Performance Management accounting

CUAC 411 Modules

Design of Management Accounting systems

Planning, Controlling and Decision Making

Hierarchy

-Planning, controlling and decision making can be classified into tree levels namely:

1. Strategic Planning

 The process of developing long term plans for the organization that is 5-10years or
more
 This mainly concerns new products to be launched, new markets to be developed etc.
 It is planning and decision making done at board level and this tends to be an outline
rather than detailed planning.

2. Management Planning/Tactical planning

 A more detailed short-term planning for example one year budget in order to ensure
resources are obtained and used efficiently to achieve the long term plans of the
company.
 This focuses on future staff needs of the company
 Control is then exercised against the budget using the aspect of variance analysis.

3. Operational Control

 The day to day management of the business in order to ensure that specific tasks are
carried out effectively and efficiently for example ensuring that budgeted production
has been achieved effectively.
 The information used will be very detailed and will be quantitative but will often be
expressed in terms of time taken that is hours or output for example units instead of
in monetary terms.

Strategic Planning

 The strategic plan covers the following:

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 Vision

MISSION

GOALS AND OBJECTIVES

ENVIRONMENTAL
CORPORATE APPRAISAL
ANALYSIS
POSITION AUDIT

STRATEGY CHOICE

STRATEGY IMPLEMENTATION

VISION

 This is a much broader way of predicting the future of an organization

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 Mission Statement

 An expression of the overall purpose and scope of the organization which is in line with
the values and expectation of the stakeholders
 It answers the question; what sort of business are we/do we want to be?
 A mission statement will generally cover or contain 4 the elements :

1. Purpose
 -what and for whom the company exist for?

2. Strategy
 The range of business in which the firm seems to compete and some indications of how
it intends to compete.

3. Polices and Behavior Standards

 These are the guidelines which help staff decide what to do on a day –to –day basis to
carry out the strategy.

4. Values
 These are the beliefs and moral principles which lie behind the firm’s culture.
 The purpose of the mission statement is to communicate to stakeholders, the nature
of the organization and to focus strategy.
 However, in practice, there are generally full meaningless phrases.
 Taking an organization of your choice, briefly outline its mission statement.

Goals and Objectives

 -Goals are broader than objectives, these are also known as aims of the entity.
 Goals and objectives are often put together without no distinction made between
them.
e.g. of goals could be to improve profit or to reduce costs .
 However, goals are statements of general intention where as objectives are more
specific or targeted.
 An objective could be to achieve a 10% return on asset or a 10% mark-up /margin
within 6 months 1 year, 2 years etc.
 - Objectives must be smart (specific,measurable,attainable,realistic and time –bound)
 Example of financial objectives are :for the next 12months :
 To increase operating profit by 20%.
 To increase return on capital employed by at least 15%.
 To cut net losses to below 0, 5%.
 Examples of goals:
 To be a clear leader in the market.
 Achieving biggest growth in volumes/meeting higher customer satisfaction.

Corporate Appraisal
 It is a critical assessment of the strengths, weaknesses, opportunities and threats in
relation with the external and internal factors affecting an organisation.

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  The purpose is to establish the condition of an organisation prior to preparing a long-
term strategic plan.

Position Audit
 This assesses the strength and weaknesses of the company by asking questions such as:
what are we good/bad at?
 In particular, existing products will be reviewed and consideration given as to which
products should be continued /promoted and which ones to be phased out
/abandoned.
 0ne thing to be considered in relation to each product is as to where it is positioned
currently on its product life cycle.
Diagram

 If the product is currently in the maturity /decline phase, the company needs to
develop strategies for replacement of the product in the long term rather than relying
on its continuing profitability.

NB. The pricing method used depends on whether they are appropriate to the circumstance in
which they are used.

