price.

From Exam Point of View: Remember characteristics of Service and understand

it is difficult to apply Target costing in Service industries

Exam Question:
Speedo Limited is a specialist car manufacturer that produces various models of
cars. The organization is due to celebrate its 100th anniversary next year. To
mark the occasion, Speedo Limited intends to produce a sports car; the Model
Royal. As this will be a special edition, production will be limited to 1,000
numbers of Model Royal Cars.

Speedo Limited is considering using a target costing approach and has

conducted market research to determine the features that consumers require in a
sports car. Based on this market research and knowledge of competitor’s
products, company has decided to price the Model Royal at ₹ 9.75 Lacs.
Company requires an operating profit margin of 25% of the selling price of
the car. Details for the forthcoming year are as follows:

Forecast of direct costs per One Model Royal Car-

Labour – 250,000 Material – 4,75,000
Forecast of annual overhead costs-

Cost In lakhs Cost Driver

Production Line Cost 2,310 See Note 1
Transportation Costs 900 See Note 2

Note 1: The production line that would be used for Model Royal has a capacity
of 60,000 machine hours per year. The production line time required for Model
Royal is 6 machine hours per car. This production line will also be used to make
other cars and will be working at full capacity.

Note 2: Some models of cars are delivered to showrooms using car transporters.
60% of the transportation costs are related to the number of deliveries made.
40% of the transportation costs are related to the distance travelled.

28
The car transporters have forecast to make a total of 640 deliveries in the year
and carry 10 cars each time. The car transporter will always carry its maximum
capacity of 10 cars.

The total annual distance travelled by car transporters is expected to be 2,25,000

kms. 50,000 kms of this is for the delivery of Model Royals car only. All 1,000
Model Royal cars that will be produced will be delivered in the year using the
car transporters.
(i) Calculate the forecast total cost of producing and delivering a Model Royal
car using Activity Based Costing principles to assign the overhead costs.
(ii) Calculate the cost gap that currently exists between the forecast total cost
and the target total cost of a Model Royal car.

Sep 16:
Helot Co develops and sells computer games. It is well known for launching
innovative and interactive role-playing games and its new releases are always
eagerly anticipated by the gaming community. Customers value the technical
excellence of the games and the durability of the product and packaging.

Helot Co has previously used a traditional absorption costing system and full
cost plus pricing to cost and price its products. It has recently recruited a new
finance director who believes the company would benefit from using target
costing. He is keen to try this method on a new game concept called Spartan,
which has been recently approved.

After discussion with the board, the finance director undertook some market
research to find out customers’ opinions on the new game concept and to assess
potential new games offered by competitors. The results were used to establish
a target selling price of $45 for Spartan and an estimated total sales volume of
350,000 units. Helot Co wants to achieve a target profit margin of 35%.

The finance director has also begun collecting cost data for the new game and
has projected the following:
Production costs per unit $
Direct material 3·00
Direct labour 2·50
Direct machining 5·05
Set-up 0·45
Inspection and testing 4·30
Total non-production costs $’000
Design (salaries and technology) 2,500
Marketing consultants 1,700
Distribution 1,400

29
a. Which of the following statements would the finance director have used to
explain to Helot Co’s board what the benefits were of adopting a target
costing approach so early in the game’s life-cycle?
(1) Costs will be split into material, system, and delivery and disposal
categories for improved cost reduction analysis
(2) Customer requirements for quality, cost and timescales are more likely
to be included in decisions on product development
(3) Its key concept is based on how to turn material into sales as quickly as
possible in order to maximise net cash
(4) The company will focus on designing out costs prior to production,
rather than cost control during live production
A 1, 2 and 4 B 2, 3 and 4
C 1 and 3 D 2 and 4 only

b. What is the forecast cost gap for the new game?

A $2·05 B $0·00
C $13·70 D $29·25
c. The board of Helot Co has asked the finance director to explain what
activities can be undertaken to close a cost gap on its computer games.
Which of the following would be appropriate ways for Helot Co to close a
cost gap?
(1) Buy cheaper, lower grade plastic for the game discs and cases
(2) Using standard components wherever possible in production
(3) Employ more trainee game designers on lower salaries
(4) Use the company’s own online gaming websites for marketing
A 1, 2 and 3 B 1, 3 and 4
C 2 and 4 D 2 and 3 only
d. The direct labour cost per unit has been based on an expected learning rate
of 90% but now the finance director has realised that a 95% learning rate
should be applied.
Which of the following statements is true?
A The target cost will decrease and the cost gap will increase
B The target cost will increase and the cost gap will decrease
C The target cost will remain the same and the cost gap will increase
D The target cost will remain the same and the cost gap will decrease

e. Helot Co is thinking about expanding its business and introducing a new

computer repair service for customers. The board has asked if target costing
could be applied to this service.
Which of the following statements regarding services and the use of target
costing within the service sector is true?
Other Relevant Question: Cam Co, CHEMICAL FREE CLEAN CO,

30
 (b) LIFE CYCLE COSTING

A product life cycle can be divided into five phases.

 Development: The product has a research or design and development
stage. Costs are incurred but the product is not yet on the market and
there are no sales revenues.

 Introduction: The product is introduced to the market. Potential customers

are initially unaware of the product or service, and the organisation may
have to spend heavily on advertising to bring the product or service to the
attention of the market.

 Growth: The product gains a bigger market as demand builds up. Sales
revenues increase and the product begins to make a profit.

 Maturity: Eventually, the growth in demand for the product will slow
down and it will enter a period of relative maturity, when sales have
reached a peak and are fairly stable. This should be the most profitable
phase of the product's life.

 Decline: At some stage, the market will have bought enough of the
product and it will therefore reach 'saturation point'. Demand will start
to fall Eventually it will become a loss- maker and this is the time
when the organisation should decide to stop selling the product or service.

Life cycle costing estimates the costs and revenues attributable to a product over
its entire expected life cycle.
The life cycle costs of a product are all the costs attributable to the product
over its entire life, from product concept and design to eventual withdrawal
from the market.

31
But doesn’t include relevant costs / opportunity costs

Life cycle costing estimates the costs and revenues attributable to a product over
its entire expected life cycle.

The life cycle costs of a product are all the costs attributable to the product over
its entire life, from product concept and design to eventual withdrawal from the
market.

The benefits of life cycle costing

(a) It helps management to assess profitability over the full life of a product,
which in turn helps management to decide whether to develop the product,
or to continue making the product.
(b) It can be very useful for organisations that continually develop products with
a relatively short life, where it may be possible to estimate sales volumes
and prices with reasonable accuracy.
(c) The life cycle concept results in earlier actions to generate more revenue or
to lower costs than otherwise might be considered.
(d) Better decisions should follow from a more accurate and realistic assessment
of revenues and costs, at least within a particular life cycle stage.
(e) It encourages longer-term thinking and forward planning, and may provide
more useful information than traditional reports of historical costs and
profits in each accounting period.

Maximising return over the product life cycle

 Design costs out of products: Between 70% and 90% of a product's life
cycle costs are determined by decisions made early in the life cycle, at the
design or development stage. Careful design of the product and
manufacturing and other processes will keep cost to a minimum over the
life cycle.

 Minimise the time to market: 'Time to market' is the time from the
conception of the product to its introduction to the market. Competitors
watch each other very carefully to determine what types of product their
rivals are developing. If an organisation is launching a new product it is
vital to get it to the marketplace as soon as possible.

32
  Minimise breakeven time (BET): A short BET is very important in
keeping an organisation liquid. The sooner the product is launched the
quicker the research and development costs will be repaid, providing the
organisation with funds to develop further products.

 Maximise the length of the life span: Product life cycles are not
predetermined; they can be influenced by the actions of management and
competitors. The life cycle of these materials can be extended by finding
new uses for them.

Particulars Introduction Growth Maturity Decline

Sales Initial stage, Rise in sales Rise in sales Sales level
Volume Low quantities at at decreasing off and
increasing rate declining
rate
Price of Either Higher Retention of Prices fall to
Gap between
Products or Low high level cost, due to Price and
except in effect of cost is
certain cases competition further
reduced
Ratio of Highest, due Amount of Ratio reaches Reduced, due
Promotion to effort Promotion a normal % to low
exp to needed to increases, of sales promotional
sales inform but ratio of efforts as the
potential S&D OH to product is no
customers Sales reduces longer
demand
Nature of Negligible Entry of Fierce Starts
competition and large no. of competition disappearing
insignificant competitors

Question:
A company is planning a new product. Market research information suggests
that 40,000 units of the product can be sold at a maximum of ₹ 25 per unit. The
company seeks a minimum mark-up of 25% on product cost. It is estimated that
the lifetime costs of the product will be as follows:
(1) Research and development, design costs ₹ 1,50,000
(2) Manufacturing costs 16 per unit
(3) End of life costs 70,000
(4) Promotion and capacity cost 20,000
Should the product be manufactured?

33
Question
P & G International Ltd. (PGIL) has developed a new product “K” which is
about to be launched into the market and anticipates to sell 80,000 of these units
at a sales price of ₹ 300 over the product’s life cycle of four years. Data
pertaining to product “K” are as follows:

Costs of Design and Development of ₹ 8,25,000

Molds, Dies, and Other Tools
Manufacturing Costs ₹ 125 per unit
Selling Costs ₹12,500 per year + ₹ 100 per unit
Administration Costs ₹ 50,000 per year
Warranty Expenses 5 Replacement Parts per 25 units at
₹10 per part ; 1 Visit per 500 units
(Cost ₹ 500 per visit)

(i) Compute the product “K”’s ‘Life Cycle Cost’.

(ii) Suppose PGIL can increase sales volume by 25% through 10% reduction
in selling price. Should PGIL choose the lower price?
Kaplan:
Question: SHOE CO
BPP: Ivey Co

Exam Question: June 19

Volt Co generates and sells electricity. It operates two types of power station:
nuclear and wind.
The costs and output of the two types of power station are detailed below:

Nuclear station
A nuclear station can generate 9,000 gigawatts of electricity in each of its 40
years of useful life. Operating costs are $486m per year. Operating costs include
a provision for depreciation of $175m per year to recover the $7,000m cost of
building the power station.

Each nuclear station has an estimated decommissioning cost of $12,000m at the

end of its life.

The decommissioning cost relates to the cost of safely disposing of spent

nuclear fuel.

Wind station
A wind station can generate 1,750 gigawatts of electricity per year. It has a life-
cycle cost of $55,000 per gigawatt and an average operating cost of $40,000 per
gigawatt over its 20-year life.
34
a. What is the life-cycle cost per gigawatt of the nuclear station (to the nearest
$’000)?
A $54,000
B $73,000
C $87,000
D $107,000

b. Which of the following will decrease the total life-cycle cost of a nuclear
station?
(1) Increasing the useful life of the station
(2) Reducing the decommissioning cost
A 1 only
B 2 only
C Both 1 and 2
D Neither 1 nor 2

c. How would the disposal cost of spent nuclear fuel be categorised in

environmental management accounting (EMA)?
A A prevention cost
B A detection cost
C An internal failure cost
D An external failure cost

d. If Volt Co sets a price to earn an operating margin of 40% over the life of a
wind station, what will be the total lifetime profit per station (to the nearest
$m)?
A $35m
B $408m
C $560m
D $933m

35
 (c) ACTIVITY BASED COSTING
Activity based costing (ABC) is an alternative to traditional absorption costing
as a method of costing.

ABC involves the identification of the factors (cost drivers) which 'cause' or
'drive' the costs of an organisation's major activities. Overheads are allocated
and apportioned to activity cost centres or 'cost pools'.

Activity based costing (ABC) is a method of costing which involves identifying

the costs of the main support activities and the factors that 'drive' the costs
of each activity. Support overheads are charged to products by absorbing cost
on the basis of the product's usage of the factor driving the overheads.

Steps:
1. Identify an organisation's major activities that support the manufacture of
the organisation’s products or the provision of its services.
2. Use cost allocation and apportionment methods to charge overhead costs to
each of these activities. The costs that accumulate for each activity cost
centre is called a cost pool.
3. Identify the factors which determine the size of the costs of an activity/affect
the costs of an activity. These are known as cost drivers. A cost driver is a
factor which has most influence on the cost of an activity.
4. For each cost pool/activity cost centre, calculate an absorption rate per unit
of cost driver.
5. Charge overhead costs to products for each activity, on the basis of their
usage of the activity (the number of cost drivers they use). Overheads are
charged by absorbing them into product costs at a rate per unit of cost
driver.

Merits of ABC:
1. The complexity of manufacturing has increased, with wider product ranges,
shorter product life cycles and more complex production processes. ABC
recognises this complexity with its multiple cost drivers.
2. In a more competitive environment, companies must be able to assess
product profitability realistically. ABC facilitates a good understanding of
what drives overhead costs.
3. ABC is concerned with all overhead costs and so it can take management
accounting beyond its 'traditional' factory floor boundaries.

36
4. ABC used in Decision Making
a. Pricing, where selling prices are derived by adding a profit mark-up to
cost.
b. Promoting or discontinuing products or parts of the business, since ABC
may help management to identify activity costs that may be either
incurred or saved.
c. Developing new products or new ways to do business, because ABC
focuses attention on the support activities that would be required for the
new product or business procedure.

Criticism of ABC:
(a) Cost apportionment may still be required at the cost pooling stage for shared
items of cost, such as rent, rates and building depreciation. Apportionment
can be an arbitrary way of sharing costs.
(b) A single cost driver may not explain the cost behaviour of all items in a cost
pool. An activity may have two or more cost drivers.
(c) Unless costs are 'driven' by an activity that is measurable in quantitative
terms, cost drivers cannot be used.
(d) There must be a reason for using a system of ABC. ABC must provide
meaningful product costs or extra information that management will use. If
management is not going to use ABC information for any practical purpose,
a traditional absorption costing system would be simpler to operate and just
as good.
(e) The cost of implementing and maintaining an ABC system can exceed the
benefits of 'improved accuracy' in product costs.

Questions to Refer:
BPP - JOLA PUBLISHING, BRICK BY BRICK, TRIPLE,
Kaplan – DUFF Co, BECKLEY HILL, BOWD,

37
 (d) THEORY OF CONSTRAINTS AND
THROUGHPUT ACCOUNTING
The theory of constraints (TOC) is an approach to production management and
optimising production performance. It was formulated by Goldratt and Cox in
the US in 1986. Its key financial concept is to turn materials into sales as
quickly as possible, thereby maximising the net cash generated from sales.

The theory of constraints also states that at any time there will always be a
bottleneck resource or factor that sets a limit on the amount of throughput that is
possible. This bottleneck resource could in theory be sales demand for the
organisation's output, but it is more likely to be a resource that the organization
uses. This 'bottleneck resource' which prevents output and throughput from
getting any higher could be:

(a) A production resource, such as time available on a type of machine, or the

available amount of skilled employee time
(b) A selling resource, such as the number of sales representatives
(c) The existence of an uncompetitive selling price
(d) A need to deliver on time to particular customers
(e) A lack of product quality and reliability
(f) The lack of reliable material suppliers

Throughput accounting (TA) is an approach to production management which

aims to maximize sales revenue less materials cost, while also reducing
inventory and operational expenses.

Steps in Managing Bottlenecks:

Step 1 - Identify the constraint (bottleneck resource).
Step 2 - Decide how to exploit the constraint in order to maximise throughput.
Step 3 - Subordinate and synchronise everything else to the decisions made in
step 2.
Step 4 - Elevate the performance of the constraint.
Step 5 -If the constraint has shifted during any of the above steps, go back to
step 1. Do notallow inertia to cause a new constraint.

Performance Evaluation:
The throughput accounting ratio (TA ratio) is the ratio of the throughput per
unit of bottleneck resource to the factory cost per unit of bottleneck resource.
This ratio should be as high as possible, and certainly more than 1.0.
Throughput accounting ratio = Throughput per unit of bottleneck resource /
Factory cost per unit of bottleneck resource

38
Measures of TOC
Item Throughput Investment Operating
Activities
Meaning It is the rate at which It is the money It is the total
system generates associated operating
money through sales with turning costs (Other than
materials into direct materials)
Sales – V/C(Only Throughput, and do incurred to earn
Material Cost) = not have to be throughput income.
Throughput immediately
Expensed
Money Measure incoming Measure money Measures the money
Aspect money locked-up in the leaving the system
system
Firm’s To maximize To keep investment To minimize the
Goals throughput at the optimum operating cost
contribution

Questions:
1. Phi Ltd. produces 4 products P, Q, R and S by using three different
machines X, Y and Z. Each machine capacity is limited to 6,000 hours per
month. The details given below are for July, 2013:

Particulars P Q R S
Selling Price p.u. (₹) 10,000 8,000 6,000 4,000
Variable Cost p.u. (₹) 7,000 5,600 4,000 2,800
Machine Hours Required p.u.
Machine X 20 12 4 2
Machine Y 20 18 6 3
Machine Z 20 6 2 1
Expected Demand (units) 200 200 200 200

(i) Find out the bottleneck activity.

(ii) Allocate the machine hours on the basis of the bottleneck.
(iii) Ascertain the profit expected in the month if the monthly fixed cost
amounts to ₹ 9,50,000.
(iv) Calculate the unused spare hours of each machine.

39
2. RTP May-20:
Z Plus Security (ZPS) manufactures surveillance camera equipment that are
sold to various office establishments. The firm also installs the equipment at
the client’s place to ensure that it works properly. Each camera is sold for
₹ 2,500. Direct material cost of ₹1,000 for each camera is the only variable
cost. All other costs are fixed. Below is the information for manufacturing
and installation of this equipment:
Particulars Manufacture Installation
Annual Capacity (camera units) 750 500
Actual Yearly Production and 500 500
Installation (camera units)
The questions below are separate scenarios and are not related to each other.
(i) IDENTIFY the bottleneck in the operation cycle that ZPS should focus
on improving. Give reasoning for your answer.
(ii) An improvement in the installation technique could increase the number
of installations to 550 camera units. This would involve total additional
expenditure of ₹ 40,000. ADVISE ZPS whether they should implement
this technique?
(iii)Engineers have identified ways to improve manufacturing technique that
would increase production by 150 camera units. This would involve a
cost ₹100 per camera unit due to necessary changes to made in direct
materials. ADVISE ZPS whether they should implement this new
technique.

