F5 LSBF Study Notes

ACCA Paper F5
Performance
Management
Class Notes
December 2014
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Contents
PAGE
INTRODUCTION TO THE PAPER 5
FORMULAE PROVIDED IN THE EXAMINATION PAPER 7
CHAPTER 1: COST ACCOUNTING AND NEW DEVELOPMENTS 9
CHAPTER 2: DECISION MAKING AND LINEAR PROGRAMMING 33
CHAPTER 3: PRICING 63
CHAPTER 4: DECISION MAKING UNDER UNCERTAINTY 75
CHAPTER 5: BUDGETING 85
CHAPTER 6: STANDARD COSTING AND VARIANCE ANALYSIS 103
CHAPTER 7: ADVANCED VARIANCE ANALYSIS 115
CHAPTER 8: PERFORMANCE EVALUATION 127
CHAPTER 9: DIVISIONAL PERFORMANCE AND T RANSFER PRICING 143
SOLUTIONS TO EXERCISES AND EXAMPLES 155
ACCA STUDY GUIDE AND INDEX 199
www .s t u d yin t e ra ct i ve .o rg 3
Introduction to the
paper
INTRO DU C TIO N TO THE P AP E R
AIM OF THE PAPER

To develop knowledge and skills in t he application of management accounting
techniques to quantitative and qualitative information for planning, decision-
making, performance evaluation and control.
OUTLINE OF THE SYLLABUS

A. Specialist cost and management accounting techniques.
B. Decision-making techniques.
C. Budgeting and control.
D. Performance measurement and control.
FORMAT OF THE EXAM PAPER

The syllabus is assessed by a three hour paper-based examination, containing a
mix of objective (Section A) and longer type (Section B) questions. All questions
are compulsory.
In addition, you will be given 15 minutes reading and planning time at the start of
the exam. During the reading time, you are not permitted to write anything in the
answer booklet. You can however read the questions and annotate the question
paper.
FAQS
What are the skills that a student must bring to the paper?
As a student approaching this paper the basic requirement is an ability to
understand and compute the differing techniques and methods in the syllabus. In
addition there is a need to understand the scenario and critically be able to write in
relation to the scenario and whatever the numbers you have already calculated.
What is an average mix of discursive and numerical elements

in the exam?
There is no strict guideline as to how many marks would be allocated to discursive
parts and number crunching questions. However, on average up to 50% of the
marks will be available for non-computational work.
Formulae provided in
the examination paper
FO RMU L AE & TABL E S P RO VIDE D IN THE E XAMIN ATIO N P AP E R
FORMULAE SHEET
Learning curve
Y  axb
Where: y = cumulative average time per unit to produce x units

a = the time taken for the first unit of output
x = the cumulative number of units produced
b = the index of learning (log LR/log 2)

LR = the learning rate as a decimal
Demand curve
P  a  bQ
changein price
b
changein quantity
a  price when Q  0
MR = a – 2bQ
Chapter 1
Cost accounting and

new developments
SYLLABUS CONTENT (as set by ACCA’s study guide)
A Specialist cost and management accounting

techniques
1. Activity based costing

a) Identify appropriate cost drivers under ABC.
b) Calculate c osts per driver and per unit using ABC.
c) Compare ABC and traditional methods of overhead absorption based on

production units, labour hours or machine hours.
2. Target costing
a) Derive a target cost in manufacturing and service industries.
b) Explain the difficulties of using target costing in service industries.
c) Suggest how a target cost gap might be closed.
3. Life-cycle costing
a) Identify the costs involved at different stages of the life-cycle.
b) Derive a life cycle cost in manufacturing and service industries.

c) Identify the benefits of life cycle costing.
C HAP TE R 1 – C O ST AC C O U NTING AND NE W DE VE L O P ME NTS
4. Throughput accounting
a) Discuss and apply the theory of constraints.
b) Calculate and interpret a throughput accounting ratio (TPAR).
c) Suggest how a TPAR could be improved.
d) Apply throughput accounting to a multi-product decision-making problem.
5. Environmental accounting
a) Discuss the issues business face in the management of environmental costs.
b) Describe the different methods a business may use to account for its
environmental costs.
C HAP TE R 1 – C O ST AC C O UNTING AND NE W DE VE L O P ME NTS
CHAPTER CONTENTS
COST CLASSIFICATION --------------------------------------------------12

DIREC T AND INDIRECT COSTS 12
PRODUCTION AND NON PRODUCTION COSTS 12
COST BEHAVIOUR 12
MARGINAL COSTING -----------------------------------------------------13
ABSORPTION COSTING --------------------------------------------------14

ABSORPTION COSTING – A REMINDER 14
STEPS USING ABSORPTION COSTING 14
ADVANTAGES AND DISADVANTAGES OF ABSORPTION COSTING 14
ACTIVITY BASED COSTING ----------------------------------------------16

ABC ANALYSIS 17
CALC ULATION STEPS WITH ABC 17
CONDITIONS UNDER WHICH ABC IS MOST APPROPRIATE 20
ADVANTAGES AND DISADVANTAGES OF ABC 20
THROUGHPUT ACCOUNTING --------------------------------------------21

STEPS IN THROUGHPUT ACCOUNTING 21
CALC ULATING THROUGHPUT 21
T HROUGHPUT ACCOUNTING RATIO (TPAR) 21
OPTIMAL PRODUCTION PLAN 22
ADVANTAGES AND DISADVANTAGES OF THROUGHPUT ACCOUNTING 23
TARGET COSTING---------------------------------------------------------24
T RADITIONAL COSTING SYSTEMS 24
T ARGET COSTING STEPS 24
CLOSING A TARGET COST GAP 24
ADVANTAGES AND DISADVANTAGES OF TARGET COSTING 26
LIFE CYCLE COSTING-----------------------------------------------------27

ADVANTAGES AND DISADVANTAGES OF LIFECYCLE COSTING 28
ENVIRONMENTAL MANAGEMENT ACCOUNTING-----------------------30

MANAGING ENVIRONMENTAL COSTS 30
ACCOUNTING FOR ENVIRONMENTAL COSTS 31
COST CLASSIFICATION
Before the different costing methods can be considered, it is important to
understand clearly the nature of the costs which are incurred by companies.
Depending on the costing system applied, these cost types may be dealt with in
different ways.
Direct and indirect costs

Direct costs are costs which can be easily linked to the production of one unit of
product or the provision of a service. This will include the direct material and direct
labour costs incurred in production. The sum of the direct costs is prime cost
Indirect costs are the costs which cannot be traced back easily to the production of
a single unit of product. Most costs incurred will be indirect. These include
insurance costs, utility bills and depreciation of machinery. The sum of the indirect
costs is the overhead cost.
Production and non production costs

Production costs are the costs which must be incurred in order to produce units of
product or provide the service to customers. Production costs in manufact uring will
include the costs associated with the factory environment, for example machinery
costs, salaries paid to factory staff, electricity bill for the factory.
Non production costs are all the other costs incurred to ensure that the business is
successful. These costs are not necessary for the production of the product, but
must be incurred nonetheless to ensure the company is well managed. Non
production costs would include head office administration costs, selling and
distribution costs and financing costs.
Cost behaviour
Cost behaviour looks at whether or not a cost changes when level of activity
changes, where level of activity is the units of output.
Variable costs
Variable costs increase or decrease in proportion to the level of activity. If the
variable cost/unit is $10, then every time an additional unit is produced the
company will incur an additional cost of $10.
While total variable cost s will change in proportion to level of activity, it is expected
that variable cost/unit will be constant at least in the short term.
Fixed costs
Fixed costs are costs which remain constant in total terms when level of activity
changes. Rent or insurance paid in relation to the factory would be examples of
fixed costs. Regardless of the number of units produced, we would expect that the
rent cost will not change.
While total fixed cost is constant, the fixed cost per unit will decrease as level of
activity increases. This is because the total fixed cost is spread across a greater
number of units as level of activity goes up.
MARGINAL COSTING
Marginal costing is a costing system which focuses on cost behaviour. When
calculating profits in a marginal costing system, the following approach is applied.
Sales - total variable costs = contribution
Contribution - fixed costs = profit
Contribution/unit of product can also be calculated as:

Selling price/unit - variable cost/unit
Marginal costing principles are a key part of the F5 syllabus and are applied in
several areas, in particular decision making.
ABSORPTION COSTING
Absorption costing – a reminder

Absorption costing is a costing method which allows the c ompany to calculate the
full production cost/unit of product. This can then be used for stock valuation,
pricing decisions and preparing budgets.
Full production cost/unit =
Direct materials + Direct labour + production overhead cost/unit
Identifying the direct costs per unit should be straightforward. However, as the
indirect costs cannot be easily linked to the production of one unit, it is more
difficult to estimate the overhead cost/unit.
Steps using absorption costing
Overhead Cost Cost

cost item Centre Units
Cost Item s
The steps using absorption costing are:

1. Overhead costs are collected in various cost centres
2. Overhead absorption is achieved by means of a predetermined Overhead

Absorption Rate.
BudgetedOverheads
Overhead Absorption Rate =
BudgetedLevelof Activity *
Activity levels generally used by examiners are number of units, labour hours ,
or machine hours, which means overheads are charged to units on these
bases.
i. Number of Units: Single product environment
ii. Labour Hours: Manual manufacturing operations (labour intensive)

iii. Machine Hours: Mechanical manufacturing operations (machine
intensive)
3. The overhead cost/unit =

OAR x labour hours/unit (if labour hours are used to calculate the absorption
rate)
Advantages and disadvantages of absorption costing

Advantages of absorption costing are:
 Less time consuming than other methods of calculating the overhead cost per
unit (e.g. ABC)
Disadvantages of absorption costing are:

● Using a single basis to allocate all overhead cost types is unlikely to give an
accurate view of the overhead cost incurred producing each product.
● Can only work in single product and simple manufacturing environments .
ACTIVITY BASED COSTING

The reason for the increasing inaccuracy of absorption costing is due to two basic
issues:
1. Increased production complexity.
2. Increased proportion of overhead cost .
Production complexity
A wide variety of production processes have become more complex in recent years
in a number of ways:
1. Flexible manufacturing systems allow for a number of differing products to
be produced on the same machinery. Absorbing overheads on a simple
volume basis is unlikely to reflect the differing overhead costs incurred by
each product.
2. Fast product development may mean that a number of differing iterations
of the same product may be produced in quick order.
Increased proportion of overhead costs

Overheads have increased as a percentage of total costs due the substitution of
direct labour with indirect labour as companies mechanise to a greater degree.
Also the increased production complexity has given rise to increased costs for such
disciplines as production planning and logistics.
Costs are also incurred in selling and distributing a product. The c osts associated
with servicing customers are often more important than production costs and
therefore it is important for management to understand what drives these costs
and how they can be controlled.
ABC analysis
Activity based costing provides a more accurate estimate of the overhead cost/unit
which takes into account the issues highlighted above.
Overhead Cost Cost

Cost Item Pool Unit
Activity based costing takes the following approach:

1. Identify each distinct fixed production overhead cost. These will be the cost
pools.
2. Identify the activity which causes that cost. This is the cost driver – the
factor which causes the cost pool to increase.
3. Work out the cost incurred each time the activity occurs.
4. For each cost pool, calculate the cost/unit of each product type.
Calculation steps with ABC

In an exam question on ABC, you will typically be expected to do the following:
1. Determine what the appropriate cost driver is for each cost pool.
2. Calculate the cost/unit using an ABC approach.
Cost drivers
Remember the cost driver is the activity which causes the cost pool to increase.
Typical examples of cost pools and cost drivers are:
Cost pool Possible Cost Drivers
Material ordering number of orders
Material handling quantity of material
Production scheduling number of production run
Despatching number of deliveries
Calculating the cost/unit

Remember the cost/unit =
Direct materials + Direct labour + Overhead cost/unit
The direct material and direct labour costs can usually be calculated quite easily
from the information given.
For the overhead cost/unit, each cost pool must be looked at individually. The
following steps must be taken for each cost pool:
1. Calculate the cost driver rate

cost pooltotal
Cost driver rate =
totalcost drivers
2. Calculate the cost/unit for that cost pool:

Cost/unit = cost driver rate x number of cost drivers/unit
Where the number of cost drivers/unit =

total cost drivers for the product /total units of that product .
Example 1 Hensau Ltd

Hensau Ltd has a single production process for which the following costs have
been estimated for the period ending 31 December 2010:
$
Material receipt and inspection costs 15,600
Power costs 19,500
Material handling costs 13,650
Three products - X, Y, and Z are produced by workers who perform a number of
operations on material blanks using hand held electrically powered drills. The
workers are paid $4 per hour.
The following budgeted information has been obtained for the period ending 31
December 2009:
Product X Product Y Product Z
Production quantity (units) 2,000 1,500 800
Batches of Material 10 5 16
Data per product unit:
Direct material (square metres) 4 6 3
Direct material cost ($) 5 3 6
Direct labour (minutes) 24 40 60
No. of power drill operations 6 3 2
Overhead costs for material receipt and inspection, process power and material
handling are presently each absorbed by product units using rates per direct
labour hour.
An activity based costing investigation has revealed that the cost drivers for the
overhead costs are as follows:
Material receipt and inspection: Number of batches of material
Process power: Number of power drill operations
Material handling: Quantity of material (square metres)
handled
Required
(a) Prepare a summary which shows the budgeted product cost per unit
for each product of X, Y, and Z for the period ending 31 December
2010 detailing the unit costs for each cost element using:
(i) the existing method for the absorption of overhead costs; and
(ii) an approach which recognises the cost drivers revealed in the
activity based costing investigation. (13 marks)
(b) Explain the relevance of cost drivers in activity based costing, and
how activity based costing can help in modern and complex
manufacturing environments. (7 marks)
(20 marks)
Conditions under which ABC is most appropriate

The usefulness of ABC techniques will depend on the characteristics of the
organisation, in particular the following:
(1) Cost structure
(2) Product mix or diversity
(3) Information.
Advantages and disadvantages of ABC
Advantages
1. Leads to a better understanding of the cost/unit of each product, and
therefore product profitability.
2. Is flexible enough to analyse costs by activity providing more useful costing

data.
3. Provides a reliable indication of long-run variable product cost .
4. Improves management understanding of how costs are being incurred and
how they can be reduced.
Disadvantages
1. Cost v benefit.
2. ABC information is historic .
3. Difficult to apply in practice.
4. Focuses on the allocation of cost rather than minimizing the cost incurred.
THROUGHPUT ACCOUNTING
Throughput is the rate at which the system generates money through sales. In a
throughput accounting environment, the focus is on putting units through the entire
production process in the minimum possible time to avoid any build-up of inventory
holdings.
In throughput, it is assumed that the only real variable costs, at least in the short
term, are the direct material costs. All labour and overhead costs are assumed to
be fixed. These are usually referred to as ‘other factory costs’.
Steps in throughput accounting

1. Identify the system bottlenecks.
Bottleneck is any limitation or restraint in the production process

which limits the production managers to fully utilise some of their
resources.
2. Concentrate on the bottleneck to ensure this process is being fully and

efficiently utilised.
3. Scale down the throughput of non-bottleneck activities to match what can be
dealt with by the bottleneck.
4. Remove the bottlenecks if possible.
5. Since throughput accounting is a continuous improvement process, return to
step 1 and re-evaluate the system now that bottlenecks have been removed.
Calculating throughput
There are a number of key formulae you need to remember f or the exam:
Throughput/unit = Selling price – direct material cost/unit
Return/hour = Throughput per unit / Number of hours per unit in the

bottleneck
Cost/factory hour = Other factor costs / total hours worked in the
bottleneck
Throughput accounting ratio (TPAR)

The throughput accounting ratio can be calculated for each product:
TPAR = Return/factory hour / Cost/factory hour
For each product, we would expect TPAR to be greater than 1. This means that the
rate at which the organisation is generating cash from sales of this product is
greater than the rate at which it is incurring costs. It follows on, then, that if the
ratio is less than 1, this is not the case, and changes need to be made quickly.
Factors affecting the value of TPAR

● The selling price of the item sold
● The purchase cost of direct materials

● Efficiency in the usage of direct materials
● The volume of the throughput

● Time taken per unit in the bottleneck
● The cost/factory hour.
Optimal production plan

Once the bottleneck has been established, the company will need to decide how
this limited resource should be used. It needs to determine which products should
be produced, and in what quantities, in order to maximise profits.
When calculating an optimal production plan, the following steps can be applied:
1. Calculate the throughput/unit for each product .
2. Calculate the return/factory hour for each product .

3. Rank the products based on return/factory hour (the highest ranking product
will be the one with the greatest return/factory hour).
4. Calculate the optimal production plan. Allocate the bottleneck resource to

each product based on the ranking established. Production of a product
should not exceed the maximum demand for that product.
Example 2 Happy Now Ltd

Happy Now Ltd produces three products using three different machines.
The following information is available for a product for a period:

Product X Y Z
Sales ($) 20 15 10
Direct materials ($) 8 5 4
Direct labour ($) 5 3 2
Overheads ($) 2 1 1
Estimated sale demand (unit) 200 200 200
Machine hours required per unit:

Machine 1 6 2 1
Machine 2 9 3 1.5
Machine 3 3 1 0.5
Machine capacity is limited to 1,600 hours for each machine.
Required:
(a) Identify the bottleneck process and explain why it is called as a

bottle neck resource. (4 marks)
(b) Calculate the throughput accounting ratio for the three products and
rank the products. (10 marks)
(c) Produce an optimal production pla n a nd maximum profit. (6 marks)
(20 marks)
Advantages and disadvantages of throughput accounting
Advantages
● Efforts are focused on the products which make the most money .
● Costs such as inventory holding costs are reduced.
Disadvantages
● Selling price could be uncompetitive.
● Material suppliers may not be reliable.
● There is a risk that product quality will be low.

● Very little attention is paid to overhead costs.
TARGET COSTING
Traditional costing systems

Traditional pricing systems:
1. Calculate unit cost.
2. Add profit margin.

3. Equals Selling price.
Problems:
● The price is based on the cost of producing the product. There is no

consideration of whether or not customers are prepared to buy at that price.
● This approach does not provide a direct incentive to keep costs low.
Target costing steps

Target costing is a marketing approach to costing which addresses the issues
highlighted above.
Target costing steps:

1. Determine the achievable selling price. At this stage the company must
consider the price customers are prepared to pay for this particular product.
They must also consider what competitors are offering.
2. Establish the required profit margin – this is based upon the overall required
return of the business and the level of perceived risk of the product .
3. Calculate the target cost – ie the cost that the company must produc e at in
order to be able to achieve the required profit level (Selling price – profit
margin).
4. Calculate and close the cost gap. The cost gap is the current actual cost/unit –
target cost/unit. If the actual cost is higher than the target, the company must
look for ways to reduce costs.
Closing a target cost gap

The design specification for each product and the production methods should be
examined for potential areas of cost reduction that will not compromise t he quality
of the products.
For example:
1. Reduced component count
● Reducing the number of components

● Using standard components wherever possible
● Using different (cheaper) materials
2. Reduce production complexity

● Acquiring new, more efficient technology
● Cutting out non-value added activities

3. Revise production process to improve efficiency
4. Revise specification of product.
Note: Remember that these above points should not be implemented if

they would compromise quality.
Example 3 Fantata Ltd

Fantata Ltd makes and sells a product H which is manufactured through two
consecutive processes; assembly and finishing. An activity-based costing approach
is used in the absorption of product specific conversion cost.
The following estimated information is available for the period.
Product H
Production/ sales units 12,000
Selling price per unit $75
Direct material cost per unit $20
ABC variable conversion cost per unit:
Assembly $20
Finishing $12
Head office fixed costs $220,000

The management wishes to achieve an overall net profit margin of 12% on sales in
this period in order to meet return on capital target.
Required:
(a) Calculate target cost.
(b) Calculate the cost gap.
(c) Explain how the cost gap for product H could be reduced.
Advantages and disadvantages of target costing
Advantages
● Cost reduction and control
Possible elimination of non-value added elements and activities in production
process.
● Market based costing
Selling price considers what customer might want to pay for the product.
● Customers
Customer requirements for quality, cost, and time are incorporated into
product and process decisions. The value of product features to the
customers must be greater than the cost of providing them.
● Design
Cost control is emphasised at the design stage so any engineering changes
must happen before production starts.
Disadvantages
● Excessive focus on cost reduction may compromise the quality of the product .
● Detailed cost data must be available in order to analyse and reduce the actual
cost/unit.
LIFE CYCLE COSTING

In the calculation of the production cost/unit, only the current costs are included.
These are the variable costs of production and the current fixed cost s for the
period. Other costs associated with the product are not included in this calculation
including:
1. Research and development costs

● Design
● Testing
● Production process and equipment.

2. The cost of purchasing and any technical data required.
3. Training costs (including initial operator training and skills updating).
4. Close down costs incurred at the end of the products life.

In order for a product to be profitable, total revenues must exceed total costs
across the life of the product. Excluding these costs from the cost/unit calculation
may lead to a selling price which will not actually cover all of the additional costs.
Life cycle costing addresses this issue by calculating a revised cost/unit:
Totallife costs for product
Life cost per unit =
Totalexpectedlife volum es
The life costs of the product could include the following:
Life Cycle Phase Costs incurred

Design Research, development, design
Manufacture Material, labour, machine depreciation, training,
inventory holding
Operation Distribution, advertising
End of life Factory clean-up costs
Advantages and disadvantages of lifecycle costing
Advantages
● Lifecycle costing ensures that the revenues earned from the product will be
greater than the sum all the costs incurred due to that product.
● Because the profitability of products is better understood, this should improve

decision making in relation to which products should be invested in by the
company. Costs are monitored and understood from early in the product’s life
cycle. This should lead to better cost control.
● If the product has a short lifecycle, then applying lifecycle costing will ensure
that the company can earn back all costs in a relatively short space of time.
Disadvantages
● It may be difficult to accurately estimate what future costs and volumes will
be over the life of the product.
● Using lifecycle costing will result in a higher selling price. This must be
carefully considered in relation to the price which customers are prepared to
pay.
Example 4 Aeon plc

Aeon Plc is designing a new, high-tech consumer product currently known as
Product 801. The research and development, design and management accounting
teams have estimated that the Product 801 could be developed and manufactured
in one of two ways. Approach 1 is the simpler option. Approach 2 requires more
development and additional machinery to manufacture the product in a more
efficient way. Market research shows that Product 801 should sell for $50 per unit.
Approach 1
Development costs = $1,250,000
Variable manufacturing cost per unit = $25
Selling price per unit = $50
Repairs and warranty costs = $50/unit needing repairs, and 1% of sales will incur
these costs
Clean-up and machinery dismantling costs at end of production $50,000
Approach 2
Development costs = $2,350,000
Variable manufacturing cost per unit = $20
Selling price per unit = $50
Repairs and warranty costs = $30/unit needing repairs, and 0.5% of sales will incur
these costs
Additional fixed cost per year to run new manufacturing machinery = $20,000
Clean-up and machinery dismantling costs at end of production = $30,000
The life of Product 801 if developed and manufactured using Approach 1 should be
5 years and 50,000 units per year should be sold. Because of the higher level of
research used in Approach 2, the product’s life will be increased to 6 years.
Required:
(a) Using a life-cycle costing approach, calculate the profits under
Approach 1 and Approach 2. (8 marks)
(b) If the target gross profit for any product sold by the company is 40%,
what is the target cost of Product 801 and calculate whether the life -
time costs per unit of Approach 1 and Approach 2 would give costs
less than the target cost. Explain, using calculations where possible,
how any cost gaps could be c losed in this case. (7 marks)
(c) Explain why life-cycle costing is particularly important in high-
technology mass production industries. (5 marks)
(20 marks)
ENVIRONMENTAL MANAGEMENT ACCOUNTING

Environmental accounting is the process of providing information on a
company’s environmental performance to internal and external users. This will
therefore include reporting to shareholders in relation to environmental issues.
Environmental management accounting (EMA) is a subset of environmental
accounting. This is the process of gathering environmental information for decision
making within the organisation. EMA focuses on the areas of this business where
there is an environmental impact , eg water use, raw material use, material
disposal. These elements have a financial impact in that the cost to the company
can be measured. However, EMA also considers non-financial environmental issues
such as the impact on company reputation of having a poor environmental
performance.
Managing environmental costs

Environmental management accounting has become increasing important in recent
years. The main reasons for this are:
1. Society generally has become more aware of environmental issues.
Stakeholders of most companies would now be aware of the need to recycle,
minimise greenhouse gas emissions or other issues which damage the
environment
2. Environmental costs have become significant for many companie s, in

particular manufacturing organisations. As environmental costs have
increased, it is more important to manage them carefully
3. Environmental regulation is increasing in most countries. Non-compliance

with environmental regulation can lead to significant fines or penalties being
imposed on the company
However, it can be challenging for managers to understand and manage the

environmental costs associated with the business.
 Environmental costs are difficult to define. What exactly should be looked at as
part of a company’s EMA?
 Even once the environmental costs have been defined, it may be difficult to
separately identify these costs within the management accounting system.
 Once the costs have been defined and identified, steps need to be put in plac e
to control the costs.
Defining environmental costs

There are many different definitions of environmental costs. Some definitions are
reasonably narrow (focusing only on issues like raw material costs or energy
consumption). Others have a far wider focus and would include, for example, the
environmental impact of the company’s supply chain as part of environmental
costs.
The US Environmental Protection Agency defines environmental costs as being the

following:
● Conventional costs
Raw materials, energy consumption.
● Potentially hidden costs
Generally these will be included as part of ‘general overheads’ and may

include inventory disposal, pollution control.
● Contingent costs
These are environmental costs which may be incurred at a future date, for
example clean-up costs, future compliance costs.
● Image and relationship costs
These are intangible environmental costs such as the cost of preparing

environmental reports.
Identifying environmental costs

Each of the environmental costs defined by the company needs to be separately
identified within the management accounts. All of this information should be held
in the general ledger.
Separately identifying each environmental cost is likely to be a time consuming
process for management. However, this is necessary in order to ensure the
effective management of these costs in the future.
Accounting for environmental costs

Environmental costs can be incorporated into the company’s existing costing
system. The techniques which can be applied include:
● Input/outflow analysis.
● Flow cost accounting.
● Activity based costing.

