Performance Management accounting

Modules: CUAC 413

TARGET COSTING
Target costing is a modern technique suitable in today’s environment where global competition,
increased customer expectations, and competitive pricing in many industries have, forced
companies to look for ways to reduce costs year after year at the same time producing products
with increased levels of quality and functionality.

Henry Ford’s thinking would fit well in today’s corporate boardrooms:

Our policy is to reduce the price, extend the operations, and improve the article.
You will notice that the reduction of price comes first. We have never considered costs as fixed.
Therefore we first reduce the price to the point where we believe more sales result. Then we go
ahead and try to make the prices. We do not bother about the costs. The new price forces the
costs down. The more usual way is to take the costs and then determine the price, and although
that method may be scientific in the narrow sense; it is not scientific in the broad sense, because
what earthly use is it to know the cost if it tells you that you cannot manufacture at a price at
which the article can be sold? But more to the point is the fact that although one may calculate
what a cost is, and of course all of our costs are carefully calculated, no one knows what a cost
ought to be. One of the ways of discovering is to name a price so low as to force everybody in
the place to the highest point of efficiency. The low price makes everybody dig for profits. We
make more discoveries concerning manufacturing and selling under this forced method than by
any method of leisurely investigation.
Henry Ford, My Life and My Work, 1923

Target costing, is whereby the firm determines the allowable (i.e., target) cost for the product or
service, given a competitive market price, so the firm can earn a desired profit: Target cost =
Competitive price= Desired profit. Target costing works well especially during competitive
times, as during an economic recession, when many firms struggle for survival. It originated in
Japan in the 1970s, it came to being as a result of recognition that customers were demanding

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more diversity in products that they bought and that the life cycle of the products were getting
shorter and as such, it meant that new products had to be designed more frequently.
Companies realised that the larger proportion of costs were committed in the design stage of the
product and hence the design stage become critical for the company to make profit. Companies
have two options for reducing costs to acceptable level:
 Through adoption of integrating new manufacturing technology, using advanced cost
management techniques such as activity-based costing, and seeking higher productivity.
 By redesigning the product or service. This approach recognizes that design decisions
account for much of total product life cycle costs. By paying attention to the design
stage, massive reductions in total cost are attainable.
Purpose
Target costing is a method that is employed to manage costs and profits. It involves setting a
target or objective for the maximum of a product /service and working out now to achieve this
target. It is used for business strategy and marketing strategy in particular by companies who
operate in a competitive environment and where new products are continuously being
introduced.
 For companies to achieve these, they need to:
 Continually improve their existing products or design new ones.
 Sell their products at a competitive price just like competitors or slightly below
competitors.
 Make a profit.
NB in order to make a profit, companies need to make the product at a cost below the expected
sale price. With its positioning in the early, upstream phases of the cost life cycle, target costing
can clearly help a firm reduce total costs.

Stages in target costing

Companies intending to implement target costing can follow the five stages below:
1. Determine the market price.
Determine the desired profit.
 Calculate the target cost at market price less desired profit.
 Use value engineering to identify ways to reduce product cost.

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  Use kaizen costing and operational control to further reduce costs.

Target costing and New product Development

It is mainly used for new product development; this is due to the fact that whenever a new
product is designed and developed for a competitive market, a company needs to know what
maximum cost to be placed on a new product so that it will sell at a profit. Keeping the cost of
the product within the target level is the major factor in controlling its design and development.

New product design and development

Setting target cost
$
Target selling price xxx
Less target margin xxx
Target cost xxx

N.B .The reason that target costing is used for new products are the opportunities for cutting
costs to meet target costs since it is from the design stage and development that all production
processes are set up.

Target costing method

The principles of target costing can be summarized as:
 Target costing is based on the idea that when a new product is developed ,a company will
have a reasonable idea about:
i) The price at which it will sell the product.
ii) The sales volume that will be able to achieve for the products over its product life.
iii) There may be need to estimate capital investments, incremental fixed costs such as
marketing costs and additional salaries.
 Taking estimates of sales volumes, capital investments, incremental costs over the life of
the product, it then becomes easier to ascertain the target cost.
 The target cost for the product might be the maximum cost for the product that will
provide at a least a required return on the investment.

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Elements in Estimates Cost and Target Cost
It is difficult to measure the cost of a product that has not yet been created and the cost must
include such items as raw material wastage, direct labour idle time which is expected to occur in
normal circumstances. The following are the major components making up a product:

Raw material
The target cost should allow for expected wastage rates/wastage in the process. The price of raw
material should also allow for any possible increase up to the time when the new product
development is completed. Estimating price of raw materials can be difficult in inflation times
when prices are subject to large price increases within short periods.
Labour
Target cost should allow for any expected idle time that occurs during the manufacturing of the
product.
Production Overheads
A target cost could be a target marginal cost or full cost. Production overheads, in some cases
make up a large portion of the total manufacturing cost and as such target cost should be based
on full cost.
N.B Activi
ty based costing can be employed to absorb costs rather than the traditional methods.

Example
A company intends to design a new product, Wedding cake; it currently estimates that in the
current market, the product could be sold for $900.00 a unit. A gross profit margin of 30% on the
selling price would be required to cover administration, marketing overheads and also make an
acceptable level of profit. A cost estimation study has produced the following estimate of
production cost for chicken lick.

Cost item
I. Direct material m1 $90/unit

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 Direct material m2 each unit would require 3kgs of material m2 but there will be a loss in
production of 10% of the material used. Material m2 cost $111.80 per kg. Direct labour –
each unit of Wedding cake will require 0,5hours of direct labour time. However, it is
expected that there would unavoidable idle time equal to 5% of total labour time paid at $190
per hour.
Production overheads –it is expected that production overheads will be absorbed to
production cost at a rate of $600 per direct labour hour for each labour hour worked
(overheads are not absorbed into cost of idle time)

Required
To calculate:
i) Expected cost per wedding cake.
ii) Target cost for wedding cake.
iii) The size of the cost gap

The following sections explain the fourth and fifth steps: the use of value engineering, kaizen
costing, and operational control.
Value Engineering
Value engineering is used in target costing to reduce product cost by analyzing the trade-offs
between different types of product functionality (different types of product features) and total
product cost. An important step in value engineering is to perform a consumer analysis during
the design stage of the new or revised product. The consumer analysis identifies critical
consumer preferences that define the desired functionality for the new product.

The type of value engineering used depends on the product’s functionality. For one group of
products including automobiles, computer software, and many consumer electronic products
such as cameras and audio and video equipment—functionality can be added or deleted
relatively easily. These products have frequent new models or updates, and customer preferences
change frequently. The manufacturer in effect chooses the particular bundle of features to
include with each new model of the product. For automobiles, this can mean new performance

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and new safety features; for computer software, it might mean the ability to perform certain new
tasks or analyses.

In contrast, for another group of products, the functionality must be designed into the product
rather than added on. These are best represented by specialized equipment and industrial
products such as construction equipment, heavy trucks, and specialized medical equipment. In
contrast to the first group, customer preferences here are rather stable.

Functional analysis,
This is another component of value engineering and is a process of examining the performance
and cost of each major function or feature of the product. The objective of the analysis is to
determine a desired balance of functionality and cost. An overall desired level of performance
achievement for each function is obtained while keeping the cost of all functions below the target
cost.

Benchmarking is often used at this step to determine which features give the firm a competitive
advantage. In a release of new software, for example, each desired feature of the updated version
is reviewed against the cost and time required for its development. The objective is an overall
bundle of features for the software that achieves the desired balance of meeting customer
preferences while keeping costs below targeted levels. In another example, auto manufacturers
must decide which performance and safety features to add to the new model.

This decision is based on consumer analysis and a functional analysis of the feature’s
contribution to consumer preferences compared to its cost. For instance, improved safety air bags
could be added, but target cost constraints could delay an improved sound system until a later
model year.

Design analysis is the common form of value engineering for products in the second group,
industrial and specialized products. The design team prepares several possible designs of the
product, each having similar features with different levels of performance and different costs.

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Benchmarking and value-chain analysis help guide the design team in preparing designs that are
both low cost and competitive. The design team works with cost management personnel to select
the one design that best meets customer preferences while not exceeding the target cost.

Target Costing and Kaizen

The fifth step in target costing is to use continuous improvement (kaizen) and operational control
to further reduce costs. Kaizen occurs at the manufacturing stage where the effects of value
engineering and improved design are already in place; the role for cost reduction at this phase is
to develop new manufacturing methods (such as flexible manufacturing systems) and to use new
management techniques such as operational control total quality management and the theory of
constraints (next section) to further reduce costs. Kaizen means continuous improvement, that is,
the ongoing search for new ways to reduce costs in the manufacturing process of a product with
a given design and functionality.

Toyota and a small number of other firms are leaders in the implementation of continuous
improvement. Toyota is using kaizen to reduce manufacturing costs on its hybrid vehicles, so
that it can bring down the premium it must now charge for these vehicles. Price is assumed to be
stable or decreasing over time for firms for which target costing is appropriate because of intense
competition on price, product quality and product functionality. These firms respond to the
competitive pressure by periodically redesigning their products using target costing to
simultaneously reduce the product price and improve their value.

Example
Solution
Production cost of chicken lick

a) Expected cost of the product $

Direct material m1 90.00
M2 (3kg*$111.80*100/90) 372.67
Direct labour- (0.5hrs*$190*100/95) 100.00
Prime cost 562.67

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 Production overheads ($600*0.5) 300.00
Expected production cost 862.67

b) Calculation of target cost

$
Selling price 900.00
Minimum expected return (30%*900.00) 300.00
Target cost 600.00

c) Cost gap = expected cost –target cost

= 862.67 - 600.00
= 262.67
 The company needs to identify ways of closing the gap.

Closing the cost gap

 Common methods of closing the gap are:
i) To redesign products to make use of common processes and components that is
already used in the manufacture of other products by the company.
ii) To discuss with key suppliers on the methods of reducing material costs.
iii) To eliminate non value added activities or non value added features of the product
design.
iv) To train staff in more efficient techniques .improvement in these reduces costs.
v) To achieve economies of scale (buying and producing in bulk.
vi) To achieve cost reduction as a result of the learning curve effect that is through
experience curve effect.

Advantages of target costing

i) It helps to improve the understanding within a company of product cost and. recognizes that
the most effective way of reducing costs is to plan and control cost from the design stage
onwards.

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ii) Increases customer satisfaction, as design is focused on customer values and hence reduces
costs, through more effective and efficient designs.
iii) Helps the firm achieve desired profitability on new or redesigned products and as such can
decrease the total time required for product development, through improved coordination of
design, manufacturing, and marketing managers.
iv) it can help provide a competitive edge in times of economic recession, as well as improve
overall product quality, as the design is carefully developed and manufacturing issues are
considered explicitly in the design phase.
v) It helps to create a focus on the final consumer for the product or service because of the
concept of value.
vi)It can be used together with recognized methods for reducing costs such as JIT, process
engineering, and total quality management.

Implications of target costing

Target costing can be used with the pricing policy for a company or service.
It assists in cost control and performance measurement that is
i) Cost savings are actively sought and made continuously over the product ‘life cycle.
ii) There is joint responsibility for achieving benchmarking that is if one department fails to
deliver the cost saving expected, other departments may find ways to achieve the savings.
iii) Staff are trained and empowered to find ways of reducing costs while maintaining
product quality.
NB Target costing is likely to succeed in company where there is a culture of continuous
improvement.
Limitations
1. It is sometimes unrealistic hence unachievable targets are set.
2. May demotivate workers if they fail to meet their targets.

Practice questions
1. Practice questions
Triple E Ltd. manufactures a range of electronics products. Technical staff recently developed a
design for a new type of in-car music player which can be used to play DVDs, digital downloads,

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and cassette tapes. The board of the company has asked the marketing, financial, and production
directors to evaluate the design before a decision is made as to whether to begin production of
the music player.

The marketing director has suggested that $90.00 would be a suitable selling price for the music
player and that 600 units per annum would be sold at this price. Variable selling costs would
amount to $10 per unit sold.

The financial director has estimated that the new capital equipment required in order to
manufacture the music player would cost $300 000. The company requires an annual return on
investment (ROI) of 8% on all capital investments.

The production director has not yet finalized her estimate of the cost of manufacturing the music
player.

However she has commented that the design has certain features which are likely to add to the
complexity and cost of the manufacturing process without significantly enhancing the
attractiveness of the product to potential customers.

REQUIRED:

(a) Using the data provided above, calculate the target cost of manufacturing the music player,
and explain fully the significance of this figure.

(10 marks)

(b) Assume now that the production director has estimated the cost of manufacturing the music
player (using the recently-developed design) at $60,00 per unit and has suggested that the
company should accept a reduced ROI if necessary. Calculate the ROI if this suggestion is
accepted and comment on the production director’s suggestion. (7 marks)

(c) It is often stated that target costing is most likely to be effective when products are still at the
design stage (i.e., before any production begins) and when comprehensive information about cost
driver rates is available from the company’s accounting system. Explain why this is so. (8 marks)

[Total: 25 marks]

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2. Taiseki Engineering Ltd. manufactures specialized engineering products. The items produced
are of high quality but are fragile by nature and therefore the packaging process must be carried
out with some care.

The company’s product development staff recently completed design work on a new product (the
Pump). Comparison with competitors’ products indicates that $20 per unit is a realistic selling
price for the Pump. The company requires a 35% margin on selling price from all products in
order to ensure an adequate companywide return on investment. Production and sales of Pump
are estimated at 13,000 units per annum.
According to the design specifications, the Pump is to be produced in batches of 500 units and
packaged in batches of 25 units. Overhead costs amount to $2000 for each batch of 500 units
produced and a further $125 for each batch of 25 units packaged.

The design specifications also indicate that the manufacture of each unit of Pump will require 3
units of Component 1 and 5 units of Component 2. Component 1 is a new item which Taiseki
Engineering Ltd. will have to manufacture at a cost of $0.20 (variable) each plus $4,000 for each
batch of 10,000 units of this component.

Component 2 is used regularly by the company and can be purchased in any desired quantity
from a reliable supplier for $0.55 each. The labour cost of fitting these components in the
manufacture of Pump is estimated at $0.45 per unit of Component 1 and $0.15 per unit of
Component 2.

