Advanced Management Accounting

CERTIFIED PUBLIC ACCOUNTANTS
CPA
PART III
SECTION 5
ADVANCED MANAGEMENT ACCOUNTING
STUDY TEXT
www.someakenya.com Contact: 0707 737 890 Page 1

PAPER NO.14 14 ADVANCED MANAGEMENT ACCOUNTING
GENERAL OBJECTIVES
This paper is intended to equip the candidate with knowledge, skills and attitudes that will enable him/her
to apply advanced management accounting techniques in business decision making
14.0 LEARNING OUTCOMES

A candidate who passes this paper should be able to:
 Use cost estimation data in decision making
 Apply inventory management techniques to decision making
 Use financial and non-financial indicators to measure organizational performance
 Apply environmental management accounting concepts in practice
CONCEPT
14.1 Nature of management accounting

- Value of information in decision making; perfect and imperfect information
- Ethical standards of management accountants
14.2 cost estimation and forecasting

- An overview of the methods of cost estimation and prediction; engineering, simulation and
statistical methods, simple and multiple regressions, the statistical properties of regression
- Learning curve and its application
14.3 short-term planning and decision-making

- Overview of single product and multiple product cost-volume-profit analysis under conditions of
uncertainty
- single product and multiple product cost-volume –profit analysis under conditions of uncertainty
- risk assessment
- application of marginal costing: product mix decisions, special orders, make or buy decision,
pricing decision and other similar short-run decisions, relevant information in decision making
14.4 budgetary control and advanced variance analysis

- flexible and static budget, purpose of budgetary control; operation of a budgetary control system,
organization and and coordination of the budgeting function
- human aspects (motivational aspects) of budgeting, emerging trends in budgetary control; ERPS,
ABB,ZBB, program budgeting
- advanced variance analysis and performance evaluation; expost variances and opportunity costs in
variances
- variance investigation models
14.5 inventory control decisions

- cost of holding and ordering inventory
- stochastic inventory models
- inventory model for perishable items
- application of simulation models in inventory control
14.6 decision theory

- Decision process
- Decision making environment- certainity, risk, uncertainity and competition

- Decision making under uncertainity-maxmin, maxmax, minimax regret, Hurwicz decision rule,
Laplace decision rule
- Decision making under risk-expected monetary value, expected opportunity loss, minimizing risk
using coefficient of variation, expected value of perfect information
- Decision trees-sequential decision, expected value of sample information
- Limitations of expected monetary value criteria
- Game theory-non zero sum, two persons zero sum games, dominance, value of the game, saddle
point, mixed strategies
- Limitations of game theory
14.7 performance measurement and evaluation

- Linkage between performance measurement and organizational vision
- Responsibility accounting and responsibility centres, segmented reporting
- Distinction between financial performance measures and non financial performance measures
- Cost of information
- Methods of evaluating responsibility centre performance such as return on investment (ROI) and
residual income (RI) and economic value added (EVA) (importance and limitations of the
methods)
- Other financial/non-financial performance measures: balance score card, performance pyramid,
Fitgerald and Moon’s building block model, performance prism
- Managerial incentives schemes
- Performance contracting
- Performance measures in the service industry
14.8 Pricing decisions

- External pricing methods
- Internal pricing methods (transfer pricing)
- Backflush accounting
- Throughput costing
- Target costing
- Life cycle costing
14.9 Environmental management accounting

- Role of accountants in environmental management accounting
- Using environmental accounting to manage costs
- Opportunities for environmental awareness in management accounting
14.10 Emerging issues and trends
TOPIC PAGE
Topic 1: Nature of management accounting……………………………………………………………4
Topic 2: Cost estimation and forecasting………………………………………………………………16
Topic 3: Short-term planning and decision-making……………………………………………………57
Topic 4: Budgetary control and advanced variance analysis………………………………………….106
Topic 5: Inventory control decisions…………………………………………………………………..155
Topic 6: Decision theory………………………………………………………………………………175
Topic 7: Performance measurement and evaluation……………………………………………….….202
Topic 8: Pricing decisions………………………………………………………………………….….244
Topic 9: Environmental management accounting…………………………………………….….……278
Revised on: June 2016

TOPIC 1
NATURE OF MANAGEMENT ACCOUNTING
INTRODUCTION
Management Accounting is the process of identification, measurement accumulation, analysis,

preparation, interpretation and communication of financial information used by management to
plan, evaluate and control within an organization and to ensure appropriate use of and
accountability for its resources.
Management accounting is concerned with providing information to managers – that is, people
inside an organization who direct and control its operations. In contrast, financial accounting is
concerned with providing information to shareholders, creditors and others who are outside an
organization. Management accounting provides the essential data with which organizations are
actually run. Financial accounting provides the scorecard by which a company’s past
performance is judged.
Because it is manager oriented, any study of management accounting must be preceded by some
understanding of what managers do, the information managers need, and the general business
environment. As the organizations and the business environment changes then the role of
management accounting changes.
Management accounting focuses on both monetary and non-monetary information (for example,
cost drivers such as labor hours and quantities of raw materials purchased) that inform
management decisions and activities such as planning and budgeting, ensuring efficient use of
resources, performance measurement and formulation of business policy and strategy. The
collective goal of all this is to create, protect and increase value for an organization’s
stakeholders. Thus, Management accounting activities include data collection as well as routine
and more strategic analysis of the data via various techniques (such as capital investment
appraisal) designed to address specific management needs.
VALUE OF INFORMATION IN DECISION MAKING: PERFECT AND IMPERFECT

INFORMATION
The uncertainty about the future outcome from taking a decision can be reduced by obtaining
more information first about what is likely to occur.
When a decision-maker is faced with a series of uncertain events that might occur, he or she
should consider the possibility of obtaining additional information about which event is likely to
occur.
Perfect information is available when a 100% accurate prediction can be made about the future.

The concept of perfect information is somewhat artificial since, in the real world, such perfect
certainty rarely, if ever, exists.
For example, predictions for future demand may only be 80% reliable. Hence, the value of
imperfect information will always be less than the value of perfect information unless both are
zero.
This would occur when the additional information would not change the decision.
The approach to calculate the value of perfect and imperfect information is the same i.e compare
the expected value of a decision if the information is acquired against the expected value with the
absence of the information.
The difference represents the maximum amount it is worth paying for the additional information
The information can be obtained from various sources e.g.

 Market surveys
 Conducting pilot tests
 Building a prototype model
 Use of consultants
Information can be categorized depending on how reliable it is likely to be for predicting what
would happen in the future and for helping managers make better decisions.
Perfect Information
Perfect information (PI) is information that can be guaranteed to predict the future with 100%
accuracy, which, although it might be quite good, it could be wrong in its prediction of the future.
Both perfect and imperfect information is costly and its value must be determined
The value of perfect information

In decision theory, the expected value of perfect information (EVPI) is the price that one would
be willing to pay in order to gain access to perfect information.
CALCULATING THE VALUE OF PERFECT INFORMATION

Value of perfect information (PI) = Expected Profit (value) WITH perfect information LESS
Expected Profit (value) WITHOUT perfect information.
Expected valueis Total of the weighted outcomes (payoffs) associated with a decision, the
weights reflecting the probabilities of the alternative events that produce the possible payoff. It is
expressed mathematically as the product of an event's probability of occurrence and the gain or
loss that will result.
Expected value of perfect information is the maximum amount a decision maker is willing to
pay for perfect information.

Payoff tables
A profit table (payoff table) is a useful way to represent and analyze a scenario where there is a
range of possible outcomes and a variety of possible responses. A payoff table simply illustrates
all possible profits/losses and as such is often used in decision making under uncertainty.
ILLUSTRATION
Constructing a payoff table
Haffen Matena supplies homemade mandazi to various customers in a city. Each mandazi is sold
to a customer for sh.10 and costs sh.8 to prepare. Therefore, the contribution per mandazi is sh.2.
Based upon past demands, it is expected that, during the 250 day working year, the customers
will require the following daily quantities:
 On 25 days of the year, 40 mandazis.
 On 75 days 70 mandazis.
He must provide the mandazis when they are fresh in batches of 10 in advance. He has asked for
assistance to decide how many mandazis he should supply for each day of the forthcoming year.
Constructing a payoff table

If 40 mandazi s will be required on 25 days of a 250 day year, then the probability that demand
will be 40 mandazis is;-
P (Demand of 40) is 25 days ÷ 250 days = 0.1
Likewise,
 P (Demand of 50) =50 days ÷ 250 days =0 .20;
 P(Demand of 60) = 60 days ÷ 250 days =0.4 and
 P(Demand of 70) =70 days ÷ 250 days= 0.30
The different values of profit or losses depending on how many mandazis are supplied and sold
can be analyzed as follows;-
For example, if he supplies 40 mandazis and all are sold, his profits amount to 40 x sh.2 = 80.
If however he supplies 50 mandazis but only 40 are bought, profits will amount to 40 × sh.2 - (10
unsold mandazis × sh.8 unit cost) = 80 - 80 = 0.

Similarly, a payoff table can be constructed as follows;-
Daily supply
Probability 40 mandazis 50 mandazis 60 mandazis 70 mandazis
40 mandazis 0.10 sh.80 sh.0 sh. (80) sh. (160)
50 mandazis 0.20 sh.80 sh.100 sh.20 sh. (60)
Daily Demand 60 mandazis 0.40 sh.80 sh.100 sh.120 sh.40
70 mandazis 0.30 sh.80 sh.100 sh.120 sh.140
To decide how many mandazis should be made every day, expected valuesof profits could be
used to make a decision.
An expected value 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.
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.
The formula for the expected value is EV = Σpx
Since the expected value shows the long-run average outcome of a decision which is repeated
time and time again,it is a useful decision rule for a risk neutral decision maker. This is because
a risk neutral investor neither seeks risk or avoids it; he is happy to accept an average outcome.
ILLUSTRATION
Continuing with our previous illustration where Haffen Matena supplies homemade mandazi to
various customers in a city. Each mandazi is sold to a customer for sh.10 and costs sh.8 to
prepare. Therefore, the contribution per mandazi is sh.2. At present Haffen must decide in
advance how many mandazis to prepare each day (40, 50, 60 or 70). Actual demand will also be
40, 50, 60 or 70 each day.
Haffens payoff as determined above is as follows;-
Daily supply
Probability 40 mandazis 50 mandazis 60 mandazis 70 mandazis
40 mandazis 0.10 sh.80 sh.0 sh. (80) sh. (160)
50 mandazis 0.20 sh.80 sh.100 sh.20 sh. (60)
Daily Demand 60 mandazis 0.40 sh.80 sh.100 sh.120 sh.40
70 mandazis 0.30 sh.80 sh.100 sh.120 sh.140
The expected value associated with each choice is as follows:

 If choose to make 40 mandazis, EV = 1×80 = 80
 If choose to make 50 mandazis, EV = 0.10×0 + 0.90×100 = 90

 If choose to make 60 mandazis, EV = 0.10×(-80) + 0.20×20 + 0.70×120 = 80
 If choose to make 70 mandazis, EV = 0.10×(-160) + 0.20×(-60) + 0.40×40 + 0.30×140 = 30
Based on expected values without additional information, he would choose to make 50 mandazis
per day with an EV of sh.90 per day. This is the expected highest payoff or profit.
Suppose a new ordering system is being considered, whereby customers must order their
mandazis online the day before. With this new system he will know with certainty the daily
demand 24 hours in advance. He can adjust production levels on a daily basis.
To find the worth of this system to Mr. Matena we compute the value of perfect information.
Note; value of perfect information = Expected Profit (Outcome) WITH the information LESS
Expected Profit (Outcome) WITHOUT the information
If supply = demand Pay off (profit) Probability Px

Sh. Sh.
40 80 0.1 8
50 100 0.2 20
60 120 0.4 48
70 140 0.3 42
118
Sh.
Expected Profit (Outcome) WITH the information 118
Less; Expected Profit (Outcome) WITHOUT the information (90)
Value of perfect information 28
ILLUSTRATION
A company is trying to decide on whether to make or sell product A or B. The demand of the
products on the market is uncertain and the payoff table is as shown below;-
Options Demand outcome

Strong Weak
Product A 4,000 -100
Product B 1,500 500
Probability 0.3 0.7
A market research can predict the nature of demand with 100% accuracy. The market researcher
is charging a fee of Shs 550 for this perfect information. Find the value of information and shares
whether it is worth paying the fee.

SOLUTION
Product A
Expected Monetary Value (EMV)= (4000 x 0.3) + (-100 x 0.7)= Sh 500
Product B
Expected Monetary Value (EMV)= (1500 x 0.3) + (500 x 0.7)= Sh 800
Decision
The company should launch product B
Value of perfect information = Expected value with perfect information (E.V.W.P.I) – Expected
value without perfect information.
Expected value without perfect information is Shs 800
Expected value with perfect information = (4,000 × 0.3) + (500 ×0.7)= Shs 1,550
Therefore the value of perfect information = E.V.W P. I – E.V without PI= 1550 – 800= Shs 750
Cost of information = Shs 550. Therefore the organizer should go for information because the
cost of information is less than the value of perfect information.
Imperfect Information
Market research finding or information from pilot studies are likely to be reasonably accurate but
can still be wrong in prediction. They provide imperfect information.
The value IPI = EV with IPI – EV without IPI
Where
IPI is imperfect information.
EV is the expected value.
ILLUSTRATION
(a) Tallo Company has the mineral rights to a piece of land that is believed to have oil
underground. There is only a 10% chance that they will strike oil if they drill, but the profit is
sh.200,000.
It costs sh.10, 000 to drill. The alternative is not to drill at all, in which case the profit is zero.
Required;-
Should Tallo Company drill the oil? Draw a decision tree to represent the problem.

(b) Before Tallo company drill, they may consult a geologist who can assess the promise of the
piece of land. She can tell whether the prospects are good or poor, but she is not a perfect
predictor. If there is oil, the probability that she will say there are good prospects is 95%. If
there is no oil, the probability that she will say prospects are poor is 85%.
Required;-
Draw a decision tree and calculate the value of imperfect information for this geologist. If the
geologist charges sh.7,000, would Tallo company use her services?
SOLUTION
(a)
EV ('Drill') = (sh.190, 000 × 0.1) + (- sh.10, 000× 0.9) = sh.10, 000.
Tallo Company should drill, because the expected value from drilling is sh.10, 000, versus
nothing for not drilling.
(b) Calculating the Expected Value of profits if the geologist is employed;-

If this exceeds sh.10, 000, the geologist would be worth employing as long as the benefit of
employing her exceeds her charge of sh.7, 000.
If the geologist is employed, the probabilities of her possible assessments can be tabulated as
follows (assume 1,000 drills in total):
Oil present No oil Total
Geologist says 95% × 100=95 15% × 900=135 230 drills
‘prospects are good’ drills drills
Geologist says 5% ×100=95 drills 85%×900=765 drills 770 drills
‘prospects are poor’
100 drills 900 drills 1,000 drills

A decision tree can be drawn to calculate the expected value of profits if a geologist is employed:
Working from right to left:
EVA = (41.30% × sh.200, 000) - sh.10, 000 drilling costs = sh.72, 600.The decision at 'C' should
be to drill, as this generates higher benefits than not drilling.
EVB = (0.65% × sh.200, 000) - sh.10, 000 drilling costs = - sh.8, 700. The decision at 'D' should
be not to drill.
EVC = 0.23 × sh.72, 600 = sh.16, 698. This is the expected value of profits if a geologist is
employed and exceeds the EV of profits if she is not employed.
Expected Value of Imperfect Information = sh.16, 698 - sh.10, 000 = sh.6, 698.
Since sh.6, 698 is less than the cost of buying the information (sh.7, 000), we should not employ
the geologist.
ILLUSTRATION
Agip Oil Company is trying to decide if to drill or not to drill particular site working for oil. The
chief engineer in the company believes that there is 20% chance of finding oil after drilling and
80% chance is of finding no oil after drilling. The company can hire a firm of consultants who
will carry out preliminary survey of the site. The company has used such consultants before in
other contracts and estimate the accuracy of their forecast. If the site has oil, there is 95% chance
that the consultant will predict favorably. If the site has no oil, there is a 10% chance that the
consultant will predict favourable. The favourable cost of drilling is Shs 10 million. The benefit
is Shs 70 million if oil is found. The cost of information is Shs 3 million. There is no benefit if no
oil found.
Required;
Determine the value of information and what the company will pay as consultant fee.