● Lifecycle costing.
Input/outflow analysis
This method looks to balance material inputs with material outputs. For example, if
50 units of material have been input to the process, then 50 units of material
should also be output from the process. If the output is less than 50 units, then
the material wastage in the production process needs to be investigated and
reduced. This will be beneficial to both the environment and the company (as it will
reduce costs).
Flow cost accounting

This technique looks at material flows throughout the organisation. Environmental
costs can be reduced by improving material efficiency. In order to improve
efficiency, material flows must be transparent. An example of material flows might
include:
Packaging
Raw material Finished
Customers
Production
storage goods storage
Suppliers
Disposal
system
Activity based costing

Activity based costing can be used to manage environmental costs. Cost pools can
be determined for each environmental cost and the cost drivers identifie d for each
cost pool. For example, at a hotel one of the environmental costs would be in
relation to towels (material cost and energy consumption for washing towels would
be the environmental costs).
The cost driver would be the frequency with which the towels are washed. Once
the cost driver is understood, management can take steps to reduce the number of
cost drivers, for example by encouraging guests to re-use their towels.
Life cycle costing

This method focuses on adding environment related costs, s uch as cost of waste
disposal, energy emissions etc into total cost of products over entire life cycle. The
main aim is to reduce total cost with environment friendly options in all stages of
the cycle.
Chapter 2
Decision making and

linear programming
B Decision-making techniques
1. Relevant cost analysis

a) Explain the concept of relevant costing.
b) Identify and calculate relevant costs for specific decision situations from given
data.
c) Explain and apply the concept of opportunity costs.
2. Cost volume profit analysis

a) Explain the nature of CVP analysis.
b) Calculate and interpret break even point and margin of safety.

c) Calculate the contribution to sales ratio, in single and multi-product situations,
and demonstrate an understanding of its use.
d) Calculate target profit or revenue in single and multi-product situations, and

demonstrate an understanding of its use.
e) Prepare break even charts and profit volume charts and interpret the
information contained within each, including multi-product situations.
f) Discuss the limitations of CVP analysis for planning and decision making.
C HAP TE R 2 – DE C ISIO N MAKING AND L INE AR P RO GRAMMING
3. Limiting factors
a) Identify limiting factors in a scarce resource situation and select an
appropriate technique.
b) Determine the optimal production plan where an organisation is restricted by
a single limiting factor, including within the context of ‘make’ or ‘buy’
decisions.
c) Formulate and solve multiple scarce resource problem both graphically and
using simultaneous equations as appropriate.
d) Explain and calculate shadow prices (dual prices) and discuss their
implications on decision-making and performance management.
e) Calculate slack and explain the implications of the existence of slack for
decision-making and performance management. (Excluding simplex and
sensitivity to changes in objective functions.)
5. Make-or-buy and other short-term decisions

a) Explain the issues surrounding make vs. buy and outsourcing decisions.
b) Calculate and compare ‘make’ costs with ‘buy-in’ costs.
c) Compare in-house costs and outsource costs of completing tasks and consider
other issues surrounding this decision.
d) Apply relevant costing principles in situations involving shut down, one-off
contracts and the further processing of joint products.
CHAPTER CONTENTS
INTRODUCTION TO DECISION MAKING -------------------------------36
RELEVANT COST ANALYSIS ---------------------------------------------37

RELEVANT COST PRICING 39
SHUTDOWN (DISCONTINUANC E) DECISIONS 42
F URTHER PROCESSING DECISIONS 43
MAKE OR BUY DECISION ------------------------------------------------44
LIMITING FACTOR ANALYSIS -------------------------------------------45

SINGLE LIMITING F ACTOR 45
SINGLE LIMITING F ACTOR WITH MAKE OR BUY 46
LINEAR PROGRAMMING – MULTI LIMITING FACTORS---------------48

LINEAR PROGRAMMING – FURTHER CONSIDERATIONS 51
ASSUMPTIONS AND LIMITATIONS OF LINEAR PROGRAMMING 52
CVP ANALYSIS (BREAKEVEN ANALYSIS) ------------------------------54

WHAT IS CVP (BREAK- EVEN) ANALYSIS ? 54
CVP – SINGLE PRODUCT ENVIRONMENT 54
CVP – MULTI PRODUCT ENVIRONMENT 59
LIMITATIONS OF BREAK- EVEN ANALYSIS 61
INTRODUCTION TO DECISION MAKING

The choice between two or more alternatives, decision making normally considers
only the short term consideration of maximising profitability . We base our
decisions on relevant costs and revenues.
RELEVANT COST ANALYSIS

Relevant cost analysis is a decision making t echnique which can be used in a
number of situations:
● Shut down decisions
● Further processing decisions
● Determining the minimum price to charge for a one off contract

Relevant costs are decision specific. When establishing the relevant cost of a
decision, we only consider the cash flows which will change as a result of the
decision being made.
A relevant cost must meet all the following criteria:
1. Future
2. Cash flow
3. Arising as a direct result of the decision

Relevant costs Non-relevant costs
Opportunity cost Sunk cost
Incremental cost Committed cost
Avoidable cost Depreciation (non cash flows)
Opportunity costs
The benefit foregone by choosing one alternative in preference to the next best
alternative.
Avoidable costs
Costs attached to a part or segment of a business which could be avoided if that
part or segment ceased to exist. Variable costs are normally considered avoidable,
fixed costs normally not. Fixed costs may be considered avoidable if arise within
the single part or segment of the business that is relevant. They are particularly
applicable in shutdown decisions.
Incremental costs
Those additional costs (or revenues) which arise as a result of the decision. This
classification is particularly useful for further processing decisions, but may be used
as a basis for tackling any relevant cost analysis.
Sunk costs
Sunk costs are costs which have been incurred in the past. These will never be
relevant as they are past cash flows (as oppose to future). For example, suppose
we purchased material costing $50,000 3 years ago. We are now considering the
relevant cost of using this material for a particular customer order. The $50,000 is
not relevant as regardless of any decision we make now, this cash flow will not
change.
Committed costs
Committed costs are costs which the company has an obligation to pay regardless
of any decision which management make today. Committed costs would include
fixed salaries which must be paid to employees.
Relevant cost pricing

Relevant cost analysis can be used to price one off orders. This approach leads to a
very competitive price being charged. It can be used in order to attract new
customers in the hope of getting further business in the future.
Relevant cost analysis cannot always be used to determine selling price however,
as non-relevant costs must be covered at some point.
NOTE: In an exam question, you must think about ‘what costs change as a
result of accepting the customer order’ and typically you must be able to
EXPLAIN why something is, or is not, considered a relevant cost.
The diagrams below can be used to assist you in determining the relevant cost of
the materials or labour to be used in a particular customer order.
Material costs flow chart
Is the material
in stock?
YES NO
Purchase price is
Next question
relevant
Is the material in
constant use?
YES NO
Replacement cost is
Next question
relevant
Is there a scrap
value?
YES NO
Opportunity cost is Nil value with

relevant possible disposal
cost
For example, suppose a particular customer order requires 5,000kg of material.

There is 6,000kg in stock which originally cost $5/kg. The company has no other
use for the material but it can be sold for scrap at $1.5/kg. What is the relevant
cost of the 5,000kg to be used in the customer order?
● Is the material in stock – Yes

● Is the material in constant use – No
● Is there a scrap value – Yes
Therefore the relevant cost is 5,000kg x $1.5 = $7,500. This is an opportunity

cost. Because the company uses the material in the order, they miss out on the
cash income from scrap sales.
Note that the original cost of materials is never relevant as this is a sunk cost.
Labour costs flow chart
Is the labour in
permanent
YES employment? NO
Hourly rate is
Next question
relevant
Is the labour fully

utilised?
YES NO
Next question Nil value
Overtime possible?
YES NO
Overtime rate is Opportunity cost is

relevant relevant
Example 1 Tricks
You are the management accountant of Tricks, an organisation which has been
asked to quote for the production of a pamphlet for an event . The work could be
carried out in addition to the normal work of the company. Due to existing
commitments, some overtime working would be required to complete the printing
of the pamphlet. A trainee has produced the following cost estimate based upon
the resources required as specified by the operations manager:
$
Direct materials:
- paper (book value) 4,000
- inks (purchase price 2,400
Direct labour: - highly skilled 250 hours @ $4.00 1,000

- semi-skilled 100 hours @ $3.50 350
Variable overhead 350 hours @ $4.00 1,400

Printing press depreciation 200 hours @ $2.50 500
Fixed production costs 350 hours @ $6.00 2,100
Estimating department costs 400
______
12,150
You are aware that considerable publicity could be obtained for the company if you
are able to win this order and the price quoted must be very competitive.
The following notes are relevant to the cost estimate above:

(1) The paper to be used is currently in stock at a value of $4,000. It is of an
unusual specification (texture and weight) and has not been used for some
time. The replacement price of the paper is $9,000, whilst the scrap value of
that in stock is $2,500. The stores manager does not foresee any alternative
use for the paper if it is not used on the pamphlet.
(2) The inks required are presently not held in stock. They would have to be
purchased in bulk at a cost of $3,000. 80% of the ink purchased would be
used in producing the pamphlet. There is no foreseeable alternative use for
the remaining unused ink.
(3) Highly skilled direct labour is in short supply, and the factory labour is already
being utilised at full capacity, therefore, to accommodate the production of
the pamphlet, 50% of the time required would be worked at weekends for
which a premium of 25% above the normal hourly rat e is paid. The normal
hourly rate is $4.00 per hour.
(4) Semi-skilled labour is presently under-utilised, and 200 hours per week are
currently recorded as idle time. If the printing work is carried out, 25
unskilled hours would have to occur during the weekend, but the employees
concerned would be given two hours time off during the week in lieu of each
hour worked at the weekend.
(5) Variable overhead represents the cost of operating the printing press and
binding machines.
(6) When not being used by the company, the printing press is hired to outside
companies for $6.00 per hour. This earns a contribution of $3.00 per hour.
There is unlimited demand for this facility.
(7) Fixed production costs are those incurred by and absorbed into production,
using an hourly rate based on budgeted activity.
(8) The cost of the estimating department represents time spent in discussions
with the organisation concerning the printing of its pamphlet .
Required:
Prepare a revised cost estimate using the opportunity cost approach,
showing clearly the minimum price that the company should accept for the
order. Give reasons for each resource valuation in your cost estimate.
(20 marks)
Shutdown (discontinuance) decisions

The decision whether to shut down a part or segment of a business. The focus of
the question is the impact of the shutdown on profits. Revenue will be foregone but
some costs will no longer be incurred (avoidable costs).
The avoidable costs include variable costs and specific fixed costs. Specific fixed
costs are those costs specific to the part or segment of the business to be
shutdown, for example machinery used only in that part of the business . General
fixed costs will not be relevant.
To make a shutdown decision, the revenue forgone must be compared to the
variable costs + specific fixed costs for that part of the business. If the revenue
forgone is greater than the avoidable costs, then management should not shutdown
that part of the business as it would reduce profits overall.
Example 2 Jones Ltd

Jones Ltd operates three divisions within a larger company. The CEO has been
shown the latest profit statements and is concerned that division C is losing
money.
You are required to advise her whether or not to close down division C.
Division A B C
($000s) ($000s) ($000s)
Sales 100 80 40
Variable costs 60 50 30
Fixed costs 20 20 20
Profit/(loss) 20 10 (10)
You are also informed that 40% of the fixed cost is division specific, the remainder
being allocated arbitrarily to the divisions from head office.
Required:
Using relevant cost analysis, advise the CEO on whether or not Division C
should be shut down.
Further processing decisions

A further processing decision may arise in a manufacturing company that produces
an item in a process or a sequence of processes. The output from a process might
have a market value, and a selling price. However, there might also be an
opportunity to further process the output to produce a finished item with a higher
selling price.
The decision is whether to sell the item in its part -finished form, or whether to
process it further and sell the finished item.
The relevant cash flows are:

● The extra revenue obtained by further processing the item (incremental
revenues), and
● The incremental costs of further processing.

The financial decision should be to further process the item if the extra revenue
exceeds the incremental costs.
Note: Any common/joint processing costs should be ignored as these do not have
any impact on the decision made.
Example 3 CF Ltd
CF Ltd manufactures two cleaning fluids, X and Y. The two fluids are manufactured
in a joint process. Every 8,000 litres of materials input to the joint process
produces 4,000 litre of X and 3,200 of Y. The costs of processing are as follows:
$
Direct material 1,600
Direct labour 200
Variable production overheads 300
Fixed production overheads 2,000
Product X sells for $1.10 per litre and product Y for $0.75 per litre.
CF Ltd could put product X through another production process, where there is
spare production capacity. The further processing would produce another cleaning
product, Zplus. Every one litre of input to the further process will produce 0.90
litres of Zplus.
The costs of further processing would be:

Product X: 4,000 litres $
Additional materials 400
Direct labour 40
Variable overheads 80
Apportioned fixed overheads 400
Total 920
Zplus would sell for $1.40 per litre
Required:
Using financial reasons only to justify the decision, state whether the
company should sell product X or should further process the product to
make Zplus.
MAKE OR BUY DECISION

The decision to make a component or product ‘in-house’ or to buy from an outside
supplier.
Financially, this decision can be made by comparing the cost of buying with the cost
of making. When calculating the cost of making components, the following costs
need to be considered:
● Variable costs such as direct material and direct labour. It is assumed that
the company would no longer incur these costs if components were bought in.
● Specific fixed costs. There may be particular fixed costs which would no
longer be incurred if the company buys in the components. For example,
specialist machinery only used to produce that component. These costs will
also be saved if the company buys in the component.
Example 4 Central Ltd

Central Ltd makes four components, W, X, Y and Z, for which costs in the coming
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
A sub-contractor has offered to supply units of W, X, Y and Z for $12, $21, $10,
and $14 respectively.
Required:
Advise whether the company should make or buy each component.
Other important factors to consider

1. If the components are sub-contracted, the company will have spare capacity.
How should that spare capacity be profitably used, that is, are there hidden
benefits to be obtained from sub-contracting?
2. Would the sub-contractor be reliable with supply and delivery time?
3. Would the sub-contractor supply the same or improved quality components as
the one produced internally?
4. Does the company wish to be flexible and maintain better control over
operations by making everything itself?
5. The going concern of the sub-contractor should also be considered.
LIMITING FACTOR ANALYSIS

Limiting factor decisions arise where there is a factor of production that is limited in
some way by:
1. Scarce raw materials.
2. Shortage of skilled labour.
3. Limited machine capacity.

If the company produces more than one different product, then it must decide what
the best use of the limited resource is in order to maximise contribution (and
therefore profits)
When applying limiting factor decision making techniques, we make the following
assumptions:
● Fixed cost is assumed to be the same whatever the production mix is

selected, so that the only relevant cost is the variable cost.
● The unit variable cost is constant at all levels of production and sales .
● The estimates of sales demand for each product are known with certainty .
Single limiting factor

If there is only one limiting factor, then the following steps should be taken.
Step 1
Calculate the contribution per unit for each product. Contribution/unit = Selling
price – Variable cost/unit
Step 2
Calculate the c ontribution per unit of limiting factor =
Contribution per unit / limiting factor usage per unit
Step 3
Use the calculations in step 2 to rank each product (highest first).
Step 4
Calculate the optimal production schedule. Produce as many units as possible of
the highest ranking product, up to the maximum demand for that product. If there
is scarce resource left over after this, then move on to the second ra nking product,
third ranking product etc.
Step 5
Calculate the maximum profit earned (if required). Remember that fixed costs will
not change when level of activity changes.
Example 5 Neal Ltd

Neal Ltd produces two products using the same machinery. The hours available on
this machine are limited to 5,000. Information regarding the two products is
detailed below:
Products (per unit data) M N
Selling price ($) 40 30
Variable cost ($) 16 15
Fixed cost ($) 10 8
Profit ($) 14 7
Machine hours 8 3
Budgeted sales (units) 600 500
Required:
Calculate the maximum profit that may be earned.
Single limiting factor with make or buy

If the company’s activities are limited due to a scarce resource, it may be possible
to buy in units of product for resale instead of producing them internally. If there is
a make or buy option available (with a limiting factor), then the following steps
apply:
Step 1
Calculate the savings made by producing the units internally =
Cost of buying - cost/unit to make.
Step 2
Calculate the savings made per unit of limiting factor =
Savings per unit / limiting factor usage per unit .
Step 3
Use the calculations in step 2 to rank each product (highest first).
Step 4
Calculate the optimal production schedule. Produce as many units as possible of

the highest ranking product, up to the maximum demand for that product. If there
is scarce resource left over after this, then move on to the second ranking product,
third ranking product etc.
Step 5
Any units which cannot be made internally should be purchased externally.
Example 6 WXYZ Ltd

WXYZ Ltd makes four products W, X, Y and Z for which costs and sales in the next
year are expected to be as follows:
W X Y Z
Sales units 2,000 4,000 3,000 1,000
$ $ $ $
Direct materials 10 5 7.5 12.5
Direct labour 7 2 4.5 6.5
17 7 12 19
Sales price 29 11 18 39
Contribution 12 4 6 20
The company is having difficulty of obtaining the materials. Each product uses the
same material, and only one type of material is used in manufacture. The
expected available materials next year are 11,000 kilos. The material cost $5 per
kilo.
An overseas manufacturer is willing to supply the items to the company at the
following costs per unit including delivery.
W X Y Z
Cost to buy $20.00 $11.00 $15.75 $21.50
Required:
Determine the number of units which should be produced or bought in for

each product in order to maximise contribution. Calculate the total
contribution earned.
LINEAR PROGRAMMING – MULTI LIMITING FACTORS

Linear programming is used where there are 2 or more scarce resources limiting
the company activities.
Linear programming involves the construction of a mathematical model to
represent the decision problem where the activities of the problem constitute
variables.
Suppose a company produc es 2 products, Product L and Product M. Labour hours
are limited to 15,000 hours and material is limited to 18,000 kg. Per unit
information for each product is as follows:
Product L M
Material 3kg 6kg
Labour hours 3hrs 4hrs

Contribution $40 $60
The company needs to determine how many units of each product should be
produced, given the limiting factors.
Steps
1. Define the problem

Let L = number of units of L produced
Let M = number of units of M produced
2. Objective Function – maximise contribution = Z

Z = 40L + 60M
3. Subject to – constraints
Labour 3L + 4M  15000
Materials 3L + 6M  18000
(non-negativity) L, M ≥0
4. Plotting the graph

If we know the constraints we are able to plot the limitations on a graph identifying
feasible and non-feasible regions. The linearity of the problem means that we need
only identify two points on each constraint boundary or line. The easiest to identify
will be the intersections with the x and y-axes.
Constraint L=0 M=0 Points on the

line
Labour 4M = 15000 3L = 15000 (0, 3750)

3L + 4M = 15000 M = 3750 L = 5000 (5000, 0)
Materials 6M = 18000 3L = 18000 (0, 3000)
3L + 6M = 18000 M = 3000 L = 6000 (6000, 0)
By plotting the individual constraints we build up an area of what is possible within

all the constraints ie the FEASIBLE REGION. The feasible region is the area on the
graph which is within ALL of the constraints.
4000
3500
3000
2500
Units of M 2000
1500
1000
500
0
0 1000 2000 3000 4000 5000 6000 7000
Units of L
5. ISO contribution line

The ISO contribution line must be shown on the graph. This is represented by the
broken line in the above graph.
The ISO contribution line represents the objective function:
Z = 40L + 60M
To draw this line in the exam, a figure for Z (total contribution) must be assumed.
Any number can be selected but you must ensure that the number you chose will
enable you to easily draw the ISO contribution line on your graph.
Using the above example, suppose Z = 60,000. The equation becomes:

60,000 = 40L + 60M
If L = 0, then M = 1,000
If M = 0, then L = 1,500
Now this line can be shown on the graph.
Regardless of the value selected for Z, the slope of the ISO contribution line will
always remain the same (as the contribution/unit of e ach product does not
change). Selecting a higher value for Z will result in the ISO contribution line being
pushed upwards on the graph.
6. Identify the optimal production schedule

Contribution will be maximized at one of the corners of the feasible region.
The optimal production schedule can be identified using either of the following
methods:
1. Using the ISO contribution line.

