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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 22.214.171.124 Discount Facts/Interest Rate……………………………. 12 Element 126.96.36.199 NPV and the Agency Theory………………………….. 12 Element 188.8.131.52 Assumption In Net Present Value………………………. 12 Element 184.108.40.206 Net Present Value, Risk and Uncertainly……………… 14 Element 1.1.2 Internal Rate of Return………………………………….... 16 Element 220.127.116.11 Decision Criteria In Internal Rate Return………………. 17 Element 18.104.22.168 The Reinvestment Assumptions………………………... 17 Element 22.214.171.124 Multiple IRR (Multiple Yields)………………….……... 22 Element 126.96.36.199 Internal Rate Of Return For Projects With Unequal Lines…... 24 Element 1.1.3 Payback Period Method…………………………………... 25 Element 188.8.131.52 Limitation Payback Period Method…………………….. 26 Element 184.108.40.206 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 220.127.116.11 Advantages of leasing…………………………………… 55 Element 18.104.22.168 Tax Benefits to The leaser………………………………. 56 Element 22.214.171.124 Tax Benefit To The Lessee……………………………… 56 Element 1.6.2 Types Of Leases……………………………………………57 Element 126.96.36.199 Finance Lease…………………………………………… 57 Element 188.8.131.52 Operating Leaser………………………………………… 58 Element 1.6.3 features Of Leases ………………………………………… 58 Element 1.7 Cost-Benefit Analysis………………………………………..64 Element 184.108.40.206 Structured And Unstructured Decisions………………… 64 Element 220.127.116.11 Goal Congruence And Decision Making………………... 64 Element18.104.22.168 Nature Of cost-Benefit Analysis…………………………. 64 Element 22.214.171.124 Cost-Benefit Analysis Techniques……………………….65 1
Element 126.96.36.199 Profitability/Net Cash-Flow……………………………... 65 Element188.8.131.52 Scoring And Ranking……………………………………..65 Element 184.108.40.206 Mechanics Of Scoring And Ranking……………………. 65 Element 1.72 Post Project Completion Audit…………………………….. 68 Element 220.127.116.11 Benefits Of Post-Completion Auditing…………………..68 Element 18.104.22.168 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 22.214.171.124 Over-Resourced Activity……………………………….. 107 Element 126.96.36.199 Inefficiently Managed Activities……………….. ……... 107 Element 188.8.131.52 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 184.108.40.206 The Sales Budget……………………………………….. 186 Element 220.127.116.11 The Production Budget…………………………………. 187 Element 18.104.22.168 Labour Budget………………………………………….. 191 Element 6.2.2 Cash Budget………………………………………..……... 193 Element 22.214.171.124 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 126.96.36.199 Imposed Style of Budgeting……………………………. 208 Element 188.8.131.52 Participation Style of Budgeting………………………... 210 Element 184.108.40.206 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%)
4 Element 2.5 Element 3.1 Element 3.1 Element 4.1 Element 1.4 Element 4.0 COST ANALYSIS – (15%) Element 3.6 Element 1.7 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 5.0 CAPITAL INVESTMENT APPRAISAL – (15%) Element 1.5 Element 4.1 Element 2.2 Element 3.6 Element 4.2 Element 1.0 MEASURES OF PERFORMANCE (10%) Element 4.5 Element 1.5 Element 2.3 Element 1.UNIT 1.3 Element 2.2 Element 2.4 Element 1.0 DECISION MAKING TECHNIQUES (15%) 8 .7 Cost Plus Pricing Marginal Pricing Target Pricing Life Cycle Pricing Other Pricing methods Changes in Price Levels Transfer Pricing theory UNIT 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 2.2 Organizations) Element 4.3 Element 4.3 Element 3.0 PRICING THEORY – (10%) Element 2.6 Element 2.6 Cost Reduction Cost Control Value Analysis Value Engineering Activity Based Costing Total Quality Management UNIT 4.4 Element 3.
1 Element 6.6 Mix Variance Yield Variance Fixed Overhead Cost Variances Sales Variances Planning Variances Operational Variances UNIT 9.3 Element 9.5 Element 5.4 Element 9.1 Element 8.5 Throughput Accounting Target Costing Service Costing Life Cycle Costing Backflush Accounting 9 .Element 5.2 Element 5.2 Element 6.1 Element 7.3 Element 6.6 Sensitivity Analysis Learning Curve theory Linear Programming Decision Trees Uncertainty and Risk Analysis Multi-product Cost Volume Profit Analysis UNIT 6.2 Element 9.4 Element 6.3 Element 8.5 AND BUDGETARY The Budgeting Process Types of Budgets Flexible Budgets Behavioural Aspects of Budgeting Applications of Information Technology in Budget preparation UNIT 7.1 Element 5.0 BUDGETING CONTROL (10%) Element 6.4 Element 5.5 Element 8.2 Element 8.1 Element 9.4 Element 8.0 ADVANCED VARIANCE ANALYSIS (10%) Element 8.2 Element 7.4 The changing Business Environment Production Management Strategies World Class Manufacturing Techniques Product Life Cycle UNIT 8.0 MODERN BUSINESS ENVIRONMENT (5%) Element 7.0 MODERN MANAGEMENT ACCOUNTING TECHNIQUES (5%) Element 9.3 Element 7.3 Element 5.
5 Element 10.7 Element 9.1 Element 10. T Hopper and R W Scapens Accounting for Management Control.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. Section A: This section will carry ONE COMPULSORY question worth THIRTY (30) marks.3 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. 10 . Section B: There will be THREE (3) questions in this section each carrying TWENTY FIVE (25) marks. C Drury (Latest Edition) Issues in Management Accounting. Section A.8 Activity Based Costing Manufacturing Resource Planning Enterprise Resource Planning UNIT 10.2 Element 10. Ashton. out of which candidates will be required to attempt any TWO (2) questions.6 Element 9.Element 9.7 Element 10.8 Element 10.4 Element 10.6 Element 10. Section B and Section C.0 INFORMATION TECHNOLOGY AND MANAGEMENT ACCOUNTING (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.
which are normally in use. • • • • • • • • 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 investment will not purely depend upon financial aspects but to a large extent.0 CAPITAL INVESTMENT APPRAISAL Learning outcomes: After studying this chapter candidates must be able to: Demonstrate knowledge of key investment.1 Appraisal Methods The main methods of investment appraisal. regarding appraisal methods and the following. Element 1.UNIT 1. corporations must compare the benefits to be derived from the acquisition/investment against the costs involved in the investment. the strategic direction of the business. 11 . Remember the financial decisions fall with the long-term corporate strategy formulation process. The traditional methods ignore the fine value of money whilst the scientific methods recognise the fine value of money in the evaluation. are: (a) (b) (c) (d) Payback Internal rate of return Net present value Accounting rate of return. The investment appraisal methods can be divided into traditional and scientific methods. Before deciding which project/assets to invest in.
12 . at which investors can borrow or lend money. the investment should be accepted.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.1. all cash flows are expressed in present day values by the cash flows. in present day terms of the total costs of the investment (cash outflows) and the total receipts from the investment (cash inflows).1. Element 1. Element 1. is key to the Net Present Value model (NPV). the net present value is positive and purely on financial grounds.Element 1.1 Discount Factors/ Interest Rate The interest rate.1. In contrast. the investor can determine whether a return in excess of discount rate ‘r’ is available from the real asset in question.1. as well as the more obvious initial investment outlay). the net present value is negative and the investment should be rejected. which are realised in the future. 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). When the present value of the inflows exceeds that of outflows (which includes any relevant taxation liabilities. 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. undertake a combination of the two options. A comparison is then made. or borrow in order to invest in real asset.1. By discounting the financial costs and benefits associated with real assets at this rate. In the Net Present value computations.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. The Net Present Value approach holds that cash received in the future is less valuable than cash received today.
The Discount rate must be a measure of the opportunity cost of funds for wealth maximisation to result.1. In the absence of past experience. Ninsh Corporation.1. Risk and Uncertainty Risk management does not leave out project appraisal and evaluation process.1. Ninsh Corporation have asked their management Accountant to evaluate the 4 projects for their viability before it commits its finances to the projects.Since Net present Value models decision rule advocates that a project whose financial benefits outweigh its financial cost. is a guide in assigning specific possible outcomes for the action currently proposed.3 Assumption in Net Present Value The Net Present Value technique is based on the following assumption. henceforth having a positive net present value should be accepted and be pursued and vice versa. the project sponsors.1. Perfect capital market and perfect information exists The model assumes that a single rate which reflects the opportunity cost for all individuals and companies. EXAMPLE 1 Chaswe engineering consultants have been engaged in developing four (4) projects on behalf of their client. Element 1. Advanced risk analysis and management are outside the scope of the text. we would have no basis upon which we can base our probability on. The net present value upholds the thenetical sole objective of business of maximisation of shareholder’s wealth through maximisation of returns from the project. All Shareholders have an objective of wealth maximisation Element 1. Past experiences can be new. The cost of funds for NINSH Corporation is 5%. 13 . However.4 Net Present Value. 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.
800 12.00 86.000) 20.35) 14 .00) 19.REQUIRED: In your capacity as Management Accountant of NINSH Corporation.00 18.38 82. Project: Capital (Outlay) year 0 Cash Inflows 1 2 3 4 Solution: Since the company’s cost of capital is 5%.000 12.800 400 400 (20.27 (2.8227 Net Present Value Cash flows K’000 (40.140.8638 4 0.000 100 100 Present Value K’000 (40.000 20.000 20.000 Year 0 1.048.000) 0 0 0 36. 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) 20.000 100 100 K’000 (40.000) (20.000. Project A Discount factor @5% A B C D (40.0000 1 0.9524 2 0.000 32.643.000) 400 400 32. thus will serve as the discount rate at which the project cashflow will be discounted.9070 3 0.
72 11.00) 380.000) 400 400 32.9070 0.60 245.8227 Net Present Value Cash flows K’000 (40.000.40 14.0000 0.9070 0.0000 0.60 26.76 Project C Discount factor @ 5 % 1.08 4.52 329.9524 2 0.92 Net Present Value Project D Year 0 1 2 3 4 Discount factor @ 5% 1.20 9.9070 3 0.641.00) 12.20 Net Present Value 15 .Project B Discount factor @5% Year 0 1.000 Present Values K’000 (20.617.8638 0.8638 4 0.8227 Cash flows K’000 (20.000 Present Values K’000 (40.190.000) 0 0 0 36.711.8227 Year 0 1 2 3 4 Cash flow K’000 (20.000.50 27.609.96 362.474.000.800 400 400 Present Values K’000 (20.9524 0.617.800 12.0000 1 0.000) 12.00) 0 0 0 29.326.000 32.8638 0.9524 0.
1. The following steps represent a systematic. Estimate the IRR of project Y using the data given at a cost of capital of 14%. Element 1. The net present value of the project at zero interest rate needs to be established. The procedure under (2) should be repeated for one or more additional discount rates.ANALYSIS AND CONCLUSION Project B. The IRR of a project with conventional cashflows can be calculated using a process of trial and error. This must be a positive figure if an investment with conventional cashflows is to have a positive IRR. methodical trial and error approach to the calculation of project IRR. purely on financial grounds. Project A is yielding a negative net present value and hence. 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. & D are giving positive present values indicating that purely on financial information. The Net Present Value profiles should be sketched and an approximate IRR estimated. 3. they are viable and hence management of Ninsh Corporation should undertake the projects in order to maximize shareholder wealth. A positive discount rate should be selected and the Net Present value of the project at this rate is calculated.1. 2. In other terms.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. the project should not be undertaken as it is posed to destroy value of Ninsh Corporation. EXAMPLE 2 Suppose a company has project Y with the following cashflows to evaluate. C. 16 .
675 0.252.000 Net Present Value Element 1. certainty.20 K’000 0 (20.769 0.40 153.2 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.2.000. Element 1.000) 200 200 160.000 Present Values K’000 (20.920. conventional cashflows and perfect capital markets and the additional assumption of independent projects.80 108.000 0. 17 .000 160.592 Cash flows K’000 (20. which in a real/free world is the prevailing base interest rate. 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) 1 200 2 200 3 160. 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.00 94. purely on financial grounds.00) 178.000 4 160.1.00 183.Project Y Year 0 1 2 3 4 Solution: Years Cashflows Discount Factors (14%) 1.e.000.877 0.1 Decision Criteria In Internal Rate of Return In case the IRR.2.1.
000) 14. The terminal value of an investment is the total value of the cashflows generated by an investment at the end of its life. It’s assumed below that the interim cashflows will be reinvested at 5%.000 8. interim cash flows must be projected forward to the end of the investment’s life by the application of a particular reinvestment rate. In calculating the terminal values.000 12. The Net terminal value is calculated by subtracting the terminal value of the initial investment from the terminal value of the cashflows. Projects Years 0 1 2 3 4 M cash flows K’000 (18.000 12. In the early years of the project running than those with low cash flows in the early years of running.000) 1.000 1. 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.000 Projects M Terminal values 18 .250 12. In contrast IRR assumes that all cash flows will be reinvested at the projects own IRR. There are not practical supporting reasons for this assumption though.000 12.000 K cash flows K’000 (16. This can be illustrated by using an example of 2 projects M & K and calculations of their terminal values.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) 14. This is clearly seen in the case of project K. 19 .000 Conclusion And Analysis By definition. 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.Years 0 1 2 3 4 Cashflows K’000 (18. EXAMPLE 3 Seakwe Ltd is considering which of two mutually inclusive projects it should undertake. Calculate the Net Present Value and internal rate of return of each project.000 Reinvestment rate 5% (1. 3.05)2 (1.340 38. the small positive NTV of M arises because 49% is a slight under estimate of the IRR as perusal of the above analysis.05)4 (1. 2. Explain the inconsistency in ranking of the two projects in the light of the remarks of the two directors. 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.05)1 1. which project you would undertake. 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.000 1.616 1.000 8.05)3 (1. Recommend with reasons.122 22.00 terminal values K’000 65.000 12.404 7.
05% Project Y 20 .621 Factor 20% 1.826 0.000 x (20%.050036333% = 16.909 0. At 10% the NPV of Project X = K58.482 0.040.280. Identify the cost of capital at which your recommendation in (2) would be reversed.050.000 IRR = 10% + [ K58. Y 0 1 2 3 4 5 Factor 10% 1.22 72.05) Project Present Y value 10% (400) (400) 436 396.000) At 10% the NPV of project Y = (K5.000 0.32 20 16.08 (38.04 104.02 8 5.84 58.19 13.694 0.10%)] = 10% + 6.751 0.58 3.000 At 10% the NPV of Project X = (K38.280.28 Present value 20% (400) 58.46 6 3.72 37.080.41 (5.16 135.52 20 15.833 0.45 24.579 0.31 111. 683 0.000 + K38.4.000) The IRR of the two projects are as follows: Project X 1NPV1 IRR = Ra + [1NPV11+1NPV21 x (Rb – Ra)] K58.30 16.88 11.050.000 0.402 Project X (400) 70 160 180 150 40 Present value 10% (400) 63.85 2.000 At 10% the NPV of project Y = K37.18 102.04 Present value 20% (400) 363.08) Therefore as it has been noticed in the calculations.63 132.280. Solution (1).
leading to a situation where project Y shows a higher internal rate of return. Project X has a positive Net Present Value. Project X indicates a higher NPV.10%)] IRR= 10% + 8. showing that it exceeds the company’s cost of capital. assuming that the company’s object is to maximise the Present Value of future cashflows Project X offers the higher Net Present Value. uncertainty and timing if cashflows may be considered by the Directors in making the final investment decisions. Risk. In addition. 21 . whereas project Y offers a higher internal rate of return where such conflicting indications appear.000 x (20%. Projects X’s cashflows are grouped in the three middle years of the project. The two projects have radically different time profiles.000 + 5.040.7939% IRR=18.000 IRR = 10% + [ K37.793922127 IRR= 18. net present value being regarded as technically more sound than internal rate of return.080. it is generally appropriate to accept the Net Present Value result. while nearly 90% of Y’s inflows come in the first year of the project.040.1NPV1 IRR = Ra + [1NPV11+1NPV21 x (Rb – Ra)] K37.79% (2) The recommendation should be to undertake Project X for the following Reasons.
the cost of which will be paid in two stages.3 Multiple IRR (Multiple Yields) At this point in time. we would want to appreciate that in cases where a project does not have conventional cashflows. although it will be expensive to break up and dispose of at the end of its useful life. there is a possibility of having multiple IRR in the project whose cashflows are unconventional. By a project having conventional cashflows.conventional cashflows may have a cash outflow followed by an inflow or inflows then followed by a further outflow or by further outflows. 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. % 0 - 20 40 Although in the above illustration we have show the graphical representation using straight lines.2.+ + + + + 100 80 60 40 20 10 20 30 40 60 Discount rate. A project with non. the true relationship between the Net Present Value and discount rate is a cumulative one.1. the IRR computation might give rise to two or more internal rate of return rates. EXAMPLE 4 Lunga Plc is proposing making a machine it will use in its manufacturing process. Revenue can be expected from its demonstration. Element 1. we mean that there will be a cash outflow followed by a stream of inflows. Years Cash flows K’000 22 .
820) 15. (7.000) 80.8300 0.868) 71. % 23 .000 Cash flows K’000 0 (7.384 47.020) Net Present Value Discount Factor (6%) 1. Interpretation And Analysis 5 10 15 Years Discount Factors (30%) 1.0000 0.8300 0.336 24.820) (18.9434 0.934 20 25 30 Discount rate.8396 PV K’000 (7.0000 0.0 1 2 3 The appropriate discount rate is 15%.8396 PV K’000 (7.000 3 (53.200 (46.000) 2 80.820) 1 (20.000 3 (53.820) 1 (20.000 (53.906) 16.000) 2 80.020) Net Present Value Graphical Representation NPV Investment NPV £ 200 100 0 (100) (200) (300) (400) Conclusion.9434 0.020) Solution: This project has two internal rates of return as shown below.034 78. Years Cash flows K’000 0 (7.820) (20.
1. Therefore. the decision whether or not to accept this investment cannot be made by reference to these rates alone.711 IRR 22% 24 . Element 1.2.000) (60.100 2 K’000 75. 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 1.000) (60. EXAMPLE 5 Consider two projects Years Project P Q 0 K’000 (60.000) 1 K’000 40. NPV method can be used to get a clearer result. A comparison can be made over an equal time span for both investments.000) 15. If NPV shows that the NPV of the same project lower consideration is positive.100 75.100 (1) Using unadjusted Cash flows K’000 NPVP = 4.100 2 K’000 40. The cashflows of two consecutive investments in Q would be as follows: Year Project Q Project Q repeated Total Cashflow 0 K’000 (60.100 (60. 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.As both IRRs are equally valid. consideration must be given to the time period over which a comparison of the investments is to be made.000) 1 K’000 75.000 - Compute the IRRs of the two projects assuming a cost of capital of 10%.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.000 75.
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.000 13.e.400 12.200 D K’000 (10. P over 2 yrs And Q over 1 yr) (2) Cashflow adjusted to Equalise project lives (I.000) 400 400 16. the payback period and accounting rate of return are the commonly used traditional methods of appraising capital investments.090 K’000 NPVP = 4. regardless of the project lives.400 32.000 25 .1 TRADITIONAL APPROACHES TO PROJECTS/ CAPITAL INVESTMENT APPRAISAL As you can remember.6.1.400 C K’000 (10. Element 1. the payback period for the four projects below will be: Projects: Initial capital outlay Cash inflows Years A K’000 0 (20.000 3 20.000) 1 10.800 13.000) 6. P over 2 yrs and Q over 2years) Conclusion and analysis NPVQ = 4. irrespective of the period over which the comparison is made.000 B K’000 (20.000) 0 0 0 18. If we assume that cashflows are received at the end of each year. 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.(I.e.711 NPVQ = 7.810 25% IRR 22% 25% Ranking project P and Q on an IRR basis makes project Q the superior choice. In conclusion.000 2 20. from the outset of the chapter. 1.500 4 21.
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.1.1. Element 1. 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. Element 1. 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. B. Hence only project A and C would be accepted and be undertaken in this instance.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.3. Exercise 1 Please compute the present values of the cashflows from the above 4 projects A. C and D at a cost of capital of 5% and you will discover that the discounted payback (year) will be as follows: 26 .3.1 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. Decision rule: Only projects with short payback periods are preferred.
This is then expressed as a return on either the initial or the average investment in the project.000 K10.000 K8.000 Deprecation: K20. & D with the following data. Average annual profit from an investment x 100 Average Investment Defines the accounting rate of return as.000 K10. B. 200. To find the ARR of an investment. the following illustration can be used. 000.000 K32.4 The Accounting Rate Of Return (ARR) Computing Accounting Rate of Return A mathematical expression of.000 Profit: K1. 200. 000. 400. C.000 K12. the average profit over the life of the investment is calculated.000 K3. 000.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. 000.000 K20. 000. Consider four projects A. 000 K18.000 K13. The model that employs accounting profits rather than cash flows from the project as the input data to the model. 000. EXAMPLE 6: Project Name: Project life: A 4 B 4 C 4 D 4 Cash –Inflows: K21. 400.1. 000. 000.000 27 . Element 1. 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. To illustrate the mechanics of the method.
000 + K0 2 years K6. Average profits for the projects Total Profit over 4 years = Profit per year Project life years Projects: A B K1. 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 K12.000 + 0 2 years K9.000 4yrs K2. 100. 000.38% Project D K18.000 4yrs K800. 500. 200. 200. 000 D K8. we are assuming that the deprecation and profit figures shown are for total (aggregate) figures over the lives of the projects. 400.In the above figures. 000.000 4yrs 4yrs K3. Project A K21.000 + 0 2 years K16. 000. 000. 400.000 = K250.000 + K0 2 years K10. 000 = K10. 000.000 C K3.000.000 Project C K13. 600.000 28 . 500.000 The Accounting Rate of return: Projects A: K250.000 Project B K32. the Average investments are calculated as a simple mathematical mean.200.000 2.
000 = K16. 000.00 per kilometer for each year the truck is in service.00 per kilometer but this will rise by K3.000 105. Scania will incur the following cost over 6 years Years 0 1 2 3 4 5 6 K’000 350. Two suitable models are available details of which are as follows: The Kenworth having a life of four (4) years and a price of K200.000 135. the decision maker needs to specify a required rate of return when ARR is used as the project evaluation method.Projects B: Projects C: K3. 000. corporations need to establish and choose as a policy.12% Projects D: = 22. 000. ANNUALISED EQUIVALENT COSTS EXAMPLE 7 Mpose Plc is considering the purchase of a new track.000 the running cost is initially K20. an accounting rate of return percentage. 600. 200.14% 12. 100.000 The cost of capital for Mpose Plc is 12% Required: 29 .22% For the technique to find use.000 K9.000 = 19.000 150.000 kilometers per year.000 120.000 K800.000 75. As mentioned under the payback period method. which will be required to travel 50.000 K2.000 90. 000 K6.
000 4.000. 340.250.7120 0.038 12% DCF Present value K’000 2.000 1.038 = K1.340.6360 3.000 200.250.000 200. 340. Solution: As we can see the comparison of the two projects is complicated by their unequal lines.000 1.950.884.950.000 0.000 89.750.000 The annualized cost of the Kenworth Truck Year Costs K’000 0 1 2 3 4 Totals: 2.400 1.000.000 100.8930 0.7970 0.000 K4.300 996.Explain which truck (between the Kenworth and the Scania) should be purchased.000 100. 428.134 30 .750.000 3. 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 2.950 The annualized equivalent of K4.000 1.250 142.113.000 1.000.000 1.
7970 0.000 120.7120 0.050 791. Year 0 1 2 3 4 5 6 Totals: Costs K’000 350. The annualized cost of the Scania truck is.550 76.000 4.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’000 350.230 74.000 150.112 = K192. the Scaina is the best option with a lower annualized cost. 890.890 The annualized equivalent of K791.037.000 is K 791.000 135.890.5070 4.0000 0.5670 0.000 90.000 75. 580.6360 0.8930 0.90 Therefore in conclusion.760 76.980 71.000 66.000 1. PREFERENCE FOR APPRAISAL METHOD Investment Appraisal method Advantages and disadvantages of Investment Appraisal Methods PAYBACK PERIOD METHOD Advantages 31 .252.320 76.000 105.
(b) It takes proper account of the size and duration of projects. (b) The Internal Rate of Rate (IRR) cannot evaluate properly the duration of projects. and its implications for liquidity are clear. (b) It's complex in its mechanics. (b) It can be used as preliminary project appraisal screening method. NET PRESENT VALUES Advantages (a) It takes account the timing of cash flows. even through the latter will contribute more to earnings. This is because IRR takes no account of what happens to the returns after they are achieved. in assessing a project’s viability.(a) It is easily understood and interpreted. Disadvantages (a) It ignores cash flows beyond the payback period and it does not take into account of the time value of money. Disadvantages (a) It produces a number which is less familiar to management than a rate of return. Disadvantages (a) It does not take account of the size of the project. INTERNAL RATE OF RETURN Advantages (a) It takes into account of the timing of the cash flow. (c) It takes into account the greater uncertainty of later years’ cash flow by using a higher discount rate for these years. 32 . (b) It is easily compared to a given return. so a small project with a high return looks better than a large project with a lower return. before scientific methods (discounted cash flows are applied for the appraisal process). which project owners are looking for. (c) Not easily understood by non-financial managers. especially to non-financial managers.
cars should be replaced at the point in time at which this cost is minimised.000 20. Initial purchases price: Annual running cost (average per year) Re-sale value if sold after: 2yrs 3yrs 4yrs 5yrs K’000 50. a replacement policy must be decided upon.000 5. or part of an asset or part of that type. demand for the output of a particular production process may extend into the indefinite future. The timetable for a planned replacement will be determined by a consideration of the costs of replacing over one time horizon rather than other. meaning that cash flows with negative and positive signs may come through during the life of the project. This usually happens when a project has unconventional cash flows. Consider the example of a company which provides its entire sales people with a company car. irrespective of the replacement cycle it can be ignored for the purposes of 33 . less the resale value at the time of disposal.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. Data on the type of 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. which our hypothetical company provides for its sales people. As the annual operating cost is constant. For instance.000 15. is the possibility of two or more solutions to the IRR calculation. If the company would like to minimise the overall cost of operating its fleet of cars.000 30. which may sometimes arise. Asset replacement may be undertaken in response to the poor physical condition of an asset or more reasonably replacement may be planned.000 Since the company requires the cars to extend into future.(c) Another potential difficulty. The cost to the company of providing the car is made up of the initial capital cost and the annual running costs. whereas the life of the machine required carrying out the process will be limited to a finite period.000 25. is given below. Element 1.
Assuming a cost of capital of 5%.790) (28. Therefore what needs to be considered are the purchase price of the car and the resale value. which is obtained by dividing the net present cost over the relevant time period.000 0.082) The final column of the table shows the net present cost of owning the car over differing time periods. This procedure allows the expression as an annual figure of a cost or income occurring on a regular but not annual basis. The net cost of the investment in each car is given by the initial outlay less the present value of the sale proceeds.setting the replacement policy. 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 30.210 21.9070 0. the computation would be as below.659) (46.7835 27.000 25.000) (50. This cost does not of itself provide a basis for comparing the relative attractiveness of the alternative replacement cycles.000/1.790.918 (50.000 15. Although.8227 0. For example taking the figures in the first row of the schedule.790. we would be indifferent as to which spending pattern we incurred.8638 0. the cost must be expressed as a net present cost per annum. and three years for the second row etc.000) (22. which in turns depends on the replacement cycle. the K22.341 3. 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) (50.642 (22.000 5.256. In order to make such a comparison. 34 .000) (50.000 spent today is equivalent to an expenditure of K12.595 12.8594) for each of the next two years at the discount rate is 5%. two years in the case of the first row.405) (37.
7232 3. Refer to section 1. Other things being equal the company should adopt a three-year replacement policy.8594 2. The concept of annual equivalent costs can be used to facilitate the comparison of assets with unequal lives.644) Conclusion and analysis It can be seen that the minimum annual equivalent cost is K10.405) (37.082) 1.000 the cost of replacing the cars on a three-year cycle.Schedule 2 Replacement Cycle (years) Net Present Cost (a) K’000 2 3 4 5 (22. 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.5459 4.2 for such a computation.5. providing the assumption can be made that assets will be required for a period which is a complete multiple of each projects own life.431) (10.4.3 Capital Rationing In some instances. assuming that projects are in line with the long-term corporate strategic objectives. In financial wisdom.790) (28.659) (46. The illustration below shows the mechanics of capital rationing 35 . managers of the business will want to select and choose projects that will give the greatest return on the total investment.567) (10. 431. Element 1.3295 Annuity factor (5%) (b) Annual Equivalent Cost (a/b) K’000 (12.620) (10.
000 Z K.907 0.000 90.000) 80.000 0.000 100. X.000) 40. 000 (120. it is clear that even if the net present values are positive the organization cannot invest in all four projects. and Z has a cost capital of 5% and that the funds available in year 0 (i. Using the profitability index technique of ranking project will be employed to rank projects.000 220.000 100.000 90.000) 40.000 140.000 Y K.000.000) (120. at the time of decision-making are K400. W.000 160.000 If we suppose that the company with these four (4) projects above.000 140. 000 (200. in the current year).000 36 .000) 120. 000 (160.000) (80. 000 (160.00.000) 120. Y. 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 Z K.000) (200.Projects: Year: 0 1 2 3 W K. 000 (120.000) 80. 000.864 W K. Discount Rate @ 5% Year 0 1 2 3 1.000 90.000 90. 000 (240.000 220.952 0. 000 (240.000 140.000 X K.000) 200.000) 200. The computation below shows the return from each project and their rankings.000) (80.000 X K.000 Y K.e. 000 (200.
It usually works very well if the company in question is not an Investment Company such as Warren Buffets Bechshire Hathaway Inc. assuming that the investments are divisible. 000 14.000 NPV 49.02% 2nd Z K21. 640. 000.000 0.000 to invest.160) 72. project W would be chosen and 5/6 of project Y.000 K160. 000.630 77.000) (76. W K49. 000.960 X K. divisibility of projects might not be possible.Discounted cash flows Year Yr 0 1 2 3 1.000 The returns on the projects are as follow.000 K120. 000 (240.400 190.000) 38.640 5. all projects have positive net present values and so they would be accepted if funds allowed.000) 181.700 120.952 0.740 14.907 0.20% 4th Y K5. 740.000 13. 000.000) (190. 000 (120.18% 3rd Analysis and comment As it can be seen above.864 W K.080 90.070 21.240 Y K.000 K200. In many circumstances.000 12. 000 (200. but for 37 .000) 85.760 Z K.000 K240. With only K400. 000. 070. so decisions will have to be made based on net present value technique. Capital rationing is not really a practical approach for the majority of organizations.560 138. 000.87% Ranking 1st X K14.000 24.680 81. 000 (160.
38 . Element 1. usually discounted to their present values. However.e. Element 1. this solution will not be very helpful.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. in reality taxes are usually levied on income earned from investment.4 Effects of Taxation on Investment Appraisal Although in many instances we are assuming that there are no taxes in perfect financial markets. the section starts by looking at basics of discounting future cashflows.most of organization providing a service or manufacturing products. which is going to be used widely in capital investment appraisal. Years 0 1 2 3 4 PV Present value Discounting FV Future value Present value (PV) is the cash equivalent now of money received/payable at some future date. The section aims to show the effects of taxation on investment appraisal.
4.000 Choose between The discount rate is 10% Please make your decision by first discounting and then compounding.000 0.000 = PV = FV x 1/ (1+r) n Compounding PV (1 + r) n = FV Year 0 (now) 10.000. 500.315.000 Therefore we would choose the k 1.000. To find present value of an annuity we would apply the factors from the annuity tables. if the discount rate is 11%? 1 2 3 4 5 6 7 8 9 10 39 .000.621 Element 1. Exercise 2: Immediate Annuity What is the present value of K100 earned each year from years 1-10. 000 now with both methods. 0.000* (1.000 Year 5 K 15.000.000.100.Exercise 1 Year 0 (now) K 10.105.000.621 =0.e.000. please note that discounting is the preferred method of comparison in SFM. Discounting Year 0 (now) Year 5 K 10.2 Annuities An annuity is a constant annual cash flow for a number of years.621 x K1. by locating the discount factor at the 10% column and the 5-year row i.000 K 9.000.000.000.10)5 or Tables (given in exam) You can simply find discount factor from the present value table. The Discount Factor Formula 1 (1.1)5 = Year 5 K 16.
To find the present value (year 0) of the annuity. Annual cash flow K200 X 40 .e. all the cash flows have been brought to year 2. the first present value factor added in an annuity factor is for year one. As the first cash flow is in year 3. Answer = Apply the structured approached to deferred annuities: 1. An annuity which commences in year one is called 'an immediate annuity’.9 Exercise 3: Deferred Annuity 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.889 = K588. 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.x The annuity factor at year ten adds together all the present value factors for the first ten years. Answer: PV = K100 X 5. In fact the annuity is quite often called the cumulative present value factors. The annuity factors assume that the first cashflow occurs at the end of year one i. which is currently valued in year two we must multiple it by the present value factor for year two.
4.3 The Basic Perpetuity PV of a perpetuity = Po = annual cash flow r Discount rate = r = annual cash flow Po Exercise 4 What is the maximum amount you would pay for perpetuity of K 25.000 250. Goddard often implies perpetuity by simply stating.2.907 K643 Perpetuities Perpetuity is an annual cash flow forever. The perpetuity with growth keeps appearing in the exam so you need to be very familiar with it. if the discount rate is 10%? Answers Po = K25.10 Element 1. Present value factor for year 2 Present value of deferred annuity 3.546 X 0. It is the simplest cash flow model known to man.000 = 0. Annuity factor for two years 1 to 4 3. PV of perpetuity – Po = Cash Flow Year 0* (1+ g) r–g 41 .000 per annum. 000 10 = K250. thus they also bring the cash flows back one year. 000 r = 25. g = growth expressed as a decimal. Element 1.4 Perpetuity with Constant Growth Perpetuity formulae also assumes that the first payment will be at the end of year one.4. “The cash flows will occur for the foreseeable future”.
05 = K525. b) That the real annual cash flow will be K250.000.826 300. 000.000 0.000.909 400.751 300.000.000.000 from year to the foreseeable future (deferred perpetuity).000.000 from year to year eighteen (deferred annuity). 000 1 K000 440.000 * (1 + 0.000. The assumptions are as follows: a) That the real annual cash flow will be K 250.000.000.000 Present value factors 1. if the discount rate is 10% and the first payment is in year 1? Answer: PV of Perpetuity = 25.000 2 K000 3 K000 4 – 18 K000 250. She wants to calculate the NPV using two different assumptions regarding the project duration.05) 0.000 250.000 Present value NPV – perpetuity NPV – annuity 2. The Financial Director of A plc has prepared the following schedule (excluding inflation) to enable her appraise a new project.1 .000 42 .000 Exercise 6: An NPV calculates with both deferred annuity and a deferred perpetuity.000 Net Cash Flow 363.Discount rate in a perpetuity – r = Cash Flow Year 0* (1 + g) Po Exercise 5 +g What is the PV of perpetuity of K 25.000.000. The project’s real WACC is 10%.000 0.000 0.000 per annum increasing at an annual rate of 5%. 000.0. Answer: Year 0 K000 2.
4.Element 1.5 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 0 K’000 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.e. Decision Rules: 43 . that the expected is greater than the required return.
44 . The allocation / apportionment of fixed costs already present prior to the decision are ignored. Ignore all sunk revenues generated prior to the decision. Negative NPV: Based on the estimates it appears that the project is not financially viable. The company depreciates plant on a straight-line basis over a five-year period. Exercise 7: R+D of K100. What are the relevant cash flows? 2. which requires an immediate investment of K6m. This project will last for five years and at the end of the project the plant will have a scrap value of K1m. Fixed overheads are allocated on the basis of K1 per labour hour. 000 was incurred last year. Element 1. Ignore all sunk costs incurred prior to the decision. If the new widgets are produced the company will have to employ an additional superior at a salary of K15. Each widget will take two hours to make.Single Project: Positive or zero NPV: Based on the estimates it appears that the project is financially viable. Exercise 8: A company is considering investing in a project. 000 per annum. 3. Mutually exclusive project (A or B): (an absolute decision not a relative decision) Simply pick the project with the highest positive NPV. E.6 The Relevant Cash Flows A key concept => include relevant / incremental cash flows in the NPV calculations. Ignore all overheads in existence prior to the decision i.000 widgets per annum. depreciation. Sunk costs are costs which have already been incurred prior to the decision. Ignore all non-cash flows.g. Exercise 9: A manufacturing company is considering the production of a new type of widget.4. nonincremental cash flows. The company will produce 10. They are therefore irrelevant to the decision making process. FUTURE CASH FLOWS THAT ARISE AS A CONSEQUENCE OF THE DECICSION 1.e. What are the relevant cash flows? Answer: Simply when you buy and a fixed asset.
P. 000 salary only. Ignore interest payments and their tax effects as implicit in the discount rate.V Two types of inflation 45 .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.000 Annual cash Flows required 200 100 300 Cost of Capital 20% Ke 10% Kd 15% Wacc Element 1. 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. This simple example ignores tax relief on interest.Answer: The K15. 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.000 1. Market values Equity Debt 1. 4.000 2.
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:
544 13. 000) 16. 000 16.909 . the main features of analysis are shown below.000 12.264 . The company is considering investing in the production of an electronic security device.000 16.826 .000 16.972 + 520 Exercise 18: Breckhall plc Assume that you have been appointed finance director of Breakall plc. 196 7.104 .751 . 579 9.683 (40.972 20% 1 (40. 000) 16.972 * (20% .000 10% 1 .000 12.10%) = 19.482 5.328 . with an expected market life of five years. choose a higher rate for the next calculate to get negative NPV. 016 8.784 (520) investment cash inflow “ “ “ Dis Factor @ PV K (40.000 Dis Factor @ IRR = 10% + 7.Rate) NPV . 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 (40.694 11.000) .216 12.833 13.IRR = Rate + 1 NPV 1 * (Rate . 000) 14. 000 16.NPV 2 1 1 2 If the first NPV is positive. 54 .39% 7. The pervious finance director has undertaken an analysis of the proposed project.
100 50 100 100 100 576 576 576 576 900 900 900 900 3. The lessee may have use of the asset for a specified period.900 600 5.131 396 1. The lessee in consideration for use of the asset promises to make a series of payments/ rentals to the lessor.050 1. The lessor remains the legal owner of the asset during the terms of the lease.500 Cumulative investment in Working capital 300 400 Sales 3.276 4.500 Materials Labour Overhead Interest Depreciation Taxable profit Taxation Profit after tax Year 5 K’000 500 4. financing by using existing cash reserves or by borrowing.276 1. It is an alternative to outright purchase.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 1.320 700 5.044 365 679 535 750 900 1.6 Treatment of Leasing and Hire Purchase Transactions Introduction Leasing is a technique used to finance the use of an asset.014 129 376 365 355 267 689 679 659 Element 1.800 100 576 900 4.044 1.320 900 1.740 700 5. The motivation for choosing leasing rather than purchasing is often tax efficiency.286 4. A lease contract is an agreement between the owner of an asset (the lessor) and the user (the lessee) under which.276 3. 55 .070 1.800 2.074 1.
