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Part A – Specialist Cost and Management Accounting Techniques ........................................................ 3

1. Costing Techniques – Recap ....................................................................................................... 3

2. Activity Based Costing ................................................................................................................. 7

3. Target Costing ............................................................................................................................. 9

4. Life Cycle Costing ......................................................................................................................12

5. Throughput Accounting ............................................................................................................16

6. Environmental Accounting ....................................................................................................... 21

Part B – Decision Making Techniques ..................................................................................................23

7. Cost Volume Profit (CVP) Analysis ...........................................................................................23

8. Limiting Factor Analysis ...........................................................................................................29

9. Pricing Decisions .......................................................................................................................38

10. Short Term Decisions ................................................................................................................48

11. Risk and Uncertainty ................................................................................................................54

Part C – Budgeting and Control ............................................................................................................ 62

12. Budgetary Systems .................................................................................................................... 62

13. Quantitative Analysis ................................................................................................................ 69

14. Standard Costing .......................................................................................................................74

15. Variance Analysis ...................................................................................................................... 76

16. Planning and Operational Variances .........................................................................................93

17. Performance Analysis................................................................................................................96

Part D – Performance Measurement and Control ................................................................................98

18. Performance Management Information Systems ..................................................................... 98

19. Sources of Management Information ......................................................................................101

20. Performance Measurement in Private Sector Organisations ..................................................103

21. Performance Analysis – Additional .........................................................................................133

F5 Revision notes Page 2

Part A – Specialist Cost and Management Accounting

1. Costing Techniques – Recap

Costing: It is the process of determining the costs of products, services or activities

Direct Cost: A cost that can be traced back in full to a product, service or department.

Indirect Production Cost: Also known as Overheads. It is a cost that cannot be directly linked in
full to the actual production of goods/ provision of services. Example: Rent of factory where five
different products are manufactured. How will the rent be split between the five products? It cannot
be traced back in full to any one or all of the products.

Indirect Non Production Cost: Also referred to as Overheads. It is a cost incurred in a support
function that is not directly involved in the manufacturing process or provision of the main service.
Example: Marketing expenses of a television sets’ manufacturer.

Traditional Costing Systems:

Absorption Costing: a form of costing in which the costs of products are calculated by adding an
amount for indirect production costs (overheads) to the direct costs of production.

Marginal Costing: a form of costing where only the direct costs are considered relevant for the cost
of a product. Fixed costs are treated as Period Costs.

Per Unit Product Cost Calculation

Absorption Costing Marginal Costing

$ $
Direct Material X Direct Material X
Direct Labour X Direct Labour X
Other Direct Expenses X Other Direct Expenses X
Absorbed Production Overheads (Step 5) X Variable Production Cost X
Full Production Cost X

$ $
Sales xx Sales xx
Less : Full production cost of sale (Full (x) Less : Variable production cost (Variable
production cost per unit x number of units) production cost per unit x units sold) (x)
Less/Add: Under/Over absorbed (Step 6) (x)/x Gross contribution xx
Production overheads Less : Variable non production cost (x)
Gross Profit xx Contribution xx
Less : Fixed non-production overhead (x) Less : Fixed non-production overhead (x)
Less : Variable non production cost (x) Less : Fixed production overhead (x)
Profit xx Profit xx

F5 Revision notes Page 3

Absorption Costing – Recap:

Step 1: Allocate direct costs to a cost unit or cost centre.

Step 2: Apportion general overheads amongst the cost centres, on a fair basis.
Step 3: Re-apportion the costs of service cost centres’ amongst the production cost centres on a fair

Step 4: Determine Absorption rate for each production cost centre using the formula:

Estimated Fixed Production Overheads

Budgeted Activity Level

With one of the following bases for activity level:

 % of direct material cost
 % of direct labour cost
 % of prime cost
 Rate per machine hour
 Rate per labour hour
 Rate per unit

Step 5: Absorbed Production Overheads: Actual activity level x Absorption rate

Step 6: Under/ Over Absorption: Absorbed Production Overheads – Actual Overheads Expenditure
Under-absorbed: Absorbed production overheads < Actual overheads expenditure
Over-absorbed: Absorbed production overheads > Actual overheads expenditure

Arguments for Absorption Costing System:

 Used for financial reporting purposes to comply with the Accounting standards and inventory
 Helpful in cases where companies attempt to set selling prices based on the full cost of
production or sales of each product.
 Best practice in case of a company selling multiple products, to determine profitability of each

Arguments for Marginal Costing System:

 Provides more useful information for managers in decision making process as contribution
calculated under this system is directly proportionate to the sales volume; which gives a more
accurate picture of the impact of sales volume on cashflows and profits.

F5 Revision notes Page 4

Worked Example:

Harp Plc manufactures and sells a single product .The following budgeted/ actual information is
provided in relation to the production of this product:

Selling price per unit 50.00
Direct material per unit 8.00
Direct labour per unit 5.00
Variable production overheads per unit 3.00

Actual production and sales for the month of April, 2017 were 500 units.

Fixed production overheads are budgeted at $6,000 per month and the budgeted level of production
is 600 units.

Other Costs per month $

Fixed selling 1,700
Fixed administration 2,300
Variable sales commission - % of sales commission 10%

Working under Absorption Costing:

Product Cost per unit $

Direct material per unit 8.00
Direct labour per unit 5.00
Variable production overheads per unit 3.00
Fixed production overhead per unit ($6,000/ 600 units) 10.00

Profit Statement $ $
Sales (500 x $50) 25,000
Less: Cost of Sales (500 x $26) (13,000)
Less under-absorbed/ Add over-absorbed overheads
Absorbed production overheads (500 x $10) 5,000
Actual overheads (budgeted are assumed to be actual) 6,000
Under-absorbed production overheads (1,000)
Gross Profit 11,000
Less: Expenses
Variable sales commission (10% of $25,000) 2,500
Fixed selling 1,700
Fixed administration 2,300
Net Profit 4,500

F5 Revision notes Page 5

Working under Marginal Costing:

Product Cost per unit $

Direct material per unit 8.00
Direct labour per unit 5.00
Variable production overheads per unit 3.00

Profit Statement $ $
Sales (500 x $50) 25,000
Less: Variable Cost of Sales (500 x $16) (8,000)
Gross Contribution 17,000
Less: Variable sales commission (10% of $25,000) (2,500)
Contribution 14,500
Less: Expenses
Fixed production overheads 6,000
Fixed selling 1,700
Fixed administration 2,300
Net Profit 4,500

Note: When there are no changes in the level of inventory due to opening and closing balances, the
profit under both absorption and marginal costing approach will be the same.

F5 Revision notes Page 6

2. Activity Based Costing


 The simplest method of dealing with the fixed production costs is to assume that all of the
production overheads can be treated together and a single overhead absorption rate per labour
hour, or cost per machine hour, can be derived.
 With production processes becoming highly automated the conventional way of treating fixed
overheads, using an over-simplified base is not good enough, especially for organisations
manufacturing multiple products. Companies need to know the cause of overhead expenses and
they need to try to assign costs to products or services on the basis of the resources they consume.
 To get a more accurate estimate of what it costs to produce each unit; it is necessary to examine
the activities that are necessary to produce each unit, because activities usually have a cost
attached. This is the logic of Activity Based Costing (ABC).

The ABC Process:

1. Identify a distinct ‘fixed’ overhead cost, also termed as a Cost Pool.

2. Identify the activity that causes this cost. This activity is the ‘Cost Driver’.
3. For each cost pool, calculate an absorption rate per cost driver.
This is calculated by manipulating the traditional overhead absorption rate formula:
Total cost pool expense
Total cost driver

4. Charge the overheads cost to each product, by identifying how much of the cost driver was utilised
by that particular product. This can then be converted into a per unit product overhead charge.

Traditional absorption costing

Production overheads

Allocated/apportioned to

Production cost centre Production cost centre

Absorbed from cost centres into:

Product costs

Activity based costing

Production overheads

Allocated/apportioned to

Activity (cost pool) Activity (cost pool)

Absorbed from cost centres into:

Product costs

F5 Revision notes Page 7

Worked Example:

An organisation manufactures 3 different products. In a year, its Fixed Production Overheads

comprise of:
Cost Pool Cost Driver
Machine Handling Costs $20,000 500 machine hours
Production Scheduling Costs $14,000 100 production runs
Total Fixed Overheads $34,000 100 labour hoours

Assuming that the manufacturing of Product A requires:

 20 labour hours
 15 machine hours
 4 production runs

Under the traditional Absorption costing method, Fixed Overheads cost for Product A will be:
$34,000 x 20 labour hours = $6,800
100 labour hours

Under the ABC method, the working will change to:

Machine Handling $20,000 x 15 machine hours = $600
500 machine hours

Production Scheduling $14,000 x 4 production runs = $560

100 production runs
= $1,160

Arguments for ABC:

 Based on the information made available, the following types of decision making processes
will be supported:
 As product costing will be more accurate, pricing on mark-up basis for individual
products will be fair.
 By identifying expenses that can be reduced, decisions regarding promoting or
discontinuing products, activities or parts of business can be effectively taken.
 New ways to run a process can be developed.

Arguments against ABC:

 Cost drivers may not be very easy to identify or quantify.

 Cost of implementing this system may be more than the benefits derived from its
 It’s an adaptation of the Absorption costing method and decision making is found to be more
effective using Marginal Costing principles.

Past Paper Analysis

Activity based costing June 08 – Q 4
June 10 – Q 1
Dec 10 – Q 4
June 14 – Q 1
June 15 – Q 1

F5 Revision notes Page 8

3. Target Costing

Traditionally the selling price of a product is determined by adding a profit mark-up to the product
cost. But the manufacturer may not be able to find customers who would buy the product at the price
set by the organisation. This could be if the product may not have features, which the customer’s value
or the competitors’ products might be cheaper, or offer better value for money. This possible challenge
in establishing the price at which the consumers will purchase the product or service is addressed by
target costing.

Target Costing:

Target costing is a marketing approach to costing, as it involves setting a selling price for the product
by reference to the market. Rather than quoting a price for the product or service being offered on the
basis of it’s production cost; the supplier will carry out market research to establish what prospective
customers may be willing to pay for the product or service. From the target selling price identified, the
desired profit margin is deducted to arrive at a target cost.

Target Costing Process:

1. Determine product specification and possible sales volume.

2. Decide on a Target Selling Price at which the product can be successfully sold.
3. Estimate Target Profit.
4. Calculate Target Cost: Target Selling Price – Target Profit
5. Based on product specification and costs level, determine the estimated Production Cost.
6. Calculate Target Cost Gap: Estimated Production Cost – Target Cost
7. Make efforts to reduce the Target Cost Gap, before production commences

Worked Example – extract from September 2016 attempt:

Helot Co develops and sells computer games. It is well known for launching innovative and interactive
role-playing games and its new releases are always eagerly anticipated by the gaming community.
Customers value the technical excellence of the games and the durability of the product and

Helot Co has previously used a traditional absorption costing system and full cost plus pricing to cost
and price its products.It has recently recruited a new finance director who believes the company
would benefit from using target costing. He is keen to try this method on a new game concept called
Spartan, which has been recently approved.

After discussion with the board, the finance director undertook some market research to find out
customers’ opinions on the new game concept and to assess potential new games offered by
competitors. The results were used to establish a target selling price of $45 for Spartan and an
estimated total sales volume of 350,000 units. Helot Co wants to achieve a target profit margin of

Target Cost Calculation:

Target selling price – Target profit

$45 – (35% of $45) = $45 – 15.75 = $29.25

F5 Revision notes Page 9

The finance director has also begun collecting cost data for the new game and has projected the
Production costs per unit $
Direct material 3.00
Direct labour 2.50
Direct machining 5.05
Set-up 0.45
Inspection and testing 4.30

Total non-production costs $000

Design (salaries and technology) 2,500
Marketing consultants 1,700
Distribution 1,400

Target cost gap calculation:

Actual cost (W1) – Target cost
$31.30 - $29.25 = $2.05

W1: Production cost per unit = $3.00 + 2.50 +5.05 + 0.45 +4.30 = $15.30
Non-production cost per unit = ($2,500,000 + 1,700,000 + 1,400,000) / 350,000 units = $16
Actual cost = $15.30 + $16 = $31.30

Closing the Target Cost Gap:

 The organisation can establish multifunctional teams consisting of marketing people, cost
accountants, production managers, quality control professionals and others. These teams are vital
to the design and manufacturing decisions required to determine the price and feature
combinations that are most likely to appeal to potential buyers of products.

 Emphasis will be placed on the planning and design stage to ensure that the design is not
needlessly expensive to make. Some decisions that can be made at the design stage, which can
affect the cost of a product are:
 Reducing components
 Arranging cheaper labour/ training existing staff
 Acquiring new and efficient technology etc.

 The total target cost can be split into broad cost categories based on functions to ensure better
control over costs. The product has to be developed using Value Engineering Techniques.

 Value engineering aims to reduce costs by identifying those parts of a product or service which do
not add value – where ‘value’ is made up of both:
 Use value (the ability of the product or service to perform its function)
 Esteem value (the status that ownership or use confers)
For example, if you are selling perfume, the design of its packaging is important. The
perfume could be sold in a plain glass bottle, and although there will be no damage to the
use value, the esteem value will be damaged. The company would be unwise to try to
reduce costs by economising too much on packaging.

F5 Revision notes Page 10

Target Costing in Service Industries:

Because of the characteristics and information requirements, it is difficult to use Target Costing in
service industries. Examples of service businesses include:
(a) Mass service e.g. the banking sector, transportation (rail, air), mass entertainment
(b) Either / or e.g. fast food, teaching, hotels and holidays, psychotherapy
(c) Personal service e.g. pensions and financial advice, car maintenance

There are five major characteristics of services that distinguish it from manufacturing.

 Intangibility There is no substantial material or physical aspects to a


 Inseparability/simultaneity Many services are created at the same time as they are
consumed. For example – dental treatment. No service exists
until it is actually being experienced/ consumed by the person
who has bought it.

 Variability/heterogeneity It is hard to attain precise standardisation of the service


 Perishability Services are time bound.

 No transfer of ownership. Services do not result in the transfer of property but only
access to or a right to use a facility.


 Services do not have any material content (tangibility) making it difficult to reduce target cost
gap through material cost reduction.
 Services vary each time resulting in there being an estimated average cost for each service but
not a specific standard cost that can be reduced.

Past Paper Analysis

Target costing Dec 01 – Q 1
Dec 09 – Q 2
June 12 – Q 2
Dec 15 – Q 1

F5 Revision notes Page 11

4. Life Cycle Costing


 Under traditional costing methods, only the current costs, comprising of marginal costs plus a
share of fixed costs, are considered and other costs, without which the goods could not have been
made, such as Research & Development costs, are ignored.
 The true profitability of a product should be assessed by comparing the total revenue arising over
the lifetime of the product with its total costs; regardless of whether these costs are incurred
before, during or after the product is produced. This is addressed by lifecycle costing.

Lifecycle Costing:

There are four principal lessons to be learned from lifecycle costing:

1. All costs should be taken into account when working out the cost of a product and its profitability.
2. Attention to all costs will help reduce the cost per unit and will help an organisation achieve its
target cost.
3. Many costs will be linked. For example, more attention to design can reduce manufacturing and
warranty costs.
4. Costs are committed and incurred at very different times. A committed cost is a cost that will be
incurred in the future because of decisions that have already been made. Costs are incurred only
when a resource is used.

Worked Example – extract from September 2016 attempt:

A manufacturing company which produces a range of products has developed a budget for the life-
cycle of a new product, P. The information in the following table relates exclusively to product P:

Lifetime Total Per Unit

Design costs $800,000
Direct manufacturing costs $20
Depreciation costs $500,000
Decommissioning costs $20,000
Machine hours 4
Production and sales units 300,000

The company’s total fixed production overheads are budgeted to be $72 million each year and total
machine hours are budgeted to be 96 million hours. The company absorbs overheads on a machine
hour basis.

What is the budgeted life-cycle cost per unit for product P?

OAR for fixed production overheads ($72 million/96 million hours) = $0·75 per hour

Total manufacturing costs (300,000 units x $20) = $6,000,000

Total design, depreciation and decommissioning costs = $1,320,000

Total fixed production overheads (300,000 units x 4 hours x $0·75) = $900,000

Total life-cycle costs = $8,220,000

Life-cycle cost per unit ($8,220,000/300,000 units) = $27·40

F5 Revision notes Page 12

Stages of Life cycle (product life cycle)

Development stage The product has a research and development stage where costs are
incurred but no revenue is generated.
Examples: R&D costs; Capital Expenditure decisions

Introduction stage The product is introduced to the market. The organisation will spend on
advertising to bring the product or service to the attention of the potential
Examples: Operating costs; Marketing and advertising; Set up and
expansion of distribution channels

Growth stage At this stage, the product becomes well-known in the market. Due to
increase in demand, it captures a bigger market and starts to make a
profit. At this stage, cost of the initial investment is progressively
Examples: Costs of increasing capacity; Maybe learning effect and
economies of scale; Increased costs of working capital

Maturity stage At this stage, demand for the product stabilises or the rate of growth
slows down. It continues to be profitable. Expenses for marketing and
distribution can be minimised at this stage. In order to sustain the
demand, the product may be differentiated / modified.

Examples: Incur costs to maintain manufacturing capacity; Marketing

and product enhancement costs to extend maturity

Decline / saturation A point comes where large / adequate quantities of the product have been
stage sold in the market and the product, therefore, reaches a saturation point.
At this stage the demand for the product starts to fall and marketing costs
are cut down. The product may start making loss at this stage. The
organisation may decide to discontinue the production and to develop a
new product.
Examples: Asset decommissioning costs; Possible restructuring costs;
Remaining warranties to be supported

F5 Revision notes Page 13

The Importance of early stage in Lifecycle:

Organisations operating within an advanced manufacturing technology environment find that

approximately 90% of a product's life cycle cost is determined by decisions made early within the cycle
at the design stage. Life cycle costing is therefore particularly suited to such organisations and

Cost reduction at the planning, design and development stage of a product's life cycle, rather than
during the production process, is one of the most important ways of reducing product cost.

Benefits of Life cycle costing:

 The potential profitability of product can be assessed before major development of the product is
carried out and costs incurred and non-profit-making products can be abandoned.
 Techniques can be used to reduce costs over the life of the product
 Pricing strategy can be determined before the product enters production.
 Attention can be focused on reducing the research and development phase to get the product to
market as quickly as possible.
 By monitoring the actual performance of products against plans, lessons can be learnt to improve
the performance of future products.

Support to Management:

An understanding of the product life cycle can also assist management with decisions about:
 Pricing: As a product moves from one stage in its lifecycle to the next, a change in pricing
strategy might be necessary to maintain the market share and recover the costs incurred over the
 Performance management: Understanding the changes in the financial performance of the
product as it moves from one stage to another and being prepared for the changes.
 Decision-making: Helps with decision about making new investments in the product (new
capital expenditure) or withdrawing a product from the market.

Service Life Cycles:

In Service lifecycles, the R & D stages do not exist in the same way and will not have the same impact
on subsequent costs. However consideration should be given in advance about how to carry out the
services and arrange them so as to minimise cost.

Project Life Cycles:

Products that take years to produce are usually called projects, and discounted cash flow calculations
are invariably used to cost them over their life cycle in advance. They are monitored very carefully
over their life to make sure that they remain on schedule and that cost overruns are not being

Customer Life Cycles:

Customers also have life cycles, and an organisation will wish to maximise the return from a customer
over their life cycle. The aim is to extend the life cycle of a particular customer by encouraging
customer loyalty.

F5 Revision notes Page 14

The initial cost is high but once customers get used to a supplier they tend to use them more
frequently, bringing in the benefit to the company.

The projected cash flows over the full lives of customers or customer segments can be analysed to
highlight the worth of customers and the importance of customer retention.

Past Paper Analysis

Life-cycle costing Dec 08 – Q 4
Dec 11 – Q 4
June 13 – Q 3
June 16 – Q 3

F5 Revision notes Page 15

5. Throughput Accounting


The throughput accounting system aims to maximise the throughput (sales revenue less material
costs) of the production process. It supports the Just in Time system to reduce inventory costs as well
as works on reducing the operational costs.

It works on the principle that sooner or later, an organisation will face a bottleneck resource, a
resource that slows down the production process.

Throughput Accounting is based on the Theory of Constraints, which focuses on maximising

throughput (Sales revenue less material cost) while keeping the organisation’s bottleneck
resources in view, and trying to minimise the operational costs (all costs except for material)

The theory of constraints – extract from ACCA technical article

The theory of constraints is applied within an organisation by following ‘the five focusing steps.’ These
are a tool developed to help organisations deal with constraints, otherwise known as bottlenecks,
within the system as a whole (rather than any discrete unit within the organisation.)

The steps are as follows:

Step 1: Identify the system’s bottlenecks

A bottleneck resource is one which slows down the product or service delivery process of an
organisation. For example, an organisation has market demand of 50,000 units for a product that
goes through three processes: cutting, heating and assembly. The total time required in each process
for each product and the total hours available are:

Process Cutting Heating Assembly

Hrs per unit 2 3 4
Total hours available 100,000 120,000 220,000

The total time required to make 50,000 units of the product can be calculated and compared to the
time available in order to identify the bottleneck.

Process Cutting Heating Assembly

Hrs per unit 2 3 4
Total hours required for 50,000 units 100,000 150,000 200,000
Total hours available 100,000 120,000 220,000
Shortfall in hours 0 30,000 0

It is clear that the heating process is the bottleneck. The organisation will in fact only be able to
produce 40,000 units (120,000/3) as things stand.

F5 Revision notes Page 16

Step 2: Decide how to exploit the system’s bottlenecks

This involves making sure that the bottleneck resource is actively being used as much as possible and
is producing as many units as possible. So, ‘productivity’ and ‘utilisation’ are the key words.

Step 3: Subordinate everything else to the decisions made in Step 2

The main objective is that production capacity of the bottleneck resource should determine the
production schedule for the organisation as a whole.

Idle time is unavoidable and needs to be accepted. To push more work into the system than the
constraint can deal with results in excess work-in-progress, extended lead times, and the appearance
of what looks like new bottlenecks, as the whole system becomes clogged up. By definition, the system
does not require the non-bottleneck resources to be used to their full capacity and therefore they must
sit idle for some of the time.

Step 4: Elevate the system’s bottlenecks

Normally, elevation will require capital expenditure. However, it is important that an organisation
does not ignore the possibility of exploiting the company’s bottlenecks and jump straight to removing
the constraint, and this is what often happens. Elevation should only be considered once exploitation
has taken place.

Step 5: If a new constraint is broken in Step 4, go back to Step 1, but do not let inertia
become the system’s new bottleneck

When a bottleneck has been elevated, a new bottleneck will eventually appear. This could be in the
form of another machine that can now process less units than the elevated bottleneck. Eventually,
however, the ultimate constraint on the system is likely to be market demand. The system should be
one of ongoing improvement because nothing ever stands still for long.

Throughput Accounting

Throughput accounting is an accounting method. It actually involves assessing how effectively a firm
utilises its constraints. T

Three measures are identified in order to know how much money the company generates, how much
money is getting invested in the form of inventory and how much money the company would require
to spend to operate it. They are ‘throughput’, ‘inventory’ and ‘operational expenses’.

Throughput is the rate at which the system generates money through sales. This is defined as sales
revenue less direct material costs.

Inventory is all the money that the system invests in purchasing things which it intends to sell.

Operational expenses are all the money the system spends in order to turn inventory into

Throughput accounting acknowledges only material cost to be truly variable. All other costs
are treated as period costs and deducted as expenses of the period.

F5 Revision notes Page 17

Throughput contribution
Throughput is the rate at which a firm generates money by spending an hour of a bottleneck resource.


Throughput contribution = Sales price – Material cost per unit

Coco Company manufactures and sells a single product. The company has recorded a contribution of
$553,000 during a year. The contribution / sales ratio and material cost of the sales for the year were
70% and 10% respectively.

Throughput for the company is calculated as follows:

Throughput = Sales revenue – Material cost

= $790,000 (W1) – ($790,000 x 10%)
= $711,000

Sales revenue= Contribution
C/S ratio

= $553,000/70% = $790,000

Limiting factor analysis and throughput accounting

Once an organisation has identified its bottleneck resource, it then has to decide how to get the most
out of that resource. Given that most businesses are producing more than one type of product (or
supplying more than one type of service), this means that part of the exploitation step involves
working out what the optimum production plan is. This is based on maximising throughput per unit of
bottleneck resource.