REQUIREMENT:
(a) Prepare calculations to indicate whether Taiseki Engineering Ltd. will achieve the target cost
for the Pump on the basis of the data provided. (9 marks)
(b) Now assume that a “target costing task force” has suggested the following changes in order to
help reduce the cost of the Pump:
_ Increase the production batch size so that each year’s total output of Pump would be produced
in just 24 batches;

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_ Increase the packaging batch size to 75 units of Pump;
_ Modify the design of the Pump, such that 2 units of Component 1 would be replaced by the
same number of units of Component 2 in each Pump.
Calculate the total annual cost savings if all of these changes are implemented, and indicate
whether the target cost would be achieved. (10 marks)
(c) The Managing Director points out that no consideration has been given to the cost of
delivering the product to customers. Discuss whether the company needs to give consideration to
delivery costs as part of the target costing exercise. (N.B. Calculations are not required in your
answer to this part). (6 marks)
[Total: 25 marks]
Question 3
The Parirenyatwa Group Hospital (PGH) provides the entire healthcare service to residents in
Zimbabwe. The PGH is funded centrally through revenues from taxpayers. However, the
government is not involved in the day-to-day running of the PGH, which is largely managed
regionally by a number of self-governing trusts, such as the Pari Trust. The Pari Trust runs one
hospital in Harare and, like other trusts in Zimbabwe, receives 70% of its income largely from
the PGH’ ‘payments by results’ scheme, which was established two years ago. Under this
scheme, the trust receives a pre-set tariff (fee income) for each service it provides. If the Trust
manages to provide any of its services at a lower cost than the pre-set tariff, it is allowed to use
the surplus as it wishes. Similarly, it has to bear the cost of any deficits itself.

Currently, the Trust knows that a number of its services simply cannot be provided at the tariff
paid and accepts that these always lead to a deficit. Similarly, other services always seem to
create a surplus. This is partly because different trusts define their services and account for
overheads differently. Also, it is partly due to regional differences in costs, which are not taken
into account by the scheme, which operates on the basis that ‘one tariff fits all’. The remaining
30% of the Trust’s income comes from transplant and heart operations. Since these are not
covered by the scheme, the payment the Trust receives is based on the actual costs it incurs in
providing the operations. However, the Trust is not allowed to exceed the total budget provided
for these operations in any one year.

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Over recent years, the Trust’s board of directors has become increasingly dissatisfied with the
financial performance of the Trust and has blamed it on poor costing systems, leading to an
inability to control costs. As a result, the finance director and his second in command – the
financial controller – have now been replaced. The board of directors has taken this decision
after complaining that ‘the Trust simply cannot sustain the big deficit between income and
spending’. The new financial controller comes from a manufacturing background and is a great
advocate of target costing, believing that the introduction of a target costing system at the Pari
Trust is the answer to all of its problems. The new financial director is unconvinced, believing
target costing to be only really suitable in manufacturing companies.

Required:
(a) Explain the main steps involved in developing a target price and target cost for a product in a
typical manufacturing company. (6 marks)
(b) Explain four key characteristics that distinguish services from manufacturing. (4 marks)
(c) Describe how the Pari Trust is likely, in the current circumstances, to try to derive: (i) a target
cost for the services that it provides under the ‘payment by results’ scheme; and (2 marks) (ii) a
target cost for transplants and heart operations. (2 marks)
(d) Discuss THREE of the particular difficulties that the Pari Trust may find in using target
costing in its service provision. (6 marks)
(20 marks)

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Chapter 2
PRODUCT LIFE CYCLE COSTING /WHOLE LIFE CYCLE COSTING
LIFE CYCLE COSTING

Life Cycle Costing is the accumulation of costs for activities that occurs over entire life cycle of
a product from the inception to the abandonment by the manufacturer and consumer. It focuses
on total cost (capital cost + revenue cost) over the products life including design, development,
acquisition, operation, maintenance and servicing. Service costs include marketing, distribution,
administration and after-sales service costs.

CIMA defines life cycle costing as the practice of obtaining over their life time, the best use of
physical asset at the lowest cost of entity. The term ‘Life Cycle Cost’ has been defined as
follows, “it includes the costs associated with acquiring, using, caring for and disposing of
physical asset including the feasibility studies, research, design, development, production,
maintenance, replacement and disposal as well as support, training and operating costs generated
by the acquisition use, maintenance and replacement of permanent physical assets.”

Life cycle costing is especially important in industries that face rapid technological or style
changes. Periodic external financial statements may make a product appear to be worthwhile,
because its development costs were initially expensed. But, in total, the company may have not
even have recovered its original investment. Over the product or service life cycle, companies
need to be aware of and attempt to control the total cost of making a product or providing a
service.

Product Life Cycle

First referenced in the 1920s, the product life cycle applies biological knowledge to products. In
nature, a seed is planted begins to sprout, becomes an adult then eventually withers away and
dies. Life cycle focuses on introduction (seed), growth (sprout), maturity (tree) and decline
(death) phases. Each phase has its own marketing mix strategy and implications regarding
product, price, distribution and promotion.

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All products and services have certain life cycles. The life cycle refers to the period from the
product’s first launch into the market until its final withdrawal and it is split up in phases.
During this period significant changes are made in the way that the product is behaving into the
market i.e. its reflection in respect of sales to the company that introduced it into the market.
These phases exist and are applicable to all products or services from a certain make of
automobile to a multimillion-dollar lithography tool to a one-cent capacitor.

These phases can be split up into smaller ones depending on the product and must be considered
when a new product is to be introduced into a market since they dictate the product’s sales
performance. Since an increase in profits is the major goal of a company that introduces a
product into a market, the product’s life cycle management is very important.
.

Sometimes, the life cycle concept applies to a brand or category of product. Fad (fashion) items
have a cycle of a few months, but some categories, such as the gasoline automobile, will be
around for at least a century. During its incubation period, the product is developed and
perfected. There are no sales during this preparatory period, but the manufacturer prepares for
the product’s introduction into the marketplace. Every product has a life cycle that is a period of
time during which it appeals to the consumer, i.e. it sells.

But during the period of the Product Life Cycle sales are not constant, there are variations in
levels of demand, the amount of competition in the market place, consumer understanding and
liking of the product and the share of the market the product captures.

Five stages of a product life cycle are:

Introduction.
Growth.
Maturity.
Saturation
Decline.

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The stages of the product life cycle:

Introduction:

The product is new to the market, few potential consumers know of its existence. Price can be
high, (for example new computer games) and sales may be restricted to early adopters (those
consumers that must have new technology, gadgets, or fashions first). Profits are often low or
losses are being made, this is because development costs have to be repaid, and advertising
expenditure can be high. Some products are introduced to the market in a splash of publicity,
hoping to capture as large a market share as soon as is possible.

Growth:

The product is becoming more widely known and consumed. Marketing is used to try to
establish or strengthen the brand and develop an image for the product. Profits may start to be
earned, but advertising expenditure is still high. Prices may fall as the first competitors enter the
market.

Maturity:

The product range may be extended, by adding both width and depth. Competitions will
increase and this has to be responded to. Advertising should be used to rein-force the images of
the product in the consumer’s minds. Sales are at their peak, profits should be high.

Saturation: Very few new customers are gained, replacement purchases are the trend. Firms
should try to reduce their costs, so that pricing strategies can be more flexible. Brand image
should be maintained, and in so doing full value is taken from the brand. Alternatively the brand
can move down market, capturing new markets, or market niches, but this should not be done at
the expense of quality. Profits may be maintained, but can start to fall.

Decline: Sales can now fall fast, and as a result the range sold is likely to be reduced, with the
firm concentrating on core products. Advertising costs will be reduced, and attempts will be
made to mop-up what is left of the potential market. Each product sold could be quite profitable
as development costs have been paid back at an earlier stage in the life cycle. But overall, total
profits will fall. Price is also likely to fall, but by concentrating on remaining market niches there
should be some price stability.

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Life cycle cost Stages
Cost of a product or asset over its useful life can be categorized into 3 namely:
1) Acquisition costs
This represents the first stage of costs and covers set up costs or market entry costs. Costs are
incurred initially to bring the product into production and start selling it or the costs incurred to
complete the construction of a building or other construction assets. Acquisition /setup costs are
mainly’ one-off’, or are once –off capital expenditure and once off only costs such as cost of
training staff ,establishing systems of documentation and performance report. It should also be
noted that end –of –life costs are also once –off costs that is they occur just once.

2) Operational costs or running costs

These are costs incurred throughout the life of the asset or product. Examples of such costs are
repairs and maintenance, advertising e.t.c. Running costs and operational costs are regular and
recurring annual costs throughout the life of the product or asset. However, these costs may vary
overtime for example maintenance and repair cost of equipment such as elevators in a building
industry which are likely to increase as equipment ages.
3) End of life costs
Costs incurred to withdraw a product from the market or to demolish the asset after its use full
life.
N.B Although costs are incurred throughout the life span of an asset, a large proportion of these
costs are incurred or committed at a very early stage of the product’s life cycle when the decision
to develop the new product or construct a new building is made.

Example on apportioning lifecycle costs.

Romantic ltd specializes in the manufacture of invertors .It is planning to produce a new inverter
specially designed for small houses. Development of the new inverter is to begin shortly and
Romantic ltd is in the process of determining the price of the inverter. It expects the new product
to have the following costs;
Year 1 2 3 4
Units manufactured 300 1200 1800 700
$ $ $ $
Research and Development 18 000 20 000 ------- --------

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 Marketing costs 1500 500 250 150
Production cost/unit 65 45 35 30
Customer service cost/unit 4 3 3 3
Disposal specialist equipment 350

The marketing Director believes that customers would be prepared to pay $48 for an inverter but
the Financial Director believes this will not cover all the costs throughout the products ‘life
cycle.
Required
Calculate the cost /unit on the whole life cycle and comment on the suggested price.

Benefits and Limitation of Product Life Cycle

In marketing terms, a product’s life cycle consists of its introduction, growth, maturity and
decline, as measured in changes in sales and market share over time. The product life cycle
concept postulates that even the most successful products may lose their appeal eventually due to
forces such as changing consumer demand or technological obsolescence. Adhering to a product
life cycle concept offers potential advantages and disadvantages for companies:

Planning

A benefit of following a product life cycle concept is that it helps companies in the planning
process. Realizing that the demand for a product typically does not last forever helps it prepare
for the inevitable decline in sales. The company gains a better idea of how to allocate marketing
funds in accordance with the phase of the cycle the product has entered. Knowing that it will
need to replace even a successful product at some point can also lead to a greater focus on
product development and innovation.

Proactive Approach

Another positive effect of the product life cycle is that rather than sitting back and waiting for the
ultimate demise of a product, it allows companies to take a more proactive approach to
maximizing sales and profits during each stage. For instance, if management recognizes that a
product is beginning to decline, it can attempt to squeeze out profits by eliminating unprofitable
distribution channels to minimize expenses as sales continue to wane.

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Unreliability

On the downside, a product life cycle is not always a reliable indicator of the true lifespan of a
product and adhering to the concept may lead to mistakes. For example, a dip in sales during the
growth stage may only be a temporary lull instead of a sign the product is reaching maturity. If
the dip causes a company to reduce its promotional efforts too quickly, it may limit the product’s
growth and prevent it from becoming a true success.

False Assumptions

Another possible drawback is that unlike the inevitable life cycle of a human being, the
occurrence of a product life cycle is not a certainty. Changes in market conditions or consumer
tastes or the introduction of a similar product by the competition can render planning based on a
predicted product life cycle totally useless. There is no guarantee that a product will even make it
out of the introduction stage, or it may move through the cycle more rapidly or slowly than
anticipated.

Pricing
As the product moves from one stage in its life cycle to the next ,a change in the pricing strategy
might be necessary to maintain market share for example as the product enters maturity prices
can be reduced. In addition, an understanding of the life cycle helps strategic decisions about the
price. Over the life cycle of the product, sales price should be sufficiently high to ensure that a
profit is made after taking into account start –up until withdrawal.
Performance Management
As the product moves from one stage to the other, financial performance will change.
Management should understand that an improvement or decline of performance could be linked
to the changes in the life cycle and therefore should act accordingly.

Decision making
In addition to helping management with decisions on pricing and understanding life cycle
costing, it can also help with decisions about making investments in the product (new capital
investment expenditure) or withdrawing the product.
Implications of using whole life cycle costing are as follows:

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By using this method, we consider all costs incurred in the manufacturing of the product, which
is different from the traditional methods which concentrate on the internal costs only. Research
and Development costs are written off as they are incurred. Profits are measured on a
time/annual basis rather than on whole life under traditional methods.

Non –production overheads are not linked to products but written off as general expenses under
traditional methods. However, life cycle costing compares the revenues and cost of the product
over its entire life and the benefits accruing there from are;
i) Potential profitability of products can be assessed before major development of the product is
carried out and the costs are incurred thereby enabling elimination of non-profitable products.
ii) Techniques can be used to reduce costs over the life of the product.
iii) The pricing strategy can be determined before the product enters production. This may lead
to better control of marketing and distribution costs.
iv) It also enables attention to be focused on reducing research and development costs
of the organisation to get the product to the market as quickly as possible.
v) By monitoring the actual performance of products against plans, lessons can be learnt to
improve the performance of future products and it may also be possible to improve the
estimating techniques.

NB. An understanding of the product life cycle can also assist management with decisions about
pricing, performance management and decision making.

Practice questions
Fit Co specialises in the manufacture of a small range of hi-tech products for the fitness market.
They are currently considering the development of a new type of fitness monitor, which would
be the first of its kind in the market. It would take one year to develop, with sales then
commencing at the beginning of the second year. The product is expected to have a life cycle of
two years, before it is replaced with a technologically superior product. The following cost
estimates have been made.
Year 1 Year 2 Year3

Units manufactured and sold 100,000 200,000

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Research and development costs $160,000
Product design costs $800,000
Marketing costs $1,200,000 $1,000,000 $1,750,000
Manufacturing costs: Variable cost per unit $40 $42
Fixed production costs $650,000 $1,290,000
Distribution costs: Variable cost per unit $4 $4·50
Fixed distribution costs $120,000 $120,000
Selling costs: Variable cost per unit $3 $3·20
Fixed selling costs $180,000 $180,000
Administration costs $200,000 $900,000 $1,500,000

Note: You should ignore the time value of money.

Required:
(a) Calculate the life cycle cost per unit. (6 marks)
(b) After preparing the cost estimates above, the company realises that it has not taken into
account the effect of the learning curve on the production process. The variable manufacturing
cost per unit above, of $40 in year 2 and $42 in year 3, includes a cost for 0·5 hours of labour.
The remainder of the variable manufacturing cost is not driven by labour hours. The year 2 cost
per hour for labour is $24 and the year 3 cost is $26 per hour. Subsequently, it has now been
estimated that, although the first unit is expected to take 0·5 hours, a learning curve of 95% is
expected to occur until the 100th unit has been completed.