Tax benefits 2. For institutions which do not pay corporation tax e. In a situation where a loss making business is still creditworthy Where we have start-up projects or businesses.1.Typically lessors would be banks or subsidiaries of subsidiaries of banks. 56 .2 Tax Benefits to the Lessor Tax saving was the original drive or motivation behind the development of the leasing market.1. Flexibility / cash flow 3. The circumstances in which some entities might not have tax capacity and hence can benefit from leasing would include the following.6.6. thus fulfilling the ownership requirements for tax purchases. local authorities universities and colleges. 2.1. Element 1. Element 1. 1.g.1 Advantages of Leasing There are two significant reasons for a company to lease assets rather than buying outright. 1. 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. Element 1.6. In many countries legal ownership of a qualifying asset entitles the owner (e.g.3 Tax Benefits to the Lessee While the tax charges reduce the benefits of leasing. a bank) to amortize the capital cost over the life or the lease period of the asset for tax purposes. Large commercial banks usually had such tax shelter. This gave valuable cash flows benefits to those with the taxable capacity to sketcher their tax allowances. The lessee chooses the asset and the lessor / bank purchases the asset. Access to additional sources of liquidity as a result of increased debt capacity. which they could use as lessors passing on to the lessee some of the economic benefits of tax relief cash flows. which may not move into profits for several years such as most Biotechnology companies and start-up information technology (IT) companies. 3.
57 . 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. Element 1. The full use of assets owner it’s economic . complex structures have been developed which facilitate the marketing of asset reconciling the news of the buyer and setter on their deliveries. Breakdowns . 1. The present value of retails for the leased asset usually exceeds the value of the asset.1. The rewards and risks which are to a very large extent transferred are as fellows: . Idle capacity .4.6. with large continuing capital expenditure and consequent large capital allowances but with low profits available as tax shelter. Obsolescence The conductance below usually acts as criteria for testing a finance lease. Finance Lease A finance lease transfers substantially all the risks and rewards of ownership of an asset to be leased.2 Types of Leases There are two main types of lease: 1 Finance leases 2 Operating leases Element 1. In many laitance of a lease is going to be classified as a finance lease. For some types of assets such as aircrafts computers.6. In a situation where a profitable corporation. containers and rail wagons. 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.2.
an operating lease is one other than a finance lease.6. In a situation where the primary contact parole is somewhat equal or approximately equal to the useful economic life of the asset in question. Usually in operating lease the present value of the rentals is way below the asset value. However. .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.2. Usually equal.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.2 Operating Lease By definition. As we allowed to earlier. The main motivation of finance lease to the lessor is to make a profit by financing the asset. Operating leases may be a sales aid for the product manufacture/ distributor. The following criteria will be distinguished with operating lease. but can be translated to sort the lessees cash flow if value contract is large enough to justify the effort.6. The motivation underlying an operating lease is the leased product (asset). 3. the lessor will be responsible for maintenance and insurance costs payments. Element 1. Relocation 58 . usually such lessor we financial institutions such as bank. 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. 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.2. Element 1. .Lease rentals.3 Features of Leases .
If a machine proves reliable. 200.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. Singa Ltd is considering this and has found some research that suggests that each machine stands a 0. Consider that a time horizon of no longer than 6 years should be used when evaluating decisions on photocopiers. once only. required. 000. b) Xero Company has now made an alternative introductory. 000. 59 .000 each year after which time it will be scraped and sold for K1. At present it hires its 35 photocopying machines from Rent-a-copier Ltd at an annual Rental fee of K11. The reliability of the machines will be discovered by the end of the first year. LEASE RENTAL COMPUTATIONS. Singa Ltd will keep it for four (4) years in total and it will generate a contribution of K16. Xero company sells photocopier machines and is trying to break into the Kitwe market and offers to sell to Singa Ltd new machines for K36.000 of contribution each year.000 each. If the machine proves unreliable.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. 000. An unreliable machine is expected to generate a contribution of K10. It will buy back. 200. as beyond the date photocopier machines are likely to be outdated technology. 30% of the machines at the end of either the first or second year if. it will be scrapped after year one (1) and sold for K800.000. The management of Singa Ltd. . payable monthly (assume that cashflows occur at the year end). offer. EXAMPLE – TREATMENT OF LEASING AND HIRE PURCHASE TRANSACTIONS Singa Ltd owns 20 print and computer shops in Kitwe. Required: a) Prepare computations to show whether a rented or purchased machine is the financially better option.000.000 each year. All machines that are reliable at the end of year 1 will still be reliable at the end of year 4. The company’s annual cost of capital is 8%.000 each payable on installation. Singa estimates that each machine generates K15. 200. The rental agreement covers a 24 hour repair service which assists Singa Ltd to maintain high reputation for a quick and reliable service.7 chance of being unreliable.
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. 200. Solution: (a) Buying a single machine: K’000 Year 0 cost 36.000 Reliable: Year 1-4 (K16. it would remain with the company during the life of the purchased and replaced photocopiers. Required Advice Singa Ltd wether or not it should accept the revised offer.312) Year 4 (K1.735) 52. Having prepared the calculations in (a) and (b) you now realize that the effect of taxation should have been considered. Assume that the 8% cost of capital is the after tax rate for part (c).874 x 0.712 1. The equipment will qualify for a 25% annual reducing balance writing down allowance. If Singa Ltd agrees to either of Xero company’s proposals. 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).7 37. Singn Ltd must nominate in advance which replacement option it prefers.000 x 0. The corporation tax rate is 30%. Because most shops have two photocopiers available.712 K’000 (36. the management of Singa Ltd has now agreed that further replaced photocopiers available. 000.992 882 33.000 x 3.000) 60 . 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. the management of Singa Ltd has now agreed that further replacements after either year 1 or year 2 would be unnecessary.
926 0.000) 36.3 3. Year 1 replacement over year 2: Year 1 Cashflow (K’000) 21.3 x 0.800 Therefore the rented machine is definitely the better option: K10.926) K800.000) Discount rate 0.000) = K4. 384. 200.600 (net benefit of new over 2 yrs option) (18.926 = Corporate figure for renting K1.001 x 0. 000.080 * 2 0. 000 x 0.000 replacing in 5 1.426(saving year 2) 0.000 4.600 (36. 200. 273.312 = K9.K11.384.000.000.3 Probability of a machine kept for 1 year: 4.7 Probability of machine kept for 4 years.000 x 0.000 K 4.600 0.000 .000 x 0.800 (i) Assume a faulty photocopier. 672.926 9.260 741 10. 2000 10. 111.200 *1 machine 61 . 000. 712.000 x 0.857 15.7 x 3.800 – K4.000 = K5.Unreliable Year 1 (K10.712 Renting machine over corporate time period: 0. = (K15.681 735 (sale of machine) by net 2 4.334) (cash received a new purchase price) 3.857 Present value (K’000) (13.
000 31.000 = K840.000 105.7 x K16.500 31.735 0.200.3 x K10.000 = K 3.000 *2 0.000 K14.630 (sale income forgone) (Loss of additional years (7.3 x K800. Renting over a 6 (six) year cycle: Yr 1-6 : 35 machines x K4.000) 497.794 0.000.220 263.440 K’000 (1.000 K1.000) 460.6 income) (1.100 16.000.500 Sale Price K’000 Total DCF Rate K’000 1.000 – K10.500 149.000) Annual inflow Reliable machines K’000 K’000 392.000 392. 200.000 0.0000 0.000 = K11.080) (14. 080.260.500 31.106) (income companion) from renting *1 0.200) 2. 200.000 117.000 = K240. that is 35 machines x 0.600 Annual inflow Unreliable machines K’000 105.623 = K647.000.000 541. 000.000 392.000 0.7 = 24.000 29.600 117.320 101.600 117.5) Year Initial investment K’000 (1.000 Replacing in year 2 – assuming a full 6 year cycle for comparison (in years 5 & 6.260.400 11. some machines will have to be rented.080 189.600 117.000 Therefore replacement at the end of year 2 is better.000 included for 0.630 NPV 0 1 2 3 4 5 K’000 (1.857 0.640 419.100 570.220.000 308.681 0.000 392.000 x 4.000 = K4.960 429.926 0.7 x K1.200.340 6 62 .260.500 31.540 101.000.
200.3 = K3.400 approximately. However.000 x 0.000 (9. Machine rented Taxation will be levied on the profit earned but the expense of renting a machine can be set against this.250 5062 15.000) x 30% = K1. ignoring the time factor (lag).000.532 5. 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 K11.376 7.500 3.200. 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.000 x 3.908 4 K’000 5 K’000 2. instead of depreciation being charged each year a capital allowance may be set against profit.000 Therefore.200.000 6. 5.478 644.360.200. Half of the tax will be paid in the year in which the profit is earned and half the following year.312 = K3.240 Rental: 5 & 6 24.5 machines x K4. (This will reduce the net present value over 4 years by K1. The government sets the capital allowance rates. 4.200.000 – K11.188 2 K’000 4.000 each year for a reliable machine).974. renting still remains the better option by a small margin. business expenses and the purchase of assets.500 3.311 128. Years 1 2 3 Year 1 K’000 Purchase price 36. 6. The amount of taxation paid will be affected by the profit earned.1.876 3 K’000 4.532 63 .000) 27. so the taxation calculation for renting a machine becomes (K15.750 20.000 per year.376 2.
526 1. though are summarized below. In the illustration below the tax effect the extreme case of 100% in the first year allowance and 50% tax rate is used. 428) : K8. managers use the least pool of experience and intellect to make sound judgments. In unstructured decision-making. Element 1.362 6.1. 64 . which we will work. 024 + K1. than the costs involved in carrying them out.7. 208.000 Lease rental calculations are very similar to a discounted cash flow exercise as you could have seen it early in this chapter.2 Goal Congruence And Decision Making All decisions which are made should be consistent with the corporate objectives.772 6.1. which are in the best interest of the company or organizations.994 Total NPV (K’000): K1. 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. We should realize at this point that business managers are leading corporations which have been established with a view to making profits.4 (sale price) Residual value Tax @30% 1. Element 1. Therefore.200 13. Element 1.1 Structured and Unstructured Decisions In structured decisions managers use standard procedures in an outlined manner to deal with situations in a prescribed way.7 Cost-Benefit Analysis In many situations where senior managers of a business make decisions. Rental calculation assumptions for an example. 406 + K2.988 1.7. the decisions made can either be structured or unstructured.350 2. 250 + K2. 100 + K1.994 9.
the qualitative costs and benefits might be more difficult to establish due to the grey nature of the qualitative consequences of our actions. Some of the methods include the following: Element 1. However.4 Cost. 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. 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. in whatever context we look at business decision making. as we mentioned earlier where.7.1.6 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.Benefit Analysis As we have mentioned above. business managers are going to consider the benefits against the cost of pursuing a given strategy before they embark on implementing that particular decision.7. Therefore. Element 1.1.7.Therefore. Element 1. Element 1.5 Profitability/ Net Cash-Flow Typically and usually when carrying out a cost benefit analysis.3 Nature of Cost. Please note that the benefits and costs can be either quantitative and / or qualitative at the same time.Benefit Analysis Techniques There are a lot of techniques used to undertake cost benefit analyses. 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. before a corporate strategy is implemented in a business.7. 65 . the managers will have need to carry out a rigorous cost benefit analysis.1.1.
66 . Most importantly. As a result. Lets illustrate with a simple situation to show how ranking and scoring can be done. Suggested illustration STEP 1. the decision maker should list possible benefits and the likely costs to be incurred as a result pursuing a given strategy. 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. a corporation / decision maker will establish a scale which will act as a rating scale.7. Assume that Chinsa Ltd has been experiencing low sales of its product. the CEO has requested you in your capacity as management accountant to carry out a comprehensive cost-benefit analysis.Element 1. the Manex. However. the finance director is a bit sceptical concerning the likely benefits of this hefty expenditure on the marketing campaign. The marketing Director has suggested that the company should invest heavily in the marketing activities.7 Mechanics of Scoring and Ranking In scoring.1. 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. As a result the entire management is concerned deeply and they have the following views. 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. This scale will give a worst and best rating on the scale.
Increase profits Total scores for benefits costs: (i) Huge financial outlay 4 67 .Bigger client base .Huge financial outlay . Assign weightings or ratings from the scale to each benefit and each cost Benefits 1. List the likely benefits and costs of staging (mounting) up a massive marketing campaign. Bigger client base Rating 3 4 2 9 3. The likely benefits and costs would be the following: These are not exhaustive Benefits .Expected continued advertising STEP 3.RATING SCALE 1 Worst 2 3 4 Best STEP 2.Increase profits Costs .Good corporate image . Good corporate image 2.
which are associated to the various benefits and costs identified by the management accountant and his team. the analysis and comparison show that the benefits of staging a massive campaign will gives Chinsa Ltd more of benefits than costs. Compare the total scores for benefits and the one for costs. This is only a simplistic approach.7. 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. lets look at an equally important aspect of project evaluation and management. which is only a part of the investment process. 68 .2 Post Project Completion Audit From the onset of the chapter we have only been looking at evaluation of projects.(ii) Expected continued advertising 4 8 Total scores for the costs: STEP 4. To conclude the chapter. Benefits Costs Difference 9 8 1 As can be seen above. the scores represent both the qualitative and quantitative benefits. and so the decision to invest in it should be upheld. Element 1. However. 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. It should be noted that in the above exercise.
which may be important in achieving greater benefits from future projects.e. typically professionals such as an engineer who had some involvement in the project. It improves the quality of decision making by providing a mechanism whereby past experience can be made readily available to decision makers. Element 1. 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. usually carries out completion audit.2 Mechanics of Post – Completion Audit A post – audit small team.2. 69 .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. Element 1.7.1 Benefits of Post –Completion Auditing There are a number of benefits that stand out so clearly from a project post – completion audit. the project under review. The benefits can be classified in two main categories. Its main purpose is to enable the experiences. The post – completion audit reviews all aspects of a completed project. Type 1 Those benefits that relate to the performance to the current project i. to assess whether it lived up to initial expectations in term of revenues and costs and analyse the causes of deviations from planned results. It encourages greater realism in project appraisal by providing a mechanism where past inaccuracies in forecasts are made public.2. good or bad gained during the life of one project to be made available for the benefit of future projects. It highlights reasons for successful projects. 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.7.
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. 70 .UNIT 2. The products and services are sold at a price.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. 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.
pricing moves in unison. (b) Existence of intermediaries If an organization distributes products or services to the market through independent intermediaries. price changes by one supplier may initiate a price war. Thus a price rise may indicate improvements in quality. so this ensures that all costs are covered. (c) Competitor Activities In the same industries. rent and so on. (d) Inflation In periods of inflation the organization may need to change prices to reflect increases in the prices of supplies. The full cost pricing is useful if prices have to be justified to customers. Traditional Pricing Bases The two main traditional methods of pricing one (i) (ii) full-cost pricing marginal cost pricing Element 2. labour. Competition is discussed in more detail below. the sales price is determined by calculating the full cost of the product and then adding a percentage mark-up for profit.The following are the main factors that influence price of services or products. 71 . customers tend to judge quality by price. such intermediaries are likely to deal with a range of suppliers and their aims concern their own profits rather than those of suppliers. a price reduction may signal reduced quality. In others. (a) Quality This is an aspect of price perception. In the absence of other information.1 Cost plus Pricing With full cost pricing.
Example 1 Muti Ltd has begun to produce a new product.000 50. K Direct materials 27. It may also require arbitrary decisions about absorption of costs.000 3. it helps to create a better awareness of the concepts and implications of marginal costing and cost-volume profit analysis. product X. This is sometimes called ‘mark-up’ pricing. 2½ hour at K6. The cost accountants may also have problems in determining the accurate profit mark-ups.000 72 .000 per hour 20.000 per hour Variable production overheads Machining. In this way. The marginal cost pricing is convenient if there is a readily identifiable variable cost e. in retail businesses. and the effects of higher or lower sales volumes on profit. a profit margin is added on to either the marginal cost of production or the marginal cost of sales. for which the following cost estimates have been.g. In practice as you already know. pricing decisions cannot ignore fixed costs in the long term. However.000 Direct labour: 4 hours at K5. It draws management attention to contribution.On the other side. Element 2.2 Marginal Pricing With marginal cost pricing. the full cost pricing method takes no account of the market or demand conditions. again it takes no account of market or demand conditions.
and it is recognized that the estimates of direct materials and direct labour costs may be subject to an error of + 15%.000.Production fixed overheads are budgeted at K300. 000 per month and because of the shortage of available machining capacity.600 Selling price per unit of product X 117.000 per month.000 3. (a) Exclude machine time opportunity costs: Ignore possible costing errors Direct materials Direct labour (4 hours) Variable production overheads Fixed production Overhead (K300.000 20.000 per machine hour on producing items other than product X.000 Profit mark-up (20%) 19.000 direct labour hour Full production cost 98.600 K 27. however.000 48. What should the full cost based price be? The following solutions have been developed based on four (4) assumptions.000 = K12. The absorption rate will be a direct labour rate.000 hours of machine time per month. The Direct Cost estimates are not certain as to material usage rates and direct labour productivity. the company will be restricted to 10. It is estimated that the company could obtain a minimum contribution of K10. and budgeted direct labour hours are 25.000 73 .000 per 25. Machine time estimates are similarly subject to an error of + 10%. The company wishes to make a profit of 20% of full production cost from product X.
000 5.000 7.(b) Include machine time opportunity costs: Ignore possible costing errors. Direct materials Direct labour Possible error (15%) Variable production Overheads Fixed production Overheads (4 hrs x K12. Full production cost is in (a) Opportunity cost of machine time (Contribution forgone (½hr x K10.000) Adjusted full cost Profit mark-up (20%) K 98.000 47.510 135.050 54.600 123.060 K 74 .000 72.050 3.000 3.550 22.000 55.000 48.600 (c) Exclude machine time opportunity costs but make full allowance for possible under-estimates of costs.200 112.000) Possible error (labour time) (15%) Potential full production cost Profit mark-up (20%) K 27.000 103.000 20.000 20.
000 Demand Units 42. there will be a profit – maximization combination of price and demand.000.500 23.000 units of its product.2. The Finance Director of Luangwa Ltd suggested that a profit margin of 25% on full cost should be charged for every product sold. The variable cost of a Luan is K5. A full cost based approach to pricing will be most unlikely.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. The Marketing Director has challenged the wisdom of this suggestion. K Potential full production cost as in (c) Opportunity cost of machine time (Potential contribution forgone) (½hr x K10. the Luan. Price per unit K 9.000 75 .000 x 110%) 112.550 5. except by coincidence or luck to arrive at the profit-maximising price.660 Element 2.(d) Include machine time opportunity costs and make a full allowance for possible under-estimates of cost.610 Profit mark-up (20%) Selling price per unit of product X 141. Example 2 Luangwa Ltd has budgeted to make 50.000. In contrast a marginal costing approach to looking at costs and prices would be more likely to help with identifying a profit–maximising price.000 and annual fixed costs are expected to be K150. and has produced the following estimates of sales demand for the Luan.
000 per unit so that sales demand would be 38.000) K000 380. Calculate the profit-maximising price.000 Required (a) (b) 38.000 units of the Luan are produced regardless of sales volume.000 units.000 units).000 (K5.000 13.10.000 = K3. K8.000.000\unit 50. Assume in both (a) and (b) that 50.000 Less increase in stocks (12.000 + K3.000 32.000) 250.000 27.000 x K3.000 11.000 76 .000 400. Solution (a) (i) The full cost per unit is K5. (production is given as 50.000 12.000 variable cost plus K150.000 x K5.e.000 Calculate the profit for the year if a full cost price is charged. (i) Profit (absorption costing) K 000 Sales Costs of production (50.000) 150.000 35.000) in total.000 units x 8) (96.000 units) Variable (50. A 25% mark-up on this cost gives a selling price of K10.000 Fixed (50.000 units hence i.
000 – 5.000 35.000 units. K Contribution (38. this profit figure is more indicate of the profitability of the Luan in the longer term. will be more helpful for establishing what the profit – maximizing price ought to be.000 Demand units 42.000 Fixed costs Profit 150.000 40.000 6.000 x K(10.000 10.000 8.000)190. (b) A profit-maximising price is one which gives the greatest net (relevant) cash flow.Cost of sales Profit (ii) 304.000 210.000 76.000 38. 77 .000 7.000 224.000 The profit maximizing price is K12.000 32.000 with annual sales demand of 32. Price K 9.000 Amount K 168.000 Unit Contribution K 4. calculating the total contribution at a variety of different selling prices.000 11.000 5. and that a marginal costing approach.000 216. This example shows that a cost based price is unlikely to be the profit – maximizing price.000 27.000 Profit using marginal costing instead of absorption costing so that fixed overhead costs are written off in the period they occur.000 Since the company go on indefinitely producing an output volume in excess of sales volume.000 190.000 13.000 12. it would be as follows (the 38.000 unit demand level is chosen for comparison purposes). which in this case is the contribution-maximising price.
000 Per hour 3.2 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. Example 3 ABP Ltd makes two products. Product X K 27.000 55.000 6.000 per month and these are absorbed on the basis of direct labour hours. 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.000 Material 150. rather than according to some arbitrary base like labour hours. Budgeted direct labour hours are 25. However. overheads are allocated to products on the basis of the activities that caused them to be incurred. Product Cost Activity 000 Set-ups 40.000 hours per month.000 Product Y K 24.000 Production runs 30 20 Production runs 30 20 Cost driver X Y K Product Total 78 . X and Y with the following cost patterns. The implication for pricing is that the full cost on which prices are based may be radically different if ABC is used. As you already know.000 25.000 20.Element 2. under the ABC approach.000.000 Direct materials Direct labour at K5.000 Production fixed overheads total K300.000/hr Variable production Overheads at K6.000 50.2.
000 Fixed production Overheads *K300.250 units of product X and 4000 units of product Y. (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. overheads will be allocated on the basis of cost drivers.000 98.000 Inspections 880 3.000\25.000 = 12.000\hr) 48. Required: Given that the company wished to make a profit of 20% on full production cost.520 Budgeted production is 1.000 138. calculate the prices that should be charged for products X and Y using the following.000 23.600 117.000 Product Y K 55.000 Profit mark-up (20%) Selling price (b) 19.000.Inspection 110.000 Using activity based costing.000 115.000 300.600 60. Product X K 000 Product Y K 000 Total K000 79 .
000 41. Target cost is an estimate of a product cost which is derived by subtracting a desired profit margin from a competitive market price.000 19.000 60. 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. 80 .000 K41. If the market will not accept a price increase. The target cost is calculated by deducting the target profit from a predetermined selling price based on customer’s views.600. Techniques such as value analysis are used to change production methods and or reduce expected costs so that the target is met.000 ÷ 4.520) 24.000 40.760 190.250 K108.800 Profit mark-up (20%) 31.200 115. Element 2.000 300.000 16.000 136.560 (c) Commentary Product X K 55.000 90.000 164.000 110.000 96.000 150.000 88.000 Budgeted units Overhead cost per unit ÷ 1. 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.800 158.000 Production overhead 108.200 The results in (b) are radically different from those in (a).Set ups (30:20) Material Handling (30:20) Inspections (880:3.3 Target Pricing Target costing is a pro-active cost control system.000 22.800 Therefore the price then calculated as before Product X K Variable costs 50.
Costs are controlled through variance analysis at monthly intervals. 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. 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.1 Managerial Thinking to Support Target Costing and Pricing Target costing requires managers to change the way they think about the relationship between cost. (b) The desired profit margin is deducted from the price leaving a figure that represents total cost. The Target Costing Process Step 1 81 . 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. (a) The traditional approach is to develop a product. During the products life the target cost will constantly be reduced so that the price can fall. 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. Element 2.Target cost management has been defined as a system that is effective in managing costs in new product design and development stages.3. price and profit. 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. 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.
Split up the manufacturing target cost per unit across the different functional areas of the product. Element 2. to enhance the product (in terms of service. and their eventual withdrawal from the market. 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. Step 2 Split the total target cost into broad cost categories such as development. durability and so on) and reduce costs. quality. They assess a product’s or project’s profitability on a periodic basis.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. If a functional product area cannot be made within the target costs. on the other hand. 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. 82 . Determine the product concept. Life cycle costs are incurred for products and services from their design stage through development to market launch production and sales. manufacturing and so on. the price customers will be willing to pay and thus the target cost. Design the product so that each functional product area can be made within the target cost. marketing. then a cost gap exists between the currently achievable cost and the target for the other areas must be reduced.Analyse the internal environment to ascertain what customers require and what competitors are producing. Step 3 Once it is decided that it is feasible to meet the total target costs. considers a product’s\project’s entire life. Life cycle costing. detailed cost sheets will be prepared and processes formalized. or the product redesigned or scrapped. The product should be developed in an atmosphere of continuous improvement using value engineering techniques and close collaboration with suppliers.
Remember the product life cycle you learnt in management. 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. such costs are traced to individual products over complete life cycles. Life cycle costing is therefore particularly suited to such organizations and products. (c) Individual product profitability can be more fully understood by attributing all costs to products. monitoring spending and commitments to spend during the early stages of a product’s life cycle. The strong force which supports life cycle costing is that generally for organizations operating within the manufacturing technology environment. this information is vital. Traditional management accounting systems usually total all non-production costs and record them as a period expense. Illustration of product life cycle Sales revenue 83 . Using life cycle costing. (a) The total of these costs for each individual product can therefore be reported and compared with revenues generated in the future. 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.Life cycle costing tracks and accumulates actual costs and removes attributable costs to each product or project over the entire product\project life cycle. (b) The visibility of such costs is increased. The total profitability of any given products\project can therefore be determined. 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.
000 barrels per month. For example Nkwazi Breweries might have a capacity of 500. However.5 Other Pricing Methods Element 2. all costs incidental to the special order and the fixed unavoidable cost should be incorporated in the special order pricing.1 Order Pricing A special order is a one-off revenue earning opportunity.5.introduction growth maturity decline sales Time Element 2. A building firm is a typical example as are many types of subcontractors. (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. It could therefore consider special orders to use up some of its spare capacity. 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. (ii) When a business has no regular source of income and relies exclusively on its ability to respond to demand. in the case of (ii) where the special order is the only source of income. 84 .000 barrels per month but only producing and selling 300. These may arise in the following situations.
If there are no scarce resources. A minimum price would leave the business no better or worse off than if it did not sell the item. Element 2. and a company has spare capacity. The opportunity costs of the resources consumed in making and selling the product/service. (i) (ii) The incremental costs of producing and selling the product/service. 85 . If there are scarce resources and a company makes more than one product.5. minimum peeves would include an allowance for the opportunity cost of using the scarce resources to make and sell the product. 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.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. the minimum price of a product would be an amount which equals the incremental cost of making it. A penetration policy may be ideal in the following cases: (a) When the firm wishes to discourage new entrants into the market.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.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.
When demand is highly elastic and so would respond well to low prices. As the product moves into the later stages of its life cycle. A firm with liquidity problems may prefer market-skimming for this reason.5. The profitable ‘cream’ is thus skimmed off in the early stages until sales can only be sustained at lower prices. Initially there is heavy spending on advertising and sales promotion to obtain sales.5. So market skimming pricing would be appropriate in the following cases. that is if lower prices were to be charged.4 Market Skimming Pricing Price skimming involves charging high prices when a product is first launched in order to maximize short – term profitability. 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. progressively lower prices are charged. 86 . Element 2. (c) (d) Element 2. When there are significant economies of scale to be achieved from a high volume of output. and so need to recover their development costs and make a profit relatively quickly. High unit prices makes it more likely that competitors will enter the market.5 Differential Pricing The use of differential pricing means that the same product can be sold at different prices to different customers.(b) 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. The aim of market skimming prices is to gain high unit profits early in the product’s life. (a) (b) (c) When the product is new and different. Where products may have a short-life cycle. so that customers are prepared to pay high prices so as to be one up on other people who do not own it. When high prices in the early stages of a product’s life might generate high initial cash flows.
Centre A sells half of its output on the open market and transfers the other half to B. We can exercise differential pricing on the following cases: (i) (ii) (iii) By market segment e. which is what A would get by selling it externally. Celtel charges less for its air time or credit in off peak period and vice versa.This can be very difficult to implement in practice because it relies for success.g.000 22.000 External sales Costs of production Company profit Required. many car models have ‘Add on’ extras which enable one brand to appeal to a wider cross-section of customers. A K’000 8.g.000 12. on the continued existence of certain market conditions. (iv) E. By product version e. 87 .g.000 10. 000. By time e.g.000 10. 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. Costs and external revenues in a period are as follows. 000. 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). services such as cinemas and hair dressing are often available at lower prices to juveniles and old age pensioners. this is perhaps the most popular type of differentiating pricing.g.000 B K’000 24. By place e. A and B. A would be happy to sell the output to B for K8. Example: Transferring Goods at market price A company has two profit centres.000 Total K’000 32. What are the consequences of setting a transfer price at market price? If the transfer price is at market price.
bad debt risks and possibly transported/delivery costs.5.000 8. with savings in selling and administration costs. B can therefore ask for and obtain as many units as it wants from A.000 10. (a) Where the supplying division has spare capacity the ideal transfer price will simply be the standard variable cost of production. although there is an external market. (a) 12. Element 2. there are two possibilities. (b) When there is a scarce production resource. and unit variable costs and sales price are constant. therefore.000 4.000 22. If profit centres are established.000 18.000 8.7 Cost-based approaches to transfer pricing Cost-based approaches to transfer pricing are often used in practice.5.000 B K’000 24.000 16.000 6. 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 must pay a commercial price for transferred goods. It would seem reasonable for the buying division to expect a discount on the external market price. Element 2. (b) A will be indifferent about selling externally or transferring goods to B because the profit is the same on both types of transaction. it is an imperfect one because there is only limited external demand.6 Adjusted Market Price Internal transfers in practice are often cheaper than external sales.000 12. 88 .000 A earns the same profit on transfers as on external sales.000 K’000 8.A K’000 K’000 Market sells Transfer sales Transfer costs Own costs _____ Profit The consequences. because there is often no external market for the product that is being transferred or because.000 Total K’000 32.000 24. are as follows. however.000 10.
000 10. Division A makes no profit on its work and using this method.000 The transfer sales of A are self-cancelling with the transfer costs of B so that total profits are unaffected.000.000 If the transfer price is at full cost.000 16.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.000) B K’000 24. 89 .000 12.000 Total K’000 32. inc Transfers Transfer costs Own costs Total costs. If a full cost plus approach is used.000.000 12.000 10.000 6. would prefer to sell its output on the open market if it could.000 (ie half of its total costs of production).000 2.000 B K’000 24. inc Transfers _____ Profit 10. The transfer price simply spreads the total profit of K10. A K’000 Open market sales Transfer sales Total sales.000 10. Costs and revenues in a period are as follows. A in our example would have ‘sales’ to B of K6.000 24.000 K’000 K’000 8.000 8.000 22. as follows. A and B.000 12. a profit margin is also included in this transfer price.000 between A and B. A company has 2 profit centers. This would be a cost to B.000 14.000 (4. Centre A can only sell half of its maximum output externally because of limited demand.000 14. External sales Costs of production in the division (Loss)/Profit A K’000 8.000 6. It transfers the other half of its output to B which also faces limited demand.
The change in the price levels may be due to external or internal factors.000 22.000.000 whereas any price above K24.000.000 = 33%. Suppose that the cost per unit to A is K15.000 17. A’s sales to B would be K7.Transfer prices based on full cost plus If the transfers are at cost plus a margin of. and so their profit performance is distorted.000.000 24. 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. It would seem to give A an incentive to sell more goods externally and transfer less to B. A K’000 Open market sales Transfer sales Transfer costs Own costs _____ Profit 3.000.000 would make a contribution. 12.500 Compared to a transfer price at cost.000 + K15.000 will include an element of fixed costs.000 per unit. The total variable cost is really K9. while division B’s own costs are K25.6 Changes in price levels Element 2.000 = K24.000.000 12.500 6.000 and that this includes a fixed element of K6. Division A’s total costs of K12.000. This may or may not be in the best interests of the company as a whole. Half of division A’s total costs are transferred to division B.500 15. including a fixed element of K10. This means that division B will be unwilling to sell the final product for less than K30. 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. 25%.500 7.000 – K6.000. However. A gains some profit at the expense of B.500.500 B K’000 K’000 24.000 7.1 : Changes in price levels are a common scenario in the operations of a company. The transfer price does not give A fair revenue or charge B a reasonable cost.000 = K30.500 10. However from the point of view of division B the cost is entirely variable.000 K’000 8. say.6. Element 2.000 + K15.000 but from division B’s point of view the variable cost is K15. which is (K8.000.000 90 .000)/ K6.
000.200.000 60.000 40. it is important to analyse the expected outcome for each price level.5 Most Probable 60.000.1 0. Buta detergent.000 20.000 0. Selling price K 8.6.6 0.000 30.000.000. Element 2.6.000 30.000 80.000 Demand 50.000.000 Contribution Fixed Cost 120.500 Demand 40.2 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.000 10.000 50.000 0. From the preliminary studies the following analysis has been made.000 30.000 12.000 91 .000.6. Any price change is bound to affect the demand and therefore the variable costs giving varying possible outcomes.000.000 0.000.4 Outcomes At Selling Price K 8.600.000.000 50.000 12.000.000.600.500 Demand Probability 0.000.000 90.000 1.000 700.000 Net Price Expected Value 70.000 50.3 Example Mwine manufacturing company has come up with a new soap product.It is important to relate the price changes to both production costs and selling price of the product or service.000 50.3 Selling price K 10. Element 2.000 Outcomes Probability Probable 40.1 Less Probable 30. Since price level changes represent decisionmaking under conditions of risk and uncertainty.4 Element 2.
700.750.000 15. If those business units are located within different countries.000 8.000.000 70.000 Net Price Expected Value 175.000 Demand 50.000.000 Contribution 225.000 60.000 55. Element 2.000.000. the term international transfer pricing is used.000.000 30.000 90.200.000 40.000 175.000.7 Transfer Pricing Theory This is the price at which goods and services are transferred between different units of the same company.000 6. even though the difference is not so significant.250.000 52.000.000 50.000 120.000.000 50.000 7.000.5 From the outcome it is evident that chosing the selling price of K 8500 gives a higher expected value.000 85. Furthermore it will not be an easy task to come up with an accurate estimate of future demand and the probable outcomes. 92 .000 70.000 135.400.000 125.600.000.000 20.000 50.000.000.000 11.000 Fixed Cost 50.000 5.000 130.000 53.700.000 105.6.500.000 50.000 At Selling Price K 10.000 20.000.000.180.000.000. In practice however other factors may be considered.000 50.000.000.000.000.000 Element 2.000 50.000 10.000.000 50.000.000.000.000 14.000.000.
This means that the transfer price should be a fair commercial price.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) 10. Costs and external revenues in a period are as follows. A and B.000.000 10.000.000 Total K 32. ideally without prejudicing the measurement of divisional performance or discouraging overall corporate maximization. and should be set at a level that enables profit centers to be measured ‘commercially”. Transfer pricing with a constant unit variable costs and sales price: An ideal transfer price should reflect the opportunity cost.000.000 93 . Where a perfect external market exists and unit variable costs and sales are constant. A K External sales Costs of production Company profits Required 8. 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. Center A sells half of its output on the open market and transfers half to B.000 B K 24.000 12.000.000 (22.Transfer prices are a way of promoting divisional autonomy.000. Example A company has two profit centers.000.
7.000.000 is fixed and K9.000) Transfer costs Own variable costs Own fixed costs Total costs and transfers (Loss)/Profit K’000 8.1 Transfer prices based on opportunity costs It has been suggested that transfer prices can be set using the following rule.000 3.600 7. of which K6.600 10. (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.200 4. A K’000 Market sales Transfer sales at variable cost (9. we shall suppose that A’s cost per unit is K15.800 12.600 11. the transfer price = standard variable cost of production 94 .000 variable.000 13.000 /15.000 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. The opportunity cost will be one of the following. Transfer price per unit = standard variable cost in the producing division plus the opportunity cost to the organization of supplying the unit internally.600 6.400 The problem is that with a transfer price at variable cost the supplying division does not cover its fixed costs.000 24. and no alternative uses for the division’s facilities. As above.000 K’000 B K’000 24.000 (400) 3. Element 2.000 x 6.
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. (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.7. Element 2. (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. The next step is to establish the transfer price at which both profit centers. 95 .7. (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 transferring division makes no profit. (e) On the other hand. Any price within the range would then be ‘ideal’.(b) If there is an external market for the item being transferred and no alternative use for the facilities.3 Problems in transfer pricing (a) If transfer prices are set at full cost. the supply division and the buying division. 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. (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. (b) (c) Element 2. the transfer price = the market price. would maximize their profits at this company-optimising output level.
Element 2. the agreed price may be finalized from a mixture of accounting arithmetic. so that the profit-share between divisions takes the riskiness of the project into consideration. and at what transfer price does the selling division earn the entire group profit? (b) Variability. Where negotiation is necessary there should be an understanding of the risk/return profile.7. Tomkins suggests the following methodology. Bearing in mind the difficulty discussed above of establishing the level at which a transfer price should be set. which head office can apply when mediating in disputes. In other words.4 Negotiated transfer prices When authority is decentralized to the extent that divisional managers negotiate to transfer prices with each other.6 Using transfer prices 96 . at what transfer price does the buying division end up earning the entire group profit. head office management might restrict its intervention to the task of keeping negotiations in progress until a transfer price is eventually settled. the transfer price mechanism allows them to move value from one country to another without actually engaging in trade. (c) Incorporate risk attitudes in a fair transfer price. Element 2. but also internationally.5 International transfer prices When firms transfer goods and services not only internally. compare each division’s expected profits and the variability of the profits. we may say that a ‘low’ price effectively moves value into the receiving country. (b) On the other hand. At each transfer price. while a ‘high’ one moves it into the transferring country. Element 2. Head office management may impose a price that maximizes the profit of the company as a whole. politics and compromise.7. (a) Identifying the outer bounds of the transfer price.7. (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.
other important strategic considerations relating to this approach.7 Centrally determined transfer prices and strategy These considerations produce pressure for multinational companies to set their transfer prices centrally. However. a centrally determined. It can be used strategically (i) (ii) It can disguise the attractiveness of an operation to competitors by reducing profits. (a) Autonomy. This can affect their overall motivation. Transaction cost theory is dealt with in Paper 5 but it is also relevant to Paper 6.This ability to decide in which country value (and particularly profit) is created is extremely useful. In terms of transaction cost economics. 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 2.7. However. Centrally determined transfer prices can seriously affect the ability of national managers to influence the performance of their divisions. A resource or competence based approach to strategy would immediately challenge this and call for detailed consideration of the benefit of a market based (b) 97 . (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. encourage them to seek ways around the restrictions imposed and make it more difficult to assess their overall performance. there may not have been any actual consideration of the market alternative. non-market based transfer price makes an implicit assumption that the hierarchy solution is the best one. There are. (a) It can be used to manage taxation. Transaction cost economics. this course of action is likely to lead to accusations of dumping.
