ACCAF5 - CourseNotes2017 - 2nd Half - 150617 - Watermark

Course Notes
ACCA F5
Performance Management
Exams from September 2017
Tutor details
JUNE 2017 RELEASE

ii Introduction AC C A F5
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AC C A F 5 Introduction iii
Contents
Page
Introduction i
1 Paper aim v
2 Rationale v
3 Syllabus overview v
4 Approach to the exam vi
5 Study planner vii
1: Specialist cost and management accounting techniques 1
1 Activity based costing (ABC) 1

2 Target costing 7
3 Life cycle costing 9
4 Throughput accounting 11
5 Environmental accounting 16
2: Decision-making techniques
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1 Relevant cost analysis 19
2 Cost volume profit analysis 24
3 Limiting factors
4 Pricing decisions ntu ght 31
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5 Make-or-buy and other short-term decisions
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6 Dealing with risk and uncertainty in decision-making 52
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3: Budgeting and control 61
1 Budgetary systems and types of budget 61

2 Quantitative analysis in budgeting 69
3 Standard costing 74
4 Basic variances and operating statements (revision of F2 material) 78
5 Material mix and yield variances 89
6 Sales mix and quantity variances 92
7 Planning and operational variances 94
8 Performance analysis 100
4: Performance measurement and control 103
1 Performance management information systems 103

2 Sources of management information 105
3 Management reports 106
4 Performance analysis in private sector organisations 106
5 Divisional performance and transfer pricing 113
6 Performance analysis in not for profit organisations and the public sector 123
7 External considerations and behavioural aspects 124
iv Introduction AC C A F5
Solutions to Class lecture examples 127
1 – Specialist cost and management accounting techniques 127

2 – Decision making techniques 130
3 – Budgeting and control 141
Supplementary section: Basic variances solutions 144
4 – Performance measurement and control 150
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AC C A F 5 Introduction v
1 Paper aim
To develop knowledge and skills in the application of management accounting techniques to
quantitative and qualitative information for planning, decision-making, performance evaluation, and
control.
2 Rationale
The syllabus for Paper F5, Performance Management, builds on the knowledge gained in Paper F2,
Management Accounting. It also prepares candidates for more specialist capabilities which are
covered in P5 Advanced Performance Management.
The syllabus begins by introducing more specialised management accounting topics. There is some
knowledge assumed from Paper F2 - primarily overhead treatments. The objective here is to ensure
candidates have a broader background in management accounting techniques.
The syllabus then considers decision-making. Candidates need to appreciate the problems surrounding
scarce resource, pricing and make-or-buy decisions, and how this relates to the assessment of
performance. Risk and uncertainty are a factor of real-life decisions and candidates need to
understand risk and be able to apply some basic methods to help resolve the risks inherent in decision-
making.
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Budgeting is an important aspect of many accountants’ lives. The syllabus explores different budgeting
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techniques and the problems inherent in them. The behavioural aspects of budgeting are important
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for accountants to understand, and the syllabus includes consideration of the way individuals react to
a budget. The preparation of fixed, flexible and incremental budgets is assumed knowledge from F2.
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Standard costing and variances are then built on. All the variances examined in Paper F2 are
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examinable here. The new topics are mix and yield variances, and planning and operational variances.
Again, the link is made to performance management. It is important for accountants to be able to
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interpret the numbers that they calculate and ask what they mean in the context of performance.
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The syllabus concludes with performance management systems, measurement and control. This is a
major area of the syllabus. Accountants need to understand how a business should be managed and
controlled.
They should appreciate the importance of both financial and non-financial performance measures in
management. Accountants should also appreciate the difficulties in assessing performance in
divisionalised businesses and the problems caused by failing to consider external influences on
performance. This section leads directly to Paper P5.
3 Syllabus overview
A Specialist cost and management accounting techniques
B Decision-making techniques
C Budgeting and control
D Performance measurement and control
vi Introduction AC C A F5
4 Approach to the exam

Paper F5, Performance Management, seeks to examine candidates’ understanding of how to manage
the performance of a business. The paper builds on the knowledge acquired in Paper F2, Management
Accounting, and prepares candidates for more specialist capabilities which are covered in Paper P5,
Advanced Performance Management.
Sessional computer based exams are available for papers F5 to F9. Until December 2017 these run
alongside the traditional paper based exams and you may sit either. At the time of printing these
Course Notes, the ACCA had announced that they are hoping to phase out the paper exams from
March 2018. If this happens you will then have to sit the CBE. If you are taking your exam from March
2018 onwards, please check the ACCA website for further detail www.accaglobal.com
The technical content of paper based and computer based exams is identical, but there is a slightly
wider variety of question styles in the computer based exam.
You will find a variety of question styles in the companion Question Bank, so that you are prepared for
the computer based exam as well as the paper one.
For more information on the computer based exam please see the ACCA website:
http://www.accaglobal.com/content/dam/ACCA_Global/Students/exam/Guide%20to%20CBEs_FINAL.PDF
Exam format
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The syllabus is assessed by a 3 hour 15 minutes paper based or a 3 hour 20 minutes computer based
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examination.
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All questions are compulsory. There will be calculation and discursive elements to the paper. Some
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questions will adopt a scenario /case study approach.
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Section A of the exam (30%) consists of 15 multiple choice questions, of 2 marks each.
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Section B of the exam (30%) consists of 3 scenario questions, each comprised of 5 multiple choice
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questions, of 2 marks each.
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Section C of the exam (40%) consists of 2 20-mark questions
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The Section A and B questions can cover any area of the syllabus.
F iThe Section C questions will come from decision making techniques, budgeting and control and/or
performance measurement and control (sections B-D of the syllabus).
All of the subject areas covered in the syllabus could be examined in either a public sector or private
sector context.
Candidates are provided with a formulae sheet.
The computer based exams will contain an extra 10 marks of content in section A or B which do not
contribute towards the final result.
Further resources
The ACCA has produced a specimen exam for CBE students. The paper version of the 2016 specimen
exam is included at the back of the companion question bank. If you are sitting the computer based
exam, it is VITAL that you work through this and the latest computer based specimen, which can be
found at the following:
https://sampletds1.pearsonvue.com/Minerva/startDelivery?sessionUUID=62571a1b-5bd0-49c6-bb44-
93a17ca4534b
In addition, it is VITAL that you look at the extra constructed response questions and the constructed
response workspace information provided at:
https://sampletds1.pearsonvue.com/Minerva/startDelivery?sessionUUID=a41f3821-909c-48cd-ab96-
05e6d799143b
AC C A F 5 Introduction vii
Examination technique
Time management
The paper is very time pressured. Students should keep track of their time carefully, and not ‘over-run’
on one question to the detriment of another.
Question requirements
Always read the question carefully.
5 Study planner
The chapter number refers to the chapter of the Course Notes. The time is a guide as to how long you
should spend on each subject, including related tuition question practice. Tick off each session when
you have completed it.
Time Questions
Notes Qs (Tuition
Chapter Subject/narrative PER relevance (min) (min) Question Complete
Bank)
1 Specialist cost and management PO12 120 60 A:Q1-Q4

accounting techniques B:Q5-Q9
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Activity based costing (ABC)
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An important topic that builds on
absorption costing from foundation
level. Make sure you learn the four-step
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approach to ABC questions and go
through the example carefully. Question
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practice is vital.
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1 Target costing PO12 45 45 A:Q10-Q16
You need to understand the basic B:Q17-Q21
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principles of target costing and be aware
that you could get a numerical question
asking you to build up the cost of a
product.
1 Life cycle costing PO12 30 40 A:Q22-Q26
The key issue here is to learn the
distinction between life cycle costing (on
syllabus) and the product life cycle
(general knowledge).
1 Throughput accounting PO12 100 40 A:Q27-Q32
A very important section and you must B:Q33-Q37
understand the principles. You also need
to be able to compare the throughput
limiting factor approach with the
traditional contribution based limiting
factor approach.
1 Environmental accounting PO12 30 15 A:Q38-Q40
General awareness only here. A new
addition to the syllabus so review the
basics.
viii Introduction AC C A F5
Time Questions
Notes Qs (Tuition
Bank)
2 Decision making techniques PO12 60 75 A:Q1-Q4

Relevant cost analysis
This section should really be revision
from your F2 paper (or prior study) but it
is important to go through the various
relevant cost calculations and principles
as these are used in section B5 of the
syllabus.
2 Cost volume profit analysis PO12 90 90 A:Q5-Q11
This is another topic that brings forward B:Q12-16
some knowledge from the F2 paper but
does introduce the concept of operating
in a multi-product situation. Care should
be taken with the multi-product material
and go slowly through the examples.
2 Limiting factors PO12 150 120 A:Q17-22
The section starts off with single limiting LF: Q1
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factors and then develops into how to
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deal with multiple resource constraints.
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This is an important area/technique and
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it is therefore important to be aware of
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the steps in single limiting factor
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situations and to be able to interpret
linear programming graphs.
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2 Pricing decisions PO12 90 135 A:Q23-28
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A mixture of practical pricing and LF:Q2
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numerical techniques in this topic. Your
F ir Examiner regards it as important to be

commercially-minded in this exam. Go
carefully through the examples on profit
maximising price and quantity as these
calculations are new to the syllabus.
2 Make or buy and other short term PO12 120 100
decisions B:Q29-33
There are a number of techniques in this
section that rely on the relevant costing
principles previously learnt at
foundation level.
2 Risk and uncertainty in decision making PO12 90 150 A:Q34-Q38
Some core techniques here that are B:Q39-Q43
popular in the exams. LF:Q3
AC C A F 5 Introduction ix
Time Questions
Notes Qs (Tuition
Bank)
3 Budgeting and control PO13 90 150 A:Q1-Q10

Budgetary systems and types of budget LF:Q1
The Examiner will expect you to have a
grasp of the main approaches to
budgeting that a company may choose
to adopt and what information may be
used to assist. Factual knowledge of the
types of budget together with their
advantages and disadvantages is always
worth a few marks in the exam.
3 Quantitative analysis in budgeting PO13 150 90 A:Q11-Q17
The key part of the budgeting section. All
the techniques are important to your
studies so go carefully through, hi-low and
learning curves. You will have already
encountered expected values in section
B4.
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3 Standard costing PO13 60 75 A:Q18-Q19
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This section should be largely familiar B:Q20-Q24
material but it sets you up for the rest of
the section so go through carefully.
3 Basic variances and operating
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PO13 60
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These notes take you through all the
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variances that are covered in the earlier
paper, F2. You should review these
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before starting the section on material
mix and yield variances.
3 Material mix and yield variances PO13 60 70 A:Q25-Q28
A new area that analyses the material B:Q29-Q33
usage variance into more detail in a LF:Q2
specific situation.
3 Sales mix and quantity variances PO13 40 90 A:Q34-Q35
In this section we look at the analysis of B:Q36-Q40
variances that can be done where a
company sells a range of products and
those products are linked in some way.
The example shows the level of detail
required at this level.
3 Planning and operational variances PO13 90 170 A:Q41-Q45
Another important new area that B:Q46-Q50
considers whether the original
budget/standard needs to be updated LF:Q3
following some changes in the
organisation. The impact of how this
affects our variances needs to be assessed.
x Introduction AC C A F5
Time Questions
Notes Qs (Tuition
Bank)
3 Performance analysis PO13,PO14 20 45 A:Q51

This section just considers how the use
of standard costing might affect the LF:Q4
behaviour of individual within an
organisation.
4 Performance measurement and control PO14 45 45 A:Q1-12
Performance management information
systems, sources of management
information and management reports
You should just make sure you’ve read
through the notes and absorbed the
information. Exam questions are likely to
be mostly getting you to use common
sense here and should not cause too
much concern.
4 Performance analysis in private sector PO14 90 200 A:Q13-Q17
organisations B:Q18-Q22
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This is really at the core of the syllabus LF:Q1,Q2
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and you must be comfortable with all
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the basic ratios and principles behind
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performance measures in financial and
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non-financial aspects of a business.
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Divisional performance and transfer
pricing
PO14 120 250 A:Q23-Q29
B:Q331-
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This section specifically considers how to Q345
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compare the performance of two or
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C:Q23-Q26
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more divisions within a business. The
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LF:Q3,Q4
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techniques of Return on Investment
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(ROI) and Residual Income (RI) are
dominant here. Make sure you follow
the basics of transfer pricing as there
may be a few basic numbers to deal with
now on this topic.
4 Performance analysis in not for profit PO14 30 50 A:Q35-Q37
organisations and the public sector
It is important to appreciate the
differences between assessing profit
making and non-profit making
organisations. The value for money (VFM)
framework is particularly useful here.
4 External considerations and behavioural PO14 45 10 A:Q38-Q39
aspects
The Examiner says that you should use
external data about the environment or
industry to assist you analysing business
performance.
Mock exam 195
TOTAL 1,825 2,310
AC C A F 5 Introduction xi
5.1 Practical Experience Requirements (PER) and Performance Objectives

ACCA requires students to have 36 months’ practical experience in order to become members. Part of
the practical experience requirements is achieving performance objectives that demonstrate that you
can apply what you’ve learnt when studying to real-life, work activities.
ACCA has set out 20 performance objectives in 10 areas. You are required to achieve 9 performance
objectives – all 5 Essentials performance objectives and any 4 from 15 Technical performance
objectives. ACCA has provided guidance on which objectives are strongly linked to which exam. The
relevant objectives for F5, which comprise Essential and Technical, are:
Essential
P01 Professionalism and ethics (relevant for all exams)
Technical
P012 Evaluate management accounting systems (relevant for F2, F5, P3, P5)
P013 Plan and control performance (relevant for F2, F5, P1, P3, P5)
P014 Monitor performance (relevant for F2, F5, P5)
You can find further guidance on Practical Experience Requirements and performance objectives at:
http://www.accaglobal.com/uk/en/student/practical-experience.html
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Further guidance and resources to support your studies from the ACCA may be found at:
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http://www.accaglobal.com/us/en/student/exam-support-resources.html
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xii Introduction AC C A F5
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1
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Specialist cost and management
accounting techniques
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1 Activity based costing (ABC)
1.1 Absorption costing and ABC
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1.1.1 Traditional absorption costing
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In paper F2 Management Accounting, we met traditional absorption costing, where the overheads of a
particular cost centre are all absorbed on the same basis (e.g. labour hours).
In traditional absorption costing one single overhead rate (overhead absorption rate or OAR) is
calculated:
OAR = Budgeted overhead/Budgeted activity level (e.g. labour hours)
1.1.2 Activity based costing

With activity based costing the overheads of a particular cost centre are split into their component
parts or cost pools and then absorbed using a number of different absorption bases or cost drivers.
KEY TERM
Cost drivers are those factors which cause the overheads to rise or fall (e.g. quality
management costs will depend upon the number of quality inspections).
ABC should give more accurate product costs in situations where:

 Overheads are a large proportion of production costs
 Overheads are caused by a wide range of diverse and complex processes
2 1: Specialist cost and management accounting techniques AC C A F5
 Products are tailor made to individual customer needs, ABC providing a clearer picture of the
usage of overhead driving activities such as order processing and support.
Overall, whether using traditional absorption costing or ABC the same overall total amount of
overheads will be charged to products. However, the allocation between products will be different.
ABSORPTION COSTING ABC
OVERHEADS OVERHEADS
Identify what the key drivers

are that determine different
types of overhead cost
Absorbed using an
OAR such as a rate COST COST COST
per unit, labour hr or POOL 1 POOL 2 POOL 3
machine hr.
Absorb overheads based on cost
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driver usage for each cost pool
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OVERHEAD COST PER OVERHEAD COST PER
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UNIT UNIT
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1.2 ABC analysis
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TEPS
F Step 1: Analyse overhead costs into cost pools

Step 2: Establish cost driver basis for each cost pool
Step 3: Work out the OAR for each cost driver
Step 4: Use the OAR calculated to absorb costs from each pool into cost units to work out the
overhead cost per unit
LECTURE EXAMPLE 1.1: ABC AND ABSORPTION

Federer Co produces two products, the Sidewinder (SW) and the Airway (AIR), budgeted information
for which is as follows:
SW AIR
Material usage per unit 5kg 8kg
Labour time per unit 3 hrs 2 hrs
Selling price/unit $110 $100
Other information:
The same basic material is used in each of the products and this material is available from a supplier at
a price of $8 per kg. The direct labour is paid at a rate of $10 per hour.
AC C A F 5 1: Specialist cost and management a ccounting techniques 3
Production overheads are as follows:

$000
Machining costs 600
Set up costs 1,400
Quality inspections 500
Stores issues 300
2,800
The following budgeted information is also available:

SW AIR
Production (units) 50,000 100,000
Size of each production run 500 2,500
Inspections per production run 5 25
Number of issues from stores 200 100
Machine time per unit 2 hrs 1 hr
Required:
Calculate the cost per unit for the two products using an ABC system.
SOLUTION
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Required:
Compare the ABC cost results to those that would be observed if a traditional absorption costing
system was used. Assume overheads are absorbed on a direct labour hour basis.
SOLUTION
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1.3 The hierarchy of activities

Using the principle that activities within an organisation can form a hierarchy:
Activity class/type What drives the cost? Examples

Product (unit) level Production volume Machine power, labour, materials
Batch level No of batches Set up costs, quality control
Product sustaining No and diversity of products Product management (e.g.
marketing, design)
Facility sustaining The fact that the business exists Rent & rates, building maintenance
Under traditional costing systems such as absorption costing most overhead costs were assumed to be
incurred at a product level. Hence absorbing overheads based on production volume was very
relevant.
In today’s environment with customers demanding products at short notice and wanting different
versions of products, more of the overheads are probably related to the batch and product sustaining
activities, supporting use of ABC.
1.4 Implications of switching to ABC

Switching from traditional absorption costing to ABC can result in a significant change in the cost per
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unit. As a result, any decisions which are based on this information can also change. An organisation
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may decide to:
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Charge more for some products and less for others
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Launch products in different markets
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Stop producing some products as they are no longer profitable at the current market price
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 Change its marketing strategy in order to more strongly push a product that is now “apparently”
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more profitable.
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Care needs to be taken as ABC is simply a more refined method of cost absorption. Fixed overheads
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should not generally have any impact on pricing, sales strategy, performance management and
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decision-making in the short term. In the long run all costs need to be covered in order to make a
profit.
1.5 Problems with ABC

 Lack of understanding – ABC is not fully understood by many managers and therefore is not
fully accepted as a means of cost control.
 Difficulty in identifying appropriate cost drivers – for example, property costs are often
significant and yet a single driver is difficult to find.
 Lack of appropriate accounting records – ABC needs a new set of accounting records; this is
often not immediately available. The setting up of new cost pools is time consuming.
2 Target costing
KEY TERM
Target costing is a market driven approach to pricing that seeks to derive an acceptable level
of costs based on a selling price that has been researched in the external market.
2.1 Deriving a target cost

2.1.1 Specification of product
Target costing begins by specifying a product an organisation wishes to sell. This will involve extensive
customer analysis, considering which features customers value and which they do not. Only those
features valued by customers should be included in the product design.
2.1.2 Price
The price will take in to account competitor products and the market conditions expected at the time
that the product will be launched. Hence a heavy emphasis is placed on external analysis before any
consideration is made of the internal cost of the product.
2.1.3 Margin
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From the above price a desired margin is deducted. This can be a gross or a net margin. This leaves
the cost target. An organisation will need to meet this target if their desired margin is to be met.
2.1.4 Cost gap

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Costs for the product are then calculated and compared to the cost target.
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If it appears that the cost target cannot be achieved, then the difference (shortfall) is called a cost gap.
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This gap would have to be closed, by some form of cost reduction.
ILLUSTRATION: TARGET COSTING
If a company has established a selling price for a new product of $80 based on desired market share
and the board of directors demands a profit margin of 25% then the target profit must be $20 (25% ×
$80). The target cost can be identified as $60 ($80 ─ $20).
The Production Manager looks at the product specification and considering the materials, labour and
overheads going into the product are likely to be $25, $30 and $10 respectively then the estimated
cost will be $65, thus creating a cost gap of $5.
2.2 Closing the target cost gap

A target cost gap occurs where the anticipated costs are greater than the target costs. This can be
closed by:
 Redesign the product or service
 Redesign the production process
 Renegotiate with suppliers
 Improve staff efficiency through training
 Use cheaper staff
2.3 Benefits of using target costing

 The business will have an external focus to its product development, reducing the time to
market
 It is useful where the business does not dominate the market and competition means it is
forced to accept the selling price
 The product design will include features that customers value
 It may force the business to examine its internal processes carefully if a cost gap exists
 Cost control will begin earlier in the product’s life cycle
2.4 Target costing in service industries

2.4.1 Characteristics of service industries
 Spontaneity – unlike goods, a service is consumed at the exact same time as it is made
available. No service exists until it is being experienced by the consumer.
 Heterogeneity/variability – services involve people. Because people are all different, the service
received may vary depending on which person performs it. Standardisation is expected by the
customer but is difficult to maintain.
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Intangibility – unlike goods, services cannot be physically touched.
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Perishability – unused capacity cannot be stored for future use.
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No transfer of ownership takes place when a service is provided.
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Service industries rely heavily on their staff, who often have face to face contact with the
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customer and represent the organisation’s brand.
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2.4.2 Difficulties of using target costing in service industries
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It may be difficult to define exactly the service being provided.
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s When the service is only at the concept stage, it may be very difficult to determine the likely
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sales volume and the price that potential customers will be prepared to pay.
 In many service industries the cost is almost all labour. If costs need to be reduced the business
must either reduce the amount of time spent or to use lower grade staff, both of which are
likely to reduce the value of the service, causing the price to fall further.
 Often in service industries each service will be tailored to suit the particular customer’s
requirements. The target costing approach would need to be re-addressed for each customer.
3 Life cycle costing

KEY TERM
Life cycle costing looks at tracing all costs and revenues to a product or service over its
complete life cycle.
Under the traditional classification costs such as research and marketing incurred this year would be
charged against this year’s profits even though the products that they relate to have not yet started
generating revenue. Profits analysed by accounting period may not give a very good indication of the
profitability of individual product lines over their entire lives.
Under life cycle costing price is set to maximise profits over the entire life cycle. Costs and revenues
are assigned to products rather than time periods. Profitability of a product can be assessed taking all
costs into consideration.
With the shortening of product life cycles and the ever increasing need to earn profits with limited
resources, understanding the overall profitability of products over their lifetime becomes crucial.
3.1 Stages of a product’s life cycle

 Research and development
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Introduction
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Growth
 Maturity
 Decline
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3.2 Life cycle costs
 Research and development – market research, product/service design, testing, plant and
equipment, staff training.
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 Introduction – marketing/advertising/promotion, production and distribution costs.
 Growth – heavy advertising to drive market share, inventory costs (warehousing, insurance etc).
Unit costs should start to fall through economies of scale. Customer support costs will increase.
 Maturity – advertising/marketing to maintain brand awareness, some discounts / promotions.
Unit costs should now be low and good profits generated. Will still have high customer service
costs to try and keep ahead of competitors.
 Decline – decommissioning costs and product retirement costs (equipment scrapping). Possibly
will have final sales promotional costs.
3.3 Deriving a life cycle cost
LECTURE EXAMPLE 1.2: DERIVING A LIFE CYCLE COST
James plc is about to launch a new automatic sprinkler system onto the market with an expected life
of three years and anticipated costs as follows:
Year 1 Year 2 Year 3
Production (units) 10,000 30,000 5,000
$ $ $
Market research 1,500,000
Product design 3,200,000
Marketing 2,000,000 2,500,000 500,000
Production cost/unit 140 120 150
Machinery disposal cost 200,000
Required:
Calculate the life cycle cost per unit considering the costs over the entire three-year period.
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SOLUTION
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3.4 Benefits of life cycle costing
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 Better idea of profitability
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Better pricing strategy over the different stages of the life cycle
 Assists long-term planning
 Avoids focus on production costs only – visibility of all costs, particularly development is
increased
4 Throughput accounting
KEY TERMS
 Throughput accounting is used to help assess performance of internal
functions/processes where there are resource limitations (bottlenecks) and efficient
use of these scarce resources is considered important.
 The theory of constraints works on the principle that there will always be a function or
resource in a business that is stopping the business from increasing returns.
4.1 Goldratt’s five focusing steps

The theory of constraints can be applied within an organisation by following Goldratt’s ‘five focusing
steps.
STEPS
Step 1: Identify the system’s bottlenecks
Often, in exam questions, you will be told what the bottleneck resource is. If not, it is usually
quite simple to work out by considering the expected output levels and their required resource
usage.
Step 2: Decide how to exploit the system’s bottlenecks
This involves making sure that the bottleneck resource is used in a way that maximises throughput.
Step 3: Subordinate everything else to the decisions made in Step 2
The production capacity of the bottleneck resource will determine the production schedule for
the organisation as a whole.
Step 4: Elevate the system’s bottlenecks
Investigate ways to obtain more of the bottleneck resource, for example expand machine
capacity by capital expenditure
Step 5: If a new constraint is broken in Step 4, go back to Step 1, but do not let inertia become
the system’s new bottleneck
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The ultimate constraint on the system is likely to be market demand.
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4.2 Throughput contribution
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Remember that contribution = revenue less all variable costs
KEY TERMS
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Throughput contribution is defined as revenue less material purchases only.
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The principle of throughput contribution is that in the short-term materials are the only truly variable cost.
F i4.3 Throughput accounting ratio

There is normally some element within a production process which is less efficient. This will restrict
what the organisation can produce and so limit its profitability. The throughput accounting ratio
(TPAR) highlights the importance of these restrictions or bottlenecks.
Sales revenue - material purchases

