ACCA F5 Study Notes.

ACCA F5 Performance Management Exam A total of 5 questions, each worth 20 marks = 100 marks. About this note This note is written based on the new syllabus starting June 2011. The note is examfocused, satisfying the study guide requirements, some of the examples are taken from part of the past year questions. It is suggested that you should take the past year questions as practice in addition to this note.

Syllabus areas A: Specialist cost and management accounting techniques

Page number 2-12

B: Decision-making techniques

13-33

C: Budgeting

34-48

D: Standard costing and variances analysis

49-71

E: Performance measurement and control

72-88

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Absorption costing (AC) and marginal costing (MC) This topic will not be examined as a full question but its basic knowledge needs to be understood. Absorption costing (AC) In AC, inventory is valued at full production cost, ie. variable + fixed production cost. It is in accordance with financial reporting standard and therefore it is acceptable for financial reporting. However adjustment may be needed for over or underabsorption of overheads, this will occur when estimated figures used in OAR don’t match the actual figures. If the actual overhead is higher than the budgeted, underabsorption will occur and this must be deducted to the gross profit or added to the cost of sales. Example: Budgeted overheads are $200000 with labour hours of 100000 hours. The actual results were 120000 hours and actual overheads are $250000. Calculate the over or under-absorption of overhead. Solution: OAR = $200000/100000 = $2 per hours. Over/(under)-absorption = absorbed overheads – actual overheads = $2 x 120000 $250000 = ($10000). Marginal costing (MC) No over or under-absorption of overhead will occur because the fixed production overhead is treated as period cost, written off as expenses in income statement in the period incurred. The inventory is valued at variable production cost only and this is not allowed by financial reporting standard. MC is only used for decision making as we can get the amount of contribution (which is a useful information for decision making) with MC, instead of sales less full cost of sales, we do sales less variable cost of sales and this equals to contribution. With this, it can facilitate CVP analysis. AC and MC compared Their profit reported will be different only if the inventory level changes. If the inventory level increases, profit reported under AC will be higher than MC, if the inventory level decreases, profit reported under MC will be higher than AC. Therefore, when in reconciling the profit, the following has to be done: MC profit X Changes in inventory level x fixed OAR X/(X) AC profit X

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Activity-based costing (ABC) In ABC, there is no fixed overhead, all overheads will be treated as variable in nature. Instead of using OAR to absorb overheads, ABC allocates overheads to product on the basis of activities consumed, cost driver which is the cost causer is used to calculate what we call the cost driver rate instead of OAR. Therefore, cost driver rate is similar to OAR concept, it is calculated as budgeted overheads/cost driver. The steps to do ABC include: 1. Identify the activities, eg. set-up, quality control etc. 2. Collect the costs associated with each activity into cost pools. 3. Identify the cost drivers for each activity, i.e. those factors which give rise to the costs (cost causers). 4. Cost driver rates are calculated for each activity. 5. Use the cost driver rates to allocate the costs to the product, the activities consumed by each activity need to be identified and multiply with the cost driver rates. Example: Cost of goods inwards department totalled $10000. During 2010 there were 1000 deliveries. 200 of these deliveries related to product X. 2000 units of product X were produced. Calculate the unit cost of product X. Solution: This is an example which only involves one activity, there will be more in exam. Cost driver of the cost of goods inwards is the number of deliveries, therefore cost driver rate = $10000/1000 = $10 per delivery. Product X needs 200 deliveries, therefore $2000 ($10 x 200) is allocated to product X. The unit cost of product X = $2000/2000 = $1 per unit. It is very hard to implement in practice although it provides accurate information. It is also acceptable by financial reporting standard to use ABC for inventory valuation as inventory is also valued at full production cost. ABC can also be used for decision making as it identifies inefficient activities and unprofitable products which manager will then be able to take control actions. ABC is suitable to be used in the following situations: 1. The production overheads are high in relation to direct costs. 2. The company produces multi-product. 3. The product’s overheads are not primarily driven by volume. 4. The production process is complex.

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Target costing Target costing is an opposite way of doing costing compared to traditional costing. Target cost = estimated selling price (competitive market price) – desired profit. Cost gap = current cost – target cost. Example: A company normally expects a mark-up on cost of 50% and estimates that a new product will sell successfully at a price of $12. Solution: Target cost per unit = $12 - $4 (50/150 x $12) = $8. This also means that company’s production costs must be not more than $8, company will then estimate its current production costs, let say $9, then cost gap = $1. To really use the target selling price of $12, the company will need to reduce this cost gap. Closing cost gap To reduce the cost gap, the concept of cost reduction is important. Cost reduction is a planned and positive approach to reducing costs, this must not affect the value of the product. There are many ways and some are explained here: 1. Reducing material costs – this can be done by reducing costs of wastage, obtain lower prices for purchases, improve stores control and use alternative materials. However, company must make sure the quality of the materials remain high enough. 2. Standardisation of product – a range of products may be basically standardised, costs of producing a standard product are most likely cheaper than costs of producing wide range of products. 3. Training the staff – this will improve the skills and efficiency of the staff and wastages can be reduced. 4. Employ cheaper labour – this is not to replace the skilled labour, but to do the easier work which does not require much skill, then the amount of skilled labour needed can be reduced. 5. Acquiring new technology – obviously technology helps to speed up the production process and less labour will be needed, production costs will be reduced. 5. Use cost reduction team – company can bring together the members of marketing, design, assembly and distribution teams to allow discussion of methods to reduce costs. Open discussion and brainstorming are useful approaches here. 6. Value engineering (or value analysis) – this is important, value engineering attempts to design the best possible value at the lowest possible cost into a new product which can then be used in a target costing system. Value engineering aims to reduce costs by identifying those parts of a product or service which do not add value. Value is made up of use value (ability of the product to function) and esteem value (status, probably related to quality). The aim of value engineering is to maximise use and esteem values while reducing costs. Techniques of value

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engineering are actually the cost reduction techniques identified above except using cost reduction team which is another good approach. Summary of typical target costing steps 1. Product specification – this means how the product is to be designed. 2. Estimate a selling price by taking into account the competitor products and the market conditions, then deduct it with the desired profit to arrive target costs. 3. Estimate current costs, then compare it to target costs. The difference is called cost gap. 4. Using cost reduction techniques to reduce the cost gap. 5. Negotiate with customers before product is launched to market to see whether company can sell at higher price or not. Difficulties of using target costing in service industries Service has HIPS characteristics: 1. Heterogeneity – variability, different people will have different result. (Key factor) 2. Intangible – unable to touch. 3. Perishability – unable to store. 4. Simultaneity – cannot be separated. A service company might deliver a number of different services through the same delivery system, using the same employees and the same assets. Therefore, introducing new service will add burden to employees. Target costing is used mainly for new product/service development.

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Life cycle costing Life cycle costing is the accumulation of costs over a product’s entire life. That means, the whole life of the product will be taken into account. Product life cycle is the life of the product, how long it can be in the market. With life cycle costing, we can identify the total profitability that a product can generate for the company. Not only product, service and customer have life cycles as well but let us focus on product. Costs involved at different stages of the life cycle Every product goes through a life cycle and there are five stages: 1. Development – In this stage, there will be no revenue generated yet and mostly research and development costs will be incurred. 2. Introduction – The product is introduced to the market. Because the product is still new, customers will not be aware of it so company may have to spend more on advertising in order to catch the attention. 3. Growth – If the product got away from introduction stage, this is a good indication. The product’s demand will keep increasing in this stage and so sales revenues and profits will also increase. Some promotion costs can be incurred to catch even more attention to increase the growth. 4. Maturity – In this stage, the growth in demand will slow down as it reaches its maturity. The product will be very profitable. Modification costs or giving discounts might be needed in order to sustain the demand longer. 5. Decline – At this stage, the demand will start to fall, the customers may be bored with this product. Therefore, company should stop selling this product if it reaches this stage and so disposal costs (costs occur at the end of a product’s life) will be incurred. Derive life cycle costs Cost per unit of the product calculated using life cycle costing is total life cycle costs/total production units. Example: Company B manufactures calculator. It planned to introduce a new calculator modeled as BB, it is expected to have life cycle of 3 years. According to market research, customers will be prepared to pay $110 per BB. The following information is given about BB, calculate cost per unit of BB and comment on the suggested price.

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Units manufactured and sold Research and development costs Marketing costs Training costs Production costs Disposal costs

Year 1 7000 $ 800000 100000 40000 700000

Year 2 30000 $

Year 3 15000 $

50000 90000 3000000

20000 10000 1500000 100000

Solution: The following presentation of answer is useful: $000 Research and development 800 Marketing costs (100 + 50 +20) 170 Training costs (40 + 90 + 10) 140 Production costs (700 + 3000 + 1500) 5200 Disposal costs 100 Total life cycle costs 6410 Total production (‘000 units) (7 + 30 + 15) 52 Cost per unit 123.27 Cost per unit of BB is higher than what the customers would be willing to pay. Therefore, cost reduction techniques like using different materials, using cheaper staff and so on could be used. Benefits of life cycle costing Now we shall look into the benefits from using life cycle costing, some is obvious but some need to be discussed: 1. Better decisions can be made as we can have a better overview of revenues and costs for the whole life of the product. 2. Life cycle thinking can promote long-term profitability rewarding. 3. Life cycle concept results in earlier actions to generate revenue or to lower costs, more opportunities for cost reduction. Just like the example above, we have an early warning that the cost per unit is too high. 4. Life cycle concept helps managers to understand acquisition costs versus operating and support costs, ie. to find a correct balance between investment costs and operating expenses. 5. Better pricing with the more realistic costs. 6. More accurate feedback can take place when assessing whether new products are a success or a failure, since the costs of researching, developing and designing those products are also taken into account.

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Throughput accounting Throughput (or throughput contribution) is defined as sales less direct material costs. Throughput accounting (TA) is a product management system which aims to maximize throughput rather than profit. This is in accordance with theory of constraints and therefore it focuses on bottleneck resource (resource which limits the throughput). Bottleneck resource is also referred as binding constraint of throughput. Conversion costs (costs other than material costs) are excluded because in the short run, they are fixed, only material cost is considered as variable costs. Therefore, businesses will become richer provided the sales revenue is more than material costs. The concept of TA has been developed from theory of constraints as an alternative system of cost and management accounting in a just-in-time (JIT) environment. In JIT, factory is highly automated and lesser labours are used, therefore material is the only truly variable costs. Calculation and interpretation of throughput accounting ratio (TPAR) TPAR tells us additional information for decision making and TPAR = throughput per factory hour/total conversion cost per factory hour. Factory hours are normally the bottleneck resource. For interpretation of TPAR, the higher the better and should be greater than 1. Example: Company A manufactures product X which has a selling price of $100 per unit. Material cost per unit for product X is $40 and conversion costs per day are $144000. The processes of making this product can only be operated 8 hours a day and 500 units can be produced for every 1 hour, ie. 0.002 hour per unit. Calculate TPAR and interpret it. Solution: Throughput per unit = $100 - $40 = $60 and therefore throughput per factory hour = $60 per unit/0.002 hour per unit = $30000. Conversion cost per factory hour = $144000/8 hours = $18000. TPAR = $30000/$18000 = 1.67. Since TPAR is more than 1, the product is worthwhile as earning rate is higher than spending rate. If other product, let say product Y has TPAR of 2, then company A should focus on producing product Y first instead of product X. Improving the TPAR Organisations should focus on how they can increase their TAR. Obvious ways are to increase selling prices, decrease material costs, or decrease factory costs. Another way would be to reduce the use of bottleneck resource probably by redesigning the production process. Provided a TAR is greater than 1 it will be worth trying to increase throughput.

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Throughput accounting in multi-product decision making In limiting factor analysis, you know that when there is one limiting factor and multiproduct, the decision of choosing which product to produce first will depend on which product has the highest contribution per limiting factor. Same situation in throughput accounting, you have to choose by consider which product has the highest throughput per bottleneck resource. Example: Company A produces product X and Y, company wishes to know which product to produce more as the machine hour is restricted, the information for each product is as follow: X Y Selling price per unit 100 120 Material cost per unit 40 50 Labour cost per unit 20 20 Variable overhead per unit 10 10 Machine hour per unit 2 3 Solution: X Y Selling price per unit 100 120 Material cost per unit (40) (50) Throughput per unit 60 70 ÷ Machine hour per unit 2 3 Throughput per machine hour 30 23.3 Ranking 1 2 Based on the above evaluation, product X earns more throughput per machine hour compared to product Y, therefore company A should produce the maximum number of product X (demand of the product may be given in exam) then only consider product Y. Although product Y has the higher throughput per unit, it is not relevant to consider in this decision.

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Environmental management accounting (EMA) United Nations Division for Sustainable Development (UNDSD) believes EMA systems generate information for internal decision making rather than external decision making. Therefore, this has distinguished EMA with environmental accounting, environmental accounting focuses on both internal and external information, so EMA is the subset of environmental accounting. Defining EMA Definition given by UNDSD is that EMA is the identification, collection, analysis and use of two types of information for internal decision making: 1. Physical information on the use, flows and destinies of energy, water and materials (including wastes). 2. Monetary information on environment-related cost, earnings and savings. Examiner defines EMA as a specialised part of the management accounts that focuses on the cost of energy and water and the disposal of waste and effluent. Definition given by BPP is that EMA is the generation and analysis of both financial and non-financial information in order to support internal environmental management processes. Importance of managing environmental costs Environmental costs are important to the businesses for a number of reasons: 1. Identifying environmental costs associated with individual products and services can assist with pricing decisions, especially when the company is using cost-plus pricing, this ensures price covered environmental costs. 2. Ensuring compliance with regulatory standards. Penalties will be charged for noncompliance with environmental regulations. 3. Potential for cost savings. For some companies, environmental costs can be very significant part of costs, waste minimisation and energy efficiency schemes can reduce environmental costs. 4. Ensure no damage to reputation. As society has became more environmentally aware, company must not be wasteful or causing pollution, this can cause image of the company to suffer. Difficulty of managing environmental costs It is quite difficult to manage environmental costs, this is because: 1. Difficult to define the actual costs involved. 2. Some costs are difficult to separate out and identify. 3. Costs need to be controlled but this can only be done if they are correctly identified in the first place. 10

Defining environmental costs US Environmental Protection Agency distinguished between four types of costs, mnemonic CPCI: 1. Conventional costs – raw materials and energy costs that have an impact on the environment. 2. Potentially hidden costs – costs captured by accounting systems but may be hidden within general overheads. 3. Contingent costs – costs to be incurred at future date, eg. clean up costs. 4. Image and relationship costs – costs incurred to maintain the reputation of the business, eg. costs of preparing environmental reports to ensure compliance with regulatory standards. Controlling environmental costs It is only after environmental costs have been defined, identified and allocated that a business can begin the task of trying to control them. The majority of environmental costs are already captured within accounting systems. The difficulty lies in identifying them and allocating them to a specific product or service. Typical environmental costs are: 1. Consumables and raw materials – these costs are usually easy to identify and discussions with senior managers may help to identify where savings can be made. 2. Transport and travel – EMA can often help to identify savings in terms of business travel and transport of goods and materials. 3. Waste and effluent disposal – to reduce it, use mass balance approach, whereby the weight of material bought is compared to product yield. With this, potential cost savings may be identified. 4. Water consumption – to reduce water bills, it is important for organisations to identify where water is used and how consumption can be decreased. 5. Energy – EMA may help to identify inefficiencies and wasteful practices, this result in opportunities for cost savings. Accounting for environmental costs UNDSD identified four management accounting techniques which are useful for the identification and allocation of environmental costs: 1. Input/outflow analysis – this is based on the principle that “what comes in must go out”. For example, if 100kg of materials have been bought and only 80kg of materials have been produced, then the 20kg difference must be accounted for in some way. It may be, for example, that 10% of it has been sold as scrap and 90% of it is waste. By accounting for process outputs in this way both in physical quantities (kg) and in monetary terms ($), businesses are forced to focus on environmental costs.

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2. Flow cost accounting – this is also using input/outflow analysis (material flows), but instead of applying simply to the business as a whole, it takes into account the organisation structure. It makes material flows transparent by looking at the physical quantities involved, their costs and their value. It divides the material flows into three categories:  Material – for the purposes of calculating the material values and costs, one needs detailed knowledge of the physical quantities of materials involved in the various flows and inventories.  System – this includes costs that are incurred in the course of in-house handling of the material flows, eg. personnel costs, depreciation.  Delivery and disposal – this includes all costs incurred in ensuring that material leaves the company, eg. payment to external third parties. The values and costs of each material flow are then calculated. The aim of flow cost accounting is to reduce the quantity of materials, this will have a positive effect on the environment and also reduce business’ total costs in the long run. 3. Activity-based costing (ABC) – ABC allocates all internal costs to the cost centres and cost drivers on the basis of the activities that caused the costs. It distinguishes between environment-related costs (eg. costs relating to sewage plant or incinerator), which are attributed to joint environmental cost centres, and environment-driven costs (eg. increased depreciation or higher cost of staff), which are allocated to general overheads. Environment-driven costs do not relate directly to a joint environmental cost centre. No definition is given for environment-related costs and environment-driven costs by UNDSD so I will define them so that you know how to differentiate:  Environment-related costs are the costs that are related to activities in the joint environmental cost centres  Environment-driven costs are the additional costs due to the activities in the joint environmental cost centres. 4. Life cycle costing – environmental costs are considered from the design stage of a new product right up to the end-of-life costs. The full consideration of whole lifecycle of new product at design stage may influence the design of the product itself, saving on future costs.

