GCMA Book

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Global Certified
Management Accountant
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Management Accountant
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ii
Contents
Page
1 Introduction to performance management...................................................................................................................1
2 Costing systems for performance management ........................................................................................................32
3 Budgeting .................................................................................................................................................................57
4 Further issues with budgets......................................................................................................................................83
5 CVP analysis ..........................................................................................................................................................100
6 Decision making techniques...................................................................................................................................117
7 Pricing....................................................................................................................................................................142
8 Transfer pricing ......................................................................................................................................................164
9 Introduction to performance measurement..............................................................................................................175
10 Comparing actual results with the budget ...............................................................................................................187
11 Standard costing.....................................................................................................................................................195
12 Other aspects of performance measurement ...........................................................................................................220
13 Divisional performance measurement .....................................................................................................................232
14 Performance in operations and production management ........................................................................................247
15 Improving performance...........................................................................................................................................258
16 Performance measurement and management..........................................................................................................300

1 Objectives of financial statements ........................................................................................................................... 313
2 Assets, liabilities and the accounting equation ........................................................................... ............................. 324
3 Qualities of financial information and measurement ................................................................................................. 338
4 Statement of comprehensive income ......................................................................................................................... 358
5 The statement of financial position ........................................................................................................................... 379
6 Reporting financial performance .............................................................................................................................. 413
7 Non-current assets .................................................................................................................................................. 422
8 Share capital and reserves ....................................................................................................................................... 448
9 Group accounts .......................................................................................................................................................... 456
10 Statement of cash flows ........................................................................................................................................... 500
11 Other elements of corporate annual reports ............................................................................................................. 513
Part A Advanced Management Accounting
Part B Financial Statements
Advanced Management Accounting
Part A
1 1: Introduction to performance management

1 Mission, objectives and targets
1.1 The purpose of an organisation: mission statements
The mission of an organisation is the reason for its existence. Some organisations issue mission
statements.
Organisations develop objectives (quantified as targets) for the achievement of its mission and long-term
goals. The strategic objectives for a commercial organisation should include one or more financial
objectives.
Mission 'describes the organisation's basic function in society, in terms of the products and services it
produces for its clients' (Mintzberg). The mission of an organisation is the reason for its existence.

Case Study

The Co-op
The Co-operative movement in the UK is a good example of the role of mission. The Co-operative
Wholesale Society and Co-operative Retail Society are business organisations, but their mission is not
simply profit. Rather, as they are owned by their suppliers/customers rather than external shareholders,
they have always, since their foundation, had a wider social concern.
The Co-op has been criticised by some analysts on the grounds that it is insufficiently profitable, certainly
in comparison with supermarket chains such as Tesco. However, the Co-op has explicit social objectives.
In some cases it will retain stores which, although too small to be as profitable as a large supermarket,
provide an important social function in the communities which host them.
Judging the Co-op's performance as a retailer on the conventional basis of profitability would ignore its
social objectives.

Introduction to
performance
management

1: Introduction to performance management 2
The mission of a company will include the aim of creating wealth for its shareholders, but a financial
purpose is not itself sufficient to explain why an organisation exists, or what it is trying to achieve.
1.2 Mission statements
Mission statements are formal statements of an organisation's mission. They might be reproduced in a
number of places (eg at the front of an organisation's annual report, on publicity material, in the
chairman's office, in communal work areas and so on). There is no standard format, but they should
possess certain characteristics:
Brevity - easy to understand and remember
Flexibility - to accommodate change
Distinctiveness - to make the firm stand out.
For example, some years ago the pharmaceuticals firm Glaxo expressed its mission by stating that it was
'an integrated research-based group of companies whose corporate purpose is to create, discover,
develop, manufacture and market throughout the world, safe, effective medicines of the highest quality
which will bring benefit to patients through improved longevity and quality of life, and to society through
economic value.'
Similarly, the British Film Institute has expressed its mission in the following terms: 'The BFI is the UK
national agency with responsibility for encouraging and conserving the arts of film and television. Our aim
is to ensure that the many audiences in the UK are offered access to the widest possible choice of cinema
and television, so that their enjoyment is enhanced through a deeper understanding of the history and
potential of these vital and popular art forms.'
1.3 Mission and planning
Although a mission statement might be seen as a set of abstract principles, it can play an important role in
the planning process.
(a) Plans should outline the fulfilment of the organisation's mission.
(b) Evaluation and screening. Mission also acts as a yardstick by which plans are judged. For example,
the mission of an ethical investment trust would preclude investing in tobacco firms. Mission also
helps to ensure consistency in decision-making.
(c) Implementation of strategy. Mission also affects the implementation of a planned strategy, in the
culture and business practices of the firm.
Problems with 'mission' are:

Problem Comment
Ignored in practice The inherent danger of a stated mission is that it will be ignored, and an
organisation may pursue objectives that are not consistent with its stated
mission.
Public relations Sometimes, a mission statement is merely for public consumption, not for
internal decision making.
'Post hoc'

Missions are sometimes produced to rationalise the existence of the
organisation to a particular audience. In other words, mission does not drive
the organisation. Rather, what the organisation actually does is assumed to
be a mission.
Full of generalisations A mission statement may be full of 'worthy' generalisations, such as 'best',
'quality', and 'major'. If so, the mission statement is in danger of becoming no
more than just a wish list.
1.4 Objectives
Objectives (or goals) are aims for achievement. They may be expressed in general terms, such as:
(a) the objective of becoming one of the two leading global providers of a range of products or
services in a particular market
(b) the objective of achieving strong annual growth in sales and profits, so as to increase the wealth of
the company's shareholders
(c) the objective of remaining at the forefront of technological developments in the industry
Objectives should be consistent with the organisation's mission. They may relate to matters such as
profitability or return on capital employed, market share, quality of products or services, and customer
satisfaction.
1.5 Targets
Targets are quantified objectives (although in practice some organisations use the terms 'targets' and
'objectives' interchangeably). Targets can be thought of as measurable goals for achievement, usually
within a specified time frame, and may be aims for either the long-term or short-term.
Objectives and targets orientate the activities of the organisation towards the fulfilment of the
organisation's mission, in theory if not always in practice.
The objectives and targets for a business must include profitability.
Targets (quantified objectives) can also be used as standards for measuring the performance of
the organisation and departments in it.
1.6 Primary and secondary objectives
Some objectives are more important than others. There is a primary corporate objective (restricted by
certain constraints on corporate activity) and other secondary objectives which are strategic objectives
which should combine to ensure the achievement of the primary corporate objective.
(a) For example, if a company sets itself an objective of growth in profits, as its primary objective, it
will then have to develop strategies by which this primary objective can be achieved.
(b) Secondary objectives might then be concerned with sales growth, continual technological innovation,
customer service, product quality, efficient resource management (eg labour productivity) or reducing
the company's reliance on debt capital.
1.7 Long-term and short-term objectives
Objectives may be long-term or short-term.
(a) A company that is suffering from a recession in its core industries and making losses in the short
term might continue to have a primary objective in the long term of achieving a steady growth in
earnings or profits, but in the short term, its primary objective might switch to survival.
(b) Secondary objectives will range from short-term to long-term. Planners will formulate secondary
objectives within the guidelines set by the primary objective, after selecting strategies for achieving
the primary objective.

Question
Mission

Using the organisation in which you work, investigate the organisation's mission, the planning that the
company employs to achieve that mission and the objectives and targets that the company sets. (There is
no answer to this activity.)

1.8 Example
A company's primary objective might be to increase its earnings per share from 30c to 50c in the next five
years.
(a) Strategies for achieving the objective might be selected.
Increase profitability in the next twelve months by cutting expenditure.
Increase export sales over the next three years.
Develop a successful new product for the domestic market within five years.
(b) Secondary objectives might then be re-assessed.
Improve labour productivity by 10% within twelve months.
Improve customer service in export markets with the objective of doubling the number of
overseas sales outlets in selected countries within the next three years.
Invest more in product-market research and development, with the objective of bringing at
least three new products to the market within five years.

Case Study

In August 2008, J Sainsbury plc opened a new flagship 'green' store in Dartmouth, Devon (UK).
The following objectives were relevant.
(a) Primary objective maximise shareholder wealth. The new store is part of Sainsbury's plans to
drive sales growth by creating an extra 75 stores between March 2007 and March 2010.
(b) Secondary objectives
Recognising that customers have become increasingly concerned with eating more healthily and
with the social and ethical consequences of shopping, Sainsbury's has stated its commitment to
being a responsible retailer. In order to achieve this it has five principles that provide a framework
for how it does business.
1 Best for food and health
2 Sourcing with integrity
3 Respect for the environment
4 Making a positive difference to the community
5 Providing a great place to work
In opening a new 'green' store, environmental objectives were also relevant and the Dartmouth
store was a key step in Sainsbury's plans to introduce sustainable features in stores across the UK.
(c) In terms of the environment, Sainsbury's has an overall objective to reduce CO
2
emissions per
square metre by 25% by 2012.
Relevant objectives for the Dartmouth store included:
Save 40% of the store's overall CO
2
emissions through the use of cutting edge technology
in the design and operation of the store.
Reduce energy consumption from the national grid by 50% by using renewable energy
sources.
Reduce mains water consumption by 1 million litres pa (60%) by collecting and reusing
rainwater.
Plant 400 trees in the local community to replace the 200 trees used in building the store.

1.9 Non-profit seeking organisations
One possible definition of a non-profit seeking organisation is that its first objective is to be involved in
non-loss operations to cover its costs, profits only being made as a means to an end.
Although most people would 'know one if they saw it', there is a surprising problem in clearly defining
what counts as a non-profit seeking organisation.
Bois has suggested that non-profit seeking organisations are defined by recognising that their first
objective is to be involved in non-loss operations in order to cover their costs and that profits are only
made as a means to an end (such as providing a service, or accomplishing some socially or morally
worthy objective).
A non-profit seeking organisation is ' an organisation whose attainment of its prime goal is not
assessed by economic measures. However, in pursuit of that goal it may undertake profit-making
activities.' (Bois)
This may involve a number of different kinds of organisation with, for example, differing legal status
charities, statutory bodies offering public transport or the provision of services such as leisure, health or
public utilities such as water or road maintenance.

Case Study

Oxfam operates more shops than any commercial organisation in Britain, and these operate at a profit.
The Royal Society for the Protection of Birds operates a mail order trading company which provides a
25% return on capital, operating very profitably and effectively.

1.10 Objectives and non-profit seeking organisations
The range of objectives of non-profit seeking organisations is as wide as the range of non-profit seeking
organisations.
A major problem with many non-profit seeking organisations, particularly government bodies, is that it is
extremely difficult to define their objectives at all. In addition they tend to have multiple objectives, so
that even if they could all be clearly identified it is impossible to say which is the overriding objective.

Question
Objectives

What objectives might the following non-profit seeking organisations have?
(a) An army (d) A political party
(b) A local council (e) A college
(c) A charity

Answer

Here are some suggestions.
(a) To defend a country
(b) To provide services for local people (such as the elderly)
(c) To help others/protect the environment
(d) To gain power/enact legislation
(e) To provide education

More general objectives for non-profit seeking organisations include:
Surplus maximisation (equivalent to profit maximisation)
Revenue maximisation (as for a commercial business)
Usage maximisation (as in leisure centre swimming pool usage)
Usage targeting (matching the capacity available, as in a public hospital)
Full/partial cost recovery (minimising subsidy)
Budget maximisation (maximising what is offered)
Producer satisfaction maximisation (satisfying the wants of staff and volunteers)
Client satisfaction maximisation (the police generating the support of the public)
It is difficult to judge whether non-quantitative objectives have been met. For example, assessing whether
a charity has improved the situation of those benefiting from its activities is difficult to research. Statistics
related to product mix, financial resources, size of budgets, number of employees, number of volunteers,
number of customers serviced and number and location of facilities are all useful for this task.
The primary objectives of commercial manufacturing and service organisations are likely to be fairly
similar and centre on satisfying shareholders. The range of objectives of non-profit seeking organisations
is as wide as the range of non-profit seeking organisations.
2 Strategy
Strategies are plans for achieving objectives and targets. Strategies are formulated for the organisation as
a whole, and for individual aspects of the organisation's operations.
Shorter-term plans are formulated within the framework of the longer-term objectives and strategies.
Most organisations prepare annual budgets, which are plans for the entire organisation, expressed in
financial terms.
A strategy is a planned course of action, including a specification of required resources, to achieve the
objectives set out in the organisation's long-term plan.
Planning means formulating ways of proceeding. Decision making means choosing between various
alternatives. These two terms are linked: you decide to plan in the first place and the plan you make is a
collection of decisions.
Control is used in the sense of monitoring something so as to keep it on course, like the 'controls' of a
car, not (or not merely) in the sense of imposing restraints, or exercising power over something.
A strategy is a course of action adopted in order to achieve a stated objective or target.
(a) Corporate strategy is concerned with what types of business the organisation should be operating
in.
(b) Functional or operating strategies are for specific areas of operations. An organisation may have
strategies for marketing, production, quality enhancement, research and development, finance,
human resources development, information systems enhancement, and so on.
(c) Strategies are formulated in tiers or layers. Within an overall marketing strategy, for example, there
may be strategies for advertising, direct selling, customer targeting, market research, sales growth,
product pricing, and so on.
Planning should be intended to ensure that an organisation achieves its objectives, in both the long and
the shorter term. Shorter-term plans should be formulated within the framework of longer-term plans
(strategic plans) and objectives. Typically, an organisation will carry out periodic strategic reviews, and
will also prepare regular annual plans (budgets) that should be consistent with the longer-term strategic
plan. Shorter-term 'operational plans' are then formulated within the framework of strategic plans and the
annual budget.
The 'planning cycle' refers to the continuous review and reformulation of plans for the future. Budgeting,
for example, is planning within an annual planning cycle. An essential element in the planning cycle is

control. Managers should be made responsible for ensuring, as far as possible, that planning targets are
achieved, or even exceeded.
The 'control cycle' refers to the process of:
(a) formulating a plan, such as a strategic plan or budget
(b) implementing the plan, and making particular managers responsible for putting particular aspects
of the plan into effect
(c) monitoring and measuring actual performance
(d) comparing actual performance against the plan
(e) taking control measures, where the comparison suggests that results should have been better, and
improvements or corrective action is necessary
(f) re-assessing, where the comparison suggests that the existing plans are unrealistic, and
producing, where appropriate, new plans and planning targets
Formulating plans within the framework of strategic planning, together with performance measurement
and management, therefore provide a means of enabling an organisation to achieve its strategic
objectives.
Planning
Management plans for both the short term and the long term. A long-range plan is necessary in
order to anticipate any future needs or opportunities that require action to be taken, either now or
in the near future. For example, management may need to consider building a new production
facility, to meet anticipated increased demand for a product. Management should constantly be
thinking ahead. They should never be surprised by any gradual developments. Planning
therefore involves converting the organisation's long-term objectives into a succession of short-
term plans. One such short-term plan is the annual budget.
Controlling
Control is exercised by comparing actual performance with the short-term plans so that
deviations from these short-term plans can be identified and corrective action taken. If the control
process indicates that the long-term objectives are not achievable, the objectives can be changed
before any serious damage to the company's future occurs.
Organising
Organising is the establishment of a framework within which necessary activities can be
performed. For example, the designation of a member of staff to be responsible for a particular
activity and the definition of managers' responsibilities and lines of authority. It requires the
breakdown of the organisation into manageable sections such as departments and the co-
ordination of activities in these sections.
Motivating
Managers need to influence employees to act in such a manner that will help achieve the
organisation's objectives.
Decision making
Management is decision taking. Managers of all levels within an organisation take decisions.
Decisions taken at the strategic level set or change the objectives or strategic targets of an
organisation. They include decisions about the selection of products and markets, the
required levels of company profitability and the purchase or disposal of subsidiary
companies or major non-current assets.

Operational-level decisions are concerned with ensuring that specific tasks are carried out
effectively and efficiently. They might include decisions concerning the allocation of
particular staff to particular tasks and jobs or the action to take in respect of customer
complaints.

Question
Decisions

What strategic-level, tactical-level and operational-level decisions might an organisation take in relation to
sales?

Answer

Here is our suggestion. Your answer could be somewhat different.
(a) At the strategic level, senior management may decide that the company should increase sales by
5% per annum for at least five years. This would be a strategic objective or target.
(b) At the tactical level, the sales director and senior sales managers may decide to increase sales by
5% in the next year, with some provisional planning for future years. This would involve making
decisions about direct sales resources, advertising, sales promotion and so on. Sales quotas could
be assigned to each sales territory.
(c) At the operational level, the manager of a sales territory may make a decision regarding the weekly
sales targets for each sales representative.

3 Performance measurement and performance
management
Managers have to plan, control, organise and make decisions. Performance measurement is a system
for comparing actual results against plans. Performance management involves using information from
performance measurement to take new planning decisions or control actions to improve the future
performance of the organisation. Performance measurement and management, within a planning
framework, should help to ensure that the strategic objectives of the organisation are pursued and
achieved.
Although it is convenient to think of a company or other organisation as a single unit, in reality it is an
association of many individuals. Objectives and strategy are decided by the board of directors in a
company, and are converted into plans and activities by management and employees.
(a) Performance measurement is a general term for systems and methods of setting targets for
achievement that are consistent with the organisation's strategic and operational goals, and
comparing actual results with the target. The nature of performance targets varies. They might be
long-term or short-term, and financial or non-financial. Targets also vary according to the nature of
the business and its operations, and according to the management responsibility structure.

Tactical-level decisions are concerned with the efficient and effective use of an organisation's
resources (sometimes referred to as the '4Ms': men, materials, machines and money).
Tactical-level decisions therefore include setting budgets for the next period for sales,
production and inventory levels, and setting measures of performance by which departmental
results can be gauged.
(b) Performance management is a general term for systems and methods for improving performance.
Performance measurement systems and performance management initiatives are an integral part of
planning and control systems and decision-making within an organisation. They provide a means by which
an organisation can translate its overall objectives and strategies into long-term and short-term plans, for
reviewing the implementation of the plans (actual performance) and for monitoring progress towards the
achievement of objectives.
4 Responsibility centre and process-based
organisations
Performance measurement and management systems should identify aspects of performance that
individual managers should be held accountable for, and that they should be able to control. A reporting
system might be based on a system of responsibility centres or strategic business units.
Within an organisation, there should be a control structure for planning and monitoring performance.
A responsibility centre-based organisation is divided into a number of responsibility centres or strategic
business units (SBUs). Each responsibility centre has its own planning objectives and targets, and its
management is responsible (and accountable) for the achievement of those targets.
A responsibility centre structure is only effective, however, if the centre's management have effective
control over the resources and factors necessary for achieving the centre's objectives. It would be
inappropriate to make management responsible for achieving stated objectives when key planning and
control decisions are outside their authority and control. Authority and responsibility should go hand-in-
hand.
A process-based organisation is one in which operations consist of a number of processes, and the work
done by different departments is inter-related. For example, work done in one department might be fed
through to another department, with the full process consisting of the work done by the two departments
together.
A responsibility centre-based organisation would be inappropriate for process-based organisations. A
process is a 'collection of activities that takes one or more kinds of input and creates an output that is of
value to the customer'.
In a process-based organisation, managers are held responsible for the performance of a process, or a
part of a process, rather than responsible for a discrete business unit.
The nature of performance measurement and management differs according to the type of organisation
structure. For example, in a responsibility centre-based structure, the centre's management would be
responsible for the production of a group of products or the provision of a particular range of services to
customers, and would also be responsible for sales, marketing and distribution, and probably also for
capital expenditure decisions for the centre. In a process-based organisation in contrast, different
managers might be responsible for production and for sales and marketing (since production and sales
and marketing are two stages in a process of delivering products to the customer).
In the following chapters, different methods of performance measurement and management are
described. The method that might be most appropriate for any organisation may depend on whether the
organisation has a responsibility centre structure or a process-based structure.
5 Information for control: IT systems
Performance measurement and management systems have been enhanced by developments in
information and communications technology.

Information is vital for performance measurement and management. The evolution of information
technology in recent years has greatly improved the ability of organisations to develop sophisticated
performance measurement systems.
(a) Organisations are able to process large amounts of data, and in a large variety of ways.
(b) Performance reports can be made available to management more regularly, and possibly on
demand.
(c) Performance information can be made more widely available to management, for example through
a corporate intranet.
A distinction is made between data and information.
(a) Data is the raw material for data processing. Data relates to facts, events and transactions and so
forth.
(b) Information is data that has been processed in such a way as to be meaningful to the person who
receives it.
5.1 Example
An example demonstrates the difference. Companies providing a consumer product or service need to find
out about consumer opinion, and might employ market research organisations to do so. In a typical
market research survey, a number of researchers ask a sample of the public (or the target market) to
answer a number of questions relating to the product.
Individually, a completed questionnaire does not tell the company very much, only the views of one
individual consumer. The data from the individual questionnaires has to be brought together, processed
and analysed. The processed output is the information that the company's management will use in
decision making.
5.2 Management information
Management information is information used by managers to help control the business. Information must
possess certain qualities to be valuable and worth having.
Information should be relevant for its purpose.
It should be complete for its purpose.
It should be sufficiently accurate for its purpose.
It should be clear to the manager using it.
The manager using it should have confidence in it.
It should be communicated to the appropriate manager.
It should not be excessive: its volume should be manageable.
It should be timely (in other words communicated at the most appropriate time).
It should be provided at a cost which is less than the value of the benefits it provides.
IT systems can improve the quality of management in a variety of ways. Information should be more
complete, because IT systems can process large quantities of data. Information can be made available
quickly, and so should improve 'timeliness'. The availability of off-the-shelf software should also mean
that information is available at a cost that is justified by the benefits it provides to management.
5.3 Modular IT systems and enterprise resource planning (ERP)
Historically, management information and data processing systems, particularly in larger organisations,
have evolved as a number of separate stand-alone systems for different departments.
For example, the production department might have a computerised system for production scheduling, the
warehousing department might have a separate system for inventory records, the accounting department
might have a system for financial and management accounting, the human resources department might
have a system for personnel records, and so on.
Developments in information and communications technology are having a big impact. Database software
allows enormous quantities of data to be held in a single source, that can be accessed by many different
users via an intranet or the Internet. This has created the potential for integrating information systems into
a single organisation-wide system, so that everyone can access whatever information he or she needs.
For example, a customer might telephone the sales department or the accounts department to ask about
the progress of an order and the likely delivery date. With an integrated information system, an immediate
answer can be provided. The sales or accounts person can simply look up the status of the order on the
company database, instead of having to refer the customer to someone in production or the warehouse
department for an answer.
A single database or 'information hub' for an entire organisation is often known as an enterprise resource
planning (ERP) system.
Organisations with an ERP system could well gain competitive advantage over rivals who still use modular
systems, by making more use of their data and producing better management information.
ERP systems have been extended outside the boundaries of the organisation, and some companies use a
shared database with suppliers and business customers in a web-based 'supply chain management'
system. Supply chain management and ERP are explained in greater detail in Chapters 15 and 14
respectively.
The developments in information technology have also made it easier for organisations to decentralise
their operations by taking out tiers of middle management and delegating authority and responsibility to
individuals who are closer to actual operations. This creates a 'flatter' organisation with fewer
management levels between top management and the operational level. The expansion of global
businesses, for example, would not have been easily possible without information technology and
delegation of authority to local managers.
Although information systems provide non-financial as well as financial information, accounting and
costing systems have traditionally been, and continue to be, a major source of management information
for performance measurement.
(a) Accounting systems are used to keep detailed records of financial transactions of the organisation,
such as sales and expenditures, receipts and payments and records of assets and liabilities. This
information is sometimes known collectively as the 'ledger accounting system' or 'ledger
accounts'. It provides the basic data, if needed, for obtaining detailed information for management
about costs and profits.
(b) Some organisations have a costing system, in addition to their main ledger accounts. A costing
system is an information system for establishing the costs of the products that an organisation
makes, or the services it provides and possibly also particular activities that it engages in.
(c) Most organisations prepare an annual financial plan, or budget. This is often a spreadsheet
model, although large organisations use much more complex planning models. The budget
remains an important planning model for companies, even when strategic plans are reviewed
regularly. Company performance is often judged by the stock market in terms of what the company
hopes to achieve over the course of the next financial year, and whether budgeted expectations
have been met in the current year. Management bonuses are also often linked to achievements
during the course of the financial year.
Although management information systems extend far beyond costing systems and budgeting systems,
costing and management accounting remain an important element and contribute significantly to
performance measurement and performance management.
5.4 Resource planning
Resource planning involves allocating the resources (and identifying potential resources) of the
undertaking in order that the defined and agreed corporate objectives may be achieved. At operational
level, there are four stages in resource planning.
(a) Establishing currently available and currently obtainable resources (by category) and details of any
which are not available or readily obtainable making a resource audit.

(b) Estimating what resources would be needed to pursue a particular strategy and deciding whether
there would be enough resources to pursue it successfully.
(c) Assigning responsibilities to managers for the acquisition, use and control of resources.
(d) Identifying all constraints and factors exerting an influence on the availability and use of resources
(internal and external environments).
Resource plans can be prepared in detail providing organisations know what they need to achieve.
(a) Critical success factors (CSFs) 'are those factors on which the strategy is fundamentally
dependent for its success'.
(b) Key tasks are what must be done to ensure each critical success factor is achieved.
(c) Priorities indicate the order in which tasks are achieved.
6 Information systems
6.1 Types of information system
Different types of information systems exist with different characteristics reflecting the different roles
they perform.
A structured decision uses a well-defined process to solve a typically repetitive situation. The data used in
making the decision is known with certainty and a standardised approach is used to make the decision.
For example an order for additional inventory can be triggered where the current inventory level falls below
the predetermined reorder level or a customer order can be rejected if this order would take the
customer's credit balance above the predetermined credit limit.
An unstructured decision is complex and no standard solution exists to resolve the situation. Some of the
elements of the decision are ill-defined or unknown. Decision makers have to use their judgement to
decide between the options that are known. For example the board of a company have to decide on the
appropriate strategic direction for their business.
A semi-structured decision lies between the structured and unstructured decision, combining elements of
both. There is some agreement as to the data and evaluation method to be used, but some judgement is
also required. For example it might be agreed that additional warehouse space is necessary, but the
selection of the location and the rent or buy decision will require judgement by management.
6.1.1 Executive Information Systems (EIS)
An Executive Information System (EIS) pools data from internal and external sources and makes
information available to senior managers in an easy-to-use form. EIS help senior managers make
strategic, unstructured decisions.
An EIS should provide senior managers with easy access to key internal and external information. The
system summarises and tracks strategically critical information, possibly drawn from internal MIS and
DSS, but also including data from external sources eg competitors, legislation, external databases such as
Reuters.
Executive Information Systems are sometimes referred to as Executive Support Systems (ESS). An
ESS/EIS is likely to have the following features.
Flexibility
Quick response time
Sophisticated data analysis and modelling tools

A model of a typical EIS follows.
An Executive Information System (EIS)

6.1.2 Management Information Systems (MIS)
Management Information Systems (MIS) convert data from mainly internal sources into information (eg
summary reports, exception reports). This information enables managers to make timely and effective
decisions for planning, directing and controlling the activities for which they are responsible.
An MIS provides regular reports and (usually) online access to the organisation's current and historical
performance.
MIS usually transform data from underlying transaction processing systems into summarised files that are
used as the basis for management reports.
MIS have the following characteristics:
Support structured decisions at operational and management control levels
Designed to report on existing operations
Have little analytical capability
Relatively inflexible
Have an internal focus
6.1.3 Decision Support Systems (DSS)
Decision Support Systems (DSS) combine data and analytical models or data analysis tools to support
semi-structured and unstructured decision making.
DSS are used by management to assist in making decisions on issues which are subject to high levels of
uncertainty about the problem, the various responses which management could undertake or the likely
impact of those actions.
Decision support systems are intended to provide a wide range of alternative information gathering and
analytical tools with a major emphasis upon flexibility and user-friendliness.
DSS have more analytical power than other systems enabling them to analyse and condense large
volumes of data into a form that aids managers make decisions. The objective is to allow the manager to
consider a number of alternatives and evaluate them under a variety of potential conditions.

6.1.4 Expert systems
Expert systems are a form of DSS that allow users to benefit from expert knowledge and information. The
system will consist of a database holding specialised data and rules about what to do in, or how to
interpret, a given set of circumstances.
For example, many financial institutions now use expert systems to process straightforward loan
applications. The user enters certain key facts into the system such as the loan applicant's name and
most recent addresses, their income and monthly outgoings, and details of other loans. The system will
then:
(a) Check the facts given against its database to see whether the applicant has a good credit record.
(b) Perform calculations to see whether the applicant can afford to repay the loan.
(c) Match up other criteria, such as whether the security offered for the loan or the purpose for which
the loan is wanted is acceptable, and to what extent the loan applicant fits the lender's profile of a
good risk (based on the lender's previous experience).
A decision is then suggested, based on the results of this processing. This is why it is now often possible
to get a loan or arrange insurance over the telephone, whereas in the past it would have been necessary
to go and speak to a bank manager or send details to an actuary and then wait for him or her to come to a
decision.
7 Costing systems and management accounting
Information about costs, revenues and profits is an important element of all performance measurement
and management systems.
Management accounting is concerned with the collection of data, its analysis and processing into
information, and the interpretation and communication of that information so as to assist management
with planning, control and decision making.
Many organisation plans are stated in financial terms. In particular, annual budgets are plans for the entire
organisation expressed in money terms.
The major objectives of a commercial organisation will include one or more financial objectives, such as
growth in return on capital employed or profitability.
Performance measurement systems should therefore include systems for establishing the costs and the
profits from operations, and the cost and profitability of the products or services provided by the
organisation to its customers.
Information about the cost of an organisation's output can also be used to analyse the efficiency of
resource utilisation.
Costing systems vary from organisation to organisation, and are a key element in performance
measurement. Various aspects of costing systems, and different costing techniques, will be explained in
subsequent chapters.
Providing costing information to operational management is one of the functions of the management
accountant.
(a) The management accountant helps in the planning process and decision-making processes, by
providing information, primarily about costs and revenues.
(b) The management accountant supplies performance reports that compare actual performance with
planned performance, highlighting those activities which are not conforming to plan.
The CIMA (Chartered Institute of Management Accountants) Official Terminology defines management
accounting.

Management accounting is the process of identification, measurement, accumulation, analysis,
preparation, interpretation and communication of information used by management to plan, evaluate and
control within an entity and to assure appropriate use of, and accountability for, its resources.
Management accounting also comprises the preparation of financial reports for non-management groups
such as shareholders, creditors, regulatory agencies and tax authorities.
The Official Terminology also describes the core activities of management accounting.
Participation in the planning process at both strategic and operational levels. This involves the
establishment of policies and the formulation of plans and budgets which will subsequently be
expressed in financial terms.
The initiation of, and the provision of guidance for, management decisions. This involves the
generation, analysis, presentation and interpretation of appropriate relevant information.
Contributing to the monitoring and control of performance through the provision of reports on
organisational (and organisational segment) performance, including comparisons of actual with
planned or budgeted performance, and their analysis and interpretation.
Management accounting is therefore concerned with the collection of data (from both internal and external
sources), its analysis and processing into information, and the interpretation and communication of that
information so as to assist management with planning, control and decision making.

Question
Functions of management accounting

Wilton, MacDonald, Pearce & Co, a medium-sized firm of architects, are about to absorb Butcher, Fowler
& Partners, a similar sized firm. They have engaged you as management accountant. Part of your duties
will be to review the management accounting function of the combined practice. You have an appointment
tomorrow morning with the senior partner to discuss this issue.
Required
Jot down notes to use in tomorrow's meeting covering the functions of management accounting, with
particular reference to Wilton, MacDonald, Pearce & Co.

Answer

Management accounting involves providing and interpreting internal accounting information for managers
to use for the following purposes.
(a) Planning the organisation's activities in the short, medium and long term
The management accounting system should provide information that will allow management to
establish longer-term objectives for the enlarged organisation, and for preparing shorter-term
financial plans (in particular, budgets) within the framework of longer-term goals.
(b) Controlling the activities of the organisation
Management will have to learn to control a larger business. They will therefore need control reports
so that they can compare actual results against plans or budgets. A system must be established for
preparing control reports, possibly on the basis of individual responsibility centres within the firm.
Performance appraisal systems can use both financial and non-financial information (eg the
percentage of contracts tendered for, that are won by the firm).
(c) Making decisions
For example, information will be needed for making financial decisions, such as pricing
architectural contracts for tendering purposes.

7.1 Management accounting compared with financial accounting
Financial accounting is an aspect of accounting dealing largely with maintaining financial records (the
'ledger accounts'), and the production of general purpose financial statements for various user groups,
including shareholders. Management accounting is concerned with the provision of information (largely of
a financial nature) for an organisation's management, where the information is provided for a specific
decision-making, planning or control purpose.
The following table summarises the main differences between management accounting and financial
accounting.
Management accounting Financial accounting
A management accounting system produces
information that is used within an organisation, by
managers and employees.
A financial accounting system produces
information that is used by parties external to the
organisation, such as shareholders, banks and
creditors.
Management accounting helps management to
record, plan and control activities and aids the
decision-making process.
Financial accounting provides a record of the
performance of an organisation over a defined
period and the state of affairs at the end of that
period.
There is no legal requirement for an organisation to
use management accounting.
Limited companies are required by the law of most
countries to prepare financial accounts.
Management accounting can focus on specific
areas of an organisation's activities. Information
may aid a decision rather than be an end-product of
a decision.
Financial accounting concentrates on the
organisation as a whole, aggregating revenues and
costs from different operations. Financial accounts
are an end in themselves.
Management accounting information may be
monetary or alternatively non-monetary.
Most financial accounting information is of a
monetary nature.
Management accounting provides both an historical
record and a future planning tool.
Financial accounting presents an essentially
historical picture of past operations.
No strict rules govern the way in which
management accounting operates. The
management accounts and information are
prepared in a format that is of use to managers.
Financial accounting must operate within a
framework determined by law and by accounting
standards (eg, IASs and IFRSs). In principle the
financial accounts of different organisations can be
easily compared.
8 Organisational structures
8.1 Tall and flat organisations
Recent trends have been towards delayering organisations of levels of management. In other words, tall
organisations (with many management levels, and narrow spans of control) are turning into flat
organisations (with fewer management levels, wider spans of control) as a result of technological
changes and the granting of more decision-making power to front line employees.
The span of control concept has implications for the length of the scalar chain.

Span of control: the number of subordinates responsible to a superior.
Scalar chain: the chain of command from the most senior to the most junior.
A tall organisation is one which, in relation to its size, has a large number of levels of management
hierarchy. This implies a narrow span of control.
A flat organisation is one which, in relation to its size, has a small number of hierarchical levels. This
implies a wide span of control.

The advantages and disadvantages of these organisational forms can be summarised as follows.
Tall organisation
For Against
Narrow control spans Inhibits delegation
Small groups enable team members to participate
in decisions
Rigid supervision can be imposed, blocking
initiative
A large number of steps on the promotional
ladders assists management training and career
planning
The same work passes through too many hands
Increases administration and overhead costs
Slow decision making and responses, as the
strategic apex is further away

Flat organisation
For Against
More opportunity for delegation Requires that jobs can be delegated. Managers
may only get a superficial idea of what goes on. If
they are overworked they are more likely to be
involved in crisis management
Relatively cheap Sacrifices control
In theory, speeds up communication between
strategic apex and operating core
Middle managers are often necessary to convert
the grand vision of the strategic apex into
operational terms
8.2 Delayering
Delayering is the reduction of the number of management levels from bottom to top.
Many organisations are delayering. Middle line jobs are vanishing. Organisations are increasing the
average span of control, reducing management levels and becoming flatter.
(a) Information technology reduces the need for middle managers to process information.
(b) Empowerment. Many organisations, especially service businesses, are keen to delegate authority
down the line to the lowest possible level. Front-line workers in the operating core are allowed to
take decisions, in order to increase responsiveness to customer demands. This perhaps removes
the need for some middle management jobs.
(c) Economy. Delayering reduces managerial/supervisory costs.
(d) Fashion. Delayering is fashionable: if senior managers believe that tall structures are inherently
inflexible, they might cut the numbers of management levels.
9 Departmentation
In most organisations, tasks and people are grouped together in some rational way: on the basis of
specialisation, say, or shared technology or customer base. This is known as departmentation. Different
patterns of departmentation are possible, and the pattern selected will depend on the individual
circumstances of the organisation.
Organisations can be departmentalised on a functional basis (with separate departments for production,
marketing, finance etc), a geographical basis (by region, or country), a product basis (eg worldwide
divisions for product X, Y etc), a brand basis, or a matrix basis (eg someone selling product X in country
A would report to both a product X manager and a country A manager). Organisation structures often
feature a variety of these types, as hybrid structures.
9.1 Geographic departmentation
Where the organisation is structured according to geographic area, some authority is retained at Head
Office but day-to-day operations are handled on a territorial basis (eg Southern region, Western region).
Many sales departments are organised territorially.
There are advantages to geographic departmentation.
(a) There is local decision-making at the point of contact between the organisation (eg a salesperson)
and its customers, suppliers or other stakeholders.
(b) It may be cheaper to establish area factories/offices than to service markets from one location (eg
costs of transportation and travelling may be reduced).

But there are disadvantages too.
(a) Duplication and possible loss of economies of scale might arise. For example, a national
organisation divided into ten regions might have a customer liaison department in each regional
office. If the organisation did all customer liaison work from head office (centralised) it might need
fewer managerial staff.
(b) Inconsistency in methods or standards may develop across different areas.
Board of
Directors
Regional
Board
A
Regional
Board
B
Regional
Board
C
Production
dept
Finance
dept
Personnel
dept
Marketing
and sales
dept
etc etc
etc etc etc
Geographic
organisation

9.2 Functional departmentation
Functional organisation involves grouping together people who do similar tasks. Primary functions in a
manufacturing company might be production, sales, finance, and general administration. Sub-
departments of marketing might be market research, advertising, PR and so on.
Advantages include:
(a) Expertise is pooled thanks to the division of work into specialist areas.
(b) It avoids duplication (eg one management accounts department rather than several) and enables
economies of scale.
(c) It facilitates the recruitment, management and development of functional specialists.
(d) It suits centralised businesses.
Disadvantages include:
(a) It focuses on internal processes and inputs, rather than the customer and outputs, which are what
ultimately drive a business. Inward-looking businesses are less able to adapt to changing demands.
(b) Communication problems may arise between different functions, which each have their own
jargon.
(c) Poor co-ordination, especially if rooted in a tall organisation structure. Decisions by one
function/department involving another might have to be referred upwards, and dealt with at a
higher level, thereby increasing the burdens on senior management.
(d) Functional structures create vertical barriers to information and work flow. Management writer
Tom Peters suggests that customer service requires 'horizontal' flow between functions rather
than passing the customer from one functional department to another.


9.3 Product/brand departmentation
Some organisations group activities on the basis of products or product lines. Some functional
departmentation remains (eg manufacturing, distribution, marketing and sales) but a divisional manager is
given responsibility for the product or product line, with authority over personnel of different functions.
Advantages include:
(a) Accountability. Individual managers can be held accountable for the profitability of individual
products.
(b) Specialisation. For example, some salespeople will be trained to sell a specific product in which
they may develop technical expertise and thereby offer a better sales service to customers.
(c) Co-ordination. The different functional activities and efforts required to make and sell each product
can be co-ordinated and integrated by the divisional/product manager.
Disadvantages include:
(a) It increases the overhead costs and managerial complexity of the organisation.
(b) Different product divisions may fail to share resources and customers.
A brand is the name (eg 'Persil') or design which identifies the products or services of a manufacturer or
provider and distinguishes them from those of competitors. (Large organisations may produce a number
of different brands of the same basic product, such as washing powder or toothpaste.) Branding brings
the product to the attention of buyers and creates brand recognition, differentiation and loyalty: often
customers do not realise that two 'rival' brands are in fact produced by the same manufacturer.
(a) Because each brand is packaged, promoted and sold in a distinctive way, the need for
specialisation may make brand departmentation effective. As with product departmentation, some
functional departmentation remains but brand managers have responsibility for the brand's
marketing and this can affect every function.
(b) Brand departmentation has similar advantages/disadvantages to product departmentation.

9.4 Customer departmentation
An organisation may organise its activities on the basis of types of customer, or market segment.
(a) Departmentation by customer is commonly associated with sales departments and selling effort,
but it might also be used by a jobbing or contracting firm where a team of managers may be given
the responsibility of liaising with major customers (eg discussing specifications and completion
dates, quality of work, progress chasing etc).
(b) Many businesses distinguish between business customers and consumers.

Question
Types of organisation

Looking at the 'Product/Brand Organisation' chart following Section 9.3 above, what types of organisation
can you identify, and why are these appropriate for their purposes? What added type of organisation might
this firm use, and in what circumstances?

Answer

At the head office level, there is functional organisation. This enables standardisation of policy and
activity in key 'staff' or support functions shared by the various divisions.
At divisional level, there is product/brand organisation. This allows the distinctive culture and
attributes of each product/brand to be addressed in production processes and marketing approach.
For each product/brand, there is functional organisation, enabling specialist expertise to be directed
at the different activities required to produce, market and distribute a product.
This firm may further organise its marketing department by customer, if its customer base includes
key (high-value, long-term) customer accounts with diverse service needs, for example.
It may further organise its sales and distribution departments by geographical area, if the customer
base is internationally or regionally dispersed: local market conditions and values, and logistical
requirements of distribution, can then be taken more specifically into account.

9.5 Hybrid structures
As suggested by our question ('Types of organisation'), organisation structures are rarely composed of
only one type of organisation, although an all-functional structure is theoretically feasible. 'Hybrid'
structures may involve a mix of functional departmentation, ensuring specialised attention to key
functions, with elements of (for example):
(a) Product organisation, to suit the requirements of brand marketing or production technologies.
(b) Customer organisation, particularly in marketing departments, to service key accounts.
(c) Territorial organisation, particularly of sales and distribution departments, to service local
requirements for marketing or distribution in dispersed regions or countries.
9.6 Matrix and project organisation
Where hybrid organisation 'mixes' organisation types, matrix organisation actually crosses functional and
product/customer/project organisation.
Project/Product
Manager B
Project/Product
Manager C
Project/Product
Manager A
Sales
Dept
Finance
Dept
Production
Dept
Distribution
Dept
R & D
Dept
Marketing
Dept

The employees represented by the dot in the above diagram, for example, are responsible to:
The finance manager for their work in accounting and finance for their functional department; and
To the project manager C for their work on the project team: budgeting, management reporting and
payroll relevant to the project, say.
Advantages of matrix organisation include:
(a) Greater flexibility of:
(i) People. Employees develop an attitude geared to accepting change, and departmental
monopolies are broken down.
(ii) Workflow and decision-making. Direct contact between staff encourages problem solving
and big picture thinking.
(iii) Tasks and structure. The matrix structure may be readily amended, once projects are completed.
(b) Inter-disciplinary co-operation and a mixing of skills and expertise, along with improved
communication and co-ordination.
(c) Motivation and employee development: providing employees with greater participation in planning
and control decisions.
(d) Market awareness: the organisation tends to become more customer/quality focused.
(e) Horizontal workflow: bureaucratic obstacles are removed, and department specialisms become less
powerful.
There are disadvantages, however.
(a) Dual authority threatens a conflict between functional managers and product/ project/area
managers.
(b) An individual with two or more bosses may suffer stress from conflicting demands or ambiguous
roles.
(c) Cost: product management posts are added, meetings have to be held, and so on.
(d) Slower decision making due to the added complexity.
10 Decentralisation and divisionalisation
10.1 Divisionalisation
In a divisional structure some activities are decentralised to business units or regions.
Divisionalisation is the division of a business into autonomous divisions, regions or product businesses,
each with its own revenues, expenditures and capital asset purchase programmes, and therefore each with
its own profit and loss responsibility.
Each division of the organisation might be:
A subsidiary company under the holding company
A profit centre or investment centre within a single company
Successful divisionalisation requires certain key conditions.
(a) Each division must have properly delegated authority, and must be held properly accountable to
head office (eg for profits earned).
(b) Each unit must be large enough to support the quantity and quality of management it needs.
(c) The unit must not rely on head office for excessive management support.
(d) Each unit must have a potential for growth in its own area of operations.
(e) There should be scope and challenge in the job for the management of each unit.
(f) If units deal with each other, it should be as an 'arm's length' transaction. There should be no
insistence on preferential treatment to be given to a 'fellow unit' by another unit of the overall
organisation.
The benefits and drawbacks of divisionalisation may be summarised as follows.
Advantages Disadvantages
Focuses the attention of management below 'top
level' on business performance.
In some businesses, it is impossible to identify
completely independent products or markets for
which separate divisions can be set up.
Reduces the likelihood of unprofitable products
and activities being continued.
Divisionalisation is only possible at a fairly senior
management level, because there is a limit to how
much discretion can be used in the division of
work. For example, every product needs a
manufacturing function and a selling function.
Encourages a greater attention to efficiency, lower
costs and higher profits.
There may be more resource problems. Many
divisions get their resources from head office in
competition with other divisions.
Gives more authority to junior managers, and so
grooms them for more senior positions in the
future (planned managerial succession).

Reduces the number of levels of management. The
top executives in each division should be able to
report directly to the chief executive of the holding
company.

10.2 Centralisation and decentralisation
A centralised organisation is one in which authority is concentrated in one place.
We can look at centralisation in two ways.
(a) Geography. Some functions may be centralised rather than 'scattered' in different offices,
departments or locations.
So, for example, secretarial support, IT support and information storage (filing) may be centralised
in specialist departments (whose services are shared by other functions) rather than carried out by
staff/equipment duplicated in each departmental office.
(b) Authority. Centralisation also refers to the extent to which people have to refer decisions upwards
to their superiors. Decentralisation therefore implies increased delegation, empowerment and
autonomy at lower levels of the organisation.
10.3 Benefits and drawbacks of decentralisation
Centralisation offers greater control and co-ordination; decentralisation offers greater flexibility.
The table below summarises some of the arguments in favour of centralisation and decentralisation.
Benefits of decentralisation Drawbacks of decentralisation
Avoids overburdening top managers, in terms of
workload and stress.
Decisions are not made at one point and may not
be co-ordinated properly.
Improves motivation of more junior managers who
are given responsibility.
Junior managers may not have all the facts to make
correct decisions.
Greater awareness of local problems by decision
makers. (Geographically dispersed organisations
are often decentralised on a regional/area basis for
this reason.)
Local decisions may not be in interests of whole
group.
Greater speed of decision making, and response to
changing events, since no need to refer decisions
upwards. This is particularly important in rapidly
changing markets.
Local management may lack experience and make
wrong decisions.
Helps develop the skills of junior managers:
supports managerial succession.
May be cheaper to not decentralise and have fewer
managers.
Separate spheres of responsibility can be identified:
controls, performance measurement and
accountability are better.
Responsibility can be identified even with
centralised operations.
Communication technology allows decisions to be
made locally, with information and input from head
office if required.
Needs sophisticated, expensive systems to co-
ordinate local decisions.
The drawbacks to decentralisation, identified in the table above, can be overcome as follows.
It is the responsibility of the holding company's board of directors to ensure that co-ordinated
decisions are taken across the group, regardless of the level of decentralisation in the group. Co-
ordination will be more difficult in a decentralised group, but that simply means that the bound
must work harder to discharge its responsibility properly.
The computerisation of management information systems in recent years has enabled managers
to have access to any facts they wish to know about a decision they are taking. The problem is
often that managers have access to too much information rather than too little.

Again it is the responsibility of the holding company's board to ensure goal congruence of
decision making across the group. Ideally systems should be structured so that local managers
are motivated to take decisions which happen to be in the best interests of the group as a whole.
Local management may certainly lack experience, but it is the role of decision support systems to
help them make the current decisions.
It may indeed be cheaper to not decentralise, but it is up to the holding company board to weigh
up the costs and benefits of decentralisation.
Unclear limits of responsibility in a decentralised organisation will only be the case when the
holding company board has failed to specify responsibilities carefully enough. It is perfectly
possible for managers in a decentralised group to know what their responsibilities and duties are.
The need for co-ordination systems has been described above, but the plummeting cost of IT
systems over the last ten or so years means that such systems need no longer be prohibitively
expensive.
11 Summary: the decision-making process
The decision-making process has six steps.
Identify objectives
Search for alternative courses of action
Collect data about the alternative courses of action
Select the appropriate course of action
Implement the decision
Compare actual and planned outcomes and take corrective action as necessary
There are three broad perspectives to performance management:
(a) Planning and decision-making
(b) Measuring performance
(c) Managing performance (control)
The following steps, describing what is sometimes known as the 'decision-making process', describe the
processes of planning, performance measurement and control.
Step 1

Identify objectives
The organisation's goals or objectives must be defined to ensure that managers are able to
assess which of the courses of action available is the most appropriate for the organisation.
The objectives of many profit-making organisations include the maximisation of profit and
so the decision option chosen should reflect this. Non-profit-making organisations such as
hospitals and charities are likely to have an objective based on providing the most effective
services with the resources available.
Step 2

Search for alternative courses of action
The next step is to find a number of possible courses of action that enable the objectives to
be achieved. A profit-making organisation might need to consider:
Developing new products to sell in existing markets
Developing new products to sell in new markets
Developing new markets in which to sell existing products

Step 3

Collect data about the alternative courses of action
The type of data that needs collecting will depend on the type of decision. If the decision is
concerned with the long-term future of the organisation, the manager will need to collect
data about the environment in which the organisation operates and about the organisation's
capabilities. If the decision is more concerned with the short-term future of the organisation
(such as deciding on the selling price for a product), data on the selling price of
competitors' products will have to be collected.
Step 4

Select the appropriate course of action
The course of action which best satisfies the organisation's objectives should be selected.
Step 5

Implement the decision

Step 6

Compare actual and planned outcomes and take any necessary corrective action if the
planned results have not been achieved
The final stage in the process involves comparing actual results with planned and taking
control action required.
Techniques for planning, decision-making, measuring performance and applying control over
performance, are the subject of the remainder of this text.
12 Reporting formats
In exam questions and the DipFM projects you may be asked to produce your answer in a specific format,
most commonly a letter, a memo, an e-mail or a formal report.
We include here some notes on the format that you should use for each of these requirements.
12.1 Letters
You are most likely to use a letter when communicating with someone outside your organisation.
Letters should be polite, accurate, clear, logical and concise; and should give appropriate references.
Spelling and punctuation should, of course, be impeccable! Also, if your company has a house-style, your
letter should conform to that.
12.2 Example: a letter
Brown Bros
24 Croxley Road
Coulton
Surrey
RH3 9BZ

Tel: 0192 730 1933
Fax: 0192 730 1934

Date: 11 May 20X1
Our ref: ACF/pj

Your ref: LRS/NP

The Invoice Clerk
Pebble and Sons
16 Rowe Street
Lambourn
Berks
MA6 3AJ

Dear Sir

Re: (subject of letter)

Yours faithfully
C Ford

Carol Ford, Accounts Supervisor
Body of letter
Yours faithfully goes with 'Dear Sir'. 'Yours sincerely' is
used when writing to a named person (eg, Mr Smith)
Type name and title under signature
Always use this if you have it from
previous correspondence
Required so that letter can
be filed and retrieved
If possible, address to a
specific individual


Question
Letters

If you begin a letter 'Dear Sir', you should sign the letter
A Yours sincerely
B Yours faithfully
C Yours truly
D Yours gratefully

Answer

B Yours faithfully is the formal ending if the recipient's name is not used. A would be used if the
recipient's name had been referred to, eg 'Dear Mr Jackson'. C and D are not generally used in
business letters.

12.3 Memos
The memorandum or memo performs internally the same function as a letter does in communication
externally. It can be used for any kind of communication that is best conveyed in writing such as reports,
brief messages or notes.
Memos need less detail than a formal letter.
12.4 Example: a memo
Forrest Fire Extinguishers Ltd
MEMORANDUM
To: All Staff Ref: PANC/mp
From: D B Gavaskar, Managing Director Date: 13 January 20X0
Subject: Overtime arrangements for January/February
I would like to remind you that thanks to Pancake Day on and around 12 February, we can expect the usual
increased demand for small extinguishers. I am afraid this will involve substantial overtime hours for
everyone.
In order to make this as easy as possible, the works canteen will be open all evening for snacks and hot
drinks. The works van will also be available in case of transport difficulties late at night.
I realise that this period puts pressure on production and administrative staff alike, but I would appreciate
your co-operation in working as many hours of overtime as you feel able.
Copies to: All staff
Main theme
Reason for writing
Finish by stating clearly what is
required of recipient in response
No need to
sign off

Question
Memoranda

A memorandum is
A Signed by the person sending it
B Generally used for the communication of short messages between different organisations
C Not used if important information is to be communicated
D For any written communication within an organisation

Answer

D A memo can be used for internal communication of information that is presented in writing, so B
and C are incorrect. A is incorrect as it does not have to be signed.

12.5 E-mails
If available, you can use e-mails in the same way as a memo, or for external communications where
signatures are unnecessary. An e-mail would therefore not be suitable for confirming a contract, but you
can use it to respond to a price query.
12.6 Reports
It is highly likely that you will have to use a report format in the DipFM projects. Further detailed guidance
on the writing of reports is given in the BPP Learning Media Project Text. See the inside front cover of this
book for details.
Standard reports are a regular part of the management information system.
Ad-hoc reports deal with a one-off issue or problem.
A formal report may be needed where a comprehensive investigation has taken place.
ELEMENTS OF A FORMAL REPORT
Title Subject of report
Terms of reference Clarify what has been requested
Introduction Who the report is from and to
How the information was obtained
Main body Divided into sections with sub-headings to aid reader
Logical order
Conclusions Summarises findings
Recommendations Based on information and evidence
May be combined with conclusion
Signature Of writer
Executive summary Saves time for managers receiving a long report
No more than one page
One example of a short formal report is shown on the next page.

12.7 Example: short formal report
REPORT ON PROPOSED UPDATING OF COMPANY POLICY MANUAL
To: Board of Directors, BCD Ltd
From: J Thurber, Opus Management Consultants
Status: Confidential
Date: 3 October 20X8
I INTRODUCTION AND TERMS OF REFERENCE
This report details the results of an investigation commissioned by the Board on 7 September
20X8. We were asked to consider the current applicability of the company's policy manual and to
propose changes needed to bring it into line with current practice.
II METHOD
The following investigatory procedures were adopted:
1 Interview all senior staff regarding use of the policy manual in their departments
2 Observe working practices in each department
III FINDINGS
The manual was last updated 10 years ago. From our observations, the following amendments are now
needed:
1 The policy section on computer use should be amended. It deals with safe storage of
disks, which is no longer applicable as data is now stored on a server. Also, it does not set
out the company's e-mail policy.
2 The company's equal opportunities policy needs to be included.
3 The coding list in the manual is now very out of date. A number of new cost centres and
profit centres have been set up in the last 10 years and the codes for these are not noted
in the manual.
4 There is no mention of the provisions of the Data Protection Act as they relate to the
company.
IV CONCLUSIONS
We discovered upon interviewing staff that very little use is made of the policy manual. When it
has been amended as above, it can be brought back into use, and we recommend that this should
be done as soon as possible.
Signed J Thurber, Opus Management Consultants
A formal report like this will of course be word-processed.

Question
Communication methods

In each of the cases below, select the form of communication which will generally be the most
appropriate.
1 A complaint to a supplier about the quality of goods supplied.
A Letter
B Memo
C Formal report
D E-mail
2 A query to a supervisor about the coding of an invoice.
A E-mail
B Memo
C Face-to-face
D All of the above are equally suitable if available
3 An investigation into the purchasing costs of your company.
A Letter
B Memo
C Formal report
D E-mail
4 Notification to customers of a change of the company's telephone number.
A Letter
B Memo
C E-mail
5 Reply to an e-mail.
A Letter
B Memo
C E-mail
D Face-to-face
6 Query to the sales department about an expenses claim.
A Memo
B E-mail
C Telephone

Answer

1 A
2 D
3 C
4 A
5 C
6 D

32 2: Costing systems for performance management

1 Costing
Costing is the process of determining the costs of products, services or activities.
Costing systems must be flexible enough to provide different costs for different purposes.
Costing is the process of determining the costs of products, services or activities.
Given the definition of costing we have adopted above, use of costing methods to provide information
(such as the estimated cost of job X) is part of cost accounting. Use of that information (such as whether
or not to proceed with job X given estimated costs) is part of management accounting.
In this text we will be looking at how to use various costing methods and considering how to use the
resulting information.
1.1 The importance of flexibility
The costing systems used by an organisation need to provide information for a wide variety of purposes
in a wide range of organisations (including not-for-profit organisations).
1.1.1 Flexibility and decision making
Management face a wide variety of decisions on an hourly, daily, weekly and monthly basis.
(a) Routine planning decisions, for example, budgeting. Budgeting decisions commonly analyse fixed
and variable costs, together with revenues, over a one-year period. They are also often concerned
with how to make the best use of scarce resources.
(b) Short-run problem decisions, typically, unforeseen 'one-off' special decisions of a non-recurring
nature, where the costs and benefits are all obtained within a relatively short period. For example,
should a contract be accepted or rejected? What price should be quoted in the tender for a
contract?
(c) Investment or disinvestment decisions, for example should an item of equipment be purchased?
Should a department be shut down? Decisions of this nature often have long-term consequences.
(d) Longer-range decisions, meaning decisions made once and reviewed infrequently, but which are
intended to provide a continuing solution to a continuing or recurring problem. They include
decisions about selling and distribution policies (such as whether goods should be sold through
middlemen or direct to customers? What type of customer should the sales force attempt to

Costing systems for
performance
management

2: Costing systems for performance management 33
attract? What should the company's discount policies be? Should a new product or service be
launched?)
(e) Control decisions, for example, should disappointing performance be investigated, given that the
benefits expected must exceed the costs from investigation and control?
It should be clear from the examples given that the management accountant will frequently be involved in
providing information for business decisions of all kinds. Costing systems therefore need to be sufficiently
flexible to provide the required information.
1.1.2 Flexibility and performance evaluation
Performance evaluation entails setting targets, recording actual performance and comparing this to target
performance. This sounds straightforward enough, doesn't it? The identification of appropriate
performance measures to affect the appropriate behavioural response is often difficult, however, and
costing systems are often unable to provide the target and actual information. For example, if divisional
management are appraised using a profit figure which includes non-controllable costs at division level and
apportioned group costs and/or the costing system is unable to provide a figure for controllable profit, a
negative motivational impact is likely. We consider these issues more fully throughout the text.
What should now be clear is that costing systems need to be flexible enough to provide different costs
for different purposes.
2 Measuring cost
The purpose of a costing system is to provide information about the costs of activities within an
organisation, and the costs of the goods produced and sold or the services provided by the organisation.
Establishing the cost of a product or service will help management to:
(a) Prepare cost budgets for the future, based on costs incurred in the past, or forecast what costs are
likely to be in the future
(b) Establish the profitability of the product or service
(c) Compare actual costs with budgeted costs, to establish whether actual costs are suitably under
control
(d) Possibly, make certain decisions, such as setting prices for the product or service at a margin or
mark-up above cost
(e) Possibly, to reward managers for good performance, for example if actual profits exceed budgeted
profits
2.1 Cost units
A cost unit is a unit of a product or service (or activity) for which costs are measured.
A cost unit may be a standard item, such as a can of baked beans or a litre of cooking oil. A cost unit is
not always a single item. It might be a batch of an item. Examples of cost units are an individual job or
contract, a batch of 1,000 pairs of shoes, or a tonne of bricks. A doctor or dentist operating a practice
might want to establish the cost per surgery hour. Other examples of cost units are a passenger mile (in
other words, the average cost of transporting a passenger for a mile) and a patient night (the average cost
of an overnight stay of a patient in a hospital bed).
2.2 Cost of a manufactured unit
The cost of manufactured products is typically measured as the sum of its production cost, plus a unit
cost of sales and distribution, plus a unit cost of administration. The requirement to identify the
production cost per unit arises because items of finished goods in inventory (and part-finished work-in-
progress) are valued at production cost in the financial statements of the business.
2.3 Cost centres
Cost centres are the essential 'building blocks' of a costing system. They act as a collecting place for
certain costs before they are analysed further.
A cost centre might be a place or physical location, such as a department (eg the stores department, the
repairs and maintenance department, the production scheduling department, the IT department, and so
on). On the other hand, a cost centre might be an individual person, such as the company solicitor. It
might be a group of people, all contributing to the same function, such as the accounts staff, say, or the
research laboratory staff. Alternatively, a cost centre might be an item of equipment, such as a machine
which incurs costs because it needs to be oiled, maintained and operated.
Cost centres may vary in nature, but what they all have in common is that they incur costs. It is therefore
logical to collect costs initially under the headings of the various different cost centres that there may be
in an organisation. Then, when we want to know how much our products cost, we simply find out how
many cost units have been produced and share out the costs incurred by that cost centre amongst the
cost units.
2.4 Profit centres
Some organisations measure performance on a profit centre basis. Cost centres only have costs
attributed to them. Profit centres, on the other hand, also receive credit for the revenues associated with
those costs. For example, an organisation with two departments each making a different product will
allocate the revenues from each product to the department where each product is made. This ensures that
the organisation has some idea as to the relative profitability of each product.
A profit centre is similar to a cost centre but is accountable for both costs and revenues.
Profit centre managers should normally have control over how revenue is raised and how costs are
incurred. Not infrequently, several cost centres will comprise one large profit centre.
3 Direct costs and indirect costs (overheads)
Costing systems are used to measure the cost of products, services and activities, and to establish their
profitability. Costs can be measured as the sum of direct costs and indirect costs (overheads). Costs may
also be measured as the sum of variable costs and fixed costs.
A distinction is made between direct and indirect costs.
3.1 Direct costs
A direct cost is a cost that can be traced in full to the cost unit or cost centre (product, service, or
department) that is being costed.
Direct material is all material becoming part of the product (unless used in negligible amounts
and/or having negligible cost), or consumed in the provision of a service.
Direct wages are all wages paid for labour (either as basic hours or as overtime) expended on the
work of making the product or providing the service. Direct wages are the costs of the employees
involved directly in the work, and exclude the labour costs of support staff. The direct wages and
salaries cost of a department consist of the wages and salaries of the individuals employed in the
department.
Direct expenses are any expenses which are incurred on a specific product, other than direct
material cost and direct wages.

Examples of direct expenses may be:
the cost of special designs, drawings or layouts for a specific job
the hire of tools or equipment for a particular job
maintenance costs of tools, fixtures, fittings and so on, incurred on a specific job or contract
3.2 Indirect costs (overheads)
Indirect costs, more commonly known as overheads, are all costs that are not direct costs.
An overhead is the cost incurred in the course of making a product, providing a service or running a
department, but which cannot be traced directly and in full to the product, service or department.
Overheads consist of the following:
indirect materials
indirect labour
indirect expenses
Unit costs therefore consist of the following items.
Materials = Direct materials + Indirect materials
+ + +
Labour = Direct labour + Indirect labour
+ + +
Expenses

=

Direct expenses

+

Indirect expenses

Total cost

=

Direct cost

+

Overhead

An absorption costing system or full costing system is used to measure the cost of items (products or
services), as the sum of direct costs plus overheads. 'Absorption' of overheads means assigning overhead
costs to cost items (products or services).
A common way of categorising overheads is between
(a) production (or factory) overhead
(b) administration overhead
(c) selling and distribution overhead
Production (or factory) overhead includes all indirect material costs, indirect wages and indirect
expenses incurred in the factory from receipt of the order until its completion.
Administration overhead is all indirect material costs, wages and expenses incurred in the
direction, control and administration of an undertaking.
Selling overhead is all indirect materials costs, wages and expenses incurred in promoting sales
and retaining customers.
Distribution overhead is all indirect material costs, wages and expenses incurred in making the
packed product ready for despatch and delivering it to the customer.
Examples of production overhead include the following.
(a) Indirect materials that cannot be traced in the finished product, such as consumable stores like
cleaning materials.
(b) Indirect wages, meaning all wages not charged directly to a product. These include the wages or
salaries of non-productive personnel in the production department, such as supervisors.
(c) Indirect expenses (other than material and labour) not charged directly to production typically
include rent, rates and factory insurance of a factory, and depreciation charges for plant and
machinery.
In traditional costing systems, all administration costs and most selling and distribution costs are treated
as indirect costs (overheads) for products or services.
Examples of administration overhead are as follows.
(a) Depreciation of office buildings and machinery.
(b) Office salaries, including salaries of administrative directors, secretaries and accountants.
(c) Rent, rates, insurance, lighting, cleaning and heating of general offices, telephone and postal
charges, bank charges, legal charges, audit fees.
Examples of selling overhead are as follows.
(a) Costs of printing and stationery, such as catalogues and price lists.
(b) Salaries of sales representatives and sales department staff.
(c) Advertising and sales promotion, market research.
(d) Rent, rates and insurance of sales offices and showrooms, bad debts and collection charges, cash
discounts allowed, after-sales service.
Sales commission that is calculated as a percentage of the value of sales should be treated as a direct
selling cost.
Distribution costs are usually treated as overheads, because of the difficulty in tracing specific costs
directly to individual cost units. Examples of distribution overhead are as follows.
(a) Cost of packing cases.
(b) Wages of packers, drivers and despatch clerks.
(c) Freight and insurance charges, rent, rates, insurance and depreciation of warehouses, depreciation
and running expenses of delivery vehicles.
3.3 Components of 'full cost'
In 'traditional' costing systems, the unit cost of production has been calculated as the sum of the
following items.

$

Direct materials

X

Direct labour

X

Direct expenses (possibly)

X

Production overhead

X

Full production cost

X

Administration overhead

X

Selling and distribution overhead

X

Full cost of sale

X

In many organisations, overhead costs are a substantial proportion of the total unit cost of a product.
4 Fixed costs and variable costs
Costs that are partly-fixed and partly-variable can be segregated into their fixed cost and variable cost
elements using the high-low method.
In addition to analysing costs as direct or indirect, they can also be categorised as fixed costs or variable
costs, according to whether they change with variations in the 'level of activity' (production and sales
volume, etc).
A fixed cost is an item of cost relating to a particular period of time and which, within certain
activity levels, is unaffected by changes in the level of activity during that time period.
A variable cost is a cost that tends to vary, in total amount, with the level of activity.

Some examples of fixed costs and variable costs are as follows.
(a) Direct material costs are variable costs because the total cost of direct materials rises as more
units of a product are manufactured.
(b) Sales commission is often a fixed percentage of sales revenue, and so is a variable cost that varies
with the level of sales.
(c) Telephone call charges are likely to increase if the volume of business expands, and so they are
likely to be a variable overhead cost.
The rental cost of business premises is a constant amount, at least within a stated time period, and so is a
fixed cost.
Within a normal range of activity levels (ie those activity levels that would be expected to occur over a
number of periods under normal circumstances) the variable cost per unit of an item is usually a constant
amount. For example, the variable cost of a product might be, say, $6 per unit. The total variable cost will
rise as output rises. The total variable cost of 500 units, for example, would be $3,000 and the total
variable cost of 600 units would be $3,600.
Within a normal range of activity levels, the total amount of a fixed cost remains the same, regardless of
the activity level. However, the fixed cost per unit of output falls as the activity level rises within a given
time period.
For example, suppose that the cost of a unit of product is $8 for direct materials, $6 for direct labour
(which is regarded as a variable cost, consisting of one hour of labour time at $6 per hour) and $1 for
variable overhead. Fixed costs are $50,000 a year.
(a) If annual output is 5,000 units, the cost per unit will be $15 of variable costs ($8 + $6 + $1) and
$10 of fixed overhead per unit ($50,000/5,000), making $25 per unit in total (full cost).
(b) However, if annual output is higher, say 10,000 units, the cost per unit will still be $15 of variable
costs ($8 + $6 + $1) but the fixed overhead cost per unit will only be $5 ($50,000/10,000), making
just $20 per unit in total (full cost).
4.1 Direct and indirect costs, and fixed and variable costs
Variable costs are often direct costs, but variable cost is not just another name for a direct cost. The
distinctions that can be made are as follows.
(a) Costs are either variable or fixed, depending upon whether they change when the volume of
production changes.
(b) Costs are either direct or indirect, depending upon how easily they can be traced to a specific unit
of production.

Question
Fixed and variable costs

Are the following likely to be fixed or variable costs?
(a) Cost of telephone calls made
(b) Cost of rental of telephone system
(c) Annual salary of the chief accountant
(d) Managing director's subscription to the Institute of Directors
(e) Cost of materials used to pack every 20 units of product X into a box

Answer

(a) Variable cost. Call charges vary with the number and duration (and time of day) of calls, but are
also likely to vary with the general volume of activity in the organisation, eg with the volume of
production output. Where an organisation agrees fixed call charges for a period with the
telecommunications service provider, call charges will be a fixed cost.
(b) Fixed cost
(c) Fixed cost
(d) Fixed cost
(e) Variable cost

4.2 Semi-variable costs
Some items of cost are known as semi-variable costs (or semi-fixed costs or mixed costs). These costs
combine a fixed element and a variable element.
A semi-variable or semi-fixed cost, or mixed cost, is a cost containing both fixed and variable
components and so is partly affected by changes in the level of activity.
Examples of semi-variable costs include the following.
(a) Electricity and gas bills
Fixed cost = standing charge
Variable cost = charge per unit of electricity used
(b) Sales representatives' salaries
Fixed cost = basic salary
Variable cost = commission on sales made
(c) Costs of running a car
Fixed cost = road tax, insurance
Variable costs = petrol, oil, repairs (which vary with miles travelled)
4.3 Separating semi-variable costs into a fixed and a variable element
Semi-variable costs can be segregated into a fixed-cost element and a variable cost per unit of activity. A
technique for doing this is known as the 'high-low method'. To apply this technique, we need two figures
for total costs:
(a) the total cost at one level of activity
(b) the total cost at another level of activity
The total cost will be lower at the lower activity level and higher at the higher activity level. Since fixed
costs are the same at both activity levels, the difference in the two costs must be the variable cost of the
difference in the activity levels.
For example, suppose that the total monthly production overhead costs of an organisation have been
measured at $78,000 when output was 4,800 units and $81,600 when output was 5,700 units. The fixed
costs per month and the variable overhead cost per unit can be calculated as follows.

$

(High)

Total cost of 5,700 units

81,600

(Low)


78,000

(Difference)

Variable cost of 900 units

3,600

Variable cost per unit ($3,600/900)

$4


$


81,600

Less: Variable cost of 5,700 units

($4 per unit)

22,800

Fixed costs

58,800

Note that the same result would have been obtained if the data for 4,800 units was used.

Question
Costs: high-low method

Sandstorm is a firm of gas boiler maintenance engineers. Its indirect costs are thought to be partly
variable, with the variable cost element depending on the number of hours worked by maintenance
engineers each month.
It has been established that costs were $57,600 in a month when 22,000 engineer hours were recorded,
and $54,800 in a month when 20,600 engineer hours were recorded.
Required
Using the high-low method, estimate the fixed costs per month and variable cost per engineer hour.
Answer

$

(High)

Total cost of 22,000 hours

57,600

(Low)


54,800

(Difference)

Variable cost of 1,400 hours

2,800

Variable cost per hour ($2,800/1,400)

$2

$


57,600


($2 per hour)

44,000

Fixed costs

13,600

4.4 Stepped costs
Another type of cost is a stepped cost. This type of cost is fixed over a certain range of activity, but if the
activity level rises above or below a certain level, the total cost of the item will rise or fall to a new fixed
level. In other words, the cost rises or falls by a step. For example, the cost of warehouse rental might be
fixed up to a certain volume of output each month, but if output rises above this level, the organisation
might have to rent additional warehouse space, raising 'fixed costs' to a new level.
4.5 Controllable costs and uncontrollable costs
A controllable cost is a cost which can be influenced by management decisions and actions.
An uncontrollable cost is any cost that cannot be affected by management within a given time
span.
It is sometimes assumed wrongly, that direct costs should be controllable, whereas indirect costs are
likely to be uncontrollable. This is not the case. Direct costs might be uncontrollable in the short term (eg
direct labour costs for a work force paid fixed wages). Some indirect costs, on the other hand, might be
controllable, through cost-cutting measures.
Managers should only be held accountable for costs over which they have some control or influence. The
behavioural implications of this for performance measurement are discussed in more detail in Chapters 9
and 13.
5 Absorption costing
Overhead is the cost incurred in the course of making a product, providing a service or running a
department, but which cannot be traced directly and in full to the product, service or department. The
main groupings of overhead costs are production overhead, administration overhead, selling and
distribution overhead.
Overheads may be dealt with by absorption costing, activity-based costing or marginal costing.
The main reasons for using absorption costing are for inventory valuations, pricing decisions and
establishing the profitability of different products.
Allocation, apportionment and absorption are the three stages of calculating the costs of overheads to be
charged to manufactured output.
Apportionment is a procedure whereby indirect costs (overheads) are spread fairly between cost centres.
Overhead absorption is the process whereby costs of cost centres are added to unit, job or process costs.
Overhead absorption is sometimes called overhead recovery.
Absorption costing is a method of measuring the cost of products, services or activities. The objective of
absorption costing is to include in the total cost of a product an appropriate share of the organisation's
total overhead. By an appropriate share we mean an amount that reflects the amount of time and effort
that has gone into producing a unit or completing a job.
The 'full cost' or 'fully-absorbed cost' of an item therefore consists of:
(a) the direct costs of the item, plus
(b) a fair share of overhead
In many absorption costing systems, only production overheads are added to product costs.
Administration overheads and sales and distribution overheads are treated as separate expenses in the
income statement.
Suppose that a company makes and sells 100 units of a product each week. The direct cost per unit is $6
and the unit sales price is $10. Production overhead costs $200 per week and administration, selling and
distribution overhead costs $150 per week. The weekly profit could be calculated as follows.

$

$

Sales (100 units $10)

1,000

Direct costs (100 $6)

600

Production overheads

200

Administration, selling, distribution costs

150

950

Profit

50

In absorption costing, production overhead costs will be added to each unit of product manufactured and
sold.

$ per unit

Direct cost per unit

6

Production overhead ($200 per week for 100 units)

2

Full factory cost

8

The weekly profit would be calculated as follows.

$

Sales

1,000

Less factory cost of sales (100 $8)

800

Gross profit

200

Less administration, selling, distribution costs

150

Net profit

50

If an organisation produced a single standard product (or provided a single standard service) then the
overhead cost per unit would be calculated by dividing the total overhead costs among the total units
produced.
In practice, firms produce a variety of products or services, or single products in different sizes, and a fair
method of sharing overhead costs between the products or services needs to be established.
5.1 Reasons for absorption costing
Before describing absorption costing in more detail, it may be useful to consider the reasons why
absorption costing might be used. The reasons for using absorption costing have traditionally been
identified as follows.
(a) Inventory valuations. Inventory in hand must be given a value. It is usual for inventory to be valued
at a full cost, inclusive of production overheads. Absorption costing is recommended for financial
reporting by the International Accounting Standard on inventories (IAS 2). IAS 2 deals with
financial accounting systems and not with internal management accounting systems. The
management accountant is (in theory) free to value inventories by whatever method seems best.
However, where companies integrate their financial accounting and cost accounting systems into a
single system of accounting records, the valuation of closing inventories will be determined by
IAS 2, and at full cost.
(b) Assessing profitability. An organisation needs to ensure that it earns sufficient revenues to cover
all its costs, including indirect costs, and make a profit. By charging all products or services with a
fair share of overheads, management can assess whether the profitability of individual products or
services is sufficient.
(c) Pricing decisions. Many companies attempt to fix selling prices by calculating the full cost of
production or sales of each product, and then adding a margin for profit. For example, a firm may
price an item by adding a standard margin of, say, 25% to the full cost. 'Full cost plus pricing' can
be particularly useful for companies that do jobbing or contract work, where each job or contract is
different, so that a standard unit sales price cannot be fixed. Without using absorption costing, a
full cost is difficult to ascertain.
5.2 Absorption costing procedures
There are three stages in measuring the amount of overhead costs to be charged to manufactured output.
These are allocation, apportionment and absorption.
(a) The first stage in absorption costing in manufacturing is to charge all production overheads to the
departments that are directly engaged in production work. This is the purpose of allocation and
apportionment.
(i) Allocation is the process of assigning costs to cost centres. An allocated overhead is an
indirect cost that is fully attributable to a particular cost centre.
(ii) Apportionment means 'sharing out'. Not all indirect costs can be allocated directly to
production departments, and so they are shared out between departments on a fair basis.
(b) Next, the overheads charged to the production departments in this way are added to ('absorbed
into') the cost of products worked on by that department. An 'absorption rate' is established for
adding overheads to product costs.
5.3 Example: overhead apportionment
A simplified example might help to illustrate the absorption costing method.
A manufacturing company produces a range of electronic products at a plant. The plant has two
production departments, department A and department B, and most products are worked on in both
departments before despatch to customers.
Production overheads for a particular period are as follows:
Item of cost

Total cost

$

Directly attributable to department A

43,700

Directly attributable to department B

60,300

Factory depreciation

3,000

Repairs and maintenance

15,000

Stores

22,000

Factory office

24,000

Equipment insurance

5,000

Heating and lighting

4,000

Canteen

21,000

Total

198,000

Other information is as follows.
Department A
Department B

Value of plant and machinery $200,000

$300,000
Machine hours worked 3,600

900
Direct labour hours worked 6,000 18,000
Number of employees 40 80
Value of materials requisitioned from stores $150,000 $50,000
Floor area (square metres) 18,000 27,000
How might the production overhead costs be charged to units of production?
Solution
In this example, some overhead costs have been directly allocated to each production department, but
other costs are 'shared' by the two departments, and cannot be allocated in full to either department.
These costs must be apportioned between the two departments on a fair basis.
There are no rules about selecting a basis for apportionment. In this example, it would seem 'fair' to
apportion the cost of depreciation of the factory building on the basis of floor area taken up by each
department, and to apportion the costs of the canteen on the basis of the number of employees in each
department. Other costs might be apportioned in any of several ways. Possible apportionments are shown
in the table below.
Cost item

Basis of apportionment

Total cost

Dept A

Dept B

$

$

$

Allocated costs

104,000

43,700

60,300

Factory depreciation

Floor area

3,000

1,200

1,800

Repairs and maint.

Machine hrs worked

15,000

12,000

3,000

Stores

Materials requis'd

22,000

16,500

5,500

Factory office

Direct labour hours

24,000

6,000

18,000

Equipment insurance

Value of plant

5,000

2,000

3,000

Heating and lighting

Floor area

4,000

1,600

2,400

Canteen

Employee numbers

21,000

7,000

14,000

Total dept overhead

198,000

90,000

108,000

The calculations are not set out in detail. As an example, the repairs and maintenance cost of $15,000 has
been shared between the departments on the basis of machine hours worked. The ratio of machine hours
is 3,600:900 or 4:1, and the overhead cost has been apportioned between the two departments on this
basis, ie $12,000: $3,000.
5.4 Overhead absorption
Having established an overhead cost for each production department, the next step is to calculate a rate
for absorbing the overhead costs into the cost of production.

Overhead absorption is the process whereby overhead costs allocated and apportioned to production cost
centres are added to unit, job or process costs. Overhead absorption is sometimes called overhead
recovery.
An organisation may use a different absorption rate for each production department, or a single 'factory-
wide' absorption rate.
(a) Where separate absorption rates are used for each production department, the overhead cost for
each department is established. This is done by means of overhead allocation and apportionment,
as illustrated above.
(b) The total overhead for each department is then divided by the activity level for each department, to
obtain a rate of overhead absorption per unit of activity. Typically, activity is measured in terms of
direct labour hours worked (to obtain an overhead rate per labour hour) or machine hours operated
(to obtain an overhead rate per machine hour).
The overhead is then added to the cost of each cost unit by applying the absorption rate. If overhead is
absorbed at, say $2 per labour hour, then a cost unit that takes 3 labour hours to produce absorbs 3 $2
= $6 in overheads.
5.5 Example: absorption
In the example above, the overhead costs of department A were measured as $90,000 and the overheads
of department B were $108,000.
If overheads were absorbed on a labour hours basis, the absorption rate for each department would be as
follows.
Department A Department B
Overheads $90,000 $108,000
Direct labour hours 6,000 hours 18,000 hours
Absorption rate $15 per direct labour hour $6 per direct labour hour
Suppose that a product with a direct materials cost of $160 and a direct labour cost of $240
manufactured, and takes 10 hours of direct labour work in department A and 20 hours of direct labour
work in department B. The full cost of the product would be:

$

$

Direct materials

160

Direct labour

240

Department A overhead (10 hours $15)

150

Department B overhead (20 hours $6)

120

Total production overhead

270


670

It is worth noting that a different basis for overhead absorption would result in a different full product cost.
Using the same example, suppose that overheads were absorbed on a machine hour basis, rather than a
direct labour hour basis, and that the product needed 3 hours of machine time in department A and 2
hours of machine time in department B.
If overheads were absorbed on a machine hours basis, the absorption rate for each department would be
as follows.
Department A Department B
Overheads $90,000 $108,000
Machine hours 3,600 hours 900 hours
Absorption rate $25 per machine hour $120 per machine hour
The full cost of the product would be:

$

$

Direct materials

160

Direct labour

240

Department A overhead (3 hours $25)

75

Department B overhead (2 hours $120)

240

Total production overhead

315


715

5.6 The arbitrary nature of absorption costing
Even when a company is trying to be 'fair', there is a great lack of precision about the way an absorption
basis is chosen. This is because:
(a) the basis for apportioning shared costs between production departments is not 'scientific'
(b) there is also an element of arbitrariness in the choice of activity (direct labour hours or machine
hours etc) as the basis for establishing an overhead absorption rate.
This arbitrariness is one of the main criticisms of absorption costing, and if absorption costing is to be
used (because of its other virtues) then it is important that the methods used are kept under regular
review. Changes in working conditions should, if necessary, lead to changes in the way in which work is
accounted for.
6 Over- and under-absorption
Predetermined overhead absorption rates are normally used, based on budgeted figures.
The 'actual' full cost of production is therefore made up of the following.
Direct materials
Direct labour
Direct expenses
Overheads (based on the predetermined overhead absorption rate)
Under- or over-absorption of overheads occurs because the predetermined overhead absorption rates are
based on forecasts (estimates).
If an organisation has estimated fixed and variable production overheads, it may calculate a separate
absorption rate for each.
One problem with absorption costing is that the overhead cost per unit will depend on the volume of
output or activity during a period. As output volume increases in a given period, the fixed overhead cost
per unit will fall.
Suppose for example that a company manufactures a single product that has a direct cost of $5 per unit,
and that indirect costs, all fixed, are $2,400 each month. Suppose that output in January, February and
March are 600 units, 400 units and 800 units respectively. The full cost per unit in each month would be
as follows:
Output Variable Fixed Full unit
cost per unit cost per unit cost
$ $ $
January 600 units 5 4 9
February 400 units 5 6 11
March 800 units 5 3 8
The unit cost ranges between $8 and $11, all because of the volume of output in the month, raising
questions about the 'fairness' or 'realism' of the costing method.

A firm might prefer to apply a constant overhead rate to all output throughout the course of a financial
year, but if actual overhead expenditure is used, it would have to wait until the year end to establish what
unit overhead costs are.
An alternative approach to overhead absorption, which is commonly used by firms that have an absorption
costing system, is to apply overhead costs at a predetermined or standard rate. This rate is derived from
the budget, ie from budgeted overhead expenditure and the budgeted volume of activity for the year.
Using the predetermined absorption rate, the actual cost of production can be established as follows.

Direct materials

plus:

Direct labour

plus:

Direct expenses (if any)

plus:

Overhead (based on the predetermined overhead absorption rate)

equals:

'Actual' full cost of production

6.1 Example: using a predetermined recovery rate
P budgeted to make 10,000 units of a product called Jasmine at a cost of $3 per unit in direct materials
and $4 per unit in direct labour. The sales price would be $12 per unit, and production overheads were
budgeted to amount to $20,000. A unit basis of overhead recovery is in operation.
During the period 12,000 units were actually produced and sold (for $12 each) and the actual cost of
direct materials was $38,000 and of direct labour, $45,000. Overheads incurred came to $21,000.
What was the cost of sales of product Jasmine, and what was the profit? Ignore administration, selling
and distribution overheads.
Solution
The cost of production and sales is the actual direct cost plus the cost of overheads, absorbed at a
predetermined rate as established in the budget. In our example, the overhead recovery rate would be $2
per unit produced ($20,000 10,000 units).
The actual cost of sales is calculated as follows.

$

Direct materials (actual)

38,000

Direct labour (actual)

45,000

Overheads absorbed (12,000 units $2 per unit)

24,000

Full cost of sales, product Jasmine

107,000

Sales of product Jasmine (12,000 units $12)

144,000

Profit, product Jasmine

37,000

The actual overheads incurred, $21,000, are not the same as the overheads absorbed into (ie included in)
the cost of production and hence charged against profit. Absorbed overheads were $24,000. Nevertheless,
in normal absorption costing $24,000 is the 'correct' cost. The discrepancy between actual overheads
incurred, and the overheads absorbed, which is an inevitable feature of absorption costing, is accounted
for at the end of the accounting period, as the under-absorption or over-absorption of overhead.
In this example, $24,000 has been added to the cost of production as overhead, but actual spending was
only $21,000. There has been an over-absorption of overheads by $3,000, which has added to costs and
so reduced the reported profits on the product. The over-absorbed overhead should therefore be added
back to profits, to establish the actual profit for the period.
6.2 Why does under- or over-absorption occur?
The rate of overhead absorption is based on two estimates, an estimate of overhead expenditure and an
estimate of production volume. Either one or both of these estimates may not turn out to be what actually
occurs. Overheads incurred will therefore almost inevitably be either greater than or less than overheads
absorbed into the cost of production. Let's consider an example.
Suppose that the estimated overhead in a production department is $80,000 and the estimated activity is
40,000 direct labour hours. The overhead recovery rate (using a direct labour hour basis) would be $2 per
direct labour hour.
Actual overheads in the period are, say $84,000 and 45,000 direct labour hours are worked.

$

Overhead incurred (actual)

84,000

Overhead absorbed (45,000 $2)

90,000

Over-absorption of overhead

6,000

In this example, the cost of produced units or jobs has been charged with $6,000 more than was actually
spent. An adjustment to reconcile the overheads charged to the actual overhead is necessary and the over-
absorbed overhead will be accounted for as an adjustment to the income statement at the end of the
accounting period.
The overhead absorption rate is predetermined from estimates of overhead cost and the expected volume
of activity. Under- or over-recovery of overhead will therefore occur in the following circumstances.
(a) Actual overhead costs are different from the estimates.
(b) The actual activity volume is different from the estimated activity volume.
(c) Both actual overhead costs and actual activity volume are different from the estimated costs and
volume.
6.3 Example: under-/over-absorption
W has a budgeted production overhead of $60,000 and a budgeted activity of 20,000 direct labour hours
and therefore a recovery rate of $3 per direct labour hour. Calculate the under-/over-absorbed overhead,
and the reasons for the under/over absorption, in the following circumstances.
(a) Actual overheads cost $57,000 and 20,000 direct labour hours are worked.
(b) Actual overheads cost $60,000 and 18,500 direct labour hours are worked.
(c) Actual overheads cost $57,000 and 18,500 direct labour hours are worked.
Solution
(a)

$

Actual overhead

57,000

Absorbed overhead (20,000 $3)

60,000

Over-absorbed overhead

3,000

Here there is over-absorption because although the actual and estimated direct labour hours are
the same, actual overheads cost less than expected and so too much overhead has been charged
against profit.
(b)

$

Actual overhead

60,000


55,500

Under-absorbed overhead

4,500

Here there is under-absorption because although estimated and actual overhead costs were the
same, fewer direct labour hours were worked than expected and hence insufficient overheads have
been charged against profit.
(c)

$

Actual overhead

57,000


55,500

Under-absorbed overhead

1,500

The reason for the under-absorption is a combination of the reasons in (a) and (b).


Question
Under-/over-absorbed overhead

WCX makes a variety of products, and uses a factory-wide absorption rate for calculating production
overhead costs of output. This overhead rate is based on budgeted production expenditure and budgeted
direct labour hours in the production departments.
In 20X4, budgeted production overheads, all fixed costs, were $380,000 and 47,500 direct labour hours
were budgeted.
During 20X4, actual production amounted to 52,000 direct labour hours, and overhead expenditure was
$405,000.
Required
What was the under- or over-absorbed overhead for the year, and to what extent was this attributable to
differences between budgeted and actual (a) overhead spending and (b) the volume of activity?

Answer

Budgeted overhead expenditure

$380,000

Budgeted direct labour hours

47,500

Absorption rate per direct labour hour

$8

$

Absorbed overhead

(52,000 $8)

416,000

Actual overhead

405,000

Over-absorbed

11,000

$

Hours

Budgeted expenditure

380,000

Budgeted hours

47,500

Actual expenditure

405,000

Actual hours

52,000

Expenditure difference

25,000

Difference

4,500

At $8 per hour

$36,000

There has been an over-absorption of overhead by $11,000, which means that too much overhead has
been charged to the cost of production. An upward adjustment should therefore be made to profits for the
period to correct the over-charging. The over-absorption is caused by a higher volume of activity than
budgeted, resulting in over-absorption of $36,000, offset by higher overhead spending than budgeted of
$25,000.

7 Activity-based costing
Activity-based costing is an alternative to absorption costing for allocating overheads. It involves the
identification of the factors (cost drivers) which cause the costs of an organisation's major activities. This
allows the overheads to be allocated to products or services based on the cost drivers.
Activity based costing (ABC) is an approach to the costing and monitoring of activities which involves the
tracing of resources to activities, and activities to end products or services, based upon usage measured
via cost drivers.
A cost driver is a factor that causes a change in the cost of an activity.

7.1 Traditional absorption costing: the quality of cost information
Traditional absorption costing was developed for manufacturing operations in the early 1900s, when the
largest items of expense were direct labour costs. Overhead costs were comparatively low, and overhead
spending was heavily influenced by direct labour activities. In such an environment, labour-hour based
absorption costing provided fairly reliable and valuable information about product costs and profitability.
In a modern business environment, where advanced manufacturing technology is used, the situation is
very different. The machine has replaced direct labour, and production overhead expenses are a much
higher proportion of total production costs. There have also been large increases in administration and
selling and marketing expenses. Direct labour may account for as little as 5% of total product costs.
There has been an increase in the cost of 'support functions' or 'service functions', such as set-up costs,
production scheduling, inspection costs, the cost of logistics (transportation and storage), despatch, order
handling, data processing and customer service.
However, the amount of work done in many support activities that incur overhead costs is not necessarily
related to production volume, nor to direct labour hours of work. In many cases, low-volume (and
possibly low-value) products make use of a large amount of resources and time in these support areas.
For example:
(a) Where order handling is a major support operation, the time and resources used in handling a
small order might be almost as great, and sometimes greater, than the time and resources needed
to process a large order.
(b) Where the costs of setting up a production run are a major overhead activity, a small production
run might need more set-up time and resources than a large standard production run.
(c) Where packing and despatch are a major overhead activity, the costs of handling non-standard
items for despatch might be much greater than the costs of packing and despatching standard
items.
Given all these changes, it is perhaps not so surprising that traditional absorption costing information has
lost most of its relevance. A system of costing that allocates overhead costs to cost items (products or
services) on the basis of production volume or output level (eg on the basis of direct labour hours) cannot
be relied on to provide a reliable or meaningful assessment of costs. Cost information needs to help a
company to maintain or improve its competitive position, by showing which of its products or services are
really the most profitable, and which operations are losing money. Traditional absorption costing simply
does not provide this information, and something better is needed.
Activity-based costing (ABC) is a concept for overcoming the weaknesses of traditional absorption
costing, by trying to attribute costs to the products or services via the activities that caused those costs to
be incurred. It has an advantage over traditional costing systems because it allocates overhead costs to
programmes and activities in a way that reflects the factors influencing those costs.
7.2 An ABC system in outline
To implement ABC, an organisation must first of all look at all its overhead costs, and try to identify the
main activities that result in costs being incurred. These are the activities that use up resources. There are
no standard rules as to what these major activities should be and they will differ in each organisation. The
activities identified in this way need not be confined to a single department, but might be carried out in a
number of different departments.
Examples of resource-consuming activities might be the processing of a customer order, procurement,
quality inspection, set-up, despatch, warehousing, and so on.
Instead of collecting overhead costs for a service department or an overhead cost centre, an organisation
collects the overhead costs for activity pools or cost pools. There is a separate activity pool for each
major resource-consuming activity. For each activity pool, there should be a cost driver. A cost driver is a
unit of activity that results in the consumption of resources, and so leads to costs being incurred.

Examples of cost drivers are as follows.
Activity Cost driver
Ordering Number of orders
Materials handling Number of materials receipts
Production scheduling Number of production runs (or set ups)
Despatch Number of despatches
There are no standard rules about what the cost driver should be for a particular activity, and an
organisation should select the cost driver that seems most appropriate for each of its activity pools. Cost
drivers might be production-oriented, such as the production cycle time, the number of orders, the
number of production runs or batches of output, the number of machine hours operated or the number of
inspections. Alternatively, cost drivers might be related to the cost of providing service to customers, such
as the number of changes to order specifications or the characteristics of a customer's order.
For each activity pool or cost pool, a cost per unit of cost driver is then calculated. The costs in an activity
pool are then assigned to products and services on the basis of:
Units of cost driver Cost per unit of cost driver.
This is similar to the absorption of overheads, using an absorption rate, in traditional costing. However,
the cost driver represents the factor that has the greatest influence on the behaviour of costs in the activity
pool. For example, if a particular product requires 60% of quality control inspections and there is a cost
pool for inspection costs, the product should attract 60% of the total costs of quality inspections.
Suppose for example that processing customer orders is a major activity for which there is a cost pool,
and that the cost driver for this activity is the number of orders processed. The total costs for the cost
pool might be, say, $200,000, and the company might process 1,000 orders in the year. The cost of order
processing would therefore be $200 per order. A product for which there are 80 orders in a year would be
charged $16,000 for order processing costs.
7.3 Example
A company manufactures two products, P and Q. The manufacturing process is highly-automated. The
following information relates to production in one year.
Product P Product Q
Number of units produced 500,000 20,000
Number of batches 500 200
Batch size 1,000 units 100 units
Average number of orders per batch 2 3
Direct materials cost per unit $5 $10
Direct labour time per unit 0.05 hours 0.05 hours
Direct labour cost per hour $10 $10
Machine hours per unit 0.08 hours 0.25 hours
Number of set-ups per batch 2 4
Annual overhead costs:
$ Annual volume
Set-up costs 900,000 1,800 set-ups
Order processing costs 880,000 1,600 orders
Handling costs 630,000 700 batches
Other production overheads 450,000 45,000 machine hours
26,000 direct labour hours
The total production overhead costs for the year are $2,860,000.
A system of ABC is used.
Set-up costs are charged to products on the basis of a cost per set-up.
Order processing costs are charged on the basis of a cost per order.
Handling costs are charged on the basis of a cost per batch.
Other production overheads are assigned to product costs on a machine hour basis.
The cost per unit for each cost driver is calculated as follows.
Cost pool Total cost Activity level Cost per unit of cost driver
$
Set-up 900,000 1,800 set-ups $500 per set-up
Order processing 880,000 1,600 orders $550 per order
Handling 630,000 700 batches $900 per batch
Other costs 450,000 45,000 machine hours $10 per m/c hour
Product costs are now calculated as follows.
Activity Total Product P Product Q
Set-ups 1,800 1,000 800
Orders 1,600 1,000 600
Batches 700 500 200
Machine hours 45,000 40,000 5,000

Total

Product P

Product Q

500,000 units

20,000 units

$

$

$

Direct materials

2,700,000

2,500,000

200,000

Direct labour

260,000

250,000

10,000

Set-up costs

900,000

500,000

400,000

Order processing costs

880,000

550,000

330,000

Handling costs

630,000

450,000

180,000

Other overheads

450,000

400,000

50,000

Total costs

5,820,000

4,650,000

1,170,000

Cost per unit

$9.30

$58.50

If this company had used traditional absorption costing instead of ABC, the production overheads would
possibly have been absorbed into production costs on a direct labour hour basis. The overhead recovery
rate per direct labour hour would have been $110 per direct labour hour (2,860,000/26,000 hours). The
production overhead cost for one unit of each product would have been 0.05 hours $110 per hour =
$5.50.
The costs of each product would then have been as follows.

Product P

Product Q

$

$

Direct materials

5.0

10.0

Direct labour

0.5

0.5

Production overhead

5.5

5.5

11.0

16.0

Units produced

500,000

20,000

Total cost

$5,500,000

$320,000

$5,820,000

The total production costs would have been the same as with ABC, $5,820,000, but the costs have been
assigned to the two products differently. With ABC, Product Q receives a higher charge for overhead
costs, because of the smaller batch sizes, the larger number of orders per batch, the larger number of set-
ups per batch and the larger number of machine hours required for each unit.

7.4 ABC and traditional absorption costing compared
Companies using ABC consider it to be a method of obtaining more relevant and accurate information
about the costs of products, processes, services and activities. Traditional absorption costing systems
allocate overhead costs to products based on the attributes of a single activity, such as direct labour hours
worked or machine hours operated. The allocation of overheads therefore varies directly with production
volume. In contrast, ABC focuses on the activities required to make a product or provide a service, based
on the consumption or use of those activities.
The unit costs of production are likely to be very different using ABC compared to traditional absorption
costing, but this might not be the case every time. For example, the cost of constructing a cupboard might
be estimated using traditional costing and ABC as follows.
Traditional absorption costing

ABC

$

$

Materials

20

Materials

20

Labour

30

Cut wood

15

Overhead

30

Paint

10

80

Erect

20

Inspect

15

80

In this example, using ABC does not change the cost of the cupboard, but it shows how the resources
have been consumed and the costs incurred by activities. Arguably, this provides a more useful, practical
insight into the way in which costs are incurred. If the company wanted to reduce costs, traditional
absorption costing data might suggest the need to reduce direct labour costs. ABC might suggest that
combining the erection of the cupboard with inspection might be a way of reducing costs.
7.5 ABC and long-run variable costs
Some activity costs might be variable costs, in the sense that if the volume of activity is reduced or
increased, the total costs of the activity will also fall or rise proportionately. But this may not be the case in
the short-run; for example, if the cost of processing an order is estimated at $400 using ABC, the actual
cost of handling an additional 10 orders is unlikely to be $4,000. This is because many overhead costs are
fixed in the short term.
However, it is argued that in the longer term, all costs are variable. By focusing on activities that use up
resources and so incur costs, ABC could provide useful information to help management to control
overhead costs over the longer term. Traditional absorption costing cannot do this because there is no
relationship between product overhead costs and the consumption of resources.
It can certainly be argued that ABC, by assigning costs to products on the basis of activities and resources
consumed, provides helpful information about the economic cost of products, and which products are
more profitable than others.
The concept of activity costing has been extended by some companies into budgeting methods (activity-
based budgeting) and the re-engineering of business activities (activity-based management and business
process re-engineering). These techniques are described later.
7.6 Drawbacks to ABC
The main disadvantages of ABC are the cost of establishing and maintaining an ABC system, and the
possible complexity of the system.
An ABC system is more expensive to set up and maintain than a traditional absorption costing system,
because activities have to be monitored and measured. The system should also be reviewed regularly to
ensure that there is a continuing relationship between expenditure and the activities and cost drivers that
have been selected.
The analysis of activities and costs can also be taken to excessive detail, by looking at the costs of
activities within broader activities. For example, purchasing activities might be a major cost item, and an
ABC cost per purchase order might be calculated for the purchasing costs pool. However, purchasing
activities could be analysed further, and costs established for sub-activities such as processing a purchase
requisition from the warehouse department, finding a supplier for a new component or sub-assembly,
putting a purchase order out to tender and chasing late deliveries from suppliers. A different cost driver
could be selected for each sub-activity.
The point to note is that to prevent an ABC system from becoming too expensive to operate, it is probably
necessary to keep the cost pools and cost drivers down to a fairly small and manageable number.

Question
ABC costing

A high-technology company manufactures a range of products, that includes product A and product B.
Product A is made in standard batch sizes of 300 units, and product B is made in standard batch sizes of
100 units. Direct production costs and other cost information is as follows.
Product A Product B
Production run (size) 300 units 100 units
Direct materials cost per unit $27.50 $40
Direct labour time per unit 0.25 hours 0.5 hours
Direct labour cost per hour $10 $10
Number of set-ups per batch 5 2
Machine hours per unit 0.5 hours 0.5 hours
Overhead costs are as follows.
Total annual costs Annual volume of activity
Set-up costs $1,500,000 2,500 set-ups
Handling costs $1,000,000 1,000 batches (production runs)
Other production overheads $2,000,000 200,000 machine hours
A system of ABC is used. Set-up costs are charged to products on the basis of a cost per set-up, and
handling costs are charged on the basis of a cost per batch/production run. Other production overheads
are absorbed on a machine hour basis.
Required
Using ABC methodology, calculate the cost per unit of product A and the cost per unit of product B.


Answer

Overhead item
Annual cost Activity level O'hd recovery rate
Set-up costs $1,500,000 2,500 set-ups $600 per set-up
Handling costs $1,000,000 1,000 batches $1,000 per batch
Other $2,000,000 200,000 machine hours $10 per m/c hour

A

B

Batch size

300 units

100 units

$

$

Direct materials

(300 $27.50)

8,250

(100 $40)

4,000

Direct labour

(300 0.25 $10)

750

(100 0.5 $10)

500

Set-up cost

(5 $600)

3,000

(2 $600)

1,200

Handling cost

1,000

1,000

Other overheads

(300 0.5 $10)

1,500

(100 0.5 $10)

500


14,500

7,200

Cost per unit

$48.33

$72.00

8 Marginal cost and marginal costing
Absorption costing is most often used for routine profit reporting and must be used for financial
accounting purposes. Marginal costing provides better management information for planning (budgeting)
and decision making.
Marginal cost is the variable cost of one unit of product or service. Contribution, which is an important
measure in marginal costing, is the difference between sales revenue and the marginal or variable cost of
sales. In marginal costing, fixed production costs are treated as period costs and are written off as they
are incurred.
Marginal costing is an alternative method of costing to absorption costing. In marginal costing, only
variable costs are charged as a cost of sale. Sales revenue minus the variable cost of sales equals
contribution, which is the contribution towards covering fixed costs and making a profit. Fixed costs are
treated as a period cost, and are charged in full to the income statement of the accounting period in which
they are incurred. Closing inventories of work in progress or finished goods are valued at marginal
(variable) production cost.
Marginal cost is the cost of a unit of a product or service which would be avoided if that unit were not
produced or provided. The marginal cost per unit is also called the variable cost per unit.
The marginal production cost per unit of an item usually consists of:
direct materials
direct labour
variable production overheads
However, there may also be some direct production expense per unit.
Direct labour costs might be excluded from marginal costs when the work force is a given number of
employees on a fixed wage or salary. Even so, it is not uncommon for direct labour to be treated as a
variable cost, even when employees are paid a basic wage for a fixed working week. If in doubt, you
should treat direct labour as a variable cost unless given clear indications to the contrary.
The marginal cost of sales consists of the marginal production cost of units sold plus the variable selling
costs, which would include items such as sales commission, and possibly some variable distribution
costs.

8.1 Contribution
Contribution is the difference between sales revenue and the marginal cost of sales.
Contribution is of fundamental importance in marginal costing, and the term 'contribution' is really short
for 'contribution towards covering fixed overheads and making a profit'.
8.2 The principles of marginal costing
The principles of marginal costing are as follows.
(a) For any given period of time, fixed costs will be the same, for any volume of sales and production
(provided that the level of activity is within the 'relevant range'). Therefore, by selling an extra item
of product or service the following will happen.
Revenue will increase by the sales value of the item sold.
Costs will increase by the variable cost per unit.
Profit will increase by the amount of contribution earned from the extra item.
(b) Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution
earned from the item.
(c) Profit measurement should therefore be based on an analysis of total contribution. Since fixed
costs relate to a period of time, and do not change with increases or decreases in sales volume, it
is misleading to charge units of sale with a share of fixed costs.
(d) When a unit of product is made, the extra costs incurred in its manufacture are the variable
production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is
increased.
Before explaining marginal costing principles any further, it will be helpful to look at a numerical example.
8.3 Example: marginal costing principles
Bain Painkillers makes a drug called 'Relief', which has a variable production cost of $6 per unit and a
sales price of $10 per unit. At the beginning of June 20X1, there were no opening inventories and
production during the month was 20,000 units. Fixed costs for the month were $45,000 (production,
administration, sales and distribution). There were no variable marketing costs.
Required
Calculate the contribution and profit for June 20X1, using marginal costing principles, if sales were as
follows.
(a) 10,000 Reliefs
(b) 15,000 Reliefs
(c) 20,000 Reliefs
Solution
The first stage in the profit calculation must be to identify the variable cost of sales, and then the
contribution. Fixed costs are deducted from the total contribution to derive the profit. All closing
inventories are valued at marginal production cost ($6 per unit).


10,000 Reliefs

15,000 Reliefs

20,000 Reliefs

$

$

$

$

$

$

Sales (at $10)

100,000

150,000

200,000

Opening inventory

0

0

0

Variable production

cost

120,000

120,000

120,000

120,000

120,000

120,000

Less value of closing

inventory (at

marginal cost)

60,000

30,000

-

Variable cost of sales

60,000

90,000

120,000

Contribution

40,000

60,000

80,000

Less fixed costs

45,000

45,000

45,000

Profit/(loss)

(5,000)

15,000

35,000

Profit/(loss) per unit

$(0.50)

$1

$1.75

Contribution per unit

$4

$4

$4

The conclusions to be drawn from this example are as follows.
(a) The profit per unit varies at differing levels of sales, because the average fixed overhead cost per
unit changes with the volume of output and sales.
(b) The contribution per unit is constant at all levels of output and sales. Total contribution, which is
the contribution per unit multiplied by the number of units sold, increases in direct proportion to
the volume of sales.
(c) Since the contribution per unit does not change, the most effective way of calculating the expected
profit at any level of output and sales would be as follows.
(i) First calculate the total contribution.
(ii) Then deduct fixed costs as a period charge in order to find the profit.
(d) In our example the expected profit from the sale of 17,000 Reliefs would be as follows.

$

Total contribution (17,000 $4)

68,000

Less fixed costs

45,000

Profit

23,000

If total contribution exceeds fixed costs, a profit is made.
If total contribution exactly equals fixed costs, no profit and no loss is made. This is known as the
breakeven point.
If total contribution is less than fixed costs, there will be a loss.

Question
Marginal costing

Wong makes two products, the Ping and the Pong. Information relating to each of these products for
August 20X1 is as follows.

Ping

Pong

Opening inventory

nil

nil

Production (units)

15,000

6,000

Sales (units)

10,000

5,000

Sales price per unit

$20

$30

Unit costs
$ $
Direct materials

8

14

Direct labour

4

2

Variable production

overhead

2

1

Variable sales overhead

2

3

Fixed costs for the month:

$

Production costs

40,000

Administration costs

15,000

Sales and distribution costs

25,000

Required
(a) Using marginal costing principles, calculate the profit in August 20X1.
(b) Calculate the profit if sales had been 15,000 units of Ping and 6,000 units of Pong.

Answer

(a)
$

Contribution from Pings (unit contribution = $20 $(8 + 4 + 2 + 2) = $4 10,000)

40,000

Contribution from Pongs (unit contribution = $30 $(14 + 2 + 1 + 3) = $10 5,000)
50,000

Total contribution

90,000

Fixed costs for the period ($40,000 + $15,000 + $25,000)

80,000

Profit

10,000

(b) At a higher volume of sales, profit would be as follows.

$

Contribution from sales of 15,000 Pings ( $4)

60,000

Contribution from sales of 6,000 Pongs ( $10)

60,000

Total contribution

120,000

Less fixed costs

80,000

Profit

40,000

8.4 The value of marginal costing
The main arguments in favour of marginal costing are that:
(a) it recognises the distinction between fixed costs and variable costs, and the fact that as activity
levels rise, only variable costs, not fixed costs, increase
(b) it recognises that fixed costs are time-related costs ('period costs') and it is therefore appropriate
to charge them in full as a cost to the period in which they arise
Recognition of the distinction between fixed and variable costs has some value in profit measurement.
Since fixed costs are not absorbed into product costs, marginal costing avoids the need to apply arbitrary
bases of apportionment of overheads, or arbitrary bases for overhead absorption. Since fixed costs are a
constant amount in each time period, profitability depends essentially on the amount of contribution
earned.
Recognition of the distinction between fixed and variable costs, and particularly between fixed and variable
overheads, assists managers to prepare more accurate budgets. Marginal costing techniques, even when
not used for measuring historical profits, is widely-used in budgeting.
9 Conclusion: costing methods
This chapter has described three costing techniques for measuring product costs and profitability. A
company might use any of these techniques for measuring profitability, and for comparing actual profits
against the budget.
In addition, marginal costing techniques are applied for budgeting and management decision-making.
An activity-based approach might also be adopted for budgeting ('activity-based budgeting').
The chapters that follow on budgeting and decision-making, performance measurement and performance
management will call for some understanding of these costing methods.
57 3: Budgeting

1 The functions of a budget
A budget is a plan for an entire organisation, typically for a one-year period, and covering all the activities
of the organisation. The overall budget is often referred to as the master budget. It is usually expressed in
financial terms, partly because 'money' is a common language for business activities and partly because a
major objective of any organisation is a financial objective (eg profits in the case of commercial
organisations and value for money in the case of not-for-profit organisations).
The functions of a system of budgeting are as follows.
To ensure the achievement of the organisation's objectives
To compel planning
To communicate ideas and plans
To co-ordinate activities
To provide a framework for responsibility accounting
To establish a system of control ('budgetary control')
To motivate employees to improve their performance
A budget is an organisation's plan for a forthcoming period, expressed in quantitative terms.
Except for capital expenditure budgets, the budget period is commonly the accounting year (sub-divided
into 12 monthly control periods or 13 four-week control periods).
The functions of a budget are as follows.
Function Detail
Ensure the achievement of
the organisation's
objectives
A budget sets quantified targets for achievement within the timescale of the
budget plan. These targets should be consistent with the organisation's
strategic objectives. Budgeting is therefore a means of ensuring that
strategic objectives are pursued.
Compel planning Budgeting forces management to look ahead, and plan for the future.
Potential problems might be anticipated, and potential opportunities
exploited, that might otherwise be missed if a formal planning process did not
take place.
Communicate ideas and
plans
Budgeting provides a plan of action for the entire organisation, and for
communicating targets for achievement. The communication of a budget
should ensure that each person affected by the plans is aware of what he or
she is supposed to be doing. Communication might be one-way, with
managers giving orders to subordinates, or there might be a two-way
dialogue.

Budgeting

3: Budgeting 58
Function Detail
Co-ordinate activities The activities of different departments need to be co-ordinated to ensure
maximum integration of effort towards common goals. This implies, for
example, that the purchasing department should base its budget on production
requirements and that the production budget should in turn be based on sales
expectations.
Provide a framework for
responsibility accounting
Budgets require that managers of budget centres are made responsible for
the achievement of budget targets for the operations under their personal
control.
Establish a system of
control
Control over actual performance is provided by the comparisons of actual
results against the budget plan. Departures from budget can then be
investigated and the reasons for the departures established. Where
appropriate, remedial action can be taken.
Motivate employees to
improve their performance
The interest and commitment of employees can be retained if there is a
system that lets them participate in the planning process and lets them
know how well or badly they are performing. The identification of
controllable reasons for departures from budget with managers responsible
provides an incentive for improving future performance.
1.1 Responsibility for the preparation of budgets
Managers responsible for preparing budgets should ideally be the managers who are responsible for
implementing the budget plan. For example, the sales manager should draft the sales budget and selling
overhead cost centre budget and the purchasing manager should draft the material purchases budget.
2 The budget preparation timetable
The budget preparation process is as follows.
Communicating details of the budget policy and budget guidelines.
Determining the factor(s) that restrict output
Preparation of the sales budget
Initial preparation of budgets
Negotiation of budgets with superiors
Co-ordination and review of budgets
Final acceptance of the budgets
Budget review
The principal budget factor should be identified at the beginning of the budgetary process, and the budget
for this is prepared before all the others.
The procedures involved in preparing a budget will differ from organisation to organisation, but the step-
by-step approach described here is indicative of the steps followed by many organisations. The
preparation of a budget may take weeks, possibly months, and the management committee responsible
for co-ordinating and approving the budget (the 'budget committee') may meet several times before an
organisation's budget is finally agreed.

59 3: Budgeting
Step 1

Communicating details of the budget policy and budget guidelines

The long-term plan is the starting point for the preparation of the annual budget. Managers
responsible for preparing the budget must be aware of how their plans for the budget
period should be consistent with the organisation's objectives and strategies. For example,
if the organisation's current strategy calls for a more aggressive pricing policy, the budget
must take this into account. Managers should also be provided with important guidelines
for wage rate increases, changes in productivity and so on, as well as information about
industry demand and output.
Step 2

Determining the factor that restricts output
The principal budget factor (also known as the key budget factor or limiting budget factor) is the factor
that sets a limit on what the organisation can do within the budget period. Activity might be restricted by
limited sales demand, in which case sales are the limiting factor. Alternatively, activity levels may be
restricted by a shortage of a key resource, such as skilled labour, capital equipment or cash.
For example, suppose that a company's sales department estimates that it could sell 1,000
units of product X, which would require 5,000 hours of grade A labour to produce. If there
are no units of product X already in inventory, and only 4,000 hours of grade A labour
available in the budget period, then the company would be unable to sell 1,000 units of X
because of the shortage of labour hours. Grade A labour would be a limiting budget factor,
and the company's management must choose one of the following options.
Reduce budgeted sales by 20%.
Try to increase the availability of grade A labour by 1,000 hours (25%) by
recruitment or overtime working.
Try to sub-contract the production of 1,000 units to another manufacturer at a cost
which will generate a profit on the transaction.
Step 3 Prepare the sales budget
In most organisations the principal budget factor is sales demand: a company is usually
restricted from making and selling more of its products because there would be no sales
demand for the increased output at a price which would be acceptable/profitable to the
company. The sales budget is therefore normally the primary budget from which the
majority of the other 'functional' budgets are derived.
Step 4 Initial preparation of budgets
After the sales budget has been drafted, other functional budgets can be prepared. The
functional budgets for a manufacturing organisation are likely to be as follows.
Budget Detail
Finished goods inventory
budget
Decides the planned increase or decrease in inventory
levels of finished goods.
Production budget Stated in units of each product and is calculated as the
sales budget in units plus the budgeted increase in
finished goods inventory or minus the budgeted decrease
in finished goods inventories.

3: Budgeting 60
Budget Detail
Budgets of resources for
production
Materials usage budget. This is a budget for the
quantities of materials and components required for
production. It is stated in quantities and cost for each
type of material used. It should take into account any
budgeted losses or materials wastage in production.
Machine utilisation budget. This is the budget for the
operating hours required on each machine or group of
machines.
Labour budget or wages budget. This is a budget for the
quantities of direct labour needed to achieve the
production budget. It will be expressed in hours for each
grade of labour and in terms of cost. It should take into
account any budgeted idle time.
Overhead cost budgets Production overheads
Administration overheads
Selling and distribution overheads
Research and development department overheads
Raw materials inventory
budget
Decides the planned increase or decrease of the level of
inventories of raw materials.
Raw materials purchase
budget
Can be prepared in quantities and value for each type of
material purchased. This budget can be prepared once
the raw material usage requirements are known, and a
decision has been taken on planned increases or
decreases in the levels of raw materials inventory.
Overhead absorption rate When the organisation uses absorption costing,
predetermined overhead absorption rates can be
calculated once the production budget and the overhead
cost centre budgets have been prepared.
Step 5 Negotiation of budgets with superiors
Budgets are prepared in draft form, discussed with senior managers, and (usually) revised. A
functional budget might go through several drafts until it is eventually approved.
Step 6 Co-ordination of budgets
It is unlikely that the above steps will be problem-free. The functional budgets must be
reviewed in relation to one another. Such a review may indicate that some budgets are out of
balance with others and need modifying. Inconsistencies should be identified by a senior
manager and brought to the attention of the manager or managers concerned, with a request
to revise the budget. The revision of one budget may lead to the revision of all budgets.
Step 7 Final acceptance of the budget
When all the budgets are in harmony with one another they are summarised into a master
budget consisting of a budgeted income statement, budgeted statement of financial position
and cash budget.
Step 8 Budget review
The budgeting process does not stop once the budgets have been agreed. Actual results
should be compared on a regular basis with the budgeted results. The frequency with which
such comparisons are made depends very much on the organisation's circumstances and the
sophistication of its control systems but it should occur at least monthly. Management
should receive a report detailing the differences and should investigate the reasons for the
differences. If adverse differences are within the control of management, corrective action
should be taken to bring the reasons for the difference under control and to ensure that such
inefficiencies do not occur in the future.
61 3: Budgeting
3 Preparing functional budgets
Once prepared, the functional budgets must be reviewed to ensure they are consistent with one another.
Functional budgets are brought together to prepare a budgeted income statement for the budget period.
Functional (or departmental) budgets are the budgets for the various functions and departments of an
organisation. They include production budgets, marketing budgets, sales budgets, personnel budgets,
purchasing budgets and research and development budgets.
In this section, we shall look at the preparation of a number of functional budgets for a manufacturing
organisation.
3.1 Production budget
The production budget is a plan for the quantities and costs for each product and product group. It must
tie in with the sales and finished goods inventory budgets.
Once the production budget has been finalised, the labour, materials and machine budgets can be drawn
up. These budgets will be based on budgeted activity levels, existing inventory positions and projected
labour and material costs.
3.2 Example: the preparation of the production budget and direct labour
budget
Pearson manufactures two products, P and L, and is preparing its budget for 20X3. Both products are
made by the same grade of labour, grade G. The company currently holds 800 units of P and 1,200 units
of L in inventory, but 250 of these units of L have just been discovered to have deteriorated in quality, and
must therefore be scrapped. Budgeted sales of P are 3,000 units and budgeted sales of L 4,000 units. The
company wishes to maintain finished goods inventories at a level equal to three months' sales.
Grade G labour was originally expected to produce one unit of P in two hours and one unit of L in three
hours, at an hourly rate of $5.50 per hour. In discussions with trade union negotiators, however, it has
been agreed that the hourly wage rate should be raised by 50c per hour, provided that the times to
produce P and L are reduced by 20%.
Required
Prepare the production budget and direct labour budget for 20X3.
Solution
The expected time to produce a unit of product P will now be 80% of 2 hours = 1.6 hours, and the time for
a unit of product L will be 2.4 hours. The hourly wage rate will be $6, so that the direct labour cost will be
$9.60 for P and $14.40 for L (thus achieving a saving for the company of $1.40 per unit of P produced
and $2.10 per unit of L).
(a) Production budget

Product P

Product L

Units

Units

Units

Units

Budgeted sales

3,000

4,000

Closing inventories

(3/12 of 3,000)

750

(3/12 of 4,000)

1,000

Opening inventories (minus

inventories scrapped)

800

950

(Decrease)/increase in inventories

(50)

50
Production

2,950

4,050

3: Budgeting 62
(b) Direct labour budget

Grade G

Cost

Hours

$

2,950 units of product P

4,720

28,320

4,050 units of product L

9,720

58,320

Total

14,440

86,640

It is assumed that there will be no idle time among grade G labour which, if it existed, would have
to be paid for at the rate of $6 per hour.
3.3 Labour budget
A useful concept in budgeting for labour requirements is the standard hour.
A standard hour is the quantity of work achievable at standard performance (the standard rate of
efficiency), expressed in terms of a standard unit of work done in a standard period of time.
Budgeted output of different products or jobs in a period can be converted into standard hours of
production, and a labour budget constructed accordingly.
Standard hours are particularly useful when management wants to monitor the production levels of a
variety of dissimilar units. For example product A may take five hours to produce and product B, seven
hours. If four units of each product are produced, instead of saying that total output is eight units, we
could state the production level as:
(4 5) + (4 7) standard hours = 48 standard hours.
3.4 Example: direct labour budget based on standard hours
Canaervon manufactures a single product, the Close, with a single grade of labour. Its sales budget and
finished goods inventory budget for month 3 are as follows.
Units
Sales 700
Opening inventories, finished goods 50
Closing inventories, finished goods 70
The goods are inspected only when production work is completed, and it is budgeted that 10% of finished
work will be scrapped.
The standard direct labour hour content of the Close is three hours. The budgeted productivity ratio for
direct labour is only 80% (which means that labour is only working at 80% efficiency).
The company employs 18 direct operatives, who are expected to average 144 working hours each in
month 3.
Required
(a) Prepare a production budget.
(b) Prepare a direct labour budget.
(c) Comment on the problem that your direct labour budget reveals, and suggest how this problem
might be overcome.
63 3: Budgeting
Solution
(a) Production budget

Units

Sales

700

Add closing inventory

70

770

Less opening inventory

50

Production required of 'good' output

720

Wastage rate

10%

Total production required
90
720
100

800

(* Note that the required adjustment is 100/90, not 110/100, since the waste is assumed to be 10%
of total production, not 10% of good production.)
(b) Now we can prepare the direct labour budget.
Standard hours per unit 3
Total standard hours required = 800 units 3 hours 2,400 hours
Productivity ratio 80%
Actual hours required
ty Productivi
hours Standard
= 3,000 hours
(c) If we look at the direct labour budget against the information provided, we can identify the
problem.

Hours

Budgeted hours available (18 operatives 144 hours)

2,592

Actual hours required

3,000

Shortfall in labour hours

408

The (draft) budget indicates that there will not be enough direct labour hours to meet the
production requirements. This problem might be overcome in one, or a combination, of the
following ways.
Reduce the closing inventory requirement below 70 units. This would reduce the number of
production units required.
Persuade the workforce to do some overtime working.
Perhaps recruit more direct labour if long-term prospects are for higher production volumes.
Discuss with the workforce (or their union representatives) the following possibilities.
Improve the productivity ratio, and so reduce the number of hours required to
produce the output.
If possible, reduce the wastage rate below 10%.

Question
Direct labour budget

Guild manufactures three products, X, Y and Z. The direct labour requirements for manufacturing these
products are as follows.
Product X Product Y Product Z
per unit per unit per unit
Grade I labour 2.5 hours 1.5 hours 3.25 hours
Grade II labour 1.75 hours 2.75 hours 2.5 hours
Budgeted production for 20X4 is to make 7,000 units of X, 12,000 units of Y and 5,000 units of Z.
Grade I labour is paid $15 an hour and Grade II labour is paid $12 an hour.
Required
Prepare a direct labour budget, in hours and cost, for the year 20X4.

3: Budgeting 64

Answer

Product

Grade I

Grade II

Total

units

hours

hours

X

7,000

(x 2.5)

17,500

(x 1.75)

12,250

Y

12,000

(x 1.5)

18,000

(x 2.75)

33,000

Z

5,000

(x 3.25)

16,250

(x 2.5)

12,500

51,750

57,750

Cost per hr

$15

$12

Total cost

$776,250

$693,000

$1,469,250

3.5 Material purchases budget
A materials purchases budget is a budget for the quantities of materials and components to be purchased
during the budget period, and their cost. The budget should be based on materials usage requirements,
and any planned increase or decrease in materials inventory levels.

Question
Material purchases budget

Taylors manufactures two products, W and S, which use the same raw materials, R and T. One unit of W
uses 3 litres of R and 4 kilograms of T. One unit of S uses 5 litres of R and 2 kilograms of T. A litre of R is
expected to cost $3 and a kilogram of T $7.
Budgeted sales for 20X2 are 8,000 units of W and 6,000 units of S; finished goods in inventory at
1 January 20X2 are 1,500 units of W and 300 units of S, and the company plans to hold inventories of 600
units of each product at 31 December 20X2.
Inventories of raw material are 6,000 litres of R and 2,800 kilograms of T at 1 January, and the company
plans to hold 5,000 litres and 3,500 kilograms respectively at 31 December 20X2.
The warehouse and stores managers have suggested that a provision should be made for damages and
deterioration of items held in store, as follows.
Product W : loss of 50 units
Product S : loss of 100 units
Material R : loss of 500 litres
Material T : loss of 200 kilograms
Required
Prepare a material purchases budget for the year 20X2.

Answer

To calculate material purchase requirements, it is first of all necessary to calculate the budgeted
production volumes and material usage requirements.

Product W

Product S

Units

Units

Units

Units

Sales

8,000

6,000

Provision for losses

50

100

Closing inventory

600

600

Opening inventory

1,500

300

(Decrease)/increase in inventory

(900)

300

Production budget

7,150

6,400

65 3: Budgeting

Material R

Material T

Litres

Litres

Kg

Kg

Usage requirements

To produce 7,150 units of W

21,450

28,600

To produce 6,400 units of S

32,000

12,800

Usage budget

53,450

41,400

Provision for losses

500

200

53,950

41,600

Closing inventory

5,000

3,500

Opening inventory

6,000

2,800

(Decrease)/increase in inventory

(1,000)

700

Material purchases budget

52,950

42,300

Cost per unit

$3 per litre

$7 per kg

Cost of material purchases

$158,850

$296,100

Total purchases cost

$454,950

3.6 Budgets for departments not involved in manufacturing
Budgets are also prepared for those departments and functions not involved directly in manufacturing. An
organisation may therefore prepare budgets for some 'production overhead' departments, such as the
warehouse, repairs and maintenance unit, production planning unit, and so on. Budgets are also required
for activities outside production, such as an administration budget, a marketing budget, a sales overhead
budget (advertising budget, sales labour budget and so on), and a research and development budget.
The example below shows a typical marketing cost budget. Notice that only the selling and agency
commission varies directly with the level of sales.
ABC: MARKETING COST BUDGET FOR THE YEAR ENDED 31 MAY 20X4

$'000

Description/detail of cost items

Salaries and wages of marketing staff

X

Advertising expenses

X

Travelling and distribution costs

X

Market research activities

X

Promotional activities and marketing relations

X

Selling and agency commission (2
1
/2% of sales)

X

X

3.7 Co-ordination of functional budgets
It is vital that the functional budgets are prepared in the correct order (for example, the material usage
budget should be prepared after the production budget) and that the overall process is co-ordinated to
ensure that the budgets are all in balance with each other. There is little point in the material usage budget
being based on a budgeted production level of 10,000 units if the budgeted production level specified in
the production budget is 15,000 units.
3.8 Example: building up the budget
Here is a fairly extensive example of how functional budgets build up, and lead to the preparation of a
budgeted income statement. Check the figures carefully, to make sure that you understand how they are
all obtained.

3: Budgeting 66
Plug Engineering produces two products, N and V. The budget for the forthcoming year to 31 March 20X8
is to be prepared. The sales director has estimated the following.
N V
(a) (i) Demand for the company's products 3,600 units 4,800 units
(ii) Selling price per unit $90 $108
(iii) Closing inventory of finished products at 31 March 20X8 400 units 200 units
(iv) Opening inventory of finished products at 1 April 20X7 NIL NIL
(b) (i) Amount of plant capacity required for each unit of product
Machining 15 min 24 min
Assembling 12 min 18 min
(ii) Raw material content per unit of each product
Material A 1.5 kilos 0.5 kilos
Material B 2.0 kilos 4.0 kilos
(iii) Direct labour hours required per unit of each product 6 hours 9 hours
(c) Raw materials
Material A Material B
(i) Closing inventory requirement in kilos at 31 March 20X8 600 1,000
(ii) Opening inventory at 1 April 20X7 in kilos 1,100 6,000
(iii) Opening inventory at 1 April 20X7, in $ $1,650 $6,000
(iv) Budgeted cost of raw materials per kilo $1.50 $1.00
(d) Direct labour
The standard wage rate of direct labour is $6.60 per hour.
(e) Production overhead
Production overhead is absorbed on the basis of machining hours, with separate absorption rates
for each department. The following overheads are anticipated in the production cost centre
budgets.

Machining

Assembling

department

department

$

$

Supervisors' salaries

10,000

9,150

Power

4,400

2,000

Maintenance and running costs

2,100

2,000

Consumables

3,400

500

General expenses

19,600

5,000

39,500

18,650

Depreciation is taken at 5% straight line on plant and equipment. A machine costing the company
$20,000 is due to be installed on 1 October 20X7 in the machining department, which already has
machinery installed to the value of $100,000 (at cost). Assembly has machinery that cost $87,000.
(f) Selling and administration expenses

$

Sales commissions and salaries

44,300

Travelling and distribution

33,500

Office salaries

40,100

General administration expenses

32,500

150,400

(g) There is no opening or closing work in progress and inflation should be ignored.
Required
Prepare the following for the year ended 31 March 20X8 for Plug Engineering.
(a) Sales budget
(b) Production budget (in quantities)
(c) Plant utilisation budget
(d) Direct materials usage budget
67 3: Budgeting
(e) Direct labour budget
(f) Factory overhead budget
(g) Computation of the factory cost per unit for each product
(h) Direct materials purchases budget
(i) Cost of goods sold budget
(j) A budgeted income statement
Solution
(a) Sales budget
Product

Market demand

Selling price

Sales value

Units

$

$

N

3,600

90.00

324,000

V

4,800

108.00

578,400

842,400

(b) Production budget

N

V

Units

Units

Sales requirement

3,600

4,800

Increase in finished goods inventory

400

200

Production requirement

4,000

5,000

(c) Plant utilisation budget
Product

Machining

Assembling

Units

Hours per unit

Total hours

Hours per unit

Total hours

N

4,000

0.25

1,000

0.20

800

V

5,000

0.40

2,000

0.30

1,500

3,000

2,300

(d) Direct materials usage budget
Material A Material B
kg kg
Required for production:
N:
4,000 1.5 kilos
6,000 -

4,000 2.0 kilos
8,000
V:
5,000 0.5 kilos 2,500
5,000 4.0 kilos
20,000

Material usage

8,500

28,000

Unit cost $1.50 per kilo $1.00 per kilo
Cost of materials used $12,750 $28,000
(e) Direct labour budget

Hours required
Product

Production

per unit

Rate per hour

Cost

Units

Total hours

$

$

N

4,000

6

24,000

6.60

158,400

V

5,000

9

45,000

6.60

297,000

Total direct wages

455,400
(f) Production overhead budget

Machining dept

Assembling dept

$

$

Production overhead allocated and apportioned

(excluding depreciation)

39,500

18,650

Depreciation costs

(i) Existing plant

(5% of $100,000 in machining)

5,000

(5% of $87,000 in assembly)

4,350

3: Budgeting 68
(ii) Proposed plant

(5% of 6/12 $20,000)

500

45,000

23,000

Total machine hours (see (c))

3,000 hrs

2,300 hrs

Absorption rate per machine hour

$15

$10

(g) Cost of finished goods
Product N Product V
$ $
Direct material A 1.5 kg $1.50 2.25 0.5 kg $1.50 0.75
B 2.0 kg $1.00 2.00 4.0 kg $1.00 4.00
Direct labour 6 hrs $6.60 39.60 9 hrs $6.60 59.40
Production overhead
Machining department 15 mins at $15 per hr 3.75 24 min at $15 per hr 6.00

Assembling department 12 mins at $10 per hr

2.00

18 mins at $10 per hr

3.00

Production cost per unit

49.60

73.15

(h) Direct material purchases budget
A B
kg kg
Closing inventory required 600 1,000
Production requirements

8,500

28,000
9,100 29,000
Less opening inventory

1,100

6,000
Purchase requirements

8,000

23,000
Cost per unit

$1.50

$1.00
Purchase costs

$12,000

$23,000
(i) Cost of goods sold budget
Product

Sales

Cost per unit

Cost of sales

Units

$

$

N

3,600

49.60

178,560

V

4,800

73.15

351,120

529,680

(j) Budgeted income statement for year to 31 March 20X8

Product N

Product V

Total

$

$

$

Sales

324,000

518,400

842,400

Less cost of sales

178,560

351,120

529,680

Gross profit

145,440

167,280

312,720

Less selling and administration

150,400

Net profit

162,320

Note. There will be no under-/over-absorbed production overhead in the budgeted income statement.
4 Budgets for service organisations
The numerical examples in this chapter have shown how budgets are prepared for manufacturing
organisations. A similar approach to budgeting is taken by service organisations, although the functional
budgets that are prepared will depend on the nature of the services provided by the organisation. There
will inevitably be differences in the budgets for a retail organisation, a software company, a provider of
electricity, a newspaper publisher or television company and a firm of accountants.
69 3: Budgeting
The basic principles in budgeting, however, are the same in service organisations as in manufacturing
organisations.
(a) Prepare a budget for sales
(b) Prepare a budget of the resources required (materials and supplies, labour, other expenses) to
achieve the sales budget
(c) Construct a budgeted income statement from these functional budgets
(d) Prepare a cash budget (see below)
5 Cash budgets
Cash budgets show the expected receipts and payments during a budget period and are a vital
management control tool.
A cash budget is a detailed budget of cash inflows and outflows incorporating revenue items (cash
received and spent for operational purposes), capital items (capital expenditure, loan repayments, etc) and
other items such as dividend payments.
A cash budget is a statement in which estimated future cash receipts and payments are tabulated in such a
way as to show the forecast cash balance of a business at defined intervals. For example, in December
20X2 an accounts department might wish to estimate the cash position of the business during the three
following months, January to March 20X3. A cash budget might be drawn up in the following format.