Where both diversification and integration are low. Element 2.7. (a) 98 . (b) Where diversification is low. once again. the transfer price should be set collaboratively. transfers are likely to be uncommon and should be at market price. as in the now unfashionable diversified conglomerate. (c) Where diversification is high and integration is low. cooperation is important. whether its services should be bought in. a transfer price may not even be required. as may be the case when there is extensive trade along a supply chain combined with similarly extensive market-based exchanges. where diversification and integration are both high. as is the rest of each subsidiary’s trade. it can be set collaboratively.approach. as.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. but if it is. as in the relationship between two different stages of product assembly. in the relationship between two shops in a retail chain. Nevertheless. 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. for example. but vertical integration is high. The crucial question is whether the business should actually be operating any given national subsidiary at all.
target costs and costing. value engineering (VE). INTRODUCTION The well-known economists’ short-and long-run cost curves are illustrated in Figure 3. life cycle budgeting. functional analysis. cost tables.1. value analysis (VA).0 COST ANALYSIS AIMS AND OBJECTIVES This chapter is concerned with the behaviour and reduction of costs in both traditional and advanced manufacturing environments. zero-base budgeting systems (PPBS).STUDY UNIT 3. focused cost-reduction programmes. the experience curve. life cycle costing. ‘traditional’ cost-reduction methods. It brings together the following syllabus and syllabus –related elements: • • • • • • • • • • • • • the learning curve in theory and practice. 99 . value-added and non-value-added activities.
The CIMA Terminology defines cost reduction as: ‘the reduction in unit cost of goods or services without impairing suitability for the use intended’. which enables a firm to continue to benefit from reducing unit cost as total output increases. generally referred to. a reduction in unit cost can be achieved simply by increasing the volume of production. 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. illustrating the economist’s ‘law of diminishing marginal returns’ in respect of short-run costs. A skilful negotiator is in a position to obtain a cost advantage for his company if competitors employ less adept buyers.1: Short-run and long-run cost curves As can be seen from the graphs. it is more appropriate to think of cost reduction as the reduction in unit cost at all levels of output. These increases can be avoided by moving onto the long-run curves by increasing capacity through a further investment in fixed assets. Similarly. The economists’ diagram is a static representation of costs. As the above cost curves indicate. a new cost effective production process or material will thus gain a cost advantage over its competitors.Figure 3. 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. but may be permanent if it allows the innovator to cut prices and gain market share at the expense of slower moving competitors. i. In reality. as economics of scale. to view it as an attempt to move the long-run average cost curve down and back towards the origin. will be familiar from stage 1 Economical Environment. 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. given a particular set of materials. Thus the short-run curves show that costs may increase in the short term. 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. these curves show a general tendency for costs to decline as the volume of output increases. many firms have a less than 100 . In the present context. as excessive demands are placed on a particular plant. The long-run average cost curve reflects changes in plant capacity and processes. The reasons for this decline. it is a firmly-established tenet of economics that unit cost will decline as output increases. who may be driven out of business as a result. A company which identifies the availability of and successfully implements or uses. Assuming the time scale allows investment. but firms can experience differing levels of success in such negotiations.e. technologies etc.
The recognition of the so-called learning curve phenomenon stems from the experience of aircraft manufacturers. such as Boeing. One of the economies of scale enjoyed by firms as output increases may be attributable to the ‘learning curve’. known as the ‘cost reduction curve’. The ‘learning’ gained on the assembly of one plane was translated into the faster assembly of the next. The actual time taken by the assembly workers was monitored. 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. cost reduction will certainly have been achieved. If output is increased. Nevertheless. However.precise understanding of the detailed cost curves relating to their industry. 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. in the sense outlined above. during World War II. their proficiency. It was found 101 . 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. 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. unit labour times tend to decrease at a constant rate. but there is also an increase in cost. cost reduction in terms of the terminology definition will have taken place. but was rather predictable. they will usually have an understanding and a bench-mark against which to measure their success in cost reduction. If the increase is proportionally greater than the increase in cost and assuming that functionality of the product has been maintained. and those which arise through management action. it may be able to distinguish between those saving which occur merely as a consequence of increased volume. and hence speed of working increased. If an expanding company is to make genuine achievements in the area of cost reduction. which the increased production has facilitated. If companies are able to reduce total cost. the position is less clear. 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). when complex and labour-intensive procedures are repeated. as it was discovered that the rate at which the learning took place was not random. This phenomenon. whilst maintaining current output.
it must be appreciated that. which applied to this particular situation. the percentage by which the cumulative average time per unit declined was typicality 80percent. this rate can only be established by observation. 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. rather than as an individual unit. other rates may be appropriate. For other industries. the unit of measurement may sensibly be taken as a batch of product. hours Log of no. it was assumed that we already knew the learning rate. However. which will 102 . 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. if the first batch of a product is produced in 100 hours. average time per batch. in order to observe the benefit of learning in the form of reduced average labour hours per unit of cumulative production. it will be appreciated that the effect of the learning rates on labour time will become much less significant as production increases. affect the underlying principle. of batches (or units) In constructing table 1.that cumulative average time per unit decreased by a fixed percentage each time the cumulative production doubled. As a doubling of cumulative production is required. Records must be kept of the number of units/batches produced and the associated time taken. In the aircraft industry. of course. in order to construct the equivalent of Table 1 (although it is likely that fewer observations would actually be taken). in the real world. Further. The figure below shows this. FIGURE 3. This does not. Let us take as an example a learning rate of 90percent.2: CUMULATIVE DATA GRAPHS Cumulative data graph Log of cum. In this case. It is then the job of the engineer or accountant to deduce the learning rate from these observations.
b must be a negative number.require the specification of an equation to fit the data. Any value of b greater than 0 would result in Yx increasing as x increased. under This is known as the cumulative average-time learning model.And.e. If no learning effect were present. Consideration of the formula in equation 1 shows that it is the value of ‘b’ which determines the shape of the learning curve. i. X = 2. b must be less than zero.e.2.e negative learning was taking place. the time taken to produce any unit would be equal to the time required to produce the first unit.e. the observation in Table 1 is plotted in Figure 3. as x. (ii) ‘a is the time required to produce the first unit/batch.e. i. If we assume that a positive learning effect is present. Y1=a Consider now the effect of doubling the output. is greater than 1 for all except the first unit. Thus. (i) (ii) X is the cumulative number of units/batches consideration The exponent ‘b’ is the index of learning. by definition. no learning is present. meaning that the average time taken to produce units was increasing rather than decreasing. For example. then Y2=Y1x learning rate And. i. Consideration of equation 1 shows that this can only be true if Xb=1. if a positive learning effect is present. b must equal 0 if Xb is to equal 1(X0=1). Yx = a And the learning ‘curve’ would be a straight line. Y2 = a x learning rate 103 . i. at one unit/batch of output. 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. i. as all units would take the same timer to produce.
a Y = xn In this case. and the two formulae are mathematically equivalent (students should note that. 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. while all numbers greater than zero have a positive logarithm. The B in the Terminology is thus equal to-b in Equation 1. when learning is taking place. Therefore. A x learning rate = a2b Learning rate =2b Log (learning rate)=b (log2) Therefore b=log (learning rate) Log2 S0. which can be calculated as: Please note the negative sign in front of this calculation of B. in examinations. by checking the cumulative average time which we would expect will be necessary to produce 64 batches: Yx = aXb Eqn (1) 104 . (iii) x is the cumulative number of units to be produced.e. b= log 0. 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. n is equal to both B as defined in the Terminology and –b as in Equation 1.But from Equation1. for a 90% learning rate. b must be negative. Y2=a2b.9 log 2 All numbers less than zero have a negative logarithm. the learning curve is expressed as). therefore. i. yet another variant of Equation 1 is often given. (iv) ‘B’ is the coefficient of learning.
890 hours.1520 =100 x 0. an average time of 49 hours for each of the batches 33 to 105 . i. and wishes to estimate the time it will take to complete the contract.05 hours.66 = 100 i. but only values of less than one imply that learning is taking place. giving learning rate of 0. Inspection of Table 1 above reveals that the average time per batch to produce 32 batches is 59. a value of exactly 1 would indicate that the time taken per unit/batch was not changing at all. giving a total production time of 56. 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.9 = -0.b = log 0.1520. let us assume that the manufacturer above has the opportunity to bid for a contract to produce 10 batches of his product.66 hours.5666 = 56.e.66 x 42 = 2. The learning rate can take any value. and thus cannot be determined by simply creating a table such as the one used earlier.1520 log 2 Yx = aX-0.1520 Yx = 53. with a total production time of 1. 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. ‘b’ equals –0. Equation 1 is not normally used to check earlier calculations in the way that we have just done. and values less than one mean that the time taken per unit/batch is declining as production increases.890 = 490 hours. The total time taken to produce the 10 batches under consideration will thus be 2. Learning rates greater than 1 imply that the time taken per unit/batch is increasing as production increases.380 – 1. the average time per batch to produce 42 batches is 56.90.380 hours.e. For example. In the example above.14 Which agrees with Table 1 above.1520 Yx =100 x 64 -0. in order to help set the tender price.
Learning is likely to be greatest in complex assembly environments.890)/32 = 47. i. obviously.20 hours indicated by Table 1 for the next doubling of a full 32 batches from 33 to 64.401 – 1.e. if hourly wages are constant. knowledge of the rate of learning can help in price setting. (iii) (iv) (v) THE EXPERIENCE CURVE 106 . The learning rate. When setting budgets.42. any overheads which vary directly with those hours. However. the labour cost per unit will decline as a result of the learning curve phenomenon. The learning curve has been found to be particularly useful in determining the likely costs to be incurred in fulfilling government contracts. of which aircraft assembly is a prime example. 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. This provides a rational basis for price negotiation and cost control. USES OF THE LEARNING CURVE (i) (ii) (iii) In circumstances where the learning curve is likely to operate i. will need to be calculated from the same formula.e. if the current level of production does not lie on a table such as Table 1. can be expected to decline as a result of the learning curve. In addition to direct labour costs. only those costs which are directly related to direct labour time. they do not measure a reduction in cost per se. This may be compared with the average of (3. A number of points about learning curves must be stressed: (ii) Learning curves chart the reduction in time per unit as experience is gained. If labour is working in a machine-paced environment. is not something which can be positively fostered as a cost –reduction technique. that particular average time. in complex assembly operations. and the corresponding cumulative hours to date. However. 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. there is no significant opportunity to alter the rate of working and thus the learning phenomenon in terms of direct labour time cannot exist. which is a function of workers’ learning.
learning rates have frequently been determined by fitting curves to total cost per unit data.1 Cost Reduction INTRODUCTION An appreciation of the relationship between cost and volume is important in many business decisions.718 to 1. Rather than relating indirectly to cost via time. This could be considered to be a western approach. rather than the learning curve as strictly defined. can be regarded as statements of what will happen in practice. adopted by the Japanese. The ‘experience curve’ extends the learning curve approach to areas other than direct labour. Moses (1991) has pointed out that the accounting policies adopted by companies can have a significant impact ob learning rates derived from experience curves. Depuy (1993) used this method to ascertain for the US government the learning rate achieved by defence contractors. The strict application of the learning curve phenomenon is seen in the area of direct labour. However. and thus was not distorted by changing price levels. and is a function which shows how total cost per unit declines as output increases. Where learning or experience curves are used to predict future costs. When average total unit cost is measured against volume. and it is arguable that. and hence what should be striven for. Experience curve. An alternative approach. in using unit cost data. substitution of materials and design modifications are reflected in an experience curve. production. is that these curves should be taken as an expression of what is desirable. of which pricing is a prime example.021.1 to be graphed. For example. The purpose in gathering this data was to help in price negotiations with the contractors. the result outlined above actually reflects the so-called ‘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. marketing and distribution – and thus cost reductions arising from factors such as factory size. with a mean of 0. a measurement is being made which allows a long-run average cost curve of the type shown in Figure 3. 107 . an experience curve relates directly to cost.858. and so the results must be treated with caution. The slope of the learning curves derived ranged from 0. Total cost in experience curves includes all overhead types – production. This data suggest that defence contractors typically enjoy a reduction of 14 per cent of average unit cost on each doubling of output. The total cost data employed was expressed in constant dollar terms. Element 3. as against the 80 per cent curve more usually found in the West. like learning curves. technology. The improvement –oriented Japanese typically aim actively to foster a 67 per cent learning curve.
which means that some areas which were of value to customers will inevitably suffer. in an attempt to reduce costs by.there is an implicit assumption that the experience of the past is helpful in predicting the future. the scope for cost reduction will be dependent on the type of cost under consideration. 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. and ideally reducing both. 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. and the time scale involved. Obviously. Element 3. A successful cost reduction programme will seek to reduce the unit cost of the good or service at all volumes of output.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 company may take a decision to cut all departmental budgets by the same 5 per cent. knowing that the learning curve has led to cost reductions in the past could give rise to a dangerous complacency on management’s part. It is suggested that such programmes are typically triggered in reaction to an immediate threat. then organisations which do not adopt such a systematic approach. The blanket cut strategy to achieving this is 108 . This can be achieved by reducing either direct costs or overhead costs. Indeed. For example. but it provides no operational guidance to management as to how cost reductions are to be achieved in the future. and have systems in place to help the accomplishment of those targets. Market pressure to reduce costs could lead companies to attempt a ‘blanket’ approach to cost cutting. but without destroying value to the customer. particularly for overheads. In a commercial organisation. say 5 per cent. Organisations which set targets for cost reduction.1. such as poor performance. which may lead to an increase in unit cost. as long as volume increases. loss of contracts. are more likely to achieve cost reductions. if it is assumed that. This may well be the case. There is some evidence to suggest that these programmes do not meet their objective. as fixed overheads (albeit reduced by 5 per cent in our example) are spread over a smaller number of units sold. or price reductions – in other words. the second survey of managers from 1. traditional programmes are often reactions to events rather than anticipations of them. This might achieve some short – term savings but it is likely to be at the expense of the long-term health of the organisation. A blanket cut will affect all activities equally. this will lead to some loss of business.
although the industrial relations implications of reduced staffing levels may make attainment of the most cost. For example. a company may currently be incurring higher costs than are strictly necessary. shop floor manning levels may have remained processes. Examination of current operations may reveal that this over – consumption of resources arises from one or a combination of the following three reasons: 1.2.2. Any organisation can be seen as a collection of activities designed to lead to a desired result.2 Examination of Current Activities The starting point for cost reduction programmes often is the examination of existing activities. The current position may be one in which a separate operative is assigned to each machine. 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. the company’s consumption of resources is excessive. Loss of material through pilferage. Inefficiently managed activities 3.2 Inefficiently Managed Activities Activities are inefficiently managed when current standards of achievement are not being attained. three. However. Firms must adopt approaches which enable them to pinpoint and realize specific opportunities for cost savings. Over – resourced activities 2.effective arrangement difficult to achieve. without any loss of machine efficiency.1.1. so that one person may be able to oversee two. Element 3.e. in a production department. four or even more machines.1. i. In carrying out these activities to meet the short-term operating plan. it may be perfectly possible for machines to be physically grouped in such a way as to allow a reduction in staffing levels.ineffective in the long term. Element 3. Element 3. excessive overtime working necessitated by poor production scheduling and excessive time spent 109 .1 Over-Resourced Activities An activity is over –resourced when the same objective could be achieved with less resource consumption. if the process requires very little human intervention. A blanket cut in resources may provide the spur to such reorganizations.
Regular monitoring will identify these deficiencies and should lead to their elimination. If the warranty department is not currently over-resourced.2. A blanket cut in resources. Problems with products are thus both a cost to company and an inconvenience to the costumer. but are non. and are sustained.added activity revolves around the customer. and is efficiently managed.1. The existence of a warranty is useful to the end user. and adds value as a result. would be unlikely in its self. to result in the action which would improve the overall product reliability.value added as far as the consumer is concerned. This department’s activities will increase the costs of the business. a blanket cut in resources may provide an additional impetus to improvement. It is only possible to eliminate such non. in as much as it provides law enhancement to product it self. the quality of the materials used and the manufacturing process. a cut in its resources is highly likely to reduce the level of service that it can provide to customerscustomers who. A non. and hence damage the competitive position of the company even more. warranty claims will decline. Self evidently. as it provides a level of insurance.value added activities if changes are made to the current policies and structure.value added activities often arise as a direct consequence of. Non. as the reliability of a product increase. and the rectification of problems which arise during a products warranty period. To control the resources consumed by overhead department effectively. The inherent reliability of a product will be the function of the product design. non of these activities are under the control of warranty department management. are already unhappy with the service which the company has provided in selling them a faulty product. and hence peace of mind. by. by definition. Element 3.value added activity is thus any activity which does not provide value to an end user. a company’s existing policies and organisational structure. Value will be added when an activity results in an addition to a product or service which they ultimate consider to be valuable. as we saw in our consideration of the value chain in the previous chapter.on rework through failure to identify problems at the earliest opportunity would all provide example which highlight variances from standards. a company may have a department devoted to dealing with customer complaints.3 Value Added and Non-Value Added Activities The concept of a value. and which is therefore some thing for which they are willing to pay. not only is a claim under a warranty and value added for the customer. For example. Delays in rectifying faults are likely to lead to a further loss of consumer goodwill. However. applied to the warranty department along with all other departments. but the customer is also invaluably put to some trouble in actually making such a claim. it is essential to understand: (a) why such departments exist. However. 110 .
(c) there relationship to other areas of the business.1. In traditional budgeting. Implicit in the traditional approach is an assumption and acceptance that current expenditure is adding value to the customer. where funds are determined by tax revenues and government grants and allocations.(b) the services they provide. Nevertheless. which is thus likely to lead to the most radical changes in discretionary areas. existing expenditure levels form the base line for discussions about future expenditure. as we shall see in the next chapter. i.e. the approach requires all activities to be justified and prioritised before the decision to devote resources to particular ones is taken. Activity-based cost management adopts this approach. 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. cutting. the income of the organisation. The aim of the fundholder is to achieve the best service levels possible within the given budget. In other words. The rejection of this base line as a starting point is what gives zero-base budgeting its name. As all cost reduction techniques must. as though the activities to which the budget relates were being undertaken for the first time. the budget allowance is zero’. as it is these costs. The reference to ‘funds available’ is particularly pertinent in public sector organisations. to which we now turn. Without approval. An incremental approach is most likely to be applied to discretionary costs. zero-base budgeting (ZBB) is designed to be used in setting levels of future expenditure. is zero-base (priority-base) budgeting. Other approaches to overhead cost reduction. The Terminology defines zero-base/priority-base budgeting as: ‘A method of budgeting which requires each cost element to be specifically justified. 111 . by definition. it is necessary to adopt a cross-functional attitude to the examination of the business processes. Element 3. which eliminates the disadvantages of blanket approach to cost. is exogenously set.3 Zero-Base Budgeting Like all budgeting techniques. 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 house or sub –contracted? (d) How much would the various alternative levels of service and provision cost? In order to answer these questions. 112 . 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. and go for these those with the greatest cost benefit in term of the objectives. 2. 5. Rank the decision packages in order of their contribution towards the organisation’s objectives. Many programmes will also have multiple results. how much should be done and how well should it be done (for example. 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. Some explanation of these steps is necessary. for example and identify the manger responsible for each activity. all existing and potential organisational activities must be described and evaluated in a series of ‘decision packages’. (e. Systematically implement the selected alternatives. 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. Determine the activities. Analyse alternatives.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 can take several years to be measurable.g. giving the following four-step process to a ZBB exercise: 1. while required to overcome these difficulties. Further. and a choice must usually be made regarding the relative weights attached to them. 120 per cent of the current level). 4. 3. Effectiveness can be judged only against predetermined benchmarks set by the organisation. Yet the activities performed by public –sector and not-for-profit organisations are often difficult to measure in a tangible way. should an economy or a de-luxe service level be provided)? (c) How should the activity be performed.
000 160. and donors to charitable causes have expressed concern about the proportion of contributed funds devoted to administrative expenses. somewhat similar to ZBB.000 680. Criticise the current method of budgeting and explain the application (give specific examples) and possible advantages of PPBS to such an organisation. money is going and. Exercise: the Alpha Group The Alpha Sufferers Group is a national charity offering support to sufferers and funding medical research.000 Budget 20. 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.000 658. This feature of PPBS is. say 10 per cent.000 484.000 724. The treasurer has heard of ‘programme – planning budgeting system’ and wonders if it would be useful in their not-for profit-organisation. for example. On a more positive note.000 113 . No further supporting information is provided for the trustees. 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. 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. PPBS specifies goals clearly.000 220. 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. eventually.000 500.000 19X4 Actual Budget Income Subscription Donations received Fund –raising 20.000 440. 19X3 Actual 18. in its result. and allows people to see where their.given the nature of public –sector and not for profit organisations and their objectives. since different levels of service are associated with each level of requested funding. to see whether or not it was spent effectively. or require that the grass in public parks be cut every ten days instead of once a week.000 200. The trustees have used an incremental approach to determine the budget.
Programmes which focus on reducing cost at these early stages after the greatest opportunities for success in the medium to long term.000 33.000) Element 3. Element 3.000 40.000 8. The most successful cost-reduction programmes at the conceptual and design stage are those which have a strong market focus.000 350. although their impact in the short term may be small.000 28. However.000 8.000 42.000 666.000 300.000 15. is ‘value analysis’ (also known as ‘value engineering’). Rather than aiming to meet the manufacturer’s own internal specification at least cost. A good cost control system should be able to bring about control over the costs of the entity. and as Figure 3.000 15.000 60.3 illustrates.000 230.4 Timing and Focus of Cost –Reduction Programmes It is axiomatic that.000 788. research and development stages.1.Expenditure Employees Premises Office expenses Administration Research Printing Room Rental Donations made 60.2 Element 3.000 12. in searching for cost savings.000 25.000 8. One technique of cost reduction. despite the evidence that the ability to influence cost is greatest at the planning. these opportunities are related to time. which recognises the importance of concentrating effort on the design and conceptual stage. which is discussed below.000 200.000 230.2. in order that these can be satisfied at least cost. cost reduction programmes have tended to focus on current production costs.000 260.000 30.1 COST CONTROL Cost control involves management action undertaken to effectively mange the costs of running an under-taking. they involve a thorough examination of customer requirements. the greatest effort should be expended in investigating those costs which provide the greatest opportunities for savings.000 Excess of income over expenditure 14. up to 90 per cent of a product’s costs will be fairly limited for an existing range of products. 114 .000 25.000 735.000 320. As Berliner and Brimson (1988) have pointed out.000 77.000 60.000 30.000 (64. Nevertheless.
2 In order to come up with an effective cost control system. Erlicher. the appropriate targets must be set. 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. who was vice-president of purchasing. be revised continuously in order to keep them in line with the current cost efficiencies. it is important that necessary action is taken to void the recurrence of the variances.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. it is notable that in order to have an effective cost control system. an effective comparison system must be in place and the results must be analysed sufficiently. To this effect.Element 3.3 The common types of cost control systems are the budgeting control systems and the standard costing systems. Element 3. Stage 3 Comparison between Targets and Actuals This stage involves comparing the targets with the actuals. the following approach can be used: Stage 1 Target Setting Any cost control system requires targets to be fixed for costs. Value analysis (VA) evolved as a result of these experiences. Stage 4 Identifying the causes for the differences Stage 5 Action to prevent variances Having identified the reasons for the variances. The target so set must. Element 3. observed that many of the enforced changes which the war had brought about had actually improved performance and/or reduced 115 .2.2. It is important that any differences between the targets and the actuals are analysed into sufficient details. From the above. Reasons for the differences must be identified. however. a methodical approach is required. and is associated with two employees in particular: Harry Erlicher and Lawrence Miles. The actual results should be measured as frequently as possible.
This definition can be seen to be consistent with the CIMA Terminology definition of ‘value analysis’. Miles used the two terms synonymously. and it is therefore at these early stages that the application of VA offers the greatest cost reduction opportunities. the Navy Bureau of Ships. 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. who was then a staff engineer. Indeed. facilities and supplies for the purpose of achieving essential functions at the lowest total cost. consistent with the needed performance. In 1954. in which the term (VE) rather than ‘value engineering programme was established in 1956 by the Army Ordnance corps. having been stimulated by the success of suppliers. At the ceassation of hostilities. and defined it as: ‘ A systematic effort directed at analysing the functional requirement of the Department of Defence systems. The Armed Service Procurement Regulations made the use of VE mandatory. The technique is regarded primarily as a means of achieving cost reduction. and they will be treated as such throughout the remainder of this chapter. 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. equipment. he decided to maintain and institutionalise the search for substitute materials and methods. as we noted earlier. In 1947. in its operation. which combines a number of preexisting techniques with its own particular procedural approach. the task of putting this into practice was assigned to Miles. aided by Miles set up a VA programme. and the Air Force began investigating the technique in 1961. such as General Electric. reliability and maintainability’. therefore. 116 .cost. The result was value analysis. However. General Electric adopted the approach as a company standard. and it was subsequently taken up by other companies and organisations. including the American military. and can be applied to existing or new products at any stage of the life cycle. the scope for achieving cost savings is greater during the pre-production phases.
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 117 .
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’). but contribute simultaneously to it. particularly when new products are being considered. 2. There is a strong inter-relationship between the zones in Figure 3. It alters with changes in design.. materials and technology etc. Miles suggests that cost estimates do not need to be of a high degree of accuracy. The VA team must ponder the following six basic questions when applying VA to any product or service: 1. 4. 3.4. The ability to make accurate estimates in respect of products and 118 . adapted from Gage (1967). . in many instances of good value work. and that design and production engineers not only understand the brief. in terms of the functionality required.In the search for cost reduction. Value analysis seeks to facilitate this simultaneous approach. the concept of minimum cost is a dynamic. It aims to ensure that the product brief is tightly specified. are frequently associated with reduced cost. when the aim is to identify fruitful avenues for investigation. Figure 3.4. really meaningful costs often must be worked up for the job’(emphasis added). materials. and lower its bulk or weight and/or the number and variety of parts required in its manufacture. when final decisions are being made. 5. Miles (1972) has suggested that . products and processes will be utilised in different ways. provides a useful description of the focus of a number of cost-reduction techniques. rather than to make final decisions. accuracy will obviously be important.. 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. 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. volume. 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. Nevertheless. A team approach is thus crucial to the VA philosophy. not a static one. particularly in the initial stages of VA. 6.
‘Functional requirements’ were mentioned in the definition of VE above. choose the object of analysis. The focus is thus very different from traditional accounting. Functional analysis can be applied in a number of ways.1 Functional Analysis Functional analysis (FA) is a systematic approach to the examination of the specified purpose of a product or service. Functional analysis can also be used to assist in the determination of expected selling prices. In value analysis. in order to determine how that functions can be supplied to the customer in the most cost – effective way. In functional analysis. such as product. This has as its major function the facilitation of communication between individuals who are physically separated. 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 be seen to underpin target costing. Element 3. but also by suppliers of any means of long distance communication – telex. Functional analysis views all products as bundles of services potential for customers. service or overhead area.6) particularly useful in this context. In this context. and it’s to this concept that we now turn. it is clear that the competition for sales of domestic telephones is represented not only by other handset manufacturers. for example. The Japanese find cost tables (see section 3. so that the cost object is represented by this intangible service potential. the postal system etc. let us consider a domestic telephone. fax. a clear understanding of the function of a product or service is essential. which often has a physical product as its cost object. The first two of the six questions above relate to the functions of the product or service.processes of which the firm may have no direct experience is therefore a valuable one. by adding new features in a cost effective manner.7.3. 119 . As an example of functional analysis. and as a means of improving products. The concept of product or service function is thus a key element in the VA approach.3 can be answered by following the nine basic steps set out below: 1. which we will discuss in the next section of this chapter. It may be used as an aid to cost reduction. When expressed in this way. as consumers may be expected to pay particular prices for particular functions. Yoshikawa et al (1993) suggest that the six basic questions listed in section 3.
Element 3. Eliminating unnecessary functions that increase the product’s costs and for which customers are not prepared to pay extra for. choose the alternatives (for manufacturing etc). On the other hand. 120 . VE undertaken at the research and development phase is something referred to as ‘zero look VE’. suggest alternatives. when a company is analysing a defence contract.2).2. Aim of Value Engineering The aim of value engineering is to achieve the assigned target cost by i. or may relate to alternative ways of satisfying a particular set of functions that will not yet have been fixed. draw a functional family tree. 9. 3. Second look VE can be used when design changes are being made to existing products. so that the analysis will probably be confined to financial evaluation of the differing means of satisfying the given functional ends. and that in the trial production phase as ‘second look VE’. and compare these with the target cost (see element 9. 8. The range of options for consideration under step 7 may relate to a whole range of functions.4 VALUE ENGINEERING As discussed above is also called value analysis. review the actual results. 5. Value analysis allows the team to consider a range of functional combinations. the required functions are likely to be very closely specified. 6. 4. gather information. 7. These descriptions illustrate the iterative nature of cost-reduction techniques. together with their associated costs and to compare these with the prices customers are likely to be willing to pay for the alternative combinations. define the functions of the object. that undertaken in the trial production phase as ‘first look VE’. Identifying improved product designs that reduce the product’s cost without sacrificing functionality and ii. select the members of the team. in order that the optimal set can be selected. evaluate the functions. 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.
make or buy etc. . QUALITY. If the cost of the function exceeds the benefit to the customer. A cost object is defined as anything for which a separate measure of costs is desired. The cost of each function of product is compared with the benefits perceived by customers. and thus the range of possible cost object is vast – from individual product to department. e.g. then the function should be either eliminated. 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. COLOUR etc (KATO 1993). drop a product. modified to reduce its cost or enhanced in terms of its perceived value so that its value exceed its cost. Element 3. RELIABILITY.e. A price or value for each element is determined which reflects the amount the customer is prepared to pay. 121 . brand or project. SPEED. To obtain this information companies normally conduct surveys and interviews with customers.5 Activity based costing INTRODUCTION A core accounting activity is the analysis of costs.and these costs are then further analysed by assigning them to cost objects. This process involves decomposing the product into its many elements or attributes. 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. service. power etc.g. labour. The costing system will routinely collect information about some but by no means all. COMFORT. functions might consist of STYLE. Costing systems accumulate costs by broad classifications – material. customer. Decision-making. Cost control and performance evaluation. product pricing. Example In the case of automobiles.Value engineering requires the use of functional analysis. Also by focusing on the product’s functions. Nokia has the same charger for each type or mode phone manufactured. Costing information is needed for a variety of reasons: (i) (ii) (iii) Stock valuation for financial accounting purposes. possible cost objects.
but often at one particular moment in time. Cost management is as important for the automobile industry in the 1990s as what quality control was in the 1970 and 1980s. These factors are often called critical success factors. Discuss why it might be considered important in today’s world. organisations are focusing on similar factors because of general economic circumstances prevailing at any stage in the life cycle etc. it is important to emphasise that the concept of a ‘product’ as a cost object needs amplification. which is sometimes known as cost management information). Solution (a) At anytime there is usually a particular factor. which is key to remaining competitive and to developing the business strategically. (ii) Discuss how a management accountant might use investment appraisal techniques to analyse customers in order to aid cost management. and particular attention has been directed to finding the ‘true’ cost of producing a product to supply information for (iii). Different businesses in different industries are likely to have different factors. (extract from & corporate annual report) Required (i) Explain the meaning of the ‘cost management’. management must focus on them. A general definition of cost management information is. (b) Cost management or cost management information are rather vague and general phrases used by different people to mean lightly different things. 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. It is common to find departments. Considerable dissatisfaction has been expressed at the information provided by ‘traditional’ costing systems for purposes (ii) and (iii). but while they are critical. However. cost centres and products as cost objects in costing systems.The selection of cost objects for the routine collection of information has implications for each of the above three purposes. 122 .
This involves providing the right product at the right place at the right time and at the right cost. It is certainly important today for all organisations to satisfy their customers by meeting their needs precisely. Distinguish between cost control and cost reduction. 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. if the company enters into long-term contract with customers. methods of data collection.The application of management accounting concepts. for example. and the importance of customer segments can be discounted over their lives in a similar way to projects. 123 . By studying the increased revenue and decreased costs generated by an ‘old’ customer. analysis and presentation. the development of the Lexus model targeted at the USA market. The management accountant has a role to play in this area. Japanese car companies such as Toyota paid a great deal of attention to quality – consider. For organisations with high customer set-up cost such as financial institutions such as mortgage leaders. (c) A management accountant can use discounted cashflow or payback to evaluate the work of customers. During the 1980s. Alternatively. it’s important that they retain all customers they have. management can find strategies to meet their needs better and to retain them. monitored and controlled. Required: i. accounts could be discounted and ranked in order of preference just as jobs/contracts might be ranked. in order to provide the information required to enable costs to be planned. and target costing and life cycle costing are particularly helpful in driving costs down.
standards and estimated selling price for new products preferable without reducing quality and/or effectiveness. The routine of budgets. Value analysis and value engineering 8. A wide range of examples can be given here: 1. Give three examples of the techniques and principles used for (i) cost control and (i) cost reduction. This is a dynamic rather than routine process. Investment appraisal 11.ii. 5. often only carried out at infrequent intervals. Zero – base budgeting 12. This is usually carried on by the formal comparison of actual results with those planned. Product life cycle costing 124 . Target costing 7. standard costs. Budgetary control 2. iii. Cost reduction is the wider ranging attempt to reduce costs below the previously accepted amount. Work studies 9. Standard costing 3. Solution: (i) Cost control is the process of containing costs to some predetermined amount. Discuss the proposition contained in the statement. Procedure for formal authorization of recruitment. operating statements and the investigation of variances. Cost reduction 6. Setting of expenditure limits by levels of management in an organisation 4. Operational research 10.
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. Solution: The three appropriate cost drives are: 125 . Quality management. Staff are engaged in three activities. but active cost reduction.000 production runs per period.000 consignments of components per period. A requires are direct labour hour to produce and B requires 0. Product A requires. 200 component consignments 50 raw materials consignments and ten production runs per period. 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. eight raw material consignments and five product runs per period. three employees engaged in receiving 10.000 consignments of raw materials for per period and three employees engaged and materials for 5. Six employees engaged in receiving 25. flexible manufacturing systems and computer integrated manufacturing. However.6 direct labour hours to produce. ABC Ltd employees produce salaried support. Required: Identify appropriate cost drivers and calculate an activity based costing system. B is a simple product of which 25. Value for money analysis and audits etc.000 are made and sold in each period. ABC Ltd produces a large number of products including A and B.000 are made and sold in each period. ABC Limited. A is a complex product of which 1. quality costs. a study of operation research techniques’ and of recent developments would lead to the conclusion that current practice is not purely control. The cost control techniques of standard costing and budgetary control would tend to support the proposition. Product B requires 100 component consignments. There has been considerable interest in a range of topics relating to new manufacturing techniques and to Japanese methods. target costing and life cycle costing.13. JIT stock and production control.
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 K500.000.000 (e) Receiving material: 3/12 x K500.000.000.000 Disbursing kits: 3/12 x K500.000 Cost driver rates • Receiving components: Total component receiving costs divided by 126 .000 = K125.000.000 = K250.000.000.
000/ 5.000 Summary of unit cost 127 .Number of consignments received = K 250.000 8 raw material consignments x K12.000/ 10.000 = K2.000 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 = K250.000 Total costs attracted by product A 200 component consignments x K10.500 = K 100.500 = K625.000 = K 100.000.000 5 production runs x K25.000.875.000.000.000 K1.000 K25.000 = K1.000 = K10.000/ 25.000 Total costs attracted by product B 100 component consignments x K10.000.500 • Disbursing kits Total disbursing costs divided by Number of issues K125.200.000 = K12.
The following budgeted data has been obtained for the year ended 31 December 20x2.000 10 5 62.Product Total cost = Example 2 A 2.000units of B K48/ unit Bean Products Ltd manufactures two types of bean bags – the standard and the Deluxe.000 25.000 300.500 200 100 Budgeted Production overheads for the year has been analysed as follows: Volume related overheads Purchases related overheads Set up related overheads 275.000 per hour.500 10 5 25.000. The company currently uses an absorption costing method of recovering overheads.000 1.000 The budgeted wage rate is K20. Both bean bags are produced on the same equipment and use similar process.875. its considering implementing a system of activity based costing. 875/units B 1.000 400 150 2.200. Product: Standard Deluxe Production quality Number purchase orders Number of sets –ups Resources required per unit Direct labour Direct labour (hours) Machine time (hours) 25.000.000 525. An activity based investigation revealed that the cost drivers for the overhead costs are as follows: Volume related overheads machine hours 128 .000 units of A K2.000. However.
000.Volume related 125.100.500hrs 12.500 200 100 K137.000.6.000 total 275.000 Machine hours required Purchase orders Total set-ups Cost per cost driver Volume related overheads Machine hours required .000 Total production overhead 1.000 K’000 Element 3. Companies are becoming customer driven and making customer satisfaction 129 .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. 500 600 250 deluxe 2.000 Direct labour hours required 250.000 400 150 K275. Standard Production quantity 25.1 the TOTAL QUALITY MANAGEMENT (TQM) Today’s business environment is remarkably different from Environment of many years or so go.500 25.6 Element 3.000 137.
