F5

Performance Management

06/08/2022 PhD. Nguyen Minh Thanh - Academy of Finance 1

 (1) THE EVOLUTION OF MANAGEMENT ACCOUNTING???
(2) WHAT ARE WE GOING TO LEARN???

20...

1985
1965

1950

PhD. Nguyen Minh Thanh - Academy

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of Finance
The examiner’s key concerns

• Students need to be able to interpret any numbers they calculate and

see the limitations of their financial analysis.
• In particular financial performance indicators may give a limited
perspective and NFPIs are often needed to see the full picture.
• Questions will be practical and realistic, so will not dwell on
unnecessary academic complications.
• Many questions will be designed so discussion aspects can be
attempted even if students have struggled with calculation aspects.

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Syllabus

Subject: F5 – Performance Management (2 credits)

• Part A: Specialist Cost and Management Accounting
Techniques
• Part B: Decision Making Techniques
• Part C: Budgeting and Control (Variance analysis)
• Part D: Performance measurement and Control

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RELATIONAL DIAGRAM OF MAIN CAPABILITIES
(F5).PartC Budgeting
(F2) (F2) Forecast, approaches,
Standard cost, Quantitative analysis in
Budgeting process… budgeting…

Traditional
costing (For
prepare FS or
• Absorption costing
• Marginal costing 1. Planning
Short term • Job, batch, process costing
management)

4. Decision (F5).PartB

making
• Activitive based costing
Modern
costing (For
• Target costing
• Lifecycle costing
3. Measuring 2.
strategic, long
term
• Throughput accounting/costing
• Environmental
performance Controlling
management) accounting/costing…

(F5).PartD
(F2) Basic Further (F2) Basic (F5).PartC
performance performance variances Further
(F5).PartA measurement measurement variances

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PART A. Specialist cost and management
accounting techniques (Traditional and Advanced
costing methods)
1. Costing
2. ABC
3. Target costing
4. Lifecycle costing
5. Throughput accounting
6. Environmental Accounting

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A1. Costing
(?) Absorption Costing or Marginal Costing
Using Absorption Costing to deal with the problem of overhead
DIRECT COSTS INDIRECT COSTS
Materials Labour Non-
Expenses Production
production

+ Under/Over
Absorbed
Absorbed
OHs
production OHs

PRODUCTION COST

TOTAL COST
Absorption costing cost accumulation system

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A1. Costing
(?) Absorption Costing or Marginal Costing
(?) Reasons for using Absorption costing
• Inventory valuations
• Pricing decisions
• Establishing the profitability of different products

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A1. Costing
(?) Absorption Costing or Marginal Costing
(?) Revision of Absorption costing
• OAR = Budgeted OH / Budgeted Activity
• 03 steps: Allocation, Apportionment and Re-apportionment, Absorption
• Methods use for Re-apportionment:
 Direct method: applied when the service centers do not use the services of each others- or ignore
the apportionment to other service centers
 Indirect methods: when services centre costs are apportioned to both production and other
service departments
 Step-down method: One service department provides services to other service departments but others do
not
 Reciprocal (Repeated) method: Service departments provide services to each other.

• Over and Under Absorption for OH

Absorbed Overhead – Actual = Negative ----- Under Absorption

Absorbed Overhead – Actual = Positive ----- Over Absorption

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A1. Costing
(?) Absorption Costing or Marginal Costing
(?) Revision of Absorption costing
• Over and Under Absorption for OH (cont.)
Example 1: Budgeted overhead is $100,000 and budgeted units
is 50,000.
⇒OAR is $2/ unit.
Actual units is 55,000.
⇒Absorbed overhead is $110,000 ($2/unit * 55,000).
While, Actual Overhead is only $105,000.
⇒The over-absorption is $5,000
Under-absorption means that the absorbed overhead is less than
the actual overhead. In the example above, if the actual
Overhead is $117,000, then the under- absorption is $ 7,000.

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A1. Costing
(?) Absorption Costing or Marginal Costing
(?) Revision of Absorption costing
• Case 1 (Study note): One product produced in one factory
• Case 2 (Study note): More than one product produced in the same
factory
• Case 3 (Study note): More than one department in the factory
• Case 4 (Study note): Fuller example of allocating and apportioning
overheads
• Case 5 + 6 (Study note): Reapportionment of service centre
overheads

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A1. Costing
(?) Absorption Costing or Marginal Costing
Using Marginal Costing to deal with the problem of overhead
DIRECT COSTS INDIRECT COSTS
(Variable costs) (Fixed costs)
Non-
Materials Labour Expenses Production
production

PRODUCTION COST

TOTAL COST
Marginal costing cost accumulation system

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A1. Costing
(?) Absorption Costing or Marginal Costing
Using Marginal Costing to deal with the problem of overhead
• Marginal cost
• Contribution = Sales revenue – Variable cost of sales
• Marginal costing: an alternative to absorption costing
Closing inventories are valued at marginal (variable) production cost.
If opening and closing inventory levels are different => the profit reported
under marginal costing and absorption costing will be different =>
Recociliation of profit.
But in the long run, total profit for a company will be the same whichever is
used because, total costs will be the same by either method of accounting.
Different accounting conventions merely affect the profit of individual
periods.

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A1. Costing
(?) Absorption Costing or Marginal Costing
The differences between Absorption and Marginal Costing

Marginal costing Absorption costing

Closing stock valued at marginal Closing stock valued at full

production cost production cost
Fixed Costs are absorbed to unit
Fixed costs are period cost
costs
Cost of sales does not included Cost of sales includes share of fixed
share of fixed overhead overhead.

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A1. Costing
(?) Absorption Costing or Marginal Costing
Example 2 (Study note):
• Required:
a) Prepare the adsorption costing profit statement for Mar
b) Prepare the marginal costing profit statement for Mar
c) Comparison of the profits
d) Reconcile the profits/loss between 2 methods

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A1. Costing
(?) Absorption Costing or Marginal Costing
Example 2 (Study note):
a) PROFIT STATEMENT FOR MAR. (ABSORPTION COSTING)
MAR
£ £
Sales (1500 units) 52,500
COS
Opening 0
Production ($20 x 2.000) 40,000
Closing ($20 x 500) 10,000
COS 30,000
Gross profit 22,500
Fixed adm., selling cost 10,000
Variable adm, selling cost 7,875
Over/under Fixed production OH (Actual – Absorped OH = $15.000 -
5,000
$5 x 2.000) = Over
Profit/loss (375)

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A1. Costing
(?) Absorption Costing or Marginal Costing
Example 2 (Study note):
b) PROFIT STATEMENT FOR MAR (MARGINAL COSTING)
MAR
£ £
Sales 52,500
COS
Opening 0
Production ($15 x 2.000) 30,000
Closing ($15 x 500) 7,500
Variable COS 22,500
Variable adm., selling cost 7,875
Contribution 22,125
Fixed adm., selling cost 10,000
Fixed production OH 15,000
Profit/loss (2,875)

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A1. Costing
(?) Absorption Costing or Marginal Costing
Example 2 (Study note):
c + d) Comparation and Reconciliation of profit
RECONCILIATION OF PROFIT MAR
£
Absorption costing profit (375)
(Increase)/Decrease in closing stock (500 * 5)
Marginal costing profit (2,875)

COMPARATION OF TOTAL PROFITS

• If there are changes in stocks during the period (opening stock and closing stock are different), the profit
generated will be different
• If opening stock and closing stock are the same, the profit generated will be the same
• In the long run the total profits generated under the two costing methods are the same.

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A1. Costing
(?) Absorption Costing or Marginal Costing
Absorption Costing vs. Marginal Costing

Arguments for Absorption costing Arguments for Marginal costing

It is fair to share fixed production costs
Simple to operate/ No apportionment of
between units of production as such
fixed cost. Under/ Over absorbed OH
costs are incurred in order to make
avoided
output

In compliance with IAS (valuation of Fixed cost = period cost unchanged at

closing stock) different levels of activity? should be fully
charged into the period

Easier to determine the profitability of Closing stock valued at realistically.

several product by charging a share of More relevance for decision making
fixed overheads to them process

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A2. Activity Based Costing (ABC)

Steps
1.Identify major activities. xác định hoạt động chính
2.Identify appropriate cost drivers (note: you may have to justify your
choice here in the exam).
A cost driver is a factor which causes a change in the cost of an activity.

Costs Possible cost driver

Ordering costs Number of orders
Materials handling costs Number of production runs
Production scheduling costs Number of production runs
Dispatching costs Number of dispatches

3.Collect the cost associated with each cost driver into what are known
as cost pools.
4.Charge costs to products on the basic of their usage of the activity.

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A2. Activity Based Costing (ABC)

Example 1 (Part one – Volumn Based Costing (Traditional))

Katrina is an SME which manufactures high quality snooker (gậy bia) and pool cues. For
a number of years the accountant has dealt with the recovery of overhead in a
traditional manner. The business has 3 major producing cost centres, and the process of
allocation and apportionment for March 2010 had been completed and the
predetermined figures were
Cost centre Machining Finishing Packing
Overheads $70,000 $27,500 $15,000
Machine hour 13,000 6,250
Labor hour 3,250
OAR = 5.38 4.4 4.61

A new product “The Wave” is estimated to take the following standard hours to
produce per unit:
Machining: 3 hours; Finishing: 1 ½ hours; Packing: ¼ hours
The accounting technician and the production manager agree the following pre-
determined standard costs per unit: Direct material $16, direct labor $33.25

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A2. Activity Based Costing (ABC)

Example 1 (Part one – Volumn Based Costing (Traditional))

The production cost of one unit of “The Wave” using Traditional
Absorption Costing is:
(Per unit) $
Direct material 16
Direct labour 33.25
Prime cost 49.25
Production overhead
Machining 5.38 x 3 16.14
Finishing 4.4 x 1.5 6.6
Packing 4.61 x 0.25 1.16
Production cost per unit 73.15

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A2. Activity Based Costing (ABC)
Example 2 (Part two – ABC (Modern))
Continue from the last example the accounting technician and the production manager have
recently analysed its value added processes and identified various activities, cost drivers within
those activities and current volumes across the producing unit as whole, and decide to apply ABC
Cost pool Cost driver volume
Activity Cost pool driver

1. Process set up 37,500 100 set up = $375 per set up

2. Material procurement 9,000 50 purchase order = $180 per purchase order

3. Maintenance 10,000 10 std maintenance plans = $1,000 per maintenance cycle

4. Material handling 22,500 2,000 material movements = $11.25 per movement

5. Quality control 20,500 250 inspections = $82 per inspection
6. Order processing 13,000 300 customers = $43.33 per customer
In the budget period ended March 2010 it plans to produce 800 “The Wave” cues. To achieve this level of output it
will require the following activity demand:
1. 4 set ups
2. 4 purchase orders
3. 2 standard maintenance plans
4. 100 material movements
5. 70 inspections
6. 8 sales customers

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A2. Activity Based Costing (ABC)

Example 2 (Part two – ABC (Modern))

Answer:
$
1. Set up 4 x 375 = 1,500
2. Material procurement 4 x 180 = 720
3. Maintenance 2 x 1,000 = 2,000
4. Material handling 100 x 11.25 = 1,125
5. Quality control 70 x 82 = 5,740
6. Order processing 8 x 43.33 = 343.64

Overhead cost per unit = 11,428.64/800 = $14.29

Therefore, production cost of one unit of output using ABC:

$
Prime cost 49.25
Production overhead 14.29
Production cost 63.54

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A2. Activity Based Costing (ABC)

Differences between ABC and Traditional absorption costing

ACTIVITY BASED COSTING ABSORPTION COSTING

ABC use many cost driver rates as absorption Absorption costing usually use only two
bases number of….
absorption bases (labor hours or machine hours)

ABC assigns overheads to each major activity (cost Traditional costing allocates overheads to
pool) production department

ABC recognizes the complexity of modern

Traditional costing was developed in a time when
production process where overheads costs has
overheads were only a small fraction of total cost.
increased.

Unnecessary to calculate under/over absorption Have to adjust for under/over absorption

Implementation of ABC may be time consuming and

Absorption costing system is simpler to operate.
problematic. mất thời gian hơn, khó khăn trong việc thực hiện dễ dàng hơn

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A2. Activity Based Costing (ABC)

Advantages of ABC
• More realistic costs. thực tế hơn có cái nhìn sâu sắc hơn into
cost drivers, dẫn đến…
• Better insight into cost drivers, resulting in better cost control.
• Particularly useful where overhead costs are a significant proportion
of total costs. đặc biệt hữu ích khi chi phí chung chiếm tỉ trọng đáng kể trong tổng chi phí
• ABC recognises that overhead costs are not all related to production
and sales volume.
• ABC can be applied to all overhead costs, not just production
overheads.
• ABC can be used just as easily in service costing as in product costing.

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A2. Activity Based Costing (ABC)

Criticism of ABC chỉ phân bổ dc cho major activitive not specific act

• It is impossible to allocate all overhead costs to specific activities.

• The choice of both activities and cost drivers might be inappropriate.
• ABC can be more complex to explain to the stakeholders of the
phức tạp

costing exercise.
• The benefits obtained from ABC might not justify the costs.

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A2. Activity Based Costing (ABC)

Implications of ABC
hàm ý của abc

• Pricing - more realistic costs improve cost-plus pricing.

• Sales strategy - more realistic margins can help focus sales strategy.
• Decision making – for example, research and development can be
directed at products with better margins.

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A3. Target Costing

Steps
1.Estimate a market driven selling price for a new product. (E.g. to
capture a required market share).
2.Reduce this figure by the firm’s required level of profit. (E.g. based
on target ROI).
3.Produce a target cost figure for product designers to meet.
4.Reduce costs to provide a product that meets that target cost.

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A3. Target Costing
Example 1:
Barricade Ltd, a car manufacturer, wants to calculate a target cost for a new car, the price of which will be
set at $17,950. The company requires an 8% profit margin.
What is the target cost?

Answer:
Profit margin = (Sales – cost)/sales
8% = (17,950 – cost)/17,950
Cost = 16,514

Example 2:
Sakamoto Ltd is considering whether or not to launch a new product. The sales department has
determined that a realistic selling price would be $20 per unit. Sakamoto Ltd has a requirement that all
products generates a gross profit of 40% of selling price.
Calculate the target cost.

Answer:
Gross profit = sales – COG
40% x 20 = 20 – COG
COG = 12

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A3. Target Costing

Closing the target cost gap

• Value analysis
• Focus is on reducing cost without compromising perceived
value.
• Can labour savings be made?
• Can productivity be improved?
• What production volume is needed to achieve economies of
scale?

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A3. Target Costing

Closing the target cost gap

• Could cost savings be made by reviewing the supply chain?
• Can any materials be eliminated?
• Can a cheaper material be substituted without affecting
quality?
• Can part-assembled components be bought in to save on
assembly time?
• Can the incidence of the cost drivers be reduced?

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A3. Target Costing

Implications of Target costing

• Pricing – might identify sufficient cost savings to reduce the
target price.
• Cost control – target cost motivates managers to find new
ways of saving costs.

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A4. Lifecycle costing

Life cycle costing

• Is the profiling of cost over a product’s life, including the pre-
production stage. là việc xác định chi phí trong suốt vòng đời của sản phầm bao gồm cả giai đoạn trước khi sản xuất
• Tracks and accumulates the actual costs and revenues attributable to
each producttheo
over a product’s entire life.
dõi và tích luỹ chi phí và doanh thu thực thế liên quan đến từng sản phẩm trong toàn bộ vòng đờisản phẩm

• Enables a product’s true profitability to be determined at the end of

its economic life. cho phép xác định lợi nhuận thực sự của sản phẩm

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A4. Lifecycle costing

Product life cycle

The product life cycle model illustrates (i) the time pattern of demands
for a product during its life (ii) the time pattern of sales and profits
earned over a life cycle.
• The product has a R&D stage where costs are incurred but no
revenue generated.
• The product is introduced to the market.
• The product gains a bigger market as demands builds up.
sản phảm có được thi trường lớn hơn khi nhu cầu tăng lên
• The demand for the product will slow down but remain to be
profitable.
• The demand of the product will eventually fall and becomes a loss-
maker.