The optimal production schedule can be determined visually by pushing the
ISO contribution upwards. The optimal production schedule is the last
corner of the feasible region which the ISO line touches before it
leaves the feasible region.
On the graph above, this would be the point where the labour constraint
meets the material constraint line.
2. Calculating the maximum cont ribution earned at each corner
Calculate the maximum contribution earned at each corner and the optimal
production schedule is whichever point earns the highest contribution
Corner 1
The point where the material constraint line meets the y axis
At this point:
L = 0, M = 3000
Contribution = 40(0) + 60(3000) = $180,000
Corner 2
The point where the material constraint line meets the labour constraint line .
Simultaneous equation technique can be used to find the point of intersection
of these 2 lines:
Labour: 3L + 4M = 15,000
Materials: 3L + 6M = 18,000
-2M = -3,000 so M = 1,500

3L + 4(1,500) = 15,000 so L = 3,000
Contribution = 40(9,000) + 60(1,500) = $210,000
Corner 3
The point where the labour constraint line meets the x axis.
At this point:
L = 5,000, M = 0
Contribution = 40(5,000) + 60(0) = $200,000
Therefore, the maximum contribution which can be earned is $210,000 – which is

the point where the labour constraint line meets the material constraint line.
NOTE: If it is possible to determine the optimal production schedule using
the ISO Contribution line then this is the technique which should be used
as it is quicker than doing all the calculations in the exam.
Linear programming – further considerations

Once the optimal production schedule has been determined, we may need to
consider the following issues:
1. Identifying slack and binding constraints.
2. Calculating shadow prices for the binding constraints.
Slack and binding constraints

A binding constraint is a constraint which is currently limiting the company’s
activities. In the above example, both labour hours and materials are binding
constraints. The company cannot increase production without increasing the
availability of both of these constraints.
A slack constraint is a constraint which is not currently limiting the company’s
activities.
Suppose that in addition to the above information, we discovered that the company
cannot produce more than 20,000 units of L due to machine hours availability.
Then the additional constraint would be:
L ≤20,000
As the company is only current ly producing 3,000 units of L (per the optimal
production plan), this is a slack constraint. There are still machine hours
available to produce further unit s of L.
Shadow prices
A shadow price is the additional contribution which would be earned if one more
unit of limiting factor became available.
Shadow prices can only be calculated for the binding constraints, as additional
availability of slack constraints could not be utilised.
Shadow prices could therefore be calculated for labour hours and materials in the
above exercise.
Labour hours – shadow price

When calculating a shadow price, the following steps should be followed:
Step 1
Add one additional unit to the constraint.
This means the availability of labour hours would increase by 1 and the new labour
constraint would be:
3L + 4M ≤ 15,001
Step 2
Calculate the new optimal production schedule.
This will be the point where the new labour constraint line meets the material
constraint line:
Labour: 3L + 4M ≤ 15,001
Materials: 3L + 6M ≤ 18,000
Solving these equations,

L = 3001 and M = 1499.5
Step 3
Calculate the new maximum contribution earned

Contribution = 40L + 60M = 40(3001) + 60(1499.5) = $210,010
Step 4
Calculate the shadow price = New max contribution – Original max contribution
The shadow price for labour hours = $210,010 - $210,000 = $10
This means that each additional labour hour added will increase contribution by $10
Assumptions and limitations of linear programming

● Linear programming may be used when relationships are assumed to be linear
and where an optimum solution does in fact exist.
● Assumes contribution per unit for each product is constant irrespective of the
total quantities produced and sold.
● Assumes utilisation of resource per unit for each product is constant
irrespective of the total quantities produced and sold.
● Assumes that units produced and resources allocated are infinitely divisible.
● When there are a number of variables, it becomes too complex to solve
manually and a computer is required.
Example 7
A company makes two products (X and Y), within three departments (A, B and
C). Production times per unit, contribution per unit and the hours available in
each department are shown below:
Product X Product Y Capacity (hours)
Contribution/unit $4 $8
Hours/unit Hours/unit
Department A 8 10 11,000
Department B 4 10 9,000
Department C 12 6 12,000
Required:
(a) Calculate the optimum production plan, assuming the company
objective is to maximise contribution.
(b) Calculate the shadow prices for the binding constraints.
(c) Calculate the slack for Department C.
CVP ANALYSIS (BREAKEVEN ANALYSIS)
What is CVP (break-even) analysis?

CVP (cost-volume-profit analysis) uses a marginal costing approach to determine
the relationship between the level of activity and costs and revenues.
CVP analysis is a technique which uses cost behaviour to identify the level of
activity at which we have no profit or loss (break-even point).
It can also be used to predict the profits or losses to be earned at varying activity
levels (using the assumed linearity of costs and revenues).
CVP analysis assumes that selling prices and variable costs are constant per unit
regardless of the level of activity and that fixed costs are just that – fixed.
In order to calculate these levels we need to consider the contribution provided by

each unit of production. Contribution is the term given to the difference between
the selling price and the variable costs which contributes first towards paying the
fixed costs and then towards providing profit.
CVP – Single product environment

There are a number of key concepts within CVP analysis.
Break even point

This is the number of units which must be produced and sold in order for the
company to break even. ‘Breaking even’ means that all costs are covered, but
profits are exactly 0. So at this point, total revenue = total cost.
Margin of safety
The margin of safety indicates by how much sales can decrease before a loss
occurs.
Target volumes
If the company wishes to earn a profit of a certain amount, CVP can be used to
determine how many units must be produced and sold in order to achieve the
target.
Contribution to sales ratio (CS Ratio)

This is calculated for each product. The CS Ratio indicates what % of the selling
price actually contributes towards covering fixed costs.
Formulae required (not given in the exam):
1. Unit contribution = Selling price - variable cost/unit
2. Total contribution = unit contribution x volume

3. Break even point (units) = Fixed costs/unit contribution
Budgetedsales- break-evenpoint
4. Margin of safety =  100%
Budgetedsales
5. Contribution target = fixed costs + target profit
6 Volume target = Contribution target/unit contribution

7. CS Ratio = Total contribution/Sales revenue or Unit contribution/selling price
8. Break even sales revenue = Fixed costs/CS Ratio.
Example 8 Single Product Ltd

A company produces and sells one product , Product Z. The following budgeted
information is available:
Product Z
$
Selling price per unit 50

Variable cost per unit 30
Contribution per unit 20
Fixed costs (total) 200,000
Budgeted sales volume 15,000
Budgeted profit 100,000
Required:
(a) Calculate the following:
(i) Break even point (units)

(ii) Margin of safety
(iii) CS Ratio for Product Z
(b) If the company wants profits to increase to $250,000, calculate how

many units would need to be produced and sold to achieve this target.
Break-even chart
Costs and Sales revenue

revenues
Total costs
Profit
Fixed costs
Margin of safety
Sales activity
Break-even point Budgeted activity
Profit/volume chart
A break-even chart shows the costs and revenues at a number of activity levels. It
does not however, show the amount of profit or loss at these levels. This is shown
on the profit/volume chart.
Profit Total profit
Sales activity
Break-even point
Loss
Fixed costs (total loss)
From this chart we can read off the amount of profit or loss for any level of activity.
1. The x axis represents sales (units or revenue).
2. The y axis shows profits above the x axis and losses below.
3. When sales = zero, the net loss is equal to the fixed costs.
4. If contribution per unit and total fixed costs are constant throughout the
relevant range, the profit/volume chart is shown as a straight line.
CVP – Multi product environment

Suppose a company produces and sells 2 products. The following budgeted
information is available:
Product A Product B
Selling price $40 $60
Variable cost $20 $25

Contribution/unit $20 $35
Budgeted sales units 16,000 8,000
CS Ratio 0.5 0.58

Fixed costs are $400,000
In a multi-product environment, the following formulae apply:
1. Weighted average CS Ratio = Total contribution/total sales revenue

= ($20 x 16000 + 35 x 8000)/($40 x 16000 + $60 x 8000) = 0.54
2. B/E sales revenue = Fixed costs/W.A. CS Ratio
= 400,000/0.54 = $746,667
3. B/E mixes = Fixed costs/contribution per mix
In multi-product CVP, it is assumed that products will be sold in a constant
mix. In the above budget, the following applies:
Product A Product B
Budgeted sales 16,000 8,000
So, for each 2 units of Product A sold, 1 unit of Product B will be sold.
The contribution per mix is then:
$20 x 2 + $35 x 1 = $75
B/E mixes = $400,000 / $75 = 5,333. The break even units of each product
can now be calculated:
Product A Product B
Units/mix 2 1
B/E units 10,666 5,333
Example 9 CVP Ltd

CVP Ltd is investigating the risks attached to sales plans and profit levels. The
management of the company feels that they are always struggling to create a
realistic sales plan which should add to the value of CVP and its shareholders.
Recently there have been production problems reported by the production director
in plant utilisation which have alerted the board. Now they are not sure whether to
allocate resources to all their products equally which they have done in the past, or
to produce and sell the products in preference to each other.
Following are the extracts from last year’s budgeted results relating t o three
products.
PINS NUMBS NEEDLES
$ $ $
Selling price per unit 12 14 9

Variable cost per unit 4 8 2
Fixed cost per unit 2 3 6
Profit per unit 6 3 1
Budgeted sales volume 3,000 2,000 1,000
Required:
(a) Calculate the budgeted profit. (2 marks)
(b) Determine the break even revenue and margin of safety if the
company sells all the products as pe r their origina l sa les plans. (6 marks)
(c) Advise the company of an alternative plan if the management wishes
to produce and se ll products in prefe rence to each other. (4 marks)
(d) Using the same graph:
(i) Plot a P/V chart when all the products are produced and sold
together in their original ratio.
(ii) Plot a P/V chart when products are made and sold using an
alternative plan dete rmined in part (c) above. (8 marks)
(20 marks)
NOTE: YOUR GRAPH SHOULD BE CLEARLY DRAWN WITH ALL POINTS
SHOWN AND LABELLED.
Limitations of break-even analysis

● Once costs and revenues have been determined, it is usually assumed that
they will have a linear relationship.
● Fixed costs will be constant over the relevant range.
● Variable cost/unit will be constant.
● Selling price will remain unchanged.

● The efficiency and productivity of the workforce remain constant.
The analysis covers either a single product or a mix of products at which it is
assumed that the proportion of each product will remain the same as volume
increases or decreases.
In constructing a break-even chart, the sales and costs are likely to be valid only in
a particular range of activity. This is referred to as THE RELEVANT RANGE. Outside
this range the same cost and revenue relationships are unlikely to exist. Eg, an
alteration in volume could affect the level of fixed costs (ste pped) or the rate of
variable costs or selling prices (economies of scale).
Chapter 3
Pricing
4. Pricing decisions
a) Explain the factors that influence the pricing of a product or service.
b) Explain the price elasticity of demand.

c) Derive and manipulate a straight line demand equation. Derive an equation
for the total cost function (including volume-based discounts).
d) Calculate the optimum selling price and quantity for an organisation, equating
marginal cost and marginal revenue.
e) Evaluate a decision to increase production and sales levels, considering
incremental costs, incremental revenues and other factors.
f) Determine prices and output levels for profit maximisation using the demand
based approach to pricing (both tabular and algebraic methods).
g) Explain different price strategies, including:

i) All forms of cost-plus
ii) Skimming
iii) Penetration
iv) Complementary product
v) Product-line
C HAP TE R 3 – P RIC ING
vi) Volume discounting

vii) Discrimination
viii) Relevant cost

h) Calculate a price from a given strategy using cost -plus and relevant cost.
CHAPTER CONTENTS
INTRODUCTION TO PRICING -------------------------------------------66

F ACTORS AFFECTING PRICING DECISIONS 66
WAYS OF CALCULATING THE PRICE 66
COST-PLUS PRICING -----------------------------------------------------67

1. F ULL COST-PLUS PRICING 67
2. MARGINAL COST- PLUS PRICING 68
OTHER PRICING STRATEGIES-------------------------------------------69
DEMAND BASED PRICING -----------------------------------------------71

DERIVING THE DEMAND CURVE 71
PRICE ELASTICITY OF DEMAND 72
PROFIT MAXIMISING PRICE AND QUANTITY -------------------------74
INTRODUCTION TO PRICING
The pricing of products or services is one of the more difficult and more import ant
decisions for the organisation. The prices adopted by a company will have an
immediate effect on the profitability of an organisation and longer term implications
on the marketing of the product.
Factors affecting pricing decisions
Factors underlying pricing decisions

There are several factors underlying all pricing decisions, including the following:
1. Organizational goals
2. Price and demand relationship
3. Competitors
4. Cost
5. Product mix
6. Quality
7. Inflation
8. Product life cycle
Ways of calculating the price

There are three ways to calc ulate the price of a product:
1. Cost-plus pricing – marginal cost or full cost as a base.
2. Demand based pricing – the application of economic theory to maximise
profit in the short-term.
3. Marketing based pricing – the aim to generate profit maximisation in the
longer term.
COST-PLUS PRICING
The simplest form of pricing, it is still widely used particularly in the retail industry
and in specific /job order situations. The price is based on the cost plus a margin.
Cost-plus pricing may be based on:
1. full cost (calculated using absorption costing or ABC), or
2. marginal / variable cost.

The rationale behind this method is that if the price is greater than the cost then a
profit must be made (providing that t he expected volumes are achieved).
1. Full cost-plus pricing
Advantages of full cost-plus pricing strategy:

● Easy to use.
● Ensures that all costs are covered.
● Ensures that the firm can generate profits and survive in the future.
● Avoids costs of collecting market information on demand and competitor

activity.
● It is believed to establish stable prices.
Disadvantages of full cost-plus pricing strategy:

● It does not consider the demand pattern of the product.
● The absorption of overheads is guess work, therefore the strategy will
produce different selling prices depending on which costing system is used.
● Takes no account of market conditions since its focus is entirely internal.
● By using a fixed mark-up it does not permit the company to respond to the
pricing decisions of its competitors.
● It is not appropriate for making special decisions involving use of spare
capacity.
An example of typical total cost plus price calculation is as follows

$ $
Direct materials 10
Direct labour 15
Prime cost 25
Factory overheads:
Fixed 10
Variable 5 15
Total production cost 40
Non production costs:
Fixed 10
Variable 0 10
Total cost 50
Add profit (20% x 50) 10
Selling price 60
2. Marginal cost-plus pricing

Pricing strategy in which a profit margin is added to the budgeted marginal or
variable cost of the product.
Advantages
● Can price below total cost when demand is low if there is spare capacity.
● Efficient and most economic use of scarce resources.
Disadvantages
● Ignores fixed overheads. The price may not be high enough to ensure that a
profit is made after fixed overheads are covered.
● Lack of consideration of overall market and customers.
OTHER PRICING STRATEGIES
Market skimming
The price is set at a high level to generate maximum return per unit in the early
units. The aim is to sell to only that small part of the market which is not price
sensitive. For market skimming to be effective the company must have a barrier to
entry in the form of a patent , brand, technological innovation or other.
Features
1 Low volume, high price.
2 Low initial investment in production capacity.
3 Low risk, if strategy fails price can be dropped.
Limitations of market skimming strategy

● It is only effective when the firm is facing an inelastic demand curve (market
is not price sensitive).
● Price changes by any one firm will be matched by other firms resulting in a
rapid growth in industry volume.
● Skimming encourages the entry of competitors as margins are high.

● Skimming results in a slow rate of diffusion and adaptation. This results in a
high level of untapped demand. This gives competitors time to either imitate
the product or leap frog it with a new innovation.
Market penetration pricing

The price is set at a level which should generate demand from the whole market
and by so doing encourage an acceleration of the life cycle quickly into growth and
maturity phases. Necessary if the market skimming approach is not possible
because of a lack of barriers to entry or customer sensitivity to price.
Features
1 Low price, mass market.
2 Substantial investment required.

3 High risk, the low price is used to deter other competitors.
Penetration pricing strategy is appropriate when:

● Product demand is highly price elastic so that demand responds to price
changes.
● Substantial economies of scale are available.
● The product is suitable for a mass market and there is sufficient demand.
● The product will face competition soon after introduction.
Complementary product pricing

Complementary products are products that are goods that tend to be bought and
used together. For example: computers and software. If sales of one increase,
demand for the other will also increase. Also referred to as joint demand.
Product line pricing

A product line is a group of products that are related to each other.
Product line pricing strategies include setting prices that are proportional to full or
marginal cost with the same profit margin for all products in the product line.
Alternatively, prices can be set to reflect demand relationships between products in
the line so that an overall return is achieved.
Volume discounting
A volume discount is a reduction in price given for purchases of large volume. The
objective is to increase sales from large customers. The discount differentiates
between wholesale and retail customers. The reduced cost of a large order will
compensate for the loss of revenues from offering the discount.
Price discrimination
This is the practice of selling the same product at different prices to different
customers. Examples: off peak travel bargains; theatre tickets sold at different
prices based on location so that customers pay different prices for the sa me
performance.
DEMAND BASED PRICING

The preparation of a price in relation to the demand for a product.
This technique considers the demand for a product at a given price by developing a
demand curve. Demand based pricing assumes that as the price of the product
increases, the quantity demanded will decrease.
P = Price
Q = Quantity Demanded
Deriving the demand curve
Formula sheet extract

Demand curve
P  a  bQ
changein price
b
changein quantity
a  price when Q  0
Example 1 Biscan
A product sells 500 units at a price of $25 and 700 units at a price of $20.
Required:
Establish the equation of the demand curve.
Example 2 Mellor
A company presently sells 20,000 units at $12.50 each. The managing director
believes that they will be more profitable if they sell 20% more unit at a price of
$11 each.
Required:
(a) Derive the demand curve.
(b) Calculate the total revenue in each circumstance.
(c) Discuss the belief of the managing director that selling more units at a
lower price will increase profits.
Price elasticity of demand

Price elasticity of demand is the measure of the extent of change in market demand
for a good in response to a change in its price. For some products, even when the
price increases demand does not change significantly (eg petrol). Other products
would be very sensitive to price, ie a small increase in price will result in a larger
decrease in demand (eg luxury goods such as jewellery).
% changein dem andof goodX
Elasticity of demand (PED) =
% changein price of goodX
Price elasticity of demand =

Q2  Q1  Q1
P2  P1  P1
If the PED is greater than one, the good is price elastic. Demand is responsive to
a change in price. If for example a 15% fall in pric e leads to a 30% increase in
quantity demanded, the price elasticity = 2.0.
If the PED is less than one, the good is inelastic. Demand is not very responsive
to changes in price. If, for example, a 20% increase in price leads to a 5% fall in
quantity demanded, the price elasticity = 0.25.
If the PED is equal to one, the good has unit elasticity. The percentage change in
quantity demanded is equal to the percentage change in price. Demand changes
proportionately to a price change.
If the PED is equal to zero, the good is perfectly inelastic. A change in price will
have no influence on quantity demanded. The demand curve for such a product
will be vertical.
If the PED is infinity, the good is perfectly elastic. Any change in price will see
quantity demanded fall to zero. This demand curve is associated with firms
operating in perfectly competitive markets.
Example 3 Spearing
The price of a good is $1.20 per unit and the annual demand is 800,000 units.
Market research indicates that an increase in pric e of 10cents per unit will result in
a fall in annual demand of 75,000 units.
Required:
What is the price elasticity of demand?
Advantages of demand based pricing

1. A consideration of the market.
2. Company understands how sensitive customers are to changes in the price.
Limitations of demand based pricing

1. It may be difficult to accurately establish the relationship between price and
demand.
2. Other factors will affect the demand for the product (not just price). These
factors include quality, advert ising, disposable income, tastes and fashions.
PROFIT MAXIMISING PRICE AND QUANTITY

It is important to understand cost behaviour in many business decisions. The rate
of increase in total cost as a consequence of increase in volume may increase or
decrease due to price changes, inflation, and discount factors etc.
The same principle applies to the rate of increase in revenues as a result of
increase in volume.
Profit maximising price and quantity can be determined by using the idea of
marginal revenue and marginal cost.
Marginal revenue is the additional revenue earned from selling one more unit.
Using a demand based approach, we assume that for one extra unit to be sold, the
selling price would have to drop by a certain amount. Therefore, as quantity sold
increases, the marginal revenue will decrease.
Marginal cost is the additional cost incurred from producing one more unit. We
can assume that this is equal to the variable cost per unit.
Cost/revenue $
Marginal Revenue
Marginal Cost
Quantity demanded
The profit maximising price and quantity will be at a point where:

Marginal revenue (MR) = marginal cost (MC)
Where MR = a – 2bQ (given in the exam)
Example 4 Kozma
A company sells 1,000 units at $10 per unit and 1,500 units $8 per unit. Variable
costs are $5 per unit.
Required:
(a) Derive the demand function for this company, and explain its
usefulness.
(b) Equate Marginal Revenue and Marginal Cost to determine the optimal
quantity and optimal price.
Chapter 4
Decision making under

uncertainty
6. Dealing with risk and uncertainty in decision-making

a) Suggest research techniques to reduce uncert ainty eg Focus groups, market
research.
b) Explain the use of simulation, expected values and sensitivity.
c) Apply expected values and sensitivity to decision-making problems.
d) Apply the techniques of maximax, maximin, and minimax regret to decision-

making problems including the production of profit tables.
e) Draw a decision tree and use it to solve a multi-stage decision problem.
f) Calculate the value of perfect and imperfect information.
C HAP TE R 4 – DE C ISIO N MAKING UNDE R UNC E RTAINTY
CHAPTER CONTENTS
RISK AND UNCERTAINTY ------------------------------------------------77

UNC ERTAINTY 77
RISK 77
PAY-OFF TABLES 77
DECISION CRITERIA -----------------------------------------------------78

MAXIMAX 78
MAXIMIN 78
MINIMAX REGRET 78
EXPECTED VALUES 78
VALUE OF PERFECT INFORMATION (VPI) -----------------------------80
DECISION TREE ANALYSIS ----------------------------------------------81
SENSITIVITY ANALYSIS -------------------------------------------------82

INTRODUCTION 82
SIMULATION --------------------------------------------------------------83
MARKET RESEARCH ------------------------------------------------------84
RISK AND UNCERTAINTY

Decisions have to be taken under the conditions of risk and uncertainty.
Uncertainty
Uncertainty simply reflects that there is more than one possible outcome for a
given event, but there is little previous statistical evidence to enable the possible
outcomes to be predicted.
Risk
Risk is where that uncertainty can be quantified in some way.
Risk attitudes
Risk preference describes the attitude of a decision-maker toward risk – as there is
a relationship between risk and reward.
● Risk averse – a risk averse decision-maker considers risk in making a
decision, and will not select a course of action that is more risky unless the
expected return is higher and so justifies the extra risk.
● Risk seeker – a risk seeker decision-maker also considers risk in making a
decision.
A risk seeker, unlike a risk averse decision-maker, will take extra risks in the
hope of earning a higher return.
● Risk neutral – a risk neutral decision-maker ignores risk in making a
decision.
A risk neutral decision-maker will select the course of action with the highest
expected return, regardless of risk
Pay-off tables
The choice between two or more alternative courses of action might be based on
the worst, most likely or best expected outcomes from each course of action.
This choice will show the full range of possible outcomes from a decision, and might
help managers to reject certain alternatives because the worst possible outcome
might involve an unacceptable amount of loss.
This requires the presentation of a pay-off table.

The pay-off matrix is a tabular layout specifying the result (pay -off) of each
combination of decision and the state of the world over which the decision maker
has no control.
DECISION CRITERIA
Once the pay-off table has been prepared, a decision has to be made between the
different courses of action.
The choice may be based on a maximax, maximin, minimax regret decision rule ,
and expected value.
Maximax
The decision maker will select the course of action with the highest possible payoff
(the best of the best).
The maximax decision rule is the decision rule for the risk seeker.
Maximin
The decision maker will select the course of action with the highest expected return
under the worst possible conditions. This decision rule might be associated with a
risk averse decision maker.
Minimax regret
The decision maker selects the course of action with the lowest possible regret. It
aims at minimising the regret from making the wrong decision.
Regret is the opportunity cost of having made the wrong decision, giv en the actual
conditions that apply in the future.
Expected values
Expected value is a weighted average value of all the possible outcomes. It does
not reflect the degree of risk, but simply what the average outcome would be if the
event were repeated a number of times.
A decision rule is to select the course of action with the highest expected value of
profit or the lowest expected value of cost.
Expected value formula

EV = Σpx
P = probability of an outcome
x = value of an outcome
Example 1 For Ltd

Consider the following sales and probabilities.
Sale probabilities
$ %
20,000 25
25,000 40
30,000 15
35,000 20
Required:
Calculate the expected value of sales.
Example 2 Mr Sartre
Mr Sartre runs a market stall selling vegetables and fruit. He buys a product for
$20 per case. He can sell the product for $40 per case on his stall. The product is
perishable and it is not possible to store it, instead any cases unsold at the end of
the day can be sold off as scrap for $2 per case.
Purchase orders must be made before the number of sales is known. He has kept
records of demand over the last 150 days.
Demand / day Number of days
10 45
20 75
30 30
Required:
(a) Prepare a summary of possible net daily margins using a payoff table.
(b) Advise Mr Sartre:
(i) How many cases to purchase if he uses expected values.
(ii) How many cases to purchase if he uses maximin / maximax.