 It may be appropriate to charge the same price as competitors, e.g if customers

perceive different producers` products as largely generic since no significant are
achieved.
 In situations where competition is limited ,competitors ‘s prices provide no real
yardstick and hence full cost +mark up provides the way of arriving at a fair price
which is reasonable relative to cost of production.
 The general problem with adhoc approaches to pricing is the danger that the pricing
approach used in particular circumstances will not be appropriate in other
circumstances, will not serve the company’s strategic objectives and ultimately will
be sub-optimum.
 The proposal to adopt a strategic approach to pricing (is a very good one especially
where it is started that there is no intention to lock the company into one particular
approach to pricing.

Possible Strategies to pricing

1. Pricing permanently a product at a level in excess of competitors’ comparable
product.
 This is only feasible as part of product differentiation strategy. Here, the supplier
needs to convince customers that its products are superior to those of competitors
and hence the need for customers to pay extra for superiority.
 However shrinking consumer incomes may cause few customers to accept to a
price premium and hence this lowers profitability of the entity.
2. Setting a high price in early months of a product’s life cycle and reducing the price
for the remainder of the cycle.
 The technique is used for ensuring that enthusiastic ‘early adopters (those who are
not price sensitive) pay a higher price for the product.
 The approach is not suitable for regular items like food where profitability is
achieved through customer frequency and repeat purchases.
 It is also not proper where competitors offer similar products.

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3. Charging a low price in the early months of a product’s life cycle and then increasing
the price for the remainder of the product’s life cycle.(addictive products) .
 It is a good way to penetrate a market where the key to profitability is to ensure that
customers make repeat purchases.
 The low initial price will encourage customers to try new products and this becomes
an effective way of gaining market share.
 Subsequent increases in selling price provide profitability although price sensitive
customers may be lost at this stage.
 The strategy is effective in building customer loyalty to a differentiated product.

4. Selling a product at loss throughout its life cycle

 This is desirable if it facilitates the profitability of some other product ranges.
 Example, in order to obtain shelf space from a bread retailer there may be need to a
comprehensive range of bread products for various allergy sufferers.
 The major goal is to achieve overall profitability of many products rather than an
individual product from the distribution channel.

5. Bundling Products
 This is a way of concealing individual product prices from the customer.
 The profitability of a bundle can be assessed by comparing its sale price with the
combined production and distribution costs of the products in the bundle.
 While bundles may be profitable, the customer is forced to buy some products which
may be unwanted.
 Difficult strategy to sustain since their opportunities for competitors to offer
customers the chance to buy similar products individually rather than purchase the
entire bundle.
 A potentially useful approach to considering each existing product is to position them
on a Boston Matrix Grid.

Market share

High low

STAR QUESTION MARK

GROWTH

CASH COW DOG

LOW
HIGH

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QUESTION MARK
 This generates income but consumes more so we have aggressive marketing to turn
product into cash cow.
Cash Cow
 This is a well invested product and this generates income, all you have to do is to
maintain the low growth.
Dog
 Is a product that no longer generates cash

STAR
 Generates cash but consumes all what it generates and investment is needed to turn
products to cash cow.
 N.B. Having positioned the products on the grid, it can then be used to consider future
strategy for each of them.

 An environmental analysis can be carried out which identifies the opportunities and
threats presented by the external environment.
 These are summarized as PEST analysis.
Additionally (esp when launching a new product) consideration may be given to Porter’s 5
forces model i.e:
 Threat new entrance
 Threat of substitute
 Bargaining power of buyers
 Bargaining power of suppliers
 Rivary between competitors

 The Ansoff’s product market matrix can also be used.

 This is commonly used by businesses that have growth as their main objective and is
used to focus management attention on the four main alternative (strategic) available
for growth.

Existing products New products

Existing market
EXISTING MARKET Market penetration
PRODUCT

PENETRATION DEVELOPMENT

MARKET

MARKET PRODUCT

NEW DEVELOPMENT DIVERSIFICATION

|||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||\\\\
MARKET

 Having carried out the position audit and environmental analysis the task is to develop
the strategies in order to:

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 1. Convert weaknesses into strength
ii) Convert threats into opportunities.
iii) Match strengths and opportunities
 The exercise is commonly

 A swot analysis helps in identifying suitable strategy

 To assist in identifying sufficient strategies, a gap analysis is also required.