Calculate the revised life cycle cost per unit, taking into account the effect of the learning curve.
Note: the value of the learning co-efficient, b, is –0·0740005. (10 marks)
(c) Discuss the benefits of life cycle costing. (4 marks)
(20 marks)

Question 2
Makudo Co manufactures webcams, devices which can provide live video and audio streams via
personal computers. It has recently been suffering from liquidity problems and hopes that these
will be eased by the launch of its new webcam, which has revolutionary audio sound and visual
quality. The webcam is expected to have a product life cycle of two years. Market research has

21
already been carried out to establish a target selling price and projected lifetime sales volumes
for the product. Cost estimates have also been prepared, based on the current proposed product
specification. Makudo Co uses life cycle costing to work out the target costs for its products,
believing it to be more accurate to use an average cost across the whole lifetime of a product,
rather than potentially different costs for different years. You are provided with the following
relevant information for the webcam:

Projected lifetime sales volume 50,000 units

Target selling price per unit $200
Target profit margin (35% selling price) $70
Target cost per unit $130
Estimated lifetime cost per unit (see note below for detailed breakdown) $160

Note: Estimated lifetime cost per unit:

$ $

Manufacturing costs Direct material (bought in parts) 40

Direct labour 26
Machine costs 21
Quality control costs 10
Rework costs 3 100
Non-manufacturing costs
Product development costs 25
Marketing costs 35 60
Estimated lifetime cost per unit 160
The average market price for a webcam is currently $150.
The company needs to close the cost gap of $30 between the target cost and the estimated
lifetime cost.
The following information has been identified as relevant:
1. Direct material cost: all of the parts currently proposed for the webcam are bespoke parts.
However, most of these can actually be replaced with standard parts costing 55% less. However,
three of the bespoke parts, which currently account for 20% of the estimated direct material cost,
cannot be replaced, although an alternative supplier charging 10% less has been sourced for
these parts.

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2. Direct labour cost: the webcam uses 45 minutes of direct labour, which costs $34·67 per hour.
The use of more standard parts, however, will mean that whilst the first unit would still be
expected to take 45 minutes, there will now be an expected rate of learning of 90% (where ‘b’ =
–0·152). This will end after the first 100 units have been completed.
3. Rework cost: this is the average rework cost per webcam and is based on an estimate of 15%
of webcams requiring rework at a cost of $20 per rework. With the use of more standard parts,
the rate of reworks will fall to 10% and the cost of each rework will fall to $18.

Required:
(a) Recalculate the estimated lifetime cost per unit for the webcam after taking into account
points 1 to 3 above. (12 marks)
(b) Explain the ‘market skimming’ (also known as ‘price skimming’) pricing strategy and
discuss, as far as the information allows, whether this strategy may be more appropriate for
Makudo Co than charging one price throughout the webcam’s entire life. (8 marks)
(20 marks)

Chapter 3
ACTIVITY BASED COSTING (ABC)
 It is a costing approach that analyses all activities to identify what drives costs incurred
that is what causes costs to increase.
 The major ideas behind ABC are:
 Activities cause costs—these activities include ordering materials, handling,
dispatching etc
 It believes that it is the products that create demand for the activities.
 Costs are assigned to products on the basis of the product’s consumption of
the activities.
NB In ABC:
 Some manufacturing costs may be excluded from product costs.

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  Non manufacturing overheads as well as manufacturing costs may be assigned to
products.
 Overhead /activity rates are based on the activity level at capacity rather than on
budgeted levels. An activity is an event that causes the consumption of overhead
resources.
 A number of overhead cost pools, each allocated to products and other costing
methods /objects using its own unique measure of activity.

Cost driver
 This is a factor that directly influences cost over a relevant range of activity. This could
be number of orders, number of production runs, number of dispatches, labour hours and
machine hours.

Cost Pool
 This is a bucket in which costs are accumulated that relate to the single activities.

Reasons for the development of Activity Based Costing

 Activity Based Costing was developed to overcome the inability of absorption costing to
deal with the features of modern manufacturing methods.
 This was re –necessisted as a result of growth of overheads and the advent of advanced
manufacturing technology (AMT) that reduce the importance of labour.
 The traditional methods failed to take into account the increasing complexity of modern
manufacturing method.
 The modern approaches are characterized by:
 An increased amount of overheads as a proportion of total cost.
 An increase in the cost of service support functions which assist in the
manufacturing of a wide range of goods and services that are unaffected by
changes in production volume varying instead with the range and complexity of
the products.

Shortfalls of the Traditional Methods (Absorption)

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  It implied that all overheads were related primarily into production volume.
 These were developed at time when organisations produced a narrow range of overheads
and these overheads formed a small fraction of total costs.
 The traditional approach tends to allocate too great a proportion of overheads to high
volume products and a too small proportion of overheads to low volume products.

Steps in Activity Based Costing

 Identify an organisation’s major activities.
 Identify the cost drivers for each major activity for example:
Activity cost driver
Ordering number of orders made
Material handling number of material movements
Production scheduling production runs
Dispatching number of dispatches etc
 Collect the cost associated with each activity into cost pools.
 Charge the activity cost to products on the basis of the number of activity depending on
the product’s demand for activities.

Example 1
Kanga Ltd. is a small but growing engineering group. Corporate guidelines indicate that no new
product should be introduced to the product range unless the anticipated rate of return over the
product lifecycle exceeds the company’s cost of capital.
Research and Development (R & D) staff at Kanga Ltd. recently carried out design work on
three proposed new products. Following consultation between R & D and marketing staff, the
following summary information is available:
_ Direct labour hours per unit of output:
Product X Product Y Product Z
2 7 5
_ Production and sales quantities per month:
Product X Product Y Product Z

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 9,500 9,000 11,000
_ Total monthly overhead activity and costs in producing the three products:
Cost per month Level of cost driver activity
Cutting operations $12500 2500 per month
Materials movements $9600 160 per month
Production set-ups $7200 15 per month

A target costing team established by Kanga Ltd. reviewed the data from the R & D staff. The
marketing staff warned that none of the three products will be adequately profitable, given the
expected market conditions and the cost of manufacturing the products using the proposed
design.
In an attempt to improve profitability, the target costing team subsequently worked with the R &
D staff to redesign Products Y and Z. The marketing staff confirmed that these design
modifications will have no effect on demand for the finished products. The reductions in
monthly activity levels as a result of these design changes are expected to be as follows:

Effect of design changes: Effect of design changes:

Product Y Product Z
Reduction in number of cutting operations 114 200
Reduction in number of materials movements 30 34
Reduction in number of production set-ups 2 1
It was found to be impossible to make any changes to the design of Product X.
REQUIRED:
(a) Assume that the proposed design changes will be implemented. Calculate the resulting
reduction in the unit cost of each of the company’s products in the following circumstances:
_ If all overheads are traced to products using activity-based costing.
_ If all overheads are allocated to products on a direct labour hour basis. (12 marks)
(b) Explain (using the example of Kanga Ltd. to illustrate your answer) why an activity based
costing system is essential for the implementation of target costing. (5 marks)
(c) A junior member of management at Kanga Ltd. has suggested that the company could expand
its product range more quickly by eliminating the requirement that no new product should be

26
introduced to the product range unless the anticipated rate of return over the product lifecycle
exceeds the company’s cost of capital. Comment on this suggestion. (3 marks)
[Total: 25 marks]

Advantages
 ABC focuses attention on the real nature of cost behavior and hence helps in reducing
cost and identifying activities which do not add value to the product.
 More realistic as the product costs are provided and overhead cost traced to the product.
 It is flexible enough to trace costs and processes, customer areas of responsibility as well
as product cost.
 Activity Based Costing recognizes the complexity and diversity of modern production by
use of multiple cost drivers many of which are transaction based rather than based solely
on production volumes.
Disadvantages
 The chosen cost driver may not be an adequate of the complexity of activities.
 The assumption of a direct linear relationship between the usage of a cost driver and the
amount of overheads can be untrue.
 ABC system is very complex due to numerous cost pools and cost drivers and hence it
can be expensive to operate.

Practical exercises
Question 1
Renco Ltd. manufactures a range of products, most of which have short product lifecycles.
Research and development staff recently designed three new products which would be
manufactured in a single production cell of the company’s factory. The combined monthly
manufacturing overhead costs of the three products are summarized as follows:

Production set-ups (10 per month) $2000

Materials movements (400 per month) $18000
Repairs (4000 per month) $30000
Total manufacturing overheads per month _50000

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The following information is available concerning the three new products:
Product A Product B Product C
Production & sales, per month 2,000 units 5,000 units 1,000 units
Direct labour hours per unit 6 4 8

The company’s target costing task group expressed the view that the new products would not be
profitable given the likely market prices and the cost of manufacturing the products using the
proposed design. In response, the product designers indicated that no design changes were
possible in relation to Products A or B, but that changes in the design of Product C would bring
about the following reductions in the amount of monthly activity involved in manufacturing that
product without compromising either the quality or quantity of output:

Production set-ups Materials movements Repairs

2 per month 100 per month 1,000 per month
REQUIRED:
(a) Calculate the reduction in the cost per unit of each of the three products which would
occur as a result of the design changes to Product C, in each of the following
circumstances:

 If manufacturing overheads are traced to products using activity-based costing (ABC);

 If manufacturing overheads are allocated to products on a direct labour hour basis.
(10 marks)
(b) Discuss the view that an ABC system is essential for the implementation of target costing,
using Renco Ltd. Case illustrate your answer.
(5 marks)

Question 2

Makudo ltd assembles three models of a bicycle at the same factory: the Kid Mountain, The
Lady Mountain and The Male Mountain, It sells the bicycles throughout the world. In response

28
to market pressures Makudo ltd has invested heavily in new manufacturing technology in recent
years and, as a result, has significantly reduced the size of its workforce.

Historically, the company has allocated all overhead costs using traditional total direct labour
hours, but is now considering introducing Activity Based Costing (ABC). Makudo ltd’s
accountant has produced the following analysis:

Annual output Annual direct Selling price Raw material

(units) labour hours ($ per unit) cost ($ per unit)

The Kid Mountain 2000 200 000 4000 400

The Lady Mountain 1600 220 000 6000 600
The Male Mountain 400 80 000 8 000 900
The three cost drivers that generate overheads are:

Deliveries to retailers – the number of deliveries of Bicycles to retail showrooms;

Set-ups – the number of times the assembly line process is re-set to accommodate a production
run of a different model of Bicycles;

Purchase orders – the number of purchase orders.

The annual cost driver volumes relating to each activity and for each model of motorcycle are as
follows:

Number of Number of set-ups Number of purchase

deliveries to retailers orders
The Kid Mountain 100 35 400
The Lady Mountain 80 40 300
The Male Mountain 70 25 100
The annual overhead costs relating to these activities are as follows:

$000

Deliveries to retailers 2,400

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Set-up costs 6,000

Purchase orders 3,600

All direct labour is paid at $5 per hour. The company holds no inventory.

Required:

(a) Calculate the total profit on each of Makudo Ltd.’s three models using the existing method of
allocating overheads based on labour hours. (5 marks)

(b) Recalculate the total profit on each of Makudo Ltd’s three models using activity based
costing. (10 marks)

(c) Evaluate the labour hours and the activity based costing methods in the circumstances of
Makudo Ltd (5 marks)

(20 marks)

Question 3

E and E Co produces three products, X, Y and Z, all made from the same material. Until now, it
has used traditional absorption costing using labour hours to allocate overheads to its products.

The company is now considering an activity based costing system in the hope that it will
improve profitability. Information for the three products for the last year is as follows:

X Y Z
Production and sales volumes (units) 15000 12000 18000
Selling price per unit $ 7.50 12 13
Raw material usage (kg) per unit 2 3 4
Direct labour hours per unit 0.1 0.15 0.2
Machine hours per unit 0.5 0.7 0.9
Number of production runs per annum 16 12 8
Number of purchase orders per annum 24 28 42
Number of deliveries to retailers per annum 48 30 62
The price for raw materials remained constant throughout the year at $1·20 per kg. Similarly,
the direct labour cost for the whole workforce was $14·80 per hour. The annual overhead costs
have been analyzed by activity as follows:

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 $

Machine set up costs 26,550

Machine running costs 66,400

Procurement costs 48,000

Delivery costs 54,320

Required:

(a) Calculate the full cost per unit for products A, B and C under traditional absorption costing,
using direct labour hours as the basis for apportionment. (5 marks)

(b) Calculate the full cost per unit of each product using activity based costing. (9 marks)

(c) Using the information given and your calculation from (a) and (b) above, explain how
activity based costing may help Gadget Co improve the profitability of each product. (6 marks)

(20 marks)

Activity Based Management

 Refers to the use of activity costing to improve management’s decisions to satisfy

customers and improve profitability.
 Areas include pricing and product mix decisions, cost reductions and business re-
engineering process.
 Development in ABC has shown a movement away from mere collection and analysis of
cost for management purposes to cost management systems whose characteristics are :
 Determination of cost of resources used up on undertaking the organisation
‘major activities.
 The identification and elimination of activities which do not add value to the
organisation’s product and services.
 A critical analysis of efficiency and effectiveness of the activities carried out in
the organisation.

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  Identification and evaluation of new activities which can prove the overall
profitability of the organisation.

Chapter 4

THROUGHPUT ACCONTING
 It is the rate of conversion of raw materials and purchased components into products sold
to customers.

Constraints and Bottle necks in the system

 Throughput accounting originated from the theory of constraints (TOC) which is based
on the view that every system has a constrain (anything that limits our ability to achieve
what you want to achieve)
 If a system had no constraints, its output would be either zero or the system would
continue to produce more and more without any limits.

32
  Therefore for any system whose output is not zero, there must be a constraint that stops it
from producing more output than it does.

Reasons for Constraints

 External factors such as limits to customer demand on products produced by the
organisation.
 Weaknesses in the system s controls that is weak management.
 Weaknesses in the system such as shortages on key resources (materials) or capacity.
 In-a manufacturing system, constraints are referred to as bottlenecks. A bottle neck is
simply a constraint that limits the output of an organisation(material ,labour and capacity)

Dealing with constraints

 Management of the business operations should focus on dealing with key constraints by
identifying what they are.
 Action by management to improve operational efficiency is a waste of time and efforts
if it is applied to any area of operations which is not a constraint.
 The key constraints limits through put since this could be a limitation in sales demand,
inefficiency production, unreliable suppliers or shortage of key resources of production.
 Godraft developed the theory of constraints .He argued that :
1. Management should identify the key constraints and consider way of removing or easing the
constraint so the system is able to produce more output.
2. When one constraint is moved, another key constraint will take place so management must be
aware of that.
3. The new key constraint must be identified and management should now turn its attention to
way of reducing / removing its key constraint.
4. By removing constraints one by one, the output of the org will improve.