In key factor analysis, the contribution per unit is first calculated for each product, then a contribution
per unit of scarce resource is calculated by working out how much of the scarce resource each unit
requires in its production.

In a throughput accounting context, a very similar calculation is performed, but this time it is not
contribution per unit of scarce resource which is calculated, but throughput return per unit of
bottleneck resource.

Example 1
Beta Co produces 3 products, E, F and G, details of which are shown below:

$ $ $
Selling price per unit 120 110 130
Direct material cost per unit 60 70 85
Maximum demand (units) 30,000 25,000 40,000
Time required on the bottleneck resource (hours per unit) 5 4 3

F5 Revision notes Page 18

There are 320,000 bottleneck hours available each month. Calculate the optimum product mix each

A few simple steps can be followed:

1. Calculate the throughput per unit for each product.
2. Calculate the throughput return per hour of bottleneck resource.
3. Rank the products in order of the priority in which they should be produced, starting with the
product that generates the highest return per hour first.
4. Calculate the optimum production plan, allocating the bottleneck resource to each one in
order, being sure not to exceed the maximum demand for any of the products.

$ $ $
Selling price per unit 120 110 130
Direct material cost per unit 60 70 85
Throughput per unit 60 40 45
Time required on the bottleneck resource (hours per unit) 5 4 3
Return per factory hour $12 $10 $15
Ranking 2 3 1

Before the time taken on the bottleneck resource was taken into account, product E appeared to be the
most profitable because it generated the highest throughput per unit. However, applying the theory of
constraints, the system’s bottleneck must be exploited by using it to produce the products that
maximise throughput per hour first. This means that product G should be produced in priority to E.

Product No. of units Hrs per unit Total hrs Throughput Total
per hr throughput
G 40,000 3 120,000 $15 $1,800,000
E 30,000 5 150,000 $12 $1,800,000
F 12,500 4 50,000 $10 $5000,000

In this example, there were enough hours to produce the full quota for G and E. However, for F out of
the 320,000 hours available, 270,000 had been used up (120,000 + 150,000), leaving only 50,000
hours to spare.

Therefore, the number of units of F that could be produced was a balancing figure i.e. 50,000 hours
divided by the four hours each unit requires – ie 12,500 units.

Performance Measures

There are three main ratios that are calculated in throughput accounting:

1. Return per factory hour

Throughput per unit

Product time on bottleneck resource

F5 Revision notes Page 19

2. Factory cost per factory hour

Factory cost per unit

Product time on bottleneck resource

The ‘total factory cost’ is simply the ‘operational expense’ of the organisation. If the organisation was a
service organisation, it would simply be called ‘total operational expense’ or something similar. The
cost per factory hour is across the whole factory and therefore only needs to be calculated once.

3. Throughput Accounting Ratio

Return per factory hour

Factory cost per factory hour

In any organisation, it is expected that the throughput accounting ratio is greater than 1. This means
that the rate at which the organisation is generating cash from sales of this product is greater than the
rate at which it is incurring costs. It follows on, then, that if the ratio is less than 1, this is not the case,
and changes need to be made quickly.

Improving the throughput accounting ratio (TPAR):

 Reduce the bottleneck

 Increase the selling price
 Buy cheaper materials
 Reduce the conversion costs etc


 Products and/or divisions can be ranked according to TPAR. The TPAR should be greater than
one for a product to be viable. Priority should be given to the products generating the highest
 Alternatively the products generating highest TP contribution per unit of constraint should be
given priority.

Assumptions of Throughput Accounting:

 In the short run, all costs except materials are fixed.

 The ideal inventory level is zero and so unavoidable, idle capacity in some operations must be
accepted (JIT system is preferred).
 WIP is valued at material cost only, as no value is added and no profit earned until a sale takes
 Closing stock is referred as unsynchronized production.

Past Paper Analysis

Throughput accounting June 09 – Q 1
June 11 – Q 5
Dec 13 – Q 2
Dec 14 – Q 2

F5 Revision notes Page 20

6. Environmental Accounting

Environmental accounting is becoming increasingly topical in the modern business environment due
to increased regulation and media coverage.

Environmental management accounting (EMA)

This is the generation and analysis of both financial and non-financial information in order to support
environmental management processes.

Importance of Environmental costs

 Identifying environmental costs associated with individual products and services can assist with
pricing decisions
 Ensuring compliance with regulatory standards to prevent legal repercussions
 Potential for cost savings
 Government support
 Reputation and goodwill

Typical environmental costs

 Consumables and raw materials

 Transport and travel
 Waste disposal
 Energy consumption
 Recycled material
 Water usage
 Pollution

The majority of environmental costs are already captured within accounting systems. It is often
difficult to pinpoint and allocate them to a particular service

Methods of Environmental accounting in different organizations

1. Input/output analysis

This method operates on the principal that what comes in must go out. Output is split across sold and
stored goods and waste.

Measuring these categories in physical quantities and monetary terms, forces a business to focus on
environmental costs.

Flow diagrams are often used to illustrate how the input is split across different output such as stored
goods and waste.

2. Environmental activity-based costing

Two costs are relevant:

 Environment -related costs such as costs relating to a sewage plant or an incinerator are
attributed to joint environmental cost centers.
 Environmental -driven costs such as increased depreciation or higher staff wages are allocated
to general overheads.

F5 Revision notes Page 21

Examples of environmental cost drivers include volume of emissions and the cost of complying with

3. Flow cost accounting

Material flows through an organization are divided into three categories

 Material
 System and delivery
 Disposal

The values and costs of each flow are calculated. This method focuses on reducing costs by
questioning them and having a positive effect on the environment.

4. Life-cycle costing

Environmental costs are considered from the design stage right up to the last stage costs such as
decommissioning and waste removal etc.

This may influence the design of the product itself, saving on future costs.

Past Paper Analysis

Environmental accounting Dec 13 – Q 1c

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Part B – Decision Making Techniques

7. Cost Volume Profit (CVP) Analysis

Introduction to CVP analysis

CVP analysis stands for 'cost-volume-profit analysis'. It is used to show how costs and profits change
with changes in the volume of activity. CVP analysis is an application of marginal costing concepts.

Tins chapter explains CVP analysis and some of its applications.

Assumptions in CVP analysis

1) Costs are either fixed or variable. The variable cost per unit is the same at all levels of activity
(output and sales). Total fixed costs are a constant amount in each period.

2) Fixed costs are normally assumed to remain unchanged at all levels of output.

3) The contribution per unit is constant for each unit sold (of the same product).

4) The sales price per unit is constant for every unit of product sold; therefore the contribution to
sales ratio is also a constant value at all levels of sales.

5) If sales price per unit, variable cost per unit and fixed costs are not affected by volume of activity
sales and profits are maximised by maximising total contribution.

6) Production = sale


Contribution is a key concept. Contribution is measured as sales revenue less variable costs.

 The contribution per unit (= sales price minus variable cost) is a constant amount.

 Total contribution = Contribution per unit x Number of units sold. Profit is measured as
contribution minus fixed costs.
Sales (Units sold x sales price per unit) S
Variable costs (Units sold x variable cost price per unit) (V)
Contribution C
Fixed costs (F)
Profit Profit

Many problems solved using CVP analysis use either contribution per unit (CPU) or the CS
(Contribution/Sales) ratio.

Break-even analysis

CVP analysis can be used to calculate a break-even point for sales.

F5 Revision notes Page 23

Break-even point is the volume of sales required in a period (such as the financial year) to 'break
even' and make neither a profit nor a loss. At the break-even point, profit is zero.

Management might want to know what the break-even point is in order to:
 Identify the minimum volume of sales that must be achieved in order to avoid a loss, or
 Assess the amount of risk in the budget, by comparing the budgeted volume of sales with the
break-even volume.

Calculating the break-even point

The break-even point can be calculated using simple CVP analysis.

At the break-even point, the profit is $0. If the profit is $0, total contribution is exactly equal to total
fixed costs.

Breakeven Point - units

Break-even point in sales units = Total fixed costs

Contribution per unit

Breakeven Point - revenue

Fixed costs
Break - even sales volume $ revenue = ---- C/S ratio

Margin of safety

It is the maximum amount by which actual sales can be lower than budgeted sales without incurring a
loss for the period. A high margin of safety indicates a low risk of making a loss.

Margin of safety (%) = budgeted sale – break even sales

budgeted sales

Target profit
Management might want to know what the volume of sales must be in order to achieve a target profit.
CVP analysis can be used to calculate the volume of sales required.

Break-even point in sales units = Total fixed costs + Target Profit

Contribution per unit

Breakeven Point – Graphical Approach – extract from ACCA technical article

With the graphical method, the total costs and total revenue lines are plotted on a graph; $ is shown
on the y axis and units are shown on the x axis. The point where the total cost and revenue lines
intersect is the break-even point. The amount of profit or loss at different output levels is represented
by the distance between the total cost and total revenue lines. Figure 1 shows a typical break-even
chart for a company. The gap between the fixed costs and the total costs line represents variable costs.

F5 Revision notes Page 24

Hence, it is the difference between the variable cost line and the total cost line that represents fixed
costs. The advantage of this is that it emphasises contribution as it is represented by the gap between
the total revenue and the variable cost lines. This is shown in Figure 2.

Figure 1

Figure 2

Breakeven Analysis – Multi-products

It is often useful in single product situations, and essential in multi-product situations, to ascertain
how much each $ sold actually contributes towards the fixed costs. This is identified by the
contribution to sales or C/S ratio.

F5 Revision notes Page 25

In multi-product situations, a weighted average C/S ratio is calculated by using the formula:

Total contribution/total sales revenue

This weighted average C/S ratio can then be used to find CVP information such as break-even point,
margin of safety etc.

Worked Example:

Company A manufactures two products. The following information is available for both products:

Product x Product y
Sales price $50 $60
Variable cost $30 $45
Contribution per unit $20 $15
Budgeted sales (units) 20,000 10,000

The weighted average C/S ratio can be calculated by dividing the total expected contribution by the
total expected sales:

(20,000 x $20) + (10,000 x $15) /(20,000 x $50) + (10,000 x $60) = 34.375%

The C/S ratio is useful in its own right as it tells us what percentage each $ of sales revenue
contributes towards fixed costs; it is also invaluable in calculating the break-even point in $ sales
revenue, or the sales revenue required to generate a target profit.

The break-even point can now be calculated this way for Company A:

Fixed costs / contribution to sales ratio = $200,000/0.34375 = $581,819 of sales revenue.

To achieve a target profit of $300,000:

Fixed costs + required profit /contribution to sales ratio = $200,000 + $300,000/0.34375 =


Such calculations provide only estimated information because they assume that products x and y are
sold in a constant mix of 2x to 1y.

Multi-product profit–volume charts

The profit–volume graph is slightly different in that it focuses purely on showing a profit/loss line and
doesn’t separately show the cost and revenue lines.

In a multi-product environment, it is common to actually show two lines on the graph: one straight
line, where a constant mix between the products is assumed; and one bow-shaped line, where it is
assumed that the company sells its most profitable product first and then its next most profitable
product, and so on.

In order to draw the graph, it is therefore necessary to work out the C/S ratio of each product being
sold before ranking the products in order of profitability. It is easy here for Company A, since only two

F5 Revision notes Page 26

products are being produced, and so it is useful to draw a quick table in order to ascertain each of the
points that need to be plotted on the graph in order to show the profit/loss lines.

Table 3: Figure 3 continued

Product x Product y
Sales price $50 $60
Variable cost $30 $45
Contribution per unit $20 $15
Budgeted sales (units) 20,000 10,000
C/S ratios 0.4 0.25
Weighted average C/S ratio 0.34375
Product ranking (most profitable first) 1 2

Cumulative profit/loss Cumulative revenue

Contribution Revenue
$'000 $'000
Product $'000 $'000
(Fixed costs) 0 (200) 0 0
X 400 200 1,000,000 1,000,000
Y 150 350 600,000 1,600,000

The graph can then be drawn (Figure 3), showing cumulative sales on the x axis and cumulative
profit/loss on the y axis. It can be observed from the graph that, when the company sells its most
profitable product first (x) it breaks even earlier than when it sells products in a constant mix. The
break-even point is the point where each line cuts the x axis.

Figure 3

F5 Revision notes Page 27

Limitations of cost-volume-profit analysis

 Cost-volume-profit analysis is invaluable in demonstrating the effect on an organisation that

changes in volume (in particular), costs and selling prices, have on profit. However, its use is
limited because it is based on the following assumptions: Either a single product is being sold or,
if there are multiple products, these are sold in a constant mix.
 All other variables, apart from volume, remain constant, ie volume is the only factor that causes
revenues and costs to change. In reality, this assumption may not hold true as, for example,
economies of scale may be achieved as volumes increase. Similarly, if there is a change in sales
mix, revenues will change. Furthermore, it is often found that if sales volumes are to increase,
sales price must fall.
 The total cost and total revenue functions are linear. This is only likely to hold a short-run,
restricted level of activity.
 Costs can be divided into a component that is fixed and a component that is variable. In reality,
some costs may be semi-fixed, such as telephone charges, whereby there may be a fixed monthly
rental charge and a variable charge for calls made.
 Fixed costs remain constant over the 'relevant range' - levels in activity in which the business has
experience and can therefore perform a degree of accurate analysis. It will either have operated at
those activity levels before or studied them carefully so that it can, for example, make accurate
predictions of fixed costs in that range.
 Profits are calculated on a variable cost basis or, if absorption costing is used, it is assumed that
production volumes are equal to sales volumes.

Past Paper Analysis

CVP analysis Dec 12 – Q 1
Dec 15 – Q 4

F5 Revision notes Page 28

8. Limiting Factor Analysis

A limiting factor is any factor that is in scarce supply and that stops the organisation from
expanding its activities further, that is, it limits the organisation’s activities.

It is assumed in limiting factor analysis that management would make a product mix decision or
service mix decision based on the option that would maximise profit and that profit is maximized
when contribution is maximised (given no change in fixed cost expenditure incurred).

Worked Example

Hopper Ltd makes two products, the Bunny and the Babbit. Unit variable costs are as follows.

Bunny Babbit
$ $
Direct materials 1 3
Direct labour ($3 per hour) 6 3
Variable overhead 1 1
8 7

The sales price per unit is $14 per Bunny and $11 per Babbit. During July the available direct labour is
limited to 8,000 hours. Sales demand in July is expected to be as follows.

Bunny 3,000 units

Babbit 5,000 units

Determine the production budget that will maximise profit, assuming that fixed costs per month are
$20,000 and that there is no opening inventory of finished goods or work in progress.

Confirm that the limiting factor is something other than sales demand.

Bunny Babbit Total

Labour hours per unit 2 hrs 1 hr
Sales demand 3,000 units 5,000 units
Labour hours needed 6,000 hrs 5,000 hrs 11,000 hrs
Labour hours available 8,000 hrs
Shortfall 3,000 hrs

Labour is the limiting factor on production.

Identify the contribution earned by each product per unit of scarce resource, that is, per labour hour
Bunny Babbit
$ $
Sales price 14 11
Variable cost 8 7
Unit contribution 6 4
Labour hours per unit 2 hrs 1 hr
Contribution per labour hour (= per unit of limiting $3 $4

F5 Revision notes Page 29

Although Bunny has a higher unit contribution than Babbit, two units of Babbit can be made in the
time it takes to make one Bunny. Because labour is in short supply it is more profitable to make Babbit
than Bunny.

Determine the budgeted production and sales. Sufficient volume of Babbit will be made to meet the
full sales demand, and the remaining labour hours available will then be used to make Bunny.

(a) Hours Hours Priority for

Product Demand Required Available Manufacture
Babbit 5,000 5,000 5,000 1st
Bunny 3,000 6,000 3,000 (bal) 2nd
11,000 8,000

(b) Hours Contribution

Product Units Needed per unit Total
$ $
Babbit 5,000 5,000 4 20,000
Bunny (balance) 1,500 3,000 6 9,000
8,000 8,000
Less fixed costs 20,000
Profit 9,000

(a) Unit contribution is not the correct way to decide priorities.
(b) Labour hours are the scarce resource, therefore contribution per labour hour is the correct
way to decide priorities.
(c) The Babbit earns $4 contribution per labour hour, and the Bunny earns $3 contribution per
labour hour. Babbit therefore make more profitable use of the scarce resource, and should be
manufactured first.

Limiting Factor – Make or Buy Decision

In a situation where a company must sub-contract work to make up a shortfall in its own in
house capabilities, its total costs will be minimised if those units bought have the lowest extra
variable cost of buying per unit of scarce resource saved by buying.

CAW manufactures two products, the L and the L1, using the same material for each. Annual demand
for the L is 9,000 units, while demand for the L1 is 12,000 units. The variable production cost per unit
of the L is $10, that of the L1 $15. The L requires 3.5 kgs of raw material per unit, the L1 requires 8 kgs
of raw material per unit. Supply of raw material will be limited to 87,500 kgs during the year.

A sub-contractor has quoted prices of $17 per unit for the L and $25 per unit for the L1 to supply the
product. How many of each product should CAW manufacture in order to maximise profits?

L L1
$ per unit $ per unit
Variable cost of making 10 15
Variable cost of buying 17 25
Extra variable cost of buying 7 10
Raw material saved by buying 3.5 kgs 8 kgs
Extra variable cost of buying per kg saved $2 $1.25
Priority for internal manufacture 1 2

F5 Revision notes Page 30

Production plan Material used
Make L (9,000 × 3.5 kgs) 31,500
L1 (7,000 × 8 kgs) 56,000

The remaining 5,000 units of L1 should be purchased from the contractor.

Linear Programming – extract from ACCA technical article

If there are multiple limiting factors, Linear programming approach is used.

Worked Example:

Suppose a profit-seeking firm has two constraints: labour, limited to 16,000 hours, and materials,
limited to 15,000kg. The firm manufactures and sells two products, X and Y.

To make X, the firm uses 3kg of material and 4 hours of labour, whereas to make Y, the firm uses 5kg
of material and 4 hours of labour. The contributions made by each product are $30 for X and $40 for
Y. The cost of materials is normally $8 per kg, and the labour rate is $10 per hour.

The first step in any linear programming problem is to produce the equations for constraints and the
contribution function, which should not be difficult at this level.

The materials constraint will be 3X + 5Y ≤ 15,000, and the labour constraint will be 4X + 4Y ≤ 16,000.

The non-negativity constraint of X,Y ≥ 0.

The contribution function is 30X + 40Y = C

Figure 1: Optimal production plan

Plotting the resulting graph (Figure 1, the optimal production plan) will show that by pushing out the
contribution function, the optimal solution will be at point B – the intersection of materials and
labour constraints.

F5 Revision notes Page 31

The optimal point is X = 2,500 and Y = 1,500, which generates $135,000 in contribution (Working 1).
The ability to solve simultaneous equations is assumed in this article.

The point of this calculation is to provide management with a target production plan in order to
maximise contribution and therefore profit. However, things can change and, in particular,
constraints can relax or tighten. Management needs to know the financial implications of such
changes. For example, if new materials are offered, how much should be paid for them? And how
much should be bought? These dynamics are important.

Working 1:
The optimal point is at point B, which is at the intersection of:
3X + 5Y = 15,000 and
4X + 4Y = 16,000

Multiplying the first equation by four and the second by three we get:
12X + 20Y = 60,000
12X + 12Y = 48,000

The difference in the two equations is:

8Y = 12,000, or Y = 1,500

Substituting Y = 1,500 in any of the above equations will give us the X value:
3X + 5 (1,500) = 15,000
3X = 7,500
X = 2,500

The contribution gained is (2,500 x 30) + (1,500 x 40) = $135,000

How many materials to buy?

As more material is bought, the constraint relaxes and so its line on the graph moves outwards and
away from the origin. Eventually, the materials line will be totally outside the labour line on the graph
and the point at which this happens is the point at which the business will cease to find buying more
materials attractive (point D on the graph). Labour would then become the only constraint.

It is important to determine how many materials are needed at point D on the graph, the point at
which 4,000 units of Y are produced. To make 4,000 units of Y, 20,000kg of materials is needed.
Consequently, the maximum amount of extra material required is 5,000kg (20,000 – 15,000).

Important Definitions:

1. Shadow price: the amount of contribution generated by having one extra unit of the binding
constraint- it’s the maximum premium the company could pay by having one extra unit of the
limited resource at optimal point
2. Slack: the best utilization of resource is not the full utilization of resource; if a resource is not
binding at the optimal point it will have slack
3. Surplus: when the resource use is more than the minimum required, it is said to have surplus

Suppose the shadow price of materials is $5 per kg (Working 2). What does this mean?

F5 Revision notes Page 32

If management is offered more materials it should be prepared to pay no more than $5 per kg over the
normal price. Paying less than $13 ($5 + $8) per kg to obtain more materials will make the firm better
off financially. Paying more than $13 per kg would render it worse off in terms of contribution gained.

There may, of course, be a good reason to buy ‘expensive’ extra materials (those costing more than $13
per kg). It might enable the business to satisfy the demands of an important customer who might, in
turn, buy more products later. The firm might have to meet a contractual obligation, and so paying
‘too much’ for more materials might be justifiable if it will prevent a penalty on the contract. Equally,
it might be that ‘cheap’ material, priced at under $13 per kg, is not attractive. Quality is a factor, as is
reliability of supply.

Working 2: Shadow price of materials (from the above example)

To find this we relax the material constraint by 1kg and resolve as follows:
3X + 5Y = 15,001 and
4X + 4Y = 16,000

Again, multiplying by four for the first equation and by three for the second produces:
12X + 20Y = 60,004
12X + 12Y = 48,000
8Y = 12,004
Y = 1,500.5

Substituting Y = 1,500.5 in any of the above equations will give us X:

3X + 5 (1,500.5) = 15,001
3X = 7,498.5
X = 2,499.5

The new level of contribution is: (2,499.5 x 30) + (1,500.5 x 40) = $135,005

The increase in contribution from the original optimal is the shadow price:
135,005 – 135,000 = $5 per kg.

F5 Revision notes Page 33

Worked Example 2:

Consider the following past exam paper question in detail

F5 Revision notes Page 34

F5 Revision notes Page 35
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F5 Revision notes Page 37
Past Paper Analysis
Limiting Factor Analysis June 08 – Q 2
June 10 – Q 3
Dec 10 – Q 3
June 14 – Q 2

F5 Revision notes Page 38

9. Pricing Decisions

Influences on Price: Price of a product is decided after taking into account many factors apart
from Cost.

Price Sensitivity If customers of the product can pass on the burden of the cost to someone else,
they will not be price sensitive. E.g. A customer will travel business class if his/
her company is bearing the expenses but will reconsider if he/ she has to spend
own money.
Price Perception E.g. if the price of sugar is increased and the customer perceives that the price will
further increase, they will stock-up on the product.
Quality Customers may consider high prices to be a reflection of the high quality of the
Competitors Some companies show unified increase in price (e.g. petrol) but in others a
change in price, may start a price war (e.g. mobile network services).
Suppliers If a company increases the price of its products, the suppliers may start providing
the raw material at a higher price too.
Inflation Prices have to reflect the increase in material and labour cost.
Newness Pricing will depend upon reference points and in the case of new products’ a
company may have to look at other markets where the product/ similar product
has been launched.
Incomes If customers have more income, their focus is quality and accessibility of product
but if income decreases, focus is on price.
Product Range Price can be spread over a complete product range to maintain profitability. E.g.
sell ink pens cheaper but make up for profit in the price of ink.
Ethics Does the company want to exploit the market by increasing prices when there is a
short term shortage of the product in the market?

Market: Price is determined by the type of market, the company operates in:

• Multiple buyers and • One seller with the

sellers power to influence price
• No power saturation



• Few companies offering •Multiple suppliers with

same product have similar products.
power to influence price •Customer preference
• Form cartels dictates who holds the power

F5 Revision notes Page 39

Competition: If competitors cut prices, a company can react in the following possible ways:

Non Price Counter Attack: maintain

Maintain exitsing prices
price but improve product/ promotion.

Raise Price and use extra revenue for

Reduce price
non price counter attack


Economic theory argues that the higher the price of a good, the lower will be the quantity demanded.

However there are two extremes to this theory:

A company is able to sell a fixed quantity (Q) of the A company is able to sell limitless quantity
product, regardless of any price (P). This is termed as (Q) of the product at a set price (P). This is
completely inelastic demand as change in price does termed as completely elastic demand as
not affect the quantity demanded. change in price will substantially affect the
quantity demanded.

A more normal situation is the downward-

sloping demand curve which shows that
demand will increase as prices are lowered.
Demand is therefore elastic.

Price Elasticity of Demand: It is a measure of the change in sales demand that would occur for a
given change in the selling price.