The TPAR is calculated as follows: Usage of bottleneck resource
(usually time e.g. hrs)
TPAR ratio = Throughput contribution per time period (Labour + overhead costs) per
Conversion cost per time period unit of bottleneck resource. May
be calculated as total conversion
costs in period divided by total
bottleneck time in period
The TPAR compares how fast you are generating money (top of fraction) with how fast you are
spending money (bottom of fraction).
If the TPAR ratio is greater than 1 then this means money is being earned faster than it is being spent.
4.4 Improving TPAR

 Reduce the bottleneck eg by making maximum use of machines or increasing labour flexibility
 Increase the selling price
 Reduce the materials cost
 Reduce the conversion cost
4.5 Tackling a TPAR question

In a throughput question where there are multiple products:
STEPS
Step 1: Identify the limiting factor (bottleneck)
Step 2: Rank products according to throughput contribution per unit of bottleneck resource
(e.g. hrs)
Step 3: Identify optimum plan based on order of ranking until all the bottleneck is used up
LECTURE EXAMPLE 1.3: THROUGHPUT IN A MULTI-PRODUCT SITUATION
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AB Co manufactures two products, ZC and YR. Each product has to pass through two departments
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(each dept uses a different grade of labour). Labour time needed in each dept is as follows:
Time taken per unit (mins)
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ZC YR
Dept A 10 20
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Dept B 15 20
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The machines used can only work on one product at a time.
Dept A has 600 minutes available per day of labour whilst Dept B has 930 minutes available.
The maximum daily demand for ZC is 50 and for YR is 25.
Cost cards for the two products are as follows: 017
ZC YR
$ per unit $ per unit
Sales price 60.00 100.00
Direct materials (12.00) (19.00)
Direct labour (14.00) (28.00)
Variable overheads (5.50) (11.00)
Fixed overheads (10.00) (20.00)
Profit 18.50 22.00
Total labour and overhead costs for the year are $309,750 and in a year 2,500 hours are worked
(10 hours per day, 5 days per week for 50 weeks).
Required:
(a) What is the optimal production plan for AB Co and the resulting annual profit?
(b) Calculate the TPAR for product YR
SOLUTION
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5 Environmental accounting
5.1 Reasons for identifying environmental costs
Environmental management accounting focuses on information required for decision making on
environmental issues within the organisation. In recent times more emphasis has been placed
businesses considering the environmental impact of decisions that organisations make. Part of this will
involve assessing what environmental costs exist.
Information on environmental costs (like any other costs) is used to help:
 Cost reduction and cost control schemes
 Pricing decisions
Additionally, there may be regulations / legislation that the environmental cost analysis is used to
monitor adherence to. For example, there may be fines for exceeding certain levels of emissions.
5.2 Environmental cost management

 Identification – there are a range of cost definitions
 Measurement – some costs may be hidden or difficult to separately identify
 Control – can only happen if costs have been correctly identified
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5.3 Environmental cost classification
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US Environmental Protection Agency

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Conventional costs – raw materials and energy costs
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 Potentially hidden costs – included in general overheads, therefore not visible
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 Contingent costs – future costs such as clean-up costs
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Image and relationship costs – costs of preparing environmental reports
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United Nations Division for Sustainable Development (UNDSD)
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Environment protection costs – pollution prevention
Wasted material, capital and labour costs – production inefficiencies
You may need to consider the methods of controlling some of the more common environmental costs
such as:
 Waste
 Water
 Energy
 Transport and travel
 Consumables and raw materials
5.4 Environmental management accounting

Environmental management accounting uses accountancy techniques to identify, analyse and attempt
to reduce environmental costs in a way that provides mutual benefit to the company and the
environment.
5.4.1 Input/output analysis

All inputs into a process must be traced to outputs (“what goes in must come out”). This approach
forces a business to consider all outputs from a process, regardless of whether they result in a finished
item, scrap item, wastage or other. Pollution and waste must be monitored very carefully (cost and
physical amounts).
5.4.2 Flow cost accounting

This monitors the flow of material through a business into three categories and aims to reduce the
quantity of material in each category:
 Material
 System and delivery
 Disposal
5.4.3 Environmental ABC

Using ABC principles to identify drivers for environmental costs will probably involve more detailed
analysis of the business processes than even traditional ABC requires. For example, activity-based
costing may be used to ascertain more accurately the costs of washing towels at a gym. The energy
used to power the washing machine is an environmental cost and the cost driver is ‘washing’.
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5.4.4 Life cycle costing
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Using life cycle costing, the environmental costs are measured at the different stages of the life cycle
from design/development through to obsolescence/decline.
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19
Decision-making techniques
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1 Relevant cost analysis
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In decision-making it is important that any decision is based upon relevant information. The correct
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financial figures are the relevant costs and revenues.
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KEY TERM
Relevant cost is a future incremental cash flow.
For a cost to be relevant it must pass three tests:

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 Future – a decision being made today cannot change the past. Only future costs are considered.
Past costs are referred to as sunk costs, are not relevant and so are ignored e.g. the price paid
for something which is already owned.
 Incremental – only those costs that are affected by the decision are relevant. Some costs are
referred to as committed costs, are not relevant and so are ignored e.g. fixed costs.
 Cash flow – these are factual and not based upon accounting conventions. Also organisations
live or die due to their cash position. So non-cash flows are not relevant e.g. depreciation.
20 2: Decision-making techniques AC C A F5
1.1 Relevant costs for materials
Is the material currently in inventory?
YES
NO
Is it currently used elsewhere

in the business?
Need to buy it for the contract
therefore relevant cost is
YES current purchase price
NO
Can it be replaced?
If we use it for the contract we are only losing
out on any scrap/resale value it currently
has.
YES NO
It is scarce and therefore, if we use it on this contract,

we must consider the ‘contribution’ it could have
We will need to buy more for helped us earn elsewhere in the business.
our business, therefore the
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current purchase price is
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relevant.
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LECTURE EXAMPLE 2.1: RELEVANT COST OF MATERIALS
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Materials Ltd is currently considering a job that requires 1,000 kg of raw material. What is the relevant
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cost in each of the following alternative situations?
(a)
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The material is used regularly within the firm for various products. The present inventory is
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10,000 kg purchased at $1.80 per kg. The current purchase price is $2.00 per kg.
F i(b) The company has 500 kg in inventory, bought two years ago for $1.50 per kg, but no longer
used for any of the firms' products. The current market price for the material is $2.00, but the
company could sell it for 80c per kg.
(c) The company has 1,500 kg in inventory. This material is not currently available to buy and if not
used on this job it would be used in the manufacture of Zed’s. Each Zed generates $8
contribution for the company and uses 2 kg of this material.
SOLUTION
AC C A F 5 2: Decision-making techniques 21
1.2 Relevant costs for labour
Is labour at full capacity?
YES NO
Could we hire more or The relevant cost is zero since getting them
work overtime? to work on this job doesn’t cost the
company anything extra.
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YES NO
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Relevant cost is the contribution (before labour cost) we
would lose out on (i.e. the opportunity cost) by moving
the labour to this job from elsewhere in the business.
Relevant cost is the
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cost of hiring more This can be shown as
staff or the overtime Lost sale proceeds less saving in material costs
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cost. (from the alternative use of the labour)
LECTURE EXAMPLE 2.2: RELEVANT COST OF LABOUR

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Labour Ltd is currently considering a job that requires 100 hours of labour. What is the relevant cost in
each of the following alternative situations?
(a) There is 300 hours’ worth of spare labour capacity. There is a union agreement that staff
cannot be laid-off. The workers are paid $6.50 per hour.
(b) The company has no surplus capacity at the moment, but additional temporary staff could be
hired at $4.50 per hour.
(c) Staff are working at full capacity and will have to be taken off production of a different product
in order to undertake this job. The details of the other product are shown below:
$/unit
Selling price 60
Direct material 10
Direct labour – 1 hour 12
SOLUTION
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1.3 Relevant costs for overheads
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LECTURE EXAMPLE 2.3: RELEVANT COST OF OVERHEADS
Overheads Ltd is considering opening a new department. If the new department is opened, then
variable overheads of $12 per labour hour would be incurred. The new department would operate in
an existing building and fixed overheads would be absorbed under the company’s normal policy at
$5 per labour hour.
What are the relevant overhead costs per week if 5,000 labour hours are worked in a week?
SOLUTION
1.4 Relevant cost of machines and other non-current assets

Relevant costs for non-current assets are exactly the same as for any other cost.
The above is sometimes referred to as deprival value and can be found by asking ….. “If we were
deprived of the use of the asset (i.e. if someone stole it from us) what would we choose to do?” and
can be shown diagrammatically as follows:
Lower of
Higher of
Replacement cost Net Realisable Economic value in the

Value business
LECTURE EXAMPLE 2.4: RELEVANT COST OF NON-CURRENT ASSETS
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Equipment plc bought a machine four years ago for $20,000. This machine could be scrapped now for
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$12,000. If it is kept it will generate $15,000. An identical machine can currently be purchased for
$14,000.
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What is the relevant cost of using this machine on another job?
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SOLUTION
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1.5 Opportunity cost
KEY TERMS
The opportunity cost is the benefit foregone by choosing one course of action instead of the
next best alternative.
The opportunity cost is a particular example of a relevant cost where an organisation faces a choice
over what to do.
LECTURE EXAMPLE 2.5: OPPORTUNITY COST
Alternative plc can undertake only one of three different jobs. The first job will generate a contribution
of $20,000, the second $25,000 and the third $28,000.
What is the relevant cost of choosing the most appropriate job?
SOLUTION
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2 Cost volume profit analysis
F 2.1 Single product breakeven analysis

2.1.1 Contribution
Contribution – A reminder!
Sales revenue X Important
Less: Variable costs X
Contribution X Contribution per unit = SP per unit – VC per unit
Less: Fixed costs X
Profit X
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐬𝐚𝐥𝐞𝐬 𝐫𝐚𝐭𝐢𝐨 = 𝑆𝑎𝑙𝑒𝑠
2.1.2 Breakeven formulae

From the above we can see that in order to break even (i.e. make zero profit),
Total contribution = Fixed costs
∴ No of units sold × Contribution per unit = Fixed costs
Exam note
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠 This formula will enable you to work out the
∴ 𝐔𝐧𝐢𝐭𝐬 𝐬𝐨𝐥𝐝 𝐭𝐨 𝐛𝐫𝐞𝐚𝐤𝐞𝐯𝐞𝐧 = 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
breakeven sales units. If you need to calculate
the breakeven revenue, then you simply
multiply the breakeven units by the selling
price per unit.
As an alternative, the breakeven revenue can be calculated using the following formula:
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
𝐁𝐫𝐞𝐚𝐤𝐞𝐯𝐞𝐧 𝐫𝐞𝐯𝐞𝐧𝐮𝐞 = 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑠𝑎𝑙𝑒𝑠 𝑟𝑎𝑡𝑖𝑜
2.1.3 Margin of safety

It is often useful for management to know how much below budget sales would have to be before a
loss is made. They can assess how sensitive their profits might be to below budget performance.
Margin of safety is a measure of how much sales would need to drop by before a loss is made:
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𝐌𝐚𝐫𝐠𝐢𝐧 𝐨𝐟 𝐬𝐚𝐟𝐞𝐭𝐲 (𝐮𝐧𝐢𝐭𝐬) = 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 𝑢𝑛𝑖𝑡𝑠 − 𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑠𝑎𝑙𝑒𝑠 𝑢𝑛𝑖𝑡𝑠
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or
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 𝑢𝑛𝑖𝑡𝑠−𝑩𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑠𝑎𝑙𝑒𝑠 𝑢𝑛𝑖𝑡𝑠
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𝐌𝐚𝐫𝐠𝐢𝐧 𝐨𝐟 𝐬𝐚𝐟𝐞𝐭𝐲 (%) = 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 𝑢𝑛𝑖𝑡𝑠
LECTURE EXAMPLE 2.6: BREAKEVEN AND MARGIN OF SAFETY

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$26,500. Budgeted sales are 125,000.
(a) How many cans must it sell to break-even?
(b) What is its margin of safety (MOS)?
SOLUTION
2.1.4 Target profit

The breakeven formulae can also be adjusted to calculate the sales volume required in order to
achieve a target profit. This applies to both single and multi-=product situations.
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠 +𝑇𝑎𝑟𝑔𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡
𝐔𝐧𝐢𝐭𝐬 𝐬𝐨𝐥𝐝 𝐭𝐨 𝐚𝐜𝐡𝐢𝐞𝐯𝐞 𝐭𝐚𝐫𝐠𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭 = 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
LECTURE EXAMPLE 2.7: TARGET PROFIT AND C/S RATIO
Zero Ltd budgets for a target profit of $39,750.

How many cans must Zero Ltd sell in order to achieve its target profit and how much revenue will it
need to generate?
SOLUTION
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2.1.5 Break even chart
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F $
BEP (revenue)
Total Revenue (selling price x no of units sold)
Total Cost (FC + VC)
Fixed costs
Output (units)
BEP (units)
A breakeven situation can be shown graphically, linking sales volumes, revenues and costs.
2.1.6 Profit/volume chart

A profit/volume chart is similar to breakeven chart but it illustrates the relationship between sales
volume and profit. For example, if zero sales are made then the business will make a loss equal to its
fixed costs (FC).
Profit Profit
Output (units)
FC
BEP (units)
2.1.7 Assumptions of breakeven analysis

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Assumptions are made in order to keep the analysis simple:
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 Constant fixed costs at any output level (i.e. no stepped costs)
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Constant variable cost per unit and constant selling price per unit. This leads to straight lines on
the graphs
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 No change in inventory levels (i.e. sales volumes = production volumes)
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The most significant other limitation is that the model can only be applied to a single product or
constant product mix scenario.
2.2 Multi-product breakeven analysis

It is unrealistic to assume that a company would only make one product so breakeven principles need
to apply as well to a multiple product situation. The main assumptions are:
 Constant product mix, or
 All products have identical C/S ratios
2.2.1 Formulae In multi-product situations we

work with a standard “mix” or
“bag” of products rather than a
standard single product.
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠 Otherwise the formulae are
∴ 𝐔𝐧𝐢𝐭𝐬 (bags) 𝐬𝐨𝐥𝐝 𝐭𝐨 𝐛𝐫𝐞𝐚𝐤𝐞𝐯𝐞𝐧 = 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑚𝑖𝑥 essentially the same.
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
𝐁𝐫𝐞𝐚𝐤𝐞𝐯𝐞𝐧 𝐫𝐞𝐯𝐞𝐧𝐮𝐞 = 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑠𝑎𝑙𝑒𝑠 𝑟𝑎𝑡𝑖𝑜 𝑝𝑒𝑟 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑚𝑖𝑥/"𝑏𝑎𝑔"
LECTURE EXAMPLE 2.8: MULTI-PRODUCT BREAKEVEN UNITS AND REVENUE
TP Ltd produces three products, the X, Y & Z. Market research has suggested that for every Z that is
sold there will be three X’s and two Y’s sold. Selling price and variable cost data for the products is as
follows:
X Y Z
Selling price ($) 10 15 20
Variable cost ($) 6 10 14
TP Ltd has fixed costs of $100,000
Required:
Calculate the breakeven sales mix and the breakeven revenue at this sales mix.
SOLUTION
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ILLUSTRATION: MARGIN OF SAFETY
Sillymoor Ltd has budgeted revenue for the period of $200,000 based on sales of its two products, the
Pad and the Pod. Each Pad generates contribution of $10 from revenue of $18 and each Pod generates
$8 contribution from revenue of $15. There are generally seven Pad’s sold for every four Pod’s.
Fixed costs are estimated at $80,000 for the period.
Calculate the margin of safety.
SOLUTION
We need to compare the budgeted revenue with the breakeven revenue to find the margin of safety.
Therefore, we will need to calculate the breakeven revenue as per Lecture example B6.
STEPS
Step 1: Calculate the average contribution per mix.
Av contribution per mix = (7 × $10) + (4 × $8) = $102
Step 2: Calculate the breakeven revenue.
BEP (mixes)
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= FC ÷ av. cont’n per mix = $80,000 ÷ $102 = 785 mixes (rounded up)
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BEP (units of Pad & Pod)
Pad = 785 × 7 = 5,495
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Pod = 785 × 4 = 3,140
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BEP (revenue) = (5,495 × $18) + (3,140 × $15) = $146,010
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Step 3: Calculate margin of safety.
MOS = budgeted sales – breakeven sales
= $200,000 – $146,010 = $53,990
Or $53,990 ÷ $200,000 = 27.0% of budgeted sales
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2.2.2 Multi-product breakeven charts
The most common approach with a multiple product breakeven chart is to assume that the products
are sold in a constant mix.
Using the data from Lecture example 2.8
TP Ltd produces three products, the X, Y & Z. Market research has suggested that for every Z that is
sold there will be 3 X’s and 2 Y’s sold. Selling price and variable cost data for the products is as follows:
X Y Z
Selling price ($) 10 15 20
Variable cost ($) 6 10 14
TP Ltd has fixed costs of $100,000.
We established earlier that the breakeven data was as follows:
BE mixes = 3,572
BE revenue = $285,714
Costs & Revenue

revenue
Total costs
285,714
Fixed costs
Sales (mix)
units
3,572
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2.2.3 Profit/Volume chart
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When the products on a breakeven chart are drawn from left to right, the chart starts with the one
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that has the highest C/S ratio.
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The practical impact of this is that the chart will include a line that has a number of ‘kinks’ in it, the
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different gradients being caused by the different C/S ratios of the individual products.
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LECTURE EXAMPLE 2.9: MULTI PRODUCT PROFIT/VOLUME CHART
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You will not be asked to draw a breakeven chart in the exam, but this illustration is designed to show
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you how a breakeven chart is produced. If we assumed that the budgeted sales of X, Y and Z were
15,000, 10,000 and 5,000 respectively, then the following analysis can be completed:
 Rank products according to C/S ratio.
 Work out total contribution earned by each product based on budget sales volumes.
 Draw PV chart starting with the highest ranked product first and starting on the y axis with a
loss equal to the fixed costs of the business.
 If we assumed that the budgeted sales of X, Y and Z were 15,000, 10,000 and 5,000 respectively,
then the following analysis can be completed:
Contribution Sales C/S ratio Cumulative sales Cumulative profit
$ $ $
X
Y
Z
–
Profit/Loss
Sales
Revenue
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3 Limiting factors 017
3.1 Identifying limiting factors
You will be faced with one of two possible situations:
 There is only one scarce resource. Identify the limiting factor first and then calculate the
contribution per unit of limiting factor. Produce as much of the highest product and then the
second and so on until you run out of the limiting factor.
 There is more than one scarce resource. Use Linear Programming,
3.2 Determining the optimal production plan with one limiting factor
STEPS
Step 1: Identify what the limiting factor is
Step 2: Calculate the contribution per unit of limiting factor (e.g. labour hours) for each of the products
Step 3: Rank the products according to the contribution per unit of limiting factor
Step 4: State the optimum production plan
LECTURE EXAMPLE 2.10: SINGLE LIMITING FACTOR
Short Ltd makes Large and Small fence panels. Data for these two products are as follows:
Large Small
Metal (per panel) 80 kg 40 kg
Labour (per panel) 7 hrs 5 hrs
Maximum demand per week 10 panels 26 panels
Short Ltd can purchase 2,000 kg of metal and has 140 hours of labour available each week.
Short Ltd pays $1 for each kg of metal and pays its staff $10 per hour. Small fencing sections are sold
for $102 per section and Large sections sell for $171 per section.
Determine the optimal production plan for Short Ltd.
SOLUTION
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3.3 Single limiting factors and make or buy decisions

Sometimes where there is a single limiting factor there may be an option to buy the products from an
external supplier rather than making them yourself. A decision has to be made as to which products, if
any, to outsource to the outside party to make. When trying to rank the use of resources the following
approach should be taken:
STEPS
Step 1: Identify what the limiting factor is (same approach as before)
Step 2: Calculate the contribution per unit of limiting factor (e.g. labour hours) for each of the
products where there is no external alternative. For products where there is an external
alternative compare the internal variable cost of making the item with the buying in price, then
divide this difference by the amount of limiting factor per unit to give the “saving from making
per unit of limiting factor”
Step 3: Rank the products according to the contribution per unit of limiting factor or saving per
unit of limiting factor
Step 4: State the optimum production plan
Fir
ILLUSTRATION: LIMITING FACTORS WITH MAKE OR BUY DECISIONS
Co
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An external supplier has now been found who is prepared to sell large fence panels to Zara Ltd for
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$175 and small panels to them for $110. How many units of each product should either be made
internally and/or outsourced if Zara Ltd is aiming to minimise costs?
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Assume that there are now 144 labour hours available internally.
SOLUTION
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The internal limiting factor is the same as before, labour hours.
Large Small
Buy 175 110
Make (variable cost) 150 90
Saving from making/unit 25 20
Labour hrs/unit 7 5
Saving per labour hr 3.57 4
Priority of making 2 1
Production plan
144 internal labour hours
(a) Produce 26 Small panels @ 5hrs = 130 hrs
(b) Produce 2 Large panels @ 7hrs = 14 hrs
144 hrs
Remaining panels to ‘buy in’
Buy in the last eight Large panels @ $175 each
The total variable cost is therefore = (26 × $90) + (2 × $150) + (8 × $175) = $4,040
This would be the lowest cost option to enable Zara Ltd to satisfy all external demand for panels.
3.4 Multiple limiting factors

Linear programming is used where there is more than one limiting factor.
STEPS
Step 1: Define the variables (call each product a letter e.g. X or Y)
Step 2: Establish the constraints (write an equation/inequality for each constraint)
Step 3: Define the objective function (write an equation that explains what you are trying to
achieve, usually maximising contribution)
LECTURE EXAMPLE 2.11: FORMULATING A MULTIPLE SCARCE RESOURCE PROBLEM

Short Co makes small and large hand forged special metal fencing sections. Data for these two
products are as follows:
Large Small
Metal per section 80 kg 40 kg
Labour per section 7 hours 5 hours
Maximum demand per week 10 sections 26 sections
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Short Co can purchase 1,200 kg of metal and has 140 hours of labour available each week.
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Short Co pays $1 for each kg of metal and pays its staff $10 per hour. Small fencing sections are sold
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for $102 per section and Large sections sell for $171 per section.
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Formulate the linear programming problem for Short Co.
SOLUTION
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3.4.1 Solving a linear programme problem graphically

You will not be asked to solve a linear programme problem graphically in the exam, but you may be
asked to interpret the graph. You may also find it helpful to sketch a graph if you are asked to work out
what the best combination of products will be. To help you do this, we summarise below the steps
taken to prepare a graph.
STEPS
Fir Co
Step 1: Plot the constraints on a graph (for each constraint that links ‘X’ and ‘Y’ simply work out
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two points on the graph. This is easily done by setting either X or Y to be zero and then work
out the maximum value of the other variable and vice versa)
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Step 2: Identify the feasible region (the area on the graph that is within all of the constraints)
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Step 3: Plot the objective function (the iso-contribution line). This can be plotted by estimating
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ANY value for contribution and then setting either X or Y to be zero and then work out the
maximum value of the other variable and vice versa)
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Step 4: Determine the optimal solution. Slide the iso-contribution line out as far as you can
away from the origin until you hit the last point within the feasible region. This will normally be
at the intersection of two of the constraint lines
ILLUSTRATION : GRAPHICAL SOLUTION

Determine the optimal solution to the linear programming problem facing Short Co using a graphical
approach.
SOLUTION
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A solution for this Illustration is found at the end of these Course Notes.
3.4.2 Solving a linear programming problem using simultaneous equations

Simultaneous equations can be used to find where two straight lines are equal, so they can be used in
linear programming to find the precise coordinates of the optimal solution.
LECTURE EXAMPLE 2.12: SIMULTANEOUS EQUATIONS
Determine the optimal solution for Short Co using simultaneous equations and assuming that the
optimal point is at the intersection of the metal and labour constraints.
SOLUTION
Fir Co
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3.5 Shadow prices
It is unusual for an organisation not to be able to obtain any more of a particular resource. More
commonly it cannot obtain any more resource at the price it is currently paying. If an organisation is
prepared to pay more for a particular resource, it normally can obtain more.
KEY TERM
The shadow price (dual price) is how much more is it worth paying (i.e. over and above the
current price) in order to obtain more of a particular resource.
The shadow price is usually measured as the increase in contribution if one more unit of the resource
is obtained.
The shadow price of any non-scarce resource is always nil.
To calculate the shadow price of a scarce resource:
 Add one to its constraint that you are trying to find the shadow price of and
 Rework the solution using simultaneous equations
The increase in contribution achieved is the shadow price.
LECTURE EXAMPLE 2.13: SHADOW PRICE
Calculate the shadow price of labour for Short Co.
SOLUTION
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So the shadow price enables us to calculate the opportunity cost of the resource in question. It is then
possible to decide when new opportunities arise where best to use this resource.
3.6 Slack
Slack is the surplus or spare capacity of a particular constraint. The slack for the constraints forming
the optimal solution is always nil. For other constraints the slack is the difference between their
current usage and their maximum availability.
Slack resource has a nil opportunity cost.
ILLUSTRATION: SLACK
Calculate the slack for Short Co.
SOLUTION
The optimal solution is at the intersection of the labour and materials constraints, so the slack for both
of these is nil.
The demand constraint for Large sections is x ≤ 10 and the optimal solution is x = 3⅓.
So Large has a slack of 10 - 3⅓ = 6⅔ sections.
The demand constraint for Small sections is y ≤ 26 and the optimal solution is y = 23⅓.
So Small has a slack of 26 - 23⅓ = 2⅔ sections.
4 Pricing decisions
4.1 Influences on prices
Fir Co
The price charged for a product or service is influenced by a number of factors:
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 Demand – for most products there is an inverse relationship between the price charged and the
quantity demanded – the higher the price the lower the demand and vice versa

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Quality –, the higher the quality, the higher the price
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 Marketing – customers will pay more for an established brand
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 Competition – this will not always take the form of price competition, but overall the greater
competition there is, the lower prices tend to be