3. H. Ltd. manufactures three products. The material cost, selling price and
bottleneck resource details per unit are as follows:
Particulars Product X Product Y Product Z
Selling Price (₹) 66 75 90
Material and Other
24 30 40
Variable Cost (₹)
Bottleneck Resource Time
15 15 20
(Minutes)
Budgeted factory costs for the period are ₹ 2,21,600. The bottlneck
resources time available is 75,120 minutes per period.
(i) Company adopted throughput accounting and products are ranked
according to ‘product return per minute’. Select the highest rank
product.
(ii) Calculate throughput accounting ratio and comment on it.
Question:
Sweet Treats Bakery (Kaplan)
BPP: Corrie Co, A Co, Yam Co,

40
 (e) ENVIRONMENTAL MANAGEMENT
ACCOUNTING (EMA)
EMA is the process of collection and analysis of the information relating to
environmental cost for internal decision making. EMA identifies and estimates
the costs of environment-related activities and seeks to control these costs.

The major areas for the application for EMA are:

 Identifying environmental costs associated with individual products and
services can assist with pricing decisions.
 Budgeting
 Investment Appraisal
 Calculating Costs and Savings of Environmental Projects, or Setting
Quantified Performance Targets.
 It ensures compliance with regulatory standards.

Impact of EMA on decision-making:

Using EMA, an entity can convert many environmental overhead cost into
direct cost, and allocate them to the product/services that are responsible for
their incurrence. Due to such improved costing, the following decisions can be
obtained:
 Re-designing of processes or products in order to reduce environmental
costs
 Phasing out products when environmental substantially exceed benefits
derived
 Re-valuation of profit margins of products
 Different pricing of products as a result of re-calculated costs.
 Better monitoring of entity’s environmental performance, etc.

Environmental Costs: Includes fines, increased liability to environment taxes,

loss in value of land, destruction of brand values and loss of sales, consumer
boycotts, and inability to secure finance, loss of insurance cover, contingent
liabilities, lawsuits, and damage to corporate image.

41
US - Conventional Costs: Raw material and energy costs
Environmental having environmental relevance.
Protection - Hidden Costs: Costs which have been accounted for but
Agency then lose their identity in ‘general overheads’.
- Contingent Costs: Costs to be incurred at a future date –
for example, clean-up costs.
- Relationship Costs: Intangible Costs, for example, the
costs of preparing environmental reports.
United Environmental Costs as comprising of:
Nations - Costs incurred to protect the environment – for example,
Division for measures taken to prevent pollution, and
Sustainable - Costs of wasted material, capital and labor, i.e.
Development inefficiencies in the production process.
In practice, Environment cost can be divided into two:
1. Internal or Has impact on the income statement of a company by the way
direct cost of cost of preventing environmental damages like, air filters,
water treatment equipment, carbon emission control etc.
2. External or are imposed on society at large, but not borne by the company
Indirect that generates the cost in the first instance
cost E.g when govt. imposes tax/fine/fee for external cost, it will
be converted into Internal

Hansen and Mendoza (1999) point out that environmental costs are incurred
because of poor quality controls. Category of cost proposed by him as follows:

Cost Meaning Examples

Environmental Costs associated with - Evaluating and picking
Prevention preventing adverse pollution control
Costs environmental impacts. equipment
- Creating environmental
policies
- Environmentally driven
R&D
- Site and feasibility
studies
- Investment in protective
equipment

42
Environmental Cost of activities executed - Monitoring, testing,
Appraisal to determine whether inspection and
Costs products, process and reporting
activities are in - Improved systems and
compliance with checks in order to
environmental - prevent fines/ penalties
standards, policies and - Regulatory compliances
laws. - Performing
contamination tests
- Audit of environmental
activities
Environmental Costs incurred from -Recycling scrap
Internal activities that -Disposing toxic material
Failure Costs have been produced but not -Back end costs such as
discharged into the decommissioning
environment costs on project completion
Environmental Costs incurred on activities -Cleaning up contaminated
External performed after discharging soil.
Failure Costs waste into the environment. -Restoring land to its natural
These costs have adverse state
impact on the
organization’s reputation
and natural resources.

Identification of Environmental cost:

1. Input-output analysis: This technique records material inflows and
balances this with outflows.

2. Flow Cost Accounting: This technique uses not only material flows but
also the organizational structure. The material flows are divided into three
categories, material, system, and delivery and disposal.

3. Life Cycle Costing: It considers the costs and revenues of a product over its
whole life rather than one accounting period. Therefore, the full
environmental cost of producing a product will be taken into account. In
order to reduce lifecycle costs an organization may adopt a TQM approach.

4. Activity Based Costing (ABC): ABC allocates internal costs to cost centers
and cost drivers based on the activities that give rise to the costs. In an
environmental accounting context, it distinguishes between environment-
related costs, which can be attributed to joint cost centres, and environment-
driven costs, which tend to be hidden on general overheads.

43
 E.g. For example, if an environmental activity is prevention of air pollution,
costs will include the costs of equipment, the cost of labour time, and so on.
These costs may be absorbed into product costs using the volume of waste
emissions as a cost driver. Each product will then be charged a share of the
costs according to the volume of waste emitted in their manufacture.

Case Study: PLX Refinery Co APM-BPP-16

PLX Refinery Co is a large oil refinery business in Kayland. Kayland is a
developing country with a large and growing oil exploration and production
business which supplies PLX with crude oil. Currently, the refinery has the
capacity to process 200,000 barrels of crude oil per day and makes profits of
$146m per year. It employs about 2,000 staff and contractors. The staff are paid
$60,000 each per year on average (about twice the national average pay in
Kayland).

The government of Kayland has been focused on delivering rapid economic

growth over the last 15 years. However, there are increasing signs that the
environment is paying a large price for this growth with public health suffering.
There is now a growing environmental pressure group, Green Kayland (GK),
which is organising protests against the companies that they see as being the
major polluters.

Kayland's government wishes to react to the concerns of the public and the
pressure groups. It has requested that companies involved in heavy industry
contribute to a general improvement in the treatment of the environment in
Kayland. The government has identified a national goal to reduce carbon
dioxide (CO2) emissions by 20% in the next five years, and is currently
debating a proposal to raise a tax on CO2 emissions in order to encourage
reductions.

As a major participant in the oil industry with ties to the nationalised oil
exploration company (Kayex), PLX believes it will be strategically important to
be at the forefront of environmental developments. It is working with other
companies in the oil industry to improve environmental reporting since there is
a belief that this will lead to improved public perception and economic
efficiency of the industry. PLX has had a fairly good compliance record in
Kayland, with only two major fines (of $1m each) being levied in the last eight
years for safety breaches and river pollution. However, main focus of PLX's
performance measures remains on financial performance.

The existing information systems within PLX also focus on financial

performance. They support financial reporting obligations and allow monitoring
of key performance metrics such as earnings per share and operating margins.

44
Recent publications on environmental accounting have suggested that activity-
based costing (ABC) and a lifecycle view may be relevant in implementing
improvements to these systems.

PLX is considering a major capital expenditure programme to enhance capacity,

safety and efficiency at the refinery. This will involve demolishing certain older
sections of the refinery and building on newly acquired land adjacent to the site.
Overall, the refinery will increase its land area by 20%.

Part of the refinery extension will also manufacture a new plastic, Kayplas.
Kayplas is expected to have a limited market life of five years after which it will
be replaced by Kayplas2. The refinery accounting team have forecast the
following data associated with this product and calculated PLX's traditional
performance measure of product profit for the new product:

All figures are $m's

20 × 2 20 × 3 20 × 4 20 × 5 20 × 6
Revenue 25.0 27.5 30.1 33.2 33.6
Costs
Production costs 13.8 15.1 16.6 18.3 18.5
Marketing costs 5.0 4.0 3.0 3.0 2.0
Development costs 5.6 3.0 0.0 0.0 0.0
Product profit 0.6 5.4 10.5 11.9 13.1

Subsequently, the following environmental costs have been identified from

PLX's general overheads as associated with the production of Kayplas.

20 × 2 20 × 3 20 × 4 20 × 5 20 × 6
Waste filtration 1.2 1.4 1.5 1.9 2.1
Carbon dioxide exhaust
0.8 0.9 0.9 1.2 1.5
extraction

Additionally, other costs associated with closing down and recycling the
equipment in Kayplas production are estimated at $18m in 20X6.

The board wishes to consider how it can contribute to the oil industry's
performance in environmental accounting, how it can implement the changes
that this might require, and how these changes will benefit the company.

45
Required
(a) Discuss and illustrate four different cost categories that would aid
transparency in environmental reporting both internally and externally at
PLX. (6 marks)
(b) Explain, and evaluate, how the two environmental accounting techniques
mentioned – ABC and lifecycle costing – can assist in managing the
environmental and strategic performance of PLX. (6 marks)
(c) Assess how the increasing focus on environmental accounting will affect
PLX's performance metrics and its information systems. (6 marks)
(d) Evaluate the costing approach used for Kayplas's performance compared to
a lifecycle costing approach, performing appropriate calculations.

Question:
A fertilizer company produces Grade A and Grade B fertilizers. One kilogram
of Grade A fertilizer sells for ₹ 280 per kilogram and one kilogram of Grade B
fertilizer sells for ₹ 400 per kilogram.

The products pass through three cost centers CC1, CC2 and CC3 during the
manufacturing process. Total direct material cost per kilogram of fertilizer
produced is ₹ 300 and direct labor cost per kilogram of fertilizer produced is
₹ 200. Allocation between the cost centres is given below:
Particulars CC1 CC2 CC3 Total
Cost of Direct Material (per kg of 90 120 90 300
fertilizer produced)
Cost of Direct Labour (per kg of 60 80 60 200
fertilizer produced)
Cost Allocation to Grade A 30% 50% 30%
Cost Allocation to Grade B 70% 50% 70%
All of expenses (considered to be overheads) per kilogram of fertilizer produced
is ₹ 150. This is allocated equally between Grade A and Grade B fertilizer.
Pricing decisions for the fertilizers is made based on the above cost allocation.

The management accountant of the company has recently come across the
concept of environmental management accounting. Pricing of products should
also factor in the environmental cost generated by each product. An analysis of
the overhead expenses revealed that the total cost of ₹ 150 per kilogram of
fertilizer produced, includes incinerator costs of ₹ 90 per kilogram of fertilizer
produced. The incinerator is used to dispose the solid waste produced during the
manufacturing process. Below is the cost center and product wise information
of solid waste produced:

46
 Waster produced (in tonnes per CC1 CC2 CC3 Total
annum)
Grade A 2 3 1 6
Grade B 2 2 5 9

Based in the impact that each product has on the environment, the management
would like to revise the cost allocation to products based taking into account the
incinerator cost that each product generates. The remaining overhead expenses
of ₹ 60 per kilogram of fertilizer produced can be allocated equally.

Required
(i) CALCULATE product wise profitability based on the original cost
allocation. RECALCULATE the product wise profitability based on activity
based costing methodology (environmental management accounting).

(ii) ANALYZE difference in product profitability as per both the methods.

(iii)RECOMMEND key takeaways for the company to undertake the above

analysis of overhead costs and pricing as per environmental management
accounting.

1. Pierce Enterprises produces two types of fertilizers: Quikrichen and

Longrichen.
Pierce recently has received significant criticism from environmental
groups, local residents, and the federal government concerning its
environmental performance. Henry Hyde, president of Pierce, wants to
know how the company’s environmental activities affect the cost of each
product. He believes that the main source of the environmental problems
lies with Quikrichen but would like some evidence to support (or refute) this
belief. The controller has assembled the following data to help answer this
question:

Quikrichen Longrichen
Pounds of fertilizer produced 1,000,000 2,000,000
Engineering hours (process design) 1,500 4,500
Pounds of solid residues treated 30,000 10,000
Inspection hours (environmental) 10,000 5,000
Cleanup hours (local lake) 8,000 2,000

47
 Additionally, the following environmental activity costs were reported:
Designing process $150,000
Treating residues 600,000
Inspecting process 120,000
Cleaning up lake 200,000

(a) Calculate the environmental cost per pound of fertilizer for each product.
(b) Based on the calculations in Requirement 1, which product appears to be the
most environmentally harmful?
(c) Would life-cycle cost assessment provide stronger evidence for the
environmental suitability of each product? Explain.
(d) Explain how a strategic-based responsibility accounting system can be used
to help improve Pierce’s performance.
Answer: for b, c and D

2. As measured by the environmental cost per unit, Quikrichen is the product

causing the most environmental damage, confirming the president’s beliefs.

3. Life-cycle assessment has three steps: inventory analysis, impact analysis,

and improvement analysis. Of the three steps, the first two are concerned
with identifying the materials and energy requirements, environmental
releases, and the environmental effects of competing process and product
designs (over the life cycle of the products). Thus, a life-cycle assessment
provides a more comprehensive analysis of environmental effects than the
environmental cost per unit (unless the cost per unit is a life-cycle
environmental cost per unit).

4. The environmental perspective (from the Balanced Scorecard framework)

can improve environmental performance by translating an environmental
improvement strategy into operational objectives, measures, targets, and
initiatives.

For example, consider the five core environmental objectives. These

objectives, if followed, will reduce the amounts of materials and energy
used (including hazardous materials) and will also reduce residues released.
Furthermore, the environmental perspective is tied to the other four
perspectives of the Balanced Scorecard. Thus, it is explicitly recognized that
improving environmental performance means that capabilities, processes,
customers, and financial consequences must be considered.

48
2. At the beginning of 2008, Kleaner Company initiated a program to improve
its environmental performance. Efforts were made to reduce the production
and emission of contaminating gaseous, solid, and liquid residues. By the
end of the year, in an executive meeting, the environmental manager
indicated that the company had made significant improvement in its
environmental performance, reducing the emission of contaminating
residues of all types. The president of the company was pleased with the
reported success, but wanted an assessment of the financial consequences of
the environmental improvements. To satisfy this request, the following
financial data were collected for 2007 and 2008 (all changes in costs are a
result of environmental improvements):
2007 2008
Sales $20,000,000 $20,000,000
Evaluating and selecting suppliers 0 600,000
Treating and disposing of toxic materials 1,200,000 800,000
Inspecting processes (environmental 200,000 300,000
objective)
Land restoration (annual fund 1,600,000 1,200,000
contribution)
Maintaining pollution equipment 400,000 300,000
Testing for contaminants 150,000 100,000
1. Classify the costs as prevention, detection, internal failure, or external failure.
2. Prepare an environmental cost report for the most recent year where costs are
expressed as a percentage of sales (instead of operating costs).
CA Final Nov -19 Q4)

A chemical company produces two chemicals SX and ZX. Environmental

activities and costs associated with the two chemicals are as follows :
SX ZX
Unit produced (kg.) 6,00,000 15,00,000
Packing Materials (kg.) 80,000 40,000
Energy Usage (KWH) 60,000 30,000
Toxin releases (Pounds into air) 2,00,000 40,000
Pollution control machine hours 32,000 8,000
Cost of environmental activities :
Packing material Costs ₹ 3,60,000
Energy Costs ₹ 96,000
Fines for release of toxins into air ₹ 48,000
Operating costs of pollution control ₹ 1,12,000
equipments
CALCULATE the environmental cost per kilogram for each chemical produced
by the company (5 Marks)

49
 III-BUDGET AND CONTROL (PART D)
(a) BUDGETARY SYSTEMS

The planning and control cycle has seven steps.

 Step 1. Identify objectives
 Step 2. Identify potential strategies
 Step 3. Evaluate strategies
 Step 4. Choose alternative courses of action
 Step 5. Implement the long-term plan
 Step 6. Measure actual results and compare with the plan
 Step 7. Respond to divergences from the plan

Top-down and bottom-up budgeting

(a) With top-down budgeting, budget targets are set at senior management
level for the organization as a whole and for each major department or
activity within the organisation. The departmental budget targets are then
given to the departmental managers, who are required to prepare a budget
that conforms to the targets that have been imposed on them from above.

(b) With bottom-up budgeting, the budgeting process starts at a relatively low
level of management. Managers are required to draft a budget for their area
of operations. These are submitted to their superior, who combines the
lower-level budgets into a combined budget for the department as a whole.

Incremental budgeting:
Incremental budgeting is a method of budgeting in which next year's budget is
prepared by using the current year's actual results as a starting point, and
making adjustments for expected inflation, sales growth or decline and other
known changes.

Fixed and flexible budgets

A fixed budget is a financial plan that does not change throughout the budget
period, regardless of any changes from the plan in the actual volume of activity.

A flexible budget recognises cost behaviour and changes as the actual volume
of activity changes.

A fixed budget is normally used for planning purposes and is prepared in

advance of the beginning of the financial period.

50
A flexible budget is used for control purposes and is normally prepared
retrospectively, when the actual level of activity in a period is known.

Fixed budget
 The budget is prepared on the basis of an estimated volume of production
and an estimated volume of sales, but no plans are made for the event that
actual volumes of production and sales may differ from budgeted
volumes.

 When actual volumes of production and sales during a control period

(month or four weeks or quarter) are achieved, the budget is not adjusted
or revised (in retrospect) to the new levels of activity.

Flexible budget
Flexible budgets may be used in one of two ways.
a. At the planning stage. An organisation may prepare flexible budgets at the
planning stage for different levels of activity.
b. Retrospectively. At the end of each month (control period) or year, the
results that should have been achieved given the actual circumstances (the
flexible budget) can be compared with the actual results.

Zero based budgeting

Zero based budgeting involves preparing a budget for each cost centre or
activity from a zero base. Every item of expenditure has then to be justified in
its entirety in order to be included in the next year's budget.

There is a three-step approach to ZBB.

 Define items or activities for which costs should be budgeted, and
spending decisions should be planned: these are 'decision packages'.
 Evaluate and rank the packages in order of priority: eliminate packages
whose costs exceed their value.
 Allocate resources to the decision packages according to their ranking.
Where resources such as money are in short supply, they are allocated to
the most valuable activities.

The advantages and limitations of implementing ZBB

The advantages of zero based budgeting are as follows.
 It is possible to identify and remove inefficient or obsolete operations.
 It forces employees to avoid wasteful expenditure.
 It can increase motivation of staff by promoting a culture of efficiency.
 It responds to changes in the business environment.

51
Disadvantages of zero based budgeting
 Short-term benefits might be emphasised to the detriment of long-term
benefits.
 It may call for management skills both in constructing decision packages
and in the ranking process which the organisation does not possess.
Managers may have to be trained in ZBB techniques.
 The organisation's information systems may not be capable of providing
suitable information.

Activity based budgeting

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

ABB is therefore based on the following principles.

(a) It is activities which drive costs and the aim is to plan and control the causes
(drivers) of costs rather than the costs themselves, with the result that in the
long term costs will be better managed and better understood.
(b) Not all activities add value, so activities must be examined and split up
according to their ability to add value.
(c) Most departmental activities are driven by demands and decisions beyond
the immediate control of the manager responsible for the department's
budget.
(d) Traditional financial measures of performance are unable to fulfil the
objective of continuous improvement. Additional measures which focus on
drivers of costs, the quality of activities undertaken, the responsiveness to
change, and so on are needed.