PED = The change in quantity demanded as a percentage of original demand

The change in sales price as a percentage of the original price

PED > 1 than demand is elastic: impact on quantity demanded is greater due to change in price

PED< 1 than demand is inelastic: impact on quantity demanded due to change in price is nominal

F5 Revision notes Page 40

Elasticity and Pricing:

Very Inelastic As price will have no impact on quantity demanded, company should focus
Demand on quality, service, product design etc to attract customers.
Inelastic Demand As price has nominal impact on demand, increase the price so that revenue
increases and costs reduce due to smaller quantity being produced.
Elastic Demand Find right balance to ensure that the revenue earned is greater than the costs
Very Elastic Demand Try and control elasticity by creating customer preferences through quality,
service etc.

Demand Influencers:

Price of other goods Substitutes: Increase in price of one product will lead to customers
moving towards the substitute available.

Complements: Increase in demand for one product will give rise to

demand of complementary product.

Increase in Income Normal goods: more income more demand

Inferior goods: more income less demand

Necessities: demand rises up to a certain point and then remains

unchanged, because there is a limit to what consumers can or want to

Tastes or fashion A change in tastes or fashion will alter the demand for a good, or a
particular variety of a good.

Expectations Stock up may occur if customers expect the prices to rise and this will
lead to more demand.
Obsolescence Many products and services have to be replaced periodically because of

Demand/ Price Influencers – Organisation Specific

 Product Life Cycle: Demand varies over the life cycle of a product.
 Introduction Phase: The price has no impact on demand at the initial stage, when
there is little or no competition in the market.
 Growth: Prices will have to be reduced as competition increases, to maintain demand.
 Maturity: Prices can be stabilised unless the competitors reduce their prices.
 Decline: Prices may fall due to lower demand or prices can be increased if the
competition withdraws from the market and you are the only one offering the
 Quality: If the product is of good quality, the demand may be high regardless of price.
 Marketing: The 4 P’s of marketing are demand influencers:
 Price
 Product
 Place: of purchase. If goods are not easily accessible, customers will turn to
 Promotion: developing a brand name and using a variety of promotional tools will
lead to increased demand for the product.

F5 Revision notes Page 41

Demand Equation:


The current price of a product is $18. At this price the company sells 100 items a month. One month
the company decides to raise the price to $22, but only 75 items are sold at this price.

Determine the demand equation.


Step 1: Find the price at which demand would be nil

Assuming demand is linear, each increase of $4 in the price would result in a fall in demand of 25
units. For demand to be nil, the price needs to rise from its current level by as many times as there are
25 units in 100 units (100/25 = 4) ie to $18 + (4 x $4) = $34.

Using the formula above, this can be shown as a = $18 + ((100/25) x $4) = $34

Step 2: Calculate b

b = Change in price $22- $18 = 4 = 0.05

Change in quantity 100 -75 75

Step 3: Substitute the known value for ‘b’ into the demand function to find ‘a’

P = a - (0.05Q)
18 = a - (0.05 x 100)
18 =a-5
a = 23
The demand equation is therefore P = 23 – 0.05Q

Step 4: Check your equation

We can check this by finding Q when P is $18.

18 = 23 – (0.05Q)
0.05Q = 23 – 18
0.05Q = 5
Q = 5 = 100

F5 Revision notes Page 42

The Total Cost Function:

Cost behaviour can be modelled using equations.

Total Cost (TC) = Fixed Cost (FC) + [Variable Cost (VC) x Quantity sold (Q)]

The following graph demonstrates the total cost function.

Errors in using these models:

 Assume that fixed costs remain constant when in reality there is a concept of Step Fixed Costs
 Assume that Variable Cost per unit remains constant when in reality they change due to
economies/ diseconomies of scale or Volume Based Discounts (discounts given for bulk

The Profit-Maximizing Price/Output Level

Profits are maximized when marginal cost (MC) = marginal revenue (MR).

Microeconomic theory and profit maximisation

Profit Maximisation is the process by which a firm determines the price and output level that returns
the greatest profit. There are two common approaches to this problem.

 The Total revenue (TR) – Total cost (TC) method is based on the fact that profit equals
revenue minus cost.

From the graph, it is evident that the

difference between total costs and total
revenue is greatest at point Q. This is the
profit maximising output quantity.

F5 Revision notes Page 43

 The Marginal revenue (MR) – Marginal cost (MC) method is based on the fact that total profit
in a perfect market reaches its maximum point where marginal revenue equals marginal cost.

Profits are maximised at the

point where MC = MR, ie at
a volume of Qn units. If we
add a demand curve to the
graph, we can see that at an
output level of Qn, the sales
price per unit would be Pn.

Determining the Profit-Maximising Selling Price: Using Equations

The optimal selling price can be determined using equations (ie when MC = MR).


It has been determined based on research that if a price of $400 is charged for product G, demand will
be 12,000 units. Demand will rise or fall by 20 units for every $1 fall/rise in the selling price. The
marginal cost of product G is $120. Calculate the profit-maximising selling price for product G.

The following step-by-step approach can be applied to most questions involving algebra and pricing.
Step 1: Establish the demand function (find the values for ‘a’ and ‘b’)
b = change in price = $1 = 0.05
change in quantity 20
a = $400 + [(12,000 /20) x $1] = $1,000
Step 2: Establish MC (the marginal cost). This will simply be the variable cost per unit
MC = $120 (given)
Step 3: State MR, assuming MR = a – 2bQ
MR = $1,000 – (2 x 0.05) Q = $1,000 – 0.1Q
Step 4: To maximise profit, equate MC and MR to find Q
$120 = $1,000 – 0.1Q

F5 Revision notes Page 44

Q = ($1,000 - $120) x (10/1) = 8,800 is profit maximising demand
Step 5: Substitute Q into the demand function and solve to find P (the optimum price)
P = a – bQ = $1,000 – (0.05 x 8,800) = $560

Price Strategies

Full cost plus pricing:

Calculate full cost of product and add desired profit to determine selling price.

Profit is expressed as either:

 a percentage of the full cost (a profit 'mark-up') or

 a percentage of the sales price (a 'profit margin').


Mark-Up Margin

% $ % $

Variable production costs 600 600

Other variable costs 200 200

Production overheads absorbed 800 800

Non-production overheads absorbed 300 300

Full cost 100 1,900 80 1,900

Profit (added to full cost) 25 475 20 475

Selling price 125 2,375 100 2,375

 Advantages:
 Quick, simple and cheap method to set product price.
 As profit % is added to full cost, all the expenses are easily recovered.
 Disadvantages:
 Ignores profit maximisation combination of price and demand.
 In reality the price has to be adjusted to market and demand conditions.
 Relies on budgeted output volume to determine appropriate absorption rate for
 Suitable basis for overhead absorption rate has to be selected.

Marginal Cost plus Pricing (Mark-Up Pricing):

A mark-up or profit margin is added to the marginal cost in order to obtain a selling price.

The method of calculating sales price is similar to full-cost pricing, except that marginal cost is used
instead of full cost.

F5 Revision notes Page 45

 Advantages:
 Simple and easy to calculate.
 Mark up % can be varied to reflect demand conditions.
 Focuses attention on the contribution of the product, which is a key factor in decision
 Useful in industries where the Variable cost per unit is easily available.
 Disadvantages:
 Apart from demand, other relevant market factors, like prices set by competitors etc.
are ignored.
 Ignores fixed overheads in pricing decisions.

Market Skimming Prices:

Charging a high price when the product is introduced in the market for the first time, with the hope of
skimming the market for profits. The price of the product is adjusted at a later date.

This is an appropriate approach for:

 When the product is new and different.

 When its demand elasticity is unknown.
 When a company is trying to resolve its liquidity issues.
 When a company is aware of market segments that are willing to pay more.
 When a product has a short lifecycle and its costs are to be recovered as soon as possible.

Market Penetration Prices:

Introducing a product at low costs to establish its stronghold in the market.

This is an appropriate approach for:

 When a company is trying to discourage new entrants in the market.

 When a company wishes to push a product to its growth and maturity stage quickly.
 When a company can enjoy great economies of scale at high sales volume.
 Product demand is highly elastic and so low prices will generate a lot of demand.

Complementary Products Pricing:

Setting a single pricing policy for goods that are complementary i.e. are normally bought together. E.g.
Computer games console and computer games.

Loss Leader: is when a company sells a low price for one product to attract customers and ends up
selling complementary products with high profit margins. This is also termed as ‘Captive Product

Product Lines Pricing:

Setting a consistent pricing policy for a group of products that are related to each other. E.g. same
policy for shampoos, skin care products etc. of the same brand.

Price Discrimination (Differential Pricing):

Charging different prices to different groups of buyers for the same product.

Some bases for price discrimination is:

 Market Segment: students get discounted tickets on public transport.

F5 Revision notes Page 46

 Product Version: Add-ons/ extras for mobile phones, that are not reflected in the original
price of the phone but offered as a separate package.
 Place: Seating arrangements in cinema halls, with expensive tickets for more comfortable
 Time: Off peak travel discounts.

Relevant Cost Pricing (Minimum Pricing):

Calculating a minimum price of the product/ order, at which the company will neither be better off,
nor worse off. If sold at more than the minimum price, the company will enjoy a profit.

The minimum price calculated must take into account the following:

 Incremental cost of producing and selling the product

 Opportunity costs in the form of resources uses to produce and sell the product

To earn a profit, the company needs to sell the product/ order at a price higher than the minimum

Past Paper Analysis

Pricing Decisions Dec 09 – Q 5
June 11 – Q 2
June 15 – Q 4

F5 Revision notes Page 47

10. Short Term Decisions

Relevant Costs: Are incremental future cash flows, arising as a direct consequence of a decision.

 Sunk costs, Committed costs and non-cash expenses like depreciation are irrelevant costs.

Relevant Costs for Material:

Relevant Costs for Labour:

 If labour is re-assigned tasks to take up new project or product, the variable cost of labour,
variable overheads and the contribution foregone are relevant for decision making.

Relevant Costs for Machinery:

 Purchase cost of machinery is irrelevant unless specifically bought for a product/ job.
 The rent of a machine hired for a job, is relevant.
 User Cost: is the fall in resale value of owned assets, due to use of the machinery in a specific

Opportunity Costs

The value of a benefit given up, in order to avail the benefit from an alternative.

For example, if a material is in short supply, it may be transferred from the production of one product
to that of another product. The opportunity cost is the contribution lost from ceasing production of
the original product.

F5 Revision notes Page 48

Worked Example – Past exam paper question

The Hi Life Co (HL Co) makes sofas. It has recently received a request from a customer to provide a
one-off order of sofas, in excess of normal budgeted production. The order would need to be
completed within two weeks. The following cost estimate has already been prepared:

1. The fabric is regularly used by HL Co. There are currently 300 m2 in inventory, which cost
$17 per m2. The current purchase price of the fabric is $17·50 per m2.
2. This type of wood is regularly used by HL Co and usually costs $8·20 per m2. However, the
company’s current supplier’s earliest delivery time for the wood is in three weeks’ time. An
alternative supplier could deliver immediately but they would charge $8·50 per m2. HL Co
already has 500 m2 in inventory but 480 m2 of this is needed to complete other existing
orders in the next two weeks. The remaining 20 m2 is not going to be needed until four weeks’
3. The skilled labour force is employed under permanent contracts of employment under which
they must be paid for 40 hours’ per week’s labour, even if their time is idle due to absence of
orders. Their rate of pay is $16 per hour, although any overtime is paid at time and a half. In
the next two weeks, there is spare capacity of 150 labour hours.
4. There is no spare capacity for semi-skilled workers. They are currently paid $12 per hour or
time and a half for overtime. However, a local agency can provide additional semi-skilled
workers for $14 per hour.
5. The $3 absorption rate is HL Co’s standard factory overhead absorption rate; $1·50 per hour
reflects the cost of the factory supervisor’s salary and the other $1·50 per hour reflects general
factory costs. The supervisor is paid an annual salary and is also paid $15 per hour for any
overtime he works. He will need to work 20 hours’ overtime if this order is accepted.
6. This is an apportionment of the general administration overheads incurred by HL Co.


F5 Revision notes Page 49

1. Since the material is in regular use by HL Co, it is replacement cost which is the relevant cost
for the contract.
2. 30 m will have to be ordered from the alternative supplier for immediate delivery but the
remaining 20 m can be used from inventory and replaced by an order from the usual supplier
at a cost of $8·20 per m.
3. There is no cost for the first 150 hours of labour because there is spare capacity. The
remaining 50 hours will be paid at time and a half, which is $16 x 1·5, i.e. $24 per hour.
4. HL Co will choose to use the agency workers, who will cost $14 per hour, since this is cheaper
than paying existing semi-skilled workers at $18 per hour ($12 x 1·5) to work overtime.
5. None of the general factory costs are incremental, so they have all been excluded. However,
the supervisor’s overtime pay is incremental, so has been included. The supervisor’s normal
salary, on the other hand, has been excluded because it is not incremental.
6. These are general overheads and are not incremental, so no value should be included for

Make or Buy Decisions:

 Normally applied in the following circumstances:

 Whether a company should manufacture its own components, or else buy the components
from an outside supplier
 Whether a construction company should do some work with its own employees, or whether it
should sub-contract the work to another company
 Whether a service should be carried out by an internal department or whether an external
organisation should be employed
 Without limiting factors the relevant costs for the make or buy decision will be the differential
costs between the two options.

Worked Example
A company makes two components F and P, for which costs in the forthcoming year are expected to be
as follows.
Production (units) 1,000 2,000
Unit marginal costs $ $
Direct materials 4 5
Direct Labour 8 9
Variable production overheads 2 3

Directly attributable fixed costs per annum and committed fixed costs:
Incurred as a direct consequence of making F $1,000
Incurred as a direct consequence of making P $5,000
A sub-contractor has offered to supply units of F & P for $12 and $21 respectively.

Should the company make or buy the components?

$ $
Unit variable cost of making 14 17
Unit variable cost of buying 12 21
2 4
Annual requirements (units) 1,000 2,000
$ $
Extra variable cost of buying (per annum) (2,000) 8,000
Fixed costs saved by buying (1,000) (5,000)
Extra total cost of buying (3,000) 3,000

F5 Revision notes Page 50

The company would save $3,000 pa by sub-contracting component W (where the purchase cost would
be less than the marginal cost per unit to make internally) and would save $2,000 pa by
subcontracting component Z (because of the saving in fixed costs of $8,000).


 This is the use of external suppliers for finished products, components or services. This is also
known as contract manufacturing or sub-contracting.
 Reasons for Outsourcing:
 Hiring specialists ensures the quality of the end product and efficiency.
 Outsourcing leads to spare resources that can be effectively utilised in other core areas.
 Company’s offering outsourcing services have the capacity and flexibility to meet ad-hoc
variations in the demand.
 There isn’t enough work to justify the recruitment of resources for a specific function.
 Companies rely on outsourcing facilities for administrative and maintenance tasks.
 The performance of ‘outsourcers’ has to be monitored and measured to make sure quality and
targets are not compromised upon.

Joint Products:

 Joint products are two or more products which are output from the same processing operation,
but which are indistinguishable from each other up to their point of separation. Each product post
separation has a substantial sales value.
 A joint product is regarded as an important saleable item, and so it should be separately costed.
The profitability of each joint product should be assessed in the cost accounts.
 The point at which joint products become separately identifiable is known as the split-off point or
separation point.
 Costs incurred prior to this point of separation are common or joint costs, and these need to be
allocated (apportioned) in some manner to each of the joint products.
 Problems in accounting for joint products are basically of two different sorts.
 How common costs should be apportioned between products, in order to put a value to
closing inventory and to the cost of sale (and profit) for each product.
 Whether it is more profitable to sell a joint product at one stage of processing, or to process
the product further and sell it at a later stage.

Worked Example

A Company produces two joint products, S and T from the same process.

Joint processing costs of $150,000 are incurred up to split-off point, when 100,000 units of S and
50,000 units of T are produced.

The selling prices at split-off point are $1.25 per unit for S and $2.00 per unit for T.

The units of S could be processed further to produce 60,000 units of a new chemical, S+, but at an
extra fixed cost of $20,000 and variable cost of 30c per unit of input.

The selling price of S+ would be $3.25 per unit.

Should the company sell S or S+?

F5 Revision notes Page 51

S S+
Selling price per unit $1.25 $3.25
$ $ $
Total sales 125,000 195,000
Post-separation processing costs ___ Fixed 20,000
___ Variable 30,000 50,000
Sales minus post-separation 125,000 145,000
(further processing) costs

It is $20,000 more profitable to convert S into S+.

Shut Down Decisions

 Discontinuance or shutdown problems involve the following decisions.

 Whether or not to close down a loss making / expensive product line, department or other
 Permanent or temporary closure?
 Employees affected by the closure must be made redundant or relocated, perhaps after
retraining, or else offered early retirement.
 It is possible, however, for shutdown problems to be simplified into short-run decisions, by
making one of the following assumptions.
 Non-current asset sales and redundancy costs would be negligible.
 Income from non-current asset sales would match redundancy costs and so these capital
items would be self-cancelling.
 In such circumstances the financial aspect of shutdown decisions would be based on short-
run relevant costs.

Worked Example

Company V makes four products, P, Q, R and S. The budget for next year is as follows:

P Q R S Total
$000 $000 $000 $000 $000
Direct materials 300 500 400 700 1,900
Direct labour 400 800 600 400 2,200
Variable overheads 100 200 100 100 500
800 1,500 1,100 1,200 4,600
Sales 1,800 1,650 2,200 1,550 7,200
Contribution 1,000 150 1,100 350 2,600
Directly attributable fixed costs (400) (250) (300) (300) (1,250)
Share of general fixed costs (200) (200) (300) (400) (1,100)
Profit/(loss) 400 (300) 500 (350) 250

'Directly attributable fixed costs' are cash expenditures that are directly attributable to each individual
product. These costs would be saved if operations to make and sell the product were shut down.

Required: State with reasons whether any of the products should be withdrawn from
the market.

F5 Revision notes Page 52

From a financial viewpoint, a product should be withdrawn from the market if the savings from
closure exceed the benefits of continuing to make and sell the product. If a product is withdrawn from
the market, the company will lose the contribution, but -will save the directly attributable fixed costs.

Product P and product R both make a profit even after charging a share of general fixed costs.

On the other hand, product Q and product S both show a loss after charging general fixed costs, and
we should therefore consider whether it might be appropriate to stop making and selling either or
both of these products, in order to eliminate the losses.

Effect of shutdown P Q R S

$000 $000 $000 $000

Contribution forgone (1,000) (150) (1,100) (350)

Directly attributable fixed costs saved 400 250 300 300

Increase/(reduction) in annual cash flows (600) 100 (800) (50)

Although product S makes a loss, shutdown would reduce annual cash flows because the contribution
lost would be greater than the savings in directly attributable fixed costs.

However, withdrawal of product Q from the market would improve annual cash flows by $100,000,
and withdrawal is therefore recommended on the basis of this financial analysis.

Decision recommended: Stop making and selling product Q but carry on making and selling product

Past Paper Analysis

Short term decision making June 09 – Q 4
Dec 11 – Q 1
Dec 14 –Q 3
June 12 – Q 1
Dec 07 – Q 4
Dec 13 – Q 1a

F5 Revision notes Page 53

11. Risk and Uncertainty

Extract of ACCA Technical Article

The basic definition of risk is that the final outcome of a decision, such as an investment, may differ
from that which was expected when the decision was taken. Risk and uncertainty are distinguished in
terms of the availability of probabilities.

Risk is when the probabilities of the possible outcomes are known (such as when tossing a coin or
throwing a dice); uncertainty is where the randomness of outcomes cannot be expressed in terms of
specific probabilities.

However, it is generally not possible to allocate probabilities to potential outcomes, and therefore the
concept of risk is largely redundant.

Attitudes to risk

Risk seeker: A decision maker interested in the best outcomes no matter how small the chance that
they may occur.

Risk neutral: A decision maker concerned with what will be the most likely outcome.

Risk Averse: A decision maker whose acts are based on the assumption that the worst outcome
might occur.


The term ‘probability’ refers to the likelihood or chance that a certain event will occur, with potential
values ranging from 0 (the event will not occur) to 1 (the event will definitely occur). The total of all
the probabilities from all the possible outcomes must equal 1, ie some outcome must occur.

A real world example could be that of a company forecasting potential future sales from the
introduction of a new product in year one, as depicted in the following table:

Table 1: Probability of new product sales

Sales $500,000 $700,000 $1,000,000 $1,250,000 $1,500,000

Probability 0.1 0.2 0. 0.2 0.1

From Table 1, it is clear that the most likely outcome is that the new product generates sales of
£1,000,000, as that value has the highest probability.

Expected values and dispersion

Using the information regarding the potential outcomes and their associated probabilities, the
expected value of the outcome can be calculated simply by multiplying the value associated with each
potential outcome by its probability. Referring back to Table 1, regarding the sales forecast, then the
expected value of the sales for year one is given by:

F5 Revision notes Page 54

Expected value
= ($500,000)(0.1) + ($700,000)(0.2) + ($1,000,000)(0.4) + ($1,250,000)(0.2) + ($1,500,000)(0.1)
= $50,000 + $140,000 + $400,000 + $250,000 + $150,000
= $990,000

In this example, the expected value is very close to the most likely outcome, but this is not necessarily
always the case. Moreover, it is likely that the expected value does not correspond to any of the
individual potential outcomes.

A further point regarding the use of expected values is that the probabilities are based upon the event
occurring repeatedly, whereas, in reality, most events only occur once.

Decision-making criteria

The decision outcome resulting from the same information may vary from manager to manager as a
result of their individual attitude to risk. Individuals can be distinguished between who are risk averse
(dislike risk) and individuals who are risk seeking (content with risk). Similarly, the appropriate
decision-making criteria used to make decisions are often determined by the individual’s attitude to

Decision making is based on the following criteria:

1 Maximin
2 Maximax
3 Minimax regret

An ice cream seller, when deciding how much ice cream to order (a small, medium, or large order),
takes into consideration the weather forecast (cold, warm, or hot). There are nine possible
combinations of order size and weather, and the payoffs for each are shown in the table below:

Decision-making combinations

Order/weather Cold Warm Hot

Small $250 $200 $150
Medium $200 $500 $300
Large $100 $300 $750

The highest payoffs for each order size occur when the order size is most appropriate for the weather,
ie small order/cold weather, medium order/warm weather, large order/hot weather. Otherwise,
profits are lost from either unsold ice cream or lost potential sales.

1 Maximin

This criteria is based upon a risk-averse (cautious) approach and bases the order decision upon
maximising the minimum payoff. The ice cream seller will therefore decide upon a medium order, as
the lowest payoff is £200, whereas the lowest payoffs for the small and large orders are £150 and $100

2 Maximax

This criteria is based upon a risk-seeking (optimistic) approach and bases the order decision upon
maximising the maximum payoff. The ice cream seller will therefore decide upon a large order, as the

F5 Revision notes Page 55

highest payoff is $750, whereas the highest payoffs for the small and medium orders are $250 and
$500 respectively.

3 Minimax regret

This approach attempts to minimise the regret from making the wrong decision and is based upon
first identifying the optimal decision for each of the weather outcomes. If the weather is cold, then the
small order yields the highest payoff, and the regret from the medium and large orders is $50 and
$150 respectively. The same calculations are then performed for warm and hot weather and a table of
regrets constructed, as below:

Table of regrets

Order/weather Cold Warm Hot

Small $0 $300 $600
Medium $50 $0 $450
Large $100 $200 $0

The decision is then made on the basis of the lowest regret, which in this case is the large order with
the maximum regret of $200, as opposed to $600 and $450 for the small and medium orders.

Decision Trees

Decision trees and multi-stage decision problems

A decision tree is a diagrammatic representation of a problem and on it all possible courses of action
that can be taken in a particular situation and all possible outcomes for each possible course of action
are shown. It is particularly useful where there are a series of decisions to be made and/or several
outcomes arising at each stage of the decision-making process.

Decision trees provide a useful method of breaking down a complex problem into smaller, more
manageable pieces.

There are two stages to making decisions using decision trees.

The first stage is the construction stage, where the decision tree is drawn and all of the probabilities
and financial outcome values are put on the tree. The principles of relevant costing are applied
throughout – ie only relevant costs and revenues are considered.

The second stage is the evaluation and recommendation stage. Here, the decision is ‘rolled back’ by
calculating all the expected values at each of the outcome points and using these to make decisions
while working back across the decision tree. A course of action is then recommended for management.