 Diagram

 The types of strategy that can be adopted in order to fill the gap are:

 Cost saving measures

 Becoming more efficient
 Making changes to the product /the market matrix, this could be by
organic or by acquisition
 Withdrawal.
Strategic Choice
 Having carried out a corporate appraisal and having identified potential strategies,it is
then necessary to appraise them and formulate a strategic plan.
 The types of techniques that may be employed in appraising the strategies are :

i) Strategy Implementation
 The strategic plan will generate the formulated on the board level and once it has
been prepared, managers of the company are then expected to implement it.
 The management will then carry out tactical planning0r management control.
II) Free Wheel Opportunitism
 This occurs where the company deals without a strategic plan but operate a
system where the opportunities are exploited as they arise.
 The major advantage is that opportunities can be sized as they arise.
 The major drawback is that it cannot guarantee that all opportunities are
identified and appraised.

Practice exercise
Question 3

Mark Tom has told you that he is anxious for KB to adopt a strategic approach to pricing. In
the past, prices have often been set on a variety of adhoc basis, such as charging full cost of
production (plus a mark-up to cover distribution costs and profit) or charging the some price
as competitors charge for similar products, but there has been Little consistency across
products or over time in the pricing bases adopted.

The proposed new strategic approach would not necessarily mean that the same basis of
pricing would not be adopted for all products, nor would it mean that a given product would

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necessarily be priced at the same level throughout its product lifecycle. However, Mark Tom
is anxious that (at the beginning of each product’s lifecycle) there should be a strategy in
place for pricing the product; such a strategy may include changing the price during the
product lifecycle. Different strategies may be adopted for different products.. Mark Tom has
given you the following examples of possible pricing strategies:

1. Permanently pricing a product at a level higher than competitors’ comparable

products.

2. Setting a high price for a product in the early months of its product life cycle, and
then significantly reducing the price for the remainder of the product lifecycle.

3. Charging a low price in the early months of a product’s life cycle, and then
significantly increasing the price for the remainder of the product life cycle.

4. “Bundling” products, that is selling some products only in combination with other
products so that the price of any individual product is not apparent to the purchaser

Required

5. Draft a report to mark Tom in which you

6. Assess whether the adhoc bases are appropriate for KB’s pricing decisions and

7. Evaluate the extent to which each of the five (strategies) examples of pricing
strategies is likely to be appropriate for the Company. In your answer, pay close
attention to the nature of KB’s products and to the nature of existing and future
competition. [Total 20 marks]

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TARGET COSTING
Historical Background
 It originated in Japan in the 1970s, it came to being as a result of recognition that
customers were demanding more diversity in products that they bought and the life
cycle of the products were getting shorter.
 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.
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.

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 xxxx
Less target margin xxx
Target cost xx

 The reason that target costing is used for new products is 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) Their e may be need to estimate capital investments, incremental fixed costs such
as marketing costs and additional salaries.

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 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.

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.
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.
NB Activity based costing can be employed to absorb costs rather than the traditional
methods.

Example
 A company has designed a new product, chicken lick; it currently estimates that in the
current market, the product could be sold for $70.00 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 $9/unit
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 $1.80 per kg. Direct labour –
each unit of chicken lick 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
$19 per hour.
Production overheads –it is expected that production overheads will be absorbed to
production cost at a rate of $60 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 chicken lick.
ii) Target cost for chicken lick
Iii) The size of the cost gap