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A4. Lifecycle costing

Product life cycle

Sales
and Profit

Maturity

Growth
Decline
Introduction

Time

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A4. Lifecycle costing

(?) Maximizing the returns over the products life cycle

• Design cost of the products. 70% – 90% product’s cost are
determined early in the life cycle => Careful design to keep cost to a
minimum over the life cycle.
• Minimizing the time to market the product. Introduce the new
tối thiểu thời gian để đưa sản phẩm ra thị trường

product to the market a.s.a.p. This ensure a long period of time in the
market and hence increase market share in the long run. do đó tăng thị phần
• Minnimizing the breakeven time. giảm thiểu thời gian hoà vốn
• Maximazing the length of the life span. This is achieved by
tối đa hoà độ dài tuổi thọ

establishing an early presence in the market.

• Maximizing product proliferation.
• Manage the product’s cash flow over its life cycle.

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A4. Lifecycle costing

(?) Differences between Life cycle costing and Traditional cost

accumulation systems
LIFE CYCLE COSTING TRADITIONAL COSTING
Life cycle costing tracks costs and Traditional cost are based on financial
revenue over the entire product life cycle accounting periods

Non production cost such as R&D are Research and development costs are
traced to individual products over written off annually against revenue as
complete life cycle period expense
Total profitability of the product can be True profitability of the product cannot be
assessed assessed

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A4. Lifecycle costing

Example:
Solaris specializes in the manufacture of solar panels. It is planning to introduce a new slim line solar panel
specially designed for small houses. Development of the new panel is to begin shortly and Solaris is in the
process of determining the price of the panel. It expects the new product to have the following costs.
Year 1 Year 2 Year 3 Year 4
Units manufactured and sold 2,000 15,000 20,000 5,000
$ $ $ $
R & D costs 1,900,000 100,000
Marketing costs 100,000 75,000 50,000 10,000
Production cost per unit 500 450 400 450
Customer service costs per unit 50 40 40 40
Disposal of specialist equipment 300,000

The Marketing Director believes that customers will be prepared to pay $500 for a solar panel but the
Financial Director believes this will not cover all of the costs throughout the lifecycle.
Required: Calculate the cost per unit looking at the whole life cycle and comment on the suggested price.

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A4. Lifecycle costing

Example:
Answer:
Life cycle costs:
$’000
R & D (1,900 + 100) 2,000
Marketing (100 + 75 + 50 + 10) 235
Production (1,000 + 6,750 + 8,000 + 2,250) 18,000
Customer service (100 + 600 + 800 + 200) 1,700
Disposal 300
Total lifecycle costs 22,235
Total production (‘000 units) 42
Cost per unit 529.40
The total lifecycle costs are $529.40 per solar panel which is higher than the price proposed by the
marketing director. Solaris will either have to charge a higher price or look at ways to reduce costs.

It may be difficult to increase the price if customers are price sensitive and are not prepared to pay
more. Costs could be reduced by analysing each part of the costs throughout the life cycle and
actively seeking cost savings. For example, using different materials, using cheaper staff or
acquiring more efficient technology.
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A4. Lifecycle costing

Implication of Lifecycle costing

• Pricing decisions can be based on total lifecycle costs rather than
simply the costs for the current period.
• Decision making - a timetable of life cycle costs helps show what
costs need to be recovered.
• Control - Lifecycle costing reinforces the importance of tight control
over locked-in costs, such as R&D.
• Performance reporting - Life cycle costing costs to products over
their entire life cycles, to aid comparison with product revenues
generated in later periods.

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A5. Throughput accounting (not a costing
system)
Background
• Application of key factor analysis to production bottlenecks.
• The only totally variable costs are the purchase cost of raw materials
/ components
• Direct labour costs are not wholly variable.

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A5. Throughput accounting (not a costing
system)
Multi-product decisions
• Rank products by looking at the throughput per hour of bottleneck
resource time
• Throughput = Revenue – Raw Material Costs

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A5. Throughput accounting (not a costing
system)
Throughput accounting ratio (TPAR) (Performance measures in
throughput accounting)
Throughput per hour of bottleneck resource

Operating expenses per hour of bottleneck resource

* Bottleneck resource usually is ‘factory hour’ => TPAR can be

rewritten as below:
Return per factory hour
Throughput accounting ratio =
Cost per factory hour∗
Sales price – material cost
Return per factory hour =
Factory hours∗∗
Total factory cost
Cost per factory hour =
Total time available on key resources∗∗∗
• * Total conversion cost per factory hour
• ∗∗ Time on key resources (bottlenecks)
• ∗∗∗ The capacity of the bottleneck activity in terms of hours
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A5. Throughput accounting (not a costing
system)
Theory of Constraints (Developed by Eliyahu M. Goldratt)
• An approach to product management => to improve the overall
profitability of the firm => maximize the rate of manufacturing
output, i.e. throughput of the organization.
• Maximize ‘throughput’ => Minimize two other measures referred to
as ‘inventory’ and ‘operating expenses’.
• TOC is based on the idea that every company has identifiable
constraints (or bottlenecks), that hinder the speed of production,
hence management should identify the most binding constraints and
manage them so that its resources are used most efficiently.

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A5. Throughput accounting (not a costing
system)
(?) Differences between Throughput accounting and Traditional
product costing
THROUGHPUT ACCOUNTING TRADITIONAL PRODUCT COSTING
Labour costs and variable overheads are treated Labour costs and variable are treated as part of
as fixed cost variable cost
Inventory is valued at material cost only Inventory is valued in the income statement and
balance sheet at total production cost
Variance analysis is used to determine why the Variance analysis is employed to determine
planned product mixed was not produced whether standards were achieved
Efficiency requires schedule adherence and Efficiency is based on labour and machines
meeting delivery dates working to full capacity
Value is added when an item is sold Value is added when an item is produced

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A5. Throughput accounting (not a costing
system)
Example 1: Throughput and TPAR
Growler manufactures computer components. Health and safety
regulations mean that one of its processes can only be operated 8
hours a day. The hourly capacity of this process is 500 units per hour.
The selling price of each component is $100 and the unit material cost
is $40. The daily total of all factory costs (conversion costs) is $144,000,
excluding materials. Expected production is 3,600 units per day.
Required: Calculate
(a) Total profit per day
(b) Return per factory hour
(c) Throughput accounting ratio

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A5. Throughput accounting (not a costing
system)
Example 1: Throughput and TPAR
Answer:
(a) Total profit per day = Throughput contribution – Conversion costs
= (3,600 x (100 – 40) – 144,000)
= $72,000
(b) Return per factory hour = (Sales – Direct material cost) / Usage
of bottleneck resource in hours (factory hours)
= (100 – 40) / (1/500) = $30,000
(c) Throughput accounting ratio = $30,000 / (144,000/8)
= 1.67

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A5. Throughput accounting (not a costing
system)
Example 2: Throughput and Limitting Factor Analysis
A company produces two products, Tatty and Messy, which have the following production costs.
Tatty Messy
$ $
Direct material cost 12 12
Direct labour cost 6 10
Variable overhead 6 10
Fixed overhead 6 10
Total product cost 30 42

Fixed overheads are absorbed on the basis of direct labour cost. Tatty and Messy pass through two
processes, blasting and smoothing which incur direct labour time as follows.
Time taken
Process Tatty Messy
Blasting 15 mins 25 mins
Smoothing 25 mins 20 mins
The current market price for Tatty is $75 and for Messy $60 and, at these prices, customers will buy as
many units as are available.
The capacity of the two processes limits the amount of units of products that can be produced. Blasting
can be carried out for 8 hours per day but smoothing can only operate for 6 hours per day.
Required: What production plan should the company follow in order to maximise profits?
(a) Using contribution per minute
(b) Using throughput per minute
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A5. Throughput accounting (not a costing
system)
Example 2: Throughput and Limitting Factor Analysis
Solution:
The constraint in this situation is the ability to process the product. The total daily processing time for the
two processes is as follows.
Maximum blasting time = 8 x 60 mins = 480 mins
Maximum smoothing time = 6 x 60 mins = 360 mins
The maximum number of each product that can be produced is therefore:
Tatty Messy
Units Units
Blasting 480/15 = 32 480/25 = 19
Smoothing 360/25 = 14 360/20 = 18
The total number of units that can be processed is greater for blasting so smoothing capacity is the
binding constraint or limiting factor.
(a) Maximizing contribution per minute
Contribution of Tatty = $(75 – 12 – 6 – 6) = $51
Contribution of Messy = $(60 – 12 – 10 – 10) = $28
Contribution of Tatty per minute in smoothing process = $51/25 = $2.04
Contribution of Messy per minute in smoothing process = $28/20 = $1.40
The profit maximizing solution is therefore to produce the maximum number of units of Tatty, giving a
contribution of 14 x $51 = $714
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A5. Throughput accounting (not a costing
system)
Example 2: Throughput and Limitting Factor Analysis
Solution (Cont.):
(b) Maximizing throughput per minute
Throughput of Tatty = $(75 – 12) = $63
Throughput of Messy = $(60 – 12) = $48
Throughput per minute of Tatty in smoothing process = $63/25 = $2.52
Throughput per minute of Messy in smoothing process = $48/20 = $2.40
The profit maximizing approach is therefore again to produce the maximum number of units of Tatty, but
the result is not as clear cut.

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A5. Throughput accounting (not a costing
system)
(?) Contribution vs. Throughput
(?) Limitations of Throughput. The factors which limit throughput may
include constraints other than a lack of production resources
(bottlenecks).
i. The existence of an uncompetitive selling price
ii. The need to deliver on time to particular customers
iii. Poor product quality and reliability
iv. The lack of reliable material suppliers

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A5. Throughput accounting (not a costing
system)
How to improve the TPAR
• Increase the sales price to increase the throughput per unit.
• Reduce total operating expenses, to reduce the cost per hour.
• Improve productivity, reducing the time required to make each unit
of product.

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A6. Environmental costs

(?) Environmental Management Accounting (Paper F5) and

Enviromental Accounting
• Environmental Accounting is a boarder term that emcompasses the
provision of environment-related information both internally and
externally.
• Two requirements of the Paper F5 – Environmental Manangement
Accounting:
• Discuss the issues businesses face in the management of environmental
costs.
• Describe the different methods a business may use to account for its
environmental costs.

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A6. Environmental costs

(?) Environmental Management Accounting

• Is a special part of the management accounts that focuses on the cost of
energy and water and the disposal of waste and effluent.
• The management of environmental cost is difficult because of:
• First, difficult to define.
• Second, difficult to separate out costs and identify although costs can be defined.
• Third, costs must be controlled only if they have been already identified.
• Much of information is needed to prepare environmental management
accounts, that could actually be found in business’s general ledger.
• Only after environmental costs are defined, identified and allocated that a
business can begin the task of controlling them.
• ABC distinguishes between environmental-related costs and environmental-
driven costs hidden on general overheads.

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 A6. Environmental costs

Environmental costs

External Costs are imposed on society at large

Internal costs directly impact on the income statement of
but not borne by the company that generates
a company.
the cost in the first instance

waste product backend usage of social

improved regulatory upfront carbon forest health
disposal take back energy welfare
systems costs costs Costs emissions
and water
degradation care costs
costs
costs costs

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 SUMMARY OF PART A – SPECIALIST COST AND
MANEGEMENT ACCOUNTING TECHNIQUES
PART A – SPECIAL COSTING AND MANAGEMENT ACCOUNTING TECHNIQUES

TRADITIONAL COSTING METHODS /

MODERN COSTING MODELS / APPROACHES
TECHNIQUES
(AIM TO LONG TERM)
(AIM TO SHORT TERM)

ABSORPTION MARGINAL Lifecycle

ABC Target costing Throughput acc. Environment acc.
COSTING COSTING costing
4 stages of Throughput =
Direct Indirect Identify market
Variable Fixed Activities lifecycle Revenue – Difficult to manage the
costs costs price
costs costs Introduction Material costs environment costs
(prime) (OHs)
Throughput
Cost driver for Growth
Set expected accounting
Allocate, Maturity Difficult to
each activities profit margin / ratio?
Apportion define
rate Decline
Costs allocated Maximize the
Re- to suitable Close the cost Maximize the rate of Difficult to
Allocate Allocate activities gap to reach returns over the manufacturing separate out costs
apportion
the expected lifecycle output and identify
Apportion costs profit
Absorption to products Minimize the Hard to control
based on Application costs related to
suitable cost ‘inventory’ and
driver Pricing ‘operating’
Cost unit Cost unit P/L
decision
Increase the
Decision sales price?
Over / Under absorption? making

Control

Profit (Income) statements? Performance

Reconciliation profit? reporting

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PART B. Decision Making Techniques

1. Relevant cost analysis

2. Cost volume profit (CVP) analysis
3. Limiting factors
4. Pricing decisions
5. Other short term decisions
6. Risk and uncertainty in decision making

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B1. Relevant cost analysis

(?) Relevant cost

• Future cost,
• Incremental cost,
• Cash flows: Costs or charges that do not incur additional spending are
irrelevant. Profit is not cash flow.
• Opportunity cost: Opportunity cost is the benefit which has been given up,
by choosing one option instead of another
(?) Differential cost is the difference in total cost between alternatives.
(?) Irrelevant cost
• Depreciation
• Sunk costs.
• Unavoidable costs.
• Apportioned fixed overheads.
• Financing cash flows (e.g. interest).

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B1. Relevant cost analysis

(?) Assumption
• Variable costs are usually relevant costs
• Fixed costs are non relevant cost
Note: Direct attributable fixed cost (specific fixed cost, may also be
called product specific fixed cost) is relevant cost when:
• additional fixed cost are incurred in a decision to increase an extra activity or
• fixed cost will decrease if the scale of an operation were reduced.

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B1. Relevant cost analysis

Relevant cost of materials is their current replacement cost

Are materials already
No
in inventory?

Yes Cost of purchase

Will they be Yes

replaced?

No
Replacement cost

Will they be used for

other purposes?
No

Yes
Net realizable value
Contribution from
alternative use

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B1. Relevant cost analysis
Relevant cost of materials is their current replacement cost
Example
Dixon Ltd has been approached by a customer who would like a special job to be done for
him, and who is willing to pay $22,000 for it. The job requires the following materials:
units units in book value realizable replacement
Material
required stock of stock value cost
$/unit $/unit $/unit
W 1000 0 - - 6.00
X 1000 600 2.00 2.50 5.00
Y 1000 700 3.00 2.50 4.00
Z 200 200 4.00 6.00 9.00

Material X is used regularly by Dixon Ltd and if units X are required for this job, they would
need to be replaced to meet other production demand.
Materials Y and Z are in stock as the result of previous overbuying, and they have a restricted
use. No other use could be found for material Y, but the units of material Z could be used in
another job as substitute for 300 units of material V, which currently costs $5 per unit (and
of which the company has no units in stock at the moment).
Required: Calculate the relevant costs of material for deciding whether or not to accept the
contract.

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B1. Relevant cost analysis
Relevant cost of materials is their current replacement cost
Example
Answer:
(a) Material W is not yet owned. It would have to be bought in full at the
replacement cost of $6 per unit.
(b) Material X is used regularly by the company. There are existing
inventories (600 units) but if these are used on the contract under review a
further 600 units would be bought to replace them. Relevant costs are
therefore 1,000 units at the replacement cost of $5 per unit.
(c) 1,000 units of material Y are needed and 700 are already in inventory. If
used for the contract, a further 300 units must be bought at $4 each. The
existing inventories of 700 will not be replaced. If they are used for the
contract, they could not be sold at $2.50 each. The realizable value of these
700 units is an opportunity cost of sales revenue forgone.
(d) The required units of material Z are already in inventory and will not be
replaced. There is an opportunity cost of using Z in the contract because
there are alternative opportunities either to sell the existing inventories for
$6 per unit ($1,200 in total) or avoid other purchases (of material V), which
would cost 300 x $5 = $1,500. Since substitution for V is more beneficial,
$1,500 is the opportunity cost.

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B1. Relevant cost analysis
Relevant cost of labour is the direct labour cost plus (+) any contribution lost
by diverting labour to produce another project

Does spare capacity

Yes
exist?
Nil cost unless over time
No worked or extra labor
hired, when cash outlay
Can extra employee No
be hired or?
Contribution from
Yes
alternative products which
must be abandoned to
create spare capacity
Cost of hiring

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B1. Relevant cost analysis
Relevant cost of labour is the direct labour cost plus any contribution lost by
diverting labour to produce another project
Example
Winterburn Ltd has been offered $21,000 by a customer to make some
equipment. The extra cost of the machine would be $3,000 for materials. It
would also require 4,000 labour hours. Winterburn’s current labour wage rate is
at $4 per hour, variable overheads is $2 per hour and fixed overheads is
absorbed at the rate of $4 per hour. Labour is in short supply, and if the job is
accepted, workers with 2,000 hours would have to be diverted from other work
which is expected to earn a contribution of $5 per hour.
Required: Assess whether the contract should be undertaken.