(iii) How many cases to purchase if he uses minimax regret.
(c) Mr Sartre has been approached by a research associate to provide him
more reliable estimate of his future demand, advise Mr Sartre what
maximum price he should pay to gain this reliable information.
VALUE OF PERFECT INFORMATION (VPI)

If perfect information about the future were available, it would be very easy to
make a decision as the uncertainty and risk associated with it would be minimum.
Therefore knowledge about cost of obtaining t he perfect information is very
important from management’s point of view.
The price that one would be willing to pay in order to gain access to perfect
information of an uncertain outcome in decision making is known as Value of
Perfect Information.
Mathematically, VPI is the difference between the payoff under certainty and the
payoff under risk.
VPI = Expected value with perfect information - highest possible expected value
without perfect information
DECISION TREE ANALYSIS

A decision tree is a diagram showing several possible courses of action and all
possible outcomes.
Each alternative course of action is represented by a branch, which leads to
subsidiary branches for further course of actions or possible outcomes.
Decision tree analysis is designed to illustrate the full range of alternatives that can
occur, under all possible given conditions.
On the decision tree:
● A decision is represented with a

● An outcome point is represented with a
In an exam question on decision trees, there will typically be 2 stages involved:
1. Constructing the decision tree (which is done from left to right on the page).
2. Evaluating the decision tree (which is done from right to left on the tree). An
expected value must be calculated at each outcome point. Decisions will be
made based on selecting the option with the highest expected value.
Example 3 Seven Trees Ltd

The following information relates to Seven Trees Ltd, a company which is
considering whether to develop and market a product.
Probability
Development
Being successful 0.75
Being unsuccessful 0.25
Estimated development costs would be $180,000.
If successful, the product will be marketed with following probabilities:

Probability Profits / (Loss)
Being very successful 0.4 $540,000
Being moderately successful 0.3 $100,000
Being failure 0.3 ($400,000)
The above profits / losses figures include the effect of the development costs.
Required:
Draw a decision tree to illustrate the above problem, and recommend to
management the best course of action.
SENSITIVITY ANALYSIS
Introduction
Sensitivity analysis is a method of risk or uncertainty analysis in which the effect on
the expected outcome of the change in values of key variables or key factors is
tested. For example, in budget planning, the effect on budgeted profit might be
tested for changes in the budgeted sales volume, or the budgeted sale price,
material and labour costs, and so on.
There are several ways of using sensitivity analysis including:

● To estimate by how much costs and revenues would need to differ from their
estimated values before the decision would change.
● To estimate whether a decision would change if estimated sales were A%

lower than estimated, or estimated costs were B% higher than estimated.
This is called ‘what if’ analysis. For example: what if the sales volume is 5%
less than the expected volume?
Example 4 Spy Ltd

A company currently produces and sells Product A at a selling price of $2,150/unit.
Management have decided to further process Product A into Product A+. The costs
of further processing will be as follows:
$/unit
Additional materials 600
Direct labour 70
Variable o/h
90
Total 760
The selling price of A+ will be $3,100/unit.

The above additional costs are estimates only and are subject to change. The
purchasing manager has indicated that the market price of the materials can be
quite volatile.
Required:
Analyse the sensitivity of the decision to changes in the above costs or

selling price of A+.
SIMULATION
Simulation is a quantitative technique that uses IT based computerised packages
with built in mathematical models for decision making under conditions of
uncertainty. It evaluates various courses of action based upon facts and
assumptions.
Monte Carlo is a widely used method of simulation, where complex problem is

solved by simulating the original data with random number generators.
Usefulness of simulation:
● Medical diagnosis
● Gambling
● Air force training
● Traffic scheduling.
MARKET RESEARCH
Market research is a process of systematically and objectively gathering, recording
and analysing information. This can be used to reduce uncertainty.
This information may relate to:
● customers;
● general trends in the market;

● competitors;
● government regulations;
● economic trends;
● technological advancements; and
● any other factors that constitute the business environment.
Chapter 5
Budgeting
C Budgeting and control
1. Budgetary systems
a) Explain how budgetary systems fit within the performance hierarchy.
b) Select and explain appropriate budgetary systems for an organisation,

including top-down, bottom-up, rolling, zero-base, activity-base, incremental
and feed-forward control.
c) Describe the information used in budget systems and the sources of the
information needed.
d) Explain the difficulties of changing a budgetary system.
e) Explain how budget systems can deal with uncertainty in the environment.
2. Types of budget
a) Prepare rolling budgets and activity based budgets.
b) Indicate the usefulness and problems with different budget types (including
fixed, flexible, zero-based, activity-based, incremental, rolling, top-down,
bottom up, master, functional).
c) Explain the difficulties of changing the type of budget used.
C HAP TE R 5 – BU DGE TING
3. Quantitative analysis in budgeting

a) Analyse fixed and variable cost elements from total cost data using high/low
methods.
b) Estimate the learning rate and learning effect.
c) Apply the learning curve to a budgetary problem, including calculations on

steady states.
c) Discuss the reservations with the learning curve.
d) Apply expected values and explain the problems and benefits.

e) Explain the benefits and dangers inherent in using spreadsheets in budgeting.
8. Performance analysis and behavioural aspects

c) Identify the factors which influence behaviour.
d) Discuss the issues surrounding setting the difficulty level for a budget.
f) Explain the benefits and difficulties of the participation of employees in the
negotiation of targets.
C HAP TE R 5 – BUDGE TING
CHAPTER CONTENTS
WHAT IS A BUDGET? -----------------------------------------------------88

F UNCTIONS OF BUDGETING (PCCCEMA) 88
BUDGET PREPARATION --------------------------------------------------89

STEPS IN BUDGETING 89
BUDGETARY CONTROL 90
F EEDBACK AND FEED- FORWARD CONTROL 90
TYPES OF BUDGET --------------------------------------------------------92

PARTICIPATORY /NON PARTICIPATORY BUDGETING 92
INCREMENTAL BUDGETING 93
ROLLING BUDGETS 93
ZERO BASED BUDGETING 94
ACTIVITY BASED BUDGETING 95
FIXED BUDGETS ----------------------------------------------------------96
FLEXIBLE BUDGETS ------------------------------------------------------97

STEPS IN FLEXIBLE BUDGETING 97
SEPARATING FIXED AND VARIABLE COST 97
LEARNING CURVE --------------------------------------------------------99

MATHEMATICAL ILLUSTRATION 99
USING THE FORMULA 100
GENERAL USE OF LEARNING CURVE 100
WHAT IS A BUDGET?
A quantitative plan prepared for specific time period. It is normally expressed in
financial terms and prepared for one year.
Functions of budgeting (PCCCEMA)

We can identify the aims of a budget in seven ways:
1. Planning
2. Control
3. Communication
4. Co-ordination
5. Evaluation
6. Motivation
7. Authorisation & Delegation
BUDGET PREPARATION
It is important that suitable administration procedures are introduced to ensure that
the budget process works efficiently.
(a) Budget Committee

The budget committee should consist of high-level executives who represent the
major segments of the business. It typically includes the chief executive, the
corporate or management accountant (acting as budget officer) and functional
heads. Their main task is to ensure that budgets are realistically established and
that they are coordinated satisfactorily.
The functions of the committee are:
● agree policy with regards to budgets
● coordinate budgets
● suggest amendments to budgets, example, because they are not adequate
● approve budgets after amendments, as necessary
● examine comparison of actual and budget and recommend corrective actions.
(b) Budget Manual

A budget manual describes the objectives and procedures involved in the budgeting
process and will provide a useful reference source for managers responsible for the
budget preparation. In addition, the manual may include a timetable specifying the
order in which the budgets should be prepared and the dates when they should be
presented to the budget committee. The manual should be circulated to all those
who are responsible for preparing budgets.
Steps in budgeting
1. Budget aims
Strategic aims.
Key assumptions.
2. Identify the principal budget factor

1. Sales demand for production environment.
2. Cash resource for non profit making organisation.
3. Prepare the sales budget

Start with the principal budget factor:
1. Marketing department function.
2. Price/volume relationship.
4. Prepare all other functional budgets

Prepare each functional budget separately.
Participatory process
1. Local knowledge.
2. Promotes ownership.
5. Negotiation
Meeting between junior management and senior managers to ensure that the
budget is a realistic target. In particular the aim is to eliminate budgetary slack.
6. Review
Bring all individual functional budgets together to form a master budget, an overall
budget for the whole organisation.
Budget assessed for:
1. Feasibility
2. Acceptability
Once completed budgeted financial statements and cash flow statements can be
prepared.
7. Acceptance
Acceptance means that the budget becomes a formal authorisation for all levels of
management to take action for and on behalf of the company.
Budgetary control
Budgetary control involves:
1. setting targets or performance standards for individuals (budget holders)

2. comparing actual performance against the budget (variances)
3. expecting the budget holder to use this information to take action where
necessary to make sure that the budget is achieved
4. where necessary, changing the budget targets or performance standards.
Feedback and feed-forward control
Feedback control
Feedback control is defined as the measurement of differences between planned
outputs and actual outputs achieved, and the modification of subsequent action
and/or plans to achieve future required results.
Control through feedback is where actual result (output) are compared with those
which were planned for the budget period. Likewise, the input (cost) are compared
with the budget, taking account of the actual level of outputs. This comparison of
actual with plan takes place after the event. The intention is to learn for the future
so that future deviations of actuals and plans are avoided or minimised. Feedback
is a reactive process.
Budgetary control systems are feedback control systems.
Feed-forward control
Feed-forward control is an alternative approach to control using feedback.
Feed-forward control is defined as the forecasting of differences between the actual
and planned outcomes and the implementation of actions before the event, to
prevent such differences.
Control through feed-forward is where prediction is made of what output and inputs
are expected for some budget period. If these predictions are different from what
was planned, then control actions are taken which attempts to minimise the
differences. The aim is for control to occur before the deviation is reported hence
feed-forward control is more proactive. Budget generation is a form of fe ed-
forward in that various outcomes are considered before one is selected.
TYPES OF BUDGET
There are a number of different ways in which a budgetary system can be
approached.
The budget types required for the F5 syllabus are:
1. Participatory/Non participatory
2. Incremental
3. Rolling budgets
4. Zero based budgeting
5. Activity based budgeting

6. Fixed and flexible budgeting.
Participatory/Non participatory budgeting

A non participatory (top down) approach to budgeting is where junior management
do not participate in the budgeting process. Senior management prepare the
budget and distribute the final budget to the relevant departments. This will
usually only be appropriate in smaller organisations or if junior management lack
the skill to prepare budgets.
A participatory (bottom up) approach to management is also called participatory

budgeting. This is where junior management prepare the budget for their area of
responsibility and submit to senior management for approval
Participatory approach advantages

1. More motivating for junior management as they have been involved in the
process.
2. Targets will be more realistic as departmental managers have a more in depth

understanding of the issues within that area.
3. Co-ordination between the different departments is improved.
Participatory approach disadvantages

1. It is more time consuming than a top down approach.
2. Junior management may introduce participatory slack.
The quality of departmental budgets will vary based on the skill of individual
managers.
Incremental budgeting
This is the traditional approach to budgeting. This approach bases the budget on
current results and adjusts for known changes, eg estimated changes in sales,
inflation.
Incremental budgeting is appropriate in environments where activities do not
change significantly each year.
Advantages
1. This is usually the quickest and easiest type of budgeting.
2. Management have more time available to focus on other areas (rather than
budget preparation).
Disadvantages
1. Inefficiencies from the current year will be included in the budget for next
year.
2. There is no incentive for management to reduce costs as this would reduce

their budget for the following year.
Rolling budgets
In a periodic budgeting system the budget is normally prepared for one year, a
totally separate budget will then be prepared for the following year. In continuous
budgeting the budget from one period is ‘rolled on’ from one period to the next.
Typically the budget is prepared for one year, only the first quarter in detail, the
remainder in outline. After the first quarter is revised for the following three
quarters based on the actual results and a further quarter is budgeted for.
This means that the budget will again be prepared for 12 months in advance. This
process is repeated each quarter (or month or half year).
Advantages (as opposed to periodic budgeting)

1. The budgeting process should be more acc urate.
2. Much better information upon which to appraise the performance of
management.
3. The budget will be much more ‘relevant’ by the end of the traditional
budgeting period.
4. It forces management to take the budgeting process more seriously.
Disadvantages
1. More costly and time consuming.
2. An increase in budgeting work may lead to less control of the actual results.
Zero based budgeting

A simple idea of preparing a budget from a ‘zero base’ each time, ie as though
there is no expectation of current activities to continue from one period to the next.
ZBB is normally found in service industries where costs are more likely to be
discretionary. A form of ZBB is used in local government.
There are four basic steps to follow:
1. Prepare decision packages

Identify all possible services (and levels of service) that may be provided and then
cost each service or level of service, these are known individually as decision
packages.
2. Rank
Rank the decision packages in order of importance, starting with the mandatory
requirements of a department. This forces the management to consider carefully
what their aims are for the coming year.
3. Funding
Identify the level of funding that is available for the organisation.
4. Utilise
Use up the funds in order of the ranking until exhausted.
Advantages
1. Emphasis on future need not past actions.
2. Eliminates past errors that may be perpetuated in an incremental analysis.
3. A positive disincentive for management to introduce slack into their budget.

4. A considered allocation of resources.
5. Encourages cost reduction.
Disadvantages
1. Can be costly and time consuming.
2. May lead to increased stress for management.
3. Only really applicable to a service environment.

4. May ‘re-invent’ the wheel each year.
5. May lead to lost continuity of action and short term planning.
Activity based budgeting

Use of activity based costing principles to provide better overhead cost data for
budgeting purposes. The advantages of using such a technique accrue from bett er
cost allocation.
Exam questions will be closely related to the ABC questions we looked at earlier on
in the course.
ABB is used in an environment with the following criteria:
1. Complex manufacturing environment.
2. Wide range of products.

3. High proportion of overhead costs.
4. Competitive market.
Advantages
1. Better understanding of overhead costs.
2. Identifies the accurate relationship between product and activ ity.

3. Each activity more accurately describes where costs are incurred.
Each and every benefit allows for better control of costs together with the
opportunity to reduce the costs using other management accounting techniques.
Disadvantages
1. Identifying appropriate cost drivers may be subjective and therefore accuracy
depends on the judgement of management .
2. The implementation and maintenance of an ABB system will be expensive and
time consuming.
FIXED BUDGETS
A budget prepared at a single (budgeted) level of activity.
The term fixed budget means the following:

1. that the budget is prepared on the basis of an estimated volume of production
and sales, but no plans are made for the event that actual volume of
production and sales may differ from budgeted volume.
2. when actual volume of production and sales during a control period are
achieved, a fixed budget is not adjusted to the new levels of activity.
Advantage:
A fixed budget is likely to be useful in circ umstances where the organisational
environment is relatively stable and can be predicted with a reasonable degree of
certainty.
FLEXIBLE BUDGETS
A budget prepared with the costs classified as either fixed or variable. The budget
may be prepared at any activity level and can be ‘flexed’ or changed to the actual
level of activity for budgetary control purposes.
Flexible budget recognises the difference in behaviour between fixed and variable
cost in relation to fluctuations in output, turnover or other variable factors and is
designed to change appropriately with such fluctuations.
Steps in flexible budgeting

1. A fixed budget is set at the beginning of the period based on estimated
production. This is the original budget .
2. This is then flexed to correspond with actual level of activity . Variable costs
and sales revenue are adjusted to reflect the actual level of activity.
3. The result is compared with actual cost and differences (variances) are
reported to the managers responsible.
Separating fixed and variable cost

One problem normally faced in examinations is how to divide cost into its fixed and
variable elements. One possible way of separating fixed and variable cost is
through the use of high-low method.
Applying the high low method, the following steps must be applied:
Step 1
Variable cost/unit =
Total cost at the high level of act ivity – total cost at the low level of activity
Volume at the high level of activity – volume at the low level of activity
Step 2
Fixed costs =
Total cost - variable cost/unit x number of units

Note: Fixed costs can be calculated by using either the information at the low level
of activity or the information at the high level of activity.
Example 1 Strauss Ltd

You have been provided with the following operating statement, which represents
an attempt to compare the actual performance for the quarter that has just ended
with the budget.
Budget Actual Variance
Number of units sold (000) 640 720 80
$000 $000 $000

Cost of sales (all variable)
Materials 168 144 24
Labour 240 288 (48)
Overheads 32 36 (4)
440 468 (28)
Fixed Labour cost 100 94 6

Selling and distribution costs
Fixed 72 83 (11)
Variable 144 153 (9)
Administration costs
Fixed 184 176 8
Variable 48 54 (6)
548 560 (12)
Total Costs 988 1,028 (40)
Sales 1,024 1,071 47
Net Profit 36 43 7
Required:
(a) Using a flexible budgeting approach, redraft the operating statement
so as to provide a more realistic indication of the variances, and
comment briefly on the possible reasons (other than inflation) why
they have occ urred. (10 marks)
(b) Explain why the original operating statement was of little use to
management. (2 marks)
(c) (i) Discuss the problems associated with the forecasting of figures
which a re to be used in flexible budgeting. (4 marks)
(ii) Further analysis has indicated that the 'variable' overheads for
cost of sales are, in fact, only semi-variable. Whilst the
budgeted overheads for 640,000 units is indicated to be
$32,000, it is felt that the budget for 760,000 units would be
$37,000. Included in this later cost is $1,000 incurred when the
activity reached 750,000 units due to extra hiring capacity.
Produce a revised flexed budget for the overheads contained in
cost of sales for an activity level of 720,000 units. (4 marks)
(20 marks)
LEARNING CURVE
Learning curve is used to estimate more accurate labour and labour related costs,
where these may change due to employees becoming more skilled.
It can be used as part of the budgeting process, but is also useful in other areas
such as target costing, life-cycle costing and decision making.
The learning curve is a statistical relationship which establishes the fact that labour
time per unit falls as a complex task is repeated. As workers become more familiar
with the production of a new product or task, average time (and average cost) will
decline at a known rate.
“As cumulative production doubles from the first unit, the cumulative
average time per unit falls by a constant percentage”
Mathematical illustration
Example 2 Learning curve

If the first unit requires 100 hours and the learning curve rate is 80%, calculate the
following cumulative and incremental data.
Incremental
Average Cum
Cumulative Incremental Incremental Average
time per total
units units total time time per
unit time
unit
1 unit
2 units
4 units
8 units
As cumulative output doubles, the cumulative average time per unit falls to a fixed
percentage of the previous average time.
Using the formula

The geometric formula can be used to establish the average time (or average cost)
per unit.
y = axb
where:
y = cumulative average time per unit to produce x units

a = time to produce the first unit
log r
b = slope = (LR = rate of learning)
log 2
x = cumulative output
Example 3 Learning curve (contd)
Required:
Using the above example calculate the incremental time taken by the 2nd, 3rd and
4th units.
General use of learning curve

Learning curve provides useful information to management accountant since it
helps with:
● setting realistic labour standards

● planning manpower needs
● formulating budgets
● calculation of incentive rates in bonus wages

● setting delivery date
● pricing for successive units, where prices are established, or quotations are
made, on a cost plus basis.
Limitations of learning curve

● It is only applicable in labour intensive operations which are repetitive and
reasonably skilled.
● It assumes that employees are motivated to learn.
● It assumes that there is a stable labour mix with a negligible turnover.
● Difficulty in determining the learning curve effect accurately.

● Difficulty in determining the level of production where the curve will be flat
and no further learning takes place.
● Breaks between production runs must be short or learning will be forgotten.

Example 4 BG
BG has recently developed a new product. The nature of their work is repetitive,
and it is usual for there to be 80% learning curve effect when a new product is
developed. The time taken for the first unit was 22 minutes. Assuming that an
80% learning effect applies:
Required:
What is the time to be taken for the fourth unit?
Example 5 Martina Ltd

Martina Ltd has received an order to make 8 units of product sampa. The time to
produce the first unit is estimated to be 80 hours and an 80% learning curve is
expected. The rate of pay is $7.50 for each hour.
The direct material cost for each unit is $4,000 and fixed costs associated with the
order are $6,400.
Required:
Calculate the average cost for each unit for this order.

Example 6 Limitation plc

Limitation plc commenced the manufacture and sale of a new product in the fourth
quarter of 2012. In order to facilitate the budgeting proc ess for quarters 1 and 2 of
2012, the following information has been collected.
(a) Forecast production/sales (batches of product) is as follows:
Quarter 4, 2012 30 batches
(b) It is estimated that direct labour is subject to a learning curve effect of 90%.
The labour cost of batch 1 of quarter 4, 2012 was $600 (at $5 per hour). The
labour output rates from the commencement of production of the product,
after adjusting for learning effects, are as follows:
Total batches produced Overall average time per batch
Batches Hours
15 79.51
30 71.56
45 67.28
60 64.40
75 62.25
90 60.55
105 59.15
120 57.96
Labour hours worked and paid for will be adjusted to eliminate spare capacity
during each quarter. All time will be paid for at $5 per hour.
(c) Variable overhead is estimated at 150% of direct labour cost during 2013.
(d) All units produced will be sold in the quarter of production at $1,200 per
batch.
Required:
(a) Calculate the labour hours requirement for the second batch and the
sum of the labour hours for the third and fourth batches produced in
quarte r 4, 2012. (3 marks)
(b) Prepare a budget for each of quarters 1 and 2, 2013 showing the
contribution earne d from the product. Show all relevant workings.
(12 marks)
(c) Limitation plc wishes to prepare a quotation for 12 batches of the

product to be produced at the start of quarter 3, 2013.
Calculate the cost of the labour and labour related costs incurred as a
result of the additional batc hes produced. (5 marks)
(20 marks)

Chapter 6
Standard costing and

variance analysis
4. Standard costing
a) Explain the use of standard costs.
b) Outline the methods used to derive standard costs and discuss the different
types of cost possible.
c) Explain and illustrate the importance of flexing budgets in performance
management.
d) Explain and apply the principle of controllability in the performance
management system.

a) Analyse and evaluate past performance using the results of variance analysis.
b) Use variance analysis to assess how future performance of an organisation or

business can be improved.

C HAP TE R 6 – STANDARD C O STING AND VARIANC E ANAL YSIS
CHAPTER CONTENTS
STANDARD COSTING --------------------------------------------------- 105

T YPES OF STANDARDS 105
PREPARATION OF STANDARD COSTS 106
USES OF STANDARD COSTS 106
PROBLEMS IN SETTING STANDARDS 106
VARIANCE ANALYSIS -------------------------------------------------- 107

MATERIAL VARIANCES 108
LABOUR VARIANCES 109
VARIABLE OVERHEAD VARIANCES 109
FIXED OVERHEAD VARIANCES ---------------------------------------- 110

ABSORPTION COSTING PRINCIPLES 110
MARGINAL COSTING PRINCIPLES 111
SALES VARIANCES ----------------------------------------------------- 112
REPORTING ON VARIANCES------------------------------------------- 113

MARGINAL COSTING OPERATING STATEMENT 113
VARIANCES AND PERFORMANCE ------------------------------------- 114

STANDARD COSTING
● A standard is ‘a benchmark measurement of resource usage, set in defined
conditions’.
● Standard costing is a system of accounting based on pre-determined costs
and revenue per unit, which are used as a benchmark to compare actual
performance, and therefore provide useful feedback information to
management.
● Variance analysis is performed by comparing the actual c ost and the standard
cost to ascertain the difference.
● Standard costs can be prepared using either absorption costing or marginal
costing.
Types of standards
Ideal standard
● A standard that assumes perfect working conditions and does not make
allowance for any losses, waste and machine breakdown.
● It can be used as a long-term organisational goal and is particularly applicable
in total quality management environments.
● The variances can only be adverse and it may have an adverse motivational
impact.
Attainable standard
● It is based upon efficient (but not perfect) levels of operation but will include
allowances for normal material losses, realistic allowances for fatigue ,
machine breakdowns, etc.
● Attainable standards must be based on a tough but realistic performance level
so that its achievement is possible, but has to be worked for.
● They are used for budgeting and budgetary control.
Basic standard
● These are long-term standards which remain unchanged over a period of
years. Their sole use is to show trends over time for such items as material
prices, labour rates and efficiency and the effect of changing methods.
● They cannot be used to highlight current efficiency because they are out -of-
date.