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Relevant costing Relevant cost is important for decision making and identifying it actually requires some common sense. Relevant costs are those costs that change as a result of making a particular decision. In general, relevant cost is always future, incremental cash flow. Future Therefore, sunk cost (past cost) should be ignored. Incremental The key question is "Is there extra cost making this choice?" When there is more cost to be incurred such as hiring new labour, it is a relevant cost. Fixed cost (like an unavoidable cost) is not relevant but if there is an increment, the increase is relevant. Cash flow Therefore, non-cash flow cost such as depreciation and provision should be ignored. Furthermore, variable cost (avoidable cost) will be relevant for decision making. A committed cost, although is a future cash flow, is not relevant as it must be incurred, cannot be avoided even if the decision is not made (not arose as the direct consequence of the decision). Opportunity cost (the sacrifice from choosing this decision instead of another) is relevant as well. Relevant cost for material This requires more common sense. Example: Company has 100 units of material in inventory and need another 200 units for the job, current purchase price is $10 per unit. Such material will not be replaced. Such material can be used for another job to earn a contribution of $15 per unit and it has a net realisable value (NRV) of $18 per unit. Solution: The problem is dealing with the 100 units, 200 units will be purchased so relevant cost is $2000 (200 x $10). For the 100 units, since they will not be replaced, if without this job company can actually sell them or use them to generate contribution of $15 per unit. It is obvious that company will sell ($18 is more than $15) if without this job, so by taking this job, the opportunity cost is 100 x $18 = $1800. Total relevant cost = 2000 + 1800 = $3800.

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Relevant cost for labour Again this needs common sense. When labour is hired the relevant cost is the cost of hiring. If labour has free time to do this job then there is no incremental cost (unless overtime) so relevant cost will be $0. If labour is transferred from other job to do this job, then again opportunity cost arises as contribution from other job is lost because of this job. Relevant cost for non-current asset If without this job, non-current asset such as machine might be sold for money or used to generate contribution. By taking this job, opportunity cost occurred again and this time, opportunity cost is the higher of NRV or contribution from using the machine elsewhere because we want to know the maximum that we lost. Alternatively, the machine could be replaced and therefore there is a replacement cost. In such situation, replacement cost can be compared to opportunity cost identified earlier, as we want to save cost, the relevant cost will be the lower of replacement cost and opportunity cost.

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Cost-volume-profit analysis (CVP analysis) The focus should be placed on the CVP analysis for multi-product. CVP analysis for one product These knowledge are brought forward from earlier studies: 1. BEP in units = fixed cost/contribution per unit 2. BEP in $ = fixed cost/ (C/S ratio) 3. C/S ratio = total contribution/total sales or contribution per unit/selling price per unit. 4. Margin of safety = budgeted sales – breakeven sales 5. Target sales in units = (fixed cost + target profit)/contribution per unit 6. Target sale in $ = (fixed cost + target profit)/ (C/S ratio) For breakeven chart, you need fixed cost so that you can draw total cost line and for P/V chart, you need fixed cost so that you have the starting point of the profit line. The BEP can be found from breakeven chart which is the intercept of sales line and total cost line, BEP can be found in P/V chart which is the intercept of profit line at the horizontal axis/x-axis. Limitations of CVP analysis The limitations of CVP analysis are also the assumptions of CVP analysis: 1. Assume products are sold in constant mix for single product or multiple products. 2. Assume volume is the only factor that causes revenues and costs to change. This is not always true in reality, for example if sales volumes are to be increased, the price must fall. 3. Assume the total cost and revenue functions are linear. 4. Assume that all costs can be divided into fixed and variable cost. In reality, some costs may be semi-fixed. 5. Assume production volumes are the same as sales volumes. 6. Assume fixed costs are same in total and variable costs are the same per unit at all levels of output, this is wrong. 7. Assume sales prices will be constant at all level of activities. CVP analysis for multi-product We will always assume that the products are sold in constant mix, eg. 3 product A and 1 product B. The knowledge that you need to have is the calculation of contribution per mix, average C/S ratio, target sales and margin of safety plus drawing the breakeven chart and P/V chart.

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Example: Company A sells two products, XX and YY. XX and YY have contribution per unit of $4.20 and $9.80 respectively. For every five units of XX sold, six units of YY are sold. Fixed costs per annum are $43980, budgeted sales revenue for next period is 700 in standard mix and company A expects a profit of $30000. Calculate BEP (units), target sales (units) and margin of safety. Solution: The constant mix is seen from the pattern of sales, XX:YY = 5:6. Contribution per mix can be calculated by ($4.20 x 5) + ($9.80 x 6) = $79.80, with this we can calculate the BEP in mixes. BEP in mixes = fixed cost/contribution per mix = $43980/$79.80 = 550 mixes, with this calculating BEP in units for both product will be possible. BEP in units for product XX = 550 x 5 = 2750 units, BEP in units for product YY = 550 x 6 = 3300 units. Therefore, selling 2750 units of XX and 3300 units of YY will breakeven. (Prove: Profit = contribution – fixed cost = ($4.20 x 2750 + $9.80 x 3300) $43980 = 0) Margin of safety in mixes = 700 – 550 = 150 mixes (to get units, just multiply the mix of the products). Target sales in mixes = ($43980 + $30000)/$79.80 = 927 mixes. Target sales in units for XX = 927 x 5 = 4635 units, target sales in units for YY = 927 x 6 = 5562 units. Example: Company A produces product X and Y. Product X has sales price of $50 and variable cost of $30 while product Y has sales price of $60 and variable cost of $45. Budgeted sales for product X are 20000 units and for product Y 10000 units. Company A’s fixed costs are $200000. Company aims to achieve profit of $300000. Calculate average C/S ratio, breakeven point (in $) and target sales (in $). Solution: Product X has a contribution per unit of $20 ($50 - $30) and product Y has a contribution per unit of $15 ($60 - $45). Average C/S ratio = total contribution/total sales = ($20 x 20000 + $15 x 10000)/($50 x 20000 + $60 x 10000) = 0.34375. With this, you can then calculate the BEP in $ and also target sales in $. BEP (in $) = $200000/0.34375 = $581819. Target sales (in $) = ($200000 + $300000) / 0.34375 = $1454546. Therefore, the company needs sales revenues of $581819 in order to breakeven and sales revenues of $1454546 in order to achieve the target profit of $300000. The breakeven chart is not a problem, it is similar to breakeven chart prepared under CVP analysis for one product. There is something new that you need to be aware of when you are doing multi-product P/V chart, you have to calculate the cumulative profit/loss for the cumulative revenues. Example is shown at the next page.

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Example: Company A produces product X and Y. Product X has sales price of $50 and variable cost of $30 while product Y has sales price of $60 and variable cost of $45. Budgeted sales for product X are 20000 units and for product Y 10000 units. Company A’s fixed costs are $200000. Company aims to achieve profit of $300000. The management wants the P/V chart to show the profits starting from the most profitable product. Prepare the figures necessary for drawing multi-product P/V chart and draw the chart. Solution: Product X’s C/S ratio = $20/$50 = 0.4 and product Y’s C/S ratio = $15/$60 = 0.25. Therefore product X has higher C/S ratio and its profit will be shown first in the graph. Then to avoid confusion, show the following information: Product Contribution Cumulative profit/loss Revenue Cumulative revenues $000 $000 $000 $000 Fixed cost 0 (200) X 400 W1 200 1000 W3 1000 Y 150 W2 350 600 W4 1600 W1 = 20000 x $20 = $400000 W2 = 10000 x $15 = $150000 W3 = 20000 x $50 = $1000000 W4 = 10000 x $60 = $600000 The P/V chart can be drawn by using the cumulative figures. The points to plot are at the coordinate of (0, -200), (1000, 200) and (1600, 350). BEP in $ can also be seen from the graph.

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Profit/ (loss) ($000)

Multi-product profit/volume chart

350 Product Y 200

Product X

Sales in constant mix

1000

1600

Sales ($000)

Breakeven point of both products

-200 Breakeven point of product X

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Linear programming Linear programming is a technique for solving problems of profit maximization or cost minimization. If a scenario contains two or more limiting factors, linear programming must be applied. Steps of linear programming 1. Define variables – For example, let x = number of units of product X and let y = number of units of product y. There are always two variables. 2. State objective function – For example, objective is to maximize contribution, C = 20x + 40y. Very likely the question will ask for contribution maximization instead of cost minimization, so in my example above, 20 is the contribution per unit of x and 40 is the contribution per unit of y. 3. State the constraints – You should state the constraints of the company, it can include material, labour and sales constraint. For example, if company A has maximum of 5400kg material, product X uses 0.27kg per unit and product Y uses 0.27kg per unit, then you should state the constraint as 0.27x + 0.27y ≤ 5400. Don’t forget the non-negativity constraint which is needed to ensure the final solution does not fall below zero, for my example, non-negativity constraint: x, y ≥ 0. 4. Draw the graph – After you stated all the constraints, you can draw their line to the graph, to draw the line, you have to solve each inequalities by making them equation first. For example 0.27x + 0.27y = 5400, if x = 0, y = 20000, if y = 0, x = 20000, this gives you a coordinate of (20000, 20000), place it on the graph and draw a straight line to complete this line. After you drawn each line, remember to label them clearly what the line shows, eg. 0.27x + 0.27y ≤ 5400. 5. Establish feasible region – To find the feasible region, look at the inequalities line, “≤” means less than or equal, so the region can be found by taking into account all line. After you found the feasible region, in clearly label each point you can find the region, for example by OABCDE [O is the point at the coordinate (0,0)], then finally clearly state to the examiner that feasible region is shown by OABCDE. 6. Add iso-contribution line to graph – Iso means isolated, iso-contribution line is based on the contribution function, using my example, C = 20x + 40y, to draw a line for it in the graph, you need the coordinate which is easy, in this contribution function, the coordinate for it is (40,20) or (4000,2000). Then draw this line on the graph using dotted line (because it is isolated). 7. Determine optimal point using iso-contribution line – With the iso-contribution line, now you need to put your ruler on the iso-contribution line and move up slowly in the same parallel as iso-contribution line. With this, you will slowly touch the points in the feasible region, ie. OABCDE, the last point that you touched before leaving feasible region is called optimal point.

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8. Determine optimal solution – With the optimal point, take the coordinate of it, for example point D (5000, 15000), put it into the contribution function, C = 20x + 40y = 20 (5000) + 40 (15000) = $70000, this is the optimal solution. You can check whether the amount found in the optimal point is correct by using simultaneous equation, according to this optimal point, x = 5000, put this into the equation of material 0.27x + 0.27y = 5400, 0.27 (5000) + 0.27y = 5400 and so y = 15000, if this is the result, then the optimal point must be correct. Shadow price and slack Normally this is examined together with linear programming. Shadow price is the extra contribution due to the 1 extra unit added to the critical scarce resource (resource that will be finished using). Shadow price is also the maximum premium that the company will be willing to pay for more critical scarce resource (later you will understand why by looking at an example). When doing linear programming, you will see that one of the limiting factors will be fully utilized (using the optimal solution) and there will be some spare capacity (slack) left for the other limiting factor. Slack = resource required – resource utilised. The one that is fully utilized is the critical scarce resource and the other is called noncritical scarce resource. Non-critical scarce resource does not have a shadow price as there is slack, so we don’t need to pay more to get more of it. Example: An optimal solution shows that company will use all the materials and there will be some labour hour left. Company produces product x and product y. Using the examples above, equation for material is 0.27x + 0.27y = 5400. From the graph, optimal point has a coordinate of (5000, 15000), it falls at a line which shows maximum sales demand for x. Contribution function is 20x + 40y. Company’s current material cost per unit is $200, it can buy extra materials from other supplier at a price of $300 per unit. Calculate shadow price and interpret it. Solution: Remember that shadow price is the extra contribution due to the 1 extra unit added to the critical scarce resource, therefore you can form a new equation, 0.27x + 0.27y = 5401, as optimal point falls at maximum sales demand line for x, we don’t need to produce x anymore. Therefore we should put x = 5000 into the equation instead of putting y = 15000 (we want to increase production units for y), 0.27 (5000) + 0.27y = 5401 and therefore y = 15004. New solution is therefore producing 5000 units of x and 15004 units of y. There are extra 4 units for y and this will earn extra contribution of $160 (4 x $40). This extra contribution of $160 is the shadow price and it is also the maximum premium that the company is willing to pay for extra material, now this makes sense because the maximum we want to pay is the extra that we earned. The supplier offers $300 per unit which is $100 above the normal price, it is acceptable since it is below than shadow price of $160.

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Pricing For every company, the price that the company offers for the goods or services is very important as profits come from the sales and different prices set will have an impact on the sales volumes and also the company’s profits. What influence the price? There are many factors that influence the pricing of product or service, the main one could be 3Cs: 1. Customer – customer demand is a major influence. According to economic theory, the higher the price of a good, the lower will be the quantity demanded. 2. Competitor – company cannot set prices without considering the products and pricing strategies of competitors. 3. Costs – this is the primary factor which accountant will consider. In the long run, company must cover its costs in order to survive and that’s why price may be set using mark-up to ensure price covers costs. There are other factors such as quality, suppliers, inflation, market conditions, product life cycle and so on to consider. Price elasticity of demand (PED) PED measures the sensitivity of the changes in demand to the changes in price. As according to economic theory, high price low demand, low price high demand. PED = % change in demand / % change in price. For example, price of a good is $1.20 per unit and annual demand is 800000 units. An increase in price of $0.10 will result in a fall in annual demand to 725000 units. Calculate PED and comment whether the demand is elastic. Solution: PED = [(800000 – 725000)/800000] x 100% / [(1.30 – 1.20)/1.20] x 100% = 1.125 The demand for this good is elastic because the price elasticity of demand is greater than 1. Demand is elastic means that if there is an increase in price, the demand will change much (sensitive demand). Demand equation, marginal cost and marginal revenue The demand equation is P = a – bQ where P is the price, Q is the quantity demanded, a is the price at which demand would be nil and b is the change in price/change in quantity. The demand equation and the formula for a and b are given in exam. According to economic profit-maximising model, profit is maximised when marginal cost (MC) = marginal revenue (MR). MR = a – 2bQ, MR equation will be given in exam as well and it is similar to demand equation, the following example will help you to understand how everything is applied. 21

Example: A company is reviewing the price of one of its products. The product has a marginal cost of $28 per unit and is currently sold for $65 per unit. At this price the demand for the product is 800 units per week. A market research study shows that for each reduction in the selling price by $5 per unit, the weekly demand would increase by 40 units, and that for each increase in the selling price by $5 per unit, the weekly demand would decrease by 40 units. Calculate the optimal selling price. Solution: A step-by-step approach can be useful to avoid any confusion: 1. We calculate b first, b = change in price/change in quantity = 5/40 = 0.125 2. In exam, formula for a is given, I have another approach, since we have the value of b now, let us put into the demand equation, P = a – 0.125Q. Now we are also given information that when price is $65 per unit, quantity demanded is 800 units, put this information inside the equation and we will have 65 = a – 0.125 (800), so a = 165. 3. Our demand equation is P = 165 – 0.125Q, with this we can get MR already because MR = a – 2bQ, the only difference is there is a “2” in front of bQ, so MR = 165 – 2 (0.125)Q and finally MR = 165 – 0.25Q. 4. For profit maximisation, MC = MR, we know our MC is $28 per unit from the information, now put into the equation and it will look like this: 28 = 165 – 0.25Q, therefore Q = 548. 5. Okay we got out optimal quantity of 548 units, now put this into the demand equation: P = 165 – 0.125 (548) and therefore P = $96.50. In conclusion, our optimal selling price is $96.50 and optimal quantity is 548 units. Total cost function including volume-based discount You are required to derive equation for total cost function and the equation is the one that you seen in F2, y = a + bx (this is covered in quantitative analysis topic). Sometime company provides volume-based discount for those who purchase in bulk, volume-based discount will reduce the variable cost per unit, b will therefore be lower if more units are purchased. Decisions to increase production and sales If you are required to evaluate a decision to increase production and sales levels, you will need to consider incremental costs, incremental revenues and other factors. If the incremental revenue – incremental cost result in an incremental profit, then this decision can be taken.