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B1. Relevant cost analysis
Relevant cost of labour is the direct labour cost plus any contribution lost by diverting
labour to produce another project
Example
Answer
The relevant costs of the scare resource, labour are the sum of the following:
(a) The variable costs of the labour and associated variable OH
(b) The contribution forgone from not being able to put it to alternative use
Fixed costs are ignore because there is no incremental fixed cost expenditure
$
Materials 3,000
Labour (2,000 hr at $4 per hr) 8,000
Variable OH (2,000 hr at $2 per hr) 4,000
15,000
Opportunity cost
Contribution forgone from other work (2,000 hr x 5/hr) 10,000
Total costs 25,000
Revenue 21,000
Net loss on contract (4,000)
The contract should not be undertaken
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B1. Relevant cost analysis
Relevant cost of using machine
The cost of using machines is the user cost (incremental cost). Such costs include repair cost,
hire charges and any fall in resale value from their usage.
Example
Adams Ltd is considering whether to undertake some contract work. The machinery required
for the contract would be as follows
a. A special cutting machine will have to be hired for three months. Hire charges for this
machine are $75 per month, with a minimum hire charge of $300.
b. All other machinery required in the production for the contract has already been
purchased by the organization on hire purchase terms. The monthly hire purchase
payments for this machinery are $500. This consists of $450 for capital repayment and $50
as an interest charge. The last hire purchase payments is to be made in two months time.
The cash price of this machinery was $9,000 two years ago. It is being depreciated on a
straight line basis at the rate of $200 per month.
However, it still has a useful life which will enable it to be operated for another 36 months.
The machinery is highly specialized and is unlikely to be required for other, more profitable
jobs, over the period during which the contract work would be carried out. Although there
is no immediate market for selling this machine, it is expected that a customer might be
found in the future. It is further estimated that the machine would lose $200 in its eventual
sale value if it is used for this job.
Required: Calculate the relevant costs of machinery for the contract.

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B1. Relevant cost analysis
Relevant cost of using machine
Example
Answer:
(a) The special cutting machine will incur an incremental cost of $300, the
minimum hire charge.
(b) The historical cost of the other machinery is irrelevant as a past cost;
depreciation is irrelevant as non-cash; and future hire purchase repayments
are irrelevant because they are committed costs. The only relevant cost is
the less of resales value of the machinery estimated at $200 through use.
This user cost will not arise until the machinery is eventually resold and the
$200 should be dicounted to allow for the time value of money. However,
sidcounting is ignored here.
(c) Summary of relevant costs:
$
Incremental hire costs 300
User cost of machinery 200
500
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B2. Cost Volumn Profit Analysis (Breakeven)
Introduction
• Cost-volume-profit (CVP) analysis is the study of relationship
between costs, volume and profit at various level of activity.
• The breakeven point is the level of activity where neither profits nor
losses are made. To breakeven the amount of contribution must
match the fixed cost.
• The margin of safety is the difference between the budgeted sales
volume (or sales revenue) and breakeven sales volume (or sales
revenue). Margin of safety may also be expressed as a percentage of
the budgeted sales revenue.
• A target profit is where a company wishes to achieve certain profit
during the period. To achieve this profit, sales must cover all cost.

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B2. Cost Volumn Profit Analysis (Breakeven)
Contribution
Profit = (Contribution per unit x units) - Fixed Costs

Contribution = Sales Value – All Variable Costs

A product has a sales price of £20 and a variable cost of £10 per unit
Units 0 100 500 1000 1500

Contribution 0 1,000 5,000 10,000 15,000

(£)
Fixed Costs (10,000) (10,000) (10,000) (10,000) (10,000)
(£)
Profit (£) (10,000) (9,000) (5,000) 0 5,000

Contribution 10 10 10 10
per unit
Profit per (90) (10) 0 3.33
unit
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B2. Cost Volumn Profit Analysis (Breakeven)
The breakeven point
Fixed Costs
(1) Breakeven point (in unit) =
Contribution per unit
= number of units of sales required to breakeven.

Fixed Costs
(2) Breakeven point (in value) =
C/S ratio∗
= sales revenue at breakeven point.

(3) C/S ratio (contribution/sales) measures the contribution

earned from $1 of sales.
Contribution per unit
=
Sales price per unit
* it is always measured in percentage.
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B2. Cost Volumn Profit Analysis (Breakeven)
The breakeven point
Breakeven point:
The Break-even chart The point where
total costs = total
Breakeven sales revenue
Point and

£ Where there is
neither a profit or
Fixed Costs loss

Output (units)

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B2. Cost Volumn Profit Analysis (Breakeven)
Sales Revenue
The breakeven point
£’000
Breakeven point
40

30
Fixed Costs
20

0
10 20 30 40 50 60 70 Number of units

Basic Breakeven chart

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 B2. Cost Volumn Profit Analysis (Breakeven)
The breakeven point Sales Revenue
£’000
Breakeven point
Contribu
Fixed tion
Costs

10 20 30 40 50 60 70 Number of units
Contribution Breakeven chart
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B2. Cost Volumn Profit Analysis (Breakeven)
The breakeven point
The profit-volume chart presents information in a way that clearly shows
the change in the level of profit – using data from the previous data table:

+£5000

Profit 0

Output
1000 1500

-£10000

The Profit-Volume Chart

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Page 30
B2. Cost Volumn Profit Analysis (Breakeven)
The margin of safety
(1) Margin of safety (in unit)
= Budgeted sales volumn - breakeven sales volumn
(2) Margin of safety (in value)
= Budgeted sales revenue - breakeven sales revenue
Margin of safety
(3) Margin of safety (in percentage) = ×100 %
Budgeted sales

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B2. Cost Volumn Profit Analysis (Breakeven)
The margin of safety
The Margin of Safety
represents the level
Breakeven by which output can
Point fall before the
£ organisation makes a
loss
Fixed Costs

Output (units) Budgeted output

Safety margin

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B2. Cost Volumn Profit Analysis (Breakeven)
A target profit
A target profit is where a company wishes to achieve certain
profit during the period. To achieve this profit sales must cover all
cost.
• Sales unit for a certain level of profit (for target profit)

Fixed Costs + Target Profit

=
Contribution per unit

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B2. Cost Volumn Profit Analysis (Breakeven)
Example 1
Discovery Ltd markets and sells a single product. Production
information is as follows:
Selling price is $150 per unit.
Variable cost is $120 per unit.
Fixed costs are $54,000 per year. Current sales 3,000 unit per
year.
Required: Calculate
a. The breakeven point and the revenue at break even point
b. The margin of safety for next year
c. The budgeted profit if selling price is increased by 10% and
the variable cost is increased by 20%

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B2. Cost Volumn Profit Analysis (Breakeven)
Example 1
Solution:
a. BEP quantity = 54,000/(150 - 120) = 1800 units
BE revenue = 54,000 / (30 / 150) = $270,000
b. Margin of safety = 3,000 – 1,800 = 1,200 units
c. Profit = sales – cost
= 3,000 x 150 x 1.1 – 3,000 x 120 x 1.2 – 54,000 = 9,000

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B2. Cost Volumn Profit Analysis (Breakeven)
Example 2
29 Palms Ltd manufactures and sells a single product which has a
selling price of $120 and has the following unit cost:
Direct materials $22
Direct labour $36
Variable overheads $14
Fixed costs $12
The fixed overhead rate is based on the normal capacity of 2,000
units per month. Budgeted sales for next month are 2,200 units.
Required: Calculate
a. The breakeven point in units per month
b. The margin of safety for next month
c. The budgeted profit for next month
d. The sales required to achieve a profit of $96,000 in a month
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B2. Cost Volumn Profit Analysis (Breakeven)
(?) Decision to change sales price
Example 3
Big Log Ltd bake and sell a single type of cake. The variable cost
of production is 15 cents and the current sales price is 25 cents.
Fixed cost are $2,600 per month, and the annual profit of the
company at current sales volume is $36,000.
The sales manager wishes to raise the sales price to 29 cents
per cake, but considers that a price rise will result in some loss of
sales.
Required: Ascertain the minimum volume of sales required each
month to justify a rise in price to 29 cents.

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B2. Cost Volumn Profit Analysis (Breakeven)
(?) Decision to change sales price
Example 3
Solution:
The minimum volume of demand which would justify a price of 29c is one
which would leave total profit at least the same as before, is $3,000 per
month. Required profit should be converted into required contribution, as
follows.
$
Monthly fixed costs 2,600
Monthly profit, minimum required 3,000

Current monthly contribution 5,600

Contribution per unit (25c – 15c) 10 cents
Current monthly sales 56,000 cake
The minimum volume of sales required after the price rise will be an amount
which earns a contribution of $5,600 per month, no worse than at the
moment. The contribution per cake at a sales price of 29c would be 14c
(=29 -15).
Required sales unit = Required contribution / Contribution per unit = $5,600
/ 14c = 40,000 cakes per month.
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B2. Cost Volumn Profit Analysis (Breakeven)
(?) Decision to change production costs
Example 4
Tin Pan Valley Ltd makes a product which has a variable
production cost of $8 and variable selling cost of $2 per unit.
Fixed cost are $40,000 per annum, and the sales price per unit is
$18, and the current volume of output and sales is 6,000 units.
The company is considering whether to have an improved
machine for production. Annual hire cost would be $10,000 and it
is expected that variable cost of production would fall to $6 per
unit.
Required
a. Determine the number of units that must be produced and
sold to achieve the same profit as is currently earned, if the
machine is hired.
b. Calculate the annual profit with the machine if output and
sales remain at 6,000 units per annum.
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B2. Cost Volumn Profit Analysis (Breakeven)
(?) Decision to change production costs
Example 4
Solution:
The current contribution per unit is $ (18 – (8+2)) = $8
(a)
$
Current contribution (6,000 x $8) 48,000
Less current fixed costs 40,000
Current profit 8,000
With the new machine fixed costs will go up by $10,000 to $50,000 per
annum. The variable cost per unit will fall to $(6+2) = $8, and the
contribution per unit will be $10 (=18-8).
$
Required profit (as currently earned) 8,000
Fixed costs 50,000
Required contribution 58,000
Contribution per unit $10
Sales required to earn $8,000 profit 5,800 units
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B2. Cost Volumn Profit Analysis (Breakeven)
(?) Decision to adopt an automated or a manual approach to
production
Example 5
Ray Co is planning to produce Product LW next year and wants to know
whether it should adopt an automated approach or a manual approach
to production. The following data relate to Product LW.
Automated approach
Variable cost per unit = $2
Fixed costs = $24.000
Manual approach
Variable cost per unit = $6
Fixed costs = $10.000
Product LW is budgeted to sell at $8 per unit. Ray Co has budgeted to
sell of the units that it produces but volume of demand have been
dropping over recent years and so Ray Co is unable to predict sales
volumes.
Required: Recommend to the management of Ray Co whether Product
LW should be produced using an automated approach or a manual
approach.
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B2. Cost Volumn Profit Analysis (Breakeven)
(?) Decision to adopt an automated or a manual approach to
production
Example 5
Solution:
Contribution per unit = Selling price - variable cost
Contribution per unit (automated approach) = $8 - $2 = $6
Contribution per unit (manual approach) = $8 - $6 = $2
Total fixed costs
Breakeven=
Contribution per unit
$24.000
Breakeven point (automated approach) = = 4.000 units
6
$10.000
Breakeven point (manual approach) = = 5.000 units
$2
It is recommended, therefore, that Ray Co should adopt the automated
approach as it has the lower breakeven point (and sales volumes are
unpredictable). It is preferable for the company to have to produce
and sell only 4.000 units of Product LW the automated approach is
adopted (compared to 5.000 units of Product LW if the manual
approach is adopted).
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B2. Cost Volumn Profit Analysis (Breakeven)
(?) Breakeven point for multiple products
• Step 1: Calculate contribution per unit
• Step 2: Calculate contribution per mix
• Step 3: Calculate the breakeven point in terms of the number of
mixes
• Step 4: Calculate the breakeven point in terms of the number of
units of the products
• Step 5: Calculate the breakeven point in terms of revenue

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B2. Cost Volumn Profit Analysis (Breakeven)
(?) Breakeven point for multiple products
Example 1:
PL produces and sells two products. The M sells for $7 per unit
and has a total variable cost of $2.94 per unit, while the N sells
for $15 per unit and has a total variable cost of $4.50 per unit.
The marketing department has estimated that for every five units
of M sold, one unit of N will be sold. The organisation's fixed
costs total $36,000.
Required: Calculate the breakeven point for PL.

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B2. Cost Volumn Profit Analysis (Breakeven)
(?) Breakeven point for multiple products
Example 1:
Solution:
• Step 1: Calculate contribution per unit
M N
$ per unir $ per unit
Selling price 7.00 15.00
Variable cost 2.94 4.50
Contribution 4.06 10.50
• Step 2: Calculate contribution per mix
= ($4.06 × 5) + ($10.50 × 1) = $30.80
• Step 3: Calculate the breakeven point in terms of the number of mixes
= fixed costs/contribution per mix = $36,000/$30.80
= 1,169 mixes (rounded)
• Step 4: Calculate the breakeven point in terms of the number of units of
the products
= (1,169 × 5) 5,845 units of M and (1,169 × 1) 1,169 units of N (rounded)
• Step 5: Calculate the breakeven point in terms of revenue
= (5,845 × $7) + (1,169 × $15)
= $40,915 of M and $17,535 of N = $58,450 in total
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B2. Cost Volumn Profit Analysis (Breakeven)
(?) Contribution to sales ratio for multiple products.
An alternative way of calculating the breakeven point is to use
the average contribution to sales (C/S) ratio for the standard
mix
• Step 1: Calculate revenue per mix
• Step 2: Calculate contribution per mix
• Step 3: Calculate average C/S ratio
• Step 4: Calculate breakeven point (in term of total value)
• Step 5: Calculate revenue ratio of mix
• Step 6: Calculate breakeven sales

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B2. Cost Volumn Profit Analysis (Breakeven)
(?) Contribution to sales ratio for multiple products.
Example 2 (Follow the previous Example):
We can calculate the breakeven point of PL as follows.
• Step 1: Calculate revenue per mix
= (5 × $7) + (1 × $15) = $50
• Step 2: Calculate contribution per mix
= $30.80
• Step 3: Calculate average C/S ratio
= ($30.80 / $50.00) × 100% = 61.6%
• Step 4: Calculate breakeven point of mix (in term of total value)
= fixed costs ÷ C/S ratio
= $36,000 / 0.616 = $58,442 (rounded)
• Step 5: Calculate revenue ratio of mix
= (5 × $7) : (1× $15)
= 35:15, or 7:3
• Step 6: Calculate breakeven sales
M = $58,442 × 7/10 = $40,909 (rounded)
N = $58,442 × 3/10 = $17,533 (rounded)
06/08/2022 PhD. Nguyen Minh Thanh - Academy of Finance 92
B2. Cost Volumn Profit Analysis (Breakeven)
(?) Margin of safety for multiple products
• Step 1: Calculate contribution per unit
• Step 2: Calculate contribution per mix
• Step 3: Calculate the breakeven point in terms of the number of
mixes
• Step 4: Calculate the breakeven point in terms of the number of
units of the products
• Step 5: Calculate the breakeven point in terms of revenue
• Step 6: Calculate the margin of safety

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B2. Cost Volumn Profit Analysis (Breakeven)
(?) Margin of safety for multiple products
Example 3:
BA produces and sells two products. The W sells for $8 per unit
and has a total variable cost of $3.80 per unit, while the R sells
for $14 per unit and has a total variable cost of $4.20. For every
five units of W sold, six units of R are sold. BA's fixed costs are
$43,890 per period. Budgeted sales revenue for next period is
$74,400, in the standard mix.
Required: Calculate the margin of safety in terms of sales
revenue and also as a percentage of budgeted sales revenue.