Preparation of standard costs

Standard costing is directly linked to the budgeting process. Individual standards
are prepared for each component of cost. From these a standard cost may be
prepared for each product produced (or service provided).
Material
Build the variable costs up to
Usage x Price
the unit cost
Labour
Hours x Rate
Var. O/H
Hours x rate
Standard cost
per unit
Fixed O/H
Budgeted fixed
cost
Break the total fixed costs down using ÷
the budgeted level of activity Budgeted number
of units
Uses of standard costs

● Preparation of budgets
● Stock valuation
● Budgetary control and variance analysis

● Decision making (pricing)
● Performance monitoring and evaluation.
Problems in setting standards

1. Deciding how to incorporate inflation into planned unit costs.
2. The cost of setting up and maintaining a system of establishing standards .
3. Possible behavioural problems.

4. Deciding on the quality of materials and grade of labour to be used.

VARIANCE ANALYSIS
The main application of standard costing is for budgetary control purposes. The
standard is compared to the actual result the difference being the variance. The
analysis provides the following information:
1. Cost control.
2. Reconciliation between budgeted and actual profit (or Contribution or cost).

3. Variances may quantify the value of a known difference.
4. Performance appraisal.
Example 1 Owen Ltd

Owen Ltd uses a standard costing system. The standard cost card for one product
is shown below:
$
Direct Material 4 kg at $5 per kg 20
Direct Labour 2 hours at $8 per hour 16
Variable Overhead 2 hours at $3.5 per hour 7
Total Variable Cost 43
Fixed Overhead 2 hours at $7 per hour 14
Total Product Cost 57
Standard Selling Price 70
Standard Profit Margin 13
The budgeted output and sales was 1,000 units. Actual production and sales for
the period were 1,300 units
Actual cost and revenue were as follows:
$
Direct Material 5,000 kg, costing 22,700
Direct Labour 2,850 hours, costing 21,500
Variable Overhead 7,800
Fixed Overhead 14,600
Sales Revenue 1,300 units at $68 per unit 88,400
Required:
Calculate all possible variances.

Material variances
Standard Cost
Direct Material 4 kg at $5 per kg
Actual Results
Actual output 1,300 units
Materials Purchased and used 5,000 Kg, costing $22,700
Key pro forma
SQSP
Usage
AQSP
Price
AQAP

Labour variances
Standard Cost
Direct Labour 2 hours at $8 per hour
Actual Results
Hours paid and worked 2,850
Labour Cost $21,500
Key pro forma
SHSR
Efficiency
AHSR
Rate
AHAR
Variable overhead variances
Standard Cost
Variable overhead 2 hours at $3.5 per hour
Actual Results
Hours worked (from above) 2,850
Variable overhead Cost $7,800
Key pro forma
SHSR
Efficiency
AHSR
Expenditure
AHAR

FIXED OVERHEAD VARIANCES

Fixed costs are a constant in total terms, hence total cost is our starting point. The
analysis of variances will be dependent on the costing methodology. Do we use
absorption costing or marginal costing? Either is potentially applicable.
Absorption costing principles

Using absorption costing the fixed cost is charged or absorbed to the cost unit or
product. The total fixed overhead variance will be similar to the under/ over
absorption of overhead.
The total variance may be sub-analysed in to two:
1. Volume variance – if the company produces more or less units and hence
absorb more or less overhead than budgeted.
2. Expenditure variance – if the company spends more or less fixed overhead
than budgeted.
Question extract
Standard and Budgeted Cost
The fixed cost is($7/hour for 2 hours) $14per unit
The budgeted number of units is 1,000
Budgeted fixed overheads is therefore $14,000
Actual Results
Hours worked (from above) 2,850
Fixed overhead Cost $14,600
Key pro forma
SHSR
(Std fixed OH cost of actual output)
Volume variance
BHSR
(Budgeted fixed OH cost)
Expenditure variance
AHAR
(Actual fixed OH cost)

Further analysis of fixed overheads

It is also possible to further analyse fixed overheads by considering actual hours in
relation to the actual and budgeted units produced. To be comparable the output
measures must be measures in terms of standard hours.
Key pro forma
SHSR
Efficiency
AHSR
Capacity
BHSR
Expenditure
AHAR
Marginal costing principles

If a marginal costing system is used, then the only fixed overhead variance which is
calculated is the fixed overhead expenditure variance.

SALES VARIANCES
Standards and
budget
Total Product Cost 57

Standard Selling Price 70
Standard Profit Margin 13
Budgeted sales 1,000
Actual Results
Sales (units) 1,300
Selling Price £68
Production units 1,300

The sales variances identify any change between the selling price and the standard
cost.
Key formulae
Volume variance (absorption costing)
(AS - BS) x SPM
Volume variance (marginal costing)
(AS - BS) x SCM
Price variance
(AP - SP) x AS

REPORTING ON VARIANCES
Once the variances have been calculated, an operat ing statement can be prepared
which reconciles budgeted contribution to actual contribution using the variances.
Marginal costing operating statement

When reconciling using marginal costing principles it is normal to reconcile from
budgeted contribution.
Example 2 Operating statement

Using information on variances, calculated in exercises above, complete the
operating statement for Owen Ltd under marginal costing.
Budgeted Contribution 27,000
Sales Volume Variance
Standard contribution for actual sales volume
Sales Price Variance
Variable Cost Variances

F A
Materials Price
Materials Usage
Labour Rate
Labour Efficiency
Variable Overhead Expenditure
Variable Overhead Efficiency
Sub-total
Actual contribution 36,400

VARIANCES AND PERFORMANCE

Variances are used to assess performance of both the company and individual
managers. It is important to understand which manager would typically be
responsible for each variance.
Variance Manager
Material price Purchasing manager
Material usage Production manager
Labour rate Production manager

Labour efficiency Production manager
Sales quantity Sales manager
Sales price Sales manager
NOTE: In an exam question, you may be specifically told who is responsible

for certain variances (eg in some cases the production manager may also
be responsible for the material price variance). However, if not told
otherwise, you may assume that the above ownership applies.

Chapter 7
Advanced variance
analysis
5. Material mix and yield variances

a) Calculate, identify the cause of, and explain material mix and yield variances.
b) Explain the wider issues involved in changing material mix eg cost, quality
and performance measurement issues.
c) Identify and explain the relationship of the material usage variance with the
material mix and yield variances.
d) Suggest and justify alternative methods of controlling production processes.
6. Sales mix and quantity variances

a) Calculate, identify the cause of, and explain sales mix and quantity variances.
b) Identify and explain the relationship of the sales volume variances with the
sales mix and quantity variances.
7. Planning and operational variances

a) Calculate a revised budget.
b) Identify and explain those fac tors that could and could not be allowed to
revise an original budget.

C HAP TE R 7 – ADVANC E D VARIANC E ANAL YSIS
c) Calculate, identify the cause of and explain planning and operational variances
for:
(i) sales, including market size and market share;

(ii) materials;
(iii) labour, including the effect of the learning curve.
d) Explain and discuss the manipulation issues involved in revising budgets.

g) Describe the dysfunctional nature of some variances in the modern
environment of JIT and TQM.
h) Discuss the behavioural problems resulting from using standard costs in
rapidly changing environments.
e) Discuss the effect that variances have on staff motivation and action.

C HAP TE R 7 – ADVANC E D VARIANC E AN AL YSIS
CHAPTER CONTENTS
INTRODUCTION--------------------------------------------------------- 118
PLANNING AND OPERATIONAL VARIANCES------------------------- 119
ADVANCED MATERIAL VARIANCES ----------------------------------- 122

MATERIAL MIX VARIANCE 122
MATERIAL YIELD VARIANCE 122
SALES MIX AND QUANTITY VARIANCES ----------------------------- 124

SALES MIX VARIANC E 124
SALES QUANTITY VARIANC E 124
MARKET SIZE AND MARKET SHARE VARIANCES 124

INTRODUCTION
Variance analysis is used to separate costs and revenues into controllable elements
(eg material, labour etc) in order that we can compare expected (standard)
performance with actual results. Advanced areas simply increase the degree to
which the variances may be sub-analysed into:
1. Planning and operational variances.

3. Material mix and yield variances.
4. Sales mix and quantity variances.

PLANNING AND OPERATIONAL VARIANCES

Traditionally, when comparing standards to actual results the comparison has
suffered from the time delay between setting the standard and the incurrenc e of
actual results.
The standard is set as part of the budgeting process which occurs before the period
to which it relates, this means that the difference between standard and actual may
arise solely due to an unrealistic budget and not due to operational factors.
Normal
analysis
Original Revised Actual

Standard Standard result
Planning Operational
variance variance
Planning error Operational

factors
Changes over
time Variances caused
by management
action
Reconciling item Controllable
Uncontrollable
Pro Forma (using materials variances)

Basic pro forma Planning Operational
(substitute actual with (substitute standard with
rev ised standard) revised standard)

SQSP SQSP RSQRSP
Usage
AQSP RSQSP AQRSP
Price
AQAP RSQRSP AQAP
Advantages
● Variances are more relevant, especially in an unpredictable environment.
● The operational variances give fair reflection of the actual results achieved in
the actual conditions that existed.
● Managers are more likely to accept and be motivated by the v ariances

reported which provide a better measure of their performance.
● It emphasises the importance of planning and the relationship between
planning and control and a better guide for cost control.
Disadvantages
● The establishment of the revised standard is very difficult.
● There is a considerable amount of administrative work.
● It may become too easy to justify all variances as being due to bad planning,
so no adverse operational variances will be highlighted.
Example 1 Performance
Standards
3kg/unit for $5/kg
Actual
Output 12,500 units
Usage 38,000 kg
Cost $195,500
Required:
Prepare the variances using basic variance analysis and assess whether
the purchasing manager and production manager individually have done a
good or bad job.

Example 1 (cont)
After further consideration the standards have been revised to reflect changes that
have occurred over time. The standard usage is now expected to be 3.1kg due to a
poor harvest leading poorer quality material inputs. In addition due to adverse
movements in the exchange rate the material costs have changed. It is now
expected that each kg will cost $5.15.
Required:
Prepare an analysis of variances into both planning and operational
elements and assess the performance of the purchasing manager and the
production manager individually.

ADVANCED MATERIAL VARIANCES

A sub-analysis of the material usage variance into a mix and a yield
component.
Applicable in a manufacturing environment where:
1. Two or more material inputs go into to making the product (a mix).
2. The material inputs are inter-changeable to some degree (process costing

environment).
Material mix variance

The material mix variance measures the quantity of each individual material used
to produce output, compared with the standard mix.
The mix variance is looking at the inputs used in production.

A favourable mix variance occurs if a greater proportion of cheaper materials has
been used in production
An adverse mix variance occurs if a greater proportion of more expensive materials
has been used in production
Material yield variance

The yield variance looks at the output from production, taking into account the
inputs.
Where there is a difference between actual level of output for a given set of inputs
and the standard output for that level of inputs, a yield variance arises.
A favourable yield variance occurs if fewer inputs have been used to produce output
when compared with the standard inputs.
An adverse yield variance occurs if more inputs have been used to produce output
when compared with the standard inputs.
Key pro forma
SQ(SM)SP
Yield
AQ(SM)SP
Mix
AQ(AM)SP
Price
AQ(AM)AP

Example 2 Dalglish
Dalglish manufactures a fertiliser by mixing three chemicals, A, B and C, and the
following standards apply:
Standard proportions Standard cost per tonne
% $
A 70 20
B 20 30
C 10 50
During the process of mixing, a process loss of 10% is regarded as the standard.
In a week, 855 tonnes of the fertiliser were produced and inputs were as follows:
Actual inputs Actual prices Actual cost
tonnes $ per tonne $
A 660 21 13,860
B 210 32 6,720
C 130 47 6,110
_____ ______
1,000 26,690
_____ ______
Required:
Calculate the material price, mix and yield variances.

SALES MIX AND QUANTITY VARIANCES

In companies where two or more different products are sold, the sales volume
variance can be sub-analysed into the sales mix and the sales quantity variance.
Sales mix variance

Sales mix variance refers to the proportion of different products in total sales.
It is the difference between planned mix of various products and actual mix or
proportion of those products.
Sales Mix Variance (for each product) =

Budgeted contribution per unit x (actual sales at actual mix - actual sales at
budgeted mix)
Sales quantity variance

It determines the effect on profit of selling a different total quantity from the
budgeted total quantity.
Sales Quantity Variance (for each product) =

Budgeted contribution per unit x (actual sales at budgeted mix - budgeted sales at
budgeted mix)
Example 3 ABC Company

ABC company budgeted sales of 10,000 units and the budgeted sales mix was 2:3
for products X and Y respectively. The actual sales of X and Y were 3,000 units and
10,000 units respectively. Sales prices were $5 and $9 respectively. The variable
costs are 50% of the sales prices.
Required:
Calculate sales mix and quantity variances.
Market size and market share variances

The sales quantity variances can further be analysed into a component due to
changes in market size and a component due to changes in market share, provided
published industry sales statistics are readily available. These are effectively the
planning and operational components of the sales volume variance.
Market size variance:

The market size variance measures the variance in sales which is due to changes in
the overall market size. For example, the market size may have shrunk in the
industry due to poor economic conditions leading to fewer people buying the
product from any company.
The market size variance is calculated by comparing the budgeted sales with the
revised budgeted sales:
(Revised budgeted sales - original budgeted sales) x Standard contribution/unit

Market share variance:

The market share variance measures the variance in sales which is due to
operational decisions, ie operational factors which have caused sales volumes to
increase or decrease.
The market share variance is calculated by comparing t he revised budgeted sales to

actual sales:
(Actual sales - revised budgeted sales) x Standard contribution/unit
Example 4 Coffee Ltd

A company producing caffeinated drinks has noticed a slump in the market due to
public being more health conscious lately. In the past the company has always had
a market share of around 5% in the local market. The total market volumes
recorded by the department of trade and industry last year were 5 million units,
which has recently shown a slump of nearly 10%.
The following are extracts from financial records relating to its product.
Budgeted volume 250,000
Budgeted selling price $10 per unit
Budgeted variable cost $4 per unit
Actual volume 240,000
Actual selling price $9 per unit
Required:
Calculate the following variances:
1. Sales price and sales volume.
2. Market size and market share.


Chapter 8
Performance
evaluation
D Performance measurement and control
1. Performance management information systems

a) Identify the accounting information requirements and describe the different
types of information systems used for strategic planning, management control
and operational control and decision-making.
b) Define and identify the main characteristics of transaction processing
systems; management information systems; executive information systems;
and enterprise resource planning systems.
c) Define and discuss the merits of, and potential problems with, open and
closed systems with regard to the needs of performance management.
2. Sources of management information

a) Identify the principal internal and external sources of management accounting
information.
b) Demonstrate how these principal sources of management information might
be used for control purposes.
c) Identify and discuss the direct data capture and process costs of management
accounting information.
d) Identify and discuss the indirect costs of producing information.
e) Discuss the limitations of using externally generated information.

C HAP TE R 8 – P E RFO RMANC E E VAL UATI O N
3. Management reports
a) Discuss the principal controls required in generating and distributing internal
information.
b) Discuss the procedures that may be necessary to ensure security of highly
confidential information that is not for external consumption.
4. Performance analysis in private sector organisations

a) Describe, calculate and interpret financial performance indicators (FPIs) for
profitability, liquidity and risk in both manufacturing and service businesses.
Suggest methods to improve these measures.
b) Describe, calculate and interpret non-financial performance indicators (NFPIs)
and suggest method to improve the performance indicated.
c) Analyse past performance and suggest ways for improving financial and non-
financial performance.
d) Explain the causes and problems created by short -termism and financial
manipulation of results and suggest methods to encourage a long term view.
e) Explain and interpret the Balanced Scorecard, and the Building Block model
proposed by Fitzgerald and Moon.
f) Discuss the difficulties of target setting in qualitative areas.
6. Performance analysis in not for profit organisations and

the public sector
a) Comment on the problems of having non-quantifiable objectives in
performance management.
b) Explain how performance could be measured in this sector.
c) Comment on the problems of having multiple objectives in this sector.
d) Outline Value for Money (VFM) as a public sector objective.
7. External considerations and behavioural aspects

a) Explain the need to allow for external considerations in performance
management, including stakeholders, market conditions and allowance for
competitors.
b) Suggest ways in which external considerations could be allowed for in
c) Interpret performance in the light of external considerations.
d) Identify and explain the behaviour aspects of performance management.

CHAPTER CONTENTS
MEASURING FINANCIAL PERFORMANCE ---------------------------- 130

PROFITABILITY RATIOS 130
LIQUIDITY RATIOS 130
GEARING RATIO 130
NON FINANCIAL PERFORMANCE MEASURES ------------------------ 132
THE BALANCED SCORECARD ------------------------------------------ 133

CUSTOMER PERSPECTIVE 133
INTERNAL BUSINESS PERSPECTIVE 133
INNOVATION AND LEARNING PERSPECTIVE 134
F INANCIAL PERSPECTIVE 134
THE BUILDING BLOCK MODEL ---------------------------------------- 135

1. STANDARDS 135
2. REWARDS 135
3. DIMENSIONS 136
PERFORMANCE MEASUREMENT IN A NOT FOR PROFIT

ORGANISATION AND THE PUBLIC SECTOR -------------------- 137
OBJECTIVES OF A NOT FOR PROFIT ENTITY 137
DIFFIC ULTIES WITH MEASURING PERFORMANCE 137
MEASURING PERFORMANCE IN NOT FOR PROFIT ORGANISATIONS 138
VALUE FOR MONEY (VFM) --------------------------------------------- 139

T HE KEY TO VFM 139
PERFORMANCE MANAGEMENT INFORMATION SYSTEMS ---------- 140

ENTERPRISE RESOURCE PLANNING SYSTEMS (ERPS) 141

MEASURING FINANCIAL PERFORMANCE

Any financial ratios could be required by the examiner to assess the performance of
a company.
Profitability ratios
net profit
Return on Capital Employed =
capitalem ployed
net profit
Net Profit margin * =
sales
sales
Asset Turnover =
capitalem ployed
*alternatively you can use gross profit to calc ulate gross profit margin
Liquidity ratios
current assets
Current ratio =
current liabilities
current assets inventory
Quick (acid test) ratio =
current liabilities
Gearing ratio
debt
Gearing =
debt  equity
Example 1 (Dec 2007 extract)

Ties Only is a new business, selling high quality imported men’s ties via the
internet. The managers, who also own the c ompany, are prepared to take risks in
order for the company to grow. They are confident that importing quality ties and
selling via a website will be successful and that the business will grow quickly.
They were prepared for a loss-making start and decided to pay themselves modest
salaries (included in administration expenses). The owners are so convinced that
growth will quickly follow that they have invested enough money in website server
development to ensure that the server can handle the very high levels of predicted
growth. All website development costs were written off as incurred and are shown
in the profit calculation below.
Significant expenditure on marketing was incurred in the first two quarters to
launch both the website and the new produc ts. It is not expected that marketing
expenditure will continue to be as high in the future.
Customers can buy a variety of styles, patterns and colours of ties at different
prices.

The business’s trading results for the first two quarters of trade are shown below.
Quarter 1 Quarter 2
$ $ $ $
Sales 420,000 680,000
Less Cost of (201,600) (340,680)

Sales
Gross Profit 218,400 339,320
Website 120,000 90,000

development
Administration 100,500 150,640
Distribution 20,763 33,320
Launch 60,000 40,800

marketing
Other variable 50,000 80,000

expenses
Total expenses (351,263) (394,760)
Loss (132,863) (55,440)
Required:
Assess the financial performance of the business during its first two
quarte rs using the data given above. (12 marks)

NON FINANCIAL PERFORMANCE MEASURES

Measuring financial performance tells us WHAT has happened in terms of company
performance. This is a limited view of company performance as it only looks at
past performance and does not provide any indication of whether or not the
company will continue to succeed in the future.
Non financial performance indicators tell us HOW the company has achieved current
performance and WHY the company has been successful. By analysing company
performance in this way (in addition to financial performance), it gives us a fuller
understanding of the company’s prospects for the future.
Furthermore, by focusing only on financial performance, management may take a
very short term view of company success. For example, cost reduction measures
may be taken in order to improve measures of profitability in the current year.
However, these cost reduction measures may affect product quality and damage
company performance in the longer time. By including non financial performance
measures such as customer satisfaction in our analysis, management should be
more likely to focus on longer term success.

THE BALANCED SCORECARD

The balanced scorecard forces managers to look at the business from four
important perspectives.
It links performance measures by requiring firms to address four basic questions:
1. How do customers see us? – Customer perspective.
2. What must we excel at? – Internal perspective.

3. Can we continue to improve and create value? – Innovation & learning
perspective.
4. How do we look to shareholders? – Financial perspective.

The justifications of the balanced scorecard over the traditional measures are that:
● accounting figures are easily manipulated and as such may be unreliable
● changes in the business and market environment do not show in the financial
results of a company until much later. Factors other than financial
performance must therefore be targeted.
Customer perspective
● How do customers perceive the firm?
● This focuses on the analysis of different types of customers, their degree of

satisfaction, and the processes used to deliver products and services to
customers.
● Particular areas of focus would include:

o Customer service.
o New products.
o New markets.
o Customer retention.
o Customer satisfaction.
Internal business perspective

● How well the business is performing.
● Whether the products and services offered meet customer expectations.
● Activities in which the firm excels.

● And in what must it excel in the future?
● Quality performance.
● Quality.
● Motivated workforce.

Innovation and learning perspective

● Can we continue to improve and create value?
● In which areas must the organisation improve?

● Product diversification.
● % sales from new products.
● Amount of training.
● Number of employee suggestions.
● Extent of employee empowerment.
Financial perspective
● This is concerned with the shareholders’ view of performance.
● Shareholders are concerned with many aspects of financial performance.

● Amongst the measures of success are:
o Market share.
o Profit ratio.
o Return on investment.
o Economic value added.
o Return on capital employed.

o Cash flow.
o Share price.

THE BUILDING BLOCK MODEL

This model is particularly suited to service industries.
Fitzgerald and Moon divide performance measurement into three areas:

1. Standards.
2. Rewards.
3. Dimensions.
Dimensions
● Financial
performance
● Competitiveness
● Quality
● Flexibility
● Resource utilisation
● Innovation
Standards Rewards
● Ownership ● Clarity
● Achievability ● Motivation
● Equity ● Controllability
●
1. Standards
This refers to the targets that are set within the organisation. These should be :
● High enough to motivate.
● Be owned by the employees (through participation in target -setting).
● Be seen to be equitable.
2. Rewards
This refers to what the organisation (and the employee) is trying to achieve.
● The organisation’s objectives should be clearly understood.

● Employees should be motivated to work towards these objectives .
● Employees should be able to control areas over which they will be held
responsible.

3. Dimensions
This refers to how performance will be measured. The areas are :
● Financial
● Competitive performance
● Quality of service
● Flexibility
● Resource Utilisation
● Innovation.

PERFORMANCE MEASUREMENT IN A NOT FOR PROFIT

ORGANISATION AND THE PUBLIC SECTOR
In simple terms the basic objective of a not for profit is to provide a service without
making a loss, a profit or surplus simply being either a timing issue or a means to
an end.
Objectives of a not for profit entity

The objectives for such an organisation will differ widely from one organisation to
another. They may include one or more of the following:
● Client satisfaction
● Employee satisfaction (particularly when volunteers are a substantial part of

the workforce)
● Maximisation of surplus (perhaps to assist in growth or protect against loss of
future funding)
● Growth
● Usage of facilities (for example library services)
● Maintenance of capability (for example a fire service or army).
Difficulties with measuring performance

As noted above, a not for profit organisation will have non-financial objectives and
may have more than one objective (multiple-objectives).
For example, the objectives of a charity would be to minimise costs and to
maximise the benefits provided to the beneficiary of the charitable activity.
This creates two difficulties in relation to performance measurement:

1. How c an the objectives be prioritised? In particular if there is conflict between
some of the objectives.
2. How can non-quantifiable objectives be measured?

