3.2 ADVANCED MAMANGEMENT ACCOUNTING……..
Purpose:…………………………………………………………………… 7 LEARNING CONTENTS…………………………………………………. 7 UNIT 1.0……………………………………………………………………11 CAPITAL INVESTMENT APPRAISAL……………………………….. 11 Element 1.1 Investment Appraisal Methods………………………………….. 11 Element 1.1.1 Net Present value…………………………………………. 12 Element 188.8.131.52 Discount Facts/Interest Rate……………………………. 12 Element 184.108.40.206 NPV and the Agency Theory………………………….. 12 Element 220.127.116.11 Assumption In Net Present Value………………………. 12 Element 18.104.22.168 Net Present Value, Risk and Uncertainly……………… 14 Element 1.1.2 Internal Rate of Return………………………………….... 16 Element 22.214.171.124 Decision Criteria In Internal Rate Return………………. 17 Element 126.96.36.199 The Reinvestment Assumptions………………………... 17 Element 188.8.131.52 Multiple IRR (Multiple Yields)………………….……... 22 Element 184.108.40.206 Internal Rate Of Return For Projects With Unequal Lines…... 24 Element 1.1.3 Payback Period Method…………………………………... 25 Element 220.127.116.11 Limitation Payback Period Method…………………….. 26 Element 18.104.22.168 Discounted Payback Period…………………………….. 26 Element 1.1.4 The Accounting Rate Of Return (ARR)………………….. 27 Element 1.2 Capital Replacement……………………………………….. 33 Element 1.3 Capital Rationing…………………………………………… 35 Element 1.4 Effect Of Taxation On Investment Appraisal…………….. 38 Element 1.4.1 Discounting Methods……………………………………… 38 Element 1.4.2 Annuities…………………………………………………... 39 Element 1.4.3 The Basic Perpetuity………………………………………. 41 Element 1.4.4 Perpetuity With Constant Growth………………………….41 Element 1.4.5 The Net Present Value Format……………………………..43 Element 1.4.6 The relevant Cash Flows…………………………………...44 Element 1.5 Effects of Inflate On Investment Appraisal………………..45 Element 1.5.1 Adjusting the discount Rate……………………………….. 47 Element 1.6 Treatment Of Leasing And Hire Purchase Transactions... 55 Element 22.214.171.124 Advantages of leasing…………………………………… 55 Element 126.96.36.199 Tax Benefits to The leaser………………………………. 56 Element 188.8.131.52 Tax Benefit To The Lessee……………………………… 56 Element 1.6.2 Types Of Leases……………………………………………57 Element 184.108.40.206 Finance Lease…………………………………………… 57 Element 220.127.116.11 Operating Leaser………………………………………… 58 Element 1.6.3 features Of Leases ………………………………………… 58 Element 1.7 Cost-Benefit Analysis………………………………………..64 Element 18.104.22.168 Structured And Unstructured Decisions………………… 64 Element 22.214.171.124 Goal Congruence And Decision Making………………... 64 Element126.96.36.199 Nature Of cost-Benefit Analysis…………………………. 64 Element 188.8.131.52 Cost-Benefit Analysis Techniques……………………….65 1
Element 184.108.40.206 Profitability/Net Cash-Flow……………………………... 65 Element220.127.116.11 Scoring And Ranking……………………………………..65 Element 18.104.22.168 Mechanics Of Scoring And Ranking……………………. 65 Element 1.72 Post Project Completion Audit…………………………….. 68 Element 22.214.171.124 Benefits Of Post-Completion Auditing…………………..68 Element 126.96.36.199 Mechanics Of Post-Completion Audit………………… 69 UNIT 2.0…………………………………………………………………... 70 PRICING THEORY……………………………………………………… 70 Element 2.1Cost Plus Pricing…………………………………….. ……... 71 Element 2.2 Marginal Pricing……………………………………………. 72 Element 2.2.1 Full Cost Versus Marginal Cost Pricing………………….. 75 Element 2.2.2 Activity Based Pricing (ABP)……………………………..77 Element 2.3 Target Pricing………………………………………………. 80 Element 2.3.1 Managerial Thinking To Support Target Costing And Pricing…81 Element 2.4 Life Cycle Pricing…………………………………………... 82 Element 2.5 Other Pricing Methods……………………………………... 84 Element 2.5.1 Order Pricing………………………………………………84 Element 2.5.2 Minimum Pricing…………………………………………. 84 Element 2.5.3 Market Penetration Pricing……………………………….. 85 Element 2.5.4 Market Skimming Pricing………………………………… 85 Element 2.5.5 Differential Pricing……………………………………….. 86 Element 2.5.6 Adjusted Market Price……………………………………. 88 Element 2.5.7 Cost-Based Approaches To Transfer Pricing…………….. 88 Element 2.6 Changes In Price Levels…………………………………… Element 2.7 Transfer Pricing Theory…………………………………… 90 Element 2.7.1Transfer Pricing Based On Opportunity Cost……………... 92 Element 2.7.2 Transfer Pricing When Unit Variable costs And Sales Prices are not constant………………………………………………… 92 Element 2.7.3 Problems In Transfer Pricing……………………………... 93 Element 2.7.4 Negotiated Transfer Prices………………………………...93 Element 2.7.5 International Transfer Prices……………………………… 94 Element 2.7.6 Using Transfer Prices……………………………………...94 Element 2.7.7 Centrally Determined Transfer Prices And Strategy……... 95 Element 2.7.8 The Eccles matrix………………………………………… 95 UNIT 3.0…………………………………………………………………... 97 COST ANALYSIS………………………………………………………... 97 Element 3.1 Cost Reductions………………………………………………. 105 Element 3.1.1 Traditional Cost-Reduction Programs……………………. 106 Element 3.1.2 Examination Of Current Activities……………………….. 106 Element 188.8.131.52 Over-Resourced Activity……………………………….. 107 Element 184.108.40.206 Inefficiently Managed Activities……………….. ……... 107 Element 220.127.116.11 Value Added And Non-Value Added Activities……….. 107 Element 3.1.3 Zero-Based Budgeting……………………………………. 109
Element 3.1.4 Timing And Focus Of Cost Reduction Programmes…….. 112 Element 3.2 Cost Control………………………………………………… Element 3.3 Value Analysis………………………………………. ……... 112 Element 3.3.1 Functional Analysis………………………………………. 116 Element 3.4 Value Engineering………………………………………….. Element 3.5 Activity Based Costing……………………………………... 117 Element 3.6 Total Quality Management………………………………… UNIT 4.0……………………………………………………………………126 MEASURES OF PERFORMANCE…………………………………….. 126 Element 4.1Balanced Score Card………………………………………... 126 Element 4.1.1 Growth In Non-Functional Measures…………………….. 126 Element 4.1.2 Balanced Score Card In Detail…………………………….127 Element 4.1.3 The Four Perspectives…………………………….. ……... 128 Element 4.2 Value For Money (Performance Measures For Net-For-Profit
Element 4.2.1 Nature Of A Net-For-Profit Organizations……………….. 132 Element 4.2.2 Nature of Performance Measurements in Not-For-Profit Organisations…………………………………………….. 132 Element 4.2.3 The Three Es (Effectiveness, Efficiency, Economic)…….. 133 Element 4.3 Financial Performance Measures…………………………. Element 4.4 Non Financial Performance Measures……………………. Element 4.5 Divisional Performance Measures………………………….134 Element 4.6 Benchmarking………………………………………………. 139 Element 4.6.1 Steps in Benchmarking…………………………………… 140 Element 4.6.2 Information Gathering……………………………………. 140 Element 4.6.3 Financial Statement And Reverse Engineering…………... 140 Element 4.6.4 Other Sources Of Information……………………………. 140 Element 4.6.5 Types Of Benchmarking………………………………….. 141 Element 4.6.6 Benefits of Benchmarking………………………………... 142 Element 4.6.7 Pitfalls Of Benchmarking………………………………… 142 Element 4.7 Behavioural Effects Of Performance Measurement………. UNIT 5.0…………………………………………………………….…….. 143 DECISION MAKING TECHNIQUES…………………………………. 143 Element 5.1 Sensitivity Analysis ………………………………………… 143 Element 5.1.1 Problems With Sensitivity Analysis……………………… 146 Element 5.1.2 Application Of Sensitivity Analysis In Project Appraisal... 149 Element 5.2 Learning Curve Theory……………………………………. Element 5.3 Linear Programming……………………………………….. 149 Element 5.4 Decision Trees………………………………………………. 164 Element 5.4.1 Notation Of A Tree Diagram……………………………... 166 Element 5.4.2 Qualitative Factors In Decision Making………………….. 169 Element 5.4.3 Identifying And calculating Relevant Costs……………… 170 Element 5.5 Uncertainty And Risk Analysis…………………………….
Element 5.6 Multi-product Cost Volume Profit Analysis……………… UNIT 6.0…………………………………………………………………... 183 BUDGETING AND BUDGETING CONTROL………………………... 183 Element 6.1 The Budget Process………………………………………….184 Element 6.1.1 The Budget Committee…………………………………… 184 Element 6.1.2 The Budget Officer……………………………………….. 184 Element 6.1.3 Role Of Budget Officer……………………………………184 Element 6.1.4 The Budgeting Manual…………………………………… 184 Element 6.1.5 The Principle Budget Factor……………………………… 185 Element 6.2 Types Of Budget……………………………………………. 185 Element 6.2.1 Functional Budget………………………………………… 185 Element 18.104.22.168 The Sales Budget……………………………………….. 186 Element 22.214.171.124 The Production Budget…………………………………. 187 Element 126.96.36.199 Labour Budget………………………………………….. 191 Element 6.2.2 Cash Budget………………………………………..……... 193 Element 188.8.131.52 Advantages of cash Budget…………………………….. 206 Element 6.3 Flexible Budgets…………………………………………….. Element 6.4 Behavioural Aspects Of Budgeting………………………... 206 Element 6.4.1 General Behavioural Budgeting…………………………...206 Element 6.4.2 Motivation………………………………………………… 207 Element 6.4.3 Poor Attitude When Setting Budgets……………………... 207 Element 6.4.4 Poor Attitude When Implementing budgets……………… 207 Element 6.4.5 Poor Attitude When Utilizing Budgeting Control information… 208 Element 6.4.6 Styles of Budgeting……………………………………….. 208 Element 184.108.40.206 Imposed Style of Budgeting……………………………. 208 Element 220.127.116.11 Participation Style of Budgeting………………………... 210 Element 18.104.22.168 Negotiated Style of Budgeting………………………….. 210 Element 6.4.7 The Management Accountant and motivator……………...211 Element 6.5 Applications Of Information In budgeting Preparation…. 214 Element 6.5.1 Merits of Using Computer Spreadsheets…………………. 214 Element 6.5.2 Limitations of Spreadsheets………………………………. 214 Element 6.5.3 Budgeting Software………………………………………. 215 UNIT 7.0…………………………………………………………………... 216 MORDEN BUSINESS ENVIROMENT…………………….…………... 216 Element 7.1 The Changing Business Environment……………………...216 Element 7.1.1 Changing Customers Needs For Changing goods………... 216 Element 7.1.2 Changing customer demands For High Quality Goods…... 217 Element 7.1.3 Increase In Operational Overheads……………………….. 217 Element 7.1.4 De-Regulation of Industries………………………………. 217 Element 7.1.5 Intensity In Competition And Globalisation……………… 217 Element 7.1.6 Shortened Product Life Cycle…………………………….. 218 Element 7.2 Production Management Strategies……………………….. 218 Element 7.2.1 Just-In-Time Production Systems………………………… 218
Element 7.2.2 Dedicated Cell Layout……………………………………. 218 Element 7.2.3 Computer-Aided design (CAD)…………………………... 219 Element 7.2.4 Computer-Added Manufacturing (CAM)………………… 219 Element 7.3 World Class Manufacturing Techniques…………………. 220 Element 7.3.1 Automated Manufacturing Techniques (AMT)…………... 220 Element 7.3.2 Synchronized Manufacturing Systems…………………… 220 Element 7.3.3 Flexible Manufacturing Systems…………………………. 220 Element 7.3.4 Computer Controlled Machinery…………………………. 220 Element 7.3.5 Automated Storage And Retrieval Systems……………….221 Element 7.3.6 Material Requirement Plan (MRP)……………………….. 221 Element 7.3.7 Enterprise Resource Planning (ERP)……………………... 221 Element 7.4 Product Life Cycle………………………………………….. 222 Element 7.4.1 Concept Of Product Life Cycle…………………………... 222 Element 7.4.2 Introduction stage………………………………………… 222 Element 7.4.3 Growth Stage……………………………………………... 222 Element 7.4.4 Maturity stage…………………………………………….. 222 Element 7.4.5 Decline stage……………………………………………… 222 Element 7.4.6 Cost Implication For The Product Life Cycle……………. 223 Element 7.4.7 Implications Of The Product Life cycle On The Advanced Manufacturing Technology Environment………………… 223 UNIT 8.0…………………………………………………………………... 232 ADVANCED VARIANCE ANALYSIS…………………………………. 232 Element 8.1 Mix Variance……………………………………………….. Element 8.2 Yield Variance………………………………………………. 234 Element 8.3 Fixed Overhead Cost Variance…………………………….. Element 8.4 Sales Variance………………………………………………. 244 Element 8.5 Planning variance…………………………………………... 246 Element 8.5.1 Definite Of Planning Variances…………………………... 246 UNIT 9.0…………………………………………………………………... 249 MORDERN MANAGEMENT ACCOUNTING TECHNIQUES……... 249 Element 9.1 Throughput Accounting……………………………………. 249 Element 9.2 Target Costing………………………………………………. 260 Element 9.2.1 Calculating Target Costs………………………………….. 262 Element 9.2.2 Establishing An Expected sales Price…………………….. 262 Element 9.2.3 Establishing A Target Project…………………………….. 263 Element 9.2.4 The Residual: Target Cost………………………………... 263 Element 9.2.5 Cost Tables……………………………………………….. 264 Element 9.3 Service Costing……………………………………………… 265 Element 9.3.1 Use Of Unit Cost In The Public Sector……………………268 Element 9.3.2 Limitation Of the Cost Units……………………………... 269 Element 9.4 Life cycle costing……………………………………………. 269 Element 9.4.1 Life Cycle Budgeting And Resource Allocation…………. 271 Element 9.5 Back flush Accounting………………………………………278
Element 9.6 Accounting Based Costing………………………………….. Element 9.7 Manufacturing Resource Planning………………………… Element 9.8 Enterprise Resource Planning……………………………… UNIT 10.0…………………………………………………………………. 286 Information Technology And Management Accounting………………. 286 Element 10.1 Decision Support Systems………………………………… 286 Element 10.1.1 Management Information Design……………………….. 288 Element 10.1.2 Management Levels And Information Requirement……. 288 Element 10.2 Transaction Processing systems………………………….. Element 10.3 Management Information Systems………………………. 291 Element 10.3.1 Characteristics Of MIS………………………………….. 291 Element 10.4 Communication Technologies……………………………..292 Element 10.4.1 Information Dissemination-Effective Presentation of Information……………………………………………… 293 Element 10.4.2 Use and Limitations of PCs……………………………... 294 Element 10.4.3 Use And Limitations of PCs In Management Accounting…… 295 Element 10.5 Computerized Manufacturing Environment…………….. Element 10.6 Computer Aided Design…………………………………... 296 Element 10.7 Computer Aided manufacturing…………………………. 297 Element 10.7.1 Computer-Integrated Manufacturing……………………. 298 Element 10.8 Flexible Manufacturing Techniques……………………… Element 10.9 Business Process Re-Engineering………………………… 301 Element 10.9.1 Principles Of Business Process Re-Engineering (BPR)… 302 Element 10.9.2 Implications Of BPR-Management Accounting Systems. 303
PAPER 3.2: ADVANCED MANAGEMENT ACCOUNTING Purpose:
To develop knowledge of planning, control, co-ordinating resource mobilisation and decision making functions of management in a wide range of sectors, including manufacturing, retail and services provision. General Learning Objectives: On completion of the paper, the student should be able to: Discuss the use of accounting based management information. Produce and present budgets Prepare and present Flexible Budgets and their accompanying variance reports. Make computational and non computational analysis of data for management control reasons and decision making purposes 5. Make recommendations for Cost Reduction and Value Enhancement. 6. Make recommendations for adopting World Class Manufacturing techniques with a view to enhancing operation efficiency. 7. Prepare forecasts of Income and Expenditure of organisations. 1. 2. 3. 4.
LEARNING CONTENTS 1. Capital Investment Appraisal - (15%) 2. Pricing Theory - (10%) 3. Cost Analysis - (15%) 4. Measures of Performance - (10%) 5. Decision Making Techniques - (15%) 6. Budgeting and Budgetary Control - (10%) 7. Modern Business Environment - (5%) 8. Advanced Variance Analysis - (10%) 9. Modern Management Accounting Techniques (5%) 10. Information Technology and Management Accounting - (5%)
3 Element 3.0 CAPITAL INVESTMENT APPRAISAL – (15%)
Element 1.3 Element 4.6 Element 1.6 Element 4.7 Cost Plus Pricing Marginal Pricing Target Pricing Life Cycle Pricing Other Pricing methods Changes in Price Levels Transfer Pricing theory
UNIT 3.3 Element 2.4 Element 2.5 Element 3.6 Cost Reduction Cost Control Value Analysis Value Engineering Activity Based Costing Total Quality Management
UNIT 4.5 Element 4.3 Element 1.0 COST ANALYSIS – (15%)
Element 3.5 Element 1.4 Element 4.5 Element 2.1 Element 3.7 Appraisal Methods Capital Replacement Capital Rationing Effects of Taxation on Investment Appraisal Effects of Inflation on Investment Appraisal Treatment of Leasing and Hire Purchase Transactions Cost-Benefit Analysis
UNIT 2.4 Element 1.0 DECISION MAKING TECHNIQUES (15%)
.1 Element 4.2 Element 1.6 Element 2.4 Element 3.2 Element 2.1 Element 1.0 MEASURES OF PERFORMANCE (10%)
Element 4.2 Organizations) Element 4.0 PRICING THEORY – (10%)
Element 2.7 Balanced Scorecard Value For Money (Performance measures for Not For Profit Financial Performance Measures Non Financial Performance Measures Divisional Performance Measures Benchmarking Behavioural Effects of Performance Measurement
UNIT 5.UNIT 1.1 Element 2.2 Element 3.
1 Element 6.5 Element 8.0 MODERN MANAGEMENT ACCOUNTING TECHNIQUES (5%)
Element 9.0 BUDGETING CONTROL (10%)
Element 6.5 Element 5.2 Element 5.4 Element 5.5 Throughput Accounting Target Costing Service Costing Life Cycle Costing Backflush Accounting 9
.3 Element 6.4 Element 6.2 Element 7.3 Element 7.1 Element 8.0 MODERN BUSINESS ENVIRONMENT (5%)
Element 7.2 Element 9.3 Element 8.4 Element 9.3 Element 5.1 Element 5.5
The Budgeting Process Types of Budgets Flexible Budgets Behavioural Aspects of Budgeting Applications of Information Technology in Budget preparation
UNIT 7.4 The changing Business Environment Production Management Strategies World Class Manufacturing Techniques Product Life Cycle
UNIT 8.2 Element 6.1 Element 9.2 Element 8.3 Element 9.6 Mix Variance Yield Variance Fixed Overhead Cost Variances Sales Variances Planning Variances Operational Variances
UNIT 9.4 Element 8.6
Sensitivity Analysis Learning Curve theory Linear Programming Decision Trees Uncertainty and Risk Analysis Multi-product Cost Volume Profit Analysis
UNIT 6.Element 5.1 Element 7.0 ADVANCED VARIANCE ANALYSIS (10%)
Element 9.6 Element 9.
. Ashton.4 Element 10.2 Element 10.8
Activity Based Costing Manufacturing Resource Planning Enterprise Resource Planning
UNIT 10. Section B: There will be THREE (3) questions in this section each carrying TWENTY FIVE (25) marks.3 Element 10.9 Decision Support Systems Transaction Processing Systems Management Information Systems Communication Technologies Computerised Manufacturing Environment Computer Aided Design Computer Aided Manufacturing Flexible Manufacturing Techniques Business Process Re-engineering
RELEVANT TEXTS ZICA Text Book Management and Cost Accounting.7 Element 9.6 Element 10. Section A.8 Element 10.5 Element 10. Section C: This section will have TWO (2) questions of TWENTY (20) marks each and candidates are required to attempt only ONE question. C Drury (Latest Edition) Issues in Management Accounting.7 Element 10. Section B and Section C. Section A: This section will carry ONE COMPULSORY question worth THIRTY (30) marks. T Hopper and R W Scapens Accounting for Management Control.0 INFORMATION TECHNOLOGY AND MANAGEMENT ACCOUNTING (5%)
Element 10. out of which candidates will be required to attempt any TWO (2) questions.1 Element 10. Emmanuel and Otley
STRUCTURE OF THE EXAMINATION PAPER The examination paper will be a THREE (3) hours paper divided into THREE (3) sections.
The investment will not purely depend upon financial aspects but to a large extent. are: (a) (b) (c) (d) Payback Internal rate of return Net present value Accounting rate of return. Element 1.
. The traditional methods ignore the fine value of money whilst the scientific methods recognise the fine value of money in the evaluation.
The investment appraisal methods can be divided into traditional and scientific methods.UNIT 1. Before deciding which project/assets to invest in. • • • • • • • • The concept of the time value of money Net present value (NPV) Real and normal interest rates Payback Internal rate of return Multiple IRRs Unequal Project appraisal & Audit
Capital Budgeting involves the assessment of how much should be spent on assets or project and which assets should be acquired. the strategic direction of the business.0 CAPITAL INVESTMENT APPRAISAL
Learning outcomes: After studying this chapter candidates must be able to: Demonstrate knowledge of key investment. regarding appraisal methods and the following. which are normally in use. Remember the financial decisions fall with the long-term corporate strategy formulation process.1 Appraisal Methods The main methods of investment appraisal. corporations must compare the benefits to be derived from the acquisition/investment against the costs involved in the investment.
1. if the present value of the outflows exceeds the present value of inflows. Real assets will only be attractive to a rational investor if they offer a rate of return in excess of the cost of money (the rate at which the money has been borrowed). By discounting the financial costs and benefits associated with real assets at this rate. the net present value is positive and purely on financial grounds. the investment should be accepted. When the present value of the inflows exceeds that of outflows (which includes any relevant taxation liabilities. In contrast. Element 1. which are realised in the future.1. in present day terms of the total costs of the investment (cash outflows) and the total receipts from the investment (cash inflows).Element 1.1. at which investors can borrow or lend money. as well as the more obvious initial investment outlay).1. the investor can determine whether a return in excess of discount rate ‘r’ is available from the real asset in question. The model is based on the assumption that an investor may invest money in the financial market at an interest rate prevailing or invest money in real assets. In the Net Present value computations.1. all cash flows are expressed in present day values by the cash flows. The Net Present Value approach holds that cash received in the future is less valuable than cash received today. undertake a combination of the two options.1 Net Present Value (NPV) The Net Present Value of a project is the difference between the sum of the project discounted cash inflows and outflows attributable to a capital investment or other long-term project. or borrow in order to invest in real asset.1 Discount Factors/ Interest Rate The interest rate. is key to the Net Present Value model (NPV). Element 1.
. the net present value is negative and the investment should be rejected. A comparison is then made.2 NPV and The Agency Theory Senior managers of an organisation normally save the interests of shareholders and they are thereby employed to maximise the wealth of shareholders.
EXAMPLE 1 Chaswe engineering consultants have been engaged in developing four (4) projects on behalf of their client. The net present value upholds the thenetical sole objective of business of maximisation of shareholder’s wealth through maximisation of returns from the project.
. Perfect capital market and perfect information exists The model assumes that a single rate which reflects the opportunity cost for all individuals and companies. Ninsh Corporation.4 Net Present Value. Ninsh Corporation have asked their management Accountant to evaluate the 4 projects for their viability before it commits its finances to the projects.1. All Shareholders have an objective of wealth maximisation
Element 1. we would have no basis upon which we can base our probability on. is a guide in assigning specific possible outcomes for the action currently proposed. Past experiences can be new.Since Net present Value models decision rule advocates that a project whose financial benefits outweigh its financial cost.1.1. However. The Discount rate must be a measure of the opportunity cost of funds for wealth maximisation to result. Element 1. Risk and Uncertainty Risk management does not leave out project appraisal and evaluation process. In the absence of past experience. Advanced risk analysis and management are outside the scope of the text. The cost of funds for NINSH Corporation is 5%. henceforth having a positive net present value should be accepted and be pursued and vice versa.1. This can also be used as the basis for assigning probabilities to these outcomes what we can use to calculate the expected cashflows of a project for our NPV computations. the project sponsors.3 Assumption in Net Present Value The Net Present Value technique is based on the following assumption.
8227 Net Present Value
Cash flows K’000 (40.27 (2.048.8638 4 0.643.00 86.140.00 18.000 100 100
Present Value K’000 (40.000
.000 100 100
K’000 (40.000) 20.0000 1 0.000) (20.000) 400 400 32. Project: Capital (Outlay) year 0 Cash Inflows 1 2 3 4 Solution: Since the company’s cost of capital is 5%.000) 0 0 0 36.800 400 400
(20.REQUIRED: In your capacity as Management Accountant of NINSH Corporation.000 20.000) 20.800 12.38 82.000 12. Project A Discount factor @5% A B C D
(40.000 20. evaluate the viability of the four (4) projects given that the cash inflows and cash outflows of the projects are as shown below on the Net Present Value basis.000 32.000. thus will serve as the discount rate at which the project cashflow will be discounted.00) 19.9524 2 0.9070 3 0.
00) 0 0 0 29.9070 0.8638 0.00) 12.20 9.641.9524 2 0.52 329.96 362.8227 Cash flows K’000 (20.800 400 400
Present Values K’000 (20.9524 0.00) 380.9070 3 0.60 26.000.8227
Year 0 1 2 3 4
Cash flow K’000 (20.190.000 32.609.474.000 Present Values K’000 (20.0000 0.0000 1 0.000.617.20
Net Present Value
.8638 0.711.9524 0.000
Present Values K’000 (40.9070 0.Project B Discount factor @5%
0 1.8227 Net Present Value
Cash flows K’000 (40.000) 0 0 0 36.72 11.8638 4 0.50 27.800 12.76
Project C Discount factor @ 5 % 1.617.0000 0.08 4.40 14.60 245.92
Net Present Value
Project D Year 0 1 2 3 4 Discount factor @ 5% 1.326.000) 400 400 32.000.000) 12.
A positive discount rate should be selected and the Net Present value of the project at this rate is calculated.1. The following steps represent a systematic. & D are giving positive present values indicating that purely on financial information. Estimate the IRR of project Y using the data given at a cost of capital of 14%. EXAMPLE 2 Suppose a company has project Y with the following cashflows to evaluate. methodical trial and error approach to the calculation of project IRR. This must be a positive figure if an investment with conventional cashflows is to have a positive IRR. they are viable and hence management of Ninsh Corporation should undertake the projects in order to maximize shareholder wealth. 1.ANALYSIS AND CONCLUSION
Project B. purely on financial grounds. 3. Project A is yielding a negative net present value and hence.2 Internal Rate of Return (IRR) Internal rate of return is achieved by a project at which the sum of the discounted cash inflows over the life of the projects is equal to the sum of the discounted cash flow.
. 2. C. In other terms. The procedure under (2) should be repeated for one or more additional discount rates. The net present value of the project at zero interest rate needs to be established. The Net Present Value profiles should be sketched and an approximate IRR estimated. the IRR of an investment is that rate which when used to discount the cash flows of the investment will result in a rate present value of zero.
Element 1. the project should not be undertaken as it is posed to destroy value of Ninsh Corporation. The IRR of a project with conventional cashflows can be calculated using a process of trial and error.
conventional cashflows and perfect capital markets and the additional assumption of independent projects.675 0.000.20
K’000 0 (20.000 4 160.000. the decision rule is to compare opportunity cost of funds and accept the project if the IRR is greater than the company’s cost of money and reject it if it is not i.000
Present Values K’000 (20. This decision rule would always lead to the selection of an identical set of projects as the application of NPV rule given the assumptions that have been made so far namely. purely on financial grounds.2 The Reinvestment Assumptions The Net Present Value technique assumes that all cash flows from a project will be re-invested at the discount rate used in the calculation of the project’s net present value.000) 1 200 2 200 3 160.
Element 1.2.000 0.2.00 94.00) 178.00 183. certainty.80 108.769 0.
.1.252.000) 200 200 160.000 160.40 153.592
Cash flows K’000 (20.1.Project Y Year 0 1 2 3 4 Solution: Years Cashflows Discount Factors (14%) 1.877 0.920.e.1 Decision Criteria In Internal Rate of Return In case the IRR.000 Net Present Value
Element 1. which in a real/free world is the prevailing base interest rate.
000) 14.000 1.000 8. In contrast IRR assumes that all cash flows will be reinvested at the projects own IRR. Projects Years 0 1 2 3 4 M cash flows K’000 (18. It’s assumed below that the interim cashflows will be reinvested at 5%.000) 1.000 12. In calculating the terminal values. The Net terminal value is calculated by subtracting the terminal value of the initial investment from the terminal value of the cashflows.000 K cash flows K’000 (16. This assumption will lead to favour projects with concentrated cash flows in the early years of the project running than those with low cash flows in the early years of running. interim cash flows must be projected forward to the end of the investment’s life by the application of a particular reinvestment rate. In the early years of the project running than those with low cash flows in the early years of running. The terminal value of an investment is the total value of the cashflows generated by an investment at the end of its life.250 12.000 12. There are not practical supporting reasons for this assumption though.This assumption is realistic as application of the NPV rule means that all projects offering a return in excess of the discount rate will be accepted and the marginal funds are invested at the prevailing interest rate.000 12.000
M Terminal values
. This can be illustrated by using an example of 2 projects M & K and calculations of their terminal values.
Years 0 1 2 3 4
Cashflows K’000 (18.122 22. The company anticipates a cost of capital of 10% and the cashflows of the projects are as follows: Years Project X K’000 0 1 2 3 4 5 (400) 70 160 180 150 40 Project Y K’000 (400) 436 20 20 8 6
REQUIRED: 1. The finance director thinks that the project with the higher net present value should be chosen where the managing director thinks that one with the higher IRR should be undertaken especially as both projects have the same initial outlay and length of life. 2.05)4 (1.000
Conclusion And Analysis By definition. Calculate the Net Present Value and internal rate of return of each project.00
terminal values K’000 65.616 1.05)3 (1. the small positive NTV of M arises because 49% is a slight under estimate of the IRR as perusal of the above analysis. the IRR is the discount rate of zero and you should not be surprised to see that it is also the discount rate which gives a net terminal value of zero. 3.000 8.404 7. Recommend with reasons. EXAMPLE 3 Seakwe Ltd is considering which of two mutually inclusive projects it should undertake.000 1. which project you would undertake.000) 14.340 38. This is clearly seen in the case of project K.000 12. Explain the inconsistency in ranking of the two projects in the light of the remarks of the two directors.05)1 1.000
Reinvestment rate 5% (1.
000) At 10% the NPV of project Y = (K5.050036333% = 16.050. Identify the cost of capital at which your recommendation in (2) would be reversed.05) Project Present Y value 10% (400) (400) 436 396.
Solution (1).000 At 10% the NPV of project Y = K37.4.040.88 11.08)
Therefore as it has been noticed in the calculations.833 0.000 x (20%.04 Present value 20% (400) 363.31 111.08 (38.63 132.621 Factor 20% 1.080.000 0.04 104.751 0.45 24.46 6 3.000 IRR = 10% + [ K58.19 13.280.000 0. 683 0.84 58.000 + K38.58 3.28 Present value 20% (400) 58.482 0.826 0.05% Project Y
.050.280.22 72.280.694 0.000) The IRR of the two projects are as follows: Project X 1NPV1 IRR = Ra + [1NPV11+1NPV21 x (Rb – Ra)] K58.72 37.16 135.32 20 16.30 16.85 2. Y 0 1 2 3 4 5 Factor 10% 1. At 10% the NPV of Project X = K58.52 20 15.18 102.10%)] = 10% + 6.402 Project X (400) 70 160 180 150 40 Present value 10% (400) 63.000 At 10% the NPV of Project X = (K38.579 0.02 8 5.909 0.41 (5.
while nearly 90% of Y’s inflows come in the first year of the project. it is generally appropriate to accept the Net Present Value result.1NPV1 IRR = Ra + [1NPV11+1NPV21 x (Rb – Ra)] K37.000 x (20%.080.7939% IRR=18. showing that it exceeds the company’s cost of capital.793922127 IRR= 18.040. In addition. assuming that the company’s object is to maximise the Present Value of future cashflows Project X offers the higher Net Present Value. Project X has a positive Net Present Value. leading to a situation where project Y shows a higher internal rate of return. net present value being regarded as technically more sound than internal rate of return.
.79% (2) The recommendation should be to undertake Project X for the following Reasons.000 + 5. uncertainty and timing if cashflows may be considered by the Directors in making the final investment decisions. The two projects have radically different time profiles.000 IRR = 10% + [ K37.10%)] IRR= 10% + 8.040. whereas project Y offers a higher internal rate of return where such conflicting indications appear. Project X indicates a higher NPV. Projects X’s cashflows are grouped in the three middle years of the project. Risk.
we mean that there will be a cash outflow followed by a stream of inflows. By a project having conventional cashflows. EXAMPLE 4 Lunga Plc is proposing making a machine it will use in its manufacturing process. the true relationship between the Net Present Value and discount rate is a cumulative one. The cashflows associated with the project are as follows. As a result of these cashflows coming in and out of the project at different times. A project with non. although it will be expensive to break up and dispose of at the end of its useful life.+ + + + +
100 80 60 40 20 10 20 30 40 60 Discount rate. we would want to appreciate that in cases where a project does not have conventional cashflows.
Element 1. Revenue can be expected from its demonstration. the IRR computation might give rise to two or more internal rate of return rates.conventional cashflows may have a cash outflow followed by an inflow or inflows then followed by a further outflow or by further outflows. Years Cash flows K’000
.2. the cost of which will be paid in two stages. there is a possibility of having multiple IRR in the project whose cashflows are unconventional. %
Although in the above illustration we have show the graphical representation using straight lines.3 Multiple IRR (Multiple Yields) At this point in time.1.
PV K’000 (7.820) 15.200 (46.000 3 (53.000) 2 80.9434 0.820) 1 (20.384 47.8396 PV K’000 (7.868) 71. Years Cash flows K’000 0 (7.034 78.000 (53.8300 0.0000 0.020) Net Present Value Discount Factor (6%) 1.336 24.934
25 30 Discount rate.9434 0.906) 16.820) (20.020) Net Present Value Graphical Representation NPV Investment NPV £ 200 100 0 (100) (200) (300) (400) Conclusion.8300 0. Interpretation And Analysis 5 10 15
Discount Factors (30%) 1.
(7.820) (18.820) 1 (20.000
Cash flows K’000 0 (7.020)
Solution: This project has two internal rates of return as shown below.000 3 (53.0000 0.000) 2 80.0 1 2 3 The appropriate discount rate is 15%.
000) 1 K’000 40.
EXAMPLE 5 Consider two projects Years Project P Q 0 K’000 (60.4 Internal Rate of Return for Projects With Unequal lines When two projects or more mutually exclusive investments with unequal lives are being evaluated and compared.100
(1) Using unadjusted Cash flows
K’000 NPVP = 4.000) 15.100 2 K’000 75. If NPV shows that the NPV of the same project lower consideration is positive. consideration must be given to the time period over which a comparison of the investments is to be made.100 (60. the decision whether or not to accept this investment cannot be made by reference to these rates alone.000) 1 K’000 75. A comparison can be made over an equal time span for both investments. Therefore.
Element 1. NPV method can be used to get a clearer result.2.000 -
Compute the IRRs of the two projects assuming a cost of capital of 10%.000 75.000) (60.000) (60.100 2 K’000 40.711
. The cashflows of two consecutive investments in Q would be as follows: Year Project Q Project Q repeated Total Cashflow 0 K’000 (60.1. then the project should be accepted as it shows that the net financial benefits far outweigh the financial costs of the project and hence demonstrating financial viability of the project. the lives of P and Q can be equalised by assuming that the company can invest in another project like Q at the end of year 1.100 75.As both IRRs are equally valid.
(I.000) 1 10.e. the project with a higher IRR should be chosen as the IRR does not seem to be affected by the length of the project life or repeated reinvestment of the cash flows. Element 1.e.000 3 20.000) 6. regardless of the project lives. from the outset of the chapter. In conclusion.090 K’000 NPVP = 4.000 13. P over 2 yrs And Q over 1 yr) (2) Cashflow adjusted to Equalise project lives (I. the payback period for the four projects below will be: Projects: Initial capital outlay Cash inflows Years A K’000 0 (20.3 Payback Period Method Computation of payback period of a project is the time required for the cash inflows from a capital investment project to equal the cash outflows.6. If we assume that cashflows are received at the end of each year.400 32.711 NPVQ = 7.400 C K’000 (10.800 13. P over 2 yrs and Q over 2years) Conclusion and analysis
NPVQ = 4.000) 0 0 0 18.000 B K’000 (20.500 4 21.1. irrespective of the period over which the comparison is made.400 12.200 D K’000 (10. the payback period and accounting rate of return are the commonly used traditional methods of appraising capital investments.810
IRR 22% 25%
Ranking project P and Q on an IRR basis makes project Q the superior choice.000 2 20.000
.000) 400 400 16.1 TRADITIONAL APPROACHES TO PROJECTS/ CAPITAL INVESTMENT APPRAISAL
As you can remember. 1.
3. B. Exercise 1 Please compute the present values of the cashflows from the above 4 projects A. Hence only project A and C would be accepted and be undertaken in this instance. Decision rule: Only projects with short payback periods are preferred.
Element 1.1.1.The pay back period for the projects is as follows: Project A B C D Payback period 2 years 4years 2years 4years
In practice corporations will have a benchmark of the payback period. which is going to be adopted in their company policy as the threshold or cut off point for appraising and assessing the payback periods of projects.1
Limitations of Payback Period Method
The payback period method has a limitation not taking the time value of money into consideration and it ignores the future cashflows beyond the payback threshold as per company policy no matter how healthy the cashflows might be. For instance if the company above has a corporate policy of only accepting project with payback period of 3 years only project A and C promise to payback a three year period.3.2 Discounted Payback Period In order to go round the problem of the lack of recognition of the time value of money some evaluators opt to use discounted pay back where the payback of the project is deferred using discounted cash flows as opposed to simple cashflows.
Element 1. C and D at a cost of capital of 5% and you will discover that the discounted payback (year) will be as follows:
4 The Accounting Rate Of Return (ARR) Computing Accounting Rate of Return A mathematical expression of. 400.000 K32.000
. 200. 400.000 Deprecation: K20. EXAMPLE 6: Project Name: Project life: A 4 B 4 C 4 D 4
Cash –Inflows: K21. An acceptable ARR must be specified by the decision maker in advance and projects exceeding this return will be accepted and those falling short of the return will be rejected. & D with the following data.1. The model that employs accounting profits rather than cash flows from the project as the input data to the model. This is then expressed as a return on either the initial or the average investment in the project.000 K13. 200. To find the ARR of an investment. 000 K18.000 K3. 000.000 K20.000 K8. To illustrate the mechanics of the method. 000. Average annual profit from an investment x 100 Average Investment Defines the accounting rate of return as.Project A B C D
discounted payback (years) No Payback 4 years 2 years 4 years
This is a slightly more comprehensive evaluation that the crude simple method of using simple cash flows. C. B. Element 1. 000. 000. 000.000 K10. the average profit over the life of the investment is calculated. 000. the following illustration can be used.000 K10.000 Profit: K1. 000.000 K12. 000. Consider four projects A.
100. 400.000 + 0 2 years K16.000
Project C K13.000 + 0 2 years K9. 200. 000.000 + K0 2 years K10. 200.000 4yrs 4yrs K3. 000.200. 500.000 4yrs K2.In the above figures.000 2.000
Project D K18.000 C K3. 000. 400. Average profits for the projects Total Profit over 4 years = Profit per year Project life years Projects: A B K1.000 K12. the Average investments are calculated as a simple mathematical mean. Project A K21. 000.000 + K0 2 years K6.000 The Accounting Rate of return: Projects A: K250. 000 = K10.000
. 500. 000
Computation of average capital investment: Assuming that all the resources invested in the project will be consumed and hence the investment at the end of the project life will reduce to zero (0).000. 000. 600. 000 D K8.000 Project B K32.000 4yrs K800. we are assuming that the deprecation and profit figures shown are for total (aggregate) figures over the lives of the projects.
Two suitable models are available details of which are as follows: The Kenworth having a life of four (4) years and a price of K200.000 kilometers per year.000 =
19. Scania will incur the following cost over 6 years Years 0 1 2 3 4 5 6 K’000 350. corporations need to establish and choose as a policy.000 K800. 000. 000. 000.000 the running cost is initially K20.Projects B: Projects C:
K3.14% 12. which will be required to travel 50.000 120.000 150.22%
For the technique to find use. an accounting rate of return percentage. 200. 600.000 K2.00 per kilometer but this will rise by K3.000 105. 100.00 per kilometer for each year the truck is in service. the decision maker needs to specify a required rate of return when ARR is used as the project evaluation method.000 75. As mentioned under the payback period method.000
The cost of capital for Mpose Plc is 12% Required:
22.000 135.000 90. ANNUALISED EQUIVALENT COSTS
EXAMPLE 7 Mpose Plc is considering the purchase of a new track.000 = K16.000 K9. 000 K6.
000 100.000 1.000 0. 340.8930 0.300 996.000 4. 428.340.000 200.000 200.750.950.113.Explain which truck (between the Kenworth and the Scania) should be purchased.250 142. Solution: As we can see the comparison of the two projects is complicated by their unequal lines.400 1.000.000 89. 340.000 1.000
The annualized cost of the Kenworth Truck Year Costs K’000 0 1 2 3 4 Totals: 2.884.000 3.134 30
. We are going to use annualized costs to compare the two projects. Therefore the annualized cost of the Kenworth is:
Year 0 1 2 3 4
Costs K’000 2.038 = K1.000 1.000.250.000 1.950
The annualized equivalent of K4.038 12% DCF Present value K’000 2.750.000.7120 0.250.000 K4.7970 0.000 1.950.6360 3.000 100.
890.6360 0. 580.980 71. The annualized cost of the Scania truck is.890
The annualized equivalent of K791.This is determined by calculating the Net Present Value of acquiring and operating a Kenwork truck over four years and converting it an equal annual equivalent cost by dividing the Net Present Value by 3.112 12% DCF Present value K’000 350.000 150.000 1. the Scaina is the best option with a lower annualized cost.550 76.320 76.050 791.230 74.037.000 75.7120 0. Year 0 1 2 3 4 5 6 Totals: Costs K’000 350.90 Therefore in conclusion.000 4.112 = K192.5070 4.7970 0.5670 0.252.8930 0.000 120. 890.000 66.760 76.
PREFERENCE FOR APPRAISAL METHOD
Investment Appraisal method Advantages and disadvantages of Investment Appraisal Methods PAYBACK PERIOD METHOD Advantages
.000 135.000 is K 791.000 90.000 105.0000 0.
in assessing a project’s viability. (b) It takes proper account of the size and duration of projects. so a small project with a high return looks better than a large project with a lower return. (b) It can be used as preliminary project appraisal screening method. and its implications for liquidity are clear. before scientific methods (discounted cash flows are applied for the appraisal process). Disadvantages (a) It produces a number which is less familiar to management than a rate of return. This is because IRR takes no account of what happens to the returns after they are achieved. especially to non-financial managers.(a) It is easily understood and interpreted.
. Disadvantages (a) It does not take account of the size of the project. Disadvantages (a) It ignores cash flows beyond the payback period and it does not take into account of the time value of money. (b) It's complex in its mechanics. INTERNAL RATE OF RETURN Advantages (a) It takes into account of the timing of the cash flow. (b) It is easily compared to a given return. which project owners are looking for. NET PRESENT VALUES Advantages (a) It takes account the timing of cash flows. (c) It takes into account the greater uncertainty of later years’ cash flow by using a higher discount rate for these years. (b) The Internal Rate of Rate (IRR) cannot evaluate properly the duration of projects. even through the latter will contribute more to earnings. (c) Not easily understood by non-financial managers.
is given below.2 Capital Replacement Corporations will most times want a specific type of capital asset for a period of time which exceeds the physical life of any one individual asset. irrespective of the replacement cycle it can be ignored for the purposes of
. demand for the output of a particular production process may extend into the indefinite future. cars should be replaced at the point in time at which this cost is minimised. This usually happens when a project has unconventional cash flows.
Element 1. which may sometimes arise. or part of an asset or part of that type. As the annual operating cost is constant. meaning that cash flows with negative and positive signs may come through during the life of the project.000 20.000
Since the company requires the cars to extend into future.000 25. The timetable for a planned replacement will be determined by a consideration of the costs of replacing over one time horizon rather than other.000 30.000 15. Data on the type of car. For instance. less the resale value at the time of disposal. The cost to the company of providing the car is made up of the initial capital cost and the annual running costs. which our hypothetical company provides for its sales people. is the possibility of two or more solutions to the IRR calculation. a replacement policy must be decided upon.(c) Another potential difficulty. Initial purchases price: Annual running cost (average per year) Re-sale value if sold after: 2yrs 3yrs 4yrs 5yrs K’000 50. Consider the example of a company which provides its entire sales people with a company car. For ease of exposition we would assume that the annual operating cost is independent of the age of the car and that the data given above will remain valid indefinitely. Asset replacement may be undertaken in response to the poor physical condition of an asset or more reasonably replacement may be planned.000 5. whereas the life of the machine required carrying out the process will be limited to a finite period. If the company would like to minimise the overall cost of operating its fleet of cars.
Therefore what needs to be considered are the purchase price of the car and the resale value. we would be indifferent as to which spending pattern we incurred.7835
27.000) (50.000 spent today is equivalent to an expenditure of K12.8227 0.642 (22.8638 0.000 5.000 25.659) (46. which in turns depends on the replacement cycle. the K22. This procedure allows the expression as an annual figure of a cost or income occurring on a regular but not annual basis. two years in the case of the first row.
Assuming a cost of capital of 5%. Although. For example taking the figures in the first row of the schedule.918
(50. the cost must be expressed as a net present cost per annum.000) (50.341 3.000 15.000)
(22.8594) for each of the next two years at the discount rate is 5%. the computation would be as below.405) (37.210 21.9070 0.790) (28.setting the replacement policy.595 12. The net cost of the investment in each car is given by the initial outlay less the present value of the sale proceeds.000) (50.790.000/1.790. the purchase price itself is not variable the total expenditure of the company is variable as it depends on the sale of the cars.000
. In order to make such a comparison. Schedule 1
Year Resale Values K’ 000 Discount factor (5%) Present values K’ 000 Purchase price K’ 000 Net Present cost K’ 000
2 3 4 5
The final column of the table shows the net present cost of owning the car over differing time periods. which is obtained by dividing the net present cost over the relevant time period. and three years for the second row etc. This cost does not of itself provide a basis for comparing the relative attractiveness of the alternative replacement cycles.256.
The concept of annual equivalent costs can be used to facilitate the comparison of assets with unequal lives.7232 3.000 the cost of replacing the cars on a three-year cycle. assuming that projects are in line with the long-term corporate strategic objectives.790) (28.5459 4.644)
Conclusion and analysis It can be seen that the minimum annual equivalent cost is K10.4.2 for such a computation. Other things being equal the company should adopt a three-year replacement policy.3 Capital Rationing In some instances. The illustration below shows the mechanics of capital rationing
.405) (37. providing the assumption can be made that assets will be required for a period which is a complete multiple of each projects own life.Schedule 2 Replacement Cycle (years) Net Present Cost (a) K’000 2 3 4 5 (22.5.
Element 1. Refer to section 1. managers of the business will want to select and choose projects that will give the greatest return on the total investment. In financial wisdom.082) 1.620) (10.3295 Annuity factor (5%) (b) Annual Equivalent Cost (a/b) K’000 (12.659) (46.431) (10. 431.567) (10.8594 2. the amounts of capital which an organization can invest in its long-term projects are limited and so a choice must be made between a number of different projects.
000.000) 40.000) 120.952 0.000 90.000 140.000 X K.000
Y K. it is clear that even if the net present values are positive the organization cannot invest in all four projects.000 100.000) 80.000
Z K. in the current year).000
If we suppose that the company with these four (4) projects above.00. at the time of decision-making are K400.000 Z K. 000 (240.Projects: Year: 0 1 2 3
W K. Y.000 140.000 220.000 90. The computation below shows the return from each project and their rankings.000) (80. X.000) 120. Discount Rate @ 5% Year 0 1 2 3 1.000) (120.000) 200.000 220. 000 (200.000) (200.000 90.000) 40. 000. and Z has a cost capital of 5% and that the funds available in year 0 (i.000 140.000) (80. 000 (120.000) 80.e. The first step is to calculate the net present values of the projects and then express them as a percentage of the project outflow so that comparable returns are obtained.000 100.000) 200. 000 (240. Using the profitability index technique of ranking project will be employed to rank projects. 000 (160. 000 (200.000 Y K. 000 (160.000 90. 000 (120. W.000 0.864 W K.907 0.000 160.000
000 K240.864 W K.740
5. 640.000 K160.02% 2nd Z K21. Capital rationing is not really a practical approach for the majority of organizations. 070. W K49.000 0.20% 4th Y K5. It usually works very well if the company in question is not an Investment Company such as Warren Buffets Bechshire Hathaway Inc.000 K200.080 90. 000 (120. but for
.Discounted cash flows Year Yr 0 1 2 3 1. 740. all projects have positive net present values and so they would be accepted if funds allowed. In many circumstances.000 K120.18% 3rd
Analysis and comment As it can be seen above. 000. project W would be chosen and 5/6 of project Y.87% Ranking 1st X K14.000
The returns on the projects are as follow.760 Z K. 000. divisibility of projects might not be possible.960 X K. 000 (240.560 138.000) (76. 000 (160.070
21. 000. so decisions will have to be made based on net present value technique.000) 38.000 24.630 77. 000.680 81.000 12.000 to invest.000) 181.240 Y K. 000.000) (190.160) 72. 000.952 0.700 120. assuming that the investments are divisible. With only K400. 000 14.000) 85.000
49.907 0. 000 (200.000 13.
The section aims to show the effects of taxation on investment appraisal.
Element 1. Element 1.
. usually discounted to their present values.4 Effects of Taxation on Investment Appraisal Although in many instances we are assuming that there are no taxes in perfect financial markets. this solution will not be very helpful.e. which is going to be used widely in capital investment appraisal.4.1 Discounting Methods Time value of money Cash flows arising at different points in time cannot be compared directly and must be converted to a common point in time i.
Years 0 1 2 3 4
PV Present value
FV Future value
Present value (PV) is the cash equivalent now of money received/payable at some future date. However. the section starts by looking at basics of discounting future cashflows.most of organization providing a service or manufacturing products. in reality taxes are usually levied on income earned from investment.
Therefore we would choose the k 1.000.Exercise
1 Year 0 (now) K 10.10)5
Tables (given in exam) You can simply find discount factor from the present value table.000. 0.000. To find present value of an annuity we would apply the factors from the annuity tables.000.621 x K1.000 Year 5 K 15.000.000. 000 now with both methods.621
Element 1. 500.000
The discount rate is 10% Please make your decision by first discounting and then compounding. The Discount Factor
Formula 1 (1.000* (1.e. if the discount rate is 11%? 1 2 3 4 5 6 7 8 9 10
.000 = PV = FV x 1/ (1+r) n Compounding PV (1 + r) n = FV Year 0 (now) 10. Discounting Year 0 (now) Year 5 K 10.4.000 0.000.000. please note that discounting is the preferred method of comparison in SFM.000.000 K 9.621
=0. Exercise 2: Immediate Annuity What is the present value of K100 earned each year from years 1-10.2 Annuities An annuity is a constant annual cash flow for a number of years.1)5 = Year 5 K 16.315.100.000. by locating the discount factor at the 10% column and the 5-year row i.105.
Answer = Apply the structured approached to deferred annuities: 1. As the first cash flow is in year 3. Answer: PV = K100 X 5. In fact the annuity is quite often called the cumulative present value factors. An annuity which commences in year one is called 'an immediate annuity’.x
The annuity factor at year ten adds together all the present value factors for the first ten years.e. The annuity factors assume that the first cashflow occurs at the end of year one i.9
What is the present value of K200 incurred each year from years 3-6 the discount rate is 5%? Answer: (1 0 1 2 200 PV 3 200 4 200 5 200 4) 6
The annuity factor brings all the cash flows to one year before the first cashflow arises. all the cash flows have been brought to year 2. Annual cash flow K200 X
. Therefore when the first cash flow arises in year one you simply have to apply the annuity factor to find the present value of the annuity. the first present value factor added in an annuity factor is for year one. which is currently valued in year two we must multiple it by the present value factor for year two. To find the present value (year 0) of the annuity.889 = K588.
546 X 0. Goddard often implies perpetuity by simply stating.907 K643
Perpetuities Perpetuity is an annual cash flow forever. Annuity factor for two years 1 to 4 3.2. thus they also bring the cash flows back one year. g = growth expressed as a decimal.10
Element 1.4. 000 r = 25.000 per annum.000 = 0.4.3 The Basic Perpetuity PV of a perpetuity = Po = annual cash flow r
annual cash flow Po
Exercise 4 What is the maximum amount you would pay for perpetuity of K 25. if the discount rate is 10%? Answers Po = K25.
