Accounting DIY Examples

FINANCIAL ACCOUNTING FOR MANAGERS
DIY EXAMPLES
PART 1- MODULES 1-7
JAMIE BERRY
jamie@berrypatchdevelopment.com
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MODULE 2: THE INCOME STATEMENT
DIY Example
XY Construction plc is in the process of building a bridge linking two Scottish Hebridean islands.
The job will take two years. At the end of the first year, which is the same date as the company’s
financial year-end, one-third of the contract of €12 million had been completed, although the
client had paid only one-sixth, namely €2 million. The company expected to make €3 million
profit on the bridge, and at the end of Year 1 costs were being incurred on a predictably even
basis. How many sales and profits should XY recognise at the end of Year 1?
Observe that:
1. One-third of the contract, namely €4 million, could be deemed to be sales in Year 1
provided this proportion could be confirmed by an independent surveyor.
2. Total costs anticipated by the company are €9 million; one-third of €9 million is €3
million.
Comment and Solution

Provided the payment to account of €2 million is not indicative of a difficulty in paying on the
part of the client, it would be acceptable to record sales as €4 million and cost of sales as €3
million at the end of Year 1; profit €1 million. Because only €2 million had been received by the
year-end, the balance of sales revenue, i.e. €2 million, would be recorded in XY’s balance sheet
as a debtor. In Year 2, XY’s sales would be €8 million and cost of sales €6 million, giving a Year 2
profit of €2 million.
Using the time-of-production method of measuring accomplishment allows XY plc to record profit
in both years of the contract rather than to wait for its completion in Year 2.
Although readers need not concern themselves with the various rules accountants have
developed to implement the production basis for measuring accomplishment, it is important to
appreciate that it is applied only when the company is producing to an order, not in the hope of
getting one.
DIY Example
A manufacturer of sports bags supplies major retail sports outlets. The relevant figures for
production and sales for one year are as follows:
Orders received during the year by the manufacturer’s sales force 15 000
Sports bags manufactured 10 000
Sports bags shipped and invoiced 12 000
Faulty bags returned and not yet repaired 1 000

How many sports bags were sold during the year?
2
1. Orders are buoyant but have not yet been satisfied. Although the figure of 15 000 can
be used to measure the sales force’s performance during the year, and to gauge the
backlog build-up between orders and production output, it cannot be used to measure
accomplishment. Don’t forget, the customers could walk away at any time (change of
mind or change of supplier) if their orders are not satisfied on time, and we don’t know
what the loss would be.
2. The figure of 10 000 bags manufactured again fails to portray economic reality, which
is that 2000 bags have been drawn from inventory (last year’s unsold production) to
satisfy the orders actually shipped.
3. Therefore the best measure of accomplishment for the year is 12 000. But because
1000 bags have been returned as faulty – the retail sports outlets will not have paid
the manufacturer for these goods – the figure of 12 000 must be reduced by 1000.
Sales will be recorded for the year at 11 000 bags, each valued at the selling price
charged by the manufacturer to the retailer. The 1000 faulty bags will be returned to
inventory or written off.
DIY Example: Rosie’s Recruitment Consultants

Now that we’ve introduced the concepts of depreciation and bad debts, here is another DIY
example to test your understanding of how these adjustments are worked through the
accounting equation. This time the context is the service sector.
1. Rosie decided to leave the international recruitment consultants she had been with for
a number of years and start up her own practice. She re-mortgaged her home and
raised €250 000 in cash to put into the practice as equity. Some friends contributed
€50 000 in cash as loan capital, requiring 4 per cent interest per annum.
2. During the year Rosie’s specialist recruitment consultants (salaries noted below)
worked on 46 successful assignments, earning, on average, €20 000 each. By year-
end, 39 clients had paid their bills.
3. Rosie signed a three-year lease for a suite of offices in a chic part of town. The annual
rental was €175 000.
4. She purchased office equipment and computers for €30 000 in cash and specialised
software that tracks potential organisations and potential individuals. This cost
€120 000, although Rosie was given it by the supplier on approval for the first year.
Only if she agreed to keep the software after one year’s approval period would she owe
the money to the supplier. By the end of the year she planned to keep it.
5. Three experienced consultants were hired for a total salary cost of €624 000. This was
paid in cash, monthly in arrears. Each month, salaries were allocated to a work-in-
progress account in the balance sheet and only transferred as a charge to owners’
equity when an assignment was completed successfully. At the end of the year, it is
estimated that 11 months’ salaries have been recovered by completed assignments;
the remainder is deemed to be work-in-progress.
6. A receptionist was hired at a salary of €60 000 per year.
7. General office overheads were €4000 per month.
8. Rosie decided to depreciate her office equipment and computers, at 25 per cent per
annum.
9. She also decided to make a provision for doubtful debts amounting to 5 per cent of
accounts receivable at year-end.
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10. At the end of the year Rosie paid the interest on her borrowings.
11. Rosie knew it would take several weeks into the next year to agree the taxes on
income she will be required to pay; she therefore decided to provide for tax at 40 per
cent on profits.
Equipment
Work-in- Owner’s Taxes Current
Action and Debtors Cash Debt
progress equity payable liabilities
computers
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11
Totals 0 0 0 0 0 0 0 0
Total assets: 0 Total equity and liabilities: 0
Worked Solution
Equipment
Work-in- Owner’s Taxes Current
Action and Debtors Cash Debt
progress equity payable liabilities
computers
1 250 000 250 000
50 000 50 000
2 140 000 780 000 920 000
– –
3
175 000 175 000
4 30 000 –30 000
120 000 120 000
–
5 624 000
624 000
–
–572 000
572 000
4
6 –60 000 –60 000
7 –48 000 –48 000
8 –7 500 –7 500
9 –7 000 –7 000
10 –2 000 –2 000
11 –19 400 19 400
Totals 142 500 52 000 133 000 141 000 279 100 50 000 19 400 120 000
Total equity and

Total assets: 468 500 468 500
liabilities:
Income statement for the year to 31 December 20x1
€ €
Revenues €920 000
Cost of revenues 572 000
Gross profit €348 000
Rental of offices €175 000
Receptionist 60 000
General overhead 48 000
Interest on loans 2 000
Depreciation 7 500
Provision for bad debts 7 000 299 500
Profit before tax €48 500
Provision for tax 19 400
Profit after tax €29 100
Balance sheet for the year to 31 December 20x1
€ €
Non-current assets
Equipment and computers €30 000
Less depreciation 7 500 €22 500
Software 120 000
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€142 500
Current assets
Work-in-progress €52 000
Debtors less provision for bad debts 133 000
Cash 141 000 326 000
Total assets €468 500
Current liabilities
Payables to software seller €120 000
Taxes payable 19 400 €139 400
Loans 50 000
Owner’s equity
Original capital €250 000
Retained profit for year 29 100 279 100
Total liabilities and equity €468 500
Cash flow statement for the year to 31 December 20x1
€ €
Cash from operations
Profit after tax €29 100
Add back items not affecting cash:
Taxes payable €19 400
Provision for bad debts 7 000 33 900
Changes in working capital:
Increase in work-in-progress –€52 000
Increase in receivables –140 000
Increase in creditors 120 000 –72 000
–€9 000
Cash from investments
Asset purchases –150 000
Cash from financing
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Capital injection by owner €250 000
Debt introduced by friends 50 000 300 000
Change in cash balance (€0–141 000) €141 000
MODULE 3: THE BALANCE SHEET
DIY Example
A new business purchases light fittings for its offices and warehouse for €1000. During the first
year it pays €100 to the local power utility company for energy consumed by these fittings. What
are the accounting treatments for these transactions?

1. The €100 energy consumption is an expense of the business; it has no future benefit
and is therefore written off as an expense in the income statement.
2. The light fittings have been purchased with a view to providing future benefit to the
business for a number of years. The cost of €1000 is therefore deemed to be an asset
and would be placed in the balance sheet as a non-current asset.
3. But assets do not last forever. Their loss in value, or lower future benefit, must be
recognised each year. Therefore a portion of the €1000 original cost must be written
off as an expense, called depreciation, in the income statement. This expense is in
addition to the energy costs paid for annually to power the light fittings.
DIY Example
A retail grocery company purchased an urban site on which it proposes to locate a new
supermarket within the next six months. The land cost €3.5 million, legal and survey fees cost
€250 000 and a promotional programme announcing the impending development, involving
billboards, handbills and local media advertising, will cost another €250 000.
How much of this expenditure should be treated as a non-current asset?

 The land is clearly a non-current asset.
 The legal and survey fees are an essential expenditure in acquiring land and should be
capitalised as part of land.
 The promotional expenditure should be written off to the income statement. Although it is
clear that the expenditure has been undertaken as a result of the acquisition of the
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new site, nevertheless the future benefits that may flow from the campaign are very
uncertain. This uncertainty leads accountants to recognise the cost as an expense in
the income statement immediately.
The accounting profession is unhappy with the cost convention in relation to some assets,
including land. The acquisition cost bears little resemblance to the current market value, which is
usually much greater than cost. Two alternative treatments are possible:
1. to continue to record acquisition cost and to publish market value in parenthesis; or

2. to revalue the land from time to time, amend the book value (acquisition cost less
depreciation to date) accordingly and add/subtract the incremental change to the
shareholders’ equity in the company. Although this increase/decrease in value is a
gain/loss in wealth, it should not be recorded as profit/loss, which is reserved, as far as
possible, for operating transactions.
MODULE 4: THE CASH FLOW STATEMENT
DIY Example
This example is concerned with the financial affairs of a sole trader, not a company. The layout
of the income statement and balance sheet is slightly different from the example of the company
above, but you should set out your cash flow statement in exactly the same way.
Income statement for year ended 30 June 20x2
€ €
Gross profit 44 439
Add: Profit on sale of plant and equipment 855
45 294
Less: Expenses
Maintenance 2 385
Depreciation on plant and equipment 1 635
Wages and salaries 13 185
Bad debts 510
Increase in provision for bad debts 180
General expenses 3 216 21 111
Net profit 24 183
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Balance sheets for years ended 30 June 20x1 and 30 June 20x2
30 June 20x1 30 June 20x2
€ € € €
Non-current assets
Plant & equipment at cost 16 800 10 800
Less: Depreciation 6 240 10 560 4 470 6 330
Current assets
Inventories 15 443 25 725
Debtors less provision for bad debts 7 785 5 070
Bank and cash 2 352 3 173
25 580 33 968
Current liabilities
Creditors 4 155 4 380
Net current assets 21 425 29 588
Total assets less current liabilities 31 985 35 918
Long-term loan 9 000 7 500
22 985 28 418
Owner’s equity
Opening balance 18 365 22 985
Net profit for year 21 120 24 183
39 485 47 168
Less: Drawings 16 500 22 985 18 750 28 418
Notes
1. Debtors less provision for bad debts:
o Year to 30 June 20x1 €8235 − Provision €450 = €7785
o Year to 30 June 20x2 €5700 − Provision €630 = €5070
2. The item of plant and equipment was sold for €3450 during the year to 30 June 20x2.
Your Solution
Make sure you don’t look at the worked solution before attempting to complete the pro forma
solution.
Cash from operations € €
9
Net profit
Add back items that do not affect cash:
Depreciation
Increase in bad debt provision
Profit on sale of equipment
Increase in inventories
Decrease in debtors
Increase in creditors
Sale of plant and equipment
Cash from financing
Loans repaid
Drawings
Change (increase) in cash during the year
Worked Solution
Cash from operations € €
Net profit 24 183
Add back items that do not affect cash:
Increase in bad debt provision 180
Profit on sale of equipment –855 960
25 143
Increase in inventories –10 282
Decrease in debtors 2 535
Increase in creditors 225 7 522
17 621
Sale of plant and equipment 3 450
Cash from financing
10
Loans repaid –1 500
Drawings –18 750 –20 250
Change (increase) in cash during the year 821

Notes and Comments on the DIY Example

The approach taken in this example is identical to the one taken in the cash flow statement of
the company. As in the company example, note the cash-greedy build-up of inventories, but, in
contrast to the company, the sole proprietor has released cash by decreasing his debtors
outstanding and increasing the balance he owes to his creditors. As before, and for the same
reasons, the movement in debtors is taken from the gross balances outstanding.
The proprietor’s drawings need some explanation. These represent the amount of cash taken out
of the business for personal use. The more the proprietor takes out, the less cash is available for
business purposes. It is important that the attention of the proprietor is drawn to this impact
through the cash flow statement. The corporate equivalent of this item would be equity dividends
paid to shareholders. Note that the proprietor is withdrawing more cash than operating activities
are producing, an imbalance that cannot continue indefinitely.
Reconciliation of numbers used in cash flow:
 Remember, when a business sells an asset, the cash is received (€3450) in cash from
investments. The profit booked on sale is good news for the owner but by itself is not
cash.
 Inventories: closing balance €25 725 less opening balance €15 443 = −€10 282.
 Debtors (using before provision amounts): closing €5700 less opening €8235 = €2535.
 Creditors: closing €4380 less opening €4155 = €225.
Readers may care to reconcile the opening and closing balances of the non-current assets
accounts in the balance sheet. There was only one movement on non-current assets during the
year – a sale of plant and equipment. We can assume, therefore, that the original purchase price
of this equipment was €6000 (€16 800 less €10 800). If the firm sold the piece for €3450 and
made a profit of €855, we can calculate that the written-down value of the piece of equipment
sold was €2595 (€3450 less €855). Therefore, the depreciation already charged on the plant at
date of sale was €3405 (€6000 less €2595):
Cost Depreciation
Opening balance (30.6.x1) €16 800 €6 240
Plant sold 6 000 3 405
€2 835
Charged for year 1 635
Closing balance (30.6.x2) €10 800 €4 470
MODULE 5: THE FRAMEWORK FOR FINANCIAL

REPORTING
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DIY Example
A consumer household-goods company with an excellent record of innovation has developed and
marketed a voice-activated vacuum cleaner. Its profile of expenditure was as follows:
1. Research phase: understanding the transferability of the engineering principles from

manually operated models; gaining knowledge of the microelectronics embedded in
speech recognition. Cost €5 million from 1 January 20x1 to 31 December 20x3.
2. Development phase: writing the software to control the product; embedding translation
capabilities into the software to cater for four of the world’s most used languages;
develop and test prototypes in several countries. Cost €12 million from 1 July 20x3 to
31 December 20x4.
3. Production phase: after launch on 1 January 20x5 updating the product to address
customer feedback, to manage the data coming back from the market and to train its
field service engineers. Cost €3 million from 1 January 20x5, and ongoing.
How much of this expenditure can be capitalised as an intangible asset?

1. The initial €5 million spent on research must be written off in the three years’ income
statements in which it was incurred.
2. Assuming the full €12 million qualifies for capitalising as an intangible asset, IAS 38
forbids a company from capitalising expenditure in the development phase that
overlaps the research phase because the two activities cannot properly be
distinguished. The amount of development expenditure that overlaps the research
phase is treated as part of research and written off as incurred. Assuming that the
vacuum cleaner producer spends the amounts indicated above evenly throughout the
years involved, it would write off €4 million of development expenditure in the year to
31 December 20x3 and capitalise the following €8 million in the year to 31 December
20x4.
3. The production phase expenditure – even though some of it may add new insights into
the product and markets – will not qualify as either research or development and must
therefore be written off. Indeed, even if the company could claim that it was still
engaged in development after the product was launched, the capitalisation process
stops at launch. So note that, out of a total outlay of €20 million in bringing the
product to market, only €8 million can be regarded as an intangible asset.
DIY Example
A company sells goods with a warranty under which customers are covered for cost of repairs of
any manufacturing defects that become apparent within the first six months after purchase. If
minor defects were detected in all products sold, repair costs of €1 million would result. If major
defects were detected in all products sold, repair costs of €4 million would result. The company’s
past experience and future expectations indicate that, for the coming year, 75 per cent of the
goods sold will have no defects, 20 per cent of the goods sold will have minor defects and 5 per
cent will have major defects. How should the warranty provision be the balance sheet at year-
end?

The expected value of the cost of repairs is:
(75% of nil) + (20% of €1 million) + (5% of €4 million) = €400 000
This amount would be charged to the income statement as an expense of the year, but because
it had not been paid by year-end the amount would be set up as a liability in the balance sheet.
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DIY Example
Would you set up a provision, a contingent liability or neither for the following events?
 As part of a major acquisition, Retail Group X has acquired a number of high-street

stores, which the competition authorities require it to dispose of. By the end of the
year, no disposals have taken place but the best estimate of their sale value is
€35 million. As part of the acquisition these stores cost the group €45 million to buy.
 An airline is required by law to subject its passenger-carrying engines to a major strip-
down and servicing every four years. Each engine strip-down and servicing costs
€2 million.
 A pharmaceutical company whose drug designed to alleviate medical condition A is
claimed by some consumers to have provoked medical condition B, which has, in an
extreme case, caused death. It is disputing liability for any alleged damage caused,
and its lawyers advise that it is probable that it won’t be found liable.

 A provision of €10 million should be set up in the accounts of Retail Group X as this is an
obligation that the company has in relation to past events and it is relatively easy to
quantify the loss that will be incurred.
 No provision or contingency need be set up. While it may be an overall legal requirement
on every airline to overhaul its engines, this airline could avoid the commitment by
selling the planes or the engines before four years elapse.
 No provision is required because, at the balance sheet date, the pharma company has no
obligation to settle. It is likely that it would record a contingent liability note in the
notes to the accounts unless the lawyers are adamant that the probability of paying
out cash in the future in settlement is extremely remote.
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11.2 The Dilemma of the Denominator
Example
Assume that the absorption costing method is applied to the fountain pen business described
above. Planned production was 5000, but actual production was 5500 due to a desire to keep
operatives busy throughout the year. The excess will be sold next year. Throughout the year
each pen will be allocated €20 fixed production costs as before, but in the light of actual
production level achieved this should have been €100 000/5500 = €18.182.
Each unit has over-absorbed €1.818, a total of €10 000 (5500 × €1.818) for the year. This sum
has been caused by the wrong denominator volume being selected and must be corrected at the
end of the year, otherwise the production would be seen to be absorbing more costs than had
been incurred.
Absorption income statement € €
Sales 5000 pens @ €100 500 000
Less: Full cost of sales 5000 @ €70 350 000
Denominator volume variance (10 000)
Other expenses 80 000 70 000
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80 000
Note that the denominator volume variance helps to reduce production costs in the income
statement that otherwise would be overstated by the over-absorption of fixed production costs.
The variable (or direct) costing income statement would be identical to the one already
produced. We set out the two methods side by side.
Absorption costing € € Variable costing € €
Sales 500 000 Sales 500 000
Less: Variable cost of

Less: Full cost of sales 350 000 250 000
sales
Gross profit 150 000 Contribution margin 250 000
Denominator volume Fixed production
(10 000
variance expenses 100 000
)
Other expenses 80 000 70 000 Other expenses 80 000 180 000
Net profit 80 000 Net profit 70 000

The two systems of accounting are reflecting identical transactions for a year, but two different
profit figures are determined. Why the difference of €10 000? Note that 500 pens have been
produced but not sold; these pens have been placed in inventory, each one valued, under
absorption costing, at €70, i.e. €35 000. Under variable costing the same 500 pens are valued at
€50 each, i.e. €25 000. Therefore under absorption costing an extra €10 000 of cost has been
held back in inventory for release in the next period. The difference in bottom-line profit has
nothing to do with the denominator volume variance; it is directly related to the change in
inventory levels.
We move our example one year on and keep all facts and figures the same except that
production is reduced to 4600 pens even though the estimate at the beginning of the year was
again 5000. For 20x3 the income statement would be:
Absorption costing € € Variable costing € €
Sales 500 000 Sales 500 000
Less: Variable cost of

Less: Full cost of sales 350 000 250 000
sales
Gross profit 150 000 Contribution margin 250 000
Denominator volume Fixed production
variance 8 000 expenses 100 000
Other expenses 80 000 88 000 Other expenses 80 000 180 000
Net profit 62 000 Net profit 70 000

There is a difference of €8000 in bottom-line profit and a denominator volume variance of
€8000, but this time variable costing profits are higher. Again the two figures are unrelated.
Denominator volume variance is caused by the fact that the 4600 pens manufactured absorbed only
€92 000 fixed production expenses while €100 000 was incurred in 20x3. The shortfall must be
written off at the end of the year.
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Difference in profits is due to the value of inventory needed to satisfy 20x3’s sales. Production was
4600; sales were 5000; therefore 400 pens were taken from inventory. Under absorption costing
these units emerge from inventory at €70 instead of €50 under variable costing. Profits therefore
fall by 400 × €20 (the difference in inventory value per pen which itself is the fixed production
costs per pen).
To summarise:
 A denominator volume variance arises when actual production ≠ planned production.
 Bottom-line profit difference arises when sales ≠ actual production.
In order to reinforce the principles set out above, we recommend that readers complete the
following table, which works a number of permutations on the above data. We supply the
numbers for three columns and the full solution is provided at the end of the text of this module.
The commentary that follows the table is based on a correct completion of the table!
As a reminder, the data are as follows.
Cost of fountain pen €
Direct material 20
Direct labour 30
Fixed production costs* 20
Full cost 70
* Based on budgeted total fixed production costs of €100 000 and a budgeted level
of production of 5000 pens per annum.
Ignore ‘other expenses’ for the purposes of completing this table.
Absorption and variable costing compared
Column 1 2 3 4 5 6 7 8 9
Sales (000s) 5 4 6 4 3 5 7 4 8
Production (000s) 5 4 6 5 4 6 5 3 7
Sales revenue 500 500 400
Absorption costing
Cost of sales 350 – – – – 350 – 280 –
Gross profit 150 150 120
Volume variance – – – – – 20 – (40) –
Net profit 150 170 80
Variable costing
Cost of sales 250 – – – – 250 – 200 –
Contribution margin 250 250 200
Fixed costs 100 – – – – 100 – 100 –
Net profit 150 150 100
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Production = Sales Production > Sales Production < Sales
Check your solution with the table that appears after the summary to this module.
11.13 Closing down a Unit

Example
The Clydeside Anchor Co. specialises in forging anchors and manufacturing ancillary equipment
for oil rigs. A world glut of oil has caused a slowing-down of oil rig building, which has had an
immediate effect on all product lines of Clydeside. Particularly badly hit has been its chain
division. The directors are considering whether this division, consisting of one factory, should be
closed until the glut has eased.
A flexible budget has been compiled.
Production capacity Fixed costs
(Fixed costs + Variable costs)
40% 60% 80% 100% Closedown Normal
Direct material 240 000 360 000 480 000 640 000 – –
Direct labour 200 000 300 000 400 000 500 000 – –
Factory overheads 200 000 220 000 240 000 260 000 120 000 160 000
Administration 130 000 140 000 150 000 160 000 80 000 120 000
Selling and distribution 140 000 160 000 180 000 200 000 80 000 120 000
Miscellaneous 30 000 40 000 50 000 60 000 20 000 20 000
940 000 1 220 000 1 500 000 1 820 000 300 000 420 000