RELEVANCE OF TOC IN THROUGHPUT A/C

Godratt argued that if the aim of the business is to make money and profit ,then the appropriate
method to do so are :
1. Increase the throughput

33
2. Reduce operating expenses
3. Reduce investment [money invested in inventory-can be reduced by reducing the level of
inventory] .
4.Godratt argued also that the most effective way of increasing profit is to increase throughput
and it can be increased by identifying bottlenecks and ease them .

THOUGHPUT ACCOUNTING

Assumptions
1. In traditional marginal costing it is assumed that direct labour cost are variable costs where as
in throughput it is termed a fixed cost since employees are paid on a continuous basis.
2. The only variable cost is the purchase of raw materials which comes from external suppliers.
3. A business makes real profit by value addition.
4. Value added should be measured as the value of sales minus the variable cost of sales.

THROUGHPUT INVENTORY AND OPERATING EXPENSES

Throughput accounting is based on these three (3) major items, that is, the throughput itself, inventory
and operating expenses.
 Therefore throughput is the rate at which the entity achieve its goal measured in goal
units :
 Thus throughput =sales –total variable cost (The variable cost is the sum of materials
and any other components.
NB. Throughput is only created when all inventories are sold
The Operating expenses
These are the expenditures incurred to produce output and it consists of labour and any other
fixed cost incurred by the organisation.
 Therefore profit in throughput accounting is measured as:
Throughput –operating expenses
$
Sales xxx
Variable cost (material) ( xx)
Through put xxx

34
 Less operating expenses (x)
Profit x

VALUE OF INVENTORY IN THROUGHPUT

 Inventories do not have value except the variable cost of the materials and components.
 Work in progress and finished goods is only money invested that cost of purchase of the
raw materials is the value and nu value addition occurs until they are sold.
 Thus, in throughput accounting, all inventories are valued at the cost of raw materials and
components.
 The variable cost should not include the cost of labour as no value addition takes place
by producing but only when items are sold.

Example -Comparison of throughput and traditional costing

 A company produces 1000units of a product during the month of June and sells 800units
for $32000. There was no opening inventory .Cost of production were as follows:
$
Direct labour 8000
Raw materials 6000
Fixed production overheads 10 000
Other Non-production overheads 5000

Required
To calculate the profit of the period using:
a)absorption costing
b) Marginal costing
c) Throughput accounting
NB. Assume for the absorption that the budgeted and actual overheads were the same and there
are no under/over absorption of overheads.

Example

35
 Solution
Comparison of costing methods
Absorption Marginal throughput
$ $ $
Sales 32 000 32 000 32 000
Less cost of production
Opening inventory - ------- ------ -------
Add production cost
Direct material cost 6000 6000 6000
Direct labour 8000 8000 -----
Prime cost 14000 14000 6000
Add fixed overheads 10000 ---- ---
Production cost 24000 14000 6000
Less closing inventory (200/1000*24000 4800 2800 1200
Cost of sales (19200) (11200) (4800)
Profit/contribution/throughput 12 (5000) (5000) (5000)
Fixed production overheads ---- (10000) (10000)
Direct labour ---- ---- (8000)
Profit 7800 5800 4200
Criticisms of throughput
 It concentrates on the short –term when a business has fixed supply of resources and
operating expenses that are largely fixed.
 It is more difficult to apply throughput accounting concepts to longer term when all costs
are variable and vary with the volume of production and sales or any other cost driver.
 In the longer term ABC might be more appropriate for measuring and controlling
performance.

How to improve throughput accounting

 Increase sales price for each unit sold so as to increase throughput per unit.
 Reduce total operating expenses to reduce cost per assembly.
 Reduce material cost per unit by changing material or switching suppliers.

36
  Improve the productivity of the assembly workforce and reduce the time required to
make each unit of the product.
 Throughput per assembly hour would increase but the expenses per assembly hour would
be unchanged therefore the throughput would increase.

PERFORMANCE MEASUREMENT RATIOS IN THROUGHPUT ACCOUNTING

KEY PERFORMANCE MEASUREMENTS
*net profit – total throughput minus operating expenses

Major objective is to increase net profit

*return on investment
*throughput per unit of the bottleneck resource
*operating expenses per unit of the bottleneck resource
*throughput accounting ratio

*ROI (returns on investment)

- It is measured a = net profit *100%
Investment

-the objective is to increase return on investment, either by increasing net profit or reducing the
size of the investment.

THROUGHPUT PRODUCTIVITY
Is measured as: throughput * 100%
Operating expenses

The major goal is to increase throughput productivity either by increasing throughput or reducing
operating expenses.

THROUGHPUT PER UNIT OF CONSTRAINT

37
The advantage is that labour is treated as a fixed cost. Thus in line in that where production
process has been automated, directed labour costs becomes less important to total production
costs. Unlike traditional approaches

THROUGHPUT ACCOUNTING RATIO

Is the ratio of (throughput in a period per unit of bottleneck resources to [operating expenses per
unit of bottleneck resource)

Thus throughput accounting ratio = throughput per hour of bottleneck resources

Operating expenses per hour of bottleneck resources

EXAMPLES
Makore investments manufacture window seals, each seal selling for $20. The materials costs are
$8 per unit. Total operating expenses each month are $12 000.
Machine capacity is the key constraint on production. There are only 600 machine hours
available each month and it takes three minutes of machine time to produce each unit.

Required
a) Calculate the throughput accounting ratio
b) How might the ratio be increased

Answers
a) Throughput per unit = ($20-8) = $ 12.
Throughput per machine hour = $12 (60m/3 minutes)

Calculated contribution throughput per hour = $240

 Operating expenses per machine hour = $12 000 = $200

600 hours

Throughput accounting ratio = 240 = 1.20

38
 200
b) To increase the throughput accounting ratio, it might be possible to:
 Raise the selling price for window seals for each unit sold to increase the throughput per
unit.
 Improve the efficiency of machine time used and so manufacture units in less than 3
minutes.
 Find ways of reducing total operating expenses per machine hour.

THROUGHPUT ACCOUNTING AND DECISION MAKING

When a company can make more than one product, throughput per unit of constraint factor
can be used to rank products in order of priority for production.

Examples
Makudo investments manufactures a single product “chair “, for which the sales price is
$35.00 per unit and the material cost per unit is $7.50
Product “chair “is made in two consecutive production operations which are carried out in
Department f1 and f2. The capacity per month in each department is 6 400 hours

Conversion costs per week in each department are as follows:

Department f1 Department f2
Conversion costs per month $ 7 360 $3 200
Hours per month capacity 640 640
Conversion cost per hour $ 1.5 $ 0.50

The company is operating at full capacity and it makes and sells 400 units of product “ chair
“ each month .It has been offered an opportunity to make or sell 150 units of product “ bench
“ each month to a large customer or, who will pay $31.00 per unit. The direct material cost
per unit of product “bench “would be $ 15.00. Product “bench “would be made in
department f1 and f2 and the production time required per unit would be as follows:

Product chair product bench

39
 Hours per unit hours per unit
Department f1 16 12
Department f2 16 6

On the basis of “traditional costing “, the decision would be to reject the customer order for
1 500 units of product bench per month, because product bench would appear to make loss.
Product chair product bench
Direct materials 7.50 15.00
Conversion costs
F1 at $ 1.15 per hour 9.20 13.80
F2 at $ 0.50 per hour 8.00 3.00
Total costs per unit 24.70 31.80
Sales price 35.00 31.00
Profit/loss 10.30 (0.80)

However, this would be an incorrect decision if the goal is to maximize profit. There is currently
spare capacity in department f1, but time in department f2 is a key constraint. Profit is
maximized by maximizing throughput per hour worked in Department f2

Product chair product bench

$ $
Sales price 35.00 31.00
Direct material cost 7.50 15.00
Throughput per unit 27.50 16.00

Hours per unit in Department f2 16 6

Throughput per f2 hour
$ 1.72 $ 2. 67

The optimal production plan is to make 150 units of product “bench “ per month, and use the rest
of the time to make units of product “chair”

40
Chapter 5
LEARNING CURVES (experience curve)
Most workers become more proficient at their task the more they do them. Learning takes
place especially through the early stages of the job e.g contractors constructing a high rise
apartment building find the 20th storey that go on faster than the 8th storey. The learning curve
represents that the time spent per unit declines by a constant percentage as the number of
units produced doubles. The phenomenon has been observed where new long-term production
activities are undertaker / where a long production cycle is conducted such as building
construction projects, plan manufacture and ship building.take note of law of diminishing returns

Selling prices and workforce needs, as well as standards for time, can be compared from such an
analysis. Care is needed, however, because management practices, design, production

41
technology, and quality requirements can interfere with the actual time spent by employees.
How ? Behavioural considerations can also affect learning. Factors such as peer pressure,
union-imposed constraints, and the state of management-worker relationships can affect
productivity and limit learning. The learning curve model states that each time the number of
units produced doubles, the cumulative average time per unit is reduced by a constant
percentage

Wright law: as cumulative output doubles, the cumulative average time per unit falls to a fixed
percentage [referred to as the learning rate] of the previous average time.

THE LEARNING RATE: CUMULATIVE AVERAGE TIME {C.A.T}

In learning theory, the cumulative average time per unit produced is assumed to decrease by a
constant % every time total output of the product doubles.

EXAMPLES
Where an 80% learning effect occurs, the cumulative average time required /unit is reduced to
80% of the previous cumulative when output is doubling of output produces a 20% decrease in
C.A.T.

EXAMPLE 1 an 80% LEARNING CURVE.(experience curve)

The first unit of a new product requires 100hrs .An 80% learning curve applies .Production time
would be :

1 2 3 4 5
Units Produced Total output Cumulative Total hours Average hours
average time [column 2x3] additional units
1 1 100 1x100=100 100
1 2 (0,8x100)=80 80x2=160 160-100=60
2 4 (0,8x80)=64 64x4=256 256-160=96
4 8 (0,8x64)=51,2 51,2x8=409,6 409,6-256=153,6
8 16 0,8x51,2=40,96 40,96x16=655,36 655,36-
409,6=245,7

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Learning curves are also used to estimate price to be quoted on customer’s orders .The
learning curve effect means that a company can afford to charge less per unit for greater
quantities.

Example 2
Angwa Ltd has been requested to supply 8 units of a new product to the customer’s
specification .The estimated labour time for the first unit is 25hrs and the labour cost is $10/hr.
a. Calculate the labour cost for the order.
B.Calculate the labour cost of a second order with the same quantity (8 units).

Example 2 Solution
In less-automated processes, however, where learning curves do occur, it is important to take the
resulting decline in labour hours and costs into account in setting standards, determining prices,
planning production, or setting up work schedules.
With the help of the learning curve theories the standard time of any batch or unit can be
computed then compared to the actual data with the standard and compute the variances.

Units Produced Total output Cum Average time Total Average Ave. hours
1 1 25 25x1=25 25
1 2 (0,9x25)=22,5 22,5x2=45 45-25=20
2 4 (0,9x22,5)=20,25 20,25x4=81 81-45=36
4 8 (0,9x20,25)=18,225 18,225x8=145,8 145,8-81=64,8
8 16 (0,9x18,225)=16,4025 16,4025x16=262,4
4

a) Total labour cost for 8 units = 145,8hx$10/h

= $1458

b) 2nd order = (262,44x$10) -$1455

=$1166, 4

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The learning curve and the steady curve
The learning effect will only apply for a certain range of production. Once the steady state is
reached, the direct labour hours will not reduce any further and this will become the basis on
which the budget is produced.
LIMINATION OF THE LEARNING CURVE MODEL
The learning, whilst being an important factor to be taken into account, if it exists, is based on
specific assumptions which may or may not apply in a modern manufacturing environment.
The model applies if the process is;
 labour intensive
 No breaks in production.
 a new product being developed
 complex
 repetitive
It may also be difficult to identify the learning curve effect in practice

The learning curve can be expressed in a form of an equation as;

y= axb

Where y = cumulative average time per unit (C. A. T)

x = cumulative total number of units produced
a = time taken to produce the first unit
b = log r where r is the learning rate expressed as %
log 2

The method can be used to calculate y values for the data straight away.

PRACTICE QUESTIONS
Question 1

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Triple E Investments experience difficulty in its budgeting process because it finds it necessary
to qualify the learning effect as new products are introduced. Substantial product changes occur
and result in the need for retraining.
An order for 30 units of a new product has been received by Triple E Investments so far, 14 units
have been completed: the first unit required 40 direct labour hours and a total of 240 direct
labour hours has been recorded for the 14units. The Production Manager expects an 80%
learning effect for this type of work.

The company uses standard absorption costing. The direct costs attributed to the centre in which
the unit is manufactured and its direct materials costs are as follows:
$
Direct material 30.00
Direct labour 6.00
Variable overhead 0.50 per direct hour
Fixed overhead $6000 per four –week operating period.

There are ten (10) direct labour employees working a five day week, eight (8) hours per day.
Personal and other down time allowances account for 25% of total available time. The company
usually quotes a four –week delivery period for orders.

You are required to:

a) Determine whether the assumption of an 80% learning effect is a reasonable one in this case
by using the standard formula: Y = aXb

where:
Y = the cumulative average time (or cost) per unit.
X = the cumulative number of units produced.
a = time (or cost) required to produce the first unit.
b = slope of the function when plotted on log-log paper.
   = log of the learning rate/log of 2. (5marks)

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b) Calculate the number of direct labour hours likely to be required for an expected second order
of 20 units. (5marks)

c) Use the cost data given, to produce an estimated product cost for the initial order, Examine the
problems which may be created for budgeting by the presence of the learning effect
(8marks)

d) Factors such as peer pressure, union-imposed constraints, and the state of management-worker
relationships can affect productivity and limit learning. Discuss this statement with the aid of
examples. (7marks)

Question 2
A company wishes to determine the price it should charge a customer for a special order .The
customer has requested a quotation for 10machines but might subsequently place another order
for a further 10 .Material costs are $30 per machine. It is estimated that the first batch of 10
machines will take 100hours to manufacture and an 80% learning curve is expected to apply.
Labour plus variable overhead costs amount to $3 per hour. Set -up costs are $1000 regardless of
the number of machines made.

a) What is the minimum price the company should quote for the initial order if there is no
guarantee of further orders?
b) That is the minimum price for the following order?
c) What would be the minimum price if both orders were placed together?
d)Having completed the initial orders for the a total of 20 machines (price at the minimum levels
recommended in (a)and (b) the company thinks that there would be a ready market for this type
of machine if its unit selling price is brought to $45.
e) At this price, what would be the profit on the first (1) 140 mass production models (that is
after the first 20 machines) assuming that marketing costs totaled $250?