Element 1. It is the simplest cash flow model known to man.000 250. Present value factor for year 2 Present value of deferred annuity
3. The perpetuity with growth keeps appearing in the exam so you need to be very familiar with it. “The cash flows will occur for the foreseeable future”. 000 10 = K250. PV of perpetuity – Po = Cash Flow Year 0* (1+ g) r–g
.4 Perpetuity with Constant Growth Perpetuity formulae also assumes that the first payment will be at the end of year one.
751 300.000.000 2 K000 3 K000 4 – 18 K000 250.1 . 000.000 per annum increasing at an annual rate of 5%.826 300.000 0.000.000. She wants to calculate the NPV using two different assumptions regarding the project duration.000.05 = K525.000
Present value factors 1.000
Exercise 6: An NPV calculates with both deferred annuity and a deferred perpetuity.000.000 * (1 + 0.0. 000 1 K000 440. Answer: Year 0 K000 2.000.000 Present value NPV – perpetuity NPV – annuity 2.000 from year to the foreseeable future (deferred perpetuity).000 from year to year eighteen (deferred annuity).000.000.000 0.Discount rate in a perpetuity – r = Cash Flow Year 0* (1 + g) Po Exercise 5
What is the PV of perpetuity of K 25.000
Net Cash Flow
363. 000.000 250. The project’s real WACC is 10%.000 0.000.909 400.000
. The Financial Director of A plc has prepared the following schedule (excluding inflation) to enable her appraise a new project.05) 0.000. b) That the real annual cash flow will be K250. if the discount rate is 10% and the first payment is in year 1? Answer: PV of Perpetuity = 25. The assumptions are as follows: a) That the real annual cash flow will be K 250.
5 the Net Present Value Format Year Receipts – (or cost savings) Payments: Wages Materials Variable / Fixed overheads Administration / Distribution expense Capital Allowances/Tax allow dep Taxable Profits = EBIT Tax: Add back: Capital Allowances Initial outlay Net Realisable Value Working capital (X) X (X) X X X X X X X(X) X X X X X X X
1 K’000 X (X) (X) (X) (X) (X) X (X) X
2 K’000 X (X) (X) (X) (X) (X) X (X) X
3 4 K’000 K’000 X X (X) (X) (X) (X) (X) X (X) X (X) (X) (X) (X) (X) X (X) X
Net Cash Flows/Free Cash Flows (X) Discount rate (X%) Present value Net Present Value X (X)
A positive NPV is when the expected return on a project more than compensates the investor for the perceived level of (systematic) risk i.Element 1.e. Decision Rules:
.4. that the expected is greater than the required return.
If the new widgets are produced the company will have to employ an additional superior at a salary of K15.Single Project: Positive or zero NPV: Based on the estimates it appears that the project is financially viable.
FUTURE CASH FLOWS THAT ARISE AS A CONSEQUENCE OF THE DECICSION
1. Exercise 7: R+D of K100. Exercise 8: A company is considering investing in a project. E.
3. depreciation. Element 1. Sunk costs are costs which have already been incurred prior to the decision. This project will last for five years and at the end of the project the plant will have a scrap value of K1m. Ignore all non-cash flows. Ignore all overheads in existence prior to the decision i. What are the relevant cash flows?
2.6 The Relevant Cash Flows A key concept => include relevant / incremental cash flows in the NPV calculations. Mutually exclusive project (A or B): (an absolute decision not a relative decision) Simply pick the project with the highest positive NPV.4. nonincremental cash flows. The allocation / apportionment of fixed costs already present prior to the decision are ignored. What are the relevant cash flows? Answer: Simply when you buy and a fixed asset. 000 per annum. which requires an immediate investment of K6m. Fixed overheads are allocated on the basis of K1 per labour hour. The company will produce 10.000 widgets per annum. They are therefore irrelevant to the decision making process. Each widget will take two hours to make.g. Negative NPV: Based on the estimates it appears that the project is not financially viable. 000 was incurred last year. Ignore all sunk revenues generated prior to the decision. Exercise 9: A manufacturing company is considering the production of a new type of widget.
.e. The company depreciates plant on a straight-line basis over a five-year period.
Ignore all sunk costs incurred prior to the decision.
5 Effects of Inflation on Investment Appraisal
NPV CALCULATION: Years 1% Sales Specific 4% Wages 3% Materials 6% Overheads Net cash flow General inflation 0 1 X (X) (X) (X) X 2 X (X) (X) (X) X 3 X (X) (X) (X) X 4 X (X) (X) (X) X 5 (X) (X) (X) (X) X
2% Discount rate – factors Present value N.P.000
Annual cash Flows required 200 100 300
Cost of Capital 20% Ke 10% Kd 15% Wacc
Element 1. This is because if it were subtracted this would amount to double counting because the opportunity cost of capital already incorporates the cost of these funds. Ignore interest payments and their tax effects as implicit in the discount rate. Exam Focus: If you are calculating an NPV in relation to the purchase or sale of a company you should include all existing fixed costs because to the purchaser / seller they represent future cash flows will commence / cease sale.000 2.
Market values Equity Debt 1.000 1. 4.Answer: The K15.V Two types of inflation
. This simple example ignores tax relief on interest. 000 salary only.
Specific inflation rates Applies to all the individual cash flows items rate
General inflation Applies to the discount This is because the investors in a Project are interested in their ability to buy a basket of general goods. Not only one particular good. Project are interested in their
The two methods
Includes the two types inflation
Excludes the inflation
Money or normal Terms Discount “money” cash flows At money discount rate
Real terms Discount “real” cash flows at real discount rate Real term cash flows are Cashflows at current prices or year zero
When to use the money or Real method Is there one rate of inflation in the question?
Money / Nominal Method are in: E.g. Wages 3%, Materials 4% and General inflation 5% Real Terms
If the cash flows
* If there is one rate of inflation in the question both the real and money method will give the same answer. However it is easier to adjust one discount rate, rather than all the cash floes over a number of years. Thus the form of the cash flows defines the method to be used.
Element 1.5.1 Adjusting The Discount rate Invariably Goddard will give you the cash flows in one form and the discount rate in the other form. So you will have to adjust the discount rate. Cash flows in real terms Discount rate in money terms Deflate to find the real discount rate cash flows in money terms discount rate in real terms inflate up to find money discount rate
Real discount rate to money discount rate The fisher Equation (1 + money rate) = (1 + real rate) x (1 + general inflation rate) Exercise If the real rate of return is 10% and general inflation is 5%, what is the money rate of return? Answer: [(1.10) (1.05)] - 1 = 1.155 therefore 15.5% Exercise
If the real rate of return is 8% and general inflation is 4%, what is the money rate of return? Answer: Money discount rate to Real discount rate The money discount rate also sometimes called the market rate of return includes general inflation. Therefore to find the real rate of return you must deflate as follows: Deflate: 1 + money rate = 1+ real rate 1+ general inflation Exercise 12 If the money rate return is 14.4% and general inflation is 4%, what is the real rate of return? Answer: (1.144/1.04) - 1 = 0.1 say 10%
Exercise 13 If the money rate of return is 13.42% and general inflation is 3%, what is the real rate of return? Answer: (1.1342/1.03) – 1 = 0.10 say 10%
CASH FLOWS DEFINE THE METHOD ESPECIALLY WHEN THERE IS AN ANNUITY: Exercise 14 ABC plc provides the following projected data for the next ten years excluding inflation. Net cash flows 0 (1,700) 1 100 2 200 3 – 10 300
The rate of inflation is 3% and the market return is 11.24%
Calculate the present value of the cash flows over the 10-year period. Real Method: - cash flows are in real terms; simply deflate the money discount rate to get the real rate. Real discount rate: (1.1124/1.03) - 1 = 0.08 say 8%
Real cash flows: Net cash flows Annuity factor Discount factor Present value NPV 0 (1,700) 1.000 (1,700) 1 100 0.926 93 42 2 200 0.857 171 3 – 10 300 5.747 0.857 1,478
Money Method: - calculate the money cash flows for each year and discount by the money discount rate.
Years 0 1 2 3 4 5 6 7 8 9 10
Net cash (1,700) 103 212
Disc F: 1 @ 11.24% PV
0.899 0.808 0 .726 0.653 0.587 0.528 0.474 0.426 171 238 221 204 189 175 162
ANSWER COMMENT: “The understanding assumption that the general inflation rate is equal to the specific inflation rates for all the cash flows items is somewhat simplistic. In reality each cash flow item would probably have a different specific rate of inflation, thus requiring the money method approach.” Examples: Twincle Plc has provided and marketed camping kits for several years. The camping bags are much heavier than some of the modern camping kits being brought into the market. The company is concerned about the effect this will
have on its sales. Twinkle Plc is considering investing in new technology that would enable them to provide a much lighter and more compact camping kits. The new machine will cost K500,000,000 and is expected to have a life of four (4) years with a scrap value of K20,000,000 in addition an investment of K70,000,000 in working capital will be required initially. The following forecast annual trading account has been prepared for the project: Sales Materials Labour Variable overheads Depreciation Annual profit K’000 400,000 (80,000) (60,000) (20,000) (40,000) 200,000
The company’s cost of capital is 10%. Corporation tax is charged at 30% and is payable quarterly, in the 7th and 10th months of the year in which the profit is earned and the 1st and 4th month of the following year. A writing down allowance of 25% on a reducing balance is available on capital expenditure. Required Advise the management of Twinkle Plc on whether they should invest in the new technology Your recommendation should be supported with relevant calculations. Solution- Writing down allowances
Year Asset Value K’000 500,000 (125,000) 375,000 (93,750) 281,250 (70,313) 210,937 (20,000) 30% Tax K’000 37,500 28,125 21,094 Year 1 K’000 18,750 Year 2 K’000 18,750 14,063 14,063 10,547 10,547 Year 3 K’000 Year 4 K’000 Year 5 K’000
Yr1 25% WDA Yr2 25% WDA Yr3 25% WDA Yr4 Scrap value Yr 4
57,281 18,750 32,813 24,610 39,188 28,641
NET PRESENT VALUE CALCULATIONS
Year Machine W/Capital K’000 (500,000) (70,000) 18,750 32,813 24,610 39,188 28,641 240,000 240,000 240,000 240,000 240,000 (36,000) (72,000) (72,000) (72,000) (36,000) Tax relief on WDA K’000 Contribution Tax on contribution K’000 Net cash flow K’000 DCF 10% Present value K’000
1 2 3 4 5
(570,000) 222,750 200,812 192,608 297,186 (7,360)
1.000 0.909 0.826 0.751 0.683
(570,000) 202,480 165,870 144.648 202,978 (4,570) 141,406
Net Present Value of new technology investment. Contribution = Annual Profit + Depreciation = K200,000,000 + K40,000,000 = K240,000,000
Therefore purely on financial grounds, management of Twincle Plc should invest in the new technology, as the Net Present Value of the new technology is positive.
DIFFERENT NPV FORMATS Exercise 15 DEF plc provides the following project financial data for the next 4 years, including inflation. Year 1 K’000s 1,000 (600) Year 2 K’000s 950 (555) Year 3 K’000s 900 (530) Year 4 K’000s 900 (500) 51
Sales Less Costs
The rate of inflation is 3% and the real discount rate is 6.80%. Machinery cost K800, 000 life 4 years, tax allowance depreciation is at straight line and the tax rate is 30%. Calculation of the present value of the cash flows. Note: Only one inflation rate and cash flows are in money terms therefore use the money method. Therefore need to calculate money discount rate i.e. (1.03) x (1.068) = 1.10. i.e. 10%. TAXABLE PROFITS APPROACH – METHOD 1 Year 0 Sales Less Costs Less tax allowance depreciation Taxable profits Tax Add back tax allowance depreciation Initial outlay (800) Net cash flow Discount rate (10%) Present values NPV (800) 1 (800) 1 1,000 (600) (200) 200 2 3 4 950 900 900 (555) (530) (500) (200) (200) (200) 195 170 200 (60) 200 335 .826 277 (59) 200 (51) 200 5
200 400 .909 364
311 349 .751 .683 234 238 276
(60) .621 (37)
TAXABLE CASH FLOW APPROACH – METHOD 2 Year 5 Sales Less Costs Taxable cash flows 0 1 1,000 (600) 400 2 950 (555) 395 (120) 60 3 900 (530) 370 (119) 60 4 900 (500) 400 (111) 60
Tax (120) Tax relief on depreciation 60 Initial outlay (800) Net cash flow (60) (800) 400
Discount rate (10%)
Present values (37) NPV
Exercise 16 Cost K200,000, Scrap value K30,000, Life 5 years, Method 25% reducing balance method and the tax rate is 30%. Answer: Cost K’000’s 200 25% W.D.A.’S K’000’S 50 50 x 0.75 = 38 38 x 0.75 28 21 Balancing Allowance (170 -137) = Total Claimable 33 170 200 – 30 = 170 Year
1 2 3 4 5
THE INTERNAL RATE OF RETURN-IRR IRR is the discount rate, which gives a zero NPV i.e. the actual rate of return on investment. ESTIMATING THE IRR VIA LINEAR INTERPOLATION Calculate the NPV at two different discount rates and then use the following formula:
Rate) NPV .544 13.972 + 520
Exercise 18: Breckhall plc Assume that you have been appointed finance director of Breakall plc. 000 16.683 (40.104 . 000) 14.000 12.264 .000 16.
. choose a higher rate for the next calculate to get negative NPV. with an expected market life of five years. 016 8.694 11. 000) 16. The company is considering investing in the production of an electronic security device.10%) = 19.000 Dis Factor @
IRR = 10% +
7.000 16.216 12.751 . Exercise 17 Calculate the IRR (the expected return) of the following project: Year 0 1 2 3 4 Answer: Year Cash flow PV 0 1 2 3 4 NPV (40.833 13.328 .IRR = Rate + 1
NPV 1 * (Rate . 579 9.NPV 2 1 1 2
If the first NPV is positive.972 * (20% .000 10% 1 .972 20% 1 (40.784 (520) investment cash inflow “ “ “ Dis Factor @ PV K (40. 000) 16.000 12. the main features of analysis are shown below.000) . The pervious finance director has undertaken an analysis of the proposed project.909 .826 . 196 7.39% 7.482 5. 000 16.
600 5.276 4.320 900 1. The motivation for choosing leasing rather than purchasing is often tax efficiency.6 Treatment of Leasing and Hire Purchase Transactions Introduction Leasing is a technique used to finance the use of an asset.800 100 576 900 4.Proposed electronic security device project Year 0 Year 1 Year 2 Year 3 Year 4 K’000 K’000 K’000 K’000 K’000 Investment in depreciable Fixed assets 4.500 Cumulative investment in Working capital 300 400 Sales 3.074 1.044 365 679
535 750 900 1.070 1.740
700 5. A lease contract is an agreement between the owner of an asset (the lessor) and the user (the lessee) under which.131 396 1. It is an alternative to outright purchase.500 Materials Labour Overhead Interest Depreciation Taxable profit Taxation Profit after tax
Year 5 K’000
500 4.050 1.500 1.320
700 5.276 3.100 50 100 100 100 576 576 576 576 900 900 900 900 3.276 1. The lessee in consideration for use of the asset promises to make a series of payments/ rentals to the lessor. financing by using existing cash reserves or by borrowing.014 129 376 365 355 267 689 679 659
Element 1. The lessor remains the legal owner of the asset during the terms of the lease.
. The lessee may have use of the asset for a specified period.800 2.044 1.
Element 1.g. Access to additional sources of liquidity as a result of increased debt capacity.
3.1. local authorities universities and colleges. The lessee chooses the asset and the lessor / bank purchases the asset. For institutions which do not pay corporation tax e. In many countries legal ownership of a qualifying asset entitles the owner (e. In a situation where a loss making business is still creditworthy Where we have start-up projects or businesses.1 Advantages of Leasing There are two significant reasons for a company to lease assets rather than buying outright. which may not move into profits for several years such as most Biotechnology companies and start-up information technology (IT) companies. the ability of lessors to pass on capital allowance tax benefits to lessees still makes leasing attractive for entities which have no tax capacity themselves.3 Tax Benefits to the Lessee While the tax charges reduce the benefits of leasing. 2. This gave valuable cash flows benefits to those with the taxable capacity to sketcher their tax allowances. 1.6.1. Large commercial banks usually had such tax shelter. 1.6. Flexibility / cash flow 3. thus fulfilling the ownership requirements for tax purchases. Tax benefits 2.
. Element 1.Typically lessors would be banks or subsidiaries of subsidiaries of banks. Element 1.g.1.2 Tax Benefits to the Lessor Tax saving was the original drive or motivation behind the development of the leasing market. The circumstances in which some entities might not have tax capacity and hence can benefit from leasing would include the following. which they could use as lessors passing on to the lessee some of the economic benefits of tax relief cash flows. a bank) to amortize the capital cost over the life or the lease period of the asset for tax purposes.6.
For some types of assets such as aircrafts computers. Lease structures can be flexible and innovative and the payment schedules can be tailored to fit the projected cash flows arising from the underlying business.2 Types of Leases There are two main types of lease: 1 Finance leases 2 Operating leases Element 1. Finance Lease A finance lease transfers substantially all the risks and rewards of ownership of an asset to be leased.
FLEXIBILITY AND ENHANCE CASH FLOWS Whilst the availability of tax allowances continues to be important the users of the leasing market rely increasingly on the advantages of cash flows and flexibility. Obsolescence The conductance below usually acts as criteria for testing a finance lease.1. containers and rail wagons. Element 1.6. complex structures have been developed which facilitate the marketing of asset reconciling the news of the buyer and setter on their deliveries.4. Breakdowns . The present value of retails for the leased asset usually exceeds the value of the asset.
In a situation where a profitable corporation.2. 1. The full use of assets owner it’s economic . Idle capacity . The rewards and risks which are to a very large extent transferred are as fellows: . with large continuing capital expenditure and consequent large capital allowances but with low profits available as tax shelter.6.
. In many laitance of a lease is going to be classified as a finance lease.
The motivation underlying an operating lease is the leased product (asset). The following criteria will be distinguished with operating lease.2.6.3 Features of Leases . but can be translated to sort the lessees cash flow if value contract is large enough to justify the effort. Operating leases may be a sales aid for the product manufacture/ distributor. Relocation
.Lease rentals. .
Element 1. usually such lessor we financial institutions such as bank. . In a situation where the primary contact parole is somewhat equal or approximately equal to the useful economic life of the asset in question. As we allowed to earlier.2. However. if the manufacturer does not have the finance or tax capacity to act as lessor it may engage the services of a finance institution to act on its behalf. Usually in operating lease the present value of the rentals is way below the asset value.2 Operating Lease By definition. Element 1.6. Where the retorm is margin over the lessor’s cost of funds reflecting the credit rate the contract. Usually the lease life (tenure) is less than the assets useful economic life. the lessor will be responsible for maintenance and insurance costs payments. Usually equal.Insurance and maintenance In finance leases the lessee will be responsible for payment of such costs where as in an operating lease since the lessor is clearly the legal owner and according to the substance over form standard.Usually underlying interest rate Usually fixed interest rates are used smaller items for simplicity and a floating rate for large items if the lessee requires it. The main motivation of finance lease to the lessor is to make a profit by financing the asset. an operating lease is one other than a finance lease. 3.
An unreliable machine is expected to generate a contribution of K10. . 59
. The management of Singa Ltd. 000. it will be scrapped after year one (1) and sold for K800.000. It will buy back. Singa Ltd will keep it for four (4) years in total and it will generate a contribution of K16. Required: a) Prepare computations to show whether a rented or purchased machine is the financially better option. All machines that are reliable at the end of year 1 will still be reliable at the end of year 4. 000.Sale proceeds In most situations the major part of the sales proceeds are typically passed to the original lessee as a refund of the lease rentals.000 each year after which time it will be scraped and sold for K1. Singa Ltd is considering this and has found some research that suggests that each machine stands a 0. At present it hires its 35 photocopying machines from Rent-a-copier Ltd at an annual Rental fee of K11.000. once only. payable monthly (assume that cashflows occur at the year end). b) Xero Company has now made an alternative introductory. Singa estimates that each machine generates K15.000 of contribution each year.000 each. 200. Consider that a time horizon of no longer than 6 years should be used when evaluating decisions on photocopiers.With finance leases the lessee is usually responsible for relocating the asset to the lessors’ instructions at the end of the lease contract so it can be sold. Xero company sells photocopier machines and is trying to break into the Kitwe market and offers to sell to Singa Ltd new machines for K36. required. 30% of the machines at the end of either the first or second year if. The rental agreement covers a 24 hour repair service which assists Singa Ltd to maintain high reputation for a quick and reliable service. 200.7 chance of being unreliable. If the machine proves unreliable.000 each year. EXAMPLE – TREATMENT OF LEASING AND HIRE PURCHASE TRANSACTIONS
Singa Ltd owns 20 print and computer shops in Kitwe. as beyond the date photocopier machines are likely to be outdated technology.000 each payable on installation. The reliability of the machines will be discovered by the end of the first year.
LEASE RENTAL COMPUTATIONS. If a machine proves reliable. 200. offer. 000. The company’s annual cost of capital is 8%.
992 882 33.7 37. 200.000 x 0. Required Advice Singa Ltd wether or not it should accept the revised offer.712 1.
Solution: (a) Buying a single machine: K’000 Year 0 cost 36.
Required: Explain and illustrate with calculations the impact of taxation on the financial appraisal of: • • a rented machine a purchased reliatie machine (that is one that is kept for 4 years).000 Reliable: Year 1-4 (K16.000)
. Singn Ltd must nominate in advance which replacement option it prefers. the management of Singa Ltd has now agreed that further replacements after either year 1 or year 2 would be unnecessary.000 x 3. Having prepared the calculations in (a) and (b) you now realize that the effect of taxation should have been considered. 000.The buy – back price will be 60% of the original purchase price at the end of year 1 and 50% at the end of year 2. The corporation tax rate is 30%.874 x 0.312) Year 4 (K1.712 K’000 (36. The equipment will qualify for a 25% annual reducing balance writing down allowance. the management of Singa Ltd has now agreed that further replaced photocopiers available. If Singa Ltd agrees to either of Xero company’s proposals. it would remain with the company during the life of the purchased and replaced photocopiers. Assume that the 8% cost of capital is the after tax rate for part (c).735) 52. It is payable in four quarterly installments in the seventh and tenth months of the year in which the profit is earned and in the first and fourth months of the following year. Because most shops have two photocopiers available.
7 Probability of machine kept for 4 years.334) (cash received a new purchase price) 3.3 3.426(saving year 2) 0.926 0. Year 1 replacement over year 2: Year 1 Cashflow (K’000) 21.926 = Corporate figure for renting K1. 111.000 replacing in 5 1.384.K11.000. = (K15.712
Renting machine over corporate time period: 0.000 x 0.000 x 0.080 * 2 0. 712. 672.000) = K4.600 (36. 000. 000 x 0. 384.857 15.Unreliable Year 1 (K10.800 – K4.000 = K5. 2000 10.926) K800.000) Discount rate 0. 200.600 0.800
Therefore the rented machine is definitely the better option: K10.312 = K9.7 x 3.3 x 0.3 Probability of a machine kept for 1 year: 4.000.001 x 0.600 (net benefit of new over 2 yrs option) (18.000 x 0.200 *1 machine
.681 735 (sale of machine) by net
4.000 4.000) 36. 000.926 9. 200.857 Present value (K’000) (13.800 (i) Assume a faulty photocopier.260 741 10.000 K 4. 273.000 .
Annual inflow Unreliable machines K’000 105.500 149.000 Replacing in year 2 – assuming a full 6 year cycle for comparison (in years 5 & 6. 200.630
0 1 2 3 4 5
K’000 (1.7 = 24.960 429.260.000 – K10.000 105.6 income)
(1.000 392.500 31.540 101.220.500 31. 200.000 0.681 0.623 = K647.7 x K1.000 = K 3.440
K’000 (1.600 117.200.000 0.000 117.3 x K800.000 541.200.340
.640 419.926 0.000.000 31.080) (14.000 *2 0.260.000 included for 0.000.7 x K16.000 29.000 x 4.0000 0.000 K14.000 392.000 = K840.5)
Initial investment K’000 (1.000 = K11.000.000 = K4. 080.000 = K240.000.000)
Annual inflow Reliable machines K’000 K’000 392. some machines will have to be rented.600 117.000 Therefore replacement at the end of year 2 is better.260.320 101.100 570.857 0.000 K1. that is 35 machines x 0.000) 497.000 308.000) 460.794 0. 000. Renting over a 6 (six) year cycle: Yr 1-6 : 35 machines x K4.600 117.500
Sale Price K’000
DCF Rate K’000 1.000 392.630
(sale income forgone) (Loss of additional years (7.220 263.106) (income companion) from renting
*1 0.400 11.200) 2.735 0.080
189.3 x K10.100 16.500 31.
000 (9. However. The amount of taxation paid will be affected by the profit earned.240
Rental: 5 & 6 24.000) 27.200.000.376 7.376 2. instead of depreciation being charged each year a capital allowance may be set against profit.5 machines x K4. (This will reduce the net present value over 4 years by K1.500 3.360.3 = K3. The government sets the capital allowance rates. so the taxation calculation for renting a machine becomes (K15.532
.500 3.750 20. 6.974.
Years 1 2 3
Year 1 K’000 Purchase price 36.200.532 5.000 per year. The capital allowance rate in the scenario is 25% on a reducing balance basis and the table below shows how this would be applied to a reliable machine and the final net present value of the capital allowances.400 approximately. 5. Half of the tax will be paid in the year in which the profit is earned and half the following year. business expenses and the purchase of assets.312 = K3. renting still remains the better option by a small margin.200.188
2 K’000 4.250 5062 15.200.478 644. Machine purchased If the machine is purchased tax will still be paid on the profit earned but there will be no rented expense to set against this (increase in tax K11. ignoring the time factor (lag).000) x 30% = K1. Machine rented Taxation will be levied on the profit earned but the expense of renting a machine can be set against this.876
3 K’000 4.000 x 3.000 6.000 each year for a reliable machine).200. 4.311
2.000 Therefore.000 – K11.1.000 x 0.
which are in the best interest of the company or organizations.526 1. 428) : K8. 250 + K2. Rental calculation assumptions for an example.1 Structured and Unstructured Decisions In structured decisions managers use standard procedures in an outlined manner to deal with situations in a prescribed way. Element 1. We should realize at this point that business managers are leading corporations which have been established with a view to making profits. 100 + K1. 208. which we will work.7 Cost-Benefit Analysis In many situations where senior managers of a business make decisions. 024 + K1.772 6. than the costs involved in carrying them out.7.
.994 9.7.4 (sale price) Residual value Tax @30%
1. In the illustration below the tax effect the extreme case of 100% in the first year allowance and 50% tax rate is used.988 1. managers use the least pool of experience and intellect to make sound judgments.2 Goal Congruence And Decision Making All decisions which are made should be consistent with the corporate objectives. the decisions made can either be structured or unstructured. Element 1. all decisions which the business managers make should be seen to be adding more value to the business ultimately in excess of the costs involved.1.350 2. Therefore.000 Lease rental calculations are very similar to a discounted cash flow exercise as you could have seen it early in this chapter.200 13. In unstructured decision-making. though are summarized below.1.362 6.994
Total NPV (K’000): K1. Element 1. 406 + K2.
most business list the financial and quantitative revenues which the business is likely to earn against the total costs likely to be incurred in the pursuing the strategy. a cost-benefit analysis will involve a comprehensive comparison of the net benefits expected to accrue to an organization by pursuing a chosen strategy against the costs which are to be incurred in pursuit of the strategy.4 Cost.1.7. the qualitative costs and benefits might be more difficult to establish due to the grey nature of the qualitative consequences of our actions.1. Therefore.7.
Element 1.6 Scoring And Ranking Another commonly used technique for carrying out a cost-benefits analysis is by the use of scoring and ranking of several capital investments available to the business.
Element 1. Element 1. Please note that the benefits and costs can be either quantitative and / or qualitative at the same time. in whatever context we look at business decision making. the managers will have need to carry out a rigorous cost benefit analysis.1.3 Nature of Cost.
. before a corporate strategy is implemented in a business.1. Some of the methods include the following: Element 1.7.7.Benefit Analysis As we have mentioned above. Ranking and scoring is used both in situations where we are evaluating a single strategy or where we are evaluating multiple strategies so that we can eventually choose the best option out of them all. business managers are going to consider the benefits against the cost of pursuing a given strategy before they embark on implementing that particular decision.Therefore. However. as we mentioned earlier where.5 Profitability/ Net Cash-Flow Typically and usually when carrying out a cost benefit analysis.Benefit Analysis Techniques There are a lot of techniques used to undertake cost benefit analyses.
1.Element 1. the CEO has requested you in your capacity as management accountant to carry out a comprehensive cost-benefit analysis. As a result. Suggested illustration STEP 1.
Example: 0 1 2 3 4 5 6 7
You can choose 7 (seven) as the best score and choose 0 as the worst scenarios possible.7 Mechanics of Scoring and Ranking In scoring. a corporation / decision maker will establish a scale which will act as a rating scale.
. Eventually the decision maker will total or aggregate the total scores for the benefits and for the costs separately and compare which one outweighs the other. The marketing Director has suggested that the company should invest heavily in the marketing activities. Lets illustrate with a simple situation to show how ranking and scoring can be done. As a result the entire management is concerned deeply and they have the following views.7. the Manex. the decision maker should list possible benefits and the likely costs to be incurred as a result pursuing a given strategy. the finance director is a bit sceptical concerning the likely benefits of this hefty expenditure on the marketing campaign. However. This scale will give a worst and best rating on the scale. Assume that Chinsa Ltd has been experiencing low sales of its product. Most importantly. Set and establish a rating scale or the purpose of this illustration assuming that 1 represents the worst situation and 5 represents the best scenario.
STEP 2. Bigger client base
Rating 3 4 2 9
3. List the likely benefits and costs of staging (mounting) up a massive marketing campaign.Increase profits
Costs .Huge financial outlay . Increase profits Total scores for benefits costs:
Huge financial outlay
.Bigger client base .Expected continued advertising
STEP 3. Good corporate image 2. The likely benefits and costs would be the following: These are not exhaustive
Benefits .Good corporate image . Assign weightings or ratings from the scale to each benefit and each cost
the scores represent both the qualitative and quantitative benefits. This is only a simplistic approach. However.(ii)
Expected continued advertising
Total scores for the costs:
STEP 4. the analysis and comparison show that the benefits of staging a massive campaign will gives Chinsa Ltd more of benefits than costs. lets look at an equally important aspect of project evaluation and management. which is only a part of the investment process. It should be noted that in the above exercise. So purely following the scoring and ranking we expect Chinsa Ltd to benefit greatly from the marketing campaign. This is the aspect of Post-completion Audit.
.7. and so the decision to invest in it should be upheld. To conclude the chapter. Compare the total scores for benefits and the one for costs. in practice so many factors are likely to be taken into consideration and the management accountant will need to be carryout the analysis with a great amount of help from marketing professionals and other business personal who may make work as researchers and general R&D employees with Chinsa Ltd. which are associated to the various benefits and costs identified by the management accountant and his team.2 Post Project Completion Audit From the onset of the chapter we have only been looking at evaluation of projects.
Element 1. Benefits Costs Difference 9 8 1
As can be seen above.
to assess whether it lived up to initial expectations in term of revenues and costs and analyse the causes of deviations from planned results. Type 2 The second and final category of benefits relates to the additional information concerning the choice and performance of future projects and the main benefits are given below. good or bad gained during the life of one project to be made available for the benefit of future projects.2. It highlights reasons for successful projects. Its main purpose is to enable the experiences. Element 1. the project under review.7. It encourages greater realism in project appraisal by providing a mechanism where past inaccuracies in forecasts are made public.2 Mechanics of Post – Completion Audit A post – audit small team.2.7. The audit is thus essentially a forward-looking one as it seeks to establish lessons from the past for the future benefit of the corporation. Type 1 Those benefits that relate to the performance to the current project i. Element 1.e.The post completion audit of projects provide the mechanism whereby experience of past projects can be fed into the firm’s decision-making process as an aid to the improvement of further projects.
It improves the quality of decision making by providing a mechanism whereby past experience can be made readily available to decision makers. The post – completion audit reviews all aspects of a completed project. which may be important in achieving greater benefits from future projects.1 Benefits of Post –Completion Auditing There are a number of benefits that stand out so clearly from a project post – completion audit. usually carries out completion audit. typically professionals such as an engineer who had some involvement in the project. The benefits can be classified in two main categories.
Therefore price refers to the monetary amount which corporations sale their chosen units of products/services. Influences on Price There are so many variations that dictate the price at which given commodities or services can be sold at.UNIT 2.0 PRICING THEORY
Learning Outcomes: At the end of this chapter candidate • • • • • Should identify and discuss market situations which influence the pricing policy adopted by an organization Should explain and discuss the variations that influence demand of a product or service Should be able to calculate prices using full cost and marginal cost as the pricing base Should be able to compare the use of full costing pricing and marginal cost pricing as planning and decision making aids Should be able to appreciate the concept of transfer pricing and its mechanics.
Definition of price Organizations operating as businesses always produce or provide tangible products or intangible services for sales to customers in order for them to pursue their primary corporate objective of enhancing shareholders wealth.
. The products and services are sold at a price.
so this ensures that all costs are covered.
. Traditional Pricing Bases The two main traditional methods of pricing one (i) (ii) full-cost pricing marginal cost pricing
Element 2. In the absence of other information.1 Cost plus Pricing With full cost pricing. a price reduction may signal reduced quality. In others. (b) Existence of intermediaries
If an organization distributes products or services to the market through independent intermediaries. the sales price is determined by calculating the full cost of the product and then adding a percentage mark-up for profit. pricing moves in unison. labour. rent and so on. (c) Competitor Activities
In the same industries. customers tend to judge quality by price. (d) Inflation
In periods of inflation the organization may need to change prices to reflect increases in the prices of supplies.The following are the main factors that influence price of services or products. Competition is discussed in more detail below. price changes by one supplier may initiate a price war. The full cost pricing is useful if prices have to be justified to customers. Thus a price rise may indicate improvements in quality. such intermediaries are likely to deal with a range of suppliers and their aims concern their own profits rather than those of suppliers.
This is an aspect of price perception.
However.On the other side. In practice as you already know. This is sometimes called ‘mark-up’ pricing.
Element 2. for which the following cost estimates have been. the full cost pricing method takes no account of the market or demand conditions.000 3. a profit margin is added on to either the marginal cost of production or the marginal cost of sales.2 Marginal Pricing With marginal cost pricing. 2½ hour at K6.000
.000 Direct labour: 4 hours at K5.000 50. again it takes no account of market or demand conditions. it helps to create a better awareness of the concepts and implications of marginal costing and cost-volume profit analysis. pricing decisions cannot ignore fixed costs in the long term. It draws management attention to contribution. product X. in retail businesses. In this way.000 per hour Variable production overheads Machining. and the effects of higher or lower sales volumes on profit.000 per hour 20. It may also require arbitrary decisions about absorption of costs. The cost accountants may also have problems in determining the accurate profit mark-ups. Example 1 Muti Ltd has begun to produce a new product. K Direct materials 27.g. The marginal cost pricing is convenient if there is a readily identifiable variable cost e.
000 direct labour hour Full production cost 98.000 48.000.000 Profit mark-up (20%) 19. however. and it is recognized that the estimates of direct materials and direct labour costs may be subject to an error of + 15%. What should the full cost based price be? The following solutions have been developed based on four (4) assumptions. It is estimated that the company could obtain a minimum contribution of K10.000
. the company will be restricted to 10. and budgeted direct labour hours are 25.000 3.000 per machine hour on producing items other than product X. The Direct Cost estimates are not certain as to material usage rates and direct labour productivity.Production fixed overheads are budgeted at K300.600 K 27. Machine time estimates are similarly subject to an error of + 10%.000 per month.600 Selling price per unit of product X 117. 000 per month and because of the shortage of available machining capacity. The company wishes to make a profit of 20% of full production cost from product X. The absorption rate will be a direct labour rate.000 hours of machine time per month.000 = K12.000 per 25.000 20. (a) Exclude machine time opportunity costs: Ignore possible costing errors Direct materials Direct labour (4 hours) Variable production overheads Fixed production Overhead (K300.
600 123.000 48.(b)
Include machine time opportunity costs: Ignore possible costing errors.510 135. Full production cost is in (a) Opportunity cost of machine time (Contribution forgone (½hr x K10.000 7.600
Exclude machine time opportunity costs but make full allowance for possible under-estimates of costs.000 47.060 K
. Direct materials Direct labour Possible error (15%) Variable production Overheads Fixed production Overheads (4 hrs x K12.000 5.050 54.000) Adjusted full cost Profit mark-up (20%) K 98.200 112.000 3.000 72.050 3.000 20.000 20.000) Possible error (labour time) (15%) Potential full production cost Profit mark-up (20%) K 27.000 103.550 22.000 55.
the Luan. there will be a profit – maximization combination of price and demand. except by coincidence or luck to arrive at the profit-maximising price. A full cost based approach to pricing will be most unlikely. In contrast a marginal costing approach to looking at costs and prices would be more likely to help with identifying a profit–maximising price.1 Full Cost Versus Marginal Cost Pricing The most important and common criticism of full cost pricing is that it fails to recognize that since sale demand may be determined by sales price.000 x 110%) 112. K Potential full production cost as in (c) Opportunity cost of machine time (Potential contribution forgone) (½hr x K10.(d)
Include machine time opportunity costs and make a full allowance for possible under-estimates of cost. The Marketing Director has challenged the wisdom of this suggestion.500 23.550
5.000 Demand Units 42.000. Example 2 Luangwa Ltd has budgeted to make 50.000
. and has produced the following estimates of sales demand for the Luan.000 and annual fixed costs are expected to be K150.660
Profit mark-up (20%) Selling price per unit of product X
141.000 units of its product. The variable cost of a Luan is K5. Price per unit K 9.2. The Finance Director of Luangwa Ltd suggested that a profit margin of 25% on full cost should be charged for every product sold.
000 per unit so that sales demand would be 38.000 x K3.000 12.000 units.000 35. (i) Profit (absorption costing) K 000 Sales Costs of production (50.000) K000 380.000 11.000 = K3. (production is given as 50. Assume in both (a) and (b) that 50.000) 150.000 (K5.000 32.000 Fixed (50.000) 250.000 units x 8) (96.e.000) in total.000 x K5.000 27.000 units of the Luan are produced regardless of sales volume.000 Less increase in stocks (12.000 units hence i.000 variable cost plus K150.000
.000 13.000.10.000 Required (a) (b)
38.000\unit 50.000 units). K8.000 units) Variable (50. A 25% mark-up on this cost gives a selling price of K10. Calculate the profit-maximising price.
Solution (a) (i) The full cost per unit is K5.000 400.000
Calculate the profit for the year if a full cost price is charged.000 + K3.
it would be as follows (the 38.000 12.000
The profit maximizing price is K12.000 210.
Profit using marginal costing instead of absorption costing so that fixed overhead costs are written off in the period they occur. This example shows that a cost based price is unlikely to be the profit – maximizing price.000 with annual sales demand of 32.000 units.000 10.000 27. calculating the total contribution at a variety of different selling prices.000 40.000 224.
Price K 9.000 x K(10. will be more helpful for establishing what the profit – maximizing price ought to be. this profit figure is more indicate of the profitability of the Luan in the longer term.000 Fixed costs Profit 150. K Contribution (38.000 190.000 13.000 216.000)190.000
Amount K 168.000
Since the company go on indefinitely producing an output volume in excess of sales volume.Cost of sales Profit (ii)
304.000 32.000 6.000
Demand units 42.000 35. and that a marginal costing approach.000 38.000 5.000
Unit Contribution K 4.000 7.000 – 5.000 76.000 11.000 unit demand level is chosen for comparison purposes). (b) A profit-maximising price is one which gives the greatest net (relevant) cash flow. which in this case is the contribution-maximising price.
2.000 Material 150. overheads are allocated to products on the basis of the activities that caused them to be incurred. Example 3 ABP Ltd makes two products. under the ABC approach.000 Product Y K 24.000 50. Budgeted direct labour hours are 25.000 Production runs 30 20 Production runs 30 20 Cost driver X Y K Product Total
. The implication for pricing is that the full cost on which prices are based may be radically different if ABC is used. Product Cost Activity 000 Set-ups 40.000 Per hour
6.000.000 55. X and Y with the following cost patterns.000/hr Variable production Overheads at K6. Product X K 27.000 20. rather than according to some arbitrary base like labour hours.000
Production fixed overheads total K300. the company has carried out an analysis of its production support activities and found that its fixed costs actually vary in accordance with non volume-related factors. However.000 hours per month.Element 2.2 Activity Based Pricing (ABP) Activity based costing provides an opportunity for organizations that use costbased pricing to gain a greater understanding of their costs and so correct pricing anomalies that derive from the distorted view given by conventional volume-related costing.000 25. As you already know.000
Direct materials Direct labour at K5.000 per month and these are absorbed on the basis of direct labour hours.
Required: Given that the company wished to make a profit of 20% on full production cost.520
Budgeted production is 1.000.000
Using activity based costing.000\hr) 48.000\25. overheads will be allocated on the basis of cost drivers.600
60. (a) (b) Full cost pricing Activity based cost pricing
Solution (a) The full cost and mark-up will be calculated as follows: Product X K Variable costs 50.250 units of product X and 4000 units of product Y.000 98.000
Fixed production Overheads *K300.000 300.000
3. calculate the prices that should be charged for products X and Y using the following. Product X K 000 Product Y K 000 Total K000
.000 Product Y K 55.600 117.000 23.000 Profit mark-up (20%) Selling price (b) 19.000 = 12.Inspection 110.000 115.000 138.
The target cost is calculated by deducting the target profit from a predetermined selling price based on customer’s views.600. On this basis it appears that the company has previously been making a huge loss on every unit of product X sold for K117. it may be worth considering leasing production of product X entirely.Set ups (30:20) Material Handling (30:20) Inspections (880:3.000 ÷ 4. Target cost is an estimate of a product cost which is derived by subtracting a desired profit margin from a competitive market price.000 150.560 (c) Commentary Product X K 55.
Element 2.760 190.200
The results in (b) are radically different from those in (a).250 K108.
. It also appears that there is scope for a reduction in the price of product Y and this would certainly be worthwhile if demand for the product is elastic.000
16.000 22.200 115.3 Target Pricing Target costing is a pro-active cost control system. Techniques such as value analysis are used to change production methods and or reduce expected costs so that the target is met.800
Therefore the price then calculated as before Product X K Variable costs 50.000 41.000 K41.000 136.000
Budgeted units Overhead cost per unit
÷ 1.000 90.000 164.000 19.000 60.000 300.000 Production overhead 108.000 88.800 158.800 Profit mark-up (20%) 31. If the market will not accept a price increase.000 110.520)
What appears to be evident is that there are almost as many misconceptions of target costing as there are companies deploying the approach and there are probably many companies engaging in various aspects of target cost management without referring to the term.Target cost management has been defined as a system that is effective in managing costs in new product design and development stages. The target costing approach is to develop a product concept and the primary specifications for performance and design and then to determine the price customers would be willing to pay for that concept.1 Managerial Thinking to Support Target Costing and Pricing Target costing requires managers to change the way they think about the relationship between cost. During the products life the target cost will constantly be reduced so that the price can fall. Costs are controlled through variance analysis at monthly intervals.3. Element 2. determine the expected standard production cost of that product and then set a selling price\probably based on cost) with a resulting profit or loss. It has also been viewed as allowing the production cost of a proposed product to be identified so that when sold it generates the desired profit level. Continuous cost reduction techniques must therefore be employed. price and profit. This is the target cost and the product cost and the product must be capable of being produced for this amount otherwise the product will not be manufactured. Target cost management has also been viewed as playing a useful role in enabling an enterprise to set and support the attainment of cost levels to effectively reflect its planned financial performance. (a) The traditional approach is to develop a product.
The desired profit margin is deducted from the price leaving a figure that represents total cost. The Target Costing Process Step 1
or the product redesigned or scrapped. Element 2. Step 3 Once it is decided that it is feasible to meet the total target costs. then a cost gap exists between the currently achievable cost and the target for the other areas must be reduced. manufacturing and so on. Life cycle costing. quality. Life cycle costs are incurred for products and services from their design stage through development to market launch production and sales. considers a product’s\project’s entire life. and their eventual withdrawal from the market. Split up the manufacturing target cost per unit across the different functional areas of the product. Design the product so that each functional product area can be made within the target cost. They assess a product’s or project’s profitability on a periodic basis. Determine the product concept.Analyse the internal environment to ascertain what customers require and what competitors are producing. the price customers will be willing to pay and thus the target cost. Traditional management accounting systems in general only report costs at the physical production stage of the life cycle and do not accumulate costs over the entire life cycle.4 Life Cycle Pricing Life cycle costing assists in the planning and control of a product’s life cycle by monitoring spending and commitments to spend during a product’s life cycle. The product should be developed in an atmosphere of continuous improvement using value engineering techniques and close collaboration with suppliers. to enhance the product (in terms of service. If a functional product area cannot be made within the target costs. marketing. durability and so on) and reduce costs. Step 2 Split the total target cost into broad cost categories such as development. Final Commentary on Target Pricing Target pricing therefore will involve pegging a pricing for a product or service which will well cover the targeted cost of manufacturing a product or providing a service. on the other hand.
. detailed cost sheets will be prepared and processes formalized.
monitoring spending and commitments to spend during the early stages of a product’s life cycle. Remember the product life cycle you learnt in management. this information is vital. (b) The visibility of such costs is increased. Life cycle costing is therefore particularly suited to such organizations and products. In today’s competitive environment were the ability to produce new and updated versions of products is paramount to the survival of an organization. more accurate feedback information is available on the organisation’s success or failure in developing products.Life cycle costing tracks and accumulates actual costs and removes attributable costs to each product or project over the entire product\project life cycle. Illustration of product life cycle
. Using life cycle costing. Life cycle pricing therefore involves pricing a product at a rate which covers the costs which are anticipated over the entire life cycle of the product in question. (d) As a consequence. The strong force which supports life cycle costing is that generally for organizations operating within the manufacturing technology environment. (a) The total of these costs for each individual product can therefore be reported and compared with revenues generated in the future. Traditional management accounting systems usually total all non-production costs and record them as a period expense. The total profitability of any given products\project can therefore be determined. (c) Individual product profitability can be more fully understood by attributing all costs to products. such costs are traced to individual products over complete life cycles. its found that approximately 90% of a product’s life cycle cost is determined by decisions made early within the cycle at the design stage.
In the case of (i) pricing for special orders need therefore take account of unavoidable fixed cost because any firm like in the case of (i) is not attempting to cover its longer-term running costs in its prices for its regular product or services. For example Nkwazi Breweries might have a capacity of 500.5 Other Pricing Methods Element 2. These may arise in the following situations.000 barrels per month. in the case of (ii) where the special order is the only source of income.000 barrels per month but only producing and selling 300. (ii) When a business has no regular source of income and relies exclusively on its ability to respond to demand.introduction
Time Element 2. all costs incidental to the special order and the fixed unavoidable cost should be incorporated in the special order pricing.
A building firm is a typical example as are many types of subcontractors. It could therefore consider special orders to use up some of its spare capacity. (i) When a business has a regular source of income but also has some spare capacity allowing it to take on extra work if demanded.5. However.
.1 Order Pricing A special order is a one-off revenue earning opportunity.
Element 2.3 Market Penetration Pricing Penetration pricing is a policy of low prices when a product is first launched in order to obtain sufficient penetration in to the market. and a company has spare capacity.5. (b) It is unlikely that a minimum price would actually be charged because if it were it would not provide the business with any incremental profit.Element 2.2 Minimum Pricing A minimum price is that which would have to be charged so as to cover the following two groups of cost. A penetration policy may be ideal in the following cases: (a) When the firm wishes to discourage new entrants into the market. the minimum price of a product would be an amount which equals the incremental cost of making it. Two important points to understand here about a minimum price are as below: (a) It is based on ‘relevant costs’ Relevant costs are incremental costs plus the opportunity costs of making and selling the product or providing a service.
A minimum price would leave the business no better or worse off than if it did not sell the item.
If there are no scarce resources. minimum peeves would include an allowance for the opportunity cost of using the scarce resources to make and sell the product. If there are scarce resources and a company makes more than one product. The opportunity costs of the resources consumed in making and selling the product/service.5. (i) (ii) The incremental costs of producing and selling the product/service.
(a) (b) (c) When the product is new and different. As the product moves into the later stages of its life cycle.
When the firm wishes to shorten the initial period of the product’s life cycle in order to enter the growth and maturity stages as quickly as possible.
Element 2.5 Differential Pricing The use of differential pricing means that the same product can be sold at different prices to different customers. When there are significant economies of scale to be achieved from a high volume of output. that is if lower prices were to be charged.5. When high prices in the early stages of a product’s life might generate high initial cash flows. Where products may have a short-life cycle. and so need to recover their development costs and make a profit relatively quickly.
. So market skimming pricing would be appropriate in the following cases. The aim of market skimming prices is to gain high unit profits early in the product’s life.5. progressively lower prices are charged. Initially there is heavy spending on advertising and sales promotion to obtain sales. A firm with liquidity problems may prefer market-skimming for this reason. High unit prices makes it more likely that competitors will enter the market. so that customers are prepared to pay high prices so as to be one up on other people who do not own it.4 Market Skimming Pricing Price skimming involves charging high prices when a product is first launched in order to maximize short – term profitability. The profitable ‘cream’ is thus skimmed off in the early stages until sales can only be sustained at lower prices. When demand is highly elastic and so would respond well to low prices. Examples of products to which market skimming pricing policy could be applied would include latest versions of products such as (i) (ii) (iii) Calculator Video recorders Desktop computers and other technology based products.
g. Centre A sells half of its output on the open market and transfers the other half to B.000 10. By product version e. We can exercise differential pricing on the following cases: (i) (ii) (iii) By market segment e.000
External sales Costs of production Company profit Required. 000. many car models have ‘Add on’ extras which enable one brand to appeal to a wider cross-section of customers. theatre seats are usually sold according to their location so that patrons pay different prices for the same performance according to the seat type they occupy. By time e. this is perhaps the most popular type of differentiating pricing. which is what A would get by selling it externally.g. Celtel charges less for its air time or credit in off peak period and vice versa.000 12.
.000 Total K’000 32. Price differentiation can only successfully be implemented if the market can be well segmented and there is little chance of arbitrage or chance of a black market developing (which would allow those in the lower priced segment or bracket resale to those in the higher priced segment or bracket). on the continued existence of certain market conditions.This can be very difficult to implement in practice because it relies for success. Example: Transferring Goods at market price A company has two profit centres.g.g. Costs and external revenues in a period are as follows. A would be happy to sell the output to B for K8.000 B K’000 24. By place e.
What are the consequences of setting a transfer price at market price? If the transfer price is at market price. services such as cinemas and hair dressing are often available at lower prices to juveniles and old age pensioners. 000. A and B.g.000 22.
E. A K’000 8.000 10.
although there is an external market.000 6. (a) Where the supplying division has spare capacity the ideal transfer price will simply be the standard variable cost of production. Element 2.000
K’000 8. however. the ideal transfer price will be the variable cost of production plus the contribution forgone by using the scarce resource instead of putting it to its most profitable alternative use. (b) When there is a scarce production resource.000 10.A K’000 K’000 Market sells Transfer sales Transfer costs Own costs _____ Profit The consequences. and unit variable costs and sales price are constant.000 4.000 10.7 Cost-based approaches to transfer pricing Cost-based approaches to transfer pricing are often used in practice. it is an imperfect one because there is only limited external demand. are as follows.000
32.000 8. If profit centres are established.
(b) A will be indifferent about selling externally or transferring goods to B because the profit is the same on both types of transaction.000 12.5.000 8. (a) 12. It would seem reasonable for the buying division to expect a discount on the external market price.000 24. with savings in selling and administration costs.
Element 2.5. bad debt risks and possibly transported/delivery costs. B must pay a commercial price for transferred goods. therefore.000 22.
B K’000 24.6 Adjusted Market Price Internal transfers in practice are often cheaper than external sales. there are two possibilities.000 18.000
A earns the same profit on transfers as on external sales.000 16. B can therefore ask for and obtain as many units as it wants from A. because there is often no external market for the product that is being transferred or because.
inc Transfers _____ Profit 10.000 10. It transfers the other half of its output to B which also faces limited demand. as follows.000 6.
External sales Costs of production in the division (Loss)/Profit
A K’000 8.000 10.000 14.000 8.000)
B K’000 24.000 (ie half of its total costs of production). Costs and revenues in a period are as follows. This would be a cost to B.000 24.000 16.000 14.000. Centre A can only sell half of its maximum output externally because of limited demand. If a full cost plus approach is used. would prefer to sell its output on the open market if it could. The transfer price simply spreads the total profit of K10. Division A makes no profit on its work and using this method. inc Transfers Transfer costs Own costs Total costs.000 10.000
The transfer sales of A are self-cancelling with the transfer costs of B so that total profits are unaffected.Transfer prices based on full cost Under this approach the full standard cost (including fixed overheads absorbed) that is incurred by the supplying division in making the product is charged to the receiving division. A in our example would have ‘sales’ to B of K6. a profit margin is also included in this transfer price. A company has 2 profit centers.000 B K’000 24. A K’000 Open market sales Transfer sales Total sales.000.000 12. A and B.000
Total K’000 32.000 12.000 K’000 K’000 8.000
If the transfer price is at full cost.000 between A and B.000 (4.000 12.