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Closing the cost gap
 Common methods of closing the gap are:
 To redesign products to make use of common processes and components that is
already used in the manufacture of other products by the company.
 To discuss with key suppliers on the methods of reducing material costs.
 To eliminate non value added activities or non value added features of the product
design.
 To train staff in more efficient techniques .improvement in these reduces costs.
 To achieve economies of scale (buying and producing in bulk.
 To achieve cost reduction as a result of the learning curve effect that is through
experience curve effect.
Advantages of target costing
 It helps to improve the understanding within a company 0f product cost.
 It recognizes that the most effective way of reducing costs is to plan and control cost
from the design stage onwards.
 It helps to create a focus on the final consumer for the product or service because of
the concept of value.
 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
 Cost savings are actively sought and made continuously over the product ‘life
cycle.
 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.
 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
Question 2

In the new industrial environment, the usefulness of traditional approach is being challenged,
and new approaches sought. One approach, pioneered by the Japanese, is to replace
traditional approach to costs by target costs.

Required
(a) To describe the problems associated with traditional costing approach to costing in the
new industrial environment;

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 (8 marks)
(b) To explain what target costs are, and how they are developed and used; (9 marks)

(c) To contrast traditional approach to costing and target costs. (8 marks)

Question 2

Hunyani Furniture manufactures office chairs. It has been observed that sales for the
current year have fallen, compared to the previous year. Therefore, Mudebhe, the
marketing manager at Hunyani conducted a market research to find out the reasons
for the decrease. He discovered that a competitor has started selling a set of 10
chairs at a lower price i.e. $2,000. He estimated that in order to maintain the
demand, the company will need to rework the pricing decisions and cost structures.

Therefore, the directors asked the accounting team to compare Hunyani’s cost
accounting system with the competitors’ system. Mangwiro, the accountant at
Hunyani Furniture, analyzed the competitors’ cost accounting system. He determined
that the competitor has adopted a target costing approach for its product. Hence, the
directors have decided to implement target costing to manage costs and maintain the
market position.

However, Mangwiro is not aware of the target costing concept.

Required:

As a management accountant you are required to:

(a) Describe the target costing process that Hunyani Furniture should take on.

(4 marks)

(b) Explain the implications of using target costing on cost control.

(4 marks)

Currently Hunyani Furniture sells a set of 10 chairs for $2275. In order to meet the
competition, Comfort’s management has decided to sell each set for $2000. The
management expects to maintain a 25% return on its sales. It has budgeted the sale of

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10,000 sets of chairs at $2000 per set for the coming period. Due to fluctuations in
the business volume, Hunyani Furniture has more labour than what is required.
Hunyani Furniture’s cost department has estimated that 5% of the hourly rate is paid
to the carpenters for idle time.

The following is a cost structure for Hunyani Furniture

(i) Raw material i.e. wooden sheets required to make one set of chairs has been
purchased for $ 20 per sheet. 10 sheets are required to make one set of 10 chairs.

(ii) Polish that is used to finish the chairs is purchased at $15 per bottle. One
complete bottle is required to polish one chair.

(iii) Other accessories used for the chair are brought in at the rate of $12 per chair.

(iv) 5 hours are needed to complete one chair. Carpenters are paid at the rate of $5
per hour.

(v) Assembly workers are paid at the rate of $4 per hour for assembling one chair. 30
minutes are needed to assemble one chair.

(vi) Overheads are absorbed on the basis of total labour hours worked on carpentry
work. Hunyani Furniture’s carpentry department generally works for 80,000 hours per
year.

The following data relates to the last two month’s production overheads:
Month Production Labour hours in Carpentry
Overheads department
1 $80,000 5000
2 $120,000 9000
Required:
(c) From the above cost data, calculate the expected cost per unit of each set. Also
identify the difference between the expected cost and the target cost per unit of
each set.
(12 marks)

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Product life cycle costing /whole life cycle costing
 This is a costing method that considers the cost of a product or on an asset over its
entire marketable or useful life.
 Life cycle costing tracks and accumulates costs and revenue attributable to each
product over the entire product life cycle.
 It can be applied to:
 Products that are introduced to the market and then manufactured and sold
over a number of years until they are eventually withdrawn from the market.
 Building and other major construction items whose cost change over their
useful life from construction to eventual demolition.
Life cycle cost
 Cost of a product or asset over its useful life can be categorized into 3 namely:

1) Acquisition costs—these 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.

