Bachelor of Commerce

Accounting (Honours)

Management Accounting

Module BACC207
Authors: Cuthbert Muza
Master of Commerce in Accounting (MSU)
Bachelor of Business Administration in Accounting (Solusi
University)
Certified Public Accountant (CPA(Z)) (ICPAZ)
Certified Professional Forensic Accountant (CPFAcct)
(ICFA-Canada)
Public Accountants and Auditors Board (PAAB)
Registration Certificate

Alphonce T. Shiri
Master of Business Administration (Bellevue University
USA)
Bachelor of Science in Business Administration: Accounting
Concentration (Midland University USA)
Diploma in Education (UZ)

Content Reviewer: Patrick Paradza

Master of Accountancy Degree (Southwest Missouri State
University)
Bachelor of Accountancy (Special) Honours (UZ)
Bachelor of Science Economics (University of Rhodesia)
Associate member (ICSAZ)

Editor: Amos Tendai Munzara

Master of Business Administration (ZOU)
Bachelor of Science in Mathematics and Statistics (ZOU)
Diploma in Education (Gweru Teachers College)
Published by: The Zimbabwe Open University

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Year: 2014

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Forewor d To the student
The demand for skills and knowledge
and the requirement to adjust and
change with changing technology,
places on us a need to learn continually
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Since attainment of independence in
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tertiary level, resulting in the
establishment of the Zimbabwe Open
University (ZOU) on 1 March, 1999.
ZOU is the first, leading, and currently
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Best wishes and success in your studies.
_____________________
Prof. Primrose Kurasha
Vice Chancellor
BACHELOR OF COMMERCE ACCOUNTING
(HONOURS)

MANAGEMENT ACCOUNTING

MODULE BACC 207

1
Authors: Cuthbert Muza
Master of Commerce in Accounting (MSU)
Bachelor of Business Administration in Accounting (Solusi
University)
Certified Public Accountant (CPA(Z)) (ICPAZ)
Certified Professional Forensic Accountant (CPFAcct) (ICFA-Canada)
Public Accountants and Auditors Board (PAAB) Registration
Certificate

Alphonce T. Shiri
Master of Business Administration (Bellevue University USA)
Bachelor of Science in Business Administration: Accounting
Concentration (Midland University USA)
Diploma in Education (UZ)

Content Reviewer: Patrick Paradza

Master of Accountancy Degree (Southwest Missouri State University)
Bachelor of Accountancy (Special) Honours (UZ)
Bachelor of Science Economics (University of Rhodesia)
Associate member (ICSAZ)

Editor: Amos Tendai Munzara

Master of Business Administration (ZOU)
Bachelor of Science in Mathematics and Statistics (ZOU)
Diploma in Education (Gweru Teachers College)

2
Table of Contents
Module Overview .................................................................................................................................10
Unit 1 ....................................................................................................................................................12
Introduction to Management Accounting .............................................................................................12
1.0 Introduction.................................................................................................................................12
1.1 Unit Objectives ...........................................................................................................................12
1.2 What is Management Accounting? .............................................................................................12
1.3 Management Accounting Information System ...........................................................................13
1.3.1 The role of Management Accounting ......................................................................................13
1.4 The Management Process ...........................................................................................................13
1.4.1 Planning ...............................................................................................................................14
1.4.2 Controlling ...........................................................................................................................14
1.4.3 Decision-making ..................................................................................................................14
Activity 1.1 .......................................................................................................................................14
1.5 Comparison of Management Accounting ...................................................................................14
1.6 Contemporary Management Accounting ....................................................................................16
1.6.1 Activity-Based Management (ABM)...................................................................................16
1.6.2 Customer orientation............................................................................................................17
1.6.3 Strategic position..................................................................................................................17
1.6.4 Value chain frame work.......................................................................................................17
Activity 1.2 .......................................................................................................................................18
1.7 Summary .....................................................................................................................................18
References.........................................................................................................................................19
Unit 2 ....................................................................................................................................................20
Quantitative Approaches to Decision-Making......................................................................................20
2.0 Introduction.................................................................................................................................20
2.1 Unit objectives ............................................................................................................................20
2.2 Problem Solving and Decision-Making......................................................................................20
2.2.1 Problem solving ...................................................................................................................20
2.2.2 Decision-making ..................................................................................................................21
2.3 Quantitative Analysis and Decision-Making ..............................................................................21
Activity 2.1 .......................................................................................................................................22
2.4 Quantitative Analysis..................................................................................................................22
2.4.1 Model development..............................................................................................................22
2.5 Mathematical Modelling Process..........................................................................................23
Activity 2.2 .......................................................................................................................................25
2.6 Models of Cost, Revenue and Profit .....................................................................................26

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 2.6.1 Cost and volume models ......................................................................................................26
2.6.2 Revenue and volume models ...............................................................................................26
2.6.3 Profit and volume models ....................................................................................................26
2.6.4 Break even point ..................................................................................................................27
Activity 2.3 .......................................................................................................................................27
2.7 Summary ...............................................................................................................................27
References.........................................................................................................................................29
Unit 3 ....................................................................................................................................................30
Basic Linear Programming Techniques................................................................................................30
3.0 Introduction.................................................................................................................................30
3.1 Unit Objectives ...........................................................................................................................30
3.3.1 Proportionality .....................................................................................................................31
3.3.2 Additivity .............................................................................................................................31
3.3.3 Divisibility ...........................................................................................................................32
3.3.4 Certainty...............................................................................................................................32
3.4 Problem Formulation in LP Linear Programming ................................................................32
Activity 3.1 .......................................................................................................................................34
3.5 Solving LP Problems (Graphical Method)............................................................................35
3.6.1 What is the simplex method? ........................................................................................39
3.6.2 Standard form................................................................................................................39
3.6.3 General basic steps of the simplex method ..................................................................40
3.6.4 Slack variables ..............................................................................................................40
3.7 Using the simplex method to solve a linear programming problem .....................................42
Activity 3.4 .......................................................................................................................................47
3.8 Summary ...............................................................................................................................48
References.........................................................................................................................................49
Unit 4 ....................................................................................................................................................50
Strategic Management Accounting.......................................................................................................50
4.0 Introduction...........................................................................................................................50
4.1 Unit Objectives .....................................................................................................................50
4.2 What is Strategic Management? ...........................................................................................50
4.2.1 Strategy ................................................................................................................................50
4.2.2 Strategic plan .......................................................................................................................51
4.3 What is Strategic Management Accounting?........................................................................51
4.3.1 The role of strategic management accounting .....................................................................51
4.4 Process Value Analysis.........................................................................................................52
4.4.1 Driver analysis .....................................................................................................................52
4.4.2 Activity analysis...................................................................................................................52

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 4.4.3 Activity performance measurement .....................................................................................52
4.5 Financial Measures of Activity Efficiency ...........................................................................53
4.5.1 Formula for value and non-value added costs......................................................................53
4.5.2 The role of Kaizen Standards...............................................................................................53
Activity 4.1 .......................................................................................................................................55
4.6 Product Life Cycle and Target Costing.................................................................................55
4.6.1 The role of target costing .....................................................................................................56
Activity 4.2 .......................................................................................................................................59
4.7 The Balanced Score Card......................................................................................................59
4.8 Summary ...............................................................................................................................62
References.........................................................................................................................................63
Unit 5 ....................................................................................................................................................64
Quality Costing and Productivity..........................................................................................................64
5.0 Introduction...........................................................................................................................64
5.1 Unit Objectives .....................................................................................................................64
5.2 What is Quality? ...................................................................................................................64
5.3 Cost of Quality..................................................................................................................65
5.7 Measuring Quality Costs.......................................................................................................70
5.7.5 The Taguchi quality loss function........................................................................................70
Activity 5.1 .......................................................................................................................................72
5.10 Summary ...............................................................................................................................75
References.........................................................................................................................................76
Unit 6 ....................................................................................................................................................77
Environmental Cost Management.........................................................................................................77
6.0 Introduction...........................................................................................................................77
6.1 Unit Objectives .....................................................................................................................77
6.2 What is Environmental Cost Management?..........................................................................77
Activity 6.1 .......................................................................................................................................79
6.3 Measuring Environmental Costs...........................................................................................79
6.3.1 Types of environmental costs .......................................................................................79
6.3.2 Other possible environmental costs ..............................................................................80
6.3.3 Steps to measure environmental costs...........................................................................81
6.3.4 Procedures for calculating and recording environmental costs.....................................81
6.4 Assigning Environmental Costs............................................................................................83
6.4.1 Environmental product costs.........................................................................................83
6.4.2 Functional-based environmental cost assignments .......................................................84
6.4.3 Activity-based environmental cost assignments ...........................................................84
Activity 6.3 .......................................................................................................................................86

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 6.5 Life Cycle Cost Assessment .................................................................................................86
6.5.1 LCA Procedure .............................................................................................................87
6.5.2 Life cycle costing ..........................................................................................................88
6.5.3 Typical life cycle costs..................................................................................................88
6.5.4 Optimising life cycle costs............................................................................................89
Activity 6.4 .......................................................................................................................................90
6.6 Strategic-Based Environmental Responsibility Accounting.................................................90
6.7 Solutions to Selected Activities ........................................................................................91
6.8 Summary ...............................................................................................................................93
References.........................................................................................................................................94
Unit 7 ....................................................................................................................................................95
Performance Evaluation in a Decentralised Firm .................................................................................95
7.0 Introduction...........................................................................................................................95
7.1 Unit Objectives .....................................................................................................................95
7.2 Responsibility Centres ..........................................................................................................95
7.2.1 Divisionalisation ...........................................................................................................95
7.2.2 Decentralisation ............................................................................................................97
Objectives of decentralisation.......................................................................................................97
Activity 7.1 .......................................................................................................................................98
7.2.3 Responsibility accounting .............................................................................................98
Activity 7.2 .....................................................................................................................................100
7.2.4 Cost centres.................................................................................................................100
7.2.5 Revenue centres ..........................................................................................................100
7.2.6 Profit centres ...............................................................................................................101
7.3 Investment Centres..............................................................................................................102
Activity 7.3 .....................................................................................................................................102
7.4 Measuring Performance of Investment Centres..................................................................102
7.4.1 Return on investment (ROI)............................................................................................102
Activity 7.4 .....................................................................................................................................104
Activity 7.5 .....................................................................................................................................105
7.4.2 Residual income (RI) ..................................................................................................107
7.4.3 Economic Value Added ® (EVA) ..............................................................................108
Activity 7.6 .....................................................................................................................................110
7.5 Goal Congruence ................................................................................................................111
7.5.1 Management compensation: Encouraging goal congruence.......................................112
7.6 Transfer Pricing ..................................................................................................................113
7.6.1 Impact on performance measures................................................................................113
7.6.2 The transfer pricing problem.......................................................................................113

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 Activity 7.7 .....................................................................................................................................114
7.6.3 Market-based transfer pricing .....................................................................................114
7.6.4 Cost-based pricing.......................................................................................................115
7.6.5 Negotiated transfer prices ...........................................................................................118
Activity 7.8 .....................................................................................................................................119
7.7 Summary .............................................................................................................................120
References.......................................................................................................................................121
Unit 8 ..................................................................................................................................................122
Tactical Decision-Making...................................................................................................................122
8.0 Introduction.........................................................................................................................122
8.1 Unit Objectives ...................................................................................................................122
8.2 Tactical Decision-Making...................................................................................................122
8.2.1 Model for making tactical decisions ..................................................................................122
8.2.2 Relevant costs defined .......................................................................................................123
8.2.3 Ethics in tactical decision-making .....................................................................................124
Activity 8.1 .....................................................................................................................................124
8.3 Relevancy, Cost Behaviour, and the Activity Resource Usage Model...............................124
8.3.1 Flexible resources ..............................................................................................................124
8.3.2 Committed resources..........................................................................................................125
8.3.3 Summary of the Resource Usage Model’s Role in Assessing Relevancy .........................126
Activity 8.2 .....................................................................................................................................126
8.4 Relevant Cost Applications.................................................................................................128
8.4.1 Make or buy decisions .......................................................................................................128
Activity 8.3 .....................................................................................................................................129
8.4.2 Keep-or –drop decisions ....................................................................................................130
8.4.3 Special-order decisions ......................................................................................................131
Activity 8.4 .....................................................................................................................................131
8.4.4 Decisions to sell or process further ....................................................................................132
8.5 Product Mix Decisions..............................................................................................................132
8.5.1 One constrained resource ...................................................................................................132
8.5.2 Multiple constrained resources ..........................................................................................133
Activity 8.5 .....................................................................................................................................133
8.6 Pricing.................................................................................................................................134
8.6.1 Cost-based pricing..............................................................................................................135
8.6.2 Target costing and pricing..................................................................................................137
8.6.3 Legal aspects of pricing .....................................................................................................137
8.7 Summary .............................................................................................................................138
References.......................................................................................................................................139

7
Unit 9 ..................................................................................................................................................140
Capital Investment ..............................................................................................................................140
9.0 Introduction.........................................................................................................................140
9.1 Unit Objectives ...................................................................................................................140
9.2 Capital Investment Decisions....................................................................................................140
9.2.1 Independent project............................................................................................................141
9.2.2 Mutually exclusive projects ...............................................................................................141
9.3 Steps in the Capital Budgeting Process...............................................................................141
Activity 9.1 .....................................................................................................................................142
9.4 Non-discounting Models.....................................................................................................142
9.4.1 The payback method ..........................................................................................................142
Activity 9.2 .....................................................................................................................................142
9.4.2 The accounting rate of return method (ARR) ....................................................................143
9.5 Discounting Models ............................................................................................................145
9.5.1 The net present value method ............................................................................................145
9.5.2 Internal rate of return (IRR) ...............................................................................................146
Interpolation method ...................................................................................................................147
9.5.3 NPV and IRR compared ....................................................................................................149
Activity 9.3 .....................................................................................................................................149
9.6 Mutually Exclusive Projects ...............................................................................................150
9.7 Reinvestment Assumption ..................................................................................................153
9.8 Modified Internal Rate of Return (MIRR) ..........................................................................154
9.9 Discounted Payback............................................................................................................154
9.10 Summary .............................................................................................................................155
References.......................................................................................................................................156
Present Value and Future Value Tables..............................................................................................157
Unit 10 ................................................................................................................................................161
Inventory Management .......................................................................................................................161
10.0 Introduction.........................................................................................................................161
10.1 Unit Objectives ...................................................................................................................161
10.2 Traditional Inventory Management ....................................................................................161
10.2.1 Inventory costs ............................................................................................................161
10.2.2 Traditional reasons for holding inventory...................................................................162
10.3 Economic Order Quantity (EOQ): The Traditional Inventory Model ............................162
Activity 10.1 ...................................................................................................................................163
10.3.1 Quantity discounts.......................................................................................................164
Activity 10.2 ...................................................................................................................................165
10.3.2 Reorder point ..............................................................................................................165

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 10.3.3 Maximum and minimum inventory levels ..................................................................166
Activity 10.3 ...................................................................................................................................166
10.4 JIT Inventory Management.................................................................................................167
10.4.1 Definitions of JIT ........................................................................................................167
10.4.2 Operational requirements of JIT .................................................................................167
10.4.3 The JIT philosophy .....................................................................................................168
10.4.4 JIT management techniques........................................................................................168
Activity 10.4 ...................................................................................................................................170
10.4.5 The Kanban system.....................................................................................................170
10.4.6 JIT Limitations............................................................................................................170
10.5 The theory of constraints (TOC).........................................................................................170
10.5.1 TOC Steps...................................................................................................................171
Activity 10.5 ...................................................................................................................................171
10.6 Summary .............................................................................................................................172
References.......................................................................................................................................173

9
Module Overview

This module has been written for students doing Management Accounting BACC 207
at the Zimbabwe Open University. Management Accounting is essentially the process
used to provide information related to an organisation’s planning, controlling and
decision making functions. This term is also used to refer to the use of such
information by management at different levels. Management Accounting can also be
referred to as management accounting information system, this is an information
system that produces outputs using inputs and processes needed to satisfy specific
management objectives. The major objective of this module is to equip you with
relevant management accounting skills, techniques and concepts in order to be able to
execute the management accountant role/duty effectively and provide relevant
information to management for sound decision making.

The module has been written with a focus to equip you with relevant information
which is applicable in the wake of many changes in the business environment. It
consists of 10 units which are summarised as follows:

Unit 1 introduces you to management accounting, and the branches of accounting.

Financial accounting, management accounting and cost accounting are differentiated.
The management process is introduced in this unit as well as contemporary
management accounting.

Unit 2 we will deal with quantitative approaches to decision making which is an

integral part of management accounting. Quantitative analysis and decision making is
conducted together with models of cost, revenue and profit.

Unit 3 takes you through basic linear programming concepts and techniques. The
underlying basic assumptions are explained. Unit 3 unfolds by explaining problem
formulation and illustrating graphical and simplex methods of solving linear
programming problems.

Unit 4 introduces you to strategic management accounting concepts. The balanced

score card is explained. Responsibility accounting is a topical issue especially in this
era of climate change. We will discuss how responsibility accounting should be
viewed from different perspectives.

Unit 5 deals with quality costs and productivity measures, reporting and control while
Unit 6 looks at environmental cost management, which is a topical issue especially in
the mining and manufacturing industries. Environmental cost management
encompasses the issues of measuring and assigning environmental costs and life cycle
cost assessment.

Performance evaluation in decentralised firms will be covered in Unit 7 while Unit 8

covers tactical decision making. Unit 9 is about capital investment based on the
inability of tactical decision making process to make major strategic decisions.
Capital Investments will dwell on aspects of capital budgeting, capital investment
decisions, discounting models and mutually exclusive projects.

10
The last unit, Unit 10, looks at aspects of working capital management, enclosed
under the facet of inventory management where we will look at traditional inventory
management models – the economic order quantity and the recent developments of
just in time inventory management. Theory of constraints will be explained in this
unit as well.

11
 Unit 1

Introduction to Management Accounting

1.0 Introduction
Management accounting is a modern tool for making informed decisions. Managers in
all types of organisations need information about business activities in order to plan
and optimise the use of organisational resources. In this unit we define Management
Accounting and describe its role in management decision-making processes. A
comparison will also be made between Cost Accounting and Management
Accounting.

1.1 Unit Objectives

By the end of this unit, you should be able to:
 define Management Accounting
 explain the need for Management Accounting information
 discuss the differences between Management Accounting and Cost
Accounting
 identify the contemporary focus of Management Accounting

1.2 What is Management Accounting?

Anthony in Ramangapai (2009) states “Management Accounting is concerned with
the efficient management of business through the presentation to management of such
information that will facilitate efficient planning and control.” This means that
Management Accounting is a tool for planning and controlling organisational
resources.

The American Accounting Association (AAAS) committee defines Management

Accounting as, the methods and concepts necessary for effective planning, for
choosing among alternative business actions, and for control through the evaluation
and interpretation of performance. This means that Management Accounting is
concerned with providing economic information for managers to plan and achieve
organisational goals.

From the above definitions it is clear that management accounting is the provision of
information to management that is useful in planning and controlling business
activities, and effective use of business resources.

Management accounting functions can be summarised as follows:

a) A tool for formulating business strategy
b) A necessary tool for planning and controlling business activities
c) An information system for decision making

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 d) A tool for optimising the use of business recourses

1.3 Management Accounting Information System

The management accounting information system is an information system that
produces output using inputs and processes needed to satisfy specific management
objectives, (Hansen and Mowen, 2000).

Management accounting system has three broad objectives which are to provide
information for:
a) determining the cost of products and services;
b) planning, controlling, evaluating and continuous improvement of business
processes; and
c) decision-making.

1.3.1 The role of Management Accounting

The Institute of Management Accountants (2008) maintains that the role of
Management Accounting has evolved from a transaction and compliance orientation
to champion corporate governance processes, providing risk management and internal
control, all necessary for an organisation to become more competitive and successful.

Among many other key functions, Management Accounting is therefore a strategic

tool for measuring the importance of a customer's perceived value. This is
accomplished through value chain analysis. By enabling companies to determine the
strategic advantages and disadvantages of activities and value-creating processes in
the market place, value chain analysis becomes essential for assessing competitive
advantage.

Value analysis or value engineering is one of the most widely used cost reduction
techniques. It can be defined as a technique that yields value improvement. It
investigates into the economic attributes of value. It attempts to reduce cost through:
a. design change,
b. modification of material specification,
c. change in the source of supply and so on.

The traditional role of Management Accounting as a mere information provider, can

be interpreted as being on the lower end of the value chain. The new role of
Management Accounting, however, is spread across the value chain including the
highest level such as:
 Contributing to key strategic decisions; and
 Providing the conceptual framework for converting data into information.

1.4 The Management Process

The management process describes the functions carried out by managers which
involve planning, controlling and decision making (Hansen and Mowen, 2000).

13
 1.4.1 Planning
This is the detailed formula of action necessary to achieve a particular outcome.
Planning therefore involves setting objectives, for example, setting an objective to
increase company profits by improving the overall quality of a company’s products.

1.4.2 Controlling
Controlling is the managerial activity of monitoring a plan’s implementation and
taking corrective action as needed. This can be achieved through the use of feed back.
Feedback is information that can be used to evaluate or correct the steps being taken
to implement a plan. Feed back is therefore a critical facet of the control function.

1.4.3 Decision-making
The process of choosing among competing alternatives in decision-making. This
pervasive managerial function is intertwined with planning and control. A manager
cannot plan without making decisions. Managers should choose among competing
objectives and methods to carry out the chosen objectives.

Decisions can be improved if information about the alternatives is gathered and made
available to managers. One of the roles of the management accounting information
system is to supply information that facilitates decision-making.

Activity 1.1
Management accountants are actively involved in the process of managing the entity.
This process includes making strategic, tactical and operating decisions while helping
to coordinate the efforts of the entire organisation. To fulfil these objectives, the
management accountant accepts certain responsibilities such as;

a) Planning
b) Controlling
c) Evaluating

Required
Describe each of these responsibilities of the management accountant and identify
examples of practises and techniques.

1.5 Comparison of Management Accounting

Cost Accounting module BACC 207 outlined the differences between Cost
Accounting and Financial Accounting, with the main difference being that Financial
Accounting aims to present a “true and fair” view of the financial position of a
business and Cost Accounting on the other hand aims to compute a “true and fair”
view of the cost of production or services offered by a firm.

Although Management Accounting derives its data from both Financial Accounting
and Cost Accounting as reflected in Figure 1.1, it is broader in scope than Cost
Accounting. The main thrust of Management Accounting is towards determining
policy and formulating of plans to achieve desired objectives of management.

14
 PREPARING OF FINANCIAL
FINANCIAL STATEMENTS
SUCH AS THE STATEMENT
ACCOUNTING
OF FINANCIAL POSITION

ANALYSING COST FOR COST

CONTROL & MAXIMISING
EFFICIENCY
ACCOUNTING

ASSISTING MANAGEMENT
MANAGEMENT IN
PLANNING & CONTROL
ACCOUNTING

Figure 1.1 Relationship between Financial, Cost and Management Accounting

(Source: Ramagopai, 2009)

While Cost Accounting and Management Accounting do not have clear cut territorial
boundaries, the distinction between the two can be made shown as in Table 1.1

15
 Table 1.1 Comparison of Management Accounting to Cost Accounting

Basics Cost Accounting Management Accounting

1. Scope Cost accounting is limited
to providing technical cost
information to
management (primary
emphasis is on cost and
involves collection,
analysis, relevance,
interpretation and
presentation of cost of
production.
2. Techniques Various techniques used
employed by cost accounting include
standard costing, variance
analysis, marginal costing
and cost-volume-profit
analysis and budgetary
control.
The main thrust is towards
determining policy and
formulating plans to achieve
desired management
objectives. It helps
management in planning,
controlling and analysing the
performance of the
organisation for continuous
improvement.
Management Accounting
also uses all these
techniques but in addition
also uses statistical analysis,
operations research,
quantitative techniques and
other branches of knowledge
that can help in most
decision making such as a
decision tree.

3. Data base It is based on data derived It is based on data derived

from financial accounts.
4. Characterisation Cost Accounting is mostly
quantitative in nature.
from cost accounting,
financial accounting and
other sources.
Management Accounting is
both quantitative and
qualitative e.g. quality, cost
measurement and reporting.

1.6 Contemporary Management Accounting

Advances in information technology and manufacturing processes have led to the
development of innovative and relevant Management Accounting practices.
Consequently activity based management accounting systems have been developed
and implemented in many organisations. The focus of management accounting has
been broadened to enable the managers to better serve the needs of customers and
manage the firm’s value chain.

1.6.1 Activity-Based Management (ABM)

The demand for more accurate and relevant accounting information has led to the
development of activity based management. Activity-based management is a system-
wide integrated approach that focuses management’s attention on activities with the
objective of improving customer value and the resulting profit.

16
Activity-based management emphasises activity based costing (ABC) and process
value analysis. Activity-based costing improves the accuracy of assigning costs by
first tracing cost of activities and then to products or customers that consume these
activities. Process value analysis, on the other hand emphasises activity analysis,
trying to determine why activities are performed and how well they are performed.
The objective of process value analysis is to find ways to perform the necessary
activities more efficiently and to eliminate those that do not create customer value.

1.6.2 Customer orientation

Customer value is a key focus of contemporary management accounting practices.
Customer value is the difference between what a customer receives (customer
realisation) and what the customers gives up (customer sacrifices). Increasing
customer value means increasing customer realisation or decreasing customer
sacrifices.

1.6.3 Strategic position

This involves increasing customer value to create a sustainable competitive advantage
through judicious selection of strategic position. Cost information plays a critical role
in this process through strategic cost management. Strategic cost management is the
use of cost data to develop and identify superior strategic approaches that will
produce a sustainable competitive advantage. Two general strategies that can be
adopted through strategic cost management approach are as follows:
1. Cost leadership strategy. This strategy involves reducing the cost of making a
product thereby creating customer value through reduced customer sacrifice.
2. Superior products through a differentiation strategy. This type of strategy
strives to increase customer value by increasing realisation. The value added
to the customer by the differentiation strategy must exceed the firms cost of
providing the differentiation. An example of differentiation is after sale
services not offered by rivals in the same market.

1.6.4 Value chain frame work

Successful pursuits of cost leadership and differentiation strategy require an
understanding of a firms internal and industrial value chains. The internal value
chain is a set of activities required to design, develop, produce, market and deliver
products and services to customers. Therefore management should determine the
activities in the internal value chain that enhance customer value. The industrial value
chain is also critical to strategic cost management. It is achieved through value
creating activities at each stage, that is, from acquiring raw materials to the disposal of
the final product to end-user customers.

17
Activity 1.2
The following items are associated with management accounting information system.
a. Incurrence of post purchase costs
b. Costing out products
c. Assigning cost of labour to a product
d. Repairing a defective part
e. Designing a product
f. Providing information for planning and control
g. Measuring the cost of design
h. Using output information to make a decision
i. Usage of materials

Required
Classify the above items into the following categories:
i. Inputs
ii. Processes
iii. Outputs
iv. Systems objectives

1.7 Summary
In this unit we discussed that managers and lower level employees use management
accounting information to identify and solve problems and to evaluate performance.
Management accounting information helps managers to carry out their responsibilities
of planning, controlling, an decision making. Planning is the detailed formulation of
action to achieve a particular end. Controlling is the monitoring of a plan’s
implementation, and decision making is choosing among competing alternatives.
While cost accounting’s primary emphasis is on the provision of technical cost
information to management, management accounting’s main thrust is towards
determining policy of plans to achieve desired management objectives. Management
Accounting provides information that allows managers to focus on customer value,
total quality management; and time based competition. This means that information
about value-chain activities and customer sacrifice (such as post purchase costs) is
accessed and analysed in order to enhance customer satisfaction.

18
References
Arora, M.N. (2009). Cost and Management Accounting, Theory, Problems, and
Solutions. Mumbai: Global Media.
Ramagopai, C. (2009). Accounting for Managers. Delhi: New Age International.

19
 Unit 2

Quantitative Approaches to Decision-Making

2.0 Introduction
In this unit we show you how management can use mathematical models to solve
corporate problems. Mathematical models are abstractions of the real world situations.
In the unit we shall define a model and show that if a model captures the major
relevant aspects of the real situation, it can provide valuable aid to decision making.
We shall, therefore, introduce you to problem solving techniques that apply
quantitative methods in order to reach a solution.

2.1 Unit objectives

By the end of this unit, you should be able to:
 explain the steps used in quantitative decision making process
 define a model
 discuss the advantages and drawbacks of using models
 explain what is a mathematical model
 analyse a problem using quantitative problem solving techniques

2.2 Problem Solving and Decision-Making

Management decision making is based on scientific methods and makes extensive use
of quantitative analysis. The scientific management revolution of the early 1900s,
initiated by Frederic W. Taylor provided the foundation for the use of quantitative
methods in management of company resources.

2.2.1 Problem solving

Anderson, Sweeney and Williams (2000) defined problem solving as the process of
identifying a difference between the actual and the desired state of affairs and taking
action to resolve the difference. Problem solving involves the following seven steps:

1) Identify and define the problem.

2) Determine the set of alternative solutions.
3) Determine the criterion or criteria that will be used to evaluate the alternatives.
4) Evaluate the alternatives.
5) Choose an alternative.
6) Implement the selected alternative.
7) Evaluate the results to determine whether a satisfactory solution has been
obtained.

20
 2.2.2 Decision-making
Decision-making is the term generally associated with the first five steps of the
problem solving process. Therefore the first step of decision-making is to identify and
define the problem. Decision-making ends with the choosing of an alternative, which
is the act of making the decision. Problems in which the objective is to find the best
solution with respect to one criterion are referred to as single-criterion decision
problems. Problems that involve more than one criterion are referred to as multi-
criterion decision problems.

An example of decision-making process is as follows:

Assume that you are currently unemployed and you would like a position that will
lead to a successful carrier. Suppose that your job hunting has resulted in offers from
companies in Bulawayo, Harare, Gweru and Mutare. The alternatives for your
decision problem can be stated as follows:
 Accept a job in Gweru
 Accept a job in Harare
 Accept a job in Bulawayo
 Accept a job in Mutare

Table 2.1 Data for the Job Evaluation for a Decision-making Problem
Alternative Starting Salary Potential for Job Location
$ Advancement
1. Harare 50 000 Average Average
2. Mutare 46 000 Excellent Good
3. Bulawayo 46 000 Good Excellent
4. Gweru 47 000 Average Good

In Table 2.1, evaluating each alternative relative to the starting salary criterion is done
by recording the starting salary for each job alternative. The potential for
advancement and job location have been rated for each alternative as poor, fair, good
or excellent.

Suppose that after a careful evaluation of the data in Table 2.1, you have decided to
select alternative 3: alternative 3 is thus referred to as the decision.

2.3 Quantitative Analysis and Decision-Making

Decision-making process may take two basic forms, qualitative and quantitative.
Qualitative analysis is based primarily on the manager’s argument and experience. If
the manager has had experience with a similar problem, he or she may use qualitative
analysis. However, if the manager has had little experience with similar problems, and
if the problem is highly complex, then quantitative analysis of the problem can be
used to make the final decision. The quantitative approach uses facts or data
associated with the problem and develops mathematical expressions that describe the
objectives, constraint, and other relationships that exist in a problem to arrive at a
decision.

21
Activity 2.1
1. Discuss the different roles played by the qualitative and quantitative approaches
to managerial decision-making. Why is it important for a manager or decision
maker to have a good understanding of both these approaches to decision-
making?

2. A firm has just completed constructing a new plant that will produce more than
500 different products, using more than 50 different production lines and
machines. The production scheduling decision are critical in that sales will be
lost if customer demands are not met in time. If no individual in the firm has
had experience with this production operation and if new production schedules
must be generated each week, which approach should the firm consider in
dealing with the production scheduling problem?

2.4 Quantitative Analysis

Render, Stair and Hanna (2012) define quantitative analysis as the scientific approach
to managerial decision-making, which processes raw data into valuable information
for decision making. This approach excludes emotions and guesswork but relies on
processing and manipulating raw data into meaningful information for decision-
making. For example, quantitative analysis can be used to determine the future value
of an investment when deposited at a bank at a given interest rate for a certain number
of years.

The quantitative analysis approach consists of defining a problem, developing a

model, acquiring input data, developing a solution, testing the solution and analysing
the results.

2.4.1 Model development

Models are representations of real objects or situations and can be presented in
various forms.

Example of Models:
 A scale model of car to represent a real car.
 A child’s toy bus is a model for a real bus

These examples are physical replicas of real objects. In modelling terminology,

physical replicas are referred to as iconic models.

A second classification of models includes models that are physical in form but do not
have the same physical appearance as the objects being modelled. Such models are
referred to as analogue models. The speedometer of an automobile is an analogue
model: the position of the needle on the dial represents the speed of the automobile. A
thermometer is another analogue model representing temperature.

A third classification of models includes representation of a problem by a system of

symbols and mathematical relationships or expressions. Such models are referred to
as mathematical models. Mathematical models are a critical part of any quantitative

22
 approach to decision making. For example, the total profit from the sale of a product
can be determined by multiplying the profit per unit by the quantity sold.

If we let x represent the number of units sold and p the profit, then with a profit of $10
per unit, we can develop the following mathematical model:

p = 10x

Advantages of Models
 The value of any model is that it enables us to make inferences about the real
situation by studying and analysing the model
 Experimenting with models requires less time and is less expensive than
experimenting with the real object or situation.
 Models also have the advantage of reducing the risk associated with
experimenting with the real situation.

Disadvantages of Models
 The value of model-based conclusions and decisions is dependent on how well
the model represents the real situation. For example, the more closely the
model car represents the real car, the more accurate the conclusions and
predictions will be.

2.5 Mathematical Modelling Process

In this module we will deal with quantitative analysis based on mathematical models.
The following terms are commonly used in mathematical models:

a) Objective function
This is a mathematical expression that describes the problem’s objective.
When considering a managerial problem, the definitions phase leads to a
specific objective such as minimisation of cost or maximisation of profit. p =
10x would be an objective function for a company attempting to maximise
profit.

b) Constraint
These are restrictions or limitations imposed on a problem, for example,
production capacity. A production capacity constraint would be included in
the model if, for example, 5 hours are required to produce each unit and only
40 hours are available per week.

Let x be the number of units produced per week.

The production time constraint can be expressed as 5x ≤ 40.
The value 5x is the total time required to produce x units.

≤ Indicates that production time required must be less than or equal to 40

hours available.
x≥ 0 Constraint requires the production quantity x to be greater than or equal
to zero.

23
 A complete mathematical model for this production problem: is

Maximise P = 10x (objective function) subject to (s.t.) 5 x ≤ 40 Constraints

x ≥0

c) Uncontrollable input
These are environmental factors or inputs that cannot be controlled by the
decision maker. For example – production time per unit
Production capacity = (40 hours per week)

Uncontrollable inputs affect both the objective function and the constraint.

d) Controllable input
These are decision alternatives or inputs that can be specified by the decision
maker, for example the production quantity (x), A decision variable is
another term for controllable inputs. The specific decision variable value or
values providing the ‘best’ output will be referred to as the optimal solution
for the model of the production problem. The model solution involves finding
the value of the production quantity decision variables x that maximises profit
while not causing a violation of the production capacity constraint.

Table 2.2 Model Solution Table (Trial and Error Solution for the Production Model)
Decision Feasible
Alternative Projected Total Hours Solution
(Production Quantity) Profit of Production (Hours Used <40)
(X) (p)
0 0 0 Yes
2 20 10 Yes
4 40 20 Yes
6 60 30 Yes
8 80 40 Yes
10 100 50 No
12 120 60 No

The recommended decision in this case is a production quantity of 8 since

feasible solution with the highest projected profit occurs at x = 8.

e) Feasible solution
This therefore is a decision alternative or solution that satisfies all constraints.

f) Deterministic model
If all uncontrollable inputs to a model are known, and cannot vary, the model
is referred to as a deterministic model. Corporate income tax rates are not
under the influence of the management and thus constitute an uncontrollable
input in many decision models.

g) Stochastic or probabilistic model

If any of the uncontrollable inputs are uncertain and subject to variation, the
model is referred to as stochastic or probabilistic model. An uncontrollable

24
 input to many production planning models is demand for the product. The
distinguishing feature of a stochastic model is that the value of the output
cannot be determined with certainty even if the value of the controllable input
is known because the specific values of the uncontrollable inputs are
unknown. In this respect stochastic models are more difficult to analyse.