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Pricing strategies There are a number of different pricing strategies that you should learn, normally you will be asked to apply the pricing strategies, so you have to suggest suitable pricing strategies in different situation: 1. Marginal cost-plus – the price is based on the mark-up of marginal cost. Some managers prefer this method because of its consistency with CVP analysis and special-order decision making (which require relevant costing). On the negative side, prices may be set too low, so if this was used, the mark-up percentage should be made higher. 2. Full cost-plus – Full costs include direct material, direct labour, variable production overhead and fixed production overhead. This reminds managers that all elements of production must be covered by the selling price. These data are readily available because absorption cost is used for valuing inventory. However, this will be inconsistent with CVP analysis and fixed production overhead is distorting when production level is different from budget (it uses overhead absorption rate which can cause over-absorption and under-absorption). When a new product is developed, there are two pricing strategies that are frequently used and each will be used based on the situation. 4. Price skimming – enter the market at a high price to earn as much profits as possible before competition enters the market. This strategy is used if the new product is “a unique new product that has not existed in the market before”, a good example for this is the i-pad, Apple company used price skimming when they first launched i-pad. 5. Penetration pricing – go in the market at a very low price, this is to gain the market share. This strategy is used if the new product is “a unique new product that existed in the market”, a good example is Samsung galaxy, since i-pad is already existed in the market and people prefer to buy i-pad, Samsung galaxy is priced at much lower price than i-pad in order to catch customers’ attention. The rest of the strategies will be as follow: 6. Target pricing – this uses target costing in product pricing, company will do market research to determine the price at which a product will sell, this is discussed in my target costing article. 7. Activity-based pricing – activity-based costing is used to set price, therefore the price will be more realistic as the costs calculated are more accurate, this is discussed in my activity-based costing article. 8. Fixed price tender – the goods will be advertised as being for sale and interested buyers are asked to tender (make an offer and indicate the price they are willing to pay). The minimum price that company can sell can be calculated using relevant costing. 23

9. Complementary pricing – this is used when marketing a set of products that tend to be bought and used together. Products sold have some connection to each other. A good example is printer and ink, a loss leader (ie. printer, which will be priced at a low price, company might make a loss by selling this product) may be used to attract customers to buy. The ink is actually the one that carries a high profit margin and customers will eventually buy the ink. 10. Product-line pricing – this is applied when selling a range of inter-related or similar products, for example different colour of pens. All products in the line may have the same or about the same price. 11. Volume-discounting – a reduction in price will be given for large quantity of purchases. 12. Price discrimination – the same product is sold at different prices to different customers. Discrimination prices can be set based on market segment, product version, place and time. 13. Relevant cost-plus – the prices are set based on the accurate understanding of the real costs of the product or service. This is normally used in special-order decision. Relevant cost is the minimum price of the product which will not generate any profit, so a margin or mark-up should be added.

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Short-term decision making Make-or-buy decision Company can choose to make the product themselves or simply buy from external seller (outsourcing). To decide about this, company has to compare the relevant costs of making (variable and specific fixed cost) and of buying (normally purchase price). If the costs of making are cheaper, definitely company will want to make. For example, company A has variable cost of $20 per unit when making this product and alternatively company can buy this product from an external seller at $30 per unit. Company will need to pay a salary of $1000 per month if it wishes to make. Advice the company whether it should make or buy. Solution: Without taking into account the specific fixed cost, the company will have a saving if make of $10 per unit ($30 – $20), but since there is a specific fixed cost if company chooses to make, then the company cannot simply decide by only looking at the saving of $10 per unit, $1000/$10 per unit = 100 units, with this, we can conclude that if company needs less than 100 units, then buy (because the fixed costs cause the making of 100 units more expensive), if company needs more than 100 units, then make. (You can check about this by calculating costs for 50 units and 200 units) If the company must buy some of the products because of scarce resources, then additional workings are needed (this only occurred if the company is deciding on more than one product). This is similar to one limiting factor situation: 1. (Purchase cost – variable cost)/limiting factor for each product. 2. Do ranking for each product, the product with highest value will be ranked first and will be considered to make first. 3. Produce an optimal production plan, the highest ranked product is made first, follow by other product until the labour hour is fully utilized. 4. The rest of unmade amount of products will be bought from outsourcer. Other than costs: 1. Reliability of the outsourcer should be assessed. If products are delivered late then the customer could be disappointed. 2. The quality of the product from outsourcer needs to be considered. 3. Loss of control over the manufacturing process can reduce the flexibility that the company currently has over production.

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Special order decision Company has to consider an order at a special price. In this case relevant costing must be used, price based on relevant costs (after mark-up) is often the minimum price that company can sell, so if this price is higher than the special price, then company should not sell to this customer. Shut-down decision This involves decision about whether to add or drop a service, product or department. The key is the proper handling of fixed costs as fixed costs are sometime avoidable (ie. relevant). When a manager is considering dropping a product line, relevant costs of dropping the product line should be calculated. If there are savings after dropping the product line (eg. Sales of other product will increase), then it is deducted from the relevant costs. At the end, the product line will be shut down if the benefit exceeds relevant costs (ie. shutting down result in benefit). Further processing decision When two or more products result from a common manufacturing process, the products are called joint products. Company will have to decide whether the joint products will be further processed or sell immediately. The key to the correct decision is considering only the further processing costs and comparing it to the increase in revenue from the extra processing, the costs of producing the joint products are not relevant (sunk cost). In other word, incremental revenue – further processing costs. For example, product A and B have been manufactured. Product A and B are able to be sold for $10 per unit and $8 per unit respectively. Product A and B can be further processed into product AA and BB respectively. Selling prices of product AA and BB are expected to be $20 per unit and $14 per unit respectively. Company will incur further processing costs of $5 per unit for product A and $7 per unit for product B. Advice the company which products should be further processed and which should be sold immediately. Solution: The incremental revenue for product AA is $10 ($20 - $10) and for product BB is $6 ($14 - $8). This will then be compared to the further processing costs: AA BB Incremental revenue $10 $6 Further processing costs ($5) ($7) Incremental profit/ (loss) $5 ($1) Based on the above calculation, we can conclude that product A should be further processed and product B should be sold immediately.

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Take note that per unit figure can only be used if the input and output quantity are the same, if let say the product A has 1000 units and after further processed it left with 900 units, then you should not use per unit to make decision, you should for example multiply $10 to 1000 units and use this $10000 (sales revenue) to compare with sales revenue after further processed. Limiting factor Sometime the production is restricted by labour hours, materials or machine hours. When only one limited resource is present, a company should focus on products that have the greatest amount of contribution per limiting factor. You have learnt this, here is a revision for you, what you have to do is: 1. Identify limiting factor. 2. Calculate contribution per unit for each product. 3. Calculate contribution per limiting factor (contribution per unit/limiting factor per unit) 4. Rank products (first for product with highest contribution per limiting factor). 5. Prepare an optimal production plan, start with the first ranked product until scarce resource is used up.

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Dealing with risk and uncertainty in decision making Risk can be measured by probability whereas uncertainty cannot be predicted with probability. There are different types of people and they will deal with risk or uncertainty differently: 1. Risk seeker – a decision maker who is only interested in best outcomes, ignoring the chances of occuring. (Optimistic) 2. Risk neutral – a decision maker who is concerned for most likely outcome. 3. Risk adverse – a decision maker who assume that the worst outcome might occur. (Careful) How to reduce uncertainty? As management accounting focuses on future and future is uncertain, we will try to reduce the uncertainty: 1. Market research – Market research is an organised effort to gather information about markets or customers. Market research enables organisations to understand the needs and opinions of their customers and other stakeholders. Therefore, more data, both quantitative and qualitative is obtained through research. Gathering and analysing all the facts will ultimately lead to better decision making (uncertainty can be reduced). 2. Focus group – Focus group is group of people, chosen based on their ability to provide specialised knowledge, interviewed in open session for market research. Much more ideas and data can be collected which can then reduce the uncertainty. Now we will deal with risk and uncertainty using the techniques available. Simulation Simulation models can be used to deal with decision problems involving a number of uncertain variables. Random numbers are used to assign values to the variables, they are allocated to the uncertain variables based on the probabilities, eg. a probability of 0.1 gets 10% of the total numbers to be assigned. You are only required to explain simulation model, not developing it, so the above is sufficient. Expected values (EV) Expected values indicate what an outcome is likely to be in the long term with repetition. Probabilities will be assigned to various possible outcomes from an analysis of previous experience. The principle is that when there are a number of alternative decisions, each with a range of possible outcomes, the optimum decision is to choose the one with highest EV. Expected values = total of probability x outcomes. EV will never actually occur, the probability is just an estimate using past experience, the EV are only average. 28

Example: A manager has to choose between options A and B, the probabilities are set: Option A Option B Profit ($) Probability Profit ($) Probability 5000 0.8 (2000) 0.1 6000 0.2 5000 0.2 7000 0.6 8000 0.1 Help the manager to decide by using expected values. Solution: Option A Option B Profit ($) Probability EV Profit ($) Probability EV 5000 0.8 4000 (2000) 0.1 (200) 6000 0.2 1200 5000 0.2 1000 5200 7000 0.6 4200 8000 0.1 800 5800 Option B offers higher EV of profits, therefore option B should be selected. Sensitivity analysis/What-if analysis Sensitivity analysis is a technique used to test the sensitivity of the output variable by changing one input variable. Input variable can be sales volume, selling price per unit, variable cost per unit or fixed cost. Output variable can be contribution or profit (the result from changing input variable). The more sensitive is the output variable, the more risk there will be. Here is an example to demonstrate: Company’s summary budgeted profit statement is as follows: $ Revenue 400 Variable costs 240 Contribution 160 Fixed costs 100 Profit 60 Assume sales mix remains the same, determine what percentage change in sales volume would be needed to change the profit to $0. Solution: As the sales mix remains, we can expect C/S ratio to stay the same, C/S ratio = 160/400 = 0.4. Next, we start by working from down to up, start by changing the profit. $ Contribution 100 Fixed costs 100 Profit 0 29

We need to know how much revenue can make $100 contribution, use the C/S ratio. 100/S = 0.4, so sales = 100/0.4 = $250 (of course the faster way will be to use breakeven point calculation). We know that when revenue is $250 we will get $0 profit, so the percentage change in sales volume to change profit to $0 = (400 – 250)/400 x 100% = 37.5%. The higher this percentage, the better because it shows the sensitivity, if the percentage is lesser, it shows that the profit is more sensitive, a little change in sales volume may cause it becomes $0 profit. Therefore, this percentage is also the margin of safety, higher margin of safety means lower risk. Value of perfect information If we do not have perfect information, we would select the decision option which offers the highest EV of profit. With perfect information, the best decision option will always be selected. Perfect information enables managers to make decisions with complete confidence. However, perfect information rarely or never exist in practice. The value of perfect information = EV with perfect information – EV without perfect information. This actually means that we calculate one EV when we have the perfect information and one EV when we don’t have that information, then compare to find out how valuable is the information. Decision tree Decision trees are diagrams which show the possible outcomes of a decision. 1. Every decision tree starts from a decision point, you should draw a square shape as the decision point. 2. Then every decision has outcomes, you should draw lines after the decision tree from left to right for each option available. 3. If the outcome from any option is certain, the line/branch of the decision tree for that option is complete. 4. If the outcome of the option is uncertain, the possible outcomes of it must be shown, we can show them by inserting an outcome point, use a circle as the symbol for outcome point. 5. Use a dot to end the decision tree. Decision tree can be drawn as a two-stage tree by drawing one more square in the situation of multi-stage decision problem. Decision tree will look like this:

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We can use rollback analysis to evaluate the decision with the decision tree. Rollback analysis evaluates the EV of each decision option. You have to work from right to left and calculate EV at each outcome point. The basic rules are as follows: 1. Start on the right hand side of the tree and work back towards the left hand side (rollback). 2. Working from right to left, we calculate the EV of revenue, cost, contribution or profit at each outcome point on the tree. The key concept is that the option made at the decision point depends on the EV of the outcome point (the higher will be chosen). Maximax, maximin and minimax regret If the probabilities are too subjective to use, management will use their attitude to deal with uncertainty in decision making. There are three types of decision rules (related to attitude) which will result in different decision being made: 1. Maximax – Maximising the maximum profits, the decision maker is risk seeker. Step 1: Look for the maximum profits. Step 2: Select the maximum. This is the easiest rule, you can actually look for all outcomes and choose the best one. 2. Maximin – Maximising the minimum profits, the decision maker is risk adverse. Step 1: Look for the minimum profits. Step 2: Select the maximum among the minimum profits. 3. Minimax regret – Minimising the maximum regret (loss). (This is the most complicated rule, be sure to understand it) Step 1: Develop a regret table and show all the regrets, uncertain variable should always be put at the left hand side and decision factor at the middle (later look at an example). Step 2: Determine the maximum regrets for each decision factor. Step 3: Select the minimum.

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This is to avoid the loss of making the wrong decision, when you made a wrong decision you will regret, therefore regret table is used to calculate the regrets. Decision factor = the variable that we are deciding on, ie. not uncertain variable. Example: A breakdown service has compiled an analysis of its members. It is anticipated that the variable cost per member could be $70, $65 or $60 (therefore this is uncertain variable) and that a flexible pricing policy will result in the following outcomes: Subscription fee ($) Number of subscribers 110 45000 100 58000 90 80000 (a) Prepare a summary showing the budgeted contribution for each of the nine possible outcomes. (b) State the membership fee strategy which will result from each of the following decision rules: maximax, maximin and minimax regret.

Solution: (a) As variable cost per member is uncertain, for each subscription fee set, there will be three possible variable cost per member, so present them clearly: Fee ($) Variable cost per member ($) Contribution ($) 110 70 (110 – 70) x 45000 = 1800000 110 65 (110 – 65) x 45000 = 2025000 110 60 (110 – 60) x 45000 = 2250000 100 70 (100 – 70) x 58000 = 1740000 100 65 (100 – 65) x 58000 = 2030000 100 60 (100 – 60) x 58000 = 2320000 90 70 (90 – 70) x 80000 = 1600000 90 65 (90 – 65) x 80000 = 2000000 90 60 (90 – 60) x 80000 = 2400000 (b) Maximax Choose the highest contribution among the best contribution for each possible decision. To save time, from all contributions, choose the highest one which is $2400000, therefore set the fee as $90 per member.

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Maximin Choose the highest contribution among the worst contribution for each possible decision. Fee ($) Worst contribution ($) 110 1800000 100 1740000 90 1600000 From here, choose the highest one, ie. $1800000. Therefore set the fee as $110 per member. Minimax regret Prepare a regret table, putting decision factor in the middle and uncertain variable at the left side: Variable cost per Fee per member (decision factor) member $110 $100 $90 (uncertain) $70 0 (best, so no $60000 (loss) $200000 (loss) regret) $65 $5000 (loss) 0 (best, so no $30000 (loss) regret) $60 $150000 (loss) $80000 (loss) 0 (best, so no regret) Maximum regret $150000 $80000 $200000 If you are not sure how to get the amount of loss, let’s pick an example, at variable cost per member of $70, from the three fee, you can see that charging $110 will earn $1800000 and charging $100 and $90 will earn $1740000 and $1600000 respectively, therefore the loss for choosing to set fee at $100 is $60000 (1800000 – 1740000). The decision is to minimise the maximum regret, so $80000 is the lowest regret, therefore set the fee as $100 per member.

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Objectives of budgeting Objectives of budgetary control system The objectives of budgetary control system are essentially the benefits of it, there are many, mnemonic PCCCME: 1. Planning – budgeting starts at planning stage, this will force management to look ahead, detailed budgets will be set. 2. Control – budget provides a yardstick for actual results to be compared and the variances may be investigated. 3. Coordination – it is important to ensure maximum integration of effort from every department towards common goals, budget will facilitate this by bringing together the activities of all different departments into a common plan. All departments in the organisation should be coordinated and be in line with the objectives and limiting factor (principal budget factor). 4. Communication – the budget is an effective way of informing departments and people what is expected of them. 5. Motivation – rewards can be given to employees who achieved the expected performance set in the budget. 6. Evaluate performance – budget is a basis for comparison of actual and budgeted performance. Performance-based rewards are given for achieving budgeted results. Other objectives include: 1. Delegate authority – a formal budget permits budget holders to make financial decisions within the specified limits agreed, ie. to incur expenditure on behalf of the organisation. 2. Ensure achievement of the management’s objectives – objectives are set not only for the organisation as a whole but also for individual targets. The budget helps to work out how these objectives can be achieved. Corporate and divisional objectives Corporate objectives concern the firm as a whole, they should relate to the key factors for business success (known as critical success factors). Examples of corporate objectives include: 1. Maximising shareholders wealth. 2. Improve market share. 3. Growth and sustainable. 4. Continuous improvement in quality (for company which has total quality management system). 5. Ensure customer satisfactions.

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Divisional objectives are set by divisional managers. These objectives are more related to how to improve the division performance. There is a danger element because sometime managers make decisions that are of self-interest, the objectives set could conflict with other divisions’ objectives and also the corporate objectives. This type of decision making is called dysfunctional decision making whereby the decisions taken by divisional manager are in the best interests of his own part of the business, but possibly against the interests of the organisation as a whole. Conflicting objectives may be resolved by: 1. Prioritisation – certain goals get priority over others. Senior managers will rank goals and strategies according to certain criteria. 2. Negotiation – allows full participation of all people who prepare the budgets and have bargaining process for each stage of budgeting process. 3. Compromise – when there is disagreement in negotiation, the parties should compromise, if it is positive then both parties win something, if it is negative then both parties lose something. Win-lose situation will cause damage to relationship. 4. Satisficing – This occurs when a satisfactory rather than optimal solution is found. Organisation may not aim to maximise performance in one area if this leads to poor performance elsewhere, so accept satisfactory solution. Every organisations should try to ensure goal congruence exists in order to avoid conflicting objectives. Goal congruence is the state which leads individuals or groups to take actions that are in their self-interest and also the best interest of the organisation (ie. manager goals = organisation goals). This is not easy to achieve, budgetary control system needs to be well designed which should encourage continuous feedback from employees.