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.

3) End of life costs

 Costs incurred to withdraw a product from the market or to demolish the asset
after its use full life.
 Acquisition /setup costs are mainly’one-off’,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.
 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.
 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.

The product life cycle

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  Most products made in large quantities for selling to customers go through a life cycle.
 A life cycle consists of several stages:
 Research and development of the product(design and development stage)
 Introduction to the market
 Growth in sales and market size
 Maturity
 Decline
 The product is finally withdrawn from the market.
Detail stages

Example of whole life costing

 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 3000 12000 18000 7000
$ $ $ $
Research and Development 1800 000 200 000 ---- ---
Marketing costs 150 000 50 000 25 000 15000
Production cost/unit 650 450 350 300
Customer service cost/unit 40 30 30 30
Disposal specialist equipment 350 000

The marketing Director believes that customers would be prepared to pay $480 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.

Implications of using whole life cycle costing

 By using this method, we consider all costs incurred in the manufacturing of the
product, this 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;
 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.
 Techniques can be used to reduce costs over the life of the product.

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  The pricing strategy can be determined before the product enters production.
This may lead to better control of marketing and distribution costs.
 It also enables attention to be focused on reducing research and development
costs to get the product to the market as quickly as possible.
 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.

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.

Practice exercise

QUESTION 2

Kentucky Co specializes in the manufacture of a small range of electrical products for the fast
growing market. They are currently considering the development of new type of electrical
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 Year 3

Units manufactured and sold 10 000 20 000

Research and development costs 16 000

Product design costs 80 000

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Marketing costs 120 000 100 000 175 000

Manufacturing costs:

Variable cost per unit 40 42

Fixed production costs 65 000 129 000

Distribution costs:

Variable cost per unit 4 4.50

Fixed distribution costs 12 000 12 000

Selling costs:

Variable cost per unit 3 3.20

Fixed selling costs 18 000 18 000

Administration costs 20 000 90 000 150 000

Note: Ignore time value of money.

Required

Calculate the life cycle cost per unit. [8 marks]

8. After preparing the cost estimates above, the company realizes that it has not taken
into account the effect of the learning curve on the production processes. The
variable manufacturing cost per unit above, of $40 in year2 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 costs per hour for labour are $24 and the year 3
cost is $26 per hour. Subsequently it has now been estimated that, although the first is
expected to take to 0.5hrs, a learning curve as is expected to occur of 100th unit has
been completed.

9. Calculate the revised life cycle cost per unit taking into account the effect of the
learning curve.

Note the value of the leaning co-efficient, b is -0.0740005. [6 marks]

10. Discuss the benefits of life cycle costing [6 marks]

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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.
N.B In ABC:
 Some manufacturing costs may be excluded from product costs.
 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.

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Shortfalls of the Traditional Methods (Absorption)
 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
Question 1

Makoni Investments makes three types of Diamond Jewelery, the Xeno (X) Yaro (Y) and Zeu
(Z). A traditional product costing system is used at present, although and activity based
costing (ABC) system being is considered. Details of the three products for a typical period
are:

HOURS PER UNIT MATERIALS COST PRODUCTION

PER UNIT $ UNITS
MACHINE HRS LABOUR HOURS

Product X 1½ ½ 2 752

Product Y 1 1½ 11 1 248

Product Z 3 1 25 7 000

Direct Labour costs $7 per hour and production overheads are absorbed on a machine hour
basis. The overhead rate for the period is $28 per machine hour.

Required

1. Calculate the cost per unit for each product using the traditional methods. [4 marks]

2. Total production overheads are $654 500 and further analysis shows that the total
production overheads can be divided as follows:

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 %

Costs relating to set ups 35

Costs relating to machinery 20

Costs relating to materials handling 15

Costs relating to inspection 30

Total production overhead 100

The following total activity volumes associated with each product line for the period as a
whole.