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Inflation – this causes costs to rise and also creates an expectation that prices will also rise
4.2 Price elasticity of demand
KEY TERM
Price elasticity of demand = % change in demand/% change in price
The price elasticity of demand (PED) measures the relationship between the price charged and the
corresponding level of demand:
Due to the inverse relationship between price and demand, the PED will be negative, but the negative
sign is often ignored.
If PED < 1, the demand is said to be inelastic. If the price is increased, the total revenue will rise and if
the price is decreased, the total revenue will fall.
If PED >1, the demand is said to be elastic. If the price is increased, the total revenue will fall and if the
price is decreased, the total revenue will rise.
A straight line demand equation will take the form:
𝑃 = 𝑎 − 𝑏𝑄 GIVEN TO YOU IN THE EXAM
Where:
P = price
a = price when Q = 0 (price above which no units are sold)
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
b= 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑡𝑦
Q = quantity demanded
a
change in price
b=
change in quantity
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LECTURE EXAMPLE 2.14: STRAIGHT LINE DEMAND EQUATION
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Charge Co manufactures and sells motorcycle batteries for $12 each. Weekly demand is currently
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1,000 batteries. If Charge was to drop its price by $1, the demand would increase by 200 batteries.
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Derive the straight line demand equation for Charge Co.
F
SOLUTION
An equation for the total cost function with fixed costs and a constant variable cost per unit will take
the form:
TC = a + BQ
Where:
TC = total cost
a = fixed costs
b = variable cost per unit (or the gradient of total cost line)
Q = quantity
TC
b =gradient = variable cost

a
fixed costs
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Q
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The high/low technique can be used as a way of splitting costs into fixed and variable components
(covered in Chapter 3).
LECTURE EXAMPLE 2.15: COST EQUATIONS (NO DISCOUNTS)

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Each time an additional battery is produced; Charge Co incurs extra costs of $3 for materials, $2 for
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labour, $1.50 for variable overheads and fixed costs of $2.50 based on the expected output of 1,000
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batteries.
Derive an equation for the total cost function for Charge Co.
SOLUTION
When volume-based discounts are available, the variable cost per unit will fall when the quantity used
reaches a certain value. There is a different equation for the total cost function beyond this point:
TC
b = discounted variable
cost
b = variable
a
fixed costs cost
LECTURE EXAMPLE 2.165: COST EQUATIONS (WITH DISCOUNTS)
Charge Co has been offered a discounted price for materials of $2 if they buy enough for 1,200
batteries. This would require an additional member of staff at a cost of $400 per week.
Derive the equation for the total cost function for Charge Co.
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SOLUTION
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F i4.3 Finding the profit maximising price and output level
If you are trying to maximise your profits you will continue to make and sell additional items as long as
the additional total revenue you gain from selling the next item (marginal revenue) is greater than the
addition to total cost that is incurred (marginal cost).
Thus profit is maximised is where:
Marginal Revenue = Marginal Cost (MR=MC)
In the exam you are given a formula that helps you work out the marginal revenue:
𝐌𝐑 = 𝐚 − 𝟐𝐛𝐐
where ‘a’ and ‘b’ are as defined at the start of the section.
Marginal cost will generally just be the variable cost of producing an item (i.e. materials + labour +
variable overheads).
If you have a question where there are discounts, and hence two potential cost equations, you first
have to work out the optimum point assuming no discounts. If the optimum point turns out to be at a
level that would generate discounts the calculation has to be done again using the marginal cost
equation including discounts.
LECTURE EXAMPLE 2.17: PROFIT MAXIMISING PRICE AND OUTPUT
Charge Co.
From the previous examples we have identified that:
P = 17 – 0.005Q
TC = 2,500 + 6.5Q (up to Q = 1,199)
TC = 2,900 + 5.5Q (Q = 1,200 and above)
Calculate the optimum selling price and quantity using the above data.
SOLUTION
Fir Co
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4.3.1 Tabular approach
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It may be possible to produce a table to arrive at a similar result in a situation where the price/demand
relationship is not a straight line P = a – bQ format. You will still produce and sell additional items as
long as MR > MC for the additional items produced.
The tabular approach will assume that only sales volumes given in the question can be achieved (i.e.
cannot sell at volumes in the middle and so may not get an exact MR = MC result).
ILLUSTRATION: TABULAR APPROACH
Needham Ltd has estimated the following data for costs at different combinations of output and
selling price.
Selling price ($) Output (units) Total costs ($)
10 4,000 15,000
9 6,000 20,000
8 7,900 27,000
7 9,900 36,000
6 11,800 47,000
5 13,700 60,000
4 15,700 75,000
Find the profit maximising selling price.
SOLUTION
Selling price Output Total revenue Total costs Profit
10 4,000 40,000 15,000 25,000
9 6,000 54,000 20,000 34,000
8 7,900 63,200 27,000 36,200
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7 9,900 69,300 36,000 33,300
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6 11,800
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70,800 47,000 23,800
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5 13,700 68,500 60,000 8,500
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4 15,700 62,800 75,000 (12,200)
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It is worth dropping the price from $9 to $8 since the extra revenue generated of $9,200 outweighs
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the extra cost of $7,000. However, it is not worth dropping price any more than that since the MC >
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MR and contribution (and hence profit) would fall.
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4.4 Impact of increased activity
F Increasing production and sales levels will not always be beneficial. It will normally be necessary to
reduce the price in order to increase the number of units sold. Lowering the price may also give the
perception that the product is now of lower quality, so this could damage the brand as well.
LECTURE EXAMPLE 2.18: INCREMENTAL COSTS/REVENUES
Charge Co is considering increasing production to 1,200 batteries to take advantage of the volume-
based discount it has been offered.
Would you support this suggestion based purely on financial grounds?
SOLUTION
4.5 Pricing strategies

4.5.1 Cost-plus
Fir Co
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Many companies price their products by identifying costs incurred. They then add a mark-up to
establish the final selling price or set the selling price so that a desired profit margin is achieved
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compared with costs. A number of different costs can be used.
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Marginal cost Usually the variable cost of the item
Useful as a minimum price in situations where there is spare capacity where
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a one-off order is being priced
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Full absorption cost (either This approach to pricing will guarantee that all costs are covered. Consumers
traditional or ABC) should be happy paying the price and the basis on which overheads have
been absorbed should be fair
Standard cost Allows a set selling price that can be kept stable and based on target
efficiency levels
Also, any internal inefficiencies will be borne by the business rather than
being passed on to the consumer
4.5.2 Skimming
Initially charge high prices, generally to recover high up-front costs (R&D, launch costs ). Then
gradually lower the price as the product becomes mature.
Used in the following situations:
 Products are new and different so customers prepared to pay high prices to own them first
 Products have a short life cycle e.g. high technology products that get updated fairly quickly
(TVs, iPods)
 High prices are expected to generate high initial cash flows, particularly if there have been high
development costs
 Barriers to entry limit competition
 Demand and price sensitivity of demand to price are unknown
4.5.3 Penetration
initially set a low initial price with the aim that high volumes will be sold and market share gained
quickly. High volumes will also reduce the unit cost of production (learning effects, experience effects,
lower fixed costs per unit).
Used in the following situations:
 High elasticity of demand so that demand is very sensitive to price
 Significant economies of scale
 Means of discouraging competitors when other barriers to entry are low
 If organisation wants product to have a short introduction stage and enter growth and maturity
stages quickly
4.5.4 Complementary product

If your product is sold in conjunction with another product e.g. fish and chips or knives and forks allow
for the price of the complementary product when setting your price.
4.5.5 Product-line
Some organisations produce a range of products e.g. a fabric manufacturer may produce nylon, cotton
and silk sheets. Price charged must fit in with the other products on the line, so the cotton sheets will
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have a lower price than the silk sheets but a higher price than the nylon sheets.
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4.5.6 Volume discounting
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The price charged depends upon the volume purchased. Larger volumes have lower unit prices and
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smaller volumes have higher unit prices. This strategy is widespread in commodity markets.
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4.5.7 Discrimination
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A different price is charged in different market segments due to different price/demand relationships
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in each segment. A market can be segmented in different ways:
F i


Time of day (e.g. peak and off peak transport)
Age of consumer (OAP, adult and young person’s prices)
Geographical market (UK v overseas)
 Type of consumer (wholesale v retail)
To be effective there needs to be controls in place to stop consumers moving between segments.
4.5.8 Relevant cost

This approach incorporates opportunity costs as well as basic incremental costs. This sets the
minimum acceptable price in situations where there are scarce resources.
ILLUSTRATION: COST PLUS AND RELEVANT COST PRICING
JD’s garage has been working on Mr Sugar’s car during June. This job was assigned a reference number
4845. The following data is relevant for Job 4845.
Spare parts used 1 exhaust pipe costing $500
Engine oil 10 litres costing $8 per litre
Mechanic’s time 5 hours at a standard rate of $20 per hour
The mechanic’s time includes two hours that the mechanic had to work as overtime. The garage
operates a policy whereby any overtime worked is at a premium of 20% above the normal hourly rate.
In this instance the overtime was worked due to Mr Sugar’s specific request to get his car fixed quickly.
5% of engine oil on average gets spilled in the workshop.
JD charges overheads to the jobs at a rate of $10 per labour hour.
Calculate the price for Job 4845 if the JD’s pricing policy is:
Co
(1) Full cost plus a 25% mark up;
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(2) Relevant cost.
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SOLUTION
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(1) Full cost plus 25%
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Job Card for Job 4845
$
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Materials
Exhaust (1 @ $500) 500
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Engine oil (10 litres @ $8 × 100/95) 84.21
Labour
Standard cost (5 hrs @ $20) 100
Overtime premium (2 hrs @ $4) 8
Overheads
Absorbed o/h (5 hrs @ $10) 50
Total cost of job 742.21
Mark up (profit) 185.55
Price charged 927.76
(2) Relevant cost (incremental, future, cash flow)

Job Card for Job 4845
$
Materials
Exhaust (1 @ $500) 500
Engine oil (10 litres @ $8 × 100/95) 84.21
Labour
Overtime (2 hrs @ $24) 48
Relevant cost of job $632.21
5 Make-or-buy and other short-term decisions

5.1 Make-or-buy decisions
KEY TERM
Make-or-buy decision involves comparing the costs and benefits of carrying out an activity
internally (make) or buying it in from an external source (buy).
Outsourcing is another term used to describe buying from an external source.

From a purely financial perspective this involves comparing the relevant costs of the two options and
selecting the cheapest.
From a non-financial perspective consider factors such as:
 Quality of external supplier
 Reliability of the external supplier
 Strategic importance of the activity
 Confidentiality – do you want someone else knowing your secrets/methods?
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 Expertise – will you be able to get access to the expertise of the outsourcer that you may be
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able to apply to other aspects of your business
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Loss of control – you will be tied to the terms of service specified in the contract
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ILLUSTRATION: MAKE OR BUY DECISIONS
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In&Out Co makes three different products, details of which are as follows:
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Positive Zero Negative
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Required number of units 1,000 2,000 4,000
F
Production costs per unit $ $ $
Direct materials 10 11 6
Direct labour 4 4 5
Variable overheads 5 2 4
19 17 15
Total direct fixed overheads 3,000 4,000 15,000
In&Out Co can buy-in identical units of all three products for $20 each.
Which products should In&Out Co make and which should it buy-in?
SOLUTION
Positive Zero Negative
Required number of units 1,000 2,000 4,000
Total cost of making:
Total variable cost per unit 19 17 15
Total variable cost 19,000 34,000 60,000
Fixed overheads 3,000 4,000 15,000
TOTAL $22,000 $38,000 $75,000
Total buying-in cost:
Cost per unit 20 20 20
TOTAL $20,000 $40,000 $80,000
So In&Out Co should buy-in Positives and make Zeros and Negatives.
5.2 Other decisions

Relevant costs are used in decision making situations to indicate which decision is best from a financial
perspective. There are a number of different decision-making situations where they can be applied:
Fir Co
 Shut down
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 One-off contracts
 Further processing of joint products
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Remember that relevant costs and revenues must be future, incremental cash flows.
LECTURE EXAMPLE 2.19: SHUTDOWN DECISIONS

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Closure Co has three departments, the performance of which is as follows:
Sales
Dept. A
$
30,000
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Dept. B
$
50,000
Dept. C
$
70,000
Total
$
150,000
Variable costs 21,000 35,000 49,000 105,000
Fixed overheads 12,000 12,000 12,000 36,000
Profit/loss (3,000) 3,000 9,000 9,000
Should Closure Co shut down Department A?

If the fixed overheads are apportioned, then they are not relevant and as Department A is making a
positive contribution of $9,000 it should not be shut down.
If however the fixed overheads are specific to each department, then they are relevant and as
Department A is making a loss of $3,000 it should be shut down.
Required:
What if as a result of shutting down Dept A, fixed overheads of $11,000 could be saved? However 10%
of sales volume in Dept B would be lost as a result of customers finding an alternative supplier. Is it
worth shutting down Dept A?
SOLUTION
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ILLUSTRATION: ONE OFF CONTRACTS
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Unique Co has the opportunity to undertake a new contract.
F ir
15 hours of labour are required for the contract. Labour is currently at full capacity producing Unique
Co’s normal product called the One-off.
Cost card for the One-off: $/unit
Direct materials (13 kg @ $3) 39
Direct labour (5 hrs @ $10) 50
Variable overheads (60% of direct labour) 30
119
Contribution 30
Selling Price 149
The new contract would also require 50 kg of the same material used to make One-off’s. Unique Co
has been offered $525 for the new contract.
Should Unique Co undertake the new contract?
SOLUTION
There are a number of different ways of arriving at the right answer here.
If we first consider the trade-off here, with 15 hours of labour time Unique Co would normally be able
to manufacture three One-off’s (since each one takes five hours). If we compare the cash flows of the
contract with that of making and selling three One-offs then we can conclude which is better.
3 One-offs Contract
$ $
Revenue 447 525
Materials (117) (150)
Labour (150) (150)
Variable O/H (90) (90)
Contribution 90 135
Thus, as contribution from the new contract is $45 better than the existing activities, the new contract
should be undertaken.
Alternatively, the same conclusion could have been reached by looking at the incremental cash flows. Since
labour and variable overheads would be incurred anyway, one could just consider the extra revenue of $78
($525 ─ $447) less the extra material cost $33 ($150 ─ $117) to give the net benefit of $45.
LECTURE EXAMPLE 2.20: FURTHER PROCESSING DECISIONS

Fir Co
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Mr & Mrs Combined own a butchers shop and buy in pig carcasses for $159 each and joint them into
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Leg Joints, Belly Pork and Off-cuts. Each can then be sold or processed further and turned into Ham
Joints, Pies and Mince respectively. Further processing does result in some waste. Further processing
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costs will only apply to the quantities finally sold.
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The quantities and associated costs are as follows:
Joints: Leg Joints Belly Pork Off-cuts
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Quantity 100 kg 40 kg 60 kg
Sales price per kg $25 $20 $17.50
After further processing: Ham Pies Mince
Quantity 90 kg 32 kg 55 kg
Sales price per kg $35 $31 $22
Further processing cost per kg $6 $7 $3
Should Mr & Mrs Combined process the different joints further?
In deciding which products to process further the following will need to be considered:
 Incremental revenues and incremental costs
 Details of any losses of material during the further processes
 Impact on sales volumes
 Impact on reputation
SOLUTION
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6 Dealing with I n t uncertainty in decision-making
r s t risk and
Fi 6.1 Dealing with uncertainty

When making decisions about products, there will always be some uncertainty as to what precisely the
outcome will be.
This uncertainty can however be reduced by undertaking research:
 Reaction of focus groups
 Market research to obtain more certainty about likely demand levels
 Mystery shopping to assess likely competitor reactions
6.2 Simulations
In real life situations there will often be a very large range of uncertain variables which are difficult to
quantify. Simulation involves identifying a number of different possible outcomes (often using random
numbers and computers) that may arise if the project goes ahead.
6.3 Expected values

If it is possible to identify possible outcomes (x) and their associated probabilities (p), by multiplying
each outcome by its probability and adding all of the results together (∑px), an overall weighted
average or expected value can be calculated. It is used by risk neutral decision makers.
6.3.1 Benefits of using expected values

 Allow the quantification of a risky situation
 Give an indication of what can be expected in the long run
6.3.2 Problems with expected values

 Can only be calculated if you can identify each future possible outcome and its associated
probability. This will be extremely difficult for something you haven’t done before
 A long run average and so only apply if facing a situation which will be repeated many times
 Ignore risk, since by taking an average the degree of spread (dispersion) is ignored
LECTURE EXAMPLE 2.21: EXPECTED VALUES
First Co is trying to decide whether to launch a new product in Europe or America.

If the product is launched in Europe the sales figures will either be high (probability 0.25) $600,000,
medium (probability 0.6) $500,000 or low (probability 0.15) $400,000,
If the product is launched in America, the sales figures will either be high (probability 0.55) $650,000
or low (probability 0.45) $350,000.
Fir Co
Where should First launch its new product, assuming it only has the resources to launch in one
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region?
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SOLUTION
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6.4 Sensitivity analysis

Sensitivity analysis involves seeing how much the estimates used to make the original decision can
change before the decision changes. The less they can change, the more sensitive the decision
becomes, so sensitive variables may need to be researched further before a final decision is made.
This analysis can be enhanced by the use of best/worst case “what if” analysis.
LECTURE EXAMPLE 2.22: SENSITIVITY ANALYSIS
Misty Co has come up with the following estimates for the Drench, a new product it is considering
launching into its market:
$
Sales 9,500 units × $35 = 332,500
Materials 9,500 kgs × $10 = (95,000)
Labour 7,125 hrs × $12 = (85,500)
Variable costs 9,500 units × $5 = (47,500)
Attributable fixed overheads (75,000)
Profit $29,500
As the above figures show that the Drench will make a profit, Misty Co is minded to go ahead with the
launch.
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How sensitive is this decision to changes in the sales price and material quantity?
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SOLUTION
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6.5 Maximax, maximin and minimax regret

Maximax, maximin, and minimax regret are decision-making techniques that do not require
probabilities.
KEY TERMS
 Maximax is short for maximising the maximum achievable return (usually measured as
profit or contribution) i.e. selecting the best outcome. This is the approach used by risk
takers (risk seekers).
 Maximin is short for maximising the minimum achievable return i.e. playing it safe. This
is the approach used by risk avoiders (risk averse).
 Minimax regret is short for minimising the maximum regret of making the wrong
decision i.e. the opportunity loss. You look back with the benefit of hindsight and
identify the opportunity cost of making the wrong decision.
LECTURE EXAMPLE 2.23: MAXIMAX, MAXIMIN, MINIMAX REGRET

Quandary Co is trying to decide which project to undertake, it has three to choose from currently code
Co
named Alpha, Beta and Gamma. The outcome of undertaking each project varies depending upon the
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state of the economy and is shown in the following profit table:
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Economic State: Alpha Beta Gamma
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Good $140,000 $95,000 $30,000
Average $90,000 $89,000 $50,000
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Poor ($10,000) $82,000 $78,000
In the exam you are likely to have to work out the profit or contribution figures to go in a table like the
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one above. For example, you might be told that if the economy is good then Project Alpha will
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generate $500k of revenue but incur $360k of costs, thus leading to $140k of profit.
Using maximax, maximin, and minimax regret, advise Quandary Co on which project it should
undertake.
SOLUTION
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Taking the Alpha, Beta and Gamma example but say now we have information about the probabilities
of the three economic states as follows:
Economic State: Probability Alpha Beta Gamma
Good 0.25 $140,000 $95,000 $30,000
Average 0.45 $90,000 $89,000 $50,000
Poor 0.30 ($10,000) $82,000 $78,000
We can work out the expected value of the profit for each of the three projects:
Project: Alpha Beta Gamma
EV $72,500 $88,400 $53,400
If our decision had been based on EV and hence a long run average return project Beta would be
chosen. The resulting EV would be $88,400.
6.6 Decision trees
KEY TERM
A decision tree is a pictorial method of showing a sequence of interrelated decisions and
their expected outcomes. Decision trees can incorporate both the probabilities of, and
values of, expected outcomes.
Decision trees can be used in any expected value decision making but are particularly useful to help
visualise a sequential set of decisions and outcomes.
There are two types of key point on a decision tree:
 Decision points where a decision has to be made
 Outcome points where an outcome based on probabilities happens
We shall use a square to And a circle to indicate an

indicate a decision outcome
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It is usual to draw the decision tree from left to right on the page to represent the order in which
decisions are made and outcomes happen. When evaluating the tree with the aid of expected values it
is normal to work from right to left. Consider the following example.
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You will not be asked to draw a decision tree in the exam, but you may be asked to interpret a decision
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tree. However, drawing a decision tree as part of your preparation will help your understanding and
ability to interpret – which will we do in Lecture Example 2.24.
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LECTURE EXAMPLE 2. 24: DECISION TREE
Loof plc is considering launching a new product and is doing some analysis to see if it is worth getting
some market research done prior to making a decision on whether to launch or not.
The market research would cost $100,000 and will indicate whether the market for the product is
likely to be good or poor. Based on past experience of the market research company there is a 70%
likelihood that the research will suggest a good market and 30% chance it will suggest a poor market.
Loof could decide to launch without getting the research and if they do then there is a 50% chance of
high sales (leading to a positive net cash flow of $800,000) and a 50% chance of low sales (leading to
$300,000 net positive cash flow). These cash flows ignore the launch costs which are expected to be
$500,000.
If the research indicates a good market Loof can decide to either launch or abandon. If they launch
there is an 85% chance of positive net cash flows of $800k and only a 15% chance of low positive cash
flows of $300k.
If the research indicates a poor market Loof can still decide to launch although the probability of
getting high cash flows of $600k is only 20%. There would be an 80% chance of low returns of $200k.
Required:
Assuming that abandonment leads to a nil cash flow and that the time value of money can be ignored,
use decision tree analysis to evaluate the market research and launch decisions.
SOLUTION
STEPS
Step 1: We first of all draw the logic of the decision tree.
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Step 2: We evaluate the decision tree either:

 On the face of the tree
 Using separate workings (probably the best approach for the exam)
6.7 Value of perfect information (VOPI)

The EV calculation of $88,400 seen earlier assumes that we do not have perfect information (i.e. we do
not know what the economic state is going to be, all we can do is build the probabilities into the
decision making).
The question is, how much would you pay someone if they were able to give you perfect information,
meaning somebody was able to tell us what the economic state was going to be before we had
decided what project to choose. Presumably our decision making would be better in this situation and
our overall return higher.
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Value of perfect information = EV (with perfect info) – EV (without perfect info)
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ILLUSTRATION: PERFECT INFORMATION
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If we use the data from Lecture example 2.23we can see that if someone told you the economic state
was going to be good, you would choose Alpha and get a $140k return. If they indicated an average
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economic state, you would still choose Alpha and get a $90k return. Beta would be chosen if a poor
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economic state was indicated, thus giving an $82k return.
This can be summarised as
Economic state
Good
Average
Probability (p)
0.25
0.45
Alpha
Alpha
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Project choice Return (x)
140,000
90,000
(px)
35,000
40,500
Poor 0.30 Beta 82,000 24,600
EV (with perfect info) 100,100
EV (without perfect info) 88,400
VOPI 11,700
In theory we would be prepared to pay someone up to a maximum of $11,700 in order to obtain this
perfect information. If these outcomes were per annum then the VOPI would be an annual amount.
The logic here is a bit like obtaining insider information for the stock market (not recommended since
it is illegal!).
6.8 Value of imperfect information

In the decision tree example, we had the following results:
EV (if have research) $157.5k (ignoring the research cost)
EV (launch, no research) $50k
Since the research is not right all of the time (i.e. it is imperfect) we can now estimate the value of this
imperfect information as the difference between the EV of having the research done ($157.5k) and not
having it done ($50k), so the value of the imperfect information here is $107.5k.
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61
Budgeting and control
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1 Budgetary systems and types of budget
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1.1 Role of budgetary systems
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The budget shows how the overall goals of the organisation will be achieved. This is of interest to the
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senior management.
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The budget then breaks this overall performance down into divisional targets. This assists the middle
management.
The budget then breaks these divisional targets into individual departmental or functional objectives.
This aids the junior management.
Thus budgetary systems support all levels of management within an organisation:
 Planning
 Control
 Integration (communication and co-ordination)
 Motivation
 Evaluation (used as a basis for comparing with actual performance)
1.1.1 Objectives of budgetary systems

 Compel planning
 Co-ordinate activities
 Communicate activities
 Motivate managers
 Establish systems of control
 Evaluate performance
 Delegate authority
 Ensure achievement of objectives
62 3: Budgeting and control AC C A F5
1.1.2 Information used in budget systems

Budget systems will use a combination of both internal and external historic and anticipated
information. The sources of this information are:
 Internal historic information – internal records such as management accounts
 External historic information – industry databases and government statistics
 Internal anticipated information – strategic plans
 External anticipated information – focus groups, market research and mystery shopping
1.2 Top-down (Imposed budget)

The budget is set by starting with the overall corporate objectives set by the senior management and
then working down through the different levels of the organisation, setting appropriate targets to
ensure the higher objectives are achieved.
1.3 Bottom-up (Participative budget)

This is the reverse of top-down. The budget is set by starting with the individual personal and
departmental objectives set by the local management and then working up through the different
levels of the organisation, setting appropriate targets to ensure the lower objectives are achieved.
1.3.1 Advantages of bottom up budgeting
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Budgets are set by those closer to where the action is so should be more informed and realistic
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Staff take ownership of budgets/targets and are more committed to achieving them
Greater staff participation leads to greater motivation
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Doesn’t take up as much senior management time
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 Encourages communication between departments
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1.3.2 Disadvantages of bottom up budgeting
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More scope for non-goal-congruent behaviour, budgets fitting local objectives rather than
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corporate goals (i.e. dysfunctional)
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 More scope for disagreements between staff
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 Lack of overall coherence
 More time consuming and costly
 Budgetary slack may be built in
 Budgets may be inaccurate if less experienced managers are in place
When looking from the perspective of a top down approach the advantages and disadvantages will be
the opposite of the above.
1.4 Rolling budgets