Benefits of ABB
 Different activity levels will provide a foundation for the 'base' package
and incremental packages of ZBB.
 It will ensure that the organisation's overall strategy and any actual or
likely changes in that strategy will be taken into account, because it
attempts to manage the business as the sum of its interrelated parts.
 Critical success factors will be identified and performance measures
devised to monitor progress towards them.
 Because concentration is focused on the whole of an activity, not just its
separate parts, there is more likelihood of getting it right first time.

52
Rolling budgets:
Rolling budgets (also called continuous budgets) are budgets which are
continuously updated throughout a financial year, by adding a further period
(say a month or a quarter) and removing the corresponding period that has just
ended.

Dynamic conditions
a. Organisational changes may occur.
(i) A change in structure from a functional basis, say, to a process-based
one
(ii) New agreements with the workforce about flexible working or safety
procedures
(iii) The reallocation of responsibilities following, say, the removal of tiers
of middle management and the 'empowerment' of workers further
down the line

b. Action may be needed to combat an initiative by a competitor.

c. New technology may be introduced to improve productivity, reduce labour

requirements or enhance quality.

d. Environmental conditions may change: there may be a general boom or a

recession, an event affecting supply or demand, or a change in government
or government policy.

e. The level of inflation may be higher or lower than that anticipated.

f. The level of activities may be different from the levels planned.

The advantages are as follows.:

1. They reduce the element of uncertainty in budgeting because they
concentrate detailed planning and control on the near-term future, where the
degree of uncertainty is much smaller.
2. They force managers to reassess the budget regularly, and to produce
budgets which are up to date in the light of current events and expectations.
3. Planning and control will be based on a recent plan which is likely to be far
more realistic than a fixed annual budget made many months ago.
4. Realistic budgets are likely to have a better motivational influence on
managers.

53
The disadvantages of rolling budgets can be a deterrent to using them.
1. They involve more time, effort and money in budget preparation.
2. Frequent budgeting might have an off-putting effect on managers who doubt
the value of preparing one budget after another at regular intervals.
3. Revisions to the budget might involve revisions to standard costs too, which
in turn would involve revisions to stock valuations. This could replace a
large administrative effort from the accounts department every time a rolling
budget is prepared.

Beyond Budgeting
Beyond Budgeting is a budgeting model which proposes that traditional
budgeting should be abandoned. Adaptive management processes should be
used rather than fixed annual budgets.

Two fundamental concepts underlie the Beyond Budgeting approach.

(a) Use adaptive management processes for making decisions rather than
tying decision-making to conformity with a rigid annual budget.
Traditional annual plans tie managers to predetermined actions which are
not responsive to current situations. Managers should instead plan on a more
adaptive, rolling basis but with the focus on cash forecasting rather than
purely on cost control. Performance is monitored against world-class
benchmarks, competitors and previous periods.

(b) Move towards devolved networks rather than centralized hierarchies. The
emphasis is on encouraging a culture of personal responsibility by
delegating decision-making and performance accountability to line
managers.

Criticisms of Incremental / Other budgeting

 Budgets are time consuming and expensive
 Budgets provide poor value to users
 Budgets fail to focus on shareholder value
 Budgets are too rigid and prevent fast response
 Budgets protect rather than reduce costs
 Budgets stifle product and strategy innovation.
 Budgets focus on sales targets rather than customer satisfaction.

54
 (b) LEARNING CURVE THEORY

Learning curve theory applies to situations where the workforce as a whole

improves in efficiency with experience. The learning effect or learning curve
effect describes the speeding up of a job with repeated performance.

Where does learning curve theory apply?

Labour time should be expected to get shorter, with experience, in the
production of items which exhibit any or all of the following features.

 Made largely by labour effort (rather than by a highly mechanised

process) or where labour skill is an important factor in the production
process.
 Brand new or relatively short lived (the learning process does not
continue indefinitely).
 Complex and made in small quantities for special orders.

Application of Learning Curve:

1. Pricing Decision
2. Product Design
3. Setting Standards
4. Budgeting and Profit Planning
5. CVP Analysis

LC ratio and Equation: LCR or Improvement ratio:

“Average labor time (or) cost for first 2N units / Average labor time (or) cost
for first N numbers. “

LC equation: Y=AXB

Y= cumulative average time (or) cost of X units or lots

X= Cumulative no. of units or lots produced
A= Average time (or) cost of the first unit of lot
B= Improvement exponent (or) learning co-efficient or index of learning =
Logarithm of learning ratio/ logarithm of 2

Concept illustration questions:

State whether LC theory applicable in the following situations
1. Skilled workers have been employed for long time. The co has adequate
market for craft pieces done by these experts.

55
2. A set of very experienced people feed data into the computer for processing
inventory records in the factory. The manager wishes to apply 80% learning
rate on data entry and calculation of inventory.
3. Pieces of hand-made furniture are assembled by the co. in a far-off location.
Labor do not know anything about final product which utilizes their work.
As a matter of further precaution, rotation of labor is done frequently.
4. An operation uses contract labor. The contractor shifts people amount
various jobs once in 2 days. The labor force performs one task in 3 days.
The manager wants to apply learning rate for these works.
5. State whether and why the following are valid or not for learning curve
theory:
a. Learning curve theory applies to a division of a company which is fully
automated.
b. Learning curve theory helps in setting standards.
c. Learning curve helps in pricing decisions.

Experienced workmen are more prone to learning effect.

Problem Questions:
1. A co. which has developed a new machine has observed that the time to
manufacture the first machine is 600 hours. Calculate the time which the co.
will take to manufacture the second machine if the actual learning curve rate
is (i) 80%, (ii) 90%. Explain which of the following learning rates will show
faster learning?

2. A factory has a special offer to produce 4 units of labor intensive product by

using its existing facilities after the regular shift timings. The product can be
produced by using only overtime hours which entails normal rate plus 25%,
so that usual production not affected. Two workers were interested to take
additional job every evening after their shift gets over. One is an
experienced man who is working on similar product. His normal wage are
48 per hour. The other worker is a new person who earns 42 per hour as
normal wages. He can safely considered to have LC ratio of 90% for this
work. The experienced man will take 20 hours for the first unit where new
worker will take 30 hours.
Evaluate who should be chose for the job?

56
Log equation based questions:
3. A firm received an order to make and supply 8 units of standard product,
which involves intricate labor operations. The first unit was made in ten
hours. It is understood that this type of operations is subject to 80% learning
effect. The workers are paid wage rate of 12 per hour.
a. What is the total time and labour cost required to execute the above
order?
b. If repeat order of 24 units is also received from the same customer, what
is the labor cost necessary for 2nd order?

4. Kaizen co. developed and manufactured a new machine. The manufacture of

the first machine took 800 direct labour hours. Wage rate is 20 Per hour.
The company experiences a learning curve effect of 80% (Index is -.3219).
The first piece was used as a demonstration piece and was not intended for
sale. On the basis of the demonstration, company received order to
manufacture 20 units. Material cost per unit 16000. Variable Overhead cost
25 per labor hour. Fixed overhead 40 per labour hour. Selling price is to
include a profit margin of 20% on selling price. Subsequently, after the
delivery of the 20 machines, the company receives repeat order for supply
of 30 machines.
a. Calculate the selling price per machine of the first lot of 20 machines
b. What is the reduction in selling price can the company allow in respect of
the repeat order?

5. The chief officer at manufacturing plant of Boeing 777-200LR aircraft

observed that workers performing manufacturing operations at the plant
showed signs of a definite learning pattern. He noted that most aircraft
manufacturing tasks experienced what he called an 80 percent learning rate,
meaning that workers need 20 percent fewer hours to make a part each time
their cumulative experience making that part doubled. Thus, if the first part
took 100 minutes, the second would require 80 minutes, the fourth would
require 64 minutes, and so on. Calculate the time required for parts 41 to 60.
[Note: learning coefficient is -0.322 for learning rate of 80%, log2=0.30103,
log3=0.47712, log5=0.69897, Antilog of 1.484 =30.48, Antilog of 1.4274
=26.75]

57
6. Bosch Ltd. has developed a special product. Details are as follows: The
product will have a life cycle of 5,000 units. It is estimated that market can
absorb first 4,500 units at ₹ 64 per unit and then the product will enter the
"decline" stage of its life cycle.
The company estimates the following cost structure:
Direct Labour... ₹ 6 per hour
Other variable costs... ₹ 19 per unit
Fixed costs will be ₹ 40,000 over the life cycle of the product. The ‘labour
rate’ and both of these costs will not change throughout the product's life
cycle.
The first batch of 100 units will take 1,000 labour hours to produce. There
will be an 80% learning curve that will continue until 2,500 units have been
produced. Batches after this level will each take the same amount of time as
the 25th batch. The batch size will always be 100 units.

Required
a) The cumulative average time per batch for the first 25 batches.
b) The time taken for the 25th batch if average time for 24 batches is
359.40 hours.
c) The average selling price of the final 500 units that will allow the
company to earn a total profit of ` 80,000 from the product.

(Note: Learning coefficient is –0.322 for learning rate of 80%). The values of
Logs have been given for calculation purpose:
log 2 = 0.30103; log3 = 0.47712; log5 = 0.69897; antilog of 2.534678 = 342.51;
antilog of 2.549863 = 354.70; antilog of 2.555572 = 359.40; antilog of
2.567698 = 369.57

58
 (c) STANDARD COSTING - VARIANCE
ANALYSIS
A standard cost is an estimated unit cost built up of standards for each cost
element (standard resource price and standard resource usage).

Standard costing is used to value inventories, prepare cost budgets for

production and provide control information (variances).

Standard costing involves the establishment of predetermined estimates of the

costs of products or services, the collection of actual costs and the comparison
of the actual costs with the predetermined estimates. The predetermined costs
are known as standard costs and the difference between standard and
actual cost is known as a variance. The process by which the total difference
between standard and actual results is analysed is known as variance analysis.

Deriving standards
1. Setting standards for materials costs:
 Purchase contracts already agreed
 Pricing discussions with regular suppliers
 The forecast movement of prices in the market
 The availability of bulk purchase discounts
 The quality of material required by the production departments

2. Setting standards for labour costs:

The payroll and to any agreements on pay rises with trade union
representatives of the employees.

3. Setting standards for material usage and labour efficiency

To estimate the materials required to make each product (material usage)
and also the labour hours required (labour efficiency), technical
specifications must be prepared for each product by production experts
(either in the production department or the work study department).

4. Setting standards for overheads:

(a) Production capacity (or 'volume capacity') measured perhaps in standard
hours of output (a standard hour being the amount of work achievable at
standard efficiency levels in an hour), which in turn reflects direct
production labour hours.

(b) Efficiency of working, by labour or machines, allowing for rest time and
contingency allowances.

59
An ideal standard is a standard which can be attained under perfect operating
conditions: no wastage, no inefficiencies, no idle time, no breakdowns.

An attainable standard is a standard which can be attained if production is

carried out efficiently, machines are properly operated and/or materials are
properly used. Some allowance is made for wastage and inefficiencies.

A current standard is a standard based on current working conditions (current

wastage, current inefficiencies).

A basic standard is a long-term standard which remains unchanged over the

years and is used to show trends.

Flexible budgets and performance management

Budgetary control involves drawing up budgets for the areas of responsibility
for individual managers (production managers, purchasing managers, and so on)
and regularly comparing actual results against expected results. The differences
between actual results and expected results are reported as variances and these
are used to provide a guideline for control action by individual managers.

Material Variances

Formulae or Concept understanding

Traditional –
1. Direct Material Price Variance: [Standard Cost of Actual Quantity – Actual
Cost] or [(SP – AP) × AQ]
Or
[(SP × AQ) – (AP × AQ)]

2. Direct Material Usage Variance: [Standard Cost of Standard Quantity for

Actual Production – Standard Cost of Actual Quantity] or
[(SQ – AQ) × SP]
Or
[(SQ × SP) – (AQ × SP)]

a. Direct Material Yield Variance:

(The difference between the Actual Quantity in standard proportion and
Actual Quantity in actual proportion, at Standard Purchase Price)
[(RAQ – AQ) × SP]
Or
[(RAQ × SP) – (AQ × SP)]
Or

60
 [Total Actual Quantity (units) × {Average Standard Price per unit of
Standard Mix Less Average Standard Price per unit of Actual Mix}]
Direct Material Yield Variance:
(The difference between the Standard Quantity specified for actual
production and Actual Quantity in standard proportion, at Standard Purchase
Price)
[(SQ – RAQ) × SP]
Or
[(SQ × SP) – (RAQ × SP)]
Or
[Average Standard Price per unit of Standard Mix × {Total Standard
Quantity (units) Less Total Actual Quantity (units)}]

1. The following information relates to April production of product CK:

Actual Budget
Units produced 580 600
Input of material (kg) 1,566 1,500
Cost of material purchased and input $77,517 $76,500
What is the materials usage variance?

2. The standard direct material cost for a product is $50 per unit (12.5 kg at $4
per kg). Last month the actual amount paid for 45,600 kg of material
purchased and used was $173,280 and the direct material usage variance
was $15,200 adverse.
a. What was the direct material price variance last month?
b. What was the actual production last month?

3. For product DR, the material price variance for the month of August was
$1,000 favorable and the material usage variance was $300 adverse.
The standard material usage per unit is 3 kg, and the standard material price
is $2 per kg. 500 units were produced in the period. Opening inventories of
raw materials were 100 kg and closing inventories 400 kg.
What were the material purchases in the period?

4. The following information relates to a month’s production of product CN:

Units produced
Input of material P (kg)
Cost of material P purchased and input $25,500 $25,839
What is the price variance for material P?

5. Yield and Mix Variance: The standard material cost for a normal mix of one
tonne of chemical Xing based on:

61
 Chemical Usage Price per kg
A 240 kg ₹6
B 400 kg ₹ 12
C 640 kg ₹ 10
During a month, 6.25 tonnes of X were produced from:

Chemical Consumption (Tonnes) Cost (₹)

A 1.6 11,200
B 2.4 30,000
C 4.5 47,250

Analyse the variances.

6. The standard cost of a certain chemical mixture is as under:

40% of Material A @ ₹ 30 per kg
60% of Material B @ ₹ 40 per kg
A standard loss of 10% of input is expected in production. The following
actual cost data is given for the period.
350 kg Material – A at a cost of ₹ 25
400 kg Material – B at a cost of ₹ 45
Actual weight produced is 630 kg.
Calculate the following variances raw material wise and indicate whether
they are favorable (F) or adverse (A):

Interpretation of variances:
Variance Interpretation
Material Price  Might be caused due to the use of a different
supplier.
- Order size can result in variance
- Any form of unexpected increase in buying costs
such as higher delivery charges.
- Efficiency or inefficiency associated with the
buying procedure adopted.
- Lack of appropriate inventory control can result in
emergency purchase of material resulting in adverse
variance.

62
 Material Usage - Purchase of inferior quality material -
Implementation of better quality control - Increased
efficiency in production can help in bringing down
wastage rate - Changes made in the material mix -
Careless way of handling material by production
department - Change in method of production/ design
- Pilferage of material from the production department
- Poor inspection.
Planning and Operation Variance - Material:
(Refer Note on Planning & Operational Variance at the end of PDF)

Question: ICAI Material

Ski Slope had planned, when it originally designed its budget, to buy its
artificial ice for `10/ per kg. However, due to subsequent innovations in
technology, producers slashed their prices to `9.70 per kg. and this figure is now
considered to be a general market price for the purpose of performance
assessment for the budget period. The actual price paid was `9.50, as the Ski
Slope procurement department negotiated strongly for a better price. The other
information relating to that period were as follows:

Original Standards Revised Standards Actual (5,500 units)

(ex-ante) (ex-post)
5,500 units x 5 `2,75,000 5,500 units x 4.75 `2,53,412.50 27,225 Kgs. x `2,58,637.50
Kgs. x `10 kgs. x `9.70 `9.50

Required
(i) Calculate the variances for ‘Ice’ by
(a) Traditional Variance Analysis; and
(b) An approach which distinguishes between Planning and
Operational Variances.

(ii) INTERPRET the result.

Question: ICAI Material

Managing Director of Petro-KL Ltd (PTKLL) thinks that Standard Costing has
little to offer in the reporting of material variances due to frequently change in
price of materials.

PTKLL can utilize one of two equally suitable raw materials and always plan to
utilize the raw material which will lead to cheapest total production costs.
However, PTKLL is frequently trapped by price changes and the material
actually used often provides, after the event, to have been more expensive than
the alternative which was originally rejected.

63
During last accounting period, to produce a unit of ‘P’ PTKLL could use either
2.50 Kg of ‘PG’ or 2.50 kg of ‘PD’. PTKLL planned to use ‘PG’ as it appeared
it would be cheaper of the two and plans were based on a cost of ‘PG’ of `1.50
per Kg. Due to market movements, the actual prices changed and if PTKLL had
purchased efficiently the cost would have been:

‘PG’ `2.25 per Kg;

‘PD’ `2.00 per Kg
Production of ‘P’ was 1,000 units and usage of ‘PG’ amounted to 2,700 Kg at a
total cost of ` 6,480/-
CALCULATE the material variance for ‘P’ by:
(i) Traditional Variance Analysis; and
(ii) An approach which distinguishes between Planning and Operational
Variances

Question on P&O Variance:

Product X had a standard direct material cost in the budget of:
4 kg of Material M at $5 per kg = $20 per unit.
Due to disruption of supply of materials to the market, the average market price
for Material M during the period was $5.50 per kg, and it was decided to revise
the material standard cost to allow for this.

During the period, 6,000 units of Product X were manufactured. They required
26,300 kg of Material M, which cost $139,390.
Required Calculate:
(a) The material price planning variance
(b) The material price operational variance
(c) The material usage (operational) variance

Question P&O Variance:

The standard materials cost of a product is 5 kg $7.50 per kg = $37.50. Actual
production of 10,000 units used 54,400 kg at a cost of $410,000.
In retrospect it was realised that the standard materials cost should have been
5.3 kg per unit at a cost of $8 per kg. The standard cost was revised to this
amount.
Calculate the materials planning and operational variances in as much detail as
possible

64
Labour Variance
Formulae or Concept:
1. Direct Labor Rate Variance:
(The difference between the Standard Rate per hour and Actual Rate per
hour for the Actual Hours paid)
Or [(SR – AR) × AH*]
Or [(SR × AH*) – (AR × AH*)]

2. Idle time Variance:

(Actual hours paid – actual hours worked) * Standard Rate

3. Labor efficiency Variance: [Standard Cost of Standard Time for Actual

Production – Standard Cost of Actual Time]
Or [(SH – AH Worked) × SR]
Or [(SH × SR) – (AH# × SR)]

a. Labor Mix variance Or Gang Variance: (The difference between the

Actual Hours worked in standard proportion and Actual Hours worked
in actual proportion, at Standard Rate)
[(RAH – AH Worked) × SR]
Or
[(RAH × SR) – (AH Worked × SR)]
Or
[Total Actual Time Worked (hours) × {Average Standard Rate per
hour of Standard Gang Less Average Standard Rate per hour of Actual
Gang@}]@ On the basis of hours worked

b. Direct Labor Yield Variance Or Sub-Efficiency Variance: (The

difference between the Standard Hours specified for actual production
and Actual Hours worked in standard proportion, at Standard Rate)
(SH – RAH) × SR
Or
(SH × SR) – (RAH × SR) Or [Average Standard Rate per hour of
Standard Gang × {Total Standard Time (hours) Less Total Actual Time
Worked (hours)}]

1. The following information relates to labour costs for the past month:
Budget
Labour rate $10 per hour
Production time 15,000 hours
Time per unit 3 hours
Production units 5,000 units

65
 Actual
Wages paid $176,000
Production 5,500 units
Total hours worked 14,000 hours
There was no idle time.
What were the labour rate and efficiency variances?