Number of set ups Number of movements Inspections

of material

Product X 75 12 150

Product Y 115 21 180

Product Z 480 87 670

670 120 1 000

Required

b. Calculate cost per unit for each product using ABC principles (work to 2 decimal places)

c. Explain why costs per unit calculated under ABC are often different to cost per unit
calculated under traditional methods. Use Makoni Investments to illustrate. [8]

d. Discuss the implications of a switch to ABC on pricing and profitability. [4]

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.

20
  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.

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

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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.
 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

22
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 is a variable cost 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 organization.
 Therefore profit in throughput accounting is measured as:
Throughput –operating expenses
$
Sales xxx
Variable cost (material) ( xx)
Through put xxx
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

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  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 rate of absorption that the budgeted and actual overheads were the same
and there are no under/over absorption of overheads.

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.
 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 Ratios in Throughput Accounting

 Various performance measurements are available, one of these is net profit and the
objectives of any business are to increase the net profit therefore the following
measures.


24
LEARNING CURVES
 Most workers become more proficient at their task that moves 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 20 th 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.
 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 pre 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.

Exercise
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
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) What is the minimum price for the following order?

25
 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?

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.

LIMITATION 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= a * b

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 = index of learning [-0, 3219 for a Lc of 80%

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

Practice questions
Question 1

Learning Curve
A company has decided to diversify its activities and a new product has been developed which
will be included in the master budget preparation for the coming year.

Required
(a) Explain ways in which the learning curve effect may assist in cost reduction using practical
examples. (16 marks)

(b) Comment on potential problems where short-term profit maximization is seen as the main
objective when setting the budget for the new product. (9 marks)

26
TRANSFER PRICING

 In divisionalised companies, where profit or investment centers are created,

interdivisional transfers of goods or services and this internal transfer create the
problem of pricing.
 A satisfactory system of transfer pricing is necessary for measuring the performance of
transfer divisions.
 A transfer price is that national value at which goods and services are transferred
between divisions in decentralized organisations.
 Transfer prices are set for intermediate products which are goods and services that
are supplied by the selling division to the buying division.

Objective of transfer pricing

 Transfer pricing should help in the accurate measurement of divisional performance
(profitability) measurement.

EXAMPLE 2
Inscor LTD owns fast food restaurant and snack food and beverage manufacturing in
Zimbabwe. One of the restaurant Pizza Inn serves a variety of beverages along with pizzas.
One of the beverages is ginger beer which is served on tap.
The MD of Imperial beverage has approached the MD of Pizza Inn about purchasing imperial
beverage’s ginger beer for sale to Pizza Inn restaurants rather than its usual brand of
ginger beer. 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 --- 10 000 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.

27
PIZZA INN
 Purchase price of regular brand of ginger beer --- $18 per barrel
 Monthly consumption of ginger beer --- 2000 barrels

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

TP < 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

a. Selling divisions with idle capacity

Imperial beverages is selling 7000 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 2000 barrels

Selling division with the no idle capacity

 Imperial has no idle capacity and is selling 10 000 barrels a month to an outside
market at $20.What range of transfer pricing would make both divisions better off
transferring 2000 barrels within the company.

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 9000 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

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

28
Transfer price where there are no out side supplier .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 .

 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

Transferring at market price

Market price is a price charged on intermediate market

Intermediate market is a market on which a transfer product or service is sold is sold
its present form to outsiders
Its only effective when there is no idle capacity

Transfer price in international market

Objective of transfer pricing in international market

To pay less taxes , duties and tarrifs

Meant to ensure that there are
To ensure better competitive position
To align with government regulation

Practice exercises
Question 5

Bamaco Company is a company specializing in the manufacturer 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 centres.

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

29
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
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

11. 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].

12. Head office is considering changing the transfer pricing policy to ensure maximization
of company profits without demotivating either of the divisional managers. Division C

30
 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]

13. 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 2

Question 9
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)

(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.