This is a budget which, having been established at the beginning of a period, is then constantly
amended and extended.
1.4.1 Uses of rolling budgets

 At times of uncertainty surrounding resource/input prices, producing regular revisions to the
budget will result in better information for control and decision making purposes
 Encourages staff to be continually looking at changing internal and external variables
AC C A F 5 3: Budgeting and control 63
1.4.2 Problems with rolling budgets

 Involves much time and effort
 Concept is not as readily understood by managers within an organisaton
 Continually changing the goalposts can lead to de-motivation
LECTURE EXAMPLE 3.1: ROLLING BUDGET
The following budget has been prepared by Zebra Ltd for next year:
Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total
$ $ $ $ $
Units 10,000 11,000 12,000 13,000
Material cost per unit ($) 5.00 5.00 5.00 5.00
Material 50,000 55,000 60,000 65,000 230,000
During Q1 actual costs of material were $47,000 which was lower than budget due to a new supplier
being found whose prices were a little lower than the previous supplier. Consequently, it has been
decided by the Finance Director that the budget for the next 12 months should be updated to reflect
the new price of $4.70 per unit (all assumptions about growth in units are to remain as per the original
budget).
Update the budget for the next 12 months (i.e. Qs 2,3,4 of current year and Q1 next year).
SOLUTION
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1.5 Zero-based budgets
This is a budget that requires managers to justify every item of expenditure even if that item had been
accepted in previous periods.
STEPS
Step 1: Identify every item that needs to be budgeted as a ‘decision package’
Step 2: Review each decision package and rank them based on their benefits / importance to
the organisation
Step 3: Allocate resources to decision packages in ranking order until all the available resources
are used
1.5.1 Uses of zero-based budgets

 Very responsive to changes in economic environment
 Result in efficient allocation of resources as based on needs and benefits
 Drive managers to find out cost effective ways to improve operations and identify opportunities
for outsourcing
 Detect inflated budgets. Identify and eliminate wastage and obsolete operations
 Increase staff motivation by providing greater initiative and responsibility in decision-making
 Increase communication and co-ordination
 Force cost centres to adopt questioning attitude, identify their mission and their relationship to
overall goals
1.5.2 Problems with zero-based budgets

 Difficult to define decision units and decision packages, as it is very time-consuming and
exhaustive
 Difficult to rank decision packages, especially if departments have different objectives
 Some departments (e.g. R and D) may find it more difficult to justify expenditure because
outcomes not short-term
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Necessary to train managers. Managers at various levels must understand it, otherwise they
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cannot successfully implement it
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Difficult to administer and communicate because more managers are involved in the process
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Volume of data may be so large that no one person could read it all. Compressing the
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information down to a usable size might remove critically important details
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 Honesty of managers must be reliable and uniform. Any manager prone to exaggeration might
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skew the results
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 Ranking process of decision packages could cause conflicts between departments
F i May prevent managers reacting to changed circumstances once the budget has been set
1.6 Activity-based budgets

Work is done initially to identify what the cost drivers are within the organisation’s activities. The
required level of each activity is then identified and a budget produced on this basis. For example, a
business may have number of orders as a cost driver and this activity may impact costs in the sales,
admin and finance departments.
1.6.1 Uses of activity-based budgets

 Focuses on true drivers behind costs within an organisation
 Will enable more efficient improvement programmes to be implemented because it considers
the whole of a cost generating activity (i.e. all the various costs that are affected by that activity)
rather than just the individual cost itself.
1.6.2 Problems with activity-based budgets

 Time consuming and resource intensive
 Concept is not as readily understood by managers within an organisation
LECTURE EXAMPLE 3.2: ACTIVITY-BASED BUDGET
The following absorption rates have been established within Giraffe Ltd as a basis for setting the
budget for next year.
Ordering costs $20 per order
Machine related costs $4 per machine hour
Set up costs $500 per production run
These OARs are calculated by analysing historic overheads into cost pools linked to appropriate cost
drivers. Giraffe Ltd always produce their products in batches of 400 units at a time.
The following activity levels are anticipated for next year for Department X and Department Y.
Dept X Dept Y
Orders processed 4,600 3,100
Machine hours worked 55,000 38,000
Units produced 24,000 7,200
Produce the activity based budget for each department, showing costs for each type of activity and
in total.
SOLUTION
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If you are given the costs of a business (by type of cost) that are then split into cost pools, you may
need to work out the OAR for each cost pool, using the same process as you have already seen in
Section 1 of the course on activity based costing.
1.7 Incremental budgets

A system whereby the budget for the forthcoming period is calculated by taking the current budget or
actual results and adjusting for changes such as anticipated inflation and growth. This is commonly
used within the public sector.
1.7.1 Uses of incremental budgets

 Budget is stable and change is gradual
 Managers can operate their departments on a consistent basis
 System is relatively simple and quick to operate and easy to understand
 Conflicts should be avoided if departments can be seen to be treated similarly
 Co-ordination between budgets is easier to achieve
 Impact of change can be seen quickly
1.7.2 Problems with incremental budgets

 Assumes activities and methods of working will continue in the same way
 No incentive for developing new ideas
 No incentive to reduce costs
 Encourages spending up to the budget, so that the budget is maintained next year
 Budget may become out of date and no longer relate to the level of activity or type of work
being carried out
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 Priority for resources may have changed since the budgets were set originally
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There may be budgetary slack built into the budget, which is never reviewed
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1.8 The master budget
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The master budget collates together the individual budgets for the business functions into a format
consistent with the overall financial statements. It includes the statement of profit or loss, the
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statement of financial position and the cash flow statement.
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1.8.1 Use of master budget
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Provides an overall picture of the planned performance for the budget period.
1.8.2 Problem with master budget

 Not very helpful for management control at a detailed level.
1.9 Functional budgets

These are budgets for each of the business functions of an organisation (sales, production, materials,
labour, overhead).
1.9.1 Use of functional budget

 Reflects the organisational structure and responsibilities.
1.9.2 Problem with functional budget

 A lot of costs do not relate specifically to individual functions.
1.10 Fixed budgets

A fixed budget is simply the main budget that is produced at the start of the year, based on anticipated
levels of sales and production.
1.10.1 Uses of fixed budgets

 Benchmark for control purposes
 Highlight what can be achieved with the expected level of resources
1.10.2 Problems with fixed budgets

 Not good as a comparison in situations where the environment is changing rapidly.
 Not useful as a performance appraisal basis if actual volumes of sales/production are different
to what was expected.
1.11 Flexible budgets

Flexible budgets are multiple budgets produced at the start of the year at different activity levels.
1.11.1 Use of flexible budgets

 Allow for changes in the actual production and sales volumes.
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1.11.2 Problem with flexible budgets
 Require detailed analysis of the organisations cost structures.
1.12 Dealing with uncertainty

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Uncertainty in budgeting may arise for a number of reasons, including the following:
 Unforeseen changes in customer demand
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 Stronger or weaker competition
 Technological advances
 Under-performance by workforce
 Breakdowns in machinery
 Unforeseen changes in price or availability of materials
 Inflation or exchange rate changes
Budget systems can deal with uncertainty in the environment by:
 Producing a range of possible outcomes e.g. a worst case, average and best case outcome
 Using past data and forecasting techniques
 Reducing the uncertainty by using research techniques
 Using expected value techniques
1.13 Feed-forward and feedback control

Comparing the forecast results to the budget and taking corrective action where deviations are
identified to ensure the budget is achieved is a feed-forward system. A cash flow budget is a good
example, where you identify potential cash problems before they arise.
A feedback system compares actual events that have happened with an original budget. This is a
reactive system. Traditional variance analysis is a good example where feedback control takes place.
1.14 Difficulty of budgets

If a budget is too easy it might promote laziness and a lack of desire to excel. Staff would be able to
gain rewards/bonuses for very average performance.
If a budget is based on ideal conditions and consequently too hard, then staff will soon stop trying as
they know they cannot meet the target.
The solution is to have budgets that are challenging but that staff believe are achievable if they
improve their performance in a manageable way compared to current levels. This will encourage
internal processes to become more efficient and the organisation to be more competitive in the
market place.
1.15 Difficulties of changing a budgetary system

 Staff resistance to changes
 Poor control as the managers may face a period of adaptation to the new system and therefore
they may struggle for a while to interpret the results
 Motivational problems
 Lack of staff knowhow and the need for re-training
 Additional costs associated with the implementation of the new system
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 Lack of comparative information
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Lack of systems and spreadsheets
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1.16 Beyond budgeting
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1.16.1 Criticisms of traditional approach
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Hope & Fraser (Harvard Business School Press) in 2003 put forward the following criticisms of
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budgeting.
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s Budgets are time consuming and expensive
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Budgets provide poor value to users
Budgets fail to focus on shareholder value – they focus on internally negotiated targets. There is
no focus on the maximisation of customer or shareholder value
 Budgets are too rigid and prevent fast response
 Budgets protect rather than reduce costs – use it or lose it. If the budget is not spent, superiors
question why the resource is needed and are reluctant to allow it into the budget for the next
period
 Budgets stifle product and strategy innovation – idea that it’s not worth taking risks and if it’s
not in the budget, you might be exposed
 Budgets focus on sales targets rather than customer satisfaction – though everyone wants to
satisfy customers, that is not how they are measured and rewarded
 Budgets are divorced from strategy
 Budgets reinforce a dependency culture – way to survive and prosper in a budgeting
environment is to do what you are told, meet the budget (but never beat it!)
 Budgets lead to unethical behaviour – many finance managers are well versed in "managing the
slack" and feeding it into the results when needed
1.16.2 Beyond budgeting

Compared with the traditional management model, beyond budgeting has two main concepts:
 A more adaptive way of managing in place of fixed annual budgets that tie managers to
predetermined actions, targets are reviewed regularly and based on stretching goals linked to
performance against world-class benchmarks, competitors and prior periods. More focus is
placed on cash forecasting rather than cost control.
 It enables decision-making and performance accountability to be devolved to line managers and
operational staff and creates a working environment and a culture of personal responsibility.
This leads to increased motivation, higher productivity and better customer service.
1.16.3 Benefits of beyond budgeting

 Faster response time – beyond budgeting is much more flexible
 More innovation
 Lower costs – managers see costs as items to be minimised rather than budgets to be spent
 Performance targets are based on competitive success and are more flexible
 Greater motivation for managers because of devolution of responsibilities
 Greater motivation for front line staff dealing with customers and suppliers
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Better relations with customers and suppliers
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Facilitates improvements in information systems throughout the organisation
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2 Quantitative analysis in budgeting
2.1 High/low method
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The fixed and variable cost elements can be analysed from the total cost data using the high/low
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method as follows:
S TEPS
Step 1: Select the highest and lowest activity levels, and their associated total costs
(Note: do not take the highest and lowest costs.)
Step 2: Find the variable cost/unit
𝐂𝐎𝐒𝐓 𝐀𝐓 𝐇𝐈𝐆𝐇 𝐀𝐂𝐓𝐈𝐕𝐈𝐓𝐘 𝐋𝐄𝐕𝐄𝐋−𝐂𝐎𝐒𝐓 𝐀𝐓 𝐋𝐎𝐖 𝐋𝐄𝐕𝐄𝐋 𝐎𝐅 𝐀𝐂𝐓𝐈𝐕𝐈𝐓𝐘
𝐕𝐀𝐑𝐈𝐀𝐁𝐋𝐄 𝐂𝐎𝐒𝐓/𝐔𝐍𝐈𝐓 = 𝐇𝐈𝐆𝐇 𝐋𝐄𝐕𝐄𝐋 𝐎𝐅 𝐀𝐂𝐓𝐈𝐕𝐈𝐓𝐘 𝐔𝐍𝐈𝐓𝐒−𝐋𝐎𝐖 𝐋𝐄𝐕𝐄𝐋 𝐎𝐅 𝐀𝐂𝐓𝐈𝐕𝐈𝐓𝐘 𝐔𝐍𝐈𝐓𝐒
Step 3: Find the fixed cost, using either the high or low activity level
𝐓𝐎𝐓𝐀𝐋 𝐂𝐎𝐒𝐓 = 𝐅𝐈𝐗𝐄𝐃 𝐂𝐎𝐒𝐓 + 𝐕𝐀𝐑𝐈𝐀𝐁𝐋𝐄 𝐂𝐎𝐒𝐓
∴ 𝐅𝐈𝐗𝐄𝐃 𝐂𝐎𝐒𝐓 = 𝐓𝐎𝐓𝐀𝐋 𝐂𝐎𝐒𝐓 − 𝐕𝐀𝐑𝐈𝐀𝐁𝐋𝐄 𝐂𝐎𝐒𝐓
LECTURE EXAMPLE 3.3: HIGH/LOW
The total costs incurred at various output levels in a factory have been measured as follows:
Output Total cost
(Units) ($)
26 6,566
30 6,510
33 6,800
44 6,985
48 7,380
50 7,310
Using the high/low method identify what the fixed and variable elements of the cost are.
SOLUTION
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2.2 Learning effect
KEY TERM
The learning effect reflects the fact that when labour undertakes a new repetitive task, the
time taken will reduce the more the task is performed.
In theory the cumulative average cost/time per batch/unit falls by a fixed percentage (dependent on the
learning rate) as the total output doubles. This relationship can be reflected in a formula as follows:
y = axb GIVEN TO YOU IN THE EXAM
where: a = the cost/time of first batch/unit

x = total number of batches/units produced
b = learning factor (log LR / log 2)
LR = the learning rate as a decimal
There are three calculations you need to be able to complete with regards to learning curves:
 Identify the rate at which learning is taking place
 Calculate time taken or cost of making ‘n’ units
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Calculate time taken or cost of making the ‘nth’ unit
LECTURE EXAMPLE 3.4: RATE OF LEARNING

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Education Co has just started producing a new product. The time taken is as follows:
Cumulative number of units
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produced Total time taken in hours
1 100
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2 160
3 211
4 256
5 298
6 337
7 374
8 410
Estimate the learning effect for Education Co’s new product.
SOLUTION
2.2.1 End of learning effect

The learning effect will not last forever. At some point the cumulative average time per unit will
become constant due to:
 Staff reaching their physical limit
 Staff being restricted by labour agreements
 Staff being restricted by other resource limits such as machine time
 Lack of incentives to improve further
When this point is reached it is described as a steady state.
LECTURE EXAMPLE 3.5: LEARNING CURVE APPLICATION
Innovation Co is just about to start producing a new product. It will produce 256 units per month.
From past experience it is felt that the first unit will take 100 hours and the learning rate is 75%.
Once 257 items have been made a steady state will have been reached, that is the time taken to
produce the 257th unit will then become the time per unit for all further units.
What should the budgeted labour time be for the first two months’ production of this new product?
SOLUTION
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2.2.2 Problems with learning effect

 In the real world the rate of learning will not be constant.
 In modern manufacturing most repetitive tasks have been automated and machines do not
learn.
 The learning curve only applies in very limited situations (in the early stages of a repetitive
manual task).
2.3 Budgeting and expected values

Expected values can be used in budgeting as well as in assessing investment choices.
ILLUSTRATION: EXPECTED VALUES
When planning next year’s sales figures, the Sales Director thought that if the economy was strong
(probability 0.3) sales would be $800,000, that if the economy was normal (probability 0.5) sales
would be $650,000 and that if the economy was weak (probability 0.2) sales would be $500,000.
What are the expected sales for next year?
SOLUTION
Fir Co
st I pyri
Economy Probability Forecast sales
p x px
Strong 0.3 $800,000 $240,000
ntu ght
Normal 0.5 $650,000 $325,000
Weak 0.2 $500,000 $100,000
itio Expected Value, ∑px = $665,000
n2
2.4 Spreadsheets in budgeting
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2.4.1 Benefits of spreadsheets
 Allow the analysis of large volumes of quantitative data
 Are very flexible
 Easy to change
2.4.2 Problems with spreadsheets

 Become blinded by the detail
 Dependent on accuracy of inputs (formulae etc) that can be quite difficult to check in large
models
 Cannot take account of qualitative factors
3 Standard costing
3.1 Uses of standard costs
KEY TERM
Standard costs are pre-determined unit costs based on anticipated levels of efficiency and
price.
A standard cost can be used to:

 Help to produce the fixed, flexible and flexed budgets
 Compare with the actual costs and hence as a control technique
 Motivate staff
 Value inventories in the actual statement of profit or loss and statement of financial position as
well as the budgeted statement of profit or loss and statement of financial position.
3.2 Types of standard

The standard cost is built up by analysing both the quantities and costs of each element of producing
t
the product or service.
i g h 1 7
When doing this, different assumptions can be made, giving rise to different standards:

y r 20
Basic – nothing has changed since the standard was first set

o p ion
Current – current efficiency and cost levels will be maintained

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Attainable (expected) – assumes that there will be some improvements in current efficiency
t
and cost levels

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Ideal – assumes an optimum level of efficiency and cost
ir s
The standard cost can either be:
F 

Standard marginal cost – including only the variable production costs
Standard absorption cost – including the variable and fixed production costs.
3.3 Flexing budgets

Performance management involves assessing current actual performance. Looking at the current
actual performance in isolation is meaningless.
In order to get a good comparison for the actual performance, organisation needs to produce a
“flexed” budget that shows what the original budget would have looked like if it had been based on
the actual volume of production and sales.
ILLUSTRATION: BUDGET FLEXING
Banjo Ltd expects to produce and sell 10,000 units of Product X and the standard cost card indicates
that each unit will contain $5 of material. The original budget (fixed budget) for material cost would
therefore be $50,000 (10,000 × $5).
If we are then told that during the period Banjo Ltd spent $45,000 on material and produced/sold
8,000 units there is a danger that the information could be misinterpreted. Banjo Ltd has clearly spent
$5,000 less on material than per the original budget and so the managers responsible for material
(purchasing and production) may be praised for saving the company money.
This is clearly a bit misleading since the $45,000 cost is based on producing fewer units (8,000
compared to 10,000) and so you would expect costs to be lower. It would make more sense to restate
or “flex” the original budget to show what you would have expected 8,000 units to cost to make. This
would give a flexed budget of $40,000 (8,000 × $5 standard cost).
The managers should therefore be questioned as to why they have spent $5,000 more than expected
($45,000 v $40,000), have they used more material than they should have (usage) or have they
purchased more expensive material (price).
Original budget Flexed budget Actual Variance
Units 10,000 8,000 8,000
Materials (@$5) $50,000 $40,000 $45,000 $5,000
Fir Co
3.4 Controllability
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Just because an actual result is above or below the flexed budget, does not necessarily mean that the
budget holder has performed well or badly.
itio
The reasons for a particular deviation from the flexed figure may be due to factors under the control of
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the budget holder or may be due to factors which are not under their control. If a factor is not
controllable, then it would not be fair to attribute this to the budget holder.
ILLUSTRATION: CONTROLLABLE COSTS 017

Willow Co set a standard material cost of $30 kg. The buying department managed to find another
supplier of the same quality material who charged $28 kg however due to the imposition of a new
green tax by the Government, Willow had to pay $31 kg.
Assess the performance of Willow’s buying department.
SOLUTION
The Buying Department has performed well; if they had done nothing Willow would now be paying
$30 + $3 = $33. The fact that they are only paying $31 shows that the Buying Department has saved
the company $2 kg. The $3 increase is due to the uncontrollable Government green tax.
LECTURE EXAMPLE 3.6: FLEXED BUDGET DETAILED EXAMPLE
Zane plc manufactures PC monitors, mainly for home users. Budgets are set by head office and then
given to the departmental managers who then have responsibility for achieving their respective
targets. Actual costs are compared to the budget and managers are asked to explain any significant
differences.
Zane plc operates a JIT inventory system where materials are purchased to match the number of units
produced and sold.
The control statement for the month is shown below.
Budget Actual Variance
Number of units 6,400 7,140
$ $ $
Revenue 576,000 606,900 30,900 (F)
Labour (51,970) (58,227) 6,257 (A)
Materials (224,000) (205,000) 19,000 (F)
Overheads (69,400) (79,500) 10,100 (A)
Profit 230,630 264,173 33,543 (A)
The budget above is based on the following assumptions:


t
The standard selling price is $90 per monitor.
h 7

g
The budget and actual labour costs include the fixed salary of $2,050 for the manager of the
y r i
assembly team.
201
p ion
 The materials cost is budgeted at $35 per monitor although the supplier of one of the major
o
parts will allow a discount if enough material is purchased to produce 7,000 units per month.
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The discount would be 5% applied only to the items purchased in excess of 7,000 units.
t
 The budgeted overhead cost is made up of two elements, a fixed part and a variable part.
t I n
Detailed historical analysis has indicated that at different volumes of units the overhead costs
s
could be expected to be as follows:
F ir Output (units)
6,500
7,250
Overhead costs ($)
70,000
74,500
Actual fixed costs for the month were as budgeted.
Prepare a flexed budget for the month and calculate more meaningful overall variances based on the
flexed budget.
SOLUTION
Fir Co
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4 Basic variances and operating statements (revision of F2 material)

4.1 Sales variances
4.1.1 Sales price variance
Sales price variance = What the sales revenue actually was – What the sales revenue should have
been
It shows whether the product has been sold for more (favourable) or less (adverse) than the standard
price.
When favourable, the sales price variance could be caused by higher inflation, market shortages,
higher quality.
4.1.2 Sales volume variance

Sales volume variance = (Actual sales volume – Budgeted sales volume) valued at the standard profit
or contribution per unit.
It shows whether more (favourable) or less (adverse) of the product has been sold than originally
budgeted.
When favourable, the sales volume variance could be caused by increased economic activity, lower
t
prices or successful advertising.
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4.2 Materials variances
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Materials total variance = What the output units should have cost for materials – What the output
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actually cost for materials
t
It is best interpreted by looking at its component parts (materials price and usage variances), but
I n
essentially arises due to spending more or less on materials in producing the quantity of actual output.
s t
Materials total variance will be caused by a combination of the causes of the price and usage
ir
variances.
F 4.2.1 Materials price variance

Materials price variance = What the materials used or purchased should have cost – What the
materials used or purchased actually cost
It shows whether less (favourable) or more (adverse) has been paid than the standard price.
When favourable, the materials price variance could be caused by using a cheaper supplier, obtaining
an unforeseen discount, a drop in commodity prices or reducing the quality.
4.2.2 Materials usage variance

Materials usage variance = (How much material should have been used – How much material was
used) valued at the standard material cost
It shows whether less (favourable) or more (adverse) material has been used than the standard
(expected) usage.
When favourable, the materials usage variance could be caused by using higher quality material, being
more efficient, dropping quality thresholds or errors in allocating materials to the job.
4.3 Labour variances

Labour total variance = What the output should have cost for labour – What the output did cost for
labour
It is best interpreted by looking at its component parts (labour rate and efficiency variances).
Labour total variance will be caused by a combination of the causes of the rate and efficiency
variances.
4.3.1 Labour rate variance

Labour rate variance = What the labour should have cost – What the labour did cost
It shows whether less (favourable) or more (adverse) has been paid for labour than the standard price.
When favourable, the labour rate variance could be caused by using lower grade staff or poor
economic conditions leading to lower pay rises than anticipated.
4.3.2 Labour efficiency variance

Labour efficiency variance = (How much labour should have been used – How much labour was used)
valued at the standard labour cost
It shows whether less (favourable) or more (adverse) labour has been used than the standard amount.
Fir Co
When favourable, the labour efficiency variance could be caused by higher motivation, better quality
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equipment or materials or errors on time sheets.
4.3.3 Labour idle time variance
ntu ght
Labour idle time variance = (Hours worked – Hours paid) valued at the standard labour cost
itio
It shows the impact on profits of not having staff working for all the hours that you are expecting them
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to be.
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Idle time is generally adverse and could be caused by lack of motivation, insufficient work to do, poor
work scheduling, staff laziness.
4.4 Variable overhead variances

Variable overhead total variance = What the variable overheads should have been for the output –
What the variable overheads were for the output
It is best interpreted by looking at its component parts (variable overhead expenditure and efficiency
variances).
Variable overhead total will be caused by a combination of the causes of the expenditure and
efficiency variances.
4.4.1 Variable overhead expenditure variance

Variable overhead expenditure variance = What the variable overhead should have cost – What the
variable overhead did cost
It shows whether less (favourable) or more (adverse) has been paid than the standard price.
When favourable, the variable overhead expenditure variance could be caused by unanticipated
economies of scale or lower prices.
4.4.2 Variable overhead efficiency variance

Variable overhead efficiency variance = (How much labour should have been used – How much labour
was used) valued at the standard variable overhead cost
It has the same interpretation as the labour efficiency variance.
Variable overhead efficiency variance will have the same causes as the labour efficiency variance.
4.5 Fixed overhead variances

Fixed overhead total variance = What the output should have cost for fixed overheads – What the
output actually cost for fixed overheads
It shows the over (favourable) or under (adverse) absorption of fixed overheads.
Fixed overhead total variance will be caused by a combination of the causes of the expenditure and
volume variances.
4.5.1 Fixed overhead expenditure variance

Fixed overhead expenditure variance = Budgeted fixed overhead expenditure – Actual fixed overhead
expenditure
It shows whether less (favourable) or more (adverse) has been paid than the budgeted cost.
t
When favourable, the fixed overhead expenditure variance could be caused by lower price rises or
h 7
savings.
r i g 201
y
4.5.2 Fixed overhead volume variance
o p ion
Fixed overhead volume variance = (Actual production volume – Budgeted production volume) valued
C uit
at the standard fixed overhead cost per unit
t
It shows whether more (favourable) or less (adverse) of the product has been produced than originally
I n
budgeted.
r s t
When favourable, the fixed overhead volume variance will be caused by increased production.
F i4.5.3 Fixed overhead capacity variance