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B2. Cost Volumn Profit Analysis (Breakeven)
(?) Margin of safety for multiple products
Example 3:
Solutions:
• Step 1: Calculate contribution per unit
W R
$ per unit $ per unit
Selling price 8.00 14.00
Variable cost 3.80 4.20
Contribution 4.20 9.80
• Step 2: Calculate contribution per mix
= ($4.20 × 5) + ($9.80 × 6) = $79.80
• Step 3: Calculate the breakeven point in terms of the number of mixes
= fixed costs/contribution per mix = $43,890 / $79.80 = 550 mixes
• Step 4: Calculate the breakeven point in terms of the number of units of the products
= (550 × 5) 2,750 units of W and (550 × 6) 3,300 units of R
• Step 5: Calculate the breakeven point in terms of revenue
= (2,750 × $8) + (3,300 × $14) = $22,000 of W + $46,200 of R = $68,200 in total
• Step 6: Calculate the margin of safety
= budgeted sales – breakeven sales = $74,400 – $68,200 = $6,200 sales in total, in the standard mix
Or, as a percentage
= ($74,400 – $68,200) / $74,400 × 100% = 8.3% of budgeted sales
06/08/2022 PhD. Nguyen Minh Thanh - Academy of Finance 95
B2. Cost Volumn Profit Analysis (Breakeven)
(?) Target profit for multiple products
• Calculate the required sales revenue (either in term of number
or value) by using contribution per unit?
Step 1: Calculate contribution per unit
Step 2: Calculate contribution per mix
Step 3: Calculate the required number of mixes
Step 4: Calculate the required sales in terms of the number of units of
the products and sales revenue of each product
• Calculate the required sales revenue (either in term of number
or value) by using C/S ratio?
Step 1: Calculate revenue per mix
Step 2: Calculate contribution per mix
Step 3: Calculate average C/S ratio
Step 4: Calculate required total revenue
Step 5: Calculate revenue ratio of mix
Step 6: Calculate required sales
06/08/2022 PhD. Nguyen Minh Thanh - Academy of Finance 96
B2. Cost Volumn Profit Analysis (Breakeven)
(?) Target profit for multiple products
Example 4:
An organisation makes and sells three products, F, G and H. The
products are sold in the proportions F:G:H = 2:1:3. The
organisation's fixed costs are $80,000 per month and details of
the products are as follows.
Selling price Variable cost
Product $ per unit $ per unit
F 22 16
G 15 12
H 19 13
The organisation wishes to earn a profit of $52,000 next month.
Required: Calculate the required sales value of each product in
order to achieve this target profit.
06/08/2022 PhD. Nguyen Minh Thanh - Academy of Finance 97
B2. Cost Volumn Profit Analysis (Breakeven)
(?) Target profit for multiple products
Example 4:
Solutions:
• Calculate the required sales revenue by using contribution per unit?
 Step 1: Calculate contribution per unit
F G H
$ per unit $ per unit $ per unit
Selling price 22 15 19
Variable cost 16 12 13
Contribution 6 3 6
 Step 2: Calculate contribution per mix
= ($6 × 2) + ($3 × 1) + ($6 × 3) = $33
 Step 3: Calculate the required number of mixes
= (Fixed costs + required profit)/contribution per mix = ($80,000 + $52,000)/$33 = 4,000 mixes
 Step 4: Calculate the required sales in terms of the number of units of the products and sales revenue of
each product
Sales revenue
Selling price
Product Units required
$ per unit
$
F 4,000 x 2 8,000 22 176,000
G 4,000 x 1 4,000 15 60,000
H 4,000 x 3 12,000 19 228,000
464,000
06/08/2022 PhD. Nguyen Minh Thanh - Academy of Finance 98
B2. Cost Volumn Profit Analysis (Breakeven)
(?) Target profit for multiple products
Example 4:
Solutions:
• Calculate the required sales revenue by using C/S ratio?
Step 1: Calculate revenue per mix
= (2 × $22) + (1 × $15) + (3 × $19) = $116
Step 2: Calculate contribution per mix
= $33
Step 3: Calculate average C/S ratio
= ($33 / $116) × 100% = 28.45%
Step 4: Calculate required total revenue
= required contribution ÷ C/S ratio = ($80,000 + $52,000) ÷ 0.2845 =
$463,972
Step 5: Calculate revenue ratio of mix
= (2 × $22) : (1 × $15) : (3 × $19) = 44 : 15 : 57
Step 6: Calculate required sales
Required sales of F = 44/116 × $463,972 = $175,989
Required sales of G = 15/116 × $463,972 = $59,996
Required sales of H = 57/116 × $463,972 = $227,986
Which, allowing for roundings, is the same answer as calculated in the
first example.
06/08/2022 PhD. Nguyen Minh Thanh - Academy of Finance 99
B2. Cost Volumn Profit Analysis (Breakeven)
(?) Limitations/Assumtions of CVP
• Costs behaviour is assumed to be linear
• Revenue is assumed to be linear
• Volume Produced = Volume Sold
• Ignores inflation
• Assumes a constant sales mix

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B3. Limiting factors
Short term decisions
Managers must decide how to acquire and utilise economic
resources in the light of company’s objectives.
Decision making can be considered very simply as the making of
a choice among alternatives.
Before decisions can be made managers must evaluate all
relevant factors, both quantifiable and non - quantifiable.

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B3. Limiting factors
Factors in limited supply
• At any particular period, an organisation may be constrained or
its output restricted by certain factors. These are termed limiting
factors.
• A limiting factor is a factor which limits the organisation’s
activities.
• A limiting factor could be sales demand, production capacity,
shortages of materials, labour shortage or machine time. The
limiting factor decision therefore involves the determination of
the contribution earned by each different product from each unit
of the limiting factor.

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B3. Limiting factors
Factors affecting make or buy and outsourcing decisions
• Cost
• Idle capacity
• Limiting factor
• New product or new entrant in market
• Technology
• Quality
• Response time
• Impact on core activities
• Increase responsiveness

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B3. Limiting factors
Step to deal with limiting factor
• Identify the limiting factor (key factor)
• Calculate contribution per unit for each product
• Calculate contribution per unit of limiting factor for each product
• Rank product according to highest contribution per unit of
limiting factor
• Make products in rank order until scarce resource is used up

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B3. Limiting factors
Dealing with limiting factors
• Key limiting factor analysis – one or two resources in short
supply (The key limiting factor can be identified by simple
calculation)
• Linear Programming – two or more scarce resources (The
limiting factor can not be identified by simple calculation)

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B3. Limiting factors
Key limiting factor analysis
• Step 1: Calculate contribution per unit for each product.
• Step 2: Calculate contribution per unit of the limiting factor for each
product.
• Step 3: Rank in order.
• Step 4: Allocate resources – make first up to max demand, then
second,...

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B3. Limiting factors
Key limiting factor analysis
Example:
Metal Men Ltd makes two products. Units variable costs are as follows:
Product X Product Y
$ $
Direct materials 1 3
Direct labour ($3/hour) 6 3
Variable overhead 1 1
The sales price is $14 for Product X and $11 for Product Y. During July
2005 the available direct labour is limited to 8,000 hours. Sales demand
in July is expected to be 3,000 units for Product X and 5,000 units for
Product Y. Fixed costs are $20,000, and opening stocks of finished
goods and work in progress are nil. To produce one product X, Metal
Men Ltd. needs 2 labour hours, and 1 labour hour for each product Y.
Required: Determine the optimal production solution
06/08/2022 PhD. Nguyen Minh Thanh - Academy of Finance 107
B3. Limiting factors
Key limiting factor analysis
Example:
Solution:
• Step 1: Confirm that the limiting factor is something other than sales
demand.
X Y Total
Labour hours per unit 2hrs 1hr
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 hour is the key limiting factor.

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B3. Limiting factors
Key limiting factor analysis
Example:
Solution:
• Step 2: Identify the contribution earned by each product per unit of scarce
resource, that is, per labour hour worked
X Y
$ $
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
$3 $4
unit of limiting factor)
Although product X have a higher unit contribution than product Y, but
two products Y can be made in the time it takes to make one product X.
Because labour is in short supply, it is more profitable to make Y than X.
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B3. Limiting factors
Key limiting factor analysis
Example:
Solution:
• Step 3: Determine the budgeted production and sales. Sufficient
Sauces will be made to meet the full sales demand, and the
remaining labour hours available will then be used to make Mashes.
a)
Hours Hours Priority for
Product Demand
required available manufacture
Y 5,000 5,000 5,000 1st
3,000
X 3,000 6,000 2nd
(balanced)
11,000 8,000

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B3. Limiting factors
Key limiting factor analysis
Example:
Solution:
• Step 3: Determine the budgeted production and sales. Sufficient
Sauces will be made to meet the full sales demand, and the
remaining labour hours available will then be used to make Mashes.
b)
Hours Contribution
Product Units Total
needed per unit
$ $
Y (1st) 5,000 5,000 4 20,000
X (balanced – 2nd) 1,500 3,000 6 9,000
8,000 29,000
Less fixed costs 20,000
Profit 9,000
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B3. Limiting factors
Key limiting factor analysis
Example:
Solution:
• Step 3: Determine the budgeted production and sales. Sufficient
product Y will be made to meet the full sales demand, and the
remaining labour hours available will then be used to make product
X.
Conclusion
(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 product Y earns $4 contribution per labour hour, and
the product X earns $3 contribution per labour hour. Product Y
therefore make more profitable use of the scare resource, and
should be manufactured first.
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B3. Limiting factors
Linear programming
Progress
• Step 1: Define variables
• Step 2: Define the objective
• Step 3: Set out constraints
• Step 4: Draw graph showing constraints and identify the feasible
region
• Step 5: Identify optimal point
• Step 6: Solve for optimal solution
• Step 7: Answer the question

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B3. Limiting factors
Linear programming
Example 1: Maximise contribution per unit of limiting factor
A Ltd produces two products: Standard and Deluxe. The only
constraint is monthly machine capacity (400 hours). Standard
requires 5 hr/ unit and Deluxe 1.5 hr/ unit. Government restriction
for maximum sales each month is only 150. That number being
made up of any combination of Standard and Deluxe. Work out
the problem and formulate the formula. Contribution per unit of
Standard and Deluxe are $100 and $200 respectively.

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B3. Limiting factors
Linear programming
Example 1: Maximise contribution per unit of limiting factor
Solution:
• Step 1: Define variables
X: Number of Standard product
Y: Number of Deluxe product
• Step 2: Define the objective
Maximise profit => Maximise contribution P = 100X + 200Y =>
Maximum
• Step 3: Set out constraints
1. Machine hours : 5X + 1.5Y <= 400 (machine capacity)
2. Number of X and Y : X + Y <=150 (sales demand)
3. Non negative X >= 0 , Y >= 0
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B3. Limiting factors
Linear programming
Example 1: Maximise contribution per unit of limiting factor
Solution:
• Step 4: Draw graph showing constraints and identify the feasible
region 300266.67

250 Feasible
200
150
region
Y value

150

100

50
0 0
0
0 20 40 60 80 100 120 140 160
X value

Machine hours Linear (X + Y < 150)

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B3. Limiting factors
Linear programming
Example 1: Maximise contribution per unit of limiting factor
Solution:
• Step 5: Identify optimal point
300266.67

250 Feasible Optimal point is

going to be the
200
150
region point on the edge
Y value

150 of the feasible

area than in the
100
middle of it!!!
50
0 0
0
0 20 40 60 80 100 120 140 160
X value

Machine hours Linear (X + Y < 150)

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B3. Limiting factors
Linear programming
Example 1: Maximise contribution per unit of limiting factor
Solution:
• Step 5: Identify optimal point
300

250
0, 266.67
Feasible Optimal point is
going to be the
200 region point on the edge
Y value

150 0, 150 of the feasible

area than in the
100
A B middle of it!!!
50 Point A, B or C?

0 80, 0 150, 0
0 20 40 60 80 C 100 120 140 160
X value

Machine hours Linear (X + Y < 150)

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B3. Limiting factors
Linear programming
Example 1: Maximise contribution per unit of limiting factor
Solution:
• Step 5: Identify optimal point
Contributi Contributi Total
X Y
Point on per on per contribution
(Units) (Units)
unit X ($) unit Y ($) ($)
A 0 150 100 200 30.000
B 50 100 100 200 25.000
C 80 0 100 200 8.000

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B3. Limiting factors
Linear programming
Example 1: Maximise contribution per unit of limiting factor
Solution:
• Step 6 + 7: Solve for optimal solution + Answer the question
The ‘best’ solution is production combination of 0 Standard model and
150 Deluxe models.

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B3. Limiting factors
Linear programming
(?) Advanced: What approach can be used to find the optimal point?
1. Iso – profit line
2. Simultaneous equations

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B3. Limiting factors
Linear programming
(?) Advanced: Dealing with Maximization Contribution Objective and
Minimization Cost Objective?

=> The difference of Feasible areas between two Objectives!!!

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B3. Limiting factors
Linear programming
Assumptions
• A single quantifiable objective.
• Each product always uses the same quantity of the scarce resources
per unit.
• The contribution per unit is constant.
• Products are independent – e.g. sell A not B.
• The scenario is short term.

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B3. Limiting factors
Linear programming
Limitations
• Linearity assumption - contribution per unit and resource
utilization per unit are the same for any quantity produced and
sold in the range under consideration.
• Infinite divisibility of products and resources. Solution may not
have integer values. eg. Produce 12 2/3 units X and 9 1/3 units
Y.
• Quality (reliability) of input data – complete, accurate, valid.
• Only one quantifiable objective to be satisfied (non-financial
objectives are not considered).
• Single value estimates. It does not account for uncertainty in its
variables.
• Only two “products” allowed for graphical solution. The
graphical method cannot be used when there are more than
two decision variables.
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B3. Limiting factors
Linear programming
(?) Shadow price
• The shadow price (or dual price) of a limiting factor is the increase in
value (or contribution) which would be created by having one
additional unit of the limiting factor at the original cost. The shadow
price of a resource is its internal opportunity cost of the scarce
resources, which is the amount of benefit forgone by not having the
availability of the extra resources.
• The shadow price therefore represents the maximum premium above
the basic rate that an organisation should be willing to pay for one
extra unit of resource.
• The shadow price is the extra contribution or profit that may be earned
by the availability of one unit of a binding resource constraint. This
measures the sensitivity of the result.
• The shadow price of a constraint that is not binding at the optimal
solution is zero.
• Shadow price are only valid for a small range before the constraint
becomes non-binding or different resources become critical.
06/08/2022 PhD. Nguyen Minh Thanh - Academy of Finance 125
B3. Limiting factors
Linear programming
(?) Shadow price
Example:
Let us suppose that WX manufactures two products, A and B. Both products
pass through two production departments, mixing and shaping. The
organisation's objective is to maximise contribution to fixed costs.
Product A is sold for $1.50 whereas product B is priced at $2.00. There is
unlimited demand for product A but demand for B is limited to 13,000 units
per annum. The machine hours available in each department are restricted
to 2,400 per annum. Other relevant data are as follows.
Machine hours required
Mixing Shaping
Hrs Hrs
Product A 0.06 0.04
Product B 0.08 0.12
Variable cost per unit $
Product A 1.30
Product B 1.70
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B3. Limiting factors
Linear programming
(?) Shadow price
Example:
Solution:
Let x is the number of product A whereas y is the number of
product B
• The constraints are:
0.06x + 0.08y ≤ 2,400 (Mixing machine hours)
0.04x + 0.12y ≤ 2,400 (Shaping machine hours)
0 ≤ y ≤ 13,000 (Number of product B)
0 ≤ x (Number of product A)
• The objective function is:
Contribution (C) = 0.2x + 0.3y => Maximum 127
06/08/2022 PhD. Nguyen Minh Thanh - Academy of Finance
B3. Limiting factors
Linear programming
(?) Shadow price 35000
30000
Example: 30000

Solution: 25000
20000
• Drawing the Graph 20000
Y

1500013000 13000

10000 A B C

5000
0 0
D
0
0 10000 20000 30000 40000 50000 60000 70000
X

Mixing machine hours: 0.06x + 0.08y = 2,400

Shaping machine hours: 0.04x + 0.12y = 2,400
Number of product B: y = 13.000

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B3. Limiting factors
Linear programming
(?) Shadow price
Example:
Solution:
• Identify optimal point by using Simultaneous equations
Point X (Unit) Y (Unit) Contribution Contribution Total
per X unit per Y unit contribution
($) ($) ($)
B 21,000 13,000 0.2 0.3 8,100

C 24,000 12,000 0.2 0.3 8,400

D 40,000 0 0.2 0.3 8,000

=> Point C is the optimal point (original point) and total contribution
can be earned at this point is $8,400.
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B3. Limiting factors
Linear programming
(?) Shadow price
Example:
Solution:
• Calculate the effect of one extra unit of limiting resource on contribution.
The availability of time in both departments are limiting factors because
both are used up fully in the optimal product mix. Let us therefore
calculate the effect if one extra hour of shaping department machine
time was made available so that 2,401 hours were available.
The new optimal product mix would be at the intersection of the two
constraint lines 0.06x + 0.08y = 2,400 and 0.04x + 0.12y = 2,401.
Solution by simultaneous equations gives x = 23,980 and y =
12,015.