Example 2.1
Gweru Parts Manufacturers produces two products, X and Y. The profit it can make
on product X is $10 per unit and it takes 5hours to produce one unit. The second
product Y has a unit profit of $5 and requires 2hours for each unit produced. Only
40hours are available per week to produce both products.

Required
a) Show the mathematical model when both products are produced
simultaneously
b) Identify the controllable and uncontrollable inputs for this model.

Solution 2.1
Let x be number of X units produced and y be number of Y units produced.
a) Maximise:
P = 10x + 5y
Subject to:
5x + 2y  40
x≥0
y≥0
b) Controllable inputs are: x and y
Uncontrollable inputs: (1) Profits
(2) Labour – hours
(3) Total labour hours available

Activity 2.2
You work as a Financial Analyst for an investment firm. A new client has just
requested you to handle an $80 000 portfolio. The client has also asked you to restrict
the portfolio to a mix of the following two shares of stock

Company Price per share Estimated Annual Maximum Possible

Return per Share Investment
TLC $50 $6 $50 000
TDK $30 $4 $45 000

Let x = number of shares of TLC

y = number of shares of TDK

Required
1. Develop the objective function assuming that the client desires to maximise
the total annual return
2. Show the mathematical expression for each of the following 3 constraints:
a. Total investment funds available are $80 000
b. Maximum TLC Investment is $50 000
c. Maximum TDK Investment is $45 000

25
2.6 Models of Cost, Revenue and Profit
Basic quantitative models in business and economic applications involve the
relationship between a volume variable such as production volume or sales volume
and cost, revenue and profit. Through the use of these models, a manager can
determine the projected cost, revenue and profit associated with established
production quantity of a forecasted sales volume. Financial planning, production
planning and other areas of decision-making do benefit from such models.

2.6.1 Cost and volume models

The cost of manufacturing or producing a product is the function of the volume
produced. This cost comprises two costs: fixed cost and variable costs. Fixed cost is
the portion of the total cost that does not depend on the production volume. Variable
cost, on the other hand, is the portion of the total cost that is dependent on and varies
with the production volume.

Example 2.2
Suppose that fixed costs of manufacturing at MAZXCO is $5 200. In addition, labour
and materials costs are $3, 50 for each unit produced. Construct the cost – volume
model for producing x units of the product.

Solution 2.2
T (x) = $5 200 + $3.50x
Where:
x = production volume in units
T (x) = Total costs of producing x units

2.6.2 Revenue and volume models

A model of the relationship between revenue and volume provides information on the
projected revenue associated with selling a specified number of units.

Example 2.3
Suppose that MAZXCO above sells each unit produced for $6. Construct the model
for total revenue associated with selling x units.

Solution 2.3
R (x) = 6x
Where:
x = Sales volume in units
R (x) = Total revenue associated with selling x units

2.6.3 Profit and volume models

One of the most important criteria for management decision-making is profit. Total
profit is given by total revenue minus total cost.

Example 2.4
Refer to example 2.2 and example 2.3 above. Construct a model for the profit
associated with producing and selling x units.

26
 Solution 2.4
P (x) = R (x) – T (x)
= 6x – (5200 + 3.50x)
= 2.5x – 5 200

2.6.4 Break even point

The volume that results in total revenue equalling total cost, thus providing $0 profit,
is called break even point. If the break even point is known, a manager can quickly
infer that a volume above the break even point will result in profit, while a volume
below the break even point will result in a loss. In the above example, the break even
point can be found by setting the profit expression equal to zero and solving for the
production volume:
P(X) = -5 200 + 2.5x = 0
2.5x = 5 200
x = 2 080 units

With this information, we know that production and sales of the product must be at
least 2 080 units before a profit can be made.

Activity 2.3
1. Gweru Publishing Company is considering publishing a Chivasa textbook on
spreadsheet applications for business. The fixed cost of manuscript preparation,
textbook design and production set-up is estimated to be $80 000. Variable
production and material costs are estimated to be $3 per book. Demand over the
life of the book is estimated to be 4 000 copies. The publisher plans to sell the
book to University students for $20 a copy.

Required
a) What is the break even point?
b) What profit/loss can be anticipated with demand of 4 000 copies?
c) With a demand of 4 000 copies, what is the minimum price per copy that the
publisher must charge to break even?

2. Models of inventory systems frequently consider the relationships among opening

stock, production quantity, demand or sales, and closing stock. For a given
production period j, let Sj – 1 = closing stock from the previous period
Xj = production quantity in period
Dj = demand in period j
Sj = closing stock for period j

Required
a) Write the mathematical relationship or model that describes how these four
variables are related.
b) What constraint should be added to produce capacity for period j is given by
cj?

2.7 Summary
In this unit we explained how quantitative approaches may be useful to management’s
decision making. We have discussed the problem orientation of this process and in an
27
overview, have shown how mathematical models can be used in the analysis of a
problem. Different classifications of a model were discussed. Advantages of using
models were also outlined. Since mathematical models are abstractions of real-world
situation, they may not capture all the aspects f the real situation. However, if a model
can capture the major relevant aspects of the problem, it can provide valuable
information for decision-making.

28
References
Garrison, R.H. and Noreen, E.W. (2003). Managerial Accounting. New York:
McGraw-Hill/Irwin.
Hilton, R.W., Maher, M.W. and Selto, F.H. (2003). Cost Management: Strategies for
Business Decisions. New York: McGraw-Hill/Irwin.
Horngren, C.T., Foster, G. and Datar, S.M. (2000). Cost Accounting: A Managerial
Enphasis. Upper Saddle River, New Jersey: Prentice-Hall.
Render, B., Stair, R.M. and Hanna, M.E. (2010). Quantitative Analysis for
Management, (11th Edition). Boston: Pearson.

29
 Unit 3

Basic Linear Programming Techniques

3.0 Introduction
Linear programming was developed by George B. Dantzing during the Second World
War, when a system with which to maximise the efficiency of resources was of
utmost importance. “programming” was a military term that referred to activities such
as planning schedules efficiently or deploying troops optimally. In this unit, we shall
define linear programming and show how it is applied in business to make decisions
that optimise the use of resources. Resources normally include machinery, labour,
cash, time, warehouse space and raw materials. These resources may be used to make
products or provide services.

3.1 Unit Objectives

By the end of this unit, you should be able to:
 explain the concept and meaning of linear programming
 describe the three basic elements of a linear programming problem
 state the underlying basic assumptions and properties of a linear programming
problem
 construct a problem formulation in linear programming
 solve a linear programming problem using the graphical method and the
simplex method

3.2 What is Linear Programming?

Linear programming is the name of a branch of applied mathematics that deals with
solving optimisation problems of a particular form. Linear programming problems
consist of a linear cost function (consisting of a certain number of variables) which is
to be minimised or maximised, subject to a certain number of constraints. The
constraints are linear inequalities of the variables used in the cost function. The cost
function can also be termed objective function. Linear programming is closely related
to linear algebra and the most noticeable difference is that linear programming often
uses inequalities in the problem statement rather than equalities.

In summary, linear programming is a mathematical technique used in optimising the

value of the linear objective functions subject to the linear relationship or constraints.
A general statement of a linear programming model consists of three basic
components or elements which are:
 Decision variables
 Objective function, and
 Constraints

30
 3.2.1 Decision variables
These are unknown variables that we seek to determine. It is important to properly
define the decision variables as a first step towards the development of a linear
programming model. Alphabetical letters such as x, y, and z or letters with subscripts
such as x1, x2…..xm are used to represent the decision variables.

All decision variables in linear programming are controllable, continuous and non-
negative, for example.

3.2.2 Objective function

An objective function is an algebraic expression in which two or more variables
describe a quantity that must be maximised (profit/present value) or minimised (cost
or scrap) . The quantity is maximised or minimised subject to constraints. Example of
an objective function:
Z = X1 + Y1
Z, being profit or loss
X1 and Y1 being constraints such as number of items produced per product x and
product y

3.2.3 Constraints
The limit of achievement for an objective function is controlled by the availability of
resources.

Therefore, the constraints of the linear programming model depend on the resources
such as labour, machine hours and raw materials.

These constraints are expressed as linear functions in terms of the decision variables.

A set of linear constraints which form the equation or inequalities can be expressed as
a11x1 +…………….. + a1nxn ≥ b1
a12 x1 +…………….. + a2nxn ≤ b2
a1m x1 +…………….. + amnxn = bm

where coefficient a (I =1…….m and ; X = 1,2……..n) are unrestricted in magnitude

and signs the coefficients a are also called the input –output or technological
coefficients. They express the rate at which a given resource is being used up.

3.3 Assumptions of Linear Programming

Assumptions that are implicit in linear programming problems include:

3.3.1 Proportionality
The contribution of any variable to the objective function or constraints is
proportional to that variable. This implies no discounts or economies to scale, for
example, the value of 12y is twice the value of 6y, no more, no less.

3.3.2 Additivity
The contribution of any variable to the objective function or constraints is
independent of the values of other variables.

31
 3.3.3 Divisibility
Decision variables can be fractions.

3.3.4 Certainty
This assumption is called the deterministic assumption. This means that all parameters
(all coefficients in the objective function and the constraints) are known with
certainty, however, realistically coefficients and parameters are often the result of
guess-work and approximation. The effect of changing these numbers can be
determined with sensitivity analysis.

3.4 Problem Formulation in LP Linear Programming

Problems are usually stated in words. It is, therefore, necessary to express the given
problem in a mathematical form in order to facilitate easy solving of the problem.

The basic steps in formulating the linear programming problems are:

Identify the decision variables. These are the variables to be
determined, and are usually represented by the algebraic symbol.
Identify all constraints or restrictions in the problem and express them
as linear functions of decision variables. The resource limitation dictates the
native of constraint’s statement.
Identify the objective function of the problem and state it as a linear
function of the decision variables. It is necessary to optimise the function by
minimising the cost or maximising the profits; subject to the given constraints.

Example 3.1
A company based at Gokwe centre specialises in the production of cooking oil and
peanut butter from peanuts. The time in hours to produce a unit 375ml for peanuts
butter and 2litres cooking oil and weekly capacity of operation are given below:

Operations Time per Unit in Hours Operation Capacity

in Hours
Peanut Butter Cooking Oil
1. Grading & Roasting 2 3 35
2. Grinding & Extraction 1 4 100
3. Finishing & Packaging 2 3 150
Cost per unit $1.05 $2.20

Required
Formulate a mathematical model for the linear programming problem.

Solution 3.1
Step 1: The decision variables are number of units of peanut butter (x) and number of
units of cooking oil (y).
Step 2: The constraints of the problem are:
2x + 3y ≤ 35 {operation 1}
1x + 4y ≤ 100 {for operation 2}
2x + 3y ≤ 150 {for operation 3}
Step 3: The objective function is to minimize.
M = 1.05x +2.20y

32
 Where M is the cost per unit.
Therefore, the combination of the above steps gives the problem as:

Minimise m = 1.05x +2.20y

Subject to: 2x + 3y ≤ 35
1x + 4y ≤ 100
2x + 3y ≤ 150
x, y ≥ 0
Example 3.2
A company produce product 1 and product 2. Product 1 requires 20 units of raw
materials and 5 hours of machine-processing time. Product 2 requires 400 units of raw
materials and 2 hours of machine-processing time. During the current period 400 units
of raw materials and 40 hours of machine-processing time are available. The
capacities of the two assembly division during the period are 6 and 9 units
respectively. Profit contribution is $100 for each unit of product 1 and $60 for each
unit of product 2.

Required
(a) Summarise the information in this problem as a table
(b) Formulate the linear –programming problem

Solution 3.2
a)
Quantity of Resources Quantity of Resources
Required per Unit of Available During
Output Period
Resource Product Product
1 2
Raw materials (units) 20 40 400
Machine-processing time 5 2 40
(hours)
Capacity of assembly
Division 1 (units) 1 0 6
Capacity of assembly
Division 2 (units) 0 1 9
Profit contribution $/unit 100 60

b) Formulation of linear programming problem

Objective function
The objective function is to maximise total contributions from production of two
products, where total profit contribution is equal to the sum of contribution per unit of
each product multiplied by the number of units produced. Therefore, the objective
function is:
Max z = 100x + 60y
Where x and y are the output levels of products 1 and 2 respectively

Constraints

33
 a. The production process described has several resources constraints imposed
on it, for example, the production of x units of product 1 requires 20x units of
raw material and production of y units of product 2 requires 40y units of the
same raw material. The sum of these two raw materials must be less than or
equal to the quantity available, which is 400 units. This can be expressed as
follows:
20x + 40y ≤ 400

b. The machine processing time constraints can be developed in the same way.
Product 1 requires 5x hours and product 2 requires 2y hours with 40 hours of
processing time available, the following constraint is obtained
5x + 2y ≤ 40

c. The capacities of the two assembly divisions also limit output and
consequently profits. For product 1, which must be assembled in division 1,
the constraint is
x≤6

For product 2, which must be assembled in division 2 , the constraint is

y ≤ 9

d. The logic of the production process suggests that negative output

quantities are not possible. Therefore each of the decision variables is
constrained to be nonnegative
x ≥ 0
y ≥ 0

The above problem can therefore be formulated as follows

Objective function
Max z = 100x + 60 y
Subject to:
20x + 40y ≤ 400
5x + 2y ≤ 40
x ≤ 6
y ≤ 9
x ≥ 0
y ≥ 0

Activity 3.1
A problem on advertising media selection

A company plans to advertise its products in three different media in order to reach a
large number of potential customers. The company’s choices of media are
newspapers, television and radio. A market survey was earlier carried out and the
following results were obtained:

Newspaper Television Radio

Number of potential customers reached per unit 250 000 200 000 500 000

34
 Number of female customers reached per unit 100 000 150 000 300 000

Cost of advertising per unit $200 $150 $100

If the company does not want to spend more than $2 000 on advertising and further
requires that:
at least 2,5 million exposures to take place among women.
advertising on television is restricted to $7 000.
the number of advertising units on radio and television should each be
between 4 and 12.

Required
Formulate the linear programming model for the problem.

3.5 Solving LP Problems (Graphical Method)

The graphical method is a method that involves the use of geometric representation of
a linear optimisation model.

The procedure of the graphical method is as follows:

Step 1: Obtain the mathematical model of the LP problem. That is, formulate the
problem.

Step 2: On a graph paper, draw the graphs of the constraints (that is, the inequalities)
and the non-negativity restrictions.

Step 3: Identify the feasible region. This is the region common to all the graphs drawn
in step 2. It is also called the “solution space” in the sense that all the points
within the region satisfy the constraints simultaneously.

Step 4: Identify and determine the coordinates of corners of the feasible solution
space. Then evaluate the values of the objective function at each extreme
point. Pick the extreme point of the feasible region that gives the optimum
(best) value. The concept of optimum can be determined by picking the
highest or smallest of these values respectively for maximisation or
minimisation problem. Note that Extreme point always give the minimum or
maximum value of Z (objective function).

Example 3.3 (Maximisation Problem)

Solve the following L.P. problem by using the graphical method.
Maximise Z = 3x + 2y
Subject to 2x + 3y ≤ 18
3x + y ≤ 9
x + 5y ≤10
x, y ≥ 0

35
Solution 3.3
Step 1: The problem is already in mathematical form

Step 2: Variables x and y are represented respectively on horizontal and vertical axes.
Consider the constraints and treat them as equations in order to draw the
graphs. Since the equations are of straight lines, two points will fix each line.
Consider:
Constraint I (2x + 3y = 18)
x = 0, y = 6 corresponds to the point (0, 6)
y = 0, x = 9 corresponds to the point (9, 0)

Constraint II (3x + y = 9)
x = 0, y = 9 corresponds to the point (0. 9)
y = 0, x = 3 corresponds to the point (3, 0)

Constraint III (x + 5y = 10)

x = 0, y = 2. Then we have point (0,2)
y= 0, x = 10. Then we have point (10,0)

With the above points, the graphs of the constraints are drawn as follows:

9
Constraint 1
8

7 Constraint 2

6 Constraint 3
(0,2)
5

4
(2.5, 1.75)
3
A (3,0)
2 B
(0,0)
1
E C
0 1 2 3 4 5 6 7 8 9 10

Step 3: From the above graph, the feasible region (ABCE) is the region to all the
constraints.

Step 4: The extreme points of the feasible region are A (0,2)

B (2.5, 1.7)
C (3,0)
E (0,0)

36
We then use the extreme points to determine the optimal value, thus

Points Max. Z = 3x+2y

A (0,2) Z=4
B (2.5, 1.75) Z = 7.5 + 3.5 = 11
C (3,0) Z=9
E (0,0) Z=0
Decision:
Since the problem is a maximisation one, the highest value of Z is 11. Hence the
optimal value of Z=11, which is obtained at x=2.5 and y=1.75

Example 3.4 Graphical solution (Minimisation problem)

Use the graphical method to solve the following linear programming problem
Minimise Z = 3x1 + 4x2
Subject to x1 + 3x2 ≥ 9
2x1+ 5x2 ≥ 20
3x1 +2x2 ≥ 12
x1 x2 ≥ 0
Solution 3.4
Step 1: The problem is already in mathematical form
Step 2: Constraints (x1 + 3x2 = 9
If x1 = 0, x2 = 3 corresponds to the point (0,3)
If x2 = 0, x1 = 9 corresponds to the point (9,0)
Constraint 2 (2x1 + 5x2 = 20)
If x1 = 0, x2 = 4 , Corresponds to the point (0,4)
If x2 = 0 , x1 = 10, Corresponds to the point (10,0)
Constraint 3 (3x1 + 2x2 = 12)
If x1= 0 x2 = 6, Corresponds to the point (0,6)
If x2 = 0, x1 = 4, Corresponds to the point (4,0)
Step 3: The use of the above points will create the following graph

37
 9

7
6 A (0,6)
5

4
B (2,3.5)
3

1
C C (10,0)
0
0 1 2 3 4 5 6 7 8 9 10

Step 4: The extreme points of the feasible region are

A (0,6)
B (2,3.5)
C (10,0)

Therefore the following table gives the objective function

Points Min Z = 3x1 + 4x2

A (0,6) Z = 24

B (2,3.5) Z = 6 + 14 = 20

C (10,0) Z = 30

Decision
Since the value of Z at B (2,3.5) is the smallest, that is the optimal value is 20, with x1
= 2 and x2 = 35

38
 Activity 3.2
Given the LP problem
Min Z = 4x1 + 5x2
Subject to: 3x1 + 6x2 ≥ 80
4x1 + 3x2 ≥ 100
X1 , x2 ≥ 0

Required
1. Obtain the optimal value by graphical method.
2. Use the graphical method to solve the following LP problem:
Minimise z=3x+ 4y
Subject to: x+3y ≥ 9
2x+5y ≥ 20
3x + 2y ≥ 12
x,y≥0

3.6 Solving LP problems: the Simplex Method

An alternative way of solving a linear programming problem is through the simplex
method. Under this section we will define the simplex method and illustrate how a
solution can be reached using a tableau.

3.6.1 What is the simplex method?

The Simplex Method is an iterative (repetitive) technique for solving linear
programming problems expressed in standard form. This technique was developed by
George B. Dantzig in 1947. The simplex method requires constraint equations to be
expressed as a canonical (slack) system from which a basic feasible solution can be
readily obtained.
Basic solution: This is a solution obtained from canonical system by setting non-basic
variables to zero.
Basic feasible solution: This is a basic solution that is feasible and at most . One
such solution yields optimum if it exists.
Adjacent basic feasible solution: Differs from the present basic feasible solution in
exactly one basic variable
Pivot operation: A sequence of elementary row operations that generates an adjacent
basic feasible solution.
Optimality criterion: When every adjacent basic feasible solution has objective
function lower than the present solution

3.6.2 Standard form

The Simplex Method requires that the constraints be written as equations and that the
problem satisfy additional requirements. The standard form of a general linear
programming problem with n variables and m constraints is as follows:
In standard form
1. the objective function is of maximisation type;
2. the constraints are equations (not inequalities);
3. the decision variables, Xi, are non negative;

39
 4. the right-hand-side constant (resource) of each constraint is non-
negative; and
5. “maximisation” of Z can be replaced by “minimisation.”

3.6.3 General basic steps of the simplex method

1. Determine the objective function.
2. Write all necessary constraints.
3. Convert each constraint into an equation by adding slack variables.
4. Set up the initial simplex tableau.
5. Locate the most negative indicator. if there are two such indicators, choose
one. This indicator determines the pivot column.
6. Use the positive entries in the pivot column to form the quotients necessary for
determining the pivot. If there are no positive entries in the pivot column, no
maximum solution exists. If 2 quotients are equally the smallest, let either
determines the pivot.
7. Multiply every entry in the pivot row by the reciprocal of the pivot to change
the pivot to 1. The use row operations to change all other entries in the pivot
column to 0 by adding suitable multiplies of the pivot to the other rows.
8. If the indicators are all positive or 0, this is the final tableau. If not, go back to
step 5 above and repeat the process until a tableau with no negative indicators
is obtained.
9. Determine the basic and non-basic variables and read the solution from the
final tableau. The maximum value of the objective function is the number in
the lower right corner of the final tableau.

3.6.4 Slack variables

 Standard form requires that all constraints be in the form of equations.
 A slack variable is added to a  constraint to convert it to an equation (=).
 A slack variable represents unused resources.
 A slack variable contributes nothing to the objective function value.
Slack: The amount by which the left-hand side falls short of the right-hand side. They
are called slack variables because they take up the slack between the left and right
hand sides of the inequalities:

8x + 8y ≤ 160
4x + 12y ≤ 180
To find the slack for a ≤ constraint algebraically, we add a slack variable to the
constraint and convert it to an equality. To use the simplex method, the constraint
inequalities must be converted to a system of linear equations by using the slack
variables. In particular, consider the two constraint inequalities. To make this into a
system of two equations, two unknowns, we use the slack variables S 1 and S2, as
follows:
8x + 8y + S1 = 160
4x + 12y + S2 = 180
We now have two equations, but four unknowns, x , y , S1, S2 The system has an
infinite number of solutions since there are more unknowns than equations. We can
make the system be consistent by assigning two of the variables a value of zero and
then solving for the remaining two variables. This is accomplished by dividing the
four variables into two groups:
Group number one: Basic variables

40
Group number two: Non-basic variables.
We are free to select any two of the four variables as basic variables while the
remaining two variables automatically become non-basic variables. The non-basic
variables are always assigned a value of zero. Then, solve the equations for the two
basic solutions.
Suppose the linear programming model in this context is:

Maximize: Z = 5x + 10y
Subject to: 8x + 8y + S1 = 160
4x + 12y + S2 = 180
X ≥0; y≥0
We will systematically assign two of these variables a zero (non-basic variables)
value and then solve for the remaining two variables (basic variables). The result is
displayed in a table.
To illustrate how the table is constructed, study the example:
Assign x =0 and y = 0 as our non-basic variables, then (0) + 8(0) + S1 = 160
therefore, S1 = 160.

Substitute x = 0 and y = 0 in the second equation to obtain

4(0) + 12(0) + S2 =180, this implies that S2 = 180
x y S1 S2 point feasible?
0 0 160 180 (0,0) yes

The result can be displayed in a table as follows:

x y S1 S2 Point Feasible?
0 0 160 180 (0,0) Yes
0 20 0 -60 (0,20) No
0 15 40 0 (0,15) Yes
20 0 0 100 (20,0) Yes
45 0 - 0 (45,0) No
200
7.5 12.5 0 0 (7.5,12.5) Yes-
solution

Example 3.5
You Are Fired Pottery Company makes ceramic bowls and mugs. How many bowls
and mugs should be produced to maximize profits given labor and materials
constraints?
Product resource requirements and unit profit:

Product Labour (hr/unit) Clay (lb/unit) Profit ($/unit)

Bowl 1 4 40
Mug 2 3 50

Problem definition

41
 Resource: 40 hrs of labor per day
Availability: 120 lbs of clay
Decision Variables:x1 = number of bowls to produce per day
x2 = number of mugs to produce per day
Objective Maximize Z = $40x1 + $50x2
Function: Where Z = profit per day
Resource 1x1 + 2x2 40 hours of labor
Constraints: 4x1 + 3x2 120 pounds of clay
Non-Negativity constraints: x1  0; x2  0
Linear Programming Model:
Maximize Z = $40x1 + $50x2
subject to: 1x1 + 2x2  40
4x1 + 3x2  120
x1, x2  0
A feasible solution does not violate any of the constraints:
Example x1= 5 bowls
x2= 10 mugs
Z = $40x1 + $50x2 = $700

Labour constraint check:

1(5) + 2(10) = 25 < 40 hours, within constraint
Clay constraint check:
4(5) + 3(10) = 50 < 120 pounds, within constraint
An infeasible solution violates at least one of the constraints:
Example x1 = 10 bowls
x2 = 20 mugs
Z = $1400
Labor constraint check:
1(10) + 2(20) = 50 > 40 hours, violates the cconstraint
Adding Slack variables
Max Z = 40x1 + 50x2 + s1 +s2
subject to:1x1 + 2x2 + s1 = 40
 4x1 + 3x2 + s2 = 120
 x1, x2, s1, s2 0
Where:
 x1 = number of bowls
 x2 = number of mugs
 s1, s2 are slack variables

3.7 Using the simplex method to solve a linear programming problem

To solve a linear programming problem in standard form, we use the following steps:
1- Convert each inequality in the set of constraints to an equation by adding
slackvariables.
2- Create the initial simplex tableau.
3- Select the pivot column (The column with the “most negative value” element
in the last row).
4- Select the pivot row (The row with the smallest non-negative result when the

42
 last element in the row is divided by the corresponding in the pivot column)
5-Use elementary row operations calculate new values for the pivot row so that
the pivot is 1 (Divide every number in the row by the pivot number.)
6- Use elementary row operations to make all numbers in the pivot column equal to 0
except for the pivot number. If all entries in the bottom row are zero or positive, this
the final tableau. If not, go back to step 3.
7- If you obtain a final tableau, then the linear programming problem has a maximum
solution, which is given by the entry in the lower-right corner of the tableau.

Pivot
Pivot Column: The column of the tableau representing the variable to be entered into
the solution mix.
Pivot Row:The row of the tableau representing the variable to be replaced in the
solution mix.
Pivot Number:The element in both the pivot column and the pivot row.
Example 3.6
A furniture Company produces tables and chairs. Each table takes four hours of labor
from the carpentry department and two hours of labor from the finishing department.
Each chair requires three hours of carpentry and one hour of finishing. During the
current week, 240 hours of carpentry time are available and 100 hours of finishing
time. Each table produced gives a profit of $70 and each chair a profit of $50. How
many chairs and tables should be made?

STEP 1
All information about example
Resource Tables ( X1 ) Chairs ( X2 ) Constraints

Carpentry (hr) 4 3 240

Finishing (hr) 2 1 100

Unit Profit $70 $50

Linear programming model:

Objective function p = 70X1 + 50X2
Subject to: 4X1 + 3X2 ≤ 240
2X1 + 1X2 ≤ 100
Non-negativity conditions X1, X2 ≥ 0

43
 The first step of the simplex method requires that each inequality be converted into an
equation. ”less than or equal to” inequalities are converted to equations by including
slack variables.

Suppose S1 carpentry hours and S2 finishing hours remain unused in a week. The
constraints become;
4X1 + 3X2 + S1 = 240 or 4X1 + 3X2 + S1 + 0S2 = 240
2X1 + 1X2 + S2 = 100 or 2X1 + 1X2 + 0S1 + S2 = 100

As unused hours result in no profit, the slack variables can be included in the
objective function with zero coefficients:
P= 70X1 + 50X2 + 0S1 + 0S2
p- 70X1 + 50X2 + 0S1 + 0S2 = 0

The problem can now be considered as solving a system of 3 linear equations

involving the 5 variables (X1, X2, S1, S2, P) in such a way that P has the maximum
value;

4X1 + 3X2 + S1 + 0S2 = 240

2X1 + 1X2 + 0S1 + S2 = 100
p-70X1-50X2-0S1-0S2 = 0

STEP 2
Variables in the solution mix are called basic variables. Each basic variables has a
column consisting of all 0’s except for a single 1. all variables not in the solution mix
take the value 0.

Under the the simplex process, a basic variable in the solution mix is replaced by
another variable previously not in the solution mix. The value of the replaced variable
is set to 0.

Now, the system of linear equations can be written in matrix form or as a 3x6
augmented matrix. The initial tableau is;

Basic x x S S P Right Hand

1 2 1 2
Variables Side

S 4 3 1 0 0 240
1

S 2 1 0 1 0 100
2

P -70 -50 0 0 1 0

The tableau represents the initial solution X1=0, X2=0, S1=240, S2=100, P=0

44
 The slack variables S1 and S2 form the initial solution mix. The initial solution
assumes that all variable hours are unused, that is; the slack variables take the largest
possible values

STEP 3
Select the pivot column (determine which variable to enter into the solution mix).
Choose the column with the “most negative” element in the objective function row.
Basic x x S S P Right hand
1 2 1 2
Variables side

S 4 3 1 0 0 240
1

S 2 1 0 1 0 100
2

P -70 -50 0 0 1 0

Pivot Column
X1 should enter into the solution mix because each unit of X1 (a table) contributes a
profit of $70 compared with only $50 for each unit of X1 (a chair)
Step 4
There are no positive elements in the pivot column above the dashed line. This means
that we can go on step 5.
STEP 5
The next step is to select the pivot row (determine which variable to replace in the
solution mix). We divide the last element in each row by the corresponding element in
the pivot column.
Enter

Basic x x S S P Right
1 2 1 2
Variables hand side
S 4 3 1 0 0 240 240 ÷ 4 = 60
1
Exit S 2 1 0 1 0 100 100 ÷ 2 = 50
2
P -70 -50 0 0 1 0
Pivot row
(Pivot number) (Pivot column)

The pivot row is the row with the smallest non-negative result. It should be replaced
by x1 in the solution mix.
60 tables can be made with 240 unused carpentry hours but only 50 tables can be
made with 100 finishing hours.

Therefore we decide to make 50 tables:

 Now calculate new values for the pivot row.
 Divide every number in the row by the pivot number.

45
 Basic x x S S P Right
1 2 1 2
Variables hand side

S 4 3 1 0 0 240
1

x 1 1/2 0 1/2 0 50 R2
1
2
P -70 -50 0 0 1 0

Next, we use row operations to make all numbers in the pivot column equal to 0
except for the pivot number which remains as 1.
Basic x x S S P Right
1 2 1 2
Variables hand side

S 0 1 1 -2 0 40 -4.R2+R1
1

x 1 1/2 0 1/2 0 50
1

P 0 -15 0 35 1 3500 70.R2+R3

In this case, X1=50, X2=0, S1=40, S2=0, P=3500

Explanation
If 50 tables are made, then the unused carpentry hours are reduced by 200 hours (4
h/table multiplied by 50 tables); the value changes from 240 hours to 40 hours.
Making 50 tables results in the profit being increased by $3500; the value changes
from $0 to $3500.

Now we repeat the steps until there are no negative numbers in the last row.
 We select the new pivot column. x2 should enter into the solution mix.
 We select the new pivot row. S1 should be replaced by x2 in the solution mix.
Enter

Basic x x S S P Right
1 2 1 2
Variables hand
side
S 0 1 1 -2 0 40 40/1=40
1
Exit New pivot row
x 1 1/2 0 1/2 0 50 50/0.5=100
1

P 0 -15 0 35 1 3500

New pivot column

46
 Next we should calculate new values for the pivot row. As the pivot number is already
1, there is no need to calculate new values for the pivot row.
We use row operations to make all numbers in the pivot column equal to except for
the pivot number.

Basic Variables x x S S P Right

1 2 1 2
hand side

x 0 1 1 -2 0 40 - R1+R2
2

x 1 0 -1/2 3/2 0 30 15.R1+R3

1

P 0 0 15 5 1 4100

Since the last row contains no negative numbers, this solution gives the
maximum value of P.
If 40 chairs are made, then the number of tables are reduced by 20 tables (1/2
table/chair multiplied by 40 chairs); the value changes from 50 tables to 30 tables.
The replacement of 20 tables by 40 chairs results in the profit being increased by
$600; the value changes from $3500 to $4100.

Result
This simplex tableau represents the optimal solution to the LP problem and is
interpreted as:

X1=30, X2=40, S1=0, S2=0 and profit or P=$4100

The optimal solution (maximum profit to be made) is to company 30 tables and 40

chairs for a profit of $4100.

Activity 3.4
A furniture manufacturer produces tables and chairs which must be processed through
assembly and finishing departments. Assembly has 60 hours available; finishing has
capacity to handle 48 hours of work. Manufacturing one table requires 4 hours in
assembly and 2 hours in finishing.
Each chair requires 2 hours in assembly and 4 hours in finishing. Profit is $8 per table
and $6 per chair.
Required
Use the simplex method to determine the most profitable combination of products to
produce given that the company’s resources are limited.

Summary of the Simplex Method (Basic Steps for a Maximisation Problem)

1. Initialization. Start with an initial basic feasible solution in canonical form.

2. Optimality. Check for optimality. Here, the relative profits of all non basic
variables are computed. If the relative profits are non positive, STOP—the
solution is optimal. Otherwise, go to step 3.

47
 3. Entering variable. Choose a non basic variable to be the new basic variable,
where a general rule is to choose the non basic variable with the largest
(positive) relative profit in order to give a large increase in Z.

4. Leaving variable. Determine the (old) basic variable to be replaced by the

(new) basic variable. Examine each constraint to see how far the new basic
variable can be increased. Examine the coefficients of the new basic variable
in each of the constraints. If a constraint has a positive coefficient, then the
maximum increase/or that constraint is the right-hand side constant (resource)
divided by the positive coefficient. (If a constraint has a non positive
coefficient, then the maximum increase in the new basic variable for that
constraint is infinite. If the coefficients of the entering variable in all
constraints are non positive, then the entering variable can be increased
indefinitely, and thus the solution is unbounded.) To satisfy all of the
constraints (for feasibility), take the minimum of these ratios. This rule usually
is called the minimum ratio rule.

5. Pivot. Find the new canonical system and the basic feasible solution by a pivot
operation. Go to step 2.

Comparison of graphical LP approach to the simplex method

Graphical Method Simplex Method

1. Solution space consists of infinity
of feasible points.
2. Candidate for the optimum solution
are given by a finite number of corner
points.
3. Use the objective function to
Determine the optimum corner points
1. The system has infinity of feasible
solution.
2. Candidate for the optimum solution
are given by a finite number of
basic feasible solution.
3. Use the objective function to
determine the optimum basic feasible
solution.

3.8 Summary
In this unit, we defined linear programming and showed how it is applied in business
to make decisions that optimise the use of resources. Resources normally include
machinery, labour, cash, time, warehouse space and raw materials. These resources
may be used to make products or provide services. We explained that a linear
programme is a mathematical model that has:
1. A linear objective function that is to be maximised or minimised.
2. A set of linear constraints.
3. Variables that are all restricted to non-negative values.

We also discussed the basic steps in formulating a linear programming problem and
how to solve a linear programming problem using the graphical approach and simplex
methods.

48
References
Render, B., Stair, R.M. and Hanna, M.E. (2012). Quantitative Analysis for
Management, (11th Edition). New York: Pearson.
Hillier, F. and Lieberman, G.T. (1995). Introduction to Operations Research (6th
Edition). Boston: McGraw-Hill.

49
 Unit 4

Strategic Management Accounting

4.0 Introduction
Businesses are increasingly being managed along strategic lines where their present
position is formally compared with their target position. In this unit we discuss the
role of management accounting in providing information that is useful for strategic
management decisions. Strategic management accounting uses cost information to
carry out tactics that implement those strategies, and to develop and implement
controls that monitor success at achieving strategic objectives. We will, therefore,
show you how management control systems are used as tools to implement strategies.

4.1 Unit Objectives

By the end of this unit, you should be able to:
 explain what is strategic management
 select appropriate analytical techniques that optimise the employment of
company resources
 evaluate a company’s adopted techniques in relation to its strategic
management goals
 explain the balance score card

4.2 What is Strategic Management?

Thompson and Strickland (2000: 6) define strategic management as “…the
management process of forming a strategic vision, setting objectives, crafting a
strategy, implementing and executing the strategy…” This means that strategic
management is an approach where the business seeks to reach its objectives by taking
advantage of its strengths. Strategic management involves the formulating of strategic
plans or strategies that take into account the business’s strengths and weaknesses.

4.2.1 Strategy
Strategy can be defined as the process by which managers, using a time horizon of
three to five years, evaluate external environmental opportunities, internal strengths
and resources in order to decide on organisational goals and how to accomplish them
(Atrill, 1995).