Constructing the tree

A decision tree is always drawn starting on the left hand side of the page and moving across to the
right. Decision points represent the alternative courses of action that are available. These are within
control – it is the organisation’s choice. It can either take one course of action or take another.
Outcomes, on the other hand, are not within the organisation’s control. They are dependent on the
external environment – for example, customers, suppliers and the economy.

F5 Revision notes Page 56

Both decision points and outcome points on a decision tree are always followed by branches. If there
are two possible courses of action – for example, there will be two branches coming off the decision
point; and if there are two possible outcomes – for example, one good and one bad, there will be two
branches coming off the outcome point. It makes sense to say that, given that decision trees facilitate
the evaluation of different courses of actions, all decision trees must start with a decision.

A simple decision tree is shown below. It can be seen from the tree that there are two choices available
to the decision maker since there are two branches coming off the decision point. The outcome for one
of these choices, shown by the top branch off the decision point, is clearly known with certainty, since
there is no outcome point further along this top branch. The lower branch, however, has an outcome
point on it, showing that there are two possible outcomes if this choice is made. Then, since each of
the subsidiary branches off this outcome point also has a further outcome point on with two branches
coming off it, there are clearly two more sets of outcomes for each of these initial outcomes. It could
be, for example, that the first two outcomes were showing different income levels if some kind of
investment is undertaken and the second set of outcomes are different sets of possible variable costs
for each different income level.

Once the basic tree has been drawn, like above, the probabilities and expected values must be written
on it. Remember, the probabilities shown on the branches coming off the outcome points must always
add up to 100%, otherwise there must be an outcome missing or a mistake with the numbers being
used. As well as showing the probabilities on the branches of the tree, the relevant cash
inflows/outflows must also be written on there too.

Once the decision tree has been drawn, the decision must then be evaluated.

Evaluating the decision

When a decision tree is evaluated, the evaluation starts on the right-hand side of the page and moves
across to the left – ie in the opposite direction to when the tree was drawn. The steps to be followed
are as follows:

1. Label all of the decision and outcome points – ie all the squares and circles. Start with the
ones closest to the right-hand side of the page, labelling the top and then the bottom ones, and
then move left again to the next closest ones.
2. Then, moving from right to left across the page, at each outcome point, calculate the expected
value of the cashflows by applying the probabilities to the cashflows.

F5 Revision notes Page 57

Finally, the recommendation is made to management, based on the option that gives the highest
expected value.


Expected values give a long run average of the outcome that would be expected if a decision was to be
repeated many times. So, if a one-off decision is being made, the actual outcome may not be very close
to the expected value calculated and the technique is therefore not very accurate. Also, estimating
accurate probabilities is difficult because the exact situation that is being considered may not well
have arisen before.

The expected value criterion for decision making is useful where the attitude of the investor is risk
neutral. They are neither a risk seeker nor a risk avoider. If the decision maker’s attitude to risk is not
known, it difficult to say whether the expected value criterion is a good one to use.

Worked Example
A company is deciding whether to develop and launch a new product.

Research and development costs are expected to be $400,000 and there is a 70% chance that the
product launch will be successful, and a 30% chance that it will fail.

If it is successful, the levels of expected profits and the probability of each occurring have been
estimated as follows, depending on whether the product’s popularity is high, medium or low:
Probability Profits
High: 0.2 $500,000 per annum for two years
Medium: 0.5 $400,000 per annum for two years
Low: 0.3 $300,000 per annum for two years

If it is a failure, there is a 0.6 probability that the research and development work can be sold for
$50,000 and a 0.4 probability that it will be worth nothing at all.

The basic structure of the decision tree must be drawn, as shown below:

Next, the probabilities and the profit figures must be put on, not forgetting that the profits from a
successful launch last for two years, so they must be doubled.

F5 Revision notes Page 58

Now, the decision points and outcome points must be labeled, starting from the right-hand side and
moving across to the left.

Now, calculate the expected values at each of the outcome points, by applying the probabilities to the
profit figures. An expected value will be calculated for outcome point A and another one will be
calculated for outcome point B. Once these have been calculated, a third expected value will need to be
calculated at outcome point C. This will be done by applying the probabilities for the two branches off
C to the two expected values that have already been calculated for A and B.

EV at A = (0.2 x $1,000,000) + (0.5 x $800,000) + (0.3 x $600,000) = $780,000.

EV at B = (0.6 x $50,000) + (0.4 x $0) = $30,000.
EV at C = (0.7 x $780,000) + (0.3 x $30,000) = $555,000

These expected values can then be put on the tree if there is enough room.

F5 Revision notes Page 59

Once this has been done, the decision maker can then move left again to decision point D. At D, the
decision maker compares the value of the top branch of the decision tree (which, given there were no
outcome points, had a certain outcome and therefore needs no probabilities to be applied to it) to the
expected value of the bottom branch. Costs will then need to be deducted. So, at decision point D
compare the EV of not developing the product, which is $0, with the EV of developing the product
once the costs of $400,000 have been taken off – ie $155,000.

Finally, the recommendation can be made to management. Develop the product because the expected
value of the profits is $155,000.

The Value of Perfect and Imperfect information

Perfect information is said to be available when a 100% accurate prediction can be made about the
future. Imperfect information, on the other hand, is not 100% accurate but provides more knowledge
than no information.

Perfect information

The value of perfect information is the difference between the expected value of profit with perfect
information and the expected value of profit without perfect information.

For example, an agency can provide information on whether the launch is going to be successful and
produce high, medium or low profits or whether it is simply going to fail. The expected value with
perfect information can be calculated using a small table.

Profit less
EV of
Demand level Probability development Proceed
High 0.2 $600,000 Yes $120,000
Medium 0.5 $400,000 Yes $200,000
Low 0.3 $200,000 Yes $60,000

EV of success with perfect information = 0.7 x $380,000 = $266,000

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Profit less
EV of
Demand level Probability development Proceed
Fail and sell 0.6 $(350,000) No 0
Fail and don't sell 0.4 $(400,000) No 0
Expected value $0

EV of failure with perfect information = 0.3 x $0 = $0.

Therefore, total expected value with perfect information = $266,000.

The value of the information can then be calculated by deducting the expected value of the decision
without perfect information from the expected value of the decision with perfect information – ie
$266,000 – $155,000 = $111,000. This would represent the absolute maximum that should be paid to
obtain such information.

Imperfect information

In reality, information obtained is rarely perfect and is merely likely to give more information about
the likelihood of different outcomes rather than perfect information about them. The value of
imperfect information will always be less than the value of perfect information unless both are zero.
This would occur when the additional information would not change the decision. Note that the
principles that are applied for calculating the value of imperfect information are the same as those
applied for calculating the value of perfect information.

Sensitivity analysis

 The essence of sensitivity analysis is to carry out calculations with one set of values for the
variables and then substitute other possible values for the variables to see how this effects the
overall outcome.
 This technique can be used in any situation where relationships between key variables can be
 Sensitivity analysis is one form of ‘what-if? Analysis.

Past Paper Analysis

Risk and uncertainty Dec 08 – Q 2
June 11 – Q 1
June 13 – Q 1
June 14 – Q 4

F5 Revision notes Page 61

Part C – Budgeting and Control

12. Budgetary Systems

Budget: is a quantified plan of action for an upcoming accounting period.

 A budget can be set from the top down (imposed budget) or from the bottom up
(participatory budget).
 In top-down budgeting, senior management level sets the budgetary targets for the
organisation. This approach is a time saving technique.
 With bottom-up budgeting, managers are required to draft a budget for their area of
operations. These are submitted to their superior, eventually becoming part of the budget for
the whole organisation. This is much more time consuming, however it reflects views of
managers actually dealing with operations and encourages motivation through participation.

 The objectives of a budgetary planning and control system.

 Ensure the achievement of the organisation's objectives
 Compel planning
 Communicate ideas and plans
 Co-ordinate activities
 Provide a framework for responsibility accounting
 Establish a system of control
 Motivate employees to improve their performance

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Planning and Control in the Performance Hierarchy

 Corporate plans/strategic plans - Prepared at a strategic level

 Focused on overall corporate performance
 Set overall plans and targets for units and departments
 Tactical plans - Prepared at lower management level ('management control' level)
 Time horizon typically 12 months
 Plans for individual departments or activities, within guidelines set by senior management
 Provides a link between strategic plans at senior level and operational planning
 Operational plans - Prepared by managers at a fairly junior level
 Based on objectives about 'what' to achieve in operational terms
 Detailed specifications of targets and standards

Feedback: This is important aspect of control once the plan is being implemented.

 Single Loop Feedback: Feedback is used to take corrective action to ensure original plan is met.
 Double Loop Feedback: Feedback is used to revise the original plan.
 Types of feedback:
a) Negative feedback indicates that results or activities must be brought back on course, as they
are deviating from the plan.
b) Positive feedback results in control action continuing the current course.
c) Feedforward control is based on forecasts. Action can be taken well in advance if issues

Behavioural Aspects of Budgeting

Behavioural problems in budgeting

There are several possible reasons why behavioural factors in budgeting can be damaging for the
 Misunderstanding and worries about cost-cutting.
 Opposition to unfair targets set by senior management
 Sub-optimisation
 Lack of goal congruence
 Budget slack or budget bias

Misunderstanding and worries about cost-cutting

Budgeting is often seen by managers as an opportunity to cut back on expenditure and find ways to
reduce costs, for example by getting rid of some staff. Managers often resent pressure front their boss
to reduce their spending, and so have a hostile attitude to the entire budgeting process.

Opposition to unfair targets set by senior management.

When senior managers use the budgeting process to set unrealistic and unfair performance targets for
the year, their subordinates may unite in opposition to what the senior managers are trying to achieve.

There may be a risk that the planning targets for individual managers are not in the best interests of
the organisation as a whole. For example, a production manager might try to budget for production
targets that fully utilise production capacity. However, working at full capacity is not in the best
interests of the company as a whole if sales demand is lower.

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Lack of goal congruence
The behavioural problems with budgeting arise because the corporate aims of an organisation are
usually not the same as the aspirations of the individuals who work for it. This is known as lack of goal
congruence and leads to dysfunctional behaviour.

Budget slack (budget bias)

Budget slack has been defined as 'the intentional overestimation of expenses and/or underestimation
of revenue in the budgeting process' (CIMA Official Terminology). Managers -who prepare budgets may
try to over-estimate costs so that it will be much easier to keep actual spending within the budget

Types of Budgeting processes

Incremental Budgeting: method of budgeting in which adjustments are made to the current
year actual data for inflation and other expected changes to arrive at the budget for the next year.

 Quick and easy method of budgeting
 Suitable for organisations that operate in a stable environment

 Previous problems and inefficiencies are automatically included in the upcoming year’s budget.
 Managers may overspend in order to be able to claim the same or more budget for the next year.

Fixed Budget: is a budget which remains unchanged throughout the budget period, regardless of
differences between the actual and the original planned volume of output or sales. E.g. Master Budget.

Flexible Budget: is a budget which is changed as the volume of output and sales changes by using
the cost behaviour patterns.
 These can be created at the planning stage, as the organisation may prepare budgets for different
levels of expected activities.
 These can also be created retrospectively to reflect the actual level of activity achieved. For
example, if actual activity was of 10,000 units produced, then a flexible budget for 10,000 units is
created. This supports the control element as management will be able to compare the actual
performance with a budget of a corresponding level of activity.

Worked Example:

The following monthly budgeted cost values have been taken from the budget working papers of Yum
Limited for the year ended 30 October 20X7.

Activity level 20,000 units 30,000 units 45,000 units

$ $ $
Direct material 50,000 75,000 112,500
Direct labour 105,000 157,500 236,250
Production overhead 60,000 65,000 72,500
Selling overhead 108,000 112,000 118,000
Administration overhead 33,500 33,500 33,500
356,500 443,000 572,750

During October 20X7, actual activity was 39,000 units and actual costs were:

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Direct material 117,000
Direct labour 169,650
Production overhead 79,250
Selling overhead 115,150
Administration overhead 37,800

Flexed Budget Actual Variance
39,000 units 39,000 units
$ $ $
Direct material (W1) 97,500 117,000 -19,500 A
Direct labour (W2) 204,750 169,650 35,100 F
Production overhead (W3) 69,500 79,250 -9,759 A
Selling overhead (W4) 115,600 115,150 459 F
Administration overhead 33,500 37,800 -4,300 A
520,850 518,850 572,750

W1: ($50,000 / 20,000 units) x 39,000 = $97,500

W2: ($105,000 / 20,000 units) x 39,000 = $204,750

W3: Apply hi-low formula to work out variable cost per unit
($72,500 - $60,000)/(45,000 units – 20,000 units) = 0.5 per unit
Work out fixed cost element
$72,500 – (45,000 units x $0.5 per unit) = $50,000
For 39,000 units = $50,000 + (39,000 x $0.5 per unit) = $69,500

W4: Apply hi-low formula to work out variable cost per unit
($118,000 - $108,000)/(45,000 units – 20,000 units) = 0.4 per unit
Work out fixed cost element
$118,000 – (45,000 units x $0.4 per unit) = $100,000
For 39,000 units = $100,000 + (39,000 x $0.4 per unit) = $115,600

Zero Based Budgeting: involves preparing a budget for each cost centre or activity from a zero
base. Every item of expenditure has then to be justified in its entirety in order to be included in the
next year's budget.

Implementation: ZBB is particularly useful for budgeting for discretionary costs and for
rationalisation purposes, in areas of operations where efficiency standards are not properly
established, such as administration work.

1. Define items or activities for which costs should be budgeted, and spending decisions should
be planned: these are 'decision packages'.

a) Mutually exclusive packages. These are alternative methods of getting the same job
done. The best option among the packages must be selected by comparing costs and benefits
and the other packages are then discarded.
(b) Incremental packages. These divide an aspect of operations into different levels of
activity. The 'base' package will contain the minimum amount of work that must be done to
carry out the activity and the cost of this minimum level. The other incremental packages
identify additional (incremental) work that could be done, at what cost and for what benefits.

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2. Evaluate and rank the packages in order of priority: eliminate packages whose costs exceed
their value.
3. Allocate resources to the decision packages according to their ranking. Where resources such
as money are in short supply, they are allocated to the most valuable activities.


 Identification and removal of inefficient or obsolete operations.

 Avoidance of wasteful expenditure.
 Increases motivation of staff by promoting a culture of efficiency.
 It responds to changes in the business environment.
 ZBB documentation provides an in-depth appraisal of an organisation's operations.
 It challenges the status quo.
In summary, ZBB should result in a more efficient allocation of resources.


 Extra volume of paperwork created and the extra time required to prepare the budget.
 Short-term benefits might be emphasised to the detriment of long-term benefits.
 It might give the impression that all decisions have to be made in the budget and discourage
innovative ideas.
 Managers may have to be trained in ZBB techniques.
 The organisation's information systems may not be capable of providing suitable information.
 The ranking process can be difficult.

Activity Based Budgeting: This involves defining the activities that underlie the financial
figures in each function and using the level of activity to decide how much resource should be
allocated and how well it is being managed and to explain variances from budget.


 Activities drive costs and the aim is to plan and control the causes (drivers) of costs rather
than the costs themselves.
 Non value adding activities should be removed.
 Most departmental activities are driven by demands and decisions beyond the immediate
control of the manager responsible for the department's budget.
 Additional measures apart from traditional financial measures are needed to ensure
continuous improvement.


 Critical success factors will be identified and performance measures devised to monitor
progress towards them. (A critical success factor is an activity in which a business must
perform well if it is to succeed.)
 Because concentration is focused on the whole of an activity, not just its separate parts, there
is more likelihood of getting it right first time.

Rolling Budget: is a budget which is continuously updated by adding a further accounting period
(a month or quarter) to the end of the budget when the corresponding period in the current budget
has ended.
As a result, a number of rolling budgets are prepared each year and each rolling budget covers the
next 12-month period.

F5 Revision notes Page 66


 Element of uncertainty in budgeting is reduced.

 Budgets are reassessed regularly, and up to date budgets produced.
 Planning and control will be based on a realistic recent plan.
 Realistic budgets are better motivational factors for employees.
 There is always a budget which extends for several months ahead.


 More time, effort and money involved in budget preparation.

 Frequent budgeting might put off the managers.

Beyond Budgeting: is a budgeting model which proposes that traditional budgeting should be
abandoned. Adaptive management processes should be used rather than fixed annual budgets.

Criticisms of Budgeting:

 Budgets are time consuming and expensive.

 Budgets provide poor value to users.
 Budgets fail to focus on shareholder value.
 Budgets are too rigid and prevent fast response.
 Budgets protect rather than reduce costs. Once a manager has an authorised budget they can
spend that amount of resource without further authorisation.
 Budgets stifle product and strategy innovation. The focus on achieving the budget discourages
managers from taking risks.
 Budgets focus on sales targets rather than customer satisfaction.
 Budgets are divorced from strategy. What is needed instead is a system of monitoring the
longer term progress against the organisation's strategy.
 The process of planning and budgeting within a framework devolved from senior
management perpetuates a culture of dependency.
 Budgets lead to unethical behaviour. For example, mean building slack into the budget in
order to create an easier target for achievement.

Fundamentals of Beyond Budgeting:

 Use adaptive management processes for making decisions. Managers should plan on a more
adaptive, rolling basis but with the focus on cash forecasting rather than purely on cost
control. Performance is monitored against world-class benchmarks, competitors and previous
 The emphasis is on encouraging a culture of personal responsibility by delegating decision-
making and performance accountability to line managers.

 The use of external benchmarks can lead to management focus on competitive success.
 Motivation. Rewards are team based which fosters cooperation and helps achieve corporate
 Faster response to threats and opportunities.

 Resistance to change. Managers who consistently meet their annual budget targets may resist
the adoption of beyond budgeting as it threatens their position and bonuses..
 Resource constraints. In addition, some public sector organisations may struggle to
implement a beyond budgeting process due to the constraints on their resources.

F5 Revision notes Page 67

Past Paper Analysis
Dec 11 – Q 3
Budgetary Systems Dec 07 – Q 3 a,b
June 09 – Q 5
June 13 –Q 5a
Dec 10 –Q 5
June 13 – Q 5 c,d
June 15 – Q 5
June 11 – Q 3a
Dec 12 – Q 4
June 13 – Q 5 b

F5 Revision notes Page 68

13. Quantitative Analysis

The learning rate and learning effect – extract from ACCA Technical Article

In practice, it is often found that the resources required to make a product decrease as production
volumes increase. It costs more to produce the first unit of a product than it does to produce the one
hundredth unit.

In part, this is due to economies of scale since costs usually fall when products are made on a larger
scale. This may be due to bulk quantity discounts received from suppliers, for example.

The learning curve, effect, however, is not about this; it is not about cost reduction. It is a human
phenomenon that occurs because of the fact that people get quicker at performing repetitive tasks
once they have been doing them for a while. The first time a new process is performed, the workers are
unfamiliar with it since the process is untried. As the process is repeated, however, the workers
become more familiar with it and better at performing it. This means that it takes them less time to
complete it.

The learning process starts as soon as the first unit or batch comes off the production line. Since a
doubling of cumulative production is required in order for the cumulative average time per unit to
decrease, it is clearly the case that the effect of the learning rate on labour time will become much less
significant as production increases. Eventually, the learning effect will come to an end altogether. See
Figure 1 below.

When output is low, the learning curve is really steep but the curve becomes flatter as cumulative
output increases, with the curve eventually becoming a straight line when the learning effect ends.

Figure 1

The learning curve effect will not always apply, of course. It flourishes where certain conditions are

 It is necessary for the process to be a repetitive one.

 Also, there needs to be a continuity of workers and they mustn’t be taking prolonged breaks
during the production process.

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Use of Learning Curve

This theory is best applied, where;

 Product made largely by labour effort

 New and relatively short lived product
 Complex product made in small quantities for special orders

Importance of Learning Curve Effect

Learning curve models enable users to predict how long it will take to complete a future task.
Management accountants must therefore be sure to take into account any learning rate when they are
carrying out planning, control and decision-making. If they fail to do this, serious consequences will

As regards its importance in decision-making, look at the example of a company that is introducing a
new product onto the market. The company wants to make its price as attractive as possible to
customers but still wants to make a profit, so it prices it based on the full absorption cost plus a small
5% mark-up for profit.

The first unit of that product may take one hour to make. If the labour cost is $15 per hour, then the
price of the product will be based on the inclusion of that cost of $15 per hour. Other costs may total
$45. The product is therefore released onto the market at a price of $63.

Subsequently, it becomes apparent that the learning effect has been ignored and the correct labour
time per unit should is actually 0.5 hours. Without crunching through the numbers again, it is obvious
that the product will have been launched onto the market at a price which is far too high. This may
mean that initial sales are much lower than they otherwise would have been and the product launch
may fail. Worse still, the company may have decided not to launch it in the first place as it believed it
could not offer a competitive price.

If standard costing is to be used, it is important that standard costs provide an accurate basis for the
calculation of variances. If standard costs have been calculated without taking into account the
learning effect, then all the labour usage variances will be favourable because the standard labour
hours that they are based on will be too high. This will make their use for control purposes pointless.

Finally, it is worth noting that the use of learning curve is not restricted to the assembly industries it is
traditionally associated with. It is also used in other less traditional sectors such as professional
practice, financial services, publishing and travel. In fact, research has shown that just under half of
users are in the service sector.

How learning curves have been examined in the past

This is a fairly common exam requirement which tests candidates’ understanding of the difference
between cumulative and incremental time taken to produce a product and the application of the
learning curve formula. It is worth mentioning at this point that learning curve calculations should
never be rounded to less than three decimal places.

The learning curve formula, as shown below, is always given on the formula sheet in the exam.

Y = ax

F5 Revision notes Page 70

Where Y = cumulative average time per unit to produce x units
a = the time taken for the first unit of output
x = the cumulative number of units produced
b = the index of learning (log LR/log2)
LR = the learning rate as a decimal

Worked Example:

Learning curve 90%

Units produced till date 500 units.

LaboUr cost = $10/ hour

Time to make first unit 100 hours

Calculate the cumulative average time and cost to produce 500 units.


= 100 (500)

= 38.88 / unit

Total cost = 500 × 38.8 × 10 = $194400

Learning Rate Calculation:

Example 1

P Co operates a standard costing system. The standard labour time per batch for its newest product
was estimated to be 200 hours, and resource allocation and cost data were prepared on this basis.

The actual number of batches produced during the first six months and the actual time taken to
produce them is shown below:

Incremental number of batches Incremental labour hours taken

produced each month to produce the batches
June 1 200
July 1 152
August 2 267.52
September 4 470.8
October 8 1,090.32
November 16 2,180.64

(a) Calculate the monthly learning rate that arose during the period.
(b) Identify when the learning period ended and briefly discuss the implications of this
for P Co.

F5 Revision notes Page 71


(a) Monthly rates of learning

Incremental Cumulative Cumulative

Incremental Cumulative
Month number of number of average hours
total hours total hours
batches batches per batch
June 1 200 1 200 200
July 1 152 2 352 176
August 2 267.52 4 619.52 154.88
September 4 470.8 8 1090.32 136.29
October 8 1090.32 16 2180.64 136.29
November 16 2180.64 32 4361.28 136.29

Learning rate:
176/200 = 88%
154.88/176 = 88%
136.29/154.88 = 88%

Therefore the monthly rate of learning was 88%.

(b) End of learning rate and implications

The learning period ended at the end of September. This meant that from October onwards the time
taken to produce each batch of the product was constant. Therefore, in future, when P Co makes
decisions about allocating its resources and costing the product, it should base these decisions on the
time taken to produce the eighth batch, which was the last batch produced before the learning period
came to an end. The resource allocations and cost data prepared for the last six months will have been
inaccurate since they were based on a standard time per batch of 200 hours.

P Co could try and improve its production process so that the learning period could be extended. It
may be able to do this by increasing the level of staff training provided. Alternatively, it could try to
incentivise staff to work harder through payment of bonuses, although the quality of production
would need to be maintained.

Example 2
The first batch of a new product took six hours to make and the total time for the first 16 units was
42.8 hours, at which point the learning effect came to an end.

Calculate the rate of learning.

F5 Revision notes Page 72


Using algebra:

Step 1: Write out the equation:

42.8 = 16 x (6 x r )

Step 2: Divide each side by 16 in order to get rid of the ’16 x’ on the right hand side of the equation:
2.675 = (6 x r )

Step 3: Divide each side by 6 in order to get rid of the ‘6 x’ on the right hand side of the equation:
0.4458333 = r

Step 4: take the fourth root of each side in order to get rid of the r on the right hand side of the
4 1/y
equation. This can be done using the button on the calculator that says r or x . Either of these can
be used to find the fourth root (or any root, in fact) of a number.

r = 0.8171

This means that the learning rate = 81.71%.

