F5 Synergy Kit

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SYNERGY
PROFESSIONALS
ACCA Paper PM
Performance Management
Lecture Notes
Downloaded by African Butterfly (africanbutterly@outlook.com)

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PAPER F5 - PERFORMANCE MANAGEMENT

Objective:
The objective of the F5 paper is to develop knowledge and skills in the application of
management accounting techniques to qualitative and quantitative information for
planning, decision making, performance evaluation and control.
Syllabus Area:
A – SPECIALIST COST AND MANAGEMENT ACCOUNTING TECHNIQUES
 Activity based costing (ABC)
 Target costing
 Lifecycle costing
 Throughput accounting
 Environmental accounting
B – DECISION MAKING TECHNIQUES
 Cost volume profit analysis
 Limiting factor analysis – Single & Multi limiting factors
 Pricing decisions
 Relevant costing
 Make or Buy and other short term decisions
 Risk and Uncertainty in decision making
C – BUDGETING & STANDARD COSTING
 Objectives
 Budgetary systems & types of budgets
 Quantitative analysis in budgeting
 Standard costs / costing
 Basic variance analysis
 Materials mix and yield / Sales mix and quantity variance
 Planning and operational variance
D – PERFORMANCE MEASUREMENT AND CONTROL
 Management Information Systems
 Sources of Management Information
 Management Reports
 Financial performance indicators
 Non financial performance indicators
 Divisional performance and transfer pricing
 Performance analysis for not for profit organization and public sector
 External considerations

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ADVANCED COSTING TECHNIQUES: PART A

ACTIVITY BASED COSTING (ABC)
Definition:
ABC involves the identification of the factors which are responsible for the cost of an
organization’s major activities. Overheads are charged to products on the basis of
their usage of the factor causing the overhead.
ABC is an alternative costing system to absorption costing
Reasons for ABC
1. Range of products: Absorption costing was developed when most
organisations produced only a narrow range of products so products went
through similar operations and consumed similar proportions of overheads.
Now manufacturers produce a wider range of products with different variants.
2. Overhead costs: Overhead costs were only a small proportion of total cost with
direct costs making up a larger proportion of total costs, there was no
motivation to accurately allocate overheads since it was a small percentage
of the total cost. Overhead cost now account for a high percentage of total
costs (due to advanced and automated manufacturing processes) so it is
important to allocate the cost more accurately.
3. Information processing cost: The cost of processing information was high so the
benefit of having a more accurate system did not cover the cost of putting it in
place. Information processing costs have now reduced drastically due to
cheap technology so organisations can afford to put in place systems that
would help generate data for the implementation of ABC.
Ideas behind ABC

1. Activity causes costs e.g. Production set-up, materials handling, ordering,
assembly, dispatching, inspection, etc.
2. Making products create demand for activities
3. Costs are allocated to products based on usage of activities.
Outline of an ABC system

1. Identify an organizations major activities
2. Identify the factors which influence the change in the level of an activity (COST
DRIVERS)
 Inspection cost – number of inspections
 Machine cost – Machine hours
 Ordering cost – number of orders
 Dispatching – number of dispatches
3. Categorize cost based on each cost driver (cost pools)
4. Charge cost to products based on the usage of the activity.

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Merits of ABC
1. It is simple to use.
2. It facilitates a good understanding of what drives cost.
3. It helps organisations control costs by identifying the activities that that
generate them.
4. It leads to more accurate product costs which help managers enhance the
quality of their decision making.
5. It recognizes the complexity of manufacturing a wider range of products with
its multiple cost drivers.
Criticisms of ABC
1. Some arbitrary allocations may still be required for some cost items.
2. Some cost drivers might not be easily identified – e.g. Training costs, cost of
external audit.
3. The cost of implementing ABC may be high
4. Implementing ABC needs the required information which may not be readily
available so existing Management Information System (MIS) may need to be
modified.

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TARGET COSTING
Target costing is a costing system that involves setting a target cost by subtracting a
desired profit margin from a market competitive selling price.
Target costing process / Steps in the implementation of a target costing system

1. Determine the product specification.
2. Set a selling price based on similar products in the market.
3. Estimate the required profit – this can be based on the ROI or other desired
profit margin.
4. Calculate the target cost = target selling price – target profit.
5. Estimated cost for the product based on the design specification and current
market cost levels.
6. Calculate target cost gap = estimated cost – target cost
7. Make efforts to close the gap. This is more effective at the design stage.
Closing a target cost gap

1. Reduce the number of components / materials
2. Train staff to be more efficient
3. Use different / cheaper materials
4. Change suppliers
5. Acquire new, more efficient technology
6. Remove non value added activities or processes.
7. Use cheaper labour or materials without compromising quality etc.
Benefits of adopting a target costing approach

1. It enables an early external focus to product development. Businesses have
competitors and need to sell to customers. An early consideration of these
factors will make them more successful.
2. Cost control will begin earlier in the process. A high proportion of cost can be
controlled at the conception and design stage of the process.
3. Cost control is more effective. Cost per unit is often lower under a target
costing environment.
4. Only features that are of value to customers will be included in the product
design.
5. It is argued that target costing reduces the time taken to get a product into
the market.

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LIFE-CYCLE COSTING
Life-cycle costing is a costing system that identifies and accumulates costs and
revenues incurred and earned by a product over the product life cycle. In other
words, life cycle costing can easily help a company determine the viability of a
product over its whole life.
Traditional costing systems are based on the financial accounting year but lifecycle
costing is based on the overall cost and revenue over the entire product life cycle.
Principles behind Lifecycle costing

Lifecycle costing is a concept which traces and tracks all costs to product over its
complete lifecycle, from design to cessation. It recognizes that for many products,
there are significant costs to be incurred in the early stages of the product lifecycle.
The profitability of a product can then be measured by taking all costs into
consideration.
The product life cycle

1. Development & Introduction
2. Growth
3. Maturity
4. Decline
Diagram of a product lifecycle

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Benefits of lifecycle costing

1. Total cost for individual products can be reported and compared with
revenues generated in future.
2. Visibility of cost is increased.
3. Individual product profitability can be better understood.
4. More accurate information is available on the organizations success or failure
in developing new products.

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THROUGHPUT ACCOUNTING
Throughput Accounting:
TA is a product management system whose major objective is to maximise
throughput (defined as the rate of production of a process over a stated period of
time). Throughput is also calculated as Sales revenue – Material cost. It focuses on
factors such as bottlenecks which are constraints to the maximizing of sales revenue.
It is a system that operates in a Just-In-Time (JIT) environment.
Bottleneck Resource (Binding Constraint):

A bottleneck resource is an activity which has lower capacity than preceding or
subsequent activity, thereby limiting throughput.
Throughput Accounting is based on three concepts

1. All manufacturing costs with the exception of material costs are regarded as
fixed costs.
So therefore, Throughput contribution = Sales – Material cost
2. The ideal inventory level is Zero. A product should not be made unless it has
been ordered for.
3. Profitability is determined by the rate at which a product contributes money
i.e. sales are made. The bottleneck resource slows the process of making
money.
The differences between a conventional cost accounting system and throughput

accounting are as follows:
Conventional Throughput
1 Inventory is an asset Inventory is not an asset; it is a result of
unsynchronised and inefficient manufacturing. It
is a barrier to profit
2 Variable costs include material, labour Material cost is the only variable cost
and some overheads
3 Cost can be classified as direct or No need for such classification
indirect
4 Variable cost includes direct materials, Material cost is the only variable production cost
direct labour and other production
overhead

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Throughput Accounting Ratio

Throughput Accounting Ratio measures the rate at which the business generates
money compared to the rate at which the business spends money.
TA ratio = Return per factory hour

Total conversion cost per factory hour
Return per factory hour

= Sales – Direct material cost
Usage of bottleneck resource in hours (factory hrs)
Total conversion cost includes ALL factory cost with the exception of material cost.
Non factory overheads to not form part of conversion cost.
Interpretation of TPAR
 A TPAR > 1 means that the firm is earning money more than it is spending so the
product should make a profit.
 A TPAR < 1 means that the firm is spending money more than it is earning,
resulting in a loss.
Improving the TPAR:
1. Increase the sales price for each unit sold, to increase the throughput per unit
2. Reduce materials cost per unit
3. Reduce total operating expenses
4. Improve the productivity of the work force and reduce the time required to
make each unit of the product.
Limitations of Throughput Accounting
1. It concentrates on the short term
2. It pays little attention to overhead costs
3. There can be other factors that limit throughput apart from bottlenecks e.g.
uncompetitive selling price, poor product quality, etc.