A business unit’s strategy depends on two interrelated aspects:

1) Its mission or goals.
2) The way the business unit chooses to compete in its industry to accomplish its
goals.

50
 4.2.2 Strategic plan
While a strategy is the overall business approach, strategic planning is the overall
planning that facilitates the accomplishment of a strategy (Atrill, 1995). A strategic
plan consists of an organisation’s mission and future direction, near-term and long
term performance targets, and strategy.

Strategic planning helps to answer the following questions:

 Who are we?
 What capacity do we have?
 What problems are we addressing?
 Which critical issues must we respond to?
 Where should we allocate our resources?
 What should our priorities be?

Once the above questions have been answered, it enables management to answer the
following questions:
 What should the immediate objective be?
 How should the company organise itself to achieve the objective?
 Who will do what and when?

4.3 What is Strategic Management Accounting?

Strategic management accounting is the provision of information that supports
strategic decisions and translates the mission and strategy of an organisation into
operational objectives (Hansen and Mowen, 2000).

Elements of strategic management accounting include:

 the extension from internal focus of management accounting to include
external information about competitors
 efforts to gain competitive advantage through exploiting linkages in the value
chain

4.3.1 The role of strategic management accounting

Strategic management accounting helps by providing the following information for
use by management:
a) External information about competitors
 Strategic management accounting helps a company to evaluate its position
relative to the rest of the industry
 Management is supplied with information that indicates by whom and how
much they are gaining or being beaten

b) Gaining competitive advantage through exploiting linkages in the value chain

 This focuses on each link in the chain from the customer’s perspective
 This also requires identifying the value chain and operation of cost drivers
of competitors in order to understand relative competitiveness

51
4.4 Process Value Analysis
Strategic management accounting involves process value analysis. Process value
analysis focuses on the accountability of activities within the organisation rather than
costs. It is concerned with:
 Driver analysis
 Activity Analysis, and
 Performance management

4.4.1 Driver analysis

Managing activities requires an understanding of what causes activity costs. Every
activity has an input and an output.

Activity inputs are the resources consumed by the activity in producing its output.

Activity output is the result or product of an activity, for example, if the activity is
writing a computer programme, the inputs would include a programmer, a computer,
and a printer; while the output would be a computer programme.

Driver analysis is therefore the process of identifying those factors that are the root
cause of activity costs. Once the root causes are known, then action can be taken to
improve the activity. For example an analysis may reveal that the root cause of the
cost of moving raw materials is the plant layout. Re-organising plant layout may
result in reduced cost of moving raw materials.

4.4.2 Activity analysis

Activity analysis is the process of identifying, describing and evaluating the activities
that an organisation performs. Activity analysis should produce four outcomes:
1) What activities are done?
2) How many people perform the activities?
3) The time and resources required to perform the activities
4) An assessment of the value of the activities to the organisation, including a
recommendation to select and keep only those activities that add value.

4.4.3 Activity performance measurement

This involves assessing how well activities and processes are performed and is
fundamental to improvement of a company’s profitability.

Measures of activity performance centre on three dimensions:

 Efficiency
 Quality
 Time

Efficiency focuses on the relationship of activity inputs to activity outputs.

Quality is concerned with doing activities right the first time. If the activity output is
defective, then the activity will need to be repeated, causing unnecessary costs.
Time taken to perform an activity is critical as it means that the longer it takes, the
more resources are consumed and less ability to respond to customer demands.

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4.5 Financial Measures of Activity Efficiency
Financial measures of performance provide specific information about the dollar
effects of activity performance. This means that financial measures should indicate
both potential and actual savings.

Financial measures of activity efficiency include:

 Value and non-value added activity costs
 Trends in activity costs
 Kaizen standard setting
 Product life-cycle cost, and target costing

4.5.1 Formula for value and non-value added costs

a) Value added costs = SQ x SP
b) Non-value added costs = (AQ – SQ ) SP
where:
SQ = the value added output level of an activity
SP = the standard price per unit of activity output measure
AQ = the actual quantity used of flexible resources or the practical activity
capacity acquired for committed resources

Example 4.1
The following data pertain to four activities
Activity Activity
Driver SQ AQ SP
Purchasing Purchasing hours 20 000 23 000 $20
Moulding Moulding hours 30 000 34 000 12
Inspecting Inspecting hours 0 6 000 15
Grinding Number of units 0 5 000 6

The value added standards (SP) for inspecting and grinding call for their elimination.

Required
Prepare a value and non-value added cost report for the financial year.

Solution 4.1
Activity Value added cost Non-value added cost Actual cost
Purchasing $400 000 $60 000 $460 000
Moulding 360 000 48 000 408 000
Inspecting 0 90 000 90 000
Grinding 0 30 000 30 000
$760 000 $228 000 $988 000

4.5.2 The role of Kaizen Standards

Kaizen costing is concerned with reducing the costs of existing products and
processes. In operational terms this translates into reducing non value added costs.

53
Example 4.2
Midlands Manufacturing has developed value added standards for its activities among
which are the following three:
1) Material usage
2) Purchasing
3) Inspecting

The value added output levels for each of the activities, their actual levels achieved,
and the standard prices are as follows:

Activity Activity driver SQ AQ SP

Using Lumber Board size 24 000 30 000 $10
Purchasing Purchase orders 800 1 000 50
Inspecting Inspecting hours 0 4 000 12

Assume that material usage and purchasing costs correspond to flexible resources
(acquired as needed) and inspection uses resources that are acquired in blocks or steps
of 2 000 hours. The actual prices paid for the inputs equal the standard prices.

Required
1) Assume that continuous improvement efforts reduce the demand for inspection
by 30 percent during the year (actual activity usage drops by 30 %). Calculate
the activity volume and unused capacity variances for the inspection activity.
Explain their meaning.
2) Prepare a cost report that details value added and non-value added costs.
3) Suppose that the company wants to reduce all non-value added costs by 30% in
the coming year. Prepare a Kaizen standards that can be used to evaluate the
company’s progress toward this goal. How much will this save or reduce
spending?

Solution 4.2
1) SP x SQ SP x AQ SP x AQ
$12 x 0 $12 x 4 000 $12 x 2 800
$0 $48 000 $33 600

Activity Volume Unused Capacity

Variance Variance
$48 000U ($48000 - $0) $14 400 ($48000-$33600)

 The activity volume variance is the non-value added cost.

 The unused capacity variance measures the cost of the unused activity
capacity.

54
 2) Value added costs Non-value added costs Total
Using Lumber $240 000 $60 000 $300 000
Purchasing 40 000 10 000 50 000
Inspecting 0 48 000 48 000
$280 000 $118 000 $398 000

3) Kaizen Standards
Quantity Cost
Using Lumber 28 200 $282 000
Purchasing 940 47 000
Inspecting 2 800 33 600

If the standards are met, then savings are as follows:

Using Lumber $10 x 1 800 = $18 000
Purchasing $50 x 60 = 3 000
Savings $21 000

Activity 4.1
A company has developed value added standards for four activities as follows:
1. Purchasing parts
2. Assembling parts
3. Administering parts
4. Inspecting parts

The activities’ activity driver and other details for the year 2011 are as follows:

Activity Activity driver SQ AQ SP

Purchasing parts Orders 500 700 $300
Assembling parts Labour hours 60 000 66 500 12
Administering parts Number of parts 6 000 8 600 110
Inspecting parts Inspection hours 0 25 000 15

The actual prices paid per unit of each activity driver were equal to the standard
prices.

Required
1) Prepare a cost report that lists the value added costs, non-value added costs, and
actual costs for each activity
2) Which activities are non-value added? Explain why. Is it possible for value
added activities to have non-value added costs?

4.6 Product Life Cycle and Target Costing

The product design stage can have a significant effect on activity costs. Product life
cycle is the time a product exists from conception to abandonment. Life cycle costs
are all the costs associated with the product for its entire life cycle. The life cycle
costs include:

55
  development (planning, designing, and testing)
 production (conversion activities), and;
 logistics support (advertising, distribution, warranty)

Life cycle cost management focuses on managing value chain activities so that long-
term competitive advantage is created. To achieve this, management should balance a
product’s whole life cost, method of delivery, innovativeness, and various product
attributes including performance, features offered, reliability, conformance, durability,
aesthetics, and perceived quality. Life cycle costing therefore is a technique which
takes account of the total cost of making a product or owning a physical asset, during
its economic life.

Uses of the product life cycle:

(i) As a Planning tool, it characterises the marketing challenges at each stage and
poses major alternative strategies.

(ii) As a Control tool, the launched PLC concept allows the company to measure
product performance against similar products launched in the past.

(iii)As a Forecasting tool, it is less useful because sales histories exhibit diverse
patterns and the stages vary in duration.

4.6.1 The role of target costing

Life cycle cost management emphasises cost reduction, and not cost control. Target
costing therefore becomes a useful tool for establishing cost reduction goals. A target
cost is the difference between the sales price needed to capture a predetermined
market share and the desired profit per unit.

Definitions of target costing: It can be defined as a structured approach to

determining the cost at which a proposed product with specified functionality and
quality must be produced, to generate a desired level of profitability at its anticipated
selling price. A critical aspect of this definition is that it emphasises that target costing
is much more than a management accounting technique. Rather, it is an important part
of a comprehensive management process aimed at helping or organisation to survive
in an increasingly competitive environment. In this sense the term “Target Costing” is
a misnomer: it is not a product costing system, but rather a management technique
aimed at reducing a product’s life-cycle costs (Hansen and Mowen, 2000).

Example 4.3
A company has the capacity of production of 80 000 units and presently sells
20 000 units at $100 each. The demand is sensitive to selling price and it has
been observed that every reduction of $10 in selling price the demand is
doubled. What should be the target cost at full capacity if profit margin on
sale is taken as 25%?

What should be the cost reduction scheme if at present 40% of cost is variable with
same % of profit? If Rate of Return is 15%, what will be maximum investment at full
capacity?

56
Solution 4.3
(a) Maximum capacity 80 000 units
Present sales 20 000 units @ $100 per unit

Selling price/unit Demand

100 20 000
90 40 000
80 80 000 = Full capacity

Target cost/unit = 80 - 25% of sales

= 80 - 20 = 60 p.u.

(b) At present
Variable cost/unit = 40% of cost, that is, (Total Cost is 75% of Sales)
Fixed cost/unit = 100 –25% = 75
Cost of Sales 75
Less: Variable cost/unit __30
Fixed cost $45 p.u.

Total fixed cost $45  80 000 = __________________?

Add full capacity target cost = $ 60/unit  80 000 units

= $ ______________?

Total estimate cost

Fixed cost = ?
Variable cost (80 000  40 = ?

Required Cost reduction following value engineering is $ 12 000.

(c) Rate of return 15% Profit p.u. 25% of 80 = 20/unit

Profit before tax = 20  80 000 = ________________________?

ROCE = (PBIInvestment)
Investment = (PBIROCE) = ______________?15% = $ 106 ⅔.

Example 4.4
Sterling Enterprises has prepared a draft budget for the next year as follows:

Quantity 10 000 units

Sales price per unit 30
Variable costs per unit: Direct Materials 8
Direct Labour 6
Variable overhead (2 hrs × $ 0.50) 1
Contribution per unit 15
Budgeted Contribution 150 000
Budgeted Fixed costs 140 000
Budgeted Profit 10 000

57
The Board of Directors is dissatisfied with this budget, and asks a working party to
come up with an alternate budget with higher target profit figures.

The working party reports back with the following suggestions that will lead to a
budgeted profit of $ 25 000. The company should spend $ 28 500 on advertising, and
the target sales price up to $ 32 per unit. It is expected that the sales volume will also
rise, in spite of the price rise, to 12 000 units.

In order to achieve the extra production capacity, however, the work force must be
able to reduce the time taken to make each unit of the product. It is proposed to offer
a pay and productivity deal in which the wage rate per hour in increased to $ 4. The
hourly rate for variable overhead will be unaffected.

Ascertain the target labour time required to achieve the target profit.

Solution 4.4
Target profit 25 000
Add: Fixed cost 140 000
Add: Additional Advertisement 28 500
(a) Total contribution 193 500
(b) Required. Sales volume 12 000
contribution/unit (ab) 16.125

Target Selling price/unit 32

Less: Contribution/unit 16.125
Target variable cost p.u. 15.875
Less: material cost p.u. 8.000
Labour + Variable overhead 7.875
Labour: x hr. @ 4
Variable overhead x hr. @ 0.5

4.5x = 7.875
x (hr.) 1.75
Time/unit 1.75
Present _2.00
Time reduced 0.25 hr.

58
Activity 4.2
Bee manufacturing company sells its product at $1 000 per unit. Due to
competition its competitors are likely to reduce price by 15%. Bee wants to
respond aggressively by cutting price by 20% and expects that the pr esent
volume of 150 000 units p.a. will increase to 200 000. Bee wants to earn a
10% target profit on sales. Based on a detailed value engineering the
comparative position is given below:
Target Existing
Direct material cost per unit $ 400 $ 385
Direct manufacturing labour per unit 55 50
Direct machinery costs per unit 70 60
Direct manufacturing cost per unit 525 495
Manufacturing overhead:
No. of orders ($ 80 per order) 22 500 21 250
Testing hours ($ 2 per hour) 4 500 000 3 000 000
Units reworked ($ 100 per unit) 12 000 13 000

Manufacturing overheads are allocated using relevant cost drivers. Other

operating cost per unit for the expected volume are estimated as follows:

Research and development $ 20

Design and processing 30
Marketing 100
Customer service 15

Required
Calculate target costs per unit and target costs for the proposed volume showing
break-up of different elements.

4.7 The Balanced Score Card

The balanced score card is a strategic management system that defines a strategic
based accounting system. The balanced score card translates an organisation’s
mission and strategy into operational objectives and performance measures for four
different perspectives, such as, financial perspective, the customer perspective, the
internal business process perspective, and the learning and growth (infrastructure
perspective.

Prior to 1980s, management accounting control systems only focused on financial

measures of performance. This approach mainly focused on cost reduction and
ignored important variables necessary to compete were not considered. These
variables include:
 Product quality
 After sale services
 Customer satisfaction

59
The balanced scorecard was developed by Kaplan and Norton in 1992. It spelled out
non-financial measures to provide management with comprehensive view of each
organisational unit (division department).

Objectives of the balanced score card

 To clarify and translate vision and strategy into specific objectives
 Communicate and link strategic objectives and measures
 To plan, set targets and align strategic initiatives.
 Enhance strategic feedback and learning
 Allow management to monitor and make adjustments when necessary

How do we look to shareholders?

Financial perspective
Goals Measures
How do customer What must we
See us excel at

Internal Business process

Customer Perspective Perspective
Vision and
Goals Measures
Strategy
Goals Measures

Can we continue to
Improve and create value?

Learning & Growth

perspective

Goals Measures

Figure 4.1: The Balanced Score Card (Source: Kaplan and Norton, 1996)

Explanation of Figure 4.1

There are four perspectives of the balanced score card.

Financial perspective
This perspective evaluates the profitability of the strategy. It focuses on how much of
operating income and return on capital employed results from reducing costs and
selling more units.

Financial perspective measures include the following:

 Operating income
 Revenue growth
 Cost reduction
 Return on investment

60
Customer perspective
This perspective identifies the targeted market segment and measures the company’s
success in these segments. This perspective focuses on increasing market share and
customer satisfaction

Customer perspective measures include the following:

 Market share
 Customer satisfaction
 Customer retention percentage
 Time taken to fulfil customer’s requests

Internal business process perspective

This perspective focuses on internal operations that create value for customers and
increase shareholders wealth.

Internal business perspective measures include:

(a) Innovation Process be measured through innovation process
 Manufacturing capabilities
 Number of new products or services
 New product development time
 Number of new patents

(b) Operations Process

Operations process can be measured through
 Defect rates
 Time taken to deliver a product to customer
 Percentage of on-time delivery
 Setup time
 Manufacturing downtime

(c) Post-sales service

Post –sale service measures
Includes:
 Time taken to replace or repair defective products
 Time taken train customer on how to use the product

Learning and growth perspective

This focuses on empowering the workforce and developing requisite skills for service.
Learning and growth also aims to enhance the business’s information capabilities

Learning and growth perspective measures include:

 The level of employee education and skills
 Employee rate of turnover
 Percentage of processes with advanced controls
 Information system capability
 Employees require effective information for effective decision making
 Information system capabilities can be measured through the
percentage of processes with real time quality and cycle time

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4.8 Summary
In this unit, we explained the concept of strategic management and showed how
management accounting can enable strategic management decisions. Process value
analysis was discussed as something that provides information about why work is
done. It involves cost driver analysis, activity analysis, and performance
measurement. The balanced score card is a strategic management system that
translates the vision and strategy of an organisation into operational objectives.

62
References
Hansen, D.R. and Mowen, M.M. (2000). Management Accounting (5th edition).
Cincinnati: South Western College Publishing.
Arora, M.N. (2009). Cost and Management Accounting, Theory, Problems, and
Solutions, Mumbai: Global Media.
Ramagopai, C. (2009). Accounting for Managers, Delhi: New Age International.

Kaplan, R.S and Norton, D.P. (1996). Using the Balanced Scorecard as a Strategic
Management Systems, “Harvard Business Review (January/February 1996).

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 Unit 5

Quality Costing and Productivity

5.0 Introduction
Quality issue is a fundamental and critical success factor for competitiveness and
customer value. Fierce market competition, global competition (global village), tough
customer demands and falling margins have driven companies to focus on quality
issues. Therefore, improving quality results in enhanced customer satisfaction and
reduced manufacturing costs. In this unit we shall define quality. Quality
improvement for any organisation can help to increase profitability in two ways (i) by
increasing customer demand for the product or services, and (2) by decreasing costs.
This unit will show you how to measure quality costs and how to compute profit-
linked productivity measurement.

5.1 Unit Objectives

By the end of this unit, you should be able to:
 define quality
 explain the types of costs of quality
 describe the different types of quality costing models
 use control charts to determine if a process is in or out of control

5.2 What is Quality?

Quality can be defined as the sum of all of the characteristics of a product or service
that influence its ability to meet the stated or implied needs of the person acquiring it
(Ahrens and Chapman, 2006). Atrill (1995) defines quality as the degree of excellence
and a quality product or service as one that meets and exceeds customer expectations.
Hansen and Mowen (2000) maintain that a quality product or service is one that meets
or exceeds customer expectations on the following dimensions:
 performance
 aesthetics
 serviceability
 features
 reliability
 durability
 quality of conformance
 fitness for use

The first four dimensions describe important quality attributes but are difficult to
measure.

Performance refers to how consistently and well a product functions.

64
 Aesthetics is concerned with the appearance of tangible products (style and beauty).
Serviceability is the ease of maintaining or repairing the product.
Features refer to characteristics of a product that differentiate functionally similar
products.
Reliability is the probability that a product will operate properly within an expected
time frame.
Durability is how long a product lasts before replacement.
Conformance is the degree to which a product meets pre-established standards.
Fitness for use refers to assurance that a customer will not suffer injury or harm from
a product.

5.2.1 Production view of quality

The production process has an impact on the quality of a product or service. Through
the production process, poor quality can be eliminated through:
 reduction of non-value added activities
 avoiding slow moving inventory
 reduction of unscheduled production interruptions
 reducing the need to process, rework, replace, repair (fit machinery for
mistake-proof operations)
 analysing where fluctuations occur in processes
 constant training of workers to prevent product defects and process
malfunctions

5.2.2 Consumer view of quality

From a customer’s perspective, a product or service that meets and satisfies all
specified needs is of good quality. Consumers gauge the level of product or service
quality using the following benchmarks, which can be objective or subjective:

Objective benchmarks Subjective benchmarks

1. Performance 1. Aesthetics
2. Features 2. Perceived quality
3. Reliability
4. Conformance
5. Durability
6. Serviceability

Consumers also judge the level of quality in a service being received through
perceived characteristics of the service such as:
 reliability
 assurance
 tangibles
 empathy
 responsiveness

5.3 Cost of Quality

In order to improve quality, an organisation should take into account the costs
associated with achieving quality since the objective of continuous improvement

65
programmes is not only to meet customer requirements but also do it at the lowest
cost.

Quality linked activities are those activities performed because poor quality may or
does exist. The cost of quality are the costs that exist because poor quality may or
does exist. This definition implies that quality costs are associated with two categories
of quality related activities:
 Control activities
 Failure activities

Control activities are performed by an organisation to prevent or detect poor quality.

Control activities are made up of prevention and appraisal activities. Control costs are
costs of performing control activities.

Failure activities are performed by an organisation in response to poor quality,

therefore failure costs are cost incurred by an organisation because failure activities
are performed.

This, therefore, means quality related activities imply four categories of quality costs:
(i) Prevention costs
(ii) Appraisal costs
(iii)Internal failure cost (Incurred when product /services do not confirm with
product specifications)
(iv)External failure costs (incurred when products /service fails to meet customer
needs /expectances)

5.3.1 Quality gurus

Fathers of quality costing and quality measurement include the following people:

Walter Shewart
 In 1920s developed control charts
 Introduced the term “quality assurance”

Edward Deming
 developed courses during World War 11 to teach statistical quality –control
techniques to engineers and executives of companies that were military
suppliers
 After the war, began teaching statistical quality control to Japanese companies

Joseph M. Juran
 Followed Deming to Japan in 1954
 Focused on strategic quality planning
 Developed the P-A-F model of quality costing

Armand V. Freigenbaum
 Introduced concepts of total quality control and continuous quality
improvement

66
 Philip Crosby
 1979 emphasised that costs of poor quality outweigh the cost of preventing
poor quality
 In 1984 defined absolutes of quality management that is
 Conformance to requirements
 Prevention and
 “Zero defects”

Kaoru Ishikawa
 Promoted use of quality circles
 Developed “fishbone” diagram
 Emphasised importance of internal customer

5.4 Cost of Quality Models (COQ)

Cost of quality models may be grouped into 5 classes as indicated in Table 5.1 below

Table 5.1 COQ Models and Cost

COQ Categories Model Cost /Activity Categories
P-A-F Model Prevention + appraisal + failure
Crosby model Prevention + appraisal + failure + opportunity
Opportunity or intangible a) Conformance + non-conformance
cost Models b) Conformance + non-conformance + opportunity
c) Tangibles + intangibles
Process cost models Conformance + non-conformance
ABC Models Value added + non-value-added

5.4.1 PAF Model

Feigenbaum (1961) categorised quality costs into prevention – appraisal and failure
(PAF). This gave birth to the P-A-F cost model.

Prevention costs
These costs are associated with the design, implementation and maintenance of the
total quality management system. Prevention costs are planned and are incurred
before actual operation.

Appraisal costs
These costs are associated with the supplier’s and customer’s evaluation of purchased
materials process, intermediaries, products and services to assure conformance with
the specified requirements.

Failure costs
These can be classified into two subcategories, internal failure and external failure
costs
1. Internal failure costs:
These can occur when the results of work fail to reach designed quality
standards and are detected before transfer to customer takes place
2. External failure costs

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 These costs occur when products or services fail to reach designed quality
standards but are not detected until after the product has reached the customer.

The basic assumptions of the PAF model are that investment in prevention and
appraisal activities will reduce failure costs, and that further investment in prevention
activities will reduce appraisal cost

5.4.2 Crosby’s Model

Crosby (1979) concluded that quality was a “conformance to requirements” and
therefore defined the cost of quality as the sum of price of conformance and price of
non-conformance.

The price of conformance is the cost involved in making certain that things are done
right the first time. This therefore includes prevention and appraisal costs. The price
of non-conformance is the money spent when a product or service fails to conform to
customer requirements. This is calculated by quantifying the cost of correcting,
reworking or scrapping, which corresponds to actual failure costs.

5.4.3 Intangible Costs Models

This group of models emphasises the role of intangible costs within the overall quality
cost scheme. An example is reduction or loss in potential revenue due to non-
conformance

5.4.4 Process Cost Model

This approach recognises the importance of process cost measurement. Process cost in
this case is the total cost of conformance and the cost of non-conformance for a
particular process.

Cost of conformance is treated as the actual process cost of providing products or

services to the required standards, first time and every time by a given specified
process. The cost on non-conformance is the failure cost associated with process not
being operated to the required standard.

The process cost model can be developed for any process within an organisation it
helps identify all the activities and parameters within the process to be monitored by
flow charting the process. (Flow Charts were discussed in Accounting Information
Systems module BACC203).

Key areas for process improvement are identified and improved by investing in
prevention activities and process redesign in order to reduce the cost of non-
conformance and excessive costs of conformance.

5.4.5 ABC Model

While the PAF approach and process cost approach are the two main approaches to
measuring coast of quality, they both cannot provide appropriate methods to include
overhead costs in the cost of quality system.

These deficiencies could be overcome using the activity based costing (ABC)
developed by Cooper and Kaplan of Harvard Business School. ABC uses the two
stage procedure to achieve the accurate costs of various cost objects (such as

68
 department, products, and channels), tracing resources costs (Including overhead
costs) to activities and then tracing the costs of activities to cost objects. A wide
variety of service and manufacturing firms have found that simplified activity based
costing can be used to identify non-value added activities and quality improvement
opportunities. The goal of simplified activity analysis is to identify the activities and
cost associated with:
 Preventing
 Identifying and
 Correcting quality problems

To do so, each activity is broken into four categories which are:

1. Essential work (this includes value added activities product or service the first
time).
2. Prevention activities (These include quality –related training and preventive
maintenance that are carried out to avoid defects, rework, or delays.
3. Appraisal activities (these include inspections and data verification that are
conducted to measure or test whether a product or service meets customer
requirements).
4. Rework and failure activities (such as problem resolution and defect correction
that arise because products or services did not meet customer requirements.

5.5 COQ Elements

In order to calculate total quantity cost, the quality cost elements should be identified
under categories of prevention, appraisal internal failure and external failure costs.

5.6 COQ Metrics

Cost of quality measurement system should contain good feedback metrics (indices)
Table 3 shows some COQ metrics.

Table 5.2 COQ Metrics

Detailed Metrics
Cost of assets and materials
Cost of preventive labour
Cost of appraisal labour
Cost of defects per 100
pieces produced
Cost of late deliveries
Global Metrics
1. ROQ = _______Increase in profit___________
Cost of quality improvement programme
2. Quality rate = input-(Quality defects + startup
defects + rework)
3. Process quality = available time-rework time
available time

4. COQ = External failure cost

Total cost of quality

Return on quality (ROQ) is the most frequently used global metric in the context of
COQ.

69
5.7 Measuring Quality Costs
Quality costs can be classified as observable or hidden. Observable quality costs are
those that are available from an organisation’s accounting records.

5.7.1 Calculating loss profits

Profit loss by selling defects = [total defective units –number of units reworked]
[Type equation here. Profit for good units – profit for
defective units]
Z = (D-Y) (P1-P2)

5.7.2 Calculating internal costs of failure

Rework cost = number of units reworked X costs to rework defective units
R = (Y)(r)

5.7.3 Calculating external costs of failure

Cost of processing customer returns= number of defective units returned X cost of a
return
W = (Dr)(w)

5.7.4 Total quality cost

Total quality cost = preventive cost + appraisal cost + failure cost
T = K+A+F

Hidden quality costs are opportunity costs resulting from poor quality.
Hidden quality costs can be estimated using the Taguchi quality loss function.

5.7.5 The Taguchi quality loss function

The traditional zero defects definition assumes that hidden quality costs exist only for
units that fall outside the upper and lower specification limits.

The Taguchi loss function assumes that any variations from the target value of a
quality characteristics causes hidden quality cost.

The Taguchi quality loss function can be expressed as follows

L (y) = K(y-T)2
Where
K = a proportionality constant depended upon the organisation’s external
failure cost structure
Y = actual value of quality characteristics
T = target value of quality characteristics
L = quality loss

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Example 5.1
Actual
Unit (y) y-T (y-T)2 K (y-T)2
1 9.9 -0.10 0.010 $4.00
2 10.1 0.10 0.010 $4.00
3 10.2 0.20 0.040 $16.00
4 9.9 -020 0.040 $16.00
Total 0.100 $40.00
Average 0.025 $10.00

Assume that K = $400 and T = 10

Notice that the cost quadruple when the deviation from the target doubles (from 0
units 2 to 3).

Therefore, the total units produced are 2 000, and the average squared deviation is
0.025, then the expected cost per unit is
$10 (0.025 x $ 400)
Expected loss for 2000 units
= $ 20 000 ($10 x 2 000)
Quality loss function example 5.1
L(y) = K(y-m)2
L(y) = Loss
K = Constant = Cost to correct
Y = Reported value
M = Mean value (average)

Using quality cost information the principal objective of reporting quality costs is to
improve and facilitate managerial planning, control and decision making, for
example, to implement a supplier selection programme as a way of improving the
quality of material inputs.

Example 5.2
A company received an average of 10 complaints per month during 2012. In
November they received complaints (y) management set an acceptable level at
(tolerance).

It costs the company $50 directly per complaint to correct the problems. They
determined the cost in lost sales to be $100.
Total cost per complaint = $150
K value is $37.50

Required
Calculate the loss for the month of November

Solution 5.2
L(y) = $ 37.50 (15-10)2
= 37.50 (5)2
= 37.50 (25)
= $ 937.50 loss for November

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Activity 5.1
A company manufactures a product that has a target value of 20ml. Specification
limits are 20ml plus or minus 0.50ml. The value of K is $80.

A sample of five units produced the following measures

unit measured weight
1 20.20
2 20.50
3 20.30
4 19.50
5 19.75
During April, 12 500 units were produced.

Required
1. Calculate the loss for each unit, calculate the average loss for the sample of
five
2. Using the average loss, calculate the hider quality cost for April.

5.8 Quality Management and Productivity

Productivity = ratio of output to input
Yield = measure of productivity
Yield = (total output)(% good units)+(total input)(1-%good units)(% reworked)
or
Y = (i)(%G)+(i)(I-%G)(%R)

Product cost = (Kd)(i)+(Kr)(R)

Where:
Kd = direct manufacturing cost per unit
i= inputs
Kr =rework cost per unit
R = rework units
Y= yield

Control charts
Reasons for using control charts
 Improve productivity
 Make defects visible
 Determine what process adjustments need to be made
 Determine if process is “in” or “out of control”
 Reduce cost associated with poor quality and increase profitability

Control chart key terms

Out of control- the process is not performing properly
In control- the process is performing correctly
UCL: upper control limit
LCL: lower control limit
Use of pchart
A pChart is used to control defective versus conforming, go versus no-go or
acceptable versus not acceptable characteristics of produced items.

72
Count charts opportunity. An area of opportunity can be:
 A roll of paper
 A section of a roll of paper
 A time period
 A stretch of highway
 Or any delineated observable region in which one or more events may be
observed.

Count chart or C chart is used to control the number of times a particular characteristic
appears in a constant area of opportunity, for example, accidents per week in a
factory. The area of opportunity is the sub group and in this case it is the factory
work.

Types of quality control

Control chart monitors
P charts process fraction defective
C chart number of defects
U chart defects per unit
Variables control charts
X-bar chart process mean
R chart (range chart) process variability
p chart
When observations can be placed into two categories
 Good or bad
 Pass or fail

Example 5.3
A company that makes car engine spark plugs wants to monitor the fraction of
defective plugs. The company decides to select a random sample of 100 plugs each
production day over a 5 day period. Each of the 100 plugs is tested to determine if
they work. The company wants to:
1) Estimate the percentage of defective bulbs, and
2) Determine if the percentage of defective bulbs is increasing over time

Notation
X = number of defects
N= Sample size
K = number of sample groups
P = sample fraction defective
p-bar= estimated process fraction defective
P= process fraction defectives (unknown)
p-bar is an estimate of P

Inspection results
Day n x
1 100 20
2 100 5
3 100 30
4 100 35
5 100 24

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 Required
1. Ascertain P and p-bar
2. Calculate the upper control limit (UCL) and lower control limit (LCL)

Solution 5.3
1. P and p-bar
Day n x p = x/n
1 100 20 0.20
2 100 5 0.05
3 100 30 0.30
4 100 35 0.35
5 100 24 0.24
Sum 1.14
p-bar 0.23

Estimated process fraction defective p-bar

p-bar= =
k
= 1.14/5
= 0.23
2. UCL = p + 3

= 0.23 +3

= 0.356

LCL = p - 3

= 0.23 - 3

= 0.104

Interpretation of the above findings

 The estimated fraction of defective plugs produced is 0.23
 On day 2, p was below LCL.
 This means that a special cause occurred on that day to cause the process to go
out of control.
 The special cause shifted the process fraction defective downward

Activity 5.2
Show how a p-chart can be used to reduce costs and control processes in the
following situations:
a) Sales department
b) Shipping department

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5.10 Summary
In this unit we defined quality. We showed you how quality improvement for any
organisation can help to increase profitability in two ways (i) by increasing customer
demand for the product or services, and (2) by decreasing costs. We also showed you
how to measure quality costs and how to compute profit-linked productivity
measurement.

75
References
Crosby, P.B. (1979). Quality is Free. New York: McGraw-Hill.
Feigenbaum, A.V. (1961). Total Quality Control. New York: McGraw-Hill.
Juran, T.M. (1951). Juran’s Quality Control Hand Book, New York: McGraw-Hill.
Hansen, D.R. and Mowen, M.M. (2000). Management Accounting (5th Edition).
Cincinnati: South Western College Publishing.
Portter, L.J. and Rayner, P. (1992). Quality Costing for Total Quality Management.
International Journal of Production Economics Vol 27 P69-81.

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 Unit 6

Environmental Cost Management

6.0 Introduction

Environmental Cost Management, also called Environmental Cost Accounting or

Environmental Management Accounting, is a practice used by businesses to minimise
the costs of environmental sustainability initiatives by managing waste reduction,
material flows and energy consumption.

Many businesses are looking for ways to manage their environmental costs or, in
other words, to reduce their impact on the environment. One of the ways to do this is
to develop a method to account for environmental costs. Because environmental costs
are often carried out over the long term, it can be difficult to calculate their present
value. Also, the impacts of pollution aren't always known, as the scientific
understanding of ecology is continuing to change and expand. Environmental Cost
Management focuses on the efficient use of resources, and the proper disposal of
waste effluent.

In this unit we will discuss the types of costs faced by businesses, and describe the
different methods a business may use to account for these costs.

6.1 Unit Objectives

By the end of this unit, you should be able to:
 measure environmental cost
 assign environmental costs
 perform a life cycle cost assessment
 explain strategic-based environmental responsibility accounting

6.2 What is Environmental Cost Management?

Environmental Cost Management has no single, universally accepted definition.
According to IFAC’s Statement Management Accounting Concepts, EMA is “the
management of environmental and economic performance through the development
and implementation of appropriate environment-related accounting systems and
practices. While this may include reporting and auditing in some companies,
environmental management accounting typically involves life-cycle costing, full-cost
accounting, benefits assessment, and strategic planning for environmental
management.”

Environmental Cost Management serves as a mechanism for identifying and

measuring the full spectrum of environmental costs of current production processes
and the economic benefits of pollution prevention or cleaner processes, and to
integrate these costs and benefits into day-to-day business decision-making.

77
An environmental Cost Management system can be thought of as a management
accounting system that has been refined so as to enable users of the system to be
provided with information that reflects the environmental performance of the
organisation. The United Nations Division for Sustainable Development has referred
to Environmental Cost Management simply as “doing better, more comprehensive
management accounting, while wearing an environmental hat that opens the eyes for
hidden costs”. The information generated from an environmental management
accounting system might be of a financial nature or it might be provided in physical
terms. The motivation for developing an environmental cost management system
would be to provide a foundation for an organisation to improve both its environment
and financial performance.

Companies are spending money on pollution abatement and control. In most cases
these costs represent the obvious and most easily measured environmentally related
costs. Hidden environmental costs may be greater than expenditures to pollution
abatement and control and uncovering these hidden costs can provide significant
opportunities for decision making and business planning.

Definitions of EMA (adapted from Burritt and Saka, 2005)

Graff et al. (1998) Environmental management accounting is the way that businesses
account for the material use and environmental costs of their business. Materials
accounting is a means of tracking material flows through a facility in order to
characterise inputs and outputs for purposes of evaluating both resource efficiency
and environmental improvement opportunities. Environmental cost accounting is how
environmental costs are identified and allocated to the material flows or other physical
aspects of a firm’s operations.

Xiaomei (2004) It is a new branch of accounting which is under the direction of

sustainable economic development goal, using the basic accounting theory and
method to recognise measure and report the environmental management system and
the environmental impact of economic activities of a business.