Element 3. claims for refunds in respect of defective supplies and the work of putting right mistakes. c) Monitoring actual quality d) Taking control action when actual quality falls below standard. 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. reliability. the customer. quality.3 The management of quality is the process of: a) Establishing standards of quality for a product or service.“the degree of excellence of a thing” – how well made it is. Element 3. Quality management becomes total (Total quality management (TQM)) when it is applied to everything a business does. QUESTION. In this spirit.What is quality? Element 3. and how it measures up against its rivals.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. or how well performed if it is a service. If costs can be controlled through TQM. Such costs could arise through loss of customers.2 Total quality management defined Quality. delivery and the choice of innovative new products. total quality management (TQM) has the customer as its focal point. how well it serves its purpose. then profits will increase.4 130 . Customers are demanding everimproving level of service regarding costs.6. It is in the eye of the beholder.an overriding priority. One aspect of Japanese management is the approach of “get it right first time”. 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.6.
quality planning and training and the extra costs of acquiring higher quality raw materials. work in process and finished goods. They include costs incurred before the product is dispatched to the customer. The term cost of quality is a collective name for all costs incurred in achieving a quality product or service. downtime and work stoppages caused by defects. 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. Cost of conformance – is the cost of achieving specified quality standards and include: i. A B 131 .6. repair. Element 3. They include costs of inspecting purchased parts. ii. Four categories of costs should be reported. They include cost of preventative maintenance. such as the costs of scrap. Cost of internal failure – are costs associated with materials and products that fail to meet quality standards.5 COST OF QUALITY This activity of improving quality to improve profits will itself cause cost to be incurred.Through TQM it is possible to obtain defect-free work first time on consistent basis. 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. repairs of returned products and the costs arising from a damaged company reputation. Cost of external failure – are cost incurred when inferior products are delivered to customers. quality audits and field tests. Cost of prevention – are costs incurred in preventing the production of products that do not conform to specification. warranty replacement.is the cost of failure to deliver the required Standard of quality and include: i. Appraisal cost – are costs incurred in order to ensure that outputs produced meet required standards. They include the costs of handling customer complaints. Cost of non-conformance. ii.
comparisons can be made with previous periods.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. an increase in spending on prevention costs should reduce the costs of internal and external failure and hence reduce total spending.Element 3. can provide some idea of the level of customer satisfaction.0 500 1000 300 132 . thereby highlighting problem areas. Element 3. The report has the following uses: a) By expressing each cost category as a percentage of sales revenue.6 Typical Cost of Quality Note that some of the items in the report will have to be estimated e.g. b) It can be used to make senior management aware of how much is being spent on quality-related costs. 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. for example. For example.6.100 5.5 K’000 COST AS % OF ANNUAL TURNOVER K20 MILLION 600 600 200 400 1. c) It can provide an indication of how total quality costs could be reduced by a more sensible division of costs between four categories. divisions within the group or other organizations. A comparison of the proportion of external failure costs to sales revenue with the figures of other organizations.800 9.
600 17. 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 .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.500 8.0 1000 1500 2000 3. These measures are also appropriate especially for lower levels of management in an effort and progress to provide and monitor cost of quality.0 MEASURES OF PERFORMANCE Learning Outcomes After studying this chapter. UNIT 4.200 11.Retesting EXTERNAL FAILURE COSTS Returns Handling customer Complaints Contribution figure from lost sales 400 2.
Element 4. The balanced scorecard is an approach to the provision of information to management to assist strategic policy formulation and achievement. 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. and do not in themselves. However. which determines the ability to survive that will be determined by its capacity to provide sufficient satisfaction at a profit. 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. profit has been the far greatest measure of business performance. it is essential to include non-financial measures in performance evaluations.• Behavioural aspects of performance measurement Element 4.2 Balanced Scorecard in Detail The incorporation of non-financial information along side financial information has become known as the balanced scorecard approach. It 134 .1. Actually.1 The Balanced Scorecard Element 4. due to expanded corporate managements’ focus. So in order to effectively manage a business. it can be argued that financial-based measures merely measure the success of other activities and policies. 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. This was exemplified by Kaplan and Norton.11 Growth in non-financial measures In a traditional sense. in the modern world. provide information that can be used as a direct guide to management action.
(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. interests and returns from the business on their behalf. The financial prospects consider how we look at shareholders. Usually. It should be noted that critical success factors of a business may change. determining the specific items to be included in a balanced scorecard requires a business to examine its operations carefully. in order to address the following considerations. following changes which are taking place in their market place. 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. management is able to assess the impact of particular actions on all perspectives of the company’s activities. especially. 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.3 The Four Perspectives (a) The Financial Perspective The financial perspective usually looks at the profit rock bottom.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. 135 . in relation to their goals. Element 4. By providing all this information in a single report.1.
In order for a business to have a comprehensive customer perspective. (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. (b) The Customer Perspective The customer perspective looks at customer satisfaction. The key measures in this regard would be the percentage of sales coming from the sale of the new products. it needs to set the following aims and goals established by the accompanied measures. the main aims and objectives which the financial perspective will have attached to one. The customer perspective looks at how customers see the providers of a service (businesses). (iii) Customer Partnership 136 .Therefore. (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. (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. (i) New products This goal would encourage seeing development of new products/services and improvements in already existing products/services. (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.
(iii) Design The design of the product will concern itself with the features embedded in the products. The key measures to measure this would include measures such as cycle times. 137 . This can be measured by efficiency. and versatility in the components used in the manufacturing process. In order to achieve good performance in relation to the internal business perspective. (ii) The manufacturing excellence The manufacturing excellence must be explained though the perceived value of the organisation’s activities different consumers. (i) Technology capability The company should have cut-edge technology. a business should set out the following goals alongside the key performance indicators (KPIs). (d) Innovation and learning perspective This perspective looks at whether we can continue to improve and create value for clients or not. (c) The Internal Business Perspective The internal business perspective looks at what the business excels at if it has to deliver shareholder value. This can be measured in terms of the corporate manufacturing geometry versus competition being faced. This partnership can be measured by the number of cooperative engineering efforts. durability and ability to stand pressure. exact cost of manufacturing and yield.How cemented and integrated are the relationships between the business and its customers.
The measure to use would be time to develop the next generation of the product. Figure 4. make and launch (deliver) the product to the market place.In order to be able to continue providing unrivalled products/services.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 Financial Perspective Client (consumer) Perspective Innovation and new services perspective 138 Internal process perspective . (ii) Time to Market This measure and goal considers the time it takes a corporation to design. (i) Technology leadership The company must be able to employ state of the art technologies in its operations. Below is a typical diagrammatic representation of the balanced scorecard for an imaginary communication utility company to illustrate the application of the balanced scorecard. a business should set the following goals and set out measures to track performance and achievement of the goals. 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.
Example of these organizations would include churches or religions organization. Tax payers e. These stakeholders would want to know how efficiently and effectively the organizations they subscribe to are operating.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. In case of local government the can have the following as the key stakeholders 1.2 Value For Money (Performance Measures For Not-For Profit Organisation) Element 4.2.Develop Key Performance Indicators (KPIs) Establish a performance evaluation system With permission from Mpangwe Kasonso@2006 Element 4.t. and local government e. Even if these organizations are not businesses they have a wide number of stakeholders who have an interest in them.c 139 . which have not been set up with the view to generating profits.c. Not for profit organizations are organizations.t. employees and the local or domestic governments in which the NGOs are operating. Citizens 3. The key stakeholders to an NGO for example would be the donors. Political leaders 2. Non-Governmental Organisations (NGOs).
2. efficiency looks at a comparison between the qualities of resources used in a particular activity to the level of output produced using the resources. 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. 2. EFFECTIVENESS Effectiveness refers to the organizations ability to attain its set out objectives. Element 4. Therefore. 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. is a measure that aims to asses whether organizations are achieving their corporate objectives or not.NATURE OF PERFORMANCE MEASUREMENT Whether in case of a business or a not for profit organization. However. Efficiency and Economic) The three Es are used as the main primary measures of performance in not for profit Organizations.3 The Three Es (Effectiveness. since these organizations do not exist to make profits.2 Nature of Performance Measurement in Not-For Profit Organisations In not for profit organization (NFPOs). So. 140 . 1. EFFICIENCY Efficiency is a measure of how well organizations utilize their available resources. However. 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.2. Element 4. the performance will be measured by comparing performance standards set out against the actual performance attained by the organization. it will not be a priority to ensure that the profit measure does not come up as a very important or paramount matter.
3. 2. Financial discipline through financial surplus posted. ECONOMY The economy aspect aims to measure the value for money for the service the organization is serving to its clients. Please refer to the ratios as illustrated in chapter 8 under variance accounting. 4. In other circumstances such as in a local government clinic.In some cases efficiency can be measured by using some efficiency ratios.6 of this chapter). patients would like to see to it that they are given good healthcare. 3. In addition they would like to see that the hospital is stocked with drugs required to cure various diseases. 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. Courtesy of employees toward. Length of waiting time. 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. They will want to ensure that the waiting times before consulting the doctors are abbreviate and reduced. Number of clients complaints Innovation levels. clients’. 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. For instance when assessing the economic or value for money in a government ministry or local government. 141 . 5. Economy or value for money will differ from circumstance to circumstance.
For example. Element 4. buns.3. 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.Element 4. This gap arises because subordinates have more information than their superiors on the 142 . 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.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. 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. Where clearly defined input-output relationships do not exist.3. such s previous period costs less a reduction of 10%. The major advantage of negotiated targets is that they address the information asymmetry gap that can exist between superior and subordinate. condiments and packaging and the number of hamburgers made.3 Negotiated Targets Are set based on negotiations between superiors and subordinates. 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.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.3 FINANCIAL PERFORMANCE MEASURE Element 4. There are three approaches that can be used to set financial target against which performance can be measured. 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. other approaches must be used to set financial targets. One approach is to use historical targets derived directly from the results of previous periods.3.
Target set levels above average are labelled as difficult.1 Within an organisation people are employed to carry out specific activities. Targets are considered to be moderately difficult ( or highly achievable) when they are set at the average level of performance for a given task.4 NON-FINANCIAL PERFORMANCE Element 4. but will have little meaning to the individual employee 143 . 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. 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. Element 4. The only aspect of their work over which they have direct control may well be the volume and the quality of tasks they undertake. setting specific difficult budget goals will promote performance. whereas superiors have a broader view of the organization as a whole and the resource constraints that apply. and the subsequent use of difficult budget goals to measure performance will minimize the incidence of dysfunctional behaviour such as falsifying accounting information. applying revenues and costs to these activities may be important to the organisation as a whole. He suggests that where uncertainty is low . 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.relationship between outputs and inputs and the constraints that exist at the operational level. According to Merchant (1990) “most companies set their annual profit budgets targets at levels that are highly achievable.4 Performance Measurement Targets vary in their level of difficulty and the chosen level has a significant effect on motivation and performance. Element 4. tight or high.4. 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). and those set below average are classed as easy loose or low.3. However Hirst (1987) has advocated that the benefits arising from setting specific difficult budget goals are dependent on the level of task uncertainty.
a flexible budget is important in ensuring that the cost targets used as a basis for comparison are flexible as levels of output change. However. Using nonfinancial performance measures does not mean that the financial performance measures may be disregarded. A performance report on the history department 144 . If the employees are involved in the entire production process.who does not sell the goods or services directly and does not purchase the input material. 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. but the individual department will have no control over that number. 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. it may not be sufficient to motivate employees directly in understanding and meeting the targets expected of them. For them.4.3 Illustration of the problems of performance measurement in a service business Take a school as an example. where activities are subdivided by subject area. 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. Element 4. then the financial target may be converted to units of product per period. 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 4.4.2 Quality Measures As stated under financial performance measures. The accounting numbers have to be converted to some measure of quantity which relates more closely to the individual. then the cost per student will vary depending on the number of students taught in any period. To ensure that the motivation of employees is consistent with the profit objectives of the organization. This is essential in order to avoid a sense of injustice in the application of management accounting techniques. it may be necessary to use non-financial performance measures to indicate what is required to achieve the overall financial targets. If teaching staff are appointed on permanent contracts. The primary measure of activity will be the number of pupils taught.
would therefore. This is so important that an external agency ( often the auditors) may be employed to provide independent certification of the quality of the process.8% RESTORE SUPPLY IN 24 HOURS TARGET 99% PERFORMANCE 99. Secondly.4. 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. in respect of demand for products: a) the number of enquires per advertisement placed and b) percentage of customers who remember the advertisement. The important aspect of quality is the process undertaken by the organisation to achieve quality. Element 4. labour and capital equipment.financial performance over a one year period.4.5 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. 2. and c) time between receiving customer order and supplying the goods or services Example : Zesco an electricity company provided the following information about non.4 Quality Measures The ultimate measure of quality is customer satisfaction. RESTORE SUPPLY IN THREE HOURS TARGET 90% PERFORMANCE 92. quality is measured also in terms of the inputs to the process. Quality f inputs may be controlled directly by imposing standards on suppliers. The nonproductive time incurred because of faulty equipment or the reliability of delivery dates and quantities. Element 4. where inputs may be materials.9% 145 . or may be monitored by reviewing the rate of return on unsatisfactory goods.
In some cases senior management at head office can delegate to divisional managers to branches and divisions of the company.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. BACKGROUND INFORMATION (KNOWLEDGE) At this point we would like to remind all candidates about the concept of • Cost-centres • • Profit-centres Investment centres. we want to examine the different performance measures we can use to assess performance of divisions. Therefore at this point.5 Divisional Performance Measures In an organization. control can be centralized. Element 4. In this case the company will be running a decentralized control system. 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. where senior management at head office exercise control over complete activities of the organization. In some organizations.MOVING A METER INSIDE 15 WORKING DAYS REPLY TO TELEPHONE CALLS WITHIN 10 SECONDS TARGET 95% PERFORMANCE 96. (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 146 .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.
147 . and market shareholder value added in this text. 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. 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. therefore it would be usual for the investment to be averaged over the time period in question. 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 will be seen by concentrating on a percentage return rather than the absolute if the divisional profit.(b) Profit centre A profit centre can be an ability location machine or business unit for both cost containment and revenue generation. 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. 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. The two commonly used financial measures of divisional performance in such cases are return on investment and residual income.an American consulting company However we are not going to consider the modern performance measures of economic value added (EVA).
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. The breakdown has considerable significance for analysis and decision-making purposes.e. BREAK DOWN OF RESIDUAL INCOME. 000 on an investment of K2.S.For instance a profit of K400. 000. 000 of an investment of K10. as the following example will show. it must be determined whether the return exceeds that which could be obtained from an alternative use of the invested finances. Division profit Divisional sale = Divisional profit Divisional 148 . 000. 000. 000. 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. Example: Sounds investments Ltd sells music records through its own. in-town street stores and through its agents out-of-town.A did quite a lot of work around the subject of divisional performance assessment and assessment measures. 000. 000 gives a return on investment of 20% This represent a more efficient use of assets than a profit of K800. 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. Divisional Sales x Division investment Investment = Return on investment. al other things being equal. 000. As it can be seen from above simplifying the divisional sale cancels out leaving the same end formula.
000 K600.000 K8.000 = 15% Break Down = Divisional sales X Divisional Investment Divisional profit Divisional sales = K8.5% = 15% K8.400.000.200. whereas the lower profit margin accepted on sales in the own-stores business if 50%.000.000 K19.000. which generator a higher sales volume leading to an investment tomour of three (3) 149 .400.000 X K4. 400.000 K4.200. ROI = Divisional profit = Divisional investment K600.000 Divisional Profit Divisional sales =15% BREAK DOWN = Divisional sale X Divisional investment = K19.000 K300.Through Agents Division profit Division Investment Divisional sales Through Agents the ROI is.000 = 2 x 7.5% the investment in the business through the agents is only tomorrow over twice.000 Through own stores K960.000 K6.000 X 100% K2.000 Through own-stores ROI = Divisional Profit = Divisional Investment K 960.000 = 3 x 5% = 15% x K960.000 K19.000 Even if the Business through agents earn a higher profit on the sales of 7.000.200.000 x 100 K6.000 K6.000.000.
4 00. 000 K6. 000. Pep stores of Chipata produced a profit of K600. 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 K1.5 to 0.080. 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. 400. 400.000.4 x 45% X 100% = 18% 150 . 000 K2. 000. 000 ROI = K1. 000. 000 Break Down = K2. 000 = 0. 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. 080. 000 x Divisional Profit Divisional sale = K600. 000 K2.Example Last year.00 on sales of K2. 000 ROI = Divisional Profit x 100% Divisional Investment = K 600. 080. The investment in the division was K4. 000 on sales of K2. 000. 000.4) lending to the overall increased ROI. 000. 000. 000.5 x 30% = 15% In the current year the divisional manager has reported an increase in his ROI to 18%. 000 x 100% K4. 000. 000 K4. 000 K6. 000 = 0. 000 = 15% BREAK DOWN: Divisional Sales x Divisional Investment K2. 000 generated by an investment of K6.
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.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. 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. Therefore benchmarking aims to encourage corporations to improve their performance by comparing their own performance to that of other companies. 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. iv. Actions (i) to (iii) will increase the profitability ratio and hence the ROI. Element 4. 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. by differing much of the periods fixed manufacturing costs to a later period then the improvement in ROI is no case for congratulation. which contribute to ROI. A reduction in the level of divisional investment. For example if all other factors were held constant. ROI would be improved by any of the following individual actions i. This will be highlighted when we consider the example looked at under behavioural implication of using divisional measures of performance. 151 . iii. it can provide a local manager with limits as to the type of action that would be necessary to improve the sub-limit return. Further at the divisional level by highlighting the different factors. ii. action (iv) will do likewise by increasing the investment tumors. By the adoption of best practice it is hoped that performance will improve.
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.Element 4. (i) (ii) Product literature Trade associations and press comments However we should realize that a product is only the end result of the process.1 Steps In Benchmarking The bench marking process starts by first relating appropriate comparators against which a company can compare its performance. Reverse engineering insists buying a competitors products and dismantling it in order to understand its content and configuration Element 4.6. 152 . Element 4. The comparators competitor should be of similar size and therefore showing as good comparator. which a business follows.6.2 Information Gathering Benchmarking starts with obtaining the information required in order to benchmark against competitors Element 4. Non-financial information about competitors and their products can be obtained by reverse engineering.3 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. This entails that the target against which benchmarking is going to be carried out should be a company with similar operations as ours.6.6. and thus effective benchmarking requires an understanding of the actual basic process of their businesses.4 Other Sources of Information In order to obtain information about their competitors we would use the following sources.
¾ Internal benchmarking ¾ External benchmarking ¾ Inter-industry benchmarking (a) Internal benchmarking With internal benchmarking. However in our studies here we want to classify benchmarking in two parts. 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. how do competitors process their customer orders. conduct their relationships with suppliers and other keep stakeholders? Element 4. we compare the performance of the different departments or business units against the least department in class. (c) Inter. For instance we would want to compare the finance department of Shoprite. for example we can compare the performance of Shoprite Checkers against the performance of Game stores in a given control period.6. For example.5 Types of Benchmarking The exercise of benchmarking can be classified in different types. (b) External benchmarking With external benchmarking. deal with customer enquiries.industry benchmarking 153 . we compare the performance of the company against the performance of others in the same line of business. Game stores and Melissa against the performance of a top performing finance department in the chain store industry. Note that in internal benchmarking we are comparing different departments in the same organisation regardless of the business activities or discipline they are handling.As noted above obtaining information about competitor’s processes is much more difficult than getting information about their products.
6.6 Benefits of Benchmarking The benefits of benchmarking are quite obvious.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. Element 4.7 BEHAVIOURAL ASPECTS OF PERFORMANCE MANAGEMENT Element 4. to establish a benchmarking relationship. a distributor of personal computers may approach a distributor of HI.FI equipment as HI.competing business.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. 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.FI City. computer connection. 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. we need to identify a non.6. Therefore to successfully carry out this. 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. with similar processes and risk to participate in the benchmarking exercise. For instance. the corporation can improve its performance by learning from the experience of others.7. 154 .In inter. By collaborating with other companies in a benchmarking exercise. however. Element 4. the comparisons might be flawed.1 The human aspects of controls in relation to performance measurement is a key factor in evaluating the control system.
This should therefore encourage the organization to incorporate other control measures which are not necessarily specified in quantitative terms. Element 4. However.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. However. In general. 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.6 BUDGETS AND PERFORMANCE MEASUREMENT 155 .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.7. It is also important not to make Departmental Heads accountable for areas where they do not seem to have significant influence. Element 4.7. This means that employees must be motivated to achieve those targets. a fair appraisal system must be used which should create a positive attitude in employees.2 PERFORMANCE INDICATORS Performance measures must be in such a way as to help the organization achieve it’s objectives. This results in some measures not achieving goal congruence or desirable organizational behaviour. 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. It is common practice for uncontrollable factors to be excluded from employee performance measurements. However. this does not mean that uncontrollable items should not be reported. it is the case that performance measures will not necessarily reflect the ideal measure of overall performance.7.5 Performance indicators should always provide for controllable and uncontrollable factors. Element 4.7. 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. Element 4. controls can sometimes result in employees’ behaviour which works against the objectives of the organization. Element 4.7.4 In evaluating performance.
From this analysis. the following conclusions are made: a) Budgets have no motivational effect unless they are accepted by the managers involved as their own personal budgets. 156 . but negative attitudes result if they are seen as too difficult. It is assumed that with each level of budget difficulty encountered by managers in meeting the targets.Budgets are supposed to provide a way of motivating employees (especially managers) to meet the desired financial targets. performance and motivation levels will start declining. b) Up to the point where the budget target is no longer accepted. It is however. it is therefore important to identify some level of budget difficulty which should at least maximise employee performance and motivational levels. This however. can only be the case if people responsible with implementing the budget are agreeable to the set financial targets.7. after a certain level of budget difficulty. Element 4. The use of departmental meetings was found helpful in encouraging managers to accept budget targets. d) Acceptance of budgets is facilitated when good communication exists. there is a corresponding increase in the performance and motivation levels.7 In a study carried out by Hofstede concerning the budget difficulties. c) Demanding budgets are also seen as more relevant than less difficult targets. e) Managers’ reactions to budget targets were affected both by their own personality and general cultural and organizational norms. practically difficult to reach a consensus as the ideal financial targets without some managers being dissatisfied. However. the more demanding the budget target the better the results achieved.
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. 157 . 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. (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. From close examination of other chapters in this book. material costs or labour costs. Element 5. 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. sales price per unit. or estimated revenues Y% lower than estimated.STUDY UNIT 5. The essence of the approach therefore. (b) To estimate whether a decision would change if estimated costs were X% higher than estimated. 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.
000 2.000 158 . the project would make a loss.000 (6.000 units) Variable Costs: material labour Contribution Less: incremental fixed Profit Required: Analyse the sensitivity of the project. Linear programming in chapter 5 under linear programming.(i) (ii) (iii) (iv) What if analysis under information systems (chapter 10) using spreadsheets). Solution: (a) If incremental fixed costs are more than 25% above estimate. 4. Flexible budgeting can also be a form of sensitivity analysis see chapter 6 under flexible budgets. Example: SENSA (Z) Ltd has estimated the following sales and profits for a new product which it may launch on to the market.000) 2. K’000 Sales (2.600) 400 K’000 8. (b) If unit costs of materials are more than 10% above estimate the project would make a loss.000 (1. 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) 2.926 0.000 7.000 0.857 present value of plant cost K’000 (7. the project would be sensitive to an increase in unit labour cost of more than 20% above estimate. Sensitivity analysis can help to concentrate management attention on the most important forecasts.500 6. The items to which profitability is most sensitive to in this example are the selling price and material costs. Example: YUKAA PLC is considering a project with the following most likely cash flows Years Purchase costs K’000 (7.000) 159 . Management would then be able to judge more clearly whether the project is likely to be profitable.000 2. Required: Measure the sensitivity (in percentages) of the project to changes in the levels of expected costs and savings.(c) Similarly.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.
1.000 x 100% K11.000 x 100% = 8% K7. Looking at factors in isolation is unrealistic since they are often interdependent. 160 .000 = 4.000 x 100% = 14% K3._______ (7.143) (3.995) 5.000.000 (c) Savings would need to fall by a present value of K560.000 that is by: K560.852) (2.000) Present values of Running costs K’000 Present Values of Savings K’000 Present Values of Net Cash Flow K’000 (7.856 560 The project has a positive NPV and would appear _____________.000 that is by: K560.704 3.999 11.000 that is by: K560. (a) Plant costs would need to increase by present value of K560.995.000 (b) Running costs would need to increase by present value of 560. The changes in cash flows which would need to occur for the project to break even (NPV = 0) are as follows.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.555 3.8 Element 5.556 5.000) (1.555.
000 x 10. Example DEF (Z) Ltd is considering the launch of a new product.000. We can approach sensitivity analysis from two perspectives.000. As the definition indicates sensitivity analysis can be applied to a variety of planning activities and not just to instruct decisions.560.000.000. while all other factors remain at their original estimated. If 10. In sensitivity analysis a single input factor is changed at a time.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. the Delta. This occurs at a volume of 10. Solution The minimum sales volume is the volume that produces a net present value of zero. but if 20.000. Of paramount importance. the net present value over five years will be K1. it is vital to identify variables that are of special significance.560. 161 .(b) Sensitivity analysis does not examine the probability that any particular variation in costs or revenues might occur.000 units K1.000 = 13.000units + K1. 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.000 + K2.875.000 units per annum are sold.560.000. Required Calculate the minimum annual sales volume that will justify the launch of the delta.000 units are sold per annum the net present value over the same period will be K2.875.000.
It is estimated that this will generate sales of 10. 564 ii. the indifference point. 000 = (26.1. The cost of capital is 5%. 564 20. Calculate the net present value By how much can each factor change before the company becomes indifferent to the project? Suggestion Solution: i. Alternatively specific charges can be calculated. 000. The contribution per unit is expected to be K6. 000 before the indifference point is reached. such as the sales decreasing by 5%. in order to determine the effect on the net present value. 000) 34. 000 x 10. 000 Units = 60. 000. 000) 120.000 units per annum for four years. 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.546 PV K’000 (100. 000 and the fixed costs are expected to be K 26. 000 per annum. 000 3. Net present value can fall by K 20. 2. Muponga Ltd is contemplating investing in a project which will need initial capital investment of K 100. 000. Example The example below shows how sensitivity analysis works in practice. This implies that the annual cash flows can change by 162 . Required: i. 000 DCF @ 5% 1. 000) 34. ii.e.000 Less: fixed costs Net cash inflow per year NPV Years 0 1–4 Outlay annual cash Inflow Cash flow K’000 (100. K’000 Total Contribution = K 6. 564.
800. However.e. 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. it has not been calculated with data on the ‘most likely’ value of each of the four variables affecting the decision. 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. Each of the factors has a significant influence on the profitability of the proposed project. However. 000 Therefore. most practical investment decisions are married with a great deal of uncertainty. we have many approaches to deal with this. 000 to K20.1. However in most projects the various variables will have interdependences amongst themselves. Element 5.X x 3. cash flows and the discount factors or costs of money were known with certainly. this is not a certain net present value. 000. 200. 000.3 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. Sensitivity analysis is one of the methods of reducing uncertainly and assessing certainty in investment decisions. 564. 000 Element 5. Therefore. 000 X = K 5. 800. In order to give decision makes a clearer understanding of the problem without providing definitive guidance though. the net present value of the investment is K 2. These variables are listed below. 163 .2 Application of Sensitivity Analysis in Project Appraisal We dealt with capital investment appraisal chapter. the costs can fall by K 5. we assumed that all the quantitative factors in the investment decision i.546 = K 20. Example: A company is contemplating investing in a new product. we cannot just take a simplistic approach to assume that each variable has to be considered in isolation.
If the aim is to maximum profits from two products X and Y. total profit = K15. 000 Y This will serve as the objective function in a situation where a business aims to maximize profits. 000 Y. at any given point in time a business will want to either minimize cost or maximize profits and therefore shareholders wealth. 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. 000 and a unit of Y gives us a profit of K 20. Supposing that one unit of X gives us a unit profit of K 15. 000 and K 28. the first step in linear programming will initiate the establishing of an objective function. 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. The profits will be maximized by either increasing turnover of the company or by minimizing costs of operations.000 respectively. 000 X + K 28. Therefore. Therefore. 000. 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. we would construct a similar objectives function which would however aim to minimize the costs of operating. which usually will aim at minimizing costs of operations or maximizing revenues from operations. 000 X + K 20. since profit is a function of Revenue against expenditure. Therefore. 164 . In a case where an organization would like to minimize costs.STEPS IN LINEAR PROGRAMMING STEP 1: Establish the objectives function In business. corporations are there to make profits as they wish maximum the wealth of shareholders. 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. we would construct the total profit equation as follows: Total profit = Profit from + Profit from one One unity of X Unit of Y. Profit = Revenue – Expenses.
The non-negativity equation therefore aims to form a block or boundary within which the graph has to be drawn.c) by the equal sign (=) STEP 3: Establish Non. +Y -X +X 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. We cannot have negative figures coming from the graph as optional solutions. In most manufacturing situations raw materials.Negativity equations.t. The next step in linear programming is the establishment and determination of inequalities which show the different constraints. Having established the inequalities you will need to convert them into equations. 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. skilled labor. if they have to make arithmetic sense. factory capacity and many more factors might act as constraints limiting factors.STEP 2: Inequalities. where we will replace the inequality signs (e. The non-negativity equation will be: 165 . Therefore the inequalities are constructed according to the constructs shown in the scenario. At this stage we want to realize that all the analysis we will conduct under linear programming will have to yield positive figures.
K2 uses s man-hours. 500 Kg 400 Litres K1 uses man-hour. and K2 and has the following constraints on a monthly production. Since this is brought forward knowledge. and the resulting equations will be X = O and Y = O respectively STEP 4: Plot the equation lines on the graph. Operative time Raw material A Raw material B 240 man-hours. 000 respectively. K. It is known that all production can be sold. Try the example below and see if you can remember your basic linear programming technique. 5Kg of A and 5 litres of B to make each unit. 5 Kg of A and 4 litres of B to make each unit. if the objective is to maximize total monthly profit. The contribution to profit from each unit of K1 and K2 are K 150. Required: Represent the above situation as a linear programming model.X ≥ And O Y ≥ O These will further need to be convert into equation.000 and K 100. STEP 5: Determine the Optimum position mix or combination. 166 . Question: Manzi Co makes two components.
The detailed linear programmes procedure described above can be applied to the molobezi scenario as a linear programme.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. The simplex method begins in the same way as the ordinary linear programming operation. There are four decision variables in the model defined as.000 ASSEMBLY 5 4 3 2 9. 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 objective variables are stated as: Let Z = total contribution earned in the coming year in kwacha from the production of the coffee tables.e. The quantities of the four types of coffee tables to be produced are the activities of the problem. by setting up equation for the objectives function and the constraints. In illustration below will explain the simplex method properly. X3.000 FINISHING 1 4 5 3 4. In addition market analysis reveals that the annual demand for the company’s small coffee table is at least 800.950 K’000 60 123 135 90 Due to other commitments no more than a total of 1. the X and Y axes. large coffee tables to be producing in the coming year. Example Mulobezi timber table require time for the cutting of the component parts for assembly and for finishing. Therefore were need different method of solving the problem: i.e. 167 . X4 = the number of small.800 coffee tables can be made in any given year. the simplex method. medium large and extra. Let X1. The company wishes to determine how many of each type of coffee table it should produce in the coming year to maximize contribution. The data in the table below has been collected for the year now being planned. X2.
000X3 + K 90. 000X4 The quantities of the four types of coffee tables made will be restricted by the limited availability of cuttings. 000X1 + K 123. 000 1X1 + 4X2 + 5X3 + 3X4 ≤ 4. assembly and finishing time. that the amount of cutting.800 X1 ≥ 800 168 .950 X1 + X2 + X3 + X4 + ≤ 1. X4 ≥ 0 The complete model for Mulobezi. 000 1X1 + 4X2 + 3X3 + 3X4 ≤ 4. X1 +X2 + X3 + X4 ≤ 1. This there will be three constraints specifying. 000 5X1 + 4X2 + 3X3 + 2X4 ≤ 9. Maximize Z = K 60. 000X2 + K 135. 000X3 + K 90. assembly and finishing time used in production cannot exceed that which is available. 000X2 + K 135.e. timber’s linear program is therefore Maximize Z = K 60. 000 5X1 + 4X2 + 3X3 + 2X4 ≤ 9.800 there is a ceiling (maximum) on the total number of coffee tables to be manufactured. Thus the following constraint must be included in the model. The requirement that at least 800 small coffee tables must be produced can be expressed in a mathematical equation as X1 ≤ 800 Finally. These are written as: 2X1 + 2X2 + 1X3 + 6X4 ≤ 3. 950 The total of the 4 decision varieties cannot exceed 1. X3. non-negatively conditions (equations) must be states for the other three decision varieties i.The company wishes to maximum contribution so the objective function is. 800. X2. 000X1 + K 123. respectively. 000X4 Subject to: 2X1 + 2X2 + 1X3 + 6X4 ≤ 3.
As it can be seen. 000 0. 0000 1. X2 = 250. 450. 0000 48. 9. 0000 Worth. 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 150. 0000 0. 000 Variable X1 X2 X3 X4 Value 950. 0000 0. X3. 000 Constraint 1 2 3 4 5 Slack / surplus 0. X3 = 600. A general algebraic method of solving linear programming problems. 000 0. 000 21. 000 600. this model cannot be solved graphically as there are more than 2 variables. 000 0. Therefore to maximize contribution in the coming year. However. Mulobezi. 0000 21. The Variable and value columns mean that X1 = 950. should manufacture 950 small coffee tables. 250 medium one and 600 large one and none (nil) of the extra large coffee table 169 . 750. 000 0. 000 1. 0000 Relative Loss. 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. 0. X4 ≥ 0. 0000 0. 000 250. X4 =0.
shows the total contribution that will be earned from the above production of the tables in the coming year. 3. c) Constraint 3 is ≤ and refers to finishing time. it can be seen that we have worth and relative loss columns. NATURE OF RISK It would be rare for the outcome of a business decision to be known with certainty in advance. It slack to Zero showing that all availability cutting time will be used. e) Constraint 5 is ≥ and specifies that at least 800 small coffee tables will be made. indicates that production is 150 above the minimum requirement. 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. d) Constraint 4 is ≤ and refers to the ceiling on the total number of coffee tables produced of 1. (This can be seen by the fact tat X1 = 950). 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. 800. The worth shows the shadow price i. This assembly time is not a binding constraint. a) Constraint 4 is ≤ and refers to cutting time. 750.2. It has a surplus equal to 150. The slack is zero. Decision theory attempts to distinguish the two concepts i. Its slack is zero indicating that all of this resource will be used. 000 and extra hour of finishing time would increase contribution by K21. A measure of risk or uncertainty is present in almost all circumstances in business. 000. the amount which contribution would alter if the availability of the resource was changed by one unit. 170 . so 950 of these tables are made. Showing that this ceiling has been net exactly. This is extra hour of cutting time would increase contribution by K 9.e. 450 unused hours of assembly time. the concept of risk and the concept of uncertainty. WORTH AND RELATIVE LOSS INTERPRETATION In the above table. 000. Z = K 168. b) Constraint Z is ≤ and refers to assembly time the slack here equals 1. 450 and this there will be 1.e.
The difference between these three types is a function of attitude towards variability of returns around an expected value (EV). i. all alternative must be considered and mutually exclusive i. Those who are risk-averse prefer in the same situation. They may be risk neutral. However.e. Decision taken under conditions of risk and uncertainly can be encapsulated in a formal model.e.Risks exist where several alternative outcomes are possible. A risk neutral decision maker ignores variability and is concerned only with the expected values of outcomes. for the consideration of our studies here. the alternative with less variation associated with it. 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.0) A set of outcomes • 171 . this would be the maximization of profits as it is the belief that the sole objective of a business is maximization of profits. • A set of the alternative states of nature that exist in respect of the situation together with the probability of each ones occurring. which contains the following time outlined elements. but previous expense enables the decision maker to give (assign) a probability to the likely outcome of each alternative. the qualification of the company’s objectives in a particular situation. • A set of alternative causes of action These can be adopted in order to achieve the desired objectives. This set must be collectively exhaustive i. Typically.e. Again this set must be collectively exhausted and mutually exclusive (and the probabilities must sum up to 1. risk-seekers or risk averse. the two words i. • An objective function. Decision makers themselves may have differing attitudes to risk. risk and uncertainty will be used synonymously. 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).e. one course of action precludes any other.
An illustration at this point in time might be used to show the use of such a model. 000. and the adoption of one precludes the other. under (2) Inspection and necessary modification reduces contribution by K20.e. Illustrative Example: NKETA Ltd buys in sub-assemblies for the manufacture of it’s own product. A risk neutral decision-maker would accept the alternative course of action that maximizes the pay-off in any particular situation. they are collectively exhaustive). they are mutually exclusive) only two alternative states of nature exists. In the case of: (1) Unnecessary inspection reduces contribution by K 10. Each outcome can be assessed in terms of it’s pay-off. There are two alternative courses of action here: INSPECT OR NOT INSPECT. The decision it faces is whether to put each sub-Assembly through a details inspection process as it comes into stock. 000 per unit. 3) Do not inspect and no problem exists 4) Do not inspect and problems do exist. 2) Inspect and find problems. under (3) There is no loss of contribution and under 172 . each one associated with a particular outcome. No alternatives are possible (i. (i. Pay-offs are expressed in terms of the objectives of the function.Each outcome associated with a particular course of action and state of nature. 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. • A set of pay-offs.e.
000 over and above the initial investment of K100. 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. 000. 000 would be made. we could have seen a high level of failures incompatible with a requirement for a quality product and the concept of continuous improvement. On a purely quantitative analysis. a policy of not carrying out an inspection would lead to contribution being on average K7. 000] = (K11. 000] + [0. 000. 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. EXPECTED REDUCTOIN IN CONTRIBUTION INSPECT [0. 000 As we already introduced the concept of expected value (EV).5x (K100.1x K20. 000] + [0. 000) Taken over a long period of time. It would cost K100. 000.(4).5xK0] + [0. therefore it is the correct policy to adopt. 000 Decision not to back the musical [0. 000 initially invested.5x K0] = K0 173 . 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. extensive rework at the finished goods stage reduces contribution by K40. Example 2.9x K0] + [0. However in the real world. An efficient middle-aged Zambian businesswoman is considering backing the production of a new musical in the west midlands. 000. 000. 000)] = K75. The extra example below introduces a further consideration. If the critics dislike it.1 x (K40. 000) DO NOT INSPECT [0.5x K250. 000. the expected value of each course of action in this particular example is as follows.9x K10. Decision to back the musical [0. 000)] = (K4.000 higher for each subassembly purchased.
The two examples below as earlier include only single-point outcomes.000. Every performance. 000. few individuals would afford to sustain a personal loss of K100. 000.000. 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. Pay-off will vary according to the actual mix achieved.000. 000. 000. 000 was worth an equal 50% percent risk (chance of losing K100. If probabilities are attached to each estimate. particularly where there is no chance of repetition and the investment is not part of a portfolio. the only feasible outcomes of this would be a profit of K250. if the loss would bankrupt them). 000. by weighting each of them by its assessed probability as follows: Examples 3 This example is a build up on Example 2. 000 predicts for a successful show in the latter is far too precise than a figure. Such as this.000 174 . 000. Whilst almost everybody welcomes a profit of K250. Conformity with present quality standard or non-conformity in example 1 and a successful show or a flop in example 2. it is equally obvious that the profit of K250.10 0.000 or a loss of K100. 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. It would be more realistic to assume a range of possible successful outcomes-after all. The analysis breaks down in a once-off situation. An economic argument will always be tempered by consideration of risk perception and preference.000 0.000 250. a theatre will not necessary sell the same number of tickets. 000.However expected value computations rely on repeated performance of an operation process or investment to give economic validity to their average figures. 000. the expected profit of K75. 000 is not a feasible outcome of this particular decision.000 50. 000. Many investors would be risk averse in such a situation they would not consider that a 50% chance of making K250.000.000. Outcome probability K 150. the expected value of a successful outcome will take account of the range of possible outcomes. obviously.000.25 expenditure value K 15.