Jan

Feb

Mar

$

$

$

Estimated cash receipts

From credit customers

14,000

16,500

17,000

From cash sales

3,000

4,000

4,500

Proceeds on disposal of non-current assets

2,200

Total cash receipts

17,000

22,700

21,500

Estimated cash payments

To suppliers of goods

8,000

7,800

10,500

To employees (wages)

3,000

3,500

3,500

Purchase of non-current assets

16,000

Rent and rates

1,000

Other overheads

1,200

1,200

1,200

Repayment of loan

2,500

14,700

28,500

16,200

Net surplus/(deficit) for month

2,300

(5,800)

5,300

Opening cash balance

1,200

3,500

(2,300)

Closing cash balance

3,500

(2,300)

3,000
In this example, the accounts department has calculated that the cash balance at the beginning of the
budget period, 1 January, will be $1,200. Estimates have been made of the cash that is likely to be
received by the business (from cash and credit sales, and from a planned disposal of non-current assets
in February). Similar estimates have been made of cash due to be paid out by the business (payments to
suppliers and employees, payments for rent, rates and other overheads, payment for a planned purchase
of non-current assets in February and a loan repayment due in January).
From these estimates of cash receipts and payments, it is a simple step to calculate any excess of cash
receipts over cash payments in each month. In some months cash payments may exceed cash receipts
and there will be a deficit for the month; this occurs during February in the above example because of the
large investment in non-current assets in that month.

3: Budgeting 70
The last part of the cash budget shows how the business's estimated cash balance can then be rolled
along from month to month. Starting with the opening balance of $1,200 at 1 January, a cash surplus of
$2,300 is generated in January. This leads to a closing January balance of $3,500, which becomes the
opening balance for February. The deficit of $5,800 in February throws the business's cash position into
overdraft and the overdrawn balance of $2,300 becomes the opening balance for March. Finally, the cash
surplus of $5,300 in March leaves the business with a favourable cash position of $3,000 at the end of the
budget period.
5.1 The usefulness of cash budgets
The cash budget is an important part of the 'master budget' for an organisation. A commercial
organisation must make a profit, but at the same time it needs to ensure that it has sufficient cash to meet
its liabilities to pay what it owes. Profits and cash flow are not the same thing.
Preparation of the cash budget can lead to a modification of the other budgets (for sales and production,
or capital expenditure) if it shows that there are insufficient cash resources to finance the planned
operations.
The cash budget can also give management an indication of potential 'liquidity' problems that could arise
and allows them the opportunity to take action to avoid such problems. A cash budget can show four
positions. Management will need to take appropriate action depending on the potential position.
Cash position Appropriate management action
Short-term cash
surplus
Pay creditors early to obtain early settlement discount
Attempt to increase sales by increasing receivables and inventories
Make short-term investments (eg put cash on deposit)
Short-term cash deficit Increase payables, ie take longer credit before paying suppliers
Reduce receivables, ie chase debtors for earlier or prompt payment
Arrange a bank overdraft
Long-term cash
surplus
Make long-term investments
Replace/update non-current assets
Consider a special dividend payment to shareholders
Long-term cash deficit As a matter of urgency, consider the profitability of each part of the
organisation's operations. An organisation that foresees a long-term cash
deficit is likely to be unprofitable
Raise long-term finance (such as via issue of share capital)
Consider shutdown/disinvestment opportunities

71 3: Budgeting
5.2 What to include in a cash budget
A cash budget shows the expected receipts of cash and payments of cash during a budget period.
Receipts of cash may come from one or more of the following.
Cash sales
Payments by debtors (credit sales)
The sale of non-current assets
The issue of new shares or loan stock and less formalised loans
The receipt of interest and dividends from investments outside the business
Although all of these receipts would affect a cash budget, some of them would not appear in the
income statement.
(a) The issue of new shares or loan stock is an item in the statement of financial position.
(b) The cash received from an asset affects the statement of financial position, and the profit or loss on
the sale of an asset, which appears in the income statement, is not the cash received but the
difference between cash received and the written-down value of the asset at the time of sale.
Payments of cash may be for one or more of the following.
Purchase of inventories
Payroll costs or other expenses
Purchase of capital items
Payment of interest, dividends or taxation
Not all cash payments are income statement items. For example, payments for the purchase of capital
equipment and the payment of sales tax are not items that appear in the income statement.
There are several reasons why the profit or loss made by an organisation during an accounting period
does not reflect its cash flow position.
Not all cash receipts affect income as reported in the income statement.
Not all cash payments affect expenditure as reported in the income statement.
Some costs in the income statement such as the depreciation of non-current assets are not cash
items but are costs derived from accounting conventions.
The timing of cash receipts and payments may not coincide with the recording of income
statement transactions. For example, a sale might be made on credit in November, and the
customer might not pay until February. The sale is treated as an income statement item in
November, but it only becomes a cash flow in February, three months later. Similarly, a company
might buy an item for re-sale in March and pay for it in April, but the item might not be re-sold (for
cash) until July. The cash payment would be in April, but the item will not be a 'cost of goods sold'
in the income statement until July.
5.3 Example: cash budget
Peter Blair has worked for some years as a sales representative, but has recently been made redundant.
He intends to start up in business on his own account, using $15,000 which he currently has invested with
a building society. Peter maintains a bank account showing a small credit balance, and he plans to
approach his bank for the necessary additional finance. Peter asks you for advice and provides the
following additional information.
(a) Arrangements have been made to purchase non-current assets costing $8,000. These will be paid
for at the end of September and are expected to have a five-year life, at the end of which they will
possess a nil residual value.
(b) Inventories costing $5,000 will be acquired on 28 September and subsequent monthly purchases
will be at a level sufficient to replace forecast sales for the month.
(c) Forecast monthly sales are $3,000 for October, $6,000 for November and December, and $10,500
from January 20X4 onwards.

3: Budgeting 72
(d) Selling price is fixed at the cost of inventory plus 50%.
(e) Two months' credit will be allowed to customers but only one month's credit will be received from
suppliers of inventory.
(f) Running expenses, including rent but excluding depreciation of non-current assets, are estimated
at $1,600 per month.
(g) Blair intends to make monthly cash drawings of $1,000.
Required
Prepare a cash budget for each month of the six months to 31 March 20X4.
Solution
The opening cash balance at 1 October will consist of Peter's initial $15,000 less the $8,000 expended on
non-current assets purchased in September. In other words, the opening balance is $7,000. Cash receipts
from credit customers arise two months after the relevant sales.
Payments to suppliers are a little more tricky. We are told that cost of sales is 100/150 sales. Thus for
October cost of sales is 100/150 $3,000 = $2,000. These goods will be purchased in October but not
paid for until November. Similar calculations can be made for later months. The initial inventory of $5,000
is purchased in September and consequently paid for in October.
Depreciation is not a cash flow and so is not included in a cash budget.
The cash budget can now be constructed.
CASH BUDGET FOR THE SIX MONTHS ENDING 31 MARCH 20X4

Oct

Nov

Dec

Jan

Feb

Mar

$

$

$

$

$

$

Payments

Suppliers

5,000

2,000

4,000

4,000

7,000

7,000

Running expenses

1,600

1,600

1,600

1,600

1,600

1,600

Drawings

1,000

1,000

1,000

1,000

1,000

1,000

7,600

4,600

6,600

6,600

9,600

9,600

Receipts

Debtors

3,000

6,000

6,000

10,500

Net surplus/(deficit) for
the month

(7,600)

(4,600)

(3,600)

(600)

(3,600)

900

Opening balance

7,000

(600)

(5,200)

(8,800)

(9,400)

(13,000)

Closing balance

(600)

(5,200)

(8,800)

(9,400)

(13,000)

(12,100)

5.4 Cash budgets and an opening statement of financial position
You might be given a cash budget question in which you are required to analyse an opening statement of
financial position to decide how many outstanding debtors will pay what they owe in the first few months
of the cash budget period, and how many outstanding creditors must be paid.
Suppose that a statement of financial position as at 31 December 20X4 shows the following details.
Due from customers (receivables) $150,000
Due to suppliers (trade payables) $60,000
The following information is relevant.
Customers are allowed two months to pay.
1
1
/2 months' credit is taken from trade suppliers.
Sales and materials purchases were both made at an even monthly rate throughout 20X4.
Let's try to ascertain the months of 20X5 in which the customers will eventually pay and the suppliers will
be paid.
73 3: Budgeting
(a) Since customers take two months to pay, the $150,000 of receivables in the statement of financial
position represents credit sales in November and December 20X4, who will pay in January and
February 20X5 respectively. Since sales in 20X4 were at an equal monthly rate, the cash budget
should plan for receipts of $75,000 each month in January and February from the receivables in the
opening statement of financial position.
(b) Similarly, since payables are paid after 1
1
/2 months, the payables in the statement of financial
position will be paid in January and the first half of February 20X5, which means that budgeted
payments will be as follows.
$
In January (purchases in 2nd half of November and 1
st

half of December 20X4) 40,000
In February (purchases in 2nd half of December 20X4)

20,000
Total payables in the statement of financial position

60,000
(The payables in the statement of financial position of $60,000 represent 1
1
/2 months' purchases, so that
purchases in 20X4 must be $40,000 per month, which is $20,000 per half month.)
5.5 Example: a month by month cash budget
From the following information which relates to George and Zola you are required to prepare a month by
month cash budget for the second half of 20X5 and to append such brief comments as you consider
might be helpful to management.
(a) The company's only product, a vest, sells at $40 and has a variable cost of $26 made up as
follows.
Material $20 Labour $4 Overhead $2
(b) Fixed costs of $6,000 per month are paid on the 28th of each month.
(c) Quantities sold/to be sold on credit
May June July Aug Sept Oct Nov Dec
1,000 1,200 1,400 1,600 1,800 2,000 2,200 2,600
(d) Production quantities
May June July Aug Sept Oct Nov Dec
1,200 1,400 1,600 2,000 2,400 2,600 2,400 2,200
(e) Cash sales at a discount of 5% are expected to average 100 units a month.
(f) Customers are expected to settle their accounts by the end of the second month following sale.
(g) Suppliers of material are paid two months after the material is used in production.
(h) Wages are paid in the same month as they are incurred.
(i) 70% of the variable overhead is paid in the month of production, the remainder in the following
month.
(j) Income tax of $18,000 is to be paid in October.
(k) A new delivery vehicle was bought in June. It cost $8,000 and is to be paid for in August. The old
vehicle was sold for $600, the buyer undertaking to pay in July.
(l) The company is expected to be $3,000 overdrawn at the bank at 30 June 20X5.
(m) No increases or decreases in raw materials, work in progress or finished goods are planned over
the period.
(n) No price increases or cost increases are expected in the period.

3: Budgeting 74
Solution
Cash budget for July 1 to December 31 20X5

July

Aug

Sept

Oct

Nov

Dec

Total

$

$

$

$

$

$

$

Receipts

Credit sales

40,000

48,000

56,000

64,000

72,000

80,000

360,000

Cash sales

3,800

3,800

3,800

3,800

3,800

3,800

22,800

Sale of vehicle

600

600

44,400

51,800

59,800

67,800

75,800

83,800

383,400

Payments

Materials

24,000

28,000

32,000

40,000

48,000

52,000

224,000

Labour

6,400

8,000

9,600

10,400

9,600

8,800

52,800

Variable o'head (W)

3,080

3,760

4,560

5,080

4,920

4,520

25,920

Fixed costs

6,000

6,000

6,000

6,000

6,000

6,000

36,000

Income tax

18,000

18,000

Purchase of vehicle

8,000

8,000

39,480

53,760

52,160

79,480

68,520

71,320

364,720

Net surplus/(deficit)
for the month

4,920

(1,960)

7,640

(11,680)

7,280

12,480

18,680

Opening balance

(3,000)

1,920

(40)

7,600

(4,080)

3,200

(3,000)

Closing balance

1,920

(40)

7,600

(4,080)

3,200

15,680

15,680

Working
Variable overhead

June

July

Aug

Sept

Oct

Nov

Dec

$

$

$

$

$

$

$

Variable overhead

production cost

2,800

3,200

4,000

4,800

5,200

4,800

4,400

70% paid in month

2,240

2,800

3,360

3,640

3,360

3,080

30% in following month

840

960

1,200

1,440

1,560

1,440

3,080

3,760

4,560

5,080

4,920

4,520
Comments
(a) There will be a small overdraft at the end of August but a much larger one at the end of October. It
may be possible to delay payments to suppliers for longer than two months or to reduce purchases
of materials or reduce the volume of production by running down existing inventory levels.
(b) If none of these courses is possible, the company may need to negotiate overdraft facilities with its
bank.
(c) The cash deficit is only temporary and by the end of December there will be a comfortable surplus.
The use to which this cash will be put should ideally be planned in advance.

Question
Cash budget

You are presented with the following budgeted data for your organisation for the period November 20X1
to June 20X2. It has been extracted from functional budgets that have already been prepared.
Nov X1 Dec X1 Jan X2 Feb X2 Mar X2 Apr X2 May X2 June X2
$ $ $ $ $ $ $ $
Sales 80,000 100,000 110,000 130,000 140,000 150,000 160,000 180,000
Purchases 40,000 60,000 80,000 90,000 110,000 130,000 140,000 150,000
Wages 10,000 12,000 16,000 20,000 24,000 28,000 32,000 36,000
Overheads 10,000 10,000 15,000 15,000 15,000 20,000 20,000 20,000
Dividends declared 20,000 40,000
Capital expenditure
incurred
30,000 40,000
75 3: Budgeting

You are also told the following.
(a) Sales are 40% cash, 60% credit. Credit sales are paid two months after the month of sale.
(b) Purchases are paid the month following purchase.
(c) 75% of wages are paid in the current month and 25% the following month.
(d) Overheads are paid the month after they are incurred.
(e) Dividends are paid three months after they are declared.
(f) Capital expenditure is paid two months after it is incurred.
(g) The opening cash balance is $15,000.
The managing director is pleased with the above figures as they show sales will have increased by more
than 100% in the period under review. In order to achieve this he has arranged a bank overdraft with a
ceiling of $50,000 to accommodate the increased inventory levels and wage bill for overtime worked.
Required
(a) Prepare a cash budget for each month of the six-month period January to June 20X2.
(b) Comment upon your results in the light of your managing director's comments and offer advice.

Answer

(a)

January

February

March

April

May

June

$

$

$

$

$

$

Cash receipts

Cash sales

44,000

52,000

56,000

60,000

64,000

72,000

Credit sales

48,000

60,000

66,000

78,000

84,000

90,000

92,000

112,000

122,000

138,000

148,000

162,000
Cash payments

Purchases

60,000

80,000

90,000

110,000

130,000

140,000

Wages 75%

12,000

15,000

18,000

21,000

24,000

27,000

25%

3,000

4,000

5,000

6,000

7,000

8,000

Overheads

10,000

15,000

15,000

15,000

20,000

20,000

Dividends

20,000

Capital expenditure

30,000

40,000

85,000

114,000

178,000

152,000

181,000

235,000

Net surplus/(deficit)
for the month

7,000

(2,000)

(56,000)

(14,000)

(33,000)

(73,000)
Opening balance

15,000

22,000

20,000

(36,000)

(50,000)

(83,000)
Closing balance

22,000

20,000

(36,000)

(50,000)

(83,000)

(156,000)
(b) The overdraft arrangements are quite inadequate to service the cash needs of the business over the
six-month period. If the figures are realistic then action should be taken now to avoid difficulties in
the near future. The following are possible courses of action.
(i) Activities could be curtailed.
(ii) Other sources of cash could be explored, for example a long-term loan to finance the capital
expenditure and a factoring arrangement to provide cash due from debtors more quickly.
(iii) Efforts to increase the speed of debt collection could be made.
(iv) Payments to creditors could be delayed.
(v) The dividend payments could be postponed (the figures indicate that this is a small
company, possibly owner-managed).
(vi) Staff might be persuaded to work at a lower rate in return for, say, an annual bonus or a
profit-sharing agreement.
(vii) Extra staff might be taken on to reduce the amount of overtime paid.
(viii) The inventory holding policy should be reviewed; it may be possible to meet demand from
current production and minimise cash tied up in inventories.

3: Budgeting

76

6 Fixed and flexible budgets
The master budget consists of a budgeted income statement, a budgeted statement of financial position
and a cash budget.
A fixed budget is a budget for one activity level, which is not changed even if the actual level of activity in
the budget period turns out to be different from that originally planned. A flexible budget is a budget that
is adjusted to allow for changes in the level of activity in the budget period.
The preparation of flexible budgets calls for an understanding of cost behaviour.
Flexible budgets might be prepared in advance of the budget period, when the organisation is uncertain
about what the actual level of activity will be. Flexible budgets might be prepared in retrospect, once the
actual level of activity is known. Retrospective flexible budgets might be used for budgetary control
purposes (comparing actual results against what results should have been at that level of activity).
6.1 Fixed budgets
A fixed budget is a budget which is designed to remain unchanged regardless of the volume of output or
sales achieved.
The master budget prepared before the beginning of the budget period is known as the fixed budget. The
term 'fixed' means:
(a) The budget is prepared on the basis of an

estimated volume of production and an estimated
volume of sales, but no plans are made for the event that actual volumes of production and sales
may differ from budgeted volumes.
(b) When actual volumes of production and sales during a control period (month or four weeks or
quarter) are achieved, a fixed budget is not adjusted (in retrospect) to the new levels of activity.
The major purpose of a fixed budget is at the planning stage, when it seeks to define the broad objectives
of the organisation.
6.2 Flexible budgets
A flexible budget is a budget which, by recognising different cost behaviour patterns, is designed to
change as volumes of output change.
Flexible budgets may be used in one of two ways.
(a) At the planning stage. For example, suppose that a company expects to sell 10,000 units of output
during the next year. A master budget (the fixed budget) would be prepared on the basis of this
expected volume. However, if the company thinks that output and sales might be as low as 8,000
units or as high as 12,000 units, it may prepare contingency

flexible budgets, at volumes of, say
8,000, 9,000, 11,000 and 12,000 units. There are a number of advantages of planning with flexible
budgets.
It is possible to find out well in advance the costs of lay-off pay, idle time and so on if
output falls short of budget.
Management can decide whether it would be possible to find alternative uses for spare
capacity if output falls short of budget (could employees be asked to overhaul their own
machines for example, instead of paying for an outside contractor?).

77 3: Budgeting
An estimate of the costs of overtime, subcontracting work or extra machine hire if sales
volume exceeds the fixed budget estimate can be made. From this, it can be established
whether there is a limiting factor which would prevent high volumes of output and sales
being achieved.
(b) Retrospectively. At the end of each month (control period) or year, flexible budgets can be used to
compare actual results achieved with what results should have been under the circumstances.
Flexible budgets are an essential factor in budgetary control and overcome the practical problems
involved in monitoring the budgetary control system.
Management needs to be informed about how good or bad actual performance has been. To
provide a measure of performance, there must be a yardstick (budget or standard) against
which actual performance can be measured.
Every business is dynamic, and actual volumes of output cannot be expected to conform
exactly to the fixed budget. Comparing actual costs directly with the fixed budget costs is
meaningless (unless the actual level of activity turns out to be exactly as planned).
For useful control information, it is necessary to compare actual results at the actual level of
activity achieved against the results that should have been expected at this level of activity,
which are shown by the flexible budget.
The use of flexible budgets for budgetary control reporting is described in a later chapter.
6.3 Preparing flexible budgets
Flexible budgets apply the principles of marginal costing, and recognise the distinction between fixed and
variable costs.
(a) For some items of expense, it might be necessary to recognise semi-variable costs, and split these
into their variable cost and fixed cost elements. The high-low method was explained in an earlier
chapter.
(b) Some variable unit costs might change if the level of activity rises above a certain level or falls
below a certain level. For example, if output rises above a certain level, it might be necessary to pay
overtime to some employees, or to recruit casual labour at a different rate of pay. Similarly, if
output rises above a certain level, it might be possible to benefit from bulk purchases of materials
or supplies, and so pay a lower unit cost.
(c) Some fixed cost items might show 'step cost' characteristics, and rise by a certain amount as the
level of activity rises above a particular level.

Question
Cost of electricity

Using the high-low method and the following information, determine the cost of electricity in July if 2,750
units of electricity are consumed.
Month Cost Electricity consumed
$ Units
January 204 2,600
February 212 2,800
March 200 2,500
April 220 3,000
May 184 2,100
June 188 2,200

3: Budgeting 78

Answer

$

(High)


220

(Low)


184

(Difference)

Variable cost of 900 units

36

Variable cost per unit ($36/900)

$0.04

$


220

Variable cost of 3,000 units

($0.04 per unit)

120

Fixed costs

100

Budget

$

Variable cost of 2,750 units

($0.04 per unit)

110

Fixed costs

100

Total cost, 2,750 units

210

We can now look at a full example of preparing a flexible budget.
6.4 Example: preparing a flexible budget
(a) Prepare a budget for 20X6 for the direct labour costs and overhead expenses of a production
department at the activity levels of 80%, 90% and 100%, using the information listed below.
(i) The direct labour hourly rate is expected to be $3.75.
(ii) 100% activity represents 60,000 direct labour hours.
(iii) Variable costs
Indirect labour $0.75 per direct labour hour
Consumable supplies $0.375 per direct labour hour
Canteen and other welfare services 6% of direct and indirect labour costs
(iv) Semi-variable costs are expected to relate to the direct labour hours in the same manner as
for the last five years.
Direct labour Semi-variable
Year hours costs

$
20X1 64,000 20,800
20X2 59,000 19,800
20X3 53,000 18,600
20X4 49,000 17,800
20X5 40,000 (estimate) 16,000 (estimate)
(v) Fixed costs

$
Depreciation 18,000
Maintenance 10,000
Insurance 4,000
Rates 15,000
Management salaries 25,000
(vi) Inflation is to be ignored.
79 3: Budgeting
(b) Calculate the budget cost allowance (ie expected expenditure) for 20X6 assuming that 57,000
direct labour hours are worked.
Solution
(a)

80% level

90% level

100% level

48,000 hrs

54,000 hrs

60,000 hrs

$'000

$'000

$'000

Direct labour

180.00

202.50

225.00

Other variable costs

Indirect labour

36.00

40.50

45.00

Consumable supplies

18.00

20.25

22.50

Canteen etc

12.96

14.58

16.20

Total variable costs ($5.145 per hour)

246.96

277.83

308.70

Semi-variable costs (W)

17.60

18.80

20.00

Fixed costs

Depreciation

18.00

18.00

18.00

Maintenance

10.00

10.00

10.00

Insurance

4.00

4.00

4.00

Rates

15.00

15.00

15.00

Management salaries

25.00

25.00

25.00

Budgeted costs

336.56

368.63

400.70

Working
Using the high/low method:

$


20,800


16,000


4,800

Variable cost per hour ($4,800/24,000)

$0.20

$


20,800

Variable cost of 64,000 hours ( $0.20)

12,800

Fixed costs

8,000

Semi-variable costs are calculated as follows.
$
60,000 hours (60,000 $0.20) + $8,000 20,000
54,000 hours (54,000 $0.20) + $8,000 18,800
48,000 hours (48,000 $0.20) + $8,000 17,600
(b) The budget cost allowance for 57,000 direct labour hours of work would be as follows.

$

Variable costs
(57,000 $5.145)

293,265

Semi-variable costs
($8,000 + (57,000 $0.20))

19,400

Fixed costs

72,000

384,665

6.5 The measure of activity in flexible budgets
The preparation of a flexible budget requires an estimate of the way in which costs (and revenues) vary
with the level of activity.
Sales revenue will clearly vary with sales volume, and direct material costs (and often direct labour costs)
will vary with production volume. In some instances, however, it may be appropriate to budget for
overhead costs as semi-variable costs (part-fixed, part-variable) which vary with an 'activity' which is
neither production nor sales volume. Taking production overheads in a processing department as an

3: Budgeting 80
illustration, the total overhead costs will be partly fixed and partly variable. The variable portion may vary
with the direct labour hours worked in the department, or with the number of machine hours of operation.
The better measure of activity, labour hours or machine hours, may only be decided after a close analysis
of historical results.
The measure of activity used to estimate variable costs should satisfy certain criteria.
The measurement of activity should be derived from the activity that causes particular costs to
vary.
The unit of a measured activity should be independent of variable factors other than its own
volume; for example, if labour hours are the measure of activity, the level of activity should be
measured in labour hours, and not the labour cost of those hours (the latter being prone to the
effect of a price change).
The measure of activity should be stable, and in this respect, a standard unit of output provides a
better measure than actual units. For example, if total costs are assumed to vary with direct labour
hours, it would be more appropriate to choose 'standard hours produced' as a measure of activity
than 'actual hours worked' because the actual hours may have been worked efficiently or
inefficiently, and the variations in performance would probably affect the actual costs incurred.

Question
Flexible budget

The fixed budget of C for 20X5 is as follows.
Sales and production

100,000 units

$'000

$'000

Sales

2,000


Direct materials

800

Direct labour

400

Variable overhead

200

1,400

Contribution

600

Fixed costs

500

Profit/(loss)

100

Sales demand is strong, and management is considering a proposal to increase the budget from 100,000
to 120,000 units.
(a) If output were to be increased above 100,000 units, all the additional output would have to be
made by the existing work force in overtime, for which the rate of pay would be 25% above the
normal rate.
(b) If output went up to 120,000 units, the company would be able to benefit from a lower purchase
price for direct materials. The purchase prices for materials would be 5% less than currently
budgeted, for all materials purchased.
(c) If output rose above 100,000 units, fixed costs would rise by $60,000, due to additional
accommodation requirements, particularly storage space.
Required
Prepare a flexible budget for output and sales of 120,000 units.
81 3: Budgeting

Answer

Sales and production

120,000 units

$'000

$'000

Sales (x 120%)

2,400


Direct materials (x 95% of 120%)

912

Direct labour [400 + (20% of 400 1.25)]

500

Variable overhead ( 120%)

240

1,652

Contribution

748

Fixed costs

560

Profit

188

6.6 Factors to consider when preparing flexible budgets
The mechanics of flexible budgeting are, in theory, fairly straightforward. In practice, however, there are a
number of points that must be considered before figures are flexed.
The separation of costs into their fixed and variable elements is not always straightforward.
Fixed costs may behave in a step-line fashion as activity levels increase/decrease.
Account must be taken of the assumptions upon which the original fixed budget was based. Such
assumptions might include the constraint posed by limiting factors, the rate of inflation,
judgements about future uncertainty, the demand for the organisation's products and so on.
7 Computers and budgeting
Computers provide invaluable assistance in co-ordinating the production of budgets.
Budgeting used to be a very time-consuming task, due to the need for a great number of numerical
manipulations to produce a budget, and the likelihood that budgets will go through several drafts before
they are finally agreed. It is likely that the budgeting process will encounter problems. Functional budgets
will be out of balance with each other and require modification. The revision of one budget may well lead
to the revision of all of the budgets. The manual preparation of a master budget and a cash budget in the
real world would therefore be daunting.
Computers can recalculate budgets in an instant, and are almost invariably used nowadays in the
budgeting process. A computerised system has a number of advantages.
A computer has the ability to process larger volumes of data.
A computerised system can process data more rapidly than a manual system.
Computerised systems tend to be more accurate than manual systems.
Computers have the ability to store large volumes of data in a readily accessible form.
Numerous scenarios can be evaluated quickly.
Budgets can go through many drafts, if necessary, with a relatively small amount of time needed to
revise one draft and prepare a new one.
A computerised budget model is ideal for taking over the manipulation of numbers, leaving staff to get
involved in the real planning process.
Budgeting may be computerised using a program written specifically for the organisation or one within
an accounting package or simply with spreadsheets. All these methods of computerisation of the
budgeting process will involve a mathematical model which represents the real world in terms of financial

3: Budgeting 82
values. The model will consist of several, or many, interrelated variables, a variable being an item in the
model which has a value.
A cash budgeting model, for example, should include all the factors (variables) which have a significant
influence on cash flow. Variables would include time taken by debtors to pay what they owe, cash sales
and credit sales, other cash expenses, and capital expenditure.
Once the planning model has been constructed, the same model can be used week by week, month after
month, or year after year, simply by changing the values of the variables to produce new results for cash
inflows, cash outflows, net cash flows and cash/bank balance.
A major advantage of budget models is the ability to evaluate different options and carry out 'what if'
analysis. By changing the value of certain variables (for example altering the ratio of cash sales to credit
sales, increasing the amount of bad debts or capital expenditure, increasing the annual pay award to the
workforce and so on) management are able to assess the effect of potential changes in their environment.
Computerised models can incorporate actual results, period by period, and carry out the necessary
calculations to produce budgetary control reports.
The use of a model allows the budget for the remainder of the year to be adjusted once it is clear that the
circumstances on which the budget was originally based have changed.
7.1 Spreadsheets and budgeting software
Currently, most organisations use standard spreadsheet packages for budgeting rather than a specific
budgeting package. However, budgeting packages are becoming more powerful and user-friendly.
Budgeting packages often look and feel like spreadsheets, but have additional budgeting-specific features
such as pre-programmed forecasting capabilities using complex statistical methods. They are less likely to
contain errors as the package is less dependent on user-entered formulae than spreadsheets.
83 4: Further issues with budgets
1 Strategic planning, operational planning and
budgeting
If an organisation is to achieve its strategic objectives, there must be an effective link between strategic
plans and operational plans. This is a link that budgets should help to provide.
Traditional budgeting has frequently been criticised for failing to provide this link, and for encouraging the
continuation of wasteful and inefficient practices and excessive spending. A few organisations have
questioned the value of having traditional budgets at all.
Alternatives to traditional budgeting have been developed, such as zero-based budgeting, activity-based
budgeting and rolling budgets.
Strategic planning is the process of specifying the objectives or targets of the organisation, consistent
with the organisation's mission, and formulating plans for the achievement of those objectives. It is the
process of deciding:
(a) where the organisation is trying to get to
(b) how it should get there, and
(c) how quickly.
Management control, also called tactical planning, is the process by which management converts
strategic plans into more detailed and shorter-term plans. It involves making sure that resources are made
available at an economic price, and are applied both efficiently and effectively towards the achievement of
strategic goals. Planning horizons are medium-term.
Operational control or operational planning is the process of ensuring that specific tasks are carried out
effectively and efficiently. Planning horizons can range, but are often short-term. Operational planning
decisions are made with a view to achieving longer-term planning goals.
1.1 Strategic planning information
Strategic planning decisions are taken at the top level of management, but strategic plans have to be
converted into practical 'action plans'. The process of converting strategy into action involves all levels of
management. Planning horizons range from long-term to fairly short-term.
For many organisations, the annual budget is the major element of planning. Strategic planning, however,
calls for different types of information, and different methods of analysis. Much of the information for
strategic planning must come from outside the organisation, and may be non-financial in nature. An
organisation should consider, at the strategic level, competitors' actions, and a range of so-called 'PEST'
factors (political, environmental, social and technological factors).
Examples of strategic information, and how it might be used, are as follows.

Further issues
with budgets

4: Further issues with budgets 84
Item Strategic management information needs
Competitors' costs What are they? How do they compare with ours? Can we beat our
competitors on cost?
Product profitability What profits or losses are made by each of our products? Why is Product
A making good profits whereas Product B is making a loss, even though
its quality is just as good? Should we be switching from focus on some
products to greater emphasis on others? Should we be targeting
particular types of customer with particular types of product or service?
Pricing decisions for new
products
Pricing a new product can be critically important for the success or failure
of the product launch. Information is needed, possibly from market
research, about how the market might respond to a new product at
various prices.
The value of market share An organisation needs to be aware of what it would be worth to increase
its share of the market for any of its products. What would be the value of
an increase of market share of, say, 1%? Is this a goal worth pursuing?
Future prices What might product prices be in the future, as the market evolves, and as
existing products go through their life cycle?
Future products How is the market likely to evolve, and what new products are likely to
succeed in the market?
Capacity expansion Should the firm expand its capacity, and if so by how much? Should it
diversify into a new area of operations or into a new market?
1.2 Ensuring a link between strategic and operational planning
Achieving longer-term strategic goals will not happen unless there is an effective link between the strategic
planning process and the formulation of operational plans. If there is no link between strategic planning
and operational planning, the result is likely to be unrealistic plans, inconsistent goals, poor
communication and inadequate performance measurement.
'Management control', of which budgeting is a key element, sits between strategic planning at a senior
management level and 'hands-on' management decision-making at the short-term level.
(a) A primary function of budgeting is therefore to ensure that the organisation's strategic objectives
are achieved, or that progress is made towards their achievement. Budgeting can support strategic
planning in various ways.
Objective Comment
Strategic direction Operations and resource plans, and hence budgets, should be derived
from business strategies.
Resource allocation Resources should be allocated according to the required outputs.
Budgets should be directed towards achieving critical success factors.
Continuous
improvement
Firms should always seek to improve their performance in relation to
customer needs, industry best practice and competitors. Budgets should
support continuous improvement.
Goal congruence Managers must understand the effect of their decisions on the work
processes beyond their departmental boundaries.
Add value The time spent on budgetary activities should be worth more than its
cost.
Objective Comment
Cost reductions When an organisation's targets include improved productivity, or
restoring profitability, cost reductions are likely to be a crucial short-
term target. The budget will be the planning mechanism.
Targets and
responsibilities
Budgets will set targets for divisions, departments, and sub-sections of
departments. Individual managers should be aware of what their
personal targets are.
1.3 Problems with budgeting
In practice, budgets and the budgeting process are frequently criticised because they fail to provide a link
between strategic and operational planning, and fail to help the organisation to achieve its strategic
objectives. The main criticisms are:
(a) the rigid organisational structure within which budgets are normally formulated, with departmental
managers often competing with each other for money and resources, and with departmental
interests taking precedence over the wider interests of the organisation
(b) the inefficient planning techniques in budgeting, that encourage the continuation of existing
inefficiencies, and fail to encourage managers to look for performance improvements
(c) the rigid one-year time frame of the budget, and the lack of flexibility in the planning horizon.
Traditional budgets are based on the management structure of the organisation. However, it has been
argued that management should think in terms of processes, stretching across departmental boundaries,
and with the customer at the end of them. Activities should not be looked at in terms of a static
organisation structure.
At its worst, the traditional budgeting process commences with management setting a revenue forecast
and financial targets. Departmental budgets are then prepared based on last year's costs and year-to-date
actual costs, 'plus or minus a bit'. Budgeting is often insufficiently concerned with how resources should
be used more efficiently and effectively, or with whether resources can even be obtained more cheaply.
Most budgets are prepared over a one-year period to enable managers to plan and control financial
results for the purposes of the annual accounts. There is a need for management to satisfy shareholders
that their company is achieving good results, and for this reason, the arbitrary one-year financial period is
usually selected for budgeting. One-year plans are not necessarily relevant to the business strategy.
As a consequence of criticisms of traditional budgeting:
(a) alternative methods of budgeting have been developed, and
(b) some organisations have questioned the value of having budgets at all.

Case Study

A small number of companies have gone so far as to abolish budgeting as traditionally practised.
(a) Volvo has dropped its once-a-year traditional budgeting process and introduced a new concurrent
planning process. This has a permanent focus on objectives and uses key performance indicators,
rolling forecasting and short- and long-term 'balanced scorecards'. (These are described in a later
chapter.)
(b) AES, the global power generation and distribution company has a 'beyond budgeting' approach to
management and has created a unique empowered organisation. AES has no central staff,
organisation charts, management or written policies and procedures. It does not have a long-term
five year plan or a corporate strategy, merely a goal 'to be the leading global power company, to be
the global industry leader'.
There are no central functions such as finance, HR, purchasing, marketing. Each operating plant
consists of a number of small flexible self-managed groups of 5-20 employees (cells). The cells
make individual and team-based decisions. The only budgeting is carried out by the actual people

in the plants deciding what resources they require based on the previous year and future
assignments, and this serves as a guideline rather than a constraint.
Founder and ex CEO Dennis Bakke believes 'strict financial planning often serves to centralise
control among a few leaders at the top of the organisation'.
Bakke sees long term planning as a waste of time because conditions change so dramatically
within the industry. 'There are some things about the way we do things in terms of freeing up
people that are amazingly adaptable to a world that's changing all the time. We may be one of the
fastest companies in being able to act and respond.'
(Beyond budgeting is described in more detail in Section 9 of this Chapter).

Some of the alternative approaches to budgeting are described below.
2 Zero-based budgeting
The principle behind zero-based budgeting (ZBB) is that the budget for each cost centre should be made
from 'scratch' or zero. Every item of expenditure must be justified in its entirety in order to be included in
the next year's budget.
There is a three-step approach to ZBB.
Define decision packages
Evaluate and rank packages
Allocate resources
A 'traditional approach' to budgeting is to base next year's budget on the current year's results plus an
extra amount for estimated growth or inflation next year. This approach is known as incremental
budgeting since it is concerned mainly with the increments in costs and revenues which will occur in the
coming period.
Incremental budgeting is a reasonable procedure if current operations are as effective, efficient and
economical as they can be, and the organisation and the environment are largely unchanged.
In general, however, it is an inefficient form of budgeting as it encourages slack and wasteful spending
to creep into budgets. Past inefficiencies are perpetuated because cost levels are rarely subjected to close
scrutiny.
To ensure that inefficiencies are not concealed, alternative approaches to budgeting have been developed.
One such approach is zero-based budgeting (ZBB), the use of which was pioneered by P Pyhrr in the
United States in the early 1970s.
2.1 The principles of zero-based budgeting
ZBB rejects the assumption inherent in incremental budgeting that next year's budget can be based on this
year's costs. In a ZBB approach to planning, every aspect of the budget is examined in terms of its cost
and the benefits it provides and the selection of better alternatives is encouraged.
Zero-based budgeting involves preparing a budget for each cost centre from a zero base. Every item of
expenditure has then to be justified in its entirety in order to be included in the next year's budget.
2.2 Implementing zero-based budgeting
Implementing ZBB calls for a questioning attitude by all those involved in the planning process. Existing
practices and expenditures must be challenged and searching questions, such as the following, must be
asked.

Does this activity need to be carried out?
What would be the consequences if the activity was not carried out?
Does this activity benefit the organisation?
Is the current level of provision appropriate?
Are there alternative ways of providing the function?
How much should the activity cost?
Is the expenditure worth the benefits achieved?
There are three stages in a zero-based budgeting process.
Stage 1 Identify and define decision packages
A decision package is an activity within the organisation that results in costs (or revenues).
There is a choice whether the activity should or should not be carried out. If it is carried out,
a certain amount of additional costs will be incurred (or, if it ceases to be carried out,
certain costs will be avoided). Decision packages can be evaluated. (Is the activity
worthwhile?) Decision packages can also be compared with each other and ranked in an
order of preference. (If we could do only A or B, which would be preferred?) Managers
prepare decision packages for the activities within the budget centre for which they have
responsibility.
There are two types of decision package.
(a) Mutually exclusive packages contain alternative methods of getting the same job
done. The best option among the packages must be selected by comparing costs
and benefits and the other packages are then discarded. For example, an
organisation might consider two alternative decision packages for the preparation of
the payroll: Package 1 might be in-house preparation of the payroll whereas Package
2 could involve the use of an outside agency.
(b) Incremental packages divide one aspect of an activity into different levels of
effort. The 'base' package will describe the minimum amount of work that must be
done to carry out the activity and the other packages describe what additional work
could be done, at what cost and for what benefits.
EXAMPLE
Suppose that a cost centre manager is preparing a budget for maintenance costs. He or she
might first consider two mutually exclusive packages. Package A might be to keep a
maintenance team of two people per shift for two shifts each day at a cost of $60,000 per
annum, whereas package B might be to obtain a maintenance service from an outside
contractor at a cost of $50,000. A cost-benefit analysis will be conducted because the
quicker repairs obtainable from an in-house maintenance service might justify its extra cost.
If we now suppose that package A is preferred, the budget analysis must be completed by
describing the incremental variations in this chosen alternative.
(a) The 'base' package would describe the minimum requirement for the maintenance
work. This might be to pay for one person per shift for two shifts each day at a cost
of $30,000.
(b) Incremental package 1 might be to pay for two people on the early shift and one
person on the late shift, at a cost of $45,000. The extra cost of $15,000 would need
to be justified, for example by savings in lost production time, or by more efficient
machinery.
(c) Incremental package 2 might be the original preference, for two people on each shift
at a cost of $60,000. The cost-benefit analysis would compare its advantages, if any,
over incremental package 1.
(d) Incremental package 3 might be for three people on the early shift and two on the
late shift, at a cost of $75,000; and so on.


Question
Packages

What might the base package for a personnel department cover? What might incremental packages
cover?

Answer

The base package might cover the recruitment and dismissal of staff. Incremental packages might cover
training, pension administration, trade union liaison, staff welfare and so on.

Stage 2 Evaluate and rank packages
Each activity (decision package) is evaluated and ranked on the basis of its benefit to the
organisation.
The ranking process provides managers with a technique to allocate scarce resources
between different activities. Minimum work requirements (those that are essential to get a
job done) will be given high priority and so too will work which meets legal obligations. In
the accounting department these would be minimum requirements to operate the payroll,
purchase ledger and sales ledger systems, and to maintain and publish a set of accounts
which satisfies the external auditors.
The ranking process can be lengthy because large numbers of different packages will have
been prepared by managers throughout the organisation. In large organisations the number
of packages might be so huge that senior management cannot do the ranking unaided. In
such circumstances, the following occurs.
(a) Cost centre managers will be asked to rank the packages for their own cost centre.
(b) The manager at the next level up the hierarchy of seniority will consolidate the
rankings of his or her subordinates into a single ranking list for the group of cost
centres, using the rankings of each cost centre as a guide.
(c) These consolidated rankings will be passed in turn one stage further up the
management hierarchy for further consolidation. At higher levels of consolidation,
the ranking process might be done by a committee of managers rather than by an
individual.
Once a consolidated ranking of packages has been prepared, it should be reviewed to make
sure that there is a general agreement that the rankings are reasonable and there are no
anomalies in them.
Stage 3 Allocate resources
Resources in the budget are then allocated according to the funds available and the
evaluation and ranking of the competing packages. Packages involving small expenditures
can be dealt with by junior managers but senior managers must make decisions involving
larger amounts of expenditure. The ZBB process must, however, run through the entire
management structure.
3 Advantages and limitations of zero-based budgets
3.1 The advantages of implementing ZBB
Zero-based budgeting has some advantages over traditional budgeting methods.
It is possible to identify and remove inefficient or obsolete operations.
It forces employees to avoid wasteful expenditure.
It can increase motivation, by involving employees in the process of looking for better ways of
performing activities.
It provides a budgeting and planning tool for management that responds to changes in the
business environment; 'obsolescent' items of expenditure are identified and dropped.
The documentation required provides all management with a co-ordinated, in-depth appraisal of
an organisation's operations.
It challenges the status quo and forces an organisation to examine alternative activities and
existing expenditure levels.
In summary, ZBB should result in a more efficient allocation of resources to an organisation's
activities and departments.
3.2 The disadvantages of ZBB
The major disadvantage of zero-based budgeting is the time and energy required to implement it,
particularly on a regular basis. The assumptions about costs and benefits in each package must be
continually updated and new packages developed as soon as new activities emerge. The following
problems might also occur.
(a) Short-term benefits might be emphasised to the detriment of long-term benefits.
(b) The false idea that all decisions have to be made in the budget might be encouraged.
Management must be able to meet unforeseen opportunities and threats at all times, and must not
feel restricted from carrying out new ideas simply because they were not approved by a decision
package, cost-benefit analysis and the ranking process.
(c) It may be a call for management skills both in constructing decision packages and in the ranking
process which the organisation does not possess. Managers may therefore have to be trained in
ZBB techniques so that they can apply them sensibly and properly.
(d) It may be difficult to 'sell' ZBB to managers as a useful technique for the following reasons.
Incremental costs and benefits of alternative courses of action are hard to quantify
accurately.
Employees or trade union representatives may resist management ideas for changing the
ways in which work is done.
(e) The organisation's information systems may not be capable of providing suitable incremental cost
and incremental benefit analysis.
(f) The ranking process can be difficult. Managers face three common problems.
A large number of packages may have to be ranked.
There is often a conceptual difficulty in having to rank packages which managers regard as
being equally vital, for legal or operational reasons.
It is difficult to rank completely different types of activity, especially where activities have
qualitative rather than quantitative benefits - such as spending on staff welfare and working
conditions - where ranking must usually be entirely subjective.
In summary, perhaps the most serious drawback to ZBB is that it requires a lot of management time and
paperwork. One way of obtaining the benefits of ZBB but of overcoming the drawbacks is to apply it
selectively on a rolling basis throughout the organisation. This year finance, next year marketing, the year
after personnel and so on. In this way all activities will be thoroughly scrutinised over a period of time.
4 Using zero-based budgeting
ZBB can be used by both profit-making and non-profit-making organisations. It has been popular in the
US and Canada but has not been taken up much in the UK.
The procedures of zero-based budgeting do not lend themselves easily to direct manufacturing costs
where standard costing, work study and the techniques of management planning and control have long
been established as a means of budgeting expenditure.

ZBB is best applied to expenditure incurred in departments that support the essential production function.
These include marketing, finance, quality control, repairs and maintenance, production planning, research
and development, engineering design, personnel, data processing, sales and distribution. In many
organisations, these expenses make up a large proportion of the total expenditure. These activities are less
easily quantifiable by conventional methods and are more discretionary in nature.
ZBB can also be successfully applied to service industries and non-profit-making organisations such as
local and central government departments, educational establishments, hospitals and so on.
ZBB can be applied in any organisation where alternative levels of provision for each activity are possible
and where the costs and benefits are separately identifiable.
Some particular uses of ZBB are:
(a) Budgeting for discretionary cost items, such as advertising, R & D and training costs. The
priorities for spending money could be established by ranking activities and alternative levels of
spending or service can be evaluated on an incremental basis. For example, is it worth spending
$2,000 more to increase the numbers trained on one type of training course by 10%? If so, what
priority should this incremental spending on training be given, when compared with other potential
training activities?
(b) Rationalisation measures. 'Rationalisation' means cutting back on production and activity levels,
and cutting costs. ZBB can be used to make rationalisation decisions when an organisation is
forced to make spending cuts. (This use of ZBB might explain any unpopularity it might have
among managers.)
5 Activity-based budgeting (ABB)
Activity-based budgeting provides a method of budgeting for 'overhead' costs whereby planned costs are
related to the activities performed. Overhead costs are not treated as fixed or variable according to
whether they vary with the level of production or sales volume. Instead, costs are assumed to vary with
changes in the level of the factor that drives the costs of each support activity.
Activity-based budgeting (ABB) is a method of budgeting based upon an activity framework, using cost
driver data in budget setting and variance analysis.
Activity-based budgeting is an approach to budgeting that applies many of the concepts of activity-based
costing. It might be particularly relevant, therefore, to high-technology industries, in which processes are
more complex, and quality issues are often important.
Like ZBB, activity-based budgeting is particularly applicable to 'support functions', away from the factory
floor, such as product design, order handling, quality control, customer service and production planning.
It is also applicable to administrative functions, such as personnel and facilities management.
The approach taken in ABB is to recognise that an organisation consists of a number of activities rather
than a number of departments, and that costs are incurred by activities. Cost drivers can also be identified
for activities. Even within a single department, costs are caused by activities, and vary with the level of that
activity.
For example, within the HR department, some costs might be driven by recruitment numbers (the costs of
setting up personnel records, medical checks, training arrangements, and so on). If so, a part of the
budget for the HR department might be prepared on the basis of the expected number of employees to be
recruited in the budget period.
ABB is an alternative to 'traditional' volume-based models for budgeting, in which costs are either fixed or
vary with the volume of production and sales. It is an approach to planning aimed primarily at
understanding the reason why costs are incurred, and giving planners the opportunity to manage those
costs.

Cost budgets can be prepared on the basis of:
(a) the activities performed in the support areas of the organisation
(b) recognising the cost driver for each of those activities
(c) analysing costs as either variable or fixed in relation to changes in the level of that activity
(d) budgeting what the level of activity will be, and
(e) preparing a cost budget for the activity accordingly.
ABB therefore brings a better analysis of costs into budgeting for overhead operations, compared with
traditional budgeting systems, where overheads are all treated as fixed unless they vary with output
volume.
A further consequence of an activity-based approach might be to identify wasteful spending, ie spending
incurred that has no value or purpose in relation to the activities of the organisation. It might also help
managers to identify limiting factors, and constraints on activities.
By focusing on activities, activity-based budgeting encourages managers to think about the most
economical or efficient way of getting something done. For example, suppose that a resources manager
states that he or she needs a new building in which to re-locate a particular operation that is growing in
size. It might well be that obtaining an additional building is the best solution. However, by looking at the
activity, it might be seen that a better solution is to employ more efficient technology, or to use a more
distributive form of doing the work, so that the operation can be performed without the need for the extra
space.

Question
Non-value-added

One consequence of the activity based budgeting process might be the identification of 'non-value-added'
activities what do you think this means, and can you give an example of such an activity in, say, a book
publishing company?

Answer

A non-value added activity is one that does nothing to enhance the value of the product from the point of
view of the consumer, and could be removed without the customer perceiving a fall in quality of the
product. So whilst proofreading in a publishing company is a value-added activity (customers would soon
notice if it wasn't done), the storage and handling of the inventories of paper for books is not. Cost
reduction is best achieved by the minimisation of such activity (for example, by only ordering paper when
a print run is about to start see Just in Time in Chapter 15).

6 Rolling budgets
Rolling budgets (or continuous budgets) are budgets which are continuously updated by adding a further
period (say a month or a quarter) and removing the earliest period.
Rolling budgets might be used to overcome the problem that a fixed budget might get out of date, and
cease to be of relevance or value once the budget period is under way. This is particularly likely to happen
to an organisation that operates in a dynamic and continually-changing environment.
Rolling budgets might also be used as a means of ensuring that the budget is not simply a once-a-year
exercise, but that the budgeting process is a more frequent and dynamic part of the planning process.
A rolling budget is a budget that is continuously updated by adding a further accounting period (a month
or quarter) when the earlier accounting period has expired.

For example, if an organisation prepares a rolling annual budget every three months:
(a) it might begin by preparing a budget for the period January December Year 1
(b) three months later, it will prepare a budget for the year April Year 1 March Year 2
(c) three months later, it will prepare a budget for the year July Year 1 June Year 2
(d) a further three months later, it will prepare a budget for the year October Year 1 September Year
2, and so on.
Each rolling budget is for one year, but there are four budgets in the year. As a result, management re-
visits its planning decisions four times a year, much more frequently than with traditional annual
budgeting.
Rolling budgets should help management to prepare targets and plans that are more realistic and certain,
by shortening the period between preparing budgets.
Computerised budget models enable rolling budgets to be prepared relatively easily.
6.1 The advantages and disadvantages of rolling budgets
The advantages of rolling budgets are as follows.
(a) By producing budgets more frequently than once a year, there is a better likelihood that the
budgets will provide an effective link between strategic planning and operational planning.
They reduce the element of uncertainty in budgeting. Rolling budgets concentrate detailed
planning and control on short-term prospects where the degree of uncertainty is smaller.
(b) They force managers to reassess the budget regularly, and to produce budgets that are up-to-date
in the light of current events and expectations. For example, if annual budgets are formulated by
adding an allowance for inflation to last year's figures, there is a danger that the annual rate of
inflation will be over-estimated so that the budgets will be too high and thus encourage
overspending by departments. In contrast, quarterly budgets prepared on a rolling basis are
likely to predict inflation rates more accurately because shorter-term forecasts are used.
(c) Planning and control will be based on a recent plan instead of a fixed annual budget that might
have been made many months ago and which is no longer realistic.
(d) Realistic budgets are likely to have a better motivational influence on managers.
(e) There is always a budget which extends for several months ahead. For example, if rolling budgets are
prepared quarterly there will always be a budget extending for the next 9 to 12 months. If rolling budgets
are prepared monthly there will always be a budget for the next 11 to 12 months. This is not the case
when fixed annual budgets are used.
The disadvantages of rolling budgets are as follows.
(a) A system of rolling budgets calls for the routine preparation of a new budget at regular intervals
during the course of the one financial year. This involves more time, effort and money in budget
preparation.
(b) Frequent budgeting might have an off-putting effect on managers who doubt the value of
preparing one budget after another at regular intervals, even when there are major differences
between the figures in one budget and the next.
(c) Revisions to the budget might involve revisions to standard costs too, which in turn would involve
revisions to inventory valuations. This could mean that a large administrative effort is required in
the accounts department every time a rolling budget is prepared to bring the accounting records up
to date.
7 The behavioural implications of budgeting
There are basically two ways in which a budget can be set: from the top down (imposed budget) or from
the bottom up (participative budget). Many writers refer to a third style (negotiated).
Participation in the budgeting process might improve the motivation of employees and junior managers.
7.1 Motivation
Motivation is what makes people behave in the way that they do. It comes from individual attitudes, or
group attitudes. Individuals will be motivated by personal desires and interests. These may be in line with
the objectives of the organisation, and some people 'live for their jobs'. Other individuals see their job as a
chore, and their motivations will be unrelated to the objectives of the organisation they work for.
It will be of enormous benefit to an organisation if the goals of its management and employees are in
harmony with the goals of the organisation itself. (This is known as 'goal congruence'.) Motivation
attitudes could affect performance. Performance may be enhanced if motivation is positive, and
performance could be damaged by poor motivation.
7.2 Participation
It has been argued that participation by individuals in the budgeting process will improve their
motivation, and that improved motivation will improve:
(a) the quality of budget decisions, and
(b) the efforts of individuals to achieve their budget targets.
7.3 Motivation and the budgeting process
Plans cannot succeed unless they are put into effect. A plan that looks wonderful on paper is of no value if
either:
(a) it is unrealistic, or
(b) it would be realistic, but only if employees were willing to make an effort to achieve the planning
targets.
An important issue in planning is how to get employees to work towards the achievement of the
organisation's objectives, particularly since the objectives of the organisation are unlikely to be of much
interest to the 'average' employee. It has been argued that the style of management can have an effect on
the performance of employees.
There are basically two ways in which a budget can be set: from the top down (imposed budget) or from
the bottom up (participative budget).
7.4 Imposed style of budgeting
In this approach to budgeting, top management prepares a budget with little or no input from junior
managers or operating personnel. The budget is then imposed on the employees who have to work to its
targets.
Imposed budgets can be implemented effectively:
in newly-formed organisations
in very small businesses
during periods of economic hardship
when operational managers lack budgeting skills
when the organisation's different units require precise co-ordination.

Possible advantages of senior management imposing a budget are that:
it might increase the probability that the organisation's strategic plans will be incorporated into
planned activities
it might enhance the co-ordination between the budgets of the various departments or divisions of
the organisation
senior managers are more aware than junior managers or employees of what resources are
available to the organisation, particularly in terms of money for extra spending
budgets should be prepared quickly, because limited negotiations (if any) are required before the
budget is agreed.
There are also disadvantages in imposing a budget.
It can produce dissatisfaction, defensiveness and low morale amongst employees on whom the
budget is imposed. It is hard for people to be motivated to achieve targets set by somebody else.
Any feeling of team spirit there might have been will probably disappear.
There may be a feeling that the budget is a punitive device, ie that employees will be punished in
some way if they fail to achieve the targets.
Lower-level management initiative may be stifled.
7.5 Participative style of budgeting
In a bottom-up approach to budgeting, budgets are developed by lower-level managers who then submit
the budgets to their superiors for discussion and approval. The budgets are based on the lower-level
managers' perceptions of what is achievable and what resources would be needed to achieve them.
Participative budgets might be effective in the following circumstances.
In well-established organisations.
In very large businesses, where junior managers often have a better understanding of local
circumstances than senior management.
When operational managers have strong budgeting skills.
When the organisation's different units or divisions act autonomously.
Advantages of participative budgets are as follows.
Information is gathered from employees most familiar with each department's needs and
constraints, strengths and weaknesses.
Knowledge spread among several levels of management is pulled together.
Morale and motivation is improved.
Acceptance of and commitment to organisational goals and objectives by operational managers is
likely to be improved.
In general, they are more realistic and achievable.
Co-ordination between units is improved.
Operating managers are more likely to develop operational plans which are consistent with the
budget and tie in with the organisation's goals and objectives.
Senior managers' overview of the organisation is mixed with operational level details.
Participative budgets have disadvantages.
They consume more time than top-down budgets.
The advantages of managerial participation could be negated if senior management over-ride or
ignore planning targets proposed by their juniors. This can lead to dissatisfaction similar to that
experienced with imposed budgets.
Junior managers might be ambivalent about wanting to participate in the budgeting process.
Managers may set budgets for their departments without trying to co-ordinate their own plans with
those of other departments.
They may encourage managers to introduce 'budgetary slack', by trying to obtain a larger spending
budget for their department.
They can support 'empire building' by subordinates.
7.6 Negotiated style of budgeting
There is a third style of budgeting, a negotiated style. Different levels of management often agree budgets
by a process of negotiation. In top-down budgeting, operational managers will try to negotiate with their
senior managers to reduce the budget targets they consider to be unreasonable or unrealistic. Likewise, in
a bottom-up budgeting environment, senior management usually review and revise budgets presented to
them, through a process of negotiation with lower level managers. Final budgets are therefore most
likely to lie between what top management would really like and what junior managers believe is
feasible. The budgeting process is hence a bargaining process.
8 Using budgets as targets
A lack of employee motivation will make it more difficult for an organisation to achieve its objectives.
In certain situations it may be useful to prepare an expectations budget and an aspirations budget.
Once decided, budgets become targets. As targets, they can motivate managers to achieve a high level of
performance. But how difficult should targets be? And how might people react to targets of differing
degrees of difficulty in achievement?
(a) There is likely to be a demotivating effect where an ideal standard of performance is set, because
adverse efficiency variances will always be reported.
(b) A low standard of efficiency is also demotivating, because there is no sense of achievement in
attaining the required standards.
(c) A budgeted level of attainment could be 'normal': that is, the same as the level that has been
achieved in the past. Arguably, this level will be too low. It might encourage the continuation of
current inefficiencies.
It has been argued that each individual has a personal 'aspiration level'. This is a level of performance in
a task with which the individual is familiar, which the individual undertakes for him or herself to reach.
This aspiration level might be quite challenging and if individuals in a work group all have similar
aspiration levels it should be possible to incorporate these levels within the official operating standards.
Some care should be taken, however, in applying this.
(a) If a manager's tendency to achieve success is stronger than the tendency to avoid failure, budgets
with targets of intermediate levels of difficulty are the most motivating, and stimulate a manager to
better performance levels. Budgets which are either too easy to achieve or too difficult are
de-motivating, and managers given such targets achieve relatively low levels of performance.
(b) A manager's tendency to avoid failure might be stronger than the tendency to achieve success.
(This is likely in an organisation in which the budget is used as a pressure device on subordinates
by senior managers.) Managers might then be discouraged from trying to achieve budgets of
intermediate difficulty and tend to avoid taking on such tasks, resulting in poorer levels of
performance than if budget targets were either easy or very difficult to achieve.
It has therefore been suggested that in a situation where budget targets of an intermediate difficulty are
motivating, such targets ought to be set if the purpose of budgets is to motivate. However, although
budgets set for motivational purposes need to be stated in terms of aspirations rather than
expectations, budgets for planning and decision purposes need to be stated in terms of the best available
estimate of expected actual performance.
Budgets to motivate, and budgets as realistic targets might therefore be inconsistent with each other. The
solution might therefore be to have two budgets.

(a) A budget for planning and decision making based on reasonable expectations.
(b) A second budget for motivational purposes, with more difficult targets of performance (that is,
targets of an intermediate level of difficulty).
These two budgets might be called an 'expectations budget' and an 'aspirations budget' respectively.
An expectations budget is a budget set on the basis of the most likely outcomes from the process. It is
used as a planning tool.
An aspirations budget is a budget set on the basis of providing challenging targets to the individuals
involved in the process. It is used as a motivational tool.
For example, a salesman might be expected to sell 20,000 units of a product next year at a fixed price of
$5 each. His character may be such that he thrives on being given a challenging target, so he may be
given a personal sales target of 22,000 units at $5 each. The sales revenue generated by this salesman
would be forecast at $100,000 in an expectations budget, but $110,000 in an aspirations budget.

Question
Budgeting process

What points would you raise in a discussion about the behavioural aspects of participation in the
budgeting process, and the difficulties you might envisage?

Answer

The level of participation in the budgeting process can vary from zero participation to a process of group
decision making. There are a number of behavioural aspects of participation to consider.
(a) Communication. Managers cannot be expected to achieve targets if they do not know what those
targets are. Communication of targets is made easier if managers have participated in the
budgetary process from the beginning.
(b) Motivation. Managers are likely to be better motivated to achieve a budget if they have been
involved in compiling it, rather than having a dictatorial budget imposed on them.
(c) Realistic targets. A target must be achievable and accepted as realistic if it is to be a motivating
factor. A manager who has been involved in setting targets is more likely to accept them as
realistic. In addition, managers who are close to the operation of their departments may be more
aware of the costs and potential savings in running it.
(d) Goal congruence. One of the best ways of achieving goal congruence is to involve managers in the
preparation of their own budgets, so that their personal goals can be taken into account in setting
targets.
Although participative budgeting has many advantages, difficulties might also arise.
(a) Pseudo-participation. Participation may not be genuine, but merely a pretence at involving
managers in the preparation of their budgets. Managers may feel that their contribution is being
ignored, or that the participation consists of merely obtaining their agreement to a budget which
has already been decided. If this is the case then managers are likely to be more demotivated than
if there is no participation at all.
(b) Coordination. If participative budgeting is well-managed it can improve the coordination of the
preparation of the various budgets. There is, however, a danger that too many managers will
become involved so that communication becomes difficult and the process becomes complex.
(c) Training. Some managers may not possess the necessary skill to make an effective contribution to
the preparation of their budgets. Additional training may be necessary, with the consequent
investment of money and time. It may also be necessary to train managers to understand the
purposes and advantages of participation.
(d) Slack. If budgets are used in a punitive fashion for control purposes then managers will be tempted
to build in extra expenditure to provide a 'cushion' against overspending. It is easier for them to
build in slack in a participative system.

9 Beyond budgeting
In fast moving markets, traditional budgets might be a handicap to efficient management, and some
companies have moved 'beyond' budgeting, decentralising authority and responsibility to front-line
managers who measure performance by reference to competition and other benchmarks rather than by
reference to budget targets.
Traditional budgeting methods have remained largely unchanged for many years, and are used by many
organisations. Zero-based budgeting and activity-based budgeting are methods for improving the way that
budgets are prepared, and there have also been vast improvements in the use of information technology,
for example, to prepare quarterly or six-monthly rolling budgets.
Traditional budgeting has its severe critics, who argue that the system is too centralised and too rigid, and
does not provide a suitable framework for improving performance. An alternative to budgeting, known as
'beyond budgeting' has been proposed.
The criticism of traditional budgeting is that it is a handicap to company performance. Budgets are a
barrier to the devolution of authority to front-line managers and to the implementation of more effective
performance management processes (such as the balanced scorecard, which is described in a later
chapter). 'The traditional performance management model is too rigid to reflect today's fast-moving
economy. Two new approaches devolution and strategic performance management have risen in
popularity, but they are equally frustrated by unyielding budgeting systems.' (Jeremy Hope and Robin
Fraser).
Events in businesses and markets are often fast-moving. Customers are able to switch from one supplier
to another quickly, often at the click of a mouse button, and to be successful, companies need to focus on
providing customer satisfaction. In rapidly-changing markets, companies need to move from decision-
making based on budget forecasts to real-time responses to events, and from centralised co-ordination of
decision-making to empowerment for local management.
In dynamic markets, companies cannot plan one year ahead with confidence. It is also difficult to separate
strategic planning from day-to-day operations. Traditional budgeting was designed to support centralised,
remote decision-making, which can now be too time-consuming, slow and inflexible. Whereas traditional
budgets are intended to provide order, control, predictability and co-ordination, this is often not true. In
reality, competitors and other benchmarks of performance provide better control than budget targets, and
the management of motivation and behaviour provides a better way than budgets of achieving co-
operation.
It has been argued that a 'beyond budgeting' model represents the best management practice in the
'information age'. This model is based on:
(a) Decentralisation and devolving authority, and empowering local managers to make their own
decisions on strategy, methods of working, managing resources, responding to customers and
self-governance
(b) The clear communication to local managers of the strategic goals of the organisation and the
boundaries within which they have freedom to make their own decisions and act
(c) Setting clear targets for performance and making local managers responsible for actual results
(d) Simplified management processes, taking out tiers of middle management to create a 'leaner
organisation'.


Case Study

A number of companies have adopted a beyond budgeting model, but the earliest exponent appears to be
the Nordic bank, Svenska Handelsbanken, which abandoned traditional budgeting in the early 1970s.
Within this company:
(a) authority was devolved to the managers of branches of the bank, and each branch became a profit
centre.
(b) branch managers were allowed to run their own business with a large degree of freedom and
responsibility. For example, they were allowed to decide which products and services to offer
individual customers, which central services of the bank to use (and negotiate a price for the
service) and how many staff to employ.
(c) their ability to act and take well-informed decisions was supported by access to up-to-date on-line
information, for example about customers gained and lost, work productivity and the profitability of
branches and different categories of customer.
(d) branch managers were empowered to make decisions and correct their mistakes. Senior managers
would only interfere where absolutely necessary.
Svenska Handelsbanken has been a very successful business, with an impressive profit record. Customer
satisfaction was high, because local managers responded to their needs. Costs were low, because cost
levels were continually challenged by the local managers rather than protected by the budget system.
Credit decisions were devolved to local managers, and possibly because local managers knew their
customers, bad debts were very low.
The culture that evolved within the company was one of seeking continuous improvement. There was
constructive rivalry between branches, and peer pressure from other branch managers to make
improvements. The bank provided league tables of branch performance, which were provided online for
everyone to see.
Employee satisfaction was also high. Handelsbanken succeeded in attracting top-quality graduates as
recruits into the bank, attracted by the opportunity to exercise devolved responsibility as local managers.
An extract from a report in the Financial Times, 11
th
February 2009 demonstrates that the approach
Handelsbanken first adopted in the 1970s is still valid today, even in extremely turbulent economic times.
'Moves by Sweden's largest banks to bolster their capital bases continued yesterday as Nordea, the Nordic
region's largest bank, announced a 2.5bn ($3.1bn) rights issue.
The proposed fundraising makes Nordea the third of Sweden's big four banks to firm up its finances after
SEB announced a SKr15bn ($1.8bn) rights issue and Swedbank a SKr12.4bn issue. The only bank not to
have raised new capital so far is Handelsbanken.
Nordea's plans were unveiled as it announced a 13 per cent decline in operating profit for 2008 from
3.88bn to 3.39bn. In contrast, Handelsbanken yesterday announced a 4 per cent rise in operating profit
for the year from SKr14.7bn to SKr15.3bn.
The overriding message from Sweden's banks yesterday was that 'boring is best' a strategy that stood
them in good stead amid global turmoil.'

A key to a beyond budgeting model is delegation of authority and decentralised decision-making. In
criticising the traditional budgeting model, Hope and Fraser have written that delegation and co-ordination
'don't make comfortable bedfellows. A constant battle is being waged in most large organisations between
the forces of decentralised initiative (usually the losers) and the forces of centralised co-ordination
(invariably the winners). The difference is the centralising power of the budgeting system that emphasises
coercion rather than co-ordination (you will co-operate, won't you?), focuses on cost reduction rather
than value creation, stifles initiative and keeps planning and execution apart, thus reinforcing the
separation between thinkers and doers.'
9.1 Ingredients of a beyond budgeting model
The key elements in a beyond budgeting model can be summarised as follows.
(a) The organisation should be governed through shared values and clear boundaries. Local managers
should be able to make fast decisions knowing that they are operating within agreed parameters for
action.
(b) The organisation should create as many profit centres as possible, and the manager of the profit
centre should have freedom to run the centre as his or her own business.
(c) Co-ordination within the organisation should be achieved through market forces. Central service
units (ie 'head office' functions) should regard the operating units as their internal customers, who
must be serviced and satisfied in the same way as external customers.
(d) Front-line managers should be provided with a fast and open information network. Everyone
should receive important information at the same time.
(e) Local managers should be given freedom to act but also the responsibility for delivering results.
Front-line managers are expected to perform!
(f) Managers should be given suitable training and support to enable them to think and act decisively.
To create wealth, firms need to exploit the benefits of effective devolution of authority (such as fast
decision-making and quick responses) and more effective performance management, supported by a
system for providing fast, open and relevant information.
Performance targets for local managers should be set with regard to competitors and other benchmarks.
Targets should be stretching, and should be continually adjusted. Setting targets calls for a process for
identifying the 'metrics' or indicators of performance that really drive better business performance. The
performance targets chosen will include non-financial as well as financial targets, and there will be more
targets than traditional budgeting measures of profits, revenues, costs and return on capital. Multiple
performance targets might be chosen, possibly using a balanced scorecard approach. (The balanced
scorecard is explained in a later chapter.)
Rolling forecasts should be produced regularly, so that local managers can adjust their strategy
continually in response to changing conditions and changing expectations. Managers must remain aware
of the financial implications of the decisions they make.
Managers should be rewarded on the basis of their relative performance, and their achievement of
performance targets (both non-financial and financial).
Traditional budgeting certainly has serious weaknesses, but is still widely practised. A beyond budgeting
model seeks to replace budgets with an alternative management system for many of the purposes for
which budgets have been used. Budgeting remains, however, an important tool for financial forecasting,
and will continue to be used for this purpose.
'With the notable exception of the forecasting of financial outcomes, there are very few elements of the
traditional budgeting process which are not performed more rigorously and more effectively within other
strategic management processes. These redundant elements of the process can be eliminated and most of
the companies that have adopted [a beyond budgeting] approach have done just that.'

Case Study

The Beyond Budgeting Round Table (BBRT) was established in 1998. BBRT is an international network of
organisations which work together to implement and develop beyond budgeting management models in
order to enable superior business performance. Organisations that apply this model include Toyota, ALDI,
Nokia and Southwest Airlines.
http://www.bbrt.org

100 5: CVP analysis

1 Introduction
CVP analysis has a number of purposes: to provide information to management about cost behaviour for
routine planning and 'one-off' decision making; to determine what volume of sales is needed at any given
budgeted sales price in order to break even; to identify the 'risk' in the budget by measuring the margin of
safety; to calculate the effects on profit of changes in variable costs, sales prices, fixed costs, and so on.
Cost-volume-profit (CVP)/breakeven analysis is the study of the interrelationships between costs, output
volume and profit at various levels of activity.
To assist planning and decision making, management should know not only the budgeted profit, but also:
the output and sales level at which there would be neither profit nor loss (break-even point)
the amount by which actual sales can fall below the budgeted sales level, without a loss being
incurred (the margin of safety)
2 Marginal costs, contribution and profit
A marginal cost is another term for a variable cost. The term 'marginal cost' is usually applied to the
variable cost of a unit of product or service, whereas the term 'variable cost' is more commonly applied to
resource costs, such as the cost of materials and labour hours.
Marginal costing is a form of management accounting based on the distinction between:
(a) the marginal costs of making and selling goods or services, and
(b) fixed costs, which should be the same for a given period of time, regardless of the level of activity
in the period.
Suppose that a firm makes and sells a single product that has a marginal cost of $5 per unit and that sells
for $9 per unit. For every additional unit of the product that is made and sold, the firm will incur an extra
cost of $5 and receive income of $9. The net gain will be $4 per additional unit. This net gain per unit, the
difference between the sales price per unit and the marginal cost per unit, is called contribution.
Contribution is a term meaning 'making a contribution towards covering fixed costs and making a profit'.
Before a firm can make a profit in any period, it must first of all cover its fixed costs. Breakeven is where
total sales for a period just covers fixed costs, leaving neither profit nor loss. For every unit sold in excess
of the breakeven point, profit will increase by the amount of the contribution per unit.
In the example above of the product selling for $9 and with a variable cost of $5, suppose that fixed costs
each month are $60,000. At a contribution of $4 for each unit, the firm would have to sell 15,000 units
each month, just to break even. To make a profit, it would have to make and sell more than this quantity.
The mathematics of cost-volume-profit analysis is based largely on this simple arithmetical concept.

CVP analysis

5: CVP analysis 101
$
Sales A
Variable cost of items sold B
Contribution A B
Fixed costs C
Profit (A B) C
3 The breakeven point
The breakeven point is the activity level (output and sales level) at which there will be neither profit nor
loss.
The breakeven point (BEP) can be calculated arithmetically.
Breakeven point =
unit per on Contributi
costs fixed Total
=
even break to required on Contributi

= Number of units of sale required to break even.
The contribution required to break even is the amount which exactly equals total fixed costs.
3.1 Example: breakeven point
Expected sales 10,000 units at $8 = $80,000
Variable cost $5 per unit
Fixed costs $21,000
Required
Compute the breakeven point.
Solution
The contribution per unit is $(85) = $3
Contribution required to break even = fixed costs = $21,000
Breakeven point (BEP) = 21,000 3
= 7,000 units
In revenue, BEP = (7,000 $8) = $56,000
Sales above $56,000 will result in profit of $3 per unit of additional sales and sales below $56,000 will
mean a loss of $3 per unit for each unit by which sales fall short of 7,000 units. In other words, profit will
improve or worsen by the amount of contribution per unit.

7,000 units

7,001 units

$

$

Revenue

56,000

56,008

Less variable costs

35,000

35,005

Contribution

21,000

21,003

Less fixed costs

21,000

21,000

Profit

0 (= breakeven)

3

3.2 Breakeven point and the contribution to sales ratio
An alternative way of calculating the breakeven point, in terms of sales revenue, is as follows.
The C/S ratio is the ratio of contribution to sales revenue (contribution/sales ratio) and is also sometimes
called a profit/volume or P/V ratio.
102 5: CVP analysis
In paragraph 3 above we saw that the contribution required to break even is the amount which exactly
equals fixed costs.
It follows that sales revenue at breakeven point =
ratio C/S
on contributi Required
=
ratio C/S
costs Fixed

In the example in Paragraph 3.1 the C/S ratio is
$8
$3
= 37.5%
Breakeven is where sales revenue equals
37.5%
$21,000
= $56,000
At a price of $8 per unit, this represents 7,000 units of sales.
The contribution/sales ratio is a measure of how much contribution is earned from each $1 of sales.
The C/S ratio of 37.5% in the above example means that for every $1 of sales, a contribution of 37.5c is
earned. Thus, in order to earn a total contribution of $21,000 and if contribution increases by 37.5c per $1
of sales, sales must be:
37.5c
$1
$21,000 = $56,000

Question
Contribution

The C/S ratio of product A is 20%. AB, the manufacturer of product A, wishes to make a contribution of
$50,000 towards fixed costs. How many units of product A must be sold if the selling price is $10 per
unit?

Answer

ratio C/S
=
20%
$50,000
= $250,000
Number of units = $250,000 $10 = 25,000.

4 The margin of safety
The margin of safety is the difference in units between the budgeted sales volume and the breakeven
sales volume and it is sometimes expressed as a percentage of the budgeted sales volume.
The margin of safety may also be expressed as the difference between the budgeted sales revenue and
breakeven sales revenue, expressed as a percentage of the budgeted sales revenue.
If the margin of safety is expressed as a percentage of the budgeted sales volume or budgeted sales
revenue it is referred to as the margin of safety ratio. It is an indication of the percentage by which sales
can fall before losses are made.
4.1 Example: margin of safety
Homer makes and sells a product which has a variable cost of $30 and which sells for $40. Budgeted fixed
costs are $70,000 and budgeted sales are 8,000 units.
Required
Calculate the breakeven point and the margin of safety.

5: CVP analysis 103
Solution
Breakeven point =
costs fixed Total
=
30) $(40
$70,000

= 7,000 units
Margin of safety = 8,000 7,000 units = 1,000 units
Margin of safety ratio =
units 8,000
units 1,000
100% = 12% of budget
The margin of safety indicates to management that actual sales can fall short of budget by 1,000 units or
12% before the breakeven point is reached and no profit at all is made.

Question
Budgeted level of sales

The margin of safety on the production of product L is 200 units and the breakeven point is 400 units.
What is the budgeted level of sales?

Answer

Let S be budgeted level of sales
Margin of safety = 200 = S 400
S = 600 units

5 CVP and decision making
At the breakeven point, sales revenue equals total costs and there is no profit.
S = V + F
where S = Sales revenue
V = Total variable costs
F = Total fixed costs
Subtracting V from each side of the equation, we get:
S V = F, that is, total contribution = fixed costs
5.1 Example: breakeven arithmetic
Bluebell makes a product which has a variable cost of $7 per unit.
Required
If fixed costs are $63,000 per annum, calculate the selling price per unit if the company wishes to break
even with a sales volume of 12,000 units.
Solution
Contribution required to break even (= Fixed costs)

=

$63,000

Volume of sales

=

12,000 units

$

Required contribution per unit (S V)

=
$63,000 12,000 =

5.25

Variable cost per unit (V)

=

7.00

Required sales price per unit (S)

=

12.25

104 5: CVP analysis
5.2 Target profits
A similar formula may be applied where a company wishes to achieve a certain profit during a period. To
achieve this profit, sales must cover all costs and leave the required profit.
The target profit is achieved when: S = V + F + P,
where P = required profit
Subtracting V from each side of the equation, we get:
S V = F + P, so
Total contribution required = F + P
5.3 Example: target profits
Whippy makes and sells a single product, for which variable costs are as follows.

$

Direct materials

10

Direct labour

8

Variable production overhead

6

24

The sales price is $30 per unit, and fixed costs per annum are $68,000. The company wishes to make a
profit of $16,000 per annum.
Required
Determine the sales required to achieve this profit.
Solution
Required contribution = fixed costs + profit
= $68,000 + $16,000 = $84,000
Required sales can be calculated in one of two ways.
(a)
=
24) $(30
$84,000

= 14,000 units, or $420,000 in revenue
(b)
ratio C/S
=
20%
$84,000

= $420,000 of revenue, or 14,000 units.

Question
Sales price

Grumpy wishes to sell 14,000 units of its product, which has a variable cost of $15 to make and sell. Fixed
costs are $47,000 and the required profit is $23,000.
Required
Calculate the required sales price per unit.

Answer

Required contribution = fixed costs plus profit
= $47,000 + $23,000
= $70,000
Required sales = 14,000 units

5: CVP analysis 105

$

Required contribution per unit sold

5

Variable cost per unit

15

Required sales price per unit

20

5.4 Decisions to change sales price or costs
You may come across a problem in which you will be expected to analyse the effect of altering the selling
price, or a change in the variable cost per unit or fixed costs for the period. These problems are slight
variations on basic breakeven arithmetic. Examples to illustrate typical questions are shown below.
5.5 Example: change in selling price
Fairy bake and sell a single type of cake. The variable cost of production is 15c and the current sales price
is 25c. Fixed costs are $2,600 per month, and the monthly profit for the company at current sales volume
is $3,000.
The sales manager wishes to raise the sales price to 29c per cake, but considers that a price rise will result
in some loss of sales.
Required
Ascertain the minimum volume of sales required each month to justify a rise in price to 29c.
Solution
The minimum volume of demand which would justify a price of 29c is one which would leave total profit at
least the same as before, ie $3,000 per month. Required profit should be converted into required
contribution, as follows.

$

Monthly fixed costs

2,600

Current monthly profit

3,000

Current monthly contribution

5,600

Contribution per unit (25c 15c)

10c

Current monthly sales

56,000 cakes

The minimum volume of sales required after the price rise will be an amount which earns a contribution of
$5,600 per month, no worse than at the moment. The contribution per cake at a sales price of 29c would
be 14c.
Required sales =
unit per on contributi
on contributi required
=
14c
$5,600

= 40,000 cakes per month.
5.6 Example: change in costs
Brickhill makes a product which has a variable cost of $12 and a sales price of $20 per unit. Fixed costs
are $304,000 per annum, and the current volume of output and sales is 39,000 units.
The company is considering whether to try to improve sales volumes. To increase output and sales above
40,000 units, it would have to hire additional equipment, at a cost of $36,000 per annum.
Required
(a) Calculate the current annual profit and the breakeven point without the additional equipment, and
calculate the breakeven point with the new equipment.
(b) Determine the number of units that must be produced and sold to achieve the same profit as is
currently earned, if the additional equipment is hired.
106 5: CVP analysis
Solution
The current unit contribution is $(20 12) = $8

$

(a)
Current contribution (39,000 $8)

312,000

Less current fixed costs

304,000

Current profit

8,000

Breakeven point is $304,000/$8 per unit = 38,000 units.
With the additional equipment, fixed costs will go up by $36,000 to $340,000 per annum. Because
fixed costs have gone up 'a step' to a new level, there is a different breakeven point.
The new breakeven point is $340,000/$8 per unit = 42,500 units.
(b)

$

Required profit (as currently earned)

8,000

Fixed costs

340,000

Required contribution

348,000

Contribution per unit $8
Sales required to earn $8,000 profit ($348,000/$8) = 43,500 units
5.7 Example: comparing the cost of two options
The managing director of a company has a mobile phone. He has been looking at two different tariffs for
his phone.
(a) Tariff A: an annual rental of $400 plus calls charged at 5c per minute
(b) Tariff B: an annual rental of $250 plus calls charged at 8c per minute
How much would he need to use his phone to be indifferent as to which tariff he pays, and if his estimated
annual usage is 9,000 minutes, which tariff would be cheaper?
Solution
This is a break-even problem, but without any sales revenue, only costs. There are two cost structures. If
V is the MD's annual usage in minutes, the total cost of each tariff will be:
(a) Tariff A: 400 + 0.05V
(b) Tariff B: 250 + 0.08V.
To be indifferent between Tariff A and Tariff B, the cost with each tariff must be the same: 400 + 0.05V =
250 + 0.08V.
This equation can be solved to find a value for V. (0.03V = 150, V = 5,000 minutes.)
The two tariffs would result in the same cost if the managing director used the mobile phone for 5,000
minutes a year. Above this level, Tariff A (5c per extra minute) is cheaper than Tariff B (8c per extra
minute). Since the managing director has 9,000 minutes of call charges each year, Tariff A is cheaper (by
4,000 minutes (8 5)c per minute, ie $120).

5: CVP analysis 107
6 Breakeven charts
Make sure that you understand how to calculate the breakeven point, the C/S ratio, the margin of safety
and target profits, and can apply the principles of CVP analysis to decisions about whether to change
sales prices or costs. You should also be able to construct a breakeven chart.
The breakeven point can also be shown graphically using a breakeven chart.
A breakeven chart is a chart showing levels of profit or loss at different sales volume levels.
A breakeven chart has the following axes.
A horizontal axis showing the sales/output (in value or units).
A vertical axis showing $ for sales revenues and costs
The following lines are drawn on the breakeven chart.
The sales line
Starts at the origin
Ends at the point signifying expected sales
The fixed costs line
Runs parallel to the horizontal axis
Meets the vertical axis at a point which represents total fixed costs
The total costs line
Starts where the fixed costs line meets the vertical axis
Ends at the point which represents the following
Anticipated sales on the horizontal axis
Total costs of anticipated sales on the vertical axis
The breakeven point is the intersection of the sales line and the total costs line.
The distance between the breakeven point and the expected (or budgeted) sales, in units, indicates the
margin of safety.
6.1 Example: a breakeven chart
The budgeted annual output of a factory is 120,000 units. The fixed overheads amount to $40,000 and the
variable costs are 50c per unit. The sales price is $1 per unit.
Required
Construct a breakeven chart showing the current breakeven point and profit earned up to the present
maximum capacity.
Solution
We begin by calculating the profit at the budgeted annual output.

$

Sales (120,000 units)

120,000

Variable costs

60,000

Contribution

60,000

Fixed costs

40,000

Profit

20,000

108 5: CVP analysis

The chart is drawn as follows.
(a) The vertical axis represents money (costs and revenue) and the horizontal axis represents the level
of activity (production and sales).
(b) The fixed costs are represented by a straight line parallel to the horizontal axis (in our example, at
$40,000).
(c) The variable costs are added 'on top of' fixed costs, to give total costs. It is assumed that fixed
costs are the same in total and variable costs are the same per unit at all levels of output.
The line of costs is therefore a straight line and only two points need to be plotted and joined up.
Perhaps the two most convenient points to plot are total costs at zero output, and total costs at the
budgeted output and sales.
(i) At zero output, costs are equal to the amount of fixed costs only, $40,000, since there are
no variable costs.
(ii) At the budgeted output of 120,000 units, costs are $100,000.

$

Fixed costs

40,000
Variable costs 120,000 50c

60,000

Total costs

100,000

(d) The sales line is also drawn by plotting two points and joining them up.
(i) At zero sales, revenue is nil.
(ii) At the budgeted output and sales of 120,000 units, revenue is $120,000.
The breakeven point is where total costs are matched exactly by total revenue. From the chart, this can be
seen to occur at output and sales of 80,000 units, when revenue and costs are both $80,000. This
breakeven point can be proved mathematically as:
units 0,000 8
unit per 50c
$40,000
costs fixed on contributi Required
= =
=

The margin of safety can be seen on the chart as the difference between the budgeted level of activity and
the breakeven level.
'000 Units

5: CVP analysis 109
6.2 The value of breakeven charts
Breakeven charts are used as follows.
To plan the production of a company's products
To market a company's products
To give a visual display of breakeven arithmetic
Breakeven charts can also be used to show variations in the possible sales price, variable costs or fixed
costs.
6.3 Example: breakeven charts and variations in selling price
Suppose that a company sells a product which has a variable cost of $2 per unit. Fixed costs are $15,000.
It has been estimated that if the sales price is set at $4.40 per unit, the expected sales volume would be
7,500 units; whereas if the sales price is lower, at $4 per unit, the expected sales volume would be 10,000
units.
Required
Draw a breakeven chart to show the budgeted profit, the breakeven point and the margin of safety at each
of the possible sales prices.
Solution
Workings Sales price $4.40 per unit Sales price $4 per unit

$

$

Fixed costs

15,000

15,000

Variable costs (7,500 $2.00)

15,000

(10,000 $2.00)

20,000

Total costs

30,000

35,000

Budgeted revenue (7,500 $4.40)

33,000

(10,000 $4.00)

40,000

110 5: CVP analysis
(a) Breakeven point A is the breakeven point at a sales price of $4.40 per unit, which is 6,250 units or
$27,500 in costs and revenues.
(check:
even break to on contributi Required
=
unit per $2.40
000 , 15 $
= 6,250 units)

The margin of safety (A) is 7,500 units 6,250 units = 1,250 units or 16.7% of expected sales.
(b) Breakeven point B is the breakeven point at a sales price of $4 per unit which is 7,500 units or
$30,000 in costs and revenues.
(check:
even break to on contributi Required
=
unit per $2
000 , 15 $
=7,500 units)

The margin of safety (B) = 10,000 units 7,500 units = 2,500 units or 25% of expected sales.
Since a price of $4 per unit gives a higher expected profit and a wider margin of safety, this price will
probably be preferred even though the breakeven point is higher than at a sales price of $4.40 per unit.
7 Multi product CVP analysis
A very serious limitation of breakeven charts is that they can show the costs, revenues, profits and
margins of safety for a single product only, or at best for a single 'sales mix' of products.
Breakeven charts for multiple products can be drawn if a constant product sales mix is assumed.
For example suppose that FA sells three products, X, Y and Z which have variable unit costs of $3, $4 and
$5 respectively. The sales price of X is $8, the price of Y is $6 and the price of Z is $6. Fixed costs per
annum are $10,000.
A breakeven chart cannot be drawn, because we do not know the proportions of X, Y and Z in the sales
mix.
If you are not sure about this point, you should try to draw a breakeven chart with the information given. It
should not be possible.
There are a number of ways in which we can overcome this problem, however.
7.1 Approach 1: output in $ sales and a constant product mix
Assume that budgeted sales are 2,000 units of X, 4,000 units of Y and 3,000 units of Z. A breakeven chart
would make the assumption that output and sales of X, Y and Z are in the proportions 2,000: 4,000: 3,000
at all levels of activity, in other words that the sales mix is 'fixed' in these proportions.
We begin by carrying out some calculations.

Budgeted costs

Costs

Revenue

$

$

Variable costs of X

(2,000 $3)

6,000

X (2,000 $8)

16,000

Variable costs of Y

(4,000 $4)

16,000

Y (4,000 $6)

24,000

Variable costs of Z

(3,000 $5)

15,000

Z (3,000 $6)

18,000

Total variable costs

37,000

Budgeted revenue

58,000

Fixed costs

10,000

Total budgeted costs

47,000

The breakeven chart can now be drawn.

5: CVP analysis 111

The breakeven point is approximately $27,500 of sales revenue. This may either be read from the chart or
computed mathematically.
(a) The budgeted C/S ratio for all three products together is contribution/sales = $(58,000
37,000)/$58,000 = 36.21%.
(b) The required contribution to break even is $10,000, the amount of fixed costs. The breakeven point
is $10,000/36.21% = $27,500 (approx) in sales revenue.
The margin of safety is approximately $(58,000 27,500) = $30,500.
7.2 Approach 2: products in sequence
The products could be plotted in a particular sequence (say X first, then Y, then Z).

In this case the breakeven point occurs at about 3,800 units of sales (2,000 units of product X and 1,800
units of product Y) and the margin of safety is roughly 2,200 units of Y and 3,000 units of Z.
112 5: CVP analysis
7.3 Approach 3: output in terms of % of forecast sales and a constant
product mix
Revenue
Costs
% of forecast sales
0
10 20 30 40
20
40
'000
Breakeven point
50
10
Costs
and
revenue
60 70 80 90
30
50
100
60
x

The breakeven point can be read from the graph as approximately 48% of forecast sales ($30,000 of
revenue).
Alternatively, with contribution of $(58,000 37,000) = $21,000, one percent of forecast sales is
associated with $21,000/100 = $210 contribution.
Breakeven point (%) = fixed costs/contribution per 1%
= $10,000/$210 = 47.62%
Margin of safety = (100 47.62) = 52.38%
The general point of setting out these three approaches is to demonstrate that output can be viewed in
several different ways.
7.4 Multi-product P/V charts
The P/V chart can show information about each product individually.
The same information could be shown on a P/V chart, as follows.

$

5: CVP analysis 113
An addition to the chart would show further information about the contribution earned by each product
individually, so that their performance and profitability can be compared.

Contribution

Sales

C/S ratio

$

$

%

Product X

10,000

16,000

62.50

Product Y

8,000

24,000

33.33

Product Z

3,000

18,000

16.67

Total

21,000

58,000

36.21

By convention, the products are shown individually on a P/V chart from left to right, in order of the size
of their C/S ratio. In this example, product X will be plotted first, then product Y and finally product Z. A
dotted line is used to show the cumulative profit/loss and the cumulative sales as each product's sales
and contribution in turn are added to the sales mix.
Cumulative Cumulative
Product sales profit
$ $
X 16,000 ($10,000 $10,000)
X and Y 40,000 8,000
X, Y and Z 58,000 11,000
You will see on the graph which follows that these three pairs of data are used to plot the dotted line, to
indicate the contribution from each product. The solid line which joins the two ends of this dotted line
indicates the average profit which will be earned from sales of the three products in this mix.

The diagram highlights the following points.
(a) Since X is the most profitable in terms of C/S ratio, it might be worth considering an increase in the
sales of X, even if there is a consequent fall in the sales of Z.
(b) Alternatively, the pricing structure of the products should be reviewed and a decision made as to
whether the price of product Z should be raised so as to increase its C/S ratio (although an
increase is likely to result in some fall in sales volume).
The multi-product P/V chart therefore helps to identify the following.
(a) The overall company breakeven point.
(b) Which products should be expanded in output and which, if any, should be discontinued.
(c) What effect changes in selling price and sales volume will have on the company's breakeven point
and profit.
114 5: CVP analysis

Question
Multi-product P/V chart

A company sells three products, X, Y and Z. Cost and sales data for one period are as follows.
X Y Z
Sales volume 2,000 units 2,000 units 5,000 units
Sales price per unit $3 $4 $2
Variable cost per unit $2.25 $3.50 $1.25
Total fixed costs $3,250
Required
Construct a multi-product P/V chart based on the above information on the axes below.

Answer

X

Y

Z

Total

Contribution per unit

$0.75

$0.50

$0.75

$

Budgeted contribution (total)

$1,500

$1,000

$3,750

6,250

Fixed costs

3,250

Budgeted profit

3,000

Cumulative Cumulative
Product sales profit
$ $
Z 10,000 ($3,750 $3,250) 500
Z and X 16,000 2,000
Z, X and Y 24,000 3,000

5: CVP analysis 115

Question
Breakeven point and sales value constraints

Sutton produces four products. Relevant data is shown below for period 2.
Product M Product A Product R Product P
C/S ratio 5% 10% 15% 20%
Maximum sales value $200,000 $120,000 $200,000 $180,000
Minimum sales value $50,000 $50,000 $20,000 $10,000
The fixed costs for period 2 are budgeted at $60,000.
Required
Fill in the blank in the sentence below.
The lowest breakeven sales value, subject to meeting the minimum sales value constraints, is $.......... .

Answer

The correct answer is $390,000
Breakeven point occurs when contribution = fixed costs
Minimum breakeven point occurs when contribution is $60,000.
Contribution achieved from minimum sales value

$

M

5% $50,000

2,500

A

10% $50,000

5,000

R

15% $20,000

3,000

P

20% $10,000

2,000

12,500

Product P has the highest C/S ratio and so should be produced first (as it earns more contribution per $ of
revenue than the others).
Contribution from sales of P between minimum and maximum points = $170,000 20% = $34,000
$
($)
116 5: CVP analysis
Required contribution from Product R (which has the next highest C/S ratio)
= $(60,000 12,500 34,000)
= $13,500
Revenue from Product R of $13,500/0.15 = $90,000 will produce $13,500 of contribution.
Lowest breakeven sales
= $130,000 (minimum sales) + $170,000 (from P) + $90,000 (from R)
= $390,000

8 The advantages and limitations of CVP analysis
Do not forget that CVP analysis does have limitations: for example, it is only valid within a 'relevant range'
of output volumes; and it measures profitability, but does not consider the volume of capital employed to
achieve such profits.
8.1 Limitations of breakeven charts
A breakeven chart can only apply to one single product or a single mix (fixed proportions) of a
group of products.
It is assumed that fixed costs are the same in total and variable costs are the same per unit at
all levels of output. This is a simplification.
Fixed costs will change if output falls or increases substantially. (Most fixed costs are 'step
costs', rising or falling in stepped amounts if output and sales rise above or fall below a
given level).
The variable cost per unit will decrease where economies of scale are made at higher output
volumes, and the variable cost per unit will also eventually rise where diseconomies of scale
begin to appear at higher volumes of output (for example the extra cost of labour in
overtime working).
A breakeven chart is drawn on the assumption that fixed costs and the variable cost per unit are constant,
this is only correct within the relevant range of output.
8.2 Advantages of CVP analysis
At its most simple level, CVP analysis assumes a constant variable cost per unit at all levels of output, a
constant sales price per unit at all levels of sales, and constant fixed costs at all levels of output. As earlier
examples in this chapter have shown, CVP analysis can be used to analyse the effects of changes in the
sales price above or below a certain level of output and sales, or changes in the variable costs per unit or
the fixed costs per period.
CVP analysis is based on fairly simple logic and simple arithmetic, but it has been found to apply to a
number of business situations, and so is a useful planning and decision-making technique.
8.3 Summary: using CVP analysis
In spite of limitations, breakeven analysis is a useful technique for managers in planning sales prices, the
desired sales mix, and profitability.
Breakeven analysis should be used with a full awareness of its limitations, but can usefully be applied to
provide simple and quick estimates of breakeven volumes or profitability given variations in sales
price, variable and fixed costs within a 'relevant range' of output/sales volumes.

It is not generally applicable to more complex decision-making situations, where an understanding of
relevant costs, such as opportunity costs, may be required. Relevant costs and opportunity costs are
explained in the next chapter.
117 6: Decision making techniques

1 Introduction: decision making and relevant costs
A large part of accounting is concerned with recording actual revenues and expenditures, and reporting
historical profits or losses. For this aspect of accounting, for example in preparing the annual financial
accounts of a company, the concepts of variable and fixed costs, and of direct and indirect costs, are not
necessary or relevant.
Another major area of accounting is the preparation of budgets and regular plans. For this aspect of
accounting, it is necessary to recognise the difference between fixed and variable costs, and that total
costs will rise or fall with rises or falls in the level of activity.
Yet another area of management accounting is the analysis of costs and revenue that would occur (or be
lost) as a result of making specific 'one-off' decisions. A decision of this type involves making a choice
between two or more possible courses of action. Examples of 'one-off' decisions include:
(a) Make-or-buy decisions, ie should an organisation make a component itself, or buy it in from an
outside supplier?
(b) Sub-contracting decisions, ie should an organisation do a job itself, or put the work out to a sub-
contractor?
(c) Minimum pricing decisions, ie what is the minimum price that should be charged for a special job
or item, to ensure that a profit will be made from the sale?
(d) Extra shift decisions, ie should work be increased from one shift a day to two shifts, or from two
shifts a day to three shifts?
The common characteristic of 'one-off' decisions is that an organisation is faced with a decision outside
the normal planning and decision-making routine, and information about the extra costs and extra
revenues (that would arise as a result) is needed to help with making the decision. An understanding of
fixed and variable costs is important for decision making, but other aspects of cost behaviour are likely to
be relevant too.
Decision making
techniques

6: Decision making techniques 118
The basic principle for decision making is assumed to be that a course of action is worth taking if, as a
result, the organisation increases its total profit. A course of action is not worth taking if it would result in
a fall in profit, or in a sub-optimal profit being achieved.
To analyse whether or not a course of action would result in higher profit or in an optimal profit being
achieved, relevant costs must be used to evaluate the decision.
Examination questions on decision problems with relevant costs can often be identified by the words:
'decide', 'decision', 'advise', 'advice', 'recommend' or 'suggest whether', 'what is the minimum price?'
or 'what is the maximum (cost)?'
2 Cost behaviour and decision making
Cost behaviour is simply a term referring to the way in which the total cost of an item will change as a
result of something new happening, or as a result of the level of activity being increased or reduced. To
analyse the consequences of a course of action, it is necessary to estimate what will happen to costs (and
revenue) as a result.
Within the normal range of output, costs can usually be assumed to be either variable, fixed or semi-
variable. A decision resulting in a higher level of activity would therefore be expected to result in higher
total variable costs, but no change in fixed costs.
Costs should be categorised as either fixed or variable in relation to the span of time under consideration.
Over a sufficiently long period of time of several years, virtually all costs are variable. For example:
Salaried employees could be released or land and buildings could be sold if demand dropped
Additional managers could be appointed and land and buildings acquired if demand increased
Rents could be renegotiated
Within shorter time periods, costs will be either fixed or variable in relation to changes in activity
level. The shorter the time period, the greater the probability that a cost will be fixed.
2.1 Stepped fixed costs
Over a time period of one year, costs associated with providing an organisation's operating capacity (such
as the salaries of senior managers) will probably be fixed in relation to changes in activity level. A decision
about the level of an organisation's operating capacity will have been made as part of the long-term
planning process and so cannot easily be reversed in the short term. For example, machinery would not be
sold simply because demand drops in one month.
Spending on some fixed costs can be adjusted in the short term to reflect changes in activity level. An
example is the salaries of supervisors. If demand drops significantly in the short-term, supervisors might
continue to be employed in the hope that the decline is only temporary. If demand fails to pick up,
supervisors might eventually be made redundant. On the other hand, if demand increases above a certain
critical level, additional supervisors may need to be employed. Thus supervisors' salaries can change in
response to changes in demand in a manner described as a stepped fixed cost. Within a given time
period, step fixed costs are fixed within specified activity levels but increase or decrease by a constant
amount at various critical activity levels.

The relationship between cost behaviour and time can be summarised as:
Over a given short time period, such as one year, costs will be fixed, variable or semi-variable.
Over longer time periods of several years, all costs will tend to change in response to large
changes in activity level.
3 Relevant costs and non-relevant costs
Accounting information can be used to identify a profit-maximising or cost-minimising decision option.
When accounting figures are used for this purpose, relevant costs must be used. A relevant cost is a
future cash flow arising as a direct consequence of a decision.
Avoidable costs, differential costs and opportunity costs are all relevant costs.
Non-relevant costs include sunk costs, committed costs and notional (imputed) costs.
Directly attributable fixed costs are relevant costs, general fixed overheads are not.
The costs which should be used for decision making are often referred to as relevant costs.
A relevant cost is a future cash flow arising as a direct consequence of a decision.
Relevant costs are future costs.
(a) A decision is about the future; it cannot alter what has been done already. A cost that has been
incurred in the past is totally irrelevant to any decision that is being made 'now'. It is a sunk cost.
(b) Costs that have been incurred include not only costs that have already been paid, but also costs
that are the subject of legally binding contracts, even if payments due under the contract have not
yet been made. These are committed costs.
Relevant costs are cash flows. Costs or charges which do not reflect additional cash inflows or spending
should be ignored for the purpose of decision making. These include the following.
Depreciation. Depreciation is a means of spreading the cost of a non-current asset over its useful
life, and is not a cash flow. The only cash flow is the cash paid to acquire the non-current asset in
the first place, and the cash received (if any) from its eventual disposal.
Any notional rent or notional interest charged in the accounts.
Relevant costs are those arising as a direct consequence of a decision. Costs that will occur whatever
decision or course of action is taken can be ignored. Only costs that will differ under some or all of the
available opportunities should be considered. Relevant costs are therefore sometimes referred to as
incremental costs. For example, if an employee is expected to have no other work to do during the next
week, but will be paid his basic wage (of, say, $200 per week) for attending work, his manager might
decide to give him a job which earns only $80. The net gain to the business is $80 and the $200 is
irrelevant to the decision, because although it is a future cash flow, it is a cost that will be incurred
anyway. The business will not want to keep paying the employee $200 each week to do work that earns
only $80, but in the short-term, for one week only, it is better to earn an extra $80 than not to earn it.
Relevant costs are therefore future, incremental cash flows.

Other terms can be used to describe relevant costs.
Avoidable costs. These are costs that would not be incurred if the activity to which they relate did not
exist.
One of the situations in which it is necessary to identify avoidable costs is in deciding whether or not to
discontinue a product. The only costs that would be saved from shutting down a product line are the
avoidable costs. These are usually the variable costs and probably also some specific fixed costs. Costs
that would be incurred whether or not the product is discontinued are unavoidable costs.
Differential cost. This is the difference in relevant costs between alternative courses of action.
The term 'differential costs' is used to compare the differences in cost between two alternative courses
of action, while 'incremental costs' is used to state the relevant costs when two or more options are
compared. If option A will cost an extra $300 and option B will cost an extra $360, the differential cost is
$60.
3.1 Opportunity cost
Opportunity cost is the benefit which has been given up, by choosing one option instead of the next most
profitable alternative.
Suppose for example that there are three mutually exclusive options, A, B and C. The net profit from each
would be $80, $100 and $70 respectively.
Since only one option can be selected option B would be chosen because it offers the biggest benefit.

$

Profit from option B

100

Less

opportunity cost (ie the benefit from the next most

profitable alternative, A)

80

Differential benefit of option B

20

The decision to choose option B would not be taken simply because it offers a profit of $100, but because
it offers a differential profit of $20 in excess of the next most profitable course of action.
3.2 Non-relevant costs
A number of terms are used to describe costs that are irrelevant for decision making.
A sunk cost is a cost that has already been incurred and hence should not be taken account of in decision
making.
Management decisions can only affect the future. In decision making, managers therefore require
information about future costs and revenues which would be affected by the decision under review. A sunk
cost has been incurred already, and the decision currently under consideration cannot affect it. An
example is the cost of goods or materials that have already been purchased. A decision about what to do
with these goods or materials should not be influenced by what they originally cost, only by the different
possible uses that these materials have in the future.
A committed cost is a future cash outflow that will be incurred anyway, whatever decision is taken now
about alternative opportunities.
Committed costs may exist because of contracts already entered into by the organisation, which it cannot
get out of.
A notional cost or imputed cost is a hypothetical accounting cost to reflect the use of a benefit for which
no actual cash expense is incurred.
Examples in cost accounting systems include the following.
(a) Notional rent, such as that charged to a cost centre or profit centre of an organisation for the use of
accommodation that the organisation owns.
(b) Notional interest charges on capital employed, sometimes made against a profit centre or cost
centre.
3.3 Fixed and variable costs
Unless you are given an indication to the contrary, it is likely that:
Variable costs will be relevant costs, and
Fixed costs are irrelevant to a decision.
This need not be the case, however, and you should analyse variable and fixed cost data carefully. Do not
forget that 'fixed' costs may only be fixed in the short term.
3.4 Attributable fixed costs
There might be occasions when a fixed cost is a relevant cost, and you must be aware of the distinction
between 'specific' or 'directly attributable' fixed costs, and general fixed overheads.
(a) Directly attributable fixed costs are those costs which although fixed within a relevant range of
activity level, or regarded as fixed because management has set a budgeted expenditure level,
would either:
(i) increase if certain extra activities were undertaken
(ii) decrease/be eliminated entirely if a decision were taken either to reduce the scale of
operations or shut down entirely
(b) General fixed overheads are those fixed overheads which will be unaffected by decisions to
increase or decrease the scale of operations. For example an apportioned share of fixed costs
which would be completely unaffected by the decisions, such as share of head office charges.
Directly attributable fixed costs are relevant to decision making, general fixed overheads are not.
4 Some rules for identifying relevant costs
The total relevant cost of a scarce resource consists of the variable cost of the scarce resource plus the
opportunity cost of the contribution forgone by not being able to use the scarce resource for its next most
profitable use.
4.1 The relevant cost of materials
The relevant cost of raw materials is generally their current replacement cost.
The exception to this rule occurs if materials have already been purchased but will not be replaced. The
relevant cost of such materials is the higher of the following:
Their current resale value, and
The value they would obtain if they were put to an alternative use.
If the materials have no resale value and no other possible use, then the relevant cost of using them for
the opportunity under consideration would be nil.
You should test your knowledge of the relevant cost of materials by attempting the following exercise.


Question
Relevant cost of materials

Darwin has been approached by a customer who would like a special job to be done, and who is willing to
pay $22,000 for it. The job would require the following materials.
Total units Units already Book value of Realisable Replacement
Material required in inventory units in inventory value cost
$/unit $/unit $/unit
A 1,000 0 6.00
B 1,000 600 2.00 2.50 5.00
C 1,000 700 3.00 2.50 4.00
D 200 200 4.00 6.00 9.00
Material B is used regularly by Darwin, and if units of B are required for this job, they would need to be
replaced to meet other production demand.
Materials C and D are in inventory as the result of previous over-buying, and they have a restricted use. No
other use could be found for material C, but the units of material D could be used in another job as
substitute for 300 units of material E, which currently costs $5 per unit (and of which the company has no
units in inventory at the moment).
Required
Calculate the relevant costs of material for deciding whether or not to accept the contract.

Answer

(a) Material A is not yet owned. It would have to be bought in full at the replacement cost of $6 per
unit.
(b) Material B is used regularly by the company. There are existing inventories (600 units) but if these
are used on the contract under review a further 600 units would be bought to replace them.
Relevant costs are therefore 1,000 units at the replacement cost of $5 per unit.
(c) 1,000 units of material C are needed and 700 are already in inventory. If used for the contract, a
further 300 units must be bought at $4 each. The existing inventories of 700 will not be replaced. If
they are used for the contract, they could not be sold at $2.50 each. The realisable value of these
700 units is an opportunity cost of sales revenue forgone.
(d) The required units of material D are already in inventory and will not be replaced. There is an
opportunity cost of using D in the contract because there are alternative opportunities either to sell
the existing inventories for $6 per unit ($1,200 in total) or avoid other purchases (of material E),
which would cost 300 x $5 = $1,500. Since substitution for E is more beneficial, $1,500 is the
opportunity cost.
(e) Summary of relevant costs

$

Material A (1,000 $6)

6,000

Material B (1,000 $5)

5,000

Material C (300 $4) plus (700 $2.50)

2,950

Material D

1,500

Total

15,450

4.2 The relevant cost of using machines
Using machinery will involve some incremental costs, user costs. These include repair costs arising from
use, hire charges and any fall in resale value of owned assets which results from their use. Depreciation is
not a relevant cost.
4.3 Example: user costs
Sydney is considering whether to undertake some contract work for a customer. The machinery required
for the contract would be as follows.
(a) A special cutting machine will have to be hired for three months. Hire charges for this machine are
$75 per month, with a minimum hire charge of $300.
(b) All other machinery required in the production for the contract has already been purchased by the
organisation on hire purchase terms. The monthly hire purchase payments for this machinery are
$500. This consists of $450 for capital repayment and $50 as an interest charge. The last hire
purchase payment is to be made in two months' time. The cash price of this machinery was $9,000
two years ago. It is being depreciated on a straight line basis at the rate of $200 per month.
However, it still has a useful life which will enable it to be operated for another 36 months.
The machinery is highly specialised and is unlikely to be required for other, more profitable jobs
over the period during which the contract work would be carried out. Although there is no
immediate market for selling this machine, it is expected that a customer might be found in the
future. It is further estimated that the machine would lose $200 in its eventual sale value if it is
used for the contract work.
Required
Calculate the relevant cost of machinery for the contract.
Solution
(a) The cutting machine will incur an incremental cost of $300, the minimum hire charge.
(b) The historical cost of the other machinery is irrelevant as a past cost; depreciation is irrelevant as a
non-cash cost; and future hire purchase repayments are irrelevant because they are committed
costs. The only relevant cost is the loss of resale value of the machinery, estimated at $200
through use. This user cost will not arise until the machinery is eventually resold and the $200
should be 'discounted' to allow for the time value of money. However, discounting is ignored here.
(c) Summary of relevant costs

$

Incremental hire costs

300

User cost of machinery

200

500

Question
Cost of use

A machine which originally cost $12,000 has an estimated life of ten years and is depreciated at the rate of
$1,200 a year. It has been unused for some time, as expected orders did not materialise.
A special order has now been received which would require the use of the machine for two months.
The current net realisable value of the machine is $8,000. If it is used for the job, its value is expected to
fall to $7,500. The net book value of the machine is $8,400.
Routine maintenance of the machine currently costs $40 a month. With use, the cost of maintenance and
repairs would increase to $60 a month.
Required
Determine the cost of using the machine for the order.


Answer

$

Loss in net realisable value of the machine through using it on the order $(8,000 7,500)

500

Costs in excess of existing routine maintenance costs $(120 80)

40

Total marginal user cost

540

Question
Minimum price

A printing company carries out work for a number of clients. One particularly important client has
telephoned to ask whether the company will do a special printing job. As a special favour, the customer
would like this job to be priced very competitively. The managing director is inclined to respond favourably
to the request, in view of the large amounts of routine work the company does for the customer.
The cost estimator has provided the following estimate for the job.

$

Grade A labour (50 hours at $15 per hour)

750

Grade B labour (10 hours at $20 per hour)

200

Ordinary paper, at cost

450

Special paper, at cost

300

Variable overhead (60 hours at $3 per hour)

180

Fixed overhead (60 hours at $20 per hour)

1,200

3,080

The following information is also available.
All Grade A labour is paid for a basic 40-hour week. This job could be done mostly in normal working
time, and only 10 hours of Grade A overtime would be needed.
Similarly, all Grade B labour is paid for a 40-hour week. Only 5 hours of Grade B overtime would be
needed to do the work.
There is no other work for which the Grade A or Grade B labour would be needed.
All overtime is paid at 50% above normal hourly rates.
The ordinary paper to do the work is already in inventory. It is regularly used on many jobs by the
company. A 10% increase in the cost of ordinary paper has just been notified by the paper suppliers.
The special paper for the job is already in inventory. It was purchased some months ago for another job,
for a customer who suddenly went out of business. There is no other use for the paper, but it could be re-
sold to the supplier for $100.
Required
What is the minimum price the company should charge for the job, if it wanted to make no profit but no
loss on doing the work? If the managing director decides to charge a 10% mark-up on this minimum
price, what price should be quoted to the customer?

Answer

(a) Labour in normal time is a committed cost, and so is irrelevant to a minimum pricing decision.
Only overtime hours, paid at 50% over the normal rate, are relevant.
(b) By using ordinary paper for this job, additional paper must be purchased by the company, at a
price 10% above the cost of paper in inventory. This replacement price is the relevant cost,
because replacement is a direct consequence of the decision to do the special job for the customer.
(c) The relevant cost of the special paper is its opportunity cost, ie its resale value.
(d) It is assumed that variable overhead is a relevant cost, and fixed overhead will be unaffected and so
is irrelevant.
(e) Summary of relevant costs

$
Grade A labour (10 hours $22.50)

225

Grade B labour (5 hours $30)

150

Ordinary paper ($450 x 110%)

495
Special paper

100

Variable overhead

180

Minimum price

1,150

If the job is priced at 10% above the minimum price, the charge to the customer will be $1,265.

5 The relevant cost of scarce resources: limiting factors
When an organisation provides a range of products or services to its markets, but has a restricted amount
of resources available to it, then it will have to make a decision about what product mix (or mix of
services) it will provide. Its volume of output and sales will be constrained by its limited key resources
rather than by sales demand, and so management faces a decision about how scarce capacity should
best be used. The scarce resource might be a type of material, machine time, cash or a particular labour
skill.
An organisation has a scarce resource if it does not have enough of the resource to undertake every
available opportunity for making more contribution towards profit. Thus machine time would be scarce if
every machine was being operated at full capacity, without being able to produce enough output to meet
sales demand in full.
From an accounting point of view, the assumption is that a firm faced with a problem of scarce resources
would select a product or service mix that would maximise overall profitability, and so maximise total
contribution.
When there is just one scarce resource, the technique for establishing the contribution-maximising
product mix or service mix is to rank the products or services in order of contribution-earning ability per
unit of the scarce resource.
5.1 Example: scarce resource
Alphabet makes two products, P and Q, for which there is unlimited sales demand at the budgeted sales
price of each. A unit of P takes 8 hours to make, and has a variable cost of $36 and a sales price of $72. A
unit of Q takes 5 hours to make, and has a variable cost of $24 and a sales price of $48. Both products use
the same type of labour, which is in restricted supply. Which product should be made in order to
maximise profits?
Solution and discussion
(a) There is no limitation on sales demand, but labour is in restricted supply, and so to determine the
profit-maximising production mix, we must rank the products in order of contribution-earning
capability per labour hour.

P

Q

$

$

Sales price

72

48

Variable costs

36

24

Contribution

36

24

Hours per unit

8 hrs

5 hrs

Contribution per labour hour

$4.50

$4.80

Ranking

2nd

1
st

Although units of Product P have the higher unit contribution, product Q is more profitable because
it earns a greater contribution per unit in each scarce hour of labour time worked. For instance,
eight units of product Q (worth 8 $24 = $192) can be made in the same time as five units of P
(worth only 5 $36 = $180).
(b) Other considerations
A profit-maximising budget would therefore be to produce units of product Q only, within the
assumptions made. It is important to remember, however, that other considerations, so far
excluded from the problem, might alter the decision entirely.
(i) Can the sales price of either product be raised, thereby increasing unit contribution, and
the contribution per labour hour, without reducing sales demand? Since sales demand is
apparently unlimited, it would be reasonable to suspect that both products are under-priced.
(ii) To what extent are sales of each product interdependent? For example, a manufacturer of
knives and forks could not expect to cease production of knives without affecting sales
demand for the forks.
(iii) Would a decision to cease production of product P entirely really have no effect on fixed
costs? The assumption that fixed costs are unaffected by limiting factor decisions is not
always valid, and closure of the production line for either product might result in fixed cost
savings (for example a reduction in production planning costs, product design costs, or
equipment depreciation).
(c) Qualitative factors
There are also qualitative factors to consider.
(i) Would a decision to make and sell just product Q have a harmful effect on customer loyalty
and sales demand?
(ii) Is the decision going to affect the long-term plans of the company as well as the short-
term? If product P is not produced next year, it is likely that competitors will take over the
markets vacated by Alphabet. Labour skilled in the manufacture of product P will be lost,
and a decision in one year's time to re-open manufacture of product P might not be
possible.
(iii) Why is there a shortage of labour? Are the skills required difficult to obtain, perhaps
because the company is using very old-fashioned production methods, or is the company a
high-tech newcomer located in a low-tech area? Or perhaps the conditions of work are so
unappealing that people simply do not want to work for the company.
Whatever the scarce resource, it is always advisable to ask why it is scarce, and whether the
shortage could be overcome. If machine hours are in short supply is this because more machines
are needed, or newer, more reliable and efficient machines? If materials are in short supply, what
are competitors doing? Have they found an equivalent or better substitute? Is it time to redesign
the product?
5.2 Scarce resource and restricted sales demand
When there is a maximum limit on sales demand for an organisation's products or services, the products
or services should still be ranked in order of contribution-earning ability per unit of the scarce resource.
However, the profit-maximising decision will be to produce the top-ranked products (or to provide the
top-ranked services) up to the sales demand limit.
5.3 Example: one scarce resource and limited sales demand
Wantmore manufactures and sells three products, B, S and N, for which budgeted sales demand, unit
selling prices and unit variable costs are as follows.

Product B

Product S

Product N

Budgeted sales demand

550 units

500 units

400 units

$

$

$

$

$

$

Unit sales price

16

18

14

Variable costs: materials

8

6

2

labour

4

6

9

12

12

11

Unit contribution

4

6

3

The company has existing inventories of 250 units of B and 200 units of N, which it is quite willing to use
up to meet sales demand. All three products use the same direct materials and the same type of direct
labour. In the next year, the available supply of materials will be restricted to $4,800 (at cost) and the
available supply of labour to $6,600 (at cost). What product mix and sales mix would maximise the
company's profits in the next year?
Solution and discussion
There appear to be two scarce resources, direct materials and direct labour. However, this is not certain,
and because there is a limited sales demand as well, it might be that there is:
(a) No limiting factor at all, except sales demand i.e. none of the resources is scarce
(b) Only one scarce resource preventing the full potential sales demand being achieved
Step 1 Begin by establishing how many scarce resources there are, and if there are any, which one
or which ones they are. In this example we have:

B

S

N

Units

Units

Units

Budgeted sales

550

500

400

Inventory in hand

250

0

200

Minimum production to meet demand

300

500

200

Minimum production to
meet sales demand
Required
materials at cost
Required labour
at cost

Units

$

$

B

300

2,400

1,200

S

500

3,000

3,000

N

200

400

1,800

Total required

5,800

6,000

Total available

4,800

6,600

(Shortfall)/Surplus

(1,000)

600

Materials are a limiting factor, but labour is not.
Step 2 The next step is to rank the three products in order of contribution earned per unit of
limiting factor/scarce resource (in this case per $1 of direct materials consumed).
B S N
$ $ $
Unit contribution 4 6 3
Cost of materials 8 6 2
Contribution per $1 materials $0.50 $1.00 $1.50
Ranking 3rd 2nd 1st

Step 3 Product N should be manufactured up to the limit where units produced plus units in
inventory will meet sales demand, then Product S second and finally Product B third, until
all the available materials are used up.

Ranking

Product
Sales demand
less units in
inventory

Production
quantity

Materials cost

Units

Units

$

1st

N

200

200

( $2)

400

2nd

S

500

500

( $6)

3,000

3rd

B

300

175

( $8)

*

1,400

Total available

4,800

* Balancing amount using up total available.
Step 4 The profit-maximising budget is as follows.

B

S

N

Units

Units

Units

Opening inventory

250

0

200

Add production

175

500

200

Sales

425

500

400

B

S

N

Total

$

$

$

$

Revenue

6,800

9,000

5,600

21,400

Variable costs

5,100

6,000

4,400

15,500

Contribution

1,700

3,000

1,200

5,900

5.4 Assumptions in limiting factor analysis
In the previous examples, the following assumptions were made. If any of the assumptions are not valid,
then the profit-maximising decision might be different.
(a) Fixed costs will be the same regardless of the decision that is taken, and so the profit maximising
and contribution-maximising output level will be the same. This will not necessarily be true, since
some fixed costs might be directly attributable to a product or service. A decision to reduce or
cease altogether activity on a product or service might therefore result in some fixed cost savings,
which would have to be taken into account.
(b) The unit variable cost is constant, regardless of the output quantity of a product or service. This
implies that:
(i) the price of resources will be unchanged regardless of quantity; for example, there will be
no bulk purchase discount of raw materials
(ii) efficiency and productivity levels will be unchanged; regardless of output quantity, the direct
labour productivity, the machine time per unit, and the materials consumption per unit will
remain the same.
(c) The estimates of sales demand for each product, and the resources required to make each
product, are known with certainty. In the previous example, there were estimates of the maximum
sales demand for each of three products, and these estimates were used to establish the profit-
maximising product mix. Suppose the estimates were wrong? The product mix finally chosen
would then either mean that some sales demand of the most profitable item would be unsatisfied,
or that production would exceed sales demand, leaving some inventory unsold. Clearly, once a
profit-maximising output decision is reached, management will have to keep their decision under
continual review, and adjust their decision as appropriate in the light of actual results.
(d) Units of output are divisible, and a profit-maximising solution might include fractions of units as
the optimum output level. Where fractional answers are not realistic, some rounding of the figures
will be necessary.

Question
Acceptable offer?

A company has been making a machine to order for a customer, but the customer has since gone into
liquidation, and there is no prospect that any money will be obtained from the winding up of the company.
Costs incurred to date in manufacturing the machine are $50,000 and progress payments of $15,000 had
been received from the customer prior to the liquidation.
The sales department has found another company willing to buy the machine for $34,000 once it has been
completed.
To complete the work, the following costs would be incurred.
(a) Materials: these have been bought at a cost of $6,000. They have no other use, and if the machine
is not finished, they would be sold for scrap for $2,000.
(b) Further labour costs would be $8,000. Labour is in short supply, and if the machine is not finished,
the work force would be switched to another job, which would earn $30,000 in revenue, and incur
direct costs of $12,000 and absorbed (fixed) overhead of $8,000.
(c) Consultancy fees $4,000. If the work is not completed, the consultant's contract would be
cancelled at a cost of $1,500.
(d) General overheads of $8,000 would be added to the cost of the additional work.
Required

Assess whether the new customer's offer should be accepted.

Answer

(a) Costs incurred in the past, or revenue received in the past are not relevant because they cannot
affect a decision about what is best for the future. Costs incurred to date of $50,000 and revenue
received of $15,000 are 'water under the bridge' and should be ignored.
(b) Similarly, the price paid in the past for the materials is irrelevant. The only relevant cost of
materials affecting the decision is the opportunity cost of the revenue from scrap which would be
forgone $2,000.
(c) Labour costs

$

Labour costs required to complete work

8,000

Opportunity costs: contribution forgone by losing other work $(30,000 12,000)

18,000

Relevant cost of labour

26,000

(d) The incremental cost of consultancy from completing the work is $2,500.

$

Cost of completing work

4,000

Cost of cancelling contract

1,500

Incremental cost of completing work

2,500

(e) Absorbed overhead is a notional accounting cost and should be ignored. Actual overhead incurred
is the only overhead cost to consider. General overhead costs (and the absorbed overhead of the
alternative work for the labour force) should be ignored.

(f) Relevant costs may be summarised as follows.

$

$

Revenue from completing work

34,000

Relevant costs

Materials: opportunity cost

2,000

Labour: basic pay

8,000

opportunity cost

18,000

Incremental cost of consultant

2,500

30,500

Extra profit to be earned by accepting the completion order

3,500

6 Make or buy decisions
In a make or buy situation with no scarce resources, the relevant costs are the differences in unit variable
costs plus differences in directly attributable fixed costs.
In a situation where a company must subcontract work to make up a shortfall in its own in-house
capabilities, its total costs will be minimised if those units bought have the lowest extra variable cost of
buying per unit of scarce resource saved by buying of all the products in question.
A make or buy decision is about whether an organisation should make a product or whether it should pay
another organisation to do so. These are some examples of make-or-buy decisions.
Whether a company should manufacture its own components, or else buy the components from an
outside supplier.
Whether a construction company should do some work with its own employees, or whether it
should sub-contract the work to another company.
Whether a service should be carried out by an internal department or whether the service should be
outsourced to an external organisation.
The 'make' option gives management more direct control over the work. The 'buy' option has the benefit
that the external organisation has a specialist skill and expertise in the work. Make or buy decisions should
not be based exclusively on cost considerations.
6.1 Example: make or buy
Starfish makes four components, W, X, Y and Z, for which costs in the forthcoming year are expected to
be as follows.

W

X

Y

Z

Production (units)

1,000

2,000

4,000

3,000

Unit marginal costs

$

$

$

$

Direct materials

4

5

2

4

Direct labour

8

9

4

6

Variable production overheads

2

3

1

2

14

17

7

12

Directly attributable fixed costs per annum and committed fixed costs are as follows.

$

Incurred as a direct consequence of making W

1,000

Incurred as a direct consequence of making X

5,000

Incurred as a direct consequence of making Y

6,000

Incurred as a direct consequence of making Z

8,000

Other fixed costs (committed)

30,000

50,000

A sub-contractor has offered to supply units of W, X, Y and Z for $12, $21, $10 and $14 respectively.

Required
Decide whether Starfish should make or buy the components.
Solution
The relevant costs are the differential costs between making and buying, and they consist of differences
in unit variable costs plus differences in directly attributable fixed costs.

W

X

Y

Z

$

$

$

$

Unit variable cost of making

14

17

7

12

Unit variable cost of buying

12

21

10

14

(2)

4

3

2

Annual requirements (units)

1,000

2,000

4,000

3,000

$

$

$

$

Extra variable cost (saving) of buying p.a.

(2,000)

8,000

12,000

6,000

Fixed costs saved by buying

(1,000)

(5,000)

(6,000)

(8,000)

Extra total cost (saving) of buying

(3,000)

3,000

6,000

(2,000)

The company would save $3,000 per annum by sub-contracting component W (where the purchase cost
would be less than the marginal cost per unit to make internally) and would save $2,000 pa by sub-
contracting component Z (because of the saving in fixed costs of $8,000).
In this example, relevant costs are the variable costs of in-house manufacture, the variable costs of sub-
contracted units, and the saving in fixed costs.
6.2 Qualitative factors to consider
Important further considerations include:
(a) If components W and Z are sub-contracted, the company will have spare capacity. How should that
spare capacity be profitably used? Are there hidden benefits to be obtained from sub-contracting?
Would the company's workforce resent the loss of work to an outside sub-contractor, and might
such a decision cause an industrial dispute?
(b) Would the sub-contractor be reliable with delivery times, and would they supply components of
the same quality as those manufactured internally?
(c) Does the company wish to be flexible and maintain better control over operations by making
everything itself?
(d) Are the estimates of fixed cost savings reliable? In the case of Product W, buying is clearly
cheaper than making in-house. In the case of product Z, the decision to buy rather than make
would only be financially beneficial if it is feasible that the fixed cost savings of $8,000 will really be
'delivered' by management. All too often in practice, promised savings fail to materialise!

Question
Accept the job?

An information technology consultancy firm has been asked to do an urgent job by a client, for which a
price of $2,500 has been offered. The job would require the following.
(a) 30 hours' work from one member of staff, who is paid on an hourly basis, at a rate of $20 per
hour, but who would normally be employed on work for clients where the charge-out rate is $45
per hour. No other member of staff is able to do the work of the member of staff in question.
(b) The use of 5 hours of mainframe computer time, which the firm normally charges out to external
users at a rate of $50 per hour. Mainframe computer time is currently used 24 hours a day, 7 days
a week.
(c) Supplies and incidental expenses of $200.
Should the firm accept the job?


Answer

The opportunity cost of the job would be calculated as follows.
$
Labour (30 hours $45) 1,350
Computer time opportunity cost (5 hours $50) 250
Supplies and expenses 200
1,800
The opportunity cost of labour and computer time is the normal charge-out rate, of $45 and $50 per hour
respectively.
A further addition to cost might be added for 'general overhead' depending on the system of costing being
used.
The opportunity cost of the job shows that the firm would increase profits by accepting the job, by $(2,500
1,800) = $700.

7 Activity-based costing (ABC) and decision making
7.1 Different uses of activity-based costing
We have seen that ABC is a method of absorbing overheads to cost units in a way that reflects the causes
of the overheads (the cost drivers) and the way that the different products make use of the overheads.
This technique can make a difference to decisions such as make or buy or product continuance. The
general principle is that ABC allocates costs to products in a manner different from traditional absorption
costing such that decisions based on traditional techniques may be changed if ABC is used.
7.2 Example: adding or deleting products (or departments)
A company manufactures three products, Pawns, Rooks and Bishops. The present net annual income
from these is as follows.

Pawns

Rooks

Bishops

Total

$

$

$

$

Sales

50,000

40,000

60,000

150,000

Variable costs

30,000

25,000

35,000

90,000

Contribution

20,000

15,000

25,000

60,000

Fixed costs

(calculated using absorption costing)

17,000

18,000

20,000

55,000

Profit/loss

3,000

(3,000)

5,000

5,000

The company is concerned about its poor profit performance, and is considering whether or not to cease
selling Rooks. It is felt that selling prices cannot be raised or lowered without adversely affecting net
income. $5,000 of the fixed costs of Rooks are direct fixed costs which would be saved if production
ceased (ie there are some attributable fixed costs). All other fixed costs, it is considered, would remain the
same.
By stopping production of Rooks, the consequences would be a $10,000 fall in profits compared to a loss
of $3,000. Therefore the production of Rooks should continue.

$

Loss of contribution

(15,000)

Savings in fixed costs

5,000

Incremental loss

(10,000)


Question
Shutdown decision

How would the above decision change if Pawns, Rooks and Bishops were manufactured in different
departments, variable costs could be split down into the costs of direct materials, labour and overheads,
and fixed costs could be analysed into the costs of administrative staff and equipment and premises
costs?

Answer

The decision would not change at all unless activity based analysis of overheads were undertaken and
unexpected cost patterns were revealed.
Thus for example an analysis of the total fixed costs of $55,000 might reveal that $40,000 was for
materials handling which under absorption costing was apportioned equally across the three product
ranges. In fact Pawns required not only a much higher proportion of deliveries inwards of small amounts
of specialised goods but also many more small production runs and set ups that were very time
consuming and used up 75% of the $40,000 cost.
This would clearly alter the allocation of fixed overheads which may well cause Pawns to be unprofitable.
If the material handling costs would be saved if production ceased then it may be advisable to discontinue
producing Pawns.

7.3 Make or buy
We shall now return to the Starfish example earlier in this chapter. The question is not repeated, but the
answer is repeated below so that the effect of ABC on the options to be considered can be examined.
Solution
(a) The relevant costs are the differential costs between making and buying, and they consist of
differences in unit variable costs plus differences in directly attributable fixed costs. Sub-
contracting will result in some fixed cost savings.