SOLUTION
We are given three sets of probability.
i) Probability that there would be oil (20%) or there will be no oil (80%).
These outcomes are mutually exclusive.
ii) The probability that if there is oil the report will say there is oil (95%) or say there is no oil
the probability is (5%).
iii) The probability that if there is no oil, the report will say there is oil (10%) or say there is
no oil is (90%).
Both (ii) and (iii) describe conditional events since the existence of oil or otherwise influences
the chance of the survey report being correct. This requires us to use the Bayes Theorem. A
quicker way of applying the Bayes Theorem, is tabulated the various probabilities as percentages.
Actual outcome
Oil No Oil Totals
Oil 95% ×20 = 19 10% ×80 = 8 27
Survey Report No oil 5% × 20 = 1 90% ×80 = 72 73
20 80 100
The probability that the survey report says there will be oil is 27% and the probability that the
survey report will say there is no oil is 73%.
If the survey say there is oil, the probability that there is oil is 1990 ÷ 27% = 0.704 and if
survey report there is oil the probability that there is no oil is 8% ÷ 27% = 0.296.
If the survey report say no oil, the probability that there is oil is 1% ÷ 73% = 0.014 and if
survey report say there is no oil the probability that there is no oil is 72% ÷ 73% = 0.986
Pay offs EMV
60m 0.2 x 60
No Oil = 0.2
Oil = 0.704 60 x 0.74 = 42.24

No information 4M No Oil = 0.8
- 10 0
Survey report say
There is oil = 0.27
Oil = 0.296 (10m)
Get information
Oil = 0.014 0
3M
39.28 x 0.27 = 10.61
Survey report say
There is no oil = Oil = 0.986 0
The expected value without perfect information is 4m

The expected value with imperfect information = (10.61 – 3m) = 7.61m)
Value of imperfect information = Expected value with imperfect information – Expected value
without perfect information.
= 7.61m – 4m = 3.61m

Conclusion
The organization can go for information as long as the cost of information is not more than
3.61m.
ETHICAL STANDARDS OF MANAGEMENT ACCOUNTANTS

Ethics in accounting is of utmost importance to accounting professionals and those who rely on
their services. Certified Public Accountants (CPAs) and other accounting professionals know that
people who use their services, especially decision makers using financial statements, expect them
to be highly competent, reliable, and objective. Those who work in the field of accounting must
not only be well qualified but must also possess a high degree of professional integrity. A
professional’s good reputation is one of his or her most important possessions.
The general ethical standards of society apply to people in professions such as medicine and
accounting just as much as to anyone else. However, society places even higher expectations on
professionals. People need to have confidence in the quality of the complex services provided by
professionals. Because of these high expectations, professions have adopted codes of ethics, also
known as codes of professional conduct. These ethical codes call for their members to maintain a
level of self-discipline that goes beyond the requirements of laws and regulations.
Management accountants should behave ethically. They have an obligation to follow the highest
standards of ethical responsibility and maintain good professional image.
The Institute of Management Accountants (IMA) has developed four standards of ethical conduct
for management accountants and financial managers.
1. Competence
Management accountants are to;-
 Maintain an appropriate level of professional competence by ongoing development of their
knowledge and skills.
 Perform their professional duties in accordance with relevant laws, regulations, and technical
standards.
 Prepare complete and clear reports and recommendations after appropriate analyses of
relevant and reliable information.
2. Confidentiality
 Refrain from disclosing confidential information acquired in the course of their work except
when authorized, unless legally obligated to do so.
 Inform subordinates as appropriate regarding the confidentiality of information acquired in
the course of their work and monitor their activities to assure the maintenance of that
confidentiality.
 Refrain from using or appearing to use confidential information acquired in the course of their
work for unethical or illegal advantage either personally or through third parties.
3. Integrity
 Avoid actual or apparent conflicts of interest and advise all appropriate parties of any
potential conflict.
 Refrain from engaging in any activity that would prejudice their ability to carry out their
duties ethically.
 Refuse any gift, favor, or hospitality that would influence or would appear to influence
their actions.
 Refrain from either actively or passively subverting the attainment of the organization's
legitimate and ethical objectives.
 Recognize and communicate professional limitations or other constraints that would
preclude responsible judgment or successful performance of an activity.
 Communicate unfavorable as well as favorable information and professional judgments or
opinions.
 Refrain from engaging in or supporting any activity that would discredit the profession.
4. Credibility
 Communicate information fairly and objectively.
 Disclose fully all relevant information that could reasonably be expected to influence an
intended user's understanding of the reports, comments, and recommendations presented.
Resolution of Ethical Conflict

In applying the standards of ethical conduct, practitioners of management accounting and
financial management may encounter problems in identifying unethical behavior or in resolving
an ethical conflict. When faced with significant ethical issues, practitioners of management
accounting and financial management should follow the established policies of the organization
bearing on the resolution of such conflict. If these policies do not resolve the ethical conflict,
such practitioners should consider the following courses of action;-
 Discuss such problems with the immediate superior except when it appears that the superior is
involved, in which case the problem should be presented initially to the next higher
managerial level.
 If a satisfactory resolution cannot be achieved when the problem is initially presented, submit
the issues to the next higher managerial level. If the immediate superior is the chief executive
officer, or equivalent, the acceptable reviewing authority may be a group such as the audit
committee, executive committee, board of directors, board of trustees, or owners. Contact
with levels above the immediate superior should be initiated only with the superior's
knowledge, assuming the superior is not involved. Except where legally prescribed,
communication of such problems to authorities or individuals not employed or engaged by the
organization is not considered appropriate.
 Clarify relevant ethical issues by confidential discussion with an objective advisor to obtain a
better understanding of possible courses of action. Consult your own attorney as to legal
obligations and rights concerning the ethical conflict.

 If the ethical conflict still exits after exhausting all levels of internal review, there may be no
other recourse on significant matters than to resign from the organization and to submit an
informative memorandum to an appropriate representative of the organization. After
resignation, depending on the nature of the ethical conflict, it may also be appropriate to
notify other parties.

TOPIC 2
COST ESTIMATION AND FORECASTING
INTRODUCTION
Cost estimation is the process of pre-determining the cost of a certain product, job or order. It is
a term used to describe the measurement of historical cost with a view of providing estimates on
which to base the future expectation on cost.
The predetermination of cost may be required for several purposes e.g. budgeting, measurement
of performance efficiency, preparation of financial statements (valuation of stocks), make or buy
decisions and fixation of sales prices of the products.
AN OVERVIEW OF THE METHODS OF COST ESTIMATION AND PREDICTION;

Introduction
Mixed costs have both a fixed portion and a variable portion. There are a handful of methods
used by managers to break mixed costs in the two manageable components--fixed costs and
variable costs. The process of breaking mixed costs into fixed and variable portions allow us to
use the costs to predict and plan for the future since we have a good insight on how these costs
behave at various activity levels. We often call the process of separating mixed costs into fixed
and variable components, cost estimation.
The Goal of Cost Estimation

The ultimate goal of cost estimation is to determine the amount of fixed and variable costs so that
a cost equation can be used to predict future costs. You should remember the concept of
functions from your business calculus class. The function that represents the equation of a line
will appear in the format of:
y=mx+b
Where y = total cost

m = the slope of the line, i.e., the unit variable cost
x = the number of units of activity
b = the y-intercept, i.e., the total fixed costs
Determining a linear function is useful in predicting cost amounts at different levels of activity.
Why do managers need to be able to predict costs? They want to plan for future operations often
through what-if analysis and budgets. A key concept you must remember is that before you
employ any of the estimation methods, you must have already determined the cost is mixed.
There is no need to analyze a cost to break it down into fixed and variable portions if you already
know whether it is variable or fixed. Your goal it to determine the variable cost per unit and total
fixed costs to plug into the cost equation.

The methods involved in cost estimation. Namely;-
- Engineering method
- High low method
- Account analysis
- Visual fit method
- Regression analysis
Engineering Method
This method is used when no previous records of costs exist. It is a very detailed method that
goes into the nitty-gritty of what constitutes a product in terms of how much material or how
much labor. From this a suitable level of activity can be determined. The result of the direct
observation of physical quantities is then converted into a cost estimate. This approach can be
lengthy and expensive. It adopts the element of motion study from the scientific theory of
management.
This method is based on a detailed study of each operation where careful specification is made
for materials, labor and equipment necessary to produce a product. It involves identifying the
level of input required of an activity in form of raw material and labor while total cost is based on
the cost of each input. This approach is applicable where no past data exists. The main setback of
the approach is that it requires a complex analysis of all the constituents of an activity and the
requirements of an activity in terms of costs detailed into materials, labor, overheads and time.
High Low Method

In this method the highest and lowest activity together with their corresponding costs is
identified.
High-Low method is one of the several techniques used to split a mixed cost into its fixed and
variable components. Although easy to understand, high low method is relatively unreliable. This
is because it only takes two extreme activity levels (i.e. labor hours, machine hours, etc.) from a
set of actual data of various activity levels and their corresponding total cost figures.
The two points i.e. the lowest and the highest are used to derive a cost function in the form of
y = a + bx.
Variable cost per unit (b) is calculated using the following formula;-
y2 − y1
Variable Cost per Unit =
x2 − x1
Where;-
y2 is the total cost at highest level of activity;
y1 is the total cost at lowest level of activity;
x2 are the number of units/labor hours etc. at highest level of activity; and
x1 are the number of units/labor hours etc. at lowest level of activity

The variable cost per unit is equal to the slope of the cost volume line (i.e. change in total cost ÷
change in number of units produced).
ILLUSTRATION
Use the high low method to obtain the cost function of the data given below;-
No. of units (x) Cost of product

(y)
100 895
80 700
200 1,294
400 1,680
450 2,550
Units(x) Cost(y)
High 450 2,550

Low 80 700
Y = a + bx
a  700  80 (5)
2,550 = a + 450b b = 1850 5
370  300
700 = a + 80 b
1,850 = 370 b
Therefore Cost of production y = 300 + 5x

Estimated cost of producing 430 units
300 + 5(430) = sh. 2,450
ILLUSTRATION
Deco Chemicals Ltd manufactures a single type of liquid chemicals. The company’s production
overheads vary with volume of production in litres. Volume of production and the amount of
overheads for 10 months that ended 31st October 2004 are presented below.
Month Volume of production Production overheads

overheads (litres ‘000’) (shs ‘000’)
January 150 1800
February 120 1400
March 200 2300
April 170 1900
May 120 1600
June 250 3000
July 220 2700
August 90 1100
September 180 2400
October 300 3200

Required:
i) Use the high-low method to determine an equation in the form y = a + bx
ii) Using the equation in (i) above determine the overheads for production of 350,000,000 units.
SOLUTION
Highest production level 300 Total cost = 3200
Lowest production level 90 Total cost = 1100
Difference 210 2100
∴ Variable cost per unit (b) = = Sh 10

y = a + bx
Using the highest production level,

a = y – bx
= 3200 x 10 x 30
a = 200
∴ = 200 + 10x
For production of 350,000 units

Y = 200 + 10 x 350
= 3700
Advantages of high low method

1. Highest and lowest covers the relevant level of operation.
2. It takes into account possible extreme values of cost thus saving time.
3. It is not expensive.
4. It is quite easy to apply.
Disadvantages of high low method.

1. It relies on two points to represent all the other points
2. The estimated cost function may poorly describe the actual cost relationship.
3. It is only useful when we have a single independent variable ( single predictor variable)
4. The method presumes that the relationship between x and y;-
i) Exists
ii) Linear
5. It does not take into consideration occurrence of any un usual situation hence giving in
accurate analysis.
Account Analysis
Under account analysis method, the accountant examines and classifies each ledger account as
variable, fixed or mixed. Mixed accounts are broken down into their variable and fixed

components. They base these classifications on experience, inspection of cost behavior for
several past periods or intuitive feelings of the manager.
This is with a view to develop a cost function in the form y=a +bx
ILLUSTRATION
Suppose a company ABC has the following costs with a value of 7,000 units.
Amount Variable Fixed

Shs. Shs. Shs.
Direct labour 150,000 150,000 -
Materials 125,000 125,000 -
Repairs and maintenance 5,000 5,000 -
Depreciation 15,000 - 15,000
Administration overheads 1,000 - 1,000
Indirect labour 4,000 - 4,000
300,000 280,000 20,000
Required;-
Determine the cost equation using account classification method and determine the cost of
producing 1,400 units
SOLUTION
,
Variable cost b = =Shs 40
,
a = shs 20,000
Substituting in the Equation y= a +bx

Y= 20,000 + 40x
Hence the cost of producing 1400 units is
Y= 20,000 + 40(1,400)
Shs. 76,000
ILLUSTRATION
In the year 2012 VIP incurred the following expenses to maintain 1500 lecturers.
Sh.
Administration expenses (40% variable) 4,000,000
Lecturing pay (60% variable) 8,000,000
Airtime allowance (fixed) 1,000,000
Sundry expenses (50% fixed) 500,000
Soda allowance (variable) 300,000

Required;-
a) Using accounts analysis method, express an equation in form y = a + bx
b) Using the equation expressed above, estimate the total cost of 2000 lecturers incurred to be
employed in 2013.
SOLUTION
Total cost Variable Fixed
Sh Sh Sh
Administration expenses 4,000,000 1,600,000 2,400,000
Lecturing pay 8,000,000 4,800,000 3,200,000
Airtime allowance 1,000,000 - 1,000,000
Sundry expenses 500,000 250,000 250,000
Soda allowance 300,000 300,000 __-____
6,950,000 6,850,000
, ,
b= = 4,633.33 a = 6,850,000
,
(a) y = a + bx ∴ y = 6,850 + 4633.33x

(b) For 2000 lecturers
Total cost y = 6,850,000 + 4633.33 ×2000

= Sh 16,116,660
Visual Fit Method

For this method a scatter diagram is constructed which is used to visually i.e. by inspection
deduce a relationship from observed pattern if there is any. By obtaining any two points on
constructed graph, we can fit a straight line if the pattern suggests a linear relationship.
Y
- Non-linear relationship
x x x x - Quadratic since has one
x x x
x x turning point
xx xx x
x x xxx x
x
X
Y
x x x No relationship between x and y

x xx x x
x x
x x xx x x
x x x xx
x x
X
y
x x Linear but inverse relationship

x x
x x
x
x x
x
x x
x
Advantages of visual fit method
1. It takes into account all the observations unlike the high low method.
2. It is easy to apply.
Disadvantages of visual –fit method

1. It cannot be used for two or more independent variables
2. We cannot measure the size of probable error.
3. It is subjective to some extend.
SIMPLE AND MULTIPLE REGRESSIONS

Simple linear regression is the least squares estimator of a linear regression model with a single
explanatory variable. In other words, simple linear regression fits a straight line through the set of
n points in such a way that makes the sum of squared residuals of the model (that is, vertical
distances between the points of the data set and the fitted line) as small as possible.
By multiple regression, we mean models with just one dependent and two or more independent
(exploratory) variables. The variable whose value is to be predicted is known as the dependent
variable and the ones whose known values are used for prediction are known independent
(exploratory) variable
Regression analysis is a technique that uses a statistical model to measure the amount of change
in one variable (dependent variable) that is associated with changes in amounts of one or more
variables.
This method is used to determine the equation of the line of best fit by minimizing the sum of the
squares of the vertical
In simple regression when it has been established that a causal relationship exists in the data and
that a linear function is appropriate the statistical technique known as least squares is frequently
used to establish values for the coefficients a and b (representing fixed and variable cost
respectively) in the linear cost function.
y = a + bx
where y is total cost – the dependent variable
and x is the agreed measure of activity – the independent variable
The values of a and b are determined after substituting data.
i) In the normal equation below.
 y  n a  b  x............................................(i)
2
 x y  a x  b  x ...................................(ii)
ii) In the formulas below
b
n  xy   x  y
a
 y  b x _ _
or a  y  b x
n  x 2  ( x ) 2 n
When it has been established that a causal relationship exists in the data and that a linear function
is appropriate the statistical technique known as least squares is frequently used to establish
values for the coefficients a and b (representing fixed and variable cost respectively) in the linear
cost function.
y = a + bx
where y is total cost – the dependent variable and x is the agreed measure of activity – the
independent variable
Characteristics of linear regression

1. It is objectively determined.
2. It makes use of all the data or observations
3. It minimizes the sum of squares of the error terms
4. If there is a linear relationship between the dependent and independent variable, this method
gives the best predictions within the relevant range.
In a multiple regression model that incorporates two or more independent variables and it is of
the general form
y = a+ b1x1 + b2x2 + ……………………… + bnxn
Where a = constant or intercept
X1,x2 ……………… xn – independent variables
b1b2 ………………….. bn – coefficient of independent variables
The values of a, b, b2 ……..bn can be determined after substituting data in the normal equations
below
i) ∑ = + ∑ + ∑ +……………………….. ∑
ii) ∑ = ∑ + ∑ + ∑ +……………………….. ∑
iii) ∑ = ∑ + ∑ + ……………………….. ∑
Manual determination of the constant and coefficients is tedious but it is no longer a problem
with computerization

An equation would be the most advantageous in predicting annual demand because of the
following reasons:-
i) It has the highest coefficient of correlation. This means that advertising funds and factory
rebates are good predictors of annual demand.
ii) It has the highest coefficient of determination of 0.793. It means 70.3% of the variation in
annual demand is explained by the variation in advertising funds and factory rebates
iii) It has the smallest standard error of estimate. This implies that the estimated or predicted
demand is closer t the actual demand than if the other models were used
In a multiple regression analysis model, no two strongly related independent variables should be
used in the same model
ILLUSTRATION
The following table shows the number of units of a good produced and the total costs incurred.
Units produced Total costs
100 40,000
200 45,000
300 50,000
400 65,000
500 70,000
600 70,000
700 80,000
Calculate the regression line for y and n.
SOLUTION
Notes on the calculation
The calculation can reduced to a series of steps as follows;-
Step 1:
Tabulate the data and determine which is the dependent variable, y, and which the independent x.
Step 2:
Calculate∑ , ∑ , ∑ , ∑ (leave room for a column for ∑ which may well be needed
subsequently)
Step 3;
Substitute in the formation in order to find b and a in that order.
Step 4;
Substitute a and b in the regression equation.
The calculation is set out as follows, where x is the activity level in units of hundreds and y is the
cost in units of sh.1,000.

x y xy x2
1 40 40 1
2 45 90 4
3 50 150 9
4 65 260 16
5 70 350 25
6 70 420 36
7 80 560 49
28 420 1,870 140 n=7
∑ ∑ ∑
b= ∑ (∑ )
(Try to avoid rounding at this stage since, although n ∑ are large, their difference is much
smaller)
( , ) ( ) , , ,
= ( ) (
= = = 6.79
)
∑ ∑
a = – = – 6.79 = 60 – 27.16= 32.84
Therefore the regressional line for y on x is:

y = 32.84 + 6.79x (x in hundreds of units produced, y in sh.1,000).
(Always specify what x and y are very carefully)
This line would be used to estimate the total costs for a given level of output. If, say, 250 units
were made we can predict the expected yield by using the regression line where x = 2.5.
y = 32.84 + 6.79 x 2.5
= 32.84 + 16.975
= 49.815
i.e. we predict total costs of sh.49,815 for production of 250 units.
Using the regression line for forecasting