Schaltegger and Burritt (2000) EMA is defined in a narrower sense to include only the
environmentally induced financial aspects of accounting that help managers to make
decisions and be accountable for the outcome of their decisions.

Bennett and James (1998) the generation, analysis and use of financial and non-
financial information in order to optimise corporate environmental and economic
performance and to achieve sustainable business.

Jasch (2003) EMA, Environmental Management Accounting represents a combined

approach which provides for the transition of data from financial accounting, cost
accounting and material flow balances to increase material efficiency, reduce
environmental impact and risk and reduce costs of environmental protection.

International Federation of Accountants (2005) Environmental management

accounting is the management of environmental and economic performance through
the development and implementation of appropriate environment-related accounting
systems and practices. While this may include reporting and auditing in some
companies, environmental management accounting typically involves life-cycle

78
 costing, full cost accounting, benefits assessment, and strategic planning for
environmental management.

United Nations (2001) Environmental management accounting serves as a mechanism

to identify and measure the full spectrum of environmental costs of current production
processes and the economic benefits of pollution prevention or cleaner processes, and
to integrate these costs and benefits into day-to-day business decision-making.

Activity 6.1
“Environmental Cost Management has no single, universally accepted definition”.
Define Environmental Cost Management from your understanding.

6.3 Measuring Environmental Costs

Environmental costs are expenditures incurred to prevent, contain or remove
environmental contamination. Environmental costs can also be defined as the costs of
environmental degradation that cannot be easily measured or remedied, are difficult to
value, and are not subject to legal liability. Environmental costs are generally
expensed. The company may elect to either expense or defer the costs in the following
cases:
 If the expenditure either extend the life or capacity of the asset or increase the
property's safety.
 If the expenditures are made to get the property ready for sale.
 If the expenditures prevent or lessen environmental contamination that may
result from future activities of property owned.

6.3.1 Types of environmental costs

Environmental costs are any costs that could be related to the environmental impacts
of a product or a manufacturing process, additionally they are any costs that arise due
to general environmental work in a company.

Up-front costs/ Sunk costs these are expenses incurred at the beginning of a business
or in beginning a new project. Up-front costs comprise the initial investments and
expenses necessary to implement Municipality Solid Waste (MSW) services. These
include public education and outreach, land acquisition, permitting, and building
construction or modification.

Operating costs are the expenses of managing MSW on a daily basis, including
operations and maintenance, capital costs, debt service, and any unexpected costs.

Back-end costs include expenditures to properly wrap up operations and take proper
care of landfills and other MSW facilities at the end of their useful lives. Costs
include site closure, building/equipment decommissioning, post-closure care, and
retirement/health benefits for current employees.

Remediation costs at inactive sites include investigation, containment, and cleanup of

known releases and closure and post-closure care at inactive sites. Many local
governments have inactive MSW landfills that require "corrective action" for known
contamination of ground water, soil, or surface water. These remediation costs can be

79
relatively well estimated, though with somewhat more uncertainty than other types of
engineering projects such as road building.

Contingent costs are costs that might or might not be incurred at some point in the
future. Examples include the costs of remediating unknown or future releases of
pollutants, such as leaks from currently operating municipal landfills. Contingent
costs also include the liability costs of compensating for undiscovered or future
damage to property or persons adversely affected by MSW services. Both of these
types of contingent costs can be projected, but not very precisely. (In contrast, where
there is a known need to remediate, costs can be projected much more precisely.)

Environmental costs are the costs of environmental degradation that cannot be easily
measured or remedied, are difficult to value, and are not subject to legal liability. To
truly capture all of the important life-cycle cost elements, some people advocate
assessing the upstream and downstream environmental costs of resource use,
pollution, and waste generated by providing goods and services.

Social costs are adverse impacts on human beings, their property and welfare that
cannot be compensated through the legal system. Social costs (also termed "social
externalities") might include the impacts of MSW transport on neighbourhoods along
the routes taken, as well as the impacts of MSW facilities themselves. Adverse effects
on property values, community image, and aesthetics, as well as the increase of noise,
odour, and traffic all contribute to social costs.

6.3.2 Other possible environmental costs

 Environmental taxes - Three types of environmental taxes have been
identified; energy tax, carbon tax and sulphur tax.
 Environmental permits or certificates - The environmental permit is needed
in order for the company to run a business that contributes to pollution of the
environment. The permit is needed in order to build, launch and run the
business.
 Environmental fees - These are environmental protection fees, registration
fees and an environmental damage and clean-up insurance. Companies that
practice environmentally hazardous activities contribute to the environmental
damage and clean-up insurance which is more similar to a compulsory fee
than insurance. The purpose of the insurance is to cover bodily injury, material
damage and pecuniary loss due to environmentally hazardous activities and is
therefore considered an environmental cost. The insurance is used in the case
no other compensation of the damage is paid due to lack of finances in the
liable company or in the case no responsible parties can be found for the liable
act. The insurance is meant to lessen the government costs for damages caused
by companies that deal with environmentally hazardous substances
(Miljobalken, 1998c).
 Environmental costs for tests in the development phase – When developing
a new chemical substance the company is obliged to test it in several ways.
The costs for the tests are considered environmental costs as the test
demonstrate to what extent a product is environmentally hazardous.
 Environmental costs of transportation - A consequence of transporting
goods is environmentally harmful emissions that originate from fuel

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 combustions. If the cost of a transporter is higher due to the environmentally
hazardousness of a product the additional cost is considered an environmental
cost.
 Measuring and testing costs during production - Some products may cause
emissions to water, ground and air when they are being manufactured. To keep
track of the level of environmentally hazardous substances in the surrounding
environment continuous testing of the outlet from the process and on the
surroundings has to be performed
 Education of employees - These are costs incurred in additional education
needed for employees to handle products that are toxic or because of other
environmental properties.
 External information - These are costs incurred to inform the public about
the environmental hazardousness of a product or production process.
 Environmental investments - These are investments in production equipment
in order to reduce environmentally hazardous emissions. Investments to
increase capacity utilisation are not considered entirely as environmental but
regular investments.
 Continuous product development
 Cost for additional cleaning
 Cost for waste management
 Potential clean up costs for shut down of business

6.3.3 Steps to measure environmental costs

1. Define Success
2. Decide what to measure
3. Determine how to measure environmental costs
4. Incorporate environmental measures into decision-making

6.3.4 Procedures for calculating and recording environmental costs

Figure 6.1 Procedures for Calculating and Recording Environmental Costs

(Source: How to Calculate Environmental Costs, p10.)

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Explanation of the procedures for calculating and recording environmental costs

Stage 1
The Entity is characterised, the environmental management system is criticised and
analysed or its existing environmental policy and calculated eco-efficiency indicators
(of Consumption, Waste and Emissions and the generic and of participation)
according to the characteristics of the entity. This analysis gives an idea of the
environmental performance of the entity and its scope.

Stage 2
Defines the scope of the life cycle, forms the material balance which is no more than
the inputs and outputs analysis processes units physical and monetary for one unit of
finished product, with emphasis on the outputs that cause impact on the environment.
Then they are classified, the impacts (Waste water, Air / Climate, Waste, Noise,
Radiation, and so on), and given the activities that are generated at the rate of the
outputs that cause environmental impacts are identified and calculated the costs
associated with them with the use of established checklists. It is important to spread
fixed costs, which are the majority for each product, if there is a great variety, using
as a basis for apportionment distribution and waste, or wastewater generated by
products and / or services.

Stage 3
Environmental costs are recorded with the use of subaccounts that extract information
from the financial accounting and establishing an extra-book where information is
broken down to where one wants. Among some sub-accounts which can be created
are:
a) Environmental Costs of Waste Management and Emissions or Wastes.
b) Costs for Environmental Prevention and Environmental Management.
c) Environmental Costs for Material Purchase Value
d) Environmental Costs of the outputs of the Non - Products.
e) Environmental costs for Costs Processing out of the Non - Products.
f) Environmental Income.

Stage 4
The budget is made based on estimated production and is known as the balance of
material the approximate amounts of waste, wastewater and waste generated by a unit
of a finished product, because it has a vision of the amount to be wasted, in that sense
re-calculations of phase II, primarily with the distribution of costs.

Stage 5
Is controlled based on the actual waste received, waste and wastewater, prorating the
differences, be they favourable or unfavourable in relation to the plan.

Stage 6
Begins the process of decision making, which can be focused on process
improvement, product utilisation, optimisation of waste, and many more., Framing
this process in a cycle of continuous improvement, continuous perfection, hence the
feedback procedure.

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Activity 6.2
Discuss the importance of measuring environmental costs.

6.4 Assigning Environmental Costs

Both products and processes are sources of environmental costs. Processes that
produce products can create solid, liquid, and gaseous residues that are subsequently
introduced into the environment. These residues have the potential of degrading the
environment. Residues, then, are the causes of both internal and external
environmental failure costs (for example, investing in equipment to prevent the
introduction of the residues into the environment and cleaning up residues after they
are allowed into the environment).

Production processes are not the only source of environmental costs, packaging is also
a source of environmental costs. Products themselves can be the source of
environmental costs. After a product is sold, its use and disposal by the customer can
produce environmental degradation. These are examples of environmental post
purchase costs. Most of the time environmental post purchase costs are borne by the
society and not by the company and, thus are societal costs. On occasion, however,
environmental post purchase costs are converted into realised external costs.

6.4.1 Environmental product costs

The environmental costs of processes that produce, market, and deliver products and
the environmental post purchase costs caused by the use and disposal of the products
are examples of environmental product costs.

Full environmental costing is the assignment of all environmental costs, both private
and societal, to products. Full private costing is the assignment of only private costs to
individual products. Private costing, then, would assign the environmental costs to
products caused by the internal processes of the organisation. Private costing is
probably a good starting point for many firms. Private costs can be assigned using
data created inside the firm. Full costs require gathering of data that are produced
outside the firm from third parties. As the firm gains experience with environmental
costing, it may be well advised to expand product cost assignments and implement an
approach called life-cycle cost assessment, discussed later in the unit.

Assigning environmental costs to products can produce valuable managerial

information. For example;
 It may reveal that a particular product is responsible for much more toxic
waste than other products. This information may lead to more efficient and
environmentally friendly alternative design for the product or its associated
processes.
 It could also reveal that with the environmental costs correctly assigned, the
product is not profitable. This could mean dropping the product to achieve
significant improvements in environmental performance and economic
efficiency. Many opportunities for improvement may exist, but knowledge of
the environmental product costs is the key. It is very critical that
environmental costs be assigned accurately.

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6.4.2 Functional-based environmental cost assignments
In most cost accounting systems, environmental costs are hidden within overhead.
Using the environmental cost definitions and classification framework, environmental
costs must be separated into an environmental cost pool. Once separated into their
own pool, functional based costing would assign these costs to individual products
using unit-level drivers such as direct labour hours and machine hours. This approach
may work well for a homogeneous product setting; however a functional based
assignment can produce cost distortions.

For example, among the products that Zimglass P/L produces are two types of glass.
Type A and Type B. There are 50 000 sheets of each type produced, and each sheet of
glass requires one-half of a machine hour. Zimglass initially used machine hours to
assign environmental costs to products. In producing glass products, cadmium
emissions occur. To produce cadmium emissions, a special government permit must
be purchased that costs $300 000. The permit must be renewed every three years.
Thus the permit cost is $100 000 per year. The permit authorises a certain level of
cadmium emissions. If emissions exceed the allowed level, a fine is imposed. There is
one unannounced inspection each quarter. The firm averages $50 000 per year in
fines.

Thus, the annual cost of cadmium emissions is $150 000 ($100 000+$50 000).
The environmental cost per machine hour is $3 ($150 000/50 000 machine hours).
Use of this rate produces an environmental cost per unit of $1.50 for each product
($3×1/2 machine hours).
The accuracy of the assignment is critical. For example, what if Type A glass is
responsible for all or most of the cadmium emissions?
If type A is responsible for all the emissions, then the environmental cost should be $3
per unit for Type A and $0 for Type B. In this case Type A was under costed and
Type B was over costed.
A producer may discover that only one product is responsible for all its emissions and
yet its cost accounting system may be assigning a portion of its cost to every product
produced. The company may resolve to improve its environmental cost system by
using activity-based costing.

6.4.3 Activity-based environmental cost assignments

The emergency of activity-based costing facilitates environmental costing. Tracing
the environmental costs to the products responsible for those costs is a fundamental
requirement of a sound environmental accounting system. Assigning costs using
causal relationships is needed. This approach is exactly what ABC does.

Zimglass P/L Example revisited

Emitting cadmium is the environmental activity (in this case, an external failure
activity).The cost of the activity is the cost of the fine and the permit fees: $150 000.
Assume now that the quantity of cadmium emissions is the activity output measure,
and let that quantity be 20 000 units.
The activity rate is $7.50per unit ($150 000/20 000 units).

If type A produces 20 000 units of emissions and Type B produces 0 units, then the
cost assignments are as they should be: $150 000 to Type A ($7.50 × 20 000) and $0
for Type B.

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This ABC assignment produces a unit environmental cost of $3 for Type A (150
000/50 000) and $0 for Type B.

All costs assigned in this example are private costs. Societal costs are also possible. If
they exist, and if they can be estimated, then a fuller costing approach can be used.
For example, suppose that cadmium emissions causes $150 000 per year in medical
expenses for those who live in the community affected by the emissions. In this case
the cost per unit of Type A would be double.

Example with multiple activities

The cadmium example had only one activity. In reality, there will be multiple
environmental activities. Each activity will be assigned costs, and activity rates will
be computed. These rates are then used to assign environmental costs to products
based on usage of the activity. Zimglass, for example, produces two types of
industrial cleaners in its Gweru Plant. Table 6.1 shows the assignments of
environmental costs to these two products when there is a variety of activities. This
cost assignment allows managers to see the relative environmental economic impact
of the two products, and to the extent that environmental costs reflect environmental
damages, the unit environmental cost can also act as an index or measure of product
cleanliness.

The “dirtier” products can then be the focus of efforts to improve environmental
performance and economic efficiency. For example, Cleanser B has more
environmental problems than Cleanser A. Cleanser B’s environmental costs total
$380 000 ($3.80 × 100 000) and are 19 percent of the total manufacturing costs. Its
environmental failure costs are $350 000, representing 92.1 percent of the total
environmental costs. Cleanser A portrays a much better picture. Its environmental
costs total $78 000, 8 percent of the total manufacturing costs, and the failure costs
are 29.5 percent of the total environmental costs. It is evident that cleanser B offers
the most environmental and economic potential for improvement.

Table 6.1: Assignment of Environmental Costs

Activities Cleanser A Cleanser B

Evaluate and select suppliers $ 0.20 $ 0.05
Design processes (to reduce pollution) $ 0.10 $ 0.10
Inspect processes (for pollution problems) $ 0.25 $ 0.15
Capture and treat chlorofluorocarbons $ 0.05 $ 1.00
Maintain nvironmental equipment $ - $ 0.50
Toxic waste disposal $ 0.10 $ 1.75
Excessive Materials Usage $ 0.08 $ 0.25
Environmental cost per unit $ 0.78 $ 3.80
Other manufacturng costs (nonenvironmental) $ 9.02 $ 16.20
Unit cost $ 9.80 $ 20.00
Units produced 100,000 100,000
(Source: Hansen and Mowen, Manageria Accounting 2007: 788)

85
Activity 6.3
Explain how environmental costs are assigned to products and processes.

6.5 Life Cycle Cost Assessment

The environmental product costs may reveal a need to improve a company’s product
stewardship. Product stewardship is the practice of designing, manufacturing,
maintaining, and recycling products to minimise adverse environmental impacts.
Lifecycle assessment is the means for improving product stewardship. Life cycle
assessment identifies the environmental consequences of a product through its entire
life cycle and then searches for opportunities to obtain environmental improvements.
Life cycle cost assessment assigns costs and benefits to the environmental
consequences and improvements.

Other definitions of life cycle assessment

The life cycle assessment is a tool used to evaluate the potential environmental impact
of a product, process or activity throughout its life cycle by quantifying the use of
resources (inputs: energy, raw materials, water) and environmental emissions
(outputs: air, water and soil) associated with the system being evaluated. Life cycle
assessment may be referred to as the investigation and valuation of the environmental
impacts of a given product or service caused or necessitated by its existence.

Life cycle assessment (LCA) is a method that attempts to account for the various
environmental impacts that are associated with a product throughout its life cycle. For
a full scale LCA, the life cycle considered consists of data from the products cradle,
the extraction of natural resources, to its grave, the final step of waste management for
the product. What is considered is not a product but rather a particular function of a
product or a service. If the product of interest is a plastic, a function could be for
example its use in plastic bags. Figure 6.2 is a flow chart of a simplified LCA.

86
 Recycling
Extraction
Process

Waste -
Extraction Process Use management

Extraction Process

Extraction

= Transport

= = System Boundary for the LCA

= Function of interest

= Material flow

Figure 6.2: Flow Chart of a Simplified LCA (Source: Chalmers, 2004)

The arrows that cross the system borders represent material flows that may or may not
have environmental impacts. Typically there are lots of different emissions and
resource uses caused by any process in the life cycle, in the figure above represented
by the material flows that cross the system boundaries. The data accounted for when
the LCA is summarised is the material flows that cross the system boundaries.

6.5.1 LCA Procedure

 Goal and scope definition
The first step of the LCA is to define the goal and scope of the study in this
case LCA. The goal definition includes the intended application of the study,
the reason for carrying it out and whom the results are intended for.

The scope of the study includes specifications of the modelling such as the
choice of a functional unit that relates the environmental impact to the
function of a product. Other modelling decisions to be considered are the
system boundaries: Decisions on what processes to include in the study, what
environmental impacts should be considered.

 Inventory analysis
When these decisions have been made a system model has to be constructed
based on the choices made in the goal and scope definition. This system model
consists of a flowchart of a technical system that includes the examined

87
 processes in the system and consists of all the environmentally relevant flows
(defined in the scope definition) needed to produce one functional unit. Once
this model is constructed, data is collected for all the processes that are
included in the system. Collection of this data is usually the main part of the
work on a Life Cycle Assessment. When sufficient data is collected, resource
use and emissions can be related to the production of a functional unit.

 Impact assessment
The aim of the Life Cycle Impact assessment is to indicate the environmental
impact of the emissions and resource use derived from the inventory analysis
(Baumann and Tillman, 2003). The first step of the impact assessment, the
classification, consists of sorting the parameters from the inventory analysis
depending on what sort of environmental impact they give rise to. Once this is
done the second step, characterisation, quantifies the relative contribution of
the emissions and resource uses to the different environmental impact
categories.

6.5.2 Life cycle costing

Life cycle costing or terotechnology can be defined as:
The practice of obtaining over their life-times, the best use of physical assets at the
lowest total cost to the entity (terotechnology). This is achieved through a
combination of management, financial, engineering and other disciplines (Lucey,
1996).

The concept of terotechnology was originally publicised with the aim of getting
industry to take account of the total cost of acquiring, operating and eventually
disposing off an asset over its whole life rather than merely concentrate on one aspect
of cost, than of acquisition. The principle of life cycle costing should apply equally to
products and services as well as conventional non-current assets (fixed Assets).

Life cycle costing involves a number of techniques that assist in the planning and
control of a product’s life cycle costs by monitoring spending and commitment to
spend during a product’s life cycle. Its aim is to minimise cost and maximise sales
revenue over the life of the product.

6.5.3 Typical life cycle costs

In general all costs incurred over the full life cycle of an asset from the original idea
for purchase or design through to disposal or withdrawal from the market are life
cycle costs.

Examples include:
 Acquisition costs
 If made by the firm these might include research and developments, design
costs, consultancy fees, testing, production and so on.
 If purchased; purchase price, any purchasing costs, testing installation, and so
forth.
 Operating costs.

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These might include, servicing and maintenance, training costs, costs of stand by
facilities, energy costs, overhead costs attributable to assets, spare parts, warehousing
and inventory costs for spares, and so on.
 Retirement or disposal costs
Include; dismantling and salvage costs, site reclamation (if applicable), any
other form of termination costs.

At any stage there may be fees for technical services or costs to bring the equipment
up to current legal standards. Examples include the costs of eliminating excess noise,
fumes or noxious discharges and waste products and of meeting more stringent safety
regulations, broadly covered under environmental costs.

Component elements of a product’s cost over its life cycle

 Research and development costs
- Design
- Testing
- Production process and equipment
 Technical data cost. Cost of purchasing any technical data required.
 Training costs including initial operator training and skills updating.
 Production costs
 Distribution costs. Transportation and handling costs.
 Marketing costs
- Customer services
- Field maintenance
- Brand promotion
 Inventory costs. Holding spare part, warehousing and so on.
 Retirement and disposal costs. Costs incurring at the end of the product’s
life.

6.5.4 Optimising life cycle costs

It will be apparent that the aim is to minimise the overall costs over the asset’s life
cycle. This will be achieved best by considering the impact of, and interacting
between, all costs prior to acquisition rather than considering the elements in a
piecemeal fashion. All too often all capital costs are considered in isolation in a
conventional project appraisal and the budgeting of maintenance and operating costs
are considered separately after the asset has been acquired. If the interactions between
the two are studied it may well be cost effective to incur higher initial capital costs to
reduce later servicing and maintenance charges and to ensure more trouble free
production.

To keep life cycle costs to a minimum, apart from initial acquisition costs, three areas
need close examination.
 Utilisation - What is the proportion of time that the asset is capable of
functioning or producing to the required standard.
 Maintainability - How easy is the asset to service and maintain and what is the
availability and cost of parts.
 Disposal - What will be the cost and problems of disposal or destruction?
Each of these areas requires technical, engineering, scientific and production
expertise; they cannot be assessed by accountants alone.

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 If any of these vital areas are overlooked it is unlikely that life cycle costs will be
minimised.

Reports and cost analyses should be related to the variable length of an asset’s life
cycle and not to the conventional reporting periods of months and years commonly
encountered.

Terotechnology does not involve any new accounting techniques or principles; rather
it is a way of integrating types of information in order to examine a problem in its
entirety.

Activity 6.4
Describe the life-cycle cost assessment model.

6.6 Strategic-Based Environmental Responsibility Accounting

Business strategy can be linked to environmental cost accounting in at least three
separate ways. Business strategy can focus exclusively on total cost assessment (refers
to the long-term, comprehensive financial analysis of the full range of internal (that is,
private) costs and savings of an investment) in which case the external environmental
costs (the costs of environmental damage external to the firm) borne by the society are
ignored. Or the external environmental costs could be included in the broader full cost
environmental assessment (the identification, evaluation and allocation of
conventional and environmental costs in an organisation) frame work.

Business strategy could be linked to the broad range of external environmental and
social costs in a full cost assessment. From a management accounting perspective, the
next step beyond Activity Based Costing is “Strategic cost management”. According
to Shank and Govindarajan (1993), strategic cost management “is cost analysis in a
broader context, where the strategic elements become more conscious, explicit, and
formal. Here, cost data is used to develop superior strategies enroute to gaining
sustainable competitive advantage”: Strategic cost management thus represents an
important link between business strategy and the choice of an environmental
accounting tool such as Total Cost Assessment, Full Costs environmental
Assessment, or Life Cycle Assessment.

Success in linking strategic cost management to environmental accounting will

depend on at least five factors:
 The motivation for environmental protection and/or pollution prevention
initiatives;
 A systematic procedure for identifying costs;
 Achievable but demanding objectives and targets;
 The integration of various corporate strategies in the organisation as a whole;
 A reporting system that provides a monitoring and corrective feedback system
for the strategy.

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 First, the motivation to link environmental accounting to business strategy needs to be
considered. A concern with compliance, for example, will drive a different choice of
management strategies than a concern for the costs of environmental impacts.
Compliance oriented strategies would lead to techniques such as environmental
auditing and the development of corporate environmental management systems.

Second, the system for gathering information is critical to the success of an

environmental accounting initiative. To this end, the purpose of environmental
accounting “is to provide relevant in-house information that will support the making
of environmentally compatible decisions by management” (Fuller, 1997:287).

Third, the managerial uses of environmental cost accounting information must be

related to achievable but demanding objectives to enhance not only environmental
performance objectives but also productivity and profitability objectives for the
company. Fuller (1999:294-295) suggests the following six areas in which
environmental cost accounting information can support marketing and managerial
decisions; product mix decisions; choosing manufacturing inputs, assessing pollution
prevention projects, evaluating waste management option, comparing environmental
costs across facilities and pricing products. Environmental cost accounting could be
used in all areas of business decision-making and these six areas provide a good
starting point for analysis.

The fourth factor to consider is the integration of corporate strategies. Schaltegger,

Muller and Hindrichsen (1996:225) argue in favour of evaluating strategic options on
at least three levels: corporate, business and product. Strategic options include, for
example, the choice of new business to enter. Business strategy may be concerned
with product-mix decisions. Finally, at the product strategy level, options include
environmental upgrades or the discontinuation of products on environmental or other
grounds. For strategic cost management to be successful, strategy at the corporate,
business and product levels needs to be coherent from an environmental accounting
perspective.

The fifth factor, reporting. Accounting and reporting are two sides of the same coin.
Rob Gray (1996:173). The two sides are mutually dependent, it is impossible to report
until one has something to report, to give account until something is accounted for.

Activity 6.5
Compare and contrast activity and strategic-based environmental control.

6.7 Solutions to Selected Activities

Activity 6.2
Discuss the importance of measuring environmental costs.

Increasing compliance costs and the emergency of eco-efficiency have intensified the
interest in environmental costing. Ecoefficiency implies that cost reductions can be
achieved by increasing environmental performance. Furthermore, for many
companies, environmental costs are a significant percentage of total operating costs.
This fact coupled with eco-efficiency emphasizes the importance of defining,

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measuring and reporting environmental costs. Environmental costs are those costs
incurred because poor environmental quality exists or may exist. There are four
categories of environmental costs, prevention, detection, internal failure and external
failure. The external failure category is divided into realised costs and unrealised
costs. Realised costs are those external costs the firm has to pay. Unrealised or
societal costs are caused by the firm but paid for by society. Reporting environmental
costs by category reveals their importance and shows the opportunity for reducing
environmental costs by improving environmental performance.

Activity 6.3
Explain how environmental costs are assigned to products and processes.

First, managers must decide whether they will assign only private costs or whether
they want all costs to be assigned (full costing). Next they must choose to use a
functional-based approach or an activity-based approach. Under functional-based
costing, an environmental cost pool is created and a rate is calculated using unit-level
drivers such as direct labour hours or machine hours. Environmental costs are then
assigned to each production based on their usage of direct labour hours or machine
hours. This approach is probably satisfactory for those forms with little product
diversity. For firms with product diversity, activity-based assignments are likely to be
superior. ABC assigns costs to environmental activities and then calculates activity
rates. These rates are used to assign environmental costs to products.

Activity 6.4
Describe the life-cycle cost assessment model.

Life cycle cost assessment is a fundamental part of life-cycle assessment. Life cycle
cost assessment assigns costs to the environmental impacts of competing product
designs. These costs are a function of materials used, the energy consumed, and the
environmental releases resulting from the manufacture of a product. Before assessing
these costs assignments, it is first necessary to do an inventory analysis that details
materials, energy and environmental releases. This analysis is carried out over the life
cycle of the product itself. Once completed, the financial and operational impacts can
be assessed and steps taken to improve environmental performance.

Activity 6.5
Compare and contrast activity and strategic-based environmental control.

Controlling environmental costs relies on a strategic based responsibility accounting

system. This system has two important features: a strategic component and an
operational component. The strategic component uses the Balanced Score Card
framework. The adaptation for environmental control is the addition of a fifth
perspective; the environmental perspective. The environmental perspective has five
objectives relating to materials and energy usage, production and release of
environmental residue, and recycling. Operational measures, such as pounds of
hazardous materials and pounds of recycled materials, are developed for each
objective. Activity-based management provides the operational system that produces
environmental improvements. Non-value-added environmental activities and their
root causes are identified. Designs for the environmental approaches are the used to
eliminate these non-value added activities. Ecoefficient improvements should produce

92
 favourable financial consequences that can be measured using trends in non-value-
added environmental costs and trends in total environmental costs.

Practice Question 1
Faraday Chemical produces two chemical products: an herbicide and an insecticide.
The controller and environmental manager have identified the following
environmental activities and costs associated with the two products.

Herbicide Insecticide
Pounds produced 12,000,000 30,000,000
Packaging materials (pounds) 3,600,000 1,800,000
Energy usage (Kilowatt hours) 1,200,000 600,000
Toxin releases (pounds into air) 3,000,000 600,000
Pollution control (machine hours) 480,000 120,000
Costs of activities:
Using packaging materials $ 5,400,000
Using energy 1,440,000
Releasing toxins(fines) 720,000
Operating pollution control equipment 1,680,000

Required:
1. Calculate the environmental cost per pound for each product. Which of the
two appears to cause the most degradation to the environment?
2. In which environmental category would you classify excessive use of
materials and energy?

6.8 Summary
In this unit we discussed environmental cost management accounting as having no single,
universally accepted definition. According to IFAC’s Statement Management Accounting
Concepts, EMA is “the management of environmental and economic performance
through the development and implementation of appropriate environment-related
accounting systems and practices. There are four categories of environmental costs,
prevention, detection, internal failure and external failure. It is very critical that
environmental costs are assigned appropriately according to their function (function-
based environmental cost assignment) or activity (Activity-based environmental cost
assignment). We also discussed Life cycle cost assessment as a fundamental part of life
cycle assessment. Life cycle cost assessment assigns costs and benefits to the
environmental consequences and improvements. Life cycle assessment can be looked at
as a way of improving a product stewardship. We closed the unit by incorporating the
concept of Strategic-Based Environmental Responsibility accounting into environmental
costs Management.

93
References
Avis, J., Burke, L. and Wilks, C. (2009). Management Accounting-Decision
Management. London: CIMA Publishing, 2008.
CIMA (2007). Managerial Paper P2: Management Accounting-Decision
Management. London: BPP learning Media.
Drucker, P. (1993). The Five Deadly Business Sins. The Wall Street Journal, p.A22.
Drury, C. (2000). Management and Cost Accounting. New York: International
Thomson Business Press.
Hansen, D.R. and Mowen, M.M. (2007). Management Accounting (8th Edition).
Dubuque: Lanchina Publishing Services.
Horngren, C., Bhimani, A., Foster, G. and Datar, S. (2002). Management and Cost
Accounting. London: FT/Prentice Hall.
Lucey, T. (1996). Management Accounting (4th Edition). London: Letts Educational
Aldine Place.

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 Unit 7

Performance Evaluation in a Decentralised Firm

7.0 Introduction
A very important source of motivation to perform well (to achieve budget targets,
perhaps, or to eliminate variances) is, not surprisingly, being kept informed about how
actual results are progressing, and how actual results compare with target. Individuals
should not be kept in the dark about their performance. Periodically, firms need to
evaluate whether everything is going as planned and whether everyone in the
organisation is on the same page. In this unit we discuss how organisations use
monitoring, incentives, and performance evaluation systems for these purposes. This
unit begins by covering responsibility accounting, which involves the accumulation,
and reporting of costs and revenue in relation to individual managers who have the
authority to incur costs and the responsibility to generate revenue. We will cover
decentralisation, the practice of delegating decisions to lower level managers.
Following this, we discuss the principle of measuring performance of investment
centres and Goal Congruence. Finally, there is detailed coverage of transfer pricing
which becomes necessary when divisions of the same company trade with each other
and it is desired to asses the profitability of each division.

7.1 Unit Objectives

By the end of this unit, you should be able to:
 outline the benefits and problems of divisionalisation
 outline the benefits and problems of decentralisation
 describe responsibility accounting in terms of cost centres, profit centres and
investment centres
 measure performance of investment centres
 discuss the concept of goal congruence
 explain transfer pricing

7.2 Responsibility Centres

7.2.1 Divisionalisation
Particularly in large companies there has been substantial decentralisation of
managerial decision making from central management to the operating division of the
company (Divisionalisation). This has occurred in existing single companies and also
as a result of merger activity. Mergers result in large diversified groups with a number
of divisions answerable to holding companies or the main board of directors. The
financial control of divisions is a complex and vital task. The management accountant
has a key role to ensure the company fulfils its overall objectives.

There are a number of advantages and disadvantages of divisionalisation. The

principal disadvantage is that it can lead to dysfunctional decision making and a lack

95
of goal congruence (the state which leads individuals or groups to take actions which
are in their self interest and also in the best interest of the entity).

In general a large organisation can be structured in one of two ways:

 Functionally - all activities of a similar type within a company, such as
production, sale, research, are placed under the control of the appropriate
departmental head.
 Divisionally - split into divisions in accordance with the products which are
made or services which are provided.

Divisional managers are therefore responsible for all operations (production, sales)
relating to their product, the functional structure being applied to each division. It is
possible that only part of a company is divisionalised and activities such as
administration are structured centrally on a functional basis with the responsibility of
providing services to all divisions.

Advantages of divisionalisation
1. Improves the quality of decisions made because divisional managers have
good knowledge of local conditions.
2. Decisions should be taken more quickly because information does not have a
long the chain of command to and from top management.
3. The authority to act to improve performance should motivate divisional
managers.
4. Frees top management from detailed involvement in day-to-day operations
and allows them to devote more time to strategic planning.
5. Provides valuable training ground for future members of top management by
giving them experience of managerial skills in a less complex environment
than that faced by top management.
6. The central head office will not have the management resources or skills to
direct operations closely enough itself. Some authority must be delegated to
local managers.

Disadvantages of divisionalisation
1. The business organisation will divide into a number of self-interested
segments, each acting at times against the wishes and interests of other
segments.
A task of head office is to try to prevent dysfunctional decision making by
individual divisional managers. Head office must reserve some power and
authority for itself so that divisional managers cannot be allowed to make
entirely independent decisions. A balance ought to be kept between
decentralisation of authority to provide incentives and motivation, and retain
centralised authority to ensure that the organisation’s divisions are all working
towards the same target for the benefit of the organisation as a whole (in other
words retaining goal congruence among the organisation’s separate divisions).
2. The costs of activities that are common to all divisions such as running the
accounting department may be greater for a divisionalised structure than for a
centralised structure.
3. Top management may loose control to divisional managers. (With a good
system of performance evaluation ad appropriate control information, top
management should be able to control operations just as effective).

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7.2.2 Decentralisation
Decentralisation is when authority for certain types of decision-making is delegated to
subordinate managers and thus some decision making moves away from the centre.
The amount of decentralisation can vary widely. Total decentralisation could occur
where by a division is completely autonomous with authority to make all types of
decisions except investment decision, senior staff appointments and salaries and
pricing decisions, although in some industries pricing is considered an operational
responsibility.

There is no absolute standard to judge the extent to which an organisation is

decentralised. An organisation may have numerous operating divisions but with all
decisions of any significance taken at the centre whilst another may have few or no
identifiable divisions yet has genuine, decentralised decision making. Decentralisation
may create semi-autonomous operating divisions, where management has
considerable, but not absolute, discretion and has responsibility for divisional
profitability. It is in such circumstances that formal performance appraisal and
monitoring system becomes necessary.

In general, a divisionalised structure will lead to decentralisation of the decision-

making process and divisional managers may have the freedom to set selling prices,
choose suppliers, make product mix and output decisions. Decentralisation is,
however, a matter of degree, depending on how much freedom divisional managers
are given.

Objectives of decentralisation
The general purpose of decentralisation and the creation of divisional structures is to
enhance the efficiency of the enterprise to meet overall objectives.
a) Improve local decision making
b) Improve strategic decision making
c) Increase flexibility and reduces communication problems.
d) Increase motivation of divisional managers
e) To provide better training for junior managers

The process of decentralisation, that is, moving decision making away from the centre
is not confined to the private sector but applies equally to the private and public
sector.

Possible problem with decentralisation

a) Sub-optimal decision making – this is caused by decisions where benefits to
one division are more than offset by costs or loss of benefits to other divisions.
Where there is a lack of congruence between the overall objectives of the
organisation and the goals and aims of the local decision maker then sub-
optimal decision making is likely unless there is a relevant and well design
appraisal system.
b) Duplication of services in the divisions and at headquarters- for example,
market research, computing services, personnel functions.
c) Decentralisation requires more sophisticated information systems.
d) Friction may occur between divisional management, where the performance of
one division is dependent on another division for example setting of transfer
prices for goods or services supplied by one division to the other.

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Activity 7.1
1. Discuss the benefits and problems of divisionalisation
2. Discuss the benefits and problems of decentralisation.