31
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: 20 marks]

Transfer pricing –

(a) The transfer pricing system operated by a divisional company has the potential to
make a significant contribution towards the achievement of corporate financial
objectives.

Required:

Explain the potential benefits of operating a transfer pricing system within a

divisionalised company. (6 marks)

(b) A company operates two divisions, Mango and Avo. Mango manufactures two
products X and Y. Product X are sold to external customers for $42 per unit. The only
outlet for product Y is Avo.

Mango supplies an external market and can obtain its semi finished supplies (product
Y) from either Avo or an external source. Mango currently has the opportunity to
purchase product Y from an external supplier for $38 per unit. The capacity of
division Avo is measured in units of output, irrespective of whether product X, Y or a

32
combination of both is being manufactured. The associated product costs are as
follows:

X Y

Variable costs per unit 32 35

Fixed overheads per unit 5 5

Total unit costs 37 40

Required:

Using the above information, provide advice on the determination of an appropriate

transfer price for the sale of product Y from division Avo to division Mango under the
following conditions:

(i) When division Avo has spare capacity and limited external demand for product X;

(3 marks)

(ii) When division Able is operating at full capacity with unsatisfied external demand
for product X.

(4 marks)

(c) The design of an information system to support transfer pricing decision making
necessitates the inclusion of specific data. Identify the data that needs to be
collected and how you would expect it to be used.

(7 marks)

(20marks)

33
DIVISIONAL PERFOMANCE

Management should know what they expect to achieve and they should also be in the
goal-setting process. Failure results in dysfunction behavior which conflicts with the
short term interest of the organization.
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
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

34
 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
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

MEASURE OF PERFORMANCE IN DIVISINALISED

The rate of return for measuring managerial 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 where 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 QUSTION
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 centres
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
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

35
 Thus average operating assets is assets at the beginning and those at end

MATOR CHALLENGER

 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
 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 he margin.
 Turnover is the measure of sales that is generated for each dollar invested in
operating assets.
 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

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 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 50 000

Calculate ROI in terms of margin and turnover.

OTHER MEASURES OF PERFOMANCE

1. 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.
 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%?

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 0perating 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

Geddes Pharmaceuticals is a division of CAPS which was formed by acquiring a previously

independent company (“Harare P”) in February 2011. The budgetary control system used in

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this division has remained largely unchanged since Harare P was acquired, including a form of
strategic planning and control which involves the comparison on a monthly basis (against
budgets) of three aggregate-level performance measures, namely:
• Economic value added ™ (EVA);
• Residual income (RI);
• Return on investment (ROI), restated to its annual equivalent (e.g., if ROI for a given month
is 1% then this is restated as 1 * 12 months = 12% annual equivalent ROI).

The following is the forecast of these three measures for the next six months:
Sept Oct Nov Dec Jan Feb
EVA 850 620 950 1,170 730 500
RI 750 700 1,000 1,100 700 700
Annual equivalent ROI 9.6% 9.2% 10.6% 11.1% 9.5% 9.7%

REQUIRED:
Prepare a report for the Group Executive in which you critically assess this approach to
budgetary control, and suggest options as to how the current approach to strategic planning
and control should be improved.
(13 marks)

Question 2
Divisional performance assessment and ROI- Matronics Ltd

Matronics Ltd is an electronics store that has a number of stores across Zimbabwe.
The manager of the company is an ambitious person, and is looking to expand his
activities, by continuously adding the number of stores.

Matronics assesses the performance of each of their stores individually. The expected
return on investment (ROI) of Matronics is 10%. Some of the stores have been able to
achieve an ROI above this target.

The market for Matronics is rapidly increasing. The stores of the company, at an
average, have a gross profit ratio of around 40%.