In the previous example, having found the equation of the line of best fit, we used this to forecast
the total cost for a given level of activity.
The validity of such forecasts will be dependent upon two main factors.
 Whether there is sufficient correlation between the variables to support a linear
relationship within the range of the data used.
 Whether the forecast represents an interpolation or an extrapolation

ILLUSTRATION
The following data have been collected on costs and output:
Output (000s) 1 2 3 4 5 6 7
Costs 14 17 15 23 18 22 31
(sh.000s)
Calculate the coefficients in the linear cost function (y = a + bx)

using
i) The Normal Equation and (ii) the coefficient formulae
SOLUTION
Output (x) Costs (y) Xy x2

1 14 14 1
2 17 34 4
3 15 45 9
4 23 92 16
5 18 90 25
6 22 132 36
7 31 217 49
Σx = 28 Σy = 140 Σxy = 624 Σx2 = 140
Where n = 7 (i.e. number of pairs of readings)

i) Using the normal equations
140 = 7a + 28b ………..I
624 = 28a + 140b ……….. II
And eliminating one coefficient thus
624 = 28a + 140b ………..I
560 = 28a + 112b ……….. 1 x 4
64 = 28b
∴ b = 2.286 and, substituting this value in one of the equations, the value of a is found to
be 10.86
∴ Regression line is y = 10.86 + 2.26x
ii) Using the coefficient formulae
( ) ( )
a= ( )
= 10.86
( ) ( )
b= ( )
= 2.286

When the coefficients have been calculated the cost function can be used for forecasting simply
by inserting the appropriate level of activity i.e. a value for x, and calculating the resulting total
cost.
For example, what are the predicted costs at output levels of:
a) 4,500 units (i.e. 4.5 in ‘000s), and
b) 8,000 units (i.e. 8 in ‘000s)
y = 10.86 + 2.286 (4.5) = sh. 21,147
Note:
A prediction within the range of the original observations (1 to 7 in Example 1) is known as an
interpolation.
y = 10.86 + 2.286 (8) = sh.29,148
A prediction outside the range of original observations is known as an extrapolation.
Evaluation of Regression Models

The regression equation cannot always be based on the assumption that there is only one
independent variable. A number of different activity measures can exist such as direct labour
hours, direct labour cost, number of production runs, etc.
It is important therefore to determine the reliability of the estimated cost function. Various tests
of reliability can be applied. These tests can be grouped into 3:
1) Logical relationship tests
2) Goodness of fit tests
3) Specification tests
1. Logical relationship tests

These tests, also referred to as economic plausibility test, are used to determine whether there is
an expected logical relationship between the independent and the dependent variable.
To carry out this test, it is important to understand the input-output relationship in the company.
There should exist a logical relationship between the selected independent variable and the
dependent variable.
The relationship between the variables may be inferred from:
i) Previous experience or knowledge of the firm activities and the behavior of cost.
ii) Experience of similar firms in the same industry.

The model y  24.43  10.53 x is economically plausible since it has a positive slope. An increase
in the number of units produced leads to an increase in labour cost.

2. Goodness of fit tests
The goodness of fit of a statistical model that describes how well it fits a set of observations.
Measures of goodness of fit typically summarize the discrepancy between observed values and
the values expected under the model in question. Such measures can be used in statistical
hypothesis testing, e.g. to test for normality of residuals, to test whether two samples are drawn
from identical, or whether outcome frequencies follow a specified distribution
These tests can be divided into two:
 Testing the whole model
 Testing the slope
Testing the whole model

Tests of the whole model are used to determine the reliability of all the independent variables
taken together. The measures used are:
i) Coefficient of determination (r2)
ii) Standard error of the estimate
iii) F-test
i. Coefficient of Determination (r2)

r2 measures the amount of variation in the dependent variable (y) which is explained by the
variations in the independent variables (x1, x2, x3............xn) therefore it gives the percentage (%)
of the explanatory power of a regression model on a scale from 0% to 100%. Generally the
higher the value of r2, the better the regression model.
Y Line of best fit = a + bx

x
x
yx x
 x
x  x
x x x
x x
x y x
x
X
Standard Symbols
y = Historical / Actual / Observed value
= Predicted value
= Average / Mean value of observed values
Analysis of Variance (ANOVA)

∑( − ) = Total sum of square = (TSS)
∑( − ) = Unexplained or error sum of squares (USS)
∑( − ) = Explained sum of squares (ESS)
Unexplained sum of squares + Explained sum of squares = Total sum of squares.

+ =
= + =1
∴ =1-
∑( )
r2= ∑( )
Where r2 = = Coefficient of determination
ILLUSTRATION
The production manager of XYZ Company is concerned about the apparent fluctuation in
efficiency and wants to determine how labour costs (in Sh.) are related to volume. The following
data presents results of the 10 most recent batches.
Batch No Units Produced(X) Labour Costs(Y)
1 15 180
2 12 140
3 20 230
4 17 190
5 12 160
6 25 300
7 22 270
8 9 110
9 18 240
10 30 320
Required;-
Compute the Coefficient of Determination
SOLUTION
Batch No. x y = 24.43+10.53x ( − ) ( − )
1 15 180 182.38 1,156 5.664
2 12 140 150.79 5,476 116.424
3 20 230 235.03 256 25.301
4 17 190 203.44 576 180.634
5 12 160 150.79 2,916 84.824
6 25 300 287.68 7,396 151.782
7 22 270 256.09 3,136 193.488
8 9 110 119.2 10,816 84.64
9 18 240 213.97 676 677.561
10 30 320 340.33 11,236 413.309
( − ) ( − )
2,140 2139.7 43,640 1,933.627

∑
= = = 214
∑( )
∴ Coefficient of determination r2 = ∑( )
.
=1–
r2 = 0.9557 = 95.57%
2
r = ≃ 0.9557
Interpretation
96% variation indirect labour cost is explained by the variation in output.
Rule of Thumb
If r2 is between 75% - 100% = Very good model.
60% - 74% = A good model
50% - 59% = A satisfactory model
Below 50% = A poor model.
∴ Using this criterion, the model above is a very good model.
The unexplained variance (residual) is 1 - r2
= 1 – 0.96
= 0.04 or 4%
This is accounted for by two factors

1. Possible explanatory variables which may not have been included in the model.
2. Chance or residual variation. Even when all the variables have been included, there is still a
disturbance term, due to chance factors which cannot be completely eliminated.
ii. Standard error of estimate (Se)

The coefficient of determination r2 gives us an indication of the reliability of the estimate of total
cost based on the regression equ
ation but it does not give us an indication of the absolute size of the probable deviations from the
line established. This information can be obtained by calculating the standard error of estimate
given by the following formula.
(∑ )
Se =
Where n = sample size

K = number of estimated coefficients
n-k =degrees of freedom
The calculation of the standard error is necessary because the least square line was calculated
from sample data. Other samples would probably result in different estimates. Obtaining the least
square calculation over all the possible observations that might occur would result in the

calculation of the true least square line. The question is “How close does the sample estimate of
least square line come to the true least square line?”
Standard error is similar to standard deviation in normal probability analysis. It is a measure of
variability around the regression line. The standard error of estimates enables us to establish a
range of values of the dependent variable within which we may have some degree of confidence
that the true value lies.
Derivation of Se
Se is a measure of dispersion/spread/variation of the predicted value of y.
Recall that;-
Parameter Standard error
√
u1- u2
+
P1P2
∑ +
Se = =
∑( )
Se =
Statistics and Parameters

Parameters are the true or population values obtained if a census is taken. These are difficult to
obtain and instead we also sample measure.
These are also known statistical estimates of the population parameters.
Statistics estimates are sample values and they are used to estimate population parameter.
Population (true) equation
y = A + Bx + E or
y = A + Bx + Σ
Sample (estimated) equation
= a + bx + e
Hence a, b and e are the respective statistical estimates of the population parameter A, B and E.
Σ and e = error term = y -

Degrees of Freedom (d.f)
In statistical analysis for any parameter estimated a degree of freedom is lost. The effect is to
reduce the sample size and hence make statistical estimate to be less reliable.
E.g. consider two scenarios in a cost function estimate

Scenario 1 – fixed cost is known only and variable cost has to be estimated.
Scenario 2 – Both fixed and unit variable cost has to be estimated.
If everything is the same, equation one is more reliable than equation 2 since equation 1 has less
parameter to be estimated.
If n = 10, then the degrees of freedom of
Equation 1 = 10 – 1 = 9 = n – k
Equation 2 = 10 – 2 = 8 = n – k
Where n = Sample size
In our illustration 8, n = 10
k = No of parameters being estimated K = 2
n – k = No of degrees of freedom
n – k = 10 – 2 = 8
∑
The standard error for: Scenario 1 =
∑
∴ Scenario 2 =
Note that standard error for case 1 is less than the standard error for case 2 and hence model 1 is
preference in this case.
∑ ∑( )
Standard error, Se = = ==
To counteract the negative effects in the loss of degree of freedom increase the sample size. For
smaller value of k (k less than or equal to 5) we ignore the subtraction of k in the formula n this
will not change the results much.
Degrees of freedom (v) = n-k
(i) y = a + bx ................ k =2 (i.e. a,b)
(ii) y = a + b1x1 + b2x2 ............... k = 3 (i.e. a, b1, b2)
ILLUSTRATION

Batch No Units Labour Costs(Y)
Produced(X)
1 15 180
2 12 140
3 20 230
4 17 190
5 12 160
6 25 300
7 22 270
8 9 110
9 18 240
10 30 320
Required;-
Standard Error of Estimate will be as follows
SOLUTION
Batch No. x y = 24.43+10.53x ( − ) ( − )
1 15 180 182.38 1,156 5.664
2 12 140 150.79 5,476 116.424
3 20 230 235.03 256 25.301
4 17 190 203.44 576 180.634
5 12 160 150.79 2,916 84.824
6 25 300 287.68 7,396 151.782
7 22 270 256.09 3,136 193.488
8 9 110 119.2 10,816 84.64
9 18 240 213.97 676 677.561
10 30 320 340.33 11,236 413.309
( − ) ( − )
2,140 2139.7 43,640 1,933.627
∑( ) , .
I.e. Se = = = 15.55
Generally the smaller the value of Se or any other the better the predicting model.
ILLUSTRATION
Compute Se of the model of: = 50 + 0.3x for the following data:
x: 800 1200 400 1600
y: 350 350 150 550
x y = 50 + 0.3x − ( − )
800 350 290 60 3600
1200 350 410 -60 3600
400 150 170 -20 400
1600 550 530 20 400
∑( − ) = 8,000

SOLUTION
∑( ) , ,
∴ Se = = = = 63.25
Provided the assumptions underline regression hold the Se can be used to construct confidence
intervals and carry out hypothesis testing.
Secan be used to construct confidence interval for gauging our confidence about the prediction
e.g. What is the 95% confidence interval for labour cost when X =40 units if the prediction is =
24.43 + 40.53 x
C.I = Point estimate ± (Test statistic × standard error)

Where CI is the confidence interval
CI = ± ( × )
When x = 40 units
= 24.43 + 10.53 (40) = 445.63
Therefore 445.63 ± (t x 15.55)

t = 0.95 + 0.025
= 0.975 from t-table = 2.31
95% confidence interval of labour cost = 445.63 ± (2.31 x 15.55)
= 445.63 + 35.92 = 481.55 the upper limit
445.63 – 35.92 = 409.71 the lower limit
409.71 ≤ labour cost ≤ 481.55
0.95
0.025 0.025
iii. F-statistic method

The significance of the regression results can be tested by using the F- statistics. The F-statistics
is a ratio which compares the explained sum of squares and the unexplained sum of squares.

It is computed as follows:-
⁄( )
F=
⁄
Alternative method
÷( ) ∑( )÷ ( )
F= =
÷( ) ∑( )÷ ( )
Note:
If the F computed is greater than the F from the table, it shows the degree of the association is
strong and function is reliable, otherwise there would be a weak association and such a function
should be rejected.
Where n = Sample size
k = No of parameters to be estimated
k – 1 = Numerator degrees of freedom (V1)
n – k = Denominator degrees of freedom (V2)
Generally the larger the value of F, the better the prediction model.
Hypothesis Test for the significance of regression model.

1. Hypothesis - believes.
Ho = Regression equation is not significance (it is not a good model)
H1 = Regression equation is significance (it is a good model)
2. Level of significance
∝ = 5%
3. Declare the test statistic
F=
4. Decision rule.
95% Accept Ho
5% Reject Ho
We require (i) ∝ = 5%
(ii) Numerator degree of freedom
k–1 =2-1 =1
(iii) Denominator degree of freedom
n – k = 10 – 2 = 8

The critical value of f = 5.32
Reject the null hypothesis if F calculated is greater than 5.32. Generally the larger value of F, the
better the model.
. .
F= = = = 192
. .
ILLUSTRATION
State whether number of units produced is statistically significant in the model y = 24.43 +
10.53x. Use a 5% of significance.
n=10 (small) = use t-statistic
.
t calculated = = = 13.16
.
0.95
0.025 0.025
=∝ = 5% 0.05
∝
= = 0.025
V = n-k
10 -2 =8
t = 0.975 table = 2.31
Since t calculated (13.16) > t critical (2.31), we conclude that the number of units produced is a
significant predictor of labour cost in the above model
3. Specifications Analysis
This is used to test whether linear regression analysis assumptions are being obeyed
The assumptions of the linear regression analysis are;-
 Assumption of linearity
 The error terms are normally distributed
 The error term has zero mean
 The error term has constant variance
 The observations and error terms are independent of one another
Assumptions of Linear Regression Analysis

1. Assumption of linearity
There is a linear relationship between the dependent variable and the independent variables
Plot a scatter diagram to check on the linearity assumption e.g.

a) Direct linear relationship
Y
x = 24.43 + 10.53
x
x x
x x
x x
x x x
x
X
b) Inverse linear relationship
Y
x
x
x x
x x
x x
x x
x
x
X
In the model = 24.43 + 10.53 , there is a direct linear relationship between the number of
units produced and labour cost
2. The error terms are normally distributed
This is assessed using a frequency diagram for the error terms
Class of errors Frequency
-30 - -20 1
-20 – 10 2
-10 -0 3
0- 10 1
10 -20 2
20 -30 1
10
Frequency
3
x
x
x
x
1
-30 -20 -10 0 10 20 30 Class mid points

With the exception of the 0-10 class the rest of the classes conform to the basic shape of the
normal distribution. This is so even if the sample is small. To improve on the normality of the
error term, use a large sample size (n ≥ 300)
3. The error term has a zero mean

Use the Z or t statistic to test on the hypothesis of the zero mean
Hypothesis
Ho = = 0 (mean of the error terms is zero)
H 1: = ≠ 0 (mean of the error terms is not zero)
Let ∝ = 5% = 0.05
̅
Test statistic, t =
√
ILLUSTRATION

1 15 180
2 12 140
3 20 230
4 17 190
5 12 160
6 25 300
7 22 270
8 9 110
9 18 240
10 30 320
Required;
Compute the test statistic.

SOLUTION
x y = 24.43+10.53x e=y- e2 = ( − )
( − )
1 15 180 182.38 -2.38 5.664 5.8081
2 12 140 150.79 -10.79 116.424 117.07
3 20 230 235.03 -5.03 25.301 25.60
4 17 190 203.44 -13.44 180.634 181.4
5 12 160 150.79 9.21 84.824 84.2724
6 25 300 287.68 12.32 151.782 151.0441
7 22 270 256.09 13.91 193.488 192.6544
8 9 110 119.2 -9.2 84.64 85.193
9 18 240 213.97 26.03 677.561 676
10 30 320 340.33 -20.33 413.309 414.53
− ( − ) ∑( − ̅ )2
= 1933.6
= 2139.7 = 0.3 1933.627
∑
= ̅=
.
= = 0.03
∑( ̅) .
= = = = 14.66
̅ .
t calculated = = . = 0.0065
√ √
Decision rule
0.95 (fail to reject Ho)
∝
0.025 = 0.025 ( )
2
Reject H0 if t calculate > 2.26 or t calculate < -2.26

From the reject H0 if -2.26 < t calculate < 2.26
Conclusion
Since t calculated(0.0065) < 2.26, we fail to reject the H0 and conclude that the mean of the
error terms is statistically equal to zero

4. The error term has a constant variance
Use a scatter diagram to test for the constant variance. This is illustrated below;-
a) Constant variance
Y
x
x
x x Slope of the model is stable
x x
x x
x x x
x
X
b) Changing variance
Slope of the model is not stable
5. The observations and error terms are independent of one another

In this case there is no serial or auto correlation.
If the error terms are not independent, then we have serial or auto correlation which in practice
means one of the following
a) Data is time series.
b) A non-linear functional form should have been used.
c) An important variable has been excluded in case of a multiple regression model.
In such a case, the remedy would be to search for the excluded variable and incorporate in the
model
NB: If there is auto-correlation and we use the regression model then
i. The standard errors of the regression coefficient, shall be under-estimated
ii. The prediction made using the model would be more variable than it is ordinarily
anticipated from ordinary lest squares estimation
To test for the auto correlation of the error terms, we use the Durbin Watson d-statistic defined as
follows:-
∑( )
d= ∑

ILLUSTRATION

1 15 180
2 12 140
3 20 230
4 17 190
5 12 160
6 25 300
7 22 270
8 9 110
9 18 240
10 30 320
Required;
Compute the Durbin Watson statistic will be determined as follows;-
No. ei = y - − ( − )
x
1 -2.38 5.664 - - -
2 -10.79 116.424 -841 70.73 -2.38
3 -5.03 25.301 5.76 33.18 -10.79
4 -13.44 180.634 -8.41 70.73 -5.03
5 9.21 84.824 22.65 513.02 -13.44
6 12.32 151.782 3.11 9.67 9.21
7 13.91 193.488 1.59 2.53 12.32
8 -9.2 84.64 -23.11 534.07 13.91
9 26.03 677.561 35.23 1241.15 -9.2
10 -20.33 413.309 -46.36 2149.25 26.03
( − )
= = 4,624.33
1933.627
∑( ) , .
∴d = ∑
= = 2.39
, .
Since 1 < d (2.39) <, we conclude that the observation and error terms are independent of one
another