W

X

Y

Z

$

$

$

$

Unit variable cost of making

14

17

7

12

Unit variable cost of buying

12

21

10

14

(2)

4

3

2

Annual requirements (units)

1,000

2,000

4,000

3,000

$

$

$

$

Extra variable cost of buying (per annum)

(2,000)

8,000

12,000

6,000

Fixed costs saved by buying

(1,000)

(5,000)

(6,000)

(8,000)

Extra total cost of buying

(3,000)

3,000

6,000

(2,000)

(b) The company would save $3,000 pa by sub-contracting component W (where the purchase cost
would be less than the marginal cost per unit to make internally) and would save $2,000 pa by sub-
contracting component Z (because of the saving in fixed costs of $8,000).
(c) In this example, relevant costs are the variable costs of in-house manufacture, the variable costs of
sub-contracted units, and the saving in fixed costs.
7.3.1 Comments on the solution in the light of ABC
As discussed in 7.2 above, a realignment of the fixed costs in the manner discussed above may very
quickly cause a change in the decision as to which products to make or buy.
We will not make fresh calculations, but you simply have to understand the effects that recalculating the
fixed overheads can have. It is all too easy to be seduced by the idea that marginal costing and
contribution analysis make the fixed costs irrelevant to many decisions. Costs that are fixed using

absorption costing may turn out to be attributable to specific products and may therefore be avoided if the
product is discontinued.
7.4 Customer costs and ABC
The creation of cost pools for activities in ABC systems allows organisations to arrange costs in a variety
of different ways. Because different customers use different amounts of activities, it is possible to build up
costs for individual customers or groups of customers on an activity basis so that their relative
profitability can be assessed.
Examples of the build up of customer costs using an activity-based system
Activity Cost driver
Order taking Number of orders taken
Sales visits Number of sales visits
Emergency orders Number of rushed orders
Delivery Miles travelled
Product handling Number of pallets or part-pallets handled
After-sales service and support Number of visits
Product repairs and service Number of repair visits

Case Study

Drury cites the case of Kanthal, a Swedish company that sells electric heating elements. Customer-related
selling costs represented 34% of total costs. In the past Kanthal had allocated these costs on the basis of
sales value when customer profitability studies were carried out. The company then introduced an ABC
system in order to determine the resources consumed by different customers.
An investigation identified two cost drivers for the resources used to service different customers.
(a) Number of orders placed. Each order had a large fixed cost, which did not vary with the number of
items ordered. A customer ordering 10 items 100 times cost more to service than a customer
placing a single order for 1,000 items.
(b) Non-standard production items. These cost more to manufacture than standard items.
A cost per order and the cost of handling standard and non-standard items were calculated and a
customer profitability analysis (CPA) carried out on the basis of the previous year's sales. The analysis
showed that only 40% of customers were profitable, and a further 10% lost 120% of the profits. In other
words, 10% of customers incurred losses equal to 120% of Kanthal's total profits. Two of the most
unprofitable customers were actually in the top three in terms of total sales volume but made many small
orders of non-standard items.

Unprofitable customers identified by CPA should be persuaded to alter their buying behaviour so they
become profitable customers. In the Kanthal example above, unprofitable customers should be
discouraged from placing lots of small orders and/or from buying non-standard products.
The activity based approach also highlights where cost reduction efforts should be focused. Kanthal
should concentrate on reducing ordering cost and the cost of handling non-standard items.
Activity-based CPA allows an organisation to adopt a more market-orientated approach to management
accounting.

Question
CPA

B Ltd manufactures components for the heavy goods vehicle industry. The following annual information
regarding three of its key customers is available.
P Q R
Gross margin $897,000 $1,070,000 $1,056,000
General administration costs $35,000 $67,000 $56,000
Units sold 4,600 5,800 3,800
Orders placed 300 320 480
Sales visits 80 50 100
Invoices raised 310 390 1,050
The company uses an activity based costing system and the analysis of customer-related costs is as
follows.
Sales visits $420 per visit
Order processing $190 per order placed
Despatch costs $350 per order placed
Billing and collections $97 per invoice raised
Required
Using customer profitability analysis, how would the customers be ranked?

Answer

P

Q

R

$'000

$'000

$'000

Gross margin

897.00

1,070.00

1,056.00

Less: customer specific costs

sales visits (80/50/100 $420)

(33.60)

(21.00)

(42.00)

order processing (300/320/480 $190)

(57.00)

(60.80)

(91.20)

despatch costs (300/320/480 $350)

(105.00)

(112.00)

(168.00)

billing and collections (310/390/1,050 $97)

(30.07)

(37.83)

(101.85)

671.33

838.37

652.95

Ranking

2

1

3

7.5 Customer profitability statement
There is no set format, but it would normally be similar to the one below. Note that financing costs have
been included.

$'000

$'000

Revenue at list prices

100

Less: discounts given

8

Net revenue

92

Less: cost of goods sold

50

Gross margin

42

Less: customer specific costs

28

financing costs:

credit period

3

customer specific inventory

2

33

Net margin from customer

9


Question
Which customer is the most profitable?

Seth Co supplies shoes to Narayan Co and Kipling Co. Each pair of shoes has a list price of $50 and costs
Seth Co $25. As Kipling buys in bulk it receives a 10% trade discount for every order for 100 pairs of
shoes or more. Narayan receives a 15% discount irrespective of order size, because that company collects
the shoes, thereby saving Seth Co any distribution costs. The cost of administering each order is $50 and
the distribution cost is $1,000 per order. Narayan makes 10 orders in the year, totalling 420 pairs of
shoes, and Kipling places 5 orders for 100 pairs. Which customer is the most profitable for Seth Co?

Answer

It can be shown that Seth Co earns more from supplying Narayan, despite the larger discount percentage:

Kipling

Narayan

$

$

Revenue

25,000

21,000

Less: discount

2,500

3,150

Net revenue

22,500

17,850

Less: cost of shoes

(12,500)

(10,500)

customer transport cost

(5,000)

customer administration cost

(250)

(500)

Net gain

4,750

6,850

The difference on a unit basis is considerable.
Number of pairs of shoes sold

500

420

Net gain per pair of shoes sold

$9.50

$16.31

Net gain per $1 of sales revenue

$0.19

$0.33

7.6 Other considerations
It is important to remember, however, that considerations other than cost data might alter a decision
entirely.
(a) Can the sales price of products be raised, thereby increasing unit contribution without reducing
sales demand?
(b) To what extent are sales of each product interdependent? For example, a manufacturer of knives
and forks could not expect to cease production of knives without affecting sales demand for the
forks.
(c) Qualitative factors
(i) Would a decision to stop selling one product have a harmful effect on customer loyalty and
sales demand?
(ii) Is the decision to stop selling a product going to affect the long-term plans of the company
as well as the short-term? It is likely that competitors will take over the markets vacated.
Labour skilled in the manufacture of the product will be lost, and a decision in one year's
time to reopen manufacture might not be possible.
(iii) Are the costs too high because the company is using very old-fashioned production
methods, or is the company a high-tech newcomer located in a low-tech area and the
company has yet to achieve sufficient economies of scale to bring down unit costs?
8 Uncertainty in decision making
Decisions are generally taken without any certainty as to what the actual outcome will be. A range of likely
outcomes may be likely. The approach to decision making under conditions of uncertainty depends on the
attitude of an organisation and its management to risk. Decision-making should certainly be taken with a
proper understanding of the different possible outcomes.
A risk-averse manager might opt for the option that offers the best 'worst result' (the maximin criterion).
Some of the assumptions that are typically made in relevant costing are as follows.
Cost behaviour patterns are known; if a department closes down, for example, the attributable
fixed cost savings would be known.
The amount of fixed costs, unit variable costs, sales price and sales demand are known with
certainty.
The objective of decision making in the short run is to maximise 'satisfaction', which is often
regarded as 'short-term profit'.
The information on which a decision is based is complete and reliable.
In reality, the future outcome from taking any particular course of action can be estimated. A future
outcome might even be probable. However, the future can rarely be predicted with certainty. Managers
must recognise that when they make a decision, there will often be an element of risk or uncertainty.
8.1 Risk preference
A risk seeker is a decision maker who is interested in the best outcomes no matter how small the chance
that they may occur.
A decision maker is risk neutral if he or she is concerned with what will be the most likely outcome.
A risk averse decision maker acts on the assumption that the worst outcome might occur.
Decision-making information could be presented to managers in such a way as to ensure that they
consider all the possibilities, including the worst.
8.2 Conservatism in decision making
Conservatism is associated with risk aversion and caution. A technique for assisting a risk-averse manager
might be to measure the most likely outcome from a decision, and the worst and best possible outcomes.
This will show the full range of possible outcomes from a decision, and might help the manager to reject
certain alternatives because the worst possible outcome might involve an unacceptable amount of loss.
8.3 Example: worst/best possible outcomes
Omelette is trying to set the sales price for one of its products. Three prices are under consideration, and
expected sales volumes and costs are as follows.
Price per unit $4 $4.30 $4.40
Expected sales volume (units)
Best possible 16,000 14,000 12,500
Most likely 14,000 12,500 12,000
Worst possible 10,000 8,000 6,000
Fixed costs are $20,000 and variable costs of sales are $2 per unit.
Which price should be chosen?

Solution
Price per unit $4 $4.30 $4.40
Contribution per unit $2 $2.30 $2.40
Total contribution $ $ $
Best possible 32,000 32,200 30,000
Most likely 28,000 28,750 28,800
Worst possible 20,000 18,400 14,400
(a) The highest contribution based on most likely sales volume would be at a price of $4.40 but
arguably a price of $4.30 would be much better than $4.40, since the most likely profit is almost as
good, the worst possible profit is not as bad, and the best possible profit is better.
(b) However, only a price of $4 guarantees that the company would not make a loss, even if the worst
possible outcome occurs. (Fixed costs of $20,000 would just be covered.) A risk averse
management might therefore prefer a price of $4 to either of the other two prices.
8.4 The maximin decision rule
The maximin decision rule suggests that a decision maker should select the alternative that offers the
least unattractive worst outcome. This would mean choosing the alternative that maximises the minimum
profits.
8.5 Example: maximin decision rule
A business is trying to decide which of three mutually exclusive projects to undertake. Each of the projects
could lead to varying net costs which the business classifies as outcomes I, II, and III. The business has
constructed the following payoff table or matrix.
Net profit in $'000s if outcome turns out to be
I (Worst) II (Most likely) III (Best)
A 50 85 130
Project B 70 75 140
C 90 100 110
Which project should they undertake? Use the maximin decision rule.
Solution
The maximin decision rule suggests that they should select the 'best worst result' that could happen. This
is the decision criterion that managers should 'play safe' and either minimise their losses or costs, or else
go for the decision which gives the highest minimum profits. If the business selects project A the worst
result is a net profit of 50. Similarly, the worst results for B and C are 70 and 90 respectively. The best
'worst outcome' is 90 and project C would therefore be selected (because this is a better 'worst possible'
than either A or B).
The maximin decision rule is also known as the minimax cost rule minimise the maximum costs or
losses.
8.6 Criticisms of the maximin decision rule
The maximin decision rule is subject to two major criticisms.
(a) It is defensive and conservative, being a safety first principle of avoiding the worst outcomes
without taking into account opportunities for maximising profits.
(b) It ignores the probability of each different outcome taking place. In the previous example, we
ignored the fact that outcome II was the most likely outcome.
Risk preference Decision rule
Risk seeker Best possible outcome
Risk neutral Most likely outcome
Risk averse Worst outcome might occurs (maximin)
8.7 Sensitivity analysis
Sensitivity analysis is a term used to describe any technique whereby decision options are tested for their
vulnerability to changes in any 'variable' such as expected sales volume, sales price per unit, material
costs, or labour costs.
Here are three useful approaches to sensitivity analysis.
(a) To estimate by how much costs and revenues would need to differ from their estimated values
before the decision would change.
(b) To estimate whether a decision would change if estimated costs were x% higher than estimated,
or estimated revenues y% lower than estimated.
(c) To estimate by how much costs and/or revenues would need to differ from their estimated values
before the decision maker would be indifferent between two options.
The essence of the approach, therefore, is to carry out the calculations with one set of values for the variables
and then substitute other possible values for the variables to see how this affects the overall outcome.
(a) Such a 'what if' analysis can be carried out using a spreadsheet.
(b) Flexible budgeting can also be a form of sensitivity analysis.
9 Probabilities and expected values
When probabilities can be estimated for possible outcomes, a weighted average of all the possible
outcomes can be calculated. This is an expected value or EV.
A risk-neutral organisation and management might decide to take the course of action offering the highest
expected value of profit or the lowest expected value of loss.
Although the outcome of a decision may not be certain, there is some likelihood that probabilities could
be assigned to the various possible outcomes from an analysis of previous experience.
For example, it might be estimated, on the basis of past experience, that the amount of sales that a
company's sales team will win at an annual trade fair are as follows:
(a) 0.3 probability of $600,000
(b) 0.5 probability of $700,000
(c) 0.2 probability of $1,000,000
All the probabilities must add up to 1.0 (which is 100% of possible outcomes).
One way of analysing these estimates is to calculate an 'average' of the different possible outcomes,
allowing for the probability that each will occur. This average is called an expected value. It is calculated by
multiplying each outcome by its associated probability, and then adding up the resulting numbers.
In the example above, the expected value of sales is as follows.

Outcome: Sales

Probability

Expected value

x

p

px

$
$

600,000

0.3

180,000

700,000

0.5

350,000

1,000,000

0.2

200,000

730,000

The expected value of probable sales is $730,000. However, the expected value is simply a weighted
average of possible outcomes, and actual sales could be much higher or lower than this average figure.
Where a choice has to be made between different decision options, and probabilities are assigned to
different possible outcomes, the expected value of profit for each of the decision options can be
calculated. Management may then choose the decision option that offers the highest expected value, i.e.
the option that has the highest expected value of profit, or the lowest expected value of cost.
Choosing the option with the best expected value is not going to guarantee that the best choice will be
made. However, it provides a basis for making a decision under conditions of uncertainty.
9.1 Example: expected values
Suppose a manager has to choose between mutually exclusive options A and B, and the probable
outcomes of each option are as follows.
Option A Option B
Probability Profit Probability Profit
$ $
0.8 5,000 0.1 (2,000)
0.2 6,000 0.2 5,000
0.6 7,000
0.1 8,000
The expected value (EV) of profit of each option would be measured as follows.

_______________Option A________________

_______________Option B_____________

Prob

Profit

EV of profit

Prob

Profit

EV of profit

$

$

$

$

0.8

5,000

= 4,000 0.1

(2,000)

=

(200)

0.2

6,000

= 1,200 0.2

5,000

=

1,000

EV

= 5,200 0.6

7,000

=

4,200

0.1

8,000

=

800

EV

=

5,800
In this example, since it offers a higher EV of expected profit, option B would be selected in preference to
A, unless further risk analysis is carried out.
The expected value of an opportunity is equal to the sum of the probabilities of an outcome occurring
multiplied by the return expected if it does occur:
=
px EV

where p is the probability of an outcome occurring and x is the value (profit or cost) of that outcome.

means 'the sum of'.

Question
Options

A manager has to choose between mutually exclusive options C and D and the probable outcomes of each
option are as follows.
Option C Option D
Probability Cost Probability Cost
$ $
0.30 15,000 0.05 14,000
0.55 20,000 0.30 17,000
0.15 30,000 0.35 21,000
0.30 24,000
Both options will produce an income of $30,000. Which should be chosen?

Answer

Option C

Option D

Cost

Probability

EV

Cost

Probability

EV

$

$

$

$

15,000

0.30

4,500

14,000

0.05

700

20,000

0.55

11,000

17,000

0.30

5,100

30,000

0.15

4,500

21,000

0.35

7,350

24,000

0.30

7,200

EV of cost

20,000

20,350

On the basis of expected values, Option C should be chosen, because it has the lowest expected value of
cost.

9.2 Limitations of expected values
In the example above, the preference for option B over option A on the basis of expected value is marred
by the fact that A's worst possible outcome is a profit of $5,000, whereas B might incur a loss of $2,000
(although there is a 70% chance that profits would be $7,000 or more, which would be more than the best
profits from option A).
Since the decision must be made once only between A and B, the expected value of profit (which is
merely a weighted average of all possible outcomes) has severe limitations as a decision rule by which to
judge preference.
Expected values are more valuable as a guide to decision making where they refer to outcomes which will
occur many times over. Examples would include the probability that so many customers per day will buy
a can of baked beans, the probability that a customer services assistant will receive so many phone calls
per hour, and so on. The reliability of expected value calculations depends upon the accuracy of both the
values assigned to the various outcomes and the probabilities of those outcomes.
142 7: Pricing

1 Pricing policy
Pricing policy is just one element in the marketing mix, but it is important that prices should be sufficient
to achieve profitability. Pricing policy is influenced by a variety of market factors/demand factors, such as
competition in the market, and the life cycle of the product.
Market penetration pricing and market skimming pricing are pricing policies for new products.
Differential pricing involves selling the same product at different prices to different customers.
Price can go by many names. Fares, rent, assessments and fees for example. All profit-making
organisations and many non-profit-making organisations face the task of setting a price for their products
or services.
In the past, setting a price was regarded as the single most important factor in marketing. In modern
marketing philosophy, pricing decisions remain important. However, price is just one element in the
marketing mix. Other factors include:
(a) The satisfaction of customer wants and needs by providing products of the right type, quality and
image

(b) Targeting particular types of customer (eg customers more concerned with product quality or
purchasing convenience, rather than customers wanting to buy at the cheapest possible price)

(c) Advertising and sales promotion

(d) The delivery of goods or services at a location or by a delivery method that customers prefer

Although there are many elements in the marketing mix, the pricing of an organisation's products or
services is crucial to its profitability.
1.1 Factors affecting pricing policy
Influences on pricing policy include the following.
Influence Comment
Price sensitivity This describes how demand for a product reacts to price changes. Sensitivity to
price levels will vary amongst purchasers. Business customers who can pass on the
cost of purchases will normally be the least sensitive to price.
For example, when looking for a hotel to stay in, the business traveller will be more
concerned about the level of service and quality of food than about price, since his or
her employer will be paying the bill. In contrast, the family on holiday are likely to be
very price-sensitive when choosing an overnight stay.

Pricing

7: Pricing 143
Influence Comment
Price perception Price perception is the way customers react to prices.
For example, customers may react to a price increase by buying more. This could be
because they expect further price increases to follow (they are 'stocking up').
Quality In the absence of other information, customers tend to judge quality by price. A
price change may send signals to customers concerning the quality of the product. A
price rise may indicate improvements in quality, a price reduction may signal
reduced quality, for example through the use of inferior components. Of two
products, the more expensive is usually judged to be of 'better quality'.
Intermediaries If an organisation distributes products or services to the market through
independent intermediaries, the objectives of these intermediaries complicate the
pricing decision. Such intermediaries are likely to deal with a range of suppliers and
their aims concern their own profits rather than those of suppliers. The
organisation's pricing policy should take into consideration the attitudes to price of
both their immediate customer (the intermediaries) and the end-consumer.
Competitors In setting prices, an organisation sends out signals to rivals. Competitors are likely
to react to these signals in some way. In some industries (such as petrol retailing)
pricing moves in unison; in others, price changes by one supplier may initiate a
price war, with each supplier undercutting the others.
Suppliers If an organisation's suppliers notice a price rise for the organisation's products,
they may seek a rise in the price for their supplies to the organisation, on the
grounds that it is now able to pay a higher price.
Inflation In periods of inflation the organisation may need to change prices to reflect
increases in the prices of supplies, labour, rent and so on. Such changes may be
needed to keep relative (real) prices unchanged.
Economic
wealth/incomes
In times of rising incomes or economic affluence, price may be less important to
consumers than product quality or convenience of access (distribution). When
income levels are falling and/or unemployment levels rising, price will become more
important.
Product range The products made by an organisation might complement each other and customers
might buy a range of the supplier's products in one buying decision. With such
'complementary products', pricing is likely to focus on the profit from the whole
range rather than the profit on each single product.
A pricing policy may use loss leaders: offering one product at a very low price is
intended to make consumers buy additional products in the range that carry higher
profit margins. An example is selling razors at a loss whilst selling the blades for the
razors at a higher profit margin. Another example would be selling the Monday
edition of a national newspaper cheaply, to encourage new readers to buy the
newspaper more regularly throughout the week.
Ethics Ethical considerations may be a further factor, for example whether or not to exploit
short-term shortages through higher prices.
Substitute
products
Pricing policy might be affected by the existence of substitute products or services
to which consumers might switch if the price of the product becomes too high. For
example if the price of train travel rises, customers might switch to coach travel or
air travel.
1.2 Product life cycle
The product life cycle is the period over which a product is initially researched and developed, then
introduced to the market; its market gradually grows until it reaches maturity, then declines until the
product is finally withdrawn from the market and abandoned.
144 7: Pricing
The product life concept is the recognition that most products do not have a limitless life. Some last much
longer than others, although not without modifications and enhancements. Some products have a very
short life cycle, and 'disappear' soon after they have been launched in the market. The aim of pricing
policy should be to set prices through the various stages of a product's life so as to optimise profitability.
This may call for a different pricing policy at each stage of the product's life.
The life cycle concept states that a typical product moves through four stages.
(a) Introduction
The product is introduced to the market. Heavy capital expenditure will be incurred on product
development and perhaps also on the purchase of new non-current assets and building up
inventories for sale.
On its introduction to the market, the product will begin to earn some revenue, but initially demand
is likely to be small. Potential customers will be unaware of the product or service, and the
organisation may have to spend further on advertising to bring the product or service to the
attention of the market.
(b) Growth
The product gains a bigger market as demand builds up. Sales revenues increase and the product
begins to make a profit. The initial costs of the investment in the new product are gradually
recovered.
(c) Maturity
Eventually, the growth in demand for the product will slow down and it will enter a period of
relative maturity. It will continue to be profitable. The product may be modified or improved, as a
means of sustaining its demand.
(d) Saturation and decline
At some stage, the market may reach 'saturation point'. Demand will start to fall. For a while, the
product will still be profitable in spite of declining sales, but eventually it will become a loss-maker
and this is the time when the organisation should decide to stop selling the product or service, and
so the product's life cycle should reach its end.
Remember, however, that some mature products will never decline: staple food products such as
milk or bread are the best example. However, even with staple products, innovations may be
necessary to sustain market demand (such as new packaging, new methods of delivery to the
consumer, and niche products such as organic food or low-calorie food items).
Not all products follow the 'standard' life cycle pattern, but it remains a useful tool when considering
decisions such as pricing. The life cycle concept is relevant when considering what pricing policy will be
adopted.
1.3 Markets and competition
The price that an organisation can charge for its products will also be influenced by the market in which it
operates.
In established industries dominated by a few major firms, a price initiative by one firm will usually be
countered by a price reaction by competitors. In these circumstances, prices tend to be stable.
If a rival cuts its prices in the expectation of increasing its market share, a firm has several options.
(a) It will maintain its existing prices if the expectation is that only a small market share would be
lost, so that it is more profitable to keep prices at their existing level. Eventually, the rival firm may
drop out of the market or be forced to raise its prices.
(b) It may maintain its prices but respond with a non-price counter-attack. This is a more positive
response, because the firm will be securing or justifying its current prices with a product change,
advertising, or better back-up services.
(c) It may reduce its prices. This should protect the firm's market share so that the main beneficiary
from the price reduction will be the consumer.

7: Pricing 145
(d) It may raise its prices and respond with a non-price counter-attack. The extra revenue from the
higher prices might be used to finance an advertising campaign or product design changes. A price
increase would be based on a campaign to emphasise the quality difference between the firm's own
product and the rival's product.
1.4 Price leadership
Given that price competition can have disastrous consequences in conditions of oligopoly, it is not
unusual to find that large corporations emerge as price leaders. The price leader indicates to the other
firms in the market what the price will be, and competitors then set their prices with reference to the
leader's price.
1.5 New product pricing
When an organisation introduces a new product to the market, a decision has to be made about the price
that will be charged. If there are no obvious rival products, the organisation will have a choice about
whether to set prices high or low. High prices should provide high unit profits, but lower demand. Low
prices will provide lower unit profits, but higher sales volume.
Two pricing policies for new products are therefore market penetration pricing and market skimming.
1.6 Market penetration pricing
This is a policy of low prices when the product is first launched in order to obtain sufficient penetration
into the market. A penetration policy may be appropriate:
If the firm wishes to discourage new entrants into the market.
If the firm wishes to shorten the initial period of the product's life cycle in order to enter the
growth and maturity stages as quickly as possible.
If there are significant economies of scale to be achieved from a high volume of output, so that
quick penetration into the market is desirable in order to gain unit cost reductions.
If demand is likely to increase as prices fall.
1.7 Market skimming pricing
In contrast, market skimming involves charging high prices when a product is first launched and
spending heavily on advertising and sales promotion to obtain sales. As the product moves into the later
stages of its life cycle (growth, maturity and decline) progressively lower prices will be charged. The
profitable 'cream' is thus skimmed off in stages until sales can only be sustained at lower prices.
The aim of market skimming is to gain high unit profits early in the product's life. High unit prices make it
more likely that competitors will enter the market than if lower prices were to be charged.
Such a policy is appropriate:
Where the product is new and different, so that customers are prepared to pay high prices so as to
be one up on other people who do not own it. Examples have been DVD players and mobile
phones.
Where the strength of demand and the sensitivity of demand to price are unknown. It is better from
the point of view of marketing to start by charging high prices and then reduce them if the demand
is insufficient.
Where products may have a short life cycle, and so need to recover their development costs and
make a profit quickly.
146 7: Pricing
1.8 Differential pricing
In certain circumstances the same product can be sold at different prices to different customers. There
are a number of bases on which such prices can be set.
Basis Example
By market segment A cross-channel ferry company would market its services at different prices in
England, Belgium and France, for example. Services such as cinemas and
hairdressers are often available at lower prices to old age pensioners and/or
juveniles.
By product version Many car models have 'add on' extras which enable one brand to appeal to a
wider cross-section of customers. The final price need not reflect the cost price
of the add-on extras directly: usually the top of the range model would carry a
price much in excess of the cost of provision of the extras, as a prestige
appeal.
By place Theatre seats are usually sold according to their location so that patrons pay
different prices for the same performance according to the seat type they
occupy.
By time This is perhaps the most popular type of price discrimination. Railway
companies, for example, are successful price discriminators, charging more to
rush hour rail commuters whose demand remains the same whatever the price
charged at certain times of the day.

Question
Different prices

Can you think of any more examples of products or services which are sold to different customers at
different prices on the basis of time?

Answer

Off-peak travel bargains, hotel prices, telephone and electricity charges are examples.

2 Setting prices
A number of techniques may be used to set prices. These include price-setting techniques based on the
cost of the item.
The prices that an organisation sets for its products or services should be consistent with its pricing
policies.
Prices are often determined by market factors, such as the prices currently charged by competitors, and
considerations of how much customers would be prepared to pay for a particular item. Pricing is therefore
often market-driven or marketing-driven.
At the same time, an organisation needs to make a profit from the items that it sells, and price-setting
should also have regard to costs and profits.
In some cases, particularly contracting work and jobbing work, an organisation may set prices by first of
all estimating the likely cost, and then quoting a price at which a suitable profit margin would be earned.
Price tenders for contracts are usually set on this basis.

7: Pricing 147
3 Economic factors influencing the price of a product
3.1 The economic analysis of demand
There are two extremes in the relationship between price and demand. A supplier can either sell a certain
quantity, Q, at any price (as in graph (a)). Demand is totally unresponsive to changes in price and is said
to be completely inelastic. Alternatively, demand might be limitless at a certain price P (as in graph
(b)), but there would be no demand above price P and there would be little point in dropping the price
below P. In such circumstances demand is said to be completely elastic.
(a) (b)

A more normal situation is shown below. The downward-sloping demand curve shows that demand will
increase as prices are lowered. Demand is therefore elastic.

3.2 Price elasticity of demand ()
Price elasticity is a measure of the extent of change in market demand for a good in response to a change
in its price. If demand is elastic a reduction in price would lead to a rise in total sales revenue. If demand
is inelastic a reduction in price would lead to a fall in total sales revenue.

Price elasticity of demand () is a measure of the extent of change in market demand for a good in
response to a change in its price. It is measured as:
price the of % a as price, in change The
demand of % a as demanded, quantity in change The

Since the demand goes up when the price falls, and goes down when the price rises, the elasticity has a
negative value, but it is usual to ignore the minus sign.
3.2.1 Example: price elasticity of demand
The price of a good is $1.20 per unit and annual demand is 800,000 units. Market research indicates that
an increase in price of 10 cents per unit will result in a fall in annual demand of 75,000 units. What is the
price elasticity of demand?

148 7: Pricing
Solution
Annual demand at $1.20 per unit is 800,000 units.
Annual demand at $1.30 per unit is 725,000 units.
% change in demand = (75,000/800,000) 100% = 9.375%
% change in price = (10c/120c) 100% = 8.333%
Price elasticity of demand = (9.375/8.333) = 1.125
Ignoring the minus sign, price elasticity is 1.125.
The demand for this good, at a price of $1.20 per unit, would be referred to as elastic because the price
elasticity of demand is greater than 1.
3.3 Elastic and inelastic demand
The value of demand elasticity may be anything from zero to infinity.
Demand is referred to as inelastic if the absolute value is less than 1 and elastic if the absolute value is
greater than 1.
(a) Where demand is inelastic, the quantity demanded falls by a smaller percentage than the
percentage increase in price.
(b) Where demand is elastic, demand falls by a larger percentage than the percentage rise in price.

Question
Price elasticity of demand

If the price elasticity of demand is zero, which of the following is/are true?
I Demand is 'perfectly inelastic'
II There is no change in price regardless of the quantity demanded
III The demand curve is a vertical straight line
IV There is no change in the quantity demanded, regardless of any change in price
A I and III only
B I and IV only
C I, II and III only
D I, III and IV only

Answer

Demand is perfectly inelastic when price changes have no impact on demand. The price elasticity of
demand will equal zero only if demand remains unchanged. Statement I is therefore correct.
The price elasticity of demand will equal zero only if demand remains unchanged. If the price remains
unchanged, the denominator of the price elasticity of demand equation will have an infinite value.
Statement II is therefore incorrect.
If the price elasticity of demand is zero it means that demand never changes and so the graph is a vertical
straight line. Statement III is therefore correct.
The price elasticity of demand will equal zero only when demand remains unchanged. Statement IV is
therefore correct.
The correct answer is therefore D since statements I, III and IV are correct.

7: Pricing 149
3.4 Elasticity and the pricing decision
In practice, organisations will have only a rough idea of the shape of their demand curve. Data about
quantities sold at certain prices over a period of time will be limited and there may be other factors that
might have an effect on the demand for a product.
Despite this limitation, an awareness of the concept of elasticity can assist management with pricing
decisions.
(a) In circumstances of inelastic demand, prices should be increased because revenues will increase
and total costs will reduce (because quantities sold will reduce).
(b) In circumstances of elastic demand, increases in prices will bring decreases in revenue and
decreases in price will bring increases in revenue. Management therefore have to decide whether
the increase/decrease in costs will be less than/greater than the increases/decreases in
revenue.
Factors that determine the degree of elasticity are as follows.
(a) The price of the good.
(b) The price of other goods. For some goods the market demand is interconnected.
Substitutes. An increase in demand for one version of a good is likely to cause a decrease
in demand for others. Common examples are rival brands of the same commodity (such as
Coca-Cola and Pepsi-Cola).
Complements. An increase in demand for one is likely to cause an increase in demand for
the other, for examples, cups and saucers.
(c) Income. A rise in income gives households more to spend and they will want to buy more goods.
Different goods are affected in different ways.
Normal goods are those for which a rise in income increases the demand.
Inferior goods are those for which demand falls as income rises (eg cheap wine).
For some goods demand rises up to a certain point and then remains unchanged, because
there is a limit to which consumers can or want to consume. Examples are basic foodstuffs
such as salt and bread.
(d) Tastes and fashions.
(e) Expectations. Where consumers believe that prices will rise or that shortages will occur they will
attempt to stock up on the product, thereby creating excess demand in the short term.
(f) Obsolescence. Many products and services have to be replaced periodically.
4 A demand-based approach to pricing
A demand-based approach to pricing involves determining a profit-maximising price.
Price theory or demand theory is based on the idea that there is a connection between price, the total
quantity demanded by customers, and total revenue and profits. Demand varies with price, and so if an
estimate can be made of demand at different price levels, it should be possible to derive either a
profit-maximising price or a revenue-maximising price.
To apply this approach to pricing in practice, it is necessary to have realistic estimates of demand at
different price levels. Making accurate estimates of demand is often difficult, since price is only one of
many variables that influence demand. Even so, some larger organisations (eg oil companies) go to
considerable effort to estimate the demand for their products or services at differing price levels.
4.1 Example: demand-based pricing
For example, a large transport authority might be considering an increase in bus fares or underground
fares. The effect on total revenues and profit of the increase in fares could be estimated from a knowledge
of the demand for transport services at different price levels. If an increase in the price per ticket caused a

150 7: Pricing
large fall in demand, total revenues and profits would fall. However, if a fares increase would cause
relatively little change in demand (eg possibly, on commuter routes) a price increase would boost total
revenue. Since a transport authority's costs are largely fixed in relation to sales volume (passenger miles),
a rise in revenues from fares would boost total profits too.
Many businesses enjoy something akin to a monopoly position, even in a competitive market. This is
because they develop a unique marketing mix, for example a unique combination of price and quality. The
significance of a monopoly situation is:
(a) The business does not have to 'follow the market' on price; in other words it is not a 'price-taker',
but has more choice and flexibility in the prices it sets.
At higher prices, demand for its products or services will be less.
At lower prices, demand for its products or services will be higher.
(b) There will be a selling price at which the business can maximise its profits.

Question
Maximising contribution

Moose sells a product which has a variable cost of $8 per unit. The sales demand at the current sales price
of $14 is 3,000 units. It has been estimated by the marketing department that the sales volume would fall
by 100 units for each addition of 25c to the sales price.
Required
Establish whether the current price of $14 is the optimal price which maximises contribution.

Answer

Sales price Unit contribution Sales volume Total contribution
$ $ Units $
13.00 5.00 3,400 17,000
13.25 5.25 3,300 17,325
13.50 5.50 3,200 17,600
13.75 5.75 3,100 17,825
14.00 6.00 3,000 18,000
14.25 6.25 2,900 18,125
14.50 6.50 2,800 18,200
14.75 6.75 2,700 18,225*
15.00 7.00 2,600 18,200
* Contribution would be maximised at a price of $14.75, and sales of 2,700 units.
The current price is not optimal.

5 Full cost plus pricing
Using full cost plus pricing, the sales price is determined by calculating the full cost of the product and
adding a percentage mark-up for profit.
As indicated earlier, pricing decisions must recognise the requirement to make a profit. Some
organisations set prices by estimating (in advance) or calculating (after the work has been done) the full
cost of the product and adding a percentage mark-up for profit. This approach to setting prices is known
as full cost plus pricing.

7: Pricing 151
In full cost plus pricing, the full cost may be a fully absorbed production cost only, or it may include some
absorbed administration, selling and distribution overhead. The full cost might also include some
opportunity costs as well, such as the opportunity cost of a production resource that is in short supply, so
that 'full cost' need not be the cost as it might be established in the accounts.
A business might have an idea of the percentage profit margin it would like to earn and so might decide on
an average profit mark-up as a general guideline for pricing decisions. This would be particularly useful for
businesses that carry out a large amount of contract work or jobbing work, for which individual job or
contract prices must be quoted regularly to prospective customers.
However, the percentage profit mark-up does not have to be fixed, but can be varied to suit the
circumstances. In particular, the percentage mark-up can be varied to suit demand conditions in the
market.
5.1 Problems with full cost plus pricing
There are several problems with full cost plus pricing.
(a) Cost plus pricing fails to recognise that since demand may be determined by price, there will be a
profit-maximising combination of price and demand. A cost plus based approach to pricing will be
unlikely to arrive at the profit-maximising price for a 'standard' product.
(b) In most markets, prices must be adjusted to market and demand conditions; the decision cannot
simply be made on a cost basis only.
(c) The calculation of a full cost plus price requires an overhead absorption rate. Output volume, which
is a key factor in the fixed overhead absorption rate, must therefore be budgeted. Output volume
will depend on demand. An estimate of demand depends on price levels. Successful use of cost
plus pricing therefore depends on the budget for output volume being reasonably accurate, and
when competition in the market is severe, this might be difficult.
Further disadvantages of full cost plus pricing are:
(a) It fails to allow for competition. A company may need to match the prices of rival firms when
these take a price-cutting initiative.
(b) A full cost plus basis for a pricing decision is a means of ensuring that, in the long run, a company
succeeds in covering all its fixed costs and making a profit out of revenue earned. However, in the
short term it is inflexible.
A firm tendering for a contract may quote a cost plus price that results in the contract going
elsewhere, although a lower price would have been sufficient to cover all incremental costs
and opportunity costs.
In the short term, rapidly-changing environmental factors might dictate the need for lower
(or higher) prices than long-term considerations would indicate.
(c) Full cost plus prices tend to ignore opportunity costs.
(d) Where more than one product is sold by a company, the price decided by a cost plus formula
depends on the method of apportioning fixed costs between the products. Products taking a
higher share of the total overheads will be charged to customers at higher prices.
5.2 Example: full cost plus pricing with more than one product
Giraffe is attempting to decide sales prices for two products, Lyons and Tygers. The products are both
made by the same workforce and in the same department. 30,000 direct labour hours are budgeted for the
year. The budgeted fixed costs are $30,000 and it is expected that the department will operate at full
capacity. Variable costs per unit are as follows.

Lyons

Tygers

$

$

Materials

4

4

Labour

(2 hours)

6

(3 hours)

9

Expenses

(1 machine hour)

2

(1 machine hour)

2

12

15

152 7: Pricing
Expected demand is 7,500 Lyons and 5,000 Tygers.
Required
Calculate the unit prices which give a profit of 20% on full cost if overheads are absorbed on the following
bases.
(a) On a direct labour hour basis
(b) On a machine hour basis
Solution
(a) A direct labour hour basis
hours labour Budgeted
costs fixed Budgeted
=
( ) 000 , 15 000 , 15
000 , 30 $
+
= $1
Absorption rate $1 per direct labour hour

Lyons

Tygers

$

$

Variable costs

12.00

15.00

Overhead absorbed

2.00

3.00

14.00

18.00

Profit (20%)

2.80

3.60

Price

16.80

21.60

The total budgeted profit would be ((2.80 7,500) + (3.60 5,000)) = $(21,000 + 18,000) =
$39,000.
(b) A machine hour basis
hours machine Budgeted
costs fixed Budgeted
=
( ) 000 , 5 500 , 7
000 , 30 $
+
=
500 , 12
000 , 30 $
= $2.40
Absorption rate $2.40 per machine hour

Lyons

Tygers

$

$

Variable costs

12.00

15.00

Overhead absorbed

2.40

2.40

Full cost

14.40

17.40

Profit (20%)

2.88

3.48

Price

17.28

20.88

The total budgeted profit would be $(21,600 + 17,400) = $39,000.
The different bases for charging overheads result in different prices for both Lyons (difference of 48c per
unit) and Tygers (difference of 72c per unit).
It is unlikely that the expected sales demand for the products would be the same at both sales prices. It is
questionable whether one (or either) product might achieve expected sales demand at the higher price. In
other words, although the budgeted profit is $39,000 whichever overhead absorption method is used, this
assumes that budgeted sales would be achieved regardless of the unit price of each product. This is an
unrealistic basis on which to make a decision.
5.3 Advantages of full cost plus pricing
Since the size of the profit margin can be varied at management's discretion, a decision based on a price
in excess of full cost should ensure that a company working at normal capacity will cover all its fixed costs
and make a profit. Companies may benefit from cost plus pricing in the following circumstances.
(a) When they carry out large contracts which must make a sufficient profit margin to cover a fair
share of fixed costs.
(b) If they must justify their prices to potential customers (for example for government contracts).
(c) If they find it difficult to estimate expected demand at different sales prices.

7: Pricing 153
It is a simple, quick and cheap method of pricing which can be delegated to junior managers. This may
be particularly important with jobbing work where many prices must be decided and quoted each day.

Question
Mark up

A product's full cost is $4.75 and it is sold at full cost plus 70%. A competitor has just launched a similar
product selling for $7.99. How will this affect the first product's mark up?

Answer

Price needs to be reduced to $7.99
Mark-up therefore needs to be

75 . 4
75 . 4 99 . 7
100% = 68%
The mark-up therefore needs to be reduced by 2%.

5.4 Advantages of activity-based costing pricing
Rather than add the profit mark-up to the full cost of the product, one could add the mark-up to the ABC-
determined cost of the product. Since ABC costs are more accurate than traditional full costs, this should
assist the organisation's recovery of its costs.
The principal idea of ABC is to focus attention on what causes costs to increase, ie the cost drivers.
(a) The costs that vary with production volume, such as power costs, should be traced to products
using production volume-related cost drivers, such as direct labour hours or direct machine
hours.
Overheads which do not vary with output but with some other activity should be traced to
products using transaction-based cost drivers, such as number of production runs and number of
orders received.
(b) Traditional costing systems allow overheads to be related to products in rather more arbitrary ways
producing, it is claimed, less accurate product costs.
(c) The result of the above is that ABC, by giving management product costs that more accurately
reflect the true cost involved in the production process, enables managers to set more realistic
prices than when using the traditional full cost plus model.

Question
Traditional costing versus ABC

A company manufactures two products, L and M, using the same equipment and similar processes. An
extract of the production data for these products in one period is shown below.
L M

Quantity produced (units)

5,000

7,000

Direct labour hours per unit

1

2

Machine hours per unit

3

1

Set-ups in the period

10

40

Orders handled in the period

15

60

Overhead costs

$

Relating to machine activity

220,000

Relating to production run set-ups

20,000

Relating to handling of orders

45,000

285,000

154 7: Pricing
Required
Calculate the production overheads to be absorbed by one unit of each of the products using the following
costing methods.
(a) A traditional costing approach using a direct labour hour rate to absorb overheads
(b) An activity-based costing approach, using suitable cost drivers to trace overheads to products.

Answer

(a) Traditional costing approach
Direct labour

hours

Product L = 5,000 units 1 hour

5,000

Product M = 7,000 units 2 hours

14,000

19,000

Overhead absorption rate
=
$285,000

19,000

= $15 per hour
Overhead absorbed would be as follows.
Product L 1 hour $15 = $15 per unit
Product M 2 hours $15 = $30 per unit
(b) ABC approach

Machine hours

Product L

= 5,000 units 3 hours

15,000

Product M

= 7,000 units 1 hour

7,000

22,000

Using ABC the overhead costs are absorbed according to the cost drivers.
$
Machine-hour driven costs 220,000 22,000 m/c hours = $10 per m/c hour
Set-up driven costs 20,000 50 set-ups = $400 per set-up
Order driven costs 45,000 75 orders = $600 per order
Overhead costs are therefore as follows.
Product L Product M
$ $

Machine-driven costs (15,000 hrs $10)
150,000

(7,000 hrs $10)

70,000

Set-up costs (10 $400)

4,000

(40 $400)

16,000

Order handling costs (15 $600)

9,000

(60 $600)

36,000

163,000

122,000

Units produced

5,000

7,000

Overhead cost per unit

$32.60

$17.43

These figures suggest that product M absorbs an unrealistic amount of overhead using a direct
labour hour basis. Overhead absorption should be based on the activities which drive the costs, in
this case machine hours, the number of production run set-ups and the number of orders handled
for each product.

7: Pricing 155
6 Variable cost plus pricing
Variable cost plus pricing (mark-up pricing) involves adding a profit margin to the marginal cost of
production or the marginal cost of sales.
Instead of pricing products or services by adding a profit margin on to full cost, a business might add a
profit margin on to the variable cost or marginal cost of the product (either the marginal cost of
production or else the marginal cost of sales). This is variable cost plus pricing, sometimes called
mark-up pricing.
If a company budgets to make 10,000 units of a product for which the variable cost of production is $3 a
unit and the fixed production cost is $60,000 a year, it might decide to fix a price by adding, say, 33
1
/3% to
full production cost to give a price of $9 1
1
/3 = $12 a unit. Alternatively, it might decide to add a profit
margin of, say, 250% on to the variable production cost, to give a price of $3 350% = $10.50.
The advantages of a marginal cost plus approach:
(a) It is a simple and easy method to use.
(b) The size of the mark-up can be varied, and so, provided that a rigid mark-up is not used, mark-up
pricing can be adjusted to reflect demand conditions.
(c) It draws management attention to contribution and the effects of higher or lower sales volumes on
profit. This helps to create a better awareness of the concepts and implications of marginal
costing and breakeven analysis. For example, if a product costs $10 a unit and a mark-up of
150% is added to reach a price of $25 a unit, management should be clearly aware that every
additional $1 of sales revenue would add 60c to contribution and profit.
(d) Mark-up pricing is convenient where there is a readily identifiable basic variable cost. Retail
industries are the most obvious example, and it is quite common for the prices of goods in shops
to be fixed by adding a mark-up (20% or 33
1
/3%, say) to the purchase cost. For example, a
department store might buy in items of pottery at $3 each, add a mark-up of one third and resell
the items at $4.
Drawbacks to marginal cost plus pricing are as follows.
(a) Although the size of the mark-up can be varied in accordance with demand conditions, it does not
ensure that sufficient attention is paid to demand conditions, competitors' prices and profit
maximisation.
(b) It ignores fixed overheads in the pricing decision. However, prices must be high enough to ensure
that a profit is made after covering fixed costs. Pricing decisions cannot ignore fixed costs
altogether.

Question
Profit margin

A product has the following costs.
$
Direct materials 5
Direct labour 3
Variable overhead 7
Fixed overheads are $10,000 per month. Budgeted sales for the month are 400 units.
What profit margin needs to be added to marginal cost to breakeven?

156 7: Pricing

Answer

To breakeven, total contribution = fixed costs
Let selling price = p
Unit contribution = p 15
Total monthly contribution = 400 (p 15)
At breakeven point, 400(p 15) = 10,000
p 15 = 25
p = 40
Profit margin =
15
15 40
100% = 166
2
/3%

7 Opportunity cost approach to pricing
(marginal pricing)
An opportunity cost approach to pricing involves allowing in the price for the opportunity costs of the
resources consumed in making and selling the item. A marginal price or minimum price is the price at
which the organisation would be no better or no worse off if it were to make and sell the item.
In some circumstances, particularly when it is working at full capacity, a firm might be willing to charge a
price for an item that leaves it no worse off than if it did the next most profitable alternative thing. This is
the marginal price or minimum price of an item. Any additional amount on top of the marginal price would
give the firm a higher profit.
To estimate the marginal price for an item, it is necessary to take into account the opportunity costs of the
resources consumed in making and selling the item.
7.1 Marginal pricing (minimum pricing)
A minimum price is the price that would have to be charged to cover:
(a) The incremental costs of producing and selling the item
(b) The opportunity costs of the resources consumed in making and selling the item.
A minimum price would leave the business no better or worse off in financial terms than if it did not sell
the item.
A minimum price is based on relevant costs. It is unlikely to be the price actually charged, because it
would not provide the business with any incremental profit. However, calculating the minimum price is
useful as it shows:
(a) An absolute minimum below which the price should not be set
(b) The incremental profit that would be obtained from any price that is actually charged in excess of
the minimum. For example, if the minimum price is $20,000 and the actual price charged is
$24,000, the incremental profit on the sale would be $4,000.
If resources are scarce, minimum prices must include an allowance for the opportunity cost of using the
resources on the job.

7: Pricing 157
7.2 Example: marginal pricing and opportunity costs
OP has begun to produce a new product, T, for which the following cost estimates have been made.

$

Direct materials

27

Direct labour: 4 hrs at $5 per hour

20

Variable production overheads: machining, hr at $6 per hour

3

50

If the company decides to make and sell product T, it will have to switch its machine capacity from making
other products, since there is a restriction on total machine time available.
Production fixed overheads are budgeted at $300,000 per month. The overhead absorption rate will be a
direct labour rate, and budgeted direct labour hours are 25,000 per month.
Because of the shortage of available machining capacity, the company will be restricted to 10,000 hours of
machine time a year for making product T. It is estimated that the company could obtain a minimum
contribution of $10 per machine hour on producing items other than product T.
Required
(a) What is the marginal price for product T?
(b) If the company wishes to make an additional profit of 20% on top of the marginal price from
making product T, what would the price be, and how much additional profit would OP make?
Solution

$

Direct materials

27.0

Direct labour (4 hours $5)

20.0


3.0

Opportunity cost: contribution forgone from alternative use of machines

(0.5 hours at $10 per hour)

5.0

Marginal price

55.0

If product T could be sold at a mark-up of 20% on top of its marginal price, the unit price would be $66
($55 plus 20%). There would be 10,000 machine hours of time spent making product T each year, 20,000
units would be produced and sold, increasing the company's profits by (20,000 $11) $220,000.
8 Fixed price tenders
Marginal cost pricing, for example in fixed price tenders, involves an analysis of relevant costs. A profit
margin (mark-up) is often added to the minimum price.
8.1 Special orders
A special order is a one-off revenue earning opportunity. These may arise in the following situations.
(a) When a business has a regular source of income but also has some spare capacity allowing it to
take on extra work if demanded. For example a brewery might have a capacity of 500,000 barrels
per month but only be producing and selling 300,000 barrels per month. It could therefore
consider special orders to use up some of its spare capacity.
(b) When a business has no regular source of income and relies exclusively on its ability to respond
to demand. A building firm is a typical example as are many types of sub-contractors. In the
service sector consultants often work on this basis.
The reason for making the distinction is that in situation (a) above, a firm would normally attempt to cover
its longer-term running costs in its prices for its regular products. Pricing for special orders need
therefore take no account of unavoidable fixed costs. This is clearly not the case for a firm in situation (b),
where special orders are the only source of income for the foreseeable future.

158 7: Pricing
The basic approach in both situations is to determine the price at which the firm would break even if it
undertook the work; that is, the minimum price that it could afford to charge.
8.2 Example: special order and minimum price
Minimax has just completed production of an item of special equipment for a customer, only to be notified
that this customer has now gone into liquidation.
After much effort, the sales manager has been able to interest a potential buyer who might buy the
machine if certain conversion work could first be carried out.
(a) The sales price of the machine to the original buyer had been fixed at $138,600 and had included
an estimated normal profit mark-up of 10% on total costs. The costs incurred in the manufacture
of the machine were as follows.

$

Direct materials

49,000

Direct labour

36,000

Variable overhead

9,000

Fixed production overhead

24,000

Fixed sales and distribution overhead

8,000

126,000

(b) If the machine is converted, the production manager estimates that the cost of the extra work
required would be as follows.
Direct materials (at cost) $9,600
Direct labour
Department X: 6 workers for 4 weeks at $210 per worker per week
Department Y: 2 workers for 4 weeks at $160 per worker per week
(c) Variable overhead would be 20% of direct labour cost, and fixed production overhead would be
absorbed as follows.
Department X: 83.33% of direct labour cost
Department Y: 25% of direct labour cost
(d) Additional information is available as follows.
(i) In the original machine, there are three types of material.
(1) Type A could be sold for scrap for $8,000.
(2) Type B could be sold for scrap for $2,400 but it would take 120 hours of casual
labour paid at $3.50 per hour to put it into a condition in which it would be suitable
for sale.
(3) Type C would need to be scrapped, at a cost to Minimax of $1,100.
(ii) The direct materials required for the conversion are already in inventory. If not needed for
the conversion they would be used in the production of another machine in place of
materials that would otherwise need to be purchased, and that would currently cost $8,800.
(iii) The conversion work would be carried out in two departments, X and Y. Department X is
currently extremely busy and working at full capacity; it is estimated that its contribution to
fixed overhead and profits is $2.50 per $1 of labour.
Department Y, on the other hand, is short of work but for organisational reasons its labour
force, which at the moment has a workload of only 40% of its standard capacity, cannot be
reduced below its current level of eight employees, all of whom are paid a wage of $160 per
week.
(iv) The designs and specifications of the original machine could be sold to an overseas
customer for $4,500 if the machine is scrapped.

7: Pricing 159
(v) If conversion work is undertaken, a temporary supervisor would need to be employed for
four weeks at a total cost of $1,500. It is normal company practice to charge supervision
costs to fixed overhead.
(vi) The original customer has already paid a non-returnable deposit to Minimax of 12.5% of the
selling price.
Required
Calculate the minimum price that Minimax should quote for the converted machine if this is the best
option. Explain clearly how you have reached this figure and conclusion.
Solution
The minimum price is the price which reflects the opportunity costs of the work. These are established as
follows.
(a) Past costs are not relevant, and the $126,000 of cost incurred should be excluded from the
minimum price calculation. It is necessary, however, to consider the alternative use of the direct
materials which would be forgone if the conversion work is carried out.
$
Type A
Revenue from sales as scrap (note (i)) 8,000
Type B
Revenue from sales as scrap, minus the additional cash costs
necessary to prepare it for sale ($2,400 (120 $3.50)) (note (i)) 1,980
Type C

Cost of disposal if the machine is not converted

(a negative opportunity cost) (note (ii))

(1,100)

Total opportunity cost of materials types A, B and C

8,880
By agreeing to the conversion of the machine, Minimax would therefore lose a net revenue of
$8,880 from the alternative use of these materials.
Notes
(i) Scrap sales would be lost if the conversion work goes ahead.
(ii) These costs would be incurred unless the work goes ahead.
(b) The cost of additional direct materials for conversion is $9,600, but this is an historical cost as
inventories already exist. The relevant cost of these materials is the $8,800 which would be spent
on new purchases if the conversion is carried out. If the conversion work goes ahead, the materials
in inventory would be unavailable for production of the other machine mentioned in item (d)(ii) of
the question and so the extra purchases of $8,800 would then be needed.
(c) Direct labour in departments X and Y is a fixed cost and the labour force will be paid regardless of
the work they do or do not do. The cost of labour for conversion in department Y is not a relevant
cost because the work could be done without any extra cost to the company.
In department X, however, acceptance of the conversion work would oblige the company to divert
production from other profitable jobs. The minimum contribution required from using department
X labour must be sufficient to cover the cost of the labour and variable overheads and then make
an additional $2.50 in contribution per direct labour hour.
Department X: costs for direct labour hours spent on conversion
6 workers 4 weeks $210 = $5,040
Variable overhead cost
$5,040 20% = $1,008
Contribution forgone by diverting labour from other work
$2.50 per $1 of labour cost = $5,040 250% = $12,600
160 7: Pricing
(d) Variable overheads in department Y are relevant costs because they will only be incurred if
production work is carried out. (It is assumed that if the workforce is idle, no variable overheads
would be incurred.)
Department Y 20% of (2 workers 4 weeks $160) = $256
(e) If the machine is converted, the company cannot sell the designs and specifications to the overseas
company. $4,500 is a relevant (opportunity) cost of accepting the conversion order.
(f) Fixed overheads, being mainly unchanged regardless of what the company decides to do, should
be ignored because they are not relevant (incremental) costs. The additional cost of supervision
should, however, be included as a relevant cost of the order because the $1,500 will not be spent
unless the conversion work is done.
(g) The non-refundable deposit received should be ignored and should not be deducted in the
calculation of the minimum price. Just as costs incurred in the past are not relevant to a current
decision about what to do in the future, revenues collected in the past are also irrelevant.
Estimate of minimum price for the converted machine

$

$

Opportunity cost of using the direct materials types A, B and C

8,880

Opportunity cost of additional materials for conversion

8,800

Opportunity cost of work in department X

Labour

5,040

Variable overhead

1,008

Contribution forgone

12,600

18,648

Opportunity cost: sale of designs and specifications

4,500

Incremental costs:

Variable production overheads in department Y

256

Fixed production overheads (additional supervision)

1,500

Minimum price

42,584

Question
Minimum price

Ship has recently shut down its London factory where it used to make cushions, although all the
inventories of raw materials and machinery are still there awaiting disposal. A former customer has just
asked whether he could be supplied with one last delivery of 500 cushions. You ascertain the following
facts.
(a) There is sufficient covering material in inventory. This originally cost $400 but has a disposal value
of $190.
(b) There is sufficient stuffing in inventory. This originally cost $350. It was to have been shipped to
the Bristol factory at a cost of $80. The Bristol factory would currently expect to pay $500 for this
quantity.
(c) Labour costs would be $450.
(d) A supervisor could be spared from the Bristol factory for the week needed to produce the cushions.
His normal wage is $160 and his rail fare and hotel bill in London would amount to $135.
(e) Before the factory was closed, fixed overheads were absorbed at 200% of direct labour cost.
Required
Calculate the minimum price that could be quoted.

7: Pricing 161

Answer

The minimum price is estimated from the relevant costs of producing the cushions.

$

Covering material

(the opportunity cost of this material is its scrap value of $190.

The original cost is irrelevant because it is a historical cost, not a future cash flow)

190

Stuffing (the opportunity cost of the stuffing is the savings forgone by not

sending it to Bristol, net of the transport costs of getting it to Bristol: $(500 80))

420

Labour: incremental cost

450

Supervisor's expenses: incremental expense item

135

Minimum price

1,195

The supervisor's basic wage and the overheads are irrelevant to the decision because these are costs that
would be incurred anyway, even if the cushions were not produced.

Question
Acceptance or refusal of contract

DDD has decided to price its jobs as follows.
(a) It calculates the minimum price for the job using relevant costs.
(b) It adds $5,000 to cover fixed costs.
(c) It adds a 10% profit margin to the total cost.
A customer who has work to be performed in May says he will award the contract to DDD if its bid is
reduced by $5,000.
Required
Assess whether the contract should be accepted.

Answer

Yes or no. Yes, if there is no other work available, because DDD will at least earn a contribution towards
fixed costs of 10% of the minimum cost. But no, if by accepting this reduced price it would send a signal
to other prospective customers that they too could negotiate such a large reduction.

In setting the price, management must decide how much profit it would consider reasonable on the job. A
simple cost-plus approach can be used (for example, add 10% to the minimum price) but the company
management should consider the effect that the additional jobs will have on the activities engaged in by
the company and whether these activities will create additional unforeseen costs.
Sometimes an organisation may depart from its typical price-setting routine and 'low-ball' bid jobs. A low-
ball bid may be a minimum price or it may even be below the minimum price. The rationale behind low-
ball bids is to obtain the job so as to have the opportunity to introduce products or services to a particular
market segment. This type of bidding cannot be sustained in the long term.
8.3 Qualitative factors
When setting the price management must consider qualitative as well as quantitative issues.
Will setting a low bid price cause the customer (or others) to feel that a precedent has been
established for future prices?
Will the contribution margin on a bid set low enough to acquire the job, earn a sufficient amount
to justify the additional burdens placed on management or employees by the activity?
How, if at all, will fixed price tenders affect the organisation's normal sales?
162 7: Pricing
If the job is taking place during a period of low business activity (off-season or during a recession),
is management willing to take the business at a lower contribution or profit margin simply to keep
a valued workforce employed?
8.4 Monitoring costs against fixed prices
Once the tender has been submitted and accepted, management must ensure that actual costs do not
exceed the estimated costs, since for every cost overrun profit is eroded. Actual costs must be monitored.
Variances between actual and estimated costs must be highlighted and, if significant, investigated.
Control action may be required.
9 Target cost pricing
In target costing, an organisation decides what the sales price of the item will be, and the required profit
margin. Subtracting the desired profit margin from the target price gives a target cost, which is the cost
for the item that the organisation should aim to achieve. The difference between the current cost and the
target cost is a cost gap, that the organisation should seek to eliminate.
To compete effectively in today's competitive markets, organisations must continually redesign their
products, with the result that product life cycles have become much shorter. The planning, development
and design stage of a product is therefore critical to an organisation's cost management process. Many
companies have to think about:
(a) How long the life cycle of the product might be
(b) What prices will need to be charged at each stage in the product's life cycle for the product to be
successful.
Target costing, and target cost pricing, is an approach to pricing that combines an awareness of market
demand conditions and the need for profitability.
Target cost means a product cost estimate derived by subtracting a desired profit margin from a
competitive market price. This may be less than the planned initial product cost, but will be expected to be
achieved by the time the product reaches the mature production stage. (CIMA, Official Terminology)
Target cost = Market price Desired profit margin
This approach to pricing and costs requires managers to change the way they think about the relationship
between cost, price and profit.
(a) Traditionally, the approach has been to develop a new product, determine what it costs to make,
and set a selling price. The product will be profitable if its selling price exceeds its cost.
(b) The target costing approach to new product development is to determine what the market selling
price will be at each stage of its life cycle and what the desired profit margin should be. As a result,
it is then possible to calculate what the cost of the product must be at each stage of its life cycle, to
ensure that the desired profits will be achieved.
The target cost for a product is likely to change over its life cycle. Typically, in the early stages of its life, a
higher sales price will be achievable, and so a higher unit production cost is acceptable. However, as the
price of a product falls, its target cost must also come down. Decisions made at the planning and design
stage for a product can be crucial in making the target cost achievable (eg decisions affecting the choice
of materials for making the item, or in the choice of the number of product features to build into the
product).
The steps for implementing a target costing approach are as follows.
Step 1 Determine a product specification for which an adequate sales volume is expected.
Step 2 Set a selling price at which the organisation will be able to achieve a desired market share.

7: Pricing 163
Step 3 Estimate the required profit based on return on sales or return on investment.
Step 4 Calculate the target cost = target selling price target profit.
Step 5 Compile an estimated cost for the product based on the anticipated design specification and
current cost levels.
Step 6 Calculate the cost gap. This is the difference between the product cost that is currently
estimated and the target cost that needs to be achieved. Cost gap = estimated cost target
cost.
Step 7 Make efforts to close the cost gap. This is more likely to be successful if efforts are made to
'design out' costs prior to production, rather than to 'control out' costs during the
production phase.
Step 8 Negotiate with the customer before making the decision about whether to go ahead with the
project.
When a product is first manufactured, its target cost may well be much lower than its currently-attainable
cost, which is determined by current technology and processes. Management can then set benchmarks
for improvement towards the target costs, by improving technologies and processes.
Various techniques of cost reduction can be employed. The objective in each case is to reduce the unit
cost of the product without reducing the customer's perception of the product in its intended use.
Possible techniques are:
Reduce the number of components if redundant components can be identified, or the product
can be reconfigured more simply while still satisfying the customer, then unit cost can be reduced.
Using different materials can plastic be used rather than more expensive metal, for example.
Using standard components whenever possible rather than building one's own components in-
house, or paying for a third party to construct components to one's individual specifications, it will
almost certainly be cheaper to design the product to incorporate industry-standard components
that can be bought in large quantities on the world market where economies of scale have already
driven the price down.
Using cheaper staff As far as possible, a few skilled staff should be used to supervise the work of
the many unqualified staff.
Training staff in more efficient techniques the time of the existing staff can then be used more
profitably.
Acquiring new, more efficient technology often an investment in new technology will enable the
same or a greater volume of output to be achieved by fewer employees, who can either be released
from employment or who can carry out alternative profitable work for the company.
Cutting out non value-added activities perhaps the work flow can be redesigned, for example to
reduce inventories of part-finished items, or perhaps the product can be redesigned, for example
not painting surfaces unseen by the customer, or cutting down on unnecessary packaging.
164 8: Transfer pricing

1 Transfer pricing: basic principles
A transfer price is 'The price at which goods or services are transferred between different units of the
same company. The extent to which the transfer price covers costs and contributes to (internal) profit is
a matter of policy.' (CIMA Official Terminology)
When there are transfers of goods or services between divisions, the transfers could be made free to the
division receiving the benefits. For example, if a garage and car showroom has two divisions, one for car
repairs and servicing and the other for car sales, the servicing division will be required to service cars
before they are sold. The servicing division could do the work without making any record of the work
done. However, unless the cost or value of such work is recorded, management cannot keep a check on
the amount of resources (such as time) that has been required for new car servicing. For planning and
control purposes, it is necessary that some record of inter-divisional services or transfers of goods should
be kept.
Inter-divisional work can be given a cost or charge, and this is its transfer price. The transfer price is
revenue to the division providing the goods or service, and a cost to the division receiving the benefit.
2 Profit centres and transfer pricing
An organisation might be divided into a number of profit centres. The manager of each profit centre is
required to make a profit from the activities for which he or she is responsible, and the performance of the
centre is measured in terms of profit (or return on capital).
A profit centre might be a division within the company, or a separate subsidiary company within the
group. The activities of a profit centre might be fairly autonomous, and separate from the activities of
other profit centres within the organisation. Alternatively, the activities of profit centres might be fairly
closely inter-related, with some profit centres providing products or services to others.
Transfer pricing

8: Transfer pricing 165
When one profit centre provides products or services to another profit centre, its manager will expect to
make a profit from these transactions, and so will charge the other profit centre a price for the work that is
in excess of the costs it incurred.
An issue that arises in such situations is how to fix a price for the work that is acceptable to both profit
centres.
2.1 Example
Suppose that profit centre A supplies goods to profit centre B, and the cost to profit centre A is, say,
$10,000. Any price in excess of $10,000 will result in a profit for profit centre A. Now suppose that profit
centre B then re-sells the goods for $18,000 without doing any further work on them.
(a) The total profit to the company is $8,000 ($18,000 $10,000).
(b) If the price charged by profit centre A to profit centre B is $12,000, profit centre A will make a profit
of $2,000 ($12,000 $10,000) and profit centre B will make a profit of $6,000 ($18,000
$12,000).
(c) If the price charged by profit centre A to profit centre B is $17,000, profit centre A will make a profit
of $7,000 ($17,000 $10,000) and profit centre B will make a profit of $1,000 ($18,000
$17,000).
The overall profit is the same, whatever price profit centre A charges to profit centre B, but the price
charged affects the share of the total profit enjoyed by each profit centre.
The purpose of having a profit centre organisation is to provide an incentive for improving profitability
within each part of the organisation. However, setting prices for work done by one profit centre for another
is a potential source of disagreement, since profit centres can improve their profits at the expense of
another, by charging higher prices.
In theory since the transfer price represents a cost to one party and income to the other, overall corporate
profits should be the same regardless of the transfer price. In practice however the transfer pricing policy
has behavioural implications, which may cause managers to take decisions in the interests of their profit
centre but which reduce the profits of the organisation as a whole. For example, if profit centre A charges
$18,000 or more, B will not be encouraged to take the transfer despite it being worthwhile for the
company as a whole. This will lead to unused capacity.
2.2 Bases for setting a transfer price
A transfer price may be:
(a) Market based
(i) full market price
(ii) discounted market price
(b) Cost based
(i) marginal cost
(ii) full cost
(iii) cost-plus (based on either marginal or full cost with a profit margin)
(c) Negotiated
3 Problems with transfer pricing
Transfer prices are a way of promoting divisional autonomy, ideally without prejudicing the divisional
performance measurement or discouraging overall corporate profit maximisation.
They may be based on market price where there is a market.
If not, problems arise with cost-based transfer prices because one party or the other is liable to perceive
them as unfair.
3.1 Divisional autonomy
Transfer prices are particularly appropriate for profit centres because if one profit centre does work for
another, the size of the transfer price will affect the costs of one profit centre and the revenues of another.
However, a danger with profit centre accounting is that the business organisation will divide into a number
of self-interested segments, each acting at times against the wishes and interests of other segments.
Decisions might be taken by a profit centre manager in the best interests of his or her own part of the
business, but against the best interests of other profit centres and possibly the organisation as a whole.
A task of head office is therefore to try to prevent dysfunctional decision making by individual profit
centres. To do this, it must reserve some power and authority for itself and so profit centres cannot be
allowed to make entirely autonomous decisions.
Just how much authority head office decides to keep for itself will vary according to individual
circumstances. A balance ought to be kept between divisional autonomy to provide incentives and
motivation, and retaining centralised authority to ensure that the organisation's profit centres are all
working towards the same target, the benefit of the organisation as a whole (in other words, retaining goal
congruence among the organisation's separate divisions).
3.2 Divisional performance measurement
Profit centre managers tend to put their own profit performance above everything else. Since profit centre
performance is measured according to the profit they earn, no profit centre will want to do work for
another and incur costs without being paid for it. Consequently, profit centre managers are likely to
dispute the size of transfer prices with each other, or disagree about whether one profit centre should do
work for another or not. Transfer prices affect behaviour and decisions by profit centre managers.
3.3 Corporate profit maximisation
When there are disagreements about how much work should be transferred between divisions, and how
many sales the division should make to the external market, there is presumably a profit-maximising level
of output and sales for the organisation as a whole. However, unless each profit centre also maximises its
own profit at this same level of output, there will be inter-divisional disagreements about output levels and
the profit-maximising output will not be achieved.
3.4 The ideal solution
Ideally a transfer price should be set at a level that overcomes these problems.
(a) The transfer price should provide an 'artificial' selling price that enables the transferring division to
earn a return for its efforts, and the receiving division to incur a cost for benefits received.
(b) The transfer price should be set at a level that enables profit centre performance to be measured
'commercially' (that is, it should be a fair commercial price).
(c) The transfer price, if possible, should encourage profit centre managers to agree on the amount of
goods and services to be transferred, which will also be at a level that is consistent with the
organisation's aims as a whole such as maximising company profits.
In practice it is very difficult to achieve all three aims.


Question
Autonomy

(a) What do you understand by the term 'divisional autonomy'?
(b) What are the likely behavioural consequences of a head office continually imposing its own
decisions on divisions?

Answer

(a) The term refers to the right of a division to govern itself, that is, the freedom to make decisions
without consulting a higher authority first and without interference from a higher body.
(b) Decentralisation recognises that those closest to a job are the best equipped to say how it should
be done and that people tend to perform to a higher standard if they are given responsibility.
Centrally-imposed decisions are likely to make managers feel that they do not really have any
authority and therefore that they cannot be held responsible for performance. They will therefore
make less effort to perform well.

4 Transfers at market price
If an external market price exists for transferred goods or services, profit centre managers will be aware
of the price they could charge or the price they would have to pay for their goods on the external market,
and so will compare this price with the internal transfer price.
It might therefore be agreed that transfers at market price are 'fair' and appropriate.
4.1 Example: transferring goods at market value
A company has two profit centres, A and B. Centre A sells half of its output on the open market and
transfers the other half to centre B. Costs and external revenues in an accounting period are as follows.

Centre A

Centre B

Total

$

$

$

External sales

8,000

24,000

32,000

Costs of production

12,000

10,000

22,000

Company profit

10,000

Required
What are the consequences of setting a transfer price at market value?
Solution
If the transfer price is at market price, centre A would be happy to sell the output to centre B for $8,000,
which is what centre A would get by selling it externally instead of transferring it.

A

B

Total

$

$

$

$

$

Market sales

8,000

24,000

32,000

Transfer sales

8,000

16,000

24,000

Transfer costs

8,000

Own costs

12,000

10,000

22,000

12,000

18,000

Profit

4,000

6,000

10,000

The consequences, therefore, are as follows.
(a) Centre A earns the same profit on transfers as on external sales. Centre B must pay a commercial
price for transferred goods, and both divisions will have their profit measured fairly.
(b) Centre A will be indifferent about selling externally or transferring goods to centre B because the
profit is the same on both types of transaction. Centre B can therefore ask for and obtain as many
units as it wants from centre A.
A market-based transfer price might therefore seem to be the ideal transfer price.
4.2 Adjusted market price
However, internal transfers are often cheaper than external sales, with savings in selling and
administration costs, bad debt risks and possibly transport/delivery costs. It would therefore seem
reasonable for the buying division to expect a discount on the external market price.
The transfer price might therefore be set at an amount slightly below market price, so that both profit
centres can share the cost savings from internal transfers compared with external sales. It should be
possible to reach agreement on this price and on output levels with a minimum of intervention from head
office.
4.3 The disadvantages of market value transfer prices
Market value as a transfer price does have certain disadvantages.
(a) The division receiving the internal transfer might decide that an external supplier would be more
convenient, or might do the job better or more quickly. There is no incentive for the division to
'buy' the goods or services internally, because it would be just as cheap to buy outside. From the
point of view of the organisation as a whole, however, it might be very desirable that internal
transfers should be preferred to external market purchases.
(b) The market price may be a temporary one, induced by adverse economic conditions, or dumping,
or the market price might depend on the volume of output supplied to the external market by the
profit centre.
(c) A transfer price at market value might, under some circumstances, act as a disincentive to use up
any spare capacity in the divisions. A price based on incremental cost, in contrast, might provide
an incentive to use up the spare resources in order to provide a marginal contribution to profit.
(d) Many products do not have an equivalent market price so that the price of a similar, but not
identical, product might have to be chosen. In such circumstances, the option to sell or buy on the
open market does not really exist.
5 Cost-based approaches to transfer pricing
Fixed costs in the supplying division can be accounted for in a number of ways to ensure that it at least
breaks even.
Standard costs should be used for transfer prices to avoid encouraging inefficiency in the supplying
division.
Cost-based approaches to transfer pricing are often used in practice, particularly where the following
conditions apply.
(a) There is no external market for the product that is being transferred.
(b) Alternatively, although there is an external market it is an imperfect one because the market price
is affected by such factors as the amount that the company setting the transfer price supplies to it,
or because there is only a limited external demand.
In either case there will not be a suitable market price upon which to base the transfer price.

5.1 Transfer prices based on full cost
Under this approach, the full cost (including fixed overheads absorbed) incurred by the supplying division
in making the 'intermediate' product is charged to the receiving division. If a full cost plus approach is
used, a profit margin is usually added to cost to reach the transfer price.
An intermediate product is one that is used as a component of another product, for example car
headlights or food additives.
5.2 Example: transfers at full cost (plus)
A company has two profit centres, P and Q. Centre P assembles a product which it then transfers to
Centre Q. Centre Q does the finishing work on the product, after which it is sold on the external market.
Budgeted production costs for the year are as follows.
Centre P Centre Q
Units produced 30,000 30,000
Variable cost per unit incurred $5 $2
Fixed costs $210,000 $180,000
The finished item sells for $25 per unit.
If a profit centre organisation did not exist, the budgeted profit would be as follows.

$

$

Sales (30,000 $25)

750,000

Variable costs (30,000 $7)

210,000

Fixed costs

390,000

Total costs

600,000

Profit

150,000

If a profit centre structure were to operate, what would be the profits of centre P and centre Q if units were
transferred between the divisions:
(a) at full cost
(b) at full cost plus a margin of 25%?
Solution
Transfer price at full cost
The full cost of output from centre P is the variable cost of $5 plus a fixed cost per unit of $7
($210,000/30,000). If the transfer price is at full cost ($12), centre P would have sales to centre Q of
$360,000 (30,000 units at $12), and the profits of each centre would be as follows.

Centre P

Centre Q

Company

$

$

$

$

$

$

External market sales

750,000

750,000
Internal transfers

360,000

Total sales

360,000

750,000
Costs

Transfers

360,000
Own variable costs

150,000

60,000

210,000
Own fixed costs

210,000

180,000

390,000
Total costs

360,000

600,000

600,000
Profit

0

150,000

150,000
The transfer sales of centre P are self-cancelling with the transfer costs of centre Q so that total profits are
unaffected by the transfer items. The transfer price simply spreads the total profit of $150,000 between P
and Q. Since the transfers are at full cost, the budgeted profit of centre P is nil. The only ways in which
centre P can make a profit would be:
(a) to produce more units than budgeted, and so make a profit because fixed costs will remain
unchanged, and a contribution of $7 per unit will be earned on every unit in excess of 30,000
(b) keep actual costs below budget.
The obvious drawback to a transfer price at cost is that division P needs a profit on its transfers in order to
be motivated to supply division Q; and transfer pricing at cost is therefore inconsistent with the use of a
profit centre accounting system.
Transfer price at full cost plus
If the transfers are at cost plus a margin of 25%, transfers by division P to division Q will be at $12 plus
25%, ie $15 per unit, or $450,000 in total. Divisional profits will be as follows.

Centre P

Centre Q

Company

$

$

$

$
$
$


750,000

750,000

Internal transfers

450,000

Total sales

450,000

750,000

Costs

Transfers

450,000

Own variable costs

150,000

60,000

210,000

Own fixed costs

210,000

180,000

390,000

Total costs

360,000

690,000

600,000

Profit

90,000

60,000

150,000

The total profit is now shared between the two divisions. However, the choice of 25% as a profit mark-up
was arbitrary and unrelated to any external market conditions. If the profit centre managers cannot agree
on the size of the mark-up, a transfer pricing decision would have to be imposed by head office. If this
were to happen, the degree of autonomy enjoyed by the profit centres would be weakened.
A potential weakness with transfers at cost plus is that the division making the transfers might not be
sufficiently motivated to control costs. On the contrary, if transfers are priced at actual cost plus, the
transferring division would make bigger profits by spending more.
To provide an incentive to control costs, transfers at cost plus should therefore be at a budgeted cost plus
or a standard cost plus.

Question
Transfer price

In the example above, what should be the transfer price, expressed in terms of cost plus, if centre P and
centre Q were to have the same budgeted profit?

Answer

The total budgeted profit is $150,000. Divided equally, this would give a profit of $75,000 to each division.
Centre P's budgeted costs are $360,000 in total, which means that to earn a profit of $75,000, it must
transfer the 30,000 units for a total revenue of $435,000, or $14.50 per unit.

Divisional profitability would then be:

Centre P

Centre Q

Company

$

$

$

$
$
$


750,000

750,000

Internal transfers

435,000

Total sales

435,000

750,000

Costs

Transfers

435,000

Own variable costs

150,000

60,000

210,000

Own fixed costs

210,000

180,000

390,000

Total costs

360,000

675,000

600,000

Profit

75,000

75,000

150,000

Both divisions can improve profitability by making and selling more units, and by keeping their costs
below budgeted levels.

5.3 Transfer price at variable cost
A variable cost approach entails charging the variable cost that has been incurred by the supplying
division to the receiving division, probably with a profit mark-up. In the above example, centre P might
transfer its output to centre Q at variable cost plus, say, 200%. This would give a transfer price of $15 per
unit ($5 plus 200%).
A problem with variable cost plus transfer prices is that unless a transfer price is sufficiently high (ie the
mark-up is sufficiently large) the supplying division will not cover its fixed costs and make a profit.
There are ways in which this problem could be overcome.
(a) Each division can be given a share of the overall contribution earned by the organisation, but it
would probably be necessary to decide what the shares should be centrally, thereby undermining
divisional autonomy. Alternatively central management could impose a range within which the
transfer price should fall, and allow divisional managers to negotiate what they felt was a fair price
between themselves.
(b) An alternative method is to use a two-part charging system: transfer prices are set at variable cost
(or variable cost plus some mark-up) and once a year there is a transfer of a fixed fee to the
supplying division, representing an allowance for its fixed costs. Care is needed with this approach.
It risks sending the message to the supplying division that it need not control its fixed costs
because the company will subsidise any inefficiencies. On the other hand, if fixed costs are
incurred because spare capacity is kept available for the needs of other divisions it is reasonable to
expect those other divisions to pay a fee if they 'booked' that capacity in advance but later failed to
utilise it. The main problem with this approach, once again, is that it is likely to conflict with
divisional autonomy.
5.4 Standard cost versus actual cost
When a transfer price is based on cost, standard cost or budgeted cost should be used, not actual cost. A
transfer of actual cost would give no incentive to control costs, because they could all be passed on.
Actual cost-plus transfer prices might even encourage the manager of the transferring profit centre to
overspend, because this would increase the divisional profit, even though the company as a whole (and
the profit centre receiving the transfers) might suffer.

Question
Transfer prices again

Motivate has two profit centres, P and Q. P transfers all its output to Q. The variable cost of output from P
is $5 per unit, and fixed costs are $1,200 per month. Additional processing costs in Q are $4 per unit for
variable costs, plus fixed costs of $800 per month. Budgeted production is 400 units per month, and the
output of Q sells for $15 per unit. The transfer price is to be based on standard full cost plus. From what
range of prices should the transfer price be selected, in order to motivate the managers of both profit
centres to both increase output and reduce costs?

Answer

Any transfer price based on standard cost plus will motivate managers to cut costs, because favourable
differences between standard costs and actual costs will add to the division's profits. Managers of each
division will also be willing to increase output above the budget of 400 units provided that it is profitable to
do so; that is:
(a) in P, provided that the transfer price exceeds the variable cost of $5 per unit;
(b) in Q, provided that the transfer price is less than the difference between the fixed selling price ($15)
and the variable costs in Q itself ($4). This amount of $11 ($15 $4) is sometimes called net
marginal revenue.
The range of prices is therefore between $5.01 and $10.99.

6 Opportunity cost and transfer pricing
If a profit-maximising output level has been established, the transfer price should be set such that there is
not a more profitable opportunity for individual divisions. In other words transfer prices should include
opportunity costs of transfer.
The problem with this approach is that it entails collecting all the relevant divisional data centrally and
imposing a transfer price, undermining divisional autonomy.
Ideally, a transfer price should be set that enables the individual divisions to maximise their profits at a
level of output that maximises profit for the company as a whole. The transfer price which achieves this is
unlikely to be a market-based transfer price (if there is one) and is also unlikely to be a simple cost plus
based price.
If optimum decisions are to be taken by profit centre managers, transfer prices should reflect opportunity
costs.
(a) If profit centre managers are given sufficient autonomy to make their own output and selling
decisions, and at the same time their performance is judged by the company according to the
profits they earn, they will be keenly aware of all the commercial opportunities.
(b) If transfers are made for the good of the company as a whole, the commercial benefits to the
company ought to be shared between the participating divisions.
Transfer prices can therefore be reached by:
(a) recognising the levels of output, external sales and internal transfers that are best for the company
as a whole; and
(b) arriving at a transfer price that ensures that all divisions maximise their profits at this same level of
output. The transfer price should therefore be such that there is not a more profitable opportunity
for individual divisions. This in turn means that the opportunity costs of transfer should be covered
by the transfer price.

6.1 Limiting factors and transfer pricing
When an intermediate resource is in short supply and acts as a limiting factor on production in the
transferring division, the cost of transferring an item is the variable cost of production plus the
contribution obtainable from using the scarce resource in its next most profitable way.
6.2 Example: scarce resources
Suppose, for example, that division A is a profit centre that produces three items, X, Y and Z. Each item
has an external market.
X Y Z
External market price, per unit $48 $46 $40
Variable cost of production in division A $33 $24 $28
Labour hours required per unit in division A 3 4 2
The maximum external sales are 800 units of X, 500 units of Y and 300 units of Z. In addition to the
external sales, product Y can be transferred to division B, but the maximum quantity that might be
required for transfer is 300 units of Y.
Instead of receiving transfers of product Y from division A at $46 per unit division B could buy similar
units of product Y on the open market at a slightly cheaper price of $45 per unit.
What should the transfer price be for each unit if the total labour hours available in division A are 3,800
hours?
Solution
Hours required to meet maximum demand:
External sales:

Hours

X (3 800)

2,400

Y (4 500)

2,000

Z (2 300)

600

5,000

Transfers of Y (4 300)

1,200

6,200

Contribution from external sales:
X Y Z
Contribution per unit $15 $22 $12
Labour hours per unit 3 hrs 4 hrs 2 hrs
Contribution per labour hour $5.00 $5.50 $6.00
Priority for selling 3rd 2nd 1st
Total hours needed 2,400 2,000 600
If only 3,800 hours of labour are available, division A would choose, ignoring transfers to B, to sell:

Hours

300 Z (maximum)

600

500 Y (maximum)

2,000

2,600

400 X (balance)

1,200

3,800

To transfer 300 units of Y to division B would take 1,200 hours (300 4 hrs) and involve forgoing the sale
of 400 units of X which also would take 1,200 hours (400 3 hrs).
Opportunity cost of transferring units of Y, and the appropriate transfer price:

$ per unit

Variable cost of making Y

24

Opportunity cost (contribution of $5 per hour

available from selling X externally): benefit forgone (4 hours $5)

20

Transfer price for Y

44

The transfer price for Y should, in this case, be less than the external market price.
7 The 'general rule'
We have studied several methods of calculating transfer prices and also the reasons for setting a transfer
price (namely the need to reconcile the possibly conflicting objectives of decentralisation, divisional
autonomy, goal congruence and managerial effort). These different objectives means that there may be no
one best transfer price - for example, the senior management may place priority on say divisional
autonomy ahead of goal congruence in the belief that this will motivate managers and lead to other
benefits and profits that are not immediately quantifiable.
However, if the company is seeking a 'mathematical' best transfer price that will maximise profits in the
short term, then the 'general rule' is that the ideal transfer price should reflect the opportunity cost of sale
to the supplying division and the opportunity cost to the buying division.
This leads to the following 'general rule':
Transfer price per unit = Standard variable cost in the producing division plus the opportunity cost to the
company as a whole of supplying the unit internally
If there is no external market for the units produced, and no alternative use for the resources in the
producing division, then the opportunity cost is zero, and the transfer price should be set as the standard
variable cost in the producing division.
In the example in paragraph 6.2, the general rule can be applied to derive the appropriate transfer price for
product Y from division A to division B.
Transfer price per unit = Standard variable cost in division A ($24)
+ Opportunity cost of supplying the unit internally (contribution forgone by not
using the labour hours in their next best alternative use, 4 hours $5 = $20
as described above)
So the transfer price = $24 + $20 = $44
8 Negotiated transfer prices
In practice, negotiated transfer prices, market-based transfer prices and full cost-based transfer prices
are the methods normally used.
A transfer price based on opportunity cost is often difficult to identify, for lack of suitable information
about costs and revenues in individual divisions. In this case it is likely that transfer prices will be set by
means of negotiation. The agreed price may be finalised from a mixture of accounting arithmetic, politics
and compromise.
The process of negotiation will be improved if adequate information about each division's costs and
revenues is made available to the other division involved in the negotiation. By having a free flow of cost
and revenue information, it will be easier for divisional managers to identify opportunities for improving
profits, to the benefit of both divisions involved in the transfer.
A negotiating system that might enable goal congruent plans to be agreed between profit centres is as
follows.

175 9: Introduction to performance measurement

1 Performance measurement and the planning and
control system
Performance measures can be divided into two groups.

Financial performance measures

Non-financial performance measures.

Non-financial performance measures can be quantitative or qualitative.
Performance measurement is part of the planning and controls cycle of an organisation. Based on
corporate objectives, expected levels of achievement expressed in both financial and non-financial terms
are set for sectors of the organisation and for individuals and compared to actual achievement to aid
future decisions.
A number of key points can be made on the topic of performance measurement:
Performance measurement is an integral part of the management control system.
The management control system includes planning and decision-making.
Planning will be influenced by strategic decisions and organisational objectives.
The management control system will influence behaviour.
Performance measurement will compare actual performance against predefined and predetermined
yardsticks.
Performance measurement will be carried out at different levels within the organisation (corporate,
division, section and individual).
Resource allocation will be influenced by performance measurement.
Both financial and non-financial measures will be used in performance measurement.

Introduction to
performance
measurement

9: Introduction to performance measurement 176
1.1 Financial performance measures
Financial measures (or monetary measures) include the following.
Measure Example
Profit Profit is probably the most common measure of financial performance for companies.
Profit may also be related to the amount of investment needed to earn the profit, and
expressed in terms of return on capital.
Revenue Financial performance might also be measured in terms of sales revenue, or sales revenue
growth.
Costs Most organisations have financial plans that include budgets for expenditure, and for the
planned cost of products or services. Performance is commonly measured in terms of
whether actual costs were higher or lower than budgeted, and so whether or not costs
appear to be under control.
Share price For companies whose shares are traded on a stock exchange, financial performance will
also be measured in terms of the returns for shareholders. These include both dividend
payments and any rise or fall in the share price.
Cash flow As well as monitoring profit, companies should also monitor their cash flow, to ensure
that the business is generating sufficient cash from its operations to meet its foreseeable
liabilities. One measure of cash flow performance is the amount of 'free cash flow' earned
by a company during a period. Free cash flow is the cash surplus available to the
company's management to spend at their discretion, for example on dividends or non-
essential capital expenditure.
1.2 Productivity measurements
Productivity is a measure of the quantity of the product or service produced (output) in relation to the
resources put into producing them (input). Examples of productivity measurements are the number of
units produced per labour hour or per machine hour, or per employee, or per tonne of material.
Productivity measures how efficiently resources are being used.
1.3 Ratios and performance measurement
It is often useful to measure performance by means of ratios.
It is easier to look at changes over time by comparing ratios in one time period with the
corresponding ratios for other periods.
Ratios relate one item to another, and so help to put performance into context. For example the
profit/sales ratio sets profit in the context of how much has been earned per $1 of sales, and so
shows how wide or narrow profit margins are.
Ratios can be used as targets, for example for productivity. Managers will then take decisions that
will enable them to achieve their targets.
Ratios provide a way of summarising an organisation's results, and comparing them with other,
similar organisations.
1.4 Percentages as performance measures
A percentage expresses one number as a proportion of another and gives meaning to absolute numbers.
Market share, capacity levels, wastage and staff turnover are often expressed using percentages. For
example, an organisation might work at 94% capacity during a month, compared to a target of 98%.
Similarly, a company might experience a 25% turnover each year in skilled staff, when the maximum
acceptable turnover rate is, say, 20%.
2 Disadvantages of financial performance indicators
Concentration on financial indicators means that important goals and factors may be ignored.
2.1 Concentration on too few variables
If performance measurement systems focus entirely on those items which can be expressed in monetary
terms, managers will concentrate on only those variables and ignore other important variables that
cannot be expressed in monetary terms.
For example, pressure from senior management to cut costs and raise productivity will produce short-
term benefits in cost control but, in the long term, managerial performance and motivation is likely to be
affected, labour turnover will increase and product quality will fall.
Reductions in cost can easily be measured and recorded in performance reports, employee morale cannot.
Performance reports should therefore include not only costs and revenues but other important
variables, to give an indication of expected future results from present activity.
2.2 Lack of information on quality
Traditional responsibility accounting systems also fail to provide information on the quality or
importance of operations. Drury provides the following example.
'Consider a situation where a purchasing department regularly achieved the budget for all expense
items. The responsibility performance reporting system therefore suggests that the department
was well managed. However, the department provided a poor service to the production
departments. Low-cost suppliers were selected who provided poor quality materials and frequently
failed to meet delivery dates. This caused much wasted effort in chasing up orders and prejudiced
the company's ability to deliver to its customers on time.'
2.3 Measuring success, not ensuring success
Financial performance indicators have been said to simply measure success. What organisations also
require, however, are performance indicators that ensure success. Such indicators, linked to an
organisation's critical success factors such as quality and flexibility, will be non financial in nature.
3 Growing emphasis on NFPIs
Changes in cost structures, the competitive environment and the manufacturing environment have led to
an increased use of non-financial performance indicators (NFPIs).
3.1 Impact of changes in cost structures and the manufacturing and
competitive environments
These have led to a shift from treating financial figures as the foundation of performance measurement to
treating them as one of a range of measures.

3.1.1 Changes in cost structures
Modern technology requires massive investment and product life cycles have got shorter. A greater
proportion of costs are sunk and a large proportion of costs are planned, engineered or designed into a
product/service before production/delivery. At the time the product/service is produced/delivered, it is
therefore too late to control costs.
3.1.2 Changes in competitive environment
Financial measures do not convey the full picture of a company's performance, especially in a modern
business environment.
In today's worldwide competitive environment companies are competing in terms of product quality,
delivery, reliability, after-sales service and customer satisfaction. None of these variables is directly
measured by the traditional responsibility accounting system, despite the fact that they represent the
major goals of world-class manufacturing companies.
3.1.3 Changes in manufacturing environment
New manufacturing techniques and technologies focus on minimising throughput times, inventory levels
and set-up times. But managers can reduce the costs for which they are responsible by increasing
inventory levels through maximising output. If a performance measurement system focuses principally
on costs, managers may concentrate on cost reduction and ignore other important strategic
manufacturing goals.
3.2 Introducing NFPIs
Many companies are therefore discovering the usefulness of quantitative and qualitative non-financial
performance indicators (NFPIs). The following definition from CIMA's Official Terminology is useful
because of the examples it provides.
Non-financial performance measures are 'measures of performance based on non-financial information
which may originate in and be used by operating departments to monitor and control their activities
without any accounting input.
Non-financial performance measures may give a more timely indication of the levels of performance
achieved than do financial ratios, and may be less susceptible to distortion by factors such as
uncontrollable variations in the effect of market forces on operations.
Examples of non-financial performance measures:
Area assessed Performance measure
Service quality Number of complaints
Proportions of repeat bookings
Customer waiting time
On-time deliveries
Production performance Set-up times
Number of suppliers
Days' inventory in hand
Output per employee
Material yield percentage
Schedule adherence
Proportion of output requiring rework
Manufacturing lead times
Area assessed Performance measure
Marketing effectiveness Trend in market share
Sales volume growth
Customer visits per salesperson
Client contact hours per salesperson
Sales volume forecast v actual
Number of customers
Customer survey response information
Personnel Number of complaints received
Staff turnover
Days lost through absenteeism
Days lost through accidents/sickness
Training time per employee.'
(CIMA Official Terminology)
4 The value of NFPIs
4.1 Ease of use
NFPIs do have advantages over financial indicators but a combination of both types of indicator is likely to
be most successful.
Unlike traditional variance reports, NFPIs can be provided quickly for managers, per shift, daily or even
hourly as required. They are likely to be easy to calculate, and easier for non-financial managers to
understand and therefore to use effectively.
The beauty of non-financial indicators is that anything can be compared if it is meaningful to do so. The
measures should be tailored to the circumstances so that, for example, number of coffee breaks per 20
pages of Study Text might indicate to you how hard you are studying!
Many suitable measures combine elements from the chart shown below. The chart is not intended to be
prescriptive or exhaustive.
Note that the chart is not to be read across each horizontal row of cells it does not for example suggest
that you should measure 'defects per second'.
Errors/failure Time Quantity People
Defects Second Range of products Employees
Equipment failures Minute Parts/components Employee skills
Warranty claims Hour Units produced Customers
Complaints Shift Units sold Competitors
Returns Cycle Services performed Suppliers
Stockouts Day kg/litres/metres
Lateness/waiting Month m/m
Misinformation Year Documents
Miscalculation Deliveries
Absenteeism Enquiries
Traditional measures derived from these lists like 'kg (of material) per unit produced' or 'units produced
per hour' are fairly obvious, but what may at first seem a fairly unlikely combination may also be very
revealing. 'Absenteeism per customer', for example, may be of no significance at all or it may reveal that a
particularly difficult customer is being avoided, and hence that some action is needed.
There is clearly a need for the information provider to work more closely with the managers who will be
using the information to make sure that their needs are properly understood. The measures used are likely

to be developed and refined over time. It may be that some will serve the purpose of drawing attention to
areas in need of improvement but will be of no further relevance once remedial action has been taken. A
flexible, responsive approach is essential.

Question
NFPIs

Using the above chart make up five non-financial indicators and explain how each might be useful.

Answer

Here are five indicators, showing you how to use the chart, but there are many other possibilities.
(a) Services performed late v total services performed
(b) Total units sold v total units sold by competitors (indicating market share)
(c) Warranty claims per month
(d) Documents processed per employee
(e) Equipment failures per 1,000 units produced
Don't forget to explain how the ones that you chose might be useful.

4.2 NFPIs and financial measures
Arguably, NFPIs are less likely to be manipulated than traditional profit-related measures and they should,
therefore, offer a means of counteracting short-termism, since short-term profit at any (non-monetary)
expense is rarely an advisable goal. The ultimate goal of commercial organisations in the long run is likely
to remain the maximisation of profit, however, and so the financial aspect cannot be ignored.
There is a danger that too many such measures could be reported, leading to information overload for
managers, providing information that is not truly useful, or that sends conflicting signals. A further danger
of NFPIs is that they might lead managers to pursue detailed operational goals and become blind to the
overall strategy in which those goals are set.
A combination of financial and non-financial indicators is therefore likely to be most successful.
4.2.1 The balanced scorecard
The need to link financial and non-financial measures of performance and to identify the key
performance measures provided the impetus for the development of the balanced scorecard, which we
look at in Chapter 12.
5 NFPIs in relation to employees
NFPIs can usefully be applied to employees and product/service quality.
One of the many criticisms of traditional accounting performance measurement systems is that they do not
measure the skills, morale and training of the workforce, which can be as valuable to an organisation as
its tangible assets. For example if employees have not been trained in the manufacturing practices required
to achieve the objectives of the new manufacturing environment, an organisation is unlikely to be successful.
Employee attitudes and morale can be measured by surveying employees. Education and skills levels,
promotion and training, absenteeism and labour turnover for the employees for which each manager is
responsible can also be monitored.
The weighting attached to employee-orientated NFPIs when assessing managerial performance should be
high. High profitability or tight cost control should not be accompanied by 100% labour turnover.
6 NFPIs in relation to product/service quality
NFPIs are extremely useful when assessing product/service quality.
6.1 Performance measurement in a TQM environment
As you may already know (but will study further in Chapter 15), Total Quality Management is a highly
significant trend in modern business thinking.
Because TQM embraces every activity of a business, performance measures cannot be confined to the
production process but must also cover the work of sales and distribution departments and administration
departments, the efforts of external suppliers, and the reaction of external customers.
In many cases the measures used will be non-financial ones. They may be divided into three types.
6.1.1 Measuring the quality of incoming supplies
The quality of output depends on the quality of input materials, and so quality control should include
procedures for acceptance and inspection of goods inwards and measurement of rejects.
(a) Inspection will normally be based on statistical sampling techniques and the concept of an
acceptance quality level (AQL).
(b) Another approach that can be used is to give each supplier a 'rating' for the quality of the goods
they tend to supply, and give preference with purchase orders to well-rated suppliers.
(c) Where a quality assurance scheme is in place, the supplier guarantees the quality of goods
supplied. This places the onus on the supplier to carry out the necessary quality checks, or face
cancellation of the contract.
6.1.2 Monitoring work done as it proceeds
This will take place at various key stages in the production process. Inspection, based on random
sampling and other statistical techniques, will provide a continual check that the production process is
under control. The aim of inspection is not really to sort out the bad products from the good ones after the
work has been done. The aim is to satisfy management that quality control in production is being
maintained.
'In-process' controls include statistical process controls and random sampling, and measures such as the
amount of scrap and reworking in relation to good production. Measurements can be made by product, by
worker or work team, by machine or machine type, by department, or whatever is appropriate.

6.1.3 Measuring customer satisfaction
Some sub-standard items will inevitably be produced. In-process checks will identify some bad output,
but other items will reach the customer who is the ultimate judge of quality. 'Complaints' may be
monitored in the form of letters of complaint, returned goods, penalty discounts, claims under guarantee,
or requests for visits by service engineers.
Some companies adopt a more pro-active approach to monitoring customer satisfaction by surveying
their customers on a regular basis. They use the feedback to obtain an index of customer satisfaction
which is used to identify quality problems before they affect profits.
6.2 Quality of service
Service quality is measured principally by qualitative measures, as you might expect, although some
quantitative measures are used by some businesses.
(a) If it were able to obtain the information, a retailer might use number of lost customers in a period
as an indicator of service quality.
(b) Lawyers use the proportion of time spent with clients.
Fitzgerald et al have identified important factors pertaining to service quality and the following table shows
the measures used and the means of obtaining the information by British Airports Authority, a mass
transport service.
Service quality factors Measures Mechanisms
Access Walking distances

Ease of finding way around
Customer survey and internal
operational data
Customer survey
Aesthetics/appearance Staff appearance
Airport's appearance
Quantity, quality, appearance of food
Customer survey
Customer survey
Management inspection
Availability Equipment availability Internal fault monitoring system
and customer survey
Customer survey and internal
operational data
Cleanliness/tidiness Cleanliness of environment and
equipment
Customer survey and management
inspection
Comfort Crowdedness of airport Customer survey and management
inspection
Communication Information clarity
Clarity of labelling and pricing
Customer survey
Management inspection
Courtesy Courtesy of staff Customer survey and management
inspection
Friendliness Staff attitude and helpfulness Customer survey and management
inspection
Reliability Number of equipment faults Internal fault monitoring systems
Responsiveness Staff responsiveness Customer survey
Security Efficiency of security checks
Number of urgent safety reports
Customer survey
Internal operational data

Question
Measuring quality

What do you conclude are the two main means of measuring service quality at BAA (the British Airports
Authority)?

6.3 Measures of customer satisfaction
You have probably filled in questionnaires in fast food restaurants or on aeroplanes without realising that
you were completing a customer attitude survey for input to the organisation's management information
system.

Case Study

Horngren cites the 'Customer Satisfaction Target' used by Holiday Inns, where information is measured by
evaluating scores (A-F) on guest inspection cards and imposing a limit of 0.457 guest complaint letters
per 1,000 room-nights sold.

Other possible measures of customer satisfaction include:
(a) Market research information on customer preferences and customer satisfaction with specific
product features
(b) Number of defective units supplied to customers as a percentage of total units supplied
(c) Number of customer complaints as a percentage of total sales volume
(d) Percentage of products which fail early or excessively
(e) On-time delivery rate
(f) Average time to deal with customer queries
(g) New customer accounts opened
(h) Repeat business from existing customers
7 Qualitative issues
Qualitative factors are 'those that can be expressed in monetary terms only with much difficulty or
imprecision'.
There will often be no conclusion that you can draw from qualitative information. Your job is to be aware
of its existence and report it under the heading of 'other matters to be considered'. In practice of course,
many decisions are finally swayed by the strength of the qualitative arguments rather than the cold facts
presented in the quantitative analysis, and rightly so.

7.1 Branding
Brand identity conveys a lot of information very quickly and concisely. This helps customers to identify the
goods or services and thus helps to create customer loyalty to the brand. It is therefore a means of
increasing or maintaining sales.
Where a brand image promotes an idea of quality, a customer will be disappointed if his experience of a
product fails to live up to his expectations. Quality control is therefore of utmost importance. It is
essentially a problem for service industries such as hotels, airlines and retail stores, where there is less
possibility than in the manufacturing sector of detecting and rejecting the work of an operator before it
reaches the customer. Bad behaviour by an employee in a face-to-face encounter with a customer will
reflect on the entire company and possibly deter the customer from using any of the company's services
again.
Brand awareness is an indicator of a product's/organisation's place in the market. Recall tests can be
used to assess the public's brand awareness.
7.2 Company profile
Company profile is how an organisation is perceived by a range of stakeholders. For example,
stakeholders may have a negative attitude towards an organisation, perhaps as a result of an ethical issue
or a crisis that has struck the organisation and the associated media comment. Market research can
determine company profile and marketing campaigns can improve it if necessary.
8 Measuring profitability
Profitability can be measured by return on investment (ROI)/return on capital employed (ROCE), profit
margin, gross profit margin or cost/sales ratios.
Profitability is a key measure of financial performance. It can be expressed in a number of ways, in
addition to a simple measurement of the actual amount of profit earned in a period.
8.1 Return on investment (ROI)
Return on investment (ROI) (also called return on capital employed (ROCE)) is a measurement of profit,
expressed as a percentage of the investment required to earn the profit. It is calculated as (profit/capital
employed) 100% and shows how much profit has been made in relation to the amount of resources
invested.
Profits alone do not show whether the return is sufficient, in view of the value of assets committed. Thus if
company A and company B have the following results, company B would have the better performance.
A B
$ $
Profit 5,000 5,000
Sales 100,000 100,000
Capital employed 50,000 25,000
ROI 10% 20%
The profit of each company is the same but company B only invested $25,000 to achieve that profit
whereas company A invested $50,000.
What does the ROI tell us? What should we be looking for? There are three principal comparisons that can
be made.
(a) actual ROI achieved against either a budget target or a longer-term financial target
(b) the change in ROI from one year to the next
(c) the ROI being earned by other organisations.

8.2 Profit margin
The profit margin (profit to sales ratio) is calculated as (profit sales) 100%.
The profit margin provides a simple measure of performance for management. Investigation of
unsatisfactory profit margins enables control action to be taken, either by reducing excessive costs or by
raising selling prices.
8.3 Example: the profit to sales ratio
A company compares its year 2 results with year 1 results as follows.

Year 2

Year 1

$

$

Sales

160,000

120,000

Cost of sales

Direct materials

40,000

20,000

Direct labour

40,000

30,000

Production overhead

22,000

20,000

Marketing overhead

42,000

35,000

144,000

105,000

Profit

16,000

15,000

Profit to sales ratio

10%

12%

An analysis of this information shows that there has been a decline in profitability in year 2 compared with
year 1, in spite of the $1,000 increase in profit, because the profit margin is less in year 2 than year 1.
Looked at another way, an increase of $40,000 in sales revenue in year 2, compared with year 1, resulted
in a rise in profit of only $1,000.
8.4 Cost/sales ratios
An organisation might measure its actual expenditures against budgeted costs, and report differences or
'variances' between actual costs and the budget. Another way of measuring costs is by expressing costs
incurred as a percentage of total sales revenue, and monitoring changes in this ratio over time. Cost ratios
that might be used are:
production costs as a percentage of sales
distribution and marketing costs as a percentage of sales

administrative costs as a percentage of sales.
Cost/sales ratios can be taken to subsidiary levels of cost, such as:
material costs as a percentage of the sales value of goods produced
direct labour costs as a percentage of the sales value of goods produced
production overheads as a percentage of the sales value of goods produced.
8.5 Example: cost/sales ratios
Look back to the example in Paragraph 8.3. An analysis of costs would show that higher direct materials
are the probable cause of the decline in profitability.
Year 2 Year 1
Material costs/sales 25% 16.7%
The other cost/sales ratios have remained the same or improved.

9 Responsibility accounting
At a departmental and divisional level within an organisation, financial performance is measured in terms
of cost control (cost centres), profitability (profit centres) and return on investment or residual income
(investment centres).
When performance at various levels within an organisation is measured in terms of accounting results the
name given to the control reporting system is responsibility accounting.
Responsibility accounting is a system of accounting that segregates revenues and costs into areas of
personal responsibility in order to monitor and assess the performance of each part of an organisation.
A responsibility centre is a unit or function of an organisation headed by a manager having direct
responsibility for its performance.
Responsibility accounting aims to provide accounting reports that make every manager aware of all the
items which are within his or her area of authority so that he or she is in a position to explain them and
judge their performance.
Responsibility centre Performance measure
Cost centres Standard costs, variance reports, efficiency measures
Profit centres Revenues, costs, output levels and, of course, profit
Investment centres Return on investment (ROI) and subsidiary ratios, residual income (RI),
costs, revenues, assets employed and liabilities
These financial reporting systems are explained in the following chapters.
9.1 Controllable costs and uncontrollable costs
Managers should only be held accountable for costs over which they have some influence. This may seem
quite straightforward in theory, but it is not always so easy in practice to distinguish controllable from
uncontrollable costs.
Controllable costs are items of expenditure which can be directly influenced by a given manager within a
given time span.
(a) A cost which is not controllable by a junior manager or supervisor might be controllable by a
senior manager. For example, there may be high direct labour costs in a department caused by
excessive overtime working. The supervisor may feel obliged to continue with the overtime in order
to meet production schedules, but his senior may be able to reduce costs by deciding to hire extra
full-time staff, thereby reducing the requirements for overtime.
(b) A cost which is not controllable by a manager in one department may be controllable by a manager
in another department. For example, an increase in material costs may be caused by buying at
higher prices than expected (controllable by the purchasing department) or by excessive wastage
and spoilage (controllable by the production department).
Some costs are non-controllable, such as increases in expenditure items due to inflation. Other costs are
only controllable in the long term not in the short term. For example, production costs might be reduced
by the introduction of new machinery and technology, but in the short term, management must attempt to
do the best they can with the resources and machinery at their disposal.
Traditionally, performance has been measured in manufacturing by means of comparing actual results
against budgeted results (budgetary control) and possibly by comparing actual costs against standard
costs. Budgetary control is described in Chapter 10 and standard cost variances in Chapter 11. Other
approaches to performance measurement are then considered in Chapters 12 and 13.

187 10: Comparing actual results with the budget
1 Budgetary control
Budgetary control is a system of financial performance measurement. Actual results are compared with
what results should have been.
An important aspect of budgeting is the co-ordination of planning and decision making across an
organisation, and the linking of strategic planning with operational plans.
A further use of budgets is as a control mechanism. Since a budget is a plan of what the organisation
wants to achieve in the planning period, it can be used to judge actual performance. Actual results and
achievements can be compared with the budget, and any differences between what has happened and
what was planned might enable management to:
(a) Identify reasons for either good or bad performance
(b) Where appropriate, identify aspects of operations where control measures might be called for
Using the budget for a comparison with actual results, identifying reasons for differences, and taking
appropriate management action to rectify any unsatisfactory aspects of performance, is known as
budgetary control.
Measuring performance through budgetary control focuses on financial

performance, in particular sales,
costs and profits, although budgeted and actual cash flows can also be monitored.
2 Variances
The differences between the components of the fixed budget and the actual results are known as budget
variances.
A variance is the difference between an actual outcome and what should have been expected. Budgetary
control measures performance by comparing actual results for each item of revenue or cost, comparing
the actual result with what the outcome should have been, and reporting the difference as a variance.
(a) When actual results are better than expected, the variance is favourable. A favourable variance is
usually reported as an amount of money, followed by (F).
(b) When actual results are worse than expected, the variance is adverse or unfavourable. An adverse
or unfavourable variance is usually reported as an amount of money, followed by either (A) or (U).

Comparing actual
results with the
budget

10: Comparing actual results with the budget 188
Budgetary control is the practice of establishing budgets which identify areas of responsibility for
individual managers (for example production managers, purchasing managers and so on) and of regularly
comparing actual results against expected results. The differences between actual results and expected
results are called variances and these are used to provide a guideline for control action by individual
managers.
Individual managers are held responsible for investigating differences between budgeted and actual
results, and are then expected to take corrective action or amend the plan in the light of actual events.
3.1 The wrong approach to budgetary control
The wrong approach to budgetary control is to compare actual results against a fixed budget. Consider
the following example.
Tree manufactures a single product, the widget. Budgeted results and actual results for June are shown below.

Budget

Actual results

Variance

Production and sales of widgets (units)

2,000

3,000

$

$

$

Sales revenue (a)

20,000

30,000

10,000 (F)

Direct materials

6,000

8,500

2,500 (A)

Direct labour

4,000

4,500

500 (A)

Maintenance

1,000

1,400

400 (A)

Depreciation

2,000

2,200

200 (A)

Rent and rates

1,500

1,600

100 (A)

Other costs

3,600

5,000

1,400 (A)

Total costs (b)

18,100

23,200

5,100 (A)

Profit (a) (b)

1,900

6,800

4,900 (F)

(a) In this example, these variances are meaningless for purposes of control. Costs were higher
than budget because the volume of output was also higher. Expected variable costs will be higher
than the variable costs in the fixed budget, given that output is higher.
(b) For control purposes, it is necessary to know:
(i) Were actual costs higher than they should have been to produce and sell 3,000 widgets, ie
the actual number of units produced?
(ii) Was actual sales revenue satisfactory from the sale of 3,000 widgets?
(iii) Has the volume of units made and sold varied from the budget favourably or adversely, and
what has been the effect on profit of this sales volume difference?

The term variance analysis refers to the process of explaining the difference between budgeted and actual
results as the sum of a number of sales variances and cost variances. The total sum of the variances adds
up to the difference between the budgeted profit and the actual profit for the period.
3 Flexible budgets and budgetary control
To obtain meaningful variances, actual results must be compared with a flexible budget for the same
level of activity. The difference between the fixed budget profit and the flexible budget profit is explained as
a sales volume variance.
Variances can be calculated for costs, revenues and profit, and also for cash flow.
In the previous example of Tree, suppose the following information on cost behaviour is available.
(a) Direct materials and maintenance costs are variable.
(b) Although basic wages are a fixed cost, direct labour is regarded as variable in order to measure
efficiency/productivity.
(c) Rent and rates and depreciation are fixed costs.
(d) 'Other costs' consist of fixed costs of $1,600 plus a variable cost of $1 per unit made and sold.
Now that the cost behaviour patterns are known, a budget cost allowance

can be calculated for each item
of expenditure. This allowance is shown in a flexible budget as the expected expenditure on each item
for the relevant level of activity. The budget cost allowances are calculated as follows.
(a) Variable cost allowances = original budgets (3,000 units/2,000 units)
eg material cost allowance = $6,000

3
/2 = $9,000
(b) Fixed cost allowances = as original budget
(c) Semi-fixed cost allowances = original budgeted fixed costs + (3,000 units variable cost per unit)
eg other cost allowance = $1,600 + (3,000 $1) = $4,600
The budgetary control analysis should be as follows.

Fixed

Flexible

Actual

Budget

budget

budget

results

variance

(a)

(b)

(c)

(b) (c)

Production & sales (units)

2,000

3,000

3,000

$

$

$

$

Sales revenue

20,000

30,000

30,000

0

Variable costs

Direct materials

6,000

9,000

8,500

500 (F)

Direct labour

4,000

6,000

4,500

1,500 (F)

Maintenance

1,000

1,500

1,400

100 (F)

Semi-variable costs

Other costs

3,600

4,600

5,000

400 (A)

Fixed costs

Depreciation

2,000

2,000

2,200

200 (A)

Rent and rates

1,500

1,500

1,600

100 (A)

Total costs

18,100

24,600

23,200

1,400 (F)

Profit

1,900

5,400

6,800

1,400 (F)

3.2 The correct approach to budgetary control: using a flexible budget
The correct approach to budgetary control is:
Identify fixed and variable costs
Produce a flexible budget for the actual volume of sales and production achieved, using marginal
costing techniques
Actual results should then be compared by:
(a) Comparing actual costs with what costs should have been for the actual volume of production and
sales (ie compare actual costs with costs in the flexed budget)
(b) Comparing actual sales revenue with what revenue should have been for the actual volume of sales
(ie compare actual prices with prices in the flexed budget)
(c) Comparing the actual sales volume achieved with what was originally budgeted, and measuring the
effect the sales volume difference has had on profit.

(b) Another reason for the improvement in profit above the fixed budget profit is the sales volume.
Tree sold 3,000 units instead of 2,000 units, with the following result.

$

$

Sales revenue increased by

10,000

Variable costs would be expected to increase by:

direct materials

3,000

direct labour

2,000

maintenance

500

variable element of other costs

1,000

6,500

Profit increased by (contribution of $3.50 per unit)

3,500

Profit was therefore increased by $3,500 because sales volumes increased, thereby increasing
contribution and profit.
(c) A full variance analysis statement, also called an operating statement, would be as follows.

$

$

Fixed budget profit

1,900

Variances

Sales volume

3,500 (F)

Direct materials cost

500 (F)

Direct labour cost

1,500 (F)

Maintenance cost

100 (F)

Other costs

400 (A)

Depreciation

200 (A)

Rent and rates

100 (A)

4,900 (F)

Actual profit

6,800

If management believes any variance is significant enough to warrant investigation, they will investigate to
see whether any corrective action is necessary or whether the plan needs amending in the light of actual
events.

Variances are favourable when actual results are better than what should have been expected, and adverse
when they are worse than expected.
We can analyse the above variances as follows.
(a) In selling 3,000 units the expected profit should have been, not the fixed budget profit of $1,900,
but the flexible budget profit of $5,400. Instead, actual profit was $6,800 ie $1,400 more than we
should have expected. The reason for the improvement is that, given actual output and sales of
3,000 units, costs were lower than expected (and sales revenue exactly as expected).
$
Direct materials cost variance 500 (F)
Direct labour cost variance 1,500 (F)
Maintenance cost variance 100 (F)
Other costs variance 400 (A)
Fixed cost variances
Depreciation 200 (A)
Rent and rates 100 (A)
1,400 (F)
Profit was therefore increased by $1,400 because costs were lower than anticipated.

Answer

We need to prepare a flexible budget for 1,800 units.

Fixed budget

Flexed budget

Actual

Variance

Units of production and sales

2,000

1,800

1,800

$

$

$

$

Sales

194,000

174,600

166,000

8,600 (A)

Costs

Direct materials

46,000

41,400

34,500

6,900 (F)

Direct labour

24,000

21,600

22,750

1,150 (A)

Variable overhead

4,000

3,600

3,750

150 (A)

Total variable costs

74,000

66,600

61,000

5,600 (F)

Contribution

120,000

108,000

105,000

3,000 (A)

Fixed costs

85,000

85,000

88,000

3,000 (A)

Profit

35,000

23,000

17,000

6,000 (A)

$

$

Fixed budget profit

35,000

Variances

Sales volume (200 units @ $60) Note 1

12,000 (A)

Sales price

8,600 (A)

Direct materials cost

6,900 (F)

Direct labour cost

1,150 (A)

Variable overhead cost

150 (A)

Fixed overhead expenditure

3,000 (A)

18,000 (A)

Actual profit

17,000

Note 1. The sales volume variance is valued at the budgeted contribution per unit ($120,000 2,000 units
= $60/unit).

Question
Budget and operating statement
The budgeted and actual results of Stint for September were as follows. The company uses a marginal
costing system. There were no opening or closing inventories.
Fixed budget Actual
Sales and production 2,000 units 1,800 units
$ $ $ $
Sales 194,000 166,000

Direct materials 46,000 34,500
Direct labour 24,000 22,750
Variable overhead 4,000 3,750
74,000 61,000
Contribution 120,000 105,000
Fixed costs 85,000 88,000
Profit/(loss) 35,000 17,000
Required
Prepare a budget that will be useful for management control purposes, and prepare an operating
statement explaining the difference between the budgeted profit of $35,000 and the actual profit of
$17,000.

(h) The company would have $30,000 in cash at the start of the year.
(i) Wages and salaries and other costs would be incurred at a constant rate each month, and would be
paid for in the month they are incurred.
The cash budget is as follows, allowing for receivables at the year end of $300,000 (three months' sales)
and payables at the year end of $30,000 (one month's purchases).

$

$

Cash receipts ($275,000 + $1,200,000 $300,000)

1,175,000

Payments

For materials purchased ($28,000 + $360,000 $30,000)

358,000

Wages and salaries

240,000

Fixed overheads ($220,000 $15,000 depreciation)

205,000

Variable overheads

60,000

Non-current asset purchase

150,000

Total payments

1,013,000

Surplus of receipts over payments

162,000

Cash at start of year

30,000

Cash at end of year

192,000

Actual sales in 20X4 were only $900,000, and actual cash flows were as follows.

$

$

Cash receipts

902,000

Payments

For materials purchased

270,000

Wages and salaries

238,000

Fixed overheads

225,000

Variable overheads

50,000


138,000

Total payments

921,000

Shortfall of receipts below payments

(19,000)


30,000

Cash at end of year

11,000

Required
A statement explaining the difference between the budgeted and the actual cash flow.
4.1 Example: cash flow variances
Brill, a retailing organisation, prepared a cash budget in the expectation that its sales in 20X4 would be a
constant $100,000 each month and that its purchases of inventory would be a constant $30,000 each
month. Its cash budget was also based on the following assumptions.
(a) All sales are on credit. Debtors would be given three months to pay.
(b) All purchases of goods are on credit, and the company takes one month's credit from suppliers.
(c) At the beginning of 20X4, there would be $275,000 of trade receivables and $28,000 of trade
payables.
(d) Wages and salaries (fixed costs) would be $240,000 for the year, all paid in cash.
(e) Other fixed expenditures would be $220,000, all paid in cash with the exception of a depreciation
charge of $15,000.
(f) Other variable costs would be $60,000, all paid in cash.
(g) A new non-current asset would be purchased during the year, at a cost of $150,000 (to be paid for
in cash).
4 Cash flow variances
A similar approach can be taken to analysing the difference between actual and budgeted cash flow, using
a 'flexed' version of the cash budget for comparing with actual results.
The comparison of budget and actual is now as follows.

Fixed budget

Flexed

budget

Actual

Variance

$

$

$

$

Cash from sales

1,175,000

950,000

902,000

48,000 (A)

Payments

For materials

358,000

275,500

270,000

5,500 (F)

Wages and salaries

240,000

240,000

238,000

2,000 (F)

Fixed overhead

205,000

205,000

225,000

20,000 (A)

Variable overhead

60,000

45,000

50,000

5,000 (A)

Purchase of non-current assets

150,000

150,000

138,000

12,000 (F)

Total payments

1,013,000

915,500

921,000

5,500 (A)
Receipts less payments

162,000

34,500

(19,000)

53,500 (A)


30,000

30,000

30,000

Cash at end of year

192,000

64,500

11,000

53,500 (A)

An operating statement reconciling the budgeted end-of-year cash position and the actual end-of-year
cash position can be drawn up, as follows.

$

$

Budgeted end-of-year cash

192,000

Variances

Sales volume ($192,000 $64,500)

127,500 (A)

Payments from debtors

48,000 (A)

Payments for materials

5,500 (F)

Payments of wages and salaries

2,000 (F)

Payments for fixed overheads

20,000 (A)

Payments for variable overheads

5,000 (A)


12,000 (F)

Total variances

181,000 (A)

Actual end-of-year cash

11,000

An analysis of the variances shows that the major reason for the difference between budgeted and actual
cash flows was the shortfall in sales. However, poor control over debt collection has worsened the
situation by a further $48,000.

Question
Cash flow variance

A company has the following cash budget for April:

$'000

$'000

Operating profit before depreciation

120

Depreciation

40

160

Solution
Actual sales were only $900,000, 75% of the original budget. If we can assume that purchases would
therefore be 75% of budget, at $270,000 for the year, or $22,500 each month, we can construct a cash
budget on the basis of a 75% activity level. In the flexed cash budget:
(a) Closing receivables should be $225,000 (three months' sales), therefore receipts from sales should
be $(275,000 + 900,000 225,000) = $950,000.
(b) Closing payables should be $22,500 (one month's purchases), therefore payments for materials
should be $(28,000 + 270,000 22,500) = $275,500.

Actual results for the month were as follows.

Start of
the month

End of
the month

$'000 $'000
Cash 30 133
Inventory 80 120
Receivables 60 65
Payables 35 25

In the month

$'000
Interest payments 8
Payments for capital expenditure 19
Actual sales in the month were 11,000 units, and the unit sales price, unit variable costs and monthly fixed
costs were as budgeted. The depreciation for the month was also as budgeted.
Required
Produce a cash flow variance statement for the month, reconciling the opening cash balance of $30,000
with the closing cash balance of $133,000.

Answer

Working
The unit contribution is ($50 $25) = $25, which means that the actual contribution from sales is 11,000
units $25 = $275,000, and after deducting fixed costs of $130,000, the actual contribution was
$145,000.
Cash flow variance statement for April

Budget

Actual

Variance

$'000

$'000

$'000

Profit before depreciation

120

145

25 (F)

Sales volume variance

Depreciation

40

40

160

185

(Increase)/decrease in inventory

(25)

(40)

15 (A)

Inventory level variance

(Increase)/decrease in receivables

10

(5)

15 (A)

Receivables level variance

Increase/(decrease) in payables

10

(10)

20 (A)

Payables level variance

Interest payment

(8)

(8)

Capital expenditure

(15)

(19)

4 (A)

Cash increase

132

103

Opening cash

30

30

Closing cash

162

133

29 (A)

Increase in inventory (25)
Decrease in receivables 10
Increase in payables 10
(5)
155
Payment of interest (8)
Capital expenditure payments (15)
(23)
Cash surplus for month 132
Opening cash 30
Closing cash 162
The company sells one standard unit at a price of $50 per unit, and unit variable costs of sales are $25.
The budgeted sales for the month are 10,000 units. Budgeted fixed costs are $130,000 for the month,
including depreciation of $40,000.
195 11: Standard costing

1 Standard costs and standard costing
A standard cost is an estimated unit cost.
A standard cost is built up of standards for each cost element (standard resource price and standard
resource usage).
Standard costing variances are used to measure performance and provide a performance control system.
Standard costing is most suited to mass production and repetitive assembly work.
A standard cost is an estimated unit cost for a standard item of production, showing the component
elements of cost.
A standard full cost of product 12345 is set out below on a standard cost card.
STANDARD COST CARD

Product No 12345

Cost

Requirement

Direct materials

$
$
A

$2.00 per kg

6 kgs

12.00

B

$3.00 per kg

2 kgs

6.00

C

$4.00 per litre

1 litre

4.00

Others

2.00

24.00

Direct labour

Grade I

$4.00 per hour

3 hrs

12.00

Grade II

$5.40 per hour

5 hrs

27.00

39.00


$1.00 per hour

8 hrs

8.00

Fixed production overheads

$3.00 per hour

8 hrs

24.00

Standard full cost of production

95.00

A standard cost is built up from standards for each cost element: standard quantities of materials at
standard prices, standard quantities of labour time at standard rates and so on. It is therefore determined
by estimates of the following.
The expected prices of materials, labour and expenses.
Efficiency levels in the use of materials and labour.
Budgeted overhead costs and budgeted volumes of activity.

Standard costing

11: Standard costing 196
1.1 The uses of standard costing
Standard costing has two principal uses.
To give a value to inventories of finished goods and to give a cost to items of production for cost
accounting purposes.
To act as a performance measure and control device. Actual costs can be compared with the
expected costs, thus highlighting areas of operations that might be out of control.
Since standard costs are made up of component elements of cost (direct materials usage and price, direct
labour hours and wage rates, and so on), the variances that can be obtained from standard cost variance
analysis are more detailed than the variances obtained from a flexed budget.
1.2 Standard costing as a control technique
Standard costing involves the establishment of predetermined estimates of the costs of products or
services, the collection of actual costs and the comparison of the actual costs with the predetermined
estimates. The predetermined costs are known as standard costs and the difference between standard and
actual cost is known as a variance. The process by which the total difference between standard and actual
results is analysed is known as variance analysis.
Standard costing is best suited to organisations that produce a range of standard items, or a range of
standard services. It is not suitable to non-standard work, such as contract and jobbing work, or
professional services.

Question
Standard costing

Can you think of a service organisation that could apply standard costing?

Answer

Just one example is standard recipes in a restaurant. If a large number of meals are produced, say, for
conference delegates, mass production systems will apply. Standards may not be calculated with the
same accuracy as in manufacturing environments, but the principles are still relevant. Other examples are
equally valid.

2 Budgets and standard costs compared
Budgets and standards are very similar and interrelated, but there are important differences between
them.
The responsibility for setting standards should be shared between the managers able to provide the
necessary information about levels of expected efficiency, prices and overhead costs.
A budget is a quantified monetary plan for a future period. It is used for communicating plans and co-
ordinating activities within an organisation.
A standard cost is a carefully predetermined cost target that should be achievable in certain conditions.
Budgets and standards are similar in the following ways.
(a) They both involve looking to the future and forecasting what is likely to happen given a certain set
of circumstances.

(b) They are both used for control purposes. Actual results are compared with the budget or standard
and action is taken to correct any variances where necessary. A standard also achieves control by
comparison of actual results against a predetermined target.
If an organisation uses standard costing, standard costs will be used to prepare the budget. In addition,
the fixed overhead cost element in a standard full unit cost will be based on the budget for fixed overhead
expenditure and the budgeted volume of activity.
There are, however, important differences between budgets and standards.
(a) A budget gives the planned total costs for a cost centre such as production department A,
whereas a standard cost shows the amount of resource that should be used for a single task, for
example the standard labour hours for a single unit of production.
(b) The use of standards is limited to situations where repetitive actions are performed and output can
be measured. Budgets can be prepared for all functions (such as administration costs), even where
output cannot be measured.

Question
Advantages of standard costing system

What are the possible advantages for the control function of an organisation of having a standard costing
system?

Answer

(a) Carefully planned standards are an aid to more accurate budgeting.
(b) Standard costs provide a yardstick against which actual costs can be measured.
(c) The setting of standards involves determining the best materials and methods that may lead to
economies.
(d) A target of efficiency is set for employees to reach and cost-consciousness is stimulated.
(e) Variances can be calculated which enable the principle of 'management by exception' to be
operated. Only the variances that exceed acceptable tolerance limits need to be investigated by
management with a view to control action.
(f) Standard costs and variance analysis can provide a way of motivation to managers to achieve
better performance. However, care must be taken to distinguish between controllable and
non-controllable costs in variance reporting.

A significant difference between a standard cost and a budgeted cost is the detailed analysis of the
component elements of cost that make up a standard cost. This detailed analysis enables an organisation
to prepare more detailed and meaningful variances in budgetary control reports.
3 Ideal, attainable and current standards
Standards may be ideal, attainable or current.
A standard cost includes an estimate of efficiency in using resources. There is a standard rate of usage of
materials, and a standard efficiency rate for labour. There are differing ways in which a 'standard'
efficiency rate may be set.
An ideal standard is a standard that can be attained under perfect operating conditions, with no wastage
of materials and no inefficiencies, idle time, or breakdowns.
An attainable standard or target standard is a standard that can be attained if production is carried out
efficiently, machines are properly operated and/or materials are properly used. Some allowance is made
for wastage and inefficiencies.

A current standard is a standard based on current working conditions (current wastage, current
inefficiencies).
These different types of standard have a number of advantages and disadvantages.
(a) Ideal standards can be seen as long-term (strategic) targets but are not very useful for day-to-day
control purposes. Ideal standards cannot be achieved. It follows that if ideal standard costs are
used for budgeting, an allowance will have to be included to make the budget realistic and
attainable.
(b) Attainable standards or target standards can be used for budgeting and performance measurement,
but reflect a level of achievement that has not yet been reached. Attainable standards are probably
the best type of standard for performance measurement and management.
(c) Current standards do not seek to achieve any improvement in performance, and regard the current
efficiency level as an adequate standard of performance. However, a current standard is possibly
best suited for budgeting, since they are based on a known and realistic level of achievement.
4 Introduction to standard cost variances
You must be able to calculate all the variances described in this chapter.
Standard cost variances are similar in concept to variances calculated with a flexed budget, but go into
greater in-depth analysis of differences between actual results and expected results ('standard').
(a) The variance for direct materials costs is analysed into a materials usage variance and a materials
price variance.
(b) The variance for direct labour costs is analysed into an efficiency variance and a labour wage rate
variance.
(c) The variance for variable production overhead costs is analysed into an efficiency variance and an
'expenditure per hour' variance.
(d) There is a sales price variance, reporting the effect on profit of the difference between the actual
selling price for products and the planned standard selling price.
Standard cost variances may be based on either a standard full cost (absorption costing) or a standard
marginal cost.
When standard costs are a standard full cost:
(a) There are fixed overhead variances that together explain the total under- or over-absorbed fixed
production overhead. These variances are called a fixed overhead expenditure variance and a fixed
overhead volume variance.
(b) There is a sales volume variance, but this is valued at the standard profit per unit, not in terms of
contribution.
The inter-relationship between the different variances can be expressed in a diagram, which you may find
easier to remember.


5 Direct materials variances
The direct material total cost variance is the difference between what the output actually cost and what it
should have cost, in terms of material. It can be divided into the following two sub-variances.
The direct material price variance is the difference between what the materials did cost and what they
should have cost.
The direct material usage variance is the difference between the actual quantity of the materials that were used
and the standard quantity of the materials that should have been used, valued at the standard cost per unit of
material.
5.1 Direct materials price variance
A materials price variance can be calculated by filling in the appropriate figures in the following table.

$

[Quantity of materials purchased] should have cost

(Quantity Standard price per unit)

but did cost

(Actual cost)

Materials price variance

=

Difference

The price variance is favourable if actual purchase costs were less than standard, and adverse if actual
purchase costs exceeded the standard.
5.2 Direct materials usage variance
A materials usage variance can be calculated by filling in the appropriate figures in the following table.

Quantities

[Quantity of standard

should have used

(Quantity of product made Standard

item produced] materials usage per unit)

but did use

(Actual usage)

Materials usage variance

(in usage quantities)

Difference

Materials usage variance

(in money terms)

Difference Standard materials price per unit

The usage variance is favourable if the actual usage of materials in production was less than standard, and
adverse if actual usage exceeded the standard.

5.3 Example: direct material variances
A unit of Product P has a standard direct material cost of 10 kilograms of material Y at $10 per kilogram
(= $100 per unit of P). During period 4, 1,000 units of Product P were manufactured, using 11,700
kilograms of material Y which cost $98,600.
Required
Calculate the following variances.
(a) The direct material total cost variance
(b) The direct material price variance
(c) The direct material usage variance
Solution
(a) The direct material total cost variance. This is the difference between what 1,000 units should
have cost and what they did cost.

$

1,000 units should have cost ( $100)
100,000

but did cost

98,600

Direct material total variance

1,400 (F)
The variance is favourable (F) because the units cost less than they should have cost. However, in
practice, this variance would not be calculated, since it is analysed further into a materials price
and a materials usage variance.
(b) The direct material price variance. This is the difference between what 11,700 kgs should have
cost and what 11,700 kgs did cost.
$

11,700 kgs of Y should have cost ( $10)
117,000
but did cost

98,600
Material Y price variance

18,400 (F)
The variance is favourable because the material cost less than it should have.
(c) The direct material usage variance. This is the difference between how many kilograms of Y
should have been used to produce 1,000 units of Product P and how many kilograms were used,
valued at the standard cost per kilogram.
1,000 units should have used ( 10 kgs)

10,000 kgs

but did use

11,700 kgs

Usage variance in kgs

1,700 kgs (A)

standard cost per kilogram

$10

Usage variance in $

$17,000 (A)

The variance is adverse (A) because more material than should have been used was used.
(d) Summary

$
Price variance

18,400 (F)
Usage variance

17,000 (A)
Total variance

1,400 (F)
5.4 Alternative method of calculating materials variances
You may prefer to calculate materials variances using the following rote-learned formulae but it is unlikely
that this approach will help you to understand the topic fully.
Let SQ = standard quantity of materials required for actual production
SP = standard price per unit of materials
QP = actual quantity of materials purchased
AQ = actual quantity of materials used
AP = actual price per unit of materials
Total materials cost variance = (SQ SP) (AQ AP)
Materials price variance = (SP AP) QP
Materials usage variance = (SQ AQ) SP
6 Direct labour variances
The direct labour total variance is the difference between what the output should have cost and what it
did cost, in terms of labour. It can be divided into two sub-variances.
The direct labour rate variance is the difference between what the labour hours worked did cost and what
they should have cost.
The direct labour efficiency variance is the difference between the hours that should have been worked
and the hours that were actually worked, valued at the standard direct wage rate per hour.
The calculation of labour variances is very similar to the calculation of material variances. The calculation
of the labour rate variance is similar to that for the material price variance while the calculation of the
labour efficiency variance is similar to that for the material usage variance.
6.1 Direct labour rate variance
A labour rate variance can be calculated by filling in the appropriate figures in the following table.