2. Fawley’s direct labour cost data relating to last month were as follows:
Standard labour cost of actual hours worked $116,000
Standard hours worked 30,000
Standard rate per hour $4
Labour rate variance $5,800 favourable
Labour efficiency variance $4,000 favourable
What is the actual rate of pay per hour (to 2 decimal places)?

3. Michel has the following results.

10,080 hours actually worked and paid costing $8,770
If the rate variance is $706 adverse, the efficiency variance $256
favourable, and 5,000 units were produced, what is the standard
production time per unit?

4. An extract from the standard cost card for product CJ is as follows:

Direct labour (0.5 hours × $12) $6
710 units of CJ were produced in the period and staff worked 378 hours
at a total cost of $4,725. Of these hours 20 were lost due to a material
shortage.
What is the labour efficiency variance?

5. Direct labour cost data relating to last month is as follows:

Actual hours worked 28,000
Total direct labour cost $117,600
Direct labour rate variance $8,400 adverse
Direct labour efficiency variance $3,900 favourable
To the nearest thousand hours, what were the standard labour hours for
actual production last month?

6. The following information relates to the labour element of X Ltd.

Type of labour Skilled Semi Unsk- Total
skilled illed
No. of workers in the standard gang 4 3 2 9
Standard rate per hour (`) 6 3 1
Number of workers in actual gang 9
Actual rate per hour (`) 7 2 2
66
 In a 40 hour week, the gang produced 270 standard hours. The actual
number of semi-skilled workers is two times the actual number of
unskilled workers.
The rate variance of semi-skilled workers is ` 160 (F).

Required
(i) The number of workers in each category
(ii) Total gang variance
(iii) Total sub-efficiency variance
(iv) Total labour rate variance
Indicate if the variances are Favourable (F) or Adverse (A or U).

P&O Variance:
Question 1
A company makes a single product. At the beginning of the budget year, the
standard labour cost was established as $8 per unit, and each unit should take
0.5 hours to make.

However, during the year, the standard labour cost was revised. A new quality
control procedure was introduced to the production process, adding 20% to the
expected time to complete a unit. In addition, due to severe financial difficulties
facing the company, the workforce reluctantly agreed to reduce the rate of pay
to $15 per hour.

In the first month after revision of the standard cost, budgeted production was
15,000 units but only 14,000 units were actually produced. These took 8,700
hours of labour time, which cost $130,500.
Required Calculate the labour planning and operational variances in as much
detail as possible.

Question 2: ICAI Material: Page. No. 12.6

HDR Ltd produces units and incurs labour costs. A change in technology after
the preparation of the budget resulted in a 25% increase in standard labour
efficiency, such that it is now possible to produce 10 units instead of 8 units
using 8 hours of labour- giving a revised standard labour requirement of 0.80
hours per unit. Details of actuals and budgeted for period XII are:
Grade Original Standards Revised Standards Actual
(ex-ante) (ex-post) (1,100 units)
X 1,100 units `11,000 1,100 units × `8,800 1,200 hrs. `10,200
× 0.80 hrs. × ×
1 hrs. × `10 10.00 `8.50

67
(i) Calculate the variances for ‘X’ by
(a) Traditional Variance Analysis; and
(b) An approach which distinguishes between Planning and Operational
Variances.
(ii) Comment on the results.

Variance Interpretation
Labour Rate  Unexpected increase in the pay rate of labour - Level of
experience of the labour can impact the direct cost of
labour - Payment of bonuses added to the direct labour
costs - Change in the composition of the workforce
can impact direct labour costs.

Labour Efficiency - Improvement in work or productivity efficiency.

- Workforce mix can have an impact upon labour
efficiency levels.
- Industrial action in relation to workforce.
- Poor supervision of the workforce.
- Learning curve effect upon the labour efficiency levels.
- Resource shortages causing an unexpected delay and
lowering of labour efficiency levels.
- Using inferior quality of material.
- Introduction of new machinery resulting in improvement
of labour productivity levels.

Planning & Operational Variance

A planning and operational approach to variance analysis divides the total
variance into those variances which have arisen because of inaccurate planning
or faulty standards (planning variances) and those variances which have been
caused by adverse or favourable operational performance, compared with a
standard which has been revised in hindsight (operational variances).
Reasons for revising a budget or standard cost (Planning Variance related)
a) The standard cost of materials for a product may have been based on an
assumption about what the market price for the materials should be.
However, due to a major change in the market, the available market price
for the materials may become much higher or much lower than originally
expected when the standard cost was prepared.

68
b) The standard quantity of materials for a product may be significantly altered
due to an unexpected change in the product specification, requiring much
more or much less of the material in the product content.

c) The standard labour rate may become unrealistic due to an unexpected

increase in pay rates for employees.

d) The standard time to produce a unit of product may also change for
unexpected reasons.

A large part of the variances will be due to changes that are outside the control
of the operational managers.
 Variances that have been caused by the revision in the budget or standard
cost, for which operational managers should not be made responsible:
these are called planning variances.
 Variances that are caused by differences between actual performance and
the revised budget or standard, for which operational managers should be
made responsible and accountable: these are called operational variances

Advantages of a system of planning and operational variances

 The analysis highlights those variances which are controllable
(operational variances) and those which are non-controllable (planning
variances).
 Managers' acceptance of the use of variances for performance
measurement, and their motivation, is likely to increase if they know they
will not be held responsible for poor planning and faulty standard setting.
 The planning and standard-setting processes should improve; standards
should be more accurate, relevant and appropriate.
 Operational variances will provide a more realistic and 'fair' reflection of
actual performance.
Limitations of planning and operational variances, which must be
overcome if they are to be applied in practice
 It is difficult to decide in hindsight what the realistic standard should have
been.
 It may become too easy to justify all the variances as being due to bad
planning, so no operational variances will be highlighted.
 Establishing realistic revised standards and analysing the total variance
into planning and operational variances can be a time-consuming task,
even if a spreadsheet package is revised.

69
  Even though the intention is to provide more meaningful information,
managers may be resistant to the very idea of variances and refuse to see
the virtues of the approach. Careful presentation and explanation will be
required until managers are used to the concepts.
Fixed Overhead Variance
General Questions:
1. The following details relate to product T, which has a selling price of
$44.00:
$/unit
Direct materials 15.00
Direct labour (3 hours) 12.00
Variable overhead 6.00
Fixed overhead 4.00
–––––
37.00
=====
During April 20X6, the actual production of T was 800 units, which was
100 units fewer than budgeted. The budget shows an annual production
target of 10,800, with fixed costs accruing at a constant rate throughout the
year. Actual overhead expenditure totaled $8,500 for April 20X6.
Overheads are absorbed on the basis of units produced. What were the
overhead variances for April 20X6?
2. A company operates a standard marginal costing system. Last month its
actual fixed overhead expenditure was 10% above budget resulting in a
fixed overhead expenditure variance of $36,000.
What was the actual expenditure on fixed overheads last month?

3. FGH has the following budgeted and actual data:

Budgeted fixed overhead cost $120,000
Budgeted production (units) 20,000
Actual fixed overhead cost $115,000
Actual production (units) 21,000
What is the fixed overhead volume variance?

4. A company budgeted to make 30,000 units of a product P. Each unit was

expected to take 4 hours to make and budgeted fixed overhead
expenditure was $840,000. Actual production of product P in the period
was 32,000 units, which took 123,000 hours to make. Actual fixed
overhead expenditure was $885,600. What was the fixed overhead
capacity variance for the period?

70
5. QRL uses a standard absorption costing system. The following details
have been extracted from its budget for April 20X7:
Fixed production overhead cost $48,000
Production (units) 4,800
In April 20X7 the fixed production overhead cost was under-absorbed by
$8,000 and the fixed production overhead expenditure variance was
$2,000 adverse.
What was the actual number of units produced?

6. QR has budgeted to produce 4,000 units in January. Actual production

was 3,700 units with fixed production overheads of $10,300. The
standard fixed overhead cost per unit was 1.5 hours at $2.40 per hour.
5,800 actual production hours were worked. What was the fixed overhead
volume variance?

7. A company uses a standard absorption costing system. Last month

budgeted production was 8,000 units and the standard fixed production
overhead cost was $15 per unit. Actual production last month was 8,500
units and the actual fixed production overhead cost was $17 per unit.
What was the total adverse fixed production overhead variance for last
month?

8. A company operates a standard absorption costing system. The standard

fixed production overhead rate is $15 per hour.
The following data relate to last month:
Actual hours worked 5,500
Budgeted hours 5,000
Standard hours for actual production 4,800
What was the fixed production overhead capacity variance?

9. In a manufacturing co. the standard units of production of the year were

fixed at 1,20,000 units and overhead expenditures were estimated to be:
Fixed ` 12,000 Variable ` 6,000
Semi-Variable ` 1,800
Actual production during April of the year was 8,000 units. Each month
has 20 working days. During the month there was one statutory holiday.
The actual overheads amounted to:
Fixed ` 1,190 Variable ` 480
Semi-variable ` 192
Semi-variable charges are considered to include 60 per cent expenses of
fixed nature and 40 per cent of variable character.

71
 (a) Calculate Overhead Cost Variance
(b) Calculate Fixed Overhead Cost Variance
(c) Calculate Variable Overhead Cost Variance
(d) Calculate Fixed Overhead Volume Variance
(e) Calculate Fixed Overhead Expenditure Variance
(f) Calculate Calendar Variance

10. A company is engaged in manufacturing of several products. The

following data have been obtained from the record of a machine shop for
an average month:
Budgeted:

No. of working days 24

Working hours per day 8
No. of direct workers 150
Efficiency One standard hour per
clock hour
Down time 10%
Overheads
Fixed ` 75,400
Variable ` 90,720
The actual data for the month of August 2013 are as follows:
Overheads
Fixed ` 78,800
Variable ` 70,870
Net operator hours worked 20,500
Standard hours produced 22,550
There was a special holiday in August 2013
(i) Calculate efficiency, activity, calendar and standard capacity usages
ratio.
(ii) Calculate all the relevant fixed overhead variances.
(iii) Calculate variable overheads expenditure and efficiency variance.

72
Variable Overhead
1. The following information has been extracted from the books of Goru
Enterprises which is using standard costing system:
Actual output = 9,000 units
Direct wages paid = 1,10,000 hours at ` 22 per hour, of
which 5,000 hours, being idle time,
were not recorded in production
Standard hours = 10 hours per unit
Labour efficiency variance = ` 3,75,000 (A)
Standard variable Overhead = ` 150 per unit
Actual variable Overhead = `16,00,000
(i) Calculate idle time variance
(ii) Calculate total variable overhead variance
(iii) Calculate variable overhead expenditure variance
(iv) Calculate variable overhead efficiency variance.

Sales Variances:
I. Turnover / Total Approach:
A. Total Sales Variance: [(AQ × AP) – (BQ × SP)] or (Actual Sales) Less
(Budgeted Sales)

B. Sales Price Variance: (Actual Sales) Less (Standard Sales) [(AP × AQ)
– (SP × AQ)]
Or
[AQ × (AP – SP)]

C. Sales Volume Variance:

(Standard Sales) Less (Budgeted Sales)
(SP × AQ) – (SP × BQ)]
Or
SP × (AQ – BQ)]
a. Sales Mix Variance: (Standard Sales) Less (Revised Standard Sales)
[(SP × AQ) – (SP × RAQ)]
Or
[SP × (AQ – RAQ)] or
[Total Actual Quantity (units) × {Average Standard Price per unit of
Actual Mix Less Average Budgeted Price per unit of Budgeted Mix}]

73
 b. Sales Quantity Variance: (Revised Standard Sales) Less (Budgeted
Sales) [(SP × RAQ) – (SP × BQ)]
Or
[SP × (RAQ – BQ)] or
[Average Budgeted Price per unit of Budgeted Mix × {Total Actual
Quantity (units) Less Total Budgeted Qty (units)}]

II. Margin/Profit approach:

Where Price will be replaced by Margin (Budgeted Margin or Actual
margin)

III. The sales volume variance can be sub-divided into a planning variance
(market size variance) and operational variance (market share variance).
a. Market Size Variance
1. Budgeted Market Share % × (Actual Industry Sales Quantity in
units – Budgeted Industry Sales Quantity in units) × (Average
Budgeted Price per unit)
Or
2. (Budgeted Market Share % × Actual Industry Sales Quantity in
units – Budgeted Market Share% × Budgeted Industry Sales
Quantity in units) × (Average Budgeted Price per unit)
Or
3. (Required Sales Quantity in units –Total Budgeted Quantity in
units) × (Average Budgeted Price per unit)

b. Market Share Variance

1. (Actual Market Share % – Budgeted Market Share %) × (Actual
Industry Sales Quantity in units) × (Average Budgeted Price per
unit)
Or
2. (Actual Market Share % × Actual Industry Sales Quantity in units
– Budgeted Market Share % × Actual Industry Sales Quantity in
units) × (Average Budgeted Price per unit)
Or
3. (Total Actual Quantity in units– Required Sales Quantity in units)
× (Average Budgeted Price per unit)

74
Questions
1. Japan Products Ltd. had drawn up the following Sales budget for August,
2013:
‘B’ Product… 5,000 units at ` 100 each
‘C’ Product 4,000 units at ` 200 each
‘S’ Product 6,000 units at ` 180 each
The actual sales for August, 2013 were:
‘B’ Product 5,750 units at ` 120 each
‘C’ Product 4,850 units at ` 180 each
‘S’ Product 5,000 units at ` 165 each
The costs per unit of B, C and S Product were ` 90, ` 170 and ` 130
respectively.
Analyse the Sales Variances to show the effects on turnover & the effects
on Profit.

2. Zed company manufactures two types of flooring rolls. Budgeted and

actual data for 2015 are-
Static Budget Actual Result
Industrial Domestic Total Industrial Domestic Total
Unit Sales in 200 600 800 252 588 840
Rolls (`000)
Contribution 100.00 240.00 340.00 119.70 246.96 366.66
Margin
(`in Lacs)
In late 2014, a marketing research estimated industrial volume for industrial
and domestic flooring at 80 Lacs Rolls. Actual industry volume for 2015
was 70 Lacs Rolls. Required
(i) Sales Mix Variance and Sales Quantity Variance by type of flooring
rolls and in total.
(ii) Market Share Variance and Market Size Variance.

All Variances:
Question 1:
Sydney manufactures one product, and the entire product is sold as soon as it is
produced. There are no opening or closing inventories and work in progress is
negligible. The company operates a standard costing system and analysis of
variances is made every month. The standard cost card for the product, a
boomerang, is as follows.

Standard Cost Card – Boomerang

Direct materials 0.5 kilos at $4 per kilo 2.00
Direct wages 2 hours at $2.00 per hour 4.00

75
Variable overheads 2 hours at $0.30 per hour 0.60
Fixed overhead 2 hours at $3.70 per hour 7.40
Standard cost 14.00
Standard profit 6.00
Standing selling price 20.00

Budgeted (planned) output for the month of June 20X7 was 5,100 units. Actual
results for June 20X7 were as follows.
Production of 4,850 units was sold for $95,600.
Materials consumed in production amounted to 2,300 kg at a total cost of
$9,800.

Labour hours paid for amounted to 8,500 hours at a cost of $16,800.

Actual operating hours amounted to 8,000 hours.
Variable overheads amounted to $2,600.
Fixed overheads amounted to $42,300.

Required
Calculate all variances and prepare an operating statement for the month ended
30 June 20X7.

Question 2:
A company manufactures a single product. An extract from a variance control
report together with relevant standard cost data is shown below.

Standard selling price per unit $70

Standard direct material cost (5 kg $2 per kg) $10 per unit

Budgeted total material cost of sales $2,300 per month

Budgeted profit margin $6,900 per month
Actual results for February
Sales revenue $15,200
Total direct material cost $2,400
Direct material price variance $800 adverse
Direct material usage variance $400 favourable
There was no change in inventory levels during the month.
a)What was the actual production in February?
b)What was the actual usage of direct material during February?
c)What was the selling price variance for February?
d)What was the sales volume profit variance for February?

76
Question 3:
The Standard Cost Sheet per unit for the product produced by Style
Manufacturers is worked out on this basis:—
Direct Materials 1.3 tons @ ` 4.00 per ton
Direct Labour 2.9 hours @ ` 2.30 per hour
Factory Overhead 2.9 hours @ ` 2.00 per hour

Normal Capacity is 2,00,000 direct labour hours per month.

The Factory Overhead rate is arrived at on the basis of a Fixed Overhead of `
1,00,000 per month and a Variable Overhead of ` 1.50 per direct labour hour.
In the month of May, 50,000 units of the product was started and completed. An
investigation of the raw material inventory account reveals that 78,000 tons of
raw material were transferred into and used by the factory during May. These
goods cost ` 4.20 per ton. 1,50,000 hours of Direct Labour were spent during
May at a cost of ` 2.50 per hour. Factory Overhead for the month amounted to `
3,40,000 out of which ` 1,02,000 was fixed.
Required
(a) Compute and identify all variances under Material, Labour and overhead as
favourable or adverse.
(b) Identify one or more departments in the company who might be held
responsible for each variance.

Question 4
The following information relates to a manufacturing concern:
Standard
Material A 24,000 kgs @ ` 3 per kg. 72,000
12,000 kgs @ ` 4 per kg 48,000
Wages 60,000 hours @ ` 4 per hour 2,40,000
Variable Overheads 60,000 hours @ ` per hour 60,000
2 per hour 1,20,000
Total Cost 5,40,000
Budgeted Profit 60,000
Budgeted Sales 6,00,000
Budgeted Production (units) 12,000
Actual `
Sales (9,000 units) 4,57,500
Material A Consumed 22,275 kgs. 62,370
Material B Consumed 10,890 kgs. 44,649
Wages Paid (48,000 hours) 1,91,250
Fixed Overhead 1,20,900
Variable Overhead 45,000
Labour Hours Worked 47,700

77
 Closing (Work in Progress) 900 units
Degree of Completion
Material A and B 100%
Wage and Overheads 50%

Calculate all variances.

