RECP 674 Advanced Management Accounting (CTA LEVEL)

MANAGEMENT ACCOUNTING
PART 2
STUDY GUIDE FOR
RECP 674 VEC
*RECP674VEC*
SCHOOL OF ACCOUNTING
VAAL TRIANGLE CAMPUS

ii

Study guide compiled by:
Prof SS Visser, Mr RJJ Barnard & Mrs EM Venter

Edited nn.
+Page layout by Elsab Botha, Graphikos.
Printing arrangements and distribution by Department Logistics (Distribution Centre).
Printed by Ivyline Technologies 018 293 0715/6.
Copyright 2013 edition. Date of revision 2013.
North-West University, Potchefstroom Campus.
No part of this book may be reproduced in any form or by any means without written
permission from the publisher.

iii
MODULE CONTENTS
Welcome ................................................................................................................................ iv
Lecturer ................................................................................................................................. iv
Prescribed books ................................................................................................................... iv
Supplementary study material (for library use) ....................................................................... iv
Aims of the course ................................................................................................................. iv
Study programme .................................................................................................................. v
Method of work ...................................................................................................................... v
Assessment ........................................................................................................................... vi
Compilation of the semester mark.......................................................................................... vi
Warning against plagiarism .................................................................................................. viii
Study unit 1 Introduction to strategic management accounting ....................... 1
Study unit 2 Introduction to management accounting and profit
planning ........................................................................................... 9
Study unit 3 Direct and absorption costing and cost classification ............... 27
Study unit 4 Cost-volume-profit analysis ......................................................... 43
Study unit 5 Profit planning ............................................................................... 53
Study unit 6 Flexible budgets ............................................................................ 63
Study unit 7 Standard costing ........................................................................... 71
Study unit 8 Job costing and activity-based costing ....................................... 93
Study unit 9 Process costing, hybrid costing and rework ............................. 105
Study unit 10 Joint product costing .................................................................. 125
Study unit 11 Relevant costs and decision making ......................................... 137
Study unit 12 Risk and uncertainty ................................................................... 149
Study unit 13 Linear programming, shadow prices and sensitivity
analysis ........................................................................................ 159
Study unit 14 Transfer pricing and service departments................................. 169
Study unit 15 Performance measurement ........................................................ 183
Study unit 16 Decentralisation .......................................................................... 193
Study unit 17 An improved and changed manufacturing environment and
a changed business environment .............................................. 197
Study unit 18 Cost management and the theory of constraints ...................... 205

iv
WELCOME
Welcome to the management accounting part of RECP 674! I hope that 2011 is a special
one for you and that your insight into management accounting improves. I hope, too, that
this subject will give you just as much pleasure as it has given me in my career. I wish you
all success.
LECTURER
NAME OFFICE TELEPHONE

PRESCRIBED BOOKS
- Vigario, F. 2007. Managerial accounting. Fourth edition. Durban: LexisNexis (referred
to as V in this study guide).
- Vigario, F. 2010. Questions in managerial accounting and finance. Sixth edition.
Durban: LexisNexis.
- Drury, C. 2011. Management and cost accounting. London: Thomson (referred to as D
in this study guide).
The page and chapter references of the older editions are given in brackets.
SUPPLEMENTARY STUDY MATERIAL (FOR LIBRARY USE)
- Garrison, R.H. & Noreen, E.W. 2006. Managerial accounting. New York: McGraw-
Hill/Irwin (referred to as G in this study guide).
- Redelinghuis, A., Julyan, F.W., Steyn, B.L. & Benade, F.J.C. 2000. Kwantitatiewe
metodes in bestuursbesluitneming. Durban: Butterworths (referred to as R in this
study guide).
- Horngren, C.T., Datar, S.M., Foster, G., Rajan, M. & Ittner, C. 2008. Cost accounting:
A managerial emphasis. Thirteenth edition. Upper Saddle River: Prentice-Hall (referred
to as H in this study guide).
- Relevant recent articles from journals.
AIMS OF THE COURSE
The highest-order teaching objectives, namely analysis, synthesis and evaluation, will make
up the most part of student assessment of this course.
God, the Creator, Owner and Keeper of the entire earth, has made us stewards of His
property. Stewardship requires accountability. Planning, control and decision making are
the three main tasks of the managerial accountant and these tasks require accountability. A
considerable amount of caution is needed for profit planning and budgetary control because
the end result of planning must be the maximum utilisation of the available resources; at the
same time the consumers needs must be met. Control is needed to ensure that the
objectives formulated in the planning process have been achieved and planning will be
useless if there is no control.

v
Decision making entails deliberately choosing between two or more alternatives. To make
decisions, information is needed and can be obtained by means of cost and management
accounting.
Management accounting involves creating methods, systems and techniques to obtain
useable information in order to achieve the three most important aims: decision making,
planning and control.
STUDY PROGRAMME
This programme involves mainly the following:
- You must be familiar with the subject terminology and acquire theoretical knowledge.
- You must be able to solve cost and management accounting problems, as well as
problems integrated with related subjects, using theoretical knowledge.
- You will have to complete assignments that require you to make full use of subject
literature, including recent journals in the library.
METHOD OF WORK
Theoretical knowledge
In each study unit the lecturer will briefly provide and explain the following:
- Overview of the study unit
- How the contents of the study unit link with existing knowledge
- Main points and problem areas
You are responsible for supplementing the given framework from the prescribed books and
the library.
Problems
When you start this course you will be given a work scheme of scheduled assignments, case
studies and problems. While working through the study units, you must solve the scheduled
problems and case studies relating to the study unit being discussed after doing the
necessary reading. Prescribed problems and case studies will be selected in order to test all
learning outcome levels, namely knowledge, insight, application, analysis, synthesis and
evaluation.
Suggested solutions to the above problems will be discussed and may be required to be
submitted without warning for marking.
Library
Assignments indicated on the work scheme can be done by using the library.

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ASSESSMENT
Assessment will take place through:
- Practicums
- Two simulated qualifying exams
- Two examinations
Consult the integrated roster of the accounting programme supplied for the individual dates.
COMPILATION OF THE SEMESTER MARK
The semester mark is compiled as indicated on the programme.
GLOSSARY OF TERMS
Learning
Objective
Verbs Used Definition

L
e
v
e
l

1

Knowledge
What you are expected to
know.
List
State
Define
Make a list of
Express, fully or
clearly, the
details/facts of
Give the exact meaning of
L
e
v
e
l

2

Comprehension
What you are expected to
understand.
Describe
Distinguish
Explain
Identify
Illustrate
Communicate the key
features of
Highlight the differences
between Make clear or
intelligible/State the
meaning or purpose of
Recognise, establish or select
after consideration
Use an example to describe or
explain something
L
e
v
e
l

3

Application
How you are expected to
apply your knowledge.
Apply
Calculate
Demonstrate
Prepare
Reconcile
Solve
Tabulate
Put to practical use
Ascertain or reckon
mathematically
Prove with certainty
or exhibit by practical
means
Make or get ready for
use
Make or prove
consistent/compatible
Find an answer to
Arrange in a table

vii
L
e
v
e
l

4

Analysis
analyse the detail of
what you have learned.
Analyse
Categorise
Demonstrate
Prepare
Reconcile
Solve
Tabulate

Examine in detail the structure
of
Place into a defined class or
division
Show the similarities and/or
differences between
Build up or compile
Examine in detail by argument
Translate into intelligible or
familiar terms
Place in order of priority or
sequence for action
Create or bring into existence

L
e
v
e
l

5

Evaluation
use your learning to
evaluate, make decisions
or recommendations.
Advise
Evaluate
Recommend
Counsel, inform or notify
Appraise or assess the value of
Propose a course of action
CIMA Verb hierarchy, 2010

viii
WARNING AGAINST PLAGIARISM

ASSIGNMENTS ARE INDIVIDUAL TASKS AND NOT GROUP ACTIVITIES. (UNLESS
EXPLICITLY INDICATED AS GROUP ACTIVITIES)
Copying of text from other learners or from other sources (for instance the study guide,
prescribed material or directly from the internet) is not allowed only brief quotations are
allowed and then only if indicated as such.
You should reformulate existing text and use your own words to explain what you have
read. It is not acceptable to retype existing text and just acknowledge the source in a
footnote you should be able to relate the idea or concept, without repeating the original
author to the letter.
The aim of the assignments is not the reproduction of existing material, but to ascertain
whether you have the ability to integrate existing texts, add your own interpretation and/or
critique of the texts and offer a creative solution to existing problems.
Be warned: students who submit copied text will obtain a mark of zero for the
assignment and disciplinary steps may be taken by the Faculty and/or University. It is
also unacceptable to do somebody elses work, to lend your work to them or to make
your work available to them to copy be careful and do not make your work available
to anyone!

Study unit 1

1

1 INTRODUCTION TO
STRATEGIC MANAGEMENT
ACCOUNTING

It will take approximately 10 hours to master this study unit.
Study material: Drury - Chapter 22

Supplemental reference material: [CIMA BBP Learning Media Enterprise Strategy 3]

LEARNING OUTCOMES
After completing this study unit, you should be able to:
Give a definition of:
- Strategy
- Vision and mission
- Entity values
- Stakeholders
- External environment
- Internal environment
Explain and give examples of:
- Strategic planning processes
- Goals and objectives of strategy development
- Components of a strategic plan
Identify and discuss the key stakeholders of an entity and their roles.
Discuss the external influences on an entitys strategic development.
Explain corporate culture.
Illustrate and explain the following analytical models:
Study unit 1

2
- Porters 5 forces
- Strengths, Weaknesses, Opportunities and Threats (SWOT) analysis

1. Introduction and overview
The three roles of a Management Accountant are:
- Planning Planning are key to the success of any business, enterprise or project.
Tools used to do planning include master budgets and cash budgets.
- Control Control over actual activities provide a Management Accountant of valuable
information regarding performance and the achievement of objectives. Measures to
ensure control includes standard cost systems and the calculation of variances.
- Decision-making Every Management Accountant are faced with decisions based on
the performance of an entity or project.
Strategic Management Accounting is a form of management accounting in which
emphasis is placed on information which relates to factors external to the entity, as well as
non-financial information and internally generated information. (CIMA official terminology)
Businesses will have different strategic positions, leading to different types of planning,
control measures and decisions. It is the role of the Management Accountant to know,
understand and apply the strategy chosen by a company to its planning, control and
decision-making processes.
2. Generic Strategies D572
Porter has suggested that there are three basic generic strategies followed by
organizations:
- Cost leadership
A cost leadership generic strategy is demonstrated in South Africas low cost airlines,
where services delivered as well as quality of services are similar, but their
competitiveness is based on the cost they charge the customer.

- Differentiation
Organisations that use differentiation as selling point include clothing stores with selected
brands or food shops with organic produce. They seek to offer products and services to
the customer that is superior and unique in relation to their competitors with less
emphasis on cost.

- Focus
These organizations are trading in segments that are exclusive or narrow, with the
delivery of special services or products, such as for example custom built cars. They can
generate competitive advantage either through cost leadership or product differentiation
in the segment they operate.

3. Strategic management accounting terms
- Strategy: specifies how an organization matches its own capabilities with the
opportunities in the marketplace to accomplish its objectives.
Study unit 1

3
- Vision and mission: The vision of a company is where it is aiming to go in the future,
while the mission is the reason for a company to exist; it defines what the organization
is all about.
- Entity values: the measure of a companys value
- Stakeholders: all parties involved in and connected to the organization directly or
indirectly.
- External environment: all factors outside of the control of the entity.
- Internal environment: the environment that can be managed by the organization to its
benefit.

4. Strategic planning processes

A Strategic Plan is a statement of long term goals along with a definition of the strategies
and policies which will ensure achievement of these goals. (CIMA official terminology)

The rational model is generally applied to strategic planning, and consists of the following
aspects:

- Strategic analysis understanding the current strategic position of a company
- Strategic choice generation of options available to the company and evaluating the
suitability, feasibility and acceptability of each strategic option
- Strategy implementation the conversion of the strategy to the operational units
through resource, operations and organizational planning

5. Goals and objectives of strategy development

The goal of the development of a strategy for an organization are derived from the
organizations mission and vision and extends generally over the long term.

Objectives set during the development of a strategy for an organization should be SMART:

S Specific
M - Measurable
A Achievable
R Realistic / Relevant
T Time-related

Often a critical success factor approach is required to ensure performance in a number of
small areas, will result in satisfactory competitive performance overall and the achievement
of goals and objectives.

Critical success factors (CSFs) are Elements of the organizational activity which are
central to its future success. Critical success factors may change over time, and may include
items such as product quality, employee attitudes, manufacturing flexibility and brand
awareness. (CIMA official terminology)
Study unit 1

4

6. Components of a strategic plan

The components of a strategic plan can include, but are not limited to, the following:

- Determining the vision of an organization
- Compiling a formal mission statement for an organization
- Analysing the stakeholders of the organization
- Setting goals for the organization within limited timeframes and utilizing available
resources
- Documenting and updating all in a strategic plan for the organization
-
Criticisms of mission statements:

- Compilation for the eye of the reader rather than the actual values of the company
- The mission statements are often to general
- The implementation strategy often do not link up to the mission statement
- The mission statement becomes obsolete if it does not grow with the organization and
its changing environment

The balanced scorecard is a performance measurement tool that links mission and strategy
into objectives and measures combining both financial and non-financial aspects.

7. Stakeholder analysis

Various methods of accepted stakeholder analysis tools can be found. The basic analysis is
as follows:
Step 1: Identify all stakeholders important to the company.
Step 2: Group all stakeholders into different dimensions of importance.
Dimensions include:
- Power (high / low)
- Support (positive / negative)
- Influence (high impact / low impact)
- Need (strong / weak)
Step 3: Incorporate the results of the stakeholder analysis into the strategic plan of the
organisation.

Study unit 1

5
8. External influences on Strategy development
Organisations can no longer focus on profitability for the shareholders only, but need to
consider external influences and stakeholders such as:
-
- Government
- Local and International Legislation
- Treaty obligations
- Consumers
- Employers
- Pressure groups

9. Corporate culture
Based on its assumptions, attitudes, values and rituals, each organization has its own
corporate culture.

Corporate social accounting is the reporting of the social and environmental impact of an
entitys activities upon those who are directly associated with the entity (for instance
employees, customers, suppliers) or those who are in any way affected by the activities of
the entity, as well as the assessment of the cost of compliance with relevant regulations in
this area. (CIMA Official terminology)

10. Analytical models:
A SWOT analysis is a tool to analyse the internal and external environment
to the organization. Strengths and weaknesses are usually internal to the
organisation, while opportunities and threats are usually external.
Example of a SWOT analysis diagram:

Strengths

What does your
organisation do better than others?

Opportunities

What new innovation could your
organisation bring to the market?
Weakness

What do other
organisations do better than you?

Threats

What is your competition doing
that could negatively impact you?

Study unit 1

6
Porters five forces
Porter's five forces of competitive position analysis were developed in
1979 by Michael E. Porter of Harvard Business School as a simple
framework for assessing and evaluating the competitive strength and
position of a business organisation.
Strategic analysts often use Porters five forces to understand whether
new products or services are potentially profitable.
The five forces are:
1. Supplier power. Can suppliers force prices up?
2. Buyer power. Can customers force prices down?
3. Competitive rivalry. How many competitors and how capable are
they?
4. Threat of substitution. What is the likelihood of customers
switching to substitute products?
5. Threat of new entry. How strong are the barriers to keep
competitors in a profitable market limited?

Class exercise:
Read the following case study:
A leading manufacturer of personal computers has set up its manufacturing operation
in a region of the country which has seen a decline of its traditional industries, lower
prosperity and higher unemployment than the rest of the country. Its decision was
seen as a success for the Regional Development Agency, which had been hoping to
attract such companies to the region.
Required:
1. Which generic strategy would you expect a manufacturer of personal
computers to follow?
2. What would you expect the vision and mission of a manufacturer of
personal computers to be?
3. Name one method to measure the value of a company that
manufactures personal computers.
4. Name five (5) stakeholders to a manufacturer of personal computers.
5. Discuss the positive and negative potential impact the external
environment can have on a manufacturer of personal computers.
6. Name three (3) risks faced by a manufacturer of personal computers in
its internal environment.
7. Perform a basic strategic analysis of the company discussed in the case
study.
Study unit 1

7
8. Which strategic choices might have been available to the company,
considering the industry?
9. Which performance measures would the company apply to assess the
success of the implementation of its strategic plan?
10. Name three (3) critical success factors to a manufacturer of personal
computers.

Suggested solution will be discussed in the contact session.

Complete 22.20 in Drury and compare your solution to the suggested solution below:

Suggested Solution Drury IM 22.6
(a) Financial statement for the year ended 31 May:
Medical
(000)
Dietery
(000)
Fitness
(000)
Total
(000)
Client fees 450.0 600.0 450.0 1500.0
Healthfood mark-up
(cost 110%)
120.0 120.0
Salaries (240.0) (336.0) (225.0) (801.0)
Budget gross margin 210.0 384.0 225.0 819.0
Variances:
Fee income
favourable/(adverse))
(37.5) (100.0 275.0 137.5
Healthfood mark-up
loss)
(30.0 (30.0)
Salaries increase (15.0) (75.0) (90.0)
Extra fitness
equipment
______ ______ (80.0) (80.0)
Actual gross margin 157.5 254.0 345.0 756.5
Less: company
costs:

Enquiry costs
budget
(240.0)
variance (60.0)
General fixed costs (300.0)
Study unit 1

8
Software systems
cost
(50.0)
Actual net profit 106.5
Budget margin per
consultation ()
35.00 32.00 25.00
Actual margin per
consultation ()
28.64 25.40 23.79

(b) Competitiveness
- Compared with the budget new business enquiries have increased by 60% and the
existing business enquiries have declined by 33%.
- The uptake from enquiries was:
New business Budget (30%) and Actual (25%)
Repeat business Budget (40%) and Actual (50%)
Repeat business represents a measure of customer loyalty and the figures are encouraging
whereas there has been a decline in the take up rate for new business.
- Even though there has been a decline in the uptake from new enquiries the increased
number of enquiries has resulted in new business exceeding budget by 5000
consultations in absolute terms. However, repeat business consultations are 2000
below budget arising from a decline in the number of client enquiries.
- Medical and dietary consultations are below budget by approximately 8% and 16%
respectively and fitness has exceeded budget by approximately 60%.
- Ideally, competitiveness should also be measured against external benchmarks rather
than the budget.
Flexibility
Flexibility relates to the responsiveness to customer enquiries. For example, the ability to
cope with changes in volume, delivery speed and the employment of staff who are able to
meet changing customer demands.
Outside medical specialists have been employed thus providing greater flexibility on the type
of advice offered and additional fitness staff has been appointed to cope with the increasing
volume. The measure of the uptake of new enquiries (see competitiveness above) can also
provide an indication of the responsiveness to customer enquiries. It could be argued that the
organization has failed to respond to a change in demand, given that dietary consultations
have declined by 16%, but staff numbers have remained unchanged. The organization may,
however, be anticipating an upsurge in future demand.
ASSIGNMENTS
Consult the work scheme.
Study unit 2

9

2 INTRODUCTION TO
MANAGEMENT ACCOUNTING
AND PROFIT PLANNING


Study material: Horngren - Chapter 1 (1)
Vigario - Chapter 1 (1)
[Drury - Chapter 1]

LEARNING OUTCOMES
- Distinguish between management accounting, financial accounting and cost
accounting and explain the purpose of each.
- Discuss the tasks of a management accountant.
- Discuss the ethical code of conduct and the characteristics (of the Chartered Institute
of Management Accountants (CIMA)) of a management accountant.
- Discuss the key management accounting guidelines.
- Discuss the value chain of business functions.
- Discuss strategic decisions of a management accountant and provide information for
competing resources and benefits.

Study unit 2

10
1. INTRODUCTION H29, V1, 4, D5
- Distinguish between management accounting, financial accounting and cost
accounting.
- The main purposes of accounting systems are:
i) Routine internal reporting for those decisions of managers that are made
regularly, e.g. determining prices and cost control.
ii) Non-routine internal reporting for those decisions of managers that are made on
each occasion but not regularly.
iii) External reporting to investors, the government and other external parties.
- The purpose of cost accounting is to gather and provide information for internal and
external purposes.
- The purpose of financial accounting is to provide information to external users, such
as creditors and the Receiver of Revenue.
- The purpose of management accounting is to provide financial and non-financial
information to management for their planning, control and decision making within the
business.
- Cost management entails the activities of managers to control costs in the short and
long term.
2. TASKS OF A MANAGEMENT ACCOUNTANT V4, D8-12
The main tasks of a management accountant are:
- Planning by means of budgets
- Evaluating performance by means of flexible budgets, standard costing, ratios, etc.
- Making decisions based on relevant costs, marginal costs, quantitative management
techniques, etc.
See the discussion in Horngren p. 37 on planning and control.
3. THE MANAGEMENT ACCOUNTANTS ROLE IN IMPLEMENTING
STRATEGY H31
3.1 Value chain
Planning and control refer to one or more business functions in which managers and
management accountants play an important role. The value chain is the sequence of
business functions that can add value to the products or services in an organisation.
Management accountants support managers in each of the following six business functions:
Value chain analysis
- Research and development (R&D)
- Design of products, services or processes
- Production
- Marketing
- Distribution
- Customer service
Study unit 2

11
3.2 Supplier chain analysis
What is the supplier chain? It is the flow of goods, services and information from the original
sources of material and services to the delivery of products to customers, regardless of
whether the activities occur in the same organisation or different ones.
4. ENHANCING THE VALUE OF MANAGEMENT ACCOUNTING SYSTEMS
H32
- Customer focus: The success of an organisation is determined by the service to the
customers.
- Key success factors: Cost, quality, time and innovation.
- Continuous improvement: This applies to the process, the product and overall
performance of the organisation.
- Value chain analysis: Two related aspects here are: (i) deal with each business
function as an essential and valuable contribution and (ii) integrate and coordinate the
efforts of all business functions.
5. KEY MANAGEMENT ACCOUNTING GUIDELINES H37
- Cost-benefit approach: A principle applied in all decisions. The costs must be
justified by the benefit that could realise.
- Behavioural and technical considerations: A management accounting system must
help managers make wise economic decisions and motivate both managers and
employees to pursue the firms objective.
- Different costs for different purposes: A cost concept used for external purposes
may differ from that used for internal purposes, e.g. compare an absorption costing
approach with a marginal costing (direct costing) approach.
6. ORGANISATION STRUCTURE AND THE MANAGEMENT ACCOUNTANT
H39
- Distinguish between line and staff management.
- Line management is directly responsible for pursuing the objectives of the
organisation, e.g. managers of manufacturing divisions may have specific levels of
budgeted operating income and certain levels of product quality, safety etc.
- Staff management, e.g. management accountants give advice and support to line
management.
- The responsibilities of the chief financial officer (CFO) or financial director are:
i. Controllership
ii. Finance
iii. Risk management
iv. Tax
v. Internal audit
Study unit 2

12
7. ETHICS OF THE MANAGEMENT ACCOUNTANT H40
The ethical codes of CIMA and the Institute of Management Accountants (IMA) for
management accountants involve competence, confidentiality, integrity and objectivity.
What characteristics can you add and how would you apply them?
8. STRATEGIC DECISIONS AND THE MANAGEMENT ACCOUNTANT H31

Do 1.29 in Horngren as practice and compare your answer with the suggested solution
below.

H + F + D 1.29
1. Possible motivation could be:
a) Management incentives: Possibly a bonus scheme based on performance for
the year
b) Promotional opportunities and job certainty
c) Maintenance of division/section autonomy
2. a) Acceptable: Cannot do much more
b) Unacceptable: Fiscal year-end 31/12
c) Unacceptable: Changing the dates is falsification
d) Acceptable: Can do little about it
e) Acceptable: No record of falsification
f) Unacceptable: Advertisements billed to current year
g) Acceptable: Transaction appears to be ethical
3. If Malonson believes that Patterson is involving her in unethical behaviour, she will
speak directly to Patterson about it. If Patterson is unwilling to change his request,
Malonson will direct her concern to the corporate controller of Nations Appliance.
Malonson could also ask for a transfer. The extreme action would be to resign if the
corporate culture of Nations Appliance is to reward divisions where managers
perform only at the end.
ASSIGNMENTS

APPENDIX TO STUDY UNIT 1

Study unit 2

13
Study Unit 1 emphasises the fact that cost management is important for a management
accountant. Cost management is the activity of managers to manage cost over the short and
long term. This includes analysis of cost, and therefore also inventory valuation.

1. DISTINCTION BETWEEN DIRECT AND ABSORPTION COST SYSTEM

It is important for you to distinguish between a direct and an absorption cost system.

What is an absorption cost system?
- Fixed AND variable manufacturing costs are included in inventory value.
What is a direct cost system?
- Only variable manufacturing costs are included in inventory value.
The difference therefore lies with inventory valuation.

The absorption cost system is used by the financial accountant.
- Why?
- Required by IAS 2.
- Fixed manufacturing overhead, e.g. rent of factory, is needed to make inventory
available for sale. Without it the products or services could not exist. Therefore, it is
necessary to take those costs in account to determine the value of inventory.
- Additional to the above, the value of the fixed manufacturing cost included in inventory,
is needed for insurance purposes, otherwise the inventory will be underinsured.
The direct cost system is used by the management accountant.
- Why?
- Fixed overheads take place in a specific period. If fixed overhead is included in closing
inventory, one effectively defers the cost to a following period.

It is important for you to realise that decisions cannot be made in an absorption cost
environment.

See the examples below for illustration:

Study unit 2

14

EXAMPLE 1:
Given: Accept the following information:
Units
Sales 1 000
Opening inventory 100
Production 1 200
Closing inventory 300

Per unit
Sales 12
Material 4
Variable labour 2
Fixed cost 4
Profit 2

Required: Prepare an income statement on both the direct and absorption cost system.

SOLUTION:

Income Statement (Direct)

Sales 12 000
Cost of sales 10 000
Production cost 11 200
Material 4 800
Labour 2 400
Fixed cost 4 000
Closing inventory 1 800
Profit 2 000
Inventory value includes variable costs ONLY, therefore:4 (material) + 2 (variable labor) = 6
per unit x 100 units = 600
Total production cost as calculated for each component separately (amount x price)
Include ONLY variable cost in inventory valuation, therefore: 6 x 300 units = 1 800

Income Statement (Absorption)
Sales 12 000
Study unit 2

15
Cost of sales 9 200
Opening inventory 1 000
Production cost 11,200
Material 4 800
Labour 2 400
Fixed cost 4 000
Profit 2 800

Now fixed cost is allocated at a rate of R4 per unit. Therefore the value of beginning
inventory: R4 + R2 + R4 = R10 x 100 units
Fixed overhead is also included, therefore R10 x 300 units

It is clear that profit differs. The difference in profit is because of:

Direct Absorption Difference
Opening inventory value 600 1 000 (400) Decrease in profit
Closing inventory value 1 800 3 000 1 200 Increase in profit
800 Difference

This is exactly the difference in profit.

On the absorption cost system, profit can therefore be manipulated. If management wants to
achieve a higher profit this year, they can see to it that inventory levels are higher. Therefore,
decisions cant be made on an absorption cost basis.

2. IN A DIRECT REPORTING ENVIRONMENT

2.1. WHAT AFFECTS PROFIT?
Study unit 2

16

Production quantity has no effect on profit in a direct reporting environment.

Sales is the only volume alteration that has an effect on profit (equal to the amount in sales
volume x contribution).

See the following example as illustration:

EXAMPLE 2:

Required: Assume the following information:
Sales 1 000

Per
unit
Sales 12
Material 4
Variable labour 2
Fixed cost 4
Profit 2

Required: Prepare 2 variable cost income statements:
(i) The first statement for production of 1 200 units
(ii) The second statement for production of 2 000 units

Study unit 2

17

SOLUTION:

(i) Income statement

Sales 12 000
Material 4 800
Labour 2 400
Fixed cost 4 000
Profit 2 000

(ii) Income statement
Sales 12 000
Material 8 000
Labour 4 000
Fixed cost 4 000
Profit 2 000

As one can see, profit remains the same, regardless of change in production volumes.

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2.2. WHAT IS CONTRIBUTION?

Contribution = Sales all variable costs

However, other variable costs does not form part of inventory valuation (in other words, non-
manufacturing costs, such as sales costs, does not form part of inventory valuation).


EXAMPLE 3:

Given: Assume the following information:

Per product A Rand
Sales price 100
Material 15
Labour 20
Variable factory rent 5
Variable audit cost 2
Variable sales cost 5
Fixed factory rent 2 000
Fixed administration cost 1 500

Required:
(i) What is the contribution of a product A?
(ii) What is the value of a product A on a direct cost basis?

Study unit 2

19

SOLUTION:

(i) The contribution will be as follows:
Sales price 100
Less ALL variable costs:
Material (15)
Labour (20)
Variable factory rent (5)
Variable audit cost (2)
Variable sales cost (5)
Contribution of Product 53

(ii) The value of 1 Product A is as follows:
Material 15
Labour 20
Variable factory rent 5
Inventory value 40

3. FORMATS

The format of the income statement does not determine the reporting method.

As mentioned above, the difference between a direct and absorption cost system is only the
inventory value (opening and closing inventory).

Do the following examples and take your answer to class where the solution will be handed
over to you:

Study unit 2

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EXAMPLE 4:


Units
Sales 1 000
Production 2 000

Budgeted costs for total production:
Rand
Material 10 000
Variable labour 20 000
Variable sales cost 4 000
Fixed labour 25 000
Fixed admin cost 15 000

Budgeted sales price:
Selling price per unit 100

Required: Calculate the budgeted profit:

1 In a contribution format income statement
(i) For a direct cost system
(ii) For an absorption cost system

2 On a traditional basis
(i) For a direct cost system
(ii) For an absorption cost system

Your answer must be as follows:

For both the direct cost system budgets = R41 000

For both the absorption cost system budgets = R53 750

The complete answer will be handed out during the contact session.

Study unit 2

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4. ABSORPTION COST SYSTEM

The following has an impact on profit in an absorption cost system:
- A change in sales (also equal to contribution x volume difference)
- A change in inventory (with the fixed overhead allocated component)

Refer to example 1:

EXAMPLE 5:

Given: Assume the same information as in example 1:

Income statement (Absorption)
Sales 12 000
Cost of sales 9 200
Opening inventory 1,000
Material 4 800
Labour 2 400
Fixed cost 4 000
Profit 2 800

Required: What will happen if production increases with 100 units? Closing inventory will
automatically also increase with 100 units, as sales remain the same.

Study unit 2

22

SOLUTION:

Income statement (Absorption)
Sales 12 000
Cost of sales 9 200

Material 5 200
Labour 2 600
Fixed cost 4 000*
Profit 8 200

This will still be 100 x R10
1300 x R4
1300 x R2
* Fixed regardless of volume
This will now be 400 x R10

It is clear that profit changes with a change in inventory volume.

A change in sales will also have an effect on profit, exactly the same as explained above.

4.1. FIXED OVERHEAD

Regardless of the method of valuation, the amount of fixed cost in the income
statement is always the ACTUAL amount. Over/under allocated overheads does NOT
have an effect on profit!

What is over/under allocated overhead?
This is the difference between the actual overhead and the allocated overhead.

How is it calculated?

Budgeted fixed overhead = Standard fixed overhead allocation rate (SFOR)
Budgeted production

The allocated fixed overhead will then be = SFOR x actual production

Study unit 2

23
The difference between the allocated and the actual overhead is the under or over allocated
overhead.

Over/under allocated overhead exists because of a volume and/or price variance. This arises
as the allocation rate is incorrect.


EXAMPLE 6:


Budgeted volume:
Production 500
Sales 400
Therefore, closing inventory 200

Budgeted costs: (Total) = standard cost Therefore, per production unit
Material 10 000 20
Labour 5 000 10
Fixed overhead 10 000 20

Sales price per unit 100

What is the standard fixed overhead rate?
10,000/500 = R20

The company follows a standard cost system.

a) What is an overhead variance because of a volume difference?