Fixed overhead capacity variance = (Actual labour hours – Budgeted labour hours) valued at the
standard fixed overhead cost per hour
It shows whether more (favourable) or less (adverse) hours have been obtained for the fixed overhead
than originally budgeted.
When favourable, the fixed overhead capacity variance will be caused by the workforce working extra
hours (overtime to get a job done, understated original budget).
4.5.4 Fixed overhead efficiency variance

Fixed overhead efficiency variance = (How much labour should have been used – How much labour
was used) valued at the standard fixed overhead cost
It shows has the same interpretation as the labour efficiency variance.
Fixed overhead efficiency variance will have the same causes as the labour efficiency variance.
LECTURE EXAMPLE 3.7: REVISION OF BASIC VARIANCES
Control Co makes tennis rackets. The standard cost of making a tennis racket is as follows:
$
Direct materials (0.3kg @ $30 per kg) 9
Direct labour (2hrs @ $12 per hr) 24
Variable overheads (2hrs @ $4 per hr) 8
Fixed overheads (2hrs @ $8 per hr) 16
Control Co budgets to sell these rackets at $70 each. The budgeted monthly sales and production is
15,000 rackets.
The following is the actual information for Month 2.
Sales/production volume 18,000 rackets
Materials cost $165,000 for 5,600kg
Labour cost $405,000 for 33,000 hours
Variable overhead $135,000
Fixed overhead $260,000
Revenue $1,245,000
Calculate the Month 2 variances for Control Co.
Fir Co
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SALES VARIANCES
SALES PRICE SALES VOLUME
$ Rackets
VARIANCE
VARIANCE IN $
MATERIALS VARIANCES
TOTAL MATERIALS
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VARIANCE
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F i MATERIALS PRICE MATERIALS USAGE
$ kg
VARIANCE
VARIANCE IN $
LABOUR VARIANCES
TOTAL LABOUR
18,000 rackets $
Should cost (18,000 x $24) 432,000
Did cost 405,000
VARIANCE 27,000 (F)
LABOUR RATE LABOUR EFFICIENCY

33,000 hrs $ 18,000 rackets hrs
Should cost (33,000 × $12) 396,000 Should use (18,000 × 2 hrs) 36,000
Did cost 405,000 Did use 33,000
VARIANCE 9,000 (A) VARIANCE in hrs 3,000 (F)
Co
Valued at the standard $12
Fir
cost per hr
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VARIANCE IN $ 36,000 (F)
VARIABLE OVERHEAD VARIANCES

ntu ght
itio
TOTAL VARIABLE OVERHEAD
18,000 rackets
n2$
Should cost (18,000 × $8)
Did cost 017
144,000
135,000
VARIANCE 9,000 (F)
VARIABLE OVERHEAD EXPENDITURE VARIABLE OVERHEAD EFFICIENCY
33,000 hrs $ 18,000 rackets kg

Should cost (33,000 × $4) 132,000 Should use (18,000 × 2 hrs) 36,000
VARIANCE 3,000 (A) VARIANCE in hrs 3,000 (F)
Valued at the standard cost $4
per hr
FIXED OVERHEAD VARIANCES
TOTAL FIXED OVERHEAD
VARIANCE
FIXED OVERHEAD EXPENDITURE FIXED OVERHEAD VOLUME
$ Rackets
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VARIANCE
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I n t VARIANCE IN $
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F i
FIXED OVERHEAD CAPACITY FIXED OVERHEAD EFFICIENCY
$ hrs
VARIANCE IN $ VARIANCE IN $
LECTURE EXAMPLE 3.8: IDLE TIME AND WASTE VARIANCES
The following is the actual information for Month 3 for Control Co.
Revenue $1,100,000
Only 5,000kg of materials were used in production, but there was no inventory at the end of the
month. The work force was only active for 29,000 hours.
Calculate the Month 3 material and labour variances for Control Co.
SOLUTION
Fir Co
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4.6 Operating statements
ILLUSTRATION: UNEXPECTED IDLE TIME
The following is the actual information for Month 4 for Control Co.
t
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Revenue
y r 20 $9,700,000
o p ion
The work force was only active for 25,000 hours, but after the experience of Month 3 the management
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of Control Co planned for 1,000 hours of idle time.
t
Calculate the Month 4 labour unexpected idle time variance for Control Co.
SOLUTION
t I n
ir s
F
Labour unexpected idle time
Hrs
Worked 25,000
Paid 26,500
Total idle time 1,500
Expected idle time 1,000
VARIANCE in hrs 500 (A)
Valued at the standard cost per hr $12
VARIANCE in $ 6,000 (A)
4.7 Operating statements

As variances explain the difference between the budget and the actual figures for the revenue and
individual costs, the total of all of the variances will reconcile budgeted profit with actual profit.
An operating statement shows the budgeted profit and the variances reconciling to the actual profit.
The basic layout of the statement is not critical but as long as you have the budgeted profit /
contribution at the top and the actual profit/contribution at the bottom with variances in between you
will be fine.
In marginal costing the fixed overheads are not absorbed and so the only fixed overhead variance that
is required is the fixed overhead expenditure variance.
Also, in marginal costing we work in terms of contribution. not profit The sales volume variance needs
to be recalculated using the standard contribution rather than the standard profit.
ILLUSTRATION: VARIANCES AND PROFIT RECONCILIATION (MARGINAL COSTING)
Reconcile budgeted profit with actual profit under standard marginal costing for Control Co.
(W1) Actual profit working
$
Revenue 1,245,000
Materials (165,000)
Labour (405,000)
Variable overhead (135,000)
Fixed overhead (260,000)
Profit $280,000
(W2) Revised sales volume variance
Rackets
Actual sales 18,000
Budget sales 15,000
Fir Co
Variance in rackets 3,000 (F)
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Valued at STANDARD CONTRIBUTION $29
SOLUTION
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$
Budgeted profit (15,000 rackets × $13) 195,000
017
Budgeted fixed overhead (15,000 rackets × $16) 240,000
Budgeted contribution 435,000
Sales volume variance 87,000
Flexed budgeted contribution (18,000 rackets × $29) 522,000
Sales price variance (15,000)
Favourable Adverse
Cost variances $ $
Material price variance 3,000
Material usage variance 6,000
Labour rate variance 9,000
Labour efficiency variance 36,000
Variable overhead expenditure variance 3,000
Variable overhead efficiency variance 12,000
Total cost variances 51,000 18,000
33,000
Actual contribution 540,000
Less: Budgeted fixed overhead 240,000
Fixed overhead expenditure variance 20,000
260,000
Actual profit 280,000
In the above reconciliation we have both added and deducted the budgeted fixed overhead. This could
be omitted and the reconciliation would still work, however the subtotals would no longer have any
meaning.
ILLUSTRATION: VARIANCES AND PROFIT RECONCILIATION (ABSORPTION COSTING)
Reconcile budgeted profit with actual profit under standard absorption costing for Control Co.
SOLUTION
$
Budgeted profit (15,000 rackets × $13) 195,000
Sales volume variance 39,000
Flexed budgeted profit (18,000 rackets × $13) 234,000
Sales price variance (15,000)
Favourable Adverse
Cost variances $ $
Material price variance 3,000
Material usage variance 6,000
Labour rate variance 9,000
Labour efficiency variance 36,000
Variable overhead expenditure variance 3,000
Variable overhead efficiency variance 12,000
Fixed overhead expenditure variance 20,000
Fixed overhead capacity variance 24,000
t
Fixed overhead efficiency variance 24,000
g
Total cost variances
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99,000 38,000
r 0
61,000
y
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Actual profit
2 $280,000
o
Note. As there is no inventory, the absorption and marginal costing profits are the same.
C uit
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5 Material mix and yield variances

5.1 Materials variances
Most products require more than one material. Some products require a set amount of each material
e.g. chairs require a set amount of metal, screws, foam, fabric. If this is the case it would be best to
calculate price and usage variances for each material separately.
However, in some products the proportion of individual materials can be varied e.g. muesli requires
oats, bran, fruit and nuts, but the precise quantity of each is not critical. Indeed, it may actually work
to the manufacturer’s advantage to increase the quantity of oats and reduce the quantity of nuts as
oats are cheaper than nuts. However, nuts are heavier than oats and so more oats would need to be
included in order to produce the same weight of output.
So a muesli manufacturer would find it useful to know how the actual inputs and outputs differed from
the standard. Thus, rather than calculating a separate material usage variance for each material, we
calculate:
 Material mix variance – input variance
 Material yield variance – output variance
5.2 Total material variance
Fir Co
The total material variance can be analysed as follows:
st I pyri
Total material
variance
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Price variance Usage variance
Mix variance
n2 Yield variance
017
(inputs) (outputs)
The usage variance indicates whether more or less material than expected was used to make the
actual production units. This is then valued at the standard material cost.
The mix variance then how much of the overall usage variance is due purely to the proportions of the
materials input into production being different to the proportions that were expected. It is based on
the actual total input levels of material.
The yield variance then isolates whether the actual amount of material input into production led to
more or less output units than would have been expected for that level of input.
Usage variance = mix variance + yield variance
5.3 Materials mix variance
KEY TERM
Materials mix variance = difference between the standard mix of materials and the actual
mix of materials, valued at the standard material cost.
In other words, looking at the quantity of material actually input, how does the actual mix of that
material compare to what we would have expected to have used of each material.
5.4 Materials yield variance
KEY TERM
Materials yield variance = difference between the actual output from the materials used
and the standard output, valued at the standard material cost
Did we get more or less finished output than we’d have expected from the amount of material being
input into the process?
LECTURE EXAMPLE 3.9: MIX AND YIELD VARIANCES
Widows Co makes a very popular chocolate coated raisin snack. The standard ingredients for one
batch are:
$
Raisins 5kg @ $8 per kg 40
Chocolate 1kg @ $12 per kg 12
52
In the month just ended Widows made 1,000 batches and used the following ingredients:
t
Raisins 4,900 kg
h 7
Chocolate 1,400 kg
r i g 01
Calculate the material usage, mix and yield variances.
2
y
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o
SOLUTION
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Fir Co
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5.5 Changing the mix
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In Lecture example 3.9 above, Widows has used more of the more expensive chocolate ingredient and
less of the cheaper raisins, giving an adverse mix variance. This has also resulted in less output.
017
However, the overall impact of this change may well be that the snack becomes more popular and so
Widows can sell more at a higher price.
We thus need to make sure that we look at the overall impact of any changes and not just individual
variances.
5.6 Alternative methods of controlling production

Variance analysis is a financial control technique, comparing the actual performance against the
standard at the end of the period. There are also non-financial control techniques including:
 Continuous supervision and monitoring – issues will be identified as soon as they start
 Staff training – highly trained staff will automatically do what is required
6 Sales mix and quantity variances

6.1 Sales volume variance
For the sales volume variance, it may be worth analysing the sales volume variance into a mix and
quantity element. This is worth doing if the company sells more than one product and the products are
to some extent linked, for example:
 Complementary products (e.g. knives and forks)
 Substitutes (Tesco ketchup or Heinz ketchup)
 Products produced using the same resources in a limiting factor environment
Remember, the sales volume variance overall considers the difference between volumes actually sold
and budget volumes but does not concern itself with the makeup of those sales.
6.2 Sales mix variance
KEY TERM
Sales mix variance = difference between the standard mix of actual sales volume and the
actual mix of actual sales volume (i.e. the actual sales volumes), valued at the standard
profit/contribution
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Looking at the volume of actual sales, how does the actual mix of sales compare to what we would
r i 0
have expected to have sold of each product to make up actual volume.
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6.2.1 Causes of sales mix variance
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An adverse sales mix variance arises if you proportionately sell fewer of your more profitable products
t
and more of your less profitable products. This could be caused by:

t I n
A downturn in the economy, leading to customers becoming more cost conscious and
s
preferring to purchase cheaper goods
F ir


Failure of a marketing campaign to try and boost sales of the more profitable item
Increased competition in the marketplace for the more profitable item
6.3 Sales quantity variance
KEY TERM
Sales quantity variance = difference between the actual sales volume (at standard mix) and
the budgeted volume valued at the standard profit/contribution.
This measures the impact on profit resulting purely from selling more or less units than budgeted and
is unaffected by the actual mix of sales.
6.3.1 Causes of sales quantity variance

A favourable quantity variance could be due to:
 An increase in the overall market size for the company’s products
 Good performance by the sales team in exceeding targets (possibly due to a new reward
scheme being introduced)
LECTURE EXAMPLE 3.10: SALES MIX AND QUANTITY VARIANCES
Healthy Eating Company (HEC) produces and sells three products, Cheeky Charlie (CC), Happy Horace
(HH) and Jolly Jake (JJ). Budgeted information per month is as follows:
CC HH JJ
Sales volume (units) 1,000 1,500 500
Selling price/unit ($) 10 8 12
Variable cost/unit ($) 6 5 7
In Month 3 the sales of CC were 900, HH were 1,300 and JJ were 700.
Required:
Calculate the sales volume variance, together with the sales mix and quantity variances.
SOLUTION
Fir Co
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7 Planning and operational variances

If the standard cost card is incorrect, then the budget and flexed budget are certain to be wrong and
so the variances will be meaningless. This problem can be overcome however by revising the standard
and budget to reflect what actually should have been included (with hindsight).
Variances can then be categorised into those caused by planning issues and those caused by
operational performance issues.
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ILLUSTRATION: REVISED BUDGET
y r i 20
p ion
Hindsight Co makes telescopes. The standard costs and revenue are as follows:
o
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Materials 2kg @ $35 per kg
$
70
n t
Labour 4hrs @ $15 per hr 60
I
Standard cost 130
s t
Standard contribution
r
69
i
Standard sales price 199
F Budgeted production and sales were 10,000 telescopes.

The above cost card was produced by a temp and Hindsight now realises that it contains some
mistakes:
 Materials should have been 2.2kg @ $30 per kg due to Hindsight having to change suppliers and
buying lower quality materials as the original supplier has been liquidated
 Labour should have been 3.5 hrs @ $16 per hr; the higher rate reflecting government minimum
wage legislation. However due to an internal dispute the workforce have been on a ‘go slow’, as
a result of which it has been taking 4 hours per unit.
 The total market size was expected to be 100,000 telescopes, however there has been a market
downturn with industry sales falling by 10%.
Calculate a revised budget.
SOLUTION
Revised standard Revised budget
Cost (per unit) Units
10,000 telescopes × 90% 1 9,000
$ $
Sales 199 1,791,000
Materials 2.2kg @ $30 per kg (66) (594,000)
Labour 3.5hrs @ $16 per hr (56) (504,000)
Contribution $77 $693,000
7.1 Manipulation of budgets

If we do not calculate planning variances all of the differences in the actual figures are the
responsibility of the operational managers. By calculating planning variances some of these differences
will become the responsibility of planning or more senior managers.
Consequently, when revising budgets there is a danger that the operational managers will try to blame
all of the adverse changes on planning or uncontrollable factors i.e. all of the planning variances will be
adverse and all of the operational variances will be favourable!
Fir Co
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7.2 Revision of original budget
The original budget should therefore only be revised for one of the following reasons:

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Poor planning – if the mistake is a planning error e.g. someone putting down the wrong figures
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 Uncontrollable factors – if the change is due to something which is outside of the control of the
organisation e.g. supplier liquidation, government legislation or market downturn.
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If there has been an operational issue, this should not be reflected in a revised budget as the whole
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purpose of variance analysis is to identify such issues.
7.3 Reasons for planning and operational variances

7.3.1 Sales variances
Planning variances for sales price
= (Revised selling price per unit – Original selling price per unit) × Revised budget sales volume
Planning variances for sales volume – market size variance
= (Revised budget sales volume – Original budget sales volume) × Original standard contribution per
unit
These variances may be caused by an upturn or downturn in general economic conditions, changes in
technology meaning a product is much more relevant now.
Operational sales variances look into the differences between actual results and the revised budget.
The operational sales volume variance is also referred to as the market share variance. These
variances could be due to new competitors, competitors leaving the industry, the performance of the
sales team, the quality of the product etc.
7.3.2 Materials variances

There are a few recognised methods of doing planning and operational variances for materials
The current Examiner’s preference is as follows:
Planning variance for material price – based on the ACTUAL usage/purchases of material
Operational variance for material usage – based on the ORIGINAL standard cost per kg/litre
Solutions in the notes are based on this approach.
Some possible causes of these variances include:
Planning
 Material price – error in original standard, market price change due to worldwide shortage or
surplus of the material, closure of a material supplier, unforeseen inflation
 Material usage – error in original standard, changes in technology leading to more / less
material being required, changes in legal / regulatory requirements for the material, flood/fire
destroying material
Operational
 Material price – buy lower / higher quality material, deliberate change of supplier, bulk buying
discounts
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 Material usage – training or supervision of staff being better or worse than expected, quality of
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material being different to what was expected
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7.3.3 Labour variances
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There are also a few recognised methods of doing planning and operational variances for
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labour. The current Examiner’s preference is as follows:
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Planning variance for labour rate – based on the ACTUAL hours for labour
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Operational variance for labour efficiency – based on the ORIGINAL standard cost per hour
ir s Solutions in the notes are based on this approach.
F Some possible causes of these variances include:

Planning
 Labour rate – error in original standard, labour shortage or surplus in the market in general
leading to market wage rates changing, change in product specification due to change in law
causing a different grade of labour to be needed
 Labour efficiency – error in original standard, change in work practices due to regulatory
requirements such as increased rest periods for staff, increased quality requirements set
externally
If there is a learning effect with labour, then there may be an impact on the planning and
operational variances for labour efficiency. If, for example, in the original budget there was
expected to be a 90% learning effect but due to an error this was incorrect and should have
been 80% then there would be a planning and operational impact.
Operational
 Labour rate – overtime working required, employing different quality staff, staff bonuses paid
for increased productivity
 Labour efficiency – different quality staff used, poor work scheduling leading to increased idle
time, training or supervision of staff being better or worse than expected
Cost Card data from previous Illustration

ORIGINAL BUDGET $/unit REVISED BUDGET $/unit
Material (2kg @ $35/kg) 70 Material (2.2kg @ $30/kg) 66
Labour (4hrs @ $15/hr) 60 Labour (3.5hrs @ $16) 56
130 122
Std contribution 69 Std contribution 77
Selling price 199 Selling price 199
LECTURE EXAMPLE 3.11 SALES PLANNING AND OPERATIONAL VARIANCES (BASED ON PREVIOUS ILLUSTRATION)
For Hindsight Co actual sales were 9,900 for revenue of $1,890,900.
Calculate planning and operational variances for sales, including market size and market share.
SOLUTION
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LECTURE EXAMPLE 3.12: MATERIALS & LABOUR PLANNING AND OPERATIONAL VARIANCES
The actual production costs for Hindsight Co were:

$
Materials: 20,790kg 652,000
Labour: 39,600 hrs 575,000
Required:
(a) Calculate the variances for materials and labour ignoring any planning errors.
(b) Analyse the materials and labour variances into planning and operational variances.
SOLUTION
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LECTURE EXAMPLE 3.13: LABOUR VARIANCES AND THE LEARNING CURVE
The following details show the direct labour requirements for the first six units of a new product that
were manufactured last month:
Budget Actual
Output (units) 6 6
Labour hours 240 195
Total labour cost $1,680 $1,365
Fir
The following variances have been reported:
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Total labour cost variance $315 favourable
Labour rate variance NIL
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Labour efficiency variance $315 favourable
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It has now been realised that the Production Manager should have informed the accountant that a
learning curve of 90% should have been expected for the first 10 units with the time for the first unit
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as budgeted:
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Calculate planning and operational variances that analyse the actual performance taking account of
the anticipated learning effect.
Note: The learning index for a 90% learning curve is -0.1520
SOLUTION
EXAM NOTE
First, find the hours per unit and the rate per hour in the original budget as this raw data will
help with the variance calculations.
Then work out the revised budget hours based on the 90% learning rate and once you have
done this the variances can be calculated in the standard way.
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8 Performance
8.1 Behavioural aspects of budgeting
Budgets act as targets and as a result can induce one of two extreme forms of behaviour:
 The budget is set at an unrealistically high level (for revenue and production and sale volumes)
or low level (for costs) to try to impress others
 The budget is set at an unrealistically high level (for costs) or low level (for revenue and
production and sale volumes) level to try to make actual performance as impressive as possible
From a budgeting perspective two key influences on behaviour will be PARTICIPATION and
ACHIEVABILITY (these two may well be linked).
8.2 Staff motivation

Variances are calculated once the period has ended i.e. they are historic and thus it is too late for the
staff to do anything about them. This can be de-motivating.
As staff know that their performance will be judged by the variances, they may be motivated to try to
set an easy standard or to falsify the actual results so that their variances are favourable.
There is a tendency to focus on adverse variances and so staff may be motivated to avoid adverse
variances rather than achieve favourable variances.
8.3 Problems with traditional systems

In a traditional costing environment, in order to achieve a favourable material price variance, the
following may occur:
 Large orders may be placed to achieve quantity discounts leading to high inventories
 Lower quality materials may be purchased leading to product quality issues
In order to achieve a favourable material usage variance or reduce the material wastage variance, the
 Materials may be used even if they are below standard, leading to product quality issues
In order to achieve a favourable labour (and variable and fixed overhead) efficiency variance the
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 Work may be rushed and errors made leading to product quality issues
In order to avoid a labour idle time variance, the following may occur:

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Production may be continued even though there is no immediate requirement, leading to high
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inventories
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8.4 The modern environment
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In rapidly changing environments it will be extremely difficult to set a standard which remains a realistic
target of what can be expected. This could result in one of the following behavioural problems:
 The standards are ignored and consequently the control benefits are lost
 Actual operations are modified to fit the standard and consequently the organisation does not
change and falls behind its environment
8.4.1 Just in time (JIT)

A JIT (Just in time) system is an inventory management system aimed at operating with minimal or
zero inventory. The idea is that making items just to have them sitting around in the warehouse is not
value adding to the business since money is tied up and warehouse/insurance costs are incurred:
 JIT purchasing – purchase items such that the suppliers deliver them just as you need to use
them in production.
 JIT production – plan production so that finished goods are produced just in time for customers
to come and purchase them.
8.4.2 Total quality management (TQM)

TQM refers to an overall philosophy within organisations of ‘getting it right first time’ and ‘continuous
improvement’. It is about everyone throughout the organisation striving for excellence in all products,
systems and procedures, so that ultimately the customer benefits from ever improving
products/services. TQM focuses on quality with the idea that there is no waste or rejection.
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103
Performance measurement
and control
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Int yrigh
1 Performance management informationtsystems
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1.1 Accounting information requirements
ion
Strategic
201 Management level Operational
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Time horizon Longer term S/T and M/T Short term
Breadth covered Wide focus Fairly wide Narrow focus
Level of detail Low level Summarised High level
Level of certainty Vague/uncertain Quite specific Specific/certain
Source of data External & internal Mostly internal Internal
Type of info Qualitative/quantitative Mostly quantitative Quantitative
Feed-forward Feedback
Examples Info on products (competitor Variance analysis Daily inventory
pricing/product spec), and markets Cash flow budgets movement reports
(market share, technology changes) Staff utilisation reports Weekly sales listing
1.2 Information systems

1.2.1 Management Information System
Management Information System (MIS) is a generic term used to describe any system which provides
information for use in the decision making at all levels within an organisation.
104 4: Performance measurement and control AC C A F5
1.2.2 Executive information systems (EIS)

EIS provide board level with summarised information for strategic decisions.
1.2.3 Expert systems

Expert systems provide access and assistance with tax legislation, Companies Act requirements etc.
1.2.4 Decision support systems (DSS)

DSS provide information in a flexible format to facilitate “what if” analysis. These will often be used to
assist resource planning at a management / tactical level.
1.2.5 Enterprise resource planning systems (ERPS)

ERPS is an integrated computer-based system used to manage internal and external resources,
including tangible assets, financial resources, materials and human resources. It integrates the various
business functions into one system and is usually looked after centrally by information management
specialists. It should cause a substantial reduction in the gathering and processing of routine
information.
Managers can directly access relevant information rather than having to rely on management
accountants. All levels within an organisation can make use of information from these types of system.
t
1.2.6 Transaction processing systems
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Transaction processing systems describe systems that are used to capture all the day-to-day routine
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transactions within a business. These will mostly be of use to the managers at an operational level.
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1.3 Open and closed systems
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KEY TERMS
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s
 Open systems refer to systems that interact with other systems or the outside
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environment
F  Closed systems refer to systems having relatively little if not no interaction with other
systems or the outside environment
In businesses truly closed systems are quite rare, since survival in business will to a great extent
depend on how you react to external factors. From a performance management perspective open
systems are preferable because of the need to assess controllability and differentiate between
planning and operational variances.
Imagine the appraisal of the purchasing team where material purchase costs have been 5% above
budget. In a closed system the staff would receive negative feedback for overspending on the budget
as a simple budget vs actual comparison would be all that was undertaken.
If the performance system was an open one, it would have considered whether there were any
external factors that might have affected performance such as worldwide shortage of the material due
to a natural disaster. If external factors suggested that prices in general were going to be pushed up by
10% due to a shortage then the actual performance of the purchasing team would be assessed as
good, only being 5% above budget.
AC C A F 5 4: Performance measurement and control 105
2 Sources of management information