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Environmental Management Accounting

Businesses have become more aware of the environmental implications of their
operations, products and services. Environmental risks cannot be ignored as they are
now a vital factor in running a successful business (just like product design, marketing
and sound financial management). Poor environmental behavior may have a real
adverse impact on the business and its finances. Punishments includes fines,
increased liability to environmental taxes, loss of value on land, destruction of brand
values, loss of sales, consumer boycotts, inability to secure finance, loss of insurance
cover, contingent liabilities, law suits and damage to corporate image.
Environmental issues can have the following impact on the financial performance of
organizations:
 Reduce cost – effective use of resources
 Increase cost – cost of compliance with legal and regulatory requirements
 Improve revenue – meeting the needs and concerns of customers, good
reputation of being environment friendly
 Reduce revenue – Loss of reputation leading to customer boycott
Environmental issues – along with the related costs, revenues and benefits – are of
increasing concern to many countries around the world but there is a growing
consensus that conventional accounting practices do not provide adequate
information for environmental management purposes. To fill the gap, the emerging
field of Environmental Management Accounting (EMA) has been receiving
increasing attention.
The Importance of Environmental Management:
Organizations are beginning to recognize that environmental awareness and
management are not optional, but are important for long term survival and
profitability.
All organizations:
 Are faced with increasing legal and regulatory requirements relating to
environment management
 Need to meet customers’ needs and concerns relating to the environment
 Need to demonstrate effective environmental management to maintain a
good public image
 Need to manage the risk and potential impact of environmental disasters
 Can make cost savings by improved use of resources such as water and fuel
 Are recognizing the importance of sustainable development, which is the
meeting of current needs without compromising the ability of future
generations to meet their needs.
Environmental Management Accounting is the management of environmental and
economic performance through the development and implementation of
appropriate environment-related accounting systems and practices.
It is the identification, collection, analysis and use of two types of information for
internal decision making:

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 Physical information on the use, flows and destinies of energy, water and
materials (including wastes) and
 Monetary information on environment-related costs, earnings and savings.
Simply speaking,
Environmental Management Accounting (EMA) is the generation and analysis of both
financial and non-financial information in order to support internal environmental
management processes.
This includes:
 Identifying and estimating the costs of environment related activities
 Identifying and monitoring the usage and cost of resources such as water, fuel,
electricity to enable such to be reduced
 Assessing the likelihood and impact of environmental risks
 Including environment related indicators as part of routine performance
monitoring
 Benchmarking activities against environmental best practices
To control environmental costs, organizations need to
 Define environmental costs
 Identify the costs and
 Allocate the costs
Defining Environmental costs
There are four types of environmental cost
1. Conventional costs – e.g. raw materials and energy costs that impact the
environment
2. Potentially hidden costs – costs that are captured in the accounting system but
are hidden within general overheads
3. Contingent cost – cost to be incurred at a future date e.g. clean up cost
4. Image and relationship cost – cost incurred to preserve the reputation of the
business. E.g. cost of compliance with regulatory requirements.
Identifying and Allocating Environmental costs
Much of the information that is needed can actually be found in the general ledger.
A close review should reveal the cost of materials, utilities and waste disposal. The
problem is that most of the cost will be found within the general overheads category
and it might be problematic allocating them appropriately. Examples of
environmental costs are:
 Waste – unused raw materials and disposals
 Water – cost of buying and then disposing
 Energy – electricity, fuel, etc
 Transport and Travel – transportation of goods and materials, etc
 Consumables and raw materials

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Accounting for environmental costs

1. Input / Output analysis:
The input / output analysis is a technique that can provide useful
environmental information. It is sometimes referred to as mass balance.
This method operates on the principle that what comes in must go out – or be
stored.
For example, if 100 kg of materials has been bought and only 80kg of materials
has been produced, then the 20kg of material must be accounted for. It may
either be sold as scrap or disposed as waste.
By accounting for outputs in this way, both in terms of physical quantities and in
monetary terms, businesses are forced to focus on environmental costs.
2. Flow cost accounting:
This method divides material flows through an organization into three
categories, namely:
 Material
 System and delivery
 Disposal
The values and costs of each material flow are then calculated. The aim is to
reduce the quantity of materials which should have a positive effect on the
environment and costs of the business in the long run.
3. Environmental Activity Based Costing:
ABC allocates internal costs to cost centres and cost drivers on the basis of the
activities that generate them.
In an environmental accounting context, a distinction is made between
 Environment - related costs (which can be attributed to joint cost
centres) – e.g. includes cost relating to sewage plants and incinerators.
and
 Environment driven costs (which tend to be hidden in general
overheads) – e.g. increased depreciation, higher cost of staff.
To decide the environmental cost drivers, the production process involved in
making a product or providing a service must be carefully analysed. The
choice of an adequate allocation key is crucial for obtaining correct
information. The four main allocation keys are:
 Volume of emission or waste
 Toxicity of emission and waste treated
 Environment impact added (volume x input per unit of volume)
 Relative cost of treating different kinds of emission
4. Lifecycle costing:
Within the context of environmental accounting, lifecycle costing is a
technique which requires the full environmental consequences. The
environmental costs are considered from the design stage up to when the
product is withdrawn from the market. Costs such as disposal costs,
decommissioning costs and removal costs are taking into consideration.
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DECISION MAKING: PART B

LIMITING FACTOR ANALYSIS
Organizations are constantly involved in decision making, it is possible that operations
are limited by certain resources or activities. Our interest is to determine the resources
that limit organizations activities and determine the best possible way to address
them. Limiting factors are also known as scarce resources, constraints, bottlenecks.
Two major scenarios are relevant
1. Where there is only one limiting factor
2. Where there are more than one limiting factor
Single limiting factor

The assumption is that there is only one limiting factor or scarce resource within the
organization. The objective therefore is to seek ways by which we can best utilize this
scarce resource and at the same time maximize profit.
In a single limiting factor environment, the objective is to share this scarce resource
among as many products in the best possible way.
Steps in single limiting factor analysis:

Step 1 – Identify the limiting factor
Step 2 – Determine the contribution per unit
Step 3 – Determine the contribution per limiting factor
Step 4 – rank based on the product with the highest contribution per limiting factor
Step 5 – Determine the Profit maximizing mix / Optimal production plan / Best
production plan
Multi-limiting factor
The assumption here is that there are more than one limiting factors or scarce
resources within the organization. The objective is to seek the best ways to utilize
these scarce resources. To solve the problem of multiple scarce resources, Linear
Programming is used.
Linear programming
This is a technique for solving problems of profit maximisation or cost minimization and
resource allocation. It is used when there are more than one resource constraints.
Steps in linear programming

1. Define variables
2. Establish constraints
3. Construct objective function
4. Graph constraints

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5. Establish feasibility region

6. Add iso -profit/contribution line
7. Determine optimal solution.
The use of Simultaneous equation

Apart from the graphical (iso-contribution method) of solving linear programming,
another method that can be used is the simultaneous equation. The graph is still
plotted but instead of drawing an iso-contribution line, the coordinates of the various
points on the graph are taken and then solved simultaneously to get the value of the
coordinates for each of the points. The point that gives the highest contribution is the
optimal mix.
Slack
Slack occurs when maximum availability of resources is not used.
Shadow prices
The shadow price is the value assigned to an extra unit of a scarce resource normally
calculated as the increase in contribution created by the availability of an extra unit
of the scarce resource at its original cost. It is the extra contribution that may be
earned by making available one unit of a binding resource constraint.
Note the following:
1. The shadow price represents the maximum premium above the basic rate that
an organization should be willing to pay for one extra unit of resource.
2. The shadow price of a constraint that is not binding at the optimal solution is
zero
3. Shadow prices are only valid for a small range before the constraint becomes
non-binding or different resources become critical.

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COST – VOLUME – PROFIT (CVP) ANALYSIS

CVP analysis looks primarily at the effect of different levels of activity on the financial
results of a business. The reason for the particular focus on sales volume is because in
the short run, sales price and the cost of materials and labour are usually known with
a degree of accuracy. Sales volume, however, is not usually so predictable and
therefore, in the short run, profitability is determined by it.
Break Even Point (BEP)
The Break Even Point is the point where the company makes neither profit nor loss.
That is the point where profit equals zero.
Methods of calculating BEP
1. Equation Method
Total Revenue (TR) – Total Variable Cost (TVC) – Total Fixed Cost (TFC) = Profit (P)
At BEP, P = 0
TR = Selling Price (SP)/unit × number of units
TVC = Variable Cost (VC)/unit × number of units
So…….
SP/unit × (number of units) – VC/unit × (number of units) – TFC = 0
We can then solve for Q which represents the Number of Units to get the BEP.
Example:
A company sells its products for $50/units. Variable cost is $30/unit. Fixed variable
cost is known to be $200,000/annum.
Determine the BEP in terms of units.
Answer: *****BEP = 10,000 units
2. Contribution Margin Method
The equation can be rewritten as follows:
(SP/unit – VC/unit) × Number of units = FC
Number of units = FC ÷ (SP/units – VC/units) = FC ÷ Contribution/unit
So…… Q = Fixed Cost ÷ Contribution/unit
Using the example above

Q = 200,000 ÷ 20 = 10,000

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3. Graphical Method
Three possible graphs can be plotted to determine BEP
a) Break Even Chart
b) Contribution Chart
c) Profit / Volume Chart

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Output required to achieve Target Profit

Helps determine the sales volume required to achieve a target profit.
Example: The same company in the example above wants to achieve a target profit
of $300,000. What is the Sales Volume necessary to achieve this?
The solution is to solve for Q using the equation above (TR – TVC – TFC = Profit)
assuming Profit = 300,000
So……. 50(Q) – 30(Q) – 200,000 = 300,000
Q= 250,000
Alternatively
Q = (Fixed Cost + Profit) ÷ Contribution/Unit
Q = (200,000 + 300,000) ÷ 20 = 25,000
Margin of Safety
Margin safety indicates by how much sales can decrease before a loss occurs. It is
the excess of the budgeted level of activity over the break-even level of activity. It
can be calculated in terms of units or value ($).
Using the company above: Assuming budgeted sales is 20,000 Units
Margin of safety = 20,000 - 10,000 = 10,000 units
Shown as %: 10,000 ÷ 20,000 × 100 = 50%
In terms of $ sales revenue: 10,000 × $50 = $500,000
Contribution to Sales ratio also called Profit Volume ratio