Actual volume:
Production 450
Sales 420
Actual costs: (Total) Therefore, per production unit
Material 9 000 18
Labour 5 200 10,4
Fixed overhead 10 000 22,22


Income statement
Sales (420 x 110) 46 200
Less: Cost of sales -21 700
Study unit 2

24
Opening inventory (100 x (20+10+20)) 5 000
Production costs:
Material* 9 000
Labour* 5 200
Fixed overhead (450 X 20) 9 000
Closing inventory (130 x (20+10+20)) -6 500
Gross profit 24 500
Under allocated overhead -1 000
Profit 23 500

Keep the costs at standard cost as given in the example.
* Actual.

b) What is an overhead variance because of a budget difference?

Actual volume:
Production 500
Sales 420

Material 9 000 18
Labour 5 200 10,4


Income statement
Sales (420 x 110) 46 200
Production costs:
Material 9 000
Labour 5 200
Gross profit 27 000
Profit 26 000

c) What is a overhead variance because of both a volume and rate variance?

Actual volume:
Production 450
Sales 420

Material 9 000 18
Labour 5 200 10,4
Study unit 2

25


Income statement
Sales (420 x 110) 46 200
Production costs::
Material 9 000
Labour 5 200
Gross profit 24 500
Profit 22 500
It is clear that fixed overhead in the income statement stays equal to the ACTUAL overhead
incurred. Over/under allocated overhead does not have an effect on profit.

Study unit 2

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Study unit 3

27

3 DIRECT AND ABSORPTION
COSTING AND COST
CLASSIFICATION


Study material: Horngren - Chapters 9 and 10
Vigario - Chapters 4 and 6
[Drury - Chapters 7 and 23]
[Garrison - Chapters 5 and 7]

LEARNING OUTCOMES
- Classify costs according to the:
* High-low method
* Graph method
* Least squares method to separate mixed costs into fixed and variable
components
- Discuss and apply the principles of direct costing by calculating net operating income
according to this method in firms where actual costs are used and in firms where
standard costs are used.
- Discuss and apply the principles of absorption costing by calculating net operating
income according to these methods in firms where actual costs are used and in firms
where standard costs are used.
- Do a profit reconciliation between the net operating income calculated as per the direct
costing method and as per the absorption costing method.
Study unit 3

28
- Do a profit reconciliation between the net operating income where actual costs are
used and where standard costs are used in each of the direct costing and absorption
costing methods.
- Give reasons for differences and congruences in profit between direct cost statements
and absorption cost statements, and prove by means of figures these differences and
congruences.
- Determine the breakeven point and make decisions if absorption costing is used.
- Convert an income statement prepared according to the direct costing method to one
prepared according to the absorption costing method and vice versa.
- Evaluate the direct and absorption costing methods as reporting methods.
- Divide cost variances and the adjustments on a pro rata basis.
- Convert from actual costs to standard costs and vice versa in absorption costing as
well as direct costing.
- Implement throughput costing and reconcile the profit with that calculated as per the
direct and absorption costing methods.
- Determine the influence of the learning curve on cost, profit and breakeven point.
- Determine the effect of a JIT approach on the reporting methods.
1. OVERVIEW AND INTRODUCTION D141, H324+, V121
- Absorption costing is also known as full costing.
- Direct costing is also known as marginal costing or variable costing.
- The name depends on which costs are included in inventory.
- Influences inventory valuation and reporting (profit realisation).
- Better planning and control because costs are divided into fixed and variable.
- Direct costs: Direct in the sense of directly variable.
- Product absorbs variable costs.
- Absorption costs: Product absorbs the total cost of acquisition.
- Reporting: (i) Internal Direct costing
- (ii) External Absorption costing
- Direct and absorption costing can be used in actual costs and standard costs.
- Distinguish between product costs and period costs.

2. METHODS OF COST CLASSIFICATION, H368+, D597, V207
2.1 Industrial engineering method Not mathematical: Work study methods and sampling
2.2 Account analysis method: Surface distinction
2.3 High-low method V207, H372 e.g.

b = Change in costs
Change in activity

Study unit 3

29
EXAMPLE

X Y
1. 1 500 R800 b = 1 350 800
2. 2 000 1 000 3 000 1 500
3. 3 000 1 350 = 550
4. 2 500 1 250 1 500
5. 1 500 800 = .366
.367
Substitute in y = a + bx
a = 1 350 - .367 x (3 000)
= 1 350 1 101
= 249

y = a + bx
y = 249 + .367 x Test at lowest level

2.4 Graph G204 (255)

Y
1 400 -
-
1 200 -
-
1 000 -
-
Rand -
-
600 -

a = 200
-

b =
000 3
700 350 1

400 -

= .38333
-
200 -
-

500 1 000 1 500 2 000 2 500 3 000

Study unit 3

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2.5 Least squares V212, H374

Exy = aEx + bEx
Ey = na + bEx

X Y XY X
1 500 800 1 200 000 2 250 000
2 000 1 000 2 000 000 4 000 000
3 000 1 350 4 050 000 9 000 000
2 500 1 250 3 125 000 6 250 000
1 500 800 1 200 000 2 250 000
10 500 5 200 11 575 000 23 750 000

11 575 000 = 10 500a + 23 750 000b
5 200 = 5a + 10 500b
x 2 100: 10 920 000 = 10 500a + 22 050 000b
- 655 000 = 1 700 000b
b = .385

Substitute in a = 5 200 10 500 (.385)
5
= 231.5
Computer a = 230.88
b = .385

2.6 Variance of average method

1. Average X : 10 500 = 2 100
5

2. Average Y : 5 200 = 1 040
5

3. 4 columns I: Difference between actual and average X
II: Square of I
III: Difference between actual and average Y
IV: I x III

4. b = EIV
EII

5. a = y bx

I II III IV
-600 360 000 -240 144 000
-100 10 000 -40 4 000 b = 655 000
+900 810 000 +310 279 000 1 700 000
+400 160 000 +210 84 000 = .385
-600 360 000 -240 144 000 a = 1 040 2 100
- 1 700 000 - 655 000 (.385)
= 231.5

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3. CONTRIBUTION MARGIN AND GROSS PROFIT H105
- Contribution margin: Sales less ALL variable costs
- Gross profit: Sales less ALL costs of acquisition (VC + FC)
- Contribution margin = Gross profit

4. ACTUAL AND STANDARD COSTS H335+
- Actual: Direct
Absorption costs
- Standard costs: Direct VC variances
All VC + FC variances
- Normal costs: Direct and absorption costs

5. PRINCIPLES (CHARACTERISTICS) OF DIRECT COSTING D144, H326,
V123
- VC as product costs (all VC at product but only production costs are in inventory)
- FC as period costs (all FC).
- Actual costs
Actual DM, DL, FC but variable overheads at predetermined rate, therefore adjust
variable overheads overallocated or underallocated.
- Standard costs
DM, DL and variable overheads at standard, therefore adjust all variable cost
variances, FC at actual.
- Net profit: Sales VC = Contribution margin - FC = Net profit
Example of income statement G283 (329), D232, H328 (297)

6. PRINCIPLES (CHARACTERISTICS) OF ABSORPTION COSTING, H327,
V124, D144
- All costs of acquisition are product costs (VC + FC).
- All costs after acquisition are period costs (VC + FC).
- Actual costs: Actual DM and DL and manufacturing overheads (FC + VC) at a
predetermined rate, therefore adjusted variable and fixed overheads overallocated or
underallocated.
- Standard costs: DM, DL and manufacturing overheads (FC + VC) at standard;
therefore adjust ALL variances.
- Net profit: Sales Cost of sales = Gross profit Selling and administrative expenses =
Net profit.

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7. INCOME STATEMENT: EXAMPLE D143, H330, V128
8. PROFIT RECONCILIATION D146, H329, V139
- When will profits be the same?
- Production = Sales, no inventory difference.
- When will profits differ?
- Production = Sales, there is an inventory difference inventory increase or decrease.
- Production > Sales: inventory increase, absorption cost highest profit
- Production < Sales: inventory decrease, direct cost highest profit
- Example

9. EXTERNAL AND INTERNAL REPORTING D148, H344
- Direct costing: Internal, important for decision making, planning and control
- Absorption costing: External
- Which form of reporting?

10. PRO RATA DIVISION OF VARIANCES

11. CRITICAL EVALUATION OF DIRECT COSTING AND ABSORPTION
COSTING AND REPORTING METHODS D148, V122
DIRECT COSTING
ADVANTAGES
- Provides more useable information for decision making.
- Inventory difference in direct costing is not reflected in profit; therefore an increase in
sales causes an increase in profit.
- Direct costing does not include FC in inventory; therefore not necessary to allocate
FC.
- Fictitious profits are not possible.

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DISADVANTAGES
- FC overallocated or underallocated are important figures and are not shown.
- Inventory valuation excludes FC, which easily leads to being underinsured; this affects
earnings per share, current ratio and liquidity ratio.

ABSORPTION COSTING
ADVANTAGES
- Emphasises the importance of FC.
- Fictitious losses cannot occur.
- Theoretically more correct for reporting, externally acceptable (FC + VC were
necessary for production and have to be included).
- Pricing.
- AC 108 (IAS 2): Paragraphs 1, 7, 10, 30. IAS 2 V111(V61).

DISADVANTAGES
- FC are allocated arbitrarily choosing a level of activity is difficult.
- Pricing dont forget selling and administrative expenses.
12. BREAKEVEN POINT AND ABSORPTION COSTING REPORTING H350
- CVP (U) = FC + [SFOR (CVP (U) Units produced)]
Contribution margin/U

13. CONVERTING INCOME STATEMENTS TO ANOTHER METHOD
- From absorption costing to direct costing. Example attached (study guide BRK 311)
- From direct costing to absorption costing. Example attached (study guide BRK 311)
Study unit 3

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13.1 Converting from absorption costing to direct costing
Experimental Ltd uses standard absorption costing. Management intends converting to
direct costing and expects you to convert the following income statement to the direct costing
method.

Income statement absorption costing method (R) (R)

Sales (5 000 units @ R50/u) 250 000
Less: Cost of sales 151 600
Plus: Production costs 171 000
Min: Closing inventory 51 000
Cost of sales at standard cost 150 000
Plus/less: Variances: Variable 5 000
Fixed ( 3 400)
Cost of sales at actual 151 600
Gross profit 98 400
Less: Other costs 70 000
Selling and admin. expenses
Variable 25 000
Fixed 45 000
Net profit 28 400

Additional information:

- The budgeted fixed production costs for the year amounted to R60 000 for a normal
volume of 5 000 units.
- There was no opening or closing work-in-process inventory.
- Inventory is valued at standard cost.
- Variances are adjusted to cost of sales where appropriate.
- The actual fixed production cost was R65 000.
REQUIRED:
1) By means of an income statement, determine the net profit according to the direct
costing method.
2) If there is a difference in net profit according to the given income statement and the one
you prepared in (1) above, do a reconciliation.

Study unit 3

35

Suggested solution

(1) Direct costing income statement

Income statement direct costing method
(R) (R)

Sales (5 000 units @ R50/u) 250 000
Less: Variable cost of sales 95 000
Less: Closing inventory 30 600
Variable cost of sales at actual 95 000
Less: Other variable costs
Selling and admin. expenses 25 000
Contribution margin 130 000
Less: Fixed costs 110 000
Production costs 65 000
Net profit 20 000

Calculations:

Total cost per unit = R150 000/5 000 units
= R30,00 per unit

Fixed costs per unit = R60 000/5 000 units
= R12 per unit

Variable costs per unit = R30 R12 per unit
= R18 per unit

Opening inventory units = R30 000/R30 per unit
= 1 000 units

Closing inventory units = R51 000/R30 per unit
= 1 700 units

Production units = R 171 000/5 000 units
= 5 700 units

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(2) Profit reconciliation: Direct costing method profit = R20 000
Absorption costing method profit = R28 400
Difference in profit = R8 400

Inventory: Opening inventory: D/C + R18 000 A/C + R30 000
Closing inventory: D/C - R30 600 A/C - R51 000
Cost reduction - R12 600 - R21 000

Inventory difference R8 400

Direct costing: Highest cost Absorption costing: Lowest cost
Therefore Lowest profit Therefore Highest profit

The costs of the direct costing method will be R8 400 higher than the absorption costing
method owing to a difference in inventory valuation this leads to a R8 400 lower profit in the
direct costing method (as indicated above). The costs of the absorption costing method will
be R8 400 lower than in the direct costing method owing to a difference in inventory valuation
this leads to a R8 400 higher profit in the absorption costing method (as indicated above).

13.2 Conversion from direct costing to absorption costing

AB Limited uses a direct costing system for internal reporting and gives you the following
information on the past third quarter:

Income statement direct costing method (R) (R)

Sales (5 500 units @ R45/u) 247 500
Less: Variable cost of sales 70 000
Variable cost of sales at actual 70 000
Less: Other variable costs
Contribution margin 165 125
Less: Fixed costs 125 000
Production costs 80 000
Net profit 40 125

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Additional information:
- Inventory is valued at standard cost.
- There was no opening or closing work-in-process inventory.
- The budgeted fixed manufacturing overheads for this quarter are R75 000 for a normal
volume of 5 000 units or 10 000 direct labour hours.

REQUIRED:
1) Prepare an income statement according to the absorption costing method where you
use standard rates.
2) Does the given net profit differ from that given in (1) above? Substantiate your answer
with the necessary figures.

Suggested solution

Income statement absorption costing method (R) (R)

Sales (5 500 units @ R45/u) 247 500
Less: Cost of sales 142 500
Cost of sales at standard costs 148 500
Fixed ( 10 000)
Cost of sales at actual 142 500
Gross profit 105 000
Less: Other costs 57 375
Selling and admin. expenses
Variable 12 375
Fixed 45 000
Net profit 47 625

Calculations:

Variable costs per unit = R66 000/5 500 units
= R12 per unit

Opening inventory units = R36 000/R12 per unit
= 3 000 units

Closing inventory units = R42 000/R12 per unit
= 3 500 units
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38

Production units = R72 000/R12 per unit
= 6 000 units

Fixed costs per unit = R75 000/5 000 units
= R15 per unit

Fixed costs variance = Actual - Allocated
= R80 000 (6 000 x 15)
= R10 000 overallocated

(2) Profit reconciliation: Direct costing method profit: R40 125
Absorption costing method profit: 47 625
Difference in profit R7 500

Inventory Opening inventory: D/C + R36 000 A/C +R81 000
Closing inventory: D/C - R42 000 A/C -R94 500
Cost reduction - R 6 000 -R13 500
Inventory difference R7 500

Direct costing: Highest cost Absorption costing: Lowest cost
Therefore Lowest profit Therefore Highest profit

The costs of the direct costing method will be R7 500 higher than the absorption costing
method owing to a difference in inventory valuation this leads to a R7 500 lower profit in the
direct costing method (as indicated above). The costs of the absorption costing method will
be R7 500 lower than in the direct costing method owing to a difference in inventory valuation
this leads to a R7 500 higher profit in the absorption costing method (as indicated above).

14. INFLUENCE OF JIT ON THE REPORTING METHODS
- Profits differ because production = sales.
- In JIT: The aim is no inventory.
- Therefore production = sales profits are closer to each other.

15. THROUGHPUT COSTING H335
- Supervariable costs
- Only materials costs in inventory

16. ALTERNATIVE VOLUMES D150, H339
- Theoretical capacity
- Practical capacity
- Normal utilisation
- Master budget utilisation
What is the effect of each on the volume variance?

Study unit 3

39
17. LEARNING CURVES H379, V217
- A function showing how labour hours per U can decrease if production U increase
because workers learn and improve in their work. Efficiency improves and unit costs
are lower.
- Experience curve: A broader application of the learning curve which shows how the full
production costs per U (manufacturing, marketing and distribution) decrease as output
increases.
- Distinguish between the cumulative average time learning model and the incremental
unit time learning model.
- See example 10.10 - 10.13 H382 for an explanation.
- Example: Assume it takes 40 hours to carry out a task and it has been determined that
an 80% learning curve is appropriate for the task when production doubles. Determine
the average unit time and the marginal unit time for the production of 16 tasks V217.
Marginal
Production Cumul. Prod. Ave. time Total time Total time Ave. time
1 1 40 40 40 40
1 2 32 64 24 24
2 4 25.6 102.4 38.4 19.2
4 8 20.48 163.84 61.44 15.4
8 16 16.384 262.14 98.3 12.3

Ave. time = Average of past x 80%
Total time = Average time x Cumulative production
Marginal total time = Current total time Previous total time
Marginal average unit time = Marginal total time Production

Graph

Ave. hours/U
of cumul. prod.

Cumul. quantity in U
Example:
Determine the learning curve % from the following:
- First batch production takes 70 hours to manufacture
- Second batch production takes 28 hours to manufacture
Study unit 3

40

Cumulative Marginal Total Ave.
1 70 70 70
2 28 98 49
Therefore the average is based on a 70% learning curve.

Do 9.18 and 9.19 in Horngren as self-assessment exercises and compare your answers with
the suggested solutions below.

H + F + D 9.18

1a INCOME STATEMENT DIRECT
COSTING
JAN. FEB. MAR.

Sales R1 750 000 R2 000 000 R3 750 000
- VC: Of sales (@ R900) 630 000 720 000 1 350 000
Selling + adm. 420 000 480 000 900 000
= Contribution margin R700 000 R800 000 R1 500 000
- FC: Production 400 000 400 000 400 000
Selling + adm. 140 000 140 000 140 000
= Net operating income R160 000 R260 000 R960 000

**(900 + 400, 900 + 500, 900 + 320)
1b.

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41
INCOME STATEMENT ABSORPTION
COSTING
JAN. FEB. MAR.
Sales R1 750 000 R2 000 000 R3 750 000
- Cost of sales (@ R1 300**) 910 000 *1 120 000 *1 850 000
= Gross profit R840 000 R880 000 R1 900 000
- Selling + adm.: VC 420 000 480 000 900 000
FC 140 000 140 000 140 000
= Net operating income R280 000 R260 000 R860 000

**VC = R 900, FC = R 400 (R400 000 1 000 units), total costs/U = R1 300
*Volume variance = (AOV NV) SFOR
Jan. = (1 000 1 000) R400 = R0 so COS 700U x R1 300 = R910 000
Feb. = ( 800 1 000) R400 = (R80 000) [ 800U x R1 300 ] + R80 000
Mar. = (1 250 - 1 000) R400 = R100 000 [1 500 x R1 300] - R100 000

2. Difference in operating income: Jan. = R120 000, Feb. = R0, Mar. = R100 000
Difference in inventory: Direct costing: January February March
+O/I : 0 R270 000 R270 000
- C/I : R270 000 270 000 45 000
-R270 000 - + R225 000

Difference in inventory: Absorption costing:
+O/I: 0 R390 000 R390 000
- C/I: R390 000 390 000 65 000
-R390 000 -R 0 +R325 000
Difference in inventory in the two above methods:

Jan: R270 000 - (-R390 000) = R120 000, compared with difference in operating income.
Feb: 0 -(0) = R0, compared with difference in operating income.
Mar: R225 000 - (R325 000) = R100 000, compared with difference in operating income.

Inventory increase in January: Absorption costing - the highest profit
Inventory decrease in March: Direct costing the highest profit
H + F + D 9.19 (refer to 9.18 for the direct costing and absorption costing statements)

Study unit 3

42
1. INCOME STATEMENT FOR 2007 JAN. FEB. MAR.
Sales R1 750 000 R2 000 000 R3 750 000
O/I - 150 000 150 000
- Direct materials production cost 500 000 400 000 625 000
C/I (150 000) (150 000) (25 000)
= Throughput contribution margin R1 400 000 R1 600 000 R3 000 000
- Direct labour 100 000 80 000 125 000
- Overheads: Manufacturing: VC 300 000 240 000 375 000
FC 400 000 400 000 400 000
Sales: VC (@ R600) 420 000 480 000 900 000
FC 140 000 140 000 140 000
= Net operating income R40 000 R260 000 R1 060 000

Compare the operating income from above three income statements: class discussion.
Make sure you do each month separately.
*: O/I + Production C/I = R390 000 + 1 120 000 420 000 = R1 090 000
: = R420 000 + 1 525 000 61 000 = R1 884 000

2. Net operating income:

Jan Feb Mar
Absorption costing
Direct costing
Throughput costing
R280 000
160 000
40 000
R260 000
260 000
260 000
R860 000
960 000
1 060 000

Throughput costing places more emphasis on sales as a source for providing net income
than direct costing and absorption costing do.

3. Throughput costing penalises production when sales and production are not
synchronised in the same period. Other costs (except for materials) that are variable
are recorded when they are incurred, in contrast to direct costing where they are
capitalised in the inventory.

ASSIGNMENTS

Study unit 4

43

4 COST-VOLUME-PROFIT
ANALYSIS


Study material: Horngren - Chapter 3
Vigario - Chapter 7
[Drury - Chapter 8]
[Garrison - Chapter 6]

LEARNING OUTCOMES
- Apply the cost-volume-profit technique to make decisions on:
* Utilising capacity
* Profitability of products or product lines
* Turnover to realise a certain percentage of return on capital
* Maximum increase in fixed or variable costs allowed in order to realise a certain
profit
* The percentage by which sales can drop before a loss occurs
* The most profitable sales mix
* Pricing
- Determine, with the aid of cost-volume-profit analysis, the effect of a change in the
assumptions (sensitivity analysis) on the profit, contribution margin, contribution ratio
and return on capital.
- Determine, in businesses selling more than one type of product, the effect of the sales
mix on the breakeven point, margin of safety and margin of safety ratio.

Study unit 4

44
1. INTRODUCTION H86, D165, V243
- Also known as breakeven analysis or CVP analysis.
- Ideal for solving problems dealing with selling price, profit maximisation, utilisation of
capacity, etc.:
i. Determine selling price to realise a particular profit.
ii. Determine turnover units to realise a particular profit.
iii. Which products to focus on to realise the highest profit.
iv. Which selling price or units to realise a particular % return on capital.
v. Influence of a change in selling price or cost or volume on the profit of the
business.
- Breakeven point is the point at which no profit or loss can be made or the point at
which the cost and the income of a certain volume are equal.
- Very suitable for manufacturing enterprises, trade enterprises and service enterprises.
2. TERMINOLOGY H110, V245
- Contribution margin: Also called marginal income. Calculated from sales less all
variable costs; it is the amount available for settling fixed costs and realising a profit.
- Contribution margin ratio (%): Contribution margin expressed in terms of sales. A
valuable figure for assessing a products profitability.
- Breakeven point: See paragraph 1; the point where contribution margin is equal to
fixed costs.
- Margin of safety: The amount or volume by which sales can drop before a loss
occurs. These are the safe sales and are calculated by sales less sales at
breakeven point, and can be expressed in units or rands.
- Margin of safety ratio (%): The percentage of sales that produces a profit, i.e. the %
by which sales can drop before a loss occurs.
- Sales mix: The combination of products sold.
3. ASSUMPTIONS H91
- SP/U is constant.
- VC/U are constant and FC in total are constant.
- Sales mix is constant.
- Production and sales are synchronised, so there is no inventory difference.
- Productivity and efficiency remain the same.
- Costs can be divided into fixed and variable costs.
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4. DETERMINING CVP H90, D166
i. Equation method
Sales = Variable costs + Fixed costs + Profit
However, the profit is zero and so the equation is:
Sales = Variable costs + Fixed costs
ii. Contribution margin method
Breakeven point = Fixed costs
(U) Contribution margin/U OR
Breakeven point = Fixed costs
(R) Contribution margin %

iii. Graph method
Not a very accurate method, but study H90 (64).

Traditional CVP graph H91, D168 Contribution margin graph D175

Profit-volume graph H94, V262, D176

5. MARGIN OF SAFETY V245, D173
- Calculated from sales less breakeven sales, therefore the sales (U or rands) that
produce a profit.
- Margin of safety % is the margin of safety divided by sales (U or rands).

A service enterprise, i.e. a laboratory taking only one type of blood test, has asked for your
help in providing the following missing information:
Income per blood test: R40
Variable cost per blood test: Fixed cost per month: Salaries R10 000
Materials R8,00 Rent R5 000
Commission R5,00
Overheads R2,00
800 blood tests were taken during July.
REQUIRED:
Using the above information, calculate the:
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i) Contribution margin %
ii) Margin of safety %

i. Contribution margin % = 62.5% ii. Margin of safety % = 25%

6. TARGET PROFIT H94
If a particular profit is the objective, use the principle of CVP, but add profit into the formula.
So: Sales = Variable costs + Fixed costs + Profit
or Turnover = Fixed costs + Profit
(U) Contribution margin/U

Turnover = Fixed costs + Profit
(R) Contribution margin %

7. INCOME TAX AND CVP H94
- No cost, only an appropriation of profit
- Note which profit is targeted: before or after tax
- Profit before tax = Profit after tax
l tax rate

8. CHANGES IN ASSUMPTIONS H97, D180
- Use sensitivity analysis
- Sensitivity analysis: What-if technique which measures how the expected values will
be affected by a change in the assumptions.
- Illustration
9. OTHER FORMULAE
i. Net profit = Sales VC - FC
or = Margin of safety x Contribution margin %
or = Sales x Contribution margin % - FC
ii. Sales = FC + Profit + VC
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or = Contribution margin
Contribution margin %
or = Variable cost
Variable cost %
or = Margin of safety
Margin of safety %
iii. Fixed costs = Sales - VC - Profit
or = Sales x Contribution margin % - Profit
or = CVP x Contribution margin %
iv. Variable costs = Sales Contribution margin
or = Sales Fixed costs - Profit
or = (l Contribution margin %) x Sales
v. Margin of safety = Sales CVP
or = Profit Contribution margin %
vi. Margin of safety % = Sales CVP
Sales
or = Net profit
Contribution margin
10. CRITICISM OF CVP
Not all the assumptions are realisable and each assumption is a constraint.
11. DECISION-MAKING MODELS AND UNCERTAINTY H95
- Role of a decision-making model
- Quantitative analysis:
i. Identify a selection criterion: Quantify an objective.
ii. Identify the set of alternatives to consider.
iii. Identify the set of events that may occur.
iv. Determine a possibility for each event.
v. Identify the set of possible outcomes.

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12. SALES OF MORE THAN ONE TYPE OF PRODUCT H101, V262, D176
- Aim for the combination that will increase the overall net profit of the firm.
- Limiting factors such as DLH, materials, capacity, etc. may affect the product mix. By
considering the contribution margin of each limiting factor, the most profitable
combination can be selected.
- The CVP principles as applied for single products remain exactly the same. Take note
of the following important information:
i. CONTRIBUTION MARGIN per unit is replaced by AVERAGE contribution
margin per unit.
ii. CONTRIBUTION MARGIN % is replaced by AVERAGE CONTRIBUTION
MARGIN % and the formulae principles remain the same.
- Average contribution margin: Calculated from the total contribution margin of the
sales mix divided by the number of units in the sales mix.
- Average contribution margin %: Calculated from the average contribution margin
per unit divided by the average selling price per unit.
Test yourself by doing the following exercise and compare your answer with the suggested
solution.

PQR Ltd produces three products P, Q and R with the following price and cost information:
PRODUCT P PRODUCT Q PRODUCT R
Selling price R12 R20 R25 R
Variable cost 6 8 10

The monthly fixed cost is R108 000.
An income tax rate of 45% is applicable.

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REQUIRED:
Consider each of the following (a, b and c) situations individually and calculate the sales of
each individual product as required in the sales mix:
a. With a sales mix in units of 4P: 2Q: 4R, determine the:
- Breakeven point in units and rands.
- Turnover (in units) to realise a net profit of R23 760 after tax per month.

b. With a sales mix in rands of 30% P: 40% Q: 30% R, determine the:
- Breakeven point in units if an increase of R6 000 in fixed cost occurs.
- Turnover (in units) to realise a net profit of R20 900 per month after tax
and the fixed cost increase of R6 000 is still applicable.

c. With a sales mix in units of 4P: 2Q: 4R consider the following situation: An
additional sales commission of 10% is applicable to P and R for all sales higher than
breakeven point. What number of sales units must be achieved to realise a profit of
R37 280 before income tax?

a. *4 000P, 2 000Q, 4 000R or P = R48 000, Q = R40 000, = R10 000
*5 600P, 2 800Q, 5 600R

b. *5 000P, 4 000Q, 2 400R
*6 667P, 5 333Q, 3 200R

c. *5 600P, 2 800Q, 5 600R

13. CVP ANALYSIS FOR DECISION MAKING H95
- Sensitivity analysis and uncertainty
- Contribution margin

14. COST PLANNING AND CVP H98
- Profit-volume graph for different options
- Contribution margin
- Operating leverage
- Influence of the time horizon

Do the self-assessment exercise 7.4 in Vigario and compare your answer with the suggested
solution below.
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Vigario 7.4

Income statement for 19x5 R000 R000 /U
Sales 9 million x R20 R180 000 R20
- VC: DM 10 000
Other mat. 26 000
DL *19 800
Overheads - 55 800 6.20
= Contribution margin R124 200 R13.80
- FC: DL 13 200
Overheads 80 000
Selling + admin. 27 000 120 200
= Net operating income R4 000
- Tax: 42% 1 680
= Net operating income after tax R2 320

* R33 000 000 x .6 % = VC Var. DL = R19 800 000
Fixed DL = R13 200 000
1. 19x6: Costs + 6% (In thousands) 2. 19x6: Cost and SP + 6%
FC
CVP = Contrib. marg./U
R127 412
CVP = 20 + 6% - 6.572
= R120 200 + 6%
R20 (6.2+6%)

= R127 412
20 6.572/U
= R127 412
21.20 6.572
= 9 488.53 U x 1000 = 8 710.14 U x 1 000
= 9 488 530 U =8 710 140 U
or R189 770 x 1000 of R184 655 x 1 000
= R189 770 600 =R184 655 000

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Let SP = _
3. Turnover = FC + VC + Profit
9 450 x = 127 412 + (6.572 x 9 450) + 4 000
x = 193 517.4
9 450
x =R20.478/U selling price

4. R20.478
20 = 102.39% is the SP in 19x6 versus 19x5
Sales U: 9 000 2.39% = 8 784.9U
Sales 8 784.9 x R20.478 = R179 897
- VC 8 784.9 x 6.572 57 734.36
= Contribution margin R122 163
- FC 127 412
= Net profit (loss) (R5 249) x 1000 = R5 249 000

Loss 2.9177 % of turnover
5. (i) Advertising costs + R15 000 000 Units 15%
(ii) Advertising costs + R20 000 000 Units 22.5%
(iii) Advertising costs + R25 000 000 Units 30%
Contribution margin = FC + Profit + Increase in advertising
In thousands (i) (ii) (iii)
FC R127 412 R127 412 R127 412
+ Profit 4 000 4 000 4 000
+ Advertising costs 15 000 20 000 25 000
= Contribution margin R146 412 R151 412 R156 412
Contribution margin/U
(20.478 6.572)
13.906 13.906 13.906
Units required 10 528.693 10 888.24 968 11 247.8 067

Increase in units:
8 784 + 15% + 22.5% + 30% 10 101.6 10 760.4 11 419.2

Margin of safety - - 171.39 U

Alternative (iii) seems
promising

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ASSIGNMENTS

Study unit 5

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5 PROFIT PLANNING


[Drury - Chapters 15, 16]
[Garrison Chapter 9]

LEARNING OUTCOMES
- Do short-term planning for manufacturing and trade enterprises by means of a master
budget.
- Discuss and implement zero-based budgeting.
- Implement kaizen budgeting in a business.
- Implement activity-based budgeting in a business.
- Evaluate the use of budgets for planning and control.
- Indicate how responsibility accounting affects budgets.
- Implement the just-in-time approach in budgeting and discuss its effect on budgeting.
- Apply the learning curve to budgeting.
- Discuss the effect of uncertainty by applying sensitivity analysis to budgets.