2.1 Internal sources
 The accounts (nominal ledger, sales ledger, purchase ledger), particularly relevant for sales,
costs and inventory valuation information
 Original budget
 Supplier and customer databases
 Meetings (formal and informal)
 Inventory management system
 Payroll department/system
From a control perspective the accounts will record actual transactions. These can be compared back
to the budget via variance analysis. Meetings could be used to monitor progression of projects.
The inventory management system can help identify slow and fast moving inventory items. The payroll
system can be used to check consistency of pay by level of staff and to check that only legitimate staff
are paid.
2.1.1 Costs of internal sources
Fir Co
Direct data capture costs include money spent on scanning, bar code systems, completion of forms
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(time, paper etc).
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If information is generated internally then there will be processing costs such as the costs of data
input personnel and costs of staff who check/summarise input data.
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There may also be some indirect costs of producing internally generated information, including lost
output from not being able to employ more production staff if budget is taken up with data personnel.
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Also, if too much information is produced there is a danger that inefficient decisions are made as staff
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get “blinded” by the detail.
2.2 External sources

 Trade journals
 Government data
 World Wide Web (Internet)
 Market research
 Trading partners (customers and suppliers)
Having access to external information means decisions can be made in a more informed way (i.e.
reduces risk) and will be made based on up to date environmental factors. This can help the control of
business operations.
2.2.1 Drawbacks of external information sources

 Reliance on third party information (for secondary data collection) in terms of quality/accuracy
 Surveys won’t always be representative of a whole population
 Data may often be out of date
2.2.2 Costs of external sources

There are certain costs that relate to the collection of data directly for a specific purpose (primary
data).
 Survey costs
 Recruitment/salary costs of those directly associated with the collection of the data
 Costs of any necessary equipment (computers, phones)
The general external information that is obtained but not specifically created for use by the company
(secondary data) will incur various costs.
 Subscriptions to trade magazines, databases
The costs above specifically relate to the collection of the data in the first place, other costs include:
 Cost of time spent analysing data
 Processing costs
 Opportunity cost of not spending time on other value adding activities
3 Management reports
It is important to make sure that information is handled very carefully whether it is for internal or
external purposes.
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3.1 Controls over information
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In generating and distributing internal information the following types of controls may be necessary:

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Input controls – passwords, checks that data is in appropriate format (e.g. alphanumeric
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checks) etc
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 Processing controls – audit trails of who has updated information and when

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Output controls – Distribution to authorised personnel only (use lists) or password access
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Controls for highly sensitive information include:
F i

Keeping passwords or other codes securely
Staff contracts specifying procedures and action to be taken if the person fails to adhere to the
security standards
 Storing physical documents in locked cabinets in secure locations
 IT department monitoring file access on a regular basis
4 Performance analysis in private sector organisations

4.1 Profitability
PBIT
𝐑𝐞𝐭𝐮𝐫𝐧 𝐨𝐧 𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐄𝐦𝐩𝐥𝐨𝐲𝐞𝐝 (𝐑𝐎𝐂𝐄) = TALCL
× 100%
Where TALCL = Total Assets Less Current Liabilities

This measures the return made by the organisation from the amount of available capital and so gives
an indication as to how efficient the organisation is at generating profits from its capital.
To improve this measure the efficiency needs to be increased.
Gross profit
𝐆𝐫𝐨𝐬𝐬 𝐏𝐫𝐨𝐟𝐢𝐭 𝐦𝐚𝐫𝐠𝐢𝐧 = Revenue
× 100%
This measures the ability of the business to sell goods for more than they cost to make. You might well
expect this ratio to remain fairly stable over time and for competitors to show similar gross margins.
To improve this measure either prices need to rise or production costs fall.
PBIT
𝐍𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭 𝐦𝐚𝐫𝐠𝐢𝐧 = Revenue
× 100%
This measures the ability of the business to make an overall profit on the goods it sells. A low net profit
margin is not necessarily a concern, as the volume of sales and hence the total absolute profit will also
be a factor to consider.
To improve this measure either prices need to rise or overall costs fall.
Revenue
𝐀𝐬𝐬𝐞𝐭 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 = TALCL
This measure looks at how well your assets are being used to generate sales. Are you being efficient at
using your assets to full potential?
Under this header you may also have to analyse factors associated with revenue, and important costs
such as salary costs.
4.2 Liquidity
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Current assets
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𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐫𝐚𝐭𝐢𝐨 = Current liabilities
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This ratio looks at the working capital of the organisation and assesses its ability to meet its short-term
debts.
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To improve this ratio either current assets need to rise or current liabilities fall.
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Current assets − Inventories
𝐐𝐮𝐢𝐜𝐤 𝐫𝐚𝐭𝐢𝐨 (𝐨𝐫 𝐚𝐜𝐢𝐝 𝐭𝐞𝐬𝐭) = Current liabilities
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This is considered a better measure of an organisation’s liquidity, especially where inventory cannot be
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turned into cash very quickly. To improve this ratio either receivables and cash need to rise or current
liabilities fall.
Additionally, elements of the working capital management of a business can be measured as follows:
Cost of sales
𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 = Inventories
Inventory
𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐝𝐚𝐲𝐬 = COS
× 365 days ∗
This ratio shows, on average, how long, on average, you are holding items in inventory
Trade receivables
𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞𝐬 𝐜𝐨𝐥𝐥𝐞𝐜𝐭𝐢𝐨𝐧 𝐩𝐞𝐫𝐢𝐨𝐝 = Credit turnover
× 365 days ∗
This ratio shows, on average, how long your debtors take to pay you.
Trade payables
𝐏𝐚𝐲𝐚𝐛𝐥𝐞𝐬 𝐩𝐚𝐲𝐦𝐞𝐧𝐭 𝐩𝐞𝐫𝐢𝐨𝐝 = Credit purchases or COS × 365 days ∗
This ratio shows, on average, how long your company takes to pay its creditors.
* The working capital cycle includes cash, receivables, inventories and payables. It effectively
represents the time taken to purchase inventories, then sell them and collect the cash. The length of
the cycle is determined using the above ratios.
4.3 Risk
The term ‘gearing’ refers to the extent to which a business is dependent on loans and preference
shares, as opposed to ordinary shares and reserves. This is sometimes known as FINANCIAL RISK.
Gearing ratios indicate the degree of risk attached to the company and the sensitivity of earnings and
dividends to changes in profitability and activity level.
Long term debt
 𝐃𝐞𝐛𝐭 𝐭𝐨 𝐞𝐪𝐮𝐢𝐭𝐲 𝐫𝐚𝐭𝐢𝐨 = Equity
%
Long term debt
 𝐆𝐞𝐚𝐫𝐢𝐧𝐠 = Equity+Long term debt %
This shows what proportion of the assets of the company have been financed by lenders rather than
shareholders. To improve this ratio either more equity needs to be raised or retained profits increased.
PBIT
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐜𝐨𝐯𝐞𝐫 = Interest payable
This determines the number of times that the company can afford to pay its interest charges out of its
current year profits
To improve this measure profits either need to improve or level of debt fall.
4.4 Comparisons of ratios
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To be meaningful, the above ratios would need to be compared:
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
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Previous years
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 Other companies
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 Other divisions within this company
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Industry standards
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Also, reference should be made to external indicators wherever possible (e.g. inflation, stock market
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performance).
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4.5 Non-financial performance measures
ir s
The financial success of an organisation will often depend upon non-financial factors such as people,
F products, service and processes. Non-financial performance indicators (NFPIs) measure the
performance of these factors.
Consequently, financial measures are very good at telling you about past and current performance
but likely future performance is best flagged with the use of non-financial measures.
Unlike FPIs, NFPIs are far more varied and need to be tailored to the particular organisation
concerned. However commonly used NFPIs include:
 Customer satisfaction – sales growth, market share
 Flexibility – delivery times, product tailoring, demand fluctuations
 Quality – level of service, reliability, number of complaints
 Delivery – on time, waiting times
EXAM SMART
Exam note:
Examiners in the past have written articles which state expectations for students with
regards the performance assessment questions. The principal points to note are as follows:
 A performance assessment question is likely to require a combination of calculation
and discussion.
 Use any background information in the question to support your analysis (e.g. is it a
competitive market? What is the state of the economy? What is inflation?)
 Don’t just explain what is happening. You should also consider hypothesising why the
observations may be happening (for example, if the company is showing a weakening
profit margin this may be because costs are getting out of control or pressure on selling
prices due to competition, poor quality). You only need to offer plausible explanations
and do not have to be right!
 Make sure you prioritise your calculation and discussion. There are likely to be a range
of different calculations that you could produce but you won’t have time to do them all.
The Examiner is looking for a well - structured answer that sets out some key financial
and non-financial indicators, discusses the likely causes and makes sensible suggestions
for changes the company can make.
See Lecture example below for more guidance.
4.6 Short-term and long-term

Short-termism is caused by the natural human condition to be more concerned about today than
tomorrow. Within organisations this manifests itself in the setting of short-term targets such as annual
budgets.
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As a result, short-termism leads to decisions being made that improve the short term profit but
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damage the long-term profit e.g. cutting R&D, training and investment, or manipulating the results to
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move profit from next year into this year.
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To encourage a long-term view an organisation could:
 Set long-term or strategic goals
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 Offer long-term incentives e.g. long term share options
 Have long-term contracts of employment

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Make more use of non-financial measures in performance assessment
4.7 Balanced scorecard

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The balanced scorecard approach to appraising performance was put forward by Kaplan & Norton in
1992 as a way of giving managers a comprehensive view of business performance. The performance is
assessed with both financial and non-financial measures, looking at four perspectives:
 Financial
 Customer
 Internal Business Processes
 Innovation & Learning
The principle is that to achieve long-term financial success you need to meet or exceed customer
expectations. To meet or exceed customer expectations your internal business processes must be very
good and you will need to keep innovating, learning and improving. In this respect the scorecard can
be considered to be a dynamic tool used to deliver on corporate strategy.
According to each of the four perspectives of the balanced scorecard there are a number of KPIs (the
examples below are not an exhaustive list).
FINANCIAL CUSTOMER
What do customers (current &

A classic set of indicators to measure potential) value from us?
whether value is being added to
shareholders.  Delivery performance in terms of
time/quantity/quality
 Cash flow o Complaints
 Profit margins o % on time deliveries
 ROI/ROCE o Returns rate
 EPS o Retention rate
 Profit and revenue growth o Warranty claims %
VISION &
STRATEGY
INTERNAL BUSINESS PROCESSES INNOVATION & LEARNING
What business processes must we excel Will the business be able to create future
at in order to satisfy our customers and value?
shareholders?
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Staff turnover
 
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Quality control reject rate Illness rate
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 
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Turnaround time/Lead time Development time for new products
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 
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Production set up time % revenue from products launched
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in last 2 years
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4.8 Building Block model
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The Building Block model was proposed by Fitzgerald and Moon in 1996. it focussed on performance
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s
measurement in service businesses. Their building blocks cover:
F ir



Dimensions – relevant aspects of the business to set measures for
Standards – what characteristics the system should have
Rewards – benefits of adopting the structured process
The principles here are:
 If staff are involved in the setting of standards/targets then they will take ownership of the
target and there will be clarity in terms of what is needed to achieve the target.
 If the targets set are viewed as tough but achievable then staff will be more motivated to
achieve.
 If targets set are fair (equitable) then they are likely to be based on areas that the staff have
control over and not things that are outside their influence.
Dimensions
Profit
Competitiveness
Flexibility
Innovation
Resource utilisation
Excellence/Quality
Standards Rewards
Ownership Clarity
Achievability Motivation
Equity Controllability
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4.9 Problems with setting qualitative targets
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There are a number of potential difficulties of target setting in qualitative areas:
 Quantifying the target
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 Measures can be subjective
 It may be hard to actually record responses/performance
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By definition a qualitative target might not be as tangible as a quantitative one. For example, if you
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want to measure how happy your staff are, they could fill in questionnaires but what one person views
as happy might not be the same as someone else.
LECTURE EXAMPLE 4.1: PERFORMANCE ASSESSMENT 017

Booty Limited is a business that sells a range of boots and shoes online through its website. They are in the
fifth year of their business and have achieved recognition as one of the more reliable footwear retailers on
the internet. Performance to date has been good given that there are many retailers using the internet for
sales of similar products. General inflation has remained steady at 3% over the two years.
The financial results of the business for the last two years are as follows:
Table 1
2016 2015
$ $ $ $
Sales 2,760,000 2,400,000
Less cost of sales (1,794,000) (1,440,000)
Gross profit 966,000 960,000
Less expenses
Admin 210,000 200,000
Distribution 240,000 220,000
Website maintenance 85,000 100,000
Other costs 255,000 250,000
(790,000) (770,000)
Profit 176,000 190,000
The Directors of Booty Ltd have also collected some non-financial data relevant to the last two years as
follows:
Table 2
Industry
2013 2012 averages
No of complaints 8,448 4,800
Pairs of boots/shoes sold 105,600 96,000
Returns % 14% 10% 11%
% on time deliveries 92% 96% 95%
Required:
(a) Assess the financial performance of the business over the two-year period using data from
Table 1 only.
(b) Comment on the likely future performance of the business incorporating information from
Table 2 in your analysis.
SOLUTION
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5 Divisional performance and transfer pricing

5.1 Transfer pricing
If a business has a divisional structure, there may be times when one division transfers goods or
services to another division. The question is ‘at what price do the divisions agree to transfer at?’ This
issue is referred to as transfer pricing.
The approach taken to setting the transfer price will depend on what type of divisions have been set
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up. With cost centres, the divisions do not have any revenue and hence profit making targets. The
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simplest way to deal with internal transfers then is to just transfer at cost. The cost centre’s
performance can be assessed by setting targets for cost control.
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A Profit/Investment centres is one where the manager has responsibility over the setting of prices and
has control over costs as well (Investment centres will generally have some control over capital
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expenditure). With these types of division profit targets are a common feature. Internal sales will
therefore be treated as income for one division (the ‘selling division’) and a cost for the other division
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(the ‘receiving division’).
5.2 Goals of transfer pricing system

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For a transfer pricing system to be judged as successful it should be capable of ensuring the following:
 Goal congruence – the system should encourage managers of individual divisions to make
decisions that are consistent with optimising group overall profitability and usage of resources
 Autonomy – in order to keep the managers of the divisions motivated they should be able to
negotiate the transfer price between themselves with minimal interference from head office
 Performance evaluation – the transfer pricing system should allow a fair appraisal of the
performance on the divisions and their managers (as per measures noted in the previous
chapter on divisional performance)
Many transfer pricing questions in the exam will require students to appreciate and discuss the above
goals and evaluate any proposed system that is being suggested by the Examiner.
The classic problem in transfer pricing is the conflict between goal congruence and autonomy. If you
allow managers too much autonomy and they are looking to maximise the benefits for their division
they may make decisions that are not in the best interests of the group as a whole. If you take away
their autonomy, then you are likely to have a negative impact on their motivation.
THE GROUP
SELLING DIVISION RECEIVING DIVISION
 Costs in this division (note  Are there additional costs in

FC likely to be not relevant) this division?
 Is there spare capacity here?  What can we sell the finished
 Could we sell to third goods for?
parties?  Can we buy from third Sale of final
parties? product to
third parties
Sell ‘intermediate’ product to third Buy goods from third parties

parties in a market that is: rather than from the selling
division?
 PERFECT (every items sells for  Which is the cheapest?
the same price)
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Approaches to setting a transfer price
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There are a number of possible approaches to the setting of transfer prices.
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To help visualise the thought process a simple diagram is used throughout this summary.
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Capello plc
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TRANSFER
COLE CROUCH
r
BALLS
i
DIVISION DIVISION
F 5.3 Market price approach

Cole could charge Crouch market price for the balls (possibly less a small amount to reflect any cost
savings arising from an internal transfer, for example reduced distribution costs, packaging, admin
etc.).
Cole would make the same return as they would selling to third parties outside the group and Crouch
would pay a fair price based on market conditions. This should ensure goal congruent behaviour, that
is both divisions should want the transfer to happen if it is in the best interests of the group.
5.3.1 Problems with market price approach

There are a couple of situations where this approach either would not be possible or is not going to be
the best approach. These are as follows:
 What if there is no external market for the balls (the intermediate good)? Some sort of cost
based approach is probably necessary.
 What if Cole is at full capacity and makes a number of other highly profitable products that it
sells to third parties as well? We will need to find what Cole’s optimum sales plan is and then
use an opportunity cost based approach to setting the transfer price.
5.4 Cost based approach

The most common approaches to transfer pricing in the real world involve using cost as the starting
point. There are a number of variants on this approach and we now consider the main variables:
 Do we use actual cost or standard cost?
 Do we use full cost (i.e. FC + VC) or marginal cost?
 Do we add a mark-up onto the cost?
5.4.1 Standard costs

Standard costs should be used. If Cole was allowed to sell to Crouch at actual cost, there is no
incentive for Cole to control its costs. Also, by using standard costs Crouch will know in advance how
much the items are going to cost and this helps it to plan.
5.4.2 Full cost

Using full cost as the basis will ensure that Cole (the seller) covers all its costs and so it will want the
transfer to happen.
By including fixed costs there is a danger that a dysfunctional decision is made. Cole may end up
charging more than a third party is charging (especially if Cole is adding on a mark-up (see below)) thus
encouraging Crouch to buy from a third party. The group overall may be worse off if the third party
cost is higher than the marginal (usually variable) cost to the group.
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5.4.3 Marginal cost
Using marginal cost would mean that Crouch would always make the optimum buying decision from
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the group perspective. However, Cole would not earn any contribution towards its fixed costs and
profitability. This would be demotivational for Cole.
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If we want to treat Cole as a profit or investment centre, then we should allow it to make a fair profit
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on internal transfers as well as external sales. This would suggest that adding on a mark-up is
appropriate.
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The downside of this is that Cole may end up charging more than an external supplier would, Crouch
buys from this external supplier and possibly results in a non-goal congruent decision.
5.4.4 Dual pricing

An alternative could be to use a dual pricing system where Cole gets credited with the market price for
the transferred item and Crouch only gets charged with variable cost. This would then require an
adjustment at head office and can be administratively challenging.
Another option would be to consider a two-part tariff whereby Cole charges Crouch a transfer price of
variable cost. However, then each period Cole is given a lump sum fixed fee to help contribute to
covering fixed costs and earn a profit. Essentially here Cole would be really being treated as a cost
centre and this may have motivational impacts for it.
ILLUSTRATION: COST BASED TRANSFER PRICING

Cole has the following standard unit costs for the production of the ‘balls’.
Direct material $3.00
Direct labour $4.50
Variable o/h $1.50
Fixed o/h (based on overheads of $1m and 200,000 budgeted production) $5.00
Full production cost $14.00
Crouch is likely to want to buy 15,000 balls off Cole during the period.
Required:
What would the transfer price be and the decision making by each division under the following
circumstances?
(a) Full cost plus 20% with no external market
(b) Full cost plus 20% with an external market for the intermediate good at a price of $16
(c) Variable cost plus 50% with an external market price of $16
SOLUTION
(a) Transfer price (TP) = $14 × 1.2 = $16.80

Since there is no external market both Cole and Crouch would probably accept the transfer
happening at this price. Crouch would probably want assurance that the standards were
reviewed regularly to ensure the price was reasonable.
(b) TP = $16.80 (as above)
Cole would want the transfer to happen but Crouch would rather buy from the external supplier
and save $0.80 per ball for the division. Therefore, if left to make their own decisions the
transfer would not happen.
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Impact on Capello plc
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The group would pay $16 for something that has an internal variable (marginal) cost of
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production of $9 (material, labour and variable overheads). The group overall would lose out by
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$7 per unit as a result of the dysfunctional decision making.
(c)
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The TP would be set at variable cost + 50% ($13.50). This would, in this instance give a price that
would be acceptable to Crouch (less than the external price of $16) but Cole would be less
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happy since it would not cover its total costs and so would show a loss on the items.
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5.5 Opportunity cost approach
To obtain the best transfer price or range of prices that will ensure goal congruent decisions then a
system based on opportunity costs should be used.
This approach involves considering the position of Cole and Crouch divisions separately and trying to
work out the following:
Cole What is the minimum Cole would accept for the transfer?
Crouch What is the maximum Crouch would be prepared to pay for the transfer?
This will normally result in a potential range of transfer prices that the individual managers are able to
negotiate within, thus maintaining a degree of autonomy.
Capello plc
TRANSFER
COLE BALLS CROUCH
DIVISION DIVISION
Minimum TP acceptable Maximum TP we would pay

MC + Opportunity Cost Lower of
 External purchase price
Depends on whether Cole  Divisional net revenue (selling
has SPARE CAPACITY. price of final product less additional
costs in Crouch)
Spare capacity Full capacity

If Cole has spare Opportunity cost will be
capacity, then the based on what contribution
opportunity cost will be Cole would be earning if it did
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zero and TP will simply not have to make and sell the
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be set at marginal cost. balls to Crouch.
LECTURE EXAMPLE 4.2: OPPORTUNITY COST BASED TRANSFER PRICES

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Cole manufactures two products, footballs and goals. Goals can be sold outside the group for $25 but
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balls can only be transferred to Crouch division before being sold to third parties by Crouch after
further processing. Crouch division is interested in purchasing 10,000 balls from Cole division.
The following data is available for each product:
017 Balls
$/unit
Goals
$/unit
Variable cost 9.00 13.00
Fixed costs 5.00 7.00
Total cost 14.00 20.00
Crouch sells the balls on the outside market for $25 after incurring an additional $5 cost per ball to
upgrade the design and colouring of the ball. An external supplier is also willing to supply balls to
Crouch for $16.
Balls and Goals require the same resources to make (i.e. one ball can be made with the same
resources as one goal). Cole has capacity to produce 25,000 units in total (i.e. balls and goals
combined) in the year.
Required:
Estimate an appropriate transfer price for the balls in each of the following situations.
(a) External customer demand for goals is 15,000.
(b) External customer demand for goals is 20,000.
SOLUTION
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5.6 Return on Investment (ROI)
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ROI has traditionally been the most widely used measure in divisional performance, largely due to its
similarity to ROCE and the fact that it can be calculated by taking figures from the statement of profit
or loss and statement of financial position.
Should use profit before head office allocations, usually

before interest and tax, if you are assessing the
Calculated as, manager’s performance. If looking at the performance of
the division it may be better to include centrally allocated
costs as well.
𝑑𝑖𝑣𝑖𝑠𝑖𝑜𝑛𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡
𝑅𝑂𝐼 =
𝑑𝑖𝑣𝑖𝑠𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
May use capital employed (TALCL) or net assets (total

assets – total liabilities) depending upon what information
The answer is expressed as a %. is given in the question. If told to use “average investment”
in the exam you will need to work it out as follows::Av
investment = (opening inv + closing inv)/2
There are a number of possible definitions for the ROI (see disadvantages later) so in an exam you
must follow any instructions that the Examiner gives you. If no instructions are given, then make it
clear what calculation you are using.
Why not just always use ROI then?
Using ROI will encourage divisional managers to make decisions that are in their best interests but not
necessarily the best interests of the company. This is referred to as dysfunctional or non-goal
congruent behaviour.
For example, a manager of a division that has an existing ROI of 25% will reject a project with an ROI of
20% even if the head office target is only 16%. This is because the project would reduce the divisional
ROI (leading to reduced bonus perhaps).
5.7 Residual Income (RI)

This measure identifies the “net” profit of a division after having deducted a notional charge for
interest based on the amount of investment tied up in the division.
This notional charge is estimated with reference to the company’s overall cost of raising finance
(referred to as ‘cost of capital’ or the ‘Weighted Average Cost of Capital (WACC)’).
$
Divisional profit (same definition as for ROI) X
Notional (imputed) interest = divisional investment × cost of capital (X)
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Residual income X
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It essentially compares the profit actually made with the minimum acceptable profit to the investors.
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For example, if you had invested £100,000 in some shares and to compensate you for the risk taken
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you want a 5% return, the minimum acceptable to you would be £5,000 p.a. If in Year 1 you received a
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£7,000 return, then you have a residual income of £2,000.
If RI is positive, it suggests that the division has generated a profit that is over and above that which
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would be required by the capital providers. Therefore, if RI is positive the division has performed well
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and value should be added to investors.
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LECTURE EXAMPLE 4.3: ROI V RI
Smith and Jones are divisions within a large diversified business, Zara Co. Jones was set up recently
whereas Smith has been in existence for 15 years. The following performance statements are available
for the year:
Smith Jones
$000 $000
Revenue 1,200 850
Variable costs (460) (400)
Contribution 740 450
Controllable fixed costs (incl depreciation on div assets) (200) (100)
Controllable profit 540 350
Apportioned central costs (160) (110)
Divisional net profit 380 240
Divisional net assets (@NBV) 2,375 2,000
The overall cost of financing for the company is 10%. Currently Zara Co sets its divisions a target ROI of
14% but is considering introducing residual income into its performance measures.
Calculate the annual ROI and RI for each division.
SOLUTION
Technically residual income is the better method because it is linked to cost of capital and should
result in fewer dysfunctional decisions being made.
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5.8 Comparison of RI and ROI
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ROI is still preferred in the majority of businesses, because:
 It gives a % answer and people understand % returns such as ROCE.

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Interdivision comparisons are easier to do since ROI is a relative measure not an absolute one
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like RI. This makes it simpler to compare divisions of differing sizes.
 It is not felt that dysfunctional decision making happens often enough to be a real problem.
 RI needs an estimate of cost of capital to be made.
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5.9 Problems with ROI and RI 017
Both techniques can run the risk that managers of divisions make decisions that are going to be best
for their short term reward rather than what might be better for the organisation over a longer period.
Ultimately, both ROI and RI use similar information in their calculations and there are certain
flaws/difficulties with identifying the relevant information.
5.9.1 Which profit figure to use?

 Identifying what is controllable and what is not
 Pre or post tax figures?
 Attributable and non-attributable costs (including central spreading of overheads)
5.9.2 Which investment figure to use?