$

[Number of hours worked] should have cost

(Quantity of hours Standard
wage rate per hour)

but did cost

(Actual cost)

Labour rate variance

=

Difference

The rate variance is favourable if actual labour costs were less than standard for the hours worked, and
adverse if actual costs exceeded the standard for the hours worked.
6.2 Direct labour efficiency variance
A labour efficiency variance can be calculated by filling in the appropriate figures in the following table.

Hours

[Quantity of standard item
produced]

should have taken (Quantity of product made Standard
hours per unit)

but did use

(Actual hours)

Labour efficiency variance

(in hours)

Difference


(in money terms)

Difference Standard rate per hour

The efficiency variance is favourable if the actual time taken to produce the output was less than standard,
and adverse if actual time taken exceeded the standard.
6.3 Example: direct labour variances
The standard direct labour cost of Product P is 2 hours of grade Z labour at $5 per hour (= $10 per unit of
Product P). During period 4, 1,000 units of Product P were made, and the labour cost of grade Z labour
was $8,900 for 2,300 hours of work.

Required
(a) The direct labour total variance
(b) The direct labour rate variance
(c) The direct labour efficiency (productivity) variance
Solution
(a) The direct labour total variance. This is the difference between what 1,000 units should have cost
and what they did cost.

$
1,000 units should have cost ( $10)
10,000
but did cost

8,900
Direct labour total variance

1,100 (F)
The variance is favourable because the units cost less than they should have done. In practice, this
total labour cost variance would not be calculated, because it can be analysed into its component
elements of a rate variance and an efficiency variance.
(b) The direct labour rate variance. This is the difference between what 2,300 hours should have cost
and what 2,300 hours did cost.

$
2,300 hours of work should have cost ( $5 per hr)
11,500
but did cost

8,900

Direct labour rate variance

2,600 (F)
The variance is favourable because the labour cost less than it should have cost.
(c) The direct labour efficiency variance. This is the difference between the number of hours it
should have taken to produce 1,000 units of P, and the number of hours it did take, valued at the
standard rate per hour.
1,000 units of P should have taken ( 2 hrs)
2,000 hrs

but did take

2,300 hrs

Efficiency variance in hours

300 hrs (A)

standard rate per hour

$5

Efficiency variance in $

$1,500 (A)

The variance is adverse because more hours were worked than should have been worked.
(d) Summary

$
Rate variance

2,600 (F)
Efficiency variance

1,500 (A)
Total variance

1,100 (F)
6.4 Alternative method of calculating labour variances
Labour variances can also be calculated using rote-learned formulae.
Let SH = standard number of hours required for actual production
SR = standard rate per hour
AH = actual hours worked
AR = actual rate per hour
Total direct labour cost variance = (SH SR) (AH AR)
Direct labour rate variance = (SR AR) AH
Direct labour efficiency variance = (SH AH) SR
6.5 Idle time variance
A company may operate a costing system in which any idle time is recorded. Idle time may be caused by
machine breakdowns or not having work to give to employees, perhaps because of bottlenecks in
production or a shortage of orders from customers. When idle time occurs, the labour force is still paid
wages for time at work, but no actual work is done. Time paid for without any work being done is
unproductive and therefore inefficient. In variance analysis, idle time is an adverse efficiency variance.
When idle time is recorded separately, it is helpful to provide control information which identifies the cost
of idle time separately and in variance analysis there will be an idle time variance as a separate part of the
labour efficiency variance. The remaining efficiency variance will then relate only to the productivity of the
labour force during the hours spent actively working.
6.6 Example: labour variances with idle time
The standard direct labour cost of product C is as follows.
3 hours of grade T labour at $2.50 per hour = $7.50 per unit of product C.
During June 20X3, 300 units of product C were made, and the cost of grade T labour was $2,200 for 910
hours. During the month, there was a machine breakdown, and 40 hours were recorded as idle time.
Required
(a) The total direct labour cost variance
(c) The idle time variance
(d) The direct labour efficiency variance
Solution
(a) The total direct labour cost variance
$
300 units of product C should cost ( $7.50) 2,250
but did cost

2,200

Total direct labour cost variance

50

(F)

Actual cost is less than standard cost. The variance is therefore favourable.
The rate variance is a comparison of what the hours paid should have cost and what they did cost.
$
910 hours of grade T labour should cost ( $2.50) 2,275
but did cost

2,200

Direct labour rate variance

75

(F)

Actual cost is less than standard cost. The variance is therefore favourable.
(c) The idle time variance
The idle time variance is the hours of idle time, valued at the standard rate per hour.
Idle time variance = 40 hours (A) $2.50 = $100 (A)
Idle time is always an adverse variance.
(d) The direct labour efficiency variance
The efficiency variance considers the hours actively worked (the difference between hours paid for
and idle time hours). In our example, there were (910 40) = 870 hours when the labour force was
not idle. The variance is calculated by taking the amount of output produced (300 units of product
C) and comparing the time it should have taken to make them, with the actual time spent actively
making them (870 hours). Once again, the variance in hours is valued at the standard rate per
labour hour.

300 units of product C should take ( 3 hrs)

900 hrs

but did take (910 40)

870 hrs

Direct labour efficiency variance in hours

30 hrs (F)


$2.50

Direct labour efficiency variance in $

$75

(F)

(e) Summary
$
Direct labour rate variance 75 (F)
Idle time variance 100 (A)
Direct labour efficiency variance
75

(F)

Total direct labour cost variance
50

(F)

Remember that, when idle time is recorded, the actual hours used in the efficiency variance calculation are
the hours worked and not the hours paid for.
7 Variable production overhead variances
In standard costing, variable overhead expenditure is usually assumed to vary with the number of direct
labour hours worked. A standard cost for variable overheads therefore consists of the number of labour
hours per unit, multiplied by the standard expenditure per hour on variable overhead expenses.
Variable overhead variances are therefore calculated in a similar way to direct labour variances. The total
cost variance for variable overheads is analysed into a variable overhead expenditure variance (similar to
a materials price variance and a labour rate variance) and a variable overhead efficiency variance.
7.1 Example: variable production overhead variances
The standard variable production overhead cost of Product P is 2 hours at $1.50 (= $3 per unit). 400 units
of Product P were made during the period. The labour force worked 760 hours. The variable overhead cost
was $1,230.
Required
(a) The variable production overhead total cost variance
(b) The variable production overhead expenditure variance
(c) The variable production overhead efficiency variance
Solution

$
400 units of Product P should cost ( $3)
1,200
but did cost

1,230

Variable production overhead total variance

30 (A)
In some variance reporting systems, the variance analysis goes no further, and expenditure and efficiency
variances are not calculated. However, the adverse variance of $30 may be explained as the sum of two
factors.
(a) The hourly rate of spending on variable production overheads was higher than it should have been,
ie. there is an adverse expenditure variance.
(b) The labour force worked efficiently, and took less time to make the output than it should have done.
Since fewer hours were worked, and variable overhead spending increases as more hours are
worked, spending on variable production overhead was less than it should have been. In other
words there is an efficiency (productivity) variance. The variable production overhead efficiency
variance is exactly the same, in hours, as the direct labour efficiency variance, and occurs for the
same reasons.
The variable production overhead total variance is the difference between what the output should have
cost and what it did cost, in terms of variable production overhead. It can be divided into two sub-
variances.
The variable production overhead expenditure variance is the difference between the amount of variable
production overhead that should have been incurred in the actual hours actively worked, and the actual
amount of variable production overhead incurred.
The variable production overhead efficiency variance is the difference between the standard cost of the
hours that should have been worked for the number of units actually produced, and the standard cost of
the actual number of hours worked.
In our example, the variable overhead expenditure and efficiency variances would be as follows.

$
(a) 760 hours of variable production overhead should cost ( $1.50) 1,140
but did cost

1,230
Variable production overhead expenditure variance

90 (A)
(b) 400 units of Product P should take ( 2 hrs) 800 hrs
but did take (active hours)

760 hrs
Variable production overhead efficiency variance in hours 40 hrs (F)

$1.50
Variable production overhead efficiency variance in $

$60 (F)
(c) Summary $
Variable production overhead expenditure variance 90 (A)
Variable production overhead efficiency variance

60 (F)
Variable production overhead total variance

30 (A)
7.2 Alternative method of calculating variable overhead variances
Variable overhead variances can also be calculated using rote-learned formulae.
Let SH = standard number of hours required for actual production
SVOR = standard variable overhead spending rate per hour
AH = actual hours worked
AVOR = actual variable overhead spending rate per hour
Total variable overhead cost variance = (SH SVOR) (AH AVOR)
Variable overhead expenditure variance = (SVOR AVOR) AH
Variable overhead efficiency variance = (SH AH) SVOR
8 Fixed production overhead variances
You may have noticed that the method of calculating cost variances for variable cost items is essentially
the same for direct materials, direct labour, and variable overheads. Fixed production overhead variances
are very different. In an absorption costing system, they are simply an attempt to explain the under- or
over-absorption of fixed overheads.
The fixed production overhead total variance may be broken down into two parts.
(a) A fixed overhead expenditure variance
(b) A fixed overhead volume variance.
The fixed production overhead volume variance sometimes causes confusion. The most important point is
that the volume variance applies to fixed production overhead costs only, and not to variable production
overheads.

(a) Variable production overhead spending will change with the volume of activity (hours worked). If
the master budget is to work for 300 hours and variable production overheads are incurred and
absorbed at a rate of $3 per hour, the variable production overhead budget will be $900. If only 200
hours are actually worked, the variable production overhead absorbed will be $600, but the
expected expenditure will also be $600. This means that there will be no under- or over-absorption
of variable production overhead because of volume changes.
(b) Fixed production overheads are different because the level of expenditure does not change as the
number of hours worked varies. If the master budget is to work for 300 hours and fixed production
overheads are budgeted to be $2,400, the fixed production overhead absorption rate will be $8 per
hour. If actual hours worked are only 200 hours, the fixed production overhead absorbed will be
$1,600, whereas expected expenditure will be unchanged at $2,400. There is an under-absorption
of $800 because of the volume variance of 100 hours multiplied by the absorption rate of $8 per
hour.
You may find it easier to calculate and understand fixed production overhead variances if you bear in mind
the whole time that you are trying to explain the reasons for any under- or over-absorbed production
overhead. Remember that the absorption rate is calculated as (budgeted fixed production overhead
budgeted level of activity).
The total fixed overhead cost variance is the total amount by which actual fixed overhead costs have been
under- or over-absorbed into the cost of production. This total variance has two causes.
(a) The fixed production overhead expenditure variance measures the under- or over-absorption
caused by the actual production overhead expenditure being different from budget.

$

Budgeted fixed overhead

X

Actual fixed overhead

Y

Fixed overhead expenditure variance

X Y

The variance is favourable if actual expenditure is less than the budgeted expenditure, and adverse
if actual spending exceeds the budget.
(b) The fixed production overhead volume variance measures the under- or over-absorption caused
by the actual production volume being different from budget.

Units

Budgeted production volume

A

Actual production volume

B

Fixed overhead volume variance, in units

A B

Standard fixed overhead rate per unit

R

Volume variance, in money terms

(A B) R

Over-absorption is 'favourable'. This is because too much overhead cost has been absorbed into
the cost of the units produced. The cost of production has therefore been over-stated. To counter-
balance this over-charging of cost, the profit for the period needs to be adjusted upwards.
If actual production volume exceeds the budgeted production volume, the variance is therefore
favourable, and if actual volume is less than budgeted, the variance is adverse.
Fixed production overhead total variance is the difference between fixed production overhead incurred
and fixed production overhead absorbed. In other words, it is the under- or over-absorbed fixed
production overhead.
Fixed production overhead expenditure variance is the difference between the budgeted fixed production
overhead expenditure and actual fixed production overhead expenditure.
Fixed production overhead volume variance is the difference between actual and budgeted production
volume multiplied by the standard absorption rate per unit.
8.1 Example: fixed production overhead variances
A company budgets to produce 1,000 units of product E during August. The expected time to produce a
unit of E is five hours, and the budgeted fixed production overhead is $20,000. The standard fixed
production overhead cost per unit of product E will therefore be 5 hours at $4 per hour (= $20 per unit).
Actual fixed production overhead expenditure in August turns out to be $20,450. The labour force
manages to produce 1,100 units of product E.
Required
(a) The fixed production overhead total variance
(b) The fixed production overhead expenditure variance
(c) The fixed production overhead volume variance
Solution
(a) Fixed production overhead total variance

$

Fixed production overhead incurred

20,450

Fixed production overhead absorbed (1,100 units $20 per unit)

22,000

Fixed production overhead expenditure variance

1,550 (F)

(= over-absorbed overhead)

The variance is favourable because more overheads were absorbed than budgeted. In practice, this
variance is not calculated, because it is further analysed into an expenditure and a volume variance.
(b) Fixed production overhead expenditure variance

$

Budgeted fixed production overhead expenditure

20,000

Actual fixed production overhead expenditure

20,450

Fixed production overhead expenditure variance

450

(A)

The variance is adverse because actual expenditure was greater than budgeted.
(c) Fixed production overhead volume variance. The production volume achieved was greater than
expected. The fixed production overhead volume variance measures the difference at the standard
rate.

$

Actual production at standard rate (1,100 $20 per unit)

22,000

Budgeted production at standard rate (1,000 $20 per unit)

20,000

Fixed production overhead volume variance

2,000

(F)

The variance is favourable because output was greater than expected.
8.2 Alternative method of calculating fixed overhead variances
Fixed overhead variances can also be calculated using rote-learned formulae.
Let BV = budgeted production volume
AV = actual production volume
BFOE = budgeted fixed overhead expenditure
AFOE = actual fixed overhead expenditure
SC = standard fixed overhead cost per unit
(SC = BFOE BV)
Total fixed overhead cost variance = (AV SC) AFOE
Fixed overhead expenditure variance = BFOE - AFOE
Fixed overhead volume variance = (BV AV) SC


Question
Various variances

Brain produces and sells one product only, the Blob, the standard cost for one unit being as follows.
$
Direct material A 10 kilograms at $20 per kg 200
Direct material B 5 litres at $6 per litre 30
Direct wages 5 hours at $6 per hour 30
Variable production overhead 5 hours at $2 per hour 10
Fixed production overhead

50
Total standard cost

320
The fixed overhead included in the standard cost is based on an expected monthly output of 900 units.
During April the actual results were as follows.
Production 800 units
Material A 7,800 kg used, costing $159,900
Material B 4,300 litres used, costing $23,650
Direct wages 4,200 hours worked for $24,150
Variable production overhead $8,600
Fixed production overhead $47,000
Required
(a) Calculate price and usage variances for each material.
(b) Calculate labour rate and efficiency variances.
(c) Calculate variable overhead expenditure and efficiency variances.
(d) Calculate fixed production overhead expenditure and volume variances.
Answer

(a) Price variance A
$
7,800 kgs should have cost ( $20) 156,000
but did cost

159,900
Price variance

3,900 (A)
Usage variance A
800 units should have used ( 10 kgs) 8,000 kgs
but did use

7,800 kgs
Usage variance in kgs 200 kgs (F)
standard cost per kilogram

$20
Usage variance in $

$4,000 (F)
Price variance B
$
4,300 litres should have cost ( $6) 25,800
but did cost

23,650
Price variance

2,150 (F)
Usage variance B litres
800 units should have used ( 5 l) 4,000
but did use

4,300
Usage variance in litres 300 (A)
standard cost per litre

$6
Usage variance in $

$1,800 (A)
(b) Labour rate variance
$
4,200 hours should have cost ( $6) 25,200
but did cost

24,150
Rate variance

1,050 (F)
800 units should have taken ( 5 hrs) 4,000 hrs
but did take

4,200 hrs
Efficiency variance in hours 200 hrs (A)

$6
Efficiency variance in $

$1,200 (A)
(c) Variable overhead expenditure variance
$
4,200 hours should have cost ( $2) 8,400
but did cost

8,600
Rate variance

200 (A)
Variable overhead efficiency variance
Same in hours as labour efficiency, but valued at $2 per hour (the standard variable overhead
spending rate).
200 hrs (b) $2 per hour = $400 (A)

(d) Fixed overhead expenditure variance
$
Budgeted expenditure ($50 900) 45,000
Actual expenditure

47,000
Expenditure variance

2,000 (A)
Fixed overhead volume variance
units
Budgeted production 900
Actual production

800
Volume variance, in units of production

100 (A)
Standard rate per unit $50
Fixed overhead volume variance, in $ $5,000 (A)

9 Sales price and sales volume variances
9.1 Selling price variance
The selling price variance is a measure of the effect on expected profit of a different selling price from
standard selling price. It is calculated as the difference between what the sales revenue should have been
for the actual quantity sold, and the actual sales revenue.
A sales price variance can be calculated by filling in the appropriate figures in the following table.

$

[Quantity of units

sold]

should sell for

(Quantity sold Standard sales price per

unit)

but did sell

for

(Actual revenue)

Sales price variance

=

Difference

The sales price variance is favourable if actual sales revenue exceeds the standard revenue, and adverse if
actual revenue is less than standard for the units sold.

9.2 Sales volume variance
The sales volume variance measures the increase or decrease in expected profit as a result of the sales
volume being higher or lower than budgeted. In an absorption costing system, the sales volume variance
is valued at the standard profit per unit, not the standard contribution.
A sales volume variance can be calculated by filling in the appropriate figures in the following table.

Units of product

Budgeted sales quantity

X

Actual sales quantity

Y

Sales volume variance, in units

X Y

Standard profit per unit

Sales volume variance, in $

(X Y) standard unit profit

The sales volume variance is favourable when actual sales volume exceeds the budget, and adverse when
actual sales volume is less than budgeted.
9.3 Example: sales price variance
The standard selling price of Product P is $15. Actual sales in March were 2,000 units at $15.30 per unit.
The selling price variance is calculated as follows.

$

2,000 units should sell for ( $15)

30,000

but did sell for ( $15.30)

30,600


600 (F)

The variance is favourable because the price was higher than expected.
9.4 Example: sales volume variance
A company budgets to sell 8,000 units of product J for $12 per unit. The standard full cost per unit is $7.
Actual sales were 7,700 units, at $12.50 per unit. The sales volume variance is calculated as follows.
Budgeted sales volume

8,000 units

Actual sales volume

7,700 units

Sales volume variance in units

300 units (A)

standard profit per unit ($(127))

$5


$1,500 (A)

The variance is adverse because actual sales were less than budgeted.
9.5 Further example: sales variances
Jasper has the following budget and actual figures for May.
Budget Actual
Sales units 600 620
Selling price per unit $30 $29
Standard full cost of production = $28 per unit.
Required
Calculate the selling price variance and the sales volume variance.
Solution
(a) $
Sales revenue for 620 units should have been ( $30) 18,600
but was ( $29)

17,980
Selling price variance

620 (A)
(b) Budgeted sales volume 600 units
Actual sales volume

620 units
Sales volume variance in units 20 units (F)
standard profit per unit ($(30 28))

$2

$40 (F)
9.6 Alternative method of calculating sales variances
Sales variances can also be calculated using rote-learned formulae.
Let BV = budgeted sales volume
AV = actual sales volume
SSP = standard selling price per unit
ASP = actual selling price per unit
SPft = standard profit per unit
Sales price variance = (ASP - SSP) AV
Sales volume variance = (BV AV) SPft
10 The reasons for variances
Standard cost variances help management to assess actual performance, and to identify situations where
actual results are significantly better or worse than planned. Variances might also provide clues as to why
actual results have been better or worse than expected.
There are many possible reasons for cost variances arising, including efficiencies and inefficiencies of
operations, errors in budgeting and standard setting and changes in exchange rates. There now follows a
list of a few possible causes of cost variances. This is not an exhaustive list and in an examination
question you should review the information given and use your imagination and common sense to
suggest possible reasons for variances.
Variance Favourable Adverse
Material price Unforeseen discounts received
Greater care in purchasing
Change in material quality standard
Fall in market price of materials
Price increase
Careless purchasing
Change in material quality standard
Material usage Material used of higher quality than
standard
More effective use made of material
Errors in allocating material to jobs
Defective material
Excessive waste
Theft
Stricter quality control
Errors in allocating material to jobs
Labour rate Use of workers at a rate of pay lower
than standard
Wage rate increase

Variance Favourable Adverse
Labour efficiency Output produced more quickly than
expected, because of work motivation,
better quality of equipment or materials
Errors in allocating time to jobs
Lost time in excess of standard allowed
Output lower than standard set because
of lack of training, sub-standard
material etc
Efficiency standard set at an ideal level
Errors in allocating time to jobs
Idle time Idle time variances are always adverse Bottlenecks in the production system
Illness or injury to worker
Problems with machines
Non-availability of materials
Overhead
expenditure
Savings in costs incurred
More economical use of services
Increase in cost of services
Excessive use of services
Change in type of services used
Overhead volume Production or level of activity greater
than budgeted
Production or level of activity less than
budgeted
Selling price Unplanned price increase Unplanned price reduction
Discounts given to customers to win
sales
Sales volume Additional demand
Low price offer attracting higher
demand
Unexpected fall in demand
Production difficulties

11 Investigating variances
Materiality, controllability and variance trend should be considered before a decision about whether or
not to investigate a variance is taken.
One way of deciding whether or not to investigate a variance is to only investigate those variances which
exceed pre-set tolerance limits.
If the cause of a variance is controllable, action can be taken to bring the system back under control in
future. If the variance is uncontrollable, but not simply due to chance, it will be necessary to review
forecasts of expected results, and perhaps to revise the budget.
Before management decide whether or not to investigate the reasons for a particular variance, there are a
number of factors to be considered.
Materiality. Because a standard cost is really only an average expected cost, small variations between
actual and standard are bound to occur and are unlikely to be significant. Obtaining an 'explanation' of the
reasons why they occurred is likely to be time consuming and irritating for the manager concerned. For
such variations further investigation is not worthwhile since such variances are not controllable.
Controllability. The cause of some variances may be known, and due to reasons beyond the manager's
control. Uncontrollable variances call for a change in the plan, not an investigation into the past.
The type of standard being used. The efficiency variance reported in any control period, whether for
materials or labour, will depend on the efficiency level set. If, for example, an ideal standard is used,

variances will always be adverse. However, adverse variances in excess of a certain amount should be
investigated, even when the efficiency standard is an ideal one.
Variance trend. Although small variations in a single period are unlikely to be significant, small variations
that occur consistently may need more attention. Cumulative trends in a variance are probably more
important than a variance for one accounting period. The trend provides an indication of whether the
variance is fluctuating within acceptable control limits or becoming out of control.
Interdependence between variances. Individual variances should not be looked at in isolation. One
variance might be inter-related with another, and much of it might have occurred only because the other
variance occurred too. When two variances are interdependent (interrelated) one will usually be
adverse and the other one favourable. Here are some examples.
Interrelated variances Explanation
Materials price and
usage
If cheaper materials are purchased for a job in order to obtain a favourable
price variance, materials wastage might be higher and an adverse usage
variance may occur. If the cheaper materials are more difficult to handle, there
might be an adverse labour efficiency variance too. If more expensive materials
are purchased, the price variance will be adverse but the usage variance might
be favourable if the material is easier to use or of a higher quality.
Labour rate and
efficiency
If employees are paid higher rates for experience and skill, using a highly
skilled team might lead to an adverse rate variance and a favourable efficiency
variance (experienced staff are less likely to waste material, for example). In
contrast, a favourable rate variance might indicate a larger-than-expected
proportion of inexperienced workers, which could result in an adverse labour
efficiency variance, and perhaps poor materials handling and high rates of
rejects too (and hence an adverse materials usage variance).
Selling price and sales
volume
A reduction in the selling price might stimulate bigger sales demand, so that an
adverse selling price variance might be counterbalanced by a favourable sales
volume variance. Similarly, a price rise would give a favourable price variance,
but possibly cause an adverse sales volume variance.
12 Operating statements
An operating statement provides a reconciliation between budgeted and actual profit.
An operating statement or statement of variances is a report to management reconciling the difference
between the budgeted profit for a period and the actual profit. This reconciliation is usually presented as a
report to senior management at the end of each control period (eg at the end of each month).
An operating statement is a regular report for management which compares actual costs and revenues
with budgeted figures and shows variances.
An extensive example will now be introduced, both to revise the variance calculations already described,
and also to combine them into an operating statement.
12.1 Example: variances and operating statements
Armoured Kangaroo manufactures one product, and the entire product is sold as soon as it is produced.
The company operates a standard costing system. The standard cost card for the product, a boomerang,
is as follows.

STANDARD COST CARD BOOMERANG
$
Direct materials 0.5 kilos at $4 per kilo 2.00
Direct wages 2 hours at $5.00 per hour 10.00
Variable overheads 2 hours at $0.30 per hour 0.60
Fixed overhead 2 hours at $3.70 per hour

7.40

Standard cost 20.00
Standard profit

6.00

Standard selling price

26.00

Budgeted output for June was 5,100 units. Actual results for June were as follows.
Production of 4,850 units was sold for $124,280
Materials consumed in production amounted to 2,300 kilos at a total cost of $9,800
Labour hours paid for amounted to 8,000 hours at a cost of $42,000
Variable overheads amounted to $2,600
Fixed overheads amounted to $42,300
Required
Calculate all variances and prepare an operating statement for June.
Solution
Workings
(a)

$

2,300 kg of material should cost ( $4)

9,200

but did cost

9,800

Material price variance

600 (A)

(b)

kg

4,850 boomerangs should use ( 0.5 kg)

2,425

but did use

2,300

Material usage variance in kg

125 (F)

Standard cost per kg

$4

Material usage variance in $

$500 (F)

(c)

$

8,000 hours of labour should cost ( $5)

40,000

but did cost

42,000


2,000 (A)

(d)

hours

4,850 boomerangs should take ( 2 hrs)

9,700

but did take

8,000

Labour efficiency variance in hours

1,700 (F)

Standard cost per hour

$5

Labour efficiency variance in $

$8,500 (F)

(e)

$

8,000 hours of variable overhead expenditure should cost ( $0.30)

2,400

but did cost

2,600

Variable overhead expenditure variance

200 (A)

(f)

hours

Variable overhead efficiency variance in hours (same as for labour)

1,700 (F)

Standard cost per hour

$0.30

Variable overhead efficiency variance in $

$510 (F)

(g)

$

Budgeted fixed overhead (5,100 units $7.40)

37,740


42,300


4,560 (A)

(h)

units

Budgeted production

5,100

Actual production

4,850

Volume variance, in units

250 (A)

Fixed overhead cost per unit

$7.40

Fixed overhead volume variance, in $

$1,850 (A)

(i)

$

4,850 boomerangs should have sold for ( $26)

126,100

but did sell for

124,280


1,820 (A)

(j)

units

Budgeted sales

5,100

Actual sales

4,850


250 (A)


$6


$1,500 (A)

There are several ways in which an operating statement may be presented. Perhaps the most common
format is one which reconciles budgeted profit to actual profit. Sales variances are reported first, and the
total of the budgeted profit and the two sales variances results in a figure for 'actual sales minus the
standard cost of sales' as follows.

$

$

Budgeted profit (5,100 units profit of $6 per unit)

30,600


1,820 (A)


1,500 (A)

3,320 (A)

Actual sales less the standard cost of sales

27,280

The cost variances are then reported, and an actual profit calculated.
ARMOURED KANGAROO - OPERATING STATEMENT FOR JUNE

$

$

$

Budgeted profit

30,600


1,820 (A)


1,500 (A)

3,320 (A)


27,280

Cost variances

(F)

(A)

Material price

600

Material usage

500

Labour rate

2,000

Labour efficiency

8,500

Variable overhead expenditure

200

Variable overhead efficiency

510


4,560

Fixed overhead volume

1,850

9,510

9,210

Total cost variances

300 (F)

Actual profit

27,580

Check: calculation of actual profit

$

$

Sales

124,280

Materials

9,800

Labour

42,000

Variable overhead

2,600

Fixed overhead

42,300

Total costs

96,700

Profit

27,580

13 Variances in a standard marginal costing system
If an organisation uses standard marginal costing instead of standard absorption costing, there will be two
differences in the way the standard costing variances are calculated.
(a) In marginal costing, fixed costs are not absorbed into product costs and so there are no fixed cost
variances to explain any under- or over-absorption of overheads. There will, therefore, be no fixed
overhead volume variance. There will be a fixed overhead expenditure variance, calculated in
exactly the same way as for an absorption costing system.
(b) The sales volume variance will be valued at standard contribution margin, not standard profit
margin (that is, sales price per unit minus variable costs of sale per unit).
13.1 Example: marginal costing operating statement
Returning to the example of Armoured Kangaroo, the variances in a system of standard marginal costing
would be as follows.
(a) There is no fixed overhead volume variance.
(b) The standard contribution per unit of boomerang is $(26 12.60) = $13.40, therefore the sales
volume variance of 250 units (A) is valued at ( $13.40) = $3,350 (A).
The other variances are unchanged, therefore an operating statement might appear as follows.
ARMOURED KANGAROO OPERATING STATEMENT FOR JUNE

$

$

$

Budgeted profit

30,600


1,820 (A)


3,350 (A)

5,170 (A)

Actual sales less the standard marginal cost of sales

25,430

Cost variances

(F)

(A)

Material price

600

Material usage

500

Labour rate

2,000

Labour efficiency

8,500


200


510


4,560

9,510

7,360


2,150 (F)

Actual profit

27,580


Question
Operating statement

Hides of March manufacture a standard leather walking boot, model number M25, for which the standard
unit cost and selling price are as follows.
$
Direct materials
Leather 3 units at $5 per unit 15
Other materials

3
18
Direct labour 1 hours at $4 per hour 6
Variable production overheads 1 hours at $2 per hour 3
Fixed production overheads 1

hours at $6 per hour

9

Standard cost 36
Selling price

48
Standard profit, before marketing and administrative expenses

12

Budgeted production and sales for period 7 of 20X3 were 3,000 units of M25.
During period 7 the actual results were as follows.
Production and sales of M25 3,200 units
Sales revenue $150,000
Leather purchased and used: quantity 9,750 units
cost $47,000
Other materials purchased and used $9,500
Direct labour: hours paid for 5,850 hours
labour cost $24,100
Variable production overheads $10,650
Fixed production overheads $31,500
A standard full costing system is in operation.
Required
Prepare an operating statement for period 7 reconciling budgeted and actual profit and specifying all the
relevant variances. Ignore marketing and administration costs.

Answer

Workings
Budgeted profit. This is 3,000 units standard profit of $12 per unit = $36,000.
(a)

$

9,750 units of leather should cost ( $5)

48,750

but did cost

47,000

Material price variance, leather

1,750 (F)

(b)

Units of

leather

3,200 units of M25 should use ( 3)

9,600

but did use

9,750

Leather usage variance in units

150 (A)

standard cost per unit

$5

Leather usage variance in $

750 (A)

Other materials. We are not given a breakdown into units of material and price per unit of material,
and so the only materials variance we can calculate is the total cost variance.

(c)

$

3,200 units of M25 should cost ( $3)

9,600

but did cost

9,500
Materials cost variance, other materials

100 (F)

(d)

$

5,850 hours of labour should cost ( $4)

23,400

but did cost

24,100


700 (A)

(e)

hours

3,200 units of M25 should take ( 1.5 hrs)

4,800

but did take

5,850

Labour efficiency variance in hours

1,050 (A)

standard cost per hour

$4

Labour efficiency variance in $

$4,200 (A)

(f)

$

5,850 hours of variable overhead expenditure should cost ( $2)

11,700

but did cost

10,650

Variable overhead expenditure variance

1,050 (F)

(g)

Variable overhead efficiency variance in hours (same as for labour)

1,050 (A)

standard cost per hour

$2

Variable overhead efficiency variance in $

$2,100 (A)

(h)

$

Budgeted fixed overhead

27,000


31,500


4,500 (A)

(i)

units

Budgeted production

3,000

Actual production

3,200

Volume variance, in units

200 (F)

Fixed overhead cost per unit

$9

Fixed overhead volume variance, in $

$1,800 (F)

(j)

$

3,200 units of M25 should have sold for ( $48)

153,600

but did sell for

150,000


3,600 (A)

(k)

units

Budgeted sales

3,000

Actual sales

3,200


200 (F)


$12


$2,400 (F)

HIDES OF MARCH OPERATING STATEMENT FOR PERIOD 7

$

$

$

Budgeted profit

36,000


3,600 (A)


2,400 (F)

1,200 (A)


34,800

Cost variances

(F)

(A)

Leather price

1,750

Leather usage

750

Other materials cost

100

Labour rate

700

Labour efficiency

4,200


1,050


2,100


4,500

Fixed overhead volume

1,800

4,700

12,250


7,550 (A)

Actual profit

27,250

Check: calculation of actual profit

$

$

Sales

150,000

Leather

47,000

Other materials

9,500

Labour

24,100

Variable overhead

10,650

Fixed overhead

31,500

Total costs

122,750

Profit

27,250

220 12: Other aspects of performance measurement

1 Measures of shareholder value
The shareholder value concept is that a company should have as its main objective the aim of maximising
shareholder value, and should therefore develop strategies for increasing shareholder value. Measures of
shareholder value include profit, return on assets and economic value added.
Companies are owned by their ordinary shareholders, who invest in their company in the expectation of
obtaining returns, in the form of dividends and a higher share value. The shareholder value concept is
that the main objective of a company should be to maximise the wealth of its shareholders, and that all
other objectives are subordinate to this.
This concept is not universally accepted. It can be argued that there are many different 'stakeholders' in a
company, in addition to the shareholders. Stakeholder groups include the senior management, other
employees, customers, suppliers and the general public. Each stakeholder group has expectations of what
a company should provide for them. For example, employees might want to earn a good income, be
rewarded for efforts made on behalf of the company and job satisfaction. Customers might expect a
company to supply products or services that satisfy their needs at a reasonable price.
Even so, there is general acceptance that companies should aim to create shareholder value, and in doing
so, other stakeholders are likely to benefit from the company's success. If a company earns bigger profits,
it can afford better wages or salaries for the people it employs and reward individuals for their
achievements. By providing better value to customers, in the form of improved products or lower prices,
companies should be successful in their markets: customer satisfaction is essential for achieving
commercial success.
If the shareholder value concept is accepted, it follows that performance measures should focus on the
creation of shareholder value. Any of several different measures might be used as the main measure or
measures of performance.
(a) Profit. Profit is either paid out to shareholders as a dividend, or reinvested in the business for
future growth. A company might therefore establish a profit target as its key objective.
Shareholders will have expectations of what the company's profits and dividends should be, and
will be disappointed if actual profit turns out less than expected. Lower profits are likely to result in

Other aspects of
performance
measurement

12: Other aspects of performance measurement 221
a fall in the share price, and a loss of shareholder value. Targets for profit will therefore normally
include an element for profit growth.
(b) Earnings per share. A company might issue new shares to raise fresh capital, for investment in
future growth. When new shares are issued for cash, total profits should increase, but the profit
per share (ie earnings per share or EPS) might fall. If a company increases its share capital by 10%
but profits increase only by 5%, it would be argued that existing shareholders have suffered some
loss in value, due to a fall in the earnings per share. The main performance measure for a company
might therefore be expressed in terms of a target for earnings per share and growth in earnings per
share.
(c) Return on assets. To earn profits, capital has to be invested. A larger investment should provide a
larger profit. For example, it can be argued that a return of $10,000 on an investment of $100,000
(10%) is much better than a return of $20,000 on an investment of $1 million (2%). Performance
should therefore be judged in terms of the size of the profit relative to the size of the capital
investment, and the main performance measure might be return on assets employed or return on
investment (ROI).
(d) Profit margin. Some companies might measure overall performance in terms of their profit/sales
ratio, or return on sales. However, although return on sales is a useful secondary measure, it is not
a reliable guide to the creation of shareholder value. Return on sales might be improved, but sales
volume might fall as a result. For example, a company might increase its profit/sales ratio from 5%
to 7% by increasing its prices, but if sales volume falls substantially as a result of the price rise, the
overall result could be a fall in total profit and a lower return on assets.
(e) Economic value added or EVA
. Profit and return on assets are based on accounting

measurements of profitability and asset values. It can be argued that accounting measurements are
unreliable guides to true economic value. Economic value added or EVA
is a measure of
performance, developed by consultants Stern Stewart, that addresses this problem. Adjustments
are made to items of expense and asset values, in order to convert reported accounting profits into
a measure that represents the economic value created for shareholders during the period. EVA
is
explained in more detail in a later chapter.
Performance measurement should consider the long-term rather than the short-term. Maximising
shareholder value means having to achieve certain performance levels over a long period of time, not just
over a 12-month time frame. Companies should therefore set targets over a time period longer than the
budget period.
2 Critical success factors and key performance
indicators
An organisation should identify critical success factors, and key performance indicators for measuring
actual performance against these factors. Critical success factors can be both financial and non-financial
in nature.
Having established its main objectives, in terms of creating shareholder value, a company should identify
the factors that are essential for success in achieving those objectives. Critical success factors are those
aspects of a business that must go right; otherwise the company will fail to achieve its objectives.
Critical success factors (CSFs) are the few key areas of a business that must go right if success is to be
achieved. They are of vital importance for achieving the organisation's objectives, and the organisation
cannot afford non-achievement for any CSF.
There will usually be just a small number of critical success factors, and at a departmental level, they
might be expressed in financial terms (eg keeping costs under control), and perhaps also in terms of
productivity and quality. At the organisational level, critical success factors might be expressed in
financial terms (eg growth in shareholders' wealth) but also in terms of market share or technological
innovation.

Critical success factors might be identified, for example, in terms of:
(a) Profitability
(b) Market share
(c) Productivity
(d) Product leadership
(e) Personnel development
(f) Employee attitudes
(g) Public responsibility
(h) Balance between long-term and short-term goals
It might be a useful exercise to look at a specific example.
A food manufacturer has the crucial marketing tasks of persuading shops and supermarkets to stock their
produce, and persuading customers to buy it. It has therefore been suggested that the critical success
factors for a manufacturer of processed food products are:
(a) New product development
(b) Good distribution, and
(c) Effective advertising.
New product development is necessary to create products that customers want to buy. Good distribution
is essential to persuade supermarket chains and other retailers to buy the goods of the manufacturer,
rather than similar goods of rival producers. Effective advertising is essential to create demand from
consumers, who will then expect to see the manufacturer's products in the places they buy their food.
Good distribution provides marketing 'push' and effective advertising, by stimulating consumer demand,
creates a marketing 'pull'.
2.1 Key performance indicators
Having established what its critical success factors are, the company must then identify targets and
measures of performance. These are key performance indicators. For a food manufacturer, the key
performance indicator might be:
(a) The number of new products developed during the period. For example, a target might be to launch
four new products on the market, of which one should be an organic food product.
(b) The amount of revenue earned from sales of new products. For example, a target might be for 20%
of annual sales to be achieved from new products launched since the previous year.
Key performance indicators for good distribution could be a target for the time from receipt of a
customer's order to delivery. The target might be that distribution time should be no longer than, say, 24
hours, and actual performance can be measured against this target.
2.2 CSFs and non-profit-making organisations
Critical success factors can be used by non-profit-making institutions. For example, a university might see
its objectives as to carry out academic research and to teach students to a high standard. The critical
success factors for a university might be:
(a) The availability of funding, for both research and teaching
(b) Student recruitment, to obtain students of a suitable calibre
(c) The skills of the academic team, in both research and teaching
(d) Course design
(e) Responding to external needs, for example the needs of employers and the demand from other
organisations (eg companies) for research
(f) The exploitation of technology.
For each critical success factor, targets and key performance indicators could be set.

An approach to establishing performance measures in both profit-making and non-profit making
organisations might therefore be to:
(a) Identify the organisation's corporate objectives
(b) Determine the critical success factors, at the organisational level, and also at divisional,
departmental or other operating level within the organisation
(c) Determine a small number of key performance indicators for each factor.

Question
CSFs

A sandwich shop in a large city is considering setting up a mobile delivery service to take sandwiches and
other refreshments to customers in their offices. Identify three CSFs for this project and suggest a key
performance indicator for each.

Answer

Three CSFs might be:
Variety of sandwiches offered
Speedy response to customer demand
Rapid establishment of customer base
For which key performance indicators might be (respectively):
Number of varieties offered in comparison with competitors, perhaps supplemented by the number
of times a customer requests something not currently offered
Percentage of orders delivered within 15 minutes of time order required by customer
Growth in sales/number of deliveries.

3 Balanced scorecard
There could be a risk that short-term financial performance will take prominence over longer-term
objectives, including non-financial objectives, and the organisation's strategy. One approach to linking
performance target setting and performance measurement to strategy is the balanced

scorecard.
Measures of shareholder value, and responsibility accounting measures of performance within an
organisation, focus on financial issues. It has already been suggested that the objectives of an
organisation, and targets for achievement, will be non-financial as well as financial.
Unless an organisation has clear targets for its non-financial objectives, and measures actual performance
in achieving those objectives, there is a severe risk that an organisation's performance management
systems will focus on financial targets, to the exclusion of non-financial factors.

One approach to target setting and performance measurement is the balanced scorecard. Since it was first
proposed by Kaplan and Norton in the early 1990s it has been successfully implemented by a number of
commercial and not-for-profit organisations. While it has been successful for many organisations, the
approach is not universally accepted.
A balanced scorecard establishes non-financial as well as financial targets, and measures actual
performance in relation to all these targets. Areas covered include profitability, customer satisfaction,
internal efficiency and innovation.
The balanced scorecard approach focuses on four different aspects of performance.
Perspective The key question
Customer What do existing customers and targeted new customers value from us? Focusing
on this issue gives rise to targets that matter to customers, such as cost (value for
money), quality or place of delivery.
Internal What processes must we excel at to achieve our financial and customer
objectives? Focusing on this issue should lead to improvements in internal
processes and decision making.
Innovation and
learning
Can we continue to improve and create value? Focus on this issue draws attention
to the ability of the business to maintain its competitive position, through the
acquisition of new skills and the development of new products. Suitable measures
of performance might include the percentage of sales derived from new products
compared to the percentage derived from longer-established products, and the
time required to bring a new product to market.
Financial How do we create value for our shareholders? Financial measures of performance
include share price growth, profitability and return on investment, and market
value added.
For organisations that adopt a balanced scorecard approach, targets are set for a range of critical financial
and non-financial areas, and the main monthly performance report for management is a balanced
scorecard report, not budgetary control reports. In other words, with a balanced scorecard, the budget
'takes a back seat' to the balanced scorecard.
Typical measures of outcomes for each of the four aspects of performance are as follows.
Perspective Outcome measures
Core financial measures Return on investment, or economic value added/market
value added
Profitability
Revenue growth/ revenue mix
Cost reduction/ productivity
Cash flow
Core customer measures Market share
Customer profitability
Attracting new customers
Retaining existing customers
Customer satisfaction
On-time delivery
Internal business measures These will vary according to the nature of the business, but
might include:
Success rate in winning contract orders
Production cycle time
Level of re-works

Perspective Outcome measures
Core learning and growth measures The percentage of total revenue generated by new products
Time to develop new products
Employee productivity
Employee satisfaction
Employee retention
Revenue per employee
Important benefits of a balanced scorecard approach are that:
(a) It looks at both internal and external factors affecting the organisation
(b) It is related to key elements of the organisation's strategy, and is a strategy-focused performance
management system
(c) Financial and non-financial measures are included, and (short-term) financial performance
measures do not take precedence over the others.

Question
Balanced scorecard

Raffles & Co own a chain of ten medium-sized restaurants in the South East of England. These restaurants
are aimed at the young professional market, and sell themselves as a place to meet, drink and eat at
lunchtime, after work and into the evening. They are generally situated in the centre of towns, which
makes rental of properties quite expensive. The directors are concerned about the impact of a new chain
of modern restaurants that are starting to encroach on Raffles' restaurants' territory and feel that a
balanced scorecard approach to evaluating performance will help to keep Raffles' business ahead in their
market.
Suggest with reasons, one key measure for each of the main aspects of a balanced scorecard for Raffles'
restaurant business.

Answer

Note: only one measure is required for each perspective.
Customer perspective %age of revenues generated at different times of day/customer satisfaction (from
surveys left on tables)/% capacity filled, benchmarked against competitors.
Internal perspective Level of food wastage/cost effectiveness of menu design.
Innovation/learning perspective frequency of menu changes/% of wine revenues derived from newly
introduced lines/number of promotions and special offers.
Financial perspective EVA
against budgeted EVA
for the chain as a whole/return on investment by

unit/revenue growth.

3.1 Implementing a balanced scorecard approach
Robert Kaplan and David Norton, originators of the balanced scorecard approach in the 1990s,
recommend that:
(a) A firm should start by translating its strategy into a balanced set of key objectives. This will
probably include setting a high-level financial objective, such as increasing the return on capital
employed from its current level to a higher target level
(b) These key objectives should then be converted into operational targets
(c) These operational targets should be communicated to employees
The focus of attention is therefore on strategic objectives and the success factors necessary for achieving
them.
A framework for adopting a balanced scorecard approach is given in the following table.
Identify the company's mission
and vision. Establish the main
objectives.

Identify strategies for achieving
objectives.
Senior management decide which strategies to follow.
Examples
We must invest in modern technology.
We must achieve cost efficiency and be cost leaders in the market.
We must achieve a high quality of product.
Identify the critical success factors
for achieving the strategic
objectives.
CSFs can be structured along the balanced scorecard approach,
with CSFs for customer, internal, innovation and learning and
financial perspectives.
Examples
Financial CSFs:
profitability
cost efficiency
Customer perspective CSFs:
on-time delivery
customer satisfaction
Internal perspective CSFs:
use the right technology
fast production throughput
Innovation and learning CSFs:
develop new products on time
innovation
employee attitudes
employee competences
Identify key performance measures
for each CSF.
For example, if a critical factor is on-time delivery of orders to
customers, a key performance indicator will be the percentage of
orders delivered on time, and the balanced scorecard should set a
target of performance, such as at least 99.5% of deliveries to
customers to be on time.
Similarly, if a CSF is to achieve fast production throughput, a key
performance indicator might be the average lead time for production
(time from starting a job to completion). The balanced scorecard
would then set a target for the average production lead time.
The balanced scorecard should be
evaluated.
Management should check that achievement of targets selected
should ensure that the company will achieve its objectives. The key
question at this stage is: Are we measuring the right things?
Create action plans for achieving
the balanced scorecard targets.

Implement. Monitor performance
against the scorecard.


Case Study

Mobil
An example of a balanced scorecard approach, described by Kaplan and Norton in their book The Strategy-
focused Organization, is the case of Mobil in the US in the early 1990s. Mobil is a major supplier of petrol,
and was competing with other suppliers on the basis of price and the location of petrol stations. The
strategic focus was entirely on cost reduction and productivity. Even so, return on capital was not high
enough.
The senior management of the company re-assessed the company's strategy, with a view to achieving
growth in market share and greater differentiation for the Mobil brand name. They wanted the company to
attract customers who bought more-than-average quantities of petrol at each visit to a petrol station,
bought higher-priced blends of petrol, and who would also buy other goods from the petrol station stores.
The company re-assessed its high-level financial objective, and set a target of improving return on capital
employed from its current level (about 6 7%) to 12% within three years.
From a financial perspective, it identified key success factors as productivity and sales growth.
(a) Targets were set for productivity. These were to reduce costs (measured in terms of operating
costs per gallon) so as to become the cost leader in the industry, and also to increase 'asset
intensity' (ie to handle a larger volume of business without increasing the asset base of the
company). Asset intensity targets were set in terms of operational cash flow.
(b) Targets for growth were to achieve an above-average growth in revenues compared to the industry
as a whole, and also to achieve a bigger volume growth in premium-priced products (measured in
terms of the percentage of total sales coming from premium-priced products).
From a customer perspective, Mobil carried out market research into who its customers were and what
factors influenced their buying decisions. It was able to group customers into five categories, of which
three were buyers of higher-priced products (ie were not price-sensitive) and who tended to use the same
petrol stations for all their petrol purchases. Targets were established for providing petrol to these
categories in a way that would 'delight' the customer and differentiate Mobil's products from rival petrol
suppliers. Basic issues were identified, such as having petrol stations that were both clean and safe, and
offering a good quality product and a trusted brand. Targets were set for these. Targets were also
identified and set for differentiating Mobil's products from those of rival suppliers: these included targets
for a speedy service at petrol stations, friendly and helpful customer service and giving some recognition
to customer loyalty.
Mobil also had to address the problem of improving the processes for delivering its products and services
to customers. Since many petrol stations in North America were not owned by the petrol companies, but
by independent owners, these processes had to be developed in collaboration with the owners.
For each aspect of its strategic planning, Mobil identified targets for achievement, and measured
performance on the basis of these targets. All targets on the balanced scorecard were given due attention.
These included short-term financial targets, but short-term financial targets did not take prominence over
the other non-financial targets.

Case Study

Analog Devices
Another interesting example is the experience of Analog Devices, a semi-conductor company in the US
which was the first company to devise a balanced scorecard approach in the 1980s when preparing its
five-year strategic plan for 1988 1992.
Analog Devices had a clearly-expressed corporate objective that set out its mission and vision. This
provided a valuable reference for the development of non-financial performance measures in the balanced
scorecard. The company's corporate objectives were summarised as follows: 'Achieving our goals for
growth, profits, market share and quality creates the environment and economic means to satisfy the
needs of our employees, stockholders, customers and others associated with the firm. Our success
depends on people who understand the interdependence and congruence of their personal goals with
those of the company and who are thus motivated to contribute towards the achievement of those goals.'
Three basic strategic objectives identified by the firm were market leadership, sales growth and
profitability. The most critical problems appeared to be customer-related, and the company established
three key targets:
(a) Percentage of orders delivered on time. A target was set for the five-year period to increase the
percentage of on-time deliveries from 85% to at least 99.8%.
(b) Outgoing defect levels. The target was to reduce the number of defects in items leaving the
company's premises for delivery to customers, from 500 per month to less than 10 per month.
(c) Order lead time. Here, the target was to reduce the time between receiving a customer order to
delivery from 10 weeks to less than three weeks.
The company also had a quality improvement programme, and used cross-functional problem-solving
teams to identify ways of improving production methods and quality. From an internal process
perspective, the drivers of success were seen as:
(a) Having products rated 'number one' by at least 50% of customers, based on their attitudes to
whether the company was making the right products, performance, price, reliability, quality,
delivery, lead time, customer support, responsiveness, willingness to co-operate and willingness to
form partnerships.
(b) Eliminating waste in all parts and at all levels in the organisation.
The company therefore developed a number of targets with an internal perspective:
(a) Manufacturing cycle time. To reduce this to 4 to 5 weeks over the five-year planning period.
(b) Defective items in production. The target was to reduce defects in production to less than 10 per
month.
At the same time, the company committed itself to pursuing aggressively company-wide cost reductions.
Targets were also set for improvements in employee productivity.
Learning and innovation targets were also set, for:
(a) The number of new products introduced to the market
(b) The amount of sales from new products
(c) The new product sales ratio. This was the percentage of total sales achieved by products
introduced to the market within the previous six quarters.
(d) Average annual revenues for new products in their third year.
(e) Reducing the average time to bring new product ideas to market.
Financial targets were set for revenue, revenue growth, profit and return on assets.
Analog Devices succeeded, through its innovative balanced scorecard approach, in integrating financial
and non-financial metrics into a single system, in which the various targets did not conflict or compete
with each other, and were not in any way contradictory.

3.2 The need for care when adopting a balanced scorecard approach
Supporters of the balanced scorecard approach to performance measurement are amongst those who
doubt the value of budgets and budgetary control as a system of planning and control and performance
management.
However, implementing a balanced scorecard approach can have its problems. The argument originally
put forward by Kaplan and Norton to support a balanced scorecard approach was that financial indicators
of performance on their own were inadequate.
(a) Accounting figures are unreliable and can be manipulated.

(b) Changes in the business and in market conditions facing a company do not show up in the financial
results until much later. Accounting results therefore do not provide early warning indicators of
change.
Performance measures should ideally be difficult to manipulate, and should provide advance warning of
what could happen in the future. They should also relate to factors that management can do something
about. In other words, performance indicators should act as pointers to what should be done to improve
matters.
3.3 Example
In an article in Financial Management (November 2001) Gering and Mntambo make a useful sporting
analogy. In a football match, the manager of a team has the responsibility for winning the match. The
ultimate measure of performance throughout the match is the score. However, the manager uses other
indicators as the match progresses, to decide what he should do to improve the prospect of winning.
During the first half, he will take note of how many scoring chances have been created, how much
possession of the ball the team has had and which players appear to be out of form. He will use these
indicators to make adjustments at half time, or to take decisions about substituting players or changing
tactics. The aim is to win the match, but performance indicators about shots on goal, possession, the
number of corner kicks for each side, and so on can help him to make decisions that will hopefully lead to
eventual victory.
A balanced scorecard operates in the same way.
The ultimate objective is to maximise profits. However, other indicators of performance can help
managers to make assessments and think about whether changes or adjustments are needed to make
achievement of the objective more likely. Financial measures, customer measures, internal business
measures and learning and growth measures can all be used. It is essential to remember, however, that
they act as guides to achieving the key financial objective, but are not in themselves the main objective.
Returning to the football match analogy, a useful measure of performance is how many shots on goal the
team has had, because this provides a guide to the likelihood of scoring. However, the number of shots on
goal is not in itself the objective. It is scoring more goals than the other team that ultimately counts.
A difficulty with the balanced scorecard approach in practice can be that the targets for each item on the
balanced scorecard might be seen as key objectives in their own right. The four categories of performance
indicator each focus on one of the major stakeholders in the company (shareholders, customers,
executive managers and employees). Each of these groups might use a balanced scorecard system to
apply pressure on the company to have regard for their interests. Instead of supporting the main financial
objective, balanced scorecard targets can become part of a political process for reconciling the interests of
stakeholder groups. The risk is that each part of the balanced scorecard becomes an independent list of
targets and measurements.

4 Benchmarking
Another way of measuring performance, that should encourage strategic thinking, is benchmarking

against the world's best.
Benchmarking has been described as 'the formalisation of the basic notion of comparing practices. It is a
systematic analysis of one's own performance against that of another organisation . The overall
objective of benchmarking is to improve performance by learning from the experience of others' (Smith).
Benchmarking therefore aims to achieve competitive advantage by learning from others' experiences
and mistakes, finding best practice and translating this best practice into use in the organisation.
4.1 Types of benchmarking
External benchmarking involves:
(a) Comparing the performance of an organisation with that of a direct competitor - ideally one that is
acknowledged to be the 'best in class' (competitive benchmarking), or
(b) Comparing the performance of an internal function with those of the best external practitioners of
those functions, regardless of the industry within which they operate (functional benchmarking).
Given that the benchmark is the 'best' in a particular field ('the world's best'), it provides a meaningful
target towards which the organisation should aim.
Internal benchmarking, on the other hand, involves comparing the performance of one part of a business
with that of a different part of the same business with the aim of establishing best practice throughout an
organisation. Some external benchmarking is still required, however, in order to establish best practice.
Although any process can be benchmarked, studies indicate that the business functions most subjected to
benchmarking are customer services, manufacturing, human resources and information services.

4.2 Why benchmark?
Performance measurements within an organisation should help it to achieve its aims and objectives.
However, there is often a tendency for performance measurements to become an end in themselves,
instead of a way of helping management to achieve their goals. Managers might even take measures that
are harmful to the organisation, in order to produce good results 'on paper'.
'Perhaps performance measures, when done correctly, help everyone in the company focus on the right
things in the right place at the right time. However ... there are many stories of dysfunctional behaviour -
the telephone company which pledged to have at least 90% of payphones working, then achieving this
figure by simply removing all public payphones from those areas most often vandalised. Or the bus
operator which, plagued by delays, decided to pay bonuses to drivers who arrived at the terminus on time.

As a result, most buses arrived at the terminus on time - however, drivers no longer tended to stop for
passengers along the way!
Measuring performance by itself has no meaning. Meaning can only be achieved through comparison,
either against poor performance, which usually provides no true indication of future or competitive
position, or through benchmarking.' (Management Accounting, November 1996)

4.3 Limitations and advantages of benchmarking
Both approaches to benchmarking suffer from a number of limitations.
(a) Limitations of external benchmarking

Deciding which activities to benchmark
Identifying which organisation is the 'best in class' at an activity
Persuading that organisation to share information

Successful practices in one organisation may not transfer successfully to another.
(b) The principal limitation of internal benchmarking centres on the relevance of the other part of the
business.
The amount of resources devoted to the units may differ
There may be local differences (use of different computer hardware)
Inputs and outputs may be difficult to define.
Benchmarking works, it is claimed, for the following reasons.
(a) The comparisons are carried out by the managers who have to live with any changes implemented
as a result of the exercise.
(b) Benchmarking focuses on improvement in key areas and sets targets which are challenging but
'achievable'. What is really achievable can be discovered by examining what others have achieved:
managers are thus able to accept that they are not being asked to perform miracles.
Benchmarking can also provide early warning of competitive disadvantage (ie helps an organisation to
identify key areas where competitors are performing better) and should lead to a greater incidence of
team-working and cross-functional learning within an organisation, through joint efforts to achieve
improvements in performance standards to 'world-class' levels.
4.4 Relationship between balanced scorecard and benchmarking
The balanced scorecard and benchmarking are similar in that they both involve identifying key areas of a
business and the selection of performance measures to monitor how the areas are performing.
The balanced scorecard identifies four specific areas (financial, customer, internal and learning), whereas
benchmarking is not so prescriptive and benchmarks any areas of the business but typically customer
services, manufacturing, human resources and information systems.
Both techniques set targets against which to assess performance. The balanced scorecard will set a target
that will typically be taken from the strategic plan for the business; benchmarking will usually take the
targets either from external competitors or use comparisons from internal divisions.
One of the main differences between the two techniques is that the balanced scorecard (as its name
suggests) does not rank any performance measure as more important than another eg it does not attribute
more importance to financial measures than non-financial. The whole point of the system is the
recognition that for long term growth a business has to move forward on all fronts exceptional strength
in one area may not compensate in the long run for a serious weakness in others. For example, a strong
profit performance may not be sufficient to mask under-investment in skills training or research and
development. A company using the balanced scorecard would consider that it was failing if the scores
were unbalanced.
Benchmarking does not necessarily concern itself with balance, although the benchmarks may be
interpreted to use the balanced scorecard concept to assess overall performance.
232 13: Divisional performance measurement

1 Divisional organisation and responsibility accounting
Performance measurement may be based on a divisional reporting system, with major divisions regarded
as autonomous investment centres. (Within investment centres, there may be a hierarchy of profit centres
and cost centres).
A division is a separately identifiable unit of an organisation, and might alternatively be called a subsidiary
or a strategic business unit (SBU).
A cost centre is a production or service location, function, activity or item of equipment for which costs
are accumulated. (CIMA Official Terminology 2000)

A profit centre is a part of a business accountable for both costs and revenues.

(CIMA Official Terminology 2000)

An investment centre is a profit centre with additional responsibilities for capital investment and possibly
for financing. (CIMA Official Terminology 2000)

Responsibility accounting is a system of accounting that attributes costs and/or revenues to individual
business units for which a particular manager is held responsible.
When the manager of a division is given a reasonable amount of autonomy, with the authority to make
important decisions for the division, there should be a system of performance measurement providing a
way of:
(a) Establishing targets for the division that are consistent with the strategic targets of the organisation
as a whole
(b) Establishing budget targets for the division
(c) Measuring actual performance against those targets, and
(d) Holding the divisional management responsible and accountable for their division's performance.

Divisional
performance
measurement

13: Divisional performance measurement 233
1.1 Cost centres
If divisional managers are responsible for the costs incurred in the division, but are not responsible for
revenue-earning activities, each division may be a cost centre, and the management will then be held
responsible for the costs of the division. Performance reports might be a form of variance report.
1.2 Profit centres
If divisional managers are responsible for both the costs incurred by their division and for revenue-earning
activities, each division may be a profit centre. The management will then be held responsible for the
profits earned by the division, and performance reports might compare the actual and budgeted profits for
the division. When divisions are established as profit centres, and carry out work for other divisions within
the organisation, they will sell their products or services internally, at an internal sales price or transfer
price. Transfer pricing was explained in an earlier chapter.
1.3 Investment centres
Divisional managers might be responsible, not only for the costs of their division and the revenue-earning
activities, but also for capital expenditure decisions, inventory-holding, invoicing customers and debt
collection and materials procurement. When this is the case, performance of the division should be
measured in terms of both the profitability of the division, and also in terms of the investment of resources
in the division. Each division should be an investment centre, and management should be held
responsible for earning a sufficient return on the amount of capital invested.
When an organisation consists of several investment centres, each centre should have strategic goals that
are consistent with the overall objectives of the organisation. The performance of each investment centre
might be measured in a similar way to the measurement of performance of the organisation as a whole.
1.4 Responsibility accounting
Cost centres, profit centres and investment centres are all responsibility centre, and there may be a
hierarchy of responsibility centres within the organisation. A large company or group of companies might
consist of a number of investment centres, and within each investment centre there may be several profit
centres. Within each profit centre, there might be several cost centres. Reporting the financial
performance of a responsibility centre is known as responsibility accounting.
Divisional performance can be measured in non-financial terms, as well as financial terms. Non-financial
performance measurements have been explained earlier in this text. This chapter deals exclusively with the
financial performance measurement of investment centres, and more particularly with profitability and
return on capital.
2 Return on investment (ROI)
Return on investment is the main measure of divisional performance, but it has several limitations. The
main problem lies in the fact that ROI might be used as a guide for investment decisions, whereas it is
inappropriate to use accounting profits to make investment decisions. There is no generally agreed
method of calculating ROI.

Return on investment (ROI), also known as return on capital employed (ROCE), is generally regarded as
the key financial performance ratio, both for an organisation as a whole and for investment centres within
the organisation. The main reasons for its widespread use as a major financial objective and as a measure
of performance are as follows.
(a) It ties in directly with the accounting process, and is identifiable from the income statement and
statement of financial position of the division.
(b) Even more importantly, ROI is the only measure of performance available (apart from residual
income or EVA
) by which the return on investment for a division or company as a single entire

unit can be measured. It is not sufficient to measure the profits of an investment centre. It is also
necessary to relate the size of the profit to the amount of capital that has been invested to earn it.
The strategic financial goal of an organisation is often expressed in terms of increasing the ROI,
and it is appropriate that investment centre performance should be measured in a consistent
manner.
Return on investment (ROI) shows how much profit has been made in relation to the amount of capital
invested and is calculated as (profit capital employed) 100%.
Suppose a company has two investment centres A and B, which achieve the following results.
A B Total
$ $ $
Profit 60,000 30,000 90,000
Capital employed 400,000 120,000 520,000
ROI 15% 25% 17.3%
Investment centre A has made double the profits of investment centre B, and in terms of profits alone has
therefore been more 'successful'. However, B has achieved its profits with a much lower capital
investment, and so has earned a much higher ROI. This suggests that B has been a more successful
investment than A.
2.1 Measuring ROI
ROI can be measured in different ways.
(a) The figure for profit is usually measured as the division's profit after charging depreciation on the
non-current assets of the division.
(b) Capital employed might consist of the non-current assets of the division only. However, capital
employed might also include an amount for working capital. Working capital is generally measured
as the total of the inventories and receivables of the division, minus the division's payables.
In dealing with an examination question, you might need to check the wording of the question carefully, to
establish how ROI is measured.
2.2 Capital employed with non-current assets at net book value
The most common method of measuring ROI is 'profit after depreciation/non-current assets net of
depreciation (at 'net book value') plus working capital'. However, there is a problem with this method of
measurement. If an investment centre maintains the same annual profit, and keeps the same assets
without a policy of regular non-current asset replacement, its ROI will increase year by year as the assets
get older and their net book value declines. This can give a false impression of improving performance
over time.
For example, the results of investment centre X, with a policy of straight-line depreciation of assets over a
5-year period, might be as follows.

Year
Non-current
assets at
cost
Depreciation
in the year
Net book
value (mid
year)
Working
capital
Capital
employed Profit ROI
$'000 $'000 $'000 $'000 $'000 $'000 %
0 100 10 110
1 100 20 90 10 100 10 10
2 100 20 70 10 80 10 12.5
3 100 20 50 10 60 10 16.7
4 100 20 30 10 40 10 25
5 100 20 10 10 20 10 50
This table of figures is intended to show that an investment centre can improve its ROI year by year,
simply by allowing its non-current assets to depreciate, and there could be a disincentive to investment
centre managers to reinvest in new or replacement assets, because the centre's ROI would probably fall if
new assets were bought.

Question
Divisional ROI

A newly-established investment centre in a company has non-current assets of $460,000 which will be
depreciated to nil on a straight line basis over 10 years. Working capital will consistently be $75,000 every
year, and annual profits will be $30,000 each year, after depreciation. Capital employed is measured as
non-current assets at net book value as at the end of the year, plus working capital. ROI is measured as
return on capital employed. What is the division's ROI in year 2 and year 6?

Answer

Non-current
assets Accumulated
Non-current
assets at Working Total capital ROI
Profit at cost depreciation net book value capital employed
$'000 $'000 $'000 $'000 $'000 $'000 %
Year 2 30 460 92 368 75 443 6.8
Year 6 30 460 276 184 75 259 11.6

A further disadvantage of measuring ROI as profit divided by net assets is that it is not easy to compare
fairly the performance of different investment centres.
For example, suppose that we have two investment centres:

Investment centre P

Investment centre Q

$

$

$

$

Working capital

20,000

20,000

Non-current assets at cost

230,000

230,000

Accumulated depreciation

170,000

10,000

Net book value

60,000

220,000

Capital employed

80,000

240,000

Profit

$24,000

$24,000

ROI

30%

10%

Investment centres P and Q have the same amount of working capital, the same value of non-current
assets at cost, and the same profit. But P's non-current assets have been depreciated by a much bigger
amount (presumably P's non-current assets are much older than Q's) and so P's ROI is three times the
size of Q's ROI. The conclusion might be that P has performed much better than Q. This comparison,
however, would not be 'fair', because the difference in performance might be entirely attributable to the
age of their non-current assets.
The arguments in favour of using net book values for calculating ROI are these.
(a) It is the 'normally accepted' method of calculating ROI.
(b) In reality firms are continually buying new non-current assets to replace old ones that wear out,
and so on the whole, the total net book value of all non-current assets together will remain fairly
constant (assuming nil inflation and nil growth).
2.3 Capital employed with non-current assets at cost
Capital employed might be measured as non-current assets at cost (or at current value) plus working
capital. ROI would then be measured as a return on gross assets. This would remove the problem of ROI
increasing over time as non-current assets get older.
If a company acquired a non-current asset costing $40,000, which it intends to depreciate by $10,000 p.a.
for 4 years, and if the asset earns a profit of $8,000 p.a. after depreciation, ROI might be calculated on the
basis of either net book values or gross values, as follows.

Year

Profit
Net book value
(mid-year value)
ROI based on
NBV

Gross value
ROI based on
gross value
$ $ % $ %
1 8,000 35,000 22.9 40,000 20
2 8,000 25,000 32.0 40,000 20
3 8,000 15,000 53.3 40,000 20
4 8,000 5,000 160.0 40,000 20
The ROI based on net book value shows an increasing trend over time, simply because the asset's value is
falling as it is depreciated. The ROI based on gross book value suggests that the asset has performed
consistently in each of the 4 years, which is probably a more valid conclusion.

Question
ROI on gross assets

Repeat the last question (Divisional ROI), measuring ROI as return on gross assets.

Answer

Profit
Non-current
assets at cost Working capital Total capital employed ROI
$'000 $'000 $'000 $'000 %
Year 2 30 460 75 535 5.6
Year 6 30 460 75 535 5.6

However, valuing non-current assets at cost to measure ROI has its disadvantages. Most important of
these is that measuring ROI as 'return on gross assets' ignores the age factor, and does not distinguish
between old and new assets.
(a) Older non-current assets usually cost more to repair and maintain. An investment centre with old
assets may therefore have its profitability reduced by repair costs, and its ROI might fall over time
as its assets get older and repair costs get bigger.
(b) Inflation and technological change alter the cost of non-current assets. If one investment centre
has non-current assets bought ten years ago with a gross cost of $1 million, and another
investment centre, in the same area of business operations, has non-current assets bought very
recently for $1 million, the quantity and technological character of the non-current assets of the
two investment centres are likely to be very different.

3 ROI and decision making
3.1 New investment
If investment centre performance is judged by ROI, we should expect that the manager of an investment
centre will probably decide to undertake new capital investments only if these new investments are likely
to increase the ROI of his or her division.
Suppose that investment centre A currently makes a return of 40% on capital employed. The manager of
centre A would probably only want to undertake new investments that promise to yield a return of 40% or
more, otherwise the investment centre's overall ROI would fall. For example, if investment centre A
currently has assets of $1,000,000 and expects to earn a profit of $400,000, how would the centre's
manager view a new capital investment which would cost $250,000 and yield a profit of $75,000 pa?
Without the new investment With the new investment
Profit $400,000 $475,000
Capital employed $1,000,000 $1,250,000
ROI 40% 38%
The new investment would reduce the investment centre's ROI from 40% to 38%, and so the manager
would probably decide not to undertake the new investment.
If the group of companies of which investment centre A is a part has a target ROI of, say, 25%, the new
investment would presumably be seen as beneficial for the group as a whole. But even though it promises
to yield a return of 75,000/250,000 = 30%, which is above the group's target ROI, it would still make
investment centre A's results look worse. The manager of investment centre A, in these circumstances,
might be motivated to do not what is best for the organisation as a whole, but what is best for his or her
division.
3.2 Using a target ROI
If a group sets a target return for the group as a whole, it might be group policy that investment projects
should only go ahead if they promise to earn at least the target return.
For example, it might be a company's policy that:
(a) There should be no new investment by any investment centre unless it is expected to earn at least
a 15% return
(b) Similarly, no non-current asset should be disposed of if the asset is currently earning a return in
excess of 15% of its disposal value
(c) Investments which promise a return of 15% or more ought to be undertaken (provided that the
degree of uncertainty or risk in the project is acceptable)
A problem with such a policy is that even if investment decisions are based on a target rate of return over
the life of the investment, actual performance would be measured each year on the basis of the ROI for
that year. Since investments often take some time before they start earning a return, there might be a fall
in ROI in the short term, that the investment centre manager might be reluctant to tolerate. New
investments might therefore be rejected because of their short-term impact on divisional profits and ROI.
Suppose that an investment in a non-current asset would cost $100,000 and make a profit of $10,000 p.a.
after depreciation. The asset would be depreciated by $25,000 p.a. for four years. It is group policy that
investments must show a minimum average annual ROI of 15% over their life. Capital employed is taken
as non-current assets at their net book value as at the middle of the year. The average annual ROI of this
investment would exceed 15%, and so the investment ought to be approved if group policy is adhered to.
In the table below, the accumulated depreciation starts as $12,500 in year 1, which is one half of the
annual depreciation charge. Accumulated depreciation then rises by $25,000 each year.
Profit
Non-current
assets at cost
Accumulated
depreciation
Non-current
assets at net
book value ROI
$'000 $'000 $'000 $'000 %
Year 1 10 100 12.5 87.5 11.4
Year 2 10 100 37.5 62.5 16.0
Year 3 10 100 62.5 37.5 26.7
Year 4 10 100 87.5 12.5 80.0
Average 10 50.0 20.0
In view of the low accounting ROI in year 1 and year 2, the investment centre manager might decide not to
undertake the investment, even though in the longer term it would appear to be worthwhile.
(a) Strictly speaking, investment decisions should be based on a discounted cash flow (DCF)
evaluation, and should not be guided by short-term accounting ROI.
(b) Even if accounting ROI is used as a guideline for investment decisions, ROI should be looked at
over the full life of the investment, not just in the short term. In the short term (in the first year or
so of a project's life) the accounting ROI is likely to be low because the net book value of the asset
will still be high.
3.3 Example: ROI and decision making
At the end of 20X3, Division S (part of a group) had non-current assets with a cost of $300,000, net
current assets (working capital) of $40,000 and net profit of $64,000.
The non-current assets of Division S consist of five separate items, each costing $60,000. Each of these
assets is being depreciated over five years on a straight-line basis. For each of the past years on 31
December, the division has bought a replacement for an asset that has just been withdrawn from service,
and it proposes to continue this policy. Because of technological advances the asset manufacturer has
been able to keep his prices constant over time. The company's target ROI is 15%. Capital employed is
measured as non-current assets at net book value as at the end of the year, plus net current assets.
Required
Division S has the opportunity of an investment costing $60,000, and yielding an annual profit of $10,000
after depreciation. This will be depreciated over four years. Calculate its new ROI if the investment is
undertaken, and on the basis of ROI, state whether you think the division's manager will undertake the
investment.
Solution
The gross cost of the five existing non-current asset items is 5 $60,000 = $300,000.

$

Net book value of asset just bought on 31.12.X3

60,000

NBV of asset bought 1 year earlier

48,000

NBV of asset bought 2 years earlier

36,000


24,000


12,000

NBV of all 5 non-current assets at 31.12.X3

180,000

Net current assets

40,000

Total capital employed, Division S

220,000

The existing ROI is ((64/220) 100% =) 29.1%. This is presumably the typical ROI achieved each year
under the current policy of asset replacement.

The ROI with the new investment is as follows.

Non-current
assets

Accumulated
Non-current
assets at

Working
Total
capital

Profit at cost depreciation net book value capital employed ROI
$'000 $'000 $'000 $'000 $'000 $'000 %
Year 1 74 360 132 228 40 268 27.6
Year 2 74 360 144 216 40 256 28.9
Year 3 74 360 156 204 40 244 30.3
Year 4 74 360 168 192 40 232 31.9
Year 5 74 360 180 180 40 220 33.6
Average 74 244 30.3
The accumulated depreciation is $180,000 each year, for the existing five items that are replaced on a five-
year cycle. The accumulated depreciation on the new item would be $12,000 in year 1, rising to $60,000 in
year 5. (Net book value is measured as at the end of the year.)
If the investment centre manager based the investment decisions on whether an investment would
increase or reduce the division's ROI, he or she might not want to make the additional investment. This is
because the division's ROI would fall in the first two years. Over the life of the new investment, however,
the divisional ROI would increase. If the investment centre manager takes a longer-term view, he or she
might decide to undertake the investment.
This example illustrates the weakness of ROI as a guide to investment decisions. An investment centre
manager might want an investment to show a good ROI from year 1, when the new investment has a high
net book value. In the case of Division S, the average net book value of the asset over its full life will be
50% of $60,000 = $30,000, and so the average ROI on the investment over time will be
($10,000/$30,000) 100% = 33.3%. However, the Division S manager might not want to wait so long to
earn a good ROI, and wants to protect the division's performance in the short run as well as the long run.
4 Residual income
Residual income is an alternative measure of divisional performance. Divisions are charged a notional
interest cost. Residual income is accounting profit minus the notional interest charge.
An alternative way of measuring the performance of an investment centre, instead of using ROI, is residual
income (RI).
Residual income is a measure of a division's profits after deducting a notional or imputed interest cost.
This interest charge is a cost of the capital invested in the division.
The divisional profit is after deducting depreciation on capital equipment.
The imputed cost of capital might be the organisation's cost of borrowing, a target rate of return on
shareholders' capital, or an average cost of the company's various sources of finance (a 'weighted
average cost of capital').
4.1 Example: residual income
A division with capital employed of $400,000 currently earns an ROI of 22%. It can make an additional
investment of $50,000 with a 5-year life, after which the investment would have no value. The annual
profit from this investment would be $12,000 after depreciation. The division's cost of capital is 14%.
Calculate the residual income before and after the investment.

Solution

Before investment

After investment

$

$

Divisional profit

88,000

100,000

Imputed interest (400,000 0.14)

56,000

(450,000 0.14)

63,000

Residual income

32,000

37,000

On the basis of residual income, the divisional manager would undertake the investment because it would
increase the residual income of the division. Residual income will rise because the additional profit before
interest exceeds the additional interest cost.
4.2 Comparison of residual income and ROI
A characteristic of residual income as a measure of divisional performance is that, in contrast to ROI, it is
more likely to motivate management to undertake new investments.
The advantages of using RI are as follows.
(a) Residual income will increase when investments earning above the cost of capital are undertaken
and when investments earning below the cost of capital are eliminated.
(b) Residual income is more flexible since a different cost of capital can be applied to investments
with different risk characteristics. A higher cost of capital can be charged for higher-risk
investments.
The main weaknesses of residual income are that:
(a) It does not facilitate comparisons between investment centres, and
(b) It does not relate the size of a centre's income to the size of the investment.
4.3 RI versus ROI: marginally profitable investments
Residual income will increase if a new investment is undertaken which earns a profit in excess of the
imputed interest charge on the value of the asset acquired. Residual income will go up even if the
investment only just exceeds the imputed interest charge, and this means that 'marginally profitable'
investments are likely to be undertaken by the investment centre manager.
In contrast, when a manager is judged by ROI, a marginally profitable investment would be less likely to
be undertaken because it would reduce the average ROI earned by the centre as a whole, at least in the
short term.
4.4 Example: residual income and decision making
In the example in Paragraph 3.3, whereas ROI would have worsened with the new investment opportunity
in the short term, residual income would have increased. Whereas the division's manager might reject the
investment if the division's performance were judged on ROI, he or she would undertake the investment if
performance were judged on residual income.
Division S

Without new

investment

Investment

With new
investment

$

$

$

Profit before notional interest

64,000

10,000

74,000

Notional interest (15% of 340,000)

51,000

9,000*

60,000

13,000

1,000

14,000

* 15% of $60,000
The investment would add $1,000 each year to residual income, and so would probably be undertaken.

Residual income does not always point to the right investment decision, because the true investment yield
on an investment is not measured by charging notional interest on accounting capital employed. (In
practice, new investment decisions ought to be taken on the basis of a discounted cash flow analysis.)
However, residual income is more likely than ROI to improve when managers make correct investment
decisions, and so is probably a 'safer' basis than ROI on which to measure performance.

Question
ROI and RI

Brampton evaluates its divisions using Return on Investment (ROI) and Residual Income (RI) measures.
In the year to 31 March 20X4 the Pickle division earned profit before interest and tax of $8.64m, paid
interest of $1.44m and had net assets of $57.6m at the year end. Brampton uses a cost of capital of 16%
to evaluate Pickle's activities.
What are the ROI and RI measures for the Pickle division for the year ended 31 March 20X4?

Answer

ROI = $8.64m/$57.6m 100% = 15%
RI = $8.64m ($57.6m 16%) = $0.576m
5 Economic value added (EVA
)
EVA
(economic value added) is a measure of performance similar to residual income, but it attempts to
measure economic profit, and to make a charge for the economic value of capital consumed. In practice, it
is calculated by making adjustments to accounting profit and accounting asset values. It has been claimed
that there is a strong correlation between EVA and changes in shareholder value (market value added).
Another measure of divisional performance, similar to residual income, is economic value added or EVA
.
It was developed by the US management consultancy, Stern Stewart.
Economic Value Added (EVA) is a measure of the degree to which a business or business unit has
added economic value to the organisation as a whole. It can be defined as
EVA = Adjusted operating profits after tax (adjusted invested capital WACC)
where the adjustments to profits and capital are made to properly reflect the extent to which transactions
in the period have helped to build value, without the constraints of accounting standards and principles.
The underlying concept is that the performance of a company as a whole, as well as investment centres
within a company, should be measured on the basis of whether the company or investment centre has
added to the economic value of the business during the period under review.
The measurement of EVA
is conceptually quite straightforward. In order to add to the economic value, an

organisation must deliver more net operating profit after tax ('NOPAT') than it costs to have access to the
total amount of capital that has been used to generate the profit.
EVA
= NOPAT minus Capital charge

The similarity between EVA
and residual income should be immediately apparent. The key difference

between EVA
and residual income is that:

(a) Residual income is calculated by taking the accounting profit for a period, and subtracting a
notional interest charge based on the accounting value of the assets employed, whereas

(b) Economic value added is calculated by taking the economic profit for a period, and subtracting a
capital charge based on the economic value of the assets employed.
5.1 Why is economic value added better than accounting profit or
residual income?
Stern Stewart have argued that when an organisation adds to its economic value, it should also add to its
total market value. EVA
is therefore closely connected to changes in shareholder value.

Stern Stewart have reinforced this argument by claiming that between 60% and 85% of the changes
affecting the market value of a business are explained by the EVA
for the period.

EVA
is a better measure of divisional and company performance than profits or residual income, because
of this close correlation between EVA
and changes in shareholder value. EVA
, it is argued, provides a
basis for measuring performance that is much more closely linked than accounting profits to the strategic
objectives of a company. It shows whether an organisation has been adding to shareholder value in the
period under review, or destroying it.
5.2 Measuring EVA

The complexities of EVA
lie in the calculation of economic profit and the economic value of assets. The
detailed methodology is beyond the scope of the examination syllabus, but it may be helpful to understand
it in outline.
The calculation of economic profit and economic value of assets is made by converting accounting profit
and accounting asset valuations. Stern Stewart make a large number of adjustments to accounting figures.
(a) Depreciation of non-current assets is deducted in arriving at NOPAT. This is because the
accounting charge for depreciation is used as a proxy for economic depreciation, which is the fall
in the economic value of a non-current asset during the period. Using the accounting charge for
depreciation saves the time and expense of revaluing non-current assets to their current economic
value each year, in order to calculate the loss in their economic value since the previous year.
Therefore the accounting figure for depreciation is still deducted.
(b) Accounting profits are based on the accruals concept of accounting, whereas EVA
is based on
cash flow principles. Adjustments are made to convert accounting profit based on the accruals
concept into cash operating profits.
(c) Where a company has written off goodwill in its accounts, the goodwill must be added back to the
economic value of its assets. Goodwill, although an intangible item, is a valuable asset that has
usually been paid for.
(d) Any spending by the company on research and development should not be charged in full against
profits in the year it is incurred. Instead, it should be capitalised (ie treated as a non-current asset
item) and amortised or depreciated over (its anticipated useful life lets say) five years. The effect of
this is that the whole R&D cost is capitalised and therefore added back to profit and then
1
/
5
of the
capitalised amount is written off and deducted from profit for 5 years.
(e) All leases must also be capitalised and amortised over the lease period. The effect of this is the
same as for R&D above.
(f) Other adjustments may be necessary, and these will vary according to the industry in which the
company or division operates, and the specific circumstances of the case.

5.3 NOPAT
Net operating profit after tax is calculated, broadly speaking, as follows:

$

Net operating profit before tax for the period, as reported in the accounts

X

Adjustments to convert from accruals-based profit to operating cash flows ((b) above)

X

Add back Any purchased goodwill written off in the accounts ((c) above)

X

Any R & D expenditure (which is capitalised per (d) above)

X

Any lease expenditure charged against profits

(which is capitalised per (e) above)

X

Subtract Amortisation of R & D and leases (the amounts capitalised and added back

above are amortised over 5 years per (d) and (e) above)

(X)

Taxation on operating profits

(X)

Equals NOPAT

X

5.4 Capital invested
The economic value of assets employed is calculated, broadly speaking, as follows.

$

Total assets, as reported in the accounts (in the statement of financial position)

X

Subtract Non-interest bearing liabilities, such as trade payables, and taxation payable

(X)

Add The economic value (net book value) of capitalised R & D expenditure

X

The economic value (net book value) of capitalised lease expenditure

X

Cumulative amortised goodwill (per (c) above)

X

Any receivables allowance (since the economic value of receivables is

their gross value, before deduction of any receivables allowance)

X

Equals Capital invested

X

Note. The 'economic value (net book value)' of R&D and lease expenditure is the capitalised amount that
has been added back in calculating NOPAT less the cumulative amount that has been written off each year.
Thus assume $50,000 of R&D was incurred on 1 January 20X7 and had been written off in the financial
accounts on 31 December 20X7. If we are calculating economic value two years later at 31 December
20X9, the value will be ($50,000 (3 $10,000)) = $20,000 (ie the capitalised amount less three years'
amortisation).
5.5 Cost of capital
The cost of capital to apply to the capital invested should be a cost that reflects the weighted average cost
of the organisation's shareholder capital and debt capital. For example, suppose that a company is 75%
financed by share capital and 25% by debt capital. If the cost of its share capital is 14% and the after-tax
cost of its debt capital is 8%, the weighted average cost of capital (WACC) to apply for the calculation of
EVA
is (75% of 14%) + (25% of 8%) = 12.5%.

5.6 Calculating EVA
example
A division has a capital value, measured by EVA
techniques, of $400 million. Net operating profit after tax

has been measured as $57 million for the year. The cost of capital for the division is 12%.
EVA
= $57 million - (12% of $400 million) = $9 million.

Question EVA

The Greenway Division's financial statements to 31 March 20X4 show a profit before tax of $56.4m.
During the year, Greenway had incurred $12.6m costs in developing a new product, which is to be
launched in the following year, with an expected market life of three years. These costs had been written
off in full against the profits for the year. Taxation for the year is $17.2m. Greenway's statement of
financial position shows net assets of $184m, with trade, taxation and other such payables standing at
$32.5m, and receivables of $42.5m, after a provision for doubtful debts of $8.5m. Greenway has a loan of
$10m upon which they are paying interest at 6.5% pa; the division's risk adjusted cost of capital is 13%.
Compute Greenway Division's EVA
as far as the information given will allow, ignoring the effects of

taxation on adjustments made.

Answer

NOPAT = 56.4 + 12.6 (12.6/3 + 17.2) = $47.6m
Capital invested = $184m + $10m + $(12.6 12.6/3)m + $8.5m = $210.9m
(note that you are given net assets, thus we just need to add back the loan capital; the other payables are
already deducted)
EVA
= $47.6m 13% $210.9m = $20.18m

5.7 Uses of EVA

EVA
can be used:
(a) To set targets for divisional and corporate performance
(b) To measure actual performance
(c) For investment decision-making. EVA
provides a clear benchmark for evaluating the effectiveness

of capital investments.
Other 'EVA
projects' might include:

(a) Identifying products and services that create a high level of EVA

(b) Giving greater emphasis to customer orders for high EVA
products
(c) Reducing excess capital that is not creating sufficient value to justify its cost; for example, reducing
plant and machinery, floor space or working capital
(d) Eliminating all activities that are not contributing to the fulfilment of customer orders.
5.8 Implementing EVA
the problems and solutions

There are four steps to implementing an EVA
system.
The first step is to develop a commitment among the managers to the EVA
process. The managers must

understand the theory of EVA
and how it works in practice.

The second step is to identify the centres in the business for which individual EVAs
will be calculated and

calculate the cost of capital that is applicable.
The third step is to develop remuneration packages for the employees that are based on the EVA
concept
so that managers are rewarded in the same way that the shareholders are rewarded if the companys
share price increases because of the increased EVA
then both managers and shareholders reap the

benefit.
The fourth step is to train the whole workforce in the EVA
technique.
The main problem of implementation is not the complexity of the process (because it is relatively
straightforward and driven by software programs that assist the decision making process). The main
problems are the time it takes to implement through the whole business (which can be reduced by using
specialist consultants) and perhaps more seriously, the culture change needed to persuade the workforce
to operate in the new way.
The required change in culture can be facilitated by the use of consultants to help explain the systems and
motivate the workforce, but management cannot simply offload their responsibility for managing the

changes to consultants and look the other way. Change management is one of the most important
responsibilities of today's executive managers.
Academics have developed models of change to assist managers in managing the process of change and
combating the resistance to change exhibited by many employees. For example, Kurt Lewin suggested a
three-stage process of change implementation:
(a) Unfreeze create the motivation to change. If there is currently no motivation, it must be induced,
for example by educating stakeholders of the benefits of the change.
(b) Change once the resisting forces have been minimised, the change can be implemented, either
by a process of rational persuasion or forced by the use of legitimate authority.
(c) Refreeze the new mindset must be crystallised across all participants, who must accept the new
practices as routine.
Lewin's three-stage model of change can be used to assist the effective implementation of any change
within an organisation; in considering Lewin's model in the possible adoption of the EVA

concept,
managers can identify their responsibilities at each stage of the change process, and only then turn to
external consultants for additional assistance if they wish.
5.9 EVA
: conclusion
The main benefits claimed for EVA
are:
(a) It is a measure of performance closely linked to changes in shareholder value (market value added)
during a period. As such, it is a better measure of performance than accounting profits or
accounting return on capital.
(b) It can be applied to the entire operating performance of a business, and at an investment centre
level as well as at the company level.
(c) Like accounting return, it can be tracked over clearly-defined time periods.
(d) It is easily understood by non-accountants.
EVA
should not be used in isolation, but should complement other performance measurement
techniques.

6 Accounting profit and controllable profit
It was suggested, in the description of EVA
above, that accounting profit has certain weaknesses as a

method of measuring performance. Specifically, there is no obvious link between annual profits and
increases in shareholder value. It might therefore be unrealistic for an organisation to achieve its strategic
objective of increasing shareholder value by setting targets based on accounting profits or return.
The great value of accounting profit, however, is that it is regularly measured by an organisation's
accounting system, and performance reports can encourage managers to improve their performance, by
cutting costs, improving efficiency, increasing revenues, switching resources from less profitable to more
profitable items and controlling investment.
A system of responsibility accounting will not be effective, however, if managers are held accountable and
responsible for costs that they cannot control. Performance reporting systems should ideally distinguish
between controllable and uncontrollable costs.
Controllable costs are items of expenditure that the manager can affect by decisions of his or her own
making. Uncontrollable costs are expenses that the manager can do nothing about, possibly because
another manager has control over them.
The significance of the distinction between controllable and uncontrollable costs is that:
(a) Divisional managers are often rewarded on the basis of the performance of their division.
(b) They will therefore normally be motivated to do what they can to improve performance.
(c) However, if they are unable to improve performance for reasons outside their control, they are
likely to feel hard done by.
(d) Giving recognition to controllable costs, profits and returns should provide a better incentive to
divisional managers, as well as providing a more realistic assessment of performance.
7 Measuring divisional performance by cash flows
Divisional performance can also be measured in terms of operating cash flows, or possibly in terms of
operating cash flows minus net capital expenditure. An alternative measure based on cash flows is cash
flow return on investment (CFROI), which should exceed the company's cost of capital.
Accounting profits earned by a division are not the same as the cash earned by the division from its
operations. This is largely because:
(a) Accounting profits are calculated using the matching concept or accruals concept of accounting
(b) Some accounting costs, notably non-current asset depreciation, do not affect cash flows
(c) Some cash flows for a division, such as capital expenditures, are not expenses in the income
statement
It has been argued that the performance of a division would be better measured on the basis of cash
flows, rather than accounting profit.
7.1 Cash flow return on investment (CFROI)
Cash flow return on investment (CFROI) is a measure of performance devised by the Boston Consulting
Group. It is a measure of the sustainable cash flow that a company (or a division) generates from its
operations, expressed as a percentage of the cash invested in the assets of the business or division.
Cash flows are operational cash flows, before deducting cash spent on capital expenditures. CFROI should
therefore be expected to exceed the company's cost of capital.

247 14: Performance in operations and production management

1 Key elements of operations management
Operations management is the management of procurement, production, logistics, quality and related
aspects of business operations.
Operations management is a general term for managing the operations within a manufacturing
organisation. Some operations management concepts can be applied to non-manufacturing organisations.
The focus of operations management is on how to achieve standards of performance that will enable the
company to succeed in highly-competitive global markets.
The main elements of operations management should be familiar to you.
(a) Procurement. An organisation buys many products and services from other suppliers.
Procurement involves processing procurement orders, placing orders with suppliers and (if
necessary) chasing up late deliveries. There have been significant developments in recent years in
procurement over the internet ('e-commerce' or 'e-procurement'), with large reductions in the
amount of paperwork needed to place orders.
(b) Production. Production management is concerned with how items are produced. An objective of
production management should be to produce items more quickly and more cheaply, and to a
higher quality. Flexibility in production methods, for example customising products to customer
specifications, might also be an important objective.
(c) Logistics. Logistics is concerned with transportation and warehousing. Items purchased from
suppliers have to be delivered to the buyer's premises and stored. Finished output might have to be
held in a warehouse until it is delivered to a customer, and then delivered to the customer. The aim
of logistics management should be to achieve a cost-efficient and reliable way of transporting and
storing purchased items and finished goods.
(d) Quality management. Quality is not just a production issue. Quality issues arise in procurement
and logistics operations. The aim of quality management is to improve the quality of operations
and production, both as a way of increasing customer satisfaction and reducing costs.

Performance in
operations and
production
management

14: Performance in operations and production management 248
2 Operational structures and process-based structures
Traditionally, operations within a manufacturing organisation have been organised on a functional basis,
with a separate department for each major operational function. For example, there might be separate
departments in a factory for making metal products, for machining, grinding, assembly and finishing. In
an old-fashioned factory for making towels, there might have been departments for carding, dyeing,
spinning, weaving and warehousing. Within an operational or functional structure, every product
manufactured by the company goes through every department, and emerges as a finished product at the
end of all the processes.
There are different types of manufacturing process.
(a) Project processes are production processes that usually deal with discrete, customised orders.
The time to complete individual projects can be long, and the work is characterised by low volume
and high variety. Examples of project processes include construction projects and the making of a
film.
(b) Jobbing processes also deal with low-volume and high-variety work. Jobs are essentially small
projects. However, whereas in project processes, each individual project has its own dedicated
resources, for example its own labour force and its own equipment, in jobbing processes, different
jobs share the same resources.
(c) A batch process is one in which products are made several at a time, in discrete batches, but are
not made continuously.
(d) Mass processes produce goods of a fairly standard type in large volumes. Some variations in
product design are possible: for example, car production is a mass process, but it allows for cars
to have different colours of paint and other differing features.
(e) Continuous processes are an extreme form of mass production, in which the volumes of output
are larger than in mass production, and product variety is less. Typically, output is in an endless,
continuing flow, and the process is highly capital-intensive. Examples of continuous processes
might be chemicals production and baked beans manufacture.
The most efficient methods of managing production are likely to vary according to the process type.
3 World-class manufacturing and the re-design of
operations
To be a world class manufacturing business, many companies have re-organised their operations,
perhaps based on focus factories, work flow production or customising orders.
Operations management strategy for a company might be to become a 'lean' manufacturer. Lean
manufacturing is based on flow production, continuous improvement, the elimination of waste, inventory
reduction, work cells etc.
World class manufacturing is a position of international manufacturing excellence, achieved by
developing a culture based on factors such as continuous improvement, problem prevention, zero defect
tolerance, customer-driven JIT-based production and total quality management.
(CIMA Official Terminology 2000).
The general term 'world class manufacturing' refers to manufacturing systems that achieve a high level of
performance, allowing the manufacturer to compete on a global stage against rival producers. It is also
associated with changes to manufacturing methods, away from traditional mass production and batch
production systems.
There are a number of production concepts, many of them closely related and compatible with each other.
Some are described below.

3.1 Focus factories
A focus factory can be defined as a collection, within a large manufacturing plant, of a group of people and
machines dedicated to the production and assembly of a specific product, often for a specific customer.
Each focus factory has its own management team, which is responsible for output and performance.
In 'traditional' manufacturing systems, all the items produced within a single plant go through the same
production departments. Each department deals with one stage in the overall production process (for
example, machining, assembly, finishing). Production is often carried out in large batches, so that at each
stage in the overall process, there are batches of part-finished items waiting to go into the next process. In
practice, production delays occur regularly, and as a result, the overall production process is often slow,
and the quantities and cost of part-finished work in process scattered around the factory floor is very
high. Since items are produced in batches, some items are made in expectation of demand that does not
yet exist, so that finished goods go into storage in a warehouse until a customer order materialises.
With focus factories, the manufacturing plant is divided into smaller units (known as focus factories) and
each unit concentrates on the manufacture of a single product or product line, replacing the large all-
purpose production departments. The entire production of an item goes through its focus factory, with the
work carried out by 'work cells'.
Experience has shown that a focus factory based arrangement can lead to very large reductions in work-
in-process, thereby saving inventory holding costs, including the interest cost of the working capital
investment in the WIP.
3.2 Flow production
With traditional manufacturing, the emphasis is on making efficient use of plant and machinery. With flow
production, the emphasis is on the responsiveness of the manufacturer to customer orders.
Flow manufacturing is a production methodology aimed at achieving fast response to customer demand,
by pulling items from suppliers and taking it through a synchronised manufacturing process to make the
item the customer has asked for. The terms one-piece flow and continuous flow manufacturing are also
used.
One-piece flow means a flow of work one unit at a time through production, at a pace determined by the
needs of customers and without the need for building up inventories of part-finished items at each stage in
the production process.
Continuous flow manufacturing is similar to flow manufacturing, but refers to a manufacturing
philosophy that is demand led such that its proponents talk of the manufacturing process being part of the
demand chain rather than the supply chain.
The entire manufacturing operation is reconfigured and based on customer requirements. Rather than
manufacturing quantities of products that are then pushed into the marketplace, the manufacturing
process is pulled by the customers requirements. Computer systems are in place to receive customer
needs and organise the supply from external suppliers of the parts needed and also organise the
companys manufacturing cells to produce the required parts and final goods. The system is a mixture of
JIT and Kanban systems, with zero inventories and the customer as the ultimate pull that initiates the
production process.
3.3 Work cell production
Work cell production has similarities to focus factories. With this type of production, the factory is divided
into a number of different work cells or units.

A work cell is a group of equipment or workstations within the same small area of the factory floor,
arranged in processing sequence. Each work cell is capable of making one or more products with similar
characteristics, and is designed to support a smooth flow of production with minimal transportation of
part-finished items and minimal delays. The team in the work cell has the entire production process under
its control.
By putting into a work cell the employees and equipment needed to make similar products, it is possible to
obtain some of the benefits of flow manufacturing (one-piece flow) faster production, simpler
production scheduling, reduced set-up times and lower inventories of work in progress.
Within a work cell, the machines and other equipment are operated by multi-skilled workers. Each person
can work on any of the machines, and does not specialise in just one type. This allows for much greater
flexibility than in traditional manufacturing systems, where each type of machine has its own specialist
handlers.
Work cell production also makes possible high variety production, because it is a flexible and adaptable
system of working. Members of the team are all in the same small area of the factory floor, and so can
communicate easily. This allows them to adapt readily to variations in customer specifications, so that the
production system is capable of customising orders. An ability to customise orders has become an
essential factor for success in many product markets.
3.4 Flexible manufacturing systems
The reorganisation of manufacturing processes into smaller units focus factories and work cells can
be accompanied by a high degree of computerisation. A flexible manufacturing system (FMS) is a cluster
of machine tools, a robot to change the work pieces and a system of conveyor belts that shuttle them from
one tool to another, all controlled by computers.
The system gets its name from its flexibility in being able to be programmed to produce a number of
different ranges of machined parts, and to switch from one to another quickly and economically.
In addition to this flexibility, the other main benefits to be derived from such a system include:
(a) The ability to continuously repeat the same operations to the same accuracy and quality
(b) Reduced lead times from design to marketing
(c) Reduced labour costs
(d) Production stability even in the case of disruption, eg due to machine breakdown, as the unit can
be reprogrammed to adapt to changes in work scheduling
3.5 Empowered work teams
The changes in operational process organisation and technology that modern manufacturing systems
bring, along with a changing workforce profile, have led many businesses to consider moving from a
traditional hierarchical management structure to a team-based organisation. Empowered work teams are
groups of employees who work together to achieve a particular task or set of tasks, who will often interact
with other groups to achieve the overall business plan.
Being competitive in a marketplace that values quality, flexibility and response times requires
manufacturers to hire or develop employees who can demonstrate these same characteristics. It's no
longer possible to take people off the street, train them in half an hour and expect them to make a profit,
as it was in the days of mass production. Employees must be able to measure and manage the quality of
their jobs to very high standards, be able to switch flexibly from one task or product to another, and to
assist in product and process innovations that can keep their business at the cutting edge. And in addition
to these high skill levels, the employee must also be able to interact and share information in a time
efficient manner, as they will be operating in one area of the business that will be interdependent with
others. Such communication is facilitated by the use of specialised work teams.
An additional motivator towards the team-based approach is the changing nature of today's workforce.
Over the last forty years or so, the proportions of women and older people in the workplace have
increased, bringing increased demand for more flexible working structures flexi-time, job shares, career
breaks etc. This requires employees to be able to support and fill in for each other, a need best fulfilled by
the use of work teams. The workforce is also growing more slowly than in the past, which makes hiring
new staff more difficult. New skills therefore need to be acquired by re-training existing employees, with
cross training to provide flexibility. This is also best accomplished within a team environment.
The particular structure and characteristics of the teams will be dictated by the particular ends they are
designed to achieve, with the underlying principle that a team should be organised in a way that will
maximise its chances of goal attainment.
For example, task forces are teams that are organised as cross-functional units. They may come together
around a single project, issue or problem, and disappear once the project has ended. Work teams are
teams whose members rely on each other every day to meet production schedules.
Whatever their format, teams need some kind of organisation a charter to determine their roles and
limits of responsibilities.
For example, it might be considered business sense to delegate the daily production scheduling
responsibility to a work team to free up a manager for more important tasks.
When setting the charter, consideration must be made of the extent to which team members can, for
example, rotate jobs, manage suppliers, redesign workflow, monitor quality, deal with substandard
performance, remove team members etc.

Question
Discussion of problems

Briefly discuss any problems you think may arise when empowered work teams are first introduced to a
previously hierarchical management structure.

Answer

The key advantage offered by work teams is increased flexibility from the ability of each team's members
to do a wide range of tasks and to swap tasks between each other as needed. This will require the ability
and willingness on the part of the employees to undertake extensive retraining and be prepared to move
from one task to another at short notice. Not all employees will be receptive to this, others will simply not
be able to cope with the demands, and there is bound to be a significant degree of staff turnover in the
early days.
In addition, front-line managers will find their traditional role subsumed within the work team, which will
take over many of his/her previous responsibilities and decisions. This is likely to lead to redundancies for
some and a radical change of role for others. Care must be taken to address this issue, with a clear
definition of the new role of such managers in managing teams rather than individuals, or valuable
managerial experience may be lost.

3.6 Lean manufacturing
The concept of lean manufacturing began in Japan after 1945, with a number of companies (notably
Toyota) and subsequently found its way into the US. 'Lean' means using less human effort, a smaller

investment of capital, less floor space, fewer materials and less time in production. Lean manufacturing
also has a customer-oriented focus, concentrating on the production and delivery of items that a customer
has asked for, rather than on large-scale batch production of standard items.
It applies a systematic approach to identifying and eliminating waste in production. Waste is any activity
that does not add value for the customer, and costs more to perform than the value of any benefit it
provides.
Two aspects of lean manufacturing are:
(a) Achieving a flow of production in response to the demands of customers, and
(b) An embedded process of continuous improvement in manufacturing (known in Japanese as
'kaizen'), in search of 'perfection'.
At the centre of lean production is an attack on waste. Several categories of waste can be identified.
(a) Over-production creates waste. Over-production means making more of an item than there is
demand from customers. If the demand never materialises, the items will have to be discarded, or
possibly sold at a heavily-discounted price. Even when the items are eventually sold, there will be a
period of time during which they are held as inventory, for which there is a holding cost. Holding
inventories of any kind is unnecessarily wasteful because it has a cost but adds no value.
(b) Part-finished work-in-process is also wasteful. This is work going through the production process,
that has completed one stage of the overall process and is waiting to be taken through the next
stage. Work-in-process tends to build up when production processes have a long lead time, so
there can be a long delay for production items between completion of one process and starting the
next.
(c) The transportation of material items does not add value. Any form of motion is waste, whether it
involves the movement of people, materials, part-finished items or finished goods. The reduction of
movement is one of the concepts underlying work cell production.
(d) There is often waste in the production process itself. Any activities within processing that do not
add value should be eliminated.
(e) Time spent by workers waiting for a machine to complete processing is wasteful. The aim should
be to maximise the use of the worker, not the machine.
(f) The manufacture of defective items is wasteful. Defective items must be either scrapped or re-
worked if they are identified before they leave the factory. After defective items have been delivered
to a customer, there are costs of handling the complaint and making good to the customer. Poor-
quality output also risks the loss of customer goodwill.
There follows a list of concepts commonly associated with lean production
The elimination of waste
Lower inventory levels
Reducing defective output
Continuous improvement (kaizen)
A stop-the-line quality system, whereby any defect in production brings the entire production line
to a halt
Achieving a level production of items, rather than manufacturing in occasional large batches
Continuous flow
Point of use storage of materials and components, to reduce materials flow, rather than having a
centralised storage area
Reduction in production lead times and in set-up times
Improvement in equipment reliability
Teamwork within work cells
3.7 Continuous improvement kaizen
Kaizen is a Japanese term for the philosophy of continuous improvement in performance in all areas of a
business's operations.
Continuous improvement, or kaizen, calls for ever-continuing efforts of finding ways to make small
improvements in production, and is an integral part of the just-in-time philosophy. The concepts
underlying continuous improvement are:
(a) The organisation should always seek perfection. Since perfection is never achieved, there must
always be scope for improving on the current methods.
(b) The search for perfection should be ingrained into the culture and mindset of all employees.
Improvements should be sought all the time.
(c) Individual improvements identified by the work force will be small rather than far-reaching.
The philosophy of continual small-scale improvements is in stark contrast to business process re-
engineering, which seeks to make radical one-off changes to improve an organisation's operations and
processes.
4 Materials requirements planning (MRP I)
There are various systems for improving operations management. Materials requirements planning
(MRP I) is a computerised system for planning and ordering materials, based on a master production
schedule, bills of materials and inventory level records.
The concepts described above relate to manufacturing methods and the re-design of manufacturing
systems. Another aspect of manufacturing is planning. Within traditional manufacturing systems, the
planning process has been improved enormously by computerisation.
Materials requirements planning, or MRP I, is a computerised system for planning the requirements for
raw materials and components, sub-assemblies and finished items.
4.1 Example
The potential benefits of MRP I can perhaps be understood with a simple example. Suppose that a
company manufactures product X, which consists of two units of sub-assembly A and one unit of sub-
assembly B. The company makes the sub-assemblies. One unit of sub-assembly A needs six units of
component C and three units of component D, and one unit of sub-assembly B needs four units of
component D and five units of component E.
In a traditional materials procurement system, new orders are generated for finished goods, sub-
assemblies, components or raw materials when the inventory level for the item falls to a re-order level. A
new batch is then ordered. In the example above, the production of a new batch of product X could result
in new production orders for sub-assembly A or B, and these in turn could generate new orders for any of
the components, depending on inventory levels.
Where a manufacturing process uses many sub-assemblies, components and raw materials items, it could
be difficult to keep check on materials requirements and the re-ordering process, and there would be a
risk of stock-outs of key items, or possibly overstocking of key items to reduce the likelihood of stock-
outs.
A further complication is that each sub-assembly, component or raw material item has its own production
lead time (if manufactured in-house) or supply lead time (if purchased externally). The task in planning
materials requirements is therefore not just a matter of what to order and in what quantities, but when to
order to ensure that deliveries occur in time.

MRP I dates back to the 1960s, and the introduction of computers into business. It is a computerised
information, planning and control system. It can be used in a traditional manufacturing environment as
well as with advanced manufacturing technologies, but is most commonly used with batch manufacturing.
The main advantage of MRP I is that it can process a large amount of data, and so simplifies what would
otherwise be a complex and time-consuming operation.
The elements of an MRP I system are as follows.
(a) The system has access to inventory records, for all items of inventory (finished goods, sub-
assemblies, components, raw materials) and so is aware of current inventory levels. For each
inventory item, there are also records for the production lead time or purchase lead time.
(b) The system has access to a bill of materials for each item of production. A bill of materials is
simply a detailed list of the sub-assemblies, components and raw materials, including the
quantities of each, needed to make the item.
(c) The system also has access to a master production schedule. This is a production schedule,
detailing the quantities of each item that need to be produced, and the time by which completed
output is required. The master production schedule is produced from firm sales orders and current
estimates of future sales demand within the planning period.
(d) Taking the production schedule, the bills of materials and inventory records, the system computes
what quantities of materials are required, and by when. In the case of items purchased externally,
the system will report when the purchase orders must be placed. Where items are produced in-
house, the system will provide a schedule for the commencement of production for each item.
(e) The system can produce works orders and materials plans and automatic purchase orders for use
by the purchasing department.
(f) As information about sales orders changes, the production schedule can be altered quickly, and a
new materials procurement programme prepared automatically.
The aims of MRP I are to:
(a) Minimise inventory levels by avoiding over-stocking and earlier-than-necessary materials
requisitions
(b) Avoid the costs of rush orders
(c) Reduce the risk of stock-outs and resulting disruptions to the flow of production.
5 Manufacturing resource planning (MRP II)
Manufacturing resource planning (MRP II) is an extension of MRP I, that integrates the manufacturing,
materials requirements planning, engineering, finance and possibly marketing databases into a single
planning control system database.
Manufacturing Resource Planning, known as MRP II, evolved out of MRP I in the 1970s.
MRP II is a computerised system for the planning of all resources in a manufacturing company, and
materials requirements planning is a core element in MRP II.
The difference between MRP II and MRP I is principally that MRP II extends the computer system beyond
manufacturing operations, and provides a common database for all functions in the organisation, such as
sales and marketing, finance and distribution and transportation (logistics). It attempts to integrate
materials requirement planning, factory capacity planning, shop floor control, production design,
management accounting, purchasing and even marketing into a single complete (and computerised)
control system.
Without an MRP II system, each separate function within the company would need its own stand-alone
database, even though some of the information they use is common to each.

5.1 Example: MRP II
The production engineering department needs information about bills of materials. If it makes a change to
a product specification, the bill of materials for the product must be changed. In the absence of an MRP II
system, the same changes would have to be made to the databases of both the production department
and the production engineering department. There would also be the risk of one database being updated
but not the other.
The finance department uses information from a production budget and bills of materials to produce
budgets and reports on product costs and product profitability. When a bill of materials is changed, the
accounts department needs to know so that product costs can be re-calculated. When the production
schedule is amended, the accounts department needs to know in order to prepare revised production cost
estimates. Without an MRP II system, any changes to the production schedule would have to be fed into
the production database and the accounting database separately.
MRP II therefore offers the advantages of a common database easier updating and a common set of
data for all departments to use.
MRP I and MRP II systems have their critics, particularly from advocates of just-in-time production and
lean production. A problem with the MRP approach is that it creates a model of what currently happens in
the manufacturing plant, not what perhaps ought to happen. It builds in bad habits and waste. It allows for
long lead times, bottlenecks in production, large batch sizes. Management will not be motivated to achieve
improvements and eliminate waste when poor productivity and poor quality are built into the MRP II
planning system.

Question
Modern manufacturing system

The major requirements of a modern manufacturing system are the flexibility to meet customer
requirements, the cost-effective production of small batches of customised products and the maintenance
of a high standard of quality with an underlying principle of continuous improvement. To what extent does
this impact upon the traditional cost control techniques such as standard costing and variance analysis?

Answer

Cost behaviour patterns are different in a modern manufacturing environment; they no longer vary in
response to cost units, or labour hours, but more to process activities. Traditional standard costing cannot
be used in this context, as it tends to focus on a standard cost per unit. There are no longer large volumes
of standardised units being produced, but small batches of customised products.
The traditional emphasis on labour measures, such as efficiency, becomes redundant for the highly
mechanised and computerised manufacturer; indeed, an emphasis on efficiency can be detrimental, as it
tends to lead to a desire for continuous production. No consideration is given to whether the inventories
produced can actually be sold and, if not, what their holding/scrap costs might be. Similarly, a common
way to improve an adverse price variance is to buy in bulk to take advantage of discounts; again, this
ignores the additional inventory holding costs that will be incurred.
Traditional variance analysis, with its total concentration on cost, does not allow for quality issues, where
costs incurred now (eg on preventative maintenance) may give improved long-term results in terms of
minimisation of breakdowns, defective production etc.
As a result of these drawbacks of the traditional techniques of cost control, alternative models have been
developed, such as activity based budgeting (ABB) and target costing.

14: Performance in operations and production management
6 Optimised production technology (OPT)
An optimised production technology (OPT) system is another type of system for planning manufacturing
and materials resource requirements. Whereas MRP plans requirements to a given production schedule,
OPT plans production schedules to known capacity constraints in the production process. The OPT
approach is based on the theory of constraints.
OPT is an alternative computer system to MRP II. Like MRP II, it can be used to plan manufacturing and
materials requisition requirements. Unlike MRP II, however, it plans production schedules to known
capacity constraints within the production process.
Optimised production technology (OPT) has making money as its primary goal, progress towards which
can be measured by three criteria: production rate (throughput), inventory and operating expenses. The
aim of OPT is to maximise throughput whilst minimising inventory levels and operating expenses.
6.1 How OPT works
Essentially, an OPT system simulates the factory or workshop and its current workload.
A production process consists of a sequence of tasks, each carried out with a different group of workers
and on a different group of machines. There are resources for each task (for example, a given number of
workers or machines) and the volume of output achievable will be restricted by the quantity of those
resources available. There will be one point in the process where output capacity is lower than at any other
point in the process. In other words, there must always be a bottleneck. An OPT system identifies the
bottleneck (or bottlenecks) in production. This could be a particular machine or group of machines, or
available skilled labour time.
When a bottleneck has been identified, management can look for ways of overcoming it and reducing the
limitation on output and optimising work flow. When one bottleneck has been alleviated, another stage in
the production process will become the new bottleneck, and management can switch its attention to the
new restriction on output. By focusing on the bottleneck, management should optimise production
throughput.
Once a plan has been prepared for maximising work flow through the bottleneck, the remainder of the
production facility should be organised for supplying parts to the bottleneck or for dealing with the
production processes after the bottleneck point. The manufacturer might try to ensure that there is always
some inventory (work in progress) waiting to go through the bottleneck operation, so that this operation is
never brought to a halt by a stock-out. Management should also avoid any unnecessary build up of part-
finished work in other parts of the manufacturing operation, which cannot be completed because of the
bottleneck. A benefit of OPT, in addition to optimising throughput, should also be to reduce inventory
levels in other parts of the operation, away from the bottleneck.
6.2 Rationale for OPT
Although OPT is a computer system, it had its origins in a 1992 love story thriller book, The Goal. This
book was co-written by Eli Goldratt, who became a management consultant. The ideas of Goldratt led to
the Theory of Constraints, which states that any system consists of multiple steps, where the output of
one step depends on the output of one or more previous steps. The output of these previous steps will be
limited (constrained) by the least productive of those steps.
The aim of a company should be to maximise profits. Higher profits can be achieved to some extent by
reducing costs and reducing inventory levels. Goldratt suggested, however, that the greatest opportunities
for improving profits will come from optimising the flow through the system. Optimum throughput is
achieved by focusing on existing constraints, and:
(a) Identifying what they are
(b) Deciding how best to optimise the work flow, given the existing constraint

256
(c) Seeking ways to overcome the constraint, for example by working overtime on the constraining
operation, or buying more machines or hiring more labour.
Once one constraint has been 'elevated' (i.e. overcome, so that it is no longer a constraint) the next task is
to identify the new constraint in the system and seek ways to overcome that.
7 Enterprise resource planning (ERP) systems
Enterprise Resource Planning (ERP) systems are software systems designed to support and automate
the business processes such as manufacturing, distribution, personnel, project management, payroll and
finances. They are accounting-oriented information systems for identifying and planning the enterprise-
wide resources needed to take, make, distribute, and account for customer orders.
Enterprise Resource Planning (ERP) systems were introduced in Chapter 1. They were originally
extensions of MRP II systems, but their scope has since been broadened.
An ERP system can be defined in its widest sense as any software system designed to support and
automate the business processes of medium and large businesses. This may include manufacturing,
distribution, personnel, project management, payroll and finances.
ERP systems are accounting-oriented information systems for identifying and planning the enterprise-
wide resources needed to take, make, distribute and account for customer orders. For example, they help
track the flow of raw materials into an organisation, the integration of those components into final
products, the cost and processes associated with running the business, and the delivery of the products to
the customer.
The benefits to be derived from this detailed and accurate tracking of such operational data include:
Enabling informed business process decisions to reduce costs
Speeding product delivery times through shortened cycle times
Increasing customer satisfaction
Increasing shareholder value
Twenty years ago these automated systems were custom projects which were only attempted at
significant cost by large organisations. There are now a number of independent software vendors who
have developed common underlying systems that can be adapted to each business's needs, enabling a
larger number of organisations to automate ERP functions.
The central feature of any ERP system is a large and powerful database, that incorporates all the
information systems necessary to plan and track resource utilisation throughout the business. ERP
systems employ highly developed technology in both their software and hardware to achieve the aims of
speedy and accurate processing of data to provide relevant up to date information for management
control.
For example, one outcome of the ERP development has been the increased availability of up to date and
accurate information to employees, management and customers wherever and whenever needed, by the
use of hand held and pocket PCs. These bypass the traditional paper-based systems by the use of
computerised forms on mobile PCs, allowing data to be entered directly into the system at its point of
origin, resulting in faster and higher quality data entry (lines cannot be left blank, data can be pre-checked
for validity etc).
Microsoft used such devices to track inventory of the company's products on store shelves, and saw a
50% reduction in the time it took to collect the data when paper forms were converted to electronic forms.

8 Conclusion
This chapter has introduced elements of operations management, and explained the objective of many
manufacturing organisations to be 'world class' manufacturers. In the next chapter, a variety of different
techniques and approaches to improving performance will be considered.
258 15: Improving performance

1 Supply chain management
An organisation should try to achieve continuous improvements, particularly by reducing costs and
improving quality.
Improvements can be achieved in purchasing and process management through improvements in the
supply chain, from suppliers through to the end customer. Supply chain management calls for close co-
operation with key suppliers.
1.1 The supply chain
A supply chain is the network of suppliers, manufacturers and distributors that is involved in the process
of moving goods for a customer order from the raw materials stage through the production and
distribution stages to the customer. Every firm operates somewhere within a supply chain.
A supply chain is a network of facilities and distribution options that performs the functions of
procurement of materials, transformation of these materials into intermediate and finished products and
the distribution of these finished products to customers. (Ganeshan and Harrison, Supply

Chain
Management)
Within a supply chain, many processes might take place between the origination of raw materials to the
eventual delivery of the finished product or service to the end customer. For each firm inside a supply
chain, some of the processes are carried out by the firm itself, and others are carried out by suppliers or
by other firms further down the supply chain.

Improving
performance

15: Improving performance 259
1.2 Example: supply chain management
For example, a company manufacturing motor vehicles might have a plant where the vehicles are
assembled and finished. It might manufacture some parts itself and produce the car body work, but most
sub-assemblies and the tyres will be purchased from outside suppliers. The suppliers of sub-assemblies
might make some components themselves, but will also purchase many of their components from other
suppliers. The manufacturer, suppliers and sub-suppliers might all purchase raw materials, such as steel,
from other suppliers. The manufacturer will also purchase capital equipment from equipment suppliers,
who are another part of the supply chain. The finished cars will not be sold directly to the end customer,
but to distributors, and the distributors will sell to the end customer.
1.3 The concept of supply chain management
A commonly-held view by the management of a company is that to improve profitability, it is necessary to
get the lowest prices from suppliers, and obtain the best prices from the customer next in line down the
supply chain. If there is a given amount of profitability in a particular market for a finished product, this
profit will be shared out between all the firms involved in the supply chain. In this sense, suppliers and
their customers compete with each other for a bigger share of the available profit. This 'traditional' attitude
is evident in negotiations between a firm and its suppliers, and efforts by the firm to get the best terms
possible and the lowest prices in their purchasing negotiations.
This view of the supply chain is challenged by the concept of supply chain management. Supply chain
management looks at the supply chain as a whole, and starts with the view that all firms in the supply
chain collaborate to produce something of value for the end customer. By adding value within the supply
chain, customer satisfaction will be improved and customers will pay more for what they buy. Firms can
also benefit collectively by reducing waste and inefficiency. A lot of wasteful activity (activity that does not
add any value to the final product) occurs at the interface between firms within the supply chain. For
example, a supplier might spend money on checking outwards supplies for quality, and the same goods
will be checked by the firm buying them when they are delivered. Inspection costs could be reduced by
closer collaboration between the firms, both to improve quality and to reduce inspection activities.
By looking at the supply chain as a collaborative effort, managers can look for ways of enhancing the
profitability of the supply chain as a whole, so that everyone, including the end customer, benefits.
The concept of supply chain management can be stated as follows.
Supply chain management views all the buyers and sellers in this chain as part of a continuum, and the
aim should be to look at the supply chain as a whole and seek to optimise the functioning of the entire
chain. In other words, a company should look beyond its immediate suppliers and its immediate
customers to add value, for example by improving efficiency and eliminating waste.
Supply chain management is also referred to as 'pipeline management' and 'value stream
management'. The overall supply chain can be thought of as a sequence of operations, each of which
should add value. An activity has value if it gives the customer something that the customer considers
worth having (i.e. values), but an activity only adds value if the amount of value added exceeds the cost of
creating it. Value is therefore added by making something worth more (in terms of the price the customer
will pay, or the quality the customer perceives) or by reducing the cost of the operation (without
sacrificing quality).
1.4 Elements of supply chain management
To apply the concept of supply chain management fully, there has to be close collaboration between firms
within the supply chain. A company must be able to work constructively with its suppliers. At the same
time, it should continually look for ways of improving the supply chain structure, and this could involve
switching to different suppliers, or selling output through new channels. The Internet has opened up new
possibilities for identifying new suppliers world-wide and for selling direct to customers instead of
through distributors.
There is no single model for the ideal supply chain, and supply chain management can involve decisions
about improving collaboration with suppliers by sharing information and through the joint development of
new products, switching to new suppliers by purchasing on-line, or outsourcing some activities that were
previously performed in-house. Effective supply chain management calls for the co-ordination of all the
different processes in the chain as quickly as possible, without losing any quality or customer satisfaction,
and at the same time trying to reduce costs.
Supply chain management is particularly associated with:
(a) Eliminating waste (activities that do not add value) in the supply chain
(b) Adding value through better commercial relationships with suppliers.
The table below sets out some of the issues facing supply chain managers.
Production The customer often wants suppliers to respond to their particular requirements, and to
customise orders to their specific needs. A supply chain that can respond quickly to
individual customer requirements is known as an 'agile' supply chain.
Issues for management include deciding what products or components to make, and
where to make them. Should the production of components, sub-assemblies or even the
final product be done in-house or by external suppliers? Management focus is on
capacity, quality and order volume. Production has to be scheduled so as to provide a
sufficient workload for the production resources, and to achieve work load balance (so
as to avoid both production bottlenecks and under-utilisation of resources). The
challenge is to meet customer orders immediately, without having to invest heavily in
inventories of finished goods, which are wasteful and expensive. Quality control is also
an issue, because producing poor-quality output has implications for both cost and
customer dissatisfaction.
Supply Most manufacturing companies cannot make everything themselves and still keep the
quality of their output high. Decisions have to be made about how much should be
purchased from 'outside'. Some companies have chosen to close in-house production
facilities and switch to external suppliers, so that they can concentrate on their 'core
competences' where they add most value.
In choosing external suppliers, management need to consider the capabilities of the
supplier, and the extent to which a close collaboration will be necessary. (Collaboration
is much more important for key supplies, and much less important for low-cost general
supplies that can be purchased from numerous sources.) The management focus
should be on the speed, quality and flexibility of supply, as well as on cost.
Inventory If a firm holds large amounts of inventory, it should be able to meet many customer
orders immediately out of inventory and should not suffer hold-ups due to inventory
shortages. However, holding inventory is expensive, and there is no certainty that
finished goods inventories will ever find a customer, unless they have been made to
satisfy specific customer orders. Ideally, inventory levels should be minimised, but
without damaging the ability of the firm to meet customer orders quickly or holding up
work flow due to a stock-out of key supplies.
Location Decisions need to be made about where to locate production facilities and warehousing
facilities. Cost and tax issues might result in production facilities being constructed in
emerging market economies.
Transportation Logistics management is another aspect of supply chain management. Supplies need to
be delivered to a firm's premises and finished goods delivered to customers efficiently,
reliably and at a low cost.
Information Information resources throughout the supply chain need to be linked together, for speed
of information exchange and to reduce wasteful paper work. Some firms link their
computer networks, or share information through the Internet.

Managing the supply chain calls for an understanding of and knowledge about:
(a) Customer demand patterns
(b) Service level requirements (speed of delivery expectations, quality expectations, and so on)
(c) Distance considerations (logistics)
(d) Cost
A firm can share its information about expected customer demand and orders in the pipeline, so that the
suppliers can get ready themselves for orders that might come to them from the firm. 'Modern' supply
chain management uses the Internet to share information as soon as it is available. A firm might have an
integrated enterprise resource planning system that is accessible via the Internet. The ERP runs the supply
chain database, holding information about a wide range of items, such as customer orders, inventory
levels, pricing structures and so on.
A critical issue for successful supply chain management is the speed with which activities can be carried
out and customer demands met. If a firm, helped by its suppliers and sub-suppliers in the chain, can
respond quickly and flexibly to customer requirements, the benefits will come from lower inventories,
lower operating costs, better product availability and greater customer satisfaction.

Question
Supply chain management

The concept of supply chain management has important implications for lean manufacturing, just-in-time
manufacturing and total quality management. Suggest some of these.

Answer

The implications of the concept of supply chain management on other aspects of modern manufacturing
include:
(a) Just-in-time manufacturing cannot operate successfully unless a company can arrange just-in-time
purchasing from its key suppliers.
(b) It will be difficult to eliminate waste successfully if there is waste at other points in the supply
chain. Suppliers should be encouraged to eliminate waste, so that lean management methods can
be applied to the entire value chain.
(c) A manufacturer cannot achieve total quality unless suppliers also deliver quality.
(d) If a company carries out 'non-core' activities, it is quite probable that those activities do not add as
much value as they should. Someone else should be able to perform the same activities more
efficiently, and so should add more value to the supply chain. This is an argument, for example,
that is used to justify the outsourcing of services.
Lean manufacturing could therefore involve outsourcing, buying from external suppliers rather than
manufacturing in-house. In principle, a company could become a 'virtual company', outsourcing and
buying everything externally, and having as its core activity the management of the supply chain.

Case Study

Supply chain management and customisation of orders
Personal computer production provides an interesting example of how supply chain management can be
used to provide fast delivery of customised products, thereby creating a 'flexible' or 'agile' supply chain.
When customers expect fast delivery of their orders for personal computers, and at the same time want
PCs produced to their individual specifications, the parts needed to deliver the item to the customer must
exist somewhere within the supply chain. A PC manufacturer operating in a build-to-order market relies on
suppliers keeping inventory available, so that the manufacturer can minimise its own inventories without
compromising the time needed to deliver the order to the customer. In the case of Dell Computers
(reported in a Financial Times supplement on supply chain management, 20
th
June 2001), Dell itself held
about five days' supply and other firms in the supply chain held about ten days' inventory of supplier-
owned items. Replenishment of inventories took between 12 hours and two days.
'Build-to-order involves balancing what is available with what the customers want and Dell has become
expert in gently massaging both these factors. Any shortage in a particular component is immediately
countered by offering other available products on promotion.' By monitoring component inventory
availability in real time, Dell and its suppliers can quickly see problems with any particular part. A first step
is to increase lead time, informing customers that their preferred configuration will take eight to 10 days to
deliver rather than the usual five. If that does not slow up demand, then would-be customers are offered a
more expensive upgrade for the same price. "Everyone wins," [says Dell's vice president in the US]. "Our
customers get a better deal, the suppliers get business and we can satisfy demand."'
The efficiency of the Dell build-to-order system depends on data sharing between Dell and its suppliers,
and the integrity of the information databases. All systems throughout the supply chain are integrated,
with common parts numbers and automated order processing and parts management.

2 E-procurement
Improvements in purchasing can be achieved through e-procurement. This involves placing orders with
suppliers electronically, and creating a data link between the organisation's computer systems and those
of suppliers.
2.1 E-business
E-business is business carried out over the Internet. There are three aspects to e-business, all of which
have relevance to supply chain management:
E-commerce: the sale and purchase of items through the Internet, either B2C (business-to-customer) or
B2B (business-to-business)

E-procurement: the purchasing from suppliers through the Internet
E-collaboration: the sharing of information between firms, typically a firm and its key suppliers, through
the Internet.
(a) E-commerce. A firm can try to sell its goods or services to buyers by offering them on a web site.
B2C (business-to-customer) e-commerce involves the sale of items to the end-customer, and
examples of B2C operations are Internet banking and the selling operations of firms such as
Amazon and eToys. B2B (business-to-business) e-commerce involves transactions between
businesses.
(b) E-procurement. Whereas e-commerce has a selling focus, e-procurement looks at the operation
from the buyer's perspective.
(c) E-collaboration. A firm might put information about customer orders on to the Internet and allow
its suppliers access. This allows suppliers to see what orders are in the pipeline, so that they can
schedule their own production accordingly. Suppliers can also post information about the progress
of their own production operations, so that customer orders can be tracked. Management can also
identify any problems in the supply chain as they arise and try to deal with them.

2.2 Electronic data interchange (EDI)
EDI is the exchange of data, in a structured form, between computer systems, without the need for any
manual intervention.
Computerisation of purchasing can be taken to the point where an organisation's computer system links
with the computer systems of its key suppliers, and there is 'electronic data interchange' (EDI) between
the two organisations.
Purchase orders and delivery instructions can be generated automatically within an organisation's
computer system, and transmitted electronically to the supplier over a network link (or possibly over the
Internet). The communication process is two-way: the supplier can use the link to acknowledge orders,
give notification of deliveries and send invoices for payment.
The data transferred between buyer and supplier has to be in a mutually-agreed form.
(a) It may be necessary to have a process for translating data sent by an organisation to a supplier (or
by a supplier to its customer). The translations may be carried out by a third-party organisation,
which takes the message from the sender, translates it and sends it on to the recipient. The term
'value added network services' or VANS is used to describe this type of arrangement. An
organisation can use this type of arrangement to communicate with many different suppliers.
(b) The direct exchange of data between buyers and suppliers has been made easier by the
development of an internationally-recognised standard for sending electronic messages. This is
known as EDIFACT, which stands for 'electronic data interchange for administration, commerce
and transport.' It is now widely used for transferring standard messages, such as purchase orders
and invoices.
EDI, although adopted by many larger firms, has failed to gain acceptance from small and medium-sized
firms, largely due to the investment costs involved. However, a major impetus to e-procurement has been
provided by the Internet and the development of XML, a language that enables business information to be
shared irrespective of its original format.
2.3 E-procurement and the electronic market place
Web-based e-procurement software is now widely available to link firms to suppliers, and, apart from the
physical delivery of the goods themselves, all stages of the procurement process can be automated,
including payments to suppliers. E-procurement involves information-sharing between buyer and supplier,
and in its most efficient form results in collaborative planning and even collaborative new product
development. By sharing information about their purchase orders, sales orders, sales forecasts and
replenishment plans, firms should be better able to match demand and supply across the whole supply
chain.
Some industries have electronic market places. Companies can link to a public electronic market.
Suppliers are able to list their prices for parts and components and firms can place orders with selected
suppliers. The advantage of a public market place is that firms can see what prices are available, and keep
costs down by purchasing at the best prices available.