Re-working Questions: ICAI
Question 1:
S. Ltd. operates a system of standard costing in respect of one of its products
which is manufactured within a single cost centre, the following information is
available:

Standard price of material is ` 2 per litre. The standard wage rate is ` 6 per hour
and 5 hours are allowed to produce one unit. Fixed production overhead is
absorbed at the rate of 100% of direct wages cost.
During the month just ended the following occurred –
Actual Price (paid for material purchased)………………………….1.95 per
litre Total Direct Wages Cost………………………………………….1,56,000
Fixed Production Overhead……………………………………... 1,58,000

Variance Favourable (`) Adverse (`)

Material Price 8,000 -
Direct Material Usage - 5,000
Direct Labour Rate - 5,760
Direct Labour Efficiency 2,760 -
Fixed Production Overhead - 8,000
Expenditure

Calculate the following for the month-

(i) Budgeted output in units.
(ii) Number of litres purchased.
(iii) Number of litres used above standard allowed.
(iv) Actual units produced.
(v) Actual hours worked.
(vi) Average actual wage rate per hours.

Question 2:
A company operates a standard cost system to control the variable works cost of
its only product. The following are the details of actual production, costs and
variances for November, 2015.

78
Production and cost (actual) Production… 10,000 units
Direct Materials (1,05,000 kg.) ` 5,20,000
Direct Labour (19,500 hrs.)… ` 3,08,000
Variable Overheads… ` 4,10,000

Cost variances
Direct materials – Price… ` 5,000 (F)
Direct materials – Usages… ` 25,000 (A)
Direct labour – Rate ` 15,500(A)
Direct labour – Efficiency ` 7,500 (F)
Variaple overheads… ` 10,000 (A)

The Cost Accountant finds that the original standard cost data for the product is
missing from the cost department files. The variance analysis for December,
2015 is held up for want of this data.
(i) Calculate- Standard price per kg. of direct material
(ii) Calculate- Standard quantity for each unit of output
(iii) Calculate- Standard rate of direct labour hour
(iv) Calculate- Standard time for actual production
(v) Calculate- Standard variable overhead rate

79
 IV – PERFORMANCE MEASUREMENT
(PART E)
(a) DIVISIONAL PERFORMANCE
MEASUREMENT & TRANSFER PRICING
Divisionalisation:

Divisionalisation is a term for the division of an organisation into divisions.

Each divisional manager is responsible for the performance of the division. A
division may be a cost centre (responsible for its costs only), a profit centre
(responsible for revenues and profits) or an investment centre or Strategic
Business Unit (responsible for costs, revenues and assets).
It is structure in two ways:
1. Functionally
2. Divisionally
Decentralisation:
a divisional structure will lead to decentralisation of the decision-making
process and divisional managers may have the freedom to set selling prices,
choose suppliers, make product mix and output decisions, and so on.

Advantages:
1. Divisionalisation can improve the quality of decisions made because
divisional managers (those taking the decisions) know local conditions and
are able to make more informed judgements.
2. Decisions should be taken more quickly
3. The authority to act to improve performance should motivate divisional
managers.
4. Divisional organisation frees top management from detailed involvement
in day-to-day operations
5. Divisions provide valuable training grounds for future members of top
management
Responsibility accounting

Responsibility accounting is the term used to describe decentralisation of

authority, with the performance of the decentralised units measured in terms of
accounting results.
With a system of responsibility accounting there are five types of responsibility
centre: cost centre; revenue centre; profit centre; contribution centre; and
investment centre.

80
Type of Manager has control Principal performance
responsibility centre over…. measures
Cost Centre Controllable costs Variance analysis
Efficiency measures
Revenue centre Revenues only Revenues
Profit centre Controllable costs sales Profit
prices (including transfer
prices)
Contribution centre As profit centre except that Contribution
expenditure is reported on a
marginal cost bass
Investment centre Controllable costs Return on investment
Sales prices (including Residual income
transfer prices) Other financial ratios
Output volumes
Investment in non-current
assets and working capital
Return on investment (ROI)
Return on investment (ROI) shows how much profit has been made in relation
to the amount of capital invested and is calculated as (profit/capital employed)
x 100%.

Point to Remember:
 If depreciation is deducted from Capital Employed, it will lead to
reduction in value of denominator and thereby increase in value of ROI
 There is no generally agreed method of calculating ROI, and it can have
behavioural implications and lead to dysfunctional decision-making when
used as a guide to investment decisions. It focuses attention on short-run
performance whereas investment decisions should be evaluated over their
full life.
i.e. Managers may behave dysfunctional not to purchase the asset even if
there is requirement of asset.
Read / Check Example in Study text to understand the concept related with
above demerits of ROI
Residual income (RI)
RI can sometimes give results that avoid the behavioural problem of
dysfunctionality. Its weakness is that it does not facilitate comparisons between
investment centres nor does it relate the size of a centre's income to the size of
the investment.
RI = Controllable Profit - Imputed Interest i.e. Capital Employed * Interest or
C.o.C

81
The advantages and weaknesses of RI compared with ROI

The advantages of using RI

(a) Residual income will increase when investments earning above the cost of
capital are undertaken and investments earning below the cost of capital are
eliminated.

(b) Residual income is more flexible since a different cost of capital can be
applied to investments with different risk characteristics.
The weakness of RI is that it does not facilitate comparisons between
investment centres nor does it relate the size of a centre's income to the size
of the investment.

82
 (b) TRANSFER PRICING
Transfer prices are a way of promoting divisional autonomy, ideally without
prejudicing the measurement of divisional performance or discouraging overall
corporate profit maximisation.
Transfer prices should be set at a level which ensures that profits for the
organisation as a whole are maximised.
A transfer price is the price at which goods or services are transferred
from one department to another, or from one member of a group to
another.

Characteristics of a good transfer price

 Goal congruence – the transfer price that is negotiated and agreed upon by
the buying and selling divisions should be in the best interests of the
company overall.
 Fairness – the divisions must perceive the transfer price to be fair since the
transfer price set will impact divisional profit and hence performance
evaluation.
 Autonomy – the system used to set the transfer price should seek to
maintain the autonomy of the divisional managers. This autonomy will
improve managerial motivation.
 Bookkeeping – the transfer price chosen should make it straightforward to
record the movement of goods or services between divisions.
 Minimise global tax liability – multinational companies can use their
transfer pricing policies to move profits around the world and thereby
minimise their global tax liability.
Scenario 1:
There is a perfectly competitive market for the product/service transferred
Transfer price = market price
A perfect market means that there is only one price in the market, there are no
buying and selling costs and the market is able to absorb the entire output of the
primary division and meet all the requirements of the secondary division.
It can be considered as Method of Fixing TP

83
Scenario 2: The selling division has surplus capacity
Transfer price
negotiated
between:

Minimum price
selling division Maximum price
will accept buying division
marginal cost will pay which is
lower of:

External purchase Net marginal

price of transferred revenue i.e. selling
products price minus
marginal cost of
buying division’s
final product

Scenario 3: The selling division does not have any surplus capacity

Transfer price
negotiated
between

Minimum price selling

division will accept = Maximum price
marginal cost buying division
+ lost contribution will pay which is
from other product lower of:
(opportunity cost)

External purchase Net marginal

price of transferred revenue i.e. selling
products price minus
marginal cost of
buying division’s
final product
While computing TP under No Spare capacity:
Exclude Expenses related with external sales from Variable cost. Effectively
Min. TP = SP (External) – Selling Expenses
Follow our class note Concept Method

84
Practical considerations when setting the transfer price

Considerations when using the market price

 As mentioned, if a perfectly competitive market exists for the product,
then the market price is the best transfer price.
 However, care must be taken to ensure the division's product is the same
as that offered by the market (for example, quality and delivery terms are
the same). If not, an adjusted market price should be used.
 In addition, the market price should be adjusted for costs not incurred on
an internal transfer, for example, delivery costs and marketing costs.

Considerations when using a cost based approach

 The cost may be:
–the marginal cost – as mentioned, this will be the very minimum the selling
division will accept. This will be preferred by the buying division, i.e. they will
consider the price to be fair.
–the full cost – this will be preferred by the selling division, i.e. they will
consider the price to be fair.
–the opportunity cost – if there is no spare capacity in the selling division, the
opportunity cost should be added to the marginal cost/full cost.
The selling division will want to recognise an element of profit on its transfer
(since it will most probably be a profit centre). Therefore, the final transfer price
can be set at cost + % profit.

Performance Measurement of Not for Profit Organization

A not for profit organization (Hereinafter referred as NFPO) is 'an organization
whose attainment of its prime goal is not assessed by economic measures.
However, in pursuit of that goal it may undertake profit-making activities.'

Objectives of NFP:
NFP organizations have multiple objectives, which are difficult to define: More
objectives that are general for not for profit organizations include:
 Surplus maximization (equivalent to profit maximization)
 Revenue maximization (as for a commercial business)
 Usage maximization (as in leisure centre swimming pool usage)
 Usage targeting (matching the capacity available, as in the NHS)
 Full/partial cost recovery (minimizing subsidy)
 Budget maximization (maximizing what is offered)
 Producer satisfaction maximization (satisfying the wants of staff and
volunteers)

85
  Client satisfaction maximization (the police generating the support of the
public)
It is very difficult to Judge whether Non-Quantifiable objectives have been met
or not?

Performance Measurement of NFPO

Problems associated with PM of NFPO:
1. Multiple objectives: Many not-for-profit organisations are formed for
multiple objectives. The prioritisation of objectives can be a challenging
task.

2. Non-quantifiable Costs and Benefits:

 Benefits may accrue over a longer term:
The expenditure incurred in one year may yield benefits over several
years. A hospital may invest in creating ICU (Intensive Care Units)
facility, the benefit of which will be obtained over multiple years.
Such benefits cannot be measured reliably.

 Benefits can’t be measured:

A large part of benefits derived from the activities of these
organisations are not quantifiable. For example - if a not-for-profit
organisation is formed for providing free education to poor students,
the benefits derived by the students cannot be quantified. In some
cases, an organisation might spend money to provide better
ambulance services to its patient. The benefits of saving lives of
patients cannot be measured in financial terms. Hence, it is difficult to
evaluate performance of not-for-profit organisations using financial
measures.

3. Assessing the use of Funds:

Many NFP organisations, particularly public sector organisations, do not
generate revenue but simply have a fixed budget for spending within which
they have to keep. The funding in public sector organisations tends to
come directly from the government.
The government will be keen to ensure that the funding is put to the best
use. However, it can be difficult to assess whether or not this is the case.

Solution: Assess Value for Money (3E Approach)

Value for money is interpreted as providing an economic, efficient and effective
service. Appropriate performance indicators should be chosen for each ‘E’.

86
1. Economy – an input measure. Are the resources the cheapest possible for the
quality desired? For example, the organization could measure the cost of buying
equipment or the cost of staff.

2. Efficiency – here we link inputs and outputs. Is the maximum output being
achieved from there sources used? For example, the productivity per staff
member may be measured and perhaps benchmarked against an average figure.

3. Effectiveness – an output measure looking at whether objectives are being

met. Different NFP organizations will have different objectives and therefore
the performance indicators will have to be tailored to the individual
organization.

Examples of Economy: Efficiency : effectiveness

3E Hospital School/College
Economy Comparing the standard cost of Comparing the standard cost
drugs used in treatments with of tutors with the actual cost
the actual cost of drugs. of the tutors.
Efficiency Comparing the number of beds Comparing actual tutor
in use in a ward with the number utilisation in hours with
of beds available in the ward. planned tutor utilisation in
hours
Effectiveness Comparing the current waiting Comparing actual exam
time for patients with the desired results (% over a certain
waiting time for patients. grade or percentage passes)
with desired exam results.

87
Question for Reference of VFM
Beeshire Local Authority (BLA) is a local government body which provides a
range of services for the area of Beeshire within the country of Seeland.
Beeshire is a wealthy area within the country with many tourist attractions. One
of BLA's tasks is to ensure that waste is collected from the homes and
businesses in Beeshire. The goal for BLA's waste management department is 'to
maintain Beeshire as a safe, clean and environmentally friendly place
where people and businesses want to both stay in and return to.' The need
for waste collection is linked to public health concerns, the desire to keep the
streets clean and attractive and the desire to increase the amount of rubbish
which is recycled. BLA is funded through a single local tax and does not charge
its residents or businesses separately for most of its services, including waste
collection. There is no public or political appetite for outsourcing services such
as waste management.

Waste collection is performed by the workforce using a fleet of vehicles. The

waste is either taken to recycling plants or else to landfill sites for burying. BLA
obtains revenues from all the recycled waste but this only just covers the cost of
running the recycling facilities.

Against a background estimate that waste will increase by 1% p.a. in the future,
the national government has ordered local authorities, such as BLA, to promote
the recycling of waste and has set a target of 40% of all waste to be recycled by
2015. In order to discourage the creation of non- recyclable waste, the
government has imposed a levy per tonne of waste buried in landfill sites and
has stated that this levy will rise over the next five years in order to encourage
continuing improvement in the amount of recycled waste.
Currently, Seeland is in a long recession and so local authority revenues have
fallen as tax revenues reflect the poor state of the economy. Along with other
local authorities, BLA has tried to cut costs and so has focused on financial
measures of performance. In a recent, private meeting, the chief executive of
BLA was heard to say 'keep costs under control and we will worry about quality
of service only when complaint levels build to an unacceptable level.' As one of
the area's largest employers, cutting staff numbers has been very difficult for
BLA due to the impact on the local economy and the reaction of the residents.
The current performance indicators used at BLA are drawn from the existing
information systems with national figures given for comparison. Those relating
to waste collection for the year ending 31 March 20X4 are:

88
 BLA National
Total cost ($m) 250 2,850
Volume of waste
landfilled (tonnes) 1,250,000 13,750,000
recycled (tonnes) 950,000 9,500,000
total (tonnes) 2,200,000 23,250,000
No. of staff 3,500 39,900
Staff cost ($m) 110 1,190
No. of households 2,380,952 26,190,476
No. of complaints about waste uncollected 18,250 200,750
Frequency of waste collections (days) 14 12

Notes on BLA data:

1. Cost data and no. of households comes from BLA's financial systems.
2. Waste data comes from weighing lorries at the landfill sites and recycling
facilities.
3. Staff data is collected from BLA's HR system.
4. Complaints data is based on numbers of letters and phone calls to the waste
management department.
5. Frequency of collection data is obtained from the department's vehicle
schedules.
Explain how the value for money provision of waste services by BLA should be
assessed by suggesting and calculating justified performance indicators using
the information in the scenario?

Solution:

Value for money

The extent to which BLA provides value for money services should be assessed
in relation to: Economy – the extent to which services of an acceptable quality
are provided at the cheapest cost possible.
Efficiency – the way BLA's services are organised, to ensure that the
department maximises the benefits and ouptut’s it obtains from its resources

Effectiveness – the extent to which the waste services department's activities

achieve its goals. Possible performance indicators at BLA

Economy
BLA's staff costs account for 44% of its total costs, and so the extent to which
BLA controls its staff costs will have a significant impact on the economy of its
services.

89
The average salary for BLA's waste collection staff is $31,429 compared to the
national average of $29,825. The fact that BLA's average salary exceeds the
national average suggests its services are not being provided as economically as
they could be. However, this may reflect the fact that Beeshire is a wealthy area,
so wage levels in general may be higher there than in other parts of the country.
Equally, though, by paying above the national average for staff, BLA may be
able to recruit more experienced or higher quality staff. As a result, this could
improve its efficiency.

Another significant cost driver for BLA is likely to be its fleet of vehicles.
Therefore, it could also measure economy in relation to the costs it pays for its
vehicles, their fuel and their maintenance.

Efficiency
Benchmarking the performance of BLA's waste collections against the national
figures indicates that BLA is relatively efficient:

BLA Nationally
Tonnes of waste collected per member of staff 629 583
Cost per tonne of waste collected ($) 114 123
Staff cost per tonne of waste collected ($) 50 51

This supports the point we made earlier: that although BLA's average salary is
above the national average, BLA benefits from the greater efficiency of its staff.

Effectiveness
Effectiveness needs to be measured against a variety of aspects, linked to the
need for waste collection:

Public health concerns – The fact that waste is only collected every 14 days
(compared to the national average of 12 days) could suggest that BLA is less
effective in maintaining public health. However, the level of public health
concerns could also be measured by the number of complaints about vermin or
other problems related to waste. If the level of complaints BLA receives is in
line with national average (or below it) there would seem to be little reason to
increase the frequency of the collections it carries out.

Clean and attractive streets – Finding a way to measure the cleanliness of

BLA's streets could be difficult, because 'cleanliness' is inherently subjective,
and therefore difficult to quantify. However, BLA could use the number of
complaints it receives from residents or businesses as an indirect measure. If the
number of complaints is relatively low, this would suggest that the cleanliness
of the streets is being maintained at an acceptable level.

90
Increased recycling – The government has set a target of 40% of all waste to
be recycled, therefore BLA needs to measure the percentage of its total waste it
recycles. It currently recycles 43% of all waste collected (950,000 / 2.2m). As
such, BLA has already achieved the target level, and the proportion of waste it
recycles is above the national average (41%).

Nonetheless, as the government is planning to increase the levy charged on

landfill, it will be important for BLA to ensure the proportion of waste that it
recycles is as high as possible. As such, this remains an important indicator to
monitor.

Case Scenario: Read Only VFM Part (Class Discussed)

Cure Hospital is running under private-public-partnership (PPP) model -
providing treatment for non-communicable diseases. ABCO Hospitals Limited
is the private partner which runs a chain of hospitals on profit basis in major
cities in India. The public partner is the State Government. Cure Hospital is a
"not- for-profit" hospital.
Private partner is to invest in Upgrading and equipping the facility and
responsible for operational management and service delivery. Government
to provide physical space and other infrastructure in “as is where is”
condition, provide support facilities and hospital amenities. Private partner
assumes the entire responsibility, for a full range of investment operation
and maintenance functions. Private partner has the authority to make daily
management decisions.
The hospital is funded to a great extent by the State Government and a fixed
level of funding is received from the government each year out of the State
budgetary allocation. It is up to the hospital to allocate this fund to different
areas such as doctors' and other staff salaries, medicines and all other costs
required to run a hospital.
Cure Hospital's objectives are:
 to give prompt access to high quality medical treatment for patients.
 to provide free treatment to poor patients in line with government
policy of inclusive development.
 to provide value for money for the taxpayer-measured by the 3 Es
framework of Economy, Efficiency and Effectiveness.
 to contribute to medical science by developing innovative ways to
deliver treatment to patients.