Some additional information is available.
1. Present sales of 50 per cent capacity are estimated at €600 000 per annum.
2. Estimated costs of closing down are €90 000. In addition, maintenance of plant and
machinery is expected to amount to €16 000 per annum.
3. Costs of reopening after being closed down would be approximately €40 000 for
overhauling machines and getting ready and €28 000 for training of key personnel.
4. Economic indicators suggest that sales should take an upward swing to around 70 per
cent capacity at prices that would reflect a dramatic uplift, producing revenue of
€2 000 000 in 12 months’ time.
The management of Clydeside must select the relevant costs and other information that will
allow it to reach a decision on whether to keep the chain division open during the recession or to
shut down and wait for the economic upturn.
It can be seen that there are only three relevant levels of operations: zero per cent (i.e. close
down and reopen), 50 per cent (present level), and 70 per cent (post-recession level). Revenues
and costs should therefore be set out for all three levels.
Level of operations in €
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0% 50% 70%
Sales – €600 000 €2 000 000
Marginal costs – 660 000 940 000
Contribution – €(60 000) €1 060 000
Fixed costs €300 000 420 000 420 000
Special costs 174 000 €474 000
Gain/(Loss) (€474 000) €(480 000) €640 000

Calculations
Marginal costs are calculated by: (a) interpolation, i.e. for 50 per cent, the mid-point between 40
per cent and 60 per cent; for 70 per cent, the mid-point between 60 per cent and 80 per cent;
then (b) deducting the fixed components of factory overheads, administration, selling and
distribution and miscellaneous from the total figures to determine the marginal cost component.
Details are set out below.
Marginal costs of operations @50% @70%
Mid-point of flexible budget:
@ 50% €1 220 000 – €940 000 €1 080 000
@ 70% €1 500 000 – €1 220 000 €1 360 000
Deduct fixed costs 420 000 420 000
€660 000 €940 000
The special costs of closing down and reopening are as follows.
€90 000 + €16 000 + €40 000 + €28 000 = €174 000
Conclusions
By focusing on contribution (sales revenue less variable (marginal) costs incurred in generating
sales revenue), management can gain a useful picture of those costs that vary with volume
changes, and those that do not. Note, however, that just because fixed costs do not change,
management cannot afford to ignore them altogether; they must be deducted from contribution
to produce a realistic gain or loss figure.
The danger facing management in the table of figures given to them initially is that it might have
ignored the fixed component of the factory overheads, administration, selling and distribution,
and miscellaneous costs, and treated all costs as variable costs. This would have produced totally
different figures and would have led to wrong decisions being taken. It is fundamental that
variable costs are kept separate from fixed costs in decisions concerning the suspension of
activities.
It is far from certain whether, on the basis of the figures of gains and losses above, management
would decide to shut down the chain division during the oil glut. If the division is kept open at a
50 per cent level of operations, the division would incur only €6000 greater loss, a cost that the
management of Clydeside may well be prepared to incur to ensure harmonious industrial
relations.
11.14 The Special Sales Order

Example
18
The Highland Shortbread Company was experiencing a decline in sales due to the economic
recession in the home market; consumers were buying only basic provisions for their families
and were consequently giving the supermarkets’ confectionery displays a wide berth. An increase
in sugar prices had also caused a fairly steep increase in the retail price of shortbread.
A British national airline approached the company with an offer to buy a special order of
shortbread to enable them to serve passengers with a complimentary cup of coffee and finger of
shortbread on overseas flights terminating in Scotland. If the experiment met with customer
approval, the airline would seek to enter into a long-term contract with the Highland Shortbread
Company. The special order was for 1000 cartons of shortbread at €10 per carton.
The sales director believed the price of €10 per carton was lower than even the cost of
manufacturing one carton of shortbread, far less the cost, taking into account the cost of selling
and distribution. To confirm his belief he called for a copy of the previous year’s income
statement, which revealed the following picture:
Sales €150 000
Manufacturing cost of goods sold 120 000
Gross margin € 30 000
Selling and administrative expenses 20 000
Operating income € 10 000

This income statement was based on sales of 10 000 cartons of shortbread. Hence the cost to
manufacture one carton was €12 (€120 000/10 000). The sales director therefore recommended
an outright rejection: ‘There is no way we can subsidise the airline on these figures; their offer of
€10 does not even cover the cost of manufacturing the stuff. We would lose €2000 on the deal.
If they want our shortbread, they can jolly well pay €15 per carton like everyone else.’
The managing director was not happy with the sales director’s conclusions. Even without
studying the figures, he would have been happy to accept the special order because of the
prospect of concluding a long-term contract with the airline. (Indeed, as he privately admitted,
he would have given the airline the shortbread at no charge just to get the long-term business!)
However, he called for a detailed breakdown of the income statement. This is what he found:
Sales €150 000
Variable expenses
Manufacturing €90 000
Selling and administration 5 000 95 000
Contribution margin €55 000
Fixed expenses
Manufacturing 30 000
Selling and administration 15 000 45 000
Operating income €10 000

The variable cost of manufacturing one carton of shortbread was, in fact, only €9
(€90 000/10 000). Therefore, since there would be no selling costs associated with the special
order (as the airline’s catering division had undertaken to wrap the fingers of shortbread), each
carton sold for €10 would provide a contribution to fixed costs of €1. The special order would
19
therefore provide a total contribution of €1000. Since the fixed costs of €45 000 would not be
affected by the airline’s order, the company’s overall profit would be increased by €1000. The
relevant costs in this example are only the variable costs.
Note, however, that the ‘full cost’ income statement used by the sales director is useful for long-
term pricing purposes. The company must recover all of its costs, fixed and variable, eventually,
and must price accordingly. Hence the full cost, namely the absorption cost (€120 000/10 000
cartons = €12 per carton), plus the selling and administration costs (€20 000/10 000 cartons =
€2 per carton, i.e. €14 per carton) must be at least equalled by the sales price if the company is
to survive. But management should not confuse costs required for long-term pricing strategies
with those required to deliberate on special orders.
11.15 Should we Process Further?

Example
Extending the wholesale butchery business example used earlier in this module, imagine that a
food scientist, newly employed by the company, has suggested that the cheap cuts of shin beef
and leg beef should be processed into both dog food and pie meat. He claims that both products
would sell well, much better than selling the unprocessed cuts of meat. The processing costs and
separate sales prices are given in Figure 11.1.
Figure 11.1 Processing costs and selling prices
Accountants deliberate long and hard about how to allocate the processing costs of €1000. As we
saw in Module 10 two methods are usually used. The weight method would allocate one-third of
€1000 to the pie meat and two-thirds to the dog meat. The sales value technique would allocate
five-thirteenths of €1000 to the pie meat and eight-thirteenths to the dog meat. This allocation
procedure would be necessary for calculating inventory costs and therefore profit for the
accounting period. Depending on the method chosen, different answers are produced.
Weight Sales value
Dog
Pie meat Pie meat Dog meat
meat
Sales €500 €800 €500 €800
Allocation of joint cost 333 667 385 615
Profit €167 €133 €115 €185
€300 €300
Plenty of arguments can be found to support either method, and in the long term, it is argued, it
does not matter which method is chosen because the profit is the same in both cases. As the
following example will show, this is misleading.
Consider a further proposal by the food scientist that the company should make the pies instead
of selling the pie meat to an outside pie maker. His proposal envisages 1-kg plate pies, requiring
€220 of pastry and further labour, which would sell for €0.60 each. If these new facts are fed
into the income statements above, the following picture emerges.
Plate Pies
By weight By sales value
Sales @ €0.60 €600 €600
Joint costs €333 €385
Additional costs 220 553 220 605
20
Profit/(Loss) €47 €(5)
This outcome is plainly ridiculous given that the same pie meat is to be processed in an identical
manner. The only approach to the problem of further processing is the incremental approach
where one compares the additional or incremental revenue from sales with the incremental costs
involved.
Incremental revenue 1000 pies @ €0.10 €100
Incremental costs 220
Net loss (€120)

The decision would be taken, therefore, to sell the pie meat in its bulk form to the outside pie
maker. No technique for allocating joint product costs is applicable to management decisions of
whether a product should be sold at the split-off point or processed further. Such decisions can
be aided only by incremental or relevant cost analysis.
Learning Summary
When management is faced with choosing one course of action from a variety of possibilities,
which includes the possibility of doing nothing, the relevant costs and revenues are the
differential costs, the costs and revenues that will change if the alternative course of action is
selected. The most attractive alternative will be the one with the lowest differential costs. But
cost calculations alone rarely provide the answer to any management problem; qualitative
factors often play the decisive role.
Solution to table on absorption and variable costing in Section 11.2
Column 1 2 3 4 5 6 7 8 9
Sales (000s) 5 4 6 4 3 5 7 4 8
Production (000s) 5 4 6 5 4 6 5 3 7
Sales revenue 500 400 600 400 300 500 700 400 800
Absorption costing
Cost of sales 350 280 420 280 210 350 490 280 560
Gross profit 150 120 180 120 90 150 210 120 240
Volume variance – (20) 20 – (20) 20 – (40) 40
Net profit 150 100 200 120 70 170 210 80 280
Variable costing
Cost of sales 250 200 300 200 150 250 350 200 400
Contribution margin 250 200 300 200 150 250 350 200 400
Fixed costs 100 100 100 100 100 100 100 100 100
Net profit 150 100 200 100 50 150 250 100 300
Production = Production >

Production < Sales
Sales Sales
21
Do you really understand what’s going on in the above table? You should be able to explain why denominator
volume variances are accounted for, why they are positive or negative, and why there are
differences in bottom-line profits.
First, take the first three columns, in which the sales units are exactly matched by production units.In such scenarios
inventory levels are not disturbed, and so the two accounting systems come up with the same
profit, i.e. fixed costs can’t be ‘parked’ or drawn from inventory (a balance sheet valuation),
thereby affecting the income statement. The denominator volume variances are caused by actual
production levels differing from the planned production level of 5000 pens. In column 2 the
difference is a shortfall of 1000 units; this leads to a further income statement charge of €20 000
to make sure all €100 000 fixed production expenses are accounted for. In column 3 the reverse
is the case; the overshoot in production is 1000 units, leading to the risk that €120 000 has been
absorbed by units produced unless a credit of €20 000 is put through the income statement.
Next, take the middle three columns, in which production is consistently higher than sales. The difference in
bottom-line profits (absorption profits being higher than variable profits) is caused entirely by
the fixed costs per unit under absorption costing attaching themselves to the units being ‘parked’
in the balance sheet. The more costs put in there, the fewer will be charged in the income
statement this year. Note that the pattern of denominator volume variances is exactly the same
as in the first three columns because the production levels in columns 4, 5 and 6 are identical to
those in columns 1, 2 and 3.
Last, take columns 7, 8 and 9. Here the pattern changes to production units being lower than sales,
leading to inventory being drawn on. Take column 7: the difference in profits of €40 000 is due to
the 2000 units drawn from inventory coming out of the balance sheet valuation at €20 more
costly each under absorption costing, this sum being the fixed costs parked in the balance sheet
in an earlier period. Notice that there is no denominator volume variance in this column because
actual production was 5000, the same as planned production. Now take column 9, in which there
is a denominator volume variance of €40 000 positive and a difference in bottom-line profits of
€20 000 in favour of variable costing. The denominator volume variance is caused by producing
2000 more units than planned, thereby triggering a credit of €40 000 in the income statement to
reflect the over-absorption of fixed production costs (20 000 × €20). The bottom-line difference
is caused by the company needing to draw on 1000 units to satisfy sales (sales of 8000 units
less actual production of 7000); each unit taken from inventory is €20 more costly under
absorption costing than under variable costing.
12.3 Why Budgeting Gets a Bad Name
DIY Example: The Cash Budget

Probably the kind of budget we are most familiar with is a cash budget, something each of us
does each month – perhaps only on the back of an envelope – to ensure domestic solvency: cash
in less cash out. Here’s a budget for a mid-range hotel group.
The group has 400 bedrooms in Northern Europe, where the heaviest occupancy is in June, July
and August. Management expects the occupancy rates in these months to be 90 per cent; in
March, April and May it expects 80 per cent; and for the remainder of the year 65 per cent.
The average room rental is €150 per night. Much of the group’s business is the corporate
market, where 10 per cent is paid as a deposit the month before the stay, 60 per cent is
received in the month of the stay, and 30 per cent is collected the month after.
The group’s costs are mostly fixed: salaries total €800 000 per month; depreciation totals
€390 000 per month; other fixed operating costs total €175 000. Variable costs are only €20 per
22
occupied night. Variable costs are paid in the month they are incurred, depreciation is recorded
at the end of each quarter, and other fixed operating costs are paid as incurred. Bank interest on
monies borrowed to purchase new properties and refurbish existing ones is €700 000 per year,
paid in two equal instalments in March and September. Refurbishment took place in January, one
of the quieter months, and is planned to cost €600 000 in cash, to be spread equally over
January and February. Although the bad debts record of the group has been excellent, it is policy
to provide for 1 per cent of total annual revenues at the end of December.
You are required to prepare a monthly cash budget for this hotel group for the year, January to
December. For simplicity, assume 30 days in each month. You may find using the accompanying
spreadsheet eases your calculations.
Advice to students: given the different timings of cash received from revenues booked, it is sensible
to start by calculating the revenues that will be booked month by month in the income statement
and then work out how much of this amount will be received as a deposit the previous month,
how much this month and how much next month.
Hotel group’s cash budget (€millions)
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Total
Revenues (as
recorded in
1.170 1.170 1.440 1.440 1.440 1.620 1.620 1.620 1.170 1.170 1.170 1.170 16.20
income
statement)
Cash collections
therefrom:
Previous
month’s sales 0
(30%)
This month’s
0
sales (60%)
Next month’s
0
sales (10%)
Total
0 0 0 0 0 0 0 0 0 0 0 0 0
collections
Cash outlays:
Variable costs 0
Fixed salaries 0
Fixed
operating 0
costs
Refurbishment
0
costs
Interest
0
payments
23
Total cash
0 0 0 0 0 0 0 0 0 0 0 0 0
outlays
Net cash flows 0 0 0 0 0 0 0 0 0 0 0 0 0
Worked Solution
Hotel group’s cash budget (€millions)
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Tota
Revenues (as
recorded in
1.170 1.170 1.440 1.440 1.440 1.620 1.620 1.620 1.170 1.170 1.170 1.170 16.200
income
statement)
Cash collections
therefrom:
Previous
month’s sales 0.351 0.351 0.351 0.432 0.432 0.432 0.486 0.486 0.486 0.351 0.351 0.351 4.860
(30%)
This month’s
0.702 0.702 0.864 0.864 0.864 0.972 0.972 0.972 0.702 0.702 0.702 0.702 9.720
sales (60%)
Next month’s
0.117 0.144 0.144 0.144 0.162 0.162 0.162 0.117 0.117 0.117 10.117 0.117 1.620
sales (10%)
Total
1.170 1.197 1.359 1.440 1.458 1.566 1.620 1.575 1.305 1.170 1.170 1.170 16.200
collections
Cash outlays:
Variable costs 0.156 0.156 0.192 0.192 0.192 0.216 0.216 0.216 0.156 0.156 0.156 0.156 2.160
Fixed salaries 0.800 0.800 0.800 0.800 0.800 0.800 0.800 0.800 0.800 0.800 0.800 0.800 9.600
Fixed
operating 0.175 0.175 0.175 0.175 0.175 0.175 0.175 0.175 0.175 0.175 0.175 0.175 2.100
costs
Refurbishment
0.300 0.300 0.600
costs
Interest
0.350 0.350 0.700
payments
Total cash
1.431 1.431 1.517 1.167 1.167 1.191 1.191 1.191 1.481 1.131 1.131 1.131 15.160
outlays
– – – –
Net cash flows 0.273 0.291 0.375 0.429 0.384 0.039 0.039 0.039 1.040
0.261 0.234 0.158 0.176
24
Workings for June (as an example)
400 rooms per night × 30 nights per month × 90% occupancy ×
Revenues
€150 per night = €1 620 000
Previous month’s
30% × €1 440 000 sales in May = €432 000
sales (30%)
This month’s sales

60% × €1 620 000 sales in June = €972 000
(60%)
Next month’s sales

10% × €1 620 000 sales in July = €162 000
(60%)
Beware the two elephant traps that were set: depreciation and provisions do not affect cash in or out of
the company. These are income statement entries.
Interpretation: the Total column shows that the hotel group will be cash positive over the year but
that significant shortfalls are going to emerge in four months. Unless the group has sufficient
cash reserves, the CFO will need to arrange bridging facilities with the group’s bank in these
months. See Figure 12.1 for a graphical representation.
Figure 12.1 Net cash flows for the hotel group
12.4 Budgeting in Action: The Go-Straight Trolley Company

Instead of setting out the steps for the preparation of a budget in a sequential and theoretical
manner removed from any commercial context, let us use the case of a successful company that
has completed its financial year to 31 March 20x3 and is planning for the next 12 months.
Clearly the exercise would commence several months before the year-end, but so that we can
use figures from the end-of-year balance sheet for the next year’s budget we imagine that what
follows transpires over the space of a few days at the end of March 20x3.
The Go-Straight Trolley Company manufactures and sells a much sought-after product, a
supermarket trolley that can be pushed by the customer without effort and in a straight line. The
special wheels and bearings that permit such easy motion are the result of careful research over
the past three years of the company’s trading history. The management of the company is keen
to grow slowly without overreaching the company’s resources; the managers have read too
many stories of similar-sized companies expanding too quickly with borrowed money only to go
into liquidation when the market turned against them, and they are determined to avoid such a
fate.
At the outset of the budget process the chief executive would issue general guidelines to the
principal heads of departments. In a larger organisation a more formal budget committee may be
convened, chaired by the chief executive, to mastermind the whole process. Such a committee
would comprise the key players in the organisation, the production director, sales director,
finance director and personnel director, together with their respective chief operating officers.
The financial controller would probably be appointed budget officer, whose task it would be to drive
the exercise forward to final approval by the budget committee on behalf of the board of
directors.
The guidelines would contain a commentary by the chief executive on the year just finishing,
reasons for the superior (or inferior) performance against budget, his view on the potential for
growth, a report on the expected product launches in the forthcoming year, the relevant
economic indicators to the business (in the case of the Go-Straight Trolley Company these would
include indicators of consumer spending, rate of construction of supermarkets and shopping
centres and family expenditure patterns). But most significant of all would be the chief
executive’s view on growth. He or she is the best-placed person to weigh the potential for growth
25
in output against the company’s ability to support this growth from its own resources or from
borrowings. It would be futile for lower-level managers to budget for a much higher rate of
expansion than the chief executive considered prudent. An assessment of expected earnings per
share may also be given.
The chief executive’s report may look like this:
Memorandum from chief executive
To all Functional Managers: Budget Preparation for year to 31 March 20x4

As a background to the forthcoming budget process I should like to sketch in a few indicators
that I should like you all to keep in mind in the next few weeks as we work towards closure on
the budget for year ending 31.3.04.
The final unaudited figures for the year ended 31.3.03 will reveal a healthy profit and a strong
balance sheet, which is reproduced below:
Go-Straight Trolley Company: Balance sheet as at 31 March 20x3
Non-current assets € €
Plant and equipment 75 000
Less: Accumulated depreciation 25 000 50 000
Current assets
Inventories:
Metal: 600 metres @ €1 600
Finished trolleys: 480 @ €55 26 400
27 000
Debtors 7 500
Cash 17 500 52 000
Total assets 102 000
Owner’s equity
Share capital 30 000
Retained earnings 69 500 99 500
Creditors 2 500
102 000
This performance is a tribute to our carefully targeted growth in specialised sectors of the
market, together with the ongoing good work of our R&D engineers in keeping our product
technologically superior.
But there is still a reluctance on the part of many supermarket chains to buy the product due to
its relatively high cost of €65. This is some 30 per cent higher than our nearest competitor, and
although they recognise the advantages of trolleys that move without steering effort they
nevertheless are prepared to purchase inferior products. Eventually consumer pressure will make
26
them change over to our product, but I do not want us to contemplate a drop in either price or
quality. Quite the reverse: I want us to consider a modest increase in price in order that we
retain the image of quality and service that sets us apart from the competition.
I know many of you want to expand production so that we can attack other markets such as
airports, coach stations and rail stations. We have commissioned a marketing study on such
possibilities, which will not be available before September. I therefore want you to consider only
a modest increase in units sold this year. It is far better that we build a secure platform for
growth, both in terms of market share and financial soundness, rather than charge ahead for
new sales just to improve our turnover ratios.
The economic indicators that I have studied indicate a slowing down in consumer spending next
year. The continued high interest rates are having an effect on disposable incomes; therefore we
can expect fewer orders from the electrical stores and furnishing outlets. A modest growth in
household spending stores (grocery stores and the like) can be expected. And the much
heralded developments in UK megacentres for shopping have not yet materialised. We can
expect some movement in 20x5.
One final word: I have detected some resentment among some of you about the high level of
spending on R&D engineering. Those who harbour such feelings should remember that our
company’s history is based on a unique design of wheel and bearing. Had it not been for our
early investment in R&D, we would not be working for this company today. We must keep
ourselves technologically in the forefront. The chief engineer is currently working on a device
that will save the customer and check-out operator from having to unload and reload the trolley
at the check-out. The designs are still in their infancy, but we anticipate significant demand for
this if we can be first to market. But this design and prototype stage costs money. So I want to
allocate 3 per cent of sales revenue to R&D. Those of you who grumble at such expense should
contemplate the future for this company when our competitors catch up with us and we have
nothing new to offer the market.
Please let the financial controller have your first thoughts on next year’s budget by the end of
the week. We can then have a meeting to iron out different views and go firm on the numbers
by 1 April.
The sales team would be called together by the sales director to plan their numbers for the
following year:
 Sales director: ‘You have all received a copy of the boss’s guidelines. I’m a little
disappointed at the request to raise prices because even at €65 some of our principal
customers were complaining.’
 Sales district manager: ‘But not all of them! Qualityrama expressed surprise to me that in
their latest order, trolleys were invoiced at €65. As we had held our prices stable for
nine months they were expecting – and I suggest would not have complained at – a
price rise. €70 per trolley would be the figure I think could be accepted by our
customers. This would be a 7.6 per cent rise against Bonecrusher’s 12 per cent rise
and Wibbly Wobbly’s 10 per cent rise.’
 Sales director: ‘OK, €70 seems reasonable, but we may have to be prepared to discount this
to some of our larger customers who show reluctance. But I don’t think we should flag
this up in the budget because it is not going to be a big amount. Now what about the
quarter-by-quarter sales profile?’
 Sales executive: ‘I have done some preliminary figures at €70 per trolley, which have been
based on this year’s profile, and I’ve allowed for a 5 per cent increase in sales units
due to the impact of our new advertising material. Here are my numbers:
Quarter Estimated sales units
27
1. to 30 June 20x3 2 500
2. to 30 September 20x3 2 800
3. to 31 December 20x3 1 700
4. to 31 March 20x4 3 000
5. to 30 June 20x4 3 000