Question 3

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Three E Plc produces microphones for mobile phones and operates a standard costing system.
Before production commenced, the standard labour time per batch for its latest microphone was
estimated to be 200 hours. The standard labour cost per hour is $12 and resource allocation and
cost data were therefore initially prepared on this basis. Production of the microphone started in
July and the number of batches assembled and sold each month was as follows:
Month No of batches assembled and sold
July 1
August 1
September 2
October 4
November 8

The first batch took 200 hours to make, as anticipated, but, during the first four months of
production, a learning effect of 88% was observed, although this finished at the end of October.
The learning formula is shown on the formula sheet and at the 88% learning rate the value of b is
–0·1844245. Three E Plc uses ‘cost plus’ pricing to establish selling prices for all its products.
Sales of its new microphone in the first five months have been disappointing. The sales manager
has blamed the production department for getting the labour cost so wrong, as this, in turn,
caused the price to be too high. The production manager has disclaimed all responsibility, saying
that, ‘as usual, the managing director prepared the budgets alone and didn’t consult me and, had
he bothered to do so, I would have told him that a learning curve was expected.’

Required:
(a) Calculate the actual total monthly labour costs for producing the microphones for each of the
five months from July to November. (9 marks)
(b) Discuss the implications of the learning effect coming to an end for Three E Plc, with regard
to costing, budgeting and production. (4 marks)
(c) Discuss the potential advantages and disadvantages of involving senior staff at Three E Plc in
the budget setting process, rather than the managing director simply imposing the budgets on
them. (7 marks)

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(20 marks

Question 1
Tsoko (pvt) experience difficulty in its budgeting process because it finds it necessary to qualify
the learning effect as new products are introduced. Substantial product changes occur and result
in the need for retraining.
An order for 30 units of a new product has been received by Tsoko (pvt so far, 14 units have
been completed: the first unit required 40 direct labour hours and a total of 240 direct labour
hours has been recorded for the 14units. The Production Manager expects an 80% learning effect
for this type of work.

The company uses standard absorption costing. The direct costs attributed to the centre in which
the unit is manufactured and its direct materials costs are as follows:
$
Direct material 20.00
Direct labour 5.00
Variable overhead 0.80 per direct hour
Fixed overhead $8000 per four –week operating period.

There are ten (12) direct labour employees working a six day week, eight (8) hours per day.
Personal and other down time allowances account for 20% of total available time. The company
usually quotes a four –week delivery period for orders.

You are required to:

a) Determine whether the assumption of an 80% learning effect is a reasonable one in this case
by using the standard formula: Y = axb

(5marks)

b) Calculate the number of direct labour hours likely to be required for an expected second order
of 20 units.

c) Use the cost data given, to produce an estimated product cost for the initial order, examine the
problems which may be created for budgeting by the presence of the learning effect

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Chapter 5
TRANSFER PRICING
TRANSFER PRICING

Large organizations are divided into a number of divisions to facilitate managerial control. The
problem of transfer pricing arises when one division of the organization transfers its output to
another division as an input.

A transfer price is the price of one segment (sub unit, department, division etc.) of an
organization charges for a product or service supplied to another segment of the same
organization. Transfer prices are used when individual entities of a larger multi-entity firm are
treated and measured as separately run entities.

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In managerial accounting, when different divisions of a multi-entity company are in charge of
their own profits, they are also responsible for their own “Return on Invested Capital”.
Therefore, when divisions are required to transact with each other, a transfer price is used to
determine costs. Transfer prices tend not to differ much from the price in the market because one
of the entities in such a transaction will lose out: they will either be buying for more than the
prevailing market price or selling below the market price, and this will affect their performance.
The transfer from one segment to another is only an internal transfer and not a sale.

Transfer pricing is needed to monitor the flow of goods and services among the divisions of a
company and to facilitate divisional performance measurement. The main use of transfer pricing
is to measure the notional sales of one division to another division. Thus the transfer prices used
in the organization will have a significant effect on the performance evaluation of the various
divisions. Transfer price creates revenues for the Transferring Division and Costs for the
Recipient Division, affecting each sub-unit’s Operating Income. This requires that the system of
transfer pricing should be objective and equitable. Transfer pricing becomes necessary when
there are internal transfers of goods or services and it is required to appraise the separate
performances of the divisions or departments involved.

Transfer pricing is the process of determining the price at which goods are transferred from one
profit center to another profit center within the same company. If profit centers are to be used,
transfer prices become necessary in order to determine the separate performances of both the
‘buying’ and ‘selling’ profit centers. If transfer prices are set too high, the selling center will be
favoured whereas if set too low the buying center will receive an unwarranted proportion of the
profits.

Objectives of Transfer Pricing

1. Goal congruence: The prices should be set so that the divisional management desire to
maximize divisional earnings is consistent with the objectives of the company as a whole.
The transfer prices should not encourage sub-optimal decision-making. The system should

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 be so designed that decisions that improve business unit profits will also improve company
profits.

2. Performance appraisal: The prices should enable reliable assessments to be made of

divisional performance. The prices form part of information, which should:

(i) Guide decision making.

(ii) Appraise managerial performance.

(iii) Evaluate the contribution made by the division to overall company profits.

(iv) Assess the worth of the division as an economic unit.

The transfer prices should be designed such that they help in measuring the economic
performance

3. Divisional autonomy: The prices should seek to maintain the maximum divisional autonomy
so that the benefits of decentralization (motivation, better decision-making, initiatives, etc.)
are maintained. The profits of one division should not be dependent on the actions of other
divisions.

4. Simple and easy: The system should be simple to understand and easy to administer.

5. The transfer price should provide each segment with the relevant information required to
determine the optimum trade-off between company costs and revenues.

6. To optimise the profit of the company over a given short period of time. Here the stress is on
maximum utilisation of plant capacity.

7. To optimise the allocation of companies’ financial resources. This is a long-term objective.

Fundamental Principles for Transfer Price

The fundamental principle is that the transfer price should be similar to the price that would be
charged if the product were sold to outside customers or purchased from outside vendors. When
profit centers of a company buy from and sell to one another, two decisions must be made
periodically for each product that is being produced by one business unit and sold to another:

(i) Should the company produce the product inside the company or purchase it from and outside
vendor? This is the sourcing decision.
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(ii) If produced inside, at what price should the product be transferred between profit centers?
This is the transfer price decision.

Transfer price systems can range from the very simple to the extremely complex, depending on
the nature of the business.

Transfer Pricing Methods:

There are three general methods for establishing transfer prices.

1. Market-Based Transfer Price:

In the presence of competitive and stable external markets for the transferred product, many
firms use the external market price as the transfer price.

When there is a perfectly competitive market for the goods and services that are bought and sold
between divisions of an organization, the transfer price should be the market price. The transfer
price may be slightly lower than the market price if the selling expenses are lower for
interdivisional transfers, e.g. because there is no advertising cost for transfers between divisions.
There is a problem for managers in that market prices may fluctuate. Transferring products or
services at market prices generally leads to optimal discussion where three conditions are
satisfied. The market for the intermediate products is perfectly competitive. Inter dependencies
of sub units are minimal.

There are no additional costs or benefits to the company as a whole from buying or selling in the
external market, instead of transacting internally.

Market conditions which are appropriate for adoption

Are generally appropriate in a perfect market, where there is homogeneous product with only
one price for both sellers and buyers and no buying or selling costs.
In a perfect market, Selling Division (SD) will be operating at full capacity and can sell whatever
quantity of intermediate product it can produce in the external market. In this situation, internal
transfers will result in a need to sacrifice external sales. The benefit forgone that is the
contribution lost (opportunity cost) from sacrificing external sales should be included in the
transfer price. Thus in this situation TP=MP will be consistent with the general TP rule.

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TP=MC+OC = MP

In a perfect market, the minimum TP is also the maximum TP. Thus, both Selling Division and
Buying Division will be happy with a transfer price set as the market price. The adoption of
market-based transfer price in a perfectly competitive market meet the criteria of a good transfer
price that is it will promote goal congruent decisions, preserve divisional autonomy and provide
an equitable basis for performance evaluation.
Advantages:

i) It forces selling division to be competitive with market conditions.

ii) It does not penalize buying division by charging a price greater than it would have to pay on
the market.
Disadvantages:

i) It may lead selling division to ignore negotiation attempts from buying division and sell
directly to outside customers and could cause an internal shortage of materials.
ii) It forces buying division to purchase materials from the outside and overall company profits
may fall even though selling division makes a profit.

2. Cost-Based Transfer price: In the absence of an established market price, many companies
base the transfer price on the production cost of the supplying division. The most common
methods are:

Full Cost
Cost-plus
Variable Cost plus Lump Sum charge
Variable Cost plus Opportunity cost
Dual Transfer Prices

Each of these methods is outlined below.

Full Cost

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This is a popular transfer price because of its clarity and convenience and because it is often
viewed as a satisfactory approximation of outside market prices.

(i) Full actual costs

This can include inefficiencies; thus its usage for transfer pricing often fails to provide an
incentive to control such inefficiencies.

(ii) Use of full standard costs may minimize the inefficiencies mentioned above.

Cost-Plus

When transfers are made at full cost, the buying division takes all the gains from trade while

the supplying division receives none. To overcome this problem the supplying division

is frequently allowed to add a mark-up in order to make a “reasonable” profit.

The transfer price may then be viewed as an approximate market price.

Variable Cost plus a Lump Sum Charge

In order to motivate the buying division to make appropriate purchasing decisions, the transfer
price could be set equal to (standard) variable cost plus a lump-sum periodical charge
covering the supplying division’s related fixed costs.

Variable Cost plus Opportunity Cost

This is also known as the Minimum Transfer Price:

Minimum Transfer Price = Incremental Cost + Opportunity Cost.

For internal decision making purposes, a transfer price should be at least as large as the sum of:

Cash outflows that are directly associated with the production of the transferred goods; and, the
contribution margin foregone by the firm as a whole if the goods are transferred internally. Sub-
optimal decisions can result from the natural inclination of the manager of an autonomous
buying division to view a mix of variable and fixed costs of a selling division plus, possibly, a
mark-up as variable costs of his buying division. Dual transfer pricing can address this problem,
although it introduces the complexity of using different prices for different managers.

Dual Transfer Prices

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To avoid some of the problems associated with the above schemes, some companies adopt a
dual transfer pricing system. For example: Charge the buyer for the variable cost.

The objective is to motivate the manager of the buying division to make optimal (short-term)
decisions.

Credit the seller at a price that allows for a normal profit margin. This facilitates a “fair”
evaluation of the selling division’s performance.
Limitations

(i) It can lead buying division (BD) to make “sub-optimal” decisions because BD regards the
transfer price (which includes the fixed costs) as a wholly variable cost.

3. Negotiated Transfer Price:

Senior management does not specify the transfer price. Rather, divisional managers negotiate
a mutually-agreeable price. Negotiated transfer prices arise from the outcome of a bargaining
process between selling and buying divisions. It is typically combined with free sourcing. In
some companies, though, H.Q. reserves the right to interfere in the negotiation process and
impose an “arbitrated” solution.

Market conditions which are appropriate for adoption

In an imperfect market (different selling costs for internal and external sales, differential market
prices), transfer prices set at the prevailing or planned market price are not optimal i.e. will not
induce SD and BD to adopt optimal output level? Central/corporate management intervention is
necessary in order to ensure that optimal output levels are set but this process may undermine
divisional autonomy.

In this situation, it is more appropriate to adopt negotiated transfer prices. If both managers had
been provided with all the information and were educated to use information correctly, it is likely
that a negotiated solution would have emerged which would have been acceptable to both the
divisions and the group. When there is unused capacity, the transfer price range for negotiations
generally buying between the minimum price at which SD is willing to sell (its marginal cost)
and the maximum price BD is willing to pay (the external supplier price net off any external
purchase related costs).
Advantages

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Autonomy ↔ Decentralisation
Better information about costs and benefits
Most appropriate where there are market imperfections for the intermediate product and when
managers have equal bargaining power.
To be effective, managers must understand how to use cost and revenue information.
Disadvantages

Can lead to sub-optimal decisions

Time – consuming
Divisional profitability may be strongly influenced by the bargaining skills and powers of the
divisional managers.

EXAMPLE 2
Inscor ltd owns fast food restaurant and snack food and beverage manufacturing in Zimbabwe.
One of its restaurants, Pizza Inn serves a variety of beverages along with pizzas. One of the
beverages served is ginger beer which is served on tap.
The Managing Director of Imperial beverage has approached the Managing Director of Pizza Inn
about purchasing imperial beverage’s ginger beer for sale to Pizza Inn restaurants rather than its
usual brand of ginger beer. The Manager at Pizza Inn agreed that the quality of their regular
brand is ok; it was just a question of price. The basic facts for the divisions were as follows:

IMPERIAL B

 A ginger beer production per month --- 1000 barrels

 Variable cost per barrel --- $8
 Fixed cost per month --- $70 000
 Selling price of Imperial beverage ginger beer on outside market is $20 per barrel.

PIZZA INN
 Purchase price of regular brand of ginger beer --- $18 per barrel
 Monthly consumption of ginger beer --- 200 barrels

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Calculate
a) The selling division’s lowest acceptance transfer price.

NB. Imperial will transfer internally if their profit increases as such the transfer price cannot be
below $8. In addition if Imperial has insufficient capacity to fulfill the Pizza Inn order then it will
give up some of its regular sales and as such need compensation for lost contribution margin on
lost sales. If the transfer price has no effect on fixed costs from the selling divisions ‘s stand
point ,the transfer price must cover both the variable cost of producing the transferred units and
only opportunity cost from lost sales.

Seller’s point of view

 Transfer price greater than or equal to variable cost /unit + total contribution
Margin on sales (lost)
Number of units transferred
Purchasing Department

Transfer Price < outside supplier’s price

The purchasing determent PIZZA INN will be interested in the proposal only if its profits
increase. In cases where the division has an outside supplier purchasing decision is simple-buy
only from the inside supplier if the price is < the price offered by outside suppliers. The
following are scenarios in Imperial Beverage, show how to deal with each case:
a) Selling divisions with idle capacity
Imperial beverages is selling 700 barrels of ginger-beer a month on the outside market .What
would be the transfer price if any would make things better off with the transfer of 200 barrels

Transfer Price = variable cost + total contribution margin on cost sales

Number of units
= 8 + 0
200

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 = $8
Purchaser = < 18

Selling division with the no idle capacity

Imperial has no idle capacity and is selling 1000 barrels a month to an outside market at $20.
What range of transfer pricing would make both divisions better off transferring 200 barrels
within the company.
Transfer Price > 8 + [selling price – variable cost] lost sales

20 - 8 (200)
200
> 8 + 12

> 20

Purchaser Transfer Price > 18

i)Therefore in this case , no transfer price taken place as it result in loss to the organization
ii) Selling division with no idle capacity
iii) Selling division with some idle capacity

Imperial Beverage is selling 900 barrels to its regular customers a month. Pizza Inn can only sale
one type of ginger beer on tape .What range of transfer if any would make both divisions better
off transferring within the company

PT > 8 + 20 - 8 (100)
200
> 8 + 6
> $14

Transfer price is possible as it is acceptable within the range.