.000 6.000 22.000 2.
A’s sales to B would be K7. Division A’s total costs of K12. A price change may be necessitated by a general increase in the cost of production or high levels of demand for the company’s products or services.000.1 : Changes in price levels are a common scenario in the operations of a company.000. Suppose that the cost per unit to A is K15.000 = K24.000 + K15. Element 2. A makes a bigger profit on external sales in this case because the profit mark-up of 25% is less than the profit mark-up on open market sales. say. which is (K8.500.000. A gains some profit at the expense of B. while division B’s own costs are K25.000 12. and so their profit performance is distorted.000.000.000 K’000 8.500 15. Half of division A’s total costs are transferred to division B. The total variable cost is really K9. The transfer price does not give A fair revenue or charge B a reasonable cost. However from the point of view of division B the cost is entirely variable.000 whereas any price above K24.000 would make a contribution. This may or may not be in the best interests of the company as a whole.000 24.500 Compared to a transfer price at cost.000.000)/ K6. A K’000 Open market sales Transfer sales Transfer costs Own costs _____ Profit 3.000 = 33%.000 but from division B’s point of view the variable cost is K15.500 B K’000 K’000 24.000 = K30. 12.000.000
.000 – K6. However.000 22.000. It would seem to give A an incentive to sell more goods externally and transfer less to B. 25%.000 7.Transfer prices based on full cost plus If the transfers are at cost plus a margin of.000 17.500
7.000 per unit.6.500 10. This means that division B will be unwilling to sell the final product for less than K30.000 will include an element of fixed costs. including a fixed element of K10.500 6.6 Changes in price levels Element 2.000 and that this includes a fixed element of K6. The change in the price levels may be due to external or internal factors.000 + K15.
From the preliminary studies the following analysis has been made.000 12.000. Since price level changes represent decisionmaking under conditions of risk and uncertainty.000 12.It is important to relate the price changes to both production costs and selling price of the product or service.3 Selling price K 10.600.000 0.000.500 Demand Probability 0.000 30.000.4
Outcomes At Selling Price K 8.000 40.6. Any price change is bound to affect the demand and therefore the variable costs giving varying possible outcomes.000 30. Buta detergent.000 60.2 A price change can also arise when a company is introducing a new product as it is common for a number of prices to be considered.500
Demand 40.5 Most Probable 60.000 Net Price Expected Value 70.000
. it is important to analyse the expected outcome for each price level.6.000.000 20. Element 2.000 10.1 Less Probable 30.3
Example Mwine manufacturing company has come up with a new soap product.000 30.000 0.000.000
Outcomes Probability Probable 40.200.000.4
Element 2.000.000.6.000 Contribution Fixed Cost 120.000 80.000 0.000 90.6 0.000 50.000 1.000. Selling price K 8.000 50.000 50.000.000 Demand 50.000.
Element 2.000 700.000.600.000 50.1 0.
000 50.000 50.700.000 50.000 50.000 14.000 Contribution 225.200.000.000 Fixed Cost 50.000.000 50.000 5.000 90.000.000 105.000.000.000
Demand 50.000 60.700.000 175.000.000 10.000
11.000 50.000 53.000 52.000
At Selling Price K 10.000 40.000.6.000.400.000.000 135.000 Net Price Expected Value 175.750.000.000. even though the difference is not so significant.000.000 20. If those business units are located within different countries.5
From the outcome it is evident that chosing the selling price of K 8500 gives a higher expected value.000.000.000.000.000 50. the term international transfer pricing is used.250.000 20.000
Element 2.000 120.000 55. Furthermore it will not be an easy task to come up with an accurate estimate of future demand and the probable outcomes.000.000.000.000 85. In practice however other factors may be considered.000 130.000.180.000.000.000 125.000 8.000 70.
Element 2.600.000 30.000.000.000.500.000 15.
.000 70.000.000 6.7 Transfer Pricing Theory This is the price at which goods and services are transferred between different units of the same company.000 7.
Center A sells half of its output on the open market and transfers half to B.000.000.000 12.000 B K 24. Transfer pricing with a constant unit variable costs and sales price: An ideal transfer price should reflect the opportunity cost.000. and should be set at a level that enables profit centers to be measured ‘commercially”. The management accountant therefore has to devise a transfer pricing method that meets the following criteria: • • • Equity (provides a fair measure of divisional performance) Neutrality (avoids the distortion of business decision making) Administrative simplicity
The transfer price should provide an “artificial” selling price that enables the transferring division to earn a return for its efforts and the receiving division to incur a cost for benefits received.000. A and B.000. the opportunity cost f transfer will be one or other of the following • • External market price External market price less savings in selling costs.000 (22.000 10. Costs and external revenues in a period are as follows.Transfer prices are a way of promoting divisional autonomy.
Example A company has two profit centers.000
. ideally without prejudicing the measurement of divisional performance or discouraging overall corporate maximization.000.000 Total K 32. A K External sales Costs of production Company profits Required 8.000) 10.000. This means that the transfer price should be a fair commercial price. Where a perfect external market exists and unit variable costs and sales are constant.
000 (400) 3.400
The problem is that with a transfer price at variable cost the supplying division does not cover its fixed costs. we shall suppose that A’s cost per unit is K15. The opportunity cost will be one of the following.000 x 6.000 3.800 12. the transfer price = standard variable cost of production
.000 is fixed and K9. Transfer price per unit = standard variable cost in the producing division plus the opportunity cost to the organization of supplying the unit internally.000 24.200 4.What are the consequences of setting a transfer price at the market price? Transfer prices based on variable cost A variable cost approach entails charging the variable cost that has been incurred by the supplying division to the receiving division.000) Transfer costs Own variable costs Own fixed costs Total costs and transfers (Loss)/Profit K’000 8.000 /15. Element 2.000
13.600 6.1 Transfer prices based on opportunity costs It has been suggested that transfer prices can be set using the following rule. (a) (b) (a) The maximum contribution foregone by the supplying division in transferring internally rather than selling externally The contribution foregone by not using the same facilities in the producing division for their next best alternative use If there is no external market for the item being transferred. As above.600 11.000 4.7.000 K’000
B K’000 24.
A K’000 Market sales Transfer sales at variable cost (9.600 7. and no alternative uses for the division’s facilities.600 10. of which K6.000 variable.000.
(b) If full cost plus is used the problem is how to set the margin at a level that all parties perceive as being fair. standards may become out of date so it is advisable to have an agreement to revise them periodically. the transfer price = the market price. (c) If variable cost is used the transferring division does not cover its fixed costs but two-part prices (the variable cost transfer price plus a fixed annual fee) might be used to overcome this.
. (e) On the other hand.(b)
If there is an external market for the item being transferred and no alternative use for the facilities. (a) The starting point should be to establish the output and sales quantities that will optimise the profits of the company or group as a whole. The next step is to establish the transfer price at which both profit centers. (d) Transfer prices based on standard cost are fairer than transfer prices based on actual costs because if actual costs are used the transferring division has no incentive to control its costs: it can pass on its inefficiencies to the receiving division.3 Problems in transfer pricing (a) If transfer prices are set at full cost. Any price within the range would then be ‘ideal’.7. the transferring division makes no profit.2 Transfer pricing when unit variable costs and sales prices are not constant When unit variable costs and/or unit selling prices are not constant there will be a profit-maximising level of output and the ideal transfer price will only be found by careful analysis and sensible negotiation. the supply division and the buying division. would maximize their profits at this company-optimising output level.
Element 2. There may be a range of prices within which both profit centers can agree on the output level that would maximize their individual profits and the profits of the company as a whole.7.
7. (c) Incorporate risk attitudes in a fair transfer price. Head office management may impose a price that maximizes the profit of the company as a whole.
Element 2. the transfer price mechanism allows them to move value from one country to another without actually engaging in trade.4 Negotiated transfer prices When authority is decentralized to the extent that divisional managers negotiate to transfer prices with each other. and at what transfer price does the selling division earn the entire group profit? (b) Variability. Bearing in mind the difficulty discussed above of establishing the level at which a transfer price should be set.7.5 International transfer prices When firms transfer goods and services not only internally. (a) Identifying the outer bounds of the transfer price. so that the profit-share between divisions takes the riskiness of the project into consideration. Where negotiation is necessary there should be an understanding of the risk/return profile. but also internationally. Tomkins suggests the following methodology. at what transfer price does the buying division end up earning the entire group profit. In other words. politics and compromise.
Element 2.Element 2. (b) On the other hand.7. while a ‘high’ one moves it into the transferring country. which head office can apply when mediating in disputes. head office management might restrict its intervention to the task of keeping negotiations in progress until a transfer price is eventually settled. we may say that a ‘low’ price effectively moves value into the receiving country. At each transfer price. compare each division’s expected profits and the variability of the profits. the agreed price may be finalized from a mixture of accounting arithmetic. (a) Head office imposition. Inter-departmental disputes about transfer prices are likely to arise and these may need the intervention of head office to settle the problem.6 Using transfer prices
Centrally determined transfer prices can seriously affect the ability of national managers to influence the performance of their divisions. However.7. It can enable a low-price strategy aimed at driving out competition without arousing the suspicions of the local tax authorities by declaring a very low level of profit.
Element 2. A resource or competence based approach to strategy would immediately challenge this and call for detailed consideration of the benefit of a market based
. non-market based transfer price makes an implicit assumption that the hierarchy solution is the best one.7 Centrally determined transfer prices and strategy These considerations produce pressure for multinational companies to set their transfer prices centrally. This can affect their overall motivation. there may not have been any actual consideration of the market alternative. (i) (ii) (iii) (b) (c) Profit can be minimized in states with high profit taxes Selling prices can be minimized in states with high levels of irrecoverable VAT (and similar taxes) The value imported into countries with high tariff levels can be minimized
It can be used to move profits to the home country from states with restrictions on repatriation of profits or on currency exchange. However. Transaction cost theory is dealt with in Paper 5 but it is also relevant to Paper 6. other important strategic considerations relating to this approach. (a) Autonomy. There are. however. a centrally determined. Transaction cost economics. this course of action is likely to lead to accusations of dumping. encourage them to seek ways around the restrictions imposed and make it more difficult to assess their overall performance.This ability to decide in which country value (and particularly profit) is created is extremely useful. In terms of transaction cost economics. (a) It can be used to manage taxation. It can be used strategically (i) (ii) It can disguise the attractiveness of an operation to competitors by reducing profits.
(b) Where diversification is low. (c) Where diversification is high and integration is low.7. as is the rest of each subsidiary’s trade. as in the now unfashionable diversified conglomerate.8 The Eccles matrix R J Eccles suggests that the method of setting transfer prices should reflect the organisation’s degree of diversification and its degree of vertical integration. where diversification and integration are both high. The crucial question is whether the business should actually be operating any given national subsidiary at all. Nevertheless. once again.approach. Where both diversification and integration are low. transfers are likely to be uncommon and should be at market price. whether its services should be bought in. so the transfer price should be negotiated: it should probably be set at full cost so that resource allocation is appropriate and the supplying division’s costs are covered. it can be set collaboratively. as may be the case when there is extensive trade along a supply chain combined with similarly extensive market-based exchanges. as. the transfer price should be set collaboratively. but vertical integration is high. for example. in the relationship between two shops in a retail chain. cooperation is important. a transfer price may not even be required. Element 2. but if it is. (a)
. as in the relationship between two different stages of product assembly.
STUDY UNIT 3. value-added and non-value-added activities. target costs and costing.0 COST ANALYSIS
AIMS AND OBJECTIVES This chapter is concerned with the behaviour and reduction of costs in both traditional and advanced manufacturing environments. ‘traditional’ cost-reduction methods. zero-base budgeting systems (PPBS).
. life cycle costing.1.
INTRODUCTION The well-known economists’ short-and long-run cost curves are illustrated in Figure 3. the experience curve. focused cost-reduction programmes. functional analysis. value analysis (VA). value engineering (VE). cost tables. life cycle budgeting. It brings together the following syllabus and syllabus –related elements: • • • • • • • • • • • • • the learning curve in theory and practice.
The economists’ diagram is a static representation of costs. these curves show a general tendency for costs to decline as the volume of output increases. It will always be beneficial for a firm to be able to produce goods at a lower cost than the competition and firms will therefore strive constantly to achieve cost reduction.e. a reduction in unit cost can be achieved simply by increasing the volume of production. as economics of scale. The CIMA Terminology defines cost reduction as: ‘the reduction in unit cost of goods or services without impairing suitability for the use intended’. In the present context. In reality. A company which identifies the availability of and successfully implements or uses. who may be driven out of business as a result. These increases can be avoided by moving onto the long-run curves by increasing capacity through a further investment in fixed assets. as excessive demands are placed on a particular plant. given a particular set of materials. the short-run average cost curve reflects the change in unit production cost that arises through the operation of a given set of production factors over a limited range of outputs. a new cost effective production process or material will thus gain a cost advantage over its competitors. generally referred to. it is more appropriate to think of cost reduction as the reduction in unit cost at all levels of output. Similarly. A skilful negotiator is in a position to obtain a cost advantage for his company if competitors employ less adept buyers. Assuming the time scale allows investment. The reasons for this decline. many firms have a less than
. illustrating the economist’s ‘law of diminishing marginal returns’ in respect of short-run costs. The long-run average cost curve reflects changes in plant capacity and processes. the economist’s cost curves are premised on the use of the most cost effective production processes and materials. This advantage will only be temporary if the competitors quickly follow suit.Figure 3. i. which enables a firm to continue to benefit from reducing unit cost as total output increases. will be familiar from stage 1 Economical Environment. As the above cost curves indicate. to view it as an attempt to move the long-run average cost curve down and back towards the origin. Thus the short-run curves show that costs may increase in the short term. it is a firmly-established tenet of economics that unit cost will decline as output increases. but may be permanent if it allows the innovator to cut prices and gain market share at the expense of slower moving competitors. technologies etc. but firms can experience differing levels of success in such negotiations.1: Short-run and long-run cost curves As can be seen from the graphs. It is accepted in economics that not all firms will enjoy the same level of success in actually attaining the minimum cost levels possible for a particular negotiate bulk discounts with suppliers.
and hence speed of working increased.precise understanding of the detailed cost curves relating to their industry. and those which arise through management action. If output is increased. However. whilst maintaining current output. One of the economies of scale enjoyed by firms as output increases may be attributable to the ‘learning curve’. they will usually have an understanding and a bench-mark against which to measure their success in cost reduction. which the increased production has facilitated. They observed that the time taken to assemble an individual aircraft declined as the number of aircrafts assembled: as workers gained experience of the process. as it was discovered that the rate at which the learning took place was not random. It was found
. known as the ‘cost reduction curve’. If companies are able to reduce total cost. The recognition of the so-called learning curve phenomenon stems from the experience of aircraft manufacturers. cost reduction will certainly have been achieved. but was rather predictable. Nevertheless. The actual time taken by the assembly workers was monitored. such as Boeing. in the sense outlined above. The learning curve models mathematically this reduction in unit production time’. (This is phenomenon to which any reader who has never put together a number of flat-pack items of furniture will readily relate). is discussed in the following THE LEARNING CURVE
THE NATURE OF THE LEARNING CURVE
According to learning curve: ‘The mathematical expression of the phenomenon that. the position is less clear. it may be able to distinguish between those saving which occur merely as a consequence of increased volume. during World War II. their proficiency. The ‘learning’ gained on the assembly of one plane was translated into the faster assembly of the next. this may not reflect a great achievement on the party of the company: the cost reduction may simply have arisen as an inevitable consequence of the economies of scale. unit labour times tend to decrease at a constant rate. If the increase is proportionally greater than the increase in cost and assuming that functionality of the product has been maintained. If an expanding company is to make genuine achievements in the area of cost reduction. but there is also an increase in cost. Management needs to be aware of both types of savings in view of the importance for budgeting and decision making of a clear understanding of how costs will vary with changing output level. This phenomenon. when complex and labour-intensive procedures are repeated. cost reduction in terms of the terminology definition will have taken place.
It is then the job of the engineer or accountant to deduce the learning rate from these observations. it was assumed that we already knew the learning rate. average time per batch. FIGURE 3. it must be appreciated that. in the real world. rather than as an individual unit. which applied to this particular situation. the percentage by which the cumulative average time per unit declined was typicality 80percent. in order to construct the equivalent of Table 1 (although it is likely that fewer observations would actually be taken). it will be appreciated that the effect of the learning rates on labour time will become much less significant as production increases. Records must be kept of the number of units/batches produced and the associated time taken. However. Further.2: CUMULATIVE DATA GRAPHS Cumulative data graph Log of cum. affect the underlying principle. hours
Log of no. of batches (or units) In constructing table 1. The figure below shows this. Let us take as an example a learning rate of 90percent. the cumulative average time taken to produce two batches (a doubling of the cumulative production) would be 90 hours giving a total production time of 20 x 90 = 180 hours.that cumulative average time per unit decreased by a fixed percentage each time the cumulative production doubled. In this case. other rates may be appropriate. which will
. In the aircraft industry. if the first batch of a product is produced in 100 hours. this rate can only be established by observation. For other industries. in order to observe the benefit of learning in the form of reduced average labour hours per unit of cumulative production. of course. the unit of measurement may sensibly be taken as a batch of product. The actual time taken to produce the second batch (the batch being the unit of measure in this case) will thus be 80 hours the cumulative total time taken to produce two batches – 80 hours – less the time taken to produce the first batch-100 hours. As a doubling of cumulative production is required. This does not.
if a positive learning effect is present. i. b must be a negative number. no learning is present. i. then Y2=Y1x learning rate And. i. as x. i.e negative learning was taking place. the observation in Table 1 is plotted in Figure 3. b must equal 0 if Xb is to equal 1(X0=1). the time taken to produce any unit would be equal to the time required to produce the first unit.e. is greater than 1 for all except the first unit. If no learning effect were present. If we assume that a positive learning effect is present. at one unit/batch of output.e. For example.e.2. (ii) ‘a is the time required to produce the first unit/batch. meaning that the average time taken to produce units was increasing rather than decreasing.And.require the specification of an equation to fit the data. Thus. X = 2. (i) (ii) X is the cumulative number of units/batches consideration The exponent ‘b’ is the index of learning. Consideration of equation 1 shows that this can only be true if Xb=1. and can be described by the equation: Yx = aXb Eqn 1 Where: (i) Yx is the cumulative average time per unit/ batch taken to produce a Cumulative numbers of units/ batches X. Consideration of the formula in equation 1 shows that it is the value of ‘b’ which determines the shape of the learning curve. Yx = a And the learning ‘curve’ would be a straight line. Y2 = a x learning rate
. Any value of b greater than 0 would result in Yx increasing as x increased.e. Y1=a Consider now the effect of doubling the output. b must be less than zero. under
This is known as the cumulative average-time learning model. i. by definition. as all units would take the same timer to produce.
when learning is taking place. i. The Terminology gives the mathematical description of the learning curve as: Y= a Xβ Where: (i) Y is the average time taken per unit/batch to produce a cumulative Number of units/batches (ii) ‘a’ is the time required to produce the first unit. by checking the cumulative average time which we would expect will be necessary to produce 64 batches: Yx = aXb Eqn (1)
. while all numbers greater than zero have a positive logarithm. b= log 0. yet another variant of Equation 1 is often given. for a 90% learning rate. the learning curve is expressed as). in examinations.9 log 2 All numbers less than zero have a negative logarithm. Let us apply the formula in Equation 1 to the operations of the manufacturer whose data is recorded in Table 1 and whose learning rate is 90 per cent. n is equal to both B as defined in the Terminology and –b as in Equation 1. b must be negative. A x learning rate = a2b Learning rate =2b Log (learning rate)=b (log2) Therefore b=log (learning rate) Log2 S0. Y2=a2b. a Y = xn In this case. therefore. (iv) ‘B’ is the coefficient of learning. The B in the Terminology is thus equal to-b in Equation 1. (iii) x is the cumulative number of units to be produced.e.But from Equation1. which can be calculated as: Please note the negative sign in front of this calculation of B. Therefore. and the two formulae are mathematically equivalent (students should note that.
and thus cannot be determined by simply creating a table such as the one used earlier. The total time taken to produce the 10 batches under consideration will thus be 2.1520.9 = -0.380 – 1.380 hours. the average time per batch to produce 42 batches is 56.14 Which agrees with Table 1 above.890 hours.66 hours.1520 Yx = 53. Equation 1 is not normally used to check earlier calculations in the way that we have just done.1520 =100 x 0.5666 = 56.1520 Yx =100 x 64 -0. The learning rate can take any value. and values less than one mean that the time taken per unit/batch is declining as production increases.1520 log 2 Yx = aX-0. Inspection of Table 1 above reveals that the average time per batch to produce 32 batches is 59. ‘b’ equals –0. and wishes to estimate the time it will take to complete the contract.890 = 490 hours.66
i. let us assume that the manufacturer above has the opportunity to bid for a contract to produce 10 batches of his product.90. If the cumulative total production of his product to date is 32 batches equation 1 can be employed to calculate the cumulative average time per batch to produce 42 batches – the 32 already produced plus the 10 under consideration: Yx Yx Yx Yx
b = aX
x 42 -0. giving learning rate of 0. giving a total production time of 56. For example. i. with a total production time of 1. a value of exactly 1 would indicate that the time taken per unit/batch was not changing at all. an average time of 49 hours for each of the batches 33 to
.e.b = log 0.05 hours.e. but only values of less than one imply that learning is taking place. but is rather used to assess the time which will be required for an output level which does not represent a doubling of the cumulative production total. In the example above. Learning rates greater than 1 imply that the time taken per unit/batch is increasing as production increases. in order to help set the tender price.66 x 42 = 2.
When setting budgets. obviously. which is a function of workers’ learning.20 hours indicated by Table 1 for the next doubling of a full 32 batches from 33 to 64.890)/32 = 47.401 – 1. If labour is working in a machine-paced environment. will need to be calculated from the same formula. The learning curve has been found to be particularly useful in determining the likely costs to be incurred in fulfilling government contracts. The learning rate. However. is not something which can be positively fostered as a cost –reduction technique. if hourly wages are constant. of which aircraft assembly is a prime example. any overheads which vary directly with those hours. Standard costs should reflect the point which has been reached on the learning has become insignificant) will be lower than those set during the learning period are to be meaningful. that particular average time. the experience which plant managers gain in scheduling work in such an environment may result in a reduction in the direct labour hours required for a given level of production. the effects of the learning curve should be taken into account. the labour cost per unit will decline as a result of the learning curve phenomenon.e. can be expected to decline as a result of the learning curve. knowledge of the rate of learning can help in price setting.42. in complex assembly operations. there is no significant opportunity to alter the rate of working and thus the learning phenomenon in terms of direct labour time cannot exist. they do not measure a reduction in cost per se. However. only those costs which are directly related to direct labour time. In addition to direct labour costs. and the corresponding cumulative hours to date. if the current level of production does not lie on a table such as Table 1.e. This provides a rational basis for price negotiation and cost control.
THE EXPERIENCE CURVE
A number of points about learning curves must be stressed: (ii) Learning curves chart the reduction in time per unit as experience is gained.
USES OF THE LEARNING CURVE
In circumstances where the learning curve is likely to operate i. i. This may be compared with the average of (3. Learning is likely to be greatest in complex assembly environments.
learning rates have frequently been determined by fitting curves to total cost per unit data. substitution of materials and design modifications are reflected in an experience curve.It has been stressed that the learning curve was derived from observations of the reduction in direct labour time taken to complete successive repetitive but complex assembly tasks that have frequently been determined by fitting curves to total tasks. is that these curves should be taken as an expression of what is desirable. An alternative approach. This data suggest that defence contractors typically enjoy a reduction of 14 per cent of average unit cost on each doubling of output. and thus was not distorted by changing price levels. of which pricing is a prime example. Moses (1991) has pointed out that the accounting policies adopted by companies can have a significant impact ob learning rates derived from experience curves. an experience curve relates directly to cost.021. production. Total cost in experience curves includes all overhead types – production. in using unit cost data. as against the 80 per cent curve more usually found in the West. This could be considered to be a western approach.718 to 1. technology.1 to be graphed. the result outlined above actually reflects the so-called ‘experience curve’.
. The slope of the learning curves derived ranged from 0.858. marketing and distribution – and thus cost reductions arising from factors such as factory size. For example. and it is arguable that. Where learning or experience curves are used to predict future costs. rather than the learning curve as strictly defined. When average total unit cost is measured against volume. with a mean of 0. The strict application of the learning curve phenomenon is seen in the area of direct labour. However. and so the results must be treated with caution. The ‘experience curve’ extends the learning curve approach to areas other than direct labour. The improvement –oriented Japanese typically aim actively to foster a 67 per cent learning curve. a measurement is being made which allows a long-run average cost curve of the type shown in Figure 3. Experience curve. Rather than relating indirectly to cost via time. and hence what should be striven for. The purpose in gathering this data was to help in price negotiations with the contractors. Depuy (1993) used this method to ascertain for the US government the learning rate achieved by defence contractors. like learning curves. and is a function which shows how total cost per unit declines as output increases. can be regarded as statements of what will happen in practice. adopted by the Japanese. Element 3. The total cost data employed was expressed in constant dollar terms.1 Cost Reduction
An appreciation of the relationship between cost and volume is important in many business decisions.
then organisations which do not adopt such a systematic approach. This might achieve some short – term savings but it is likely to be at the expense of the long-term health of the organisation. savings will continue to be made in the future even if no positive action is undertaken to secure them.005 corporations found that more than half the corporations had failed to meet their cost – reduction targets. but without destroying value to the customer. as long as volume increases.1. or price reductions – in other words. Obviously. traditional programmes are often reactions to events rather than anticipations of them. if it is assumed that. and ideally reducing both. which means that some areas which were of value to customers will inevitably suffer. Organisations which set targets for cost reduction. Indeed. such as poor performance. Fisher (1991) cites two surveys on this point: half the managers in the first survey (representing corporations accounting for 26 per cent of US GNP) said that the cost –cutting or restructuring programmes had failed to meet their objectives. particularly for overheads. a company may take a decision to cut all departmental budgets by the same 5 per cent. and have systems in place to help the accomplishment of those targets. This can be achieved by reducing either direct costs or overhead costs. The blanket cut strategy to achieving this is
. say 5 per cent. There is some evidence to suggest that these programmes do not meet their objective. This may well be the case. For example. the scope for cost reduction will be dependent on the type of cost under consideration. and the time scale involved.1 ‘Traditional’ Cost-Reduction Programmes ‘Traditional’ cost reduction programmes have been characterized as ‘a collection of crash programs that focus on cutting costs by reducing payrolls and eliminating jobs’ (shields and Young (1992). A blanket cut will affect all activities equally. knowing that the learning curve has led to cost reductions in the past could give rise to a dangerous complacency on management’s part. which may lead to an increase in unit cost. in an attempt to reduce costs by. this will lead to some loss of business. Element 3. are more likely to achieve cost reductions. Market pressure to reduce costs could lead companies to attempt a ‘blanket’ approach to cost cutting. A successful cost reduction programme will seek to reduce the unit cost of the good or service at all volumes of output.there is an implicit assumption that the experience of the past is helpful in predicting the future. In a commercial organisation. as fixed overheads (albeit reduced by 5 per cent in our example) are spread over a smaller number of units sold. It is suggested that such programmes are typically triggered in reaction to an immediate threat. loss of contracts. but it provides no operational guidance to management as to how cost reductions are to be achieved in the future. the second survey of managers from 1.
the company’s consumption of resources is excessive. Over – resourced activities 2.effective arrangement difficult to achieve.1 Over-Resourced Activities An activity is over –resourced when the same objective could be achieved with less resource consumption. Unnecessary (non-value added/diversionary) activities Each of these reasons will be looked at in turn and the effectiveness of a blanket cut in resources to achieve cost reduction in these circumstances will be considered. so that one person may be able to oversee two. Any organisation can be seen as a collection of activities designed to lead to a desired result. i.1. although the industrial relations implications of reduced staffing levels may make attainment of the most cost.ineffective in the long term. Loss of material through pilferage. Inefficiently managed activities 3. without any loss of machine efficiency. it may be perfectly possible for machines to be physically grouped in such a way as to allow a reduction in staffing levels. In carrying out these activities to meet the short-term operating plan. excessive overtime working necessitated by poor production scheduling and excessive time spent
. in a production department. if the process requires very little human intervention.1.
Element 3. a company may currently be incurring higher costs than are strictly necessary.2. Firms must adopt approaches which enable them to pinpoint and realize specific opportunities for cost savings.2 Examination of Current Activities The starting point for cost reduction programmes often is the examination of existing activities. four or even more machines.1. three. The current position may be one in which a separate operative is assigned to each machine.2. For example.2 Inefficiently Managed Activities Activities are inefficiently managed when current standards of achievement are not being attained.e.
Element 3. A blanket cut in resources may provide the spur to such reorganizations. shop floor manning levels may have remained processes. However. Examination of current operations may reveal that this over – consumption of resources arises from one or a combination of the following three reasons: 1.
a company may have a department devoted to dealing with customer complaints. Value will be added when an activity results in an addition to a product or service which they ultimate consider to be valuable. by. and adds value as a result. not only is a claim under a warranty and value added for the customer. Problems with products are thus both a cost to company and an inconvenience to the costumer. warranty claims will decline. in as much as it provides law enhancement to product it self.value added activities if changes are made to the current policies and structure. non of these activities are under the control of warranty department management. a cut in its resources is highly likely to reduce the level of service that it can provide to customerscustomers who. A non. and which is therefore some thing for which they are willing to pay.3 Value Added and Non-Value Added Activities The concept of a value. but the customer is also invaluably put to some trouble in actually making such a claim. If the warranty department is not currently over-resourced. by definition.on rework through failure to identify problems at the earliest opportunity would all provide example which highlight variances from standards. However. Non. and is efficiently managed.added activity revolves around the customer. it is essential to understand: (a) why such departments exist. and the rectification of problems which arise during a products warranty period. applied to the warranty department along with all other departments. However. as we saw in our consideration of the value chain in the previous chapter. and are sustained. and hence damage the competitive position of the company even more.value added activity is thus any activity which does not provide value to an end user. Delays in rectifying faults are likely to lead to a further loss of consumer goodwill. but are non. and hence peace of mind.2. as the reliability of a product increase. are already unhappy with the service which the company has provided in selling them a faulty product. as it provides a level of insurance. The inherent reliability of a product will be the function of the product design. This department’s activities will increase the costs of the business. to result in the action which would improve the overall product reliability. For example.1. A blanket cut in resources. the quality of the materials used and the manufacturing process. a company’s existing policies and organisational structure.value added activities often arise as a direct consequence of. a blanket cut in resources may provide an additional impetus to improvement. The existence of a warranty is useful to the end user.value added as far as the consumer is concerned. Regular monitoring will identify these deficiencies and should lead to their elimination.
. would be unlikely in its self. Self evidently. Element 3. It is only possible to eliminate such non. To control the resources consumed by overhead department effectively.
The reference to ‘funds available’ is particularly pertinent in public sector organisations.
Element 3. by definition. relate to the reduction of future costs (past costs being sunk) it follows that cost-reduction programs and budgeting procedures are in inextricably entwined. In traditional budgeting. The aim of the fundholder is to achieve the best service levels possible within the given budget. existing expenditure levels form the base line for discussions about future expenditure. Activity-based cost management adopts this approach.e. is zero-base (priority-base) budgeting. to which we now turn. the budget allowance is zero’. The Terminology defines zero-base/priority-base budgeting as: ‘A method of budgeting which requires each cost element to be specifically justified. which is thus likely to lead to the most radical changes in discretionary areas. cutting.
. Nevertheless. Implicit in the traditional approach is an assumption and acceptance that current expenditure is adding value to the customer. The rejection of this base line as a starting point is what gives zero-base budgeting its name. i. it is necessary to adopt a cross-functional attitude to the examination of the business processes. the income of the organisation. In other words. is exogenously set. as though the activities to which the budget relates were being undertaken for the first time. As all cost reduction techniques must. which eliminates the disadvantages of blanket approach to cost. An incremental approach is most likely to be applied to discretionary costs. Other approaches to overhead cost reduction. zero-base budgeting (ZBB) is designed to be used in setting levels of future expenditure. (c) there relationship to other areas of the business. Without approval.(b) the services they provide. the approach requires all activities to be justified and prioritised before the decision to devote resources to particular ones is taken. as we shall see in the next chapter.1. as it is these costs. where funds are determined by tax revenues and government grants and allocations.3 Zero-Base Budgeting Like all budgeting techniques. and the focus of its attention is simply the justification of any proposed increases in the expenditure – it therefore adopts an incremental philosophy to budgeting.
. for example and identify the manger responsible for each activity.in house or sub –contracted? (d) How much would the various alternative levels of service and provision cost? In order to answer these questions. Request the managers identified in (1) above to prepare a number of alternative decision packages normally requested: one which sets out what could be delivered 80 per cent of the current level and one for an enhanced level of funding. Analyse alternatives.g. Determine the activities.
Some explanation of these steps is necessary. Many programmes will also have multiple results. and can take several years to be measurable. Systematically implement the selected alternatives. (e. 5. 3. 120 per cent of the current level). Rank the decision packages in order of their contribution towards the organisation’s objectives.All activities are subjected to the most basic scrutiny and answers sought to such fundamental questions as: (a) Should the activity be undertaken at all? (b) If the company undertakes. and a choice must usually be made regarding the relative weights attached to them. how much should be done and how well should it be done (for example. and go for these those with the greatest cost benefit in term of the objectives. 2. Yet the activities performed by public –sector and not-for-profit organisations are often difficult to measure in a tangible way. 4. Further. Effectiveness can be judged only against predetermined benchmarks set by the organisation. all existing and potential organisational activities must be described and evaluated in a series of ‘decision packages’. which are to be used as the object of decision packages – the provision of home support for the elderly or provision of catering facilities for the work force. while required to overcome these difficulties. giving the following four-step process to a ZBB exercise: 1. should an economy or a de-luxe service level be provided)? (c) How should the activity be performed. there will often be questions regarding the legitimacy of casual relationships when measuring these results: particular outcomes could be brought about by the actions of more than one programme.
000 200.000 680. Thus the director of leisure services in a local authority should be in a position to say that such a cut would reduce the hours that a swimming pool could open. Exercise: the Alpha Group The Alpha Sufferers Group is a national charity offering support to sufferers and funding medical research. or require that the grass in public parks be cut every ten days instead of once a week. On a more positive note. You have been invited to attend a trustees’ meeting at which the following report on this year’s performance and next year’s annual budget will be discussed. The interest in PPBS probably owes much to an increasing public demand for accountability by public and other not-for-profit organisations: taxpayers appear to have become dissatisfied with the performance of central and local government agencies. eventually. and allows people to see where their. The trustees have used an incremental approach to determine the budget. Criticise the current method of budgeting and explain the application (give specific examples) and possible advantages of PPBS to such an organisation. for example. PPBS specifies goals clearly. somewhat similar to ZBB.000 500.given the nature of public –sector and not for profit organisations and their objectives. in its result.000 160.000 724.000
. No further supporting information is provided for the trustees. The treasurer has heard of ‘programme – planning budgeting system’ and wonders if it would be useful in their not-for profit-organisation. This feature of PPBS is.000
20. one feature of PPBS that should be particularly beneficial is that managers making budget requests are expected to be able to state clearly what would happen if their requests were cut by. money is going and.000 658. 19X3 Actual 18. to see whether or not it was spent effectively.000 220. say 10 per cent.000 484.000 19X4 Actual
Budget Income Subscription Donations received Fund –raising 20. and donors to charitable causes have expressed concern about the proportion of contributed funds devoted to administrative expenses. since different levels of service are associated with each level of requested funding.000 440.
000 40. The most successful cost-reduction programmes at the conceptual and design stage are those which have a strong market focus. they involve a thorough examination of customer requirements.000 320. which is discussed below. As Berliner and Brimson (1988) have pointed out.000 788.000 230. Nevertheless. the greatest effort should be expended in investigating those costs which provide the greatest opportunities for savings. up to 90 per cent of a product’s costs will be fairly limited for an existing range of products. A good cost control system should be able to bring about control over the costs of the entity.000 200.000 8.4 Timing and Focus of Cost –Reduction Programmes It is axiomatic that.Expenditure Employees Premises Office expenses Administration Research Printing Room Rental Donations made
60. in order that these can be satisfied at least cost.2 Element 3. despite the evidence that the ability to influence cost is greatest at the planning. Rather than aiming to meet the manufacturer’s own internal specification at least cost.000 28. Element 3.000 8. and as Figure 3.000 30.3 illustrates. One technique of cost reduction.000) Element 3.000 25.000 30. although their impact in the short term may be small.1 COST CONTROL Cost control involves management action undertaken to effectively mange the costs of running an under-taking.000 42.000
60.000 33.000 735.000 300.000
Excess of income over expenditure 14.000 260.000 666. However.1. Programmes which focus on reducing cost at these early stages after the greatest opportunities for success in the medium to long term. research and development stages.000 15.000 15. cost reduction programmes have tended to focus on current production costs.000 77.000
60. these opportunities are related to time. is ‘value analysis’ (also known as ‘value engineering’).000 350.000 8. in searching for cost savings.000 (64.000 25.000 230.
. which recognises the importance of concentrating effort on the design and conceptual stage.000 12.2.
Reasons for the differences must be identified. who was vice-president of purchasing. The target so set must. be revised continuously in order to keep them in line with the current cost efficiencies.3
The common types of cost control systems are the budgeting control systems and the standard costing systems. Erlicher. the following approach can be used: Stage 1 Target Setting Any cost control system requires targets to be fixed for costs.2
In order to come up with an effective cost control system. To this effect.Element 3. Stage 3 Comparison between Targets and Actuals This stage involves comparing the targets with the actuals.
Element 3.2. a methodical approach is required. it is important that necessary action is taken to void the recurrence of the variances.2. the appropriate targets must be set.3 Value Analysis The disruption of normal supply lines to American manufacturers in World War II necessitated a search for substitute materials and alternative designs.
Element 3. observed that many of the enforced changes which the war had brought about had actually improved performance and/or reduced
. Value analysis (VA) evolved as a result of these experiences. It is important that any differences between the targets and the actuals are analysed into sufficient details. however. Stage 4 Identifying the causes for the differences Stage 5 Action to prevent variances Having identified the reasons for the variances. From the above. it is notable that in order to have an effective cost control system. Stage 2 Measure the Actual Results There must be an effective and up-to-date system to measure actual results. The approach was championed by General Electric of America. The actual results should be measured as frequently as possible. an effective comparison system must be in place and the results must be analysed sufficiently. and is associated with two employees in particular: Harry Erlicher and Lawrence Miles.
General Electric adopted the approach as a company standard. which is taken from BS 3138: Although the term ‘value engineering’ is used by purists to refer to the applicant of the ideas of value analysis. reliability and maintainability’. the task of putting this into practice was assigned to Miles. This definition can be seen to be consistent with the CIMA Terminology definition of ‘value analysis’. The result was value analysis. including the American military. The technique is regarded primarily as a means of achieving cost reduction. consistent with the needed performance. in which the term (VE) rather than ‘value engineering programme was established in 1956 by the Army Ordnance corps. the Navy Bureau of Ships. The Armed Service Procurement Regulations made the use of VE mandatory. Miles used the two terms synonymously. aided by Miles set up a VA programme. the scope for achieving cost savings is greater during the pre-production phases. and can be applied to existing or new products at any stage of the life cycle. In 1954. he decided to maintain and institutionalise the search for substitute materials and methods. having been stimulated by the success of suppliers. and it is therefore at these early stages that the application of VA offers the greatest cost reduction opportunities. therefore. such as General Electric. the US Defence Department became so convinced of the benefits to be gained from VE that Secretary of Defence McNamara referred to it in 1962 as a key element in the drive to reduce defence costs. However. equipment. and it was subsequently taken up by other companies and organisations. Indeed.
. which combines a number of preexisting techniques with its own particular procedural approach. and they will be treated as such throughout the remainder of this chapter. and the Air Force began investigating the technique in 1961. who was then a staff engineer. and defined it as: ‘ A systematic effort directed at analysing the functional requirement of the Department of Defence systems. as we noted earlier. in its operation. facilities and supplies for the purpose of achieving essential functions at the lowest total cost. In 1947. At the ceassation of hostilities.cost.
Figure 3.4 ______________ A Cost content attributable to the product A-C Minimum amount that must be spent to make the product B Work added by Unnecessary design and specification features Work added by inefficient methods of manufacture
Value analysis zone Method study zone
C Total cost Associated with the product (under absorption system) A-D D
Overhead carried because man or machine or both are
Production control zone
particularly in the initial stages of VA. It alters with changes in design.4. not a static one. The accountant clearly has a role to play in determining the cost of these alternatives. Meaningful costs may be obtained from a variety of sources or from a combination of sources: But since. when final decisions are being made. Miles suggests that cost estimates do not need to be of a high degree of accuracy. 5. There is a strong inter-relationship between the zones in Figure 3. provides a useful description of the focus of a number of cost-reduction techniques. 6. are frequently associated with reduced cost. really meaningful costs often must be worked up for the job’(emphasis added). but contribute simultaneously to it.4. particularly when new products are being considered. Nevertheless. and lower its bulk or weight and/or the number and variety of parts required in its manufacture. the concept of minimum cost is a dynamic. A simultaneous consideration of the two (‘simultaneous engineering’) is likely to lead to lower –cost solutions rather than a sequential consideration (‘over-the-wall engineering’). . adapted from Gage (1967). materials. Figure 3. products and processes will be utilised in different ways. What is it? What does it do? What is it worth? What does it cost? What else would work? What does that cost?
Alternatives that reduce the design complexity of a product. Miles (1972) has suggested that .In the search for cost reduction. Value analysis seeks to facilitate this simultaneous approach. in terms of the functionality required.. materials and technology etc. A team approach is thus crucial to the VA philosophy. and that design and production engineers not only understand the brief. accuracy will obviously be important. The minimum amount which must be spent to produce a new product cannot be determined until the design and specification of the product has been determined – the value analysis zone – and until the method of manufacture. rather than to make final decisions. volume. in many instances of good value work. It aims to ensure that the product brief is tightly specified. 4. when the aim is to identify fruitful avenues for investigation. 3. 2. The VA team must ponder the following six basic questions when applying VA to any product or service: 1. The ability to make accurate estimates in respect of products and
such as product.3 can be answered by following the nine basic steps set out below: 1. It may be used as an aid to cost reduction. The first two of the six questions above relate to the functions of the product or service. service or overhead area. so that the cost object is represented by this intangible service potential. as consumers may be expected to pay particular prices for particular functions. Functional analysis can be applied in a number of ways. Functional analysis views all products as bundles of services potential for customers. In functional analysis. The concept of product or service function is thus a key element in the VA approach.3. but also by suppliers of any means of long distance communication – telex. When expressed in this way. the cost object is the function of the product or service itself. and we have talked of ‘functionality’ in the context of the requirements of the product brief. Functional analysis can also be used to assist in the determination of expected selling prices. the postal system etc.7. by adding new features in a cost effective manner. Yoshikawa et al (1993) suggest that the six basic questions listed in section 3.
. ‘Functional requirements’ were mentioned in the definition of VE above. The focus is thus very different from traditional accounting. choose the object of analysis. a clear understanding of the function of a product or service is essential. and it’s to this concept that we now turn. for example. in order to determine how that functions can be supplied to the customer in the most cost – effective way. In this context. The Japanese find cost tables (see section 3. This has as its major function the facilitation of communication between individuals who are physically separated. which we will discuss in the next section of this chapter. In value analysis. which often has a physical product as its cost object.processes of which the firm may have no direct experience is therefore a valuable one.1 Functional Analysis Functional analysis (FA) is a systematic approach to the examination of the specified purpose of a product or service. fax. As an example of functional analysis. let us consider a domestic telephone. and as a means of improving products.
Element 3.6) particularly useful in this context. it is clear that the competition for sales of domestic telephones is represented not only by other handset manufacturers. functional analysis can be seen to underpin target costing.
These descriptions illustrate the iterative nature of cost-reduction techniques. Identifying improved product designs that reduce the product’s cost without sacrificing functionality and ii. Second look VE can be used when design changes are being made to existing products. 4. Value analysis allows the team to consider a range of functional combinations. suggest alternatives. in order that the optimal set can be selected. 9. evaluate the functions. define the functions of the object. review the actual results. or may relate to alternative ways of satisfying a particular set of functions that will not yet have been fixed. choose the alternatives (for manufacturing etc). when a company is analysing a defence contract.
select the members of the team. the required functions are likely to be very closely specified. The range of options for consideration under step 7 may relate to a whole range of functions. draw a functional family tree. and compare these with the target cost (see element 9. 7. Aim of Value Engineering The aim of value engineering is to achieve the assigned target cost by i. so that the analysis will probably be confined to financial evaluation of the differing means of satisfying the given functional ends.2).2. Eliminating unnecessary functions that increase the product’s costs and for which customers are not prepared to pay extra for. that undertaken in the trial production phase as ‘first look VE’.4 VALUE ENGINEERING As discussed above is also called value analysis. and that in the trial production phase as ‘second look VE’. On the other hand. VE undertaken at the research and development phase is something referred to as ‘zero look VE’. 5. together with their associated costs and to compare these with the prices customers are likely to be willing to pay for the alternative combinations. Definition: This is a systematic interdisciplinary examination of factors affecting the cost of a product or service in order to devise means of achieving the specified purpose at the required standard of quality and reliability at target cost.
. 8. gather information. Element 3. 3. 6.
make or buy etc. The costing system will routinely collect information about some but by no means all. COMFORT. labour. If the cost of the function exceeds the benefit to the customer. drop a product. The total of the values for each function gives the estimated selling price from which the target profit is deducted to derive the target cost. service. brand or project. SPEED.g. Example In the case of automobiles. possible cost objects.5 Activity based costing
A core accounting activity is the analysis of costs. product pricing. A cost object is defined as anything for which a separate measure of costs is desired. customer.g. power etc. COLOUR etc (KATO 1993). The cost of each function of product is compared with the benefits perceived by customers. Cost control and performance evaluation. RELIABILITY. . Costing systems accumulate costs by broad classifications – material. Costing information is needed for a variety of reasons: (i) (ii) (iii) Stock valuation for financial accounting purposes. Nokia has the same charger for each type or mode phone manufactured.
Element 3. e. Also by focusing on the product’s functions. functions might consist of STYLE.Value engineering requires the use of functional analysis. Decision-making.e. the design team will often consider components that perform the same function in other products thus increasing the possibility of using standard components and reducing costs. modified to reduce its cost or enhanced in terms of its perceived value so that its value exceed its cost. A price or value for each element is determined which reflects the amount the customer is prepared to pay. and thus the range of possible cost object is vast – from individual product to department. QUALITY. To obtain this information companies normally conduct surveys and interviews with customers.
. then the function should be either eliminated. This process involves decomposing the product into its many elements or attributes.and these costs are then further analysed by assigning them to cost objects.
organisations are focusing on similar factors because of general economic circumstances prevailing at any stage in the life cycle etc. For this automobile company this key factor is now cost management: in the recent past it was quality control: before the 1970s factors change over time. Cost management is as important for the automobile industry in the 1990s as what quality control was in the 1970 and 1980s. it is important to emphasise that the concept of a ‘product’ as a cost object needs amplification. cost centres and products as cost objects in costing systems.
. A general definition of cost management information is. Considerable dissatisfaction has been expressed at the information provided by ‘traditional’ costing systems for purposes (ii) and (iii). It is common to find departments. and particular attention has been directed to finding the ‘true’ cost of producing a product to supply information for (iii). but while they are critical. However. These factors are often called critical success factors. Discuss why it might be considered important in today’s world. which is key to remaining competitive and to developing the business strategically. (b) Cost management or cost management information are rather vague and general phrases used by different people to mean lightly different things. (ii) Discuss how a management accountant might use investment appraisal techniques to analyse customers in order to aid cost management.
Solution (a) At anytime there is usually a particular factor. management must focus on them. Different businesses in different industries are likely to have different factors.The selection of cost objects for the routine collection of information has implications for each of the above three purposes. (extract from & corporate annual report)
Required (i) Explain the meaning of the ‘cost management’. but often at one particular moment in time. which is sometimes known as cost management information).
in order to provide the information required to enable costs to be planned. and the importance of customer segments can be discounted over their lives in a similar way to projects. For organisations with high customer set-up cost such as financial institutions such as mortgage leaders. By studying the increased revenue and decreased costs generated by an ‘old’ customer. Cost Reduction Example It has been suggested that much of the training of management accountants is concerned with cost control where as the major emphasis should be on cost reduction.
. Japanese car companies such as Toyota paid a great deal of attention to quality – consider. if the company enters into long-term contract with customers. analysis and presentation. management can find strategies to meet their needs better and to retain them. This involves providing the right product at the right place at the right time and at the right cost. The management accountant has a role to play in this area. accounts could be discounted and ranked in order of preference just as jobs/contracts might be ranked. methods of data collection. (c) A management accountant can use discounted cashflow or payback to evaluate the work of customers. Required: i. monitored and controlled. the development of the Lexus model targeted at the USA market. and target costing and life cycle costing are particularly helpful in driving costs down. Alternatively. for example. It is certainly important today for all organisations to satisfy their customers by meeting their needs precisely. Distinguish between cost control and cost reduction. During the 1980s.The application of management accounting concepts. it’s important that they retain all customers they have.
The routine of budgets. iii. Budgetary control 2.ii. 5. Operational research 10. This is a dynamic rather than routine process. Discuss the proposition contained in the statement. Standard costing 3.
Solution: (i) Cost control is the process of containing costs to some predetermined amount. Procedure for formal authorization of recruitment. A wide range of examples can be given here: 1. Setting of expenditure limits by levels of management in an organisation 4. Cost reduction 6. Target costing 7.
Give three examples of the techniques and principles used for (i) cost control and (i) cost reduction. Investment appraisal 11. operating statements and the investigation of variances. often only carried out at infrequent intervals. Zero – base budgeting 12. standard costs. standards and estimated selling price for new products preferable without reducing quality and/or effectiveness. Cost reduction is the wider ranging attempt to reduce costs below the previously accepted amount. Work studies 9. This is usually carried on by the formal comparison of actual results with those planned. Product life cycle costing
. Value analysis and value engineering 8.
There have been innovations in strategic management accounting and the links between management accounting in areas where it has been relatively under developed in service industries and the public sector often with the development of new techniques. flexible manufacturing systems and computer integrated manufacturing.000 production runs per period. Required: Identify appropriate cost drivers and calculate an activity based costing system. ABC Ltd produces a large number of products including A and B. The cost control techniques of standard costing and budgetary control would tend to support the proposition. but active cost reduction. Product A requires.000 consignments of components per period. A requires are direct labour hour to produce and B requires 0. 200 component consignments 50 raw materials consignments and ten production runs per period. However. a study of operation research techniques’ and of recent developments would lead to the conclusion that current practice is not purely control. Staff are engaged in three activities.000 are made and sold in each period.000 consignments of raw materials for per period and three employees engaged and materials for 5.000 are made and sold in each period. B is a simple product of which 25. quality costs. three employees engaged in receiving 10. Quality management. ABC Ltd employees produce salaried support. There has been considerable interest in a range of topics relating to new manufacturing techniques and to Japanese methods. Six employees engaged in receiving 25. There has also been interest in a range of innovations in IT making management accounting faster and more effective especially with developments in data capture and transmission. ABC Limited. Value for money analysis and audits etc. target costing and life cycle costing.6 direct labour hours to produce. JIT stock and production control.13.
Solution: The three appropriate cost drives are:
. Product B requires 100 component consignments. A is a complex product of which 1. eight raw material consignments and five product runs per period.
000.000.000.000 = K125.000.000.000.000 = K125.(i) (ii) (iii)
Receiving components Receiving raw materials Disbursing kits of components and raw materials
Relating overhead costs to these drivers using the number of indirect staff engaged in each activity as the indirect staff engaged in each activity as the basis gives the following results: Number of staff (iv) (v) (vi) Receiving components 6 Number of staff receiving material 3 Number of staff disbursing kits 3
Total number of staff 12 Therefore the total amount of overhead expenditure relating to each of the activities is as follows: (d) Receiving components: 6/12 x K500.000 Cost driver rates • Receiving components:
Total component receiving costs divided by
.000 = K250.000 Disbursing kits: 3/12 x K500.000 (e) Receiving material: 3/12 x K500.
500 = K 100.500 = K625.000 = K1.200.000.000 K1.000.000 = K 100.875.000.000 Total costs attracted by product A 200 component consignments x K10.000/ 5.000 K2.000.000 K25.000 = K10.000 = K250.000 8 raw material consignments x K12.000/ 10.500 • Disbursing kits
Total disbursing costs divided by Number of issues K125.000/ 25.000 Total costs attracted by product B 100 component consignments x K10.Number of consignments received = K 250.000 50 material consignments x 10 production runs x K12.000 = K2.000 per component • Receiving materials
Total component receiving costs divided by Number of consignments received = K125.000 Summary of unit cost
.000 5 production runs x K25.000 = K12.000.
000. The following budgeted data has been obtained for the year ended 31 December 20x2. However. Both bean bags are produced on the same equipment and use similar process.000units of B K48/ unit
Bean Products Ltd manufactures two types of bean bags – the standard and the Deluxe.000.200.000 per hour.000 25.000
The budgeted wage rate is K20.000 units of A K2.Product Total cost = Example 2
A 2.875.000 400 150 2.000 300.000. Product: Standard Deluxe Production quality Number purchase orders Number of sets –ups Resources required per unit Direct labour Direct labour (hours) Machine time (hours) 25. its considering implementing a system of activity based costing.000 1. 875/units
B 1. An activity based investigation revealed that the cost drivers for the overhead costs are as follows: Volume related overheads machine hours
.500 200 100
Budgeted Production overheads for the year has been analysed as follows: Volume related overheads Purchases related overheads Set up related overheads 275.500 10 5 25. The company currently uses an absorption costing method of recovering overheads.000 525.000 10 5 62.