The C/S ratio reveals the amount of contribution that is earned for every $1 worth of
sales revenue. It is constant at all levels of activity.
C/S Ratio = Total Contribution ÷ Total Sales or
(Contribution/unit) ÷ (SP/unit)

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Break Even Point (BEP) in terms of sales revenue can be calculated with the C/S ratio.
BEP (in terms of value - $) =Fixed Cost ÷ C/S Ratio
To achieve Target profit

Sales Revenue to achieve target profit = (Fixed Cost + Profit) ÷ C/S Ratio
BREAK EVEN ANALYSIS IN A MULTI-PRODUCT ENVIRONMENT

Organizations produce and sell a variety of products & services. To perform Break
Even Analysis in a multi-product environment on a constant product sales mix is
assumed
Break Even Point (Multiple Products)
Example:
A company produces and sells 2 products. Product1 sells for $7/unit with variable
cost of $2.94/unit. Product 2 sells for $15/unit with variable cost of $4.50/unit. It is
estimated that for every 5 unit of Product 1 sold, one unit of Product 2 will be sold.
Fixed cost is $36,000. Calculate the Break Even Point for the company.
Solution
 Step 1: Calculate the contribution/unit for each product
Product 1 Product 2
Selling Price 7.00 15.00
Variable 2.94 4.50
Cost
Contribution 4.06 10.05
 Step 2: Calculate the contribution/mix

= (4.06 × 5) + (10.50 × 1) = $30.80
 Step 3: Calculate the Break Even Point in terms of the number of mixes
= Fixed Cost ÷ contribution/mix = 36,000 ÷ 30.8
= 1,169 Mixes
 Step 4: Calculate the Break Even Point in terms of the number of units
= (1169 × 5) for Product 1 = 5845

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= (1169 × 1) for Product 2 = 1169

 Step 5: Break Even Point in terms of Revenue
= (5845 × 7) + (1169 × 15) = 40,915 (Product 1) + 17,535 (Product 2) = $58,450
(Total Revenue)
Contribution to Sales Ratio (Multiple Products)

To calculate the Contribution to Sales Ratio
 Step 1: Calculate the Revenue/Mix
 Step 2: Calculate Contribution/Mix
 Step 3: Calculate the weighted average C/S ratio
Using Previous example
 Step 1: (5 × 7) + (1 × 5) = 50
 Step 2: (5 × 4.06) + (1 × 10.50) = 30.8
 Step 3: 30.8 ÷ 50 = 0.616
BEP (Value) can also be determined

BEP ($) = Fixed Cost ÷ C/S ratio = 36,000 ÷ 0.616 = $58,442 (rounded figure)
Illustration:
Synergy manufactures and sells product 3 products A, B & C. Relevant information is
as follows:
A B C
Selling 135.0 165.0 220.0
Price
Variable 73.5 58.9 146.2
Cost
Total Fixed Cost of $950,000

An analysis of past trading patterns indicate that the products are sold in the ratio of
3: 4: 5
Determine the BEP in terms of unit and value using
1) The contribution per unit approach
2) The Contribution/Sales Ratio approach
*******Solution
A = 2916 units = $393,660
B = 3888 units = $641,520
C = 4860 units = $1,069,200
Points to note
1) A change in the product mix will change the BEP
2) If the mix shift towards products which lower contribution margins, BEP(Units) will
be higher
3) If the mix shifts towards product with higher contribution margins BEP contribution
will be lower
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Illustration: A company products 2 products A & B. The company expects to sell one
units of A for every two units of B. It has monthly sales revenue of $150,000. Product A
has a C/S Ratio of 20% and product B has a C/S ratio of 40%. Budgeted monthly Fixed
Costs are $30,000. What is the Budgeted BEP in terms of sales revenue?
Solution
Weighted Average C/S Ratio = ((20 × 1) + (40 × 2)) ÷ 3
=33.33%
BEP (Sales) = Fixed cost ÷ C/S Ratio
BEP (Sales) = $30,000 ÷ 0.333 = $90,000
Margin of Safety (Multiple Products)

Margin of Safety for a multi-product organization is equal to the Budgeted Sales in
the standard mix less Break Even Sales. It may be expressed as a % of the budgeted
solution.
Output required to achieve Target Profit (Multiple Product)

Number of mixes to achieve target profit = (Fixed Cost + Target Profit) ÷
Contribution/mix
Illustration:
An Organization makes and sells 3 products F, G & H. The products are sold in
proportions of F: G: H = 2: 1: 3 Fixed cost is $80,000 per month & details of the
products are as follows:
SP/unit VC/unit
F 22 16
G 15 12
H 19 13
The organization wishes to earn a profit of $52,000 next month. Calculate the
required sales value of each product in order to achieve the target profit.
 Step 1: Calculate the contribution per unit
F G H
SP 22 15 19
VC 16 12 13
Contribution 6 3 6
 Step 2: Contribution Per mix

= (6 × 2) + (3 × 1) + (6 × 3) = 33
 Step 3: Number of mixes to achieve target profit
= (Fixed Cost + Profit) ÷ Contribution/mix = (80,000+ 52,000) ÷ 33 = 4,000 mixes
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 Step 4: Required Sales (Units & Revenue)

Units SP/unit Sales
Revenue
F 4,000 × 2 = 22 176,000
8,000
G 4,000 × 1 = 15 60,000
4,000
H 4,000 × 3 = 19 228,000
12,000
TOTAL 464,000
Alternatively, the C/S ratio could be used

********Classwork use C/S ratio
Multi Product Break Even Chart

Multi Product Profit / Volume Chart
Illustration:
Assume that budgeted sales are 2,000 units of product X, 4,000 units of Product Y and
3,000 units of Product Z. Also assume that the output and sales of X, Y and Z are in
constant proportions. Fixed cost is $10,000.
The following information also applies.
X Y Z
SP/unit 8 6 6
VC/unit 3 4 5

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Draw the Profit Volume Chart and determine the break-even point.
*****
Read up
1. Limitations of CVP Analysis
2. Advantages of CVP Analysis

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PRICING DECISIONS
Factors that affect or influence the prices of goods and services
1. Cost
2. Customers
3. Competitors
Demand:
Economic theory argues that the higher the price of a good, the lower the quantity
demanded.
Price
Demand
A normal demand curve
Other possible demand curves
Price
Demand
Q
Demand is totally unresponsive to price and is said to be COMPLETELY INELASTIC

(supplier can sell a certain quantity at any price)

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Price
Demand
Demand might be limitless at any price but there would be no demand above price
P & there is no point dropping price below P. Demand is said to be COMPLETELY
ELASTIC.
Price Elasticity of Demand (η)
Price elasticity of demand is a measure of the extent of change in demand for a

good or product in response to a change in its price.
η = % change in quantity demanded

% change in price
Demand is elastic if η is greater than 1 but is inelastic if it is less than 1.
Perfectly inelastic η = 0, perfectly elastic η = ∞
Deriving the demand equation
P= a – bQ
Where,
P = Price, Q = quantity, a = price when Q = 0, b = Change in price
Change in qty
Total Cost Function
An organization’s total cost (TC) might be determined using the equation
Y = a + bx
Where,
y = Total cost, a = Fixed cost, b = Variable cost per unit, x= no of

units
TC = FC + VC/unit * no of units

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And Q = number of units sold.
TC
No of units
Pricing Strategies
1. Cost – Plus Pricing:

a. Full cost plus pricing – This is a pricing strategy that involves adding a profit
margin to the full cost of the product or service.
Advantages
i. It is a simple method of pricing

ii. It is a cost effective method of setting prices
iii. The full cost plus the profit margin will ensure that fixed cost is covered and
profit is made.
Disadvantages
i. It does not recognize that demand may be determined by price and that
there will be a profit maximizing combination of price and demand.
ii. It does not consider market and demand conditions
iii. Budgeted output volume will have to be determined so as to get a
reasonable overhead absorption rate.
iv. A suitable basis for overhead absorption must be selected.
b. Marginal cost plus pricing – This involves adding a profit margin to the
marginal cost of production or sales.
Advantages
i. It is simple and easy to use
ii. Profit mark up can be varied to reflect demand conditions
iii. It draws management attention to contribution
Disadvantages
i. It ignores fixed overheads

ii. It does not completely ensure that attention is paid to demand condition,
competitor prices and profit maximization.