Case Study

Some firms have chosen not to use a public market place, but to establish their own 'private exchange'.
An article in the Financial Times (15
th
October 2001) described the e-procurement system at Sun
Microsystems, the US technology company. 'Whereas B2B (public) marketplaces were meant to be
collaborative ventures, run usually by a third-party software company or an industry consortium, private
exchanges exist only to handle a single company's procurement. Sun's reasons for rejecting B2B
marketplaces offer clues to why the vast majority failed. "I was taking 30 calls a week from people trying to
persuade us to join a B2B marketplace," recalls [Sun's director of procurement strategy], "But we could
not see the advantage in sharing information with our competitors. Our ability to manage the supply chain
and build supplier relationships is a source of competitive advantage." '
The article suggested that it is likely that the success or failure of large companies such as Sun or United
Technologies in developing private exchanges for e-procurement will determine whether the Internet will
really be able to squeeze big efficiencies for companies from their supply chain.
In Sun Microsystems' e-procurement system:
(a) Suppliers are invited to bid against each other for contracts to supply specified components. A
number of suppliers are given, about two weeks in advance, detailed specifications of the
components that Sun will want to buy over the Internet. These suppliers can therefore plan in
advance the prices that they might be willing to submit in the auction.
(b) The 'window' for bidding is left open for 30 60 minutes. Bidders are free to revise their bids in
that time.
(c) The bidding takes place over the Internet, and rival bids are shown on screen for all suppliers to see.
(d) The lowest bid does not necessarily win the contract. The bids are weighted by Sun in accordance
with its assessment of each supplier's quality control processes, security of supply and other
factors.
(e) A procurement team also carries out due diligence to check that the promised price is deliverable.
Sun's experience to date suggests that 'dynamic bidding' could result in significant purchase cost savings.
'Even so, the suspicion remains that the private exchange is a zero-sum game: every dollar in Sun's
pocket comes out of the supplier's wallet. [Sun] is well aware of the danger that suppliers may in fact
loathe the process. In the long run this would damage supply chain efficiency, whatever the short-term
financial gains.'

2.4 The benefits and problems with e-procurement
The benefits of e-procurement include:
(a) reductions in the cost of purchase order processing (for the buyer) and sales order processing (for
the seller). There are savings in the time needed to place an order and the time needed to amend
orders, as well as savings in stationery costs and postage
(b) reductions in the lead time between placing an order and receiving delivery. Shorter supply lead
times should help the buyer to reduce inventory holding levels, and so reduce inventory costs.
E-procurement is normally an element in 'just-in-time' purchasing.
E-procurement has its problems too:
(a) To set up an integrated e-procurement system for an entire supply chain would be expensive and
complex.
(b) There is consequently an investment risk for firms that decide to become involved in developing e-
procurement systems.
(c) Intermediaries in the supply chain might be reluctant to collaborate, due to a fear that they might
be eliminated from the chain if their suppliers start 'talking' directly to their customers.
(d) Firms will not become involved in e-procurement and collaboration in supply chain management
unless they can see the benefit for themselves. There is a problem of which firms will benefit most
and which might lose out as a result.
(e) Although larger firms might consider the investment in e-procurement systems worthwhile,
smaller firms might decide that the investment is too expensive and risky. The larger firms will then
have to decide whether to try to coerce their smaller suppliers to invest, or whether to invest
money themselves in conversion by their small suppliers to e-procurement.

3 Just-in-time production and purchasing
Just-in-time purchasing and production seek to minimise inventory levels, by acquiring raw materials or
producing goods only when they are needed. JIT purchasing calls for close co-operation between an
organisation and its suppliers.
Just-in-time is an approach to operations planning and control based on the idea that goods and services
should be produced only when they are needed, and neither too early (so that inventories build up) nor too
late (so that the customer has to wait). JIT is also known as 'lean operations', 'stockless production' and
'fast throughput manufacturing'. It contrasts with the 'traditional' approach to purchasing and production,
in which an organisation seeks to maintain sufficient inventories of all key supply items and finished
goods to meet foreseeable demand.
Definitions of JIT are:
(a) 'JIT aims to meet demand instantaneously, with perfect quality and no waste.' (Bicheno,
Implementing Just-in-time)
(b) 'Just-in-time is a disciplined approach to improving overall productivity and eliminating waste. It
provides for the cost-effective production and delivery of only the necessary quantity of parts at the
right quality, at the right time and place, while using a minimum amount of facilities, equipment,
materials and human resources. JIT is dependent on the balance between the supplier's flexibility
and the user's flexibility. It is accomplished through the application of elements which require total
employee involvement and teamwork. A key philosophy of JIT is simplification.' (Voss, Just-in-
Time Manufacture).
Just-in-time (JIT) is a system whose objective is to produce or to procure products or components as
they are required (by a customer or for use) rather than for inventory. A just-in-time system is a 'pull'
system, which responds to demand, in contrast to a 'push' system, in which inventories act as buffers
between the different elements of the system, such as purchasing, production and sales.
Just-in-time production is a production system which is driven by demand for finished products whereby
each component on a production line is produced only when needed for the next stage.
Just-in-time purchasing is a purchasing system in which material purchases are contracted so that the
receipt and usage of material, to the maximum extent possible, coincide. (CIMA Official Terminology)
In 'traditional' manufacturing, where there is a production process with several stages, management seek
to insulate each stage in the process from disruption to another stage, by means of producing for
inventory and holding inventory. For example, a manufacturing process consists of four consecutive
stages. In a traditional manufacturing system, there would be inventories of raw materials and finished
goods, and also inventories of part-finished items between stage 1 and stage 2, between stage 2 and stage
3 and between stage 3 and stage 4. If there is disruption to production at, say, stage 2, the other stages
would not be immediately affected. Stages 3 and 4 would continue to operate, using the inventories of
part-finished items from stages 2 and 3. Stage 1 would also continue to operate, producing inventory for
stage 2. The responsibility for resolving the disruption would fall mainly on the managers of the stage
affected, which in this example would be the management of stage 2.
In contrast, in its extreme form, a JIT system seeks to hold zero inventories. In the same four-stage
process described above, a disruption at any stage would immediately have an impact on all the other
stages. For example, if a disruption occurs at stage 2, stages 3 and 4 will have to stop working because
they have no output from stage 2. Stage 1 will also have to stop working, because it will only produce
when stage 2 is ready to receive and use its output.
In JIT a disruption at any part of the system becomes a problem for the whole operation to resolve.
Supporters of JIT management argue that this will improve the likelihood that the problem will be
resolved, because it is in the interest of everyone to resolve it. They also argue that inventories are a
'blanket of obscurity' that help to hide problems within the system, so that problems go un-noticed for too
long.

3.1 Requirements of JIT
The operational requirements for JIT are as follows.
(a) High quality. Disruption in production due to errors in quality will reduce throughput and reduce
the dependability of internal supply.
(b) Speed. Throughput in the operation must be fast, so that customer orders can be met by
production rather than out of inventory.
(c) Reliability. Production must be reliable and not subject to hold-ups.
(d) Flexibility. To respond immediately to customer orders, production must be flexible, and in small
batch sizes.
(e) Lower cost. As a consequence of high quality production, and with a faster throughput and the
elimination of errors, costs will be reduced.
A consequence of JIT is that if there is no immediate demand for output, the operation should not produce
goods for inventory. Average capacity utilisation could therefore be low (lower than in a 'traditional'
manufacturing operation). However, with a traditional manufacturing system, a higher capacity utilisation
would only be achieved by producing for inventory at different stages of the production process.
Supporters of JIT argue that there is no value in producing for inventory, and, as suggested above, it could
damage the overall efficiency of an operation.
3.2 The JIT philosophy
JIT can be regarded as an approach to management that encompasses a commitment to continuous
improvement and the search for excellence in the design and operation of the production management
system. Its aim is to streamline the flow of products through the production process and into the hands of
customers.
The JIT philosophy originated in Japan in the 1970s, with companies such as Toyota. At its most basic,
the philosophy is:
(a) To do things well, and gradually do them better (continuous improvement), and
(b) To squeeze waste out of the system.
Three key elements in the JIT philosophy are:
(a) Elimination of waste. Waste is defined as any activity that does not add value. Examples of waste
identified by Toyota were:
(i) Overproduction, i.e. producing more than was immediately needed by the next stage in the
process
(ii) Waiting time. Waiting time can be measured by labour efficiency and machine efficiency.
(iii) Transport. Moving items around a plant does not add value. Waste can be reduced by
changing the layout of the factory floor so as to minimise the movement of materials.
(iv) Waste in the process. There could be waste in the process itself. Some activities might be
carried out only because there are design defects in the product, or because of poor
maintenance work.
(v) Inventory. Inventory is wasteful. The target should be to eliminate all inventory by tackling
the things that cause it to build up.
(vi) Simplification of work. An employee does not necessarily add value by working. Simplifying
work is an important way of getting rid of waste in the system (the 'waste of motion')
because it eliminates unnecessary actions.
(vii) Defective goods are 'quality waste'. This is a significant cause of waste in many operations.
(b) The involvement of all staff in the operation. JIT is a cultural issue, and its philosophy has to be
embraced by everyone involved in the operation if it is to be applied successfully. Critics of JIT
argue that management efforts to involve all staff can be patronising.
(c) Continuous improvement. The ideal target is to meet demand immediately with perfect quality and
no waste. In practice, this ideal is never achieved. However, the JIT philosophy is that an

organisation should work towards the ideal, and continuous improvement is both possible and
necessary. The Japanese term for continuous improvement is 'kaizen'.
3.3 JIT techniques
JIT is not just a philosophy, it is also a collection of management techniques. Some of these techniques
relate to basic working practices.
(a) Work standards. Work standards should be established and followed by everyone at all times.
(b) Flexibility in responsibilities. The organisation should provide for the possibility of expanding the
responsibilities of any individual to the extent of his or her capabilities, regardless of the
individual's position in the organisation. Grading structures and restrictive working practices
should be abolished.
(c) Equality of all people working in the organisation. Equality should exist and be visible. For example,
there should be a single staff canteen for everyone, without a special executive dining area; and all
staff including managers might be required to wear the same uniform.
(d) Autonomy. Authority should be delegated to the individuals responsible directly in the activities of
the operation. Management should support people on the shop floor, not direct them. For example,
if a quality problem arises, an operative on the production line should have the authority to bring
the line to a halt ('line stop authority'). Gathering data about performance should be delegated to
the shop floor and the individuals who use it. Shop floor staff should also be given the first
opportunity to solve problems affecting their work, and expert help should only be sought if it is
needed.
(e) Development of personnel. Individual workers should be developed and trained.
(f) Quality of working life. The quality of working life should be improved, through better work area
facilities, job security, involvement of everyone in job-related decision-making and so on.
(g) Creativity. Employees should be encouraged to be creative in devising improvements to the way
their work is done.
E J Hay (The Just-in-Time Breakthrough)

identified seven aspects of JIT.
Aspect Explanation
JIT purchasing Small, frequent deliveries, rather than bulk supply orders. This requires close
integration of suppliers with the company's manufacturing process.
Machine cells The grouping of machines or workers by product or component instead of by type of
work performed. For example, instead of having a single machining department and
a single assembly or finishing department for all products made by the organisation,
there is a small area on the factory floor (a 'cell') for the machining and assembly or
finishing for each product or group. The entire production process for the product is
carried out within the cell.
Set-up time
reduction
The recognition of machinery set-ups as non 'value-adding' activities, which should
be reduced or even eliminated.
Uniform loading The operating of all parts of the production process at a speed that matches the rate
at which the customer demands the final product.
Pull system
(Kanban)
The use of a Kanban, or signal, to ensure that products/components are only
produced when needed by the next process. Nothing is produced for inventory, in
anticipation of need.
Total quality The design of products, processes and vendor quality assurance programmes to
ensure that the correct product is made to the appropriate quality level on the first
pass through production.
Aspect Explanation
Employee
involvement
JIT involves major cultural change throughout an organisation. This can only be
achieved if all employees are involved in the process of change and continuous
improvement inherent in the JIT philosophy.
There are other JIT techniques and methodologies.
(a) Design for manufacture. In many industries, the way that a product is designed determines a large
proportion of its eventual production costs. Production costs can therefore be significantly reduced
at the design stage, for example by reducing the number of different components and sub-
assemblies required in the product (i.e. achieving greater simplicity).
(b) Use several small, simple machines, rather than a single large and more complex machine. Small
machines can be moved around more easily, and so offer greater flexibility in shop floor layout.
The risk of making a bad and costly investment decision is reduced, because relatively simple small
machines usually cost much less than sophisticated large machines.
(c) Work floor layout and work flow. Work can be laid out to promote the smooth flow of operations.
Work flow is an important element in JIT, because the work needs to flow without interruption in
order to avoid a build-up of inventory or unnecessary down-times. The movement of materials and
part-finished work is wasteful because it does not add value, which means that waste can be
reduced by laying out the work floor and designing the work flow so as to minimise movements.
(d) Total productive maintenance (TPM). Total productive maintenance seeks to eliminate unplanned
breakdowns and the damage they cause to production and work flow. Staff operating on the
production line are brought into the search for improvements in maintenance, and are encouraged
to 'take ownership' of their machines and carry out simple repairs on them. This frees up
maintenance specialists to use their expertise to look for 'higher level' ways of improving
maintenance systems, instead of spending their time on 'fire fighting' repairs and maintenance
jobs.
(e) Visibility. The work place and the operations taking place in it are made more visible, through open
plan work space, visual control systems (such as kanbans, described later), information displays in
the work place showing performance achievements, and signal lights to show where a stoppage
has occurred.
3.4 Value added and JIT
JIT aims to eliminate all non-value-added costs. Value is only added when a product is actually being
processed. Whilst it is being inspected for quality, moving from one part of the factory to another, waiting
for further processing and held in store, value is not being added. Non-value-added activities should
therefore be minimised, and ideally eliminated.
A value-added cost is an expense that cannot be eliminated without the customer perceiving a
deterioration in the performance or quality of a product.
The costs of those activities that can be eliminated without the customer perceiving deterioration in the
performance or quality of a product are non-value-added.
As a simple example of the distinction between value-added and non-value-added:
(a) the cost of the memory chips in a computer is value-added. The memory chips cannot be removed,
or the memory capacity reduced, without the customer noticing a deterioration in quality
(b) the cost of handling the components in assembling a computer may be non-value-added. Changes
can be made in the assembly process and in materials handling that do not affect the performance
or quality of the computer that is produced.


Question
Traditional vs JIT

Solo produces one product, the Potten. Parts for the product are quality inspected on arrival and stored in
a warehouse until needed. They are then moved from the warehouse to the machine room where they are
machined to the product specification. This work is then inspected and, if satisfactory, the machined parts
are moved to the assembly area. Once this processing is complete, the finished product is inspected and
tested. This is then passed to the despatch department, where employees pack it in an attractive box with
a printed instruction sheet. Finished goods are stored back in the warehouse until despatched to
customers.
List all the activities in order under the traditional manufacturing system. Then eliminate the non-value-
added activities to produce the set of activities that would take place under a JIT approach. Comment upon
your answer.

Answer

Traditional system activities
Parts received
Parts quality inspected
Parts stored in warehouse
Parts moved to machine room
Parts machined
Machined parts inspected
Machined parts moved to assembly area
Machined parts assembled
Finished product inspected and tested
Finished goods passed to despatch department
Finished goods packaged
Packed goods moved back to warehouse
Packed goods stored
Packed goods despatched to customer
JIT activities
Parts received
Parts machined
Machined parts assembled
Finished goods packaged
Packaged goods despatched to customers
Comment
The JIT approach has 5 value-added activities, compared with 14 activities under the traditional approach
9 non-value-added activities have been eliminated.
Receipt of parts, their machining, assembly, packaging and despatch to the customer are essential
activities that increase the saleability of the product.
Solo needs to negotiate with its suppliers to guarantee the delivery of high quality parts to eliminate the
need for quality inspection on arrival.
Storage and movement of parts, work in progress and finished goods do not add value; rather they
introduce unnecessary delays. The machining, assembly and packaging areas should be in close proximity
to avoid excessive movement, and ordering and processing should be scheduled so that there is no need
to store parts before they go into production. Similarly, production should be scheduled to finish goods
just as they are needed for despatch to avoid storage of finished goods.
Proper maintenance of machinery and good staff training in quality production procedures should ensure
finished goods of a consistently high quality, removing the need for inspection and testing.
Thus the JIT approach eliminates all wastage of time in the storage of goods, unnecessary movement of
goods and all quality checks, resulting in one continuous string of value-added activities.

3.5 Kanban
Holding inventories is one source of waste in production. Not having materials or parts when they are
needed is another. In other words, both having inventory in hand and having stock-outs is wasteful
practice.
'Kanban' is the Japanese word for 'card' or 'signal'. A kanban control system is a system for controlling
the flow of materials between one stage in a process and the next. In its simple form, a card is used by an
'internal customer' as a signal to an 'internal supplier' that the customer now requires more parts or
materials. The card will contain details of the parts or materials required.
Kanbans are the only means of authorising a flow of materials or parts. The receipt of a card from an
internal customer sets in motion the movement or production or supply of one unit of an item, or one
standard container of the item. The receipt of two cards will trigger the movement, production or supply of
two units or two standard containers, and so on.
There are variants on the basic kanban system. For example, a production system might use 'kanban
squares'. A space is marked out on the work shop floor. When the space is empty, it acts as a signal for
production to start at the previous stage. When it is full, it acts as a signal that production at the previous
stage should be halted.
Colour-coded kanban cards might be used, with each colour representing a different part or item of
materials, or a different degree of urgency.
3.6 JIT in service operations
The JIT philosophy can be applied to service operations as well as to manufacturing operations. Whereas
JIT in manufacturing seeks to eliminate inventories, JIT in service operations seeks to remove queues of
customers.
Queues of customers are wasteful because:
(a) They waste customers' time
(b) Queues require space for customers to wait in, and this space is not adding value
(c) Queuing lowers the customer's perception of the quality of the service.
The application of JIT to a service operation calls for the removal of specialisation of tasks, so that the
work force can be used more flexibly and moved from one type of work to another, in response to demand
and work flow requirements.
Where tasks are specialised, JIT can be achieved by outsourcing the function. For example, certain
aspects of the Human Resources department such as employment law can be outsourced. Similarly,
specialised maintenance can be outsourced in manufacturing operations.
3.7 Control of JIT purchasing: quality assurance
JIT usually requires some form of quality assurance scheme. Suppliers are required to guarantee not
only reliable deliveries but also the quality of the goods or materials they supply. The effect of this should
be to reduce returns, and reduce the costs of waste and re-working.
Against this, a JIT purchasing system might call for:
(a) long-term supply contracts with suppliers
(b) expenditure on operating a quality assurance scheme, and monitoring quality

3.8 Use of JIT
JIT might not be appropriate in all circumstances.
(a) It is not always easy to predict patterns of demand.
(b) JIT makes the organisation far more vulnerable to disruptions in the supply chain.
(c) JIT was originated by Toyota when all of Toyota's manufacturing was done within a 50 km radius
of its headquarters. Wide geographical spread makes JIT difficult, particularly where key suppliers
are in another country.
(d) Suppliers are likely to charge a premium price for contractually guaranteed frequent small
deliveries.
(e) JIT purchasing does not make it easier to respond to changes in demand on its own: it must be
accompanied by JIT production systems.

Case Study

In October 1991 the workforce at Renault's gear-box production plant at Clon went on strike. The day
afterwards a British plant had to cease production. Within two weeks Renault was losing 60% of its usual
daily output a day. The weaknesses were due to the following:
Sourcing components from one plant only
Heavy dependence on in-house components
Low inventory
The fact that Japanese-style management techniques depend on stability in labour relations,
something that was not widespread in many European countries at the time.

3.9 Financial implications of JIT
(a) In the short term
Inventory is eliminated so the cost of holding inventories is reduced to nil (warehouse costs
and interest charges on the capital tied up in inventory).
Cash flow may be affected. In a traditional purchasing system, payment to creditors for
purchases may be delayed offering a source of working capital. It may be more difficult to
do this with suppliers with JIT when much depends on them delivering goods on demand.
If suppliers require immediate payment then both inventories and trade payables will be
eliminated from the statement of financial position.
There will be a considerable initial investment and cash flow as new systems, software and
staff training are needed to implement the new ordering processes.
(b) In the medium term
The first two points above will still be relevant.
JIT is more than just quick inventory replenishment. It is rather a culture that benefits from
lower wastage and mistakes, better procedures and plant layout, more flexible work
procedures, better maintenance that reduces unplanned machine down time and generally
better working practices and staff morale. All these tend to reduce costs, and the greater
flexibility, quality and reliability may also increase sales and profits.
4 Target costing and kaizen costing
An organisation might set targets for reducing costs. A programme of setting targets for continual cost
reductions over time is known as kaizen costing.
Target costing is the process of setting cost estimates for products by subtracting a desired profit margin
from a target price. This may be less than original expectations of cost, but the aim will be to achieve this
unit cost by the final production stage prior to launch.
Kaizen costing is a process of re-establishing new target costs after product launch, when operational
improvements have been made, to ensure that the intended benefits of the improvements are obtained.
Target pricing is used in decision-making for new product design and development. When a new product
idea is proposed, the attributes of the product should be considered, with a view to estimating what price
customers might be willing to pay for the product if it is developed for the market. If a decision is taken to
go ahead with the product development, the probable selling price can be established as a target price that
the company will want to achieve.
Cost gap is the difference between the cost that must be achieved using a target pricing approach and the
current actual cost of the product.
Having established a target price, management can then decide what the size of the profit margin should
be. A target cost can then be established by subtracting the desired profit from the target price. The target
cost will usually be lower than can reasonably be achieved using current manufacturing methods and
processes, and the design team has to find innovative ways of bringing costs down to the target level
without sacrificing value. This process of reducing costs during product design without sacrificing value is
known as value engineering. Value engineering aims to help design products which meet customer
requirements at the lowest cost while assuring that the customers required standards of reliability and
quality are maintained.
In designing and developing the new product, the design team must then work within the constraint that
the cost of the product that is eventually developed must not cost more to produce than the target cost. If
it appears that the product will cost more than the target, the design team should consider ways of
reducing costs without reducing the value of the product to the customer (i.e. without reducing the price
that customers will be prepared to pay).This can done for example by cutting out non-value added
activities, training staff in most efficient techniques and working practices, acquiring new, most efficient
terminology or using cheaper employees to manufacture the product.
Target costing is therefore a technique for new product design, which ends when the product is launched
on the market.
Kaizen costing, also known as enhancement estimation, is applied to a product after it has been launched
on the market. The concept was developed by Yashuhiro Monden. It is connected to the management
philosophy of kaizen, or continuous improvement.
When a continuous improvement philosophy is applied, a firm should find ways of making small
improvements in the way that operations are carried out and products are made. Many of these small
improvements should result in lower costs. Kaizen costing is a process of re-establishing new target costs
when improvements have been made, to ensure that the intended benefits of the improvements are
obtained.
Kaizen costing can be compared with more 'traditional' budgeted cost or standard costing systems.
(a) In a standard cost system, the expected cost is the standard. There is an assumption that existing
production facilities and processes will be maintained unchanged. Management should therefore
try to ensure that actual costs do not exceed the standard.
(b) In a kaizen costing system, the organisation seeks to reduce costs below the initial standard cost
level, through continual small improvements. Cost reduction targets are set, to reflect the

improvements that have been made. Management should try to ensure that actual costs are below
standard costs, such that the cost reduction targets are met.

Question
Definitions

Match each of the following terms with its definition.
Terms
A Supply chain B ERP system
C Kaizen D FMS
Definitions
1. An accounting-oriented information system for identifying and planning the enterprise-wide
resources needed to take, make, distribute and account for customer orders.
2. An integrated, computer-controlled production system, which is capable of producing any of a
range of parts, and of switching quickly and economically between them.
3. A philosophy of continuous improvement in performance in all areas of an organisation's
operations, incorporating benchmarks of excellent practice and instilling a sense of employee
ownership of the process.
4. A network of facilities and distribution options that performs the functions of procurement of
materials, transformation of these materials into intermediate and finished products and the
distribution of these finished products to customers.

Answer

A 4; B 1; C 3; D 2

5 Outsourcing, joint ventures and partnerships
Organisations might choose to focus on activities where they have core competences, and to outsource
other functions to external organisations. Outsourcing of various services, such as information systems,
facilities management, accounting functions and so on, is quite common.
Organisations can seek to obtain benefits of new product developments or new technology by entering
into joint ventures or partnerships with other organisations.
5.1 The trend in outsourcing
A significant trend in the 1990s was for companies and government bodies to concentrate on their core
competences what they are really good at (or set up to achieve) and turn other functions over to
specialist contractors. A company that earns its profits from, say, manufacturing bicycles, does not also
need to have expertise in, say, mass catering or office cleaning. Facilities management companies such
as Rentokil have grown in response to this.
Outsourcing is the use of external suppliers for finished products, components or services. This is also
known as contract manufacturing or sub-contracting.
Reasons for this trend include:
(a) Frequently the decision is made on the grounds that specialist contractors can offer superior
quality and efficiency. If a contractor's main business is making a specific component it can invest
in the specialist machinery and labour and knowledge skills needed to make that component.

However, this component may be only one of many needed by the contractor's customer, and the
complexity of components is now such that attempting to keep internal facilities up to the standard
of specialists detracts from the main business of the customer.
(b) Contracting out manufacturing frees capital that can then be invested in core activities such as
market research, product definition, product planning, marketing and sales.
(c) Contractors have the capacity and flexibility to start production very quickly to meet sudden
variations in demand. In-house facilities may not be able to respond as quickly, because of the
need to redirect resources from elsewhere.
5.1.1 Internal and external services
In administrative and support functions, too, companies are increasingly likely to use specialist
companies. Decisions such as the following are now common.
(a) Whether the design and development of a new computer system should be entrusted to in-house
data processing staff or whether an external software house should be hired to do the work
(b) Whether maintenance and repairs of certain items of equipment should be dealt with by in-house
engineers, or whether a maintenance contract should be made with a specialist organisation
Even if you are not aware of specialist 'facilities management' companies such as Securicor, you will be
familiar with the idea of office cleaning being done by contractors.

Question
Outsourcing

What do you think are the advantages and disadvantages of outsourcing? Try to think of at least four of
each.

Answer

Advantages of outsourcing
(a) It frees up time, both of the staff performing the functions, and also of those not directly involved
in carrying out the function, but who spend some of their time supporting it for example, the time
of management and supervisors.
(b) It allows the organisation to benefit from the specialised expertise and equipment of the external
sub-contractor. It also avoids the requirement to have to employ similar staff and buy similar
equipment, and run the risk of under-utilising them. If the sub-contractor is well-chosen it is likely
that the service will be performed more quickly and to a higher standard than if the service is
provided by in-house staff.
(c) It may be cheaper in the long term, once time savings and opportunity costs are taken into
account.
(d) An organisation can pay for the services it needs, and no more. The amount of support provided
by the external sub-contractor can be adjusted according to requirements.
Disadvantages of outsourcing
(a) Without proper monitoring, there is no assurance that the service will be performed to the
required standard. There may be a penalty clause in the contract with the sub-contractor, but
financial compensation will not necessarily undo the damage caused by a sub-standard service.
However, if a sub-contractor has to be closely monitored, this removes one of the arguments in
favour of outsourcing in the first place.
(b) There is a likelihood that outsourcing will be more expensive, at least in the short term, than doing
the work in-house, although this is not always the case.
(c) When any aspect of information-handling is outsourced, there is an increased risk of
commercially-sensitive data getting into the wrong hands.
(d) There will almost certainly be opposition from the employees affected by a decision to outsource.

5.2 Criteria for selecting functions to outsource
There are three main criteria for selecting functions for outsourcing.
(a) Whether or not the organisation sees the function as one that is part of its 'core business' or
'core competences'. Functions that are not a part of core competences, such as office cleaning,
are potential candidates for outsourcing.
(b) The relative costs and relative benefits of outsourcing the function, compared with providing the
service in-house.
(c) The consequences of mistakes. If the sub-contractor makes mistakes in carrying out the work,
what would be the consequences, and how (if at all) would they be remedied?
5.3 Exercising control over the cost of outsourced activities
Controls over the cost of outsourcing should be implemented at the planning and negotiation stage.
(a) The organisation should document the details of the level and quality of the service it wants from
the external organisation.
(b) External organisations should then be invited to tender for the work. Ideally, the organisation
should have a policy for its tendering processes, such as a specification of the number of bids
required.
(c) The organisation should confirm a price with the successful bidder.
The organisation should also give consideration to dealing with problems that could arise with the external
provider.
(a) How is the quality of the service provided to be judged, to assess whether or not it is acceptable?
(b) A process should be established for approving costs in excess of those agreed in the contract.
(c) The organisation might want to include a get-out clause in the contract, in the event that it
becomes dissatisfied with the service provided.
(d) A price increase clause should be included in the contract, to agree a procedure for increasing the
price paid for the service at regular review intervals (e.g. annually).
(e) A price reduction clause might be included in the contract, to apply if the level of service is lower
than anticipated.
(f) The potential failure of the external provider, or the external provider pulling out of the contract,
leaving the organisation with, eg no cover for IT services.
When the outsourcing service has begun, there should be ongoing controls to ensure that the service
delivered reaches the contracted standards for volume and quality.
5.4 Joint ventures and partnerships
In the continuous search for improvements, and for new products and services, an organisation might
decide that it is unable to bear the full cost itself.
Joint ventures and partnerships are ways of carrying out an activity (for example, research and
development work) in collaboration with one or more other organisations. The companies in a joint
venture or partnership might even be competitors in other aspects of their operations.
An organisation might have a strategic objective of entering into partnerships, for example engineering
partnerships, with customer organisations, as a means of establishing long-term relationships with those
customers.
The main advantage of joint ventures or partnerships is to obtain the benefits of product developments or
activities that the organisation would otherwise be unable to have. The main disadvantage is that the
benefits are shared.
5.5 Preferred suppliers
A preferred supplier is one to whom a buyer gives advantages over other suppliers, usually in the form of
regular purchases, perhaps for a guaranteed future period. In many cases such a relationship is likely to
emerge as a result of long-standing good performance as a supplier in the past.
A buyer will enter into this sort of relationship if it wishes to be a preferred customer a customer whom
the supplier will favour over other customers. The major reason for choosing to have preferred suppliers
is that they can provide the customer with a competitive advantage they can provide a unique product
or service, or a degree of quality or value that is not made available to the customers competitors, or is
not available from other suppliers.
Examples might include providing unique access to the suppliers most talented staff, first right of refusal
on the supplier's time or manufacturing capacity, favourable intellectual property licensing or ownership
rights, first rights to the supplier's new ideas and technology, in-country presence or expertise, or a
suppliers willingness to forgo working on another customers projects.
A number of matters need to be carefully considered if preferred supplier status is being sought with a
customer. Many of these relate to the maintenance of a good relationship and good communication.
(a) Can the supplier afford to make this level of commitment to a particular customer? It may mean
investing in new systems and new processes that would not otherwise be needed (for example to
obtain ISO 9001:2000 certification). And this may not be a one-off expense: the supplier may be
asked to invest in new equipment in the future at its own expense as a means of growing its own
capabilities to match those required by the customer. The customer may also wish to influence
personnel selection, how they work and what they focus on.
(b) Is the supplier in a position to offer a competitive advantage to a customer, and if so can it do so
without compromising its own strategy or other business relationships? A good deal of existing
business may be lost if other customers are always placed second in the supplier's priorities, or
even if they just feel that they are placed second, despite the fact that they get the same level of
service as before.
(c) Is there any danger that the customer in question will renege on the agreement, or go out of
business, or be taken over by a third party who will not wish to continue the agreement? The
supplier must beware of putting all its eggs in one basket. Too much commitment to one customer
may make the supplier too inflexible, and unable to respond to changes in circumstances.
(d) Turnover of personnel on both sides may be a problem. If the relationship is too dependent on
individuals buyers may move business from one firm to another to stay with a person who has
provided good service in the past. It is important for suppliers to make sure that they meet the
customers needs via systemic approaches rather than through methods that are dependent on key
persons.
(e) Trust is a major issue. Both the customer and supplier need to be willing to share information with
each other that they might not normally share with another customer or supplier. This may be
difficult for some managers and employees to accept, especially at first.
(f) Customers will often make the mistake of assuming that since they are outsourcing to an expert in
the field, they can forget about having to manage that particular piece of their business. For day to
day issues this may be true, but the effort required to understand each other's expectations and
objectives, together with that required to build strong relationships, can far exceed the
management effort required for in-house work.
(g) The status of work needs to be communicated regularly and routinely. The customer should hear
about problems as quickly as if it had performed the work in-house. Overspending by the supplier

should not happen: if additional funds are required this should be discussed proactively with the
customer. Again such methods of working may be difficult for some managers and employees to
accept at first, if they are used to doing things differently.
(h) Clear definitions of leadership and overall accountability for the work will need to be established
from the outset. These may conflict with existing arrangements, and once again be difficult for
managers and employees to accept. On the other hand, in a preferred customer-supplier
relationship, the axiom 'the customer is always right' does not hold true. The customer depends
upon the expertise that the supplier brings to the table. Thus, if the supplier does not understand
why the customer wants the work done in a certain manner, or the supplier thinks it has a better
approach, this should be discussed. If the customers desires prevail, there should be mutual
agreement as to why this is appropriate, as well as a clear delineation of the responsibilities and
liabilities of each party.
(i) The business ethics of the supplier should be the same as those of the customer. The supplier
should understand the customers principles and behave accordingly. However, in certain
circumstances this may require a change of culture, which the supplier may find hard to achieve.

Case Study

Preferred suppliers
For many businesses, streamlining the number of suppliers that need to be linked into the corporate
systems is a mammoth task. Industrial gas supplier BOC spent over two years in the late 1990s paring
down the number of companies in its supply chain from 200 to 10. Ted Dwyer, BOC materials manager,
says the streamlining process is essential if a company is going to be in a position where it can strengthen
links with its suppliers.
'By working together, defences go down and a desire to build on a relationship comes through,' he says.
'We can consolidate spend, put in place agreements and negotiate prices that can only be achieved when
you have fewer suppliers.'
An extract from the BOC website emphasises many of the key points made in this section.
'BOC aims to work with suppliers who share our dedication and commitment to quality and continuous
improvement. BOC aims to operate with suppliers and partners who operate within a legal and ethical
framework. BOC will terminate relationships with suppliers that fail repeatedly to maintain or who show a
gross disregard for the standards outlined in the ethical purchasing policy. Additionally, we seek to do
business with those who can provide us with a competitive advantage and who can supply goods and
services in a reliable and cost-effective manner. These business relationships are based on more than just
price. The mutual lasting benefits to both parties come through innovation and improvements in
specification, service, business process and a deeper understanding of each other's businesses. We will
develop meaningful performance measurement together, along with a greater focus and understanding of
our customers' needs and requirements.'
(www.boc.com/suppliers and partners/)

5.6 Measuring the outcomes of outsourcing
When a business outsources certain functions the business loses a certain amount of control over the
performance of the function. Before the decision to outsource is taken, the business will have to consider
two things.
(a) Will the supplier perform the function better than or as well as the business itself (where better
will include both a cost and a performance criterion)?
The answer to (a) will depend on the nature of the outsourced function. Most businesses consider
outsourcing non-core activities to a specialist provider on the basis that the expertise and the
economies of scale that are available to the provider will ensure that the outcome is satisfactory.
Airlines often use external caterers, taking the attitude that we fly planes, we dont make
sandwiches. Before entering into the agreement the business would have to
decide the performance targets that the supplier would have to meet
obtain some indication (probably based on the past record of the supplier) that the supplier
would meet those targets
calculate the cost to the business of performing to that standard themselves, including the
management time and the opportunity cost of that management time
agree a price with the supplier that was acceptable.
(b) Can the business identify and enforce performance measures on the supplier?
Identifying performance should not present a problem for the business as it is likely that the
business already has performance measures for the function which it will be performing itself.
The measures should be both quantitative and qualitative. The quantitative measures will depend
on the function itself and must be easily measurable.
The qualitative measures will be very important to the business particularly if the function involves
direct contact with the businesss own customers. Differences in attitude and culture between the
business and the supplier company have to be minimised or eliminated in case the customers do
not receive the proper experience that the business fosters in all its dealings.
5.7 Measuring the outcomes of joint ventures and partnerships
As with outsourcing, a business that is considering joint ventures or partnerships must assess whether
the arrangements will improve overall performance and whether it can measure and control that
improvement.
The difference from outsourcing is that the business may not be seeking external assistance because it is
not itself specialised in the particular area, but rather because there may be some joint benefits or joint
expertise that both parties may enjoy.
The decision whether the arrangement will offer improved performance will be made more difficult
because the business will be sharing the results of the arrangement and will not have sole ownership or
control.
As with outsourcing however, the same broad principles apply.
(a) The decision to enter into the arrangement will be based on calculations as to profitability, market
share, brand perception and whatever other objectives the business is seeking. Even more
importantly, the business will consider the culture of the proposed partner and whether it is similar
enough to their own.
(b) The control of the outcome when the arrangement is in place will involve qualitative and
quantitative measures as before.
6 Activity-based management and business process
re-engineering
Activity-based management is an approach to management based on the study of major activities within
an organisation. ABM seeks improvements in these activities, in terms of cost, quality, time to complete
and innovation.
Business process re-engineering involves a radical re-assessment of processes within an organisation,
and questions why activities are carried out, when, where and by whom. The aim is to overhaul processes,
with a view to achieving improvements in performance.

6.1 Activity-based management (ABM)
Activity-based management has connections with activity-based costing and activity-based budgeting. It
is a system of management that uses activity-based cost information to improve performance, for example
by reducing costs, or for cost-modelling or customer profitability analysis.
Whereas the emphasis of activity-based costing is to produce more accurate product costs and
assessments of profitability, activity-based management is the application of activity cost analysis to the
management of costs. ABM has been defined as 'a system-wide, integrated approach that focuses
management's attention on activities with the object of improving customer value and the profit achieved
by providing this value'. (Hansen and Mowen, Cost Management Accounting and Control).
The aim of ABM is to analyse the activities within an organisation, their cost drivers, and the resources
they consume, with a view to reducing costs by improving the way in which the activities are carried out
and managed. The aim is to question the purpose of activities, as well as how well they are performed.
ABM analysis provides information about the costs of activities, including inefficient activities, and the
potential benefits to be gained from improvements.
ABM information can support measures to introduce radical changes and improvements to business
operations, through business process re-engineering, re-designing the layout of plants, or outsourcing
some aspects of operations.
An activity-based approach to cost analysis is useful for studying cost trends, and for assessing whether
improvements are being achieved.
6.2 Example
For example, a major area of 'overhead' in manufacturing organisations used to be known as
'warehousing', but is now commonly known as 'materials handling'. If the cost driver for materials
handling is the number of production runs, a materials handling cost per production run can be measured,
and trends in this cost monitored over time. Targets can also be set for reductions in this activity cost.

Case Study

An example from the 1990s is the Dutch company Wavin, a manufacturer of plastic pipe systems. This
company identified strong relationships between activities and costs.
Activity/cost pool Cost drivers
Extrusion production Product weights, number of production runs
Injection moulding Cycle times, set-ups, number of pieces
Finishing Standard times, number of pieces
Maintenance Production volume, planned maintenance programme
Warehousing Number of warehouse locations, number of lanes, number of products,
demand levels
Order entry Customer groups, number of customers/order lines
Selling costs Number of sales representative's calls
Finance Number of customers/suppliers/transactions
An ABM approach would consider ways of reducing costs in each of these areas, improving quality, reducing
times to get work done and encouraging innovation. Each activity should be studied, together with the drivers
that give rise to cost, and methods for improvements devised. In the example of Wavin, one approach to the
management of warehousing might be to consider ways of reducing the number of warehouse locations, or re-
designing the layout of warehouses. Similarly, an approach to managing selling costs would be to consider
ways of reducing the number of sales representatives' calls that are necessary.

6.3 Activity-based approach to cost management
An activity-based approach to the management of costs is based on a number of different perceptions.
(a) Organisation structure. Traditionally, costs have been reported in a way that reflects the structure
of an organisation (e.g. production costs, administration overheads, departmental costs). What
businesses do, however, are processes or activities that cut across departmental boundaries.
Activity costs should be studied, rather than departmental costs.
(b) Overhead costs. Overhead costs are a large proportion of total costs in many organisations.
Management attention should therefore focus on these 'overhead' areas, in administration, selling
and distribution, as well as in production.
(c) Timing. Traditional costing focuses on the costs of production for established products. However,
the costs of a product are largely determined by their design. It is at the design stage that decisions
are made about what materials will be used in a product, what features should be incorporated in
the product, and what production methods will be used to make it. In the car industry, it has been
estimated that 85% of all future product costs are largely determined by the end of the new model
testing stage.
(d) Controllable costs. It has been argued that only a small percentage of direct costs are actually
controllable, whereas a much larger proportion of overhead costs are controllable. Management
should therefore give close attention to the management of these costs.
(e) Many costs are driven by customers; for example, order-handling costs, selling costs, after-sales
service, finance costs, and so on. Companies might be trading at a loss with some of its
customers, without being aware of this fact. An ABC approach to customer profitability analysis will
show which customers are more profitable than others, and which customers make losses for the
company. Improvement measures can then be devised from this analysis.
6.4 Elements of activity-based management
ABM is not just about cost reduction. There are four areas of activity-based management. These are:
(a) Cost. Addressing the problems of activity costs, and finding ways to reduce costs.
(b) Quality. Exploring factors that inhibit performance and restrict quality.
(c) Time. Exploring the causes of inflexibility, inertia and bottlenecks in work flow.
(d) Innovation. Exploring ways of enhancing innovation and process flexibility.
ABM, defined broadly, therefore encompasses a range of performance management methodologies, such
as just-in-time, total quality management, business process re-engineering, and customer profitability
analysis, as well as activity-based costing, activity-based cost management and activity-based budgeting.
The following comments have been made about ABM.
(a) 'True ABM involves the use of activities in planning, budgeting, costing, modelling and
performance measurement.'
(b) 'ABM allows all activities to be linked to business processes and hence encourages managers to
take a cross-functional view of the organisation.'
(c) 'ABM encourages people to focus on business processes and hence eliminate the need for complex
management structures often associated with functional organisations.'
6.5 Activity-based management and activity-based costing compared
Activity-based management and activity-based costing are approaches to performance measurement and
management based on an analysis of activities. An activity-based costing system might also be
established as part of an activity-based management programme. However, it is also possible to have
ABM without ABC, and ABC without ABM.
Activity-based costing is a costing system that can be introduced into an organisation to replace the
traditional absorption costing system. It can be used to cost products, and can also be used as a basis for
budgeting and for setting product prices (cost plus pricing).

In contrast, ABM is an approach to improving efficiency within the organisation by focusing on
improvements in the activities that are carried out. Improvements include not just cost reduction, but also
quality improvements, reduction in times and innovation. ABM applications are not concerned with the
cost of end products, but with the cost of activities. Many ABM applications may be one-off exercises,
whereas activity-based costing is a system of costing that will be used continually, for costing or for
pricing products.
It has been suggested by some writers on management that an organisation can use ABM for decision-
making, but should keep its traditional absorption costing system, without introducing ABC.
(a) ABM is an approach to improving performance, and does not need a formal ABC costing system to
support it.
(b) The use of activity-based costing information should be flexible, and (like information on relevant
costs and opportunity costs) does not need to be incorporated into the organisation's formal
costing system.
(c) However, where organisations have introduced ABC as their costing system, an ABM approach to
improving performance should make use of the ABC information available from the costing system.
6.6 Business process re-engineering (BPR)
Business process re-engineering can be regarded as an element of activity-based management.
Business process re-engineering (BPR) is the 'selection of areas of business activity in which repeatable
and repeated sets of activity are undertaken, and the development of improved understanding of how they
operate and the scope for radical re-design, with a view to creating and delivering better customer value.'
(CIMA Official Terminology)
There are three underlying themes in BPR.
(a) The need to make radical changes to the organisation. In effect, the approach in BPR is to start
with a clean sheet of paper, and ask the question: 'If we were starting again from scratch, how
would we do things?'. Other critical questions are:
What is done? Why do it?
How is it done? Why do it that way?
Where is it done? Why do it there?
When is it done? Why do it then?
Who does it? Why that person?
(b) The need to change functional hierarchies. A traditional functional hierarchy within an
organisation encourages functional excellence. However, the various functions often fail to work
well together to meet customer needs. The interface between different functions is often a cause of
major problem, resulting in inter-departmental rivalries, inefficiencies, excess costs, wasting of
time and loss of quality.
(c) The need to address the problem of fragmented staff roles. Many employees are now highly-
specialised, with the result that they are only responsible for a small part of the overall task. This
can result in loss of accountability for a finished task, and also a need for highly-complex
scheduling and control systems.
Properly-implemented, BPR may help an organisation to reduce costs, improve service to customers, cut
down on the complexity of the business and improve internal communications. At best, it might bring
about new insight into the objectives of an organisation and how best to achieve them. At worst, BPR is a
glorified term for squeezing costs (usually through redundancies).
6.7 Example: cellular manufacturing
An example of a development in manufacturing that might be described as BPR is cellular manufacturing.
Traditionally, manufacturing industries have fallen into a few broad groups according to the nature of the
production process and materials flow.
Type of production Description
Jobbing industries Items are produced individually for a specific customer order or 'job'. Versatile
equipment and highly-skilled workers are needed to give business the flexibility to
do a variety of jobs. The jobbing factory is typically laid out on a functional basis
with, say, a milling department, a cutting department and so on.
Batch processing The manufacture of standard goods in batches. Batch production is often carried
out using functional layouts but with a greater number of more specialised
machines.
Mass production Involves the continuous production of standard items from a sequence of
continuous or repetitive operations. Often uses a product-based layout whereby
Product A moves from its milling machine to its cutting machine to its paint-
spraying machine, Product B moves from its sawing machine to its milling
machine and so on. There is no separate 'milling department' or 'assembly
department' to which all products must be sent to await their turn on the
machines: each product has its own dedicated machines.
Cell manufacturing combines the flexibility of the functional layout with the speed and productivity of the
product layout. It involves a U-shaped production line along which are arranged a number of different
machines that are used to make products with similar machining requirements.
The machines are operated by workers who are multi-skilled rather than limited to one operation such as
'grinder', or whatever. The aim is to facilitate just-in-time production and obtain the associated
improvements in quality and reductions in costs.

Case Study

Dedicated cells
In January 1994 the Financial Times carried a good example of this approach in an article about the Paddy
Hopkirk car accessory factory in Bedfordshire.
One morning the factory was just an untidy sprawl of production lines surrounded by piles of crates
holding semi-finished components. Two days later, when the workforce came to work [after Christmas],
the machines had been brought together in tightly grouped "cells". The piles of components had
disappeared, and the newly-cleared floor space was neatly marked with colour-coded lines mapping out
the flow of materials.
Overnight there were dramatic differences. In the first full day, productivity on some lines increased by up
to 30%, the space needed for some processes had been halved, and work-in-progress had been cut
considerably. The improved layout had allowed some jobs to be combined, freeing up operators for
deployment elsewhere in the factory.
The new layout encourages 'one-piece production', with as many processes as possible being carried out
on a single part consecutively rather than one process being done in a big batch. Parts are only delivered
to the next stage of the production or assembly process when they are needed rather than piling up in
huge storage bins, as before. Unnecessary walking and movements are eliminated by setting up
production in a horseshoe shape rather than a straight line: 'in this way an operator doing a number of
tasks will end up at the starting point for the next cycle'.

The advantages of cellular manufacturing are:
(a) increased flexibility, because staff are multi-skilled and will do any task necessary.

(b) reductions in idle time, because temporary lulls in activity will be filled by routine maintenance
work rather than sitting waiting for production to pick up.
(c) reduction in work-in-progress, because products do not have to wait in a queue for a machine to
be available. This frees up working capital for other uses.
(d) reduction in unnecessary movement of operatives and handling of materials (and associated
costs), because of the horseshoe layout.
(e) reduction in process losses and returns of faulty goods, because ongoing training means that staff
are more highly skilled and more careful, have more responsibility for the whole product, and are
committed to producing high quality output.
(f) rapid response to sudden changes in demand or requirements, because of increased skills and the
reduced likelihood of bottlenecks. Late delivery will be much reduced or eliminated, increasing
customer satisfaction.
(g) better motivation amongst workers, partly because they will probably receive better rates of pay to
allow for increased responsibilities, but also because the cultivation of a team spirit should
increase levels of performance as employees take more pride in their work, and more account of
each others' needs.
(h) the improvement in the working environment and the support offered by team members should
reduce the level of staff turnover and its associated costs.
6.8 Problems caused by the technological interdependence between
departments
The value chain describes a series of activities from input of raw materials to output of finished
goods/services for the customers. These activities may be organised into departments even though the
actual process of adding value may cross departmental boundaries.
The links between different departments of a business can vary, however, and hence the need to
manage the relationships between them. Interdependence is the extent to which different departments
depend on each other to accomplish their tasks. It is possible to identify three types of interdependence.
(a) In pooled interdependence, each department/section works independently of the others, subject
to achieving the overall goals of the organisation.
(b) Sequential interdependence is when there is a sequence (or a linked chain of activities) with a
start and end point. An example is an assembly line: raw materials are taken, moulded to the right
sizes and shapes and are assembled into a product. The outputs of each stage sequence must be
precisely tailored to the inputs of the next standardisation of outputs might be one form of co-
ordination used. The first activity must be performed correctly before the second can be tackled.
Management effort is required to ensure that the transfer of resources between departments is
smooth. They therefore need information about the process as a whole.
(c) Reciprocal interdependence exists when a number of departments acquire inputs from and

offer
outputs to each other. In other words, while resources have to be transferred, there is no preset
sequence. The output of one department might be sent to another for processing, and then
returned to the original department.
You should now have some idea as to the complexities of business processes overlapping different
departments. Some organisations have redesigned their structures on the lines of business processes,
adopting

BPR to avoid all the co-ordination problems caused by reciprocal interdependence.
6.9 Changes that affect organisations which have adopted BPR
(a) Work units change from functional departments to process teams, which replace the old
functional structure.
(i) For example, within a functional framework, a sales order may be handled by many different
people, in different departments or business functions. (One person takes the order in the
department, and one person delivers.)
(ii) In process teams, the people are grouped together. A case team might combine to do all the
work on a process and this applies not only to one-off projects but to recurring work.
Multi-skilling also means that one individual does many of the tasks in a process.
(b) Jobs change. People do more, as team members are responsible for results. This ties in with job
enlargement and job enrichment.
(c) People's roles change. They are empowered to make decisions relevant to the process.
(d) Performance measures concentrate on results rather than activities. Process teams create 'value'
which is measurable.
(e) Organisation structures change from hierarchical to flat (ie delayered).
(i) When a process becomes the work of a whole team, managing the process is the team's
responsibility. Interdepartmental issues become matters the team resolves itself, rather
than matters requiring managerial intervention.
(ii) Companies require less managerial input. Managers have less to do, there are fewer of
them and so fewer layers.
(iii) Organisation structure determines lines of communication, and in many organisations is a
weighty issue. This is not the case in process organisations, as lines of communication
'naturally' develop around business processes.
7 Further aspects of ABM and BPR
The aim of activity-based management (ABM) is to provide management with a method of introducing and
managing process and organisational change.
It focuses on activities within a process, decision-making and planning relative to those activities and the
need for continuous improvement of all organisational activity. Management and staff must determine
which activities are critical to success and decide how these are to be clearly defined across all functions.
Everyone must co-operate in defining:
Cost pools
Cost drivers
Key performance indicators
They must be trained and empowered to act; all must be fairly treated and success recognised.
Clearly, ABM and employee empowerment take a critical step forward beyond ABC by recognising the
contribution that people make as the key resource in any organisation's success.
It nurtures good communication and team work
It develops quality decision-making
It leads to quality control and continuous improvement
Some accountants do not appear to understand that ABM provides an essential link to total quality
management (TQM) and its concepts of 'continuous improvement'.
ABM helps deliver:
improved quality
increased customer satisfaction
lower costs
increased profitability
It provides accountants and other technical managers with a meaningful path into the business
management team.

Perhaps the clearest and most concise definition is offered by Kaplan et al in Management Accounting.
Activity-based management (ABM) is 'the management processes that use the information provided by
an activity-based cost analysis to improve organisational profitability. Activity-based management (ABM)
includes performing activities more efficiently, eliminating the need to perform certain activities that do not
add value for customers, improving the design of products, and developing better relationships with
customers and suppliers. The goal of ABM is to enable customer needs to be satisfied while making fewer
demands on organisational resources.'
7.1 Cost reduction and process improvement
Traditional cost analysis analyses costs by types of expense for each responsibility centre. ABM, on the
other hand, analyses costs on the basis of cross-departmental activities and therefore provides
management information on why costs are incurred and on the output of the activity in terms of cost
drivers. By controlling or reducing the incidence of the cost driver, the associated cost can be
controlled or reduced.
This difference is illustrated in the example below of a customer order processing activity.
Traditional analysis

$

Salaries

5,700

Stationery

350

Travel

1,290

Telephone

980

Equipment depreciation

680

9,000

ABC analysis

$

Preparation of quotations

4,200

Receipt of customer orders

900

Assessment of customer creditworthiness

1,100

Expedition of orders

1,300

Resolution of customer problems

1,500

9,000

Suppose that the analysis above showed that it cost $250 to process a customer's order. This would
indicate to sales staff that it may not be worthwhile chasing orders with a low sales value. By eliminating
lots of small orders and focusing on those with a larger value, demand for the activities associated with
customer order processing should fall, with spending decreasing as a consequence.
7.1.1 Problems associated with cost reduction and ABM
(a) The extent to which activity based approaches can be applied is very dependent on an
organisation's ability to identify its main activities and their associated cost drivers.
(b) If a system of 'conventional' responsibility centres has been carefully designed, this may already be
a reflection of the key organisational activities. For example, a despatch department might be a cost
centre, but despatch might also be a key activity.
(c) In some circumstances, the 'pooling' of activity based costs and the identification of a single cost
driver for every cost pool may even hamper effective control if the cost driver is not completely
applicable to every cost within that cost pool. For example, suppose the cost of materials handling
was allocated to a cost pool for which the cost driver was the number of production runs.
Logically, to control the cost of materials handling the number of production runs should be
controlled. If the cost is actually driven by the weight of materials being handled, however, it can
only be controlled if efforts are made to use lighter materials where possible.
7.2 Activity analysis
The activity based analysis above provides information not available from a traditional cost analysis. Why
was $1,500 spent on resolving customer problems, for example? An activity analysis usually surprises
managers who had not realised the amount being spent on certain activities. This leads to questions
about the necessity for particular activities and, if an activity is required, whether it can be carried out
more effectively and efficiently.
Such questions can be answered by classifying activities as value added or non-value added (or as
core/primary, support or diversionary/discretionary).
7.2.1 Value-added and non-value-added activities
An activity may increase the worth of a product or service to the customer; in this case the customer is
willing to pay for that activity and it is considered value-added. Some activities, though, simply increase
the time spent on a product or service but do not increase its worth to the customer; these activities are
non-value-added. (Rayborn, Barfield and Kinney, Managerial Accounting)
As an example, getting luggage on the proper flight is a value-added activity for airlines, dealing with
the complaints from customers whose luggage gets lost is not.
The time spent on non-value-added activities creates additional costs that are unnecessary. If such
activities were eliminated, costs would decrease without affecting the market value or quality of the
product or service.
The processing time of an organisation is made up of four types.
(a) Production or performance time is the actual time that it takes to perform the functions necessary
to manufacture the product or perform the service.
(b) Performing quality control results in inspection time.
(c) Moving products or components from one place to another is transfer time.
(d) Storage time and time spent waiting at the production operation for processing are idle time.
Production time is value added. The other three are not. The time from receipt of an order to
completion of a product or performance of a service equals production time plus non-value-added
time.
JIT would of course eliminate a significant proportion of the idle time occurring from storage and wait
processes but it is important to realise that very few organisations can completely eliminate all quality
control functions and all transfer time. If managers understand the non-value-added nature of these
functions, however, they should be able to minimise such activities as much as possible.
Sometimes non-value-added activities arise because of inadequacies in existing processes and so they
cannot be eliminated unless these inadequacies are addressed.
(a) The UK's National Health Service (NHS) is a classic example of this. Some heart patients on the
NHS wait up to four months for critical heart surgery. During this time they are likely to be severely
ill on a number of occasions and have to be taken to hospital where they spend the day receiving
treatment that will temporarily relieve the problem. This non-value-added activity is totally
unnecessary and is dependent on an inadequate process: that of providing operations when
required.
(b) Customer complaints services can be viewed in the same way: eliminate the source of complaints
and the need for the department greatly reduces.
(c) Setting up machinery for a new production run is a non-value-added cost. If the number of
components per product can be reduced the number of different components made will reduce and
therefore set-up time will also reduce.
One of the costliest things an organisation can do is to invest in equipment and people to make non-
value-added activities more efficient. The objective is to eliminate them altogether or subject them to a

major overhaul, not make them more efficient. For example, if a supplier of raw materials makes a
commitment to supply high-quality materials, inspection is no longer required, and buying testing
equipment and hiring more staff to inspect incoming raw material would waste time and money. Non-
value-added activities are not necessary for an organisation to stay in business.
7.2.2 Core/primary, support and diversionary/discretionary activities
This is an alternative classification of activities.
A core activity or primary activity is one that adds value to a product, for example cutting and drilling
materials and assembling them.
A secondary activity is one that supports a core activity, but does not add value in itself. For example
setting up a machine so that it drills holes of a certain size is a secondary activity.
Diversionary activities or discretionary activities do not add value and are symptoms of failure within an
organisation. For instance repairing faulty production work is such an activity because the production
should not have been faulty in the first place.
The aim of ABM is to try to eliminate as far as possible the diversionary activities but, as with non-value-
added activities, experience has shown that it is usually impossible to eliminate them all, although the time
and cost associated with them can be greatly reduced.
7.3 Performance evaluation
ABM encourages and rewards employees for developing new skills, accepting greater responsibilities, and
making suggestions for improvements in plant layout, product design, and staff utilisation. Each of these
improvements reduces non-value-added time and cost. In addition, by focusing on activities and costs,
ABM is better able to provide more appropriate measures of performance than are found in more
traditional systems.
To monitor the effectiveness and efficiency of activities, performance measures relating to volume, time,
quality and costs are needed.
(a) Activity volume measures provide an indication of the throughput and capacity utilisation of
activities. For example reporting the number of times an activity such as setting-up is undertaken
focuses attention on the need to investigate ways of reducing the volume of the activity and hence
future costs.
(b) To increase customer satisfaction, organisations must provide a speedy response to customer
requests and reduce the time taken to develop and bring a new product to the market.
Organisations must therefore focus on the time taken to complete an activity or sequence of
activities. This time can be reduced by eliminating (as far as is possible) the time spent on non-
value-added activities.
(c) A focus on value chain analysis is a means of enhancing customer satisfaction. The value chain is
the linked set of activities from basic raw material acquisition all the way through to the end-use
product or service delivered to the customer. By viewing each of the activities in the value chain as
a supplier-customer relationship, the opinions of the customers can be used to provide useful
feedback on the quality of the service provided by the supplying activity. For example the quality of
the service provided by the processing of purchase orders activity can be evaluated by users of the
activity in terms of the speed of processing orders and the quality of the service provided by the
supplier chosen by the purchasing activity. Such qualitative evaluations can be supported by
quantitative measures such as percentage of deliveries that are late.
(d) Cost driver rates (such as cost per set-up) can be communicated in a format that is easily
understood by all staff and can be used to motivate managers to reduce the cost of performing
activities (given that cost driver rate activity level = cost of activity). Their use as a measure of
performance can induce dysfunctional behaviour, however. By splitting production runs and
therefore having more set-ups, the cost per set-up can be reduced. Workload will be increased,
however, and so in the long run costs could increase.
7.4 Problems with ABM
ABM is not a panacea, however.
(a) The amount of work in setting up the system and in data collection must be considered.
(b) Organisational and behavioural consequences. Selected activity cost pools may not correspond
to the formal structure of cost responsibilities within the organisation (the purchasing activity may
spread across purchasing, production, stores, administrative and finance departments) and so
determining 'ownership' of the activity and its costs may be problematic.
7.5 Comparing ABM and BPR
We have already said that business process re-engineering can be regarded as an element of activity
based management.
BPR is concerned with analysing the business processes across the whole company (not just the
engineering process part of a manufacturing company) and studying in particular the areas where
repeated activities are undertaken. This may be an activity that is repeated in a given process (for example
materials handling) such that the process may be reorganised to reduce the number of materials
movements. Alternatively it may be an activity that occurs only once in a process but is repeated in
different processes such that the activity may perhaps be reorganised to satisfy both processes at the
same time. This could again be materials handling where two processes are serviced by internal deliveries
at different times of the day rescheduling the deliveries and the processes may remove the need for the
second delivery.
ABM concentrates more on the major activities within the organisation and seeks improvements in these
activities in terms of cost, quality, time to complete and innovation. It is a more complete overhaul of the
business than BPR and encompasses such techniques as JIT, TQM, customer profitability analysis and
BPR.
8 Total quality management (TQM)
Total quality management is an approach to quality improvements that seeks to eliminate waste entirely
and to achieve perfect quality standards.
Quality means 'the degree of excellence of a thing' how well it is made, or how well it is performed (if it
is a service), how well it serves its purpose, and how it measures up against its rivals.
The management of quality is the process of:
(a) Establishing standards of quality for a product or service
(b) Establishing procedures or production methods which ought to ensure that these required
standards of quality are met in a suitably high proportion of cases
(c) Monitoring actual quality
(d) Taking control action when actual quality falls below standard
Quality management becomes total when it is applied to everything a business does.
TQM is 'An integrated and comprehensive system of planning and controlling all business functions so
that products or services are produced which meet or exceed customer expectations. TQM is a philosophy
of business behaviour, embracing principles such as employee involvement, continuous improvement at
all levels and customer focus, as well as being a collection of related techniques aimed at improving
quality such as full documentation of activities, clear goal setting and performance measurement from the
customer perspective.' (CIMA, Official Terminology)

TQM has been described as a 'natural extension' of previous approaches to quality management, which
were:
(a) Inspection, i.e. inspecting output in order to detect and rectify errors.
(b) Quality control, i.e. using statistical techniques to establish quality standards and monitor process
performance.
(c) Quality assurance. This extended quality management to areas other than direct operations, and
uses concepts such as quality costing, quality planning and problem solving.
8.1 Get it right first time
One of the basic principles of TQM is that the cost of preventing mistakes is less than the cost of
correcting them once they occur. The aim should therefore be to get things right first time.
'Every mistake, every delay and misunderstanding directly costs a company money through wasted time
and effort, including time taken in pacifying customers. Whilst this cost is important, the impact of poor
customer service in terms of lost potential for future sales has also to be taken into account'.
8.2 Continuous improvement
A second basic principle of TQM is dissatisfaction with the status quo: the belief that it is always possible
to improve and so the aim should be to 'get it more right next time'.

Case Study

In an average factory only one second is spent adding value - like drilling holes or packing - for every
1,000 seconds spent not adding value. Experts say that they have never seen a factory cut this ratio to less
than 1:200. This nevertheless indicates the extent to which continuous improvement is possible and how
workers should continuously be seeking ways to reduce time-wasting effort.

8.3 The requirements of quality
There are nine elements in a TQM approach.
(a) Accept that the only thing that matters is the customer.
(b) Recognise the all-pervasive nature of the customer-supplier relationship, including internal
customers: passing sub-standard material to another division is not satisfactory or acceptable.
(c) Move from relying on inspecting to a predefined level of quality to preventing the cause of the
defect in the first place.
(d) Each operative or group of operatives must be personally responsible for defect-free production
or service in their domain. TQM requires an awareness by all personnel of the quality
requirements compatible with supplying the customer with products of the agreed design
specification.
(e) Move away from 'acceptable' quality levels. Any level of defects is unacceptable. TQM aims
towards an environment of zero defects at minimum cost.
(f) It also aims towards the elimination of waste, where waste is defined as anything other than the
minimum essential amount of equipment, materials, space and workers' time.
(g) All departments should try obsessively to get things right first time: this applies to misdirected
telephone calls and typing errors as much as to production.
(h) Quality certification programmes should be introduced.
(i) The cost of poor quality should be emphasised: good quality generates savings.
When quality improvements are achieved by introducing new technology or new practices, then training
to show people how to use the new technology or implement the new practices will be required.
However, workers themselves are frequently the best source of information about how (or how not) to
improve quality. 'Training' means training workers to want to improve things: it is matter of changing
attitudes.
(a) Workers can be motivated by a positive approach to quality: producing quality work is a tangible
and worthwhile objective. Where responsibility for quality checking has been given to the worker
(encouraging self-supervision), job satisfaction may be increased: it is a kind of job enrichment,
and also a sign of trust and respect, because imposed controls have been removed.
(b) Cultural orientation (the deep 'belief' in quality, filtered down to all operatives) and work group
norms and influence can be used. Competition to meet and beat quality standards, for example,
might be encouraged. Quality circles may be set up, perhaps with responsibility for implementing
improvements which they identify.
8.4 Involvement of all parts of the organisation: internal customers and
internal suppliers
In a TQM approach, all parts of the organisation are involved in quality issues, and need to work together.
Every person and every activity in the organisation affects the work done by others.
TQM promotes the concept of the internal customer and internal supplier. The work done by an internal
supplier for an internal customer will eventually affect the quality of the product or service to the external
customer. In order to satisfy the expectations of the external customer, it is therefore also necessary to
satisfy the expectations of the internal customer at each stage of the overall operation. Internal customers
are therefore linked in quality chains. Internal customer A can satisfy internal customer B who can satisfy
internal customer C who in turn can satisfy the external customer.
The management of each 'micro operation' within an overall operation has the responsibility for managing
its internal supplier and internal customer relationships. They should do this by specifying the
requirements of their internal customers, for example in terms of quality, speed, dependability and
flexibility, and the requirements for the operation itself (for example, in terms of cost).
The concept of internal supplier-customer relationships in a series of micro-operations helps to focus
attention on the 'up-stream' activities in an operation, several stages removed from the external customer.
Failure at an early stage on the operation, for example in new product design, has an adverse impact on all
the supplier-customer relationships down the line to the external customer. The cost of rectifying an error
becomes more expensive the further it goes down the 'supply chain' without rectification.
Some organisations formalise the internal supplier-internal customer concept by requiring each internal
supplier to make a service level agreement with its internal customer. A service level agreement is a
statement of the standard of service and supply that will be provided to the internal customer and will
cover issues such as the range of services supplied, response times, dependability and so on. Boundaries
of responsibility and performance standards might also be included in the agreement.
Service level agreements have been criticised, however, for over-formalising the relationship between the
internal supplier and internal customer, and so creating barriers to the development of a constructive
relationship and genuine co-operation between them.
8.5 Empowerment
Empowerment has a vital place in the quality control process: 'the people lower down the organisation
possess the knowledge of what is going wrong within a process but lack the authority to make changes.
Those further up the structure have the authority to make changes but lack the profound knowledge
required to identify the right solutions. The only solution is to change the culture of the organisation so
that everyone can become involved in the process of improvement and work together to make the
changes'. (Max Hand)
Empowerment has two key aspects.
(a) Allowing workers to decide how to do the necessary work, using the skills they possess and
acquiring new skills as necessary to be an effective team member.

(b) Making those workers personally responsible for achieving production targets and for quality
control. (The French word for empowerment is 'responsibilisation'.)
8.6 Quality circles
A quality circle consists of a group of employees who meet regularly to discuss problems of quality and
quality control in their area of work, and perhaps to suggest ways of improving quality. The quality circle
has a leader who directs discussions and possibly also helps to train other members of the circle. It is also
a way to encourage innovation.
8.7 Design for quality
Quality control happens at various stages in the process of designing a product or service.
(a) At the product design stage, quality control means trying to design a product or service so that its
specifications provide a suitable balance between price and quality (of sales and delivery, as well as
manufacture) which will make the product or service competitive.
Modern manufacturing businesses use Computer Aided Design (CAD) to identify or rectify design
features such as the following.
(i) Opportunities to reduce the number of parts in a product overall. The fewer the number of
parts, the less parts there are to go wrong.
(ii) Opportunities to use parts or materials that are already used (or could be used) by other
products. The more common parts overall, the less chance there is of a product failing to
meet quality standards due to a rogue supplier of just one of many components. For
example if a car with electric windows can be designed to use the same glass as a cheaper
model with manually-wound windows, there will only be one glass supplier to keep a check
on.
(iii) Opportunities to improve physical characteristics such as shape, size or positioning of
controls and so on to make the product more user-friendly.
(b) Production engineering is the process of designing the methods for making a product (or service)
to the design specification. It sets out to make production methods as efficient as possible, and to
avoid the manufacture of sub-standard items.
(c) Administration: information systems should be designed to get the required information to the
right person at the right time; distribution systems should be designed to get the right item to the
right person at the right time; and so on.
8.8 Quality control and inspection
A distinction should be made between quality control and inspection.
(a) Quality control involves setting controls for the process of manufacture or service delivery. It is
aimed at preventing the manufacture of defective items or the provision of defective services.
(b) Inspection is concerned with looking at products made, supplies delivered and services provided,
to establish whether they are up to specification. It is a technique of identifying when defective
items are being produced at an unacceptable level. Inspection is usually carried out at three main
points.
(i) Receiving inspection - for raw materials and purchased components
(ii) Floor or process inspection for WIP
(iii) Final inspection or testing for finished goods
8.9 Quality costs
The cost of quality is defined as: 'The difference between the actual cost of producing, selling and
supporting products or services and the equivalent costs if there were no failures during production or
usage.' (CIMA, Official Terminology).
Quality costs are therefore incurred because the quality of production or a service is not perfect. There are
four categories of quality costs.
(a) Prevention cost. This is a cost incurred prior to making the product or delivering the service, in
order to prevent substandard quality or defective product being delivered.
(b) Appraisal cost or inspection cost. This is a cost incurred after a product has been made, to ensure
that the output meets the required quality standard.
(c) Internal failure cost. This is a cost arising from inadequate quality, where the problem is identified
before the transfer of the item from the organisation to the customer.
(d) External failure cost. This is a cost arising from inadequate quality, where the problem is identified
after the transfer of the item from the organisation to the customer.
8.10 Example
The different categories of quality cost can be illustrated in the context of a manufacturing operation.
(a) Prevention costs
The cost of building quality into the product design.
The cost of training staff in quality improvement and error prevention.
The cost of prevention devices (e.g. fail-safe features).
(b) Appraisal/inspection costs
The cost of inspecting finished goods or services, and other checking devices such as supplier
vetting.
Cost of inspecting goods inwards.
(c) Internal failure costs
Cost of materials scrapped due to inefficiencies in the procedures for goods received and stores
control.
Cost of materials and components lost during production.
Cost of units rejected during the inspection process.
Cost of re-working faulty output.
Cost of reviewing product specifications after failures.
Losses due to having to sell faulty output at lower prices.
(d) External failure costs
Cost of product liability claims from customers.
Cost of repairing products returned by customers.
Cost of replacing sub-standard products.
Delivery costs of returned units.
Cost of the customer services section and its operations.
Loss of customer goodwill and loss of future sales.
A 'traditional' approach to quality management is that there is an optimal level of quality effort, that
minimises total quality costs, and there is a point beyond which spending more on quality yields a benefit
that is less than the additional cost incurred. Diminishing returns set in beyond the optimal quality level.

The TQM philosophy is different. It takes the view that:
(a) Failure and poor quality are unacceptable. It is inappropriate to think of an optimal level of quality at
which some failures will occur, and the inevitability of errors is not something that an organisation
should accept. The target should be zero defects.
(b) Quality costs are difficult to measure, and failure costs in particular are often seriously under-
estimated. The real costs of failure include not just the cost of scrapped items and re-working
faulty items, but also all the management time spent sorting out problems and the loss of
confidence between different parts of the organisation whenever faults occur.
(c) A TQM approach does not accept that the prevention costs of achieving zero defects becomes
unacceptably high as the quality standard improves and goes above a certain level. In other words,
diminishing returns do not necessarily set in. If everyone in the organisation is involved in
improving quality, the cost of continuous improvement need not be high.
(d) If an organisation accepts an optimal quality level that it believes will minimise total quality costs,
there will be no further challenge to management to improve quality further.
The TQM quality cost model is based on the view that:
(a) Prevention costs and appraisal costs are subject to management influence or control. It is better to
spend money on prevention, before failures occur, than on inspection to detect failures after they
have happened.
(b) Internal failure costs and external failure costs are the consequences of the efforts spent on
prevention and appraisal. Extra effort on prevention will reduce internal failure costs and this in
turn will have a knock-on effect, reducing external failure costs as well.
In other words, higher spending on prevention will eventually lead to lower total quality costs, because
appraisal costs, internal failure costs and external failure costs will all be reduced. The emphasis should be
on 'getting things right first time' and 'designing in quality' to the product or service.
8.11 Quality systems and procedures
TQM is a management philosophy. However, implementing TQM is not simply a matter of involving
employees and encouraging a quality culture. There is also a need for systems and procedures for
ensuring quality. Quality systems should be documented thoroughly, in the form of:
(a) A company quality manual, summarising the quality management policy and system
(b) A procedures manual, setting out the functions, structures and responsibilities for quality in each
department, and
(c) Detailed work instructions and specifications for how work should be carried out, to achieve the
desired quality standards.
'ISO 9000' is shorthand for a family of standards for quality management systems, which has been
adopted by organisations world-wide. A company registering for ISO 9001:2000 certification is required to
submit its quality standards and procedures to external inspection. If it receives a certificate, it will be
subjected to continuing audit. The aim of an ISO 9001:2000 certificate is to provide an assurance to
customers (and suppliers) of the organisation that its products are made or its services are delivered in a
way that meets certain standards for quality.
Adopting the ISO 9000 family of standards can also give a company the discipline to focus on quality
issues and to implement a quality management system.
Despite revisions that bring it more into line with TQM thinking, ISO 9000 has been criticised for
encouraging a culture of 'management by manual'. The requirement to document all procedures and to
conduct internal audits of the system and its procedures, is also both time consuming and expensive.
9 Value for money (VFM)
Performance in some organisations, particularly in not-for-profit organisations, can be managed through
value for money. There are three elements to VFM: economy, efficiency and effectiveness. A VFM
approach to performance involves setting targets for achievement (effectiveness) and seeking to achieve
those targets economically and efficiently.
Value for money (VFM), as the term suggests, means giving or getting good value for the money spent.
The management of VFM means trying to ensure that value for money is obtained, or improved.
There are three elements in getting value for money, sometimes called the 'three Es'.
(a) Economy
(b) Efficiency
(c) Effectiveness
Economy. Economy means obtaining the appropriate quantity and quality of input resources (labour,
materials, machinery and equipment, finance, etc.) at the lowest cost.
Efficiency. Efficiency describes the relationship between the utilisation of resources (inputs) and the
output produced with those resources. Improving efficiency means getting more output from each unit of
input, or getting the same amount of output with fewer input resources.
Effectiveness. Effectiveness is concerned with whether an activity or output succeeds in fulfilling the
purpose for which it was intended.
VFM management can be applied in any organisation, but VFM is more usually associated with not-for-
profit organisations. The results of a not-for-profit organisation cannot be measured in terms of profits or
return on investment. Instead, results can be measured in terms of whether the organisation has
succeeded in achieving what it intended (effectiveness) at the lowest cost, through economic purchasing
and efficient use of resources.
9.1 Studying and measuring the three Es
Economy, efficiency and effectiveness can be studied and measured with reference to inputs, outputs and
impacts.
(a) Inputs. Inputs are resources used by an organisation or activity. Resources are labour, materials
and supplies, capital equipment and money. In a school, for example, inputs include the teaching
staff and administrative staff, the school buildings, teaching equipment and books.
(b) Outputs. Outputs are the results of an activity, which are measurable as the services actually
provided, and the quality of those services. In a school, outputs would include the number of pupils
taught, the number of subjects taught per pupil, the number of examinations taken by pupils, the
number of examinations passed and the grades obtained, the number of sixth-form pupils going on
to higher education, and so on.
(c) Impacts. Impacts are the effect that the outputs of an activity or programme have in terms of
achieving policy objectives. For example, in a school system, policy objectives might include
providing a minimum level of education up to the age of sixteen, and for a target percentage of
sixteen year olds to continue with their education and then go on to further education.
Economy is concerned with the cost of inputs, and obtaining the desired quality of resources at the lowest
cost. Economy does not mean straightforward cost-cutting, because resources must be of a suitable
quality to provide the service to the desired standard. However, economy is an important element in
performance in not-for-profit organisations, such as government services.
Efficiency is concerned with maximising output with a given quantity of resources, or achieving a target
output with the minimum quantity of resources. Examples of improving efficiency might be to increase the
number of cases handled by members of the police force or a hospital service.

Effectiveness means ensuring that the outputs of an activity or programme succeed in achieving the policy
objectives. For example, if the government has a policy of eliminating the incidence of a particular disease,
the effectiveness of the programme of elimination will be judged on whether it succeeds, and how quickly.

Question
Economy, efficiency or effectiveness

State whether each of the following events in a hospital service are examples of economy, efficiency or
effectiveness.
(a) The average waiting time for individuals requiring minor surgery has been reduced to 14 weeks.
The government's target is 15 weeks or less.
(b) A regional health authority recruited several hundred qualified nurses from the Philippines, to be
paid at standard rates of pay for nurses. This will reduce the requirement for overtime working by
the current nursing staff in hospitals and for the need to hire agency nurses.
(c) The average length of stay for patients in hospital beds in a particular area is reduced from 10 days
to 8 days.
(d) Fewer drugs are now needed to treat patients for a particular condition than was previously the
case.

Answer

(a) Effectiveness
(b) Economy
(c) Efficiency. If the government has a policy target for average stay, effectiveness would also be
involved.
(d) Efficiency

9.2 Example
Examples of VFM in the police force have included:
(a) Civilianisation of duties. Some tasks for which police training is unnecessary, previously carried out
by uniformed officers or detectives, are now carried out by civilian staff, at a lower cost. This also
frees up more time for uniformed staff and detectives to do work for which they are trained ('put
more bobbies on the beat').
(b) Life cycle costing techniques have been used to optimise the policy for managing the fleet of police
cars and other vehicles (optimal servicing policy, life cycle for cars before their replacement,
optimum use of the vehicles available, proper specifications of requirements prior to purchasing,
etc.)
9.3 VFM audits
A value for money audit is an investigation into whether proper arrangements have been made for
securing economy, efficiency and effectiveness in the use of resources. A VFM audit in the public sector
can be seen as an attempt to provide an independent verification that management has not spent
wastefully, unnecessarily or excessively.

Case Study

VFM: schools management
An illustrative example of applying VFM is in schools management in the UK. Since 1998, a larger
proportion of control over funding and spending decisions has been devolved to the managers of
individual schools. The UK government, through the Department for Children, Schools and Families
(DCSF), wants to ensure that schools management focus on the need to achieve value for money and has
issued a number of guidelines.
Examples of economy, efficiency and effectiveness in schools management are:
(a) Economy. Are costs being minimised having regard to the quality required? For example, are
schools supplies of the quality specified being purchased at the best available price? Would it be
cheaper to buy books via the Internet rather than through a bookshop or direct from the publisher?
(b) Efficiency. Have the costs of school meals been minimised, whilst at the same time enhancing the
nutritional quality of the food given to pupils? Would it be more efficient to hire a temporary
secretary to key examination data into the school's database instead of expecting a staff member to
do the work? Using a temp will release the staff member to do more appropriate professional work,
and the work should be completed in less time. Similarly, would it be more efficient to hire a full-
time information and computer technology engineer instead of expecting staff members to deal
with all problems in the school's computer systems?
(c) Effectiveness. Have the school's educational programmes improved examination success rates?
Did the external provider of the school care-taking service improve the standard of care-taking?
The DCSF recommends that when they look at VFM, school managers should look at the answers to three
questions.
(a) Are we spending money properly, and are we sure that our financial procedures are sound?
(b) Are we making wise decisions about spending money? Does our spending properly reflect the
school's priorities? Are we choosing the right things to spend our money on? (For example, if the
school has prioritised the need to improve standards of education at years 10 and 11, it should not
be spending a larger part of its budget on new equipment for the infants' department.)
(c) Are we making sure that the money we spend is spent well, and do we know whether it achieves
the desired results?
To deliver VFM, schools need to have in place:
(a) Sound financial management for the control of resources and proper accounting
(b) A system for organising the school's resources so as to maximise the effectiveness of those
resources
(c) Strategic management skills that allow the school to respond to changes in its environment, and to
innovate by introducing new initiatives.
Applying VFM to supply teacher decisions
The DCSF has suggested guidelines for how VFM should be applied to decisions about using 'supply
teachers' to cover for full-time teaching staff absent through illness or on training days. Research has
shown that schools make frequent use of supply teachers to cover for absences of full-time staff, but that
even with good supply teachers, children do not seem to learn much in the lessons they deliver. In some
areas, schools have great difficulty in finding supply teachers and a large number of supply teacher
agencies have opened up to meet the growing demand.
VFM suggestions are to:
(a) Limit the use of supply teachers, to improve teaching quality without increasing costs. It might be
better to employ a full-time 'floating' teacher to cover for the absences of colleagues. Smaller
schools might pool their budgets and share a full time 'floating' member of staff. Measures might
also be taken to reduce the absences of staff during term on training courses, by encouraging them
to go on courses during holidays, or to use distance learning programmes.
(b) Make better use of supply teachers. The inefficiency of supply teachers is probably due largely to
their lack of familiarity with the school, the way it operates, and its teaching programmes for each
term. Supply teachers might be used more efficiently and effectively if they are given an induction
to the school and better support from the full-time staff. A school might consider introducing a
formal system for evaluating their supply teachers, and to identify and deal with any weaknesses
and shortcomings revealed by the evaluation. There should also be strategic absence policies, so

that when full-time staff are absent, it is clear what the supply teacher should be teaching in each
particular lesson.

9.4 VFM and best value
In the UK, local government authorities are required to achieve 'best value' in the functions they carry out.
Best value has similarities to VFM, although the 3 Es of VFM are replaced by the 4 Cs of best value.
(a) Challenge. Challenge why, how and by whom each service is provided.
(b) Comparison. Compare the performance with the performance of other local authorities. Seek to
identify and apply good practice.
(c) Consultation. Consult with the users of local government services and with the community at large.
(d) Competition. Use fair competition, where practicable, to obtain efficient and effective local
government services.
10 Problems with value for money
10.1 Evaluation of VFM
When a value for money programme is established, an important element in the system should be review
and evaluation. Managers need to know whether the intended value for money has actually been achieved.
There are various ways of assessing VFM.
(a) Through benchmarking an activity against similar activities in other organisations. For example,
hospitals can compare what they do with practices in other hospitals.
(b) Through performance indicators. Actual performance can be monitored against targets.
(c) By seeking out recognised good practice and seeing whether this can be applied to the
organisation's own situation.
(d) Internal audit.
(e) By retaining documentation to show how an operation or activity has been planned, as evidence
that good practice has been adopted.
(f) By examining the results or outcomes of an activity or operation.
Economy, efficiency and effectiveness should seem desirable targets for management to achieve, but in
practice, there can be problems in performance measurement, particularly in the public sector. These
problems relate to:
(a) How to identify objectives, and then state them in quantifiable terms
(b) How to measure outputs and impacts.
A further problem is that there may be several totally different ways of meeting the service needs of the
public. If so, a government cannot easily compare the alternatives using VFM. For example, suppose that
the government's transport ministry is considering ways of easing congestion on the roads.
(a) It could build more roads.
(b) It could encourage the public to switch from using cars to other forms of transport, by increasing
the tax on petrol or imposing motorway tolls.
These alternatives cannot be compared in quantifiable terms, and so VFM could not be used as a
technique for reaching a policy decision.

Question
Assessing VFM

To bring the problems of measuring value for money into sharper focus, think about how you might
assess VFM in the following situations.
(a) A government's decision to spend $600 million in the next five years on controls to curb emissions
of sulphur dioxide from power stations, with a view to reducing acid rain in Europe.
(b) A manifesto from the Royal College of Nursing, criticising the government for a deep malaise in
nurses' training.
(c) Fluoride in water a long campaign for dental health care through prevention rather than cure.

Answer

(a) The input costs are measurable in money terms ($600 million), and the outputs can be measured
in non-monetary terms (emissions of sulphur dioxide). The problem is that the impact of any
reduction in the emissions on acid rain in Europe cannot be measured in a reliable way.
(b) The suggestion is that nurses' training should be improved, presumably by spending more money
on training, so that nurses will be able to do their work better, or carry out a wider range of tasks
and take some work load from doctors. Some outputs are measurable in non-financial terms, such
as numbers trained and courses provided. However, there could be a problem in measuring other
outputs, such as the improvement, if any, in the quality of the work done by nurses, and so the
effects on the quality or practices of the health service.
(c) The costs of providing fluoride in the water supply (inputs) can be measured, but again, there is a
problem in establishing a link between cause and effect. Just what impact is the programme having
on dental health in the longer term, and what health benefits and cost benefits (from a reduced
need for dental treatment) will there be? Are resources being used economically and efficiently?
For example, could the same results be achieved by putting less fluoride into water?

10.2 Barriers to value for money
Value for money is improved by making changes that reduce costs, increase efficiency or make an
operation more effective in achieving its desired target. However, a willingness to make changes calls for:
(a) Management that is willing to innovate and take serious steps to improve performance
(b) Generating ideas for improving VFM, and the ability to evaluate these ideas and put them into
practice
(c) The co-operation of employees, and a general motivation to improve VFM.
10.3 Effectiveness audit
An effectiveness audit is a technique for assessing the effectiveness of a project by carrying out an
ongoing review of the working of the project to assess whether it is working according to the original
intention. The performance measures that are examined are both financial and non-financial.
There are various ways in which the audit can take place but an example of the Public Finance Initiative
(PFI) in the UK National Health Service will illustrate the manner in which the audit is conducted.
The starting point is the design of a post-decision project evaluation system (PPE system). This is a
system for assessing how a PFI has functioned after the decision to implement it has been taken and the
project (say the building and running of a hospital) has been running for a period of time.
The PPE system should concentrate on the key features of the project, should cover all the risks of the
project and should engage with all stakeholders as to how they perceive the project is working.

The effectiveness audit should take place at about five yearly intervals and its function is to consider the
PPE system and assess how effectively the operation of the project satisfies the expectations set down
before the project started.
10.4 Programme budgeting
Programme budgeting and marginal analysis is a technique for allocating resources within the UK Health
Service. The system uses the notion of opportunity cost to determine where the marginal resource should
be spent if the marginal pound spent in project A delivers more value than the marginal pound spent in B
then the resource should be diverted to A. Thus if treating smoking addiction offers greater benefits than
knee joint surgery then resources should be diverted to curing the former.
The system is based on five questions. The first two relate to programme budgeting and are designed to
identify how the current budget is spent. The next three relate to the marginal analysis and are designed to
assess how resources should be moved to different procedures.

300 16: Performance measurement and management

1 Using performance measures to manage performance
Performance measures are used to provide a target for achievement. They are also used to compare
actual performance against target, and to identify areas where performance needs to be improved.
The purpose of a system of performance measures is to set targets for achievement, and then to compare
actual results against the target. Performance is managed because:
(a) Managers have clearly-defined targets that they are required to achieve
(b) Providing managers with information about actual performance allows them to monitor their
progress towards the targets, and to take control action where this seems appropriate
An individual manager should be given responsibility for trying to achieve one or more particular targets,
and should be accountable for the actual performance achieved (i.e. for 'success or failure'). Targets will
be ignored unless someone is given the task of reaching them.
The individual responsible for achieving a particular target needs to have the authority to make decisions
that could affect whether or not the targets are achieved. In other words, managers should only be made
responsible and accountable for results over which they have some control. The significance of
controllable costs in responsibility accounting systems has been mentioned in an earlier chapter.
Setting targets for which individual managers are responsible and accountable should be done at all levels
of management within the organisation structure. Management implies having some authority, and
managers should be made responsible for performance within their area of authority. The measures of
performance selected for each manager should be appropriate for that manager's responsibilities.

Performance
measurement and
management

16: Performance measurement and management 301
A system of setting performance targets and measuring actual results against performance is more likely
to be effective when managers (and other employees) are motivated to work towards achievement of
those targets. Motivation can be enhanced by reward/incentive systems.
1.1 Financial and non-financial targets
Each manager might be given just one performance target, or might have several different targets, both
financial and non-financial. The performance measures chosen for an individual manager should be
consistent with the goals of the organisation.
There will usually be at least one financial target for managers. At a senior level within the organisation, or
at divisional level, the main financial target might be ROI, residual income or economic value added. At
other levels of management, performance might be measured in terms of profitability, cost variances, cost
reduction, progress towards a target cost, or achieving sales revenue growth.
Various non-financial targets might be set for individual managers. The balanced scorecard approach is
useful in this respect, because it suggests how strategic targets can be set for non-financial goals, and
how these can be converted into operational goals for individual managers throughout the organisation.

Case Study

As an alternative to the balanced scorecard approach, it might be useful to note that as long ago as 1952,
General Electric undertook a performance measurement project and concluded that there were eight key
results areas or critical success factors that should be measured.
These were:
(a) Profitability
(b) Market position
(c) Productivity
(d) Product leadership
(e) Personnel development
(f) Employee attitudes
(g) Public responsibility
(h) Short- versus long-term balance

1.2 The danger of short-termism
Short-termism is the tendency to place greater significance on short-term performance than on the long-
run.
An organisation might focus its attention on short-term performance, particularly profitability or return on
capital employed in the current financial year. When attention is focused on short-term financial returns,
the danger is that other objectives, both non-financial and longer-term goals, will be ignored. Decisions
might even be taken that will improve profits in the short-term, but at the expense of strategic objectives
and longer-term interests.
2 Divisional performance and transfer pricing
Divisional financial performance is measured by profitability. Transfer pricing issues can result in sub-
optimal decision making.
Many organisations are organised on a divisional basis, with the managers of each division having the
authority to make decisions affecting costs, revenues and capital expenditures.

Multiple performance measures might be set for each divisional manager, based on a number of critical
success factors, and possibly using a balanced scorecard approach.
Typically, the divisional manager is rewarded on the basis of success in achieving the performance
targets.
2.1 The problem of transfer pricing
The main financial target for a division is usually return on investment, residual income or possibly
economic value added. A major problem with measuring the financial performance of divisions is
accounting for the transactions that are carried out between different divisions within the organisation.
Some divisions will supply goods or services to other divisions, and are paid for these internal transfers.
The price paid for internal transfers is a transfer price.
Internal transfers do not affect the profitability of the organisation as a whole, but do affect the profitability
of individual divisions. A high transfer price means that the supplying division will earn a larger profit than
if the transfer price is set lower. Equally, a high transfer price means that the 'buying' division will make a
lower profit than if the transfer price were set lower. The nature of transfer pricing means that divisional
profitability depends on the level at which transfer prices are set, even though transfer prices are totally
irrelevant when it comes to measuring the profitability of the organisation.
The various ways in which transfer prices might be set were explained in an earlier chapter.
(a) A transfer price might be set at the market price for the product or service. However, a market
price does not always exist. A further problem is that when a market price does exist for the
transferred item, and the transfer price is set at the market price, the buying division has no
incentive to 'buy' the item from the supplying division. It would be just as cheap to buy the item
from an external supplier. For example, suppose that an organisation has an IT department that
sells its services to other divisions in the company, charging a market price for its services. A
division that uses IT services might decide that it is more convenient to use the services of an
external IT company, or might be able to negotiate a cheaper price from an outside supplier, or get
a faster or better quality service from the outside supplier. If so, the division might refuse to buy IT
services internally. Such a decision is unlikely to benefit the organisation as a whole, because it will
usually be cheaper to do the work internally than to buy it externally at market price.
(b) A transfer price might be set at cost. The drawback to using cost is that the supplying division has
no motivation to supply items on which it makes no profit. If there is an external market for the
item, the supplying division would make more profit by selling its output externally rather than
supplying to other divisions within the company. Any decisions to sell externally rather than
internally, or any reluctance to supply internally, are likely to be damaging to the company as a
whole.
(c) A transfer price might be set at cost plus a fixed margin for profit. This will be necessary if there is
no external market for the transferred item, and so no market price. Where transfer prices are set at
cost plus, there is a serious risk of disputes between divisions about what the transfer price should
be.
(d) Transfer prices might be negotiated, at a level somewhere above the marginal cost of supply to the
supplying division and somewhere below market price. Even so, setting transfer prices can be a
very contentious issue.
A major risk with transfer prices is that prices may be set badly, in a way that results in sub-optimal profits
for the respective divisions.
2.2 Example: transfer pricing
Suppose for example that an organisation has two divisions, Division A and Division B, and that Division A
supplies two products to Division B, Product 1 and Product 2.

Suppose also that:
(a) At the current transfer prices for the two products, Division A makes a contribution of $6 per unit
from Product 1, which needs two labour hours, and a contribution of $4 per unit from Product 2,
which needs one labour hour. Labour hours in Division A are restricted by a shortage of skilled
labour.
(b) At the current transfer prices, Division B makes a contribution of $14 per unit from Product 1 and
$8 per unit from Product 2. It can sell whatever quantities of each product that Division A supplies.
In this situation, the organisation as a whole will earn a larger profit from selling Product 2 than Product 1.
This is because Division A labour is in short supply (a limiting factor), and the organisation earns a larger
contribution per labour hour from Product 2 than Product 1.
Product 1 Product 2
Contribution per unit $(6 + 14) $20 $(4 + 8) $12
Division A labour hours 2 hours 1 hour
Contribution per labour hour $10 $12
Profitability ranking 2
nd
1
st

Making more of Product 2 and less of Product 1 would benefit the organisation as a whole. It would also
be more profitable for Division A, because Division A would earn a contribution of $4 per hour from
Product 2 but only $3 per hour from Product 1, and labour is in short supply. Division B, however, might
argue for higher volumes of Product 1, because this earns it a higher unit contribution.
The difficulty with transfer pricing is to establish a transfer price that motivates the managers of every
division to organise operations in such a way as to maximise the profits of the company as a whole. When
divisional managers are given the authority to negotiate transfer prices, they might put their self-interest
(i.e. the division's profits) ahead of the interests of the company.
If transfer prices are imposed on divisions by senior managers, or if senior management dictates what
each division should sell to or buy from other divisions, many of the advantages of divisional performance
measurements (local autonomy and motivation of managers) will be lost.
3 Behavioural consequences of performance measures
Setting financial targets can act as a motivation to management, who will try to achieve or exceed those
targets.
Motivation can be improved through participation.
Extensive research has been carried out into the behavioural aspects of performance measurement. The
aim of setting targets for performance, and then measuring actual results against the targets, is to
encourage management to work towards the achievement of these targets.
Two important questions, however, are:
(a) does setting performance targets motivate managers to achieve targets?
(b) what can be done to improve the motivation of managers to achieve performance targets?
3.1 Human behaviour and budgeting
Interest in the behavioural factors at work in the budgeting and budgetary control process was stimulated
by Chris Argyris in the 1950s. He identified four behavioural problems with budgeting and budgetary
control.

Issue Comment
Pressure device The budget might be seen as a pressure device, used by management to force
'lazy' employees to work harder. The intention of pressure by management is
to improve performance, but employees react adversely to it.
'Budget men' want to
see failure
The accounting department is usually responsible for putting the budget
figures together, and then for preparing variance reports or other financial
performance reports. The accountants are seen as 'successful' if they report
significant adverse variances, and identifying the managers responsible. The
success of the 'budget man' is the failure of another manager. A tension exists
between the information providers (the accountants) and management, and
management might lose interest in the budget and their performance.
Targets and goal
congruence
The budget usually sets targets for each division or department. Achieving the
divisional target is of paramount importance, regardless of the effect this may
have on other departments or on the overall performance of the company. This
is the problem of lack of goal congruence.
Management style Budgets are used by managers to express their character and style of
leadership over subordinates. Subordinates resentful of the manager's style
might blame the budget rather than the manager.
These issues in budgeting are reasons why a budget might fail to motivate managers and employees.
3.2 Can budgets motivate?
Despite the potential behavioural problems, there is evidence to suggest that budgets and other
performance targets can motivate managers and other employees to achieve those targets.
There is less evidence, however, to suggest that greater motivation will translate itself into better
performance!
To provide motivation, performance targets should be:
(a) Clear and specific. Individuals must know exactly what is expected of them
(b) Challenging, but realistic. If targets are too easily achieved, there will be no particular motivation to
improve performance. However, if targets are unrealistic, they too are likely to fail to motivate,
because 'failure' is certain.
Motivation can also be improved by incentive schemes (discussed later), and might possibly be improved
by allowing subordinates to participate in the budget-setting (or target-setting) process, rather than having
the targets imposed on them.
3.3 The effect of participation on motivation
There has been considerable debate about whether involving managers and other employees in the
budget-setting or target-setting process will improve their motivation and performance.
The general argument in favour of participation in setting targets is that the individual will be more willing
to accept the targets, having been involved in setting them. Identifying personally with targets is more
likely to make the individual want to achieve them. However, participation needs to be 'real'. It will not be
effective if senior managers pay lip service to participation, and having discussed targets with their
subordinates, then impose entirely different ones on them. This would be 'pseudo-participation' only, and
ineffective as a motivator.
It has also been argued that the effectiveness of participation will depend on the nature of the task being
undertaken.
(a) In a highly-programmed and well-established area of operations, where performance standards are
well-established, participation might have little to offer by way of motivation.

(b) In contrast, when the work involves high-levels of uncertainty, and calls for a flexible approach,
innovation and the ability to deal with unexpected problems, participation in target setting and
decision making can be very effective in motivating staff.
Other writers have drawn attention to the importance of the organisation structure. It has been found that
where an organisation has decentralised authority, managers perceive themselves to be more closely-
involved in the budget-setting process and to be more motivated by their performance targets than
managers in a highly-centralised organisation.
There is also some evidence to suggest that personality has some effect on whether participation
improves motivation. Some individuals are stimulated by participation in target-setting, whereas others
prefer to be told what they need to do.

Question
Problems setting budgets

What do you think would be some of the potential problems with managers participating in setting their
own budgets?

Answer

There are several problems that could arise when managers participate in setting their own budgets.
(a) Lack of commitment. Some individuals do not like 'number crunching'. Whereas they would like to
have their views listened to, they do not want to do the detailed planning themselves. They might
argue that they are 'too busy' to spend time on figures. Other managers might like the idea of being
involved in target-setting, but dislike the formality and constraints of the formal budgeting process.
(b) Lack of expertise. Managers should be given adequate training in the skills required for planning
and target-setting.
(c) Budget slack. There might be a temptation for managers to build in some 'comfort' into their
budget, by over-estimating expected costs, or under-estimating likely revenues. Their performance
will then seem good, when actual costs are below budget, or actual revenues exceed the budget.
Building in 'budget slack' also provides a safety margin, in the event of unexpected costs or an
unexpected shortfall in revenue.

3.4 Practical problems with participation in budgeting
The effectiveness of participation in budgeting as a motivator might also depend on the general
management philosophy within the organisation. In an organisation that promotes 'employee
empowerment' and 'team work', participation in budgeting would be just one example of the philosophy
applied in practice.
4 Incentive schemes
Incentive schemes are also designed to motivate managers and employees to achieve performance
targets.
In most companies, managers are not the owners. The shareholders might have no day-to-day
involvement in their company at all. The overall objective of the company might be expressed in terms of
adding to shareholder value, but what will motivate management to show any concern for shareholder
value?
A well-established method of linking the concerns of managers for their company's performance with the
interests of their shareholders is to provide incentive schemes. Arguably, incentives can be a powerful

motivator to managers to improve performance but only those aspects of performance for which
incentives are provided.
Rewards are most obviously thought of in terms of monetary reward or something with a monetary value.
Alternatively, reward might take the form of promotion to a higher level within the organisation.
4.1 How to link performance to rewards
A good reward system should have the following characteristics.
(a) It should offer real incentives, sufficiently high to make it worthwhile for the individual to make a
big effort.
(b) It should relate payments to performance over which the individual has control. If performance is
not controllable, there is no point in offering incentives.
(c) There should be clear rules for the calculation of the incentive payments, and a clear
understanding of the conditions that apply. This is to enable the individual to decide whether the
reward is worth the extra effort.
(d) It should be sufficiently flexible to allow differing rewards for different levels of achievement. The
payments should not be 'all or nothing'.
(e) It should be cost-effective for the organisation.
It might also be argued that:
(a) There should be a minimum level of performance, below which no incentive payments should be
made. It is inappropriate to give rewards for mediocrity
(b) There should also be a cap on incentive payments for an individual, partly because excessive
incentives might not be deserved and partly because of the risk that a manager might take short-
term measures to maximise the reward. High incentive payments to one or two individuals, that are
far in excess of rewards paid to other managers in the organisation, will almost inevitably create a
sense of 'unfairness' and resentment within the organisation.
Care should be taken to ensure that the incentive scheme results in the desired outcome, for example if
the desired outcome is improved product quality then an incentive scheme may be based around reducing
the level of rework, whereas an incentive scheme based on, say, production volume may have the reverse
effect.
4.2 Types of incentive scheme
There are four common types of scheme.
(a) A scheme in which bonuses are paid for the achievement of a range of financial and non-financial
performance targets. For example, a manager might receive a bonus for achieving a particular
financial target (such as a target ROI or target profit), and further bonuses for achieving other non-
financial targets (related to other critical success factors for the organisation, or balanced
scorecard targets).
(b) A profit-related pay scheme, in which the bonus is tied specifically to profitability.
(c) A profit-sharing scheme, in which managers receive a reward, possibly in the form of share
options in the company, in proportion to the profits earned by the company.
(d) A group bonus scheme, in which a group of managers and employees are paid a bonus in relation
to the size of the profits earned by their division. The achievement of non-financial targets might
also determine the total size of the group bonus. Group bonus schemes are appropriate in
situations where performance cannot be attributed to any individual, but is the result of team work.
Although incentives are commonly cash payments or share options, other incentives might be offered. For
example, successful sales staff might be rewarded not just with higher sales commission, but also with
holidays paid for by the company.

4.3 Problems with incentive schemes
Short-termism. A significant problem with many incentive schemes is their focus on short-term
performance, to the exclusion of longer-term objectives. Incentives for longer-term achievements might
be ineffective, partly because of the length of time before performance can be assessed, and partly
because an individual manager might not be in the same position long enough to benefit from longer-term
achievement.
Problems of measurement. There are three major problems with deciding on performance measurements
on which to base rewards.
(a) Performance targets for individual managers might encourage decision making that is not in the
best interests of the organisation as a whole. For example, when the performance of divisional
managers is assessed on the basis of profitability, transfer prices might be set badly, and
discourage goal congruence in decision making. It is also questionable whether any set of
performance measures can provide a comprehensive assessment of an individual's performance
during a period.
(b) When performance is measured by non-financial targets, there may be practical difficulties in
measuring achievements. For example, if a manager's targets include improving customer
satisfaction, how should customer satisfaction be measured?
(c) It may be difficult to segregate the controllable elements of performance from the elements over
which an individual has no control.
Problems of motivation. Incentive schemes will only work if they motivate individuals to make a greater
effort to improve their performance, or achieve their targets. Money acts as a motivator, but is more of an
incentive to some individuals than to others. There is also evidence to suggest that the motivational effect
of a bonus scheme might wear off over time, as bonus payments become the norm. When this happens,
there is a risk that failure to pay a sufficient bonus in any year might create dissatisfaction amongst the
staff affected.
Problems in the public sector. There are further difficulties with any incentive scheme that might be set
for managers in the public sector.
(a) Effective performance can often only be judged over the longer-term; for example initiatives in
health or education can take many years to implement fully.
(b) The political dimension. A change of government could result in a change in policy objectives. A
new government will not want to reward managers for achieving policy objectives that it opposes,
and intends to scrap.

Question
Definitions and examples

Bonuses or other incentives for managers might be market-based, earnings-based or based on internal
measures. What do you think is meant by each of these terms? Give an example of each.

Answer

(a) A market-based incentive is one that ties the bonus to a change in the market value of the
shareholders investment. This might be total shareholder return over a period of time, measured
as the dividend payments and the increase in the share price in the period, expressed as a
percentage of the share price.
(b) An earnings-based incentive is one that ties the bonus to the companys earnings. Examples of
earnings-based incentives are bonuses for achieving (or exceeding) a target growth in operating
profit before interest and tax, or a target growth in total earnings or a target growth in earnings
per share.
(c) An internal measure is any measure of performance that can be calculated or assessed, and
reported internally to management. Examples are achieving or exceeding a target for the increase in
the number of clients during a period, or a target for unit cost reduction, or a target for
improvement in product or service quality.

5 External influences on performance
External events can disrupt the plans and targets of an organisation. When these are serious or long-
lasting, an organisation might have to re-assess its longer-term strategies.
An organisation cannot control all the aspects of its business. External events might arise that prevent
performance targets from being achieved. Any such events might also undermine the incentive schemes
operated by the organisation.
A variety of external events might affect an organisation's performance. Some examples are as follows.
Actions of competitors. Competitors might take an action that forces an organisation to respond, or to re-
assess its own objectives. For example, in a market where rival firms compete on the basis of price, a
price-reduction initiative by another firm might call for an immediate response. When a 'price war' occurs,
the profits of all the firms in the market are likely to suffer.
Price movements. Unexpected changes in the prices of resources (materials, labour, equipment, finance)
will affect performance, particularly if the price increases cannot be passed onto the customer in the form
of higher prices. An organisation might be able to respond to changes in prices, but only after a time
delay. For example:
(a) An unexpected price rise in labour costs will reduce short-term profits. In the longer-term, the
organisation can think about increasing automation and the use of technology, and reducing the
need for labour.
(b) If there is an unexpected price rise in a key raw material, short-term profits will be affected. In the
longer-term, the organisation can reassess what materials it should use in its products or services,
and consider whether a change to a cheaper material might be possible.
Foreign exchange movements. Many organisations are involved in international trade, buying or selling
abroad. Some organisations have subsidiary companies in other countries. A significant change in foreign
exchange rates can seriously affect performance.
5.1 Examples
(a) Suppose that a UK company exports a large proportion of its goods to the US, and prices its goods
in sterling. If the dollar falls in value against sterling, the company's goods would become more
expensive to US buyers, and demand in the US is likely to fall. To counter a fall in demand, the
company might have to reduce its prices.

(b) Suppose that a UK company exports a large proportion of its goods to the US, and prices its goods
in dollars. If the dollar falls in value against sterling, the company will earn less from its sales to the
US, because the dollar revenue will convert into a smaller amount of sterling. To counter this
problem, the company might have to raise its prices, but demand in the US would then fall.
(c) Similar problems face importers. For example a UK company buying a large proportion of its goods
from the euro-zone of the European Community might pay for these goods in euros. A rise in the
value of the euro against sterling (i.e. a fall in the value of sterling) would make the cost of the
imports higher.

16: Performance measurement and management
309
A long-term shift in exchange rates, such as a long-term shift in the value of sterling against the US dollar,
might force a company to reconsider its strategy for business location. For example, a long-term fall in the
value of the US dollar against sterling might force a company to consider moving its production facilities
out of the UK and into another country in the 'dollar zone'.
Labour disputes. An organisation may have an industrial dispute that disrupts its output. Equally, a labour
dispute in a supplier organisation, or even a national strike in a key industry, might affect output. When a
dispute is prolonged, short-term performance will be adversely affected.
Supply problems. Many organisations rely on just one or two suppliers for several of their key raw
materials or components. This is a feature, for example, of just-in-time purchasing systems. Supply
problems can have a knock-on effect, and prevent an organisation from meeting the demands of its
customers. Supply problems could be due to a world-wide shortage of a raw material, local problems with
the supply of power (electricity) or water, a strike at the supplier's organisation or a failure by a supplier to
meet promised supply dates.
6 Cultural factors
Charles Handy sums up culture as 'that's the way we do things round here'. It is the sum total of the
beliefs, knowledge, attitudes of mind and customs to which people are exposed.
There are many factors which influence an organisation's culture.
Influencing factor Detail
Economic conditions and
strategy
In prosperous times organisations will either be complacent or
adventurous, full of new ideas and initiatives. In recession they may be
depressed, or challenged. The struggle against a main competitor may
take on 'heroic' dimensions.
The nature of the business
and its tasks

The types of technology used in different forms of business create the
pace and priorities associated with different forms of work. Task also
influences work environment to an extent.
Leadership style

The approach used in exercising authority will determine the extent to
which subordinates feel alienated and uninterested or involved and
important. Leaders are also the creators and 'sellers' of organisational
culture: it is up to them to put across the vision.
Policies and practices

The level of trust and understanding which exists between members of an
organisation can often be seen in the way policies and objectives are
achieved, for example the extent to which they are imposed by tight
written rules and procedures or implied through custom and
understanding.
Structure The way in which work is organised, authority exercised and people rewarded
will reflect an emphasis on freedom or formal control, flexibility or rigidity.
Characteristics of the
work force
Organisation culture will be affected by the demographic nature of the
workforce, for example its typical manual/clerical division, age, sex and
personality.

6.1 The value of culture
'Positive' organisational culture may therefore be important in its influence on the following.
(a) The motivation and satisfaction of employees (and possibly therefore their performance) by
encouraging commitment to the organisation's values and objectives, making employees feel
valued and trusted, fostering satisfying team relationships, and using 'guiding values' instead of
rules and controls.
(b) The adaptability of the organisation, by encouraging innovation, risk-taking, customer care,
willingness to embrace new methods and technologies etc.
(c) The image of the organisation. The cultural attributes of an organisation (attractive or unattractive)
will affect its appeal to potential employees and customers.
6.2 Cultural problems
The symptoms of a negative, unhealthy or failing culture (and possibly organisation as a whole) might be
as follows.
(a) No 'visionary' element: no articulated beliefs or values widely shared, nor any sense of the future.
(b) No sense of unity because no central driving force. Hostility and lack of co-ordination may be
evident.
(c) No shared norms of dress, habits or ways of addressing others. Sub-cultures may compete with
each other for cultural 'superiority'.
(d) Political conflict and rivalry, as individuals and groups vie for power and resources and their own
interests.
(e) Focus on the internal workings of the organisation rather than opportunities and changes in the
environment. In particular, disinterest in the customer.
(f) Preoccupation with the short term.
(g) Low employee morale, expressed in low productivity, high absenteeism and labour turnover,
'grumbling'.
(h) Abdication by management of the responsibility for doing anything about the above perhaps
because of apathy or hopelessness.
(i) No innovation or welcoming of change: change is a threat and a problem.
(j) Rigorous control and disciplinary systems have to be applied, because nothing else brings
employees into line with the aims of the business.
(k) Lacklustre marketing, company literature and so on.
6.3 Changing a culture
It may be possible to 'turn round' a negative culture, or to change the culture into a new direction.
(a) The beliefs expressed by managers and staff can be used to 'condition' people, to sell a new
culture to the organisation by promoting a new sense of corporate mission, or a new image.
Slogans, mottos ('we're getting there'), myths and so on can be used to energise people and to
promote particular values which the organisation wishes to instil in its members.
(b) Leadership provides an impetus for cultural change: attitudes to trust, control, formality or
informality, participation, innovation and so on will have to come from the top especially where
changes in structure, authority relationships or work methods are also involved. The first step in

deliberate cultural change will need to be a 'vision' and a sense of 'mission' on the part of a
powerful individual or group in the organisation.
(c) The reward system can be used to encourage and reinforce new attitudes and behaviour, while
those who do not commit themselves to the change miss out or are punished, or pressured to 'buy
in or get out'.
(d) The recruitment and selection policies should reflect the qualities desired of employees in the
new culture. To an extent these qualities may also be encouraged through induction and training.
(e) Visible emblems of the culture for example design of the work place and public areas, dress
code, status symbols can be used to reflect the new 'style'.
7 Conclusion: effective performance management
Performance management is concerned with improving performance, by identifying goals and setting
targets for achievement. Performance is then controlled by measurements of actual achievement and
comparisons with the targets.
There are various ways of setting performance targets and monitoring performance. None are perfect, and
all of them have weaknesses. However, an effective performance management system should include the
following elements.
(a) Targets for achievement that are consistent with the strategic objectives of the organisation, and that
will enable the organisation to achieve its goals in a manner consistent with its purpose (mission).
(b) Information systems and costing systems to provide information for setting targets and monitoring
performance.
(c) The use of appropriate techniques for financial planning and decision making.
(d) Giving recognition to non-financial objectives as well as financial objectives.
(e) A commitment to improving performance.
(f) The use of performance measures to provide a control system for the achievement of targets, and
an incentive to management.
It has been said that 'what you measure is what you get', or alternatively 'what you measure is what you
manage'. The two cryptic comments amount to much the same thing. The fact that you bother to establish a
performance measure and then measure the relevant activities or results is half the battle. Having measured
something, you will naturally want to do something about it you will manage it, change it, improve it and
finally you will get it, ie you will get the target figure that the performance measure is aimed at.

Question
Bonuses

(a) A group of employees is paid a collective bonus for achieving six different targets, three financial
and three non-financial. How might the amount of the bonus be decided, for example if four targets
are achieved but two are not?
(b) What are the main benefits and drawbacks to paying a bonus on the basis of long-term results?

Answer

(a) A bonus can be set for each of the six targets, so that the group receive a bonus for achieving four
of the six targets. Alternatively, the bonus can be paid on a sliding scale, with $A payable for
achieving just one target, $B for achieving two targets, $C for achieving three targets, and so on
up to six targets.
(b) The benefits are that (a) a long-term bonus scheme will be based on achieving the long-term
objectives of the company, thereby avoiding short-termism, and (b) the scheme should also
persuade employees to remain with the company, at least until the bonus is earned. The main
disadvantage is that employees will not necessarily be willing to wait a long time before earning a
bonus for their efforts. (The solution might be to base the bonus on achieving internal targets that
ought to lead on to improved company performance in the longer term.)

Financial Statements
Part B
313 1: Objectives of financial statements
1 The purpose of financial statements
Financial statements provide information about the position and performance of a business.
The main purpose of financial statements is to provide information about the financial

position of a
business entity, and about how it has performed financially over a given period of time. The individual
financial statements, which will be explained in some detail later in this text, each provide particular
information which could be of value to one or more interest groups.
1.1 What is a business entity?
A reporting entity is a discrete, separately-identified unit or organisation that produces financial reports. A
business entity may be a company, a group of companies, a business partnership or the business of a
sole trader.
Financial statements are prepared for an 'entity' that makes money transactions. The term 'entity' can refer
to non-business organisations and not-for-profit organisations, such as government departments,
charities, clubs and societies. A 'business entity' is involved specifically in business, usually for the
purpose of making a profit: the term refers to companies, business partnerships and individuals running
their own business ('sole traders').
An entity preparing financial statements (the 'reporting entity') must be identifiable as a distinct and
discrete unit or organisation; in other words, it should be a cohesive economic unit. To prepare financial
statements, an entity must have a system of accounting for its transactions, because it is from the records
of money transactions held in this system that financial statements are constructed. Such an accounting
system is generally referred to as a 'book-keeping system'.
The entity concept assumes that the business is a separate entity from its owners. If a sole trader sets up
a business mowing lawns, then that business is separate from the sole trader. Separate accounting
records must be kept for the business.
The capital that the sole trader puts into the business is treated as money owed to the owner in the
business accounts, and is sometimes called 'proprietors' funds'.
The entity concept applies to sole traders, partnerships and companies. Sole traders and partnerships are
not legally separate from their businesses, but are treated as such for accounting purposes. However, a
company is legally separate from its owners.

Objectives of
financial statements
1: Objectives of financial statements 314
1.2 How does control define the boundary of the reporting entity?
When beginning to study the interpretation of financial statements, it is convenient to think of the
reporting entity as a single company. In reality, companies are more commonly linked together as a single
group, with a holding or parent company and many subsidiary companies and sub-subsidiaries. A
subsidiary is a company that is controlled by another company, for example through a controlling interest
in its ordinary share capital.
1.3 Example
Suppose for example that Alpha Co owns 100% of the share capital of Beta Co, which in turn holds 100%
of the share capital of Gamma Co.

Alpha Co should provide statements about its financial performance and position (statement of financial
position (balance sheet), income statement, statement of cash flows, and so on). But should it report
exclusively on the performance of Alpha Co or should it report on the performance of Alpha, Beta and
Gamma taken together, since Alpha Co controls the businesses of Beta and Gamma?
The view taken in financial reporting is that the reporting entity is not the individual company. The
reporting entity should be defined by the scope of control. A parent company (holding company) of a
group of companies should therefore present financial statements to its shareholders about the
performance and position of the group as a whole. Published accounts are therefore usually 'group
accounts' or 'consolidated accounts', which bring the performance and position of all the group
companies together as a single entity.
Special features of group accounts are dealt with in Chapter 10 of this text.
1.4 Financial performance
Businesses of whatever size or nature exist to make a profit. The financial statement showing the profit or
loss earned in a period is the income statement.
The purpose of a business is to make money for its owners. A business invests money in resources with
the intention of making even more money. Business enterprises vary in character, size and complexity.
They range from very small businesses (the local shopkeeper or plumber) to very large ones (eg Glaxo
Smithkline, Marks and Spencer, Diageo). But the objective of earning profit is common to all of them.
Profit is the excess of income over expenditure. When expenditure exceeds income, the business is
running at a loss.
One purpose of financial statements is to show whether a business has made a profit or a loss over a
period of time from its operations. A statement showing the performance of a business in a given period
of time is called an income statement, or a statement of comprehensive income.

Entities that do not exist to make a profit must nevertheless spend within their means. These organisations
produce a performance statement disclosing their income and expenditure for a given period, rather than
a statement of profit or loss.
The definition of profit above is slightly simplified. It is more correct to state that a profit or gain arises
when the value of the owners' interest in a business rises, without the owners putting in any additional
new capital. This definition might become clearer as you work your way through this text, but it is possible
for a gain or a loss to arise without any transaction involving income or expenditure.
1.5 Financial position
A statement of the financial position of an entity at a particular point in time is the statement of financial
position (previously called the balance sheet). This shows the assets, liabilities and capital of the entity at a
specific point in time.
Another purpose of financial statements is to show the financial position of an entity. In reality, the
financial position of most businesses is always changing, and is not static. The financial position of a
company next week is not going to be the same as its financial position now. However, a financial
statement can only show the position of a business at a given point in time, and this 'snapshot' picture will
hopefully give a fairly representative picture.
The main elements affecting the financial position of a business are:
(a) the economic resources it controls
(b) its financial structure
(c) its liquidity and solvency
(d) its capacity to adapt to changes in its environment
The financial position of a business (or any other entity) is largely concerned with what resources the
business has and how much the business owes. This is reported in a statement known as the statement
of financial position (previously called the balance sheet) which shows the assets and liabilities of a
business, and how much capital it has.
1.6 Financial adaptability
Businesses must generate cash as well as profit. The financial statement showing the generation and uses
of cash over a period is the statement of cash flows.
In order to be able to adapt to changing circumstances, markets and commercial environments,
companies need to generate cash. The generation of cash is different from the generation of profit due to
the concept of accruals, which is discussed in more detail in Section 4 of this chapter.
The cash generated by a company in a period is reported in a statement of cash flows. This is discussed in
more detail in Chapter 11.
2 Assets and liabilities
2.1 Assets
An asset is something valuable which a business owns or has the use of.
Examples of assets are factories, office buildings, warehouses, delivery vans, lorries, plant and machinery,
computer equipment, office furniture, cash and also goods held in store awaiting sale to customers, and
raw materials and components held in store by a manufacturing business for use in production.
Some assets are held and used in operations for a long time. These are known as non-current assets. An
office building might be occupied by administrative staff for years. A machine might have a productive life
of many years before it wears out.

Other assets are held for only a short time. These are known as current assets. The owner of a newsagent
shop, for example, will have to sell his newspapers on the same day that he gets them, and weekly
newspapers and monthly magazines also have a short shelf life. The more quickly a business can sell the
goods it has in store, the more profit it is likely to make, provided, of course, that the goods are sold at a
higher price than the cost the business incurred to acquire them.
In financial statements, assets are analysed as either current or non-current, depending on the length of
time that they are expected to be held. Any assets expected to be held for 12 months or more are generally
classified as non-current.
The definition of asset given above is somewhat simplified, although it is useful for introducing the idea of
what an asset is. A more formal definition is that an asset is a resource controlled by the business from
which future economic benefits are expected to flow, arising out of a past transaction or event (we will
look at this definition in more detail in Chapter 4).
(a) An item of office equipment is an asset. A company buying a computer will expect to use it over a
number of years, and will derive economic benefits from it. The computer is an asset because it
will provide economic benefits to the company in the future that have arisen out of a past event, the
purchase of the computer.
(b) Money owed by a customer to a business is an asset of the business. For example, suppose that a
company sells goods on credit to a customer for $3,000, and the customer is given 30 days to
make the payment. Until the debt is paid, the customer is a 'debtor' of the company for $3,000. The
debt is an asset because it gives the company future economic benefit (money income) arising out
of a past transaction, the sale of the goods.
PAST EVENT
Supply a product
or service
RIGHT TO FUTURE
ECONOMIC BENEFITS
Receive payment

ASSET
CREATED
Receivable

The customer who owes money is called a 'debtor'. The balance owed in the business accounts will be
referred to as a 'receivable'.
2.2 Liabilities
A liability is something which is owed to somebody else.
'Liabilities' is the accounting term for the debts of a business, amounts that the business owes.
Some examples of liabilities are given below.
A bank loan or bank overdraft. The liability is the amount which must eventually be repaid to the
bank.
Amounts owed to suppliers for goods purchased but not yet paid for. For example, a boat-builder
might buy some sails on credit from a sail-maker, which means that the boat-builder does not have
to pay for the sails until some time after they have been delivered. Until the boat-builder pays what
he owes, the sail-maker will be his creditor for the amount owed. Note that the supplier who is

owed money is called a 'creditor'. The balance payable by the business will be referred to as a
'payable'.
Taxation owed to the government. A business pays tax on its profits but there is normally a gap in
time between when a company declares its profits and becomes liable to pay tax and the time when
the tax bill must eventually be paid.
Again, there is a more 'formal' definition of liability. A liability has been defined in the IASB's Framework
as a present obligation of the entity arising from past events, the settlement of which is expected to
result in an outflow from the entity of resources embodying economic benefits (we will look at this
definition in more detail in Chapter 4).
As is the case for assets, liabilities presented in the financial statements are analysed between non-current
(long term) and current (short term). Amounts due within 12 months are generally classified as current,
and those due in 12 or more months are non-current.
The IASB definitions are important and play a key role in financial reporting. Do try to memorise them.

Activity 2.1

What do you think the following items are, an asset or a liability?
Item Asset (A) or
Liability (L)
Money owed to a company by a customer for the provision of consultancy services
Shares held by the company in another company, Dredge Co
Sales Tax collected from customers and owed to the tax authority
Money held in a bank deposit
Company car used by the chief executive
Damages for unfair dismissal owed to a former employee

3 The IASBs Framework for the preparation and
presentation of financial statements
There are various groups of people who need information about the activities of a business. You should be
fully aware of these different user groups and their varying needs.
3.1 Purpose and underlying assumptions of the Framework
The Framework sets out the concepts that underlie the preparation and presentation of financial
statements.
The purpose of the Framework is:
(a) to assist in the development of future International Financial Reporting Standards and in the review
of current standards;
(b) to provide a basis for reducing the number of alternative accounting treatments permitted by IFRS;
(c) to assist national standard setting bodies in developing national standards;
(d) to assist preparers of financial statements in applying IFRS and dealing with transactions that are
not covered by IFRS;
(e) to assist auditors in forming an opinion as to whether financial statements comply with IFRS;
(f) to assist users in interpretation of the information contained in financial statements; and
(g) to provide information about the approach to the formulation of accounting standards.

The Framework is not an accounting standard, and in cases where an accounting standard is in conflict
with the Framework it is the accounting standard that should be followed.
3.2 Role of general purpose financial statements

The IASBs Framework states that 'the objective of financial statements is to provide information about the
reporting entity's financial position, performance and changes in financial position of an entity that is
useful to a wide

range

of

users for making

economic

decisions.'
Financial information about a company is of interest to a wide range of users. Some of these users are
able to obtain special-purpose reports about a company specific to their information needs. Management
can obtain internal management accounting reports, and on occasion, someone else, such as a lending
bank or the tax authorities, can obtain specially-prepared reports. Many users of accounts, however, do
not have access to special-purpose reports, and must rely for their information on general purpose
financial statements, such as the company's published financial statements.
3.3 Users of financial statements
The following diagram depicts the users of financial statements.

Shareholders Other investors

Creditors Lenders

Government Customers

Employees General public

BPP 's
Financial
Statements
2009

The IASB suggests that general purpose financial statements will meet the needs of most users.
3.4 Financial statements for assessing stewardship
Management is accountable to investors for the stewardship of the company. To understand this, you
might find it useful to think of the stewardship of an estate, which involves looking after the assets and
condition of the estate, and managing it in the interest of the owner. In much the same way, managers are
responsible for the safeguarding of the assets and other resources of the company, and for putting these
resources to an efficient and profitable use. Investors will be interested in any information that helps
them to judge how well management has carried out their stewardship responsibility.
3.5 Decision usefulness of financial statements
Various groups make use of a company's financial statements to make economic decisions.
(a) Present and potential investors in the company will consider their investment decision. Should
they buy shares in the company? Should they sell their shares? To make an investment decision,
the investor needs information about profitability and the ability to generate cash to pay dividends,
and also about the risks in the investment. Financial statements should help an investor to assess
both the cash-generating capabilities of a company, and also its ability to respond to risks and
change (its financial adaptability).
(b) Lenders to a company will be interested in any information that helps them to assess whether the
company will have the ability to meet its obligations: to pay interest and repay the loan principal on
time. Potential lenders need similar information to decide whether to lend to the company, and if
so, how much and on what terms.
(c) Suppliers to the company and other trade creditors need to know how reliable the company will be
in paying its debts, and how much credit can safely be given.
(d) Employees want information about the financial stability and profitability of their employer,
particularly in the part of the company's business where they work. Their decision to remain with
the company will depend to a large extent on the ability of the company to continue to offer them
secure and well-paid employment. They will also be interested in how much the company is
earning in order to reach a view on what remuneration levels should be.
(e) Customers are interested in the financial performance and position of a company in order to decide
whether to continue buying from it. Where a customer relies on a long-term warranty, or expects to
purchase replacement parts from the company over a long period, it will want reassurance that the
company is financially stable, with good long-term future prospects.
(f) The government (and its agencies) can often obtain the information it needs from a company from
special-purpose reports. Even so, general purpose financial statements can provide additional useful
information. For example, the tax authorities are provided with specially-prepared information about
the company's trading and profits to determine how much tax is payable. A comparison with general
purpose financial statements can then help the tax authorities to assess whether the amounts payable
in tax seem consistent with the published information. They would certainly be interested if a
company declares profits of several million dollars but pays no company tax.
(g) Enterprises affect members of the public in a variety of ways. A major employer in a local
community, for example, will help to boost the local economy and stimulate business and
employment. Members of the general public might therefore use the financial statements of a
company to assess trends and recent developments in its business, and the implications these
might have in the future.
Any analysis of financial statements should be set in the context of the particular user and their
requirements. For example, as mentioned above, lenders are interested in the ability of a company to
repay them; they have little interest in operational details, such as the time taken for a debtor to pay the
company, or the profitability of a certain product line. This information is, however, of interest to
management.
Financial information does have limitations. It is backward looking, reporting events that have already
happened and does not assess what might happen in the future.
It is usually based on historic costs which report items such as non-current assets at their original cost
which may be very different from their current market value.
3.6 Types of financial information available to users
The information needs of different users are not the same. General purpose financial statements do not
provide all the information that individuals need, or would like, to make their decisions, and the limitations

of a company's report and accounts should be understood. Financial statements are backward-looking,
reporting what has happened in the past, when users are more often concerned with the future. They also
report on the company in purely financial terms, and do not properly address non-financial matters.
Managers responsible for the running of a business are likely to find detailed management accounts

showing actual performance against budget, usually on a monthly basis, to be more useful than statutory
financial statements. Moreover, these are likely to be used alongside business plans projected into the
future usually over a period of three to five years.
3.7 Investor focus
The Framework states that 'As investors are providers of risk capital to the entity, the provision of financial
statements that meet their needs will also meet most of the needs of other users that financial statements
can satisfy'. For example, investors need information about the ability of a company to generate profits
and cash flows from its operations and on the company's financial adaptability (ie its ability to respond to
unexpected events and new opportunities). Essentially, other user groups are interested in the same
information, although with different emphasis, as discussed above.
3.8 The information required by investors
Investors need information about a company's financial performance and financial position.
(a) Financial performance relates to the return that the company has made on the resources at its
disposal. Information about performance provides an account of the stewardship by management,
and can also be used to assess the ability of the company to generate cash from its existing
resources. Information about historical performance can help investors to make judgements about
future prospects.
(b) The financial position of a company relates to the assets that it owns (including its cash position),
the liabilities it owes and the amount of capital invested. This information helps investors to assess
the stewardship of management. It also helps them to understand how the future cash flows

generated by the business will be distributed among those with an interest in or a claim on the
company (eg lenders, trade creditors, employees and shareholders). Information about the cash
position and liquidity helps investors to assess the ability of the company to meet its financial
obligations as they fall due. Information about the risk profile of a company will help them to
judge the financial adaptability of the company, and its ability to deal with unexpected future
setbacks and opportunities.
(c) Information about changes in the financial position of an entity is useful in order to assess its
investing, financing and operating activities during the reporting period. This information is useful
in providing the user with a basis to assess the ability of the enterprise to generate cash and cash
equivalents and the needs of the business to utilise those cash flows.
(d) The main general purpose financial statements are the statement of financial position of a
company, an income statement or statement of comprehensive income for the period under
review and a statement of cash flows for the same period. In broad terms, profits and cash flow
information can be used to assess the ability of the company to generate cash. A statement of
financial position provides information about the financial position. Taken together, they provide
information on performance and the stewardship of management.

Activity 2.2

It is easy to see how 'internal' people get hold of accounting information. A senior manager, for example,
can just go along to the accounts department and ask the staff there to prepare whatever accounting
statements he needs. But external users of accounts cannot do this. How, in practice, can (a) a business
contact, (b) a financial analyst, (c) a bank or (d) an employee of the company obtain financial statements
about the company?

4 Accounting concepts: going concern and accruals
In order to meet their objectives financial statements are prepared on the going concern and accruals
basis.
4.1 Going concern
The going concern concept requires assets to be valued on the assumption that the business will continue
and will not be broken up or dissolved.
The entity is normally viewed as a going concern, that is, as continuing in operation for the foreseeable
future. It is assumed that the entity has neither the intention nor the necessity of liquidation or of curtailing
materially the scale of its operations. (IASB Glossary)
This assumption is based on the notion that, when preparing a normal set of accounts, it is always
expected that the business will continue to operate in approximately the same manner for the foreseeable
future (at least the next 12 months should be considered). In particular, the entity will not go into
liquidation or scale down its operations in a material way.
The main significance of the going concern assumption is that the assets of the business should not be
valued at their 'break-up' value, which is the amount that they would sell for if they were sold off
piecemeal and the business were thus broken up.

4.1.1 Example: going concern
Suppose, for example, that Emma acquires a T-shirt printing machine at a cost of $60,000. The asset has
an estimated life of six years, and it is normal to write off the cost of the asset to the income statement
over this time. In this case a depreciation cost of $10,000 per year will be charged.
Using the going concern assumption, it would be presumed that the business will continue its operations
and so the asset will live out its full six years in use. A depreciation charge of $10,000 will be made each
year, and the value of the asset in the statement of financial position will be its cost less the accumulated
amount of depreciation charged to date. After one year, the carrying value of the asset would therefore be
$(60,000 10,000) = $50,000, after two years it would be $40,000, after three years $30,000 etc, until it
has been written down to a value of 0 after 6 years.
Now suppose that this asset has no other operational use outside the business, and in a forced sale it
would only sell for scrap. After one year of operation, its scrap value might be, say, $8,000.
The carrying value of the asset, applying the going concern assumption, would be $50,000 after one year,
but its immediate sell-off value is only $8,000. It might be argued that the asset is over-valued at $50,000
and that it should be written down to its break-up value (ie in the statement of financial position should be
shown at $8,000 and the balance of its cost should be treated as an expense). However, provided that the
going concern assumption is valid, so that the asset will continue to be used and will not be sold, it is
appropriate accounting practice to value the asset at its carrying value.
(We will look at the treatment of assets in more detail in Chapter 8.)

Activity 2.3

A retailer commences business on 1 January and buys inventory of 20 washing machines, each costing
$100. During the year he sells 17 machines at $150 each. How should the remaining machines be valued
at 31 December if:
(a) He is forced to close down his business at the end of the year and the remaining machines will
realise only $60 each in a forced sale?
(b) He intends to continue his business into the next year?