000 Machine hours required Purchase orders Total set-ups Cost per cost driver Volume related overheads Machine hours required .000 137.Purchase related overheads orders Set up related overheads
number of purchase number of set-ups
Required: (2) Calculate the unit costs for each type of bean bag using the proposed activity based costing approach.500hrs 12.000 Total production overhead 1. Companies are becoming customer driven and making customer satisfaction
.500 25. Standard Production quantity 25.000 400 150 K275.000 total 275.Volume related 125. 500 600 250 deluxe 2.1 the
TOTAL QUALITY MANAGEMENT (TQM) Today’s business environment is remarkably different from Environment of many years or so go.6.000 K’000
Element 3.100.000 Direct labour hours required 250.500 200 100 K137.000.6 Element 3.000.
delivery and the choice of innovative new products. total quality management (TQM) has the customer as its focal point. TQM is therefore a management function which could be seen as the key to improving profitability because there is a cost associated with failing to meet quality standards in products and services. c) Monitoring actual quality d) Taking control action when actual quality falls below standard. It is in the eye of the beholder.What is quality? Element 3. Customers are demanding everimproving level of service regarding costs. then profits will increase.6. the customer. how well it serves its purpose. claims for refunds in respect of defective supplies and the work of putting right mistakes. One aspect of Japanese management is the approach of “get it right first time”. Quality management becomes total (Total quality management (TQM)) when it is applied to everything a business does. b) Establishing procedures or production methods which ought to ensure that these required standards of quality are met in a suitably high proportion of cases. Quality has become one of the key competitive variables and this has created the need for management accountants o become more involved in the provision of information relating to the quality of products and services and activities that produce them.an overriding priority.6.2 Total quality management defined Quality.3 The management of quality is the process of: a) Establishing standards of quality for a product or service. quality. If costs can be controlled through TQM. and how it measures up against its rivals. In this spirit. reliability.“the degree of excellence of a thing” – how well made it is.4
. Such costs could arise through loss of customers.
Element 3. Element 3. or how well performed if it is a service.6. These criteria imply two things: a) That quality is something that requires care on the part of the provider b) That quality is largely subjective. QUESTION.
warranty replacement. downtime and work stoppages caused by defects. They include costs incurred before the product is dispatched to the customer. quality audits and field tests. repair. work in process and finished goods.Through TQM it is possible to obtain defect-free work first time on consistent basis. Element 3. Appraisal cost – are costs incurred in order to ensure that outputs produced meet required standards.6. They include the costs of handling customer complaints. such as the costs of scrap.5 COST OF QUALITY This activity of improving quality to improve profits will itself cause cost to be incurred. Though this looks like an idealistic target but to have such a target encourages a culture where prevention of error is a key feature of operations. quality planning and training and the extra costs of acquiring higher quality raw materials. repairs of returned products and the costs arising from a damaged company reputation.is the cost of failure to deliver the required Standard of quality and include: i. The term cost of quality is a collective name for all costs incurred in achieving a quality product or service. Cost of external failure – are cost incurred when inferior products are delivered to customers. Cost of internal failure – are costs associated with materials and products that fail to meet quality standards. Cost of non-conformance. ii. A cost of quality report should prepared to indicate the total cost to the organization of producing products or services that do not conform with quality requirements. ii. Four categories of costs should be reported. They include costs of inspecting purchased parts. Cost of conformance – is the cost of achieving specified quality standards and include: i. Cost of prevention – are costs incurred in preventing the production of products that do not conform to specification.
. They include cost of preventative maintenance.
Element 3.100 5. can provide some idea of the level of customer satisfaction.800 9. divisions within the group or other organizations. comparisons can be made with previous periods.0
500 1000 300
. an increase in spending on prevention costs should reduce the costs of internal and external failure and hence reduce total spending. The report has the following uses: a) By expressing each cost category as a percentage of sales revenue. forgone due to sales lost because of poor quality is difficult to calculate and its preferable to include an estimate rather than omit it from the report.6
Typical Cost of Quality Note that some of the items in the report will have to be estimated e. For example. A comparison of the proportion of external failure costs to sales revenue with the figures of other organizations.5 K’000 COST AS % OF ANNUAL TURNOVER K20 MILLION
600 600 200 400 1. b) It can be used to make senior management aware of how much is being spent on quality-related costs.6. thereby highlighting problem areas.Element 3.7
COST OF QUALITY REPORT YEAR ENDED DECEMBER 2006
K’000 PREVENTION COSTS Quality training Quality engineering Preventive maintenance APPRAISAL COSTS Inspection of materials Received Inspection of WIP Testing equipment Quality audits INTERNAL FAILURE COSTS Srap Re-work Downtime 500 200 400 1. for example. c) It can provide an indication of how total quality costs could be reduced by a more sensible division of costs between four categories.g.
1000 1500 2000 3.500 8. candidates will be expected to have full knowledge and they should be able to explain the different reasons of performance as shown below: • • • • • • • • The balanced scorecard Value for money measures The growth in non-financial performance measures Bench marking Investment centres Return on investment Residual income The measurement of assets and related problems 133
UNIT 4. These measures are also appropriate especially for lower levels of management in an effort and progress to provide and monitor cost of quality.Retesting EXTERNAL FAILURE COSTS Returns Handling customer Complaints Contribution figure from lost sales
400 2.200 11.5 43
TQM ideas are widely practiced and there are many nonfinancial performance measures being used in business organisations such as: ¾ Number of customer complaints ¾ Number of warranty claims ¾ Number of defective units delivered to customers as a percentage of total units delivered.0 MEASURES OF PERFORMANCE
Learning Outcomes After studying this chapter.600 17.
However. The balanced scorecard is an approach to the provision of information to management to assist strategic policy formulation and achievement. So in order to effectively manage a business. in the modern world.•
Behavioural aspects of performance measurement
Element 4. Element 4. which determines the ability to survive that will be determined by its capacity to provide sufficient satisfaction at a profit. provide information that can be used as a direct guide to management action. it is essential to include non-financial measures in performance evaluations. profit has been the far greatest measure of business performance.1. due to expanded corporate managements’ focus. it can be argued that financial-based measures merely measure the success of other activities and policies. This was exemplified by Kaplan and Norton.11 Growth in non-financial measures In a traditional sense. The main non-financial measures of performance which are commonly applied and used are: Innovation Flexibility Short-lead times Quality Cost The importance of these measures or attributes ties in their contribution to the delivery of customer satisfaction. It
. we need information to a large extent which is not financial in nature to aid our actions which will result in running an organization smoothly and ultimately result (lead) to good financial performance. This to a large extent can be attributed to the fact that theory has it that business’s sole objective is maximisation of shareholder’s wealth through payment of high streams of dividend’s and growing the invested capital in the business through raising the share price of a corporation from good economic performance. and do not in themselves.2 Balanced Scorecard in Detail The incorporation of non-financial information along side financial information has become known as the balanced scorecard approach.1 The Balanced Scorecard Element 4. Actually.
management is able to assess the impact of particular actions on all perspectives of the company’s activities. determining the specific items to be included in a balanced scorecard requires a business to examine its operations carefully.3 The Four Perspectives (a) The Financial Perspective
The financial perspective usually looks at the profit rock bottom.1.
. The financial prospects consider how we look at shareholders.emphasises the need to provide the user with a set of information which addresses all relevant areas of performance in an objective and liberalised fashion. By providing all this information in a single report. in order to address the following considerations.
It should be noted that critical success factors of a business may change. (i) (ii) (iii) Identity of the company’s critical success factors Selection of performance measures which can be used to monitor attainment against the identified critical success factors. in relation to their goals. interests and returns from the business on their behalf. The identification of the changes that must be made to organizational processes in order to facilitate the improvement of performance against the critical success factors.
Kaplan and Norton gave examples of the types of measures used to assess performance under the four perspectives. especially. following changes which are taking place in their market place. The typical contents of a balanced scorecard would be the following measures: (i) (ii) (iii) (iv) The financial perspective The customer perspective The internal business perspective Innovation and learning perspective. Usually.
The key measures in this regard would be the percentage of sales coming from the sale of the new products. (i) New products
This goal would encourage seeing development of new products/services and improvements in already existing products/services. (i) Survival of the business
The survival of the corporation will be to a large extent be measured by level of cashflow or how healthy cashflows are. (b) The Customer Perspective
The customer perspective looks at customer satisfaction. In order for a business to have a comprehensive customer perspective. The customer perspective looks at how customers see the providers of a service (businesses). (iii) Prosperity
The prosperity of the business is going to be measured by the breakthrough of increases in market share and the return on equity which the business is giving on investor’s capital. it needs to set the following aims and goals established by the accompanied measures.Therefore. (ii) Success of the Business
The success of the business will usually be gauged by the sales growths being experienced and the operating income trickling down to the business. (iii) Customer Partnership
. (ii) Responsiveness to Supply
How does the corporation handle its supply chain system? The main measure would be on-time delivery as defined by customers. the main aims and objectives which the financial perspective will have attached to one.
(c) The Internal Business Perspective The internal business perspective looks at what the business excels at if it has to deliver shareholder value. a business should set out the following goals alongside the key performance indicators (KPIs). The key measures to measure this would include measures such as cycle times. durability and ability to stand pressure. (iii) Design
The design of the product will concern itself with the features embedded in the products.How cemented and integrated are the relationships between the business and its customers.
. This can be measured by efficiency.
The manufacturing excellence
The manufacturing excellence must be explained though the perceived value of the organisation’s activities different consumers. This can be measured in terms of the corporate manufacturing geometry versus competition being faced. (i) Technology capability
The company should have cut-edge technology. In order to achieve good performance in relation to the internal business perspective. This partnership can be measured by the number of cooperative engineering efforts. and versatility in the components used in the manufacturing process. exact cost of manufacturing and yield. (d) Innovation and learning perspective This perspective looks at whether we can continue to improve and create value for clients or not.
(i) Technology leadership
The company must be able to employ state of the art technologies in its operations. (ii) Time to Market
This measure and goal considers the time it takes a corporation to design.
Figure 4. a business should set the following goals and set out measures to track performance and achievement of the goals. Below is a typical diagrammatic representation of the balanced scorecard for an imaginary communication utility company to illustrate the application of the balanced scorecard.1 The Balanced Scorecard and its application in performance evaluation
Overview of operations of Communications Utility
Identification of key Activities and the Value Creation Process
Categorising activities Into the four (4) Perspectives
Client (consumer) Perspective
Innovation and new services perspective 138
Internal process perspective
.In order to be able to continue providing unrivalled products/services. The main measure of performance in this area would be the number of new products and how the newly launched products are competing with similar rival products. The measure to use would be time to develop the next generation of the product. make and launch (deliver) the product to the market place.
Example of these organizations would include churches or religions organization. In case of local government the can have the following as the key stakeholders 1. which have not been set up with the view to generating profits.1 Nature of a Not-For Profit Organisation At this point in your studies you should appreciate that organizations can exist as business or non-business. and local government e. Tax payers e. Non-Governmental Organisations (NGOs). Political leaders 2.Develop Key Performance Indicators (KPIs)
Establish a performance evaluation system
With permission from Mpangwe Kasonso@2006 Element 4. The key stakeholders to an NGO for example would be the donors.c
.2 Value For Money (Performance Measures For Not-For Profit Organisation)
Element 4. Not for profit organizations are organizations.t. These stakeholders would want to know how efficiently and effectively the organizations they subscribe to are operating. employees and the local or domestic governments in which the NGOs are operating.2. Even if these organizations are not businesses they have a wide number of stakeholders who have an interest in them.t. Citizens 3.c.
Element 4. performance measurement looks at an exercise of comparing the actual performance level attained by an organization against the set objectives and set performance parameters (standards) Therefore we can have several and different performance measures depending on the nature of business or activities of an organization. 1. 2. So.3 The Three Es (Effectiveness.NATURE OF PERFORMANCE MEASUREMENT
Whether in case of a business or a not for profit organization. Element 4. EFFECTIVENESS Effectiveness refers to the organizations ability to attain its set out objectives. most NFPOs aim to have a surplus (an excess of income over their expenditure) as they are not expected to continue pestering and exerting pressure on donor funds or tight government fiscal and monetary policies. the performance will be measured by comparing performance standards set out against the actual performance attained by the organization.
. efficiency looks at a comparison between the qualities of resources used in a particular activity to the level of output produced using the resources.2.2 Nature of Performance Measurement in Not-For Profit Organisations In not for profit organization (NFPOs). Therefore. since these organizations do not exist to make profits. However. However.2. Care must be taken to realize that in effectiveness we do not give a lot of consideration to the resources we are putting into use when pursing the organizational goals. Efficiency and Economic) The three Es are used as the main primary measures of performance in not for profit Organizations. is a measure that aims to asses whether organizations are achieving their corporate objectives or not. it will not be a priority to ensure that the profit measure does not come up as a very important or paramount matter. EFFICIENCY Efficiency is a measure of how well organizations utilize their available resources.
In addition they would like to see that the hospital is stocked with drugs required to cure various diseases. Please refer to the ratios as illustrated in chapter 8 under variance accounting.6 of this chapter). Courtesy of employees toward.
If a not for profit organization is not performing according to stakeholders expectations we would want to utilize benchmarking as a way of trying to enhance the performance of a given not for profit organization (you should remember that you will look at the subject of benchmarking in section 4. Length of waiting time. Financial discipline through financial surplus posted. 4. In other circumstances such as in a local government clinic. 2. For instance when assessing the economic or value for money in a government ministry or local government. They will want to ensure that the waiting times before consulting the doctors are abbreviate and reduced. patients would like to see to it that they are given good healthcare. 3.
KEY PERFORMANCE INDICATORS (KPI’S)
The mostly used key performance indicates in assessing performance in not for profit organization will include the following and depending on the nature of business an organization is involved in: 1. Economy or value for money will differ from circumstance to circumstance. Number of clients complaints Innovation levels. the tax payers will want to hold government official accountable and they will make independent assessments as to whether the taxes paid are being used according to public expectation or not. clients’. ECONOMY The economy aspect aims to measure the value for money for the service the organization is serving to its clients.In some cases efficiency can be measured by using some efficiency ratios. 5.
3. condiments and packaging and the number of hamburgers made. For example. such s previous period costs less a reduction of 10%. There are three approaches that can be used to set financial target against which performance can be measured. in a fast-food restaurant for a given output of hamburgers it is possible to estimate the inputs required because there is a physical relationship between the ingredients such as meats. One approach is to use historical targets derived directly from the results of previous periods.2 Engineered Targets These can be used when there are clearly defined and stable inputs – output relationships such that the input required can be estimated directly from product specifications. This gap arises because subordinates have more information than their superiors on the
.3.3 Negotiated Targets Are set based on negotiations between superiors and subordinates.1 There is substantial evidence from a large number of studies that the existence of a defined quantitative goal or target is likely to motivate higher levels of performance than when no such target is stated. Previous results plus an increase for expected price changes may form the basis for setting the targets or an improvement factor maybe incorporated into the estimate. other approaches must be used to set financial targets.3. Element 4. buns. Where clearly defined input-output relationships do not exist. The major advantage of negotiated targets is that they address the information asymmetry gap that can exist between superior and subordinate. They are: a) Targets derived from engineering studies of input – output relationship b) Targets derived from historical data and c) Targets derived from negotiations between superiors and subordinates Element 4.Element 4. People perform better when they have a clearly defined goal to aim for and are aware of the standards that will be used to interpret their performance. The advantage of using historical targets is that they may include past inefficiencies or may encourage employees to under-perform if the outcome of efficient performance in a previous period is used as a basis for setting a more demanding target in the next period.3
FINANCIAL PERFORMANCE MEASURE
1 Within an organisation people are employed to carry out specific activities. Their budget are set to be challenging but achievable say 80 – 90 % time by an effective management team working at a consistently high level of effort. Negotiated targets enable the information asymmetry gap to be reduced so that the targets set incorporate the constraints applying at both the operational level and the firm as a whole. The only aspect of their work over which they have direct control may well be the volume and the quality of tasks they undertake.3. According to Merchant (1990) “most companies set their annual profit budgets targets at levels that are highly achievable. tight or high.relationship between outputs and inputs and the constraints that exist at the operational level. and those set below average are classed as easy loose or low. Targets are considered to be moderately difficult ( or highly achievable) when they are set at the average level of performance for a given task. but will have little meaning to the individual employee
. He suggests that where uncertainty is low . Research evidence suggests that setting specific difficult budget targets leads to higher task performance than setting specific moderate or easy targets (Stedry and Kay 1966). Target set levels above average are labelled as difficult. Element 4. applying revenues and costs to these activities may be important to the organisation as a whole. and the subsequent use of difficult budget goals to measure performance will minimize the incidence of dysfunctional behaviour such as falsifying accounting information. setting specific difficult budget goals will promote performance.
Element 4.4. A flexible budget therefore is an important tool in performance measurement as it ensures that the cost targets used as a basis for comparison are flexible as levels of output change. whereas superiors have a broader view of the organization as a whole and the resource constraints that apply.4
Element 4. However Hirst (1987) has advocated that the benefits arising from setting specific difficult budget goals are dependent on the level of task uncertainty.4 Performance Measurement Targets vary in their level of difficulty and the chosen level has a significant effect on motivation and performance.
However. examination success rates are the prime performance measure and they will be concerned to ensure that fluctuations in pupils number do not affect that success rate. The accounting numbers have to be converted to some measure of quantity which relates more closely to the individual. where activities are subdivided by subject area.2 Quality Measures As stated under financial performance measures. A performance report on the history department
. If the employees are involved in the entire production process.4.4. This is essential in order to avoid a sense of injustice in the application of management accounting techniques.3 Illustration of the problems of performance measurement in a service business Take a school as an example. They are ways of translating financial targets and measures into something that s more readily identifiable by a particular employee or group of employees. Element 4. then the cost per student will vary depending on the number of students taught in any period. it may not be sufficient to motivate employees directly in understanding and meeting the targets expected of them. but the individual department will have no control over that number. so that salary costs are largely fixed costs. A performance measure of cost per student may be attractive to the management accountant but will have little impact on the staff of the history department whose main aim is to ensure that their pupils achieve high grades in the end-of-year examinations. Element 4. a flexible budget is important in ensuring that the cost targets used as a basis for comparison are flexible as levels of output change. then the financial target may be converted to units of product per period. Using nonfinancial performance measures does not mean that the financial performance measures may be disregarded. If teaching staff are appointed on permanent contracts. For them. This approach may be more difficult when a service activity is involved or a group of employees are involved in only part of a production process. The primary measure of activity will be the number of pupils taught. To ensure that the motivation of employees is consistent with the profit objectives of the organization. it may be necessary to use non-financial performance measures to indicate what is required to achieve the overall financial targets.who does not sell the goods or services directly and does not purchase the input material.
and c) time between receiving customer order and supplying the goods or services Example : Zesco an electricity company provided the following information about non. This is so important that an external agency ( often the auditors) may be employed to provide independent certification of the quality of the process. Element 4. The nonproductive time incurred because of faulty equipment or the reliability of delivery dates and quantities. where inputs may be materials. Element 4. or may be monitored by reviewing the rate of return on unsatisfactory goods. in respect of demand for products: a) the number of enquires per advertisement placed and b) percentage of customers who remember the advertisement. 2.
RESTORE SUPPLY IN THREE HOURS TARGET 90% PERFORMANCE 92. labour and capital equipment.9%
.4.4 Quality Measures The ultimate measure of quality is customer satisfaction.8% RESTORE SUPPLY IN 24 HOURS TARGET 99% PERFORMANCE 99.financial performance over a one year period. quality is measured also in terms of the inputs to the process. Quality f inputs may be controlled directly by imposing standards on suppliers.would therefore. in respect of delivering the product: a) error free deliveries as a percentage of total deliveries b) number of complaints as a percentage of units sold.4. The important aspect of quality is the process undertaken by the organisation to achieve quality. Secondly.5 Some specific examples of on-financial measures are: 1. emphasise first of all the non-financial performance in terms of examination success but would then additionally report the cost implications so that the consequences of achieving high or low success rat could be linked to the cost of that activity.
BACKGROUND INFORMATION (KNOWLEDGE)
At this point we would like to remind all candidates about the concept of • Cost-centres • • Profit-centres Investment centres.5 Divisional Performance Measures In an organization. where senior management at head office exercise control over complete activities of the organization. control can be centralized.MOVING A METER INSIDE 15 WORKING DAYS REPLY TO TELEPHONE CALLS WITHIN 10 SECONDS
TARGET 95% PERFORMANCE 96.
Element 4. the degree of authority delegated by top management to lower level operating management can be viewed as an issue.7% TARGET PERFORMANCE 90% 86%
Element 4. In the later case it will become necessary to provide program measures which will serve as guides and targets for performance expected of the various divisions operating under head office.6 ACTIVITY Write out any non-functional performance measures which could be reported by an organization which delivers parcels to the general public and businesses. we want to examine the different performance measures we can use to assess performance of divisions. Therefore at this point. In this case the company will be running a decentralized control system.
(a) A Cost Centre A cost centre according to the CIMA official terminology can be an ability location machine or business unit in relation to which cost are included
. In some organizations.4. In some cases senior management at head office can delegate to divisional managers to branches and divisions of the company.
revenue generation and the acquitting and disposal of the objects used to support the centre’s activities In different cases the division can be treated as any or in light of the abovementioned centres. As it will be seen by concentrating on a percentage return rather than the absolute if the divisional profit. so that ultimately an actual motional profit can be determined (c) Investment centre An investment centre can be an activity location machine or business unit where managers are responsible for cost containment.
.(b) Profit centre A profit centre can be an ability location machine or business unit for both cost containment and revenue generation.
RETURN ON INVESTMENT (ROI)
This is the divisional equipment of the generally known as the on capital employment measure used in financial statement analysis and simply expresses percentage of the funds invested in the particular sub-unit.an American consulting company However we are not going to consider the modern performance measures of economic value added (EVA). therefore it would be usual for the investment to be averaged over the time period in question. Return on investment adopt an efficiency criterion which recognizes the critical relationship / connection between a divisional income and the assets employed in generating the income. However divisional and corporate performance nowadays can be assessed by use of other modern performance measures such as economic value added (EVA) a trademark from stern and Co. and market shareholder value added in this text. The two commonly used financial measures of divisional performance in such cases are return on investment and residual income. The return on investment can be calculated using the formula: Return on = Investment Divisional profit x 100% divisional Investment
As it can be understood profit only related to a period of time and investment can only be measured at a point in time.
As it can be seen from above simplifying the divisional sale cancels out leaving the same end formula. Division profit Divisional sale = Divisional profit Divisional
. as the following example will show. The breakdown has considerable significance for analysis and decision-making purposes. 000. 000 gives a return on investment of 20% This represent a more efficient use of assets than a profit of K800. al other things being equal. Example: Sounds investments Ltd sells music records through its own. 000 on an investment of K2. 000.S.e. in-town street stores and through its agents out-of-town. 000. 000.For instance a profit of K400.A did quite a lot of work around the subject of divisional performance assessment and assessment measures. We appreciate that capital will always have alternative uses and a firm must satisfy itself that it is not an opportunity cost associated with an investment in a particular division i. Divisional Sales x Division investment Investment = Return on investment. 000. it must be determined whether the return exceeds that which could be obtained from an alternative use of the invested finances. 000. Both businesses through agents and through own stores yield the same return on investment of 15% but this is earned in quite difficult ways.
In order to have fair insight into a divisions performance the basic formula as broken down by means of the so called Du Point method of probability analysis into the product of the investment tomour and profitability ratio: As you could have read further the Du Point Company of U. 000.
BREAK DOWN OF RESIDUAL INCOME. 000 of an investment of K10.
000.200.400. whereas the lower profit margin accepted on sales in the own-stores business if 50%.000.200.000 K4.000 K6. ROI = Divisional profit = Divisional investment K600.000
Even if the Business through agents earn a higher profit on the sales of 7.5% = 15% K8.000
K600.000 X K4.000 Divisional Profit Divisional sales
=15% BREAK DOWN = Divisional sale X Divisional investment = K19.000
Through own-stores ROI = Divisional Profit = Divisional Investment K 960. which generator a higher sales volume leading to an investment tomour of three (3)
.000 K8.000 X 100% K2.000.Through Agents Division profit Division Investment Divisional sales Through Agents the ROI is.5% the investment in the business through the agents is only tomorrow over twice.000
= Divisional sales X Divisional Investment
Divisional profit Divisional sales
Through own stores K960.000 K6.000.000 K19.000 = 2 x 7. 400.400.000 = 3 x 5% = 15% x K960.000 x 100 K6.000.200.
000 x 100% K4. 400. 000. 000. 000 Break Down = K2. 000. How is this to be interpreted? First sight it is an unqualified improvement but review of the figure reveal that the 18% comes from a profit of K1. 000 K2. 080.5 x 30% = 15%
In the current year the divisional manager has reported an increase in his ROI to 18%.4 00. 000 K2. 000. 000 K6. 000. 000. 000. 000
= 0. 000 K6. Pep stores of Chipata produced a profit of K600. 000 on sales of K2. 080. 000 x
Divisional Profit Divisional sale
K600.000.080. 000 K4. 000.5 to 0. 400. If however the determination in the investment tumors was causes by an undesirable and expensive hand-up of stocks of finished goods due to excessive production during the current period and the dramatic rise in profit x K1. The investment in the division was K4. 000. 000 = 15%
Divisional Sales x Divisional Investment K2.4 x 45% X 100% = 18%
.Example Last year.00 on sales of K2. 000 = 0. 000 ROI = K1. 000. 000 = 18% From the analysis it can be seen that a dramatic increase in the profit margin (form 30% to 45%) which has fortunately more than affected a marked determination in the investment tumors (from 0. 000 ROI = Divisional Profit x 100% Divisional Investment = K 600.4) lending to the overall increased ROI. 000 generated by an investment of K6.
. A reduction in the level of divisional investment.
Actions (i) to (iii) will increase the profitability ratio and hence the ROI. action (iv) will do likewise by increasing the investment tumors. For example if all other factors were held constant. An increase in selling price (for any given volume of sales) An increase in sales volume (at a given selling price) A reduction in either fixed or variable costs. Element 4.6 Benchmarking The term benchmarking refers to the establishment through data gathering of target and comparators through whose use relation levels of performance can be identified. which contribute to ROI. by differing much of the periods fixed manufacturing costs to a later period then the improvement in ROI is no case for congratulation.margin was a function of the operation of an absorption costing system which had improved profitability on those goods actually sold in the current period. This will be highlighted when we consider the example looked at under behavioural implication of using divisional measures of performance. By the adoption of best practice it is hoped that performance will improve. ROI would be improved by any of the following individual actions i. ii. iv. Further at the divisional level by highlighting the different factors. it can provide a local manager with limits as to the type of action that would be necessary to improve the sub-limit return. It is obvious that any combination of (i) to (iv) will also improve the ROI as well as a combination containing opposite movements that happen to be more than affect by positive factors. Therefore benchmarking aims to encourage corporations to improve their performance by comparing their own performance to that of other companies. iii. The breakdown of ROI into investment tumors and profitability ratio provides top management with two additional criteria with which to measure a division’s performance.
Financial information is much more readily available especially for listed companies as we can easily access their published accounts through the register of company’s files/archives.
. which a business follows.1 Steps In Benchmarking The bench marking process starts by first relating appropriate comparators against which a company can compare its performance. The comparators competitor should be of similar size and therefore showing as good comparator. Element 22.214.171.124 Financial Statement and Reverse Engineering The data obtained can be either financial information or non-financial information and we should acknowledge here that non-financial is not easy to obtain. Reverse engineering insists buying a competitors products and dismantling it in order to understand its content and configuration Element 4. Non-financial information about competitors and their products can be obtained by reverse engineering.6. and thus effective benchmarking requires an understanding of the actual basic process of their businesses.Element 4.6.2 Information Gathering Benchmarking starts with obtaining the information required in order to benchmark against competitors Element 4. This entails that the target against which benchmarking is going to be carried out should be a company with similar operations as ours.4 Other Sources of Information In order to obtain information about their competitors we would use the following sources. (i) (ii) Product literature Trade associations and press comments
However we should realize that a product is only the end result of the process.
5 Types of Benchmarking The exercise of benchmarking can be classified in different types. conduct their relationships with suppliers and other keep stakeholders? Element 4. deal with customer enquiries. Note that in internal benchmarking we are comparing different departments in the same organisation regardless of the business activities or discipline they are handling. how do competitors process their customer orders. For instance we would want to compare the finance department of Shoprite. For example. for example we can compare the performance of Shoprite Checkers against the performance of Game stores in a given control period. (c) Inter. ¾ Internal benchmarking ¾ External benchmarking ¾ Inter-industry benchmarking (a) Internal benchmarking With internal benchmarking. (b) External benchmarking With external benchmarking.As noted above obtaining information about competitor’s processes is much more difficult than getting information about their products.6. Game stores and Melissa against the performance of a top performing finance department in the chain store industry. However in our studies here we want to classify benchmarking in two parts. we compare the performance of the company against the performance of others in the same line of business.industry benchmarking
. we compare the performance of the different departments or business units against the least department in class. External benchmarking does not only apply to corporate performance but external benchmarking mighty also include the comparisons of departments in organization against the performance in the group of these departments from companies operating in the same industry.
the corporation can improve its performance by learning from the experience of others.7 BEHAVIOURAL ASPECTS OF PERFORMANCE MANAGEMENT
Element 4.industry benchmarking we compare the performance of our corporation against the top in the class (or top) performing corporations regardless of the industry in which the top performing company originates from. For instance.
. we need to identify a non.6.7. a distributor of personal computers may approach a distributor of HI.6. with similar processes and risk to participate in the benchmarking exercise. Element 4. it might be a situation of a ‘one eyed person operating as king among the blind’ and this is not going to help the lagging companies or departments to make quantum leaps in terms of their performance improvement.1 The human aspects of controls in relation to performance measurement is a key factor in evaluating the control system. By collaborating with other companies in a benchmarking exercise.
Element 4. however we can dwell on these few: Benchmarking enables the corporation to benefit from the experience of the others and thereby establishing ‘best practice’ in their common business processes.
Element 4.In inter.6 Benefits of Benchmarking The benefits of benchmarking are quite obvious. Therefore to successfully carry out this.FI City. In a situation where the company or business unit that has been identified as the best in class is not a highly performing business unit or company. the comparisons might be flawed. however. to establish a benchmarking relationship.FI equipment as HI.7 Pitfalls of Benchmarking We should be mindful of that benchmarking might give planned results sometimes The planned results can be obtained in the following situations: In a situation where a comparative competitor is not right or comparable size and background.competing business. computer connection.
However. However.5 Performance indicators should always provide for controllable and uncontrollable factors. This means that employees must be motivated to achieve those targets. Element 4. it is the case that performance measures will not necessarily reflect the ideal measure of overall performance.7. It is common practice for uncontrollable factors to be excluded from employee performance measurements. It is a basic principle that performance evaluations are considered fair only when employees are not held accountable for results which they have little control.A control system’s objective is primarily to enable the organization achieve its objectives. Further more the outcomes should not be used as means of punishing employees but as a way of improving the efficiency and effectiveness of the organisations activities. However.6 BUDGETS AND PERFORMANCE MEASUREMENT
. It is also important not to make Departmental Heads accountable for areas where they do not seem to have significant influence. Consequently such behaviour will lead to the non-achievement goal congruence. performance measurement should result in desirable behaviour which will enable the organization to meet its corporate objectives. this does not mean that uncontrollable items should not be reported. It is common for individual employees to pursue their personal performance in order to meet the control system measures even if in doing so the overall organisational objectives are impacted negatively.2 PERFORMANCE INDICATORS Performance measures must be in such a way as to help the organization achieve it’s objectives. controls can sometimes result in employees’ behaviour which works against the objectives of the organization. Element 4.7.7. Element 4. Element 4.7.7. This results in some measures not achieving goal congruence or desirable organizational behaviour. Element 4. This should therefore encourage the organization to incorporate other control measures which are not necessarily specified in quantitative terms. In general. a fair appraisal system must be used which should create a positive attitude in employees.3 It is also important that employees do not concentrate only on what is measured even if it does not ultimately lead to achieving goal congruence.4 In evaluating performance.
it is therefore important to identify some level of budget difficulty which should at least maximise employee performance and motivational levels. However. after a certain level of budget difficulty. e) Managers’ reactions to budget targets were affected both by their own personality and general cultural and organizational norms. but negative attitudes result if they are seen as too difficult. The use of departmental meetings was found helpful in encouraging managers to accept budget targets. performance and motivation levels will start declining. the following conclusions are made: a) Budgets have no motivational effect unless they are accepted by the managers involved as their own personal budgets. d) Acceptance of budgets is facilitated when good communication exists. practically difficult to reach a consensus as the ideal financial targets without some managers being dissatisfied.
. Element 4.7. can only be the case if people responsible with implementing the budget are agreeable to the set financial targets. b) Up to the point where the budget target is no longer accepted. It is assumed that with each level of budget difficulty encountered by managers in meeting the targets. c) Demanding budgets are also seen as more relevant than less difficult targets. From this analysis. there is a corresponding increase in the performance and motivation levels. This however. the more demanding the budget target the better the results achieved. It is however.7 In a study carried out by Hofstede concerning the budget difficulties.Budgets are supposed to provide a way of motivating employees (especially managers) to meet the desired financial targets.
Typically this involves changing the value of a variable and seeing how the results are affected. you will actually discover that sensitivity analyses are included through the following exercises. The main common approaches to sensitivity analysis are as follows: (a) To estimate by how much costs and revenues would need to differ from their estimated values before the decision would change. (b) To estimate whether a decision would change if estimated costs were X% higher than estimated. (c) To estimate by how much costs and or revenues would need to differ from their estimated values before the decision maker would be indifferent between two options. Definition 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.0 DECISION MAKING TECHNIQUES
Learning outcomes: After studying this chapter students should be able to • • • • Understand risk Demonstrate various ways of assessing risk and uncertainty Demonstrate full knowledge of sensitivity analysis Draw and prepare decision tree diagrams.
.STUDY UNIT 5. From close examination of other chapters in this book. is to carry out the calculations with one set of values for the variables and then substitute other possible values for the variables to see how this affects the whole outcome.1 Sensitivity Analysis Sensitivity analyses can be used in any situation so long as the relationship between the key variables can be established. sales price per unit. The essence of the approach therefore. or estimated revenues Y% lower than estimated.
Element 5. material costs or labour costs.
600) 400 K’000 8.000 (6. 4.
Example: SENSA (Z) Ltd has estimated the following sales and profits for a new product which it may launch on to the market. Linear programming in chapter 5 under linear programming.(i) (ii) (iii) (iv)
What if analysis under information systems (chapter 10) using spreadsheets).000 2.000 (1.000) 2.000 units) Variable Costs: material labour Contribution Less: incremental fixed Profit Required: Analyse the sensitivity of the project. the project would make a loss. K’000 Sales (2. Flexible budgeting can also be a form of sensitivity analysis see chapter 6 under flexible budgets. (b) If unit costs of materials are more than 10% above estimate the project would make a loss. Sensitivity analysis is one method of analyzing the risk surrounding a capital expenditure project and enables an assessment to be made of how responsive the project’s NPV (net present value) is to changes in the variables that are used to calculate the net present values (NPV).000
. Solution: (a) If incremental fixed costs are more than 25% above estimate.
000 2.(c) Similarly. Required: Measure the sensitivity (in percentages) of the project to changes in the levels of expected costs and savings.000 Running costs K’000 Savings K’000
0 1 2
The cost of capital for the project is 8%. Solution: The present values of the cash flows are as follows Year discount Factor 8% 0 1 2 1.000) 2.500 6. The items to which profitability is most sensitive to in this example are the selling price and material costs.000 7. Management would then be able to judge more clearly whether the project is likely to be profitable. Sensitivity analysis can help to concentrate management attention on the most important forecasts. Example: YUKAA PLC is considering a project with the following most likely cash flows Years Purchase costs K’000 (7.926 0.000 0. the project would be sensitive to an increase in unit labour cost of more than 20% above estimate.000)
.857 present value of plant cost K’000 (7.
8 Element 5.000) (1.000) Present values of Running costs K’000 Present Values of Savings K’000 Present Values of Net Cash Flow K’000 (7.000 = 4. (a) Plant costs would need to increase by present value of K560. The changes in cash flows which would need to occur for the project to break even (NPV = 0) are as follows.143) (3.000 that is by: K560._______ (7.000 x 100% = 8% K7. Looking at factors in isolation is unrealistic since they are often interdependent.852) (2.000.556 5.1.704 3.999 11.856 560
The project has a positive NPV and would appear _____________.995) 5.1 Problems with sensitivity analysis (a) The method requires that changes in each key variable are isolated but management is more interested in the combination of the effects of changes in two (2) or more key variables.000 that is by: K560.000 that is by: K560.000 (b) Running costs would need to increase by present value of 560.000 x 100% K11.000 (c) Savings would need to fall by a present value of K560.000 x 100% = 14% K3.995.555.555 3.
.560.000 units per annum are sold.000.000.000.517 units Sensitivity Analysis is a modelling and risk assessment procedure in which changes are made to significant variables in order to determine the effect of theses changes on the planned outcome. For instance it can be used in conjunction with break-even analysis to ascertain by how much a give factor can change before the project ceases to make a profit. while all other factors remain at their original estimated.875. In sensitivity analysis a single input factor is changed at a time.000 units are sold per annum the net present value over the same period will be K2.000 = 13.560. Required Calculate the minimum annual sales volume that will justify the launch of the delta. the Delta.000units + K1.000.000. As the definition indicates sensitivity analysis can be applied to a variety of planning activities and not just to instruct decisions.(b) Sensitivity analysis does not examine the probability that any particular variation in costs or revenues might occur.875. We can approach sensitivity analysis from two perspectives.560. the net present value over five years will be K1.000 x 10. Of paramount importance. it is vital to identify variables that are of special significance.000.000 + K2.000. This occurs at a volume of 10.000 units K1. If 10. Example DEF (Z) Ltd is considering the launch of a new product. Solution The minimum sales volume is the volume that produces a net present value of zero. but if 20.
000 3. in order to determine the effect on the net present value.1. 000. Example The example below shows how sensitivity analysis works in practice. 564 ii.000 Less: fixed costs Net cash inflow per year NPV Years 0 1–4 Outlay annual cash Inflow Cash flow K’000 (100. It is estimated that this will generate sales of 10. 000 x 10. 000. 000) 34. Muponga Ltd is contemplating investing in a project which will need initial capital investment of K 100. 000 and the fixed costs are expected to be K 26. 000) 34. K’000
Total Contribution = K 6. The cost of capital is 5%. ii. 2. Net present value can fall by K 20. 000) 120.000 units per annum for four years.e. the indifference point. The contribution per unit is expected to be K6. such as the sales decreasing by 5%. 000 DCF @ 5% 1. 000 Units = 60.546 PV K’000 (100. Alternatively specific charges can be calculated. 000 = (26. 000 before the indifference point is reached. 000. An analysis can be made of all the key input factors to ascertain by how much each factor must change before the net present value reaches zero i. 564 20. This implies that the annual cash flows can change by
. Required: i. Calculate the net present value By how much can each factor change before the company becomes indifferent to the project?
Suggestion Solution: i. 564. 000 per annum.
However. it has not been calculated with data on the ‘most likely’ value of each of the four variables affecting the decision. cash flows and the discount factors or costs of money were known with certainly. the costs can fall by K 5.
Element 5. 564. Sensitivity analysis is one of the methods of reducing uncertainly and assessing certainty in investment decisions. 000 X = K 5. most practical investment decisions are married with a great deal of uncertainty. 800. we assumed that all the quantitative factors in the investment decision i. In order to give decision makes a clearer understanding of the problem without providing definitive guidance though. 000. As it can be seen that most work in sensitivity analysis involves altering key variables and an assessment spreadsheet can be easily employed to carry out sensitivity analysis.1.e.546 = K 20.3 Linear Programming
BASIC MECHANICS OF LINEAR PROGRAMMING
At this stage you are expects for know how to use basic linear programming technique to handle situation where you have two constraints limiting the undertaking of an entity. Each of the factors has a significant influence on the profitability of the proposed project.2 Application of Sensitivity Analysis in Project Appraisal We dealt with capital investment appraisal chapter. Therefore. 000
Element 5. Example: A company is contemplating investing in a new product. 200. 000. 000.
. However in most projects the various variables will have interdependences amongst themselves. we cannot just take a simplistic approach to assume that each variable has to be considered in isolation. 000 to K20. These variables are listed below. However. 000 Therefore.X x 3. we have many approaches to deal with this. this is not a certain net present value. 800. Sensitivity analysis can be used as an attention – directing technique as it directs attention to those factors that have the most significant impact on the outcome of a given Project. the net present value of the investment is K 2.
since profit is a function of Revenue against expenditure. If the aim is to maximum profits from two products X and Y. 000. 000 Y. In a case where an organization would like to minimize costs.STEPS IN LINEAR PROGRAMMING
STEP 1: Establish the objectives function In business. 000 Y This will serve as the objective function in a situation where a business aims to maximize profits.000 respectively. Profit = Revenue – Expenses. 000 and K 28. we would construct a similar objectives function which would however aim to minimize the costs of operating. corporations are there to make profits as they wish maximum the wealth of shareholders. Assuming that we have the same two products X and Y in our product catalogue at which each unit of the products income to that cost of production is K20. which usually will aim at minimizing costs of operations or maximizing revenues from operations. total profit = K15. how would we construct the objectives function? Total cost = cost of manufacturing + cost of manufacturing One unit of X one unit of Y Total cost = K 20. Supposing that one unit of X gives us a unit profit of K 15. the first step in linear programming will initiate the establishing of an objective function. Therefore. Therefore. 000 X + K 28. The profits will be maximized by either increasing turnover of the company or by minimizing costs of operations. we would construct an equation showing the total profit we would earn from the sale of one unit of X and one Unit of Y.
. 000 X + K 20. we would construct the total profit equation as follows: Total profit = Profit from + Profit from one One unity of X Unit of Y. Therefore. Therefore in this case the above equation will be the objective function in a case where the company aims to minimize the costs of operating. 000 and a unit of Y gives us a profit of K 20. at any given point in time a business will want to either minimize cost or maximize profits and therefore shareholders wealth.
The next step in linear programming is the establishment and determination of inequalities which show the different constraints. The non-negativity equation therefore aims to form a block or boundary within which the graph has to be drawn. +Y
The shaded area shows the region where we will expect ourselves to have the linear programming results as this is the area where both the X and Y variables will be positive on the graph.Negativity equations. Having established the inequalities you will need to convert them into equations. We cannot have negative figures coming from the graph as optional solutions.STEP 2: Inequalities. In most manufacturing situations raw materials.c) by the equal sign (=) STEP 3: Establish Non. if they have to make arithmetic sense. Therefore the inequalities are constructed according to the constructs shown in the scenario. Therefore all the analysis and graphic representation will have to be made in the quadrant which has both positive X and Y variables on the graph as represented below. The non-negativity equation will be:
. where we will replace the inequality signs (e. skilled labor.t. factory capacity and many more factors might act as constraints limiting factors. At this stage we want to realize that all the analysis we will conduct under linear programming will have to yield positive figures.
K.000 and K 100. Required: Represent the above situation as a linear programming model. 5 Kg of A and 4 litres of B to make each unit.
.X ≥ And
Y ≥ O These will further need to be convert into equation. and the resulting equations will be X = O and Y = O respectively
STEP 4: Plot the equation lines on the graph. It is known that all production can be sold.
STEP 5: Determine the Optimum position mix or combination. K2 uses s man-hours. 000 respectively. Operative time Raw material A Raw material B 240 man-hours. Try the example below and see if you can remember your basic linear programming technique. and K2 and has the following constraints on a monthly production. Since this is brought forward knowledge. The contribution to profit from each unit of K1 and K2 are K 150. 5Kg of A and 5 litres of B to make each unit. if the objective is to maximize total monthly profit. Question: Manzi Co makes two components. 500 Kg 400 Litres
K1 uses man-hour.
large coffee tables to be producing in the coming year. In addition market analysis reveals that the annual demand for the company’s small coffee table is at least 800.000
ASSEMBLY 5 4 3 2 9. There are four decision variables in the model defined as. In illustration below will explain the simplex method properly. X4 = the number of small. Example Mulobezi timber table require time for the cutting of the component parts for assembly and for finishing. The simplex method begins in the same way as the ordinary linear programming operation. medium large and extra.THE SIMPLEX METHOD
A linear programming problem with more than two constraints or decision varieties cannot be plotted on the two axes of the graph i. by setting up equation for the objectives function and the constraints. The detailed linear programmes procedure described above can be applied to the molobezi scenario as a linear programme.950
K’000 60 123 135 90
Due to other commitments no more than a total of 1. The objective variables are stated as: Let Z = total contribution earned in the coming year in kwacha from the production of the coffee tables. X3.000
FINISHING 1 4 5 3 4. The data in the table below has been collected for the year now being planned. The quantities of the four types of coffee tables to be produced are the activities of the problem.e.e. the X and Y axes. Therefore were need different method of solving the problem: i. the simplex method.
HOUR REQUIRED FOR TABLE
CONTRIBUTION OF EACH TABLE
TABLE Small Medium Large Extra large Available Charge In Hours
CUTTING 2 2 1 6 3. The company wishes to determine how many of each type of coffee table it should produce in the coming year to maximize contribution.
.800 coffee tables can be made in any given year. Let X1. X2.
assembly and finishing time used in production cannot exceed that which is available. 800. 000X4 The quantities of the four types of coffee tables made will be restricted by the limited availability of cuttings. 000X2 + K 135. The requirement that at least 800 small coffee tables must be produced can be expressed in a mathematical equation as X1 ≤ 800 Finally. 000X3 + K 90.800 X1 ≥ 800
. 000X2 + K 135. 000X1 + K 123. X3. 000X4 Subject to: 2X1 + 2X2 + 1X3 + 6X4 ≤ 3. timber’s linear program is therefore Maximize Z = K 60. This there will be three constraints specifying. respectively.e. 000 5X1 + 4X2 + 3X3 + 2X4 ≤ 9. 000X1 + K 123. 000X3 + K 90. Maximize Z = K 60. X1 +X2 + X3 + X4 ≤ 1. 950 The total of the 4 decision varieties cannot exceed 1. 000 1X1 + 4X2 + 5X3 + 3X4 ≤ 4. assembly and finishing time.The company wishes to maximum contribution so the objective function is. X2. that the amount of cutting. 000 1X1 + 4X2 + 3X3 + 3X4 ≤ 4. 000 5X1 + 4X2 + 3X3 + 2X4 ≤ 9. These are written as: 2X1 + 2X2 + 1X3 + 6X4 ≤ 3. Thus the following constraint must be included in the model. X4 ≥ 0 The complete model for Mulobezi.950 X1 + X2 + X3 + X4 + ≤ 1.800 there is a ceiling (maximum) on the total number of coffee tables to be manufactured. non-negatively conditions (equations) must be states for the other three decision varieties i.
Worth. 000 600. 0000 21. 750. 000 Variable X1 X2 X3 X4 Value 950. 000
Constraint 1 2 3 4 5
Slack / surplus 0. 000 0. based on the fundamental concept that the optical solution occurs at a corner point of the seeable region could be used this is called the simplex method. 000 21. 0000 0. 000
1. 0000 1. X4 ≥ 0. Mulobezi. 0000 48. X2 = 250. 000 0. 000 0. However. 0. a computer package that incorporators this method has been used and this will typically yield the information as shown below: Objectives function Variable (Z) =K168.X2. 0000 0. 9. 000 0. As it can be seen. 0000 150. 000 250. this model cannot be solved graphically as there are more than 2 variables. should manufacture 950 small coffee tables. 450. 0000 0. X3. Therefore to maximize contribution in the coming year. X3 = 600. X4 =0. 250 medium one and 600 large one and none (nil) of the extra large coffee table
. A general algebraic method of solving linear programming problems. 0000 Relative Loss.
The Variable and value columns mean that X1 = 950.
450 unused hours of assembly time. It has a surplus equal to 150.2. The slack is zero. 450 and this there will be 1. e) Constraint 5 is ≥ and specifies that at least 800 small coffee tables will be made. b) Constraint Z is ≤ and refers to assembly time the slack here equals 1. This assembly time is not a binding constraint. From your studies of linear programming we know that a slack variable is the amount of resource which will be unused in a specific linear programming solution and a surplus is the extra that is produced above the minimum requirement in a greater than or equal to constraint. 3.
Z = K 168. Showing that this ceiling has been net exactly. c) Constraint 3 is ≤ and refers to finishing time. 000. d) Constraint 4 is ≤ and refers to the ceiling on the total number of coffee tables produced of 1. shows the total contribution that will be earned from the above production of the tables in the coming year. 000 and extra hour of finishing time would increase contribution by K21. the amount which contribution would alter if the availability of the resource was changed by one unit. 800. 000.
. indicates that production is 150 above the minimum requirement. it can be seen that we have worth and relative loss columns. 750. A measure of risk or uncertainty is present in almost all circumstances in business. the concept of risk and the concept of uncertainty.e. Decision theory attempts to distinguish the two concepts i. a) Constraint 4 is ≤ and refers to cutting time. (This can be seen by the fact tat X1 = 950).e. This is extra hour of cutting time would increase contribution by K 9. The constraints and slack/surplus columns provide information concerning the slack values for the less than or equal to constraints and the surplus values for any ‘greater than or equal to’ constraints. Its slack is zero indicating that all of this resource will be used. The worth shows the shadow price i. so 950 of these tables are made.
WORTH AND RELATIVE LOSS INTERPRETATION
In the above table. It slack to Zero showing that all availability cutting time will be used.
NATURE OF RISK
It would be rare for the outcome of a business decision to be known with certainty in advance.
The difference between these three types is a function of attitude towards variability of returns around an expected value (EV). • A set of the alternative states of nature that exist in respect of the situation together with the probability of each ones occurring. the qualification of the company’s objectives in a particular situation. risk-seekers or risk averse. They may be risk neutral. Typically. Decision makers themselves may have differing attitudes to risk. risk and uncertainty will be used synonymously. However. all alternative must be considered and mutually exclusive i. Again this set must be collectively exhausted and mutually exclusive (and the probabilities must sum up to 1. • An objective function. the alternative with less variation associated with it. A risk neutral decision maker ignores variability and is concerned only with the expected values of outcomes. • A set of alternative causes of action These can be adopted in order to achieve the desired objectives. i. the two words i.e. Those who are risk-averse prefer in the same situation.e. This set must be collectively exhaustive i. but previous expense enables the decision maker to give (assign) a probability to the likely outcome of each alternative. one course of action precludes any other.e. which contains the following time outlined elements. this would be the maximization of profits as it is the belief that the sole objective of a business is maximization of profits.e. Uncertainty on the other hand refers to a situation where a decision maker has no previous experience and therefore no statistical evidence on which to base his predictions. Risk seekers prefer of two outcomes with the same expects value time one until greater variation (usually the variation or risk can be measured by the standard deviation).0) A set of outcomes
. Decision taken under conditions of risk and uncertainly can be encapsulated in a formal model.Risks exist where several alternative outcomes are possible. for the consideration of our studies here.
(i. under (2) Inspection and necessary modification reduces contribution by K20. • A set of pay-offs.e. There are two alternative courses of action here:
INSPECT OR NOT INSPECT. they are mutually exclusive) only two alternative states of nature exists. The decision it faces is whether to put each sub-Assembly through a details inspection process as it comes into stock. each one associated with a particular outcome.e. In the case of: (1) Unnecessary inspection reduces contribution by K 10.Each outcome associated with a particular course of action and state of nature. 3) Do not inspect and no problem exists 4) Do not inspect and problems do exist. they are collectively exhaustive). 2) Inspect and find problems. An illustration at this point in time might be used to show the use of such a model. 000. under (3) There is no loss of contribution and under
. with the same characteristics either the subassembly comes up to the required quality standard (which it is likely to do 90% of the time) or it fonts to do so (which occurs 10% of the time) Four outcomes are possible: 1) Inspect and find no problems.
No alternatives are possible (i. and the adoption of one precludes the other. 000 per unit. Pay-offs are expressed in terms of the objectives of the function.
A risk neutral decision-maker would accept the alternative course of action that maximizes the pay-off in any particular situation. Each outcome can be assessed in terms of it’s pay-off. Illustrative Example: NKETA Ltd buys in sub-assemblies for the manufacture of it’s own product.
000. 000) DO NOT INSPECT [0. 000 to stage for the first month if it is well received by the critics and will be kept for a further 6 months in which case a profit of K250. extensive rework at the finished goods stage reduces contribution by K40. 000. An efficient middle-aged Zambian businesswoman is considering backing the production of a new musical in the west midlands.9x K0] + [0. we could have seen a high level of failures incompatible with a requirement for a quality product and the concept of continuous improvement.5x K0] = K0
. 000. If the critics dislike it. There is a 50/50 chance of a favourable review using expects value leading to a decision to back the project as it’s shown in the computation below. it will close at the end of the K100. 000 over and above the initial investment of K100. the expected value of each course of action in this particular example is as follows. 000] + [0.000 higher for each subassembly purchased. The extra example below introduces a further consideration. 000)] = K75. Example 2. 000] = (K11. 000 Decision not to back the musical [0.5x (K100. 000 initially invested. Decision to back the musical [0. However in the real world.1 x (K40. It would cost K100. therefore it is the correct policy to adopt. 000. On a purely quantitative analysis. It would be more useful to ask the supplier some basic questions regarding his quality management in order to bring about a fundamental shift towards outcome (3) rather than simply adopt a policy on the basis of such an uncritical situation. a policy of not carrying out an inspection would lead to contribution being on average K7. 000) Taken over a long period of time. 000] + [0. 000.1x K20.(4).5x K250.5xK0] + [0. 000 would be made. 000)] = (K4.9x K10. 000 As we already introduced the concept of expected value (EV). 000.