Past Paper Analysis

Quantitative Analysis Dec 08 – Q 3
Dec 09 – Q 2
Dec 13 – Q 3
Dec 14 – Q 1

F5 Revision notes Page 73

14. Standard Costing

Standard Cost: This is an estimated unit cost


The standard cost of a product XYZ might be:

Direct Materials:
aterial A: 2 litres at $4.50 per litre 9
Material B: 3 kilos at $4 per Kilo 12
Direct Labour:
Grade 1 labour: 0.5 hours at $20 per hour 10
Grade 2 labour: 0.75 hours at $16 per hour 12
Variable production overheads: 1.25 hours at $4 per hour 5
Fixed production overheads: 1.25 hours at $40 per hour 50
Standard ( production) cost per unit 95

 Standards are set by managers for their respective areas of expertise.

 Standard costing has four main uses.

Alternative system of cost accounting It is an alternative system of cost accounting. In a standard

costing system, all units produced are recorded at their
standard cost of production.

Used to prepare budgets When standard costs are established for products, they can
be used to prepare the budget.

System of performance measurement It is a system of performance measurement. The differences

between standard costs and actual costs can be measured as
variance. Variances can be reported regularly to
management, in order to identify areas of good performance
or poor performance.

Control reporting It is also a system of control reporting.

As a System for Control:

 Differences between actual and expected results are termed Variances.

 When the variances occur, this indicates that the operational performance is not as it should be,
and so the causes of the variance should be investigated, regardless of whether the variances are
adverse of favourable. Favourable variances could indicate errors in the standard or compromise
on quality aspects. This investigation is generally termed as Variance Analysis
 Management can therefore use variance reports to identify whether control measures might be
needed, to improve poor performance or continue with good performances.

F5 Revision notes Page 74

Types of Standards:

Ideal Standards The ideal standard cost is the cost that would be achievable if operating
conditions and operating performance were perfect. In practice, the ideal
standard is not achievable. Will demotivate employees if enforced.

Attainable standard These assume efficient but not perfect operating conditions. An allowance is
made for waste and inefficiency. However the attainable standard is set at a
higher level of efficiency than the current performance standard, and some
improvements will therefore be necessary in order to achieve the standard
level of performance. This can be a basis of motivating employees.

Current standards These are based on current working conditions and what the entity is capable
of achieving at the moment. Current standards do not provide any incentive
to make significant improvements in performance, which may cause
employee performance to slack.

Basic Standards These are standards which remain unchanged over a long period of time.
Cause employees to lose interest.

Using Standards in Performance Management

Flexible budgets are used to carry out effective performance management.

So if an organisation had originally budgeted for an activity level of 5,000 units but ended up
producing/ selling 7,000 units, the following steps will have to be carried out to carry out an effective
variance analysis:

Step 1: Use the standard cost card to determine flexible budget for 7,000 units. If the cost card is not
available, information from the fixed budget of 5,000 units can be picked up to create a budget for the
7,000 units. This will depend on following knowledge points:
 Total Budgeted Fixed Costs (unless Step Fixed) will not change regardless of level of activity
 Budgeted Variable Cost Per Unit will not change regardless of level of activity

Step 2: Compare the actual revenue and costs of 7,000 units with the flexed budget created in Step 1.

Step 3: Identify the differences between the actual and budget as positive (Favourable) or negative

Step 4: Carry out an investigation to determine causes of the variances (if material). Remember both
favourable and adverse variances may require investigation.

Controllability in Performance Management:

 During Variance Analysis, the performance of various managers will be put to question but
they should only be held accountable for controllable aspects.
 The principle of controllability is that managers should only be held accountable for costs over
which they have some influence.
 Controllable costs: Controllable costs are expenses which can be directly influenced by a given
 Variable costs are considered controllable in the short term.
 Committed fixed costs are uncontrollable.
 Discretionary fixed costs can be controlled by the relevant authority.
 Managers should not be held accountable for apportioned overhead costs.

F5 Revision notes Page 75

15. Variance Analysis

Material Cost Variance:

Example: A unit of product P123 has a standard cost of five liters of material A at $3 per liter. The
standard direct material cost per unit of product 123 is therefore $15.

In a particular month, 2,000 units of product 123 were manufactured. These used 10,400 liters of
material A, which cost $33,600.

The total direct material cost variance is calculated as follows:

2,000 units of product P123 should cost (x$15) 30,000
2,000 units of product P123 did cost 33,600
Total direct materials cost variance (3,600) (A)

The total direct materials cost variance is adverse, because actual costs were higher than the standard

F5 Revision notes Page 76

Example: A unit of product p123 has a standard cost of five liters of material A at $3per liter. The
standard direct material cost per unit of product 123 is therefore $15. In a particular month, 2,000
units of product 123 were manufactured. These used 10,400 liters of Material A, which cost $33,600.

The total direst material cost variance is $3,600 (A), as calculated earlier, in the previous example.

The price variance is calculated as follows.

10,400 liters of materials should cost (x$3) 31,200
10,400 liters of materials did cost 33,600
Material price variance 2,400 (A)

The price variance is adverse because the materials cost more to purchase than they should have.

Example: Using the same example above that was used to illustrate the material price variance; the
usage variance should be calculated as follows:

2,000 units of Product P123 should use (x 5 kilos) 10,000
2,000 units of Product P123 did use 10,400
Material usage variance in kilos 400 (A)
Standard price per kilo of Material A $3
Material usage variance in $ $1,200 (A)

The usage variance is adverse because more materials were used than expected, and this has added to

Causes of materials price and usage variances

Materials usage variance Materials price variance

 Efficient/ Inefficient use of material  Inflation/ Unexpected discounts

 Experience of workforce  New supplier/ emergency purchase
 Quality of material  Also: The standard materials price in the
 Production process standard cost for materials might be a poor
 Also: The standard usage rate in the standard estimate
cost for materials might be a poor estimate

F5 Revision notes Page 77

Labour cost variance

Example: Product P123 has a standard direct labour cost per unit of: 1.5 hours x $12 per direct
labour hour = $18 per unit.

During a particular month, 2,000 units of Product 123 were manufactured. These took 2,780 hours to
make and the direct labour cost was $35,700.

Required: Calculate the total direct labour cost variance.

2,000 units of product P123 should cost (x $18) 36,000
2,000 units of product P123 did cost 35,700
Total direct labour cost variance 300 F

The variance is favourable, because actual costs were less than the standard cost.

The direct labour total cost variance can be analysed into a rate variance and an efficiency variance.
The calculations are similar to the calculations for the materials price and usage variances.

Example: Using the same example that was used previously to calculate the total labour cost
variance, calculate the direct labour rate variance.

F5 Revision notes Page 78

2,730 hours should cost (x $12) 33,360
2,730 hours did cost 35,700
Direct labour rate variance 2,340 (A)

The rate variance is adverse because the labour hours worked cost more than they should have.

Example: Using the same example above that was used to illustrate the total direct labour cost
variance and the direct labour rate variance; the efficiency variance should be calculated as follows:

2,000 units of Product P123 should take (x 1.5 hours) 3,000
2,000 units of Product P123 did take 2,780
Efficiency variance in hours 220 F
Standard direct labour rate per hour $12
Direct labour efficiency variance in $ $2,640 F

The efficiency variance is favourable because production took less time than expected, which has
reduced costs.

Causes of labour rate and efficiency variances

Labour efficiency variance Labour rate variance

 Efficient or inefficient working by the work  The grade or level of labour actually used
force. is different from the grade of labour in the
 New workforce due to high labour turnover. standard cost
 Quality of supervision good or bad, resulting in  New workforce due to high labour
favourable or unfavourable efficiency variance turnover.
 The effect of a new incentive scheme.  Wage rates have been altered (usually,
 Problems in the production process, for raised).
example machine breakdowns, reducing

F5 Revision notes Page 79

Variable production overhead variance

Example: Product P123 has a standard variable production overhead cost per unit of 1.5hours x $2
per direct labour hour= $3 per unit. During a particular month, 2,000 unit of a product 123 were
manufactured. These took 2,780 hours to make and the variable production overhead cost was

Required: Calculate for the month the total variable production overhead cost variance.

(Note: this same example will be used to illustrate the variable overhead expenditure and efficiency


2,000 units of output should cost (x$3) 6,000
2,000 units of output did cost 6,550
Total variable production overhead cost variance 550 (A)

The variance is adverse, because actual costs were more than a standard cost.

F5 Revision notes Page 80

Example: Using the same example that was used previously to calculate the total variable production
overhead cost variance, calculate the variable production overhead expenditure variance.

2,780 hours should cost (x$2) 5,560
2,789 hours did cost 6,550
Variable production overhead variance 990 (A)

The expenditure variance is adverse because the expenditure on variable overhead is the hours worked
was more than it should have been.

2,000 units of Product P123 should take (x 1.5 hours) 3,000
2,000 units of Product P123 did take 2,780
Efficiency variance in hours 220 F
Standard variable production overhead rate per hour $2
Variable production overhead efficiency variance in $ $440 F

The efficiency variance is favourable because production took less time than expected, which has
reduced costs.

Variable production overhead variances cost variances: $

Variable production overhead expenditure variance 990 (A)
Variable production overhead efficiency variance 440 F
Total variable production overhead cost variance 550 (A)

Causes of variable overhead variances

 The causes of variable overhead efficiency variances are the same as the causes of labour
efficiency variances, when variable overhead expenditure is assumed to vary with the number
of direct labour hours worked.
 The causes of variable overhead expenditure variances maybe:
 Efficient or inefficient spending on overhead items of cost
 Inaccurate estimates of the variable overhead expenditure rate per hour.

F5 Revision notes Page 81

Fix overhead variances

Example: A company budgeted to make 5,000 units of a single standard product in Year 1. Budgeted
direct labour hours are 10,000 hours. Budgeted fixed production overhead is $40,000. Actual
production in Year 1 was 5,200 units and fixed production overhead was $40,500.

F5 Revision notes Page 82

Standard fixed overhead cost per unit = $8 (2 hours per unit x $4 per hour).

Fixed production overhead total cost variance $

5,200 units: standard fixed cost (x $8) = fixed overhead absorbed 41,600
Actual fixed overhead cost expenditure 40,500
Fixed production overhead total cost variance 1,100 F

The variance is favourable, because fixed overhead costs have been over-absorbed.

Fixed overhead expenditure variance $

Budgeted fixed production overhead expenditure 40,000
Actual fixed production overhead expenditure 40,500
Fixed overhead expenditure variance 500 (A)

This variance is adverse because actual expenditure exceeds the budgeted expenditure.

Fixed overhead volume variance units of production

Budgeted production volume in units 5,000
Actual production volume in units 5,200
Fixed overhead volume variance in units 200 F
Standard fixed production overhead cost per unit $8
Fixed overhead volume variance in $ $1,600 F

This variance is favourable because actual production volume exceeded the budgeted volume.

Summary $
Fixed overhead expenditure variance 500 (A)
Fixed overhead volume variance 1,600 F
Fixed overhead total cost variance 1,100 F

Example: A company budgeted to make 5,000 units of a single standard product in Year 1. Budgeted
direct labour hours are 10,000 hours. Budgeted fixed production overhead is $40,000. Actual
production in Year 1 was 5,200 units in 10,250 hours of work, and fixed production overhead was

The fixed production overhead volume variance is $1,600F, calculated earlier.

Fixed production overhead efficiency variance hours

5,200 units produced should take (x 2 hours per unit) 10,400
They did take 10,250
Fixed production overhead efficiency variance in hours 150 F
x Standard fixed overhead rate per hour $4
Fixed production overhead efficiency variance in $ $600 F

Fixed production overhead capacity variance hours

Budgeted hours of work 10,000
Actual hours of work 10,250
Capacity variance in hours 250 F
x Standard fixed overhead rate per hour $4
Fixed overhead capacity variance in $ $1,000 F

F5 Revision notes Page 83

The capacity variance is favourable because actual hours worked exceeded the budgeted hours
(therefore more units should have been produced).

Summary $

Fixed overhead efficiency variance 600 F

Fixed overhead capacity variance 1,000 F

Fixed overhead volume variance 1,600 F

Sales Variances

Example: A company budgets to sell 7,000 units of Product P456. The standard sales price of
Product P456 is $50 per unit and the standard cost per unit is $42.

Actual sales were 7,200 units, which sold for $351,400. The sales price variance and sales volume
variance would be calculated as follows:

Sales price variance $

7,200 units should sell for (x $50) 360,000
7,200 units did sell for 351,400
Sales price variance 8,600 (A)

The sales price variance is adverse because actual sales revenue from the units sold was less than

F5 Revision notes Page 84

Sales volume variance units
Actual sales volume (units) 7,200
Budgeted sales volume (units) 7,000
Sales volume variance in units 200 F
Standard profit per unit ($50 - $42 = $8) $8
Sales volume variance (profit variance) $1,600 F

The sales volume variance is favourable because actual sales exceeded budgeted sales.

Causes of sales price and sales volume variances

Sales price variance Sales volume variance

 Demand for the product.  Price of product.
 Trade discounts.  Major new customer in the market.
 Inflation.  Loss of major customer.
 New competitor in the market.  Effective or ineffective advertising
 Distribution methods.
 Product design or after sales services

Operating Statements:

Format of an operating statement under Standard Absorption Costing

Fav Adv
£000 £000 £000
Budgeted profit xxx
Sales margin variances
Price xxx (xxx)
Volume xxx (xxx)
Cost variances
Materials Price xxx (xxx)
Usage xxx (xxx)
Labour Rate xxx (xxx)
Idle time (xxx)
Efficiency xxx (xxx)
Variable Overhead Expenditure xxx (xxx)
Efficiency xxx (xxx)
Fixed Overhead Expenditure xxx (xxx)
Capacity xxx (xxx)
Efficiency xxx (xxx)
xxx (xxx)
Actual profit XXX

F5 Revision notes Page 85

Standard Marginal Costing

Standard marginal costing and standard absorption costing compared

When a company uses standard marginal costing rather than standard absorption costing: finished
goods inventory is valued at the standard variable production cost, not the standard full production
cost variances are calculated and presented in the same way as for standard absorption costing, but
with two important differences:

 Fixed production overhead variances: In standard marginal costing, there is a fixed

production overhead expenditure variance, but no fixed production overhead volume
 Sales volume variances: In standard marginal costing, the sales volume variance is calculated
using standard contribution.

Format of an Operating Statement under Standard Marginal Costing:

Fav Adv
£000 £000 £000
Budgeted contribution xxx
Sales margin variances
Price xxx (xxx)
Volume xxx (xxx)
xxx (xxx) xxx/(xxx)
Cost variances
Materials Price xxx (xxx)
Usage xxx (xxx)
Labour Rate xxx (xxx)
Idle time (xxx)
Efficiency xxx (xxx)
Variable Overhead Rate xxx (xxx)
Efficiency xxx (xxx)
xxx (xxx)
Actual contribution XXX
Fixed overheads
Budgeted overhead xxx
Expenditure variance xxx (xxx)
Actual profit XXX

F5 Revision notes Page 86

Factor Description
Size of the variance. As a general rule, the larger the variance, the greater the
potential benefit from investigation and control measures.

Favourable or adverse Significant controllable favourable variances should be

variance. investigated as well as adverse variances.

Probability that the cause of Whether or not to investigate the cause of a variance -will also
the variance will be depend on the expectation of management that the cause of the
controllable. variance will be controllable.

Costs and benefits of control Investigating a variance has a cost in terms of both management
action. time and expenditure. A variance should not be investigated
unless the expected benefits exceed the costs of investigation
and control.

Random variations in Management might take the view that a favourable or adverse
reported variances. variance in one month is due to random factors that will not
recur next month. If the variance is due to random factors, it
should not happen again next month, and management can
probably ignore it without risk.

Reliability of budgets and Management might have a view about whether the variance is
measurement systems. caused by poor planning and poor measurement systems, rather
than by operational factors. If so, investigating the variance
would be a waste of time and would be unlikely to lead to any
cost savings.

F5 Revision notes Page 87

Mix and Yield Variances:

Mix Variance: A mix variance occurs when the materials are not mixed or blended in standard
proportions and it is a measure of whether the actual mix is cheaper or more expensive than the
standard mix.

Yield Variance: A yield variance arises because there is a difference between what the input should
have been for the output achieved and the actual input.

 Materials mix and yield variances

Direct materials usage variance

When standard costing is used for products which contain two or more items of direct material, the
total materials usage variance can be calculated by calculating the individual usage variances in the
usual way and adding them up (netting them off).

Example: Product N is produced front three direct materials, A, B and C that are mixed together in a
process. The following information relates to the budget and output for the month of January

Budget Actual
Material Quantity Standard price Standard Quantity
per kilo cost used
kg $ $
A 1 20 20 160
B 1 22 22 I80
C 8 6 48 1,760
10 90 2,100
Output 1 unit 200 units

Direct materials usage variance

Material A Material Material
Making 200 units used up 160 180 1,760
Making 200 units should have used 200 200 1,600
Usage variance (kgs) 40 F 20 F (160) A
Standard cost per kg $20 $22 $6
Volume variance (contribution) $800 $440 ($960)
Total usage variance $280 F

Direct materials mix variance

The materials mix variance measures how much of the total usage variance is attributable to the fact
that the actual combination or mixture of materials that was used was more expensive or less
expensive than the standard mixture for the materials.

The mix component of the usage variance therefore indicates the effect on costs of changing the
combination (or mix or proportions) of material inputs in the production process.

The materials mix variance is calculated as follows (making reference to the example above):

F5 Revision notes Page 88

Step 1: Take the total quantity of all the materials used and divide this into a standard mix for the
materials used.

Step 2: The difference between the quantity of material used and the quantity hat should have been
used according to the standard mix; is the mix variance.

Material Actual mix Standard Mix variance Std. cost per kg Mix variance
mix (kgs) (Standard)

kgs Units units $ $

A 160 1 210 50 F 20 1,000 F
B 180 1 210 30 F 22 660 F
C 1,760 8 1,680 (80) (A) 6 (480) (A)
2,100 2,100 0 1,180 (F)

Direct materials yield variance

The materials yield variance is the difference between the actual yield from a given input and the yield
that the actual input should have given in standard terms. It indicates the effect on costs of the total
materials inputs yielding more or less output than expected.

Based on the above example note that:

The standard cost of each unit (kg) of input = $90/10kg = $9 per kilo

The standard cost of each unit of output = $90 per unit

Method 1: This compares the actual yield to the expected yield from the material used. The difference
is then valued at the standard cost of output.

In the above example 10 kg of material in should result in 1 unit of output. Therefore, 2,100 kg of
material in should result in 210 units of output.

The difference between this figure and the actual output is the yield variance as a number of units.
This is then multiplied by the expected cost of a unit of output.

2,100 kgs of input should yield (@10 kg per unit) 210
did yield 200
Yield variance in units 10 (A)
Standard cost of output $90
Materials yield variance $900 (A)

Method 2: This compares the actual usage to achieve the yield to the expected usage to achieve the
actual yield. The difference is then valued at the standard cost of input.

In the above example 1 unit should use 10 kg of input, therefore, 200 units should use 2,000 kg of

The difference between this figure and the actual output is the yield variance as a number of units.
This is then multiplied by the expected cost of a unit of output.

F5 Revision notes Page 89

200 units of product N should use (x 10 kilos) 2,000
did use 2,100
Yield variance in quantities 100 (A)
Standard cost of input $9/kg
Yield variance in money value = $900 (A)

Mix variance 1,180 (F)
Yield variance 900 (A)
Usage variance (= mix + yield variances) 280 (F)

Factors to consider when changing the mix

 Analysis of the material usage variance into the mix and yield components is worthwhile if
management have control of the proportion of each material used. Management will seek to find
the optimum mix for the product and ensure that the process operates as near to this optimum as

 Identification of the optimum mix involves consideration of several factors:

 Cost. The cheapest mix may not be the most cost effective. Often a favourable mix variance is
offset by an adverse yield variance and the total cost per unit may increase.
 Quality. Using a cheaper mix may result in a lower quality product and the customer may not
be prepared to pay the same price. A cheaper product may also result in higher sales returns
and loss of repeat business.

 Sales Mix and Quantity Variances

Sales volume variance

It measures the increase or decrease in the standard profit or contribution as a result of the sales
volume being higher or lower than budgeted.

It is calculated as the difference between actual sales units and budgeted sales units, multiplied by the
standard profit per unit.

Sales mix and quantity variances

If a company sells more than one product, it is possible to analyse the overall sales volume variance
into a sales mix variance and a sales quantity variance.

Sales mix variance: The sales mix variance occurs when the proportions of the various products sold
are different from those in the budget.

Sales quantity variance: The sales quantity variance shows the difference in contribution/profit
because of a change in sales volume from the budgeted volume of sales.

The unit’s method of calculation

The sales mix variance is calculated as the difference between the actual quantity sold in the standard
mix and the actual quantity sold in the actual mix, valued at standard margin per unit.

F5 Revision notes Page 90

The sales quantity variance is calculated as the difference between the actual sales volume in the
budgeted proportions and the budgeted sales volumes, multiplied by the standard margin.

Example: The following information relates to the sales budget and actual sales volume results for X
Inc for the month of March.
Product X Y Z Total
Budgeted sales (units) 2,400 1,400 1,200 5,000
Unit contribution $5 $7 $6
Total contribution $12,000 $9,800 $7,200 $29,000
Average contribution per unit $5.80
Actual sales (units) 2,000 2,200 1,800 6,000

Sales volume variance

Actual sales (units) 2,000 2,200 1,800
Budgeted sales (units) 2,400 1,400 1,200
Volume variance (units) (400) A 800 F 600 F
Standard contribution per unit 5 7 6
Volume variance (contribution) ($2,000) $5,600 3,600
Total $7,200

Sales quantity variance

The sales quantity variance indicates the effect on profits of the total quantity of sales being different
front that budgeted, assuming that they are sold in the budgeted sales mix.

If this was the case the average standard contribution per unit would be the same as budgeted at:

$29,000/ 5,000 units = $5.80 per units

The quantity variance is calculated as follows:

of sale
Budgeted sales in total 5,000
Actual sales in total 6,000
Sales quantity variance in units 1,000 (F)
Weighted average standard contribution per unit $5.80
Sales quantity variance in $ of standard contribution $5,800 (F)

The sales mix variance

The sales mix variance is calculated as follows (making reference to the example above):

Sum up the budgeted sales of each individual product and calculate the percentage that each bears to
the total (Product X: 2,400/5,ooo = 48%; Product Y: 1,400/5,000 = 28%; Product Z: 1,200/5,000 = 24%).

F5 Revision notes Page 91

Apply the percentages to the actual total sales to give the actual number of each that would have been
sold if the actual sales were made in the standard mix. (For product X this figure is 48% of 6,000 =
2,880 units).

The mix variance (in units) for each product is the difference between this number and the actual sales
of that product. (For product X this is 2,400 - 2,880 = 480 units. Thus the company has sold 480
units of X less than it would have if the actual sales were made in the standard mix)

The variance for each product expressed as units is multiplied by the standard contribution per unit of
that product to give the impact on contribution.

These figures are summed to give the total mix variance

Product Actual Standard Mix Std. contn Mix variance

mix Mix Variance per unit (Std conf")
units units units $ $
X 2,000 48% 2,880 880 (A) 5 4,400 (A)
Y 2,200 28% 1,680 520 (F) 7 3,640 (F)
Z 1,800 24% 1,440 360 (F) 6 2,160 (F)
6,000 6,000 0 1,400 (F)

The total mix variance in units must come to zero.

In this illustration the total mix variance is favourable because the company has sold more high
contribution items and less low contribution items.


Mix variance 1,400 (F)
Quantity variance 5,800 (F)
Volume variance 7,200 (F)

Past Paper Analysis

Variance Analysis Dec 07 – Q 3 c,d,e
June 09 – Q 3
Dec 09 – Q 1a
June 10 – Q 2
Dec 10 – Q 1a, i, iii.

Mix/yield variances June 09 – Q 2

Dec 11 – Q 5a
Dec 14 – Q 5
Dec 15 – Q 3

Sales mix and quantity June 11 – Q 3 b,c

June 13 Q 4, b,c
June 14 – Q 5

F5 Revision notes Page 92

16. Planning and Operational Variances


Sometimes based on circumstances the budget and the standard cost established by an organisation
turns out to be inaccurate and this contributes towards the variances. Under the circumstances, the
budgets/ standard costs should be revised based on the new information available and the variances
should be split into Planning or Operational variances.

Planning Variance: Variance arising as a result of error in planning. This is the difference between
the original budget and the revised budget. Strategic level management is responsible for these.