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1. Market Skimming Pricing:

Price skimming involves charging high prices when the product is launched into
the market to maximise short term profit.
Price scheming is appropriate when:
i. The product is new and different so customers are prepared to pay.
ii. The strength of demand and the sensitivity of demand to price are not
known. It is better to start with a high price and then reduce them.
iii. Products have a short lifecycle.
2. Market Penetration Pricing:

Penetration pricing is a policy of low prices when a product is first launched in
order to obtain penetration into the market.
It is appropriate in the following cases:

i. The firm wishes to discourage new entrants
ii. The firm wants to enter the growth and maturity stages of the product
lifecycle as quickly as possible.
iii. Economies of scale can be achieved from a high volume of output.
iv. Demand is highly elastic and so would respond well to low prices.
3. Complimentary Product Pricing

Some products are used and bought together so one product is priced low
and the other is priced higher to give a desirable profit margin.
4. Volume Discounting
A volume discount is a reduction in price given for larger than average
purchases. The aim is to increase sales
5. Price discrimination
The use of price discrimination means that the same product can be sold at
different prices to different customers.
Price discrimination can only be effective if
i. The market is segment able in price terms and the different segments
respond differently to price.
ii. There is little chance of a black market
iii. Competitors cannot undercut the firms prices in higher priced market
segments
iv. The cost of creating and administering segments does not exceed the extra
revenue to be derived.
Product line pricing
Relevant cost pricing

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Profit Maximizing Price
This part of the syllabus extends the concept of price elasticity of demand and the linear relationship
that exists between Price and Quantity demanded.
The idea here is based on the micro economic theory that profit maximization is the process by which a
firm determines the price and output level that returns the greatest profit.
 The approach to this problem that is relevant here is this: Marginal revenue (MR)-Marginal Cost
(MC), this is based on the fact that total profit in a perfect market reaches its maximum point
where marginal revenue is equal to marginal cost
 In summary the theory states that as output increases the marginal cost rises because of the law
of diminishing returns and in a normal price-demand relationship this means that MR reduces. A
point is then reached when MC is greater than MR and it will not make sense to produce an
extra unit of the product.
 This implies that profit will only continue to maximized at an output level where marginal cost
has risen to be exactly equal to Marginal revenue.
 Simply put profit is maximized when MR=MC.
Determining the profit maximizing price using Equations
The following steps should be followed when determining the profit maximizing price:
1. Determine the demand equation P=a - bQ from information given

2. Determine using exam formula MR=a - 2bQ, the profit maximizing quantity Q and then ascertain
that MR= MC
3. Insert Q into the Demand equation P= a – bQ to determine the profit maximizing price.
Examples will be demonstrated in Class

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SHORT TERM DECISIONS

Relevant costs
Relevant costs are future cashflows arising as a direct consequence of a decision.
 Relevant costs are future costs

 Relevant costs are cashflow
 Relevant costs are incremental costs
 Relevant costs are opportunity costs
Make or buy decisions
A ‘Make or Buy’ decision is a decision that an organization takes to either make a

product by itself or pay another organization to do so.
The make option should give management more direct control over the work but the
buy option has the benefit that the external organization has a specialist skill and
expertise in the work.
The following are some reasons to buy from other companies:
1. Flexibility to meet urgent demand of customers;

2. Overcome limiting factor problem;
3. Concentrate on its own core competencies;
4. Take advantage of the specialist skill and expertise of the outsiders;
5. Overcome production bottleneck and
6. Solve seasonal demand problem
The relevant cost of making and the relevant cost of buying should be considered. If
it is cheaper to make, the company should manufacture internally and if it cheaper
to buy then the company should buy from the outsiders. In a Make or Buy situation,
there are other factors to consider:
1. The quality of the products being purchased externally;
2. Whether delivery time is able to be met and
3. Customer loyalty might be affected if sales are forgone due to cases of full
capacity
Outsourcing Decision
Outsourcing is the use of external suppliers for finished products, components or

services. This is also known as contract manufacturing or subcontracting.
Reasons for outsourcing
1. The decision is made on the ground that specialist contractors can offer
superior quality and efficiency.

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2. Contracting out manufacturing frees the capital that can be invested in core
activities such as market research, product definition, marketing and sales, etc.
3. Contractors have the capacity and flexibility to start production very quickly to
meet sudden variations in demand.
Factors to consider before outsourcing
1. Control:
The in-house option should give management more direct control over the
work
2. Skill and expertise:
The outsourcing option often has the benefit that external organization has a
specialist skill and expertise in the work that may not be available in – house.
3. Capacity:
Will the outsourcing create spare capacity?
4. Are there hidden benefits to be obtained from outsourcing?
5. Would the company’s work force resent the loss of work to outside contractors
and can it possibly cause an industrial dispute?
6. Would the subcontractor be reliable with delivery times?
7. Would the subcontractor be reliable with quality?
Further processing decisions
The decision to sell a product as it is or to process it further to generate additional

revenue is another common management decision. A product should be processed
further past the split of point if sales value minus post separation costs is greater than
sales value at split off point.
Shut down decisions
A shut down decision involves
1. Whether or not a company should close down a product line, department or

other activity, either because it is making a loss or it is too expensive to
maintain
2. Whether the closure should be permanent or temporary.
Implications of a shut down
1. A shut down should result in savings in annual operating costs

2. Closure would release unwanted noncurrent assets for sale
3. Employees affected by the closure must be made redundant or relocated.
Qualitative factors to consider
1. What will the impact of the shut down have on employee morale?
2. What signal will the decision give to competitors?
3. How will customers react?
4. How will suppliers be affected?

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RISK AND UNCERTAINTY

Risk or uncertainty is the possibility that a situation or event may or may not occur.
Risk involves situations or events whose probability of occurrence can be calculated

statistically and the frequency predicted from past records. Uncertainty involves
situations that cannot be predicted (i.e. probability cannot be assigned.)
Risk Preference
1. Risk seeker – interested in the best outcomes no matter how small the chance
2. Risk neutral – concerned with the most likely outcome
3. Risk averse – acts on the assumption that the worst possible outcome might
occur
Probabilities and Expected Values
An expected value is a weighted average value based on probabilities. Expected

values indicate what an outcome is likely to be in the long term.
Where probabilities are assigned to different outcomes, we can evaluate the worth
of the decision as the expected value (weighted average) of these outcomes.
Limitations of Expected Values
1. It does not consider the worst possible outcome

2. Expected value is merely a weighted average. It is unlikely to ever occur
3. Supports a risk neutral attitude
Decision Rules
1. Maximin decision rule:

This rule suggests that a decision maker should select the alternative that offers
the least unattractive worst outcome. I.e. maximize the minimum profit.
The maximin decision rule suggests that he should select the ‘smallest worst result’
that could happen.
2. Maximax decision rule:
This suggests that the decision maker looks at the best possible result. i.e. maximize
the maximum profits.
Criticism of Maximin
 It is defensive and conservative
 It ignores the probability of each different outcome taking place.
Criticisms of Maximax
 It ignores probabilities
 It is overoptimistic

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3. Minimax regret rule

Minimax regret rule aims to minimize the regret from making the wrong decision.
Regret is the opportunity lost through making the wrong decision.
****Note****
Regret for any = Profit for best action in those - Profit for
combination of actions circumstance action actually chosen
and circumstance in those circumstance
The decision rule is the action that minimizes the maximum potential regret.
Sensitivity Analysis
Sensitivity analysis is a term used to describe any technique whereby decision options
are tested for their vulnerability to changes in any variable such as expected sales,
sales price per unit, material costs or labor costs.
Sensitivity analysis can be used in any situation so long as a relationship between the
key variables can be established. This involves changing the value of a variable and
seeing how the results are affected.
Simulation Models
Decision Trees
A further method for analyzing risk and uncertainty is the decision tree. These are diagrams
that show the options and possible outcomes of a decision. For a decision tree analysis to be
complete a roll back analysis must be carried out.
Rollback Analysis simply evaluates the EV of each decision option. A decision tree is done
from left to right and rollback analysis is done for right to left after the decision tree is
completed.
Developing and Using a Decision Tree
 All possible choices that can be made are shown as branches of a tree
 All possible outcomes of each choice are shown as subsidiary branches on the tree
 Every decision tree starts form a decision point from which the decision options are
being considered
 A square is used to represent a decision point and a circle is used to represent an
outcome point
(A decision point indicates choice and outcome point highlights outcomes)
 Outcome points are usually represented indicated by probabilities.
 A decision can only be reached by the use of rollback analysis
 At each decision point a decision is taken between 2 or more options and at each
outcome point the EV i.e.( weighted average) is determined and rolled back to the
next point.
It is typical for the examiner to test questions here with the assumptions that you are able to
identify and differentiate between options and outcomes and apply your understanding
accurately. Example is thoroughly demonstrated in class

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BUDGETING: PART C
Budgetary planning and control
A budgetary planning and control system is a system for ensuring communication,
co-ordination and control within an organization.
Objectives of a budgetary system:
1. Ensure the achievement of the organizations objectives
2. Compel planning
3. Communicate ideas and plans
4. Co-ordinate activities
5. Provide a framework for responsibility accounting
6. Establish a system of control
7. Motivate employees to improve performance
Approaches to Budgeting (ways in which budgets can be set)
There are three approaches to budgeting
1. Imposed style (Top Down)
In this approach to budgeting, top management prepares a budget with little or
no input from operations personnel which is then imposed on the employee who
have to work to the budget figures.
This method is effective in the following cases:
i. The organization is a newly formed organization
ii. The organization is a small business
iii. During periods of economic hardship
iv. When operational managers lack budgeting skills
v. When the organizations different units require precise co-ordination.
Advantages
i. Strategic plans are likely to be incorporated into planned activities
ii. They enhance the coordination between plans and objectives
iii. They use senior managements awareness of total resource availability
iv. They decrease input from inexperienced or uninformed lower level
employees
v. They decrease the time taken to draw up budgets.
Disadvantages
i. Dissatisfaction, defensiveness and low morale amongst employees
ii. The feeling of team spirit may disappear
iii. Acceptance of organizational goals and objectives could be limited
iv. Feeling that the budget is a punitive device would arise
v. Lower level management initiative could be stifled.
vi. Unachievable budgets could be set for some divisions if consideration
is not given to local conditions.

