ACCA PM NOTES THEORY
ACCA PM NOTES THEORY
PERFORMANCE
MANAGEMENT
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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.
MULTIPLE PRODUCTS
Weighted Average CPU = Total Contribution for MIX / No. of Units in 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.
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
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.
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(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.
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.
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
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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.
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).
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.
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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
The shaded portion in the diagram represents the feasible region. Value of the
objective function at the feasible points is calculated below:
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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.
(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.
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(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
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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?
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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.
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.
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(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.
(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.
Try Question
BPP: Ennerdale , T Co, BELTON PARK RESORT
Kaplan: SIP Co, Choice of Contracts
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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 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?
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**Committed Payment (Salary), If Skilled labor paid hourly, then Opportunity
cost + Hourly rate is relevant cost.
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:
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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
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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.
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.
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.
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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:
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(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.”
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.
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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.
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Pricing Methods:
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.
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.
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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:
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.
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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
(ii) Quantity discounts are price reductions related to the quantities purchased.
(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.
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3. Stock pf processed ready to eat product’s, whose shelf life will soon be over
in the next 2 months
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?
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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.
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. 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.
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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:
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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.
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)
(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)
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II. SPECIFIC COST MANAGEMENT
TECHNIQUES (PART B)
(a) TARGET COSTING
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.
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.
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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.
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
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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
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(b) LIFE CYCLE COSTING
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.
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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.
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.
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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.
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?
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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:
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.
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.
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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
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
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(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'.
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:
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
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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
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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.
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:
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.
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.
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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.
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.
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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.
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:
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).
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
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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
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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)
49
III-BUDGET AND CONTROL (PART D)
(a) BUDGETARY SYSTEMS
(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.
A flexible budget recognises cost behaviour and changes as the actual volume
of activity changes.
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.
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.
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.
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
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.
(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.
54
(b) LEARNING CURVE THEORY
LC equation: Y=AXB
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.
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?
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?
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).
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
(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.
Material Variances
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)}]
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?
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:
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.
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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)
Required
(i) Calculate the variances for ‘Ice’ by
(a) Traditional Variance Analysis; and
(b) An approach which distinguishes between Planning and
Operational Variances.
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:
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
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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*)]
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
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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)?
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.
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(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.
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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.
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
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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?
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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?
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(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
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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)]
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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)}]
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)
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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.
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.
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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.
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.
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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
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
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Closing (Work in Progress) 900 units
Degree of Completion
Material A and B 100%
Wage and Overheads 50%
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
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.
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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
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IV – PERFORMANCE MEASUREMENT
(PART E)
(a) DIVISIONAL PERFORMANCE
MEASUREMENT & TRANSFER PRICING
Divisionalisation:
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
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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
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The advantages and weaknesses of RI compared with ROI
(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.
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(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.
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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:
Scenario 3: The selling division does not have any surplus capacity
Transfer price
negotiated
between
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Practical considerations when setting the transfer price
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)
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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?
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.
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.
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:
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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
Solution:
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.
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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.
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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%).
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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.
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.
In-patient H: Incompetent paramedic staff, poor quality of food and bed linen.
Staff M: Management undermines our role in running the hospital.
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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
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“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.
(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.
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?
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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.
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(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.
97
Examples for Different type of Business as follows:
1. Brewery
2. E-commerce Dealer
98
3. Jewellery Shop
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.
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
(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.
(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.
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.
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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 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)
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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.
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.
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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
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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.
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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.
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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.
Solution
(i) New Product tie up --- Innovation / Learning Perspective
(ii) Growth of Volume --- Financial Perspective
(iii) Time for Loan / Fresh Products --- Customer Perspective
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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.
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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:
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Evaluate the performance of the company using Balance Scorecard approach.
Solution:
(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.
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(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
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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.
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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.
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.
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.
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.
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Innovation
Number of new in-company courses.
Time to develop new courses.
New course formats.
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.
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)
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SECTION A
MANAGING INFORMATION
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
119
Intranets are used for many purposes:
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.
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.
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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.
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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.
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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
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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.)
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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.
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
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.
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