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Budgetary systems In paper F5, you will not be required to prepare sales budget, production budget, material usage budget, material purchase budget and so on, these are all covered in earlier studies. Planning and control in the performance hierarchy Planning and control occurs at all level of the performance hierarchy to different degrees. Budgetary systems fit into the planning and control stage. Planning is deemed as more significant at the higher levels of performance hierarchy while budgetary control occurs at the lower levels of the performance hierarchy. There are three types of planning: long-term, medium-term and short-term, budgeting occurs at short-term planning which is for less than one year. At the control stage, management will collect all the feedback after the comparison of actual and budgeted results, both positive and negative, and take action based on it. Different types of budgetary systems 1. Top-down budgeting (imposed) – top management prepare the budget and then impose to the employees. This is suitable in the following situation: (a) New organisation. (b) Very small business. (c) During period of recession. (d) Operational managers lack budgeting skills. 2. Bottom-up budgeting (participative) – this is the opposite of top-down budgeting, operational managers are brought together to discuss and make the budgets. This could improve motivation as the budget is not one-sided. This may also improve the quality of budget decisions as the skills of the managers are pooled. This is suitable in the following situation: (a) Organisation is well-established. (b) Very large business. (c) During period of good economic environment. (d) When operational managers have strong budgeting skills. 3. Rolling budget – rolling budgets are budgets which are continuously updated by adding a further accounting period when the earlier accounting period has expired. For example, let say a budget is for four quarters (Q), when Q1 is over, a new Q1 will be added, at the end of Q1, company will also update Q2 budget and make it more detailed. It takes into account the latest information.

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4. Zero-based budgeting (ZBB) – as the name suggested, this involves preparing the budget from zero base. Every item of expenditure has to be justified before it is included in the budget. There are three steps of ZBB: (a) Define decision packages – decision package (description of activity) is prepared at the base level (base package), representing the minimum level of service or support needed to achieve the organisation’s objectives. Further incremental packages may then be prepared to reflect a higher level of service or support. (b) Ranking of decision packages – management will evaluate and rank each activity (incremental decision package) on the basis of its benefit to the organisation. This will help management decide what to spend and where to spend it. (c) Allocate resource – the resources are then allocated based on the order of priority up to the spending level. For example, a car manufacturer may choose to allocate more funds to production processes than service and admin functions, based on the ranking of each activity. ZBB is useful for budgeting for discretionary costs (eg. training costs, research and development costs), service industries, non-profit-making organisations and support expenses (expenses to support the essential production function). 5. Activity based budgeting (ABB) – ABB involves defining the activities that caused the costs and using the level of activity to decide how much resource should be allocated, how well it is being managed and to explain variances from budget. ABB involves the use of costs determined using activity based costing (ABC) as a basis of preparing budgets. 6. Incremental budgeting – this is the traditional approach to budgeting. Budget is prepared using a previous period’s budget or actual performance as a base, with incremental amounts then being added for the new budget period. It is known for encouraging slack and wasteful spending, hence it is particularly unsuitable for public sector organisations which are aiming to achieve desired results with the minimum use of resources. 7. Feed-forward control – this is different from feedback and business organisation uses feedback for control. Feed-forward control is control based on forecast results, control action will be taken in advance if the forecast is bad. Advantages of top-down budgeting 1. Budgeting time is reduced. 2. Budget is set by experienced top management instead of some inexperienced employees. 3. Enhance the coordination between the plans and objectives of divisions. 4. Strategic plans are more likely to be incorporated into budget as top management understands better the strategic plan which is set by them.

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Disadvantages of top-down budgeting 1. May not be agreed by the employees, so motivation may be affected. 2. If employees feel the budget is unachievable, it will cause great demotivation. 3. The lower-level managers now may still be inexperienced when they had become top management. Advantages of bottom-up budgeting 1. Knowledge of several levels of management is pooled. 2. Can improve motivation. 3. They are based on information from employees most familiar with the department. 4. In general they are more realistic. Disadvantages of bottom-up budgeting 1. Need more time. 2. Managers may introduce budgetary slack (deliberate overestimation of costs and/or underestimation of revenues in the budget). 3. Managers may not be experienced enough and so the quality of budget can be affected. Advantages of rolling budgets 1. Reduce uncertainty because they concentrate detailed planning and control on short-term prospects. 2. Up-to-date budgets are always available. 3. The budget will be more realistic and this would have a better motivational influence on managers. 4. Reduce the time of preparing annual budget because for example, at the time of preparing annual budget, three quarters budget could had been done. Disadvantages of rolling budgets 1. Need more time, effort and money. 2. Frequent budgeting could have a demotivating effect on managers. Advantages of ZBB 1. Prevent budgetary slack. 2. It responds to changes in the business environment. 3. Remove inefficient or obsolete operations. 4. More efficient allocation of resources.

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Disadvantages of ZBB 1. Take up a lot of time and costs may be more than benefits. 2. Managers may have to be trained in ZBB techniques as it requires skills in constructing decision packages. 3. Ranking of decision packages can be difficult. Advantages of ABB 1. A more accurate budget is available. 2. Costs are analysed into activities, therefore it is easier to identify what cause more costs. 3. Different activity levels will provide a foundation for the base package and incremental package of ZBB. 4. Can increase management commitment to the budget process. Disadvantages of ABB 1. Require more time and costs. 2. Costs of preparing ABB could be higher than benefits from it. 3. When there are a lot of activities involved, it will be complicated to prepare ABB. Advantages of incremental budgeting 1. Quickest and easiest method of budgeting. 2. Suitable for organisations that operate in a stable environment. 3. Build from the readily available figures from last year. Disadvantages of incremental budgeting 1. Encourage budgetary slack. 2. Uneconomic activities may be continued. 3. Can lead to misallocation of resources. Information used in budget systems and sources of information needed Past data may be used as a starting point for the preparation of budgets but other information from a wide range of sources will also be used because in budgeting, we have to be forward-looking. In case of sales budget, the information needed would be the past sales patterns and also the forecast of future sales patterns. The sources of information include the results of market research, economic environment, pricing policies and discounts offered, legislation and so on. In case of production budget, the sources of information include labour costs, raw material costs and machine hours. Therefore, you have to think where to get the information for preparing a realistic budget, this is an important role of management accountant. 39

Difficulties of changing a budgetary system 1. Resistance by employees – employees who had familiar with the current system may be unwilling to go for new control system. 2. Loss of control – senior management may take time to be familiar with new system and understand the implications of results. 3. Training – everyone needed to be fully trained if new budget system is to be introduced. 4. Costs of implementation may be high (include training costs, installation costs etc). 5. Lack of accounting information. How budget systems can deal with uncertainty in the environment Rolling budgets are a way of trying to reduce uncertainty by continuously updating budget. Probabilistic budgeting (probabilities are assigned to different conditions) and sensitivity analysis are also useful. Flexible budget is a budget which recognises cost behaviour and is designed to change as volume of activity changes. Uncertainty can be allowed in flexible budgeting. These methods are suitable when the degree of uncertainty is quantifiable.

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Quantitative analysis in budgeting High-low method and linear regression analysis Both of these methods can be used to analyse fixed and variable cost elements from total cost data. High-low method is used to identify fixed and variable costs from semi-variable cost. Step 1: (Total costs at highest activity level – total costs at lowest activity) ÷ (total units at highest activity level – total units at lowest activity level). Step 2: Calculate fixed cost by fixed cost = total cost – (variable cost per unit x units) Step 3: Summarise the relationship by making an equation, eg. Fixed cost = $600, variable cost per unit = $0.2, total cost equation is y = a+ bx, so y = 600+ 0.2x. Below example is when there is step-fixed cost: Company A produces product G. The following information related to G: Total costs ($) Activity level (units) 40000 2300 28000 1500 After 2000 units of G are produced, there will be an increase in fixed costs of $2000, calculate the total costs of 1800 units. Solution: You have to exclude step-fixed cost when you calculate variable cost per unit. When you calculate fixed cost, you should use the activity level and total costs that are not affected by step-fixed cost. Variable cost per unit = (40000 – 2000 – 28000) ÷ 2300 – 1500 = $12.5 Fixed cost = $28000 – ($12.5 x 1500) = $9250 y = 9250 + 12.5x when activity level is less than 2000 units. y = 11250 + 12.5x when activity level is 2000 units or more. Therefore, total costs of 1800 units = 9250 + 12.5 x 1800 = $31750. High-low method is simple and easy to use. However it is based on historical information and the cost estimates may not be accurate. Linear regression analysis, also known as least squares technique, is a statistical method of estimating costs using historical data from a number of previous accounting period. Linear relationship is expressed as y = a + bx. There are formula to calculate a and b, you don’t have to memorise the formula as they are given in exam, however you should be able to use them quickly in exam. When y = a + bx, b =

and a =

-

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Example: You are given the following data for output at a factory and costs of production over the past five months. Month Output (‘ooo units) (x) Costs ($000) (y) 1 20 82 2 16 70 3 24 90 4 22 85 5 18 73 (a) Derive an equation to determine the expected cost level. (b) Prepare a budget for total costs if output is 22000 units. Solution: (a) For your workings, you should prepare to calculate the following amount (note that is used to calculate correlation coefficient which will be used later): x y xy 20 82 1640 400 6724 16 70 1120 256 4900 24 90 2160 576 8100 22 85 1870 484 7225 18 73 1314 324 5329 = 100 ∑y = 400 ∑xy = 8104 = 2040 ∑ = 32278 n = 5 (There are five pairs of data for x and y values)

=

b= a=

-

= 2.6

= 400/5 – (2.6 x 100)/5 = 28

y = 28 + 2.6x (b) When output is 22000 units, total costs = y = 28 + 2.6 x 22 = 85.2 = $85200 When we use linear regression analysis, cost function is assumed to be linear. It is still based on past data and it is not reliable if we don’t know the correlation coefficient. Correlation coefficient is a measure of how linear the relationship between variables is. A correlation coefficient of +1 indicates perfect positive linear correlation, whereas -1 indicates perfect negative linear correlation, it must be within this range, if not then there must be mistake. The formula of it is given in exam, r =

Using the above example, the r =

= 0.99, the

variables are considered linear and so the linear regression analysis is quite reliable.

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Coefficient of determination is a measure of how much the change in the dependent variable (y) is explained by the change in the independent variable (x). Coefficient of determination = and this is not given in exam. It should be within 0 and 1. Forecasting techniques Management can use a number of forecasting methods such as: 1. Judgement and experience – sales personnel can be asked to provide estimates. 2. Market research can be used (especially for new products or services). 3. Simulation. 4. Simple average growth model – growth rate of sales for example, can be estimated by looking at the sales revenue of past few years. 5. Assigning probabilities for identifying expected values. 6. Time series – this is a series of figures or values recorded over time, main focus is on this method. Time series analysis A time series has four components: 1. Trend (T) – the general direction which sales follow. 2. Seasonal variations (S) – the short-term fluctuations in recorded values. For example, sales of ice cream will be higher in summer than in winter. 3. Cyclical variations (C) – medium-term changes in results caused by events which repeat in cycles, these are the longer-term version of seasonal variations. 4. Random variations (R) – fluctuations caused by unforeseen events, it is unpredictable. Therefore, actual time series (A) = T + S + C + R, but you can ignore C and R. Trend Trend line can be determined by regression analysis, you could be asked to do this in exam, you can be given sales of the product for a number of years, you have to find the y = a + bx and y will be the trend. An example is needed here: Sales of product B over the seven year period from 20X1 to 20X7 were as follows. Year 20X1 20X2 20X3 20X4 20X5 20X6 20X7 Sales of B (‘000 units) 22 25 24 26 29 28 30 Calculate the trend line of sales and forecast sales in 20X8.

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Solution: Shows the same workings excluding because you don’t need to calculate correlation coefficient, start the x by numbering from 0 upwards. Year x y xy 20X1 0 22 0 0 20X2 1 25 25 1 20X3 2 24 48 4 20X4 3 26 78 9 20X5 4 29 116 16 20X6 5 28 140 25 20X7 6 30 180 36 ∑x = 21 ∑y = 184 ∑xy = 587 = 91 n=7

=

b= a=

-

=

= 1.25 –

= 22.5

Trend line, y = 22.5 + 1.25x. Sales in 20X8 (year 7) will be 22.5 + 1.25 x 7 = 31.25 = 31250 units. Seasonal variations There are two types of models to estimate seasonal variations: 1. Additive model, this is based on A = T + S + R (you can ignore R), so for example the trend of Q1 adds seasonal variation of Q1 = actual time series/forecast sales. It is more suitable when the trend is constant. 2. Multiplicative model, this is based on A = T x S x R, so for example the trend of Q1 multiplies seasonal variation of Q1 = forecast sales. It is more suitable when the trend is increasing or decreasing over time. Normally you would be given seasonal variations for 4 quarters and told to use either model to forecast sales. There is something to check here, when using additive model, adding all four seasonal variations should equal to 0, when using multiplicative model, adding all four seasonal variations should equal to 4, if not you should make adjustment to the seasonal variations. When the seasonal variations given are with ‘+’ or ‘-‘, then it is understood that additive model is used, if not then multiplicative model. Example: Company A wishes to forecast sales for Q1 of 2011. Trend line determined using linear regression analysis is y = 21 + 5x, x = 0 at 2008 quarter 1. The seasonal variations for four quarters are estimated as follow: Q1 Q2 Q3 Q4 Total Seasonal variations -$50 $150 -$70 $50 $80 Using additive model, forecast sales for 2011 for the company.

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Solution: Q1 Q2 Q3 Q4 Total Seasonal variations -50 150 -70 50 80 Adjustment -20 -20 -20 -20 -80 Adjusted seasonal variations -70 130 -90 30 0 x = 0 at 2008 quarter 1, so x = 1 at 2008 quarter 2, x = 4 at 2009 quarter 1, x = 12 at 2011 quarter 1. Trend for Q1 of 2011 = 21 + 5 (12) = 81, forecast sales for Q1 of 2011 = 81 + (-70) = $11. Good news here is that you can ignore the adjustment of seasonal variations in exam (unless examiner specifically requires it). Learning curve theory Learning curve theory applies to situations where the workforce as a whole improves in efficiency with experience. The learning effect describes the speeding up of a job with repeated performance. The lesser the learning rates, it means the faster the labour learns and total time required for production is reduced. Learning curve theory can be used to: 1. Calculate incremental cost of making extra units of a product. 2. Quote selling prices for a contract by taking into account the learning effect, labour costs would be lower and so the price can be charged lower. 3. Prepare realistic production budgets and more efficient production schedules. 4. Prepare realistic standard costs for cost control purposes. An important concept for you to learn, learning curve theory is based on the following concept: Each time output doubles, the average time taken is reduced to a certain % (learning rate) of the average time take before output doubled. Tabular approach Example: The first unit of output of a new product requires 1 hour. A 90% learning curve applies. Calculate the total time required to produce 8 units. Solution: There are three basic things to present using tabular approach, remember the output doubles each time. Units Cumulative average time per unit Total time required 1 1 hour 1 hour 2 1 x 0.9 = 0.9 hours 2 x 0.9 hours = 1.8 hours 4 0.9 x 0.9 = 0.81 hours 3.24 hours 8 0.81 x 0.9 = 0.729 hours 5.832 hours The total time required to produce 8 units are 5.832 hours with learning effect.

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Algebraic approach The formula for learning curve is given in exam, , y is the cumulative average time per unit to produce x units, x is the cumulative number of units, a is the time taken for the first unit of output, b is the index of learning (log LR/log 2), LR is the learning rate as a decimal. It is common that examiner gives you the learning index, however examiner can choose not to give you so you have to know that it is calculated as log LR/log 2. Using the above example, let’s try to get 0.729 hours, remember that y represents the cumulative average time per unit, so y = 1 x =1x = 0.729 hours. Steady state Eventually, the learning process will stop when there is nothing more for the labour to learn, this is probably when a certain amount of units of products had been produced. Steady state is when it reaches peak efficiency, learning stopped. Example: Company B estimates that the first chair will take two hours to prepare but this will be subject to a learning rate (LR) of 95%. The learning improvement will stop once 128 chairs have been made and the time for the 128th chair will be the time for all subsequent chairs. The cost of labour is $15 per hour. Value of b is -0.074000581. Calculate the labour cost of the 128th chair made. Solution: Be careful, learning stops once 128 chairs have been made, so this is the steady state, when you are required to calculate labour hour or cost of 128 chairs or the subsequent chairs, they will be the same. To find out the labour hour for 128 th chair, the only way is by total time taken to produce 128 chairs – total time taken to produce 127 chairs. Producing 128 chairs, y = = 1.396674592. Total time taken to produce 128 chairs = 1.396674592 x 128 = 178.77 hours. Producing 127 chairs, y = = 1.39748546. Total time taken to produce 127 chairs = 1.39748546 x 127 = 177.48 hours. Labour hour for 128th chair (and subsequent chairs) = 178.77 hours – 177.48 hours = 1.29 hours. Labour cost of the 128th chair made = 1.29 x $15 = $19.35 Example: Company B expects that the first kitchen will take 24 man-hours to fit but thereafter the time taken will be subject to a 95% learning rate. If the second kitchen alone is expected to take 21.6 man-hours to fit, demonstrate how the learning rate of 95% has been calculated.