For a charity, it may be difficult to keep costs low while at the same time improving
the benefits provided to the beneficiaries of the charity. Measuring the benefits
provided will also be very difficult as this is not something which can be quantified.

Measuring performance in not for profit organisations

In order to establish meaningful measures within such an environment we can
employ the following solutions:
1. Input measurement
In the absence of easily measured output then more consideration can be put
into the costs and resourcing of an organisation.
2. Independent scrutiny and target setting

There is need for fine judgement when setting qualitative targets. By use of
independent experts then measures can be set that reflect performance levels
appropriate without introducing bias.
3. External comparison
A powerful assessment of the performance of an organisation is to benchmark

that performance in relation to similar organisations. This allows for both
historical results to be used but also best practice measures to be developed.
4. Value for money

See next section.

VALUE FOR MONEY (VFM)

Value for money is a framework by which not for profit organisations can be
measured. It separates the performance of the business into three areas – the
three Es:
1. Effectiveness
2. Efficiency
3. Economy
1. Effectiveness (an output measure)

This may be described as how well the organisation meets its objectives. Perhaps
an easier way of understanding it would be to see how well the output of services
match the client need.
2. Efficiency (the relationship between input and output)

This describes how well resources are utilised; it measures the output of services
for a given level of resource or input.
3. Economy (an input measure)

This considers the cost of sourcing the input resources. The aim being to minimise
the costs of the input for a given standard and level of resource.
The key to VFM

The key to VFM is to understand that performing in a single area is not sufficient,
instead the organisation must achieve in relation to all three aspects in order to
provide value for money.

PERFORMANCE MANAGEMENT INFORMATION SYSTEMS
Strategic 0 Executive information system
Tactical Management information

0 system
Operational 0 Transaction
processing system
Transaction Processing Systems (TPS)

A TPS captures, stores, batch processes and summarises routine transactions and
other accounting data. It is mainly used at operational level of management.
Inventory and Ledger records are good examples of routine TPS.
Management Information Systems (MIS)

A MIS converts data from internal sources into information to aid managers make
decisions. Information from these systems tends to be used by tactical managers.
It maybe manual or automated, but mostly it is automated to timely process the
data to be used in decision making. The MIS will include information from the TPS
as well as other internal information such as Human Resource information (e.g.
staff surveys)
Executive Information Systems (EIS)

An EIS aids strategic decision making by providing internal and external information
which is relevant to the critical success factors of the organisation. EIS will include
the internal information from MIS. It will also include external information such as
government data or trade reports.
The external information must be from a reliable source.

Enterprise Resource Planning Systems (ERPS)

An ERP system is a computer syst em that pulls together information from all parts
of the organisation and provides more integration between different parts of the
company.
Involves the planning of:
● manufacturing
o planning for production
o planned purchasing of materials
o quality management and control

● sales and distribution
o management of sales orders and customers
o transportation and shipping

● accounting
o accounts receivables and payables
o budgeting
o standard costing
● human resources
o training
o recruitment
o employee development.


Chapter 9
Divisional performance
and transfer pricing
5. Divisional performance and transfer pricing

a) Explain and illustrate the basis for setting a transfer price using variable cost,
full cost and the principles behind allowing for intermediate markets.
b) Explain how transfer prices can distort the performance assessment of
divisions and decisions made.
c) Explain the meaning of, and calculate, Return on Investment (ROI) and
Residual Income (RI), and discuss their shortcomings.
d) Compare divisional performance and recognise the problems of doing so.

C HAP TE R 9 – DIVISIO NAL P E RFO RMAN C E AND TRANSFE R P RIC ING
CHAPTER CONTENTS
DIVISIONALISATION -------------------------------------------------- 145
MEASURING DIVISIONAL PERFORMANCE --------------------------- 146

RETURN ON INVESTMENT 146
RESIDUAL INCOME (RI) 147
BEHAVIOUR ISSUES 148
SHORT-TERMISM AND DEPRECIATION OF ASSETS 148
MANAGEMENT FRAUD 148
TRANSFER PRICING ---------------------------------------------------- 150

WHAT IS A TRANSFER PRIC E? 150
BENEFITS OF TRANSFER PRICING 150
T RANSFER PRICES 151
WHO DETERMINES THE TRANSFER PRIC E? 151
T RANSFER PRICING 152

DIVISIONALISATION
Decentralisation refers to delegating responsibilities to divisional managers or unit
heads.
Advantages
● It increases motivation of the divisional managers as they feel involved in the
decision making of the organisation.
● It is a form of training for the divisional managers and it easy for them to rise
through the ranks to strategic positions.
● It should promote goal congruence (see later), as all decisions been taken are
all geared towards achieving the objectives of the whole organisation.
● It drastically reduces the time taken to make decisions.
Disadvantages
● Divisional managers may make dysfunctional decisions (decisions that are not
in the best interests of the organisation).
● There is a need for a performance appraisal system to assess the performance
of individual managers.
● Top management may lose control by delegating decision making to divisional

managers, since they are not aware of what is going on in the whole
organisation.
● Lack of economies of scale. For example, efficient cash management can be

achieved much more effectively if all cash balances are centrally controlled.

MEASURING DIVISIONAL PERFORMANCE

The basic measure of performance for a division is profit. The measure of profit
that is used is normally related to operating profit or PBIT – this being the measure
that is within the control of operational management.
When assessing the performance of a manager it is important to only assess the
manager on a profit measure that is within the control of the manager. This means
that any costs or revenues that are outside the control of the manager should be
excluded.
In practice the obvious uncontrollable cost for a division would be apportioned head
office costs on the basis that the incurrence of cost is controllable by head office
and is charged in an arbitrary manner to the division.
When looking at an investment centre the manager is able to control the amount of
investment in the division. It is normal to assess the performance of profit in
relation to investment made by head office in the division using either return on
investment (ROI) or residual income (RI)
Return on investment
profit beforeinterestand tax
ROI =  100
capitalem ployed
If return on investment is greater than the cost of capital (or target return where
given), then divisional performance has been good (based on ROI).
Advantages of ROI
1. It is easy to understand and easy to calculate.
2. ROI is still the commonest way in which business unit performance is
measured and evaluated, and is certainly the most visible to shareholders.
3. Managers may be happy in expressing project attractiveness in the same

terms in which their performance will be reported to shareholders, and
according to which they will be evaluated and rewarded.
Disadvantages of ROI
1. It fails to take account of the project life or the timing of cash flows and time
value of money within that life.
2. When assets are valued at net book value, reported performance improves
with time as the assets get old. In this case there is a disincentive to invest
in new assets.
3. It uses accounting profit and capital employed, hence subject to manipulation

due to various accounting conventions.

Residual income (RI)

RI = profit - (capital employed x the cost of capital)
If residual income is positive, then divisional performance has been good (based on
RI).
Advantages of residual income

Residual income overcomes many of the problems of ROI:
● It encourage investment centre managers to undertake new investments if
they add to residual income.
● As a consequence it is more consistent with the objective of maximising the
total profitability of the c ompany (promotes goal congruency).
● It is possible to use different rates of interest for different types of asset.
Disadvantages of residual income

● Like ROI, residual income is also based on accounting profit and capital
employed which can be manipulated.
● It encourage investment centres managers to think in the short -term about
how to increase next year’s residual income for the centre, hence does not
encourage decision making for long-term.
● Residual income is not as widely used as the ROI despite overcoming some of
the problems in ROI.
Example 1 Tata
Tata is a division of Tatan group. Its manager has the authority to invest in new
capital expenditure, within limit set by head office. The senior management team
of the division is considering an investment of $4.2 million. This would have a
residual value of zero after four years. Net cash flows from the investment would
be $1.4 million for each of the next four years.
The cost of capital for the Tata division is 10%. It is the group’s policy to use
straight-line depreciation when measuring divisional profit.
For measuring purpose and reporting purposes, capital is defined as the opening
net book value at the start of each year.
Required:
(a) Calculate residual income each year.
(b) Calculate the return on investment each year.

Behaviour issues
In decision making, managers should not use measures like ROI and RI. However,
generally the aforementioned measures are used in performance measurement;
therefore managers tend to include these in their assessments of new projects.
Assessing divisional performance using ROI or RI may lead to the following
behavioural issues:
● Short termism.
● Management fraud.
● Disputes in relation to transfer prices. (see next section).
Short-termism and depreciation of assets

However the performance is appraised, it is normal to appraise divisional managers
over one year. When using ROI and RI the investment will fall in value over time
as a result of depreciation. This has the impact of increasing the reported
performance for each year that investment is not made within the division.
A cynical manager could improve their perceived performance simply as a result of
deferring investment and using increasingly outdated assets. This could well have
adverse consequences to the business including:
1. Poorer quality output due to worn out machines.
2. Higher risk of machine breakdown.
3. Using outdated technology.
Management fraud
Having a single profit measure or relatively few related measures of performance
appraisal allows managers to manipulate the figures underpinning these measures.
In simple terms the manager only needs to overstate profits in a period or
understate the investment.
Simple ways to overstate of profits

1. Phasing of apportioned costs to charge fewer costs during the period.
2. Revenue recognition of sales in previous periods or future periods.
3. Ignoring part of the cost base.

4. Incorporate sales from other divisions.
5. Double count sales.
To reduce the opportunity for fraud a range of performance measures should be

used that are inter-linked. They will make it more difficult for managers to
manipulate the figures for personal gain.

Example 2 Tonic Ltd

There are two divisions with the following performance for the current year
Division X y
Investment ($m) 10 30
Controllable Profit ($m) 2 3
Required rate of return 15%
Required:
Calculate the performance of each division based using:
(a) ROI
(b) RI
Which division has superior performance?
Example 2 contd
Continuing from the previous example each division has the opportunity to invest in
a new project.
Division X y
Investment ($000s) 500 1,000
Controllable Profit ($000) 80 120
Required rate of return is 15% (set by the head office).
Assume cost of capital to be 15%.
Required:
Using the measures of performance above assess the decisions that would
be made by:
(a) the divisional managers;
(b) head office;
(c) whether the decisions are congruent with each other.

TRANSFER PRICING
Transfer pricing is used when divisions of an organization need to charge other
divisions of the same organization for goods or services they provide to them.
What is a transfer price?
Buying
Supplying Division
Division
The supplying division provides some product or service to the buying division.
The supplying division may also sell this product to external customers.
The buying division pays the supplying the division for the product which has
been provided. The price the buying division pays is called the transfer price.
Note that transfer pricing is an internal activity which does not affect the company’s
overall financial performance. However, the transfer price will affect division
performance as the transfer price is revenue for the supplying division and a cost to
the buying division.
Benefits of transfer pricing
Goal congruent decision making

Any decision by the management to improve the performance of either of the
divisions must also improve the performance of the company as a whole.
“Fair” performance measurement

The transfer price used will normally have a substantial effect on the distribution of
profit between divisions, it is important that this distribution is seen to be equitable
to all parties.
Minimising global tax liability

If transactions occur within one tax regime little can be gained by manipulating
transfer prices. A multinational organisation can and will use transfer pricing to
move profits “round the world” either to a low tax regime or alternatively to the
country of the holding company.

Recording the movement of goods and services

An important function of transfer pricing is simply to record movement of goods
and services in financial terms.
Transfer prices
There are a number of different transfer prices which could be used:
● External market price.
● Marginal cost of production.
● Full cost of production.

● Full cost + margin/mark up.
We can assume that the supplying division will want the transfer price to be as high
as possible, whereas the buying division will want to transfer price to be as low as
possible. The transfer price will be somewhere within the following range:
1. Minimum transfer price will be the marginal cost of production for the
supplying division. They will not provide units of product if the marginal costs
are not covered.
2. Maximum transfer price will be the lowest market price at which the buying
division could purchase the units externally, less any savings made from
selling the units internally. The buying division will not purchase the units
internally if it is possible to get a cheaper price externally.
It may be difficult to select the ‘fairest’ transfer price between the two extremes.
Generally, a fair transfer price will be:
1. The market price if an external market for the product exists (less any savings
made from selling internally)
2. If there is no external market price, then a fair transfer price would be the
opportunity cost to the supplying division of producing the units.
Who determines the transfer price?

Transfer prices may be decided by head office, or negotiated between divisional
management.
Advantages of head office determined transfer prices:

● Faster than divisional negotiations
● Reduces conflict between divisions
● More likely to result in a ‘fair’ transfer price

Advantages of negotiation between divisional managers:
● Maintains divisional autonomy.

Transfer pricing and performance

The setting of the transfer price will have no direct impact on the overall
performance of the company but a very real impact on individual divisional
performance.
The setting of transfer prices will therefore be highly political. The manager can
improve his own reported performance more easily by arguing for a better transfer
price than in any other way.
If the transfer price is too high, the supplying division will benefit at the expense of
the buying division (and vice versa). This would be demotivating for the buying
division manager.

Example 3 Transfer pricing

Furniture Co manufactures and sells luxury couches. Each couch is produced using
a standard frame and other covering materials. Within the company, Division R
manufactures the standard frames which are then sold on to Division S as well as
to external customers. Division S produces fully completed couches which are sold
to external customers only. Both of the divisions have performance assessed
based on Return on Investment (ROI). The required rate of return is 15%. The
following information is available for the previous year.
Division R Division S
$000’s $000’s
Sales External@$900/unit 4,500 External 5,300
Internal@$900/unit 1,800 -
Production Variable@$300/unit 2,100 Standard 1,800

costs frames@$900/unit
Other
1,400
materials@$700/unit
Fixed 1,400 Fixed 600
Selling and Variable@$100/unit 500 Variable@$120/unit 240

distribution
Fixed 400 Fixed 200
Controllable profit 1,900 1,060
Divisional net assets 10,000 7,800
Division R variable selling costs are only incurred where sales are made to external
customers.
Required:
(a) Calculate ROI for each division and comment briefly on the
performa nce of eac h. (3 marks)
(b) The transfer price was established a number of years ago. Head office will
only allow Division S to purchase the frames from Division R, although the
manager of Division S believes the frame could be purchased externally for
$825.
Calculate the total company profits if Division S is allowed to

purc hase the frames externally. (6 marks)
(c) Explain how transfer pricing policies may result in managers taking
decisions which are not in the best interest of the company.
Recommend a suita ble tra nsfe r price for Furniture Ltd. (6 marks)
(15 marks)


Solutions to exercises
and examples

SO L U TIO NS TO E XE RC ISE S AND E XA MP L E S
CHAPTER 1
Example 1 Hensau Ltd
(a) (i) Cost per Unit ($)

X Y Z
Direct materials 5 3 6
Direct labour 1.6 2.7 4
------ ----- ------
6.6 5.7 10
Production Overheads 7.5 12.5 18.75
------ ------- --------
Total Cost per unit 14.1 18.2 28.75
(a) (ii)
Cost Drivers Calculation:
Number of batches
X 10
Y 5
Z 16
Total 31
Number of drill operations:
X 2,000 x 6 = 12,000
Y 1,500 x 3 = 4,500
Z 800 x 2 = 1,600
Total 18,100
Quantity of materials:
X 2,000 x 4 = 8,000
Y 1,500 x 6 = 9,000
Z 800 x 3 = 2,400
Total 19,400
Cost Driver rate Calculation:

Material receipts and inspections $15,600 / 31 $503.23 / batch
Power $19500 / 18100 $1.08 / drill ops
Material Handling $13,650 / 19400 $0.70 / sq. Meter
Cost Per Unit ($)

X Y Z
Prime Costs 6.6 5.7 10
Overheads:
Material receipts 2.52 1.68 10.06
Power 6.48 3.24 2.16
Material Handling 2.8 4.20 2.10
------- ------- --------
Cost per unit 18.4 14.82 24.32

SO L UTIO NS TO E XE RC IS E S AND E XAMP L E S
OR
Drivers
Drivers X Y Z TOTAL
Batches of material 10 5 16 31
Drill operations (2000 x 6) (1,500 x 3) (800 x 2)

12,000 4,500 1,600 18,100
Material Handing (2,000 x 4) (1,500 x 6) (800 x 3)
8,000 9,000 2,400 19,400
Cost Pool X Y Z TOTAL

Material receipts and (10/31 x 15,600)
inspections
5,032 2,516 8,052 $15,600
Power (12,000/18,100 x
19,500)
12,928 4,848 1,724 $19,500
Material handling (8,000/19,400 x
13,560)
5,592 6,290 1,678 $13,560
Total 23,552 13,654 11,454
Divide by units (23,552/2,000) (13,654/1,500) (11454/800) 48,750

11.78 9.10 14.32
Cost Per Unit ($)

X Y Z
Prime Costs 6.6 5.7 10
Overheads 11.78 9.10 14.32
------- ------- --------
Cost per unit 18.38 14.80 24.32
(b)
Relevance of cost drivers in ABC environment:
The basic principle in developing an ABC model is to establish a relationship
between the manufacturing activities and the cost generat ion. This is best
described as “cause and effect” relationship. It is only possible and fruitful exercise
if the production process is divided into clear sub activities, where the cost effect
can be fairly linked. Linking the right activity with the true cost driver makes the
cost allocation fairer, and hence, better product costing and pricing.
Overhead costs are so complex in reality that finding a true relationship between
every single overhead cost to the relevant activity may be difficult enough, and
therefore, for many general overhead costs, we still apply absorption costing
principles adopting labour or machine hours to charge overheads to the products.
ABC in modern manufacturing environment:

Production has become a more complex model as compared to simple
manufacturing environments many years ago. This has been due to following
changes over period of time:
1. Improvement in science and technology, bringing better and efficient
production methods, saving time and money.

2. Reduced reliance on the manual techniques, using automated manufacturing

support and even robotics in manufacturing process.
3. Volume of products has increased many times

4. Number of product lines has increased many folds.
5. Proportion of overhead costs as compared to direct costs has increased
considerably.
Due to all above issues, simple absorption costing finds it difficult to truly relate
overhead costs to various products relying only on the number of machine or labour
hours etc. ABC has helped businesses to create a cause and effect relationship, so
that overhead costs can be fairly linked to various product lines.
Example 2 Happy Now Ltd
(a)
A bottleneck is the activity or resource which limits company production activity.
Machine 2 is the bottleneck. This is because all products take the longest amount
of time in Machine 2. Production will be limited to the quantity of units which can
be produced in Machine 2.
NOTE: Calculations are NOT required to answer this question as it is clear

that Machine 2 is the bottleneck. However, if it is not clear in the question
asked, the following calculations can be performed to establish the correct
bottleneck.
Total machine hours required for each product

X Y Z
Sales demand 200 200 200
Required machine hours:

Machine 1 (6, 2, 1) 1,200 + 400 + 200 = 1,800
Machine 2 (9, 3, 1.5) 1,800 + 600 + 300 = 2,700
Machine 3 (3, 1, 0.5) 600 + 200 + 100 = 900
Required hours as a percentage of hours available

Machine 1 1800/1600 = 112%
Machine 2 2700/1600 = 169%
Machine 3 900/1600 = 56%
Machine 2 represents the bottleneck activity because it has the highest machine
utilization.

(b)
Calculation of return per factory hour
Sales- direct m aterialcost

Usagein hours of bottleneckresource
X Y Z
Sales 20 15 10
Direct materials 8 5 4
Throughput 12 10 6
Usage in hours of bottleneck 9 3 1.5
Return per factory hour 1.333 3.333 4
Cost per factory hour

Totalfactory cost
bottleneckresourcehours available
Total factory cost (labour and overheads)

X Y Z
Factory cost per unit (5+2), (3+1),(2+1) = 7 4 3
Units 200 200 200
Total factory cost 1,400 800 600 = 2,800
Cost per factory hour 1.75 1.75 1.75
Cost per factory hour = $2,800/ 1600 = $1.75
Throughput accounting ratio

Returnper factoryhour
Costper factoryhour
X Y Z
Return per factory hour 1.33 3.33 4.00
Cost per factory hour 1.75 1.75 1.75
Throughput accounting ratio 0.76 1.90 2.29
Ranking 3 2 1

(c)
The allocation of the 1,600 hours of the bottleneck activity is:
Production Machine hours balance of hours available
200 units of Z 300 1,300
200 units of Y 600 700
77 units of X 700 -
The maximum profits to be generated from the above production plan would be as
follows:
Throughput Return: $
200 units of Z x $6 1,200
200 units of Y x $10 2,000
77 units of Xx $12 924
Total Throughput 4,124
Less: Total factory cost 2,800 ($14 x 200 units)

Net profit $1,324

Example 3 Fantata Ltd
(a) Target Cost

Target selling price 75
Target profit margin @ 12% (9)
Target Cost 66
(b)
Expected current cost per unit: $
Direct materials 20
ABC conversion cost
Assembly 20
Finishing 12
Head office fixed cost 18.33
Total expected current cost per unit 70.33
Cost Gap (70.34 – 66) 4.33
(c)
The company is falling considerably short of its 12% net profit margin target. If
sales quantities and prices are to remain unchanged, costs must be reduced if the
required return is to be reached.
Cost reduction methods exercise must be concentrated particularly on this product
if its production is to continue to be seen to be worthwhile.
The designed specification for each product and the production methods should be
examined for potential areas of cost reduction that will not compromise the quality
of the products. For example:
● Can any materials be eliminated, eg cut down on packing materials?
● Can a cheaper material be substituted without affecting quality?
● Can part assembled components be bought in to save on assembly time?

● Can the incidence of the cost drivers be reduced?

Example 4 Aeonplc
(a)
Approach 1
Life-time costs are:
Approach 1 $
Development costs 1,250,000
Clean-up costs 50,000
Variable manufacturing c osts 6,250,000
5 x 25 x 50,000
Repairs and warranty costs 125,000
5 x 50,000 x 1% x 50
Total costs 7,675,000
Approach 2 $
Development costs 2,350,000
Clean-up costs 30,000
Variable manufacturing costs 6,000,000
6 x 20 x 50,000
Repairs and warranty costs 45,000
6 x 50,000 x 0.5% x 30
Additional fixed costs 120,000
20,000 x 6
Total costs 8,545,000
Approach 1
Total revenue = 5 x 50,000 x $50 = 12,500,000
Total costs = 7,675,000
Total profit = 4,825,000
Approach 2
Total revenue = 6 x 50,000 x $50 = 15,000,000
Total costs = 8,545,000
Total profit = 6,455,000
Therefore, Approach 2 is preferable as it yields the higher total profits.
(b)
Target cost = 60% x $50 = $30
Approach 1 cost per unit = 7,675,000/(5 x 50,000) = $30.70
Approach 2 cost per unit = 8,545,000/(6 x 50,000) = $28.48
Approach 2 produces product below the target cost, but with Approach 1 there is a
cost gap of $0.70/unit.
This cost gaps could potentially be closed by:
● Reducing the development costs – though there might be adverse knock-on

effects in the variable cost of production or in repair/warranty costs.
Development costs would have to reduce by 0.7 x 5 x 50,000 = $175,000,
which is 14% of estimated costs.

● Reducing the clean up costs – though completely eliminating those would save
only $50,000/(5 x 50,000) = $0.20 per unit.
● Increasing the production run length. The variable costs relate to variable
manufacturing and warranty costs, and these amount to 6,375,000 over
250,000 units = $25.50 per unit. This leaves a maximum cost of $4.50 per
unit for the development costs and clean-up costs. Therefore, the required
production would be: 1,300,000/4.50 = 288,889 units.
If production stayed at 50,000 per year, then a production run of 5.78 years
would achieve the required target cost.
● Reducing the variable production costs per unit by $0.70. For example, by
negotiating a better deal with suppliers or attempting to use less labour on
each item.
(c)
Life-cycle costing is particularly important in high-technology mass production
industries because:
● Development costs are likely to be substantial – new products are complex.
Therefore, these must not be ignored.
● Once a product is designed then the company will be committed to many

future costs and it is too late to make substantial savings at the production
stage. If a product is badly designed so that it is overly complex and difficult
to make, efficient production can do little to reduce costs.
● The machinery used to make the product is likely to be specialist and so it s
cost must also be included.
● High-tech products often have short lives, so it is important to estimate if all

costs can be covered by revenue and to see how a product’s life might be
extended.
Complex production technology can often produce toxic by -products and the
disposal of these must be taken into account.