(You should solve the problem yourself if you are doubtful about the
derivation of the solution.)
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B3. Limiting factors
Linear programming
(?) Shadow price
Example:
Solution:
• Calculate the effect of one extra unit of limiting resource on contribution.
New contribution at new optimal product mix is:
= 23,980 x 0.2 + 12,015 x 0.3 = $8,400.5
Whereas, contribution of origin problem is: $8,400
Increase in contribution from one extra hour of shaping time: $0.5
• The shadow price of an hour of machining time in the shaping
department is therefore the standard machine cost plus $0.50.
• This means that extra machine capacity could be rented, for example,
provided the cost is less than $0.50 per hour.
• This value of machine time only applies as long as shaping machine
time is a limiting factor. If more and more machine hours become
available, there will eventually be so much machine time that it is no
longer a limiting factor.
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B3. Limiting factors
Linear programming
(?) Shadow price and Slack
• Slack is the amount by which a resource is under utilized. It will occur
when the optimum point does not fall on the given resource line

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B3. Limiting factors
Linear programming
(?) Shadow price and Slack
Example:
The Cosmetic Co is a company producing a variety of cosmetic creams
and lotions. The creams and lotions are sold to a variety of retailers at
a price of $23.20 for each jar of face cream and $16.80 for each bottle
of body lotion. Each of the products has a variety of ingredients, with
the key ones being silk powder, silk amino acids and aloe vera. Six
months ago, silk worms were attacked by disease causing a huge
reduction in the availability of silk powder and silk amino acids. The
Cosmetic Co had to dramatically reduce production and make part of
its workforce, which it had trained over a number of years, redundant.

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B3. Limiting factors
Linear programming
(?) Shadow price and Slack
Example:
The company now wants to increase production again by ensuring that it uses
the limited ingredients available to maximise profits by selling the optimum
mix of creams and lotions. Due to the redundancies made earlier in the year,
supply of skilled labour is now limited in the short-term to 160 hours (9,600
minutes) per week, although unskilled labour is unlimited. The purchasing
manager is confident that they can obtain 5,000 grams of silk powder and
1,600 grams of silk amino acids per week. All other ingredients are unlimited.
The following information is available for the two products:
Cream Lotion
Materials required: silk powder at $2.20 3 grams 2 grams
per gram)
-silk amino acids (at $0.80 per gram) 1 gram 0.5 gram
-aloe vera (at $1.40 per gram) 4 grams 2 grams
a Labour required: skilled ($12 per hour) 4 minutes 5 minutes
-unskilled (at $8 per hour) 3 minutes 1.5 minutes
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B3. Limiting factors
Linear programming
(?) Shadow price and Slack
Example:
Each jar of cream sold generates a contribution of $9 per unit, whilst each
bottle of lotion generates a contribution of $8 per unit. The maximum demand
for lotions is 2,000 bottles per week, although demand for creams is
unlimited. Fixed costs total $1,800 per week. The company does not keep
inventory although if a product is partially complete at the end of one week,
its production will be completed in the following week.
Required:
(a) On the graph paper provided, use linear programming to calculate the
optimum number of each product that the Cosmetic Co should make per
week, assuming that it wishes to maximise contribution. Calculate the total
contribution per week for the new production plan. All workings MUST be
rounded to 2 decimal places.
(b) Calculate the shadow price for silk powder and slack for silk amino acids.
All workings MUST be rounded to 2 decimal places. (6 marks)

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B3. Limiting factors
Linear programming
(?) Shadow price and Slack
Example:
Solution:
(a) Finding optimal mix production plan
• Define the variables
• State the objective function
• State the constrains
• Draw the graph
• Find the optimal point

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B3. Limiting factors
Linear programming
(?) Shadow price and Slack
Example:
Solution:
(a) Finding optimal mix production plan
• Define the variables
Let x = number of jar of face cream will be produced,
Let y = number of bottle of lotion will be produced, and
C = contribution of the optimal production plan
• State the objective function
C = 9x + 8y => maximum
• State the constrains
4x + 5y ≤ 9,600 (skilled labour hours)
3x + 2y ≤ 5,000 (silk powder)
1x + 0.5y ≤ 1,600 (silk amino acids)
y ≤ 2,000 (bottle of lotion)
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B3. Limiting factors
Linear programming
(?) Shadow price and Slack
Example:
Solution:
(a) Finding optimal mix production plan
• Draw the graph 4000

3000

Skilled labour hours: 4x +

2000 5y = 9,600
A Silk powder: 3x + 2y = 5000
B
1000
Silk amino acids: 1x + 0,5y
C = 1,600

0 D bottle of lotion: y = 2000

A 0 500 1000 1500 2000 2500 3000

-1000

a
-2000
06/08/2022 PhD. Nguyen Minh Thanh - Academy of Finance 138
B3. Limiting factors
Linear programming
(?) Shadow price and Slack
Example:
Solution: 4000
(a) Finding optimal mix production plan
• Find the optimal point by
3000
Using iso-profit line
⇒ Draw the iso profit line (contribution) Skilled labour hours: 4x +
5y = 9,600
9x + 8y = 14,400 2000
=> Point B is the farest point from the A Silk powder: 3x + 2y =
5000
iso-profit line => B is the optimal
B Silk amino acids: 1x + 0,5y
point 1000
= 1,600
Call out the point B: C
Bottle of lotions: y = 2000
4x + 5y = 9,600 (1)
3x + 2y = 5,000 (2) 0 D
0 500 1000 1500 2000 2500 3000 Linear (iso-profit line: 9x
=> x = 828.58; y = 1257.14 + 8y = 14,400)
Contribution = 9 x 828.58 +
-1000
8 x 1,257.14 = 17,514.34

-2000
a
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B3. Limiting factors
Linear programming
(?) Shadow price and Slack
Example:
Solution:
(b) Calculate the Shadow price for silk powder and Slack for silk amino acids.
• The shadow price for silk powder can be found by solving the two simultaneous equations intersecting at point
B, whilst adding one more hour to the equation for silk powder.
4x +5y = 9,600
3x + 2y = 5,001
⇒New optimal point is called out at (x = 829,29; y = 1,256.57)
⇒New contribution is 9 x 829,29 + 8 x 1,256.57 = 17,516.17
⇒Shadow price for silk powder is: 17,516.17 - 17,514.34 = $1.83

• The slack for silk amino acids can be calculated as follows:

Number of gram of silk amino acid to be used at optimal point is:
1 x 828.58 + 0.5 x 1257.14 = 1,457.15 grams
Whilst the are 1,600 grams of silk amino acids are available
=> The slack for silk amino acids is 1,600 - 1,457.15 = 142.85 grams

a
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B3. Limiting factors
Linear programming
(?) Shadow price and Slack
• Slack is the amount by which a resource is under utilized. It will
occur when the optimum point does not fall on the given
resource line.

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B4. Pricing decisions

• Factors to consider when pricing.

• Calculation aspects.
• Pricing approaches.

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B4. Pricing decisions

Factors to consider when pricing

Costs
Competitors
Corporate objectives
Customers

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 B4. Pricing decisions

Calculation aspects
(?) Price elastic of demand (PED)
Price (a) Completely inelastic: Demand Price (b) Completely elastic: Demand is Price (c) Elasticity (Downward sloping):
is totally unresponsive to change limitless at a certain price Demand curve shows that
in price demand will increase when
prices are lowered (According to
the Economic theory – Higher
price, lower quantity demanded).

Q Demand Q Demand Q Demand

% 𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂 𝐢𝐢𝐢𝐢 𝐝𝐝𝐝𝐝𝐝𝐝𝐝𝐝𝐝𝐝𝐝𝐝

PED =
% 𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂 𝐢𝐢𝐢𝐢 𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩

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B4. Pricing decisions

Calculation aspects
(?) Price elastic of demand (PED)
Price (c)

PED = ∞ -> Completely elastic

Demand is elastic

PED = 1

Demand is inelastic

PED = 0 ->
Completely inelastic

Q Demand

PED may be absolute valued from 0 (Completely inelastic) to

infinity (∞ Completely elastic).
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B4. Pricing decisions

Calculation aspects
(?) Price elastic of demand (PED)
Example:
The price of a good is $1.20 per unit and annual demand is 800,000 units. Market research
indicates that an increase in price of 10 cents per unit will result in a fall in annual demand of
75,000 units. What is the price elasticity of demand between prices of $1.20 and $1.30 per
unit?

𝟕𝟕𝟕𝟕,𝟎𝟎𝟎𝟎𝟎𝟎
% 𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂 𝐢𝐢𝐢𝐢 𝐝𝐝𝐝𝐝𝐝𝐝𝐝𝐝𝐝𝐝𝐝𝐝 �𝟖𝟖𝟖𝟖𝟖𝟖,𝟎𝟎𝟎𝟎𝟎𝟎
PED = = $𝟎𝟎.𝟏𝟏� = 𝟏𝟏. 𝟏𝟏𝟏𝟏𝟏𝟏
% 𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂 𝐢𝐢𝐢𝐢 𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩 $𝟏𝟏.𝟐𝟐

Therefore, the price elastic of demand is 1.125 or the demand is elastic.

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B4. Pricing decisions

Calculation aspects
(?) Equation of a straight line demand curve
• P = a – bQ
• “a” = the price at which demand would fall to zero
• “b” = gradient = change in price/change in demand
• Calculate “b” first
⇒As like “high-low method”
Example: The current price of a product is $12. At this price the company sells 60 items a
month. One month the company decides to raise the price to $15, but only 45 items are sold
at this price. Determine the demand equation, which is assumed to be a straight line
equation.
Solution:
b = ($15 - $12) / (45 – 60) = 0.2 in absolute
a = $12 + 0.2 x 60 = $24
=> P = $24 – 0.2 x Q
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B4. Pricing decisions

Calculation aspects
(?) Equation of a cost curve
In order to decide a profit-maximising price and sales quantity, we need to consider costs as
well as revenue.
• C = F + vQ
• F = Fixed cost
• v = variable cost per unit
• Q = Unit sold
• C = Total costs
⇒As like “high-low method”

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B4. Pricing decisions
Economies of Scale
Calculation aspects Average cost

(?) Equation of a cost curve

Problems with equation of a cost curve:
• Step fixed cost? (Fixed cost is not unchanged)
• Marginal cost (average cost) in Economies or Constant returns
to scale
Diseconomies scale? => Marginal cost (or variable cost
per unit is not constant).
• Volume based discount?
Quantity

The marginal (average) cost curve is typically

U-shaped. This is because marginal costs
decrease as output increases due to
economies of scale. However, at some point
diseconomies of scale (eg more supervision
and larger workforce) appear and marginal
costs begin to rise
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B4. Pricing decisions

Calculation aspects
(?) The profit-maximising price
Microeconomic theory and profit-maximization => Determine the price and output level that return the
greatest profit. There are two common approaches to this problem:
a) The Total revenue (TR) – Total cost (TC) method is based on the fact that profit equals revenue minus
cost.
b) 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.
Total revenue (TR) – Total cost (TC) Marginal revenue (MR) – Marginal cost (MC)
$ $
per
TR unit
MC
Profit Optimal
TC price Pn

MR = MC

Optimum
volume
MR
Quantity Qn Quantity
Q

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B4. Pricing decisions

Calculation aspects
(?) The profit-maximising price
From the equation for the demand curve (P = a – bQ), we can determine the
equation for MR = a – 2bQ, where:
P: the price
Q: The quantity demanded
a: the price at which demand would be nil
b: change in price / change in quantity

Whilst, MC is simply the variable cost per unit

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B4. Pricing decisions
Calculation aspects
(?) The profit-maximising price
Example:
MOC makes and sells a copyrighted, executive game for two distinct markets, in which it has a monopoly.
The fixed costs of production per month are $20,000 and variable costs per unit produced, and sold, are
$40. (The monthly sales can be thought of as X, where X = X1 + X2, with X1 and X2 denoting monthly sales
in their respective markets.) Detailed market research has revealed the demand functions in the markets
to be as follows, with prices shown as P1, P2.
Market 1: P1 = 55 – 0.05X1
Market 2: P2 = 200 – 0.2X2
The management accountant believes there should be price discrimination; the price is currently $50 per
game in either market.
Required:
Analyse the information for the executive game and, given the management accountant's belief, do the
following.
(a) Calculate the price to charge in each market, and the quantity to produce (and sell) each month, to
maximise profit.
(b) Determine the revenue function for each market and the maximum monthly profit in total.
(c) Calculate and comment on the change in total profitability and prices.

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B4. Pricing decisions

Calculation aspects
(?) The profit-maximising price
Example:
Solution:
(a) Calculate the price to charge in each market, and the quantity to produce (and sell) each month, to
maximise profit.
• MR1 = 55 – 0.1X1
• MR2 = 200 – 0.4X2
Whilst, MC = 40. We can calculate the optimal quantity for Market 1 and 2 as below:
• Market 1: X1 = 55 – 0.1X1 = 40 => X1 = 150 units
• Market 2: X2 = 200 – 0.4X2 = 40 => X2 = 400 units
And the price to charge in each market to maximize profit are:
Market 1: P1 = 55 – 0.05 x 150 = $47.50 per unit
Market 2: P2 = 200 – 0.20 x 400 = $120 per unit
Total product should be produced each month is 550 units

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B4. Pricing decisions

Calculation aspects
(?) The profit-maximising price
Example:
Solution:
(b) Determine the revenue function for each market and the maximum monthly profit in total.
Revenue functions
• TR1 = P1 x X1 = 55X1 – 0.05X12
• TR2 = P2 x X2 = 200X2 – 0.2X22
Maximum monthly profit in total = ($47.50 - $40) x 150 + ($120 - $40) x 400 - $20,000 = $13,125
(c) Calculate and comment on the change in total profitability and prices.
Current units sold at each market:
• 50 = 55 – 0.05X1 => X1 = 100 units
• 50 = 200 – 0.2X2 => X2 = 750 units
Current total profit = 850 x ($50 - $40) - $20,000 = -$11,500 (Loss)
Hence, if the prices are changed to $47.50 in market 1 and $120 in market 2, the company can expect to
turn a monthly loss of $11,500 into a profit of $13,125.
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B4. Pricing decisions

Pricing approaches
1. Cost plus pricing
2. Price skimming
3. Penetration pricing
4. Linking pricing decisions for different products
5. Volume discounts
6. Price discrimination
7. Relevant cost pricing

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B4. Pricing decisions

Pricing approaches/strategies
(?) Cost plus pricing
• Establish cost per unit – options include Marginal costing, Total absorption costing, Prime cost
• Calculate price using target mark-up or margin. You can see some examples of target mark-up or margin
in the F2 Revision kit (e.g 10.2, 10.9)
Note:
 Mark-up: Profit as a percentage of cost
 Margin: Profit as a percentage of price
• Often used as a starting point even when using other methods
ADVANTAGES DISADVANTAGES
• Widely used and accepted. • Ignores link between price and
• Simple to calculate if costs are known. demand.
• Selling price decision may be • No attempt to establish optimum price.
delegated to junior management. • Which absorption method?
• Justification for price increases. • Does not guarantee profit
• May encourage price stability. • Which cost?
• Inflexibility in pricing.
• Circular reasoning.

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B4. Pricing decisions

Pricing approaches/strategies
(?) Skimming pricing
• Set a high initial price to ‘skim off’ customers who are willing
to pay extra.
• Prices fall over time.
• Suitability?

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B4. Pricing decisions

Pricing approaches/strategies
(?) Penetration pricing
• Set a low initial price to gain market share
• If a high volume is achieved, the low price could be
sustainable.
• Suitability?