If the going concern assumption is not followed, that fact must be disclosed, together with:
(a) The basis on which the financial statements have been prepared; and
(b) The reasons why the entity is not considered to be a going concern.
4.2 Accruals basis of accounting
The non-cash effect of transactions should be reflected in the accounting period in which they occur and
not in the period any cash involved is received or paid.
The revised IAS 1 gives a definition of accruals based on recognition. However, for your exam the
definition under the old IAS 1 is more relevant.
Accrual basis of accounting. The effects of transactions and other events are recognised when they occur
(and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and
reported in the financial statements of the periods to which they relate. (IAS 1, old version)

Entities should prepare their financial statements on the basis that transactions are recorded in them, not
as the cash is paid or received, but as the revenues or expenses are earned or incurred in the accounting
period to which they relate.
According to the accrual assumption, then, in computing profit revenue earned must be matched against
the expenditure incurred in earning it.
4.2.1 Example: accrual
Suppose that Emma (from Paragraph 4.1.1 above), prints 20 T-shirts in her first month of trading (May) at
a cost of $5 each. She then sells all of them for $10 each. Emma has therefore made a profit of $100 by
matching the revenue ($200) earned from the sale of 20 T-shirts against the cost ($100) of acquiring
them.
If, however, Emma had only sold 18 T-shirts, it would have been incorrect to charge her income statement
with the cost of 20 T-shirts, as she still has two T-shirts in inventory. If she intends to sell them in June
she is likely to make a profit on the sale. Therefore, only the purchase cost of 18 T-shirts ($90) should be
matched with her sales revenue, leaving her with a profit of $90. ($180 $90).
The two remaining T-shirts would be carried forward in the statement of financial position as assets
(inventory) held at a cost of $10. (2 $5).
If, however, Emma had decided to give up selling T-shirts, then the going concern assumption would no
longer apply and the value of the two T-shirts in the statement of financial position would be a break-up
valuation rather than cost. Similarly, if the two unsold T-shirts were now unlikely to be sold at more than their
cost of $5 each (say, because of damage or a fall in demand) then they should be recorded on the statement
of financial position at their net realisable value (ie the likely eventual sales price less any expenses incurred
to make them saleable, eg paint) rather than cost. This also shows the application of the prudence concept,
which we will look at in Chapter 4.
In this example, the concepts of going concern and accrual are linked. Because the business is assumed
to be a going concern it is possible to carry forward the cost of the unsold T-shirts as a charge against
profits of the next period.
324 2: Assets, liabilities and the accounting equation

1 Introduction: accounting fundamentals
In order to understand financial statements properly, it is important to understand not only what the
elements of financial statements are, but also how these elements interact. An accounting or book-keeping
system is used to record business transactions. Financial statements are produced from the accounting
records in the system at the end of a financial reporting period, and these records include all the
transactions that have taken place since the previous financial statements were prepared.
Every business transaction has an effect on the financial position of a business. Business transactions
involving income or expenditure affect both the profit of the business and its financial position. The effect
of business transactions on the financial position of a business (on its assets, liabilities or its owners'
capital) will be explained by means of the accounting equation. The effect of some transactions on profit
will be explained with the business equation, and the link between profitability and changes in financial
position will be explained by the relationship between the accounting and business equations.
This chapter examines these basic concepts. Note that this information is for background reading only and
will not be examined in detail.
2 The business as an entity separate from its owners
In accounting a business is treated as an entity that is separate from its owners. Capital comprises the
funds which the owners put into the business as initial capital, plus retained profits. Capital also
represents what the business 'owes' to its owner.
Before looking at the accounting equation, a key concept in accounting needs to be introduced. This is the
separate entity concept. The preparation of accounts and financial statements starts from the assumption that
the business is a separate entity, separate from its owners. For example, if Paula Bell sets up a hairdressing
business, All Curls, the accounting records and financial statements of the business will be prepared on the
assumption that the business, All Curls, is separate from its owner, Paula Bell. The owner is seen as 'putting
money into the business'. The money put into a business by its owner or owners is called 'owners' capital'.
A company by law is a legal person, separate from its owners, the shareholders. For example, a company
can make contracts in its own right, such as contracts to buy, to sell, to borrow and to employ people. The
separation in the financial statements of the company as a business entity from its shareholders, who
provide capital, is therefore supported in concept by legal reality.
Business partnerships and the businesses of sole traders are not legal persons. Even so, the separate
entity concept is applied in accounting. Owners' capital is money the owners have invested in the
business. The capital 'belongs' to the owners, and it could be said that the owners have a claim on the
business for the capital they have invested, or that the business has an obligation to the owners for the
capital they have provided.

Assets, liabilities and
the accounting equation
2: Assets, liabilities and the accounting equation 325
2.1 Capital
The money put into a business by its owners is capital. As long as that money remains in the business,
accountants will treat the capital as money owed to the proprietor by the business.
Capital is an investment of money (funds) with the intention of earning a return. A business proprietor
invests capital with the intention of earning profit. The business owes the capital and the profit to the
proprietor.
Capital invested is therefore a form of liability. It represents a claim on the business, or an obligation of
the business to someone else.
3 The accounting equation
An accounting equation can be used to show the value of the assets, liabilities and capital of a business at
any point in time. Total assets are always equal to the sum of total liabilities plus owners' capital.
Since a business is a separate entity from its owners, it follows that:
(a) the business can 'owe money' to its owners, and capital should be treated as a form of liability
(b) the assets and liabilities of the business should be treated as belonging to the business, rather than
its owners.
A fundamental rule of accounting, which flows from the separate entity concept, is that the assets of a
business will always be equal to the sum of its liabilities plus its owners' capital. This is the
accounting equation, and the practice of financial accounting is built on it.
An accounting equation is a simple statement of financial position of a business.
The accounting equation
Assets = Liabilities + Capital
This is the format in which the statement of financial position of a business is shown. A statement of
financial position, like the accounting equation, is simply a statement of the assets, liabilities and capital of
a business at a particular point in time. Both the accounting equation and the statement of financial
position of a business are altered by every business transaction, but the basic rule of 'Assets = Liabilities +
Capital' always remains true.
Let's demonstrate this with an example, which we will build up as this chapter progresses.
3.1 Example: the accounting equation
On 1 July, Eliza Doolittle decides to open up a flower stall in the market, to sell flowers and potted plants.
She has $2,500 to put into her business.
As soon as the business is set up, an 'accountant's picture' can be drawn of what it owns and what it
owes. The business begins by owning the cash that Eliza has put into it, $2,500. Does it owe anything?
The answer is yes.
The business is a separate entity in accounting terms. It has obtained its assets, in this example cash,
from its owner, Eliza Doolittle. It therefore 'owes' this amount of money to its owner. The money is the
owner's starting capital. If Eliza changed her mind and decided not to go into business after all, the
business would be dissolved by the 'repayment' of the cash by the business to Eliza.
Capital invested is therefore a form of liability. Adapting this to the idea that liabilities and assets are
always equal amounts, we can state the accounting equation as follows.

The accounting equation 1
$2,500 (cash) = $0 + $2,500
3.2 Example continued: different assets
Eliza Doolittle purchases a market stall from Sanjay Patel for $1,800.
She also purchases some flowers and potted plants from a trader in the New Covent Garden wholesale
market, at a cost of $650.
This leaves $50 in cash, after paying for the stall and goods for resale, out of the original $2,500. She is
now ready for her first day of market trading on 3 July. How does the accounting equation look now?
Solution
The assets of the business have now changed. There is less cash, but the business now owns a stall and
some flowers and plants. At 3 July, before trading begins, the state of her business is as follows.
Assets
=

Liabilities

+

Capital

$

Stall

1,800

$0

$2,500

Flowers and plants

650

Cash

50

2,500

There is no change in the capital of the business. There has simply been a reduction of $2,450 in one
asset (cash) and a corresponding increase in two other types of asset.
3.3 Example continued: trading to make a profit
On 3 July Eliza has a very successful day. She sells all of her flowers and plants, for $900 cash.
Since Eliza has sold goods costing $650 to earn income (often referred to in accounting as 'revenue') of
$900, we can say that she has earned a profit of $(900 650) = $250 on the day's trading.
Profit, like capital, belongs to the owners of a business. It's why they invest in their business in the first
place. In this case, the $250 belongs to Eliza Doolittle. However, although the money is in Eliza's own
hands, it is treated at the moment as remaining within the business. As long as a business retains its
profits, and does not pay anything out to its owners, the retained profits are accounted for as an
addition to the proprietor's capital: they become part of that capital.
This is how the accounting equation looks for Eliza's business after making the profit of $250. Notice that
the total amount of assets and the owner's capital have increased by $250, the profit earned.
Assets
=

Liabilities

+

Capital

$

$

Stall

1,800

Capital

Flowers and plants

0

introduced

2,500

Cash (50 + 900)

950

Retained

2,750

$0

profit

250

2,750

So we could expand the accounting equation as follows.
The accounting equation with retained profits
Assets = Liabilities + (Capital introduced + Retained profits)
3.4 Increase in net assets
Net assets = Total assets Total liabilities
Another way of showing the accounting equation is as follows.
Assets Liabilities = Capital
Net assets = Capital
At the beginning and then at the end of 3 July Eliza Doolittle's financial position was as follows.

Net assets =

Capital

(a) At the beginning of the day:

$(2,500 0) =

$2,500

(b) At the end of the day:

$(2,750 0) =

$2,750

Increase in net assets

250 = Retained profit for day

250

We can now state various principles.
(a) At any point in time, a business's net assets represent the capital introduced by the owner plus
the business's retained profit to that point in time.
(b) At a later point in time, the increase in the business's net assets represents the additional profit
made in the intervening period.
(c) Total net assets at that later point represent the capital introduced by the owner plus the business's
increased retained profit.
For example:

$m

$m

$m

1 Jan

Net assets

170

=

Capital introduced

20

+

Retained profit

150

1 Jan-31 Dec

Increase in net assets

34

=

Profit made in year

34

31 Dec

Total net assets

204

=

Capital introduced

20

+

Total retained profit

184
3.5 Drawings
Profits earned by a business add to capital, and losses reduce capital. Drawings reduce capital. This
means that the capital of a business is increased by the retained profits (profits earned minus drawings).
Drawings are amounts of money paid out of a business to its owner. The term 'drawings' is used for
business partnerships and the businesses of sole traders. For companies, money paid out of the business
to its owners is a dividend.
3.6 Example continued: drawings
Since Eliza Doolittle has made a profit of $250 from her first day's work, she feels justified in drawing
some of the profits out of the business, for living expenses. She decides to pay herself $180, in what she
thinks of as 'wages', as a fair reward for her day's work.
If Eliza had hired someone to do the work for her, and paid that person $180, the payment would be
wages (or salary). The wages or salary would then be treated as an expense of the business, and deducted
in calculating the amount of profit that the business has earned. In contrast, money paid out of profits to
its owner is not salary or wages.
As Eliza is the owner of her business, the $180 is not an expense to be deducted before the figure of profit
is arrived at.
Any amounts paid by a business to its proprietor are treated by accountants as withdrawals of profit
(drawings), and not as expenses incurred by the business. In the case of Eliza's business, the position is
that the profit earned is the $250 surplus on sale of flowers, but the profit retained in the business is

$(250 180) = $70. In other words, the business made a profit of $250, of which $180 has been taken out
as drawings and only $70 has been retained in the business.

$

Profit earned by business

250

Less: profit withdrawn by Eliza

(180)

Profit retained in the business

70

The drawings are taken in cash, and so the business loses $180 of its cash assets. After the drawings have
been made, the accounting equation would be restated as follows.

$

$

Stall

1,800

Capital introduced

2,500

Flowers and plants

0

Profit earned

250

Cash $(950 180)

770

Less drawings

(180)

2,570
=
$0
+
2,570

The increase in net assets since trading operations began is now only $(2,570 2,500) = $70, which is
the amount of the retained profits.
Profits are recorded in the accounting equation (and statement of financial position) of a business
because they are capital as long as they are retained in the business. When they are paid out as
drawings, the business suffers a reduction in capital.
We can therefore restate the accounting equation again.
The accounting equation adjusted for withdrawal of profit
Assets = Liabilities + Capital introduced + (Earned profit Drawings)
3.7 Dual effect of all business transactions
All business transactions have a dual effect. The dual effect of transactions is the basis of the 'double
entry' system of bookkeeping that is used to record business transactions.
It is essential to remember that the basic equation (Assets = Liabilities + Capital) always holds good. This
means, for example, that if a transaction has the effect of adding an asset to the resources of a business,
there will be a reduction in another asset by an equal amount, or there will be an increase in capital, or an
increase in a liability.
Any transaction affecting the business has a dual effect, as shown in the table below.
Asset = Capital + Liabilities
Increase Increase
or Increase Increase
or Increase Decrease
or Decrease Increase
or Decrease Decrease
or Decrease Decrease

2: Assets, liabilitie s and the accounting equation 329

Activity 3.1

Consider each of the transactions below, and mark on the grid how assets, liabilities and capital will be
increased or decreased by the transaction. We have done the first one for you.
(a) A business is informed by its bank that it no longer owes the bank $100 in bank charges.
(b) The business finds it has been overcharged $50 for some furniture it bought on credit.
(c) A gas bill of $200 is received by the business.
(d) The owner withdraws $500 from the business.
(e) Cash is introduced into the business by its owner.
(f) A car is bought by the business, for payment in one month's time.
Transaction = Assets = Capital + Liabilities
a Increase Decrease
b
c
d
e
f

4 The business equation
The increase in net assets during a period of time is explained by the retained profit for the period (profit
earned minus drawings) plus any new capital introduced. This connection between profits and changes in
net assets is an expression of the business equation.
The business equation is an elaboration of the accounting equation which gives a definition of profits
earned. Whereas the accounting equation is a rudimentary statement of financial position, the business
equation is a way of showing the link between the income statement and the opening statement of
financial position at the start of a period and the closing statement of financial position at the end. The
example of Eliza Doolittle has shown that the amount of profit earned in a time period can be related to
the increase in the net assets of the business, the drawings of profits by the proprietor and the
introduction of new capital.
We know that
which is the same as
Assets = Liabilities + Capital introduced
+ Retained profits
which is the same as
+ Profits earned
Drawings
As time goes on, retained profit (profit earned less profit taken out in drawings) builds up the amount of
capital in the business. At the start of an accounting period, retained profits will form part of the 'opening
balance' of capital, i.e. the business capital at the start of the period. As we proceed through another
period of trading, additional profit will (hopefully) be earned. So we should look at the accounting equation
again.

The accounting equation re-stated
+ Profit retained in previous periods
+ Profit earned in current period
Drawings in current period
Let's see how this works in the case of Eliza Doolittle.
4.1 Example continued: earning more profits
The next market day is on 10 July, and Eliza purchases more flowers and plants for cash, at a cost of
$740. She is not feeling well, because of a heavy cold, and so she accepts the offer of help for the day
from her cousin, Charlie, whom she agrees to pay a wage of $40.
Eliza and Charlie sell all their goods for $1,100 cash. Eliza pays Charlie his wage of $40 and draws out
$200 for herself. How do these transactions affect Eliza's capital?
Solution
The accounting equation before trading begins on 10 July, and after trading ends on 10 July, can be set
out as follows.
(a) Before trading begins
Assets = Capital + Liabilities

$

$

Stall

1,800

Capital introduced

2,500

Flowers and plants

740

Retained profit

70

Cash $(770 740)

30

2,570

2,570

$0

(b) After trading ends
On 10 July, all the goods are sold for $1,100 cash, and Charlie is paid $40. The profit for the day is
$320, computed as follows.
$ $
Sales

1,100


740

Charlie's wage

40

780

Profit

320

Eliza withdraws $200 of this profit for her personal use.

$

$

Stall

1,800

At beginning of 10 July

2,570

Flowers and plants

0

Profits earned on 10 July

320

Cash (30 + 1,100 40 200)

890

Less drawings

(200)

2,690

2,690
+
$0

4.2 Introducing more capital
When a business is going well, the owner may decide to invest more money in it, in the expectation of
generating even more profit. We need to include introductions of new capital into the accounting equation.
In doing so, we will arrive at the business equation, which allows us to compute profit from analysing the
increase in net assets of the business, drawings and new capital introduced.
4.3 Example: more capital introduced
On 10 July, in addition to all the other transactions, Eliza decides to hire a van at a cost of $50 to transport
the flowers and plants, paying for the hire out of cash from her own purse. How would this affect the
accounting equation at the end of 10 July?
Solution
After trading ends
On 10 July, all the goods are sold for $1,100 cash, Charlie is paid $40 and the van cost $50. Profit for the
day is $270.

$

$

Sales

1,100


740

Charlie's wage

40

van hire

50

830

270

Eliza withdraws $200 for her personal use.
$ $
Stall 1,800 At start of trading 2,570
Goods 0 Capital introduced 50
Cash (30 + 1,100 + 50 40 50 200) 890 Profits earned 10 July 270
Drawings
(200)

2,690

2,690
$0
New capital introduced to the business should also be brought into the accounting equation.
The accounting equation re-stated
Assets = Liabilities + Capital introduced in previous periods
+ Capital introduced in current period
If we put Eliza Doolittle's figures into this, we get
Assets
$

Capital

Liabilities

$ $
Stall

1,800

= Capital introduced in previous periods

2,500

+

0

Cash 890

70


270

+ Capital introduced in current period

50


(200)

2,690

2,690

0

4.4 The business equation
We are now ready to see how profit earned in a period can be expressed simply in terms of transactions
within the period. Concentrating on the current period box above, we can state the business equation as
follows.
PREVIOUS
Assets at start of
period
= Capital introduced in previous
periods
+ Liabilities at start
of period
PERIODS + Profit retained in previous
periods

+
CURRENT
Increase/decrease
in assets (I)
= Profit earned in current
period (P)
+ Increase/decrease
in liabilities (I)
PERIOD + Capital introduced in current
period (C)

Drawings in current period (D)
=
END OF CURRENT
PERIOD
Total assets at end
of period
= Total capital at end of period + Liabilities at end of
period
The business equation
P = I + D C
Where:
P = Profit earned in the current period
I = Increase (or decrease) in net assets during the period. (This is a net figure for the increase (or
decrease) in assets minus the increase (or plus the decrease) in liabilities in the period)
D = Drawings in the current period
C = Capital introduced during the period
Let's see how Eliza's figures for 10 July go into this equation.
Profit = Increase in net assets + Drawings Capital introduced
= $(2,690 2,570) + $200 $50
= $270
You may be a little concerned about why the capital introduced in the period is a negative figure in the
equation. When a business is given new capital, perhaps in the form of extra money paid in by the
proprietor herself, there will be an increase in the net assets of the business without any profits being
earned. This means that if a proprietor puts an extra $5,000 into his business, the profit from the
transaction according to the business equation would be P = $5,000 + 0 $5,000 = $0.
Similarly we saw with Eliza Doolittle that the $50 cash introduced was added to assets (cash) in the
accounting equation in Paragraph 4.3 but was also added to capital.
P = $50 + 0 $50 = 0
5 Payables and receivables
Many business transactions are made on credit. Creditors are owed money by a business and are
liabilities (payables) of the business. Debtors owe money to the business, and are assets (receivables)
of the business.
5.1 Credit transactions
We have been concentrating on capital (including retained profits) and assets (cash, goods for resale,
non-current assets), where the transactions of a business have been in cash. In reality, many business

transactions are made on credit. Goods or services are obtained without payment for cash on delivery.
Instead, the customer takes credit, and undertakes to pay later. Businesses give credit to their customers,
and they also take credit from their suppliers.
In addition, businesses do not rely entirely on owners' capital for their long-term funding. Sometimes they
borrow.
We shall now look at business transactions involving credit, and payables and receivables.
5.2 Payables
A creditor is a person from whom a business has purchased items and to whom a business owes
money. A payables balance is the liability of the business which arises. Examples of payables
include bank loans (money owed to the bank) and unpaid telephone and electricity bills.
A trade creditor is a person to whom a business owes money for debts incurred in the course of
trading operations. The term might refer to amounts still outstanding which arise from the
purchase from suppliers of materials, components or goods for resale. In the accounts the amount
owed to suppliers will be recorded as trade payables.
It is a common business practice to make purchases on credit terms, with a promise to pay within 30
days perhaps, or two months or even three months of the date of the purchase. For example, Alpha might
buys goods costing $2,000 on credit from Beta. Beta might send Alpha an invoice for $2,000, dated 1
March, with credit terms that payment must be made within 30 days. If Alpha chooses not to pay the
invoice immediately and delays payment until 31 March, Beta will be a creditor of Alpha for $2,000,
between 1 and 31 March. There will be a trade payables balance of $2,000.
5.3 Receivables
A debtor is a person to whom the business has sold items and by whom the business is owed
money. A receivable is an asset of a business (the business 'owns' a right to receive payment).
A trade debtor is a customer who owes the business money for amounts incurred in the course of
trading operations, i.e. because the business has sold its goods or services on credit to the debtor.
In the accounts the amount owed by customers will be recorded as trade receivables.
Just as a business might buy goods on credit, so too might it sell goods to customers on credit. For
example, suppose that Gamma sells goods on credit to Delta for $6,000 on terms that payment is due
within two months of the invoice date, 1 October. If Delta takes the credit and does not pay the $6,000
until 30 November, Delta will be a debtor of Gamma for $6,000 from 1 October until 30 November.
There will be a trade receivables balance of $6,000.
This might serve as a useful summary.
CREDIT TRANSACTIONS
SALES PURCHASES
by the business to a customer by the business from a supplier

creates a creates a
DEBTOR CREDITOR
(a customer who owes money to the business) (a supplier who is owed money by the
business)
recorded as an recorded as a
ASSET (receivable) LIABILITY (payable)
of the business of the business
settled when the business settled when the business
RECEIVES CASH PAYS CASH

5.4 Example continued: receivables and payables
Let's continue further the example of Eliza Doolittle's market stall, by looking at the consequences of the
following transactions in the week to 17 July.
(a) Eliza realises that she is going to need even more money in the business and so she makes the
following arrangements.
(i) She invests immediately a further $250 of her own capital.
(ii) She persuades her friend Professor Higgins to lend her $500 immediately. Professor
Higgins tells her that she can repay the loan whenever she likes, but in the meantime she
must pay him interest of $5 per week at the end of the market day. They agree that it will
probably be quite a long time before the loan is eventually repaid.
(b) She decides to buy a second-hand van to pick up flowers and plants from her supplier and bring
them to her stall in the market. She finds a car dealer, Laurie Loader, who agrees to sell her a van
on credit for $700. Eliza agrees to pay for the van after 30 days' trial use.
(c) During the week, Eliza's Uncle Henry telephones her to ask whether she would be interested in
selling him some garden gnomes and furniture for his garden. Eliza tells him that she will look for a
supplier. After some investigations, she buys what Uncle Henry has asked for, paying $300 in cash
to the supplier. Uncle Henry accepts delivery of the goods and agrees to pay $350 at a later date.
(d) Eliza buys flowers and plants costing $800. Of these purchases $750 are paid in cash, with the
remaining $50 on seven days' credit. Eliza decides to use Charlie's services again as an assistant
on market day, at an agreed wage of $40.
(e) On 17 July, Eliza sells all her goods, earning revenue of $1,250 (all in cash). She takes out
drawings of $240 for her week's work. She also pays Charlie $40 in cash. She decides to make the
interest payment to her Uncle Henry the next time she sees him.
(f) There were no van expenses.
First of all we can state the following accounting equations:
(a) After Eliza and Professor Higgins have put more money into the business
(b) After the purchase of the van
(c) After the sale of goods to Uncle Henry
(d) After the purchase of goods for the weekly market
(e) At the end of the day's trading on 17 July, and after drawings have been withdrawn from profit
Then we are going to state the business equation showing profit earned during the week ended 17 July.
Solution
There are a number of different transactions to deal with here. This solution deals with them one at a time
in chronological order, highlighting the numbers that change each time in bold type. In practice, as you
can possibly imagine, it would be possible to do one set of calculations combining the results of all the
transactions. The transactions are taken separately here to illustrate the effect of each on the accounting
equation and statement of financial position of the business.
(a) The addition of the extra capital by Eliza and the loan from Professor Higgins.
The loan from Professor Higgins is for the long term, but he is not an owner of the business, even
though he has made a long-term loan to it. He would only become an owner if Eliza offered him a
partnership in the business, or turned the business into a company and offered him some shares.
She has not done so; therefore Professor Higgins is simply a long-term creditor. His loan is a
liability of the business it is not business capital.
The accounting equation after $(250 + 500) = $750 cash is put into the business will be as follows:

$

$

$

Stall
1,800

Loan

500

As at end of 10

July

2,690

Goods

0

Additional capital

250

Cash $(890 + 750)

1,640

3,440

500

2,940

2: Assets, liabilitie s and the accounting equation 335
(b) The purchase of the van (cost $700) is on credit, so Eliza doesn't have to pay until later.
Assets
=

Liabilities

+

Capital

$

$

$

Stall

1,800

Loan

500

As at end of 10 July

2,690

Van

700

Payable

700

Additional capital

250

Cash

1,640

4,140

1,200

2,940

(c) The sale of goods to Uncle Henry is on credit ($350), the cost to the business being $300 (cash
paid). This gives a profit of $50. Uncle Henry, because he is paying later, is shown as a receivable.
Assets
=

Liabilities

+

Capital

$

$

$

Stall

1,800

Loan

500


2,690
Van

700

Payable

700

Additional capital

250
Receivable

350

Profit on sale

50
Cash (1,640 300)

1,340

4,190

1,200

2,990
(d) After the purchase of goods for the weekly market ($750 paid in cash and $50 of purchases on credit).
Assets
=

Liabilities

+

Capital

$

$

$

Stall

1,800

Loan

500


2,690

Van

700

Payable for van

700

Additional capital

250

Goods

800

Payable for

goods

50

Profit on sale to Uncle

Henry

50

Receivable

350

Cash (1,340 750)

590

4,240

1,250

2,990

(e) After market trading on 17 July, sales of goods costing $800 earned revenues of $1,250. Charlie's
wages were $40 (paid), the interest charge on the loan from Professor Higgins is $5 (not paid yet)
and drawings out of profits were $240 (paid). The profit for 17 July may be calculated as follows,
taking the full $5 of interest as a cost on that day.

$

$

Revenue

1,250

Cost of goods sold

800

Wages

40

Interest

5

845

Profits earned on 17 July

405

Profit on sale of goods to Uncle Henry

50

Total profit for the week

455

Assets
=

Liabilities

+

Capital

$

$

$

Stall

1,800

Loan

500


2,690
Van

700

Payable for

van

700

Additional capital

250
Goods

0

Payable for

goods

50

Profit on sale to Uncle
Henry

50
Receivable

350

Payable for

interest

5

Cash (590 + 1,250 40

240)

1,560

Profit for the week

405

Drawings

(240)

4,410

1,255

3,155
The increase in the net assets of the business during the week was as follows.
$

Net assets as at the end of 17 July $(4,410 1,255)

3,155

Net assets as at the end of 10 July

2,690

Increase in net assets in week

465

The business equation for the week ended 17 July is as follows. (Remember that extra capital of $250 was
invested by Eliza.)
P = I + D C
=
=
$465 + $240 $250
$455
This confirms the calculation of total profit.

Activity 3.2

Show the effect on the accounting equation of each of the following transactions.
1 A business buys goods for $800 for cash.
2 The business sells these goods on credit for $1,400.
3 The customer pays three weeks later.
4 The business receives an invoice for a telephone bill for $2,600, all relating to the current
accounting period.
5 The business pays the bill.
Transaction Change in assets Change in liabilities Change in capital
1

2

3

4

5

6 Double entry bookkeeping
Since the total of liabilities plus capital is always equal to total assets, any transaction has a dual effect

if it changes the amount of total assets it also changes the total liabilities plus capital, and vice versa.
Alternatively, a transaction might use up assets of a certain value to obtain other assets of the same value.
For example, if a business pays $50 in cash for some goods, its total assets will be unchanged, and as the
amount of cash falls by $50 and the value of goods in inventory increases by $50.
We can say then that there are two sides to every business transaction. Out of this concept has developed
the system of accounting known as the 'double entry' system of bookkeeping, so called because every
transaction is recorded twice in the accounts.
Double entry bookkeeping is the system of accounting which reflects the fact that:
every financial transaction gives rise to two accounting entries
each entry shows one of the effects of the transaction on the accounting equation
'Ledger accounts' in a system of book-keeping are used to record transactions and show the current total value
of a category of assets, or a category of liabilities, or owners' capital, or revenue or a category of expenditure.
Each asset, liability, item of expense or item of income has a ledger account in which the effect of
business transactions are recorded. At any time, provided the accounting records are kept up-to-date:
(a) The total 'balance' on an asset account shows the current value of those assets owned by the
business. For example, the balance on an office equipment account shows the total value of office
equipment owned by the business, the total balance on the inventories account shows the total
value of inventories held by the business, and the balance on the receivables account shows the
total amount owed to the business by its debtors.
Similarly, the total balance on a liabilities account shows the total amount owed by the business
for that type of liability (e.g. bank loans, trade payables).
(b) The total balance on the sales account shows the total sales revenue to date for the period.
(c) The total balance on various expenses accounts shows the total expenditure to date for the period
for the particular item of expense (e.g. wages and salaries, telephone costs, advertising
expenditure, legal expenses, and so on).
At the end of an accounting period, the balances are taken from each of these accounts, and form the basis for
calculating the profit or loss for the period, and constructing a statement of financial position for the end of the
period.
7 The business equation as a link between profit and
changes in the accounting equation
It has already been stated that the accounting equation is similar to a statement of financial position,
showing the assets, liabilities and capital of the business at a given moment in time. This chapter has
shown that the business equation explains the change in the net assets of a business at the start of a
period (i.e. the accounting equation at the start of the period) and the net assets at the end of the period.
Although it is not a part of the statutory accounts of a company, this link between opening net assets,
profit, drawings, new capital and closing net assets might be shown in the income statement of a
business, as follows.
$
Revenue 500,000
Expenditure
360,000

Profit earned in the period 140,000
Less: Drawings
110,000

Retained profit for the period 30,000
Net assets at the start of the period 850,000
New capital introduced
70,000

Net assets at the end of the period
950,000

Activity 3.3

Try to explain the dual effects of each of the following transactions.
(a) A business receives a loan of $5,000 from its bank
(b) A business pays $800 cash to purchase goods for resale
(c) The proprietor of a business removes $50 from the till to buy her husband a birthday present
(d) A business sells goods costing $300 at a profit of $140
(e) A business repays a $5,000 bank loan, plus interest of $270

338 3: Qualities of financial information and measurement

1 Qualitative characteristics of financial information
The Framework states that qualitative characteristics are the attributes that make the information provided
in financial statements useful to users.
The four principal qualitative characteristics are
(1) understandability
(2) relevance
(3) reliability
(4) comparability.
1.1 Understandability
Users must be able to understand financial statements. The Framework however takes the view that
preparers of financial statements can assume that users have some business, economic and accounting
knowledge and are able to apply themselves to study the information properly. Information about complex
matters should not be left out of financial statements simply due to its difficulty if it is relevant information.
1.2 Relevance
Relevant information can have predictive and confirmatory value.
Relevance. Information has the quality of relevance when it influences the economic decisions of users by
helping them evaluate past, present or future events or confirming, or correcting, their past evaluations.
(Framework)
There are two ways in which information can influence decisions. It can have a predictive value and it can
have a confirmatory value. The Framework states that the predictive and confirmatory roles of information
are interrelated, in that the same information can have both predictive and confirmatory value. For
example, an investor might have purchased shares in ABC Co some time ago, expecting the company to
be profitable and pay high dividends. The annual financial statements of ABC Co published at a later date
might both confirm the investor's expectations of what profits and dividends were likely to be and also
help him to make a further assessment about what profits and dividends might be in future.
The Framework also explains that information does not need to be in the form of an explicit forecast to
have predictive value. However the ability to make decisions is enhanced by the manner in which the
information is presented eg by highlighting unusual items.

Qualities of financial
information and measurement
3: Qualities of financial information and measurement 339
1.2.1 Materiality
Materiality revolves around whether the information involved would have influenced the economic
decisions made by users.
The relevance of information is affected by its nature and materiality.
Materiality. Information is material if its omission or misstatement could influence the economic
decisions of users taken on the basis of the financial statements. (Framework)
The Framework states that information may be judged relevant simply because of its nature (eg share
capital). In other cases, both the nature and materiality of the information are important. Materiality is not
a primary qualitative characteristic itself (like reliability or relevance), because it is merely a threshold or
cut-off point.
In practical terms materiality is a final test of what information should be included in the financial
statements. If the inclusion of further information would not have a material effect on the usefulness of the
financial information (in terms of relevance, reliability and so on) it need not be included. In preparing
accounts it is important to assess what is material and what is not, so that time and money are not wasted
in the pursuit of excessive detail.
Determining whether or not an item is material is a very subjective exercise. There is no absolute
measure of materiality. It is common to apply a convenient rule of thumb (for example to define material
items as those with a value greater than 5% of the net profit disclosed by the accounts). But some items
disclosed in accounts are regarded as particularly sensitive and even a very small misstatement of such an
item would be regarded as a material error. An example in the accounts of a limited liability company
might be the amount of remuneration paid to directors of the company.
The assessment of an item as material or immaterial may affect its treatment in the accounts. For
example, the income statement of a business will show the expenses incurred by the business grouped
under suitable captions (heating and lighting expenses, rent and local taxes etc); but in the case of very
small expenses it may be appropriate to lump them together under a caption such as 'sundry expenses',
because a more detailed breakdown would be inappropriate for such immaterial amounts.
In assessing whether or not an item is material, it is not only the amount of the item which needs to be
considered. The context is also important.
(a) If a statement of financial position shows non-current assets of $2 million and inventories of
$30,000 an error of $20,000 in the depreciation calculations might not be regarded as material,
whereas an error of $20,000 in the inventory valuation probably would be as this directly affects
profit. In other words, the total of which the erroneous item forms part must be considered.
(b) If a business has a bank loan of $50,000 and a $55,000 balance on bank deposit account, it might
well be regarded as a material misstatement if these two amounts were displayed on the statement
of financial position as 'cash at bank $5,000'. In other words, incorrect presentation may amount
to material misstatement even if there is no monetary error.
Users are assumed to have a reasonable knowledge of business and economic activities and accounting
and a willingness to study the information with reasonable diligence.
1.3 Reliability
Faithful representation, substance, neutrality and prudence are important aspects of reliability.
Information must also be reliable to be useful. The user must be able to depend on it being a faithful
representation.

Reliability. Information has the quality of reliability when it is free from material error and bias and can be
depended upon by users to represent faithfully that which it either purports to represent or could
reasonably be expected to represent. (Framework)
Even if information is relevant, if it is very unreliable it may be misleading to recognise it, eg a disputed
claim for damages in a legal action.
1.3.1 Faithful representation
Information must represent faithfully the transactions it purports to represent in order to be reliable. There
is a risk that this may not be the case, not due to bias, but due to inherent difficulties in identifying the
transactions or finding an appropriate method of measurement or presentation. Where measurement of
the financial effects of an item is so uncertain, entities should not recognise such an item, eg internally
generated goodwill.
1.3.2 Substance over form
Faithful representation of a transaction is only possible if it is accounted for according to its substance
and economic reality, not with its legal form.
Substance over form. The principle that transactions and other events are accounted for and presented in
accordance with their substance and economic reality and not merely their legal form. (Framework)
This is looked at in more detail in Chapter 6.
1.3.3 Neutrality
Information must be free from bias to be reliable. Neutrality is lost if the financial statements are prepared
so as to influence the user to make a judgement or decision in order to achieve a predetermined outcome.
1.3.4 Prudence
Prudence means exercising a reasonable degree of caution when there is some uncertainty in order that
gains and assets are not overstated in value and liabilities are not under-stated.
Uncertainties exist in the preparation of financial information, eg the collectability of doubtful receivables. These
uncertainties are recognised through disclosure and through the application of prudence. Prudence does not,
however, allow the creation of hidden reserves or excessive provisions, understatement of assets or income or
overstatement of liabilities or expenses.
1.3.5 Completeness
Financial information must be complete, within the restrictions of materiality and cost, to be reliable.
Omission may cause information to be misleading.
1.4 Comparability
Disclosure of accounting policies aids comparability.
The usefulness of financial information increases enormously if it can be compared with similar
information.
Users must be able to compare an entity's financial statements:
(a) Through time to identify trends
(b) With other entities financial statements, to evaluate their relative financial position, performance
and changes in financial position
The consistency of treatment is therefore important across like items over time, within the entity and
across all entities.

The disclosure of accounting policies is particularly important here. Users must be able to distinguish
between different accounting policies in order to be able to make a valid comparison of similar items in the
accounts of different entities.
Comparability is not the same as uniformity. Entities should change accounting policies if they become
inappropriate.
Corresponding information for preceding periods should be shown to enable comparison over time.
1.5 Constraints on relevant and reliable information
1.5.1 Timeliness
Information may become irrelevant if there is a delay in reporting it. There is a balance between
timeliness and the provision of reliable information. Information may be reported on a timely basis
when not all aspects of the transaction are known, thus compromising reliability.
If every detail of a transaction is known, it may be too late to publish the information because it has become
irrelevant. The overriding consideration is how best to satisfy the economic decision-making needs of the users.
1.5.2 Balance between benefits and cost
This is a pervasive constraint, not a qualitative characteristic. When information is provided, its benefits
must exceed the costs of obtaining and presenting it. This is a subjective area and there are other
difficulties: others than the intended users may gain a benefit; also the cost may be paid by someone other
than the users. It is therefore difficult to apply a cost-benefit analysis, but preparers and users should be
aware of the constraint.
1.5.3 Balance between qualitative characteristics
A trade off between qualitative characteristics is often necessary, the aim being to achieve an
appropriate balance to meet the objective of financial statements. It is a matter for professional
judgement as to the relative importance of these characteristics in each case.
Examples of the trade off required are as follows:
Understandability and completeness (reliability): providing more complete financial information
may make the financial statements less understandable
Relevance and reliability: relevant information may not be reliable. In this case, the most relevant of
the reliable information should be used.
1.6 True and fair view/fair presentation
The Framework does not attempt to define these concepts directly. It does state, however, that the
application of the principal 'qualitative' characteristics and of appropriate accounting standards with
additional disclosure if necessary will usually result in financial statements which show a true and fair
view of, or present fairly, the financial performance, financial position and cash flows of an entity.
2 The elements of financial statements
Transactions and other events are grouped together in broad classes and in this way their financial effects
are shown in the financial statements. These broad classes are the elements of financial statements.
The Framework lays out these elements as follows.
Elements of
financial statements

Measurement of Measurement of
financial position in performance in the
the statement of financial position income statement

Assets Income
Liabilities Expenses
Equity
A process of sub-classification then takes place for presentation in the financial statements, eg assets and
liabilities are first analysed into current (to be used or settled within 12 months) or non-current, and then
further classified by their nature or function in the business to show information in the best way for users
to take economic decisions.
2.1 Financial position
We need to define the three terms listed under this heading above. We looked at the basic definitions of
assets and liabilities in Chapter 2.
Asset. A resource controlled by an entity as a result of past events and from which future economic
benefits are expected to flow to the entity.
Liability. A present obligation of the entity arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits.
Equity. The residual interest in the assets of the entity after deducting all its liabilities. (Framework)
These definitions are important, but they do not cover the criteria for recognition of any of these items,
which are discussed in the next section of this chapter. This means that the definitions may include items
which would not actually be recognised in the statement of financial position because they fail to satisfy
the recognition criteria, particularly the probable flow of any economic benefit to or from the business.
This is explored in more detail below.
Whether an item satisfies any of the definitions above will depend on the substance and economic reality
of the transaction, not merely its legal form. For example, consider finance leases (see Chapter 6).
2.2 Assets
We can look in more detail at the components of the definitions given above.
Future economic benefit. The potential to contribute, directly or indirectly, to the flow of cash and cash
equivalents to the entity. The potential may be a productive one that is part of the operating activities of
the entity. It may also take the form of convertibility into cash or cash equivalents or a capability to reduce
cash outflows, such as when an alternative manufacturing process lowers the cost of production.
(Framework)

Assets are usually employed to produce goods or services for customers; customers will then pay for
these. Cash itself renders a service to the entity due to its command over other resources.
The existence of an asset, particularly in terms of control, is not reliant on:
(a) physical form (hence patents and copyrights); nor
(b) legal rights (hence leases).
Transactions or events in the past give rise to assets; those expected to occur in the future do not in
themselves give rise to assets. For example, an intention to purchase a non-current asset does not, in
itself, meet the definition of an asset.
2.3 Liabilities
Again we can look more closely at some aspects of the definition. An essential characteristic of a liability is
that the entity has a present obligation.
Obligation. A duty or responsibility to act or perform in a certain way. Obligations may be legally
enforceable as a consequence of a binding contract or statutory requirement. Obligations also arise,
however, from normal business practice, custom and a desire to maintain good business relations or act
in an equitable manner. (Framework)
It is important to distinguish between a present obligation and a future commitment. A management
decision to purchase assets in the future does not, in itself, give rise to a present obligation.
Settlement of a present obligation will involve the entity giving up resources embodying economic benefits in
order to satisfy the claim of the other party. This may be done in various ways, not just by payment of cash.
Liabilities must arise from past transactions or events. In the case of, say, recognition of future rebates to
customers based on annual purchases, the sale of goods in the past is the transaction that gives rise to the liability.
2.3.1 Provisions
A provision is a liability of uncertain timing or amount. An example is the future payment of damages as
the result of a court case which is ongoing at the reporting date. At the reporting date, the company does
not know how much (if anything) will have to be paid, or when it will be paid.
Provision. A present obligation which satisfies the rest of the definition of a liability, even if the amount of
the obligation has to be estimated. (Framework)
A provision is recorded as a liability in the statement of financial position if:
(a) there is a present obligation as a result of a past event, and
(b) the transfer of economic benefits (payment) is probable, and
(c) the transfer can be reliably measured.
These recognition criteria are discussed in more detail in Chapter 6.

Activity 4.1

Consider the following situations. In each case, do we have an asset or liability within the definitions given
by the Framework? Give reasons for your answer.
(a) Pat Co has purchased a patent for $20,000. The patent gives the company sole use of a particular
manufacturing process which will save $3,000 a year for the next five years.
(b) Baldwin Co paid Don Brennan $10,000 to set up a car repair shop, on condition that priority
treatment is given to cars from the company's fleet.
(c) Deals on Wheels Co provides a warranty with every car sold.

2.4 Equity
Equity is defined above as a residual, but it may be sub-classified in the statement of financial position
into share capital and reserves. Reserves may include share premium, retained earnings, a general reserve
and a revaluation reserve.
This sub-division is necessary to indicate legal or other restrictions on the ability of the entity to distribute
or otherwise apply its equity. Some reserves are required by statute or other law, eg for the future
protection of creditors. Share capital, share premium and the revaluation reserve are deemed capital
reserves and are not distributable, i.e. they may not be paid out as dividends. The general reserve and
retained earnings are distributable and may be paid out as dividends.
The amount shown for equity depends on the measurement of assets and liabilities. It has nothing to do
with the market value of the entity's shares.
2.5 Performance
Profit is used as a measure of performance, or as a basis for other measures (eg earnings per share,
calculated as profit divided by the number of shares in issue. This is discussed in more detail in Chapter
13). Profit depends directly on the measurement of income and expenses, which in turn depend (in part)
on the concepts of capital and capital maintenance adopted (see section 7 of this chapter).
The elements of income and expense are therefore defined.
Income. Increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than
those relating to contributions from equity participants.
Expenses. Decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurrences of liabilities that result in decreases in equity, other than those
relating to distributions to equity participants. (Framework)
Income and expenses can be presented in different ways in the income statement, to provide information
relevant for economic decision-making. For example, it is helpful to distinguish between income and
expenses which relate to continuing operations and those which do not.
Items of income and expense can be distinguished from each other or combined with each other. For
example, expenses are aggregated and reported within one of three expense categories: cost of sales,
distribution costs or administrative expenses. Finance costs are, however, reported separately. Income
and related expense items are generally reported separately and not netted off, however in a minority of
instances this rule is relaxed.
2.6 Income
Both revenue and gains are included in the definition of income. Revenue arises in the course of ordinary
activities of an entity.
Gains. Increases in economic benefits. As such they are no different in nature from revenue. (Framework)
Gains include those arising on the disposal of non-current assets. The definition of income also includes
unrealised gains, eg on revaluation (uplift in value) of marketable securities. An unrealised gain is a paper
gain that results from holding an asset or liability but which has not yet been realised in the form of cash.
2.7 Expenses
As with income, the definition of expenses includes losses as well as those expenses that arise in the
course of ordinary activities of an entity.
Losses. Decreases in economic benefits. As such they are no different in nature from other expenses.
(Framework)
Losses will include those arising on the disposal of non-current assets. The definition of expenses will also
include unrealised losses, eg exchange rate effects on borrowings. Unrealised losses are paper losses
which result from holding an asset or liability but which have not yet been realised in the form of cash.
2.8 Capital maintenance adjustments
A revaluation gives rise to an increase or decrease in equity.
Revaluation. Restatement of assets and liabilities. (Framework)
These increases and decreases meet the definitions of income and expenses. They are not included in the
income statement under certain concepts of capital maintenance, however, but rather in equity (see Section 8).
3 Recognition of the elements of financial statements
Recognition is based on the definition of an element, probability of future economic benefits and
reliability of measurement.
The financial statements report the assets, liabilities and capital of a company in its statement of financial
position and the income and expenditure during an accounting period in the income statement. Rules are
needed to establish exactly when an asset or liability comes into existence and so should be reported in
the statement of financial position. Similarly there must be rules when income is earned or expenditure
incurred for inclusion in the income statement. These rules relate to the 'recognition' of items in the
financial statements and are closely linked to the accruals concept, materiality and to a lesser extent prudence.
Recognition. The process of incorporating in the statement of financial position or income statement an
item that meets the definition of an element and satisfies the following criteria for recognition:
(a) it is probable that any future economic benefit associated with the item will flow to or from the
entity; and
(b) the item has a cost or value that can be measured with reliability.
(Framework)
3.1 Probability of future economic benefits
Probability here means the degree of uncertainty that the future economic benefits associated with an
item will flow to or from the entity. This must be judged on the basis of the characteristics of the entity's
environment and the evidence available when the financial statements are prepared.
3.2 Reliability of measurement
The cost or value of an item, in many cases, must be estimated. The Framework states, however, that the
use of reasonable estimates is an essential part of the preparation of financial statements and does not
undermine their reliability. Where no reasonable estimate can be made, the item should not be recognised,
although its existence should be disclosed in the notes, or other explanatory material.
Items may still qualify for recognition at a later date due to changes in circumstances or subsequent events.

3.3 Recognition of items
We can summarise the recognition criteria for assets, liabilities, income and expenses, based on the
definition of recognition given above.
Item Recognised in When
Asset The statement of financial
position
It is probable that the future economic benefits will flow to the
entity and the asset has a cost or value that can be measured
reliably.
Liability The statement of financial
position
It is probable that an outflow of resources embodying economic
benefits will result from the settlement of a present obligation
and the amount at which the settlement will take place can be
measured reliably.
Income The income statement An increase in future economic benefits related to an increase in
an asset or a decrease of a liability has arisen that can be
measured reliably.
Expenses The income statement A decrease in future economic benefits related to a decrease in
an asset or an increase of a liability has arisen that can be
measured reliably.
4 Revenue recognition
Revenue should be recognised when it is probable that future economic benefits will flow to the entity and
when these benefits can be measured reliably.
4.1 Introduction
Accruals accounting is based on the matching of costs with the revenue they generate. It is crucially
important under this convention that we can establish the point at which revenue may be recognised so
that the correct treatment can be applied to the related costs. For example, the costs of producing an item
of finished goods should be carried as an asset in the statement of financial position until such time as it
is sold; they should then be written off as a charge to the trading account. Which of these two treatments
should be applied cannot be decided until it is clear at what moment the sale of the item takes place.
The decision has a direct impact on profit since under the prudence concept it would be unacceptable to
recognise the profit on sale until a sale had taken place in accordance with the criteria of revenue recognition.
Revenue is generally recognised as earned at the point of sale, because at that point four criteria will
generally have been met.
The product or service has been provided to the buyer.
The buyer has recognised his liability to pay for the goods or services provided. The converse of this
is that the seller has recognised that ownership of goods has passed from himself to the buyer.
The buyer has indicated his willingness to hand over cash or other assets in settlement of his
liability.
The monetary value of the goods or services has been established.
At earlier points in the business cycle there will not in general be firm evidence that the above criteria will
be met. Until work on a product is complete, there is a risk that some flaw in the manufacturing process
will require it to be written off; even when the product is complete there is no guarantee that it will find a
buyer.
At later points in the business cycle, for example when cash is received for the sale, the recognition of
revenue may occur in a period later than that in which the related costs were charged. Revenue
recognition would then depend on fortuitous circumstances, such as the cash flow of a company's
customers, and might fluctuate misleadingly from one period to another.

However, there are times when revenue is recognised at other times than at the completion of a sale.
For example, in the recognition of profit on long-term construction contracts. Under IAS 11 Construction
contracts (see Chapter 6) contract revenue and contract costs associated with the construction contract
should be recognised as revenue and expenses respectively by reference to the stage of completion of the
contract activity at the reporting date.
(a) Owing to the length of time taken to complete such contracts, to defer taking profit into account
until completion may result in the income statement reflecting, not so much a fair view of the
activity of the company during the year, but rather the results relating to contracts which have been
completed by the year end.
(b) Revenue in this case is recognised when production on, say, a section of the total contract is
complete, even though no sale can be made until the whole contract is complete.
4.2 IAS 18 Revenue
IAS 18 governs the recognition of revenue in specific (common) types of transactions. Generally,
recognition should be when it is probable that future economic benefits will flow to the entity and when
these benefits can be measured reliably.

Probable flow of
economic benefits
Recognition
Reliable
measurement

Income, as defined by the IASB's Framework document, includes both revenues and gains. Revenue is
income arising in the ordinary course of an entity's activities and it may be called different names, such as
sales, fees, interest, dividends or royalties.
4.3 Scope
IAS 18 covers the revenue from specific types of transaction or events.
Sale of goods (manufactured products and items purchased for resale)
Rendering of services
Use by others of entity assets yielding interest, royalties and dividends
Interest, royalties and dividends are included as income because they arise from the use of an entity's
assets by other parties.
Interest is the charge for the use of cash or cash equivalents or amounts due to the entity.
Royalties are charges for the use of non-current assets of the entity, eg patents, computer software and
trademarks.
Dividends are distributions of profit to holders of equity investments, in proportion with their holdings, of
each relevant class of capital.
The standard specifically excludes various types of revenue arising from leases, insurance contracts,
changes in value of financial instruments or other current assets, natural increases in agricultural assets
and mineral ore extraction.
4.4 Definitions
The following definitions are given in the standard.
Revenue is the gross inflow of economic benefits during the period arising in the course of the ordinary
activities of an entity when those inflows result in increases in equity, other than increases relating to
contributions from equity participants.
Fair value is the amount for which an asset could be exchanged, or a liability settled, between
knowledgeable, willing parties in an arm's length transaction. (IAS 18)
Revenue does not include sales taxes, value added taxes or goods and service taxes which are only
collected for third parties, because these do not represent an economic benefit flowing to the entity. The
same is true for revenues collected by an agent on behalf of a principal. Revenue for the agent is only the
commission received for acting as agent.
4.5 Measurement of revenue
When a transaction takes place, the amount of revenue is usually decided by the agreement of the buyer
and seller. The revenue is actually measured, however, as the fair value of the consideration received,
which will take account of any trade discounts and volume rebates.
4.6 Identification of the transaction
Normally, each transaction can be looked at as a whole. Sometimes, however, transactions are more
complicated, and it is necessary to break a transaction down into its component parts. For example, a sale
may include the transfer of goods and the provision of future servicing, the revenue for which should be
deferred over the period the service is performed.
At the other end of the scale, seemingly separate transactions must be considered together if apart they
lose their commercial meaning. An example would be to sell an asset with an agreement to buy it back at a
later date. The second transaction cancels the first and so both must be considered together.
4.7 Sale of goods
Revenue from the sale of goods should only be recognised when all of the following conditions are satisfied:
(a) The entity has transferred the significant risks and rewards of ownership of the goods to the buyer
(b) The entity has no continuing managerial involvement to the degree usually associated with
ownership, and no longer has effective control over the goods sold
(c) The amount of revenue can be measured reliably
(d) It is probable that the economic benefits associated with the transaction will flow to the entity
(e) The costs incurred in respect of the transaction can be measured reliably
The transfer of risks and rewards can only be decided by examining each transaction. Mainly, the transfer
occurs at the same time as either the transfer of legal title, or the passing of possession to the buyer -
this is what happens when you buy something in a shop.
If significant risks and rewards remain with the seller, then the transaction is not a sale and revenue
cannot be recognised, for example if the receipt of the revenue from a particular sale depends on the buyer
receiving revenue from his own sale of the goods.
It is possible for the seller to retain only an 'insignificant' risk of ownership and for the sale and revenue
to be recognised. The main example here is where the seller retains title only to ensure collection of what
is owed on the goods. This is a common commercial situation, and when it arises the revenue should be
recognised on the date of sale.
The probability of the entity receiving the revenue arising from a transaction must be assessed. It may
only become probable that the economic benefits will be received when an uncertainty is removed, for
example government permission for funds to be received from another country. Only when the uncertainty
is removed should the revenue be recognised. This is in contrast with the situation where revenue has
already been recognised but where the collectability of the cash is brought into doubt. Where recovery
has ceased to be probable, the amount should be recognised as an expense, not an adjustment of the
revenue previously recognised. These points also refer to services and interest, royalties and dividends
below.
Matching should take place, ie the revenue and expenses relating to the same transaction should be
recognised at the same time. It is usually easy to estimate expenses at the date of sale (eg warranty costs,
shipment costs, etc). Where they cannot be estimated reliably, then revenue cannot be recognised; any
consideration which has already been received is treated as a liability.
4.8 Rendering of services
When the outcome of a transaction involving the rendering of services can be estimated reliably, the
associated revenue should be recognised by reference to the stage of completion of the transaction at the
reporting date. The outcome of a transaction can be estimated reliably when all of the following conditions
are satisfied:
(a) The amount of revenue can be measured reliably
(b) It is probable that the economic benefits associated with the transaction will flow to the entity
(c) The stage of completion of the transaction at the reporting date can be measured reliably
(d) The costs incurred for the transaction and the costs to complete the transaction can be measured
reliably
The parties to the transaction will normally have to agree the following before an entity can make reliable
estimates.
(a) Each party's enforceable rights regarding the service to be provided and received by the parties
(b) The consideration to be exchanged
(c) The manner and terms of settlement
There are various methods of determining the stage of completion of a transaction, but for practical
purposes, when services are performed by an indeterminate number of acts over a period of time, revenue
should be recognised on a straight line basis over the period, unless there is evidence for the use of a
more appropriate method. If one act is of more significance than the others, then the significant act should
be carried out before revenue is recognised.
In uncertain situations, when the outcome of the transaction involving the rendering of services cannot be
estimated reliably, the standard recommends a no loss/no gain approach. Revenue is recognised only to
the extent of the expenses recognised that are recoverable.
This is particularly likely during the early stages of a transaction, but it is still probable that the entity will
recover the costs incurred. So the revenue recognised in such a period will be equal to the expenses
incurred, with no profit.
Obviously, if the costs are not likely to be reimbursed, then they must be recognised as an expense
immediately. When the uncertainties cease to exist, revenue should be recognised as laid out in the first
paragraph of this section.
4.9 Interest, royalties and dividends
When others use the entity's assets yielding interest, royalties and dividends, the revenue should be
recognised on the bases set out below when:
(a) it is probable that the economic benefits associated with the transaction will flow to the entity; and
(b) the amount of the revenue can be measured reliably.
The revenue is recognised on the following bases.
(a) Interest is recognised on a time proportion basis that takes into account the effective yield on the
asset
(b) Royalties are recognised on an accruals basis in accordance with the substance of the relevant
agreement
(c) Dividends are recognised when the shareholder's right to receive payment is established
The effective yield on an asset mentioned above is the rate of interest required to discount the stream of
future cash receipts expected over the life of the asset to equate to the initial carrying amount of the asset.
Royalties are usually recognised on the same basis that they accrue under the relevant agreement.
Sometimes the true substance of the agreement may require some other systematic and rational method
of recognition.
Once again, the points made above about probability and collectability on sale of goods also apply here.
It is unlikely that you would be asked about anything as complex as this in the exam, but you should be
aware of the basic requirements of the standard.

Activity 4.2

Given that prudence is the main consideration, discuss under what circumstances, if any, revenue might
be recognised at the following stages of a sale.
(a) Goods are acquired by the business which it confidently expects to resell very quickly.
(b) A customer places a firm order for goods.
(c) Goods are delivered to the customer.
(d) The customer is invoiced for goods.
(e) The customer pays for the goods.
(f) The customer's cheque in payment for the goods has been cleared by the bank.

5 Measurement in financial statements
Measurement is defined as follows.
Measurement. The process of determining the monetary amounts at which the elements of the financial
statements are to be recognised and carried in the statement of financial position and income statement.
(Framework)
This involves the selection of a particular basis of measurement. A number of these are used to different
degrees and in varying combinations in financial statements. They include the following.
Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair
value of the consideration given to acquire them at the time of their acquisition. Liabilities are
recorded at the amount of proceeds received in exchange for the obligation, or in some
circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to
be paid to satisfy the liability in the normal course of business.
Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be
paid if the same or an equivalent asset was acquired currently.
Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be
required to settle the obligation currently.
Realisable (settlement) value.
Realisable value. The amount of cash or cash equivalents that could currently be obtained
by selling an asset in an orderly disposal.
Settlement value. The undiscounted amounts of cash or cash equivalents expected to be
paid to satisfy the liabilities in the normal course of business.
Present value. A current estimate of the present discounted value of the future net cash flows in
the normal course of business. (Framework)
Historical cost is the most commonly adopted measurement basis, but this is usually combined with
other bases, eg inventory is carried at the lower of cost and net realisable value.
5.1 Example
Suppose that a manufacturing company acquires a machine that has an expected useful life of four years.
At the end of two years the company is preparing its statement of financial position and has to decide what
monetary amount to attribute to the asset.
Several valuations might be considered:
The original cost (historical cost) of the machine
Half of the historical cost, on the ground that half of its useful life has expired
The amount the machine might fetch on the second-hand market ('disposal value')
The amount it would cost now to replace the machine with an identical machine ('replacement cost')
The amount it would cost to replace the machine with a more modern machine, incorporating the
technological advances of the previous two years
The machine's 'economic value', which is the amount of the profits the machine is expected to
generate for the company during its remaining life.
All of these valuations have something to commend them, but a perceived advantage of the first two is
that they are based on a figure (the machine's historical cost) which is objectively verifiable. The
subjective judgement involved in the other valuations, particularly economic value, is so great as to lessen
the reliability of any accounts in which they are used. The first two valuations are on a historical cost
basis and the others are different current value measurements.
6 Basic principles of historical cost accounting
Traditionally financial statements have been prepared using the historical cost convention. This maintains
that items should be recorded in the accounts at their original cost. This has serious drawbacks
particularly with regard to property valuations and in times of high inflation.
A long-established practice in accounting is that resources are normally, but not always, stated in
accounts at their historical cost. The historical cost of an item is the amount that the business paid to
acquire it. An important advantage of this procedure is that the objectivity of accounts is achieved: there is
usually objective, documentary evidence to prove the amount paid to purchase an asset or pay an
expense.
Traditionally, there have been two main reasons for the preparation of accounts:
(a) To meet the needs of the owners of a business for information about it
(b) To assist management in controlling the business and in making decisions about its future.
Although the information needs of internal and external users differ considerably, it has become clear that
accounts prepared on a traditional historical cost basis can present financial information in a misleading
manner. The greatest criticisms of traditional accounting concepts have stemmed from their inability to
reflect the effects of changing price levels.
6.1 Non-current asset values are unrealistic
The most notable example is the valuation of property in financial statements. Businesses with freehold or
long leasehold property often retain it for many years, and in the longer term, property values normally
rise over time. (This has been a particular issue in the UK). A property purchased in 1960 for $100,000
could be worth much more now. Companies may gain from rising property values simply by holding on
to the property, and should they ever decide to sell the property they will realise a large gain on the sale.
If assets such as property are valued in financial statements at their historical cost, unrealised holding
gains are not recognised. This means that the total holding gain will be recorded as profit for the year in

which the asset is eventually sold and the gain 'realised'. Arguably, it would be more appropriate to spread
the holding gain over the period during which the asset was owned.
A further problem with historical cost values, for long-term assets (and even for shorter-term assets
during a period of high inflation) is that the book values of different assets cease to provide comparability.
For example, suppose that a company bought a freehold property for $500,000 in 1970, another property
for $800,000 in 1980, a third property for $1,000,000 in 1990 and a fourth property for $1,200,000 in
2000. Using the historical cost convention, the property disclosures would be reported as $3,500,000 in
total. However, given the different times at which the properties were bought, a total book value of
$3,500,000 has no real meaning. It would certainly not reflect their current values.
This problem has been overcome to some extent because companies are permitted to re-value long-term
assets such as property to a current market value. To this extent, provided revaluations are carried out
regularly and by an independent valuer, reported asset values should be more meaningful. However, when
some assets (but not others) are revalued to a current market value, the historical cost convention has
been partially abandoned.
There are, in essence, two points to be considered.
(a) It has long been accepted that a statement of financial position prepared under the historical cost
concept is a historical record and not a statement of current worth. However, many people argue
that the statement of financial position of a company should at least give an indication of the
current value of its assets.
(b) Traditionally, the prudence concept required that profits be recognised only when they are
eventually realised. It may be argued that recognising unrealised holding gains on long-term
assets, and permitting revaluations, is contrary to this traditional and conservative approach to
applying prudence.
On balance, the weight of opinion is now in favour of restating asset values. It is felt that the criticism
based on prudence can be met by ensuring that valuations are made as objectively as possible (e.g. in the
case of property, by having independent expert valuations) and by not reporting unrealised gains (from
upward revaluations of assets) within the income statement.
In a period of high inflation, profits may be seriously overstated
In principle, a business can distribute all its profits to its owners. For example, if a company makes a profit
of $500,000 after taxation, it can pay out the full $500,000 in dividends to its shareholders. However,
because of inflation, paying out profits in full would leave the company with fewer net assets, in 'real
terms', than it had before. The money values of its net assets would not be reduced, but the actual
quantity of assets that is represented by the money value would have eroded. For example, the company
originally has $12,000 of inventory made up of 400 items of $30 each. If the price of an item goes up to
$40, closing inventory of $12,000 would only comprise 300 items. A powerful argument, particularly
during periods of high inflation, is that profit should be measured in such a way that if it were to be paid
out in full to the business owners, the business would not lose any 'real' substance. Its operating
capability, for example, should be maintained. In order to measure profits in this way, the historical cost
convention would have to be abandoned.
6.2 Profits (or losses) on monetary items are not reported
In periods of inflation the purchasing power, and thus the value, of money falls. It follows that if a
business has a money investment, such as a bank deposit, the investment will have a lower real value at
the end of a period of time than it did at the beginning. In reality, a loss has been incurred. Similarly, the
real value of a monetary liability will reduce over a period of time and a gain will be made. This is seen by
private individuals as one of the benefits of a mortgage: over time, property values rise with inflation, but
the amount owed on the mortgage does not. The same benefit applies to businesses that owe money, for
example by borrowing from a bank or by issuing 'bonds' to raise money in the capital markets.
6.3 Comparisons over time are unrealistic
Using the historical cost convention tends to exaggerate the growth in profits of a business over time. For
example, if a company's profit in 1984 was $200,000 and in 2004 it was $500,000, a shareholder's initial
reaction might be that the company had done rather well. If, however, it was then revealed that with
$200,000 in 1984 he could buy exactly the same goods as with $500,000 in 2004, the 150% growth in
profits would seem less impressive.
7 Capital maintenance
Current value accounting provides for the maintenance of the real value of the owner's capital in times of
rising prices, whereas historical cost accounting does not.
The principle of capital maintenance is that a company should at least maintain the amount of capital

invested, and (if there has not been a new issue of equity in the period) retained profit is measured by the
amount by which capital (net assets) is increased in the period.
There are two concepts of capital maintenance detailed in the Framework:
(a) Financial capital maintenance; and
(b) Physical capital maintenance.
The concept of financial capital maintenance means that a profit is only earned if the financial amount of
the net assets at the end of the period exceeds the financial amount at the beginning of the period, after
excluding any transactions with owners in the period. Eg dividends or new capital introduced are excluded.
The concept of physical capital maintenance means that a profit is earned only if the physical productive
capacity at the end of the period exceeds the capacity at the beginning of the period, after excluding
transactions with owners in the period.
Under the historical cost accounting convention, capital maintenance is measured in nominal money
values. If an item with a historical cost of $500 is sold for $500, there has been no profit, but capital has
been maintained. Under the current cost accounting convention, capital maintenance is measured in terms
of the physical maintenance of the operating capability of the company. If an item that cost $500 is sold
for $500 when its replacement cost has risen to $510, there has been a loss in current cost terms,
because the $500 earned from the sale would be insufficient to replace the item that has been sold. In the
same way, the depreciation of non-current assets should be based on the current cost of the non-current
assets, not their original cost, if the company is to maintain its physical operating capability over time.
Supporters of current value accounting argue that, in a period of rising prices, historical cost accounting
overstates real profit, because it does not provide properly, in the measurement of profit, for maintaining
the physical operating capability of the business.
7.1 The unit of measurement
Another way to tackle the problems of capital maintenance in times of rising prices is to look at the unit of
measurement in which accounting values are expressed.
It is an axiom of conventional accounting, as it has developed over the years, that value should be
measured in terms of money. It is also implicitly assumed that money values are stable, so that $1 at
the start of the financial year has the same value as $1 at the end of that year. But when prices are rising,
this assumption is invalid: $1 at the end of the year has less value (less purchasing power) than it had
one year previously.

This leads to problems when aggregating amounts which have arisen at different times. For example, a
company's non-current assets may include items bought at different times over a period of many years.

They will each have been recorded in $s, but the value of $1 will have varied over the period. In effect the
non-current asset figure in a historical cost statement of financial position is an aggregate of a number
of items expressed in different units. It could be argued that such a figure is meaningless.
Faced with this argument, one possibility would be to re-state all accounts items in terms of a stable
monetary unit. There would be difficulties in practice, but in theory there is no reason why a stable unit
($ CPP = $s of current purchasing power) should not be devised. In Section 8 we will look at a system of
accounting (current purchasing power accounting, or CPP) based on precisely this idea.
7.2 Specific and general price changes
We can identify two different types of price inflation.
When prices are rising, it is likely that the current value of assets will also rise, but not necessarily by the
general rate of inflation. For example, if the replacement cost of a machine on 1 January 20X2 was $5,000,
and the general rate of inflation in 20X2 was 8%, we would not necessarily expect the replacement cost of
the machine at 31 December 20X2 to be $5,000 plus 8% = $5,400. The rate of price increase on the
machinery might have been less than 8% or more than 8%. (Conceivably, in spite of general inflation, the
replacement cost of the machinery might have gone down.)
(a) There is specific price inflation, which measures price changes over time for a specific asset or
group of assets.
(b) There is general price inflation, which is the average rate of inflation, which reduces the general
purchasing power of money.
To counter the problems of specific price inflation some system of current value accounting may be used
(such as current cost accounting). The capital maintenance concepts underlying current value systems do
not attempt to allow for the maintenance of real value in money terms.
8 Current value models of accounting
Alternatives to historical cost accounting are different systems of current value accounting. These take
into consideration the effect of inflation, and as a consequence, assets are revalued to current value, but
the reported operating profits of a business exclude the effects of 'holding gains'.
The points mentioned in Section 6 should suggest that with the historical cost convention of accounting,
problems arise with reporting asset values, the substance of debts and profits in times of severe and
prolonged inflation. Various suggestions have been put forward, as alternatives to the historical cost
accounting method. Of these various possible systems of 'accounting for price changes', most can be
divided into one of two categories.
(a) General price change bases of accounting, and in particular current purchasing power (CPP)
(b) Current value bases. The basic principles of current value accounting are:
(i) to show items in the statement of financial position at some form of current value rather
than historical cost
(ii) to compute profits by matching the current value of costs at the date of consumption
against revenue
The current value of an item will normally be based on replacement cost, net realisable value or economic value.
8.1 Current purchasing power accounting
CPP measures profits as the increase in the current purchasing power of equity. Profits are therefore
stated after allowing for the declining purchasing power of money due to price inflation.
CPP is a system of accounting which makes adjustments to income and capital values to allow for the
general rate of price inflation.

8.2 Example
Beep Co has non-current assets purchased on 1 January 20X1 held at historical cost of $60,000.
The general price index includes the following information:
Year Date Price index
20X1 1 January 100
20X4 31 December 160
At 31 December 20X4 CPP cost of non-current assets would be:
160
60,000 $96,000
100
=
8.3 Current cost accounting
Current Cost Accounting (CCA) reflects an approach to capital maintenance based on maintaining the
operating capability of a business.
The conceptual basis of CCA is that assets should be valued at their 'value to the business' (also known
as 'deprival value'). This is usually the current replacement cost of the asset, although it will be the
recoverable amount of the asset, if this is lower than replacement cost. Recoverable amount in turn, is
the higher of net realisable value and value in use. Value in use is the economic value to the company of
continuing to use the asset for the remainder of its expected useful life.

8.4 Example
A company has an item of equipment that has a replacement cost of $50,000. Its net realisable value is
$25,000 and its value in use is $80,000. The current cost value of the asset is its replacement cost,
$50,000, because this is lower than the recoverable amount of $80,000.
8.5 Holding gains
Holding gains are gains that are made simply by holding on to assets in a time of rising prices. They are
equal to the difference between costs measured on a historical cost accounting basis and costs measured
on a current cost accounting basis. For example, if the historical cost of an item of inventory was $50, and
its current value (replacement cost) is now $54, there has been a holding gain of $4.
A holding gain is unrealised as long as it remains in the ownership of the business. The holding gain is
realised when the asset is sold or used in the period. For example, suppose that an item of inventory is
purchased at the start of the year for $100, and when it is sold, its replacement cost has risen to $109.
There is a realised holding gain of $9. The historical cost of sale is $100, but the current cost of sale is
$109, to reflect the replacement cost of the sold item.
Holding gains also relate to non-current assets (and depreciation charges for the year) as well as the cost
of inventories sold or consumed.
In a system of current cost accounting, both realised and unrealised holding gains are transferred to a
special current cost reserve in the statement of financial position. This segregates the holding gains from
current cost profit.
8.6 Example
Fudge Co commenced business on 1 January 20X0. The statements of financial position of the company
at 31 December 20X0 have been prepared on two bases, the historical cost accounting basis and the
current cost accounting basis. These are given below:
Statements of financial position as at 31 December 20X0

Historical cost

Current cost

$

$

$

$

Tangible non-current assets

70,000

73,000

Less: Accumulated depreciation

(6,000)

(6,600)

64,000

66,400

Current assets

Inventory

8,000

9,000

Cash

2,000

2,000

10,000

11,000

Total assets

74,000

77,400

Share capital

49,000

49,000

Profit for the year

20,000

15,000

Current cost reserve

-

8,400

69,000

72,400

Loans

5,000

5,000

Total equity and liabilities

74,000

77,400

The current cost reserve is made up of unrealised holding gains of $3,400 and realised holding gains of
$5,000.
The unrealised holding gains are the difference in non-current asset values ($2,400) plus the difference in
the closing inventory values ($1,000). Since this is the first year of operation, the remaining $5,000 of the
total current cost reserve must have arisen during trading this year, and will represent the difference in the
historical profit and the current profit. This can be seen in profit for the year which was $20,000 under
historical cost but has reduced to $15,000 under current cost. A part of this difference is attributable to
the difference in the depreciation charge for the year ($600). The remainder must be due to the difference
between the historical cost and the current cost of the inventories sold.
The current cost accounting figures show that the company can distribute up to $15,000 in dividends
without reducing the operating capability of the company below the level at the start of the year (when it
began operating).-
9 Accounting for public sector organisations
Public sector organisations are expected to achieve value for money. VFM is achieved through a
combination of effectiveness, efficiency and economy.
Public sector organisations differ from companies in the private sector because:
(a) companies seek to earn a profit, and the directors are accountable to the shareholders
(b) public sector organisations are not-for-profit organisations, and have different objectives. They are
also accountable to the public (or representatives of the public, in the form of a government
representative).

9.1 Value for money regime
Whereas companies in the private sector are expected to make profits, public sector organisations have
traditionally been expected to achieve value for money. Value for money has three elements:
(a) Effectiveness. This means success in achieving its not-for-money objectives. The objectives of a
public sector organisation vary with the nature of the organisation. Hospitals have the objective of
treating patients or reducing the incidence of certain illnesses. Schools have the objective of
teaching numbers of students and achieving certain educational standards. Effectiveness is judged
by success in reaching any identifiable and measurable measure of achievement, or in making
progress towards a stated goal for achievement.
(b) Efficiency means using resources well. Efficiency is a measurement of the quantity of outputs
obtained per given quantity of inputs. In medicine, it might be the number of patients treated by
each general practitioner. In education, it might be measured as a student: teacher ratio.
Improvements in efficiency mean getting more out of fewer input resources, and so reducing
costs per unit of output, and getting better value for money.
(c) Economy means keeping down the cost of input resources. Economy is achieved by paying less for
materials, labour, finance and other costs such as accommodation. Whereas reducing over-
staffing is a form of efficiency improvement, paying staff less to do a certain type of work would be
an economy. In the hospitals, for example, switching the responsibility for a type of work from
qualified doctors to trained nurses would be a form of economy, because nurses' time costs less
than doctors' time. Similarly, switching responsibilities in the classroom from teachers to
unqualified assistant helpers would be a form of economy.
Value for money is achieved by any combination of effectiveness, efficiency and economy. These factors
are therefore likely to be the main focus of attention in the preparation and analysis of accounts for public
sector organisations.
9.2 Best value framework
In some countries eg the UK, public sector organisations are required to review their services and set
challenging targets for improving them.
There are various key elements to the best value approach.
Continuous improvement
Achieving a balance between quality and cost
Improving accountability through better responsiveness to stakeholder needs.
The best value review process provides the opportunity to improve effectiveness, efficiency and economy
by focusing on the so-called four Cs.
Challenge
Why is the service provided?
Can the service be provided in a better way?
Consult
What do our customers think about the service?
How do our employees believe we could improve the service?
What do other service providing organisations think?
Compare
How do our processes and practices compare with other similar organisations?
Could we improve our services by adopting approaches used by others?
Compete
How do our prices/charges, speed and quality compare with other service providers?
Could the work be done more efficiently and effectively by another contractor?
Could the service be improved by working in partnership with other organisations?
358 4: Statement of comprehensive income

1 The nature of limited companies
Limited companies are subject to extensive regulations in the preparation of their annual accounts. The
form and content of the accounts may be regulated primarily by national legislation. This will often specify
the minimum information that the accounts must show. The provisions of the legislation are normally
supplemented by the requirements of the accounting standards. IAS 1 Presentation of financial statements
gives substantial guidance on the form and content of published financial statements.
The owners of a company are its members or shareholders, but a company is managed by its board of
directors. In some companies, the directors are major shareholders. In larger companies, the directors
may have some shares, but are not the major shareholders. Other shareholders use the annual accounts
to assess the performance of their company and its management.
1.1 Share capital and dividends
The ownership of a limited company is represented by shares. The owners of a company are its members

or shareholders.
The owners' capital in a limited company is represented by share capital. When a company is set up for
the first time, it issues shares. The shares are 'allotted' to investors, who pay for them and become
shareholders of the company. Shares are denominated in units of 25 cents, 50 cents, $1 or whatever
seems appropriate. The 'face value' of the shares is called their nominal value.
For example, when a company is set up with a share capital of, say, $100,000, the directors may decide to
issue:

Statement of
comprehensive income
4: Statement of comprehensive income 359
(a) 100,000 shares of $1 each nominal value, or
(b) 200,000 shares of 50 cents each, or
(c) 400,000 shares of 25 cents each, or
(d) 250,000 shares of 40 cents each etc
There may be several 'classes' of shares in a company.
(a) Preferred shares do not convey any right to ownership. They entitle their holders to a dividend each
year. A preferred dividend is usually fixed, and expressed as a percentage amount each year on the
nominal value of the shares. For example, a company with $1,000,000 of 5% preferred shares in
issue will pay an annual preferred dividend of $50,000 to the holders of these shares.
(b) Ordinary shares represent the 'real' ownership of a company. Ordinary shareholders receive
dividends out of profits, after preferred dividends have been paid. The amount of dividend in any
year depends on the profitability of the company. Dividends are usually declared for ordinary
shares in terms of 'x cents per share'. For example, if a company has 2 million ordinary shares of
50c each, and declares a dividend of 20 cents per share, the dividend payable will be $400,000
(2 million shares 20c).
1.2 Declaring a dividend and paying a dividend
Shareholders receive dividends out of profits. Dividends are commonly paid in two stages: an interim
dividend and a final dividend.
Dividends are an appropriation of profit by the company's owners, and are similar to drawings by a sole
trader or business partners from their business. Unlike drawings for sole traders and partnerships,
however, company dividends are paid out of profits after the deduction of taxation. Companies are legal
persons, and are liable to tax and shareholders 'own' the profits after tax.
Whilst some companies pay dividends annually, many companies pay dividends to their shareholders
twice a year.
(a) An 'interim dividend' is paid in the middle of the financial year. For ordinary shares, the size of the
interim dividend is decided by the board of directors. With preferred shares, shareholders receive
one half of their fixed annual dividend.
(b) A 'final dividend' is paid after the end of the financial year. The final ordinary dividend is proposed to
shareholders at the annual general meeting (AGM) of the company, which takes place some months
after the end of the financial year. In this case the final proposed dividend is disclosed in the notes to
the annual accounts of the company but under IAS 10 Events after the Reporting Period it is only
recognised as a liability in the financial statements if it is declared on or before the reporting date (the
year end).
1.3 Limited liability
Unlimited liability means that if a business runs up debts that it is unable to pay, the owners will become
personally liable for the unpaid debts. They would be required, if necessary, to sell their private
possessions in order to repay the debts of the business.
Sole traders and partners in most business partnerships have unlimited liability for the debts of their
business. A new category of partnership, the 'limited liability partnership', has recently been introduced in
some countries.
Limited companies offer limited liability to their owners.
Limited liability means that the maximum amount that an owner stands to lose in the event that the
company becomes insolvent and cannot pay off its debts, is his share of the capital in the business. If the
shares have been 'fully paid', the maximum that any investor stands to lose by investing in a company is
the amount of his investment.
As a business grows, it needs more capital to finance its operations, and significantly more than the people
currently managing the business can provide themselves. One way of obtaining more capital is to invite investors

from outside the business to invest in the ownership or equity of the business. These new co-owners would not
usually be expected to help with managing the business. To such investors, limited liability is very attractive.
Investments are always risky undertakings, but with limited liability the investor knows the maximum
amount that he stands to lose when he puts some capital into a company.
1.4 Public and private companies
There are two classes of limited company.
(a) Private companies. Being private, they cannot invite members of the public to invest in their equity
(ownership).
(b) Public companies. These are much fewer in number than private companies, but are generally
much larger in size. Public limited companies can invite members of the general public to invest in
their equity, and the shares of these companies may be traded on a public stock exchange, such as
The London Stock Exchange in the UK.
2 The financial statements of a limited company
IAS 1 covers the form and content of financial statements. The main components are:
Statement of financial position
Income statement/statement of comprehensive income
Statement of changes in equity
Statement of cash flows
Accounting policies and explanatory notes to the financial statements
2.1 Overview
As well as covering accounting policies and other general considerations governing financial statements,
IAS 1 Presentation of financial statements gives substantial guidance on the form and content of published
financial statements. IAS 1 was revised in September 2007 and has changed the presentation of financial
statements. We will look at this later in the chapter. First of all, some general points are made about
financial statements.
2.2 Profit or loss for the period
The income statement (statement of comprehensive income) is the most significant indicator of a
company's financial performance. So it is important to ensure that it is not misleading.
The income statement will be misleading if costs incurred in the current year are not deducted from the
current year profits. This would present the current year's results more favourably.
IAS 1 stipulates that all items of income and expense recognised in a period shall be included in profit or
loss unless a Standard (or an Interpretation) requires otherwise.
Circumstances where items may be excluded from profit or loss for the current year include the correction
of errors and the effect of changes in accounting policies. These are covered in IAS 8 which we look at in
Chapter 7.
2.3 How items are disclosed
IAS 1 specifies disclosures of certain items in certain ways.
Some items must appear on the face of the statement of financial position or income
statement/statement of comprehensive income
Other items can appear in a note to the financial statements instead
Recommended formats are given which entities may or may not follow, depending on their
circumstances

Obviously, disclosures specified by other standards must also be made, and we will mention the
necessary disclosures when we cover each statement in turn. Disclosures required by both IAS 1 and
other standards must be made either on the face of the statement or in the notes unless otherwise stated,
ie disclosures cannot be made in an accompanying commentary or report.
2.4 Identification of financial statements
As a result of the above point, it is most important that entities distinguish the financial statements very
clearly from any other information published with them. This is because all IFRSs apply only to the financial
statements (ie the main statements and related notes), so readers of the annual report must be able to
differentiate between the parts of the report which are prepared under IFRSs, and other parts which are not.
The entity should identify each component of the financial statements very clearly. IAS 1 also requires
disclosure of the following information in a prominent position. If necessary it should be repeated
wherever it is felt to be of use to the reader in their understanding of the information presented.
Name of the reporting entity (or other means of identification)
Whether the accounts cover a single entity only or a group of entities
The date of the end of the reporting period or the period covered by the financial statements (as
appropriate)
The presentation currency
The level of rounding used in presenting amounts in the financial statements
Judgement must be used to determine the best method of presenting this information. In particular, the
standard suggests that the approach to this will be very different when the financial statements are
communicated electronically.
The level of precision is important, as presenting figures in thousands or millions of units makes the
figures more understandable. The level of rounding must be disclosed, however, and it should not omit
material information or make the information less relevant.
2.5 Reporting period
It is normal for entities to present financial statements annually and IAS 1 states that they should be
prepared at least as often as this. If (unusually) an entity's reporting date is changed, for whatever reason,
the period for which the statements are presented will be less or more than one year. In such cases the
entity should also disclose:
(a) the reason(s) why a period other than one year is used; and
(b) the fact that the comparative figures given are not in fact comparable (in particular for the income
statement, changes in equity, cash flows and related notes).
For practical purposes, some entities prefer to use a period which approximates to a year, eg 52 weeks,
and this approach is allowed provided it will produce statements not materially different from those
produced on an annual basis.
2.6 Timeliness
If the publication of financial statements is delayed too long after the reporting date, their usefulness will
be severely diminished. The standard states that entities should be able to produce their financial
statements within six months of the reporting date. An entity with consistently complex operations
cannot use this as a reason for its failure to report on a timely basis. Local legislation and market
regulation imposes specific deadlines on certain entities.
IAS 1 looks at the statement of financial position, the income statement and statement of comprehensive
income. We will not give all the detailed disclosures as some are outside the scope of your syllabus.
Instead we will look at a 'proforma' set of accounts based on the Standard.
2.7 Disclosure of accounting policies
There should be a specific section for accounting policies in the notes to the financial statements. The
following disclosure should be made:
(a) Measurement bases used in preparing the financial statements.
(b) Each specific accounting policy necessary for a proper understanding of the financial statements.
3 Income statement and statement of comprehensive
income
A statement of comprehensive income gives detailed information about the income, expenses and profits
of a business as well as the other aspects of performance. It can be presented as a single statement of
comprehensive income or as an income statement and a separate statement of comprehensive income.
IAS 1 requires that an entity presents all items of income and expense recognised in a period:
(a) in a single statement of comprehensive income, or
(b) in two statements: a statement displaying components of profit or loss (separate income
statement) and a second statement beginning with profit or loss and displaying components of
other comprehensive income (separate statement of comprehensive income)
A useful starting point is to look at an example of both statements. The proformas below are taken from
IAS 1.
3.1 Examples of statement of comprehensive income and income
statement
3.1.1 Single statement of comprehensive income
The single statement of comprehensive income is shown below. This example discloses expenses by
function.
XYZ STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 DECEMBER 20X7
20X7

20X6
$'000

$'000
Revenue

X

X
Cost of sales

(X)

(X)
Gross profit

X

X
Other income

X

X
Distribution costs (X)

(X)
Administrative expenses

(X)

(X)
Other expenses

(X)

(X)
Finance costs

(X)

(X)
Share of profit of associates

X

X
Profit before tax

X

X
Income tax expense

(X)

(X)
Profit for the year from continuing operations

X

X
Loss for the year from discontinued operations

-

(X)
PROFIT FOR THE YEAR

X

X
Other comprehensive income:

Gains on property revaluation

X

X
Income tax relating to components of other comprehensive income

(X)

(X)
Other comprehensive income for the year, net of tax

X

X
TOTAL COMPREHENSIVE INCOME FOR THE YEAR

X

X


20X7

20X6
$'000

$'000
Profit attributable to:

Owners of the parent

X

X
Non-controlling interest

X

X

X

X

Total comprehensive income attributable to:


X

X


X

X

X

X
The only items to be disclosed as other comprehensive income in the DipFM syllabus are the gains or
losses on revaluation of a non-current asset.
Other comprehensive income is defined in IAS 1 as "items of income and expense that are not recognised
in profit or loss as required or permitted by other IFRSs". It therefore includes unrealised gains and
unrealised losses. As mentioned in the last chapter, these are gains or losses that result from the change
in value of an asset or liability held by a company. These remain unrealised until the asset or liability is
disposed of, and the associated gain or loss realised in the form of cash.
The surplus on revaluation of a non-current asset is not recognised as a gain in the income statement but
is taken to the revaluation reserve (see Chapter 8). The statement of comprehensive income shows total
comprehensive income. This is the change in equity in a period resulting from transactions and other
events, other than those changes resulting from transactions with owners in their capacity as owners, ie
transactions with shareholders.
The aim of the statement is to show a more complete view of an entity's performance in a financial period.
3.1.2 Separate income statement and statement of comprehensive income
IAS 1 also allows the 'traditional' income statement to be published along with a separate statement of
comprehensive income. This example discloses expenses by nature, but the expenses could be disclosed
by function as in the previous example.
XYZ INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20X7

20X7

20X6

$'000

$'000

Revenue

X

X

Other income

X

X

Changes in inventories of finished goods and work in progress

(X)

(X)

Work performed by the entity and capitalised

X

X

Raw material and consumables used

(X)

(X)

Employee benefits expense

(X)

(X)

Depreciation and amortisation expense

(X)

(X)

Impairment of property, plant and equipment

(X)

(X)

Other expenses

(X)

(X)

Finance costs

(X)

(X)


X

X

Profit before tax

X

X

Income tax expense

(X)

(X)


X

X

Loss for the year from discontinued operations

-

(X)

PROFIT FOR THE YEAR

X

X



X

X


X

X

X

X

XYZ STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 DECEMBER 20X7

20X7

20X6

$'000

$'000

Profit for the year

X

X



X
X
Income tax relating to components of other comprehensive income

(X)

(X)

Other comprehensive income for the year, net of tax

X

X

TOTAL COMPREHENSIVE INCOME FOR THE YEAR

X

X



X

X


X

X

X

X

3.2 Information presented on the face of the statement of
comprehensive income or income statement
IAS 1 lists the following as the minimum to be disclosed on the face of an income statement or a single
statement of comprehensive income.
(a) Revenue
(b) Finance costs
(c) Share of profits and losses of associates and joint ventures accounted for using the equity method
(this relates to group accounts which we deal with in a later chapter)
(d) Tax expense
(e) A single amount comprising the total of:
(i) the post-tax profit or loss of discontinued operations and
(ii) the post-tax gain or loss recognised on the measurement to fair value less costs to sell or
on the disposal of assets constituting the discontinued operation (see Chapter 7)
(f) Profit or loss for the period
In the single statement of comprehensive income or the separate statement of comprehensive income the
following should be disclosed:
(g) Each component of other comprehensive income classified by nature
(h) Share of the other comprehensive income of associates and joint ventures accounted for using the
equity method; and
(i) Total comprehensive income.
The following items should be disclosed in the statement of comprehensive income as allocations of profit
or loss for the period:
(a) Profit or loss for the period attributable to:
(i) non-controlling (minority) interests, and
(ii) owners of the parent
(b) Total comprehensive income for the period attributable to:
(i) non-controlling (minority) interests, and
(ii) owners of the parent
(These relate to group accounts, covered later in this text.)
Income and expense items can only be offset when, and only when:
(a) It is permitted or required by an IFRS, or
(b) Gains, losses and related expenses arising from the same or similar transactions and events are
immaterial, in which case they can be aggregated.
3.3 Information presented either on the face of the statement of
comprehensive income/income statement or in the notes
An analysis of expenses must be shown either on the face of the statement of comprehensive
income/income statement (as above, which is encouraged by the standard) or by note. This sub-
classification of expenses indicates a range of components of financial performance; these may differ in
terms of stability, potential for gain or loss and predictability.
When items of income and expense are material their nature and amount should be disclosed separately.
This might include write downs of inventory or property, plant and equipment, disposals of property, plant
and equipment or investments, discontinuing operations, reversals of provisions and litigation
settlements.
3.4 Dividends
Dividends are not shown on the face of the statement of comprehensive income/income statement.
However, IAS 1 requires disclosure in the notes of the amount of dividends per share (declared or
proposed) for the period covered by the financial statements.
3.5 Other points to note
(a) Revenue excludes items of income such as income from investments and interest receivable.
(b) Companies are required to analyse their operating costs. IAS 1 allows expenses to be classified by
function or by nature. (see 3.1)
The format classifying expenses by function is much more common in practice and should be used
in your exam unless the question specifies otherwise.
Operating costs are split between cost of sales, distribution costs and administrative expenses. IAS
1 does not specify which costs should be allocated to which category. Typically, however
distribution costs and administrative expenses would include the following:
(i) Distribution costs: Delivery costs, depreciation of warehouse, showroom, delivery vehicles
and salesmen's cars, advertising, salesmen's salaries and commissions.
(ii) Administrative expenses: rent, light and heat, directors remuneration, depreciation of
officers and staff cars and other overheads.
(c) Gross profit is sales revenue minus the cost of sales.
3.6 Example: statement of comprehensive income
The accountant of Pretzel Co has prepared the following trial balance for the financial year ended 31
December 20X7
$m
Share capital 550
Share premium 100
Revaluation reserve 125
Retained earnings 563
Land and buildings (carrying value) 678
Plant and machinery (carrying value) 585
Inventory 1 Jan 20X7 120
Sales revenue 925
Purchases 512
Administration expenses 102
Distribution costs 165
Finance costs 42
Trade receivables 345
Trade payables 286

Further information:
(a) Inventory at 31 December 20X7 amounted to $235m
(b) The taxation expense for the year is estimated to be $62m
(c) The revaluation reserve relates to land that was revalued during the year.
Required
Prepare the statement of comprehensive income for the year ended 31 December 20X7.
Solution

20X7

$m

Revenue

925

Cost of sales (120 + 512 235)

(397)

Gross profit

528

Distribution costs

(165)


(102)

Finance costs

(42)

Profit before tax

219

Income tax expense

(62)

Profit for the year

157



125

Total comprehensive income for the year

282

4 Changes in equity
IAS 1 requires a statement of changes in equity.
4.1 Statement of changes in equity
As a result of the new statement of comprehensive income, which shows all non-owner changes in equity,
the statement of changes in equity has been revised. It now concentrates on showing all owner changes in
equity.
Previously, the statement of changes in equity showed the movements in reserves balances, but as many
of these are now shown in the statement of comprehensive income, IAS 1 now requires a statement of
changes in equity showing:
(a) Total comprehensive income for the period, showing the amounts attributable to owners of the
parent and non-controlling (minority) interest
(b) The effects of retrospective application or restatement as a result of a change in accounting policy
under IAS 8 (see Chapter 7).
(c) For each component of equity, a reconciliation between the carrying amount at the beginning and
end of the period, separately disclosing changes resulting from:
(i) profit or loss
(ii) each item of other comprehensive income; and
(iii) transactions with owners in their capacity as owners, showing separately contributions by
and distributions to owners.

4.2 Example: statement of changes in equity
XYZ STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 DECEMBER 20X7

Share

capital

Retained

earnings

Revaluation

surplus

Total

Non-
controlling

interest

Total

equity

$'000

$'000

$'000

$'000

$'000

$'000

Balance at 1 January 20X6

X

X

X

X

X

Changes in accounting policy

X

X

X

X

Restated balance X X X X X
Changes in equity for 20X6

Dividends

(X)

(X)

(X)

Total comprehensive income for
the year

X

X

X

X

X

Balance at 31 December 20X6 X X X X X X
Changes in equity for 20X7

Issue of share capital

X

X

Dividends

(X)

(X)

(X)

Total comprehensive income for
the year

X

X

X

X

X

Transfer to retained earnings

X

(X)

Balance at 31 December 20X7 X X X X X X
5 Current tax
The tax charge for the year will include an estimate of the current year's tax and an adjustment for any
under/over provisions from previous years.
5.1 Introduction
The taxable profits of an entity essentially comprise its net profit before dividends adjusted for certain
items where the tax treatment differs from the accounting treatment.
The amount of tax to which a company is assessed on its profit for an accounting period is called its tax
liability for that period. In general, an entity must pay its tax liability a certain amount of time after the
period end (although in some countries, entities may have to make monthly or quarterly 'payments on
account.')
In a simple situation the adjustment for tax would affect the financial statements as follows.
introduce tax charge in the income statement/statement of comprehensive income (debit tax charge)
create tax liability in the statement of financial position (credit tax liability)
However it must be understood that the tax liability included in the income statement and statement of
financial position is only an estimate. This figure will only be confirmed by the tax authorities in the
following year. Therefore there may be adjustments for under or over-provisions.
5.2 Recognition of current tax liabilities and assets
IAS 12 Income taxes requires any unpaid tax in respect of the current or prior periods to be recognised as
a liability.
Any excess tax paid is deducted from the tax charge in the following period. Alternatively, it could be
shown in the statement of financial position as an asset.


Activity 5.1

In 20X8 Darton Co had taxable profits of $120,000. In the previous year (20X7) income tax on 20X7
profits had been estimated as $30,000.
Required
Calculate tax payable and the charge for 20X8 if the tax due on 20X7 profits was subsequently agreed with
the tax authorities as:
(a) $35,000; or
(b) $25,000.
Any under or over payments are not settled until the following year's tax payment is due.
Assume a corporate income tax rate of 30%.
5.3 Presentation
In the statement of financial position, tax assets and liabilities should be shown separately from other
assets and liabilities. (See chapter 6).
The tax expense/(income) should be shown on the face of the statement of comprehensive income/income
statement.
6 Deferred tax
Deferred tax is an accounts measure, used to match the tax effects of transactions with their accounting
impact.
6.1 What is deferred tax?
When a company recognises an asset or liability, it expects to recover or settle the carrying amount of
that asset or liability. In other words, it expects to sell or use up assets, and to pay off liabilities. What
happens if that recovery or settlement is likely to make future tax payments larger (or smaller) than they
would otherwise have been if the recovery or settlement had no tax consequences? In these
circumstances, IAS 12 requires companies to recognise a deferred tax liability (or deferred tax asset).
6.2 Definitions
Don't worry too much if you don't understand the concept of deferred tax yet; things should become
clearer as you work through this section. First of all, here are the definitions relating to deferred tax given
in IAS 12.

Deferred tax liabilities are the amounts of income taxes payable in future periods in respect of
taxable temporary differences.
Deferred tax assets are the amounts of income taxes recoverable in future periods in respect of:
Deductible temporary differences
The carryforward of unused tax losses
The carryforward of unused tax credits
Temporary differences are differences between the carrying amount of an asset or liability in the
statement of financial position and its tax base. Temporary differences may be either:
Taxable temporary differences, which are temporary differences that will result in taxable
amounts in determining taxable profit (tax loss) of future periods when the carrying amount
of the asset or liability is recovered or settled
Deductible temporary differences, which are temporary differences that will result in
amounts that are deductible in determining taxable profit (tax loss) of future periods when
the carrying amount of the asset or liability is recovered or settled
The tax base of an asset or liability is the amount attributed to that asset or liability for tax
purposes. (IAS 12)
Tax rate. IAS12 requires deferred tax assets and liabilities to be measured at the tax rates expected
to apply in the period when the asset is realised or the liability settled, based on tax rates and laws
enacted (or substantively enacted) at the end of the reporting period. In other words, IAS12
requires the liability method to be used.
We need to look at some of these definitions in more detail.
6.3 Tax base
We can expand on the definition given above by stating that the tax base of an asset is the amount that
will be deductible for tax purposes against any taxable economic benefits that will flow to the entity when
it recovers the carrying value of the asset. Where those economic benefits are not taxable, the tax base of
the asset is the same as its carrying amount.

Activity 5.2

State the tax base of each of the following assets.
(a) A machine cost $10,000. For tax purposes, depreciation of $3,000 has already been deducted in
the current and prior periods and the remaining cost will be deductible in future periods, either as
depreciation or through a deduction on disposal. Revenue generated by using the machine is
taxable, any gain on disposal of the machine will be taxable and any loss on disposal will be
deductible for tax purposes.
(b) Interest receivable has a carrying amount of $1,000. The related interest revenue will be taxed on a
cash basis.
(c) Trade receivables have a carrying amount of $10,000. The related revenue has already been
included in taxable profit (tax loss).
(d) A loan receivable has a carrying amount of $1m. The repayment of the loan will have no tax
consequences.

In the case of a liability, the tax base will be its carrying amount, less any amount that will be deducted for tax
purposes in relation to the liability in future periods. For revenue received in advance, the tax base of the
resulting liability is its carrying amount, less any amount of the revenue that will not be taxable in future periods.

Activity 5.3

State the tax base of each of the following liabilities.
(a) Current liabilities include accrued expenses with a carrying amount of $1,000. The related expense
will be deducted for tax purposes on a cash basis.
(b) Current liabilities include interest revenue received in advance, with a carrying amount of $10,000.
The related interest revenue was taxed on a cash basis.
(c) Current liabilities include accrued expenses with a carrying amount of $2,000. The related expense
has already been deducted for tax purposes.
(d) Current liabilities include accrued fines and penalties with a carrying amount of $100. Fines and
penalties are not deductible for tax purposes.
(e) A loan payable has a carrying amount of $1m. The repayment of the loan will have no tax
consequences.

IAS 12 gives the following examples of circumstances in which the carrying amount of an asset or liability
will be equal to its tax base.
Accrued expenses have already been deducted in determining an entity's current tax liability for the
current or earlier periods.
A loan payable is measured at the amount originally received and this amount is the same as the
amount repayable on final maturity of the loan.
Accrued expenses which will never be deductible for tax purposes.
Accrued income which will never be taxable.
6.4 Temporary differences
You may have found the definition of temporary differences somewhat confusing. Remember that
accounting profits form the basis for computing taxable profits, on which the tax liability for the year is
calculated; however, accounting profits and taxable profits are different. There are two reasons for the
differences.
(a) Permanent differences. These occur when certain items of revenue or expense are excluded from
the computation of taxable profits (for example, entertainment expenses are not allowable for tax
purposes in the tax system in many countries).
(b) Temporary differences. These occur when items of revenue or expense are included in both
accounting profits and taxable profits, but not for the same accounting period. For example, an
expense which is allowable as a deduction in arriving at taxable profits for 20X7 might not be
included in the financial accounts until 20X8 or later. In the long run, the total taxable profits and
total accounting profits will be the same (except for permanent differences) so that temporary
differences originate in one period and are capable of reversal in one or more subsequent periods.
Deferred tax is the tax attributable to temporary differences.
6.5 Taxable temporary differences
All taxable temporary differences give rise to a deferred tax liability.
Examples
The following are examples of circumstances that give rise to taxable temporary differences. However,
don't worry too much about the detail. You just need to be aware of what might cause deferred tax to
appear in the financial statements.
Interest revenue received in arrears and included in accounting profit on the basis of time
apportionment. It is included in taxable profit, however, on a cash basis.

Sale of goods revenue is included in accounting profit when the goods are delivered, but only
included in taxable profit when cash is received.
Depreciation of an asset is accelerated for tax purposes. When new assets are purchased,
allowances may be available against taxable profits which exceed the amount of depreciation
chargeable on the assets in the financial accounts for the year of purchase.
Development costs which have been capitalised will be amortised in the statement of
comprehensive income/income statement, but they were deducted in full from taxable profit in the
period in which they were incurred.
Prepaid expenses have already been deducted on a cash basis in determining the taxable profit of
the current or previous periods.
Property, plant and equipment is revalued by an entity (under IAS 16), but no equivalent
adjustment is made for tax purposes.
6.5.1 Example: taxable temporary differences
A company purchased an asset costing $1,500. At the end of 20X8 the carrying amount is $1,000. The
cumulative depreciation for tax purposes is $900 and the current tax rate is 25%.
Required
Calculate the deferred tax liability for the asset.
Solution
First, what is the tax base of the asset? It is $1,500 $900 = $600.
In order to recover the carrying value of $1,000, the entity must earn taxable income of $1,000, but it will
only be able to deduct $600 as a taxable expense. The entity must therefore pay income tax of $400
25% = $100 when the carrying value of the asset is recovered.
The entity must therefore recognise a deferred tax liability of $400 25% = $100, recognising the
difference between the carrying amount of $1,000 and the tax base of $600 as a taxable temporary
difference.
6.5.2 Timing differences
Some temporary differences are often called timing differences, when income or expense is included in
accounting profit in one period, but is included in taxable profit in a different period. The main types of
taxable temporary differences which are timing differences and which result in deferred tax liabilities are
included in the examples given above.
Interest received which is accounted for on an accruals basis, but which for tax purposes is
included on a cash basis.
Accelerated depreciation for tax purposes.
Capitalised and amortised development costs.
6.5.3 Example: Current and deferred tax
Jonquil Co buys equipment for $50,000 on 1 January 20X1 and depreciates it on a straight line basis over
its expected useful life of five years. For tax purposes, the equipment is depreciated at 25% per annum on
a straight line basis. Tax losses may be carried back against taxable profit of the previous five years. In
year 20X0, the entity's taxable profit was $25,000. The tax rate is 40%.
Required
Assuming nil profits/losses after depreciation in years 20X1 to 20X5 show the current and deferred tax
impact in years 20X1 to 20X5 of the acquisition of the equipment.
Solution
Jonquil Co will recover the carrying amount of the equipment by using it to manufacture goods for resale.
Therefore, the entity's current tax computation is as follows.

Year

20X1

20X2

20X3

20X4

20X5

$

$

$

$

$

Net profit

Add back depreciation (50,000/5)

10,000

10,000

10,000

10,000

10,000

Depreciation for tax purposes
(50,000 25%)

(12,500)

(12,500)

(12,500)

(12,500)

0

Taxable profit/(tax loss)

(2,500)

(2,500)

(2,500)

(2,500)

10,000

Current tax expense/(income) at 40%

(1,000)

(1,000)

(1,000)

(1,000)

4,000

The entity recognises a current tax asset of $1,000 at the end of years 20X1 to 20X4 because it recovers
the benefit of the tax loss against the taxable profit of year 20X0.
The temporary differences associated with the equipment and the resulting deferred tax asset and liability
and deferred tax expense and income are as follows.

Year

20X1

20X2

20X3

20X4

20X5

$

$

$

$

$

Carrying amount

40,000

30,000

20,000

10,000

0

Tax base

37,500

25,000

12,500

0

0

Taxable temporary difference

2,500

5,000

7,500

10,000

0

Opening deferred tax liability

0

1,000

2,000

3,000

4,000

Deferred tax expense/(income): bal fig

1,000

1,000

1,000

1,000

(4,000)

Closing deferred tax liability @ 40%

1,000

2,000

3,000

4,000

0

The entity recognises the deferred tax liability in years 20X1 to 20X4 because the reversal of the taxable
temporary difference will create taxable income in subsequent years. The entity's statement of
comprehensive income/income statement is as follows.

Year

20X1

20X2

20X3

20X4

20X5

$

$

$

$

$

Income

10,000

10,000

10,000

10,000

10,000

Depreciation

10,000

10,000

10,000

10,000

10,000

Profit before tax

0

0

0

0

0

Current tax expense/(income)

(1,000)

(1,000)

(1,000)

(1,000)

4,000

Deferred tax expense/(income)

1,000

1,000

1,000

1,000

(4,000)

Total tax expense/(income)

0

0

0

0

0

Net profit for the period

0

0

0

0

0

Notice that the charge (or credit) to the statement of comprehensive income/income statement for
deferred tax is the difference between the opening and closing liability.
6.6 Deductible temporary differences
All deductible temporary differences give rise to a deferred tax asset.
6.6.1 Examples
The deferred tax asset must also satisfy the recognition criteria given in IAS 12. These state that a
deferred tax asset should be recognised for all deductible temporary differences to the extent that it is
probable that taxable profit will be available against which it can be utilised. This is an application of
prudence. Before we look at this issue in more detail, let us consider the examples of deductible temporary
differences given in the standard. Again, don't worry too much about the detail. These examples are a
useful aid in trying to understand the principles.

4 : Statement of comprehensive income 373
6.6.2 Transactions that affect the statement of comprehensive income/income
statement
Retirement benefit costs (pension costs) are deducted from accounting profit as service is
provided by the employee. They are not deducted in determining taxable profit until the entity pays
either retirement benefits or contributions to a fund. This may also apply to similar expenses.
Accumulated depreciation of an asset in the financial statements is greater than the accumulated
depreciation allowed for tax purposes up to the reporting date.
The cost of inventories sold before the reporting date is deducted from accounting profit when
goods/services are delivered, but is deducted from taxable profit when the cash is received.
The NRV of inventory, or the recoverable amount of an item of property, plant and equipment falls
and the carrying value is therefore reduced, but that reduction is ignored for tax purposes until the
asset is sold.
Research costs (or organisation/other start-up costs) are recognised as an expense for accounting
purposes but are not deductible against taxable profits until a later period.
Income is deferred in the statement of financial position, but has already been included in taxable
profit in current/prior periods.
6.6.3 Example: deductible temporary differences
Pargatha Co recognises a liability of $10,000 for accrued product warranty costs on 31 December 20X7.
These product warranty costs will not be deductible for tax purposes until the entity pays claims. The tax
rate is 25%.
Required
State the deferred tax implications of this situation.
Solution
What is the tax base of the liability? It is nil (carrying amount of $10,000 less the amount that will be
deductible for tax purposes in respect of the liability in future periods).
When the liability is settled for its carrying amount, the entity's future taxable profit will be reduced by
$10,000 and so its future tax payments by $10,000 25% = $2,500.
The difference of $10,000 between the carrying amount ($10,000) and the tax base (nil) is a deductible
temporary difference. The entity should therefore recognise a deferred tax asset of $10,000 25% =
$2,500 provided that it is probable that the entity will earn sufficient taxable profits in future periods to
benefit from a reduction in tax payments.
6.7 Measurement and recognition of deferred tax
IAS 12 requires the full provision method of accounting for deferred tax to be used.
The full provision method has the advantage that it recognises that each temporary difference at the end
of the reporting period has an effect on future tax payments. If a company claims an accelerated tax
allowance on an item of plant, future tax assessments will be bigger than they would have been otherwise.
Future transactions may well affect those assessments still further, but that is not relevant in assessing the
position at the reporting date. The disadvantage of full provision is that, under certain types of tax
system, it gives rise to large liabilities that may fall due only far in the future, if at all.
You should understand the difference between permanent and temporary differences.
Deferred tax is the tax attributable to temporary differences.
7 IAS 33 Earnings per share
Earnings per share is a measure of the amount of profits earned by a company for each ordinary share.
Earnings are profits after tax and preferred dividends.
7.1 Significance of earnings per share
Earnings per share (EPS) is one of the most frequently quoted statistics in financial analysis. It is a
measure of the amount of profit earned by a company during the financial year that can be attributed to
each ordinary share.
EPS contributes to the calculation of the price earnings (P/E) ratio, calculated as share price divided by
EPS. Because of the widespread use of the price earnings (P/E) ratio as a yardstick for investment
decisions, EPS has become increasingly important. A weakness is, however, that a direct comparison of
companies based on the ratio is only valid where both companies shares have the same value.
7.2 Basic EPS
Basic EPS should be calculated by dividing the net profit or loss for the period attributable to ordinary
shareholders by the weighted average number of ordinary shares outstanding during the period.
Basic EPS =
period the during g outstandin shares ordinary of number average Weighted
rs shareholde ordinary to le attributab ss) profit/(lo Net

Earnings
Earnings includes all items of income and expense (attributable to the parent entity) less the after tax
profits attributable to preference shareholders, including preference dividends.
(Note that items of other comprehensive income are not included.)
Preference dividends deducted from net profit consist of:
(a) Preference dividends on non-cumulative preference shares declared in respect of the period
(b) The full amount of the required preference dividends for cumulative preference shares for the
period, whether or not they have been declared (excluding those paid/declared during the period in
respect of previous periods)
Per share
The number of ordinary shares used should be the weighted average number of ordinary shares during
the period. By using this figure the corresponding EPS for the previous year will be comparable with the
current year because as the weighted average number of shares has risen or fallen, there has been a
corresponding increase or decrease in resources.

6.8 Section summary
Deferred tax is an accounting device. It does not represent tax currently payable to the tax
authorities.
The tax base of an asset or liability is the value of that asset or liability for tax purposes.
7.2.1 Example: weighted average
A Co has earnings of $200,000 and a year end of 31 December. On 1.10.X7 the company has 600,000
shares. On 1.10.X7 the company issued 300,000 shares at full market price.

Solution
In this case a weighted average number of shares would have to be calculated as follows:
1.1.X7 600,000

9
12

450,000

1.10.X7 900,000

3
12

225,000

675,000

EPS =
$200,000
675,000
= $0.296
There are however other events which change the number of shares outstanding without a corresponding
change in resources. These include bonus issues and rights issues. In these circumstances it is necessary
to make adjustments so that the current and prior period EPS figures are comparable.

Activity 5.4

Flame Co is a company with a called up and paid up capital of 100,000 ordinary shares of $1 each and
20,000 10% preferred shares of $1 each. The company manufactures gas appliances.
The profit before tax was $150,000. Flame Co paid the required preferred share dividend and declared an
ordinary dividend of 42c per share. Assuming an income tax rate of 30% on the given figures show the
trading results and EPS of the company.
7.3 Example: earnings per share with a bonus issue
Greymatter Co had 400,000 shares in issue, until on 30 September 20X2 it made a bonus issue of 100,000
shares. Calculate the EPS for 20X2 and the corresponding figure for 20X1 if total earnings were $80,000
in 20X2 and $75,000 in 20X1. The company's accounting year runs from 1 January to 31 December.
Solution

20X2

20X1

Earnings

$80,000

$75,000

Shares at 1 January

400,000

400,000

Bonus issue

100,000

100,000

500,000
shares

500,000
shares
EPS 16c 15c
The number of shares for 20X1 must also be adjusted if the figures for EPS are to remain comparable.
Note that in a bonus issue, the company has issued new shares but has not received any proceeds from
the issue. The EPS ratio will decrease, as there are more shares for the same amount of earnings. Hence,
the prior year EPS ratio must also be adjusted for the effect of the bonus issue.
7.4 Rights issue
A rights issue of shares is an issue of new shares to existing shareholders at a price below the current
market value. The offer of new shares is made on the basis of x new shares for every y shares currently
held; eg a 1 for 3 rights issue is an offer of 1 new share at the offer price for every 3 shares currently held.
This means that there is a bonus element included.
To arrive at figures for EPS when a rights issue is made, we need to calculate first of all the theoretical
ex-rights price. This is a weighted average value per share, and is perhaps explained most easily with a
numerical example.
7.5 Example: theoretical ex-rights price
Suppose that Egghead Co has 10,000,000 shares in issue. It now proposes to make a 1 for 4 rights issue
at a price of $3 per share. The market value of existing shares on the final day before the issue is made is
$3.50 (this is the 'with rights' value). What is the theoretical ex-rights price per share?
Solution
$
Before issue 4 shares, value $3.50 each 14.00
Rights issue 1 share, value $3

3.00

Theoretical value of 5 shares

17.00

Theoretical ex-rights price =
5
$17.00
= $3.40 per share
Note that this calculation can alternatively be performed using the total value and number of outstanding
shares.
7.6 Procedures
The procedures for calculating the EPS for the current year and a corresponding figure for the previous
year are now as follows.
(a) The EPS for the corresponding previous period should be multiplied by the following fraction.
(Note. The market price on the last day of quotation is taken as the fair value immediately prior to
exercise of the rights, as required by the standard.)
rights) (with quotation of day last on price Market
price rights - ex l Theoretica

(b) To obtain the EPS for the current year you should:
(i) Multiply the number of shares before the rights issue by the fraction of the year before the
date of issue and by the following fraction
price rights - ex l Theoretica
rights with quotation of day last on price Market

(ii) Multiply the number of shares after the rights issue by the fraction of the year after the date
of issue and add to the figure arrived at in (i)
The total earnings should then be divided by the total number of shares so calculated.
Calculate the EPS for 20X2 and the corresponding figure for 20X1 given total earnings of $50,000 in 20X2
and $40,000 in 20X1.
Solution
Calculation of theoretical ex-rights price:

$
Before issue 5 shares, value $1.60 8.00
Rights issue 1 share, value $1.00

1.00

Theoretical value of 6 shares

9.00

Theoretical ex-rights price =
6
$9
= $1.50
EPS for 20X1
EPS as calculated before taking into account the rights issue = 40c ($40,000 divided by 100,000 shares).
EPS =
60 . 1
50 . 1

40c = 37c
(Remember: this is the corresponding value for 20X1 which will be shown in the financial statements for
Brains Co at the end of 20X2.)
EPS for 20X2
Number of shares before the rights issue was 100,000. 20,000 shares were issued.
Stage 1: 100,000

9
/12

50 . 1
60 . 1
= 80,000
Stage 2: 120,000

3
/12 =

30,000

110,000

EPS =
110,000
$50,000

= 45c

The figure for total earnings is the actual earnings for the year.
7.8 Diluted EPS
Diluted EPS is calculated by adjusting the net profit attributable to shareholders and the weighted average
number of shares outstanding for the effects of all dilutive potential ordinary shares.
At the end of an accounting period, a company may have in issue some securities which do not (at
present) have any 'claim' to a share of equity earnings, but may give rise to such a claim in the future.
These securities include:
(a) A separate class of equity shares which at present is not entitled to any dividend, but will be
entitled after some future date
(b) Convertible loan stock or convertible preferred shares which give their holders the right at some
future date to exchange their securities for ordinary shares of the company, at a pre-determined
conversion rate
(c) Options or warrants

7.7 Example: earnings per share with a rights issue
Brains Co had 100,000 shares in issue, but then makes a 1 for 5 rights issue on 1 October 20X2 at a price
of $1. The market value on the last day of quotation with rights was $1.60.
In such circumstances, the future number of ordinary shares in issue might increase, which in turn results
in a fall in the EPS. In other words, a future increase in the number of ordinary shares will cause a
dilution or 'watering down' of equity, and it is possible to calculate a diluted earnings per share (ie the
EPS that would have been obtained during the financial period if the dilution had already taken place). This
will indicate to investors the possible effects of a future dilution.
Diluted EPS is complicated, but you only need to be able to deal with straightforward situations.
7.8.1 Example: diluted EPS
In 20X7 Farrah Co had a basic EPS of 105c based on earnings of $105,000 and 100,000 ordinary $1
shares. It also had in issue $40,000 15% Convertible Loan Stock which is convertible in two years' time at
the rate of 4 ordinary shares for every $5 of stock. The rate of tax is 30%. In 20X7 gross profit of
$200,000 and expenses of $50,000 were recorded, including interest payable of $6,000.
Required
Calculate the diluted EPS.
Solution
Diluted EPS is calculated as follows.
Step 1 Number of shares: the additional equity on conversion of the loan stock will be 40,000
4/5 = 32,000 shares
Step 2 Earnings: Farrah Co will save interest payments of $6,000 but this increase in profits will be
taxed. Hence the earnings figure may be recalculated:

$

Gross profit

200,000
Expenses (50,000 6,000)

(44,000)
Profit before tax

156,000

Tax expense (30%)

(46,800)

Earnings

109,200

Step 3 Calculation: Diluted EPS =
132,000
$109,200
= 82.7c
Step 4 Dilution: the dilution in earnings would be 105c 82.7c = 22.3c per share
7.9 Presentation, disclosure and other matters
Basic and diluted EPS should be presented by an entity on the face of the income statement or statement
of comprehensive income for each class of ordinary share that has a different right to share in the net
profit for the period. The basic and diluted EPS should be presented with equal prominence for all periods
presented.
Disclosure must still be made where the EPS figures (basic and/or diluted) are negative (ie a loss per
share).
An entity may present alternative EPS figures if it wishes.
If additional EPS figures are disclosed, IAS 33 requires that:
the weighted average number of shares is that used in the EPS figure according to IAS 33.
basic and diluted amounts should be displayed with equal prominence in the notes.
an indication of how the earnings figure is calculated should be given.
a reconciliation should be given of the earnings figure used in the calculation and earnings in the
income statement or statement of comprehensive income.
379 5: The statement of financial position

1 The format of a statement of financial position
1.1 Introduction
As a result of the revised IAS 1 Presentation of financial statements, the IASB have changed the name of
the balance sheet to the statement of financial position.
The IASB's view is that the name change better reflects the function of the statement as the balance sheet
shows the financial position of an entity.
For the purposes of this text, all references to balance sheet have been replaced with statement of financial
position. However, the IASB have stated that entities are free to use either term.
1.2 Statement of financial position
IAS 1 suggests a format for the statement of financial position.
A statement of financial position is a statement of the assets, liabilities and owners' capital of a business at
a specific moment in time, typically at the end of the financial year. It is therefore a statement of the
accounting equation for the business at that moment.

The statement of
financial position
5: The statement of financial position 380
XYZ GROUP
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X8

20X8

20X7

$'000

$'000

$'000

$'000

Assets

Non-current assets

Property, plant and equipment

X

X

Goodwill

X

X

Other intangible assets

X

X

Investments in associates

X

X

Available-for-sale investments

X

X

X

X

Current assets

Inventories

X

X

Trade receivables

X

X

Other current assets

X

X

Cash and cash equivalents

X

X

X

X

Total assets

X

X

Equity and liabilities

Equity attributable to equity holders of the parent

Share capital

X

X

Retained earnings

X

X

Other components of equity

X

X

X

X

Non-controlling interests

X

X

Total equity
X

X

Non-current liabilities

Long-term borrowings

X

X

Deferred tax

X

X

Long-term provisions

X

X

Total non-current liabilities
X

X

Current liabilities

Trade and other payables

X

X

Short-term borrowings

X

X

Current portion of long-term borrowings

X

X

Current tax payable

X

X

Short-term provisions

X

X

Total current liabilities
X

X

Total liabilities
X

X


X

X

IAS 1 specifies various items which must appear on the face of the statement of financial position as a
minimum disclosure.
(a) Property, plant and equipment
(b) Investment property
(c) Intangible assets
(d) Financial assets (excluding amounts shown under (e), (h) and (i))
(e) Investments accounted for using the equity method
(f) Biological assets
(g) Inventories
(h) Trade and other receivables
(i) Cash and cash equivalents
(j) The total of assets classified as held for sale, and assets included in disposal groups classified and
held for sale as in IFRS 5
(k) Trade and other payables
(l) Provisions
(m) Financial liabilities
(n) Liabilities and assets for current tax, as defined in IAS 12
(o) Deferred tax liabilities and deferred tax assets as defined in IAS 12
(p) Liabilities included in disposal groups classified as held for sale as in IFRS 5
(q) Non-controlling interests, presented within equity
(r) Issued capital and reserves attributable to owners of the parent
We will look at these items throughout the rest of the text.
Any other line items, headings or sub-totals should be shown on the face of the statement of financial
position when it is necessary for an understanding of the entity's financial position.
The example shown above is for illustration only (although we will follow the format in this Study Text).
IAS 1 does not prescribe the order or format in which the items listed should be presented. It simply
states that they must be presented separately because they are so different in nature or function from
each other.
The examiner has stated that it is more important to know and understand whether items are included in
the statement of financial position or statement of comprehensive income, than memorising detailed
formats of the statement of financial position and statement of comprehensive income. Bear this in mind
in your studies.
1.3 Information presented either on the face of the statement of
financial position or by note
Further sub-classification of the line items listed above should be disclosed either on the face of the
statement of financial position or in notes to the statement of financial position. The classification will
depend upon the nature of the entity's operations. As well as each item being sub-classified by its nature,
any amounts payable to or receivable from any group company or other related party should also be
disclosed separately.
2 Current assets
An entity must present current and non-current assets as separate classifications on the face of the
statement of financial position.
2.1 The current/non-current distinction
An entity must present current and non-current assets as separate classifications on the face of the
statement of financial position. A presentation based on liquidity should only be used where it provides
more relevant and reliable information, in which case all assets and liabilities must be presented broadly in
order of liquidity.
In either case, the entity should disclose any portion of an asset or liability which is expected to be
recovered or settled after more than twelve months. For example, for an amount receivable which is due
in instalments over 18 months, the portion due after more than twelve months must be disclosed.
The IAS emphasises how helpful information on the operating cycle is to users of financial statements.
Where there is a clearly defined operating cycle within which the entity supplies goods or services, then
information disclosing those net assets that are continuously circulating as working capital is useful.
This distinguishes them from those net assets used in the long-term operations of the entity. Assets that
are expected to be realised and liabilities that are due for settlement within the operating cycle are
therefore highlighted.

The liquidity and solvency of an entity is also indicated by information about the maturity dates of assets
and liabilities. IFRS 7: Financial instruments: Disclosures requires disclosure of maturity dates of both
financial assets and financial liabilities. (Financial assets include trade and other receivables; financial
liabilities include trade and other payables.) In the case of non-monetary assets, eg inventories, such
information is also useful.
2.2 Current assets
An asset should be classified as a current asset when it:
is expected to be realised in, or is held for sale or consumption in, the normal course of the entity's
operating cycle; or
is held primarily for trading purposes or for the short-term and expected to be realised within
twelve months of the reporting date; or
is cash or a cash equivalent asset which is not restricted in its use.
All other assets should be classified as non-current assets. (IAS 1)
Non-current assets includes tangible, intangible, operating and financial assets of a long-term nature.
Other terms with the same meaning can be used (eg 'fixed', 'long-term').
The term 'operating cycle' has been used several times above and the standard defines it as follows.
The operating cycle of an entity is the time between the acquisition of materials entering into a process
and its realisation in cash or an instrument that is readily convertible into cash. (IAS 1)
Current assets therefore include inventories and trade receivables that are sold, consumed and realised as
part of the normal operating cycle. This is the case even where they are not expected to be realised
within twelve months.
Current assets will also include marketable securities if they are expected to be realised within twelve
months of the reporting date. If expected to be realised later, they should be included in non-current assets.
Receivables represent the amounts owed to the business. Strangely, perhaps, the receivables shown as
current assets may include debts that are not due to be paid within the next 12 months. Where there are
long-term receivables, the statement of financial position must show separately the amounts falling due
within one year and the amounts falling due in over one year.
A note to the accounts itemises receivables in further detail. Categories of receivables that are shown include:
(a) amounts receivable from trade customers (receivables arising in the course of the company's
trading)
(b) prepayments
(c) other amounts
A prepayment is an amount of money that has been paid by the company for an expense that will not be
chargeable against profits until the next financial year. For example, when a company pays rent of $20,000
in advance, for a rental period in the next financial year, the $20,000 is a prepayment, and included in
receivables in the statement of financial position. (In terms of the accounting equation, a prepayment
reduces cash and increases prepayments, which is another asset.)
Accrued income relates to income that is properly attributable to the current financial year, but that has
not yet been invoiced. Since there is no invoice yet, there is no amount receivable. For example, suppose
that a company of consultants agrees to undertake a six-month contract for a client, and invoice the client
for $500,000 when the job has been finished. If the job is half-finished at the end of the company's
financial year, it might decide that $250,000 of income is properly attributable to the year just ended. If so,
it will include $250,000 for the part-finished job in sales revenue, and accrued income of $250,000 as a
receivable. (In terms of the accounting equation, profits (capital) and assets are both increased.) Accrued
income is often included with prepayments.
A company might make an allowance for receivables. This is an amount set aside to provide for the fact
that some current receivables may fail to pay what they owe. By making an allowance for these doubtful
receivables, the company will recognise a loss before the bad debt actually occurs. The value of
receivables in the statement of financial position is the total receivables minus the allowance for debts.
However, a company is not required to disclose the size of any allowance it has made.
2.3 Example
A company, which began trading on 1 January, Year 1, had trade receivables of $800,000 as at 31
December, Year 1. The allowance for debts was 2% of total trade receivables.
At 31 December Year 2 the company had total trade receivables of $1,000,000 and made an allowance of
3% for debts.
At 31 December Year 1, the trade receivables in the statement of financial position should be $784,000:
$
Trade receivables

800,000

Less allowance for debts (2%)

(16,000)

784,000

There should be a charge against profits for the year of $16,000, which is the increase in the receivables
allowance for the year.
At 31 December Year 2, the trade receivables should be $970,000:

$

Trade receivables

1,000,000

Less allowance for debts (3%)

(30,000)

970,000

There should be a charge against profits for Year 2 of $14,000, which is the increase in the allowance for
receivables in the year ($30,000 $16,000).
3 Inventory
Inventory must be valued at the lower of cost and net realisable value. The most commonly used methods
to derive cost are FIFO and weighted average cost.
Note: Inventories are a popular exam topic.
The statement of financial position includes an amount for inventories. This is the 'closing inventories'
held by the company as at the end of its financial year. The valuation of closing inventory can be
important, because the inventory value affects not just the statement of financial position, but also the
income statement/statement of comprehensive income.
The trading part of an income statement includes:

$

Opening inventory

X

Plus purchases

X

Less closing inventory

(X)

Cost of goods sold

X

However, just writing down this formula hides two basic problems with inventories.
(a) How do you manage to get a precise count of inventory in hand at any given moment?
(b) Even once it has been counted, how do you value the inventory?

3.1 Inventory counting
Business trading is a continuous activity, but accounting statements must be drawn up at a particular
date. In preparing a statement of financial position it is necessary to 'freeze' the activity of a business so
as to determine its assets and liabilities at a given moment. However, a business buys inventory
continually during its trading operations and either sells the goods onwards to customers or incorporates
them as raw materials in manufactured products. This constant movement of inventories makes it difficult
to establish what exactly is held at any precise moment. It is important that no inventory is subject to
double/multiple counting or is missed out of the count.
Establishing proper 'cut off' is a traditional problem with inventory counting eg Domeselec Co delivers a
TV before the year end but only invoices the customer after the year end.
When a business holds easily-counted and relatively small amounts of inventory, quantities of inventories
on hand at the end of the reporting period can be determined by physically counting them in an inventory
count.
The continuous nature of trading activity may cause a problem in that inventory movements will not
necessarily cease during the time that the physical inventory count is in progress. Two possible solutions
are:
(a) Close down the business while the count takes place; or
(b) Keep detailed records of inventory movements during the course of the inventory count.
Closing down the business for a short period for an inventory count (e.g. over a weekend or at Christmas)
is the usual method preferred.
In more complicated cases, where a business holds considerable quantities of varied inventory, an
alternative approach to establishing inventory quantities is to maintain a continuous inventory counting
process. For example, a company may have a system whereby all inventory lines are counted at least once
a year and agreed to the inventory records with (say) high value items being counted more frequently,
especially towards the end of the reporting period.
3.2 Valuing inventories
There are several methods which, in theory, could be used for the valuation of inventory items.
(a) Inventories might be valued at their expected selling price. However, the use of selling prices for
inventory valuation is ruled out, because the inventory would be valued above its original cost,
which would create a profit for the business before the inventory has been sold.
(b) Inventories might be valued at their expected selling price, less any costs still to be incurred in
getting them ready for sale and then selling them. This amount is referred to as the net realisable
value (NRV) of the inventories. Again, this may include a profit element.
(c) Inventories might be valued at their historical cost (i.e. the cost at which they were originally
bought).
(d) Inventories might be valued at the amount it would cost to replace them. This amount is referred to
as the current replacement cost of inventories. In traditional accounts, inventories are not valued
in this way.
Historical cost is the normal basis of inventory valuation. Most inventory items are valued at their original
cost. However, there may be occasions when the net realisable value of inventory falls below its
original cost owing to reasons such as fall in market demand, deterioration or obsolescence. Where there
is uncertainty as to whether cost will be recorded prudence will come into play. Consequently, when the
net realisable value of an inventory item falls below its original cost, its value must be written down from
cost to the lower amount.
The accounting treatment of inventory is governed by an accounting standard, IAS 2 Inventories. IAS 2
states that inventory should be valued at the lower of cost and net realisable value. It is essential that
you know this as it is frequently examined.

Activity 6.1

From the following figures, calculate the figure for inventory valuation, on an item by item basis.
Remember that inventory is valued at the lower of cost and net realisable value.
Inventory at 31 December 20X4
Item Cost ($) Net realisable value ($)
1
2
3
4
5
6
7
8
9
560
880
780
340
420
800
1,720
1,140
1,540
660
740
960
500
620
700
1,200
1,320
1,980

Activity 6.2

The Great Flag Co has a 31 December year end. During September 20X6, the country hosted a major
international sporting event and the accounts for the year ended 31 December 20X6 are likely to reflect a
heightened profit blip, which is unlikely to be repeated in 20X7. However, demand is likely to pick up again
in 20X8, when more tournaments are scheduled.
As at 31 December 20X6, the company had considerable inventories of flags costing $5 each of which the
normal selling price is $12. The directors are considering writing down the value of the flags to $3 each so
that the current year won't show such a big profit while allowing 20X7 sales to face a lower brought
forward cost.
What comments would you have regarding the directors' proposals for carrying forward a low inventory
figure in 20X7?