91
Except select surgeries, all services are free for poor patients that are below
poverty line (BPL) card holders. 40% beds are reserved for poor patients. Free
out patient department (OPD) services to poor. CT Scan and MRI diagnostics
are free for poor patients, subsidised rates for others. Cure Hospital also runs a
generic medicine shop inside the hospital premises which sells medicines to all
patients at discount ranging from 40% to 56% - the only shop of this kind in the
city.

WHO has agreed to provide financial and technical support to the neonatal care
unit. The hospital enabled it to obtain five accreditation certificates from various
leading authorities on different aspects of hospital management.
Feedback is taken from each in-patient about the quality of service provided by
the hospital and the satisfaction level is taken in 1 to 10 point scale. 1 being the
least satisfied and 10 represents totally satisfied.

In a recent meeting of the managing committee of the hospital, discussions were

held about inadequate performance measurement systems in place to assess
whether the hospital is achieving its objectives and that insufficient attention is
given to the importance of non-financial performance indicators.

A four member team consisting of a performance management expert and three

senior doctors was created to give their advice in these aspects.
The four member team met with doctors, staff and other stakeholders at length
and breadth. Some of the conversations were as below:

Doctor A: I think the hospital always deliver value for money. We have always
achieved our total financial budgets.

Doctor B: We work here much longer hours than doctors in other hospitals,
often without being paid for working overtime.

Doctor C: There is not enough government and private partner funding to

recruit more doctors and paramedic staff.
Doctor D: Number of out-patients has increased considerably. Earlier an out-
patient had to wait for an average period of 2 hours 20 minutes and now the
same has increased to 3 hours.

Senior Doctor K: I do not know how much time we spend developing

innovative ways to deliver treatment to patients though, as most of the
performance data we doctors receive relates to financial targets.

In-patient H: Incompetent paramedic staff, poor quality of food and bed linen.
Staff M: Management undermines our role in running the hospital.

92
Recent performance data of the hospital vis-a-vis national average are as
follows:
Cure Hospital National
average of
other PPP run
hospitals
Number of doctors 80 76
Average doctors' salaries per month ` 1,20,000 1,60,000
including overtime
Average doctors' salaries including ` 1,20,000 1,25 000
overtime as per budget
Number of in-patients treated 8,360 6,369
Average satisfaction rating of in- patients 6 9
Number of patients readmitted for 627 128
treatment of the same ailment within short
period of time after discharge from the
hospital
Average staff satisfaction rating (0% 16% 86%
represents totally dissatisfied and 100%
represents totally satisfied)
Number of out-patients treated 76,212 63,318
(a) EXPLAIN why non-financial performance indicators are particularly
important to measure the performance of "not-for-profit" organisations
such as Cure Hospitals. (4 Marks)
(b) EVALUATE whether Cure Hospital is delivering value for money for each
of the components of the value for money framework. (12 Marks)
(c) The CEO of the hospital intends to introduce a nominal fee for out-patient
treatment given to poor patients and remove subsidised rate of CT Scan
and MRI diagnostic for other patients in order to achieve its objectives in a
better way. EVALUATE the proposal of the CEO. (4 Marks)
Solution: As per ICAI Suggested Answer:
(a) Cure Hospital has been formed in a public-private partnership to provide
quality healthcare to the public, with focus on the poorer sections of the
society. Healthcare service is provided for free, except for select surgeries.
A sufficient portion of its capacity (hospital beds) is reserved entirely for
Below Poverty Line (BPL) patients. Generic medicines are provided at a
discounted price, to make them more affordable. World Health
Organization (WHO) has decided to fund its neo-natal unit. With all this
information, it can be summarized that Cure Hospital has been formed

93
 “not-for-profit” objective, attending to a social cause of providing quality
healthcare to the economically poorer sections of the society.

Cure Hospital has been formed in partnership with ABCO Hospitals Ltd.
and the State Government. The State Government has provided physical
space, infrastructure, other support facilities and hospital amenities. ABCO
Hospital, the private partner has the entire responsibility of taking care of
allocation of funds, investment, operations, and maintenance functions.
Daily management decisions are also handled by the private partner.

Since the Government has provided substantial funding and facilities to

Cure Hospital, it owes a fiduciary responsibility of reporting the financial
measures to its stakeholders, the government in this case. At the same time,
financial measures alone are not enough to assess the performance of not-
for-profit organizations. Due to its objective of public service,
measurement of appropriate non- financial metrics are equally important.
The reasons are:

(i) Benefits cannot be quantified: Cure Hospital essentially provides public

healthcare service to the economically weaker sections of the society. Due
to political, legal, and social reasons, not-for-profit organizations like Cure
Hospital cannot be shut down merely for not being economically /
financially viable. Therefore, financial measures are less relevant. Due to
its non-financial objective, appropriate non-financial measures become
more important. For example, the benefits of saving lives cannot be
quantified in financial terms.

(ii) Benefits may accrue over long term: The expenditure incurred in one year
may yield benefits over several years. For example, the investment in an
Intensive Care Unit (ICU) facility may accrue of multiple years. Neonatal
care unit have been given financial and technical support from WHO
which will give long term benefits to hospital.

(iii) Measurement of utilization of funds and expenditure: In the case of Cure

Hospitals, many hospital services are free, allocation of capacity is aimed
at providing free service to the BPL section of the society, medicines are
provided at discounted rates. Therefore, Cure Hospital does not have a
substantial revenue stream to earn from its patients. It gets a fixed budget
allocation from the State Government, while ADCO Hospital allocates
these funds for various investments and expenditures. The assessment
whether the spending have been appropriate is a key challenge. Defining
cost per unit would be subjective since it could be cost of patients arriving

94
 at the hospital or cost of patients successfully treated at the hospital. Either
figure could be tweaked to make it seem that the objectives are being met.
The management may resort to rampant spending simply to meet the
expenditure targets. Therefore, non-financial measure need to be put in
place help stakeholders scrutinize whether the objectives for which funds
have been given are being met.
(iv) Multiple objectives: Not-for-profit organizations have multiple objectives.
It may be unclear which are the most important. Cure Hospital aims at
providing high quality treatment to its patients while also developing
innovative ways to deliver treatment to its patients. Both objectives are
equally important and inter-related. Non-financial measures provide better
information about how each of these objectives have been met.
The benefits of organizations like Cure Hospital are non-financial in
nature. Except for providing fiduciary information to the stakeholders,
all other objectives of Cure Hospital can be measure only using non-
financial measures.
(b) Value for money for Cure Hospital would comprise of the 3Es: Economy,
Efficiency and Effectiveness.
 Economy: Has the desired output (and quality of service) been achieved
at the lowest cost?

The medical resource at Cure Hospital in terms of doctors is 80, higher

than the national average of 76 at other centers. Doctor’s salaries would
be a significant expenditure for Cure Hospital. The average doctor’s
salary at Cure Hospital (including overtime) is `120,000 per month,
this is within the budget figure as pointed out by Doctor A. The
salary is lower than the national average at other PPP run hospitals,
where doctors earn `160,000 per month. Therefore, economy of
money is being achieved at Cure Hospital. The relatively lower levels of
salary could be due to differences in levels of experience or that the
doctors at Cure Hospital work overtime without getting paid (as pointed
out by Doctor B). This may be one of the reasons why staff satisfaction
is only 16% compared to 86% in other centers.

 Efficiency: Has maximum output been achieved with the minimum

resources?
Treating patients is the key objective of Cure Hospitals, while doctors are the
main resource to deliver it. The number of patients treated per year is a good
measure of efficiency achieved.

95
Cure Hospital treats 84,572 patients (in house patient 8,360 + outpatient
76,212) while the national average at other centers is only 69,687 (in house
patient 6,369 + outpatient63,318). Cure Hospital has 80 doctors as
compared to 76 national average. Therefore, each doctor at Cure Hospital
treats 1,057 patients (84,572 patients/ 80 doctors) as compared to 917
patients (69,687 patients / 67 doctors) at other centers. Resource utilization
of its pool of doctors is higher in Cure Hospital.
Doctor C mentions that there is not enough funding to hire more doctors and
para- medic staff. Therefore, there is a constraint on the limited resources of
doctors and support staff.
This might be the reason, why each doctor at Cure Hospital works longer than
colleagues at other centers.
Therefore, while efficiency in terms of number of patients treated by each
doctor is high, there are other hidden costs that need to be taken into account.
Few such costs could be low employee morale, higher waiting time of patients
to receive treatment. This impacts the effectiveness of service provided.
 Effectiveness: Has Cure Hospital achieved its mission or objective? Cure
Hospital has the objective of providing high quality medical service to its
patients. Better quality of treatment would ensure that re-admission for
treatment of the same ailment within a short span of time would be minimal.
Number of such re- admitted patients in much higher at 627 at Cure
Hospital as compared to 128 at other centers. Assuming all such re-
admissions to be in-house patients, this return of patients for medical care
for the same ailment within a short span of time is 7.50% compared to the
national average of 2.01%. Prompt medical treatment can also be questioned
since the waiting time of patients to receive treatment has increased from 2
hours 20 minutes to 3 hours.

Senior Doctor K points out the time spent on delivering innovative care to
patients may be limited due to financial constraints and overwork staff. All
this would have resulted in dissatisfaction among patients, whose survey
indicates a score of 6 against a national average of 9. This shows that
objective of Cure Hospital is not being met effectively.

To summarize, Cure Hospital is achieving economy by maintaining lower

salaries for doctors. Out-reach to patients is also high as compared to
national average. However, due to limited availability of resources, doctors
and staff are overworked. While it does well on the efficiency aspect, it
comes with a hidden cost in terms of dissatisfaction among patients and
employees and low quality of medical care. Therefore, medical treatment is
not effective, which is an important aspect in the value for money
framework.

96
 (c) BALANCED SCORECARD
Kaplan and Norton’s balanced scorecard was designed to be used as strategic
performance measurement and
management framework. It provides a
framework which can be utilised to
develop a multi-dimensional set of
performance measures for strategic
control of the business.
The balanced scorecard includes:
 financial measures (these reveal
the results of actions already
taken)
 non-financial measures (these are
drivers of future financial performance)
 external as well as internal information.

Perspective Basic Question Identifying Performance target

Customer What do existing and Gives rise to targets that matter to
new customers: cost, quality, delivery,
customers value from us? inspection, handling, and so on
Internal What processes must we Aims to improve internal processes
Business excel at to achieve our and decision making
financial and customer
objectives?
Learning Can we continue to Considers the business's capacity to
and Growth improve and create future maintain its competitive position
value? through the acquisition of new skills
and the development of new products
Financial How do we create value Covers traditional measures such as
for our shareholders? growth, profitability and shareholder
value but set through talking to the
shareholder or shareholders directly

97
Examples for Different type of Business as follows:
1. Brewery

2. E-commerce Dealer

98
3. Jewellery Shop

Case Study: CS -12: ICAI SCM Material

Case Study / Practice Question: KPLN-SM-TYU -383PN
Jump is a listed business operating a chain of quality health clubs in a European
country. The company has a strong reputation for the quality of its service but
there are a number of other health clubs operating in the country and the market
is fiercely competitive.

The country in which Jump is located is currently in recession. Consumer

spending is falling throughout the economy and there is no immediate
likelihood of a resumption of growth. Appendix 1 shows the financial data for
Jump for the past two years.

Jump’s Chief Executive Officer (CEO) has recently conducted a strategic

review of the business in the context of the current economic recession. He has
identified the following strategy as critical for Jump’s success:
(1) Focus on key customers.
(2) Ensure Jump’s offerings meet the needs of these customers.
(3) Reduce or eliminate costs, which do not address the needs of these
customers.
(4) Build for the future using a programme of sustainable development.

Jump recognizes that it operates in a highly competitive environment and

periodically monitors its share of the market and compares its prices with those
of its competitors. The CEO has identified the need to operate a more
systematic method of performance improvement. To this end, he believes that

99
competitor benchmarking is necessary and has information that at least one of
Jump’s main competitors benchmark already.
Appendix 2 contains data analysing Jump and its two main competitors; Fitness
Matters and Active First.

Appendix 1: Financial data for Jump

20X0 20X1
€m €m
Operating profit 51.9 42.7
Interest 4.2 6.1
Profit before tax 47.7 36.6
Profit for the year 37.2 26.3
EVA 20.6 7.2

20X0 20X1
Average number of shares in issue 140 million 140 million
Stock market information:
Country's market index 1,020. 7 704.3
Health club sector index 1,711.3 1,320.3
Jump's average share price €1.22 €1.03

Appendix 2: Comparative data

Fitness Matters Active First Jump
20X0 20X1 20X0 20X1 20X0 20X1
Revenue €m 246 239 521 508 483 522
Profit for the year €m 19.3 17.4 40.4 25.9 37.2 26.3
No. of health clubs 18 20 26 35 20 21
Market share 12.4% 12.2% 16.9% 15.6% 16.0% 16.0%
Revenue per health 13.7 12.0 20.0 14.5 24.2 24.9
club €m

(a) Describe the different perspectives of the balanced scorecard showing

how the new strategy as outlined by the CEO links to these perspectives.
Suggest appropriate performance measures for Jump for each of the
detailed points within the strategy.

(b) Assess the financial performance of the company using share price, EPS
and EVA. Critically evaluate the use of these performance metrics and
how they may affect management behaviour.

(c) Prepare a report for the board on a bench marking exercise using the
information given in appendix 2.

100
 (i) Evaluate the benefits and difficulties of benchmarking in this
situation.
(ii) Evaluate the performance of Jump using the data given in the
question. Conclude as to the performance of the company.

Case Study: APM-BPP-49

Pharmaceutical Technologies Co (PT) is a developer and manufacturer of
medical drugs in Beeland. It is one of the 100 largest listed companies on
the national stock exchange. The company focuses on buying prospective
drugs (which have shown initial promise in testing) from small bio-
engineering companies. PT then leads these drugs through three
regulatory stages to launch in the general medical market.
The three stages are:

(1) to confirm the safety of the drug (does it harm humans?), in small
scale trials; (2) to test the efficacy of the product (does it help cure?),
again in small scale trials; and (3) finally, large scale trials to definitively
decide on the safety and efficacy of the product. The drugs are then
marketed through the company's large sales force to health care providers
and end users (patients). The health care providers are paid by either
health insurance companies or the national government dependent on the
financial status of the patient.

The Beeland Drug Regulator (BDR) oversees this testing process and
makes the final judgement about whether a product can be sold in the
country.

Its objectives are to protect, promote and improve public health by

ensuring that:

 medicines have an acceptable balance of benefit and risk;
 the users of these medicines understand this risk-benefit profile; and
 new beneficial product development is encouraged.

The regulator is governed by a board of trustees appointed by the government. It

is funded directly by the government and also through fees charged to drug
companies when granting licences to sell their products in Beeland.

PT has used share price and earnings per share as its principal measures of
performance to date. However, the share price has underperformed the market
and the health sector in the last two years. The chief executive officer (CEO)
has identified that these measures are too narrow and is considering
implementing a balanced scorecard approach to address this problem.
101
A working group has drawn up a suggested balanced scorecard. It began by
identifying the objectives from the board's medium-term strategy:
 Create shareholder value by bringing commercially viable drugs to
market
 Improve the efficiency of drug development
 Increase shareholder value by innovation in the drug approval process

The working group then considered the stakeholder perspectives:

 Shareholders want a competitive return on their investment
 Payers / Purchasers (governments, insurers and patients) want to pay a
reasonable price for the drugs
 Regulators want an efficient process for the validation of drugs
 Doctors want safe and effective drug products
 Patients want to be cured

Finally, this leads to the proposed scorecard of performance measures:

(i) Financial – share price and earnings per share
(ii) Customer – number of patients using PT products
(iii) Internal business process – exceed industry-standard on design and
testing; time to regulatory approval of a product
(iv) Learning and growth – training days undertaken by staff; time to market
of new product; percentage of drugs bought by PT that gain final
approval

The balanced scorecard now needs to be reviewed to ensure that it will address
the company's objectives and the issues that it faces in its business environment.
Evaluate the performance measures proposed for PT's balanced scorecard

Questions ON BSC:
1. Faster Pasta is an Italian fast food restaurant that specialises in high
quality, moderately priced authentic Italian pasta dishes and pizzas. The
restaurant has recently decided to implement a balanced scorecard
approach and has established the following relevant goals for each
perspective:

102
 Perspective Goal
Customer  To increase the number of new and
returning customers
 To reduce the % of customer complaints
Internal  To reduce the time taken between taking a
customer's order and delivering the meal to
the customer.
 To reduce staff turnover
Learning and  To increase the proportion of revenue from
Growth new Dishes
 To increase the % of staff time spent on
training
Financial  To increase spend per customer
 To increase gross profit margin

The following information is also available for the year just ended and for the
previous year.
Particulars 2018 2019
Total Customers 11,600 12,000
- New customers 4,400 4,750
- Existing customers 7,200 7,250
Customer Complaint 464 840
Time between taking order and customer 4 Mins 13 Mins
receiving meal
% staff turnover 12% 40%
% time staff spend training 5% 2%
Revenue 110,000 132,000
- From New dishes 22,000 39,600
- From Existing Dishes 88,000 92,400
Gross Profit 22,000 30,360
Using appropriate measures, calculate and comment on whether or not Faster
Pasta has achieved its goals (MA – KPLN- Ill. 5 PNO555)

2. Jamair - PM – BPP/RK – 250- 254

Jamair is one of a growing number of low-cost airlines in the country of
Shania. Jamair's strategy is to operate as a low-cost, high efficiency airline.
The airline was given an 'on time arrival' ranking of seventh best by the
country's aviation authority, who rank all 50 of the country's airlines based
on the number of flights which arrive on time at their destinations. The
average 'ground turnaround time' for airlines in Shania is 50 minutes,
meaning that, on average, planes are on the ground for cleaning, refuelling,
etc for 50 minutes before departing again.

103
 The number of passengers carried by the airline has grown from 300,000
passengers on a total of 3,428 flights in 2007 to 920,000 passengers on
7,650 flights in 2013.

The overall growth of the airline has been helped by the limited route
licensing policy of the Shanian government, which has given Jamair
almost monopoly status on some of its routes. However, the government is
now set to change this policy with almost immediate effect, and it has
become more important than ever to monitor performance effectively.

a. The ________ perspective considers whether the management in Jamair

meets the expectations of its shareholders and how it creates value for
them. Which of the following words is missing from the above statement?
A) Customer B) Internal business C) Innovation and learning D) Financial

b. The following performance measure has been suggested for Jamair:

Improve on the 'on time arrival' ranking of seventh best in the country's
aviation authority ratings.
To which perspective of the balanced scorecard does this measure belong?

c. The following performance objective has been suggested for Jamair:

Improve the turnaround time on the ground
To which perspective of the balanced scorecard does this objective belong?

d. The following performance objective has been suggested for Jamair:

Increase seat revenue per plane
To which perspective of the balanced scorecard does this objective belong?