Rule of the thumb
Presence of +ve serial Independence

Presence of –ve serial correlation
correlation
1 2 3
Since 1<d (2.39) <3, we conclude that the observations and error terms are independent of one
another
In a multiple regression analysis, no two independent variables should be strongly correlated with
each other.
If the independent variables are strongly correlated, multi collinearity is said to exist.
Presence of multi collinearity implies that one or more independent variables are super flows (not
necessary)
The remedy is to drop one of the two highly correlated independent variables. A scatter diagram
or correlation matrix may be used in assessing the independent variable to be drawn
ILLUSTRATION
Consider the correlation matrix below derived from a model of the form y = a + b1x1 + b2x2 +
b3 x3
Y X1 X2 X3
Y 1 0.7 0.9 0.3
X1 1 0.8 0.4
X2 1 0.4
X3 1
Application of correlation matrix

1. It helps in identifying and ranking suitable predictors of y
Predictor variable r Rank
x1 0.7 2
x2 -0.9 1
x3 -0.1 3
2. It helps in screening and hence weeding out collinear independent variables

Independent variable r Rank
x1 vs x2 0.8 Collinear since r is >
x1 vs x3 0.4 0.7
x2 vs x3 -0.4 Not collinear
Not collinear

Result
Since x1 and x2 are highly collinear, we have to exclude one of them from the forecasting model.
We exclude x1 since x2 is a better predictor of y.
MULTI LINEAR REGRESSION MODEL

This is a model that incorporates two or more independent variables and it is of the general form
y = a+ b1x1 + b2x2 + ……………………… + bnxn
Where a = constant or intercept

X1,x2 ……………… xn – independent variables
b1b2 ………………….. bn – coefficient of independent variables
The values of a, b, b2 ……..bn can be determined after substituting data in the normal equations
below
i. ∑ = + ∑ + ∑ +……………………….. ∑
ii. ∑ = ∑ + ∑ + ∑ +……………………….. ∑
iii. ∑ = ∑ + ∑ + ……………………….. ∑
Manual determination of the constant and coefficients is tedious but it is no longer a problem
with computerization
An equation would be the most advantageous in predicting annual demand because of the
following reasons:-
i. It has the highest coefficient of correlation. This means that advertising funds and factory
rebates are good predictors of annual demand.
ii. It has the highest coefficient of determination of 0.793. It means 70.3% of the variation in
annual demand is explained by the variation in advertising funds and factory rebates
iii. It has the smallest standard error of estimate. This implies that the estimated or predicted
demand is closer t the actual demand than if the other models were used
In a multiple regression analysis model, no two strongly related independent variables should be
used in the same model
Multi-collinearity
Multiple regression analysis is based on the assumption that the independent variables are not
correlated with each other. When the independent variables are highly correlated with each other
then it is very difficult to isolate the effect of each one of these on the dependent variables. This
occurs when there is a simultaneous movement of two or more independent variables in the same
direction and almost at the same time. This condition is called multi-collinearity.
We can use the correlation matrix to determine whether 2 independent variables are highly
correlated. If a correlation value of more than 0.8 exists between two independent variables, then
the problem of multi-collinearity is bound to occur. Alternatively if the correlation coefficient
between the two variables is greater than the multiple correlation coefficients, then multi-

collinearity problem will occur. To remove the problem of multi-collinearity, we drop one of the
correlated variables. You can drop any of the variables
ILLUSTRATION
Tony Kichumi, a financial analyst at Green City Bus Company Ltd. is examining the behaviour
of the company’s monthly transportation costs for budgeting purposes. The transportation costs
are a sum of a two types of costs:
1) Operating costs, such as fuel and labour.
2) Maintenance costs, such as overhaul of engines and spraying.
Kichumi collects monthly data on items 1 and 2 above and the distance covered by the buses.
Monthly observations for the year ended 31 December 2004 were as follows:
Month Operating costs Maintenance costs Distance covered

in kilometers (d)
Shs. ‘000’ Shs. ‘000’ Shs. ‘000’
January 471 437 3,420
February 504 388 5,310
March 609 343 5,410
April 690 347 8,440
May 742 294 9,320
June 774 211 8,910
July 784 176 8,870
August 986 210 10,980
September 895 280 4,980
October 651 394 5,220
November 481 381 4,480
December 386 514 2,980
Kichumi ran three linear regression equations based on the data above and came up with the
following results:
Regression equation I
Operating costs = a + bd
Variable Coefficient Standard error t - value
Constant 309.19 96.05 3.22
Distance covered in kilometers 0.054 0.014 3.86
r2 = 0.61, Durbin – Watson statistic = 1.61

Regression equation II
Maintenance costs = a + bd
Variable Coefficient Standard error t - value

Constant 531.55 46.95 11.32
Distance covered in kilometers - 0.031 0.007 - 4.43
Regression equation III

Total transportation costs = a + bd
Variables Coefficient Standard error t - value

Constant 840.73 80.25 10.48
Distance covered in kilometers 0.023 0.011 2.09
Required:
(a) Evaluate the three linear regression equations using:
i) Economic plausibility.
ii) Goodness of fit
iii) Significance of independent variables.
iv) Specifications analysis criteria
(Use a 95% confidence level where applicable).
(b) List three variables, other than distance covered, that could be important drivers of the
company’s operating costs.
SOLUTION
a) The three linear regression equations using:
i. Economic plausibility
Equation 1
Operating cost = 309.19 + 0.054d
This equation is economically plausible since it has a positive slope. An increase in distance
covered would lead to an increase in operating cost
Equation 2: Maintenance cost

= 531.55 - 0.031d
This equation is not economically plausible since it has a negative slope
In real life, we expect maintenance cost to increase with increase in distance covered
Equation 3
Total transportation cost 840.73 + 0.023d
This equation is economically plausible since it has a positive slope

An increase in distance covered would lead to an increase in total transportation cost
ii. Goodness of fit

r2 r
Se Sb
F statistic Z or t
r2 = 0.61 or 61% = Fair goodness of fit

61% of the variation in operating cost is explained by the variation in distance covered
r2 = 0.68 or 68% -Fair goodness of fit
68% of the variation in maintenance cost is explained by the variation in distance covered
r2 = 0.29 or 29% - Poor goodness of fit
Only 29% of the variation in total transportation cost is explained by the variation in
distance covered
iii. Significance of independent variable

Operating costs
309.19 + 0.054d
Where h = 12 (small sample), use t-statistic

t=
0.95 (Not significant)
∝
= 0.025 ( )
2
t=
V = n-k
12 -2 =10
1-0.025 = 0.975 thus t = 2.23
t Value = 3.86 > 2.23
Therefore Distance covered is statistically significant in equation 1
Equation 2
t Calculated= -4.43 < -2.23
Therefore Distance covered is statistically significant in equation 2
t calculated= 2.09 < 2.23
Distance covered is not statistically significant in equation 3

iv.Specification analysis criteria
Specifications are the assumptions of the model
 Linearity
 Error terms are normally distributed
 Constant variance
 Zero mean
 Independence of error terms and observation
 Independence or error terms (Durbin Watson statistic)
Equation 1: Operating cost

309.19 + 0.054d
Durbin Watson statistic = 1.61
1, d = 1.61 < 3
There is a linear relationship between distance covered and operating cost
The error terms are independent of one another since the Durbin Waston statistic lies between
1 and 3
Equation 2: Maintenance cost

531.55 – 0.031d
Durbin Waston statistic = 1.72
There is a liner relationship between maintenance cost and distance covered
1 and 3
Equation 3: Total transportation cost

= 840.73 + 0.023d
Durbin Waston statistic = 2.34
There is a linear relationship between distance covered and total transportation cost
1 and 3
Assignment: b, c, d
Limitations of linear regression analysis

i. The analysis assumes that the cost can be predicted by one variable that distance covered
in the transport business, cost depends on other cost drivers such as the model would have
been more appropriate
ii. The analysis assumes that teacher is a linear relationship between cost and distance
covered. In some cases, the relationship may become non-linear especially after the buses
have covered long distance
iii. The analysis assumes that past figures will be useful in predicting future figures. Future
figures may be affected by inflation rate

LEARNING CURVE AND ITS APPLICATION
Whenever an individual starts a job, he (or she) may be relatively slow at completing the work
tasks involved while he is becoming familiar with them. However, as the individual gains
experience and becomes more confident and knowledgeable about the task, he becomes more
efficient and can perform the task more quickly. He benefits from 'learning by doing'.
Learning curves are particularly relevant to tasks which are fairly repetitive in nature. However,
learning curves are unlikely to be experienced in tasks where the individual's speed of work is
dictated by the speed of machinery (as it would be on a production line, for example.).
Eventually, however, when he has acquired enough experience, there will be nothing more for
the individual to learn, and so the learning process will stop.
Learning curve theory applies to situations where the work force as a whole improves in
efficiency with experience. The learning effect or learning curve effect describes the speeding up
of a job with repeated performance.
Learning curves suggest that labour time should be expected to get shorter, with experience, in
the production of items which exhibit any or all of the following features:
 Made largely by labour effort (rather than by a highly mechanized process)
 Fairly repetitive in nature
 Brand new or relatively short-lived (learning process does not continue indefinitely)
The costs are affected by the learning curve are;-

a) Direct labour time and costs
b) Variable overhead costs, if they vary with direct labour hours worked.
c) Materials costs are usually unaffected by learning among the workforce, although it is
conceivable that materials handling might improve, and so wastage costs be reduced.
d) Fixed overhead expenditure should be unaffected by the learning curve (although in an
organization that uses absorption costing, if fewer hours are worked in producing a unit of
output, and the factory operates at full capacity, the fixed overheads recovered or absorbed
per unit in the cost of the output will decline as more and more units are made).
Learning curve is a non-linear cost or time function of the form

= = ( )
Where – cumulative average time of producing a unit of a product

y = cumulative total time of producing the products
a = time or cost of producing the fort unit
x = cumulative production level
b = learning index

T1
T2
X1 2X2 x
The learning curve model is based on the assumption that the average cost or average time of
production decreases by a constant percentage when cumulative production doubles
If cumulative production doubles from x1 to 2x1 the average time decreases from T1 to T2 as
shown in the figure above
Learning percentage or improvement rate = × 100
If the learning rate is 15%, then we have an 85% learning curve
Learning curve graphs
( )
y=
( )
=
ILLUSTRATION
Shahada Ltd. produces and sells product X. The product requires skilled labour and entails a
learning curve effect in its production. An extract of the production hours for the product is
provided below.

Cumulative production Cumulative time
(units) (hours)
1 200
2 360
4 648
8 1,166
Additional information:
1. The following information relates to the previous production period
 Cumulative production at start of period 528
 Production during the period units
86 units
2. The standard and budgeted data for the product were as follows:
 Budgeted production 86 units
 Budgeted overheads Sh.150,903
 Standard labour cost Sh.10 per
 Standard material cost hour
Sh.250 per
unit
Required:
i) The learning curve rate.
ii) Unit production cost of product X during the previous production period.
SOLUTION
Learning curve rate
i) Learning curve table
Units Cumulative time Average time

(T)
1 200 200
2 360 180
Recall average time falls from T to r% T i.e. 180 = 200

⟹r = 18 20 = 90% (Learning curve %)
ii) Total time required for 86 units

Recall y = axb+1
Y = Total time
X = Cumulative units
a = Production time for first unit
.
b = Leaning index = =0.152

Hence
. .
Y 614 – y528 = 200{614 − 528 } = 5558.88 hours
.
Average time/unit = = 64.64
Standard overhead rate/hr = = Sh27.15

.
Hence unit cost

Sh.
Material 250.00
Labour 64.64 x 10 646.40
Overheads 64.64x27.15 1,754.98
2,651.38
Application of the learning curve in management accounting

Learning curve theory can be used to:
a) Calculate the marginal (incremental) cost of making an extra unit of a product.
b) Quote selling prices for orders or new contracts, where prices are calculated at cost plus a
percentage mark-up for profit. An awareness of the learning curve can allow an organization
to forecast future cost reductions and any selling price reductions which it may be able to
make as a result. This could make the difference between winning contracts and losing them,
or between making profits and selling at a loss-making price.
c) Prepare realistic production budgets and more efficient production schedules.
Understanding the learning curve allows firms to predict their required inputs more
accurately. This greater accuracy can benefit both material inputs and the time taken to
process products.
Having a better understanding of their production schedules enables an organization to
estimate delivery schedules for customers more accurately. This in turn may lead to improved
customer relationships and further sales in future.
d) Prepare realistic standard costs for cost control purposes. For example, if a budget is set
without considering the learning curve effect it may be too easy to achieve, and so will not
serve to motivate performance.
If an organization has a culture in which learning is encourage, then it should also expect
improvements in efficiency to occur. These should be-reflected in the budgets.
Considerations to bear in mind include:

a) Sales projections, advertising expenditure and delivery date commitments. Identifying a
learning curve effect should allow an organization to plan its advertising and delivery
schedules to coincide with expected production schedules. Production capacity obviously
affects sales capacity and sales projections.
b) Budgeting with standard costs. Companies that use standard costing for much of their
production output cannot apply standard times to output where a learning effect is taking
place. This problem can be overcome in practice by:
i) Establishing standard times for output, once the learning effect has worn off or become
insignificant, and
ii) Introducing a 'launch cost' budget for the product for the duration of the learning period.
c) Budgetary control. When learning is still taking place, it would be unreasonable to compare
actual times with the standard times that ought eventually to be achieved when the learning
effect wears off. Allowance should be made accordingly when interpreting labour efficiency
variances.
d) Cash budgets. Since the learning effect reduces unit variable costs as more units are produced,
this reduction should be allowed for in cash flow projections.
e) Work scheduling and overtime decisions. To take full advantage of the learning effect, idle
production time should be avoided and work scheduling/overtime decisions should take
account of the expected learning effect.
f) Pay. Where the workforce is paid a productivity bonus, the time needed to learn a new
production process should be allowed for in calculating the bonus for a period.
g) Recruiting new labour. When a company plans to take on new labour to help with increasing
production, the learning curve assumption will have to be reviewed.
h) Market share. The significance of the learning curve is that by increasing its share of the
market, a company can benefit from shop-floor, managerial and technological 'learning' to
achieve greater economies of scale.
Learning curve ideas could also be used to help forecast the cost reductions (and consequently
reductions in selling price) which competitors may be able to achieve. If a competitor is able to
reduce its selling price this might enable it to increase its sales and market share.
Limitations of learning curve theory

a) The learning curve phenomenon is not always present.
b) It assumes stable conditions at work which will enable learning to take place. This is not
always practicable, for example because of labour turnover.
c) It also assumes a certain degree of motivation amongst employees; but if employees have
no interest in 'learning' or increasing their efficiency, then there will be no learning effect.
d) Breaks between repeating production of an item must not be too long, or workers will
'forget' and the learning process will have to begin all over again.
e) It might be difficult to obtain accurate data to decide what the learning curve is.
f) Workers might not agree to a gradual reduction in production times per unit.
g) Production techniques might Change, or product design alterations might be made, so that it
takes a long time for a 'standard' production method to emerge, to which a learning effect
will apply.
ILLUSTRATION
Uhuru na maendeleo ltd. A local computer assembly company, intends to launch a locally
manufactured computer printer in the month of July 2007.

The research and development department of the company has provided the following
information relating to the production of the printer.
Sh. Sh.
Selling price per unit 16,800
Direct materials 7,840
Variable overheads (45minutes at sh. Sh. 2,800 per 2,100 (9,940)
hour) 6,860
Contribution
Additional information;-
1. Production of the printer is scheduled to commence on July 2007.
2. The annual fixed cost attributable to the production of the computer printer is sh. 24 million.
This cost accrues evenly throughout the year.
3. The company plans to produce and sell 2,000 units of the computer printer monthly
4. A direct material loss of 10% is expected. This. Loss has no resale value.
5. A learning curve effect of 95% is expected.
Required;-
Determine the standard variable cost of production for the month of January 2008.
Hint: A 95% learning curve is given by y=ax-0074
SOLUTION
i) Standard variable cost
Direct material (7,840/90% x 2,000) = 17,422,222.22
Variable overheads
At end of January, cumulative output = 14,000 units
.
∴Y=
= 45x 14000 . = 22.20
14,000 x 22.20 = 310 800 Minutes
At end of December, cumulative output = 12 000
Y = 45 x 12000 . = 22.46
12 000 x 22.46 = 269,520 minutes
Time of production in January
= 310 800 minutes
=
,
Cost = 41,280/60 x 2,800 = Sh. 1,926,400

Total variable cost in January
= Sh. 17,422,222.22
+ Sh. 1,926,400.00
19,348,622.22

REVISION EXERCISE
QUESTION 1
High-tex Engineering Company Limited wishes to set flexible budgets for each of its operating
departments. A separate maintenance department performs all routine and major repair works on
the company’s equipment and facilities. The company has determined that maintenance
department performs all routine and major repair works on the company’s equipment and
facilities. The company has determined that maintenance cost is primarily a function of machine
hours worked in the various production departments.
The maintenance cost incurred and the actual machine hours worked during the months of
January, February, March and April 2003 were as follows:
Month Machine hours in Maintenance

Production department’s Costs
departments
Sh.
January 800 350
February 1,200 350
March 400 150
April 1,600 550
Required:
a) Determine the cost estimation function using:
i) High-low method.
ii) Regression analysis
b) Using the regression function estimate:
i) The maintenance costs that would have been incurred if the machine hours were expected
to be 900 in the month of May 2003.
ii) The maximum machine hours that would have been worked If the maintenance cost
incurred had been limited to Sh.400,000 for the month of May 2003.
Assuming that in the month of May 2003 machine hours were 900, establish a 95% confidence
interval for this point estimate. (Assume tc = 2.7764 and standard error of estimate, se = 63.25).