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2. Participative Style (Bottom Up)

In this approach, budgets are developed by lower level managers who then
submit the budgets to their superiors.
This method is effective in the following circumstance:
i. The organization is well established
ii. The organization is very large
iii. During periods of economic affluence
iv. When operational managers have strong budgeting skills
v. When the organizations different units act autonomously.
Advantages
i. Based on information from employees most familiar with the
department
ii. Knowledge spread among several levels of management is pulled
together
iii. Morale and motivation is improved
iv. Budgets are more realistic
v. Specific resource requirements are included
Disadvantages
i. This approach consumes more time
ii. Changes implemented by senior management may cause
dissatisfaction
iii. May cause introduction of SLACK
iv. They support ‘empire building’ by subordinates
3. Negotiated style of budgeting

This is a combination of the two approaches mentioned and it attempts to
draw on their strengths and advantages.
Adequate participation in the budgeting process is expected to improve motivation.

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Budgetary Systems
A budget is a quantified plan of action for a forth coming accounting period. It can
be set from “top down’ or ‘bottom up’.
Key points to consider when setting and preparing for budgets:
1. Long term plan
2. Limiting factor
3. Budget manual
4. Sales budget
5. Production capacity
6. Functional budgets
7. Discretionary costs
8. Consolidation and coordination
9. Cash budget
10. Master budget
Types of budgetary systems
1. Incremental budgeting
This is so called because it is concerned mainly with the increments in costs and
revenue which will occur in the coming period.
The traditional approach to budgeting, known as incremental budgeting, bases
the budget on the current years result plus an extra amount for estimated growth
or inflation next year.
Incremental budgeting is a reasonable procedure if current operations are as
effective, efficient and economical as they can be. It is appropriate for costs such
as salaries.
In general, it is an inefficient form of budgeting as it encourages slack and
wasteful spending to creep into budgets.
Advantages
i. It is a quick and relatively simple method
ii. The information is readily available so very limited quantitative analysis
is needed
iii. Assuming historic figures are acceptable, only the increment needs to
be justified.
Disadvantages
i. It builds on wasteful spending if the actual figures for this year includes
overspends caused by some form of error.
ii. It encourages organizations to spend up to the maximum allowed so
that they can get a larger budget the next period.
iii. It is not appropriate in a rapidly changing environment.
iv. Uneconomic activities may be continued. It does not let organizations
consider cheaper options.

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2. Fixed and flexible budgets

Fixed budget
A fixed budget is a budget which is designed to remain unchanged regardless
of the volume of output or sales achieved.
The budget is prepared on the basis of an estimated volume of production
and an estimated volume of sales but no plans are made for the event that
actual volumes of production and sales may differ from budgeted volumes.
When actual volumes of sales or production change, a fixed budget is not
adjusted to the new levels of activity.
Flexible budget
A flexible budget is a budget which, by recognizing different cost behavior
patterns, is designed to change budget volumes as volume of output changes.
Flexible budgets can be used at
i. The planning stage
ii. Retrospectively
Preparing a flexible budget

Step 1: Determine the cost behavior patterns, which mean deciding whether
the costs are fixed, variable or semi variable.
Step 2: Allocate costs based on the fixed cost and the variable costs. The semi
variable costs should be separated into the fix and variable component.
3. Zero based budgeting
Zero based budgeting rejects the assumption, inherent in incremental
budgeting, that this year’s activities will continue at the same level or volume
next year and that next year’s budget can be based on this year’s costs plus
an extra amount.
Zero based budgeting involves preparing a budget for each cost center from
a zero base. Every item of expenditure then has to be justified in its entirety in
order to be included in the next year’s budget.
Implementing zero based budgeting
The basic approach of ZBB has three steps
i. Define decision Packages
ii. Evaluate and rank each decision package
iii. Allocate resources according to funds available and the evaluation and
ranking of the competing packages.
Advantages
i. It is possible to identify and remove inefficient or obsolete operations
ii. It forces employees to avoid wasteful expenditure
iii. It responds to changes in the business environment
iv. It challenges the status quo

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v. It results in a more efficient allocation of resources

Disadvantages
i. Increased volume of paper work
ii.Time consuming
iii.
It might give the impression that all decision have to be made in the budget
iv.The organizations information systems might not be capable of providing
suitable information.
v. Ranking process can be difficult.
Applications of zero based budgeting
i. ZBB is not particularly suitable for direct manufacturing. It is best applied to
support expenses
ii. ZBB can be applied to successfully to service industries and local / central
government departments.
iii. ZBB can be used to make rationalization decisions, cutting back on
production and activity levels and cutting costs.
4. Activity based budgeting (ABB)

Activity based budgeting involves defining the activities that underlie the
financial figures in each function and using the level of activity to decide how
much resources should be allocated, how well it is being managed and to
explain variances from budget.
Principles of ABB
i. It is activities which drive costs and the aim is to control the causes (drivers)
of costs rather than the costs themselves, with the result that in the long
term, costs will be better managed and understood.
ii. Not all activities are value adding activities
iii. Most departmental activities are driven by demand and decisions beyond
the immediate control of the manager responsible for the department’s
budget.
iv. Traditional financial measures of performance are unable to fulfill the
objective of continuous improvement.
Benefits of ABB
i. Different activity levels will produce a foundation for the base package and
incremental packages for ZBB
ii. It will ensure that the organizations overall strategy and any likely change
will be taken into account
iii. Concentration is focused on the activities and there is the likelihood that
the activities would be carried out efficiently.

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5. Rolling Budgets
A rolling budget is a budget which is continuously updated by adding a further
accounting period when the earlier accounting period has expired.
Rolling budget is an attempt to prepare targets and plans which are more
realistic and certain.
Advantages
i. It reduces the element of uncertainty
ii. It forces managers to reassess the budget regularly and to produce
budgets that are up to date
iii. Planning and control will be based on a recent plan which is likely to be
more realistic than a fixed annual budget made months ago
iv. Realistic budgets have a better motivational influence on managers
v. There is always a budget which extends for several months ahead.
Disadvantages
i. Involves more time, effort and money
ii. Frequent budgeting is usually not desired by managers as it shifts their focus
from important operational issues.

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Beyond budgeting
This is a model that proposes that traditional budgets should be abandoned.
Adaptive management processes should be used rather than a fixed annual budget.
Criticisms of budgeting
1. Budgets are time consuming and expensive
2. Budgets produce poor value to users
3. Budgets focus on the short term
4. Budgets are too rigid and prevent fast response
5. Budget protects rather than reduce costs
6. Budgets focus on sales targets rather than customer satisfaction
7. Budgets leads to unethical behavior
Concepts of beyond budgeting

1. Use adaptive management processes rather than the more rigid process.
E.g. focus on cash forecasting rather than cost control.
2. Move towards devolved networks rather than centralized hierarchy.
Changing budgetary systems

An organization might need to change its budgetary system or practices and this will
likely lead to the following challenges:
1. Resistance by employees
2. Loss of control
3. Training costs
4. Cost of implementation
5. Lack of accounting information
Budget systems and uncertainty

The element of uncertainty can be allowed for in budgeting by means of the
following:
1. Flexible budgeting
2. Rolling budgets
3. Sensitivity analysis
Possible causes of uncertainty in budgeting are
1. Customers may decide to buy less than forecast
2. Product / services might not be required by customers
3. Inflation and movements in interest and exchange rate
4. Competitors might eat into the organizations market share
5. Employees may not work as hard as expected
6. Machines may breakdown unexpectedly
7. There may political unrest, natural disaster, etc.

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STANDARD COSTING:
A standard cost is an estimate unit cost.
Uses of Standard Costing
Main uses
1. To value inventories and cost production for cost accounting purposes. (an
alternative to FIFO & LIFO)
2. To act as a control device by establishing standards and comparing actual
costs with expected costs.
Other uses
3. To assist in setting budgets and evaluating management performance

4. To provide a prediction of future cost
5. To motivate staff
Types of standards:
There are four types of standards
1. Ideal standard – a standard that can be achieved under perfect operating

conditions. No wastage, no inefficiencies, no idle time, no breakdown.
2. Attainable standard – a standard that can be achieved if production is carried
out efficiently, machines are properly operated and materials are properly
used. Some allowance is made for wastage and inefficiencies.
3. Current standard – a standard based on current working conditions
4. Basic standard – a long term standard which remains unchanged over the
years and used to show trend.
VARIANCE ANALYSIS
A variance is the difference between an actual result and an expected result.
Variance analysis is the process by which total difference between standard and
actual results are analyzed.
Types of Variances
Cost variances:
1. Direct Material

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2. Direct Labor
3. Variable Production Overhead
4. Fixed Production Overhead
Sales Variances:
1. Selling Price Variance

2. Sales Volume Variance
Operating statement in a marginal costing environment
There are two main differences between the variances calculated in an absorption
costing system and in a marginal costing system.
1. In a marginal costing system, the only fixed overhead variance is an

expenditure variance (i.e. no volume variance).
2. Sales Volume variance is valued at standard contribution not standard profit.