 ‘The anticipated drop in units in Quarter 3 follows the trend in previous years. As our
customers are stocking up for Christmas their cash flow prevents any significant outlay
on such items as trolleys. But after Christmas we can expect a replacement
programme to be embarked on and for this to be carried forward, together with new
business, into the first quarter of next year.’
 Advertising manager: ‘I really think we want to step up the spend on advertising this year. I
agree that the current campaign is having an effect, although we were taking a risk in
portraying a housewife being pinned against a freezer by one of our competitor’s
trolleys. I should like to argue for similar funding to R&D; say, a 5 per cent spend
linked to sales revenue in addition to the €3000 per quarter fixed salaries.’
The production team would have a similar meeting:
 Production director: ‘Given the chief executive’s view on not wanting to ramp up production
next year in advance of sales I suspect we should examine the sales team’s view on
units to be sold and cost our production activity on these.’
 Production controller: ‘A word of caution here. Our suppliers are still fairly erratic despite our
best efforts to signal demand to them in plenty of time. I should like to argue for
having raw material inventories on hand equivalent to 10 per cent of next quarter’s
requirement. And another thing, despite these apparently well thought out sales
figures, the sales people are always wanting rush orders put through because they
have messed up their forecasting. From the experience of this year I think we should
have finished goods inventory equal to 20 per cent of expected sales next quarter.’
 Purchasing officer: ‘The price of wire metal will go up midway through the year but I’ve
negotiated a 12-month purchasing bulk discount with our principal suppliers. So the
cost per metre will be €1 on average for next year.’
 Production controller: ‘The cost per hour for our skilled labour will increase marginally, but I
anticipate this will be offset by increased speed of operations due to the new
equipment we purchased last year. All in all, the variable costs and fixed costs should
look like this:
per trolley
Direct material €
10 metres of wire metal @ €1 per metre 10
Direct labour
1.5 hours @ €20 per hour 30
Variable overhead (absorbed by direct labour hours)
1.5 hours @ €10 per hour 15
Variable cost per trolley 55
Fixed manufacturing overhead €2 400 per quarter
(includes depreciation on plant and equipment €1 500 per quarter)
Consumables €2 000 per quarter
28
The finance and administration team would also discuss the forthcoming year:
 Financial controller: ‘We must attempt to tighten up on debtors’ collection next year. We
should plan for 70 per cent of sales being collected in the quarter of sales with the
balance being collected in the next quarter. Yet again we had no bad debts this year
due to the quality customers our sales team is targeting, so we should not predict any
for next year.’
 Financial director: ‘We should be careful, then, about not paying our creditors too quickly. I
suggest that raw material purchases should be paid for 60 per cent in the quarter of
purchase and 40 per cent in the next quarter. All other selling, advertising and
administration costs, including administrative salaries of €2000, will be paid for, as
usual, in the quarter they are incurred.’
These reports and supporting schedules would be submitted to the financial controller, whose
task it would be to draw up the company’s master budget for the year to 31 March 20x4. This
master budget would comprise the build-up schedules from production and sales and culminate
in the budgeted cash flow statement for the year together with the budgeted income statement
and balance sheet.
[Readers should carefully follow each of the schedules set out in the next few pages, tracing the
numbers back into the data given above and following the calculations given below each
schedule. This is not only an exercise in budgeting but also allows readers to test themselves on
the fundamentals of financial accounting again.]
The fulcrum on which the entire budget is balanced is the sales budget. Without sales the
company’s other functions are superfluous. It is important not only to track the profile of sales
but to convert these sales, which would appear in the financial accounts, into cash receipts.
12.4.1 Sales Budget for Year Ending 31 March 20x4 (Schedule 1)

(a) Q1 Q2 Q3 Q4 Total
Turnover in units 2 500 2 800 1 700 3 000 10 000
Price × €70 × €70 × €70 × €70 × €70
Recorded sales €175 000 €196 000 €119 000 €210 000 €700 000

(b) Cash inflow from sales
Last quarter’s collection €7 500 €52 500 €58 800 €35 700 €154 500
This quarter’s collection 122 500 137 200 83 300 147 000 490 000
€130 000 €189 700 €142 100 €182 700 €644 500

The upper schedule sets out the sales turnover figures as they would appear in the financial
accounts of the Go-Straight Trolley Company. Readers will remember from their study of the first
seven modules in this text that accountants are prepared to record sales even though the cash
has not been received provided all effort has been completed and that there is no evidence to
suggest that customers will default. Therefore in the budgeted income statement for the year to
31 March 20x4 the turnover will be given as €700 000.
But the cash flow impact of these sales must be assessed, for cash is more important to a
business day by day than is a profit figure. Take Quarter 1’s sales of €175 000; 70 per cent of
this amount, €122 500, will be collected in Quarter 1, and the balance, €52 500, next quarter.
Quarter 4’s sales will be collected: €147 000 in Quarter 4 and €63 000 next year, which will be
the debtors figure for the budgeted balance sheet at 31 March 20x4. By the same token the
opening debtors figure in the balance sheet at 31 March 20x3, €7500, will be collected in Quarter
1 together with the €122 500 from Quarter 1’s sales.
29
12.4.2 Production Budget for Year Ending 31 March 20x4 (Schedule 2)
Q1 Q2 Q3 Q4 Total
Sales units 2 500 2 800 1 700 3 000 10 000
Add: Planned units
in closing inventory 560 340 600 600 600
3 060 3 140 2 300 3 600 10 600
Less: Units
in opening inventory 480 560 340 600 480
Units required 2 580 2 580 1 960 3 000 10 120

The sales targets of Schedule 1 would then be converted into production numbers, which would
take account of the production controller’s observation that inventory of finished units should be
carried to meet the uncertainties of demand. To the planned sales units is added the requirement
to hold 20 per cent of next quarter’s sales. For Quarter 1 this amounts to 20 per cent × Q2’s
2800 units = 560; therefore in Q1 3060 units should be manufactured. But the opening balance
of inventory of finished units would reduce this requirement. We learn from the opening balance
sheet that 480 units were in inventory at the beginning of Q1; therefore only 2580 units need be
made in Q1.
The production unit’s budget must now be converted into a cost budget, comprising direct
materials, direct labour and manufacturing overhead. There are three components to the direct
materials budget: the consumption of metal, the purchases required to meet the production
schedule, and the payment to creditors profile.
12.4.3 Direct Materials Budget for Year Ending 31 March 20x4 (Schedule 3)

(a) Consumption of direct material
Q1 Q2 Q3 Q4 Total
Units required 2 580 2 580 1 960 3 000 10 120
Direct materials
metres of metal × 10 × 10 × 10 × 10 × 10
Metres of metal required 25 800 25 800 19 600 30 000 101 200
Cost per metre €1 €1 €1 €1 €1
Total cost of metal
consumed €25 800 €25 800 €19 600 €30 000 €101 200

This schedule is self-explanatory, being based on the production schedule just calculated. This
profile would allow for a rise in price to be recorded midway through the budget year if
necessary.
(b) Purchases budget
Direct materials required
(in metres) 25 800 25 800 19 600 30 000 101 200
Add: Planned closing
30
inventory 2 580 1 960 3 000 3 000 3 000
28 380 27 760 22 600 33 000 104 200
Less: Planned opening
inventory 600 2 580 1 960 3 000 600
Metres required 27 780 25 180 20 640 30 000 103 600
Cost per metre × €1 × €1 × €1 × €1 × €1
Total cost of metal
purchased €27 780 €25 180 €20 640 €30 000 €103 600

The starting point for the purchases budget is the number of metres of metal required to
manufacture the units to be made (from Schedule 2). But again the production controller’s
wishes for inventory must be built into the figures; this time 10 per cent of the next quarter’s
production must be added to this quarter’s requirements, but the opening inventory balance
reduces the metres of metal that need to be purchased. And again Q1’s opening inventory figure
of 600 metres is taken from the closing balance sheet as at 31 March 20x3. Note that we have
assumed that the desired closing direct material inventory for Q4 is planned to be the same as at
the end of Q3.
(c) Cash outflow for purchases

Q1 Q2 Q3 Q4 Total
Creditors end 20x3 € 2 500 € 2 500
Purchases: Q1 16 668 €11 112 27 780
Q2 15 108 €10 072 25 180
Q3 12 384 € 8 256 20 640
Q4 18 000 18 000
€19 168 €26 220 €22 456 €26 256 €94 100

Readers will notice that the total column in this schedule bears a resemblance to the quarter-by-
quarter profile in the previous one. The cash outflow schedule splits up the purchase budget into
the quarters that match the cash payments. In Q1, for example, the company will pay
outstanding creditors from the end of last year, €2500 (see closing balance sheet), and 60 per
cent of €27 780 purchases made in Q1. The balance of Q1’s purchases, €11 112, will be paid for
in Q2. Q4’s purchases of €30 000 will be paid for: €18 000 in Q4 and €12 000 in next year’s Q1.
Therefore creditors at the end of the year will be €12 000.
The direct labour budget presents no difficulties because labour cannot be ‘inventoried’. Schedule
4 is based on the production units calculated in Schedule 2.
12.4.4 Direct Labour Budget for Year Ending 31 March 20x4 (Schedule 4)

Q1 Q2 Q3 Q4 Total
Units required 2 580 2 580 1 960 3 000 10 120
Hours per unit × 1.5 × 1.5 × 1.5 × 1.5 × 1.5
Total no. of labour hours 3 870 3 870 2 940 4 500 15 180
Cost per hour × €20 × €20 × €20 × €20 × €20
31
Total cost of direct labour €77 400 €77 400 €58 800 €90 000 €303 600
The actual cash outlays for labour will match exactly the calculations of this schedule.
The manufacturing overhead budget is equally straightforward except that (a) variable and fixed
overhead are kept separate, and (b) the depreciation element of the fixed manufacturing
overhead is deducted from the total manufacturing overhead to give a final figure that
represents the quarterly outflow of cash for overheads.
12.4.5 Manufacturing Overhead Budget for Year Ending 31 March 20x4 (Schedule 5)

Q1 Q2 Q3 Q4 Total
Total cost of direct labour €77 400 €77 400 €58 800 €90 000 €303 600
Absorption rate for
variable overhead €0.50 €0.50 €0.50 €0.50 €0.50
Variable overhead €38 700 €38 700 €29 400 €45 000 €151 800
Fixed overhead 2 400 2 400 2 400 2 400 9 600
Total manufacturing
overhead €41 100 €41 100 €31 800 €47 400 €161 400
Less: Depreciation
(non-cash) 1 500 1 500 1 500 1 500 6 000
€39 600 €39 600 €30 300 €45 900 €155 400

Management would expect a detailed analysis of variable and fixed overhead and would not
accept the formula of 50 per cent of direct labour cost (or €10 per direct labour hour) without
such an analysis.
12.4.6 Selling and Administrative Budget for Year Ending 31 March 20x4 (Schedule 6)
Q1 Q2 Q3 Q4 Total
Total sales €175 000 €196 000 €119 000 €210 000 €700 000
Selling and admin. variable
Advertising 5% €8 750 €9 800 €5 950 €10 500 €35 000
R&D 3% 5 250 5 880 3 570 6 300 21 000
Fixed
Salaries 2 000 2 000 2 000 2 000 8 000
Consumables 2 000 2 000 2 000 2 000 8 000
Advertising 3 000 3 000 3 000 3 000 12 000
Total selling and admin. €21 000 €22 680 €16 520 €23 800 €84 000

The variable component of this budget for Advertising and R&D is based on the quarterly sales
revenue figure as entered in the financial accounts (not as received in the form of cash). The
fixed elements of overhead are all traceable in the text of the case, and the entire budget is paid
quarter by quarter as it is incurred.
32
Now that all the detailed schedules are compiled, the financial controller would pull the various
components together in the form of a cash budget and budgeted income statement and balance
sheet. But first he would monitor the quarterly closing balances for inventory, both raw materials
and finished goods.
12.4.7 Closing Inventory Budget for Year Ending 31 March 20x4 (Schedule 7)

Q1 Q2 Q3 Q4 Total
Direct materials
Units × €1 per unit €2 580 €1 960 €3 000 €3 000 €3 000
Finished goods
Units 560 340 600 600 600
× variable cost × €55 × €55 × €55 × €55 × €55
€30 800 €18 700 €33 000 €33 000 €33 000

Readers will remember that businesses carry inventory in their balance sheets ‘at the lower of
cost or market value’. The costs inserted in Schedule 7 imply that the market values for both
metal and finished trolleys are greater than the cost. Should the position reverse, the company
would be required to write off the difference immediately to the income statement. Notice also
that the finished goods inventory valuation is €55 each; that is, the variable cost of manufacture.
If the company were to switch to full absorption costing, a portion of the fixed manufacturing
overhead would be included in inventory but the selling and administrative budget would
continue to be written off in full in the income statement.
12.4.8 Cash Budget for Year Ending 31 March 20x4 (Schedule 8)

Q1 Q2 Q3 Q4 Total
Opening balance €17 500 €(9 668) €14 132 €28 156 €17 500
Cash from sales 130 000 189 700 142 100 182 700 644 500
Cash inflows €147 500 €180 032 €156 232 €210 856 €662 000
Direct materials €19 168 €26 220 €22 456 €26 256 €94 100
Direct labour 77 400 77 400 58 800 90 000 303 600
Manufacturing overhead 39 600 39 600 30 300 45 900 155 400
Selling and
administrative 21 000 22 680 16 520 23 800 84 000
€157 168 €165 900 €128 076 €185 956 €637 100
Closing balance €(9 668) €14 132 €28 156 €24 900 €24 900

The cash budget comprises those elements from the previous schedules that have an impact on
the inflows and outflows of cash over the next 12 months. The closing cash balance of €17 500 in
the balance sheet as at 31 March 20x3 forms the opening figure in the above schedule. To this
sum is added the cash received from sales in Q1 (see Schedule 1(b)). Outlays of cash comprise
direct materials (Schedule 3(c)), direct labour (Schedule 4), manufacturing overhead (Schedule
5) and selling and general overhead (Schedule 6). The closing cash balance in Quarter 1, a
deficit of €9668, forms the opening balance in Quarter 2, and so on. The closing balance in Q4,
€24 900, forms the cash balance in the budgeted balance sheet as at 31 March 20x4.
33
The managerial significance of Schedule 8 should not be ignored. Apart from the deficit balance
in Quarter 1, caused by a low debtors figure to collect from the end of 20x3 (see Schedule 1(b)),
which would provoke the financial director to arrange bridging facilities with the company’s
bankers, the build-up of cash needs to be addressed. Cash is not an asset that works well for a
business. True it earns interest, and it provides a cushion against which the company can fall in
times of hardship, but it is not productive in the real meaning of the word. Could the company
contemplate a better strategic use of this amount? Investment in more R&D? Purchase of more
capacity? Acquisition of another business – a competitor or supplier? This kind of analysis would
only be undertaken when it became obvious that a cash mountain was building up.
The construction of the budgeted income statement and balance sheet follows the principles
enunciated in Module 1 to Module 6. The layout of these statements should now be familiar to our
readers:
12.4.9 Budgeted Income Statement for Year Ending 31 March 20x4 (Schedule 9)
Q1 Q2 Q3 Q4 Total
Sales units 2 500 2 800 1 700 3 000 10 000
€ € € € €
Sales revenue 175 000 196 000 119 000 210 000 700 000
Variable cost of
sales manufacturing (137 500) (154 000) (93 500) (165 000) (550 000)
Selling and
administrative (14 000) (15 680) (9 520) (16 800) (56 000)
Contribution margin 23 500 26 320 15 980 28 200 94 000
Fixed costs of
manufacturing (2 400) (2 400) (2 400) (2 400) (9 600)
Selling and
administrative (7 000) (7 000) (7 000) (7 000) (28 000)
Profit before tax 14 100 16 920 6 580 18 800 56 400

12.4.10 Budgeted Balance Sheet for Year Ending 31 March 20x4 (Schedule 10)
Q1 Q2 Q3 Q4 Total
Plant and equipment 75 000 75 000 75 000 75 000 75 000
Accumulated
(26 500) (28 000) (29 500) (31 000) (31 000)
depreciation
Inventory:
Raw materials 2 580 1 960 3 000 3 000 3 000
Finished goods 30 800 18 700 33 000 33 000 33 000
Debtors 52 500 58 800 35 700 63 000 63 000
Cash (9 668) 14 132 28 156 24 900 24 900
Total assets 124 712 140 592 145 356 167 900 167 900
34
Ordinary shares 30 000 30 000 30 000 30 000 30 000
Retained earnings 83 600 100 520 107 100 125 900 125 900
Creditors 11 112 10 072 8 256 12 000 12 000
Total equity and

124 712 140 592 145 356 167 900 167 900
liabilities
The sales revenue line in the income statement is taken from Schedule 1(a). Variable cost of
sales is the product of the quarterly sales units and €55 per unit. Variable selling and
administrative costs are derived from Schedule 6 (the addition of variable advertising costs and
variable R&D costs). Contribution margin is the result of subtracting all variable costs from sales
revenue. Fixed costs come from two schedules: manufacturing from Schedule 5 (€2400 per
quarter includes €1500 depreciation) and selling and administration from Schedule 6. For the
purposes of illustration we have ignored the impact of taxation. In reality tax would be calculated
for 20x3/x4 on the final budgeted profit of €56 400 but not paid until the next year.
The items in the balance sheet need little explanation:
1. Accumulated depreciation’s opening balance of €25 000 is added to at the rate of

€1500 per quarter.
2. Debtors are drawn from Schedule 1(b); the sums of money collected in the next
quarter are the debtors for the current quarter. Therefore the figure of €52 500
collected in cash in Q2 serves as the debtors figure for Q1. The paragraphs below
Schedule 1 explain where the closing debtors figure in Q4 comes from.
3. Retained earnings are old profits not distributed. The opening figure for 20x3/x4 is
€69 500; to this is added the profit figure from the income statement quarter by
quarter.
4. Creditors, like debtors, is the figure paid out in the subsequent quarter; hence from
Schedule 3(c) we see that €11 112 paid in Q2 refers to purchases made in Q1. This
then is the creditors figure at the end of Q1.
The schedules, particularly Schedules 8, 9 and 10, would form the basis of a review by the chief
executive and a meeting with his functional managers. Adjustments may be called for and the
numbers reworked (a computer-based spreadsheet makes such amendments an easy process).
Eventually, agreement would be reached and the budget distributed to the various departmental
heads and other officials. Quarter-by-quarter actual performance would be measured against
budget and reasons for variances sought. This will be the subject of Module 13.
12.5 Discretionary Expenditure and Zero-Base Budgeting
Example
Consider the following packages that have been presented to the top management of an
electronics company whose discretionary budget has been set at €250 000.
(Read the table below from the bottom to the top):
Research and development Legal services
Package 4 of 4. One lawyer to

handle legal aspects
surrounding intellectual
€40 000
property rights, copyrights
and trademarks.
Further computer facilities.
Package 3 of 3. Two software scientists €70 000
35
to design and write customised operating
systems; to work with electronic
engineers in design of new products.
Package 3 of 4. Two further

lawyers to handle all contracts
€80 000
and property transactions.
Database purchase in support.
Package 2 of 4. Fully qualified

lawyer to handle routine
contractual problems. External €30 000
consultant still to handle
complex contracts.
Package 2 of 3. Two electronic engineers

€70 000
to design and build own prototypes.
Package 1 of 4. Partially
Package 1 of 3. Development engineer to
qualified assistant to liaise
test bought-in components and
€40 000 with external €10 000
prototypes, altering the designs as
consultant lawyers who
required.
undertake all legal work.
€180 00
€160 000
0
Management of this electronics company is faced with packages totalling €340 000 to be fitted
into a budget of €250 000. On the basis that the budget limit is indeed the maximum amount,
possible packages worth €90 000 will have to be dropped. A likely scenario may be as follows:
1. Each Package 1 would be accepted as representing the absolute minimum activity

required to keep alive R&D and legal services. (It is possible, however, that
management could decide to close down either function and allow the other function to
go ahead with all packages.) Amount used €50 000.
2. Legal Package 2 provides a minimum level of in-house legal service that can be built
on in future years. It also represents less than half the commitment of R&D Package 2.
Equally it could be argued that a buoyant R&D activity represents the lifeblood of the
company in the future; there is little point in keeping an in-house legal service to
negotiate contracts if there are no new products to sell and no contracts to negotiate!
Both Level 2 packages could be accepted; amounts used so far – €150 000.
3. The next layer of ranking becomes more difficult and depends on a top-level strategic
view of the future of the company. Can a company afford to turn its back on
technology at the expense of legal services? But can the company be assured of
receiving value for money for the €70 000 to be spent on the proposed software
initiative? If a positive decision is made for the R&D Level 3 package, can management
be certain that no further support costs will emerge before the next budget round? A
likely outcome could be agreement on R&D Level 3 (amount used so far, €220 000)
and the two departments invited to resubmit packages totalling €30 000 each. Then
the ranking process could adjudicate on these top-up packages.
The principal advantage of ZBB, as seen from the above example, is the involvement of top
management in the allocation of discretionary funds. Too often senior executives who have
generalist backgrounds fail to wrestle with expert fields such as R&D and law; in these
circumstances, budgets tend to be ‘nodded through’ without any scrutiny. ZBB forces top
36
management to become involved and to relate the budget expectations of experts with the
strategic direction of the business.
ZBB, however, suffers from two significant drawbacks.
1. The process of cutting up relatively homogeneous activities into discrete, separately

costed packages is fraught with problems and involves considerable effort (and
therefore cost) on the part of the staff of the functions involved. The sheer effort
involved in implementing ZBB in some companies has been a barrier to extending the
technique to further areas.
2. The definition of packages is left, inevitably, to the management of the function under
review. The vested interest locked up in the process must leave some questions
hanging over the packages and the order in which they are presented. The temptation
with ZBB is to define the packages in such a way that the status quo is maintained.
This can be achieved by submitting a fulsome Level 1 package. Top management may
need to seek external expert opinion on the definitions if it is in doubt about the
requests being made.
13.4 Flexible Budgets
Imagine a quarterly report on production cost performance along the following lines:
Third quarter ended 31 March 20x4
Budget Actual
Units produced 2 000 1 800
€ €
Cost of materials 8 000 7 380
Cost of labour 6 000 5 310
Cost of overhead 2 000 2 050
Total production cost 16 000 14 740

Commentary by production manager to chief executive:
Yet again we’ve had a good quarter by coming in €1260 below budgeted cost. One more quarter
like this and the production team will be wanting to share in the savings by way of a year-end
bonus.
After such a comment the only savings the production team are likely to see is that of their
production manager’s salary when he is fired! True, the production facility has spent €1260 less
than budgeted, but the production level was reduced from 2000 to 1800. It is therefore futile to
compare the actual costs of making 1800 with the budgeted costs of making 2000. The
metaphor of comparing apples with oranges is apposite in this context. But which column should
be adjusted? Should we flex the budget column down to the 1800 level or the actual column up
to the 2000 level?
The answer is that we must flex the budgeted column of costs down to the level of output
actually achieved so that management can compare the actual costs of producing 1800 with
37
those that should have been incurred in producing 1800. (Flexing the actual costs to the 2000
level would leave management comparing two columns neither of which reflected reality!)
A far more meaningful presentation would use a flexible budget presentation:
Third quarter ended 31 March 20x4
Budget Actual Variance*
Planned production in units 2 000
Actual production in units 1 800 1 800
€ € €
Cost of materials 7 200 7 380 (180)
Cost of labour 5 400 5 310 90
Cost of overhead** 1 900 2 050 (150)
14 500 14 740 (240)

* The term ‘variance’ means the difference between the budgeted (or standard)
cost and actual cost.
** Overhead comprises a fixed component of €1000 and a variable component of

€0.50 per unit produced (1800 × €0.50 = €900)
This report now gives a better picture of the activities of production over the third quarter to 31
March 20x4. And it is a bleak picture. Materials and overhead exceeded budget, while labour was
less than budget. The net effect of these overruns and underruns was €240, or 1.65 per cent
over budget; management would need to decide whether these variances from budget require
investigation. This style of report is much more informative than the earlier one, which was, in
fact, dangerously misleading. But, even in the preferred report, an explanation of why the
production level had fallen from 2000 to 1800 would be necessary. This could reflect some
serious production difficulties (machine unreliability or raw material supply problems?), which, if
not resolved, could lead to customer supply problems in Quarter 4 and beyond as finished goods
inventory levels decline.
Note that the flexible budget for 1800 units was based on the standard cost of the unit.
€
Material 4.00
Labour 3.00
Variable overhead 0.50
Fixed overhead* 0.50
8.00
* Based on the planned production level of 2000 units per quarter.
Note that the per-unit fixed overhead component of standard cost is only valid if 2000 units are
made, simply because the fixed overheads amount to €1000 regardless of volume produced. The
38
flexed budget above explains how the overhead is included in the total amount for overhead.
Beware the temptation to multiply the fixed overhead per unit (€0.50) by units produced (1800)
to calculate fixed overheads in total. (You should revise Module 9 if you are unsure of the risk of
unitising fixed costs.)
13.5 The Anatomy of Variances: Materials and Labour

The variances column in the flexible budget is informative, but only to a degree. Take materials:
for management of the production facility to be told that €180 more was spent in Quarter 3 than
anticipated tells them that something did not go according to plan, but gives them no indication
of where the problem is. More detail is required.
Material costs can be more (or less) than standard for only two reasons:
1. actual production used more (or less) material than planned, and/or
2. the price to purchase the material was more (or less) than planned.
A combination of these two reasons leads us to split them out for individual analysis:
Material efficiency variance = (Standard quantity − Actual quantity) × (Standard price per unit)
= (SQ – AQ)SP
Material price variance = (Standard price per unit − Actual price per unit) × (Actual quantity used)
= (SP – AP)AQ
Example
A kilt-making firm in London makes 50 kilts per month. Last month, against a budgeted
production cost of €3000, it reported a production cost of €2860. Management has called for an
explanation. You determine that the standard cost of each kilt contains 4 metres of tartan tweed
purchased in bales from a company in the Outer Hebrides, each metre costed at €15. Last month
each kilt consumed 4.4 metres and each metre cost €13.
Application of the above formulae produces the following variances:
Material efficiency variance = (SQ – AQ)SP

= [(50 × 4) – (50 × 4.4)]€15
= (200 − 220)€15
= €300 adverse
Material price variance = (SP – AP)AQ
= (€15 – €13)220
= €440 favourable
Total material variances = €300 adverse + €440 favourable
= €140 favourable
An adverse variance is one where actual cost is above standard cost; a favourable variance is
one where actual cost is less than standard cost.
Calculation of variances is of little value unless it prompts investigation into possible reasons for
them. Here are a number of possible reasons for the variances so far calculated:
39
Material efficiency = €300 adverse
 faulty bale of tweed, which prevented easy matching of pattern;
 inexperienced staff, leading to waste, mismatch or excessive hems;
 use of sewing machines that require maintenance;
 pilferage among staff, leading to inventory losses;
 poor-quality material (see below).