3. Squarize is a large company which started as a pay-TV broadcaster and

then started offering broadband and telephone services to its pay-TV
customers. Customers could take advantage of discounts for 'bundle'
packages of all three services.
All contracts to customers of Squarize are for a minimum three-month
period. The pay-TV box is sold to the customer at the beginning of the
contract; however, the broadband and telephone equipment is only rented
to them.
In the first few years after product bundling was introduced, the company
saw a steady increase in profits. Then, Squarize saw its revenues and
operating profits fall. Several reasons were identified for the deterioration
of results:

104
(1) In a bid to save cash, many pay-TV customers were cancelling their
contracts after the minimum three month period as they were then able
to still keep the pay-TV box. The box comes with a number of free
channels, which the customer can still continue to receive free of charge,
even after the cancellation of their contract.
(2) Some bundle customers found that the broadband service that they had
subscribed to did not work. As a result, they were immediately
cancelling their contracts for all services within the 14 day cancellation
period permitted under the contracts.
In a response to the above problems and in an attempt to increase revenues
and profits, Squarize made the following changes to the business:
(i) It made a strategic decision to withdraw the bundle package from
the market and, instead, offer each service as a standalone product.

(ii) It investigated and resolved the problem with customers' broadband

service. It is now one year since the changes were made and the
finance director wants to use a balanced scorecard to assess the
extent to which the changes have been successful in improving the
performance of the business.

a. The following performance objective has been suggested for

Squarize:
Reduce the number of contracts cancelled due to the broadband
service not working
To which perspective of the balanced scorecard does this objective
belong?
b. The following performance measure has been suggested for Squarize:
Volume of sales to new customers for each product/service
To which perspective of the balanced scorecard does this measure
belong?
c. Which of the following would be the most suitable measure of
performance from the innovation and learning perspective in Squarize
balanced scorecard?
A Development cost per new standalone service
B Sales revenue per new standalone service
C Sales revenue from new standalone service as a percentage of
total revenue
D Sales revenue per hour worked on new standalone service

105
 d. Which of the following is most likely to be used as a measure of
performance from the customer perspective in Squarize balanced
scorecard?
A Increase in size of the product range
B Percentage of customers renewing their subscription or making
repeat orders
C Number of orders won per sales representative
D Speed of processing an order

RTP Nov-19
B. Steels is a leading manufacturer of flat and long products and have state-of
the-art plants. These plants manufacture value added products covering entire
steel value chain right from coal mining to manufacturing Pig Iron, Billets, HR
Coils, Black Pipe/GI Pipe, Cable Tapes etc. conforming to international
standards. The rock-solid foundation combined with nonstop upgradation and
innovation has enabled the B. Steels to surpass its goals constantly. Its vision
and values for sustainable growth is balancing economic prosperity and social
equality while caring for the planet. It is preparing its balanced scorecard for the
year 2018-19. It has identified the following specific objectives for the four
perspectives.
 Improve post-sales  Improve employee  Improve employee
service morale job satisfaction
 Increase gross margin  Increase number of  Increase profitability
customers of core product line
 Increase plant safety  Increase plant
safety

B. Steels has collected Key Performance Indicators (KPIs) to measure progress

towards achieving its specific objectives. The KPIs and corresponding data
collected for the year 2018-19 are as follows:
Key Performance Indicator Goal Actual
Average replacement time (number of days) 2 1.5
Gross margin growth percentage 15% 16%
Number of customers 15,000 15,600
Number of plant accidents 0 2
Percentage of repeat customers 83% 81%
Core product line profit as a percentage of core- 5% 4.4%
product line sales
Employee turnover rate (number of employees 2% 3%
leaving/ Average number of total employees)
Employees satisfaction rating (1-5, with 1 being the 1 1.2
most satisfied)

106
For preparation of Balanced Scorecard report, the following format has been
developed:

Required
(i) PREPARE a balanced scorecard report using the above-mentioned format.
Place objective under the appropriate perspective heading in the report.
Select a KPI from the list of KPIs that would be appropriate to measure
progress towards each objective.

(ii) B. Steels desires to integrate sustainability and corporate social

responsibility related KPIs in their balance scorecard to adhere vision and
values. ADVISE B. Steels, using TBL framework.

4. “Hard Rock Coconut” is an exclusive resort located in a famous Island of

Pacific Ocean that vows to isolate its guests from the hustle and bustle of
everyday life. Its leading principle is “all contemporary amenity wrapped
in old-world charisma”. Each of the resort’s 18 villas has a separate theme
like Castle, Majestic, Ambassador, Royal Chateau, Coconut, Lemon,
Balinese etc. and guests often ask for a specific villa when they make
reservations. Villas are Ideal for families or friends travelling together and
these villas feature luxurious accommodation spanning two floors. Since it
is located within a 300-acre estate on white sand beach, the resort offers its
guests a wide variety of outdoor activities such as horse back riding,
hiking, diving, snorkeling, sailing, golf and so on. Guests could also while
away the day relaxing in the pool and availing themselves of the resort’s
world-famous spa “HardCoco Spa”. The dining room, which only has
three tables for the public, is acceptable proud of its 4-star rating.
Required
Develop a Balanced Scorecard for “Hard Rock Coconut”. It is sufficient to
give two measures in each of the four perspectives.

107
Answer:
Financial Perspective Economic Value Added
Revenue per villa
Customer Perspective % repeat customers
Number of customer complaints
Internal Business Service rating of spa
Staff hours per guest
% cost spent for maintenance
Travel guide rank for restaurant
Innovation and Employee retention
Learning
Number of new services offered

5. ABC Ltd. has supermarkets located in most towns and cities. Over the last
few years, profits have fallen. ABC Ltd. has recognized that customer care
has been paid insufficient attention. ABC Ltd. has now realized the
importance of the customer experience at its supermarkets.

ABC Ltd. has introduced a loyalty card scheme that rewards customers
with discount vouchers based on their spend and buying patterns at
supermarkets in an attempt to earn the loyalty of its customers.
The management of ABC Ltd. is considering the introduction of a
Balanced Scorecard approach to manage the performance of its stores.

Required
Recommend an objective and a suitable performance measure for each of
three non-financial perspectives of a Balanced Scorecard that ABC Ltd.
could use to support its new strategy of improving the customer
experience. You should state three perspectives, an objective and a
performance measure for each one of the three perspectives.

108
Answer:
Non- Objective Performance Measure
Financial
Perspective
Customer Increase the customer loyalty. Percentage of customers
Perspective Or using loyalty cards. Or
Retaining the existing No. of discount vouchers
customers redeemed.
Internal For customers to pay for goods Time spent by customers in
Business in a reasonable time. queuing to pay for products
Perspectives Or at a check out.
Paying proper attention to the Or
customers and their product Time spent by customers
enquiries. care executives in handling
Or customers queries.
Provide necessary support to Or
the existing loyal customers. No. of times home delivery
made.
Learning & To have qualified staffs able to No. of staff training days.
Growth meet the needs of the customer. Or
Perspectives Or No. of schemes launched.
Adding new products for new
segments.

6. Classify the following measures under appropriate categories in a Balanced

Scorecard for a banking company which excels in it s home loan products:
i. A new product related to life insurance is being considered for a tie up
with the successful housing loan disbursements.
e.g. every housing loan applicant to be advised to take a life policy or
compelled to take a fire insurance policy.
ii. How different sectors of housing loans with different interest rates
have been sanctioned, their volumes of growth in the past 4 quarters.
iii. How many days are taken to service a loan, how many loans have
taken longer, what additional loans are to be released soon, etc.

Solution
(i) New Product tie up --- Innovation / Learning Perspective
(ii) Growth of Volume --- Financial Perspective
(iii) Time for Loan / Fresh Products --- Customer Perspective

109
7. Your Bank Ltd., was established on the 30th September, 1940 under the
provisions of Co- operative Societies Act by the eminent professionals to
encourage self-help, thrift, cooperation among members. Bank was issued
Banking License under Banking Regulation Act, 1949 on October 25,
1986 to carry out the Banking Business within the national capital and
since then the Bank has been growing continuously. At present, Bank has
large number of membership of individuals from different sections. The
Bank has 12 branches in the NCT of Delhi. Bank offers ‘traditional counter
service’. Opening hours are designed to coincide with local market days.
Board of Directors were worried from growing popularity of new style
banks. These banks offer diverse range of services such as direct access to
executive management, a single point of contact to coordinate all banking
needs, appointment banking to save time, free online banking services
24/7, free unlimited ATM access etc.
It has now been decided that the bank will focus on “What Customers
Want” and will use a balanced scorecard to achieve this goal.
Required
Produce, for each of the three non-financial perspectives of a ‘Balanced
Scorecard’, an objective and a performance measure that the bank could
use with appropriate reason.
Solution:
a) Internal Business Process Perspective
Objective: Cross-sell Products
Measure: Products Purchased per customer
Reason: Cross-selling, or encouragement customers to purchase additional
products e.g. insurance, forex etc. is a measure of customer satisfaction.
Only if a service is perceived as highly satisfactory the service would be
repeated/ additional products or services would be accepted.

b) Learning and Growth Perspective

Objective: Increase the Number of New Products or Services Sold
Measure: Number of Customers Buying the New Products/ New Services
Reason: Long term financial success requires bank to create new products /
services(e.g. internet banking, ATM access) that will meet emerging needs
of current / future customers such as 24/7 banking.

110
c) Customer Perspective
Objective: Increase Customer Loyalty
Measure: Number of Accounts Closed or Closure Request Received
Reason: Customer loyalty describes the extent to which bank maintains
durable relations to its customers. The share of existing customers should
have a high importance as it indicates about image and reputation. Closure
request is not a good sign for bank. Bank should investigate reasons for the
same and take appropriate actions to improve services offered to retain
customers.
8. Balanced Scorecard- Credit Card Company AEB Banking Corp. is the
world's largest card issuer by purchase volume and having vision statement
“to be leading provider of payment solutions in India”. Required Suggest
performance indicators to include in the Balanced Scorecard. Solution:

9. Standard Telecom Ltd. is a leading cellular service provider having a

global presence. It aims to be the most innovative and trusted telecom
company in the world. To achieve this aim, it is constantly working on its
overall functioning. It is trying to adopt best managements practices in the
world. Following are some information related to the company’s
performance for a particular period:

Particulars Current Base Target

Year Year
Operating Ratio 60% 54% Reduce it to 50%
Average Revenue per user ` 225 ` 210 Increase it to `250
Unresolved Consumer 27,500 25,000 Reduce it by 20%
Complaints
Customer Relationship Centres 280 200 Take the total to
250
Employee Coverage under 10% 8% At least 15%
Training Programme

111
Evaluate the performance of the company using Balance Scorecard approach.
Solution:

The balanced scorecard is a method which displays organisation’s performance

into four dimensions namely financial, customer, internal and innovation. The
four dimensions acknowledge the interest of shareholders, customers and
employees taking into account of both long-term and short-term goals. The
detailed analysis of performance of the company using Balance Scorecard
approach as follows:

(i) Financial Perspective: Operating ratio and average revenue will be covered
in this prospective. Company is unable to achieve its target of reducing
operating ratio to 50% instead it has increased to 60%. Company is required to
take appropriate steps to control and manage its operating expenses. Average
revenue per user has increased from ` 210 to ` 225 but remains short of targeted
` 250. This is also one of the reasons of swelled operating ratio. Company can
boost up its average revenue per user either by increasing the price of its
services or by providing more paid value added services.

(ii) Customer Perspective: Service complaints will be covered under this

perspective. The company had set a target of reducing unresolved complaints by
20% instead unresolved complaints have risen by 10%[(27,500-
25,000)/(25,000) × 100]. It shows dissatisfaction is increasing among the
consumers which would adversely impact the consumer’s general perception
about the company and company may lose its consumers in long run.

(iii)Internal Business Perspective: Establishing customer relationship centres

will be covered under this perspective. Company has established 80 relationship
centres in the current period exceeding its target of 50 (250-200) to cater to the
needs of existing consumers as well as soliciting new consumers. This shows
the seriousness of the company towards the consumer satisfaction and would
help them in the long run.

(iv)Learning and Growth Perspective: Employee training programmes are

covered under this perspective. Company had set a target to cover at least 15%
employee under its training programmes but covered only 10%. This could hurt
capabilities of the employees which are needed for long term growth of the
organisation necessary to achieve the objectives set in the previous three
perspectives. People or the human resource of the company is one of the three
principle sources where organisational learning and growth comes

112
 (d) THE BUILDING BLOCK MODEL
Fitzgerald and Moon have developed an approach to improving the performance
measurement system in service organizations. It suggests that the performance
measurement system should be based on the three building blocks of
dimensions, standards, and rewards.
Dimensions of Performance:
are the aspects of performance that are measured. Fitzgerald and Moon
suggested that there are six aspects to performance measurement that link
performance to corporate strategy.
Dimension Meaning Type of Measures
Results Financial It give an indication of  Profitability
Performance overall business at a glance  Liquidity
in monetary terms. These  Capital Structure
indication can be used to  Market Ratios
identify the areas of
strengths and weaknesses.
Competitiv- How they stand in  Relative Market
eness comparison to its Share and Position
competitors? How are the  Sales Growth
different from their  Measures of the
competitors? Ex, offering of Customer Base
products of higher quality (Retention rate of
than competitors and customers)
products having distinct  Success rate of
features than rival products. converting
enquiries into
sales
Determin Quality of It is the ability to deliver  Reliability
ants Service goods and service with  Responsiveness
consistency. Quality should  Aesthetics/appear
be judged from eyes of the ance
customers. Quality is the  Communication
level of benefits customers  Cleanliness/tidine
expects from the product. ss
Quality should be enough  Comfort
for a product price paid.
 Friendliness
 Courtesy
 Competence
 Number of
complaints

113
  Customer
satisfaction, as
revealed by
customer opinion
surveys
Flexibility It is the responsiveness to  Volume Flexibility
change in the factor  Delivery Speed
influencing the business Flexibility
performance. Ex, ability to  Specification
cope with sudden increase Flexibility
in sales demand.  Mix of different
types of work done
by employees
 Speed in
responding to
customer requests
Resource It is the ability to use  Productivity
Utilization resources to achieve  Efficiency
business objectives.  Capacity
Business assets should be utilisation rates
used for the proper purpose
and in most efficient way
Innovation Ability of the business to  Performance of the
devise new products and Innovation Process
new ways of doing things.  Performance of
Like packaging of products Individual
with environment friendly Innovations
(recyclable) material.

Standards:
The second part of Fitzgerald and Moon's framework for performance
measurement concerns setting the standards or targets of performance, once the
measures for the dimensions of performance have been selected.
There are three aspects to setting standards of performance.
1. Individuals need to feel that they 'own' the standards and targets for
which they will be made responsible.
2. Individuals also need to feel that the targets or standards are realistic
and achievable.
3. The standards and targets should be seen as 'fair' and equitable for all
the managers in the organization.

114
In Other Words,
Equity- Performance measures should be equally challenging for all parts of
business. Relaxation given to one part of the business leads to perception of
unfair treatment which hinders productivity.

Ownership- Performance measure should be acceptable to everyone.

Employees should be got involved in the identification of measures rather than
being imposed on them. Ownership means here is responsibility for the results.

Achievable- Performance measure should be realistic. Ex, using actual results

for the competitors to set as target. Employee will not be motivated to achieve
targets if consider them impossible.

Rewards
This refers to the structure of the rewards system, and how individuals will be
rewarded for the successful achievement of performance targets.
There are three aspects to consider in a reward system.

1. The system of setting targets and rewarding individuals for achieving

the targets should be clear. Clarity will improve the motivation to
achieve the targets.
2. Achievement of performance targets should be suitably rewarded.
3. Individuals should be made responsible only for aspects of
performance that they are in a position to control.

Example:
Fitzgerald and Moon applied to a Washing Machine Manufacturer
Dimension = Flexibility – On Quality of Financial
CSF time delivery Service Performance
Standard = KPI Delivery speed Reliability Profitability
Reward Points for each on % commission for Management
time delivery– repair engineers profit related
leading to a bonus from fee or bonuses
warranty paid

Questions:
FL provides training on financial subjects to staff of small and medium sized
businesses. Training is at one of two levels – for clerical staff, instructing them
on how to use simple financial accounting computer packages, and for
management, on management accounting and financial management issues.
Training consists of tutorial assistance, in the form of workshops or lectures,
and the provision of related material – software, texts and printed notes.

115
Tuition days may be of standard format and content, or designed to meet the
client’s particular specifications. All courses are run on client premises and, in
the case of clerical training courses, are limited to 8 participants per course.
FL has recently introduced a ‘helpline’ service, which allows course
participants to phone in with any problems or queries arising after course
attendance. This is offered free of charge.

FL employs administrative and management staff. Course lecturers are hired as

required, although a small core of technical staff is employed on a part-time
basis by FL to prepare customer-specific course material and to man the
helpline.
Material for standard courses is bought in from a group company, who also
print up the customer-specific course material. Suggest a measure for each of
the six dimensions of the building block model.
Possible measures include:
Financial performance
 Fee levels.
 Material sales.
 Costs.
 Net profit.
 Outside lecturer costs.

Competitiveness
 Market share.
 Sales growth.
 Success rate on proposals.

Quality of service
 Repeat business levels.
 Number of customer complaints.
 Help-line use may be related to tuition quality.

Flexibility
 Availability and use of freelance staff.
 Breadth of skills and experience of lecturers.

Resource utilisation
 Use of freelance lecturers.
 Levels of non-chargeable staff time.

116
Innovation
 Number of new in-company courses.
 Time to develop new courses.
 New course formats.

Case Study / 54 APM-BPP:

APX Accountancy (APX) is an accountancy partnership with 12 branches
covering each of the main cities of Emland. The business is well established,
having organically grown over the last 40 years to become the second largest
non-international practice in Emland. The accountancy market is mature and
expands and contracts along with the general economic performance of Emland.
APX offers accountancy, audit, tax and business advisory services. The current
business environment in Emland is dominated by a recession and the associated
insolvency work is covered within the business advisory area of APX.