Solution:
(a) (i)
Machine Maintenance
Hours
Month X Cost Y XY X2 Y2
1 800 350 280,000 640,000 122,500
2 1,200 350 420,000 1,440,000 122,500
3 400 150 60,000 160,000 22,500
4 1,600 550 880,000 2,560,000 302,500
Sum 4,000 1,400 1,640,000 4,800,000 570,000
High Low method

X Y
Highest point 1,600 550
Lowest point 400 150
Difference 1,200 400
b = 400 = 0.33
1200
Yˆ = a + bx
Substitute Highest point

550 = a + 0.33 (1,600)
a = 17
The cost function is Yˆ = 17 + 0.3X.
Regression analysis
(ii)
n x y -  x y 4 (1, 640 , 000 )  4 , 000 (1, 400 )
b 
n  x 2  ( x ) 2 4 ( 480 , 000 )  ( 4 , 000 ) 2
 0.3
1, 400 4 , 000
a   Y  b x   0 .3 ( )  50
n n 4 4
The function is Ŷ  50  0.3x

b) (i)
Ŷ  50  0.3X
If x  900
Ŷ  50  0.3 (900)  320 ( in Sh. '000' )
Xˆ  a 1  b 1 Y
4 (1 , 640 , 000 )  4000 (1400 )

b 1  n  XY   X  Y 
2
N  Y  ( Y ) 2 4 ( 570 , 000 )  (1400 ) 2
960 , 000
  3
320 , 000
(ii)
a 1   x  b1  Y
n n
4,000 1, 400 
  3     50
4  4 
c)
X̂  - 50  3Y Ŷ - t c se  Y  Ŷ  t c s e
If Y  400 320  2.7764(63.25)  Y  320  2.27764(63.25)
X̂  - 50  3(400)  1,150 machine hours. 144.39  Y  495.6
We are 95% confident that maintenance cost next period will lie between Sh.144,390 and
Sh.495,600

TOPIC 3
SHORT TERM PLANNING AND DECISION- MAKING
INTRODUCTION
Short term planning isthe process of setting smaller, intermediate milestones to achieve within
closer time frames when moving toward an important overall goal. Many businessoperators will
engage in short term planning that typically covers time frames of less than one year in order to
assist their company in moving gradually toward its longer term goals.
Decision- making is the thought process of selecting a logical choice from the availableoptions.
When trying to make a gooddecision, a person must weigh the positives and negatives of each
option, and considerall the alternatives. For effective decision making, a person must be able to
forecast the outcome of each option as well, and based on all these items, determine which option
is the best for that particular situation.
DEFINITION OF TERMS
A CVP analysis is a systematic method of examining the relationship between changes in

activity (output) and changes in total sales revenue, expenses and net profit.
Relevant revenue is any revenue that differs among alternatives and will influence the final
outcome.
Avoidable costs are costs which will not be incurred if a particular decision is made.
Incremental costs are extra costs incurred as a result of a decision.
Opportunity costs are costs that measure the opportunity that is lost or sacrificed when the
choice of one course of action requires that an alternate course of action be given up.
Marginal revenue is the increase in total revenue from sale of an additional unit
Marginal cost is the increase in total cost from the production of an additional unit
Break even analysis is mainly used to explain the relationship between the cost incurred, the
volume operated at and the profit earned.
The margin of safety is the amount by which actual output or sales may fall short of the budget
without the company incurring losses.
Demand is the quantity of a good which consumers want and are willing and able to pay for.
104 MANAGEMENT ACCOUNTING

Cost plus pricing system is based on costs and adding some profit margin to it to arrive at the
selling price for the product.
Full cost plus pricing (absorption) involves the use of conventional techniques to come up with
the total cost for a product to which is added a markup to arrive at the selling price.
Minimum price is the price to charge for a job that will be able to cover the incremental costs of
producing and selling the item and the opportunity cost of resources consumed in making and
selling the item.
Market penetration relates to the attempt to break into a market and to establish that market
share which will enable the firm to achieve its revenue and profit targets.
Market skimming involves setting a relatively high price stressing the attractions of new
features likely to appeal to those with a genuine interest in the products or associated attractions.
Differential pricing is the ability of the firms to split the market into segments based on different
characteristics.
OVERVIEW OF SINGLE PRODUCT AND MULTIPLE PRODUCT

COST-VOLUME-PROFIT ANALYSIS UNDER CONDITIONS OF CERTANITY
Cost volume profit (CVP) analysis

This is a systematic method of examining relationship between profits at various levels of
activity
It uses many of the principles of marginal cost thus important in short term planning
It explores relationship existing between cost, revenue, output levels and resulting profits
In short run, most of the costs and prices of the firm are generally well determined and thus the
principle course of uncertainty in demand that affects a short run profitability of a product
CVP may be used to make short term decisions e.g. determinants of break-even point, order,
acceptance or rejection etc.
In cost-volume-profit analysis, you:

 Should consider only short-term operations. The short term may be defined as a period too
short to permit facilities expansion or contraction or other changes that might affect overall
pricing relationships.
 Assume that a straight line can reasonably be used in analysis. While actual price behavior
may not follow a straight line, its use can closely approximate actual cost behavior in the
short run.
 If purchase volume moves outside the relevant range of the available data, the straight-line
assumption and the accuracy of estimates become questionable.
 If you know that product variable costs per unit are decreasing as quantity increases, consider
using the log-linear improvement curve concept. Improvement curves are particularly useful
in limited production situations where you can obtain cost/price information for all units sold.
In CVP, output is given more attention in the relationship between it and sales, expenses or
profits since the knowledge of this will enable management to identify critical output levels
such as the level at which neither profit nor loss will occur i.e. break-even point. The
relationship being analyzed is normally the short-run normally being a period of 1 year or
less.
In the short run, costs can be of three general types:

 Fixed Cost. Total fixed costs remain constant as volume varies in the relevant range of
production. Fixed cost per unit decreases as the cost is spread over an increasing number of
units. Examples include: Fire insurance, depreciation, facility rent, and property taxes.
 Variable Cost. Variable cost per unit remains constant no matter how many units are made in
the relevant range of production. Total variable cost increases as the number of unit’s
increases. Examples include: Production material and labor. If no units are made, neither cost
is necessary or incurred. However, each unit produced requires production material and labor.
 Semi-variable Cost. Semi-variable costs include both fixed and variable cost elements.
Costs may increase in steps or increase relatively smoothly from a fixed base. Examples include:
Supervision and utilities, such as electricity, gas, and telephone. Supervision costs tend to
increase in steps as a supervisor’s span of control is reached. Utilities typically have a minimum
service fee, with costs increasing relatively smoothly as more of the utility is used.
Basic / certainty CVP models

Assumptions
i) Revenue, cost of profit function are linear with respect of level of output of relevant range
ii) All cost can be categorized as either fixed or variable
iii) Fixed cost remains constant of the relevant activity range
iv) The price per unit and variable per unit remain constant of activity range
v) Volume is the only driver to cost and revenue i.e. only factor affecting cost and revenues
vi) Technology, production methods and efficiency levels remain unchanged
vii) All units produced are sold i.e. no proceeds for sale
viii) The period of time selected is short and assumed that time value of money is not
significant
ix) There are no demand or restriction e.g. contractual obligations
x) The model relates to one product and incase of multi-product as constant mix is maintained
Accountant Model of CVP

A constant VC per unit and selling price will result in a linear relationship. The result is ONE

Breakeven point and profits increase with an increase in volume. The most profitable output is
therefore at the maximum practical capacity. The economist’s point of view however is more
superior and more accurate on this point since the TC line is non-linear
Relevant R
Range
Ra
Rb BEP
f
Loss
π
Zone
Xb Xa x
NOTE
i. This model assumes that unit price for unit variable cost are constant, this results to only
one BEP and that profit zone widens as volume increases
ii. The most profitable output is thus the maximum product capacity
iii. BEP is as a point where R=C and profit zero
iv. The usefulness of being able to determine BEP is to compare the planned expected level of
production with the BEP and make judgment concerning riskiness of activity
v. A level of activity below the BEP will lead to loss while above it leads to π this is known as
margin of safety (MOS) that is a difference between expected / actual level of activity and
the BEP
a) MOS (x) = Xa –Xb
b) MOS ® = Ra –Rb
c) MOS (%) = x 100
d) MOS as profit = (Xa –Xb) P-U
vi. The bigger the MOS the better for a firm since any slight decline will still leave the firm
with the profit making zone
Relevant range– Objective of a model is to represent the behavior of cost and revenue over the
range of output at which firms expect to be operating
The range represents the output levels that the firm has experience of operating in the past and for
which information is available

Economist’s model of CVP
C
BEP
BEP
R
RC π
Xb Xb
X
MC=MR
This model is summarized by the above graph;-

From the graph that;-
1. The revenue and cost function are non-linear. The cost obeys law of increasing and
diminishing returns to sale
2. Revenue function is non- linear indicating that the firm is only able to sell increasing quantity
of output by reducing the price, this results in revenue curve rising less steeply and eventually
begins to decline
3. There are 2 BEPs because of shape of revenue and put curves. To make profit, a firm should
operate where gap / profit zone is wider that is MC=MR
4. A firm will make a loss if it operates between 1st BEP and above second BEP
Algebraic Analysis
The assumption of linear cost behavior permits use of straight-line graphs and simple linear
algebra in cost volume analysis.
Total cost is a semi variable cost-some costs are fixed, some are variable and others are semi
variable.
In analysis, the fixed component of a semi-variable cost can be treated like any other fixed cost.
The variable component can be treated like any other variable cost. As a result, we can say that:
Abbreviations
P – Price per unit
V – Unit Variable cost
F – Total fixed cost
X – Activity level of output
R – Revenue (Px)
π – Profit (R-C)
t – Target profit
Vx – Total variable cost
Xb – BEP in units
Rb – BEP in shillings
C - Total cost (f + Vx)
UDYTEXT
The variable component can be treated like any other variable cost. As a result, we can say that:
Total cost = Fixed cost + Variable cost
Using symbols:
C = F + Vx
Where:
C = Total cost
F = Fixed cost
Vx = Variable cost
Total Variable cost depends on two elements:
Variable cost = Variable cost per unit × Volume produced
Using symbols:
V = VU (Q)
Where:
VU = Variable cost per unit
Q = Quantity (Volume) produced
Substituting this variable cost information into the basic total cost equation, we have the equation
used in cost-volume analysis:
C= F + VU (Q)
ILLUSTRATION
Fixed cost = Sh.500
Variable cost = Sh.10
Volume produced = 1,000
Required: Calculate the total cost of production.
SOLUTION
C= F + VU (Q) = 500 + 10 (1,000)= Sh.10,500
Given total cost and volume for two different levels of production, and using the straight-line
assumption, you can calculate variable cost per unit.

Remember that:
Fixed costs do NOT change no matter what the volume, as long as production remains within the
relevant range of available cost information. Any change in total cost is the result of a change in
total variable cost.
Variable cost per unit does NOT change in the relevant range of production.
As a result, we can calculate variable cost per unit (VU) using the following equation:
VU = Change in Total cost
Change in Volume
= C2 – C1
Q2 – Q1
Where:
C1 = Total cost for Quantity 1
C2 = Total cost for Quantity 2
Q1 = Quantity 1
Q2 = Quantity 2
ILLUSTRATION
You are analyzing an offeror cost proposal. As part of the proposal the offeror shows that a
supplier offered 5,000 units of a key part for Sh.60,000. The same quote offered 4,000 units for
Sh.50, 000. What is the apparent variable cost per unit?
SOLUTION
, ,
VU = = = Sh.10
ILLUSTRATION
Christian pass limited operates in an entirely different industry. However, it also produces to
order and carries no inventory. Its demand function is estimated to be P = 100 – 2Q
Where P = unit selling price in shillings
Q = quantity demanded in thousands of units
TC functions is estimated to be C = Q2 + 10Q + 500
Where C = Total cost in thousand shillings
You required in respect of Christian pass Limited
i. Calculate the output in units that will maximize total profit and to calculate the
corresponding unit selling price, total profit and the total sales revenue
ii. Calculate the output in units that will maximize total revenues and total sales revenue

SOLUTION
i. P = 100 -2Q
Total revenue, TR = Price × Quantity = (100 -2Q) Q = 100Q -2Q2
MR = = 100 − 4
TC = Q2 + 10Q + 500
MC = = 2 + 10
Profit will be maximized at point where MR =MC

100 -4Q = 2Q + 10
6Q = 90
Q = 15 units
Therefore quantity demanded = 15 x 1000 = 15,000
Unit selling price p = 100 -2 x 15

P = 70
Total revenue = selling price x quantity = 70 x 15,000 = sh. 1,050,000
TC = Q2 + 10Q + 500 = (152 + 10 x 15 + 500) x 1000 = sh. 875,000
Profit TR –TC = 1,050,000 – 875,000 = sh. 175,000
ii. TR = 100Q – 2Q2
= = 100 − 4
For = 0 for a maxmum or minimum turning point

Therefore
0 = 100 –Q
4q = 100
Q = 25,000 units
Unit selling price, P = 100 – 2x25 = sh. 50

Total revenue = selling price x quantity = 50 x 250,000 = sh, 1,250,000
TC = (252 + 10 x 25 + 500) x 1000 = 1,375,000

Profit = TR-TC
1,250,000 – 1375,000 = (sh. 125,000)

Break Even Point
The break-even point is the point at which the total revenue is equivalent to the total cost.
To compute the break-even point we let
S be the selling price per unit
VU be Variable cost per unit
Q be break-even quantities
F be total fixed costs
At break-even point:
Total revenue (TR) = Total Cost (TC)
Total revenue will be given by SQ while Total Cost (TC) = VU Q + F
Margin Of Safety (Mos)

The margin of safety is the amount by which actual output or sales may fall short of the budget
without the company incurring losses. It is a measure of the risk that the company might make a
loss if it fails to achieve the target. A high margin of safety means high profit expectation even if
the budget is not achieved. Margin of safety (MOS) can be computed as follows:
MOS = Expected sales - Break even sales

Expected sales
Taxes In C-V-P Analysis
Lump sum Taxes

This is a tax which is a fixed amount in a given period e.g. in a year. Examples include trade
licenses, vehicle insurance etc. This should be treated as fixed costs
Income / corporate tax

This is a tax on the company’s income and it is usually expressed as a % of the income
Let t = corporate tax rate
Π = (Cmx – F) (1-t)
At the break-even point, profit = 0

Cmx – F = 0 or 1-t = 0
T = 1 this is NOT practical

Vable =

Conclusion
The % tax on income has no effect on the break-even point. However, it affects income in the
sense that it reduces the income
ILLUSTRATION
Assume that you are planning to sell 600 badges at the forthcoming Nairobi show at a sh. 9 each.
The badges cost sh. 5 to produce and you incur sh. 2000 to rent a booth in the showground
Required;-
a) Compute the break-even point in units and in shillings
b) Compute the margin of safety in units % and I shillings
c) Compute the number of units that must be sold to earn a profit before of 20% of sales
d) Compute the number of units that must be sold to earn an after tax profit of sh. 1,640
assuming that the tax rate is 30%
SOLUTION
a) Break-even point in units
Xable = = = 500 units
Break even points in shillings

Break-even point in units x selling price per unit
500 units x 9 = sh. 4500
Or
CMR = =
BEP = = 2000 x = sh.4500
b) Margin of safety
MOS in units
Budgeted output in units – break-even point in units = 600 – 500 = 100 units
MOS in % = × 100%= × 100= 16.67%
MOS in shillings = MOS in units x selling price = 100 x 9 = sh. 900
c) Units to be produced to earn profit before tax of 20% of sales

Π = Cmx – F
Π = TR –TC

X =number of units produced and sold
Π = 9x – (Fc + Vc)
Π 9x – (Fc + 5x)
= × 9 = 9 − (2000 + 5 )
18x = 9x -2000 -5x

18x+4x=-2000
X = 909 units
d) Units to produce in order to earn an after tax profit of sh. 1640
Operating income after tax profit

( )
= =
Operating income =
X=
F+ After tax profit

= 1-t
cm
.
=
= 1,086 units
ILLUSTRATION
The following information relates to Bonoko Co. limited
Selling price per unit = sh. 200 per unit
Variable cost price per unit = sh. 120
Fixed cost = sh. 2000
Budgeted output = 40 units
Required;
a) Compute break-even point in units and in shillings
b) MOS in units % and in shillings
c) Compute the number of units to be sold to an after tax profit of sh. 1,200 if the corporation
income tax is 30%

SOLUTION
A
i. Break even in units
Xble = F/CM = = 25 units
ii. Break-even point in shillings

Break-even point in units x selling price per unit = 25 x 200 = sh. 5000
B
i. MOS in units
Budgeted output in units – Break-even point in units = 40 -25 = 15 units
ii. MOS in shillings

MOS in units’ ×selling price = 15 × 200 = sh. 3000
iii. MOS in % = × 100% = × 100%= 37.5%
C. Π = cmx –F
Units to be produced in order to earn after tax II of 1200
.
=F+ = = 46 units
MULTI-PRODUCT CVP MODEL
CVP Analysis multiple products under certain conditions

The simple product C-V-P analysis can be extended to handle the more realistic situations where
the firm produces more than one product. The objective in such a case is to produce a mix that
maximizes the total contribution. This is applied where a company is producing and selling more
than one item.
The assumptions noted in single product case still apply here with additional one that the sales
mix will remain constant through the relevant range.
Since the fixed costs are incurred as a single figure for all the products, the computation of profits
must be on average basis
Where we had contribution margin, it changes to weighted average contribution margin