Material price = €440 favourable
 change of supplier (although this looks unlikely given the facts supplied);
 quantity discounts given being more generous than planned for;
 inferior quality of tweed (which leads to more metres being used);
 end-of-tartan bales that are supplied at a lower price.
Labour cost variances are caused by a combination of the same two reasons:
1. actual production requiring more (or less) time than planned; and/or
2. the labour rates actually paid were more (or less) than planned.
A combination of these two reasons leads us to split them out for individual analysis:
Labour efficiency variance = (Standard time allowed − Actual time taken) × (Standard rate per hour)
= (ST – AT)SR
Labour rate variance = (Standard rate per hour − Actual rate per hour) × (Actual time taken)
= (SR – AR)AT
Note that the term ‘rate’ is used here for labour variances and ‘price’ is used for material.
Sometimes ‘price’ is used for both variances. Also, the formulae are sometimes laid out as
follows: e.g. Labour rate variances AT(SR − AR).
Example
At the end of the same month as above, the kilt makers’ production department reported its
actual labour costs equalling the budgeted labour costs at €3000. Initially management is
pleased with this outcome until you investigate the standard costs and produce the variances
that follow. Each kilt’s standard time to cut and sew is three hours; each hour being paid at the
standard rate of €20. In the month under review 175 hours were used, costing €2999.50.
Application of the above formulae produces the following variances:
Labour efficiency variance = (ST – AT)SR

= [(50 × 3) – (50 × 3.5)]20
= (150 − 175)20
= €500 adverse
Labour rate variance = (SR – AR)AT
= (20 – 17.14)175
= €500 favourable
40
Total labour variances = €500 adverse + €500 favourable
= Nil
Management would be well advised to ignore the fact that labour variances net to nil because
both efficiency and rate require investigation and possible managerial remedy action. Possible
explanations?
Labour efficiency = €500 adverse

 use of faulty material requires more time spent per kilt;
 uncertain supply of material leading to broken runs and downtime;
 inexperienced staff;
 untrained staff or faulty equipment.
Labour rate = €500 favourable

 lower calibre of staff used during the month, leading to more time required;
 anticipated pay settlement deferred until later in the year;
 less overtime paid than budgeted for.
13.6 Responsibility for Variances

DIY Example: Materials and Labour Variances
Consider the following standard cost data for a business making cases for carriage clocks:
Direct material 0.4 sq m metal @ €20 per sq m 8.00
Direct labour 2 hours @ €10 per hour 20.00
28.00
Actual statistics for last month were:
Cases produced 6 000
Square metres of metal purchased @ €22 per sq m 2 100 sq m
Square metres of metal used 2 280 sq m
Direct labour @ €10.10 per hour 11 100 hours

Using the pro forma analysis sheet below, calculate the material and labour variances and
consider possible reasons for these variances. The material variances should recognise the
responsibilities of the production manager and purchasing manager respectively.
Material variances Labour variances
Material efficiency = (SQ − AQ)SP Labour efficiency = (ST − AT)SR
= =
= =
41
= =
Possible explanations?
Material price = (SP − AP)AQ Labour rate = (SR − AR)AT
= =
= =
Worked Solution
Material variances Labour variances
Material efficiency Labour efficiency
= (SQ − AQ)SP = (ST − AT)SR
= [(6000 × 0.4) − (6000 × 0.38)]€20 = [(6000 × 2) − (6000 × 1.85)]€10

= (2400 − 2280)€20 = (12 000 − 11 100)€10
= €2400 favourable = €9000 favourable
 better calibrated cutting equipment;

 use of more appropriate sheets of metal;  greater motivation;
 superior quality of metal;  result of increased training;
 change in design since setting of  improved mechanisation.
standard.
Material price = (SP − AP)AQ Labour rate = (SR − AR)AT
= (€20 − €22)2100 = (€10 − €10.10)11 100
= €4200 adverse = €1110 adverse
 unforeseen wages settlement;

 price rise due to world shortage;
 more overtime;
 change of supplier.
 superior level of operatives.
Notes
1. The production manager is responsible only for volume of raw material used; hence we
use the square metres of metal drawn from stores into production. On the other hand
the purchasing manager is responsible for the price obtained for the quantity
purchased. The price variance’s ‘actual quantity’ is deemed to be the number of square
metres purchased (as opposed to the number issued to production). Had the
production manager also been held responsible for the material price variance, the
variance would have been:
(SP − AP)AQ = (€20 − €22)2280 = €4560 adverse

2. Variances should be calculated at the stage when they arise, and the products should
be passed on to the next department or process at standard cost. For example, the
carriage clock casings will be passed to the assembly department; it would be
inappropriate to ‘pass on’ the €2400 favourable material efficiency variance arising in
the casing department. This variance is the responsibility of the casing department’s
manager.
3. Consistent variances arising in the same area of operations may indicate that the
standard is no longer appropriate and needs adjustment. For example, in the casing
department above, it may be seen that a sizeable favourable variance in labour
efficiency occurs every month. If this is so, then the labour input process needs further
42
engineering study to establish the new standard time in the light of improved
machining and automated techniques. A detailed study could conclude that 1.85 hours
per clock actually achieved above is excessive in comparison with what could be
achieved at normal efficiency.
4. We have used simple formulae above to calculate four variances. We would caution readers
against memorising these without fully understanding the concepts behind them. In our experience
managers understand the identities inside the brackets but are unsure of those outside
the brackets. Take the material variances:
Efficiency = (SQ − AQ)SP
Price = (SP − AP)AQ
Why do we use standard price outside the brackets with efficiency and actual quantity
outside the brackets with price?
Careful thought about what is being examined will give a satisfactory answer: with the
efficiency variance formula we are analysing the financial impact on the business of the
manufacturing or assembly process taking more or less material than standard to do
the job. The physical quantity of material beyond standard is valued at standard price,
otherwise the combined sum would be a hotchpotch of two variances, efficiency and
price. By holding all prices at standard, management can gain an insight into the
efficiency of production. On the other hand, with the price variance, the gain or
slippage in price achieved for raw materials used or purchased is multiplied by the
actual quantity used or purchased. Were we to use the standard quantity, we would
produce a figure that bore no resemblance to reality; thus, in the worked example
above the purchasing department actually purchased 2100 square metres of metal,
each one €2 more than standard. If the standard quantity of 2400 square metres were
used, the purchasing manager would be penalised with a higher adverse variance than
he incurred. In the example we could argue that he kept the purchasing of metal to a
minimum so as to minimise the impact of the increase in unit price. The price variance
recognises this foresight by using actual quantity outside the brackets.
13.7 Variable and Fixed Overhead Analysis

DIY Example: Variable and Fixed Overheads
A company uses a standard cost system to plan and control its manufacturing process of CDs.
The standard cost of a CD, based on a denominator volume of one million CDs per annum,
includes four machine-hours of variable overhead at €0.50 per hour and four machine-hours of
fixed overhead at €10 per hour. Actual output for the year under review was 1.2 million CDs;
actual variable overhead was €1 900 000; actual machine-hours recorded were 4 100 000; actual
fixed overhead was €39 000 000.
Variable overhead variances
[Standard cost of flexible budget [Standard cost of actual time

Efficiency = Less
time allowance for units produced] taken for units produced]
Possible explanation?
[Standard cost of actual time taken

Spending = Less [Actual costs incurred]
for units produced]
43
=
Fixed overhead variances
Spending = Budgeted amount Less Actual amount
Amount applied to units

Denominator = Budgeted amount Less
produced
Worked Solution
Variable overhead variances
[Standard cost of flexible

[Standard cost of actual time taken
Efficiency = budget time allowance for units Less
for units produced]
produced]
= (1 200 000 × 4 × €0.50) − (4 100 000 × €0.50)
= €2 400 000 − €2 050 000
= €350 000 favourable
Possible explanation? The number of hours budgeted for downtime did not materialise, and
therefore the machine-hours recorded in manufacturing 1.2 million CDs were 700 000 less than
anticipated. Alternatively, the standard time of four machine-hours per disc needs to be
tightened up.
Standard cost of actual time

Spending = Less Actual costs incurred
taken for units produced
= (4 100 000 × €0.50) − €1 900 000
= €2 050 000 − €1 900 000
Possible explanation? Given the variable overhead allowed for every machine-hour recorded, the
company was entitled to spend €2 050 000 on variable overhead; instead it spent €1 900 000.
This could indicate tighter operational control over the components of variable overhead or more
advantageous prices negotiated than budgeted for.
44
Fixed Overhead Variances
Spending = Budgeted amount Less Actual amount
= €40 000 000 − €39 000 000
= €1 million favourable
Possible explanation? The sheer magnitude of fixed overheads may be surprising. But in high-
technology industry with a high level of automation and high level of research and development
expenditure, this proportion between variable and fixed overhead can be expected. The
difference between the two amounts is small in percentage terms (2.5 per cent) and would
perhaps be due to slightly less expensive machines being acquired, thereby lowering the fixed
annual depreciation charge, or to an extended view on machine life cycles (which would have a
similar effect on depreciation).
Amount applied to units

Denominator = Budgeted amount Less
produced
= €40 000 000 − 1 200 000 × 4 × €10
= €40 000 000 − €48 000 000
= €8 000 000 favourable
Possible explanation? Production was running at 20 per cent higher than budgeted. This
inevitably led to 20 per cent more fixed overhead being applied to the production than budgeted.
(Note: the increased production would have no impact on the amount of fixed overhead
actually spent.) If this increase in output is viewed as normal then the denominator volume has to
be increased for next year’s predetermined overhead rate, thereby reducing the cost of each unit
of product.
13.9 Sales Variances
So far we have focused our attention on the cost of sales figure surrounding production,
encompassing direct material, direct labour, variable and fixed overhead. Now we turn our
attention to the top line of businesses’ income statements: sales.
Case Study
A company manufactures and sells one product. Its budgeted sales for September were
€555 000; it recorded actual sales of €576 000.
A superficial comparison of the top-line sales for the month would suggest that the company has
had a better month that planned by €21 000, but, just as we did for the other costs (material,
labour, variable and fixed overhead), we need to drill a little deeper to see precisely what
happened. Against a budgeted sales figure of 15 000 units in September, the company sold
16 000 units. The actual price achieved softened from €37 planned to €36.
Sales volume and price variances

As before, we can break down the month’s performance into a volume variance and a price
variance:
Volume variance = (Actual volume sold − Planned volume) × Planned price per unit
= (16 000 − 15 000) × €37
45
Price variance = (Actual price − Planned price) × Actual volume sold
= (€36 − €37) × 16 000
= €16 000 adverse
Therefore, we can deconstruct the difference in top-line sales of €21 000 into two variances: a
volume variance of €37 000 favourable and a price variance of €16 000 adverse. Once again,
investigations would have to be conducted to understand why (a) the company managed to
achieve a higher volume, and (b) why the unit price fell by €1 during the month. Could it be as
simple as a drop in unit price prompting higher sales? But is this the price point that
management is happy with? How easy companies find it to drop their prices to stimulate sales
only to find it impossible to raise them again! Without this deconstructed data, management
cannot ask the right questions.
Sales volume contribution variance

Let’s think about what signals the volume variance calculated above gives management. Clearly
good news, surely: any variance that is deemed ‘favourable’ is good news, isn’t it? Not always!
By selling 1 000 units more, the top line has improved by €37 000, but what about the impact on
profits such an improvement in sales brought? For this calculation we need one further fact, the
contribution margin (sales less variable costs) per unit expected to be earned in September by
this company, namely €7 per unit. Some companies prefer to calculate the sales volume contribution
variance to measure the impact of a change in volumes sold on the bottom line of the company. In
this case it would be:
Sales volume
= (Actual volume sold − Planned volume sold) × Budgeted contribution
contribution
margin per unit
variance
= (16 000 − 15 000) × €7
= €7000 favourable
Although this is still good news for management, it is a slightly less exuberant number and signal
than the €37 000 favourable number as calculated by the earlier sales volume variance. In other
words, this latter variance is more nuanced in the way it combines changes in sales volumes with
their impact on profit. By adding the favourable variance to the budgeted profit for the month,
this will give management a figure of what profit should be, given the increased sales. We will
see this in operation in the next section.
13.10 Pulling It All Together

This section of the module uses one case study (already introduced in Section 13.9) to illustrate
how most of the variances we have covered can be used to maximise signals to management.
Case Study
As above, a company manufactures and sells one product. The facts of sales and production are
as follows:
Sales price €37
Materials 3 kg @ €4 per kg = €12 per unit
Labour 2 hours @ €9 per hour = €18 per unit
Standard contribution per unit €37 – €30 = €7
Fixed costs per month €25 000
Budgeted sales for 15 000 units
46
September
This budget will be used to plan all aspects of the business for the month ahead, including
distribution, purchasing, advertising, cash planning and manufacturing.
During September the company makes and sells 16 000 units. The actual costs were as follows:
Sales price €36
Materials 3.1 kg @ €3.90 per kg = €12.09 per unit
Labour 1.8 hours @ €9.50 per hour = €17.10 per unit
Fixed costs €26 000

We have been given two sets of information, the budget for September and the actual for
September. But, given that there has been a change in units made and sold (16 000 instead of
15 000), we can’t simply compare budget with actual performance. We must work out what our
costs should have been based on the increased output, against which we will compare actual
costs (this is called the flexed budget). We therefore need to construct a three-column analysis:
Flexed
Actual Original budget
budget
Units 16 000 16 000 15 000
€ € €
Sales 576 000 592 000 555 000
Material costs (193 440) (192 000) (180 000)
Labour costs (273 600) (288 000) (270 000)
Contribution margin 108 960 112 000 105 000
Fixed costs (26 000) (25 000) (25 000)
Profit for the month 82 960 87 000 80 000

Management needs an explanation as to why profits have climbed from the budgeted level of
€80 000 to €82 960. Let’s then calculate the variances we’re familiar with and give them the
reconciliation they need.
Calculation of variances
Sales volume contribution variance Sales price variance
= (SV − AV)Contribution per unit = (SP − AP)AV

= (15 000 − 16 000)€7 = (€37 − €36)16 000
= €7000 favourable = €16 000 adverse
Material efficiency variance Material price variance
= (SQ − AQ)SP = (SP − AP)AQ

= (3 kg × 16 000 − 3.1 kg × 16 000)€4 = (€4 − €3.90) × (16 000 × 3.1 kg)
= €6400 adverse = €4960 favourable
Labour efficiency variance Labour rate variance
47
= (ST − AT)SR = (SR − AR)AT
= (16 000 × 2 − 16 000 × 1.8)€9 = (€9 − €9.50) × (16 000 × 1.8)
= €28 800 favourable = €14 400 adverse
Fixed overhead variance
(Since the company is not attempting to apply fixed overhead to each unit of output we can
calculate the overhead variance very simply.)
= Actual fixed overhead − Budgeted fixed overhead
= €26 000 − €25 000
= €1000 adverse
Note that the company does not incur variable overhead.
Now we are in a position to present management with a useful reconciliation between budgeted
profit for September, €80 000, and the actual profit, €82 960:
€ €
Original budgeted profit 80 000
Sales volume denominator variance 7 000

Flexed budget profit 87 000
Sales price variance (16 000)
Material efficiency variance (6 400)
Material price variance 4 960 (1 440)
Labour efficiency variance 28 800
Labour rate variance (14 400) 14 400
Fixed overhead expenditure variance (1 000)
Actual profit 82 960

How would you interpret this reconciliation for management?
First, the three profit figures picked out in bold are the profit figures at the foot of the columns in
the three-column analysis above. This gives a powerful message: despite an increased volume in
sales, which should have produced a profit of €87 000, the company’s performance was not
good, producing a profit of only €82 960.
Second, suggest potential reasons for the variances:
 Sales volume: increased demand in market; successful marketing or negotiating.

 Sales price: competitive pressures; buyer clout necessitating heavy discounting; unilateral
action to grab market share.
 Material efficiency: using inferior-quality inputs; inefficient production methods leading to
excessive waste; pilferage.
 Material price: effective negotiations with suppliers; reduction in market prices.
 Labour efficiency: using higher-quality labour than planned; better motivation among the
workforce triggered perhaps by a wage rise; using higher-quality materials and/or
equipment.
48
 Labour rate: using more highly skilled staff than planned; unforeseen wage demands;
labour shortages forcing up rates.
 Fixed overhead expenditure: increase in cost items that comprise this sum; unrealistic initial
budgeting; wasteful consumption of resources.
DIY Example
A company manufactures a single product that has the following budgeted specifications:
Material Zip: 5 kg per unit costing €20 per kg
Zap: 6 kg per unit costing €25 per kg

Labour 20 direct labour hours per unit at €8.50 per hour
Fixed overhead expenditure €14 000 per month
Production and sales per month 200
The actual figures for May emerged shortly after month-end:
Material Zip: 950 kg used, costing €19 per kg
Zap: 1090 kg used, costing €27 per kg
Total material cost: €47 480

Labour Actual hours worked in May = 3900. This cost €31 980.
Fixed overhead incurred €14 200
Production and sales 180 units, realising €108 000 (at the standard selling price per unit).
You are required to present an insightful report to management to help design actions to take, if
any, to address areas of weak performance. Once again, try this exercise on your own without
first looking at the answer!
Draw up the three-column spreadsheet, indicating the profit that should have been earned on
the reduced sales volume (i.e. the flexed budget).
Flexed Original
Actual
budget budget
Units
€ € €
Sales
Material costs
Labour costs
Contribution margin
Fixed costs
Profit for the month

Management therefore requires an explanation as to why profits have fallen in May as follows:
Budgeted = €
49
Actual = €
Note that the original budgeted contribution per unit is €180 (€36 000/200).
= =
= =
Material efficiency variance for Zip Material price variance for Zip
= =
= =
Material efficiency variance for Zap Material price variance for Zap
= =
= =
= =
= =
Note: The actual labour rate is €8.20, being the actual spend on labour in May, €31 980, divided
by the actual number of hours worked, 3900.
(Since the company is not attempting to apply fixed overhead to each unit of output we can
=
Now we are in a position to present the management with a useful reconciliation between
budgeted profit for May and the actual profit.
€ €
Original budgeted profit
Sales volume denominator variance
Flexed budget profit
Sales price variance
50
Material efficiency variance (Zip)
Material efficiency variance (Zap)
Material price variance (Zip)
Material price variance (Zap)
Labour efficiency variance
Labour rate variance
Fixed overhead expenditure variance
Actual profit
Worked Solution
Draw up the three-column spreadsheet, indicating the profit that should have been earned on
the reduced sales volume (i.e. the flexed budget).
Flexed Original
Actual
budget budget
Units 180 180 200
€ € €
Sales 108 000 108 000 120 000
Material costs (47 480) (45 000) (50 000)
Labour costs (31 980) (30 600) (34 000)
Contribution margin 28 540 32 400 36 000
Fixed costs (14 200) (14 000) (14 000)
Profit for the month 14 340 18 400 22 000

Management therefore requires an explanation as to why profits have fallen in May as follows:
Budgeted = €22 000
Actual = €14 340
Note that the original budgeted contribution per unit is €180 (€36 000/200).