7.2.3 Responsibility accounting

Responsibility accounting is a system of accounting that segregates revenue and costs
into areas of personal responsibility in order to monitor and assess the performance of
each part of an organisation. Responsibility accounting is the term used to describe
decentralisation of authority, with the performance of the decentralised units
measured in terms of accounting results.

With a system of responsibility accounting there are three types of responsibility

centre:
 Cost centre – is a department or section or function over which a designated
individual has responsibility for expenditure.
 Profit Centre – this is a unit of the organisation, often called a division, which
is responsible for expenditures, revenues and profits.
 Investment centre – This is a profit centre for which the designated manager is
responsible for profit in relation to the capital invested in the division.

Table 7.1 Types of Responsibility Centres Summary

Centre type: Cost Centre Profit Centre Investment
Centre
Responsible for:
Costs √ √ √
Revenues √ √
Profits √ √

Profits in relation √
to investments

(Source: Lucey (1996) Management Accounting)

The creation of divisions allows for the operation of a system of responsibility

accounting. There are a number of types of responsibility accounting unit, or
responsibility centre that can be used within a system of responsibility
accounting. Budget control and budget centres are part of the overall system of
responsibility accounting within an organisation.

In the weakest form of decentralisation a system of cost centres might be used.

As decentralisation becomes stronger the responsibility accounting framework
will be based around profit centres. In its strongest form investment centres
are used.

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Table 7.2 Principal Performance of Responsibility Centres
Type of Principal
responsibility centre Manager has control over… performance
Cost centre Controllable costs Variance analysis
Efficiency measures
Revenue centre Revenues only Revenues
Profit centre Controllable costs Profit
Sales prices ( Including transfer prices)
Contribution centre As for profit centre except that Contribution
expenditure is reported on a marginal
Investment centre cost basis costs
Controllable Return on investment
Sales prices ( Including transfer prices) Residual income
Output volume other financial ratios
Investment in non-current assets and
working capital

(Source: CIMA - Management Accounting-Performance Evaluation,

2004:387)

In a system of responsibility accounting costs and revenues are segregated into

areas of personal responsibility in order to monitor and assess the performance
of each part of an organisation.

Controllable costs are those costs which are within the control of the manager
of a responsibility centre whereas uncontrollable costs are outside the control
of the centre manager.

A budget cost allowance is the cost that should be incurred in a responsibility

centre for the actual activity level that was achieved. It is the flexible budget
cost that is obtained by flexing the variable cost allowance in line with
changes in the level of activity.

All three items are important from a point of view of control and motivation.
Better cost control is achieved if those areas that a manager can control
(controllable costs) are highlighted separately from those costs that the
manager cannot control (uncontrollable costs).

Better cost control is also achieved through more meaningful variances that
are obtained by comparing a realistic flexible budget cost allowance with the
actual results that were achieved.

Motivation of managers is improved if uncontrollable items are analysed

separately, since otherwise they will feel they are being held accountable for
something over which they have no control. Similarly the realistic flexible
budget of comparison is more likely to have a positive motivational impact
because a more meaningful comparative measure of actual performance is
obtained.

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Activity 7.2
1. Describe responsibility accounting in terms of cost centres, profit centres and
investment centres.
2. Explain the meaning and importance of controllable costs, uncontrollable costs
and budget cost allowance in the context of a system of responsibility
accounting.

7.2.4 Cost centres

A cost centre manager is responsible, and has control over, the costs incurred in the
cost centre. The manager has no responsibility for earning revenue or for controlling
assets and liabilities of the centre. A cost centre is any part of an organisation to
which costs can be separately attributed. A cost centre forms the basis for building up
cost records for cost measurement, budgeting and control.

Functional departments might be treated as cost centres and made responsible for their
costs.

Table 7.3 Example of a Performance Report for a Cost Centre

Cost Centre Y
PERFORMANCE REPORT FOR THE PERIOD

Budgeted activity Units

Actual Activity Units
Budgete Budgete Actual
d Costs d costs costs Variance
(original (flexed)
$ $ $ $
Material costs
Labour costs
Variable overhead costs
Depreciation costs
etc

a) The performance report should only include controllable costs, although

information for uncontrollable costs can be provided. There should be a clear
distinction in the report between controllable and uncontrollable costs.
b) The actual costs are compared to the flexed budget costs to the actual activity
level achieved. This approach provides better information for the purpose of
control and motivation.
c) Costs attributable to discretionary cost centres (advertising, research and
development, training costs) are difficult to control. Fixed costs must be used
for the control of discretionary costs.

7.2.5 Revenue centres

The revenue centre manager is responsible for raising revenue but has no
responsibility for forecasting or controlling costs. A sales centre is an example of a
revenue centre.

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 Revenue centres are used for control purposes in non profit organisations. The
revenue centre manager may have responsibility for revenue targets within an overall
fundraising exercise, but that manager does not control the costs incurred. The
responsibility to control costs will pass to a more senior manager to whom the
revenue centre manager reports.

7.2.6 Profit centres

A profit centre is a part of a business accountable for both costs and revenues. For a
profit centre organisation structure to be established it is necessary to identify units of
the organisation to which both revenues and costs can be separately attributed.
Revenue might come from sales of goods and services to external customers, or from
goods and services provided to other responsibility centres within the organisation.

A profit centre’s performance report identify separately the controllable and non-
controllable costs.

Table 7.4 Example of a Profit Centre Performance Report

PROFIT CENTRE Z
INCOME STATEMENT FOR THE PERIOD
Budget Actual Variance
$'000 $'000 $'000
Sales revenue X X
Variable cost of sales (X) (X)
Contribution X X
Directly attributable/controllable fixed costs
Salaries X X
Stationery X X
etc X X
(X) (X)
Gross profit (directly attributable/controllable) X X
Share of uncontrollabe costs (eg head office costs) (X) (X)
Net profit X X

The budget for the sales revenue and variable cost of sales will be flexed according to
the activity level achieved. The variances could be analysed further or the profit
centre manager.

There are three profit levels highlighted in the report as follows:

1. Contribution which is within the control of the profit centre manager
2. Directly attributable gross profit, which is also within the manager’s control
3. Net profit, which is after charging certain uncontrollable costs and which is
therefore not controllable by the profit centre manager.

In responsibility accounting, an attributable cost is a cost that can be specifically

identified with a particular responsibility centre. No arbitrary apportionment is
necessary to share the cost over a number of different responsibility centres.

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 Most attributable costs will be controllable cost. An example of an attributable fixed
cost is the salary of the supervisor working in a particular responsibility centre.

Depreciation in Profit Centre Z is attributable to the profit centre but is not a

controllable cost because the manager has no control over the level of investment in
equipment in Profit Centre Z, otherwise the centre will be classified as an investment
centre.

It is necessary to include a third measure of ‘profit’ in our performance report, which

would be the controllable profit before the deductions of those costs which are
attributable to the profit centre, but which are not controllable by the profit centre
manager.

7.3 Investment Centres

An investment centre is a profit centre with additional responsibilities for capital
investments and possibly for financing and whose performance is measured by its
return on investments. An investment centre manager has responsibility for capital
investment in the centre.

Where a manager of a division is allowed some discretion about the amount of

investment undertaken by the division, assessment of results by profit alone is clearly
inadequate. The profit earned must be related to the amount of capital invested.

Performance is measured by return on capital employed (ROCE), often referred to as

return on investment (ROI) and other subsidiary ratios, or by residual income (RI).

Managers of subsidiary companies are treated as investment centre managers

accountable for profit and capital employed. Within each subsidiary company there
are major divisions with cost centres and profit centres. Regular performance reports
should be given to all managers for their own areas of responsibility.

The amount of capital employed in an investment centre should consist only of

directly attributable non-current assets and working capital (net current assets).

Activity 7.3
Discuss the four types of responsibility centres.

7.4 Measuring Performance of Investment Centres

Typically, investment centres are evaluated on the basis of return on investment (ROI)
(also known as return on capital employed (ROCE). Other measure such as residual
income (RI) and economic value added (EVA) will be discussed in this unit.

7.4.1 Return on investment (ROI)

Return on investment (ROI) (or return on capital employed (ROCE)) shows how
much profit has been made in relation to the amount of capital invested. ROI is one
way to relate operating profits to assets employed, which is, profit earned per dollar of
investment. ROI is calculated as (profit/capital employed) × 100%. Or as follows:

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 ROI = Operating income ÷ Average operating assets.

Operating income refers to earnings before interest and taxes. Operating assets are all
assets acquired to generate operating income including, cash receivables, inventories,
Land, buildings and equipment. Average operating assets is computed as follows:

Average Operating Assets = (beginning Assets + Ending Assets) ÷ 2

Example 7.1: Calculation of ROI

Suppose that a company has two investment centres X and Y for the year as follows:

X Y
$ $
Profit 120,000.00 60,000.00
Capital Employed 800,000.00 240,000.00
ROI 15% 25%

Investment centre X has made double the profits of investment centre Y, and in terms
of profits alone has therefore been more successful. However Y has achieved its
profits with a much lower capital investment, and so has earned a much bigger ROI.
This suggests that Y has been more successful investment than X.

Margin and turnover

ROI can be calculated by separating the formula (operating income/Average operating
assets) into margin and turnover.

Margin Turnover

Operating Income Sales

ROI = ×
Sales Average Operating Assets

Note: Sales in the above formula can be cancelled to give the original ROI formula.

Margin is the ratio of operating income to sales. It tells how many cents of operating
income result from each dollar of sales; it expresses the portion of sales that is
available for interest, taxes, and profit. Margin can also be referred to as return on
sales.

Turnover is found by dividing sales by average operating asset. Turnover tells how
many dollars of sales result from every dollar invested in operating assets; it shows
how productively assets are being used to generate sales.

The calculation of margin and turnover gives the manager valuable information about
the changes in ratios from one year to the other, understand the causes of managerial
accounting measures (that is, variances, margin, turnover, and so on) in order to take
actions to improve the division.

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Activity 7.4
Mable Company’s Harare Division earned operating income last year as shown in the
following income statement:

Sales $480 000

Cost of goods sold 222 000
Gross Margin $258 000
Selling and administrative expenses 210 000
Operating income $ 48 000

At the beginning of the year, the value of operating assets was $277 000. At the end
of the year, the value of operating assets was $323 000

Required:
For the Harare Division, calculate:
1. Average operating Assets
2. Margin
3. Turnover
4. Return on Investment

Solution 7.4
1. Average operating Assets = (Beginning + Ending Assets)/2
= ($277 000 + $323 000)/2
= $300 000
2. Margin = Operating income/Sales
= $48 000/$480 000
= 0.10, or 10%
3. Turnover = Sales/Average operating assets
= $480 000/$300 000
= 1.6
4. ROI = Margin × Turnover
= 0.10 × 1.6
= 0.16, or 16%
Measuring ROI
There is no generally accepted method of calculating ROI and it can have behavioural
implications and lead to dysfunctional decision making when used as a guide to
investment decisions. It focuses attention on short term short-run performance
whereas investment decisions should be evaluated over their full life (CIMA,
Management Accounting-Performance Evaluation, 2004: 392).

ROI can be measured as follows:

1. Profit after depreciation as a percentage of net assets employed
If an investment centre maintains the same annual profit, and keeps the same
assets without a policy of regular replacement of non-current assets, its ROI
will increase year by year as the assets get older. This can give a false
impression of improving performance over time.

An investment centre can improve its ROI year by year by allowing its fixed
assets to depreciate. There could be a disincentive to investment managers to

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 reinvest in new or replacement assets, because the centre’s ROI would
probably fall.

A disadvantage of measuring ROI as profit divided by net assets is that it is

not easy to compare fairly the performance of investment centres because the
difference in performance might be entirely attributable to the age of their non
current assets.

Example 7.2
The results of investment centre X, with a policy of straight line depreciation of assets
over a 5-year period, might be as follows.

Non-current Depreciation NBV (Mid Working Capital

Year assets at cost in the year year) capital employed Profit ROI
$'000 $'000 $'000 $'000 $'000 $'000
0 100 10 110
1 100 20 90 10 100 10 10%
2 100 20 70 10 80 10 13%
3 100 20 50 10 60 10 17%
4 100 20 30 10 40 10 25%
5 100 20 10 10 20 10 50%

This table of figures is intended to show that an investment centre can improve its
ROI year by year by allowing its fixed assets to depreciate.

Activity 7.5
A company has non-current assets of $460 000 which will be depreciated to nil on a
straight line basis over 10 years. Net current assets will consistently be $75 000 and
annual profit will consistently be $30 000. ROI is measured as return on net assets.

Required:
Calculate the company’s ROI in years 2 and 6.

2. Profit after depreciation as a percentage of gross assets employed

In the previous scenario ROI was measured as a return on net assets. ROI can
also be measured as a return on gross assets. This would remove the problem
of ROI increasing over time as non-current assets get older.

Example 7.3
A company acquired a non-current asset costing $40 000 which it intends to
depreciate by $10 000 pa for 4 years and the asset earns a profit of $8 000 pa after
depreciation. Calculate ROI on net book value or gross values.

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Solution

NBV (mid-year ROI based ROI based on

Year Profit value) on NBV Gross value gross value
$ $ $ $ $
1 8000 35000 23% 40000 20%
2 8000 25000 32% 40000 20%
3 8000 15000 53% 40000 20%
4 8000 5000 160% 40000 20%

The ROI based on net book value shows an increasing trend over time, simply
because the asset’s value is falling as it depreciates. The ROI based on gross book
value suggests that the asset has performed consistently in each of the four years,
which is probably a more valid conclusion.

Disadvantages of measuring ROI as return on gross book values

a) Measuring ROI as return on gross assets ignores the age factor, and does not
distinguish between old and new assets.
b) Older non-current assets usually cost more to repair and maintain, to keep
them running.
c) Inflation and technological changes alter the cost of non-current assets.

3. Constituent elements of the investment base

The appropriate constituent elements of an investment base are considered as
follows;
a) If a manager’s performance is being evaluated, only those assets which can be
traced directly to the division are controllable by the manager should be
included.
b) If it is the performance of the investment centre that is being appraised, a
proportion of the investment in the head office assets would need to be
included because an investment centre could not operate without the support
of head office assets and administrative backup.

4. Profits
If the performance of an investment centre manager is being assessed it should
seem reasonable to base profit on the revenues and costs controllable by the
manager and exclude service and head office costs except costs specifically
attributable to the investment centre. If it is the performance of the investment
centre that is being assessed, however, the inclusion of general service and head
office costs would seem reasonable.

5. Tangible and intangible assets

The management accountant may capitalise or expense assets. When significant
expenditure on an intangible asset which is expected to provide future benefits is
expensed, profits will be reduced and ROI/RI artificially depressed. In the future,
the investment should produce significant cash inflows and the ROI/RI will be
artificially inflated. Such expenditure should be capitalised so as to smooth out
performance measures and eradicate the risk of drawing false conclusion from
them.

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6. Massage the ROI
If a manager’s large bonus depends on ROI being met, the manager may feel
pressure to massage the measure. The asset base of the ratio can be altered by
increasing/decreasing payables and receivables.

7.4.2 Residual income (RI)

Residual income is the difference between operating income and the minimum dollar
return required on a company’s operating assets:

RI = Operating income – (minimum rate of return x Average operating assets)

RI can also be defied as a measure of the centre’s profits after deducting a notional or
imputed interest cost. The centre’s profit is after deducting depreciation on capital
equipment. The imputed cost of capital might be the organisation’s cost of borrowing
or its weighted average cost of capital.

Example 7.4
A division with capital employed of $400 000 currently earns a ROI of 22%. It can
make an additional investment of $50 000 for a 5 year life with nil residual value. The
average net profit from this investment would be $12 000 after depreciation. The
division’s cost of capital is 14%.

What are the residual incomes before and after the investment?

Solution:
Before investment After investment
$ $
Divisional profit ($400 000 × 22%) 88 000 100 000
Imputed interest
(400 000 × 0.14) 56 000
(450 000 × 0.14) 63 000
Residual income 32 000 37 000

The advantages and disadvantages of RI compared with ROI

The advantages of using RI

1. Residual income will increase when investments earning above the cost of
capital are undertaken and investments earning below the cost of capital are
eliminated.
2. Residual income is more flexible since a different cost of capital can be
applied to investments with different risk characteristics.

The weakness of RI is that it does not facilitate comparison between investment

centres nor does it relate the size of a centre’s income to the size of the investment.

Example 7.5: ROI versus residual income

Suppose that Department H has the following profit, assets employed and an imputed
interest charge of 12% on operating assets.

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 $ $
Operating profit 30 000
Operating assets 100 000
Imputed interest (12%) 12 000
Return on investment 30%
Residual income 18 000

Suppose now that an additional investment of $10 000 is proposed, which will
increase operating income in Department H by $1 400. The effect of the investment
would be:
$ $
Total operating income 31 400
Total operating assets 110 000
Imputed interest (12%) 13 200
Return on investment 28.5%
Residual income 18 200

Comment

If the Department H manager is made responsible for the department’s performance,

he would resist the new investment if he were to be judged on ROI, but would
welcome the investment if he were judged according to RI, since there would be a
marginal increase of $200 in residual income from the investment, but a fall of 1.5%
in ROI.

The marginal investment offers a return of 14% ($1 400 on an investment of $10 000)
which is above the ‘cut-off rate’ of 12%. Since the original return on investment was
30%, the marginal investment will reduce the overall divisional performance. Indeed,
any marginal investment offering an accounting rate of return of less than 30% in the
year would reduce the overall performance.

7.4.3 Economic Value Added ® (EVA)

Economic Value Added (EVA) is a registered trade mark owned by Stern Stewart and
Company. It is a specific type of residual income (RI) calculated as follows:

EVA = net operating profit after tax (NOPAT) less capital charge
Where the capital charge = weighted average cost of capital × net assets or total
capital employed.

If EVA is positive the company is creating wealth. If it is negative, then the company
is destroying capital. EVA is a dollar figure, not a percentage rate of return. The key
feature of EVA is its emphasis on after tax operating profit and the actual cost of
capital. Investors like EVA because it relates profit to the amount of resources needed
to achieve it.

EVA and RI are similar because both result in an absolute figure which is calculated
by subtracting an imputed interest charge from the profit earned by the investment
centre. However there are differences as follows.

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 a) The profit figures are calculated differently. EVA is based on an economic
profit which is derived by making a series of adjustments to the accounting
profit.
b) The notional capital charges use different bases for net assets. The
replacement cost of net assets is usually used in the calculation of EVA.

The calculation of EVA is different to RI because the net assets used as the basis of
the imputed interest charge are usually valued at their replacement cost and are
increased by any costs that have been capitalised.

There are differences in the way NOPAT is calculated compared with the profit figure
that is used for RI, as follows.

a) Costs which would normally be treated as expenses, but which are considered
within an EVA calculation as investments building for the future, are added
back to NOPAT to derive a figure for ‘economic profit’. These costs are
included instead as assets in the figure for net assets employed, that is, as
investments for the future. Costs treated in this way include items such as
goodwill, research and development expenditure and advertising costs.

b) Adjustments are sometimes made to the depreciation charge, whereby

accounting depreciation is added back to the profit figures, and economic
depreciation is subtracted instead to arrive at NOPAT. Economic depreciation
is a charge for the fall in assets value due to wear and tear or obsolescence.

c) Any lease charges are excluded from NOPAT and added in as a part of capital
employed. Interest is excluded from NOPAT because interest costs are taken
into account in the capital charge.

Example 7.6: Calculation of EVA

An investment centre has reported operating profits of $21 million. This was after
charging $4 million for the development and launch costs of a new product that is
expected to generate profits for four years. Taxation is paid at the rate of 25% of the
operating profit.

The company has a risk adjusted weighted average cost of capital of 12% per annum
and is paying interest at 9% per annum on a substantial long term loan.

The investment centre’s non-current assets value is $50 million and the net current
assets have a value of $22 million. The replacement cost of the non-current assets is
estimated to be $64 million.

Required:
Calculate the investment centre’s EVA for the period.

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 Solution:
Calculation of NOPAT $million
Operating profit 21
Add back development costs 4
Less one year’s amortisation of development costs ($4m/4) (1)
24
Taxation at 25% (6)
NOPAT 18

Calculation of economic value of net assets

$ million
Replacement cost of net assets ($22m +$64m) 86
Add back investment in new product to benefit future 3
Economic value of net assets 89

Calculation of EVA
The capital charge is based on the weighted average cost of capital, which takes
account of the cost of share capital as well as the cost of loan capital. Therefore, the
corrected interest rate is 12%.
$ million
NOPAT 18.00
Capital charge (12% × $89m) (10.68)
EVA 7.32

Activity 7.6
Division D operates as an investment centre. The book value of the non-current
assets is $83 000 but their replacement value is estimated to be $98 000. Working
capital in the division has a value of $19 000.

Latest operating profit for the division were $18 500, after charging historical cost
depreciation of $8 100 and the costs of a major advertising campaign which
amounted to $6 000. The advertising campaign is expected to boost revenues for
two years.

An economic depreciation charge for the period would have been $12 300. The
risk adjusted weighted cost of capital for the company is 11% pa

Required:
Calculate the EVA for division D. Ignore tax

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 Solution to Activity 7.6
$
Operating profit 18,500.00
Add back historical cost deprciation 8,100.00
less economic depreciation (12,300.00)
add back advertising costs 6,000.00
Less amortisation of advertising costs ($6000/2) (3,000.00)
NOPAT (ignoring tax) 17,300.00
Replacement value of non-current assets 98,000.00
Working capital 19,000.00
Add investment in advertising to benefit next year 3,000.00
Economic value of net assets 120,000.00
NOPAT 17,300.00
Capital charge (11% × $120 000) 13,200.00
EVA 4,100.00

Advantages of EVA
The advantages of EVA include the following.

a) Maximisation of EVA will create real wealth for the shareholders.

b) The adjustments within the calculation of EVA mean that the measure is based
on figures that are close to cash flows than accounting profits. Hence EVA
may be less distorted by the accounting policies selected.
c) The EVA measure is an absolute value which is easily understood by non-
financial managers.
d) If management are assessed using performance measures based on traditional
accounting policies they may be unwilling to invest in areas such as
advertising and development for the future because such costs will
immediately reduce the current year’s accounting profits. EVA recognises
such costs as investments for the future and thus they do not immediately
reduce the EVA in the year of expenditure.

Disadvantages of EVA
a) EVA is a relatively short term measure which can encourage managers to
focus on short term performance.
b) EVA is based on historical accounts which may be of limited use as a guide to
the future.
c) Making the necessary adjustments can be problematic as sometimes a large
number of adjustments are required.
d) Investment centres which are larger in size may have larger EVA figures for
this reason. Allowances for relative size must be made when comparing the
relative performance of investment centres.

7.5 Goal Congruence

Goal congruence is the state which leads individuals or groups to take actions which
are in their self interest and also in the best interest of the entity. Goal incongruence
exists when the interests of individuals or of groups associated with an entity are not

111
in harmony. One of the best ways to achieve goal congruence is to involve managers
in the preparation of their own budgets, so that their personal goals can be taken into
account in setting targets.

7.5.1 Management compensation: Encouraging goal congruence

Management compensation frequently includes incentives tied to performance. The
objective is to encourage goal congruence so that managers will act in the best interest
of the firm. Managerial rewards include salary increase, bonuses based on reported
income, stock options, and non cash compensation.

Cash compensation
Cash compensation includes salaries and bonuses. A company may reward good
managerial performance by granting periodic raises. However, once the raise takes
effect, it is usually permanent. Bonuses give a company more flexibility. Many
companies use a combination of salary and bonuses to fluctuate with reported income.
This incentive pay scheme makes increasing net income – an objective of the owner-
important to the manager as well.

Income-based compensation can encourage dysfunctional behaviour. The manager

may engage in unethical practices, such as postponing needed maintenance. If the
bonus is capped at a certain amount, managers may postpone revenue recognition at
the end of the year in which maximum bonus has already been achieved to the net
year.

Issues in structuring Income-based compensation Single measures of performance,

which are often the basis of bonuses, may encourage gaming behaviour. That is,
managers may increase short-term measures at the expense of the long-term health of
the firm. For example, a manager may keep net income up by refusing to invest in
more modern and efficient equipment, keeping depreciation expense low, an
accounting change from FIFO to LIFO.

Cash bonuses can encourage a short-term orientation. To encourage a longer term

orientation, some companies are requiring top executives to purchase and hold a
certain amount of company stock to retain employment.

Owners and managers are affected differently by the risk of holding stock. When
managers have so much of their own capital they may be less apt to take risk.
Managers must be insulated from catastrophic downside risks to encourage them to
make entrepreneurial decisions.

Non-cash compensation
Non-cash compensation is also important. Autonomy in the conduct of daily business
is an important perquisite. Perquisites are a type of fringe benefit received over and
above salary. For example, nice office, use of company car or jet, expense accounts,
and company paid country club memberships. Each of these perquisites signals upper
management’s approval of lower manager’s performance. Use of perquisites is an
important feature of management compensation. They can be used well to make the
manager more efficient and they may be abused as well.

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7.6 Transfer Pricing
Transfer pricing is the process of determining the price at which good are transferred
from one profit centre to another profit centre within the same company (Lucey,
1996). A transfer price is ‘the price at which goods or services are transferred between
different units of the same company’, (CIMA-Performance Evaluation, 2004).

7.6.1 Impact on performance measures

Transfer pricing affects both transferring divisions and the firm as a whole. It does
this through impact on:

1. Divisional performance measure – The price charged for the transferred goods
affects the costs of the buying division and the revenues of the selling division.
The profits of both divisions, as well as the evaluation and compensation of
their managers, are affected by the transfer price.
2. Firmware profits – While transfer price nets out for the company as a whole,
transfer pricing can affect the level of profits earned by a company in two
ways: if it affects divisional behaviour and if it affects income taxes. Divisions
acting independently may set transfer prices that maximise divisional profits
but adversely affect firm wide profits. Transfer pricing can affect overall
corporate income tax. The corporation may try to set the transfer price so that
more revenue is assigned to divisions in low–tax countries and more cost is
assigned to divisions in high-tax countries.
3. Autonomy – Because transfer pricing decisions can affect firm wide
profitability, top management is often tempted to intervene and dictate
desirable transfer prices. In doing so the organisation would have abandoned
decentralisation and all its advantages. Intervention by central management
will prove to be costly in the long run than non-intervention.

7.6.2 The transfer pricing problem

A transfer pricing system should satisfy three objectives:
1. Accurate performance evaluation- means that no one divisional manager
should benefit at the expense of another.
2. Goal congruence - means that divisional managers select actions that
maximise firm wide profits
3. Autonomy – means that central management should not interfere with the
decision-making freedom of divisional managers.

The transfer pricing problem concerns finding a system that simultaneously satisfies
all three objectives. Ideally a transfer price should be set at a level that overcomes
these problems.

a) The transfer price should provide an ‘artificial’ selling price that enables the
transferring division to earn a return for its efforts, and the receiving division
to incur a cost for benefits received.
b) The transfer price should be set at a level that enables profit centre
performance to be measured ‘commercially’. This means that the transfer
price should be a fair commercial price.
c) The transfer price, if possible, should encourage profit centre managers to
agree on the amounts of goods and services to be transferred, which will also

113
 be at a level that is consistent with the aims of the organisation as a whole
such as maximising company profits.

Transfer pricing problem can be solved through the opportunity cost approach which
identifies the minimum transfer price or “floor” of the bargaining range and maximum
transfer price or “ceiling” of the bargaining range.

Activity 7.7
1. Explain the term ‘divisional autonomy’.
2. Discuss the likely behavioural consequences of a head office continually
imposing its own decisions on divisions.

Firms need to use methods for setting transfer prices which are feasible, which use
information that is available without undue costs, and which meet as many objectives
as possible. The methods utilised can be divided into three categories:

a) Market based pricing

b) Cost-based pricing
c) Negotiated pricing

7.6.3 Market-based transfer pricing

If there is a perfect competitive outside market for the transferred product, the correct
transfer price is the market price. Divisional managers’ actions will simultaneously
optimise divisional profits and firmware profits. No division can benefit at the
expense of another and central management will not be tempted to intervene. The
opportunity approach also signals that the correct transfer price is the market price.
Since the selling division can sell all that it produces at the market price, transferring
internally at a lower price would make the division worse off. The buying division
can always acquire the goods at the market price so it would be unwilling to pay more
for an internally transferred good.

Since the minimum transfer price for the selling division is the market price and the
maximum price for the buying division is also the market price, the only possible
price is the market price. Moving away from the market price will decrease the
overall profitability of the firm.

Example 7.7: Transferring goods at market value

A company has two profit centres, A and B. A sells half of its output on the open
market and transfers the other half to B. Costs and external revenues in an accounting
period are as follows.
A B Total
$ $ $
External sales 8 000 24 000 32 000
Costs of production 12 000 10 000 22 000
Company profits 10 000

Required:
What are the consequences of setting a transfer price at market value?

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Solution:
If the transfer price is at market price, A would be happy to sell the output to B for
$8 000, which is what A would get by selling it externally instead of transferring it.

A B Total
$ $ $ $ $
Market sales 8,000 24,000 32,000
Transfer sales 8,000 - -
16,000 24,000
Transfer costs - 8,000
Own costs 12,000 10,000 22,000
12,000 18,000
Profit 4,000 6,000 10,000

The transfer sales of A are self cancelling with the transfer cost of B, so that the total
profits are unaffected by the transfer items. The transfer price simply spreads the total
profit between A and B.

Consequences
a) A earns the same profit on transfers as on external sales. B must pay a
commercial price for transferred goods, and both divisions will have their
profit measured in a fair way.
b) A will be indifferent about selling externally or transferring goods to B
because the profit is the same on both types of transactions, B can therefore
ask for and obtain as many units as it wants from A.

A market based transfer price therefore seems to be the ideal transfer price.

7.6.4 Cost-based pricing

Cost-based approaches to transfer pricing are often used in practice, because in
practice the following conditions are common.
a) There is no external market for the product that is being transferred
b) Alternatively, although there is an external market it is an imperfect one
because the market price is affected by such factors as the amount that the
company setting the transfer price supplies to it, or because there is only a
limited external demand.

Companies that use cost-based transfer pricing require that all transfers take place at
some form of cost. Three forms of cost-based transfer pricing will be considered:

1. Full-cost transfer pricing

Full cost includes the cost of direct materials, direct labour, variable overhead, and
a portion of fixed overhead. Under this approach, unsurprisingly, the full cost that
has been incurred by the supplying division in making the intermediate product is
charged to the receiving division. If a full cost approach is used a profit margin is
also included in this transfer price.

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Example 7.8
Suppose a company has two profit centres, A and B. A can only sell half of its
maximum output of 800 units externally because of limited demand. It transfers the
other half of its output to B which also faces limited demand. Costs and revenue in an
accounting period are as follows.

A B Total
$ $ $
External sales 8,000 24,000 32,000
Costs of production in the division 13,000 10,000 23,000
Profit 9,000

Division A’s costs included fixed production overheads of $4 800 and fixed selling
and administration costs of $1 000. There are no opening and closing inventory.

Solution 7.8
If the transfer price is at full cost, A in our example would have ‘sales’ to B of $6 000
(($13 000 - $1 000) × 50%). Selling and Administration costs are not included as
these are not incurred on the internal transfers. This would be a cost to B, as follows.

Company
A B as a whole
$ $ $ $ $
Open market sales 8,000 24,000 32,000
Transfer sales 6,000 -
Total sales, inc transfers 14,000 24,000
Transfer costs 6,000
Own costs 13,000 10,000 23,000
Total costs, inc transfers 13,000 16,000
Profit 1,000 8,000 9,000

The transfer sales of A are self cancelling with the transfer cost of B so that total
profits are unaffected by the transfer items. The transfer price simply spreads the total
profit of $9 000 between A and B.

The obvious draw back to the transfer price at cost is that A makes no profit on its
work, and the manager of the division A would much prefer to sell output on the open
market to earn a profit, rather than transfer to B, regardless of whether or not transfers
to B would be in the best interests of the company as a whole. Division A needs a
profit on its transfers in order to be motivated to supply B; therefore, transfer pricing
at cost is inconsistent with the use of a profit centre accounting system.

2. Full cost plus mark-up

Full cost plus mark-up suffers from the same problem as full cost. It is somewhat
less perverse, however, if the mark-up can be negotiated. In some cases full cost
plus mark-up formula may be the outcome of negotiation.

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If the transfers are at cost plus a margin of, say 10%, A’s sales to B would be $6 600
($13 000 – 1 000) × 50% ×1.10).

A B Total
$ $ $ $ $
Open market sales 8,000 24,000 32,000
Transfer sales 6,600 -
14,600 24,000
Transfer costs 6,600
Own costs 13,000 10,000 23,000
Total costs, inc transfers 13,000 16,600
Profit 1,600 7,400 9,000

Compared to a transfer price at cost, A gains some profit at the expense of B.

However, A makes a bigger profit on external sales in this case because the profit
mark-up of 10% is less than the profit mark-up on open market sales. The choice
of 10% as a profit mark-up was arbitrary and unrelated to external market
conditions.

The transfer price fails on all three criteria (divisional autonomy, performance
measurement and corporate profit measurement) for judgement.
a) Arguably, the transfer price does not give A fair revenue or charge B a
reasonable cost, and so their profit performance is distorted. It would certainly
be unfair, for example, to compare A’s profit with B’s profit.
b) The autonomy of each divisional manager is under threat. If they cannot agree
on what is a fair split of the external profit a decision will have to be imposed
from above.
c) It would seem to give A an incentive to sell more goods externally and transfer
less to B. This may or may not be in the best interests of the company as a
whole.

The method is flawed from the point of view of corporate profit maximisation.
Division A’s total production costs of $12 000 include an element of fixed costs.
Half of division A’s total production costs are transferred to division B. However,
from the point of view of division B the cost is entirely variable.

The cost per unit of A is $15 ($12 000 ÷ 800) and this includes a fixed element of
$6 ($4 800 ÷ 800), while division B’s own costs are $25 ($10 000 ÷ 400) per unit,
including a fixed element of $10(say). The total variable cost is really $9 + $15 =
$24, but from division B’s point of view the variable cost is $15 + $(25-10) = $30.
This means that division B will be unwilling to sell the final product for less than
$30, whereas any price above $24 would make a contribution to overall costs.
Thus, if the external prices for the final product fall, B might be tempted to cease
production.

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3. Variable cost plus fixed fee
Variable cost plus fixed fee can be a useful transfer pricing approach provided that
the fixed fee is negotiable. This method has one advantage over full cost plus
mark-up: if the selling division is operating below capacity, variable cost is its
opportunity cost. Assuming that the fixed fee is negotiable, the variable cost
approach can be equivalent to negotiated transfer pricing. Negotiation with full
consideration of opportunity costs is preferred.

7.6.5 Negotiated transfer prices

If division managers are allowed to negotiate transfer prices with each other, the
agreed price may be finalised from a mixture of accounting arithmetic, negotiation
and compromise.

A transfer price based on opportunity cost is often difficult to identify, for lack of
suitable information about costs and revenue in individual divisions. In this case, it is
likely that transfer prices will be set by means of negotiation. The agreed price may be
finalised from a mixture of accounting arithmetic, politics and compromise.
a) A negotiated price might be based on market value, but with some reductions
to allow for the internal nature of the transaction, which saves external selling
and distribution costs.
b) Where one division receives near-finished goods from another, a negotiated
price might be based on the market value of the end product, minus an amount
for the finishing work in the receiving division.

Disadvantages of negotiated transfer prices

1. A division manager who has private information may take advantage of
another divisional manager.
2. Performance measure may be distorted by the negotiating skills of managers.
3. Negotiation can consume considerable time and resources.

Advantages of negotiated transfer prices

1. Negotiated transfer prices offer some hope of complying with the three criteria
of goal congruence, autonomy, and accurate performance evaluation.
2. Negotiated transfer prices have been identified as a means by which goal
congruence throughout the firm can be achieved.
3. There is no need for top management to intervene in divisional affairs.
4. If negotiating skills of divisional managers are comparable, or if the firm
views these skills as an important managerial skill, concerns about motivation
and accurate performance measures are avoided.

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Activity 7.8
The Components Division produces a part that is used by the Goods Division. The
cost of manufacturing the part is as follows:

Direct materials $10

Direct labour 2
Variable overhead 3
Fixed overhead* 5
Total cost $20

*Based on a practical volume of 200 000 parts

Other costs incurred by the Components Division are as follows:

Fixed selling and administrative $500 000

Variable selling (per unit) $1

The part usually sells for between $28 and $30 in the external market. Currently
the, Components Division is selling it to external customers for $29. The division
is capable of producing 200 000 units of the part per year; however, because of a
weak economy, only 150 000 parts are expected to be sold during the coming
year. The variable selling expenses are avoidable if the part is sold internally.