(WACM) while contribution margin ratio changes to weighted average contribution margin ratio
(WACMR)
WACM = W1CM1 + W2CM2 + …………………….. WnCMn
WACMR = W1CMR1 + W2CMR2 + ………………… WnCMRn
Using the algebraic approach the formulae will appear as follows:-
Details Sales in units Sales in shillings

Profit function = − = × −
Sales for target profit x= R=
Break-even point Xble = Rble=
Margin of safety (MOS) X –xble R - Rble
Budgeted output – Break-even point in units
ILLUSTRATION
Party sound diskette (PSD) manufactures and sells a line f diskette for macro computers. Three
models are produced i.e economy standards and premium limit costs and revenue data as well as
fixed cost of PSD are as follows
Economy Standard Premium
Selling price 10 15 25
Variable costs
D. materials 2 3 5
D. labour 2 4 6
Overheads 1 2 3
Selling commissions 2 2 2
Contribution margin 7/3 11/4 16/9
Product of total Sales (units) 10% 50% 40%
Fixed manufacturing costs = Sh.200,000

Advertising = Sh.100,000
Fixed administration Costs = Sh.100,000
Total expected sales for all the products = 80,000 units

Capacity (total for all the products) = 100,000 units
You have been asked by management to prepare a report analyzing each of the following issue:
a) What is the projected profit given the initial data? What is the break-even point?
b) The management is considering increasing advertisement budget by sh. 100,000 to increase
the total unit product will remain the same. Is advertising campaign desirable?
c) The management is considering altering the manufacturing budget so that more effort would
be placed on selling the premium model. The advertising budget could be increased
150,000/= while this would not increase the total unit sale this campaign would result in the
mix of the economy standard a premium model changing to 5%, 30% and to 65%
respectively. Is this change desirable?
d) The management is considering increasing the selling commission paid to the sales force.
The marketing management believes that is the selling commission of each product is
increased by 2%, the total level of sales would rise to 90,000 units. is this change desirable?
e) The management is considering altering the production process. By installing new
manufacturing equipment, the d. materials, direct labour and variable overhead costs can be
reduced to 75% of their current levels for all the products. Fixed manufacturing cost would
rise by sh. 200,000 reflecting depreciation on the new equipment. What is the minimum
level of total sales for which this change would be desirable?
Treat each part independently
SOLUTION
a) WACM = W1CM1 + W2CM2 + W3CM3n= (0.1 x 3) + (0.5 x 4) + (0.4 x 9) = 5.9
Fixed costs = 200,000 + 100,000 + 100,000 = sh. 400,000
Projected profit = WACM × X –F = 5.9 x 80,000 – 400,000

Sh. 72,000
,
Break-even point in units = = = 67797
.
Economy = 10% x 67797 = 6779.7 units

Standard = 50% x 67797 = 33898.5 units
Premium = 40% x 67797 = 27,118.8 units
b) New fixed costs = 400,000 + 100,000 = sh. 500,000

Π = WACM x – F = 5.9 x 100,000 – 500,000 =Sh. 90,000
Therefore
The advertising campaign is desirable because this will lead to increase in profit from sh.
72,000 to sh. 90,000
c) Fixed costs = 400,000 + 150,000 + (550,000)

WACM = (0.05 x 3) + (0.3 x 4) + (0.65 x 9) = 72
Π = WACMx –F = 72 x 80,000 -550,000 = Sh. 26,000
The change is not desirable because this will lead to decrease in profit from 72,000 to sh.
26,000
d)
Product New contribution margin per unit
Economy 3 – (2% x2) = 2.96
Standard 4 – (2% x 2) = 3.96
Premium 9 – (2% x 2) = 8.96
WACM = (0.1 x 2.96) + (0.5 x 3.96) + (0.4 x 8.96) = 5.86
Π=WACMx-F
Π = 5.86 x 90,000 -400,000 = sh. 127,400

Therefore, this change is desirable because this will lead to increase in profit from sh. 72,000 to
sh.127,400
Fixed costs will now be sh. 400,000 + sh. 200,000 = sh. 600,000
Product Unit contribution margin

Economy 3 + (25% x 5) = 4.25
Standard 4 + (25% x 9) = 6.25
Premium 9 + (25% x 14) = 12.5
WACM = (0,1 x 4,25) + (0.5 x 6.25) + (0.4 x 12.5) = 8.55

For the change to be desirable, the profit should be at least sh. 72,000
The point of indifference

Let x be the number of units
Π = 8.55x – 600,000 = 72,000
8.55x = 672,000
,
X= = 78,596 units
.
The objective of any inventory management system model is to minimize the totality of all these
costs
Limitations of CVP analysis

i. Cost profit and revenue functions may not be linear with respect to the level of activity
ii. Sometimes it is hard to categorize total cost into fixed and variable elements especially for
mixed cost
iii. Prices may change during the period under consideration e.g. Competitors may force prices
downwards; government taxes may increase prices etc.
iv. All units produced may not be sold
v. There may be restrictions such as contractual supply obligations
OVERVIEW OF SINGLE PRODUCT AND MULTIPLE PRODUCT

COST-VOLUME-PROFIT ANALYSIS UNDER CONDITIONS OF UNCERTANITY
Uncertainty in the markets and global instability oblige firms to plan for future and to act quickly.
Therefore, profit planning plays an important role in realizing their foremost aim “to make a
profit”. Profit planning requires determining the factors affecting profit and coordination between
them. Cost-Volume-Profit analysis (CVP) aims to determine effects of factors which are required
for profit planning on profit.

Managers use CVP analysis to guide their decisions, many of which are strategic decisions. For
example, CVP analysis helps managers decide how much to spend on advertising, whether or not
to reduce selling price, whether or not to expand into new markets, and which features to add to
existing products. Of course, different choices can affect fixed costs, variable cost per unit,
selling
prices, units sold, and operating income.
Single-number “best estimates” of input data for CVP analysis are subject to varying degrees of
uncertainty, the possibility that an actual amount will deviate from an expected amount. One
approach to deal with uncertainty is to use sensitivity analysis. Another approach is to compute
expected values
using probability distribution
Sensitivity analysis
Sensitivity analysis is a “what if” technique that managers use to examine how a
result will change if the original predicted data are not achieved or if an underlying assumption
changes. In the context of CVP analysis, sensitivity analysis examines how operating income (or
the breakeven point) changes if the predicted data for selling price, variable cost per unit, fixed
costs, or units sold are not achieved.
The sensitivity to various possible outcomes broadens managers’ perspectives as to what might
actually occur before they make cost commitments. Electronic spreadsheets, such as
Excel, enable managers to conduct CVP-based sensitivity analyses in a systematic and efficient
way.
An aspect of sensitivity analysis is the margin of safety, the amount by which budgeted (or
actual) revenues exceed the breakeven quantity. The margin of safety answers the “what-if”
question: If budgeted revenues are above breakeven and drop, how far can they fall below budget
before the breakeven point is reached?
CVP-based sensitivity analysis highlights the risks and returns that an existing cost structure
holds for a company. This insight may lead managers to consider alternative cost structures. For
example, compensating a salesperson on the basis of a sales commission (a variable cost) rather
than a salary (a fixed cost) decreases the company’s downside risk if demand is low but
decreases its return if demand is high. The risk-return tradeoff across alternative cost structures
can be measured as operating leverage. Operating leverage describes the effects that fixed costs
have on changes in operating income as changes occur in units sold and contribution margin.
Companies with a high proportion of fixed costs in their cost structures have high operating
leverage.
Consequently, small changes in units sold cause large changes in operating income. At any given
level of sales

Operating Degree of Operatingleverage =
Knowing the degree of operating leverage at a given level of sales helps managers calculate the
effect of changes in sales on operating income.
Point Estimate of Probabilities

This approach requires a number of different values for each of the uncertain variables to be
selected.
These might be values that are reasonably expected to occur but usually 3 values are selected.
These are:
 The worst possible outcome
 The most likely outcome
 The best possible outcome
For each of these 3 values, a probability of occurrence will be estimated.
ILLUSTRATION
Assume that a management accountant of a Company that makes and sells product X has made
the following estimate:
Selling price Sh.1 Unit variable

cost
Condition Unit Probability Condition Cost Sh.
Worst possible 45000 0.3 Best possible 3.5 0.30
Most likely 50000 0.6 Most likely 4.0 0.55
Best possible 55000 0.1 Worst possible 5.5 0.15
Fixed cost = Sh.240,000
Required:
a) Compute the expected profit
b) Compute the probability that the company will fail to break even
c) If the Company has a profit target of Sh.60,000 what is the probability that the company will
not achieve this target
SOLUTION
a) E (Demand) = (45,000 x 0.3) + (50,000 x 0.6) + (55,000 x 0.1) = 49000
E (Variable cost) = (3.5 x 0.3) + (4 x 0.55) + (55 x 0.15) = Sh.4.075
E (Profit) = (10-4.075) 49,000 – 240,000 = Sh.50325
This can be worked out differently as shown below:

A B C D E F G F×G
Demand Prob. Unit VC Prob. Contr. Profit Joint Weighted
45000 0.3 3.5 0.30 292500 52500 0.09 4725
4.0 0.55 270000 30000 0.165 4950
5.5 0.15 202500 (37500) 0.045 (1687.5)
50000 0.6 3.5 0.3 325000 85000 0.18 15300
4.0 0.55 300000 60000 0.33 19800
5.5 0.15 225000 (15000) 0.09 (1350)
55000 0.1 3.5 0.3 357500 117500 0.33 3525
4.0 0.55 330000 90000 0.055 4950
5.5 0.15 247500 7500 0.015 112.5
Expected profit 50,325
b) The P (Profit < 0) = 0.045 + 0.09

= 0.135
Note: This can be read from the table above
c) P (profit < 60,000)

= 0.3 + 0.09 + 0.015 = 0.405
Continuous Probability Distribution (use of normal distribution)

In reality the C-V-P variables might take any values in a continuous range. It could therefore be
more appropriate to use a continuous probability distribution such as the normal distribution with
an estimated mean and standard deviation. Estimates may be made of the expected sales volume,
the expected selling prices, the expected variable cost and the expected fixed costs together with
their probabilities.
It would therefore be possible to compute the expected profit and the likelihood that the company
would break even or achieve a given target profit.
P
ILLUSTRATION
Assume that the selling price of a product is estimated to be Sh.100, the variable cost Sh.60, and
budgeted fixed cost is Sh.36000. The demand is normally distributed with a mean of 1000 units
and a standard deviation of 90 units
Required;-
Compute the expected profit and standard deviation of profit
Solution
E (profit) = contribution margin ×E(D) – F.C
= (100-60) 1,000 – 36,000 = Shs.4, 000

RISK ASSESSMENT
The process of determining the likelihood that a specified negative event will occur. Investors
and business managers use risk assessments to determine things like whether to undertake a
particular venture, what rate of return they require to make a particular investment and how to
mitigate an activity's potential losses
The Risk Management Process

When establishing a risk management process or initiative, auditors should recommend that
organizations examine best management practices in the area.
Typically, risk management plans have the following objectives:

1. To eliminate negative risks.
2. To reduce risks to an "acceptable" level if risks cannot be eliminated. This means a risk
level the organization can live with, making sure that proper controls are in place to keep
risks within an acceptable range.
3. To transfer risks by means of insurance (i.e., insuring company assets for theft or
destruction, such as hurricane or fire damage) or to transfer the risk to another organization
(i.e., using a third-party vendor to install network equipment so that the vendor is made
responsible for the installation's success or failure).
Identifying Risks
Risk assessment process begins with the identification of risk categories. An organization most
likely will have several risk categories to analyze and identify risks that are specific to the
organization. Examples of risk categories include:
 Technical or IT risks.
 Project management risks.
 Organizational risks.
 Financial risks.
 External risks.
 Compliance risks.
For instance, technical risks are associated with the operation of applications or programs
including computers or perimeter security devices (e.g., a computer that connects directly to the
Internet could be at risk if it does not have antivirus software). An example of a project
management risk could be the inadequacy of the project manager to complete and deliver a
project, causing the company to delay the release of a product to the marketplace.
Organizational risks deal with how the company's infrastructure relates to business operations
and the protection of its assets (e.g., the company does not have clear segregation of duties
between its production and development environments), while financial risks encompass events
that will have a financial impact on the organization (e.g., investing the company's cash reserves
in a highly speculative investment scheme). External risks are those events that impact the
organization but occur outside of its control (e.g., natural disasters such as earthquakes and

floods). Finally, a compliance risk occurs when a company does not comply with mandated
federal regulations, which often results in fines or legal sanctions.
Determining the Risk Likelihood Level

Once risks are identified, the next step is to determine the likelihood that the potential
vulnerability can be exploited. Several factors need to be considered when determining this
likelihood. First, the auditor needs to consider the source of the threat, the motivation behind the
threat, and the capability of the source. Next, auditors need to determine the nature of the
vulnerability and, finally, the existence and effectiveness of current controls to deter or mitigate
the vulnerability. The likelihood that a potential vulnerability could be exploited can be described
as high, medium, or low, as noted in Table 1 at right.
Risk Likelihood Level

Likelihood Level Likelihood Definition
High The threat's source is highly motivated and sufficiently capable, and
controls that prevent the vulnerability from being exercised are ineffective.
Medium The threat's source is motivated and capable, but controls are in place that
may impede a successful exercise of the vulnerability.
Low The threat's source lacks motivation or capability, and controls are in place
to prevent or significantly impede the vulnerability from being exercised.
Identifying the Risk's Impact

The next step is to determine the impact that the threat could have on the organization. It is
important for auditors to understand that not all threats will have the same impact. This is
because each system in the organization most likely will have a different value (i.e., not all
systems in the organization are worth the same or regarded in the same way). For instance, to
evaluate the value of a system, auditors should identify the processes performed by the system,
the system's importance to the company, and the value or sensitivity of the data in the system. A
system that handles the company's payroll will have more value than the system that is used to
keep the lunchroom menu database.
The impact of a security event can be defined as a breach or loss of confidentiality, integrity, or
availability, which may result in an unauthorized disclosure of company information (i.e., loss of
confidentiality), the improper modification of the information (i.e., loss of integrity), and a
system's unavailability when needed (i.e., loss of availability). The magnitude of impact also can
be categorized as high, medium, or low as shown in below.

Risk's Impact table
Impact Definition
High High impact risks may result in the high costly loss of assets; risks that
significantly violate, harm, or impede operations; or risks that cause human death
or serious injury.
Medium Medium impact risks may result in the costly loss of assets; risks that violate,
harm, or impede operations; or risks that cause human injury.
Low Low impact risks may result in the loss of some assets or may noticeably affect
operations
In addition, auditors need to measure the risk's actual impact on the organization. This can be
done by measuring the risk's impact in a quantitative (e.g., revenue loss or the cost to replace IT
equipment) or qualitative manner (e.g., the loss of public confidence when a security breach is
announced in the media). There are advantages and disadvantages to both approaches.
The quantitative impact analysis approach provides a definite measure of the impact's magnitude,
which can be used to calculate a control's cost-benefit analysis. For instance, if an asset's loss of
availability impact is defined quantitatively as sh.1,000, then a sh.10 dollar control to mitigate the
threat has a cost-benefit of 100 to 1 (sh.1,000/sh.10).
A major disadvantage of this quantitative approach is the use of wide numerical ranges that can
become quite confusing. For example, a 100 to 1 cost-benefit calculation can be obtained from a
sh.1,000 loss and a sh.10 mitigating control or from a sh.500 loss and a sh.5 mitigating control.
Therefore, simply looking at the final 100 to 1 cost benefit does not really give auditors an idea
of the actual negative impact or the cost of the mitigating control. All the auditor gets are
numbers in the form of ratios.
On the other hand, the advantage of qualitative (i.e., high, medium, or low) analysis is that it
allows the auditor to prioritize risks and identify improvement areas quickly. However, this
approach does not provide the means to calculate the cost-benefit for any of the recommended
controls. That is, the auditor can determine that a particular asset has a high risk, but he or she
will not know what the impact's cost will be or the mitigating control's effectiveness.
Once a risk's impact is measured, the auditor can identify its probability of occurring and
complete an impact assessment for each risk. Table below can be used when determining the
risk's probability or likelihood of occurrence:

Threat Probability Table
Threat Probability Low Impact Medium Impact High Impact

(1–10) (11–20) (21–30)
High (1.0) Medium Medium High
10 (10 x 1.0) 20 (20 x 1.0) 30 (30 x 1.0)
Medium (0.5) Low Medium Medium
5 (10 x 0.5) 10 (20 x 0.5) 15 (30 x 0.5)
Low (0.1) Low Low Low
1 (10 x 0.1) 2 (20 x 0.1) 3 (30 x 0.1)
When using Table above, the auditor will rate the risk as having a low, medium, or high impact.
The table defines the risk's impact scale as:
 Low: 1 to 10.
 Medium: 11 to 20.
 High: 21 to 30.
Table above also defines a high risk as having a value of 1.0, a medium risk as having a value of
0.5, and a low risk as having a value of 0.1. A threat has the highest risk (i.e., a value of 30) if the
impact is high and the threat probability is high (i.e., a value of 1.0). A threat has the lowest risk
(i.e., a value of 1) if the impact is low and the threat probability is low (i.e., a value of 0.1).
Before using this table, auditors need to keep in mind that the ranges used in these examples are
arbitrary. Auditors may use any ranges, such as 1 to 25 for low-impact threat, 26 to 50 for a
medium-impact threat, and 51 to 75 for a high-impact threat if desired. For instance, auditors can
only choose one of the numbers from each of the sets (i.e., 1, 2, 3 for low-impact threats; 5, 10,
15 for medium-impact threats; and 10, 20, 30 for high-impact threats.) The main concept is to
assign a value range for low-, medium-, and high-impact threats so that the auditor has a common
risk assessment reference point. The same is true of the threat possibility numbers used in the
chart.
When addressing risks, many organizations usually start by correcting those risks with a lower
impact to the organization and a lower probability because these are easier to fix — and fixing a
greater number of open issues in a short amount of time looks better on paper. However, auditors
should recommend that organizations start by addressing those risks that will have the highest
likelihood of occurring and will have the highest impact. This is because by focusing on the low-
impact risks first, the company still remains vulnerable to the high impact risks that can cause
irreparable damage.
In addition, while high impact/high likelihood risks should be a high priority, low impact/high
likelihood risks and high impact/low likelihood risks also may require immediate attention.
Therefore, each risk should be carefully evaluated before determining which risk needs to be
addressed first. For example, a system that is connected to the Internet may be highly vulnerable
because a specific software patch is not installed and any Trojan coming from the Internet can
infect the system. As a result, if the system remains unpatched, it could greatly impact the

organization's day-to-day operations (i.e., should the system remain unpatched, there is a high
likelihood the system will have a high impact on the organization).
Now, imagine that the organization uses another system that is not connected to the Internet. In
this case, the impact to the organization is still high because the system is not patched and
vulnerable to any Trojan that makes its way through the network. However, because the machine
is not connected to the Internet, the threat likelihood is low (i.e., this is an example of a high
impact/low probability risk). From these two situations, the auditor can determine that the first
system poses a higher risk to the organization and should be fixed first.
Many organizations are implementing risk management programs that can help them address
companywide risks and potential threats. In the area of IT, an effective risk management program
relies on the auditor's expertise, thus enabling the organization to apply the necessary risk
management controls to a specific area or IT system.
To maximize its effectiveness, auditors should recommend that the risk management initiative
receives the support and commitment from senior management. This will help to set the proper
tone at the top for the program, as well as ensure that controls are managed properly and
implemented risk management policies and procedures are adhered to by company staff. In
addition, the proper tone at the top will help to establish the organization's attitude toward risk
and the kinds of risks that are acceptable. Finally, the audit team needs to have the proper training
or expertise in the area of risk management to better identify and rate risk levels as well as
evaluate controls to determine if they meet the organization's risk management needs.
APPLICATION OF MARGINAL COSTING

In marginal costing product costs should only be made of variable production overheads.
Fixed production costs are not included as part of product cost. They are written off to profit and
loss statement. These costs will be incurred whether production takes place or not and therefore
they will be treated as periodic cost rather than production cost.
Marginal cost is change in total cost due to increase or decrease one unit or output. It is technique
to show the effect on net profit if we classified total cost in variable cost and fixed cost. The
ascertainment of marginal costs and of the effect on profit of changes in volume or type of output
by differentiating between fixed costs and variable costs. In marginal costing, marginal cost is
always equal to variable cost or cost of goods sold.
Marginal costing is very helpful in managerial decision making. Management's production and
cost and sales decisions may be easily affected from marginal costing. That is the reason; it is the
part of cost control method of costing accounting.
By effective use of marginal costing formulae, we can apply marginal costing for managerial
decisions such as the non-routine decisions.

Non – Routine Decisions
They refer to the decisions that are not routinely made frequent intervals. They are to be
distinguished from routine decisions such as what is to be included in annual budget or how to
invest fund or the best way of marketing the products. They include:
a) Make or buy decisions.
b) Special selling price decisions.
c) Product mix decisions when there is a limiting factor.
d) Discontinuation decisions
e) Choice of a product from alternatives.
Relevant costs.
The term relevant pertinent to the decision at hand, Relevant costs represent those future costs
that will be changed by a particular decision. They are the costs appropriate to a specific
management decision.
Relevant costs are costs that change with respect to a particular decision. Sunk costs are never
relevant. Future costs may or may not be relevant. If the future costs are going to be incurred
regardless of the decision that is made, those costs are not relevant. Committed costs are future
costs that are not relevant. Even if the future costs are not committed, if we anticipate incurring
those costs regardless of the decision that we make, those costs are not relevant. The only costs
that are relevant are those that differ as between the alternatives being considered.
Including sunk costs in a decision can lead to a poor choice. However, including future irrelevant
costs generally will not lead to a poor choice; it will only complicate the analysis. For example, if
I am deciding whether to buy a Toyota Camry or a Subaru Legacy, and if my auto insurance will
be the same no matter which car I buy, my consideration of insurance costs will not affect my
decision, although it will slightly complicate the analysis.
Rules about relevant costs

1. Only relevant costs should be considered when revaluating the financial consequences of a
decision. This is because a decision is forward looking.
2. A relevant cost is a future cash flow that will arise or be reduced as a direct consequence of
the decision.
3. A relevant cost is a future cost. This means that any cost that has been incurred in the past
(historical cost cannot be relevant to a decision.
4. A relevant cost is a cash flow. Any costs that are not cash flow items are not relevant. E.g.
non-cash charges such as depreciation of fixed assets.
- Notional costs such as notional interest charges and
- Absorbed fixed overheads.
5. A relevant cost is one that will arise as a direct consequence of decision being taken.
If a decision is a future cash flow that would be incurred anyway regardless of the decision
hence should be ignored.
6. As general rule, variable costs are relevant and fixed costs are unchanged regardless of a
decision hence irrelevant.
Determination of relevant costs
i) Direct material cost
a) Expected purchase cost of materials is relevant cost
b) Stocks that have already been purchased. Their original purchase cost is irrelevant as a
sunk cost. However the current purchase price (account paid to replace such stocks) if
used is relevant cist
c) Stocks in store but with no use except
i) Be resold
The relevant cost is the resale value if the materials are used in a decision disposed.
ii) Be disposed
It used on a decision, the disposal cost will not be incurred and therefore will be
treated as an opportunity savings hence relevant.
iii) Be used as a substitute material for another
It is used on a decision the alternative material will have to be purchased; therefore
the purchase cost of this material becomes relevant.
iv) Direct labour cost
a) Amount paid to employee to execute a duty in a decision is relevant cost.
b) It labour is in short supply that cares, there may be two options
 Work overtime –relevant cost will be will the normal wages + overtime
premium
 To divert from current production
Relevant cost will be the normal wage + the lost contribution from the fewer units
produced in normal production due to labour diversion.
NB: If both are available in a decision, select whichever is cheaper
d) If labour is idle that is excess labour force which is un-utilized
Use of this labour in a decision means utilization of excess hours and the about cost will be
irrelevant
ii) Overheads
Variable overheads
It is an incremental cost which varies with activity level and it is therefore relevant
Fixed overheads
It is expected to remain constant irrespective of activity level and therefore irrelevant.
However, if there is actual increase arising from a decision made, the amount of increase is
relevant cost
ILLUSTRATION
A company has spent Sh.100, 000 acquiring patent rights to manufacture a product. It hopes to
sell 30,000 units at a selling price of Sh.10 each and the variable costs of production will be Sh.7
per unit.
Should the company proceed with production?

Solution
Sh.100, 000 is known as a past cost or a sunk cost. That money is gone and what the company
has to do is to concentrate on future cash flows. The future cash flows will generate a
contribution of:
30,000 × (Sh.10 - Sh.7) = Sh.90, 000
Therefore, proceeding with production will increase the company’s wealth, so it should proceed.
[Note: The incorrect approach would be to look at all costs: 30,000 (Sh.10 - Sh.7) - Sh.100, 000
= -Sh.10, 000. This incorrect because the business has no control over the past cost of Sh.
100,000. The company has to make the best of what can be done in the future.]
ILLUSTRATION
A company rents a factory for sh.100, 000 per year. Half of the factory is already occupied by a
machine. The company is considering installing an additional machine which would produce
20,000 units for a variable cost of sh.5 per unit. These units would sell for sh.7 each. Half of the
factory rent would be apportioned to the new machine.
Should the company purchase new machine?
Solution
The factory rent of sh.100, 000 will be paid irrespective of whether the factory is empty, has one
machine or two machines. It is a fixed cost, is non-incremental and is therefore irrelevant to the
decision.
The new machine will generate a contribution of 20,000 × (sh.7 - sh.5) = sh.40, 000
The new machine should therefore be purchased.
ILLUSTRATION
A company is considering installing a machine which would produce 20,000 units for a variable
cost of sh.5 per unit. These units would sell for sh.7 each. Additional space would have to be
rented at a cost of sh.50, 000.
Should the company take on this project?
Solution
Here the rent of sh.50, 000 is an incremental cost and is therefore relevant to the decision.
The new machine will generate a contribution of 20,000× (sh.7 - sh.5) - sh.50, 000 = - sh.10, 000.
Therefore, the project should not be taken on.
ILLUSTRATION
A company has some inventory that was bought for sh.10, 000.
 It could be sold for sh.4, 000 or used to make a product that would sell for sh.15, 000.
 There is no other use for the inventory.

Additional costs needed to convert the inventory into the product are sh.9, 000. The material
could be bought now for sh.8,000
Required;-
What should the company do?
SOLUTION
The sh.10, 000 cost of the inventory is irrelevant: it is a sunk or past cost.
The sh.8, 000 current price is irrelevant because the company has no use for the material so
would not buy more.
The sh.4, 000 resale value of the inventory is relevant as the company could receive that cash by
selling the inventory. Therefore, sh.4, 000 is a future incremental cash flow. If the company
keeps the inventory and produces the product sh.4, 000 will not be obtained and the sh.4, 000 is
known as an opportunity cost.
If the company proceeds with the new product, the incremental cash flows will be:
Sh.
Sales revenue 15,000
Conversion costs (9,000)
Opportunity cost of not selling the material (4,000)
Contribution 2,000
Product Mix Decisions

A manufacturing Company may be faced with a decision about whether to change the product
mix in its process so as to produce a greater proportion of one product and less of another e.g. if a
process produces product X and Y in the ratio of 2:1, it may be possible to change the ratio to 3:2
but such a decision requires consideration of the relevant costs and relevant revenue of the
change.
ILLUSTRATION
Sanders Ltd is a manufacturing company producing two joint products P1 and P2 in the ratio of
3:1 at the split-off point. The two products are taken to the mixing plant for blending and
refining after the split off point. The following information is also provided:
Product P1 Product P2
Sales volume (litres) 300,000 100,000
Selling price per litre Sh.3,500 Sh.7,000
Joint process costs* Sh.300,000,000 Sh.100,000,000
Blending and refining costs Sh.250,000,000 Sh.250,000,000
Other separable costs (all variable) Sh.50,000,000 Sh.20,000,000
*Joint costs are apportioned on the basis of volume

The joint process costs are 70% fixed and 30% variable whereas the mixing plant costs are 30%
fixed and 70% variable. There are only 5000 hours available in the mixing plant. Usually 4000
hours are taken in processing of Product P1 and P2, 2000 hours for each product while the
remaining 1000 hours are used for other work that generates a contribution of Sh.100,000 per
hour.
The company is now planning to change the production mix of the joint process to 3:2 for
product P1 and P2 respectively. This change will result in an increase in the joint cost by Sh.500
for each additional litre of P2 produced.
Required:
(a) Advise the company on whether to change the production mix.
(b) Explain other qualitative factors that are important to consider before changing the
production mix.
SOLUTION
a)
Profit / operating statement (3:1)
Details P1 sh. P2 Sh. ‘000’
000
Revenue (Px) 1050,000 700,000
Les: Variable cost
Joint process cost 90,000 30,000
Blending and refining 175,000 175000
Other separable cost 50,000 20,000
Contributions 735,000 475,000
Total contribution = 735,000 + 475,000 + (1,000hrs @100)

= sh. 1,310,000
Proposed mix3:2
i. Volume P1 = × 400,000 = 240,000
P2 = × 400,000 = 160,000
ii. Joint process cost (volume is the driver)

P1 = × 90,000 = 72,000
P2 = × 30,000 = 48,000
Additional cost 60000 x 500 = 30,000

78,000
iii. Blending and refining cost
Mixing hours
P1= × 2,000ℎ = 1600ℎ
Therefore × 175,000 = 140,000
P2 = × 2,000ℎ = 3200ℎ
Therefore × 175,000 = 230,000
iv. Excess hours available

5000hrs – (1600 +3200) = 200hrs
Profit / operating statement (3.2)

Details P1 Sh. 000 P2 Sh. 000
Revenue (Px) 840,000 1,120,000
Less: Variable cost
Joint process cost 72,000 78,000
Blending and refining 140,000 280,000
Other separate costs 40,000 32,000
Contribution 588,000 730,000
Separate cost
,
P1 = × 50,000 = 40,000
,
P2 = × 20,000 = 32,000
Total contribution = 588,000,000 + 730,000,000 + (200@100,000) = 1,338,000

Incremental cont. / profit = 1,338,000,000 -1,310,000,000
=28,000,000
Advice
The company should change the current production mix to 3:2 for an incremental profit of sh. 28
million
b) Qualitative factors to consider before changing production mix

- Contractual obligations
- Market –increased P
- Resistance to change
- Maintaining quality of products

Product Mix With Limiting Factors
A limiting factor is a scarce factor / resources that prevent further expansion or increase in output
as the resource is not enough. The total demand for the company’s product cannot be satisfied
and therefore the company must determine how it will maximize profitability from the available
resources
The firm should concentrate on the most profitable products per unit of the scarce resources
being utilized rather than the product with the highest contribution
Steps to follow:-
i) Compute contribution per unit
ii) Identify the limitng factor / unit of output
iii) Compute contribution per limiting factor
iv) Rank the products based on (3) above
v) Allocate the available resources based on the ranking
ILLUSTRATION
Westlife company limited manufacturers three products X, Y, and Z
The following data relating to the products is provided
Cost per unit
Product X Product Y Product Z
Sh. Sh. Sh.
Direct materials 150 450 300
Direct labour Mixing 360 300 450
Testing 150 180 300
Packaging 180 90 360
Variable overheads 300 200 500
Fixed costs 200 200 200
Total costs 1,340 1,420 2,110
Selling price 1,500 1,900 2,600
Additional information
1. The rates to pay per hour for the direct labour use
Direct labour Rate per hour
Sh.
Mixing 30
Testing 60
Packaging 30
2. Labour in the testing departments is in short supply and cannot be realized
3. Fixed costs are recovered on a unit basis
4. The current production and forecasted production for the three products are as shown
below
Product X units Product Y units Product Z units
Current production 10,000 5,000 6,000
Forecasted production 12,000 7,000 9,000

Required:
i) Optimal production mix that would result in the maximum profit
ii) Forecasted profits statement using the optimal production mix in (i) above
SOLUTION
i) X Y Z
Selling price 1,500 1,900 2,600
Less: V. cost
D. materials 150 450 300
D. labour mix 360 300 450
Test 150 180 300
Pack 180 90 360
V. O/H 300 200 500
CM 360 680 690
Margin 360 680 690
Limiting factor 2.5 3 5
CM/L factor 144 226.6669 138
Ranking 2 1 3
Hours currently utilized (L. current products x Lf per unit)

X: 10,000 x 2.5 = 25,000
Y: 5000 x 3 = 15,000
Z: 6000 x 5 = 30,000
70,000
Allocation
Products Hrs per Demand Hours Units Hrs Hrs left
unit available produced utilized
Y 3 7,000 70,000 7,000 21,000 49,000
X 2.5 12,000 49,000 12,000 30,000 19,000
Z 5 9,000 19,000 3,800 19,000 -
Optimal output
X 12,000
Y 7,000
Z 3,800
ii)
X Y Z Total
Sales 18,000,000 13,300,000 9,880,000 41,180,000
Less: cost
Variable costs 13,680,000 8,540,000 7,258,000 29,478,000
4,320,000 4,760,000 2,622,000 11,702,000
4,200,000
Fixed costs (10,000 + 5,000 + 6,000) x 200 = 7,502,000

Special Orders
Products are normally sold at cost plus profit and capacity may remain un-utilized due to demand
constraints at the current selling price.
Companies may consider accepting offers at price below the current price so as to utilize idle
capacity
If the revenue covers the relevant cost, the offer should be accepted
ILLUSTRATION
Mzalendo Ltd. is currently operating at 80% of its capacity. The following is the income
statement of the company for the month of November 2008.
Sh. Sh.
Sales 1,280,000
Cost:
Direct materials 400,000
Direct labour 160,000
Variable overheads 80,000
Fixed overheads 520,000 1,160,000
120,000
The company has received an export order that would utilise 50% of the factory's capacity. The
order has either to be accepted in full and executed at a price which is 10% below the domestic
selling price, or rejected totally.
The company has the following alternatives:

1. Reject the order.
2. Accept the order and turn away excess domestic demand.
3. Increase production capacity In order to maintain the present domestic sates and accept the
export order. This could be achieved through:
 Buying equipment that would increase the factory's capacity by 10% and fixed costs
by Sh.40,000 per months with the balance being produced overtime at an hourly rate
of one and a half times the normal rate; or
 Work overtime at an hourly rate of one and a half times the normal rate.
Required:
Prepare a comparative statement of profitability and recommend the best alternative.
SOLUTION
Alternative 1: Reject the order

The status quo remains and therefore profit shall be sh. 120000

Alternative 2: Accept and turn away excess domestic demands 100%
Income statement
Domestic demand 50% Foreign demands 50%
Sales 800,000 Less: cost of sales 720,000
Less cost Less cost
Direct material (50/80 x400) 250,000 Direct materials 250,000
Direct labour (50/80 x160) 100,000 Direct labour 100,000
Variable overheads (50/80 x80) 50,000 Variable overheads 50,000
Fixed overheads 520,000 ________
Net loss (120,000) Net profit 320,000
Total profit = (120,000) + 320,000 = sh. 200,000
Alternative 3: Accept order and maintain domestic demand 130%

Income statement
Option 1 (foreign DD) Option 2 (foreign DD)
Normal capacity 110-80 30% Normal capacity 110-80 20%
Overtime 20% Overtime 30%
50% 50%
Sales 720,000 Sales 720,000