= (200 − 180)180 = (€600 − €600)180
= €3600 adverse = €nil
Material efficiency variance for Zip Material price variance for Zip
51
= (180 × 5 − 950)€20 = (€20 − €19)€950
Material efficiency variance for Zap Material price variance for Zap

= (180 × 6 − 1090)€25 = (€25 − €27)€1090
= €250 adverse = €2180 adverse

= (20 × 180 − 3900)€8.50 = (€8.50 − €8.20)3900
Note: The actual labour rate is €8.20, being the actual spend on labour in May, €31 980, divided
by the actual number of hours worked, 3900.
(Since the company is not attempting to apply fixed overhead to each unit of output, we can
= €14 200 − €14 000
= €200 adverse
Now we are in a position to present the management with a useful reconciliation between
budgeted profit for May and the actual profit:
€ €
Original budgeted profit 22 000
Sales volume denominator variance (3 600)
Flexed budget profit 18 400
Sales price variance –
Material efficiency variance (Zip) (1 000)
Material efficiency variance (Zap) (250) (1 250)
Material price variance (Zip) 950
Material price variance (Zap) (2 180) (1 230)
Labour efficiency variance (2 550)
Labour rate variance 1 170 (1 380)
Fixed overhead expenditure variance (200)
Actual profit 14 340

52
 First, the three profit figures picked out in bold are the profit figures at the foot of the
three columns in the first spreadsheet. Yet again, this gives a powerful message: even
though the company had experienced a decline in sales volume, it should have
recorded a profit of €18 400 if costs had behaved as budgeted. They didn’t, and
management would expect a line-by-line explanation of variances to reconcile to the
company’s recorded profit of only €14 340.
 Second, suggest potential reasons for the variances: the reasons for variances, both
variable and adverse, would need to be suggested at this stage in the report to
management. Our earlier explanations should give students an idea of what these
might be.
14.4 Defining Profits and Investments

If one of the aims of a divisional accounting system is to allow the performance of its
management to be measured (the other being the traditional one of providing information
relevant to the managers for decision making) then it follows that only those revenues, costs and
net assets under the control of the divisional manager should be included in the calculations.
Consider the following divisional income statement.
Division XYZ: Income statement for year ended 30 September 20x4
€000s €000s
Sales 9 000
Cost of sales
Materials 2 000
Labour 1 500
Production overheads 500
Depreciation on machinery 500
Other costs
Rent and rates 1 000
Sales and marketing (divisional) 300
Sales and marketing (share of HQ) 550
R&D (divisional) 700
R&D (share of HQ) 300
Share of corporate HQ services
Personnel 200
Depreciation on computer 100
Lease of corporate aircraft 100 7 750
Profit 1 250
53
The traditional accounting profit of €1250 arises after deducting all costs (incurred and HQ-
allocated) from revenue. But is it fair to hold the divisional manager responsible for all of these
HQ-allocated charges? Consider each one.
Sales and Marketing €550

This expenditure incurred by HQ on behalf of all trading divisions is concerned with brand
awareness advertising and TV commercials, from which all trading divisions benefit but which
cannot be afforded by any division individually. The cost has been allocated on the basis of gross
sales. But Division XYZ’s management argues that, of its €9 million sales, only 10 per cent refers
to domestic products covered by the brand awareness campaign. The balance is industrial
products, which are marketed under the divisional budget.
R&D €300
It is usual for a divisionalised company to maintain a central R&D facility to undertake more
basic research than that undertaken at the divisional level, which tends to focus on development
work. Divisional R&D personnel have little input into the selection of programmes and
recruitment of scientific staff.
Personnel €200
Instead of maintaining its own personnel function Division XYZ uses the HQ personnel and
training staff as and when required. The cost shown in the income statement arose from the
vacancies filled during the year and training course spaces taken by the division.
Depreciation on Computer €100

This charge is made by HQ to cover the cost of salary preparation for all staff including divisional
staff and to handle production scheduling issues arising at divisions. But Division XYZ has
recently purchased a software program to handle all aspects of production scheduling, and its
salary payroll is compiled on site as well. No divisional use is made of the computer.
Lease of Corporate Aircraft €100

The executive jet is kept for the exclusive use of the chairman on both company and domestic
visits. In the year to 30 September 20x4, the chairman did not visit Division XYZ.
The income statement can therefore be restructured around those costs that are controllable by
divisional management and those that are deemed to be non-controllable. For this purpose we
will assume that, although the division did not control its share of sales and marketing cost and
personnel cost, the fact that it benefited from both these items amounts to ‘controllable’ costs.
Division XYZ: Income statement for year ended 30 September 20x4
€000s €000s
Sales 9 000
Cost of sales
Materials 2 000
Labour 1 500
54
Production overheads 500
Depreciation on machinery 500 4 500
Other controllable costs:
Rent and rates 1 000
Sales and marketing (300 + 55) 355
R&D 700
HQ services: personnel 200 2 255
Controllable profit 2 245
Non-controllable costs
Sales and marketing 495
R&D 300
Depreciation on computer 100
Lease of corporate aircraft 100 995
Net profit 1 250

The management of Division XYZ feels ‘ownership’ of a profit of €2 245 000 rather than that of
€1 250 000. Even then the division’s managers may argue that other costs deemed to be
controllable by them are not controllable. For example the charge for rent and rates may have
resulted from an HQ decision some years previously to site Division XYZ in its present position;
the current divisional management may argue that it would prefer to re-site the plant in a
development area, which would cause the annual charge of €1 000 000 to be reduced
significantly. Such a debate would not be easy to resolve between HQ and divisional
management.
Similarly with net assets: most assets situated physically within the division can be reasonably
expected to be controlled by divisional management, but some exceptions can arise:
1. Certain productive or research capacity may be made available to a division by either

another division or by headquarters. For example Division XYZ may ship products to
Division ABC for final assembly using a dedicated piece of plant located in ABC. Such
equipment or a proportion thereof should be included in the asset base of XYZ. Or
perhaps an expensive piece of research equipment located in the central research
laboratories is used exclusively on projects commissioned by a specific division. Again
this should be allocated to the commissioning division’s asset base for purposes of
performance measurement.
2. Divisions may be required to retain surplus assets for the future use of other parts of
the company. Warehouse space is an example of such an asset; Division XYZ may
have been requested by HQ to hold on to a warehouse that had been freed up as a
result of investment in just-in-time manufacturing procedures (which eliminate the
holding of significant inventory levels), such a request being made in the light of future
plans elsewhere within the group. The value of the warehouse would have to be taken
out of Division XYZ’s asset base and allocated centrally; otherwise it would be unfair on
XYZ’s management to be burdened with a larger asset base than was being used in the
division’s activities.
55
14.6 Residual Income: An Alternative to ROI
Example
A company, comprising three divisions, charges each division 12 per cent for the use of
corporate resources for investment purposes. Each division’s profit performance and investment
base is given below.
Division 1 Division 2 Division 3
Controllable profit €100m €240m €95m
Investment in net assets €350m €850m €300m

Performance measures
ROI 28.57% 28.23% 31.66%

RI
Controllable profit €100m €240m €95m
Imputed interest:
12% on net assets 42m 102m 36m
RI €58m €138m €59m

In terms of ROI, Division 3 is making the best use of its assets, but with the imputed interest
charge of 12 per cent Division 2 is performing best of all.
Explanation of Division 1’s calculations:

ROI = (€100/€350m) × 100 = 28.57%
RI = €100m less 12% of €350m = €100m − €42m = €58m
Residual income overcomes the dysfunctional element of ROI by encouraging divisional
managers to invest, provided the expected returns exceed the imputed cost of capital. For
example, imagine that the management of Division 3 is presented with a proposal that will boost
controllable profit by €15m for a local investment of €50m, an ROI of 30 per cent, which makes
the proposal extremely attractive to corporate management, whose cost of capital is 12 per cent.
But the managers in Division 3 would oppose such a suggestion because they would witness a
drop in their ROI:
Before investment ROI: €95m/€300m = 31.6%
After investment ROI: (€95m + €15m)/(€300m + €50m) = 31.4%

Although this drop is only marginal, Division 3 would wish to avoid the incremental investment
for fear of being presented with further proposals with similar financial impact; Division 3’s ROI
is ahead of the field, and that is where its managers would want it to stay, particularly if
managerial remuneration or promotion is based on ROI. But RI would allow local management to
accept the proposal for the benefit of both the division and the company as a whole:
Before investment RI: €95m less 12% of €300m = €95m − €36m = €59m
After investment RI: €110m less 12% of €350m = €110m − €42m = €68m
Dysfunctional behaviour is eliminated by the use of RI, but two problems must be overcome
before a company can use it.
56
1. The imputed charge for capital must be determined. Companies may use their cost of
capital – itself not an easy number to calculate (see the MBA Finance course for further
elaboration on this topic) – or may want to assess the commercial risks attaching to
each division, thereby imputing differential rates of interest across divisions. This can
lead to managerial friction, particularly when remuneration or advancement are based
on RI.
2. The valuation of the asset base is once again a significant factor in the calculation. The
weaknesses identified in the two methods discussed above are still prevalent in RI
calculations.
14.7 The Imputed Rate of Interest Does Matter!

Example
A company has three divisions with different net assets bases and profit performances.
Corporate HQ is undecided about the rate of interest to impute for the use of corporate
resources. Depending on various factors, it has been advised that 8 per cent, 12 per cent or 15
per cent could be adopted.
Division Division Division
Small Medium Large
Controllable profits €25m €80m €120m
Net assets investment €100m €400m €800m
ROI 25% 20% 15%
Ranking (1) (2) (3)

€m €m €m
Profits 25 80 120
Imputed interest @ 8% −8 −32 −64
RI 17 48 56
Ranking (3) (2) (1)
RI 13 32 24
Ranking (3) (1) (2)
RI 10 20 NIL
Ranking (2) (1) (3)

Explanation of column 3’s calculations:
ROI = (€120m/€800m) × 100 = 15%
First RI = €120m less 8% of €800m = €120m less €64m = €56m
Second RI = €120m less 12% of €800m = €120m less €96m = €24m
Third RI = €120m less 15% of €800m = €120m less €120m = Nil
57
This example reveals that the selection of the interest rate does matter! First, note how the ROI
is absolutely clear-cut about its ranking; Small has turned in the superior performance. But when
the performance measure switches to RI the picture changes dramatically. The effect of gearing
yet again manifests itself in this example. Low interest rates favour divisions with high
investment in net assets, but when rates are ramped up the high investments make themselves
felt in the high imputed interest charge levied. The managers of these three divisions would
certainly have a vested interest in the rate selected for RI purposes!
DIY Example
Compute plc is split into four operating divisions, Chip, PC, Printer and Drive. Each division is
seen as being an autonomous unit with profit and investment responsibilities. The cost of capital
for the company is 13 per cent. In the ROI calculations for performance measurement purposes,
the beginning-of-year asset base is used for each division. Non-current assets are depreciated on
a straight-line basis.
The following positions are recorded as at 1 April 20x5.
Investment in net assets Budget for year to 31 March 20x6 Controllable

1 April 20x5 (€m) profit (€m)
Chip 192.0 48.0
PC 270.0 90.0
Printer 168.0 50.4
Drive 120.0 15.6

After the divisional budgets for 20x5/x6 were drawn up, each division had additional investment
proposals to consider, which, if accepted, would alter the above figures because each would be
completed on 1 April 20x5. The divisional proposals are as follows:
An investment of €60 million in new clean-room facilities for wafer fabrication, which
Chip would produce sales of €90 million per annum. Expected net profit is €12 million per
annum.

Termination of the assembly of personal computers, which is budgeted to yield a

profit of €9 million for 20x5/x6. Anticipated revenue from sale of dedicated assets
PC
€45 million whose original cost seven years ago was €360 million. When purchased,
the division believed the equipment would last eight years.

Sale of entire production line of dot matrix printers for book value being €12 million.
The budgeted figures above include a profit of €12 million from this line.
Printer
Additionally, €60 million would be invested in a laser printer production line, which
would give €18 million profit per annum.

Investment in an additional production line to cope with increased demand for small-
Drive diameter disks; €48 million required, with expected sales of €21.6 million and
annual profits of €6.72 million.
As the financial consultant to Compute plc you are required to do the following:
1. On the basis that all proposals are implemented on 1 April 20x5:

1. calculate the updated ROI for each division for the year to 31 March 20x6;
58
2. identify those divisional managers who would expect to receive a higher
bonus if bonuses are related to ROI;
3. explain how the decisions of each divisional management may affect the
company’s overall financial performance for 20x5/x6.
2. Imagine that the company has an investment limit of €120 million for 20x5/x6. Which
proposals would be selected?
3. Calculate the lowest price at which the personal computer assembly line should be sold
by PC Division so that the company makes neither a profit nor a loss on the deal.
4. Calculate the budgeted RI for each division on the basis that each
investment/disinvestment goes ahead.

Note: Make sure, before you read this section, that you have made a reasonable attempt at the
case study, committing your solution to writing. Otherwise you may deceive yourself about how
well you understand the subject!
Requirement 1
It is fairly clear from the case and the second question that the company is supplying the fresh
funds required for the investment proposals under consideration. On this basis we shall assume
that cash freed up on the sale of assets is remitted to corporate headquarters and not retained in
divisional balance sheets.
Chip PC Printer Drive
Controllable profit per original
budget 20x5/x6 €48.0m €90.0m €50.4m €15.60m
Adjustments to profit* + 12.0m − 9.0m + 6.0m + 6.72m
Revised profit €60.0m €81.0m €56.4m €22.32m

* These adjustments are the upward or downward movements in divisional profits that would
occur if all the capital plans are implemented. For example, Printer’s profits would drop by €12m
on the sale of the dot matrix printer line but would be boosted by €18m on the installation of the
laser printer line, a net uplift of €6m.
Net asset investment base
per original budget 20x5/x6 €192.0m €270.0m €168.0m €120.0m
Adjustment to base** + 60.0m − 45.0m + 48.0m + 48.0m
€252.0m €225.0m €216.0m €168.0m

** These adjustments are the upward or downward movements in divisional asset bases that
would occur if all the investment and sale proposals are implemented. For example, Printer
would sell assets valued in its balance sheet for €12m and invest in new line costing €60m, a net
uplift in assets of €48m.
ROI per original budget 25.00% 33.33% 30.00% 13.00%
ROI as adjusted 23.81% 36.00% 26.11% 13.28%

ROI as adjusted is calculated by expressing divisional revised profits as a percentage of divisional
revised investments. For example, Printer’s revised profit is €56.4m and its revised investment is
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€216m, an ROI of 26.11 per cent. The non-adjusted ROIs are calculated in the same way except
they use the original figures: Printer €50.4m/€168m × 100 = 30%.
On a straight comparison of changes in ROI the managers of Divisions PC and Drive will
anticipate receiving an increased bonus as a result of the new proposals being implemented.
An individual breakdown of returns on investment can be compared with the company-wide cost
of capital of 13 per cent:
Incremental new profits €12.0m (€9.0) €6.0m €6.72m
Incremental new investment €60.0m (€45.0) €48.0m €48.0m
Incremental ROI 20% (20%) 12.5% 14%

Printer’s investment opportunities, when taken together, do not match up to the company’s cost
of capital of 13 per cent and should not be accepted. Similarly the loss of a project in PC
Division, which is currently earning 20 per cent, is not a wise move from the company’s point of
view. The opportunities presenting themselves to the divisional management of Chip and Drive,
because they exceed the company’s cost of capital, should be accepted. But note that, if the
investment decisions are left entirely to the discretion of local management, the management of
PC and Drive would accept the proposals because their ROI performance measures improve while
Chip and Printer managers would reject their proposals. (Take Chip: its divisional ROI before
investment is 25 per cent; with the new investment it is 23.81 per cent, which would not be
attractive to Chip’s management. However, from the corporate point of view, Chip’s ROI on its
incremental investment is 20 per cent, beating the company-wide cost of capital of 13 per cent.)
Decisions Chip PC Printer Drive
Divisional view No go Go No go Go
Company view Go No go No go Go
Note the dysfunctional behaviour that could emerge from the use of ROI by itself; the
management of Chip and PC would take decisions that harmed the financial position of the
company.
Requirement 2
Companies typically have more investment proposals to consider than funds to support them.
Management must therefore select those projects that it feels fit with the overall strategic plan of
the group. There are many factors to be taken into consideration in this selection process,
including the financial implications. On the basis that the financial aspects are paramount (an
assumption that is seldom the case) the following numbers would be considered:
Overall sum required €156 million*
Limit on funds €120 million
Excess requirement € 36 million

* Overall sum required: this is the summation of the new investment proposals less the proceeds
of sale of Printer’s old equipment, which would definitely be realised if Printer were to receive the
new equipment (that is, €60m + €60m − €12m + €48m). Note that we don’t take into account
the prospective sale of PC’s assets, since Corporate cannot be certain if divisional management
will take this decision, as the old equipment is earning 20 per cent on using it.
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Division Funds required ROI RI
Chip €60m 20.0% €12m less (13% × €60m) = €4.2m**
Printer €48m 12.5% €6m less (13% × €48m) = (€0.24m)
Drive €48m 14.0% €6.72m less (13% × €48m) = €0.48m

** Calculations for Chip’s RI: incremental profits that will flow from new investment, €12m, less
a notional charge for the cost of capital provided to allow the new investment to be made, 13%
× €60m = €7.8m. This gives an RI of €4.2m.
By adopting either ROI or RI, management would select the proposals emanating from divisions
Chip and Drive (both beat cost of capital of 13 per cent; both produce a positive RI). Module
15discusses further the subject of investment project selection.
Requirement 3
The suggestion from PC Division that it sell off its assembly line was rejected because it was
currently earning 20 per cent per annum against a cost of capital of 13 per cent. Unless there
was a strategic decision lying behind this proposal (for example, to source the assembly of PCs in
Asia), this would be a move that would penalise the group. The question asks how much would
have to be offered to Compute plc before such a deal would make some sense. That is, what
price would have to be received for the assembly line before the company made neither a profit
nor a loss? The proposal would therefore require the sale proceeds of plant to drop to a point
where the loss to the company was equivalent to 13 per cent ROI:
€9m lost proceeds = 13% of X
X = €69.23 million
Requirement 4
€m €m €m €m
Revised profit forecast 60.00 81.00 56.40 22.32
Imputed interest @ 13%* 32.76 29.25 28.08 21.84
RI 27.24 51.75 28.32 0.48

* Imputed interest is calculated at 13 per cent on the revised divisional investment in the second
table of numbers in Requirement 1, i.e. Chip 13 per cent on €252m = €32.76m.
14.10 Criteria for Establishing a Transfer Price

Example
Division A makes and sells a component to external customers for €10 each. Division B has a
need for this component for its own manufacturing process, which it could buy for €8 from
outside the group. Division A refuses to drop its price for an internal transfer, and Division B
buys outside. Such an outcome follows the principle of giving divisional managers complete
autonomy in the running of their affairs. Spare capacity exists in Division A.
But an examination of the costs of Division A’s component reveals that only €5 were spent on
making it and Division A was making a profit of a further €5 per unit sold. Therefore from the
company’s point of view the company is €3 worse off on the decision of the two divisions not to
do business with each other (Division B’s purchase price of €8 less Division A’s costs of €5).
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Therefore we may have to qualify the simple rule: divisional managers are free to do business
with each other provided the interests of the divisions are congruent with those of the company.
In the example would headquarters force the divisions to do business with each other? And at
what price? €5? €8? And who decides? Can the company continue to have a divisionalised
structure that treats divisional managers as independent and autonomous when HQ steps in and
forces a deal between two reluctant managers and then measures their performance as if they
are free agents?
Two prices are possible for transferring goods and services between divisions in the same
company: market prices and cost-based prices.
Full Costs
When full costs are used, the selling division would calculate the transfer price using variable
costs plus a proportion of fixed costs, using the normal absorption formula of the division. On the
face of it this method is the most appropriate, for it would appear to prevent the selling division
from losing money on the deal. But, of course, the selling division’s control over costs may be
slack and its absorption of fixed costs based on a low denominator volume of activity (which
would lead to a high fixed cost per unit). When full costing is used, it may be appropriate to
allow the buying division’s accountants to audit the selling division’s cost structures prior to
agreement.
The buying division must exercise care when full costs are used. For the buying division the price
paid to the selling division becomes a variable cost to which it would add its own variable costs of
manufacture and assembly. If the division then prices its product with an eye on contribution,
the ‘variable’ cost would contain an element of fixed cost belonging to another division. Imagine
that Division A’s cost structure is as follows:
Division A €
Variable cost 3
Fixed cost 2
Full cost 5
Profit 5
Selling price 10
On the basis that the transfer price is concluded at full cost, Division B’s cost structure may look
like this:
Division B
Variable cost €
Division A’s component 5
Material and labour 10
Fixed cost 5
Full costs 20
Division B’s ability to recover full cost in the market may be severely constrained by intense
competition. If its management had to resort to pricing on variable cost only, it might believe
that the lowest price it could charge would be €15 (Division A’s bought-in component plus its
own material and labour costs). But in terms of company variable cost, it could afford to drop to
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€13 (Division A, €3, plus Division B, €10). If the market is really distressed, the difference
between €15 and €13 may be significant where the wrong signals given by full-cost transfer
pricing could lead to loss of sales.
Variable Costs
From a company point of view the use of variable costs in transfer prices overcomes the
shortcomings described above. So, too, would the perennial problem of fixed overhead allocation
in Division A, which, by itself, could be a source of dispute between the two dealing divisions. But
its use leaves Division A neither up nor down on the deal, and it must sit back and watch Division
B making all the profit on the ultimate sale. Why should Division A be penalised in this way,
particularly if there is a buoyant market for its goods? At the least, they would argue, let us
cover our fixed costs by using full costs.
Negotiated Costs
The term ‘negotiated costs’ is a delightful euphemism for a managerial punch-up! Behind the
need for negotiation lies the reality that market price and cost-based prices have not worked and
top management has instructed the two managers to propose a solution that will not harm the
company. On the basis that ‘Everything is negotiable,’ management can expect an outcome from
this process. However, top management may wish to contribute to the discussion. For example,
let us assume that in our illustration the price of €8 for which Division B could buy the
component is reckoned by all parties to be artificially low and will soon move up to €10 (the price
currently being charged by Division A). To preserve divisional autonomy HQ may be prepared to
countenance Division A selling to Division B at €10 and Division B buying from Division A for €8.
The difference of €2 on the deal would be absorbed by an HQ contingency account in the short
term, and the two divisions’ results would be capable of being assessed on true investment
centre criteria. Such a dual pricing procedure cannot be adopted for a lengthy period of time;
otherwise the motivation of both divisions, and their confidence in the system, will deteriorate.
14.11 The International Dimension

DIY Example
The Ten Ton Trailer Company comprises two divisions, one of which is the Freezer division, which
manufactures freezing equipment for refrigerated containers. Some of the freezer units are sold
directly by the Freezer division to outside customers. The others are passed to the Box division,
which incorporates the freezer units into each of its containers for sale to outside customers.
Both divisions have been set up as profit centres and have had a long history of rivalry about
which is the more profitable; the question of transfer prices charged by the Freezer division has
always been a sensitive issue. For some time now the market price of freezing units has been
used because a number of competitors are active in the UK and Continental Europe.
The following information is available to both divisions’ management.
Selling price for completed container 33 750
Selling price for freezer unit from Freezer division 22 500
Freezer division’s costs per unit 13 500
Box division’s costs per unit 16 875

For his part, the manager of the Box division is concerned with the way his numbers look.
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€ €
Selling price 33 750
Cost: Bought-in component 22 500
Own division 16 875 39 375
Loss per container 5 625

You are required to address the following issues:
1. If there is no surplus capacity, should the Freezer division be required to transfer
freezer units to the Box division? If so, is the market price (as currently used) the most
appropriate one?
2. Present space limitations restrict Freezer division from making more than 1400 units
per month, of which 1100 units are sold to external customers. Should the balance be
transferred to Box division, and, if so, at what price?
3. On the basis that Freezer division decided to charge a transfer price of €16 875 for up
to 300 units, calculate the contribution to the Ten Ton Trailer Company. Would you, as
manager of Box division, buy at €16 875?