3.3 Determining the purchase cost
Inventory is valued at the lower of cost or net realisable value. But how is the cost of inventory
established? This is a problem for all types of business, from retailers and companies in service industries
to manufacturing organisations.
In a retail business, inventory will consist mainly of goods for resale. In a manufacturing company,
inventory may be raw materials or components bought from suppliers, finished goods which have been
made by the business but not yet sold, or work in the process of production and only part-completed (this
type of inventory is called work in progress or WIP). It will simplify matters, however, if we begin by
thinking about the historical cost of purchased raw materials and components, which ought to be their
purchase price.
A business may be continually purchasing consignments of a particular inventory item, and may pay a
different purchase price each time. As each consignment is received from suppliers the items are stored in
the appropriate bin or on the appropriate shelf or pallet, where they will be mingled with previous
consignments. When the storekeeper issues inventory to production he will simply pull out from the shelf
or pallet the nearest items to hand, which may have arrived in the latest consignment or in an earlier
consignment or in several different consignments. For accounting purposes, an inventory pricing
technique is needed to attribute a cost to each of the components issued from stores. A technique has to
be chosen because the purchase price of inventories varies from consignment to consignment. If prices
did not vary, there would be no need to bother with choosing a valuation method.
There are several valuation methods that might be used.
FIFO (First in, first out) Using this technique, we assume that inventories are used in the order in
which they are received from suppliers and are costed accordingly.
LIFO (Last in, first out). This involves the opposite assumption, that the first items used up are the
most recently acquired items. This is not allowed as a method of inventory costing.
Average cost Inventories are valued at their weighted average purchase cost. This can be either
continuous or periodic. With the continuous method, a new weighted average cost is calculated
every time a new consignment of the inventory item is received. With the periodic method, an
average cost of inventory received during an accounting period is calculated.
For financial accounts, only FIFO or average cost can be used to value inventory for the statement of
financial position.
3.4 Example
The purchases and consumption of an item of inventory during an accounting period were as follows.
Date
Purchases

Consumed

units

$ per unit
$
units

1 February

300

10

3,000

28 March

400

11

4,400

25 April

200

8 May

300

12

3,600

3 June

600

1,000

11,000

800

Using the FIFO valuation method, the cost of the inventory used and the value of the closing inventory are
as follows.
Date
Units

Value

$

25 April

200

(200 $10)

2,000

3 June

600

(100 $10)

(400 $11)

(100 $12)

6,600

8,600

The value of closing inventory is 200 units $12 = $2,400.
The average cost method calculates an average cost of inventory to be used in pricing issues. There are two
methods of calculating average cost cumulative weighted average pricing or periodic weighted average.
Cumulative weighted average pricing calculates a weighted average price whenever a new delivery of
materials into stores is received. This method continually updates the inventory cost.
Periodic weighted average calculates a weighted average price on a periodic basis, for example, on a
monthly basis.
Using the cumulative weighted average pricing method, the cost of inventory used and the closing
inventory is calculated as follows:
Date
Purchases

Consumed

Total

Average

Total

units

$ per unit

units

units

unit cost $

inventory value $

1 February

300

10

300

3,000

28 March

400

11

400

4,400

700

10.57

7,400

25 April

200

(200)

10.57

(2,114)

500

5,286

8 May

300

12

300

3,600

800

11.11

8,886

3 June

600

(600)

11.11

(6,666)

200

2,220

As each purchase or issue occurs, the average price is recalculated. Closing inventory is 200 units at a
total cost of $2,220. The cost of issues is $8,780.
Using the periodic weighted average approach, the average cost per unit for the period would be valued
at $11,000/1,000 units = $11 per unit. The cost of the 800 units consumed would therefore be $8,800 and
the value of the 200 units of closing inventory would be $2,200.
Each valuation method produces a different figure for an accounting period for the cost of inventory
consumed/sold and the value of closing inventory. Inventory valuation therefore affects the reported profit
in any one period, although not over the long term.
3.5 Inventory valuations and profit
In the previous example, using the FIFO and average cost method of inventory valuation produced
different costs of closing inventory and issues into production.
Because of this, it is important to be consistent in valuing inventory and use the same method from one
period to the next.
In times of rising inventory costs, using the FIFO method will give rise to higher profits. The closing
inventory is the most recently purchased and therefore will be at a higher price, giving a higher value of
closing inventory and a lower cost of sales. This directly impacts profit.
The average cost method has less of an impact in times of rising prices as it takes the average of all
inventory held, reducing the effect on profits.
3.6 Inventory: IAS 2
The standard gives the following important definitions.
Inventories are assets:
held for sale in the ordinary course of business;
in the process of production for such sale; or
in the form of materials or supplies to be consumed in the production process or in the
rendering of services.
Cost includes all costs of purchase, costs of conversion and other costs in bringing inventory to its
present location and condition.
Net realisable value is the estimated selling price in the ordinary course of business less the
estimated costs of completion and the estimated costs necessary to make the sale.
Inventories can include any of the following.
Goods purchased and held for resale, eg goods held for sale by a retailer, or land and buildings
held for resale
Finished goods produced
Work in progress being produced
Materials and supplies awaiting use in the production process (raw materials)
3.6.1 Measurement of inventories
The standard states that 'Inventories should be measured at the lower of cost and net realisable value.'
We introduced this rule earlier.
The cost of inventories will consist of all costs of:
Purchase
Costs of conversion
Other costs incurred in bringing the inventories to their present location and condition
The standard lists the following as comprising the costs of purchase of inventories:
Purchase price plus
Import duties and other taxes plus
Transport, handling and any other cost directly attributable to the acquisition of finished goods,
services and materials less
Trade discounts, rebates and other similar amounts
Costs of conversion of inventories consist of two main parts.
(a) Costs directly related to the units of production, eg direct materials, direct labour
(b) Fixed and variable production overheads that are incurred in converting materials into finished
goods, allocated on a systematic basis.
You may have come across the terms 'fixed production overheads' or 'variable production overheads'
elsewhere in your studies. The standard defines them as follows.
Fixed production overheads are those indirect costs of production that remain relatively constant
regardless of the volume of production, eg the cost of factory management and administration.
Variable production overheads are those indirect costs of production that vary directly, or nearly
directly, with the volume of production, eg indirect materials and labour. (IAS 2)
The standard emphasises that fixed production overheads must be allocated to items of inventory on the
basis of the normal capacity of the production facilities. This is an important point.
(a) Normal capacity is the expected achievable production based on the average over several
periods/seasons, under normal circumstances.
(b) The above figure should take account of the capacity lost through planned maintenance.
(c) If it approximates to the normal level of activity then the actual level of production can be used.
(d) Low production or idle plant will not result in a higher fixed overhead allocation to each unit.
(e) Unallocated overheads must be recognised as an expense in the period in which they were incurred.
(f) When production is abnormally high, the fixed production overhead allocated to each unit will be
reduced, so avoiding inventories being stated at more than cost.
(g) The allocation of variable production overheads to each unit is based on the actual use of
production facilities.
Any other costs should only be recognised if they are incurred in bringing the inventories to their present
location and condition.
The standard lists types of cost which would not be included in cost of inventories. Instead, they should
be recognised as an expense in the period they are incurred.
(a) Abnormal amounts of wasted materials, labour or other production costs
(b) Storage costs (except costs which are necessary in the production process before a further
production stage)
(c) Administrative overheads not incurred to bring inventories to their present location and conditions
(d) Selling costs
3.6.2 Net realisable value (NRV)
As a general rule assets should not be carried at amounts greater than those expected to be realised from
their sale or use. In the case of inventories this amount could fall below cost when items are damaged or
become obsolete, or where the costs to completion have increased in order to make the sale.
In fact we can identify the principal situations in which NRV is likely to be less than cost, ie where there
has been:
(a) An increase in costs or a fall in selling price
(b) A physical deterioration in the condition of inventory
(c) Obsolescence of products
(d) A decision as part of the company's marketing strategy to manufacture and sell products at a loss
(e) Errors in production or purchasing
A write down of inventories would normally take place on an item by item basis, but similar or related
items may be grouped together. This grouping together is acceptable for, say, items in the same product
line, but it is not acceptable to write down inventories based on a whole classification (eg finished goods)
or a whole business.
The assessment of NRV should take place at the same time as estimates are made of selling price, using
the most reliable information available. Fluctuations of price or cost should be taken into account if they
relate directly to events after the reporting period, which confirm conditions existing at the end of the
period.
The reasons why inventory is held must also be taken into account. Some inventory, for example, may be
held to satisfy a firm contract and its NRV will therefore be the contract price. Any additional inventory of
the same type held at the period end will, in contrast, be assessed according to general sales prices when
NRV is estimated.
Net realisable value must be reassessed at the end of each period and compared again with cost. If the
NRV has risen for inventories held over the end of more than one period, then the previous write down
must be reversed to the extent that the inventory is then valued at the lower of cost and the new NRV.
This may be possible when selling prices have fallen in the past and then risen again.
On occasion a write down to NRV may be of such size, incidence or nature that it must be disclosed
separately.
3.7 Disclosure
This information is of great relevance to users of financial statements, particularly the change in assets
from period to period. The standard lists common classifications for inventories.
Merchandise
Production supplies
Materials
Work in progress
Finished goods
Accounting policies adopted in measuring inventories should also be disclosed.

4 Construction contracts
Companies with construction contracts may take credit for some of the anticipated profit before the
contract has been completed. IAS 11 specifies how this should be dealt with.
4.1 Introduction
Imagine that you are the accountant at a construction company. Your company is building a large tower
block that will house offices, under a contract with an investment company. It will take three years to build
the block and over that time you will obviously have to pay for building materials, wages of workers on the
building, architects' fees and so on. You will receive periodic payments from the investment company at
various predetermined stages of the construction. How do you decide, in each of the three years, what to
include as income and expenditure for the contract in the income statement / statement of
comprehensive income?
This is the problem tackled by IAS 11 Construction contracts.
4.2 Example: construction contract
A numerical example might help to illustrate the problem. Suppose that a contract is started on 1 January
20X5, with an estimated completion date of 31 December 20X6. The final contract price is $1,500,000. In
the first year, to 31 December 20X5:
(a) Costs incurred amounted to $600,000.
(b) Half the work on the contract was completed.
(c) Certificates of work completed have been issued, to the value of $750,000. (Note. It is usual, in a
construction contract, for a qualified person such as an architect or engineer to inspect the work
completed, and if it is satisfactory, to issue certificates. This will then be the notification to the
customer that progress payments are now due to the contractor. Progress payments are
commonly the amount of valuation on the work certificates issued, minus a precautionary retention
of 10%).
(d) It is estimated with reasonable certainty that further costs to completion in 20X6 will be $600,000.
What is the contract profit in 20X5, and what entries would be made for the contract at 31 December 20X5 if:
(a) Profits are deferred until the completion of the contract?
(b) A proportion of the estimated revenue and profit is credited to the income statement in 20X5?
Solution
(a) If profits were deferred until the completion of the contract in 20X6, the revenue and profit
recognised on the contract in 20X5 would be nil, and the value of work in progress on 31
December 20X5 would be $600,000. IAS 11 takes the view that this policy is unreasonable,
because in 20X6, the total profit of $300,000 would be recorded. Since the contract revenues are

earned throughout 20X5 and 20X6, a profit of nil in 20X5 and $300,000 in 20X6 would be contrary
to the accruals concept of accounting.
(b) It is fairer to recognise revenue and profit throughout the duration of the contract.
As at 31 December 20X5 revenue of $750,000 should be matched with cost of sales of $600,000
leaving an attributable profit for 20X5 of $150,000.
The only statement of financial position entry as at 31 December 20X5 is a receivable of $750,000
recognising that the company is owed this amount for work done to date. No balance remains for
work in progress, the whole $600,000 having been recognised in cost of sales.
4.3 What is a construction contract?
A contract which needs IAS 11 treatment does not have to last for a period of more than one year. The
main point is that the contract activity starts in one financial period and ends in another, thus creating
the problem: to which of two or more periods should contract income and costs be allocated? In fact the
definition given in the IAS of a construction contract is very straightforward.
Construction contract. A contract specifically negotiated for the construction of an asset or a combination
of assets that are closely interrelated or interdependent in terms of their design, technology and function
or their ultimate purpose or use. (IAS 11)
Fixed price contract. A contract in which the contractor agrees to a fixed contract price, or a fixed
rate per unit of output, which in some cases is subject to cost escalation clauses.
Cost plus contract. A contract in which the contractor is reimbursed for allowable or otherwise
defined costs, plus a percentage of these costs or a fixed fee.
Construction contracts may involve the building of one asset, eg a bridge, or a series of interrelated assets
eg an oil refinery. They may also include rendering of services (eg architects) or restoring or demolishing
an asset.
4.4 Contract revenue
Contract revenue will be the amount specified in the contract, subject to variations in the contract work,
incentive payments and claims if these will probably give rise to revenue and if they can be reliably measured.
The result is that contract revenue is measured at the fair value of received or receivable revenue.
4.5 Contract costs
Contract costs consist of:
costs relating directly to the contract
costs attributable to general contract activity which can be allocated to the contract, such as
insurance, cost of design and technical assistance not directly related to a specific contract and
construction overheads
any other costs which can be charged to the customer under the contract, which may include
general administration costs and development costs
Costs that relate directly to a specific contract include the following.
Site labour costs, including site supervision
Costs of materials used in construction
Depreciation of plant and equipment used on the contract
Costs of moving plant, equipment and materials to and from the contract site
Costs of hiring plant and equipment
Costs of design and technical assistance that are directly related to the contract
Estimated costs of rectification and guarantee work, including expected warranty costs
Claims from third parties
Some costs cannot be attributed to contract activity and so the following should be excluded from
construction contract costs.
General administration costs (unless reimbursement is specified in the contract)
Selling costs
R&D (unless reimbursement is specified in the contract)
Depreciation of idle plant and equipment not used on any particular contract
4.6 Recognition of contract revenue and expenses
Revenue and costs associated with a contract should be recognised according to the stage of completion
of the contract at the reporting date, but only when the outcome of the activity can be estimated reliably.
If a loss is predicted on a contract, then it should be recognised immediately. This is often known as the
percentage of completion method.
The percentage of completion method is an application of the accruals assumption. Contract revenue is
matched to the contract costs incurred in reaching the stage of completion, so revenue, costs and profit
are attributed to the proportion of work completed.
We can summarise the treatment as follows.
Recognise contract revenue as revenue in the accounting periods in which the work is performed
Recognise contract costs as an expense in the accounting period in which the work to which they
relate is performed
Any expected excess of total contract costs over total contract revenue should be recognised as an
expense immediately
Any costs incurred which relate to future activity should be recognised as an asset if it is probable
that they will be recovered (often called contract work in progress, ie amounts due from the
customer)
Where amounts have been recognised as contract revenue, but their collectability from the
customer becomes doubtful, such amounts should be recognised as an expense, not a deduction
from revenue
4.7 When can reliable estimates be made?
IAS 11 only allows contract revenue and costs to be recognised when the outcome of the contract can be
predicted, ie when it is probable that the economic benefits attached to the contract will flow to the entity.
4.8 Determining the stage of completion
How should you decide on the stage of completion of any contract? The standard lists several methods.
Proportion of contract costs incurred for work carried out to date
Surveys of work carried out
Physical proportion of the contract work completed
When the stage of completion is determined using the contract costs incurred to date, only contract costs
reflecting the work to date should be included in costs incurred to date.
Exclude costs relating to future activity, eg cost of materials delivered but not yet used
Exclude payments made to subcontractors in advance of work performed
4.9 Outcome of the contract cannot be predicted reliably
When the contract's outcome cannot be predicted reliably the following treatment should be followed.
Only recognise revenue to the extent of contract costs incurred which are expected to be
recoverable
Recognise contract costs as an expense in the period they are incurred
4.10 Recognition of expected losses
Any loss on a contract should be recognised as soon as it is foreseen. The loss will be the amount by
which total expected contract revenue is exceeded by total expected contract costs. The loss amount is not
affected by whether work has started on the contract, the stage of completion of the work or profits on
other contracts (unless they are related contracts treated as a single contract).
4.11 Disclosures
The following should be disclosed under IAS 11
Contract revenue recognised as revenue in the period
Methods used to determine the contract revenue
Methods used to determine stage of completion of contracts which are in progress
For contracts in progress at the end of the reporting period, show the following.
Total costs incurred and recognised profits (less recognised losses) to date
Advances received
Retentions (progress billings not paid until the satisfaction of certain conditions)
Amounts owed by customers and to sub-contractors for contract work must be shown gross as an asset
and a liability respectively. These are determined by comparing the total costs incurred plus recognised
profits to the sum of recognised losses and progress billings.
Any contingent gains or losses, eg due to warranty costs, claims, penalties or possible losses, should be
disclosed in accordance with IAS 37 Provisions, contingent liabilities and contingent assets (detailed later
in this chapter).
4.12 Summary of accounting treatment
The following summarises the accounting treatment for construction contracts.
(a) Revenue and costs
(i) Sales revenue and associated costs should be recorded in the income statement/statement
of comprehensive income as the contract activity progresses.
(ii) Include an appropriate proportion of total contract value as sales revenue in the income
statement/statement of comprehensive income.
(iii) The costs incurred in reaching that stage of completion are matched with this sales revenue,
resulting in the reporting of results which can be attributed to the proportion of work completed.
(iv) Sales revenue is the value of work carried out to date.
(b) Profit recognised in the contract
(i) It must reflect the proportion of work carried out.
(ii) It should take into account any known inequalities in profitability in the various stages of a
contract.
IAS 11 states that the statement of financial position should disclose two items:
(a) the gross amount due from customers for contract work as an asset; and
(b) the gross amount due to customers for contract work as a liability.
The gross amount due from customers for contract work is the net amount of:
(a) costs incurred plus recognised profits; less
(b) the sum of recognised losses and progress billings for all contracts in progress for which costs
incurred plus recognised profits (less losses) exceed progress billings.
The gross amount due to customers for contract work is the net amount of:
(a) costs incurred plus recognised profits; less
(b) the sum of recognised losses and progress billings for all contracts in progress for which progress
billings exceed costs incurred plus recognised profits (less losses).
In the December 2006 paper, seven marks were available for discussion of the correct method of
accounting for construction contracts and performing related calculations. The examiner commented that
only a minority of candidates were able to provide the correct calculations.
In the June 2010 paper a full 20 mark question was set on construction contracts. The first 4 marks were
for discussion of why profits on construction contracts can be recognised before completion of the
contract. The second part of the question required calculations of revenue, costs, profit and statement of
financial position figures for two contracts. The examiner commented that two particular problems with
answers were that the fact that one contract was expected to the profitable whereas the other was
potentially loss making was not recognised and that the stage of completion of the contract was not taken
into account.

Activity 6.3

Haggrun Co has two contracts in progress, the details of which are as follows.
Happy (profitable) Grumpy (loss-making)
$'000 $'000
Total contract price 300 300
Costs incurred to date 90 150
Estimated costs to completion 135 225
Progress payments invoiced and received 116 116
Required
Show extracts from the income statement and the statement of financial position for each contract,
assuming they are both:
(a) 40% complete; and
(b) 36% complete.

5 Liabilities
Liabilities must be split in the statement of financial position between current and non-current liabilities.
A liability should be classified as a current liability when it:
is expected to be settled in the normal course of the entity's operating cycle; or
is due to be settled within twelve months of the reporting date; or
the entity does not have an unconditional right to defer settlement of the liability for at least twelve
months after the reporting date.
All other liabilities should be classified as non-current liabilities. (IAS 1)
The categorisation of current liabilities is very similar to that of current assets. Thus, some current
liabilities are part of the working capital used in the normal operating cycle of the business (ie trade
payables and accruals for employee and other operating costs). Such items will be classed as current
liabilities even where they are due to be settled more than twelve months after the reporting date.
There are also current liabilities which are not settled as part of the normal operating cycle, but which are
due to be settled within twelve months of the reporting date. These include bank overdrafts, income taxes,

other non-trade payables and the current portion of interest-bearing liabilities. Any interest-bearing
liabilities that are used to finance working capital on a long-term basis, and that are not due for settlement
within twelve months, should be classed as non-current liabilities.
As we saw in Section 1 current liabilities include trade and other payables.
This is normally analysed in the accounts as follows:
(a) Trade payables
(b) Income tax payable
(c) Dividends payable
(d) Accrued expenses
(e) Other payables
An accrual represents an expense charged to the income statement/statement of comprehensive income
for which an invoice has not yet been received, and so a debt is not yet payable. For example, there may
be an accrual for four months' rental on a building where the rental is paid every six months in arrears. At
the end of the accounting period, the company would have had the benefit of using the property for four
months, but the rent is not payable for another two months.
Accrued expenses are charged to the income statement/statement of comprehensive income in order to
apply the matching or accruals concept. The dual effect of making an accrual is to reduce capital/profit by
the amount of the accrued expense, and to add to liabilities (since an accrual is a liability).
Deferred income arises when an organisation invoices a customer for goods or services, but some of the
goods or services will not be provided until a future accounting period. For example, a training company
might invoice a trainee for $500 for a course that runs for two weeks in December Year 1 and another two
weeks in January Year 2. If the company's year-end is 31 December, it will include only half the price of
the course ($250) revenue for Year 1. The remaining $250 of income will be deferred until Year 2.
Deferred income is a liability, and the dual effect is + Assets (Cash received or Receivable invoiced) and +
Liability (Deferred income). This would normally form part of accrued expenses.
6 Accounting for leases
Under finance leases
assets acquired should be capitalised
interest element of instalments should be charged against profit
Operating leases are rental agreements and all instalments are charged against profit.
Businesses might acquire some of their non-current assets under a finance lease arrangement. (Some
types of lease are called hire purchase agreements in some countries). In a leasing transaction there is a
contract between the lessor and the lessee for the hire of an asset. The lessor retains legal ownership but
conveys to the lessee the right to use the asset for an agreed period of time in return for specified rentals.
IAS 17 defines a lease and recognises two types.
Lease. An agreement whereby the lessor conveys to the lessee in return for rent the right to use an
asset for an agreed period of time.
Finance lease. A lease that transfers substantially all the risks and rewards incidental to ownership
of an asset. Title may or may not eventually be transferred.
Operating lease. A lease other than a finance lease.
The essential distinction between a finance lease and an operating lease is that with a finance lease, the
lessee obtains and uses the asset for most, if not all, of its useful economic life. In substance, the lessee
obtains a long-term asset from the lessor, but pays for it in the form of lease rentals over the term of the
lease agreement. In contrast, an operating lease is a short-term lease, and when the lease agreement
ends, the owner takes back the asset and leases it to someone else.

The term 'lease' here does not refer at all to leasehold property, for which a full market price is paid when
the asset is acquired. Finance leases refer to agreements where the lessee takes an asset without paying
for it, and then makes periodic rental payments.
A finance lease is very similar in substance to a hire purchase agreement. (The difference in law is that
under a hire purchase agreement the customer eventually, after paying an agreed number of instalments,
becomes entitled to exercise an option to purchase the asset. Under a simple leasing agreement,
ownership remains forever with the lessor.)
6.1 Accounting for operating leases: lessees and lessors
Operating leases do not really pose an accounting problem.
(a) The leased asset is the property of the lessor, and is a non-current asset in the lessor's statement
of financial position.
(b) Lease rental payments are income of the lessor and an expense of the lessee.
Lease payments are charged as an expense in the income statement/statement of comprehensive income
on a straight line basis.
6.2 Substance over form in accounting for finance leases
For assets held under

finance leases (including hire purchase) this accounting treatment

would not
disclose the reality of the situation. If a lessor

leases out an asset on a finance lease, the asset will
probably never be seen on his premises or used in his business again. It would be inappropriate for a
lessor to record such an asset as a non-current asset. In reality, what the lessor owns is a stream of
future cash flows receivable from the lessee. The asset is a receivable rather than a non-current
asset.
Similarly, a lessee

may use a finance lease to fund the 'acquisition' of a major asset which he will then use
in his business, perhaps for many years. The substance of the transaction is that the lessee has
acquired a non-current asset, and this is reflected in the accounting treatment prescribed by IAS 17,
even though in law the lessee never becomes the owner of the asset.
Accounting for finance leases (and hire purchase agreements) is an example of showing the substance of
a transaction in the accounts, rather than the 'legal form'. In other words, accounting for finance leases is
an example of the principle of 'substance over form'.
6.3 Accounting for finance leases: the basic rules for lessees
The basic rules in accounting for a finance lease or a hire purchase agreement are, from the perspective of
the lessee, as follows:
(a) The asset acquired under the lease agreement is effectively a non-current asset of the lessee, and
should be accounted for as such.
(b) The leased asset should be shown in the statement of financial position at the lower of the fair
value and the present value of the minimum lease payments.
(c) The leased asset, being a non-current asset, should be depreciated in the normal way, and there
will be an annual charge for depreciation of leased assets against the lessee's income. The asset
should be depreciated over the shorter of the lease term and the asset's useful life.
(d) In effect, the acquisition of the leased asset by the lessee is being financed by the lessor. The
accounts of the lessee will show a liability to the lessor. This is split into the current liability and
long-term liability.
(e) A finance lease commits the lessee to making a stream of future payments to the lessor. Since the
lessor is effectively providing finance for the asset, the rental payments can be divided into two
component elements: interest on the debt and part-repayment of the debt. Each year, there
should be a charge in the income statement/statement of comprehensive income of the lessee for
the interest element. The part-repayment of the debt reduces the outstanding debt to the lessor.
(f) By the end of the lease term, this debt will have reduced to zero, and the liability will have been
settled in full.
The accounts of a company will therefore show leased assets as non-current assets, and there will be a
payable for lease finance as a liability in the statement of financial position. The income
statement/statement of comprehensive income will include an 'interest charge' on the lease finance.
6.4 Accounting for finance leases: the basic rules for lessors
The same principles apply to accounting by lessors for finance leases. The lessor owns the asset legally,
but in substance has surrendered ownership of the asset to the lessee. In return, the lessor has obtained a
long-term receivable.
(a) A lessor cannot treat as non-current assets any items leased under a finance lease arrangement to
a lessee.
(b) A lessor should show instead in its statement of financial position a receivable for the lease finance
split between current and non-current.
(c) Lease payments received should be divided into an interest element and a part-repayment of the
debt element. The interest element should be treated as part of revenue in the income
statement/statement of comprehensive income. The part-repayment of the lease finance debt will
reduce the outstanding balance of the debt in the statement of financial position. By the end of the
lease period, the debt should be repaid in full.
6.5 Example
A company acquires a non-current asset under a finance lease agreement. The asset has an expected
useful life of four years, after which it will have a nil residual value. The asset will be depreciated by the
straight-line method.
The annual lease payments will be $30,000 for four years. The purchase cost of the asset would have been
$100,000. It has been calculated that the interest element in the lease payments ($20,000 in total) will be
as follows:
Year 1 $10,000
Year 2 $6,000
Year 3 $3,000
Year 4 $1,000
The finance lease is accounted for as follows.
(a) The asset is treated as a non-current asset costing $100,000, and depreciated accordingly.
(b) In the income statement/statement of comprehensive income, there will be charges for non-current
asset depreciation and the interest element in the lease payments.
(c) When the non-current asset is acquired, a liability for the finance lease is also created, with a
starting value of $100,000. The liability is gradually repaid over the term of the lease. The
repayments are the annual lease payments minus the interest element, i.e. $20,000 in year 1,
$24,000 in year 2, $27,000 in year 3 and $29,000 in year 4.
Year 1 Year 2 Year 3 Year 4
$ $ $ $
Depreciation 25,000 25,000 25,000 25,000
Interest 10,000 6,000 3,000 1,000

Start

Year 1

Year 2

Year 3

Year 4

$
$
$
$
Non-current asset

Cost

100,000

100,000

100,000

100,000

100,000

Accum. dep'n

25,000

50,000

75,000

100,000

Carrying value

100,000

75,000

50,000

25,000

0

Payable for finance lease

100,000

80,000

56,000

29,000

0

Of which

Current payables

$20,000

$24,000

$27,000

$29,000

Non-current payables

$80,000

$56,000

$29,000

0

6.6 Apportionment of rental payments
As we have already seen when the lessee makes a rental payment it will comprise two elements.
(a) An interest charge on the finance provided by the lessor. This proportion of each payment is
interest payable and interest receivable in the income statements or statements of comprehensive
income of the lessee and lessor respectively.
(b) A repayment of part of the capital cost of the asset. In the lessee's books this proportion of each
rental payment must reduce the outstanding liability. In the lessor's books, it must reduce the
amount owing.
The accounting problem is to decide what proportion of each instalment paid by the lessee represents
interest, and what proportion represents a repayment of the capital advanced by the lessor. There are
three apportionment methods you may encounter:
The actuarial method
The sum-of-the-digits method
The straight line method
The actuarial method is the best and most scientific method. It derives from the common-sense
assumption that the interest charged by a lessor company will equal the rate of return desired by the
company, multiplied by the amount of capital it has invested. (It is sometimes given as the interest rate
implicit in the lease.)
(a) At the beginning of the lease the capital invested is equal to the fair value of the asset (less any
initial deposit paid by the lessee).
(b) This amount reduces as each instalment is paid. It follows that the interest accruing is greatest in
the early part of the lease term, and gradually reduces as capital is repaid. In this section, we will
look at a simple example of the actuarial method.
The sum-of-the-digits method approximates to the actuarial method, splitting the total interest (without
reference to a rate of interest) in such a way that the greater proportion falls in the earlier years. The
procedure is as follows.
(a) Assign a digit to each instalment. The digit 1 should be assigned to the final instalment, 2 to the
penultimate instalment and so on.
(b) Add the digits. A quick method of adding the digits is to use the formula
2
1) n(n +
where n is the
number of instalments. If there are twelve instalments, then the sum of the digits will be 78. For
this reason, the sum of the digits method is sometimes called the rule of 78.
(c) Calculate the interest charge included in each instalment. Do this by multiplying the total interest
accruing over the lease term by the fraction:
digits the of Sum
instalment the to applicable Digit

The straight line method is rarely used in practice but as it is a very simple method then it may appear in
exam questions. Under this method the total amount of interest is spread equally over the period of the
lease and charged to the income statement on that basis.
6.7 Example: apportionment methods
On 1 January 20X0 Pop Co, a drinks supplier, buys a small bottling and labelling machine from Silenus Co
under a finance lease. The cash price of the machine was $7,710 while the amount to be paid was
$10,000. The agreement required the immediate payment of a $2,000 deposit with the balance being
settled in four equal annual instalments commencing on 31 December 20X0. The charge of $2,290
represents interest of 15% per annum, calculated on the remaining balance of the liability during each
accounting period. Depreciation on the plant is to be provided for at the rate of 20% per annum on a
straight line basis assuming a residual value of nil.
You are required to show the breakdown of each instalment between interest and capital, using in turn
each of the apportionment methods described above.
Solution
In this example, enough detail is given to use both of the apportionment methods. In an examination
question, you would normally be directed to use one method specifically.
(a) Sum-of-the-digits method
Each instalment is allocated a digit as follows.
Instalment Digit
1st (20X0) 4
2nd (20X1) 3
3rd (20X2) 2
4th (20X3)
1

10

Or using the formula,
2
5 4
= 10.
The $2,290 interest charges can then be apportioned.

$

1st instalment

$2,290 4/10

916

2nd instalment

$2,290 3/10

687

3rd instalment

$2,290 2/10

458

4th instalment

$2,290 1/10

229

2,290

The breakdown is then as follows.

1st

2nd

3rd

4th

instalment

instalment

instalment

instalment

$

$

$

$

Interest

916

687

458

229

Capital repayment (balance)

1,084

1,313

1,542

1,771

2,000

2,000

2,000

2,000

(b) Actuarial method
Interest is calculated as 15% of the outstanding capital balance at the beginning of each year. The
outstanding capital balance reduces each year by the capital element comprised in each instalment.
The outstanding capital balance at 1 January 20X0 is $5,710 ($7,710 fair value less $2,000 deposit).

Total

Capital

Interest

$

$

$

Capital balance at 1 Jan 20X0

5,710

1st instalment

(interest = $5,710 15%)

2,000

1,144

856


4,566

2nd instalment

(interest = $4,566 15%)

2,000

1,315

685


3,251

3rd instalment

(interest = $3,251 15%)

2,000

1,512

488


1,739

4th instalment

(interest = $1,739 15%)

2,000

1,739

261

8,000

2,290

(c) Straight line method
Under this method the total interest of $2,290 would be written off to the income statement as the
same amount each year of $572.50 ($2,290/4 years).
6.8 Summary
IAS 17 requires various disclosures to be made in the accounts about finance leases (and hire purchase
agreements). The detailed disclosures are not listed here as they are not likely to be required in the exam. If
you are asked a question about leases in your examination, you should remember the basic principles of:
(a) 'substance over form', and what it means
(b) leased assets (finance leases) as non-current assets in the accounts of the lessee
(c) inclusion in the accounts of the lessee of a payable for lease finance
(d) lease payments consisting partly of interest (an expense to the lessee) and partly of repayment of
the lease finance debt
7 Provisions
Under IAS 37 a provision should be recognised when:
an entity has a present obligation, legal or constructive
it is probable that a transfer of economic benefits will be required to settle it
a reliable estimate can be made of its amount
IAS 37 Provisions, contingent liabilities and contingent assets aims to ensure that appropriate recognition
criteria and measurement bases are applied to provisions, contingent liabilities and contingent assets
and that sufficient information is disclosed in the notes to the financial statements to enable users to
understand their nature, timing and amount.
Before IAS 37, there was no accounting standard dealing with provisions. Companies wanting to show
their results in the most favourable light used to make large 'one off' provisions in years where a high level
of underlying profits was generated. These provisions, often known as 'big bath' provisions, were then
available to shield expenditure in future years when perhaps the underlying profits were not as good.
In other words, provisions were used in the past for profit smoothing. Profit smoothing is misleading.
The key aim of IAS 37 is to ensure that provisions are made only where there are valid grounds for them.
IAS 37 views a provision as a liability.
A provision is a liability of uncertain timing or amount.
A liability is an obligation of an entity to transfer economic benefits as a result of past transactions or
events. (IAS 37)
The IAS distinguishes provisions from other liabilities such as trade payables and accruals. This is on the
basis that for a provision there is uncertainty about the timing or amount of the future expenditure. Whilst
some uncertainty is clearly present in the case of certain accruals this is generally much less than for
provisions.
7.1 Recognition
IAS 37 states that a provision should be recognised as a liability in the financial statements when:
An entity has a present obligation (legal or constructive) as a result of a past event
It is probable that a transfer of economic benefits will be required to settle the obligation
A reliable estimate can be made of the obligation
IAS 37 defines a constructive obligation as
'An obligation that derives from an entity's actions where:
by an established pattern of past practice, published policies or a sufficiently specific current
statement the entity has indicated to other parties that it will accept certain responsibilities; and
as a result, the entity has created a valid expectation on the part of those other parties that it will
discharge those responsibilities.'

Activity 6.4

In which of the following circumstances might a provision be recognised at 31 December 20X9?
(a) On 13 December 20X9 the board of an entity decided to close down a division. The accounting date
of the company is 31 December. Before 31 December 20X9 the decision was not communicated to
any of those affected and no other steps were taken to implement the decision.
(b) The board agreed a detailed closure plan on 20 December 20X9 and details were given to
customers and employees.
(c) A company is obliged to incur clean up costs for environmental damage (that has already been
caused).
(d) A company intends to carry out future expenditure to operate in a particular way in the future.

7.2 Probable transfer of economic benefits
For the purpose of the IAS, a transfer of economic benefits is regarded as 'probable' if the event is more
likely than not to occur. This appears to indicate a probability of more than 50%. However, the standard
makes it clear that where there is a number of similar obligations the probability should be based on
considering the population as a whole, rather than one single item.
7.3 Example: transfer of economic benefits
If a company has entered into a warranty obligation then the probability of transfer of economic benefits
may well be extremely small in respect of one specific item. However, when considering the population as
a whole the probability of some transfer of economic benefits is quite likely to be much higher. If there is a
greater than 50% probability of some transfer of economic benefits then a provision should be made for
the expected amount.
7.4 Measurement of provisions
The amount recognised as a provision should be the best estimate of the expenditure required to settle the
present obligation at the reporting date.
The estimates will be determined by the judgement of the entity's management supplemented by the
experience of similar transactions.
Allowance is made for uncertainty. Where the provision being measured involves a large population of
items, the obligation is estimated by weighting all possible outcomes by their associated probabilities, ie
expected value.
7.5 Example
Parker Co sells goods with a warranty under which customers are covered for the cost of repairs of any
manufacturing defect that becomes apparent within the first six months of purchase. The company's past
experience and future expectations indicate the following pattern of likely repairs.
Cost of repairs if all items
% of goods sold Defects suffered from these defects
$m
75 None
20 Minor 1.0
5 Major 4.0
What is the expected cost of repairs?
The cost is found using 'expected values' (75% $nil) + (20% $1.0m) + (5% $4.0m) = $400,000.
Where the effect of the time value of money is material, the amount of a provision should be the present
value of the expenditure required to settle the obligation. An appropriate discount rate should be used.
The discount rate should be a pre-tax rate that reflects current market assessments of the time value of
money. The discount rate(s) should not reflect risks for which future cash flow estimates have been
adjusted.
Future events which are reasonably expected to occur (eg new legislation, changes in technology) may
affect the amount required to settle the entity's obligation and should be taken into account.
Gains from the expected disposal of assets should not be taken into account in measuring a provision.
Some or all of the expenditure needed to settle a provision may be expected to be recovered from a third
party. If so, the reimbursement should be recognised only when it is virtually certain that
reimbursement will be received if the entity settles the obligation.
The reimbursement should be treated as a separate asset, and the amount recognised should not
be greater than the provision itself.
The provision and the amount recognised for reimbursement may be netted off in the income
7.6 Changes in provisions
Provisions should be reviewed at each reporting date and adjusted to reflect the current best estimate. If a
provision is to be increased the amount of the increase will be a charge to the income statement and a
credit to the provision. If a provision is to be decreased the amount of the decrease will be a credit to the
income statement and debit to the provision.
If it is no longer probable that a transfer of economic benefits will be required to settle the obligation, the
provision should be reversed.
7.7 Use of provisions
A provision should be used only for expenditures for which the provision was originally recognised.
Setting expenditures against a provision that was originally recognised for another purpose would conceal
the impact of two different events.
7.8 Future operating losses
Provisions should not be recognised for future operating losses. They do not meet the definition of a
liability and the general recognition criteria set out in the standard.
7.9 Onerous contracts
If an entity has a contract that is onerous, the present obligation under the contract should be recognised
and measured as a provision. An example might be vacant leasehold property.
An onerous contract is a contract entered into with another party under which the unavoidable costs of
fulfilling the terms of the contract exceed any revenues expected to be received from the goods or services
supplied or purchased directly or indirectly under the contract and where the entity would have to
compensate the other party if it did not fulfil the terms of the contract.
7.10 Examples of possible provisions
It is easier to see what IAS 37 is driving at if you look at examples of those items which are possible
provisions under this standard. Some of these we have already touched on.
(a) Warranties. These are argued to be genuine provisions as on past experience it is probable, ie more
likely than not, that some claims will emerge. The provision must be estimated, however, on the basis
of the class as a whole and not on individual claims. There is a clear legal obligation in this case.
(b) Major repairs. In the past it has been quite popular for companies to provide for expenditure on a
major overhaul to be accrued gradually over the intervening years between overhauls. Under IAS
37 this is no longer possible as IAS 37 would argue that this is a mere intention to carry out
repairs, not an obligation. The entity can always sell the asset in the meantime. The only solution is
to treat major assets such as aircraft, ships, furnaces etc as a series of smaller assets where each
part is depreciated over shorter lives. Thus any major overhaul may be argued to be replacement
and therefore capital rather than revenue expenditure.
(c) Self insurance. A number of companies have created a provision for self insurance based on the
expected cost of making good fire damage etc instead of paying premiums to an insurance
company. Under IAS 37 this provision is no longer justifiable as the entity has no obligation until a
fire or accident occurs. No obligation exists until that time.
(d) Environmental contamination. If the company has an environmental policy such that other parties
would expect the company to clean up any contamination or if the company has broken current
environmental legislation then a provision for environmental damage must be made.
(e) Decommissioning or abandonment costs. When an oil company initially purchases an oilfield it is
put under a legal obligation to decommission the site at the end of its life. Prior to IAS 37 most oil
companies set up the provision gradually over the life of the field so that no one year would be
unduly burdened with the cost.
IAS 37, however, insists that a legal obligation exists on the initial expenditure on the field and
therefore a liability exists immediately. This would appear to result in a large charge to profit and
loss in the first year of operation of the field. However, the IAS takes the view that the cost of
purchasing the field in the first place is not only the cost of the field itself but also the costs of
putting it right again. Thus all the costs of abandonment may be capitalised.
(f) Restructuring. This is considered in detail below.
7.11 Provisions for restructuring
One of the main purposes of IAS 37 was to target abuses of provisions for restructuring. Accordingly, IAS
37 lays down strict criteria to determine when such a provision can be made.
IAS 37 defines a restructuring as:
A programme that is planned and is controlled by management and materially changes one of two things.
The scope of a business undertaken by an entity
The manner in which that business is conducted
The IAS gives the following examples of events that may fall under the definition of restructuring.
The sale or termination of a line of business
The closure of business locations in a country or region or the relocation of business activities
from one country region to another
Changes in management structure, for example, the elimination of a layer of management
Fundamental reorganisations that have a material effect on the nature and focus of the entity's
operations
The question is whether or not an entity has an obligation - legal or constructive - at the reporting date.
For this to be the case:
An entity must have a detailed formal plan for the restructuring
It must have raised a valid expectation in those affected that it will carry out the restructuring by
starting to implement that plan or announcing its main features to those affected by it
A mere management decision is not normally sufficient. Management decisions may sometimes trigger
off recognition, but only if earlier events such as negotiations with employee representatives and other
interested parties have been concluded subject only to management approval.
Where the restructuring involves the sale of an operation then IAS 37 states that no obligation arises until
the entity has entered into a binding sale agreement. This is because until this has occurred the entity will
be able to change its mind and withdraw from the sale even if its intentions have been announced publicly.
The IAS states that a restructuring provision should include only the direct expenditures arising from the
restructuring, which are those that are both:
Necessarily entailed by the restructuring; and
Not associated with the ongoing activities of the entity.
The following costs should specifically not be included within a restructuring provision.
Retraining or relocating continuing staff
Marketing
Investment in new systems and distribution networks
7.12 Disclosure
Disclosures for provisions fall into two parts.
Disclosure of details of the change in carrying value of a provision from the beginning to the end
of the year
Disclosure of the background to the making of the provision and the uncertainties affecting its
outcome
8 Contingencies
An entity should not recognise a contingent asset or liability, but they may require disclosure.
Now you understand provisions it will be easier to understand contingent assets and liabilities.
IAS 37 defines a contingent liability as:
A possible obligation that arises from past events and whose existence will be confirmed only by
the occurrence or non-occurrence of one or more uncertain future events not wholly within the
entity's control; or
A present obligation that arises from past events but is not recognised because:
It is not probable that a transfer of economic benefits will be required to settle the
obligation; or
The amount of the obligation cannot be measured with sufficient reliability.
As a rule of thumb, probable means more than 50% likely. If an obligation is probable, it is not a
contingent liability instead, a provision is needed.
8.1 Treatment of contingent liabilities
Contingent liabilities should not be recognised in financial statements but they should be disclosed. The
required disclosures are:
A brief description of the nature of the contingent liability
An estimate of its financial effect
An indication of the uncertainties that exist
The possibility of any reimbursement
8.2 Contingent assets
IAS 37 defines a contingent asset as:
A possible asset that arises from past events and whose existence will be confirmed by the occurrence or
non-occurrence of one or more uncertain future events not wholly within the entity's control.
A contingent asset must not be recognised. Only when the realisation of the related economic benefits is
virtually certain should recognition take place. At that point, the asset is no longer a contingent asset!
8.3 Disclosure
A brief description must be provided of all material contingent liabilities unless the possibility of
payment is remote. In addition, provide
An estimate of their financial effect
Details of any uncertainties
The possibility of any reimbursement

Contingent assets must only be disclosed in the notes if they are probable. In that case a brief description
of the contingent asset should be provided along with an estimate of its likely financial effect.
8.4 'Let out'
IAS 37 permits reporting entities to avoid disclosure requirements relating to provisions, contingent
liabilities and contingent assets if they would be expected to seriously prejudice the position of the entity
in dispute with other parties. However, this should only be employed in extremely rare cases. Details of
the general nature of the provision/contingencies must still be provided, together with an explanation of
why it has not been disclosed.
8.5 Flow chart
Study the flow chart, taken from IAS 37, which is a good summary of its requirements concerning provisions
and contingent liabilities.

9 Events after the reporting period
IAS 10 deals with events occurring after the reporting period. It distinguishes between adjusting and
non-adjusting events and gives examples. You should be able to define and discuss all these terms and
apply them to practical examples.
The financial statements are significant indicators of a company's success or failure. It is important,
therefore, that they include all the information necessary for an understanding of the company's position.
IAS 10 (Revised) Events after the reporting period requires the provision of additional information in order
to facilitate such an understanding. IAS 10 deals with events after the reporting period which may affect
the position at the end of the reporting period. (Note that prior to the revision of IAS 1, IAS 10 was called
'Events after the balance sheet date'.)
The standard gives the following definition.
Events occurring after the reporting period are those events, both favourable and unfavourable, that
occur between the end of the reporting period and the date on which the financial statements are
authorised for issue. Two types of events can be identified.
Those that provide evidence of conditions that existed at the end of the reporting period
Those that are indicative of conditions that arose after the end of the reporting period (IAS 10)
Between the reporting date and the date the financial statements are authorised (ie for issue outside the
organisation), events may occur which show that assets and liabilities at the end of the reporting period
should be adjusted, or that disclosure of such events should be given.
9.1 Events requiring adjustment
The standard requires adjustment of assets and liabilities where the event arising after the reporting period
provides evidence of conditions that existed at the end of the reporting period. This is an adjusting event.
An entity shall adjust the amounts recognised in its financial statements to reflect adjusting events after
the end of the reporting period. An entity shall not adjust the amounts recognised in its financial
statements to reflect non-adjusting events after the end of the reporting period. (IAS 10)
An example of additional evidence which becomes available after the end of the reporting period is where
a customer goes bankrupt, thus confirming that the trade account receivable balance at the year end is
uncollectable.
In relation to going concern, the standard states that, where operating results and the financial position
have deteriorated after the end of the reporting period, it may be necessary to reconsider whether the
going concern assumption is appropriate in the preparation of the financial statements.
9.2 Events not requiring adjustment
The standard then looks at events which do not require adjustment. These non-adjusting events do not
provide evidence of a condition which existed at the reporting date.
If non-adjusting events after the end of the reporting period are material, non-disclosure could influence the
economic decisions of users taken on the basis of the financial statements. Accordingly, an entity shall
disclose the following for each material category of non-adjusting event after the end of the reporting period:
(a) the nature of the event; and
(b) an estimate of its financial effect, or a statement that such an estimate cannot be made. (IAS 10)

The example given by the standard of such an event is where the value of an investment falls between
the end of the reporting period and the date the financial statements are authorised for issue. The fall
in value represents circumstances during the current period, not conditions existing at the previous
reporting date, so it is not appropriate to adjust the value of the investment in the financial statements.
Disclosure is an aid to users, however, indicating 'unusual changes' in the state of assets and liabilities
after the end of the reporting period.
The rule for disclosure of events occurring after the end of the reporting period which relate to conditions
that arose after that date, is that disclosure should be made if non-disclosure would hinder the user's
ability to make proper evaluations and decisions based on the financial statements. An example might be
the acquisition of another business.
9.3 Dividends
Dividends on equity shares declared by the entity after the reporting date should not be recognised as a
liability at the reporting date, but should be disclosed in the notes to the financial statements.
9.4 Disclosures
The following disclosure requirements are given for events which occur after the end of the reporting
period which do not require adjustment. If disclosure of events occurring after the end of the reporting
period is required, the following information should be provided.
(a) The nature of the event
(b) An estimate of the financial effect, or a statement that such an estimate cannot be made

Activity 6.5

State whether the following events occurring after the end of the reporting period require an adjustment to
the assets and liabilities of the financial statements.
(a) Purchase of an investment
(b) A change in the rate of corporate tax, applicable to the previous year
(c) An increase in pension benefits
(d) Losses due to fire
(e) A bad debt suddenly being paid
(f) The receipt of proceeds of sales or other evidence concerning the net realisable value of inventory
(g) A sudden decline in the value of property held as a long-term asset

10 Reporting the substance of transactions
There has been some concern about the use of creative accounting methods. In particular 'off-balance
sheet' financing transactions might be used to keep assets or liabilities off a company's statement of
financial position. Attempts have been made to restrict these practices.

10.1 'Off balance sheet' finance
'Off balance sheet' finance is the funding or refinancing of a company's operations in such a way that,
under legal requirements and traditional accounting conventions, some or all of the finance may not be
shown on its statement of financial position.
'Off balance sheet transactions' are transactions which meet the above objective. These transactions may
involve the removal of assets from the statement of financial position as well as liabilities, and they are
also likely to have a significant impact on the income statement/statement of comprehensive income.
Why might company managers wish to enter into such transactions?
(a) In some countries, companies traditionally have a lower level of gearing than companies in other
countries. Off balance sheet finance is used to keep gearing low, probably because of the views of
analysts and brokers.
(b) A company may need to keep its gearing down in order to stay within the terms of loan covenants
imposed by lenders.
(c) A quoted company with high borrowings is often expected (by analysts and others) to declare a
rights issue in order to reduce gearing. This has an adverse effect on a company's share price and
so off balance sheet financing is used to reduce gearing and the expectation of a rights issue.
(d) Analysts' short term views are a problem for companies developing assets which are not
producing income during the development stage. Such companies will match the borrowings
associated with such developing assets, along with the assets themselves, 'off balance sheet.' They
are brought back onto the statement of financial position once income is being generated by the
assets. This process keeps return on capital employed higher than it would have been during the
development stage.
(e) In the past, groups of companies have excluded subsidiaries from consolidation in an 'off balance
sheet' transaction because they carry out completely different types of business and have different
characteristics. The usual example is a leasing company (in say a retail group) which has a high
level of gearing.
You can see from this brief list of reasons that the overriding motivation is to avoid misinterpretation. In
other words, the company does not trust the analysts or other users to understand the reasons for a
transaction and so avoids any effect such transactions might have by taking them 'off balance sheet'.
Unfortunately, the position of the company is then misstated and the user of the accounts is misled.
You must understand that not all forms of 'off balance sheet finance' are undertaken for cosmetic or
accounting reasons. Some transactions are carried out to limit or isolate risk, to reduce interest costs
and so on. In other words, these transactions are in the best interests of the company, not merely a
cosmetic repackaging of figures which would normally appear in the statement of financial position.
The result of the use of increasingly sophisticated 'off balance sheet' finance transactions is a situation
where the users of financial statements do not have a proper or clear view of the state of the company's
affairs. The disclosures required by national company law and accounting standards did not in the past
provide sufficient rules for disclosure of 'off balance sheet' finance transactions and so very little of the
true nature of the transaction was exposed.
Whatever the purpose of such transactions, insufficient disclosure creates a problem. This problem has
been debated over the years by the accountancy profession and other interested parties and some
progress has been made. However, company collapses during recessions have often revealed much
higher borrowings than originally thought, because part of the borrowing was 'off balance sheet'.
The main argument used for banning 'off balance sheet' finance is that the true substance of the
transactions should be shown, not merely the legal form, particularly when it is exacerbated by poor
disclosure.
10.2 Substance over form
The concept of 'substance over form' is described in IAS 17 Leases as follows.
'Transactions and other events are accounted for and presented in accordance with their substance and
financial reality and not merely with legal form.' This concept is designed to reduce the use of off balance
sheet finance and to make accounting statements more transparent to users. The financial statements will
reflect the economic substance of transactions rather than their strict legal form.
An application of this principle in relation to accounting for finance leases has already been described. The
legal form is that the lessor owns the leased asset, but in substance the lessee is the owner.
Other examples include sale or return transactions and arrangements to raise finance on maturing
inventory (see 10.6 below).
Another issue involving substance over form is the establishment of 'quasi subsidiaries' by a company. A
quasi-subsidiary is an organisation that does not meet the definition of a subsidiary company, under the
control of its parent company, but operates just like a subsidiary. At one time, companies did not have to
include quasi-subsidiaries in their consolidated accounts ('group accounts').
Some companies used 'off balance sheet' transactions with quasi-subsidiaries to manipulate their
accounts. Examples of 'off balance sheet' transactions that were undertaken at one time are as follows.
(a) Sale of assets. The sale of assets to a quasi-subsidiary would be carried out to remove the
associated borrowings from the statement of financial position of the company, or perhaps so that
the company could credit a profit in such a transaction. The asset would then be rented back to the
vendor company under an operating lease (no capitalisation required by the lessee).
(b) Purchase of companies or assets. One reason for such a purchase through a quasi-subsidiary is if
the acquired entity is expected to make losses in the near future. Post-acquisition losses can be
avoided by postponing the date of acquisition to the date the holding company acquires the
purchase from the quasi-subsidiary.
IAS 27 Consolidated and separate financial statements contains a definition of a subsidiary based on
control rather than just ownership rights, thus substantially reducing the effectiveness of this method of
'off-balance sheet' financing. We will look at this definition in Chapter 10.
10.3 Creative accounting
Creative accounting is the manipulation of figures for a desired result. It can take various forms, and
might make use of 'off balance sheet' finance.
It is very rare for a company or its directors to manipulate results for the purpose of fraud. The major
consideration with creative accounting is usually the effect the results will have on the share price of the
company.
Analysts, brokers and economists, whose opinions affect the stock markets, are often perceived as having
an outlook which is both short-term and superficial. Consequently, companies will attempt to produce the
results the market expects or wants. The companies will aim for steady progress in a few key numbers
and ratios and they will aim to meet the market's stated expectation.
Some examples of creative accounting are described below.
10.4 Revenue recognition and year-end cut-off
A company may issue invoices before the year end and inflate sales for the current year, when in fact they
have not received firm orders for the goods.
Another example of recognising income before it should properly be recognised is where a company sells
software under contract, and the sales contracts will only be realised in full over a period of time. The
company might recognise the full sales value of the contract as soon as it has been secured, even though
some payments from clients will fall due over several years. This is clearly imprudent, but the company
might justify it by pointing to the irrevocable nature of the contract. But what if a customer should go in to
liquidation? If a customer went into liquidation, no further income would be received from the contract,
but the company would already have credited this non-existent income to its profits in a previous year.
10.5 Reserves
Reserves are often used to manipulate figures, and to avoid any adverse impact on the profit for the year.
This occurs particularly in situations where an accounting standard allows a choice of treatments. Recent
standards have aimed to reduce these choices.
10.6 Examples of 'off balance sheet' finance
Consignment goods are an arrangement where inventory is held by one party (say a distributor) but is
owned by another party (for example a manufacturer or a finance company). Consignment goods are
common in the motor trade and are similar to goods sold on a 'sale or return' basis.
To identify the correct accounting treatment of consignment goods, it is necessary to identify the point at
which the distributor acquired the benefits of the asset (the goods) rather than the point at which legal title
was acquired. If the manufacturer has the right to require the return of goods, and if that right is likely to
be exercised, then the goods are not an asset of the dealer. If the dealer is rarely required to return the
goods, then this part of the transaction will have little commercial effect in practice and should be ignored
for accounting purposes. The potential liability would need to be disclosed in the accounts.
Sale or return transactions are where goods are sent to a customer on the agreement that they can be
returned within a certain period. Generally the sale will not be recognised until this time period has passed.
Sale and repurchase agreements are arrangements under which an asset is sold by one party to another
on terms that provide for the seller to repurchase the assets in future. The aim of the transaction is for the
seller to raise finance currently but to be able to retain the goods in the longer term. These transactions
are often found with properties and maturing inventory such as whisky. In many of these cases it will be
seen that in substance this was not a sale at all but a secured loan transaction and should be accounted
for as such.
Sale and leaseback transactions are arrangements under which the company sells an asset (eg a
building) to another person on the terms that allow the company to lease back the asset in certain
circumstances. The key question is whether the transaction is a straightforward sale, or whether it is, in
effect, a secured loan. It is necessary to look at the arrangement to determine who has the rights to the
economic benefits that the asset generates, and the terms on which the asset is to be leased back.
10.7 Example of sale and repurchase transaction
Ark Co sells its office building to XY Bank on 1 January 20X6 for $100m. At that date, the market price of
the building is $130m. Ark has committed to buy back the building on 1 January 20X9 for $130m.
Ark Co has derecognised the building from its accounts on the sale to XY Bank, but will continue to
occupy the building. Consider the accounting treatment of this transaction.
Solution
The substance of this transaction is different from its legal form. Legally, Ark Co has sold an asset.
However, because of the commitment to repurchase the asset in three years' time, the substance of the
transaction is not an asset sale, rather it is a secured loan from XY Bank to Ark Co.
The first indicator of a secured loan is that Ark Co sold its building for less than its market value. In an
arms length transaction, this would be very unusual.
The commitment to repurchase the asset suggests that Ark Co did not sell the asset, but used it as
security for the loan. Additionally, Ark Co retains the right to occupy the building, therefore receiving the
benefits of ownership.
The substance of the transaction is that XY Bank has lent Ark Co $100m, secured on the asset. Ark Co will
repay the loan by repurchasing the building and the $30m difference between the sale and repurchase
price is interest paid to XY Bank.
Ark Co must retain the asset in the statement of financial position, and must recognise the 'proceeds' of
$100m as a loan from XY Bank. Over the three year period the $30m interest will be charged in the income
413 6: Reporting financial performance

1 IAS 8: Accounting policies, changes in accounting
estimates and errors

Changes in accounting policy and prior period errors should be dealt with retrospectively. In other words,
brought forward and comparative amounts should be presented as if the new accounting policy had
always been in place, or the error had never occurred. Changes in accounting estimates should be dealt
with prospectively. In other words, brought forward and comparative amounts are not amended, and the
new accounting estimate is applied going forward.
1.1 Accounting policies
Accounting policies are the specific principles, bases, conventions, rules and practices adopted by an
entity in preparing and presenting financial statements.
Accounting policies are determined by applying the relevant accounting standards. Where there is no
applicable accounting standard, management should use its judgement in developing and applying an
accounting policy that results in information that is relevant and reliable.
Examples of accounting policies are:
the valuation of inventories using FIFO
the depreciation of non-current assets.
1.2 Changes in accounting policies
The same accounting policies are usually adopted from period to period, to allow users to analyse trends
over time in profit, cash flows and financial position.
Changes in accounting policy are rare and should be made only if required:
(a) By statute

(b) By an accounting standard setting body

(c) To result in a more appropriate presentation of events or transactions in the financial statements
of the entity
IAS 8 requires that a change in accounting policy is applied retrospectively. In other words, brought
forward and comparative amounts are presented as if the new accounting policy had always been in place.
This will result in an adjustment to the retained earnings balance brought forward in the statement of
changes in equity. The adjustment is the cumulative effect of the change.

Reporting financial
performance
6: Reporting financial performance 414
Certain disclosures are required when a change in accounting policy has a material effect on the current
period or any prior period presented, or when it may have a material effect in subsequent periods.
(a) Reasons for the change
(b) Amount of the adjustment for the current period and for each period presented
(c) Amount of the adjustment relating to periods prior to those included in the comparative
information
(d) The fact that comparative information has been restated or that it is impracticable to do so
1.3 Example
An entity values its inventory using the average weighted cost method. Closing inventory is valued at 31
December 20X6 as $12,600. During 20X7, the entity decides that use of the FIFO method to value
inventory would result in fairer presentation. Closing inventory at 31 December 20X6 would have been
valued at $12,450 using this method.
In the 20X7 financial statements:
Cost of sales in the 20X7 financial statements should be calculated based on opening inventory of
$12,450.
The 20X6 comparative figure should be calculated based on closing inventory of $12,450.
The 20X6 comparative statement of financial position should report inventory as $12,450.
In the 20X7 statement of changes in equity, an adjustment of $150 should be made to the retained
earnings balance brought forward.
1.4 Accounting estimates
Accounting estimates are judgements made in order to arrive at estimated amounts for the financial
statements.
Estimates arise in relation to business activities because of the uncertainties inherent within them.
Judgements are made based on the most up to date information; examples include
(a) An allowance for receivables

(b) Useful lives of depreciable assets
(c) An allowance for obsolescence of inventory

1.5 Changes in accounting estimates
Changes in accounting estimates are dealt with prospectively. In other words the change is applied from
the date of the change, but does not result in the restatement of brought forward or comparative balances.
The nature and amount of a change in an accounting estimate that has a material effect in the current
period (or which is expected to have a material effect in subsequent periods) should be disclosed. If it is
not possible to quantify the amount, this impracticability should be disclosed.
1.6 Example
An entity calculates its allowance for receivables as 2% of the year end receivables balance. At the 20X6
year end, the receivables balance is $430,000. At the end of 20X7, the entity decides to change its
allowance to 3% of year end receivables, in response to economic conditions. The receivables balance at
the 20X7 year end is $480,000.
If it is impracticable to determine the cumulative amount of change, prospective application is allowed.
In other words the new policy is applied from the date of the change in policy, but brought forward and
comparative amounts are not restated.
1.7 Errors
Errors discovered during a current period which relate to a prior period may arise for a number of
reasons, including fraud.
Material prior period errors must be corrected retrospectively (i.e. the financial statements are presented
as if the error had never occurred). This involves:
(a) restating the comparative amounts for the prior period(s) in which the error occurred, or
(b) if the error occurred before the earliest prior period presented, restating the opening balances of
assets, liabilities and equity for that period
If it is impracticable to determine the cumulative effect of an error on prior periods, an entity can correct
an error prospectively.
Various disclosures are required, providing information about the nature of the error and its effect on the
financial results.
2 IFRS 5: Non-current assets held for sale and

discontinued operations
IFRS 5 requires assets 'held for sale' to be presented separately on the face of the statement of financial
position.
2.1 Background
IFRS 5 deals with two distinct issues:
the measurement and presentation of non-current assets held for sale, and
the presentation of discontinued operations
It requires assets and groups of assets that are held for sale to be presented separately on the face of
the statement of financial position.
It also requires the results of discontinued operations to be presented separately in the income
statement or statement of comprehensive income.
The purpose of these requirements is to help users of financial statements make projections about the
financial position, profits and cash flows of the entity.
IFRS 5 does not apply to certain assets covered by other accounting standards including:
Deferred tax assets (IAS 12)
Investment properties accounted for in accordance with the fair value model (IAS 40)
2.2 Classification of assets held for sale
A non-current asset (or disposal group) should be classified as held for sale if its carrying amount will be
recovered principally through a sale transaction rather than through continuing use. A number of
detailed criteria must be met:
(a) The asset must be available for immediate sale in its present condition.
(b) Its sale must be highly probable (ie, significantly more likely than not).

The change from a 2% to 3% allowance is a change in accounting estimate. The allowance for receivables
at the 20X6 year end, calculated as $8,600 (2% x $430,000) is not restated. The allowance for receivables
at the 20X7 year end is calculated as $14,400, based on the revised estimate of 3%. The increase in
allowance of $5,800 is charged to profits as normal.
Disposal group a group of assets to be disposed of, by sale or otherwise, together as a group in a single
transaction, and liabilities directly associated with those assets that will be transferred in the transaction.
(In practice a disposal group could be a subsidiary, a cash-generating unit or a single operation within an
entity.) (IFRS 5)
For the sale to be highly probable, the following must apply.
(a) Management must be committed to a plan to sell the asset.
(b) There must be an active programme to locate a buyer.
(c) The asset must be marketed for sale at a price that is reasonable in relation to its current fair
value.
(d) The sale should be expected to take place within one year from the date of classification.
(e) It is unlikely that significant changes to the plan will be made or that the plan will be withdrawn.
An asset (or disposal group) can still be classified as held for sale, even if the sale has not actually taken
place within one year. However, the delay must have been caused by events or circumstances beyond the
entity's control and there must be sufficient evidence that the entity is still committed to sell the asset or
disposal group. Otherwise the entity must cease to classify the asset as held for sale.
If an entity acquires a disposal group (eg, a subsidiary) exclusively with a view to its subsequent disposal
it can classify the asset as held for sale only if the sale is expected to take place within one year and it is
highly probable that all the other criteria will be met within a short time (normally three months).
An asset that is to be abandoned should not be classified as held for sale. This is because its carrying
amount will be recovered principally through continuing use. However, a disposal group to be abandoned
may meet the definition of a discontinued operation and therefore separate disclosure may be required
(see below).

Activity 7.1

On 1 December 20X3, a company became committed to a plan to sell a manufacturing facility and has
already found a potential buyer. The company does not intend to discontinue the operations currently
carried out in the facility. At 31 December 20X3 there is a backlog of uncompleted customer orders. The
company will not be able to transfer the facility to the buyer until after it ceases to operate the facility and
has eliminated the backlog of uncompleted customer orders. This is not expected to occur until spring
20X4.
Required
Can the manufacturing facility be classified as held for sale at 31 December 20X3?

2.3 Measurement of assets held for sale
Fair value: the amount for which an asset could be exchanged, or a liability settled, between
knowledgeable, willing parties in an arms length transaction.
Costs to sell: the incremental costs directly attributable to the disposal of an asset (or disposal
group), excluding finance costs and income tax expense.
Recoverable amount: the higher of an asset's fair value less costs to sell and its value in use.
Value in use: the present value of estimated future cash flows expected to arise from the
continuing use of an asset and from its disposal at the end of its useful life.
A non-current asset (or disposal group) that is held for sale should be measured at the lower of its
carrying amount and fair value less costs to sell. Fair value less costs to sell is equivalent to net
realisable value.
An impairment loss should be recognised where fair value less costs to sell is lower than carrying amount.
(see Chapter 8)
Non-current assets held for sale should not be depreciated, even if they are still being used by the entity.
A non-current asset (or disposal group) that is no longer classified as held for sale (for example,
because the sale has not taken place within one year) is measured at the lower of:
(a) its carrying amount before it was classified as held for sale, adjusted for any depreciation that
would have been charged had the asset not been held for sale
(b) its recoverable amount at the date of the decision not to sell
2.4 Presentation of a non-current asset or disposal group classified as
held for sale
Non-current assets and disposal groups classified as held for sale should be presented separately from
other assets in the statement of financial position. The liabilities of a disposal group should be presented
separately from other liabilities in the statement of financial position.
2.5 Presenting discontinued operations
The results of discontinued operations should be presented separately in the income statement or
statement of comprehensive income.
An entity should present and disclose information that enables users of the financial statements to
evaluate the financial effects of discontinued operations and disposals of non-current assets or disposal
groups. (As discontinued operations relate to the income statement part of the statement of
comprehensive income, this section will refer to its income statement.)
Discontinued operation: a component of an entity that has either been disposed of, or is classified as held
for sale, and:
(a) Represents a separate major line of business or geographical area of operations
(b) Is part of a single co-ordinated plan to dispose of a separate major line of business or geographical
area of operations, or
(c) Is a subsidiary acquired exclusively with a view to resale.
An entity should disclose a single amount on the face of the income statement comprising the total of:
(a) The post-tax profit or loss of discontinued operations, and
(b) The post-tax gain or loss recognised on the measurement to fair value less costs to sell or on the
disposal of the assets or disposal group(s) constituting the discontinued operation.
An entity should also disclose an analysis of this single amount into its component parts. This may be
presented either on the face of the income statement or in the notes. If it is presented on the face of the
income statement it should be presented in a column identified as relating to discontinued operations, ie
separately from continuing operations. This analysis is not required where the discontinued operation is a
newly acquired subsidiary that has been classified as held for sale.
An entity should disclose the net cash flows attributable to the operating, investing and financing activities
of discontinued operations. These disclosures may be presented either on the face of the statement of
cash flows or in the notes. We will look at statements of cash flows in Chapter 11.
Gains and losses on the remeasurement of a disposal group that is not a discontinued operation but is
held for sale should be included in profit or loss from continuing operations.

2.6 Illustration
The following illustration is taken from the implementation guidance to IFRS 5. Profit for the period from
discontinued operations would be analysed in the notes.
As you can see the income statement is essentially the same as the example which we looked at in Chapter
5.
XYZ GROUP
INCOME STATEMENT
FOR THE YEAR ENDED 31 DECEMBER 20X7

20X7 20X6
Continuing operations

$000

$000

Revenue

X

X

Cost of sales

(X)

(X)

Gross profit

X

X

Other income

X

X

Distribution costs

(X)

(X)


(X)

(X)

Other expenses

(X)

(X)

Finance costs

(X)

(X)


X

X

Profit before tax

X

X

Income tax expense

(X)

(X)


X

X

Discontinued operations

Profit for the year from discontinued operations

X

X

Profit for the year

X

X

Attributable to:

Equity holders of the parent

X

X


X

X

X

X

An alternative to this presentation would be to analyse the profit from discontinued operations in a
separate column on the face of the income statement.
Note that if a single statement of comprehensive income is prepared, the disclosure relating to discontinued
operations remains the same, only the other comprehensive income is disclosed beneath profit for the year.
3 IFRS 8: Operating segments
An important aspect of reporting financial performance is segment reporting. This is covered by IFRS 8
Operating segments.
3.1 Introduction
Large entities produce a wide range of products and services, often in several different countries. Further
information on how the overall results of entities are made up from each of these product or geographical
areas will help the users of the financial statements. This is the reason for segment reporting.
The entity's past performance will be better understood
The entity's risks and returns may be better assessed
More informed judgements may be made about the entity as a whole
Risks and returns of a diversified, multi-national company can only be assessed by looking at the
individual risks and rewards attached to groups of products or services or in different geographical areas.
These are subject to differing rates of profitability, opportunities for growth, future prospects and risks.

3.2 Objective
An entity must disclose information to enable users of its financial statements to evaluate the nature and
financial effects of the business activities in which it engages and the economic environments in which it
operates.
3.3 Scope
Only entities whose equity or debt securities are publicly traded (ie on a stock exchange) need disclose
segment information. In group accounts, only consolidated segmental information needs to be shown.
(IFRS 8 also applies to entities filing or in the process of filing financial statements for the purpose of
issuing instruments.)
3.4 Definition of operating segment
Reportable segments are operating segments or aggregations of operating segments that meet specified
criteria.
Operating segment: This is a component of an entity:
(a) That engages in business activities from which it may earn revenues and incur expenses (including
revenues and expenses relating to transactions with other components of the same entity)
(b) Whose operating results are regularly reviewed by the entity's chief operating decision maker to
make decisions about resources to be allocated to the segment and assess its performance, and
(c) For which discrete financial information is available. (IFRS 8)
The term 'chief operating decision maker' identifies a function, not necessarily a manager with a specific title.
That function is to allocate resources and to assess the performance of the entity's operating segments.
3.5 Aggregation
Two or more operating segments may be aggregated if the segments have similar economic
characteristics, and the segments are similar in each of the following respects:
The nature of the products or services
The nature of the production process
The type or class of customer for their products or services
The methods used to distribute their products or provide their services, and
If applicable, the nature of the regulatory environment.
3.6 Determining reportable segments
An entity must report separate information about each operating segment that:
(a) Meets the definition of an operating segment; and
(b) Segment total is 10% or more of total:
(i) Revenue (internal and external), or
(ii) Profit or loss (being the combined profit of all segments reporting a profit, or the
combined loss of all segments reporting a loss, whichever is the greater), or
(iii) Assets.
At least 75% of total external revenue must be reported by operating segments. Where this is not the
case, additional segments must be identified (even if they do not meet the 10% thresholds).
Two or more operating segments below the thresholds may be aggregated to produce a reportable
segment if the segments have similar economic characteristics, and the segments are similar in a majority
of the aggregation criteria above.

Operating segments that do not meet any of the quantitative thresholds may be reported separately if
management believes that information about the segment would be useful to users of the financial
statements.
3.7 Disclosures
IFRS 8 disclosures are of:
operating segment profit or loss
segment assets
segment liabilities
certain income and expense items
Disclosures are also required about the revenues derived from products or services and about the
countries in which revenues are earned or assets held, even if that information is not used by
management in making decisions.
Disclosures required by the IFRS are extensive, and best learned by looking at the example and proforma,
which follow the list.
(a) Factors used to identify the entity's reportable segments
(b) Types of products and services from which each reportable segment derives its revenues
(c) Reportable segment revenues, profit or loss, assets, liabilities and other material items:
External
Revenue
Inter segment
Interest revenue

Interest expense

Depreciation and amortisation

Other material non-cash items

Material income/expense (IAS 1)
Profit, assets Share of profit of associates/jointly controlled entities equity
& liabilities accounted
Profit or loss (as reported to chief operating decision maker)
Income tax expense

Non-current assets

Investments in associates/ jointly controlled entities

Expenditures for reportable assets

Segment liabilities

A reconciliation of each of the above material items to the entity's reported figures is required.
Reporting of a measure of profit or loss and total assets by segment is compulsory. Other items
are disclosed if included in the figures reviewed by or regularly provided to the chief operating
decision maker.

(d) External revenue by each product and service (if reported basis is not products and services)
(e) Geographical information:

Geographical
areas
External revenue (1)
Non-current assets (2)
by:
entity's country of domicile, and
all foreign countries
(subdivided if material)

Notes
(1) External revenue is allocated based on the customer's location.
(2) Non-current assets excludes financial instruments, deferred tax assets, post-employment
benefit assets, and rights under insurance contracts.
(f) Information about reliance on major customers (ie those who represent more than 10% of
external revenue)
3.7.1 Disclosure example from IFRS 8
The following example is adapted from the IFRS 8 Implementation Guidance, which emphasises that this
is for illustrative purposes only and that the information must be presented in the most understandable
manner in the specific circumstances.
The hypothetical company does not allocate tax expense (tax income) or non-recurring gains and losses to
reportable segments. In addition, not all reportable segments have material non-cash items other than
depreciation and amortisation in profit or loss. The amounts in this illustration, denominated as dollars,
are assumed to be the amounts in reports used by the chief operating decision maker.

Car
parts
Motor
vessel

Software

Electronics

Finance
All
other

Totals
$ $ $ $ $ $ $
Revenues from external
customers 3,000 5,000 9,500 12,000 5,000 1,000
a
35,500
Intersegment revenues 3,000 1,500 4,500
Interest revenue 450 800 1,000 1,500 3,750
Interest expense 350 600 700 1,100 2,750
Net interest revenue
b
1,000 1,000
Depreciation and
amortisation
200 100 50 1,500 1,100 2,950
Reportable segment profit 200 70 900 2,300 500 100 4,070
Other material non-cash
items:

Impairment of assets 200 200
Reportable segment assets 2,000 5,000 3,000 12,000 57,000 2,000 81,000
Expenditure for reportable
segment non-current assets

300

700

500

800

600

2,900
Reportable segment liabilities 1,050 3,000 1,800 8,000 30,000 43,850
(a) Revenues from segments below the quantitative thresholds are attributable to four operating
segments of the company. Those segments include a small property business, an electronics
equipment rental business, a software consulting practice and a warehouse leasing operation.
None of those segments has ever met any of the quantitative thresholds for determining reportable
segments.
(b) The finance segment derives a majority of its revenue from interest. Management primarily relies
on net interest revenue, not the gross revenue and expense amounts, in managing that segment.
Therefore, as permitted by IFRS 8, only the net amount is disclosed.
422 7: Non-current assets
1 Non-current assets: basic provisions
Non-current assets are long-term assets held by a business. This chapter looks at tangible and intangible
non-current assets.
Tangible non-current assets are 'physical' long-term assets. The main category included in the IAS 1
format for the statement of financial position is property, plant and equipment. The accounting treatment
of these is dealt with in IAS 16 Property, plant and equipment.
Intangible non-current assets are long-term items bringing future benefits to the company, but that do
not have a physical existence. They include deferred development costs and purchased goodwill as we will
see later.
1.1 Capital and revenue expenditure
Expenditure can be classified as either capital expenditure or revenue expenditure. Capital expenditure is
on the purchase of non-current assets (see below) which are for long-term use in the business. Revenue
expenditure is all other expenditure and includes all the day to day running costs of the business. For
example if a business purchases a car for a salesman to use the cost of the car is an example of capital
expenditure and this cost will be included in the statement of financial position as a non-current asset of
the business. However the road tax for the car, the petrol required and any servicing costs are all revenue
expenditure and will be charged to the income statement.
1.2 Valuation of non-current assets
Non-current assets are normally valued in the statement of financial position at their original cost, minus
depreciation. When a non-current asset is purchased (rather than constructed) its cost is the purchase
price plus any expenses incidental to the acquisition. When a non-current asset is constructed for the
company's own use, the cost will include the production or construction costs, including an amount for
'directly attributable' costs (indirect costs).
The carrying value of a non-current asset that has a limited economic life must be reduced by
depreciation, that will write off the asset's cost (less any estimated residual value of the asset) in a
systematic way over the expected useful life of the asset. Both tangible and intangible assets must be
depreciated. However, whereas the term 'depreciation' is applied to tangible non-current assets, the term
'amortisation' is applied to intangible non-current assets.
Non-current assets
7: Non-current assets 423
Usually land does not have a limited economic life, and so does not have to be depreciated. An exception
to this rule is land such as a quarry, which is depleted by the activities of the business. The buildings
constructed on land, however, do have a limited economic life, and ought to be depreciated.
If a non-current asset suffers an impairment, the fall in value must be charged as an expense in the
income statement/statement of comprehensive income and the asset should be included in the statement
of financial position at its reduced value. We will look at impairment in detail in Section 8.
Non-current assets are valued at cost minus depreciation under the 'historical cost convention' of
accounting. However, companies may apply alternative accounting rules to their assets, and revalue
non-current assets to a current cost or current market value. As long as the company applies a consistent
policy, one class of non-current assets may be revalued whilst other groups are reported at historical cost.
Many companies therefore apply the alternative accounting rules to their land and buildings, and revalue
these to current market value.
When a non-current asset is revalued, the increase in value should be added to a revaluation reserve. This
is explained in the next chapter. In addition, depreciation charges on the asset, charged as an expense in
the income statement/statement of comprehensive income, must be based on the revalued amount, rather
than on the historical cost.
(Note: references to the income statement in this chapter apply to the income statement or single statement
of comprehensive income.)
2 Depreciation
The cost of a non-current asset, less its estimated residual value, is allocated fairly between accounting
periods by means of depreciation. The allowance for depreciation is both:
charged against profit
deducted from the value of the non-current asset in the statement of financial position.
If an asset's life extends over more than one accounting period or it earns profits over more than one
period it is a non-current asset.
With the exception of land, every non-current asset eventually wears out over time. Machines, cars and
other vehicles, fixtures and fittings, and even buildings do not last for ever. When a business acquires a
non-current asset, it will have some idea about how long its useful life will be, and it might decide what to
do with it.
(a) Keep on using the non-current asset until it becomes completely worn out, useless, and worthless.
(b) Sell off the non-current asset at the end of its useful life, either by selling it as a second-hand item
or as scrap.
Since a non-current asset has a cost, and a limited useful life, and its value eventually declines, it follows
that a charge should be made in the income statement to reflect the use that is made of the asset by the
business. This charge is called depreciation.
2.1 Definition of depreciation
Depreciation accounting is governed by IAS 16 Property, plant and equipment which we will look at in
Section 4 of this chapter. However, this section will deal with some of the IAS 16 definitions concerning
depreciation.
Depreciation is the result of systematic allocation of the depreciable amount of an asset over its
estimated useful life. Depreciation for the accounting period is charged to net profit or loss for the
period either directly or indirectly.
Depreciable assets are assets which:
Are expected to be used during more than one accounting period
Have a limited useful life

Are held by an entity for use in the production or supply of goods and services, for rental to
others, or for administrative purposes
Useful life is one of two things.
The period over which a depreciable asset is expected to be used by the entity, or
The number of production or similar units expected to be obtained from the asset by the
entity.
Depreciable amount of a depreciable asset is the historical cost or other amount substituted for
cost in the financial statements, less the estimated residual value.
(IAS 16)
An 'amount substituted for cost' will normally be a current market value after a revaluation has taken
place.
IAS 16 requires the depreciable amount of a depreciable asset to be allocated on a systematic basis to
each accounting period during the useful life of the asset. Every part of an item of property, plant and
equipment with a cost that is significant in relation to the total cost of the item must be depreciated
separately.
One way of defining depreciation is to describe it as a means of spreading the cost of a non-current asset
over its useful life, and so matching the cost against the full period during which it earns profits for the
business. Depreciation charges are an example of the application of the accrual assumption to calculate
profits.
There are situations where, over a period, an asset has increased in value, ie its current value is greater
than the carrying value in the financial statements. You might think that in such situations it would not be
necessary to depreciate the asset. The standard states, however, that this is irrelevant, and that
depreciation should still be charged to each accounting period, based on the depreciable amount,
irrespective of a rise in value.
An entity is required to begin depreciating an item of property, plant and equipment when it is available for
use and to continue depreciating it until it is derecognised even if it is idle during the period.
2.2 Useful life
The following factors should be considered when estimating the useful life of a depreciable asset.
Expected physical wear and tear
Obsolescence
Legal or other limits on the use of the assets
Once decided, the useful life should be reviewed at least every financial year end and depreciation rates
adjusted for the current and future periods if expectations vary significantly from the original estimates.
The effect of the change should be disclosed in the accounting period in which the change takes place.
The assessment of useful life requires judgement based on previous experience with similar assets or
classes of asset. When a completely new type of asset is acquired (ie through technological advancement
or through use in producing a brand new product or service) it is still necessary to estimate useful life,
even though the exercise will be much more difficult.
The standard also points out that the physical life of the asset might be longer than its useful life to the
entity in question. One of the main factors to be taken into consideration is the physical wear and tear the
asset is likely to endure. This will depend on various circumstances, including the number of shifts for
which the asset will be used, the entity's repair and maintenance programme and so on. Other factors to
be considered include obsolescence (due to technological advances or improvements in production or
reduction in demand for the product/service produced by the asset) and legal restrictions, eg length of a
related lease.
2.3 Residual value
The residual value is the amount an entity expects to obtain for an asset at the end of its useful life net of
disposal expenses. In most cases the residual value of an asset is likely to be immaterial. IAS 16 states
that an entity must review residual values of all items at least each financial year end. Any changes in
residual value are accounted for as a change in an estimate according to IAS 8. The residual value is the
price the asset would fetch in today's prices. A review of residual values should be done in conjunction
with a review of useful lives.
2.4 The total charge for depreciation: the depreciable amount
The total amount to be charged over the life of a non-current asset ('the depreciable amount') is usually its
cost less any expected 'residual' sales value or disposal value at the end of the asset's life.
(a) Plant and equipment costing $20,000 which has an expected life of five years and an expected
residual value of nil should be depreciated by $20,000 in total over the five-year period.
(b) Plant and equipment costing $20,000 which has an expected life of five years and an expected
residual value of $3,000 at the reporting date should be depreciated by $17,000 in total over a five-
year period.
2.5 Depreciation in the accounts
When a non-current asset is depreciated, two things must be accounted for.
(a) The charge for depreciation is a cost or expense of the accounting period.
(b) At the same time, the non-current asset is wearing out and diminishing in value, and so the value
of the non-current asset in the statement of financial position must be reduced by the amount of
depreciation charged. The statement of financial position value of the non-current asset will be its
'carrying value' which is the value net of its accumulated depreciation to date.
The amount of depreciation deducted from the cost of a non-current asset to arrive at its carrying value
will build up (or 'accumulate') over time, as more depreciation is charged in each successive accounting
period.
For example, if plant and equipment costing $40,000 has an expected life of four years and an estimated
residual value of nil, it might be depreciated by $10,000 per annum.
Depreciation
charge for the
year (Income
statement)
Accumulated
depreciation at
end of year

Cost of the
asset

Carrying value at
end of year

(A)

(B)

(C)

(C-B)

$

$

$

$

At beginning of its life

-

-

40,000

40,000

Year 1

10,000

10,000

40,000

30,000

Year 2

10,000

20,000

40,000

20,000

Year 3

10,000

30,000

40,000

10,000

Year 4

10,000

40,000

40,000

0

40,000

At the end of year 4, the full $40,000 of depreciation charges have been made in the income statement of
the four years. The carrying value of the plant and equipment asset is now nil. In theory (although perhaps
not in practice) the business will no longer use the plant and equipment, which would now need replacing.
2.6 Methods of depreciation
There are several different methods of depreciation. A company must select a method for each group of
assets, and apply this method consistently to those assets. The choice of method should be the one that
most fairly reflects the consumption of the benefits of the non-current asset over time. The depreciation
methods you need to know about are:
Straight line method
Reducing balance method
Machine hour or unit method
2.7 The straight line method
This is the most commonly used method. The total depreciable amount is charged in equal instalments to
each accounting period over the expected useful life of the asset. In this way, the carrying value of the
non-current asset declines at a steady rate, or in a 'straight line' over time.
The annual depreciation charge is calculated as:
asset the of life useful Expected
value residual minus asset of Cost

For example, suppose that plant and equipment costing $110,000 has an estimated life of 5 years and a
residual value of $10,000. The annual depreciation charge using the straight line method would be:
years 5
10,000) $(110,000
= $20,000 per annum
The cost, depreciation and carrying value of the non-current asset would be as follows:

After 1

year
After 2

years
After 3

years
After 4

years
After 5

years

$

$

$

$

$

Cost of asset

110,000

110,000

110,000

110,000

110,000


Brought forward

-

20,000

40,000

60,000

80,000

Charge for the year (20%)

20,000

20,000

20,000

20,000

20,000

At the end of the year

20,000

40,000

60,000

80,000

100,000

Carrying value

90,000

70,000

50,000

30,000

10,000
Since the depreciation charge per annum is the same amount every year with the straight line method, it is
often convenient to state that depreciation is charged at the rate of x per cent per annum on the net cost of
the asset. For example, if plant and equipment costing $50,000 is depreciated to a nil residual value over
five years by the straight line method, the annual depreciation charge would be 20% of cost.
The straight line method of depreciation is a fair allocation of the total depreciable amount between the
different accounting periods, provided that it is reasonable to assume that the business enjoys equal
benefits from the use of the asset in every period throughout its life.
2.8 The reducing balance method
The reducing balance method of depreciation calculates the annual depreciation charge as a fixed
percentage of the carrying value of the asset, as at the end of the previous accounting period.
For example, take the plant and equipment bought for $110,000 in the above example with an estimated
life of 5 years and a residual value of $10,000. To achieve this using the reducing balance method would
require an annual rate of 38%.
The cost, depreciation and the carrying value of the asset will be as follows:

After 1
year
After 2
years
After 3
years
After 4
years
After 5
years

$

$

$

$

$

Cost of asset

110,000

110,000

110,000

110,000

110,000


Brought forward

-

41,800

67,716

83,785

93,747
Charge for the year (38%)

41,800

25,916

16,069

9,962

6,176

41,800

67,716

83,785

93,747

99,923
Carrying value

68,200

42,284

26,215

16,253

10,077

Activity 8.1

Draw a rough graph showing how the depreciation under the two above examples compare with each
other, to illustrate the profile of depreciation under the straight line versus the reducing balance method.

With the reducing balance method, the annual charge for depreciation is higher in the earlier years of the
asset's life, and lower in the later years. In the example above, the annual charges for years 1, 2, 3, 4 and
5 are $41,800, $25,916, $16,069, $9,962 and $6,176 respectively. The reducing balance method might
therefore be used when it is considered fair to allocate a greater proportion of the total depreciable amount
to the earlier years and a lower proportion to later years, on the assumption that the benefits obtained by
the business from using the asset decline over time.
The reducing balance rate is calculated to bring the carrying value down to the residual value at the end of
the economic life. Often the rate will be rounded to a convenient percentage, and thus it may not quite
work. In the above example, 40% would have given a residual value of $8,554 at the end of year 5.
2.9 Machine hour or units method
Another approach is to estimate the use that will be made of the non-current asset over its useful life, in
terms of the number of hours it will be operated, or the number of units it will process. The depreciation
charge is then calculated as the depreciable amount divided by the expected machine hours of use or the
expected units to be processed, and expressed as a depreciation rate per hour or per unit.
The depreciation charge in any year is calculated as the actual number of hours the asset is used for
multiplied by the rate per hour, or the actual number of units processed multiplied by the rate per unit.
This method is not commonly used, but it is a fair way of applying the accruals concept to the calculation
of profit, where it is considered that the consumption of the asset's value relates to the use made of the
asset in each accounting period.
Choosing a method of depreciation, as well as deciding on the appropriate useful life for a non-current
asset, calls for the exercise of judgement.
(a) The straight line method is the simplest and the most commonly used in practice.
(b) The reducing balance method is an accelerated method of charging depreciation which leads to a
higher charge in earlier years. Since repair and maintenance costs tend to increase as assets grow
older these methods lead to a more even allocation of total non-current asset costs (depreciation
plus maintenance).
(c) The machine hour method is suited to assets which depreciate primarily through use rather than
through passing of time. Such assets might include mines and quarries, which are subject to
gradual exhaustion of the minerals that they contain, and also delivery lorries, which may be
argued to depreciate in accordance with the number of miles travelled.
2.10 The need for consistency
Having selected a depreciation method for a category of non-current assets, a business must apply the
method consistently from one year to the next. Similarly, it is up to the business to decide what a sensible
life span for a non-current asset should be, but once that life span has been chosen, it should not be
changed unless something unexpected happens to the non-current asset.
A business may depreciate different categories of non-current assets in different ways. For example, if a
business owns three cars, then each car would normally be depreciated in the same way (e.g. by the
straight line method) but another category of asset, say, photocopiers, might be depreciated using a
different method (e.g. by the machine hour method).

Activity 8.2

A company purchased a lorry at a cost of $17,000. The lorry is expected to last for five years and then be
sold for scrap for $2,000. Usage over the five years is expected to be:
Year 1 200 days
Year 2 100 days
Year 3 100 days
Year 4 150 days
Year 5 40 days
Required
Work out the depreciation to be charged each year under:
(a) The straight line method
(b) The reducing balance method (using a rate of 35%)
(c) The machine hour method.

2.11 Misconceptions about depreciation
Depreciation is a process of allocation of the cost of a non-current asset over several accounting periods.
It is worth mentioning here two common misconceptions about the purpose and effects of depreciation.
(a) It is sometimes thought that the carrying value (CV) of an asset should equal the current net
realisable value, and that the object of charging depreciation is to reflect the fall in value of an asset
over its life. This misconception is the basis of a common, but incorrect, argument that properties
(say) need not be depreciated in times when property values are rising. It is true that historical cost
statements of financial position often give a misleading impression of property when a property's
carrying value in the statement of financial position is much below its market value. However, in
such a case it is open to a business to revalue its assets. This is a separate problem from the
requirement to allocate the property's cost over successive accounting periods.
(b) Another misconception is that depreciation is provided so that an asset can be replaced at the end
of its useful life. This is not the case.
(i) If there is no intention of replacing the asset, it could then be argued that there is no need to
provide for any depreciation at all.
(ii) If prices are rising, the replacement cost of the asset will exceed the amount of depreciation
provided.
2.12 Depreciation is not a cash expense
Depreciation spreads the cost of a non-current asset (less its estimated residual value) over the asset's
life. The cash payment for the asset will be made when, or soon after, the asset is purchased. Annual
depreciation of the asset in subsequent years is not a cash expense - rather it allocates costs to those later
years for a cash payment that has occurred previously. This is in line with the accruals basis of accounts
preparation.
For example, suppose a business purchased some shop fittings for $6,000 on 1 July 20X5 and paid for
them in cash on that date. Subsequently, depreciation may be charged at $600 per annum for ten years.
So each year $600 is deducted from profits and the carrying value of the fittings goes down, but no actual
cash is being paid. The cash was all paid on 1 July 20X5. So annual depreciation is not a cash expense,
but rather an allocation of the original cost to later years.
2.13 A fall in value of a non-current asset
When the 'market' value of a non-current asset falls so that it is worth less than the amount of its carrying
value and the fall in value is not going to be recovered from future use of the asset, the asset should be
written down to its new low market value. We say that the asset has been 'impaired'. The charge in the
income statement for the diminution in value of the asset during the accounting period should then be:

$

Carrying value at the beginning of the period

X

Less new reduced value

(X)

Charge for the impairment in the assets value in the period

X

This charge is like 'extra' depreciation.
3 Non-current asset disposals
When a non-current asset is sold, there is likely to be a profit or loss on disposal. This is the difference
between the net sale price of the asset and its carrying value at the time of disposal.
Property, plant and equipment are not purchased by a business with the intention of reselling them in the
normal course of trade. However, they might be sold off at some stage during their life, either when their
useful life is over, or before then. A business might decide to sell off a non-current asset long before its
useful life has ended.
Whenever a business sells something, it will make a profit or a loss. When non-current assets are
disposed of, there will be a profit or loss on disposal. These gains or losses are reported in the income
and expenses part of the income statement. They are commonly referred to as 'profit on disposal of non-
current assets' or 'loss on disposal'.
3.1 The principles behind calculating the profit or loss on disposal
The profit or loss on the disposal of a non-current asset is the difference between:
(a) The carrying value of the non-current asset at the time of its sale.
(b) Its net sale price, which is the price minus any costs of making the sale.
A profit is made when the sale price exceeds the carrying value, and a loss is made when the sale price is
less than the carrying value.
Suppose a company purchased an asset on 1 January 20X1 for $25,000. It had an estimated life of five
years and an estimated residual value of nil. The asset was eventually sold after three years on 1 January
20X4 to another trader who paid $17,500 for it.
The profit or loss on disposal, assuming that the business uses the straight line method for depreciation
($5,000 per annum), would be

$

Cost of asset

25,000

Less accumulated depreciation (three years)

15,000

Carrying value at date of disposal

10,000

Sale price

17,500

Profit on disposal

7,500

4 IAS 16: Property, plant and equipment
IAS 16 Property, plant and equipment covers the major categories of tangible non-current assets. As well
as depreciation it looks at recognition criteria, components of cost and revaluations.
The standard gives a large number of definitions.
Property, plant and equipment are tangible assets that:
are held for use in the production or supply of goods or services, for rental to others, or for
administrative purposes; and
are expected to be used during more than one period.
Cost is the amount of cash or cash equivalents paid or the fair value of the other consideration
given to acquire an asset at the time of its acquisition or construction.
Residual value is the net amount that an entity would currently obtain for an asset at the end of its
useful life after deducting the expected costs of disposal.
Entity specific value is the present value of the cash flows an entity expects to arise from the
continuing use of an asset and from its disposal at the end of its useful life, or expects to incur
when settling a liability.
Fair value is the amount for which an asset could be exchanged between knowledgeable, willing
parties in an arm's length transaction.
Carrying amount is the amount at which an asset is recognised in the statement of financial
position after deducting any accumulated depreciation and accumulated impairment losses.
An impairment loss is the amount by which the carrying amount of an asset exceeds its
recoverable amount. (IAS 16)
4.1 Recognition
In this context, recognition simply means incorporation of the item in the business's accounts, in this case
as a non-current asset. The recognition of property, plant and equipment depends on two criteria.
(a) It is probable that future economic benefits associated with the asset will flow to the entity
(b) The cost of the asset to the entity can be measured reliably
These recognition criteria apply to subsequent expenditure as well as costs incurred initially.
Property, plant and equipment can amount to substantial amounts in financial statements, affecting the
presentation of the company's financial position (in the statement of financial position) and the profitability of
the entity, through depreciation and also if an asset is wrongly classified as an expense and taken to the income
statement.
Looking at the first of the two recognition criteria the degree of certainty attached to the flow of future
economic benefits must be assessed. This should be based on the evidence available at the date of initial
recognition (usually the date of purchase). The entity should thus be assured that it will receive the rewards
attached to the asset and it will incur the associated risks, which will only generally be the case when the
rewards and risks have actually passed to the entity. Until then, the asset should not be recognised.
Regarding the second criterion it is generally easy to measure the cost of an asset as the transfer amount
on purchase, ie what was paid for it. Self-constructed assets can also be measured easily by adding
together the purchase price of all the constituent parts (labour, material etc) paid to external parties.
For very large and specialised items, an apparently single asset should be broken down into its
composite parts. This occurs where different parts have different useful lives and different depreciation
rates are applied to each part e.g. an aircraft where the body and engines have different useful lives.

4.2 Initial measurement
Once an item of property, plant and equipment qualifies for recognition as an asset, it will initially be
measured at cost.
The standard lists the components of the cost of an item of property, plant and equipment.
Purchase price, less any trade discount or rebate
Import duties and non-refundable purchase taxes
Directly attributable costs of bringing the asset to working condition for its intended use, eg:
The cost of site preparation
Initial delivery and handling costs
Installation costs
Testing
Professional fees (architects, engineers)
Initial estimate of the unavoidable cost of dismantling and removing the asset and restoring the site
on which it is located
Additional guidance is given regarding 'directly attributable costs' as follows:
(a) These costs bring the asset to the location and working conditions necessary for it to be capable of
operating in the manner intended by management, including those costs to test whether the asset
is functioning properly.
(b) They are determined after deducting the net proceeds from selling any items produced when
bringing the asset to its location and condition.
The standard also states that income and related expenses of operations that are incidental to the
construction or development of an item of property, plant and equipment should be recognised in the
income statement.
The following costs will not be part of the cost of property, plant or equipment unless they can be
attributed directly to the asset's acquisition, or bringing it into its working condition.
Administration and other general overhead costs
Start-up and similar pre-production costs
Initial operating losses before the asset reaches planned performance
All of these will be recognised as an expense rather than an asset.
The 'cost' will be the total of the construction costs (although abnormal costs, e.g. waste material, labour
and other resources should be excluded). In the case of self-constructed assets, the same principles are
applied as for acquired assets. An example of a self-constructed asset is when a building company builds
its own head office.
4.3 Measurement subsequent to initial recognition
The standard offers two possible treatments here, essentially a choice between keeping an asset recorded
at cost or revaluing it to fair value.
(a) Cost model. Carry the asset at its cost less depreciation (and any accumulated impairment losses).
(b) Revaluation model. Carry the asset at a revalued amount, being its fair value at the date of the
revaluation less any subsequent accumulated depreciation (and subsequent accumulated impairment
losses). IAS 16 makes clear that the revaluation model is available only if the fair value of the item
can be measured reliably.
4.4 Revaluations
When an asset is revalued the gain is recorded in the revaluation reserve and depreciation is then charged
on the revalued amount.
The market value of land and buildings usually represents fair value, determined from market-based
evidence. Such valuations are usually carried out by professionally qualified valuers.
In the case of plant and equipment, fair value can also be taken as market value. Where a market value is
not available, however, depreciated replacement cost should be used. There may be no market value
where types of plant and equipment are sold only rarely or because of their specialised nature (ie they
would normally only be sold as part of an ongoing business).
The frequency of valuation depends on the volatility of the fair values of individual items of property, plant
and equipment. The more volatile the fair value, the more frequently revaluations should be carried out.
Where the current fair value is very different from the carrying value then a revaluation should be carried out.
Most importantly, when an item of property, plant and equipment is revalued, the whole class of assets to
which it belongs should be revalued.
All the items within a class should be revalued at the same time, to prevent selective revaluation of
certain assets and to avoid disclosing a mixture of costs and values from different dates in the financial
statements. A rolling basis of revaluation is allowed if the revaluations are kept up to date and the
revaluation of the whole class is completed in a short period of time.
How should any increase in value be treated when a revaluation takes place? The 'debit' will be the
increase in value in the statement of financial position, but what about the credit? IAS 16 requires the
increase to be credited to a revaluation surplus (ie part of owners' equity), unless the increase is
reversing a previous decrease which was recognised as an expense. To the extent that this offset is made,
the increase is recognised as income; any excess is then taken to the revaluation reserve.
Revaluation gains and losses that are recognised through the revaluation reserve are reported as other
comprehensive income in the statement of comprehensive income (see Chapter 5).
4.5 Example
Heap Co has a freehold property that is valued at $4m in the statement of financial position, with
accumulated depreciation of $250,000 on the building. The property has been revalued and its current
value is now $5.6 million, but with accumulated depreciation of $400,000 on this revalued amount. The
net increase in value of the asset is the increase in the total valuation ($1.6 million) minus the increase in
the accumulated depreciation of $150,000. The net increase in valuation is therefore $1,450,000.
The adjustment to the statement of financial position should be:
(a) increase the asset from $4 million to $5.6 million
(b) increase accumulated depreciation from $250,000 to $400,000
(c) increase the revaluation surplus by $1,450,000.
The surplus on revaluation of $1,450,000 is reported as other comprehensive income in the statement of
comprehensive income.
In future years, depreciation should be charged against profits based on the revalued amount of the
building, $5.6 million.

Activity 8.3

Barney Co has an item of land carried in its books at $13,000. There has been a surge in land values in the
current year and the land has been revalued to $20,000.
How will this be reflected in the statement of financial position?

4.6 Depreciation
The standard states:
The depreciable amount of an item of property, plant and equipment should be allocated on a
systematic basis over its useful life.
The depreciation method used should reflect the pattern in which the asset's economic benefits
are consumed by the entity.
The depreciation charge for each period should be recognised as an expense unless it is included
in the carrying amount of another asset.
Land and buildings are dealt with separately even when they are acquired together because as we have
already seen land normally has an unlimited life and is therefore not depreciated. In contrast buildings do
have a limited life and must be depreciated. Any increase in the value of land on which a building is
standing will have no impact on the determination of the building's useful life.
Depreciation is usually treated as an expense, but not where it is absorbed by the entity in the process of
producing other assets. For example, depreciation of plant and machinery can be incurred in the
production of goods for sale (inventory items). In such circumstances, the depreciation is included in the
cost of the new assets produced.
A review of the useful life of property, plant and equipment should be carried out at least at each
financial year end and the depreciation charge for the current and future periods should be adjusted if
expectations have changed significantly from previous estimates. Changes are changes in accounting
estimates and are accounted for prospectively as adjustments to future depreciation.
The depreciation method should also be reviewed at least at each financial year end and, if there has
been a significant change in the expected pattern of economic benefits from those assets, the method
should be changed to suit this changed pattern. When such a change in depreciation method takes place
the change should be accounted for as a change in accounting estimate and the depreciation charge for
the current and future periods should be adjusted.
4.7 Retirements and disposals
When an asset is permanently withdrawn from use, or sold or scrapped, and no future economic benefits
are expected from its disposal, it should be withdrawn from the statement of financial position. An asset is
withdrawn from use when no future economic benefit is expected from either its use or disposal, for
example an obsolete machine which cannot be used in a business and has no sale value.
Gains or losses are the difference between the estimated net disposal proceeds and the carrying amount
of the asset. They should be recognised as income or expense in the income statement.
An entity cannot classify as revenue (ie in the top line of the income statement) a gain it realises on
the disposal of an item of property, plant and equipment.
4.8 Disclosure
The standard has a list of disclosure requirements, for each class of property, plant and equipment.
(a) Measurement bases for determining the gross carrying amount (if more than one, the gross
carrying amount for that basis in each category)
(b) Depreciation methods used
(c) Useful lives or depreciation rates used
(d) Gross carrying amount and accumulated depreciation (aggregated with accumulated impairment
losses) at the beginning and end of the period
(e) Reconciliation of the carrying amount at the beginning and end of the period showing:
(i) Additions
(ii) Disposals
(iii) Acquisitions through business combinations (see Chapter 10)
(iv) Increases/decreases during the period from revaluations and from impairment losses
(v) Impairment losses recognised in the income statement
(vi) Impairment losses reversed in the income statement
(vii) Depreciation
(viii) Net exchange differences (from translation of statements of a foreign entity)
(ix) Any other movements.
The financial statements should also disclose the following.
(a) Any recoverable amounts of property, plant and equipment
(b) Existence and amounts of restrictions on title, and items pledged as security for liabilities
(c) Accounting policy for the estimated costs of restoring the site
(d) Amount of expenditures on account of items in the course of construction
(e) Amount of commitments to acquisitions
Revalued assets require further disclosures.
(a) Basis used to revalue the assets
(b) Effective date of the revaluation
(c) Whether an independent valuer was involved
(d) Nature of any indices used to determine replacement cost
(e) Carrying amount of each class of property, plant and equipment that would have been included in
the financial statements had the assets been carried at cost less accumulated depreciation and
accumulated impairment losses.
(f) Revaluation surplus, indicating the movement for the period and any restrictions on the distribution
of the balance to shareholders.
The standard also encourages disclosure of additional information, which the users of financial
statements may find useful.
(a) The carrying amount of temporarily idle property, plant and equipment
(b) The gross carrying amount of any fully depreciated property, plant and equipment that is still in use
(c) The carrying amount of property, plant and equipment retired from active use and held for disposal
(d) The fair value of property, plant and equipment when this is materially different from the carrying
amount
The following format (with notional figures) is commonly used to disclose non-current assets movements.
Land and
buildings
Plant and
equipment

Total

$

$

$

Cost or valuation

At 1 January 20X4

40,000

10,000

50,000

Revaluation surplus

12,000

12,000

Additions in year

4,000

4,000

Disposals in year

(1,000)

(1,000)

At 31 December 20X4

52,000

13,000

65,000

Depreciation

At 1 January 20X4

10,000

6,000

16,000

Charge for year

1,000

3,000

4,000

Eliminated on disposals

(500)

(500)

At 31 December 20X4

11,000

8,500

19,500

Carrying value

At 31 December 20X4

41,000

4,500

45,500

At 1 January 20X4

30,000

4,000

34,000

5 IAS 40: Investment property
An entity may own land or a building as an investment rather than for use in the business. It may
therefore generate cash flows largely independently of other assets which the entity holds.
Consider the following definitions.
Investment property is property (land or a building or part of a building or both) held (by the owner or
by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for:
(a) Use in the production or supply of goods or services or for administrative purposes, or
(b) Sale in the ordinary course of business
Examples of investment property include:
(a) Land held for long-term capital appreciation rather than for short-term sale in the ordinary course
of business
(b) A building owned by the reporting entity (or held by the entity under a finance lease) and leased
out under an operating lease
An accounting standard IAS 40 Investment property was introduced to set down special rules for these
types of property.
5.1 Recognition
Investment property should be recognised as an asset when two conditions are met.
(a) It is probable that the future economic benefits that are associated with the investment property
will flow to the entity.
(b) The cost of the investment property can be measured reliably.
5.2 Initial measurement
An investment property should be measured initially at its cost, including transaction costs.
A property interest held under a lease and classified as an investment property shall be accounted for as if
it were a finance lease. The asset is recognised at the lower of the fair value of the property and the
present value of the minimum lease payments. An equivalent amount is recognised as a liability.
5.3 Measurement subsequent to initial recognition
IAS 40 requires an entity to choose between two models.
The fair value model
The cost model
Whatever policy it chooses should be applied to all of its investment property.
Where an entity chooses to classify a property held under an operating lease as an investment property,
there is no choice. The fair value model must be used for all the entity's investment property,
regardless of whether it is owned or leased.

5.4 Fair value model
Fair value is the amount for which an asset could be exchanged between knowledgeable, willing parties in
an arm's length transaction.
(a) After initial recognition, an entity that chooses the fair value model should measure all of its
investment property at fair value, except in the extremely rare cases where this cannot be
measured reliably. In such cases it should apply the IAS 16 cost model.
(b) A gain or loss arising from a change in the fair value of an investment property should be
recognised in net profit or loss for the period in which it arises.
(c) The fair value of investment property should reflect market conditions at the reporting date.
This is not the same as a revaluation, where increases in carrying amount above a cost-based measure are
recognised as revaluation surplus. Under the fair value model all changes in fair value are recognised in
the income statement.
5.5 Cost model
The cost model is the cost model in IAS 16. Investment property should be measured at depreciated
cost, less any accumulated impairment losses. An entity that chooses the cost model should disclose
the fair value of its investment property.
5.6 Changing models
Once the entity has chosen the fair value or cost model, it should apply it to all its investment property. It
should not change from one model to the other unless the change will result in a more appropriate
presentation. IAS 40 states that it is highly unlikely that a change from the fair value model to the cost
model will result in a more appropriate presentation.
5.7 Transfers
Transfers to or from investment property should only be made when there is a change in use. For
example, owner occupation commences so the investment property will be treated under IAS 16 as an
owner-occupied property.
When there is a transfer from investment property carried at fair value to owner-occupied property or
inventories, the property's cost for subsequent accounting under IAS 16 or IAS 2 should be its fair value
at the date of change of use.
Conversely, an owner-occupied property may become an investment property and need to be carried at
fair value. An entity should apply IAS 16 up to the date of change of use. It should treat any difference at
that date between the carrying amount of the property under IAS 16 and its fair value as a revaluation
under IAS 16.
5.8 Disposals
Derecognise (eliminate from the statement of financial position) an investment property on disposal or
when it is permanently withdrawn from use and no future economic benefits are expected from its
disposal.
Any gain or loss on disposal is the difference between the net disposal proceeds and the carrying amount
of the asset. It should generally be recognised as income or expense in the income statement.
5.9 Disclosures
These relate to:
Choice of fair value model or cost model
Whether property interests held as operating leases are included in investment property
Criteria for classification as investment property
Assumptions in determining fair value
Use of independent professional valuer (encouraged but not required)
Rental income and expenses
Any restrictions or obligations
An entity that adopts the fair value model must also disclose a reconciliation of the carrying amount of
the investment property at the beginning and end of the period.
For the cost model additional disclosures relate mainly to the depreciation method. In addition, an entity
which adopts the cost model must disclose the fair value of the investment property.
6 Intangible assets
Intangible assets are defined by IAS 38 as non-monetary assets without physical substance. Intangible
assets should initially be measured at cost, but subsequently they can be carried at cost or at a revalued
amount.
6.1 Definition
An intangible asset is an identifiable non-monetary asset without physical substance. The asset must be:
(a) controlled by the entity as a result of events in the past, and
(b) something from which the entity expects future economic benefits to flow.
Examples of items that might be considered as intangible assets include computer software, patents,
copyrights, motion picture films, customer lists, franchises and fishing rights. An item should not be
recognised as an intangible asset, however, unless it fully meets the definition in the standard.
An intangible asset must be identifiable i.e distinguishable from goodwill. With non-physical items, there
may be a problem with 'identifiability'.
(a) If an intangible asset is acquired separately through purchase, there may be a transfer of a legal
right that would help to make an asset identifiable.
(b) An intangible asset may be identifiable if it is separable, ie if it could be rented or sold separately.
However, 'separability' is not an essential feature of an intangible asset.
Another element of the definition of an intangible asset is that it must be under the control of the entity as
a result of a past event. The entity must therefore be able to enjoy the future economic benefits from the
asset, and prevent the access of others to those benefits. A legally enforceable right is evidence of such
control, but is not always a necessary condition.
(a) Control over technical knowledge or know-how only exists if it is protected by a legal right.
(b) The skills of employees, arising out of the benefits of training costs, are most unlikely to be
recognisable as an intangible asset, because an entity does not control the future actions of its
staff.
(c) Similarly, market share and customer loyalty cannot normally be intangible assets, since an entity
cannot control the actions of its customers.
An item can only be recognised as an intangible asset if economic benefits are expected to flow in the
future from ownership of the asset. Economic benefits may come from the sale of products or services, or
from a reduction in expenditures (cost savings).

An intangible asset, when recognised initially, must be measured at cost. It should be recognised if, and
only if both the following occur.
(a) It is probable that the future economic benefits that are attributable to the asset will flow to the
entity.
(b) The cost can be measured reliably.
Management has to exercise its judgement in assessing the degree of certainty attached to the flow of
economic benefits to the entity. External evidence is best.
(a) If an intangible asset is acquired separately, its cost can usually be measured reliably as its
purchase price (including incidental costs of purchase such as legal fees, and any costs incurred in
getting the asset ready for use).
(b) When an intangible asset is acquired as part of a business combination (ie an acquisition or
takeover), the cost of the intangible asset is its fair value at the date of the acquisition.
IFRS 3 which we will look at later explains that the fair value of intangible assets acquired in business
combinations can normally be measured with sufficient reliability to be recognised separately from
goodwill.
6.2 Internally generated goodwill
Internally generated goodwill is a value attributable to a business from factors other than its tangible
assets. It consists of elements such as having a strong reputation with customers for quality or giving
value for money, a high and favourable public profile or a skilled work force.
Internally generated goodwill cannot be recognised as an asset.
The standard deliberately precludes recognition of internally generated goodwill because it requires that,
for initial recognition, the cost of the asset rather than its fair value should be capable of being measured
reliably and that it should be identifiable and controlled. Thus you do not recognise an asset which is
subjective and cannot be measured reliably.
6.3 Research and development costs
In many companies, especially those producing food, or 'scientific' products such as medicines, or 'high
technology' product, there is a large amount of expenditure on research and development (R+D). When
R+D is a large item of cost its accounting treatment may have a significant influence of the profits of a
business and its valuation in the statement of financial position. The issue with R+D costs is whether these
costs should be
(a) treated as an expense, and written off against profit in full in the year they are incurred, or
(b) capitalised as an intangible asset because they represent value that the business has created, and
that the business will benefit from for several years into the future.
Research activities by definition do not meet the criteria for recognition under IAS 38. This is because, at
the research stage of a project, it cannot be certain that future economic benefits will probably flow to the
entity from the project. There is too much uncertainty about the likely success or otherwise of the project.
Research costs should therefore be written off as an expense as they are incurred.
Examples of research costs
(a) Activities aimed at obtaining new knowledge
(b) The search for, evaluation and final selection of, applications of research findings or other
knowledge
(c) The search for alternatives for materials, devices, products, processes, systems or services
(d) The formulation, design, evaluation and final selection of possible alternatives for new or improved
materials, devices, products, systems or services
Development costs qualify for recognition as intangible assets provided that the following strict criteria
can be demonstrated.
(a) The technical feasibility of completing the intangible asset so that it will be available for use or sale.
(b) Its intention to complete the intangible asset and use or sell it.
(c) Its ability to use or sell the intangible asset.
(d) How the intangible asset will generate probable future economic benefits. Among other things, the
entity should demonstrate the existence of a market for the output of the intangible asset or the
intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset.
(e) Its ability to measure the expenditure attributable to the intangible asset during its development
reliably.
In contrast with research costs development costs are incurred at a later stage in a project, and the
probability of success should be more apparent. Examples of development costs include the following.
(a) The design, construction and testing of pre-production or pre-use prototypes and models
(b) The design of tools, jigs, moulds and dies involving new technology
(c) The design, construction and operation of a pilot plant that is not of a scale economically feasible
for commercial production
(d) The design, construction and testing of a chosen alternative for new or improved materials,
devices, products, processes, systems or services
6.4 Other intangibles
The standard prohibits the recognition of internally generated brands, mastheads (newspaper headers
such as The Times), publishing titles and customer lists and similar items as intangible assets. These
all fail to meet one or more (in some cases all) of the definition and recognition criteria and in some cases
are probably indistinguishable from internally generated goodwill.
6.5 Cost of an internally generated intangible asset
The costs allocated to an internally generated intangible asset should be only costs that can be directly
attributed or allocated on a reasonable and consistent basis to creating, producing or preparing the asset
for its intended use. The principles underlying the costs which may or may not be included are similar to
those for other non-current assets and inventory.
The cost of an internally generated intangible asset is the sum of the expenditure incurred from the date
when the intangible asset first meets the recognition criteria. If, as often happens, considerable costs
have already been recognised as expenses before management could demonstrate that the criteria have
been met, this earlier expenditure should not be retrospectively recognised at a later date as part of the
cost of an intangible asset.

Activity 8.4

Doug Co is developing a new production process. During 20X3, expenditure incurred was $100,000, of
which $90,000 was incurred before 1 December 20X3 and $10,000 between 1 December 20X3 and 31
December 20X3. Doug Co can demonstrate that, at 1 December 20X3, the production process met the
criteria for recognition as an intangible asset. The recoverable amount of the know-how embodied in the
process is estimated to be $50,000.
How should the expenditure be treated?

6.6 Recognition of an expense
All expenditure related to an intangible which does not meet the criteria for recognition either as an
identifiable intangible asset or as goodwill arising on an acquisition should be expensed as incurred. The
IAS gives examples of such expenditure.
Start up costs
Training costs
Advertising costs
Business relocation costs
Prepaid costs for services, for example advertising or marketing costs for campaigns that have been
prepared but not launched, can still be recognised as a prepayment.
6.7 Measurement of intangible assets subsequent to initial recognition
The standard allows two methods of valuation for intangible assets after they have been first recognised.
Applying the cost model, an intangible asset should be carried at its cost, less any accumulated
amortisation (and less any accumulated impairment losses).
The revaluation model allows an intangible asset to be carried at a revalued amount, which is its fair
value at the date of revaluation, less any subsequent accumulated amortisation and any subsequent
accumulated impairment losses.
(a) The fair value must be able to be measured reliably with reference to an active market in that type
of asset.
(b) The entire class of intangible assets of that type must be revalued at the same time (to prevent
selective revaluations).
(c) If an intangible asset in a class of revalued intangible assets cannot be revalued because there is no
active market for this asset, the asset should be carried at its cost less any accumulated
amortisation and impairment losses.
(d) Revaluations should be made with such regularity that the carrying amount does not differ from
that which would be determined using fair value at the reporting date.
This treatment is not available for the initial recognition of intangible assets. This is because the cost of
the asset must be reliably measured.
The guidelines state that there will not usually be an active market in an intangible asset; therefore the
revaluation model will usually not be available. For example, although copyrights, publishing rights and
film rights can be sold, each has a unique sale value. In such cases, revaluation to fair value would be
inappropriate. A fair value might be obtainable however for assets such as fishing rights or quotas or taxi
cab licences.
6.8 Useful life
An entity should assess the useful life of an intangible asset, which may be finite or indefinite. An
intangible asset has an indefinite useful life when there is no foreseeable limit to the period over which
the asset is expected to generate net cash inflows for the entity.
Many factors are considered in determining the useful life of an intangible asset, including: expected usage;
typical product life cycles; technical, technological, commercial or other types of obsolescence; the stability
of the industry; expected actions by competitors; the level of maintenance expenditure required; and legal or
similar limits on the use of the asset, such as the expiry dates of related leases. Computer software and many
other intangible assets normally have short lives because they are susceptible to technological obsolescence.
However, uncertainty does not justify choosing a life that is unrealistically short.
The useful life of an intangible asset that arises from contractual or other legal rights should not exceed
the period of the rights, but may be shorter depending on the period over which the entity expects to use
the asset.
6.9 Amortisation period and amortisation method
An intangible asset with a finite useful life should be amortised over its expected useful life.
(a) Amortisation should start when the asset is available for use.
(b) Amortisation should cease at the earlier of the date that the asset is classified as held for sale in
accordance with IFRS 5 Non-current assets held for sale and discontinued operations and the date
that the asset is derecognised.
(c) The amortisation method used should reflect the pattern in which the asset's future economic
benefits are consumed. If such a pattern cannot be predicted reliably, the straight-line method
should be used.
(d) The amortisation charge for each period should normally be recognised in profit or loss.
The residual value of an intangible asset with a finite useful life is assumed to be zero unless a third party
is committed to buying the intangible asset at the end of its useful life or unless there is an active market
for that type of asset (so that its expected residual value can be measured) and it is probable that there will
be a market for the asset at the end of its useful life.
The amortisation period and the amortisation method used for an intangible asset with a finite useful life
should be reviewed at each financial year-end.
6.10 Intangible assets with indefinite useful lives
An intangible asset with an indefinite useful life should not be amortised. (IAS 36 requires that such an
asset is tested for impairment at least annually.)
The useful life of an intangible asset that is not being amortised should be reviewed each year to
determine whether it is still appropriate to assess its useful life as indefinite. Reassessing the useful life of
an intangible asset as finite rather than indefinite is an indicator that the asset may be impaired and
therefore it should be tested for impairment.

Activity 8.5

It may be difficult to establish the useful life of an intangible asset, and judgement will be needed.
Consider how to determine the useful life of a purchased brand name.

Activity 8.6

List the examples given in IAS 38 of activities that might be included in either research or development.

7 Goodwill
Purchased goodwill arising on consolidation is retained in the statement of financial position as an
intangible asset under IFRS 3. It must then be reviewed annually for impairment.
Internally generated goodwill cannot be recognised.
Goodwill is created by good relationships between a business and its customers.
(a) By building up a reputation (by word of mouth perhaps) for high quality products or high
standards of service
(b) By responding promptly and helpfully to queries and complaints from customers
(c) Through the personality of the staff and their attitudes to customers
The value of goodwill to a business might be extremely significant. However as we have seen in Section
6, internally generated goodwill is not usually valued in the accounts of a business at all, and we should
not normally expect to find an amount for such goodwill in its statement of financial position. Internally
generated goodwill does not meet the definition of an intangible asset in IAS 38 or an asset in the
Framework.
For example, the welcoming smile of the shop staff may contribute more to a shop's profits than the fact
that a new electronic cash register has recently been acquired. Even so, whereas the cash register will be
recorded in the accounts as a non-current asset, the value of staff would be ignored for accounting
purposes.
On reflection, we might agree with this omission of goodwill from the accounts of a business.
(a) The goodwill is inherent in the business but it has not been paid for, and it does not have an
'objective' value. We can guess at what such goodwill is worth, but such guesswork would be a
matter of individual opinion, and not based on hard facts.
(b) Goodwill changes from day to day. One act of bad customer relations might damage goodwill and
one act of good relations might improve it. Staff with a favourable personality might retire or leave
to find another job, to be replaced by staff who need time to find their feet in the job, etc. Since
goodwill is continually changing in value, it cannot realistically be recorded in the accounts of the
business.
7.1 Purchased goodwill
There is one exception to the general rule that goodwill has no objective valuation. This is when a
business is sold. People wishing to set up in business have a choice of how to do it they can either buy
their own long-term assets and inventory and set up their business from scratch, or they can buy up an
existing business from a proprietor willing to sell it. When a buyer purchases an existing business, he will
have to purchase not only its long-term assets and inventory (and perhaps take over its accounts payable
and receivable too) but also the goodwill of the business.
Purchased goodwill is then shown in the buyers statement of financial position because it has been paid
for. It has no tangible substance, and so it is an intangible non-current asset.
When a business is sold, there is likely to be some purchased goodwill in the selling price. But how is the
amount of this purchased goodwill decided?
This is not really a problem for accountants, who must simply record the goodwill in the accounts of the
new business. The value of the goodwill is a matter for the purchaser and seller to agree upon in fixing
the purchase/sale price. However, two methods of valuation are worth mentioning here.
(a) The seller and buyer agree on a price for the business without specifically quantifying the
goodwill. The purchased goodwill will then be the difference between the price agreed and the
value of the tangible net assets in the books of the new business.

(b) However, the calculation of goodwill often precedes the fixing of the purchase price and becomes a
central element of negotiation. There are many ways of arriving at a value for goodwill and most
of them are related to the profit record of the business in question.
No matter how goodwill is calculated within the total agreed purchase price, the goodwill shown by the
purchaser in his accounts will be the difference between the purchase consideration and his own
valuation of the tangible net assets acquired.
Purchased goodwill normally arises when one company (a parent company) takes over another company
(a subsidiary) usually by purchasing a controlling interest in shares. This is referred to as a business
combination. (Accounting for this situation is dealt with in Chapter 10).
Suppose, for example that a company purchases another business for $20 million. The acquired business
has net assets of $15 million. The excess of the purchase price over the net assets acquired is $5 million
and is purchased goodwill.
7.2 IFRS 3: Business combinations
IFRS 3 covers the accounting treatment of goodwill acquired in a business combination.
Goodwill acquired in a business combination is recognised as an asset and is initially measured at cost.
Cost is the excess of the cost of the combination over the acquirer's interest in the net fair value of the
acquirees identifiable assets, liabilities and contingent liabilities.
After initial recognition goodwill acquired in a business combination is measured at cost less any
accumulated impairment losses. It is not amortised. Instead it is tested for impairment at least annually,
in accordance with IAS 36 Impairment of assets.
Negative goodwill arises when the acquirers interest in the net fair value of the acquirees identifiable
assets, liabilities and contingent liabilities exceeds the cost of the business combination. IFRS 3 refers to
negative goodwill as the excess of acquirer's interest in the net fair value of acquiree's identifiable assets,
liabilities and contingent liabilities over cost.
Negative goodwill can arise as the result of errors in measuring the fair value of either the cost of the
combination or the acquiree's identifiable net assets. It can also arise as the result of a bargain purchase.
Where there is negative goodwill, an entity should first reassess the amounts at which it has measured
both the cost of the combination and the acquiree's identifiable net assets. This exercise should identify
any errors.
Any negative goodwill remaining should be recognised immediately in profit or loss (that is, in the
income statement).
IFRS 3 requires extensive disclosures. These include a reconciliation of the carrying amount of goodwill
at the beginning and end of the period, showing separately:
(a) The gross amount and accumulated impairment losses at the beginning of the period
(b) Additional goodwill recognised during the period
(c) Impairment losses recognised during the period
(d) Net exchange differences arising during the period, and
(e) The gross amount and accumulated impairment losses at the end of the period
Goodwill is discussed in more detail in Chapter 10.

Activity 8.7

What are the main characteristics of goodwill which distinguish it from other intangible non-current
assets?

8 IAS 36: Impairment of assets
Impairment is determined by comparing the carrying amount of the asset with its recoverable amount.
Assets should not be carried at above their recoverable amount. An entity should write down the carrying
value of an asset to its recoverable amount if the carrying value of an asset is not recoverable in full. In
this case the asset is said to have been impaired.
Impairment: a fall in the value of an asset, so that its 'recoverable amount' is now less than its
carrying value in the statement of financial position.
Carrying amount is the net value at which the asset is included in the statement of financial
position (ie after deducting accumulated depreciation and any impairment losses). (IAS 36)
The basic principle underlying IAS 36 is relatively straightforward. If an asset's value in the accounts is
higher than its realistic value, measured as its 'recoverable amount', the asset is judged to have suffered
an impairment loss. It should therefore be reduced in value, by the amount of the impairment loss. The
amount of the impairment loss should be written off against profit immediately.
The main accounting issues to consider are therefore as follows.
(a) How is it possible to identify when an impairment loss may have occurred?
(b) How should the recoverable amount of the asset be measured?
(c) How should an 'impairment loss' be reported in the accounts?
8.1 Identifying a potentially impaired asset
An entity should assess at each reporting date whether there are any indications of impairment to any
assets. The concept of materiality applies, and only material impairment needs to be identified.
If there are indications of possible impairment, the entity is required to make a formal estimate of the
recoverable amount of the assets concerned.
IAS 36 suggests how indications of a possible impairment of assets might be recognised. The
suggestions are based largely on common sense.
(a) External sources of information
(i) A fall in the asset's market value that is more significant than would normally be expected
from passage of time over normal use.
(ii) A significant change in the technological, market, legal or economic environment of the
business in which the assets are employed.
(iii) An increase in market interest rates or market rates of return on investments likely to affect
the discount rate used in calculating value in use.
(iv) The carrying amount of the entity's net assets being more than its market capitalisation.
(b) Internal sources of information: evidence of obsolescence or physical damage, adverse changes in
the use to which the asset is put, or the asset's economic performance
Even if there are no indications of impairment, the following assets must always be tested for impairment
annually.
(a) An intangible asset with an indefinite useful life
(b) Goodwill acquired in a business combination

8.2 Measuring the recoverable amount of the asset
What is an asset's recoverable amount?
The recoverable amount of an asset should be measured as the higher value of:
(a) the asset's fair value less costs to sell; and
(b) its value in use. (IAS 36)
An asset's fair value less costs to sell is the amount net of selling costs that could be obtained from the
sale of the asset. Selling costs include sales transaction costs, such as legal expenses.
(a) If there is an active market in the asset, the net selling price should be based on the market value,
or on the price of recent transactions in similar assets.
(b) If there is no active market in the assets it might be possible to estimate a net selling price using
best estimates of what 'knowledgeable, willing parties' might pay in an arm's length transaction.
Net selling price cannot be reduced, however, by including within selling costs any restructuring or
reorganisation expenses, or any costs that have already been recognised in the accounts as liabilities.
The value in use of an asset is measured as the present value of estimated future cash flows (inflows
minus outflows) generated by the asset, including its estimated net disposal value (if any) at the end of its
expected useful life.
You do not need to worry about the detailed calculation of value in use but you should be aware of what it
is and its relevance.
8.3 Recognition and measurement of an impairment loss
If the recoverable amount of an asset is lower than the carrying amount, the carrying amount should be
reduced by the difference (ie the impairment loss) which should be charged as an expense in the income
statement.
The rule for assets held at a revalued amount (such as property revalued under IAS 16) is:
The impairment loss is to be treated as a revaluation decrease under the relevant IAS.
In practice this means:
To the extent that there is a specific revaluation surplus held in respect of the specific asset, the
impairment loss should be charged to revaluation surplus.
Any excess should be charged to the income statement.
8.4 Cash generating units
As a basic rule, the recoverable amount of an asset should be calculated for the asset individually.
However, there will be occasions when it is not possible to estimate such a value for an individual asset,
particularly in the calculation of value in use. This is because it may be difficult to attribute cash inflows
and outflows to the individual assets.
If it is not possible to calculate the recoverable amount for an individual asset, the recoverable amount of
the asset's cash generating unit should be measured instead.
A cash generating unit is the smallest identifiable group of assets for which independent cash flows can
be identified and measured.
8.5 Accounting treatment of an impairment loss
If, and only if, the recoverable amount of an asset is less than its carrying amount in the statement of
financial position, an impairment loss has occurred. This loss should be recognised immediately.
(a) The asset's carrying amount should be reduced to its recoverable amount in the statement of
financial position.
(b) The impairment loss should be recognised immediately in the income statement (unless the asset
has been revalued in which case the loss is treated as a revaluation decrease).
After reducing an asset to its recoverable amount, the depreciation charge on the asset should then be
based on its new carrying amount, its estimated residual value (if any) and its estimated remaining useful
life.
An impairment loss should be recognised for a cash generating unit if (and only if) the recoverable
amount for the cash generating unit is less than the carrying amount in the statement of financial position
for all the assets in the unit. When an impairment loss is recognised for a cash generating unit, the loss
should be allocated between the assets in the unit in the following order.
(a) First, to the goodwill allocated to the cash generating unit
(b) Then to all other assets in the cash-generating unit, on a pro rata basis
In allocating an impairment loss, the carrying amount of an asset should not be reduced below the highest
of:
(a) Its fair value less costs to sell
(b) Its value in use (if determinable)
(c) Zero
Any remaining amount of an impairment loss should be recognised as a liability if required by other IASs.
8.6 Example: impairment loss
A company that extracts natural gas and oil has a drilling platform in the Caspian Sea. It is required by
legislation of the country concerned to remove and dismantle the platform at the end of its useful life.
Accordingly, the company has included an amount in its accounts for removal and dismantling costs, and
is depreciating this amount over the platform's expected life.
The company is carrying out an exercise to establish whether there has been an impairment of the
platform.
(a) Its carrying amount in the statement of financial position is $3m.
(b) The company has received an offer of $2.8m for the platform from another oil company. The bidder
would take over the responsibility (and costs) for dismantling and removing the platform at the end
of its life.
(c) The present value of the estimated cash flows from the platform's continued use is $3.3m.
(d) The carrying amount in the statement of financial position for the provision for dismantling and
removal is currently $0.6m.
What should be the value of the drilling platform in the statement of financial position, and what, if
anything, is the impairment loss?
Solution
Fair value less costs to sell = $2.8m
Value in use = PV of cash flows from use less the carrying amount of the
provision/liability = $3.3m $0.6m = $2.7m
Recoverable amount = Higher of these two amounts, ie $2.8m
Carrying value = $3m
Impairment loss = $0.2m
The carrying value should be reduced to $2.8m.

9 Investments
A company may have investments e.g. shares in another company. These would be treated as a financial
asset under IAS 39.
This is an extremely complex standard outside the scope of your syllabus. You should assume that
investments are recognised at their cost.
448 8: Share capital and reserves
1 Share capital of limited companies
Share capital consists of ordinary shares, and there may also be other classes of shares such as preferred
shares.
The proprietors' capital in a limited company consists of share capital. Share capital may be divided into
several different classes. Each class of shares entitles the shareholders to different rights.
(a) All companies have ordinary shares (and may have more than one class of ordinary shares)
(b) A company may have one or more classes of preferred shares. Most classes of preferred shares
entitle the shareholders to a fixed annual dividend.
Preferred shares are shares which confer certain preferential rights on their holder. These normally
include the right to receive a dividend ahead of the ordinary shareholders and, in the event of the company
becoming insolvent, the right to recovery of their nominal investment ahead of the ordinary shareholders.
Ordinary shares are shares which are not preferential with regard to dividend payments. Thus a holder
only receives a dividend after fixed dividends have been paid to preferred shareholders. The ordinary
dividend could well be higher than the preference dividend. Ordinary shareholders are the real owners
(and 'risk takers'). Ordinary shares are commonly referred to as 'equity' or 'equity shares'.
Shareholders receive returns in the form of dividends. Dividends are paid out of the distributable profits of
the company. Distributable profits are profits that have been 'realised' (from the sale of goods or services,
from the disposal of non-current assets, from income from various sources, such as income from
investments, etc).
It is usual for a company to pay dividends out of its profits after tax for the year. Total after-tax profits will
usually be higher than the dividend payments, and the remaining profits will be retained in the business. In
effect, retained profits are a way of making shareholders continue to invest in their company.

Share capital and
reserves
8: Share capital and reserves 449

Activity 9.1

Garden Gloves Co has issued 50,000 ordinary shares of 50 cents each and 20,000 7% preferred shares of
$1 each. Its profits after taxation for the year to 30 September 20X5 were $8,400. The board of directors
has decided to pay an ordinary dividend (i.e. a dividend on ordinary shares) which is 50% of profits after
tax and preference dividend.
Required
Show the amount in total of dividends and of retained profits.

1.1 Authorised, allotted and called up share capital
Share capital is reported in the accounts at the nominal value of the shares allotted, but only to the extent
that the capital on the shares has been called up.
A distinction must be made between authorised, allotted (issued), called-up and paid-up share capital.
(a) Authorised (or legal) capital is the maximum amount of share capital that a company's directors
are permitted to issue. The amount of authorised share capital varies from company to company,
and can only be increased by agreement.
For example, a company's authorised share capital might be 5,000,000 ordinary shares of $1 each.
This would then be the maximum number of shares it could issue, unless the authorised share
capital were to be changed with agreement from the shareholders.
(b) Allotted capital, also called issued share capital, is the nominal amount of share capital that has
been issued to shareholders. The amount of issued capital cannot exceed the amount of authorised
capital.
In the example above, suppose the company with authorised share capital of 5,000,000 ordinary
shares of $1 has allotted 4,000,000 shares. This would still give it the option to issue 1,000,000
more shares at some time in the future, without the need to increase the authorised share capital.
(c) Called-up capital. When shares are issued or allotted, a company does not always expect to be
paid the full amount for the shares at once. It might instead call up only a part of the issue price,
and wait until a later time before it calls up the remainder.
For example, if a company allots 4,000,000 ordinary shares of $1, it might call up only, say, 75
cents per share. The issued share capital would be $4,000,000, but the called up share capital
would only be $3,000,000.
(d) Paid-up capital. Like everyone else, investors are not always prompt or reliable payers. When
capital is called up, some shareholders might delay their payment (or even default on payment).
Paid-up capital is the amount of called-up capital that has been paid.