1. INTRODUCTION AND MOTIVATION H206, V285, D351
- Short-term planning: The environment of today, physical, human and financial
resources currently available.
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- Long-term planning: Strategic or corporate planning, e.g. profit maximisation,
increasing market share.
- Budgeting: Plan of action for future periods to coordinate activities within the business
or quantify the objectives in an accounting plan to provide a basis for control and
performance evaluation.
- A quantitative expression of a plan of action for a specific future period.
- Budgets reflect the firms policy.
- Master budget: Coordination of all the financial projections in the organisation.
- Purpose of budgeting: Planning and control
- Planning Fixed budget
- Control Flexible budget
- Personal budgets
- Strategic analysis Short-term planning Short-term budgets
2. STEPS IN THE PLANNING PROCESS D352
i) Identify objectives: Formulate mission, firms objectives/goals and division
objectives/goals, e.g. what type of enterprise? Which market will be served? Profit
objective? Growth rate?
ii) Identify potential strategies, e.g. in the development of a new market, new product, or
both.
iii) Evaluate strategic options: Criteria, e.g. suitability, possibility and acceptability.
iv) Select the alternative possibilities of actions: Choose the activities with the greatest
potential.
v) Implement the long-term plans: The annual budget is prepared from this.
vi) Monitor the actual results.
vii) Respond to deviations from the plan.
3. WHY BUDGETING? D355, H209, V286
The aims of budgeting become advantages if they are achieved.
- Planning and strategy: Forces management to plan.
- Coordination: Cooperation between divisions.
- Communication: Various divisional heads must communicate and iron out problems in
good time.
- Motivation: Employees are motivated because they know what is expected of them.
- Raises awareness of costs.
- Control: Framework for comparing the budgeted and actual.
- Performance evaluation: Evaluation on the basis of deviations prevented benchmark.
4. BUDGET PERIOD D357, H211
- Period for which budget applies.
- Period determines the name, e.g. short-term is one year and long-term is five years.
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- Rolling budget.
5. ADMINISTRATION OF BUDGETS D357, H209
- Budget committee: High-level representatives of various segments (divisions).
- Budget officer coordinates the budgets of the different segments.
- Accounting staff assist.
- Budget manual.
- Participatory budgets.
6. STEPS IN THE BUDGETING PROCESS D358
- Communicate the details of the budgeting policy.
- Determine limiting factors, e.g. sales.
- Prepare the sales budget.
- Initial preparation of budgets.
- Negotiate with budget representatives.
- Coordinate and revise budgets.
- Final approval.
7. MASTER BUDGET D361, H211, V290
E Diagram in Horngren on p. 213
7.1 Operating budget with budgeted income statement as the goal
i) Sales budget D364, H215, V291
E Starting point or cornerstone if sales is the bottleneck.
E Sales managers responsibility.
E Prepare in units (U), prices, per product, sales territory, period.
ii) Production budget D364, H215, V291
E Production managers responsibility to convert the sales plan into activities.
E Indicate per product, in units, per period.
E Production = Sales + Closing inventory (C/I) Opening inventory (O/I)
iii) Closing inventory budget H218
E What inventory must be held to support sales?
E Which remains constant: inventory or production? Show units, costs and value
of raw material, work-in-process and finished goods.
iv) Production cost budget
E Raw material
a) Materials usage budget D364, H216
- Usage = Production units x Raw material needed per unit
- Indicate type, quantity, per department, time, cost.
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- MRP, JIT, EOQ
b) Materials purchases budget D365, H216
- Which purchases should be provided for usage and kept in stock?
- Indicate type, quantity, price and time.
- Strive for an optimal balance between purchases, inventory and usage.
- Purchases = Usage + C/I O/I
- Check quantity shortages, storage capacity, delivery time
- Direct labour budget D365, H216, V292
- How many labourers? Which labourers? At what rates? When? Where
necessary? As per the requirements of the production budget
- Standard times established from time and motion studies, estimates and
past data.
- Manufacturing overheads budget D366, H218
- Distinguish between fixed (non-controllable) and variable (controllable)
overheads, each item separately.
- Distinguish between production and service departments.
- Establish link between cost and activity.
v) Cost of sales budget
E How is cost of sales determined? (Production costs plus/less Work-in-process
inventory difference plus/less Finished goods inventory difference).
E The cost of sales budget can form part of the income statement or is composed
of (ii) to (iv).
vi) Selling expenses budget D367, H219
E Sales managers responsibility.
E What sales expenses must be incurred to make the intended sales?
E Distinguish between fixed and variable, each item separately.
vii) Administrative expenses budget H219
E Chief administrative officers responsibility.
E Cost of management, administration and venues.
E Distinguish between fixed and variable.
E All expenses except for production, sales, distribution and R&D expenses.

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viii) Distribution cost budget
E Based on sales, not production
E Consists of storage and transport costs
E Essential for the product to reach the consumer
E Distribution managers responsibility
E Distinguish between fixed and variable, may include advertising costs

ix) Budgeted income statement D368, H220
E Summary of the above budgets
7.2 Financial budget with budgeted balance sheet as the goal D369, H229
i) Cash budget D6369, H229
E Purpose is to ensure that sufficient cash is available and not to leave too much
unproductive cash in the business
E Short periods, e.g. monthly
E Cash receipts:
- Sales (cash and credit), note discount, collection and bad debts. Rent,
interest received, disposal of non-current assets, profit on alienation?
E Cash payments:
- Materials purchases (note discount and payment terms), direct labour,
operating expenses (note in arrears and prepaid), non-current assets,
dividends, loans, etc.
E What about depreciation and loss on alienation?
E Closing balance: Opening balance + Receipts Payments
E If a minimum balance is required: financing will be needed
Note the comprehensive examples in each of the prescribed books.
ii) Budgeted cash flow statement
IAS 7
Every change in a balance sheet item
a) - Cash generated
- Cash utilised
b) - Operations
- Investment activities
- Financing activities
Refer to Financial Accounting
iii) Budgeted balance sheet H230, D368
Each item is projected as per the business plan, as reflected in the above budgets.
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8. ZERO-BASED BUDGETING (ZBB) D375, V305
- Background: Does not use traditional annual budgeting as the basis, but is rather
based on priorities.
- Also known as priority-based budgeting.
- How to implement ZBB V306, nine steps summarised briefly:
i. Describe each activity in a decision package.
ii. Evaluate the package and place it in order of preference.
iii. Allocate the resources.
(Note: Vigario on page 305 gives a detailed discussion on the implementation of ZBB, as
well as the advantages and disadvantages.)
- Advantages over the other budgets (See specifically Vigario, who identifies nine)
i. The process has to be reviewed each time and resources allocated according to need
ii. Requires a questioning attitude
iii. Focuses the attention on output in terms of value for money
iv. Leads to increased staff involvement and improved motivation
- Disadvantage: Very time-consuming. (See Vigarios ten disadvantages)
9. EVALUATING THE USE OF BUDGETS H209
- Advantages: Refer to the aims, paragraph 3
- Disadvantages:
i. Based on forecasts
ii. High administration costs
iii. Does not replace management
iv. Responsibilities may overlap and this may cause conflict
10. EFFECT OF A JUST-IN-TIME (JIT) APPROACH TO BUDGETING
- Distinguish between JIT purchases and JIT production
- JIT production occurs only in manufacturing enterprises
- JIT purchases occur in manufacturing and trade enterprises
- Principles of JIT purchases (5)
- Principles of a JIT approach
i. Saves cost of keeping inventory
ii. Quality purchases
iii. Number of suppliers limited
iv. Long-term agreements with suppliers
v. Saves administrative expenses
- Effect on short-term budgets
i. JIT production: Production production costs, inventory, cash, balance
sheet, etc.
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ii. JIT purchases: Materials purchases, purchase of inventory, trading stock, cash,
balance sheet, etc.
- JIT purchases and the economic order quantity.
11. RESPONSIBILITY ACCOUNTING AND BUDGETING H223
- A system measuring the plans (budgets) and actions (actual results) of each
responsibility centre.
- Principle: A person is responsible for the department, segment or centre.
- Responsibility centres:
i. Cost centre: Control over costs
ii. Income centre: Control over income
iii. Profit centre: Control over income and expenses
iv. Investment centre: Control over investment and return (profit)
- Controllability: The effect (control) of a specific manager over expenses, income and
other items.
12. KAIZEN BUDGETING H221
- Kaizen is derived from the Japanese word kaizen meaning continuous improvement.
- Continuous improvement results in continuous adjustments to the budget.
13. ACTIVITY-BASED BUDGETING D371, H217
- Activity-based costing (ABC) leads to activity-based budgeting (ABB).
- An activity-based budget is prepared on the basis of activity-based costs.
- Steps for preparing an activity-based budget:
i. Determine the budgeted costs for each unit in each activity.
ii. Determine the demand for each activity based on production, new product
development, etc.
iii. Determine the cost of realising each activity.
iv. Prepare the budget to realise the costs of each activity (rather than past information).
14. LEARNING CURVE APPLICABLE TO BUDGETS V300
- Efficiency increases as a result of the learning curve.
- Make provision in the direct labour budget for the increase in efficiency.
15. SENSITIVITY ANALYSIS AND CASH FLOW H233
- This helps managers to anticipate outcomes and take steps to minimise the effect of
expected cash flow reductions in the industry.
16. COMPUTER-BASED FINANCIAL PLANNING MODELS H220, D370
17. RESPONSIBILITY AND CONTROLLABILITY H223
- Controllability
- Controllable expenses
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18. HUMAN ASPECTS OF BUDGETING H225
- Budgetary slack
19. BUDGETING IN MULTINATIONAL COMPANIES H227

Do IM 15.9 and IM 15.11 in Drury as practice and compare your answer with the suggested
solution below.

Solution IM 15.9
a) (i) Sales budget in quantity and value

July August September Total
Sales units 400 300 600 1 300
Sales value (R) 100 000 75 000 150 000 325 000

(ii) Production budget in units

Sales 1300
Closing stock 225
1525
Opening stock (200)
Good output required 1325
Normal loss (1325 x 1/9) 147
Production required 1472

(iii) Raw material usage budget

(iv) Raw material purchases budget

A B C Total
(kgs) (kgs) (kgs)
Kgs used 4416 2944 5888
Stock increase (20%) 200 80 120
Purchases in kgs 4616 3024 6008
Unit cost R3.50 R5.00 R4.50
Production (units) 1472
(kg)
Material A (at 3kg per unit) 4416
Material B (at 2kg per unit) 2944
Material C (at 4kg per unit) 5888
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Purchases cost R16 156 R15 120 R27 036 R58 312

(v) Labour requirements budget

Production in units 1472
Unit labour hours 10
Total hours 14 720
Cost per hour R8.00
Total cost R117 760

b) The principal budget factor (also known as the limiting factor) is the factor that
constrains or limits the activities of the organization during a budget period. During
the budget process, the principal budget factor is the foundation upon which all of the
budgets must be based and which constrains activity from being expanded. For
example, if machine hours are the principal budget factor, the production budget,
sales budget and all of the remaining budgets will be restricted to the maximum
output from the available machine hours. Prior to the preparation of the budgets it is
necessary for management to identify the principal budget factor, since this factor will
determine the point at which the annual budgeting process should begin.

Solution IM 15.11

a) Cash budget
Week

1 2 3 4 5 6
(R000) (R000) (R000) (R000) (R000) (R000)
Cash receipts from sales* 80 80 75 70 70 80
Cash payments:
Materials** 27 46 12 - - -
Direct labour and
variable overhead***
41 41 16 16 16 16
Fixed overhead**** 16 16 12 12 12 12
84 103 40 28 28 28
Weekly surplus / (deficit) (4) (23) 35 42 42 52
Opening cash balance (39) (43) (66) (31) 11 53
Closing cash balance (43) (66) (31) 11 53 105

Week
*Cash Receipts
1 2 3 4 5 6
(R000) (R000) (R000) (R000) (R000) (R000)
Opening debtors 80 40
Week 1 sales 40 40
2 35 35
3 35 35
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4 35 35
5 __ __ __ __ __ 45
80 80 75 70 70 80

The above sales can be achieved because opening stocks of finished goods (2800 units) +
production in weeks 1 and 2 (2400 units) are greater than sales in weeks 15 (3800 units) by
1400 units.

**Purchase of Materials
Week 1 Week 2
(R) (R)
Closing stock 40 000 10 000
+ Production (1200xR35) 42 000 42 000
- Opening stock (36 000) (40 000)
= Purchases 46 000 12 000 (paid for 1 week later)

*** Direct labour and variable overhead; fixed overhead

(R)
Weeks 1 and 2 = 1200 x R30 = 36 000
+ 5 000 (overtime premium)
41 000
Weeks 3-6 = 800 x R20 = 16 000
**** Weeks 1 and 2 = 800 x R25 = 20 000
- 4 000 (depreciation)
16 000
Weeks 3-6 = R16 000 - R4 000 = 12 000

b) The matters which should be drawn to the attention of the management are:
(i) The overdraft limit will be exceeded in week 2, and arrangements should be made to
increase this limit.
(ii) Excess funds will be available from weeks 4 to 6 and plans should be made to invest
these funds on a short-term basis.
(iii) Funds will be required as soon as production recommences in order to re-establish
stocks of raw materials and finished goods.

ASSIGNMENTS
Consult work scheme.

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6 FLEXIBLE BUDGETS


Study material : Horngren - Chapters 7 and 8
[Drury - Chapter 17, 18]

LEARNING OUTCOMES
- Distinguish between a flexible and a fixed (static) budget.
- Prepare a variable budget using three methods:
* Formula method
* Table method (multi-activity level)
* Graph method
- Compile a performance report in which an analysis of variance is given at levels 0, 1, 2
and 3.
- Calculate and interpret budget variances and divide them into various causes, i.e.
spending and efficiency causes, and make recommendations for corrective action.
- Analyse and interpret sales volume variances.
- Critically evaluate the use of flexible budgets in a business.
- Discuss benchmarking and re-engineering, apply benchmarking to motivate
performance measurement and make recommendations for improving performance.
- Discuss the use of activity-based costing in flexible budgets.
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1. INTRODUCTION D417, H251, V303
- Distinguish between monitoring and control D451, V303, H251
- Control is the process of ensuring that a businesss activities are in line with the
planning and objectives. It requires planning, comparison and activity. It takes place at
the end of an activity, i.e. periodically.
- Monitoring takes place continually, e.g. materials inventory control.
- Distinguish between fixed and flexible budgets H252
- Fixed budget: For one specific level of activity, therefore for planning.
- Flexible budget: For more than one level of activity, therefore for control.
- Static (fixed) budget: Identify sales volume variance.
- Static budget variance: Level 1 and divided into:
i. Flexible budget variance and
ii. Sales volume variance, distinguished at level 2
- Uses of flexible budgets:
1. To estimate annual manufacturing overheads.
2. To evaluate performance of departmental managers.
3. Adjust automatically to actual activitys budgeted costs; therefore effective for
control.
Proviso: It must be possible to separate costs into fixed and variable.
2. METHODS FOR PREPARING A FLEXIBLE BUDGET H254
2.1 Formula method: allowance: based on output
- Before period begins:
i. Budget for usual activity level.
ii. Separate into fixed and variable.
iii. Determine variable rate per activity unit and construct the formula.
- End of the period:
i. Determine actual activity.
ii. Budget for actual activity.

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i. Information given: 5 000U
ii.
Fixed Variable /U
Separate:
IM
- R7 000 1.4
IL - R8 000 1.6
Electr. 2 500 R5 000 1.
Maint. 3 000 R9 000 1.8
Rent 11 250 -
Depr. 6 250 -
23 000 29 000 5 000U
= R5.8/U
6 250/mh
= R4.64/mh
y = 23 000 + 5.8X where X = Units
Budget for 6 000U : 23 000 + 5.8 (6 000)
= R57 800
End of the period: (i) 7 200U
(ii) 41 760
y = 23 000 + 5.8 (7 200)
= R64 760

2.2 Table method (multi-activity level method)
Budget Interpolate: 7 200 =
7 000 + 20% of difference
7 200U 5 000U 6 000U 7 000U 8 000U
IM (1.4) R10 080 R7 000 R8 400 R9 800 11 200 9 800 + 20% x 1 400) = 10 080
IL (1.6) 11 520 8 000 9 600 11 200 12 800 11 200 + ( x 1 600) = 11 520
Electr. (2 500 + 1) 9 700 7 500 8 500 9 500 10 500 9 500 + ( x 1 000) = 9 700
Maint. (3 000 + 1.8) 15 960 12 000 13 800 15 600 17 400 15 600 ( x 1 800) = 15 960
Rent (11 250) 11 250 11 250 11 250 11 250 11 250 11 250
Depr. (6 250) 6 250 6 250 6 250 6 250 6 250 6 250
R64 760 R52 000 R57 800 R63 600 R69 400 R64 760

Y = 23 000 + 5.8 (7 000) = R63 600
Test Y = 23 000 + 5.8 (8 000) = R69 400

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2.3 Graph method
- On a graph draw the flexible budget line by plotting the costs of different activities.
- Vertical: cost; horizontal: activity
3. STEPS IN DEVELOPING A FLEXIBLE BUDGET H254
i) Determine the budgeted selling prices, budgeted variable costs per unit and the
budgeted fixed costs. Determine the income of the actual activities.
ii) Determine the income as per the flexible budget. Determine the actual activity of the
cost driver.
iii) Prepare the flexible budget for costs based on the actual activity.
These steps lead to a level 2 variance analysis.
4. ANALYSES: LEVELS 0 TO 3 H254-257
(Work through the detailed example in Horngren p. 254+, which illustrates the analysis of
levels 0-2.)
- Level 0: Compare actual operating income with budgeted operating income. The
difference is the static budget variance H252.
- Level 1: Compare the actual results (units sold, sales income, variable costs and fixed
costs) with the static budget in contribution margin format. The difference is the static
budget variance in detail. (Analysis of level 1 is simply more detailed than level 0)
H253.
- Level 2: The static budget variance calculated at level 1 is divided into a flexible budget
variance and a sales volume variance as follows H254:
i. Flexible budget variance = Difference between the actual results and the
flexible budget (budgeted for the actual). Take careful note of everything, i.e.
units sold, sales income, variable costs, contribution margin, fixed costs and
operating income.
ii. Sales volume variance = Difference between the flexible budget and the static
budget. Take careful note of everything in detail: the income statement in
contribution margin format, therefore sales units, sales income, variable costs
and fixed costs.
- Level 3: Divide the flexible budget variance into a price variance and an efficiency
variance H257 as follows:
i. Price (spending/rate) variance = Difference between the actual price and
budgeted price x Actual input quantity.
ii. Efficiency variance = Difference between the actual quantity (input) and the
budgeted (standard) quantity allowed for the actual output x Budgeted price.
[Note: See the illustration of analysis level 3 in the next paragraph and H262. There is also
a detailed example of analysis levels 0 to 3 in H272.]

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5. COST VARIANCES D457, H250
- A cost variance occurs if the actual and allowed (budgeted) costs differ.
- Budget variance: Actual less budgeted actual output (from level 2)
- Spending variance + Efficiency variance (from level 3)
- Spending variance: Budgeted actual input less actual input
- Efficiency variance: Budgeted actual input less budget for standard input (actual
output)
EXAMPLE: Flexible budgeting using the table method with a performance
report
Control Ltd provides the following information about a product being produced.
Budgeted information:
5 000 units or 6 250 machine hours are regarded as the normal monthly volume. The cost
for this volume is:
FIXED COSTS BUDGETED AMOUNT FOR
NORMAL VOLUME
Indirect materials - R7 000
Indirect labour - 8 000
Electricity 2 500 7 500
Maintenance 3 000 12 000
Rent 11 250 11 250
Depreciation 6 250 6 250

Intended (budgeted) production for October: 6 000 units.
Actual activity for October: 7 200 units and 10 000 machine hours.

ACTUAL COSTS FOR OCTOBER

Indirect materials R10 400
Indirect labour 11 450
Electricity 9 900
Maintenance 16 000
Rent 11 800
Depreciation 6 250

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REQUIRED:
1. Prepare a budget for October.
2. Compile a performance report for October in which you analyse as many variances as
possible for each cost item.

Solution
1. Budget for October
BUDGET
OCTOBER
6 000U RATES/U RATE PER
MACHINE
HOURS

Indirect materials R8 400 R1.4 R1.12
Indirect labour 9 600 1.6 1.28
Electricity 8 500 1 + R2 500 .8 + R2 500
Maintenance 13 800 1.8 + R3 000 1.44 + R3 000
Rent 11 250 11 250 11 250
Depreciation 6 250 6 250 6 250
R57 800

2. Performance report
7 200 x 1.25
Budgeted Budget Budgeted Budgeted Effic.
/mh 7 200U Actual variance 10 000mh Spend. 9 000mh
1.12 IM R10 080 R10 400 (R320) R11 200 R800+ R10 080 (R1 120)
1.28 IL 11 520 11 450 70+ 12 800 1 350+ 11 520 (1 280
.80 Elect. 9 700 9 900 (200) 10 500 600+ 9 700 (800)
1.44 Maint. 15 960 16 000 (40) 17 400 1 400+ 15 960 (1 440)
Rent 11 250 11 800 (550) 11 250 550(-) 11 250 -
Depr. 6 250 6 250 - 6 250 - 6 250 -
R64 760 R65 800 (R1 040) R69 400 R3 600+ R64 760 (R4 640)

Distinguish between efficiency and effectiveness H267.

6. COST CLASSIFICATION D463
- Controllability depends on two factors
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i. Level of management authorisation
ii. Duration (activity) allowed
E For the enterprise as a whole, all costs are controllable.
E Controllable costs: Costs which a person, e.g. production manager, can control,
such as indirect labour, indirect materials, electricity, etc.
E Non-controllable costs: Costs which a person cannot control, e.g. depreciation.
E The question is: should all costs be included in a flexible budget? If the purpose
of the flexible budget is only cost control, non-controllable costs can be left out,
but if the purpose is also for product costs, all costs should be included in the
flexible budget.
E Traceable costs: Costs of a service department which can be allocated to a
production department.
7. CAUSES OF VARIANCES H266
- To eliminate problems, the causes should be established.
- Spending variance: Mainly as a result of price or rate.
- Efficiency variance: As a result of more or less time taken and only for controllable
costs.
8. ADVANTAGES OF FLEXIBLE BUDGETING H266
- Provides a dynamic foundation for assessment.
- Adaptable to actual activity.
- The causes of variances are highlighted.
- Useful in cost estimates.
9. ACTIVITY-BASED COST (ABC) CALCULATIONS AND FLEXIBLE
BUDGETS H266
- ABC works well together with flexible budgets.
- Difference between traditional cost systems and ABC systems is the QUANTITY.
- ABC: For each activity centre there is a separate flexible budget.
- Example: G493 (481), H269
- Advantage: A number of flexible budgets ensures accuracy.
10. PERFORMANCE MEASUREMENT: BENCHMARKING AND RE-
ENGINEERING H266
- Benchmarking: Key activities are compared with the worlds best. The purpose is to
determine how existing activities can be improved and to ensure that they are
implemented.
- Business process re-engineering (BPR): The business processes are examined to
make them more streamlined and eliminate activities or reduce those that do not add
value.
- Purpose of the re-engineering: To improve key processes by focusing on simplifying,
reducing costs and improving quality and customer satisfaction, e.g. changing from a
traditional layout to a just-in-time system, for instance.
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Do IM 17.1 in Drury as practice and compare your answer with the suggested solution below.

Solution IM 17.1

a) i) Flexed budget for month 6
Original budget Flexed budget Actual cost Total variance
Units of J 20 000 18 500 18 500
(R) (R) (R) (R)
Direct materials 480 000 444 000 442 650 1 350 F
Direct labour 140 000 129 500 129 940 440 A
Variable overhead 60 000 55 500 58 800 3 300 A
Fixed overhead 100 000 100 000 104 000 4 000 A
780 000 729 000 735 390 6 390 A

Material price variance = (standard price - actual price) x actual quantity
= (AQ x SP) - (AQ x AP)
= (113 500 x R4) - R442 650 actual cost = R11 350F

Material usage variance = (standard quantity - actual quantity) x standard price
= ((18 500 x 6) - 113 500) x R4 = R10 000A

Wage rate variance = (standard rate - actual rate) x actual hours
= (SR x AH) - (AR x AH)
= (R7 x 17 800) - R129 940 = R5340A

Labour efficiency variance = (standard hours - actual hours) x standard rate
= (18 500 x 1 hr - 17 800) x R7 = R4900F
ASSIGNMENTS
Consult work scheme.

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7 STANDARD COSTING

Study material: Horngren - Chapters 7, 8 and 14
Vigario - Chapter 9
[Drury - Chapters 17, 18]

LEARNING OUTCOMES
- Discuss standard costing under the following headings:
* Purpose
* Distinction between standard costing and budgeting
* Price and quantity standards
* Advantages and disadvantages of using standard costing for budgetary control
- Do a detailed analysis of the static budget variance, i.e. explain why the budgeted profit
and actual profit differ by pointing out the causes relating to:
a) Flexible budget variance
i) Spending variance
ii) Efficiency variance, divided into mix and yield variances for materials,
labour and overheads
b) Sales volume variance
i) Sales mix variance
ii) Sales volume variance, divided into market size variance and market share
variance
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- Calculate the standard costing variances for:
a) Materials regarding materials price and materials quantity, as well as the division
of the price variance into pure price variance and pure efficiency variance.
b) Labour in terms of labour rate variance and labour efficiency variance.
c) Overheads where the normal volume is based on inputs:
i) Spending
ii) Efficiency
iii) Volume, divided into efficiency variance and pure volume variance
d) Overheads where the normal volume is based on outputs:
i) Budgeted
ii) Volume
e) Overheads if the overheads rate is combined:
i) Spending
ii) Efficiency
iii) Volume
- Discuss the causes of standard cost variances as analysed under learning outcomes 2
and 3, and make recommendations on eliminating variances.
- Do a graphical analysis of cost variances for materials, labour and overheads.
- Reconstruct a journal using standard costing, open accounts for each variance and
show the inventory accounts where:
i) all inventory accounts are at standard cost
ii) not all inventory accounts are at standard cost
- Critically evaluate the use of standard costing.
- Discuss productivity measurement and calculate partial and total factor productivity.

1. INTRODUCTION D451, H286, H250
- Responsibility reporting requires that costs and income information be collected and
variances pointed out to responsible people.
- Standard costs: Predetermined or target costs that will be incurred under efficient
circumstances (benchmark).
- Standard costing is the cornerstone of budgets, i.e. the planned cost per unit, and a
budget is the cost plan for a certain period.
- Benchmark: Point from which comparisons can be made. An ongoing process of
measuring products, services and activities at the best performance levels.
- Performance gap: Difference between actual and benchmark.
- Variance: Difference between actual and budgeted (allowed).
- Purposes of standard costing
i) Preparing budgets and performance evaluation
ii) Exercising control
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iii) Forecasts
iv) Inventory valuation
v) Prepare a challenging goal and motivate individuals
vi) Pricing
- Costs consist of price and quantity
(Standard cost = Price standard x Quantity standard)
- Mechanised environment?
- Added value costs and non-added-value costs
2. COST STANDARDS
2.1 Price standards D420
- Materials price standard (MPS): The price for a specific material under the most
favourable and economic circumstances. Freight + Quantity discount are taken into
account D729
- Labour price standard (LPS): The price that should be paid for an efficient labourer
D729
2.2 Quantity standards D730
- Materials quantity standard (MQS): The quantity of materials needed to manufacture
one unit, determined as per essential input-output ratios.
- Labour quantity standard (LQS): Number of hours needed by an efficient labourer to
manufacture one unit of product, determined as per essential input-output ratios.
3. TYPES OF STANDARDS D423, V328
- Basic cost standard: Remains constant over a longer period. Provides a basis for
quantities but not suitable for price standards.
- Theoretical or ideal standard: Includes minimum costs that are recoverable under the
most efficient circumstances. No provision for normal or abnormal spoilage or lost
hours.
- Currently attainable standard: Can be achieved under efficient circumstances.
Provides for normal spoilage or lost time; meaningful evaluation of performance.
4. REVISION OF STANDARDS
At least annually, price standards can be revised more often.
5. HOW A STANDARD COSTING SYSTEM WORKS D423, V328
- Especially suitable for enterprises with a series of repetitive processes.
- Can also be used in non-manufacturing enterprises that have repetitive activities.
- Proviso: It must be possible to set price and quantity standards.
- Variances must be allocated to responsibility centres.

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6. STANDARD COST CARD D426
Direct material s : 2 kg @ R5 = R10
Direct labour : 3 hours @ R10 = R30
Overheads: Variable : 4 mh @ R3 = R12
Fixed : 4 mh @ R5 = R20
R72
7. COST VARIANCES D425
- Favourable variance = Actual costs < allowed costs
- Unfavourable variance = Actual costs > allowed costs
- Controllable variance: Within a persons control, usually variable cost variances.
- Non-controllable variance: Not normally within a persons control or responsibility and
relates more to fixed costs.
7.1 Materials cost variances H259, D425, V342
- Materials cost variance = Price variance and quantity variance V346
- Reasons for: Price and quantity variances
- Mix variances: Discussed later in detail
- MPV = (SP - AP) AQ bought, purchasing department D429, V345
- MQV = (SQ - AQ) SP, production department D428, V347
7.2 Labour cost variances H260, D430, V350
- Labour cost variance = Rate variance and efficiency variance V350
- Reasons for: Rate and efficiency variances V355
- LCV = (SC - AC) AQ worked or actual time used D430, V351
- LEV = (SR - AH) SR D430
7.3 Overheads variances D432, H289, V356
- More difficult than the previous because:
E Overheads are fixed and variable.
E Overheads are indirect and occur as a whole. An allocation basis must be found
to match costs and product.
- Predetermined rate = Budgeted overheads Normal volume
Where the normal volume input can be, for example, hours or costs in terms of output,
e.g. units produced
- Allocated (allowed) overheads = Rate x Actual output or its equivalent, i.e. standard
input volume (SIV) depending on whether normal volume is input or output
- Overallocated or underallocated overheads = Total of all the overhead variances.
- Volumes
i) Normal volume (NV) = Budgeted capacity aimed at, e.g. input or output
denominator activity
ii) Actual output volume (AOV) = Units produced
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iii) Actual input volume (AIV) = Actual hours worked or any input volume, e.g.
direct labour costs actually incurred
iv) Standard input volume (SIV) = Input allowed for actual production

7.3.1 Overheads variances (normal volume =input, 3 plan)
- Overheads spending variance - (see flexible budgeting) D432, H291, V356, 359
Calculated from budgeted overheads for AIV less actual overheads.
Fixed overheads = Budgeted normal volume less actual fixed overheads
Variable overheads = Budgeted AIV less actual variable overheads
= SVOR x AIV Actual VC

- Overheads efficiency variance H290, D433, V358
Calculated from the difference between budgeted variable overheads for AIV less
budgeted variable overheads for SIV
= (SIV - AIV) standard variable overhead rate

- Overheads volume variance H295, V360
Calculated from difference between allocated fixed overheads and budgeted fixed
overheads
= (SIV NV) standard fixed overhead rate
This variance can also be divided into:
i. Volume efficiency variance = (SIV - AIV) SFOR
ii. Volume capacity variance = (AIV - NV) SFOR

7.3.2 Overheads variances (normal volume =output, 2 plan)
- Overheads budget variance calculated from the difference between budgeted AOV
and actual overheads.
Fixed overheads = Budgeted normal volume less actual fixed overheads
= Same as spending variance
Variable overheads = Budgeted AOV less actual variable overheads
= SVOR x AOV Actual VC
- Overheads volume variance calculated from the difference between allocated fixed
overheads and budgeted fixed overheads
= (AOV - NV) standard fixed overhead rate

Note that budget variance = spending variance plus efficiency variance
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Do 8.29 and 8.32 in Horngren as practice and compare your answers with the suggested
solutions below.