The Goods Division has been buying the same part from an external supplier for
$28. It expects to use 50 000 units of the part during the coming year. The
manager of the Goods Division has offered to buy 50 000 units from the
Components Division for $18 per unit.

Required:
1. Determine the minimum transfer price that the Components Division would
accept.
2. Determine the maximum transfer price that the manager of the Goods Division
would pay.
3. Should an internal transfer take place? Why? If you were the manager of the
component division, would you sell the 50 000 components for $18 each?
Explain.
4. Suppose that the average operating assets of the Components Division total
$10million. Compute the ROI for the coming year, assuming that the 50 000
units are transferred to the Goods Division for $21 each.

Solution to Activity 7.8

1. The minimum transfer price is $15. The Components Division has idle
capacity and so must cover only its incremental costs, which are the variable
manufacturing costs. (Fixed costs are the same whether or not the internal
transfer occurs; the variable selling expenses are avoidable.)
2. The maximum transfer price is $28. The Goods Division would not pay more
for the part than it has to pay an external supplier.
3. Yes, an internal transfer ought to occur; the opportunity cost of the selling
division is less than the opportunity cot of the buying division. The

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 Components Division would earn an additional $150 000 profit ($3 × 50 000).
The total joint benefit, however, is $650 000 ($13 × 50 000). The manager of
the Components Division should attempt to negotiate a more favourable
outcome for that division.
4. Income statement:
Sales [($29 × 150 000) + ($21 × 50 000)] $5 400 000
Less: Variable cost of goods sold ($15 × 200 000) (3 000 000)
Variable selling expenses ($1 × 150 000) (150 000)
Contribution margin $2 250 000
Less: Fixed overhead ($5 × 200 000) (1 000 000)
Fixed selling and administrative (500 000)
Operating income $ 750 000

ROI = Operating income ÷ Average operating assets

= $750 000 ÷ $10 000 000
= 0.075

7.7 Summary
Firms with multiple responsibility centres usually choose one of two decision making
approaches to manage their diverse and complex activities: Centralised or
decentralised. Responsibility accounting is a system that measures the results of
responsibility centres and compares those with expected outcomes. The four types of
responsibility centres are cost centre, revenue centre, profit centre, and investment
centre. To increase overall efficiency, many companies choose to decentralise. The
essence of decentralisation is decision making freedom. In this unit we explained the
concept of measuring performance of investment centres through basis of return on
investment (ROI) (also known as return on capital employed (ROCE), residual
income (RI) and economic value added (EVA). We further explained goal congruence
(the state which leads individuals or groups to take actions which are in their self
interest and also in the best interest of the entity) and Transfer pricing (the process of
determining the price at which good are transferred from one profit centre to another
profit centre within the same company) in detail. In the following unit we will look at
tactical decision making based on theoretical information covered in this unit and
previous units.

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References
Avis, J., Burke, L. and Wilks, C. (2009). Management Accounting-Decision
Management. London: CIMA Publishing, 2008.
CIMA (2007). Managerial Paper P2: Management Accounting-Decision
Management. London: BPP learning Media.
Drucker, P. (1993). The Five Deadly Business Sins. The Wall Street Journal, p.A22.
Drury, C. (2000).nManagement and Cost Accounting. New York: International
Thomson Business Press.
Hansen, D.R. and Mowen, M.M. (2007). Management Accounting (8th Edition).
Dubuque: Lanchina Publishing Services.
Horngren, C., Bhimani, A., Foster, G. and Datar, S. (2002). Management and Cost
Accounting. London: FT/Prentice Hall.
Lucey, T. (1996). Management Accounting (4th Edition). London: Letts Educational
Aldine Place.

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 Unit 8

Tactical Decision-Making

8.0 Introduction
In the previous unit we covered performance evaluation in a decentralised firm, in this
unit we try to ensure that we convert this information into tactical decision-making.
This unit will cover various facets of the all important activities of decision-making.
A significant part of the task of management accountant is to supply information for
decision-making purposes and it is essentially that there is full awareness of the
decision process and of the techniques that may be of help in choosing between
alternatives.

We will cover tactical decision-making, relevancy, cost behaviour and resource usage
model, product mix decisions and pricing.

8.1 Unit Objectives

By the end of this unit, you should be able to:
 describe the tactical decision-making model
 explain how the activity resource usage model is used in assessing relevancy
 apply the tactical decision-making concepts in a variety of business situations
 choose the optimal product mix when faced with one constrained resource
 explain the impact of cost on pricing decisions

8.2 Tactical Decision-Making

Tactical decision-making consists of choosing among alternatives with an immediate
or limited end in view. Some tactical decisions tend to be short-run in nature; however
it should be emphasised that short-run decisions often have long-run consequences.
Tactical decisions are often small-scale actions that serve a larger purpose.

The overall objective of strategic decision-making is to select among alternative

strategies so that a long-term competitive advantage is established. Tactical decision-
making should support this overall objective, even if the immediate objective is short-
run (accepting a one-time order to increase profits) or small-scale (making instead of
buying a component). No tactical decision should be made that does not serve the
overall strategic goal of an organisation.

8.2.1 Model for making tactical decisions

The company can go about making good tactical decisions by following the
recommended general approach to tactical decision-making process described in six
steps below:
1. Recognise and define the problem.

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 2. Identify alternatives as possible solutions to the problem; eliminate
alternatives that are clearly not feasible.
3. Identify the costs and benefits associated with each feasible alternative.
Classify costs and benefits as relevant or irrelevant and eliminate irrelevant
ones from consideration.
4. Total the relevant costs and benefits for each alternative.
5. Assess qualitative factors.
6. Select the alternative with the greatest overall benefit.

These six steps define a simple decision model. A decision model is a set of
procedures that, if followed, will lead to a decision.

Table 8.1: Sequence of Steps to be Followed

Step 1 Define the problem Increase capacity for warehouse and production

Step 2 Identify the alternatives 1. Build new facility

2. Lease larger facility; sublease current facility
3. Lease additional facility.
4. Lease warehouse space.
5. Buy shafts and bushings; free up needed space.

Step 3 Identify cost and benefits associated Alternative 4:

with each feasible alternative. Variable production costs $343,000
Warehouse lease 135,000
Alternative 5:
Purchase price $460,000

Step 4 Total relevant costs and benefitsfo Alternative 4 $480,000

each feasible alternative. Alternative 5 $460,000
Differential cost $ 20,000

Step 5 Assess qualitative factors. 1. Quality of external supplier

2. Reliability of external supplier
3. Price stability
4. Labor relations & community image

Step 6 Make the decision. Continue to produce shafts and bushings

internally; lease warehouse.

(Source: Hansen and Mowen, 5th ed., 2000: 685)

8.2.2 Relevant costs defined

The tactical decision-making approach emphasised the importance of identifying and
using relevant costs. Relevant costs are future costs that differ across alternatives. All
decisions relate to the future; accordingly, only future costs can be relevant to
decisions. However, to be relevant, a cost must not only be a future cost but must also
differ from one alternative to another. An irrelevant cost is a future cost which is the
same for more than one alternative.

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 Depreciation is an example of a sunk cost. A sunk cost, is a cost that cannot be
affected by any future action. Sunk costs are past costs. They are always the same
across alternatives and are, therefore, always irrelevant. It should be noted that
salvage value of the machinery would be relevant and would be included as a benefit
of purchasing from outside suppliers.

8.2.3 Ethics in tactical decision-making

Ethical concerns revolve around the way in which decisions are implemented and the
possible sacrifice of long-run objectives for short-run gain. Relevant cots are used in
making tactical decisions. Decision makers should always maintain an ethical
framework. Reaching objectives is important, but how you get there is perhaps more
important. For example, laying off employees to increase profits in the short-run
could loosely qualify as a tactical decision. However, if the only benefit is an increase
in short-run profits and there is no evidence that the decision supports the longer-term
strategic objectives of the firm, then the decision can be questioned. There should be a
consistent message throughout the company on its mission and goals to avoid
inconsistencies which might be viewed by customers as an ethical lapse. Ethical
standards should provide guidance for individuals in decision-making.

Activity 8.1
Describe and explain the tactical decision-making model.

8.3 Relevancy, Cost Behaviour, and the Activity Resource Usage Model

 Most tactical decisions require more complicated analysis – in particular they

require more extensive consideration of cost behaviour.
 Relevant costing emphasised the importance of variable versus fixed costs.
Variable costs are relevant and fixed costs are not. Depreciation expense and
factory lease are not relevant costs and an example of fixed costs.
 Activity – based costing allows us to go further as we consider variable costs
with respect to both unit-based and non-unit based cost drivers.
 Changes in supply and demand for activity resources must be considered when
assessing relevance. If changes in demand and supply for resources across
alternative bring about changes in resource spending, then the changes in
resource spending are the relevant costs that should be used in assessing the
relative desirability of the two alternatives.
 The activity resource usage model reminds us to consider both flexible and
committed resources.

8.3.1 Flexible resources

Resources acquired as used and needed are flexible resources. The supply equals
demand. If demand for an activity changes across alternatives, then resources
appending will change and the cost of the activity is relevant to the decision. This type
of resource spending is variable cost. The amount of resource demanded should equal
the amount of resource supplied.

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8.3.2 Committed resources
Resources acquired in advance of usage are categorised as committed resources.
These resources may have unused capacity and the cost may or may not be relevant. If
committed resources have sufficient unused capacity, their cost is not relevant. If
there is not sufficient excess capacity, the additional cost is relevant.

We will consider two types of committed resources:

1. Committed resources for the short-run
Some committed resources are acquired in advance of usage through implicit
contracting; they are usually acquired in lumpy amounts. This category represents
resource spending associated with salaried and hourly employees. The implicit
understanding is that the organisation will maintain employment levels even
though there may be temporary downturns in the quantity of an activity used. An
activity may have unused capacity available. An increase in demand for an
activity may not mean an increase in activity cost because the increase in demand
is absorbed by the unused activity capacity.

Example 8.1
A company has five manufacturing engineers that supply a capacity of 10 000
engineering hours (2 000 hours each). The cost of this activity capacity is
$250 000, or $25 per hour. This year the company expects to use 9 000
engineering hours for its normal business.

Calculate the unused capacity. Explain whether the company should accept or
reject a special order that requires 500 engineering hours.

Solution 8.1
The engineering activity has 1 000 hours (10 000 - 9 000) of unused capacity.
In deciding to reject or accept a special order that requires 500 engineering hours,
the cost of engineering would be irrelevant. The order can be filled using the
unused capacity and the resources spending is the same for each alternative
($250 000 will be spent whether the order is accepted or not).

If a change in demand across activities produces a change in resource supply, then

the activity cost will change and, be relevant to the decision. A change in
resources spending can occur in one of two ways:
a) The demand for the resource exceeds the supply (increasing resource
spending).
b) The demand for the resource drops permanently and supply exceeds demand
enough so that activity capacity can be reduced (reducing resource spending).

2. Committed resources for multiple periods

Resources can be acquired in advance for multiple periods, before resource
demands are known, for example, leasing or buying a building by paying cash
upfront. Up-front resource spending is a sunk cost and, thus, never relevant.
Resource spending such as leasing is independent of resource usage. Decisions
involving multi-period capabilities are called capital investment decisions and are
discussed in Unit 9. For the multi-period resource category, changes in activity
demands across alternatives rarely affect resource spending and are not relevant
for tactical decision-making.

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 Example 8.2
A company leases a plant for $100 000 per year for 10 years. The plant is capable
of producing 20 000 units of a product – the level expected when the plant was
leased. After five years the demand for the product drops and the plant needs to
produce only 15 000 units each year.

Comment on the production of 15 000 units and increasing capacity beyond

20 000 unit capacity.

Solution 8.2
The lease payment of $100 000 still must be paid each year even thought
production activity has decreased. If demand increased beyond 20 000 unit
capacity, the company may consider acquiring or leasing an additional plant.

8.3.3 Summary of the Resource Usage Model’s Role in Assessing Relevancy

Resource Category Demand and Supply Relationships Relevancy
Flexible Resources Supply = Demand
a. Demand Changes a. Relevant
b. Demand Constant b. Not Relevant

Committed Resources Supply - Demand = Unused Capacity

(Short-Term)
a. Demand Increase < Unused Capacity a. Not Relevant
b. Demand Increase > Unused Capacity b. Relevant
c. Demand Decrease (Permanent)
1. Activity Capacity Reduced 1. Relevant
2. Activity Capacity Unchanged 2. Not Relevant

Committed Resources Supply - Demand = Unused Capacity

(Multiperiod Capacity)
a. Demand Increase < Unused Capacity a. Not Relevant
b. Demand Decrease (Permanent) b. Not Relevant
c. Demand Increase > Unused Capacity c. Capital Decision

(Source: Hansen and Mowen, 5th ed., 2000: 692)

Activity 8.2
A one year contract has been offered which will utilise an existing machine that is
only suitable for such contract work. The machine cost $35 000 five years ago and has
been depreciated $4 000 per year on a straight line basis and thus has a book value of
$5 000. The machine could be sold now for $8 000 or in 1 year’s time for $1 000.

Four types of material would be needed for the contract as follows:

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 Units Price per Unit

Required for Purchase Price of Current Buying-in Current

Material In Stock Contract Stock Price Resale price
W 1200 300 1.80 1.50 1.20
X 200 1100 0.75 2.80 2.10
Y 3000 600 0.50 0.80 0.60
Z 1800 1200 1.80 2.00 1.90

W and Z are in regular use within the firm. X could be sold if not used for the contract
and there are no other uses for Y, which has been deemed to be obsolete.

What are the relevant costs in connection with the contract (ignoring the time value of
money)?

Solution to Activity 8.2

Machine costs. The historic cost is a sunk cost and is not relevant. The depreciation
details given relate to accounting conventions and are not relevant.

The relevant cost is the opportunity cost caused by the reduction in resale value over
the one year duration of the contract, that is, $8 000 – 1 000 = $7 000.

Material costs
W
Although there is sufficient in stock the use of 300 units for the contract would
necessitate the need for replenishment at the current market price.
Relevant cost = 300 × $1.50 = $450

X
If the contract were not accepted 200 units of X could be sold at $2.10 per unit. The
balance of 900 units required would be bought at current buying-in price of $2.80.

Relevant cost = 200 × $2.10 = $ 420

900 × $2.80 = $2 520
$2 940

Y
If the 600 units were used on the contract they could not be sold so the opportunity
cost is the current resale price of $0.60 per unit.

Relevant cost = 600 × $0.60 = $360

Z
Similar reasoning to W, that is, replenishment at current buying-in price

Relevant cost = 1200 × $2 = $2 400

Note: It will be seen from the above activity that the recorded historical cost, which is
the ‘cost’ using normal accounting conventions, is not the relevant value in any of the
circumstances considered.
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8.4 Relevant Cost Applications
Relevant costing is of value in solving many different types of problems. Relevant
cost applications include decisions to make or buy a component, to keep or drop a
segment or product line, to accept a special order at less than the usual price, and to
process a joint product further or sell it at the split-off point.

8.4.1 Make or buy decisions

A make or buy problem involves a decision by an organisation about whether it
should make a product or carry out an activity with its own internal resources, or
whether it should pay another organisation to make the product or carry out the
activity.

The make option should give management more direct control over the work, but the
‘buy’ option often has the benefit that the external organisation has a specialist skill
and expertise in the work. Make or buy decisions should not be based exclusively on
cost considerations.

If an organisation has the freedom of choice about whether to make or buy externally
and has no scarce resources that put a restriction on what it can do itself, the relevant
costs for the decision will be differential costs between the two options.

The variable cost of buying is likely to be higher than the variable cost of making in-
house, but savings in directly attributable fixed costs by using an outside supplier also
need to be considered.

Example 8.3
An organisation makes four components, WX, Y and Z, for which costs in the
forthcoming year are expected to be as follows:

W X Y Z
Production (Units) 1,000 2,000 4,000 3,000

Unit Marginal costs $ $ $ $

Direct Materials 4 5 2 4
Direct labour 8 9 4 6
Variable production overheads 2 3 1 2
14 17 7 12

Directly attributable fixed costs per annum and committed fixed costs are as follows:
$
Incurred as a direct consequence of making W 1 000
Incurred as a direct consequence of making X 5 000
Incurred as a direct consequence of making Y 6 000
Incurred as a direct consequence of making Z 8 000
Other fixed costs (committed) 30 000
50 000
A subcontractor can supply units of W, X, Y and Z for $12, $21, $10 and $14
respectively.

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 Required:
Decide whether the organisation should make or buy the components.

Solution 8.3
a) The relevant costs are the differential costs between making and buying, and they
consist of differences in unit variable costs plus differences in directly attributable
fixed costs. Subcontracting will result in some fixed cost savings.
W X Y Z
$ $ $ $
Unit variable cost of making 14 17 7 12
Unit variable cost of buying 12 21 10 14
(2) 4 3 2

Annual requirements (units) 1,000 2,000 4,000 3,000

W X Y Z
$ $ $ $
Extra variable cost of buying (per annum) (2,000) 8,000 12,000 6,000
Fixed costs saved by buying 1,000 5,000 6,000 8,000
Extra Total cost of buying (3,000) 3,000 6,000 (2,000)

b) The company would save $3 000 pa by subcontracting component W (where the

purchase cost would be less than the marginal cost per unit to make internally) and
would save $2 000 pa by subcontracting component Z (because of the saving in fixed
costs of $8 000).

c) Important further consideration would be as follows:

i. If component W and Z are subcontracted, the company will have spare

capacity. How should that spare capacity be profitably used?
ii. Would subcontracting be reliable with delivery times, and would he supply
components of the same quality as those manufactured internally?
iii. Are estimates of fixed cost savings reliable?

Activity 8.3
SL manufactures three components, S,A and T using the same machine for each. The
budget for the next year calls for the production and assembly of 4,000 of each
component. The variable production cost per unit of the final product is as follows:
Machine hours Variable cost
$
1 unit of S 3 20
1 unit of A 2 36
1 unit of T 4 24
Assembly 20
100

Only 24 000 hours of machine time will be available during the year, and a sub-
contractor has quoted the following unit prices for supplying components: S $29; A
$40; T $34.

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Required:
Advise SL.

Solution to Activity 8.3

The company’s budget calls for 36 000 hours of machine time, if all the components
are to be produced in-house. Only 24 000 hours are available, and so there is a
shortfall of 12 000 hours of machine time, which is therefore a limiting factor. The
shortage can be overcome by sub-contracting the equivalent of 12 000 machine hours
output to the subcontractor.

The assembly costs are not relevant costs because they are unaffected by the decision.

The decision rule is to minimise the extra variable costs of sub-contracting per unit of
scarce resource saved (that is, per machine hour saved).

S A T
$ $ $
Variable cost of making 20 36 24
Variable cost of buying 29 40 34
Extra variable cost of buying 9 4 10
Machine hours saved by buying 3hrs 2hrs 4hrs
Extra variable cost of buying per hour saved $3 $2 $2.50

This analysis shows that it is cheaper to buy A than to buy T and it is most expensive
to buy S. The priority for making the components in-house will be in the reverse
order: S, then T, then A. There are enough machine hours to make all 4 000 units of S
(12 000 hours) and to produce 3 000 units of T (another 12 000 hours). 12 000 hours
production of T and A must be sub-contracted.

The cost-minimising and so profit-maximising make and buy schedule is as follows.

Machine hours Unit variable Total variable

Component Used/Saved Number of units cost cost
$ $
Make: S 12,000 4,000 20 80,000
:T 12,000 3,000 24 72,000
24,000 152,000

Buy: T 4,000 1,000 34 34,000

:A 8,000 4,000 40 160,000
12,000
Total variable cost of components, excluding assembly costs 346,000

8.4.2 Keep-or –drop decisions

Managers need to determine whether or not a segment, such as a product line should
be kept or dropped. Segmented reports prepared on a variable-costing basis provide
valuable information for these keep-or-drop decisions. Segment contribution margin

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 and segment margin are useful in evaluating the performance of segments. Relevant
costing describes how the information should be used to arrive at a decision.

Tactical decision-making process should be followed in keep-or-drop decisions.

Managers may not have all the information necessary to make the best decision. They
may also not be able to identify all feasible solutions. Managers should gather
information before making final make or drop decisions. Limited information can
result in poor decisions.

8.4.3 Special-order decisions

Special order decisions focus on whether a specially priced order should be accepted
or rejected. These orders can be attractive especially when the firm is operating below
its maximum productive capacity.

Activity 8.4
An ice-cream company is operating at 80% of its productive capacity. The company
has a capacity of 20 million half-gallon units. The company produces only premium
ice cream. The total cost associated with producing and selling 16 million units are as
follows (in thousands of dollars):
Total cost Unit cost
Variable costs: $ $
Dairy ingredients 11 200 0.70
Sugar 1 600 0.10
Flavouring 2 400 0.15
Direct labour 4 000 0.25
Packaging 3 200 0.20
Commissions 320 0.02
Distribution 480 0.03
Other 800 0.05
Total variable cost 24 000 1.50

Fixed costs: $ $
Salaries 960 0.060
Depreciation 320 0.200
Utilities 80 0.005
Taxes 32 0.002
Other 160 0.010
Total Fixed costs 1 552 0.097
Total costs 25 552 1,597
Wholesale selling price 32 000 2.00

PC an ice cream distributor offered to buy 2 million units at $1.55 per unit, provided
its own label can be attached to the product. PC has also agreed to pay the
transportation costs. There is no sales commission. As the manager of the sales
company would you accept this order or reject it?

Solution to Activity 8.4

The offer of $1.55 is well below the normal selling price and the total unit cost.
Accepting the order may be profitable. The company does have idle capacity, and the
order will not displace other units being produced to sell at the normal price. Many of

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 the units are not relevant; fixed costs will continue regardless of whether the order is
accepted or rejected.

All variable costs will be incurred except for distribution ($0.03) and commission
($0.02), producing a cost of $1.45 per unit. The net benefit is $0.10 ($1.55 - $1.45)
per unit.

Relevant cost analysis.

Accept Reject Differential benefit to Accept
Revenues $3 100 000 $- $3 100 000
Dairy ingredients (1 400 000 - (1 400 000)
Sugar (200 000) - (200 000)
Flavouring (300 000) - (300 000)
Direct labour (500 000) - (500 000)
Packaging (400 000) - (400 000)
Other (100 000) - (100 000)
Profit $ 200 000 $0 $ 200 000

Accepting the special order will increase profits by $200 000 ($0.10 × 2 000 000).

8.4.4 Decisions to sell or process further

Joint products have common processes and costs of production up to a split-off point.
At that point they become distinguishable. The point of separation is called split off
point. Joint products are usually sold at split off point. Sometimes it is more profitable
to process a joint product further, beyond the split off point, prior to selling it.
Determining to sell or process further is an important decision that a manager has to
make.

8.5 Product Mix Decisions

Many organisations have total discretion in choosing their product mix. Decisions
about product mix can have a significant impact on an organisation’s profitability.
Each mix represents an alternative that carries with it an associated profit level. A
manager should choose a mix that maximises profit levels. Fixed costs are not
relevant to decision-making since they would be the same for all possible mixes. A
manager needs to choose an alternative that maximises the total contribution margin.

Every firm faces limited resources and limited demand for each product. These
limitations are called constraints. A manager must choose the optimal mix given the
constraints found within the firm. The selection of the optimal mix can be
significantly affected (in terms of quantity and contribution margin that can be
earned) by the relationships of the constrained resources to the individual products.

8.5.1 One constrained resource

Example 8.4
A company produces two types of gears: X and Y with unit contribution margins of
$25 and $10, respectively. Each gear must be notched by a special machine. The firm
owns eight machines that together provide 40 000 hours of machine time per year.
Gear X requires 2 hours of machine time, and Gear Y requires o.5 hour of machine
time. Assuming no other constraints, what is the optimal mix of gears?

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 Solution 8.4
Since each unit of Gear X requires 2 hours of machine time, 20 000 units can be
produced per year (40 000 ÷ 2).

At $25 per unit, the company can earn a total contribution margin of $500 000 ($25 ×
20 000).

Gear Y requires 0.5 hours of machine time per unit; therefore, 80 000 (40 000 ÷ 0.5)
gears can be produced. At $10 per unit the total contribution margin is $800 000 ($10
× 80 000).

The contribution margin per unit of scarce resource is the deciding factor. The product
yielding the highest contribution margin should be selected.

Gear X = $25 ÷ 2 = $12.50 per machine hour

Gear Y = $10 ÷ 0.5 = $20 per machine hour

The optimum mix is 80 000 units of Gear Y and none for Gear X.

8.5.2 Multiple constrained resources

The presence of only one constrained resource is unrealistic. All organisations face
multiple constraints: limitations of raw materials, limitations of labour inputs, limited
demand for each product and so on. The solution of the product mix problem in the
presents of multiple constraints requires the use of linear programming which has
been covered in the previous units. Linear programming is a method that searches
among possible solutions until it finds the optimal solution.

Activity 8.5
JM makes and sells two products, the J and the M. The budgeted selling price of the J
is $60 and that of the M, $72. Variable costs associated with producing and selling the
J are $30 and, with the M, $60. Annual fixed production and selling costs of JM are
$3 369 600.

JM has two production/sales options. The J and the M can be sold either in the ratio
two Js to three Ms or in the ratio one J to two Ms.

Decide on the optimal mix of JM.

Solution to Activity 8.5

We can decide on the optimal mix by looking at the breakeven points. Determine
contribution per unit:
J M
$ per unit $ per unit
Selling price 60 72
Variable cost 30 60
Contribution 30 12

Mix 1
Contribution per 5 units sold = ($30 × 2) + $12 × 3) = $96

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 Breakeven point = $3 369 600 ÷ $96 = 35 100 sets of five units

Breakeven point: J M
In units (35 100 × 2) 70 200 (35 100 × 3) 105 300
In $ (70 200 × $60) $4 212 000 ($105 300 × $72) $7 581 600

Total breakeven point = $11 793 600

Mix 2
Contribution per 3 units sold = ($30 × 1) + ($12 × 2) = $54

Breakeven point = $3 369 600 ÷ $54 = 62 400 sets of three units.

Breakeven point: J M
In units (62 400 × 1) 62 400 (62 400 × 2) 124 800
In $ (62 400 × $60) $3 744 000 ($124 800 × $72) $8 985 600

Total breakeven point = $12 729 600

Mix 1 is preferable to Mix 2 because it results in a lower level of sales to break even
(because of the higher average contribution per unit sold). The average contribution
for mix 1 is $19.20 ($96 ÷ 5). In mix 2 it is $18 ($54 ÷ 3). Mix 1 contains a higher
proportion (40% as opposed to 33⅓%) of the more profitable product.

8.6 Pricing
Pricing is the determination of a selling price for the product or service produced. A
number of methodologies may be used.
1. Competitive pricing – setting a price by reference to the prices of competitive
products
2. Cost plus pricing – determination of price by adding a mark – up, which may
incorporate a desired return on investment, to a measure of the cost of the
product/service
3. Dual pricing – form of transfer pricing in which the two parties to a common
transaction use different prices.
4. Historical pricing – basing current prices on prior period prices, perhaps
uplifted by a factor such as inflation
5. Market based pricing – setting a price based on the value of the product in the
perception of the customer. Also known as perceived value pricing
6. Penetration pricing – setting a low selling price in order to gain market.
7. Predatory pricing – setting a low selling price in order to damage competitors.
May involve dumping, that is, selling a product in a foreign market at below
cost, or below the domestic market price (subject to, for example, adjustments
fro taxation differences, transportation costs, specification differences).
8. Price Skimming – setting a high price in order to maximise short-term
profitability, often on the introduction of a novel product.
9. Range pricing – the pricing of individual products such that their prices fit
logically within a range of connected products offered by one supplier, and
differentiated by a factor such as weight of pack or number of product
attributes offered.

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 10. Selective pricing – setting different prices for the same product or services in
different markets.

8.6.1 Cost-based pricing

Many firms base price on simple cost-plus rules (costs are estimated then a mark-up is
added in order to set the price). The following are the reason or the predominance of
this method.
a) Planning and use of scarce capital resources are easier.
b) Assessment of divisional performance is easier.
c) It emulates the practice of successful large companies.
d) Organisations fear government action against excessive profits.
e) There is a tradition of production rather than marketing in many countries
f) Cost-based pricing strategies based o internal data are easier to administer.
g) Over time, cost-based pricing produces stability of pricing production and
employment.

Full cost-plus pricing is a method of determining the sales price by calculating the full
cost of the product and adding a percentage mark-up for profit. The full cost may be a
fully absorbed production cost only, or it may include some absorbed administration,
selling and distribution overheads.

Example 8.5
Mark-up has begun to produce a new product, Product X, for which the following cost
estimates have been made.
Direct materials $27
Direct labour: 4hrs at $5 per hour $20
Variable production overheads: machining, ½hr at $6 per hour $ 3
$50
Production fixed overheads are budgeted at $300 000 per month and, because of the
shortage of available machining capacity, the company will be restricted to 10 000
hours of machine time per month. The absorption rate will be a direct labour rate,
however, and budgeted direct labour hours are $25 000 per month. It is estimated that
the company could obtain a minimum contribution of $10 per machine hour on
producing items other than product X.

The direct cost estimates are not certain as to material usage rates and direct labour
productivity, and it is recognised that the estimates of direct materials and direct
labour costs may be subject to an error of ± 15%. Machine time estimates are
similarly subject to an error of ± 10%.

The company wishes to make a profit of 20% on full production cost from product X.

Required:
Ascertain the full cost-plus based price.

Solution 8.5
Even for a relatively simple cost-plus pricing estimate, some problems can arise, and
certain assumptions must be made and stated. In this example we can identify two
problems.
 Should the opportunity cost of machine time be included in cost or not?

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  What allowance, if any, should be made for the possible errors in cost
estimates?

Different assumptions could be made.

a) Exclude machine time opportunity costs: ignore possible costing errors.
$
Direct materials 27.00
Direct labour (4 hours) 20.00
Variable production overheads 3.00
Fixed production overheads ($300 000 ÷ 25 000
= $12 per direct labour hour) 48.00
Full production cost 98.00
Profit mark-up (20%) 19.60
Selling price per unit of product X 117.60

b) Include time opportunity costs: ignore possible costing errors.

$
Full production cost 98.00
Opportunity cost of machine time: contribution forgone
(½ hr × $10) 5.00
Adjusted Full cost 103.00
Profit mark-up (20%) 20.60
Selling price per unit of product X 123.60

c) Exclude machine time opportunity costs but make full allowance for possible
under-estimates of cost.

$ $
Direct Materials 27,00
Direct labour 20,00
47,00
Possible error (15%) 7,05
54,05
Variable production overheads 3,00
Possible error (10%) 0,30
3,30
Fixed production overheads (4hrs × $12) 48,00
Possible error (Labour time) (15%) 7,20
55,20
Potential full production cost 112,55
Profit mark-up (20%) 22,51
Selling price per unit of product X 135,06

d) Include machine time opportunity costs and make a full allowance for possible
under-estimates of cost.

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 $
Potential full production cost 112,55
Opportunity cost of machine time:
Potential contribution forgone (1/2 hr × $10 × 110%) 5,50
Adjusted potential full cost 118,05
Profit mark-up (20%) 23,61
Selling price per unit of product X 141,66

Using different assumptions, we could arrive at any of four different unit

prices in the range $117,60 to $141,66.

8.6.2 Target costing and pricing

Target costing is a method of determining the cost of a product or service based on the
price (target price) that customers are wiling to pay. This is also referred to as price-
driven costing. Most prices are set as the sum of the cost and the desired profit. Peter
Drucker (1993, p.A22) writes, “the only sound way to price is to start out with what
the market is willing to pay”.

Target costing is a method of working backwards from price to find cost. The
company should design a product such that cost and profit can be covered by the
price.

Target costing involves much more up-front work than cost-based pricing. Additional
work must be done if the cost-based price turns out to be higher than what customers
will accept. Target costing can be used most effectively in the design and
development stage of the product life cycle. At that point the features of the product
as well as its costs are still fairly easy to adjust.

8.6.3 Legal aspects of pricing

Cost is an important justification for price. Competition is good and should be
encouraged but collusions by companies to set prices and the deliberate attempt to
drive competitors out of business is prohibited.

Predatory pricing
The practice of setting prices below cost for the purpose of injuring competitors and
eliminating competitors is called predatory pricing. Setting price below cost is not
necessarily predatory pricing. Companies may have loss leaders or week specials.
Laws on predatory pricing create a patchwork for legal definition, some states require
retailers to sell products at a price at least 6,75% above cost and some orbits the sell
of products below cost for the purpose of injuring competitors and destroying
competition.

Price discrimination
Price discrimination refers to the charging of different prices to different customers
for essentially the same product. The US Patman Act 1963states that it is unlawful to
practice price discrimination, to create monopoly, or to injure, destroy or prevent
competition, except if the competitive situation demand it and if costs can justify the
lower price.

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Activity 8.6
Explain the impact of cost on pricing decision.

8.7 Summary
The tactical decision-making model described in this unit consists of six steps. In
using cost analysis to choose among alternatives, managers should take steps to
ensure that all important feasible alternatives are being considered. The activity
resource usage model breaks costs into two groups, flexible resources and committed
resources. In dealing with a resource constraint it is important to phrase the product
contribution margin in terms of contribution margin per unit of constrained resources.
In the unit we explained and gave examples to illustrate make or buy decisions, keep
or drop decisions, special order decisions and sell or process further decisions. The
impact of cost on pricing decisions was explained in full. Costs are important input
into the pricing decision. Cost-based pricing uses a mark-up based on a subset of
costs. Target costing works backwards from a price acceptable to consumers, to
finding the cost necessary to manufacture the product. In the next unit we will look at
capital investment decisions.

138
References
Avis, J., Burke, L. and Wilks, C. (2009). Management Accounting-Decision
Management. London: CIMA Publishing, 2008.
CIMA (2007). Managerial Paper P2: Management Accounting-Decision
Management. London: BPP learning Media.
Drucker, P. (1993). The Five Deadly Business Sins. The Wall Street Journal, p.A22.
Drury, C. (2000). Management and Cost Accounting. New York: International
Thomson Business Press.
Hansen, D.R. and Mowen, M.M. (2007). Management Accounting (8th Edition).
Dubuque: Lanchina Publishing Services.
Horngren, C., Bhimani, A., Foster, G. and Datar, S. (2002). Management and Cost
Accounting. London: FT/Prentice Hall.
Lucey, T. (1996). Management Accounting (4th Edition). London: Letts Educational
Aldine Place.

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 Unit 9

Capital Investment

9.0 Introduction
Capital investment decisions are long-run decisions where consumption and
investment alternatives are balanced over time in the hope that investment now will
generate extra returns in the future. There are many similarities between the tactical
decision we covered in the previous unit and capital investment decisions to be
covered in this unit, for example, the choice between alternatives, the need to consider
future costs and revenues and the importance of incremental changes in costs and
revenues. There is the additional requirement for investment decisions that, because
of the time scale involved, the time value of the money invested must be considered
(Discounting and non-discounting models). The time scale also makes the
consideration of uncertainty and inflation of even greater importance than when
considering short term decisions covered in Unit 8. Capital investment decision
making is invariably a top management exercise. This is because of the scale and long
term nature of the consequences of such decisions. The management accountant’s role
is to gather the essential data from various sources, consider the financial and taxation
implication, analyse data using one or more of the appraisal techniques and present
the decision maker with the results, so that informed and better decisions may be
taken.

In this unit we will cover capital investment decisions, mutually exclusive projects
and Discounting models in detail.

9.1 Unit Objectives

By the end of this unit, you should be able to:
 explain a capital investment decision
 distinguish between independent and mutually exclusive capital investment
decisions
 differentiate between non-discounting models and discounting models
 compute the payback period and accounting rate of return for a proposed
investment and explain their roles in capital investment decisions
 conduct net present value analysis for capital investment decisions involving
independent projects

9.2 Capital Investment Decisions

Capital investment decisions are concerned with the process of planning, setting goals
and priorities, arranging financing, and using certain criteria to select long-term
assets. Capital investment decisions place large amounts of resources at risk for long
periods of time and affect the future development of the company, they are among the
most important decisions managers make. Poor capital investment decisions can be

140
 disastrous and making the right capital investment decisions is essential for long-term
survival.