 Opening, closing or average net assets?
 Use of statement of financial position values based on historic cost and NBV will make
comparing divisions of differing ages hard. A solution to this is to use replacement cost of assets
rather than NBV.
 Inclusion of assets that are not reflected on the statement of financial position such as
intangible assets (for example, in a service or people orientated business)
5.10 Comparing divisional performance

In comparing divisional performance care needs to be taken to ensure you are comparing like with
like. In particular, you need to consider:
 When was the division established (age of assets etc)? It may be necessary to use current
replacement costs for assets in order to fairly compare two divisions’ performance.
 How long has the current divisional manager been in place?
 What are the market conditions for the division’s goods or services?
 How old are the assets used by the division? It is generally noted that both the ROI and RI
measures will appear to improve as assets get older since the investment figure will reduce by
the amount of depreciation each year. This may discourage managers from investing in newer,
more efficient equipment simply because in the short term it reduces the division’s ROI or RI.
ILLUSTRATION: ROI V RI DISCUSSION
Compare the divisional performance of Smith and Jones.
SOLUTION
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The following observations could be made in relation to the ROI and RI:

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Smith has achieved the target ROI but Jones has not. As a result Jones may get penalised for
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falling short of the 14% ROI target even though it has generated a return (12%) that is higher
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than the company’s cost of raising funds of 10%.
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 Since Jones is a newer division, it is likely to have newer assets on its statement of financial
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statement. This would impact the ROI comparison between the two divisions and this should be
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investigated. If comparison between divisions is important to Zara Co then they might consider
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restating the net assets figures to replacement cost or current value rather than using the net
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book value of the assets.
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
s Both divisions are adding value to Zara Co as evidenced by their positive RI figures.
F  Both divisions could be susceptible to dysfunctional decisions by the managers if ROI is used.
For example, if the manager of Smith was offered a new project that had a 15% return he would
reject it because it would lower his divisions ROI. Clearly, a 15% return would be good for the
company as a whole since the cost of funds is only 10%. Use of RI would ensure that this
dysfunctional behaviour did not occur. A new project with a 15% return would show a positive
RI and would therefore increase the division’s overall RI.
6 Performance analysis in not for profit organisations and the public sector
6.1 Problems of non-quantifiable objectives
Some of the problems of objective setting in not for profit organisations and the public sector spring
from the need to keep different stakeholder groups satisfied:
 Objectives can be viewed differently by different stakeholders – provision of services in the
public sector will be viewed differently by the recipients and taxpayers who have to pay for the
services but don’t derive any benefit
 Interpreting actual performance becomes subjective – it will depend on the priorities of
stakeholders
 It may be harder to identify a step by step guide to improving the performance
 Lack of suitable benchmarks
Problems with determining non-quantifiable objectives may feed through into the problems with
determining qualitative targets, which were discussed above.
6.2 Problems of having multiple objectives

 It may not be possible to simultaneously achieve all objectives, that is some sort of prioritising
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may be necessary
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 The importance of individual objectives may change over time. For example, there may be
political pressure on certain objectives around election time
6.3 Measurement of performance

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Performance may be measured in the following ways:
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 Comparing actual performance to non-financial targets
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 Questioning users
 Appointing regulators/experts to monitor performance
Examples of performance measurement at a school might include the following:
 Costs compared with budget
 Number of students taught
 Number of teachers
 Cost per student
 Cost per teacher
 Time spent in classroom by teachers
 Teacher/ student ratios
 Class sizes
 Exam results
 Results of inspection by local or national government
 Learning resources available, for example computers
 Provision of out-of-school activities
Note that measures cover what matters to beneficiaries (the students), and compare student provision
with resources available (mainly, but not just, teachers) and the costs.
6.4 Value for money

The most common way of measuring performance in not for profit organisations and the public sector
is to identify whether they are offering value for money (VFM).
 Economy – cost of resources used (are you spending more on resources than you should?
Improvements here might focus on changing the cost base. )
 Efficiency – outputs vs. inputs (is there more wastage than expected? Improvements here are
likely to focus on internal processes.)
 Effectiveness – achieving targets (even if you are being economical and efficient is what you’re
doing helping the organisation achieve its overall goals? If the organisation feels that it is not
achieving effectiveness, it is likely to look at its overall strategy and the way the strategy is being
implemented, obstacles to implementation.)
6.5 Short-term and long-term objectives

The conflict between short and long-term objectives, discussed above for private sector organisations,
may also apply to public sector and not for profit organisations but in different ways. Short-term
pressures in the public sector may well be due to politicians wanting to achieve electoral success. This
may encourage a focus on ‘headline’ figures that will be popular with voters and can be presented as
achievements.
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With charities, there may be a balance between fulfilling the requirements of the trust deed to ensure
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the interests of beneficiaries are met and longer-term actions to ensure the charity’s activities remain
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sustainable, for example training volunteers.
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All these types of organisations will be expected to have long-term or strategic goals. However other
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measures discussed for the private sector, for example, long-term incentives or contracts of
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employment, may not be considered appropriate for some of these organisations.
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7 External considerations
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7.1 External considerations
Performance of an organisation is not entirely dependent upon what happens internally. It will also be
influenced by market conditions e.g. economic boom or recession, competitors’ actions e.g. mergers
or insolvency and the demands of stakeholders e.g. change to a 24/7 society.
Consequently, if we were to ignore these factors when assessing the performance of an organisation,
we would only be looking at part of the picture and thus may well reach the wrong conclusion (e.g.
10% sales growth is not so great if inflation is running at 20%).
Examiners have expressed in articles that they are very keen for students to display a practical
interpretation of data in light of both external and internal influences.
7.2 Behavioural aspects

When people know that their performance is being monitored their behaviour can change. Such
change can be positive or negative.
7.2.1 Positive change

 Improved efficiency
 Improved motivation
 Achievement of targets
7.2.2 Negative change

 Become stressed and ill
 Unite and oppose targets
 Loss of confidence
Generally speaking, people are more concerned to avoid failure rather than achieve success, so
employees will do what they can to ensure their performance achieves the minimum level, including
setting easy targets and manipulating their actual results.
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127
Solutions to Class lecture

examples
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1 – Specialist cost and management accounting
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Lecture Example 1.1 – ABC and absorption
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ABC
Step 1: Cost pools - Given in this question.
Step 2: Cost drivers for each cost pool.
$000 Cost driver
Machining costs 600 Machine hours
Set up costs 1,400 No of production runs
Quality inspections 500 No of inspections
Stores issues 300 No of issues from stores
2,800
Step 3: OAR for each cost driver.

(1) Machining costs
Total machine hours = (50,000 × 2hrs) + (100,000 × 1hr) = 200,000 hrs
OAR = $600,000 ÷ 200,000 hrs = $3 per hour
(2) Set up costs
Production runs for SW = 50,000 units ÷ 500 units per run = 100 runs
Production runs for AIR = 100,000 ÷ 2,500 = 40 runs
OAR = $1,400,000 ÷ 140 production runs = $10,000 per prodn run
128 Solutions to Class lecture examples AC C A F5
(3) Quality inspections

Total inspections (SW) = 100 prodn runs × 5 inspections per run = 500
Total inspections (AIR) = 40 × 25 = 1,000
OAR = $500,000 ÷ 1,500 inspections = $333.33 per inspection
(4) Stores issues
There are a total of 300 issues from the stores
OAR = $300,000 ÷ 300 = $1,000 per issue
Step 4: Absorb overheads into the products.
(1) Machining costs
o/h per unit = no of machine hours per unit x cost per machine hour
SW - cost per unit = 2 hrs × $3 per hr = $6
AIR - cost per unit = 1 hr × $3 per hr = $3
(2) Set up costs
o/h per unit = no of production runs per unit × cost per production run
SW - (100÷50,000) × $10,000 = $20
AIR - (40÷100,000) × $10,000 = $4
(3) Quality inspections
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SW - (500÷50,000) × $333.33 = $3.33
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AIR - (1,000÷100,000) × $333.33 = $3.33
(4)
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Stores issues
o/h per unit = issues per unit × cost per issue
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SW - (200÷50,000) × $1,000= $4
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AIR - (100÷100,000) × $1,000= $1
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This information can then be summarised in a cost card statement for each product, as follows:
Summary using ABC
SW AIR
$/unit $/unit
Material 40 64
Labour 30 20
Overheads:
Machining 6 3
Set up 20 4
Quality inspections 3.33 3.33
Stores issues 4 1
Total cost 103.33 95.33
AC C A F 5 So l u t i o n s t o C l a s s l e c t u r e e x a m p l e s 129
Traditional absorption
Step 1: OAR based on labour hours.
First, an Overhead Absorption Rate (OAR) needs to be calculated.
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠 $2,800,000
𝑂𝐴𝑅 = 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑙𝑎𝑏𝑜𝑢𝑟 ℎ𝑜𝑢𝑟𝑠
= (50,000×3ℎ𝑟𝑠)+(100,000×2ℎ𝑟𝑠)
= $𝟖 𝒑𝒆𝒓 𝒉𝒓
Step 2: Absorb the overheads into the product costs.

Now the summary cost cards can be produced as above.
SW AIR
$/unit $/unit
Material 40 64
Labour 30 20
Overheads (@ $8 per hr) 24 16
Total cost 94 100
With the ABC allocation the SW product gets allocated a much larger portion of the overhead costs
($33.33 compared to $24). This principally arises due to this product being very resource intensive
when it comes to the production set ups. SW is produced in much smaller production runs (i.e. 500
units at a time rather than 2,500 for the AIR product).
This leads to the fixed production set up costs being spread over fewer items and thus the cost per
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unit is much higher for SW ($20 rather than $4 for AIR).
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Lecture Example 1.2 – Deriving a life cycle cost
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$000
Market research 1,500
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Product design 3,200
Marketing (2,000 + 2,500 + 500) 5,000
Production cost ({10,000 × 140} + {30,000 × 120} + {5,000 × 150})
n2 5,750
017
Machinery disposal 200
Life cycle costs 15,650
Production units (000 units) 45
Cost per unit 347.78
Lecture Example 1.3 – Throughput in a multi-product situation

Step 1: First, we need to identify the bottleneck resource.
To do this we identify the maximum amount of each product that can be produced in each
department:
Maximum Maximum
ZC YR
Dept A 600÷10 = 60 600÷20 = 30
Dept B 930÷15 = 62 930÷20 = 46.5
Department A is therefore the bottleneck resource as fewer of each product are able to pass through
this department.
Step 2: The next step is to decide which product to produce first by calculating the throughput
contribution per minute of Dept A time.
ZC YR
Sales price 60.00 100.00
Less: material costs (12.00) (19.00)
Throughput contribution 48.00 81.00
Dept A time per unit (mins) 10 20
Throughput contribution per minute $4.80 $4.05
st nd
Ranking 1 2
Step 3: Identify the optimum production plan and resulting annual profit.
Throughput contribution will therefore be maximised by producing ZC’s first (up to the maximum of
50 per day) and then produce YR’s with any remaining time.
Product Time (mins) Contribution per min Total
ZC (50 × 10 min) 500 4.80 2,400
YR (5 × 20 min) 100 (bal fig) 4.05 405
600 Contribution per day 2,805
Contribution per yr (2,805 × 250) 701,250
Less fixed costs (lab + o/h) 309,750
Profit 391,500
TPAR for product YR
h t 7
r i g 01
Return per bottleneck min = $4.05 per minute (as calculated above)
2
y
Cost per bottleneck min = $309,750/(2,500×60min) = $2.065 per min
o p ion
TA ratio = 4.05/2.065 = 1.96
Cmaking techniques
u i t
2 – Decision
I n t
r s t
i
Lecture Example 2.1 – Relevant cost of materials
F (a) The relevant cost is $2.00 × 1,000kg = $2,000 purchase price, since any material used will have
to be replaced.
(b) The relevant cost is ($0.80 × 500kg) + ($2 × 500kg) = $1,400, which, for 500kg in inventory is the
benefit forgone from the next best alternative use of the material and the current purchase
price for the other 500kg.
(c) The relevant cost is ($4 × 1,000kg) = $4,000 which represents the contribution foregone by
diverting the material to this particular job (each kg could have helped earn $4 elsewhere).
Lecture Example 2.2 – Relevant cost of labour

(a) The relevant cost is nil as there is no incremental cost.
(b) The relevant cost is $4.50 x 100 hours = $450 since the additional temporary staff will have to
be paid.
(c) If we compare the current cash flows with those if this job is undertaken, we can identify the
incremental cash flow:
Current cash flows from existing New cash flows in relation
product $/unit to new job $/unit
Selling price 60
Direct material (10)
Direct labour – 1 hour (12) Direct labour – 1 hour (12)
Contribution 38 (12)
So the change in the future cash flow is that we no longer receive the selling price or incur the
direct material cost i.e. a net cash flow $50.
Alternatively, another way of arriving at the same figure is to add together the labour cost and
the lost contribution i.e. $12 + $38 = $50.
Thus the relevant cost is $50 × 100 hours = $5,000.
Lecture Example 2.3 – Relevant cost of overheads

For fixed overheads the relevant cost is nil since there are no additional fixed overheads incurred (not
incremental).
The relevant cost of the variable overheads will be 5,000 hours at $12 per hour = $60,000.
Fir Co
Lecture Example 2.4 – Relevant costs of non-current assets
st I pyri
The original purchase price of $20,000 is not relevant as this is a sunk cost. Ignoring the new
opportunity, Equipment plc would keep the machine as it will earn more money ($15,000) than its
ntu ght
scrap value ($12,000).
itio
If the machine is used on the new opportunity, the final question to ask is, will Equipment plc replace
it. The answer is yes as the replacement cost ($14,000) is less than the money it will earn ($15,000).
So the relevant cost is $14,000.
n2
Lecture Example 2.5 – Opportunity cost
017
In choosing the best option (i.e. the $28,000 job) Alternative are foregoing the ability to undertake the
next best alternative ($25,000). The relevant cost of choosing the best job is therefore the $25,000
foregone by not being able to take the next best job.
Lecture Example 2.6 – Breakeven and margin of safety

(a) Break-even point = $26,500 = 50,000 cans
($0.75 – $0.22)
Zero Ltd budgets to sell 125,000 cans.
(b) MOS = 125,000 cans – 50,000 cans = 75,000 cans
Or 75,000 cans/125,000 cans × 100 = 60%
Lecture Example 2.7 – Target profit and C/S ratio

Target profit point = $26,500 + $39,750 = 125,000 cans
$0.53
Target revenue = 125,000 cans × $0.75 = $93,750.
Or, alternatively target revenue could be worked out directly as follows:
Contribution to sales ratio = $0.53/$0.75 = 0.707
Target revenue = $26,500 + $39,750 = $93,750
0.707
Lecture Example 2.8 – Multi-product breakeven units and revenue

Step 1: Calculate the contribution per standard sales mix
The contribution per unit for X, Y and Z can be calculated as:
X $4
Y $5
Z $6
Thus, contribution per standard mix = ($4 × 3) + ($5 × 2) + ($6 × 1) = $28
t
Step 2: Calculate the breakeven number of ‘mixes’.
Breakeven =
i g h 1 7
FC ÷ contribution per mix
r 0
= 100,000 ÷ 28
y
p ion 2
= 3,572 mixes (rounded up)
o
Step 3: Calculate the breakeven sales units for individual products.
X
C uit 3,572 × 3 = 10,716 units
Y
I n t 3,572 × 2 = 7,144 units
t
Z 3,572 × 1 = 3,572 units
ir s
Step 4: Calculate the breakeven revenue.
F Either use the above sales units

Breakeven revenue = (10,716 × $10) + (7,144 × $15) + (3,572 × $20)
= $285,760
Or use the c/s ratio
Breakeven revenue = Fixed costs ÷ average c/s ratio per std mix
Average c/s ratio per std mix
Revenue per std mix = ($10 × 3) + ($15 × 2) + ($20 × 1) = $80
Contribution per std mix = $28 (see step 1 above)
Therefore, average c/s ratio = 28÷80 = 0.35 or 35%
Breakeven revenue = $100,000 ÷ 0.35 = $285,714 (rounding difference to above)
If you then wanted to work out the revenue that would need to be generated by each individual
product you have to apportion the total revenue of $285,714 based on the standard revenue mix for X,
Y and Z ($30:$30:$20).
This would give breakeven revenue by product as:

X $285,714 × 30/80=$107,143
Y $285,714 × 30/80=$107,143
Z $285,714 × 20/80=$ 71,429
Lecture Example 2.9 – Multi product profit/volume chart

If we assumed that the budgeted sales of X, Y and Z were 15,000, 10,000 and 5,000 respectively,
then the following analysis can be completed:
Contribution Sales C/S ratio Cumulative sales Cumulative profit
$ $ $
X 60,000 150,000 0.4 150,000 (40,000)
Y 50,000 150,000 0.33 300,000 10,000
Z 30,000 100,000 0.3 400,000 40,000
Profit/Loss
Fir Co
40,00
st I pyri
ntu ght
0 Z
itio
10,00
0
n2
0 Y Sales
Revenue
017
285,714
(40,000)
(100,000)
Lecture Example 2.10 – Single limiting factor

(1) What is the limiting factor for Short Ltd?
Maximum metal requirement = (40 kg × 26 panels) + (80kg × 10 panels) = 1,840kg.
Maximum metal available = 2,000 kg.
Therefore metal is not a limiting factor.
Maximum labour requirement = (5 hours × 26 panels) + (7 hours × 10 panels) = 200 hours.
Maximum labour available = 140 hours.
Therefore labour is a limiting factor.
(2) Contribution per labour hour and ranking of products
The optimal production plan is the one that maximises the contribution given the availability of the
labour. We then produce as much of the product with the highest contribution per unit of limiting
factor as we can and then move onto the second etc, until we run out of the limiting factor.
Large Small
$ $
Revenue per panel 171 102
Materials per panel (80) (40)
Labour per panel (70) (50)
Contribution per panel 21 12
Labour hours required 7 hours 5 hours
t
Contribution per labour hour $3.00 $2.40
h 7
RANKING 1st 2nd
r i g 01
Thus Large sections are the most profitable product for Short Ltd to produce.
2
(3)
y
p ion
Optimum production plan
o
C uitLabour available
Hours
140
t
Large sections use (7 hours × 10 sections) (70)
I n
Labour available for Short sections 70
r s t This will allow 70/5 = 14 Small sections to be made.
F i Thus the optimal production plan is to produce 14 Small panels and 10 Large panels. This will
generate a total contribution of ($12 × 14 sections) + ($21 × 10 sections) = $378 per week.
Lecture Example 2.11 – Formulating a multiple scarce resource problem

(1) Let x = weekly production of Large sections
y = weekly production of Small sections
(2) Metal 80x + 40y ≤ 1,200
Labour 7x + 5y ≤ 140
Demand x ≤ 10
y ≤ 26
Non-negativity x,y ≥ 0
(3) Maximise contribution (first need to work out contribution per unit)
Large Small
$ $
Revenue per panel 171 102
Materials per panel (80) (40)
Labour per panel (70) (50)
Contribution per panel 21 12
TOTAL CONTRIBUTION = 21x + 12y
Illustration – Graphical solution
Small Demand
30
Metal
28
A B Demand
26
23 C
21
Feasible region OABCDE
Optimal solution is at C
Fir
D
Co
st I pyri
ntu ght
Objective function
itio Labour
n2
3
E
10 12 15
017 20
Large
From inspection of the graph the optimum contribution appears to be found where the number of
small fence panels made is 23 and large ones 3, per week.
Lecture Example 2.12 – Simultaneous equations

From the graph we already know that the optimal solution is at C, the intersection of the Metal and
Labour constraints:
Metal 80x + 40y = 1,200
Labour 7x + 5y = 140
We will multiply the Labour constraint by 8 so that both constraints have the same number of y’s:
Labour 56x + 40y = 1,120
We will then deduct the labour constraint from the metal constraint:
Metal 80x + 40y = 1,200
Labour 56x + 40y = 1,120
24x = 80
x = 3⅓
We can substitute our answer into either of the original constraints to find the value of y:
Labour (7 × 3⅓) + 5y = 140
23⅓ + 5y = 140
5y = 140 - 23⅓ = 116⅔
y = 23⅓
Thus the maximum contribution = (21 × 3⅓) + (12 × 23⅓) = $350 per week.
Lecture Example 2.13 – Shadow price

Add 1 to the Labour constraints:
Metal 80x + 40y = 1,200
Labour 7x + 5y = 140 + 1
We will multiply the Labour constraint by 8 so that both constraints have the same number of y’s:
Labour 56x + 40y = 1,128
We will then deduct the labour constraint from the metal constraint:
Metal 80x + 40y = 1,200
Labour 56x + 40y = 1,128
24x = 72
x=3
ht 7
We can substitute our answer into either of the original constraints to find the value of y:
r
Labour
i g 01
(7 × 3) + 5y = 141
2
y
p ion
21 + 5y = 141
o
5y = 141 - 21 = 120
C uit
y = 24
t
Thus the maximum contribution = (21 × 3) + (12 × 24) = $351 per week. This is an increase or shadow
I n
price of $1, so Short Co could afford to pay up to $1 per labour hour i.e. $10 + $1 = $11 per hour.
r s t
i
Lecture Example 2.14 – Straight line demand equation
F change in P −$1
b = change in Q = 200 units = −0.005
Therefore as P = a - bQ, we now know that P = a – 0.005Q and we also know that when P = $12, Q =
1,000 batteries.
so, 12 = a − (0.005 × 1,000)
∴ 12 = a − 5
∴ 𝐚 = 𝟏𝟕
Thus: P = 17 – 0.005Q
Lecture Example 2.15 – Cost equations (no discounts)

b = variable cost = $3 + $2 + $1.50 = $6.50
a = fixed costs = $2.50 × 1,000 = $2,500
Thus; TC = 2,500 + 6.50Q
Lecture Example 2.16 – Cost equations (with discounts)

There is no volume-based discount available until we reach a quantity of 1,200 batteries, so the
equation between 0 and 1,199 batteries is unchanged: TC = 2,500 + 6.50Q.
Once the volume is 1,200 batteries or above, the variable cost falls by $1 to $5.50, so the equation for
the total cost function becomes:
TC = 2,900 + 5.50Q
Lecture Example 2.17 – Profit maximising price/output levels

If P = 17 – 0.005Q then
MR = a – 2bQ = 17 – 2(0.005Q) = 17 – 0.01Q
Assuming no discounts, the marginal cost is $6.50 per unit.
Therefore,
MR = MC
17 – 0.01Q = 6.50
10.5 = 0.01Q
Q = 10.5/0.01 = 1,050
The price to charge to sell 1,050 units and hence maximise profits is:
P = 17 – 0.005(1,050) = $11.75
Fir Co
st I pyri
To maximise profits Charge Co should set a price of $11.75.
ntu ght
Revenue achieved = $11.75 × 1,050 = 12,337.50
Costs = 2,500 + 6.5 (1,050) = (9,325)
itio
Profit therefore = 12,337.50 – 9,325 = $3,012.50
Lecture Example 2.18 –Incremental costs / revenues

n2
017
Current revenue = $12 × 1,000 = $12,000
In order to sell 1,200 batteries, the price will need to fall to:
P = 17 – 0.005Q
P = 17 – (0.005 × 1,200)
P = 17 – 6
P = $11
Thus the new revenue = $11 × 1,200 = $13,200
So the revenue will increase by $13,200 – $12,000 = $1,200.
Current total cost = $2,500 + 6.5(1,000) = $9,000
New total cost = $2,900 + 5.5(1,200) = $9,500
So the total costs will increase by $9,500 - $9,000 = $500
Thus if Charge Co drops its price by $1 and produces and sells 1,200 batteries, its profits will rise by
$1,200 – $500 = $700.
Lecture Example 2.19 – Shutdown decisions

$
Contribution lost from shutting A (30,000 – 21,000) (9,000)
Fixed costs saved 11,000
Contribution lost from dept B (10% of {50,000 – 35,000}) (1,500)
Net financial benefit from closing dept A 500
Lecture Example 2.20 – Further processing decisions

Joints: Leg Joints/Ham Belly Pork/Pies Off-cuts/Mince
Revenue after further processing 3,150 992 1,210
Revenue before further processing 2,500 800 1,050
Revenue increase 650 192 160
Further processing costs 540 224 165
Added value if processed further $110 ($32) ($5)
Thus Leg Joints should be processed further and sold as Ham, but Belly Pork and Off-cuts should be
sold as they are.
Lecture Example 2.21 – Expected values

Europe
Probability (p) Forecast sales (x) (px)
ht
High 0.25 $600,000 $150,000
Medium
Low
r i g 01 7 0.60
0.15
$500,000
$400,000
$300,000
$60,000
y
p ion 2
Expected Value = $510,000
o
America
C uit
Probability Forecast sales (px)
t
High 0.55 $650,000 $357,500
I n
Low 0.45 $350,000 $157,500
t
Expected Value = $515,000
ir s
Based on the expected values, First Co should launch its new product in America.
F Lecture Example 2.22 – Sensitivity analysis

If the sales price falls and the revenue falls by more than $29,500, then the Drench will make a loss:
$29,500 × 100 = 9%
$332,500
This suggests that if the sales price were to reduce by 9% or more then the product launch will not
appear profitable.
If the money spent on materials goes up by more than $29,500, then the Drench will make a loss.
As materials cost $10 kg, this represents an increase of 2,950 kgs:
2,950 kgs × 100 = 31%
9,500 kgs
If the material quantity increases by more than 31% then the product launch would not be financially
viable.
Thus, the Drench is most sensitive to the sales price. Misty Co may thus decide to undertake some
market research on the selling price before making a final decision to go ahead.
Sensitivity analysis can be used in many situations where you want to establish by how much the
variables in a decision would need to be changed before the overall decision was affected.
Lecture Example 2.23 – Maximax, maximin and minimax regret