EXPECTED REDUCTOIN IN CONTRIBUTION
and seats in different parts of the theatre audition usually carry different prices and the theatre may offer group or other discounted deals to a potential audience. 000 predicts for a successful show in the latter is far too precise than a figure. 000. few individuals would afford to sustain a personal loss of K100. It would be more realistic to assume a range of possible successful outcomes-after all.000 or a loss of K100. 000. If probabilities are attached to each estimate. 000 was worth an equal 50% percent risk (chance of losing K100. 000. 000. 000. by weighting each of them by its assessed probability as follows: Examples 3 This example is a build up on Example 2. Many investors would be risk averse in such a situation they would not consider that a 50% chance of making K250. obviously. Conformity with present quality standard or non-conformity in example 1 and a successful show or a flop in example 2. Whilst almost everybody welcomes a profit of K250.000. a theatre will not necessary sell the same number of tickets.000
. 000. particularly where there is no chance of repetition and the investment is not part of a portfolio. The two examples below as earlier include only single-point outcomes. the expected value of a successful outcome will take account of the range of possible outcomes. if the loss would bankrupt them). Outcome probability K 150. Pay-off will vary according to the actual mix achieved. it is equally obvious that the profit of K250.25 expenditure value K 15. 000 is not a feasible outcome of this particular decision.000. Such as this. the only feasible outcomes of this would be a profit of K250. 000. Every performance.000.000.However expected value computations rely on repeated performance of an operation process or investment to give economic validity to their average figures.000 250. The analysis breaks down in a once-off situation. While it is obvious that the two outcomes of the former represent the only possible alternative and qualification of the related pay-offs along the lines of our example appear reasonable.000. the expected profit of K75. 000.000 50.000 0. 000. An economic argument will always be tempered by consideration of risk perception and preference.000.000.10 0.
15 0. given the circumstances (unlike the overall expected value of a decision to back the project: (0. 000 we can conclude that there is a 75% probably that profit will be K250.000
Although the expected value is again seen to be infeasible.000. it makes sense in economic terms.5 x K245. 000) + [0. 000. 000.000. 000. 000. Still on economically non-superficial outcome for this unique project.250.5 x (K100. if there is a 50% probability of the musical in examples 2 and 3 being well recurred and a 40% probability of its making a profit of K250. K200.000 45. Its presentation to management in this form allows two further useful inferences to be drawn from the data: 1) The most likely outcome (being the outcome with highest probability a profit of K250.000 300. uncertainly may be associated with more than one variable and value of variables may be interdependent giving rise to many different outcomes.000. 000. 000.000 35. 000)] = K 72. 000.10 1.00
100. 000. i.000 245. in as much as it does not correspond to any of the range of point estimates for a possible such outcome. 000. 000 or more in the event of success is only 25%). by summary the probabilities for pay-offs of K150. 000.000 350. 000 allows us to say that the probability of a profit of K300. 000 in our example 2) The probability of an outcome being above or below a particular figure (e.000.g.000. 500. In the following example we want to understand the application of the probability two or more states of nature occurring together. 000.40 0.000
0. 000 and K350.e. The statement of ranging possible outcomes and their assigned probabilities is known as a probability distribution.000. 000. In practice a grater number of alternative course of action may exist.000. 000 or less if the musical is successful and summarising those for K300. It is going to be taken that the probability of two or more states of nature occurring together is the product of their individual probabilities. 000. 000 (as opposed to any other profit figure) if it is well recurred then the probability of
. 000 and K250.
000. 000 160. the decision becomes more complex.2 0.0
As the number of individual variables subject to uncertainty increase. 000 0. Example 2 Musa ltd manufactures a product called the chumbu.3 1. the variable cost of a unit of the chumbu is K30.000 units. One batch of the chumbu is produced and sold each quarter.5% chance of no net contribution /10 loss. This concept and application of multiple probabilities is gong of be amplified and shown further in the last example of this section.5 0.1 1. The variables costs are all labour-related and the production of chumbu involves an 80% learning curve. The organizing committee members who specialize in marketing and finance came up with the following data: Sales probability (units) attaches to sales units 200.0 800 900 500 0.5 0. The expected value table below shows that the company’s that contribution on the project has an expected value of K………………………… and (summering up the joint probability in each lose) it has a 56-56% chance of making a net contribution as 33 percent chance of making a loss and a 10. Example 4. NCWALA CEREMONY ORGANISING COMMITTEE is assessing the desirability of producing a souvenir to celebrate life of the souvenir will be one year only. Market research has it that demand for the quarter of the chumbu relates as shown below to the selling price per unit.0 contribution probability attaches to contribution fixed cost probability attaches to fixed costs K’000 0.000. 000 is 0. It is not possible to hold stocks of the chumbu for any significantly long period of time.3 0.5 1.
.4 = 0. Uncertainly surrounds the likely sales volume and contribution as well as the fixed costs of the venture. In this instance where we have three alternative sales volume two alternative contributions and three alternative levels of fixed costs the number of possible outcomes will be 3 x 2 x 3 = 18.promoting a successful musical which makes a profit of K250.2 or 20%.6 0. At a batch size of 24. 000 120.5 x 0.
h is K30.000 15.Selling price per unit (K) Sales of the Chumbu 50. You may assume that the variable cost per Chumbu (h) on an 80% learning curve may be obtained from the following formula.000 17.000 90.From the formula given and using information supplied in regard to the batch size of K24. 437.000 There is a complete discontinuation between the batches as regards learning effects.380211242 X 0.322 log 24.380211242 4.000.Once you have calculated the variable cost at different batch sizes. then it is quite straight forward to calculate the total variable costs at different batch sizes. 000 = _____a______ 24. it is a simple matter to identify the batch size which maximizes contribution using revenue analysis.67 as it can be seen from the calculation below. 000.000 X 24.41042802 = 25. therefore.72930291 a = K30. where B is the batch size and is a constant.322 = 1. When B is 24.000 60. 000.000 0.000 unit K773. 23. 437. K30. 000 units it may be deduced that ‘a’ = K773.For as long as the candidate knows the mechanics of the learning curve effect. .41042802 Antilog of 1.67
.500 80.000 23.000 70. h = ____a____ B 0. . Suggested solution: .322
Calculate the optimum batch size for the Chumbu production.000 12. It does not make a difference that is expressed in kwacha (monetary) terms rather than hours. 000 = 4.
622 657. 000 0. 000 1. 175. 000 15. 500 1. The technique is usually used to evaluate alternative investment plans. 069
Computation of the variable cost per batch h = K 773. 228 700. 067 642. 000 0. as always. The illustration below gives a simple example to illustrate a diagrammatic representation of the decision tree. 577. 000 1.4 Decision Trees The decision tree is one way or method of analyzing risk and uncertainty.7
.58241045 h = K 37.322
h = K 773.4 0. 931
Contribution for the batches K ‘000 463. 000 net profits
Probabilities 0. 225. 000) Yr 2 120. 000 23.60 As it can be seen. 000 batch units of the Chumbu. 000
Variable costs K ‘000 711.67
Element 5. 000 17. where contribution is being maximized is at the K 23. Illustration. 416 629.67 K 12. 000 1. Return in Investment C Probabilities Investment D Yr 1 40. 000
Expected 80. 000 160.5 180. the batch. The main difficult is of course. The decision tree is a pictorial representation of the probabilistic information to manage and aid decision making. 437. 500 1. 584 450.5 (20. 437. 378 524. 000 12. 200. 380. 080.Revenue Analysis:
Sales revenue Batch size (units) K ‘000 23. The decision tree model is only as good as the information it contains. 000
0. 772 679. accurately providing the probabilities that determine the uncertainties involved in the investments. 933 582.
4 chance of a loss K 20. it appears that plan D would be the best option.1 Notation of A Tree Diagram The tree diagram has squares and circles as symbols that take on extraordinary meaning. in practice.
This illustration is only a simplification.
Element 5. 000 whereas plan C will always generate a profit of some point. 000.When the expected profit is calculated. in this case there is only one decision to be made – the choice between plan C and D at the onset. The “payoff” figures are then calculated by multiplying the possible outcomes by their probabilities of taking place. the branches of the tree represent the logical sequence between possible outcomes. The lines. The diagram below shows the pictorial representation of the data in the table below. there could be many 179
. The values under the profit heading in the diagram below represent the possible outcomes. But the plan has a 0. The square represents a point at which a decision is made.4. The circle represents a point at which a chance event takes place.
features and factors that can be dictating or impacting strongly on the decision to be made in any given situation. These factors which might merit out attention could be the following; - The time value of money. - This is dealt with under Unit 1 where you studied capital investment appraisal methods in great detail. - The assumption of risk neutrality. - Again we might need to consider the level of risk involved in any given project as in practice all projects have some level of risk attached to them. This is dealt with under sensitivity analysis and management is outside the scope of this text. - In practice, other grey areas might be inherent in the analysis to be made. Therefore, these cannot be overlooked, they need to be considered in the investment evaluation process as well. Example; Munda corporation is considering launching a new product. There are 0.3 chances that the demand for the product will be strong and 0.2 chance that the demand will be weak. Two strategies for the launch are under consideration. Strategy A involves high promotion expenditure and it is likely to generate a net cash inflow of K 240,000,000 if demand proves to be strong. On the other hand, if demand proves to be weak, then a net Cashflow of (60,000,000) will result. Strategy B involves low promotion expenditure. If the demand proves to be strong, then this will generate a net cash inflow of only K160,000,000 but if the demand proves to be weak, then the net cash inflow of K40,000,000 is still expected to be generated. Required; (a) Draw a decision tree and advise which course of action generates the greatest expected profit. (b) What is the maximum amount that should be paid for market research to determine with certainty whether demand will be strong or weak?
Figure 5.1 Conclusion and analysis; As it can be seen from the tree diagram above,
strategy, A should be adopted purely on financial grounds as its insights that it will generate a higher expected value of K60,000 as opposed to strategy B which will only promise to generate K56,000,000 as the net expected value. - If the research predicts that the demand would be strong then strategy A would be adopted giving a cash inflow of K240,000,000. - If the research predicts that the demand would be weak, then strategy B would be adopted, giving a cash inflow of K40,000,000. - Therefore, the expected cash inflow outcome with research, will be K80,000,000, that is [(K240,000,000 X 0.3) + (K40,000,000 X 0.2)] - The expected cash inflow outcome without research is K120,000,000. -Therefore, the value of the research with certainty would be K20,000,000 i.e. (K80,000,000 – K60,000,000). - The maximum amount that the decision making expenditure should pay for the research is therefore K20,000,000.
A relevant cost is a future cash flow arising as a direct consequence of a decision. Thus, only costs, which differ under some or all of the available opportunities, should be considered, relevant costs are therefore sometimes referred to as incremental costs or differential costs.
RELEVANT COSTING TERMINOLOGY
Available Costs These are costs which are usually associated with shutdown or disinvestments decisions and are defined as those costs which can be identified with an activity or sector of a business and which could be avoided if that activity or sector did not exist. Opportunity Costs An opportunity cost is the benefit forgone by choosing an opportunity instead of the next best alternative. Non-Relevant Costs These are costs which are irrelevant for decision-making because they are either not future cash flows or they are costs which will be incurred anyway regardless of the decision that is taken. Sunk Cost
A sunk cost is used to describe the cost of an asset which has already been incurred and which can continue to since 2/3 present purpose, but which has as significant realizable value and no income value from any other alternative purpose. Committed Costs A Committed Cost is a future cash outflow that will be incurred anyway, whatever decision is taken now about alternative opportunities. They may exist because of contracts already entered into by the organization, which it cannot get out of. Notional Cost/Imputed costs These are costs, which are hypothetical in nature to reflect the benefit from the use of something for which no actual cash expense is incurred. Examples include notional rent and notional interest charged on management accounts for use of a freehold factory or interest charged on a loan obtained from within a group of companies. Assumptions in Relevant Costing (i) (ii) Cost behaviour patterns are known. It follows that, if a department closes, say, the attributable fixed cost savings would be known. The amount of fixed costs, unit variable costs, sales price and sales demand are known with certainty. It is assumed that it is possible to apply risk and uncertainty analysis to decisions and so recognize that what will happen in the future is not certain. (iii) The objective of decision-making in the short-run is to maximize ‘satisfaction’. Satisfaction is often regarded as ‘short-term profit’. However, there are many other qualitative factors or financial considerations which may influence a final decision. (iv) The information on which a decision is based is complete and reliable. Decisions usually have to be based on imperfect information.
Element 5.4.2 Qualitative Factors In Decision Making
Qualitative factors in decision-making will inevitably vary with the circumstances and nature of the opportunity being considered. Here are some examples: Factor Availability of cost Comment An opportunity may be profitable, but there must be Sufficient cost to finance any purchase of Equipment and build up working capital Any decision involving the shutdown of plant, Charges in work procedures and so on will require acceptance by employees, and out to have regard to employee welfare. Some decisions may stimulate a response from rival companies. The decision to reduce selling prices in order to raise demand may not be successful if all competitors take similar contraction. Suppliers’ long-term goodwill may be damaged by a decision. Decisions to change the specifications for bought-out components, or to charge stockholding policies so as to stockholding policies so as to create patchy, uneven demand, might put a strain on suppliers. If a company is the supplier’s main customer, a decision might dime the supplier out of business Feasibility out in practice. Legal Restraints proposed action. A decision might occasionally be deferred or reflected because of doubts about the legality of the A proposal may look good or paper, but managers may have some reservations about their ability to carry it
Element 5.4.3 Identifying and Calculating Relevant Costs As defined earlier, an opportunity cost is the benefit forgone by choosing one opportunity instead of the next best alternative.
A scarce resource may be defined as a resource (machine, labour, materials, cash and so on) that is in short supply, so that the total opportunities that exist for making profitable use of the resource exceed the amount of the resource available. So when a decision-maker is faced with an opportunity which would call for use of a scarce resource, the total incremental cost of using the resource will be higher than the direct cash cost of purchasing it. This is because the resource could be used for other purposes, and so by using it in one way, the benefits obtainable from using it another way must be forgone. Example: Suppose that a customer has asked whether your company would be willing to undertake a contract for him. The work would involve the use of certain equipment for 5 (five) hours and its running costs would be K20,000 per hour. However, your company faces heavy demand for usage of the equipment which earns a contribution of K70, 000 per hour from this other work. If the contract is undertaken, some of this work would have to be foregone. The contribution obtainable from putting the scarce resources to its alternative use is its opportunity costs (sometimes referred to as its ‘internal’ opportunity cost). Since the equipment can earn K70, 000 per hour in an alternative use, the contract under consideration should also be expected to earn at least the same amount. This can be accounted for by charging K70, 000 per hour as an opportunity cost to the contract and the total relevant cost of 5 hours of equipment time would be? Solution: Running Costs (5 hrs x K20, 000) Internal Opportunity Cost (5 hrs x K70, 000) Relevant Cost K 100,000 350,000 450,000
It is important to note that the variable running costs of the equipment are included in the total relevant costs. Rule for identifying the relevant costs of a scarce resource.
The total relevant cost of a scarce resource is the sum of the contribution/incremental profit foregone from the next best opportunity for using the scarce resource and the variable cost of the scarce resource (that is, the cast expenditure to purchase the resource). Identifying Relevant Costs In this section, we provide an introduction to the sort of thought processes that you will have to go through when you encounter a decision-making question. First some general points about machinery, labour and materials that often catch people out will be considered. Machinery User costs Once a machine has been bought its costs is a sunk cost. Depreciation is not a relevant cost, because it is not a cash flow. However, using machinery may involve some incremental costs. These costs might be referred to as user costs and they include hire charges and any fall in resale value of owned assets through use. Example: PQZ Ltd is considering whether to undertake some contract work for a customer. The machine required for the contract would be as follows: (a) A special cutting machine will have to be hired for three months for the work (the length of the contract). Hire charges for this machine are K75,000 per month, with a minimum hire charge of K300,000. All other machinery required in the production for the contract have already been purchased by the organization on hire purchase terms. The monthly hire purchase payments for this machine are K500,000. This consists of K450,000 for capital repayment and K50,000 as an interest charge. The last hire purchase payment is to be made in two months time. The cost price of this machinery was K9,000,000 two years ago. It is being depreciated on a straight-line basis at the rate of K200,000 per month. However, it still has a useful life that will enable it to be operated for another 36 months. Solution: (a) The cutting machine will incur an incremental cost of K300, 000. The minimum hire charge.
The historical cost of the other machinery is irrelevant as a past cost; depreciation is irrelevant as a non-cash cost; future hire purchase repayments are irrelevant because they are committed costs. The only relevant cost is the loss of resale value of the machinery, estimated at K200, 000 through use. This ‘user-cost’ will not arise until the machinery is eventually resold and the K200, 000 should be discounted to allow for the time value of money. However, discounting is ignored here, as they have already discussed in Chapter 1. Summary of relevant costs Incremental hire costs User cost of other machinery K 300,000 200,000 500,000
Labour Often the labour force will be paid irrespective of the decision made and the costs are therefore not incremental. Take care, however, if the labour force could be put to an alternative use, in which case the relevant costs are the variable costs of the labour and associated variable overheads plus the contribution forgone from not being able to put it to its alternative use. 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 estimated that the machine would lose K200, 000 in its eventual sale value if it is used for the contract work. Required What is the relevant cost of machinery for the contract? Materials The relevant cost of raw materials is generally their current replacement cost, unless the materials have already been purchased and would not be replaced once used. If materials have already been purchased but will not be replaced, then the relevant cost of using them is either (a) their resale value or (b) the value they
then the relevant cost of using them for the opportunity under consideration would be nil. if this is greater than their current resale value.would obtain if they were put to an alternative use. The higher of (a) or (b) is then the opportunity cost of the materials. Are the materials already in stock. provided that the materials are not in short supply. The flow chart below shows how the relevant costs of the materials can be identified. or would they be scrapped if not used? Scrapped If not Used Other use available Relevant Cost = higher of value in other use or scrap value/disposal value
Relevant cost = future/current purchase cost of materials
Relevant Costs = Scrap value/ Disposal value
. or contracted to buy in a Purchase Agreement? YES NO Are the materials regularly used and replaced with fresh supplies when stocks run out? YES NO Relevant cost = future/current purchase cost of materials Do the materials have an alternative use. and so have no internal opportunity cost. If the materials have no resale value and no other possible use.
000 Replacement cost K/unit 6. 000 per unit. Required: What are the relevant costs of material. Material B is used regularly by the company.000 for it.000 5.000 3. 1.500 6. in deciding whether or not to accept the contract? Solution:
Material A is not owned and would have to be bought in full at the replacement cost of K6.000
Material B is used regularly by Muma Ltd.000 4. The job requires the following materials:
Materials A B C D Total units required 1. Relevant cost therefore.000 Realisable value K/unit 2.000 4. No other use could be found for material C.
. and if units of B are required for this job.000. but the units of material D could be used in another job as substitute for 300 units of material E.000 1. Materials C and D are in stock as the result of previous over-buying.500 2.000 1.000 units at the replacement cost of K5. 000 per unit (of which the company has no units in stock at the moment).000 9. they would need to be replaced to meet other production demand. There are existing stocks (600 units) but if these are used on the contract under review a further 600 units would be bought to replace them.000 200 Units already in stock 0 600 700 200 Book value of units in stock K/unit 2.500 2.Decision Making Techniques Example: A customer who would like a special job to be done for him has approached Muma Ltd. which currently costs K5. and is willing to pay K22. 000 per unit. and they have a restricted use.
000 per unit (K1. 500 each.000. but it is somewhat misleading as it implies that the only concern is with that level of activity that produces neither profit nor loss – the break-even point – although the behaviour of costs and profits at other levels is usually of much greater significance. would cost 300 x K5. If used for the contract. There is an opportunity cost of using D in the contract because there are alternative opportunities either to sell the existing stocks for K6. Material D: These are already in stocks and will not be replaced.000 15.
USES OF C. Because of this on alternative term. 000 =K1.000 units are needed and 700 are already in stock.000 5. 000 Since substitution for E is more beneficial. The existing stocks of 700 will not be replaced.000 is the opportunity cost. they could not be sold at K2. 000 each.V.500) Material D Total K 6. is frequently used and is more descriptive. volume and profit at various levels of activity.
Summary of Relevant Costs Material A (1.P. 000) Material C (300 x 4. Frequently these relationships are depicted by graphs. a further 300 units must be bought at K4. 500.000.000 2.000) + (700 x 2. cost-volume-profit analysis or C-V-P analysis.500. 500.000) or avoid other purchases (of material E).450. The term break-even analysis is the one commonly used. 200.Material C: 1.000 1. K1. The realizable value of these 700 units is an opportunity cost of sales revenue forgone.000 x K6. 000) Material B (1. but this is not essential.000
BREAK EVEN ANALYSIS
This is the term given to the study of the interrelationships between costs.000 x K5.950. ANALYSIS
. If they are used for the contract.
P.V. Typical short-run decisions where C.P. the amount of fixed costs and the marginal cost per unit.V. In these cases the established cost patterns are likely to continue. Over greater changes of activity and in the longer-term existing cost structures e. so C. so C. choices of sale mix.V.V.P. analysis may be useful for decision-making. analysis becomes less appropriate.P.P.V. analysis uses many of the principles of marginal costing and is an important tool in short term planning.g. ANALYSIS
Before any formulae are given or graphs drawn. There are no stock level changes or that stocks are valued at marginal cost only it will be apparent that these are over simplifying assumptions for many practical problems.
.P.C. output levels and resulting profit and is more relevant where the proposed changes in the levels of activity are relatively small. the major assumptions behind C. revenue. Over the activity range being considered costs and revenues behave in a linear fashion That the only factor affecting costs and revenues is volume That technology. Fixed costs will remain constant and variable costs vary proportionately with activity. production methods and efficiency remain unchanged Particularly for graphical methods that the analysis relates to one product only or to a constant product mix. pricing policies.V. analysis can be useful include. It explores the relationships that exists between costs. are likely to change. multi-shift working and special order acceptance. analysis must be stated. These are: (a) (b) (c) (d) (e) (f) (g) All costs can be resolved into fixed and variable elements.
ASSUMPTION BEHIND C.
volume. or by simple formulae that are listed below and illustrated by examples. Nevertheless. revenue and profit. tactical decision. Analysis by formula C.V. (a) (b) Break-even point = (In units) fixed costs contribution/unit Fixed costs x sale price/unit Contribution/unit = Fixed x Cost (c) Contribution/sale = contribution/unit x 100% ratio (d) sales price per unit contribution/sales ratio 1
Break-even point (K sales) =
Level of sales to result in target profit (units) = Fixed costs + Target profit Contribution/unit
Level of sales to result in target profit = Fixed costs + Target profit Contribution/unit
Level of sales to result in target profit (K sales)
.It is because of this that C. useful guidance can be provided for managers making short run. analysis can be undertaken by graphical means that are dealt with later in this chapter. by highlighting the interaction of costs.V. analysis can only be an approximate guide for decision making.P.
BROUGHT FORWARD KNOWLEDGE
Example: A company which has fixed costs of K50.000 20.000 40. the sales and contribution of which are shown below. Product X Y Z Sales K’000 150. 000.000 60.000 per annum and has three products.000 25.=
(Fixed cost + Target profit) x Sales price/unit Contribution/unit
NOTE: The above formulae relates to a single product firm or one with an unvarying mix of sales. With a multi-product firm it is possible to calculate the break-even point as follows: Break -even-point = Fixed costs x sales value (K sales) Contribution
Graphs and computations of a mix of products can be derived from appropriate data.000 Contribution K’000 20.000 C/S ratio 20% 50% 42%
Required: (a) Plot the products on a profit chart and show the break-even sales
. in the sequence of their C/S ratio i. Z.000
200. The dotted line represents the resulting profit of this particular sales mix and C/S ratios.000
NOTES (a) (b) (c) The solid lines represent the contributions of the various products.
-50.Solution: The axes on the profit chart are drawn in the usual way and the contribution from the products.000
-25. X drawn on the chart. Reading from the graph the break-even point is approximately. Y.000
but in actual fact.000.000 250.000 40. a more accurate representation.000 X 100% 250.K170.3 K166.000 30% Fixed costs C/S ratio K50.
.000 Overall Contribution/Sales Ratio = Contribution K’000 30.000.666. they can exhibit features of stepped fixed cost. charts assume that fixed costs are always unaffected by activity.V. The exact figure can be calculated as follows: Product X Y Z Sales K’000 150.000 75.000.000
75.P.000 60. The charts and the analysis depicts relationships which are essentially short-term.000 0.000.000 30/100 K50. This makes them inappropriate for planning purposes where the time scale stretches over several years.000 25.667
= Break-even point = = = =
LIMITATIONS OF BREAK-EVEN CHARTS AND ANALYSIS
The C.000 20.
5 RISK AND UNCERTAINTY Element 5. Where several possible outcomes are expected. a probability distribution can be tabulated. usually sales or production.5.P.(c)
The charts and C. Probability is the likelihood that an event will occur. Element 5.5. Element 5. past experience and observations of current variables which are likely to have an impact on future events. A possibility distribution is a list of all possible outcomes for an event and the probability that each will occur. This is gross over simplification and reduces the accuracy of the charts and C. Tossing a coin. Expected value is the average value of an event which ha several possible outcomes.g. Subjective probabilities are based on an individuals expert knowledge. but there is little past statistical evidence to enable the predicting of the possible outcomes.V. unlike stating the most likely outcome. The expected value of a decision represents the long-run
. Subjective probabilities are probabilities which are established by judgement rather than past data. Quite often. Element 5. Most business decisions involve subjective probabilities since many past observations or repeated experiments for particular decisions are not possible.5. subjective probabilities have the advantage of providing more meaningful information.3 PREDICTING POSSIBLE OUTCOMES Predicting possible outcomes makes use of probabilities.5 PROBABILITY AND EXPECTED VALUE Expected value is a simple way of showing the effects of uncertainty into decision-making.5.5. However. Element 5.1 Risk arises in situations where several possible outcomes are expected and where past experience provides statistical evidence which can be used to predict the possible outcomes. Objective probabilities are probabilities which are established mathematically or compiled from past data e.4 Probability can either be objective probabilities or subjective probabilities.
Element 5. most business decisions fall in the uncertainty category.2 Uncertainty on the other-hand arises where there are several possible outcomes. analysis make the assumption that all variable costs vary according to the same activity indicator. analysis.V.P.
400 7. It is important to note that the expected values are the averages of the possible outcomes based on management estimates.120 Probability 0.000 9.07 0.08 0.21 0.38 0. This is the conventional measure of the dispersion of a probability distribution.6 For example: A company is to make a decision to manufacture two products X and Y and the decision is repeated several times.400 8.15 0.
.368.200 4.600 6.080 800 6.10 Weighted Amount K’000 432 1.160 1.5.800 5.27 0.120. Element 5.8 MEASURING DEGREE OF UNCERTAINTY The degree of uncertainty can be measured by calculating the standard deviation.7 From the above.432 2.368
Element 5. Element 5.200 8.000 and Y will produce profits of K 7.45 0.average outcome that is expected to occur if a particular course of action is under-taken several times.5.000. It is therefore very possible for the actual results to be different from the expected values.5.800 6.600 Probability 0. X will produce profits of K 6.000 PRODUCT Y : Outcome Profits K’000 3.09 0.880 1.20 Weighted Amount K’000 224 384 2. we can conclude that if a decision was made to produce X and Y several times repeatedly.176 2. the expected values can be calculated thus: PRODUCT X : Outcome Profits K’000 4.920 7.
11 DECISION – TREE ANALYSIS
.424 Probability Weighted amount (K’000) 0.20 Weighted amount (K’000) 1.07 0.10 So far we have defined risk in terms of the spread of possible outcomes.480 Standard Probability deviation (K’000) 15.200 4.681 Element 5.6 the standard deviation of Product X and Product Y can be calculated: PRODUCT X Profit Amount (K’000) 4.400 6.632 Standard deviation (K’000) 2.663.320 .088 126.96.36.1990 5.10 2.400 518.382.Element 5.000 Deviation from (K’000) .720 880 2.400
Standard Deviation = √3 142 000 = K 1.992 209.458.38 0.27 0.445 PRODUCT Y Profit Amount (K’000) 3. This is the case with Product Y which has a higher expected value.200 8.568 -768 32 832 1.276 0.400 7.112.400 774.5.863 0.142.9 Using the data in 5.
Element 5.800 5.224 2.09 221.1.834 0.920 .592 196.21 1 23.000 9.400 0.45 461 0.648 430.5.15 103.5.024 692.080 3.600 6.776
Standard Deviation = √3 112 776 000 = K 1.366.400 8. but at the same time has risk (standard deviation) higher than Product X.624 589.3.08 0.150.075.095.663 342 3.230.800 6.772. so that risk may be large even if all the possible outcomes involve earning high profits.824 1.600 Deviation from (K’000) .
In addition the company has estimated an amount of K 14. Element 5.4 for failure. The purpose of decision trees is to show the full range of alternatives and events that occur.A decision tree is a diagram showing several possible courses of action and possible events and the potential outcomes for each course of action.5) LAUCH SUCEEDS
Expected Profit (K’000) 43. The advantage of a decision tree is that it methodically and logically analyses a situation so that all possible outcomes are considered before a business can commit itself.18 0. Element 5. The probability that the project will succeed is 0.400.840
.000 32. under all possible conditions.
P(0.5.000 32.200 8. From these two decisions we can develop a decision-tree. The following estimates have been made: Profit estimate K’000 43.6 and 0.000 Probability 0.200 8.5.30 0.3 0.12 To illustrate how decision tree can be considered the following example will be used: Example: Koko Plc is a manufacturing company.440 3.50 0.13 SOLUTION There are two decisions which must be considered by the company: to develop the product or not to develop the product.12
Value (K’000) 12.000 as the investment needed. The company is considering launching a product.
000 as compared to the decision not to develop the product as it gives zero profit.5.3 The only situation when the mix of products does not affect the analysis is when all of the products have the same ratio of contributions to sales (C/S ratio).18 Element 5. a constant product sales mix must be assumed.6 CVP ANALYSIS IN A MULTIPLE PRODUCT ENVIRONMENT Element 5.6 = 0.000 will be achieved.000.000 will be achieved (P = 0. the weighting being on the basis of the quantities of each product in the constant mix. there must be joint probability. Element 188.8.131.52.3). To perform CVP analysis in a multi-product organisation. y units of products B and z units of product C are also sold. Element 5.
Element 5.800.800.14 For two events to occur together.800
Element 5.3 * 0. the probability of the development succeeding and the company making a profit of K 8. For example.15 It is also worth noting that if the decision was repeated several times.1 Organisations typically produce and sell a variety of products and services.2 Such an assumption allows us to calculate a weighted average contribution per mix. an average expected profit of K 4.000 is made up of the probability that the launch will succeed (P = 0.760 0 4.6. however.6) and the probability that a profit of K 8. This means that the unit contribution of the product that makes up the largest proportion of the mix has the greatest impact on the average contribution per mix. In other words.4 1
5. hence giving a joint probability of 0.000.400
0. we assume that whatever x units of product A are sold.
.5. In theory this means that the decision to develop the product should be favoured as it results in n average profit of K 4.
169 * 1) 184.108.40.2065 units of M and (1.80 Step 3.169 * 5) 5.6.169 units of N (rounded) M K per unit 7. Element 5.5 EXAMPLE:BREAKEVEN POINT FOR MULTIPLE PRODUCTS Suppose that P Ltd produces and sells two products. Calculate contribution per unit Selling price Variable cost Contribution Step 2. Lets look at an example. while the N sells for K 15 per unit and has a total variable cost of K 4. Calculate the breakeven point in terms of the number of units of the products = (1.06 * 5) + (K 10.94 per unit. Element 5.169 mixes (rounded) Step 4.6.80 = 1.50 10. The organisation’s fixed costs total K 36.000/K 30. Calculate the breakeven point in terms of the number of mixes = fixed costs/contribution per mix = K 36.94 4.50 per unit.6 SOLUTION We calculate the breakeven point as follows: Step 1.00 4. Calculate contribution per mix = (K 4.50
.4 This calculation is exactly the same as that for single products but the single product is the standard mix.00 2. one unit of N will be sold. The M sells for K7 per unit and has a total variable cost of K 2. The marketing department has estimated that for every five units of M sold.000.94 N K per unit 15.50 * 1) = K 30.Breakeven point is ‘The level of activity at which there is neither profit nor loss’ (CIMA Official Terminology) Element 5.4 BREAKEVEN POINT FOR MULTIPLE PRODUCTS Element 5.
845 + 1.616 =K 58.915 of M and K 17. The breakeven point is K 58.845 * K 7) + (1.450 in total Element 5.535 of N = K 58. Calculate breakeven point (total) Fixed costs ÷ C/S ratio =K 36.442 (rounded) Step 5.1An alternative way of calculating the breakeven point is to Use the average contribution to sales (C/S) ratio for the standard mix.169 * K 15) = K 40. Calculate breakeven sales
.3 We can calculate the breakeven point of P LTD as follows: Step 1.8.450 provided that the sales mix remains 5:1.169) 7.450 of revenue.8.8 CONTRIBUTION TO SALES (C/S) RATIO FOR MULTIPLE PRODUCTS Element 5.845 units of M and 1.7 It is important to note that the breakeven point is not K 58. Calculate revenue per mix = (5 * K 7) + (1 * K 15) = K 50 Step 2.6.80/K 50.000/0. Element 5.00) * 100% = 61.6. Element 5. Calculate revenue ratio mix =35:15. Calculate the breakeven point in terms of revenue = ( 5. Calculate contribution per mix = K 30. Calculate average C/S ratio = (K 30.80 Step 3.6% Step 4. Element 5. Rather. it is when 5.6.169 units of N are sold. the C/S ratio is sometimes called the profit/volume ratio or P/V ratio. whatever the mix of products.Step 5.6. assuming a sales mix of 5:1.2 As you should already know. or 7:3 Step 6.6.8.Likewise the breakeven point is not at a production/sales level of (5.014 units.
4 Alternatively you might be provided with the individual C/S ratios of a number of products. The C/S ratio of 33 1/3% in the question above means that for every K1 of sales of the standard mix of products.533 (rounded) Element 5.442 * 7/10 = K 40. the MK and KL. What is the budgeted breakeven sales revenue? A B C D K 150.000 K 50. a
.000. the average C/S ratio is calculated as follows. The company expects to sell 1 MK for every 2 KLs and have monthly revenue of K 150.000 = K90. Budgeted monthly fixed costs are K 30.000 K 90.6.5 The C/S ratio is a measure of how much contribution is earned from each K1 of sales of the standard mix.000 K 300.909 (rounded) Breakeven sales of N = K 58.Breakeven sales of M = K 58.The Mk has a C/S ratio of 20% whereas the KL has a C/S ratio of 40%. Average C/S ratio = (20% * 1) + (40% * 2)= 33 1/3% 3 Sales revenue at the breakeven point = fixed cost = K 30.8. For example if an organisation sells two products (A and B) in trhe ratio 2:5 and if the C/S ratio of A is 10% whereas that of B is 50%.333 Element 5.000. Average C/S ratio = (2 * 10%) + (5 + 50%) 2+5
QUESTION: average C/S ratio TIM Ltd produces and sells two products.6.442 * 3/10 = K 17.000 C/S ratio 0.000
Answer The correct answer is C.8.
the breakeven point ( in units ) will increase and profits will fall unless there is a corresponding increase in total revenue.6. K 72.
Element 5.9. b) A shift towards products with higher contribution margins without a corresponding decrease in the revenues will cause an increase in profits and a lower breakeven point c) If sales are at the specified level but not in the specified mix.1 One use of the methodology we have been looking at is to determine the most profitable sales mix option of number open to management.9 SALES/PRODUCT MIX DECISIONS Element 5.000 sales revenue from the standard mix must therefore be K1 * K 20.8. Element 5.6. The budgeted selling price of the J is K 60 and that of the M.369.6.000 = K 60. a) If the mix shifts towards products with lower contribution margins.Variable costs associated with producing and selling the J are K 30 and. say.6 Any change in the proportions of products in the mix will change the contribution per mix and the average C/S and hence the breakeven point.2 EXAMPLE: SALES MIX DECISIONS JM Ltd makes and sells two products.33n Points to bear in mind Element 5. K 60.6.600.9.33 ngwee is earned. The J and the m can be sold either in the ratio two Js to three Ms or in the ratio one J to two Ms. the J and M. with the m. J M K per unit K per unit Selling price 60 72
. there will be either a profit or a loss depending on whether the mix shifts towards products with higher or lower contribution margins. JM Ltd has two production/sales options.6. We need to begin by determining contribution per unit.contribution of 33.3 We can decide on the optional mix by looking at breakeven points. Element 5.Annual fixed production and selling costs of JM Ltd are K 3. To earn a total contribution of.9.000 33. K 20.
6 QUESTION : CHANGING THE PRODUCT MIX A Ltd sells three products – Exe.5 The following question looks at the effect on the overall C/S ratio of a product/sales mix.000 (105.800 In K (62.200 * K 60) K 4.9. Element 5.369.00 (124.300 * K 72) K7.100 * 2) 70.9220.127.116.119. Why 505 and Zed 30%.300 In K (70. Mix 1 contains a higher proportion (40% as opposed to 33 1/3%) of the more profitable product. Element 5. mix 1 is preferable to mix 2.6.Variable cost Contribution
Mix 1 Contributions per 5 units sold = (K 30 * 2) + (K 12 * 3) = K 96 Breakeven point = K 3.100 sets of five units K96 J M Breakeven point: In units (35.200 (35.600 Total breakeven point = K 11.800 * K 72) K 8.600 = 35.6.600 Total breakeven point = K 12.600 Mix 2 Contribution per 3 units sold = (K 30 * 1) + (K 12 * 2) = K 54 Breakeven point = K 3.400 sets of three units.400 * 1) 62.100 * 3) 105.9.400 * 2) 124. The C/S ratio is 55%. K 54 J M Breakeven point: In units (62.20 (K 96 ÷ 5).369.6.600 = 62.400 (62. Suppose the product mix is changed to Exe 20%.600 Element 5.744.4 Ignoring commercial considerations.This is because it results in a lower level of sales to break even (because of the higher average contribution per unit sold). Why and Zed – in equal quantities and at the same selling price per unit.581.793.
.In mix 2 it is K 18 (K 54 ÷ 3).The average contribution for mix 1 is K 19.400 * K60) K 3.
549 (W2) *1/3 *1/3 0.5 *1/3 0.6 0.1647 0.2 0.167 Why Zed Total 0. and there is no profit: S=V=F Suppose an organisation wishes to achieve a certain level of profit (P) during this period.183 ÷ 1/3 = 0.
Element 5.5 0.167 – 0. sales revenue (S) is equal to variable Costs plus fixed costs (V + F).6.183 2 This figure is then calculated as 0.6.1 Why 0.549 *0.7 SOLUTION Original proportions C/S ratio Market share Exe 0.10.3 Zed Total 0. To achieve this profit.1
TARGET PROFITS FOR MULTIPLE PRODUCTS At breakeven point. sales must cover all costs and leave the required profit: S=V+F+P
.2 = 0.55 – 0.6 *0. Element 5.183 (W1) 0.5 *0.3 0.10 Element 5.9.549
Revised proportions C/S ratio (as above) Market share Exe 0.5647
The total C/S ratio will increase because of the inclusion In the mix of proportionately more of Why.55
Workings 1 The total C/S ratio is the sum of the weighted C/S ratios and so this figure is calculated as 0.200 0.6. which has the Highest C/S ratio.Required Calculate the revised total contribution/total sales ratio.
The company wishes to earn a profit of K 52. EXAMPLE: TARGET PROFITS FOR MULTIPLE PRODUCTS A company makes and sells three products. Calculate contribution per unit F G K per unit K per unit Selling price 22 15 Variable cost 16 12 Contribution 6 3 Step 2.10. Element 5.The company’s fixed costs are K 80.10.10. Calculate the required number of mixes = (Fixed costs + required profit)/contribution per mix = (K 80.4 SOLUTION Step 1. G and H. F.000 next month. Calculate the required sales value of each product in order to achieve this target profit.000 per month and details of the products are as follows. The products are sold in the proportion F:G:H = 2:1:3.6. Calculate contribution per mix = (K 6 * 2) + (K 3 * 1) + (K 6 * 3) = K 33 Step 3. Product F G H Selling price K per unit 22 15 19 Variable cost K per unit 16 12 13
Element 5.6.2 Once we know the total contribution required we can calculate the sales revenue of each product needed to achieve a target profit. The method is similar to the method used to calculate the breakeven point.therefore S – V = F + P So total contribution required = F + P Element 5.000)/K 33
H K per unit 19 13 6
.000 + K 52.
10.000 if the products are sold in the mix 2:1:3 Element 5.5 Alternatively the C/S ratio could be used to determine the required sales revenue for a profit of K 52. Calculate average C/S ratio = (K 33/K 116) * 100% = 28. Calculate revenue per mix = (2 * K 22) + (1 * K 15) + (3 * K 19) = K 116 Step 2.3 Step 1.000 22 15 19 176. Calculate contribution per mix = K 33 (from Paragraph 5.000 * 2 8.6.000 4.45% Step 4.6.6 EXAMPLE:USING THE C/S RATIO TO DETERMINE THEREQUIRED SALES We’ll the data from paragraph 5.000 228.000 will generate a profit of K 52.= 4.6. Calculate the required sales in terms of the number of units of the products and sales revenue of each product Sales Selling revenue Product price required Units K per unit K F G H Total 4. Element 5.10.000 464.000 * 1 4.10.000 60.4) Step 3.000 4.972 Step 5.6.000) ÷ 0.000.000 + K 52.000
The sales revenue of K 464.000 mixes Step 4. Calculate revenue ratio of mix
. The method is again similar to that demonstrated ealier when calculating the breakeven point. Calculate required total revenue = required contribution ÷ C/S ratio = (K 80.2845 = K 463.10.000 * 3 12.
Step 1. Element 5. J Ltd’s fixed costs are K 43.3 SOLUTION To calculate the margin of safety we must first determine the breakeven point.972 = K 227.20.972 = K 59.11. is the same answer as calculated in Paragraph 5.
. Calculate contribution per unit W K per unit Selling price 8. For every five units of W sold. The W sells for K 8 per unit and has a total variable cost of K 3.890 per period.400.6.996 Required sales of H = 57/116 * K 463. while the R sells for K 14 per unit and has a total variable cost of K 4. The easiest way to see how its done is to look at an example.2 MARGIN OF SAFETY FOR MULTIPLE PRODUCTS J Ltd produces and sells two products.4 Element 5.= (2 * K 22) : (1 * K 15) : (3 * K 19) = 44:15:57 Step 6. but the single product is the standard mix.00 R K per unit 14.11.989 Required sales of G = 15/116 * K 463.10.9789 Which.6.6.1 It should not surprise you to learn that the calculation of The margin of safety for multiple products is exactly the same as for single products. Budgeted sales revenue for next period is K 74.11 MARGIN OF SAFETY FOR MULTIPLE PRODUCTS
Element 18.104.22.168. six units of R are sold.972 = K 175. in the standard mix. allowing for roundings. Calculate required sales Required sales of F = 44/116 * K 463.80 per unit.
200)/K 74.200 in total Step 6.750 * K 8) + (3.6.200 sales in total.6.80
Step 2.400 * 100% = 8.300 * K 14) = K 22.12. in the standard mix Or.Variable cost Contribution
4.20 * 5) + (K 9.80 4.80 = 550 mixes
Step 4.12 Element 5. profits and margins of
Element 5.400 – K 68.200 = K 6. Calculate the breakeven point in terms of revenue = (2. revenues.200 of R = K 68. Calculate the breakeven point in terms of the number of units of the products = (550 8 5) 2.2
MULTI – PRODUCT CVP CHARTS Breakeven charts KEY TERM: A breakeven chart is ‘A chart which indicates approximate profit or loss at different levels of sales volume within a limited range’. Calculate the margin of safety = budgeted sales – breakeven sales = K 74.12. as a percentage = (K 74.000 of W and K 46. (CIMA official Terminology) A very serious limitation of breakeven charts is that they can show the costs.750 units of W and (550 * 6) 3.80 * 6) = K 79.400 – K 68.3% of budgeted sales
Element 5.80 Step 3.890/K 79.20 9. Calculate the breakeven point in terms of the number of mixes = fixed costs/contribution per mix = K 43. Calculate contribution per mix = (K 4.300 units of R Step 5.6.
K 4 and K 5 respectively. We begin carrying out some caculations.000 : 4. Y and Z which have variable unit costs of K 3.000 37.12. however.000 units of X.000
Element 5. The sales price of X is K 8.000 X (2.000 X (2.9
The breakeven chart can now be drawn.6.6.12.000 at all levels of activity.000 : 3. Fixed costs per annum are K 10.000 X (2.000 47.000 * K 6) 18. A breakeven chart would make the assumption that output and sales of X.6. Output in K sales and a constant product mix Assume that budgeted sales are 2. A breakeven chart cannot be drawn.000 * K 6) 24. because we do not know the proportions of X.12.000 10.6.6. in order words that the sales mix is ‘fixed’ in these proportions.8
Element 5. There are a number of ways in which we can overcome this problem.000 16.3 For example suppose that Farmyard Ltd sells three products.000 * K 3) Varible costs of Y (4.000 * K 8) 16.12.000.
Budgeted costs Varible costs of X (2.000 15. Y and Z are in the proportions 2.000 units of Y and 22.214.171.124
. the price of Y is K 6 and the price of Z is K 6. or at best for a single ‘sales mix’ of products.000 units of Z.6.7
Element 5.000 Budgeted revenue 58.12.6 Element 5. Y and Z in the sales mix.000 * K 4) Varible costs of Z (3.000 * K 5) Total variable costs Fixed costs Total budgeted Costs Revenue K K 6. 4.5
Element 5.safety for a single product only. Element 5. X.
the fixed costs.000. The breakeven point is K 10.10
The breakeven point is approximately K 27.500 of sales revenue.21% b) The required contribution to break even is K 10.000 – 27.12.000/36.Element 5.500
. The margin of safety is approximately K (58.500 (approx) in sales revenue.000)/K 58.6. This may either be read from the chart or computed mathematically.000 = 36.500) = K 30. a) The budgeted C/S ratio for all three products together is contribution/sales = K (58.21% = K 27.00037.
STUDY UNIT 6. Understand the use of flexible budgets and be able to prepare them from details of fixed and variable costs. showing incurred and the capital to be needed in generating the Revenues for a specified future period.
BROUGHT FORWARD KNOWLEDGE
Candidates should remember what they learned at their lower levels of Natech. Appreciate behavioural respect of budgeting Understand the use and application of information technology in the Budgeting process.0 BUDGETING AND BUDGETARY CONTROL
Learning Outcomes: After reading this chapter candidates should: • • • • Understand the purpose of preparing budgets and the main processes and techniques involved in the budgeting process. Among the concepts learned earlier were: Objective of Budgeting • • • • Communicating Compel planning Control Motivation
INTRODUCTION TO BUDGETING
A Budget is a plan that is quantified in monetary terms.
Element 6.THE CONCEPTUAL FRAMEWORK OF THE BUDGETING PROCESS
Budgeting and long term planning: The Budgeting process forms part of the long-term corporate planning process. which will comprise departmental heads from each department that exist in an organisation. The main theme of the manual will include the following:
.1.1. Element 6.
Element 6. Element 6.1The Budget Committee The Board appoints a budget committee.3 Role of Budget Officer Drawing budgeting meeting time tables Conducting Budgeting meetings Drawing Agendas for meetings Producing Budgeting meeting minutes ‘giving technical expertise to non – finance managers who sit on the Budget committee. Therefore the Budgeting process should not be looked at as a stand-alone process.1 The Budget Process The Budgeting process starts with the board of Directors in a Business setting and mapping out the organisation’s horizon of two to ten years depending on the stability or dynamism of its business environment.
Element 6.2 The Budget Officer The Budget committee is headed by a Budget officer who usually is a qualified Accountant or any finance profession with vast budgeting experience.1.1.4 The Budgeting Manual The Budgeting committee should produce a Budgeting manual which will act as a key guide to the whole budgeting process.
2 Types of Budgets There is a wide array of Budgets.
Element 6. interest rates and growth rates in other lay economic variables. Classic examples of principal budget factors could be the following.1 Functional Budget Functional Budget are budgets which are prepared to show the expenditure to be incurred and revenues to be generated by each department in their nature allow the departments to be both revenue generating and expenditure incurring. It is an item.
The committee will be charged with the whole process of preparing Budgets and presenting them to the Board of Directors for approval. • Sales demand • Scarcity of raw material • Skilled labour • Factory/ machine capacity.
.5 The Principal Budget Factor It’s of Paramount importance to identify the organisation’s limiting factor (resources) first.1.• • • • •
The company (organisation’s) Mission statements and corporate objectives An organisation chart Pretensions of manager’s responsibilities A timetable for preparation of the budgets Statements of assumptions to be made in the budget as regards risk factors. which a company can prepare: • • • • Functional Budget Cash Budget’ Flexible Budgets Master budgets
Element 6.2. which limits an entity’s undertakings. inflation levels. The principal budget factor is an alternative name for a ‘limiting factor’.
46.000 Q2 Units 43.000 TOTAL Units 170. and 4 of 20X7 respectively of its only product the LYN at K5. Example 1.000 and 41. Solution: KAZHIKA Ltd Sales budget for 20X7 – Quarter by quarter basis In UNITS Q1 Units 40.000 units.000 in the last quarter of 20X7.000
.1 The Sales Budget The Sales budget shows Quantities of products or events of a service which the firm intends to sale in a given future period. The Quantities of the sales should ultimately be expressed in monetary terms. Kazhika Ltd intends to sell 40. 3. 43. Requied: Produce a sales budget both in units and money terms for KAZHIKA Ltd for its control period 20X7.1. The main functional Budget which are typically drawn are (a) (b) (c) (d) (e) (f) Sales budget Production budgets Production cost budget Labour budget Material requirement budget Material purchase budgets
Element 6. by multiplying the units budgeted to be sold by the relevant unit selling price.000 Q4 Units 41. 2.It’s the duty of the departmental Head to prepare the budget for the departments over which they preside.000 units.000 Q3 Units 46.2.000 units in quarters 1.000 per unit in the first 3 quarters of the year and at K6.
000 Q3 K5.000 Q2 K5.000 X40.000
Working 1 Q1 K5. XXX Plc PRODUCTION BUDGET FOR THE FOUR QUARTERS Q1 Budgeted units to be sold Add: closing stock for each quarter X X Q2 X X (X) X Q3 X X (X) X Q4 X X (X) X
LESS: Opening stock for each quarter (X) Production X
.2. The usual schedule for drawing up the production budget is drawn below.000 Q2 K’000 215.000units = K215.000 Q4 K6.000units = K230. A quarter by quarter format has been adopted here but note that the format of the budget will be dictated by the length of time under consideration.1.000 TOTAL K’000 891.000.000.000X43.000
Element 6.000 Q4 K’000 246.2 The Production Budget The Production Budget aims to maintain how many units of the product should be produced in a given budget period for an organisation to meet the sales demand for its product in the environment.000.000X46.000units = K200.IN MONEY TERMS Q1 K’000 200.000.000 X 41.000 Q3 K’000 230.000units = K246.
500 Q4 Units 41.000units 4.300 Q3 Units 46.000 units in quarter 1 of 20X8.000 units of the LYN on 1 January 20X7.000 4.000 16.100 (4.100) 41.000 4.000 5.Example 2.300 units Q2 10% x 46.300) 43.600 47.000) Production 34.100 50.300 Q2 Units 43. and the company has a policy of hold 10% of the following quarters projected sales as closing stock. Assuming that KAZHIKA Ltd has stocks of 10.000 (4.300 44.000units 4.600 (4.600) 45. The company hopes to sell 50.600 units Q3 10% x 41.000units 4. Closing stock figure Fine policy is to hold 10% of the subsequent quarter’s sales the closing stocks for the quarters will be calculated as follows: Q1 10% x 43.100 units
Budgeted sales units Add: closing stock
Less: Opening stock (10. Required: Prepare the production budget for KAZHIKA Ltd for the year 20X7 KACHIKA LTD – PRODUCTION BUDGET Q1 Units 40.000 4.300 Workings:
184 Q3 45.98 44.500 0. KACHIKA LTD – REUSED PRODUCTION BUDGET Q1 Production Per Example 2 Less (Scrap) factor Production 98 = 0.000 Q2 43.300 0. Required: Redraft the production budget for KACHIKA Ltd for the year 20X7 Solution: Since the production budget earlier drawn represents good units to be sold in the market place. we need to build in ‘extra’ units which have to be produced but however scrapped at the ends. then the extra units to be scrapped would be.
.98 35.98 100% Since 2% will be scrapped Scrap factor 34.98 42.755
Since 2% of the production will have to be scrapped.000units 5.429 Q4 41.Q4 10% x 50.900 0.98 46.000 units
Assume that the KAZHIKA Ltd’s production system is experiencing problems and as a result 2% of all units produced will be defective and they will have to be scrapped of since they will not find use anywhere.300 0.