Operational Variance: This is a result of the operational performance: favourable or adverse.

These are calculated by looking at the difference between the actual result and the revised budget/
standard. Operational level managers are responsible for these.

Causes of Planning and Operational Variances:

 Unexpected market changes related to sales demand, material cost, availability of labour etc.
 Unexpected changes in the product specification etc.

Revising Budgets:
 Budgets should be revised when it is confirmed beyond reasonable doubt that the original
budget is redundant or ineffective under the circumstances.
 The changes have to be approved by the senior management.
 However care needs to be taken as there is a possibility of management manipulating the
budget revision so that the end result is favourable variances.

Planning and Operational Variances:


Material Price Planning Variance Original Standard Price

Less: Revised Standard Price
Price Planning Variance ($) .

Variance x Actual quantity of material used

Material Price Operational Variance Revised standard cost for material actually used
Less: Actual cost for material actually used .
Price Operational Variance ($) .

Material Usage Planning Variance Quantity of material to be used as per original standard
Less: Quantity of material to be used as per revised
Usage Planning Variance

Variance x Original Standard Price ($)

Material Usage Operational Variance Quantity of material to be used as per revised standard
Less: Quantity of material actually used for the actual

F5 Revision notes Page 93

Usage Operational Variance

Variance x Original Standard Price ($)


Labour Rate Planning Variance Original Standard Rate

Less: Revised Standard Rate
Rate Planning Variance ($) .

Variance x Actual number of hours worked

Labour Rate Operational Variance Revised standard rate for hours actually worked
Less: Actual rate for hours actually worked .
Rate Operational Variance ($) .

Labour Efficiency Planning Variance Hours to be worked as per original standard

Less: Hours to be worked as per revised standard
Efficiency Planning Variance .

Variance x Original Standard Rate per hour ($)

Labour Efficiency Operational Variance Hours to be worked as per revised standard

Less: Hours actually worked for the actual production
Efficiency Operational Variance .

Variance x Original Standard Rate per hour ($)


Sales Price Planning Variance Original budgeted sales price

Less: Revised budgeted sales price
Price Planning Variance ($) .

Variance x Actual number of units sold

Sales Price Operational Variance Revised budgeted sales price for units actually sold
Less: Actual sales price for units actually sold
Price Operational Variance ($) .

Sales Volume Planning Variance Original budgeted sales

Less: Revised budgeted sales
Volume Planning Variance .

Variance x Standard contribution per unit ($)

Sales Volume Operational Variance Revised sales volume

Less: Actual sales volume
Volume Operational Variance

Variance x Standard contribution per unit ($)

F5 Revision notes Page 94

Advantages and disadvantages of using planning and operational variances


 They identify variances due to poor planning and put a realistic value to variances resulting
from operations.
 Planning variances can be used to update standard costs and revise budgets.
 The performance of managers is assessed on 'realistic' variance calculations.

 It takes time and effort to revise budgets and prepare revised standard costs.
 Managers might try to blame poor results on poor planning and not on their operational
 Manipulation issues in revising budgets

Past Paper Analysis

Planning and operational variances Dec 09 Q 1 b,c
Dec 10, Q 1 a, ii, b
Dec 12 – Q 2
June 13 – Q 4 a,c
Dec 13 – Q 5
June 15 -- Q 3

F5 Revision notes Page 95

17. Performance Analysis

Uses of Variance Analysis:

 Variance Analysis is a measure of control. Managers responsible for the variances should be asked
to account for them. Senior Management/ people involved in the planning aspect should be made
accountable for the Planning Variances. And managers/ people given responsibility for
implementing the budget, should only be held accountable for Operational Variances.
 The monetary value of the variances also gives an indication of the profit or loss suffered in a
 Variances not only identify the possible areas of concern but can be used to improve future
performances. The analysis could highlight areas where efficiency needs to be improved etc.

Behavioural Aspects of Standard Costing

 The effect of variance on staff motivation and action

In principle, when variances are reported the staff responsible should investigate the causes of
variances that appear to be significant, and if it is discovered on investigation that the cause of
variance can be controlled, suitable control actions should be taken.
This response by staff is only likely to happen under certain conditions:
 Senior managers should indicate the importance they attach to variance reports, and should
demand explanations from their subordinates about significant variances and what has been
done to investigate them. Subordinates are unlikely to treat variances seriously unless their
seniors do.
 Reported variances must be realistic and reliable. Staff will be reluctant to investigate
variances if they do not trust the reported figures and consider the variances to be unrealistic.
 The possible causes of a variance should be controllable by the person who is made
responsible and accountable for the variance. If the cause of a variance is unlikely to be
controllable, it would be a waste of time to investigate its cause.
 Variances should be fairly current. If variance reports are not provided to management until
several weeks after the control period, the variances might be considered 'out of date' an 'no
longer relevant'.
 If managers and other staff are given incentives for achieving favourable variances - for example if
an annual cash bonus depends partly or entirely on achieving favourable variances - the
individuals concerned should be motivated by performance and variance reports.

Variances and a TQM environment

 The concept of Total Quality Management (TQM) is an approach to management based on the
principle that all aspects of quality in an entity's operations should be managed so as to improve
value for the customer.
 The concept of 'continuous improvement' is a view that in order to manage quality it is essential to
keep looking for and identifying ways of improving quality in procedures, systems, products and
 Variance analysis and variance reporting becomes inconsistent with TQM. This is because:
 Variances are calculated by comparing actual results with a fixed standard: performance is
considered 'good' if actual results are better than the standard
 In a system of TQM, the aim is to improve continually. Therefore it would be disappointing if
actual results are ever worse than the standard.
 Variance reporting in a TQM environment may lead to dysfunctional behaviour if managers
ignore aspects of performance where the variance is close to $0, because in TQM any aspect of
performance should be considered capable of improvement.

F5 Revision notes Page 96

Variances and a JIT Environment

 Just in time (JIT) management involves purchasing raw materials and producing output 'just in
time' for when they are needed.
 In principle, in a JIT environment there will be no inventory of raw materials or finished goods,
(in practice the aim is to keep these inventories as low as possible).
 This approach to management may possibly be inconsistent with some variance reporting,
especially if a system of absorption standard costing is used.
 In a system of absorption costing, there will be favourable fixed production overhead
variances if actual output exceeds budgeted output. In other words, favourable variances are
obtained and profit is improved by increasing finished goods inventory levels. But in JIT
output is produced when and according to what is needed.
 A consequence of JIT purchasing and production is that sometimes the purchase price for raw
materials or the production cost for finished goods may be higher than they might otherwise
be, because a supplier may charge a higher unit price for a small quantity. Production costs
per unit may also be higher when batch sizes are smaller. This will be an adverse factor from
Standard costing perspective.

Standard Costing in a Dynamic Environment:

 Standard costs may be incompatible with rapid change, for similar reasons to those of TQM.
In a rapidly-changing environment, it should be expected that the original standard or budget
may get out of date, and action to try to eliminate an adverse variance may in fact be
inappropriate because operating conditions have now changed.
 Many companies produce nonstandard products and try to customise their products according to
needs of particular customers. Even where companies do not customise products for individual
customers, there is extensive fragmentation of markets into segments or niches, with different
product designs manufactured for each separate segment. It is extremely difficult to establish a
standard in such an environment.

Other Problems with Using Standard Costing in Today's Environment

 Variance analysis concentrates on only a narrow range of costs, and does not give sufficient
attention to issues such as quality and customer satisfaction.
 Standard costing places too much emphasis on direct labour costs. Direct labour is only a small
proportion of costs in the modern manufacturing environment and so this emphasis is not
 Many of the variances in a standard costing system focus on the control of short-term variable
costs. But in most organisations the majority of costs, including direct labour costs, tend to be
fixed in the short run.
 The use of standard costing relies on the existence of repetitive operations and relatively
homogeneous output. Nowadays many organisations are forced continually to respond to
customers’ changing requirements, with the result that output and operations are not so
 Most standard costing systems produce control statements weekly or monthly. The modern
manager needs much more prompt control information in order to function efficiently in a
dynamic business environment

Past Paper Analysis

Reconciliation and TQM June 08 – Q 1
June 12 – Q 4

F5 Revision notes Page 97

Part D – Performance Measurement and Control

18. Performance Management Information Systems

Information for Management Accountants:

Management Accounting Information: Information that is used to support strategic planning,

control and decision making.

Strategic Planning: Long term planning decisions that define the objectives of the organisation.

Features of Management Accounting Information:

 Management Accounting information is primarily used for strategic level planning i.e. plans for
long periods of the future and so relies on forecasts and estimates.
 Management accounting information also therefore incorporates some risk and uncertainty
 The management accountant requires information for:
 Project assessments: at the time of decision making and post implementation feedback.
 Handling cash and operational matters
 Management accounting information is primarily derived from internal sources but also takes
into impact of external factors.
 Management Accounting information has the following limitations:
 It may provide misleading information, leading to ineffective decisions.
 It is internally focused as it focuses on performance targets and ignores market
competition and demand.
 Data is inflexible as it is often just based on historical performance, so the challenge lies in
providing more relevant information for strategic planning, control and decision making.

Strategic Management Accounting: focuses on external factors, non-financial and internally

generated information. It takes into account the following:
 Competitive edge by understanding customer demands and competitors USP (unique selling
 Input from many different areas of the organisation to ensure that the goals and targets link
together smoothly.
 Brings together comparable information regarding different strategies.
 Ensures business operations are focused on meeting shareholder’s needs.
 It provides information about: pricing of product, product profitability, cashflows; customer
analysis; market analysis etc.

Management Control: The process of utilising resources, efficiently and effectively with the aim
of achieving the strategic objectives of the organisation. Also known as Tactical Planning.

Efficiency in the use of resources means that optimum output is achieved from the input resources
Effectiveness in the use of resources means that the outputs obtained are according to set objectives or

 The time horizon involved in management control will be shorter than at the strategic decisions
 Management control activities are short-term non-strategic activities.

F5 Revision notes Page 98

 Features of management control information
 Primarily generated internally
 Covers the entire organisation
 Summarised at a relatively low level
 Relevant to the short and medium terms
 Collected in a standard manner
 Commonly expressed in money terms

Operational Control: Routine processing of transactions as per directions laid down in the
Tactical plans.

 Scheduling of unexpected or 'ad hoc' work must be done at short notice. These are termed as
short-term non-strategic activities.
 Information requirements:
 Operational information includes transaction data which is needed for the conduct of day-to-
day implementation of plans.
 Detail of information provided depends upon the purpose, it is required for.
 Operational information, although quantitative, is expressed in terms of units, hours,
quantities of material, and so on.

Transaction Processing Systems (TPS) collect, store, modify and retrieve the transactions of
an organisation.

 The four important characteristics of a TPS are as follows.

 The processing is controlled as it supports the organisations operations.
 All transactions are recorded in a pre-defined manner or format.
 Provides rapid response to support customer satisfaction.
 Back-up and recovery procedures are in place as organisations rely heavily on TPS.

 Batch transaction processing (BTP) collects transaction data as a group and processes it after a
time delay. Information is entered in batches.
 Real time transaction processing (RTTP) is the immediate processing of data.

Management information systems (MIS) convert data from mainly internal sources into
information, which enables managers to make timely and effective decisions for planning and
controlling the activities.

MIS have the following characteristics.

 Support structured decisions at operational and management control levels and is internally
 Designed to report on existing operations rather than analyse data.

Executive information systems (EIS) provides a quick and efficient computing and
communication environment for senior managers to support strategic decisions.

Executive information systems draw data from the MIS and allow communication with external
sources of information.

Executive resource planning systems (ERP systems) are modular software packages
designed to integrate the key processes in an orgnanisation so that a single system can serve the
information needs of all functional areas.

F5 Revision notes Page 99

ERP systems have the principal benefit that the same data can easily be shared between different
departments. ERP systems work in real time.

Benefits of ERP

 Easy access to shared real time information to support decision making.

 A lot of inefficiencies in the way things are done can be removed; as the company restructures
its processes so that multiple departments can work together.
 Standardising Information and work practices so that the terminology used is similar.

Closed system is isolated and shut off from the environment. Information is not received from or
provided to the environment. Social systems cannot be part of closed system.

Open system is connected to and interacts with the environment and is influenced by it.

An open system accepts inputs from its surroundings, processes the inputs in some manner and then
produces an output.

 Strong communication which leads to effective decision making.
 Adaptable. Keeps pace with the dynamic environment.
 It helps managers focus on the external factors that affect the organisation.

F5 Revision notes Page 100

19. Sources of Management Information

Types of Data:

Secondary data: data not directly collected from the source by the user.

Primary data: market research – is more tailored to the user's exact needs.

Internal Sources:

 Formal communication channels

 Informal communication between management and staff
 Communication between managers
 The financial accounting records

External Sources:

 Legal/ Tax expert

 Research & Development and Marketing departments
 Directories & other published sources
 Associations and Government agencies
 Information from customers
 Information from suppliers (product details, pricing etc.)
 Internet & online databases
 Database information
 Data warehouses

Use of Information by Management

Information is primarily used in an organisation, broadly, for the following purposes:

 Plans at all levels are made based on external information and current performance of the
organisation. Awareness of the business environment is required to ensure that the full
potential of the organisation is tapped.
 Control measures are dependent upon the feedback of the actual performance.

Cost of Information:

Direct search costs

 Cost of a marketing research survey
 Subscriptions to online information, surveys etc

Indirect access costs

 Time spent by employees on unsuccessful searches for information
 Time spent on sifting through possibly inaccurate data to extract useful facts.

Management costs
 Recording, processing and dissemination of external information

Infrastructure costs
 Installation and maintenance of systems – communication, internet etc. to facilitate flow of

F5 Revision notes Page 101

Time theft
 Wasted time caused by abuse of internet and email access facilities
 Information overload

Benefits of Information:

 Improvement in the quality of the decisions made based on the information available.
 Reduction in risk and uncertainties.

Using External Information:

Limitation: Quality of information may not be up to mark because of limitations in the parameters
defined for collecting the information, the method of collecting the data and age of the data etc.

Advantages: Cost savings can be substantial because secondary external data is cheaper than
gathering primary data.

 The data may not be relevant to the research objectives as it has originally been collated by
someone else.
 Some external information is expensive to access and may not be easily accessible.
 The accuracy of the data is questionable.

Using Internal Information:

Generating Information:
 Determine if the benefits of the information generated will be higher than the costs incurred
to prepare it.
 Ensure that the desired information will be of use to the decision makers before the
information is gathered.
 Standardised formats for the information to be prepared should be set, especially if there are
multiple prepares of the information. The formats should ideally focus on being user friendly
for the ultimate users.
 The limitations of the information gathered should be communicated to the users as well as
the details of the preparer/ originator, so that any queries can be directly forwarded.

Distributing Information:
 A procedures manual should be in place. This would indicate what reports are to be prepared
and issued to whom.
 Confidential information should be highlighted as such and users guided on how to deal with
sensitive information.
 E-mail policy should be established specifying the do’s and donts’ for on-line communication.
 Physical computer security
 Internal security should be established. Senior management should specify which
user can have access to which assets and information.
 External security through firewalls should be established, as they can be used to
protect data and databases from being accessed by unauthorised people.
 Security and confidential information
A number of procedures can be used to ensure the security of highly confidential information
that is not for external consumption. Measures such as passwords,firewalls, database controls
can be implemented.

F5 Revision notes Page 102

20. Performance Measurement

Performance Measurement

Performance measurement is a vital part of control and aims to establish how well something or
somebody is doing in relation to a planned activity.

Reasons for measuring performance

The purpose of measuring performance is to:

 Determine whether the planning targets or standards are being met.

 Determine the performance of each of function/ department.
 Indicate the risk that targets will not be met, so that action to correct the situation can be
 Indicate poor performance, so that corrective action can be taken.
 Reward the successful achievement of targets or standards.

Responsibility and controllability

Two essential features of an effective performance reporting system are:

Responsibility. Performance reports should be provided to the individuals (and their managers) who
are actually responsible for the performance. Performance reports are irrelevant if they are sent to
individuals with no responsibility.

Controllability. Performance reports should distinguish between aspects of performance that should
be controllable by the individual who is made responsible and accountable. There is no sensible
purpose in judging the performance of an individual by looking at factors that are outside the
individual's control.

Performance measures over Time

Performance measurement should cover the long-term, medium-term and short- term.

Long-term performance: Measures should be linked to the long-term objectives and the strategies of
the organisation. The most significant long-term objectives might be called critical success factors or
CSFs. in order to achieve its long-term and strategic objectives, the critical success factors must be

For each critical success factor, there should be a way of measuring performance, in order to check
whether the CSF targets are being met. Performance measurements for CSFs might be called key
performance indicators (KPIs) or possibly key risk indicators (KRIs).

Medium term performance: Medium-term performance measurement is perhaps most easily

associated with the annual budget, and meeting budget targets. Targets, whether financial or non-
financial, can be set for a planning period such as the financial year, and actual results should be
compared against the planning targets.

Short-term performance: Short-term performance should be monitored by means of operational

performance measures.

F5 Revision notes Page 103

Financial Performance Indicators (FPI)

 Financial performance indicators are the tools used by financial analysts for making decisions
regarding credit and investments. This method utilises the data found in financial statements
to determine a company’s standing.
 Analysts will compare the company’s ratios to its past performance, as well as to industry
statistics to determine risks, trends and to identify any peculiarities. This analytical tool
facilitates inter-company as well as intra company comparisons.

Percentage annual growth in sales = (Current Year Sales / Previous Year Sales) x 100%

If a company wishes to increase its annual profits, it will probably want to increase its annual sales
revenue. Sales growth is usually necessary for achieving a sustained growth in profits over time.

Sales growth (or a decline in sales) can usually be attributed to two causes: Sales prices and sales

Profitability Indicators

Profitability ratios are good indicators of the operating efficiency of an organisation. The management
of an organisation is usually keen to measure its operating efficiency. Again, the owners/ shareholders
invest their funds in the expectation of reasonable returns. The operating efficiency of a firm and its
ability to ensure ample returns to its owners/ shareholders depends basically on the profits earned by

Profit margin ratio

Gross Profit Margin = (Gross Profit / Sales) x 100%
Net Profit Margin = (Net Profit / Sales) x 100%

It is wrong to conclude, without further analysis, that a high profit margin means 'good performance'
and a low profit margin means 'bad performance'. To assess performance by looking at profit margins,
it is necessary to look at the circumstances in which the profit margin has been achieved.

Some companies operate in an industry or market where profit margins are high, although sales
volume may be low. Other companies may operate in a market where profit margins are low but sales
volumes are much higher.

Any change in profit margin front one year to the next will be caused by: changes in selling prices, or
changes in costs as a percentage of sales, or a combination of both.

F5 Revision notes Page 104

Cost/sales ratios

Profitability may also be measured by cost/sales ratios, such as:

Ratio of cost of sales : sales
Ratio of administration costs : sales
Ratio of sales and distribution costs : sales
Ratio of total labour costs : sales.

Performance may be assessed by looking at changes in these ratios over time. A large increase or
reduction in any of these ratios would have a significant effect on profit margin.

Asset Turnover = (Total Sales / capital Employed) x 100%

This ratio indicates the efficiency with which company is able to use all its (net) assets to gearing $1
sales. Generally, the higher a company’s total net asset turnover, the more efficiently its assets have
been used.

Earnings per share (EPS) = Profits available to ordinary shareholder / Number of ordinary shares

EPS is a convenient measure as it shows how well the shareholder is doing.

EPS is widely used as a measure of a company's performance, especially in comparing results over a
period of several years. A company must be able to sustain its earnings in order to pay dividends and
reinvest in the business so as to achieve future growth. Investors also look for growth in the EPS from
one year to the next.

EPS is a figure based on past data, and it is easily manipulated by changes in accounting policies and
by mergers or acquisitions. The use of the measure in calculating management bonuses makes it
particularly liable to manipulation.

Return on capital employed (ROCE) = (Capital Employed / Profit Before Interest & Tax) x 100%

Capital employed = Shareholders' funds plus 'payables: amounts falling due after more than one year'
plus any long-term provisions for liabilities = Total assets less current liabilities.
The change in ROCE from one year to the next
The ROCE being earned by other companies, if this information is available
A comparison of the ROCE with current market borrowing rates

We may analyse the ROCE, to find out why it is high or low, or better or worse than last year. There
are two factors that contribute towards a return on capital employed, both related to turnover.

Profit margin. A company might make a high or a low profit margin on its sales.

Asset turnover. Asset turnover is a measure of how well the assets of a business are being used to
generate sales.

Profit margin and asset turnover together explain the ROCE, and if the ROCE is the primary
profitability ratio, these other two are the secondary ratios. The relationship between the three ratios
is as follows

Profit Margin x Asset Turnover = ROCE

F5 Revision notes Page 105

Financial Risk

Financial risk is the risk to a business entity that arises for reasons related to its financial structure or
financial arrangements.

There are several major sources of financial risk, such as credit risk (= the risk of bad debts because
customers who are given credit will fail to pay what they owe) and foreign exchange for companies
that import or export goods or services (= the risk of an adverse movement in an important currency
exchange rate).

The risk is that if an entity borrows very large amounts of money, it might fail to generate enough cash
front its business operations to pay the interest or repay the debt principal.

Debt ratios

Debt ratios can be used to assess whether the total debts of the entity are within control and are not

Gearing ratio (leverage) = (Long term debt/ Share capital and reserves) x 100%

Or (Long term debt/ Share capital and reserves plus long term debts) x 100%

When there are preference shares, it is usual to include the preference shares within long-term debt,
not share capital.

A company is said to be high-geared or highly-leveraged when its debt capital exceeds its share capital
and reserves. This means that a company is high-geared when the gearing ratio is above either 50% or
100%, depending on which method is used to calculate the ratio.

A company is said to be low-geared when the amount of its debt capital is less than its share capital
and reserves. This means that a company is low-geared when the gearing ratio is less than either 50%
or 100%, depending on which method is used to calculate the ratio.

The gearing ratio can be used to monitor changes in the amount of debt of a company over time. It can
also be used to make comparisons with the gearing levels of other, similar companies, to judge
whether the company has too much debt, or perhaps too little, in its capital structure.

Interest cover ratio = Profit before interest and tax / Interest charges in the year

Interest cover measures the ability of the company to meet its obligations to pay interest.

An interest cover ratio of less than 3.0 times is considered very low, suggesting that the company
could be at risk from too much debt in relation to the amount of profits it is earning.

The risk is that a significant fall in profitability could mean that profits are insufficient to cover
interest charges, and the entity will therefore be at risk from any legal action or other action that
lenders might take.

Operating gearing = Contribution / PBIT

Financial risk, as we have seen, can be measured by financial gearing. Business risk refers to the risk
of making only low profits, or even losses, due to the nature of the business that the company is
involved in. One way of measuring business risk is by calculating a company's operating gearing or
'operational gearing'.

F5 Revision notes Page 106

Liquidity Ratios

Liquidity for a business entity means having enough cash, or having ready access to additional cash, to
meet liabilities when they fall due for payment. The most important sources of liquidity for non-bank
companies are:

 operational cash flows (cash front sales)

 liquid investments, such as cash held on deposit or readily-marketable shares in other
 a bank overdraft arrangement or a similar readily-available borrowing facility from a bank.

Cash may also come front other sources, such as the sale of a valuable non-current asset (such as land
and buildings), although obtaining cash front these sources may need some time.

Liquidity is important for a business entity because without it, the entity- may become insolvent even
though it is operating at a profit. If the entity is unable to settle its liabilities when they fall due, there
is a risk that a creditor will take legal action and this action could lead on to insolvency proceedings.

On the other hand a business entity may have too much liquidity, when it is holding much more cash
than it needs, so that the cash is 'idle', earning little or no interest. Managing liquidity is often a matter
of ensuring that there is sufficient liquidity, but without having too much.

Current Ratio = Current Assets / Current Liabilities

It is sometimes suggested that there is an 'ideal' current ratio of 2.0 times (2:1). However, this is not
necessarily true and in some industries, much lower current ratios are normal. It is important to
assess a current ratio by considering:
 changes in the ratio over time
 the liquidity ratios of other companies in the same industry.

Quick Ratio = Current Assets excluding inventory / Current Liabilities

The quick ratio or acid test ratio is the ratio of 'current assets excluding inventory' to current
liabilities. Inventory is excluded from current assets on the assumption that it is not a very liquid item.

It is sometimes suggested that there is an 'ideal' quick ratio of 1.0 times (1:1). However, this is not
necessarily true and in some industries, much lower quick ratios are normal. As indicated earlier, it is
important to assess liquidity- by looking at changes in the ratio over time and comparisons with other
companies and the industry norm.