Note: The warning already given applies here too! Make sure you have made a reasonable
attempt at the case study, committing your solution to writing, before you read the solution.
Otherwise you may deceive yourself about how well you understand the subject!
Requirement 1
Freezer division should certainly not be required to transfer units to Box. Freezer division is
making more money on units sold to external customers than the company is making on the
complete container.
Company Position
Freezer unit Container
Sales price €22 500 €33 750
Costs 13 500 30 375 (13 500 + 16 875)
Profit € 9 000 € 3 375

The more freezer units sold outside the better.
The market-price-based transfer price would appear to be the best available transfer price
because €22 500 is the cash that would be foregone if Freezer division redirected a unit away
from the market towards Box division. It could reasonably expect to be recompensed fully for
that income by Box division. If Box division could purchase the freezer unit at a lower price
outside, then it should be free to do so. But this is unlikely if €22 500 represents ‘market price’.
Requirement 2
As soon as excess capacity can be detected in Freezer division, the €22 500 market price
becomes invalid for use as a transfer price for those units that cannot be disposed of externally.
The divisional costs of €13 500 would seem to be the best price to settle at in the absence of
additional information. In this way Freezer division breaks even on the surplus 300 units and
Container division makes a profit of €3375 as outlined above on each of the 300 surplus units.
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Requirement 3
If Box division accepted this transfer price, the following picture would emerge for each of the
surplus 300 units.
Freezer unit Container
Sales price €16 875 €33 750
Costs 13 500 33 750 (16 875 + 16 875)
Profit € 3 375 €0
Container division would ‘take the hit’ on profits, but the company as a whole would earn a profit
of €3375. Indeed, if the transfer price for the surplus 300 units lay between €13 500 and €16 875
each, this would lead to a beneficial outcome for the company. But should Freezer division be
allowed to keep all of the €3375 profit or should it perhaps be distributed? Otherwise Box
division has little incentive to buy at €16 875.
15.3 Concept of Present Value

Example
Under an annual interest rate of 10 per cent, €100 today invested for one year will amount to
€110, being the original investment of €100 plus the €10 interest. Similarly if the €100 is
invested for two years it will amount to €121, being the original €100 plus the first year’s
interest of €10 amounting to €110 plus the second year’s interest of €11 (10 per cent of €110)
added on to this to give the total amount of €121. This can be generalised as follows:
€100 invested for two years at 10 per cent will amount to €100 × 1.10 × 1.10 = €121.
This is the original sum × (1 + the rate of interest) × (1 + the rate of interest), which equals the
original sum × (1 + the rate of interest)2. If n is the number of years and i the rate of interest,
then any sum invested for n years at i per cent will amount to that sum multiplied by (1 + i)n.
Therefore €100 invested for two years at 10 per cent amounts to €100 × (1 + 0.10)2, which
equals €121. This €121 can be referred to as the future value. We can use the reciprocal of the
equation, i.e.:
to calculate the present value of a sum payable or receivable sometime in the future. A sum of
€121 receivable in two years at 10 per cent has a present value today of only €100, i.e.:
Present value is the sum that would have to be invested today to amount to a given sum at a
rate of interest over a given time period.
The present value today of €200 in two years at 9 per cent is:
The present value today of €170 in one year at 9 per cent is:
65
The present value today of €300 in 10 years at 9 per cent is:
These different values of €200, €170 and €300 receivable or payable at different future times
have now been reduced to present or equivalent values and can be ranked, with €200 having the
highest present value, €170 the second and €300 the lowest.
This concept of present value – that is, the value today of a sum receivable or payable sometime
in the future at a given rate of interest – is one of the most important concepts in all financial
calculations that involve different sums over different time periods. It forms the basis of what is
popularly known as the discounted cash flow approach to the evaluation of investment opportunities.
15.5 Net Present Value (NPV)

Example
Suppose an investment of €300 now will produce cash flows of €114 for the next three years and
that the cost of capital is 5 per cent. The cash profile of the investment is as follows:
Cash flow
Year 0 (beginning of the investment) −€300
Year 1 114
Year 2 114
Year 3 114
Unadjusted cash flow € 42

The net present value of this positive cash flow at 5 per cent is:
If we set the present values alongside the cash flows, we can see the impact of adjusting the
cash flows by the 5 per cent cost of capital.
Cash flow Net present value at 5% of cash flow
Year 0 −€300 −€300.00
1 114 108.50
2 114 103.40
3 114 98.60
€ 42 € 10.50
From this analysis we can immediately deduce a number of things that are of interest to the
manager. First, the project is profitable because it has a positive present value. Second, it has a
rate of return greater than 5 per cent. Third, if the project is undertaken and these results
achieved, then the wealth of the business will increase by, in today’s terms, €10.50. Finally, if
66
there is a choice between this project and another one that gives a smaller increase in wealth –
that is, has a lower present value – then this is the one to choose if the objective is to maximise
wealth/profit. We will return to this question of choice later, but for now let us look more closely
at the concept of increasing wealth by €10.50. If we knew with absolute certainty that the
investment of €300 would generate the cash flows of €114 per annum for three years and that
the cost of financing this was 5 per cent, then we could spend/consume €10.50 now. The table
below sets out the repayment schedule on the loan if we borrowed all of €310.50 at 5 per cent
interest. With annual repayments of €114, the loan is repaid in full by the end of Year 3, allowing
also for declining interest costs.
Capital Cash flow

Year 5% interest Total due Capital due at end
due at beginning (repayment)
1 €310.50 €15.50 €326.00 €114 €212.00
2 212.00 10.60 222.60 114 108.60
3 108.60 5.40 114.00 114 –

To calculate the net present value, therefore, we need to estimate all the cash flows – capital
and revenue, positive and negative – that will be incurred if the project is undertaken and then
discount them at the cost of capital.
Another illustration will demonstrate how this is done.
Example
The AB Company is considering the investment of €100 000 in capital equipment. The equipment
will last for 10 years, at the end of which it will have a scrap value of €2500. The net operating
cash flows (cash income received less cash expenses paid out) will be €27 500 per annum for the
first three years and thereafter €37 500 per annum. The company’s cost of capital is 15 per cent.
The first (and most important) step in this illustration and indeed in any investment appraisal
problem in practice is to establish the cash flows in the relevant time periods. Second, we then
find the present value of these at 15 per cent. These are as follows:
Cash flow 15% PV factor PV at 15%
€ €
Year 0 Capital investment −100 000 1.000 –100 000
1 Operating cash flow 27 500 0.870 23 925
67
11 Scrap value 2 500 0.215 537
Net present value 65 909

Although net present value is a useful measure, it is not a term with which the business
community is familiar, and managers are often uncomfortable with it as a measure of cost or
profitability. It shows whether a project is profitable and whether the rate of return is above or
below the cost of capital, but it does not tell us what the actual rate of return is. To do this we
have to turn to the other and more popular technique: the discounted cash flow rate of return.
15.6 Discounted Cash Flow (DCF) Rate of Return

Using our previous example of the investment of €300 and the annual cash inflows of €114 for
three years, the DCF rate of return is 7 per cent. In other words:
Provided the cost of capital to the business is less than 7 per cent, this project is profitable.
An alternative presentation of this is:
Capital
Capital outstanding at Total
7% interest Cash flow outstanding at
commencement of period outstanding
close of period
Year 1 €300 21 321 114 207
2 207 14 221 114 107
3 107 7 114 114 0

(NB: Figures have been rounded to nearest whole number.)
This can be illustrated again by using the example of the AB Company, previously considered.
The cash flows were as follows:
Year 0 −100 000
1 27 500
2 27 500
3 27 500
4 37 500
5 37 500
6 37 500
7 37 500
8 37 500
9 37 500
10 37 500
68
11 2 500
The interest rate that will give all of the above cash flows a total present value of zero is just
over 28 per cent. The project therefore has a rate of return of just over 28 per cent.
The DCF rate of return is then a measure of return or profitability, which is more familiar and
similar to the language of the marketplace, and for that reason is more popular with managers.
‘What return on capital will we get if we invest in new plant?’ is the sort of question the DCF rate
of return seeks to answer. Perhaps the technique is less rigorous than that of net present value;
it is certainly more easily understood.
The actual calculation of the DCF rate of return can be arithmetically tedious and for most
managers is not something they will be likely ever to have to do. All computers and semi-
sophisticated calculators are or can be programmed to do this calculation. What is important for
managers is that they know what the return figure means and are aware of what has gone into,
and perhaps what has been left out of, the figures and the assumptions that have had to be
made and from which the calculated return has been derived. For the manager who wishes to do
the rate of return calculation, a simple step by step method is shown in Appendix 15.2.
15.7 Comparison of Net Present Value and DCF Rate of

Return
Example
An organisation is considering two mutually exclusive proposals. Both require the same piece of
land, so that if one project is selected the other has to be abandoned. Project A requires an
investment of €2000 and generates cash flows of €1309 per annum for two years whereas
Project B requires an investment of €20 000 and generates cash flows of €12 302 per annum for
two years. If we apply the appraisal techniques using 8 per cent as the cost of capital, we get the
following:
Project A Project B
Net present value at 8% €334 €1936
DCF rate of return 20% 15%

We can see therefore that on the basis of NPV we would choose Project B but on the basis of DCF
rate of return we would choose Project A. So which one do we choose? This question has led to
much discussion over the years, and the weight of academic opinion would suggest that the
answer should be Project B, i.e. use NPV. It is not appropriate in this Accounting course to consider
the rationale behind this choice. In any event the choice tends to be discussed in the context of a
‘rational man’ taking decisions in an ‘economic world of certainty’, which differs substantially
from the real world of business. Nevertheless, the use of management accounting techniques
always requires the exercise of judgement, and in this case further analysis can be done that will
help this judgement. It requires the application of the general rule that says that where two
projects that have different patterns of cash flows are being considered, an evaluation of the
difference between the two may provide an insight into the implications of accepting one and
rejecting the other. In this case we can take the difference between the projects and analyse
them as follows:
Project A Project B Difference
cash flow cash flow B−A
€ € €
Year 0 −2 000 −20 000 −18 000
69
1 1 309 12 302 10 993
2 1 309 12 302 10 993

This difference can be looked at in a variety of ways. If we accept Project B, it gives us all that
Project A gives us plus a return of €10 993 per annum for two years for an investment of
€18 000. Is this worth having? Or, if we accept Project A, we will save the initial investment of
€18 000 but will have forgone €10 993 per annum for two years. Is this worth doing? What could
we do with the extra €18 000 that would be available if we accepted A in favour of B? If, for
example, the next best project available required an investment of €18 000 and only generated
cash flows over two years of €10 000 per annum, we could see that it would be better in the first
place to go for Project B because this is better than the combination of Project A and the next
best available project.
It is also useful to apply the normal appraisal analyses on this difference; that is, what the DCF
rate of return is on an investment of €18 000 with cash flows of €10 993 per annum for two
years, and what its NPV is at 8 per cent.
Cash flow of difference between projects

A and B
Year 0 −18 000
1 10 993
2 10 993
NPV @ 8% 1 602
DCF rate of return 14%

We can now see that Project B gives the same rate of return as Project A on the same level of
investment plus 14 per cent on the extra. In light of this, other investment opportunities in the
organisation must be looked at before a decision is reached.
In all cases the first step in evaluation is to calculate the profitability of an investment
opportunity. This is the key information most often required by managers. While familiarity with
the idea of a rate of return on capital makes the DCF rate of return perhaps a more popular
choice, there is no reason why both calculations should not be done.
15.8 Investment Appraisal in Non-Revenue and Not-for-Profit

Situations
For example, suppose an organisation is faced with installing a central heating system in a new
building and has the choice of two different systems or two tenders for the same system. One
system has a higher capital cost but lower operating costs than the other. The organisation’s cost
of capital is 16 per cent. If the different systems have cash flows over their respective lives of six
years as follows, then the evaluation will be:
System 1 System 2
Discount Discount
Cash flows PV at 16% Cash flows PV at 16%
factor factor
Year 0 −€8 000 1.000 €8 000 −€12 000 1.000 €12 000
1 −2 000 0.862 1 724 −1 500 0.862 1 293
70
2 −2 000 0.743 1 486 −1 500 0.743 1 114
3 −2 500 0.641 1 602 −1 500 0.641 961
4 −2 500 0.552 1 380 −2 000 0.552 1 104
5 −3 000 0.476 1 428 −2 000 0.476 952
6 −3 000 0.410 1 230 −2 000 0.410 820
Net present value €16 850 €18 244

System 1 is the cheaper; that is, it has the lower present value, €16 850 compared to €18 244.
On a cost minimisation basis, therefore, System 1 would be the better. Here again, if it helps
(and it is up to managers to decide if indeed it does), we can evaluate the difference between
the two systems to give an additional indication of the financial superiority of one over the other.
Cash flows Cash flows Difference

system 1 system 2
Year 0 −8 000 −12 000 −4 000
1 −2 000 − 1 500 500
2 −2 000 − 1 500 500
3 −2 500 − 1 500 1 000
4 −2 500 − 2 000 500
5 −3 000 − 2 000 1 000
6 −3 000 − 2 000 1 000
NPV at 16% −1 394

Not only does System 1 have a lower present value by €1394, but the investment of the
additional €4000 to achieve savings in costs of €500 in Years 1, 2 and 4, and €1000 in Years 3, 5
and 6 also gives a return of only 3 per cent. (Calculate the 3 per cent for yourself.)
The approach of evaluating differences is a practical way of incorporating into the management
accounting system a very important concept for management: that of opportunity cost. Most
decisions result in changes not only because of what is done but also because of what is not
done; that is, one or more alternatives are forgone. A financial indication that highlights this
forces management to give proper consideration to opportunity cost.
15.11 Payoff or Payback Period

Example
Suppose, for example, that there are two mutually exclusive projects, each concerned with
heavy mining operations in the same place but on different scales. The evaluation might be as
follows:
Option A Option B
Investment €5 000 000 €20 000 000
NPV €2 500 000 €11 000 000
Cost of capital 14% 14%
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Rate of return 19% 24%
Payback 2.5 years 6 years

Despite the higher profitability of Option B, management might still prefer to go for Option A
because of, say, risk factors such as political instability and reliance on government concessions.
15.12 Sensitivity Analysis
Sensitivity analysis could be used on our previous example of AB Company to test what the
outcome would be if selling prices were 10 per cent higher or lower than forecast, assuming that
all the other variables remained the same. The 10 per cent figure is again management
judgement, perhaps based on the reliability and accuracy of past forecasting; it could equally
have been 5 per cent or 15 per cent.
The investment of €100 000 generated cash flows of €27 500 for the first three years, €37 500
for the next seven years, and €2500 from the scrap value proceeds of the equipment in the 11th
year. We saw that the rate of return was just over 28 per cent and with a cost of capital of 15
per cent had a net present value of €65 909. The project also breaks even (i.e. has a discounted
payback) in five years. Suppose now that the forecasters are reasonably confident about their
forecast of production/sales volumes, capital costs, wages and other operating costs but are
uncertain about selling prices because of the relatively volatile market in which trading will take
place. Let us assume also that in setting the forecasts annual sales revenue was estimated as
follows:
Years 1–3 €70 000 per annum
Years 4–10 €75 000 per annum

In order to test the impact of variations in selling prices (a sensitivity analysis) we can
recalculate what the position would be if selling prices were, say, ±10 per cent; that is, a sales
revenue of €70 000 per annum would increase or decrease by €7000.
Original cash Cash flow with 10% Cash flow with 10%
flow decrease in selling prices increase in selling prices
Year 0 −€100 000 −€100 000 −€100 000
1 27 500 20 500 34 500
2 27 500 20 500 34 500
3 27 500 20 500 34 500
4 37 500 30 000 45 000
5 37 500 30 000 45 000
6 37 500 30 000 45 000
7 37 500 30 000 45 000
8 37 500 30 000 45 000
9 37 500 30 000 45 000
10 37 500 30 000 45 000
11 2 500 2 500 2 500
NPV at 15% 65 909 29 409 102 410
72
With reduced selling prices of 10 per cent the project still shows a profit, but much lower than
before. Indeed, if selling prices were more than 18 per cent lower than expected, the project
would run at a loss unless some of the other variables could be adjusted. Of course,
management may regard the prospect of an 18 per cent reduction in selling prices as so remote
as to give confidence that the project will be profitable.
We can now assess the impact a change in selling prices would make, and management must
decide whether this affects its overall assessment and/or whether a reappraisal or new strategy
is required.
15.14.2 Operating Cash Flows

Example
Suppose an investment of €100 000 in new equipment generates operating cash flows of €40 000
per annum for five years with no recovery of the original investment. The DCF rate of return on
this is just over 28.5 per cent, but if the equipment is written off equally over the five years –
straight-line depreciation – then the published financial statements will be:
Year 1 Profit for year €20 000 (€40 000 less depreciation €20 000).
Balance sheet as at Year-end 1

Cost Depreciation Book value
Non-current asset €100 000 €20 000 €80 000
Year 2 Profit for year €20 000 (€40 000 less depreciation €20 000).
Balance sheet as at Year-end 2

Cost Depreciation Book value
Non-current asset €100 000 €40 000 €60 000

This procedure will continue right to the end of the fifth year, when the equipment will be shown
in the balance sheet as having no book value, but the annual profit for the fifth year will still be
€20 000. Looking at the published financial statements, we see that there is no way that the
annual profit of €20 000 can be related to the opening book value, the closing book value or the
average book value for any year to arrive at a figure of 28.5 per cent. This is because investment
appraisal techniques look at profitability over the total life of the project, whereas financial
reporting tries to allocate profit to a specific accounting period. Published financial statements
and what they contain are very important for the overall financial management of a business,
and many organisations, in addition to assessing the DCF profitability of a project, wish also to
see how its image will be reported in successive financial statements.
15.15 Projected Weighted Average Cost of Capital

Example: Residual Equity Shares
Suppose a company has, at present, 100 000 ordinary €1 shares already issued and its current
after-tax earnings are €20 000; that is, it has earnings per share of 20c and the market value of
a €1 ordinary share is €2. This gives an earnings yield of 20c or 10 per cent, i.e. 20c on €2. If
there were no costs of issuing such shares and €2 was actually received for every share issued,
then the rate of return for the cost of capital calculation would be 10 per cent. However, there
will be issue expenses and the cash actually received will be less than the price paid, so this will
have to be allowed for. If issue costs are, say, 5 per cent of cash paid – that is, out of the €2 the
company only receives €1.90 – then the target rate of return will have to be higher than the 10
per cent previously calculated. If €50 000 is to be raised by the issue of ordinary shares, then the
number of shares to be issued at a price of €2 will be €50 000/€1.90 = 26 316. To earn on that
number of shares the same 20c per share as before, the earnings will have to be 26 316 × 20c,
73
which equals €5263. The target return on the €50 000 invested will therefore be €5263/€50 000,
or 10.5 per cent.
15.16 Weighted Average Cost of Capital

Suppose the corporate plan shows a projected capital structure as follows:
Optimum
Source of finance Estimated cost
proportion (%)
Long-term loans 30 8.75%
Preference share capital 5 10.50%
Existing ordinary share capital 20 10.00%
New ordinary share capital 10 10.50%
Retained earnings 35 10.00%
100
Using the optimum proportions as weights, the weighted average cost of capital can be
calculated as:
Long-term loans 0.30 × 8.75 = 2.625
Preference share capital 0.05 × 10.50 = 0.525
Existing ordinary share capital 0.20 × 10.00 = 2.000
New ordinary share capital 0.10 × 10.50 = 1.050
Retained earnings 0.35 × 10.00 = 3.500
9.700
The weighted average cost of capital is therefore 9.7 per cent.
15.17 Opportunity Cost, Risk and the Cost of Capital

Case Study
The AB Company is considering investing €100 000 in capital equipment – payable €60 000 on
receipt, €40 000 in one year. Installation costs €10 000. The machine will last for 10 years at the
end of which the scrap value will be €2500. Working capital will increase as follows:
Debtors €30 000
Creditors 20 000
Stocks 15 000
The net operating cash flows will be €30 000 per annum for the first four years and thereafter
€35 000 per annum.
The cash flows do not include interest on an increased bank overdraft of €15 000, which is
estimated at €2500 per annum.
The company intends to issue a 10-year €50 000 12 per cent long-term loan (debenture)
repayable at par.
The company’s cost of capital is based on a target long-term capital structure of:
74
 60 per cent equity at cost of 18 per cent;
 40 per cent loans (debentures) at average cost of 13 per cent.
The cash profile of the proposed investment is therefore:
1 2 3 4 5 6
Working Bank Operating
Equipment Installation Total cash flow
capital overdraft cash flows
€ € € € € €
Year 0 −60 000 −10 000 15 000 −55 000
1 −40 000 −25 000 −2 500 30 000 −37 500
2 −2 500 30 000 27 500
3 −2 500 30 000 27 500
4 −2 500 30 000 27 500
5 −2 500 35 000 32 500
6 −2 500 35 000 32 500
7 −2 500 35 000 32 500
8 −2 500 35 000 32 500
9 −2 500 35 000 32 500
10 −17 500 35 000 17 500
11 2 500 25 000 27 500

Notes
1. Capital equipment – payable in two instalments of €60 000 and €40 000 with allowance
for scrap value received in Year 11, i.e. after end of project life.
2. Installation – assumed to take place and to be paid at beginning of project.
3. Working capital – debtors plus stock less creditors. It is assumed that investment takes
place in Year 1, and that all of this is recovered (disinvestment) at end of project.
4. Bank overdraft (short-term loans) – according to information given short-term loans do not
form part of target capital structure and do not enter into the calculation of the cost of
capital. All the cash flows associated with this therefore must be included in the cash
profile; that is, the original loan as an inflow and the interest charged and the
repayment of the loan as outflows.
5. Operating cash flows – as given in the original data.
6. Total cash flows – the year by year total cash outflow or inflow.
7. €50 000 12 per cent long-term loan (debenture) – this is not included in the cash profile
because it is assumed it is allowed for in the cost of capital calculation (see 8 below) as
part of the 40 per cent of capital that is, or is to be, raised from long-term loans.
8. Cost of capital – the cost of capital can be calculated as 16 per cent, as follows:
60% Equity at 18% 10.80%
40% Long-term loans at 13% 5.20%
16.00%
75
If the project is now evaluated it gives a net present value of €34 007 at 16 per cent or a rate of
return of 24.4 per cent. It breaks even after 6.5 years. If required, a sensitivity analysis could be
done on the key variables.
PV 16% PV cash PV 24% PV cash PV 28% PV cash flow at

Cash flow
factor flow at 16% factor flow at 24% factor 28%
€ € € €
Year 0 −55 000 1.000 −55 000 1.000 −55 000 1.000 −55 000
1 −37 500 0.862 −32 325 0.806 −30 225 0.781 −29 287
2 27 500 0.743 20 432 0.650 17 875 0.610 16 775
3 27 500 0.641 17 627 0.524 14 410 0.477 13 117
4 27 500 0.552 15 180 0.423 11 632 0.373 10 257
5 32 500 0.476 15 479 0.341 11 082 0.291 9 457
6 32 500 0.410 13 325 0.275 8 937 0.227 7 377
7 32 500 0.354 11 505 0.222 7 215 0.178 5 785
8 32 500 0.305 9 912 0.179 5 817 0.139 4 517
9 32 500 0.263 8 547 0.144 4 680 0.108 3 510
10 17 500 0.227 3 972 0.116 2 030 0.085 1 487
11 27 500 0.195 5 362 0.094 2 585 0.066 1 815
€34 007 €1 038 −€10 190
16.2 Target Costing
Example
Environmentally-Unfriendly Ltd. (E-U) specialises in designing and manufacturing products that
allow consumers to overcome what they regard as harsh and oppressive environmental
regulations. The market research department recently identified a power saw so quiet that trees
could be cut down without the tiresome attention of neighbours or environment protectionists.
The company already makes a range of power tools that are designed to give assistance to
consumers who find natural happenings irritating (a recent best-seller was a vacuum that sucked
autumn leaves from trees before they dropped).
Market research indicated that there would be demand for the power saw at around €500. This
would represent a significant premium on power saws of comparable motor and blade size, but
consumers indicated they were prepared to pay extra for the deafening features of the saw
together with a built-in spotlight (most consumers would use this product after dark), which the
designers had inserted into the prototype. Existing cost records of E-U indicated that the
following costs would be incurred in the manufacturing process:
Direct materials €260; direct labour €120; overhead €160; Total €540.
E-U required a gross margin of 20 per cent on the manufacturing costs of its power products.
Comment
76
Applying standard costing to this problem, E-U would add its required mark-up of 20 per cent to
its identified manufacturing costs, namely a cost-plus approach:
Manufacturing cost €540.00
Mark-up @ 20% 108.00
Price €648.00
Under this view of costing E-U would not wish to produce the new range of quiet power saws
because it would not be able to sell them for anywhere near €648. If the market researchers
have done their job correctly, E-U is €148 too expensive to be competitive.
Target costing approaches the potential product launch from the other end. First, it would
calculate what gross margin it would require to make on a product that sells for €500:
Assumed selling price €500.00
less Mark-up @ 20%* 83.34
Target cost €416.66