Below is financial data given for two of Matronics Ltd’s stores for the last year: Store
A, Trafalgar court and Store B, Orr Street

Store A Store B

($'000) ($'000)

Sales 860 675

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Gross profit 362 285

Net profit 75 50

Assets employed (investment) 585 360

Required:

(a) Discuss the past financial performance of store A and B using ROI and any other
measure you feel appropriate from the given data. Using your findings discuss
whether each of the measures you used correctly reflects the stores’ actual
performance. (13 marks)

(b) Discuss the disadvantages of comparing divisional performance. (7 marks

Question 3

Tapera 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 behavior by division managers.
The following sample data is available concerning two of the company’s divisions for
last year:
Division X Division Y
Operating profit $15200
$7200
Capital invested $160000
$57600
The cost of capital is 7% for both divisions. It can be assumed that there are no intra-
company transfers between Divisions X and Y.

(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 Tapera PLC.
(8 marks)

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(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 $22000? Are their reactions in the best interests of the company’s
shareholders? Justify your answer. (8 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).
(4 marks)

(d) Although there are no intra-company transfers between Divisions X and Y, there
are a significant number of intercompany transfers between other divisions of Tapera
PLC. Discuss the circumstances in which it is feasible and appropriate to use external
market prices as the basis for setting transfer prices in such cases. (5 marks)

[Total: 25 marks]

BUDGETING

 A BUDGET is a formal statement of a company’s future plans.

 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.

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.

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  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.

2. COORDINATION PURPOSES
 The budget serves as a vehicle through which actions of different parts of an
organization 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.

3. 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.
 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.

4. 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.
5.CONTROL

 T he budget assist managers in controlling and managing activities for which

they is responsible.
 It promotes management by exception.

6.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 dependant 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.

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 BEHAVIOURAL ASPECTS OF BUDGETS
 Individuals react to the demands of budgeting and budgetary control in different
ways and their behaviour can damage the budget process.
BEHAVIOUR PROBLEMS INCLUDES

 Dysfunctional and budget stock. Dysfunctional is whereby individual managers

seek to achieve their own objectives at the expense of goal congruence.
 The system of targets and measures used should then encourage goal
congruence
 Budgets slack/bias - is a deliberate over –estimation of the expenditure and or
under – estimation of revenues in the budgeting process.
 This can happen because managers want easy target [for any easy life] or to
ensure targets is exceeded and bonuses won or simply to pay the system.

Question 1

Some commentators argue that “with continuing pressure to control costs and maintain
efficiency, the time has come for all public sector organizations to embrace zero based
budgeting. There is no longer a place for incremental budgeting in any organization,
particularly public sector ones, where zero based budgeting is far more suitable anyway”.

Required

14. Discuss the particular difficulties encountered when budgeting in public sector
organizations compared with budgeting in private sector organizations, drawing
comparisons between the two types of organizations. [5 marks]

15. Explain the terms ‘incremental budgeting’ and zero based budgeting’. [4 marks]

16. State the main stages involved in preparing zero-based budgets. [3 marks]

17. Discuss the view that “there is no longer a place for incremental budgeting in any
organization, particularly public sector one, highlighting any drawbacks of zero-based
budgeting that need to be considered. [8 marks] [Total 20 marks]

QUESTION 2

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.

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Required

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

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

QUESTION 3 budgeting

(a) ‘… corporate planning and budgeting are complementary, rather than the former
superseding the latter.’(DURY 2002)
Compare the aims and main features of ‘corporate planning’ and ‘budgeting systems.
(12 marks)
(b) The aims of zero-base budgeting have been described recently in the following terms:
‘Zero-base budgeting is a general management tool that can provide a systematic way to
evaluate all operations and programmes; a means of establishing a working structure to
recognise priorities and performance measures for current and future plans; in essence, a
methodology for the continual redirection of resources into the highest priority programmes,
and to explicitly identify tradeoffs among long-term growth, current operations, and profit
needs.(DURY 2002)’
Explain how a system of zero-base budgeting works, and to assess its likely success in
attaining the aims set out above. (13 marks)

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