Accounts Receivable Payment Period: (Trade Receivables/ Credit Sales Turnover) x 365

This is a rough measure of the average length of time it takes for a company's accounts receivable to
pay what they owe.

Inventory Turnover Period = (Inventory / Cost of Sales) x 365

This indicates the average number of days that items of inventory are held for. As with the average
accounts receivable collection period, this is only an approximate figure, but one which should be
reliable enough for finding changes over time.

A lengthening inventory turnover period indicates:

 A slowdown in trading, or
 A build-up in inventory levels, perhaps suggesting that the investment in inventories is
becoming excessive

F5 Revision notes Page 107

Accounts Payable Payment Period: (Trade Payables/ Credit Purchases) x 365

The accounts payable payment period often helps to assess a company's liquidity; an increase in
accounts payable days is often a sign of lack of long-term finance or poor management of current
assets, resulting in the use of extended credit from suppliers, increased bank overdraft and so on.

Non Financial Performance Indicator

Non-financial performance refers to every aspect of operations within a business except the financial
aspect, and performance targets can be set for every- department throughout the entity. Some
indicators are:

 Product quality or quality of service

 Speed of order processing or speed of any other processing cycle
 Customer satisfaction
 Brand awareness amongst target customers
 Labour turnover rate
 Number of man-days of training provided for employees
 Amount of down-time with IT systems
 Number of suppliers identified for key raw material supplies
 Length of delays on completion of projects
 Capacity utilised (as a percentage of 100% capacity).

Non Financial Performance indicators are adequately covered through different models – covered

Analysing NFPIs

It is not sufficient simply to calculate a performance ratio or other performance measurement.

You need to explain the significance of the ratio - What does it mean? Does it indicate good or bad
performance, and why?

Look at the background information given in the exam question and try- to identify a possible cause or
reason for the good or bad performance.

Possibly, think of a suggestion for improving performance. What might be done by management to
make performance better?

NFPIs in service industries

Performance measures - both financial and non-financial - are needed for service industries, but the
key measures that are best suited to service industries are often very different from the key NFPIs in

Below are some examples of non-financial measures:


Competitiveness sale growth by product or service
relative market share and position

Activity sales units

labour/ machine hours
number of material requisitions serviced

F5 Revision notes Page 108

Productivity efficiency measurements of resources planned against those
production per person

Quality of Service number of customer complaints

rejections as a percentage of production or sales

Quality of Working Life labour turnover


Innovation proportion of new products and services to old ones

new product or service sales level

Customer Satisfaction informal listening by calling a certain number of customers each

number of customer visit to the factory or workplace

Performance measurement in a TQM environment

Total Quality Management embraces every activity of a business so performance measures cannot be
confined to the production process but must also cover the work of sales and distribution departments
and administration departments, the efforts of external suppliers, and the reaction of external

In many cases the measures used will be non-financial ones. They may be divided into three types.

 Measuring the quality of incoming supplies. Quality control should include procedures for
acceptance and inspection of goods inwards and measurement of rejects.
 Monitoring work done as it proceeds. 'In-process' controls include statistical process controls
and random sampling, and measures such as the amount of scrap and reworking in relation to
good production.
 Measuring customer satisfaction. This may be monitored in the form of letters of complaint,
returned goods, penalty discounts, claims under guarantee, or requests for visits by service

Short-termism and manipulation

Short-termism is when there is a bias towards short-term rather than long-term performance.

Organisations often have to make a trade-off between short-term and long-term objectives. Decisions
which involve the sacrifice of longer-term objectives include the following.

 Postponing or abandoning capital expenditure projects, which would eventually contribute to

growth and profits, in order to protect short term cash flow and profits.
 Cutting R&D expenditure to save operating costs, and so reducing the prospects for future
product development.

F5 Revision notes Page 109

Balanced Scorecard

A useful approach for a complete strategic performance evaluation is to include both financial and
non-financial factors for an organisation, using the balanced scorecard. The balanced scorecard
measures an organisation’s performance in four key areas:

Customer satisfaction

Financial performance

Internal business process

Learning and growth

The justifications of balanced scorecard over the traditional measures are that:

 Accounting figures are easily manipulated and as such unreliable changes in the business and
market environment do not show in the financial results of a company until much later.
 Factors other than financial performance must therefore be targeted.

Customer perspective

How do customers perceive the firm?

This focuses on the analysis of different types of customers, their degree of satisfaction and the
processes used to deliver products and services to customers.

Particular areas of focus would include:

 Customer service.
 New products.
 New markets.
 Customer retention.
 Customer satisfaction.

Internal business perspective

How well the business is performing.

Particular areas of focus would include:

 Quality performance.
 Quality.
 Motivated workforce.

Innovation and learning perspective

Can we continue to improve and create value?

Particular areas of focus would include:

 Product diversification.
 % sales from new products.
 Amount of training.
 Number of employee suggestions.
 Extent of employee empowerment.

F5 Revision notes Page 110

Financial perspective

This is concerned with the shareholders view of performance. Shareholders are concerned with many
aspects of financial performance.

Particular areas of focus would include:

 Market share.
 Profit ratio.
 Return on investment.
 Economic value added.
 Return on capital employed.
 Cash flow.
 Share price.

Diagram: A format of Balanced Scorecard


The targets for each of the four perspectives might often conflict with each other. When this happens,
there might be disagreement about what the priorities should be.

This problem should not be serious, however, if it is remembered that the financial is the most
important of the four perspectives for a commercial business entity. The term 'balanced' scorecard
indicates that some compromises have to be made between the different perspectives.

F5 Revision notes Page 111

Building Block Model

Fitzgerald and Moon (1996) suggested that a performance management system in a service
organisation can be analysed as a combination of three building blocks:

 dimensions
 standards, and
 rewards.

These are shown in the following diagram, which is known as the 'building block model'.

Building blocks for performance measurement systems

(Fitzgerald and Moon 1996)

Dimensions of Performance

Dimensions of performance are the aspects of performance that are measured. To establish a
performance measurement system for a service industry, a decision has to be made about the
dimensions of performance that should be used for measuring performance.

Research by Fitzgerald and others (1993) and by Fitzgerald and Moon (1996) concluded that there are
six aspects to performance measurement that link performance to corporate strategy. These are:

 profit (financial performance)

 competitiveness
 quality
 resource utilisation
 flexibility
 innovation.

Performance measures should be established for each of these six dimensions. Some performance
measures that might be used for each dimension are set out in the following table.

Dimension of performance Possible measure of performance

Financial performance Profitability
Growth in profits

Competitiveness Growth in sales

Retention rate for customers (or percentage of customers who
buy regularly: 'repeat sales')

F5 Revision notes Page 112

Service quality Number of complaints
Customer satisfaction, as revealed by customer opinion surveys
Number of errors discovered

Flexibility Possibly the mix of different types of work done by employees, to

assess the flexibility of the work force
Possibly the speed in responding to customer requests, to assess
flexibility of response to customers' needs

Resource utilisation Efficiency/productivity measures, such as material wastage

rates, rates of loss in production, labour efficiency
Utilisation rates: percentage of available time utilised in
'productive' activities, machine utilsation

Innovation Number of new services offered

Percentage of total sales income that comes from services
introduced in the last one or two years

Standards of performance

The second part of the framework for performance measurement suggested by Fitzgerald and Moon
relates to setting expected standards of performance, once the dimensions of performance have been
selected. This considers behavioral aspects of performance targets.

There are three aspects to setting standards of performance:

 To what extent do individuals feel that they own the standards that will be used to assess their
performance? Do they accept the standards as their own, or do they feel that the standard
shave been imposed on them by senior management?
 Do the individuals held responsible for achieving the standards of performance consider that
these standards are achievable, or not?
 Are the standards fair ('equitable') for all managers in all business units of the entity?

It is recognised that individuals should 'own' the standards that will be used to assess their
performance, and managers are more likely to own the standards when they have been involved in the
process of setting the standards.

It has also been argued that if an individual accepts or 'owns' the standards of performance, better
performance will be achieved when the standard is more demanding and difficult to achieve than
when the standard is easy to achieve.

This means that the standards of performance that are likely to motivate individuals the most are
standards that will not be achieved successfully all the time. Budget targets should therefore be
challenging, but not impossible to achieve.

Finding a balance between standards that the company thinks are achievable and standards that the
individual thinks are achievable can be a source of conflict between senior management and their

Rewards for performance

The third aspect of the performance measurement framework of Fitzgerald and Moon is rewards. This
refers to the structure of the re-wards system, and how individuals will be rewarded for the successful
achievement of performance targets. This aspect of performance also has behavioral implications.

F5 Revision notes Page 113

One of the main roles of a performance measurement system should be to ensure that strategic
objectives are achieved successfully, by linking operational performance with strategic objectives.

According to Fitzgerald, there are three aspects to consider in the reward system.

 The system of setting performance targets and rewarding individuals for achieving those
targets must be clear to everyone involved. Provided that managers accept their performance
targets, motivation to achieve the targets will be greater when the targets are clear (and when
the managers have participated in the target-setting process).
 Employees may be motivated to work harder to achieve performance targets when they are
rewarded for successful achievements, for example with the payment of an annual bonus.
 Individuals should only be held responsible for aspects of financial performance that they can
control. This is a basic principle of responsibility accounting. A common problem, however, is
that some costs are incurred for the benefit of several divisions or departments of the
organisation. The costs of these shared services have to be allocated between the divisions or
departments that use them. The principle that costs should be controllable therefore means
that the allocation of shared costs between divisions must be fair, in practice; arguments
between divisional managers often arise because of disagreements as to how the shared costs
should be shared.

F5 Revision notes Page 114

Divisional Performance Evaluation

Decentralisation of authority

Decentralisation involves the delegation of authority within an organisation. Within a large

organisation, authority is delegated to the managers of cost centres, revenue centres, profit centres
and investment centres.

A divisionalised structure refers to the organisation of an entity in which each operating unit has its
own management team which reports to a head office. Divisions are commonly set up to be
responsible for specific geographical areas or product lines within a large organisation. The term
'decentralised divisionalised structure' means an organisation structure in which authority has been
delegated to the managers of each division to decide selling prices, choose suppliers, make output
decisions, and so on.

Benefits of decentralisation

 Decision-making should improve, because the divisional managers make the tactical and
operational decisions, and top management is free to concentrate on strategy and strategic
 Decision-making at a tactical and operational level should improve, because the divisional
managers have better 'local' knowledge.
 Decision-making should improve, because decisions will be made faster. Divisional managers
can make decisions 'on the spot' without referring them to senior management.
 Managers may be more motivated to perform well if they are empowered to make decisions
and rewarded for performing well against fair targets
 Divisions provide useful experience for managers who will one day become top managers in
the organisation.
 Within a large multinational group, there can be tax advantages in creating a divisional
structure, by locating some divisions in countries where tax advantages or subsidies can be

Disadvantages of decentralisation

 The divisional managers might put the interests of their division before the interests of the
organisation as a whole. Taking decisions that benefit a division might have adverse
consequences for the organisation as a whole. When this happens, there is a lack of 'goal
 Top management may lose control over the organisation if they allow decentralisation without
accountability. It may be necessary to monitor divisional performance closely. The cost of
such a monitoring system might be high.
 It is difficult to find a satisfactory measure of historical performance for an investment centre
that will motivate divisional managers to take the best decisions. For example, measuring
divisional performance by Return 011 Investment (ROI) might encourage managers to make
inappropriate long-term investment decisions. This problem is explained in more detail later.
 Economies of scale might be lost. For example, a company might operate with cute finance
director. If it divides itself into three investment centres, there might be a need for four
finance directors - one at head office and one in each of the investment centres. Similarly
there might be a duplication of other systems, such as accounting system and other IT

Controllable profit and traceable profit

Controllable profit is used to assess the manager and is therefore sometimes called the managerial

F5 Revision notes Page 115

Traceable profit is used to assess the performance of the division and is sometimes called the
economic evaluation.

Profit is a key measure of the financial performance of a division. However, in measuring

performance, it is desirable to identify:

 costs that are controllable by the manager of the division, and also
 costs that are traceable to the division. These are controllable costs plus other costs directly
attributable to the division over which the manager does not have control.

There may also be an allocation of general overheads, such as a share of head office costs.

In a divisionalised system, profit centres and investment centres often trade with each other, buying
and selling goods and services. These are internal sales, priced at an internal selling price (a 'transfer
price'). Reporting systems should identify external sales of the division and internal sales as two
elements of the total revenue of the division.

Responsibility Accounting

Responsibility accounting is the term used to describe decentralisation of authority, with the
performance of the decentralised units measured in terms of accounting results.

With a system of responsibility accounting there are five types of responsibility centre: cost centre;
revenue centre; profit centre; contribution centre; investment centre.

Responsibility centre Manager has control over …

Cost centre Controllable costs

Revenue centre Revenues only
Profit centre Controllable costs

Contribution centre As for profit centre

Investment centre Controllable costs

Sales prices (including transfer prices)
Output volumes
Investment in non-current assets and working capital

F5 Revision notes Page 116

Transfer Pricing

Purpose of transfer pricing

When a company has a divisionalised structure, some of the divisions might supply goods or services
to other divisions in the same company.
 One division sells the goods or services. This -will be referred to as the 'selling division'.
 Another division buys the goods or services. This will be referred to as the 'buying division'.
For accounting purposes, these internal transfers of goods or services are given a value. Transfers
could be recorded at cost. However, when the selling division is a profit centre or investment centre, it
will expect to make some profit on the sale.

Definition of a transfer price

A transfer price is the price at which goods or services are sold by one division within a company to
another division in the same company. Internal sales are referred to as transfers, so the internal
selling and buying price is the transfer price.

When goods are sold or transferred by one division to another, the sale for one division is matched by
a purchase by the other division, and total profit of the company as a whole is unaffected. It is an
internal transaction within the company, and a company cannot make a profit from internal transfers.
A decision has to be made about what the transfer price should be. A transfer price maybe:
 the cost of the item (to the selling division), or
 a price that is higher than the cost to the selling division, which may be cost plus a profit margin or
related to the external market price of the item transferred.

Transfers at cost

The transfer price may be the cost of making the item (goods) or cost of provision (services) to the
selling division. A transfer at cost maybe at either:
 marginal cost (variable cost), or
 full cost.

An entity has to divisions, Division A and Division B, Division A makes a component X which is
transferred to Division B. Division B uses component X to make end-product Y.
Details of budgeted annual sales and costs in each division are as follows:

Division A Division
Units produced/sold 10,000 10,000
$ $
Sales of final product - 350,000
Costs of production
Variable costs 70,000 30,000
Fixed costs 80,000 90,000
Total costs 150,000 120,000

What would be the budgeted annual profit for each division if the units of component X are
transferred from Division A to Division B:
a) at marginal cost

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b) at full cost?
How would the reported profit differ if actual sales prices, actual variables costs per unit and total
fixed costs were as budgeted, but units sold are 10% more than budget?

Transfers at marginal cost: budgeted performance:

Division A Division B Company as a whole

Units produced/sold 10,000 10,000 10,000
$ $ $
External sales of final product - 350,000 350,000
Internal transfers (10,000 x $7) 70,000 - 0
Total sales 70,000 350,000 350,000
Costs of production
Internal transfers (10,000 x $7) - 70,000 0
Other variable costs 70,000 30,000 100,000
Fixed costs 80,000 90,000 170,000
Total costs 150,000 190,000 270,000

Profit/(net cost or loss) (80,000) 160,000 80,000

By transferring goods at variable cost, the transferring division earns revenue equal to its variable cost
of production. It therefore bears the full cost of its fixed costs, and its records a loss (or a net cost)
equal to its fixed costs.
On the other hand, the buying division (Division B) reports a profit. Because te fixed costs of Division
A are not included in the transfer price, the profit of Division B exceeds the total profit of the company
as a whole.

Transfers at marginal cost: actual sales higher than budget

The same situation occurs if actual output and sales differ from budget. If production and sales are
11,000 units, the profits of Division B will increase, but Division A still makes a loss equal to its fixed
costs. The total company profits increase by the same amount as the increase in the profits of Division

Division A Division B Company as a whole

Units produced/sold 11,000 11,000 11,000
$ $ $
External sales of final product - 385,000 385,000
Internal transfers (11,000 x $7) 77,000 - 0
Total sales 77,000 385,000 385,000
Costs of production
Internal transfers (11,000 x $7) - 77,000 0
Other variable costs 77,000 33,000 110,000
Fixed costs 80,000 90,000 170,000
Total costs 157,000 200,000 280,000

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Profit/(net cost or loss) (80,000) 185,000 105,000

Transfers at full cost: budgeted performance:

In this example, the full cost per unit produced in Division A is $15, with an absorption rate for fixed
overheads of $S per unit produced and transferred

Division A Division B Company as a whole

Units produced/sold 10,000 10,000 10,000
$ $ $
External sales of final product - 350,000 350,000
Internal transfers (10,000 x $15) 150,000 - 0
Total sales 150,000 350,000 350,000
Costs of production
Internal transfers (10,000 x $15) - 150,000 0
Other variable costs 70,000 30,000 100,000
Fixed costs 80,000 90,000 170,000
Total costs 150,000 270,000 270,000

Profit 0 80,000 80,000

Since the transfer price includes the fixed costs of the selling division, Division A is able to cover all its
costs, but it reports neither a profit nor a loss. It covers its costs exactly.
The buying division (Division B) has to pay for the fixed costs of division A in the transfer price. It still
reports a profit, but this profit is now equal to the profit earned by the company as a whole.

Transfers at full cost: actual sales higher than budget

A similar situation occurs if actual output and sales differ from budget. If production and sales are
11,000 units, the profits of Division B will increase. However, Division A will make some 'profit', but
this is simply the amount by which its fixed overhead costs are over-absorbed.

Division A Division B Company as a whole

Units produced/sold 11,000 11,000 11,000
$ $ $
External sales of final product - 385,000 385,000
Internal transfers (11,000 x $15) 165,000 - 0
Total sales 165,000 385,000 385,000
Costs of production
Internal transfers (11,000 x $15) - 165,000 0
Other variable costs 77,000 33,000 110,000
Fixed costs (incurred) 80,000 90,000 170,000
Total costs 157,000 288,000 280,000

Profit 8,000 97,000 105,000

F5 Revision notes Page 119

These examples should illustrate that if transfers are at cost, the selling division has no real incentive,
because it will earn little or no profit from the transactions, in effect, the selling division is a cost
centre rather than a profit centre or investment centre.

Transfer pricing at cost plus

For the purpose of performance measurement and performance evaluation in a company with profit
centres or investment centres, it is appropriate that:
 the selling division should earn some profit or return on its transfer sales to other divisions and
 the buying division should pay a fair transfer price for the goods or services that it buys from other

One way of arranging for each division to make a profit on transfers is to set the transfer price at an
amount above cost, to provide the selling division with a profit margin. However the transfer price
should not be so high that the buying division makes a loss on the items it obtains from the selling

Transfer pricing at market price

It would be more realistic to set the transfer price at or close to a market price for the item transferred,
but this is only possible if an external market exists for the item.

The objectives of transfer pricing

Transfer prices are decided by management. When authority is delegated to divisional managers, the
managers of the selling and buying divisions should be given the authority to negotiate and agree the
transfer prices for any goods or services 'sold' by one division to the other.
The objectives of transfer pricing should be to make it possible for divisionalisation to operate
successfully within a company, and:
 give autonomy (freedom to make decisions) to the managers of the profit centres or investment
 enable the company to measure the performance of each division in a fair way.

Divisional autonomy

Autonomy is freedom of action and freedom to make decisions. Divisional managers should be free to
make their own decisions. Autonomy should improve motivation of divisional managers.
For example, when transfer prices have been decided, the managers of all divisions within the entity
should be free to decide:
 whether to sell their output to other divisions (internal transfers) or -whether to sell them to
external customers, if an external market exists for the output
 whether to buy their goods from another division (internal transfers) or whether to buy them from
external suppliers, if an external market exists.

Acting in the best interests of the company

 In addition, divisional managers should be expected to make decisions that are in the best interest
s of the company as a whole.
 Unfortunately, divisional managers often put the interests of their own division before the
interests of the company as a whole, particularly if they are rewarded (for example with an annual
cash bonus) on the basis of the profits or ROI achieved by the division.
 In certain circumstances, the personal objectives of divisional managers may be in conflict with
the interests of the company as a whole. A division may take action that maximises its own profit,

F5 Revision notes Page 120

but reduces the profits of another division. As a result, the profits of the entity as a whole may also
be reduced.

Problems with Transfer Pricing

External intermediate markets

A system of transfer pricing should allow the divisional managers the freedom to make their own
decisions, without having to be told by head office what they must do. At the same time, the system
should not encourage divisional managers to take decisions that do harm to the company.

The main problems arise when there is an external market for the goods (or services) that one division
transfers to another. When an external market exists for goods or services that are also transferred
internally, the market might be called an external intermediate market.
 The selling division can sell its goods into this market, instead of transferring them internally.
 Similarly the buying division can buy its goods from other suppliers in this market, instead of
buying them internally from another division.

Divisional managers will put the interests of their division before the interests of the company. When
there is an external intermediate market, divisional managers will decide between internal transfers
and using the external market in a way that maximises the profits of their division.

Market-based and cost-based transfer prices, and transfer prices based on opportunity

As a general rule:
 when an external intermediate market does not exist for transferred goods, the transfer price will
be based on cost
 when an external intermediate market does exist for transferred goods, the transfer price will be
based on the external market price.
However, the situation is more complicated when:
 there is a limit to production capacity in the selling division, or
 there is a limit to sales demand in the external intermediate market.

In these circumstances, we need to consider the opportunity costs for the selling division of
transferring goods internally instead of selling them externally.

The opportunity cost of transfers

The selling division and the buying division have opportunity costs of transferring goods internally
when there is an intermediate external market.
 For the selling division, the opportunity cost of transferring goods internally to another division
might include a loss of contribution and profit from not being able to sell goods externally in the
intermediate market.
 For the buying division, the opportunity cost of buying internally from another division is the
price that it would have to pay for purchasing the items from external suppliers in the
intermediate market.
The ideal transfer price is a price at which both the selling division and the buying division -will want
to do what is in the best interests of the company as a whole, because it is also in the best interests of
their divisions.

Ideal transfer prices must therefore take opportunity costs into consideration.

F5 Revision notes Page 121

Identifying the ideal transfer price

The following rides should help you to identify the ideal transfer price in any situation:
 Step 1. Begin by identifying the arrangement for transferring goods internally that would
maximise the profits of the company as a whole, in other words, what solution is best for the
 Step 2. Having identified the plan that is in the best interests of the company as a whole, identify
the transfer price, or range of transfer prices, that will make the manager of the buying division
want to work towards this plan. The transfer price must ensure that, given this transfer price, the
profits of the division will be maximised by doing what is in the best interests of the company as a
 Step 3. In the same way, having identified the plan that is in the best interests of the company as
a whole, identify the transfer price, or range of transfer prices, that will make the manager of the
selling division want to work towards the same plan. Again, the transfer price must ensure that,
given the transfer price, the profits of the division will be maximised by doing what is in the best
interests of the company as a whole.

Finding the ideal transfer price: No external intermediate market

When there is no external intermediate market, the ideal transfer price is either:
 cost or
 cost plus a contribution margin or profit margin for the selling division.

Transfers at cost do not provide any profit for the selling division; therefore transfer prices at cost are
inappropriate for a divisional structure where the selling division is a profit centre or an investment
centre, with responsibility for making profits.

Transfers at cost are appropriate only if the selling division is treated as a cost centre, with
responsibility for controlling its costs but not for making profit.

If the selling division is a profit centre or an investment centre, and there is 110 external intermediate
market for the transferred item, transfers should therefore be at a negotiated 'cost plus' price, to
provide some profit to the selling division.


A company has two divisions, Division A and Division B. Division A makes a component X which is
transferred to Division B.

Division B uses component X to make end-product Y. Both divisions are profit centres within the

Details of costs and selling price are as follows:

Division A $
Cost of component X
Variable cost 10
Fixed cost 8
Total cost 18

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Division B
Further processing costs
Variable cost 4
Fixed cost 7

Selling price per unit of product Y 40

The further processing costs of Division B do not include the cost of buying component X from
Division A. One unit of component X goes into the production of one unit of Product Y. Fixed costs in
both divisions will be the same, regardless of the volume of production and sales.

Required: What is the ideal transfer price, or what is a range of prices that would be ideal for the
transfer price?

Step 1: What is in the best interests of the company as a whole?