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B4. Pricing decisions

Pricing approaches/strategies
(?) Complementary product pricing / Linking pricing
decisions for different products
• Basic idea: product A is cheap to attract customers who then
also buy the higher margin product B.
E.g an electric toothbrush and replacement toothbrush heads.
The electric toothbrush may be priced competitively to attract
demand but the replacement heads can be relatively
expensive.
• Key issue is the extent to which customer must buy the
other products.
• Suitability?
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B4. Pricing decisions

Pricing approaches/strategies
(?) Volumn discounts
• Discount for individual large order.
• Cumulative quantity discounts.
• Suitability?

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B4. Pricing decisions

Pricing approaches/strategies
(?) Price discrimination
• Have different prices in different markets for the same
product.
• Suitability?

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B4. Pricing decisions

Pricing approaches/strategies
(?) Relevent cost pricing
• Price = net incremental cash flow.
• Suitability?

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B5. Other short term decisions (based on
relevant costs)
• Relevant costing principles.
• Make v buy decisions.
• Shut down decisions.
• Joint products – the further processing decisions.

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B5. Other short term decisions (based on
relevant costs)
Relevant costing principles
• Include
Future incremental cash flows.
Opportunity costs
• Exclude
Depreciation.
Sunk costs.
Unavoidable costs.
Apportioned fixed overheads.
Financing cash flows (e.g. interest).

Note: You can review ‘relevant costing principles’ in the ‘B1. Relevant cost analysis’

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B5. Other short term decisions (based on
relevant costs)
Make or Buy decision
• Look at future incremental cash flows.
• Watch out for opportunity costs – especially whether or not spare
capacity exists and alternative uses for capacity.
• Practical factors?

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B5. Other short term decisions (based on
relevant costs)
Make or Buy decision
Example:
Shellfish Co makes 04 components W, X, Y and Z, for which cost in the forthcoming year are expected to be
as bellows. W X Y Z
Production (units) 1,000 2,000 4,000 3,000
Unit marginal costs ($) $ $ $ $
Direct materials 4 5 2 4
Direct labour 8 9 4 6
Variable production overhead 8 3 1 2
20 17 7 12

Directly attributable fixed costs per annum and committed fixed costs: $
Incurred as a direct consequence of making W 1,000
Incurred as a direct consequence of making X 5,000
Incurred as a direct consequence of making Y 6,000
Incurred as a direct consequence of making Z 8,000
Other fixed costs (committed) 30,000
50,000

Directly attributable fixed costs are all items of cash expenditure that are incurred as a direct consequence
of making the product in-house.
A subcontractor has offered to supply units of W, X, Y and Z for $12, $21, $10 and $14 respectively. Should
Shellfish make or buy the components?
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B5. Other short term decisions (based on
relevant costs)
Make or Buy decision
Solution:
The relevant costs are the differential costs between making and buying, and they consist of differences in
unit variable costs plus differences in directly attributable fixed costs. Subcontracting will result in some
fixed cost savings.
W X Y Z
$ $ $ $
Variable cost per unit of making 20 17 7 12
Variable cost per unit of buying 12 21 10 14
(8) 4 3 2
Annual requirements 1,000 2,000 4,000 3,000
$ $ $ $
Extra variable cost of buying (8,000) 8,000 12,000 6,000
Fixed cost saved by buying (1,000) (5,000) (6,000) (8,000)
Extra total cost of buying (9,000) 3,000 6,000 (2,000)

In this example, relevant costs are the variable costs of in-house manufacture, the variable costs of
subcontracted units, and the saving in direct fixed costs.

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B5. Other short term decisions (based on
relevant costs)
Shut-down decision
• Look at future incremental cash flows.
• Apportioned overheads not relevant
• Closure costs – e.g. redundancies.
• Alternative uses for resources?
• Practical factors?

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B5. Other short term decisions (based on
relevant costs)
Shut-down decision
Example:
A company manufactures three products, Pawns, Rooks and Bishops. The present net annual income from these is
as follows.
Pawns Rooks Bishops Total
$ $ $ $
Sales 50,000 40,000 60,000 150,000
Variable cost 30,000 25,000 35,000 90,000
Contribution 20,000 15,000 25,000 60,000
Fixed cost 17,000 18,000 20,000 55,000
Profit/loss 3,000 (3,000) 5,000 5,000

The company is concerned about its poor profit performance, and is considering whether or not to cease selling
Rooks. It is felt that selling prices cannot be raised or lowered without adversely affecting net income. $5,000 of
the fixed costs of Rooks are direct fixed costs which would be saved if production ceased (ie there are some
attributable fixed costs). All other fixed costs, it is considered, would remain the same.
By stopping production of Rooks, the consequences would be a $10,000 fall in profits. $
Loss in contribution (15,000)
Direct fixed cost saved 5,000
Incremental loss (10,000)
Therefore, the company shouldn’t cease producing and selling Rooks.
However, what else if the resources realised by stopping production of Rooks switch to producing a new product,
named Crowners, which would sell for $50,000 and incurred variable costs of $30,000 and extra direct fixed costs
of $6,000?
⇒Contribution added by switching to Crowners = ($50,000 - $30,000) - $15,000 = $5,000. Extra direct fixed cost of
switching to Crowners = $6,000 - $5,000 = $1,000 => Extra profit = $5,000 - $1,000 = $4,000. In this situation,
the company should switch from Rooks to Crowners.
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B5. Other short term decisions (based on
relevant costs)
Joint product – the further processing decision
A further processing decision often involves joint products from a
common manufacturing process. The decision is whether to sell the
products at the split-off point, as soon as they emerge from the
common process, or whether they should be processed further before
selling them.
• Look at future incremental cash flows:
• sell at split off v process further and then sell.
• Pre-separation (“joint”) costs not relevant
• only include post split-off aspects.

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B5. Other short term decisions (based on
relevant costs)
Joint product – the further processing decision
Example:
The Poison Chemical Company produces two joint products, Alash and Pottum
from the same process. Joint processing costs of $150,000 are incurred up to the
split-off point, when 100,000 units of Alash and 50,000 units of Pottum are
produced. The selling prices at the split-off point are $1.25 per unit for Alash and
$2.00 per unit for Pottum.
The units of Alash could be processed further to produce 60,000 units of a new
chemical, Alashplus, but at an extra fixed cost of $20,000 and variable cost of 30c
per unit of input. The selling price of Alashplus would be $3.25 per unit. Should
the company sell Alash or Alashplus?

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B5. Other short term decisions (based on
relevant costs)
Joint product – the further processing decision
Example:
Solution:
Only relevant costs and incomes should be compared between selling Alash or Alashplus. We
have the relevant informations as below:
Alash Alashplus
$ $
Selling price 1.25 3.25
Revenue (Alash x 100,000 units; Alashplus x 60,000 units) 125,000 195,000
Incremental costs:
- Fixed cost - 20,000
- Variable cost (30cent per input unit) - 30,000
50,000
Sales minus further processing costs 125,000 145,000

It is more $20,000 profitable to convert Alash into Alashplus.

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B6. Risk and uncertainty in decision making
• Basic concepts.
• Pay-off tables.
• Expected values rule.
• Other decision rules.
• Decision tree.
• Sensitivity analysis.
• Simulation models.

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B6. Risk and uncertainty in decision making
Basic concepts
‘Risk’ and ‘uncertain’ are often used to mean the same thing (events may
or may not occur in the future). However,
RISK UNCERTAIN
• Profitability (Outcome) • Profitability (Outcome)
can be estimated can NOT be estimated
statistically. statistically.
Types of investors’ Obtain more
risk aversion information – one of
approaches to deal
Risk Risk Risk with uncertainty
seeker neutral averse
Market research:
investigate, describe,
A fairly simple approach to assess measure, understand
or explain a situation or
risk and uncertainty: Pay-off table
problem
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B6. Risk and uncertainty in decision making
Pay-off table
Example:
Omelette Co is trying to set a sale price for one of its products. Three prices are under consideration, and
expected sales volumns and costs are as bellows.
Pricing choices Sales demand (units)
$4 Best possible 16,000
Most likely 14,000
Worst possible 10,000
$4.30 Best possible 14,000
Most likely 12,500
Worst possible 8,000
$4.40 Best possible 12,500
Most likely 12,000
Worst possible 6,000

Fixed costs are $20,000 and variable costs of sales are $2 per unit.
Required: Prepare a pay-off table for different possible outcomes for each decision option.

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B6. Risk and uncertainty in decision making
Pay-off table
Example:
Solution: Pay-off table
Sales price $4 $4.30 $4.40
Variable per unit $2 $2 $2
Contribution per unit $2 $2.30 $2.40
Total contribution 14,000
towards fixed costs
Best possible 32,000 32,200 30,000
Most likely 28,000 28,750 28,800
Worst possible 20,000 18,400 14,400

So how does a pay-off table help with reaching a decision?

(a) The highest contribution based on most likely sales volume would be at a price of $4.40. However, it
may be argued that $4.30 would be a much better choice for price than $4.40, since the most likely profit
is almost as good, the worst possible profit is not as bad, and the best possible profit is better.
(b) However, given fixed costs of $20,000, only a price of $4 guarantees that the company would not make
a loss, even if the worst possible outcome occurs. (The fixed costs of $20,000 would just be covered.) A
risk-averse management might therefore prefer a price of $4 to either of the other two prices.
To use a pay-off table to reach a decision, we need to establish the 'rule' or 'criterion' for making the
decision. There are different possible decision criteria or rules, such as the expected value (EV) rule, the
maximin rule, the minimax regret rule, and so on.

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B6. Risk and uncertainty in decision making
Expected value (EV) – one of decision rules/criterion
Weighted average value Rule
of the different outcomes of a Decision based on the highest EV of
decision benefit or lowest EV of cost.

Example:
IB Newsagents stocks a weekly lifestyle magazine. The owner buys the magazines at the beginning of each
week for $0.30 each and sells them at the retail price of $0.50 each.
At the end of the week unsold magazines are obsolete and have no value, so they are discarded as
recycled waste. The estimated probability distribution for weekly demand is shown below.
Weekly demand in units Probability
20 0.20
30 0.55
40 0.25
1.00
The actual demand in each week does not affect the actual demand in the following week.
Required:
If the owner is to order a fixed quantity of magazines per week, how many should that be? Since the
outcomes occur every week, many times over, the EV decision rule is considered appropriate here.
Assume no seasonal variations in demand

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B6. Risk and uncertainty in decision making
Expected value (EV) – one of decision rules/criterion
Example:
Solution:
Start by identifying the different decision options. These are assumed here to be the different buying decisions, with three
options: buy 20 per week, buy 30 per week or buy 40 per week.
The different possible outcomes are the three possibilities for actual demand: 20 units, 30 units or 40 units.
The next step is to set up a decision matrix of possible strategies (numbers bought) and possible demand. The 'pay-off' from
each combination of action and outcome is then computed.
No sale = cost of $0.30 per magazine
Sale = profit of $0.20 per magazine ($0.50 – $0.30)
Pay-off table
Probability Outcome (Demand) Decision
(Buy)
20 30 40
$ $ $
0.20 20 (Worst) 4.00 1.00* (2.00)**
0.55 30 (Likely) 4.00 6.00 3.00***
0.25 40 (Best) 4.00 6.00 8.00
* Buy 30, sell 20 => profit = 20 x $0.50 – 30 x $0.30 = $1.00
** Buy 40, sell 20 => profit = 20 x $0.50 – 40 x $0.30 = ($2.00)
*** Buy 40, sell 30 => profit = 30 x $0.50 – 40 x $0.30 = $3.00

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B6. Risk and uncertainty in decision making
Expected value (EV) – one of decision rules/criterion
Example:
Solution:
Expected value (EV) of each decision

Decision option EV of weekly profit

Buy 20 0.20 x $4.00 + 0.55 x $4.00 + 0.25 x $4.00 $4.00
Buy 30 0.20 x $1.00 + 0.55 x $6.00 + 0.25 x $6.00 $5.00
Buy 40 0.20 x ($2.00) + 0.55 x $3.00 + 0.25 x $8.00 $3.35

The strategy which gives the highest expected value of pay-off is to stock 30 magazines each week.
Note. The expected value of weekly demand in this example is (20 × 0.20) + (30 × 0.55) + (40 × 0.25) = 30.5 copies, but this
does not help with the calculation of the expected value of profit, because the profit is dependent on the purchase quantity
as well as the sales demand quantity.)

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B6. Risk and uncertainty in decision making
Other decision rules
Maximin decision rule Maximax decision rule Minimax regret rule
• least unattractive worst • best possible results. • minimise the regret from
outcome. • maximise the maximum making the wrong decision.
• maximises the minimum profits. profit • Regret is the opportunity lost
through making the wrong
decision.

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B6. Risk and uncertainty in decision making
Decision tree
Decision trees are diagrams which illustrate the choices and possible outcomes of a decision. The
possible outcomes are usually given associated probabilities of occurrence.
Example:
Beethoven Co has a new wonder product, the vylin, of which it expects great things. At the moment the
company has two courses of action open to it, to test market the product or abandon it.
If the company test markets it, the cost will be $100,000 and the market response could be positive or
negative with probabilities of 0.60 and 0.40.
If the response is positive the company could either abandon the product or market it full scale.
If it markets the vylin full scale, the outcome might be low, medium or high demand, and the respective
net gains (losses) would be (200), 200 or 1,000 in units of $1,000 (the result could range from a net loss of
$200,000 to a gain of $1,000,000). These outcomes have probabilities of 0.20, 0.50 and 0.30 respectively.
If the result of the test marketing is negative and the company goes ahead and markets the product,
estimated losses would be $600,000.
If, at any point, the company abandons the product, there would be a net gain of $50,000 from the sale of
scrap. All the financial values have been discounted to the present.
Required:
(a) Draw a decision tree.
(b) Include figures for cost, loss or profit on the appropriate branches of the tree.

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B6. Risk and uncertainty in decision making
Decision tree
Example:
High 0.3
Solution: +1,000

Market Medium 0.5 +200

E
Positive Low 0.2
-200
0.6
C

Test Abandon
-100 +50
B
Negative
Market
0.4 D -600
A Abandon +50

Abandon +50

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B6. Risk and uncertainty in decision making
Sensitivity analysis
Sensitivity analysis is a term used to describe any technique whereby decision
options are tested for their vulnerability to changes in any 'variable', such as
expected sales volume, sales price per unit, material costs and labour costs

• Identify key variables by calculating how much an estimate can change

before the decision reverses.
• Can only vary one estimate at a time.

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B6. Risk and uncertainty in decision making
Sensitivity analysis
Example:
Sensivite Co has estimated the following sales and profits for a new product which it may launch on to the
market.
$ $
Sales (2,000 units) 4,000
Variable costs:
- Material 2,000
- Labour 1,000
3,000
Contribution 1,000
Incremental fixed cost 800
Profit 200
Required: Analyse the sensitivity of the project to the changes in key variable

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B6. Risk and uncertainty in decision making
Sensitivity analysis
Example:
Solution:
a) If incremental fixed cost are more than 25% above estimate (200/800), the project would make a loss.
b) If unit cost of material is more than 10% above estimate (200/2,000), the project would make a loss.
c) Similarly, the project would make a loss if labour cost of unit is more than $200, which is 20% above
to the original estimate
d) Morover, the project would become unprofitable if the selling price is more than 5% (200/4,000)
below the estimate, given no change in sales volumn.
e) Breakeven point = $800/($1,000/2,000 units) = 1,600 units. Therefore, the margin of safety = (2,000 –
1,600)/2,000 = 20%.

Management would then be able to judge more clearly whether the product is likely to be profitable, by
making an assessment of the scale of the uncertainty in the estimates. The items to which profitability is
most sensitive in this example are the selling price (5%) and material costs (10%). Sensitivity analysis can
help to concentrate management attention on the most important factors.

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B6. Risk and uncertainty in decision making
Simulation models
Simulation models can be used to deal with decision problems when there are a large number of
uncertain variables in the situation. Random numbers are used to assign values to the variables.
• Apply probabilities to key factors in scenario analysis.
• Use random numbers to select a particular scenario and calculate outcome.
• Repeat until build up a picture of possible outcomes
• Make decision based on risk aversion.

Note. You will not be required to develop a simulation model in your exam.