CHAPTER 2
Example 1 Tricks
Revised estimate: $
Direct materials- paper (opportunity cost) 2,500
Inks(full purchase value) 3,000
Direct Labour: Highly skilled (125 x 4 + 125 x 5) 1,125

Semi skilled (idle capacity) 0
Variable overheads (as per original 1,400

Printing press(200 hours x 3.00) 600
Fixed production costs (not relevant) 0
Estimating department costs (not relevant) 0
Total relevant cost (minimum price) 8,625
NOTES
Direct materials – paper

The book value is not relevant as this is a sunk cost (money spent in the past).
The replacement value is not relevant as the paper has no other use to the
company. The sales value is relevant as this is the opportunity cost (revenue lost
by using the paper in the order).
Direct materials – inks

As there is no alternative use for the unused ink, the full cost is a relevant cost.
Direct labour – highly skilled
As there is no spare capacity, t he variable cost of the full 250 hours is relevant at
$4/hour. In addition, the overtime is an incremental cost of accepting the order.
Direct labour – semi skilled
Semi skilled labour cost is not relevant as:

● 7.5 hours are taken from midweek idle time (t his would be paid for anyway).
● The 25 hours weekend time equates to 25 x 2 = 50 hours midweek which is
also taken from idle time.
Variable o/h
This varies proportionately with activity so is relevant.
Printing press
The relevant cost of the printing press is the contribution lost (opportunity cost).
Fixed production o/h
These costs will be incurred regardless of this order so are not relevant.

Estimating costs
These are sunk costs so are not relevant.
Example 2 Jones Ltd

If Division C is shut down as per the CEO’s concerns, the following would be the
financial impact on the company.
Revenue earned in division C 40,000
Variable costs (30,000)
Division specific fixed costs (8,000)

Profit earned from division C 2,000
Decision: Division C should not be closed down as this would reduce company
profits by $2,000.
Example 3 CF Ltd
The joint processing costs are irrelevant to the decision. They will be incurred
whether product X is sold for $1.10 per litre or is processed further to make Zplus.
The analysis of relevant cash flow is as follows:
Every 4,000 litres of product X can be further processed to make 3,600 litres of
Zplus.
$ $
Revenue from sale of 3,600 litres of Zplus @ $1.4 5,040
Revenue from sale of 4,000 litres of X @ $1.1 4,400
Incremental revenue from further processing 640
Incremental cost of further processing

Added materials 400
Direct labour 40
Variable production overheads 80
520
Incremental gain from further processing 120
This analysis assumes that there would be no additional fixed costs from further
processing, and that no capital expenditure would be required to make further
processing possible.
Example 4 Central Ltd
The relevant costs are the differential costs between making and buying, and they
consist of differences in unit variable costs plus the differences in directly
attributable fixed costs.
W X Y Z
$ $ $ $
Unit variable cost of making 14 17 7 12
Marginal cost of buying $12 $21 $10 $14
Decision Buy Make Make Buy

Example 5 Neal Ltd
Step 1: Calculate the extent of Limiting factor (shortage)

Product M 600 units x 8 hours/unit = 4,800 hours
Product N 500 units x 3 hours/unit = 1,500 hours
Total hours required = 6,300
Hours available = 5,000
Shortage = 1,300 hours
That explains that hours at present are not sufficient to fulfil demand for both
products so we will have to develop the optimal production plan using 5,000 hours
which maximises the profit.
Step 2: Calculate contribution per unit M N
24 15
Step 3: Calculate contribution per hour 3/hour 5/hour

Ranking 2 1
Step 4: Develop optimal (most profitable) production plan using 5,000 hours
Product 1 (N) 500 units x 3 hours per unit = 1,500 hours

Leaving 3,500 remaining hours to be allocated to product 2 (M)
3,500 hours / 8 per unit = 437 units
Step 5: Total contribution from M and N
M 437 unit x 24 per unit 10,488
N 500 units x 15 per unit 7,500
Total contribution 17,988
Less fixed cost 10,000*
Total profit 7,988
*Fixed cost (M =10 x 600 + N = 8 x 500)

Example 6 WXYZ Ltd
Are the materials a limiting factor?

W X Y Z
Units 2,000 4,000 3,000 1,000
Materials (kilos) per unit 2 1 1.5 2.5
4,000 4,000 4,500 2,500 = 15,000
Available = 11,000
Shortage = 4,000
Therefore materials are a limiting factor.
W X Y Z
$ $ $ $
Variable cost per unit to make 17 7 12 19
Cost of buying 20 11 15.75 21.5
Savings if made internally 3 4 3.75 2.5
Materials per unit 2 1 1.5 2.5

Savings per kilo 1.5 4 2.5 1
Ranking 3rd 1st 2nd 4th
The make or buy decision should be as follows, to maximise contribution and profit.
Total
Products Units Materials(Kilos) Contribution/unit
contribution
$ $
Make
X 4,000 4,000 4 16,000
Y 3,000 4,500 6 18,000
W (balance) 1,250 2,500 12 15,000
11,000 49,000
Buy
W (balance) 750 9 6,750
Z 1,000 9 17,500
Total
73,250
contribution

Example 7 Linear programming
Define the unknowns

Let x = number of units of X produced
Let y = number of units of Y produced
Objective function
Z = 4x + 8y
Where Z = total contribution
Constraints
(Dept A hrs) 8x + 10y  11000
(Dept B hrs) 4x + 10y  9000
(Dept C hrs) 12x + 6y  12000

(non-negativity) x, y ≥0
Graph
If we know the constraints we are able to plot the limitations on a graph identifying
feasible and non-feasible regions. The linearity of the problem means that we need
only identify two points on each constraint boundary or line. The easiest to identify
will be the intersections with the x and y-axes.
For example:
Dept A hrs – equating the formula 8x + 10y = 11,000
If x = 0 then y = -1,100 Co-ordinates (0, 11,00)

If y = 0 then x = 1,375 (1,375, 0)
And hence:
Dept B hrs – 4x + 10y = 9,000 (0, 900) (2,250, 0)

Dept C hrs – 12x + 6y = 12,000 (0, 2,000) (1,000, 0)
By plotting the individual constraints we build up an area of what is possible within
all the constraints, ie the FEASIBLE REGION.
The ISO contribution line can be established by select ing an arbitrary value for Z.
Suppose Z = 3,000. The objective function would be:
4x + 8y = 3,000.
If x = 0, then y = 375
If y = 0, then x = 750

2500
U
n
2000
i
t
1500
s
1000
o
f
500
Y
0
0 500 1000 1500 2000 2500
Units of X
Identify the optimal solution
The ISO-contribution (IC line) line is plotted identifying points of equal c ontribution.
The linear nature of the problem means that this line will be a straight line
identifying an inverse relationship between the two products.
The IC line is of importance because the relationship of the contribution earned by

each product is constant (ie $4 for X against $8 for Y). This means that the
gradient of the line will remain constant as the total contribution figure gets larger
or smaller.
If we ‘push out’ the IC line to the point where it leaves the feasible region, that
point will be the point of maximum contribution.
The optimal solution can now be found by interrogating the point at which the IC
line leaves the feasible region to identify the co-ordinates and hence the product
mix and maximum contribution.
The intersection or VERTEX identified is where two constraints meet, those

constraints can be solved simultaneously to identify the product mix.
a 8x + 10y = 11,000
b 4x + 10y = 9,000
(a – b) 4x = 2,000
x = 500
y = 700
Therefore the optimal product mix is to make and sell 500 units of X and 700 units
of Y. The maximum contribution is (500 x 4 + 700 x 8) = $7,600.

Shadow prices
Department A:
If one more hour was available (ie 11,001 hours), the constraint of department A
will relax outward slightly which should improve the overall optimum solution.
Solve the new constraint equations:
Dept A 8x + 10y = 11,001
Dept B 4x + 10y = 9,000
Solving these equations:
X = 500.25 and y = 699.9

New maximum contribution = 4x500.25 + 8x699.9 = $7600.2
Shadow price of Dept A = $7600.2 - $7600 = $0.2/hour
Department B:
If one more hour was available (ie 9,001 hours), the constraint of department B will
relax outward slightly which should improve the overall optimum solution.
Solve the new constraint equations:

Dept X 8x + 10y = 11,000
Dept Y 4x + 10y = 9,001
4x + 0 = 1,999
Revised solution x = 499.75, y = 700.2
Revised contribution 499.75 x 4 + 700.2 x 8 = $7600.6

Shadow price $7,600.6 - $7,600.0 =$0.6/hour
Department C Slack
This can be checked by seeing how much of the constraints are used up, based on
the existing optimum production schedule:
Dept hours used hours available
C 500 x 12 + 700 x 6 = 10,200 hours 12,000 hours

The slack for department C = 12,000 hours – 10,200 hours = 1,800 hours
Example 8 Single Product Ltd
Break even points =

200,000 / 20 = 10,000 units
Margin of safety =
(15,000 – 10,000)/15,000 x 100% = 33%
CS Ratio = 20/50 = 0.4
Target profit = $250,000

Target contribution = 250,000 + 200,000 = $450,000
Target volumes = $450,000 / 20 = 22,500 units

Example 9 CVP Ltd
(a)
Budgeted profit:
$
Pins 3,000 units x $6/unit = 18,000
Numbs 2,000 units x $3/unit = 6,000
Needles 1,000 units x $1/unit = 1,000
25,000
(b)
Totalfixedcosts
Breakeven revenue =
Weightedaveragec/s ratio
Total fixed costs = ($2 x 3,000) + ($3 x 2,000) + ($6 x 1,000) = $18,000
$8  3,000  $6  2,000  $7  1,000
Weighted average c/s ratio =
$12  3,000  $14  2,000  $9  1,000
= $43,000 / $73,000 = 0.589 or 58.9%
Break even revenue = $18,000 / 58.9%
= $30,560 (rounded)
Budgetedsales- break evenrevenue 100

Margin of safety =
Budgetedsales
= $73,000 - $30,560 / $73,000
= 58.14%
(c)
C/S ratios for each product:

Pins Numbs Needles
$8/$12 $6/$14 $7/$9
66.67% 42.86% 77.78%
From the above c/s ratios, Needles has the highest c/s ratio, Pins has the second
highest whereas Numbs with the lowest one. Therefore, the products should be
produced in the above preference to maximise profits and to reach the break even
point more quickly.
(d)
Workings:
Breakeven point with priority production plan:

Total fixed costs: $18,000
Contribution from Needles $7,000
Contribution from Pins required to break even $11,000
Therefore total contribution required to break even using above plan will be
calculated as follows:
Revenue from Needles = $9,000
Revenue required from Pins = $11,000/$8 x $12 $16,500
$25,500

Graph:
Profit
($)
25,000
13,000 x
(ii)
BEP
(25,500)
x x x x x
9,000 B BEP 45,000 73,000 Sales Revenue ($)
(30,560)
(i)
Loss x
A
($)
18,000 Fixed Cost
A – Needles
B - Pins
C - Numbs

CHAPTER 3
Example 1 Biscan
25 = a – (b x 500)
b = 5/200 = 0.025
25 = a – (0.025 x 500)
A = 37.50
So:
P = 37.50 – 025Q
Example 2 Mellor
(a)
12.50 = a – (b x 20,000)
b = 1.50/(20,000 x 20%) = 0.000375
12.50 = a – (0.000375 x 20000)
a = 20
So:
P = 20 – 0.000375Q
(b)
PxQ =
If price = $12.50
12.50 x 20,000 = $250,000

If price = $11
11.00 x (20,000 x 1.2) = $264,000
(c)
The MD is correct in that revenue will increase if more units are sold at a lower
price. However, this does not necessary mean that profits will increase. More
information would be needed on the costs incurred. If there is a step up in fixed
costs when activity exceeds a certain level, then profits may not increase due to the
higher volumes.

Example 3 Spearing
% changeQ
% changeP
Annual demand at $1.20 = 800,000 units
Annual demand at $1.30=725,000 units
 75,000 
  100
Elasticity of demand  800,000  = -1.125
 0.10 
  100
 1.20 
Ignoring the negative sign, the elasticity of demand is 1.125.
The demand will therefore be elastic, because the price elasticity of demand is
greater than 1.
Example 4 Kozma
(a) Demand Curve (function)
P = a – bQ (given in formulae sheet)

First we need to calculate b = change in price / change in quantit y
10 - 8 / 1,000 – 1,500
= 2/500
= 0.004
Now substitute any price and demand pair given in the question
$10 = a – 0.004 x 1,000
a = 14
So P = 14 – 0.004Q
(b) Now we equate MC = MR (MR = a – 2bQ) given in
formulae sheet
5 = 14 – 2 x 0.004 Q
Q = 1,125
Substituting Q in demand function above
P = a – bQ
P = 14 – 0.004 x 1,125
And P = 9.5

CHAPTER 4
Example 1 For Ltd
Sale (x) Prob (p) EV = (px)
20,000 0.25 5,000
25,000 0.4 10,000
30,000 .15 4,500
35,000 .2 7,000
∑26,500
EV of sales is £26,500.

Example 2 Mr Sartre
(a) Payoff Table

Workings – Probability of demand
Number of Days Probability
45 45/150 = 0.3
75 75/150 = 0.5
30 30/150 = 0.2
Total 150
TABLE IN $ DECIDE 10 20 30
To Buy
PROBABLE COLUMN FOR

OUTCOME PROBABILITY
Demand
10 *1 200 *420 (160)
20 *2 200 *5 400 220
30 *3 200 *6 400 600
*1 - Buy 10 sell 10,

10 x (40-20) = 100
*2,*3 - only bought 10 so maximum
*4– Buy 20 only sell 10 and scrap 10

Income (10 x $40) + (10 x $2) = 420
Costs (20 x $20) (400)
£20
*5, *6
Income (20 x $40) = 800
Costs (20 x $20) = (400)
$400

Add probability:
To Buy
PROBABLE COLUMN FOR

OUTCOME PROBABILITY
Demand
10 0.3 200 20 (160)
20 0.5 200 400 220
30 0.2 200 400 600
Expected 200 286 182

Values
(b) (i)
0.3 X 200 200
0,5 X 200 200
0.2 X 200 200
∑200
0.3 X 20 6
0,5 X 400 600
0.2 X 200 80
∑286
0.3 X (160) (48)
0,5 X 220 110
0.2 X 600 120
∑182
EV = $286per day so buy 20
(b) (ii)
Maximin buy 10, Maximax buy 30

(b) (iii) Minimax Regret
To Buy
PROBABLE
OUTCOME
Demand
10 0 180 360
20 200 0 180
30 400 200 0
Max 400 200 360
Minimax regret buy 20

Value of perfect information:
With perfect information gained from the research associate, following decisions will
be made:
To buy 10 and sell 10, expected value = $200 x 0.3 = 60

Total expected value with information = $380
Without perfect information, expected value = $286

Value of perfect information = $94

Example 3 Seven Trees Ltd
Step 1: Draw the tree from left to right showing appropriate decisions and
events/outcomes.
Symbols to use:
A square is used to represent a Decision point. At a decision

point the decision maker has a choice of which course of
action he wishes to undertake.
A circle is used at a chance Outcome point. The branches

from here are always subject to probabilities.
Label the tree and relevant cash inflows/outflows (discounted to present
values) and probabilities associated with outcomes.
Step 2: Evaluate the tree from right to left carrying out these two actions:
1. Calculate an EV at each Outcome Point.
2. Choose the best option at each Decision Point.

Step 3: Recommend a course of action to management.
3 (0.4) $540,000
2 (0.75) B 4 (0.3)
$100,000
A
1 5 (0.3) $(400,000)
6 (0.25) $(180,000)
7
$0
1. Develop product
2. Development succeeds
3. Very successful
4. Moderately successful
5. Failure
6. Development fails
7. Do not develop the product

Calculation of EV of each outcome:
EVALUATING THE DECISION TREE
To do this, you must move from right to left, calculating the expected value at each
outcome point.
OUTCOME POINT B
Value of outcome Probability Expected Value
$540,000 0.4 $216,000
$100,000 0.3 $30,000
$(400,000) 0.3 $(120,000)
Expected value $126,000
OUTCOME POINT A
Value of outcome Probability Expected Value
$126,000 0.75 $94,500
$(180,000) 0.25 $(45,000)
Expected value $49,500
Do not Develop product EV 0
Thus, based on expected values developed from the decision tree, the company
should develop the product as the expected value is positive and greater than the
expected value of not developing.
Example 4 Spy Ltd
Incremental Revenue ($3,100 - $2,150) $950

Less: Incremental costs:
Added materials $600
Direct labour 70
Variable overhead 90 (760)
Incremental profit from further processing $190

Sensitivity:
Selling price $190 x 100 unviable if price goes down by 6.13%
$3100
Added materials
$190 x 100 unviable if material price goes up by 31.67%
$600
Direct labour $190 x 100 unviable if labour cost goes up by 271%
$3100
Variable overhead
$190 x 100 unviable if variable overhead goes up by 211%
$3100

CHAPTER 5
Example 1 Strauss
(a)
Flexible budget Operating statement flexed at actual units of 720,000

Flexed Budget Actual Variance
$000 $000 $000
Cost of sales: (all variable)

Materials 189 144 45 F
Labour 270 288 18 A
Overheads 36 36 0
Variable S&D costs 162 153 9F

Variable admin costs 54 54 0
Total variable costs 711 675 36 F
Fixed costs:
Labour 100 94 6F
Selling & Distribution 72 83 11 A
Administration 184 176 8F
Total fixed costs 356 353 3F
Sales 1,152 1,071 81 A

Contribution 441 396 45 A
Net Profit 85 43 42 A
(b)
The original operating statement was prepared on the basis of fixed budgeting
basis, and is of little use to management due to following reasons:
1. Out of date budgeted figures were compared with actual results – which were
a year later.
2. Market fluctuations were not considered and updated into the original budget
in order to give better ideas to management , thus providing less meaningful
variance analysis.
3. The original budgeted statement was produced on the basis of original
budgeted output, whereas actual results were drafted on actual output
achieved – which was significantly different from the budget.
4. Variable costs should have been flexed on the basis of actual output to
provide reasonable comparison. For example, the material costs original
budget was produced on the basis of 640,000 units whereas 720,000 units
were actually produced: therefore the flexed costs for materials should have
been calculated to compare with act ual material costs – thus providing more
meaningful variance.

5. The original statement was misleading in terms of providing more meaningful

feedback for various operations. It therefore might de-motivate some
managers since their performance would be monitored on wrong basis.
(c) (i)
The following are the main problems associated with forecasting of figures used in
flexible budgeting:
1. Accurate identification of different cost behaviours, in their variable and fixed
components, may be complicated in complex manufacturing environments.
2. Determination of linear relationship of variable costs based on their activity

levels such as output . Some costs may directly depend on volume of units
and some costs may depend on other factors like labour hours, machine
hours.
3. Accurate understanding of activity levels (cost drivers) affecting various costs
may be difficult to determine.
4. Use of different forecasting models may produce different results which may
create a misleading effect.
5. Cost bases used in original budgets may be different as to the flexible budgets
due to change in cost behaviours and market patterns. Furthermore, they
may be significantly different from actual spending patterns.
6. Currency fluctuations and inflation adjustment can be complicated to be
incorporated on exact and accurate basis.
(c) (ii)
Using High Low method
Variable cost per unit $4,000 / 120,000 units = $0.0333 per unit
Fixed cost will be = $10,667
Flexed budget for 720,000 units (720,000 x $.0333) + $10,667 = $34,667
Example 2
Average Cum
Cumulative Incremental Incremental
time per total
units units total time
unit time
1 unit 100 100 1 100
2 units 80 160 2nd 60
4 units 64 256 3rd and 4th 96
8 units 51.2 409.6 5th to 8th 153.60

Example 3
2nd = 60 hours
3rd and 4th – can’t do using this as you can get time of next 2 so 2 take 96 hours
but not actual time of 3rd and 4th
Example 4 BG
b = log 0.8/log 2 = -0.3219
Total time of 4
(22 (4- 0 .3 2 1 9 )) x 4 = 14.08 x 4 = 56.32 minutes

Total time of 3
(22 (3- 0 .3 2 1 9 )) x 3 = 15.45 x 3 = 46.34 minutes
Time of 4th 9.98 minutes
Example 5 Martina Ltd
Direct Material ($4,000 x 8) $32,000

Direct Labour average *1 $2,458
Fixed cost $6,400
Total for 8 $40,858
Average per unit $40,858/8 = $5,107
*1 b = log 0.8/log 2 = -0.3219

Time to make 8 = (80 x (8- 0 .3 2 1 9 )) x 8 = 40.96 hours x 8 = 327.7 hours x $7.50 =
$2,458

Example 6 Limitation plc
(a) Time for second batch, sum of third and fourth together
Average Cum
Cumulative Incremental Incremental
time per total
units units total time
unit time
1 unit 120 120 1 120
2 units 108 216 2nd 96
4 units 97.2 388.8 3rd and 4th 172.8
(b)
Quarter 1 Quarter2
$ $
Sales ($1,200 per batch) 54,000 54,000
Variable costs:
Material
Labour *1 12,610 11,432
Variable Overheads (150% labour) 18,915 17,148
Total variable costs 31,525 28,580
CONTRIBUTION 22,475 25,420
*1 Cumulative total to end Q1 = 75 batches

75 batches – first 30 batches in Q4 = Q1 45 batches
For 75 in total (y = axb ) x 75 = (120 (75 - 0 .152)) x 75 = 62.25 x 75 =
4,668.75hours (note 62.25 hours was given too)
For first 30 in total = (120 (30 - 0 .152)) x 30 = 71.56 x 30 = 2,146.8hours
(note 71.56 hours was given too)
4,668.75hours
(2,146.8hours)
2,521.95 hours @$5 = £12,610
Cumulative total to end Q2 = 120 batches
120 batches – first 70 batches in Q4 and Q1
For 120 in total = (120 (120 - 0 .152)) x 120 = 57.96 x 120 = 6,955.2hours
For 75 in total (y = axb ) x 75 = (120 (75 - 0 .15 )) x 75 = 62.25 x 75 =
4,668.75hours (note 62.25 hours was given too)
6,955.2hours
(4,668.75hours)
2,286.45 hours @$5 = £11,432.25

(c)
Cumulative total to end Q3 = 132 batches
132 batches – first 120 batches in Q4, Q1and Q2
For 132 in total (y = axb ) x 132 = (120 (132 - 0 .152)) x 132 = 57.13x 132 =
7,541hours
For 120 in total = (120 (120 - 0 .152)) x 120 = 57.96 x 120 = 6,955.2hours
7,541.16 hours
(6,955.2hours)
585.96 hours @$5 = $2,929.80 are the labour costs
And variable overhead would be = $4,394.70

CHAPTER 6
Example 1 Owen Ltd
Direct Materials:
Total Variance = Standard material cost for actual output – actual material cost
($20 x 1,300) – $22,700 = $3,300 F

Price Variance = (SP – AP) x AQ
($5 – 4.54) x 5,000 = 2,300 F
Usage Variance = (SQ – AQ) x SP

(5,200kg – 5,000kg) x $5 = $1,000 F
Direct Labour Variances:
Total Variance = Standard labour cost for actual output - actual labour
cost
($16 x 1300) - $21,500 = $700 A
Rate variance = (SR – AR) x AH paid for

(£8 - $7.543) x 2850 = $1,300 F
Efficiency variance = (SH – AH) x SR
(2,600 – 2,850) x $8 = $2,000 A
Variable overheads variances:

Total variance = Standard variable overheads cost for actual output -
actual cost
($7 x 1,300) - $7,800 =$1,300 F
Expenditure variance = (SR – AR) x AH
($3.50 - $2.736) x 2850 = $2,175 F

Efficiency Variance = (SH – AH) x SR
(2,600 – 2,850) x $3.50 =$875 A
Fixed Overheads variances:

Total variance = Standard fixed overheads cost for actual output -
actual cost
($14 x 1,300) – $14,600 = $3,600 F

Expenditure Variance = Budgeted fixed cost – actual fixed cost
($14 x 1,000) – $14,600 = $600 A
Volume Variance = (BV – AV) x OAR

(1,000 – 1,300) x $14 = $4,200 F

Sales variances:
Price variance = (SP – AP) x actual units sold
($70 x $68) 1300 = $2,600 A

Volume Variance = (SV – AV) x Standard profit per unit
(1,000 – 1,300) x $13 = $3,900 F
Example 2 Operating statement

Marginal Costing Operating Statement:
Budgeted Contribution 27,000
Sales Volume Variance 8,100Fav
Standard contribution for actual sales 35,100

volume
Sales Price Variance 2,600Adv
Sub-total 32,500
Variable Cost Variances

F A
Materials Price 2,300
Materials Usage 1,000
Labour Rate 1,300
Labour Efficiency 2,000
Variable Overhead Expenditure 2,175
Variable Overhead Efficiency 875
Sub-total 6,775 2,875 3,900 Fav
Actual contribution 36,400

CHAPTER 7
Example 1
SQSP
12,500 x 3kg x $5 = $187,500
Usage variance = -$2,500 adverse

AQSP
38,000kg x $5 =$190,000
Price variance = -$5,500 adverse

AQAP
= $195,500
Based on the above, the purchasing manager has not done a good job. The actual
price paid for material per kg was higher than expected. Actual price =
195,500/38,000 = $5.14/kg
The production manager has also done a poor job as material usage was higher
than expected which has also increased costs. Actual usage per unit was
38,000/12,500 = 3.04kg.