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 K250.15 0. In the following example we want to understand the application of the probability two or more states of nature occurring together. 000)] = K 72.000. by summary the probabilities for pay-offs of K150. 000. 000.5 x (K100.000 245. 000 or less if the musical is successful and summarising those for K300. 000.g. given the circumstances (unlike the overall expected value of a decision to back the project: (0.5 x K245.000 45. 000. it makes sense in economic terms. K200. 000 in our example 2) The probability of an outcome being above or below a particular figure (e. 000 or more in the event of success is only 25%). 000 and K350. 000 allows us to say that the probability of a profit of K300.000 35.000. 000. 000 and K250.000. 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 0. 000.000.40 0. The statement of ranging possible outcomes and their assigned probabilities is known as a probability distribution.000 300. 000. 000. 000.000 350. 000. 000.000. 500. 000 we can conclude that there is a 75% probably that profit will be K250. 000. In practice a grater number of alternative course of action may exist. 000) + [0. uncertainly may be associated with more than one variable and value of variables may be interdependent giving rise to many different outcomes. i.000.10 1. 000.00 100.000 Although the expected value is again seen to be infeasible. Still on economically non-superficial outcome for this unique project. in as much as it does not correspond to any of the range of point estimates for a possible such outcome. 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 (as opposed to any other profit figure) if it is well recurred then the probability of 175 .250.000.e.
0 contribution probability attaches to contribution fixed cost probability attaches to fixed costs K’000 0. Uncertainly surrounds the likely sales volume and contribution as well as the fixed costs of the venture.3 1.6 0. 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. The organizing committee members who specialize in marketing and finance came up with the following data: Sales probability (units) attaches to sales units 200.5 x 0.2 0.0 14 5 As the number of individual variables subject to uncertainty increase. 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. One batch of the chumbu is produced and sold each quarter.1 1.5 0. 000 is 0. Market research has it that demand for the quarter of the chumbu relates as shown below to the selling price per unit.5% chance of no net contribution /10 loss. Example 2 Musa ltd manufactures a product called the chumbu. 000 160.4 = 0. the variable cost of a unit of the chumbu is K30. 000. This concept and application of multiple probabilities is gong of be amplified and shown further in the last example of this section. It is not possible to hold stocks of the chumbu for any significantly long period of time. 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.5 1.000.promoting a successful musical which makes a profit of K250. 176 . The variables costs are all labour-related and the production of chumbu involves an 80% learning curve.0 800 900 500 0.5 0. the decision becomes more complex. 000 0. 000 120.2 or 20%.000 units. At a batch size of 24.3 0.
000 17.41042802 = 25. where B is the batch size and is a constant.380211242 4. . Suggested solution: .67 177 . it is a simple matter to identify the batch size which maximizes contribution using revenue analysis.322 Requirements: Calculate the optimum batch size for the Chumbu production. 000 = _____a______ 24. 000 = 4.500 80. 000 units it may be deduced that ‘a’ = K773.67 as it can be seen from the calculation below.From the formula given and using information supplied in regard to the batch size of K24. 437. You may assume that the variable cost per Chumbu (h) on an 80% learning curve may be obtained from the following formula.380211242 X 0.000.41042802 Antilog of 1.000 unit K773.000 X 24.000 15.Once you have calculated the variable cost at different batch sizes. 000.000 23. h is K30. h = ____a____ B 0.72930291 a = K30. When B is 24.For as long as the candidate knows the mechanics of the learning curve effect.Selling price per unit (K) Sales of the Chumbu 50.000 60. . 437. 23.000 There is a complete discontinuation between the batches as regards learning effects.000 0.000 12. therefore. 000.322 log 24. It does not make a difference that is expressed in kwacha (monetary) terms rather than hours.000 90.000 70. K30. then it is quite straight forward to calculate the total variable costs at different batch sizes.322 = 1.
000 17. where contribution is being maximized is at the K 23. 378 524. 000 Variable costs K ‘000 711. 500 1. The main difficult is of course. 000 0. 437. The decision tree model is only as good as the information it contains. 933 582. the batch. 200. 000 batch units of the Chumbu. 500 1.5 180. 622 657. 000 160.67 20. 000 23. 416 629. 380.7 178 . 931 Contribution for the batches K ‘000 463.60 As it can be seen. 000 15. 175. 080. 437. 000 1.67 K 12. 000 0. 228 700. Illustration. 000 net profits Probabilities 0.4 0. 225. The technique is usually used to evaluate alternative investment plans. 067 642. 584 450. The illustration below gives a simple example to illustrate a diagrammatic representation of the decision tree. 000 1. 000 Expected 80.Revenue Analysis: Sales revenue Batch size (units) K ‘000 23. 000) Yr 2 120. Element 5. The decision tree is a pictorial representation of the probabilistic information to manage and aid decision making. 000 0. 000 12. 577. Return in Investment C Probabilities Investment D Yr 1 40.4 Decision Trees The decision tree is one way or method of analyzing risk and uncertainty.322 h = K 773. 772 679. 000 1. as always.5 (20. 069 Computation of the variable cost per batch h = K 773. accurately providing the probabilities that determine the uncertainties involved in the investments.58241045 h = K 37.
4 chance of a loss K 20. The circle represents a point at which a chance event takes place. there could be many 179 . Element 5. it appears that plan D would be the best option. The lines. 000. The diagram below shows the pictorial representation of the data in the table below. in practice. But the plan has a 0.When the expected profit is calculated. 000 whereas plan C will always generate a profit of some point.4. The values under the profit heading in the diagram below represent the possible outcomes. the branches of the tree represent the logical sequence between possible outcomes. This illustration is only a simplification.1 Notation of A Tree Diagram The tree diagram has squares and circles as symbols that take on extraordinary meaning. in this case there is only one decision to be made – the choice between plan C and D at the onset. The square represents a point at which a decision is made. The “payoff” figures are then calculated by multiplying the possible outcomes by their probabilities of taking 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
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. then the relevant cost of using them for the opportunity under consideration would be nil. and so have no internal opportunity cost. 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 187 . Are the materials already in stock.would obtain if they were put to an alternative use. If the materials have no resale value and no other possible use. The flow chart below shows how the relevant costs of the materials can be identified. provided that the materials are not in short supply. The higher of (a) or (b) is then the opportunity cost of the materials. if this is greater than their current resale value.
000 1. Material B is used regularly by the company. 000 per unit. and if units of B are required for this job. in deciding whether or not to accept the contract? Solution: (b) (a) (b) Material A is not owned and would have to be bought in full at the replacement cost of K6.000 9.000 200 Units already in stock 0 600 700 200 Book value of units in stock K/unit 2. No other use could be found for material C.500 2.000 Realisable value K/unit 2. 000 per unit.500 2. which currently costs K5.000 3. but the units of material D could be used in another job as substitute for 300 units of material E. 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. 188 . The job requires the following materials: Materials A B C D Total units required 1.500 6. 1.000. 000 per unit (of which the company has no units in stock at the moment).000 4.Decision Making Techniques Example: A customer who would like a special job to be done for him has approached Muma Ltd. and they have a restricted use. they would need to be replaced to meet other production demand.000 4.000 for it. Relevant cost therefore.000 1. Required: What are the relevant costs of material.000 units at the replacement cost of K5. and is willing to pay K22. Materials C and D are in stock as the result of previous over-buying.000 (a) Material B is used regularly by Muma Ltd.000 Replacement cost K/unit 6.000 5.
000.000) + (700 x 2.P. K1. The existing stocks of 700 will not be replaced. Material D: These are already in stocks and will not be replaced. 200. cost-volume-profit analysis or C-V-P analysis.000 1. 000 =K1. If used for the contract. 000 Since substitution for E is more beneficial. would cost 300 x K5. 000 per unit (K1. The term break-even analysis is the one commonly used. 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. The realizable value of these 700 units is an opportunity cost of sales revenue forgone.000.000 is the opportunity cost.000 5. 000) Material C (300 x 4.500) Material D Total K 6. There is an opportunity cost of using D in the contract because there are alternative opportunities either to sell the existing stocks for K6. Summary of Relevant Costs Material A (1.Material C: 1.000) or avoid other purchases (of material E).000 2. but this is not essential.950. Because of this on alternative term.450.000 x K6. they could not be sold at K2.000 BREAK EVEN ANALYSIS This is the term given to the study of the interrelationships between costs. USES OF C. 000 each.000 15.V. ANALYSIS 189 . If they are used for the contract. volume and profit at various levels of activity. Frequently these relationships are depicted by graphs. 500. a further 300 units must be bought at K4.000 units are needed and 700 are already in stock.000 x K5. 500 each. is frequently used and is more descriptive. 500.500. 000) Material B (1.
C. In these cases the established cost patterns are likely to continue.g.P.P. Over greater changes of activity and in the longer-term existing cost structures e. Typical short-run decisions where C. It explores the relationships that exists between costs. 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. These are: (a) (b) (c) (d) (e) (f) (g) All costs can be resolved into fixed and variable elements. 190 . ASSUMPTION BEHIND C. pricing policies.V. the major assumptions behind C. analysis may be useful for decision-making. production methods and efficiency remain unchanged Particularly for graphical methods that the analysis relates to one product only or to a constant product mix.P.V. output levels and resulting profit and is more relevant where the proposed changes in the levels of activity are relatively small. so C. ANALYSIS Before any formulae are given or graphs drawn. are likely to change.V. multi-shift working and special order acceptance.P.P. so C. analysis must be stated. analysis becomes less appropriate. choices of sale mix. Fixed costs will remain constant and variable costs vary proportionately with activity.V. analysis uses many of the principles of marginal costing and is an important tool in short term planning. the amount of fixed costs and the marginal cost per unit. revenue.P. analysis can be useful include. 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.V.V.
or by simple formulae that are listed below and illustrated by examples. Nevertheless. analysis can be undertaken by graphical means that are dealt with later in this chapter.It is because of this that C. tactical decision. by highlighting the interaction of costs. BROUGHT FORWARD KNOWLEDGE C. (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 (e) Level of sales to result in target profit = Fixed costs + Target profit Contribution/unit (f) Level of sales to result in target profit (K sales) 191 . analysis can only be an approximate guide for decision making.V.P. useful guidance can be provided for managers making short run. Analysis by formula C.V.P. revenue and profit.P. volume.V.
000 per annum and has three products.000 20.= (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.000 60.000 Contribution K’000 20. Example: A company which has fixed costs of K50. 000. the sales and contribution of which are shown below. Product X Y Z Sales K’000 150.000 C/S ratio 20% 50% 42% Required: (a) Plot the products on a profit chart and show the break-even sales 192 .000 25. 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 MULTI-PRODUCT CHART Graphs and computations of a mix of products can be derived from appropriate data.000 40.
000 +25. The dotted line represents the resulting profit of this particular sales mix and C/S ratios. Y.000 NOTES (a) (b) (c) The solid lines represent the contributions of the various products. in the sequence of their C/S ratio i.000 100.e. Reading from the graph the break-even point is approximately. 193 .000 Y -50. +50.000 50.000 Z -25.Solution: The axes on the profit chart are drawn in the usual way and the contribution from the products.000 250.000 150. Z. X drawn on the chart.000 200.
000 75.000 250.000 X 100% 250.000 30% Fixed costs C/S ratio K50. charts assume that fixed costs are always unaffected by activity.000.000 40.3 K166.000 60. The charts and the analysis depicts relationships which are essentially short-term.000. This makes them inappropriate for planning purposes where the time scale stretches over several years.000 Overall Contribution/Sales Ratio = Contribution K’000 30.000 30/100 K50. The exact figure can be calculated as follows: Product X Y Z Sales K’000 150.000.667 = Break-even point = = = = LIMITATIONS OF BREAK-EVEN CHARTS AND ANALYSIS (a) The C.000 25.000. a more accurate representation.666.K170.P.V.000 75. but in actual fact. (b) 194 .000 20. they can exhibit features of stepped fixed cost.000 0.
V. Element 5. analysis. Subjective probabilities are probabilities which are established by judgement rather than past data. Subjective probabilities are based on an individuals expert knowledge.5. usually sales or production. This is gross over simplification and reduces the accuracy of the charts and C. However.g. unlike stating the most likely outcome.P. A possibility distribution is a list of all possible outcomes for an event and the probability that each will occur.(c) The charts and C.5 PROBABILITY AND EXPECTED VALUE Expected value is a simple way of showing the effects of uncertainty into decision-making. Most business decisions involve subjective probabilities since many past observations or repeated experiments for particular decisions are not possible. Where several possible outcomes are expected. most business decisions fall in the uncertainty category. but there is little past statistical evidence to enable the predicting of the possible outcomes. Probability is the likelihood that an event will occur. Quite often. Objective probabilities are probabilities which are established mathematically or compiled from past data e.3 PREDICTING POSSIBLE OUTCOMES Predicting possible outcomes makes use of probabilities. past experience and observations of current variables which are likely to have an impact on future events.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. Element 5.5.2 Uncertainty on the other-hand arises where there are several possible outcomes. subjective probabilities have the advantage of providing more meaningful information.5. Expected value is the average value of an event which ha several possible outcomes. Element 5. analysis make the assumption that all variable costs vary according to the same activity indicator. Element 5.V. Tossing a coin.4 Probability can either be objective probabilities or subjective probabilities.5 RISK AND UNCERTAINTY Element 5. a probability distribution can be tabulated. Element 5.P.5. The expected value of a decision represents the long-run 195 .
200 4. It is therefore very possible for the actual results to be different from the expected values.10 Weighted Amount K’000 432 1.920 7.432 2.6 For example: A company is to make a decision to manufacture two products X and Y and the decision is repeated several times.000 9.5.176 2. Element 5.120.20 Weighted Amount K’000 224 384 2. 196 .average outcome that is expected to occur if a particular course of action is under-taken several times.080 800 6.7 From the above.07 0.8 MEASURING DEGREE OF UNCERTAINTY The degree of uncertainty can be measured by calculating the standard deviation.120 Probability 0.000.200 8.5.21 0. Element 5.09 0.27 0. This is the conventional measure of the dispersion of a probability distribution.800 6.880 1.5.000 PRODUCT Y : Outcome Profits K’000 3.400 8.800 5. the expected values can be calculated thus: PRODUCT X : Outcome Profits K’000 4.45 0. It is important to note that the expected values are the averages of the possible outcomes based on management estimates.600 Probability 0.08 0.368. X will produce profits of K 6.15 0.600 6. we can conclude that if a decision was made to produce X and Y several times repeatedly.400 7.368 Element 5.38 0.000 and Y will produce profits of K 7.160 1.
08 0.824 1.142.400 8.663.5.600 Deviation from (K’000) .400 518.772.445 PRODUCT Y Profit Amount (K’000) 3. This is the case with Product Y which has a higher expected value. so that risk may be large even if all the possible outcomes involve earning high profits.920 .27 0.424 Probability Weighted amount (K’000) 0.38 0.6 the standard deviation of Product X and Product Y can be calculated: PRODUCT X Profit Amount (K’000) 4.200 4.458. Element 5.592 196.15 103.000 9.624 589.400 5.080 3.276 0.07 0.11 DECISION – TREE ANALYSIS 197 .230.632 Standard deviation (K’000) 2.024 692.10 2.09 221.Element 5.000 Deviation from (K’000) .568 -768 32 832 1.400 0.400 Standard Deviation = √3 142 000 = K 1.776 Standard Deviation = √3 112 776 000 = K 1. but at the same time has risk (standard deviation) higher than Product X.600 6.800 5.834 0.720 880 2.400 6.21 1 23.863 0.681 Element 5.9 Using the data in 5.320 .366.3.45 461 0.20 Weighted amount (K’000) 1.5.800 6.480 Standard Probability deviation (K’000) 15.5.075.400 7.088 1.382.10 So far we have defined risk in terms of the spread of possible outcomes.1.200 220.127.116.11.224 2.5.992 209.400 774.663 342 3.095.648 430.
Element 5.000 Probability 0.969 1.5) LAUCH SUCEEDS Probability Expected Profit (K’000) 43.000 0. The purpose of decision trees is to show the full range of alternatives and events that occur.50 0.000 32. The company is considering launching a product.000 as the investment needed.13 SOLUTION There are two decisions which must be considered by the company: to develop the product or not to develop the product.4 for failure.840 198 .400.A decision tree is a diagram showing several possible courses of action and possible events and the potential outcomes for each course of action.18 0.12 To illustrate how decision tree can be considered the following example will be used: Example: Koko Plc is a manufacturing company.000 32.440 3. Estimated P(0. 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.200 8.200 8.12 Value (K’000) 12. The following estimates have been made: Profit estimate K’000 43. Element 5.5.5. From these two decisions we can develop a decision-tree.20 In addition the company has estimated an amount of K 14. The probability that the project will succeed is 0.6 and 0.3 0. under all possible conditions.30 0.
000. Element 5.000 is made up of the probability that the launch will succeed (P = 0.000 will be achieved (P = 0.14 For two events to occur together. an average expected profit of K 4. hence giving a joint probability of 0. To perform CVP analysis in a multi-product organisation. In other words.800 0 NOT DEVELOP Element 5. Element 5.000 will be achieved.6 = 0.6.000.4 1 5. Element 5.5.400 FAILS 0. In theory this means that the decision to develop the product should be favoured as it results in n average profit of K 4.3). a constant product sales mix must be assumed.18 Element 5.15 It is also worth noting that if the decision was repeated several times. y units of products B and z units of product C are also sold.14.3 * 0. 199 . we assume that whatever x units of product A are sold.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).6.6.800.2 Such an assumption allows us to calculate a weighted average contribution per mix.000 as compared to the decision not to develop the product as it gives zero profit.1 Organisations typically produce and sell a variety of products and services. For example. the probability of the development succeeding and the company making a profit of K 8. however.800.760 0 4. 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.5. the weighting being on the basis of the quantities of each product in the constant mix. there must be joint probability.6) and the probability that a profit of K 8.6 CVP ANALYSIS IN A MULTIPLE PRODUCT ENVIRONMENT Element 5.
000/K 30.94 4.845 units of M and (1.169 * 1) 1.169 mixes (rounded) Step 4.Breakeven point is ‘The level of activity at which there is neither profit nor loss’ (CIMA Official Terminology) Element 5. Calculate the breakeven point in terms of the number of mixes = fixed costs/contribution per mix = K 36. Lets look at an example. Calculate contribution per unit Selling price Variable cost Contribution Step 2. The organisation’s fixed costs total K 36.50 10.5 EXAMPLE:BREAKEVEN POINT FOR MULTIPLE PRODUCTS Suppose that P Ltd produces and sells two products.4 This calculation is exactly the same as that for single products but the single product is the standard mix.06 * 5) + (K 10.4 BREAKEVEN POINT FOR MULTIPLE PRODUCTS Element 5.00 2. Calculate contribution per mix = (K 4. The M sells for K7 per unit and has a total variable cost of K 2.6. one unit of N will be sold. Calculate the breakeven point in terms of the number of units of the products = (1.94 N K per unit 15.50 200 .80 Step 3.6.00 4. Element 5. The marketing department has estimated that for every five units of M sold. Element 5.94 per unit.6.6 SOLUTION We calculate the breakeven point as follows: Step 1.6.80 = 1. while the N sells for K 15 per unit and has a total variable cost of K 4.000.50 per unit.50 * 1) = K 30.169 * 5) 5.169 units of N (rounded) M K per unit 7.
it is when 5.6. or 7:3 Step 6.169) 18.104.22.168 It is important to note that the breakeven point is not K 58.169 units of N are sold. Calculate the breakeven point in terms of revenue = ( 5.845 + 1. Element 5.014 units. Calculate contribution per mix = K 22.214.171.124 CONTRIBUTION TO SALES (C/S) RATIO FOR MULTIPLE PRODUCTS Element 5.845 * K 7) + (1. Calculate breakeven point (total) Fixed costs ÷ C/S ratio =K 36.915 of M and K 17.169 * K 15) = K 40.00) * 100% = 61. assuming a sales mix of 5:1.6. Calculate revenue per mix = (5 * K 7) + (1 * K 15) = K 50 Step 2.80/K 50.450 provided that the sales mix remains 5:1.80 Step 3.2 As you should already know.6.1An alternative way of calculating the breakeven point is to Use the average contribution to sales (C/S) ratio for the standard mix. The breakeven point is K 58.8. Element 5.450 of revenue. the C/S ratio is sometimes called the profit/volume ratio or P/V ratio.616 =K 58.6% Step 4.442 (rounded) Step 5.000/0.845 units of M and 1. Calculate average C/S ratio = (K 30.Step 5.450 in total Element 5. whatever the mix of products. Rather.Likewise the breakeven point is not at a production/sales level of (5. Calculate breakeven sales 201 . Element 5. Calculate revenue ratio mix =35:15.3 We can calculate the breakeven point of P LTD as follows: Step 1.535 of N = K 58.
333 Element 5. a 202 . What is the budgeted breakeven sales revenue? A B C D K 150.909 (rounded) Breakeven sales of N = K 58.4 Alternatively you might be provided with the individual C/S ratios of a number of products.000 C/S ratio 0.000. the MK and KL.442 * 7/10 = K 40. the average C/S ratio is calculated as follows.000 Answer The correct answer is C. Budgeted monthly fixed costs are K 30.6.Breakeven sales of M = K 58.000 K 300.The Mk has a C/S ratio of 20% whereas the KL has a C/S ratio of 40%.5 The C/S ratio is a measure of how much contribution is earned from each K1 of sales of the standard mix.000 = K90.000 K 50.000 K 90.000.442 * 3/10 = K 17.6.8. Average C/S ratio = (2 * 10%) + (5 + 50%) 2+5 QUESTION: average C/S ratio TIM Ltd produces and sells two products. 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%.8.533 (rounded) Element 5. The company expects to sell 1 MK for every 2 KLs and have monthly revenue of K 150. Average C/S ratio = (20% * 1) + (40% * 2)= 33 1/3% 3 Sales revenue at the breakeven point = fixed cost = K 30. 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.
8. with the m.6.33 ngwee is earned. the breakeven point ( in units ) will increase and profits will fall unless there is a corresponding increase in total revenue.2 EXAMPLE: SALES MIX DECISIONS JM Ltd makes and sells two products. K 60. K 20.9.6. K 72. 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.600. To earn a total contribution of.contribution of 33.33n Points to bear in mind Element 5.000 33.000 sales revenue from the standard mix must therefore be K1 * K 20. The budgeted selling price of the J is K 60 and that of the M. Element 5.6 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.Variable costs associated with producing and selling the J are K 30 and. say. Element 5. there will be either a profit or a loss depending on whether the mix shifts towards products with higher or lower contribution margins. We need to begin by determining contribution per unit. J M K per unit K per unit Selling price 60 72 203 .9. a) If the mix shifts towards products with lower contribution margins.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.000 = K 60. the J and M.369.9 SALES/PRODUCT MIX DECISIONS Element 5.6.6.Annual fixed production and selling costs of JM Ltd are K 3. 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.6. Element 5. JM Ltd has two production/sales options.3 We can decide on the optional mix by looking at breakeven points.9.
400 * K60) K 3.744. Mix 1 contains a higher proportion (40% as opposed to 33 1/3%) of the more profitable product.400 * 1) 62.6.400 * 2) 124. The C/S ratio is 55%.200 (35.6.100 * 3) 105.400 (62.800 * K 72) K 8.6.800 In K (62.100 * 2) 70.9.6 QUESTION : CHANGING THE PRODUCT MIX A Ltd sells three products – Exe.300 In K (70.369. Element 5. mix 1 is preferable to mix 2.The average contribution for mix 1 is K 19.9.300 * K 72) K7.5 The following question looks at the effect on the overall C/S ratio of a product/sales mix.985.9.600 = 62. Why 505 and Zed 30%. Element 5.212.This is because it results in a lower level of sales to break even (because of the higher average contribution per unit sold).20 (K 96 ÷ 5).00 (124. Why and Zed – in equal quantities and at the same selling price per unit.000 (105.600 Total breakeven point = K 11.Variable cost Contribution 30 30 60 12 Mix 1 Contributions per 5 units sold = (K 30 * 2) + (K 12 * 3) = K 96 Breakeven point = K 3.581. 204 .600 Element 5.600 Mix 2 Contribution per 3 units sold = (K 30 * 1) + (K 12 * 2) = K 54 Breakeven point = K 3.793.In mix 2 it is K 18 (K 54 ÷ 3).600 Total breakeven point = K 12.600 = 35. Suppose the product mix is changed to Exe 20%.200 * K 60) K 4. K 54 J M Breakeven point: In units (62.729.369.400 sets of three units.4 Ignoring commercial considerations.100 sets of five units K96 J M Breakeven point: In units (35.
6.183 2 This figure is then calculated as 0.10.55 Workings 1 The total C/S ratio is the sum of the weighted C/S ratios and so this figure is calculated as 0. sales must cover all costs and leave the required profit: S=V+F+P 205 . and there is no profit: S=V=F Suppose an organisation wishes to achieve a certain level of profit (P) during this period. which has the Highest C/S ratio. To achieve this profit.9.10 Element 5.1 Why 0. Element 5.183 ÷ 1/3 = 0.3 Zed Total 0. Element 5.167 Why Zed Total 0.549 (W2) *1/3 *1/3 0.183 (W1) 0.6 *0.6.Required Calculate the revised total contribution/total sales ratio.5 0.2 = 0.200 0.1647 0.5 *0.2 0.55 – 0.167 – 0.549 Revised proportions C/S ratio (as above) Market share Exe 0.3 0.549 *0.6 0.5647 The total C/S ratio will increase because of the inclusion In the mix of proportionately more of Why. sales revenue (S) is equal to variable Costs plus fixed costs (V + F).5 *1/3 0.6.7 SOLUTION Original proportions C/S ratio Market share Exe 0.1 TARGET PROFITS FOR MULTIPLE PRODUCTS At breakeven point.
G and H.6. Product F G H Selling price K per unit 22 15 19 Variable cost K per unit 16 12 13 Element 5. F.6.10.therefore S – V = F + P So total contribution required = F + P Element 5. 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. The products are sold in the proportion F:G:H = 2:1:3.10.000 + K 52.4 SOLUTION Step 1. Calculate the required number of mixes = (Fixed costs + required profit)/contribution per mix = (K 80.000)/K 33 H K per unit 19 13 6 206 . The method is similar to the method used to calculate the breakeven point. Element 5.3 The company wishes to earn a profit of K 52.000 next month.The company’s fixed costs are K 80.6.000 per month and details of the products are as follows. EXAMPLE: TARGET PROFITS FOR MULTIPLE PRODUCTS A company makes and sells three products. Calculate the required sales value of each product in order to achieve this target profit. Calculate contribution per mix = (K 6 * 2) + (K 3 * 1) + (K 6 * 3) = K 33 Step 3.10.2 Once we know the total contribution required we can calculate the sales revenue of each product needed to achieve a target profit.
000 4. Calculate required total revenue = required contribution ÷ C/S ratio = (K 80.000 mixes Step 4.000 60. Calculate contribution per mix = K 33 (from Paragraph 5.6. Calculate revenue ratio of mix 207 . Calculate revenue per mix = (2 * K 22) + (1 * K 15) + (3 * K 19) = K 116 Step 2.4) Step 3.000 if the products are sold in the mix 2:1:3 Element 5.45% Step 4.000 + K 52.6 EXAMPLE:USING THE C/S RATIO TO DETERMINE THEREQUIRED SALES We’ll the data from paragraph 5.000) ÷ 0.972 Step 5.= 4.2845 = K 463.000 * 1 4.000 464.5 Alternatively the C/S ratio could be used to determine the required sales revenue for a profit of K 52.6.10.000 * 2 8.000 * 3 12. The method is again similar to that demonstrated ealier when calculating the breakeven point. 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 4.000 22 15 19 176.000 The sales revenue of K 464.000 will generate a profit of K 52.3 Step 1. Calculate average C/S ratio = (K 33/K 116) * 100% = 28.000 228.10. Element 5.000.10.6.000 4.10.6.
989 Required sales of G = 15/116 * K 463.996 Required sales of H = 57/116 * K 463.11. six units of R are sold.11 MARGIN OF SAFETY FOR MULTIPLE PRODUCTS Element 5. Element 5. while the R sells for K 14 per unit and has a total variable cost of K 4. allowing for roundings. is the same answer as calculated in Paragraph 5. Budgeted sales revenue for next period is K 74.11.400.00 R K per unit 14. but the single product is the standard mix.890 per period. The easiest way to see how its done is to look at an example. in the standard mix.972 = K 227.00 208 .20. The W sells for K 8 per unit and has a total variable cost of K 3.11. Element 5.6.972 = K 59.= (2 * K 22) : (1 * K 15) : (3 * K 19) = 44:15:57 Step 6. Step 1.6.6. Calculate required sales Required sales of F = 44/116 * K 463.6.4 Element 5. Calculate contribution per unit W K per unit Selling price 8. J Ltd’s fixed costs are K 43.2 MARGIN OF SAFETY FOR MULTIPLE PRODUCTS J Ltd produces and sells two products.972 = K 175.3 SOLUTION To calculate the margin of safety we must first determine the breakeven point.10. For every five units of W sold.9789 Which.80 per unit.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.
750 units of W and (550 * 6) 3.80 Step 2.890/K 79.2 209 .20 * 5) + (K 9.20 4. Calculate contribution per mix = (K 4.20 9.6.200 of R = K 68.400 – K 68.200)/K 74.000 of W and K 46.80 * 6) = K 79.300 units of R Step 5.6. profits and margins of Element 5.750 * K 8) + (3. revenues. Calculate the breakeven point in terms of the number of mixes = fixed costs/contribution per mix = K 43.80 = 550 mixes Step 4. (CIMA official Terminology) A very serious limitation of breakeven charts is that they can show the costs.80 4.12.80 Step 3. as a percentage = (K 74.3% of budgeted sales Element 5. Calculate the breakeven point in terms of revenue = (2.200 = K 6.6.12 Element 5. Calculate the margin of safety = budgeted sales – breakeven sales = K 74.400 * 100% = 8.400 – K 68.300 * K 14) = K 22. in the standard mix Or.1 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 breakeven point in terms of the number of units of the products = (550 8 5) 2.200 sales in total.200 in total Step 6.12.Variable cost Contribution 3.
6.6.6. The sales price of X is K 8.5 Element 5.6 Element 5.000 10.9 The breakeven chart can now be drawn.7 Element 5.8 Element 5. Y and Z which have variable unit costs of K 3. in order words that the sales mix is ‘fixed’ in these proportions. Output in K sales and a constant product mix Assume that budgeted sales are 2. 210 .12.000 Element 5. Y and Z are in the proportions 2.3 For example suppose that Farmyard Ltd sells three products.000 X (2. the price of Y is K 6 and the price of Z is K 6. We begin carrying out some caculations. K 4 and K 5 respectively.000 * K 8) 16.000 at all levels of activity. because we do not know the proportions of X.000 16.12.000 X (2.000 * K 5) Total variable costs Fixed costs Total budgeted Costs Revenue K K 6.12.000 * K 4) Varible costs of Z (3. however.safety for a single product only.6. A breakeven chart would make the assumption that output and sales of X.000 * K 6) 18.000 : 3. X.6. Fixed costs per annum are K 10.12.000 37.000 * K 3) Varible costs of Y (4.000 : 4.12. There are a number of ways in which we can overcome this problem. Y and Z in the sales mix.000 15. 4.000 * K 6) 24.000 units of X.000 Budgeted revenue 58.4 Element 5.000 units of Y and 3.12.000 X (2.6.000 units of Z.6. A breakeven chart cannot be drawn.000. Budgeted costs Varible costs of X (2.12.000 47. or at best for a single ‘sales mix’ of products. Element 5.
The margin of safety is approximately K (58.21% = K 27.500) = K 30.000 – 27. This may either be read from the chart or computed mathematically.Element 5.000.500 (approx) in sales revenue. a) The budgeted C/S ratio for all three products together is contribution/sales = K (58. The breakeven point is K 10.12.10 The breakeven point is approximately K 27.6.21% b) The required contribution to break even is K 10. the fixed costs.500 211 .500 of sales revenue.000/36.00037.000)/K 58.000 = 36.
Understand the use of flexible budgets and be able to prepare them from details of fixed and variable costs. 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.STUDY UNIT 6. Among the concepts learned earlier were: Objective of Budgeting • • • • Communicating Compel planning Control Motivation 212 . 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. INTRODUCTION TO BUDGETING A Budget is a plan that is quantified in monetary terms.
1.1.1 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.1The Budget Committee The Board appoints a budget committee.1.3 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. 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. Element 6.1. Element 6. which will comprise departmental heads from each department that exist in an organisation. Element 6. The main theme of the manual will include the following: 213 .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.5 The Principal Budget Factor It’s of Paramount importance to identify the organisation’s limiting factor (resources) first. The principal budget factor is an alternative name for a ‘limiting factor’. It is an item. Classic examples of principal budget factors could be the following. Element 6. interest rates and growth rates in other lay economic variables.• • • • • 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. inflation levels.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.1. which a company can prepare: • • • • Functional Budget Cash Budget’ Flexible Budgets Master budgets Element 6. 214 .2. 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. which limits an entity’s undertakings. Element 6.
000 in the last quarter of 20X7. Example 1.000 units in quarters 1. 3.000 Q3 Units 46. Requied: Produce a sales budget both in units and money terms for KAZHIKA Ltd for its control period 20X7. and 4 of 20X7 respectively of its only product the LYN at K5. 2. The Quantities of the sales should ultimately be expressed in monetary terms.000 215 .1. 46.000 Q2 Units 43. Kazhika Ltd intends to sell 40. by multiplying the units budgeted to be sold by the relevant unit selling price. Solution: KAZHIKA Ltd Sales budget for 20X7 – Quarter by quarter basis In UNITS Q1 Units 40.000 units. 43.2.000 Q4 Units 41.000 per unit in the first 3 quarters of the year and at K6.000 units.000 and 41.It’s the duty of the departmental Head to prepare the budget for the departments over which they preside. 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 6.000 TOTAL Units 170.1 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.
000units = K230.000 X 41. 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. 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 216 .000. The usual schedule for drawing up the production budget is drawn below.000units = K246.000units = K215.000 Q3 K’000 230.000 Q3 K5.000.2.2 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 Working 1 Q1 K5.000 Q2 K5.000 Q4 K6.1.000 X40.000.000.000X46.000units = K200.IN MONEY TERMS Q1 K’000 200.000X43.000 Q4 K’000 246.000 TOTAL K’000 891.000 Element 6.000 Q2 K’000 215.
000 (4.000 units in quarter 1 of 20X8.000 4.300 44.000 16.000units 4.500 Q4 Units 41. 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.Example 2.300) 43. Assuming that KAZHIKA Ltd has stocks of 10.100) 41.600 47.100 50.000units 4.300 Q3 Units 46.100 (4.600 (4.000units 4.000 4. and the company has a policy of hold 10% of the following quarters projected sales as closing stock. The company hopes to sell 50.000 4.100 units 217 .900 Budgeted sales units Add: closing stock Less: Opening stock (10.300 Q2 Units 43.300 units Q2 10% x 46.000 5.000 units of the LYN on 1 January 20X7. Required: Prepare the production budget for KAZHIKA Ltd for the year 20X7 KACHIKA LTD – PRODUCTION BUDGET Q1 Units 40.600) 45.300 Workings: 1.000) Production 34.600 units Q3 10% x 41.
218 .755 ANALYSIS: Since 2% of the production will have to be scrapped.98 100% Since 2% will be scrapped Scrap factor 34. we need to build in ‘extra’ units which have to be produced but however scrapped at the ends.Q4 10% x 50.500 0.184 Q3 45.300 0. then the extra units to be scrapped would be.900 0.000 units FURTHER CONSIDERATION 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.98 44. KACHIKA LTD – REUSED PRODUCTION BUDGET Q1 Production Per Example 2 Less (Scrap) factor Production 98 = 0.429 Q4 41.300 0.000 Q2 43.000units 5.98 35. 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.98 42.98 46.
Sales forecast January February March April May 9. There are 1.750 Cases 10.500 Cases 9.250 Cases 12. March and April (b) The maize meal purchase budget (in kg) for the months of January.755 (41. Z Non-Alcoholic Brewers manufacturers Maheu drinks.429 (45. 219 .000.5kgs 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.Revised production LESS: Good units Scrapped units Q1 35. Required: (a) Prepare the production Budget (in cases) for the months January. February.184 (43.125 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.500) 929 Q4 42. The company is currently in the process of preparing budgets for the next few months and the following Draft figures are available.750 Cases A CASE OF Maheu has a standard cost of K20.000 and a selling price of K25. July and August.300) 700 Q2 44. Each case uses 2.000 (34.700kgs of maize meal in stock on 1 January. (c) The Budgeted gross profit for the quarter from January to March.300) 884 Q3 46. There are 8.000 Cases 11.900) 855 Example 3.
50 15.425 Less opening stock ( 1.312.475 (1.050 13.250 1.5 = 31.275 12.050) 10. 220 .125 Element 6.800 (1.25 13. Example 4.000 x 2.Solution: (a) Z Ltd Production Budget January Sales quarters 9.2.000 Closing stock 1.275) 12.25) 19.125) 9.525 April 10.250 x 2.500 Closing stocks 14.700) 18.656.500 31. SOLINE Ltd makes two products.938 19.500 11.656.250 Less opening stock (8. X and Y.1.525 (1.125 10.250) (15.5 = 22.5 = 28.125 February 11.032 (14.3 Labour Budget The labour budget aims to show the expenditure to be expended on labour at the calculated production budget.50 February March Kg Kg 28.500 12.125) 11.312.400 March 12.700 Working (W1) January February March 9.500 975 11.750 x 2.750 1. The following Data relates to the two products.000 (b) INGREDIENTS PURCHASE BUDGET January Kg Budgeted material usage (W1) 22.
500 Rate per hour K5.350 9. PRODUCTION BUDGET SOLINE LTD X Units Required sales Closing stock Opening stock Production 5. we need to know what the product budget is first.150 (200) 950 SOLINE LTD DIRECT LABOUR BUDGET FOR YEAR 2 Labour Hour X – 5.000 Workings – number of labour hours 221 .Direct labour is paid at K5.050 Y Units 1.750.000 per unit It is estimated that at 1 January year 2 there will be 100 of X and Y units. The selling prices are: X .K130.000 units respectively during year 2.500.K115.050 units Y. Direct labour X 7hrs Y 10hrs The sales manager forecasts that sales of X and Y will be 5.950 units 35.000 per hour.000 K224.000 and 1. 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.000 per unit Y .150 (100) 5.000 150 1.000 K47.250.000 K5.000 labour cost K176.000 150 5.