Capital investment decisions are concerned with investments in long-term assets. A

sound capital investment will earn back its original capital outlay over its life and
provide reasonable return on the original investment. The manager should decide
whether or not a capital investment will earn back its original outlay and provide a
reasonable return. A reasonable return means a new investment should cover the
opportunity cost of the funds invested.

The process of making capital investment decisions is often referred to as capital

budgeting. Two types of capital budgeting projects will be considered: independent
projects and mutually exclusive projects.

9.2.1 Independent project

Independent projects are projects that if accepted or rejected, do not affect the cash
flows of other projects.

9.2.2 Mutually exclusive projects

Mutually exclusive projects are those that, if accepted, preclude the acceptance of all
other competing projects. New investments replacing existing investments must prove
to be economically superior.

To make a capital investment decision, a manager must estimate the quantity and
timing of cash flows, assess the risk of the investment, and consider the impact of the
project on the firm’s profits. In estimating the cash flows, projections must be made
years into the future. Managers must set goals and priorities for capital investments.
They also must identify some basic criteria for the acceptance or rejection of proposed
investments. We will study four basic methods to guide managers in accepting or
rejecting potential investments. The methods include both non-discounting and
discounting decision approaches. The discounting methods are applied to investment
decisions involving both independent and mutually exclusive projects.

9.3 Steps in the Capital Budgeting Process

Horngren et al. (2002) have identified the following steps in the capital budgeting
process:

i. Identification of investment projects which are necessary to achieve

organisational objectives, for example, to increase revenue or to cut operating
cost.
ii. Search for potential projects which meet the organisation’s minimum criteria
for investment, for example, a 20% return on investment.
iii. Information acquisition to consider the expected costs and benefits of projects
identified in step (ii) taking into account both financial and non financial
factors.
iv. Selection of projects whose expected benefits exceed expected costs,
particularly in financial terms. However, it should be noted that a project

141
 which does not meet minimum requirements can be undertaken if it is
considered to be strategic.
v. Financing of approved project(s) from internal and/or outside sources. Note
here the separation of the investing decision (Steps 1 – 4) and the financing
decision which is only effected after a thorough consideration of the merits of
proposed projects.
vi. Implementation and control of projects to ensure that necessary actions are
taken and the projects are completed within time and cost budgets.

Activity 9.1
Explain what a capital investment decision is and distinguish between independent
and mutually exclusive capital investment decisions.

9.4 Non-discounting Models

The basic capital investment decision models can be classified into two major
categories: non-discounting models and discounting models. Non-discounting models
ignore the time value of money, whereas discounting models explicitly consider it.

9.4.1 The payback method

The payback method looks at how long it takes for a project’s net cash inflows to
equal the initial investment. Payback period is the time required for a firm to recover
its original investment.

When deciding between two or more competing projects, the usual decision is to
accept the one with the shortest payback. A project should not be evaluated on the
basis of payback alone. Payback should be a first screening process, and if a project
gets through the payback test, it ought then to be evaluated with a more sophisticated
project appraisal technique.

When payback is calculated, we take profits before depreciation, because we are

trying to estimate the cash returns from a project and profit before depreciation is
likely to be a rough approximation of cash flows.

Activity 9.2

An asset costing $120 000 is to be depreciated over ten years to a net residual
value. Profits after depreciation for the first five years are as follows.

Year $
1 12 000
2 17 000
3 28 000
4 37 000
5 8 000
How long is the payback to the nearest month?

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Solution to Activity 9.2

Profit after Profit before Cumulative

Year Depreciation Depreciation Depreciation profit
$'000 $'000 $'000 $'000
1 12 12 24 24
2 17 12 29 53
3 28 12 40 93
4 37 12 49 142
5 8 12 20

Payback period = 3 year + {(120-93) ÷ (142-93)} × 12 months

= 3 years 7 months

Disadvantages of the payback method

a) It ignores the timing of cash flows within the payback period, the cash flows
after the end of payback period and therefore, the total project return.
b) It ignores the time value of money.
c) The project is able to distinguish between projects with the same payback
period.
d) The choice of any cut off payback period by an organisation is arbitrary.
e) It may lead to excessive investment in short-term projects.
f) It takes account of the risk of the timing of cash flows but does not take
account of the variability of those cash flows.

Advantages of the payback method

a) Long payback means capital is tied up
b) Focus on early payback can enhance liquidity
c) Investment risk is increased if payback is longer
d) Shorter-term forecasts are likely to be more reliable
e) The calculation is quick and simple
f) Payback is an easily understood concept.

9.4.2 The accounting rate of return method (ARR)

The accounting rate of return (ARR) method (also known as the return on capital
employed (ROCE) method or the return on investment (ROI) method) of appraising a
project is to estimate the accounting rate of return that the project should yield. If it
exceeds a target rate of return, the project will be undertaken. The ARR measures the
return on a project in terms of income, as opposed to using a project’s cash flow.

Average annual profit from investment

Definition is × 100
Average investment

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Example 9.1
A company has a target accounting rate of return of 20%, and is now considering the
following project.
Capital cost of asset $80 000
Estimated life 4 years
Estimated profit before depreciation
Year 1 $20 000
Year 2 $25 000
Year 3 $35 000
Year 4 $25 000

The capital assets would be depreciated by 25% of its cost each year, and will have no
residual value.

Required:
Assess whether the project should be undertaken.

Solution 9.1
Profit after Mid-year net ARR in the
Year depreciation Book value year
$ $ %
1 0 70,000 0
2 5,000 50,000 10
3 15,000 30,000 50
4 5,000 10,000 50

The ARR is low in the early stages of the project, partly because of low profits in
Year 1 but mainly because the net book value of the assets is much higher early on in
its life. So the project does not achieve the target ARR of 20% in its first two years,
but exceed it in years 3 and 4.

When the ARR from a project varies from year to year, it makes sense to take an
overall or average view of the project’s return. In this case, we should look at the
return as a whole over the four year period.

Total profit before depreciation over four years $105 000

Total profit after depreciation over four years $ 25 000
Average annual profit after depreciation $ 6 250
Original cost of investment $ 80 000
Average net book value over the four year period ((80 000 + 0)/2 $ 40 000

The project would not be undertaken because its ARR is 6 250/40 000 = 15.625% and
so it would fail to yield the target return of 20%.

Disadvantages of ARR method

a) It does not take account of the timing of the profits from a project.
b) It is based on accounting profits which are subject to a number of different
accounting treatments.
c) It is a relative measure rather than an absolute measure and hence takes no
account of the size of the investment.

144
 d) It takes no account of the length of the project
e) Like the payback method, it ignores the time value of money

Advantages to the ARR method

a) It s quick and simple to calculate
b) It involves a familiar concept of a percentage return
c) Accounting profits can be easily calculated from financial statement
d) It looks at the entire project life
e) It is easily understood because it employs profits in calculation

9.5 Discounting Models

Discounting models explicitly consider the time value of money and, therefore,
incorporates the concept of discounting cash inflows and outflows. Two discounting
models will be considered: Net present vale (NPV) and internal rate of return (IRR).

9.5.1 The net present value method

Net present value (NPV) is the difference between the sum of the projected
discounted cash inflows and outflows attributable to a capital investment or other
long-term projects.

Net present value (NPV) measures the profitability of an investment. If the NPV is
positive, it measures the increase in wealth. To use the NPV method, a required rate
of return must be defined. The required rate of return is the minimum acceptable rate
of return. It is also referred to as the discount rate, the hurdle rate, and the cost of
capital.

NPV is calculated as the PV of cash inflows minus the PV of cash outflows.

a) If the NPV is positive, it means that the cash inflows from a project will yield
a return in excess of the cost of capital, and so the project should be
undertaken if the cost of capital is the organisation’s target rate of return.
b) If the NPV is negative, it means that the cash inflows from a project will yield
a return below the cost of capital, and so the project should not be undertaken
if the cost of capital is the organisation’s target rate of return.
c) If the NPV is exactly zero, the cash inflows from a project will yield a return
which is exactly the same as the cost of capital, and so if the cost of capital is
the organisation’s target rate of return, the project will be only just worth
undertaking.

NPV =
=
=
Where:
= the present value of a project’s cost (usually the initial outlay)
= the cash inflow to be received in period t, with t = 1….n.
n = the useful life of the project
= the required rate of return
t = the time period
= the present value of the project’s future cash inflows
= , the discount factor

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Example 9.2
Mcaine has a cost of capital of 15% and is considering a capital investment project,
where the estimated cash flows are as follows:
Year Cash flow
$
0 (100 000)
1 60 000
2 80 000
3 40 000
4 30 000

Required:
Calculate the NPV of the project, and assess whether it should be undertaken.

Solution 9.2
Year Cash flow Discount factor Present value
$ 15% $
0 -100,000 1.000 -100,000
1 60,000 1/(1.15) =0.870 52,200
2 80,000 1/(1.15)² =0.756 60,480
3 40,000 1/(1.15)³ =0.658 26,320
4 30,000 1/(1.15)^4 =0.572 17,160
NPV = 56,160

The discounting factor for any cash flow ‘now’ is always = 1, regardless of what the
cost of capital is.

The PV of cash inflows exceed the PV of cash outflows by $56 160, which means that
the project will earn a DCF yield in excess of 15%. It should therefore be undertaken.

Discounted tables for the PV of $1

The discounting factor that we use in discounting is 1/ ,= . Instead
of calculating this factor every time we can use tables. Discounting tables for the
present value of $1 and n are shown at the end of the unit.

9.5.2 Internal rate of return (IRR)

The internal rate of return is defined as the interest rate that sets the present value of a
project’s cash inflows equal to the present value of the project’s cost. It is the interest
rate that sets the project’s NPV at zero. The IRR can be said to be the annual
percentage return achieved by a project, at which the sum of the discounted cash
inflows over the life of the project is equal to the sum of the discounted cash outflow.

The IRR method of project appraisal is to accept projects which have an IRR (the rate
at which the NPV is Zero) that exceeds a target rate of return. If the IRR is greater
than the required rate, the project is deemed acceptable; if the IRR is equal to the
required rate of return, acceptance or rejection of the investment is equal; if the IRR is
less than the required rate of return, the project is rejected.

An estimate of the IRR is made using either a graph or using a hit-and-miss technique
known as the interpolation method.

146
 Graphical approach
To estimate the IRR of a project find the project’s NPV at a number of costs of capital
and sketch graph of NPV against discount rate. You can then use the sketch to
estimate the discount rate at which the NPV is equal to zero (the point where the
curve cuts the axis)

Example 9.3
A project might have the following NPVs at the following discount rates.

Discount rate NPV

% $
5 5 300
10 2 900
15 (1 700)
20 (3 200)
This could be sketched on the graph as follows.

NPV $'000
6000
5000
4000
3000
2000
1000
0
-1000 0 5 10 15 20 25 Discount
-2000 Rate
-3000
-4000

The IRR can be estimated as 14%. The NPV should then be recalculated using this
interest rate. The resulting NPV should be equal to or very near, zero. If it is not,
additional NPVs at different discount rates should be calculated, the graph re-sketched
and a more accurate IRR determined.

Interpolation method
The closer our NPVs are to zero, the closer our estimate will be to the true IRR.

The IRR interpolation formula to apply is:

IRR =

Where:
A is the (lower) rate of return with a positive NPV
B is the (higher) rate of return with a negative NPV
P is the amount of the positive NPV
N is the absolute value

147
Example 9.4
A company is trying to decide whether to buy a machine for $80 000 which will save
costs of $20 000 per annum for 5 years and which will have a resale value of $10 000
at the end of year 5.

Required:
It is the company’s policy to undertake projects only if they are expected to yield a
DCF return of 10% or more, ascertain whether this project should be undertaken.

Solution 9.4
The first step is to calculate two net present values, both as close as possible to zero,
using rates for the cost of capital which are whole numbers. One NPV should be
negative and the other negative.

Closing rates for the cost of capital which will give an NPV close to zero (that is, rates
which are close to the actual rate of return) is a hit-and-miss or trial and error
exercise, and several attempts may be needed to find satisfactory rates. As a rough
guide, try starting at a return figure which is about two thirds or three quarters of the
ARR.

Annual depreciation would be $(80 000 – 10 000)/5 = $14 000.

The ARR would be (20 000 – 14 000)/( of (80 000 + 10 000)) = 6 000/45 000
= 13.3%
Two thirds of this is 8.9% and so we can start by trying 9%.

Trial at 9% Year Cashflow PV factor PV of cash flow

$ 9% $
0 -80,000 1,000 -80,000
1-5 20,000 3,890 77,800
5 10,000 0,650 6,500
NPV 4,300

This is fairly close to zero. It is also positive, which means that the real rate of return
is more than 9%. We can use 9% as one of our two NPVs close to zero, although for
greater accuracy, we should try 10% and even 11% to find an NPV close to zero if we
can. As a guess it might be worthy trying 12% next, then see what the NPV is.

Trial at 12% Year Cashflow PV factor PV of cash flow

$ 12% $
0 -80,000 1,000 -80,000
1-5 20,000 3.605 72,100
5 10,000 0.567 5,670
NPV -2,230

This is fairly close to zero and negative. The real rate of return is therefore greater
than 9% (positive NPV of $4 300) but less than 12% (negative NPV of $2 230).

Note: If the first NPV is positive, choose a higher rate for the next calculation to get a
negative NPV. If the first NPV is negative, choose a lower rate for the next
calculation.

148
 So IRR = = 10.98%

If it is the company policy to undertake investments which are expected to yield 10%
or more, this project would be undertaken.

9.5.3 NPV and IRR compared

When compared with the NPV method, the IRR method has a number of
disadvantages.
 It ignores the relative size of the investment
 There are problems with its use when a project has non-conventional cash
flows or when deciding between mutually exclusive projects.
 Discount rates which differ over the life of a project cannot be incorporated
into IRR calculations.

Advantages of IRR method

 The information it provides is more easily understood by managers and non
financial managers.
 A discount rate does not have to be specified before the IRR can be calculated.

Disadvantages of IRR method

 If managers were given information about both ROCE (ROI) and IRR. It
might be easy to get their relative meaning and significance mixed up.
 It ignores the relative size of the investment
 There are problems with its use when a project has non-conventional cash
flows or when deciding between mutually exclusive projects.
 Discount rates which differ over the life of a project cannot be incorporated
into IRR calculations.

Activity 9.3
Kenny Day, manager of Medical Laboratory, is investigating the possibility of
acquiring some new test equipment. To acquire the equipment requires an initial
outlay of $300 000. To raise the capital, Kenny will sell stock valued at $200 000
(the stock pays dividends of $24 000 per year) and borrow $100 000. The loan for
$100 000 would carry an interest rate of 6%. Kenny figures that his weighted cost
of capital is 10% ([⅔ × 0.12] + [⅓ × 0.06]).This weighted cost of capital is the
discount rate that will be used for capital investment decisions. Kenny estimates
that the new test equipment will produce a cash inflow of $50 000 per year. Kenny
expects the equipment to last for 20 years.

Required:
1. Compute the payback period.
2. Assuming that depreciation is $14 000 per year, compute the accounting rate
of return (on total investment).
3. Compute the NPV of the test equipment.
4. Compute the IRR of the test equipment
5. Should Kenny buy the equipment

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 Solution to Activity 9.3
1. The payback period is $300 000/$50 000 = 6 years
2. The ARR is ($50 000-$14 000)/$300 000 = 12%
3. From the present value tables, the discount factor of an annuity with I at 10%
and n at 20 years is 8.514. Thus, the NPV is (8.514 × $50 000) - $300 000 =
$125 700
4. The discount factor associated with the IRR is 6.00 ($300 000/$50 000). From
the NPV tables, the IRR is between 14 and 16 percent (using the row
corresponding to period 20).
5. Since the NPV is positive and the IRR is greater than Kenny’s cost of capital,
the test equipment is a sound investment. This, of course, assumes that the
cash flow projections are accurate.

9.6 Mutually Exclusive Projects

Many capital investment decisions deal with mutually exclusive projects. NPV model
is generally preferred to the IRR model when choosing among mutually exclusive
alternatives.

NPV and IRR both yield the same decision for independent projects. If the NPV is
greater than zero, then the IRR is also greater than the required rate of return; both
models signal the correct decision. For competing projects the two methods can
produce different results. Intuitively, for mutually exclusive projects, the projects with
the highest NPV or the highest IRR should be chosen. The method that consistently
reveals the wealth-maximising projects is preferred for mutually exclusive projects.

NPV differs from IRR in two major ways:

1. NPV assumes that each cash inflow received is reinvested at the required rate
of return, whereas the IRR method assumes that each cash inflow is reinvested
at the computed IRR. Reinvesting at the required rate of return is more
realistic and produce more reliable results when comparing mutually exclusive
projects.
2. The NPV method measures profitability in absolute terms, whereas the IRR
method measures it in relative terms.

There are three steps in selecting the best project from several competing projects:
1. Assessing the cash flow pattern for each project
2. Computing the NPV for each project, and
3. Identifying the project with the greatest NPV.

Example 9.5
A company has committed to improve its environmental performance. Two different
process designs are being considered that prevent the production of contaminants,
Design A and Design B. Design B is more elaborate than design A and will require a
heavier investment and greater annual operating cost and will generate greater annual
benefits. The following information is provided.

150
 Design A Design B
Annual revenues $179 460 $239 280
Annual operating costs $119 460 $169 280
Equipment (purchase before year 1) $180 000 $210 000
Project life 5 years 5 years

All cash flows are expressed on an after-tax basis. Assume the cost of capital for the
company is 12%. Which design should the firm choose?

Solution 9.5
Design A requires a initial cash outlay of $180 000 and has an net annual cash inflow
of $60 000 (179 460 – 119 460). Design B, with an initial cash outlay of $210 000,
has a net annual cash inflow of $70,000 (239.280 – 169 280).

Cash flow pattern and NPV analysis.

CASH-FLOW PATTERN
Year Design A Design B
0 ($180,000) ($210,000)
1 60,000 70,000
2 60,000 70,000
3 60,000 70,000
4 60,000 70,000
5 60,000 70,000

Design A: NPV Analysis

Year Cash flow Discount Factora Present value
0 $(180 000) 1.000 $(180 000)
1-5 60 000 3.605 216 300
Net present value $ 36 300

IRR Analysis

Discount factor =

= 3.000
From the tables = 3.000 for five years implies that IRR = 20%

Design B: NPV Analysis

Year Cash flow Discount Factora Present value
0 $(210 000) 1.000 $(210 000)
1-5 70 000 3.605 252 350
Net present value $ 42 350

151
 IRR Analysis

Discount factor =

= 3.000
From the tables = 3.000 for five years implies that IRR = 20%

Based on NPV analysis design B is more profitable; it has the larger NPV. The
company should select design B over design A.

Designs A and B have identical IRR. Even thought IRR of the two projects is 20%,
the firm should not consider the two designs equally desirable. Design B should be
chosen.

Example 9.6
The IRR and NPV methods give conflicting rankings as to which project should be
given priority. A company with a cost of capital of 16% is considering two mutually
exclusive options, option A and option B. The cash flows for each are as follows:

Year Option A Option B

$ $
0 Capital outlay (10 200) (35 250)
1 Net cash inflow 6 000 18 000
2 Net cash inflow 5 000 15 000
3 Net cash inflow 3 000 15 000

The NPV of each project is calculated below.

Option A Option B
Year Discount factor Cash flow Present value Cash flow Present value
$ $ $ $
0 1.000 -10,200 (10,200) (35,250) (35,250)
1 0.862 6,000 5,172 18,000 15,516
2 0.743 5,000 3,715 15,000 11,145
3 0.641 3,000 1,923 15,000 9,615
NPV = 610 NPV = 1,026

The DCF yield of Option A is 20%, while the yield of Option B is only 18%
(Working not shown).

On a comparison of NPVs, option B would be preferred, but on a comparison of

IRRs, option A would be preferred.

The preference should go to option B. This is because the difference in the cash flows
between the two options, when discounted at the cost of capital of 16%, shows that

152
 the present value of the incremental benefits from option B compared with option A
exceed the incremental costs. This can be re-stated in the following ways.
a) The NPV of differential cash flows (option B cash flows minus option A cash
flows) is positive, and so it is worth spending extra capital to get the extra
benefits.
b) The IRR of the differential cash flows exceeds the cost of capital 16%, and so
it is worth spending extra capital to get the extra benefits.

Option A Option B Present value

Year Cash flow Cash flow Difference Discount factor of difference
$ $ $ 16% $
0 (10,200) (35,250) (25,050) 1.000 (25,050)
1 6,000 18,000 12,000 0.862 10,344
2 5,000 15,000 10,000 0.743 7,430
3 3,000 15,000 12,000 0.641 7,692
NPV = 416

The NPV of the difference is also the difference between the NPV of option A ($610)
and the NPV of option B ($1 026).

The IRR of the differential cash flows is a little over 18%.

The $416 would be lost if project A was to be accepted.

Mutually exclusive projects do not have to be considered over equal time periods
For example, suppose an organisation has two investment options, one lasting two
years and one lasting four years. The two options can be compared and the one with
the highest NPV chosen. If, however, the investment is an asset which is required for
four years, the organisation will have to reinvest if it chooses the two year option. In
such circumstances the investment option should be compared over a similar period of
time.

9.7 Reinvestment Assumption

An assumption underlying the NPV method is that any net cash inflows generated
during the life of the project will be reinvested elsewhere at a cost of capital (the
discount rate). The IRR method assumes these cash flows can be reinvested elsewhere
to earn a return equal to the IRR of the original project. In example 9.6, the NPV
method assumes that the cash inflows of Option A will be reinvested at the cost of
capital of 16% whereas the IRR method assumes they will be reinvested at 20%. If the
IRR is considerably higher than cost of capital this is an unlikely assumption. In,
theory a firm will have accepted all projects which provide a return in excess of the
cost of capital and any other funds which become available can only be reinvested at
the cost of capital. If the assumption is not valid the IRR method overestimates the
real return.

153
9.8 Modified Internal Rate of Return (MIRR)
The MIRR overcomes the problem of the reinvestment assumption and the fact that
changes in the cost of capital over the life of the project cannot be incorporated in the
IRR method.

Consider a project requiring an initial investment of $8 000, with cash inflows of

$5 000 in years 1 and 2 and cash inflows of $900 in years 3 and 4. The cost of capital
is 10%.

The table below shows the values of the inflows if they were immediately reinvested
at 10%. For example, the $5 000 received at the end of year 1 could be reinvested for
three years at 10% pa multiply by 1.1 × 1.1 ×1.1 = 1.331)

Amount when
Year Cash flow Interest rate multiplier Reinvested
$ $ $
1 5000 1.331 6,655
2 5000 1.210 6,050
3 900 1.100 990
4 900 1.000 900
14,595

The total cash outflows in year 0 ($8 000) is compared with the possible cash inflows
at year 4, and the resulting figure of $8 000/14,595 = 0.548 is the discount factor in
year 4. By looking along the year 4 row in present value tables you will see that this
gives a return of about 16%. This means that the $14 595 received in year 4 is
equivalent to $8 000 if the discount rate is 16%.

The MIRR is a fairly recent development.

9.9 Discounted Payback

Payback can be combined with DCF and a discounted payback period calculated. The
discounted payback period (DPP) is the time it will take before a project’s cumulative
NPV turns from being negative to being positive. A company can set a target DPP,
and choose not to undertake any projects with a DPP in excess of a certain number of
years say 5years.

Activity 9.4
If we have a cost of capital of 10% and a project with initial investment of
$100 000, with cash flows over 5 years, as follows: year 1 $30 000, year 2
$50 000, year 3 $40 000, year 4 $30 000 and year 5 $20 000. Calculate the
discounted payback period.

154
 Solution to Activity 9.4

Cumulative
Year Cash flow Discount factor Present value Net
$ 10% $ Present Value
0 (100,000) 1.000 (100,000) (100,000)
1 30,000 0.909 27,270 (72,730)
2 50,000 0.826 41,300 (31,430)
3 40,000 0.751 30,040 (1,390)
4 30,000 0.683 20,490 19,100
5 20,000 0.621 12,420 31,520
NPV = 31,520

The DPP is early in year 4.

9.10 Summary
In this unit we explained what capital investment decisions are, and discussed the
capital budgeting as the process of making capital investment decisions. Two types of
capital budgeting projects were considered: independent projects and mutually
exclusive projects. We unit discussed non-discounting models and discounting models
of investment decision making. There are two non-discounting models, the payback
period and the ARR. The payback period is the time required for a firm to recover its
initial investment. The ARR is computed by dividing the average income expected
from an investment by either the original or average investment. Discounting models
explicitly consider the time value of money and, therefore, incorporates the concept of
discounting cash inflows and outflows. Two discounting models were considered: Net
present value (NPV) and internal rate of return (IRR). We closed the unit by making a
detailed analysis of mutually exclusive projects. Mutually exclusive projects are those
that, if accepted, preclude the acceptance of all other competing projects. New
investments replacing existing investments must prove to be economically superior.
In evaluating mutually exclusive or competing projects, managers have a choice of
using NPV or IRR. When choosing among competing projects, the NPV model
correctly identifies the best investment alternative. IRR, at times, may choose an
inferior project. Since NPV provides the correct signal, it should be used.

155
References

Avis, J., Burke, L. and Wilks, C. (2009). Management Accounting-Decision

Management. London: CIMA Publishing, 2008.
CIMA (2007). Managerial Paper P2: Management Accounting-Decision
Management. London: BPP learning Media.
Drucker, P. (1993). The Five Deadly Business Sins. The Wall Street Journal, p.A22.
Drury, C. (2000). Management and Cost Accounting. New York: International
Thomson Business Press.
Hansen, D.R. and Mowen, M.M. (2007). Management Accounting (8th Edition).
Dubuque: Lanchina Publishing Services.
Horngren, C., Bhimani, A., Foster, G. and Datar, S. (2002). Management and Cost
Accounting. London: FT/Prentice Hall.
Lucey, T. (1996). Management Accounting (4th Edition). London: Letts Educational
Aldine Place.

156
Present Value and Future Value Tables
Table A-1 Future Value Interest Factors for One Dollar Compounded at k Percent for n Periods: FVIFk,n= (1 + k)n
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 20% 24% 25% 30%
1 1.01 1.02 1.03 1.04 1.05 1.06 1.07 1.08 1.09 1.1 1.11 1.12 1.13 1.14 1.15 1.16 1.2 1.24 1.25 1.3
2 1.0201 1.0404 1.0609 1.0816 1.1025 1.1236 1.1449 1.1664 1.1881 1.21 1.2321 1.2544 1.2769 1.2996 1.3225 1.3456 1.44 1.5376 1.5625 1.69
3 1.0303 1.0612 1.0927 1.1249 1.1576 1.191 1.225 1.2597 1.295 1.331 1.3676 1.4049 1.4429 1.4815 1.5209 1.5609 1.728 1.9066 1.9531 2.197
4 1.0406 1.0824 1.1255 1.1699 1.2155 1.2625 1.3108 1.3605 1.4116 1.4641 1.5181 1.5735 1.6305 1.689 1.749 1.8106 2.0736 2.3642 2.4414 2.8561
5 1.051 1.1041 1.1593 1.2167 1.2763 1.3382 1.4026 1.4693 1.5386 1.6105 1.6851 1.7623 1.8424 1.9254 2.0114 2.1003 2.4883 2.9316 3.0518 3.7129
6 1.0615 1.1262 1.1941 1.2653 1.3401 1.4185 1.5007 1.5869 1.6771 1.7716 1.8704 1.9738 2.082 2.195 2.3131 2.4364 2.986 3.6352 3.8147 4.8268
7 1.0721 1.1487 1.2299 1.3159 1.4071 1.5036 1.6058 1.7138 1.828 1.9487 2.0762 2.2107 2.3526 2.5023 2.66 2.8262 3.5832 4.5077 4.7684 6.2749
8 1.0829 1.1717 1.2668 1.3686 1.4775 1.5938 1.7182 1.8509 1.9926 2.1436 2.3045 2.476 2.6584 2.8526 3.059 3.2784 4.2998 5.5895 5.9605 8.1573
9 1.0937 1.1951 1.3048 1.4233 1.5513 1.6895 1.8385 1.999 2.1719 2.3579 2.558 2.7731 3.004 3.2519 3.5179 3.803 5.1598 6.931 7.4506 10.604
10 1.1046 1.219 1.3439 1.4802 1.6289 1.7908 1.9672 2.1589 2.3674 2.5937 2.8394 3.1058 3.3946 3.7072 4.0456 4.4114 6.1917 8.5944 9.3132 13.786
11 1.1157 1.2434 1.3842 1.5395 1.7103 1.8983 2.1049 2.3316 2.5804 2.8531 3.1518 3.4785 3.8359 4.2262 4.6524 5.1173 7.4301 10.657 11.642 17.922
12 1.1268 1.2682 1.4258 1.601 1.7959 2.0122 2.2522 2.5182 2.8127 3.1384 3.4985 3.896 4.3345 4.8179 5.3503 5.936 8.9161 13.215 14.552 23.298
13 1.1381 1.2936 1.4685 1.6651 1.8856 2.1329 2.4098 2.7196 3.0658 3.4523 3.8833 4.3635 4.898 5.4924 6.1528 6.8858 10.699 16.386 18.19 30.288
14 1.1495 1.3195 1.5126 1.7317 1.9799 2.2609 2.5785 2.9372 3.3417 3.7975 4.3104 4.8871 5.5348 6.2613 7.0757 7.9875 12.839 20.319 22.737 39.374
15 1.161 1.3459 1.558 1.8009 2.0789 2.3966 2.759 3.1722 3.6425 4.1772 4.7846 5.4736 6.2543 7.1379 8.1371 9.2655 15.407 25.196 28.422 51.186
16 1.1726 1.3728 1.6047 1.873 2.1829 2.5404 2.9522 3.4259 3.9703 4.595 5.3109 6.1304 7.0673 8.1372 9.3576 10.748 18.488 31.243 35.527 66.542
17 1.1843 1.4002 1.6528 1.9479 2.292 2.6928 3.1588 3.7 4.3276 5.0545 5.8951 6.866 7.9861 9.2765 10.761 12.468 22.186 38.741 44.409 86.504
18 1.1961 1.4282 1.7024 2.0258 2.4066 2.8543 3.3799 3.996 4.7171 5.5599 6.5436 7.69 9.0243 10.575 12.375 14.463 26.623 48.039 55.511 112.46
19 1.2081 1.4568 1.7535 2.1068 2.527 3.0256 3.6165 4.3157 5.1417 6.1159 7.2633 8.6128 10.197 12.056 14.232 16.777 31.948 59.568 69.389 146.19
20 1.2202 1.4859 1.8061 2.1911 2.6533 3.2071 3.8697 4.661 5.6044 6.7275 8.0623 9.6463 11.523 13.743 16.367 19.461 38.338 73.864 86.736 190.05
21 1.2324 1.5157 1.8603 2.2788 2.786 3.3996 4.1406 5.0338 6.1088 7.4002 8.9492 10.804 13.021 15.668 18.822 22.574 46.005 91.592 108.42 247.07
22 1.2447 1.546 1.9161 2.3699 2.9253 3.6035 4.4304 5.4365 6.6586 8.1403 9.9336 12.1 14.714 17.861 21.645 26.186 55.206 113.57 135.53 321.18
23 1.2572 1.5769 1.9736 2.4647 3.0715 3.8197 4.7405 5.8715 7.2579 8.9543 11.026 13.552 16.627 20.362 24.891 30.376 66.247 140.83 169.41 417.54
24 1.2697 1.6084 2.0328 2.5633 3.2251 4.0489 5.0724 6.3412 7.9111 9.8497 12.239 15.179 18.788 23.212 28.625 35.236 79.497 174.63 211.76 542.8
25 1.2824 1.6406 2.0938 2.6658 3.3864 4.2919 5.4274 6.8485 8.6231 10.835 13.585 17 21.231 26.462 32.919 40.874 95.396 216.54 264.7 705.64
30 1.3478 1.8114 2.4273 3.2434 4.3219 5.7435 7.6123 10.063 13.268 17.449 22.892 29.96 39.116 50.95 66.212 85.85 237.38 634.82 807.79 *
35 1.4166 1.9999 2.8139 3.9461 5.516 7.6861 10.677 14.785 20.414 28.102 38.575 52.8 72.069 98.1 133.18 180.31 590.67 * * *
36 1.4308 2.0399 2.8983 4.1039 5.7918 8.1473 11.424 15.968 22.251 30.913 42.818 59.136 81.437 111.83 153.15 209.16 708.8 * * *
40 1.4889 2.208 3.262 4.801 7.04 10.286 14.974 21.725 31.409 45.259 65.001 93.051 132.78 188.88 267.86 378.72 * * * *
50 1.6446 2.6916 4.3839 7.1067 11.467 18.42 29.457 46.902 74.358 117.39 184.57 289 450.74 700.23 * * * * * *

157
 n
Table A-2 Future Value Interest Factors for a One-Dollar Annuity Compounded at k Percent for n Periods: FVIFA k,n = [(1 + k) - 1 ] /
k

Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 20% 24% 25% 30%
1 1 1.02 1.03 1.04 1.05 1.06 1.07 1.08 1.09 1.1 1.11 1.12 1.13 1.14 1.15 1.16 1.2 1.24 1.25 1.3
2 2.01 2.02 2.03 2.04 2.05 2.06 2.07 2.08 2.09 2.1 2.11 2.12 2.13 2.14 2.15 2.16 2.2 2.24 2.25 2.3
3 3.0301 3.0604 3.0909 3.1216 3.1525 3.1836 3.2149 3.2464 3.2781 3.31 3.3421 3.3744 3.4069 3.4396 3.4725 3.5056 3.64 3.7776 3.8125 3.99
4 4.0604 4.1216 4.1836 4.2465 4.3101 4.3746 4.4399 4.5061 4.5731 4.641 4.7097 4.7793 4.8498 4.9211 4.9934 5.0665 5.368 5.6842 5.7656 6.187
5 5.101 5.204 5.3091 5.4163 5.5256 5.6371 5.7507 5.8666 5.9847 6.1051 6.2278 6.3528 6.4803 6.6101 6.7424 6.8771 7.4416 8.0484 8.207 9.0431
6 6.152 6.3081 6.4684 6.633 6.8019 6.9753 7.1533 7.3359 7.5233 7.7156 7.9129 8.1152 8.3227 8.5355 8.7537 8.9775 9.9299 10.98 11.259 12.756
7 7.2135 7.4343 7.6625 7.8983 8.142 8.3938 8.654 8.9228 9.2004 9.4872 9.7833 10.089 10.405 10.73 11.067 11.414 12.916 14.615 15.073 17.583
8 8.2857 8.583 8.8923 9.2142 9.5491 9.8975 10.26 10.637 11.028 11.436 11.859 12.3 12.757 13.233 13.727 14.24 16.499 19.123 19.842 23.858
9 9.3685 9.7546 10.159 10.583 11.027 11.491 11.978 12.488 13.021 13.579 14.164 14.776 15.416 16.085 16.786 17.519 20.799 24.712 25.802 32.015
10 10.462 10.95 11.464 12.006 12.578 13.181 13.816 14.487 15.193 15.937 16.722 17.549 18.42 19.337 20.304 21.321 25.959 31.643 33.253 42.619
11 11.567 12.169 12.808 13.486 14.207 14.972 15.784 16.645 17.56 18.531 19.561 20.655 21.814 23.045 24.349 25.733 32.15 40.238 42.566 56.405
12 12.683 13.412 14.192 15.026 15.917 16.87 17.888 18.977 20.141 21.384 22.713 24.133 25.65 27.271 29.002 30.85 39.581 50.895 54.208 74.327
13 13.809 14.68 15.618 16.627 17.713 18.882 20.141 21.495 22.953 24.523 26.212 28.029 29.985 32.089 34.352 36.786 48.497 64.11 68.76 97.625
14 14.947 15.974 17.086 18.292 19.599 21.015 22.55 24.215 26.019 27.975 30.095 32.393 34.883 37.581 40.505 43.672 59.196 80.496 86.949 127.91
15 16.097 17.293 18.599 20.024 21.579 23.276 25.129 27.152 29.361 31.772 34.405 37.28 40.417 43.842 47.58 51.66 72.035 100.82 109.69 167.29
16 17.258 18.639 20.157 21.825 23.657 25.673 27.888 30.324 33.003 35.95 39.19 42.753 46.672 50.98 55.717 60.925 87.442 126.01 138.11 218.47
17 18.43 20.012 21.762 23.698 25.84 28.213 30.84 33.75 36.974 40.545 44.501 48.884 53.739 59.118 65.075 71.673 105.93 157.25 173.64 285.01
18 19.615 21.412 23.414 25.645 28.132 30.906 33.999 37.45 41.301 45.599 50.396 55.75 61.725 68.394 75.836 84.141 128.12 195.99 218.05 371.52
19 20.811 22.841 25.117 27.671 30.539 33.76 37.379 41.446 46.018 51.159 56.939 63.44 70.749 78.969 88.212 98.603 154.74 244.03 273.56 483.97
20 22.019 24.297 26.87 29.778 33.066 36.786 40.995 45.762 51.16 57.275 64.203 72.052 80.947 91.025 102.44 115.38 186.69 303.6 342.95 630.17
21 23.239 25.783 28.676 31.969 35.719 39.993 44.865 50.423 56.765 64.002 72.265 81.699 92.47 104.77 118.81 134.84 225.03 377.47 429.68 820.22
22 24.472 27.299 30.537 34.248 38.505 43.392 49.006 55.457 62.873 71.403 81.214 92.503 105.49 120.44 137.63 157.42 271.03 469.06 538.1 *
23 25.716 28.845 32.453 36.618 41.43 46.996 53.436 60.893 69.532 79.543 91.148 104.6 120.21 138.3 159.28 183.6 326.24 582.63 673.63 *
24 26.973 30.422 34.426 39.083 44.502 50.816 58.177 66.765 76.79 88.497 102.17 118.16 136.83 158.66 184.17 213.98 392.48 723.46 843.03 *
25 28.243 32.03 36.459 41.646 47.727 54.865 63.249 73.106 84.701 98.347 114.41 133.33 155.62 181.87 212.79 249.21 471.98 898.09 * *
30 34.785 40.568 47.575 56.085 66.439 79.058 94.461 113.28 136.31 164.49 199.02 241.33 293.2 356.79 434.75 530.31 * * * *
35 41.66 49.994 60.462 73.652 90.32 111.44 138.24 172.32 215.71 271.02 341.59 431.66 546.68 693.57 881.17 * * * * *
36 43.077 51.994 63.276 77.598 95.836 119.12 148.91 187.1 236.13 299.13 380.16 484.46 618.75 791.67 * * * * * *
40 48.886 60.402 75.401 95.026 120.8 154.76 199.64 259.06 337.88 442.59 581.83 767.09 * * * * * * * *
50 64.463 84.579 112.8 152.67 209.35 290.34 406.53 573.77 815.08 * * * * * * * * * * *