* Calculation of mark-up:
Selling price of €500 equals 100% cost plus 20% margin on cost = 120%
Therefore cost equals €500 divided by 1.20 = €416.66
(Test: add 20% mark-up to €416.66 cost = €500)
Now the target price has been identified. E-U would set about the task of reducing its
manufacturing costs from the standard cost of €540 to the new target of €417, a tough task
indeed. First its designers would consider using modules common to other power saws in the
range rather than employing brand new modules designed especially for this model; next the
external supplier of the silence muffler module would be approached to see if improvements
could be made on the price initially quoted. This may involve E-U guaranteeing minimum
purchase levels or committing itself to purchase other parts from the supplier. At the same time
the production engineers would study the proposed new model to see if savings could be made in
purchasing sub-assemblies rather than manufacturing all internally. An activity-based costing
study should also be carried out to ensure that the elements comprising the overhead of €160
have been properly accounted for and that the new product would actually consume resources
amounting to this amount.
The tensions will begin to emerge when E-U discovers that there is still a gap between the target
cost of €417 and the higher re-calculated manufacturing cost. The difficult decision is to drop the
notion and devote one’s efforts to other new ideas. But so many companies admit that they are
so far down the road by the time the bad news is received they tend to proceed with the new
product and hope that the gap will close as the project progresses: manufacturing costs will
somehow become lower, the price point will miraculously rise, the volumes anticipated become
larger in reality, the product’s life will be longer than first thought. In reality, all of those
parameters usually become worse, not better, and the damage done to the company by
launching with a negative gap becomes even greater.
Example
77
Puff Safe Ltd is a manufacturer of side-impact airbags for the luxury quality car market. The
company currently sells 100 000 models of its top-of-the range ABX airbag principally to two car
manufacturers, which have both indicated to Puff Safe that they expect a 10 per cent reduction
in price next year together with new features including an even faster response from impact to
inflation. Currently the ABX airbag is sold to car manufacturers for €100 and Puff Safe can expect
to lose virtually all of its sales next year if it does not reduce the price to €90 and add the
required extra features. Equally, there is no guarantee that volume will increase if the price
reduction is implemented.
Currently each airbag costs €63 to manufacture or €6 300 000 per year. The individual costs are
set out below.
Direct material 3 640 000
Direct labour 560 000

Machine costs 630 000
R&D costs 422 800
Chemical and explosive testing 700 000
Recalibration costs 280 000
Ordering and facilitating costs 67 200
6 300 000
An activity-based costing exercise carried out last year at the insistence of one of the car
manufacturers to which Puff Safe supplies airbags revealed the following principal activities and
drivers:
Cost per unit of

Activity Description of activity Cost driver
cost driver
Machining of individual
Machine cost components and some None identified Fixed cost
mechanical assembly
Designing new products and

R&D testing bought-in None identified Fixed cost
components
Chemical and Each bag is tested for speed of €3.50 per

No. of hours of testing
explosive testing inflation and chemical afterburn hour
Reworking of microdevices in €18.66 per

Recalibration No. of bags recalibrated
each bag which failed test bag
Ordering of microdevices and

No. of orders placed
Ordering and other components and €224 per
with
facilitating facilitation of smooth running of order
suppliers
plant
Each airbag contains 10 components, each supplied by a separate supplier. On average 30
orders per year are placed with each supplier. Currently 15 per cent of airbags fail the chemical
and explosive test, which takes two hours, and are therefore subject to recalibration.
78
To assess the impact of the warning from the two major customers, the CEO of Puff Safe
convened a meeting of his senior management team.
CEO
We had an idea that this was going to happen when we heard earlier this year that a Taiwanese
supplier had entered the market for ABX side-impact airbags. I had rather hoped for another six
to 12 months’ breathing space. However, we know that we’ve got to drive down costs without
sacrificing quality.
Financial Controller
It doesn’t take a genius to work out that if our costs of manufacture are currently €63 we really
have to shave those by €10 to match the 10 per cent reduction in sales prices. Otherwise, our
margins will be eroded on the ABX. We’re under so much pressure on our other ranges we really
must meet the new target cost of €53.
R&D Manager
We’ve reverse-engineered a couple of competitors’ products and reckon we can reduce the
number of components from 10 to eight. This is possible because two of the existing components
have been upgraded to carry extra features. We can therefore drop two components.
Purchasing & Logistics Manager

Excellent. That means we can drop the suppliers of these two components. It’s a goal of mine to
source our component purchasing with only three suppliers, but R&D keeps telling us that the
components and microdevices are so specialised no supplier can handle more than one. I’ve
looked into the number of orders we make each year, and with smarter procedures we can drop
from 30 to 25. I’m reluctant to go further because of the constant upgrades being made by some
suppliers; we don’t want to be landed with obsolete stock.
R&D Manager
We’re working on this and clearly the reduction from 10 to eight shows you what’s possible. I’ve
every confidence of reducing this further, but not in the time scale to meet this target cost of
€53.
Chemical & Explosion Manager

The new kit we bought last year will allow us to test each bag in 1.75 hours, a reduction from the
two hours we currently take.
Recalibration Manager
One of the depressing features of our production techniques is the large percentage of failures
coming from the explosion bunker. Currently we’re running at 15 per cent. I hope R&D is right in
saying that a simplified construction using only eight components will reduce failures to 10 per
cent. Even at this level, we’ve a long way to go if we want to become world class.
Purchasing & Logistics Manager

We’ve made headway with negotiating lower prices for our fabric, which will cut the material cost
per bag by €6. And a more flexible use of direct labour will result in a modest headcount
reduction, leading to €1 less direct labour per bag.
CEO
Okay, that’s a good start. Could you [to his financial controller] factor in all these adjustments to
the current unit cost of €63 and let us know where we stand? I suggest you use the cost drivers
we calculated last year. If we can’t make €53, we’ll all have to look again for more improvement.
I’m determined to meet this demand for a reduced sales price and I’m not prepared to sacrifice
margin.
Comment
79
The financial controller’s task is, first, to quantify the savings described in the CEO’s
brainstorming session and, second, to recommend where further reductions might be made.
Direct material: Savings of €6 per bag × 100 000 bags €600 000
Direct labour: Savings of €1 per bag × 100 000 bags €100 000
Machine costs: No change envisaged: fixed costs
R&D costs: No change envisaged: fixed costs
Chemical and explosives Savings in time = 0.25 hours × 100 000 bags
testing: × €3.50 per hour € 87 500
Recalibration costs: Savings in failures (from 15% to 10%) = 5000
× €18.66 € 93 300
Ordering and facilitating costs: Current orders 10 × 30 = 300
Planned orders 8 × 25 = 200
Savings in orders 100 × €224 € 22 400

These savings are now displayed against the current total costs to give the proposed total costs:
Current costs Savings New costs
€ € €
Direct material 3 640 000 600 000 3 040 000
Direct labour 560 000 100 000 460 000
Machine costs 630 000 – 630 000
R&D costs 422 800 – 422 800
Chemical and explosives 700 000 87 500 612 500
Recalibration 280 000 93 300 186 700
Ordering and facilitating 67 200 22 400 44 800
6 300 000 903 200 5 396 800
Volume produced 100 000 100 000
Cost per unit €63.00 €53.968

Note that the target cost has not been reached and the CEO is clearly going to look for the
management team to ‘sharpen their pencils’ to shave another €1 or so from the indicative unit
price of €53.968. The financial controller would be concerned that no explanation was provided
at the meeting for the fact that machine costs and R&D costs should still be regarded as fixed.
The contracts under review are to run next year, and so there is no reason why costs cannot be
taken out of these so-called fixed costs. If the number of components is set to fall, the machine
costs are bound to fall, because of the relatively simplified procedures required to manufacture
and assemble the bags. Costs for R&D are too often regarded as sacrosanct, not to be cut under
any circumstances. Recently, we have seen major companies in the high-technology sectors
reduce headcount and geographical locations thereby giving sharper focus to their efforts,
resulting in an improvement in their innovation indicators. Indeed the entire activity could be
outsourced – which could result in short-term savings. However, this action could have long-
80
term implications because the company would be at the mercy of the market in terms of price
and service standards at the end of the contract, having no internal resource to use as a
benchmark.
The financial controller would be well advised to warn his colleagues that this operational review
brought about by a reduction in the target cost is likely to be ongoing in an industry that uses
microdevices.
16.3 Life Cycle Costing

Example
A major firm of accountants and financial consultants is considering putting effort into one of
three new products: a risk management assessment package, a tax planning module, or a
training package in activity-based costing. Each would have a ‘shelf life’ of three years, and each
would require substantial design time at the beginning of the life cycle.
The marketing consultants used by the firm of accountants have sounded out their existing client
list, the clients of other targeted accounting firms and other similar products in the market and
have produced the following profile of suggested selling prices and annual sales.
Packages sold
Selling price Year 1 Year 2 Year 3
Risksave €1 200 3 000 4 000 1 000
Taxplan 1 500 4 000 2 000 2 000
ABCost 1 000 2 000 2 000 2 000

Because of bad experiences in the past, when new products were launched without care being
taken to evaluate their profitability with all associated costs, the partner in charge of the financial
consulting division insisted that a life cycle costing exercise be carried out to attempt to
profile all costs for the duration of the sales period and beyond.
The following costs are collated for each of the three products. Note that for Taxplan the costs
will run beyond the end of Year 3 (when sales stop), to indicate the need to upgrade customers’
software tax packages with current fiscal legislation. None of the others requires such an
upgrade.
Risksave (€000s)
Year 1 Year 2 Year 3
Revenue from sales 3 600 4 800 1 200
Costs:
Expert design of concept 2 000 100 –
Software writing 3 000 200 –
Manual authorship 1 200 100 –
Production of packs 500 100 200
Advertising and distribution 500 200 100
Customer training 800 200 200
Taxplan (€000s)
81
Year 1 Year 2 Year 3 Year 4 Year 5
Costs:
Expert design of concept 4 000 200 100 100 100
Software writing 2 000 500 500 400 300
Manual authorship 1 000 100 100 100 100
Production of packs 1 000 600 300 – –
Advertising and distribution 500 300 300 – –
Customer training 100 100 100 – –
ABCost (€000s)
Year 1 Year 2 Year 3
Costs:
Expert design 1 000 – –
Software writing 1 000 – –
Manual authorship 500 – –
Production of packs 200 200 200
Advertising and distribution 200 – –
Customer training 100 100 100
Purchase of PC 900
Comment
A life cycle costing approach to project appraisal simply tracks against the revenue generated
from the product all the costs associated with its design, manufacture, distribution and field
service. It therefore breaks down two barriers erected by the normal accounting processes: (a)
the differentiation between capital and revenue is removed, that is, the purchase of an asset
dedicated to a product is viewed alongside the annual costs of manufacture and distribution; and
(b) the annual focus of accounting is obliterated as the lifetime revenues are matched
against lifetime costs.
Lifetime income statements (€000s)
Risksave Taxplan ABCost
Costs:
Expert design of concept 2 100 4 500 1 000
Software writing 3 200 3 700 1 000
Manual authorship 1 300 1 400 500
Production of packs 800 1 900 600
82
Advertising and distribution 800 1 100 200
Customer training 1 200 300 300
Purchase of hardware – – 900
9 400 12 900 4 500
Profit/(Loss) 200 (900) 1 500
9 600 12 000 6 000

On the face of it, ABCost is by far the most profitable of the three proposed software products,
promising a return of 25 per cent on revenue against a 2.08 per cent return for Risksave and a
loss for Taxplan. However, the firm may want to consider how the returns on Risksave and
Taxplan could be improved before abandoning them, since each would provide a market
penetration of 8000 packages against only 6000 for ABCost. If the firm believed it could sell
other services on the back of the software products, then ABCost yields lower opportunities.
An analysis of Taxplan’s life cycle costs and revenues shows that the lifetime loss of €900 000 is
due to the ‘tail’ of costs envisaged in Years 4 and 5. This may be inevitable because of the built-
in annual obsolescence of a product based on fiscal legislation; new tax rules and rates have to
be embedded in the software and the manuals accompanying the packages have to be updated
with the same information. Perhaps a solution to this problem would be for the software package
to be designed to be manual-independent (by having all operating instructions and the text of
legislation accessible on screen). This would remove €1 400 000 from the life cycle costs, thereby
producing a return of €500 000 (or 4.16 per cent) for Taxplan. It is also unclear why this product
requires annual expenditure on expert design for each of the five years; if Years 4 and 5 could be
eliminated, a further €200 000 would drop into the bottom line.
16.4 Throughput Accounting
Scenario 1
A plant supervisor is under pressure to avoid running up adverse cost variances this quarter. He
must therefore choose the manufacturing alternative that minimises his costs. Alternative A
employs a brand-new computer-controlled machine with a consequent low labour input. The cost
accountants view the high depreciation charge on this machine as a production overhead to be
loaded to products by use of direct labour hours. Since the new machine causes less labour to be
used, the supervisor is attracted by this alternative as a way of holding down product costs.
Alternative B, however, looks at depreciation differently. This alternative involves using an older
machine to do the manufacturing task. The older machine has a relatively lower depreciation
charge than the new machine, and since depreciation under this alternative is to be loaded via a
machine-hour base the supervisor is attracted to the use of the older machine.
Scenario 2
The supervisor is concerned about idle time beginning to appear on his labour variances and
machines that are shut down for parts of the working week. His training leads him to the view
that spare capacity must be filled; he is also aware that inventory levels are flexible. So he
instructs that production be increased to full capacity and that the inventories of finished goods
be increased. In this way he will avoid adverse production variances and the asking of questions
about how best to shed spare capacity (which may include getting rid of him). And adding value
to materials is always a beneficial goal, he reminds himself.
83
Scenario 3
The managing director of the company wants to know which of the two products manufactured is
more profitable. They are very similar in selling price, the materials component and labour. Both
products take about the same time to make and go through the same number of processes. He
calls for a contribution analysis by product:
Product X Product Y
€ €
Selling price 200 200
Direct material 50 50
Direct labour* 100 105
Direct cost 150 155
Contribution 50 45

*The calculation for direct labour is based on a detailed timing in each of four
operational processes:

Cutting Stamping Machining Assembly Total hours
Available hours per

400.0 500.0 200.0 400.0
week
Product X per unit 2.0 3.0 4.0 1.0 10.0
Product Y per unit 2.5 4.5 2.0 1.5 10.5

At a labour rate of €10 per hour Product X costs €100 and Product Y €105. The managing
director is now convinced that Product X is the more profitable of the two.
The three scenarios view the provision of cost information from a traditional costing point of
view. However, the solutions described fail to recognise the reality of the business situation as
looked at from throughput; that is, the rate at which money is earned. Taking a throughput
perspective we would analyse the three scenarios differently:
Throughput Concept 1
Depreciation is merely the accounting for a previously incurred cost on non-current assets. In the
short term, the supervisor is stuck with both the old and new machines regardless of whether he
uses them. Such costs, and many other factory costs of a similar fixed nature, should be
excluded from performance measures; total factory costs, that is, those costs over the short
term that do not move with production, should be grouped together as one cost. Direct labour
will also be included in total factory cost because, in the short term, labour costs do not move
with production. Only material costs are excluded from total factory cost.
Value is created by a business when it sells products, not when it makes them. This, of course,
runs counter to the perception given by financial reporting procedures that rewards a business
with a high end-of-year inventory with a high end-of-year profit. There is no value in inventory,
only costs. If productive capacity is idle because demand is slack over the short term, so be it. It
84
is much less costly for the business to incur total factory cost (described above) than total
factory cost plus a build-up of unwanted inventory. By treating inventory as something to be
driven down and out of a business, management can concentrate on maximising throughput
from manufacturing to the customer. This is the link in which profit lies, not in a misguided
notion of maximising the efficiency of men, women and machines by producing unwanted
inventory.
Contribution is a notion that has been discussed widely in these modules. But readers will
remember that limiting factors or bottlenecks must be taken into consideration in determining
relative product profitability. In the example in Scenario 3 the major bottleneck was the
machining operation with only 200 hours available. If profitability is defined as the rate at which
cash is received from customers, then Product Y becomes profitable simply because twice the
number of Product Ys can be produced at the bottleneck than can Product Xs:
Product X at the bottleneck = 200/4 = 50 units
Product Y at the bottleneck = 200/2 = 100 units

By concentrating production and sales on throughputting Product Y, the business would earn
money more quickly. Product profitability, therefore, is the rate at which products earn money,
not the method whereby they share costs.
These concepts can be put to use in re-examining contribution as a measure of profitability.

Throughput accounting stresses that products do not earn profit, but rather businesses earn
profit by selling products. Proponents use measures of return per factory hour and cost per factory
hour in calculating a throughput ratio:
These two numbers are then combined to give a throughput accounting ratio:
This latter ratio informs management about the rate at which products earn money for the
business. A ratio less than 1 indicates that a product is losing money. Extending our example we
can see the throughput accounting ratio in action:
For both Products X and Y
Selling price per unit: €200
Direct material per unit: €50
Total factory cost: €8 000

Product X Product Y
(€200 − €50)/4 hours Return per factory hour (€200 − €50)/2 hours
€37.50 per hour €75 per hour

The return per factory hour is the amount of money earned through sales of a specific product
per hour of limiting factor, or bottleneck. Because the limiting factor is the machining operation,
we select the number of hours each product spends in machining as the denominator of the
fraction.
85
€8000/200 Cost per factory hour €8000/200
€40 per hour €40 per hour

The cost per factory hour is the total cost of running the productive capacity (all costs except
material costs) divided by the number of hours available at the bottleneck.
Product X Product Y
€37.50/€40.00 Throughput accounting ratio €75.00/€40.00
0.9375 1.8750
When this firm manufactures only Product X it loses money, but if only Product Y is made it
makes money. Earning money is not the same as earning contribution; the former is a much
more immediate measure of performance, which can very often be forgotten in the accountant’s
concentration on contribution. A business can only earn profits if the rate at which it earns
money from sales is greater than the rate at which it spends money on production. Product Y
demonstrates this ability; Product X does not. The throughput ratio allows management to direct
its business by helping managers to concentrate on current production constraints. Note that,
where more than one constraint can be identified, linear programming would be used as a
decision tool.
16.5 Costing for Competitive Advantage

Example
The Electric Motor Company Ltd is a medium-sized and profitable business with a long and
distinguished history of supplying electrical motors to the white goods industry (washing
machines, freezers, dishwashers, tumble dryers and refrigerators). Currently its entire output is
taken by two European-based multinational companies whose white goods divisions are enjoying
buoyant demand. Both of these companies have recently intimated that they require, between
them, 2100 motors per month and can guarantee take-up for the next 12 months. The company
sells its motors for €80.
The limiting factor at Electric Motor is supply of skilled machinists – whose dexterity is rewarded
at higher remuneration levels by a nearby US computer firm manufacturing laptop computers.
Skilled machinist labour hours available per month amount to 4500 hours. However, Electric
Motor has often used Sparks Ltd as a subcontractor at peak demand time and has always been
happy with the quality of service delivered by Sparks.
At the recent strategy retreat at a nearby country house hotel, the managing director of Electric
Motor, Mr Volt, set out the two strategies that confronted his company when reviewing the next
12 months in the light of the increased orders from his two customers.
Strategic Option No. 1

Electric Motor should manufacture and assemble complete motors up to the limit of machinist
hours available and subcontract any balance remaining to Sparks. Electric Motor would inspect
and test Sparks’ motors; each test costs €3.00.

Electric Motor should manufacture as many of the three separate components of each motor as
the limiting factor would permit and subcontract the remaining components to Sparks, which has
indicated its willingness to receive business on this basis. Electric Motor would continue to
inspect and test. Ignore assembly costs.
86
Mr Volt has asked you as his management accountant to cost the two strategies outlined above.
To allow you to do so, you receive some technical production information from Mr Amp, the
production director. This is as follows.
Each motor comprises three components – casing, rotor and resistor – each of which has more
than one part and has the following production characteristics:
Casing Rotor Resistor
Subcontract price €75 €34.00 €18.00 €23.00
Parts for component 4 3 2
Material cost per part €1.50 €1.25 €1.00
Machinist minutes per part 15 10 25
Machinist labour rate per hour €15
Variable overhead 40% of labour cost
Fixed overhead per month €20 000

Solution
Limiting factor is machinist labour hours per month = 4500 (expressed in minutes = 270 000)
Machinist labour per motor (in minutes)
Casing 4 × 15 = 60
Rotor 3 × 10 = 30
Resistor 2 × 25 = 50 140
No. of complete motors that can be made 1928
Total demand per month 2100
No. of motors to be subcontracted 172

Strategic Option No. 1 (Status quo)
Electric Motor’s cost profile € €
Sales price 80.00
Direct material (€6 + €3.75 + €2) 11.75
Direct labour (€15 + €7.50 + €12.50) 35.00
Variable overhead (40% × DL) 14.00
Inspection and testing 3.00 63.75
Contribution per motor 16.25
Total contribution: €
By manufacture and sale 1928 × €16.25 31 330
By subcontracting and sale 172 × [€80 less (€75 + €3)] 344
31 674
Fixed costs of electric motors 20 000
87
Profit 11 674
Strategic Option No. 2 (‘Cherry-pick’)
Electric Motor’s contribution per limiting factor
Component Casing Rotor Resistor
€ € €
Direct material 6.00 3.75 2.00
Direct labour 15.00 7.50 12.50
Variable overhead 6.00 3.00 5.00
Total variable cost 27.00 14.25 19.50
Buy-in price 34.00 18.00 23.00
Contribution per component 7.00 3.75 3.50
Limiting factor in minutes 60 30 50
Contribution per limiting factor €0.1167 €0.1250 €0.0700
Ranking 2 1 3
Limiting factor in minutes 270 000
1. Rotors 2100 × 30 minutes 63 000
2. Casing 2100 × 60 minutes 126 000
3. Resistors 1620 × 50 minutes (balancing figure) 81 000
270 000
Electric Motor should therefore manufacture the above numbers of each component and
subcontract 480 resistors to Sparks Ltd.
Profitability of Strategic Option No. 2

Internal contribution: € €
Rotors 2100 × €3.75 7 875

Casings 2100 × €7.00 14 700
Resistors 1620 × €3.50 5 670
28 245
Contribution from subcontracting 2100 × (€80 − €75) 10 500
Total contribution* 38 745
Less: inspection and testing 2100 × €3 6 300
Fixed costs 20 000 26 300
Profit 12 445
* Electric Motor earns contribution from two sources:
1. From own manufacturing where own variable costs are below buy-in costs from
Sparks. This contribution is based on only those components manufactured in house.
88
2. From sales of all units. Electric Motor sells each of the 2100 motors at €80 and the
buy-in equivalent price is €75.
An alternative way of looking at Electric Motor’s contribution is to view the business as having
made and sold 1620 complete motors, with the balance being made up by ‘cherry-picking’ the
best alternatives from one of two sources:
Contribution from 1620 motors made internally (€80 − €60.75) 31 185
Contribution from 480 motors bought in (€80 − €75) 2 400
Contribution from components made internally:
Casings: 480 × (€34 − €27) 3 360
Rotors: 480 × (€18 − €14.25) 1 800
Total contribution (as above) 38 745

Comment
In a straight comparison of bottom lines Strategic Option No. 2 is more profitable by €771. But
remember that accounting numbers do not drive managerial decisions. Mr Volt may consider that
the incremental financial advantage does not merit the ‘cherry-picking’ style of production that
Electric Motor would be adopting in Option 2. Sparks may realise what is happening and offer
quantity discounts or a discount on a completed motor and continue to charge current prices for
individual components. A price uplift of €1.60 per resistor would negate any advantage of this
strategy (€771/480).
16.5 Costing for Competitive Advantage

Example
The Electric Motor Company Ltd is a medium-sized and profitable business with a long and
distinguished history of supplying electrical motors to the white goods industry (washing
machines, freezers, dishwashers, tumble dryers and refrigerators). Currently its entire output is
taken by two European-based multinational companies whose white goods divisions are enjoying
buoyant demand. Both of these companies have recently intimated that they require, between
them, 2100 motors per month and can guarantee take-up for the next 12 months. The company
sells its motors for €80.
The limiting factor at Electric Motor is supply of skilled machinists – whose dexterity is rewarded
at higher remuneration levels by a nearby US computer firm manufacturing laptop computers.
Skilled machinist labour hours available per month amount to 4500 hours. However, Electric
Motor has often used Sparks Ltd as a subcontractor at peak demand time and has always been
happy with the quality of service delivered by Sparks.
At the recent strategy retreat at a nearby country house hotel, the managing director of Electric
Motor, Mr Volt, set out the two strategies that confronted his company when reviewing the next
12 months in the light of the increased orders from his two customers.