There are 8. (c) The Budgeted gross profit for the quarter from January to March.125 cases of finished Maheu in stock on 1 January and it is policy to have stocks at the end of each month to cover 10% of the next month’s sales.750 Cases
A CASE OF Maheu has a standard cost of K20.755 (41.5kgs of Maize Meal and it is policy to have stocks of Maize meal at the end of each month to cover 50% of next month’s production. February.184 (43.429 (45. The company is currently in the process of preparing budgets for the next few months and the following Draft figures are available.700kgs of maize meal in stock on 1 January.500) 929
Q4 42. Each case uses 2.
. There are 1.500 Cases 9.000 (34.250 Cases 12.300) 884
Q3 46. Z Non-Alcoholic Brewers manufacturers Maheu drinks.Revised production LESS: Good units Scrapped units
Q1 35. Required: (a) Prepare the production Budget (in cases) for the months January.000 and a selling price of K25. July and August. March and April (b) The maize meal purchase budget (in kg) for the months of January.750 Cases 10.
Sales forecast January February March April May 9.900) 855
Example 3.000.000 Cases 11.300) 700
500 11.500 Closing stocks 14.50 February March
Kg Kg 28. SOLINE Ltd makes two products.250 x 2.25 13.125
Element 6.5 = 28.
.656.125) 11.000 x 2. The following Data relates to the two products.275) 12.000
(b) INGREDIENTS PURCHASE BUDGET January Kg Budgeted material usage (W1) 22.3 Labour Budget The labour budget aims to show the expenditure to be expended on labour at the calculated production budget.2.500 12.525
April 10.312.125 10.525 (1.938 19.125) 9.5 = 31.032 (14.425
Less opening stock ( 1.312.656.125
March 12.250 Less opening stock (8.1.Solution: (a) Z Ltd Production Budget January Sales quarters 9.800 (1.700 Working (W1) January February March 9.25) 19.275 12.750 x 2.5 = 22.475 (1.050) 10.500 31.50 15.050 13.750 1.000 Closing stock 1. Example 4.250) (15.500 975 11.700) 18. X and Y.250 1.
Workings – number of labour hours 221
.000 per hour.050
Y Units 1.000 K5.000 and 1. PRODUCTION BUDGET
X Units Required sales Closing stock Opening stock Production 5.Direct labour is paid at K5.000 K224.250. we need to know what the product budget is first.000 labour cost K176.000 per unit It is estimated that at 1 January year 2 there will be 100 of X and Y units.000 per unit Y .150 (200) 950
DIRECT LABOUR BUDGET FOR YEAR 2 Labour Hour X – 5. At the end of year 2 the sales manager will need to close year 2 with stock levels of 150 units of each production in order to prepare the labour budget.750.000 K47. Direct labour X 7hrs Y 10hrs
The sales manager forecasts that sales of X and Y will be 5.950 units 35.350 9.050 units Y.000 150 5.150 (100) 5. The selling prices are: X .000 150 1.000 units respectively during year 2.K115.K130.500 Rate per hour K5.
Balance sheet Responsibility Accounting and Flexible Budgeting Responsibility accounting is a system of accounting that is based upon the identification of individual rates of a business.Bad debts & provisions . corporations have to prepare cash budgets. which fall under the responsibility of a single manager. A cash budget compares cash receipts and cash expenses in respective periods.500 hrs Element 6. All the items of expenditure and income are cash transactions.Profit/ loss on disposal of Assets . This requires the classification of the individual parts of the business as responsibility centres. The non-cash expenses to be excluded from the cash budget would be the following . there are four types of responsibility centres 1.
. Cost centre This can be defined as a production or service location. They will include both capital and revenue expenses as long as they are cash based. Cash budgets are an integral part of the feed forward control system which enables management to anticipate future cash requirements and provide remedies for the future now. function.X – 5050 x 7 hrs/unit = 35.Profit and loss accounts . It follows that all non-cash based items will not be incorporated in the cash budgets.2. activity or item equipment whose cost may be attributed to units of output.Depreciation .350 hours Y – 950 x 10hrs/unit = 9.2 Cash Budget From time to time and generally in the process of budgeting. A responsibility centre is an individual part of a business headed by a manager who has responsibility over its performance. In general.
Revenue centre This is a centre that is devoted to raising revenue with no responsibility for the cost of doing so. In order for profit centres to be operated. • • • Problems Communication of the final budget Comparison of actual with budget figures and investigations of variances. A manager’s performance for a profit centre is measured on the basis of profits. 2. Profit centre This is a part of the business organisation that is accountable for both costs and revenues. data must be collected about costs and revenues. The performance of the manager who is responsible for revenue is judged on the basis of the revenue raised. The following are the steps: • • • • • identification of limiting budget factors preparation of the sales budget (assumption sales to be limiting) preparation of a finished stock preparation of production budget preparation of budget for production resources o materials usage budgets o machine usage budgets o labour budget preparation of raw material purchase budget both quantity and cost preparation of overhead administration overheads
• • •
.The performance of a manager who is responsible for a cost centre is judged on the extent to which cost targets are achieved. 3.
Budget preparation The procedure will differ from organisation to organisation.
Most control system makes use of a comparison between results of the current period and the planned results. which means that contribution is highlighted. which takes into account the difference in cost behaviour patterns and is designed to change as volume of output changes. 2. It is called incremental since it is concerned more with the increments in costs and revenue. Flexible budgets are often prepared on a marginal cost basis.• • • • • •
selling and distribution budgets calculation of overheads absorption rates preparation of cash budget others would be capital expenditure budget working capital budgets the master budget
A flexible budget is a budget. Feedback is used to describe both the process of reporting control information to management and the control information itself.
Alternative approaches to budgeting • Incremental budgeting
The traditional approach to budgeting is to base years on the current years plus an extra amount for estimated growth or inflation next year. Define decision package. Evaluate and rank each activity on the basis of its benefits to the organisation. The steps in ZBBB are: 1. • Zero base budgeting A method of budgeting. 224
. description of specific organisation activities which management can use to evaluate the activities and rank them in order of priority against other activities. which requires each cost element to be specifically justified as though the activities to which the budget relates were being undertaken for the first time. Past events are therefore used as a means of controlling or adjusting future activities. This is called feed forward. Variable cost must be separately identified from the fixed costs so that it is possible to determine which costs will change as the activity level changes and which will remain Fixed. which will occur in the coming period.
Flexible budgets are used for control purposes. Allocate resources in the budget according to the funds available and the evaluation and ranking of the competing packages. Even when costs are identified as controllable and non-controllable it would be unrealistic to judge the performance by comparing actual costs with budgeted costs. by recognising the distinction between fixed and variable costs. This is because no matter how carefully budgets would be set. flexible budgets are an essential feature in the budgetary control and variance analysis process. is designed to change in response to changes in output. There should be a distinction made between controllable and non-controllable costs. Adjustment of the original budget to the actual level of performance is what is known as flexing a budget flexible budget is designed to change in output. The original budget should be adjusted to the actual level of performance in order to judge the performance of a manager.3. actual performance will not be the same as budgeted performance. Most of the costs. in the modern industry most of the cost items are fixed in nature and this fact makes 225
Requirements for responsibility accounting A system of responsibility accounting requires each responsibility centre to have its own budget. However. A variance report will be prepared and a manager will be asked to provide explanations for significant adverse variances. The advantages and limitation of ZBB Advantages • • • it is possible to identify and remove inefficient or obsolete operation it forces employees to avoid wasteful expenditure it can increase motivation
This is a form of a profit centre whose performance is measured on the basis of the return on capital employed. A Flexible budget is one. As such. Flexible budgets have also been used for planning purposes. they will change if the level of activity from the budgeted level of activity. A manager for an investment centre will normally be responsible for investment decisions as well. especially when dealing with cost centres. are variable costs and as a result. which will be under a manager’s control.
we do not mean that the budget is kept unchanged. The term fixed means that the budget is prepared based on an estimated volume of production and an estimated volume of sales. K’000 X X X X X X X X X X SEPT. Fixed and flexible budgets By the term fixed.000 July K’000 100.000
Sales Wages Overheads
The following information is available concerning the direct materials. July and August.
. Revisions to a fixed budget will be made. K’000 K’000 X X X X X X X X X X X X X X X X X X X X X
Add: Opening Balance X X
Examples 5 The following data and estimates are available for KASEMPA LTD for the month of June. OCT. no plans are made for the event that actual volume may differ in terms.000 17. June K’000 90.000 18.000 August K’000 120. In those businesses where most of the costs are variable.000 19. Format of cash budgets Periods Receipts Other Income Expenses Materials cost Labour Overheads Corporation Tax Capital Expenditure Surplus/ Deficit JUNE K’000 X X X X X X X X JULY K’000 X X X X X X X X X X X AUG.flexible budgets not to be so useful anymore in budgetary planning. flexible budgets will still be a useful technique for budgetary planning.000 26. However.000 29.000 24.
Required: (a) Prepare a cash budget for KASEMPA LTD in your capacity’s Management Accountant of KASEMPA LTD.000
expenses incurred in month K’000 2. Purchases of direct materials are paid for in the month purchased.000 3.000.000 80.000.000 is to be paid in June for May’s overheads.000 60. Cash budgets – Examples Example 1. Overheads are settled the month following K13.000
July K’000 7.500 3.000.000 -
Notes (i) (ii) (iii) (iv) (v) (vi) 10% of sales are for cash. Wages are paid in the month they are incurred. The opening cash balance in June is K23.000. Kafue Ltd operates a small business purchases are sold at cost plus 33⅓%.000 20.000 30. The amount to be received in June for May’s sales s K59.500
January February March April
20.500 2.000 3.June K’000 Opening stock 10.000 Material usage 16.000.000 per month for depreciation.000. Overheads include K3.000 18.500 2.000
September K’000 8.000 Corporation tax of K50. (a) Months
Budgeted sales in months K’000
labour cost in month K’000 1. 227
.500 1. the balance is received the following month.000
August K’000 12.000 is to be paid in July.000
It is management policy to have sufficient inventory in hand at the end of each month to meet half of next month’s sales demand.
750 (W3) 1.000.000.250 (W3) 2.000 30.000(W4) 1.000. (i) 75% of sales are for cash (ii) 25% of sales are on month’s credit.Suppliers for materials and expenses are paid in the month after the purchases are made/ expenses incurred.
Solution: (1) Cash Budget February K’000 Receipts Receipts from sales 27.000 in March. Labour costs and expenses are treated as period costs in the income statement.000 for cash in February and will pay a divided of K10.000 (W4) 2.500
. The company will buy equipment costing K9. Expenses include a monthly depreciation charge of K1.250 41.500(W2) March K’000
Payments Trade payables Expenses payables Labour Equipment purchase Dividend Total payment 18.500 10.000. The opening cash balance at 1 February is K500.000.500 9.000 9. Required : 1) Prepare a cash budget for February and March 2) Prepare an income statement for February and March.500 (W1) 67. Labour is paid in full by the end of each month.
250 7.Receipts less payments Opening cash balance b/f Closing cash balance b/f Workings
(2.750) 500 (2.250)
11. K’000 11.000) February For February Sales (50% x K22.000) are paid in February and March respectively.500 K’000 22.000) and February (K3.000 27.250 18.000.000.000 – K1.000) For February Sales (50% x K22.500 67.000.750
.250 30.000.000) (3) Receipts in March 75% of March Sales (75% x K80.750 2.000) For March Sales (50% x K60.500 5.000.000) 25% of January sales (25% x 20.500 11. (5) Expenses Cash expenses in January (K2.250 (9.000) These purchases are paid for in February and March.500.500.000.500)
(2) Receipts of February 75% of February Sales (75% x 30. Depreciation is not a cash item.000 41.000.000) 25% of February Sales (25% x K30.000) K’000 60’000 7.500
(4) Purchases K’000 January For January Sales (50% x K15.000.000.K1.000.
500 2. The differences are explained by the following causes and reason.000
A COMPARISON OF PROFIT AND CASHFLOWS
The cash flows and profit during the above example need not be the same amount and infact.500 3. This is not a cash expenses and will never appear in cash budget.(ii) Income Statement February K’000 K’000 Sales Less: Cost of purchases Gross profit Less: Labour Expenses 1. An income statement may show a charge for depreciation. Sales and cost of sales are recognized in an income statement as soon as they are made/incurred.500) 7.000 March K’000 K’000 80.000 (60.500 (6. are actually more likely to be different.000) 20. insurance and other expenses.000 30. In the cash budget such amounts will appear in full in the period in which they are paid. There is no attempt to apportion payments to which they related. No attempt is made to allocate the purchase cost over the life of the asset. The cash budget will show purchases of a non – current asset as a payment in the period when the asset is paid for.500) Net Profit 3.000 (22.500 3. and may also show the proceeds on disposal of a non – current asset as a receipt of cash.000 (4. The cash budget does not show figures for sales of sales but is concerned with cash actually received from customers and paid to suppliers.000) 14.
. An income statement may include accrued amounts for rates.
Actual expenditure on labour was K54.000.000.000.000.000. which were sales for K138. 680 28.800
Actual sales turned out to be 230 units.800) 16. Fixed cash totaled K20.
Required: Prepare a flexible budget that will be useful for management control purpose. 220 230 units K’000 138. 200 25.400) 54.000. 000 K’000 26. 980 54. 142.200 25. K’000 Sales Variable costs Labour Material Contribution Fixed costs Profit 63.000 and on material K48.000. 000 18.400 (37.220(A) Budget Flexed budget Actual
.020(A) per unit K’000 714 230 units K’000 164. 000 316 126 72.600 K’000 142.680(F) 19.200 (88.Flexible Budget Example: Chintu Ltd budgeted to sell 200 units and produced the following budget. 000 48. Solution: Budget Variance 200 units K’000 Sales. 800 Variance Costs Labour Material 63.
000 (A) 1. the sisy.000 145.560(A) 17.000 10.000 47.000 (F) 2. Budget results and actual returns for May are as follows: Budget Production and Sales of the Sales (units) Actual Variance
15.600 K’ 000 12.000
Direct Materials 45. 000) __24.88. 400 Contribution 54.000 31.760(A). 000 26.000.000
2. 000 __
Example: Kuku Ltd manufactures a single product.800(F) 8.000 (A) 600 (A)
150. 000 36.600 (A) 6.
20. 400 K’ 000 162. (c) Production overhead is a semi – variable costs the budgeted cost for an activity level of 20.000 Direct labour Production overheads Admin overhead Profit 30.
(37. 660 62. (b) Direct material and direct labour are variable costs.000 45. 560
102. 600 _
101.000 (A) 5.400(F)
Make the following assumption in dealing with the above scenario. 400 Fixed costs (37. 800) (20.000 140.000.000 16. 760__ 16. 000 K’000
16.000 units being K50. (d) Administration overhead is a fixed cost. 800) Profits _16.
000 (A) ________ 2.400 K’ 000 164.200 32. 000 __10.800 46.600 16.000 _______ 145. Solution: Fixed budget Production and sales (units) 15.000 49. 000 45.000 (A) 2. Required: Prepare a budgeting control analysis.000 47. 000 K’ 000 Sales revenue Direct Materials Direct labour Production overhead Administration over head Profit Flexible Budget 16.400 20. 000 20.800 (F) 800 (F) 2.200 (F) 1.000 45.600 16.000 31.400 K’ 000 162.400 Actual results 16.000 ________ 145.800 800 (F) 150.(e) Selling prices are constant at all levels of sales. 000__ Variance
. 000 140. 000 45.600 22.400 K’ 000 2. 000 30.
000) = K 46.000 x 16.000 = K10. .000)_ 20.000. 000 per unit .000.Workings: ¾ Selling price per unit K 150.000.000.400 x K1. Budget cost allowance = 30. fixed production overhead cost = K30.000 ¾ Direct labour cost per unit = K 30.000 per unit Flexible Budget sales revenue = K10.200.400 units = K 49.000 + (16. .400.000 ¾ Variable production overhead cost per unit. = _(K50.000. Using the high – low method.000 units = K2.000.400 units = K32.000 ÷ 15. 400 units = K164.000 x 16.000. . Budget cost allowance = K2. 000 units = K 1.000 ÷ 15. .000.000 x 16.000 ¾ Direct material cost per unit = K 45.000 Budget cost allowance = K 3.000.000 ÷ 15.800.000 – K45. 000 – 15.000 units = K3.000 ¾ Administration overhead is a fixed cost and hence budget cost allowance
If the cash budget indicated a forecast cash shortfall then managers can take action in advance to cover the shortfall. Flexibility however. or to introduce some flexibility and compare actual outcome with the standard expected for the new level of activity? Element 6. Element 6.3. When the standard costs are set at the beginning of the reporting period.3.1 Advantages of Cash Budgets The cash budget reveals to senior managers whether there will be sufficient cash to enable the organisation to meet its cash obligations as they fall due. It gives forewarning of the cash effect of the decisions that could be taken in the budgetary planning process e.3 FLEXIBLE BUDGET PREPARATIONS AND VARIANCE ANALYSIS
. Flexible budgets therefore are prepared based on the original level of activity and taking into account the changes in the new level of activity.g.000 Element 6. is often over looked when the need t analyse variances arise.000. If the cash budget forecasts a cash surplus then advance plans can be made to invest the cash investment portfolios as allowed by the corporate risk and investment policy of the company.2 DEFINITION Budgets which do allow for changing levels are called flexible budgets.2.1 One of the most commonly occurring problems in variance analysis is deciding which benchmark to use as a basis for comparison. whether to decide to increase stocks and offer more credit to customers or not. they will be presented in the form of a budget based on activity levels expected at that point.3
Element 6. Suppose activity level subsequently fall because of a downturn? It is preferable to base the variance analysis on the standard set for the original level of output.
Element 6.3.= K 20.2. by for example starting to negotiate for a bank loan.
Each unit of output requires 0. By the time July was reached.000 6.000 7.3.5 Kg of raw materials and 12 minutes of labour time. The original budget is based on a standard direct cost of K 4000 per Kg of raw material.4 SOLUTION It is quite tempting to compare these two columns of figures directly and call the difference the cost variance. But that would be totally misleading because the budget is based on 10.000 43.000 36.720 11. So a flexible budget is therefore prepared as follows.000 10.000 units per month because of a fall in market share of sales.800 28. output had fallen to 8.Kuchinja Company sets the standards for the month coming to manufacture 10.000 Actual Budget 8.000 35.000 K’000 16.000 43. The actual variable overhead cost rate was K 2800 per direct labour hour. 3800 kg of materials were used and the actual labour hours worked was 2000.820
Element 6. Data relevant to the month of July is set out below: ORIGINAL BUDGET AND ACTUAL COSTS FOR JULY Units Manufactured Direct material Direct labour Variable overhead Fixed overhead Total costs Original Budget 10.000 K’000 16.000 10’000 6.000 units.000 units of output and the actual output was down to 8.000 4.500 40. The information below is for the original budget and the actual outcome for the month of July.000 Actual for July 8.000 7.000 8.600 7.000 K’000 20. The actual cost of direct labour was found to be k 5000 per hour and raw materials K 4400 per Kg.800 7. Units manufactured Variable costs Direct materials Direct labour Variable overhead Total variable costs Fixed costs Total costs Original Budget 10. a standard cost rate of K 3000 per direct labour hour.800
.000 5.000 K’000 20.000 units.
720 11. The manger that set the budget or standards are often not the mangers that are then made responsible.4.1 General Behavioral of Budgeting 1.000 16.020
Calculations : i) The fixed overhead are not flexible and therefore remain the same ii) Analysis of standard costs Item Standard cost Standard of item amount of item/unit of output Std Quality Std cost for for output for output level of of 8.600 7.000 Kg 16.000 8.000 8. Element 6.820 Variance
720 (A) 3.000 5.
.000 12 min 1.800 7.000 12 min per direct 1. The goals of the organisation as a whole as expressed in a budget.Variance analysis Units manufactured Variable Costs Direct materials Direct labour Variable overhead Fixed overhead Total costs Flexible Budget 8.4 Behavioral Aspects of Budgeting When used correctly a budgeting control system can motivate but it can also produce undesirable negative relations from employees.500 40.800 labour hour labour hour
K’000 Direct material 4 per Kg Direct labour 5 per hour Variable o/head 3 per direct labour hour
Element 6.600 direct 4.600 hours 8.000 16.000 35.000 units K’000 0.000 Actual for July 8.000 (A) 800 (A) 500 (A) 5. may not coincide with the personal operations of individual managers. 2.000 4.5 Kg 4.
A supervisor might get weekly control reports. Managers might build budget slacks into the cost center budget of expenditure estimates. Control is applied at different stage by different people. It comes mainly from individual attitude or group attitudes. implementing budgets and giving feedback on organisational performance. It is important that goals of management and employees harmonize with the goals of the whole organisation. which will help an organisation to work towards goal congruence. Managers can complain that they want to spend their total time on their daily schedule activities and not on budgeting.4.4 Poor Attitude When Implementing Budgets
. 4.4. poor attitude or hostile behaviour towards the budgetary control system can begin at the planning stage.
Element 6. 1. Element 6. This is known as goals congruence.
Element 6. 2. his supervisor might get monthly reports. Mangers might all together not want to be involved in the budget process. and act on them. Mangers may set budgets for their budgets center and not co-ordinate their own plans with those of other budget centers. When budgeting. Individuals will usually be motivated by personal interests and desires.3 Poor Attitude When Setting Budgets If managers are involved in preparing a budget. Management accountants should therefore try to ensure that employees have positive attitude towards setting budgets.4. and decide to take different control action.2 Motivation Motivation is what makes people behave in the way that they do.3. Different mangers can get in each other’s way and resist the interference from others. Therefore management accountants should endeavor to design budgeting control systems. 3.
mangers will dismiss control information as unreliable. Budgets might be seen.6 Styles of budgeting It has been argued that motivation levels in the entire budgeting process will depend to a large extent on the level of participation from the members of the organisation. If there are flows in the system of recording actual costs.4. as pressure devices that are just meant into doing better. (a) A formal budget might encourage rigidity and discourage flexibility.
.4. Managers (Budget holders) might be held responsible for variances outside their control. control reports will be resented. (b) Some budgets implementing may fall on short-term goals at the expense of the long – term goals of the organisation.Poor attitude also arise when a budget is implemented. (a) Mangers might put in only enough effort to achieve budget targets without aiming to beat target. (a) Management accounting control responses could well be seen as having a relating low priority in the list of budget tasks. (b) Poor communication among different budget holders may creep and it may teal to poor co-operation.
Element 6. Therefore let’s at this point in time examine the main budgeting style which incorporates participation at different levels.
(b) (c) (d)
Element 6.5 Poor Attitude When Utilizing Budgeting Control Information The attitude of managers towards the accounting control information they receive might reduce its effectiveness. as set is the budget. Managers might take the view that they have more pressing jobs on hand than looking at routine control reports.
this is because the targets are set by strategic managers who are detached form the implementers.4.1 Imposed Style of Budgeting An imposed or top – down budgeting is a budget allowance which is set without permitting the ultimate budget holder to have the opportunity to participate in the budgeting process.
. In the imposed style of budgeting. defensive and low morale amongst employees. 4) The acceptance of organisation goals and electives could be limited. 2) Lower – level management initiative may be stifled.6. 1) During the period of economic down forms.
IDEAL SITUATION FOR IMPOSED BUDGETS
Imposed budget will ideally be effective in the following circumstances. 3) Operational staff may be dissatisfied.
Disadvantages of imposed budgeting 1) The filling of team spirit may disappear.Element 6.
Advantages of imposed style budgeting 1) They tend to decrease the period of time taken to draw up the budgets. 4) In newly – formed organisations. 2) Strategic plans are likely to be incorporated into planned activities. 2) When operation managers lack budgeting skills 3) In very small businesses. the management prepares a budget with little or no input from the operating core personnel which is then imposed upon the employees who have to work according to the budget figures.
2) Morale and motivation among operation staff is improved.6. 3) They can support empire buildings by operational staff.
Advantages of participative budget 1) The budgets are usually very realistic as they are prepaid by people who know the actual needs of the organisation on the ground. as a lot of people will need to have an input into the budgeting process. 4) An earlier start to the budgeting process could be required.
.4. budgets are developed by lower level managers who then submit the budgets to their superiors for review and approval.
Disadvantage of participative budgets 1) They consume more time.
Element 6. 3) Co-ordination between units is improved.3) They use senior managements awareness o total resource availability. In this style of budgeting. 5) Managers may set ‘easy’ budgets to ensure that they are achievable.3 Negotiated Style of Budgeting A negotiated budget is a budget in which the budget allowance is set largely on the basis of negotiations between budget holders and those to whom they report.
Element 6. 4) They decrease the input from independencies or uninformed lower – level employees. 4) Specific resource requirements are included and budget slacks are avoided.4.6.2 Participative Style of Budgeting Participative/bottom – up budgeting is a budgeting system in which all holders are given the opportunity to participate in setting their own budgets. 2) They may cause managers to introduce budgeting slack and budget bias.
Element 6. the budget targets which they consider to be unreasonable and unrealistic. • • Accounting measure of performance can’t provide a comprehensive assessment of what a person has achieved for the organisation. different levels of management often agree to budget by a process of negotiation. But what then is the effect on motivation. targeting can bring conflict and bring an effect on management behavior. A management accountant should supply accounting reports. if employees view performance standards as chargeable. Operational Manager will try to negotiate with senior managers. Like wise senior management usually review and revise budgets presented to them under a participative approach through a process of negotiation with lower managers.
. In practice. determining whether the budget is an effective management tool.7 The Management Accountant and Motivation As it has been highlighted.
This can be done by adopting the following. Therefore the final budgets are therefore most likely to lie between what top management would realty like and what junior managers believe is feasible. Hence the management accountant therefore will need to devise strategies and methods of dealing with the resulting tensions and conflict.The budgeting process is hence a bargaining process and it is this bargaining which is of virtual importance.4. which try to provide information requirements to several users and to satisfy several needs. The management accountant should devise performance measures and budgeting control systems that will motivate managers towards achieving organisational goals.
Ensure that budgets are up to date. iv. Explain the meaning of budgets and control reports Keep accounting jargon in these reports to a minimum in their Accounting reports. which will focus on both short–term and long-term achievements of an organisation. Provide control information with a minimum delay.•
Management accountants should prepare Accounting reports. iii. ii. They may lead to short tenure especially where managers are remunerated on the basis of financial results. managers. Make sure that actual costs are recorded accurately. 3) Budgets fail to focus on shareholder value.
. 1) Budgets are time consuming and expensive 2) Budgets provide poor value to the organisation generally the value added by the budgeting process has been found to be negotiable.
Develop a working relationship with operational. going out to meet them and discussing the control reports. v. either by having a system of rolling budgets or by updating budgets or standards as necessary and ensuring that standards are ‘fair’ so that control information is realistic.
HOW MANAGEMENT ACCOUNTANTS SHOULD DELIVER HIGH QUALITY BUDGETARY CONTROL SYSTEM DATA
The beyond budgeting round table have proposed that traditional budgeting should be abandoned and they attack the current budgeting process by giving the following criticisms.
participative basis. 5) Budgets may stifle product and strategy innovation. which might not move in tandem with the current happenings.
FURTHER EXPLANATION ON THE CONCEPTS
Adaptive management process An adaptive management process does not tie a manger to the achievement of a fixed target but it expects managers to work on a continuous performance improvement in response to changing business environment conditions. Their performance is monitored against world – class benchmarks.4) Budgets are too rigid and prevent fast response to changes in the environment. Therefore beyond budgeting suggests that manages should use forecasts on the cash expenses rather than focusing on purely cost control. Planning is a continuous. For example in this chapter on budgeting we have discussed dysfunctional behaviour such as building slack into the budget in order to create an easier target for achievement.
CONCEPTS OF BEYOND BUDGETING
The following are the two pillar concepts on which beyond budgeting approach in based. The emphasis is on encouraging a culture of personal responsibility by delegating decisions to personal. 6) Budgets lead to unethical behaviour. Evaluation of manager’s performances therefore is based on a relative improvement and this evaluation is carried out using a range of relative
. (b) Move towards networks rather than centralized hierarchies. and performance accountabilities to managers. Traditional annual plans tie managers to predetermined actions. (a) Use of adaptive management processes rather than more rigid annual budgets. competitions and previous periods.
5 Application Of Information Technology in Budget Preparation Computers are finding increasing employment in the management accountant’s daily duties.1 Merits of Using Computer Spreadsheets a) b) c) d) The spreadsheets are fast They are more accurate Can handle huge volumes of data Quick replanning and recalculations can be made with ease. 245
. alterations will have to be made to the budget.
Element 6. Today computer spreadsheet such as Microsoft Excel and Quato pro can be used to assist in the preparation of budgets.e. managers are given the resources they need to deliver their duties and corporations are cross – functionally coordinated to respond to customer demands. In addition. taking account of the actual conditions in which the manager was working.5.performance indicators with highlights i. if the Board of Directors do not approve the budget. Similar to Coldratt’s proposition in adaptive management process.
Illustration of a spreadsheet 1 2 3 4 5 A Cell B C D E
Spreadsheets come in handy in budgeting because the process involves a lot of alteration to be made as the key assumptions upon which they are based could need to be changed.
Element 6.5.3 Budgeting Software Just like in financial accounting where we can use dedicated financial amounting packages such as PASTEL.5. Spreadsheets just process all data fed to them. several dedicated Budgeting packages (Modules) have been developed to handle all the complexity in budgeting and to give detailed and robust analyses in budgeting. SUNSYSTEM and NAVISION. ACCPAC.2 Limitations of Spreadsheets a) They cannot judge.Element 6. Examples of such packages include a) COMSHARE b) HYPERNION etc. b) They may be costly to acquire c) Some spreadsheet are difficult to use.
all customers of both services and tangibles products want to buy these products at a very low or reasonably low prices.0 MODERN BUSINESS ENVIRONMENT
Learning objectives: At the end of the chapter. Now. In order to meet these demands.STUDY UNIT 7.
Element 7. These developments have therefore demanded that management accountants develop new management accounting techniques that will accurately record and report costs in a more meaningful manner to aid management decision-making in a business or indeed in any other organization.1 The Changing Business Environment From the 1970s. process them into finished goods and dispense them to the clients/customers.
. a candidate should be able to • • • • • • • Understand factors driving changes in business Explain the factors Identify need for new management accounting techniques Explain modern production strategies Explain what world class manufacturing techniques are Appreciate the concept of product life cycle Appreciate life cycle costing
Element 7.1 Changing Customer Demands For Cheaper Goods Modern customers have become very complex in terms of product quality and the price at which they buy commodities.1. more than ever before. corporations are being forced to find new and cheaper methods and techniques that will see the production or delivery of cheap products or services respectively. the world has seen a number of changes that are greatly impacting on business and revolutionalising the way businesses acquire their inputs.
for instance the European union (EU) and COMESA. have formed economic blocks (unions) through which given economic objectives are being pursued.5 Intensity In Competition and Globalisation World over. most countries have loosened their former protective measures that they had. All these developments are turning the world into a global village where corporations can conduct business across boarders and continents with very little restraint.
Element 7.Element 7. These turns in events have really increased competition among modern businesses and they have also unlevelled the competitive grounds.
.2 Changing Customer Demands For High Quality Goods Customers also want high quality products and services in the modern world. This scenario will result in an increased operational risk of a firm. companies want to devise new approaches to production and service delivery that will go round the increased operational risks. and henceforth less government control in the management of these corporations.
Element 7. Therefore this has put unprecedented pressure on corporations to suit their new environments. businesses now need to find ways and means of differentiating themselves from the rest in order to ward off the competition. Therefore in order to survive this cutthroat competition.1.3 Increase In Operational Overheads The cost structures of most businesses now exhibit a situation where most businesses have a big proportion of their costs being fixed in nature. This has resulted in formation of self-regulatory bodies. As a result corporations are being forced to better their production systems or their service delivery systems so that they deliver very high quality goods and services.1. This being the case.1. Yet other countries still.4 De-Regulation of Industries There has been a wave of privatisation of formerly state owned companies to private owners.1.
In order to achieve this goal.2 Dedicated Cell Layout The dedicated cell layout concept stipulates that for a business to increase productivity among its workforce. Following the suggestions of the concept. The concept promotes demand-pull production.1 Just-In-Time Production Systems The concept of just-in-time production was conceived by the Japanese in their relentless pursuit of excellence in the manufacturing factories.2.1. meaning that corporations should only manufacture their products when there is demand for the products. many businesses are indeed investing in non-traditional production methods that will help them achieve just that goal.2.
Element 7. it needs to arrange its production factory and factory equipment in a certain manner. The suppliers will provide high quality inputs because there will be a strong and good relationship between the supplier and the company using just-in-time.Element 7. there will be no need to hold huge stocks of raw materials as these will also only be needed when there is a production run that has been initiated by client demands. To make just-in-time production a success. companies that use the technique should endeavour to have only a few reliable suppliers to provide inputs to avoid delays and poor quality inputs.2 Production management Strategies
Element 7. The dedicated cell layout suggests that an employee’s work bench or work station should be surrounded by all the equipment and utensils which the employee needs in order to carry out his work without any need to walk long
Element 7.6 Shortened Product Life Cycles There has been a growing trend among many corporations to shorten their products’ lifecycles. This has heightened the quest to innovate the new and required techniques therefore. If there is no ready demand then there is no need to manufacture any products at all because they may end up going to waste.
Of late.4 Computer Aided Manufacturing (CAM) Computer aided manufacturing entails using computers and computer related technologies in the manufacturing process. revealing the component being designed from all aspects or angles showing all intricacies which would have otherwise been hidden.2. Further. that is. Computer aided design enables designers to easily alter or change the designs they are making of given components because the computer software has tools that can be used to make these alterations easily. A further merit of using computers in designing is that it brings the design in three dimension on the computer screen.
Element 7. as a computer has high precisions measurements embedded in it.
.distances across the factory floor. it follows then that raw materials to be fed to the production system should also be located near the production site or factory for easy of retrieval when needed for production. we have. • Accuracy is achieved at all levels of the manufacturing process.3 Computer Aided Design (CAD) Computer aided design is a modern approach to designing of components and products where complex computer software is used in their design stage. Therefore engineers will be employing computers in their design work. a practice that can waste time and reduce employee productivity. using a computer monitor and mouse to make designs on a computer screen.
Element 7. Use of computers in manufacturing brings in a pool of benefits to the companies that employ these techniques. Designing using a computer also offers high levels of accuracy in the design work being done. seen a big growth in the use of computers in manufacturing through the extensive use of robotics and computer controlled equipment in manufacturing by many automobile manufacturers like General motors and Toyota Corporation.2.
Therefore they will establish systems. in its basic terms.
Element 7. Zambia bottlers uses computer controlled machinery to fill Fanta and Coca-Cola drinks of a predetermined quantity or volume in each bottle. involves the automation of the manufacturing processes and all peripherals involved in service delivery systems. which streamline and unify all their systems.3 World Class Manufacturing Techniques Element 7.4. This means that the same equipment can be varied in order to accommodate different production settings in production runs.3. These computer controlled machinery systems have been put in place for the benefits that we discussed in element 7.3. For instance.
Element 7.1 Automated Manufacturing Technology (AMT) As the term suggests.• •
Reduces operational costs in the long-term Can easily be integrated with other key information systems within the enterprise.4 Computer Controlled Machinery Most companies have their machinery controlled by computers.3.3 Flexible Manufacturing Systems Flexible manufacturing systems are manufacturing systems that will enable a corporation to run different kinds of production runs to be made in different settings using the same machinery and factory equipment.3. So.2.2 Synchronised Manufacturing Systems Corporations with worldwide operations will need to bring uniformity in their manufacturing systems.
Element 7. the machine has been programmed to fill an exact quantity of the soft drink in each bottle. This really illustrates the application of computer-controlled machinery in practice.
the enterprises resources planning will highlight all resources including raw materials.
Element 7. storage spaces can be opened.3. hence they can easily be manipulated by use of a central computer to which the shelves and pigeonholes are connected. It helps a company to know before actual production the quantities of materials required for any given production level.5 Automated Storage And Retrieval Systems In order to ease the process of storing and retrieving raw materials. So. raw materials.7 Enterprise Resource Planning (ERP) The enterprise resource planning system is a higher version of resource planning. peripheral resources and overheads needed to meet given production levels. most companies have invested heavily in automated systems that help them in the storage and retrieval of their raw material stocks. The inbuilt shelves and pigeonholes are all computer-controlled. These automated systems provide a means by which by a computer button. The enterprise resource planning system involves planning for all resources required to successfully meet a given production level. which only looks at one resource.3.
Element 7. stocks packed and retrieved when necessary. This is a vital part of a production material budget.6.
.Element 7.6 Material Requirement Plan (MRP) Material requirement planning system is a system that enables a manufacturing company to create a bill of materials that are required to meet a given production level. man-hours required.3.3. The enterprise resources planning system considers all resources required to meet a certain production level. This is a very comprehensive resource plan because it looks at all resources unlike the MRP that has been considered in section 7.
5 Decline Stage Eventually. so the products gains stability and clients build confidence in the product or service.
Element 7. In many instances.
Element 7. price competition will reduce the profitability of each firm.
Element 7. In a static market.1 Concept of Product Life cycle The concept of product life cycle proposes that products go through a cycle or phases from the time of their introduction right up to the time of their decline.4. Traditionally. the product will become obsolete and falling sales will ensue. Therefore. sales volumes and sales revenues of the product or service increase. At this stage the product’s sales volume and hence revenues are relatively low. namely. design and production facilities establishment. the product life cycle has been split into four main stages or phases. introduction. maturity and decline stages.
Element 7. Firms seek to differentiate their services and products at this stage.4. Before this stage is reached.4.4 Maturity Stage The product will be said to have reached its maturity stage when sales demand levels off. new entrants from competitor companies may surface. the product is successfully introduced to the market and it is supported usually by an expensive advertising campaign. The product/ services falls out of favour with the clients and therefore sales from the product fall. the business should have developed a replacement product. thereby incurring further large research and development costs.2 Introduction Stage At the introduction stage of a product’s life.Element 7.4.4 Product Life Cycle Element 7.4. growth.
. at this stage.3 Growth Stage In the growth stage a product gains more support and acceptance of the clients/customers.
fewer costs are going to be incurred at this stage. it will let the product to die a natural death by not investing any further support expenditure. At maturity.4. the fixed unit costs even reduce further as the product will have stabilized. Therefore.Element 7. On the other hand if the company does not want to continue offering the product. most models must be renewed in much shorter timeframes. sometimes corporations might spend more money if they want to resuscitate the ailing product. At decline stage. but it will harvest all the revenues coming from the dying product. the time period for the product life cycle is decreasing.7 Implications of The Product Life Cycle On The Advanced Manufacturing Technology Environment In the advanced manufacturing technology (AMT) environment.
. For example. However. the product finds acceptance and less advertising or marketing is needed than what was needed to sustain the introduction stage. Vauxhall is setting up new production facilities for manufacturing a revamped Corsa in the United Kingdom. further advertising costs will be incurred in order to help the product to find acceptability in the market place. the business should have developed a replacement product. by and large. At the Growth stage.
Element 7.4. design and production facilities establishment. thereby incurring further large research and development costs. the firm will have incurred huge research and development costs. designing the product and building or re-equipping the production line Before the decline stage is reached. which ceased production in 1996. the situations vary. The unit fixed costs will decrease. the longest life cycle for a mass-produced motor car has reduced from over 4 decades for both the VW Beetle and the Morris minor to less than 25 years for the Renault.6 Cost Implications For The Product Life Cycle The costs that are going to be incurred by a corporation throughout the life of the product will vary according to stages at which the product will have reached. a very large amount of fixed costs will already have been incurred in research and development. In the AMT environments. At the introduction stage.
LIFE CYCLE COSTING
Life cycle costing involves collecting cost data for each product from inception. Thus for manufacturers. marketing and so on. Life cycle is a technique that may be used to improve management decision-making in such conditions. through its useful life and including any end-costs. whereas traditional costing methods follow costs by function e.The Corsa was launched only a few years ago. Thus the early decisions regarding product design and production methods are paramount and life cycle costing attempts to recognize this situation. production. coupled with reduced life cycle periods are a major challenge to profitability in advanced manufacturing environments.
. cash flows and marketing activities. The high fixed costs of introducing a new product. It has been recognized in the AMT environments that up to 90% of the costs incurred throughout a product life cycle will be determined before the product reached the market. This comparison will show if the expected savings from using new technology or production methods would be worthwhile. life cycle costing makes explicit the relationship between design choice and production and marketing costs. computer skills training and extra software will cost three times the cost of the PC and maintenance will cost twice the purchase cost over the life of a personal computer. These data are compared with the life cycle budgeted costs for the product.g. A recent analysis has shown that the life cycle cost of purchasing a personal computer (PC) is around six times the purchase cost. The product life cycle concept enables corporations to carry out clear strategic plans regarding the development of new products. Consumer as well as producers may use life cycle costing. The recognition of the total support required over the life of the product. research and development. The insights gained from comparing budgeted and actual life cycle costs may be used to refine future decisions.
Identify and comment on any theme that the two practices have in common.Question 1 Most companies that are operating in an advanced manufacturing environment are finding that about 90% of a product’s life cycle cost is determined by decisions made early in the cycle. (7 marks)
. Required (a) Explain the nature of the product life cycle concept and its impact on businesses operating in an advanced manufacturing environment. (10 marks) (b) Explain life cycle costing and state what distinguishes it from more traditional management accounting practices (8 marks) (c) Compare and Contrast life cycle budgeting with activity based management. Management accounting systems should therefore be developed that aid the planning and control of product life cycle costs and monitor spending at the early stages of the life cycle.
it will only achieve a relatively low sales volume.Suggested Solution to Question 1 (a) The product life cycle (PLC) is shown in the diagram below. supported by an expensive advertising campaign. Firms seek to differentiate their product at this stage.
Illustration of product life cycle
Time When a product is first introduced successfully to the market. designing the product and building or re-equipping the production facilities. In a static market. a large amount of fixed costs will already have been incurred in research and development. The product is said to be mature when sales demand levels off. In an advanced manufacturing technology environment. In the growth stage. price competition will reduce the profitability of each firm. This is the most profitable stage of the product life cycle traditionally. sales increase and unit costs fall as the high fixed cost per unit decrease although new entrants may start to compete at this stage.
through its useful life and including any end costs. Research and development costs. production. thereby incurring further large fixed costs for Research and development. At this stage. the firm must have developed a replacement product.g. Staff training and extra software will cost three times the cost of the personal computer and maintenance will cost twice the purchase cost over the life of the personal computer. life cycle costing makes explicit the relationship between design. design and new production facilities. the time period for the product life cycle is decreasing for most products such as automobiles (motor vehicles).Eventually. Before the stage is reached. This is the decline phase of the product life cycle. This comparison will show if the expected savings from using new technology or production methods are worthwhile or not. the product will become obsolete and falling sales will ensue. marketing and so on. The high fixed cost of introducing a new product coupled with reduced life cycle periods is a major challenge to profitability in AMT
. Thus for manufacturers. These data are compared with the life cycle budgeted cost for the product. whereas traditional costing methods follow costs by function e. firms will begin to pull out of the market or focus on promotional marketing strategies and reducing selling prices. A recent analysis has shown that the life cycle cost of purchasing a personal computer is around six times the purchase cost. It has been observed over the years that in the advanced manufacturing environment. It has been recognised in the AMT environments that up to 90% of the costs incurred throughout a product life cycle will be determined before the product reaches the market. Thus the early decisions regarding product design and production methods are paramount and life cycle costing attempts to recognise this situation. (b) Life cycle Costing (LCC) involves collecting cost data for each product from inception. Both consumers and manufacturers of commodities may use life cycle costing. The recognition of the total support required over the life of the product. choice and production and marketing costs. The insights gained from comparing budgeted and actual life cycle costs may be used to refine future decisions.
(c) Activity based management (ABM) uses the understanding of cost drivers formed from activity based costing (ABC) to make more informed decisions. Activity based management (ABM) aims to improve performance by: • • • • Eliminating waste Minimising cost driver Emulating best practise Considering how the use of resources supports both operational and strategic decisions
Thus. In particular. Results of activity of activity based management in an AMT environment include: • • • • Increased production efficiency Reduced production costs Increased throughput Increased quality assurance
These gains may be realised by: • • Simplified product design More use of common sub-assembles
. this approach yields a better understanding of overhead costs in AMT environments compared to traditional absorption methods.environments. Life cycle costing is a technique that may be used to improve management decision-making in such conditions. activity based management seeks to consider all activities performed by the organisation in order to serve a customer or produce a product.
• • •
Reduced set up times Reduced material handling Better use of the workforce e.g. Multi-Skilling
Therefore activity-based management is very similar to life cycle costing in the following aspects: • • Both attempt to increase management understanding of overhead costs Both consider how the use of resources supports strategic decisions, that is, both look at how resources inputs are used to obtain the organisational output.
In an AMT environment both methods focus management attention on the need to produce simplified product using common components and common sub-assemblies and to maximise the output from expensive capital investments. Life cycle costing leads to major review at the major stages in a product life cycle, whereas activity based management is a continuous system that strives to drive down both short term and long-term costs.
Question 2 Mode ltd is a company that manufactures mobile phones. This market is extremely volatile and competitive. Achieving adequate product profitability is extremely important. Mode is a mature company that has been producing electronic equipment for many years and has all the costing systems in place that one would expect in such a company. These include a comprehensive overhead absorption system, annual budgets and monthly variance reports and the balanced scorecard for performance measurement. The company is considering introducing: (1) Target Costing: and (2) Life Cycle Costing systems
Required: Discuss the advantages that this specific company is likely to gain from these two systems. (20 marks)
Suggested Solution to Question 2 The modern business environment tends to be an unstable one and is rapidly changing in terms of customer requirements, economic factors, technology and so on. Mode is in a particular unstable business because technology is changing rapidly as digital telephones takeover and text messaging develops. Both target costing and life cycle costing are systems that should help the company cope with this. These systems will help Mode ltd to compete in terms of cost and product development in the competitive telecommunications market. The specific advantages of the two systems are as follows. 1 Target Costing Target costing may replace and is often compared to traditional standard costing/ variance analysis, which has long been in place in the manufacturing world. Mode ltd may wish to replace standard costing/ variance analysis with target costing for control and reduction for the following reasons: • It puts pressure on costs. It can be used as a cost reduction technique unlike standard costing and can incorporate a learning effect. This is likely to be important in the manufacture of phones. Traditional standards may be too rigid for cost control and reduction purposes for a company such as Mode ltd as they usually need to be set for a year at a time. Target costing is more flexible and targets can change/reduce from month to month
It considers the market and price customers are prepared to pay, so it forces an organisation to be outward rather than inward looking. Mode ltd needs to consider the final customer as well as the system supplier. It should motivate staff if used correctly and help break down any artificial functional barriers as it involves staff at all levels and in most functions and forces them to communicate. It leads towards the use of other techniques, such as value analysis and value engineering, which should simplify production methods and reduce costs. This is particularly important in an industry with short product life cycles.
(2) Life Cycle Costing The life cycle of Mode ltd’s products is likely to be short because of changing technology; therefore, it is imperative that the products begin to generate profits quickly. Estimating life cycle costs and revenues will highlight the following: • • Research and development costs are likely to be quite high and must be recovered in a short period. Many of Mode ltd’s costs are likely to be “locked in” during the design stage, say 84% to 94%. So it is important to control costs initially in order to maximise the profit over the product’s life It focuses on time as well as money. Time to market is often a key factor in generating profit. It is more important to measure time than money/ cost. It may be vital for Mode ltd to bring new products to market quickly and on time in order to achieve a profit. Monitoring of costs and benefits over the life cycle helps to stop a project early if events have changed or not turned out as planned. It presents a different perspective that could be advantageous to Mode ltd, as it is not tied to period reporting.
Because of the above, it would be advantageous for the company to adopt both of these techniques.
STUDY UNIT 8.0 Advanced Variance Analysis
Learning Outcomes After reading this chapter candidates should be able to • • • • • • • • Reconcile budgeted and actual profits through use of variance analysis Calculate and interpret variances and yield variance Calculate and interpret fixed production overhead variances Calculate and interpret planning and operational variances Appreciate principal sources of variances Appreciate and use rule of thumb investigation model Use statistical models in investigation Establish relationship of variances
Brought Forward Knowledge At this point in your studies, you should know and appreciate how to calculate basic variances. The main categories of these basic variances are: Price (a) Material variances Usage (b) Labour variances Idle time Efficiency Rate Variable overhead efficiency variances Variable overhead expenditure variance Fixed production overhead expenditure Fixed production volume
Candidates must be able to make reconciliations of budgeted and actual profits in any given control period using the variances mentioned above. Working backwards is another area that candidates must demonstrate strong knowledge of:
Example 1: A company has the following standards for a mix to produce 500kg of product K: Input A B Kg 200 400 600 Cost/Kg K 1,000 1,600 Total cost of mix K 200,000 640,000 840,000
. . . 600kg of input should produce 500kgs of K at a standard cost of
K1,689/kg. K1,680/kg = K840,000 500kg In a particular period, the actual results of the process were as follows: Actual input A B kg 300 300 Actual cost/kg K 1,000 1,600 Total actual cost K 300,000 480,000
Actual output of K was 400 kg. Please note that in the above shown data, there is no direct material price variance, as the actual cost per kilogramme of inputs A and B was the standard cost in each case. The whole of the direct material variance is thus due to changes in the usage thereof. The total variance is the difference between the standard cost of the output of 400kg of K (400 x K1,680 = K672,000) and the output cost of K780,000. This gives an adverse direct material usage variance of K108,000. The direct material mix variance is defined as: “Where substitutes within the mix of materials input to a process are possible, the mix variance measures the cost of any variation from the standard mix. The variance for each input, is based on :” (a) The change in its weighting within the overall mix,
(b) Whether its unit standard cost is greater or less than the standard weighted average cost of all natural inputs, which is a subdivision of the direct material usage variance. Therefore, the mix variance is calculated using the formula Direct material mix variance: Total material X Input in a standard mix prices standard Actual material X prices
The standard price per kilogramme of the standard input mix is K840,000 ________ 600 kg = K1,400
Applying the formula above, the mix variance is then: (600 x K1,400) – [(300 x K1,000) + (300 x K1,600)] K840,000 – K780,000 = K60,000 (F) The mix yield is favourable as we have used less mixture of material than the standard proportion/mix
Element 8.1 MIX VARIANCE Element 8.1.1 When a product requires two or more raw materials in it’s make up it I often possible to sub-analyse the materials usage variance into materials mix and materials yield variances. Element 8.1.2 Adding a greater proportion of one material (therefore a smaller proportion of a different material) might make the materials mix cheaper or more expensive. For example, the standard mix materials for a product might consist of the following: Mix (2/3) 2 Kg of material A @ K 1,000 per Kg (1/3) 1 Kg of material B @ K 500 per Kg K 2000 500 2500
It may be possible to change the mix so that one kilogram of material A is used and two kilograms of material B. The mix would be cheaper. Mix (1/3) 1 Kg of material A @ K 1,000 per Kg (2/3) 2 Kg of material B @ K 500 per Kg K 1000 1000 2000
Element 8.1.3 By changing the proportions in the mix, the efficiency of the combined material usage may change. In our example, in making the proportions of A and B cheaper, at 1:2, the product may now require more than three kilograms of input for it’s manufacture, and the new materials requirement per unit of product might be 3.6 kilograms. Mix (1/3) 1.2 Kg of material A @ K 1,000 per Kg (2/3) 2.4 Kg of material B @ K 500 per Kg K 1200 1200 2400
In establishing a materials usage standard, management may therefore have to balance the cost of a particular mix of materials with the efficiency of the yield of the mix. Once the standard has been established it may be possible to exercise control over the mix. Element 8.1.4 Calculating the variances A) The mix variance for each material input is based on the following: a) The change in the materials weighing within the overall mix b) Whether the materials unit standard cost is greater or less than the standard weighted average cost of all the materials input. B) When to calculate the mix and yield variances. Mix and yield variances have no meaning and should never be calculated unless they are a guide to control action. They are only appropriate in the following situations: a) Where proportions of materials in the mix are changeable and controllable. If the mix is different in units, say, kilograms and litres, they are obviously completely different and can not be substituted for each other.
000 (F) Total usage variance K 10. 80 units of Mbeba Killer were produced from 500 Kg of Miseshi and 730 Kg of Bondwe. Required Calculate the materials usage. mix and the yield variances. For example.000 15 Kg In a particular period.000 Bondwe 10 Kg @ K 3000 per Kg 30. It would be totally inappropriate to calculate a mix variance where the materials in the “mix” are discrete items. Element 8.1. stuffing and glue.000 (F)
.000 40. Element 8. The usage of each material must be controlled separately.b) Where the usage variance of individual materials is of limited value because of the variability of the mix.6 Example A company manufactures a chemical used for eradicating rats called “Mbeba Killer”. The standard materials used and cost of one unit of Mbeba Killer are as follows: K Miseshi 5 Kg @ K 2000 per Kg 10. a chair might consist of wood.000 (A) K 210.5 Formula for the materials mix variance: (Actual quantity in standard mix proportions – Actual quantity used) * Standard price
Element 8.1.7 SOLUTION a) Usage variance Miseshi Bondwe 80 units of Mbeba Killer should have used 400 Kg 800Kg but did use 500 Kg 730 Kg Usage variance (Kg) 100 Kg (A) 70 Kg (F) * Standard cost per Kg * K 2000 * K 3000 Usage variance in K K 200. using two compounds Miseshi and Bondwe. These materials are separate components and it would not be possible to think in terms of controlling the proportions of each material in the final product.1. covering material.