158
Table A-3 Present Value Interest Factors for One Dollar Discounted at k Percent for n Periods: PVIF k,n = 1 / (1 + k) n

Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 20% 24% 25%
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.885 0.8772 0.8696 0.8621 0.8333 0.8065 0.8
2 0.9803 0.9612 0.9426 0.9246 0.907 0.89 0.8734 0.8573 0.8417 0.8264 0.8116 0.7972 0.7831 0.7695 0.7561 0.7432 0.6944 0.6504 0.64
3 0.9706 0.9423 0.9151 0.889 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513 0.7312 0.7118 0.6931 0.675 0.6575 0.6407 0.5787 0.5245 0.512
4 0.961 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.735 0.7084 0.683 0.6587 0.6355 0.6133 0.5921 0.5718 0.5523 0.4823 0.423 0.4096
5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.713 0.6806 0.6499 0.6209 0.5935 0.5674 0.5428 0.5194 0.4972 0.4761 0.4019 0.3411 0.3277
6 0.942 0.888 0.8375 0.7903 0.7462 0.705 0.6663 0.6302 0.5963 0.5645 0.5346 0.5066 0.4803 0.4556 0.4323 0.4104 0.3349 0.2751 0.2621
7 0.9327 0.8706 0.8131 0.7599 0.7107 0.6651 0.6227 0.5835 0.547 0.5132 0.4817 0.4523 0.4251 0.3996 0.3759 0.3538 0.2791 0.2218 0.2097
8 0.9235 0.8535 0.7894 0.7307 0.6768 0.6274 0.582 0.5403 0.5019 0.4665 0.4339 0.4039 0.3762 0.3506 0.3269 0.305 0.2326 0.1789 0.1678
9 0.9143 0.8368 0.7664 0.7026 0.6446 0.5919 0.5439 0.5002 0.4604 0.4241 0.3909 0.3606 0.3329 0.3075 0.2843 0.263 0.1938 0.1443 0.1342
10 0.9053 0.8203 0.7441 0.6756 0.6139 0.5584 0.5083 0.4632 0.4224 0.3855 0.3522 0.322 0.2946 0.2697 0.2472 0.2267 0.1615 0.1164 0.1074
11 0.8963 0.8043 0.7224 0.6496 0.5847 0.5268 0.4751 0.4289 0.3875 0.3505 0.3173 0.2875 0.2607 0.2366 0.2149 0.1954 0.1346 0.0938 0.0859
12 0.8874 0.7885 0.7014 0.6246 0.5568 0.497 0.444 0.3971 0.3555 0.3186 0.2858 0.2567 0.2307 0.2076 0.1869 0.1685 0.1122 0.0757 0.0687
13 0.8787 0.773 0.681 0.6006 0.5303 0.4688 0.415 0.3677 0.3262 0.2897 0.2575 0.2292 0.2042 0.1821 0.1625 0.1452 0.0935 0.061 0.055
14 0.87 0.7579 0.6611 0.5775 0.5051 0.4423 0.3878 0.3405 0.2992 0.2633 0.232 0.2046 0.1807 0.1597 0.1413 0.1252 0.0779 0.0492 0.044
15 0.8613 0.743 0.6419 0.5553 0.481 0.4173 0.3624 0.3152 0.2745 0.2394 0.209 0.1827 0.1599 0.1401 0.1229 0.1079 0.0649 0.0397 0.0352
16 0.8528 0.7284 0.6232 0.5339 0.4581 0.3936 0.3387 0.2919 0.2519 0.2176 0.1883 0.1631 0.1415 0.1229 0.1069 0.093 0.0541 0.032 0.0281
17 0.8444 0.7142 0.605 0.5134 0.4363 0.3714 0.3166 0.2703 0.2311 0.1978 0.1696 0.1456 0.1252 0.1078 0.0929 0.0802 0.0451 0.0258 0.0225
18 0.836 0.7002 0.5874 0.4936 0.4155 0.3503 0.2959 0.2502 0.212 0.1799 0.1528 0.13 0.1108 0.0946 0.0808 0.0691 0.0376 0.0208 0.018
19 0.8277 0.6864 0.5703 0.4746 0.3957 0.3305 0.2765 0.2317 0.1945 0.1635 0.1377 0.1161 0.0981 0.0829 0.0703 0.0596 0.0313 0.0168 0.0144
20 0.8195 0.673 0.5537 0.4564 0.3769 0.3118 0.2584 0.2145 0.1784 0.1486 0.124 0.1037 0.0868 0.0728 0.0611 0.0514 0.0261 0.0135 0.0115
21 0.8114 0.6598 0.5375 0.4388 0.3589 0.2942 0.2415 0.1987 0.1637 0.1351 0.1117 0.0926 0.0768 0.0638 0.0531 0.0443 0.0217 0.0109 0.0092
22 0.8034 0.6468 0.5219 0.422 0.3418 0.2775 0.2257 0.1839 0.1502 0.1228 0.1007 0.0826 0.068 0.056 0.0462 0.0382 0.0181 0.0088 0.0074
23 0.7954 0.6342 0.5067 0.4057 0.3256 0.2618 0.2109 0.1703 0.1378 0.1117 0.0907 0.0738 0.0601 0.0491 0.0402 0.0329 0.0151 0.0071 0.0059
24 0.7876 0.6217 0.4919 0.3901 0.3101 0.247 0.1971 0.1577 0.1264 0.1015 0.0817 0.0659 0.0532 0.0431 0.0349 0.0284 0.0126 0.0057 0.0047
25 0.7798 0.6095 0.4776 0.3751 0.2953 0.233 0.1842 0.146 0.116 0.0923 0.0736 0.0588 0.0471 0.0378 0.0304 0.0245 0.0105 0.0046 0.0038
30 0.7419 0.5521 0.412 0.3083 0.2314 0.1741 0.1314 0.0994 0.0754 0.0573 0.0437 0.0334 0.0256 0.0196 0.0151 0.0116 0.0042 0.0016 0.0012
35 0.7059 0.5 0.3554 0.2534 0.1813 0.1301 0.0937 0.0676 0.049 0.0356 0.0259 0.0189 0.0139 0.0102 0.0075 0.0055 0.0017 0.0005 *
36 0.6989 0.4902 0.345 0.2437 0.1727 0.1227 0.0875 0.0626 0.0449 0.0323 0.0234 0.0169 0.0123 0.0089 0.0065 0.0048 0.0014 * *
40 0.6717 0.4529 0.3066 0.2083 0.142 0.0972 0.0668 0.046 0.0318 0.0221 0.0154 0.0107 0.0075 0.0053 0.0037 0.0026 0.0007 * *
50 0.608 0.3715 0.2281 0.1407 0.0872 0.0543 0.0339 0.0213 0.0134 0.0085 0.0054 0.0035 0.0022 0.0014 0.0009 0.0006 * * *

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Table A-4 Present Value Interest Factors for a One-Dollar Annuity Discounted at k Percent for n Periods: PVIFA = [1 - 1/(1 + k)n] / k

Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 20% 24% 25% 30%
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.885 0.8772 0.8696 0.8621 0.8333 0.8065 0.8 0.7692
2 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334 1.808 1.7833 1.7591 1.7355 1.7125 1.6901 1.6681 1.6467 1.6257 1.6052 1.5278 1.4568 1.44 1.3609
3 2.941 2.8839 2.8286 2.7751 2.7232 2.673 2.6243 2.5771 2.5313 2.4869 2.4437 2.4018 2.3612 2.3216 2.2832 2.2459 2.1065 1.9813 1.952 1.8161
4 3.902 3.8077 3.7171 3.6299 3.546 3.4651 3.3872 3.3121 3.2397 3.1699 3.1024 3.0373 2.9745 2.9137 2.855 2.7982 2.5887 2.4043 2.3616 2.1662
5 4.8534 4.7135 4.5797 4.4518 4.3295 4.2124 4.1002 3.9927 3.8897 3.7908 3.6959 3.6048 3.5172 3.4331 3.3522 3.2743 2.9906 2.7454 2.6893 2.4356
6 5.7955 5.6014 5.4172 5.2421 5.0757 4.9173 4.7665 4.6229 4.4859 4.3553 4.2305 4.1114 3.9975 3.8887 3.7845 3.6847 3.3255 3.0205 2.9514 2.6427
7 6.7282 6.472 6.2303 6.0021 5.7864 5.5824 5.3893 5.2064 5.033 4.8684 4.7122 4.5638 4.4226 4.2883 4.1604 4.0386 3.6046 3.2423 3.1611 2.8021
8 7.6517 7.3255 7.0197 6.7327 6.4632 6.2098 5.9713 5.7466 5.5348 5.3349 5.1461 4.9676 4.7988 4.6389 4.4873 4.3436 3.8372 3.4212 3.3289 2.9247
9 8.566 8.1622 7.7861 7.4353 7.1078 6.8017 6.5152 6.2469 5.9952 5.759 5.537 5.3282 5.1317 4.9464 4.7716 4.6065 4.031 3.5655 3.4631 3.019
10 9.4713 8.9826 8.5302 8.1109 7.7217 7.3601 7.0236 6.7101 6.4177 6.1446 5.8892 5.6502 5.4262 5.2161 5.0188 4.8332 4.1925 3.6819 3.5705 3.0915
11 10.368 9.7868 9.2526 8.7605 8.3064 7.8869 7.4987 7.139 6.8052 6.4951 6.2065 5.9377 5.6869 5.4527 5.2337 5.0286 4.3271 3.7757 3.6564 3.1473
12 11.255 10.575 9.954 9.3851 8.8633 8.3838 7.9427 7.5361 7.1607 6.8137 6.4924 6.1944 5.9176 5.6603 5.4206 5.1971 4.4392 3.8514 3.7251 3.1903
13 12.134 11.348 10.635 9.9856 9.3936 8.8527 8.3577 7.9038 7.4869 7.1034 6.7499 6.4235 6.1218 5.8424 5.5831 5.3423 4.5327 3.9124 3.7801 3.2233
14 13.004 12.106 11.296 10.563 9.8986 9.295 8.7455 8.2442 7.7862 7.3667 6.9819 6.6282 6.3025 6.0021 5.7245 5.4675 4.6106 3.9616 3.8241 3.2487
15 13.865 12.849 11.938 11.118 10.38 9.7122 9.1079 8.5595 8.0607 7.6061 7.1909 6.8109 6.4624 6.1422 5.8474 5.5755 4.6755 4.0013 3.8593 3.2682
16 14.718 13.578 12.561 11.652 10.838 10.106 9.4466 8.8514 8.3126 7.8237 7.3792 6.974 6.6039 6.2651 5.9542 5.6685 4.7296 4.0333 3.8874 3.2832
17 15.562 14.292 13.166 12.166 11.274 10.477 9.7632 9.1216 8.5436 8.0216 7.5488 7.1196 6.7291 6.3729 6.0472 5.7487 4.7746 4.0591 3.9099 3.2948
18 16.398 14.992 13.754 12.659 11.69 10.828 10.059 9.3719 8.7556 8.2014 7.7016 7.2497 6.8399 6.4674 6.128 5.8178 4.8122 4.0799 3.9279 3.3037
19 17.226 15.678 14.324 13.134 12.085 11.158 10.336 9.6036 8.9501 8.3649 7.8393 7.3658 6.938 6.5504 6.1982 5.8775 4.8435 4.0967 3.9424 3.3105
20 18.046 16.351 14.877 13.59 12.462 11.47 10.594 9.8181 9.1285 8.5136 7.9633 7.4694 7.0248 6.6231 6.2593 5.9288 4.8696 4.1103 3.9539 3.3158
21 18.857 17.011 15.415 14.029 12.821 11.764 10.836 10.017 9.2922 8.6487 8.0751 7.562 7.1016 6.687 6.3125 5.9731 4.8913 4.1212 3.9631 3.3198
22 19.66 17.658 15.937 14.451 13.163 12.042 11.061 10.201 9.4424 8.7715 8.1757 7.6446 7.1695 6.7429 6.3587 6.0113 4.9094 4.13 3.9705 3.323
23 20.456 18.292 16.444 14.857 13.489 12.303 11.272 10.371 9.5802 8.8832 8.2664 7.7184 7.2297 6.7921 6.3988 6.0442 4.9245 4.1371 3.9764 3.3254
24 21.243 18.914 16.936 15.247 13.799 12.55 11.469 10.529 9.7066 8.9847 8.3481 7.7843 7.2829 6.8351 6.4338 6.0726 4.9371 4.1428 3.9811 3.3272
25 22.023 19.523 17.413 15.622 14.094 12.783 11.654 10.675 9.8226 9.077 8.4217 7.8431 7.33 6.8729 6.4641 6.0971 4.9476 4.1474 3.9849 3.3286
30 25.808 22.396 19.6 17.292 15.372 13.765 12.409 11.258 10.274 9.4269 8.6938 8.0552 7.4957 7.0027 6.566 6.1772 4.9789 4.1601 3.995 3.3321
35 29.409 24.999 21.487 18.665 16.374 14.498 12.948 11.655 10.567 9.6442 8.8552 8.1755 7.5856 7.07 6.6166 6.2153 4.9915 4.1644 3.9984 3.333
36 30.108 25.489 21.832 18.908 16.547 14.621 13.035 11.717 10.612 9.6765 8.8786 8.1924 7.5979 7.079 6.6231 6.2201 4.9929 4.1649 3.9987 3.3331
40 32.835 27.355 23.115 19.793 17.159 15.046 13.332 11.925 10.757 9.7791 8.9511 8.2438 7.6344 7.105 6.6418 6.2335 4.9966 4.1659 3.9995 3.3332
50 39.196 31.424 25.73 21.482 18.256 15.762 13.801 12.233 10.962 9.9148 9.0417 8.3045 7.6752 7.1327 6.6605 6.2463 4.9995 4.1666 3.9999 3.3333

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 Unit 10
Inventory Management
10.0 Introduction
Managing the levels of inventory is fundamental to establishing a long-term
competitive advantage. Quality, product engineering, prices, overtime, excess
capacity, ability to respond to customers (due-date performance), lead times, and
overall profitability are all affected by inventory levels. In general, firms with higher
inventory levels than their competitors tend to be in a worse competitive position.
Inventory and how it is managed is strongly related to the ability of firms to obtain the
necessary competitive edge to make money now and in the future. Inventory
management policy has become a competitive weapon. How inventory policy can be
used to aid in establishing a competitive advantage is the focus of this unit.

We will review the traditional inventory management model –Economic Order

Quantity, the basics of this model and its underlying conceptual foundation in order to
understand where it can still be appropriately applied. We will also look at advantages
of inventory managed methods such as JIT and the theory of constraints. The major
purpose of this unit is to examine approaches to managing inventory efficiently. The
two most important approaches are the EOQ model and the ‘just-in-time’ approach.

10.1 Unit Objectives

By the end of this unit, you should be able to:
 explain the traditional inventory management model
 calculate economic order quantity using economic order quantity formula
 describe just-in-time inventory management
 discuss the theory of constraints
 explain how the theory of constraints can be used to manage inventory

10.2 Traditional Inventory Management

The traditional inventory management model is the model that has been the mainstay
of manufacturing firms for decades.

10.2.1 Inventory costs

Four major costs associated with inventory are as follows:
1. Ordering costs– these are costs of placing and receiving an order. Examples
include the costs of processing an order (clerical costs and documents), the
costs of insurance for shipment, and unloading costs. Ordering costs can be
referred to as procuring cost, purchase costs or re-order costs.
2. Setup costs – these are costs of preparing equipment and facilities so they can
be used to produce a particular product or component. Examples are wages of
idled production workers, the cost of idled production facilities (lost income),
and the costs of test runs (labour, materials, and overhead).

161
 3. Carrying costs/holding costs/ – these are costs of carrying inventory.
Examples include insurance, inventory taxes, obsolescence, the opportunity
cost of funds tied up in inventory, handling costs, and storage space.
4. Stock out costs/shortage costs are the costs of not having a product available
when demanded by a customer. Examples are lost sales (current and future),
the costs of expediting (increasing transportation chares, overtime and so on),
and the costs of interrupted production.

Ordering costs and setup costs are similar in nature – both represent costs that must be
incurred to acquire inventory. They only differ in the nature of prerequisite activity
(filling out and placing an order versus configuring equipment and facilities). Any
reference to ordering costs can be viewed as a reference to setup costs.

The fourth cost, Stock out costs incur if demand is not known with certainty.

10.2.2 Traditional reasons for holding inventory

The following are reasons given to justify carrying inventories.
1. To balance ordering or setup costs and carrying costs.
2. To satisfy customer demands ( for example, meet deliver dates)
3. To avoid shutting down manufacturing facilities because of
a. Machine failure
b. Defective parts
c. Unavailable parts
d. Late delivery of parts
4. To buffer against unreliable production process
5. To take advantage of discounts
6. To hedge against future price increases

10.3 Economic Order Quantity (EOQ): The Traditional Inventory Model

In developing an inventory policy, two basic questions must be addressed:
1. How much should be ordered (or produced)?
2. When should the order be placed (or the setup done)?
These questions are addressed through assessment of the EOQ model.

Economic order quantity (EOQ) is the most economic inventory replenishment order
size, which minimizes the sum of the inventory ordering costs and inventory holding
costs. EOQ is used in an ‘optimising’ inventory control system.

Inventory holding and ordering costs can be minimized using the economic order
quantity model. If discounts are offered for bulk purchases, the higher holding costs
should be weighted against the lower ordering and purchasing costs.

Let D = the usage in units for one year ( the demand)

Co = the cost of making an order } Relevant costs only
Ch = the holding cost per unit of inventory for one year } Relevant costs only
Q = the order quantity

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 Assume that:
a) Demand is constant
b) The lead time is constant or zero
c) Purchase costs per unit are constant (that is, no bulk discounts)

The total annual costs of having inventory (T) is:

Holding costs + ordering costs

The order quantity, Q, which will minimise these total costs (T) is given by the
following formula.

Economic Order Quantity, EOQ =

Where Co = cost of placing an order

Ch = cost of holding one unit in inventory for one year
D = annual demand

Example 10.1
The demand for a commodity is 40 000 units a year, at a steady rate. It costs $20 to
place an order and $0.40 to hold a unit for a year. Find the order size to minimise
inventory costs, the number of orders placed each year, and the length of the
inventory cycle.

Solution 10.1
Q= = = 2 000 units. This means that there will be

= 20 orders placed each year, so that the inventory cycle is once every
52 ÷ 20 = 2.6 weeks.

Total cost will be (20 × $20) + = $800 a year.

Activity 10.1
DS Timbers has demand for 40 000 desks p.a. the purchase price for each desk is
$25. There are ordering costs of $20 for each order place. Inventory holding costs
amount to 10% p.a. of inventory value.

1. Calculate the inventory costs p.a. for the following order quantities.
a) 500 units
b) 750 units
c) 1000 units
d) 1250 units
2. Use the EOQ formula to calculate the EOQ
3. Calculate the total inventory costs for this order quantity

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10.3.1 Quantity discounts
Often, discounts will be offered for ordering in large quantities. The problem may be
solved using the following steps:
1. Calculate EOQ ignoring discounts
2. If it is below the quantity which must be ordered to obtain discounts, calculate
the total annual inventory costs
3. Recalculate total annual inventory costs using the order size required to just
obtain the discount
4. Compare the cost of step 2 and 3 with the saving from the discount and select
the minimum cost alternative
5. Repeat for all discount levels

Example 10.2
The annual demand for an item of inventory is 45 units. The item costs $200 a unit to
purchase, the holding costs for one unit for one year is 15% of the unit cost and
ordering costs are $300 an order. The supplier offers a 3% discount for orders of 60
units or more, and a discount of 5% for orders of 90 units or more. What is the cost-
minimising order size?

Solution 10.2
a) The EOQ ignoring discount is:

= 30 units

Purchases (no discount) 45 × $200 $9 000

Holding costs 15 units × 300 $ 450
Ordering costs 1.5 orders × $300 $ 450
Total annual costs $9 900

b) With a discount of 3% and an ordering quantity of 60 units costs are as

follows:

Purchases $9 000 × 97% $8 730

Holding costs 30 units × 15% of 97% of $200 $ 873
Ordering costs 0.75 orders × $300 $ 225
Total annual costs $9 828

c) With a discount of 5% and an ordering quantity of 90 units costs are as

follows:

Purchases $9 000 × 95% $8 550.00

Holding costs 45 units × 15% of 95% of $200 $1 282.50
Ordering costs 0.5 orders × $300 $ 150.00
Total annual costs $9 982.50

The cheapest option is to order 60 units at a time.

164
Activity 10.2
For the information given in Activity 1.1 the supplier now offers us discounts on
purchase price as follows:
Order Quantity Discount
0 to < 5 000 0%
5 000 to < 10 000 1%
10 000 or over 1.5%

Calculate the Economic Order Quantity.

10.3.2 Reorder point

The reorder point is the point in time when a new order or replenishment order should
be placed or set up started. It is a function of the EOQ, the lead time, and the rate at
which inventory is depleted. Lead time is the time required to receive the economic
order quantity once an order is placed or a setup is initiated.

The following formula builds in a measure of safety inventory and minimises the
possibility of the organisation running out of inventory, a stock out.

Re-order point = maximum usage × maximum Lead time

When the volume of demand is uncertain, or the supply lead time is variable, there are
problems in deciding what the re-order level should be. By holding a safety inventory,
a company can reduce the likelihood that inventories run out during the re-order
period. Safety inventory is extra inventory carried to serve as insurance against
fluctuations in demand. Safety stock is computed by multiplying the lead time by the
difference between the maximum rate of usage and the average rate of usage.

The average annual cost of safety inventory would be:

Quantity of safety inventory (in units) × Inventory holding cost per unit per annum

With the presence of safety stock, the reorder point is computed as follows
Re-order point = (Average rate of usage × Lead time) + Safety stock

Example 10.3
Farm Corp, a large manufacturer of farm implements with several plants throughout
the nation has provided you with the following information.

Average demands for blades 320 per day

Maximum demand for blades 340 per day
Annual demand for blades 80 000
Unit carrying costs $5
Setup costs $12 500
Lead time $20 days

Based on this information, compute the economic order quantity and the re-order
point for the company.

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 Solution 10.3
EOQ = =
= 20 000 blades

Maximum usage 340

Average usage 320
Difference 20
Lead time ×20
Total safety stock 400

Re-order point = (Average usage × Lead time) + Safety stock

= (320 × 20) + 400
= 6 800 units

The blades should be produced in batches of 20 000, and a new setup should be
started when the supply of blades drops to $6 800.

10.3.3 Maximum and minimum inventory levels

Maximum-inventory level = re-order level + re-order quantity – (minimum usage ×
minimum lead time)

It is the inventory level set for control purposes which actual inventory holding should
never exceed. The maximum levels acts as warning signal to management that
inventories are reaching a potential wasteful level.

Minimum inventory level or safety inventory = re-order level – (average usage ×

average lead time)

It is the inventory level set for control purposes below which inventory holding
should not fall without being highlighted. The minimum levels acts as warning to
management that inventories are approaching a dangerously low level and that
stockouts are possible.

Average inventory = Minimum level +

Activity 10.3
A local TV repair shop uses 36 000 units of a part each year (an average of 100
units per working day). It costs $20 to place and receive an order. The shop orders
in lots of 400 units. It costs $4 to carry one unit per year in inventory.

Required:
1. Calculate the total annual ordering cost
2. Calculate the total annual carrying cost
3. Calculate the total annual inventory cost
4. Calculate the EOQ
5. Calculate the total annual inventory cost using the EOQ inventory policy

166
 6. How much is saved per year using the EOQ versus an order size of 400
units?
7. Compute the reorder point, assuming the lead time is 3 days.
8. Suppose that the usage of the part can be as much as 110units per day.
Calculate the safety stock and the new reorder point.

10.4 JIT Inventory Management

Just-in-time is an approach to operations planning and control based on the idea that
goods and services should be produced only when they are needed, and neither too
early (so that inventories build up) or too late (so that customer has to wait). A JIT
system seeks to hold zero inventories.

With JIT, a disruption at any point in the system becomes a problem for the whole
operation to resolve. JIT has two strategic objectives: to increase profits and improve
a firm’s competitive position.

10.4.1 Definitions of JIT

 JIT aims to meet demand instantaneously, with perfect quality and no waste.
 Just-in-time is a disciplined approach to improve overall productivity and
eliminate waste. It provides for the cost effective production and delivery of
only the necessary quantity of parts at the right quality, at the right time and
place, while using a minimum amount of facilities, equipment, materials and
human resources. JIT is dependent on the balance between the supplier’s
flexibility and the user’s flexibility. It is accomplished through the application
of elements which require total employees involvement and team work.
 JIT is a system whose objective is to produce or to procure products or
components as they are required (by a customer for use) rather than for stock.
A just-in-time system is a ‘pull’ system, which responds to demand, in
contrast to a ‘push’ system, in which stocks act as buffers between the
different elements of the system, such as purchasing, production and sales.
 Just-in-time production is a production system which is driven by demand for
finished products whereby each component on a production line is produced
only when needed for the next stage.
 Just-in-time purchasing is a purchasing system in which material purchases are
contracted so that the receipt and usage of material, to the maximum extent
possible, coincide.

10.4.2 Operational requirements of JIT

a) High quality. Disruptions in the production due to errors in quality will reduce
throughput and reduce the dependability of internal supply.
b) Speed. Throughput in the operation must be fast, so that customer orders can
be met by production rather than out of inventory.
c) Reliability. Production must be reliable and not subject to hold ups.
d) Flexibility. To respond immediately to customer orders, production must be
flexible, and in small batch sizes
e) Lower costs. As a consequence of high quality production, and with faster
throughput and the elimination of errors, costs will be reduced.
Throughput accounting is a system of cost and management accounting which
can be used with just-in-time.
167
10.4.3 The JIT philosophy
JIT can be regarded as an approach to management that encompasses a commitment
to continuous improvement and the search for excellence in the design and operation
of the production management system. Its aim is to stream line the flow of production
through the production process and into the hands of customers.

The JIT philosophy originated in Japan in the 1970s, with companies like the car
manufacturer, Toyota. At its most basic, the philosophy is:
 To do things well, and gradually do them better (continuous improvement)
 To squeeze waste out of system

A criticism of JIT, in its extreme form, is that having no inventory between any stage
in the production process ignores the fact that some stages, by their very nature, could
be less reliable than others, and prone to disruptions. It could, therefore, be argued
that some inventory should be held at these stages to provide a degree of extra
protection to the rest of the operation.

Three key elements in the JIT Philosophy

1. Elimination of waste – Waste is defined as any activity that does not add
value. Examples of waste identified by Toyota are as follows:
a. Overproduction
b. Waiting time
c. Transport
d. Waste in the production process itself
e. Inventory
f. Unnecessary work
g. Defective goods
2. The involvement of all staff in the operation – JIT is a cultural issue, and its
philosophy has to be embraced by everyone involved in the operation if it is to
be applied successfully.
3. Continuous improvements –The organisation should work towards the ideal,
to meet demand immediately with perfect quality and no waste.

10.4.4 JIT management techniques

JIT is a collection of management techniques. Some of these techniques relate to basic
working practice.

a) Work standards – should be established and followed by everyone at all times.

b) Flexibility in responsibility – the organisation should provide for the
possibility of expanding responsibilities of any individual to the extent of his
or her capabilities. Restrictive working practices should be abolished.
c) Equality of all people working in the organisation.
d) Autonomy –Authority should be delegated to individuals directly responsible
for the activities of the operation. Management should support people on the
shop floor, not direct them. Shop floor workers should be given the first
opportunity to solve problems affecting their work.
e) Development of personnel – Individual workers should be developed and
trained.

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 f) Quality of working life –should be improved, through better work area
facilities, job security, involvement of everyone in job related decision
making.
g) Creativity. Employees should be encouraged to be creative in devising
improvements to the way their work is done.

Other JIT techniques and methodologies

(a) Design for manufacture – production costs can be reduced at the design stage.
(b) Use several small, simple machines – small machines can be moved around
more easily, and offer greater flexibility in shop floor layout. Small simple
machines cost much less than sophisticated large machines.
(c) Work floor layout and work flow. Work can be laid out to promote the smooth
flow of operations. Work need to flow without interruptions to avoid inventory
build-up or unnecessary down-times. Machines or workers should be grouped
by product or component instead of by type of work performed. Eliminate
space between work stations. Products should flow from machine to machine.
Lead times and work in progress is reduced.
(d) Total productive maintenance (TPM). TPM seeks to eliminate unplanned
breakdowns and the damage they cause to production and work flow. Staff
working on the production line should search for improvements and take
ownership of the machine carrying out simple repairs.
(e) Set-up reduction. Setup is the collection of activities carried out between
completing work on one job or batch of production and preparing the process
or machine to take the next batch. Set-up time is non-productive time. The aim
of JIT is to reduce set-up times. This can be done by undertaking some tasks
previously not done until the machines had stopped whilst the machines are
running.
(f) Total people involved. Staff is encouraged to use their abilities for the best of
the organisation. They are trusted and given authority for monitoring and
measuring their own performance, reviewing the work they had done each
day, dealing directly with suppliers about quality issues and to find out about
material delivery times, dealing with customer problems and queries, selecting
new staff to work with them.
(g) Visibility – The work place and the operations taking place in it are more
visible, through open plan work space, visual control systems, information
displays showing performance achievements, and signal lights to show where
a stoppage has occurred.
(h) JIT purchasing – establish a close, long-term relationship with suppliers, and
develop an arrangement with the suppliers for being able to purchase materials
only when they are needed for production.

JIT aims to eliminate all non-value-added costs. Value is only added while a product
is actually being processed. Whilst it is being inspected for quality, moving from one
part of factory to another, waiting for further processing and held in store, value is not
being added. Non-value-added activities should be eliminated.

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Activity 10.4
1. Define JIT in detail.
2. (a) Explain the JIT philosophy and management technique.
(b) How will you apply the JIT management techniques in today’s business?

10.4.5 The Kanban system

Kanban is the Japanese word for card or signal. To ensure that parts or materials are
available when needed, a system called the Kanban system is employed. This is an
information system that controls production through the use of markers or cards. The
Kanban system is responsible for ensuring that the necessary products (or parts) are
produced (or acquired) in the necessary quantities at the necessary time. It is the heart
of the JIT inventory management system.

A basic Kanban system uses three cards:

1. A withdrawal Kanban which specifies the quantity that a subsequent process
should withdraw from the preceding process.
2. A production Kanban which specifies the quantity that the preceding process
should produce
3. Vendor Kanbans are used to notify suppliers to deliver more parts, they also
specify when the parts are needed.

10.4.6 JIT Limitations

JIT should not be seen as a panacea for all the endemic problems associated
manufacturing. It might not be appropriate for all circumstances.

(a) It is always not easy to predict patterns of demand

(b) JIT makes the organisation far more vulnerable to disruptions in the supply
chain
(c) JIT was designed at a time when all of Toyota’s manufacturing was done
within a 50km radius of its headquarters. Wide geographical spread, however
makes this difficult.
(d) Time is required to build sound relationships with suppliers, insisting on
immediate changes in delivery times and quality may not be realistic and may
cause difficult confrontation between a company and its supplier.
(e) The absence of inventory to buffer production interruptions
(f) Workers may be affected by JIT. Studies have shown that sharp reductions in
inventory buffers may cause a regimented work flow and high levels of stress
among production workers.

10.5 The theory of constraints (TOC)

Theory of constraints (TOC) is a set of concepts which aim to identify the binding
constraints in a production system and which strive for evenness of production flow
so that the organisation works as effective as possible. No inventory should be held
except prior to the binding constraints.

Every firm faces limited resources and limited demand for each product. These
limitations are called constraints. The theory of constraints recognises that the
performance of any organisation is limited by its constraints. If performance is to

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 improve an organisation must identify its constraints, exploit the constraints in the
short-run, and in the longer term, find ways to overcome the constraints.

TOC focuses on three measures of organisational performance: throughput, inventory

and operating expenses.

Throughput is the rate at which an organisation generates money through sales. In

operational terms throughput is the difference between sale revenue and unit-level
variable costs such as materials and power.

Inventory is all money the organisation spends in turning raw materials into
throughput.

Operating expenses are defined as the money the organisation spends in turning
inventories into throughput. The objective of management is to increase throughput,
minimising inventory, and decreasing operating expenses.

TOC, like JIT, assigns inventory management a much more prominent role than the
traditional viewpoint. TOC recognises the lowering inventory decreases carrying costs
and, thus, decreases operating expenses and improves net income. TOC however
argues that lowering inventory helps produce a competitive edge by having better
products, lower prices, and faster responses to customer needs.

10.5.1 TOC Steps

The theory of constraints uses five steps to achieve its goal of improving
organisational performance:

1. Indentify the organisation’s constraint(s).

2. Exploit the binding constraint(s).
3. Subordinate everything else to the decision made in step 2
4. Elevate the binding constraint(s).
5. Repeat the process.
A bottleneck resource or binding constraint is an activity within an
organisation which has a lower capacity than preceding or subsequent
activities, thereby limiting throughput.

Steps should be taken to remove bottle necks as follows:

 Buy more equipment
 Provide additional training for slow workers
 Change a product design to reduce the processing time on bottle neck activity
 Eliminate idle time at the bottleneck (for example, machine set-up time)

Activity 10.5
1. Describe the theory of constraints
2. Explain how the TOC can be used to manage inventory.

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10.6 Summary
In this unit we discussed that the traditional approach uses inventories to manage the
trade-offs between ordering (setup) costs and carrying costs. The optimal trade off
defines the Economic Order quantity. Other reasons for inventory are also offered:
due-date performance, avoiding shutdowns (protecting sales), hedging against future
price increase, and taking advantage of discounts. JIT and TOC on the other hand,
argue that inventories are costly and are used to cover up fundamental problems that
need to be corrected so that the organisation can become more competitive. JIT uses
long-term contracts and continuous replenishment to reduce ordering costs. TOC
identifies an organisation’s constraints and exploits them so that throughput is
maximised and inventories and operating costs are minimised.

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