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 SUMMARY
OF PART B – DECISION MAKING TECHNIQUES
PART B – DECISION MAKING TECHNIQUES

CONCEPTS / TOOLS DECISION MAKING (SHORT TERM)

RELEVANT COSTS CVP ANALYSIS APPLICATION OF DECIDE optimal PRICING OTHER SHORT
CVP ANALYSIS production structure with DECISIONS TERM DECISIONS
LIMITTING FACTORS
Cash Oppor
Contribution concepts Price Application of
Future Incremental
flow tunity
Decision of Maximum
changing selling One or two limiting elastic of relevant costs
demand? profit?
price factors (easy to identify analysis
Relevant cost of material Break-even point the key factor)
Decision of P=a– Make or Buy?
Material M. used Fixed cost / Key limiting factor analysis MR = MC
No Fixed cost / changing bQ
material in will be for other Contribution or (C/S ratio) production cost Shut down?
storage replaced purposes per unit
Adopt an which has greater ‘Prioritize MR < P
automated or the product contribution per MR = a – Joint product
Replace Net Breakeven point for multiple
Cost of manual approach unit of limited resource’ 2bQ Futher process
ment realized products?
purchase to production decision
cost value Cost plus pricing
Two or more limiting
Margin of safety factors (hard to identify
Relevant cost of labour Etc. the key factor) Skimming pricing
Budgeted output – Breakeven
Direct Contribution point
Linear programming Penetration pricing
labour lost by diverting
cost labour Margin of safety for multiple
products? Feasible region Linking pricing decision
for different products

Relevant cost of using machine Target profit Find optimal point Volumn discounts
by using ‘Iso-profit
User costs (Incremental costs) (Fixed cost + Target profit) / line’ or Relevant cost
Contribution per unit ‘Simultaneous pricing
equations’
Etc
Fall in Target profit for multiple
Hire Shadow price
Repair products?
charge resale
Slack
Decide to accept or not an extra
order? (one of the short term RISK & UNCERTAINTY: HOW TO MEASURE AND MANAGE IN PROCESS OF DECISION
decisions) MAKING?

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PART C. Budgeting

1. The purposes of budgeting

2. Budgeting for planning purpose
3. Budgeting for controlling purpose
4. Budgeting for performance measurement purpose
5. The behavioural aspects of budgeting

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C1. The purposes of budgeting
• Forecasting
• Planning
• Control
• Communication
• Co-ordination
• Evaluation (performance measurement)
• Motivation
• Authorisation and delegation

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C2. Budgeting and planning purpose
• Standard costs (F2)
• Fixed budget (F2)
• Flexible/Flexed budget (F2)
• Budgeting approaches
• Alternatives of datas for budgeting (other approaches)
• Quantitative analysis

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C2. Budgeting and planning purpose
Budgeting approaches

Top-down approach Bottom-up approach

(Impose) (Propose)
• Senior marnagers: set • Lower managers: draft the
Budget targets. budgets at each area that
• Lower managers: target are they are incharged.
then given to the lower • Senior managers: combine
managers in the organization lower budgets into a co-
hierarchy. Lower managers ordinated budget for the
are required to prepare organization as a whole.
budgets that are meet the
targets

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C2. Budgeting and planning purpose
Alternatives of datas for budgeting (other approaches)

Incremental Zero based Activity based

Rolling budgets Beyond budgeting
budgeting budgeting budgeting
•Traditional •Budget of each •The use of Activity •Continuously •Beyond Budgeting
approach for centre should be based costing (ABC) updated throughout is a budgeting model
budgeting. made from ‘scratch’ method as a basis a financial year, by which proposes that
•Budget for the next or zero. for preparing add a further period traditional
year is based on the •Every item of budgets. (say a month or a budgeting should be
actual results of the expenditure must be •Principles of ABB: quarter) abandoned.
current year; justified in its •Plan and control •Reasons for the •Adaptive
adjusted for entirety in order to the causes (cost need of RB: management
expected growth or be included in the drivers). •Organizational processes should be
inflation. next year’s budget. •Not all activities changes used rather than
•IB encourages slack •ZBB reject the add value. •Competitors fixed annual
and wasteful assumption budgets.
•Most departmental •New technology
spending to creep inherent in activities are driven •Move towards
•Enviromantal
into budgets. incremental by demands and developed networks
conditions
budgeting. deicisions beyond rather than
•Inflation centralized
the control of
•Level of activity… hierarchies.
departmental
managers.

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C2. Budgeting and planning purpose
Quantitative analysis in budgeting for planning purpose
1. Identify fixed and variable costs by using quantitative approach, such as ‘high-low
method’ (F2)
2. Learning curve: useful for forecasting production time and labour costs in circumstances
where a workforce makes a new product and improve it efficiency with experience and
learning. The learning effect or learning curve effect describes the speeding up of a job
with repeated performance.
 Learning rate: percentage value, such as 80% learning curve
 Learning effect: a big reduction in time taken to make additional units
3. Expected value (EV) in budgeting Performance
Learning curve
(Review the B6. Risk and uncertainty
in decision making)

Learning time / number of trial

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C2. Budgeting and planning purpose
Quantitative analysis in budgeting for planning purpose
02 Methods to deal with Learning curve scenarios/problems
• The Tabular method: can only be used to calculate average times when cumulative output doubles. A
table can be used to calculate: (i) cumulative average time per unit; (ii) total time to produce all the
units produced so far.
The rule to remember is that every time that cumulative output doubles the average production time is
x% of what is was before, where x is the learning rate.

Example: First unit of a new product requires 100 hours. An 80% learning curve is applied. The production
times would be as follows.
Cumulative Cumulative Cumulative total Incremental Incremental
number of units average time time (hours) number of units total time
per unit (hours) (hours)
1 100.0 100.0 - -
2* 80.0 160.0 1 60.0
4* 64.0 256.0 2 96.0
8* 51.2 409.6 4 153.6

* Output is being doubled at each time.

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C2. Budgeting and planning purpose
Quantitative analysis in budgeting for planning purpose
02 Methods to deal with Learning curve scenarios/problems
• The Algebraic method: The formula for the Learning curve is Y = aXb, where:
 Y: the cumulative average time per unit to produce X units.
 X: the cumulative number of units.
 a: the time taken for the first unit of outputs.
 b: the index of learning (LogLR/log2)
o LR: the learning rate as a decimal

This formula will be provided in the exam paper. It refers to time rather
than labour cost. The formula can also be used to calculate the labour
cost per unit. The labour times are calculated using the curve formula
and then converted to cost.

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C3. Budgeting and controlling purpose
02 processes of controlling:

1. Comparing 2. Taking actions

• Measure actual • Take actions to

results against adjust actual
the plan performance to
achieve or to
change the plan
altogether

=> The essence of control is ‘measurement of results’ and ‘comparing’

them ‘with the original plan’. Any ‘deviation from the plan’ indicates that
‘control actions are required’ to make the ‘results more closely with the
plan’.
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C4. Budgeting and Performance measurement
purpose – A further control
• Fixed budget, Flexible/Flexed budget (F2)
• Budget and standard compare (F2)
• Responsibility accounting: Budget centres, Controllable cost (F2)
• Variance = different between actual results and expected results. It can
be used to provide a guideline for control actions (F2)
• Variance analysis (Further analysis than F2)
• Planning and operational variances

4. Compare 5. Investigate
2. Prepare
1. Set up 3. Measure actual to reasons for
budgets and
standard costs actual budget (e.g via differences and
targets
variances) take action

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C4. Budgeting and Performance measurement
purpose – A further control
Responsibility accounting: Budget centres, Controllable cost
• Responsibility accounting divides the organisation into budget centres,
each of which has a manager who is responsible for its performance.
• The budget is the target against which the performance of the budget
centre or the manager is measured.

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C4. Budgeting and Performance measurement
purpose – A further control
Variance analysis (Basic variances in F2)
Basic Variances

Definitions Variances

Variable
Variance Sales revenue Material cost Labour cost Fixed OHs
variances variances variances production OHs variances
variances
Variance
Selling price Material price Labour rate Var. pro. Ohs. Fixed Ohs
analysis variance variance variance expenditure
expenditure
variance variance
Favourable Sales volumn Material usage Labour efficiency
variance (F) variance variance variance Var. pro. Ohs. Only Absorption
efficiency costing: Fixed
Absorption variance Ohs Volumn
Adverse costing: using variance
variance (A) standard profit

Marginal Fixed Ohs.

costing: using Efficiency
standard variance
contribution
Fixed Ohs.
Capacity
variance

• Investigate the reasons for variances and

• Prepare Pperating statements (for Absoption costing and Marginal costing)
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C4. Budgeting and Performance measurement
purpose – A further control
Variance analysis (Further variance analysis than F2)
• Material usage variance can be divided into:
• Material mix variance and;
• Material yield variance
• Sales volumn variance can be divided into:
• Sales mix variance and;
• Sales quantity variance

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C4. Budgeting and Performance measurement
purpose – A further control
Variance analysis (Further variance analysis than F2)
Material usage variance can be divided into:
• Material mix variance and;
• Material yield variance
when more than one material is used in the product.

Material Mix variance occurs

when the materials are not mixed Material Yield variance arises
or blended in standard because there is a difference
proportions and it is a measure between what the input should
of whether the actual mix is have been for the output
cheaper or more expensive than achieved and the actual input.
the standard mix.

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C4. Budgeting and Performance measurement
purpose – A further control
Variance analysis (Further variance analysis than F2)
Material mix variance and Material yield variance
Example:
A company manufactures a chemical, Dynamite, using two compounds Flash and Bang. The
standard materials usage and cost of one unit of Dynamite are as follows.
$
Flash 5 kg at $2 per kg 10
Bang 10 kg at $3 per kg 30
40
In a particular period, 80 units of Dynamite were produced from 600 kg of Flash and 750 kg
of Bang.
Required:
Calculate the materials usage, mix and yield variances.

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C4. Budgeting and Performance measurement
purpose – A further control
Variance analysis (Further variance analysis than F2)
Material mix variance and Material yield variance
Example
Solution:
(a) Material usage variance. If we don’t calculate the mix and yield variance, we can
calculate the usage variance separately for each material.
Material Standard Actual usage Variance Standard Variance
usage for price per kg
actual units
kg kg kg $ $
Flash 400 600 200 (A) 2 400 (A)
Bang 800 750 50 (F) 3 150 (F)
Total 1,200 1,350 250 (A)

The material usage variance can be analysed into a mix variance and a yield variance; and
these can be reported instead of the material usage variance.

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C4. Budgeting and Performance measurement
purpose – A further control
Variance analysis (Further variance analysis than F2)
Material mix variance and Material yield variance
Example
Solution:
b) Material mix variance

Material Actual Standard mix Variance Standard Variance

usage/mix in actual price per kg
usage (5:10
or 1:2)
Kg kg kg $ $
Flash 600 450 150 (A)* 2 300 (A)
Bang 750 900 150 (F)** 3 450 (F)
Total 1,350 1,350 150 (F)

* Actual uses more of Flash

** Actual uses less of Bang

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C4. Budgeting and Performance measurement
purpose – A further control
Variance analysis (Further variance analysis than F2)
Material mix variance and Material yield variance
Example
Solution:
c) Material yield variance
The weighted average cost per kg of materials = $40 / 15kg = $2.67 per kg.
80 units of product needs in total 1,200 kg
They did actually use 1,350 kg
Yield variance in kg 150 kg (A)
Weighted average standard price $2.67
Yield variance in $ $400 (A)

=> The material usage variance = Mix variance + Yield variance = $150 (F) + $400 (A) = $250
(A)

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C4. Budgeting and Performance measurement
purpose – A further control
Variance analysis (Further variance analysis than F2)
Sales volumn variance can be divided into:
• Sales mix variance and;
• Sales quantity variance
when more than one type of product is sold.

Sales quantity variance

Sales Mix variance occurs
shows the difference in
when the proportion of the
contribution/profit because
various products sold is
of a change in sales volume
different from those in the
from the budgeted volume
budget
of sales.

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C4. Budgeting and Performance measurement
purpose – A further control
Variance analysis (Further variance analysis than F2)
Sales mix variance and Sales quantity variance
Example
Just Desserts Limited makes and sells two products, Chocolate Crunch and Strawberry Sundae. The
budgeted sales and profit are as follows.

Product Sales units Revenue Costs Profit Profit per unit

Units $ $ $ $
Chocolate Crunch (CC) 400 8,000 6,000 2,000 5
Strawberry Sundae (SS) 300 12,000 11,100 900 3
Total 2,900

Actual sales were 280 units of Chocolate Crunch and 630 units of Strawberry Sundae. The company
management is able to control the relative sales of each product through the allocation of sales effort,
advertising and sales promotion expenses.
Required
Calculate the sales volume variance, the sales mix variance and the sales quantity variance.

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C4. Budgeting and Performance measurement
purpose – A further control
Variance analysis (Further variance analysis than F2)
Sales mix variance and Sales quantity variance
Example
Solution:
a) Sales volumn variance
Product Budgeted sales Actual sales Variance Profit per Variance in
unit
Units Units Units $ $
Chocolate Crunch (CC) 400 280 120 (A) 5 600 (A)
Strawberry Sundae (SS) 300 630 330 (F) 3 990 (F)
Total 390 (F)

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C4. Budgeting and Performance measurement
purpose – A further control
Variance analysis (Further variance analysis than F2)
Sales mix variance and Sales quantity variance
Example
Solution:
b) Sales mix variance
Product Actualsales Actual sales at Variance Profit per Variance in
expected unit
proportion
(4:3)
Units Units Units $ $
Chocolate Crunch (CC) 280 520 240 (A) 5 1,200 (A)
Strawberry Sundae (SS) 630 390 240 (F) 3 720 (F)
Total 910 910 0 480 (A)

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C4. Budgeting and Performance measurement
purpose – A further control
Variance analysis (Further variance analysis than F2)
Sales mix variance and Sales quantity variance
Example
Solution:
c) Sales quantity variance
The weighted average profit of 2 products = $2,900 / 700 products = $29/7 per unit.
Budgeted sales in total 700 units
They did actually sold 910 unit
Quantity variance in unit 210 units (F)
Weighted average standard price $29/7
Quantity variance in $ $870 (F)

=> The sales volumn variance = Sales Mix variance + Sales quantity variance = $480 (A) + $870 (F) = $390
(F)

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C4. Budgeting and Performance measurement
purpose – A further control
Planning variances and operational variances
(?) The nature of planning and operational variances

3. Planning variance:
1. Uncertainty happened, 2. We need to revise the operational managers
some of them were not budget or standard cost to should not be made
responsibility of a find out what operational responsible
operational managers managers should be Operational variance:
(beyond their control) responsible or not operational managers
should be made responsible

Revised
budget???

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C4. Budgeting and Performance measurement
purpose – A further control
Planning variances and operational variances
• Planning and operational variances for sales
• Planning and operational variances for materials
• Planning and operational variances for labour

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C4. Budgeting and Performance measurement
purpose – A further control
Planning variances and operational variances
• Planning and operational variances for sales
 Planning variances for sales = Market size variance
 Operational variance for sales = Market share variance
Example
Dimsek budgeted to make and sell 400 units of its product, the Role, in the four-week period no. 8, as
follows.
$
Budgeted sales (100 units per week) 40,000
Variable costs (400 units x $60) 24,000
Contribution 16,000
Fixed costs 10,000
Profit 6,000
At the beginning of the second week, production came to a halt because inventories of raw materials ran
out, and a new supply was not received until the beginning of week 3. As a consequence, the company lost
one week's production and sales.

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C4. Budgeting and Performance measurement
purpose – A further control
Planning variances and operational variances
• Planning and operational variances for sales
Example
Actual results in period 8 were as follows.
$
Sales (320 units) 32,000
Variable costs (320 units x $60) 19,200
Contribution 12,800
Fixed costs 10,000
Actual profit 2,800
In retrospect, it is decided that the optimum budget, given the loss of production facilities in
the third week, would have been to sell only 300 units in the period.
Required
Calculate appropriate planning and operational variances for sales volume.