230 Kg = 410 Kg Bondwe 2.000 1.230 Kg = 820 Kg 1230 Kg Actual proportions Miseshi Bondwe Total Input should have been 410 Kg 820 Kg 1230 Kg But was 500 Kg 730 Kg 1230 Kg Variance in Kg 90 Kg (A) 90 Kg (F) * Standard price * K 2000 *K 3000 Variance in K K 180. The favourable total variance is due to the greater use in the mix of the cheaper material.000 (A) K 270. c) YIELD VARIANCE Each unit of output “Mbeba Killer” requires 5 Kg of Miseshi = K 10.The total usage variance can be analysed into mix and yield variances.230 kg Should have yielded (15 Kg) But did yield Yield variance in units * Standard cost per unit of output Yield variance in K 82 units of MK 80 units of MK 2 units (A) * K 40.000 (F) The total difference or mix variance in Kgs must always be zero as the mix variance measures the change in the relative proportions of the atual total input.000 (F) K90.2 Yield Variance
. b) Mix variance Actual input = (500 + 730) Kg = 1.000 (A)
The address yield variance is due to the output from the input being less than standard.
. Miseshi 1/3 * 1.
Element 8. Miseshi.230 Kg Actual usage in standard proportions.000 and 10 Kg of Bondwe = K 30./3 * 1.000 K 80.
000 = K168. it is a subdivision of the direct material usage variance.400] – [(600) x K1.
Actual quantity of Input Cost of Actual Actual quantity Cost of Column Standard Input Cost at Input at Standard Input at standard at standard quantity for actual output Mix actual output standard Column 3 200 400 Column 4 K200.400] = 120 x K1. a tabular representation could also be used as an alternative presentation.000 – K780.000
Remember that: Figures in columns 3 and 4 can only be calculated only after the other columns have been completed.000 Column 5 160 320 Column 6 K160.000 K512.000 Adverse Again.
Calculation of Material Yield Variance
(Standard quantity of materials specified for actual production X standard prices) (Actual total material input in standard proportions X standard prices)
Using the formula above.000 = K60.000 (A)
. Total Column 4 – Total Column 2 = K840.000 – K840.400 = K168.000 K640.000 (F) Direct material Yield variance – Total Column 4 = K672.000
Column 1 Column 2 300 300 K300. the yield variance is: [(400 x 6/5) x K1. Direct material mix variance.000 K480.Direct material yield variance is defined as the measures of the effect on cost of any difference between the actual material usage and that justified by the output produced.
In both cases. The total labour input associated with production of one unit is 10 (ten) hours at an average hourly rate of K12. Mix Labour Variances The same logic applied to the calculation of material mix and yield variances can be used or applied to labour cost mix & yield variances as well.000 adverse. The direct material mix and yield variances must be interpreted into core.
. which in the absence of a direct material price variance.e. as there is a very strong interrelationship between them. is equal to the total direct material variance. then this alternative would have been selected as the standard. If some other combinations of inputs could produce a lower cost output without detriment to quality.000 i.000 per hour.000/hour x 6 hours)] = K120. Any change in the input mix must therefore be expected to have an impact on the yield from the process. 6 hours of unskilled labour at K10. We can demonstrate this by use of a simplistic example below: Example: KANSO Plc produces product 5. as well as on the price of the input mix. The standard labour cost of one unit is [(K15.000 x 4 hours) + (K10. the sum of the direct material mix variance and the direct material yield variance can be seen to be K108. It is highly unlikely that any meaningful control can be exercised over the output from a process independent of the input to it.000 per hour. it is clear that such a mix will represent the combination of inputs which provides an acceptable quality of output at the least possible. The standard labour input associated with the production of one unit is as follows: 4 hours of skilled labour paid at K15. When different classes of labour are engaged then the labour efficiency variance can be split into mix and yield components.000. and thus the two variances should be considered simultaneously. If we consider the concept of a standard mix.
Compute labour cost variance This is the difference between the standard labour cost of producing 25 units and the actual labour costs incurred. *40% = 4 hours x 100% 10 hours (total) = 40% *60% = 6 hours 10 hours = 60% Labour Yield Variances During period 4 the following performance level was achieved: 25 units were produced 95 hours of skilled labour was used 175 hours of unskilled labour are used.000. analyse the labour efficiency variance into labour mix and labour yield components. K Actual labour cost incurred 3.000) 3.500 in wages was paid. In addition.K120.500 Standard labour cost of 25 units (25 x K120. Stage 1: .000 x 100%
It can also be established that the standard labour mix is 40 per cent skilled and 60 percent unskilled. Required: Compute the labour cost variance and analyse this into labour rate and labour efficiency component variances. K3.000 10 hours
Labour Yield Variance
270 hours of work should yield: (270 hours ÷ 10 hours/unit) But did yield In money terms: 2 units x standard cost per unit (K120.000 K10.000 (A) Yield variance = K240. = = 27 units 25 units 2 units (A)
Analysis and Interpretation: 272
.000 (A) K 65. The labour efficiency variance is the standard hours required for output achieved – actual hours Stage 3: Labour mix variance For 270 hours actually worked: Grade Actual Hours
Skilled 95 (40%) Unskilled 175 (60%) 270
Standard Mix variance Standard Mix Mix of hours Hours rate per hour Variance
108 162 270 13 (F) 13 (A) K15.000 (A)
Stage 2: .Labour cost variance
________ 267.000 (Adverse).Calculation of labour rate and labour efficiency variances The labour rate variance is the difference between the actual hours worked x standard rate and the actual wages paid.000 K195.000 (F) K130.000) = K240.
Less 5% at 8 hours: 8hours – 0.60 hours 100 hours – 95 standard hours = 5 hours .4hours = 7. 982.The analysis carried out above. 000 K4. in stage 3 indicates that a cost advantage has been attained by substituting unskilled labour for skilled labour in the production process. . Labour Grade A B # of employees in each team 5 3 Hourly labour rate K6. The standard composition of each team is five grade A employees paid at K6. 000 = = Total cost per group per hour K30. Output is measured in standard hours and expected output is 95 standard hours for 100 hours worked in total. Suggested solutions: Preliminary work (calculation) Calculation of standard rate per hour of output.000. However. .280 standard hours of output were produced using 1. 750. 000 K42. During the last period. 2. Nkungu Ltd uses two (2) grades of labour that work together to produce product E.000 and 852 hours of grade B labour costing K2. 5hours
. the advantage has been more than offset by a cost disadvantage coming from the diminished efficiency of the entire workforce. 000 per hour and three (3) grade B employees are paid at K4.500 hours of grade A labour costing K9. 000 per hour. the mix and yield labour variances.
Required: Calculate the labour efficiency variance. 000 K12.
95 x ⅜) But did take ________ Efficiency variance in hours. Standard mix of actual input Hours
.500 Take an input of (2280 ÷ 0. the Labour mix variance (team composition variance) and the labour yield (team productively varies).500 _________ 900 552 (48 hrs F)
2280 standard Hours Hours of output should K1. 526.6 hours
Direct labour efficiency variance: Grade A Grade B Hours (2280 ÷ 0.000/hr -K192.30 per standard hour 7.100 hours = 5% .000/hr ___________
x K 4. 000 = K5.000 (F)
Now we can further analyze the labour efficiency variances to its two subsidiary i. 352 hours. X standard Rate per hour ___________
x K6.95 x ⅜) K1. the standard rate per hour of output is = K42.e. . (i) Labour Mix Variance Total actual hours = 1. 500 hrs + 852 = 2. .
470 882 ______ 2. 000 (F)__
Standard hours hour to perform audit
Rate per K
Standard cost of audit
. 526◦30 _____________ K 252.0
________ 45◦6 standard K 5. 000 (F)
(ii) Labour yield variance (team productivity) 2352 hours of work should have produced x (0.95) standard hours But did produce standard hors team productivity variance in hours hours (F) x standard rate standard hour labour yield variance Try the following exercise RPP consultancy has established the following standard composition of a team of its staff performing the year and audit as follows. 000 ________ K120. 2. 352 hrs ⅜ x 2.500 hrs 30 hrs (A) x K 6. 000/hrs __________ K180.Grade A: Grade B:
⅝ x 2.000 (A)
Grade B 882 hrs 852 hrs 30 hrs (F) K 4. 352 hrs
1.470 hrs 1. 2. 234.40 280. 352
Grade A Mix should have been but was X standard rate per hour 1.
000 __________ 36.000
13. they should demonstrate full knowledge on how to work out capacity ratios.500.500. 3) The labour mix variance.000 50.000 20. 1) The labour efficiency. 2) The labour yield variance. 000
A year-end audit has not been completed for KWAZI breweries and the hours recorded in respect of each grade of staff are as follows:
Actual hours to perform the audit Audit Manager Junior Auditor Audit clerks 27 125 58 210
Required: Calculate the following labour variance for the KWAZI year end audit.000 2.
Capacity Ratios At this point in time we would want to remind candidates that at this level.Audit manager Junior Auditor Auditor clerk
30 120 50 ___ 200
.000 170.400. We are only going to highlight the three main ratios to be appreciated here. 400.
1. taking into account budgeted sales. 2. Full capacity The output (expressed in standard hours) that could be achieved if sales orders. Budgeted capacity The standard hours planned for a period.
3. workforce availability and efficiency expected. A standard hour is a useful way of measuring output when a number of dissimilar products are manufactured. A standard hour or minute is the amount of work achievable at standard efficiency levels. in an hour or minute. supplies. Practical capacity Full capacity less an allowance for known unavailable volume losses. supplies and workforce were available for all installed work places. Example: A corporation has the following information: Full capacity standard hours Practical capacity standard hours Budgeted capacity standard hours (Budgeted input hours 90. at 90% efficiency) Actual input hours Standard hours produced From the information above.budget capacity capacity ________________ x 100% Practical capacity 100 95 81 85 68
. it can be seen that the (i) Idle capacity = Practical .
= 95 – 81 _______ x 100% 95 = 15% This means that the budgeted activity level would not utilize 15% of the practical capacity. compared to a budget of 90% efficiency. This ratio may be measured in either direct labour or machine hours as appropriate.
(ii) Production volume ratio = Standard hours produced ___________________ X 100% Budgeted capacity 68_ x 100% = 84% 81 This means that actual output achieved amounted to only 84% of the budgeted output: Efficiency ratio = = Standard hours produced x100% Actual hours 68 x 100% = 80% 85
This means that an 80% efficiency level was achieved.
3. It is therefore the difference between actual fixed overheads and allowed or budgeted fixed overheads. The fixed overhead total variance is made up of fixed overhead expenditure variance and the fixed overhead volume variance.1
Element 8.3.2 Fixed overhead total variance This is the difference between the standard cost of fixed overhead absorbed in the production achieved.
FIXED OVERHEAD VARIANCES Fixed overhead variance and variable overhead variance are defined in the same manner as over head variance as they represent the difference between the standard specified and the actual incurred. and the fixed overhead attributed and charged for that period. Fixed overhead variances are a product of the overhead absorption process. the fixed express incurred and the volume of production obtained. Further more.Element 8.3.4 Fixed overhead volume variance This is the part of the fixed production overhead variance which I the difference between the standard cost absorbed in the production achieved and the budget cost allowance for the period. This
. Fixed overhead variance depends on two i.
Element 8. It is also important to note that overhead rates are calculated from estimates of expenditure and activity levels.3 Fixed overhead expenditure variance This is the difference between the budget cost allowance for production for a specified period and the actual expenditure charged for that period. Types of fixed overhead variances:
Element 8. The volume of product is in turn dependant upon the capacity the factory works. it’s common for overhead absorption to be based on labour hours and therefore any variation in labour efficiency will directly affect the overhead variance. It is worth noting that the volume variance is due to the actual volume of production differing from the planned volume.e.
difference in the planned volume of production can be due to the hour worked being less or more than planned (capacity) or labour efficiency being less or more than planned (efficiency).3.3. Element 8.740.
Element 8.6 Fixed overhead efficiency variance This is the difference between the standard cost absorbed in the production achieved and the actual direct labour hours worked valued at the standard hourly absorption rate.
Fixed overhead total variance SC – AC
Expenditure Variance BFO – AFO
Volume Variance (AP – BP) * SR
Capacity Variance (AH – BH) * SR
Efficiency Variance (SH – AH) * SR
.3.5 Fixed overheads efficiency variance This is the difference between the budget cost allowance and the actual labour hours worked valued at the standard hourly absorption rate.7 Example The following data relates to PJ Ltd: October budgeted activities: Direct labour hours Standard hours of production Fixed overheads
16 400 hours 16 400 hours K 5.
400 hrs) * K 350 = 650 hrs * K 350 = K 227.000 (F)
.050.500 (A) Fixed overhead capacity variance (Actual hours – Budgeted hours) * Standard rate = (15.000
Element 8.750 hrs – 16.3.150 hrs – 15. 500 (A) Fixed overhead expenditure Budgeted fixed overheads – Actual fixed overheads = K 5.500 (A) Fixed overhead efficiency variance (Standard hours – Actual hours) * Standard rate = (16.050.150 hours K 6.000 (A) Fixed overhead volume variance (Actual Standard hours – Budgeted Standard fours) * Standard rate = (16 150 hrs – 16 400 hrs) * K350 = K 87.The actual results were as follows: Actual direct labour hours Standard hours produced Fixed overheads
15.740.8 SOLUTION Fixed overhead absorption rate = K 5 740 000 16 400 = K 350/hour
Fixed overhead total variance Standard cost – Actual cost = ( 16 150 * K 350 ) – K 6 050 000 = 5 652 500 – 6 050 000 = K 399.000 = K 310.750 hours 16.750 hrs) * K 350 = 400hrs * K 350 = K 140.000 – K 6.
000hrs Volume ratio = 17 000 * 100 18 000 = 94% Capacity ratio = 16 000 * 100 18 000 = 89% Efficiency ratio = 17 000 * 100 16 000 = 106%
Note: Further analysis can be done on the volume. These control ratios provide more relevant information than the variance measures as they are able to highlight important aspects of the organisation’s operations.10 Example: Calculate the volume.3. The ratios which can be calculated are: Volume ratio = Standard labour produced *100 Budgeted labour hours Capacity ratio = Actual labour hours * 100 Budgeted labour hours Efficiency ratio = Standard hours produced *100 Actual labour hours
Element 8.000 hrs Labour hours 16. capacity and efficiency ratios from the data below: Budgeted: Actual Results: Labour hours 18.Element 8.3.000 hrs Standard hours 17. efficiency and capacity variances using control ratios.000hrs Standard hours 18.
Example: LUNA Co. we will be looking at sale variances.000/unit 81.000/unit K23.000/units K24.000/unit K6.4 Sales Variances At this point of our studies. of which the main two variances are the selling price variances and the sales volume variance. manufactures a single product. An illustration below can well explain the application of the sales variances.Element 8.000/unit
.400 units K57.000/unit K4. Budget and actual data for the latest pencil is as follows: Budget Sales and production volume Standard selling price Standard variation cost Standard fixed cost The actual results were as follows: Sales & production volume Actual selling price Actual variable costs Actual fixed cost Using the above data Calculate the (i) Selling price variance (ii) Sales volume (profit) variance (i) Selling price variance = Budgeted x Standard profit -Actual sales x std sales units profit per unit units profit per unit 82.600 units K59.
Sales Volume Variance This variance calculates the profit differences which is caused by selling a different quantity from that budgeted.000 – K24.600 82. if the selling price and the cost per unit had been equal to the standards. Units Budgeted sales volume Actual sales volume *Standard profit per Unit (K59.e.5 Planning Variances
.000 K 2.400) Selling price variance
K59.000) = K31.400 800 (favourable)
The favourable variance shows that the increased sales volume could have increased profit by K24.800.800.000 K57.000 i.000 (F) 81.000 – K4.000 Sales volume variance K24.000 (Adverse)
The adverse variance shows that the actual selling price was lower than the standard price. It is important to note that the sales volume variance is expressed in terms of the standard profit lost or gained as a result of change in the sales volume.Selling price per unit should have been But was Actually Units sold (82.
Element 8.000 (Adverse)
ii. Planning variances may arise from faulty standard – setting.000/hr) actual production of 1.000 unit of the NSELE took 12. A planning variance can also be referred to as a revision variance.
Required: Calculate the: i.5.000 (8 hours x K5. it cannot be held responsible for them.e K48. but the responsibility for this lies with senior rather than operational management.400 hours at a cost of K47.600. and there is no other benefit to be gained in spending time investigating such variances at an operational level.CHISWE Ltd estimates that the standard direct labour cost for NSELE. As planning variances are self-evident not under the control of operational management.
Element 8. Analysis and Comments Management will wish to draw a distinction between those two variances in order to gain a realistic measure of operational efficiency. its only product should be K40. in retrospect. 000.Some variances can arise from changes in factors internal to the business and may therefore be referred to as planning variances. i.000 units should take at 12 hrs/unit but did take 12. it is realized that the standard cost should have been 12 hours x K4.000 per hour.1 Definition of Planning Variances A classification of variances caused by ----.budget allowances being changed to a post basis. 400 400 hours (A)
. Planning variance Operational variance
Solution: (c) Operational variance Hours 1.000 per unit. 000 12.
IMPORTANCE OF PLANNING AND OPERATIONAL VARIANCES
Advantages of a system of planning and operational 1.00 (A)
12.000/hour 1. 2. 000 8. which are controllable and those. 000.600. 000. 000/hr Original standard cost of 1. 000. 000. 000 (F) K 47. 600. 000 (F)) = 400. 000/hr But did cost
49. 000 Total operation variance (K1. which are non-controllable. 000) = 48. Manager’s acceptance of the variances for performance measurement. 000 units x 8 hours x K5. 000/hr 48. 000 units x 12hrs x K4. 000 40. 000. and their motivation.
. 000 (F)
(b)Planning Variance K Revised standard cost 1. 600. The planning and standard setting process should improve. standards should be more accurate. The analysis highlights those variances.x revised standard cost per hour
K4. 600. 000
= 47. 000
Check Actual costs
Received standard cost (100 x K48. 600. relevant and appropriate.000. is likely to increase if they know they will not be held responsible for poor planning and faulty standard setting. 000 2. 000. 3. 000 (A) + K2. 400 hours should cost @ K4.
LIMITATIONS OF PLANNING AND OPERATIONAL VARIANCE
1. Even though the intention is to provide more meaningful information managers may be resistant to the very idea of variances and refuse to see the virtues of the approach. Operational variances will provide a fairer’ reflection of actual performance.
. 3.4. Careful presentation and explanation will be required until managers are used to the concepts. 2. Establishing realistic revised standards and analyzing the total variance into planning and operational variances can be a time consuming task even if a spreadsheet package is devised. It is many times difficult to decide in hindsight what the realistic standard should have been.
1 Throughput Accounting Introduction The CIMA Official Terminology defines ‘throughput’ as: ‘The rate of production of a defined process over a stated period of time. The aim of throughput accounting is to maximise this measure of throughput. or other meaningful measurements (CAM-I)’. The principle behind throughput accounting is that all costs other than material are effectively fixed. The focus of throughput: As the equation shows. throughput is dependent on four elements:
. or costs which would normally be split into fixed and variable elements. even those costs which are seen as variable in the traditional sense. Rates may be expressed in terms of units of products. The direct material cost referred to in the above definition relates to all material purchased during a particular period. are treated as entirely fixed. batches produced.STUDT UNIT 9. The term ‘throughput’ is defined by Goldratt and Cox (1989) by means of the following equation: Throughput = sales revenue less direct material cost.0 MODERN MANAGEMENT ACCOUNTING TECHNIQUES
Learning Outcomes After studying this chapter candidates should be able to • • • • Appreciate the various developments in the modern manufacturing scenario Demonstrate strong knowledge of throughput accounting Discuss target costing To show understanding of life cycle costing
Element 9. turnover. and not simply to material used.
Some of the constraints may be interrelated: a poor reputation for meeting delivery dates could be associated with inadequate production resources. In throughput accounting. in order to alleviate a resource constraint and therefore increase the speed of throughput. which in turn may be related to the signals generated by the management accounting system. inappropriate management accounting system. if a company operates a traditional standard costing system. The throughput approach is therefore in sympathy with the JIT approach. it would expect to see an increase in its sales volume. and the value of the sales feeds through into sales revenue in the throughput equation. work-in-progress or finished goods increases direct material cost. but does not increase throughput. will result in an adverse direct labour efficiency variance being reported. Poor physical distribution system. Throughput is only increased when finished goods are sold. particularly between 1. organisational and production – which are preventing the company from expanding at the present time?’ These factors might include: (i) (ii) (iii) (iv) (v) (vi) Inadequately trained sales force. so that goods can be completed to satisfy a customer’s rush order. 2and 4. Unreliability of material suppliers. it is recognized that it may sometimes be necessary to maintain stock.1) 2) 3) 4)
unit selling price . Poor reputation for meeting delivery dates. inadequate production resources. Material held in raw material. It asks: ‘what are the factors – market. Usage of direct materials
A focus on throughput necessarily focuses management attention on these four areas. Constraints on throughput The idea of ‘constraint’ is central to the throughput approach. There are strong interrelationship between the above four items. and might also see an increase in the speed of use of raw materials. purchase of usage of direct material.
Once the constraints have been identified. However. particularly when the new sales are satisfied from stock. if the interruption in work requires the machine to be stopped and reset
. management attention and action can be focused on alleviating them. interrupting the production schedule of a particular work station. For example. delivery and/or quality. if faced with a downward sloping demand curve. sales volume. the throughput approach does not go as far as the JIT philosophy in its attitude to stock. If a company were to reduce its selling price.
The throughput approach is dedicated to the identification and subsequent elimination of bottleneck resources. – is to enable production to take place in a complete balanced manner.
. If reorganization of existing resources cannot get rid of a bottleneck. a philosophy which traditional accounting systems have tended to encourage. However. Where elimination is not possible. and alternatives such as buying in particular components are not available or are rejected. This can sometimes be done with existing resources: it may be possible. to modify other machinery in such a way that it can perform the operations of the bottleneck resource. The throughput may thus lead to a better allocation of capital investment funds than would be possible under traditional system. JIT etc. in order to avoid the output of machine A simply becoming work-in-progress. it would make more sense in terms of the overall efficiency of the facility if machine A were to limit its production to the capacity of machine B. However. The ultimate aim of many modern manufacturing approaches – CIM. A reassessment of the measures traditionally employed to record the efficiency of surrounding resources may sometimes be required. Bottleneck resources Throughput accounting is most associated with the management of production resources. the almost invariable result of this is simply to move the bottlenecks to some other part of the plant. and machine B is a bottleneck resource. it is the aim of the throughput approach to eliminate it. once a bottleneck has been identified. This means that there are no constraints – known as bottleneck resources – within a factory. and thereby eliminate the problem.to meet this rush demand. a company must consider investing in new equipment in order to alleviate it. so that productive resources are an exact match for the demand placed upon them. despite the signal sent out from the accounting system. the throughput approach recognizes that this will rarely be the case when there is a healthy demand for the changes in demand by the consumer. which would increase neither the throughput of the organisation nor its profit. A stoppage of this kind is not necessarily undesirable. if the output of machine A becomes the input to machine B. For example. but it needs to be noted that such a stoppage would always be discouraged if efficiency variances were based on keeping 100 per cent utilization of particular resources. it seeks to ensure that bottleneck resources are utilized for 100 per cent of their availability. As noted above. and management’s attention would then have to focus on the elimination of this second constraint. for example.
Throughput measures The role of the accountant in a throughput environment is to devise measures which will. help production staff to achieve greater throughput volume. The behavioural impact of this definition is to encourage managers to minimize stockholdings. throughput is an approach to managing a business and management should select the measure which is most appropriate to the particular circumstances. However. rather than another technique which simply reports on the status quo. if an attempt is being made to integrate throughput measure with traditional accounting systems. it will readily be appreciated that dividing this figure by total production time available results in a rate per throughput hour dramatically in excess of the cost of operating the bottleneck machine as measured by traditional accounting methods. Attention should be drawn to the financial effects of bottlenecks. As noted earlier. an aim frequently found in modern manufacturing environments and one referred to throughout this chapter. However. A throughput report that deals with direct material in a manner which is consistent with traditional accounting measures is shown below: Throughput report Sales Direct material cost of sales Throughput Direct labour Production overhead Administration costs Selling expenses Operating profit x (x) x (x) (x) (x) (x) (x) x
. the measure of throughput would obviously need to be modified to reflect the more traditional approach. if a particular machine which is a bottleneck resource fails to operate for one single hour as a whole. Consistency between throughput as so far defined and traditional financial reporting The reader will have noted that ‘direct material cost’ in the definition of ‘throughput’ given earlier related to the cost of material purchased in a period. thus highlighting the problem. the authors wish to point out that a debate as to which is the right measure of throughput is sterile. For example. rather than the cost of the material actually used.The throughput approach should therefore be viewed as a search for continuous improvement.
it has been conventional to look at the contribution – selling price less direct costs and variables production overheads – and to give priority to producing those items which show the highest contribution per unit. direct material costs are associated with raw materials. any change in the mix of products demanded by customers can
. this measure is often used as the basis for encouraging salesmen to push particular products. Horngren et al(1997) refer to throughput accounting as an example of ‘super. It must be stressed that such product ranking are relevant for short-term production scheduling only. In this second ‘version’ of throughput accounting. product A.(the reader will note that the ‘throughput’ in this report is an absolute measure in financial terms.e. will receive the same treatment under both throughput accounting and traditional systems). so that the ranking can be expected to change –possibly very quickly – over period of time. and their use should not be extrapolated to determine longer term sales effort. work-in-progress. we should note. as indicated above. the throughput approach is simply employing the common short term decision – making technique of maximizing contribution per limiting factor. In throughput accounting. ‘throughput’ emphasises flow in the management of the production process. the attractiveness of particular products is related to their consumption of bottleneck resources. The production scheduling process would result in priority being given to those products which were best able to generate throughput. In a throughput environment. Indeed. to be expensed in the period in which they are incurred and are thus treated in exactly the same way as selling. distribution and administrative costs (which. both ‘versions’ of throughput accounting differ from conventional accounting in their treatment of direct labour costs and production overheads. with a unit contribution of £ 40. with a unit contribution of £20 but a requirement of two minutes of a bottleneck resource. these results in all stocks in a throughput accounting system being held at raw materials cost only. direct materials are treated in precisely the same way as in traditional accounting systems. i. Clearly. In this respect. would be preferred to product B. it is process management rather than accounting which reflects the true focus of the throughput approach). However. This may be surprising as the English word ‘throughput’ contains connotations of movement or flow. Certainly. it would be expected that bottlenecks will be alleviated. However. finished goods and cost of sales. For example. and as reiterated above. these are regarded as period costs. but a requirement for five minutes of the bottleneck resource. Throughput and contribution When making short –term judgments as to the relative profitability of particular product lines. of course. When adopting a throughput approach.variable costing’.
with associated labour costs of £10 per direct labour hour in each. Process Y is a dual process line. Y and Z. 39min. The products pass through two processes. The company operates a two-shift system. although this doubles the
. The relationship between the traditional accounting technique of maximising contribution per unit of scare resource and throughput accounting The relationship between the traditional accounting technique of maximising contribution per unit of scare resource and the throughput approach is illustrated by the simple example given below.
Selling prices are set by the market. A and B. Example A company produces two products. the production costs of which are shown below: A K 10 5 5 5 25 B K 10 9 9 9 37
Direct material cost Direct labour material cost Variable overhead Fixed overhead Total production cost
Fixed overhead is absorbed on the basis of direct labour cost. At these prices. The ability of the company to produce A and B is limited by the capacity to process the products in Y and Z. the market will absorb as many units of A and B as the company can produce. Process Z is a single–process line. and hence altering the relative attractiveness of particular products.have the effect of immediately switching the bottleneck resource within a production capacity. the current market price for A being K65 and that for B K25. giving 16 working hours per day. and for technical reasons this line can only be operated for a maximum of 12 hours per day. 15min. 20 min. The direct labour associated with the two products during these processes is shown below: Process Y Z Time Taken Product A Product B 10 min. and thus two units can be processed simultaneously.
Maximum process time Y = 2 x 16 x 60 =1.920 = 49. as explained in Stage 2 Management Science Applications. but not all. the problem. the profit maximising solution is found by maximising the contribution per unit of the scare recourse. Where the number of products is limited to two. As the number of potentially binding constraints increase. and/or the problem can be expressed in the form of a set of simultaneous equations.920 = 192 10 720 20 = 36
Product B Max units 1. i. where there is only one binding constraint. and thus the capacity of process Y is not a binding constraint.920minutes Maximum process time Z = 12 x 60 =720minutes So the maximum number which could be produced of each of the two products is:
Products A Max units Y 1. the maximum number of units which can be produced in process Y exceeds the number which can be produced in process Z. the problem can easily be expressed graphically to reveal the profit –maximising solution.e. the greater the number of constraints the more difficult the problem is to solve.requirement for labour. Question: Based on the above information. the use of a computer becomes the only feasible way to solve the necessary number of simultaneous equations. feasible solutions. the binding constraint. Process Y operates for the full 16 working hours each day.23 39 720 = 48 15
In the case of both products. what production plan should the company follow in order to maximise profits? Solution: In order to find the profit-maximising solution in any problem. In the most simple case. the constraints which prevent the profit from being infinite must be identified. Linear programming may be used to solve the problem where more than one constraint is binding for some. and such constraints are relatively few in number.
. therefore becomes one of deciding how to allocate the scare production capacity of process Z in such a way as to maximise profit.
25 20 Contribution of B per minute in process Z = K24 = K1. with a contribution of K1. some other costs are also variable.016 – 48 (K9 + K9) – fixed cost = profit K2. other than material. A comparison of the two – the ‘traditional’ approach and the ‘throughput’ approach – shows that the former indicates that profits will be maximised by producing A only.60 15 The profit–maximising solution is therefore to produce the maximum possible number of units of A. The throughput approach is. It is a special case in as much as contribution is measured after material
.Traditional approach – maximizing the contribution per minute in process Z Contribution of A =K65 (selling price) less K20 (variable cost) = K45 Contribution of B =K52 (selling price) less K28 (variable cost) = K24 Contribution of A per minute in process Z = K45 = K2.620 – fixed costs = profit Throughput method = 48 units of B yielding K2. 016 K2. This dichotomy of prescription arises solely because the traditional method holds that in addition to materials. other than materials. whereas the throughput approach treats all costs. as fixed. in fact. given their different solutions that the two approaches cannot both lead to profit maximization.016) – fixed cost = profit The fixed cost is common to both cases. which are variable – and identifiable with particular products – in the short run. Profit maximization It is clear. 36 giving a contribution of K45 x 36 =K1. Thus the throughput solution is suboptimal where there are costs. and the throughput solution is suboptimal. while the latter indicates that product B alone should be produced. a special case of the ‘traditional’ method of maximising contribution per unit of scarce resource in short–term decision making.620 K1.016 – (variable labour cost + overhead) – fixed cost = profit K2.620. The calculation below shows this: Traditional method = 36 units of A. the profits will be maximized by producing A only. If these ‘other’ costs that are identified as variable under the traditional approach really are variable in the short term.
The capacity of Y limits production of B. where no costs other than material are variable (i. as has been urged. as they are both utilized to 100 per cent of their capacity.920 = 192 10 780 20 = 39 Product B Max units 1.57 x 15] + [2. the contribution should be measured in this way. fixed. the above analysis suggests that. However. Thus.57 = 1896. if one extra hour is provided to relieve the bottleneck at Z.57 x 39] + 2.23 39 720 = 52 15
Whether a particular constraint is binding now depends on the production plan.e. In this example. the traditional approach could be reworked to recognize this fact. if the only variable cost is material.6 + 51. If all costs other than material are.57 units of B and 2. and the further aim of alleviating the constraint. with the immediate aim of ensuring that such resources are utilized for 100 per cent of their capacity. rather than B alone. and the profit-maximising output would be recognized as the production of B only. But. in fact. Provision of additional resources to bottleneck The aim of throughput management is to focus attention on bottleneck resources. Adoption of a linear programming approach (calculation not shown) reveals that the profit maximising output. Y and Z both become bottlenecks in this case. Y: [48.cost only. If management is able to find a way to enable this machine to work for one extra hour.8 Z: [48. as assumed in the throughput approach). whilst the capacity of Z limits production of A. the effect is to alter the optimal production plan so that both A and B would be produced. the profit maximising output is to produce 48.920 = 49. if labour and variable overhead are truly variable. The traditional approach would then be identical to the throughput approach.4 = 780mins
. the maximum number which could be produced of the two products becomes: Products A Max units Y 1. is to produce units of A only.57 units of A. Z is the bottleneck resource.57 x 20] = 728. if this is an accurate representation of reality.
It relates to a company producing only two standard products. except insofar as additional units of A can now be produced. employees etc. the example above is trivial in many respects. Managing the throughput of a factory reflects the philosophy of ‘management by walking about’. However. It was shown that this choice is dependent on the assumptions that are made about the behaviour of costs.e. The contribution of the throughput accounting approach may lie in the insights it can offer in such chaotic. whilst spare capacity continues to exist in Y. the provision of one extra hour at Z does alter the optimal production plan. Traditional variance reporting may encourage the attainment of high levels of local efficiency at the expense of overall efficiency. being used to 100 per cent of its capacity. By drawing attention to impediments to that flow. as assumed in the traditional approach).
. It can therefore be argued that throughput accounting does not add anything to the accountant’s existing set of techniques.. With a given level of resources. and it is completely beyond a textbook such as this to provide numerical examples to show how such situations should be managed in order to maximize profit. The quality of the decision regarding the appropriate production schedule to follow is thus crucially dependant upon the quality of the assumption on which the decision is based. and with a stable demand for the products is largely unpredictable. Throughput accounting as a technique of production management The example above focused on the choice of product to product. requiring only two production processes.the bottleneck resources – management will focus on alleviating problems which are inhibiting the profitability of the factory as a whole.If costs other than material are variable (i. rather than sub-units or particular product lines. an increase in the throughput of the manufacturing unit period by period would give a simple measure improvement in the flow of goods through the factory and to the customer. The actual profits which a company makes are clearly dependent on the accuracy of the data on which decisions are based. machinery. even with modern information technology. premises. A global measure of throughput at the factory level may give a clear signal as to the efficacy of factory management. Z remains a bottleneck. bottleneck machines or processes are generally much more easily identified by direct observation than by relying on the output of conventional accounting reports. Such situations are difficult to model accurately.e. i. The throughput approach has been shown to be a specific application of the ‘contribution per unit of limiting resource’ approach. production conditions. but realistic.
it has often been pointed out that maximisation of profit is a largely theoretical concept. it can readily be imagined that the throughput approach will actually lead to the profit-maximising output being achieved in many cases. which has been shown in a number of organisations to result in increasing profit from period to period. since the diagram relates to a single product. Figure 2. owing to the problems associated with production scheduling. a company has a range of products produced from common facilities. As Figure 2. whereas adoption of the profit-maximising approach would result in lower level of profit. it is impossible to realise that objective because output is invariably lower than the level which can be achieved using the throughput approach if we assume that output will generally not exceed 90 per cent of the profit-maximising output. a company could find itself producing beyond the profitmaximising point-hence the criticism. This criticism may be regarded as unfair.Criticisms of throughput accounting Throughput accounting has been criticised as not representing a profit– maximising approach.4 Profit maximisation
. when facing a downward-sloping demand curve. Advocates of throughput accounting would suggest that. In attempting to maximize throughput. Furthermore. The classical approach is illustrated below.4 shows. which have as their objective profit maximization. For single-product firms as we have. by operating under the aegis of traditional techniques. output should be limited in order to maximize profit. however. and does not detract from the attractions of the throughput approach.
at the minimum possible cost. A further criticism is that. in that all costs other than direct material are regarded as fixed.
Element 9. It is not a costing system as such. research and development stage. but rather refers to an activity whose aim. This approach may not be realistic. it says nothing about why other costs are incurred. the throughput approach could be argued to be either the direct opposite of. The most widely held view of target costing can be summarised as follows: View 1 An activity whose aim is that of reducing the life cycle cost of new products. in concentrating only on direct material. In focusing on direct materials costs.2 Target Costing
SOME VIEWS OF TARGET COSTING
The CIMA Terminology defines ‘target cost’ as follows: ‘A product cost estimate derived from a competitive market price. The aim is to meet customer requirements. A further criticism suggests that the approach is excessively short-term in that all costs other than direct material are regarded as fixed. it is an approach which focuses very clearly on measures designed to ensure that the production facility is responsive to the needs of the marketplace. even in the short term. The term ‘target cost’ is not included in the terminology. namely that the ability to influence cost is greater at the product planning. it has been
. However. Used to reduce costs through continuous improvement and replacement of technologies and processes’. consistent with the Terminology definition of target cost. View 1 sees target costing as moving the focus of cost-reduction efforts from the production phase of the life cycle to earlier phases in the cycle. or the perfect complement to. This interpretation of target costing emphasis an important point made earlier in this chapter. and therefore fits in well with modern manufacturing creeds. and therefore can do nothing to help their control. and may be regarded as a misnomer. such as quality and reliability.The philosophy underpinning throughput accounting is that the goal of manufacturing is to make money. where the opportunities for cost reduction efforts are greatest. rather than the production stage itself. Critics suggest that the approach is excessively short-term. the activity based costing approach with the latter’s focus labour and overhead costs. is that of reducing cost. Nevertheless. through the examination of all ideas for cost reduction of the product at the preproduction stage.
The word ‘target’ in English has connotations of something one aims for. However. rather than something which one is committed to achieving. Agreed target costs are final. In Japan.5 Target Costing Target costing Target cost o Stepped strategy
o Single-target strategy
Concept Design Testing Process Prod’n planning
. as Figure 3. different targets may be set for different phases of the development process. Unfortunately. or tries to achieve.5 shows. the English translation of the Japanese term as ‘target’ does not. other things being equal. a target cost is a cost to which people are committed. when it is applied in the sense of View 2. in assembly type environments 80 per cent of the major Japanese companies employ the technique. it is known as ‘Genka Kikaku’.argued that this view of target costing is too restrictive and an alternative interpretation may be expressed as follows: View 2 Target cost is an approach to cost reduction which can be applied to the production phase of the life cycle for both new and existing products. Indeed. The reason for making the distinction between them is to clarify what may or may not be included in a particular discussion of target costing. in this context. Yoshikawa et al (1993).
Figure 3. fully capture the Japanese approach. where different words are used for the two versions: when target costing is being applied in the sense of View 1. These different interpretations are in no way contradictory and could be applied in tandem. Monden and Hamada (1991). This confusion in the terminology does not arise in Japan. Target costing for products has been employed by the Japanese industry for more than 30 years. they are never expected to change. it is known as ‘Genka Kaizen’ (Kato (1993).
this approach views any product as a collection of individual functions. which are first to market. which is the method most frequently encountered. will enter established market with knowledge of the relevant existing product market. 2) The integrated method.
Element 9. as follows: Expected sales price – target profit = target cost (allowable cost) The starting point in this method will obviously be the establishment of an expected selling price. The deductive /subtraction method is –called because the target cost is simply the residual figure arrived at by deducting the target profit from the expected sales price. by definition there will be no established market for it and therefore no existing market price that can be used as a guide. However.2 Establishing An Expected Sales Price New brands of existing product types.1 Calculating Target Costs There are three ways of arriving at a target cost. and was applied over a wide range of expenses. and uses the current of existing or similar components or products to set a target cost for the new product. For companies. or minor varieties of existing products. and these are listed below in order of increasing sophistication: 1) The additional method. many Japanese companies employ functional analysis (see section 3. and the place of the new good within it. The ‘Design to Cost’ programme of the American Department of Defence in the mid –70s was an early Western example.6). with the
. the potential profits are much greater for the former than the latter. establishing an appropriate selling price is much harder than for those that follow. should enable a competitive price to be set. which is based on the price of competitor’s products. and works backwards from the market price to derive the target cost. and employ ‘pricing by function’. We shall limit our discussion to the last of these.
Element 9. To help with the pricing decision in such situations.and the deductive/subtraction method (see below) 3) The deductive/subtraction method. As we saw earlier.2. which is based on existing technology and cost data. in the case of a totally new product. it can also be applied to other areas. However.2.Although target costing is most commonly applied to product costs. which is a mixture of the addition method – and thus derives some parts of the target cost from existing cost data.
As we noted earlier.3 Establishing a Target Profit It is at this point that target costing provides a mechanism whereby the company’s product planning can be fully integrated into the strategic plans of the organisation. irrespective of whether the company currently has the capacity to put into practice the plans on which the costing is based. as opportunities for cost reduction will usually have been identified during the life of the existing product.4 The Residual: Target Cost The deduction of the target profit from the expected selling price will give the target cost. reliability. to establish an expected selling price. Value analysis (see section 3.
Element 9.2.appearance.3) and functional analysis (see 3. the initial estimate will almost invariable be higher that the target post.2.consumer being willing to pay a price for each of them.
. the difference between the two representing the socalled ‘cost gap’. this cost will have been determined primarily by looking outward to the market. it is rarely possible to implement all the potentially benefited changes that come to management’s attention. materials. The strategy of a business in the short. – and placing a value on each of this particular collection of functions can be established. As the process described above makes clear. Even when this is done. which must be bridged without sacrificing any of the ructions that were included in setting the expected selling price. By decomposing the new product into its separate functions. once production has commenced. In the case of a modification of an existing product. This information can then be used in conjunction with the company’s strategic plan for the product in terms of desired sales volume and market position. medium or long term will be reflected in its short-medium and long–term profit plans. and production processes. and this must now be done. management will obviously have the benefit of ‘on-going’ cost data in building up the target cost. ease of operation and maintenance etc. This cost will always be greater than the target profit.
Element 9. No estimate of the actual cost which will be incurred in the manufacture of the product will have been made up to this stage.6) can fruitfully be employed to assist this estimating process. but companies should be able to calculate the cost that would reflect the position if the changes where incorporated in the design and production process. The costing should be based on the most cost-effective design. and the target profit for any individual product will be a function of its place within those plans.
by definition the costing will be based on internal information relating to previously experience costs. and the historic costing records are thus limited in use in supplying the required data. and the incorporation of functional analysis (see section 3. This greatly enhances the likelihood of its acceptability to the consumer and its efficient manufacture.In the case of the totally new product.6) into the manipulation of the database. and autonomous agencies exist to provide the relevant data for various industrial sectors. ensure that the cost implications of changes in basic design and functions can be readily determined at the earliest stages of a product’s life.and hence its profitability. The integration of cost tables with a company’s CAD system (see section2.2.. They can be assumed to play no small part in the ability of Japanese companies to estimate the final unit cost of a product at the planning stage to an accuracy of + 12 per cent. labour.
. including those not currently used or experienced by the company. To help reduce cost To minimise the cost of new products. In Japan. Cost tables thus allow Japanese companies to perform a vast number of ‘what if? Calculations on all aspects of a product before it enter the production stage. to test the validity of design modifications. whether internally or externally driven. and indeed data to support modified versions of the existing products. equipment and production costs. in the absence of sufficient in-house information. and a specific requirement to achieve a target cost.
Element 9. Cost tables are very widely used in Japanese industry.1). ii. even though these costs are not necessarily attainable with current facilities. these data. which are briefly described in the following section. The purpose of cost tables is implicitly in the definition: i.5 Cost Tables Sato (1965) defines a ‘cost table’ as follows: ‘. This database enables companies to establish ‘state–of-the-art’ costs for new or existing products.3.a measurement to decide cost and to be able to evaluate the cost of not only existing products but also the future products at the very beginning of the design processes. The ‘measurement’ of the definition is derived from a comprehensive database of detailed cost information on alternative materials. The dictates of world-class manufacturing mean that cost tables continue to be used throughout the life of an individual product. are often provided by ‘cost tables’.
Their use is thus consistent with the general principle of cost reduction..
Therefore the services provided may be for sale e. canteens. departments or functions. library and stores.Element 9. Number of Operations. Service costing using 304
. ASCERTAINMENT AND COST CONTROL Typical cost units used in service costing are shown below: Service Transport Hospitals Electricity Hotels Restaurants Colleges Possible Cost Units Tonne per kilometer. maintenance. Whatever cost unit is decided upon. for example. maintenance. Passenger per kilometer Patient per day.e. the hotel industry may use the ‘occupied bed per night’ as an appropriate unit for cost. hotel accommodation.3 Service Costing Service costing is cost accounting for specific services or functions e. Kilowatt per hour Occupied bed per night Meals served Full time equivalent student
Each organization will have to determine what cost is most appropriate for use according to the nature of the business. personnel.g. Cost per service Unit = Total cost per period Number of service units supplied in the period
It will be realized that the calculations shown above is similar to the calculation of cost driver rates using activity based costing. public transport.g.g. power generation etc or they may be provided within the organization e. the calculation of the cost per unit is done in a similar fashion to output costing i. Frequently a composite cost unit is deemed the more relevant. A particular difficulty is to define a realistic cost unit that represents a suitable measure of the service provided. restaurants.
472 7 ½ days 216.patients K’000 Direct Patient Care Supplies.845.821.308.
COST BREAKDOWN Hilltop Hospital In.350 285.050
635.patients Average stay Number of out patients visits 780 23.563.500 Indirect Costs General services 3.patients K’000 outpatients K’000
1.patients K’000 Copmed Hospital in.720
.729.590 2.832.380 1.166.937.487.975.721.285.homogenous service centres or function and cost units that are a good measure of the service provided is a form of activity based costing.210.620 3. drugs 1.100 Support services 2.700 1.450 out.410 12.591.800 8.920
*Not recorded but bed occupation percentage was 85%.288.050 693.500 Copmed Hospital 500 8.600 4. Example Information has been collected about two hospitals over the last year: Hilltop Hospital Number of beds Number of in.524.950 6.551.700 1.470 16.165 * 63.520 Medical stores 8.
average stay = 155.patient days Therefore.700
.patient attendance for both hospitals and comment on the results.125 8.500 x 0.patient days = 23.patient days in a year.165 = 19 days.
Solutions: (a) Average stay in Copmed hospital.5 x 100% 780 x 365 = 176.85 = 155.040 284. Potential in.Required: Calculate: (a) Average length of stay in Copmed hospital (b) Bed occupation percentage in Hilltop hospital (c) Cost per in patient day for both hospitals (d) Cost per out. = Actual in.472 x 7. (b) Bed occupation percentage in hilltop. Therefore.125 in. 85% occupancy = 182.patient days x 100% Potential in. 500 beds x 365days = 182.500.
5 = K92.=
(c) Costs per in.285.472 x 7.3.590. in patient days) is used to calculate the costs.patients Number of out patient attendances
Hilltop Hospital =K 8.720 63.165 x 19 = K78.510
(d) Cost per out.patient day
Costs for in.166.1 Use of Unit Costs In The Public Sector
It will be seen that a composite cost unit (i.050 216.500 = K38.000 23.487.patient attendance = Costs for out.920 K70.288.patient days Copmed Hospital K12.280
Copmed Hospital K4.430
Hilltop Hospital K16.e.000 8.
Element 9.patients November of in.840.
The regular production of unit costs and comparison with the costs of other establishments in the same field helps to control costs and engenders a more cost conscious attitude. whereby products or services entering a market go through four stages: introduction. (c) As an aid to cost control.5).Cost per patient per day at various hospitals. the local authority’s costs to cater for the children’s home catering services for disturbed and disabled children will differ greatly to those homes catering for normal children. local authorities. Throughputs are numeric indicators where as outcomes are the impact which the activity has on the recipient of the service. cost per pupil in different education authorities. (b) As measures of efficiency over time. Like must be compared with like for the comparison to be fair. These can help to indicate whether efficiency is increasing or decreasing over time. 308
. (c) The throughput mix is likely to differ.
Element 9.4 Life Cycle Costing
THE NATURE AND PURPOSE OF LIFE COSTING
It is appropriate that we finish this chapter on cost behaviour and cost reduction by looking at the topic of life cycle costing. In the section on pricing (see section 5. (b) Throughputs are used rather than outcomes.2 Limitations of The Cost Units (a) Quality of performance is usually ignored. They serve as: (a) As indicators of relative frequency e.g. Examples include primary and secondary state education.
Element 9. For instance. the national health services.Cost per night in police cells. These unit costs have three main uses. police and so on. Costs are collected. . the reader will find a description of the product life (a concept introduced at stages 2 in the Management Science Applications paper). .The public sector organizations cover an enormous range.3. related to some measure of throughput or output and a unit cost calculated as described above.
The aim of any business must be to ensure that these costs rise at a rate which is less than proportionate to the actual increase in sales revenue. being largely the manufacturing and support costs mentioned above. via:
. This reported association with increased effectiveness clearly indicates that life cycle costing is a process which goes beyond the simple recording of information. by defining it as: ‘The practice of obtaining. From the suppliers point of view. over their lifetimes. components and the method of manufacture. the mere recording of financial information does not of itself impact on the transactions which are undertaken.4) once production commences. as was the case with value analysis. costs will increase. the actual profit associated with any individual product will have been largely determined before it is introduced to the market.as sales increase. However. with a tendency for costs to follow the sales pattern. and thus the absolute level of cost incurred on a product will rise over its life. The Terminology definition of ‘life cycle costing’ creates some confusion in this context. We make no apology for reiterating that as much as 90 per cent of the future cost that will be incurred throughout the remaining life of the product is actually dictated by the fundamental decisions taken at the pre-introduction stage regarding functions. as we have stressed throughout this chapter. as do the other techniques. It is not clear how a costing method can itself be a practice that results in something being obtained. and it can only influence cost if it results into action. The initial expenditure will invariably be lower in absolute terms than the manufacturing costs to produce and support the product. but clarification is fortunately provided in an explanatory sentence that appears after the definition. Indeed. and emphasises. materials. the best use of physical assets at the lowest total cost to the entity (terotechnology)’.7 ). the importance of early decisions in determining what these costs will be. maturity and decline. the life cycle will obviously begin before the product is introduced to the marketing and distribution before the first unit of product is sold or the first service is delivered. life cycle costing was taken up in the early 1960s by the American Department of Defence as part of a drive to increase the effectiveness of government procurement.5) and target costing (see section3.growth. The interactions of the revenue curve and the cost curve measures the profitability of the product over its life. in that it recognises (albeit indirectly) the importance of understanding cost throughout the whole life of a product. Life cycle costing has much with value analysis (see section 3.3. Although a relative decline in cost per unit may be expected from economics of scale and the experience curve (see section 3. as students of accounting are well aware.
Horngren et al (1994) state that: ‘Life cycle costing tracks and accumulates the actual costs attributable to each product from its initial research and development to its final customer servicing and support in the market place’.4. have actually been delivered. This indicates to the authors that life cycle costing of itself does not result in the reduction of cost.1 Life Cycle Budgeting and Resource Allocation The breakdown of the production costs predicted to occur over the life of a product will form the basis for the budgeted production cost of each period. a mature product requires less marketing support than a product in the introductory phase. When used in this sense. and support may be withdrawn almost entirely from a product in the introductory phase. it can be seen that life cycle costing supplies the means whereby a company can establish whether the lower costs which were expected through the application of cost reduction techniques. it can be appreciated that a life cycle budget cost for a product has much in common with a target cost. statutory) accounting. not only will the production cost of a product be forecast. and no offence is committed if two companies follow exactly the same set of procedures and attach a different title to their common activities. will also be considered. both prior to and following a product’s introduction.‘This is achieved through a combination of management. its recognition of the changing cost structure of products over time provides a valuable tool. life cycle budgeting. such as value analysis. a semantic debate as to the exact boundaries. such as marketing. if any. Element 9. and support
. they do not necessarily require the precision of terms relating to financial (i. but when used in combination with other techniques. However. The expected costs against which the actual costs are compared reflect the careful analysis and planning which should take place before the production stage of a product and the cost reductions expected during the production phase through the application of the firm’s decision – making and control structure of these expected product cost changes throughout the product’s life is achieved by the process known as ‘life cycle budgeting’. engineering and other disciplines’. financial. As costing terms have no legal validity. distribution and customer service. As life cycle budget relates specifically to products or services. of life cycle costing.e. a life cycle approach can also help managers in allocating resources to non-production activities: for example. particularly in companies where different targets are established for different phases of the product’s life cycle. for management in gaining control over the firm’s activities. but those costs attributable to the product in respect of non-production overheads.
For example. The life cycle costing/budgeting approach can thus be seen to allow the integration and expression within the traditional accounting system of a number of approaches to.g. Most companies are operating in an adraw manufacturing environment are finding that about 90% of a product’s life cycle cost is determined by decisions made early in the cycle. distribution. but life cycle costing makes the knowledge explicit. such as the learning curve (see section 3. along the same lines as capital expenditure post-completion audits (see section 6. can lead to a more effective allocation of resources. rather than a substitute for. Indeed. This may have been known implicitly. a useful format which is not seen in traditional systems. For example. it could be used in support of decision packages in zero-base budgeting (see section 3. In contrast. which represents a significant change to traditional accounting reporting. based on an understanding of its individual life cycle. reducing cost at the customer service stage. many overhead costs are budgeted.9). research and development etc.4. 4) The existence of life cycle reports facilities the conduct of postcompletion product audits. recorded and reported by function – customer service. such in terms of focus and timing. 3) The relationship between different cost areas/categories is highlighted. traditional accounting reports and practice. marketing and customer service are highlighted on a product–line basis. and represents an improvement of the traditional incremental approach to budgeting. Reports produced in this way can be seen to have four clear benefits: 1) The costs of pre-production activities e. Life cycle cost reports will thus normally be an addition to.3) and value analysis. research. this identification of costs with particular products forms the whole basis of the system – it is only by tracking these costs throughout the life of a product that the overall product profitability can be ascertained. and techniques for cost reduction. development and design and post production activities e. with life cycle costing. Management accounting systems should therefore be developed that aid the planning and control of product life cycle costs and monitor spending at the early stages of the life cycle. in traditional systems. However.