H + F + D 8.29

Actual FC R350 208 Budgeted AOV: FC R348 096 (NV)
VC 76 608 VC 76 800

Allocated FC R376 200 NV = 888 U or 1 776 mh
VC 76 800 AIV = 1 824 mh
Budgeted VC (NV) R71 040
a) 888 x 2 mh = 1 776 mh

b) SFOR =
NV
FC Budgeted

=
776 1
096 348 R

= R196/mh
c) SVOR =
mh
R
776 1
040 71

= R40/mh
d) SIV = Input allowed for actual production
= R76 800 40/mh
= 1 920 mh
e) 1 920 mh 2 mh/U
= 960 units
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f) Actual mh/U: = AIV Actual units
= 1 824 mh 960
= 1.9 mh/U

H + F + D 8.32 (8.32) (Case A)
All figures with * were given
CASE A:
Actual
cost
Actual input
Budgeted rate
Flexible budget:
Budgeted input
for actual output
Budgeted rate
Allocated:
Budgeted input
for actual output
Budgeted rate
Case A:
Variable
manufac-
turing
overheads

R15 000*

(1,325 R15)
R19 875

(1,250* R15)
R18 750*

(1,250* R15)
R18 750*
Therefore spending variance = 4 875
Efficiency variance = 1 125
There will never be a variance between the flexible budget and the allocated.

Fixed
overheads

R26 500*

R25 000*

R25 000*
(1,250 R20
a
)
R25 000*
Spending variance = 1 500
There will never be a variance between actual input at budgeted rate and budgeted input.
Production volume variance = 25 000 25 000
= 0
This is the difference between the budgeted input and allocated.
Total budgeted overheads = 18 750 + 25 000= 43 750

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CASE B:

Variable
overheads

R13 813

(1,625 R8,50*)
R13 813

(1,625* R8,50*)
R13 813

(1,625* R8,50*)
R13 813

Spending variance = 13 813 13 813 = 0
Efficiency variance = 13 813 13 813 = 0
There will never be a variance between flexible budget and allocated.

Fixed
overheads

R16 750

R17 500
b

R17 500
b

(1,625* R10)
R16 250

Spending variance = 16 750 17 500 = 750 F
There will never be a variance between actual input at budgeted rate and flexible budget.
Production volume variance = 17 500 16 250 = 1 250 U
Denominator = Budgeted fixed overheads Budgeted fixed overheads allocated rate
= R17,500 R10 = 1,750 hours
CASE C:
Variable
overheads

R15 500

(2,925 R5,00*)
R14 625

(2,875 R5,00*)
R14 375
c

(2,875 R5,00*)
R14 375
c

Spending variance = 15 500 14 625 = 725 U
Efficiency variance = 14 625 14 375 = 250 F
There will never be a variance between flexible budget and allocated.

Fixed
overheads

R30 000*

R27 500*

R27 500*

R28 750
d

Spending variance = 30 000 27 500 = 2 500 U
There will never be a variance between actual input at budgeted rate and flexible budget.
Production volume variance = 1 250 F
Total budgeted overheads = R14,375 + R27,500 = R41,875

a
Budgeted fixed overheads allocated rate = Budgeted fixed overheads Budgeted activity
= R25 000 1,250 = R20
b Budgeted
total overhead

=
Budgeted
fixed manuf. overhead
+
Budgeted
variable manuf. overhead

R31 313* = BFMOH + (1,625 R8,50)
BFMOH = R17 500
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Budgeted hours allowed for actual output must be derived from the output volume variance
or, since the fixed overheads allocated rate is R27 500 2 750 = R10, and the allocated
amount is R28 750, the budgeted hours of output needed are 2 875 (R28 750 R10).
d
2 875 (R27 500* 2 750*) = R28 750
8. VARIANCES DETERMINED IN GRAPHS
Price and quantity variances Overheads budget variance
(materials and labour)
Actual
Budgeted Budget var. Flex. budget line
AC LCV
SR
R

LEV
Rate/
Price
SH AH AOV or SIV
Time/Quantity Volume

Overheads volume variance
Alloc. FC

BVV (+)
Cost Budgeted FC
BVV(-)

NV (volume)

9. ACCOUNTING ENTRIES D452, H263
- Debit unfavourable variances.
- Credit favourable variances
- Inventory accounts must be kept at standard costs in the general ledger (there are
variations in method).

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Transactions:
i. Materials purchases:
Materials inventory control (AQ x SP) Dr
MPV Dr
Creditors (AQ x AP) Cr
ii. Materials usage:
WIPC (SQ x SP) Dr
MQV Dr
Materials inventory control (AQ x SP) Cr
iii. Direct labour costs incurred:
W/SR (AH x AC) Dr
Credit Wages (AH x AC) Cr
iv. Direct labour costs imputed:
WIPC (SH x SR) Dr
LCV Dr
LEV Dr
W/SR (AH x AC) Cr
v. Overheads incurred:
Overheads control VC Dr
FC Dr
Creditors/Bank Cr
vi. Overheads allocated:
WIPC (AOV or SIV x SOH) Dr
Unallocated overheads Dr
Overheads control Cr
vii. Overheads variances (e.g. all unfavourable)
BOHV - FC Dr
- VC Dr
BEV Dr
BVV Dr
Over/underallocated overheads Cr
viii. Finished goods:
FGC (Finished x S/Ke/U) Dr
WIPC Cr
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ix. a) Cost of sales:
COS (Sales x S/Ke/U) Dr
FGC Cr
b) Selling price: Debtors Dr
Sales (Sales x Selling price/U) Cr
10. WHEN TO INVESTIGATE VARIANCES H266
- Rules that apply, e.g. a certain percentage variance on standard costs.
- Statistical models that dont consider the costs and benefits of the investigation.
- Statistical decision-making models that do consider the costs and benefits of the
investigation.
- Management by exception (MBE).
11. CAUSES OF COST VARIANCES H266, D461
- Measurement errors, e.g. in the distinction between direct labour and indirect labour.
- Standards that are not up to date: Prices and rates change easily or labourers may
take less time to complete production as a result of the learning curve.
- Activities beyond control: Inefficient activities as a result of faulty machinery or human
error.
- Uncontrollable factors: The same instruction given to the same labourer under the
same conditions at a different time is performed differently uncontrollable factors.
12. WHAT HAPPENS TO BALANCES IN VARIANCE ACCOUNTS? D456
- Written off at cost of sales
- Adjustment to profit
- Pro rata allocation and adjustment to WIPC, FGC and COS
13. CRITICAL EVALUATION OF USE OF STANDARD COSTING
Advantages:
- Management by exception (MBE)
- Cash and inventory planning
- Establishes efficiency
- Easier to determine income
- Supports responsibility accounting
- Assists in planning, control and performance measurement
Disadvantages:
- Which variances must receive attention?
- Emphasis is on variances, but what about trends?
- Implementation requires high administrative expenses
- MBE principle has a negative effect on supervisor morale

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14. VARIANCE ANALYSIS IN A MECHANISED MANUFACTURING
ENVIRONMENT
- Standard costing and mechanisation: Direct labour is more fixed and less valuable.
Objective of higher quality.
- New performance measures: JIT, flexible manufacturing systems (FMS) lead to quality
control, materials control, inventory control, machine performance and delivery
performance.
- Quality control measures: Guarantee claims, customer complaints, defective units.
- Materials control measures: Emphasis on high quality, waste control, shorter waiting
periods.
- Inventory control measures: Inventory turnover higher because there is less inventory.
- Machine performance measures: Use as a percentage of available capacity to control
bottlenecks.
- Delivery performance measures: Speed just as important as quality. Percentage of
on-time delivery (strive for 100%). Depends on factors such as delivery cycle time and
throughput time.
- Note financial and non-financial performance measures H305.
15. PLANNING VARIANCES D429
- Purchases planning variance
- Purchases efficiency variance
16. PROFIT RECONCILIATION V328-341
- Production > sales
- Production < sales
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17. VARIANCE ANALYSIS MORE THAN JUST ONE TYPE OF PRODUCT OR
INPUT MIX H542-547, D457-459, V348
17.1 Introduction and mix variances: Analysis levels 2, 3 and 4 H262, 547 (233, 513)
Note the diagram H547 (513)

Level 1: Static budget variance

Level 2: Flexible budget variance Sales volume variance

Level 3: Spending variance Effic. var. Sales mix var. Sales quantity var.

Mix Yield
variance var. Market size Market share
Level 4: var. var.

- So far we have dealt with production cost variances.
- Sales of more than one type of product: A variance in the sales mix also can also
cause a variance in the yield.
- Analyse sales volume variance in: Sales mix variance and sales yield variance.
- The latter is analysed in market size and market share variances.
17.2 Sales of more than one type of product
Sales volume variance (as analysed at level 2) is calculated from H543, D459-461:
The difference between the actual and budgeted quantity of units sold multiplied by
the budgeted selling price per unit.
So: = (Actual sales quantity Budgeted sales quantity) x Budgeted selling price per
unit, but if VC is known, use contribution margin instead of SP.
If the actual variable costs per unit differ from the budgeted variable costs per unit,
the budgeted contribution margin per unit can be used in the formula instead of the
budgeted selling price.
Remember: Actual sales quantity (U) = Flexible budget quantity (U)
and
Budgeted sales quantity (U) = Static budget quantity (U)
The sales volume variance can be analysed in a sales quantity variance (yield
variance) and the sales mix variance, which are calculated as follows:
i. Sales quantity variance (yield variance) D461, H545, V295: Calculated from the
difference between the total units actually sold and the total budgeted units sold
multiplied by the sales mix % multiplied by the budgeted selling price. The formula
looks like this:
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84
= (Actual total U sold Budgeted total U sold) Budgeted mix % x Budgeted SP/U
ii. Sales mix variance H543, D 459 460, V362:
Calculated from the difference between the actual mix % and the budgeted mix %
multiplied by the actual units sold in total multiplied by the budgeted selling price per
unit. The formula looks like this:
= (AM% - BM%) A total sales U x Budgeted SP/U

Note the signs of whether the variances are favourable or unfavourable. Remember,
you are working with sales and not expenses. If the actual mix % > budgeted mix %,
then the variance is favourable. The reverse is also true.
The sales quantity variance in (i) above can be further divided into a market size and
market share variance, which indicate how the organisation has performed in the
industry. These variances are calculated like this:
a) Market size variance H546
Calculated from the difference between the actual market size in units and the
budgeted market size in units multiplied by the budgeted market share multiplied by
the budgeted average selling price per unit. The formula looks like this:
=(A market size U Budgeted market size U) x Budgeted market share x Budgeted
average SP/U
(A market size > Budgeted market size = Favourable variance. The reverse is also
true.)

b) Market share variance H545
Calculated from the difference between the actual market share and the budgeted
market share multiplied by the actual market size in units multiplied by the budgeted
average selling price per unit. The formula looks like this:
= (A market share Budgeted market share) x A market size U x Budgeted ave.
SP/U

(A market share > Budgeted market share = Favourable variance. The reverse is also
true.)
- Horngren p. 547 contains a detailed example.

solutions below.

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85

H + F + D 14.34
1. Sales volume variance: (AU - BU)Contribution margin/U

CC = (57 600 - 45 000) R2 = R25 200(+)
OR = (18 000 - 25 000) 2.30 = R16 100(-)
C = ( 9 600 - 10 000) 2.60 = R 1 040(-)
WC = (13 200 - 5 000) 3 = R24 600(+)
MN = (21 600 - 15 000) 3.10 = R20 460(+)
R53 120(+)
2. Sales yield variance (TAU - TBU) x BM% x Contribution margin/U

CC = (120 000 - 100 000) x .45 x 2 = R18 000(+)
OR = (120 000 - 100 000) x .25 x 2.3 = R11 500(+)
C = (120 000 - 100 000) x .10 x 2.6 = R5 200(+)
WC = (120 000 - 100 000) x .05 x 3 = R3 000(+)
MN = (120 000 - 100 000) x .15 x 3.10 = R9 300(+)
R47 000(+)

3. Sales mix variance: (AM% - BM%) x TAU x Contribution margin/U
576
CC = (1 200
-
.45) x 120 000 x 2 = R 7 200(+)
18
OR = ( 120
-
.25) x 120 000 x 2.3 = (R27 600)
96
C = (1 200
-
.10) x 120 000 x 2.6 = (R 6 240)
132
WC = (1 200
-
.05) x 120 000 x 3 = R 21 600(+)
216
MN = (1 200
-
.15) x 120 000 x 3.10 = R 11 160(+)
R 6 120(+)

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4. Actual sales were more than budgeted sales, which causes a favourable volume
variance. More of the more profitable products (those with the highest individual
contribution margin) were sold, namely WC and MN. This further improves the
situation. The budgeted average contribution margin per unit is R2,35 [(2 x 45 000 +
2.3 x 25 000 + 2.6 x
10 000 + 3 x 5 000 + 3.l0 x 15 000) 100 000U]
The sales of more profitable products caused a volume variance of R53 120;
this is better than (20 000U x R2,35) = R47 000

H +F + D 14.35
- Market size variance = (Actual market size Budgeted market size) x BM/share x
Budgeted ave.
e
contribution margin
= (960 000 - 1 000 000) x 10% x *2.35
= R9 400(-)

*Ave.
e
contribution margin/U: [(2 x 45 000) + (2.30 x 25 000) + (2.6 x 10 000) + (3 x 5
000)
+ (3.10 x 15 000)] 100 000U
= 2.35/U
- Market share variance = (Actual market share Budgeted market share) Actual market
size x Ave
e
contribution margin/U
120 000
= (960 000-10%) 960 000 x 2.35
= R56 400(+)

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- Comments:
Actually increasing the market share from 10%, which was budgeted, to 12.5%
120 000
(960 000) resulted in a market share variance of R56 400(+). The market size variance
of R9 400(-) was caused by the Chicago market which was 40 000 kg less than the
budgeted market of 1 000 000 kg.

Sales volume variance
R53 120(+)

Sales yield variance Sales mix variance
R47 000(+) R6 120(+)

Market size variance Market share variance
R9 400(-) R56 400(+)

17.3 Production with inputs in a fixed ratio H550-553
Production mix variances occur when more than one type of raw material, direct
labour or overhead is needed in a specific ratio (mix or %) to manufacture a product.
Refer to the introductory paragraph 17.1 of this lecture.

Level 2: Flexible budget variance

Level 3: Spending var. Effic. var.

Level 4: Mix var. Yield var.
For materials, labour and overheads

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- Direct materials
- Materials price (spending) variance: The same formula as discussed previously.
- Materials quantity (efficiency) variance: The same formula as discussed
previously, except that in calculating the standard quantity, the input:output ratio must
be taken into account. For example H551 (517):

Input of 1.6 tons (consisting of 50% L, 30% C and 20% F) produces 1 ton of output.
A production of 4 000 tons of output needs a standard input of (4 000 x 1.6) x 5L, 3C
and 2F, which sets a standard input of 3 200 tons L, 1 920 tons C and 1 280 tons F.

The materials quantity variance can be analysed in a materials mix variance (variance in the
input) and a materials yield variance (variance in the output).

These variances are calculated as follows:
i. Materials yield variance H552, D458, V347
Calculated from the difference between the total actual quantity of materials used less
the total budgeted quantity allowed for actual production (SQ) multiplied by the
budgeted materials mix % multiplied by the standard price or budgeted price of
materials. The formula is as follows:
= (Total AQ - Total SQ) x Budgeted input mix % x SP (Budgeted price)
Example H(869) 593
If the AQ > SQ, the variance is unfavourable. The reverse is also true.

ii. Materials mix variance H552, D457, V347
Calculated from the difference between the budgeted cost of actual materials input
mix and the budgeted cost provided the budgeted materials input mix has not
changed. The formula is as follows:
=(A Mat. input mix % - Budgeted mat. input mix %)
x A total quantity mat. used x SP (Budgeted price)

If the A mix > budgeted mix, the variance is unfavourable. The reverse is also true.

below.

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H + F + D 14.37

MPV = (SP - AP)AQ bought MQV = (SQ - AQ)SP
O = ($6.10 $6.00)
23,180 = $2,318 U
O = (23,180 24,000)
$6.00 = $4,920 F

P = ($1.80 $2.00)
37,820 = 7,564 F
P = (37,820 36,000)
$2.00 = 3,640 U

Total $5,246 F Total $1,280 F

2. MMV = (AM% - BM%) x ATQ x SP
Oak = (0.38 0.40) 61,000 $6.00 = 0.02 61,000 $6.00 = $7,320 F
Pine = (0.62 0.60) 61,000 $2.00 = 0.02 61,000 $2.00 = 2,440 U
Total variance $4,880 F

-
MYV = (SQ - AQ) x Budgeted input mix x SP
Oak = (61,000 60,000) 0.40 $6.00 = 1,000 0.40 $6.00 = $2,400
Pine = (61,000 60,000) 0.60 $2.00 = 1,000 0.60 $2.00 = 1,200 F
$3,600 F
3.

Actual input Actual mix
Budgeted quantity input for actual
output
Budgeted
mix
Oak 23,180 b.f. 38% 8 b.f. 3,000 u = 24,000 b.f. 40%
Pine 37,820 b.f. 62% 12 b.f. 3,000 u = 36,000 b.f. 60%
Total 61,000 b.f. 100% 60,000 b.f. 100%

- Direct labour V350
Exactly the same principles and formulae as in direct materials, except that the
names of the variances differ, e.g. price variance becomes rate variance and quantity
variance becomes efficiency variance.
- Overheads
Exactly the same principles and formulae as in materials.

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17.4 Measuring productivity H515-518
- Partial productivity: This compares the quantity of output produced with the
quantity of a single input used, e.g. output units labour hours or materials inputs or
machine hours, etc. The formula looks like this:
Partial productivity = Quantity of output units produced
* Quantity of input used

* May be direct labour hours, materials quantity or machine hours.
In this way, the partial productivity of one year can be compared with that of a previous
year and trends can be determined.

- Total factor productivity (TFP): This is also known as total productivity and it is a
technique to measure productivity that measures inputs simultaneously, i.e. the ratio
of the quantity of outputs produced to the cost of all inputs used where the inputs are
combined on the basis of current prices. The formula looks like this:
Total factor productivity = Quantity of output units produced
Cost of all inputs used
The advantage of this method of measurement is that it measures the productivity of
the combination of all inputs.

18. BENCHMARKING AND VARIANCE ANALYSIS H270
19. VARIANCE ANALYSIS AND ABC H268, 306
20. STANDARD COSTING AND THE BALANCED SCORECARD
ASSIGNMENTS

APPENDIX TO STUDY UNIT 6

Fixed overheads:
There are 2 types of overhead variances:
1. Budget / spending variance
2. Volume variance

1. Budget variance:
This is the easiest variance to calculate. It is the difference between the budgeted and the
actual fixed overheads. (The total amount budgeted and the total amount actually incurred).
This variance tells us that our budget was incorrect and we paid more or less overheads than
we thought we would.

In a direct cost environment, (inventory carried at variable production costs), this will be the
only fixed overhead variance you will find.

2. Volume variance
This variance is only in an absorption environment. (In an absorption cost environment, you
will therefore have a budget variance AS WELL AS a volume variance).
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The volume variance identifies the part of the overhead as a result of the actual production
being different from the budgeted production. If we knew, from the beginning, that production
will differ, the allocation rate would have been different.

Therefore, this is the difference between actual production (AP) and budgeted production
(BP) multiplied by the standard fixed overhead allocation rate (SR).
(AP-BP) x SR

The volume variance is further divided into:
a. Volume efficiency variance
b. Volume capacity variance
These two variances try to identify the reason for the volume variance.

a. Volume efficiency variance
This variance asks how efficient production was. If we always use 10 units of input to get 8
units of output, and in actuality we only get 8 units of output from 10 units of input, we are
unproductive. The unit we refer to, is the allocation activity (machine hours, labour hours,
etc.)

Therefore, this is the difference between the standard hours of output (SH) and the actual
hours of input (AH) for the period, multiplied by the standard fixed overhead allocation rate
(SR).
(SH-AH) x SR

b. Volume capacity variance
This variance asks why actual production is different from budgeted production. If the budget
aims to use 10 000 hours of input and in actuality only uses 9 000 hours, it will be clear that
the entity failed to use the budgeted capacity to the full.

Therefore, this is the difference between the actual hours of input (AH) and the budgeted
hours of input (BH) multiplied by the standard fixed overhead rate. SR).
(AH BH) x SR

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See the next example to illustrate the above:
Given information:
Budgeted production 100 000 units
Budgeted machine hours 200 000 hours
Budgeted total fixed overhead R500 000

Actual production 120 000 units
Actual machine hours 180 000 hours
Actual total fixed overhead R600 000

Fixed overhead is allocated on the basis of machine hours.

Required: Analyze the fixed overhead variances in as much detail as possible.

Solution:
Initially the plan was to use 2 machine hours (input) to produce 1 unit of output.
200 000 hours / 100 000 units

The budgeted fixed overhead allocation rate:
R500 000 / 200 000 = R2,50 per machine hour (this is technically more correct).
Or R500 000 / 100 000 = R5,00 per unit

Spending variance:
R600 000 R500 000 = R100 000
We paid more than we budgeted, so this variance is negative.

Volume variance
(120 000 100 000) x R2,50 x 2h/u = R100 000
We produced more units than planned. We were more productive than planned, so this will
be a positive variance. Here we are working in units, so it will be necessary to use the
allocation rate in a per unit form rather than a per hour form.

The total spending variance and volume variance is the under- or over allocated fixed
overhead in the income statement. In this expample it will be R0 and it is therefore neither
under- or over absorped. If this amount is positive, the amount in the income statement will
be an over allocated fixed overhead (more was allocated than planned, so the overhead
must be reduced, so the expense is reduced and therefore it is like income. Vice versa.
The volume variance is further divided:

Volume efficiency variance:
Standard hours input: We produced 120 000 units. If we worked at the efficiency rate that we
planned, we would have needed 240 000 hours (120 000 x 2h/u) to produce this output.

(240 000-180 000) x R2,50 = R150 000
We can see that we were much more efficient with the units input we used. Thus, this is a
positive variance.

Volume capacity variance
(180 000 200 000) x R2,50 = R50 000
We can see that we did not use all the capacity. Therefore, this is a negative variance.

The total volume capacity- and volume efficiency variance is equal to the total volume
variance:

R150 000 R50 000 = R100 000 (positive)

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8 JOB COSTING AND ACTIVITY-
BASED COSTING


Vigario - Chapters 2 and 5
[Drury - Chapters 4 and 10]

LEARNING OUTCOMES
- Implement a job costing system in a service enterprise and a manufacturing enterprise.
- Reconstruct a general ledger with an integrated operating ledger and financial ledger.
- Allocate over- / under allocated overheads using the following methods:
- Total over- / under allocated overheads to cost of sales per IAS 2
- In proportion to different inventory accounts
- Identify circumstances in an enterprise in which a costing system would be
implemented.
- Define activity-based costing (ABC) and name the differences between this system and
the traditional costing system.
- Incorporate ABC in job costing and process costing.
- Apply ABC in service enterprises.
- Evaluate ABC as a method of improving or weakening costing systems in enterprises.
- Define and provide examples of the following concepts, among others:
a) Cost driver
b) Activity centre
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1. INTRODUCTION H122, D79
- Costing systems: Job costing and process costing.
- Job costs: Each product or service is individual and meets particular needs of a
specific consumer.
- Process costs: Mass production of the same product or service.
- Activity-based costing (ABC): Costs are allocated accurately to different jobs or
processes.

2. SOURCE DOCUMENTS H128, D80
- Job cost record: Contains materials, labour and overheads
- Materials: Materials requisition H129
- Labour: Time ticket or clock card
- Overheads: Predetermined rates, e.g. Rate = Budgeted overheads
Budgeted volume
i.e. direct labour hours, machine hours, direct labour rate, units
or post-determined rates, e.g. Rate = Actual overheads
Actual volume
3. RECORDING TRANSACTIONS IN SUBSIDIARY JOURNALS AND THE
GENERAL LEDGER H136, D82-95, V48
The same as in MACC 211 and MACC 311 (the format for standard costs)
- Materials purchases
- Materials issues
- Labour costs incurred on wage statement
- Wage analysis
- Overheads incurred
- Overheads allocated
- Overheads overallocated/underallocated
- Jobs completed
- Jobs sold: costs
- Selling price

Note the example in Horngren pp. 137-141 illustrating the general ledger and subsidiary
ledgers, as well as T-accounts and journal entries.
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4. COST AND INCOME STATEMENTS
- Cost of sales statement is prepared as follows by manufacturing enterprises:
Direct materials usage (O/I + Purchases C/I)
+ Direct labour
= Primary costs
+ Allocated overheads
=Manufacturing costs
WIP inventory difference + O/I
- C/I
=Cost of finished goods
FG inventory difference + O/I
- C/I
= Cost of sales (at normal)
Underallocated or overallocated overheads
=Cost of sales at actual

- Income statement (as per the traditional or absorption costing method)
Sales
- Cost of sales (fixed + variable)
=Gross profit
- Selling and administration expenses
Fixed
Variable
=Net operating income

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- Income statement (as per the contribution margin method)
Sales
-Variable costs: of sales
Selling and admin.
=Contribution margin/marginal income
-Fixed costs: production
Selling and admin.
=Net operating income

5. WHEN TO USE JOB COSTING H123
- Costs are recorded on a job cost sheet, i.e. materials, labour and overheads.
- The cost of each job is individual because the composition differs.
- Produced for a specific consumer.
- Costs are known once the job has been completed.
- Denominator is small.
- Examples: Manufacturing furniture, contracts, aeroplanes, etc.
Service - doctors, lawyers, auditors
Trade - catalogues distributed, special promotions
6. JOB COSTING IN SERVICE ENTERPRISES H146
Steps taken by service enterprises, e.g. public accounting practice. The general approach to
job costing can be applied in this type of enterprise according to the following seven steps:
i. Identify the job selected as the cost object.
ii. Identify the direct costs of the job.
iii. Identify the indirect cost pools associated with the job.
iv. Select the cost allocation base for allocating indirect costs to the job.
v. Determine the cost allocation rate.
vi. Determine the indirect costs of the job.
vii. Determine the total costs of the job: direct and indirect.
7. PRORATION OF UNDERALLOCATED OR OVERALLOCATED
OVERHEADS H142
Method 1: The pro rata portion is based on the total amount of overheads (before proration)
included in the closing inventory of WIP, finished goods and cost of sales [Example H143].

Method 2: The pro rata portion is based on the total closing balances (before proration) of
WIP, finished goods and cost of sales.

Method 3: All overallocated or underallocated overheads are written off to cost of sales.

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8. JOB COSTING IN MANUFACTURING ENTERPRISES H135
The steps are the same as discussed in (6) above for service enterprises, except that the
cost items in step (vi) consist of direct materials and direct labour instead of only professional
labour. The indirect costs consist of manufacturing overheads and not indirect support
services.


Solution IM 4.2
a) See the comparison between management accounting and financial accounting in
Chapter 1 for the answer to this question.
b) Note that the job ledger control account shown in the question is equivalent to the
work in progress control account described in Chapter 4.
Stores ledger control account
(R000) (R000)
Opening balance 176.0 Job ledger control A/c
(64 500kg x R3.20)
206.4
Financial ledger control A/c 224.2 Production o/head control A/c
(Balancing figure)
24.3
____ Closing balance 169.5
400.2 400.2

Production wages control account
(R000) (R000)
Financial ledger control A/c 196.0 Job ledger control A/c (75%) 147.0
____ Production o/head control A/c (25%) 49.0
196.0 196.0

Production overhead control account
(R000) (R000)
Financial ledger control A/c 119.3 Job ledger control A/c* 191.1
Stores ledger control A/c 24.3 Under-absorbed overhead (Balance to 1.5
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profit and loss A/c)
Production wages control A/c 49.0 ____
192.6 192.6
* Direct labour hours = Direct labour wages (R147 000) / Direct labour wage rate (R5) =
29 400 hours.
Overhead charged to production = 29 400 direct labour hours x direct labour rate
(R6.50) = R191 100.
Job ledger control account
(R000) (R000)
Opening balance 114.9 Cost of sales A/c (balancing figure) 506.4
Store ledger control A/c 206.4 Closing balance 153.0
Production wages control A/c 147.0
Production o/head control A/c 191.1 ____
659.4 659.4

CLASS DISCUSSION

9. MOTIVATION FOR ABC D222, H162, V172
- ABC: Accurate pricing helps in cost management decisions by improving processes
and product designs.
- Product cost cross-subsidisation: As a result of inaccurate cost allocation caused by
a broad average allocation (peanut-butter costing).
- Traditional product costing was designed when a small range of products was
produced, and materials and labour costs formed the majority of the production costs.
- Variable manufacturing environment: Makes traditional product costing and cost
allocation obsolete.
- Competition in the global market requires accurate costs and prices.
- A refined costing system uses ABC.
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10. DEFINITION H170, D221, V172
- ABC systems refine costing systems by focusing on individual activities as the
fundamental cost objects. An activity is an event, job or unit of work with a specific
purpose, e.g. designing a product, setting up a machine, distributing products.
- ABC systems calculate the costs of individual activities and impute costs to cost
objects like products and services on the basis of the activities carried out for each
product or service.
11. COMPARATIVE ANALYSIS OF ABC AND TRADITIONAL COSTING D223,
H178, V189
In ABC costs are imputed to activities according to the products demands for activities.
Work through the example in V178-180.
12. HOW ABC WORKS D228, H174, V187
Drury identifies the following four steps for designing ABC systems:
- Identify the major activities in an organisation.
- Impute costs to the activity cost centres.
- Determine the cost driver and the cost driver rate for each major activity.
- Impute the costs of the activities to the products as per the products demand for
activities.

Vigario 172 discusses the process in five steps, which correspond with Drurys four we
mentioned above.
Horngren expands these steps more clearly:
i. Identify the cost objects, e.g. products.
ii. Identify the direct costs of the products.
iii. Select a cost allocation base for allocating indirect costs to the products.
iv. Identify the indirect costs associated with each cost allocation base.
v. Determine the allocation rate.
vi. Determine the indirect costs imputed to the products.
vii. Determine the total costs from the direct and indirect costs of each product.

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Work through the example in Horngren p. 176.
Note the cost hierarchy in Horngren p. 173, D230 and the levels of activity that cause costs:
- Output unit-level costs
- Batch-level costs
- Product-sustaining costs
- Facility-sustaining costs

13. EVALUATION OF THE USE OF ABC D235, V188

Advantages
i. More accurate costs as a result of a larger number of cost pools, the change of the
allocation base and change in managements perception.
ii. Because the costs are more accurate, more effective and efficient decisions can be
made.
iii. More efficient cost control.
iv. More efficient planning.

Disadvantages/limitations
i. Arbitrary cost allocation.
ii. High costs of measurement.
iii. ABC is based on absorption costing techniques, which are only valid at one historical
level of production.
iv. Selecting cost drivers is difficult and in some instances has little relevance for activities.

14. ABC AND SERVICE ENTERPRISES D236, H183
This system works very well in these enterprises. Simply replace products with services.
However, there are two common problems that make implementation difficult: a larger
portion of the costs in service enterprises are facility-level costs and it is more difficult to
establish activities in a service enterprise.