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Reasons for Variances
Variance Favorable Adverse

Material  Actual purchase prices lower  Actual price higher than
Price than standard standard
 Price inflation lower than  Price inflation higher than
expected expected
 Unforeseen discounts received  Careless purchasing
 Greater care in purchasing  Change in standard quality of
 Change in standard quality of material
material  Material purchased in a hurry
 New supplier selling at a lower so at a higher price
price
Material  Material used of higher quality  Defective materials
Usage than standard  Excessive wastage
 More efficient use of materials  Theft
 Experienced workforce  Inexperienced workforce
 Improvement in production  Stricter quality control
methods  Errors in allocating material to
 Errors in allocating material to jobs
jobs
Labor rate  Use of low quality workers at a  Use of experienced and high
lower rate than standard quality workforce at a higher
 Wage rate reduction rate than standard
 Wage rate increase
Idle time  Idle time variance is usually  Machine breakdown
adverse  Non availability of materials
 Expected idle time greater  Illness or injury to workers
than actual idle time
Labor  Output produced more quickly  Output lower than standard
efficiency than expected due to set due to lack of training
motivation of staff  Substandard materials
 better quality of equipment or  High labor turnover leading to
materials, etc relatively new and
 Use of experienced workforce inexperienced workforce
 Good quality supervision  Low quality supervision
 Errors in allocating time to jobs  Errors in allocating time to jobs
Overhead  Savings in cost of services  Increase in cost of services
expenditure incurred  Excessive use of services
 More economical use of  Change in type of service
services used
Overhead  Production or level of activity  Production or level of activity
volume greater than budgeted less than budgeted
Selling price  Unplanned price increase  Unplanned price reduction
 Strong demand so that higher  Weak demand so price had to
prices can be charged be dropped
 Inflation resulting to higher  Trade discounts not planned
prices for
 General increase in market  Completion so price had to be
prices dropped
Sales  Additional demand probably  Unexpected fall in demand
volume due to low prices probably due to high prices
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 New customers leading to  Production difficulties

increased sales (volumes)  Loss of major customer leading
 Effective marketing to reduced sales (volumes)
 Improvement in product  Ineffective marketing
design or service delivery  Poor after sales service
resulting in loss of customers
Investigating Variances
To investigate variances, their significance should be decided using
1. Materiality
2. Controllability
3. Variance trend
4. Type of standard
5. Interdependence between variances
 Material price and usage
 Labor rate and efficiency
 Selling price and sales volume
6. Cost of investigation
Possible control actions
1. Review standards if out of date

2. Identify efficient or inefficient operations
3. Improve accuracy of the recording system if due to measurement errors.
MATERIALS MIX AND YIELD VARIANCE

The material usage variance can be subdivided into a materials mix variance and a
materials yield variance.
A mix variance occurs when the materials are not mixed or blended in standard
proportions and it is a measure of whether the actual mix is cheaper or more
expensive than the standard mix.
A yield variance arises because there is a difference between what the input should
have been for the output achieved and the actual input.
Sales and mix Quantity Variance
Just as we have mix and yield variances for materials issued into production when there are
more than one materials that make up a product, Sales volume variances can also be
analyzed into Mix and Quantity variances, if a company produces and sells more than one
product.
Other conditions that need to be fulfilled to calculate mix and quantity variances are as
follows
1. Company must be able to control the proportions of the products sold

2. There must be some link between the products been produced for example the
following;

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 Products may be complementary products

 Products may be substitutes
 Same Products but different sizes
 Products within a limiting factor environment
Sales Mix variance
This variance occurs when the proportion of the various products sold are different from
those in the budget.
Sales Quantity Variance
This shows the difference in contribution that arises as a result of a change in sales volume
from the budgeted volume of sales.
The same approach used in mix and yield variances can be used. We will be comparing as
follows;
Sales Mix variance is calculated as the difference in Actual Quantity in Standard Mix and
Actual quantity in Actual mix (AQSM compared with AQAM), valued at standard margin per
unit
Sales Quantity Variance is calculated as the difference between the Actual Quantity in
Budgeted mix and Budgeted Quantity in Budgeted Mix
Examples will be demonstrated in class

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PART D - PERFORMANCE MEASUREMENT

MANAGEMENT INFORMATION SYSTEMS
PLANNING, CONTROL AND DECISION MAKING
Information flows within organizations to help people formulate plans, take decisions and
carry out control actions when the plans and decisions do not work.
Planning: Formulates ways to move the organization forward.
Decision Making: Choosing between various alternatives. Strategic decisions are usually long
term decisions and have a greater impact. Usually done by top management
Control: monitoring and taking corrective actions.
MANAGEMENT LEVELS
Anthony’s decision making hierarchy
Strategic (Strategic Planning): Long term planning and decision.

Tactical (Management Control): Medium term planning and management control decisions.
Operational (Operational Control): Operational and short term decisions and processing of
transactions.
Strategic Planning:
This is the process of deciding on the objectives of the organization, on changes in these
objectives, on the resources used to attain these objectives and on the policies that govern
the acquisition, use and disposition of the resources.
Accounting information required:
1. Information about competition – costs / products
2. Developments in the industry
3. Information about customers – customer profitability
4. Pricing
5. Capacity expansion
6. Resource availability
7. Market share

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Management Control:
This is the process by which managers ensure that resources are obtained and used
effectively and efficiently in accomplishing organizations objectives. It is also called tactical
planning.
Accounting information required: Usually generated internally.
1. Productivity measurements
2. Budgetary control and variance analysis reports
3. Cashflow forecasts
4. Staffing levels
5. Profits within departments
6. Short term purchase requirements
Operational Control:
This is the process of ensuring that specific tasks are carried out effectively and efficiently. It is
more narrow focused and have shorter time frame than the tactical level.
Accounting information required: the information is more detailed than the others.
1. Operational information needed for the day to day implementation of plans
2. Transaction data e.g. customer orders, purchase orders, cash receipts, payments.
MANAGEMENT INFORMATION SYSTEMS
Transaction Processing Systems:
A transaction is an event that generates or modifies data that is eventually stored in an
information system.
A transaction processing system (TPS) collects, stores, modifies and retrieves the transactions
of an organization.
Types:
1. Batch transaction processing
2. Real time transaction processing.
Characteristics:
1. Controlled processing: The processing must support the organization’s operations.
2. Inflexibility: Transactions are processed the same way.
3. Rapid response: Inputs must become outputs in seconds
4. Reliability: The system must be reliable. Backup and recovery should be quick and
accurate.
Management Information Systems:
The MIS converts data from mainly internal sources into information. This information enables
managers make timely and effective decisions for planning, control and decision making. It
generates information for monitoring performance and maintaining coordination.
Characteristics:
1. Supports structural decisions at operational and management control levels.
2. Designed to report on existing operations.
3. Have little analytical capability
4. Relatively inflexible
5. Have internal focus

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Executive Information Systems:

EIS provides a generalized computing and communications environment to senior managers
to support strategic decisions. It draws data from the MIS and allows communication with
external sources of information.
Characteristics:
1. Menu driven user friendly interface
2. Interactive graphics to help visualization
3. Communication links to external databases.
Enterprise Resource Planning System:

ERP systems are modular software packages designed to integrate the key processes in an
organization so that a single system can serve the information needs of all functional areas.
Characteristics:
1. Integrated to all key processes of the organization
2. Share the same database
3. Standardized information
4. Online, real-time.
OPEN AND CLOSED SYSTEMS
Closed Systems:
A closed system is a system that is isolated and shut off from the environment. Information is
not received from or provided to the environment.
Open Systems:
An open system is a system that is connected to and interacts with the environment. It is
influenced by the environment.
Advantages of an open system:
1. It encourages communication
2. It adapts to the changing environment
3. It helps leaders become aware of external factors
4. Highlights interdependence of different operations
Limitations:
1. Non-linear relationships could exist. A small change in one variable can lead to a
large change in another variable
2. It may be difficult to measure the success of the system.

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SOURCES OF MANAGEMENT INFORMATION

Internal sources
1. Financial accounting records
2. Payroll system
3. Production system, etc
External sources
1. Government agencies
2. Associations
3. Published sources
4. Internet, etc
PERFROMANCE MEASUREMENT:
Performance measurement aims to establish how well an organization or an individual is
doing in relation to a plan. Performance measurement is a vital part of the control process.
A performance measure is the basis against which the action of an individual can be
compared.
Reasons for performance measures:
1. To Evaluate
2. To Control
3. To Budget
4. To Motivate
5. To Improve performance
Factors to consider in determining performance measures
1. The performance measure should be relevant
2. It should be realistic
3. It should be fair
4. It should reflect both short and long term objectives
5. Performance must be measured in relation to something
Types of performance measures

1. Financial Performance Indicators (FPI)
2. Non Financial Performance Indicators (NPFI)
FINANCIAL PERFORMANCE INDICATORS:

Financial performance indicators are quantitative or monetary performance measures.
Examples include
1. Profit
2. Revenue
3. Costs
4. Share price
5. Cash flow
Financial ratios are usually calculated when analyzing financial performance.