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Solution: This question is different, however it is still easy if you understand. You are given the time taken to produce the 2nd kitchen, so it is like working backward, use tabular method to reduce confusion: Number of kitchens Cumulative average time per unit Total time required 1 24 24 2 (21.6 + 24) = 45.6 nd The time required to produce 2 kitchen is 21.6 hours, therefore the total time required to produce 2 kitchens is 45.6 hours. With this, you can also get the cumulative average time per unit for producing 2 kitchens: Number of kitchens Cumulative average time per unit Total time required 1 24 24 2 (45.6/2) = 22.8 45.6 As you know, 24 x learning rate (LR) = 22.8, therefore LR = 22.8/24 = 95% (demonstrated). Reservations/limitations of learning curve 1. The learning curve phenomenon is not always present. 2. It assumes stable working environment which will enable learning to take place. 3. It might be difficult to obtain accurate data to decide what the learning curve is. 4. Workers might not agree to a gradual reduction in production time per unit. 5. It assumes a certain degree of motivation among the employees. Applying expected values Expected values can be used to determine the best combination of expected profit and risk. Probabilistic budgeting is used to assign probabilities to different conditions (most likely, worst possible, best possible) to derive an EV of profit. EV is covered in the topic of dealing with risk and uncertainty in decision making. Using spreadsheets in budgeting Spreadsheet packages can be used to build business models to assist the forecasting and planning process. As you know, spreadsheet is particularly useful for ‘what if’ analysis or sensitivity analysis and also simulation. The main advantage of using spreadsheet is that it can manipulate information very fast, for example when you change the sales amount of the sales budget, production units in production budget (which is linked to sales budget) will also change accordingly. However it will be difficult to trace errors and cannot take into account the qualitative factors.

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Behavioural aspects of budgeting Budgets can affect people’s behaviour. Motivation is the key issue. Budget targets are normally set with pay as a reward of achieving it, this is hoped to motivate employees to work harder. Setting difficulty level for a budget Targets can assist motivation if they are set at the right level: 1. If they are too difficult then they will de-motivate (ideal standard). 2. If they are too easy then managers are less likely to put in maximum effort as there is no sense of achievement. There are four types of standards and each having impact on employee motivation: 1. Ideal standard – standard that is based on perfect working conditions, this has a demotivating effect as it is unattainable. This could be used for long-term targets. 2. Attainable standard – standard that can be attained if the work is carried out efficiency, some allowance is made for wastage and inefficiencies. This has motivating effect and aspirations budgets use it. 3. Current standard – standard that is based on current working conditions, this is used in expectations budget, it does not have motivation effect. 4. Basic standard – standard that is unchanged over the years and is used to show changes in efficiency or performance, it should not be used as a target because it is too easy for managers. Ideally budget should be slightly higher than expected performance level, this is known as aspirations budgets. This is likely to motivate higher levels of performance. However the budget for planning and decision making should be based on reasonable expectations (expectations budget). Therefore, manager can show the employees the targets set under aspirations budgets but when doing standard costing (next topic), manager should compare the actual results with the expectations budget. Participation of employees in the negotiation of targets This can have motivating effect as the employees have chance to voice out what they think the targets should be. The budgets will therefore be more realistic to the employees (they will have a sense of ownership of the budgets) and they will have the motive to achieve their suggested targets. However do not forget that employees have lesser experience and they might build budgetary slack to the budget. It would be better to have a higher level person to negotiate the targets with the employees so that guidance is provided and avoid budgetary slack. 48

Budgeting and standard costing Standard costing is a system of accounting based on pre-determined costs and revenue per unit which are used as a benchmark to assess actual performance. This will then provide useful feedback information to the management. The use of standard costs Standard cost is an estimated unit cost. For each type of costs, management will set a standard cost on it. Standard costing is used widely for: 1. Inventory valuation. 2. Budget preparation and budgetary control. 3. Performance measurement. 4. Motivating staff using standards as targets. Standard costing is most suited to mass production and repetitive assembly work. Methods to derive standard costs The methods are different for each type of costs and revenues, some examples are as follow: Material price – set by purchasing department, depend on pricing discussions with regular suppliers, forecast movement of prices in the market, availability of bulk purchase discounts, quality of material required by production department and so on. Material usage and labour efficiency – set by production department, depend on the quality of material needed, the production method and so on. Labour rate – set by payroll department, depend on different grade of labour. Overheads – using standard absorption rate for fixed production overheads, it is based on budgeted fixed production overhead and expected production volume. Selling price – depend on anticipated market demand, competing products, manufacturing costs and inflation estimates. Importance of flexing budgets in performance management Flexible budget is a budget which, by recognising different cost behaviour patterns, is designed to change as volume of activity changes. Normally it is prepared for three levels of activities. One thing you have to remember is to split the semi-variable cost into fixed and variable costs, only variable costs changed when the level of activity changed. Flexing budget is important for performance management because effective performance measurement requires comparison of like with like. Budget should be flexed to actual level of activity so that the comparison is like with like. The following example gives you a view of the importance. 49

Example: Budgeted direct material cost is $8000 at 1000 units produced, in actual 700 units are produced and direct material cost is $6000. If you compare $8000 to $6000, it will result in favourable variance of $2000, is this means that the purchasing department is doing very well? Solution: It is not fair to compare like this, the budget should be flexed first. Budgeted direct material cost per unit = $8000/1000 = $8, flexed direct material cost = $8 x 700 = $5600. Therefore, $5600 should be compared to $6000, this shows an adverse variance of $400 and the purchasing department is actually not doing well. A true picture occurs after flexing the budget and this is important for accurate performance measurement and so assists the performance management. Allowing for waste and idle time Sometime you might see a situation where the company allows for waste and idle time in the budget. You need to prepare a budget that takes into account of it, ie. Adjust the standard. A business requires 15400 units of production in a period and each unit uses 5kg of raw materials. The production process has a normal loss of 10% during the production process. What is the total amount of the raw material required for the period? Solution: Remember to take into account the normal loss. Originally the production will require 77000kg (15400 x 5kg) of raw material, but it is anticipated that 10% is lost in the production process, so you need even more raw materials to be prepared for the loss. Therefore 77000 is assumed to be 90%, the total amount of raw material required = 77000/90 x 100 = 85556kg. 8556kg (85556 – 77000) of raw material is expected as wastage. Example: A production requires 10 labour hours for each unit. However 10% of working hours are idle time. How long must an employee be paid for in order to produce 20 units. Solution: Originally it takes 200 hours (20 x 10 hours), as 10% of working hours are idle time, company needs to provide for more labour hour, 200 hours will be assumed to be 90%, total hours needed to produce 20 units = 200/90 x 100 = 222 hours. Principle of controllability in the performance management system The principle of controllability is that managers of responsibility centres should only be held accountable for costs that they can control. Responsibility accounting is therefore relevant.

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Responsibility accounting is a system of accounting that segregates revenue and costs into areas of personal responsibility in order to monitor and assess the performance of each part of an organisation. Controllable costs are items of expenditure which can be directly influenced by a given manager within a given time span. The performance of the manager must be assessed by looking at the controllable costs, exclude the non-controllable costs such as fixed costs. An example is enough to demonstrate the importance of principle of controllability: Purchasing manager is normally responsible for the raw material costs, if their performance is also assessed by looking at the labour costs, then what will happen? The answer is purchasing manager will feel unfair and de-motivated, and might leave the company as soon as possible. However, it is quite often that a particular cost might be the responsibility of two or more managers. For example, raw material costs might be the responsibility of the purchasing manager (prices) and the production manager (usage). Sometime if the production manager needs good quality material, the material price variance may become adverse because purchasing manager has to buy with higher costs. Problem may arise to determine who is responsible for the variance. A reporting system must allocate responsibility appropriately. Preparation of flexible budget and flexed budget Example: Company’s management accountant has prepared a fixed budget for 1000 units of sales and production. He has asked you to assist in prepare for 900 and 1100 units. The company uses a marginal costing system. There is no opening or closing inventory. The following information is available: Fixed budget Actual Sales and production 1000 units 700 units $ $ Sales 20000 15000 Direct material costs 8000 6000 Direct labour costs 3000 2000 Overheads (semi-variable) 5000 3000 Profits 4000 4000 Overheads are expected to be $3000 when 500 units are produced. (a) Prepare flexible budget for 900 units, 1000 units and 1100 units. (b) Flexed the budget, show the variances and comment on its usefulness.

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Solution: Remember to split overheads into fixed and variable elements. (a) Variable cost per unit = (5000 – 3000)/(1000 – 500) = $4 Fixed cost = total cost – variable cost = $5000 – ($4 x 1000) = $1000 Flexible budget Sales and production 900 units 1000 units units $ $ Sales (20000/1000 x 900 etc) 18000 20000 Direct material costs (8000/1000 x 900 etc) 7200 8000 Direct labour costs (3000/1000 x 900 etc) 2700 3000 Variable overheads ($4 x 900 etc) 3600 4000 Fixed overheads 1000 1000 Profits 3500 4000 (b) Sales and production Sales (20000/1000 x 700) Direct material costs (8000/1000 x 700) Direct labour costs (3000/1000 x 700) Overheads ($4 x 700 + $1000) Profits

Flexed 700 units $ 14000 5600 2100 3800 2500

Actual 700 units $ 15000 6000 2000 3000 4000

1100 $ 22000 8800 3300 4400 1000 4500 Variances $ 1000 F 400 A 100 F 800 F 1500 F

When the budget is flexed, it removes the difference in sales or production volume, the variances will all be price variance. With this we compare like with like and able to measure performance more effectively, for example there is a favourable variance in sales, this means that the sales price charged are higher than expected. More useful information can be collected here.

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Basic variances and operating statements Most of the time, basic variance analysis involves standard vs actual except for the case of fixed overhead variances, so it is recommended that you understand how to calculate the variances instead of remembering the formula. General causes of variances There are some general reasons why the actual results are not the same as standard: 1. Inappropriate standard – If a standard is set at a level that does not reflect current conditions, then variances will be recorded even if the organisation is operating at the required level of efficiency. 2. Inaccurate recording of actual costs and revenues – an organisation may be operating efficiently, but if costs are recorded inaccurately then variances will occur. 3. Random events – this is unpredictable, the happening of it may cause expected results to differ. 4. Operating inefficiency – If the three causes above can be eliminated, then the variance must be due to operating inefficiency (all discussed below together with calculation). Improving operating efficiency is the key to stimulating improved performance. Interdependence of variances The cause of one variance might be wholly or partly explained by the cause of another variance, for example one adverse variance may be caused by another favourable variance. Situation of this normally occurred for: 1. Material price and usage variances – eg. buying cheaper material may result in more losses in production (poor quality). 2. Material price and labour efficiency variances – eg. buying cheaper material may result in labour requiring more time to finish the production. 3. Labour rate and efficiency variances – eg. using less skilled labour may cause inefficiency in production. 4. Sales price and volume variances – eg. reducing the price may increase the sales volume. Sales price and volume variances For volume variance, you have to be aware that standard margin per unit should be used, ie. standard profit (for absorption costing situation) or standard contribution (for marginal costing situation). Sales price variance can be caused by price increased due to improved quality (favourable) or price cuts to increase sales (adverse). Sales volume variance can be caused by price cutting (favourable) or poor product quality (adverse). 53

Example: The standard selling price of product A is $15. Actual sales were 2000 units at $15.30 per unit. Budgeted sales were 2200 units and standard full cost per unit of product A is $12.30. Solution: Sales price variance = ($15 - $15.30) x 2000 = $600 F (price charged was higher than expected). Sales volume profit variance = (2200 – 2000) x $3 (standard margin = $15.30 - $12.30) = $600 A (actual sales were less than budgeted). Material price and usage variances Material price variance can be caused by bulk purchase discount (favourable) or failing to shop around (adverse). Material usage variance can be caused by careful usage (favourable) or poor quality material (adverse). Example: Material M is used to make product A, 10kg of material M at $10 per kg. (standard cost per unit = $100). During a period, 1000 units of A were produced using 11700kg of material M, which cost $98600. Solution: Material price variance = ($10 x 11700) - $98600 = $18400 F (the actual cost is less than the expected cost for 11700kg of material). Material usage variance = (10kg x 1000 – 11700) x $10 = $17000 A (actual usage is more than expected for 1000 units). Material total variance = price + usage variance = $18400 F + $17000 A = $1400 F (check: material total variance = $100 x 1000 - $98600 = $1400 F). Labour rate and efficiency variances Labour rate variance can be caused by using less skilled labour (favourable) or unscheduled overtime work (adverse). Labour efficiency variance can be caused by good motivation (favourable) or using less skilled labour (adverse). Example: Product A needs grade A labour, 2 hours of grade A labour at $5 per hour (standard cost per unit = $10). During a period, 1500 units of product A were produced, direct labour cost of grade A was $17500 for 3180 hours of work. Solution: Labour rate variance = ($5 x 3180) - $17500 = $1600 A (the actual rate is higher than expected rate for 3180 hours of work). Labour efficiency variance = (2 x 1500 – 3180) x $5 = $900 A (actual hours worked are longer than expected hours needed for 1500 units of product A, ie. slow). Labour total variance = $1600 A + $900 A = $2500 A (check: labour total variance = $10 x 1500 - $17500 = $2500 A).

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Variable overhead expenditure and efficiency variances Variable overhead expenditure variance can be caused by careful use of electricity (favourable) or poor negotiation with suppliers (adverse). The causes of variable overhead efficiency variance are the same as labour efficiency variance, it is also calculated by taking into account the labour hours worked. Example: Variable production overhead cost of product A is based on standard of 2 hours at $1.50 per hour (standard cost per unit = $3). During a period, 400 units of product A were made. The labour worked 760 hours and variable overhead cost was $1230. Solution: Variable overhead expenditure variance = ($1.50 x 760) - $1230 = $90 A (the actual cost is higher than expected cost for 760 hours). Variable overhead efficiency variance = (2 x 400 – 760) x $1.50 = $60 F (actual hours worked are lesser than the expected hours needed for 400 units of product A). Variable overhead total variance = ($3 x 400) - $1230 = $30 A (actual overheads are higher than expected for 400 units). (Check: variable overhead total variance = $90 A + $60 F = $30 A). Fixed overhead expenditure, volume, capacity and efficiency variances These are the different one. In an absorption costing system, fixed overhead variances are an attempt to explain the under or over absorption of fixed production overheads. That’s why fixed overhead total variance is the difference between actual and absorbed fixed overhead. When you calculate fixed overhead expenditure variance, you should compare actual overhead and budgeted overhead. When you calculate fixed overhead capacity variance, you have to compare the actual hours worked and budgeted hours worked. When you calculate fixed overhead efficiency variance, you have to compare actual hours worked with standard hours worked for actual production. Fixed overhead volume variance is like normal and capacity + efficiency variances = volume variance. Fixed overhead expenditure variance can be caused by good cost management (favourable) or some variable overheads misclassified as fixed (adverse). Fixed overhead capacity variance can be caused by overtime working due to high demand (favourable) or low production due to lack of order (adverse). The causes of fixed overhead efficiency variance are the same as labour efficiency variance, it is also calculated by taking into account the labour hours worked. Example: Budgeted production for product A is 1000 units. Time required to produce one unit of product A is 5 hours. Budgeted fixed overhead is $20000 and standard fixed overhead cost per unit is $20. Actual fixed overhead is $20450, actual production is 1100 units and actual hours worked are 5400 hours.