15. USING ABC TO IMPROVE COST MANAGEMENT AND PROFITABILITY
H178
- Pricing and product mix decisions
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- Cost reduction and process improvement
- Design decisions
- Planning and managing activities
ABC leads to activity-based management, activity-based cost management and activity-
based management accounting.
16. INTERNATIONAL USES
John Deere (USA), Europe, particularly Germany and Northern Europe. South Africa?
17. KEY TERMS H189
See especially: ABC, batch-level activities, unit-level activities, facility-level activities,
product-level activities, NVA**please give English equivalent** activities, process value
analysis.
18. ABC AND STRATEGIC DECISIONS V190
- Traditional: Absorption costing is used for product costs and then in decision making.
- ABC is more sophisticated. Work through the example in Vigario.
- Decision making: Marginal costing is more effective.
- Compare the Western and Eastern style of management. The Japanese use target
costing for pricing.
- Bhimani & Bromwich

below.
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H + F + D 5.39
1. Sold.: R942 000 1 570 000 = R0.60 / sold.p.
Shipm: 860 000 20 000 = 43. / shipment
Qual. contr.: 1 240 000 77 500 = 16 / inspection
Purch. orders = 5 / order
Machine power = .3 / mh
Machine setups = 25 / setups

M R
DM: (R208 584) R208 R584
DL: 18 42
Mach. costs 144 72
Direct costs (total) R370 R698
Indirect costs:
Solder. (.60 x 1 185 000, 385 000) R711 000 R231 000
Shipm. 696 600 163 400
Qual. contr. 899 200 340 800
Purch. orders 400 500 549 900
Mach. power 52 800 4 800
Mach. setup 400 000 350 000
R3 160 100 R1 639 900

Income

R19 800 000

R4 560 000
- Cost: Direct (22 000 x 370, 4 000 x 698) 8 140 000 2 792 000
Indirect 3 160 100 1 639 900
= Gross profit R8 499 900 R128 100
GP/U R386.36 R32.025
GP % 42.93% 2.8%

2. The existing system allocates manufacturing overheads differently than machine costs
on the basis of machine hours. M uses twice as many machine hours as R and the
costs are therefore double. ABC uses various cost drivers and more accurate costs
could have been realised. M would then be more profitable than R.
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3. Duvals comments on ABC implementation are valid. When designing and
implementing ABC, management and the management accountants must play costs
and benefits off against one another. More activities added result in higher costs for
implementation, but increase the accuracy of cost information, which may lead to more
effective decisions.
4. ABC is the use of the information to make improvements to the organisation, e.g.
products can be revised on the basis of revised cost information. For the long term,
ABC management can help to make decisions on the viability of product lines,
distribution channels, marketing strategies, etc. ABC emphasises improvements such
as eliminating activities that dont add value, selecting lower cost activities, etc. It
focuses on long- and short-term strategies and tactics.
5. Faulty reporting to M and to maintain R is unethical.
What about the ethical code of management accountants?
E Competence
E Integrity
E Objectivity

ASSIGNMENTS

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Study unit 9

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9 PROCESS COSTING, HYBRID
COSTING AND REWORK


Vigario - Chapter 3
[Drury - Chapter 5]

LEARNING OUTCOMES
- Identify when to implement a process costing system.
- Determine the closing inventory value for finished goods and work-in-process units if:
* An addition of materials to Dept I causes an increase in units.
* Units are spoilt in all the production departments that can be attributed to
avoidable and unavoidable causes at different inspection points, e.g. at the
beginning, during or end of the process.
- There are unfinished units at the beginning of the period.
- Determine the closing inventory value of finished and work-in-process units if:
* A weighted average method and
* A first-in-first-out method is applicable to the opening work-in-process inventory.
- Compile a cost report and quantity schedule for any production department.
- Make accounting entries in the general ledger from the cost report and quantity
schedule.
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- Determine the closing inventory value for finished and work-in-process units if standard
costs are used.
- Determine the variances between actual and allowed costs.
- Determine the operating income for an enterprise after taking all the above objectives
into account.
- Discuss the influence of activity-based costs in process costing.
- Define important terms and determine the value of finished goods and work-in-process
if any of the following occur during the production process:
* Rework
* Normal spoilage
* Abnormal spoilage
* Hybrid costing
* Scrap units
1. INTRODUCTION H123, 626, D99, V65
- Process costing is a system used in enterprises that produce homogeneous
products or services.
- Mass production, therefore not for a specific consumer; a continuous flow.
- Equivalent units: Equivalent of the finished units.

2. WHEN PROCESS COSTING IS USED H123, 626
- Mass production: For inventory and not a specific consumer.
- Continuous flow: Therefore costs are recorded per period and not per job.
- Denominator large: In contrast to job costs, which have a small denominator.
- Homogeneous products: Total costs divided by the units produced; therefore an
average unit price.
- Costs are recorded per cost centre, per period; work-in-process therefore occurs and
equivalent units become relevant.
- Examples:
Production: Chemical industry, canning industry, mining companies, rubber and steel
Service: Mail sorting at post office, premiums at insurance companies, banks
Trade: Marketing corn, processing new magazine subscriptions

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3. BASIC STEPS H630
i. Determine physical flow: From where to where?
Opening inventory + Added = Finished + WIP
ii. Determine equivalent units: note the instruction, i.e. weighted average or first-in-
first-out (FIFO) method.

Remember: With the weighted average the equivalent units are made up of finished units +
work-in-process units X% completed by the end.
In FIFO the equivalent units are made up of units that could absorb costs during the period
concerned, i.e. WIP Opening inventory X% to complete + Units started and finished +
WIP closing inventory X% completed.

iii. Determine unit costs: Weighted ave.: = Opening balance + Cost for period
Equiv. U as in (ii)

FIFO = Cost for period
Equiv. U as in (ii)

iv. Set out the total costs and determine the value of finished goods and work-in-process.

4. PROBLEMS TO AVOID H649
- Remember that any department after the first one has the costs from the preceding
department.
- In FIFO: Units completed and transferred out include opening WIP inventory that was
completed during the period.
- Unit costs can fluctuate from one period to the next.
- Units may be measured differently in different departments, e.g. in kg in one
department and in litres in another.

5. PRODUCTION COST REPORT H649
- Groups costs according to department or segment
- Groups costs as per time, e.g. daily, weekly, monthly
- Quantity schedule for each department
- Determine unit prices according to cost elements
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6. SPOILAGE IN THE FIRST PRODUCTION DEPARTMENT AND
THEREAFTER D101, H664-678, V74-80
6.1 Uncontrollable spoilage
Costs are carried by the good units. This spoilage is through normal causes, such as
evaporation, shrinkage etc.
Dept I: Influences only the unit costs of the first department.
After Dept I: Influences the unit costs of the department concerned as well as those of
the preceding department (adjust the unit price of the costs of the
preceding department).
6.2 Controllable spoilage
Costs of the spoilage are carried by assigning a value to spoilage and imputing them
as a loss in the income statement. This spoilage is through spillage or negligence.
In paragraph 13 H664-678 spoilage, reworked units and inspection points are discussed in
detail.

7. ADDITION OF MATERIAL TO DEPT 1
- The appearance changes, but not the units themselves, e.g. paint on toys, cars. The
additional material changes the character only, but not the quantity it is therefore only
an additional cost element, i.e. materials.
- The additional material causes an increase in the units, e.g. liquids this is the
opposite of spoilage.
- Cost in current department: Only an additional cost element.
- Cost from preceding department: Carried by more units, therefore a new lower unit
price.

8. WORK-IN-PROCESS AT THE START OF THE PERIOD D106, H628+
8.1 Weighted average method H634, D110
- Equivalent units: As discussed in paragraph 3 above.
- Total costs: (Opening inventory plus cost for the period) divided by the total units
(opening inventory plus addition).
- Unit costs: Total costs divided by equivalent units.
- Work through the example on pp. 71 to 78.

8.2 FIFO method and modified FIFO method H636, D168
- Equivalent units: As discussed in paragraph 3 above.
- Unit costs: Costs for the period divided by the equivalent units as determined in
paragraph 3 above for the current department. For the preceding department the same
method for determining unit costs is used as for the weighted average.

Study unit 9

109
Work through the example with two departments for two months (as practice and
compare your answer with the suggested solution below) on pp. 71 to 78 of this study guide.
You will not find this type of situation in any prescribed book.
(i) Note the values of the closing WIP inventory from July, which becomes the opening WIP
inventory value for August and, most importantly, WHERE the amounts are indicated in the
cost report and quantity schedule
(ii) Also note the values of the finished goods transferred out of department 1 to department
2 and, very important, WHERE the amounts are indicated in the cost report and quantity
schedule.

Below are the instructions for an exercise of one department for only one month. Do this
exercise below first before you work through the example on pp. 71 to 78.

solutions below.

H + F + D 17.30

1. Physical flow: 5 000 + 20 000 = 22 500 + 2 500
2. Equiv. U: Materials: 22 500 + 2 500 = 25 000u
A + B: 22 500 +1 750 = 24 250u
3. Unit costs:
Materials: 1 250 000 + 4 500 000/25 000u= R 230
A + B: 402 750 + 2 337 500/24 250u= R 113
4. Completed and transferred out:
5 000u (230 + 113) = R1 715 000
17 500u (230 + 113) = R 6 002 500
Total = R 7 717 500

C/I WIP:
2 500u x (230 X 100%) = 575 000
2 500u x (113 x 70%) = 197 750
Total = 772 750
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H + F + D 17.32
1. Physical flow: 5 000 + 20 000 = 22 500 + 2 500
2. Equiv. U: M A + B
WIP O/I to complete - 2 000
Started and completed 17 500 17 500
WIP C/I x % 2 500 1 750
20 000 21 250
3. U/price:
Mat: 4 500 000/20 000u= R225/U
A + B: 2 337 500/21 250u= R110/U

4. Value: WIP: Mat: 2 500 x 100% x R225 = R562 500
A + b: 2 500 x 70% x R 110 = R192 500
R755 000
FG: WIP O/I: R1 250 000 + 402 750 = R1 652 750
5 000 x 40% x 110 = 220 000
Started + completed: 17 500 x (225 + 110) = R5 862
500
R7 735 750
Difference:
a) Cost per equivalent unit: WA FIFO
Mat. R230 225
A + B 113 110
(Differences in unit costs are caused by the fact that in FIFO only the costs for the
current period are divided by the units that could absorb costs for the current period)
b) Work-in-process: WA FIFO
Mat. 575 000 R562 500
A + B 197 750 R192 500
R772 750 R755 000

Difference R17 750

c) Finished goods R 7 717 500 R7 735 750

Difference 18 250
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9. ACCOUNTING ENTRIES FOR PROCESS COSTING H643
- The top part of the cost report and quantity schedule is the debit side of the WIP
control account of the department concerned.
- The bottom part of the cost report and quantity schedule is the credit side of the WIP
control account of the department concerned.
- For each department, a work-in-process control account is opened.
- From the last department, the work is transferred out to the finished goods and then
cost of sales.
- The procedure for recording this in the books is the same as for job costing.

10. STANDARD COSTING AND PROCESS COSTING H641
- Easy to apply: Homogeneous products, and use price and quantity standards.
- Also calculate price and quantity variances.

Example: The following information relates to business A. A standard costing system is used
together with the first-in-first-out method for inventory valuation. Determine the cost
variances per cost element for the period concerned.
Standard direct material/U R74, standard conversion costs/U R54

Actual costs: DM R19 800 Conversion costs R16 380
Quantity schedule: WIP O/I 225 U (100% completed in terms of DM and 60%
converted)
Added 275U
Completed and transferred out 400U
WIP C/I 100U (100% completed in terms of DM and 50%
converted)

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Suggested solution (according to the four basic steps as discussed in paragraph 3)
1. Physical flow: 225 + 275 = 400 + 100
2. Equiv. U: DM Conversion
WIP - O/I......... - 90
Started + completed 175 175
WIP - C/I x % 100 50
275 315
3. U/price: DM = R74, conversion R54 (given)
4. Finished goods: 400U x (74 + 54) = R51 200
Work-in-process: DM 100 x 100% x 74 = R7 400
Conversion 100 x 50% x 54 = R2 700

Variances: DM Conversion
Actual costs R19 800 R16 380
Allowed: (275 x 74) R20 350
(315 x 54) R17 010
R550(+) R630(+)
Both variances are favourable and thus credited.

11. ACTIVITY-BASED COSTING AND PROCESS COSTING
Applicable in allocating overheads.

12. PROCESS COSTING FOR DECISION MAKING AND COST CONTROL
- For decision making: Costs must be divided into fixed and variable components, but
in process costing with a unit price this has not yet been done. Refinement will have to
take place.
- Cost control: It is important to compare costs in the current period to apply cost
control and not costs that have been carried over from a previous period. See
paragraph 10 above.
13. SPOILAGE AND INSPECTION POINTS H674, V74
IAS 2 paragraph 14:
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Examples of costs excluded from the costs of inventory and dealt with as expenses in the
period in which they were incurred:
(a) Abnormal contribution margins for scrap material, labour and other production costs
(b) Storage costs unless they were necessary for the production process before a further
production phase
(c) Administrative overheads unrelated to generating inventory...
(d) Selling expenses
The most common methods for valuing inventory are LIFO, FIFO and weighted average.
LIFO is used to reflect a profit determined from current income and expenses and therefore it
is suitable for internal reporting. For external reporting: IAS 2 Inventory must be shown
at FIFO or weighted average.
- Distinguish:
- Spoilage: Unacceptable production units, e.g. defective units that may be partially
complete or can be completed, and classified as unacceptable upon inspection.
- Rework: Unacceptable production units which are subsequently repaired to be sold as
acceptable units, e.g. computer hard drives.
- Scrap: A product with minimal sales value compared to the other products, e.g. offcuts
of material and leather, where the pattern for the main product has been cut out.
- Normal spoilage: Spoilage under efficient circumstances, e.g. evaporation or
shrinkage.
- Abnormal spoilage: Spoilage not expected to arise under efficient circumstances it
is not part of the process, but arises through avoidable causes and is therefore
controllable. Abnormal spoilage costs are written off in the period in which they are
incurred.

Work through example H668+
Note example 2 H668 where the inspection point is at the end and normal spoilage is 10% of
the good units; the rest are abnormal.
..10% x 7 000 = 700 of the units are normal spoilage and 300 (1 000 - 700) are abnormal
spoilage. The cost of the abnormal spoilage is written off in the income statement (R5 925)
as a loss and the cost of the normal spoilage (R13 825) is added to the cost of finished
goods because the inspection took place after completion. Work-in-process at the end was
50% complete in respect of labour and overheads and therefore does not form part of the
costs of normal spoilage.
The inspection point therefore plays a very important role in imputing the costs of normal
spoilage.
The same principle is applied in the illustration of this example according to the weighted
average, FIFO and standard costing method.
The principle in imputing costs of normal spoilage is that these costs will go to all good units
that are past the inspection point.
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14. IMPORTANT TERMS H656
Hybrid costing systems H650: This system has characteristics of both job and process
costing. Job and process costing have extreme characteristics and hybrid costing is a
combination of the two. Job costing deals with heterogeneous products or services with
individual compositions, whereas process costing deals with homogeneous products or
services, mass production and a continuous flow in the production process.
A hybrid costing system is applied when there is a combination of production for a specific
consumer but also mass production, e.g. at Ford Motor Company where there is continuous
flow, but a special combination of engine, transmission, radio etc.
Modified FIFO: In practice, it is not possible to apply the FIFO principle or pure IFO principle
in process costing after the first department, and it therefore becomes an adapted or
modified FIFO.
Modified FIFO means that:
i. The costs of the preceding department are dealt with as the weighted average for
determining the unit price because it is not possible to determine practically which units
increased and which units were spoilt.
ii. Costs of the current department are dealt with as FIFO in determining equivalent units
and unit price.

15. COST OF ABNORMAL SPOILAGE V79
- Abnormal spoilage: The costs must be carried by the products themselves, so a
value must be allocated to record it in the income statement.
- Equivalent units?
- Unit price? Higher or lower than when there is normal spoilage.
- What happens with weighted average and FIFO?

solutions below. Note that the information between the two editions of Horngren differs
slightly.
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H + F + D 18.30
Cleaning dept Mat. added at beginning of process.
O/I = 80%, C/I = 25% completed Normal spoilage = 10% x Good units

1. Physical flow: 1 000 + 9 000 = 7 400 + 740 + 260 + [1 600]
2. Equiv. U: Mat: 7 400 + 740 + 260 + 1 600 = 10 000U
A + B: 7 400 + 740 + 260 + (1 600 x .25) = 8 800U

R1 000 + 9 000
3. U/price: M: 10 000U = R1/U

R 800 + 8 000
A + B: 8 800U = R1/U

4. Value: FG: 7 400U x R2 = R14 800
+ Cost of normal spoilage: (740 x 2) = 1 480 R16
280

WIP: Mat: 1 600 x 100% x R1 = R1 600, A + B: 1 600 x .25 x 1 = R400
Abnormal spoilage: 260U x R2 = R520
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116

H + F + D 18.31
1. Physical flow: 1 000 + 9 000 = 7 400 + 740 + 260 + [1 600]
2. Equiv. U: Mat A + B
O/I WIP - 200
+ Started + completed 6 400 6 400
+ WIP C/I x % 1 600 400
+Normal spoil. (100% completed) 740 740
+Abn. spoilage (100% completed) 260 260

9 000 8 000

R9 000 R8 000
3. U/price: Mat: 9 000U = R1/U, A + B: 8 000U = R1/U

6 400 x R2 = R12 800
R1 800 2 000
4. Value: FG: 7 400U
1 000 (200 x 1) R14 800
+ Cost of normal spoilage: 740 x 2 = R1 480
TOTAL R16 280

WIP: M: 600 x 100% x R1 = R1 600, A + B: 1 600 x .25 x 1 = R400

Abnormal spoilage: 260 x R2 = R520

Coincidentally, the U/prices, FG and WIP of 18.30 + 18.31 are the same. Why?

Study unit 9

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16. LAST-IN-FIRST-OUT METHOD (LIFO) V81
This method has limited applicability in process costing. Note that it can be applied in
valuing work-in-process inventory.
17. JOB COSTING AND SPOILAGE H674

18. EXAMPLE: TWO PRODUCTION DEPARTMENTS FOR TWO MONTHS
ACCORDING TO THE WEIGHTED AVERAGE AND FIFO METHOD
Company A manufactures a product that moves through two production departments. The
production and cost information for two months is given to you to determine the closing
inventory values of WIP and finished goods at the end of each period if:
- The weighted average cost method is used.
- The FIFO method is used.

Production and cost information
July: Dept I

There is no opening WIP inventory. During the month 1 000 units are placed into production,
of which 75% are completed, 20% have a closing WIP inventory (50% conversion costs) and
5% are spoilt.

Production costs: Direct materials R9 500
Conversion costs 8 500
Dept II
There is no opening WIP inventory. A materials addition of R7 500 in this department
increases the units by 100 and at the end of the month 600 units are completed and
transferred out to storage. 150 units have not been completed ( completed in terms of
conversion costs).
Conversion costs for the month amount to R9 750.
August Dept I
800 units are placed into production at a cost of R7 225 and are processed with R6 056
conversion costs. During the period 600 units are completed and there are 300 work-in-
process units (40% completed in respect of conversion costs) at the end of the month.

Dept II
The materials addition at a cost of R6 375 causes the units to increase by 50 and conversion
costs of R9 132,50 are incurred during the month. At the end of the month 550 units are
completed and there are 200 work-in-process units 60% completed in respect of conversion
costs.
Notes: (i) All materials are added at the beginning of the process in both
production departments.
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(ii) All spoilage is attributed to normal causes.
(iii) Unit costs to three decimal points.

COST REPORT AND QUANTITY SCHEDULE (WEIGHTED AVERAGE COST)

JULY
I II
QUANTITY VALUE U/PRICE QUANTITY VALUE U/PRICE
Costs of preceding dept
WIP O/I
+ Added
= Average price 750 15 000 20
+ Increased U 100
= New price 850 15 000 17.647
+ Additional costs
= Adjusted price 20.
Costs of current dept:
WIP O/I:
DM
Conversion costs
Month: DM 1 000 9 500 10 7 500 10
Conversion costs 8 500 10 9 750 15
1 000 18 000 20 850 32 250 45
Completed + transf. 750 15 000 20 600 27 000 45
WIP: Preceding dept 200 150 3 000
DM 2 000 1 500
Conversion costs 1 000 750
Spoilage 50 100
1 000 18 000 20. 850 32 250 45

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COST REPORT AND QUANTITY SCHEDULE (WEIGHTED AVERAGE COST)

AUGUST
I II
Costs of preceding dept
WIP O/I 150 3 000
+ Added 600 12 030
= Average price 750 15 030 20.04
+ Increased U 50
= New price 800 15 030 18.788
+ Additional cost
= Adjusted price 20.04
WIP O/I:
DM 200 2 000 1 500
Month: DM 800 7 225 10.25 6 375 10.5
Conversion costs 6 056 9.8 9 132.5 14.75
1 000 16 281 20.05 800 32 787.5 45.29
Completed + transf. 600 12 030 20.05 550 24 909.5 45.29
DM 3 075 2 100
Conversion costs 1 176 1 770
Spoilage 100 50
1 000 16 281 20.05 800 32 787.5 45.29

Calculations: Basic steps, H 669

1. Physical flow:

July
Dept I : 1 000 = 750 + 200 + 50
II : 750 + 100 = 600 + 150 + ? 100 (spoilage)

August
Dept I : 200 + 800 = 600 + 300 + ? 100 (spoilage)
II : 150 + 600 + 50 = 550 + 200 + ? 50 (spoilage)

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2. Equivalent units:

July
Dept I : Materials: 750 + (200 x 100%) = 950U
Conversion costs: 750 + (200 x 50%) = 850U
II : Materials: 600 + (150 x 100%) = 750U
Conversion costs: 600 + (150 x ) = 650U
August

Dept I : Materials: 600 + (300 x 100%) = 900U
II : Materials: 550 + (200 x 100%) = 750U

3. Total costs (see report)

4. Unit costs Materials Conversion costs
July - Dept I:
U
R
950
500 9
= R10
U
R
850
500 8
= R10

Dept II:
U
R
750
500 7
= R10
U
R
650
750 9
= R15

August - Dept I:
U 900
225 7 000 2 +
= 10.25
U 720
056 6 000 1 +
= 9.8

Dept II:
U 750
375 6 500 1 +
= 10.50
U 670
5 . 132 9 750 +
= 14.75

5. Value of closing inventory:
Finished goods

July - Dept I: 750 x 20 = R15 000
Dept II: 600 x 45 = R27 000

Aug. - Dept I 600 x 20.05 = R12 030
Dept II: 550 x 45.29 = R24 909,50

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Work-in-process

July - Dept I: 200U x R10 = R2 000
200U x 50% x R10 = R1 000
Dept II: 150U x R20 = R3 000
150U x R10 = R1 500
150U x x 15 = R750

August - Dept I: 300U x 10.25 = 3 075
300U x 40% x 9.8 = R1 176
Dept II: 200U x 20.04 = R4 008
200U x 10.5 = R2 100
200U x 60% x 14.75 = R1 770

COST REPORT AND QUANTITY SCHEDULE (FIFO)
JULY
I II
Costs of preceding dept:
WIP O/I
+ Added
= Average price 750 15 000 20
+ Increased U 100
= New price 850 15 000 17.647
+ Additional cost
= Adjusted price 20.
WIP O/I:
DM
Conversion costs
Month: DM 1 000 9 500 10 7 500 10
Conversion costs 8 500 10 9 750 15
1 000 18 000 20 850 32 250 45
Completed + transf. 750 15 000 20 600 27 000 45
DM 2 000 1 500
Spoilage 50 100
1 000 18 000 20. 850 32 250 45
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Calculations: Basic steps H630

1. Physical flow: The same as for weighted average method.

2. Equivalent units

July Dept I and II: The same as for the weighted average method because there
is no opening work-in-process inventory.

DEPT I
August
Materials Conversion costs
WIP O/I to complete - 100
+ Units started + completed 400 400
+ WIP C/I x % completed 300 120
700 620

DEPT II
August Materials Conversion costs
WIP O/I to complete - 100
+ Units started + completed 400 400
+ WIP C/I x % completed 200 120
600 620

AUGUST
I II
Costs of preceding dept:
WIP O/I 150 3 000
+ Added 600 12 012.54
= Average price 750 15 012.54
+ Increased U 50
= New price 800 15 012.54 18.766
+ Additional cost
= Adjusted price 20.017
WIP O/I:
DM 200 2 000 1 500
Month: DM 800 7 225 10.321 6 375 10.625
Conversion costs 6 056 9.768 9 132.5 14 730
1 000 16 281 800 32 770.04
Completed + transf. 600 12 012.54 550 24 874.04
WIP: Preceding dept 300 200 4 003.4
DM 3 096.3 2 125
Conversion costs 1 172.16 1 767.6
Spoilage 100 50
1 000 16 281 800 32 770.04
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3. Total costs (report)

4. Unit prices:
July: The same as for the weighted average method because there is no
opening work-in-process inventory.

August: Materials Conversion costs
Dept I
U
R
700
225 7
= R10.321
U
R
620
056 6
= R9.768

Dept II
U
R
600
375 6
= R10.625
U
R
620
5 . 132 9
= 14.730

5. Closing inventory value
Work-in-process:

July: The same as for weighted average method.

August: Dept I: 300U x 10.321 = R3 096.3, 300 x 40% x 9.768 =
R1 172.16.

Dept II: 200U x 20.1 071 = R4 003.4, 200 x 10.625 =
R2 125

200 x 60% x 14.730 = R1 767.6

Finished goods:

July: The same as for the weighted average method.

August:

Dept I: R16 281 less WIP = R12 012.54
200U: 2 000 + 1 000 = 3 000
x 50% x 9.768 = 976.8

Test: 600U

400U x (10.321 + 9.768) n = 8 035.6
R12 012.4
-
Dept II: R32 770.04 less WIP = R24 874.04
150:U 1 500 + 750 + (150 x 20.017) = R 5 252.55
x 2/3 x 14.730 = 1 473

Test: 550U

400U x (20.017 + 10.625 + 14.73) = R18 148.8
R24 874.35

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ASSIGNMENTS

Study unit 10

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10 JOINT PRODUCT COSTING


Study material: Horngren - Chapter 16 (16)
[Drury - Chapter 6]

- Clearly define the following concepts and provide examples of them:
* Main products, joint products, co-products, by-products and waste
* Technically common costs
* Separable costs
* Net realisable value
* Opportunity costs
- Allocate technically common costs to joint products by:
* Physical units
* Sales value
* Relative sales value
* Constant gross profit percentage
- Deal with by-products and technically common costs according to various methods
including:
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* By-product income regarded as other income
* By-product sales regarded as other sales
* By-product income to reduce costs in a variety of applicable methods
- Apply IAS 2, paragraph 14 to by-product costs.
- Determine the closing inventory values and operating income for joint products and by-
products in all the methods mentioned in learning outcomes 2 and 3.
- Do the accounting entries for allocating common costs to joint products and by-
products.
- Make decisions and recommendations to management regarding the further
processing of products and utilisation of products as raw material for other products
using two methods:
* Differential income and cost
* Opportunity cost
- Solve integrated problems covering several topics, such as process costs, technically
common costs, standard costs, budgets and relevant costs.

1. INTRODUCTION H598, D125, V92
- Technically common costs (TCC): These are the costs of a single process that
produces more than one type of product simultaneously but unavoidably.
- Products differ in value and some are classified as main products, joint products or by-
products.
- Cost allocation: Arbitrary, no method is 100% accurate.
- Cost allocation is important: To determine costs accurately for:
i. Inventory valuation
ii. Profit determination
- Examples: Oil refinery, meat packers, canning factory, mining companies, farms,
chemical industry, etc.

2. TERMINOLOGY H599, D126, V92
- Split-off point: The point at which products can be identified individually.
- TCC: Costs relating to more than one type of product which are produced
simultaneously; also known as pre-separation costs.
- Separable costs: All costs after split-off relating to specific products.
- J oint products: When two or more products are manufactured simultaneously and
neither one can be identified as the main product, e.g. meat packing**this example is
very cryptic Id suggest expanding a bit more to explain exactly which products in a
meat packing plant could be considered joint products**. All the products are
economically equally important for the business and have a relatively high sales
value.
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- Co-products: Products that are manufactured at the same time, but not necessarily
with the same raw material or the same processes, e.g. tree felling **this example is
very cryptic Id suggest expanding a bit more to explain exactly which products in tree
felling could be considered co-products**.
- By-product: Manufactured under the same circumstances as the previous two types
of products, but is not the main (primary) objective of the business and has a smaller
sales value. In economic terms, therefore, it is not as important as a joint or main
product. The measure is that by-product income is less than 10% of the total sales
value of the businesss production.
- Main product: This is the most important product in the business and the primary
purpose of the business, e.g. gold in a gold mine, fuel at SASOL.
- Waste: Products with little, if any, sales value.

3. COST ALLOCATION
3.1 Joint products H601, D126, V93
i. Physical measure: All the products must be measurable with the same measure, e.g.
kg, litres, metres.
The TCC are allocated on the basis of the physical units of each product released.
Disadvantage: Sales value is ignored.
ii. Sales value method: The total value of each product, i.e. production units multiplied
by the selling price, is used to allocate the TCC to products. This method is used if
products dont require further processing.
iii. Net realisable value (NRV) method: The NRV is obtained by reducing the final sales
value (Production units x Selling price) by the post-separation costs. It can then be
used to allocate the TCC to the different products.
iv. Constant gross profit %: In this method the same gross profit % is obtained for all
the products by doing the following:
E Determine the businesss gross profit and gross profit % from total sales less total
manufacturing costs.
E Use the overall gross profit % and deduct the gross profit for each product from
sales to calculate the cost of production.
E Deduct the post-separation cost from production cost to obtain the TCC portion of
each product.

Example: Use the information in Horngren question 16.28 (16.28) on page 623 (589) which
illustrates the above four methods (question 1). Question 2 of 16.28 requires comparative
income statements in which the four methods of overheads allocation are done. You will be
able to do question 3 of 16.28 once you have studied paragraph 5. The solution appears
below.

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16.28
1a) Sales value at split-off: **this solution contains a mixture of gallons and grams.
Id recommend using one or the other system, preferably gallons, since the question
uses US measures. Id then also recommend changing R to $. If you do the latter, then
youd probably need to do it for all the exercises, or else insert a sentence at the
beginning saying that even though the exercise in the Horngren textbook uses dollars,
you will use rands**

CPL
(600 g x 21)
CP: 6 000 kg x R4
Beans

15 000 kg MCL
(900 g x 26)
MC: 10 200 kg x R5
(R30 000)
CPL: 600 gall. x 21 = R12 600
36000
12600
x 30 000 = R10 500
MCL: 900 gall. x 26 = R23 400
36000
23400
x 30 000 = R19 500
1b) Physical measure:
CPL: 600 gall.
15
6
x 30 000 = R12 000
MCL: 900 gall.
15
9
x 30 000 = R18 000
1c) NRV:
CPL: (6 000 x 4) 12 750 = R11 250
36000
11250
x 30 000 = R9 375
MCL: (10 200 x 5) 26 250 = R24 750
36000
24750
R
x 30 000 = R20 625

1d) Constant gross profit %:

Sales (6 000 x 4) + (10 200 x 5) R75 000
- Cost (30 000 + 12 750 + 26 250) 69 000
=Total gross profit R6 000 % =
75000
6000
= 8%

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CPL MCL
Final sales value:
(6 000 x 4) (10 200 x 5) R24 000 R51 000
Less: Gross profit 8% 1 920 4 080
= Cost of sales R22 080 R46 920
Less: Separable costs 12 750 26 250
= Common costs allocated R9 330 R20 670

2.
CPL MCL
a) Sales R24 000 R51 000
-TCC 10 500 19 500
-Separable costs 12 750 26 250
=Gross profit R750 R5 250
Gross profit % 3.125% 10.294%

b) Sales R24 000 R51 000
-TCC 12 000 18 000
=Gross profit (R750) R6 750
Gross profit % (3.125%) 13.23

c) Sales R24 000 R51 000
-TCC 9 375 20 625
=Gross profit R1 875 R4 125
Gross profit % 7.81% 8.088%

d) Sales R24 000 R51 000
-TCC 9 330 20 670
=Gross profit R1 920 R4 080
Gross profit % 8% 8%

3. Further processing?
CPL: Incr. income:
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130
(6 000 x 4) (600 x 21) = R11 400
Less: Incr. costs 12 750
Disadvantage to process (R1 350)

MCL: Incr. income:
(10 200 x 5) (900 x 26) = R27 600
Less: Incr. costs 26 250
Advantage to process R1 350

Do the following self-assessment question and compare your answer with the suggested
solution below.