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Profitability ratios
1. Gross Profit Margin: This ratio indicates average gross profit on turnover. It indicates
how much of total revenue is used in the purchase of materials (and other direct
expenses) for production.
Gross Profit Margin = Gross Profit * 100
Sales
2. Operating Profit Margin: This ratio measures how well a company is able to control its
expenses.
Operating Profit Margin = Profit Before Interest and Tax (PBIT) * 100
Sales
3. Asset Turnover: Asset turnover is a measure of how well the assets of a business are
being used to generate sales.
Asset Turnover = Sales
Capital Employed
4. Return On Capital Employed: This ratio measures how efficiently and effectively
management has deployed the resources available to it, irrespective of how those
resources have been financed. Capital Employed in this case is Total Assets less
Current Liabilities or Long term Liabilities plus Shareholders funds. It is a combination of
the Operating Profit margin and Asset Turnover.
ROCE = PBIT
Capital Employed
Long Term Solvency
1. Financial Gearing: Gearing measures the relationship between Shareholders Capital
plus reserves and debt. Debt is any loan which pays interest, medium to long term and
are usually secured. Overdrafts do not form part of debt in a gearing ratio.
Gearing = Debt
Debt + Equity
A gearing ratio of over 50% indicates a high gearing.
A highly geared company must earn enough profits to cover its interest charges
before anything is available for equity. On the other hand, if borrowed funds are
invested in projects which provide returns in excess of the cost of debt capital, the
shareholders will enjoy returns on their equity.
2. Operating Gearing: This measures the business risk the company is exposed to. Business
risk refers to the risk of making low profits or even losses due to the nature of the
business that the organization is involved in.
Operating gearing = Contribution
Profit Before Interest and Tax
Short Term Liquidity
Liquidity is the amount of cash a company can obtain quickly to settle its debt (and possible
meet other unforeseen demands for cash flow).
1. Current ratio = Current asset
Current Liabilities
Ideally a ratio of excess of 1 is desirable but what is ideal varies between the different
types of business.
2. Quick ratio = Current asset less inventory
Current liabilities

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Ideally the ratio should be at least 1. For companies with fast inventory turnover, a
ratio of less than 1 might be acceptable.
Efficiency ratios
1. Inventory Turnover period: this shows how long inventory is held by a company
Inventory turnover period = Inventory *365
Cost of Sales
2. Accounts receivable collection period: This measures the number of days it takes a
company to recover its debt from customers.
= Trade debtors * 365
Credit sales (or turnover if credit sales figure is not
available)
3. Accounts payables payment period: This measures the number of days it takes a
company to pay its creditors.
= Trade Creditors * 365
Credit purchases (or cost of sales)
Investors’ ratios
1. Earnings per share: ‘Earnings per share’ (EPS) is defined as the profit attributable to
each equity (ordinary share).
EPS = Profit after tax less preference dividend interest
Number of ordinary shares
2. Dividend per share: This is defined as the dividend payable on each ordinary share.
DPS = Total dividend payable (paid)
Number of ordinary share
Limitations of financial performance indicators

1. Concentration on too few variables. FPIs focuses entirely on those items which can be
expressed in monetary terms so managers will usually concentrate on only those
measures and ignore other important measures that cannot be expressed in
monetary terms.
2. Lack of information on quality. FPIs do not provide information on the quality or
importance of operations.
3. Changes in cost structures. A greater proportion of costs are sunk and a large
proportion of costs are planned, engineered or designed into a product/service
before production/delivery. At the time the product/service is produced/delivered, it
is therefore too late to control costs.
4. Changes in competitive environment. Financial measures do not convey the full
picture of a company's performance, especially in a modern business environment.
5. Indicators of past performance. Financial performance indicators are based on
historical figures so they tend to indicate past performance and focus on the short
term. They do not necessarily indicate future performance.
NON FINANCIAL PERFORMANCE INDICATORS:
NFPIs are measures of performance based on non financial information which may be used
to monitor and control organizational activities, without any accounting input. NFPIs are a
better indicator of future prospects. NFPI’s usually relate to Customer satisfaction, Quality of

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service, Marketing effectiveness, Personnel, Research and development, Production

performance, The environment.
1. Customer satisfaction / Quality of service: Possible measures of customer satisfaction
are:
a. Customer complains
b. Waiting time
c. Delivery time
d. Number of returns
2. Marketing effectiveness
a. Number of customers
b. Market share
c. Volume of sales
3. Personnel
a. Staff turnover
b. Staff complains
c. Employee satisfaction
d. Training time per employee
4. Research and development
a. Research and development vs competition
b. Failure rate
c. No of new products developed
5. Production performance
a. Quality of output
b. Scrap and reworks
c. Production turnaround time
6. The environment
a. Cleanliness
b. Environmental impact assessment
c. Safety
Short-Termism:
This occurs when there is a bias towards short term performance rather than long term
performance. Organizations often have to make a trade off short term and long term and
short term objectives. Methods of encouraging a long term view are as follows:
1. Making short term targets realistic
2. Providing sufficient information to allow managers see the tradeoffs they are making.
They should be aware of both long term and short term targets
3. Evaluating managers in terms of long term and short term objectives
4. Link managers reward to share price
5. Set quality based targets as well as financial targets.
It is more suitable to use multiple measures of performance where each measure reflects a
different area of achievement. There are models that combine both Financial Indicators and
Non Financial indicators in measuring performance. Examples are The Balanced Scorecard
and The Building Blocks model (by Fitzgerald and moons).

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THE BALANCED SCORECARD:

The balanced scorecard approach emphasizes the need to provide management with a set
of information which covers all relevant areas of performance in an objective and unbiased
fashion. The information provided will be both financial and non financial and should cover
areas such as profitability, customer satisfaction, internal efficiency and innovation.
The balanced scorecard focuses on four (4) different perspectives
1. Customer perspective- Gives rise to targets that matter to customers. For example,
cost, quality, delivery, handling, etc.
2. Internal perspective - Aims to improve internal processes and decision making
3. Innovation and learning perspective- Considers the business capacity to maintain its
competitive position through acquisition of new skills and development of new
products.
4. Financial perspective – covers traditional measures such as growth, profitability and
shareholder value.
Performance measurement in service organizations

Service organizations have a number of limitations that make it difficult to determine
performance measures. Some of the limitations are as follows:
1. Unavailability of a physical product
2. Intangibility of service rendered
3. Service not transferable
4. Services are perishable
BUILDING BLOCK MODEL

Fitzgerald and Moons building blocks for Dimensions, Standards and Rewards attempt to
overcome the problems associated with performance measurement in service industries as
the measurement of performance in service industries is perceived to be difficult.
Fitzgerald and Moons provide building blocks for Standards, Rewards and Dimensions.
Building blocks for standards:
1. Ownership – to ensure employees take ownership of standards, they need to
participate in the budget and standard setting process
2. Achievability – standards need to be set high enough to ensure a sense of
achievement but should not be so high as to make it unachievable.
3. Equity – Equity should be seen to occur when applying standards. For example,
different units should not be measured against the same standards if some units have
advantages unconnected with their efforts.
Building blocks for rewards:
The reward structure should guide individuals to work towards the standards. The reward
system should
1. Be clear - the organizations objectives should be clearly understood and rewards and
penalties should also be clearly stated
2. Motivate – individuals should be motivated to achieve organizations objectives.
Bonuses can be used to motivate.

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3. Based on areas of responsibility and control – managers should have certain level of
control over their areas of responsibility.
Dimensions:
These are the dimensions with which the performance measures would take
1. Competitive performance – focuses on factors such as sales growth, market share
2. Financial performance – profitability, cost, capital structure
3. Quality of service - matters like reliability, courtesy and competence
4. Flexibility – ability to deliver at the right time, respond to customer needs, cope with
demand
5. Resource utilization – efficiency in the usage of resources like labor, materials, time,
space, etc
6. Innovation – innovative processes, new products
The first two (1 and 2) are known as results while the remainder (3 to 6) are known as
determinants. This means that items 3 - 4 determine the results 1 & 2.

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DIVISIONAL PERFORMANCE MEASURES

Large organizations can be structured divisionally. A divisionalized structure refers to the
organization of an entity in which the different operating units has its own management
team which reports to the head office.
Divisional managers are therefore responsible for all operations (sales, production, etc)
relating to their product or service. A divisional structure will lead to decentralization of the
decision making process and divisional managers may have the freedom to set selling prices,
choose suppliers, employ staff, invest in fixed assets, etc.
Advantages of divisionalization
1. Quality of decisions should improve because divisional managers understand local
conditions
2. Allows decisions to be taken more quickly
3. The authority to act should motivate divisional managers
4. Divisions provide valuable training ground for future members of top management
Disadvantages of divisionalization
1. Divisional managers might put the interest of their divisions before the interests of the
organization as a whole. Thereby taking actions that benefit their division but works
against the whole group.
2. Cost of activities that are common to all organizations may be greater for a
divisionalized structure than for a centralized structure
3. Top management may lose control since they may not be aware of happenings in
the individual divisions. Cost of monitoring will be high.
Responsibility Accounting
Responsibility accounting is the term used to describe the decentralization of authority with
the performance of the decentralized unit measured in terms of accounting results.
Types of responsibility center
1. Cost center – Managers have control over costs. Measures of performance include
cost efficiency, variances, etc.
2. Revenue center – Managers have control over revenues generated. Measures of
performance include revenue (sales).
3. Profit center – Managers have control over costs and revenues. Measures of
performance will include profit.
4. Contribution center – Similar to profit centers but expenditure is in terms of marginal
costs. Performance measures include contribution
5. Investment center – Managers have control over costs, revenues and investment in
noncurrent assets and working capital. Measures of performance include ROI (Return
on Investment), RI (Residual Income), etc.
The performance of an investment centre is usually monitored using Return on Investment
(ROI) and Residual Income (RI).