At present, the practice collects the following information for strategic

performance evaluation:
Audit Tax Business Advisory Total
Revenue ($m)
APX 69.1 89.2 64.7 223.0
Accounting industry 557.0 573.0 462.0 1,592.0
Change in revenue on previous year
APX 3.0% 8.0% 22.0% 10.0%
Accounting industry 2.5% 4.5% 16.0% 6.8%
Profit margin at APX 6.4% 7.8% 10.5% 8.1%
Customer service score (1 to 5 with 5 being excellent)
APX 3.4 3.9 4.1

The above figures are for the most recent financial year and illustrate the
metrics used by APX. Equivalent monthly figures are produced for each of the
monthly partner meetings which review practice performance. The staff are
remunerated based on their grade, with non-partners obtaining a bonus of up to
10% of basic salary based on their line managers' annual review. The partners
receive a fixed salary with a share of profit which depends on their contractual
responsibilities within the partnership.

The managing partner of APX is dissatisfied with the existing performance

management system, as she is not convinced that it is helping to achieve the
long-term goal of expanding and ultimately floating the business on the national
stock exchange. Therefore, she has asked you to consider the impact of applying
Fitzgerald and Moon's building block approach to performance management in
the practice.

117
In addition, the marketing manager at APX believes that the firm as a whole
doesn't pay enough attention to customer service. At the last management
meeting he said that, in his opinion, the customer service score(*) was the most
important figures out of the performance metrics currently used by APX, and he
said he felt it was no coincidence that the area of the business with the highest
customer service score had also performed best financially. [* Customer service
scores reflect ratings given by customers in relation to the level of service they
feel they have received from APX.]

Required
(a) Briefly describe Fitzgerald and Moon's building block model of performance
management. (4 marks)
(b) Evaluate the existing performance management system at APX by applying
the building block model. (8 marks)
(c) Explain the main improvements the introduction of a building block
approach to performance management could provide, and suggest specific
improvements to the existing system of performance measures at APX in
light of the introduction of the building block model. (8 marks)
(d) Briefly evaluate the marketing manager's statement about the customer
service score. (5 marks)

118
 SECTION A
MANAGING INFORMATION

Organizations require information systems for a range of purposes. Supporting

operations:
 Processing and recording transactions Supporting managerial activities:
 Decision making
 Planning
 Performance measurement
 Control

An information system is a combination of hardware, software and

communications capability, where information is collected, processed and
stored.

The role of an information system encompasses more than just activity

automation. Information systems can be used to improve processes within
organisations as well as externally with suppliers and customers. Organisations
need information systems to enable them to capture and generate the
information that managers need for planning, control and decision-making
purposes.

Costs of information systems

Information system costs include
 hardware and software costs,
 Implementation costs associated with a new systems development
(especially labour costs and training costs) and
 Day to day costs, such as salaries and accommodation.
e.g. Companies Like DLF invests million of Rupees on it’s internal software
and data management systems.

Communication of information
Communicating information is much easier when computers are connected
together to form a network.
Networks: Some computers within the network could be dedicated to file
storage, known as file servers, or other dedicated services such as printing.
Others could be charged with performing major number crunching tasks

Intranets: A cluster of computers can be networked together to form an

organisation-wide network. This is known as an intranet and used to share
information internally. Intranets are effectively private networks.

119
Intranets are used for many purposes:

1. Performance data: linked to sales, inventory, job progress etc.

2. Employment information: online policy and procedures manuals
3. Employee support/information: advice on first aid, healthy working at
computer terminals, training courses offered and resources held in the
corporate library and so on.
4. Notice boards for the posting of messages to and from employees
5. Departmental home pages

Extranets: An extranet is an intranet that is accessible to authorised outsiders,

using a valid username and password.

Wireless technology: Wireless technology allows communication using

electromagnetic, radio and microwave signals.
Main benefits of wireless technology include:

(a) Remote working and increased mobility

(b) Increase productivity (because employees can work together wherever they
need to)
(c) Reduced costs as the business expands (because it is easier to add new
users to a wireless network than to install new cabling)

The internet: The internet represents a physical global network with access to
this 'web'. The terms 'world wide web' and 'internet' are often used
interchangeably although strictly speaking, this is not correct. The world wide
web uses the internet for global transmission between computers.

Controls over generating and distributing internal information

1. Controls over generating internal information in routine reports:
(a) Carry out a cost-benefit analysis
(b) A trial preparation process should be carried out and a prototype
prepared. Users should be asked to confirm that their requirements
will be met.
(c) A consistent format and consistent definitions should be used to
ensure that reporting is accurate and the chance of misinterpretation is
minimized.
(d) The originator of the report should be clearly identified so that users'
queries can be dealt with quickly.
(e) The report should clearly set out limits to the action that users can
take as a result of the information in the report.
(f) The usefulness of the report should be assessed on a periodic basis to
ensure that its production is necessary.

120
2. Controls over generating internal information in ad hoc reports
a. Carry out a cost-benefit analysis as above.
b. Ensure that the required information does not already exist in another
format.
c. Brief the report writer so that only the relevant information is
provided.
d. Ensure that the originator is clearly identified.
e. Ensure that report writers have access to the most up-to-date
information.

3. Controls over distributing internal information

(a) Procedures manual (for standard reports)
(b) Other controls
a. Payroll and personnel information should be kept in a locked
cabinet or be protected by password access on a computer
system.
b. All employees should be contractually required not to divulge
confidential information.
c. The internal mail system should make use of 'private and
confidential' stamps.
d. Physical computer security
e. An appropriate email policy should be set up.

Security and confidential information

A number of procedures can be used to ensure the security of highly
confidential information that is not for external consumption.
1. Passwords: Passwords are a set of characters allocated to a person,
terminal or facility which have to be keyed into the system before
further access is permitted.

2. Logical access systems: While physical access control (doors, locks,

and so on) is concerned with the prevention of unauthorised persons
gaining access to the hardware, logical access control is concerned
with preventing those who already have access to a terminal or a
computer from gaining access to data or software.

A logical access system performs three operations when access is

requested.
(a) Identification of the user
(b) Authentication of user identity
(c) Check on user authority

121
 3. Database controls
Databases present a particular problem for computer security. In
theory, the database can be accessed by large numbers of people, and
so the possibility of alteration, unauthorised disclosure or fraud is so
much greater than with application-specific files. It is possible to
construct complicated password systems, and the system can be
programmed to give a limited view of its contents to particular users
or restrict the disclosure of certain types of information to particular
times of day. It is possible to build a set of privileges into the system,
allowing authorised users with a particular password to access more
information.

4. Firewalls
Systems can have firewalls to prevent unauthorised access into
company systems. Firewalls can be implemented in both hardware
and software, or a combination of both. Firewalls are frequently used
to prevent unauthorised internet users from accessing private
networks connected to the internet, especially intranets. All messages
entering or leaving the intranet pass through the firewall, which
examines each message and blocks those that do not meet specified
security criteria.

5. Encryption: Information transmitted from one part of an organisation

to another may be intercepted. Data can be encrypted (scrambled) in
an attempt to make it unintelligible to eavesdroppers.

6. Personnel security planning: Certain employees will always be placed

in a position of trust; for example, senior systems analysts, the
database administrator and the computer security officer

The following types of measure are therefore necessary.

(a) Careful recruitment
(b) Job rotation
(c) Supervision and observation by a superior
(d) Review of computer usage (eg via systems logs)
(e) Enforced vacations

7. Anti-virus and anti-spyware software:

Computer viruses typically arrive by email and are triggered when the
user opens the email and an attachment. The virus is a self-replicating
computer program that infiltrates and then damages a computer system.

122
 Spyware is a type of program that watches what users do with their
computer and then sends that information over the internet to a third party.
Customers of online bank accounts have experienced particular problems
with spyware when their personal financial data has been captured by key
logging software.

Anti-virus software works to achieve this by:

(a) Scanning files to look for known viruses
(b) Identifying suspicious behaviour from any computer program that
might indicate infection

Sources of management accounting information

Internal sources of information include the financial accounting records and
other systems closely tied to the accounting system.
Capturing data/information from inside the organisation involves the following.
(a) A system for collecting or measuring transactions data – eg sales,
purchases, inventory and revenue – which sets out procedures for
what data is collected, how frequently, by whom and by what
methods, and how it is processed and filed or communicated

(b) Informal communication of information between managers and staff

(eg. by word of mouth or at meetings)

(c) Communication between managers

Sources of monetary and non-monetary information

1. The financial accounting records
2. Information about personnel will be linked to the payroll system
3. Much information will be produced by a production department about
machine capacity, movement of materials and work in progress, set up
times, maintenance requirements, and so on.
4. Many service businesses – notably accountants and solicitors – need to
keep detailed records of the time spent on various activities, both to justify
fees to clients and to assess the efficiency of operations.

External sources of information

Secondary data, such as government statistics or data provided by online
databases, is not collected by or for the user.
Primary data – more expensive than secondary data – is more tailored to the
user's exact needs. Market research is an example.

123
1. Directories
2. Associations
3. Government agencies
4. Other published sources
5. Syndicated services
6. Consumer panels
7. Information from customers
8. Information from suppliers
9. The internet
10. Database information
a. Online databases
b. Data warehouses

Costs of information
Cost Examples
Direct data  Use of bar coding and scanners (eg in retailing and
capture manufacturing)
 Employee time spent filling in timesheets
 Secretary time spent taking minutes at a meeting
Processing  Payroll department time spent processing and analysing
personnel costs
 Time for personnel to input data (eg in relation to
production) on to the MIS
Inefficient use  Information collected but not needed
of information  Information stored long after it is needed
 Information disseminated more widely than necessary
 Collection of the same information by more than one
method
 Duplication of information

Information systems and data analytics

Introduction to planning, control and decision-making
Planning means formulating ways of proceeding. Decision-making means
choosing between various alternatives. These two terms are virtually
inseparable: you decide to plan in the first place and the plan you make is a
collection of decisions.
Strategic decisions are long-term decisions and are characterised by their wide
scope, wide impact, relative uncertainty and complexity

124
Management accounting information for strategic planning, control and
decision-making
Management accounting information can be used to support strategic planning,
control and decision- making. Strategic management accounting differs from
traditional management accounting because it has an external orientation and a
future orientation.
Strategic management accounting is 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.
External orientation: The important fact which distinguishes strategic
management accounting from other management accounting activities is its
external orientation, towards customers and competitors, suppliers and perhaps
other stakeholders.
(a) Competitive advantage is relative. Understanding competitors is therefore
of prime importance.
For example, knowledge of competitors' costs, as well as a firm's own
costs, could help inform strategic choices: a firm would be unwise to
pursue a cost leadership strategy without first analysing its costs in relation
to the cost structures of other firms in the industry.
(b) Customers determine if a firm has competitive advantage.
Future orientation: A criticism of traditional management accounts is that they
are backward looking.
(a) Decision-making is a forward- and outward-looking process.
(b) Accounts are based on costs, whereas decision-making is concerned with
values
Goal congruence: Business strategy involves the activities of many different
functions, including marketing, production and human resource management.
The strategic management accounting system will require inputs from many
areas of the business.
(a) Strategic management accounting translates the consequences of different
strategies into a
common accounting language for comparison.
(b) It relates business operations to financial performance, and therefore helps
ensure that business activities are focused on shareholders' needs for profit.
In not for profit organisations this will not apply, as they do not focus on
shareholder profitability. (We look at not for profit organisations in more
detail later in this Study Text.)
125
What information could strategic management accounting provide?
Item Comment
Competitors' costs What are they? How do they compare with ours? Can
we beat them? Are competitors vulnerable because of
their cost structure?
Financial effect of How might competitors respond to our strategy? How
competitor response could their responses affect our sales or margins?
Product profitability A firm should want to know not just the profits or
losses that are being made by each of its products but
also why one product should be making good profits
whereas another equally good product might be
making a loss.
Customer profitability Some customers or groups of customers are worth
more than others.
Pricing decisions Accounting information can help to analyse how
profits and cash flows will vary according to price
and prospective demand.
The value of market A firm ought to be aware of what it is worth to
share increase the market share of one of its products.
Capacity expansion Should the firm expand its capacity and, if so, by how
much? Should the firm diversify into a new area of
operations, or a new market?
Brand values How much is it worth investing in a brand which
customers will choose over competitors' brands?
Shareholder wealth Future profitability determines the value of a
business.
Cash flow A loss-making company can survive if it has adequate
cash resources, but a profitable company cannot
survive unless it has sufficient liquidity.
Effect of acquisitions How will the merger affect levels of competition in
and mergers the industry?
Decisions to enter or What are the barriers to entry or exit? How much
leave a business area investment is required to enter the market?

126
Types of information systems
1. Transaction processing systems collect, store, modify and retrieve the
transactions of an organisation.
The four important characteristics of a TPS are as follows.
(a) Controlled processing. The processing must support an organisation's
operations.
(b) Inflexibility. A TPS wants every transaction to be processed in the
same way regardless of user or time. If it were flexible there would be
too many opportunities for non-standard operations.
(c) Rapid response. Fast performance is critical. Input must become
output in seconds so customers don't wait.
(d) Reliability. Organisations rely heavily on transaction processing
systems, with failure potentially stopping business. Back-up and
recovery procedures must be quick and accurate.

Types of TPS
Batch transaction processing (BTP) collects transaction data as a group and
processes it later, after a time delay, as batches of identical data.

Real time transaction processing (RTTP) is the immediate processing of data.

It involves using a terminal or workstation to enter data and display results and
provides instant confirmation.

Management information systems

Management information systems (MIS) generate information for monitoring
performance (eg productivity information) and maintaining co-ordination (eg
between purchasing and accounts payable).
 Support structured decisions at operational and management control
levels
 Designed to report on existing operations
 Little analytical capability
 Relatively inflexible
 An internal focus

Enterprise resource planning systems

Enterprise resource planning systems (ERP systems) are modular software
packages designed to integrate the key processes in an organisation so that a
single system can serve the information needs of all functional areas.
ERP systems work in real time, meaning that the exact status of everything is
always available. Further, many of these systems are global. Since they can be
deployed at sites around the world, they can work in multiple languages and
currencies.

127
Benefits of ERP
(a) Allowing access to the system to any individual with a terminal linked to
the system's central server
(b) Decision support features, to assist management with decision-making
(c) A lot of inefficiencies in the way things are done can be removed; the
company can adopt so-called 'best practices' – a cookbook of how similar
activities are performed in world-class companies
(d) A company can restructure its processes, so that different functions (such
as accounting, shipping and manufacturing) work more closely together to
get products produced
(e) Standardising Information and work practices so that the terminology used
is similar, no matter where you work in the company

Customer relationship management systems

CRM systems are often used by customer-facing staff who handle customer
enquiries, orders or complaints and who need to understand the customer's
immediate needs and provide an appropriate response. By providing a CRM,
motivation can be increased in customer-facing staff who feel they are properly
equipped to do their job
There are a number of criticisms of CRM systems, although most can be applied
to any new system (not just CRMs).
 Cost of purchasing the system (can be expensive if bespoke)
 Additional costs (such as purchasing new hardware or other systems in
order to use the CRM)
 Opportunity costs (money used on the CRM system could be spent on
other projects)
 Staff costs (training costs, getting staff support and costs to the business of
the disruption of introducing a CRM)
 Effect on business processes (which may have to be changed to fit the
system)
 Effect on customer relationship strategy (software takes over, rather than
supports, the strategy)

Big Data
Big Data refers to the mass of data that society creates each year, extending far
beyond the traditional financial and enterprise data created by companies.
Sources of Big Data include social networking sites, internet search engines,
and mobile devices.

128
The three Vs of Big Data
(a) Volume. The scale of information which can now be created and
stored is staggering. Advancing technology has allowed embedded
sensors to be placed in everyday items such as cars, video games and
refrigerators.
(b) Velocity. Timeliness is a key factor in the usefulness of financial
information to decision makers, and it is no different for the users of
Big Data.
(c) Variety. Big Data consists of both structured and unstructured data.
While the sources of data have grown, the software tools for
interpreting the data have not kept pace with this change.

The uses of Big Data:

Big Data is an emerging technology that has implications across all business
departments. It involves the collection and analysis of large amounts of data to
find trends, understand customer needs and help organisations to focus
resources more effectively and to make better decisions.
A. Big Data and business value
Business value is measured in many ways, such as profit, shareholder value,
brand value and intellectual value. Big Data can be used to analyse
opportunities to increase revenue and reduce costs, thereby increasing profit.
[
B. Big Data and the customer
By understanding the customer, the business can respond to their needs and
tailor the customer experience to be more personal and therefore improve
customer loyalty.
C. Big Data and corporate strategy
Big Data must fit into the organisation's overall aims and objectives. After
identifying how business value can be improved, and the requirements of
the customer, business priorities can be determined.
Effect of Big Data on decisions
The key effects of Big Data on decisions can be summarised as follows:
a) Decisions can be made quickly.
b) Businesses can respond earlier to environmental changes and be more
flexible in their response.
c) Decisions can be based on current situation but also have an element of
taking potential future situations into account.
d) Decisions are made on hard data evidence that can be quantified.
e) Decisions can be made on a collaborative basis because data is easily
shared and converted from one form into another.
f) 'Outside the box' decisions are more likely because all factors are taken
into account, not just the ones managers think of.
129
Benefits of Big Data analytics
Benefits Comment
Examine vast quantities of data Big Data analytics allows for large quantities
relatively quickly of data to be examined to identify trends and
correlations eg. shopper buying habits.
Improves organisational decision Better data analysis helps management to
making take advantage of current social trends by
introducing new products to meet customers'
needs.
Cost reduction Improved data about customers and internal
operations may help to reduce costs. This is
illustrated in the following case study.

Criticisms of Big Data

Critics argue:
(a) Big Data is simply a buzzword, a vague term that has turned into an
obsession in large organisations and the media. Very few examples exist
where analysing vast amounts of data has resulted in significant new
discoveries.
(b) There is a focus on finding correlations between data sets and less of an
emphasis on causation. Critics suggest that it is easier to identify
correlations between two variables than to determine what is actually
causing the correlation.

Other issues relating to Big Data include:

 Security and data protection – To store and protect vast amounts of
personal information is difficult and comes with great risk.
 Privacy – Have customers consented to data about them being captured
and stored?
 Personnel issues – The availability of suitably qualified employees to
capture, maintain and analyse Big Data may be difficult and expensive. A
change in corporate culture may be needed to make the most of the
opportunities Big Data brings.
 Information – There may be technical difficulties involved when
integrating new Big Data systems with existing technology. Also, could
valuable time be wasted collecting data that has no value to the
organisation? Just because information can be collected does not mean it
has to be collected.

130
Corporate Office
Adv.Easwara Iyer Road, Kochi Kerala-682035
Branches
Kochi | Calicut | Thrissur | Kottayam | Trivandrum | Kannur | Dubai
IND +91 9061277777 | UAE +971 568631499
www.lakshyacommerce.com | www.lakshyaca.com