A firm manufactures three products, namely X, Y and Z with a TCC of R140 000.

The production and selling prices are: X: 4 000 units @ R12/U
Y: 8 000 units @ R20/U after R50 000
separable costs have been spent
Z: 2 000 units @ R25/U after R20 000
separable costs have been spent.

REQUIRED:

Allocate the TCC according to four methods and calculate the gross profit % of each product
in each of the methods you have chosen.

(i) Physical measure:
TCC allocated: X R40 000 GP% 17%
Y 80 000 19%*
Z 20 000 20%*
*Remember the post-separation costs throughout

(ii) Sales value method:
TCC allocated X R26 047 GP% 46%
Y R86 822 14%
Z R27 131 6%

(iii) Net realisable value:
TCC allocated X R35 745 GP% 26%
Y 81 915 18%
Z 22 340 15%

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(iv) Constant gross profit %:
TCC allocated X R39 072 GP% 18.6%
Y R80 240 18.6%
Z R20 688 18.6%

1.1 Cost allocation by-products H610+, D133, V96

i. When by-products are recognised in the general ledger
At production: As cost reduction or other income
At sales: As cost reduction or other income

ii. When by-products are recorded in the income statement
As a cost reduction of the main or joint product
As a separate item, i.e. additional income

IAS 2 par 14: In joint products and by-products where conversion costs cannot be
identified separately in products, they must be allocated on a rational basis, e.g.
relative sales value at split-off point or upon completion of production. Most by-
products are not as important and are valued at net realisable value, which is
deductible from the cost of the main product.

Work through the example on pp. 611-613 of Horngren.

Note the important points that the example highlights.

The alternatives for question (i) above are illustrated in income statements in Horngren 611.
They can be summarised briefly as follows:
A: Record the by-product in the general ledger at production. The income is used from
production of the by-product to reduce the TCC. Note the by-product closing
inventory (valued at SP).
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B: Record the by-product at sales. The income from sales of the by-product is recorded
as other income and the by-products closing inventory is shown at its zero value.
By-products can be dealt with in a variety of ways. The two most common ways are:
i. The cost of sales of the main product is reduced by the income from sales of the
by-product.
ii. The TCC of the main products are reduced by the net realisable value of the by-
product.
When should you use which method?

Note the instruction you are given in the question. If no instruction is given, the most
common methods can be used.

below. Note that the information in the old and new editions differs slightly.

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16.25

1.
SP (R40 000) 20 000 kg @ R10

(R320 000) RP 120 000 kg @ R2
240 000 kg
PB (R20 000) 40 000 kg @ R3 10% profit, 25% sales

20 000 kg SP

240 000 kg raw material given 120 000 kg RP

40 000 kg PB

NRV: SP: (20 000 x R10) 40 000 = R160 000 (
40
16
)
RP: 120 000 x 2 = 240 000 (
40
24
)
PB: 40 000 x R3 20 000 10% - 25% = R58 000 TCC

SP:
40
16
= R104 800
TCC: R320 000 58 000 = R262 000
RP:
40
24
= R157 200

Unit costs: SP: (R104 800 + 40 000) 20 000 = R7,24/kg
RP: R157 200 120 000 = R1,31/kg
PB: (R58 000 + 20 000) 40 000 = R1,95/kg for invent. valuation

2. SP: R160 000 (NRV)
470
160
x 320 000 = R108 936
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RP: R240 000
470
240
x 320 000 = 163 404
PB: 120 000 20 000 = R70 000
470
70
x 320 000 = 47 660
R470 000
Unit costs: SP: (R108 936 + 40 000) 20 000 = R7,45 /kg
RP 163 404 120 000 = 1,36 /kg
PB: (R47 660 + 20 000) 40 000 = 1,69 /kg

4. ACCOUNTING ENTRIES H611
5. DECISION MAKING H608, V95, D131
- Relevant costs: Expected future costs that differ between alternative actions
- Differential income: Difference in income between two alternatives
- Incremental income: Increase in income resulting from an alternative
- Sunk costs: Costs that have already been incurred and can make no difference to the
decision to be made currently
- Differential costs: Costs that arise as a result of an alternative
- Opportunity costs: Forfeited income, i.e. sacrificing an opportunity to earn income

5.1 Further processing
- Decision to process further if the differential income exceeds the differential cost.
- Decision to process further if the opportunity cost plus differential (separable) costs are
less than the sales value after processing.
- TCC are sunk costs and have no effect on the decision to process further.
- Refer to paragraph 2 on p. 83 of this study guide. Question 16.28 in Horngren contains
an illustration of decision making.
- Illustration: Lecture.

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5.2 Using a product as raw material
The same principles as discussed in paragraph 5.1 apply.

ASSIGNMENTS

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Study unit 11

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11 RELEVANT COSTS AND
DECISION MAKING


Vigario - Chapter 11
[Drury - Chapters 9

- Clearly formulate the following concepts and apply each in internal decision making:
* Relevant and irrelevant costs
* Avoidable and unavoidable costs
* Opportunity costs
* Differential costs and income
* Qualitative and quantitative factors
* Traceable costs
* Replacement costs
* Imputed costs
* Sunk costs
* Deferred costs
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- Discuss decision making as part of the primary task of management.
- Make the following decisions with the aid of cost information:
Dropping a product/department
Short-term and long-term pricing
Acceptance of special orders at a lower price than the normal selling price
Temporarily and permanently dropping activities
Make or buy
Expanding capacity
Product mixes
Replacing means of production
Profitability of products
- Identify the influence of risk and uncertainty in internal decision making and suggest a
solution to overcome this factor.
- Discuss the effect of activity-based costing on relevant costs in decision making.

1. INTRODUCTION D191, H412, V441
- Decision making requires a choice between alternatives.
- Cost information is very important for making decisions.
- Contribution theory is very valuable.
- Main problem: To determine in advance what the impact of the decision will be in the
long term.
- Relevant information: Relates to the future and differs according to alternatives.
- Qualitative and quantitative factors. Examples.
2. DECISION MAKING AND LIMITING FACTORS D197, H426, V449
- Limiting factor/constraint: A scarce factor, e.g. machinery, direct labour hours,
materials, preventing an enterprise from expanding without limitation.
- If there is a scarce factor, the best decision is the alternative with the highest
contribution margin per limiting factor.
e.g. Product A B C
Cont. marg./U R12 R10 R6
Production time 3 hours 2 hours 1 hour
If there is no limit: Order of preference A, B, C
If there is a limit: Order of preference C, B, A
- Decision model H426, D198, AT29-34
Obtain information, make forecasts, select an alternative, implement the decision and
evaluate the performance.
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3. TERMINOLOGY AT85, H439, V442, D213
- Relevant cash flow: Relates to the future and differs according to alternatives.
- Relevant costs: The same characteristics as relevant cash flow.
- Irrelevant costs: Costs that have already been incurred and are the same among the
alternatives.
- Quantitative factors: Expressed in monetary terms, e.g. expenses, income
- Qualitative factors: Not expressed in monetary terms, e.g. reliability of suppliers,
employee morale, product quality.
- Differential or incremental cash flow: Difference in cash flow between two alternatives.
- Differential or incremental costs: Difference in costs as a result of an alternative.
- Avoidable costs: Costs that will not be incurred if another activity is undertaken or when
a product or service is dropped.
- Unavoidable costs: Costs that will still be incurred even if a product or service is
dropped.
- Traceable costs: Costs that can be directly imputed to a job, product or cost centre.
- Replacement costs: Cost of replacing a product or asset, thus the current or future
market price.
- Opportunity costs: Forfeited income or contribution margin or the costs that arise as a
result of an opportunity to earn income being sacrificed.
- Imputed costs: The amount to use any productive service.
- Sunk costs: Costs that have already been incurred and cannot affect the decision.
- Deferred cost: Costs that can be shifted to the future with more or less no effect on the
efficiency of current production.
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Example
40 kg (R200) 45 kg @ R25/kg Hamburgers
@ R20
Permanent labourers @ R1 000 per week
(R4 000)
Carcass

Calculate the:
- Relevant costs
- Irrelevant costs
- Differential cash flow
- Differential costs
- Opportunity costs
- Avoidable costs
- Sunk costs
- Unavoidable costs
- Traceable costs

4. DECISIONS
4.1 Dropping a product/department D205, V443, H430
- Loss? Look at contribution margin.
- If the product/department is still making a contribution, dont drop it but consider the
avoidable and unavoidable costs.
- Contribution margin > Avoidable costs = Continue. The reverse is also true.
- Take limiting factors into account.
- The limiting factor is the availability of the capacity.
- Note the cash breakeven point where the cash inflow and the cash expenses can be
plotted on a graph. This is only a short-term solution.

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4.2 Short- and long-term pricing D193-197, V447
- Price can be set on a cost basis.
- Pricing: Keeps record of customers, competitors and costs.
- Short-term: A price higher than the variable costs is acceptable, provided there is spare
capacity.
- Contribution theory works well for pricing.
- If there is no capacity, set the price at VC + Cost of capacity, i.e. FC.
- If absorption costing is used, remember selling and administrative expenses and be
sure to deal with FC as unit costs because volume is an important factor in allocating
FC.
4.3 Pricing for special orders H416, D193, V444
- A special order must not affect normal sales, but is an additional order.
- Is there capacity for production?
- If there is capacity: Any price higher than the variable cost is acceptable because it
can make a contribution to paying the enterprises FC.
- If there is no capacity: Price must then be set at variable cost plus cost of capacity, e.g.
overtime, double shifts, additional FC, or the contribution margin on existing products
lost when production has to be sacrificed.
- Proviso: Special orders at special prices may not decrease normal sales.

below.

11.18
1. Normal SP = R10
VC = 4.5 Contribution margin of R5.5/pair
FC = 1.5

Special order: 20 000 x (R6 4.50) = R30 000
Additional contribution margin and income
b) R30 000 increase
2. Reno currently: VC: R48
R9 avoidable
FC: 16
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R64 7 unavoidable

Purchase price R60/U + R7/U unavoidable

If made, the unit cost is R64
If bought, the unit cost is R67
Difference R3/U x 20 000 U
= R60 000, but Reno wants to save at least R25 000
So: Essential relevant cost that must be saved is
R60 000 + 25 000 = R85 000
Therefore: 2(b)

4.4 Temporarily or permanently dropping activities
- Temporary: Contribution margin? Loss? Cost of reopening.
- Permanent: VKV**Please insert English equivalent** analysis.

4.5 Make or buy decision H419, D201, V443
- Capacity?
i. If there is capacity, compare the cost that will change (VC) if the decision to make
is made to the purchase price.
ii. If there is no capacity, compare VC + FC of production with the purchase price.
- When a buy decision causes an idle loss, recover the capacity costs from the purchase
price.
- Volume is important in make or buy decisions.
- Example: Production costs R20/U plus R51 000 fixed
Purchase price R50/U
>1 700 U: rather make; < 1 700 U: rather buy
- Distinguish between avoidable and unavoidable costs

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- Graph
Buy

Make

Cost (R)

1 700

Volume (U)
- Qualitative factors: Quality of the product, long-term relationship with suppliers,
technological changes
- Outsourcing and insourcing


Solution IM 9.6
a)
C D
(R) (R)
Selling price 127 161
Variable costs 66 87
Contribution 61 74

The drilling and grinding hours required to meet the production requirements for the period
are calculated as follows:
A B C D Total
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Hours per unit: Drilling 2 1 3 4
Grinding 2 4 1 3
Units of output 50 100 250 500
Drilling hours required 100 100 750 2000 2950
Grinding hours required 100 400 250 1500 2250

Drilling hours are the limiting factor (1650 hours are available). The contributions per drilling
hour are R20.33 for product C (R61/3 hours) and R18.50 (R74/4 hours) for product D.
Therefore the maximum demand of product C should be met, resulting in 950 drilling hours
being utilized (750 for product C and 200 hours for components A and B). The remaining
capacity of 700 hours can be used to produce 175 units of product D. It is assumed that the
internal demand for components A and B must have priority over meeting the demand for
product D. The estimated profit per week is:

(R)
Contribution from product C (250 units at R61) 15 250
Contribution from product D (175 units at R74) 12 950
Total contribution 28 200
Allocated fixed overheads (250xR23)+(175xR39) 12 575
15 625

b) i) Components A and B are not used to produce either of the finished products but if
they are purchased drilling time can be freed up to expand production of product D.
The variable costs of components A and B are R32 and R78 respectively and the
outside purchasing costs are R50 and R96. Thus variable costs will increase by R18
per unit for both components but the contribution per drilling hour from producing
product D is R18.50. Purchase of component
A releases 2 drilling hours (yielding R37 additional product D contribution) and
purchase of component B releases 1 drilling hour (yielding R18.50 additional
contribution). Thus components A and B should be purchased from outside and this
will free up 200 drilling hours (50 components x 2 hours for component A plus 100 x
1 hour for component B). This will enable output of product D to be expanded by 50
units (200 hours/4 hours per unit). The increase in contribution is calculated as
follows:

(R) (R)
Additional contribution from product D (50xR74) 3 700
Less additional purchasing costs:
Component A (50xR18) 900
Component B (100xR18) 1 800 2 700
Additional contribution 1 000

b) ii) For the answer to this question see Single-resource constraints and Two
resource constraints in Chapter 25.
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4.6 Expanding capacity or product lines
- Consider advertising, incremental marketing, commission and incremental
administrative costs. Also consider working capital regarding inventory and debtors.
- Opportunity costs: Whether income of any current production must be sacrificed.
- Capacity? The same principles apply as in paragraph 4.2.
4.7 Replacing means of production H431, D199
Refer to investment decisions in RECP 674 (Financial Management).
- Book value of old machine (asset): Relevant? Cash flow?
- Current sales value of old asset: Relevant? Cash flow?
- Profit or loss through alienation: Relevant? Cash flow?
- Purchase price of new asset: Relevant? Cash flow?
4.8 Product mix decisions H426
- Limited capacity: Product mix with the highest contribution margin per constraint.
5. MANAGING CONSTRAINTS H426, V449
- Careful planning is needed to make the best use of facilities.
- Opportunity costs come to the fore.
- Product mix at capacity limits: Linear programming (Study unit 13).
- Outsourcing.
6. RISK AND UNCERTAINTY IN DECISION MAKING: STUDY UNIT 11
7. CUSTOMER PROFITABILITY, ABC AND RELEVANT COSTS H427
- Decisions on whether to add or drop a product line/branch/segment similarly, the
product line/segment can be a customer.
- Decision: Add or drop a customer.
- Principle of relevant costs and relevant income where the customer is the cost object
rather than the product.
- Examples 11.8 and 11.9 H428 [393] explain this.
- These examples also contain the ABC principle for allocating overheads.
- Note the information that must be provided relating to the bases used for allocating
costs. Why?

Customer profitability analysis for Allied West

Customer
Vogel Brenner Wisk Total
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Revenues R500 000 R300 000 R400 000 R1 200 000
Cost of sales 370 000 220 000 330 000 920 000
Furniture-handling labour 41 000 18 000 33 000 92 000
Furniture-handling equipment cost written off
as depreciation
12 000 4 000 9 000 25 000
Rent 14 000 8 000 14 000 36 000
Marketing support 11 000 9 000 10 000 30 000
Sales-order and delivery processing 13 000 7 000 12 000 32 000
General administration 20 000 12 000 16 000 48 000
Allocated corporate-office costs 10 000 6 000 8 000 24 000
Total costs 491 000 284 000 432 000 1 207 000
Operating income R9 000 R16 000 R(32 000) R(7 000)

REQUIRED:
1. Should Wisk be dropped?
2. Should Loral be added instead of Wisk? (Loral needs the same as Wisk plus
R9 000 equipment).

Relevant revenue and relevant cost analysis for dropping Wisk and adding Loral

Loss in revenues and
savings in costs from
dropping Wisk
account
Incremental revenues
and incremental
costs from adding
Loral account
(1) (2)
Revenues R(400 000) R400 000
Cost of sales 330 000 (330 000)
Furniture-handling labour 33 000 (33 000)
Furniture-handling equipment cost
written off as depreciation
0 (9 000)
Rent 0 0
Marketing support 10 000 (10 000)
Sales-order and delivery processing 12 000 (12 000)
General administration 0 0
Corporate-office costs 0 0
Total costs 385 000 (394 000)
Effect on operating income (loss) R(15 000) R6 000

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Do Drury IM 9.9 as practice and compare your answer with the suggested solution below.

Suggested solution IM 9.9
(a) The relevant costs of the contract are as follows:

(R) (R)
Salary of G. Harrison 2 000
Supervision cost * 10 000
Cost of craftsmen * 16 000
Cost of equipment ** 3 000
Material costs: ***
A (100 x R3) + (900 x R3) 3 000
B (1000 x R0.90) 900
C (100 x R6) 600
D (100 x R2) + (100 x R3) 500
E (5000 x R0.20) 1 000
F (1000 x R1) + (2000 x R2) 5 000 11 000
Other direct expenses 6 500
Owners opportunity cost ^ 3 000
51 500
Less savings on maintenance work ^^ (1 500)
Minimum contract price 50 000

Notes:
* The costs given in the question include apportioned fixed overheads which are not a
relevant cost. Therefore R1000 has been deducted from the supervision cost (10% x
R10 000) and R800 from each of the craftsmens costs.

** The historical cost of the equipment is a sunk cost. It is assumed that the existing
equipment would have been sold if the contract were not accepted. Therefore the relevant
cost of using the equipment is the reduction in the scrap value over the duration of the
contract.

*** Material A: It is assumed that the usage of the 100 units in stock will be replaced in the
coming year and be used on property maintenance. This is more profitable than the
alternative of selling the materials for R2 and replacing them at a later date at R3. The
remaining quantities will be replaced at the current purchase price.
Material B: It is assumed that the 1000 units issued from stock for the contract will be
replaced at R0.90 per unit. This material is used regularly in the business.
Material C: This material is purchased specially for the contract.
Materials D and F: The stocks of these materials have no alternative use within the business
and will be sold if not used on the contract. Hence the sale price represents the opportunity
cost of using these materials. The remainder of the materials will be purchased at current
prices.
Material E: It is assumed that the material taken from stock for this contract will be replaced
at the current purchase price. This material is used regularly in the business.
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^ It is assumed that the alternative is for Johnson to pay out R12 000 to maintain the existing
business while he earns R15 000 on the one year appointment. If the contract is undertaken
then Johnson will lose R3000.

^^ It is assumed that the contract could be completed and maintenance programme carried
out during the period in which the supervisor and craftsmen are employed (one year). It is
also assumed that the supervision and craftsmen will be employed for one year only. A
further assumption is that the lowest quotation will be accepted. Other assumptions: The
lease of the yard would have to be paid even if the contract were not accepted.

(b)
(i) What is the likelihood that Johnson will obtain other contract work during the year? If there
is a possibility then any lost contribution should be covered in the minimum contract price.
(ii) Given that the profit was R12 000 last year, Johnson should consider closing operations
and obtaining a permanent salary of R15 000 per annum.
(iii) Do any alternative uses for the accommodation of the yard exist? If so then appropriate
opportunity cost should be added.
(iv) The contract price represents a minimum price. Johnson should aim to earn a surplus on
the contract.
(v) Will the loss of one-quarter of Johnsons time to the existing business result in a reduction
in profit? If this is the case then the lost profits should be included as an opportunity cost.

ASSIGNMENTS

Study unit 12

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12 RISK AND UNCERTAINTY


Study material: Vigario - Chapter 10
[Drury - Chapter 12]
[Redelinghuis - Chapter 4]

LEARNING OUTCOMES
- Discuss and calculate expected values.
- Distinguish between certainty, uncertainty and risk.
- Draw a decision tree and evaluated expected values.
- Define the following terms:
* Objective probability
* Marginal probability
* Mutually exclusive events
* Collectively exhaustive events
* Expected monetary value
* Statistical dependence and independence
* Maximin
* Maximax
* Minimax
- Make decisions by using the maximin, maximax and minimax decision criteria.
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- Make decisions based on risk by using the following methods:
* Expected monetary value
* Expected value of perfect information
* Expected opportunity loss

1. INTRODUCTION R127
- Information for decision making contains both quantitative and qualitative
characteristics.
- Decisions are made on future events because historical events are irrelevant for
current decisions.
- No one can predict the future with certainty.
- Risk and uncertainty deal with future events.
- Risk: Situations have several possible outcomes and there is material statistical
evidence for this. The decision maker is therefore able to assign a probability to the
outcome of the various events.
- Uncertainty: There are various possible outcomes, but little statistical evidence to
support the decision maker in their forecast. This limited information therefore does not
enable the decision maker to assign a probability to the outcome of an event.
2. TERMINOLOGY V409, R160
- Subjective probabilities: The decision maker has no basis from past experience to
support the probabilities. Probabilities are therefore assigned according to individual
judgement, which differs from one person to the next.
- Objective probabilities: Based on historical evidence or experience.
- Marginal probabilities: The outcome of any event is not influenced or caused by a
preceding event.
- Mutually exclusive events: Only one event occurs at a time. The probabilities of
events that are mutually exclusive can be added and must always total 1.
- Collectively exhaustive events: List of all the possibilities or probabilities of a given
action. Events can be mutually exclusive and collectively exclusive, but the sum of
probabilities must be 1.
- Statistical independence: The occurrence of one event will not affect the occurrence of
a second event.
- Statistical dependence: One event is affected by or dependent on the occurrence of
another.
- Decision trees: Diagrammatical representation of a decision-making problem.
- Decision node: Point on a decision tree, represented by a box, where a choice has to
be made between different alternatives.
- Decision table: A table showing all the outcomes of the various events for each
alternative action.
- Event note: Point on a decision tree, represented by a circle, from which the various
possible events that may arise branch out.
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- Maximax: Optimistic decision-making criterion in decision making based on uncertainty
which maximises the maximum outcome.
- Minimax: Decision-making criterion in decision making based on uncertainty which is
based on opportunity loss.
- Expected monetary value: The expected average result if the same decision were to
be taken repeatedly over a long period.
- Maximin: Pessimistic decision-making criterion in decision making based on
uncertainty which is based on maximising the minimum outcome.
3. DECISION MAKING BASED ON UNCERTAINTY R127, V417
In these circumstances, the decision maker has no information that would enable them to
assign a probability to the outcome of an event. If the manufacturer produces a new product
without the opportunity of doing market research, the decision is based on uncertainty. The
following criteria can be used in these types of decisions: maximax, maximin, minimax and
the criterion of realism (lies between maximax and maximin values). To explain this, we use
the example from Vigario 417.
Company A plans to market one of the following products X, Y or Z. Only one can be
marketed and there is no statistical evidence as to the probable success of the products.
Product X is considered to be a high-risk, high-return product.
Product Y is considered to be of average risk and return.
Product Z is a low-risk, low return product.
Consumer attitude towards general buying power could be high, static, low or highly
depressed. A estimates that the potential profits, given one of the four economic states for
each of the products, is as follows:

Profit given in R000 States
1 2 3 4____
Product X 50 Mama 25 4 -10
Product Y 30 20 15 0
Product Z 10 8 6 6 Maximin

REQUIRED:
Show how you would arrive at a decision on product choice using the maximin, maximax and
minimax decision criteria.
Suggested solution
- Maximin decision (pessimistic criterion)
According to this criterion, the worst state is 4 and the product that will make the
highest profit there is Z, i.e. R6 000. Therefore Z will be selected.
- Maximax decision
This is the opposite of the maximin decision and takes the most optimistic view of the
best outcome. The product with the highest risk profile will be chosen, i.e. X with a
maximum profit of R50 000.
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- Minimax decision (minimise the maximum regret)
This decision considers the opportunity cost of making the wrong decision. We could
ask: What is the opportunity cost of making the wrong decision or by how much would
the decision maker regret not having made the correct decision? For example, in state
1 if product X is chosen, the profit will maximise and there will be no opportunity cost.
If product Y is chosen, the maximum opportunity cost or regret is R20 000 (R50 000 -
R30 000). For product Z the maximum regret will be R40 000 (R50 000 10 000).
The final choice is the product that minimises the opportunity cost or maximum regret.
Apply the method as follows:
Step 1: For state 1, select the highest profit, i.e. X and deduct the profit of all other
products in state 1.
Step 2: Do the same for states 2, 3 and 4.
Step 3: Select the maximum values for each product row.
Step 4: Select the product with the smallest (lows) of the maximum values under step
3.

Minimax table State
1 2 3 4
Product X 0 0 11 16
Product Y 20 5 0 6
Product Z 40 17 9 0

The highest value for each row is:
X 16
Y 20
Z 40
Selection: Product X which minimises the maximum regret or opportunity cost.
4. DECISION MAKING BASED ON RISK R131
Risk in decision making arises from the possibility that the actual result of a particular event
may deviate from the expected result. This problem can be overcome by assigning a
probability to each outcome of an event. The degree of risk will depend on the confidence in
the probability. Probabilities may be determined from past experience, market research, pilot
studies, etc. If past information is not available, the decision maker must rely on the
probabilities, which are assigned subjectively and therefore there is a lower confidence level
in them.
Methods used to make decisions based on risk are:
- Selecting the alternative with the highest expected monetary value
- Expected value of perfect information
- Expected opportunity loss
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4.1 Expected monetary value R131
The formula for calculating the expected value is:
E() = n iP(i) Where E = Expected value
= Outcome i
i = 1 P(i)= Probability i

Example: R131 - 136
A market buys highly perishable products at R3 a box and sells them for R5 a box. If the box
is not sold within one day, it must be destroyed at 25 cents per box. How many boxes must
be ordered to meet the next days demand?
Sales records for the past 150 days are as follows:

Boxes sold per day Number of days on which that quantity was sold
100 15
200 45
300 60
400 30

Examples of combinations:
i. If 100 boxes are ordered and sold, the income is R200 (100 x 5 - 3).
ii. If 100 boxes are ordered and the demand is for 200, 300 or 400 boxes, the sales are
lost and the provisional value remains R200.
iii. If 200 boxes are ordered and demand is only for 100 boxes, the remaining 100 boxes
have to be destroyed at 25 cents each and the provisional value is then -R125 (200 x 3
+ 100 x .25 expense as opposed to income of 100 x 5).

Decision table
Alternative actions
Number of boxes
Demand 100 200 300 400
R R R R
100 200 (125) (450) (775)
200 200 400 75 (250)
300 200 400 600 275
400 200 400 600 800

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The probability distribution is:

Daily
sales
Number
of days
Probability (P)
100 15 0,1 (15/150)
200 45 0,3 (45/150)
300 60 0,4 (60/150)
400 30 0,2 (30/150)
150 1,0

The expected monetary value using the above formula is:
U (order 100 boxes) = * 200 (.1) + 200(.3) + 200(.4) + 200(.2)
= 200
*Income from 100 boxes = 100(5 - 3) = R200
U (order 400 boxes) = -775(.1) - 250(.3) + 275(.4) + 800(.2)
= 117.5

Expected monetary values:

Demand P Alternative actions
Number of boxes ordered
100 200 300 400
R R R R
100 .1 20 (12.5) (45) (77.5)
200 .3 60 120 22.5 (75)
300 .4 80 160 240 110
400 .2 40 80 120 160
Expected value 200 347.5 337.5 117.5
The best solution would therefore be to order 200 boxes. Note that the expected monetary
value is not the income that will be realised on one particular day, but the expected average
over a long period.

4.2 Expected value of perfect information
Perfect information refers to complete and accurate information. The expected value of
perfect information is the expected income that will be realised if the optimal number can be
bought every day and is calculated in the table below. The provisional values are the
maximum possible income for each sales volume.

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Expected value of perfect information
Demand P Provisional income based Expected
(boxes) on certainty value
100 .1 R200 R20
200 .3 R400 120
300 .4 R600 240
400 .2 R800 160
Expected value of perfect information R540
The value of additional information is:
Expected value of perfect information R540
Expected value based on risk (p6) 347.5
Value of additional information R192.50

The purchasing manager of the market must therefore not pay more than R192,50 for a
market researcher.

Do IM12.5 in Drury as practice and compare your answer with the suggested solution below.

Suggested solution IM 12.5
There are two possible selling prices and three possible direct material costs for each selling
price. The contributions per unit before deducting direct material costs are R12 (R15 - R3) for
a R15 selling price and R17 for a R20 selling price. The purchase costs per unit of output are
R9 (3 kg x R3), R8.25 (3 kg x R2.75) and R7.50. Where the firm contracts to purchase a
minimum quantity, any surplus materials are sold at R1 per kg.

Statement of outcomes
Sales
quantities
Gross
contribution
Net
purchase
cost
Fixed cost Profit /
(loss)
Probability Expected
value
(000) (R000) (R000) (R000) (R000) (R000)

R15 selling price (R3 purchase price)
36 432 324 65 43 0.3 12.9
28 336 252 65 19 0.5 9.5
18 216 162 65 (11) 0.2 (2.2)
20.2

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R15 selling price (R2.75 purchase price)
36 432 297 65 70 0.3 21.0
28 336 231 65 40 0.5 20.0
18 216 148.5 65 2.5 0.2 0.5
41.5

36 432 270 65 97 0.3 29.1
28 336 210 65 61 0.5 30.5
18 216 159* 65 (8) 0.2 (1.6)
58.0

R20 selling price (R3 purchase price)
28 476 252 136 88 0.3 26.4
23 391 207 136 48 0.5 24.0
13 221 117 136 (32) 0.2 (6.4)
44.0
28 476 231 136 109 0.3 32.7
23 391 189.75 136 65.25 0.5 32.625
13 221 126.5** 136 (41.5) 0.2 (8.3)
57.025

28 476 210 136 130 0.3 39.0
23 391 174*** 136 81 0.5 40.5
13 221 144**** 136 (59) 0.2 (11.8)
67.7
Notes:
* 170 000 kg minimum purchases at R2.50 per kg less 16 000 kg [70 000 - (3 kg x 18 000) at
R1 per kg].
** 50 000 kg minimum purchases at R2.75 per kg less 11 000 kg [50 000 - (3 kg x 13 000) at
R1 per kg].
*** 70 000 kg minimum purchases at R2.50 per kg less 1000 kg [70 000 - (3 kg x 23 000) at
R1 per kg].
**** 70 000 kg minimum purchases at R2.50 per kg less 31 000 kg [70 000 - (3 kg x 13 000)
at R1 per kg].

If the objective is to maximize expected profits then the R20 selling price combined with
purchasing option (iii) is recommended. On the other hand, if the maximin criterion is
adopted then the R15 selling price combined with purchasing option (ii) is recommended. An
alternative approach is to examine the probability distributions (final column of the statement)
and adopt a combination which best satisfies the decision-makers risk/return preferences.

(b) If demand is predicted to be optimistic, the highest payoff of R130 000 (R20 selling price
and R2.50 purchase price) for the most optimistic demand level would be chosen. If the most
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likely demand is predicted, the highest payoff is R81 000 (R20 selling price and R2.50
purchase price). If the pessimistic demand level is predicted, the highest payoff is R2500.
The expected value of profits assuming it is possible to obtain perfect information is:

R
R130 000 x 0.3 = 39 000
R81 000 x 0.5 = 40 500
R2 500 x 0.2 = 500
80 000

The highest expected profit without perfect information in (a) is R67 700. Therefore the
maximum price payable for perfect information is R12 300 (R80 000 - R67 700).