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Solution: Standard overhead cost per unit is $20, therefore the standard overhead cost per hour = $20/5 = $4 per hour (important to calculate capacity and efficiency variances). Fixed overhead expenditure variance = $20000 - $20450 = $450 A (actual expenditure was higher than budgeted expenditure). Fixed overhead volume variance = (1000 – 1100) x $20 = $2000 F (output is greater than expected). Fixed overhead capacity variance = (5 x 1000 – 5400) x $4 = $1600 F (actual hours worked are greater than budgeted hours of work, ie. workers are capable). Fixed overhead efficiency variance = (5 x 1100 – 5400) x $4 = $400 F (actual hours worked are lesser than the expected hours to produce 1100 units, ie. efficient). Fixed overhead total variance = ($20 x 1100) - $20450 = $1550 F (absorbed overhead is higher than actual overhead, therefore over-absorption occurred). (Check: fixed overhead total variance = $450 A + $2000 F = $1550 F). How learning curve affects on labour variances With learning effect the hours worked will be reduced. This affects the calculation of labour efficiency variance, labour rate variance is not affected because it is calculated based on hours paid. You have to adjust the standard hour per unit. Example: A new product has been introduced for which an 80% learning curve is expected to apply. The standard labour information has been based on estimates of the time needed to produce the first unit which is 200 hours at $50 per hour. The first 4 units took 700 hours to produce at a cost of $37500. Solution: Remember only labour efficiency variance is affected, you can use the formula method to calculate the average time per unit required for 4 units. Labour rate variance = ($50 x 700) - $37500 = $2500 A (actual cost is higher than the expected cost for 700 units). Learning curve formula: y = 200 x 4^(log 0.8/log 2) = 128 hours, total time required for 4 units = 128 x 4 = 512 hours. The standard shows that to produce 4 units it will take 800 hours (200 x 4), but now we should use 512 hours as standard time required to produce 4 units. Labour efficiency variance = (512 – 700) x $50 = $9400 A (actual hours worked are longer than expected hours to produce 4 units). Operating statement Operating statement is a regular report for management which compares actual costs and revenues with budgeted figures and shows variances. You must be able to prepare operating statement in both a marginal cost and full absorption costing environment. In MC system, the only fixed overhead variance is an expenditure variance and the sales volume variance is valued at standard contribution per unit. 56

Standard costing operating statement (AC) Budgeted profit Sales volume profit variance Standard profit from actual sales Sales price variance Actual sales less standard full cost of sales Cost variances: Material price Material usage Labour rate Labour efficiency Labour idle time (discussed later) Variable overhead expenditure Variable overhead efficiency Fixed overhead expenditure Fixed overhead capacity Fixed overhead efficiency

$ X X (F/A) X X (F/A) X F ($) X

A ($) X

X X X X X X X X XX

XX

Actual profit

XX (F/A) XXX

Standard costing operating statement (MC) Budgeted contribution Sales volume contribution variance Standard contribution from actual sales Sales price variance Actual sales less standard variable cost of sales Cost variances: Material price Material usage Labour rate Labour efficiency Variable overhead expenditure Variable overhead efficiency

$ X X (F/A) X X (F/A) X F ($) X

X X X X XX

Actual contribution Budgeted fixed production costs Fixed overhead expenditure variance Actual fixed production costs Actual profit

A ($)

X XX

XX (F/A) XXX

X X (F/A) (X) XXXX 57

Idle time and waste on variances In your earlier studies, you may had learnt that idle time variance is always adverse, however here you will see how the it can be favourable, if the company had budgeted for idle time, it will be compared to actual idle time, favourable variance may occur. Idle time variance can be caused by unexpected efficiency of labour (favourable) or machine breakdowns/shortage of orders (adverse). Company needs to control the idle time by investigating why the idle time occurred/excess than expected. Idle time variance = idle hours (hours paid – hours worked) x standard rate per hour. Example: Product A needs grade A labour, 2 hours of grade A labour at $5 per hour (standard cost per unit = $10). During a period, 1500 units of product A were produced, direct labour cost of grade A was $17500 for 3080 hours of work of which 100 hours were idle time. Solution: Be careful when there is idle time, actual hours used in efficiency variance are hours worked and actual hours used in rate variance are hours paid. Labour rate variance = ($5 x 3080) - $17500 = $2100 A Labour efficiency variance = (2 x 1500 – 2980) x $5 = $100 F Idle time variance = 100 x $5 = $500 A (always adverse if idle time is not allowed in budget). The additions of all three variances are equal to labour total variance. Let say 200 hours of idle time had been budgeted, if so then the idle time variance = (200 – 100) x $5 = $500 F, the actual idle time is lower than the budgeted. Waste is the same case, company may allow for waste in the budget. Wastage could occur due to evaporation, spillage and natural wastage. The variance will need to be calculated by comparing actual results with the adjusted standard for expected wastage. To reduce the wastage, company should plan carefully and not buying too many materials, they may spoil if kept too long without using. Example: Material M is used to make product A, 10kg of material M at $10 per kg. (standard cost per unit = $100). Waste of 5% is expected. During a period, 1000 units of A were produced using 11700kg of material M, which cost $98600. Solution: Standard kg before adjusted = 10 x 1000 = 10000kg, standard kg after adjusted for waste = 10000/95 x 100 = 10526kg. Material price variance (no effect) = ($10 x 11700) - $98600 = $18400 F Material usage variance = (10526 – 11700) x $10 = $11740 A

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ABC-based variances All overheads within an ABC system are treated as variable costs. Therefore only expenditure and efficiency variances are calculated. Cost driver rate is important, it is like the standard cost per unit, will be used to calculate variances. The calculation of variances is similar to variable overhead variances. Example: The following information relates to company A’s ordering activity. Budgeted: output = 10000 units, activity level = 2000 orders, total cost of activity = $90000. Actual: output = 10500 units, activity level = 1800 orders, total cost of activity = $84000. Solution: When you calculate efficiency variance, be sure not to compare the output, you should compare the activity level because the cost driver rate will be based on activity. Therefore, when calculating efficiency variance, you should flex the activity level and then compare to actual activity level. Cost driver rate (standard rate per order) = $90000/2000 = $45. Expenditure variance = (1800 x $45) - $84000 = $3000 A (actual cost is higher than expected cost for 1800 orders). Efficiency variance = (2000/10000 x 10500 – 1800) x $45 = $13500 F (actual orders are lesser than expected orders for 10500 units). Investigating variances When deciding which variances to investigate, the following factors should be considered: 1. Reliability and accuracy of the figures – mistakes in calculating budget figures or in recording actual costs and revenues, could lead to a variance being reporting where no problem actually exists. 2. Materiality – the size of variance may indicate the scale of problem and the potential benefits arising from its correction, if the variance is not significant, then there is no point investigating it. 3. Possible interdependence of variances (discussed earlier) – the two variances would need to be considered jointly before making an investigation decision. 4. Adverse or favourable – adverse variances tend to attract most attention as they indicate problems. However, there is an argument for the investigation of favourable variances so that business can learn from its successes. 5. Trend in variances – one adverse variance may be caused by a random event. A series of adverse variances usually indicates that a process is out of control. 6. Controllability – If a cost or revenue is outside the manager’s control (such as the world market price of a raw material) then there is little point in investigating its cause.

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7. Costs and benefits of correction – If the cost of correcting the problem is likely to be higher than the benefit, then there is little point of investigating further. Variance investigation model There are many ways the organisations apply to decide which variances to investigate, some are discussed below: 1. Percentage of standard cost approach/rule-of-thumb model – any variance larger than a fixed percentage of standard cost is investigated. 2. Probability-based model – variances should only be investigated if the expected value of the resulting benefits exceeds costs of investigation. 3. Control chart – this is widely used. Control charts provide a visual representation of the variation of actual costs around standard and also the trend in variances. Warning limit and action limit line are drawn for both favourable and adverse variances. Actual costs are plotted as they occur. As long as the actual cost percentage remains within the warning limits no action is taken. If actual costs move outside the warning limits, this indicates the need for careful monitoring. If actual costs move outside the action limits, this indicates the need for corrective action.

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Material mix and yield variances Material usage variance can be subdivided into material mix and yield variances when more than one material is used in the product. This will involve the use of standard mix, the ratio will depend on how much quantity of materials from each types of materials are expected to be used. Material mix and yield variances Mix variance indicates the cost of a change in the mix of materials and yield variance indicates the productivity of the manufacturing process. Let A = actual, Q = quantity, S = standard, M = mix Mix variance = AQSM – AQAM Yield variance = SQSM – AQSM Usage variance = SQSM – AQAM The AQAM is always given, for yield variance I will suggest you to use another way. Yield variance will show the difference between standard yield from actual input of materials and actual yield, valued at standard cost per unit. A number of examples will be used to illustrate the calculations using the way I found most useful. Example: one unit of product requires the following standard inputs: $ Material X: 5 kg @ $8 40 Material Y: 10kg @ $3 30 In a given period, actual production of 12 units required 50 kg of X and 145 kg of Y. Solution: I will always start from preparing workings for AQSM. Standard mix for X and Y is 5:10 = 1:2. AQSM is based on the actual input (50kg + 145kg = 195kg). AQSM for X = 1/3 x 195 = 65kg AQSM for Y = 2/3 x 195 = 130kg Material mix variance AQSM AQAM Standard cost/kg Variances ($) X 65 50 8 120 F Y 130 145 3 45 A 75 F If the AQAM is lesser than AQSM, that means the actual mix is cheaper than standard mix and therefore favourable variance will occur. For yield variance, we need standard yield from actual input and also standard cost per unit. Standard cost per unit = $40 + $30 = $70. Standard yield is the standard expected output from actual input. Standard yield = 195/(5 + 10) = 13 units. Material yield variance = (13 – 12) x $70 = $70 A (actual output is less than standard expected output). 61

Example: The standard materials cost of product A is as follows: $ Material X: 3kg at $2.00 per kg 6 Material Y: 5kg at $3.60 per kg 18 24 During period 2, 2000kg of material X (costing $4100) and 2400kg of material Y (costing $9600) were used to produce 500 units of A. Solution: Material X price variance = ($2 x 2000) - $4100 = $100 A Material Y price variance = ($3.6 x 2400) - $9600 = $960 A Total material price variance = $100 A + $960 A = $1060 A Standard mix = X:Y = 3:5 AQSM for X = 3/8 x (2000 + 2400) = 1650kg AQSM for Y = 5/8 x (2000 + 2400) = 2750kg Material mix variance AQSM AQAM Standard cost/kg X 1650 2000 2 Y 2750 2400 3.6

Variances ($) 700 A 1260 F 560 F

Standard cost per unit = $24 Standard yield from actual input = 4400kg/ (3kg + 5kg) = 550 units Material yield variance = (550 – 500) x $24 = $1200 A Example: Simply Soup Limited manufactures and sells soups in a JIT environment. The standard cost card is as follows for the period under review: $ 0.90 litres of liquidised vegetables @ $0.80/ltr 0.72 0.05 litres of melted butter @$4/ltr 0.20 1.10 litres of stock @ $0.50/ltr 0.55 Total cost to produce 1 litre of soup 1.47 The board has asked that the variances be calculated for Month 4. In Month 4 the production department data is as follows: Actual results for Month 4 Liquidised vegetables: Bought 82,000 litres, costing $69,700 Melted butter: Bought 4,900 litres, costing $21,070 Stock: Bought 122,000 litres, costing $58,560 Actual production was 112,000 litres of soup

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Solution: Actual input = 82000 + 4900 + 122000 = 208900 litres. Standard mix = 0.9 : 0.05 : 1.1 (0.9 + 0.05 + 1.1 = 2.05) AQSM for vegetables = 0.9/2.05 x 208900 = 91712.2 litres AQSM for melted butter = 0.05/2.05 x 208900 = 5095.1 litres AQSM for stock = 1.1/2.05 x 208900 = 112092.7 litres Material mix variance AQSM AQAM Standard cost/litre Variances ($) V 91712.2 82000 0.8 7770 F M 5095.1 4900 4 780 F S 112092.7 122000 0.5 4954 A 3596 F Standard cost per soup = $1.47 Standard yield from actual input = 208900 litres/2.05 = 101902.4 litres Material yield variance = (101902.4 – 112000) x $1.47 = $14843 F Example: Company A makes product B in a continuous process, which standard quantities for this month were as follows: $ Material X: 40000kg @ $2.50 100000 Material Y: 20000kg @ $4.00 80000 60000kg 180000 10% losses of materials input are expected. Actual quantities used were: $ Material X: 34000kg @ $2.50 85000 Material Y: 22000kg @ $4.00 88000 56000kg 173000 Actual output during this month was 53000kg. Solution: There is no problem calculating mix variance, however for yield variance, you have to adjust the actual input with the losses to get the standard yield and be careful when calculating standard cost per kg. Standard mix = X:Y = 40000:20000 = 2:1 AQSM for X = 2/3 x 56000 = 37333.33kg AQSM for Y = 1/3 x 56000 = 18666.67kg Material mix variance AQSM AQAM Standard cost/kg Variances ($) X 37333.33 34000 2.5 8333 F Y 18666.67 22000 4 13333 A 5000 A

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Standard yield from actual input = 56000 x 0.9 = 50400kg In this case, we cannot use standard cost per unit since we are given actual output in kg, so we have to calculate standard cost per kg. In normal situation, standard cost per kg = standard total cost/standard total kg, but with the 10% losses expected, the standard total kg should only be 90% as only 90% of it is expected to be needed for output of 53000kg. Standard cost per kg = $180000/ (60000kg x 90%) = $3.33 Material yield variance = (50400 – 53000) x $3.33 = $8667 F Issues involved in changing mix The actual mix may not be the same as standard mix set, the study guide had identified that the changing of mix (using different kg of materials for each types of materials) can have impact on cost, quality and performance measurement. Cost – for example, material A costs $2 per kg and material B costs $3 per kg, if more material B and less material A are used in actual, then costs can increase. Quality – the quality of the final product may change when there is changes in mix, customers may not accept the change in quality unless it has became better. The decreasing of quality can then lead to reduced yield (adverse material yield variance), more labour hours required (adverse labour efficiency variance) and lower sales volume (adverse sales volume variance). Performance measurement – production manager’s performance may be measured by mix and yield variances, they might change the mix to improve performance, ie. by making the variances favourable, this can have impact on quality. Quality targets should be set to avoid this. Relationship of material price variance with the material mix and yield variances As you know, when cheaper materials are brought, material price variance becomes favourable, however the usage variance could become adverse because the quality is lower. With the lower quality material, yield variance will be affected because it is measured by comparing the standard quantity with the actual quantity used. However mix variance is not affected because we are only interested to compare standard mix with actual mix in mix variance. Alternative methods of controlling production processes As modern manufacturing environment focuses on quality management rather than just reducing cost, using mix and yield variances for control purposes may be inadequate as quality is more important than only reducing cost. Alternative methods include: 1. Customer satisfaction ratings – this can indicate the quality of the product. 2. Percentage of deliveries on time – keeping customer happy is more important than reducing costs in modern environment. 64

3. Rates of wastage – reducing the wastage will save a significant amount of costs. 4. Average cost of input calculations – as costs incurred to improve quality are allowed, calculating the cost of input, ie. the cost before the production starts is more useful. 5. Yield percentage calculations or output to input conversion rates – with this, you can identify the rates of wastage as well and also observe the productivity.

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Sales mix and quantity variances After you knew how to do the mix and yield variances, this will not be a problem, in fact this will be easier as there is no such thing as standard yield from actual input. Sales mix and quantity variances If a company sells more than one product, sales mix and quantity variances can be calculated and further analyse the performance of sales manager. Sales mix variance occurs when the proportions (ratio) of various products sold are different from budgeted, ie. actual mix is different from standard mix. Sales quantity variance shows the difference in contribution or profit because of different volume of sales compared to budget. The total of sales mix and quantity variances are sales volume variance. Example: Company A makes and sells two products, X and Y. The budgeted sales and profit are as follows. Sales units Revenue ($) Costs ($) Profit ($) X 400 8000 6000 2000 Y 300 12000 11100 900 700 2900 Actual sales were 280 units of X and 630 units of Y. Solution: Standard mix = X:Y = 400:300 = 4:3. AQSM for X = 4/7 x (280 + 630 = 910) = 520 units. AQSM for Y = 3/7 x 910 = 390 units. Sales mix variance AQSM AQAM Standard profit/unit Variances ($) X 520 280 2000/400 = 5 1200 A Y 390 630 900/300 = 3 720 F 480 A (Favourable if actual mix generates higher revenue than standard mix, adverse if actual mix generates lower revenue than standard mix). Standard profit per unit = $2900/700 = 4.143 Sales quantity variance = (budgeted quantity – actual quantity) x standard profit per unit = (700 – 910) x $4.143 = $870 F (actual quantity sold had increase the profit) Interpret: In sales mix variance, there is a $480 A variance, this shows that actual way of selling the products are not as good as the budgeted way, ie. 4:3, the profit would be $480 higher if 910 units had been sold in standard mix of 4:3. In sales quantity variance, $870 F variance represents the extra profit generated from the actual volume of sales. The sales volume variance will be equal to $480 A + $870 F = $390 F. 66

Planning and operational variances If you are good in basic variances, then this topic will be easier. If you calculate basic variances by using my way, then it is very similar when calculating planning and operational variances. Calculate a revised budget Due to changing market and technical circumstances, standards may become outdated. In such cases, it may be necessary to revise a standard, even during a budget period already in progress. Then a revised budget will be produced based on revised standard. This involves revising standards for sales, materials and/or labour. Example: Standard selling price of A is $50 each and B $100 each. In period 1, there was a special promotion on B with a 5% discount being offered. Sales of A and B are 2000 and 500 units respectively. Solution: Original budgeted sales = $50 x 2000 + $100 x 500 = $150000. Revised budgeted sales = $50 x 2000 + $100 x 95% x 500 = $147500. Factors that could and could not be allowed to revise an original budget A budget revision should be allowed if something has happened which is beyond the control and which makes the original budget unsuitable for use in performance management. For example, increase in market price of raw material cannot be controlled and therefore the standard can be revised to allow for it. These adjustments should be approved by senior management who should attempt to take an objective and independent view. Any item that is within the operational control of an organisation should not be adjusted. However, it can be very difficult to identify what is due to operational problems (controllable) and what is due to planning error (uncontrollable). Now you know that planning variance is not controllable, the cause of it could be inaccurate planning or faulty standards. Operational variance is controllable by operational manager, the cause of it is probably the favourable or adverse operational performance. Planning and operational variances You might find it useful to put this picture in your mind: Original standard Planning variance Revised standard Operational variance Actual result 67