The total variable cost of one unit of the end product, product Y, is $14 ($10 + $4). The sales price of
product Y is $40.
The entity therefore makes additional contribution of $26 for every unit of product Y that it sells. It is
therefore in the best interests of the company to maximise production and sales of product Y.

Step 2: What will motivate the buying division to buy as many units of component X as possible?
Division B will want to buy more units of component X provided that the division earns additional
contribution from every unit of the component that it buys.

Division B $
Selling price of Product Y, per unit 40
Variable further processing costs in Division B 4

The opportunity cost of not buying units of component X, ignoring the transfer price, is $36 per unit.
Division B should therefore be willing to pay up to $36 per unit for component X. Any transfer price
below $36 but above $4 per unit -will increase its contribution and profit

Step 3: What will motivate the selling division to make and transfer as many units of component X as
Division A will want to make and sell more units of component X provided that the division earns
additional contribution from every unit of the component that it sells. The marginal cost of making
and transferring a unit of component X is $10. Division A should therefore be willing to transfer as
many units of component X as it can make (or Division B has the capacity to buy) if the transfer price
is at least $10.

Ideal transfer price

The ideal transfer price is anywhere in the range $10 to $36. A price somewhere within this range
maybe negotiated, which will provide profit to both divisions and the company as a whole, for each
additional unit of product Y that is made and sold.

F5 Revision notes Page 123

Finding the ideal transfer price: An external intermediate market and no production

When there is an external intermediate market for the transferred item, a different situation applies.
If there are no production limitations in the selling division, the ideal transfer price is usually the
external market price.

A company has two divisions P and Q. Division P makes a component X which it either transfers to
Division Q or sells in an external market. The costs of making one unit of component X are:

Component X $
Variable cost 60
Fixed cost 30
Total cost 90

Division Q uses one unit of component X to make one unit of product Y, which it sells for $200 after
incurring variable further processing costs of $25 per unit.

Required What is the ideal transfer price or range of transfer prices, if the price of component X in
the external intermediate market is:
 $140
 $58?

Step 1: What is in the best interests of the company as a whole?

The company will benefit by maximising the total contribution from the total external sales of
component X and product Y.

If component X is not transferred by Division P to Division Q, Division Q will have to buy units of
component X in the external market. Every unit of component X transferred internally therefore
reduces the need to purchase a unit externally.
 The additional contribution for the company from making and selling one unit of product Y is
$115 ($200 - $60 - $25).
 The additional contribution from making one unit of component X and selling it externally is $80
($140 - $60) when the external price is $140.
 When the external market rice is $58 for component X, Division P would make an incremental
loss of $2 per unit ($58 - $60) by selling the component externally.

A profit-maximising plan is therefore to maximise the sales of Division Q, and transfer component X
from Division P to Division Q rather than sell component X externally. This is the optimum plan if the
external price for component X is either $140 or $58.

Step 2: What will motivate the buying division (Division Q) to buy as many units of component X as
possible from Division P?
Division Q will be prepared to buy component X from Division P as long as it is not more expensive
than buying in the external market from another supplier. Division Q will be willing to buy internally
if the transfer price is:
a) not more than $140 when the external market price is $140
b) not more than $58 when the external market price is $58.
If the external market price and transfer price are both $140, Division Q will make an incremental
contribution of $35 ($200 - $140 - $25) from each unit of component X that it buys and uses to make
and sell a unit of product Y.

F5 Revision notes Page 124

If the external market price and transfer price are both $58, Division Q will make an incremental
contribution of $117 ($200 - $58 - $25) from each unit of component X that it buys and uses to make
and sell a unit of product Y.
It the transfer price is higher than the external market price, Division Q will choose to buy component
X in the external market, which would not be in the best interests of the company as a whole.

Step 3: What will motivate the selling division to make and transfer to Division Q as many units of
component X as possible?
Division P should be prepared to transfer as many units of component X as possible to Division Q
provided that its profit is no less than it would be if it sold component X externally.
Units transferred to division Q are lost sales to the external market; therefore there is an opportunity
cost of transfer that Division P will wish to include in the transfer price.

Component X: market price $140 $

Variable cost 60
Opportunity cost of lost external sale (140-60) 80
Total cost = minimum transfer price 140

Component X: market price $58 $

Variable cost 60
Opportunity cost of lost external sale (58 -60) (2)
Total cost = minimum transfer price 58

Ideal transfer price

The ideal transfer price is the maximum that the buying division is prepared to pay and the minimum
that the selling division will want to receive, in both situations, the ideal transfer price is therefore the
market price in the external intermediate market.
When the external market price is $58, Division P is losing contribution by selling component X
externally. It would also be cheaper for the entity as a whole to buy the component externally for $58
rather than make internally for a marginal cost of $60. Division P should consider ending its
operations to produce component X.

Finding the ideal transfer price: An external intermediate market and production

When there is an external intermediate market for the transferred item, and the selling division has a
limitation on the number of units it can produce, the ideal transfer price should allow for the
opportunity cost of the selling division. Every unit transferred means one less external sale.

A company consists of two divisions, Division A and Division B. Division A is working at full capacity
on its machines, and can make either Product Y or Product Z, up to its capacity limitation. Both of
these products have an external market.
The costs and selling prices of Product Y and Product Z are:

Product Y Product Z
$ $
Selling price 15 17

Variable cost of production 10 7

Variable cost of sale 1 2

F5 Revision notes Page 125

Contribution per unit 4 8

The variable cost of sale is incurred on external sales of the division's products. This selling cost is not
incurred for internal sales/transfers from Division A to Division B.
To make one unit of Product Y takes exactly the same machine time as one unit of Product Z.
Division B buys Product Y, which it uses to make an end product.
The profit of the company as a whole will be maximised by making and selling as many units as
possible of Division B’s end product.

Required: What is the ideal transfer price or range of transfer prices?

Step 1: What is in the best interests of the company as a whole?

This is stated in the example. The company wants to make and sell as many units of the end product
of Division B as possible. It is not clear, however, whether it is better for Division B to buy Product Y
externally or to buy internally from Division A.
If Division A does not make Product Y, it can make and sell Product Z instead. Product Z earns a
higher contribution per unit of machine time, the limiting factor in Division A.

Step 2: What would motivate the buying division to buy as many units of Product Y as possible from
Division A?
Division B will be prepared to buy Product Y from Division A as long as it is not more expensive than
buying in the external market from another supplier.
Division B will be willing to buy Product Y internally if the transfer price is $15 or less.

Step 3: What would motivate the selling division to make and transfer as many units of Product Y as
The selling division will only be willing to make Product Y instead of Product Z if it earns at least as
much contribution as it would front making Z and selling it externally, (in this situation, the division
can make as many units of Z as it can make of Y, and Product Z earns a higher contribution).

Product Y $
Variable cost of making Product Y (the variable cost of sale is not
relevant for internal transfers) 10
Opportunity cost of lost external sale of Product Z (17 - 7 - 2 ) 8
Total cost = minimum transfer price 18

Ideal transfer price/ideal production and selling plan

Division B will not want to pay more than $15 for transfers of Product Y; otherwise it will buy Product
Y externally. Division A will want to receive at least $13 for transfers of Product Y; otherwise it will
prefer to make and sell Product Z, not Product Y.
The ideal solution is for Division B to buy Product Y externally at $15 and for Division A to make and
sell Product Z.

Transfer Pricing in Practice

Transfer prices might be decided by head office and imposed on each division. Alternatively, the
managers of each division might have the autonomy to negotiate transfer prices with each other.

In practice, transfer prices may be agreed and expressed in one of the following ways.

F5 Revision notes Page 126

Transfer price at market price

A transfer price may be the external selling/buying price for the item in an external intermediate
market. This price is only possible when an external market exists.

If the selling division would incur some extra costs if it sold its output externally rather than
transferred it internally to another division, the transfer price may be reduced below market price, to
allow for the variable costs that would be saved by the selling division. This is very common as the
selling division may save costs of packaging and warranties or guarantees. Distribution costs may also
be cheaper and there will be no need for advertising.

Advantages of market price as the transfer price

Market price is the ideal transfer price when there is an external market. A transfer price below this
amount will make the manager of the selling division want to sell externally, and a price above this
amount will make the manager of the buying division want to buy externally.
Transferring at market price also encourages efficiency in the supplying division, which must compete
with the external competition.

Disadvantages of market price as the transfer price

The current market price is not appropriate as a transfer price when:

 the current market price is only temporary, and caused by short-term conditions in the market, or
 the selling price in the external market would fall if the selling division sold more of its output into
the market. The opportunity cost of transferring output internally would not be the current
market price, because the selling price would have to be reduced in order to sell the extra units.

It may also be difficult to identify exactly what the external market price is. Products from rival
companies may be different in quality, availability may not be so certain and there may be different
levels of service back-up.

Transfer price at full cost plus

A transfer price may be the full cost of production plus a margin for profit for the selling division.

Standard full costs should be used, not actual full costs. This will prevent the selling division from
increasing its profit by incurring higher costs per unit.

Full cost plus might be suitable when there is no external intermediate market.

However, there are disadvantages in using full cost rather than variable cost to decide a transfer price.
 The fixed costs of the selling division become variable costs in the transfer price of the buying
division. This might lead to decisions by the buying division manager that are against the best
interests of the company as a whole. This is because a higher variable cost may lead to the buying
division choosing to set price at a higher level which would lose sales volume.
 The size of the profit margin or mark-up is likely to be arbitrary.

Transfer price at variable cost plus or incremental cost plus

A transfer price might be expressed as the variable cost of production plus a margin for profit for the
selling division.

F5 Revision notes Page 127

Standard variable costs should be used, not actual variable costs. This will prevent the selling
division from increasing its profit by incurring higher variable costs per unit.

Variable cost plus might be suitable when there is no external intermediate market. It is probably
more suitable in these circumstances than full cost plus, because variable cost is a better measure of
opportunity cost. However, as stated earlier, when transfers are at cot, the transferring division
should be a cost centre, and not a profit centre.

Other methods that maybe used to agree transfer prices include:

 Two-part transfer prices
 Dual pricing

Two-part transfer prices

With two-part transfer prices, the selling division charges the buying division for units transferred in
two ways:
 a standard variable cost per unit transferred, plus
 a fixed charge in each period.

The fixed charge is a lump stun charge at the end of each period. The fixed charge would represent a
share of the contribution front selling the end product, which the selling/transferring division has
helped to earn. Alternatively, the charge could be seen as a charge to the buying division for a share of
the fixed costs of the selling division in the period.

The fixed charge could be set at an amount that provides a 'fair' profit for each division, although it is
an arbitrary amount.

Dual pricing
In some situations, two divisions may not be able to agree a transfer price, because there is no transfer
price at which the selling division will want to transfer internally or the buying division will want to
buy internally. However, the profits of the entity as a whole would be increased if transfers did occur.

These situations are rare. However, when they occur, head office might find a solution to the problem
by agreeing to dual transfer prices.
 the selling division sells at one transfer price, and
 the buying division buys at a lower transfer price.

There are two different transfer prices. The transfer price for the selling division should be high
enough to motivate the divisional manager to transfer more units to the buying division. Similarly, the
transfer price for the buying division should be low enough to motivate the divisional manager to buy
more units from the selling division.
In the accounts of the company, the transferred goods are:
 sold by the selling division to head office and
 bought by the buying division from head office.

The loss from the dual pricing is a cost for head office, and treated as a head office overhead expense.
However, dual pricing can be complicated and confusing. It also requires the intervention of head
office and therefore detracts from divisional autonomy.

Negotiated transfer prices

A negotiated transfer price is a price that is negotiated between the managers of the profit centres.
The divisional managers are given the autonomy to agree on transfer prices. Negotiation might be a
method of identifying the ideal transfer price in situations where an external intermediate market
does not exist.

F5 Revision notes Page 128

An advantage of negotiation is that if the negotiations are honest and fair, the divisions should be
willing to trade with each other on the basis of the transfer price they have agreed.

Disadvantages of negotiation are as follows:

 The divisional managers might be unable to reach agreement. When this happens, management
from head office will have to act as judge or arbitrator in the case.
 The transfer prices that are negotiated might not be fair, but a reflection of the bargaining
strength or bargaining skills of each divisional manager.

These profit measures can be used with variance analysis, ratio analysis, return on investment,
residual income and non-financial performance measurements to evaluate performance.

F5 Revision notes Page 129

Return on Investment (ROI)

The reason for using ROI as a financial performance indicator

 Return on investment (ROI) is a measure of the return on capital employed for an investment
centre. It is also called the accounting rate of return (ARR).
 It is often used as a measure of divisional performance for investment centres because:
 the manager of an investment centre is responsible for the profits of the centre and also the
assets invested in the centre, and
 ROI is a performance measure that relates profit to the size of the investment.

Profit is not a suitable measure of performance for an investment centre. It does not make the
manager accountable for his or her use of the net assets employed (the investment in the investment

Measuring ROI

Performance measurement systems could use ROI to evaluate the performance of both the manager
and the division. ROI is the profit of the division as a percentage of capital employed.

Capital employed (size of investment)

Profit. This should be the annual accounting profit of the division, without any charge for interest on
capital employed. This means that the profit is after deduction of any depreciation charges on non-
current assets.

Capital employed/investment.

This should be the stun of the non-current assets used by the division plus the working capital that it
uses. Working capital = current assets minus current liabilities, which for a division will normally
consist of inventory plus trade receivables minus trade payables.

ROI and investment decisions

 The performance of the manager of an investment centre may be judged on the basis of ROI.
 A divisional manager may receive a bonus on the basis of the ROI achieved by the division.
 When an investment centre manager's performance is evaluated by ROI, the manager will
probably be motivated to make investment decisions that increase the division's ROI in the
current year, and reject investments that would reduce ROI in the current year.
 The problem is that investment decisions are made for the longer term, and a new investment
that reduces ROI in the first year may increase ROI in subsequent year.
 An investment centre manager may therefore reject an investment because of its short-term
effect on ROI, without giving proper consideration, to the longer term.

Disadvantages of using ROI

 As explained above, investment decisions might be affected by the divisions ROI short term
effect and this is inappropriate for making investment decisions.
 There are different ways of measuring capital employed. Comparison of performance between
different organisations is therefore difficult.
 When assets are depreciated, ROI will increase each year provided that annual profits are
constant. The division's manager might not want to get rid of ageing assets, because ROI will
fall if new (replacement) assets are purchased.

F5 Revision notes Page 130

Residual Income (RI)

Measuring residual income

Residual income = Divisional profit minus Imputed interest charge.

Divisional profit is an accounting measurement of profit, after depreciation charges are subtracted.
It is the same figure for profit that would be used to measure ROI.

Imputed interest (notional interest) and the cost of capital: The interest charge is calculated
by applying a cost of capital to the division's net investment (net assets).

Imputed interest (notional interest) is the division's capital employed, multiplied by:

 the organisation's cost of borrowing, or

 the weighted average cost of capital of the organisation, or
 a special risk-weighted cost of capital to allow for the special business risk characteristics of
the division. A higher interest rate would be applied to divisions with higher business risk.

Residual income and investment decisions

One reason for using residual income instead of ROI to measure a division's financial performance is
that residual income has a monetary value, whereas ROI is a percentage value.

Advantages of residual income

 It relates the profit of the division to the capital employed, by charging an amount of notional
interest on capital employed, and the division manager is responsible for both profit and
capital employed.
 Residual income is a flexible measure of performance, because a different cost of capital can
be applied to investments with different risk characteristics.

Disadvantages of residual income

 Residual income is an accounting-based measure, and suffers from the same problem as ROI
in defining capital employed and profit.
 Its main weakness is that it is difficult to compare the performance of different divisions using
residual income.
 Residual income is not easily understood by management, especially managers with little
accounting knowledge.

Past Paper Analysis

Performance measures in private sector organizations Dec 07 – Q 2
June 09 – Q 2
Dec 09 – Q 4
June 10 – Q 5
Dec 10 – Q 2
Dec 12 – Q 3

Further Aspects of performance measurement Dec 15 – Q 2

Divisional performance June 08 – Q 3

Dec 13 – Q 4
June 15 – Q 2
Dec 15 – Q 5

F5 Revision notes Page 131

Balance scorecard June 11 – Q 4 a
June 13 – Q 2
Dec 14 – Q 4

ROI/ROCE Dec 08 – Q 1
June 11 – Q 4b
June 12 – Q 5
June 14 Q 3a

Transfer pricing June 10 – Q 4

Dec 11 – Q 2
Dec 12 – Q 5
Dec 13 -- 1 b
June 14 – Q 3 b

F5 Revision notes Page 132

21. Performance Analysis – Additional

Not-For-Profit Organisations and the Public Sector

 The public sector refers to the sector of the economy that is owned or controlled by the
government in the interests of the general public.
 Not-for-profit organisations are entities that are not government-owned or in the public sector,
but which are not in existence to make a profit. They include charitable organisations and
professional bodies.
 A common feature of public sector organisations and not-for-profit organisations is that their
main objective is not financial.
 A not-for-profit organisation will nevertheless have some financial objectives:
 State-owned organisations must operate within their spending budget.
 Charitable organisations may have an objective of keeping running costs within a certain
limit, and of raising as much funding as possible for their charity work.

The need for performance measurement

Although the main objective of not-for-profit and public sector organisations is not financial, they
need good management, and their performance should be measured and monitored as the directors or
senior managers of public sector bodies are accountable to the public. In practice, this usually means
accountability to the government, which in turn should be accountable to the public.

The leaders of not-for-profit organisations outside the public sector should also be accountable to the
people who provide the finance to keep them in existence.

More general objectives for not-for-profit organisations include:

 Surplus maximisation (equivalent to profit maximisation)

 Revenue maximisation (as for a commercial business)
 Usage maximisation (as in leisure centre swimming pool usage)
 Usage targeting (matching the capacity available, as in the NHS)
 Full/partial cost recovery (minimising subsidy)
 Budget maximisation (maximising what is offered)
 Producer satisfaction maximisation (satisfying the wants of staff and volunteers)
 Client satisfaction maximisation (the police generating the support of the public)

Performance measurement should be related to achieving targets that will help the organisation to
achieve its objectives, whatever these may be.

Identifying performance targets in not-for-profit and public sector organisations

The selection of appropriate targets will vary according to the nature and purpose of the organisation.
The broad principle, however, is that any not-for-profit organisation should have:

 strategic targets, mainly non-financial in nature

 operational targets, which may be either financial (often related to costs and keeping costs
under control) or non-financial (related to the nature of operations).

To identify suitable performance targets for Not for Profit organisations and Public sector
organisations, focus on:

 Decide what the objectives of the organisation are

F5 Revision notes Page 133

 Identify what the managers of the organisation (or area of management responsibility within
the organisation) must do to achieve those objectives
 Identify a suitable way of measuring performance to judge whether those objectives are being

Problems with measuring performance in this sector

A good performance measurement system seeks to monitor the success of an organisation in achieving
its objectives.

 To do this it must have clear objectives

 set targets which are linked to objectives
 measure performance against these targets.

However, there are several reasons why the problems with performance measurement in the public
sector are greater than those in commercial business organisations.

 Multiple objectives: An organisation in the public sector (and also not-for-profit organisations)
may have a number of different 'main objectives', and they are required to achieve all these
objectives within the constraint of limited available finance. This will also lead to conflict and it
becomes difficult to prioritise.
 Measuring outputs: Outputs can seldom be measured in a way that is generally agreed to be
meaningful. \Data collection can be problematic. For example, unreported crimes are not
included in data used to measure the performance of a police force.
 Lack of profit measure: If an organisation is not expected to make a profit, or if it has no sales,
indicators such as ROI and RI are meaningless.
 Nature of service provided: Many not-for-profit organisations provide services for which it is
difficult to define a cost unit.
 Financial constraints: Although every organisation operates under financial constraints, these are
more pronounced in not-for-profit organisations.
 Political, social and legal considerations: Unlike commercial organisations, public sector
organisations are subject to strong political influences. The public may have higher expectations
of public sector organisations than commercial organisations. The performance indicators of
public sector organisations are subject to far more onerous legal requirements than those of
private sector organisations.

Value for Money

How can performance be measured?

The performance of not-for-profit organisations or departments of government may be assessed on

the basis of value for money 'VFM'. Value for money is often referred to as the '3Es':

 Economy means spending within limits, and avoiding wasteful spending. It also means achieving
the same purpose at a lower expense.
 Efficiency means getting more output from available resources. Applied to employees, efficiency is
often called 'productivity'.
 Effectiveness refers to success in achieving end results or success in achieving objectives. Whereas
efficiency is concerned with getting more outputs from available resources, effectiveness is
concerned with achieving outputs that meet the required aims and objectives.

Management accounting systems and reporting systems may provide information to management
about value for money.

F5 Revision notes Page 134

Value for money audits may be carried out to establish how much value is being achieved within a
particular department and whether there have been improvements to value for money.

VFM as a public sector objective

 Value for money is an objective that can be applied to any organisation whose main objective is
non-financial but which has restrictions on the amount of finance available for spending. It could
therefore be appropriate for all organisations within the public sector.
 The objective of economy focuses on the need to avoid wasteful expenditure on items, and to keep
spending within limits. It also helps to ensure that the limited finance available is spent sensibly.
Targets could be set for the prices paid for various items from external suppliers. Audits by the
government's auditors into departmental spending may be used to identify:
 any significant failures to control prices, and
 unnecessary expense.

Quantitative measures of efficiency

Efficiency relates the quantity of resources to the quantity of output. This can be measured in a variety
of ways

 Actual output/Maximum output for a given resource x 100%

 Minimum input to achieve required level of output/actual input x 100%
 Actual output/actual input x 100% compared to a standard or target

External Considerations in Performance Measurement

External considerations are factors that arise or exist outside an organisation, and within its external
environment, that could have an impact on the objectives that the organisation should try to achieve
and the targets that it sets for those objectives, or its actual performance.

The external factors that affect an organisation vary according to the type of organisation and the
environment in which it operates. Broad categories of external factors include:

 Political and legal developments: new laws may affect what a company is allowed to do or is
not permitted to do, and this change could affect its performance
 Economic conditions and economic developments
 Changes in public attitudes and behaviour
 Technological changes
 Competition in the market.


 Stakeholders of a company are any organisations, individuals or groups with an interest in what
the company does and how it performs. It is often convenient to group stakeholders into
categories, such as shareholders, lenders, suppliers, customers, employees, the government and
the general public.
 Public sector entities and not-for-profit organisations also have different stakeholder groups.
 The interests of each stakeholder group differ, and each group has different expectations about
what the organisation should do. They also judge its performance in different ways.
 Shareholders in a company have invested money by buying shares. Their main expectation is
likely to be that the company should provide good returns on investment, in the form of
dividends or share price growth.
 Lenders to a company expect to make a profit or return in the form of interest. Lenders will
want the company to have a secure business, and will not want the company to take risks that
could threaten its ability to make the interest payments and repay the lending at maturity.

F5 Revision notes Page 135

 Major suppliers to a company may depend on the company for a large proportion of their
profits. They will expect honest and fair dealing from the company, and they will expect to be
paid on time.
 Customers of a company expect to receive value for the money they pay to buy the goods or
services that the company provides. If they think they are receiving poor value, they are likely
to switch to buying the products of competitors, or to finding an alternative product.
 Employees are stakeholders in a company because the company provides them with a job and
possibly also career opportunities. They also have an interest in working conditions.
 The government and the general public. Some large companies can have a major influence on
the national economy. They provide work for large numbers of people, and they produce the
goods or services that many people buy and rely on. In addition, companies are major users of
natural resources, and are a cause of much pollution in the environment. Public expectations
of what particular companies should or should not be doing may become quite strong, and in
some cases a company may come under severe criticism from protest groups.
 For each company, some stakeholders are likely to be more influential than others. However,
when there are several influential stakeholder groups the company may need to take their
conflicting interests into consideration, and set their objectives and performance targets

Market conditions

Market conditions are any factors that influence the state of the market or markets in which a
company operates. These include:

 the state of the economy

 innovation and technological change.

Companies will usually hope to achieve growth in sales and profits, and economic conditions may be
either favourable or adverse.

Other financial conditions may affect a company's performance, such as changes in rates of taxation,
interest rates or foreign exchange rates.

Allowance for competitors

The targets that a company sets, and the performance that it achieves, are also affected the by nature
of competition in the market. When the size of a market is fixed, and competition is strong, the rival
firms will compete for market share.

The performance of a company in a competitive market may be measured by the size of market share
that it obtains.

The performance of a company may also be affected by the actions taken by competitors. For example
if a major competitor has reduced its sales prices, a company may feel obliged to respond by cutting its
own prices.

F5 Revision notes Page 136