Transfer price where there are no outside supplier

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If Pizza Inn has no outside supplier the highest price the purchasing department will be to buy
depends on how the purchasing division expect to make on transfer units excluding price.

Transfer cost

Variable cost = $8
Full cost = $15 [8 + 7000
1000
= $15

 No profit for selling division and profit can be shown by buying division when they sell
to outside customers
 Cost price do not provide incentives to control costs and will affect goal congruence

Practical exercises
Makudo Ltd. is a divisionalised company. Each month the company’s Industrial Division
manufactures 600 tons of a product which it sells to external customers at a price of $20 per ton.
The fixed costs of the Industrial Division are $28 800 per month and the marginal costs of
production and sale amount to $9 per ton. An absorption costing system is used to work out a
‘full cost per ton’ on the basis of this level of cost and activity.

Another division of the company (the Consumer Division) buys 200 tons of a very similar
chemical component from an external supplier each month at a price of $15 per ton. However,
the Industrial Division has sufficient spare capacity to enable it to supply the monthly needs of
the Consumer Division. The transfer price which the Industrial Division would charge would be
the ‘full cost per ton’ as calculated on the basis of the increased level of output. The Consumer
Division has indicated that this transfer price would be acceptable.

REQUIRED:

59
(a) Calculate the transfer price proposed by the Industrial Division, and show that this transfers
pricing arrangement will motivate both divisions to act in a manner which is in the best interests
of Makudo Ltd. as a whole.
(7 marks)

(b) Assume now that the two divisions cannot agree on transfer pricing arrangements for the 200
tons. Specifically, the Industrial Division will not accept any price lower than $14,50 per ton but
the Consumer Division will not agree to pay any price higher than $9,50 per ton.

Discuss whether, in these circumstances, the board of directors of Makudo Ltd. should intervene
to order the divisions to make the transfer at the price calculated in your answer to part (a). (9
marks)

(c) Assume now that the Consumer Division requires a further 50 tons per month (in addition to
the 200 tons), but that the Industrial Division has no additional spare capacity and therefore these
50 tons could only be provided to the Consumer Division if the Industrial Division were to
reduce sales to its external customers by an equivalent amount.
Assume also that the marginal cost to the Industrial Division of supplying a ton to the Consumer
Division is $0, 30 lower than the cost of supplying a ton to an external customer. What is the
appropriate transfer price per ton for these 50 tons? Explain your answer.
(4 marks)
[Total: 25 marks]

Question 2

Mangwiro Ltd. manufactures advanced technical components for the computer hardware
industry. The company’s Uhuru Division manufactures a special subcomponent at a variable cost
of $70 per unit. This division’s maximum monthly production capacity is 2700 units, but its
actual production each month is 2500 units. Of this actual monthly production, 1500 units are
sold to external customers (at a price of $100 each) while the remaining 1000 units are
transferred to the company’s Chopa Division at the same price.

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The Chopa Divisions’ maximum production capacity is 1350 units per month. However, market
demand for the division’s product is only 1000 units and therefore production is carried out at
this level. In producing one unit of its product, Chopa Division uses one unit of the
subcomponent purchased from Uhuru Division and incurs additional variable costs of $90 per
unit. The selling price of Chopa Division’s product is $200 per unit.
The Chopa Division recently received an enquiry from a new customer, who has offered to
purchase 300 units of that division’s product each month at a price of $185 per unit.

REQUIREMENT:

(a) Prepare calculations to indicate the increase in the monthly profits of Mangwiro Ltd., if the
new customer’s offer is accepted.
(7 marks)

(b) Prepare calculations to indicate whether the existing transfer pricing arrangements would
motivate each of the two divisions to cooperate in transferring the 300 subcomponents needed in
order to manufacture the new customer’s order. (6 marks)
(c) Identify the minimum transfer prices which would be acceptable to Uhuru Division and
identify the maximum transfer prices which would be acceptable to Chopa Division. Then,
suggest a transfer price per unit for the 300 subcomponents which would achieve the following:

_ the incremental profits from doing business with the new customer are to be shared equally
between the two divisions.
_ The same transfer price per unit is to apply to all units transferred.
(7 marks)

Question 3
Rungano Ltd. manufactures a wide range of specialized electrical products. The company is
structured along divisional lines.
“Division X” manufactures a specialized motor. Monthly production is 3000 units and the
marginal cost of production is $140 per unit. Half of all output is sold to external customers at a

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price of $200 per unit. The remaining output is sold within Rungano Ltd. to “Division Y”. In
accordance with the company’s rules, these internal transfers are made at the same price per unit
as sales to external customers (i.e. $200).
“Division Y” uses the motor as a component in the manufacture of an industrial heater, which is
sold to external customers at a price of $350 per unit. (One motor is required for each heater).
“Division Y” incurs a marginal cost of $100 per unit, in addition to the transfer price paid for the
motor.
A potential new customer (Kwangu Ltd.) has offered to purchase 750 units per month of the
industrial heater from “Division y” at a special contract price of $275 each. “Division Y” has
sufficient spare production capacity to produce these additional heaters.

REQUIRED:
(a) Assume that “Division X” has sufficient spare production capacity to enable it to produce the
additional motors required by “Division Y” to enable it to fulfill the Kwangu Ltd. contract.
In these circumstances, explain:
i) Whether it would be in the best interests of Rungano Ltd. to accept the Kwangu Ltd. contract,
and
ii) Whether the existing transfer pricing arrangements motivate the division managers to take the
decisions which are in the best interests of Rungano Ltd. as a whole.
(10 marks)

(b) Now assume that “Division X” has no spare production capacity. If “Division X” were to
produce the additional motors required by “Division Y” to enable it to fulfill the Kwangu Ltd.
contract, then “Division X” would reduce its sales of motors to external customers.
Explain how your answer to part (a) would differ in these circumstances.
(7 marks)

(c) Critically evaluate the transfer pricing arrangements in Rungano Ltd., using your answers to
parts (a) and (b) to illustrate your answer.
(8marks)

(Total 25marks)

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Question 4

Bamaco Company is a company specializing in the manufacture and sale of kitchen sink. Each
sink consist of a main unit plus a set of kitchen fittings. The company is split into two divisions
C and D. Division C manufactures the sink and Division D manufactures set of kitchen fittings.
Currently, all of Division C’s sales are made externally. Division D, however, sells to Division C
as well as to external customers. Both of the divisions are profit centers.

The following data is available for both divisions.

Division C
Current selling price for each sink $450.00
Cost per sink
Fittings from Division C $75.00
Other materials from external suppliers $200.00
Labour costs $45.00
Annual fixed overheads $7 440 000
Annual production on sales of sink (units) 80 000
Maximum annual market demand for sink (units) 80 000

Division C
Current external selling price per set of fittings $80
Current price for sales to Division A $75

Costs per set of fittings:

Materials $5
Labour costs $15
Annual fixed overheads $4 400 000
Maximum annual production on sales of set of fitting (units) (including 200 000

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Internal and External sales)
Maximum annual external demand for sets of Fittings (units) 180 000
Maximum annual internal demand for sets of fittings (units) 80 000

The transfer price charged by Division D to Division C was negotiated some years ago between
the previous divisional managers, who have now both been replaced by new managers. Head
Office only allows Division C to purchase its fittings from Division D, although the new
manager of Division C believes that he could obtains fittings of the same quality and appearance
for $65 per set. If he was given autonomy to purchase from outside the company, Division D
makes no cost savings from supplying internally to Division C rather than selling externally.

Required

1. Under the current transfer pricing system, prepare a profit statement showing the profit for
each of the divisions and for Bamco Company as whole. Your sales and costs figures should be
split into external sales and inter-divisional transfers, where appropriate. [6 marks].

1. Head office is considering changing the transfer pricing policy to ensure maximization of
company profits without demotivating either of the divisional managers. Division C will
be given autonomy to buy from external suppliers and Division D to supply external
customers in priority to supplying to Division C. [6 marks]

Calculate the maximum profit that could be earned by Bamco Company if transfer pricing is
optimized.[8 marks]

2. Discuss the issues of encouraging divisional managers to take decisions in the interest of
the company as a whole, where transfer pricing is used. Provide a reasoned
recommendation of a policy Bamco Company should adopt. [6 marks]

Question 5

E and E investments consists of several stand alone divisions, including "Potato-Division" and
"Maize Division". Each month "Potato-Division" purchases 50,000 kilograms of a chemical

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product ("Fertiliser") from an outside supplier at a price of $7.80 per kilogram. "Potato-Division"
uses the Fertiliser as a raw material in the production of one of its products.

E and E investment’s managing director is aware that "Maize-Division" manufactures

"Fertiliser" for sale to external customers.
The following is a summary of the typical monthly activities of "Maize-Division":

Production and sales selling price Marginal cost Fixed costs to external
(=variablecost) Customers ]
$9 per kg. $6 per kg. $120,000 per month 200,000 kg.

The managing director believes that it might benefit the company as a whole if "Maize-Division"
were to sell some output to "Potato-Division", thus reducing the amount which "Potato-Division"
would need to purchase from its outside supplier. He has asked the two division managers to try
to agree possible transfer pricing arrangements.

REQUIRED:
N.B.: Answer each of the following three requirements separately.
(a) If the maximum monthly capacity of "Maize-Division" is 200,000 kg., will the two divisions
be able to agree on a transfer price? Is this outcome in the best interests of E and E investments
as a whole? Explain your answer fully.
(6 marks)

(b) Assume now that the maximum capacity of "Potato-Division" is 260,000 kg. Per month but
that demand from external customers is just 200,000 kg per month.
· Discuss whether, in this situation, it will be possible for the two divisions to agree on a transfer
price.
· If the two divisions can agree on a transfer price, by how much will the monthly profits of E
and E investments as a whole be increased? (8 marks)
(c) Assume now that the maximum capacity of "Maize-Division" is 220,000 kg per month but
that demand from external customers is just 200,000 kg per month.

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In this situation, suggest a transfer pricing arrangement which would increase the profits of each
of the two divisions and would be optimal for E and E investments as a whole. Support your
answer with appropriate calculations and explanations.
(6 marks)
d) Discuss the variants of costing method as a transfer price giving examples in each case.
(5marks)
Total marks 25MARKS

Question 6

Makudo ltd has a production capacity of 12000 batches of paper per month. Costs are $17 per
batch (variable) and $60000 per month (fixed). At present all sales are made to unconnected
third-party customers at a price of $30 per batch.
The Director has noticed that another of Makudo ltd’s subsidiaries Tsoko purchases 2000
batches of paper each month for its newspaper printing business from an unconnected local
supplier. Tsoko’s reason for buying from its local supplier rather than from Makudo ltd is that
the local supplier charges a much lower price ($24 per batch).
The Director suspects that the Makudo ltd and Tsoko operations may each be trying to maximise
its own profits rather than acting in the best interests of Mhuka Ltd. as a whole. He has decided
that the possibility of Tsoko obtaining its monthly paper needs through transfers from Makudo
ltd (rather than continuing to buy from its local supplier) should be actively considered.
REQUIRED:
(a) Assume that Makudo can sell 12000 batches per month to unconnected third-party customers.
In these circumstances:
i) Explain whether Makudo and Tsoko will be able to voluntarily agree on a transfer price, and
whether this situation is in the best interests of Mhuka Ltd. as a whole. (4 marks)
ii) If Makudo were to agree to make transfers to Tsoko at the price charged by the latter’s local
supplier, what would be the effect on the profits of Makudo, Tsoko, and Mhuka Ltd. as a whole?
(3 marks)
(b) Now assume that, because of limited market demand, Makudo can sell only 8500 batches per
month to unconnected third-party customers. In these circumstances:
i) Discuss whether Makudo and Tsoko will be able to voluntarily agree on a transfer price.

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(4 marks)
ii) If Tsoko’s local supplier were to reduce its price to $20 per batch, should Makudo agree to
reduce the transfer price to the same figure? Consider this question from the viewpoints of
Tsoko, Makudo, and Mhuka Ltd. as a whole. (3 marks)
iii) Following a refusal by Tsoko to agree to transfers at the $20 price, The Director is
considering the possibility of issuing a directive that Tsoko must purchase its monthly paper
requirements from Makudo at $30 transfer price. Advise The Director as to the merits (or
otherwise) of this proposal.(5marks/)
Question 7

At the request of Makondo, Shiri ltd recently purchased 100% of the share capital of Marko Ltd.
This request was made to ensure a steady supply of Cotton wool jackets to Makondo in Kadoma,
where they are an extremely popular item, but Shiri has no plans to sell the jackets in Chinhoyi.
Following the acquisition, Marko Ltd. retained its existing profit centre structure. Division A
manufactures lengths of wool and operates at its full capacity of 6,000 lengths per month. Of this
amount, 25% is sold to Division B (which produces one Cotton wool jacket from each length of
wool) and the other 75% is sold to other Chinhoyi Cotton wool garment manufacturers. Variable
costs in Division A are $24 per length, and variable costs in Division B are $28 per jacket (plus
the transfer price paid to Division A for the length of cotton wool). Fixed costs per month are
$30,000 in Division A and $25,000 per month in Division B.
Division B sells all of its output to Makondo for $80 per jacket. At present it purchases all of its
lengths of wool from Division A, but it has recently been approached by an external supplier
which has offered to supply lengths of cotton wool of the same quality at a price of $44 each.
Division A has been approached by another garment manufacturer which has offered to purchase
(under a long-term supply arrangement) the 1,500 lengths of wool which are at present sold to
Division B. The price offered by this garment manufacturer is $50 per length, although the
manager of Division A estimates that the incremental cost of transporting these lengths of tweed
to the garment manufacturer would be $10 each (payable by Division A).

REQUIRED:
(a) In terms of maximising Makondo’s Wool monthly profits, is it preferable that Division B
should continue to source its lengths of wool from Division A? Explain your answer fully.