Remember that the way of calculating the variances is the same, the difference is that for example, if you use my way to calculate material price variance it is (standard price – actual price) x actual kg purchased, now material price planning variance will be (original price – revised price) x revised kg purchased. Now can you see the difference? If not then have a look at some examples: Example: Original budget Revised budget Actual Material price $5/kg $4.85/kg $4.75/kg Material used 10kg per unit 9.5kg per unit 108900kg Budgeted production 10000 units Actual production 11000 units Solution: Material price planning variance = ($5 - $4.85) x 9.5 x 11000 = $15675 F (revised price was lower than the original budgeted price). Material usage planning variance = (10 x 11000 – 9.5 x 11000) x $5 = $27500 F (revised usage is lower than the original budgeted usage). Material price operational variance = ($4.85 - $4.75) x 108900 = $10890 F (actual price is lower than the revised price). Material usage operational variance = (9.5 x 11000 – 108900) x $4.85 = $21340 A (actual usage is higher than the revised usage). Comment: As the planning variances (planning errors) are not controllable by managers, we don’t consider it as relevant for performance evaluation. Managers have done well in negotiating the price of material but the material usage operational variance is adverse and it is bigger than price variance. With this we can say that the overall performance was quite poor. Note: If you find the above confusing, then refer back to the basic variance examples, if you are going to use this way to calculate, then my way of calculating basic variances is very important. If you have learnt the other ways, then you can decide which one to use. Planning and operational variances for sales price variance are similar to material and labour variances, planning and operational variances for sales volume variance are the interesting one. Planning sales volume variance is also called market size variance and operational sales volume variance is also called market share variance. Example: The market for leather bound diaries has been shrinking as the electronic versions become more widely available and easier to use. Spike Co has produced the following data relating to leather bound diary sales for the year to date:

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Budget Sales volume 180,000 units Sales price $17·00 per unit Standard contribution $7·00 per unit The total market for diaries in this period was estimated in the budget to be 1·8m units. In fact, the actual total market shrank to 1·6m units for the period under review. Actual results for the same period Sales volume 176,000 units Sales price $16·40 per unit (a) Calculate total sales price and total sales volume variance. (b) Analyse the total sales volume variance into components for market size and market share. (c) Comment on the sales performance of the business. Solution: (a) Sales price variance = ($17 - $16.40) x 176000 = $105600 A Sales volume variance = (180000 – 176000) x $7 = $28000 A (b) Market size variance = (180000 – 160000) x $7 = $140000 A Market share variance = (160000 – 176000) x $7 = $112000 F (c) When you are asked to comment, you should try to identify the reason why the variances occurred, answer: Sales price variance show a significant variance, the business reduced the price, probably this was to sustain the sales of leather bound diaries. Sales volume variance of $28000 A is not useful because it only show the loss in profit from selling 4000 units less than budgeted. Analysing sales volume variance into market size and share variances had shown more valuable information. Market size variance is not relevant because it is a planning variance which is not controllable. The improvement in market share shows that business had sold more than the revised level of sales. The reduction in selling price could have contributed to this improvement. Overall the business is performing well although the market is shrinking, but it might not be able to sustain for long-term, business might need to invest in other project. Manipulation issues in revising budgets Be careful that operational managers may manipulate the variances by revising the budgets. For example, when they are not performing well, they might revise the budget to make them have a favourable operational variance although adverse planning variance may occur as they know they are assessed by operational variance. Therefore, to avoid this, senior management should take into account the factors that could or could not be allowed to revise an original budget.

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Behavioural aspects of standard costing There are some recognised problems of using standard costing in the modern environment such as organisation running just-in-time (JIT) and total quality management (TQM) system. Variance analysis can also impact the behaviour of people just like budgets. Just-in-time (JIT) JIT aims to hold as little inventory as possible and production systems need to be very efficient to achieve this. Deliveries will be small and frequent rather than in bulk. Company needs to have a reliable supplier as that supplier will guarantee to deliver raw materials components of appropriate quality always on time. Workforce must also be flexible and multi-skilled in order to minimize delay and eliminate poor quality production. JIT is often associated with TQM. In summary, order inventory only when needed. Total quality management (TQM) Quality management becomes TQM when it is applied to everything a business does. TQM is the process of applying zero defects philosophy, avoiding wastages. The two basic principles of TQM are: (a) Getting things right first time. (b) Continuous improvement. In TQM, quality is the most important of all, costs incurred to maintain or improve quality are allowed. Dysfunctional nature of some variances in the modern environment of JIT and TQM Some variances are not so useful in JIT or TQM environment, for example: 1. Material price variance – in JIT, company is prepared to pay for higher price as supplier always will deliver no-defect raw material. In TQM, company is prepared to pay for higher price to acquire better quality material so that things will get right first time. Material price variance may not be relevant for measuring performance. 2. Efficiency variance – this includes labour, variable overhead and fixed overhead efficiency variance. In TQM, labour is working toward minimizing wastes and improving quality, efficiency variance could be adverse but it is allowed as long as final product meets customers’ expectations. 3. Material usage variance – in JIT, since the workforce needs to be fast in the production process, more wastage could occur. In TQM, the final product sent to customer must not come back, ie. no defect, so more materials might be used as only good quality finished goods are acceptable. Material usage variance might not be useful to assess performance. 70

Behavioural problems resulting from using standard costs in rapidly changing environment Standard costing is most appropriate in a stable, standardised and repetitive environment but now, most of the business environment is rapidly changing. Standard costing has the following problems: 1. Concentrates on reducing costs and ignore quality or customer satisfaction. 2. Too much emphasis on direct labour costs but in modern environment, production is automated, so direct labour is only a small proportion of costs. 3. Focus on the control of short-term variable costs but in modern environment, most costs including direct labour costs are fixed costs. 4. Modern environment is dynamic, unstable and operations are more complex. Standard costing may not be suitable for it. 5. Achieving standard is enough in standard costing but modern business environment focuses more on continuous improvement. 6. Standard costing systems produce control statements weekly or monthly but in a dynamic business environment, managers need more prompt control information in order to deal with any changes. Although standard costing has been criticised for using in modern business environment, it is still widely used by many organisations. As with information technology (IT), standards can be updated rapidly to keep up with the changing environment. Therefore with the assistant of IT, standard costing system becomes possible in rapidly changing environment. Effects of variances on staff motivation and action Managers will know that their performance is being assessed by the variances, they get reward if variances reported are favourable. Therefore, they will either work hard to achieve the standards or manipulate the standards. Care must be taken to distinguish between controllable and non-controllable costs in variance reporting, if managers are assessed by planning variance, they will be de-motivated. If variances achieved are adverse, managers should not be punished or blamed before finding out the true picture. Adverse variance caused by using ideal standard will only demotivate managers. Therefore, variances are important for managers, they might do anything to make the variances favourable, other performance measures should be set so that managers cannot escape from poor performance.

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The scope of performance measurement Performance measurement aims to establish how well something or somebody is doing. It is a vital part of control process. As a management accountant, you have to be able to identify a suitable performance measure for a person or a thing (eg. division), we call the performance measure as key performance indicator (KPI). KPI can be divided into financial performance indicators (FPIs) and non-financial performance indicators (NFPIs). Financial performance indicators (FPIs) FPIs analyse the performance by looking at profitability, liquidity and risk. This type of KPI is commonly used and accountant will calculate a range of ratios for performance appraisal. In exam, you might need to calculate the ratios and then compare with last year’s ratios, other company’s ratios or industry averages, then comment on the company’s performance (give a hypothesis of possible causes and link the ratios to the scenario). Profitability and asset utilisation Ratios such as return on capital employed (ROCE), profit margin, asset turnover, change in turnover, earnings per share (EPS) and price earnings ratio (P/E ratio) are the common one to measure the performance of this area. ROCE = profit before interest and tax (PBIT)/capital employed. The capital employed can be equity + debt or you can say capital + reserves + non-current liabilities. This will show the percentage of profit earned from capital employed. Therefore you can see that if you know how to calculate the ratio, you will be able to explain it and give a hypothesis of possible causes of the changes of ratio compared to a benchmark (use the background information whenever possible). Profit margin = PBIT/sales x 100%. This shows the percentage of profit earned from sales. Asset turnover = sales/capital employed. The answer will be in ‘times’, showing how much times of sales are generated from the assets, ie. is the business using asset effectively? Notice that ROCE = profit margin x asset turnover (the formula shows it), they are interrelated. Change in turnover = this year sales/last year sales x 100%. This is a basic comparison showing the changes in sales. EPS = profit attributable to shareholders (profit for the year)/number of shares. The growth or fall in EPS is very important for the investors, EPS can then be used to calculate P/E ratio. P/E ratio = market price per share/EPS. If this is high, it means that shares of the company are highly valued in the market, ie. people like it. 72

Liquidity A company can be profitable but at the same time get into cash flow problems, failing to repay the debts when demanded may cause the company to be in bankruptcy. Liquidity is about the ability of the company to repay its debts and this area has to be well-managed. We are concerned in measuring the liquidity position of the business, typical ratios include current ratio, quick or acid test ratio, receivable days, inventory days and payable days. Current ratio = current assets/current liabilities. A ratio in excess of 1 should be expected (but not for all companies), if it is less than 1, it indicates that the liabilities are too much and liquidity risk is there. Quick ratio = (current assets – inventories)/current liabilities. This is similar to current ratio but exclude inventory because inventory is actually a non-cash item. This ratio should ideally be at least 1 and again not for all companies, company with fast inventory turnover has no problem even if it is less than 1. Receivable days = receivables/credit sales x 365 days. This measures the time taken for receivables to pay the amount owed to the company. If it is too long compared to a benchmark, it means that the company is not efficient in collecting back the money and this will cause problem in working capital. Inventory days = inventory/cost of sales x 365 days. This will indicate the number of days that items of inventory are held for. If it is too long compared to a benchmark, it means that inventory is moving slow, money is tied-up in inventory and some inventory may also be obsolete. Payable days = payables/credit purchases x 365 days. If credit purchases are not given, use cost of sales as the best alternative. This measures the time taken to pay back the suppliers. If it is too long compared to a benchmark, it means that company is taking extended credit, this can cause a loss of goodwill of suppliers. Risk We have two types of risks, financial risk and business risk. Financial risk is caused by the liabilities and it can be measured using gearing ratio and interest cover. Interests must be repaid in order for the business to be going concern. Business risk is caused by the variability in profit and can be measured using operating gearing. Gearing ratio = debt/(equity + debt), you should take non-current liabilities as debt. The lower the gearing, the lower the financial risk. A highly geared company must earn enough profits to cover its interest charges before anything is available for equity. Interest cover = PBIT/interest payable. The answer will be in ‘times’, showing how many times the profit can cover the interest. The lower the level of interest cover the greater the risk to lenders that interest payments will not be met.

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Operating gearing = contribution/PBIT. If the contribution is high but PBIT is low, fixed costs will be high and only just covered by contribution, business risk will be high. The changes of profit will impact this ratio. These ratios, however, are subject to limitations as they are calculated based on past information and people are able to manipulate it. Therefore, there is an increasing use of NFPIs. Non-financial performance indicators (NFPIs) Changes in cost structures, the competitive environment and the manufacturing environment have lead to an increased use of NFPIs. People argued that NFPIs are a better indicator of future prospects as FPIs tend to focus on short-term. NFPIs are likely to be easy to calculate and easier for non-financial managers to understand. NFPIs also tend to be more specific to the critical success factors (CSFs). CSFs are objectives that will lead business toward success. The below are some of the examples of indicators for different CSFs/goals: 1. Competitiveness – sales growth, market share, size of customer base. 2. Productivity – cost per unit, capacity utilisation of facilities and personnel, average number of units produced per day, average set up time for new production run. 3. Customer satisfaction – average time taken to respond to customer order, number of customer complaints, customer surveys. 4. Human resources – days absence per week, labour turnover rate, qualification levels of newly recruited staff, expressed job satisfaction. 5. Innovation – number of new products/services brought to market, percentage of sales relating to new products, technology leadership, lead time to bring new products to market. Note: NFPIs don’t mean not in numbers, the difference between FPIs and NFPIs is that NFPIs do not look at the financial matters. Short-termism, financial manipulation and methods to encourage a long-term view Short-termism means the focus on short-term rather than long-term performance. Managers whose performance are measured by short-term results will try to reduce or delay the costs such as research and development, training and so on so that they can achieve a higher profit in short-term, but these costs have a significant effect in long-term, research and development are needed to be competitive, training costs are needed to keep the labour skills up-to-date. This is a type of manipulation that can be done by managers. Therefore, to avoid the manipulation by managers, we can include quality based targets or other targets. With this, manipulation can be easily found out if managers tried to improve performance by manipulation. Other methods include linking 74

managers’ rewards to share price or evaluate managers’ performance in terms of contribution to long-term and short-term objectives. NFPIs can also help to reduce managers’ focus on short-term success. However, we must make sure that the shortterm targets are realistic before saying that the managers are manipulating, sometime they are forced due to unrealistic targets. Balanced scorecard This is one of the most widely used models in organisation. Instead of looking at profitability, risk or other areas, balanced scorecard (by Kaplan and Norton) approach to performance measurement focuses on four different perspectives and uses FPIs and NFPIs. It takes a long-term perspective of business performance. The four perspectives are: 1. Financial 2. Customer 3. Internal business process 4. Innovation and learning For each perspective, you should identify the CSFs before talking about the KPIs, KPIs are based on CSFs. The following example demonstrates how balanced scorecard can be used by college. Example: Using balanced scorecard, show the KPIs for each of the four perspectives for a private college. Solution: Perspectives CSFs KPIs Financial Increase revenues % of revenue changes Increase share price in market P/E ratio Customer Increase students Number of new students Internal business process

Innovation and learning

Increase student satisfaction Well organised timetable

Satisfaction rating Rating from students

On-time beginning and ending of classes Successive programmes introduced Increase research productivity

Number of times the class is delayed % of revenue from new programmes Number of approved books published

You do not need to show the CSFs in exam if you are required to use balanced scorecard unless CSFs are required. CSFs are normally mentioned as goals.

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Fitzgerald and Moon’s Building Block model There are some problems in measuring performance of the service industries because of the characteristics of heterogeneity, intangible, perishability and simultaneity. This model is developed for performance measurement of service industries, but it can also be applied to other industries. Building Block model focuses on standards, rewards and dimensions for performance measurement systems in service businesses. Standards (SOAE) The three key words to keep in mind: 1. Ownership 2. Achievability 3. Equity (fairness) Fitzgerald and Moon suggested that that employees should participate in the setting of standards/targets since this would encourage ownership of the target and a commitment to it. They said that the target should be achievable after putting in effort and all targets should be seen to be fair by the employees. To achieve fairness, adjustments might have to be made, for example when the divisions operate in different countries, some divisions have advantages in other country such as cheaper rental, we have to allow for the cheaper overseas rents. In this way all divisions could be compared fairly. Rewards (RCMC) The three key words to keep in mind: 1. Clarity (clear and understandable) 2. Motivation 3. Controllability Reward structure of performance measurement system should guide individuals to work towards standards. Fitzgerald and Moon suggested that any reward system should be easily understood, concern conditions that are controllable by the employees and motivate them to strive for more (probably by giving bonuses for achieving standard). Dimensions Fitzgerald and Moon proposed six dimensions or areas that service organisations should set standards. As each business is different, some organisations would concentrate on the areas that they felt were important to them. 1. Financial performance – most of the non-financial performance models recognise that businesses cannot entirely focus on the future and so suggest measuring shortterm financial performance in some way such as profitability, liquidity and risk.

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2. Competitive performance – setting standards on market share and sales growth is sensible as competitors will almost always present. 3. Flexibility – an organisation needs to be flexible and punctual in the way it deals with its customers. The more it is able to say ‘yes’ to a customer request, the more customers it will have. However, before saying ‘yes’, make sure the organisation is able to cope with demand. For example in the context of a restaurant, range of items on the menu, overtime worked, times of booking and so on can be used as KPIs. 4. Resource utilisation – organisation has to consider how efficiently the resources/assets are being utilised. Asset turnover is normally used, but other NFPIs are possible as well depending on the type of business. For example a hotel, rooms occupied can be compared to rooms available. 5. Innovation – organisation that can find innovative ways of satisfying customers’ needs has an important competitive advantage. Standards can be set for the number of new ideas it generates and the successfulness of the new ideas (eg. sales from new products). 6. Quality of service – an organisation has to decide what quality means for it. For example, a restaurant’s quality might be based around standards for waiting times, taste of food, service level and so on. The dimensions can be divided into two sets: the results (measured by financial and competitive performance) and the determinants (the remainder). Improvement of determinants should lead to improvement in results. You may find that mnemonic FRIQ is useful to remember the determinants. Difficulties of target setting in qualitative areas It is not easy to set target in qualitative areas as sometimes we don’t know what target is the most suitable one and qualitative information is not in numbers. A single target can easily be abused, for example when the chef is asked to cook as fast as possible, the chef can do it but the taste of food could be ignored. But too many targets can confuse people as well. There are no rules guiding you how many targets/measures to be set in qualitative areas, qualitative measures are by nature subjective. Therefore, the organisation has to be clear on what it considers to be important and targets must be set there. For example, instead of asking the chef to cook faster, the restaurant can keep the customers waiting for a while and in return providing them a fresh cooked delicious food. With this, the target is set at a right area. Note that your daily experience in life is important for this topic, for example if you are asked to suggest some performance measures for hotel, restaurant, railway station, hospital, car repair shop and so on, you should think from your experience.