For maximax we first identify the best possible outcome for each project:
Best outcome $140,000 $95,000 $78,000
We then select the largest of these figures i.e. $140,000.
So, using maximax Quandary Co should select project Alpha.
For maximin, we first identify the worst possible outcome for each project:
Best outcome ($10,000) $82,000 $30,000
We then select the largest of these figures i.e. $82,000.
So, using maximin Quandary Co should select project Beta.
For minimax regret, we first construct a table of regrets i.e. the amount lost by making that decision:
Economic state: Alpha Beta Gamma
Good nil $45,000 $110,000
Average nil $1,000 $40,000
Poor $92,000 nil $4,000
Fir Cop
We then identify the largest regret figure for each project:
st I yri
Largest regret $92,000 $45,000 $110,000
ntu ght
We then select the smallest of these figures i.e. $45,000.
So, using minimax regret Quandary Co should select project Beta.
itio
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017
Lecture Example 2.24 – Decision tree
800
800
0.5 0.85
0.5 300 300

F 0.15
B launch
(500)
launch
abandon
(500) D NIL
A research 0.7
C
(100)
abandon
t
E NIL
h 7
0.3
r i g 201
y
do nothing
launch
o p ion (500)
C uit NIL G 600
n t
0.2
s t I
ir
0.8
F Evaluation of decision tree

(1) Get research
200
EV (point F) = (0.85×800) + (0.15×300) = 725

Therefore, at decision point D the choice is either to:
Launch and get 725 – 500 = 225
Abandon and get NIL
Decide to launch and get 225
EV (point G) = (0.2×600) + (0.8×200) = 280
Therefore, at decision point E the choice is either to: The decision would be to get
the market research given that
Launch and get 280 – 500 = (220) this gives the highest EV at point
Abandon and get NIL A of $57.5k.
Decide to abandon and get NIL
If the research was to cost more
EV (point C) = (0.7×225) + (0.3×NIL) = 157.5 than $107.5k this would bring the
EV down to below $50k and this
Therefore, EV of research at point A = 157.5 – 100 = $57.5k would mean launching with no
research would be better.
(2) Launch with no research

EV (point B) = (0.5×800) + (0.5×300) = 550
Therefore, EV of launch at point A = 550 – 500 = $50k
(3) Do nothing
EV at point A of doing nothing = NIL
3 – Budgeting and control

Lecture Example 3.1 – Rolling budget
Quarter 1
Quarter 2 Quarter 3 Quarter 4 Next year Total
$ $ $ $ $
Units 11,000 12,000 13,000 14,000
Material cost per unit ($) 4.70 4.70 4.70 4.70
Material 51,700 56,400 61,100 65,800 235,000
Lecture Example 3.2 – Activity based budget

BUDGET Dept X Dept Y
$ $
Co
Ordering $20 × 4,600/3,100 92,000 62,000
Fir
Machine hrs $4 × 55,000/38,000 220,000 152,000
st I pyri
Set up costs $500 × 60/18 30,000 9,000
TOTAL 342,000 223,000
W1
ntu ght
itio
Production runs (Dept X) = 24,000/400 = 60 production runs
Production runs (Dept Y) = 7,200/400 = 18 production runs
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017
Lecture Example 3.3 – High/low
Output (units) Total cost ($)
High 50 7,310
Low 26 6,566
Difference 24 744
Variable cost per unit = $744 ÷ 24 = $31

Using the high output level fixed costs can now be estimated as follows:
TC = FC + VC
Therefore, FC = TC – VC = 7,310 – ($31 × 50) = $5,760
A cost equation could then be written as;
TOTAL COST = $5,760 + ($31 × no of units)
Lecture Example 3.4 – Rate of learning

First, we calculate the cumulative average time per unit for exact doublings in the cumulative number
of units produced:
Cumulative average
Cumulative number of units produced Total time taken in hours time per unit
1 100 100
2 160 80
4 256 64
8 410 51.25
Then we identify the rate of reduction in the cumulative average time per unit (80/100 or 64/80 or
51.25/64), which is 0.8.
So the learning effect is 80%.
Lecture Example 3.5 – Learning curve application

The cumulative average time per unit for 256 units could have been calculated using the formula:
y = 100 × 256 (log 0.75 / log 2) = 10.011292
Month 1
So the budget for the first month should be 10.011292 × 256 = 2,563 hours (2,562.89)
Month 2
ht 7
r i g 01
To work out the budgeted labour time in month 2 we first need to calculate how long it takes to make
2
y
the 257th unit.
o p ion
𝐓𝐢𝐦𝐞 𝐭𝐚𝐤𝐞𝐧 𝐭𝐨 𝐦𝐚𝐤𝐞 𝟐𝟓𝟕 𝐮𝐧𝐢𝐭𝐬 = 𝐭𝐨𝐭𝐚𝐥 𝐭𝐢𝐦𝐞 𝐭𝐨 𝐦𝐚𝐤𝐞 𝟐𝟓𝟕 − 𝐭𝐨𝐭𝐚𝐥 𝐭𝐢𝐦𝐞 𝐭𝐨 𝐦𝐚𝐤𝐞 𝟐𝟓𝟔
C uit
Where, 𝐓𝐨𝐭𝐚𝐥 𝐭𝐢𝐦𝐞 𝐭𝐨 𝐦𝐚𝐤𝐞 𝟐𝟓𝟕 = 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 𝐭𝐨 𝐦𝐚𝐤𝐞 𝟐𝟓𝟕(𝐮𝐬𝐞 𝐟𝐨𝐫𝐦𝐮𝐥𝐚) × 𝟐𝟓𝟕
I n t
The cumulative average time per unit for 257 units is:
r s t y = 100 × 257 (log 0.75 / log 2) = 9.9951056
F iSo the total time taken to make 257 units = 9.9951056 × 257 = 2,568.74
So the time taken to make the 257 unit = 2,568.74 – 2,562.89 = 5.85 hours
Thus the total budgeted time for the second month = 5.85 hours × 256 units = 1,498 hours.
Lecture Example 3.6 – Flexed budget detailed example

We need to prepare a flexible budget for 7,140 units.
Original Flexed
Budget Budget Actual Variances
6,400 7,140 7,140
units units units
$ $ $ $
Sales 576,000 642,600 606,900 35,700 (A)
Variable costs
Direct labour 49,920 55,692 56,177 485 (A)
Direct material 224,000 249,655 205,000 44,655 (F)
Variable overhead 38,400 42,840 48,500 5,660 (A)
Contribution 263,680 294,413 297,223
Manager salary 2,050 2,050 2,050 0
Fixed overhead 31,000 31,000 31,000 0
Profit/(loss) 230,630 261,363 264,173 2,810 (F)
Workings
1 Sales
Flexed budget sales 7,140 units @ $90 = $642,600
2 Labour
Fir Co
st I pyri
VC per unit = (51,970 – 2,050) ÷ $7.80
ntu ght
Flexed budget = 7,140 units @ $7.80 = $55,692
3 Material
itio
Flexed budget = (7,000 × £35) + (140 x $35 × 95%) = $249,655
4 Overhead
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017
Output Overhead
(units) costs ($)
6,500 70,000
7,250 74,500
750 4,500
Variable cost per unit = $4,500 ÷ 750 units = $6 per unit
Given that, total cost = fixed cost + variable cost
70,000 = FC + ($6 × 6,500)
FC = 70,000 – 39,000 = $31,000
Flexed budget variable cost = 7,140 × $6 = $42,840
Supplementary section: Basic variances solutions

Lecture Example 3.7 – Revision of basic variances
Sales variances
Sales price Sales volume
For 18,000 rackets $ Rackets
Actual revenue 1,245,000 Actual sales 18,000
Expected revenue (18,000 × $70) 1,260,000 Budget sales 15,000
VARIANCE 15,000 (A) Variance in rackets 3,000 (F)
Valued at STANDARD PROFIT $13
Materials variances
Total materials
18,000 rackets $
Should cost (18,000 × $9) 162,000
Did cost 165,000
VARIANCE 3,000 (A)
ht 7
r i g 201
y
p ion
o
Materials price Materials usage
C uit
5,600 kg purchased $ 18,000 rackets kg
n t
Should cost (5,600 x $30) 168,000 Should use (18,000 × 0.3kg) 5,400
I
r s t
VARIANCE 3,000 (F) VARIANCE in kg 200 (A)
i
Valued at the standard cost per kg $30
F
Fixed overhead variances

Total fixed overhead
18,000 rackets $
Should cost (18,000 × 288,000
$16)
Did cost 260,000
VARIANCE 28,000 (F)
Fixed overhead expenditure Fixed overhead volume

$ Rackets
Budgeted cost (15,000 × $16) 240,000 Actual production 18,000
Actual cost 260,000 Budget production 15,000
VARIANCE 20,000 (A) Variance in rackets 3,000 (F)
Valued at standard cost $16
Fir Cop
Fixed overhead capacity Fixed overhead efficiency
st I yri
hrs 18,000 rackets hrs
ntu ght
Did take 33,000 Should use (18,000 × 2
hrs) 36,000
itio
Budgeted to take (15,000 × 2 hrs) 30,000 Did use 33,000
VARIANCE in hrs 3,000 (F) VARIANCE in hrs 3,000 (F)
n2
Valued at the standard cost per Valued at the standard
hr $8 cost per hr $8
017
VARIANCE in $ 24,000 (F) VARIANCE in $ 24,000 (F)
Lecture Example 3.8 – Idle time and waste variances

Material price Material usage
5,100 kg purchased $ 16,000 rackets kg
Should cost (5,100 × $30) 153,000 Should use (16,000 × 0.3kg) 4,800
VARIANCE 8,000 (F) VARIANCE in kg 200 (A)
Valued at the standard cost per
kg $30
Material wastage Labour rate (of pay)
kg 30,000 hrs $
Used 5,000 Should cost (30,000 × $12) 360,000
Purchased 5,100 Did cost 375,000
VARIANCE in kg 100 (A) VARIANCE 15,000 (A)
Valued at the standard cost
per kg $30
Labour efficiency Labour idle time

16,000 rackets hrs hrs
Should use (16,000 × 2 hrs) 32,000 Worked 29,000
Did use 29,000 Paid 30,000
VARIANCE in hrs 3,000 (F) VARIANCE in hrs 1,000 (A)
Valued at the standard cost Valued at the standard cost
per hr $12 per hr $12
VARIANCE in $ 36,000 (F) VARIANCE in $ 12,000 (A)
If idle time has been budgeted for, then we can calculate whether the actual idle time is greater or less
than the standard.
Lecture Example 3.9 – Mix and yield variances

Materials usage – Raisins Materials usage – Chocolate
1,000 batches kg 1,000 batches kg
Should use (1,000 × 5kg) 5,000 Should use (1,000 × 1kg) 1,000
Did use 4,900 Did use 1,400
VARIANCE in kg 100 (F) VARIANCE in kg 400 (A)
Valued at the standard cost Valued at the standard cost
per kg $8 per kg $12
VARIANCE in $ 800 (F) VARIANCE in $ 4,800 (A)
t
Materials mix
g h 1 7
Raisins Chocolate Total
r i 0
kg kg Kg
y 2
Standard mix 5,250 1,050 6,300
o p ion
Actual mix 4,900 1,400 6,300
C uit
VARIANCE in kg 350 (F) 350(A)
Valued at the standard cost per kg $8 $12
t
VARIANCE in $ 2,800 (F) 4,200 (A) 1,400 (A)
t I n
Materials yield
ir s Batches
F
Actual yield 1,000
Standard yield 6,300kg/6kg 1,050
VARIANCE in batches 50 (A)
Valued at the standard cost per batch $52
Note: The total usage variances = 800 (F) + 4,800 (A) = 4,000 (A)
The mix and yield variances = 1,400 (A) + 2,600 (A) = 4,000 (A)
Lecture Example 3.10 – Sales mix and quantity variances

Sales volume
CC HH JJ Total
Actual sales 900 1,300 700 2,900
Budget sales 1,000 1,500 500 3,000
VARIANCE in units 100 (A) 200 (A) 200 (F)
Valued at the standard contribution 4 3 5
VARIANCE in $ 400 (A) 600 (A) 1,000 (F) NIL
Sales mix
CC HH JJ Total
Actual sales @ std mix 966 ⅔ 1,450 483 ⅓ 2,900
Actual sales @ actual mix 900 1,300 700 2,900
VARIANCE in units 66 ⅔ (A) 150 (A) 216 ⅔ (F) NIL
VARIANCE in $ 266⅔ (A) 450 (A) 1,083⅓ (F) 366⅔ (F)
Sales quantity
CC HH JJ Total
Actual qty @ std mix 966⅔ 1,450 483⅓ 2,900
Budget qty @ std mix 1,000 1,500 500 3,000
VARIANCE in units 33⅓ (A) 50 (A) 16⅔ (A) 100 (A)
Co
Fir
VARIANCE in $ 133⅓ (A) 150 (A) 83⅓ (A) 366⅔ (A)
st I pyri
Lecture Example 3.11 – Sales planning and operational variances
Planning variances
ntu ght
Planning sales price
itio Planning sales volume or market size
n2
For 9,000 telescopes $ Telescopes
@ Revised budget rev/unit ($199) 1,791,000 Revised budget sales 9,000
@ Original budget rev/unit ($199)
VARIANCE
1,791,000
Nil
017
Original budget sales
Variance in telescopes
Valued at STANDARD
10,000
1,000 (A)
CONTRIBUTION $69
VARIANCE IN $ 69,000 (A)
Operational variances
Operating sales price Operating sales volume or market share
For 9,900 telescopes $ Telescopes
Actual revenue 1,890,900 Actual sales 9,900
Revised budget revenue (9,900 Revised sales 9,000
× $199) 1,970,100
VARIANCE 79,200 (A) Variance in telescopes 900 (F)
Valued at STANDARD
CONTRIBUTION $77
Lecture Example 3.12 – Materials & labour planning and operational

variances
(a)
Material price Labour rate
20,790kg purchased $ For 39,600 hours $
@ original std cost (20,790 × @ original std cost (39,600
$35) 727,650 × $15) 594,000
did cost (actual cost) 652,000 did cost (9,000 × $56) 575,000
VARIANCE 75,650 (F) VARIANCE 19,000 (F)
Material usage Labour efficiency
9,900 telescopes produced kg 9,900 telescopes produced hrs
should use (9,900 × 2kg) 19,800 should use (9,900 × 4hrs) 39,600
did use 20,790 did use 39,600
VARIANCE in kg 990 (A) VARIANCE in hrs NIL
Valued at the standard cost per Valued at the standard
kg $35 cost per hr $15
VARIANCE in $ 34,650 (A) VARIANCE in $ NIL
Total materials variance = 75,650 – 34,650 = $41,000 (F)
Total labour variance = 19,000 (F)
t
(b)
g h 1
Material variances
i 7
y r 20
Material price planning Material price operational
o p ion
20,790kg actual purchased $ 20,790kg purchased $
C uit
@ original std cost (20,790 × @ revised std cost
$35) 727,650 (20,790 × $30) 623,700
t
@ revised std cost (20,790 × did cost (actual cost) 652,000
t I n
$30) 623,700
s
VARIANCE 103,950 (F) VARIANCE 28,300 (A)
F ir Material usage planning Material usage operational

9,900 telescopes produced kg 9,900 telescopes kg
produced
@ original usage (9,900 × 2kg) 19,800 @ revised usage (9,900 ×
2.2kg) 21,780
@ revised usage (9,900 × 2.2kg) 21,780 Did use 20,790
VARIANCE in kg 1,980 (A) VARIANCE in kg 990 (F)
Valued at the original std cost Valued at the original $35
per kg $35 standard cost per kg
$35
VARIANCE in $ 69,300 (A) VARIANCE in $ 34,650 (F)
Labour variances
Labour rate planning Labour rate operational
39,600 actual hours paid $ 39,600 hrs $
@ original std cost (39,600 @ revised std cost (39,600
× $15) 594,000 × $16) 633,600
@ revised std cost (39,600 did cost (actual cost)
× $16) 633,600 575,000
VARIANCE 39,600 (A) VARIANCE 58,600 (F)
Labour efficiency planning Labour efficiency operational
9,900 telescopes produced hrs 9,900 telescopes produced hrs
@ original usage (9,900 × 4hrs) 39,600 Revised usage (9,900 × 3.5hrs) 34,650
@ revised usage (9,900 × 3.5hrs) 34,650 Did use 39,600
VARIANCE in hrs 4,950 (F) VARIANCE in hrs 4,950 (A)
Valued at the original std rate Valued at the original
per hr $15 standard rate per hour $15
VARIANCE in $ 74,250 (F) VARIANCE in $ 74,250 (A)
Lecture Example 3.13 – Labour variances and the learning curve
Co
We know the original budget/standard is 240 hours and this is based on no learning being expected.
Fir
st I pyri
We need to work out what the revise budget/standard hours are based on the 90% learning rate so
that we can separate the overall variances into a planning and operating component.
ntu ght
W1
Time for 1st unit per original standard = 240 hrs/6 units = 40 hrs/unit
itio
Since there was originally no learning expected the time for each unit must have been expected to be
n2
constant.
017
W2
Revised total time for 6 units = average time for each unit (formula) × 6
Average time per unit = axb = 40 × 6-0.1520 = 30.46 hrs
Total for 6 units = 30.46 × 6 = 182.8 hrs
W3
Budgeted labour rate per hour = $1,680/240 hrs = $7
Revised budget labour cost = 182.8 hrs × $7 =
Original Budget Revised Budget Actual
Units 6 6 6
Labour hours 240 182.8 195
Labour cost $1,680 $1,279.6 $1,365
Planning variances
(a) Rate
Since there is no mention of the labour rate of $7 per hour being adjusted the planning variance
for labour rate is $NIL
(b) Efficiency
Original budget hrs = 240
Revised budget hrs = 182.8
Planning variance = 57.2 hrs (F) × $7 = $400.4 (F)
Therefore, total planning variance = $400.4 (F)
Operational variances
(a) Rate
195 actual hours
Should cost (@ $7) $1,365
Did cost $1,365
Variance $NIL
(b) Efficiency
Revised budget hrs 182.8
Actual hrs 195
ht
Variance 12.2 (A) × $7 = $85.4 (A)
r i g 1 7
Therefore, total operational variances = $85.4 (A)
0
y 2
The planning and operational variances net off to $315 (F)
o p ion
C measurement
u i t
4 – Performance
I n t and control
r s t
Lecture Example 4.1 –Performance assessment
F i (a) Sales
Sales revenue has increased by 15% from 2015 to 2016. This is encouraging in a market where
there is much competition. There are a number of reasons why this may have happened:
 More pairs of boots/shoes have been sold (push on marketing perhaps, reputation for
quality, competitor has closed down etc…)
 Selling price per pair of boots/shoes has increased (inflation, less price sensitive
customers due to shoes/boots being “fashionable”)
 Proportionately more sales of higher value items have been made (deliberate marketing
effort etc)
Gross profit
Gross profit has increased by $6,000 to $966,000, an increase of less than 1%. The gross profit
margin has decreased from 40% (960k/2,400k) to 35% (966k/2,760k). Since the revenue has
increased by 15% the drop in gross profit % must be due to the cost of sales increasing by more
than 15%.
The purchase cost per pair of shoes/boots must have increased by a greater amount than the
selling price per unit. In fact, the cost of sales has increased by 24.6% from 2015 to 2016.
Possible reasons for this are;
 Change of supplier to a more expensive one (normal supplier gone out of business,
moving to a better quality supplier)
 Loss of bulk buying discounts
 Unfavourable exchange rate movement with an overseas supplier.
Other measures
Admin costs have been kept in line and have only increased by 5%. This is a little above inflation
but would appear reasonable in light of rising revenues.
Distribution costs are up 9% in 2016 to $240,000. This would seem fair given the growth in the
business. Presumably they are able to take advantage of economies of scale with their
distributors so an increase that is lower than the increase in sales would seem logical.
Website maintenance is actually down 15% to $85,000. For an internet retailer it is important
that the website is operating effectively all the time. If the reduced cost means the website is
not being as carefully maintained, then this could have future implications for customer
satisfaction. If they are just being less wasteful with the spending, then the reduction may give
no cause for concern.
Overall performance is a little mixed with the biggest concern being that gross margins have
reduced significantly.
(b) Sales volumes have increased from 96,000 to 105,600 pairs, an increase of 10% which in itself is
Co
encouraging in a competitive market (see part (a)). The average selling price per pair can be
Fir
established as $26.14 (2016) and $25 (2015). This data supports some of the comments made
st I pyri
about revenue in part (a).
ntu ght
Complaints have gone up by 76%, a very worrying statistic and now represent a complaint for
every 12.5 pairs sold (105,600/8,448). In 2012 there was a complaint on average for every
itio
20 pairs sold. This suggests that some aspect of the product or service has declined significantly
between 2012 and 2013 and this is likely to affect future sales if not rectified.
n2
Consistent with the concerns over complaints are the statistics for returns and on time
017
deliveries. In 2012 the % of returns at 10% was lower than industry average of 11%, but by 2016
returns % had increased to 14% (a 40% rise!) and is now well above the industry average. This
would suggest either the wrong items were being delivered or the quality was not what the
customer was expecting. Either way this flags concerns for the future.
A similar picture can be seen with the on time deliveries figure which at 92% is well below the
industry average of 95%. This is a critical aspect of an internet business and needs to be urgently
investigated and appropriate action taken if Booty Limited wants to see continued growth for
the future.
Lecture Example 4.2 – Opportunity cost based transfer prices

(a) Minimum that Cole would accept
MC + Opportunity cost
In this situation the opportunity cost will be zero since Cole has spare capacity and as such is not
losing out on anything if some of that capacity is used up by making balls to transfer internally
Minimum = $9 + 0 = $9
As long as Cole is covering its costs for this internal transfer it will be happy for the transfer to happen.
Maximum Crouch would be prepared to pay

Lower of
(i) External mkt price $16
(ii) Divisional net revenue ($25 – $5) $20
The transfer price would need to be set in the range: $9 < TP < $16
This will lead to a goal congruent decision.
In reality, the two divisions would probably negotiate on a transfer somewhere in the middle of
this range (depending on who has the better negotiating skills), say $12.50.
(b) If Cole is operating at full capacity and there is unsatisfied demand for Goals then Cole division
would be keen to keep making Goals to sell to the external market since these earn them a
contribution of $12 ($25 ─ $13).
If Cole was forced to divert some resources away from making and selling Goals in order to supply
some Balls for Crouch, then they would want to make sure that they were at least as well off.
Minimum that Cole would accept
1st 5,000 units (i.e. where there is spare capacity)
As above in part (a), a transfer price between $9 and $16
Next 5,000 units (i.e. where there is no spare capacity)
ht 7
r i g 01
MC + Opportunity cost
2
Contribution foregone by not
y
being able to sell a Goal
p ion
Minimum = $9 + $12 = $21
o
C uit
Maximum Crouch would be prepared to pay
t
As part (a) = $16
t I n
This tells us that it is in the interests of Capello plc to let Cole concentrate on selling Goals to the
s
external market for this 5,000 units and Crouch can buy 5,000 Balls from the outside supplier for $16.
F ir
Lecture Example 4.3 – ROI v RI
Smith Jones
ROI
× 100
Divisional net assets 2,375 2,000
16% 12%
RI
Notional interest (divisional net assets × 10%) 237.5 200
Residual Income 142.5 40

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Course Notes

JUNE 2017 RELEASE

Any unauthorised reproduction or distribution in any form is strictly

© First Intuition Ltd, 2017

1: Specialist cost and management accounting techniques 1

1 Activity based costing (ABC) 1

1 Budgetary systems and types of budget 61

4: Performance measurement and control 103

1 Performance management information systems 103

Solutions to Class lecture examples 127

1 – Specialist cost and management accounting techniques 127

4 Approach to the exam

1 Specialist cost and management PO12 120 60 A:Q1-Q4

2 Decision making techniques PO12 60 75 A:Q1-Q4

F ir Examiner regards it as important to be

3 Budgeting and control PO13 90 150 A:Q1-Q10

3 Performance analysis PO13,PO14 20 45 A:Q51

5.1 Practical Experience Requirements (PER) and Performance Objectives

1.1.2 Activity based costing

ABC should give more accurate product costs in situations where:

ABSORPTION COSTING ABC

Identify what the key drivers

Absorb overheads based on cost

F Step 1: Analyse overhead costs into cost pools

LECTURE EXAMPLE 1.1: ABC AND ABSORPTION

Production overheads are as follows:

The following budgeted information is also available:

1.3 The hierarchy of activities

Activity class/type What drives the cost? Examples

1.4 Implications of switching to ABC

1.5 Problems with ABC

2.1 Deriving a target cost

2.1.4 Cost gap

ILLUSTRATION: TARGET COSTING

2.2 Closing the target cost gap

2.3 Benefits of using target costing

2.4 Target costing in service industries

3 Life cycle costing

3.1 Stages of a product’s life cycle

3.3 Deriving a life cycle cost

LECTURE EXAMPLE 1.2: DERIVING A LIFE CYCLE COST

4.1 Goldratt’s five focusing steps

F i4.3 Throughput accounting ratio

Sales revenue - material purchases

4.4 Improving TPAR

4.5 Tackling a TPAR question

LECTURE EXAMPLE 1.3: THROUGHPUT IN A MULTI-PRODUCT SITUATION

5.2 Environmental cost management

5.4 Environmental management accounting

5.4.1 Input/output analysis

5.4.2 Flow cost accounting

5.4.3 Environmental ABC

For a cost to be relevant it must pass three tests:

1.1 Relevant costs for materials

Is the material currently in inventory?

Is it currently used elsewhere

It is scarce and therefore, if we use it on this contract,

1.2 Relevant costs for labour

Is labour at full capacity?