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C4. Budgeting and Performance measurement
purpose – A further control
Planning variances and operational variances
• Planning and operational variances for sales
Example
Solution:
a) Sales volumn planning variance = Revised budget – original budget = Market size variance
Revised sales volumn, given material shortage 300 units
Original budgeted sales volumn 400 units
Planning variance (market size variance) in units 100 units (A)
X Standard contribution per unit ($16,000 / 400 units) $40
Planning variance (market size variance) in $ $4,000 (A)
b) Sales volumn operational variance = Actual – Revised budget = Market share variance
Revised sales volumn 300 units
Actual sales volumn 320 units
Operational variance (market share variance) in units 20 units (F)
X Standard contribution per unit ($16,000 / 400 units) $40
Operational variance (market share variance) in $ $800 (F)

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C4. Budgeting and Performance measurement
purpose – A further control
Planning variances and operational variances
• Planning and operational variances for sales
Example
Solution:
In case, fixed cost did not change (no fixed cost variance), we can prepare an operating
statement as bellows.
$ $
Budgeted profit 6,000
Planning variance: sales vol. $4,000 (A)
Opertional variance: sales vol. $800 (F)
$3,200 (A)
Actual profit $2,800

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C4. Budgeting and Performance measurement
purpose – A further control
Planning variances and operational variances
• Planning and operational variances for sales
Example
Summary: Revised budget
(Change in standard
Fixed budget Volumn) Flexed budget Actual results
400 units 300 units 320 units 320 units

Sales vol. planning var. = Sales vol. operational Sales price var. = (Actual
(Revised units – Original var. = (Actual units – price – Standard price) x
units) x Standard Revised units) x Standard Actual unit = $0
contribution = $4,000 (A) contribution = $800 (F)

Sales vol. var. = (Actual units – Original

units) x Standard contribution = $3,200 (A)

Total Sales var. = $3,200 (A)

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C4. Budgeting and Performance measurement
purpose – A further control
Planning variances and operational variances
• Planning and operational variances for sales
(?) Planning and operational variances for sales price???

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C4. Budgeting and Performance measurement
purpose – A further control
Planning variances and operational variances
• Planning and operational variances for materials
Planning and operational variances can be reported for direct materials, when the standard cost is revised for the
material price, material usage per unit, or both
Example
Product X had a standard direct material cost in the budget of:
4 kg of Material M at $5 per kg = $20 per unit.
Due to disruption of supply of materials to the market, the average market price for Material M during the
period was $5.50 per kg, and it was decided to revise the material standard cost to allow for this.
During the period, 6,000 units of Product X were manufactured. They required 26,300 kg of Material M,
which cost $139,390.
Required
Calculate:
(a) The material price planning variance
(b) The material price operational variance
(c) The material usage (operational) variance

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C4. Budgeting and Performance measurement
purpose – A further control
Planning variances and operational variances
• Planning and operational variances for materials
Example
Solution:
a) The material price planning variance

Standard material price $5

Revised material price, due to disruption of supply $5.5
Material price planning variance, in a unit $0.5 (A)
X Actual usage 26,300 kg
Material price planning variance $13,150 (A)

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C4. Budgeting and Performance measurement
purpose – A further control
Planning variances and operational variances
• Planning and operational variances for materials
Example
Solution:
b) The material price operational variance

Actual material price ($139,390 / 26,300 kg) $5.3

Revised material price $5.5
Material price operational variance, per unit $0.2 (F)
X Actual usage 26,300 kg
Material price operational variance $5,260 (F)

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C4. Budgeting and Performance measurement
purpose – A further control
Planning variances and operational variances
• Planning and operational variances for materials
Example
Solution:
c) The material usage (operational) variance

6,000 units should use (x4kg) 24,000 kg

They did used 26,300 kg
Material operational variance, in kg 2,300 kg (A)
Standard material price $5
Material operational variance, in $ $11,500 (A)

⇒Total material variance = material price planning var. + material price operational var. material usage
(operational) variance = $13,150 (A) + $5,260 (F) + $11,500 (A) = $19,390 (A)
Check:
6,000 units at standard material cost (x $20) $120,000
Actual material cost $139,390
Total material variance $19,390 (A)
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C4. Budgeting and Performance measurement
purpose – A further control
Planning variances and operational variances
• Planning and operational variances for materials
Example
Summary: Revised budget
(Change in
Fixed budget Flexed budget Actual usage x standard price) Actual results
6,000 units original price 6,000 units 6,000 units

Material usage var. Material price planning Material price operational

= (Actual usage – var. = (Revised price – var. = (Actual price – revised
Standard usage at Original price) x Actual price) x Actual usage = ($5.3 -
actual units) x usage = ($5.5 - $5) x $5.5) x 26,300 kg = $5,260 (F)
Original price = 26,300 kg = $13,150 (A)
(26,300 kg – 24,000)
x $5 = $11,500 (A)
Material price var. = (Actual
price – original price) x Actual
usage = ($5.3 - $5.0) x 26,300
kg = $7,890 (A)

Total material var. = $19,390 (A)

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C4. Budgeting and Performance measurement
purpose – A further control
Planning variances and operational variances
• Planning and operational variances for labour
Planning and operational variances can be reported for direct labour, when the standard cost is revised for the
labour rate per hour, the standard labour time per unit, or both.
Example
A company makes a single product. At the beginning of the budget year, the standard labour cost was
established as $8 per unit, and each unit should take 0.5 hours to make. => Standard labour rate per hour
= $8 / 0.5 hours = $16 per hour.
However, during the year, the standard labour cost was revised. A new quality control procedure was
introduced to the production process, adding 20% to the expected time to complete a unit. In addition,
due to severe financial difficulties facing the company, the workforce reluctantly agreed to reduce the rate
of pay to $15 per hour.
In the first month after revision of the standard cost, budgeted production was 15,000 units but only
14,000 units were actually produced. These took 8,700 hours of labour time, which cost $130,500.
Required
Calculate the labour planning and operational variances in as much detail as possible.

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C4. Budgeting and Performance measurement
purpose – A further control
Planning variances and operational variances
• Planning and operational variances for labour
Example
Solution:
A new quality control procedure was applied and severe financial difficulties are beyond the control of
operational managers, therefor, they don’t need to take any responsibility on variances were made by
above reasons.
- Labour hour (efficiency) planning variance?
- Labour rate planning variance?
And:
- Labour hour (efficieny) operational variance?
- Labour rate operational variance?

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C4. Budgeting and Performance measurement
purpose – A further control
Planning variances and operational variances
• Planning and operational variances for labour
Example
Solution:
- Labour rate planning variance?
Standard labour rate $16 per hour
Revised labour rate $15 per hour
Labour rate planning var., in $/hour $1 per hour (F)
X Actual labour hours worked 8,700 hours
Labour rate planning var., in $ $8,700 (F)

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C4. Budgeting and Performance measurement
purpose – A further control
Planning variances and operational variances
• Planning and operational variances for labour
Example
Solution:
- Labour hour planning variance?
Standard labour hour per unit 0.5 hour
Revised labour hour per unit (adding 20%) 0.6 hour
Labour efficiency planning var., in hour 0.1 hour (A)
X Standard rate at actual production units $224,000 ($16 x 14,000 units)
Labour efficiency planning var., in $ $22,400 (A)

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C4. Budgeting and Performance measurement
purpose – A further control
Planning variances and operational variances
• Planning and operational variances for labour
Example
Solution:
- Labour rate operational variance?
8,700 hours should cost (x revised standard $15) $130,500
They did cost $130,500
Labour rate operational variance $0
- Labour hour operational variance?
14,000 units should take (x revised standard 0.6 hour) 8,400 hours
They did take 8,700 hours
Labour hour operational variance, in hours 300 hours (A)
X Original standard rate $16
Labour hour operational variance, in $ $4,800 (A)
⇒Total labour cost variance = $8,700 (F) + $22,400 (A) + $0 + $4,800 (A) = $18,500 (A)
Check:
Actual labour cost $130,500
Original standard cost at actual units $112,000 ($8 x 14,000 units)
$18,500 (A)
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 C4. Budgeting and Performance measurement
purpose – A further control
Planning variances and operational variances
• Planning and operational variances for labour
Example => Summary
Fixed Actual hours
Flexed Budget Revised Budget Revised Budget Actual result
worked x
Budget 14,000 units (Change in standard Original (Change in standard 14,000 units
15,000 units hours) standard rate price)

Actual units x Actual units x $139,200 Actual hours worked x Actual hours
Original standard Revised standard Revised standard rate worked x
hours. x hours x = $130,500 Actual rate
Original standard rate Original standard rate = $130,500
= $112,000 = $134,400

Labour efficiency Labour efficiency Labour rate planning Labour rate

planning var. = operational var. = var. = $8,700 (F) operational var. = $0
$22,400 (A) $4,800 (A)

Labour efficiency var. Labour rate var. =

= $27,200 (A) $8,700 (F)

Total labour cost var.

= $18,500 (A)
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C5. Behavioural aspects of Budgeting
Key issues
• Dysfunctional behaviour – want goal congruence.
• Budgetary slack.
Management styles (Hopwood)
• Budget constrained
• Profit conscious
• Non-accounting

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C5. Behavioural aspects of Budgeting
Target setting and motivation
• Expectations v aspirations
• Ideal target?
• Targets should be:
 communicated in advance
 dependent on controllable factors
 based on quantifiable factors
 linked to appropriate rewards
 chosen to ensure goal congruence.

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C5. Behavioural aspects of Budgeting
Participation
Advantages of participative budgets
• Increased motivation
• Should contain better information,
• Increases managers’ understanding and commitment
• Better communication
• Senior managers can concentrate on strategy.

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C5. Behavioural aspects of Budgeting
Participation
Disadvantages of participative budgets
• Loss of control
• Inexperienced managers
• Budgets not in line with objectives
• Budget preparation slower and disputes can arise
• Budgetary slack
• Certain environments may preclude participation

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C6. Modern manufacturing enviroments and
Planning and Controlling
Total Quality Management (TQM)
• TQM is the continuous improvement in quality, productivity and effectiveness
through a management approach focusing on both process and the product.

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C6. Modern manufacturing enviroments and
Planning and Controlling
Just-in–time (JiT)
• JIT is a pull-based system of planning and control.
• Pulling work through the system in response to customer demand.
• Goods are only produced when they are needed.
• This eliminates large inventories of materials and finished goods.

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 SUMMARY
OF PART C – BUDGETING
PART C - BUDGETING

MEASURING PERFORMANCE – A FURTHER BEHAVIOURAL MORDERN

PLANNING CONTROLLING
CONTROL ASPECTS OF MANUFACTURING
1.1. Measure BUDGETTING ENVIRONMENTS
1.2. Prepare Types of budgets: Fixed budget, flexible/flexed
actual results AND PLANNING &
budgets (Flexible budget, revised budget?
1.1. Set up against the plan CONTROL
budgets) Motivation
standard Budget and standard compared?
1.2. Take action
1. 02 processes
cost 1.3. Choose one
to implement to (feedback):
Responsibility accounting Participation TQM JIT
(Fixed budgets) adjust actual
performance
Budget centres Controllable cost
2.1. Top – 2.2. Bottom-up to Achieve
down approach approach the plan, or Variance = Actual results – Expected results
Change the => Variance provides a guideline for control
3. Alternatives of Budgeting plan action
altogether
Variance analysis
Incremental Budgeting
2. The essence of Basic analysis (F2)
Zero based Budgeting control is
measurement of
Activity based Budgeting Further analysis
results and comparing
Rolling Budgets them with the original
Mix material or Mix product
(Continuous) plan. Any deviation
from the plan indicates Material usage Sales volumn var.
Beyond Budgeting that control action is var. = Material = Sales mix var. +
required to make the mix var. + Sales quantity
High – Low method results more closely
analysis in planning

Material yield var. var.

for identifying variable with the plan.
4. Quantitative

and budgeting

When we rivise budgets => Planning and

and fixed costs
Operational Var. for:
Learning curves for
budgeting labour cost Sales Materials Labours
Expected value (EV)
in uncertainty

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PART D. Performance measurement and
Control
• Ratio analysis.
• NFPIs.
• Behavioural considerations.
• Divisional performance and transfer pricing
• Performance measurement and not-for-profit organisations

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D1. Ratio analysis
Preliminaries
• Ratios may not be representative of the position throughout a period.
• Need a basis for comparison.
• Ratios can be manipulated
• Ratios indicate areas for further investigation rather than giving answers.

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D1. Ratio analysis
Profitability ratios
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
• ROCE = × 100%
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒
𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚
• Gross marin = × 100%
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝑁𝑁𝑁𝑁𝑁𝑁 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
• Net margin = × 100%
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
• Asset turnover = × 100%
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒
• Return on capital employed (ROCE) = Asset turnover × Net margin

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D1. Ratio analysis
Liquidity / working capital ratios
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
• Current ratio = × 100%
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙
𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
• Quick ratio = × 100%
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙
Quick assets = Current assets - Inventory
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
• Receivables days = × 365
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
• Payables days = × 365
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
• Inventory days = × 365
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠

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D1. Ratio analysis
Ratios to measure risk
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
• Financial gearing =
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
• Financial gearing =
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 +𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸

𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑡𝑡𝑡𝑡𝑡𝑡 (𝑃𝑃𝑃𝑃𝑃𝑃)

• Dividend cover =
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑎𝑎𝑎𝑎𝑎𝑎 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 (𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃)
• Interest cover =
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼

𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
• Operating gearing =
𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
• Operating gearing =
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

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D2. Non-financial performance indicators
• Financial performance appraisal often reveals the ultimate effects of operational
factors and decisions but non-financial indicators are needed to monitor causes.
• Critical success factors often non-financial
• Stakeholder objectives may also be non-financial

Balanced Buiding
Scorecard Block Model

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D3. Behavioural aspects
Measures designed to assess performance should
• provide incentives to promote goal congruence.
• only incorporate factors for which the manager can be held responsible.
• recognise both financial and non financial aspects of performance.
• recognise longer-term, as well as short term, objectives.

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D3. Behavioural aspects
Potential problems with inappropriate measures
• manipulation of information provided by managers
• demotivation and stress-related conflict
• excessive concern for control of short term costs, possibly at the expense of
longer-term profitability.

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D4. Devisional performance and Transfer
pricing
• Transfer pricing.
• Divisional performance measurement.

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D4. Devisional performance and Transfer
pricing
Transfer pricing
Objectives
• Goal congruence
• Performance measurement.
• Autonomy.
• Minimising global tax liability.
• To record the movement of goods and services.
• Fair split of profit between divisions.

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D4. Devisional performance and Transfer
pricing
Transfer pricing
Exam question
Will often be given a TP and asked to comment. Look at the following.
• Implications for divisional performance – e.g. is a target ROI achieved?
• Resulting manager behaviour - does it give dysfunctional decision
making – e.g. will a manager reject a new product that is acceptable to
the company as a whole?

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D4. Devisional performance and Transfer
pricing
Transfer pricing
General rules
• TP = marginal cost + opportunity cost
• In a perfectly competitive market,
TP = market price.
• If spare capacity exists,
TP = marginal cost.
• With production constraints,
TP = marginal cost + opportunity cost of not using those resources elsewhere.

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D4. Devisional performance and Transfer
pricing
Transfer pricing
Practial transfer pricing systems
• Market price
• Production cost + mark-up
• Negotiation

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D4. Devisional performance and Transfer
pricing
Divisional performance measurement
Key considerations
• Manager or division?
• Type of division.
• Cost centre
• Profit centre
• Investment centre

Return on
Residual
investment
income (RI)
(ROI)

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D5. Performance measurement and not-for-
profit organisations
• Objectives.
• Performance Measurement.

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D5. Performance measurement and not-for-
profit organisations
Objectives
Planning for NFPs usually more complex.
• Multiple objectives
• Difficult to quantify objectives
• Conflicts between stakeholders
• Difficult to measure performance
• Different ways to achieve the same objective
• Objectives may be politically driven

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D5. Performance measurement and not-for-
profit organisations
Performance measurement
Value for money (VFM)
• Effectiveness
• Efficiency
• Economy

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D6. Performance measurement information
systems
• Systems
• Sources of management information
• Management reports

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SUMMARY
OF PART D – PERFORMANCE MEASUREMENT AND CONTROL
PART D – PERFORMANCE MEASUREMENT AND CONTROL

Non-financial performance Behavioural Divisional PM for not-for-

Ratio analysis PM information
indicators aspects performance and profit
systems
Transfer pricing organisations
Profitability ratios Design appropriate
Building
Balanced measures Divisional
ROCE Block performance
Effectiveness Planning levels
Scorecard
Model
Gross margin
ROI RI Efficiency
Net margin Design of system
Asset turnover
Economy Informations
Transfer pricing (Source, cost,
Liquidity / Working capital
ratios type, assess?)

Current ratio
Quick ratio
Receivables days
Payables days
Inventory days

Ratios to measure risk

Financial gearing
Dividend cover
Interest cover
Operating gearing

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