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(4 marks)
(b) Calculate the “optimal transfer price” and show that this will motivate the two Division
Managers to engage in behaviour which is goal congruent from Makondo’s point of view.
(5 marks)
(c) Assume that the price which you calculated in part (b) is used for transfers between the two
divisions. Show how much of the net profit (after deduction of fixed costs) from the sale of 1,500
jackets would be included in each division’s monthly performance report.
(6 marks)
(d) Comment on whether the results in your answer to part (c) provide a fair reflection of the
performance of each division, and respond to the suggestion that Division B should be closed
down. (6 marks)
[Total: 20

The budget serves as a vehicle through which actions of different parts of an organization
Nhongo Ltd. is a divisionalised company. Each month the company’s Chemicals Division
manufactures 6000 tons of a product which it sells to external customers at a price of _$200 per
ton. The fixed costs of the Chemicals Division are _$288 000 per month and the marginal costs
of production and sale amount to $90 per ton. An absorption costing system is used to work out a
‘full cost per ton’ on the basis of this level of cost and activity.

Another division of the company (the Detergents Division) buys 2000 tons of a very similar
chemical from an external supplier each month at a price of _$150 per ton. However, the
Chemicals Division has sufficient spare capacity to enable it to supply the monthly needs of the
Detergents Division. The transfer price which the Chemicals Division would charge would be
the ‘full cost per ton’ as calculated on the basis of the increased level of output. The Detergents
Division has indicated that this transfer price would be acceptable.

REQUIRED:
(a) Calculate the transfer price proposed by the Chemicals Division, and show that this transfers
pricing arrangement will motivate both divisions to act in a manner which is in the best interests
of Nhongo Ltd. as a whole.
(7 marks)

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(b) Assume now that the two divisions cannot agree on transfer pricing arrangements for the
2000 tons. Specifically, the Chemicals Division will not accept any price lower than _$145 per
ton but the Detergents Division will not agree to pay any price higher than $95 per ton.

Discuss whether, in these circumstances, the board of directors of Nhongo Ltd. should intervene
to order the divisions to make the transfer at the price calculated in your answer to part (a). (9
marks)

(c) Assume now that the Detergents Division requires a further 500 tons per month (in addition
to the 2000 tons), but that the Chemicals Division has no additional spare capacity and therefore
these 500 tons could only be provided to the Detergents Division if the Chemicals Division were
to reduce sales to its external customers by an equivalent amount.

Assume also that the marginal cost to the Chemicals Division of supplying a ton to the
Detergents Division is $3 lower than the cost of supplying a ton to an external customer.
What is the appropriate transfer price per ton for these 500 tons? Explain your answer.
(4 marks)
[Total: 25 marks]

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Chapter 7

DECISION MAKING WITH RISK AND UNCERTAINTY

Uncertainty – occurs when there is insufficient information about what will happen, or what will
probably happen in future.

Risk – occurs when the future outcome from a decision could be any of several different
possibilities.

Reducing uncertainty

It can be reduced by obtaining more information on which some reliance can be placed.It is
uncertainty of volume of sales demand for a product: For established products estimates of future
sales can be, by taking historical sales figures and making adjustment for sales growth or decline
and planned changes in the sales price. New products –estimate of sales demand is difficult as no

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benchmark exist on which to base. Uncertainty about future sales demand can be reduced
through market research.

Using probabilities: expected values

Expected values

These are widely used in decision making under uncertainty for analysing the information where
risk can be assessed in terms of probabilities of different outcomes. It is a weighted average of
all possible outcomes. It calculates the average return that will be made if a decision is repeated
again and again. Worth of a decision can be the expected value or weighted average of these
outcomes.

Expected values (EV) =weighted average of possible outcomes.

In other words it is obtained by multiplying the value of each possible outcome (x) by the
probability of that outcome (p) and summing the results.

EV=SUMMATION PX

 Where p=the probability of each outcome

x= the value of each outcome

Example 1

The following are the estimates of results of a small survey by a new restaurant business
depending on whether a competitor decides to open up in the same small town of Chinhoyi. The
estimated results were as follows:

Competitor probability Project net value px

opens up
yes 0.3 (10 000) (3000)
no 0.70 20 000 14 000
11 000
Worth of a decision can be the expected value or weighted average of these outcomes. Since
expected value shows the long run average outcome of a decision which is repeated time and

71
time again, it is a useful decision rule for risk neutral decision maker. The risk neutral investor
either seeks risks or avoids it. He is happy to accept an average outcome.

N.B An expected value is a measurement of weighted average value. A decision is based on

selecting the course of action that offers the highest of EV of profit or the lowest EV of cost.
That is the decision rule is to select the course of action with the highest EV of profit or the
lowest EV of cost. The main advantage is that it takes into account uncertainty by considering
the probability of each possible outcome and using this information to calculate an expected
value. Also the information is reduced to a single number resulting in easier decisions.

 Example 1

 JB ltd has to decide which of the three projects to select for investment. The three
projects are mutually exclusive and only one of them can be selected. The projects do not
involve any initial capital expenditures. The expected annual profit from investing in
each of the projects will depend on the state of the market. The following estimates of
annual profits (operational cash flows) have been prepared.

State of market declining static expanding

Probability 0.4 0.3 0.3

$ $ $

Project 1 100 200 800

2 0 400 600

3 180 190 200

Required:

Identify which project would be selected if the decision is to choose the project with the highest
expected value of annual profit.

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Expected value should be reliable for decision making when: Probabilities can be estimated with
reasonable accuracy. The outcome from the decision will happen many times and will not be a
“one off” event.

Advantages of expected values;

i)They take into account uncertainty by considering the probability of each possible outcome and
using this information to calculate an expected value.

ii) The information is reduced to a singular number resulting in easier decisions.

ii) The calculations are relatively simple.

Disadvantages

i) The probabilities used are usually very subjective.

ii) The expected value is merely a weighted average and therefore has little meaning for a one off
project.

ii) The expected values gives no indication of the dispersion of possible outcomes about the
expected values that the risk.

iv) The expected values may not correspond to any of the actual possible outcome.

Practice question1

E and E Investments manufactures product pipe. At the moment, when customers complain that
there is one or more defects in the product they have bought, the company repairs the product, at
its own cost. Management is now considering a new policy , whereby the company will accept
no liability at all for any defects in the product , but will reduce the sales price by $6.00 per unit.

 The estimates of defects in each product, and cost of repairs each defect, have been
estimated from historical records as follows:

 Number of defects probability cost probability

per product of repairs

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 $

0 0.99 20 .20

1 0.007 30 .50

2 0.002 40 . 30

3 0.001 -

The company makes and sells 10000units of product pipe each month. Would it be cheaper to
continue repairing faulty products, or would it be more profitable to reduce the sales price by
$6.00 per unit for all units of the product?

Pay off Table

A profit table (pay-off table) can be a useful way to represent and analyse a scenario where there
is a range of possible outcomes and a variety of possible responses. A pay off table simply
illustrates all possible profits/ losses and as such is often used in decision making under
uncertainty.

Example

Mamie runs a kitchen that provides food for various canteens throughout a large organisation. A
particular salad is sold to the canteen for $10.00 and costs $8.00 to prepare. The contribution per
salad in this case is $2.00. Based upon past demands, it is expected that during the 250day
working year, the canteens will require the following daily quantities:

 On 25days of the year 40 salads

 On 50days of the year 50 salads
 On 100days of the year 60salads
 On 75days 70 salads.

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The kitchen must prepare the salads in batches of 10 meals in advance. The manager has asked
you to help decide how many salads the kitchen should supply for each of the fourth coming
year.

Constructing a Payoff able

If 40 salads will be required on 25days of the 250day year the probability that demand is
40salads can be represented as:

Probability of 40salads is = P (Demand of 40) = 25days /250 =0.1 likewise:

P(demand 50) = 0.20

P(demand 60) = 0.40

P(demand 70) = 0.30

Different Profit values

For example if 40 salads are supplied and all are sold, our profit amount to 40 *$2.00
contribution =$80.00.

If however we supply 50 salads and 40 are sold out profit is 40*2 =80-(10 unsold salads *$8unit
cost) =80 contribution – 80 cost ($8*10) =0.

The full table can be as follows:

Daily Probability 40 50 60 70
supply
Daily 40 0,1 80 0 (80) (160)
demand
50 0,20 80 100 20 (60)
60 0,40 80 100 120 40
70 0,30 80 100 120 140

Decision making

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This involves making a choice out of the many available alternatives. Decision making under
uncertainty may fall under three categories namely:

Maximax

The maxi max rule involves selecting the alternative that maximises the maximum payoff
available. This approach would be suitable for an optimist or risk seeking investor who seeks to
achieve the best results if the best happens. The manager who employs the maxi max criterion is
assuming that whatever action is taken, the best will happen: he/she is a risk taker. So how many
salads should Mamie decide to supply?

From the payoff table the highest maximum possible pay-off is $140. This means 70 salads can
be supplied every day.

Maxi min

The maximin rule involves selecting the alternative that maximises the minimum pay-off
achievable. The investor would at the worst possible outcome at each supply level, and then
selects the highest one of these. The decision maker therefore chooses the outcome which is
guaranteed to minimise his losses. In the process, he loses out on the opportunity of making big
profits. This approach would be appropriate for a pessimistic who seeks to achieve the best
results if the worst happens. So, how many salads will Mamie decide to supply?

From the payoff table:

If 40 salads are supplied minimum payoff is $80.00

50 salads are supplied minimum payoff is $0.00

60 salads are supplied minimum payoff is ($80.00)

70 salads are supplied minimum payoff is ($160).

The highest minimum payoff arises from supplying 40 salads. This ensures that the worst
possible scenario still results in a gain of at least $80.00

Mini max regret

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This is the decision that minimises the maximum regret. It is useful for a risk –neutral decision
maker. This is the technique for a risk neutral decision maker. This is the technique for a “sore
loser” who does not wish to make the wrong decision. Regret is defined as the opportunity loss
through having made the wrong decision. To solve this table showing the size of regret needs to
be constructed. This means we need to find the biggest payoff for each demand row then subtract
all other numbers in this row from the largest number.

For example, if the demand is 40 salads, we will make a maximum profit of $80.00 if they sell. If
we had decided to supply 50 salads we would achieve a nil profit. The difference or regret
between that nil profit and the maximum of $80 achievable is $80.00.

The minimax regret criterion focuses on avoiding the worst possible consequences that could
result when making a decision. It views actual losses and missed apportunities as equally
comparable.

Regert can be tabled as follows:

Daily supply
(salads) 40 50 60 70
Daily demand 40 0 80 160 240
50 20 0 80 160
60 40 20 0 80
70 60 40 20 0

The maximum regrets for each choice are thus as follows (reading down the column)

If supply is 40 salads the maximum regret is $60.00

50 salads the maximum regret is $80.00

60 salads the maximum regret is $160.00

70 salads the maximum regret is $240.00

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A manager employing the minimax regret criterion would wait to minimize that maximum
regret, and therefore supply 40 salads only.

DIVISIONAL PERFOMANCE

Management should know what they expect to achieve and they should also be in the
goal-setting process. Failure results in dysfunctional behavior which conflicts with the
short term interest of the organisation.
Thus, managers should know what they are achieving; this should involve the setting up
and maintenance of a well co-ordinate information system.
Managers should be provided with a measure of performance which is constant with their
responsibilities and they should not be held accountable for the actions and course which
are outside their control.

TYPES OF SEGMENTS \ BUDGET CENTERS THAT CAN BE CREATED

1. Cost centre

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 In this unit , the manager has authority to control amount of expenses incurred but has no
authority to change the resource investment
In this centre , fin performance is measured by whether the assigned task is completed
within the budgeted cost levels
Managers of cost centers are expected to minimize cost while providing the level of
service or amounts of products demanded by other parts of the organisation. For
example ,the manager of a product center will be evaluated at least in part by comparing
actual cost as to how much should have been the actual cost for the units provided [flexed
costs] for the period.

2. Revenue centre
In this centre , performance is measured by whether the unit achieves budgeted levels of
sales revenue
The issue of expenses incurred in generating revenue is not the responsibility of a
revenue center management
Zimra is atypical Zimbabwe revenue center

3. Profit center
IN this centre , financial performance is measured whether the unit has achieved its
budgeted profit
A profit centre manager is therefore responsible for the sales revenue and expenses but
his major aim is to promote the profit motive throughout the organisation
In addition to the selling price based on normal arms length transaction with 3 rd parties
,transfer prices have to be negotiated for intercompany sales of goods and services
Where negotiations are made, revenues of one department or division will constitute cost
of another.
CUT marketing department may be a profit center

4. Investment centre
In this centre , financial performance is measured by whether the actual return on
investment is equal to or exceed the budgeted return

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 In addition to controlling sales revenue and cost , an investment centre manager is
responsible for capital investment decisions and is able to influence the size of
investment
Investment center managers are encouraged to plan, control and make decisions for the
cost, revenue and investment entrusted in them.
The investment centre managers who have details of knowledge of local customers and
economic conditions can use that knowledge to the advantage of their division and
ultimately to the company as a whole
NB An investment centre manager does not however enjoy total control over the level of
investment as he has to compete with other divisions for the scarce resources whose
disbursement may be controlled by head office

PERFORMANCE MEASURES IN PRIVATE SECTOR

 Who benefit most from the operation of the company?(is it company stakeholders) e.g
customers, employees , managers e.t.c.
 The company survives due to investment put by shareholders and hence should benefit
most.
 The objective of financial performance is concerned with benefit of its shareholders.
 To achieve the objective the company should “survive and grow”. Darwin’s theory of
evolution ‘survival of the fittest’ is therefore true in corporate world. In order to pass the
fittest test mere profitability is not sufficient.
 Profit figure alone cannot be an indicator but must be assessed together with liquidity,
gearing.
 It should be noted that despite huge profits a company may not be able to meet its debts.
Primary objective of financial performance
 The major objective is to maximize shareholder value. Shareholders provide funds,
assume risk and expect value.
 The shareholder value perspective emphasis profitability over responsibility and see
organizations as instruments of the owner.