Electric Motor should manufacture and assemble complete motors up to the limit of machinist
hours available and subcontract any balance remaining to Sparks. Electric Motor would inspect
and test Sparks’ motors; each test costs €3.00.

Electric Motor should manufacture as many of the three separate components of each motor as
the limiting factor would permit and subcontract the remaining components to Sparks, which has
89
indicated its willingness to receive business on this basis. Electric Motor would continue to
inspect and test. Ignore assembly costs.
Mr Volt has asked you as his management accountant to cost the two strategies outlined above.
To allow you to do so, you receive some technical production information from Mr Amp, the
production director. This is as follows.
Each motor comprises three components – casing, rotor and resistor – each of which has more
than one part and has the following production characteristics:
Casing Rotor Resistor
Subcontract price €75 €34.00 €18.00 €23.00
Parts for component 4 3 2
Material cost per part €1.50 €1.25 €1.00
Machinist minutes per part 15 10 25
Machinist labour rate per hour €15
Variable overhead 40% of labour cost
Fixed overhead per month €20 000

Solution
Limiting factor is machinist labour hours per month = 4500 (expressed in minutes = 270 000)
Machinist labour per motor (in minutes)
Casing 4 × 15 = 60
Rotor 3 × 10 = 30
Resistor 2 × 25 = 50 140
No. of complete motors that can be made 1928
Total demand per month 2100
No. of motors to be subcontracted 172

Strategic Option No. 1 (Status quo)
Electric Motor’s cost profile € €
Sales price 80.00
Direct material (€6 + €3.75 + €2) 11.75
Direct labour (€15 + €7.50 + €12.50) 35.00
Variable overhead (40% × DL) 14.00
Inspection and testing 3.00 63.75
Contribution per motor 16.25
Total contribution: €
By manufacture and sale 1928 × €16.25 31 330
By subcontracting and sale 172 × [€80 less (€75 + €3)] 344
90
31 674
Fixed costs of electric motors 20 000
Profit 11 674
Strategic Option No. 2 (‘Cherry-pick’)
Electric Motor’s contribution per limiting factor
Component Casing Rotor Resistor
€ € €
Direct material 6.00 3.75 2.00
Direct labour 15.00 7.50 12.50
Variable overhead 6.00 3.00 5.00
Total variable cost 27.00 14.25 19.50
Buy-in price 34.00 18.00 23.00
Contribution per component 7.00 3.75 3.50
Limiting factor in minutes 60 30 50
Contribution per limiting factor €0.1167 €0.1250 €0.0700
Ranking 2 1 3
Limiting factor in minutes 270 000
1. Rotors 2100 × 30 minutes 63 000
2. Casing 2100 × 60 minutes 126 000
3. Resistors 1620 × 50 minutes (balancing figure) 81 000
270 000
Electric Motor should therefore manufacture the above numbers of each component and
subcontract 480 resistors to Sparks Ltd.
Profitability of Strategic Option No. 2

Internal contribution: € €
Rotors 2100 × €3.75 7 875
Casings 2100 × €7.00 14 700
Resistors 1620 × €3.50 5 670
28 245
Contribution from subcontracting 2100 × (€80 − €75) 10 500
Total contribution* 38 745
Less: inspection and testing 2100 × €3 6 300
Fixed costs 20 000 26 300
Profit 12 445
91
* Electric Motor earns contribution from two sources:
1. From own manufacturing where own variable costs are below buy-in costs from
Sparks. This contribution is based on only those components manufactured in house.
2. From sales of all units. Electric Motor sells each of the 2100 motors at €80 and the
buy-in equivalent price is €75.
An alternative way of looking at Electric Motor’s contribution is to view the business as having
made and sold 1620 complete motors, with the balance being made up by ‘cherry-picking’ the
best alternatives from one of two sources:
Contribution from 1620 motors made internally (€80 − €60.75) 31 185
Contribution from 480 motors bought in (€80 − €75) 2 400

Contribution from components made internally:
Casings: 480 × (€34 − €27) 3 360
Rotors: 480 × (€18 − €14.25) 1 800
Total contribution (as above) 38 745

Comment
In a straight comparison of bottom lines Strategic Option No. 2 is more profitable by €771. But
remember that accounting numbers do not drive managerial decisions. Mr Volt may consider that
the incremental financial advantage does not merit the ‘cherry-picking’ style of production that
Electric Motor would be adopting in Option 2. Sparks may realise what is happening and offer
quantity discounts or a discount on a completed motor and continue to charge current prices for
individual components. A price uplift of €1.60 per resistor would negate any advantage of this
strategy (€771/480).
16.6 The Balanced Scorecard

DIY Example
Fontainebleau Fashions (FF), is a growing retailer of chic clothes for the young professional
females of Paris and Ile-de-France, the part of France surrounding Paris. It developed an image
of who its targeted customers were:
 Range: 19- to 38-year-old female (target: 30 years)

 University- (or college)-educated
 Works full-time in a professional executive position
 Innovatively fashionable
 Self-confident, active social life, great sense of humour
It then communicated this targeted customer image externally, through a variety of carefully
targeted advertising, in-store promotional materials and on its web pages.
By communicating a clear image to potential customers, the stores group enabled its existing
and future customers to imagine themselves as fitting an image associated with purchasing
clothes at FF. The company creates for its customers an image of who they can be, in addition to
selling them fashionable clothing of high quality at reasonable prices.
FF started the development of its customer objective by defining a customer strategy:
92
1. FF must increase its customers’ ‘share of wardrobe’.
2. Increased share of wardrobe will be achieved by customer loyalty: ‘We want the customer
to visit us throughout the year, not just in the spring and autumn, and come to FF for
the complete range of her lifestyle needs.’
3. To create this loyalty:
 Our Merchandise must define our customer, her needs, and her aspirational
image;
 Our Brand must satisfy the customer’s aspirational and lifestyle goals;
 Our Shopping Experience must promote customer loyalty.
4. We must do a superb job of defining who our customers are and what their buying
behaviour is.
FF identified three objectives as key product attributes for its consumers’ value proposition:
price, fashion and quality. The price objective was stated as ‘Provide fashion and quality that the
customers perceive as high value and consider to be fairly priced.’ The fashion objective was to
‘Provide fashionable merchandise that satisfies our customers’ aspirational and wardrobe needs
within the FF brand.’ The quality objective was to ‘Ensure the highest quality and consistency of
fit both within a style and across all product categories.’
The shopping experience dimension was considered extremely important. Key attributes were
availability of merchandise and the in-store shopping experience. The in-store shopping
experience dimension was captured by an explicit vision of the six elements of the ‘perfect
shopping experience’:
1. Great looking shops in trendy locations with fashion impact.

2. Customer welcomed by attractive sales staff, fashionably dressed, with a smile on their
faces.
3. Clear communication of special sales.
4. Sales staff with good product knowledge.
5. Personal name recognition by attending sales staff.
6. A warm ‘thank you’ and an invitation to return soon.
The goal was to deliver the six elements every time the customer enters a store.
FF had constructed a very specific definition of its ‘ideal shopper’. The ideal shopper image
communicated to all employees the fashion expectations of their customers. The brand image
objective for FF was stated as ‘We will build FF into a dominant national brand by clearly
understanding our target customer and differentiating ourselves in meeting her needs.’
You are required to select appropriate measurements for Fontainebleau

Fashions’ customer and internal business process perspectives of its Balanced Scorecard.
In the solution that follows, it is assumed that the student has an understanding of basic marketing principles and
practices.
FF’s core customer outcome measures should include market share, account share (e.g. share of
wardrobe), retention, and satisfaction for customers in its targeted segment (19–38 year-old,
university-/college-educated, managerial and executive females). Information, especially on
market and account share, will generally not be available from public sources; FF will likely have
to engage a market research firm to conduct surveys to estimate its performance with this
targeted customer segment. But such information should be worth the cost since it provides
direct feedback on whether FF’s strategy is succeeding. For customers already purchasing from
FF, the company should attempt to maintain data on purchasing behaviour so that it can
estimate frequency of purchase, retention, loyalty (e.g. growth in annual purchases), and
satisfaction (from periodic or in-store surveys).
93
FF developed measures of the customer value proposition using all three components of the
value equation: product attributes, brand image and relationships.
Product Attributes
1. Price benefits
 Average unit retail price (absence of discounting).
 Number of transactions per store.
2. Fashion and design
 Average annual growth in purchases on ‘strategic merchandise’ (key items
that best exemplified the image FF was attempting to convey).
 Average mark-up achieved (an indicator of well-received merchandise design
and fashion).
3. Quality
 Return rate (an indicator of the consumer’s satisfaction with the quality of
the product and fairness of price).
Brand and Image

1. Market share in strategic merchandise items.
2. Premium price earned on branded items (if FF was successful in communicating an
attractive brand image, it should command a higher price over non-branded or generic
items of comparable product characteristics and quality).
Relationship: Creating the Perfect Shopping Experience

1. Availability
 Out-of-stock percentage on strategic merchandise (data were collected by
responses on a ‘What do you think?’ card solicited from each customer,
asking about satisfaction with the availability of size and colour on selected
items).
2. Shopping experience
 Mystery shopper audits (an independent third-party shopper was hired to
purchase selected items at each FF location, and evaluate the experience
according to the six criteria established for the ‘perfect shopping experience’.
FF’s internal business process objectives and measures focused on helping it deliver the value
proposition to its targeted customer segments. FF identified five critical internal business
processes:
1. Brand management;
2. Fashion leadership;
3. Sourcing leadership;
4. Merchandise availability;
5. Creating a memorable shopping experience.
FF then proceeded to develop measures for these five internal processes.
1. Brand Management (to contribute to FF’s desired brand image in the value proposition).
 Market share in selected categories (e.g. casual trousers and jeans);
 Brand recognition (from market research);
 New accounts opened per year.
2. Fashion Leadership (to contribute to the product attribute aspect in the value proposition).
 Number of key items in which FF was first or second to the market;
 Percentage of sales from items newly introduced into stores.
3. Sourcing Leadership (to contribute to the price and quality components of the product
attributes).
 Percentage of items returned to vendors because of quality problems;
94
 Vendor performance rating (incorporating dimensions of vendors’ quality,
price, lead time and ability to provide input into fashion decisions).
4. Merchandise Availability (to contribute to the ‘perfect shopping experience’)
 Stores’ out-of-stock percentage on selected key items;
 Inventory turnover on selected key items (a ‘balancing’ measure to ensure
that high in-stock was achieved by excellent supplier and distribution
performance, not by holding excess inventories).
5. Memorable Shopping Experience
 Mystery shopper rating (duplicating the measure already described for the
value proposition component of the customer perspective; this measure was
repeated in the internal business process perspective to signal to employees
the importance of performing their everyday tasks in ways that will create
this great experience with every customer who enters a FF store).
Fontainebleau Fashions will have no doubt other aspects to its Balanced Scorecard like
‘innovation and learning’ and the ‘financial perspective’, but we have focused in this suggested
solution only on ‘customers’ and ‘internal business process’.
[1]
Numerous articles and books have been written by Robert S. Kaplan and David P. Norton on the
Balanced Scorecard. We would recommend The Balanced Scorecard, HBS Press, 1996; Strategy Maps:
Converting Intangible Assets into Tangible Outcomes, HBS Press, 2004; and The Execution Premium: Limiting
Strategy to Operations for Competitive Advantage, HBS Press, 2008.
16.7 Time-Driven Activity-Based Costing

Example
A call centre wishes to understand better its departmental costs and the impact of idle capacity
that it is currently experiencing. The centre has three principal activities:
 Answering incoming calls: each operator is technically skilled to handle 95 per cent of all
queries.
 Quality control audits: this is conducted on a random basis by a small team of supervisors to
check for telephone manner, technical accuracy of replies given and to detect any
trend in product problems experienced by the customer.
 Training sessions: these are short, individual sessions for each operator conducted by a
team of product experts. They are designed to bring the operator up to speed with
product developments and common faults reported by users.
The original ABC approach outlined in Module 10 would address the costing exercise as follows:
Activity
Activity % of time spent Allocated cost Cost–Driver rate
quantity
Answering calls 75 €462 000 53 900 €8.57 per call
Quality audits 10 61 600 1 540 €40 per audit
Training sessions 15 92 400 2 750 €33.60 per session
Total 100% €616 000

The budget of €616 000 is allocated across the three activities according to the percentage of
effort adjudged to be expended, and the three cost-driver rates that emerge in the last column
95
would be applied to the product groups, geographies or major customers who use the resources
of the call centre.
Some users of traditional ABC complain that too much managerial time goes into arguing about
the accuracy of the cost-driver rates rather than taking action on the problems the technique
reveals, namely inefficient processes, unprofitable products and customers. Significantly,
because employees do not want to own up to being underemployed, the traditional model has
difficulty in uncovering idle capacity. This weakness, together with the relative simplicity of the
model, is overcome by employing time measurement.
 Step 1: Assess the theoretical and practical capacity of the call centre.
Theoretical capacity is the level of activity a facility, machine or person can handle
working flat out for the given workday. It is unrealistic for managers to think that
theoretical levels can be reached on a regular basis. Practical capacity, a figure lower
than theoretical capacity, takes into account such run-of-the-mill occurrences as
downtime for maintenance, illness and breaks, and temporary shortfall in demand.
Let’s assume the call centre has a practical capacity of 80 per cent of theoretical
capacity. This needs to be built into the ABC calculation. Our unit of time measure is
hours, and 32 employees each work a 7-hour day for a 22-day month:
= 7 hours per day × 22 days per month × 32 employees × 3

Theoretical capacity for a
months
quarter
= 14 784 hours
Practical capacity = 14 784 × 0.80 = 11 827 hours

 Step 2: Calculate the cost per hour of supplying capacity.
€616 000/11 827 hours = €52.08 (say, €52)
 Step 3: Estimate the time spent on each unit of activity.

This is a relatively easy step, carried out either by watching employees perform their
tasks or by interviewing them. Let’s assume the following times have been recorded
for the call centre:
Activity Time spent in hours
Answering calls 0.1334 (0.13)
Quality audits 0.7334 (0.73)
Training sessions 0.8334 (0.83)

For ease of calculation we will use the figures in brackets.
 Step 4: Calculate the cost-driver rates for each activity.

Cost per hour Cost–Driver rate
Activity Time spent in hours
(€) (€)
Answering calls 0.13 52 6.76
Quality audits 0.73 52 37.96
Training sessions 0.83 52 43.16

 Step 5: Calculate the allocated costs per activity using time-based ABC.
We can now work out the cost allocation between the three departments using our
time calculations, based on the actual activity levels recorded:
Activity Actual quantity Unit time Total time used Cost–Driver Total cost
96
in hours in hours rate allocated
Answering calls 53 900 0.13 7 007 €6.76 €364 364
Quality audits 1 540 0.73 1124 €37.96 €58 458
Training sessions 2 750 0.83 2 283 €43.16 €118 690
Total used 10 414 €541 512
Total supplied 11 827 €616 000
Idle capacity 1 413 €74 488

The total costs allocated are calculated by multiplying the actual quantity of activity in the first
column by the cost-driver rates in the fourth column.
With the traditional ABC methodology, the survey of work patterns produced a 75 per cent, 10
per cent and 15 per cent split of employee time across the three activities in the call centre. This
split records the employees’ productive time but fails to record their unproductive time. By
switching to measuring resource costs per time unit, the company is able to incorporate
estimates of its practical capacity, thereby allowing the ABC cost driver rates to provide more
accurate information and smarter management signals about embedded inefficiencies.
The above display provides management with information on both total capacity supplied to the
cost centre (both in time and cost) and the capacity actually consumed by the centre. Clearly the
signals emerging in our example would trigger questions regarding the additional capacity
supplied to the centre: what are the chances of this spare capacity being filled by increased
volumes? Is this outcome a one-off demonstration of too much resource being devoted to the
call centre or a signal of endemic spare capacity that should be removed? Should this resource
be re-positioned elsewhere in the company, thus avoiding fresh spending in other areas?
Another claim made for the model is that it is easy to update. For example, if another activity is
added to the call centre, say a ring-back facility for callers whose queries required research, this
could be accommodated by estimating the time spent on each unit of the new activity without
having to re-assess the percentage contributions made by everyone in the facility. Similarly,
changes in prices of resources can be incorporated immediately. Imagine an across-the-board
salary increase of 4 per cent was introduced mid-year to address recruitment difficulties: this
uplift would be added to the total costs of €616 000, and a new cost per hour for supplying
capacity would be calculated. Efficiency improvements through, say, continuous improvement
programmes could also be incorporated quickly. For example, the call centre may introduce
screen-based online training sessions for its call centre operators rather than employing high-
cost engineers to conduct face-to-face training sessions; the reduction in time spent on training
(currently 0.83 hours) would fall, so would the cost-driver rate of €43.16, but of course the fresh
investment in the online training packages would increase costs elsewhere in the budget.
The proponents of time-based ABC believe that it is transparent, scalable and easy to implement
and update. These qualities are not necessarily possessed by more traditional ABC systems. Very
little has been written on the topic to date, and only anecdotal evidence is available to support
the claims of its supporters. Until a body of evidence and experience builds up, we will include
the topic in this module and not in Module 10.
97

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FINANCIAL ACCOUNTING FOR MANAGERS

Comment and Solution

Sports bags manufactured 10 000

Sports bags shipped and invoiced 12 000

Faulty bags returned and not yet repaired 1 000

DIY Example: Rosie’s Recruitment Consultants

Total assets: 0 Total equity and liabilities: 0

2 140 000 780 000 920 000

Totals 142 500 52 000 133 000 141 000 279 100 50 000 19 400 120 000

Total equity and

Income statement for the year to 31 December 20x1

Cost of revenues 572 000

Gross profit €348 000

Rental of offices €175 000

General overhead 48 000

Interest on loans 2 000

Provision for bad debts 7 000 299 500

Profit before tax €48 500

Provision for tax 19 400

Profit after tax €29 100

Balance sheet for the year to 31 December 20x1

Equipment and computers €30 000

Less depreciation 7 500 €22 500

Debtors less provision for bad debts 133 000

Cash 141 000 326 000

Total assets €468 500

Payables to software seller €120 000

Taxes payable 19 400 €139 400

Original capital €250 000

Retained profit for year 29 100 279 100

Total liabilities and equity €468 500

Cash flow statement for the year to 31 December 20x1

Cash from operations

Profit after tax €29 100

Add back items not affecting cash:

Taxes payable €19 400

Provision for bad debts 7 000 33 900

Changes in working capital:

Increase in work-in-progress –€52 000

Increase in receivables –140 000

Increase in creditors 120 000 –72 000

Cash from investments

Asset purchases –150 000

Cash from financing

Debt introduced by friends 50 000 300 000

Change in cash balance (€0–141 000) €141 000

MODULE 3: THE BALANCE SHEET

Comment and Solution

How much of this expenditure should be treated as a non-current asset?

Comment and Solution

1. to continue to record acquisition cost and to publish market value in parenthesis; or

MODULE 4: THE CASH FLOW STATEMENT

Income statement for year ended 30 June 20x2

Gross profit 44 439

Add: Profit on sale of plant and equipment 855

Depreciation on plant and equipment 1 635

Wages and salaries 13 185

Bad debts 510

Increase in provision for bad debts 180

General expenses 3 216 21 111

Net profit 24 183

30 June 20x1 30 June 20x2

Plant & equipment at cost 16 800 10 800

Sports bags manufactured 10 000

Sports bags shipped and invoiced 12 000

Faulty bags returned and not yet repaired 1 000

2 140 000 780 000 920 000

Totals 142 500 52 000 133 000 141 000 279 100 50 000 19 400 120 000

Cost of revenues 572 000

Gross profit €348 000

Rental of offices €175 000

General overhead 48 000

Interest on loans 2 000

Provision for bad debts 7 000 299 500

Profit before tax €48 500

Provision for tax 19 400

Profit after tax €29 100

Equipment and computers €30 000

Less depreciation 7 500 €22 500

Debtors less provision for bad debts 133 000

Cash 141 000 326 000

Total assets €468 500

Payables to software seller €120 000

Taxes payable 19 400 €139 400

Original capital €250 000

Retained profit for year 29 100 279 100

Total liabilities and equity €468 500

Profit after tax €29 100

Taxes payable €19 400

Provision for bad debts 7 000 33 900

Increase in work-in-progress –€52 000

Increase in receivables –140 000

Increase in creditors 120 000 –72 000

Asset purchases –150 000

Debt introduced by friends 50 000 300 000

Change in cash balance (€0–141 000) €141 000

Gross profit 44 439

Depreciation on plant and equipment 1 635

Wages and salaries 13 185

General expenses 3 216 21 111

Net profit 24 183

Plant & equipment at cost 16 800 10 800

Less: Depreciation 6 240 10 560 4 470 6 330

Inventories 15 443 25 725

Debtors less provision for bad debts 7 785 5 070

Bank and cash 2 352 3 173

Creditors 4 155 4 380

Net current assets 21 425 29 588

Total assets less current liabilities 31 985 35 918

Long-term loan 9 000 7 500

Opening balance 18 365 22 985

Net profit for year 21 120 24 183

Less: Drawings 16 500 22 985 18 750 28 418

Net profit 24 183

Increase in inventories –10 282

Decrease in debtors 2 535

Increase in creditors 225 7 522

Sale of plant and equipment 3 450

Drawings –18 750 –20 250

Opening balance (30.6.x1) €16 800 €6 240

Plant sold 6 000 3 405

Charged for year 1 635

Closing balance (30.6.x2) €10 800 €4 470

(75% of nil) + (20% of €1 million) + (5% of €4 million) = €400 000

Sales 5000 pens @ €100 500 000

Less: Full cost of sales 5000 @ €70 350 000

Gross profit 150 000

Denominator volume variance (10 000)

Other expenses 80 000 70 000

Sales 500 000 Sales 500 000

Gross profit 150 000 Contribution margin 250 000

Other expenses 80 000 70 000 Other expenses 80 000 180 000

Net profit 80 000 Net profit 70 000

Sales 500 000 Sales 500 000

Gross profit 150 000 Contribution margin 250 000

variance 8 000 expenses 100 000

Other expenses 80 000 88 000 Other expenses 80 000 180 000

Net profit 62 000 Net profit 70 000