Profit/ loss on disposal of Assets . A cash budget compares cash receipts and cash expenses in respective periods. A responsibility centre is an individual part of a business headed by a manager who has responsibility over its performance.X – 5050 x 7 hrs/unit = 35. function.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.Depreciation . It follows that all non-cash based items will not be incorporated in the cash budgets.500 hrs Element 6. The non-cash expenses to be excluded from the cash budget would be the following . Cost centre This can be defined as a production or service location. there are four types of responsibility centres 1. This requires the classification of the individual parts of the business as responsibility centres.2 Cash Budget From time to time and generally in the process of budgeting.2.350 hours Y – 950 x 10hrs/unit = 9. 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. They will include both capital and revenue expenses as long as they are cash based. corporations have to prepare cash budgets. which fall under the responsibility of a single manager.Profit and loss accounts . 222 .Bad debts & provisions . In general. activity or item equipment whose cost may be attributed to units of output. All the items of expenditure and income are cash transactions.
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 • • • 223 . 3. The performance of the manager who is responsible for revenue is judged on the basis of the revenue raised. Revenue centre This is a centre that is devoted to raising revenue with no responsibility for the cost of doing so. Budget preparation The procedure will differ from organisation to organisation. • • • Problems Communication of the final budget Comparison of actual with budget figures and investigations of variances.The performance of a manager who is responsible for a cost centre is judged on the extent to which cost targets are achieved. data must be collected about costs and revenues. 2. A manager’s performance for a profit centre is measured on the basis of profits. Profit centre This is a part of the business organisation that is accountable for both costs and revenues. In order for profit centres to be operated.
description of specific organisation activities which management can use to evaluate the activities and rank them in order of priority against other activities. which will occur in the coming period. 2. 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. Past events are therefore used as a means of controlling or adjusting future activities. 224 . This is called feed forward. 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. Most control system makes use of a comparison between results of the current period and the planned results. 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. Flexible budgets are often prepared on a marginal cost basis. • Zero base budgeting A method of budgeting. Feedback is used to describe both the process of reporting control information to management and the control information itself. The steps in ZBBB are: 1. which means that contribution is highlighted. It is called incremental since it is concerned more with the increments in costs and revenue.• • • • • • 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. which takes into account the difference in cost behaviour patterns and is designed to change as volume of output changes. Define decision package. Evaluate and rank each activity on the basis of its benefits to the organisation.
especially when dealing with cost centres. As such. This is because no matter how carefully budgets would be set. A Flexible budget is one. which. 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. Most of the costs. There should be a distinction made between controllable and non-controllable costs. in the modern industry most of the cost items are fixed in nature and this fact makes 225 . are variable costs and as a result. 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. Allocate resources in the budget according to the funds available and the evaluation and ranking of the competing packages. The original budget should be adjusted to the actual level of performance in order to judge the performance of a manager. is designed to change in response to changes in output. A variance report will be prepared and a manager will be asked to provide explanations for significant adverse variances. Requirements for responsibility accounting A system of responsibility accounting requires each responsibility centre to have its own budget. Flexible budgets have also been used for planning purposes. flexible budgets are an essential feature in the budgetary control and variance analysis process. actual performance will not be the same as budgeted performance. A manager for an investment centre will normally be responsible for investment decisions as well. Flexible budgets are used for control purposes. However. they will change if the level of activity from the budgeted level of activity. by recognising the distinction between fixed and variable costs. 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. which will be under a manager’s control.3.
K’000 X X X X X X X X X X SEPT. 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.000 29. flexible budgets will still be a useful technique for budgetary planning. we do not mean that the budget is kept unchanged. In those businesses where most of the costs are variable.000 August K’000 120.000 Sales Wages Overheads The following information is available concerning the direct materials. July and August.000 17. June K’000 90. However.000 18. 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. Fixed and flexible budgets By the term fixed. OCT.000 July K’000 100. no plans are made for the event that actual volume may differ in terms. The term fixed means that the budget is prepared based on an estimated volume of production and an estimated volume of sales. Revisions to a fixed budget will be made.000 19.000 26. 226 .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 2.000 60.000 per month for depreciation. (a) Months Budgeted sales in months K’000 labour cost in month K’000 1. The amount to be received in June for May’s sales s K59.000.000 is to be paid in June for May’s overheads.000 - Notes (i) (ii) (iii) (iv) (v) (vi) 10% of sales are for cash. The opening cash balance in June is K23.000 Corporation tax of K50. 227 .000 3.June K’000 Opening stock 10.000 3.500 1.000 July K’000 7. Purchases of direct materials are paid for in the month purchased. Overheads are settled the month following K13.000 18.000 August K’000 12.000 Material usage 16. Overheads include K3. Kafue Ltd operates a small business purchases are sold at cost plus 33⅓%.000.000.000.500 2. Wages are paid in the month they are incurred.000 20.500 3. the balance is received the following month.500 January February March April 20.000 is to be paid in July.000 September K’000 8.000 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.000 30.500 2.000 80. Cash budgets – Examples Example 1.000.000.
The company will buy equipment costing K9. The opening cash balance at 1 February is K500.500 10.000 (W4) 2.500(W2) March K’000 Payments Trade payables Expenses payables Labour Equipment purchase Dividend Total payment 18.000. Labour is paid in full by the end of each month.000 in March.500 228 .500 (W1) 67.000.000 9.000. Solution: (1) Cash Budget February K’000 Receipts Receipts from sales 27. Labour costs and expenses are treated as period costs in the income statement.000. Expenses include a monthly depreciation charge of K1.Suppliers for materials and expenses are paid in the month after the purchases are made/ expenses incurred.000(W4) 1.000 30.750 (W3) 1. (i) 75% of sales are for cash (ii) 25% of sales are on month’s credit.000 for cash in February and will pay a divided of K10.000. Required : 1) Prepare a cash budget for February and March 2) Prepare an income statement for February and March.250 (W3) 2.500 9.250 41.
500.000) (3) Receipts in March 75% of March Sales (75% x K80.000.000) are paid in February and March respectively. Depreciation is not a cash item.K1.000.000) For February Sales (50% x K22.750) 500 (2.000) 25% of February Sales (25% x K30. K’000 11.000) February For February Sales (50% x K22.500 (4) Purchases K’000 January For January Sales (50% x K15.000.000 27.250) 11.000) K’000 60’000 7.Receipts less payments Opening cash balance b/f Closing cash balance b/f Workings (2.000) For March Sales (50% x K60.000.500 5.000.500 67.000. (5) Expenses Cash expenses in January (K2.000.000) These purchases are paid for in February and March.500.500) (2) Receipts of February 75% of February Sales (75% x 30.000.750 2.500 11.000) and February (K3.000.250 30.250 18.000.000 41.000) 25% of January sales (25% x 20.250 7.000 – K1.750 229 .250 (9.500 K’000 22.
000 30. insurance and other expenses. The cash budget does not show figures for sales of sales but is concerned with cash actually received from customers and paid to suppliers. An income statement may include accrued amounts for rates. The cash budget will show purchases of a non – current asset as a payment in the period when the asset is paid for.000 A COMPARISON OF PROFIT AND CASHFLOWS The cash flows and profit during the above example need not be the same amount and infact. are actually more likely to be different.000 (22. Sales and cost of sales are recognized in an income statement as soon as they are made/incurred. No attempt is made to allocate the purchase cost over the life of the asset.000 March K’000 K’000 80.500 (6. An income statement may show a charge for depreciation. - - 230 .000) 20.500 3.000 (60.500 2. The differences are explained by the following causes and reason.(ii) Income Statement February K’000 K’000 Sales Less: Cost of purchases Gross profit Less: Labour Expenses 1.000 (4. and may also show the proceeds on disposal of a non – current asset as a receipt of cash.500 3. There is no attempt to apportion payments to which they related.500) Net Profit 3. This is not a cash expenses and will never appear in cash budget.000) 14. In the cash budget such amounts will appear in full in the period in which they are paid.500) 7.
680 28. 800 Variance Costs Labour Material 63.400) 54.000 and on material K48. 000 K’000 26.200 25.400 (37. Fixed cash totaled K20. 000 18.800) 16.000. 200 25. Required: Prepare a flexible budget that will be useful for management control purpose. 980 54.000.680(F) 19.Flexible Budget Example: Chintu Ltd budgeted to sell 200 units and produced the following budget.220(A) Budget Flexed budget Actual 231 .020(A) per unit K’000 714 230 units K’000 164.800 Actual sales turned out to be 230 units. which were sales for K138. Actual expenditure on labour was K54. 000 48. K’000 Sales Variable costs Labour Material Contribution Fixed costs Profit 63.000. Solution: Budget Variance 200 units K’000 Sales. 142.000.600 K’000 142. 000 316 126 72.200 (88.000.000. 220 230 units K’000 138.000.
000 45. 800) Profits _16. Budget results and actual returns for May are as follows: Budget Production and Sales of the Sales (units) Actual Variance 15.000.000 145. 600 _ 442 272 101. 400 K’ 000 162.000 Direct labour Production overheads Admin overhead Profit 30. 000 36. 000 __ Example: Kuku Ltd manufactures a single product. (d) Administration overhead is a fixed cost.600 K’ 000 12. 560 102.000 140.600 (A) 6.000.000 20. 400 Fixed costs (37.760(A).000 (F) 2.000 10. 760__ 16.000 22. the sisy. 400 Contribution 54.400 2. 232 .000 Direct Materials 45. (b) Direct material and direct labour are variable costs.000 units being K50. 800) (20.000 45.000 31.000 (A) 1.000 (A) 5. (37. 660 62. 000 26.000 16. 000) __24. 000 K’000 16.000 47.800(F) 8.000 (A) 600 (A) Sales revenue 150.560(A) 17.88. (c) Production overhead is a semi – variable costs the budgeted cost for an activity level of 20.400(F) Make the following assumption in dealing with the above scenario.
400 K’ 000 2.000 _______ 145.600 16.000 31.200 (F) 1.000 49.400 K’ 000 164.800 800 (F) 150. 000__ Variance 233 . 000 20. 000 140.400 20.400 Actual results 16.600 22.(e) Selling prices are constant at all levels of sales. 000 __10.600 16.400 K’ 000 162.200 32.000 45. 000 30. Required: Prepare a budgeting control analysis.000 (A) 2.000 47.000 (A) ________ 2. Solution: Fixed budget Production and sales (units) 15.800 46. 000 K’ 000 Sales revenue Direct Materials Direct labour Production overhead Administration over head Profit Flexible Budget 16. 000 45.800 (F) 800 (F) 2. 000 45.000 ________ 145.
000.000 = K10. fixed production overhead cost = K30.200.000 units = K3.800. .000 – K45.400 x K1.000. 000 – 15.000.000 Budget cost allowance = K 3.000 x 16.000.000 x 16. 000 per unit .000 ÷ 15.000 ÷ 15. Budget cost allowance = K2.000 ¾ Direct labour cost per unit = K 30.400 units = K32. 400 units = K164.000 ÷ 15.000 . Using the high – low method. 000 units = K 1.000 ¾ Variable production overhead cost per unit.000.000 units = K2.000) = K 46.000. = _(K50.000 ¾ Administration overhead is a fixed cost and hence budget cost allowance 234 .400 units = K 49. .000.000. .400. .000 + (16.000 x 16.000)_ 20. Budget cost allowance = 30.000.Workings: ¾ Selling price per unit K 150.000 ¾ Direct material cost per unit = K 45.000 per unit Flexible Budget sales revenue = K10.
000.g.= K 20. Element 6.1 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.000 Element 6.3.3 FLEXIBLE BUDGET PREPARATIONS AND VARIANCE ANALYSIS 235 . or to introduce some flexibility and compare actual outcome with the standard expected for the new level of activity? Element 6. 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. Element 6. Flexibility however. by for example starting to negotiate for a bank loan.2. If the cash budget indicated a forecast cash shortfall then managers can take action in advance to cover the shortfall. Flexible budgets therefore are prepared based on the original level of activity and taking into account the changes in the new level of activity. It gives forewarning of the cash effect of the decisions that could be taken in the budgetary planning process e. they will be presented in the form of a budget based on activity levels expected at that point. is often over looked when the need t analyse variances arise.2 DEFINITION Budgets which do allow for changing levels are called flexible budgets. When the standard costs are set at the beginning of the reporting period.1 One of the most commonly occurring problems in variance analysis is deciding which benchmark to use as a basis for comparison.3.3.3 FLEXIBLE BUDGETS 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. whether to decide to increase stocks and offer more credit to customers or not.2.
5 Kg of raw materials and 12 minutes of labour time.000 K’000 16.000 Actual for July 8. 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. output had fallen to 8.800 7. Units manufactured Variable costs Direct materials Direct labour Variable overhead Total variable costs Fixed costs Total costs Original Budget 10.000 K’000 16.000 36. So a flexible budget is therefore prepared as follows.000 Actual Budget 8. a standard cost rate of K 3000 per direct labour hour.000 7.000 units.000 K’000 20.000 K’000 20.000 6.3.500 40.800 236 . The information below is for the original budget and the actual outcome for the month of July.000 7.000 units.000 units per month because of a fall in market share of sales.000 5.820 Element 6. But that would be totally misleading because the budget is based on 10.000 43.000 35. The actual cost of direct labour was found to be k 5000 per hour and raw materials K 4400 per Kg.600 7.000 4. Each unit of output requires 0.Kuchinja Company sets the standards for the month coming to manufacture 10.000 43.4 SOLUTION It is quite tempting to compare these two columns of figures directly and call the difference the cost variance.000 8.000 units of output and the actual output was down to 8. The original budget is based on a standard direct cost of K 4000 per Kg of raw material. 3800 kg of materials were used and the actual labour hours worked was 2000. The actual variable overhead cost rate was K 2800 per direct labour hour.000 10’000 6.720 11. By the time July was reached.800 28.000 10.
000 (A) 800 (A) 500 (A) 5.720 11.500 40. The goals of the organisation as a whole as expressed in a budget.000 16.4.000 5.000 16. 237 .1 General Behavioral of Budgeting 1.000 4.000 12 min 1.600 hours 8.820 Variance 720 (A) 3.000 Kg 16. may not coincide with the personal operations of individual managers.600 direct 4. 2.Variance analysis Units manufactured Variable Costs Direct materials Direct labour Variable overhead Fixed overhead Total costs Flexible Budget 8.000 8.800 7.000 35.020 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 8.000 12 min per direct 1. The manger that set the budget or standards are often not the mangers that are then made responsible. Element 6.600 7.800 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 6.000 Actual for July 8.000 units K’000 0.4 Behavioral Aspects of Budgeting When used correctly a budgeting control system can motivate but it can also produce undesirable negative relations from employees.5 Kg 4.000 8.
3 Poor Attitude When Setting Budgets If managers are involved in preparing a budget. 3.4 Poor Attitude When Implementing Budgets 238 . Therefore management accountants should endeavor to design budgeting control systems. and act on them. This is known as goals congruence. It is important that goals of management and employees harmonize with the goals of the whole organisation. 2. Different mangers can get in each other’s way and resist the interference from others. which will help an organisation to work towards goal congruence.3. Managers might build budget slacks into the cost center budget of expenditure estimates.2 Motivation Motivation is what makes people behave in the way that they do.4. Control is applied at different stage by different people. and decide to take different control action. Managers can complain that they want to spend their total time on their daily schedule activities and not on budgeting. Element 6.4. Management accountants should therefore try to ensure that employees have positive attitude towards setting budgets. Individuals will usually be motivated by personal interests and desires. his supervisor might get monthly reports.4. poor attitude or hostile behaviour towards the budgetary control system can begin at the planning stage. It comes mainly from individual attitude or group attitudes. implementing budgets and giving feedback on organisational performance. 4. Element 6. Mangers may set budgets for their budgets center and not co-ordinate their own plans with those of other budget centers. Mangers might all together not want to be involved in the budget process. Element 6. 1. When budgeting. A supervisor might get weekly control reports.
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. 239 . If there are flows in the system of recording actual costs. as set is the budget.5 Poor Attitude When Utilizing Budgeting Control Information The attitude of managers towards the accounting control information they receive might reduce its effectiveness. (b) Some budgets implementing may fall on short-term goals at the expense of the long – term goals of the organisation. (b) (c) (d) Element 6. Element 6.Poor attitude also arise when a budget is implemented. (a) Management accounting control responses could well be seen as having a relating low priority in the list of budget tasks. Therefore let’s at this point in time examine the main budgeting style which incorporates participation at different levels. as pressure devices that are just meant into doing better. (a) A formal budget might encourage rigidity and discourage flexibility.4. (b) Poor communication among different budget holders may creep and it may teal to poor co-operation. control reports will be resented.4. Managers might take the view that they have more pressing jobs on hand than looking at routine control reports. Budgets might be seen. mangers will dismiss control information as unreliable. Managers (Budget holders) might be held responsible for variances outside their control. (a) Mangers might put in only enough effort to achieve budget targets without aiming to beat target.
2) Strategic plans are likely to be incorporated into planned activities. In the imposed style of budgeting. this is because the targets are set by strategic managers who are detached form the implementers. defensive and low morale amongst employees.4. 3) Operational staff may be dissatisfied. 240 .Element 6. 4) In newly – formed organisations.6. 2) Lower – level management initiative may be stifled. Disadvantages of imposed budgeting 1) The filling of team spirit may disappear. 1) During the period of economic down forms. 4) The acceptance of organisation goals and electives could be limited.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. 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. Advantages of imposed style budgeting 1) They tend to decrease the period of time taken to draw up the budgets. IDEAL SITUATION FOR IMPOSED BUDGETS Imposed budget will ideally be effective in the following circumstances.
6. 241 . 4) Specific resource requirements are included and budget slacks are avoided. as a lot of people will need to have an input into the budgeting process. Disadvantage of participative budgets 1) They consume more time.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. 2) Morale and motivation among operation staff is improved. 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. Element 6.3) They use senior managements awareness o total resource availability.4. 5) Managers may set ‘easy’ budgets to ensure that they are achievable. Element 6. 3) Co-ordination between units is improved.6.3 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. budgets are developed by lower level managers who then submit the budgets to their superiors for review and approval.4. 4) An earlier start to the budgeting process could be required. 4) They decrease the input from independencies or uninformed lower – level employees. 3) They can support empire buildings by operational staff. In this style of budgeting.
Therefore the final budgets are therefore most likely to lie between what top management would realty like and what junior managers believe is feasible. targeting can bring conflict and bring an effect on management behavior. 242 . the budget targets which they consider to be unreasonable and unrealistic. Like wise senior management usually review and revise budgets presented to them under a participative approach through a process of negotiation with lower managers. • • Accounting measure of performance can’t provide a comprehensive assessment of what a person has achieved for the organisation.4. determining whether the budget is an effective management tool. In practice.The budgeting process is hence a bargaining process and it is this bargaining which is of virtual importance. A management accountant should supply accounting reports. Hence the management accountant therefore will need to devise strategies and methods of dealing with the resulting tensions and conflict. different levels of management often agree to budget by a process of negotiation. if employees view performance standards as chargeable. Element 6. The management accountant should devise performance measures and budgeting control systems that will motivate managers towards achieving organisational goals. which try to provide information requirements to several users and to satisfy several needs. Operational Manager will try to negotiate with senior managers. This can be done by adopting the following. But what then is the effect on motivation.7 The Management Accountant and Motivation As it has been highlighted.
ii. iv. 243 . Ensure that budgets are up to date. iii. 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. vi. 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. v. HOW MANAGEMENT ACCOUNTANTS SHOULD DELIVER HIGH QUALITY BUDGETARY CONTROL SYSTEM DATA i. which will focus on both short–term and long-term achievements of an organisation.• Management accountants should prepare Accounting reports. Develop a working relationship with operational. BEYOND BUDGETING 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. They may lead to short tenure especially where managers are remunerated on the basis of financial results. Provide control information with a minimum delay. managers. Make sure that actual costs are recorded accurately. 3) Budgets fail to focus on shareholder value. Explain the meaning of budgets and control reports Keep accounting jargon in these reports to a minimum in their Accounting reports. going out to meet them and discussing the control reports.
Planning is a continuous. (a) Use of adaptive management processes rather than more rigid annual budgets. CONCEPTS OF BEYOND BUDGETING The following are the two pillar concepts on which beyond budgeting approach in based. and performance accountabilities to managers. competitions and previous periods. (b) Move towards networks rather than centralized hierarchies. participative basis. 5) Budgets may stifle product and strategy innovation. 6) Budgets lead to unethical behaviour.4) Budgets are too rigid and prevent fast response to changes in the environment. 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. Evaluation of manager’s performances therefore is based on a relative improvement and this evaluation is carried out using a range of relative 244 . Therefore beyond budgeting suggests that manages should use forecasts on the cash expenses rather than focusing on purely cost control. Traditional annual plans tie managers to predetermined actions. The emphasis is on encouraging a culture of personal responsibility by delegating decisions to personal. 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. which might not move in tandem with the current happenings.
alterations will have to be made to the budget. Today computer spreadsheet such as Microsoft Excel and Quato pro can be used to assist in the preparation of budgets.e. if the Board of Directors do not approve the budget.5 Application Of Information Technology in Budget Preparation Computers are finding increasing employment in the management accountant’s daily duties. 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. managers are given the resources they need to deliver their duties and corporations are cross – functionally coordinated to respond to customer demands.performance indicators with highlights i. Element 6. In addition.5. 245 .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. Similar to Coldratt’s proposition in adaptive management process. Element 6. taking account of the actual conditions in which the manager was working.
2 Limitations of Spreadsheets a) They cannot judge.5. Element 6.5.Element 6. ACCPAC. SUNSYSTEM and NAVISION. b) They may be costly to acquire c) Some spreadsheet are difficult to use. Spreadsheets just process all data fed to them.3 Budgeting Software Just like in financial accounting where we can use dedicated financial amounting packages such as PASTEL. several dedicated Budgeting packages (Modules) have been developed to handle all the complexity in budgeting and to give detailed and robust analyses in budgeting. 246 . Examples of such packages include a) COMSHARE b) HYPERNION etc.
1. In order to meet these demands. all customers of both services and tangibles products want to buy these products at a very low or reasonably low prices. the world has seen a number of changes that are greatly impacting on business and revolutionalising the way businesses acquire their inputs.0 MODERN BUSINESS ENVIRONMENT Learning objectives: At the end of the chapter.STUDY UNIT 7. Now. 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. more than ever before. 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. 247 .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. 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. process them into finished goods and dispense them to the clients/customers. Element 7.
1. for instance the European union (EU) and COMESA. All these developments are turning the world into a global village where corporations can conduct business across boarders and continents with very little restraint.1.1.2 Changing Customer Demands For High Quality Goods Customers also want high quality products and services in the modern world.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.4 De-Regulation of Industries There has been a wave of privatisation of formerly state owned companies to private owners. 248 . Element 7. These turns in events have really increased competition among modern businesses and they have also unlevelled the competitive grounds. Yet other countries still. This has resulted in formation of self-regulatory bodies.Element 7.1. This being the case. 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. have formed economic blocks (unions) through which given economic objectives are being pursued. most countries have loosened their former protective measures that they had. 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.5 Intensity In Competition and Globalisation World over. Element 7. and henceforth less government control in the management of these corporations. Element 7. companies want to devise new approaches to production and service delivery that will go round the increased operational risks. This scenario will result in an increased operational risk of a firm. Therefore this has put unprecedented pressure on corporations to suit their new environments.
2 Production management Strategies Element 7. companies that use the technique should endeavour to have only a few reliable suppliers to provide inputs to avoid delays and poor quality inputs. This has heightened the quest to innovate the new and required techniques therefore.6 Shortened Product Life Cycles There has been a growing trend among many corporations to shorten their products’ lifecycles. In order to achieve this goal.Element 7.2. 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. 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 249 . many businesses are indeed investing in non-traditional production methods that will help them achieve just that goal. 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.2. 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. meaning that corporations should only manufacture their products when there is demand for the products. Following the suggestions of the concept. Element 7. The concept promotes demand-pull production.1. it needs to arrange its production factory and factory equipment in a certain manner.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. Element 7.2 Dedicated Cell Layout The dedicated cell layout concept stipulates that for a business to increase productivity among its workforce.
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. 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.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. we have.distances across the factory floor. as a computer has high precisions measurements embedded in it. Of late.4 Computer Aided Manufacturing (CAM) Computer aided manufacturing entails using computers and computer related technologies in the manufacturing process. 250 . 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. Therefore engineers will be employing computers in their design work. 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. A further merit of using computers in designing is that it brings the design in three dimension on the computer screen.2. Element 7. revealing the component being designed from all aspects or angles showing all intricacies which would have otherwise been hidden. using a computer monitor and mouse to make designs on a computer screen. Element 7. • Accuracy is achieved at all levels of the manufacturing process. a practice that can waste time and reduce employee productivity. that is. Further.2.
which streamline and unify all their systems. involves the automation of the manufacturing processes and all peripherals involved in service delivery systems.4.3.3. Element 7.3. These computer controlled machinery systems have been put in place for the benefits that we discussed in element 7.1 Automated Manufacturing Technology (AMT) As the term suggests.2. So.3 World Class Manufacturing Techniques Element 7. Zambia bottlers uses computer controlled machinery to fill Fanta and Coca-Cola drinks of a predetermined quantity or volume in each bottle. in its basic terms.3. This really illustrates the application of computer-controlled machinery in practice.• • Reduces operational costs in the long-term Can easily be integrated with other key information systems within the enterprise. Element 7.3 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. Therefore they will establish systems. For instance. Element 7.4 Computer Controlled Machinery Most companies have their machinery controlled by computers. 251 . Element 7. the machine has been programmed to fill an exact quantity of the soft drink in each bottle.2 Synchronised Manufacturing Systems Corporations with worldwide operations will need to bring uniformity in their manufacturing systems. This means that the same equipment can be varied in order to accommodate different production settings in production runs.
6. storage spaces can be opened. which only looks at one resource.7 Enterprise Resource Planning (ERP) The enterprise resource planning system is a higher version of resource planning.3.3. hence they can easily be manipulated by use of a central computer to which the shelves and pigeonholes are connected. the enterprises resources planning will highlight all resources including raw materials. Element 7. It helps a company to know before actual production the quantities of materials required for any given production level. 252 . So. most companies have invested heavily in automated systems that help them in the storage and retrieval of their raw material stocks.5 Automated Storage And Retrieval Systems In order to ease the process of storing and retrieving raw materials. These automated systems provide a means by which by a computer button. This is a very comprehensive resource plan because it looks at all resources unlike the MRP that has been considered in section 7. The enterprise resources planning system considers all resources required to meet a certain production level.Element 7. Element 7.3. The enterprise resource planning system involves planning for all resources required to successfully meet a given production level. The inbuilt shelves and pigeonholes are all computer-controlled.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. This is a vital part of a production material budget. stocks packed and retrieved when necessary. raw materials. peripheral resources and overheads needed to meet given production levels.
the product is successfully introduced to the market and it is supported usually by an expensive advertising campaign. Traditionally.Element 7. namely. maturity and decline stages. the product life cycle has been split into four main stages or phases.4. design and production facilities establishment. sales volumes and sales revenues of the product or service increase.4. so the products gains stability and clients build confidence in the product or service.4. introduction. Element 7. Element 7. price competition will reduce the profitability of each firm.4. Element 7. In a static market. In many instances. the product will become obsolete and falling sales will ensue.4 Product Life Cycle Element 7.4. At this stage the product’s sales volume and hence revenues are relatively low. thereby incurring further large research and development costs.2 Introduction Stage At the introduction stage of a product’s life. 253 . Therefore. Element 7. The product/ services falls out of favour with the clients and therefore sales from the product fall. at this stage. new entrants from competitor companies may surface. Before this stage is reached.4 Maturity Stage The product will be said to have reached its maturity stage when sales demand levels off. the business should have developed a replacement product.5 Decline Stage Eventually.3 Growth Stage In the growth stage a product gains more support and acceptance of the clients/customers. Firms seek to differentiate their services and products at this stage. growth.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.
most models must be renewed in much shorter timeframes.4. At maturity. it will let the product to die a natural death by not investing any further support expenditure. Therefore. the product finds acceptance and less advertising or marketing is needed than what was needed to sustain the introduction stage. For example. which ceased production in 1996. 254 . 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. a very large amount of fixed costs will already have been incurred in research and development.4. sometimes corporations might spend more money if they want to resuscitate the ailing product. At the introduction stage. further advertising costs will be incurred in order to help the product to find acceptability in the market place. At decline stage. fewer costs are going to be incurred at this stage.7 Implications of The Product Life Cycle On The Advanced Manufacturing Technology Environment In the advanced manufacturing technology (AMT) environment. At the Growth stage. designing the product and building or re-equipping the production line Before the decline stage is reached. by and large. In the AMT environments. design and production facilities establishment. the situations vary. Vauxhall is setting up new production facilities for manufacturing a revamped Corsa in the United Kingdom. The unit fixed costs will decrease. the business should have developed a replacement product.Element 7. but it will harvest all the revenues coming from the dying product. On the other hand if the company does not want to continue offering the product. Element 7. the firm will have incurred huge research and development costs.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. However. the fixed unit costs even reduce further as the product will have stabilized. the time period for the product life cycle is decreasing. thereby incurring further large research and development costs.
This comparison will show if the expected savings from using new technology or production methods would be worthwhile. through its useful life and including any end-costs. The high fixed costs of introducing a new product. 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. Life cycle is a technique that may be used to improve management decision-making in such conditions. Thus for manufacturers. 255 . 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. The recognition of the total support required over the life of the product. research and development. LIFE CYCLE COSTING Life cycle costing involves collecting cost data for each product from inception. cash flows and marketing activities. 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. Consumer as well as producers may use life cycle costing.g. The insights gained from comparing budgeted and actual life cycle costs may be used to refine future decisions. marketing and so on.The Corsa was launched only a few years ago. production. whereas traditional costing methods follow costs by function e. These data are compared with the life cycle budgeted costs for the product. coupled with reduced life cycle periods are a major challenge to profitability in advanced manufacturing environments. Thus the early decisions regarding product design and production methods are paramount and life cycle costing attempts to recognize this situation.
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) 256 . (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. Identify and comment on any theme that the two practices have in common. 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. Required (a) Explain the nature of the product life cycle concept and its impact on businesses operating in an advanced manufacturing environment.
Firms seek to differentiate their product at this stage. Illustration of product life cycle Sales revenue introduction growth maturity decline Time When a product is first introduced successfully to the market. price competition will reduce the profitability of each firm. designing the product and building or re-equipping the production facilities. In an advanced manufacturing technology environment. The product is said to be mature when sales demand levels off. a large amount of fixed costs will already have been incurred in research and development. In a static market. sales increase and unit costs fall as the high fixed cost per unit decrease although new entrants may start to compete at this stage.Suggested Solution to Question 1 (a) The product life cycle (PLC) is shown in the diagram below. This is the most profitable stage of the product life cycle traditionally. it will only achieve a relatively low sales volume. In the growth stage. 257 . supported by an expensive advertising campaign.
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. choice and production and marketing costs. 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. design and new production facilities. Thus for manufacturers. This is the decline phase of the product life cycle. whereas traditional costing methods follow costs by function e. the firm must have developed a replacement product. It has been observed over the years that in the advanced manufacturing environment. life cycle costing makes explicit the relationship between design.g. This comparison will show if the expected savings from using new technology or production methods are worthwhile or not. The recognition of the total support required over the life of the product. Both consumers and manufacturers of commodities may use life cycle costing. Research and development costs. The insights gained from comparing budgeted and actual life cycle costs may be used to refine future decisions. These data are compared with the life cycle budgeted cost for the product. (b) Life cycle Costing (LCC) involves collecting cost data for each product from inception. through its useful life and including any end costs. firms will begin to pull out of the market or focus on promotional marketing strategies and reducing selling prices.Eventually. thereby incurring further large fixed costs for Research and development. Thus the early decisions regarding product design and production methods are paramount and life cycle costing attempts to recognise this situation. The high fixed cost of introducing a new product coupled with reduced life cycle periods is a major challenge to profitability in AMT 258 . marketing and so on. Before the stage is reached. At this stage. production. A recent analysis has shown that the life cycle cost of purchasing a personal computer is around six times the purchase cost. the product will become obsolete and falling sales will ensue. the time period for the product life cycle is decreasing for most products such as automobiles (motor vehicles).
In particular. Life cycle costing is a technique that may be used to improve management decision-making in such conditions. 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 259 . activity based management seeks to consider all activities performed by the organisation in order to serve a customer or produce a product. 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.environments. this approach yields a better understanding of overhead costs in AMT environments compared to traditional absorption methods. (c) Activity based management (ABM) uses the understanding of cost drivers formed from activity based costing (ABC) to make more informed decisions.
• • •
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.
1.5 Formula for the materials mix variance: (Actual quantity in standard mix proportions – Actual quantity used) * Standard price Element 8.000 Bondwe 10 Kg @ K 3000 per Kg 30. Required Calculate the materials usage. using two compounds Miseshi and Bondwe. a chair might consist of wood. For example. The standard materials used and cost of one unit of Mbeba Killer are as follows: K Miseshi 5 Kg @ K 2000 per Kg 10.000 40.000 (F) Total usage variance K 10. Element 8. mix and the yield variances. stuffing and glue.1. covering material.000 (F) 267 .6 Example A company manufactures a chemical used for eradicating rats called “Mbeba Killer”.000 (A) K 210. 80 units of Mbeba Killer were produced from 500 Kg of Miseshi and 730 Kg of 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.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. It would be totally inappropriate to calculate a mix variance where the materials in the “mix” are discrete items.000 15 Kg In a particular period.1.b) Where the usage variance of individual materials is of limited value because of the variability of the mix. The usage of each material must be controlled separately. Element 8.
230 Kg = 410 Kg Bondwe 2. . Element 8.000 (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 1. c) YIELD VARIANCE Each unit of output “Mbeba Killer” requires 5 Kg of Miseshi = K 10./3 * 1. The favourable total variance is due to the greater use in the mix of the cheaper material. b) Mix variance Actual input = (500 + 730) Kg = 1.The total usage variance can be analysed into mix and yield variances.000 K 80. Miseshi 1/3 * 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 180.000 (A) The address yield variance is due to the output from the input being less than standard.000 and 10 Kg of Bondwe = K 30.230 Kg Actual usage in standard proportions. Miseshi.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 40.2 Yield Variance 268 .000 (A) K 270.000 (F) K90.
a tabular representation could also be used as an alternative presentation. it is a subdivision of the direct material usage variance.000 – K840. 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 K200.000 = K60.000 K480.000 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 K640.400 = K168.400] = 120 x K1. Total Column 4 – Total Column 2 = K840.000 = K168.000 Column 1 Column 2 300 300 K300. the yield variance is: [(400 x 6/5) x K1. Direct material mix variance.400] – [(600) x K1.000 (A) 269 .000 Adverse Again.000 (F) Direct material Yield variance – Total Column 4 = K672. 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.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.000 – K780.
which in the absence of a direct material price variance. If we consider the concept of a standard mix.000 i. then this alternative would have been selected as the standard.000.000 adverse.In both cases. When different classes of labour are engaged then the labour efficiency variance can be split into mix and yield components. 270 .000 per hour. We can demonstrate this by use of a simplistic example below: Example: KANSO Plc produces product 5. Any change in the input mix must therefore be expected to have an impact on the yield from the process. it is clear that such a mix will represent the combination of inputs which provides an acceptable quality of output at the least possible. and thus the two variances should be considered simultaneously. the sum of the direct material mix variance and the direct material yield variance can be seen to be K108.000 per hour.000 x 4 hours) + (K10. is equal to the total direct material variance.000/hour x 6 hours)] = K120. It is highly unlikely that any meaningful control can be exercised over the output from a process independent of the input to it. as well as on the price of the input mix. 6 hours of unskilled labour at K10. The direct material mix and yield variances must be interpreted into core. The standard labour input associated with the production of one unit is as follows: 4 hours of skilled labour paid at K15. 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. If some other combinations of inputs could produce a lower cost output without detriment to quality. as there is a very strong interrelationship between them.e. The standard labour cost of one unit is [(K15.
In addition.267.000 x 100% 271 .000.000 It can also be established that the standard labour mix is 40 per cent skilled and 60 percent unskilled. analyse the labour efficiency variance into labour mix and labour yield components. Required: Compute the labour cost variance and analyse this into labour rate and labour efficiency component variances. K3.500 Standard labour cost of 25 units (25 x K120.K120.000 10 hours = K12.267.Compute labour cost variance This is the difference between the standard labour cost of producing 25 units and the actual labour costs incurred. K Actual labour cost incurred 3.500 in wages was paid. Stage 1: . *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) 3.
= = 27 units 25 units 2 units (A) Analysis and Interpretation: 272 .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 K10. 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.Labour cost variance ________ 267.000) = K240.000 K195.000 (Adverse).000 (A) K 65.000 (A) Yield variance = K240.000 (F) 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 (F) K130.000 (A) Stage 2: .
000 K12.4hours = 7. 2. However. Required: Calculate the labour efficiency variance. Output is measured in standard hours and expected output is 95 standard hours for 100 hours worked in total. the mix and yield labour variances. the advantage has been more than offset by a cost disadvantage coming from the diminished efficiency of the entire workforce.The analysis carried out above. 000 Less 5% at 8 hours: 8hours – 0. . .000. 000 per hour and three (3) grade B employees are paid at K4. in stage 3 indicates that a cost advantage has been attained by substituting unskilled labour for skilled labour in the production process.60 hours 100 hours – 95 standard hours = 5 hours . 000 K4. 5hours x 100% 273 . 000 K42.000 and 852 hours of grade B labour costing K2.500 hours of grade A labour costing K9. Nkungu Ltd uses two (2) grades of labour that work together to produce product E. The standard composition of each team is five grade A employees paid at K6. 000 per hour. Labour Grade A B # of employees in each team 5 3 Hourly labour rate K6. 750. During the last period. Suggested solutions: Preliminary work (calculation) Calculation of standard rate per hour of output.280 standard hours of output were produced using 1. 982. 000 = = Total cost per group per hour K30.
the standard rate per hour of output is = K42.000/hr -K192.95 x ⅜) K1. Standard mix of actual input Hours 274 .30 per standard hour 7. 500 hrs + 852 = 2. .500 _________ 900 552 (48 hrs F) 2280 standard Hours Hours of output should K1. .000/hr ___________ x K 4. 000 = K5. 352 hours. X standard Rate per hour ___________ x K6.000 (F) Now we can further analyze the labour efficiency variances to its two subsidiary i.e. the Labour mix variance (team composition variance) and the labour yield (team productively varies).6 hours i) Direct labour efficiency variance: Grade A Grade B Hours (2280 ÷ 0. (i) Labour Mix Variance Total actual hours = 1.95 x ⅜) But did take ________ Efficiency variance in hours. 526.500 Take an input of (2280 ÷ 0.100 hours = 5% .