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  Proponents in this area believe that an organisation’s success can be measured by factors
such as share price, dividends, economic profit and see shareholder management as a
means to an end rather an end in itself.
 The company aims first and for most to maximize shareholder value within whaat is
legally permissible and advocates are convinced that society is best served if economie
rationales are followed.
 Thus the responsibility of crating employment, improving local communities, protecting
the environment, consumer welfare and social developments are not organizational
matters but are better left to individuals and governments.
 Paying attention to enlightened self interest and maintaining market based relationships
between the corporation and all stakeholders, maximizing value for the shareholder will
result in the maximization of societal wealth.
 Shareholder value refer to:
 Market capitalization of the company
 Paying dividends and causing stock price to increase.
Appropriateness and measures of Performance
 Managers are given autonomy that the various profit and investment centers are taken as
independent businesses with their managers having about the same control over divisions
as if they were running their own independent firms
 With autonomy , fierce completion developments among managers with each striving to
make his segment the best in the company
KEY QUESTION
 How do top managers at headquarters go about deciding who gets new investing funds as
soon as they become available and how do these managers in the centers decide which
investment funds
 Headquarter managers may use rate of return on investment [ ROI ]
The return of Investment
 Defined as net operating income divided by average operating assets.
 The higher the ROI of a business segment, the greater the profits generated per dollar
invested in the segment’s operating assets.
 Net operating income is profit before interest and tax, popularly known as EBIT.
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  Operating assets include cash and cash equivalent, trade receivables, PPE, non-current
assets and all other assets held for productive us in the organization
 Excluded are assets such as land held for future development of investment held in other
companies.
 Thus average operating assets is assets at the beginning and those at end
MAJOR CHALLENGES
 Non-current assets debate is on what base to us cost or NBV of the assets
 Other advocate prefers net book value and other advocators prefer cost
 In calculating ,both approaches were used but yield different figure
ADVOCATES FOR NBV
 They say NBV is consisted with how PPE[property plant and equipment] are reported on
statement of financial position[SOFP]
 NBV is also consistent with the computation of operating income which includes
depreciation as an operating cost
ADVOCATE FOR COST
 The cost method eliminates both the age of equipment since the method of depreciating
used is factors in depreciating which is used in the computation of operating income.
 Under NBV, ROI tends to increase overtime as book value of assets decline due to
depreciation.
 Cost method does not discourage replacement of old worn out equipment.
 However, due to the need of maintaining consistency, most companies use book value.
CONTROLLING RATE OF RETURN
 ROI = O. I
A.O, A(average operating assets)
 This can be modified to - ROI = operating income(margin) * 100 * Turnover
Turnover or sales 1 A.O.A
 Margin is the measure of management’s ability to control operating expenses per dollar
of sale, the higher the margin.
 Turnover is the measure of sales that is generated for each dollar invested in operating
assets.

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  So ROI using turnover and margin is calculated as:
ROI = MARGIN * TURNOVER
 To this end, which formula now to use as both gives the same answer?
 The second one gives better insights about the organisation
 ROI forces managers to control the investment in operating assets as well as to control
the expenses and hence the margin.
 The DUPONT pioneered the ROI concept and recognized the importance of looking at
both margin and turnover in assessing performance of a manager.
 The investment manager can control the ROI in 3[three] ways;
1. Increase sales
2. Reduce expenses
3. Reduce assets
EXAMPLE
ABC LTD presence the following data which represents results of operations for the most recent
month:
Net Operating Income 10 000
Sales/Turnover 100 000
Available Operating Assets 50 0
Calculate ROI in terms of margin and turnover.
SOLUTION

R. O. I = operating income * 100 * turnover /sales

Turnover/ sales 1 A. O. A
= 10 000 * 100 * 10 000
100 000 1 50 000
= 20%
INCREASE IN SALES
 If the manager increases sales from $100 000 to $110 000 with other costs remaining
constant as well as the assets. What is the new R.OI?
ROI = 20 * 10 000

100

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 = $2 000

For every $10 000 increase in sales, the profit will increase by $2000
 R. 0. I = 12 000 * 100 * 110 000

110 000 1 50 000

= 24%
REDUCE THE EXPENSES
 Assume that the manager of ABC LTD reduces expenses by $1000, what is the new R.
O.I if sales and operating income remain constant
New operating income = $11 000 [10 000 + 1000]
R. O. I = 11 000 * 100 * 100 000
100 000 1 50 000
= 22%
REDUCE ASSETS
 Assume the manager can reduce assets from 50 000 to 40 000, sales and net operating
income remain unchanged, what is the new R. O. I?
R. O. I = 10 000 * 100 * 100 000
100 000 1 40
= 25%
A manager should have a clear understanding of the 3(three) approaches to improving R O I
figure for it is critical to effective management of an investment centre.
OTHER MEASURES OF PERFOMANCE
RESUDUAL INCOME
 This refers to controllable contribution less cost of capital charge.
 For divisional purpose, residual income can be defined as divisional contribution less cost
of capital charge on total investment in assets employed by the division.
 It enables managers when acting in their own best interest also to act in the best interest
of the organisation.
EXAMPLE
 A company has two divisions, x and y .Proposed investments in the two divisions were
packed at $10 000 each for which 5he controllable contribution of x $2 000 and y is $1
300. What is the residual income if cost of capital charged is 15%?

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SOLUTION
Residual income =Controllable contribution - Cost of capital charge

x = 2000 - 1 500
= 500

Y = 1 300 - 1 500
= (200)

ECONCMIC VALUE ADDED [ EVA ]

 Economic profit is wealth created above the capital cost of investment.
 EVA prevents managers from thinking that the cost of capital is free
 It is therefore a measure of a company’s financial profit based on operating
profits[adjusted for taxes on a cash bases]
 Therefore EVA = net Operating profit after tax[NOPAT] – The cost of capital charge.
[cost of capital being the capital - cost of capital]
 It therefore measures whether operating profit is sufficient enough to cover the cost of
capital.
 If EVA is negative, it means the firm is destroying the share holder’s wealth.
 EVA means real profitability.EVA focuses managers on the question, “for any given
investment, will the company generate returns above the cost of capital.
 Companies that use EVA have bonus compensation skills in place that reward/ punish
managers for adding/ subtracting value for the company
PRACTICE EXERCISES
Question 1
Fanago Manufacturing PLC is a divisionalised company. Maguire is the manager of the
Company’s Textiles Division and he is considering the introduction of a new product line. This
would require an immediate investment of $100000 in new fixed assets plus $50000 in additional
working capital.
The fixed assets would have a useful life of four years, and the product line would be
discontinued at the end of that time.

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During each of the four years, 15000 units of the product would be produced and sold at a price
of $18 each. Variable costs of production would be $12 per unit and fixed costs (other than
depreciation) would amount to $50000 per annum. It is believed that a cash sum of $20000
would be received when the fixed assets are sold for scrap at the end of their four year life.
However, in accordance with the company’s standard accounting practices, the full purchase cost
of the fixed assets would be depreciated on a straight-line basis over their useful life (i.e. a zero
residual value would be assumed in the calculation of the annual depreciation charge). The
working capital investment would be recovered in full at the end of the projects life.

The performance of the Textiles Division is measured each year on the basis of Return on
Investment (ROI).
For this purpose, profit is defined to include any gains or losses on fixed asset disposals and the
investment base is defined as working capital investment plus the net book value of fixed assets
at the beginning of the year.
Maguire is paid a bonus each year which is linked to the extent by which his divisions actual
ROI exceeds the divisions required (or target) ROI. The required rate of return for the Textiles
Division is 10% per annum, and this is also the divisions cost of capital. Maguire’s own financial
forecasts indicate that (in the absence of the proposed investment in the new product line) the
Textiles Division will earn a ROI of 15% per annum for the next five years.
Maquire plans to leave his current employment within the next two to three years and set up in
business as a consultant to manufacturing companies who could benefit from his experience and
advice.
REQUIREMENT:
(a) Calculate the ROI of the proposed investment in each of the next four years. Then, explain
whether or not Maguire is likely to accept this proposed investment, assuming that he acts to
maximize his own self interest.
(10 marks)
(b) Calculate the net present value of the proposed investment.
(4 marks)

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(c) The use of ROI as a performance measure does not necessarily ensure that a division manager
will take decisions which are in shareholders’ best interests. Give three examples of why this so,
using the case of Fanago Manufacturing PLC to illustrate.
(6 marks)
[Total: 20 marks]
Question 2
Sunset PLC, a large multinational company, is undertaking a review of its organizational
structure. Top management is concerned that the methods used for divisional performance
evaluation and transfer pricing may be encouraging dysfunctional behaviour by division
managers.
The following sample data is available concerning two of the company’s divisions for last year:
Beverages Hardware
Operating profit $15 200 $7 200
Capital invested $160 000 $57 600

The cost of capital is 7% for both divisions. It can be assumed that there are no intra company
transfers between Divisions B and H.

REQUIRED:
(a) Calculate the Return on Investment (ROI) and residual income for each division. Explain
which of these two measures (ROI or residual income) gives the clearer indication of divisional
contribution to the overall success of Sunset PLC.
(6 marks)
(b) Assume that ROI is used for divisional performance evaluation purposes. How would each of
the two division managers react to an additional investment opportunity which would increase
operating profit by $2300 but would require capital investment of $22 000? Are their reactions in
the best interests of the company’s shareholders? Justify your answer. (6 marks)
(c) At what cost of capital would the two divisions have the same residual income? (In answering
this part, ignore the additional investment opportunity in part (b) above). (6 marks)
(d) Although there are no intra-company transfers between Divisions B and H, there are a
significant number of intra-company transfers between other divisions of Sunset PLC. Discuss

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the circumstances in which it is feasible and appropriate to use external market prices as the basis
for setting transfer prices in such cases. (7 marks)
[Total: 25 marks]

BUDGETARY SYSTEMS
 A budget is a formal statement of a company’s future plans. It is also viewed as planning
and controlling tool for an organisation.
 It is expressed in monetary terms because the economic and financial aspects of the
business are the primary factors driving management’s decisions.
 All managers should be involved in budgeting.
How does a budgetary system fit within performance hierarchy?
 Budgeting provides a yard stick for evaluating performances as such it encourages the
employees in an organization to maximize their contribution towards achieving the set
goals in the budget.

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  Budgeting is mainly suitable for operational levels only, however top management
participates in budgeting process to ensure operational plans are drawn up within the
scope of the organisation’s strategic, planning and overall objective.
 See diagram
 N.B The shareholders and top management decide on the mission statement ie the broad
objectives of the business(aims)
 Using performance hierarchy model, performance should be evaluated at all levels ie
strategic, tactical and operational levels.
 Lower and middle management levels are assigned targets that are then evaluated by top
level.
 A budget acts as a management tool for setting operational plans into action.
 Budgetary systems aims at explaining the relationship between performance goals and
the costs for achieving the targeted levels- this then evaluates the whole system.
Types of budgetary systems
 Top down –approach
 Top management specifies their expectations and objectives for the overall budget. The
approach enables communication between the top level management and other levels.
 Top management may set high standards/ targets in order to motivate the employees to
chase these targets.
 By adopting the approach it is possible to achieve synergy in the working of an
organisation however it is not suitable to small organisations where superiors have
overall knowledge of the working of the organisation but in situations where
organisation cannot allow much time or cost for planning.
Bottom up approach
 Lower level manager’s starts with the targets set by lower level management which is
then rolled over to successive stages for review.
 Once all divisional budgets have been collected an overall budget for the organisation is
prepared thereby achieving coordination that is essential for the success of a budgeting
system.

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  This approach allows greater involvement of those responsible for the implementation of
the budget.
 It avoids conflict of budgeting as it is more realistic basing on how it is prepared.
Rolling budgeting
 A budget that needs to be continuously updated by deducting the earliest period and
taking into account future periods.
 Such budgeting eliminates the adverse impact of environmental uncertainties in setting
goals by updating the budget in quick succession.
 The budget encourages a forward looking attitude.
 These are prepared on the basis of current experience and hence are updated with current
changes. This helps minimize the operational variances.
Zero –based budget (ZBB)
 Is a method of budgeting which needs each cost element to be specifically justified, as
though the activities to which the budget relates were being undertaken for the first time?
Without approval budget allowance is zero.
External factors that affect / influence budgeting
Customers
 Information about class of customers, any changes in the customers’ taste, their
preferences guide in estimating potential demand for the product in the market.
 Estimating demand helps in deciding sales target.
 In most cases these act as a limiting factor in preparation of budgets. It determines
production targets.

Competititors
 Information about the competitors, their strategies, their market share, price charged by
them etc all these help in determining the strategy of an organisation.
Legal framework
 Organisations works within legal framework, thus an organisation must have information
on the requirements for safety measures working conditions so that it can comply with
these requirements.
Suppliers and availability of other resources
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  Information regarding availability of resources such as the availability of suitable man
power, the availability of the required quantities and quality of material, substitutes, plant
and machinery etc also determines a production budget.

Political and regulatory framework

 Decisions of regulatory authorities may affect operation of organisations thus one needs
to be aware of the policies of the regulatory authorities and government before devising a
budget.
 In addition, the political environment of a country may influence the government policy
towards an industry.
PURPOSE AND USES OF BUDGETS

1. Planning annual operations.

 Annual budgeting process leads to the refinement of previous plans since managers must
produce detailed plans for the implementation.
 Ensure that manager’s plan for future operations and that they consider how conditions in
the next year might change and what step they should take now to respond to these
changes.
 These processes encourage managers to anticipate problems before they arise and hasty
decisions that are made on the spur of the moment, based on expedients rather than
reasoned judgment will be minimized.

COORDINATION PURPOSEs
 Can be brought together and be reconciled into a common plan.
 Budgeting compares managers to examine the relationship between their co-operation
and those of other departments and in the process, identify and resolve conflicts.

IT ENHANCES COMMUNICATION
 Budgeting ensures that the definite terms of communication are laid down so that all
parts of the organization will be kept fully informed of the plans and policies which the
organization expects to achieve.

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  It ensures that appropriate individuals are made accountable for implementation of the
business.
 Through the budget, top management communicates its expectations to lower level
management so that all members of the organization may understand these expectations
and can co-ordinate their activities to attain them. Therefore communication takes place
much more during the preparation stage.

THEY ASSIST IN MOTIVATION

 Budgets produce a standard that in certain circumstances a manager may be motivated,
inspired.
 However they can also encourage conflicts between managers
 Through participation, it assists managers in managing their departments and it therefore
acts as a strong motivational device which provides a challenge.
 However where a budget is imposed from above it becomes a threat rather than a
challenge and it can be resisted thereby doing more harm than good.
CONTROL
 The budgets assist managers in controlling and managing activities for which they is
responsible.
 It promotes management by exception.

PERFORMANCE EVALUATION
 Performance is evaluated by measuring his/her success in meeting the budgets
 Bonuses may also be awarded on the basis of an employee’s ability to achieve targets
specified in the periodic budgets or promotions may be partly dependent upon the
manager’s budget record.
 Budgets also provide a means of improving or measuring how managers are performing
in meeting targets that they previously helped to set.

Practice 1
QUESTION 1

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You have recently been appointed as an assistant management accountant in large company,
Delta Beverages. When you meet the production manager, you overhear him speaking to one of
his staff, saying: “Budgeting is a waste of time. I don’t see the point of it. It tells us what we
can’t afford but it doesn’t keep us from buying it. It simply makes us invent new ways of
manipulating figures. If all levels of management aren’t involved in the setting of the budget,
they might as well not bother preparing one.

Required

3. Identify and explain six objectives of a budgeting control system. [13 marks]

4. Discuss the concept of a participative style of budgeting in terms of the six objectives
identified in past (a). [12 marks]

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