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Divisional performance measurement Performance measures which are suitable to the division will depend on which responsibility centre is the division. Principle of controllability is very relevant. Most organisations are divisionalised where managers of business areas are given a degree of autonomy to make decision such as set selling prices, choose suppliers and so on without referring to senior management. Responsibility centres We have four types of responsibility centres as part of the organisation structure: 1. Cost centre – managers are responsible for cost only and do not generate revenues. 2. Revenue centre – managers are responsible for raising revenue without any link to associated costs. 3. Profit centre – managers are responsible for both costs and revenues. 4. Investment centre – managers are responsible for capital investment and also the responsibilities of the profit centre. According to principle of controllability, managers are only accountable for what they can control, therefore we should measure the performance based on the responsibility of the managers in different responsibility centres. Performance measurement for responsibility centres – in general Performance measures should include financial performance indicators (FPIs) and non-financial performance indicators (NFPIs) so that managers cannot manipulate the results easily. Balanced scorecard is commonly used to evaluate performance of managers and also the divisions. Benchmarking is another suitable way to measure the performance. Performance measurement for cost centres Standard costing variance analysis is commonly used in the measurement of cost centre performance. It gives a detailed explanation of why costs may have differed from standard. Budget must be flexed to actual before we can do variance analysis. It is important to take into account the controllable and non-controllable costs, planning and operational variances will be calculated for this purpose. Performance measurement for revenue centres Measures like profit margin or percentage of sales growth compared to last year would be suitable for measuring the performance of managers in revenue centres since they are only responsible for sales. Sales price and sales volume variances are common as well.

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Performance measurement for profit centres Note that divisional performance and management performance are two different things, you cannot measure the management performance by looking at the profit made by the division because there are some costs that are not controllable by the managers. Therefore, the following presentation of information for performance measurement might be useful: $ Sales X Controllable divisional costs (x) Controllable divisional profit X Traceable divisional costs (x) Traceable divisional profit X Apportioned head office cost (x) Net profit X When assessing the performance of a manager we should only consider costs and revenues under the control of that manager, and hence judge the manager on controllable profit. In assessing the success of the division, our focus should be on costs and revenues that are traceable to the division and hence judge the division on traceable profit. For example, depreciation on divisional machinery would not be included as a controllable cost in a profit centre. This is because the manager has no control over investment in fixed assets. It would, however, be included as a traceable fixed cost in assessing the performance of the division. Performance measurement for investment centres Two measures of divisional performance are commonly used: 1. Return on investment (ROI) = profit before interest and tax (PBIT)/net asset x 100%. 2. Residual income (RI) = PBIT – imputed interest charge on investment. Imputed interest charge on investment = cost of capital x net assets. ROI is a relative measure (ie, in %) and RI is an absolute measure (ie. in $). The advantages and disadvantages of each of them must be taken into account. Advantages of ROI 1. It is a relative measure and so it facilitates comparison of performance between the divisions. 2. Easy to understand as the amount is in percentage. 3. Information needed to calculate ROI is readily available in income statement and statement of financial position.

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Disadvantages of ROI 1. ROI will increase as assets get older (accumulated depreciation reduces the value of non-current assets and therefore the capital employed). This can encourage managers to retain outdated plant and machinery. Therefore, the improving of performance over time is giving a false view. 2. Sometime it is not fair to compare performance of divisions using ROI because of different depreciation method used. 3. The disposal of non-current assets can increase the ROI as well but it may affect the efficiency of the business. 4. Can cause short-termism as managers might attempt to increase the ROI at the expense of long-term performance. Therefore, we can say that ROI is a short-term measure. 5. Can result in sub-optimal behaviour where division managers make decisions which are self-interested, not in the interest of the company as a whole. 6. ROI and net present value (NPV) might conflict, eg. project may show high ROI but negative NPV, a project with positive NPV should be chosen. Advantages of RI 1. It makes divisional managers aware of the cost of financing their divisions, this is because the cost of capital is used as part of the calculation. 2. It is an absolute measure of performance, positive figure means good. 3. All divisions will be motivated to take projects which have a higher return than the company’s cost of capital, this will avoid sub-optimal decisions made by managers. 4. In the long run it supports the NPV approach to investment appraisal (present value of a project’s RI equals net present value of that project). Disadvantages of RI 1. Residual income gives the symptoms not the causes of problems. If residual income falls the figures give little clue as to why. 2. Problems exist in comparing the performance of different sized divisions (large divisions will earn larger residual incomes simply due to their size). This is because RI is an absolute measure. 3. RI when applied on a short term basis is a short term measure of performance and may lead to short-termism. 4. Require an estimate of the cost of capital which can be difficult to calculate. 5. Some managers may be unfamiliar with RI.

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Transfer pricing It is common that one division (selling division) produces immediate product (one that is used as a component of another product) and sells it to another division (buying division), then buying division will incur some extra costs to come out with the final product. Transfer price is the sales of selling division and is a variable cost to the buying division. Good transfer price It is difficult to have a good transfer price in practice, a good transfer price should: 1. Preserve divisional autonomy where managers can make their own divisions concerning internal transactions. 2. Be perceived as being fair for the purposes of performance evaluation and investment decisions. 3. Permit each division to make a profit. 4. Encourage divisions to make decisions which maximise group profits – the transfer price will achieve this if the decisions which maximise divisional profit also happen to maximise group profit, this is known as goal congruence. Transfer pricing system needs to take into account the behavioural impact of the prices being charged. Transfer pricing when there is perfect market exists for immediate good In this case, transfer prices may be based on the market price of the immediate good. With this, the selling division will be motivated to sell internally (since it is the same price as selling externally) and it can make a fair profit. A market price as the transfer price can result in decisions which would be in the best interests of the company as a whole. However there are some disadvantages of market price based transfer price: 1. A comparable product might not be available to establish the price. 2. Prices are not always consistent and stable. 3. An internal transfer of goods may involve savings in advertising, packaging and delivery costs, so market price would not be entirely appropriate. Transfer pricing when there is imperfect or no market exists for immediate good When there is imperfect market (market in which some of the producers and/or consumers are significant enough to affect the price and quantity of goods by their actions alone) or no market for the immediate good, market price is not suitable as a transfer price. Other methods such as cost-based or cost-plus will be common, note that standard costs instead of actual costs should be used for transfer prices to avoid encouraging inefficiency in the selling division.

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Transfer price at variable cost A transfer price set equal to the variable cost of the selling division produces very good economic decisions because this will result in the variable cost of the buying division equal to the variable cost of the whole firm. However, selling division will have little incentive at this price because fixed cost is not covered. Transfer price at full cost This is slightly more satisfactory to selling division as it means that it can aim to breakeven. However, sub-optimal decision might be made by the buying division. Example: Selling division has a variable cost of $18 and fixed cost of $12. The transfer price is $30 (full cost), buying division has its own variable cost of $10 and market price of immediate product is $35. Solution: The buying division would not trade because its variable cost would be $40 ($30 + $10), but from a group perspective, the marginal cost is only $28 ($18 + $10) and a positive contribution would be made even at a selling price of only $35. If the manager of the buying division is forced to transfer-in, the manager might be demotivated as reported performance will be affected. However even if the buying division accepts to transfer in, the inclusion of $40 as variable cost can cause wrong decision being made by the group as from the group perspective, variable cost will be $18 + $40 = $58 but in fact it should be $28. Inclusion of fixed cost in setting transfer price will cause this problem. Transfer price at variable/full cost plus With cost-plus, selling division will be motivated because it has an opportunity to make profit. Mark-up percentage will be higher for variable cost-plus but lower for full cost-plus. This may also allow profits to be made by the buying division. However, again this can lead to dysfunctional decisions as the final selling price will fall as there is a higher transfer-in cost for buying division. Negotiated transfer price In practice, negotiated transfer prices, market-based transfer prices and full costbased transfer prices are the methods normally used. Negotiated transfer prices are those set through a process of negotiation between the buying and selling divisions. With this, the resulting transfer price should be acceptable to both the buying and selling division. Again there are disadvantages to be taken into account: 1. The negotiations may be time-consuming. 2. Managers may not reach agreement and sub-optimisation or head office intervention may result. 3. The system favours the more powerful division, ie. the manager in one division may have very good negotiation skills, this may be unfair on another division. 82

The best transfer price When there is no market for the immediate product, the transfer price should be at variable cost of the selling division. When there is market for the immediate product, ie. the selling division can sell to market, then the transfer price should be at variable cost + opportunity cost, ie. market price. Inclusion of opportunity cost will allow for the lost contribution by selling division of not being able to sell outside. Example: Immediate product/part-finished goods can be bought and sold in the market at $60. Selling division is A. The following information is available: A $ Variable cost 18 Fixed cost 12 Solution: There is an external market for the immediate product, so the best transfer price is $18 + ($60 - $18) = $60, ie. same as market price. If the group wants A to transfer at variable cost only, A will sell to the market as many as possible, therefore inclusion of the opportunity cost will motivate A to sell to the buying division. Effects of different transfer prices 1. Performance measurement – normally the performance of the divisions is measured using ROI or RI. Transfer price can have a significant effect on the ROI or RI as both are profitability measures. If the selling division sells at a self-interested transfer price, its profitability can increase at the expense of buying division which made the comparison of both divisions’ performance unfair. 2. Decision making – if the transfer price is too high, the buying division might not want to buy from the selling division. Buying division might decide to abandon the product line or buy-in cheaper immediate products from outside. It is likely that the overall group performance is ignored by the managers. 3. Motivation – if a transfer price was such that one division found it impossible to make a profit, then the employees in that division would probably be de-motivated. In contrast, the other division would make profits easily and it would not be motivated to work more efficiently. 4. Investment appraisal – cash inflows arising from an investment will be affected by transfer price, so capital investment decisions can depend on the transfer price.

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Performance analysis in not for profit organisations and the public sector Not-for-profit organisations (NFPOs) are those organisations that are not formed primarily to make profit but probably to serve public interest. Examples of NFPOs include schools, public hospitals, public universities and so on. Public sector organisations exist to implement government policy. Problems of having non-quantifiable objectives in performance management When we have a quantified objective, we can easily measure the performance by comparing the actual performance with the stated objective, the differences in numbers can be managed and controlled. However, normally NFPOs will have nonquantifiable objectives such as improved discipline of students, less traffic jam, clean street and so on, how to judge whether the non-quantifiable objective has been met? Problems of having multiple objectives in this sector Beside non-quantifiable objectives, NFPOs have multiple objectives which are difficult to define. Even if they can be clearly identified, it is hard to say which the overriding objective is. For example, in a school, the objectives can include improved discipline of students, better learning process, good passing rate, more straight As students, better environment for learning, more sports and so on, can you rank which objectives are the best to achieve first? However, we can say that the main objective of NFPOs is to provide best possible services with lowest possible costs. Measuring performance in this sector Although it is more difficult than in the commercial sector, there are still some recognised suitable measures. Firstly, balanced scorecard can still be used, probably the financial perspective may not be too important, customer, internal, innovation and learning are all important perspectives to determine the successfulness of the NFPOs. For example a school, parents must be satisfied for the education system provided, teachers must be able to improve students’ understanding on particular topics and the new teachers employed must be qualified. By looking at the perspectives, suitable CSFs can be identified and therefore it is possible that the best KPIs can be used to measure the performance. Since normally NFPOs have financial constraints, resource utilisation measures such as output/input are also useful to determine whether the resources are well-utilised. Benchmarking is also useful to measure the performance in this sector. A widely used method to measure the performance in this sector is value for money (VFM). VFM means providing a service in a way which is economical, efficient and effective. 84

Value for Money (VFM) as a public sector objective Public sector can also take VFM as their objectives. That means achieving economy, efficiency and effectiveness, the 3Es. 1. Economy can be achieved if company is able to obtain appropriate quantity and quality of inputs at lowest cost. In other word, comparing inputs with money spent. 2. Efficiency can be achieved if company is able to get as much outputs as possible from the inputs. In other word, comparing outputs with inputs. 3. Effectiveness can be achieved if company’s outputs are in line with the objectives set. In other word, comparing objectives with outputs. Taking a school as an example, let say the objective is to increase the overall passing rate, the school is said to be economical if teachers are trained with lowest possible cost, the school is said to be efficient if the number of students passing the exam have increased with the trained teachers, the school is said to be effective if there are 95% of students passing the exam which achieved the objective to increase overall passing rate. Therefore, to be able to use VFM for performance measurement, input and output have to be identified. We can say that economy + efficiency = effectiveness.

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External considerations and behavioural aspects External considerations are factors that arise outside an organisation which can have impact on the objectives and actual performance of the organisation. We have to allow for external considerations in performance management. The need to allow for external considerations in performance management In performance management, performance measurement must be fair so that the results of measurement give the true picture of the performance level achieved and this will then assist in performance management. We need to allow for external considerations so that the performance measurement is fair, a good example is by looking at divisions, one division may be operating in a country with advantage of good business environment and one division may be operating in a difficult environment, comparison of performance between these two divisions is not fair unless the external considerations are allowed. Ways to allow for external considerations in performance management External considerations include stakeholders, market conditions and competitors. Stakeholders Stakeholders are a group of people who have interest in the company’s activities. There are three types of stakeholders: 1. Internal stakeholders – employees and management. 2. Connected stakeholders – shareholders, customers, suppliers and lenders. 3. External stakeholders – community, government and pressure groups. Stakeholders will influence the activities of an organisation, the level of influence depends on the power and interest of the stakeholders. When there are several influential stakeholder groups, the company may need to take their conflicting interests into consideration and set objectives and performance targets accordingly. Market conditions Market conditions are factors that influence the state of market. These include political, economy, social and technological factors (PEST). 1. Political – investors would not like to invest in a company operating in an unstable political environment unless the returns are high enough to compensate the risks. 2. Economy – inflation, interest rates, exchange rates, tax rates and so on can have a very serious influence on business. 3. Social – changes in populations such as social structure and the wealth of people can influence the sales of the business. 4. Technological – the technology level of the business will decide the competitiveness of it and different countries have different technology level. 86

These four factors will affect the market conditions and the performance of the organisation can be affected by them. Competitors Performance of an organisation will also be affected by the nature of competition in market and also actions taken by competitors. This is especially in the case of pricing, company cannot set a price without taking competitors’ price into account. Performance of the company in a competitive market may be measured by the size of market share that it obtains. We can alter the objectives to allow for external considerations, set performance targets by making assumptions about external factors and assess actual performance by taking into consideration unexpected developments in the external environment. With this, the true performance of the organisation can be seen and the comparison of performance between divisions in different countries will be possible. Interpreting performance in the light of external considerations In the exam, if one division is being affected by the external consideration, do not directly compare the performance of it with the other division and comment on the performance, same goes to the comparison of the performance of the organisation as a whole with other organisation. If you are able to adjust the profit which is affected by external consideration to a profit which is not affected by external consideration, do it. If you are only told about the external considerations and not able to adjust for anything, then talk about the effect of external considerations when commenting on the performance. The importance of external considerations must be taken into account because they can have significant impact on the business performance. Behavioural aspects of performance management Divisional performance measurement is a good example to demonstrate the behavioural aspect. Divisional performance and managerial performance must be separately assessed, it is unreasonable to assess managers’ performance in relation to matters that are beyond their control, always remember the principle of controllability. Therefore, management performance measures should only include those items that are directly controllable by the manager, for example, when you use return on investment (ROI) to measure the manager’s performance, the profit figure should be controllable profit before interest and tax (PBIT), traceable PBIT should only be used to measure divisional performance as traceable profit includes items that are not controllable by the manager of the division. Managers will be demotivated if their performance is assessed by something that cannot be controlled by them. 87

Here is an example: A skilful manager may succeed in improving the performance of the worst division in an organisation but the division may continue to be a poor performer compared to other divisions. If the manager is assessed purely on the division’s results he will not appear to be a good performer, in fact the manager is doing very well. Many organisations have systems for linking the achievement of performance targets with rewards for successful individuals. But there are also behavioural problems with rewards systems. The problems include: 1. Manager may take decisions that increase his divisional performance at the expense of other divisions and group’s performance, eg. transfer pricing decision. 2. High level of output may be achieved at the expense of quality. 3. Managers may revise the budget so that they can get favourable operational variances to get rewards. 4. Purchase managers may buy raw materials at cheaper price to get favourable material price variance without considering the quality. 5. Managers may not wish to make investments if their performance is measured by ROI so that ROI will not reduce. It is very important that the top management set up a good reward system so that it will not affect the performance measurement. A good reward system should be fair, motivational, understandable, consistently applied and objective.

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