Example 1 (contd)
Revised standard quantity = 3.1kg

Revised standard price = $5.15
PLANNING VARIANCES
SQSP
12,500 x 3kg x $5 = $187,500
Planning usage variance = -$6,250 adverse
RSQSP
12,500 x 3.1kg x $5 =$193,750
Planning price variance = -$5,812.5 adverse
RSQRSP
12,500 x 3.1kg x $5.15 = $199,562.5
OPERATIONAL VARIANCES
RSQRSP
12,500 x 3.1kg x $5.15 = $199,562.5
Operational usage variance = $3,862.5 favourable
AQRSP
38,000 x $5.15 =$195,700
Operational variance = $200 favourable
AQAP
= $195,500
The planning variances calculated above reflect the variances which have been
caused by factors outside of management control. Therefore, these would not be
used to assess the performance of the purchasing or production managers.
Only the operational variances should be considered as they are the variances
which have arisen due to individual manager actions.
Based on this, the production manager has performed well as the operational usage
variance is favourable. Actual usage of material was 3.04kg per unit which, given
the poor harvest, was actually quite good. The production manager may have
provided training to staff to reduce material wastage.
The purchasing manager has also had a reasonable performance as the price
variance is also favourable. This means that they have negotiated effectively with
suppliers and therefore slightly reduced the impact of adverse exchange rates on
material costs.
Care must be taken when planning and operational variances are calculated
separately. Senior management must ensure that the revised standards are
reasonable. It may be tempting for individual managers to ‘blame’ adverse
variances on poor planning rather than operational issues.

Example 2 Dalglish
Material A B C Total/Variance
SQ(SM)SP 13,300 5,700 4,750 23,750
A:950x70%x$20 Yield variance =

-$1,250 Adv
B:950x20%x$30
C:950x10%x$50
AQ(SM)SP 14,000 6,000 5,000 25,000
A:1000x70%x$20 Mix variance = -

$1,000 Adv
B:1000x20%x$30
C:1000x10%x$50
AQ(AM)SP 13,200 6,300 6,500 26,000
A:660 x $20
B:210 x $30
C:130 x $50
AQ(AM)AP 13,830 6,720 6,110 26,690
Price variances 630 Adv 420 Adv 390 Fav 690 Adv
SQ(SM)SP
The 950 is the total quantity of inputs which should have been used to produce 855
tonnes of output. A loss of 10% of material input is expected. Therefore to output
855 units, we should have input 855/0.9 = 950 units in total.
This is then divided out into the standard mix (valued at the standard price).
AQ(SM)SP
This is the total actual quantity of material used, divided out into the standard mix.
If 1,000 units were input in total, then 70% of this should have been material A,
20% should have been material B and 10% should have been material C.

Example 3 ABC Company
Sales Quantity variance:

Budgeted contribution per unit x (Standard sales at budgeted mix – Actual
sales at budgeted mix)
Budgeted sales 10,000 units, so the standard mix of these budgeted sales will be:
A 10,000 x 2/5 = 4,000 units
B 10,000 x 3/5 = 6,000 units.
Actual sales 13,000 units, the actual sales at budgeted mix will be:
A 13,000 x 2/5 = 5,200 units
B 13,000 x 3/5 = 7,800 units.
Sales quantity variance:

A $2.50 x (4,000 – 5,200) = $3,000 F
B $4.50 x (6,000 – 7,800) = $8,100 F
Total sales quantity variance = $11,100 F
Example 4 Coffee Ltd

Sales price variance: ($9 - $10) x 240,000 units = $240,000 adverse
Sales volume: (240,000 – 250,000) x $6 = $60,000 adverse

Original budgeted volume 250,000 units x $6 = $1,500,000
Market size variance $150,000 adverse
Revised budgeted volume 225,000 x $6 = $1,350,000

Market share variance $90,000 favourable
Actual sales volume 240,000 x $6 = $1,440,000

CHAPTER 8
Example 1 Dec 2007 extract
Sales
680,000/420,000 x 100% = 162%
Ties only have done very well in Q1 with first quarter sales of $480,000 which is
excellent for a new business. In addition, sales have increased by 62% in quarter 2
which also reflects a strong initial performance.
Cost of Sales and Gross Profit Margin

340,680/201,600 x 100% = 169%
Cost of sales have increased by 69% which is significantly higher than the %
increase in sales revenue. This has resulted in the decrease in gross profit margin.
Gross profit margin:
Q1: 218,400/420,000 x 100% = 52%
Q2: 339,320/680,000 x 100% = 50%

This could be due to a decrease in selling price in order to increase volumes and
gain market share. Whilst this may be necessary in the short term, the decrease in
GPM is worrying and needs to be addressed.
This could also have been as a result of increased cost/unit in the cost of sales. If
this is the case, then cost control measures must be implemented in Ties Only to
ensure future profitability.
Website development
90/120 x 100% = 75%
Website development costs have decreased 25%. This c ost should continue to
decrease as website development is completed. This should lead to further
improvements to net profits in the future.
Administration costs
150,640/100,500 x 100% = 160%
Administration costs have increased by 60% versus an increase in sales of 62%.
This is good, as larger volumes have been processed in Q2 which suggests good
cost control or use of resource.
Distribution costs
33,320/20,760 x 100% = 160%

Again, this increase of 60% is less than the increase in sales. This cost is likely to
be related to postage and packaging so it would be expected in increase in
proportion to sales volumes.

Launch marketing
40,800/60,000 x 100% = 68%
This has decreased by 32% which is good. On-going marketing costs will still be
incurred, but these should be lower than the initial high cost of launch marketing.
Other variable expenses
80,000/50,000 x 100% = 160%

Again, this is a reasonable increase given that this cost varies with sales volumes.

CHAPTER 9
Example 1 Tata
(a)
YEAR 1 2 3 4
Profit 0.35 0.35 0.35 0.35

(1.4-1.05)
Asset 4.2 3.15 2.1 1.05
Cost-
accumulated
depreciation
ROI 8.33% 11.11% 16.67% 33.33%
(b)
YEAR 1 2 3 4
Profit 0.35 0.35 0.35 0.35
(1.4-1.05)
Asset 4.2 3.15 2.1 1.05

Cost-
accumulated
depreciation
RI 0.07 0.035 0.14 0.245
Example 2 Tonic
(a)
ROI
X = $2 m / $10 m = 20%
Y = $3m / $30m = 10%
(b)
RI = NOPAT – internal cost of capital
X $2m - $1.5m = $0.5m
Y $3m - $4.5m = -$1.5m
Hence division A has performed better currently on both yardsticks.

Example 2 contd
X ROI = $80,000/$500,000 = 16%
RI = $80,000 - $75,000 = $5,000
Y ROI = $120,000/$1,000,000 = 12%
RI = $120,000 - $150,000 = -$30,000
(a) ROI: Using ROI, division X would reject the project as it would reduce the
average ROI for the division. Division Y would accept their project as it would
increase the average ROI for the division.
RI: Using RI, division X would accept the project as having a positive RI and
would therefore increase the RI for the division. Division Y would reject their
project due to the negative RI.
(b) Head office would accept project X and reject project Y as they would only
accept projects where ROI is greater than the cost of capital (or have a
positive RI). Note that using ROI leads to divisional management making a
different decision to Head Office. However, using RI leads to the same
decision being made by both parties.

Example 3 Transfer pricing
Part (a) ROI

Division R = 1900/10000 x 100% = 19%
Division S = 1060/7800 x 100% = 14%
Based on the above results, Division R has performed very well with an ROI
comfortably above the required rate of return of 15%. Division S however is
slightly below, so has not performed well.
Part (b) Company profits
Division R Division S
$000’s $000’s
Sales External@$900/unit 4500 External 5300
Production Variable@$300/unit 1500* Standard 1650

costs frames@$825/unit
Other
1400
materials@$700/unit
Fixed 1400 Fixed 600
Selling and Variable@$100/unit 500 Variable@$120/unit 240

distribution
Fixed 400 Fixed 200
Controllable profit 700 1210
Total company profit = $700,000 + $1,210,000 = $1,910,000
*External company sales = $4,500,000/$900 = 5,000 units. Total variable

production costs = $300 x 5,000 = $1,500,000. As Division S are buying all frames
externally, Division R has no internal sales to record.
Part (c)
Transfer pricing and divisional decisions:
Under the current transfer pricing policy, Division S is incurring a cost of $900/unit
purchased. By buying the frames externally for $825, division profits increase to
$1,210,000. This results in an improved ROI for the division of $1,120/$7,800 x
100% = 15.5% which is above the required rate of return. The Division S manager
would therefore be keen to take advantage of the cheaper external purchase price.
Purchasing the frames from the external supplier, however, results in company
profits of $1,910. Purchasing the frames internally results in company profits of
$2,960. This is because the contribution lost in Division R is greater than the
savings made in Division S from purchasing externally. It is therefore not in the

company’s best interest as a whole to purchase the frames from an external

supplier.
Recommend a suitable transfer price:

Currently, Division R charges the same selling price to Division S as it does external
customers. Given that selling costs are only incurred by Division R when sales are
made externally, this does not seem fair. The transfer price could be reduced to
$900 - $100 = $800/unit. Division R would then earn the same margin on internal
sales as it does for external sales so this should be satisfactory to the Division R
manager.
The Division S manager would be happy with this option as the transfer price would
be lower than the external price of $825.
Changing the transfer price would not impact company profits as the reduction in
revenue in Division R would be equal to the reduction in costs of Division S.

ACCA STUDY GUIDE
and INDEX

AC C A STU DY GU IDE AND INDE X
ACCA STUDY GUIDE
Can I rely on these Class Notes to cover the syllabus?
The answer is YES!

Each chapter begins with ACCA’s STUDY GUIDE.
To quote ACCA:
This is the main document that students, tuition providers and

publishers should use as the basis of their studies, instruction and
materials. Examinations will be based on the detail of the study guide
which comprehensively identifies what could be examined in any
examination sitting. The study guide is a precise reflection and
breakdown of the syllabus.
Below I have set out ACCA’s Study Guide in detail for you. To help you even more,
I have also cross-referenced the individual items to the relevant chapters in your
Notes.
A Specialist cost and management accounting

techniques
1. Activity based costing chapter 1

a) Identify appropriate cost drivers under ABC.
b) Calculate costs per driver and per unit using ABC.
c) Compare ABC and traditional methods of overhead absorption based on
production units, labour hours or machine hours.
2. Target costing chapter 1

a) Derive a target cost in manufacturing and service industries.
b) Explain the difficulties of using target costing in service industries.

c) Suggest how a target cost gap might be closed.
3. Life-cycle costing chapter 1

a) Identify the costs involved at different stages of the life-cycle.
b) Derive a life cycle cost in manufacturing and service industries.
c) Identify the benefits of life cycle costing.
4. Throughput accounting chapter 1

a) Discuss and apply the theory of constraints.
b) Calculate and interpret a throughput accounting ratio (TPAR).

c) Suggest how a TPAR could be improved.

AC C A STUDY GUIDE AND INDE X
d) Apply throughput accounting to a multi-product decision-making problem.
5. Environmental accounting chapter 1

a) Discuss the issues business face in the management of environmental costs.
b) Describe the different methods a business may use to account for its
environmental costs.
1. Relevant cost analysis chapter 2

a) Explain the concept of relevant costing.
b) Identify and calculate relevant costs for a specific decision situations from
given data.
c) Explain and apply the concept of opportunity costs.
2. Cost volume profit analysis chapter 2

a) Explain the nature of CVP analysis.
b) Calculate and interpret breakeven point and margin of safety.

c) Calculate the contribution to sales ratio, in single and multi-product situations,
and demonstrate an understanding of its use.
d) Calculate target profit or revenue in single and multi-product situations, and

demonstrate an understanding of its use.
e) Prepare breakeven charts and profit volume charts and interpret the
information contained within each, including multi-product situations.
f) Discuss the limitations of CVP analysis for planning and decision making.
3. Limiting factors chapter 2

a) Identify limiting factors in a scarce resource situation and select an
appropriate technique.
b) Determine the optimal production plan where an organisation is restricted by

a single limiting factor, including within the context of ‘make’ or ‘buy’
decisions.
c) Formulate and solve multiple scarce resource problem both graphically and
using simultaneous equations as appropriate.
d) Explain and calculate shadow prices (dual prices) and discuss their
implications on decision-making and performance management.
e) Calculate slack and explain the implications of the existence of slack for
decision-making and performance management. (Excluding simplex and
sensitivity to changes in objective functions.)

4. Pricing decision chapter 3

a) Explain the factors that influence the pricing of a product or service.
b) Explain the price elasticity of demand.
c) Derive and manipulate a straight line demand equation. Derive an equation
for the total cost function (including volume-based discounts).
d) Calculate the optimum selling price and quantity for an organisation, equating
marginal cost and marginal revenue.
e) Evaluate a decision to increase production and sales levels, considering

incremental costs, incremental revenues and other factors.
f) Determine pric es and output levels for profit maximisation using the demand
based approach to pricing (both tabular and algebraic methods).
g) Explain different price strategies, including:
i) All forms of cost-plus
ii) Skimming
iii) Penetration
iv) Complementary product
v) Product-line
vi) Volume discounting
vii) Discrimination
viii) Relevant cost

h) Calculate a price from a given strategy using cost -plus and relevant cost.
5. Make-or-buy and other short-term decisions chapter 2

a) Explain the issues surrounding make vs. buy and outsourcing decisions.
b) Calculate and compare ‘make’ costs with ‘buy-in’ costs.
c) Compare in-house costs and outsource costs of completing tasks and consider
other issues surrounding this decision.
d) Apply relevant costing principles in situations involving shut down, one-off
contracts and the further processing of joint products.
6. Dealing with risk and uncertainty in decision-making

chapter 4
a) Suggest research techniques to reduce uncertainty eg Focus groups, market
research.
b) Explain the use of simulation, expected values and sensitivity.
c) Apply expected values and sensitivity to decision-making problems.

d) Apply the techniques of maximax, maximin, and minimax regret to decision-
making problems including the production of profit tables.
e) Draw a decision tree and use it to solve a multi-stage decision problem.

f) Calculate the value of perfect and imperfect information.

1. Budgetary systems chapter 5

a) Explain how budgetary systems fit within the performance hierarchy.
b) Select and explain appropriate budgetary systems for an organisation,
including top-down, bottom-up, rolling, zero-base, activity-base, incremental
and feed-forward control.
c) Describe the information used in budget systems and the sources of the
information needed.
d) Explain the difficulties of changing a budgetary system.
e) Explain how budget systems can deal with uncertainty in the environment.
2. Types of budget chapter 5

a) Prepare rolling budgets and activity based budgets.
b) Indicate the usefulness and problems with different budget types (including
fixed, flexible, zero-based, activity- based, incremental, rolling, top-down,
bottom up, master, functional).
c) Explain the difficulties of changing the type of budget used.
3. Quantitative analysis in budgeting chapter 5

a) Analyse fixed and variable cost elements from total cost data using high/low
methods.
b) Estimate the learning rate and learning effect.

c) Apply the learning curve to a budgetary problem, including calculat ions on
steady states.
c) Discuss the reservations with the learning curve.

d) Apply expected values and explain the problems and benefits.
e) Explain the benefits and dangers inherent in using spreadsheets in budgeting.
4. Standard costing chapter 6

a) Explain the use of standard costs.
b) Outline the methods used to derive standard costs and discuss the different
types of cost possible.
c) Explain the importance of flexing budgets in performance management.
d) Explain and apply the principle of controllability in the performance

management system.
5. Material mix and yield variances chapter 7

a) Calculate, identify the cause of, and explain material mix and yield variances.
b) Explain the wider issues involved in changing material mix eg cost, quality
and performance measurement issues.

c) Identify and explain the relationship of the material usage variance with the
material mix and yield variances.
d) Suggest and justify alternative methods of controlling production processes.
6. Sales mix and quantity variances chapter 7

a) Calculate, identify the cause of, and explain sales mix and quantity variances.
b) Identify and explain the relationship of the sales volume variances with the
sales mix and quantity variances.
7. Planning and operational variances chapter 7

a) Calculate a revised budget.
b) Identify and explain those factors that could and could not be allowed to
revise an original budget.
c) Calculate, identify the cause of and explain planning and operational variances
for:
i) sales, including market size and market share,

ii) materials
iii) labour, including the effect of the learning curve.
d) Explain and discuss the manipulation issues involved in revising budgets.

chapters 5, 6 & 7
a) Analyse and evaluate past performance using the results of variance analysis
b) Use variance analysis to assess how future performance of an organisation or
business can be improved.
c) Identify the factors which influence behaviour.
d) Discuss the issues surrounding setting the difficulty level for a budget.
e) Discuss the effect that variances have on staff motivation and action.
f) Explain the benefits and difficulties of the participation of employees in the
negotiation of targets.
g) Describe the dysfunctional nature of some variances in the modern

environment of JIT and TQM.
h) Discuss the behavioural problems resulting from using standard costs in
rapidly changing environments.

1. Performance management information systems chapter 8

a) Identify the accounting information requirements and describe the different
types of information systems used for strategic planning, management control
and operational control and decision-making.
b) Define and identify the main characteristics of transaction processing
systems; management information systems; executive information systems;
and enterprise resource planning systems.
c) Define and discuss the merits of, and potential problems with, open and
closed systems with regard to the needs of performance management.
2. Sources of management information chapter 8

a) Identify the principal internal and external sources of management accounting
information.
b) Demonstrate how these principal sources of management information might

be used for control purposes.
c) Identify and discuss the direct data capture and process costs of management
accounting information.
d) Identify and discuss the indirect costs of producing information.
e) Discuss the limitations of using externally generated information.
3. Management reports chapter 8

a) Discuss the principal controls required in generating and distributing internal
information.
b) Discuss the procedures that may be necessary to ensure security of highly

confidential information that is not for external consumption.
4. Performance analysis in private sector organisations

chapter 8
a) Describe, calculate and interpret financial performance indicators (FPIs) for
profitability, liquidity and risk in both manufacturing and service business es.
Suggest methods to improve these measures.
b) Describe, calculate and interpret non-financial performance indicators (NFPIs)
and suggest method to improve the performance indicated.
c) Analyse past performance and suggest ways for improving financial a nd non-
financial performance.
d) Explain the causes and problems created by short -termism and financial
manipulation of results and suggest methods to encourage a long term view.
e) Explain and interpret the Balanced Scorecard, and the Building Block model
proposed by Fitzgerald and Moon.
f) Discuss the difficulties of target setting in qualitative areas.

5. Divisional performance and transfer pricing chapter 9

a) Explain and illustrate the basis for setting a transfer price using variable cost,
full cost and the principles behind allowing for intermediate markets.
b) Explain how transfer prices can distort the performance assessment of
divisions and decisions made.
c) Explain the meaning of, and calculate, Return on Investment (ROI) and
Residual Income (RI), and discuss their shortcomings.
d) Compare divisional performance and recognise the problems of doing so.
6. Performance analysis in not for profit organisations and

the public sector chapter 8
a) Comment on the problems of having non-quantifiable objectives in
b) Explain how performance could be measured in this sector.
c) Comment on the problems of having multiple objectives in this sector.

d) Outline Value for Money (VFM) as a public sector objective.
7. External considerations and behavioural aspects chapter 8

a) Explain the need to allow for external considerations in performance
management, including stakeholders, market conditions and allowance for
competitors.
b) Suggest ways in which external considerations could be allowed for in
c) Interpret performance in the light of external considerations.

d) Identify and explain the behaviour aspects of performance management.

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ACCA Paper F5

INTRODUCTION TO THE PAPER 5

FORMULAE PROVIDED IN THE EXAMINATION PAPER 7

CHAPTER 1: COST ACCOUNTING AND NEW DEVELOPMENTS 9

CHAPTER 2: DECISION MAKING AND LINEAR PROGRAMMING 33

CHAPTER 4: DECISION MAKING UNDER UNCERTAINTY 75

CHAPTER 6: STANDARD COSTING AND VARIANCE ANALYSIS 103

CHAPTER 7: ADVANCED VARIANCE ANALYSIS 115

CHAPTER 8: PERFORMANCE EVALUATION 127

CHAPTER 9: DIVISIONAL PERFORMANCE AND T RANSFER PRICING 143

SOLUTIONS TO EXERCISES AND EXAMPLES 155

ACCA STUDY GUIDE AND INDEX 199

AIM OF THE PAPER

OUTLINE OF THE SYLLABUS

D. Performance measurement and control.

FORMAT OF THE EXAM PAPER

What is an average mix of discursive and numerical elements

Where: y = cumulative average time per unit to produce x units

b = the index of learning (log LR/log 2)

Cost accounting and

SYLLABUS CONTENT (as set by ACCA’s study guide)

A Specialist cost and management accounting

1. Activity based costing

c) Compare ABC and traditional methods of overhead absorption based on

c) Suggest how a target cost gap might be closed.

b) Derive a life cycle cost in manufacturing and service industries.

d) Apply throughput accounting to a multi-product decision-making problem.

COST CLASSIFICATION --------------------------------------------------12

MARGINAL COSTING -----------------------------------------------------13

ABSORPTION COSTING --------------------------------------------------14

ACTIVITY BASED COSTING ----------------------------------------------16

THROUGHPUT ACCOUNTING --------------------------------------------21

LIFE CYCLE COSTING-----------------------------------------------------27

ENVIRONMENTAL MANAGEMENT ACCOUNTING-----------------------30

Direct and indirect costs

Production and non production costs

Contribution/unit of product can also be calculated as:

Absorption costing – a reminder

Steps using absorption costing

Overhead Cost Cost

The steps using absorption costing are:

2. Overhead absorption is achieved by means of a predetermined Overhead

ii. Labour Hours: Manual manufacturing operations (labour intensive)

3. The overhead cost/unit =

Advantages and disadvantages of absorption costing

Disadvantages of absorption costing are:

ACTIVITY BASED COSTING

Increased proportion of overhead costs

Overhead Cost Cost

Activity based costing takes the following approach:

Calculation steps with ABC

2. Calculate the cost/unit using an ABC approach.

Calculating the cost/unit

1. Calculate the cost driver rate

2. Calculate the cost/unit for that cost pool:

Where the number of cost drivers/unit =

Example 1 Hensau Ltd

Conditions under which ABC is most appropriate

Advantages and disadvantages of ABC

2. Is flexible enough to analyse costs by activity providing more useful costing

Steps in throughput accounting

Bottleneck is any limitation or restraint in the production process

2. Concentrate on the bottleneck to ensure this process is being fully and