.g. – and no attempt is made to attribute these costs particular products.required by a product. 2) An understanding of the cost commitment/cost incurrence relationship is gained for different products. The knowledge gained from such audit reports can be fed into the company’s decision making processes to improve future product decisions.7). life cycle costing reports require the tracking of costs and revenues throughout the entire life of a product.
This is the decline phase of the Plc. In AMT environments the time period for the product life cycle is decreasing. The product is said to be nature when sales demand levels off. In the growth stage sales increase and unit costs fall as the high fixed costs per unit decrease although new entrants may start to complete at this stage. In a static market price competition will reduce the profitability of each firm.
Solution: • The product life cycle (PLC) is shown in the diagram below:
When a product is first successfully introduced for the market. Eventually. However. Compare and contrast life cycle budgeting with activity-based management identify and comment on any themes that two practices have in common. a very large amount of fixed costs will already have been incurred in RAD designing the product and building or re-equipping the production line.Required: • • Explain the nature of the product life cycle concept and it’s impact on businesses operating in an advanced manufacturing environment. Vauxhall is setting up new production facilities for manufacturing a revamped Corsa in the UK. Explain life cycle costing and state what distinguisher it from more traditional management accounting practices. Firms seek to differentiate their product at this stage. thereby incurring further large fined costs for R&D. most models must be renewed in much shorter time frames. the product will become obsolete and falling sales will ensure.
. In an advance manufacturing technology (AMT) environment. This is the most profitable stage of the product life cycle. for example the longest life cycle for a mass produced motor care has reduced from over 4 decades for both the VW beetle and the Morris minor less than 25 years for the Renaults which ceased production in 1996. suggested by an expensive advertising campaign it will only achieve a relatively low sales volume. design and new production facilities. Firms will begin to pull out of the market have developed a replacement product.
Minimizing cost drivers 3. Thus the early decisions regarding product design and production method are paramount and LCC attempts to recognize this situation. This for manufacturers LCC makes explicit the relationship between design choice and production and marketing costs. • Life Cycle Costing (LCC) involves collecting cost data for each product from inception through its useful life and including any end cost. Consumer as well as producers may use LCC. These data are compared with the life cycle budgeted cost for the product. marketing and so on. LCC is used to improve management decision making in breach conditions. this approach yields a better understanding of overhead costs in AMT environments compared to traditional absorption methods. R&D. The high fixed costs of introducing a new product compared with reduced life cycle periods is a major challenge to profitability in AMT environments. ABM aims to improve performance by: 1. In particular.
The recognition of the total support required over the life of the product whereas traditional costing by function e. A recent analysis has shown that the life cycle cost of purchasing a personal computer (PC) is around six times the purchase cost. It has been recognized in AMT environment that up to 90% of the costs incurred throughout a product life cycle will be determined before the product reaches the market. The Plc concept enables dear strategies planning regarding the development of new products cashflows on marketing activities. • Activity based management (ABM) uses the understanding of cash drivers found from activity based costing (ABC) to make more informed decisions. Emulating best practice
. production.The Corsa was launched only a few years ago. Staff the training and extra software will cost three times the cost of the PC and maintenance will cost twice the purchase cost over the life of the PC. The insights gained from company budgeted and actual life cycle costs may be used to refine future decisions. This comparison will show if the expected savings from using new technology or production methods etc. Eliminating waste 2.g.
Considering how the use of resources supports both operational and strategic decisions. Simplified product designs More use of common sub – assembly Reduced set-up times Reduced material handling Better use of the workforce e.
In an AMT environment both methods focus management attention on the need to produce simplified products using common components and common subassemblies and to maximize the output from expensive capital instruments. Both attempt to increase management understanding of overhead costs Both consider how the use of resources supports strategic decisions.
. ix.g. that is.. Multi – skilling
Their ABM is very similar to LCC in some respects. iv. vi. Results of ABM in an AMT environment include: (vii) Increased production efficiency
(viii) Reduced production costs (ix) (x) Increase throughput Increased quality assurance
These gains may be realized by: iii. vii. This ABM seeks to consider all activities performed by the organisation in order to serve a customer or produce a product. For example: viii. v. both look at how resources inputs are used to obtain the required organizational outputs.4.
Target costing Nsonsi Ltd is a company that manufactures mobile phones. lope with this. Life cycle costing systems. Nsunsi is a mature company that has been producing electric equipment for many years and has all the costing system in place that one would expect such a company. where as ABM is a continuous system that tries to drive down both short terms and long terms costs. Both target costing and life cycle costing are systems. economic factors.
. Nsunsi is in a particularly versatile business because technology is changing rapidly as digital telephones take over and tent messaging develops. Nuns may wish to replace standard costing/variance analysis with target costing for cost control and reduction for the following reasons 1. Their specific advantages are as follows: 1. Target costing: and 2. Target costing Target costing may replace and is often compared with traditional standard costing/variance analysis. which has long been in place in the historical world. This market is extremely volatile and competitive and achieving adequate product profitability is extremely important. annual budgets and monthly variance respects and the balance scorecard for performance measurements. technology and so on.LCC lied to major reviews at the major stages in a product life cycle. These systems help Nsunsy to complete in terms of cost to product development in the competitive telecommunicating market. The company is considering introducing. This is likely to be important in the manufacture of phones. It puts pressure on cost it can be used as a cost reduction technical unlike standard costing and can incorporate a leaving effect. which should help the company. 1. Solution The modern business encouragement terms to be an instate one and is rapidly changing in terms of customer requirement. These include a comprehensive overhead absorption system.
say 94%. Monitoring a costs and benefits over the life cycle helps to stop a project early if events have changed or not turned out as planned. It leads towards the use of other techniques. 3. Life cycle costing 1.2. it is vital that the product begin to generate profits quickly. Traditional standards may be too rigid for cost control in reduction purpose for a company such as Nsunsy as they usually need to be set for a year at a time. 5. It should motivate staff if used contently and help. Many of Nsunsi’s costs are likely to be “looked in” during the design stage. Estimating life cycle costs and revenue will highlight this 2. such as value analysis and value engineering. It presents a different perspective that could be advantageous to Nsuni as it is not tied to period reporting. 6. This is particularly important in an industry with shunt produce life cycles. 3. 2. Time to the market is often a key as money factor is generally profited. The life cycle of Nsunsu’s products are likely to be shunt because of charging technology.
. therefore. which should supply production methods and reduce costs. It is more important to measure time than money/cost it may be vital for Nsunsi to bring new products to market quickly and on time in order to achieve a product. 4. Nsunsi needs to consider the final customer as well as the system supplier. 4. It considers the market to price customers are prepaid to pay so it forces an originating to be outward rather than inward looking. It focuses on the time as well as money. Research and development costs are likely to be quite high and must be recovered in a short period. Break down any artificial functional barriers as it involves staff at all levels and in most functions and forces them to communicate. so it is important to control cash initially in order to maximize the profit over the product’s life. Target costing is more flexible and target can charge/reduce from years to months. 5.
Central education from senior managers. This facility is important: although the disposition of the costs between the first two of these stock categories is of little consequence.Because of the above it would be advantage for the company to adopt both of these techniques. a valuation period. the traditional system has been referred to as one of sequential tracking. Stock valuation. 100% internal resoucing of ancihary seniors. the physical flow of materials and conversion costs is exactly mirrored in the costing system: the product flow beings with raw materials and other prime manufacturing costs. Companies may have stocks of raw materials.5 Backflush Accounting
In traditional accounting systems. 9. To unitary structure with one profit center. and the finished goods still remaining in stock at the end of the period. Management information system
. financial accounting is concerned to draw a clear distinction between goods that have been sold in an accounting period. The reason for this concern is obvious: the latter will simply remain in the balance sheet. workin-progress and finished costs through these accounts. By tracking material and conversion costs through these accounts. proceeds through work-inprogress to finished goods and finally ends with costs – indeed. Such a system has two main benefits: i. Information technology During 1990 a printing company defined and installed a management system that met the business news of a commercial environment which was characterized at that time by: 7. 8. a valuation can easily be placed on each for financial accounting purposes.
both in terms of the number and frequency of entries to the accounting system. It must be stressed from the start that it is not a more accurate system of costing than those traditionally employed. A further point must be stressed: as backflush costing does not attach conversion costs to products until they are completed. associated with a JIT production system. but also over the costs incurred by individual products or jobs. it can be criticized as being less accurate. as we shall see.
. stock and cost of sales). and thus the need to distinguish between the goods sold during a period and those on hand at the period end becomes largely redundant. it follows that the system cannot be successfully operated in situations in which work-in-progress is significant and/ or fluctuates from period to period. This benefit applies most obviously to situations in which job costing. but are attached to output produced (finished goods. and the level of supporting data and documentation.
However. when the same situation applies to raw materials and finished goods in some variants). Backflush costing is a system that has been developed in response to these concomitants of the traditional method and the change in the environment. or even sold. all but an insignificant amount of any one period’s costs of production will end up in cost of sales on the income statement. not only over costs in total. The primary benefit offered by backflush costing is the considerable reduction in the clerical effort required to maintain it.
Control of costs. Indeed. and would be inconsistent with the reporting requirements of financial accounting. and more than outweighed by the cost savings to be gained from its operation. to support it. in which low stock levels are becoming the general rule. Furthermore. the use of backflush costing would lead to different results than would have been obtained under the traditional tracking systems. Distinguishing features of backflush costing The Terminology defines backflush costing as follows: ‘A method of costing. In such a situation. the traditional system is time-consuming and expensive to operate as it requires large volumes of documentation. this reduction in accuracy is regarded by the system’s advocates as relatively unimportant. on the assumption that such backflushed costs are a realistic measure of the actual costs incurred’. against the general background of low stock levels mentioned above. Detailed tracking of costs allow a considerable level of control to be exercised. rather than batch or process costing is the norm. such as material requisitions and time tickets. However. In such situations (and. which applies cost to the output of a process.ii. Costs do not mirror the flow of products through the production process. the benefits associated with it are less obvious in the modern manufacturing environment.
the purchase of raw materials or components and the completion of good finished units of product. the feature which distinguishes it from other systems. Although the treatment of material costs in backflush accounting differs from variant to variant. It is not
. and then ‘flushed back’ through the system to attach to particular products. The authors call this initial stock account ‘raw and in process’. The next trigger point is the production of finished goods: a debit is made to the finished goods account equal to the standard cost of the produced. Accounting entries in backflush costing Horngren et al (1997) describe three variants of a backflush costing system. In a modern manufacturing environment. noted therefore. is that its focus is on output: costs are associated with output. The above text and Drury (1996) have qualified examples of this and the following variant. This variant not only excludes from costing record any raw materials purchased but not yet used to produce a finished good. and thus problems would be immediately evident to all concerned and solutions rapidly sought). in the JIT environment in which backflush costing is most likely to be employed. as it combines both the traditional raw material and work-in-progress accounts. It follows from this that another prerequisite for successful introduction of backflush system is that management control of the production process is capable of being carried out effectively in the absence of costing information. is triggered by certain events. The purchase of materials triggers a debit to the initial stock account and a credit to creditors for the cost of the materials purchased. but also fails to record a creditor for material until the production process has been completed. the identification of conversion costs with particular products cannot be used as an effective control mechanism during production. showing respectively the standard material value and conversion costs of the completed goods. it can be argued that effective operational control could be maintained through computer monitoring of the process. whatever variant is being considered. rather than ‘raw material’. The variant which differs least from traditional sequential accounting (method 1) has the following two trigger point. However. by the use of non-financial measures expressed in physical quantity terms and by direct observation of the operations themselves (for example. Different ‘triggers’ or ‘trigger points’ can be employed in backflush accounting and therefore a number of variants of the system exist. The simplest and most extreme version (method 2) has only one trigger point: the completion of good finished goods for the actual produced and conversion costs.The recognition of the costs to be associated with products in the backflush system and thus their point of entry into the cost accounts. a further common feature. a lack of raw materials would cause the production line to come to a standstill. and credits are made to the raw and in-process and conversion costs accounts.
The triggers for entry into the cost accounting ledgers are the purchase of materials and the completion of finished goods.clear to the present authors (nor. Example of accounting for backflush costing (method 1) As 31 December a widget manufacturer has no stocks. as profit can no longer be bolstered by simply producing for stock. There is only one stock account – merely called ‘inventory’. By charging all conversion costs to the income statements. but takes as its second trigger point the sale. this variant is intended to focus management attention on selling the products.000 units. work-in-progress and finished goods.410 11. when the liability is eventually recognized. rather than the manufacture. The analogy with throughput accounting should be obvious. The third variant (method 3) again has a similar initial trigger point to the first (i. apparently. Presumably.
.050 units 1.580 4.which contains only the outstanding material costs of raw materials. of finished units and expenses all conversion costs immediately on sale. it would be feasible only where the throughput time of the manufacturing process is so fast that stocks of raw materials and work-in-process are non-existent – a highly improbable situation (see the detailed criticism below for amplification of this point).100kg Labour: 175 hours Overheads incurred Finished goods produced Finished goods sold 20. The entries to record these transactions are as follows. it appears to be recorded at standard rather than actual cost. Further.e. The standard cost of a widget is: K Materials: 2kg at K10 per kg 20 Labour: 10minutes at K24 per hour 4 Overheads: K6 per kg of material 12 Total cost 36 Budgeted monthly production is 1. During January: Materials purchased and used: 2. the purchase of raw materials or components). to the authors of the above two standard cost accountancy textbooks) how this latter point can be reconciled with the financial account requirement to recognize liabilities.500 1. and the mechanics for recording actual costs and calculating variances are also unclear.
CREDIT Creditors or cash With the actual cost of labour and overheads. DEBIT Conversion cost account with the actual cost of labour and overheads. CREDIT Raw and in process account with the standard cost of material CREDIT Conversion cost account with the standard cost of labour and overheads. • When the goods are sold: DEBIT Cost of sales account CREDIT finished goods account with the standard cost of goods sold. The balance on the accounts are then: Cost variances written off to the profit and loss account.
.• When materials are purchased: DEBIT Raw and in process account CREDIT Creditors or cash with the actual cost of the materials. • When the goods are completed: DEBIT Finished goods account with the standard cost of finished goods. The value of closing stock at standard cost (permitted by the international accounting standards).
Finished goods account K K (4) cost of sales (1.800 16.800 (6) Stock b/d 1.580 (1.800 (5) Profit and loss account 1.050 x K36) stock c/d 37.000 x K36) (3) Standard cost of production 36.800 37.800 Conversion account K K (4) Creditors/ cash (2) Standard cost of labour 15.800 420 37.050 x £20) (5) Profit and loss account 21.800 Cost of sales account K (5) Finished goods (1.000 Criticism of Backflush 322 K
.000 420 21.Raw and in process account K (1) Creditors/ cash (2) Standard cost of materials 20.000 (1.000 x £36) 36.050x (4 ÷12)) (5) Profit and loss account 16.800 890 16.000
21.910 and overheads (1.
adding functions. The name RIP is at best a cosmetic change. traditional systems require the identification of products at different stages of completion in work-in-progress. raw material inventories never actually reach zero. Among other things. Typically. If there is no raw material inventory on hand. a small but very real raw material inventory exists in an ideal situation. accountants waited until the end of the fiscal period to take a physical count of the inventory.As the introductory remarks to part of the appendix made clear. and conclude their criticisms with the following remarks: ‘Because of no reports from accounting on inventory. After all. except what is needed to complete the work in progress. Several criticisms of backflush costing have been made passim. traditional accounting has always ‘backflushed’ costs from work-inprogress to finished goods when products are completed. At that time. One might be forgiven for a measure of puzzlement and confusion at all this. They object to the late appearance of entries in the accounting system when backflush costing is used.
. The backflush system looks very similar to what used to be called a periodic system. material also goes directly into the production process and there is no need for a separate raw material inventory account. managers have to take a physical count. The physical inventory counts not only increase overhead costs directly but also disrupt production that reduces efficient use of plant resources. but a detailed critique can be found in Calvasina et al (1989). However. A job that contradicts one of the basic objectives of the JIT philosophy – the elimination of wasteful. Thus. they argue that elimination of raw material stocks is an impossibility and that the raw and inprocess account (RIP – the acronym perhaps meant as a joke) is simply a misnomer. the company at a minimum will receive items in a cost – effective delivery size. For example. the appropriate numbers were derived from the ending inventory count. the virtue of backflush accounting is its sheer simplicity. While this goal is achievable theoretically. which would involve considerably more physical stock counting then the envisaged in a backflush system. it would seem that the new situation is identical to the old situation when the appropriate title was work-in-process’. While the JIT presents management with less accounting and less information on which to base its decisions’. On the other hand. ‘In a true JIT manufacturing system with a JIT purchasing system. In this system. it is axiomatic that simple systems provide rather less information than more complex systems. non-value. it will receive a truckload or a railcar load.
if the manufacturing circumstances are such that high levels of stock are unavoidable. number of orders made (for ordering costs). Cost drivers are activities which give rise to costs.6. (CIMA) From the above terminology it is clear that ABC looks at activities as the causes of costs (cost drivers).6. Therefore distortions arising from overhead allocations were not as significant.2
Element 9. In addition the main cost elements were made up of direct materials and direct labour. Need for ABC The development of ABC was due to the limitations in the traditional product costing systems.While backflush costing will reduce the documentation flow-most obviously from raw materials to work-in-progress – the combination of raw materials and work-in-progress in backflush’s ‘raw and in. However.1
ACTIVITY BASED COSTING Activity based costing (ABC) can be defined as‘an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs.process’ account does not allow the important distinction to be made between raw materials that are still available for use and those that have already been built into unsold products. Resources are assigned to activities and activities to cost objects based on consumption estimates.3
. These may include. The latter utilise cost drivers to attach activity costs to outputs’. number of production runs (for material handling costs).
Element 9.6 Element 9. Costs should therefore be allocated to products based on the activities that the products have consumed. as compared to overhead costs. demand is created for the activities.6. In addition ABC acknowledges the fact that by producing products. The traditional product costing systems were established at a time when a number of firms were producing a narrow range of products. The reader looking for prescriptive advice on the use and usefulness of backflush costing will be disappointed: the present authors must fall back on the truism that the circumstances of the particular operation under consideration will determine
Element 9. backflush costing becomes an impossibility anyway.
These costs are added to the production cost centres cost. materials purchasing. in ABC systems separate cost driver rates for support centres are
Element 9. 2. number of purchase orders and number of production runs.In contrast. The common bases used are direct labour hours and machine hours. 3. a number of cost drivers which will include non-production volume related are used.5
. Instead overhead costs are considerable. In the first stage the system allocates overheads to production and service departments and then reallocates service department costs to the production departments. In addition traditional systems normally allocate service/support costs to production centres. set-up machines. Even though activity cost centres my be identical to traditional cost centres. Create a cost pool for each activity.6. Identifying the major activities that take place in an organization. Traditional Vs ABC Systems In a typical traditional cost system there will be the usual two-stage cost allocation process. Element 9. For ABC systems. Determining the cost driver for each major activity. Assigning the cost of activities to products according to the products demand for activities. Activities in an ABC system will be made up of a number of tasks. product inspections and production scheduling. In a traditional cost system overheads are traced to products using a limited number of allocation bases which vary in direct proportion with production volume. firms today produce a range of products which do not need significant labour. This mean that the traditional approach of overhead allocation using direct labour basis does not reflect a true picture. However.6. 4. ABC systems tent to have more activity cost centres. Therefore a more accurate cost allocation system becomes necessary and this was made possible with advancements in the cost information systems which reduced the cost of operating a more complex system.4 Establishing an activity-based-Costing System There are basically FOUR steps involved: 1. A number of activity-based cost centres (cost pools) will therefore need to be established. Such activities may include. These will include. In an ABC system overhead costs are assigned to each major activity instead of departments.
established and support activities costs re assigned to cost objects without any reallocation to production centres. ABC systems can more accurately measure the resources consumed by cost objects.6. This unitising approach is an allocation which yields a constant average cost per unit of output which vary depending on the level of activity. such a detailed and complex system will be more costly to a traditional costing system.8
.6. This is so because to calculate unit costs of products. Costs associated with an ABC system will include software and staff training which may be prohibitive.
Element 9. In contrast traditional cost systems tend to produce less accurate costs as most allocation bases used are not related to the cost objects. Drawbacks of ABC Systems The following pitfalls of ABC Systems can be noted: a) The calculation of unit of costs under ABC faces the same disadvantages of the traditional cost system. Element 9. For decision-making there is a danger that what started out as a non-volume related. Therefore ABC must meet the cost/benefit criterion and improvements should be made in the level of sophistication of the costing system up to the point where the marginal cost of improvement equals the marginal benefit from improvement. It is quite obvious that the more complex the ABC system is the more beneficial it will be in the organization.6. Poor decisions may relate to having to having unprofitable products and dropping profitable products. Other Considerations The cost/benefit of implementing an ABC system should be analysed. Consideration must be given to the poor decisions that will be made as a result of having an inaccurate traditional costing system. However it’s not always that an ABC system will greatly improve the quality of cost allocation nor is it the case that a traditional cost system will produce inaccurate cost reports. the batch level activity costs are divided by the number of units in the batch.6 It is therefore evident from the above that by having a number of cost centres and cost drivers.7
Element 9. It is however a fact that.
9 following data is available for the month of February: A B Output (units) 800 800 Production runs 20 20 Direct Labour hrs per unit 2 6 Machine hrs per unit 2 4 Material cost per unit (K) 1000 4000 Labour cost per hour is K 8000 The following overheads were also incurred: K’00 Production Scheduling 7 280 Material Handling 6 160 Set-up Costs 8 736 22 176 Calculate the cost of each Product using ABC and traditional cost system. A B C K’000 K’000 K’000 Raw Materials 800 3200 2000 Direct Labour 12800 38400 32000 Production Scheduling 1040 1040 5200 Material Handling 880 880 4400 1248 6240 Set-up 1248 Cost per unit 16768 800 44768 800 49840 2000 C 2000 100 2 2 1000 EXAMPLE Chiatu Plc manufactures THREE products A. B and C. Element 9.6.b) It is not all costs which will be caused by activities that are measurable in quantitative terms and which can be related to production output. In such situations cost drivers can not be used. The
. c) The behaviour of cost items in a cost pool cannot be explained by single cost driver. ABC System: Under ABC system the overheads will be allocated to the Products using the number of production runs as the costdriver.
Production runs and Production scheduling).96
= K55.Overheads absorption = K 2217600= K 2132.96
Traditional System: Raw Material Direct Labour Overheads A K’000 800 12800 3412 17012 B K’000 3200 38400 10235 51835 C K’000 2000 32000 8529 42529
Workings: 1.000 per run 140 3.000 = K 52.Set-up = K 8736000 = K 62.= K20.400 per run 140 4.
. consumes more of those activities (Set-ups.Materials Handling = K 6160000 = K 44.Production Scheduling = K 7. as stated earlier on. Under the traditional system Product B has been over-allocated with the overheads since the allocation is based on the number of labour hours. because of the many production runs.000 per run 140 2. than Products A and B. However. most modern firms have automated operations therefore the use of labour hours like in the case does not reflect the causes of the overheads.280.3 10400 NOTE: It can be seen that under ABC the allocation of overheads is more reflective of the actual activities in production since Product C.
Activity-based budgeting (ABB). It therefore attempts to integrate materials requirement planning.10 Other aspects of ABC Further approaches which revolve around ABC have been developed.6. this is a method of budgeting based on the activity framework and utilizing cost driver data in the budget-setting and variance feedback processes.7 MANUFACTURING RESOURCE PLANNING (MRPII) Is an expansion of material requirements planning (MRPII) to give a broader approach than MRPI to the planning and scheduling of resources. it has been eriheised as a planning system. manufacturing. logistics. MRPII is used by many companies for manufacturing planning but with the advent of JIT manufacturing. Most MRPII systems are a collection of computer programs that permit the sharing of information with and between departments in an organisation. Element 9.8
ENTERPRISE RESOURCE PLANNING (ERP) ERP systems are accounting oriented information systems for identifying and planning the enterprise-wide resources needed take. especially when JIT methods are unsuitable. Originally.Activity-based management (ABM): Activitybased management (ABM) is a system of management which uses activity-based cost information for variety of purposes including cost reduction. They allow an
. MRPII plans production jobs and also calculates resource needs such as labour and machine hours. finance and personnel operators. purchasing. embracing areas such as finance. factory capacity planning.
Element 9. Even so MRPII has advantages as a controlling system for planning and controlling manufacturing systems. make. distribute and account for customer orders. ERP has been described as an umbrella term for integrated business software systems that power a corporate information structure.Element 9. shop-floor and even marketing into single complete (and computerised) manufacturing control system. ERP systems were simple extensions of MRPII systems . but their scope has now widened. engineering and marketing. cost modelling and customer profitability analysis. MRPI evolved into MRPII. thus helping companies to control their inventory.
These are fully integrated within the ERP system 2. They include production. Some provide links into ERP system to third party software that performs tasks. an organisation in Zambia e. accounting. information retrieval. CORE APPLICATIONS The applications that need to work in the organisation will be unable to function. Some ERP software includes these.organization to automate and integrate most of its business processes. selling and servicing a bus assembled in India using parts from China. decision support. requisition and deployment
. For example. They help large national and multi-national in particular to manage geographically dispersed and complex operations. There are two groups of applications within an ERP: 1. TATA sales office may be responsible for marketing. ERP may also incorporate transactions with organisations supplies. d) Greatly increased depth and breadth of data analysis e) Reduced response times to information requests f) Reduced need for manual intervention in data access and analysis g) Reduced risk of errors in data or in its analysis h) Greatly reduced lead times in report generation i) Greatly increased efficiency in materials ordering. Business analysis applications Examples include modelling. ERP enables the organisation to understand and mange demand placed on the plan in China. Some advantages of ERP systems The advantage of ERP systems compared to traditional system architectures include: a) increased data consistency b) reduced data redundancy c) Greatly enriched data. distribution and planning.g. simulation and “what if” analysis. share common data and practices across the whole enterprise and produce and access information in a real-time environment. sales. including access to qualitative data by functions that do not typically have access to it.
or these two concepts?
. What are the advantages of a ERP system 3.Questions 1. Why will those organisations that integrate their ERP systems with supply chain management benefit more than those that introduce only one or the other. What is enterprise resource planning? 2.
Characteristics of EIS
• • •
Outputs are very user friendly Utilizes graphed and other pictorial representations of data for ease of analysis and understanding Provides drill-down tools to help executives to perform some analysis of the information
(i) EXECUTIVE INFORMATION SYSTEM (EIS)
This system is usually used by the senior corporate executives in a corporation.
Element 10. Should be able to explain the different communication technologies Should be able to discuss the application of computer aided design and manufacturing technologies Should explain the application of flexible manufacturing techniques and the technique of business process Re-engineering. candidates are expected to: • • • • • • Highlight the impact of IT on management accounting Explain how information systems should be designed Should appreciate the use and limitations of personal computers. The following are the common decision support systems in use.STUDY UNIT 10.0 INFORMATION TECHNOLOGY AND MANAGEMENT ACCOUNTING
Learning Outcomes After studying this chapter. It is designed to provide quick access to important information concerning both the company analysis and economic information such as forecast demand for the companies’ projects.1 Decision Support Systems There are various decision support systems that can be used in management accounting.
the effect of the company entering the new sector can be seen. Each rule will be given a set of possible answers or links to other rules so that finally a complete summary of the tax system is built up in the computer. Element 10. where there are many potential input and output and the decision itself is made only infrequently.(ii) DECISION SUPPORT SYSTEM (DSS) These are systems which help manages value decisions. By a question and answer process. For example the taxation system of most countries is quite complex and there are few people who understand it completely. Your studies of management and strategy should remind you of this.1 Management Information Design A business/organization will have several departments or business areas headed by different groups of people of the work force from specialized disciplines. Expert systems can also be found in medical diagnosis and mineral prospecting (exploration) activities. the problem and provides a solution. Expert systems are used in situations where there is a large volume of information about a particular subject and the information can be summarised as a set of rules. market size.1. Decision support system will be used where the decision to be made is unstructured i. the expert system identifies the process. An expert system can be designed to incorporate the knowledge from some of these tax specialists in form of rules.e. if a company may be considering launching a project in a new market sector. forecast programming. For instance. The decision support system could be used to analyze the market considering default of current products. The summarized organization structure below shows what is being explained
. themselves. A person with very little tax knowledge can then ask various questions about tax from the expert system. In effect the expect system allows an individual to consult a tax specialist without having to pay for the expensive time of the specialist. (iii) EXPERT SYSTEMS. Even EIS and Expert systems form part of the general decision support.
at these different levels of management. finance.1.
.2 Management Levels and Information Requirements Different levels of management in an organization will require different information to fulfil their roles. Other functions will also be staffed with individuals from their discipline in the areas of their speciality. It is important to note at this stage that the determinations of information needed by managers will be the jobs which are described for them. finance department carrying out accounting related. Managers and their subordinate’s will need different types of information to fulfil their jobs. let us examine the different levels of management and therefore look at the information requirement needed to some. At this stage therefore.MD
Research & Development Department
Different people will be working in the highlighted departments. treasury related and tax related activities. The managers will obviously want to make sure that the information they get is appropriate to their various roles.
STRATEGIC MANAGEMENT Strategic management will comprise a team of top-notch corporate executives involved in overall corporate planning. ii. internal and external information. strategy formation and policy making in an organization.LEVELS OF MANAGEMENT
OPERATIONAL MGT The three levels of management above are responsible for the following activities.e. iii. TACTICAL MANAGEMENT Tactical management implement some strategic decisions and decisions involving the running of business units and section.
The operational management of an organization will be carrying out day-today basic work which will be the means by which the company earns it’s revenues. The information they use will come from two main sources: From within the company and outside the company i. managers therefore need different types of information to help them make those decisions correctly.
. i. Each levels of management make different decisions.
Raw materials prices
. Prepared as needed.Absenteeism reports
. Highly summarized Related to long-term of the planning horizon.Daily production schedule .Computer prices . STRATEGIC INFORMATION Should have the following cardinal characteristics • • • • ιι. Details of the company as a whole.Monthly output reports .Variance Analysis
TACTICAL INFORMATION Should have the following characteristics • Less summarized • Relate to short / medium term in the planning horizon • Retails on singular department • It should be prepared regularly
.Board minutes .Production fore costs future periods
EXTERNAL INFORMATION NEEDED .Computer information . ι.LEVELS OF MANAGEMENT
INTERNAL INFORMATION NEEDED .Computer factory layouts
For the various information to be useful to the users it needs to exhibit appropriate characteristics.Market demand Summaries
OPERATIONAL INFORMATION Should have the below listed following characteristics • It should be detailed • It should relate to daily / hourly activity. the common ones being. Such transactions may include. important to note that a TPS has serious effects when there is failure in the system. A TPS therefore is an important function in a business’ daily operations. • Detailed down to individuals machine level • It must be prepared continually. In addition.
Element 10.2 A TPS collects details of transactions in a number of ways.1 Transaction Processing Systems (TPS).2. The transactions processed can either be internal or external. It is however. it will usually be stored in a database management system. In a typical TPS transactions will occur within a local-area network within a firm. such as purchases in real time and then upload by a batch system later on to the mainframe computer. information such as supply requests can be transmitted on demand in real time. to check raw materials level or from the database. This entails that the stored data can easily be retrieved if the need arises. with real-time processing and data transfer occurring across a wide-area network with a central mainframe computer. A TPS therefore processes ecommerce transactions within a business and between the business and the third parties. Information on transaction details can be accessed from the system on-line e. customers ordering goods from the business. Element 10. This is due to the fact that a TPS has direct effect on the daily routine transactions 337
. the business placing orders for raw materials.ιιι.2. The transactions thus processed by a TPS provide operational level management with processed transaction information. However a local server can store transaction data.2
TRANSACTION PROCESSING SYSTEMS
Element 10.g. When the transaction data is input. Keying in the on-screen data entry forms or the use of bar-code system. Electronic data interchange (EDI) can enable a link to be established with suppliers and customers. process the frequent routine transactions.
Element 10.conducted by the business. Improved operational efficiency by automatic links to suppliers and better information on product demand and availability. They should have (i) input of data (ii) processing of data (iii) output of information. Improved customer service through more choice.3. banks and customers. A number of smaller MIS may be needed to produce the information for the different levels of management.3 Management Information Systems (MIS) A management information system is a computer system or a related group of systems. suppliers. warehouses. Can improve stocking through EDI links between stores.
i. if the TPS cannot provide stock levels information due to some system failure with a TPS.1 Characteristics of MIS All management information system have the following components or aspects.2. it can directly affect production or sales. ii. INPUTS OF DATA
. lower prices and better quality of produce. iii. For example. Assessment of effectiveness product promotion through availability of better information. Therefore a management information system should collect data from various sources and process it into the type of information that managers need to help them run the business. which collects and presents management information relating to a business in order to facilitate its control activities.
Element 10. Assuming that different levels of management require information at different levels of details it is likely that no one management information system will be able to supply the total information requirements of a company.3 Some common uses of TPS include: i. iv.
Electronic mail E-mail is useful for sending short messages. This section investigates the relative merits of the different methods that can be used to disseminate information within a company. Other data can be obtained from external sources so that manages have complete information for them to perform their roles well.
OUTPUT OF INFORMATION
The final output from a MIS can take many forms.Data will be received from a number of sources. For example summarizing data or looking for exceptional items in a large amount of data. together with an indication of their appropriateness in particular situations. It is likely that data will be available from other systems within the company. The
. These sources will vary depending on the final output that is required from the MIS.4 Communication Technologies Outputs from information systems can and should vary greatly in terms of length. such as the accounts department. Information Dissemination-Systems Information can be circulated in a number of different ways. The method chosen will depend largely on the urgency and volume of information to be distributed. particularly when the circulation involves a large number of people. PROCESSING OF DATA
The data which has been input will be processed in one way or the other. and the characteristics of effective information. Summarised below are the main methods of dissemination in a large company. it is not necessarily recommended for urgent communication. format of presentation and urgency of action required. The processing that takes places in most MISs will take the form of. Some outputs will be quite summarized merely showing trends and exceptional items but at the operational level some very detailed outputs will be appropriate.
Element 10. Because recipients may not have the system switched on. The output from the MIS will tailored to management’s individual requirements. the extent of the processing depends on the final output required. Again.
Telephone The telephone is still the preferred communication medium for urgent messages. A cheaper and quicker alternative is to distribute the computer file via e-mail. Unfortunately. A later call-back is always possible. and the
. Personal call The best way to communicate an urgent message is a personal visit (assuming that the recipient is not far away). If people are not at their desks. Voicemail Voicemail is the alternative to frequent call-backs. Paper mail The amount of paper mail should decrease in companies where e-mail and voicemail have been introduced. E-mail is particularly suited to sending out agendas. the use of a photocopier and internal mailing envelopes can be a much more efficient method than re-typing and e-mailing. Assuming that those to be contacted are at their desks. voice mail allows the use of the telephone as an urgent communication device to be subverted – staff can activate voicemail while still at their desk.attachment facility means that other computer files can be distributed simultaneously for checking or review by recipients. and the transmission of lengthy hand-written documents that would need re-typing before they could be sent. although this will waste some time for the caller. a telephone ringing is almost guaranteed to interrupt anything they are doing and elicit a response. and the caller does not have to call again. in the absence of voicemail. to avoid the telephone ringing. Few people ignore a personal caller. this is a costly and slow communication method. the using of paper mail transfer should be restricted to the transfer of confidential documents (such as appraisal reports) that are not to be placed on the computer system. However. messages cannot be left if the telephone is not answered. and messages left with a secretary may lose their urgency. If both e-mail and voicemail are available. this is not always the case. If further communication is necessary. a personal answering service can be activated to take the message. or confirming meeting arrangements made on the telephone. Unfortunately. In this latter case. the onus is on the person receiving the message to call back. Unfortunately. Computer printout Computer printouts are often still distributed though the internal mail system.
because each manager on the circulation list assumes that another manager will deal with it.
Element 10. Care must be taken to ensure that reports are targeted at the correct manager(s). the report may simply not be reviewed at all. Use terms. whether in hard-copy form or displayed on a computer screen. This is a much better use of management time than having to wade through pages of data. they should be received within a time scale that enables effective management action to be taken on them. Use exception reporting . This rule applies particularly to information in a management report. Strategic management will expect reports to be in summary format. a ‘scattergun’ approach. whilst operational management will require extremely detailed reports. may be counterproductive. most of which is (hopefully) wholly unexceptional. Most managers receive too many reports. and that might require action of some sort as a result.two-way communication that results should resolve problems quickly and efficiently. it is important that it is presented correctly. presentation of numbers etc. if numbers are large. For example. consistently .to the person receiving the report. the data should be presented clearly and consistently. Be timely . adverse variances could always be shown in brackets.if a report is to be read and understood quickly.We have seen that different levels of management need reports to be at different levels of detail.4. 341
. Be relevant . To be effective.If management reports are to be of use in decision-making.exception reporting draws the attention of management to matters that are not proceeding as planned. In this situation. written (or non-screen) reports should: • Be set at the correct level of detail .1 Information Dissemination – Effective Presentation of Information For information to be communicated efficiently. they could be rounded to the nearest hundred or thousand. in which a report is sent to a number of different managers on the chance that one or more may want to see it. to distinguish them from favourable variances (or vice versa) or.
Element 10. Some of the sources that may be useful to the accountant include: • • Internal data on production. Please refer back to your Stage 1 manuals for more information if any of these items are unfamiliar to you or you have forgotten what they do. Figure 9. External information on competitors via competitors’ homepages or via specialist data collection agencies who have already obtained the Internet data. stock reports etc. Using a type of bulletin board.2 Uses and Limitations of PCs What is a PC? You will already have learnt about PCs in your Stage 1 studies.3 Uses and limitations of PCs in Management Accounting With the fall in price and size of computers over the last few years. and be clear about the decisions that must be taken. Uses of PCs in management accounting To provide assistance with information gathering PCs give management accountants access to a wide range of information. The aim should be to produce a report from which the manager can quickly assimilate information. Reports from other offices
As a communications medium Computers make e-mail systems available which can be used to send messages quickly.7 is designed to remind you of the important ‘bits’. other qualities can be added to this list. Rather than describe the computer hardware again. managers can post questions into the 342
. cheaply and efficiently. it is likely that most accountants will have access to some form of computing resource. Element 10. the information that can be retrieved from the system is almost endless. and there is also an internet connection.4. financial accounts.4.Obviously. Assuming that the PC is networked and the company’s central file servers are available. particularly where a number of similar products are being produced across a series of locations. Other applications can be used to provide discussion databases.
This is a particular problem where spreadsheets have been used and the data have not been subject to the normal detailed checking routines (see 9. simply because the system can do this. it can take a considerable time to check through all the detail and determine whether amendments are needed. The use of computerised manufacturing systems has resulted in firms producing high-quality and low-priced goods. The cost of implementing such a system may well be insignificant when savings in management time are taken into account.5
COMPUTERISED MANUFACTURING SYSTEM
Element 10. Information overload One of the main problems with computerized systems is the temptation to produce more and more information. If part of the information looks incorrect. add their own comments.
Element 10. e. 343
.1 Computerised manufacturing systems are systems which involves the use of computers directly to control production equipment and indirectly to support manufacturing operators.3).7. Other managers can then review these questions. This is where an efficient and effective MIS can literally save the accountant hours of work each day. The management accountant ensures that all computer applications are adequately checked before they are used in ‘live’ situations.system.5.: • • • Financial Reporting Standards Training material on management accounting topics Product directories and similar information to assist raw-material purchasing decisions
Limitations of PCs in management accounting Difficulty in checking the accuracy of management accounting information The management accounting information produced by many computer systems can be quite detailed. For reference material A large amount of reference material for accounting is now available on CD ROM.g. The management accountant may find that the reports he has to review increase in both number and detail. and raise further queries. There is therefore a need for an efficient data filtering system. so that the accountant can receive exception reports rather than detailed analysis. and contain a lot of supporting data.
Element 10. Using CAD new products can be designed on computer screen. This in effect reduces throughput times.5.5.5. there is the need to be more innovative and flexible in their manufacturing methods. This system has rearranged the production flow whereby groups of products with similar requirements are grouped together so that they can utilize the same facilities. scheduling is made easier.5. It also connects to database to be recalled and developed easily. advanced manufacturing technology (AMT) has emerged. To this effect. One of the new tyes of manufacturing systems known as group technology ( or repetitive manufacturing) has emerged. Element 10. Element 10. quality control and inventory control systems. Indirect CAM applications include MRP. Element 10. Advanced Manufacturing Technology (AMT) Advanced Manufacturing Technology (AMT) encompasses automatic production technology. computer-aided design and manufacturing.5. including other innovative computer equipment.4 COMPUTER –AIDED DESIGN (CAD) Computer-aided design (CAD) provides interactive graphics that assist in development of product and service designs. An example is a computerised numerical control (CNC) machine which reads instructions for making parts.6 COMPUTER-AIDED MANFACTURING (CAM) Computer-aided manufacturing (CAM) is the use of computers to control the physical production process. Automated guided vehicles (AGV) are computerised materials handling machines can replace the traditional conveyor belts. Element 10. Direct CAM applications link a computer directly to production equipment in order to monitor and control the actual production process. flexible manufacturing systems. set-up costs and a reduction in work in progress. designs can be assessed in terms of cost and simplicity and utilsation of materials. they should be in a position to produce a range of product at reduced costs.6 COMPUTER-INTEGRATED MANUFACTURE (CIM)
.2 Computerised manufacturing systems encompass the whole production process from materials resource planning (see 9.8) up the point when finished products are due for distribution. In addition.3 In order for firms to compete effectively.
and instantly appreciate the effect of these changes on the finished product. thereby minimizing the possibility of production errors. Computer –aided design (CAD) allows huge numbers of alternative configurations to be analysed both for cost and simplicity. quality and time. where possible. to enable the transformation of a product idea into a delivered product at a minimum time and cost. such as order product entry and accounting. and aided manufacturers’ ability to compete on the dimensions of cost. The use of a database to match. will enable the company to minimize stockholdings by reducing the total number of product parts required. CAM and operational activities such as MRP. The advanced graphics facilities of the typical CAD program enable the draughtsman not only to move parts around the design. At the initial design stage of a product. and the time taken to work through an initial engineering drawing – and. in the case of the latest generation of software. ‘walk through’ it). It incorporates design activities such as CAD.and its cost structure – in most of the major manufacturing companies of the world. but also to manipulate the drawing. the considerable space occupied by the drawing tables of a typical design office has been replaced by computer terminals. which. Simple designs lead to a more reliable product.Computer-integrated manufacture (CIM) aims to integrate information for manufacturing and external activities. together with its concomitant software. more importantly. changes to existing
.7 Computer Aided manufacturing The manufacturing process is carried out by a range of machinery. CNC machines are programmable machines or bank of machines. a simple product is easier to manufacture.6 Computer Aided Design The introduction and wide dissemination of advanced manufacturing technologies (AMTs) has changed the face of the product development and production process. FMS and inventory control. the requirements of the new design with existing product parts.
Element 10. facilitating a change in configuration in a matter of seconds via the keyboard. Significant elements of CAM are computer numerical control (CNC) and robotics.
Element 10. and view the design from any desired angle (and even. comes under the collective heading of computer aided manufacturing (CAM). and further. Thus CAD allows quality and cost reduction to be built at the design stage of a product. rework the drawing –has shortened dramatically as a result of the software currently available.
parts or tools through a variety of simple tasks without human intervention. the possibility of producing smaller and smaller batch sizes at an economic cost also increases.
Element 10. OTED refers to ‘one touch exchange of dies. such as spot welding or painting. and to deliver stock to the required place within the production facility. even a batch size of one unit. The holy grail of CAM in this respect is a set –up time of zero – in such a situation. Two brief examples will serve to illustrate the dramatic impact of CAM on manufacturing flexibility. found that the time taken to completely retool car body panel jigs in their intelligent body assembly system (IBAS) fell from 12 months to less than 3 months by reprogramming the process machinery by computer and using computerized jig robots. the car producer. These changes have reduced the changeovers time in moving from one process to another. and NTED to ‘no touch exchange of dies’. who tire and are error prone. and the time taken to develop a product and bring it to the market. However. Nissan.configurations and new configurations are easily accommodated.1 Computer – Integrated Manufacturing
. repetitive manufacturing functions. the implicational important benefits. so that the production schedule can be driven more and more by customer requirements.7. unlike human operators. In the case of the latter. the benefits in terms of market flexibility of the ability to produce cost-efficient small batches are obvious. Toyota. to a completely consistent level of accuracy and machine tolerance. As the speed of production changeover increases under CAM. Furthermore. and dramatically reduced set –up times. Again it is a Japanese company. CNC machines are able to repeat the same operations continuously in an absolutely identical manner. The terminology used by Toyota has now been generally adopted: SMED stands for ‘single minute exchange of dies’ and is used for all those changes which are less than 10 minutes in duration. CNC therefore offers great flexibility. the cost advantage of mass production would disappear completely. the abbreviations AGV (automated guidance vehicles) and ASRS (automated storage and retrieval systems) are often worth noting. Similar advances have been made in the resetting of machines and in the exchange of dies. and any batch size would be optimal in production cost terms. They tend to be used to perform relatively straightforward. which provides one of the best examples of the advances made in this area. rather than the constraints of the traditional manufacturing process. The field of robotics applied to the manufacturing situation has produced a series of reprogramable multi-function devices designed to move materials.
which brings together all the elements of automated manufacturing and quality control into one coherent system.
Solution: • Management information system is a set of formalized procedures designed to produce managers at all levels with appropriate information from all relevant sources (internal and external). in the form of a flexible manufacturing system (FMS). Explain.
Example: 1. with the computer ensuring minimum changeover time and maximum built in quality. all operating under synchronized computer control to ensure continuous work flow. with a relevant example. Baggage weight is
. handling mechanisms and robots in such a way as to synchronise workflow. with its overtones of ‘ghost factories’.The ultimate extension – and logical long-term direction. check in procedures monitor which passengers have turned up and whether any ‘stand-by’ seats are available. The FMS cell is often referred to as an ‘island of automation’. A somewhat watered-down version of CIM is already with us. however. An FMS produces a range of machines tools. to enable them to make timely and effective decisions for planning and controlling the activities for which they are responsible. conveyor belts that transfer the individual part being worked upon from machine tool to machine.
An example of a management information system can be seen in an airline business. a computer program coordinates a cell of CNC machines. State and explain some of the general qualities of good information. controlled entirely by means of a computer network with no human interference.is not yet with us (and indeed. would not necessarily be universally welcomed). and robots to transfer the parts from belt to tool and vice verse. The FMS also includes a facility for monitoring the quality of the parts being produced. At an operational level. The ‘ideal’ technological world of CIM – the fully – automated production facility. what is meant by a management information system (MIS). In a FMS.of AMT in the production environment is computer –integrated manufacturing (CIM). The title aptly describes the systems strength – its flexibility to produce a range of different components automatically. 2.
Completeness. More recently developments are concerned with the provision of better information for management. 2.accommodated and external weather data will be used to plot the most economical and safest route. Decision support system The first computer systems were designed to produce cost effective replacement for routine electrical tasks. In addition the outline will attempt to find out what other flights passengers may have used for part of their journeys. 3. i. passenger destiny on each route will be monitored and analyzed. The main qualities regarded of good information are: 1. 5. At tactical level. This may help the airline to decide whether to form alliances with other carriers (As recently delta 40 with virgin). Describe four common corporate administrative functions switched to computerization. At strategic level overall profitability on each route will be monitored.
. it is unlikely to be useful. Relevance Only that information which is useful to the decision making process should be included. Timelines Unless the information is up to date and produced in time for the decision to be made. This will allow few structures and aircraft types to be determined. 4. Accuracy The information must be sufficiently accurate for the purpose of the decision bringing made but any greater levels of precession may reduce its overall value. Significance To ensure that the information is meaningful to the person using it should concentrate on the prompts. details of all possible options should be available for consideration. which are needed by the decision-maker. If a decision is being made.
and in its environment. different strategies
. delivery. Management information and decision support systems are linked by the data which they use to improve the efficiency of the management function in an organization. although more specialize financial modeling software also exist.ii. Given the background within which decision are made using information based on analyses and reports from the other components of the overall data processing system. who can request for the reports that they think necessary. production transaction recording and the production transaction recording and the production of regular analysis of sales and debtors. Payroll production: Taking hours worked as input and producing pay slips coin analysis or bank transfer details and costing information. Fixed asset accounting including the maintenance of registers. analysis etc. the recording of purchases and sales. The management information system normally uses the principal of exception reporting to highlight aspects of co-operational information. 2. or could be under the control of individual managers. which is important for planning purposes. 3. the calculation of depreciation charge and the production of lists. note invoice. 4. In order to keep up with changing circumstances within the organizations. Both rely on data produced from the computerization of corporate administrative functions and both produce information to help managers fulfill their function and improve the quality of the decision making. Decision support systems use computer software to modern the behavior of parts of the organization and to allow the simulation of difficult decisions and their results.
Solution: Among the most commonly administrative functions are: computerized corporate
1. Sales accounting: Including input. Stock control: Including the recording of receipts and issues the automatic generation of requisitions for stock falling below the reorder level and the production of stock lists and movement analysis. Comment on management information and decision support systems in improving the efficiency of the management process. The most common example is the spreadsheet. the criteria used to select information should be constantly reviewed.
Computerised and automated storage and retrieval system for raw material and parts. Element 10.
Element 10.can be tried and their results examined and compared to aid in determining the optimum decisions. Computerised-integrated manufacturing (CIM) ii.8. The system aims to use computer control to produce a variety of output quickly.2 FMS are most suited to batch production systems which have intermediate amounts of variety and volume of outputs.9 Business Process Re-Engineering (BPR) Business process re.8.8 Element 10.8.
Element 10. Computerised material handling system iv. A just-in-time (JIT) system iii. Element10.engineering involves focusing attention inwards to consider how business processes can be redesigned or re.1
FLEXIBLE MANUFACTURING SYSTEMS (FMS)
Such a system is made up of a group of machines with programmable controllers linked by an automated materials handling system that enables a variety of parts with similar processing requirements to be manufactured.3 The main features of an FMS include: i.
. Management information systems and decisions support software can then be seen as integrating the information produced from the operational levels of the data processing function and analyzing and summarizing it to make it useful to managers in fulfilling their decision making and planning functions.engineered to improve efficiency. It can and should lead to fundamental changes in the way organizations function.
A RE. services and speed. incremental improvements. quality.arranging of the business in order to deliver quality.ENGINEERED PROCESS HAS CERTAIN CHARACTERISTICS. v.1 Principles of Business Process Re-Engineering (BPR) a) Process should be designed to achieve a desired outcome rather than focusing on existing tasks. vii. The advantages of centralized and decentralized operations are combined. ii. indicating that business process reengineering is somewhat akin to zero base budgeting.engineering (BPR) is the fundamental rethinking and radical redesign of business processes to achieve dramatic improvements in critical contemporary measures of performance.engineering involves the re.
. iii. Key Term A process is a collection of activities that takes one or more kinds of inputs and creates output. BPR recognizes that there is a need to change functional hierarchies which have evolved into functional departments that encourage functional excellence but which do not work well together in meeting customers’ requirements. Work is performed where it makes most sense. b) Personnel who use the output from a process should perform the process. reliability. cost efficiency and effectiveness.Business process re. such as cost.
Element 10. Checks and controls may be reduced and quality built in.
i. (c) Process. One manager provides a single point of contact. iv. vi.
Often several jobs are combined into one Workers often make decisions The steps in the process are performed in a logical order.9. Key words in the phrase (a) Fundamental and radical. (b) Dramatic means that BPR should achieve ‘quantum leaps in performance’ not just marginal. Business process re.
e) Parallel activities should be linked rather than integrated. which replace the old functional structure. (b) Job change. g) Information should be captured once at source. (e) Organization structures change from hierarchical to flat (team) structures. (d) Performance measures concentrate on results rather than activities.NGINEERING
(a) Work units change from functional departments to process teams. (c) People’s roles change.2 Implications of BPR – Management Accounting System
ASPECT (i) Performance measurement around
IMPLICATION Performance measure must be built
.c) Information processing should be included in the work.it should tie in with job enlargement and job enrichment. which produces the information. f) Doers should be allowed to be self-managing. d) Geographically dispersed resources should be treated as if they are centralized.
CHARACTERISTICS OF ORGANIZATIONS WHICH HAVE ADOPTED BUSINESS PROCESS RE. They are empowered to make decisions relevant to the process.9. Process teams create ‘value’ which is measurable.
this may affect the design of responsibility centres. Consider a materials handling process. storing materials.ENGINEERING
(a) A move from a traditional functional plant layout to a just in time cellular product layout is a simple example. (ii) Reporting (iii) Activity (iv) Structure There is a need to identify where value is being added. ABC might be used to model the business processes Reports should be designed round the process teams and the whole reporting system should be centered around the organizational structure.
EXAMPLE OF BUSINESS PROCESS RE. New variances may have to be developed in addition to the existing traditional variances. inspecting materials and paying suppliers. (b) Elimination of non-value added activities. processing purchase order.processes not departments. which incorporates scheduling production.