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Return on Investment (ROI)

Return on Investment (ROI) shows how much profit has been made in relation to the amount
of capital involved and is calculated as:
ROI = Profit * 100%
Capital employed
Advantages of ROI
1. ROI is related to the standard accounting process and widely understood
2. ROI appeal to investors who are interested in assessing % return on their investment
3. ROI allows comparisons between projects that differ in absolute size
4. It is a convenient method of measuring performance.
Disadvantages of ROI
1. It can give a false impression of improving performance over time.
2. It is not easy to compare fairly the performance of investment centre.
3. It focuses on the short term.
4. It is subject to manipulation by management.
Residual Income
The alternative way of measuring the performance of an investment centre instead of using
ROI is Residual Income (RI).
Residual Income is a measure of the centre’s profit after deducting a notional or imputed
interest cost.
Note that:
 The centre’s profit is after deducting depreciation on capital equipment.
 The imputed cost of capital is the organization’s cost of borrowing or weighted
average cost of capital.
Advantages of RI
1. Residual income will increase when investments earnings above the cost of capital
are undertaken and investments below cost of capital are eliminated.
2. Residual income is more flexible since a different cost of capital can be applied to
investments with different risk characteristics.
3. Disadvantages
1. It does not facilitate comparison between investment centres.
2. It does not relate the size of a centre’s income to the size of the investment.
3. It is not easily understood by managers with little accounting knowledge.
Transfer Pricing
Transfer pricing is used when divisions of an organization need to charge other divisions of the
same organization for goods and services they provide to them. For example, subsidiary A
might make a component that is used as part of a product made by subsidiary B of the
same company, but can also be sold to the external market. i.e there are 2 sources of
revenue for A

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1. External sales revenue from sales made to other organizations.

2. Internal sales revenue from sales made within the same organization (values at the
transfer price)
A transfer price is a price at which goods or services are transferred from one department or
subsidiary to another or from one member of a group to another.
Objectives of Transfer Prices

1. Maintaining the right level of divisional autonomy
2. Ensuring divisional performance is measured fairly
3. Ensuring corporate goals are achieved
Setting Transfer Prices

Generally, transfer price should be set between the following ranges:
1. Minimum – The sum of the supplying divisions marginal cost and opportunity cost of
the item transferred.
2. The Maximum – The lowest market price at which the receiving division could
purchase the goods or services externally, less any internal cost savings in packaging
and delivery.
3. Where there is no external market and no alternative for facilities, transfer price should
at the marginal cost.
Illustration
Division X produces product L at a marginal cost per unit of $100. If a unit is transferred
internally to division Y, $25 contribution is forgone on an external sale. The item can be
purchased externally for $150.
Minimum = $(100 + 25) = $125 (Division X should not agree to transfer price of less than $125)
Maximum = $150 (Division Y should not agree to a transfer price in excess of $150)
Approaches to Transfer Pricing

Market based transfer pricing: Transfer prices are set on the basis of the market price.
Consequences
1. The transferring dept earns the same profit on transfers as on external sales. The
receiving dept must pay a commercial price for transferred goods, but division will
have their profits measured in a fair way.
2. The transferring dept will be indifferent about selling external or transferring goods
because the profit is the same on both types of transactions. The receiving dept can
therefore, ask for and obtain as many units as its wants from the transferring dept. A
market based transfer price seems to be the ideal transfer price.
Advantages
1. It enhances divisional autonomy.
2. It should result to over-all profit maximization.
3. It allows divisional performance to be measured fairly

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Disadvantages
1. The market price might be a temporary.
2. Many products might not have an equivalent market price
3. There external market might be imperfect.
Cost based transfer pricing: Cost based approach to transfer pricing is often used in
practice, because the following conditions are common:
1. There is no external market
2. The external market is imperfect.
The cost based approach can either be based on full cost or variable cost.
Full Cost: Under this approach, the full cost, including fixed overhead absorbed incurred by
the supplying division is changed to the receiving division and only its profit mark up/margin is
included to make up the transfer price.
Variable Cost: The marginal cost is used and it does not include the fixed cost.
Limitations of cost based transfer pricing

1. It can undermine divisional autonomy
2. It can distort divisional performance
PERFORMANCE MEASURES IN NOT-FOR-PROFIT ORGANIZATIONS

Not-for-profit Organizations
A not-for-profit organization is an organization whose attainment of its primary goal is not
assessed by economic measures. However, in pursuit of that goal, it may undertake profit
making activities.
Problems with measuring performance of not-for-profit organizations
1. They have multiple objectives and it is difficult to say which is overriding
2. Outputs can be difficult to measured in a way that is generally agreed to be
meaningful
3. Lack of a profit measure
4. The nature of the service provided is such that it is difficult to define a cost unit
5. Political, social and legal considerations
6. There are lots of restrictions when it comes to raising finance
This creates problems when measuring performance of not-for-profit organizations. To solve
this problems
1. Performance can be measured in terms of inputs and outputs
2. Judgments can be made by experts or people providing finance since performance
can be subjective
3. Performance can be compared by benchmarking with similar organizations

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Value for money

Performance is usually judged in terms of inputs and output so the ‘Value for money criteria’
is used to assess not-for-profit organizations.
‘Value for money’ means providing a service in a way which is economical, efficient and
effective. It is measured in terms of
1. Economy
2. Efficiency
3. Effectiveness
Economy: This is concerned with the cost of inputs and it is achieved by obtaining these
inputs at the lowest acceptable cost. The resources must be of the acceptable level of
quality
Efficiency: This means the following:
1. Maximizing output for a given input, or
2. Achieving the minimum input for a given output
Effectiveness: This means ensuring that the outputs of a service have the desired impact. That
is objectives have been met.

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EXTERNAL CONSIDERATIONS TO PERFORMANCE MANAGEMENT

Measuring and managing performance is not done in isolation. Performance management
needs to consider external factors. Such factors include
1. Stakeholders: These are groups of people or individuals who have a legitimate interest
in the activities of an organization. There are 3 types of stakeholders
a. Internal – Employees, management
b. Connected – Suppliers, shareholders, customers
c. External – Community, government, pressure groups
Corporate objectives are usually shaped and influenced by the stakeholders that have
sufficient involvement or interest in the organizations operational activities.
2. Economic Environment (market conditions): These include factors like
a. Economic growth – has the economy grown or is there a recession
b. Local economic trend – are local businesses expanding
c. Inflation – how high is the rate
d. Interest rate – is the cost of borrowing increasing
e. Exchange rate – is it stable, are prices charged to overseas customers affected?
f. Government Fiscal policy
g. Government spending
3. Competition
Performance management should consider information on competitors’ prices and cost
structures. It should also identify features of an organizations product that add the most value
compared to its competitors.

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PAPER F5 - PERFORMANCE MANAGEMENT

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ADVANCED COSTING TECHNIQUES: PART A

Ideas behind ABC

Outline of an ABC system

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Target costing process / Steps in the implementation of a target costing system

Closing a target cost gap

Benefits of adopting a target costing approach

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Principles behind Lifecycle costing

The product life cycle

Diagram of a product lifecycle

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Benefits of lifecycle costing

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Bottleneck Resource (Binding Constraint):

Throughput Accounting is based on three concepts

The differences between a conventional cost accounting system and throughput

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Throughput Accounting Ratio

TA ratio = Return per factory hour

Return per factory hour

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Environmental Management Accounting

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Accounting for environmental costs

DECISION MAKING: PART B

Single limiting factor

Steps in single limiting factor analysis:

Steps in linear programming

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5. Establish feasibility region

The use of Simultaneous equation

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COST – VOLUME – PROFIT (CVP) ANALYSIS

Using the example above

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c) Profit / Volume Chart

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Output required to achieve Target Profit

Q = (200,000 + 300,000) ÷ 20 = 25,000

Contribution to Sales ratio also called Profit Volume ratio

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To achieve Target profit

BREAK EVEN ANALYSIS IN A MULTI-PRODUCT ENVIRONMENT

 Step 2: Calculate the contribution/mix

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= (1169 × 1) for Product 2 = 1169

Contribution to Sales Ratio (Multiple Products)

BEP (Value) can also be determined

Total Fixed Cost of $950,000

Margin of Safety (Multiple Products)

Output required to achieve Target Profit (Multiple Product)

 Step 2: Contribution Per mix

 Step 4: Required Sales (Units & Revenue)