Sometimes, a company's directors might want to pay out dividends in excess of the company's after-tax
profits for the year. This is permissible, provided the company has sufficient retained profits from previous
years.
Under IAS 32 Financial instruments: Presentation, redeemable preferred shares are shown as liabilities in
the statement of financial position and their dividends treated as finance costs in the income statement or
statement of comprehensive income. All other preferred shares are treated as shares and their dividends
appropriated, with ordinary dividends.
The statement of financial position of the company would then include called up capital not paid on
the assets side, as follows:

$

Called-up capital not paid

100,000

Cash (called-up capital paid)

2,900,000

3,000,000

Called-up share capital

4,000,000 ordinary shares of $1, with 75c per share called up

3,000,000

1.2 Share capital in the statement of financial position
Share capital is reported in the statement of financial position at its called up value. Since most shares are
issued fully paid, the called up share capital and the allotted share capital are normally the same amount.
Shares are reported in different classes, for example:
Equity

$'000
Ordinary shares of 10c each 120,000
6% preferred shares of $1

3,000

123,000

On the face of the statement of financial position, there will be a single figure for share capital, with further
details in a note to the account. The further details will include the authorised share capital, and the called
up share capital, the number and nominal value of the shares issued. For example:

Authorised Allotted, called up and fully paid

Number of 50c
shares
Number of 50c
shares
Nominal
value

$
'000

$
'000

$'000

At the start of the year

10,000

7,000

3,500

Issued during the year

1,000

500


10,000

8,000

4,000

1.3 The issue price for shares
The amount at which the shares are allotted/issued will often exceed their nominal value, especially in the
case of a public company making a new issue of shares. For example, a company might issue 100,000 $1
shares at a price of $1.20 each. Subscribers will then pay a total of $120,000. The issued share capital of
the company would be shown in its accounts at nominal value, $100,000; the excess of $20,000 is
described not as share capital, but as share premium.
Stock market companies making a new issue of shares are likely to price the issue at an amount that
reflects the current market price of the shares, which could be well in excess of the nominal value of the
shares. The statement of financial position shows the nominal value of issued shares, not their market
value. Thus, when new shares are issued, the share premium could be very large.
For example, if a company issues 4,000,000 ordinary shares of $1 each, calls up 75 cents per
share, and receives payments of $2,900,000, we would have:
$
Allotted or issued capital 4,000,000
Called-up capital 3,000,000
Paid-up capital 2,900,000
Called-up capital not paid 100,000
2 Shareholders' equity
The net assets of a company (i.e. assets minus liabilities) are 'financed' by the shareholders' capital. The
share capital is recorded in the statement of financial position of a company. The rest of the capital of a
company is represented by reserves.
Shareholders' equity consists of:
(a) The nominal value of issued capital (minus any amounts not yet called up on issued shares)
(b) Other equity
The share capital itself might consist of both ordinary shares and preferred shares. All reserves, however,
are owned by the ordinary shareholders, who own the 'equity' in the company. We looked at share capital
in detail above.
'Other equity' under IAS 1 consists of four elements.
(a) Capital paid-in in excess of par value (share premium)
(b) Revaluation surplus
(c) Reserves
(d) Retained earnings
We will look at each in turn.
3 Share premium account
A share premium account is an account into which sums received as payment for shares in excess of
their nominal value must be placed.
In this context, 'premium' means the difference between the issue price of the share and its par value. The
account is sometimes called 'capital paid-in in excess of par value'. When a company is first incorporated
(set up) the issue price of its shares will probably be the same as their par value and so there would be no
share premium. If the company does well, the market value of its shares will increase, but not the par
value. The price of any new shares issued will be approximately their market value.
The difference between cash received by the company and the par value of the new shares issued is
transferred to the share premium account. For example, if X Co issues 1,000 $1 ordinary shares at $2.60
each the book entry will be:

$ $
Cash 2,600

Ordinary shares 1,000
Share premium account 1,600
A share premium account only comes into being when a company issues shares at a price in excess of
their nominal value. The market price of the shares, once they have been issued, has no bearing at all on

1.4 The market value of shares
The nominal value of shares will be different from their market value, which is the price at which someone
is prepared to purchase shares in the company from an existing shareholder. If Mr A owns 1,000 $1
shares in Z Co he may sell them to B for $5.60 each.
This transfer of existing shares does not affect Z Co's own financial position in any way whatsoever. There
are no accounting entries to be made for the share sale, as the transaction is between Mr A and B.
4 Revaluation surplus
The revaluation surplus is a statutory reserve and consists of non-distributable profits (see Section 6).
A company may revalue some of its assets. For example, a company may revalue its properties from $40
million, say, to $50 million. An increase in an asset value for a company represents a gain for the
company. This gain has to be included in its reserves. (The dual effect is + Assets, + Capital.) We looked
at the mechanics of this in Chapter 8.
If the company continues to hold the asset, any gain on revaluation is unrealised. The company has not
sold the asset, and has not earned any cash from the revaluation gain. It would therefore be inappropriate
to allow the company to pay dividends out of unrealised gains. (Apart from the fact that the company
might not have the cash to afford a dividend on the gain, the asset might subsequently fall in value, thus
incurring a loss. It would therefore be premature to pay dividends out of unrealised gains, i.e. before the
asset is actually sold and the gain is realised.)
Companies are therefore required to make a 'transfer' to a revaluation surplus, whenever it revalues a non-
current asset. Both the asset and the reserve are increased by the amount of the revaluation (i.e. by the
amount of the increase in the total value of the asset minus any accumulated depreciation on the asset to
date.) The revaluation is taken directly to the revaluation surplus account, and is not reported as part of
the company's profit for the year. The revaluation gain will be reflected in the statement of comprehensive
income which we looked at in chapter 5.
4.1 Disposal of a revalued asset
When an asset is disposed of, having been revalued in the past, the revaluation gain that had previously
been unrealised is now realised. Since the gain is realised, the company can, if it wishes, pay dividends
out of the profit (after tax).
After disposal, it is therefore inappropriate to keep an amount in the revaluation surplus for an asset the
company no longer owns. The accounting treatment is as follows.
(a) The company may report a profit (or loss) on the disposal of the asset, but this is the difference
between the net sales proceeds and the carrying value of the asset at the time of the disposal. The
carrying value is a term for the value of the asset in the statement of financial position and in the
accounting records at the time. With a revalued asset, the carrying value is the revalued amount
less accumulated depreciation.
(b) The rest of the realised profit on disposal is transferred directly from the revaluation surplus to the
retained earnings account, without being reported as part of the profit for the year. The gain is now
distributable, but it does not form part of the 'current year' profits.

Activity 9.2

A company owns a property which was valued at cost $5 million minus accumulated depreciation on the
building of $250,000. It was then revalued to $10 million less accumulated depreciation of $500,000. Some

the company's accounts, and so if their market price goes up or down, the share premium account would
remain unaltered.
Once established, the share premium account constitutes capital of the company which cannot be paid out
in dividends, ie it is a capital reserve. The share premium account will increase in value if and when new
shares are issued at a price above their par value. The share premium account can be 'used' - and so
decrease in value - only in certain very limited ways, which are largely beyond the scope of your syllabus.
One common use of the share premium account, however, is to 'finance' the issue of bonus shares, which
are described later in this chapter. Other uses of this account may depend on national legislation.
The share premium account cannot be distributed as dividend under any circumstances as it is a statutory
reserve (see Section 6).
5 Reserves
Reserves can be classified as non-statutory (distributable in dividends) and statutory (non-distributable).
In most countries, a distinction must be made between:
(a) Statutory reserves, which are reserves which a company is required to set up by law, and which
are not available for the distribution of dividends. We have looked at the share premium account
and the revaluation surplus.
(b) Non-statutory reserves, which are reserves consisting of profits which are distributable as
dividends, if the company so wishes
We are concerned with the latter type, which the company managers may choose to set up. These may
have a specific purpose (eg plant and machinery replacement reserve) or not (eg general reserve). The
creation of these reserves usually indicates a general intention not to distribute the profits involved at any future
date, although legally any such reserves, being non-statutory, remain available for the payment of dividends.
Profits are transferred to these reserves by making an appropriation out of profits, usually profits for the
year. Typically, you might come across the following.

$

$

Profit after taxation

100,000

Appropriations of profit

Dividend

60,000

Transfer to general reserve

10,000

70,000

Retained profit for the year

30,000

Retained earnings b/f

250,000

Retained earnings c/f

280,000

6 Why statutory reserves are non-distributable
Statutory reserves are non-distributable to avoid a reduction in the capital of the company.
The reason for creating statutory reserves is to maintain the capital of the company. This capital 'base'
provides some security for the company's creditors, bearing in mind that the liability of shareholders is limited
in the event that the company cannot repay its debts. It would be most unjust - and illegal - for a company to
pay its shareholders a dividend out of its base capital when it is not even able to pay back its debts.
Another reason why statutory reserves such as the share premium account cannot be distributed as
dividends is the fact that they often represent unrealised profits. A profit does arise when assets are
revalued but it is not realised into cash. It is a generally accepted accounting principle that profit can only
be distributed when it is realised because an unrealised profit can disappear if the value of the revalued
asset subsequently drops.
7 Retained earnings
This is the most significant reserve and is variously described as:
(a) Retained earnings (as in IAS 1)
(b) Revenue reserve
(c) Retained profits
(d) Accumulated profits
(e) Undistributed profits
(f) Unappropriated profits

time later, the building was sold for $12 million. At this time, the accumulated depreciation was $700,000.
(a) How would the revaluation be accounted for?
(b) How would the disposal of the property be accounted for?
Provided that a company is earning profits, this reserve generally increases from year to year, as most
companies do not distribute all their profits as dividends. Dividends can be paid from it: even if a loss is
made in one particular year, a dividend can be paid from previous years' retained earnings.
For example, if a company makes a loss of $100,000 in one year, yet has unappropriated profits from
previous years totalling $250,000, it can pay a dividend not exceeding $150,000. One reason for retaining
some profit each year is to enable the company to pay dividends even when profits are low (or
non-existent). Another reason is usually shortage of cash.
Very occasionally, you might come across a negative balance on the retained earnings account. This
would indicate that the company has retained (accumulated) losses.
8 Bonus issues of shares
A bonus issue capitalises some of the reserves of the company.
A company may wish to increase the number of shares in issue without needing to raise additional finance
by issuing new shares. For example, a profitable company might expand from modest beginnings over a
number of years. Its profitability would be reflected in large balances on its reserves, while its original
share capital might look like that of a much smaller business.
It is open to such a company to re-classify some of its reserves as share capital. This is purely a paper
exercise which raises no funds. Any reserve may be re-classified in this way, including a share premium
account or other statutory reserve.
Suppose for example that Bubbles Co has the following shareholders' equity.
BUBBLES CO
STATEMENT OF FINANCIAL POSITION (EXTRACT)

$'000

$'000

Shareholders' equity

Share capital

$1 ordinary shares (fully paid)

100,000

Reserves

Share premium

100,000

Retained earnings

200,000

300,000

400,000

Bubbles decided to make a '3 for 2' bonus issue (ie issue 3 new shares for every 2 already held).
150 million new ('bonus') shares are issued to existing shareholders, so that if shareholder X previously
held 20,000 shares, he will now hold 50,000. The total value of his holding should theoretically remain the
same however, since the net assets of the company remain unchanged and his share of those net assets
remains at 0.02% (i.e. 50,000/250,000,000; previously 20,000/100,000,000).
The company will almost certainly use up its share premium account to increase the share capital. The
remaining addition to share capital would have to be 'financed' by a transfer from the retained earnings.
The share capital and reserves after the bonus issue will be:

$ million

$ million


Share capital

$1 ordinary shares (fully paid)

250

Reserves

Share premium

0

Retained earnings

150

150

400

These are profits earned by the company and not appropriated by dividends, taxation or transfer to
another reserve account.
The total for share capital and reserves is unchanged. No new money has been raised or assets acquired
by the share issue.
9 Rights issues of shares
When a rights issue occurs, there will be an increase in both share capital (nominal value of shares
issued) and share premium.
A rights issue (unlike a bonus issue) is an issue of shares for cash. Existing shareholders are offered new
shares that the company is issuing, in proportion to their existing shareholding. For example, suppose that
a company has 100 million shares in issue and plans to issue a further 50 million shares to raise cash. In
a rights issue, it would offer existing shareholders 1 new share for every 2 shares they currently hold.
The share price in a rights issue is normally below the current market price for the shares.
Bubbles Co (above) decides to make a rights issue, shortly after the bonus issue. The terms are '2 for 5 at
$2.50' (i.e. two new shares for every five already held, at a price of $2.50). Assuming that all shareholders
take up their rights (which they are not obliged to), the company will issue 100 million new shares (250
million already in issue, x 2/5) to raise $250 million. This will be raised in cash. Share capital and reserves
will increase by $250 million in total, of which $100 million is the nominal value of the new shares and
$150 million is share premium. The statement of financial position after the rights issue is as follows.

$ million

$ million


Share capital

$1 ordinary shares (fully paid) (250 million + 100 million)

350

Reserves

Share premium ( + 150 million)

150

Retained earnings

150

300

650

Rights issues are a popular way of raising cash by issuing shares and they are relatively cheap to
administer. In addition shareholders retain control of the business as their holding is not diluted.
10 Disclosures in the accounts
In most countries companies must include a note in their annual accounts giving details of movements on
the reserve accounts during the year.
Although local rules may vary, in most jurisdictions companies are required to disclose, in notes to their
accounts, information about their share capital and about movements on their reserves during the year. An
example of a note on reserves (based on the UK Companies Act) is shown below.
[Note number] Reserves

Share

Revaluation

General

Retained

premium
account

surplus

reserve

earnings

$'000

$'000

$'000

$'000

At 1 January 20X5

750

240

70

1,400

On issue of shares

120

Retained profit for the year

360

Revaluation

80

Transfers

25

(25)

At 31 December 20X5

870

320

95

1,735

Note that detailed disclosures will not be required in the exam.

456 9: Group accounts
1 Definitions
This chapter explains the concept of a group and introduces several important definitions.
You will probably know that most large 'companies' actually consist of several companies controlled by
one central or administrative company. Together these companies are called a group. The controlling
company, called the parent (sometimes referred to as the holding company), will own some or all of the
shares in the other companies. The other companies in a group are called subsidiary companies and
there may also be associated companies.
For example, a parent company Parent Co might own all the shares of another company, Sub. The parent
company's statement of financial position will show its investment in Sub as a long-term investment,
either at cost (less any diminution in value) or market value. The parent's own statement of financial
position will not disclose any details about the assets of Sub.
In some countries (eg the UK), parent companies of a group are required by law to prepare consolidated
accounts for the group as a whole. The purpose of consolidated accounts is to show the results and
financial position of the group as a whole. Consolidated accounts combine the assets and liabilities, and
the profits, of all the companies in the group, and report them as if the group is just a single undertaking.
The purpose of consolidated accounts is to give users of the accounts (e.g. shareholders in, and creditors
of, the parent company) a much better understanding of the financial position and performance of the
assets and liabilities of the group that the parent company controls.
Group accounts (consolidated accounts) are prepared by the parent company for all the companies in the
group.
We will look at some of these definitions in more detail later, but they are useful here in that they give you
an overview of all aspects of group accounts.

Group accounts
9: Group accounts 457
Control. The power to govern the financial and operating policies of an entity so as to obtain
benefits from its activities. (IFRS 3, IASs 27, 28, 31)
Subsidiary. An entity that is controlled by another entity (known as the parent). (IASs 27, 28)
Parent. An entity that has one or more subsidiaries. (IAS 27)
Group. A parent and all its subsidiaries. (IAS 27)
Associate. An entity, including an unincorporated entity such as a partnership, in which an investor
has significant influence and which is neither a subsidiary nor a joint venture of the investor.
(IAS 28)
Significant influence is the power to participate in the financial and operating policy decisions of
an investee or an economic activity but is not control or joint control over those policies.
(IASs 28, 31)
Joint venture. A contractual arrangement whereby two or more parties undertake an economic
activity which is subject to joint control. (IAS 31)
1.1 Investments in subsidiaries
The important point here is control. In most cases, this will involve the parent company owning a majority
of the ordinary shares in the subsidiary (to which normal voting rights are attached). There are
circumstances, however, when the parent may own only a minority of the voting power in the subsidiary,
but the parent still has control.
IAS 27 Consolidated and separate financial statements states that control can usually be assumed to exist
when the parent owns more than half (ie over 50%) of the voting power of an entity unless it can be
clearly shown that such ownership does not constitute control (these situations will be very rare).
What about situations where this ownership criterion does not exist? IAS 27 lists the following situations
where control exists, even when the parent owns only 50% or less of the voting power of an entity.
(a) The parent has power over more than 50% of the voting rights by virtue of agreement with other
investors
(b) The parent has power to govern the financial and operating policies of the entity by statute or
under an agreement
(c) The parent has the power to appoint or remove a majority of members of the board of directors
(or equivalent governing body)
(d) The parent has power to cast a majority of votes at meetings of the board of directors
IAS 27 also states that a parent loses control when it loses the power to govern the financial and operating
policies of an investee. Loss of control can occur without a change in ownership levels. This may happen
if a subsidiary becomes subject to the control of a government, court administrator or regulator (for
example, in bankruptcy).
1.2 The requirement to consolidate
IAS 27 requires a parent to present consolidated financial statements, in which the accounts of the
parent and subsidiary (or subsidiaries) are combined and presented as a single entity, unless it is able to
use a permissible exemption from this requirement.
Consolidated financial statements. The financial statements of a group presented as those of a single
economic entity. (IAS 27)
When a parent issues consolidated financial statements, it should consolidate all subsidiaries, both
foreign and domestic.
1.3 Exemption from preparing group accounts
A parent need not present consolidated financial statements if and only if all of the following hold:
(a) The parent is itself a wholly-owned subsidiary or it is a partially owned subsidiary of another
entity and its other owners, including those not otherwise entitled to vote, have been informed
about, and do not object to, the parent not presenting consolidated financial statements
(b) Its securities are not publicly traded
(c) It is not in the process of issuing securities in public securities markets; and
(d) The ultimate or intermediate parent publishes consolidated financial statements that comply with
International Financial Reporting Standards
Where this is the case disclosure in the individual financial statements is required.
1.4 Investments in associates
This type of investment is something less than a subsidiary, but more than a simple investment (nor is it a
joint venture). The key criterion here is significant influence. This is defined as the 'power to participate',
but not to 'control' (which would make the investment a subsidiary).
Significant influence can be determined by the holding of voting rights (usually attached to shares) in the
entity. IAS 28 Investments in associates states that if an investor holds 20% or more of the voting power
of the investee, it can be presumed that the investor has significant influence over the investee, unless it
can be clearly shown that this is not the case.
Significant influence can be presumed not to exist if the investor holds less than 20% of the voting power
of the investee, unless it can be demonstrated otherwise.
The existence of significant influence is evidenced in one or more of the following ways.
(a) Representation on the board of directors (or equivalent) of the investee
(b) Participation in the policy making process
(c) Material transactions between investor and investee
(d) Interchange of management personnel
(e) Provision of essential technical information
IAS 28 requires the use of the equity method of accounting for investments in associates. This method
will be explained in detail in Section 14.
1.5 Accounting for investments in joint ventures
There are situations where venturers control jointly either operations or assets of the joint venture. The case
of a jointly controlled entity will be considered in detail in Section 15.
IAS 31 Interests in joint ventures allows two treatments for investments in joint entities.
(a) Either: proportionate consolidation
(b) Or: equity method
Proportionate consolidation is explained in detail in section 15.5.1, and the equity method in section 14.
1.6 Other investments
Investments which do not meet the definitions of any of the above should be accounted for according to
IAS 39 Financial instruments: recognition and measurement.

1.7 Definitions summarised
Investment Criteria Required treatment in group accounts
Subsidiary Control (> 50% rule) Full consolidation (IAS 27)
Associate Significant influence
(20%+ rule)
Equity accounting (IAS 28)
Joint venture (jointly
controlled entity)
Contractual joint control Either: proportionate consolidation
Or: equity accounting (IAS 31)
Investment which is
none of the above
Asset held for accretion of
wealth
As for single company accounts (IAS 39)

2 Content of group accounts and group structure
Group accounts show the results of the parent plus any subsidiaries as if they were a single company.
The information contained in the individual statements of a parent company and each of its subsidiaries
does not give a picture of the group's total activities. A separate set of group statements can be prepared
from the individual ones. Remember that a group has no separate (legal) existence, except for accounting
purposes.
Consolidated accounts are one form of group accounts which combines the information contained in the
separate accounts of a parent company and its subsidiaries as if they were the accounts of a single entity.
'Group accounts' and 'consolidated accounts' are terms often used synonymously.
In simple terms a set of consolidated accounts is prepared by adding together the assets and liabilities of
the parent company and each subsidiary. The whole of the assets and liabilities of each company are
included, even though some subsidiaries may be only partly owned. The 'equity and liabilities' side of the
statement of financial position will indicate how much of the net assets are attributable to the group and
how much to outside investors in partly owned subsidiaries. These outside investors are known as non-
controlling interests (previously they were known as minority interests, see Section 4).
Non-controlling interest. That part of the profit or loss and of net assets of a subsidiary attributable to
equity interests which are not owned directly, or indirectly through subsidiaries, by the parent.

(IAS 27)
Non-controlling interests should be presented in the consolidated statement of financial position within
equity, separately from the parent shareholders' equity.
Most parent companies present their own individual accounts and their group accounts in a single
package. The package typically comprises the following.

Parent company financial statements, which will include 'investments in subsidiaries as an asset
in the statement of financial position, and income from subsidiaries (in dividends) in the income
statement

Consolidated statement of financial position

Consolidated income statement or statement of comprehensive income

Consolidated statement of cash flows

It may not be necessary to publish all of the parent company's financial statements, depending on local or
national regulations.

Activity 10.1

Are the following companies a subsidiary or associate of P Co, or neither?
1 Bump is 75% owned by Clump, which is itself 60% owned by P Co
2 Pump is 30% owned by P Co
3 Frump is 15% owned by P Co

3 Introduction to the consolidated statement of
financial position
Balances of the parent company and subsidiaries are added together on a line-by-line basis. Intra-group
balances are cancelled out.
3.1 Basic procedure
The financial statements of a parent and its subsidiaries are combined on a line-by-line basis by adding
together like items of assets, liabilities, equity, income and expenses.
The following steps are then taken, in order that the consolidated financial statements should show
financial information about the group as if it was a single entity.
(a) The carrying amount of the parent's investment in each subsidiary and the parent's portion of
equity of each subsidiary are eliminated or cancelled
(b) Non-controlling interests in the net income of consolidated subsidiaries are adjusted against
group income, to arrive at the net income attributable to the owners of the parent
(c) Non-controlling interests in the net assets of consolidated subsidiaries should be presented
separately in the consolidated statement of financial position (see Section 4)
Other matters to be dealt with include the following.
(a) Goodwill on consolidation should be dealt with according to IFRS 3 (see Section 6)
(b) Dividends payable by a subsidiary must be accounted for (see Section 5)
IAS 27 states that all intragroup balances and transactions, and the resulting unrealised profits, should be
eliminated in full. Unrealised losses resulting from intragroup transactions should also be eliminated
unless cost can be recovered. This will be explained later in this chapter.
3.2 Cancellation and part cancellation
The preparation of a consolidated statement of financial position, in a very simple form, consists of two
procedures.
(a) Take the individual accounts of the parent company and each subsidiary and cancel out items
which appear as an asset in one company and a liability in another.
(b) Add together all the uncancelled assets and liabilities throughout the group.
Items requiring cancellation may include the following.
(a) The asset 'shares in subsidiary companies' which appears in the parent company's accounts will
be matched with the liability 'share capital' in the subsidiaries' accounts.

(b) There may be intra-group trading within the group. For example, S Co may sell goods on credit to
P Co. P Co would then be a receivable in the accounts of S Co, while S Co would be a payable in
the accounts of P Co.
3.3 Example: cancellation
P Co regularly sells goods to its subsidiary company, S Co. P Co has owned all the share capital of S Co
since S Cos incorporation. The statements of financial position of the two companies on 31 December
20X6 are given below.
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X6

P Co

S Co

$

$

Assets

Non-current assets


35,000

45,000

Investment in 40,000 $1 shares in S Co at cost

40,000

75,000

Current assets

Inventories

16,000

12,000

Receivables: S Co

2,000

Other

6,000

9,000

Cash at bank

1,000

Total assets

100,000

66,000


Equity

40,000 $1 ordinary shares

40,000


70,000

Retained earnings

16,000

19,000

86,000

59,000

Current liabilities

Bank overdraft

3,000

Payables: P Co

2,000

Other

14,000

2,000


100,000

66,000

Required
Prepare the consolidated statement of financial position of P Co at 31 December 20X6.
Solution
The cancelling items are:
(a) P Co's asset 'investment in shares of S Co' ($40,000) cancels with S Co's liability 'share capital'
($40,000);
(b) P Co's asset 'receivables: S Co' ($2,000) cancels with S Co's liability 'payables: P Co' ($2,000).
The remaining assets and liabilities are added together to produce the following consolidated statement of
financial position.
P CO
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X6
Assets $ $
Non-current assets
Property, plant and equipment 80,000

Current assets
Inventories
28,000

Receivables
15,000

Cash at bank
1,000

44,000

Total assets
124,000

Equity
70,000

Retained earnings
35,000

105,000

Current liabilities
Bank overdraft
3,000

Payables
16,000

19,000

124,000

Note the following.
(a) P Co's bank balance is not netted off with S Co's bank overdraft. To offset one against the other
would be less informative and would conflict with the principle that assets and liabilities should not
be netted off.
(b) The share capital in the consolidated statement of financial position is the share capital of the
parent company alone. This must always be the case, no matter how complex the consolidation,
because the share capital of subsidiary companies must always be a wholly cancelling item.
3.4 Part cancellation
An item may appear in the statements of financial position of a parent company and its subsidiary, but not
at the same amounts.
(a) The parent company may have acquired shares in the subsidiary at a price greater or less than
their nominal value. The asset will appear in the parent company's accounts at cost, while the
liability will appear in the subsidiary's accounts at par value. This raises the issue of goodwill,
which is dealt with later in this chapter.
(b) Even if the parent company acquired shares at par value, it may not have acquired all the shares
of the subsidiary (so the subsidiary may be only partly owned). This raises the issue of non-
controlling interests, which are also dealt with later in this chapter.
(c) The inter-company trading balances may be out of step because of goods or cash in transit.
(d) One company may have issued loan stock of which a proportion only is taken up by the other
company.
The following question illustrates the techniques needed to deal with items (c) and (d) above. The
procedure is to cancel as far as possible. The remaining uncancelled amounts will appear in the
consolidated statement of financial position.
(a) Uncancelled loan stock will appear as a liability of the group.
(b) Uncancelled balances on intra-group accounts represent goods or cash in transit, which will
appear in the consolidated statement of financial position.

Activity 10.2

The statements of financial position of P Co and of its subsidiary S Co have been made up to 30 June. P
Co has owned all the ordinary shares and 40% of the loan stock of S Co since its incorporation.
P CO
STATEMENT OF FINANCIAL POSITION AS AT 30 JUNE

$

$

Assets

Non-current assets


120,000

Investment in S Co, at cost

80,000 ordinary shares of $1 each

80,000

$20,000 of 12% loan stock in S Co

20,000

220,000

Current assets

Inventories

50,000

Receivables

40,000

Current account with S Co

18,000

Cash

4,000

112,000

Total assets

332,000


Equity

Ordinary shares of $1 each, fully paid

100,000

Retained earnings

95,000

195,000


10% loan stock

75,000

Current liabilities

Payables

47,000

Taxation

15,000

62,000


332,000

S CO
STATEMENT OF FINANCIAL POSITION AS AT 30 JUNE

$

$

Assets

Non-current assets


100,000

Current assets

Inventories

60,000

Receivables

30,000

Cash

6,000

96,000

Total assets

196,000


Equity

80,000 ordinary shares of $1 each, fully paid

80,000

Retained earnings

28,000

108,000


12% loan stock

50,000

Current liabilities

Payables

16,000

Taxation

10,000

Current account with P Co

12,000

38,000


196,000

The difference on current account arises because of goods in transit.
Required
Prepare the consolidated statement of financial position of P Co.

4 Non-controlling interests
In the consolidated statement of financial position it is necessary to distinguish non-controlling interests
from those net assets attributable to the group and financed by shareholders' equity.
4.1 Introduction
It was mentioned earlier that the total assets and liabilities of subsidiary companies are included in the
consolidated statement of financial position, even in the case of subsidiaries which are only partly owned.
A proportion of the net assets of such subsidiaries in fact belongs to investors from outside the group
(non-controlling interests).
IFRS 3 (revised) allows two alternative ways of calculating the non-controlling interest in the group
statement of financial position. The non-controlling interest can be valued at:
(a) Its proportionate share of the value of the subsidiary's net assets; or
(b) Full (or fair) value (usually based on the market value of the shares held by the interest).
You are not required to be able to apply both of these methods in DipFM. Exam or project questions will
require you to use the full (or fair) value method.
In some cases, you may be told the value of the non-controlling interest. Obviously if this information is
provided, you can simply include the value in the consolidated statement of financial position. A more
likely situation is that you will be required to calculate the fair value of the non-controlling interest. In this

case, there are two alternative approaches that the examiner may use. The most likely approach is that you
will be given the share price immediately before the acquisition. Therefore the value of the non-controlling
interest on that date is simply the number of shares held by the non-controlling interest multiplied by the
share value.
Alternatively, if no share value is provided, you can assume that the parent acquired the shares at their fair
value. You can therefore use this value to calculate the value of the non-controlling interest.
The following example shows how the non-controlling interest is calculated.
4.2 Example: non-controlling interests
P Co has owned 75% of the share capital of S Co since the date of S Co's incorporation. Their latest
statements of financial position are given below.
P CO
STATEMENT OF FINANCIAL POSITION
$ $
Assets
Non-current assets
Tangible assets
50,000

30,000 $1 ordinary shares in S Co at cost
30,000

80,000

Current assets
45,000

Total assets
125,000

Equity
80,000

Reserves
25,000

105,000

Current liabilities
20,000

125,000

S CO
STATEMENT OF FINANCIAL POSITION
$ $
Assets
35,000

Current assets
35,000

Total assets
70,000

Equity
40,000

Reserves
10,000

50,000

Current liabilities
20,000

70,000

On the date of S Co's incorporation, the fair value of a share in S Co was $1.
Required
Prepare the consolidated statement of financial position.
Solution
All of S Co's net assets are consolidated despite the fact that the company is only 75% owned. This is
because P Co controls S Co and therefore controls all the assets and liabilities of S Co.
The value of non-controlling interests (NCI) at the reporting date is calculated as follows.
$
Value of NCI at acquisition (40,000 shares 25% @ $1) = 10,000
NCI share of post-acquisition reserves ($10,000 25%) =

2,500

thus, value of NCI
12,500

The consolidated statement of financial position can now be prepared.
P GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION
$ $
Assets
85,000

Current assets
80,000

Total assets
165,000

Equity
Share capital
80,000

Reserves $(25,000 + (75% $10,000))
32,500

112,500

12,500

125,000

Current liabilities
40,000

165,000

4.3 Procedure
(a) Aggregate the assets and liabilities in the statement of financial position ie 100% P + 100% S
irrespective of how much P actually owns.
This shows the amount of net assets controlled by the group.
(b) Share capital is that of the parent only.
(c) Calculate the value of the non-controlling interest
(value of NCI at date of acquisition + NCI share of post-acquisition profits)
(d) The parent's share of the subsidiary's post-acquisition reserves are consolidated (after cancelling
any intra-group items).

Activity 10.3

Set out below are the draft statement of financial position of P Co and its subsidiary S Co. You are
required to prepare the consolidated statement of financial position. There is no difference between book
values and fair values.
P CO
$ $
Assets

Non-current assets


Investment in S Co

12,000 $1 ordinary shares at cost 12,000

$8,000 10% loan stock at cost

8,000

20,000

51,000

Current assets

21,000

Total assets

72,000


Equity

Ordinary shares of $1 each 40,000

Retained earnings

22,000

62,000

Current liabilities

10,000


72,000

S CO

$ $

Assets

Current assets

32,000

Total assets

66,000


Equity

Ordinary shares of $1 each 20,000

Revaluation surplus 6,000

Retained earnings

4,000

30,000


10% loan stock 26,000

Current liabilities

10,000


66,000

5 Dividends payable by a subsidiary
Dividends payable by a subsidiary to the parent should be cancelled on consolidation.
Dividends payable by a subsidiary to the parent company should be cancelled on consolidation.
When a wholly-owned subsidiary pays a dividend out of its profits, the dividend payment has no effect on
the consolidated statement of financial position, because the money remains within the group. It is simply
transferred from the subsidiary to the parent.
The only time that dividends paid by a subsidiary are relevant to group accounts is when there is a non-
controlling interest. When the subsidiary has declared a final dividend on or before the reporting date, the

amount of this dividend payable to the non-controlling interest must be reported as a current liability in the
statement of financial position of the group.
Suppose that a parent company P Co has one subsidiary, in which it holds 90% of the shares. The profits
after tax of P Co were $5 million and the profits of its subsidiary S Co were $3 million. P Co has declared a
final dividend of $4 million to its shareholders before the year end. S Co has declared a final dividend of $2
million.
(a) The total consolidated profits for the year are $5 million + $3 million, i.e. $8 million.
(b) The non-controlling interest in the group profits is 10% of $3 million, i.e. $300,000. Of this, S Co
proposes to pay a dividend of $200,000.
(c) The group share of the profits is $5 million + 90% of $3 million, i.e. $7.7 million.
(d) In the group's statement of financial position, the items reported as current liabilities are the
dividend declared by P Co ($4 million) and the NCI dividend of $200,000.
(e) The non-controlling interest in the share capital and reserves of the subsidiary will have increased
during the year by $100,000, which is the NCI's share in the retained profits of the subsidiary.
6 Goodwill arising on consolidation
Goodwill arising on consolidation is the difference between the consideration transferred plus the non-
controlling interest and the fair value of the identifiable assets and liabilities acquired.
In the examples we have looked at so far the cost of shares acquired by the parent company has always
been equal to the par value of those shares. This is seldom the case in practice and we must now consider
some more complicated examples.
6.1 Accounting
To begin with, we will examine the entries made by the parent company in its own statement of
financial position when it acquires shares.
Suppose P Co purchases all 40,000 $1 shares in S Co and pays $60,000 cash to the previous
shareholders in consideration. P Co's books would record:
An asset for the investment in S Co, recorded at cost of $60,000
A reduction in the bank balance to reflect the payment of $60,000
However, the previous shareholders might be prepared to accept some other form of consideration. For
example, they might accept an agreed number of shares in P Co. P Co would then issue new shares in the
agreed number and allot them to the former shareholders of S Co. This kind of deal might be attractive to
P Co since it avoids the need for a heavy cash outlay. The former shareholders of S Co would retain an
indirect interest in that company's profitability via their new holding in its parent company.
Continuing the example, suppose the shareholders of S Co agreed to accept one $1 ordinary share in P Co
for every two $1 ordinary shares in S Co. P Co would then need to issue 20,000 new $1 shares. How
would this transaction be recorded in the books of P Co?
P Co must record an asset for the investment in S Co. As before this would be recorded at cost. If we
assume that the value of P has not changed, this is, as before, $60,000.
However, instead of paying the full value of the investment in cash, share capital with a par value of
$20,000 has been issued, so the balance of $40,000 must also be recorded.
As the 40,000 $1 shares acquired in S Co have a value of $60,000 the former shareholders of S Co have
agreed to accept 20,000 shares in P Co because they consider each of those shares to have a value of $3.
Thus the transaction is recorded in P Co's books as follows.

An asset for the investment in S Co $60,000
Financed by:
Increase in share capital $20,000
Increase in share premium account $40,000
Goodwill on acquisition
The amount which P Co records in its books as the cost of its investment in S Co may be more or less
than the book value of the assets it acquires. Suppose that S Co in the previous example has nil reserves
and nil liabilities, so that its share capital of $40,000 is balanced by tangible assets with a book value of
$40,000. For simplicity, assume that the book value of S Co's assets is the same as their market or fair
value.
When the directors of P Co agree to pay $60,000 for a 100% investment in S Co they must believe that, in
addition to its tangible assets of $40,000, S Co must also have intangible assets worth $20,000. This
amount of $20,000 paid over and above the value of the tangible assets acquired is called goodwill
arising on consolidation (sometimes premium on acquisition).
Following the normal cancellation procedure the $40,000 share capital in S Co's statement of financial
position would be cancelled against $40,000 of the 'investment in S Co' in the statement of financial
position of P Co. This would leave an asset of $20,000 uncancelled in the parent company's accounts.
This $20,000 is goodwill, and it would appear in the consolidated statement of financial position under the
caption 'Intangible non-current assets: goodwill arising on consolidation'.
6.2 Goodwill and pre-acquisition profits
Up to now we have assumed that S Co had nil reserves when its shares were purchased by P Co.
Assuming instead that S Co had earned profits of $8,000 in the period before acquisition, its statement of
financial position just before the purchase might look as follows.
$
Total tangible assets

48,000

Share capital 40,000
Reserves

8,000

48,000

If P Co now purchases all the shares in S Co it will acquire total tangible assets worth $48,000 at a cost of
$60,000. Clearly in this case S Co's intangible assets (goodwill) are being valued at $12,000. It should be
apparent that any reserves earned by the subsidiary prior to its acquisition by the parent company must
be incorporated in the cancellation process so as to arrive at a figure for goodwill arising on
consolidation. In other words, not only S Co's share capital, but also its pre-acquisition reserves, must be
cancelled against the asset 'investment in S Co' in the accounts of the parent company. The uncancelled
balance of $12,000 represents goodwill and appears in the consolidated statement of financial position.
The consequence of this is that any pre-acquisition reserves of a subsidiary company are not
aggregated with the parent company's reserves in the consolidated statement of financial position. The
figure of consolidated reserves comprises the reserves of the parent company plus the post-acquisition
reserves only of subsidiary companies. The post-acquisition reserves are simply reserves now less
reserves at acquisition.
6.3 Example: goodwill and pre-acquisition profits
Sing Co acquired the ordinary shares of Wing Co on 31 March when the draft statements of financial
position of each company were as follows.
SING CO
STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH

$
Assets
Non-current assets
Investment in 50,000 shares of Wing Co at cost
80,000

Current assets
40,000

Total assets
120,000

Equity
Ordinary shares
75,000

Retained earnings
45,000

120,000

WING CO
STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH
$
Current assets
60,000

Equity
50,000 ordinary shares of $1 each
50,000

Retained earnings
10,000

60,000

Prepare the consolidated statement of financial position as at 31 March.
Solution
The technique to adopt here is to produce a new working: 'Goodwill'. A proforma working is set out below.
Goodwill

$

$

Consideration paid by parent

X

Non-controlling interest at acquisition

X

Net assets acquired as represented by:

Ordinary share capital

X

Share premium

X

Retained earnings on acquisition

X

(X)

Goodwill

X

Applying this to our example the working will look like this.

$

$

Consideration transferred

80,000


-

Net assets acquired as represented by:


50,000

Retained earnings on acquisition

10,000

(60,000)

Goodwill

20,000

SING CO
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH

$

Assets

Non-current assets

Goodwill arising on consolidation

20,000

Current assets

100,000

120,000

Equity

Ordinary shares

75,000

Retained earnings

45,000

120,000

6.4 Goodwill and non-controlling interest
Now let us look at what would happen if Sing Co had obtained less than 100% of the shares of Wing Co.
If Sing Co had paid $80,000 for 40,000 shares in Wing Co, the goodwill working would be as follows:

$

Consideration paid

80,000

Non-controlling interest (at fair value, say $12,000)

12,000

92,000

Net assets acquired

(60,000)

Goodwill

32,000

The goodwill has been increased by the non-controlling interest Sing Co has paid the same amount but
acquired a smaller shareholding.
6.5 Non-controlling interest at fair value
As noted in section 4.1, IFRS 3 (revised) gives entities the option of valuing the non-controlling interest at
either the fair value of the shares held by the non-controlling interest (the full or fair value method) or the
fair value of the proportion of net assets held by the non-controlling interest. The thinking behind the fair
value method is that the non-controlling interest, in owning their shares, also own goodwill in the
subsidiary, and that the approach used prior to the revision of the standard does not show this goodwill.
Remember that in DipFM you will be required to apply only the full or fair value method.
IFRS 3 (revised) suggests that the closest approximation to fair value will be the market price of the
shares held by non-controlling shareholders just before acquisition by the parent.
Continuing our example in 6.4 above, we will assume that the market price of the shares of Wing Co on
31 March was $1.25. The goodwill calculation will then be as follows:

$


80,000

Non-controlling interest (10,000 $1.25)

12,500

92,500

Net assets at acquisition

(60,000)

Goodwill

32,500

Goodwill is $500 higher than goodwill calculated measuring non-controlling interest at its share of the net
assets of the subsidiary. This $500 represents the goodwill attributable to the non-controlling interest.
6.6 Non-controlling interest at year end
Where the option is used to value the non-controlling interest at fair value, this applies only to the non-
controlling interest at acquisition. At the year end, the non-controlling interest is measured either as:
NCIs share of net assets at year end

X

NCI goodwill arising on acquisition

X

X

Or
Fair value of NCI at acquisition date

X
NCIs share of post acquisition profits

X

X

Both calculations will result in the same answer, but in some cases, the information provided in a question
lends itself to one method rather than the other.
This is illustrated in the following worked example.
6.7 Worked example
P acquired 75% of the shares in S on 1 January 20X7 when S had retained earnings of $15,000. The
market price of Ss shares just before the date of acquisition was $1.60. P values the non-controlling
interest at fair value. Goodwill is not impaired.
The statements of financial position of P and S at 31 December 20X7 were as follows:

P

S

$

$


60,000

50,000

Shares in S

68,000

128,000

50,000

Current assets

52,000

35,000

180,000

85,000

Share capital $1 shares

100,000

50,000

Retained earnings

70,000

25,000

170,000

75,000

Current liabilities

10,000

10,000

180,000

85,000

Prepare the consolidated statement of financial position of the P Group at 31 December 20X7.
6.8 Solution

$

Assets

Property, plant and equipment (60,000 + 50,000)

110,000

Goodwill (W1)

23,000

Current assets (52,000 + 35,000)

87,000

Total assets

220,000

$

Equity attributable to the owners of P

Share capital

100,000

Retained earnings (W2)

77,500

177,500

Non-controlling interest (W3)

22,500

Total equity

200,000

Current liabilities (10,000 + 10,000)

20,000

220,000

Workings
1 Goodwill

$


68,000

Non-controlling interest at acquisition (12,500 shares @ $1.60)

20,000

Net assets of S at acquisition (50,000 + 15,000)

(65,000)

Goodwill (parent and non-controlling interest)

23,000

Non-controlling interest at fair value (as above)

20,000

Non-controlling share of net assets at acquisition (65,000 25%)

(16,250)

Goodwill attributable to non-controlling interest

3,750

2 Retained earnings

P

S

$

$

Per statement of financial position

70,000

25,000

Less pre-acquisition

(15,000)

10,000

Group share of S (10,000 75%)

7,500

Group retained earnings

77,500

3 Non-controlling interest at year end

$

Share of net assets of S (75,000 25%)

18,750

Goodwill (W1)

3,750

22,500

Or

NCI at fair value at acquisition (12,500 shares @ $1.60)

20,000

NCI share of post acquisition profits (25% x $10,000)

2,500

22,500

6.9 Effect of non-controlling interest at fair value
You can see from the above example that the use of the fair value option increases goodwill and the non-
controlling interest by the same amount. That amount represents goodwill attributable to the shares held
by non-controlling shareholders. It is not necessarily proportionate to the goodwill attributed to the parent.
The parent may have paid more to acquire a controlling interest.
6.10 Impairment of goodwill
Goodwill arising on consolidation should be recorded in the group statement of financial position and
reviewed for impairment each year.
Goodwill arising on consolidation is subjected to an annual impairment review and impairment may be
expressed as an amount or as a percentage. If the subsidiary is 100% owned by the parent, any
impairment will reduce both the carrying value of goodwill, and the retained earnings of the group.
However, as discussed above, when the non-controlling interest is valued at fair value the carrying value
of goodwill in the statement of financial position includes goodwill attributable to the non-controlling
interest. In this case the fall in the value of goodwill through impairment must be allocated between the
retained earnings of the group and the non-controlling interest. The allocation will be based on the relative
proportions of the shareholding.
In our solution above in 6.8 the non-controlling interest holds 25%. If the goodwill of $23,000 was
impaired by 20% the double entry for this would be:
Reduction in Goodwill

$4,600
Reduction in retained earnings (75%) $3,450

Reduction in non-controlling interest (25%) $1,150

The non-controlling interest at the year end would then be $21,350.
6.11 Forms of consideration
The consideration paid by the parent for the shares in the subsidiary may sometimes take the form of a
share exchange. Here is an example:
6.11.1 Share exchange
The parent has acquired 12,000 $1 shares in the subsidiary by issuing 5 of its own $1 shares for every 4
shares in the subsidiary. The market value of the parent company's shares is $6.
Cost of the combination:
12,000 5/4 $6 = $90,000
Note that this gives rise to both an asset (for the full value of the cost of the acquisition) and a
corresponding increase in both the share capital and share premium of the parent company as follows:
$ $
Investment in subsidiary 90,000
Share capital ($12,000 5/4) 15,000
Share premium ($12,000 5/4 5) 75,000

6.11.2 Expenses and issue costs
Expenses of the combination, such as lawyers and accountants fees are written off as incurred. However,
IFRS 3 requires that the costs of issuing equity are treated as a deduction from the proceeds of the equity
issue. Share issue costs will therefore be debited to the share premium account. Issue costs of financial
instruments are deducted from the proceeds of the financial instrument.
7 A technique for consolidation
We have now looked at the topics of cancellation, non-controlling interests and goodwill arising on
consolidation. It is time to set out an approach to be used in tackling consolidated statements of
financial position.
1 Aggregate the assets and liabilities on the statement of financial position. Cancel common items.
2 Calculate non-controlling interest.
3 Calculate goodwill.
4 Calculate retained earnings.

Activity 10.4

The draft statements of financial position of Ping Co and Pong Co on 30 June 20X4 were as follows.
PING CO
STATEMENT OF FINANCIAL POSITION AS AT 30 JUNE 20X4
$ $
Assets
Non-current assets

50,000

20,000 ordinary shares in Pong Co at cost
30,000

80,000
Current assets
Inventory
3,000

Receivables
16,000

Cash
2,000

21,000

Total assets
101,000

Equity
Ordinary shares of $1 each
45,000

Revaluation reserve
12,000

Retained earnings
26,000

83,000
Current liabilities
Owed to Pong Co
8,000

Trade payables
10,000

18,000

101,000

PONG CO
STATEMENT OF FINANCIAL POSITION AS AT 30 JUNE 20X4
$ $
Assets

Current assets
Inventory
8,000

Owed by Ping Co
10,000

Receivables
7,000

25,000

Total assets
65,000

Equity
25,000

Revaluation reserve
5,000

Retained earnings
28,000

58,000
Current liabilities
Trade payables
7,000

65,000

Ping Co acquired its investment in Pong Co on 1 July 20X1 when the retained earnings of Pong Co stood
at $6,000. There have been no changes in the share capital or revaluation reserve of Pong Co since that
date. At 30 June 20X4 Pong Co had invoiced Ping Co for goods to the value of $2,000 which had not been
received by Ping Co.
There is no impairment of goodwill. It is group policy to value the non-controlling interest at full fair value.
Prepare the consolidated statement of financial position of Ping Co as at 30 June 20X4.
Note: this is an example of the third approach to calculating the fair value of the non-controlling interest,
as mentioned in Section 6.9. As no information is given about the fair value of the shares at the date of
acquisition, we can assume that the parent paid the fair value.

8 Fair values in acquisition accounting
Fair values are very important in calculating goodwill.
8.1 Goodwill
To understand the importance of fair values in the acquisition of a subsidiary we will look at a formal
definition of goodwill.
Goodwill Any excess of the cost of the acquisition over the acquirer's interest in the fair value of the
identifiable assets and liabilities acquired as at the date of the exchange transaction.
The statement of financial position of a subsidiary company at the date it is acquired may not be a guide
to the fair value of its net assets. For example, the market value of a building may have risen greatly since
it was acquired, but it may appear in the statement of financial position at historical cost less accumulated
depreciation.

8.2 What is fair value?
Fair value is defined as follows by IFRS 3 and various other standards it is an important definition.
Fair value The amount for which an asset could be exchanged, or a liability settled, between
knowledgeable, willing parties in an arm's length transaction.
8.3 Fair value adjustment calculations
Until now we have calculated goodwill as the difference between the cost of the investment and the book
value of net assets acquired by the group. If this calculation is to comply with the definition above we
must ensure that the book value of the subsidiary's net assets is the same as their fair value.
There are two possible ways of achieving this.
(a) The subsidiary company might incorporate any necessary revaluations in its own books of
account. In this case, we can proceed directly to the consolidation, taking asset values and
reserves figures straight from the subsidiary company's statement of financial position.
(b) The revaluations may be made as a consolidation adjustment without being incorporated in the
subsidiary company's books. In this case, we must make the necessary adjustments to the
subsidiary's statement of financial position as a working. Only then can we proceed to the
consolidation.
Note. Remember that when depreciating assets are revalued there may be a corresponding alteration in
the amount of depreciation charged and accumulated.
8.4 Example: fair value adjustments
P Co acquired 75% of the ordinary shares of S Co on 1 September 20X5. The fair value of S Co's shares
prior to the acquisition was $3.20. At that date the fair value of S Co's non-current assets was $23,000
greater than their carrying value, and the balance of retained profits was $21,000. The statements of
financial position of both companies at 31 August 20X6 are given below. S Co has not incorporated any
revaluation in its books of account.
P CO
STATEMENT OF FINANCIAL POSITION AS AT 31 AUGUST 20X6

$

$

Assets

Non-current assets

Tangible assets

63,000

Investment in S Co at cost

51,000

114,000

Current assets

82,000

Total assets

196,000


Equity


80,000

Retained profits

96,000

176,000

Current liabilities

20,000


196,000

S CO
STATEMENT OF FINANCIAL POSITION AS AT 31 AUGUST 20X6

$

$

Assets


28,000

Current assets

43,000

Total assets

71,000


Equity


20,000

Retained profits

41,000

61,000

Current liabilities

10,000


71,000

If S Co had revalued its non-current assets at 1 September 20X5, an addition of $3,000 would have been
made to the depreciation charged in the income statement for 20X5/X6.
Required
Prepare P Co's consolidated statement of financial position as at 31 August 20X6. Non-controlling interest
is to be valued at fair value.
Solution
P CO CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 AUGUST 20X6

$

$

Non-current assets

Property, plant and equipment $(63,000 + 48,000)*

111,000

Goodwill (W2)

3,000

114,000

Current assets

125,000

239,000


Equity


80,000

Retained earnings (W3)

108,750

188,750


20,250

209,000

Current liabilities

30,000

239,000

* (28,000 + 23,000 3,000)
Workings
1 Non-controlling interest at reporting date

$

NCI at acquisition (5,000 shares $3.20)
16,000

NCIs share of post acquisition profits 25%($41,000 - $21,000 - $3,000)

4,250

20,250

2 Goodwill

$

$


51,000

Non-controlling interest (5,000 shares x $3.20)

16,000

67,000
Net assets acquired as represented by


20,000

Retained earnings

21,000

Fair value adjustment

23,000

(64,000)

Goodwill

3,000

3 Retained earnings

P Co

S Co

$

$

Per question

96,000

41,000

Pre acquisition profits

(21,000)

Depreciation adjustment

(3,000)

Post acquisition S Co

17,000

Group share in S Co

($17,000 75%)

12,750


108,750

9 Intra-group trading
The effects of intra-group trading should be cancelled on consolidation.
9.1 Unrealised profit
Any receivable/payable balances outstanding between the companies are cancelled on consolidation. No
further problem arises if all such intra-group transactions are undertaken at cost, without any mark-up for
profit.
However, each company in a group is a separate trading entity and may wish to treat other group
companies in the same way as any other customer. In this case, a company (say A Co) may buy goods at
one price and sell them at a higher price to another group company (B Co). The accounts of A Co will quite
properly include the profit earned on sales to B Co; and similarly B Co's statement of financial position will
include inventories at their cost to B Co, ie at the amount at which they were purchased from A Co.
This gives rise to two problems.
(a) Although A Co makes a profit as soon as it sells goods to B Co, the group does not make a sale or
achieve a profit until an outside customer buys the goods from B Co.
(b) Any purchases from A Co which remain unsold by B Co at the year end will be included in B Co's
inventory. Their value in the statement of financial position will be their cost to B Co, which is not
the same as their cost to the group.
The objective of consolidated accounts is to present the financial position of several connected companies
as that of a single entity, the group. This means that in a consolidated statement of financial position

the
only profits recognised should be those earned by the group in providing goods or services to outsiders;
and similarly, inventory in the consolidated statement of financial position should be valued at cost to the
group.

Suppose that a parent company P Co buys goods for $1,600 and sells them to a wholly owned subsidiary
S Co for $2,000. The goods are in S Co's inventory at the year end and appear in S Co's statement of
financial position at $2,000. In this case, P Co will record a profit of $400 in its individual accounts, but
from the group's point of view the figures are:
Cost $1,600
External sales Nil
Closing inventory at cost $1,600
Profit/loss Nil
If we add together the figures for retained reserves and inventory in the individual statements of financial
position of P Co and S Co the resulting figures for consolidated reserves and consolidated inventory will
each be overstated by $400. A consolidation adjustment is therefore necessary to reduce both group
retained earnings and group inventory in the statement of financial position.
The reduction is the amount of profit not yet unrealised by the group.
9.2 Non-controlling interests in unrealised intra-group profits
A further problem occurs where a subsidiary company which is not wholly owned is involved in intra-
group trading within the group. If a subsidiary S Co is 75% owned and sells goods to the parent company
for $16,000 cost plus $4,000 profit, ie for $20,000 and if these items are unsold by P Co at the reporting
date, the 'unrealised' profit of $4,000 earned by S Co and charged to P Co will be partly owned by the non-
controlling interest of S Co. As far as the non-controlling interest of S Co is concerned, their share
(25% of $4,000) amounting to $1,000 of profit on the sale of goods would appear to have been fully
realised. It is only the group that has not yet made a profit on the sale.
There are three different possibilities as regards the treatment of these intra-group profits.
(a) Remove only the group's share of the profit loading
(b) Remove the whole profit loading, charging the NCI with their proportion
(c) Remove the whole of the profit without charging the NCI (to reduce group reserves by the whole
profit loading)
The method given under (b) is usually considered best practice and leads to the following adjustments.
Reduce group inventory in the consolidated statement of financial position with the full value of the
profit not yet realised by the group
Reduce group retained earnings by the group's share of the profit not yet realised
Reduce non-controlling interest by the remainder (the proportion held by the NCI)
9.3 Example: non-controlling interests and intra-group profits
P Co has owned 75% of the shares of S Co since the incorporation of that company. During the year to 31
December 20X2, S Co sold goods costing $16,000 to P Co at a price of $20,000 and these goods were
still unsold by P Co at the end of the year. Draft statements of financial position of each company at 31
December 20X2 were as follows.

P Co

S Co

Assets

$

$

$

$

Non-current assets


125,000

120,000

Investment: 75,000 shares in S Co at cost

75,000

200,000

120,000

Current assets

Inventories

50,000

48,000

Trade receivables

20,000

16,000

70,000

64,000

Total assets

270,000

184,000


Equity

Ordinary shares of $1 each fully paid

80,000

100,000

Retained earnings

150,000

60,000

230,000

160,000

Current liabilities

40,000

24,000


270,000

184,000

Required
Prepare the consolidated statement of financial position of P Co at 31 December 20X2. It is the group
policy to value the non-controlling interest at fair value.
Solution
The profit earned by S Co but unrealised by the group is $4,000 of which $3,000 (75%) is attributable to
the group and $1,000 (25%) to the non-controlling interest. Remove the whole of the profit loading,
charging the non-controlling interest with their proportion.

P Co

S Co

$

$

Retained earnings
Per question

150,000

60,000

Less unrealised profit

(4,000)

56,000

Share of S Co: $56,000 75%

42,000

192,000


S Co's net assets (184,000 24,000)

160,000

Unrealised profit

(4,000)

156,000

25%

39,000

P CO

$

$

Assets


245,000

Current assets

Inventories $(50,000 + 48,000 4,000)

94,000

Trade receivables

36,000

130,000

Total assets

375,000


$ $

Equity


80,000

Retained earnings

192,000

272,000


39,000

311,000

Current liabilities

64,000


375,000

Note: there is no goodwill as S Co has been owned since incorporation.
10 Summary: consolidated statement of financial
position
Purpose To show the net assets which P controls and the ownership of those assets.
Net assets Always 100% P plus 100% S providing P holds a majority of voting rights.
Share capital P only.
Reason Simply reporting to the parent company's shareholders in another form.
Retained
earnings
100% P plus group share of post-acquisition retained earnings of S less
consolidation adjustments.
Reason To show the extent to which the group actually owns total assets less
liabilities.
Non-controlling
interest
NCI share of S's consolidated net assets, valued at fair value.
Reason To show the equity in a subsidiary not attributable to the parent.

11 Consolidated income statement
The consolidated statement of comprehensive income combines the statements of comprehensive income
of each group company. The principles applied to the consolidated statement of financial position also
apply to the consolidated statement of comprehensive income.
Depending on the approach taken by an entity, it may prepare a single statement of comprehensive
income or two statements: an income statement and separate statement of comprehensive income.
This chapter will refer to the income statement but the same procedures would apply if a single statement
of comprehensive income was prepared.

11.1 Simple example: consolidated income statement
P Co acquired 75% of the ordinary shares of S Co on that company's incorporation in 20X3. The
summarised income statements of the two companies for the year ending 31 December 20X6 are set out
below.

P Co

S Co

$

$

Sales revenue

75,000

38,000

Cost of sales

30,000

20,000

Gross profit

45,000

18,000


14,000

8,000

Profit before taxation

31,000

10,000

Taxation

10,000

2,000

Profit for the year

21,000

8,000

Retained earnings brought forward

87,000

17,000

Retained earnings carried forward

108,000

25,000

Required
Prepare the consolidated income statement for the year.
Solution
P CO
CONSOLIDATED INCOME STATEMENT

$

Sales revenue (75 + 38)

113,000

Cost of sales (30 + 20)

50,000

Gross profit

63,000

Administrative expenses (14 + 8)

22,000


41,000

Taxation (10 + 2)

12,000


29,000

Non-controlling interest (25% $8,000)

2,000

Group profit for the year

27,000


(group share only: 87 + (17 75%))

99,750


126,750

Notice how the non-controlling interest is dealt with.
(a) Down to the line 'profit for the year' the whole of S Co's results is included without reference to
group share or NCI. A one-line adjustment is then inserted to deduct the NCI's share of S Co's
profit after taxation.
(b) The NCI's share ($4,250) of S Co's retained profits brought forward is excluded. This means that
the carried forward figure of $126,750 is the figure which would appear in the statement of
financial position for group retained earnings.
This last point may be clearer if we revert to our statement of financial position technique and construct
the working for group retained earnings.

$

P Co

108,000

Share of S Co's post-acquisition retained earnings (75% $25,000)

18,750

126,750

The non-controlling interest share of S Co's reserves comprises the NCI in the $17,000 profits brought
forward plus the NCI ($2,000) in $8,000 retained profits for the year.
Notice that a consolidated income statement links up with a consolidated statement of financial position
exactly as in the case of an individual company's accounts: the figure of retained earnings carried forward
at the bottom of the income statement appears as the figure for retained earnings in the statement of
financial position. (Note. Under IAS 1 this would be shown as a movement on reserves; for convenience
the reserve movements are shown here with the income statement.)
11.2 Intra-group trading
Intra-group sales and purchases are eliminated from the consolidated income statement.
Like the consolidated statement of financial position, the consolidated income statement should deal with
the results of the group as those of a single entity. When one company in a group sells goods to another
an identical amount is added to the sales revenue of the first company and to the cost of sales of the
second. Yet as far as the entity's dealings with outsiders are concerned no sale has taken place.
The consolidated figures for sales revenue and cost of sales should represent sales to, and purchases
from, outsiders. An adjustment is therefore necessary to reduce the sales revenue and cost of sales
figures by the value of intra-group sales during the year.
We have also seen in an earlier section that any unrealised profits on intra-group trading should be
excluded from the figure for group profits. This will occur whenever goods sold at a profit within the group
remain in the inventory of the purchasing company at the year end. The best way to deal with this is to
calculate the unrealised profit on unsold inventories at the year end and reduce consolidated gross
profit by this amount. Cost of sales will be the balancing figure.
11.3 Example: intra-group trading
Suppose in our earlier example that S Co had recorded sales of $5,000 to P Co during 20X6. S Co had
purchased these goods from outside suppliers at a cost of $3,000. One half of the goods remained in P
Co's inventory at 31 December 20X6. Prepare the revised consolidated income statement.
Solution
The consolidated income statement for the year ended 31 December 20X6 would now be as follows.

$

Sales revenue (75 + 38 5)

108,000

Cost of sales (30 + 20 5 + 1*)

(46,000)

Gross profit (45 + 18 1*)

62,000


(22,000)


40,000

Taxation

(12,000)


28,000



26,250

Non-controlling interest (25% x (8 1 unrealised profit))

1,750

28,000

*Unrealised profit: ($5,000 $3,000)

Note:

99,750

Profit for the year

26,250


126,000

An adjustment will be made for the unrealised profit against the inventory figure in the consolidated
statement of financial position, as explained earlier in this chapter.

11.4 Pre-acquisition profits
Only the post acquisition profits of the subsidiary are brought into the consolidated income statement.
As explained above, the figure for retained earnings at the bottom of the consolidated income statement
must be the same as the figure for retained earnings in the consolidated statement of financial position.
We have seen in the previous section that retained earnings in the consolidated statement of financial
position comprise:
(a) The whole of the parent company's retained earnings
(b) A proportion of the subsidiary company's retained earnings. The proportion is the group's share
of post-acquisition retained earnings in the subsidiary. From the total retained earnings of the
subsidiary we must therefore exclude both the NCI's share of total retained earnings and the
group's share of pre-acquisition retained earnings.
A similar procedure is necessary in the consolidated income statement if it is to link up with the
consolidated statement of financial position. Previous examples have shown how the NCI share of profits
is excluded in the income statement. Their share of profits for the year is deducted from profit after tax,
while the figure for profits brought forward in the consolidation schedule includes only the group's
proportion of the subsidiary's profits.
In the same way, when considering examples which include pre-acquisition profits in a subsidiary, the
figure for profits brought forward should include only the group's share of the post-acquisition retained
profits. If the subsidiary is acquired during the accounting year, it is therefore necessary to apportion its
profit for the year between pre-acquisition and post-acquisition elements.
With the part-year method, the entire income statement of the subsidiary is split between pre-acquisition
and post-acquisition proportions. Only the post-acquisition figures are included in the consolidated
income statement.

Activity 10.5

P Co acquired 60% of the equity of S Co on 1 April 20X5. The income statements of the two companies
for the year ended 31 December 20X5 are set out below.

P Co

S Co S Co (
9
/
12
)

$

$

$

Sales revenue

170,000

80,000

60,000

Cost of sales

65,000

36,000

27,000

Gross profit

105,000

44,000

33,000

Other income dividend received from S Co

3,600


43,000

12,000

9,000

Profit before tax

65,600

32,000

24,000

Income tax expense

23,000

8,000

6,000

Profit for the year

42,600

24,000

18,000

Note
Dividends (paid 31 December)

12,000

6,000

Profit retained

30,600

18,000


81,000

40,000


111,600

58,000

Prepare the consolidated income statement and retained earnings extract from the statement of changes
in equity.

11.5 Goodwill
If goodwill suffers an impairment in the accounting period administrative expenses in the consolidated
income statement will be charged with the fall in value.
12 Summary: consolidated income statement
Purpose To show the results of the group for an accounting period as if it were a single
entity.
Sales revenue to
profit for year
100% P + 100% S (excluding adjustments for inter-company transactions).
Reason To show the results of the group which were controlled by the parent company.
Intra-group sales Strip out inter-company activity from both sales revenue and cost of sales.
Unrealised profit on
intra-group sales
(a) Goods sold by P. Increase cost of sales by unrealised profit.
(b) Goods sold by S. Increase cost of sales by full amount of unrealised profit
and decrease non-controlling interest by their share of unrealised profit.
Depreciation If the value of S's non-current assets have been subjected to a fair value uplift
then any additional depreciation must be charged in the consolidated income
statement. The non-controlling interest will need to be adjusted for their share.
Transfer of non-
current assets
Expenses must be increased by any profit on the transfer and reduced by any
additional depreciation arising from the increased carrying value of the asset.
Non-controlling
interests
S's profit after tax (PAT) X
Less: * unrealised profit (X)
* profit on disposal of non-current assets (X)
additional depreciation following FV uplift (X)
Add: ** additional depreciation following
disposal of non-current assets X
NCI% X
* Only applicable if sales of goods and non-current assets made by subsidiary.
** Only applicable if sale of non-current assets made by subsidiary.
Reason To show the extent to which profits generated through P's control are in fact
owned by other parties.
Reserves carried
forward
As per the calculations for the statement of financial position.
13 The consolidated statement of comprehensive
income
The consolidated statement of comprehensive income is produced using the consolidated income
statement as a basis.
The only items of other comprehensive income that are included in your syllabus are revaluation gains and
losses, so a consolidated statement of comprehensive income will be easy to produce once you have done
the income statement.
We will look at a question and then add an item of comprehensive income to illustrate this.

13.1 Example
The following information relates to Brodick Co and its subsidiary Lamlash Co for the year to 30 April
20X7.

Brodick Co

Lamlash Co

$'000

$'000

Sales revenue

1,100

500

Cost of sales

(630)

(300)

Gross profit

470

200


(105)

(150)

Dividend from Lamlash Co

24

Profit before tax

389

50

Income tax expense

(65)

(10)

Profit for the year

324

40

Note
Dividends paid

200

30

Profit retained

124

10


460

106


584

116

Additional information
(a) The issued share capital of the group was as follows.
Brodick Co : 5,000,000 ordinary shares of $1 each.
Lamlash Co : 1,000,000 ordinary shares of $1 each.
(b) Brodick Co purchased 80% of the issued share capital of Lamlash Co in 20X0. At that time, the
revenue reserves of Lamlash amounted to $56,000.
Required
Insofar as the information permits, prepare the Brodick group consolidated income statement for the year
to 30 April 20X7 in accordance with IFRS, and an extract from the statement of changes in equity showing
retained earnings.
Solution
BRODICK GROUP
CONSOLIDATED INCOME STATEMENT
FOR THE YEAR TO 30 APRIL 20X7

$'000

Sales revenue (1,100 + 500)

1,600

Cost of sales (630 + 300)

(930)

Gross profit

670

Administrative expenses (105 + 150)

(255)

Profit before tax

415

Income tax expense (65 + 10)

(75)

Profit for the year

340



332


8

340
STATEMENT OF CHANGES IN EQUITY Retained earnings

$'000

Balance brought forward (W2)

500

Dividend paid (parent)

(200)


332

Balance carried forward

632

Workings
1 Non-controlling interests

$'000

In Lamlash (20% 40)

8

2 Retained earnings brought forward

Brodick Co

Lamlash Co

$'000

$'000

Per question

460

106

Less pre-acquisition

(56)

50

Share of Lamlash: 80% 50

40

500

13.2 Example: Consolidated statement of comprehensive income
The consolidated income statement of the Brodick Group is as in the answer to the last question.
In addition, Lamlash made a $200,000 revaluation gain on one of its properties during the year.
13.3 Solution
BRODICK GROUP
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR TO 30 APRIL 20X7

$'000

Sales revenue

1,600

Cost of sales

(930)

Gross profit

670


(255)

Profit before tax

415

Income tax expense

(75)

Profit for the year

340


Gain on property revaluation

200


540



332


8

340


Owners of the parent (332 + (200 80%))

492

Non-controlling interest (8 + (200 20%))

48

540

13.4 Consolidated statement of comprehensive income (separate
statement)
If we were using the two-statement format (as explained in Chapter 3) we would produce a separate
income statement and statement of comprehensive income.
13.5 Example: Statement of comprehensive income
BRODICK GROUP
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
$'000
Profit for the year

340


Gain on property revaluation

200


540


Owners of the parent (332 + (200 80%))

492

Non-controlling interest (8 + (200 20%))

48

540

13.6 Consolidated statement of changes in equity
These amounts would appear in the consolidated statement of changes in equity as follows.
Retained
earnings

Revaluation
surplus

Total Non-controlling
interest

Total
$'000 $'000 $'000 $'000 $'000
Total comprehensive
income for the year
332 160 492 48 540
14 Accounting for associates
IAS 28 requires that, in consolidated accounts, associates should be accounted for using equity
accounting principles.
IAS 28 requires all investments in associates to be accounted for in the consolidated accounts using the
equity method, unless the investment is classified as 'held for sale' in accordance with IFRS 5 in which
case it should be accounted for under IFRS 5 (see later in this Chapter), or the exemption in the paragraph
below applies.
Equity method A method of accounting whereby the investment is initially recorded at cost and adjusted
thereafter for the post acquisition change in the investor's share of net assets of the investee. The profit or
loss of the investor includes the investor's share of the profit or loss of the investee.
An investor is exempt from applying the equity method if:
(a) It is a parent exempt from preparing consolidated financial statements under IAS 27, or
(b) All of the following apply:
(i) The investor is a wholly-owned subsidiary or it is a partially owned subsidiary of another
entity and its other owners, including those not otherwise entitled to vote, have been
informed about, and do not object to, the investor not applying the equity method
(ii) The investor's securities are not publicly traded
(iii) It is not in the process of issuing securities in public securities markets; and
(iv) The ultimate or intermediate parent publishes consolidated financial statements that
comply with International Financial Reporting Standards.
If an investor that does not issue consolidated financial statements (ie it has no subsidiaries) but has an
investment in an associate this should be included in the financial statements of the investor normally at cost.

14.1 Application of the equity method: consolidated accounts
Many of the procedures required to apply the equity method are the same as are required for full
consolidation. In particular, intra-group unrealised profits must be excluded.
Goodwill is calculated as the difference (positive or negative) between the cost of acquisition and the
investor's share of the fair values of the net identifiable assets of the associate. This should be treated as
required by IFRS 3.
14.2 Equity method: income statement
The basic principle is that the investing company (X Co) should take account of its share of the earnings
of the associate, Y Co, whether or not Y Co distributes the earnings as dividends. X Co achieves this by
adding to consolidated profit the group's share of Y Co's profit after tax.
Notice the difference between this treatment and the consolidation of a subsidiary company's results. If Y
Co were a subsidiary X Co would take credit for the whole of its sales revenue, cost of sales etc and would
then make a one-line adjustment to remove any non-controlling interest share.
Under equity accounting, the associated company's sales revenue, cost of sales and so on are not
amalgamated with those of the group. Instead the group share only of the associate's profit after tax for
the year is added to the profits of the parent company and its subsidiaries. In effect, this is the
corresponding treatment to the associate's parent company's treatment: the investing company is the
non-controlling interest here.
14.3 Equity method: statement of financial position
A figure for investment in associates is shown which at the time of the acquisition must be stated at cost.
This amount will increase (decrease) each year by the amount of the group's share of the associated
company's profit (loss) for the year.
14.4 Example: associate
P Co, a company with subsidiaries, acquires 25,000 of the 100,000 $1 ordinary shares in A Co for
$60,000 on 1 January 20X8. In the year to 31 December 20X8, A Co earns profits after tax of $24,000,
from which it pays a dividend of $6,000.
How will A Co's results be accounted for in the individual and consolidated accounts of P Co for the year
ended 31 December 20X8?
Solution
In the individual accounts of P Co, the investment will be recorded on 1 January 20X8 at cost. Unless
there is an impairment in the value of the investment (see below), this amount will remain in the individual
statement of financial position of P Co permanently. The only entry in P Co's individual income statement
will be to record dividends received. For the year ended 31 December 20X8, P Co will record the cash
receipt of $1,500 ($6,000 25%) and record the income of $1,500.
In the consolidated accounts of P Co equity accounting principles will be used to account for the
investment in A Co. Consolidated profit after tax will include the group's share of A Co's profit after tax
(25% $24,000 = $6,000). To the extent that this has been distributed as dividend, it is already included
in P Co's individual accounts and will automatically be brought into the consolidated results. That part of
the group's profit share which has not been distributed as dividend ($4,500) will be brought into
consolidation.
The asset 'Investment in associates' is then stated at $64,500, being cost plus the group share of
post-acquisition retained profits.
14.5 Consolidated income statement
In the consolidated income statement the investing group takes credit for its share of the after-tax profits
of associates, whether or not they are distributed as dividends.
A consolidation schedule may be used to prepare the consolidated income statement of a group with
associates. The treatment of associates' profits in the following example should be studied carefully.
The following consolidation schedule relates to the P Co group, consisting of the parent company, an 80%
owned subsidiary (S Co) and an associated company (A Co) in which the group has a 30% interest.
CONSOLIDATION SCHEDULE

Group

P Co

S Co

A Co

$'000

$'000

$'000

$'000

Sales revenue

1,400

600

800

300

Cost of sales

770

370

400

120

Gross profit

630

230

400

180


290

110

180

80

340

120

220

100

Interest receivable

30

30

370

150

220

100

Interest payable

(20)

(20)

350

150

200

100

Group share of associated company profit after tax

18

(30% 60)

368

150

200

100

Taxation

(145)

(55)

(90)

(40)


223

95

110

60


(22)

(22)

201

95

88

60

Inter-company dividends

20

(18)

(2)

Group profit

201

115

70

58

Note the following:
(a) Group sales revenue, group gross profit and costs such as depreciation etc exclude the sales
revenue, gross profit and costs etc of associates.
(b) The group share of the associates post-tax profits is included in to the group income statement
(here, 30% of $60,000 = $18,000). If the associated company had been acquired during the year, it
would be necessary to deduct the pre-acquisition profits.
(c) The non-controlling interest will only ever apply to subsidiary companies.

14.6 Pro-forma consolidated income statement
The following is a suggested layout (using the figures given in the illustration above) for the consolidated
income statement for a company having subsidiaries as well as associates.

$'000

Revenue

1,400

Cost of sales

770

Gross profit

630

Distribution costs and administrative expenses

290

340

Interest receivable

30

370

Finance costs

(20)

350

Share of profits (less losses) of associated companies

18

Profit before tax

368

Income tax expense

(145)

Profit for the year

223

Attributable to:
Equity holders of the parent
201

22

223
14.7 Consolidated statement of financial position
In the consolidated statement of financial position the investment in associates should be shown as:
Cost of the investment in the associate; plus
Group share of post acquisition retained profits; less
Any amount written off the investment
As explained earlier, the consolidated statement of financial position will contain an asset 'Investment in
associates'. The amount at which this asset is stated will be its original cost plus the group's share of any
profits earned since acquisition which have not been distributed as dividends less any impairment
losses.
14.8 Example: consolidated statement of financial position
On 1 January 20X6 the net tangible assets of A Co amount to $220,000, financed by 100,000 $1 ordinary
shares and revenue reserves of $120,000. P Co, a company with subsidiaries, acquires 30,000 of the
shares in A Co for $75,000. During the year ended 31 December 20X6 A Co's profit after tax is $30,000,
from which dividends of $12,000 are paid.
Show how P Co's investment in A Co would appear in the consolidated statement of financial position at
31 December 20X6.
Solution
AS AT 31 DECEMBER 20X6 (extract)

$

Non-current assets

Investment in associate

Cost

75,000

Group share of post-acquisition retained profits

(30% $18,000)

5,400

80,400

An important point to note is that this figure of $80,400 can be arrived at in a completely different way. It
is the sum of:
(a) the group's share of A Co's net assets at 31 December 20X6, and
(b) the goodwill paid for the shares acquired.
This can be shown as follows.

$

$

(a)

A Co's net assets at 31 December 20X6

Net assets at 1 January 20X6

220,000

Retained profit for year

18,000

Net assets at 31 December 20X6

238,000

Group share (30%)

71,400

(b)

Goodwill

Net assets acquired by group on 1 Jan 20X6

(30% $220,000)

66,000

Price paid for shares

75,000

Goodwill

9,000

Investment in associate per statement of financial position

80,400
14.9 Associates: summary
Income statement Include group share of associates' profit after tax as a single amount.

Statement of
financial position
Interests in associates should be stated at: $
(a) Group share of net assets other than goodwill of associate X
(b) Goodwill on acquisition so far as it has not already been written off
X

X

15 Joint ventures and jointly controlled entities
Joint ventures are characterised by joint control evidenced by a contractual arrangement.
Two or more persons may decide to enter into a business venture together without wishing to form a
formal long-term partnership.
Usually the venturers agree to place limitations on their activities, for example, a joint venture to
manufacture and sell 'total eclipse of the sun' souvenirs could be limited by time, while a joint venture to
buy and sell a bankrupt's inventory (a fairly common occurrence in practice) comes to an end when all the
inventory has been sold.
Joint ventures are often found when each party can contribute in different ways to the venture. For
example, one venturer may provide finance, another purchases or manufactures goods, while a third
offers his marketing skills.

Joint ventures generally have the following characteristics.
They are limited by time and/or activity
The venturers usually carry on their principal businesses at the same time
Separate books for the venture are not normally maintained
The venturers usually agree to a profit/ loss sharing ratio for the purpose of the venture
IAS 31 Interests in joint ventures covers all types of joint ventures. It is not concerned with the accounts
of the joint venture itself (if separate accounts are maintained), but rather how the interest in a joint
venture is accounted for by each joint venturer (ie each 'partner' in the joint venture).
The assets and liabilities, income and expenses of the joint venture must be reported in the financial
statements of the venturers and investors, whatever the form of the joint venture.
IAS 31 looks at the various forms of joint venture which may be undertaken and then looks at how joint
ventures are dealt with in the individual financial statements of the venturer and the group financial
statements.
15.1 Definitions
The IAS begins by listing some important definitions.
Joint venture A contractual arrangement whereby two or more parties undertake an economic
activity which is subject to joint control.
Control The power to govern the financial and operating policies of an economic activity so as to
obtain benefits from its activities.
Joint control The contractually agreed sharing of control over an economic activity.
Significant influence The power to participate in the financial and operating policy decisions of an
economic activity but is not control or joint control over those policies.
Venturer A party to a joint venture that has joint control over that joint venture.
Proportionate consolidation A method of accounting whereby a venturer's share of each of the
assets, liabilities, income and expenses of a jointly controlled entity is combined line-by-line with
similar items in the venturer's financial statements or reported as separate line items in the
venturer's financial statements.
Equity method A method of accounting whereby an interest in a jointly controlled entity is initially
recorded at cost and adjusted thereafter for the post acquisition change in the venturer's share of
net assets of the jointly controlled entity. The income statement reflects the venturer's share of the
profit or loss of the jointly controlled entity. (IAS 31)
15.2 Forms of joint venture
The form and structure of joint ventures can vary enormously. There are, however, three main types
identified by the standard.
Jointly controlled operations
Jointly controlled assets
Jointly controlled entities
We will look at each of these below. They are all usually described as joint ventures and fulfil the definition
of a joint venture given above.
Whatever the form and structure, every joint venture will have two characteristics.
Two (or more) venturers are bound by a contractual arrangement.
The contractual relationship establishes joint control.
15.3 Jointly controlled operations
In this type of joint venture, there is no separate entity set up to deal with the joint venture, whether in the
form of a corporation, partnership or other entity. Instead, the venturers use their own assets and
resources for the joint venture, ie their own property, plant and equipment is used and they carry their
own inventories.
The venturers also incur their own expenses and liabilities, and raise their own finance which then
represents their own obligations. In these situations, the activities of the joint venture will often be
performed by the venturers' staff alongside the venturers' other similar activities. The way that income
and expenses are shared between the venturers is usually laid out in the joint venture agreement.

Activity 10.6

Can you think of an example of a situation where such a joint venture might occur?

When a joint venture in the nature of jointly controlled operations exists, IAS 31 requires a venturer to
recognise the following in its financial statements.
(a) The assets it controls and the liabilities it incurs
(b) The expenses it incurs and the income it earns from the sale of goods or services by the joint
venture
Separate accounts for the joint venture are not required, although the venturers may prepare management
accounts for the joint venture, in order to assess its performance.
15.4 Jointly controlled assets
In this type of joint venture, the venturers have joint control, and often joint ownership of some or all of
the assets in the joint venture. These assets may have been contributed to the joint venture or purchased
for the purpose of the joint venture, but in any case they are dedicated to the activities of the joint
venture. These assets are used to produce benefits for the venturers; each venturer takes a share of the
output and bears a share of the incurred expenses.
As with jointly controlled operations, this type of joint venture does not involve setting up a corporation,
partnership or any other kind of entity. The venturers control their share of future economic benefits
through their share in the jointly controlled asset.
IAS 31 requires each venturer to recognise (ie include in their financial statements) the following in
respect of its interest in jointly controlled assets.
(a) Its share of the jointly controlled assets, classified by their nature, eg a share of a jointly
controlled oil pipeline should be classified as property, plant and equipment
(b) Any liabilities it has incurred, eg in financing its share of the assets
(c) Its share of any liabilities incurred jointly with the other venturers which relate to the joint venture
(d) Any income from the sale or use of its share of the joint venture's output, together with its share of
any expenses incurred by the joint venture
(e) Any expenses which it has incurred in respect of its interest in the joint venture, eg those relating
to financing the venturer's interest in the assets and selling its share of the output
This treatment of jointly controlled assets reflects the substance and economic reality, and (usually) the
legal form of the joint venture. Separate accounting records need not be kept for the joint venture and
financial statements for the joint venture need not be prepared. Management accounts may be produced,
however, in order to monitor the performance of the joint venture.
15.5 Jointly controlled entities
Jointly controlled entities may be accounted for using:
proportionate consolidation, or
equity method as per IAS 28.
This type of joint venture involves the setting up of a corporation, partnership or other entity. This
operates in the same way as any other entity, except that the venturers have a contractual arrangement
establishing their joint control over the economic activity of the entity.
A jointly controlled entity effectively operates as a separate entity: it controls the joint venture's assets,
incurs liabilities and expenses and earns income. It can, as a separate entity, enter into contracts in its
own name and raise finance to fund the activities of the joint venture. The venturers share the results of
the jointly controlled entity, and in some cases they may also share the output of the joint venture.
The substance of jointly controlled entities is often similar to the joint ventures discussed above (jointly
controlled assets/operations). In other circumstances, a jointly controlled entity may be set up to deal with
only certain aspects of the jointly controlled operations.
As a separate entity, the jointly controlled entity must maintain its own accounting records and will
prepare financial statements according to national requirements and IFRS.
IAS 31 states that where a venturer prepares separate financial statements (as a single company),
investments in jointly controlled entities should be either:
(a) accounted for at cost, or
(b) in accordance with IAS 39.
The same accounting treatment must be applied consistently to all jointly controlled entities.
In the consolidated financial statements of a venturer IAS 31 requires all interests in jointly controlled
entities to be accounted for using either proportionate consolidation or the equity method.
15.5.1 The proportionate consolidation method
A venturer can report its interest in a jointly controlled entity in its consolidated financial statements using
one of the two reporting formats for proportionate consolidation.
IAS 31 maintains that this treatment reflects the substance and economic reality of the arrangement, ie
the control the venturer has over its share of future economic benefits through its share of the assets and
liabilities of the venture.
The proportionate consolidation method differs from normal consolidation in that only the group share of
assets and liabilities, income and expenses are brought into account. There is therefore no non-
controlling interest.
There are two different formats with which the proportionate consolidation method can be used.
(a) Combine on a line-by-line basis the venturer's share of each of the assets, liabilities, income and
expenses of the jointly controlled entity with the similar items in the venturer's consolidated
financial statements.
(b) Include in the venturer's consolidated financial statements separate line items for the venturer's share
of the assets and liabilities, income and expenses of the jointly controlled entity.
15.5.2 Example: proportionate consolidation
Both of the above methods produce exactly the same net results and they are demonstrated in this
example.
Set out below are the draft accounts of Parent Co and its subsidiaries and of Joint Venture Co. Parent Co
acquired 50% of the equity capital of Joint Venture Co three years ago when the latter's reserves stood at
$40,000.

SUMMARISED STATEMENTS OF FINANCIAL POSITION

Parent Co Joint Venture

& subsidiaries Co

$'000

$'000


220

170

Investment in joint venture

75

Current assets

100

50

Loan to Joint Venture

20

415

220

Share capital ($1 shares)

250

100

Reserves

165

100

Loan from Parent Co

20

415

220

SUMMARISED INCOME STATEMENTS

Parent Co Joint Venture

& subsidiaries Co

$'000

$'000

Net profit

95

80

Taxation

35

30

60

50

Dividends payable

50

10

Retained profit

10

40

Parent Co has taken credit for the dividend receivable from Joint Venture Co.
You are required to prepare the summarised consolidated statement of financial position of Parent Co,
under each of the formats of proportionate consolidation described by IAS 31.
Solution: line-by-line format
PARENT CO

$'000

Tangible non-current assets (220 + (50% 170))

305

Goodwill (W1)

5

Current assets (100 + (50% 50))

125

Loan to joint venture (note)

10

445

Share capital

250

Reserves (W2)

195

445

Note. The loan is the proportion of the $20,000 lent to the other venturer.
Workings
1 Goodwill

$'000

Cost of investment

75

Share of net assets acquired (50% 140)

70

5

2 Reserves

Parent Co &

Joint Venture

subsidiaries Co

$'000

$'000

Per question

165

100

Pre-acquisition

(40)

Post-acquisition

60

Group share in joint venture

($60 x 50%)

30

Group reserves

195

Solution: separate line method
PARENT CO

$'000

$'000


Group

220

Joint venture (170 50%)

85

305

Goodwill (as above)

5

Current assets

Group

100

Joint venture (50% 50)

25

125

Loan to joint venture

10

445

Share capital

250

Reserves (as above)

195

445

In both these cases the consolidated income statements would be shown in the same way.
The use of the proportionate consolidation method should be discontinued from the date the venturer
ceases to have joint control over the entity.
15.5.3 Allowed alternative: equity method
A venturer can report its interest in a jointly controlled entity in its consolidated financial statements under
the equity method, as used for associates. The argument for this method is that it is misleading to
combine controlled items with jointly controlled items. It is also felt by some that venturers have
significant influence over the entity, not merely joint control.
16 Investments held for sale
A subsidiary which is to be sold is treated as a disposal group according to IFRS 5 and is remeasured to
the lower of carrying value and fair value less costs to sell. It is also disclosed separately in the financial
statements.
16.1 Disposal of investments
If a parent company decides to sell a subsidiary or associate then it must be treated in accordance with
IFRS 5 Non-current assets held for sale and discontinued operations. This standard was discussed in
Chapter 7.

For example, if J Co decided to sell one of its subsidiaries, M Co, then M Co will be treated as a disposal
group.
A disposal group is a group of assets and related liabilities to be disposed of in a single transaction. To be
classified as a disposal group, there are certain criteria to be met:
(a) Management must be committed to a plan to sell the asset.
(b) There must be an active programme to locate a buyer.
(c) The asset must be for sale at a reasonable price.
(d) The sale should be expected to occur within one year.
(e) It is unlikely any changes to the plan should be made.
The assets and liabilities of the disposal group should be measured at the lower of fair value less costs to
sell and the carrying amount. Additionally, they will be separately disclosed on the face of the statement of
financial position.
The same accounting treatment applies if a subsidiary has been acquired with a view to immediate resale.
This may occur if a group of subsidiaries is acquired and the parent company does not wish to retain them
all.
500 10: Statement of cash flows
1 The need for statements of cash flows

A statement of cash flows is a useful addition to a company's financial statements as a measure of
performance, because it recognises that accounting profit is not the only indicator of a company's
performance.
As a result of the terminology changes in the revised IAS 1 Presentation of Financial Statements, the cash
flow statement has been renamed the statement of cash flows. The form and content of the statement has
not changed.
It has been argued that 'profit' does not always give a useful or meaningful picture of a company's
operations. Readers of a company's financial statements might even be misled by a reported profit figure.
(a) Shareholders might believe that if a company makes a profit after tax, of say, $100,000 then this is
the amount which it could afford to pay as a dividend. Unless the company has sufficient cash
available to stay in business and also to pay a dividend, the shareholders' expectations would be
wrong.
(b) Employees might believe that if a company makes profits, it can afford to pay higher wages next
year. This opinion may not be correct: the ability to pay wages depends on the availability of cash.
(c) Survival of a business entity depends not so much on profits as on its ability to pay its debts
when they fall due. Such payments might include 'revenue' items such as material purchases,
wages, interest and taxation etc, but also capital payments for new non-current assets and the
repayment of loan capital when this falls due (for example on the redemption of debentures).
From these examples, it may be apparent that a company's performance and prospects depend not so
much on the 'profits' earned in a period, but more realistically on liquidity or cash flows.
1.1 Funds flow and cash flow
Some countries, either currently or in the past, have required the disclosure of additional statements
based on funds flow rather than cash flow. However, the definition of 'funds' can be very vague and such
statements often simply require a rearrangement of figures already provided in the statement of financial
position and income statement. By contrast, a statement of cash flows is unambiguous and provides
information which is additional to that provided in the rest of the accounts. It also lends itself to
organisation by activity and not by statement of financial position classification.
Statements of cash flows are frequently given as an additional statement, supplementing the statement of
financial position, income statement or statement of comprehensive income and related notes.

Statement of cash flows
10: Statement of cash flows 501
2 Objective of IAS 7 Statement of cash flows
Statements of cash flows concentrate on the sources and uses of cash and are a useful indicator of a
company's liquidity and solvency.
The aim of IAS 7 is to provide information to users of financial statements about the entity's ability to
generate cash and cash equivalents, as well as indicating the cash needs of the entity. The statement of
cash flows provides historical information about cash and cash equivalents, classifying cash flows
between operating, investing and financing activities.
Cash comprises cash on hand and demand deposits.
Cash equivalents are short-term, highly liquid investments that are readily convertible to known
amounts of cash and which are subject to an insignificant risk of changes in value. (IAS 7)
The standard expands on the definition of cash equivalents: they are not held for investment or other long-
term purposes, but rather to meet short-term cash commitments. To fulfil the above definition, an
investment's maturity date should normally be within three months from its acquisition date. It would
usually be the case then that equity investments (ie shares in other companies) are not cash equivalents.
An exception would be where preferred shares were acquired with a very close maturity date.
Loans and other borrowings from banks are classified as investing activities. In some countries, however,
bank overdrafts are repayable on demand and are treated as part of an entity's total cash management
system. In these circumstances an overdrawn balance will be included in cash and cash equivalents. Such
banking arrangements are characterised by a balance which fluctuates between overdrawn and credit.
Movements between different types of cash and cash equivalent are not included in cash flows. The
investment of surplus cash in cash equivalents is part of cash management, not part of operating,
investing or financing activities.
A statement of cash flows should be presented as an integral part of an entity's financial statements. All
types of entity can provide useful information about cash flows as the need for cash is universal, whatever
the nature of their revenue-producing activities. Therefore all entities are required by the standard to
produce a statement of cash flows.
2.1 Benefits of cash flow information
The use of statements of cash flows is very much in conjunction with the rest of the financial statements.
Users can gain further appreciation of the change in net assets, of the entity's financial position (liquidity
and solvency) and the entity's ability to adapt to changing circumstances by affecting the amount and
timing of cash flows. Statements of cash flows enhance comparability as they are not affected by
differing accounting policies used for the same type of transactions or events.
Cash flow information of a historical nature can be used as an indicator of the amount, timing and
certainty of future cash flows. Past forecast cash flow information can be checked for accuracy as actual
figures emerge. The relationship between profit and cash flows can be analysed as can changes in prices
over time.
3 Format of a statement of cash flows
You need to be aware of the format of the statement as laid out in IAS 7; setting out the format is an
essential first stage in preparing the statement, so this format must be learnt.
IAS 7 requires statements of cash flows to report cash flows during the period classified by operating,
investing and financing activities.

The manner of presentation of cash flows between operating, investing and financing activities depends
on the nature of the entity. By classifying cash flows between different activities in this way users can see
the impact on cash and cash equivalents of each one, and their relationships with each other. We can look
at each in more detail.
3.1 Operating activities
This is perhaps the key part of the statement of cash flows because it shows whether, and to what extent,
companies can generate cash from their operations. It is these operating cash flows which must, in the
end pay for all cash outflows relating to other activities, ie paying loan interest, dividends and so on.
Most of the components of cash flows from operating activities will be those items which determine the
net profit or loss of the entity, ie they relate to the main revenue-producing activities of the entity. The
standard gives the following as examples of cash flows from operating activities.
(a) Cash receipts from the sale of goods and the rendering of services
(b) Cash receipts from royalties, fees, commissions and other revenue
(c) Cash payments to suppliers for goods and services
(d) Cash payments to and on behalf of employees.
Certain items may be included in the net profit or loss for the period which do not relate to operational
cash flows, for example the profit or loss on the sale of a piece of plant will be included in net profit or
loss, but the cash flows will be classed as investing.
Cash flows from operating activities can be presented using either the direct or indirect method. These
are discussed in more detail in Section 8.
3.2 Investing activities
The cash flows classified under this heading show the extent of new investment in assets which will
generate future profit and cash flows. The standard gives the following examples of cash flows arising
from investing activities.
(a) Cash payments to acquire property, plant and equipment, intangibles and other non-current assets,
including those relating to capitalised development costs and self-constructed property, plant and
equipment
(b) Cash receipts from sales of property, plant and equipment, intangibles and other non-current
assets
(c) Cash payments to acquire shares or debentures of other entities
(d) Cash receipts from sales of shares or debentures of other entities
(e) Cash advances and loans made to other parties
(f) Cash receipts from the repayment of advances and loans made to other parties.
3.3 Financing activities
This section of the statement of cash flows shows the share of cash which the entity's capital providers
have claimed during the period. This is an indicator of likely future interest and dividend payments. The
standard gives the following examples of cash flows which might arise under this heading.
(a) Cash proceeds from issuing shares
(b) Cash payments to owners to acquire or redeem the entity's shares
(c) Cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short or long-
term borrowings
(d) Principal repayments of amounts borrowed under finance leases.
Item (d) needs more explanation. Where the reporting entity uses an asset held under a finance lease, the
amounts to go in the statement of cash flows as financing activities are repayments of the principal
(capital) rather than the interest. The interest paid will be shown under operating activities.
4 Example of a statement of cash flows
STATEMENT OF CASH FLOWS (INDIRECT METHOD)

$m

$m

Cash flows from operating activities


3,570

Adjustments for:

Depreciation

450

Investment income

(500)

Interest expense

400

3,920

Increase in trade and other receivables

(500)

Decrease in inventories

1,050

Decrease in trade payables

(1,740)

Cash generated from operations

2,730

Interest paid

(270)

Income taxes paid

(900)

Net cash from operating activities

1,560

Cash flows from investing activities

Purchase of property, plant and equipment

(900)

Proceeds from sale of equipment

20

Interest received

200

Dividends received

200

Net cash used in investing activities

(480)

Cash flows from financing activities

Proceeds from issue of share capital

250

Proceeds from long-term borrowings

250

Dividends paid*

(1,290)

Net cash used in financing activities

(790)

Net increase in cash and cash equivalents

290

Cash and cash equivalents at beginning of period (Note)

120

Cash and cash equivalents at end of period (Note)

410

* This could also be shown as an operating cash flow

Note: Cash and cash equivalents
Cash and cash equivalents consist of cash on hand and balances with banks, and investments in money
market instruments. Cash and cash equivalents included in the statement of cash flows comprise the
following amounts in the statement of financial position.

20X7

20X6

$m

$m

Cash on hand and balances with banks

40

25

Short-term investments

370

95

Cash and cash equivalents

410

120

The company has undrawn borrowing facilities of $2,000m of which only $700m may be used for future
expansion.
5 Interest and dividends
Cash flows from interest and dividends received and paid should each be disclosed separately. Each
should be classified in a consistent manner from period to period as either operating, investing or
financing activities.
Dividends paid by the entity can be classified in one of two ways.
(a) As a financing cash flow, showing the cost of obtaining financial resources.
(b) As a component of cash flows from operating activities so that users can assess the entity's
ability to pay dividends out of operating cash flows.
6 Taxes on income
Cash flows arising from taxes on income should be separately disclosed and should be classified as cash
flows from operating activities unless they can be specifically identified with financing and investing
activities.
Taxation cash flows are often difficult to match to the originating underlying transaction, so most of the
time all tax cash flows are classified as arising from operating activities.
7 Disclosure
IAS 7 requires a reconciliation of cash and cash equivalents. This should be presented as a disclosure
note.
The components of cash and cash equivalents should be disclosed and a reconciliation should be
presented, showing the amounts in the statement of cash flows reconciled with the equivalent items
reported in the statement of financial position. This note is shown in our example in Section 4.
It is also necessary to disclose the accounting policy used in deciding the items included in cash and cash
equivalents, in accordance with IAS 1 Presentation of Financial Statements, but also because of the wide
range of cash management practices worldwide.
All entities should disclose, together with a commentary by management, any other information likely to
be of importance, for example:
(a) Restrictions on the use of or access to any part of cash equivalents
(b) The amount of undrawn borrowing facilities which are available
(c) Cash flows which increased operating capacity compared to cash flows which merely maintained
operating capacity
(d) Cash flows arising from each reported industry and geographical segment
8 Reporting cash flows from operating activities
Cash flows from operating activities can be presented using the direct or the indirect method. The indirect
method is normally more straightforward.
The standard offers a choice of method for this part of the statement of cash flows.
(a) Direct method: disclose major classes of gross cash receipts and gross cash payments
(b) Indirect method: net profit or loss is adjusted for the effects of transactions of a non-cash nature,
any deferrals or accruals of past or future operating cash receipts or payments, and items of
income or expense associated with investing or financing cash flows. This is the method used in
the example in Section 4.
The direct method is the preferred method because it discloses information, not available elsewhere in
the financial statements, which could be of use in estimating future cash flows, but IAS 7 does not require
it. In practice the indirect method is more commonly used, since it is quicker and easier.

8.1 Using the indirect method
This method is undoubtedly easier from the point of view of the preparer of the statement of cash flows.
The net profit or loss for the period is adjusted for the following.
(a) Changes during the period in inventories, operating receivables and payables
(b) Non-cash items, eg depreciation, provisions, profits/losses on the sales of assets
(c) Other items, the cash flows from which should be classified under investing or financing activities.
A proforma of such a calculation, taken from the IAS, is as follows and this method may be more common
in the exam. (The proforma has been amended to reflect changes to IFRS.) We have already seen this in
the example in Section 4.

$



X

Adjustments for:

Depreciation

X

Investment income

(X)

Interest expense

X

X

Increase in trade and other receivables

(X)

Decrease in inventories

X

Decrease in trade payables

(X)


X

Interest paid

(X)

Income taxes paid

(X)


X

It is important to understand why certain items are added and others subtracted. Note the following
points.
(a) Depreciation is not a cash expense, but is deducted in arriving at the profit figure in the income
statement. It makes sense, therefore, to eliminate it by adding it back.
(b) By the same logic, a loss on a disposal of a non-current asset (arising through underprovision of
depreciation) needs to be added back and a profit deducted.
(c) An increase in inventories means less cash you have spent cash on buying inventory.
(d) An increase in receivables means the company's customers have not paid as much, and therefore
there is less cash.
(e) If we pay off payables, causing the figure to decrease, again we have less cash.
8.2 Using the direct method
The only difference when using the direct method is the way in which cashflows from operating activities
are presented. (See below.) The rest of the statement of cash flows will be exactly the same as the
example shown in Section 4. This information may be time consuming to produce hence the more
frequent use of the indirect method.

$m

$m


Cash receipts from customers

30,330

Cash paid to suppliers and employees

(27,600)


2,730

Interest paid

(270)

Income taxes paid

(900)


1,560

9 Preparing a statement of cash flows
Remember the step-by-step preparation procedure and use it for all the questions you practise.
In essence, preparing a statement of cash flows is very straightforward. Each cash flow is derived from
balances in the statements of financial position and income statement. You should therefore simply learn
the format and apply the steps noted in the example below. Note that the following items are treated in a
way that might seem confusing, but the treatment is logical if you think in terms of cash.
(a) Increase in inventory is treated as negative (in brackets). This is because it represents a cash
outflow; cash is being spent on inventory.
(b) An increase in receivables would be treated as negative for the same reasons; more receivables
means less cash.
(c) By contrast an increase in payables is positive because cash is being retained and not used to
settle accounts payable. There is therefore more of it.
9.1 Example: preparation of a statement of cash flows
Kane Co's income statement for the year ended 31 December 20X2 and statements of financial position at
31 December 20X1 and 31 December 20X2 were as follows.
KANE CO
INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20X2

$'000

$'000

Sales

720

Raw materials consumed

70

Staff costs

94

Depreciation

118

Loss on disposal of non-current asset

18

300

Profit from operations

420

Interest payable

28

Profit before tax

392

Taxation

124

Profit for the year

268


490

Profit for the year

268

Dividend

(72)
686

KANE CO
STATEMENTS OF FINANCIAL POSITION AS AT 31 DECEMBER

20X2

20X1

$'000

$'000

$'000

$'000

Assets

Non-current assets

Cost

1,596

1,560

Depreciation

318

224

1,278

1,336

Current assets

Inventory

24

20

Trade receivables

76

58

Bank

48

56

148

134

Total assets

1,426

1,470


Equity

Share capital

360

340

Share premium

36

24

Retained earnings

686

490

1,082

854


Long-term loans

200

500

Current liabilities

Trade payables

12

6

Taxation

102

86

Dividend payable

30

24

144

116

1,426

1,470

During the year, the company paid $90,000 for a new piece of machinery. Proceeds received on disposal
of a piece of machinery were $12,000.
Required
Prepare a statement of cash flows for Kane Co for the year ended 31 December 20X2 in accordance with
the requirements of IAS 7, using the indirect method. Notes to the statement are not required.
Solution
Step 1 Set out the proforma statement of cash flows with the headings required by IAS 7. You
should leave plenty of space. Ideally, use three or more sheets of paper, one for the main
statement, one for the notes and one for your workings. It is obviously essential to know the
formats very well.
Step 2 Begin with the cash flows from operating activities as far as possible. When preparing the
statement from statements of financial position, you will usually have to calculate such
items as depreciation, loss on sale of non-current assets, profit for the year and tax paid
(see Step 4). Note that you may not be given the tax charge in the income statement. You
will then have to assume that the tax paid in the year is last year's year-end provision and
calculate the charge as the balancing figure.
Step 3 Calculate the cash flow figures for dividends paid, purchase or sale of non-current assets,
issue of shares and repayment of loans if these are not already given to you (as they may
be).
Step 4 If you are not given the profit figure, open up a working for the income statement. Using
the opening and closing balances of retained earnings, the taxation charge and dividends
paid and declared, you will be able to calculate profit for the year as the balancing figure to
put in the cash flows from operating activities section.
Step 5 You will now be able to complete the statement by slotting in the figures given or
calculated.
KANE CO
STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 DECEMBER 20X2

$'000

$'000


Profit before tax

392

Depreciation charges

118

Loss on sale of tangible non-current assets

18

Interest expense

28

Increase in inventories

(4)

Increase in receivables

(18)

Increase in payables

6


540

Interest paid

(28)

Dividends paid (72 30 + 24)

(66)

Tax paid (86 + 124 102)

(108)


338

Cash flows from investing activities

Payments to acquire tangible non-current assets

(90)

Receipts from sales of tangible non-current assets

12

Net cash used in investing activities

(78)

Cash flows from financing activities

Issues of share capital (360 + 36 340 24)

32

Long-term loans repaid (500 200)

(300)

Net cash used in financing activities

(268)

Decrease in cash and cash equivalents

(8)

Cash and cash equivalents at 1.1.X2

56

Cash and cash equivalents at 31.12.X2

48

Activity 11.1

Set out below are the financial statements of Emma Co. You are the financial controller, faced with the task
of implementing IAS 7 Statement of cash flows.
EMMA CO
INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20X2

$'000

Revenue

2,553

Cost of sales

1,814

Gross profit

739

Distribution costs

125


264


350

Interest received

25

Interest paid

75

Profit before tax

300

Income tax expense

140

Profit for the year

160

Dividends payable

100

EMMA CO
STATEMENTS OF FINANCIAL POSITION AS AT 31 DECEMBER
20X2 20X1
Assets $'000 $'000
Non-current assets
Tangible assets 380 305
Intangible assets 250 200
Investments 25
Current assets
Inventories 150 102
Receivables 390 315
Short-term investments 50
Cash in hand
2

1

Total assets
1,222

948

Equity
Share capital ($1 ordinary shares) 200 150
Share premium account 160 150
Revaluation reserve 100 91
Retained earnings 160 100
Long-term loan 170 50
Current liabilities
Trade payables
127

119

Bank overdraft
85

98

Taxation
120

110

Dividends payable
100

80

1,222

948

The following information is available.
(a) The proceeds of the sale of non-current asset investments amounted to $30,000.
(b) Fixtures and fittings, with an original cost of $85,000 and a carrying value of $45,000, were sold for
$32,000 during the year. New fixtures and fittings were purchased costing $201,000.
(c) The following information relates to tangible non-current assets.

31.12.20X2 31.12.20X1

$'000

$'000

Cost/revaluation

720

595


340

290

Carrying value

380

305

(d) 50,000 $1 ordinary shares were issued during the year at a premium of 20c per share.
(e) The short-term investments are highly liquid and are close to maturity.
Required
Prepare a statement of cash flows for the year to 31 December 20X2 using the format laid out in IAS 7.

9.2 Example: non-current assets
In exam questions a common complication is to work out the cash flows for purchases of non-current
assets and sales of non-current assets.
At 31 December 20X8 the carrying value of non-current assets was $78,000 and at 31 December 20X9 the
carrying value had increased to $100,000. The income statement has been charged with depreciation for
the year ending 31 December 20X9 of $14,000 and there is also a loss on disposal of $3,000 for assets
with a carrying value of $10,000.
Calculate the figures that would be shown for acquisition and disposal of non-current assets in the
statement of cash flows.
Disposal of non-current assets
If the non-current assets disposed of had a carrying value of $10,000 and a loss of $3,000 was recorded
then the cash proceeds from disposal must have been $7,000.
Acquisition of non-current assets
This is most easily calculated using a ledger account for non-current assets at carrying value.
Non-current assets at carrying value
$ $
Opening carrying value 78,000 Depreciation charge 14,000
Carrying value of disposal 10,000
Cash paid for acquisitions (bal fig)
46,000
Closing carrying value
100,000

124,000

124,000
10 Consolidated statements of cash flows
Consolidated statements of cash flows follow the same principles as for single company statements, with
some additional complications.
10.1 Intra-group cash flows
The purpose of a consolidated statement of cash flows is to report cash flows between group companies
and third parties. Cash flows that are internal to the group (i.e. between parent and subsidiaries) should
therefore be eliminated in the preparation of a consolidated statement of cash flows.
10.2 Acquisitions and disposals of subsidiaries and other business units
Where a subsidiary joins or leaves a group during a financial year the cash flows of the group should
include the cash flows of the subsidiary concerned for the same period as that for which the group's
income statement includes the results of the subsidiary.
The cash flows directly associated with the acquisition or disposal of a subsidiary are classified as cash
flows from investing activities:
The cash outflow to acquire a subsidiary will be the net amount of consideration paid less the cash
balance of the subsidiary acquired.
The cash inflow from the sale of a subsidiary will be the net amount of proceeds received less the
cash balance of the subsidiary sold.

10.3 Non-controlling interests
Dividends paid to non-controlling interests are included under the heading 'cash flows from financing
activities'.
10.4 Associates
The consolidated statement of cash flows does not include any cash flows between an associate and third
parties, as the associate is not part of the group. The following cash flows are, however included:
Sales by parent or subsidiary to an associate (operating cash flows)
Purchases by parent or subsidiary from an associate (operating cash flows)
Investments by parent or subsidiary in an associate (investing cash flows)
Dividends received from associates (investing cash flows)
11 Interpretation of statements of cash flows
Note that you may be expected to analyse or interpret a statement of cash flows.
IAS 7 Statement of cash flows was introduced on the basis that it would provide better, more
comprehensive and more useful information than what was already shown in the financial statements.
So what kind of information does the statement of cash flows, along with its notes, provide?
Some of the main areas where IAS 7 should provide information not found elsewhere in the financial
statements are as follows.
(a) The relationships between profit and cash can be seen clearly and analysed accordingly.
(b) Cash equivalents are highlighted, giving a better picture of the liquidity of the company.
(c) Financing inflows and outflows must be shown, rather than simply passed through reserves.
One of the most important things to realise at this point is that it is wrong to try to assess the health or
predict the death of a reporting entity solely on the basis of a single indicator. When analysing cash flow
data, the comparison should not just be between cash flows and profit, but also between cash flows
over a period of time (say three to five years).
Cash is not synonymous with profit on an annual basis, but you should also remember that the
'behaviour' of profit and cash flows will be very different. Profit is smoothed out through accruals,
prepayments, provisions and other accounting conventions. This does not apply to cash, so the cash flow
figures are likely to be 'lumpy' in comparison. You must distinguish between this 'lumpiness' and the
trends which will appear over time.
The relationship between profit and cash flows will vary constantly. Note that healthy companies do not
always have reported profits exceeding operating cash flows. Similarly, unhealthy companies can have
operating cash flows well in excess of reported profit. The value of comparing them is in determining the
extent to which earned profits are being converted into the necessary cash flows.
Profit is not as important as the extent to which a company can convert its profits into cash on a
continuing basis. This process should be judged over a period longer than one year. The cash flows
should be compared with profits over the same periods to decide how successfully the reporting entity
has converted earnings into cash.
Cash flow figures should also be considered in terms of their specific relationships with each other over
time. A form of 'cash flow gearing' can be determined by comparing operating cash flows and financing
flows, particularly borrowing, to establish the extent of dependence of the reporting entity on external
funding.
Other relationships can be examined.
(a) Operating cash flows and investment flows can be related to match cash recovery from investment
to investment.

(b) Investment can be compared to distribution to indicate the proportion of total cash outflow
designated specifically to investor return and reinvestment.
(c) A comparison of tax outflow to operating cash flow minus investment flow will establish a 'cash
basis tax rate'.
The 'ratios' mentioned above can be monitored inter- and intra-firm and the analyses can be undertaken
in monetary, general price-level adjusted, or percentage terms.
11.1 The advantages of cash flow accounting
The advantages of cash flow accounting are as follows.
(a) Survival in business depends on the ability to generate cash. Cash flow accounting directs
attention towards this critical issue.
(b) Cash flow is more comprehensive than 'profit' which is dependent on accounting conventions and
concepts.
(c) Creditors (long and short-term) are more interested in an entity's ability to repay them than in its
profitability. Whereas 'profits' might indicate that cash is likely to be available, cash flow
accounting is more direct with its message.
(d) Cash flow reporting provides a better means of comparing the results of different companies than
traditional profit reporting.
(e) Cash flow reporting satisfies the needs of all users better.
(i) For management, it provides the sort of information on which decisions should be taken (in
management accounting, 'relevant costs' to a decision are future cash flows); traditional
profit accounting does not help with decision-making.
(ii) For shareholders and auditors, cash flow accounting can provide a satisfactory basis for
stewardship accounting.
(iii) As described previously, the information needs of creditors and employees will be better
served by cash flow accounting.
(f) Cash flow forecasts are easier to prepare, as well as more useful, than profit forecasts.
(g) They can in some respects be audited more easily than accounts based on the accruals concept.
(h) The accruals concept is confusing, and cash flows are more easily understood.
(i) Cash flow accounting should be both retrospective, and also include a forecast for the future. This
is of great information value to all users of accounting information.
(j) Forecasts can subsequently be monitored by the publication of variance statements which
compare actual cash flows against the forecast.

Activity 11.2

Can you think of some possible disadvantages of cash flow accounting?

513 11: Other elements of corporate annual reports
1 Notes to the financial statements
Financial statements must be supported by notes to the accounts, which give additional information about
figures in the accounts themselves.
1.1 Contents of notes
The notes to the financial statements will amplify the information given in the statement of financial
position, income statement / statement of comprehensive income, statement of cash flows and statement
of changes in equity. We have already noted in an earlier chapter the information which IAS 1 allows to be
shown by note rather than on the face of the statements. To some extent, then, the contents of the notes
will be determined by the level of detail shown on the face of the statements.
1.2 Structure
The notes to the financial statements should perform the following functions.
(a) Provide information about the basis on which the financial statements were prepared and which
specific accounting policies were chosen and applied to significant transactions/events
(b) Disclose any information, not shown elsewhere in the financial statements, which is required by
IASs

(c) Show any additional information that is necessary for a fair presentation which is not shown on
the face of the financial statements.
The way the notes are presented is important. They should be given in a systematic manner and cross
referenced back to the related figure(s) in the statement of financial position, income statement or
statement of cash flows.
Notes to the financial statements will amplify the information shown therein by giving the following.
(a) More detailed analysis or breakdowns of figures in the statements
(b) Narrative information explaining figures in the statements
(c) Additional information, eg contingent liabilities and commitments.
IAS 1 suggests a certain order for notes to the financial statements. This will assist users when
comparing the statements of different entities.
(a) Statement of compliance with IASs/IFRSs
(b) Statement of the measurement basis (bases) and accounting policies applied
(c) Supporting information for items presented on the face of each financial statement in the same
order as each line item and each financial statement is presented.

Other elements of
corporate annual
reports
11: Other elements of corporate annual reports 514
(d) Other disclosures, eg:
(i) Contingent liabilities, commitments and other financial disclosures
(ii) Non-financial disclosures.
The order of specific items may have to be varied occasionally, but a systematic structure is still required.
1.3 Presentation of accounting policies
The accounting policies section should describe the following.
(a) The measurement basis (or bases) used in preparing the financial statements
(b) The other accounting policies used, as required for a proper understanding of the financial
statements.
This information may be shown in the notes or sometimes as a separate component of the financial
statements.
The information on measurement bases used is obviously fundamental to an understanding of the
financial statements. Where more than one basis is used, it should be stated to which assets or liabilities
each basis has been applied.
1.4 Other disclosures
An entity must disclose in the notes:
(a) The amount of dividends proposed or declared before the financial statements were authorised for
issue but not recognised as a distribution to equity holders during the period, and the amount per
share
(b) The amount of any cumulative preference dividends not recognised.
IAS 1 ends by listing some specific disclosures which will always be required if they are not shown
elsewhere in the financial statements.
(a) The domicile and legal form of the entity, its country of incorporation and the address of the
registered office (or, if different, principal place of business)
(b) A description of the nature of the entity's operations and its principal activities
(c) The name of the parent entity and the ultimate parent entity of the group.
2 Management report
In most jurisdictions, all companies apart from small companies must include a management report as
part of their accounts.
In most jurisdictions, with the exception of small companies, all companies must include a management
report (sometimes termed a directors report) in their accounts.
The management report is largely a narrative report, although certain figures must also be included. The
purpose of the report is to give the users of accounts a more complete picture of the state of affairs of the
company.
In principle, narrative descriptions in the management report put flesh on the bare bones of the information
provided by the figures in the accounts themselves. However, in practice, the management report is often a
rather dry and uninformative document. This is probably because it is often a statutory report and must be
verified by the company's external auditors, whereas the chairman's statement need not be.
The report must typically show:
(a) The amount, if any, recommended for dividend
(b) The principal activities of the company in the course of the financial year, and any significant
changes in those activities during the year

(c) where significant, an estimate should be provided of the difference between the book value of land
held as non-current assets and its realistic market value
(d) information about the company's policy on employment of disabled persons
(e) the names of persons who were directors at any time during the financial year and their interests in
shares or debentures of the company
(f) political and charitable contributions made in the year
(g) particulars of any important events affecting the company since the end of the financial year (i.e.
significant events after the reporting period)
(h) an indication of likely future developments in the business of the company and of its subsidiaries
(i) an indication of the activities (if any) of the company and its subsidiaries in the field of research
and development
(j) particulars of any purchases of its own shares by the company during the year, including reasons
for the purchase
(k) in the case of public companies, a statement of the company's policy on payments to creditors.
The management report of companies employing larger numbers of staff may also be required to include
details of what action has been taken to introduce, maintain or develop arrangements aimed at:
(a) providing information to employees about matters concerning them
(b) consulting with employees about decisions likely to affect their interests
(c) employee involvement, for example the availability of an employees' share option scheme
(d) achieving awareness on the part of all employees of the financial and economic factors affecting
the performance of the company.
3 Auditors' report
The accounts of large limited companies must be audited and a report produced by the auditors as to
whether or not the financial statements show a fair presentation of the activities of the company.
It is the duty of the directors of a company to prepare financial statements. The role of the auditor is to
perform an independent review of the financial statements on behalf of the shareholders. This process
adds credibility to the financial statements.
When the annual accounts of a limited company are audited, the auditors must provide a report as to
whether or not the accounts show a true and fair view of the company's results for the year and its
financial position at the end of the year. The audit report is governed by auditing regulations.
Typically, auditors are able to report that they have carried out their work in accordance with auditing
standards and that, in their opinion, the accounts show a fair presentation of the companys affairs. This is
described as an unqualified audit report.
The auditors' report covers the financial statements and the notes to the accounts. In addition the auditors
are often required to consider whether the information given in the management report is consistent with
the audited accounts. If they believe it is not consistent then they must state that fact in their report. Note
that the statement of cash flows is not mentioned outright in a typical audit report. The report does not
cover the chairman's statement.
The auditors' report is included as a part of the company's published accounts. It is normally addressed to
the shareholders of the company (not to the directors).
3.1 Modified audit opinions
It is fairly unusual for an auditors' report to give a qualified opinion as to whether a company's accounts
give a fair presentation of its affairs. However, there are two circumstances where this might occur: where
there is a disagreement or where there is a limitation on the scope of the auditors work.

Disagreement
(a) An adverse opinion is given where the auditors are materially in disagreement with the statements
given by the company's directors in the accounts, and the auditors have concluded that the
accounts are seriously misleading.
(b) A qualified opinion or disagreement is where the auditors disagree with an item in the accounts,
but they do not consider the disagreement sufficient to give an adverse opinion. Their opinion will
refer to the item in question.
Limitations on scope
(a) Disclaimer: where there has been such a restriction or limitation on the work that the auditors have
been able to carry out that they are unable to give an opinion on the financial statements. This
might occur, for example, when a large part of the company's operations are conducted in a
country to which the auditors have been unable to gain access.
(b) A qualified opinion: where there has been a limitation on the work that the auditors have been able
to carry out that they are unable to form an opinion, but the item is not so material as to justify a
total disclaimer of opinion.
4 Chairman's statement
In most jurisdictions large companies include a chairman's statement in their published financial
statements.
This is purely voluntary as there is no statutory requirement to do so.
The chairman's statement is not governed by any regulations and is often intended to present a rosy
picture of the company, what it has achieved and its future prospects. Often, it is unduly optimistic.
5 Operating and Financial Review
In the UK, listed companies may be called upon to produce an Operating and Financial Review in their
financial statements. The IASB has issued an exposure draft, Management Commentary, detailing what
should be contained in these reports.
The requirement to issue financial reviews varies from jurisdiction to jurisdiction. In the UK, listed
companies are required to prepare an operating and financial review. The IASB has issued an exposure
draft similar to the Operating and Financial Review called 'Management Commentary'. This details the
information that should be included if the management commentary is to be useful.
The Management Commentary should be of considerable benefit to less sophisticated users.
5.1 Definition
The IASB define management commentary as:
'Information that accompanies financial statements as part of an entity's financial reporting. It
explains the main trends and factors underlying the development, performance and position of the
entity's business during the period. It also explains the main trends and factors that are likely to
affect the entity's future development'.
5.2 Objective of management commentary
The IASB state in the exposure draft that a management commentary should assist current and potential
investors in assessing the entity's strategies and performance and in assessing how management are
dealing with the issues facing the entity.

Management commentary goes hand in hand with the information in the financial statements. It should
provide an analysis of the entity from a management perspective and be looking towards the future
prospects of the entity.
5.3 Content of a management commentary
The IASB aim to be flexible in the content of management commentary so it meets the needs of entities in
varying industries.
An entity should disclose the following information:
(a) the nature of the business
(b) the business objectives and strategies
(c) key resources, risks and relationships
(d) results and prospects
(e) performance measures and indicators.
6 Summarised information
Listed companies may include a five year summary of their results in their published accounts. This can
help interested parties to see trends and developments over the period.
The financial statements provide figures for the year just ended, and comparative figures for the previous
year. It is not always sufficient, however, to assess the financial performance and financial position of a
company simply on the strength of a two-year comparison.
Listed companies are often required to include a summary in their published annual report and accounts.
As its name suggests, this gives abbreviated details of the company's profits and net assets and capital
typically for a five-year period up to and including the year just ended.
The benefit to users of accounts is that the information can be used to look at trends and developments
over a five-year period, instead of relying on a two-year comparison of the year just ended and the
previous year.
There is not normally a set format or layout. An illustrative example is shown below.

20X1 20X2 20X3

20X4

20X5

$m $m $m $m

$m
Revenue

10.6 11.2 13.5

14.8

17.1


2.4 2.2 2.9

3.2

3.7

Profit before interest

and tax

2.4 4.2 2.2

3.2

3.3
Interest

(0.2) (0.1) (0.3)

(0.3)

0.2
Profit before tax 2.2 4.1 1.9 2.9

3.5
Taxation

(0.6) (1.2) (0.6)

(0.7)

(1.2)
Profit for the year 1.6 2.9 1.3

2.2

2.3

(0.1) (0.2) (0.2)

(0.3)

(0.4)
Profit attributable to the group

1.5 2.7 1.1

1.9

1.9

Earnings per share

3.0c 5.4c 2.1c

1.6c

1.6c

$m $m $m $m

$m
Intangible assets 1.2

2.5

3.0
Tangible assets

6.3 8.0 8.5

9.9

10.8
Cash net of overdrafts

1.3 0.2 0.7

1.2

2.8
Inventory and receivables less payables and

provisions

2.1 2.4 2.4

2.6

2.7

9.7 10.6 12.8

16.2

19.3

Share capital and reserves

9.1 9.7 11.8

15.0

17.8
Non-controlling interests

0.6 0.9 1.0

1.2

1.5

9.7 10.6 12.8

16.2

19.3

6.1 Limitations of summarised information
In most jurisdictions it is up to the management team to decide how the information is to be summarised.
Depending on exactly how the various balances are combined, a different impression of the results can be
achieved. It is possible that information could be summarised in such a way that the readers of the
accounts are misled.
7 Interim accounts
Listed companies publish half-yearly accounts, interim accounts, for the first six months of their financial
year.
Interim accounts are much shorter than annual accounts, and contain:
(a) a brief statement of the revenue and profit for the first six months, and the amount of the interim
dividend that will be paid (and the date of payment of the dividend)
(b) (usually) a chairman's statement
(c) an unaudited group income statement for the first six months of the year
(d) an unaudited group statement of financial position as at the mid-year date
(e) an unaudited group statement of cash flows for the six month period
(f) an unaudited group statement of the changes in equity
(g) some notes to these financial statements.
Comparative figures are provided for both the first six months of the previous year and for the whole of
the previous year.
Interim accounts are not audited, but they can be used to:
(a) make an assessment of how the company has performed in the first six months of the current year,
compared with the first six months of the previous year
(b) make an assessment of how the company might perform in the next six months, by looking at what
it achieved in the second six months of the previous year
(c) make an assessment of the financial position of the company, compared with its position at both the
mid-year point in the previous year and the end of the previous year
(d) compare cash flows in the first six months of the current and the previous year.
8 Preliminary announcements
Listed companies make a preliminary announcement of their annual results once prepared, to publish
news of the company's results and dividends as soon as they are available.
A listed company is normally required to make a preliminary announcement of its annual results without
delay. Since it takes several weeks to prepare and print the published annual accounts, a preliminary
announcement is used to communicate the company's annual results and dividends as soon as they are
available. Note that a preliminary announcement is of actual results; expected results would be
communicated via a profit forecast.
The announcement:
(a) must have been agreed in advance with the company's auditors
(b) must show the figures in the form of a table (or tables) and must contain at least the items of
information that are included in the company's interim statement
(c) must include any other additional information that is necessary for assessing the results.
If the auditors' report will be qualified, this must also be revealed in the announcement.

9 Environmental reporting
Environmental reporting involves making statements about the impact of the business's operations on
the environment and any steps taken by the company to reduce any negative effects.
At the end of the 1980s there were perhaps only two or three companies in the world issuing
environmental reports. Now most listed companies produce them. Worldwide there are around 20 award
schemes for environmental reporting, notably the ACCA's. This section looks at environmental reporting
mainly under three headings:
the effect of environmental matters on management information and accounting
external reporting and auditing
possible future developments
Let us consider the major areas of impact on (any) accountant's job caused by consideration of
environmental matters.
(a) Management accountant
(i) Investment appraisal: evaluation of environmental costs and benefits.
(ii) Incorporating new costs, capital expenditure and so on, into budgets and business plans.
(iii) Undertake cost/benefit analysis of any environmental improvements.
(b) Financial accountant
(i) The effect of revenue costs: site clean up costs, waste disposal or waste treatment costs
and so on, which will affect the income statement.
(ii) Gauging statement of financial position impacts, particularly liabilities, contingencies,
provisions and valuation of assets.
(iii) The effect of environmental matters, and particularly potential liabilities, on a company's
relationship with bankers, insurers and major shareholders (institutional shareholders).
(iv) Environmental performance evaluation in annual reports.
(c) Project accountant
(i) Environmental audit of proposed takeovers, mergers and other planning matters.
(ii) Investment appraisal.
(d) Internal auditor: environmental audit.
(e) Systems accountant: effect on, and required changes to, management and financial information
systems.
9.1 What is environmental accounting?
The following list encompasses the major aspects of environmental accounting.
(a) Recognising and seeking to mitigate the negative environmental effects of conventional accounting
practice.
(b) Separately identifying environmentally related costs and revenues within the conventional
accounting systems.
(c) Devising new forms of financial and non-financial accounting systems, information systems and
control systems to encourage more environmentally benign management decisions.
(d) Developing new forms of performance measurement, reporting and appraisal for both internal and
external purposes.
(e) Identifying, examining and seeking to rectify areas in which conventional (financial) criteria and
environmental criteria are in conflict.
(f) Experimenting with ways in which sustainability may be assessed and incorporated into
organisational orthodoxy.
Accounting for the Environment Bob Gary (with Jan Bebbington and Diane Walters)

The whole environmental agenda is constantly changing and businesses therefore need to monitor the
situation closely. Most businesses, certainly those in the UK, have generally ignored environmental
matters in the past. How long will they be able to do so?
9.2 Management information and accounting
The means of codifying a company's attitude towards the environment is often the creation of a published
environmental policy document or charter. This may be internally generated or it may be adopted from a
standard environmental charter, such as the CERES Principles.
TheValdez Principles
Weadopt, support and will implement theprinciplesof:
1 Protection of thebiosphere
2 Sustainableuseof natural resources
3 Reduction and disposal of waste
4 Wiseuseof energy
5 Risk reduction
6 Marketing of safeproductsand services
7 Damagecompensation
8 Disclosure
9 Environmental directorsand managers
10 Assessment an annual audit Assessment and annual audit
The CERES Principles
We adopt, support and will implement the principles of:
1 Protection of the biosphere
2 Sustainable use of natural resources
3 Reduction and disposal of waste
4 Wise use of energy
5 Risk reduction
6 Marketing of safe products and services
7 Damage compensation
8 Disclosure
9 Environmental directors and managers
10 Assessment and annual audit

The problem here, as with other similar principles or charters, is that the commitment required from
companies is generally too high and the fear exists that the principles may have legal status which could
have a severe effect on a company's liability. Other documents available which are similar to the CERES
Principles are:
The Global Reporting Initiative sustainability reporting guidelines
The International Chamber of Commerce Business Charter for Sustainable Development
The Chemical Industries Association Responsible Care Programme
The Confederation of British Industry Agenda for Voluntary Action
Friends of the Earth Environmental Charter for Local Government
Adopting such a charter is one thing; implementing and monitoring it are more important and generally
more difficult to achieve.
9.3 Environmental audit
Environmental auditing is exactly what it says: auditing a business to assess its impact on the
environment, or as the CBI expressed it 'the systematic examination of the interactions between any
business operation and its surroundings'.
The audit will cover a range of areas and will involve the performance of different types of testing. The
scope of the audit must be determined and this will depend on each individual organisation. There are,
however, some aspects of the approach to environmental auditing which are worth mentioning.
(a) Environmental Impact Assessments (EIAs) are required, under EC directive, for all major projects
which require planning permission and have a material effect on the environment. The EIA process
can be incorporated into any environmental auditing strategy.
(b) Environmental surveys are a good way of starting the audit process, by looking at the organisation
as a whole in environmental terms. This helps to identify areas for further development, problems,
potential hazards and so forth.
(c) Environmental SWOT analysis. A 'strengths, weaknesses, opportunities, threats' analysis is useful
as the environmental audit strategy is being developed. This can only be done later in the process,
when the organisation has been examined in much more detail.
(d) Environmental Quality Management (EQM). This is seen as part of TQM (Total Quality
Management) and it should be built in to an environmental management system. Such a strategy has
been adopted by companies such as IBM, Dow Chemicals and by the Rhone-Poulenc Environmental
Index which has indices for levels of water, air and other waste products.
(e) Eco-audit. The European Commission has adopted a proposal for a regulation for a voluntary
community environmental auditing scheme, known as the eco-audit scheme. The scheme aims to
promote improvements in company environmental performance and to provide the public with
information about these improvements. Once registered, a company will have to comply with
certain on-going obligations involving disclosure and audit.
(f) Eco-labelling. Developed in Germany, this voluntary scheme will indicate those EC products which
meet the highest environmental standards, probably as the result of an EQM system. It is
suggested that eco-audit must come before an eco-label can be given.
(g) BS 7750 Environmental Management Systems. BS 7750 also ties in with eco-audits and eco-
labelling and with the quality BSI standard BS 5750. Achieving BS 7750 is likely to be a first step in
the eco-audit process.
(h) Supplier audits, to ensure that goods and services bought in by an organisation meet the
standards applied by that organisation.
9.4 Financial reporting
There are no disclosure requirements relating to environmental matters under IASs, so any disclosures
tend to be voluntary unless environmental matters happen to fall under standard accounting principles (eg
recognising liabilities).
(a) In most cases disclosure is descriptive and unquantified.
(b) There is little motivation to produce environmental information and many reasons for not doing so,
including secrecy.
(c) The main factor seems to be apathy on the part of businesses but more particularly on the part of
shareholders and investors. The information is not demanded, so it is not provided.
Environmental matters may be reported in the accounts of companies in the following areas.
Contingent liabilities
Exceptional charges
Operating and financial review comments
Profit and capital expenditure forecasts
The voluntary approach contrasts with the position in the United States, where the SEC/FASB accounting
standards are obligatory.
While nothing is compulsory, there are a number of published guidelines and codes of practice, including:
The Confederation of British Industry's guideline Introducing Environmental Reporting
The ACCA's Guide to Environment and Energy Reporting
The Coalition of Environmentally Responsible Economies (CERES) formats for environmental
reports
The Friends of the Earth Environmental Charter for Local Government
The Eco Management and Audit Scheme Code of Practice
The Sustainability Reporting Guidelines issued by the Global Reporting Initiative.
9.5 Example: environmental report
A good example of an environmental report is the Tesco report for 2007/2008. Extracts from the report are
reproduced below to give you a feel for it.

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. Profit and return on assets are based on accounting

against budgeted EVA

for the chain as a whole/return on investment by

) by which the return on investment for a division or company as a single entire

is conceptually quite straightforward. In order to add to the economic value, an

= NOPAT minus Capital charge

and residual income should be immediately apparent. The key difference

and residual income is that:

is therefore closely connected to changes in shareholder value.

for the period.

and changes in shareholder value. EVA

is (75% of 14%) + (25% of 8%) = 12.5%.

techniques, of $400 million. Net operating profit after tax

= $57 million - (12% of $400 million) = $9 million.

as far as the information given will allow, ignoring the effects of

= $47.6m 13% $210.9m = $20.18m

provides a clear benchmark for evaluating the effectiveness

projects' might include:

the problems and solutions

process. The managers must

and how it works in practice.

will be calculated and

then both managers and shareholders reap the

above, that accounting profit has certain weaknesses as a

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