5. DECISION TREES R139
Refer to RECP 674 (Financial Management)
ASSIGNMENT

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13 LINEAR PROGRAMMING,
SHADOW PRICES AND
SENSITIVITY ANALYSIS



LEARNING OUTCOMES
- Use linear programming to find the optimal solution to a problem with multiple
constraints.
- Formulate linear programming equations and find solutions in graph form to maximise
profit or minimise cost.
- Apply the concept of shadow prices.
- Evaluate linear programming as a technique to make decisions where there are
multiple constraints concerning:
* Utilisation of capacity.
* Profitability of product lines.
* The desirability of additional marketing efforts.
* Limitation in capacity, direct labour or materials.
* Utilisation of storage space, etc.
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1. INTRODUCTION R215
- Decision making thus far: One constraint use contribution margin per limiting factor.
- What if there is more than one constraint? Linear programming (LP).
- Examples of problems that can be solved with LP:
i. Rationing scarce resources, e.g. capacity, raw material, direct labour hours.
ii. The combination of products to sell.
iii. Fixing transfer prices.
iv. Establishing transport routes.
- The purpose: Maximum profit or minimum costs.
- LP: A mathematical technique that can be used by management to determine how
limited resources can be used optimally.
2. ASSUMPTIONS AND LIMITATIONS OF LP V478, R220
- It is assumed that the coefficients (i.e. the values, costs, production requirements, etc.)
in the objective function and constraint equations can be determined with certainty and
will not change during the period.
- A linear relationship is assumed in the objective function and constraints.
- Divisibility: It is assumed that the decision-making variables in the optimal solution
need not be whole numbers, but may be fractions.
- Product independence: The assumption is that the demand for one product will not
affect the demand for another. If products are complementary, however, it could affect
demand.
- Accuracy of information: The final solution is as accurate as the information for the
model.
3. TERMINOLOGY R241
- Algebraic method: Once the determining constraints have been identified by means of
a graph, the optimal solution can be calculated by solving two equations algebraically.
- Constraints: Resources that are available in limited quantities and are formulated in
the linear programming model as mathematical equations.
- Upper bound: Indicates that the use of a resource must be less than or equal to (<) a
particular quantity.
- Objective function: Mathematical expression of a target or objective, e.g. maximising
profit or minimising costs.
- Duality: An alternative way of approaching a linear programming problem.
- Linear programming model: A decision model consisting of linear objective functions
and linear constraints.
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- Non-negativity constraint: A constraint that prevents decision variables from
assuming negative values. All decision variables must be greater than or equal to
zero, e.g. 0.
- Lower bound: Indicates that the use of a resource must be greater than or equal to
(>) a particular quantity.
- Shadow prices: The value of one additional unit of a resource that is already fully
utilised.
- Feasible region: The area on a graph in which any feasible solution must fall. It has
lower bounds below and left and upper bounds above and right.
- Profit line (cost line) method: The optimal solution is determined by plotting profit
lines arbitrarily on the graph. The optimal solution of a maximisation problem occurs
before the point that is the furthest away from the origin where the profit line intercepts
the feasible region (in minimising, this is the point closest to the origin).
4. USE OF LP R238
- In production: Production planning, product composition and mix composition.
- In marketing: Advertising and distribution, e.g. develop a system with LP to minimise
the transport costs to the various marketing territories.
- In human resources: Staff planning and composition.
- In financing: LP can be used in determining the optimal combination of sources of
financing and in investment portfolios to decide on shares and stocks.
5. STEPS IN LP H437, V467
i. Determine the objective function: Maximise profit or minimise costs.
ii. Identify the constraints: Examples: capacity, direct labour hours, materials.
iii. Determine the optimal solution with the aid of trial-and-error graphs.
Work through the example in Horngren 392 carefully, where all the steps are explained
clearly. Make sure you are very familiar with the algebraic and graph methods of
determining the optimal combination.
6. SENSITIVITY ANALYSIS H439, V474
Uncertainty in the LP model means that a change in the coefficients affects the slope of the
objective function or the area of feasible solutions, e.g. a change in the contribution margins
of the products will affect the optimal solution.
7. DUALITY AND SHADOW PRICES V469, R235
A shadow price is the value of an additional unit of a particular resource added to the existing
quantity (or the value of a unit that is removed). It is therefore the marginal change in the
objective function if a resource increases or decreases by one unit. The equation for the
shadow price is sometimes known as the dual problem.
If the primary objective function equation entails the maximisation of profit, the purpose of the
dual equation will be to minimise costs. The upper bounds (<) will be converted to lower
bounds (>) and vice versa. For management the most useable information that is obtained
by solving the dual is the shadow prices.

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Assume the following in an example:
XYZ Limited manufactures two products: A and B with the following production requirements:
Product A Product B
Selling price R60 R65
Variable cost:
Materials: 8 kg x R2 = R16 4 kg x R2 = R8
Labour: 6 hours x 4 = 24 8 hours x 4 = 32
Overheads: 4mh x 1 = 4 6mh x 1 = 6

Constraints: 2 880 direct labour hours, 3 440 kg direct materials
REQUIRED:
Using the algebraic method, determine what the optimal composition of the products must
be, taking the constraints into account.

- Objective function: 16A + 19B
- Equations: 8A + 4B < 3 440------- Only A A = 430, Only B B = 860
6A + 8B < 2 880------- Only A A = 480, Only B B = 360
A > 0 ; B > 0
Optimal composition A = 400, B = 60

x 2 : 16A + 8 B 6 880 - -
- 10A = 4 000 Substitute A = 400 in
A = 400 B =
4
) 400 ( 8 440 3
= 60
If machine hours are also a constraint, e.g. 2 760, the solution can be determined in a graph
by adding the equation 4A + 6B < 2 760 to the above two. Only A A = 690, Only B B =
460. If the problem is solved in a graph and the vertex method is used to substitute the
different alternatives for the composition of the products in the equation 16A + 19B, the
optimal composition is A = 400 and B = 60 as the highest contribution margin [400 (16) + 60
(19) = R 7 540].

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Shadow prices can be used to do a sensitivity analysis on the availability of the constraint.
For 400 of A and 60 of B the two constraints, i.e. 2 880 direct labour hours and 3 440 kg
direct material, are fully utilised. By the way, this was the intersection of these two
equations.

Here is an example to illustrate the shadow price concept. Assume that 10 direct labour
hours are lost and only 2 870 direct labour hours are available.

The new optimal product mix will still be at the intersection of:
8A + 4B < 3 440
6A + 8B < 2 870
Solve simultaneously A = 401 and B = 58

The new contribution margin is 16 (401) + 19 (58) = R7 518. Compare this with the previous
contribution margin of R7 540. This indicates a drop in contribution margin of R22 caused
by the 10 lost direct labour hours the shadow price per hour is R22 10 = R2,20.
Do the same for materials and work out that the shadow price for materials is R0,35/kg.

8. SIMPLEX METHOD V476, R255-279
- So far the application of LP has been limited to problems with two decision variables
and it was possible to find solutions using a two-dimensional graph.
- Problems often have many, sometimes even hundreds of, variables and the scope of
the problems is too big for a two-dimensional graph.
- The simplex method can be used to solve LP problems with several variables.
- The simplex method is an algebraic procedure of systematic iteration. The principle is
simple and similar to the graph vertex method. Because of the many different levels
and dimensions it is not possible to draw the feasible region on a graph, but the optimal
solution will still be at the vertex.
- The simplex method evaluates each vertex by starting at a certain vertex and
systematically and iteratively (i.e. by repeating the same procedure each time) moving
to the next vertex until the optimal solution has been found. The starting point is an
initial feasible solution that is systematically adjusted in a way that improves the
objective function with each iteration. Each iteration is therefore closer to the optimal
solution.
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- The repetitive nature of this procedure makes it extremely suitable for solving by
computer.

EXAMPLE: THREE CONSTRAINTS (add the following to the example in paragraph 7)
Suppose there is a constraint of machine hours, i.e. 2 760. Now the optimal composition
can be indicated in a graph as below.

The equation for the constraint of machine hours is:
4A + 6B 2 760 ONLY A A = 690, ONLY B B = 460

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S
R
Products A and B will be plotted on the x- and y-axis, respectively, as follows (DLH in black,
MH in blue, materials in red):
B

9

8

7

6

5

4

3 Q

2

1

E
(00) P 1 2 3 4 5 6 7 8
(00) Units

Do 12.5 in Vigario as practice and compare your answer with the suggested solution below.

Polygon: P Q R S Objective function 16A +
19B
(feasible region)
P: 16(0) + 19(0) = 0
Q: 16(0) + 19(360) = R6 840
*R: 16(400) + 19(60) = 7 540 Optimal
S: 16(430) + 19(0) = 6 880
*Determined algebraically in paragraph 7.
For a contribution margin of R6 080 the
profit line (in green) can be plotted.
(A =
16
080 6 R
= 380)
(B =
19
6080 R
= 320)
More contribution margin lines could be
included (arbitrarily)
A
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Vigario 12.5
a)
Gamma Delta
Contribution margin
Contribution
margin/blending hour
R4 000/kg
R4 000/100 blending
hours
= R40/blending hour
R8 000/kg
R8 000/250 blending
hours
R32/blending hour

Contribution margin R4 000 x 10.5 kg = R42 000
- FC 36 000
Income R6 000

This point is the optimal, since Gamma earns R40 per blending hour and Delta only R32 per
hour. This is true because blending hours are the only constraint and any potential loss if
Delta is not sold is not taken into account the reason being that it is not relevant.

b) Objective function = 4 000G + 8 000D
Constraints: G: D > 0 400G + 120D s 1 200
100G + 90D s 450
100G + 250D s 1 050

Vertices:
A: 4 000 (3) + 8 000 (0) = R12 000
B: 4 000 (2.25) + 8 000 (2.5) = R29 000
C: 4 000 (1.125) + 8 000 (3.75) = R34 500 (optimal)
D: 4 000 (0) + 8 000 (4.2) = R33 600
Profit = R34 500 36 000 = (R1 500) loss
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c) Implications:
Question 2 implies a loss of R1 500 for the three months, so the following must be
considered:
- Are there other more profitable products to produce with the limited capacity?
- Is it possible to expand capacity, e.g. through overtime, outsourcing?
- Are the fixed costs unavoidable or what would happen if other products were
produced?
- How will demand for the products in the future change?
- Can Gamma or Delta be bought externally or only made internally?
- Can selling prices be raised or is there any other way of saving costs?
- Can unrefined Gamma or Delta be sold to overcome a temporary production shortage?

d) Blending:
100G + 90D s 450
100G + 250D s 1 051
D s 3.75625
G s 1.119375
4 000 (1.119375) + 8 000 (3.75625) = R34 527.50
Compared to R34 500 (of 2)
Management will not pay more than R27,50 for the additional blending hour.
Refining:
100G + 90D s 451
100G + 250D s 1 050
D s 3.74375
G s 1.140625
4 000 (1.140625) + 8 000 (3.74375) = R34 512.5
Compared to R34 500 (of 2)
Management will not pay more than R12,50 for an additional refining hour.
This information can be used in the following ways:
- Usine will pay up to R12,50 more than the normal rate for an extra refining hour.
- Other uses of the refining time is that at least R12,50 per hour must be recovered and
shadow prices can be used to determine rates for new products when they have to be
evaluated.
The limitation of shadow prices is the same as for linear programming, with one other
important issue, namely that shadow prices will only be relevant for a particular range. If
more refining hours become available, the constraint on the graph will move further right and
the composition changes for determining the most profitable combination.
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Other limitations:
- Are the objective function and constraints linear functions?
- Reliability of estimates?
- Are there no other constraints?
- Qualitative factors?
- Interdependence, e.g. the sales volume of one product may affect the sales of other
products.
ASSIGNMENTS

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14 TRANSFER PRICING AND
SERVICE DEPARTMENTS



LEARNING OUTCOMES
- Discuss the objectives of transfer pricing.
- Discuss the objectives and method of target pricing.
- Discuss transfer pricing when the transferring division sells to the external market and
when it sells only to an internal division.
- Explain why cost-plus transfer prices will not maximise group profits.
- Discuss multinational transfer prices and tax considerations.
- Discuss and prepare life cycle budgets.
- Discuss departmentalisation and allocate costs in service departments and production
departments.
- Discuss and apply four methods of determining transfer prices.
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1. INTRODUCTION H794
- Pricing decisions not only involves those decisions made by management about the
price of a product or service, but also include decisions about the profitability of
products.
- Costs must be known in order to set prices. Unfortunately there is no single method to
determine costs for pricing because the pricing may be for different purposes. For
example, a price for a special order is based on variable costs and a price for the long
term is based on total costs (FC + VC).
- Three important factors that can influence a price are customers, competitors and
cost (the 3Cs).
- An internal focus, i.e. continuous improvement, is key to keeping costs low.
2. MANAGEMENT CONTROL SYSTEMS H795
- A management control system is a means of gathering and using information to
coordinate planning and control decisions throughout the organisation.
- Levels of management control systems:
i) Total organisational level: For example, inventory price, net income, return on
investment, total employment.
ii) Customer/market level: For example, customer satisfaction, time taken to respond to
customer requests for products and cost of competitors products.
iii) Individual-facility level: For example, materials costs, labour costs, absenteeism
rates and accidents in various divisions of business functions, i.e. R&D, production and
distribution.
iv) Individual-activity level: For example, time taken and costs incurred for receiving,
storage, assembly and distribution.
Financial and non-financial information is gathered.
3. CONSIDERATIONS OTHER THAN COST IN PRICING DECISIONS
- Target price: This is an important form of market-based price. It is the estimated price
of a product or service that potential customers will be prepared to pay.
- Target profit: This is the income (profit) that a business wants to earn on a product or
service.
- Target costs: These are the estimated long-term costs per unit (product or service) if it
is sold for the target price.
- Costs that are relevant for target costing: FC + VC.
- Target costs are used by Ford, General Motors, Mercedes, Toyota, Panasonic, Sharp,
Compaq and Toshiba.
- Implementation of target costing.
- Pricing with target costing works opposite to cost-based pricing. The steps are as
follows:
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i. Develop a product that satisfies the needs of potential customers.
ii. Choose a target price that will be acceptable to potential customers.
iii. Subtract the target profit from the target price to obtain the target cost.
iv. Design and develop the product at the target cost (note that re-planning, value-
chain analysis and valuation are allowed to come off the target costs).
- Target costing is customer oriented because it starts with the selling price.
- Distinguish between price discrimination and peak load pricing.
4. DEPARTMENTALISATION H572
- Cost allocation: Costs relating to more than one department or activity can be
allocated in various ways, e.g. between production departments and also to service
departments.
- Cost allocation and service departments: Refer to MACC221.
i. Direct allocation method: This is the most common method where the costs of
the service departments are allocated directly to the production departments, e.g.
by means of a measure such as maintenance hours, cafeteria workers etc.
ii. Step-down allocation method: Service department costs are allocated in a
particular sequence.
iii. Reciprocal allocation method: The mutual services of service departments to
one another are taken into account, which means that a service department may
receive costs after its own have been allocated.
5. RESPONSIBILITY CENTRES H799
To measure the performance of subunits (departments) in centralised and decentralised
organisations, management can use one or a combination of four types of responsibility
centres:
i. Cost centre: Control over costs.
ii. Income centre: Control over income only.
iii. Profit centre: Control over income and expenses.
iv. Investment centre: Control over investment, income and expenses.
6. TRANSFER PRICING H799+, D503, V505
- Transfer price: The price at which a product or service is transferred from one
segment/department to another within the organisation.
- Methods of determining transfer prices:
i. Market-based transfer prices: This represents the price of a similar product or
service external to the organisation.
ii. Cost-based transfer price: This cost base may be a marginal cost (variable
cost) or an absorption cost (total cost) base, depending on capacity. It may be an
actual or budgeted cost.
iii. Negotiated transfer price: This price is set after negotiation between the
departments concerned or price negotiations could be held with external parties.
Work through the example in Horngren H766+ (767) and the explanation of the
theory H767+ (768+).
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iv. Target profit: V290. Vigario adds a fourth method, i.e. target profit, which is
also based on cost but with the addition of a fixed percentage for profit. This
method is used when a market price is not available or when the above methods
produce unsatisfactory results.
7. GENERAL GUIDELINES FOR TRANSFER PRICING D512, H808, V507
The minimum transfer price must be based on variable costs plus opportunity costs
(forfeited contribution margin on existing products of the supplying department).
If there is no capacity: Minimum transfer price = VC or incremental costs + Opportunity
costs.
If there is capacity: Minimum transfer price = VC or incremental costs.
8. TRANSFER PRICING AND SELLING MARKETS V509
- Transferring department.
- Receiving department.
- Transfer price.
- Goal congruence.
- Perfect and imperfect markets.

Study Vigario 505 to 523 and work through the examples. Note when there is an external
market for the product and when not and also when there is a market for the transferring
department and for the receiving department.

Do Drury IM 20.5 and Horngren 22.21 as practice and compare your answer with the
suggested solutions below.
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Solution IM 20.5
The report should include an estimate of divisional profits and return on investment (ROI)
based on current demand:

Division A Division B
(R000) (R000)
Contribution from outside sales 1500 250
Contribution from internal transfers 375 ___
Total contribution 1875 250
Fixed costs 500 225
Profit 1375 25
Investment 6625 1250
ROI 20.8% 2%

Assuming there is a single market price of R30, the current system is motivating correct
decisions since both managers are encouraged to expand output. However, the current
transfer pricing system is causing motivational problems because it under estimates the
contribution which division B makes to overall company profits. In other words, the current
system results in an inadequate measure of divisional performance. Division A has 30 000
units capacity available to meet the demand of Division B. Therefore Division A can meet the
demand of Division B without forgoing any sales to outside customers. Consequently the
relevant cost of the transfers is R15 per unit variable cost. A transfer price of R15 per unit
would be unfair to Division A, since internal transfers would not provide any contribution to
fixed costs. A possible solution is to set the transfer price at R15 per unit, and Division B
should also pay Division A an annual lump sum contribution to cover the fixed costs of
Division A. Total output of Division A is 125 000 units, consisting of 100 000 units outside
sales and 25 000 units internal transfers. Therefore 20% of Division As capacity is devoted
to Division B, and thus the lump sum payment should be R100 000 (20% of R500 000 fixed
costs). If in any year it is anticipated that demand in the external market will be in excess of
Division As capacity, the transfer price should be set at the prevailing market price. It is
assumed that additional sales of 5 000 units of product J can only be obtained if a new
branch is opened. The incremental costs to the company are R175 000 (R125 000 variable
cost + R50 000 establishment costs) and the incremental revenues are R250 000. Therefore
total company profits will increase by R75 000 if the new branch is opened. However, with
the present transfer pricing system Division B will regard the transfer price as an incremental
cost. Consequently contribution will be R10 per unit and the annual establishment costs of
R50 000 will equal Division Bs total contribution of R50 000. Therefore Division B profits will
remain unchanged and the manager will not be motivated to open the new branch. If the new
branch is opened then, with the present transfer pricing system, the R75 000 additional profit
will be allocated to Division A.

A transfer price system consisting of R15 variable cost plus a lump sum payment is
recommended. The revised transfer pricing system will motivate the manager of division B to
open the new branch. The divisional profit calculations (without the new branch) based on
the proposed transfer pricing system are as follows:

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Division A Division B
(R000) (R000)
Contribution from outside sales 1500 625
Contribution from internal transfers - -
Lump sum payment 100 (100)
Fixed costs (500) (225)
Profit 1100 300
Investment 6625 1250
ROI 16.6% 24%
H 22.21
Transfer price
@ MP
Transfer price @
110% x man. cost
1.
Mining Division:
Income: 400 000 x R90, 60 x 110% R36 000 000 R26 400 000
Less: Costs:
VC: 400 000 x (12 + 16 + 24) 20 800 000 20 800 000
FC: 400 000 x 8 3 200 000 3 200 000
Division operating income R12 000 000 R2 400 000

Metals Division:
Income: 400 000 x R150 R60 000 000 R60 000 000
Less: Costs:
Transfer costs of preceding department
400 000 x R90, 60 x 110% 36 000 000 26 400 000
Division VC: (6 + 20 + 10) x 400 000 14 400 000 14 400 000
Division FC: 15 x 400 000 6 000 000 6 000 000
Division operating income R3 600 000 R13 200 000

2.
Bonus:
Mining Division (1%) R120 000 R24 000
Metals Division (1%) 36 000 132 000

The Mining Division manager would prefer the transfer price @ MP and the Metals Division
manager would prefer the transfer price @ 110% x manufacturing costs. Give figures.
3. Class discussion. Jones would prefer the market price to the transfer price because it
yields the highest bonus and competition exists that makes the market price relevant. This
leads to goal achievement.

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9. MULTINATIONAL TRANSFER PRICES AND TAX CONSIDERATIONS
D517, H810
Work through the example in Horngren H813.
10. LIFE CYCLE BUDGETING AND COSTING
- Product life cycle: This spans the time from the development of the product until it
reaches the customer.
- Life cycle budgeting: These budgets contain the income and expenses of a product
or entity from research and development until customer service.
- Life cycle costs: These consist of all the actual costs of each product from the cradle
to the grave.
- Life cycle budgeting can be used in pricing.

Do 13.3 in Vigario as practice and compare your answer with the suggested solution below.

VIGARIO 13.3
a) Contribution margin/U (1 000u) (2 000u) (3 000u) Govt contract
SP R170 R150 R120 R125
70 70 70 70
-VC 16 16 16 16
= Contr margin 84 64 34 39
Number U 1 000 2 000 3 000 1 000
=Total contribution R84 000 R128 000 R102 000 R39 000

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Income statement for 19x1
Contribution margin: 1 000U x R39 (Govt contract) = R 39 000
2 000U x 64 128 000
Total contribution margin R167 000
-FC: Manuf. overheads R24 x 3 000U = R72 000:
Avoidable = 50% 36 000
Depr. = 30% 21 600
Head office = 20% 14 400
Net operating income R72 000

b) 1 000U x (R170 86) = R84 000
2 000U x ( 150 86) = 128 000
3 000U x ( 120 86) = 102 000

R161 - VC(86) = R75 x 2 000U = R150 000
151 - 86 = 65 x 3 000U = 195 000 desired demand
111 - 86 = 25 x 4 000U = 100 000
Income statement for 19x2
Contribution margin: Open market: 2 000 x 64 R128 000
* Internal division: 3 000 x 22.50** 67 500
Total contribution margin R195 500
-FC: Avoidable: (36 000 + 30%) 46 800
Depr. 21 600
Head office 14 400
Net operating income R112 700
*The maximum group profit will be realised if 2 000 units are sold on the open market
(the highest contribution margin) and the rest based on transfer prices to the receiving
division.

Lowest transfer price:
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1 000U x R125 (Govt contract)
Rest 2 000U x R86 variable costs

Highest transfer price:
If 2 000U produced, contribution margin is R150 000.
If 3 000U produced, contribution margin is R195 000.
Therefore for 1 000U extra, contribution margin increases to R45 000, which yields a
contribution margin/U of R45.

The highest transfer price will therefore be:
VC + Contribution margin
= R86 + R45
= R131/U

The mid transfer price:
For the 3 000U = (86 + 131) 2 = 108.50

Contribution margin: 3 000U x (R108.50 86) = R22.50**

c) Performance evaluation can be in the long or short term. For the long term, capital
invested must also be taken into account. Then measures (criteria) such as return on
investment (ROI), return on sales (ROS), residual income (RI), and economic value
added (EVA) will be relevant.
For the short term performance evaluation can take place to determine bonuses of
divisional managers. The issue of ethics is involved here and it is important to note the
overall performance of the organisation, otherwise strong competition between
divisions may derail the pursuit of the organisation objective to the long-term benefit of
the organisation as a whole. Performance criteria of the whole organisation may
include increase in sales volume, market share of product sales, manufacturing
efficiency, product quality and customer satisfaction, new products and employee
relations.

ASSIGNMENTS
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SUPPLEMENTARY TO TRANSFER PRICING (D501-526, CIMA 436-452)
1. Aims and aspects
Any transfer pricing system must aim at the following:
- To ensure that resources are allocated optimally.
- To provide information to make good economic decisions.
- To be useful in evaluating division performance.
- To shift profits between divisions.
- To ensure that divisional autonomy is not undermined.
- To promote goal congruence.
- To motivate divisional managers.
- To facilitate management performance.
The overall aims must be simple calculations and implementation, and not frequent
adjustments.

2. General rules for implementing transfer pricing
Minimum: The minimum price will always be the variable costs plus consideration of
circumstances such as capacity and how it is to be obtained, e.g. overtime, sacrificing other
products, acquiring additional assets. Factors such as the market price of products of the
supplying departments external sales also make things difficult, but the minimum remains
the margin cost plus circumstances.

Maximum: The lowest market price at which the purchasing department obtains the goods
or services externally less any internal cost savings in packaging and delivery.

This is because:
(a) the transferring department will not agree to transfer units if the price is lower than the
marginal cost plus opportunity costs and
(b) the receiving department will not accept internal products if the internal price is higher
than the price at which the product can be bought externally

3. Methods for setting transfer prices
3.1 Cost-based prices
These include marginal costs, absorption costs, standard costs and marginal costs plus a
two-part tariff. Actual costs can vary with volume, season and other factors, and if actual
costs are used as the basis for the transfer price, any inefficiency in the production
department will be transferred to the receiving department. For this reason, standard costs
are recommended instead of actual costs so that the transferring departments efficiencies
and inefficiencies are carried by that department itself.
i. Marginal costs: Be careful about using marginal cost alone if you are not sure of the
related circumstances as discussed in paragraph 2. Remember the concept of
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opportunity cost which arises if the transferring department already has an external
market for the product being transferred.
ii. Absorption costs: If this method is used to set the transfer price, the variable and fixed
costs must be included. The principles are the same as for relevant costs, but you
must consider here that two departments are involved and the organisation as a whole
cannot be placed at a disadvantage.
iii. Standard costs: The transferring department may not transfer its inefficiencies to the
receiving department and standard costs will eliminate this risk, except that the volume for
the allocation of fixed costs must be selected carefully.
iv. Two-part tariff: In this method the transferring department will ask a price equal to the
marginal cost (including the opportunity cost) plus a fixed annual fee for the privilege of
receiving the product or service at that price.
3.2 Market-based prices
- For decision-making and performance evaluation purposes, it is optimal to set the
transfer price at competitive market prices and this will be used when there is a
perfectly competitive market.
- A perfectly competitive market exists when all products are homogeneous and no
buyer or seller can affect the prices.
- With this pricing strategy, the income of each division will be the same as if they were
separate organisations.
- In a perfectly competitive market, the transferring department will have to produce as
much as the receiving department requires (at the current market price) for as long as
the incremental costs are lower than the market price. If the quantity is insufficient for
the receiving department, additional units must be obtained by buying externally at the
current market price.
- The transferring department may give the buying department discount on the variable
selling expenses that are saved if the product is sold internally.
- The market price for the intermediary product (the product transferred between
departments or divisions) is suitable only when the quality, delivery, discount and
support services are the same.
(Consult Vigario 505 to 523 for the circumstances in which an external market exists for the
product and when not for the transferring and receiving departments.)

3.3 Marginal cost
This method may be to the disadvantage of the transferring department because the product
must be produced at a price lower than the cost. This in essence means that this department
is subsidising the receiving department. The following economic theory applies: For an
imperfect market the marginal cost will be the correct price to use if the groups income is
optimised.
The motivation and morale of the transferring department may suffer because there is risk in
recovering the fixed costs. The marginal cost base may be adjusted with a mark-up to
overcome this problem.
The principle, as with relevant costs, is:
- If there is spare capacity, products/services are transferred at variable cost.
- If there is no spare capacity, transfer is at variable cost plus lost contribution margin.
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Example
Situation 1
The capacity of division A is to manufacture 20 000 units. It currently only manufactures
15 000 which it produces for the market. The variable cost is R100 per unit. Division B needs
3 000 units in its production cycle. The transfer price is therefore R100.
Situation 2
The capacity of division C is 20 000 units. It currently only manufactures 19 000 which it
produces for the market. The variable cost is R100 per unit and the selling price is R200.
Division D needs 3 000 units in its production cycle.
Contribution margin per unit: R100 demand capacity
Lost sales (19 000 + 3 000 = 22 000 20 000 = 2 000 units lost)

Variable costs: R100 x 3 000 = R300 000
Opportunity costs: R100 x 2 000 = R200 000
Contribution margin lost
Total cost R500 000
Units 3 000
Cost per unit R167

Study the example from Drury 509-512 after paragraph 3.5.
In the absence of a perfect market for intermediary products, none of the transfer pricing
methods can achieve both the objectives of decision making and performance measurement
perfectly, and divisional autonomy is also undermined.
Intervention by head office may be necessary to instruct the selling division to transfer
products at marginal cost, thus undermining autonomy.
A better option is to transfer at marginal cost plus a fixed lump sum (e.g. R100 per unit and
R10 000), or dual prices, where different prices are set for different quantities.
3.4 Dual prices
This method is used to overcome the problems of marginal costing, such as keeping the
morale of the transferring department high and motivating them to maximise the group profit.
The dual pricing method means that two prices are used:
- The transferring department is credited with a price equal to cost plus mark-up.
- The receiving department is debited with the marginal cost.

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The transferring department is therefore also permitted to realise a profit and the receiving
department has the right information to make the right sales decision to maximise the group
profit. The difference between the two prices is debited to the groups account, i.e. Transfer
price adjustment account, and is taken into account at the end of the year to calculate the
groups profit.
Dual prices can also be used with the market price instead of the marginal cost for the
receiving department. They are not used often because they are complicated to administer,
include head offices involvement in accounting and the other methods we have discussed
are more practical.
3.5 Negotiated price
- As mentioned, it is important for divisional managers to have equal bargaining power.
- Unequal bargaining power may occur if one division is small and all its products or
services are sold to another very large division, and the purchases constitute a small
part of the large divisions total purchases.
- Sometimes it is necessary and essential for top management to intervene if divisions
cannot reach a compromise.
- Negotiated transfer prices are therefore more suitable if there is an imperfect market.
Problems
- Because the price agreed upon depends on the negotiating skills and bargaining power
of the divisional heads, this may lead to:
E Suboptimal decisions for the company as a whole
E Unfair performance measurement
- This may lead to conflict between divisions which may necessitate management
intervention.
- This is very time consuming for management and may mean that they have less time
to spend on other management responsibilities.

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15 PERFORMANCE
MEASUREMENT



LEARNING OUTCOMES
- Distinguish between financial and non-financial performance measures.
- Discuss the balanced scorecard according to:
* Four perspectives.
* Elements of a well-balanced scorecard.
* Implementation problems.
- Describe the following performance measures and evaluate the performance of an
enterprise or division in an enterprise:
* ROI and compare it with the Du Pont method
* Residual income (RI)
* Economic value added (EVA)
* Return on sales (ROS)
- Discuss the alternative definitions for performance measures.
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- Discuss performance measurement in multinational companies.
- Discuss the ethical responsibilities involved in performance measurement.

1. INTRODUCTION H824
- So far we discussed performance management in a particular context, but in this study
unit the design, implementation and uses of performance measurement are more
general.
- Performance measurement and evaluation and reward are key elements for motivating
employees.
- Measuring the performance of an organisations subunits (departments) is essential for
allocating resources within the organisation.
- Performance measurement of managers is used in decisions about their salaries,
bonuses, future tasks etc.

2. FINANCIAL AND NON-FINANCIAL PERFORMANCE MEASURES H825
- Most performance measures, e.g. operating income, rely on internal financial and
accounting information. In addition, external financial information can be used, such as
share prices, internal non-financial information (e.g. waiting time in manufacturing) and
external non-financial information (e.g. customer satisfaction). Businesses can
compare their financial and non-financial performance measures with others through
benchmarking.
- Businesses can show their financial and non-financial performance measures of all the
subunits (department) in a single report, i.e. the balanced scorecard.

3. BALANCED SCORECARD D576, H492-499
- The management accountants role to implement a strategy, e.g. the balanced
scorecard.
- Balanced scorecard: Rewriting the enterprises mission and strategy in a
comprehensive set of performance measures that provide a framework for
implementing its strategy. It contains financial and non-financial goals of the
organisation.
- Performance evaluation from four perspectives:
* Financial
* Customer
* Internal business process
* Learning and growth
- Purpose of a balanced scorecard: Balance financial and non-financial performance
measures to evaluate short- and long-term performance in a single report.
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- Re-engineering: Fundamental reconsideration and redesign of the business process to
make improvements to critical measures of performance such as cost, quality, service,
speed and customer satisfaction.
3.1 Four perspectives of the balanced scorecard D576-583, H493
- Financial: Evaluate the profitability of the strategy, e.g. which part of operating income
and return on capital was affected by reducing costs or increasing sales.
- Customer: This perspective identifies the target market segments and measures the
companys success in these segments.
- Internal business process: Focus on internal activities, i.e. three sub processes such
as innovation, operations and after-sales service.
- Learning and growth: Identify the ability of the organisation to distinguish itself from
competitors by pursuing superior internal processes that can be of value to customers
and shareholders.