352 Grade A Mix should have been but was X standard rate per hour 1.0 ________ 45◦6 standard K 5. 000/hrs __________ K180. 2.40 280. 000 ________ K120.95) 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 (F) (ii) Labour yield variance (team productivity) 2352 hours of work should have produced x (0.470 hrs 1. 526◦30 _____________ K 252.500 hrs 30 hrs (A) x K 6.Grade A: Grade B: ⅝ x 2. 352 hrs = = 1. 000 (F)__ Standard hours hour to perform audit Rate per K Standard cost of audit 275 . 352 hrs ⅜ x 2.000 (A) Grade B 882 hrs 852 hrs 30 hrs (F) K 4. 234. 470 882 ______ 2. 2.
000 2.500. 276 .Audit manager Junior Auditor Auditor clerk 30 120 50 ___ 200 450.400. We are only going to highlight the three main ratios to be appreciated here. they should demonstrate full knowledge on how to work out capacity ratios.000 __________ 36.000 20.500. Capacity Ratios At this point in time we would want to remind candidates that at this level. 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.000 170.000 50.000 13. 1) The labour efficiency. 400. 2) The labour yield variance. 3) The labour mix variance.
2. in an hour or minute. taking into account budgeted sales. Example: A corporation has the following information: Full capacity standard hours Practical capacity standard hours Budgeted capacity standard hours (Budgeted input hours 90. workforce availability and efficiency expected. supplies and workforce were available for all installed work places. A standard hour or minute is the amount of work achievable at standard efficiency levels. Full capacity The output (expressed in standard hours) that could be achieved if sales orders. at 90% efficiency) Actual input hours Standard hours produced From the information above. A standard hour is a useful way of measuring output when a number of dissimilar products are manufactured. Practical capacity Full capacity less an allowance for known unavailable volume losses. it can be seen that the (i) Idle capacity = Practical . 3. supplies.budget capacity capacity ________________ x 100% Practical capacity 100 95 81 85 68 277 . Budgeted capacity The standard hours planned for a period.1.
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. 278 .= 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.
3. This 279 . 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. It is also important to note that overhead rates are calculated from estimates of expenditure and activity levels.3 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. Fixed overhead variance depends on two i.1 Element 8. Fixed overhead variances are a product of the overhead absorption process.Element 8. Further more. 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. and the fixed overhead attributed and charged for that period. The fixed overhead total variance is made up of fixed overhead expenditure variance and the fixed overhead volume variance.3. It is therefore the difference between actual fixed overheads and allowed or budgeted fixed overheads. Types of fixed overhead variances: Element 8. Element 8.3 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.e.2 Fixed overhead total variance This is the difference between the standard cost of fixed overhead absorbed in the production achieved. the fixed express incurred and the volume of production obtained.3. It is worth noting that the volume variance is due to the actual volume of production differing from the planned volume.
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.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.3.740.7 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. 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 Element 8. Element 8.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. Element 8.3.000 280 .
000 – K 6.050.3.500 (A) Fixed overhead efficiency variance (Standard hours – Actual hours) * Standard rate = (16.500 (A) Fixed overhead capacity variance (Actual hours – Budgeted hours) * Standard rate = (15.000 = K 310.400 hrs) * K 350 = 650 hrs * K 350 = K 227.750 hours 16.740.750 hrs) * K 350 = 400hrs * K 350 = K 140.000 Element 8.150 hrs – 15.000 (F) 281 .750 hrs – 16.050. 500 (A) Fixed overhead expenditure Budgeted fixed overheads – Actual fixed overheads = K 5.000 (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 15.8 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 399.150 hours K 6.
000 hrs Standard hours 17.Element 8.3. efficiency and capacity variances using control ratios.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 8.10 Example: Calculate the volume.000hrs Standard hours 18.9 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.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% 282 .000 hrs Labour hours 16. capacity and efficiency ratios from the data below: Budgeted: Actual Results: Labour hours 18.
Element 8.400 units K57.000/units K24. manufactures a single product.4 Sales Variances At this point of our studies. Example: LUNA Co. of which the main two variances are the selling price variances and the sales volume variance.000/unit 81.000/unit K6.000/unit 283 .000/unit K23. 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. we will be looking at sale variances.600 units K59.000/unit K4. An illustration below can well explain the application of the sales variances.
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. if the selling price and the cost per unit had been equal to the standards.800.000 – K24.400) Selling price variance K59.400 800 (favourable) The favourable variance shows that the increased sales volume could have increased profit by K24. Sales Volume Variance This variance calculates the profit differences which is caused by selling a different quantity from that budgeted.800.000 K57.800. Element 8.5 Planning Variances 284 .000 Sales volume variance K24. Units Budgeted sales volume Actual sales volume *Standard profit per Unit (K59.000 (F) 81.600 82.000 (Adverse) The adverse variance shows that the actual selling price was lower than the standard price.000 i.e.000 – K4.000) = K31.000 (Adverse) K164.000 K 2.Selling price per unit should have been But was Actually Units sold (82.
e K48. its only product should be K40. 400 400 hours (A) 285 . Planning variances may arise from faulty standard – setting.CHISWE Ltd estimates that the standard direct labour cost for NSELE.budget allowances being changed to a post basis. 000 12. and there is no other benefit to be gained in spending time investigating such variances at an operational level. it cannot be held responsible for them. in retrospect. ii.600. A planning variance can also be referred to as a revision variance.1 Definition of Planning Variances A classification of variances caused by ----. Analysis and Comments Management will wish to draw a distinction between those two variances in order to gain a realistic measure of operational efficiency. 000.000 unit of the NSELE took 12.000 (8 hours x K5.400 hours at a cost of K47.5.000/hr) actual production of 1.000 per hour. Element 8.000 units should take at 12 hrs/unit but did take 12. As planning variances are self-evident not under the control of operational management. Required: Calculate the: i.000 per unit. it is realized that the standard cost should have been 12 hours x K4. Planning variance Operational variance Solution: (c) Operational variance Hours 1. but the responsibility for this lies with senior rather than operational management. i.Some variances can arise from changes in factors internal to the business and may therefore be referred to as planning variances.
000 (F) (b)Planning Variance K Revised standard cost 1. 000. 000 iii) Check Actual costs Received standard cost (100 x K48. 000 (F)) = 400. 000 40. relevant and appropriate. 000) = 48. 400 hours should cost @ K4. 000 units x 8 hours x K5. which are non-controllable. 000/hr 48. 3.000. 000 units x 12hrs x K4.000/hour 1. 000. 000. 000 (F) K 47. 000 8. The planning and standard setting process should improve. 286 . and their motivation. 000 (A) + K2. is likely to increase if they know they will not be held responsible for poor planning and faulty standard setting. Manager’s acceptance of the variances for performance measurement. 000_(A) IMPORTANCE OF PLANNING AND OPERATIONAL VARIANCES Advantages of a system of planning and operational 1. 600. 000/hr Original standard cost of 1. 000 Total operation variance (K1. 600. which are controllable and those.600. 000 = 47. standards should be more accurate. 600. 000.00 (A) ii) 12. 000. 2. 600. 000. 000 2. 000/hr But did cost = 49. The analysis highlights those variances.x revised standard cost per hour K4.
2. 3. 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. Operational variances will provide a fairer’ reflection of actual performance. It is many times difficult to decide in hindsight what the realistic standard should have been. LIMITATIONS OF PLANNING AND OPERATIONAL VARIANCE 1. Careful presentation and explanation will be required until managers are used to the concepts. 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. 287 .4.
turnover.STUDT UNIT 9. even those costs which are seen as variable in the traditional sense. throughput is dependent on four elements: 288 . The term ‘throughput’ is defined by Goldratt and Cox (1989) by means of the following equation: Throughput = sales revenue less direct material cost. or costs which would normally be split into fixed and variable elements. The focus of throughput: As the equation shows.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. batches produced. are treated as entirely fixed. and not simply to material used.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 direct material cost referred to in the above definition relates to all material purchased during a particular period. The aim of throughput accounting is to maximise this measure of throughput. The principle behind throughput accounting is that all costs other than material are effectively fixed. Rates may be expressed in terms of units of products. or other meaningful measurements (CAM-I)’.
if a company operates a traditional standard costing system. Poor reputation for meeting delivery dates. purchase of usage of direct material. Constraints on throughput The idea of ‘constraint’ is central to the throughput approach. will result in an adverse direct labour efficiency variance being reported. 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. delivery and/or quality. it would expect to see an increase in its sales volume. There are strong interrelationship between the above four items. However. Poor physical distribution system. inappropriate management accounting system. if the interruption in work requires the machine to be stopped and reset 289 . If a company were to reduce its selling price. interrupting the production schedule of a particular work station. and the value of the sales feeds through into sales revenue in the throughput equation. so that goods can be completed to satisfy a customer’s rush order. Unreliability of material suppliers. The throughput approach is therefore in sympathy with the JIT approach. For example. Material held in raw material. Throughput is only increased when finished goods are sold. In throughput accounting. It asks: ‘what are the factors – market. management attention and action can be focused on alleviating them. 2and 4. it is recognized that it may sometimes be necessary to maintain stock. which in turn may be related to the signals generated by the management accounting system. particularly between 1. Usage of direct materials A focus on throughput necessarily focuses management attention on these four areas. and might also see an increase in the speed of use of raw materials. sales volume. Once the constraints have been identified. work-in-progress or finished goods increases direct material cost. but does not increase throughput. particularly when the new sales are satisfied from stock.1) 2) 3) 4) unit selling price . Some of the constraints may be interrelated: a poor reputation for meeting delivery dates could be associated with inadequate production resources. in order to alleviate a resource constraint and therefore increase the speed of throughput. the throughput approach does not go as far as the JIT philosophy in its attitude to stock. if faced with a downward sloping demand curve. inadequate production resources.
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.to meet this rush demand. and alternatives such as buying in particular components are not available or are rejected. and thereby eliminate the problem. However. This can sometimes be done with existing resources: it may be possible. The throughput approach is dedicated to the identification and subsequent elimination of bottleneck resources. a philosophy which traditional accounting systems have tended to encourage. JIT etc. and machine B is a bottleneck resource. 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. The ultimate aim of many modern manufacturing approaches – CIM. despite the signal sent out from the accounting system. 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. if the output of machine A becomes the input to machine B. which would increase neither the throughput of the organisation nor its profit. 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. it is the aim of the throughput approach to eliminate it. in order to avoid the output of machine A simply becoming work-in-progress. Where elimination is not possible. and management’s attention would then have to focus on the elimination of this second constraint. For example. for example. to modify other machinery in such a way that it can perform the operations of the bottleneck resource. the almost invariable result of this is simply to move the bottlenecks to some other part of the plant. Bottleneck resources Throughput accounting is most associated with the management of production resources. A reassessment of the measures traditionally employed to record the efficiency of surrounding resources may sometimes be required. This means that there are no constraints – known as bottleneck resources – within a factory. The throughput may thus lead to a better allocation of capital investment funds than would be possible under traditional system. 290 . As noted above. – is to enable production to take place in a complete balanced manner. If reorganization of existing resources cannot get rid of a bottleneck. However. A stoppage of this kind is not necessarily undesirable. once a bottleneck has been identified.
The throughput approach should therefore be viewed as a search for continuous improvement. Throughput measures The role of the accountant in a throughput environment is to devise measures which will. thus highlighting the problem. rather than another technique which simply reports on the status quo. As noted earlier. 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. the authors wish to point out that a debate as to which is the right measure of throughput is sterile. help production staff to achieve greater throughput volume. if an attempt is being made to integrate throughput measure with traditional accounting systems. However. Attention should be drawn to the financial effects of bottlenecks. 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. However. 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. 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. 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 291 . an aim frequently found in modern manufacturing environments and one referred to throughout this chapter. For example. rather than the cost of the material actually used.
Indeed. i. but a requirement for five minutes of the bottleneck resource. However. When adopting a throughput approach. these results in all stocks in a throughput accounting system being held at raw materials cost only. it is process management rather than accounting which reflects the true focus of the throughput approach). both ‘versions’ of throughput accounting differ from conventional accounting in their treatment of direct labour costs and production overheads. these are regarded as period costs. For example. the throughput approach is simply employing the common short term decision – making technique of maximizing contribution per limiting factor.variable costing’. However.(the reader will note that the ‘throughput’ in this report is an absolute measure in financial terms. Throughput and contribution When making short –term judgments as to the relative profitability of particular product lines. This may be surprising as the English word ‘throughput’ contains connotations of movement or flow. Horngren et al(1997) refer to throughput accounting as an example of ‘super. with a unit contribution of £ 40. direct materials are treated in precisely the same way as in traditional accounting systems. In a throughput environment. to be expensed in the period in which they are incurred and are thus treated in exactly the same way as selling. finished goods and cost of sales. and their use should not be extrapolated to determine longer term sales effort. this measure is often used as the basis for encouraging salesmen to push particular products. the attractiveness of particular products is related to their consumption of bottleneck resources.e. it would be expected that bottlenecks will be alleviated. In this respect. work-in-progress. any change in the mix of products demanded by customers can 292 . Clearly. The production scheduling process would result in priority being given to those products which were best able to generate throughput. as indicated above. In throughput accounting. product A. direct material costs are associated with raw materials. distribution and administrative costs (which. with a unit contribution of £20 but a requirement of two minutes of a bottleneck resource. Certainly. so that the ranking can be expected to change –possibly very quickly – over period of time. of course. would be preferred to product B. and as reiterated above. 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. we should note. In this second ‘version’ of throughput accounting. ‘throughput’ emphasises flow in the management of the production process. will receive the same treatment under both throughput accounting and traditional systems). It must be stressed that such product ranking are relevant for short-term production scheduling only.
and for technical reasons this line can only be operated for a maximum of 12 hours per day. and hence altering the relative attractiveness of particular products. The ability of the company to produce A and B is limited by the capacity to process the products in Y and Z. the current market price for A being K65 and that for B K25. 39min. with associated labour costs of £10 per direct labour hour in each. A and B. giving 16 working hours per day. At these prices. The company operates a two-shift system. 15min. Process Z is a single–process line. Process Y is a dual process line. Example A company produces two products. The products pass through two processes. although this doubles the 293 .have the effect of immediately switching the bottleneck resource within a production capacity. Selling prices are set by the market. 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. 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. 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. 20 min. and thus two units can be processed simultaneously. Y and Z. the market will absorb as many units of A and B as the company can produce.
i. where there is only one binding constraint.920 = 192 10 720 20 = 36 Product B Max units 1. 294 . Question: Based on the above information.e. and thus the capacity of process Y is not a binding constraint. the problem. the constraints which prevent the profit from being infinite must be identified. what production plan should the company follow in order to maximise profits? Solution: In order to find the profit-maximising solution in any problem. the greater the number of constraints the more difficult the problem is to solve. Linear programming may be used to solve the problem where more than one constraint is binding for some. the profit maximising solution is found by maximising the contribution per unit of the scare recourse. Maximum process time Y = 2 x 16 x 60 =1. As the number of potentially binding constraints increase. but not all.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 1.23 39 720 = 48 15 Z In the case of both products. feasible solutions.920 = 49. and such constraints are relatively few in number. the maximum number of units which can be produced in process Y exceeds the number which can be produced in process Z. Process Y operates for the full 16 working hours each day. Where the number of products is limited to two. as explained in Stage 2 Management Science Applications. and/or the problem can be expressed in the form of a set of simultaneous equations.requirement for labour. In the most simple case. the problem can easily be expressed graphically to reveal the profit –maximising solution. therefore becomes one of deciding how to allocate the scare production capacity of process Z in such a way as to maximise profit. the binding constraint. the use of a computer becomes the only feasible way to solve the necessary number of simultaneous equations.
016 K2. Thus the throughput solution is suboptimal where there are costs. It is a special case in as much as contribution is measured after material 295 . some other costs are also variable. while the latter indicates that product B alone should be produced. The throughput approach is.25 20 Contribution of B per minute in process Z = K24 = K1.620. other than materials. whereas the throughput approach treats all costs.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. with a contribution of K1. a special case of the ‘traditional’ method of maximising contribution per unit of scarce resource in short–term decision making. 36 giving a contribution of K45 x 36 =K1.620 K1. given their different solutions that the two approaches cannot both lead to profit maximization. as fixed.620 – fixed costs = profit Throughput method = 48 units of B yielding K2. in fact.60 15 The profit–maximising solution is therefore to produce the maximum possible number of units of A. Profit maximization It is clear. which are variable – and identifiable with particular products – in the short run. 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. other than material. the profits will be maximized by producing A only.016 – (variable labour cost + overhead) – fixed cost = profit K2.016) – fixed cost = profit The fixed cost is common to both cases. If these ‘other’ costs that are identified as variable under the traditional approach really are variable in the short term. and the throughput solution is suboptimal. The calculation below shows this: Traditional method = 36 units of A. This dichotomy of prescription arises solely because the traditional method holds that in addition to materials.016 – 48 (K9 + K9) – fixed cost = profit K2.
Y and Z both become bottlenecks in this case.57 x 39] + 2. the profit maximising output is to produce 48. is to produce units of A only. Y: [48. the above analysis suggests that. The traditional approach would then be identical to the throughput approach. in fact. If management is able to find a way to enable this machine to work for one extra hour. if this is an accurate representation of reality.920 = 49. the traditional approach could be reworked to recognize this fact.920 = 192 10 780 20 = 39 Product B Max units 1. and the further aim of alleviating the constraint. the effect is to alter the optimal production plan so that both A and B would be produced.57 x 15] + [2. But. as they are both utilized to 100 per cent of their capacity. if one extra hour is provided to relieve the bottleneck at Z.57 units of B and 2. Provision of additional resources to bottleneck The aim of throughput management is to focus attention on bottleneck resources.57 = 1896. Adoption of a linear programming approach (calculation not shown) reveals that the profit maximising output. In this example. as has been urged.57 units of A.e.23 39 720 = 52 15 Z Whether a particular constraint is binding now depends on the production plan. However. The capacity of Y limits production of B. where no costs other than material are variable (i. as assumed in the throughput approach). rather than B alone. the contribution should be measured in this way. If all costs other than material are. whilst the capacity of Z limits production of A. Thus. if labour and variable overhead are truly variable. fixed. and the profit-maximising output would be recognized as the production of B only.8 Z: [48.6 + 51. with the immediate aim of ensuring that such resources are utilized for 100 per cent of their capacity. Z is the bottleneck resource. if the only variable cost is material.4 = 780mins 296 . the maximum number which could be produced of the two products becomes: Products A Max units Y 1.57 x 20] = 728.cost only.
the provision of one extra hour at Z does alter the optimal production plan. even with modern information technology. Traditional variance reporting may encourage the attainment of high levels of local efficiency at the expense of overall efficiency. production conditions. It relates to a company producing only two standard products. It can therefore be argued that throughput accounting does not add anything to the accountant’s existing set of techniques. premises. The throughput approach has been shown to be a specific application of the ‘contribution per unit of limiting resource’ approach. The actual profits which a company makes are clearly dependent on the accuracy of the data on which decisions are based. employees etc. 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 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.the bottleneck resources – management will focus on alleviating problems which are inhibiting the profitability of the factory as a whole. being used to 100 per cent of its capacity. but realistic. Such situations are difficult to model accurately. With a given level of resources. It was shown that this choice is dependent on the assumptions that are made about the behaviour of costs. 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 example above is trivial in many respects. By drawing attention to impediments to that flow. 297 . except insofar as additional units of A can now be produced. Z remains a bottleneck.If costs other than material are variable (i. i. bottleneck machines or processes are generally much more easily identified by direct observation than by relying on the output of conventional accounting reports. and with a stable demand for the products is largely unpredictable.e.. rather than sub-units or particular product lines. machinery. as assumed in the traditional approach). Throughput accounting as a technique of production management The example above focused on the choice of product to product. requiring only two production processes. A global measure of throughput at the factory level may give a clear signal as to the efficacy of factory management. whilst spare capacity continues to exist in Y. However. The contribution of the throughput accounting approach may lie in the insights it can offer in such chaotic. Managing the throughput of a factory reflects the philosophy of ‘management by walking about’.e.
Criticisms of throughput accounting Throughput accounting has been criticised as not representing a profit– maximising approach. In attempting to maximize throughput. output should be limited in order to maximize profit.4 shows. This criticism may be regarded as unfair. owing to the problems associated with production scheduling. For single-product firms as we have. Figure 2. The classical approach is illustrated below. which have as their objective profit maximization. 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.4 Profit maximisation 298 . a company has a range of products produced from common facilities. whereas adoption of the profit-maximising approach would result in lower level of profit. when facing a downward-sloping demand curve. it has often been pointed out that maximisation of profit is a largely theoretical concept. however. and does not detract from the attractions of the throughput approach. As Figure 2. Furthermore. Advocates of throughput accounting would suggest that. a company could find itself producing beyond the profitmaximising point-hence the criticism. 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. by operating under the aegis of traditional techniques.
at the minimum possible cost. However. the throughput approach could be argued to be either the direct opposite of. It is not a costing system as such. Critics suggest that the approach is excessively short-term. 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. it says nothing about why other costs are incurred. The term ‘target cost’ is not included in the terminology. 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. it has been 299 . consistent with the Terminology definition of target cost. through the examination of all ideas for cost reduction of the product at the preproduction stage. where the opportunities for cost reduction efforts are greatest. The aim is to meet customer requirements. such as quality and reliability. research and development stage. is that of reducing cost. This approach may not be realistic. namely that the ability to influence cost is greater at the product planning. and therefore fits in well with modern manufacturing creeds. This interpretation of target costing emphasis an important point made earlier in this chapter. A further criticism suggests that the approach is excessively short-term in that all costs other than direct material are regarded as fixed. or the perfect complement to. In focusing on direct materials costs. and therefore can do nothing to help their control.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 philosophy underpinning throughput accounting is that the goal of manufacturing is to make money. Element 9. A further criticism is that. Used to reduce costs through continuous improvement and replacement of technologies and processes’. and may be regarded as a misnomer. 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. in that all costs other than direct material are regarded as fixed. the activity based costing approach with the latter’s focus labour and overhead costs. in concentrating only on direct material. even in the short term. rather than the production stage itself. but rather refers to an activity whose aim. Nevertheless.
In Japan. Target costing for products has been employed by the Japanese industry for more than 30 years. Monden and Hamada (1991). a target cost is a cost to which people are committed. Unfortunately. other things being equal. rather than something which one is committed to achieving. when it is applied in the sense of View 2. These different interpretations are in no way contradictory and could be applied in tandem. Yoshikawa et al (1993). where different words are used for the two versions: when target costing is being applied in the sense of View 1. The word ‘target’ in English has connotations of something one aims for. fully capture the Japanese approach. different targets may be set for different phases of the development process. in assembly type environments 80 per cent of the major Japanese companies employ the technique.5 shows. This confusion in the terminology does not arise in Japan. it is known as ‘Genka Kikaku’. 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. or tries to achieve. as Figure 3.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. However. Figure 3. Agreed target costs are final. it is known as ‘Genka Kaizen’ (Kato (1993).5 Target Costing Target costing Target cost o Stepped strategy o Single-target strategy Concept Design Testing Process Prod’n planning 300 . Indeed. the English translation of the Japanese term as ‘target’ does not. they are never expected to change.
this approach views any product as a collection of individual functions. which is based on existing technology and cost data.6). the potential profits are much greater for the former than the latter. which is based on the price of competitor’s products. and the place of the new good within it. Element 9.1 Calculating Target Costs There are three ways of arriving at a target cost. For companies. will enter established market with knowledge of the relevant existing product market.2. As we saw earlier. which are first to market. and these are listed below in order of increasing sophistication: 1) The additional method. it can also be applied to other areas.Although target costing is most commonly applied to product costs. 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. The ‘Design to Cost’ programme of the American Department of Defence in the mid –70s was an early Western example.2.and the deductive/subtraction method (see below) 3) The deductive/subtraction method. or minor varieties of existing products. To help with the pricing decision in such situations.2 Establishing An Expected Sales Price New brands of existing product types. in the case of a totally new product. and was applied over a wide range of expenses. 2) The integrated method. establishing an appropriate selling price is much harder than for those that follow. with the 301 . and employ ‘pricing by function’. which is a mixture of the addition method – and thus derives some parts of the target cost from existing cost data. and uses the current of existing or similar components or products to set a target cost for the new product. However. Element 9. by definition there will be no established market for it and therefore no existing market price that can be used as a guide. and works backwards from the market price to derive the target cost. We shall limit our discussion to the last of these. should enable a competitive price to be set. which is the method most frequently encountered. many Japanese companies employ functional analysis (see section 3. 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. However.
As the process described above makes clear. as opportunities for cost reduction will usually have been identified during the life of the existing product. 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.appearance. this cost will have been determined primarily by looking outward to the market. reliability. the difference between the two representing the socalled ‘cost gap’.3) and functional analysis (see 3. to establish an expected selling price. By decomposing the new product into its separate functions. irrespective of whether the company currently has the capacity to put into practice the plans on which the costing is based.consumer being willing to pay a price for each of them. materials. and this must now be done. This cost will always be greater than the target profit. As we noted earlier. management will obviously have the benefit of ‘on-going’ cost data in building up the target cost. 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.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. – and placing a value on each of this particular collection of functions can be established. In the case of a modification of an existing product. Element 9.2. The strategy of a business in the short. No estimate of the actual cost which will be incurred in the manufacture of the product will have been made up to this stage. Value analysis (see section 3. 302 .6) can fruitfully be employed to assist this estimating process. Element 9. which must be bridged without sacrificing any of the ructions that were included in setting the expected selling price. Even when this is done.4 The Residual: Target Cost The deduction of the target profit from the expected selling price will give the target cost.2. it is rarely possible to implement all the potentially benefited changes that come to management’s attention. medium or long term will be reflected in its short-medium and long–term profit plans. The costing should be based on the most cost-effective design. once production has commenced. the initial estimate will almost invariable be higher that the target post. ease of operation and maintenance etc. and the target profit for any individual product will be a function of its place within those plans. and production processes.
including those not currently used or experienced by the company.In the case of the totally new product. Cost tables are very widely used in Japanese industry.6) into the manipulation of the database. Element 9.1).3. by definition the costing will be based on internal information relating to previously experience costs. To help reduce cost To minimise the cost of new products. even though these costs are not necessarily attainable with current facilities. and autonomous agencies exist to provide the relevant data for various industrial sectors. The integration of cost tables with a company’s CAD system (see section2. which are briefly described in the following section. The dictates of world-class manufacturing mean that cost tables continue to be used throughout the life of an individual product. Their use is thus consistent with the general principle of cost reduction. The ‘measurement’ of the definition is derived from a comprehensive database of detailed cost information on alternative materials.. The purpose of cost tables is implicitly in the definition: i. and a specific requirement to achieve a target cost. and the incorporation of functional analysis (see section 3. and indeed data to support modified versions of the existing products. ii. This greatly enhances the likelihood of its acceptability to the consumer and its efficient manufacture.2.and hence its profitability.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. 303 . labour. to test the validity of design modifications. In Japan.. are often provided by ‘cost tables’. equipment and production costs. 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.5 Cost Tables Sato (1965) defines a ‘cost table’ as follows: ‘. 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 the historic costing records are thus limited in use in supplying the required data. whether internally or externally driven. these data. in the absence of sufficient in-house information. 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. This database enables companies to establish ‘state–of-the-art’ costs for new or existing products.
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.3 Service Costing Service costing is cost accounting for specific services or functions e. for example. Therefore the services provided may be for sale e.e.g. hotel accommodation. public transport. Service costing using 304 . power generation etc or they may be provided within the organization 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. Number of Operations.g.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. maintenance. the calculation of the cost per unit is done in a similar fashion to output costing i. Whatever cost unit is decided upon. library and stores. the hotel industry may use the ‘occupied bed per night’ as an appropriate unit for cost.Element 9. departments or functions. Frequently a composite cost unit is deemed the more relevant. canteens. Passenger per kilometer Patient per day. maintenance. personnel. restaurants. A particular difficulty is to define a realistic cost unit that represents a suitable measure of the service provided.
COST BREAKDOWN Hilltop Hospital In.308.975.600 1.720 305 .563.832.800 8.937.590 2.patients K’000 outpatients K’000 1.472 7 ½ days 216.166.600 4.821.homogenous service centres or function and cost units that are a good measure of the service provided is a form of activity based costing.500 Copmed Hospital 500 8.500 Indirect Costs General services 3.050 693.524.patients K’000 Direct Patient Care Supplies.288.410 12.700 1.620 3.210.285.721.050 1.845.470 16.520 Medical stores 8.840 635.350 285. Example Information has been collected about two hospitals over the last year: Hilltop Hospital Number of beds Number of in.700 1.380 1.920 *Not recorded but bed occupation percentage was 85%.patients Average stay Number of out patients visits 780 23.patients K’000 Copmed Hospital in.591.551.729.100 Support services 2. drugs 1.950 6.487.165 * 63.450 out.
500 beds x 365days = 182.patient days x 100% Potential in.500.patient days = 23.5 x 100% 780 x 365 = 176.165 = 19 days.700 306 . Potential in. = Actual in.85 = 155.125 in.040 284.patient attendance for both hospitals and comment on the results.125 8. 85% occupancy = 182.500 x 0.patient days in a year.472 x 7. average stay = 155. (b) Bed occupation percentage in hilltop.patient days Therefore. Therefore.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. Solutions: (a) Average stay in Copmed hospital.
487.500 = K38.472 x 7.285.590.e.patient day = Costs for in.1 Use of Unit Costs In The Public Sector 307 . Element 9.166.5 = K92.840.patients November of in.patient attendance = Costs for out.patient days Copmed Hospital K12.050 216. in patient days) is used to calculate the costs.920 K70.= 62% (c) Costs per in.280 Copmed Hospital K4.000 8.430 Hilltop Hospital K16.288.165 x 19 = K78.510 (d) Cost per out.720 63.210 It will be seen that a composite cost unit (i.3.patients Number of out patient attendances Hilltop Hospital =K 8.000 23.
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.3. Costs are collected. the national health services. These unit costs have three main uses. 308 . (b) Throughputs are used rather than outcomes. (c) As an aid to cost control. (c) The throughput mix is likely to differ. 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.g. cost per pupil in different education authorities.2 Limitations of The Cost Units (a) Quality of performance is usually ignored. They serve as: (a) As indicators of relative frequency e.Cost per night in police cells. In the section on pricing (see section 5. police and so on. local authorities. Like must be compared with like for the comparison to be fair.The public sector organizations cover an enormous range. Element 9. .5). These can help to indicate whether efficiency is increasing or decreasing over time. Element 9. (b) As measures of efficiency over time. 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. Examples include primary and secondary state education. related to some measure of throughput or output and a unit cost calculated as described above. Throughputs are numeric indicators where as outcomes are the impact which the activity has on the recipient of the service. the reader will find a description of the product life (a concept introduced at stages 2 in the Management Science Applications paper). . whereby products or services entering a market go through four stages: introduction. For instance.Cost per patient per day at various hospitals.
materials. From the suppliers point of view. The interactions of the revenue curve and the cost curve measures the profitability of the product over its life. and emphasises. Life cycle costing has much with value analysis (see section 3. The Terminology definition of ‘life cycle costing’ creates some confusion in this context.growth.3. The initial expenditure will invariably be lower in absolute terms than the manufacturing costs to produce and support the product. in that it recognises (albeit indirectly) the importance of understanding cost throughout the whole life of a product.5) and target costing (see section3. costs will increase. with a tendency for costs to follow the sales pattern. as students of accounting are well aware. Indeed. the importance of early decisions in determining what these costs will be. by defining it as: ‘The practice of obtaining. as was the case with value analysis. Although a relative decline in cost per unit may be expected from economics of scale and the experience curve (see section 3.as sales increase. 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.4) once production commences. as do the other techniques. and it can only influence cost if it results into action. and thus the absolute level of cost incurred on a product will rise over its life. the mere recording of financial information does not of itself impact on the transactions which are undertaken. maturity and decline. components and the method of manufacture. This reported association with increased effectiveness clearly indicates that life cycle costing is a process which goes beyond the simple recording of information.7 ). However. the best use of physical assets at the lowest total cost to the entity (terotechnology)’. 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. being largely the manufacturing and support costs mentioned above. as we have stressed throughout this chapter. the actual profit associated with any individual product will have been largely determined before it is introduced to the market. over their lifetimes. It is not clear how a costing method can itself be a practice that results in something being obtained. but clarification is fortunately provided in an explanatory sentence that appears after the definition. 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. via: 309 . 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.
it can be appreciated that a life cycle budget cost for a product has much in common with a target cost. both prior to and following a product’s introduction. financial. but when used in combination with other techniques. and no offence is committed if two companies follow exactly the same set of procedures and attach a different title to their common activities. 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’. particularly in companies where different targets are established for different phases of the product’s life cycle. 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. As costing terms have no legal validity. they do not necessarily require the precision of terms relating to financial (i. a mature product requires less marketing support than a product in the introductory phase. its recognition of the changing cost structure of products over time provides a valuable tool. a life cycle approach can also help managers in allocating resources to non-production activities: for example. a semantic debate as to the exact boundaries. distribution and customer service. This indicates to the authors that life cycle costing of itself does not result in the reduction of cost.‘This is achieved through a combination of management. such as value analysis. for management in gaining control over the firm’s activities.4. have actually been delivered. However. life cycle budgeting. and support 310 .e. When used in this sense. will also be considered. if any. Element 9. As life cycle budget relates specifically to products or services. 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’.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. statutory) accounting. but those costs attributable to the product in respect of non-production overheads. engineering and other disciplines’. of life cycle costing. and support may be withdrawn almost entirely from a product in the introductory phase. not only will the production cost of a product be forecast. such as marketing.
3) The relationship between different cost areas/categories is highlighted. For example. such in terms of focus and timing.4. 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. traditional accounting reports and practice. recorded and reported by function – customer service. a useful format which is not seen in traditional systems. which represents a significant change to traditional accounting reporting. research. marketing and customer service are highlighted on a product–line basis.required by a product. The knowledge gained from such audit reports can be fed into the company’s decision making processes to improve future product decisions. such as the learning curve (see section 3.7). many overhead costs are budgeted. 311 . research and development etc. and techniques for cost reduction. Indeed. can lead to a more effective allocation of resources. distribution. reducing cost at the customer service stage. Reports produced in this way can be seen to have four clear benefits: 1) The costs of pre-production activities e. in traditional systems. along the same lines as capital expenditure post-completion audits (see section 6. However. 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. development and design and post production activities e. This may have been known implicitly. 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. based on an understanding of its individual life cycle. In contrast. and represents an improvement of the traditional incremental approach to budgeting. 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 no attempt is made to attribute these costs particular products. life cycle costing reports require the tracking of costs and revenues throughout the entire life of a product. 4) The existence of life cycle reports facilities the conduct of postcompletion product audits. 2) An understanding of the cost commitment/cost incurrence relationship is gained for different products. Life cycle cost reports will thus normally be an addition to. but life cycle costing makes the knowledge explicit.9).3) and value analysis. with life cycle costing.g. For example. it could be used in support of decision packages in zero-base budgeting (see section 3.g. rather than a substitute for.
Compare and contrast life cycle budgeting with activity-based management identify and comment on any themes that two practices have in common. • Solution: • The product life cycle (PLC) is shown in the diagram below: When a product is first successfully introduced for the market. suggested by an expensive advertising campaign it will only achieve a relatively low sales volume. Vauxhall is setting up new production facilities for manufacturing a revamped Corsa in the UK. Firms will begin to pull out of the market have developed a replacement product. However. 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. This is the decline phase of the Plc. Firms seek to differentiate their product at this stage. This is the most profitable stage of the product life cycle. In an advance manufacturing technology (AMT) environment. the product will become obsolete and falling sales will ensure. most models must be renewed in much shorter time frames. 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. design and new production facilities. 312 . thereby incurring further large fined costs for R&D. 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. In a static market price competition will reduce the profitability of each firm.Required: • • Explain the nature of the product life cycle concept and it’s impact on businesses operating in an advanced manufacturing environment. Explain life cycle costing and state what distinguisher it from more traditional management accounting practices. In AMT environments the time period for the product life cycle is decreasing. Eventually.
• Life Cycle Costing (LCC) involves collecting cost data for each product from inception through its useful life and including any end cost. LCC is used to improve management decision making in breach conditions. The high fixed costs of introducing a new product compared with reduced life cycle periods is a major challenge to profitability in AMT environments. This comparison will show if the expected savings from using new technology or production methods etc. Thus the early decisions regarding product design and production method are paramount and LCC attempts to recognize this situation. this approach yields a better understanding of overhead costs in AMT environments compared to traditional absorption methods. This for manufacturers LCC makes explicit the relationship between design choice and production and marketing costs. The recognition of the total support required over the life of the product whereas traditional costing by function e. The insights gained from company budgeted and actual life cycle costs may be used to refine future decisions. A recent analysis has shown that the life cycle cost of purchasing a personal computer (PC) is around six times the purchase cost. 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. • Activity based management (ABM) uses the understanding of cash drivers found from activity based costing (ABC) to make more informed decisions. In particular. Consumer as well as producers may use LCC. marketing and so on. production. These data are compared with the life cycle budgeted cost for the product. 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. Minimizing cost drivers 3. ABM aims to improve performance by: 1.g. Eliminating waste 2. The Plc concept enables dear strategies planning regarding the development of new products cashflows on marketing activities.The Corsa was launched only a few years ago. R&D. Emulating best practice 313 .
both look at how resources inputs are used to obtain the required organizational outputs.. Both attempt to increase management understanding of overhead costs Both consider how the use of resources supports strategic decisions. v. iv. 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. that is. 314 . Simplified product designs More use of common sub – assembly Reduced set-up times Reduced material handling Better use of the workforce e. vii. vi. ix. 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. For example: viii.4. This ABM seeks to consider all activities performed by the organisation in order to serve a customer or produce a product. Considering how the use of resources supports both operational and strategic decisions. Multi – skilling Their ABM is very similar to LCC in some respects.g.
The company is considering introducing. Their specific advantages are as follows: 1. Both target costing and life cycle costing are systems. 315 . It puts pressure on cost it can be used as a cost reduction technical unlike standard costing and can incorporate a leaving effect. technology and so on. Nuns may wish to replace standard costing/variance analysis with target costing for cost control and reduction for the following reasons 1. annual budgets and monthly variance respects and the balance scorecard for performance measurements. Solution The modern business encouragement terms to be an instate one and is rapidly changing in terms of customer requirement. Nsunsi is in a particularly versatile business because technology is changing rapidly as digital telephones take over and tent messaging develops. 1. which has long been in place in the historical world.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. Life cycle costing systems. economic factors. 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. This is likely to be important in the manufacture of phones. Target costing: and 2. These include a comprehensive overhead absorption system. lope with this. Target costing Target costing may replace and is often compared with traditional standard costing/variance analysis. Target costing Nsonsi Ltd is a company that manufactures mobile phones. This market is extremely volatile and competitive and achieving adequate product profitability is extremely important. which should help the company. where as ABM is a continuous system that tries to drive down both short terms and long terms costs.
it is vital that the product begin to generate profits quickly.2. The life cycle of Nsunsu’s products are likely to be shunt because of charging technology. Nsunsi needs to consider the final customer as well as the system supplier. Research and development costs are likely to be quite high and must be recovered in a short period. 5. 5. so it is important to control cash initially in order to maximize the profit over the product’s life. Break down any artificial functional barriers as it involves staff at all levels and in most functions and forces them to communicate. 6. Many of Nsunsi’s costs are likely to be “looked in” during the design stage. Time to the market is often a key as money factor is generally profited. 3. 3. 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. therefore. It presents a different perspective that could be advantageous to Nsuni as it is not tied to period reporting. 316 . Estimating life cycle costs and revenue will highlight this 2. 4. Target costing is more flexible and target can charge/reduce from years to months. say 94%. such as value analysis and value engineering. 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. It should motivate staff if used contently and help. It leads towards the use of other techniques. This is particularly important in an industry with shunt produce life cycles. It focuses on the time as well as money. 2. 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. which should supply production methods and reduce costs. 4. It considers the market to price customers are prepaid to pay so it forces an originating to be outward rather than inward looking. Life cycle costing 1.
317 .5 Backflush Accounting INTRODUCTION In traditional accounting systems. Management information system Element 9. and the finished goods still remaining in stock at the end of the period. Such a system has two main benefits: i. 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. 9. a valuation period. This facility is important: although the disposition of the costs between the first two of these stock categories is of little consequence. the traditional system has been referred to as one of sequential tracking. Central education from senior managers. workin-progress and finished costs through these accounts.Because of the above it would be advantage for the company to adopt both of these techniques. The reason for this concern is obvious: the latter will simply remain in the balance sheet. To unitary structure with one profit center. Stock valuation. 8. proceeds through work-inprogress to finished goods and finally ends with costs – indeed. a valuation can easily be placed on each for financial accounting purposes. By tracking material and conversion costs through these accounts. 100% internal resoucing of ancihary seniors. financial accounting is concerned to draw a clear distinction between goods that have been sold in an accounting period. 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. Companies may have stocks of raw materials.
but are attached to output produced (finished goods. when the same situation applies to raw materials and finished goods in some variants). However. Control of costs. the traditional system is time-consuming and expensive to operate as it requires large volumes of documentation. In such a situation. Costs do not mirror the flow of products through the production process. stock and cost of sales). The primary benefit offered by backflush costing is the considerable reduction in the clerical effort required to maintain it. In such situations (and. and more than outweighed by the cost savings to be gained from its operation. it can be criticized as being less accurate. 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. and the level of supporting data and documentation. rather than batch or process costing is the norm. and would be inconsistent with the reporting requirements of financial accounting. on the assumption that such backflushed costs are a realistic measure of the actual costs incurred’. Furthermore. associated with a JIT production system. against the general background of low stock levels mentioned above. the use of backflush costing would lead to different results than would have been obtained under the traditional tracking systems. which applies cost to the output of a process. the benefits associated with it are less obvious in the modern manufacturing environment. such as material requisitions and time tickets. this reduction in accuracy is regarded by the system’s advocates as relatively unimportant. However. not only over costs in total. and thus the need to distinguish between the goods sold during a period and those on hand at the period end becomes largely redundant. all but an insignificant amount of any one period’s costs of production will end up in cost of sales on the income statement. A further point must be stressed: as backflush costing does not attach conversion costs to products until they are completed. or even sold. both in terms of the number and frequency of entries to the accounting system. as we shall see. Indeed. Distinguishing features of backflush costing The Terminology defines backflush costing as follows: ‘A method of costing. but also over the costs incurred by individual products or jobs. to support it. 318 . Backflush costing is a system that has been developed in response to these concomitants of the traditional method and the change in the environment. It must be stressed from the start that it is not a more accurate system of costing than those traditionally employed. This benefit applies most obviously to situations in which job costing.ii. Detailed tracking of costs allow a considerable level of control to be exercised. in which low stock levels are becoming the general rule.
The variant which differs least from traditional sequential accounting (method 1) has the following two trigger point. but also fails to record a creditor for material until the production process has been completed. the feature which distinguishes it from other systems. the identification of conversion costs with particular products cannot be used as an effective control mechanism during production. is triggered by certain events. The authors call this initial stock account ‘raw and in process’. and then ‘flushed back’ through the system to attach to particular products. However. This variant not only excludes from costing record any raw materials purchased but not yet used to produce a finished good. 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. In a modern manufacturing environment. as it combines both the traditional raw material and work-in-progress accounts. Accounting entries in backflush costing Horngren et al (1997) describe three variants of a backflush costing system.the purchase of raw materials or components and the completion of good finished units of product. 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. Different ‘triggers’ or ‘trigger points’ can be employed in backflush accounting and therefore a number of variants of the system exist. in the JIT environment in which backflush costing is most likely to be employed. noted therefore. whatever variant is being considered. and thus problems would be immediately evident to all concerned and solutions rapidly sought). and credits are made to the raw and in-process and conversion costs accounts. a further common feature. showing respectively the standard material value and conversion costs of the completed goods. The above text and Drury (1996) have qualified examples of this and the following variant. is that its focus is on output: costs are associated with output. by the use of non-financial measures expressed in physical quantity terms and by direct observation of the operations themselves (for example.The recognition of the costs to be associated with products in the backflush system and thus their point of entry into the cost accounts. it can be argued that effective operational control could be maintained through computer monitoring of the process. rather than ‘raw material’. Although the treatment of material costs in backflush accounting differs from variant to variant. The purchase of materials triggers a debit to the initial stock account and a credit to creditors for the cost of the materials purchased. It is not 319 . a lack of raw materials would cause the production line to come to a standstill. 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.
this variant is intended to focus management attention on selling the products. and the mechanics for recording actual costs and calculating variances are also unclear. apparently. of finished units and expenses all conversion costs immediately on sale. 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. rather than the manufacture.500 1. The analogy with throughput accounting should be obvious.410 11.580 4. The third variant (method 3) again has a similar initial trigger point to the first (i. 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). The entries to record these transactions are as follows. Example of accounting for backflush costing (method 1) As 31 December a widget manufacturer has no stocks. but takes as its second trigger point the sale. Further. During January: Materials purchased and used: 2. Presumably.050 units 1.which contains only the outstanding material costs of raw materials.clear to the present authors (nor. the purchase of raw materials or components). as profit can no longer be bolstered by simply producing for stock. There is only one stock account – merely called ‘inventory’. work-in-progress and finished goods.000 units.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. when the liability is eventually recognized.100kg Labour: 175 hours Overheads incurred Finished goods produced Finished goods sold 20.000 units The triggers for entry into the cost accounting ledgers are the purchase of materials and the completion of finished goods. it appears to be recorded at standard rather than actual cost. 320 . By charging all conversion costs to the income statements.
The value of closing stock at standard cost (permitted by the international accounting standards). • 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. 321 . DEBIT Conversion cost account with the actual cost of labour and overheads. • When the goods are completed: DEBIT Finished goods account with the standard cost of finished goods. 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 materials are purchased: DEBIT Raw and in process account CREDIT Creditors or cash with the actual cost of the materials. CREDIT Creditors or cash With the actual cost of labour and overheads.
050x (4 ÷12)) (5) Profit and loss account 16.800 Cost of sales account K (5) Finished goods (1.000 x K36) (3) Standard cost of production 36.000 K 21.580 (1.800 37.Raw and in process account K (1) Creditors/ cash (2) Standard cost of materials 20.000 Finished goods account K K (4) cost of sales (1.800 16.000 Criticism of Backflush 322 K .000 (1.800 (6) Stock b/d 1.000 x £36) 36.000 420 21.800 (5) Profit and loss account 1.800 890 16.050 x K36) stock c/d 37.910 and overheads (1.800 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.
The physical inventory counts not only increase overhead costs directly but also disrupt production that reduces efficient use of plant resources. They object to the late appearance of entries in the accounting system when backflush costing is used. For example. the virtue of backflush accounting is its sheer simplicity. After all.adding functions. except what is needed to complete the work in progress. However. While the JIT presents management with less accounting and less information on which to base its decisions’. traditional accounting has always ‘backflushed’ costs from work-inprogress to finished goods when products are completed. managers have to take a physical count. the company at a minimum will receive items in a cost – effective delivery size. and conclude their criticisms with the following remarks: ‘Because of no reports from accounting on inventory. At that time. it is axiomatic that simple systems provide rather less information than more complex systems. it would seem that the new situation is identical to the old situation when the appropriate title was work-in-process’. If there is no raw material inventory on hand. but a detailed critique can be found in Calvasina et al (1989). Several criticisms of backflush costing have been made passim. The name RIP is at best a cosmetic change. Typically. 323 . A job that contradicts one of the basic objectives of the JIT philosophy – the elimination of wasteful. 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 backflush system looks very similar to what used to be called a periodic system. Among other things. a small but very real raw material inventory exists in an ideal situation. the appropriate numbers were derived from the ending inventory count. On the other hand. raw material inventories never actually reach zero. which would involve considerably more physical stock counting then the envisaged in a backflush system. While this goal is achievable theoretically. non-value. In this system. One might be forgiven for a measure of puzzlement and confusion at all this.As the introductory remarks to part of the appendix made clear. Thus. traditional systems require the identification of products at different stages of completion in work-in-progress. material also goes directly into the production process and there is no need for a separate raw material inventory account. it will receive a truckload or a railcar load. accountants waited until the end of the fiscal period to take a physical count of the inventory. ‘In a true JIT manufacturing system with a JIT purchasing system.
Element 9. However.2 Element 9. The traditional product costing systems were established at a time when a number of firms were producing a narrow range of products. In addition the main cost elements were made up of direct materials and direct labour.6.3 324 . as compared to overhead costs. 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 9.6. Cost drivers are activities which give rise to costs. if the manufacturing circumstances are such that high levels of stock are unavoidable.6. number of production runs (for material handling costs).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. In addition ABC acknowledges the fact that by producing products. demand is created for the activities. (CIMA) From the above terminology it is clear that ABC looks at activities as the causes of costs (cost drivers). number of orders made (for ordering costs).6 Element 9. The latter utilise cost drivers to attach activity costs to outputs’.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. Therefore distortions arising from overhead allocations were not as significant. Need for ABC The development of ABC was due to the limitations in the traditional product costing systems. These may include. Resources are assigned to activities and activities to cost objects based on consumption estimates. backflush costing becomes an impossibility anyway.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. Costs should therefore be allocated to products based on the activities that the products have consumed.
ABC systems tent to have more activity cost centres. firms today produce a range of products which do not need significant labour. In the first stage the system allocates overheads to production and service departments and then reallocates service department costs to the production departments. The common bases used are direct labour hours and machine hours.6. For ABC systems. Assigning the cost of activities to products according to the products demand for activities. Even though activity cost centres my be identical to traditional cost centres. 4. Instead overhead costs are considerable. product inspections and production scheduling. These will include. However. set-up machines. Identifying the major activities that take place in an organization. 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. 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. in ABC systems separate cost driver rates for support centres are Element 9.4 Establishing an activity-based-Costing System There are basically FOUR steps involved: 1. Traditional Vs ABC Systems In a typical traditional cost system there will be the usual two-stage cost allocation process.5 325 .In contrast. Element 9. In an ABC system overhead costs are assigned to each major activity instead of departments. materials purchasing. These costs are added to the production cost centres cost. Such activities may include. In addition traditional systems normally allocate service/support costs to production centres. number of purchase orders and number of production runs. Activities in an ABC system will be made up of a number of tasks. 2. 3. A number of activity-based cost centres (cost pools) will therefore need to be established. Create a cost pool for each activity. a number of cost drivers which will include non-production volume related are used. This mean that the traditional approach of overhead allocation using direct labour basis does not reflect a true picture. Determining the cost driver for each major activity.6.
6. ABC systems can more accurately measure the resources consumed by cost objects.6.6. Element 9.8 326 . such a detailed and complex system will be more costly to a traditional costing system.established and support activities costs re assigned to cost objects without any reallocation to production centres. 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. 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.7 Element 9. Poor decisions may relate to having to having unprofitable products and dropping profitable products. It is quite obvious that the more complex the ABC system is the more beneficial it will be in the organization. the batch level activity costs are divided by the number of units in the batch. 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. It is however a fact that. For decision-making there is a danger that what started out as a non-volume related. This unitising approach is an allocation which yields a constant average cost per unit of output which vary depending on the level of activity. Costs associated with an ABC system will include software and staff training which may be prohibitive.6 It is therefore evident from the above that by having a number of cost centres and cost drivers. In contrast traditional cost systems tend to produce less accurate costs as most allocation bases used are not related to the cost objects. Consideration must be given to the poor decisions that will be made as a result of having an inaccurate traditional costing system. Element 9. Other Considerations The cost/benefit of implementing an ABC system should be analysed. This is so because to calculate unit costs of products.
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. Element 9.9 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. c) The behaviour of cost items in a cost pool cannot be explained by single cost driver. B and C. In such situations cost drivers can not be used.6. The 327 .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. ABC System: Under ABC system the overheads will be allocated to the Products using the number of production runs as the costdriver.
consumes more of those activities (Set-ups. Under the traditional system Product B has been over-allocated with the overheads since the allocation is based on the number of labour hours.280. as stated earlier on. Production runs and Production scheduling).Production Scheduling = K 7.000 = K 52.3 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.Set-up = K 8736000 = K 62.96 = K24.400 per run 140 4. most modern firms have automated operations therefore the use of labour hours like in the case does not reflect the causes of the overheads.Overheads absorption = K 2217600= K 2132.= K20.Materials Handling = K 6160000 = K 44. than Products A and B.92 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. However.000 per run 140 3.96 = K55. because of the many production runs. 328 .000 per run 140 2.
ERP has been described as an umbrella term for integrated business software systems that power a corporate information structure. logistics. Even so MRPII has advantages as a controlling system for planning and controlling manufacturing systems. MRPII plans production jobs and also calculates resource needs such as labour and machine hours.10 Other aspects of ABC Further approaches which revolve around ABC have been developed. embracing areas such as finance.6. It therefore attempts to integrate materials requirement planning.Element 9. manufacturing. They allow an 329 . make. Element 9. this is a method of budgeting based on the activity framework and utilizing cost driver data in the budget-setting and variance feedback processes. factory capacity planning.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.8 ENTERPRISE RESOURCE PLANNING (ERP) ERP systems are accounting oriented information systems for identifying and planning the enterprise-wide resources needed take. MRPI evolved into MRPII. ERP systems were simple extensions of MRPII systems . it has been eriheised as a planning system. MRPII is used by many companies for manufacturing planning but with the advent of JIT manufacturing. distribute and account for customer orders. cost modelling and customer profitability analysis. Originally. thus helping companies to control their inventory. especially when JIT methods are unsuitable.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. Element 9. purchasing. finance and personnel operators. engineering and marketing. Activity-based budgeting (ABB). shop-floor and even marketing into single complete (and computerised) manufacturing control system. but their scope has now widened. Most MRPII systems are a collection of computer programs that permit the sharing of information with and between departments in an organisation.
simulation and “what if” analysis. For example. accounting. an organisation in Zambia e. requisition and deployment 330 . 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.g. ERP may also incorporate transactions with organisations supplies. distribution and planning. These are fully integrated within the ERP system 2. selling and servicing a bus assembled in India using parts from China. share common data and practices across the whole enterprise and produce and access information in a real-time environment. Business analysis applications Examples include modelling. ERP enables the organisation to understand and mange demand placed on the plan in China. They help large national and multi-national in particular to manage geographically dispersed and complex operations. Some ERP software includes these.organization to automate and integrate most of its business processes. There are two groups of applications within an ERP: 1. sales. They include production. including access to qualitative data by functions that do not typically have access to it. 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. Some provide links into ERP system to third party software that performs tasks. decision support. information retrieval. CORE APPLICATIONS The applications that need to work in the organisation will be unable to function. TATA sales office may be responsible for marketing.
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. or these two concepts? 331 . What are the advantages of a ERP system 3.Questions 1.
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. The following are the common decision support systems in use. 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. 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.1 Decision Support Systems There are various decision support systems that can be used in management accounting. (i) EXECUTIVE INFORMATION SYSTEM (EIS) This system is usually used by the senior corporate executives in a corporation.0 INFORMATION TECHNOLOGY AND MANAGEMENT ACCOUNTING Learning Outcomes After studying this chapter.STUDY UNIT 10. 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 332 . Element 10.
In effect the expect system allows an individual to consult a tax specialist without having to pay for the expensive time of the specialist. Your studies of management and strategy should remind you of this. Decision support system will be used where the decision to be made is unstructured i.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. For example the taxation system of most countries is quite complex and there are few people who understand it completely. themselves. 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. By a question and answer process. Even EIS and Expert systems form part of the general decision support. The summarized organization structure below shows what is being explained 333 . market size. Element 10. A person with very little tax knowledge can then ask various questions about tax from the expert system. if a company may be considering launching a project in a new market sector. the effect of the company entering the new sector can be seen. the expert system identifies the process. For instance. where there are many potential input and output and the decision itself is made only infrequently. Expert systems can also be found in medical diagnosis and mineral prospecting (exploration) activities. The decision support system could be used to analyze the market considering default of current products.e. the problem and provides a solution. forecast programming.1.(ii) DECISION SUPPORT SYSTEM (DSS) These are systems which help manages value decisions. 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. An expert system can be designed to incorporate the knowledge from some of these tax specialists in form of rules. (iii) EXPERT SYSTEMS.
at these different levels of management. The managers will obviously want to make sure that the information they get is appropriate to their various roles. let us examine the different levels of management and therefore look at the information requirement needed to some. Element 10. Other functions will also be staffed with individuals from their discipline in the areas of their speciality. finance.MD Finance Department Sales Department Research & Development Department IT Department Production Department Different people will be working in the highlighted departments.1.2 Management Levels and Information Requirements Different levels of management in an organization will require different information to fulfil their roles. At this stage therefore. 334 . Managers and their subordinate’s will need different types of information to fulfil their jobs. 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. treasury related and tax related activities. finance department carrying out accounting related.
managers therefore need different types of information to help them make those decisions correctly. The information they use will come from two main sources: From within the company and outside the company i. OPERATIONAL MANAGEMENT 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. Each levels of management make different decisions.e. TACTICAL MANAGEMENT Tactical management implement some strategic decisions and decisions involving the running of business units and section. iii.LEVELS OF MANAGEMENT STRATEGIC MGT TACTICAL MGT OPERATIONAL MGT The three levels of management above are responsible for the following activities. strategy formation and policy making in an organization. 335 . internal and external information. STRATEGIC MANAGEMENT Strategic management will comprise a team of top-notch corporate executives involved in overall corporate planning. i. ii.
Details of the company as a whole.Absenteeism reports .Monthly output reports .Computer factory layouts For the various information to be useful to the users it needs to exhibit appropriate characteristics.Computer information .Board minutes . ι.Market demand Summaries STRATEGIC MANAGEMENT TACTICAL MANAGEMENT .Daily production schedule . Prepared as needed.LEVELS OF MANAGEMENT INTERNAL INFORMATION NEEDED .Production fore costs future periods EXTERNAL INFORMATION NEEDED .Variance Analysis .Raw materials prices OPERATIONAL MANAGEMENT . STRATEGIC INFORMATION Should have the following cardinal characteristics • • • • ιι. Highly summarized Related to long-term of the planning horizon. 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 336 .Computer prices .
customers ordering goods from the business. It is however. • Detailed down to individuals machine level • It must be prepared continually. important to note that a TPS has serious effects when there is failure in the system. 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. such as purchases in real time and then upload by a batch system later on to the mainframe computer.2.ιιι. the business placing orders for raw materials.2 A TPS collects details of transactions in a number of ways. to check raw materials level or from the database. it will usually be stored in a database management system. Keying in the on-screen data entry forms or the use of bar-code system.g. with real-time processing and data transfer occurring across a wide-area network with a central mainframe computer. OPERATIONAL INFORMATION Should have the below listed following characteristics • It should be detailed • It should relate to daily / hourly activity. This is due to the fact that a TPS has direct effect on the daily routine transactions 337 . Element 10.1 Transaction Processing Systems (TPS). the common ones being. Element 10. In a typical TPS transactions will occur within a local-area network within a firm. Such transactions may include. When the transaction data is input. information such as supply requests can be transmitted on demand in real time. This entails that the stored data can easily be retrieved if the need arises.2. process the frequent routine transactions. However a local server can store transaction data. In addition. A TPS therefore is an important function in a business’ daily operations. The transactions thus processed by a TPS provide operational level management with processed transaction information. Electronic data interchange (EDI) can enable a link to be established with suppliers and customers. The transactions processed can either be internal or external.2 TRANSACTION PROCESSING SYSTEMS Element 10.
warehouses. banks and customers.3 Management Information Systems (MIS) A management information system is a computer system or a related group of systems. iii. For example. Improved operational efficiency by automatic links to suppliers and better information on product demand and availability. INPUTS OF DATA 338 . Element 10. Can improve stocking through EDI links between stores. i. They should have (i) input of data (ii) processing of data (iii) output of information. suppliers. Element 10. which collects and presents management information relating to a business in order to facilitate its control activities.3.conducted by the business. lower prices and better quality of produce. it can directly affect production or sales. 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. 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.2. Improved customer service through more choice. Assessment of effectiveness product promotion through availability of better information. 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. iv. Element 10. ii. A number of smaller MIS may be needed to produce the information for the different levels of management.3 Some common uses of TPS include: i.
The method chosen will depend largely on the urgency and volume of information to be distributed. The processing that takes places in most MISs will take the form of. iii. The 339 . For example summarizing data or looking for exceptional items in a large amount of data. it is not necessarily recommended for urgent communication. ii. and the characteristics of effective information. particularly when the circulation involves a large number of people.4 Communication Technologies Outputs from information systems can and should vary greatly in terms of length. PROCESSING OF DATA The data which has been input will be processed in one way or the other. Summarised below are the main methods of dissemination in a large company. Information Dissemination-Systems Information can be circulated in a number of different ways. The output from the MIS will tailored to management’s individual requirements. such as the accounts department. the extent of the processing depends on the final output required. These sources will vary depending on the final output that is required from the MIS. format of presentation and urgency of action required. 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. Some outputs will be quite summarized merely showing trends and exceptional items but at the operational level some very detailed outputs will be appropriate. Electronic mail E-mail is useful for sending short messages. Because recipients may not have the system switched on. together with an indication of their appropriateness in particular situations. It is likely that data will be available from other systems within the company.Data will be received from a number of sources. Again. Element 10. This section investigates the relative merits of the different methods that can be used to disseminate information within a company.
Paper mail The amount of paper mail should decrease in companies where e-mail and voicemail have been introduced. A cheaper and quicker alternative is to distribute the computer file via e-mail. and the transmission of lengthy hand-written documents that would need re-typing before they could be sent. Unfortunately. If both e-mail and voicemail are available. However.attachment facility means that other computer files can be distributed simultaneously for checking or review by recipients. a personal answering service can be activated to take the message. and the 340 . 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. 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. Unfortunately. this is a costly and slow communication method. If further communication is necessary. In this latter case. Computer printout Computer printouts are often still distributed though the internal mail system. A later call-back is always possible. and messages left with a secretary may lose their urgency. the onus is on the person receiving the message to call back. 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. Unfortunately. Assuming that those to be contacted are at their desks. and the caller does not have to call again. Voicemail Voicemail is the alternative to frequent call-backs. a telephone ringing is almost guaranteed to interrupt anything they are doing and elicit a response. although this will waste some time for the caller. E-mail is particularly suited to sending out agendas. messages cannot be left if the telephone is not answered. this is not always the case. to avoid the telephone ringing. Telephone The telephone is still the preferred communication medium for urgent messages. in the absence of voicemail. the use of a photocopier and internal mailing envelopes can be a much more efficient method than re-typing and e-mailing. Few people ignore a personal caller. or confirming meeting arrangements made on the telephone.
in which a report is sent to a number of different managers on the chance that one or more may want to see it. Use terms. presentation of numbers etc. it is important that it is presented correctly. 341 • • • • . Strategic management will expect reports to be in summary format. whilst operational management will require extremely detailed reports. the data should be presented clearly and consistently. may be counterproductive.to the person receiving the report.We have seen that different levels of management need reports to be at different levels of detail. Be timely . This is a much better use of management time than having to wade through pages of data. a ‘scattergun’ approach. consistently . This rule applies particularly to information in a management report. adverse variances could always be shown in brackets. Element 10. to distinguish them from favourable variances (or vice versa) or. Be relevant . and that might require action of some sort as a result.if a report is to be read and understood quickly. To be effective. Use exception reporting . if numbers are large. they should be received within a time scale that enables effective management action to be taken on them.If management reports are to be of use in decision-making.4. because each manager on the circulation list assumes that another manager will deal with it.two-way communication that results should resolve problems quickly and efficiently. they could be rounded to the nearest hundred or thousand. For example.exception reporting draws the attention of management to matters that are not proceeding as planned. most of which is (hopefully) wholly unexceptional. In this situation. the report may simply not be reviewed at all.1 Information Dissemination – Effective Presentation of Information For information to be communicated efficiently. Care must be taken to ensure that reports are targeted at the correct manager(s). Most managers receive too many reports. whether in hard-copy form or displayed on a computer screen. written (or non-screen) reports should: • Be set at the correct level of detail .
it is likely that most accountants will have access to some form of computing resource.Obviously. particularly where a number of similar products are being produced across a series of locations. Using a type of bulletin board. Rather than describe the computer hardware again. Figure 9. stock reports etc. Other applications can be used to provide discussion databases. other qualities can be added to this list. Element 10. Reports from other offices • As a communications medium Computers make e-mail systems available which can be used to send messages quickly. cheaply and efficiently.3 Uses and limitations of PCs in Management Accounting With the fall in price and size of computers over the last few years. Uses of PCs in management accounting To provide assistance with information gathering PCs give management accountants access to a wide range of information. and there is also an internet connection. and be clear about the decisions that must be taken. 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.4.7 is designed to remind you of the important ‘bits’.2 Uses and Limitations of PCs What is a PC? You will already have learnt about PCs in your Stage 1 studies. Assuming that the PC is networked and the company’s central file servers are available. External information on competitors via competitors’ homepages or via specialist data collection agencies who have already obtained the Internet data.4. managers can post questions into the 342 . the information that can be retrieved from the system is almost endless. Some of the sources that may be useful to the accountant include: • • Internal data on production. financial accounts. The aim should be to produce a report from which the manager can quickly assimilate information. Element 10.
it can take a considerable time to check through all the detail and determine whether amendments are needed.g. simply because the system can do this. For reference material A large amount of reference material for accounting is now available on CD ROM. This is where an efficient and effective MIS can literally save the accountant hours of work each day.system. add their own comments. e. The cost of implementing such a system may well be insignificant when savings in management time are taken into account. so that the accountant can receive exception reports rather than detailed analysis.7.: • • • 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. Information overload One of the main problems with computerized systems is the temptation to produce more and more information. and raise further queries. The management accountant ensures that all computer applications are adequately checked before they are used in ‘live’ situations. There is therefore a need for an efficient data filtering system. The management accountant may find that the reports he has to review increase in both number and detail. 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. and contain a lot of supporting data. Other managers can then review these questions.5. 343 .5 COMPUTERISED MANUFACTURING SYSTEM Element 10. Element 10. If part of the information looks incorrect.1 Computerised manufacturing systems are systems which involves the use of computers directly to control production equipment and indirectly to support manufacturing operators. The use of computerised manufacturing systems has resulted in firms producing high-quality and low-priced goods.3).
2 Computerised manufacturing systems encompass the whole production process from materials resource planning (see 9. To this effect.Element 10. advanced manufacturing technology (AMT) has emerged. This in effect reduces throughput times.5. Using CAD new products can be designed on computer screen. 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.6 COMPUTER-INTEGRATED MANUFACTURE (CIM) 344 . Indirect CAM applications include MRP.4 COMPUTER –AIDED DESIGN (CAD) Computer-aided design (CAD) provides interactive graphics that assist in development of product and service designs.5. set-up costs and a reduction in work in progress.5.6 COMPUTER-AIDED MANFACTURING (CAM) Computer-aided manufacturing (CAM) is the use of computers to control the physical production process. there is the need to be more innovative and flexible in their manufacturing methods. Direct CAM applications link a computer directly to production equipment in order to monitor and control the actual production process. flexible manufacturing systems. It also connects to database to be recalled and developed easily.5. quality control and inventory control systems. Element 10. scheduling is made easier. Automated guided vehicles (AGV) are computerised materials handling machines can replace the traditional conveyor belts. One of the new tyes of manufacturing systems known as group technology ( or repetitive manufacturing) has emerged.5.3 In order for firms to compete effectively. including other innovative computer equipment. Element 10. An example is a computerised numerical control (CNC) machine which reads instructions for making parts. Element 10. Advanced Manufacturing Technology (AMT) Advanced Manufacturing Technology (AMT) encompasses automatic production technology.8) up the point when finished products are due for distribution. computer-aided design and manufacturing. Element 10. 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. In addition.
and further. together with its concomitant software. It incorporates design activities such as CAD. to enable the transformation of a product idea into a delivered product at a minimum time and cost. quality and time. in the case of the latest generation of software. a simple product is easier to manufacture.Computer-integrated manufacture (CIM) aims to integrate information for manufacturing and external activities. FMS and inventory control.and its cost structure – in most of the major manufacturing companies of the world. The use of a database to match. Element 10. will enable the company to minimize stockholdings by reducing the total number of product parts required. where possible. and instantly appreciate the effect of these changes on the finished product. the requirements of the new design with existing product parts. and aided manufacturers’ ability to compete on the dimensions of cost. which. At the initial design stage of a product. Thus CAD allows quality and cost reduction to be built at the design stage of a product. the considerable space occupied by the drawing tables of a typical design office has been replaced by computer terminals. thereby minimizing the possibility of production errors. Simple designs lead to a more reliable product. but also to manipulate the drawing. and view the design from any desired angle (and even. comes under the collective heading of computer aided manufacturing (CAM). The advanced graphics facilities of the typical CAD program enable the draughtsman not only to move parts around the design. Significant elements of CAM are computer numerical control (CNC) and robotics. facilitating a change in configuration in a matter of seconds via the keyboard. rework the drawing –has shortened dramatically as a result of the software currently available. more importantly. CNC machines are programmable machines or bank of machines. changes to existing 345 . Computer –aided design (CAD) allows huge numbers of alternative configurations to be analysed both for cost and simplicity. ‘walk through’ it).7 Computer Aided manufacturing The manufacturing process is carried out by a range of machinery. such as order product entry and accounting. and the time taken to work through an initial engineering drawing – and. Element 10. CAM and operational activities such as MRP.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.
These changes have reduced the changeovers time in moving from one process to another. Toyota. the cost advantage of mass production would disappear completely. and NTED to ‘no touch exchange of dies’. 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. who tire and are error prone. even a batch size of one unit. and to deliver stock to the required place within the production facility. and dramatically reduced set –up times. Nissan. unlike human operators. so that the production schedule can be driven more and more by customer requirements. repetitive manufacturing functions.7. parts or tools through a variety of simple tasks without human intervention. CNC therefore offers great flexibility. Element 10. CNC machines are able to repeat the same operations continuously in an absolutely identical manner. such as spot welding or painting. the benefits in terms of market flexibility of the ability to produce cost-efficient small batches are obvious. 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. However. and the time taken to develop a product and bring it to the market. Furthermore. to a completely consistent level of accuracy and machine tolerance. Again it is a Japanese company. They tend to be used to perform relatively straightforward. Two brief examples will serve to illustrate the dramatic impact of CAM on manufacturing flexibility. the car producer. and any batch size would be optimal in production cost terms. The holy grail of CAM in this respect is a set –up time of zero – in such a situation. the implicational important benefits. 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. OTED refers to ‘one touch exchange of dies. In the case of the latter.1 Computer – Integrated Manufacturing 346 .configurations and new configurations are easily accommodated. which provides one of the best examples of the advances made in this area. the possibility of producing smaller and smaller batch sizes at an economic cost also increases. As the speed of production changeover increases under CAM. The field of robotics applied to the manufacturing situation has produced a series of reprogramable multi-function devices designed to move materials. rather than the constraints of the traditional manufacturing process.
is not yet with us (and indeed. and robots to transfer the parts from belt to tool and vice verse. State and explain some of the general qualities of good information. to enable them to make timely and effective decisions for planning and controlling the activities for which they are responsible. Baggage weight is 347 . all operating under synchronized computer control to ensure continuous work flow. check in procedures monitor which passengers have turned up and whether any ‘stand-by’ seats are available. which brings together all the elements of automated manufacturing and quality control into one coherent system.of AMT in the production environment is computer –integrated manufacturing (CIM). with the computer ensuring minimum changeover time and maximum built in quality. conveyor belts that transfer the individual part being worked upon from machine tool to machine. would not necessarily be universally welcomed). what is meant by a management information system (MIS). In a FMS. a computer program coordinates a cell of CNC machines. Example: 1. handling mechanisms and robots in such a way as to synchronise workflow. with a relevant example. controlled entirely by means of a computer network with no human interference. 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). At an operational level. with its overtones of ‘ghost factories’. A somewhat watered-down version of CIM is already with us. An example of a management information system can be seen in an airline business. Explain. in the form of a flexible manufacturing system (FMS). The title aptly describes the systems strength – its flexibility to produce a range of different components automatically. 2. An FMS produces a range of machines tools.The ultimate extension – and logical long-term direction. The FMS cell is often referred to as an ‘island of automation’. The FMS also includes a facility for monitoring the quality of the parts being produced. The ‘ideal’ technological world of CIM – the fully – automated production facility. however.
passenger destiny on each route will be monitored and analyzed. Completeness. details of all possible options should be available for consideration. At tactical level. Describe four common corporate administrative functions switched to computerization. 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. Decision support system The first computer systems were designed to produce cost effective replacement for routine electrical tasks. More recently developments are concerned with the provision of better information for management. Relevance Only that information which is useful to the decision making process should be included. If a decision is being made.accommodated and external weather data will be used to plot the most economical and safest route. This may help the airline to decide whether to form alliances with other carriers (As recently delta 40 with virgin). 3. Significance To ensure that the information is meaningful to the person using it should concentrate on the prompts. The main qualities regarded of good information are: 1. 2. In addition the outline will attempt to find out what other flights passengers may have used for part of their journeys. it is unlikely to be useful. This will allow few structures and aircraft types to be determined. 348 . which are needed by the decision-maker. i. At strategic level overall profitability on each route will be monitored. 4. Timelines Unless the information is up to date and produced in time for the decision to be made. 5.
different strategies 349 . The management information system normally uses the principal of exception reporting to highlight aspects of co-operational information. delivery. the criteria used to select information should be constantly reviewed. Sales accounting: Including input. and in its environment. 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. analysis etc. or could be under the control of individual managers.ii. note invoice. Solution: Among the most commonly administrative functions are: computerized corporate 1. who can request for the reports that they think necessary. the calculation of depreciation charge and the production of lists. production transaction recording and the production transaction recording and the production of regular analysis of sales and debtors. Fixed asset accounting including the maintenance of registers. In order to keep up with changing circumstances within the organizations. 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. 3. Payroll production: Taking hours worked as input and producing pay slips coin analysis or bank transfer details and costing information. The most common example is the spreadsheet. which is important for planning purposes. 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. 4. 2. the recording of purchases and sales. 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. although more specialize financial modeling software also exist. 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. Comment on management information and decision support systems in improving the efficiency of the management process.
Element10. It can and should lead to fundamental changes in the way organizations function. Computerised and automated storage and retrieval system for raw material and parts.8 Element 10. The system aims to use computer control to produce a variety of output quickly.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.can be tried and their results examined and compared to aid in determining the optimum decisions. Computerised material handling system iv. 350 . Computerised-integrated manufacturing (CIM) ii.engineering involves focusing attention inwards to consider how business processes can be redesigned or re. A just-in-time (JIT) system iii. 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.2 FMS are most suited to batch production systems which have intermediate amounts of variety and volume of outputs.3 The main features of an FMS include: i.9 Business Process Re-Engineering (BPR) Business process re.8. Element 10. Element 10. Element 10.8.8.
services and speed.engineering involves the re.Business process re. Often several jobs are combined into one Workers often make decisions The steps in the process are performed in a logical order. reliability. cost efficiency and effectiveness. vii. ii. Key Term A process is a collection of activities that takes one or more kinds of inputs and creates output.9. indicating that business process reengineering is somewhat akin to zero base budgeting. vi. One manager provides a single point of contact.ENGINEERED PROCESS HAS CERTAIN CHARACTERISTICS. (b) Dramatic means that BPR should achieve ‘quantum leaps in performance’ not just marginal. 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. The advantages of centralized and decentralized operations are combined. b) Personnel who use the output from a process should perform the process. A RE. Element 10.arranging of the business in order to deliver quality. Business process re. incremental improvements. quality.engineering (BPR) is the fundamental rethinking and radical redesign of business processes to achieve dramatic improvements in critical contemporary measures of performance. 351 . iv.1 Principles of Business Process Re-Engineering (BPR) a) Process should be designed to achieve a desired outcome rather than focusing on existing tasks. such as cost. Checks and controls may be reduced and quality built in. v. i. iii. Key words in the phrase (a) Fundamental and radical. Work is performed where it makes most sense. (c) Process.
CHARACTERISTICS OF ORGANIZATIONS WHICH HAVE ADOPTED BUSINESS PROCESS RE. (b) Job change. They are empowered to make decisions relevant to the process. Element 10.2 Implications of BPR – Management Accounting System ASPECT (i) Performance measurement around IMPLICATION Performance measure must be built 352 . f) Doers should be allowed to be self-managing. which produces the information. (c) People’s roles change. g) Information should be captured once at source. which replace the old functional structure. d) Geographically dispersed resources should be treated as if they are centralized.c) Information processing should be included in the work.NGINEERING (a) Work units change from functional departments to process teams. e) Parallel activities should be linked rather than integrated. Process teams create ‘value’ which is measurable. (e) Organization structures change from hierarchical to flat (team) structures.9.it should tie in with job enlargement and job enrichment. (d) Performance measures concentrate on results rather than activities.
inspecting materials and paying suppliers. 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. which incorporates scheduling production. this may affect the design of responsibility centres.processes not departments. (v) Variances EXAMPLE OF BUSINESS PROCESS RE. Consider a materials handling process. New variances may have to be developed in addition to the existing traditional variances. (b) Elimination of non-value added activities. 353 . storing materials. processing purchase order. (ii) Reporting (iii) Activity (iv) Structure There is a need to identify where value is being added.ENGINEERING (a) A move from a traditional functional plant layout to a just in time cellular product layout is a simple example.