Information on the balanced scorecard:
i. Profitability measures: Operating income, income growth, ROI and EVA.
ii. Customer satisfaction measures: Market share, customer response time, on-
time performance, product reliability and customer complaints.
iii. Efficiency, quality and time measures: Direct materials efficiency, overheads
spending variance and return on defects as a % of production.
iv. Innovation measures: Number of new patents, number of new products
introduced, new product development time and spending on research and
development.
3.2 Elements of a good balanced scorecard H497
i) It tells a story about the organisations strategy (cause-and-effect relationships).
ii) It helps to communicate the strategy to all members of the organisation.
iii) Places strong emphasis on financial objectives and measurement.
iv) Limits the number of measures to the most critical.
v) Emphasises managements error of not dealing with operational and financial
measures together.
3.3 Problems in implementing the balanced scorecard H498
i) Dont assume the cause-and-effect link is precise.
ii) Dont constantly look for improvements in the measures.
iii) Dont only use objective measures in the balanced scorecard.
iv) Consider costs and benefits.
v) Dont ignore non-financial measures in evaluating managers and employees.
vi) Dont use too many measures.
4. DESIGN OF AN ACCOUNTING-BASED PERFORMANCE MEASURE H826
Take the following steps:
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i) Choose the performance measures that represent top managements financial goals,
e.g. operating income, return on assets or income (paragraph 4).
ii) Choose the time horizon of each performance measure in step (i) (paragraph 5).
iii) Choose definitions of the terms included in each performance measure in step 1
(paragraph 6).
iv) Choose measurement alternatives for each performance measure in step 1 (paragraph
7).
v) Choose a target level of performance, e.g. should all divisions (departments) have the
same rate of return on assets as their goal? (paragraph 8).
vi) Choose the timing of feedback, e.g. should performance reports be sent daily, weekly
or monthly to top management? (paragraph 9).

5. PERFORMANCE MEASURES H826
Step 1
5.1 Return on investment (ROI) D482, V545, H827
Calculated from Operating income
Investment
Also known as accounting rate of return. Businesses differ on the denominator and the
numerator and take net income instead of operating income or total assets instead of total
assets less current liabilities as the denominator.
Du Ponts method of profitability analysis contains two parts for profit: the use of assets to
earn more income and increase income in rands. See the example in Horngren p. 824+ for
the explanation of the Du Pont method.

assets Total
Income
x
Income
income Operating
=
assets Total
income Operating

5.2 Residual income D483, H829, V552, 557+
This is calculated from income less the required ROI. The required ROI is also known as
imputed costs.
Work through the example in Horngren on p. 483.

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5.3 Economic value added D484, H830, V552
EVA is equal to the after-tax operating income less the after-tax weighted average cost of
capital multiplied by total assets less current liabilities.
EVA = After-tax operating income - [WACC x (Total assets Current liabilities)]

5.4 Return on sales H831
ROS is one component of return on investment in the Du Pont method of profitability
analysis.
ROS = Operating income Sales

6. CHOICE OF TIME HORIZON H832
Step 2
- The ROI, RI, EVA and ROS calculations all represent the results for a single period.
- Subunits, e.g. divisions within a business, can be evaluated by the above performance
measures over a number of years. For comparison purposes the performance over a
number of years is very valuable.

7. ALTERNATIVE DEFINITIONS FOR PERFORMANCE MEASURES H833
Step 3
i) Total assets available: Include all assets regardless of their specific purpose.
ii) Total assets employed: All available assets less the sum of all unutilised assets and
assets bought for future expansion.
iii) Total assets employed less current liabilities: This definition excludes part of total
assets employed that are financed by short-term creditors.
iv) Shareholders equity

8. CHOICE OF MEASUREMENT ALTERNATIVES FOR PERFORMANCE
MEASURES H833
Step 4
- Current costs
- Longer term assets: Gross or net book value. Note example H833.

9. CHOICE OF TARGET LEVELS OF PERFORMANCE H836
Step 5
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These target levels entail setting targets (goals) to compare the actuals. A popular method is
to set targets that continuously improve.
10. CHOICE OF TIMING OF FEEDBACK H836
Step 6
The timing of the feedback depends largely on how critical the information is for the success
of the organisation, the specific level of management receiving the feedback and the
sophistication of the organisations information technology.


Solution IM 19.7
Return on investment
A B C D
Profit (Rm) 4.0 1.1 1.2 0.5
Net assets (Rm) 23.5 9.5 4.0 1.8
Return on investment 17.02% 11.58% 30% 27.78%

Residual income
Profit (Rm) 4.0 1.1 1.2 0.5
Interest charge (16% on net assets) (Rm) 3.76 1.52 0.64 0.29
Residual income (Rm) 0.24 (0.42) 0.56 0.21

Assumptions
The divisions are investment centres, and it is therefore appropriate to charge
managers an imputed interest charge on divisional assets. The interest/cost of capital charge
is based on the average cost of capital for the company (0.4 *10% + 0.6 *20% = 16%). It is
assumed that the risk attaching to the activities of each division is equivalent to the average
overall risk on the companys assets. If risk varies from division to division, a different
percentage cost of capital/interest charge should be applied to each division. The higher the
risk, the higher should be the interest charge. The group interest charge has been ignored,
since it is a purely notional charge which bears no relation to the companys cost of capital.
The above calculations are after taking into account the exchange gain by division A. It is
assumed that managers are accountable for foreign exchange management where overseas
transactions occur. However, the exceptional charge to division C has not been included in
the above calculations, since it is assumed to be an exceptional item and results from a
decision taken at head office level. The profits are after charging depreciation, since this
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reflects a charge for the use of divisional assets. It would be preferable to base the
depreciation charge on replacement cost rather than historical cost. For a detailed discussion
of the usefulness of residual income (RI) and return of investment (ROI) see Chapter 19. The
answer should stress that ROI is a relative measure which gives an approximate indication of
the return on a divisions investment. This can be compared with an appropriate cost of
capital and thus signify whether or not divisional investments are obtaining adequate returns.
The measure highlights those divisions where economic viability may need to be reviewed
using appropriate relevant economic cost and revenue estimates. ROI can also be used for
comparing the returns between divisions of different sizes. It is also widely used by financial
analysts for making intercompany comparisons. RI is an absolute measure which in the long-
run takes into account the opportunity cost of an investment and is equivalent to NPV. By
making a risk-adjusted cost of capital charge, risk is incorporated into the performance
measure. RI also encourages managers to invest in projects whose returns are in excess of
the cost of capital. Possible standards for comparison include budgeted/target ROI or RI,
comparisons with other divisions within the group, comparisons with previous periods and
comparisons with similar companies operating outside the group. However, care must be
taken to ensure that one is comparing like with like and that the measurements are
consistent and based on the same asset valuation and profit measurement principles.

(b) It is unclear whether the question relates to the evaluation of the division as an
economic entity or the evaluation of the performance of the divisional managers. Where the
economic performance of a division is being evaluated, all head office costs should be
allocated to divisions. Allocations should be based on benefits received (e.g. sales values for
the credit control department) using appropriate cost allocation bases. Alternatively a transfer
pricing system can be established for those head office services where divisional usage can
be measured. Head office costs are joint costs, and it is inevitable that arbitrary allocations
will be used to trace some costs to divisions. Care should therefore be taken when
interpreting the economic performance of a division, and the performance measures should
be seen as a monitoring system which can be used to trigger off an economic investigation of
the viability of a division. For evaluating managerial performance, only controllable head
office expenses should be charged to divisional managers. For the answer to this part of the
question see Alternative divisional profit measures in Chapter 19. Arbitrary allocations
should be avoided. It is preferable to use transfer prices based on divisional usage when
charging head office costs to divisional managers.

(c) The main problems are:
(i) The initial high investment together with long paybacks may result in a low ROI or
negative RI in the early years of a projects life.
(ii) The cash flows are more uncertain in high-tech industries, and it is therefore
difficult to set budgets against which to monitor actual performance.
(iii) Many of the benefits are of a qualitative nature and not easy to quantify.
(iv) It is difficult to establish an appropriate cost of capital which takes into account
risk when calculating RI. If ROI is used, the ROI should be higher to compensate for
the increased risk. However, it is extremely difficult to determine the additional return
which is required to justify the additional risk.
(v) The RI and ROI measures are overstated if written down values are used in the
calculations. Managers will be reluctant to replace old assets with new assets,
because this will lead to a large increase in the investment base and an
accompanying decline in ROI and RI.

The following actions should be taken to improve these measures:
(i) Value assets at replacement cost instead of historical cost. Depreciation charges
should also be based on replacement costs (see The impact of depreciation in
Chapter 19).
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(ii) Use other performance measures in addition to ROI and RI so that some of the
dysfunctional consequences which arise from placing too much emphasis on single
financial measures can be avoided (see Addressing the dysfunctional consequences
of short-term financial measures in Chapter 19).
(iii) Set realistic budgets and accept that cash flows may decline in the short term.
Compare actual results with realistic budgets and avoid placing too much emphasis on
short-term results.
(iv) Use risk-adjusted imputed interest charges using the capital asset pricing model (see
Chapter 14). For a more detailed discussion of the conflict between short-run and long-
run performance measures and alternative depreciation methods see Learning Note
19.1 on the open access website.
11. PERFORMANCE MEASUREMENT IN MULTINATIONAL COMPANIES
H837
Comparing the performance of divisions of a multinational company is difficult because:
i) The difference in economic, legal, political, social and cultural environments,
ii) Control over selling price,
iii) Availability of materials and skilled labour as well as the cost of materials, labour and
infrastructure and
iv) Different currencies.

12. DISTINCTION BETWEEN MANAGERS AND ORGANISATIONAL UNITS
H839
- Incentives regarding risk.
- Intensity of incentives and financial and non-financial measures.
- Benchmarking and relative performance evaluation.

13. PERFORMANCE MEASURES AT INDIVIDUAL ACTIVITY LEVEL H841
- Multiple tasks.
- Team-based compensation arrangements.

14. EXECUTIVE PERFORMANCE MEASURES AND COMPENSATION
H842

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15. ENVIRONMENT AND ETHICAL RESPONSIBILITIES

ASSIGNMENTS

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16 DECENTRALISATION



LEARNING OUTCOMES
- Discuss the reasons for decentralisation.
- Discuss the factors to consider in measuring and evaluating the performance of
management and divisions.
- Distinguish between functional and divisional structures.
- Evaluate decentralisation as a method or attempt to analyse performance.
- Compare interdepartmental performance and discuss problems.
- Discuss responsibility centres and distinguish between four such centres.

1. INTRODUCTION H794, V539
- Decentralisation: Freedom for managers at lower levels to make decisions.
- Autonomy: Refers to the degree of freedom for decision making.
- Subunit: Any part of an organisation, e.g. division, Chevrolet at General Motors.
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- Total decentralisation: Minimum restrictions and maximum freedom for lower levels of
managers to make decisions.
- Total centralisation: Maximum restrictions and minimum freedom for lower level
managers.
- Measurement of division performance: Divisional net profit, divisional controllable net
profit, ROI.
- Degree of autonomy: Determine whether the division is a cost, income or investment
centre.
2. STRUCTURE OF DIVISION V542
2.1 Functional structure
i) Divisions have no profit responsibility.
ii) Decision making is done at head office level.
iii) Divisions are responsible for buying good quality materials at minimum cost, producing
at minimum cost and good quality and meeting delivery dates, marketing.
iv) Decisions on pricing, product mixes etc. are made by central management.

2.2 Divisional structure
i) Decentralised decision making requires greater responsibility and independence.
ii) Management sets selling prices, selects suppliers, makes production decisions,
markets their own products.
3. ADVANTAGES OF DECENTRALISATION H797, V543
i) Improves the quality of decision making and management,
ii) Business units are more responsible,
iii) Business problems can be solved quicker,
iv) Management is free to do long-term planning,
v) Management is better motivated,
vi) Divisional managers can act more as entrepreneurs and take the initiative,
vii) Participatory decision making leads to team building,
viii) Unprofitable activities can be identified and eliminated.

4. DISADVANTAGES OF DECENTRALISATION H798, V544
i) Activities are duplicated, e.g. purchasing departments and computer systems,
ii) Decisions of divisional managers are not necessarily to the benefit of the company,
iii) Difficult to design performance criteria where divisions are interdependent,
iv) Conflict may occur through competition,
v) Inexperienced managers may make mistakes,
vi) Greater staff numbers,
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vii) Reduces loyalty to the organisation as a whole,
viii) Increases the cost of gathering information.
5. RESPONSIBILITY CENTRES H799, V544
- Cost centres: Control over/responsible for costs
- Income centres: Control over/responsible for income
- Profit centres: Control over/responsible for cost and income
- Investment centres: Control over/responsible for investment
6. PERFORMANCE EVALUATION OF DIVISIONS V544
- Short- and long-term performance evaluation
- LT: Long-term return on capital, future cash flow at targeted weighted average cost of
capital
- ST: Evaluate personal performance of management:
i. Increase in sales volume
ii. Market share of product sales
iii. Manufacturing efficiency
iv. Product quality and customer satisfaction
v. New products
vi. Employee relations
- Comparing the performance of different divisions is good, but may be meaningless if:
i. The age of assets is different
ii. One division is labour intensive and the other capital intensive
iii. One division owns its building and the other leases it
iv. Products are sold in different markets with different pricing strategies
v. There are different inventory valuation methods
7. MANAGERIAL PERFORMANCE EVALUATION
Refer to chapter 23 in Horngren and the rest of chapter 14 of Vigario in Study unit 18 on
performance evaluation.

ASSIGNMENT

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17 AN IMPROVED AND CHANGED
MANUFACTURING
ENVIRONMENT AND A
CHANGED BUSINESS
ENVIRONMENT


Study material: Horngren - Chapters 12, 13 and 20

LEARNING OUTCOMES
- Apply the different pricing methods.
- Define the following concepts and apply and implement the principles of each:
* Activity-based cost management.
* Activity-based management.
* Activity-based management accounting.
* Activity-based budgeting.
* Just-in-time approach.
* Cost of quality.
* Backflush costing.
* Throughput accounting.
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* Balanced scorecard.
- Distinguish between partial and total factor productivity.
- Discuss inventory management in the implementation of JIT system.
- Discuss the main elements of a JIT system.
- Discuss the JIT approach and evaluate it as a development in managing costs.
- Discuss backflush costing as a development in managing costs.

1. INTRODUCTION D569
- Mechanisation has brought about a number of changes in the production process and
consequently the management of costs.
- Developments through mechanisation: ABC, ABCM, ABM, activity-based
management accounting (ABMA), activity-based budgeting (ABB), JIT, cost of quality
(COQ), backflush costing, throughput accounting, balanced scorecard.
- Changed manufacturing circumstances lead to developments in cost allocation, cost
recovery and consequently also pricing.
- A highly competitive market, especially globally, requires sophisticated cost allocation
and pricing to be implemented for survival.
- The changed business environment is caused by global competition, which means
that customers are far more demanding and organisations must perform to make their
product or service highly competitive.
- A protected competitive environment no longer exists, mainly because of
deregulation, government subsidies, the diversity of products and intense competition
from overseas markets.
- The changed manufacturing and business environments make new demands of
management accounting regarding cost management, quality, eliminating activities that
do not add value and new developments to determine costs accurately.
2. PRICING H455
- Pricing: Discussed under relevant costs and transfer pricing.
- Main influences on price: Customers, competitors and costs (CCC).
- Time horizon: Affects price in the long or short term.
- Target costs as a basis for target pricing four steps.
- Distinguish: Costs of activities that add value and those that do not.
- Locked-in cost: Costs that have not yet been incurred but have already been included
in the decision.
- Cost-plus prices: Includes an objective for return on capital in the mark-up.
- Advantages of including fixed costs in prices H437.
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- Life cycle budgets and costs: Also include R&D costs, design, marketing, customer
service, etc.
- Considerations other than cost for pricing: Price discrimination and peak loaded
pricing.
3. COSTING AND PRICING H456
- Short and long term: Principles of relevant costs.
- Alternative pricing approach: Market based (target price) and cost based.
- Implementing target prices and target costs H416 (4 steps).
- Two strategies: Product differentiation and cost leadership.
4. EVALUATION OF THE SUCCESS OF A STRATEGY H499
- Analyse changes in operating income to evaluate strategies.
5. STRATEGIC ANALYSIS OF OPERATING INCOME H500
- Example H500.
- Which part of the growth in operating income is caused by:
i) Growth component: Increase in number of units sold (the same as the sales
volume variance).
ii) Price recovery component: Change in prices of inputs and outputs, e.g. selling
price variance and price or spending variances for materials, labour and
overheads.
iii) Productivity component: Measures the change in cost of inputs used for the
respective years.
a) Partial productivity
= Output units
Quantity of inputs
Calculated for materials quantities, labour hours, etc.
The higher the rate, the higher the productivity.
b) Total factor productivity
= Output units
*Cost of inputs

*Materials + labour + overheads, quantities x prices

6. INVENTORY MANAGEMENT AND MRP H736
- MRP requires: (i) Demand forecast of the final product,
(ii) Requisition for material and
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(iii) Amount of raw material required for end-products.
- Inventory management is a key challenge for an MRP system.
- Key aspect of MRP: Push-through system rather than the just-in-time demand-pull
system.

7. INVENTORY MANAGEMENT AND JIT H732
Five main aspects of JIT.
See paragraphs 10 and 17.

8. INVENTORY MANAGEMENT IN RETAIL ORGANISATIONS H725
Costs associated with cost of sales:
i) Purchasing costs: Cost of goods acquired from suppliers, freight included.
ii) Ordering costs: Preparation and issue of and payment for purchase orders plus
receipt and inspection costs.
iii) Stockout costs: Problem when there is a demand for the product but the inventory is
zero.
iv) Cost of quality: Four categories, i.e. prevention costs, appraisal costs, internal failure
costs and external failure costs.

9. SAFETY STOCK H729
10. THEORY OF CONSTRAINTS AND THROUGHPUT CONTRIBUTION H706-
707
Theory of constraints: Methods of maximising operating income when there are
bottlenecks and when there are no bottlenecks. Three important measures in the theory of
constraints are:
i) Throughput contribution: Sales less direct materials.
ii) Investment: Total of inventory (materials, work-in-process and finished goods) plus
R&D costs plus equipment and buildings.
iii) Operating expenses: All operating expenses except materials.

An organisation manufactures four products, i.e. P, Q, R and S. The products use a range of
different machines, but there is one machine that is essential for all the products, i.e. X,
which has caused a bottleneck. The standard selling prices and standard costs per unit for
each product for the following year are as follows:

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201
P Q R S
Rand/U Rand/U Rand/U Rand/U
Selling price 2 000 1 500 1 500 1 750
Costs:
Dir. materials 410 200 300 400
Dir. labour 300 200 360 275
Variable
overheads
250 200 300 175
Fixed overheads 360 300 210 330
Profit 680 600 330 570
Machine X:
Minutes/Unit
120 100 70 110
Use the throughput costing approach to arrange the products in order of preference.

P Q R S
SP R2 000 R1 500 R1 500 R1 750
- Mat. 410 200 300 400
=Through. contr. R1 590 R1 300 R1 200 R1 350
Machine X (minutes) 120 100 70 110
=Through. contr./
machine

R13,25

R13

R17,14

R12,27
Order 2 3 1 4

11. HYBRID COSTS AND SIMPLE JOB COSTING SYSTEMS
Hybrid costs: A system with features of a job costing system and a process costing system,
e.g. at Ford Motor Company where cars are manufactured in a constant flow but with specific
combinations.

12. OPERATIONAL COSTING
This is a hybrid costing system applied in batches of similar products. Each batch is
sometimes a variation of a single design and goes through a series of selected activities or
operations. Operational costing has elements of both job and process costing and is
therefore regarded as the product costs between job and process costs. These product
costs can be combined with actual costs or normal costs or standard costs. ABC can also be
added to the combination.

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202
13. JIT H737
JIT is a system in which materials arrive when needed and production takes place when a
product is requested. The most common way of working with this pull aspect of JIT is the
Japanese kanban system (Japanese word for visual record or card).
- Main elements of JIT H737
i) Production is organised into manufacturing cells where equipment is grouped together.
ii) Employees are trained to be multi-skilled so that they can be moved easily.
iii) Total quality management (TQM) is instituted aggressively to eliminate defects.
iv) Reducing setup time is emphasised.
v) Suppliers are selected because of their ability to supply quality inspected parts or raw
materials.
- Financial benefits of JIT H737
i) Lower investment in inventory.
ii) Reduced carrying and handling costs of inventory.
iii) Reduced risk of obsolete inventory.
iv) Lower investment in storage for inventory.
v) Reduced setup costs and total manufacturing costs.
vi) Improved quality leads to a cost reduction in spoilage.
vii) Higher income as a result of quick response by customers.
viii) Decreased paperwork.

14. BACKFLUSH COSTING H740
The absence of inventory in a JIT system brings the weighted average, FIFO and LIFO
closer together, and therefore also direct and absorption costing systems.

Backflush costing is a system in which recording transactions is delayed until the product
has been completed. Only then are they recorded. An extreme form of applying this principle
is to wait until the finished product has been sold before recording transactions.
NB. No work-in-process is recorded in backflush costing.
Trigger points where transactions can be recorded are:
i) Purchase of materials
ii) Completion of products

A job costing system is organised in seven steps in backflush costing. See Horngren 740-
743. Also see the example on pp. 742-743.

Study unit 17

203

Do 20.33 in Horngren as practice and compare your answers with the suggested solution
below.

H + F + D 20.33
1.a) Raw material + WIPC (work-in-process
control)
Dr R550 000
Creditors R550 000
b) Conversion costs control Dr R440 000
W/SR/Cred
e
440 000

c) FGC (21 000 x 25 + 20) Dr R945 000
Raw mat. + WIPC 525 000
Conversion costs added 420 000

d) COS Dr 900 000
FGC (20 000 x 45) 900 000
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2. Raw material + WIPC
FGC
a) R550 000 c) R525 000 c) R945 000 d) R900 000
Balance b/f 25 000 Balance b/f
45 000

Labour + Overheads control COS
b) R440 000 c) Added R420 000 d) FGC R900 000
Underalloc. 20 000

15. ECONOMIC ORDER QUANTITY (EOQ) AND JIT H733

ASSIGNMENTS

Study unit 18

205

18 COST MANAGEMENT AND THE
THEORY OF CONSTRAINTS



LEARNING OUTCOMES
- Discuss the following developments in management accounting and apply the
principles in support of an improved manufacturing environment and management of
costs:
* Life cycle costing.
* Target costing.
* Kaizen costing.
* Cost of quality.
* Benchmarking.
* Balanced scorecard.
* Value-chain analysis.
* Activity-based management.
* Business process re-engineering.
* Just-in-time.
* Theory of constraints.
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- Discuss quality management based on:
* Methods to identify quality problems.
* Relevant costs and the advantages of quality improvement.
* Quality and customer satisfaction measures.
* Evaluating quality performance.
* Time as a competitive tool.

1. INTRODUCTION D537
- Cost management focuses on reducing costs, particularly relevant in times of fierce
competition in the global market.
- Cost management is an action by management to reduce costs, e.g. by instituting more
effective and efficient processes without affecting customer satisfaction negatively.
- Purpose of cost management: Reduce costs without affecting the quality and increase
customer satisfaction.

2. DEVELOPMENTS TO SUPPORT COST MANAGEMENT D538+, M380
- Life cycle costing H469-471: An estimate and accumulation of costs in a products
lifetime (life cycle) to determine whether the profit from the manufacturing stage is
sufficient to cover the costs in the pre- and post-manufacturing stages.
- Target costing D539, H460-465: A customer-oriented technique initially started by the
Japanese, but adopted widely in Europe and the USA. Four steps were discussed
earlier, i.e. start with the target price and work backwards. An important element is that
teamwork is required to achieve the target costs. This team includes designers,
engineers, purchasing, manufacturing, marketing and management accounting staff.
Costs are managed and controlled in the development stage of the product.
- Kaizen costing D543: These costs begin where target costs end. Target costing
requires a proactive approach to cost management in the pre-production stage and
kaizen costing requires a proactive approach to cost management during the
production stage of a products lifetime.
- Cost of quality D548: See paragraph 4.
- Benchmarking D554: A systematic approach to identify the best practices an
organisation can use to improve performance. Compare with the best, top achievers in
the market.
- Balanced scorecard: Rewriting the enterprises mission and strategy in a
comprehensive set of performance measures that provides a framework for
implementing its strategy. It contains financial and non-financial goals of the
organisation.
- Value-chain analysis D552: A systematic interdisciplinary determination of factors that
may influence the cost of a product or service to achieve a specific purpose at a
required standard of quality and reliability of target costs. In this process activities that
do not add value can be eliminated. Consequently, customer satisfaction can be
guaranteed and costs managed more effectively.
Study unit 18

207
- Activity-based management (ABM) D544: This entails the cost management
applications of an activity-based costing approach.
- Business process re-engineering (BPR) D547: A re-engineering of the business
process to avoid activities that do not add value.
- J IT D556: See Study unit 16.

3. OPTIMISED MANUFACTURING TECHNOLOGY
CAM, CAD, CIM, FMS, NC, MRP, JIT

4. TOTAL QUALITY MANAGEMENT (TQM) H691
Quality is a competitive tool because TQM is a very important factor of success in reducing
costs and increasing customer satisfaction. In times of intense competition, improved quality
and prompt delivery can attract customers.
- Aspects of quality: Quality design and conformance quality. Quality design
measures how closely the features of products and services can meet the needs of
customers. Conformance quality is the performance of a product or service in meeting
the design and product specifications.
- Cost of quality (COQ): This entails the costs of preventing poor quality or improving
quality. These costs focus on quality assurance and can be classified as prevention
costs, appraisal costs, internal failure costs and external failure costs H693.
Note the seven steps that Horngren discusses.
4.1 Methods (techniques) to identify quality problems H696
i) Control chart: This is a graph of a series of successive observations of a
specific step, procedure or activity taken at regular intervals. Each observation is
plotted on the graph and only those outside the specified limits are recorded as
non-random and must be investigated. See example in Horngren 697. A control
chart is an important aid in statistical quality control (SQC).
ii) Pareto diagram: Observations outside the control limits are used as input for the
Pareto diagram. A Pareto diagram shows how frequently each type of defect
occurs. According to the example in Horngren 697, unclear copies are the most
frequent problem and therefore result in high rework expenses and repair costs.
Other problems are copies that are too light, too dark, paper jams, etc.
iii) Cause-and-effect diagrams: The most frequently occurring problem as
identified by the Pareto diagram is analysed using the cause-and-effect diagram.
A cause-and-effect diagram identifies potential causes of defects. On p. 698 of
Horngren a diagram is shown of the most frequently occurring problem, i.e.
unclear copies. On this cause-and-effect diagram, four main categories of
potential causes of defect are shown, i.e. human error, methods and design
factors, machine-related factors and material and component factors.

Study unit 18

208
4.2 Relevant costs and advantages of quality improvement H698
To identify the relevant costs for each cost of quality category, each cost in these categories
must be divided into fixed and variable costs.
4.3 Quality and customer satisfaction measures H695
Products and services may be of good quality, but they must also meet customers needs
before they can be sold. Customers will be satisfied if a product or service is good value for
money, delivered as promised, the product has no defects and they are assured that the
product will not fail in any way or disappoint when used.
- Financial measures of customer satisfaction: Financial indicators of customer
dissatisfaction are repair costs during guarantee period, lost contribution margin as a
result of lost sales and lower prices at which damaged goods must be sold.
- Non-financial measures of customer satisfaction: These include number of defect
units sold as a % of the total units shipped, number of customer complaints, the
difference between the delivery date and the date required by the customer, on-time
deliveries.
- Non-financial measures of internal performance: Prevention costs, appraisal costs
and internal failure costs are examples of financial measures and quality performance
within the business. It is essential to measure financial and non-financial internal
performance.
4.4 Evaluating quality performance H700
- Advantages of measuring COQ
i) It focuses attention on the cost of poor quality.
ii) It provides information for comparing different quality improvement programmes.
iii) It provides information regarding prevention or the cost of rectifying defects
(mistakes).
- Advantages of non-financial measures of quality
i) Non-financial measures are sometimes easy to quantify and understand.
ii) They focus attention on the problem areas.
iii) They provide immediate short-term feedback on whether quality improvement
efforts have succeeded.
4.5 Time as a competitive tool H701
- Operational measures of time: Two measures:
i) Customer response time: This is how long it takes from when an order is
placed for a product or service until the product or service is delivered.
ii) On-time performance: Examples are manufacturing cycle time, which is the
time from the beginning of the production line to the finished product, and order
delivery time, which is the time from completion of production to delivery to the
customer.
- Effect of uncertainty and bottlenecks on delays H703
- On-time performance H702
Study unit 18

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5. THEORY OF CONSTRAINTS (TOC) AND THROUGHPUT CONTRIBUTION
H706-707
TOC: Methods of maximising operating income when there are bottlenecks and when there
are no bottlenecks. The purpose of this theory is to increase throughput contribution margins
while reducing investment and operating costs. Three important measures:
i) Throughput contribution margin: Sales less direct materials.
ii) Investment: Total inventory (materials, WIP and finished goods) plus R&D costs plus
equipment and buildings.
iii) Operating expenses: All operating expenses except materials.
TOC has a short-term time horizon and assumes that all operating expenses are fixed.
There are four steps to manage bottleneck situations H703.

6. TIME DRIVERS AND COSTS OF TIME H702
- Uncertainty and bottlenecks as time drivers.
- Relevant income and relevant costs of time.

Additional sources used in this study unit
- Drury, C. 2000. Management and cost accounting. London: Business Press
- Morse, W J., Davis, J.R. & Hartgraves, A.L. 2000. Management accounting. A
strategic approach. Ohio: South Western.


Study unit 18

210

IM 21.7
Evaluation of quality management programme
Synthetic slabs cost reduction (R)
Elimination of synthetic slabs stores losses 68 711 units x (R40-1)/100 26 797
Specification check

14 000
Savings on purchase quantity of synthetic slabs:
(2 748 450 2 090 651) x R40/100 263 120
Less: increase price: 2 090 651 x R4/100

(83 626)
Curing/moulding process cost:
Variable cost reduction (2 679 739 2 090 651) x R20/100 117 818
Scrap sales forgone of sub-components (267 974 20 907) x R5/100

(12 353)
Finishing process cost reduction:
Variable cost reduction (See note 1) 158 656
Scrap sales forgone (361 765 51 744) x R10/100

(31 002)
Finished goods stock:
Holding costs (45 000 1 500) x R15/1 000 653
454 063
Less: cost of quality management programme 250 000
Net (cost) / benefit of proposed changes 204 063
** Note 1: Variable cost of reduction for curing/moulding process
Existing cost
Type AX 964 706 x R15/100 = 144 706
Type BX 1 447 059 x R25/100 = 361 765
506 471
Amended cost
Type AX 826 667 x R12/100 (99 200)
Type BX 1 243 077 x R20/100 (248 615)
Net reduction in cost 158 656
b) See Cost of quality in Chapter 21 for the answer to this question.
Study unit 18

211

2. NON-FINANCIAL QUALITY MEASURES
- Outgoing quality return on each product.
- Returned refrigerators % of each product.
- On-time deliveries.
- Employee turnover.

ASSIGNMENTS

RECP 674 Advanced Management Accounting (CTA LEVEL)

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