Less: cost Less: cost
Direct materials 250,000 Direct materials 250,000
Direct labour Direct labour
Normal capacity (30/50) x100 60,000 Normal capacity (20/50) x100 40,000
Overtime (20/50 x100 x1.5) 60,000 Overtime (30/50 x100 x1.5) 90,000
Variable overheads 50,000 Variable overheads 50,000
Incremental fixed costs 40,000 Incremental fixed costs -_______
Net profit 260,000 Net profit 290,000
NB: It is profitable to work overtime

Therefore total profit =Domestic demand profit + Foreign demand profit = 120,000 +290,000
= sh. 410,000
Conclusion:
The optimal alternative is to accept the order and maintain domestic demand working overtime
Summary
Alternative Profits
1 120,000
2 200,000
3 (410,000)

Make or Buy Decision
Outsourcing is the process of obtaining goods or services from outside suppliers of providing the
same services within the organization.
In arriving on such a make or buy decision, the price asked by the outside supplier should be
compared with the marginal cost of producing the component parts. Other consideration affecting
the decision is:
i) Continuity and control of supply e.g. can be the outsource company be relied upon to meet
the requirement in terms of quality, delivery dates and price stability.
ii) Alternatives use of resources. Can resource used make this article be transferred.
The choice between making or buying a given component is one which is likely to face all
businesses at some time. It is often one of the most important decisions for management for the
critical effect on profits that may ensue. The choice is critical, too, for the management
accountant who provides the cost data on which the decision is ultimately based.
A make or buy problem involves a decision by an organisation about whether it should make a
product or carry out an activity with its own internal resources or whether it should pay another
organisation to carry out the activity. The make option gives management more direct control
over the work, but the buy option may have benefits in that the external organisation has
expertise and special skills in the work making it cheaper.
There are certain situations where the make or buy decision is not really a choice at all. There can
be no alternative to making, where product design is confidential or the methods of processing
are kept secret. On the other hand, patents held by suppliers may preclude the use of certain
techniques and then there is no choice other than buying or going without. The supplier who has
developed a special expertise or who uses highly specialized equipment may produce better-
quality work which suggests buying rather than making. In other cases, the special qualities
demanded in the product may not be available outside and so making becomes necessary.
Where technical considerations do not influence the make or buy decision, the choice becomes
one of selecting the least-cost alternative in each decision situation. Comparative cost data are
necessary, therefore, to determine whether it is cheaper to make or to buy. In general this requires
a comparison of the respective marginal costs or, in some cases, the incremental costs of each
alternative. Incremental costs are relevant in decisions which include capacity changes. For
example, a certain component has always been bought out because the plant and equipment for
its manufacture has not been installed in the factory. When considering the alternative to buying,
the cost of making comprises all the incremental costs (including additional fixed expenditure)
arising from the decision. The incremental cost also includes the opportunity cost of the
investment in capital equipment, that is, the expected return from an alternative investment
opportunity. A decision to buy a part which has previously been manufactured may release
capacity for other uses or for disposal so that the incremental cost of the decision also includes
the relevant fixed cost savings.

ILLUSTRATION
BB Limited makes 3 components S, T and U. the following costs have been applied.
Component Component Component
S T U
Variable costs 2.50 8.00 5.00
Fixed costs 2.00 8.30 3.75
4.50 16.30 8.75
Another company has offered to supply the components to BB Limited at the following prices.
Component Price each
S Shs 4
T Shs 7
U Shs 5.50
Required;-
Which components if any should BB ltd consider to buy?
SOLUTION
Assuming the fixed costs remain unchanged whether the company buys or makes the
components, the relevant cost of manufacture will be variable cost. Under this circumstance the
company should only purchase the components if the purchases price is less than variable costs.
Therefore the company should only purchase component T.
ILLUSTRATION
The cost of making component B 56 is given as below
Sh
Direct material 100
Direct labour 60
Production overheads 50
210
The production overhead is 40% variable. The component could be bought at sh. 160 from an
outsider supplier.
Required
Advice whether to make or buy the component.
SOLUTION
Relevant cost of making component B56
Direct material = Sh 100
Direct labour = Sh 60
Production overheads = 40% x 50 = Shs 20
Sh 180

Decision
The company should buy the component as it is cheaper.
PRICING DECISIONS
The simplest way to set price is through uniform pricing. At the profit-maximizing uniform price,
the incremental margin percentage equals the reciprocal of the absolute value of the price
elasticity of demand. The most profitable pricing policy is complete price discrimination, where
each unit is priced at the benefit that the unit provides to its buyer. To implement this policy,
however, the seller must know each potential buyer’s individual demand curve and be able to set
different prices for every unit of the product.
Factors affecting pricing decisions

Several factors underlie all pricing decisions and effective decisions will be based on careful
consideration of the following:
1. Organizational goals and objectives.

Is the firm a profit or revenue maximized or is it pursuing satisficing objectives? Is the objective
cash maximizing; if so the selling price should reflect the intention of the firm.
2. Product mix.
When producing a range of different products, a firm is faced with the problem of setting a
selling price to obtain the optimum mix; that which will maximize cash inflows generated form
sale of the product.
3. Price and demand relationship.
For most products, there exists a relationship between the quantity demanded and the price
tolerable at that level. Product quality will also tend to affect the price-demand relationship.
Setting product prices to high or too low will ‘chase away customers’.
Knowledge of price elasticity of demand for the product is also important.
4. Competitors and markets.
Is the market perfect, imperfect competition or oligopolistic or monopolistic conditions?
What is the extent and nature of competition? The organization’s competitors will always react in
some way to changes to the selling price structure.
5. Product life cycle
At what stage is it; introduction, growth, maturity or decline. Each stage will influence the firms
pricing policy.
6. Marketing strategy
Product design and quality, advertising and promotion, distribution methods etc. are likely to
influence the sales pricing decisions.
7. Cost
In the long-run, all operating costs must be fully covered by the sales revenues.

Other factors include:
 Relative position of the firm
Is the firm dominant enough to be a price maker or is it a price taker?
 Level of activity
Will the firm be working at full or below capacity? What positions are the competitors?
 Government restrictions or legislation.
 Inflation
 Availability of substitute products.
Demand is the quantity of a good which consumers want and are willing and able to pay for.
Several factors will affect the quantity of product demanded:
i) Price
ii) Income of consumers
iii) Price of substitute goods
iv) Price of complimentary goods
v) Tastes and preferences of consumers
vi) The market size
vii) Advertising
If a company raises the price of a product, unit sales of a normal good will ordinarily fall. It is
important for a firm therefore to consider the reactions of consumers to alterations in price.
This sensitivity of unit sales to changes in price is called the price elasticity of demand.
METHODS OF PRICING/ SETTING PRICES
Uniform Pricing
Uniform pricing: a pricing policy where a seller charges the same price for every unit of the
product.
Profit maximizing price (incremental margin percentage rule): a price where the incremental
margin percentage (i.e., price less marginal cost divided by the price) is equal to the reciprocal of
the absolute value of the price elasticity of demand. This is the rule of marginal revenue equals
the marginal cost.
Price elasticity may very along a demand curve, marginal cost changes with scale of production.
The above procedure typically involves a series of trials and errors with different prices.
Intuitive factors that underlie price elasticity: direct and indirect substitutes, buyers’ prior
commitments, search cost.
Price adjustments following changes in demand and cost.

To maximize profits, a seller should consider both demand and costs.
A seller should adjust its price to changes in either the price elasticity or the marginal cost.
It must consider the effect of the price change on the quantity demanded.

If demand is more elastic (price elasticity will be a larger negative number), the seller should aim
for a lower incremental margin percentage, and not necessarily a lower price, and likewise,
If demand is less elastic, the seller should aim for a higher incremental margin percentage, and
not necessarily a higher price.
A seller should not necessarily adjust the price by the same amount as a change in marginal cost.
NB
Only the incremental margin percentage (i.e., price less marginal cost divided by the price) is
relevant to pricing.
Contribution margin percentage (i.e., price less average variable cost divided by the price) is not
relevant to pricing.
Variable costs may increase or decrease with the scale of production, and hence, marginal cost
will not be the same as average variable cost.
Setting price by simply marking up average cost will not maximize profit. Problems of cost plus
pricing:
In businesses with economies of scale, average cost depends on scale, but scale depends on price.
It is a circular exercise.
Cost plus pricing gives no guidance as to the markup on average cost.
Limitations of uniform pricing (incremental margin percentage rule).

1) The inframarginal buyers do not pay as much as they will be willing to pay. A seller could
increase its profit by taking some of the buyer surplus.
2) Economically inefficient quantity of sales. By providing the product to everyone whose
marginal benefit exceeds marginal cost, the seller could earn more profit.
Economic Theory
The theoretical solutions to pricing decisions are derived from economic theory which explains
how the optimal selling price is determined.
Micro economics has provided much of theoretical background to pricing and whilst there
difficulties in applying the basic theory in practice it serves as a useful starting point.
Determination of optimal selling price using calculus approach

Profit is maximum where
i. =0
ii. Marginal cost (MC) = marginal revenue (MR)
iii. Fixed Overheads Costs ( ) = 0
iv. SOC ( )<0 (-ve)

Steps to follow
i. Derive the price, revenue and cost functions
ii. Determine the optimal output
iii. Determine the price from the price function using the optimal quantity
ILLUSTRATION
A division sells a single product with an annual fixed cost of sh. 70M and variable cost per unit
of sh.7000. The current Selling price has been set at sh. 160,000 per unit and at this price 10,000
units are demanded per year. It is estimated that for every increase in price of sh. 200 demand
will reduce by 500 units. Alternatively, for every sh. 200 reduction I price, demand increases by
500 units
Required;-
Determine the optimal output and selling price assuming
a) Profit is to be minimized
b) Revenue is to be maximized
Profit maximizing output

FOC =0
Where π=R-C
R =PQ
P = f (Q)
P = a –bq
∆
Where b =
∆
b= = 0.4
Currently P = 16,000
Q = 10,000
16000 =a-0.4(10,000)
16000=a-4000
A =20,000
Therefore P =20,000 -0.4Q

Revenue =(20000 -0.4Q)Q = 20,000Q -0.4Q2
Where C =VC+ F = 7000Q + 70million

π= (20,000Q -0.4Q2) – (7,000Q + 70M) = 13,000Q -0.4Q2 -70M
Therefore FOC = = 13000- 0.8Q =0

0.8Q = 13000
Q = 16,250 units
Price = 20,000-0.4 (16,250)= sh. 13,500

P
20,000
Current
16,000
13,500 Optimal
P=20,000 - 0.4Q
0 10,000 1,650 Q
Revenue maximizing output
MR = 0 where MR is the marginal revenue
Where MR=
Revenue = 20000Q -0.4Q2
0.8Q =20000
Q=25,000
Where P = 20000-0.4(25,000) = sh. 10,000
Profit under
a) π= 13,000 (16,250) – 0.4 (16,2502) -70M =35,625,000
b) π= 13,000 (25,000) -0.4 (25,0002) -70M =5M
ILLUSTRATION
Alvis Kiptoo has budgeted that output of his single product will be 100,000 units in the coming
year. At this level his unit variable cost is sh. 50 and his unit foxed cost is sh. 25. His sales
manager estimates that demand for the product would increase by 1000 units for every sh. 1
decreases in selling price and vice versa, and that at a unit selling price of sh. 200 demand would
be nil. Information about two price increases has just been received from suppliers.
One is for materials included in variable cost) and one is for fuel (included in fixed costs). Their
effect will be to increase the variable cost and fixed cost by 20% respectively over the budgeted
figures
Required:
a) calculate the budgeted contributions and profit at the budgeted level before cost increase
b) calculate the level of sales at which profit would be maximized and the amount of this max
profit before cost increases
c) show whether and how much Alvis Kiptoo should adjust his selling price in respect to
increase in:-
i) Material cost
ii) Fuel cost
d) compute the break-even point in units and MOS before and after cost increases
SOLUTION
a) Budgeted contribution
BC = (P-V)X where P is the price, V is the variable cost and X is the number of units
Where V = Sh. 50
X =100,000
P = f(x)
∆ .
b= = = −0.001
∆
a = 200 (price intercept)
Therefore P = 200 -0.001x

Where x = 100,000
Budgeted price =200-0.001 (100,000) = sh. 100
Therefore BC = (100 -50) 100,000 = 5,000,000
Profit = contribution –fixed cost
Where Fixed costs = 25 x 100,000 = 2,500,000
Therefore 5000,000 - 2,500,000 = sh. 2,500,000
b) Profit maximizing output

Where π = (P-V) x –F
Where P is the price, V is the variable cost and X is the number of units

π =Revenue-Costs
R = (200 – 0.001) x
R = 200x -0.001x2
C = 50x + 2.5M
Therefore π = (200x -0.001x2) – (50x + 2.5M) = 150x -0.001x2 -2.5M
= 150 − 0.02
X= = 75000
.
P = 200 – 0.001 (75000) = sh. 125

π = 150 (75000) -0.001 (75000)2 -2.5M = sh. 3125,000
c) Cost increases
i. Material cost
V = 120% 50 = sh. 60
C = 60x + 2.5M
π (200x – 0.001x2) – (60x +2.5M)
π = 140x – 0.001x2 -2.5M
= 140 − 0.002 =0
140 = 0.002
X = 70,000 units
P=200-0.001(70,000) =shs.130
Therefore he shall adjust price by sh. 5 (130-125) increase
ii. Fuel cost

F = 120% 2.5M = 3M
π (200x – 0.001x2) – (50x +3M)
π = 150x – 0.001x2 - 3 M
= 150 − 0.002 =0
X = 75,000 units
P = 200 -0.001 (75000) = sh. 125
Therefore he shall not adjust price
Profit under
i. π= 140 (70,000) -0.001 (70,0002) -2.5M = sh. 2,400,000
ii. π= 150 (75,000) – 0.001 (75,0002 -3M = sh. 2,625,000

d) BEP in units
= = where F is the fixed cost, P is the price and V is the variable cost.
Before cost increases

.
= = 33,333
After cost increases

Material cost = = 42857
MOS = current sales –Xb

100,000 – 33,333= 4167 units
REVISION EXERCISES
QUESTION 1
A processing company, Timao Co. Ltd., is extremely busy. It has increased its output and sales from
12,900 kg in 1st quarter of the year to 17,300 kg in the 2nd quarter. Although demand is still rising, it
cannot increase its output more than an additional 5% from its existing labour force, which is now at its
maximum.
Data for its four products in 2nd quarter were:
Product Product Product Product

P Q R S
Output (Kg) 4560 6960 3480 2300

Selling price (Sh. Per kg) 162 116.40 99.20 136.80
Costs (Sh. Per kg)
Direct labour @ Sh.60 per hour) 19.60 13.00 9.90 17.00
Direct materials 65.20 49.00 41.00 54.20
Direct packaging 8.40 7.40 5.60 7.00
Fixed overhead
(Absorbed on basis of direct
labour cost) 39.20 26.00 19.80 34.00
132.40 95.40 76.30 112.20
The Kagocho Company has offered to supply 2000 kg of product Q at a delivered price of 90% of
Timao’s Co. Ltd. Selling price. Timao Co. Ltd., will then be able to produce extra of product P instead of
product Q to the plant’s total capacity.
Required:

a) State with supporting calculations, whether Timao Co. Ltd should accept the Kagocho Company’s
offer.
b) Which would be the most profitable combination of subcontracting 2000kg of one product at a price
of 90% of its selling price and producing extra quantities of another product up to the plant total
capacity?
Assume that the market can absorb the extra output
SOLUTION:
(a) Existing capacity Kshs
P 4560 x 19.6 = 89,376
Q 6960 x 13.0 = 90,480
R 3480 x 9.9 =34,452
S 2300 x 17.0 = __39,100
Total Existing Capacity 253,408
Add 5% increase to full
Capacity 5% x 253,408 12,670.4
Total Direct Labour of
Full capacity 266,678.4
Switching of 2000 kg of Q releases Direct Labour cost by-: which is switch to P.
2000 x 13 26,000
Add 5% increase 12,670.4
Available cost to be switched 38,670.4
Labour cost of P = 19.6
Therefore units to be switched = 38,670.4 = 1973 Kg

19.6
Increased contribution therefore is: -
Shs Shs.
Sales 197 x 162 319,626
Less: Variable Cost
Direct labour (1973 x 19.6) 38,670.8
Direct materials (1973 x 65.20) 128,639.6
Direct packaging 91973 x 8.4) 16,573.2 (183,883.6)
Contribution of P 135,742.4
Less: Lost contribution from
Q = 2000{(0.9 x 116.40) – (13 + 49 + 7.4)} (70,720)_
Incremental Contribution 65,022.4
Decision
Timao Company Limited should subcontract 2000kg from Kagocho Company due to the incremental
contribution of Kshs. 65,022.4

(b) P Q R S
Timao’s selling prices (A) 162 116.40 99.20 136.80
Subcontracts price = (90% x 4) 145.80 104.76 89.28 123.12
Less: Variable cost of marking
Direct labour 19.60 13.00 9.90 17.00
Direct materials 65.20 49.00 41.00 54.20
Direct packing 8.40 7.40 5.60 7.00
Total Variable cost 93.20 69.40 56.50 78.20
Lost Contribution 52.60 35.40 32.90 44.90
Switching of 2000kg to different products. This can be done in a matrix form as follows.
Additional Production (Kg) from switching direct labour cost.

Source of units P Q R S
Shs.39,200 from P (a) 0 3015 (e) 3959 (f) 2305 (g)
Shs.26,000 from Q (b) 1326 (h) 0 2626 (i) 1529 (j)
Shs.19,800 from R (c) 1010 (k) 1523 (l) 0 1164 (m)
Shs.34,000 from S (d) 1734 (n) 2615 (o) 3434 (p) 0
Extra 5 % of capacity Shs.12,670.4 646 (q) 974 (r) 1280 (s) 745 (t)
Workings
(a) 2000 x 19.60 (e) 39,200 ÷ 13 (i) 26,000 ÷ 9.9
(b) 2000 x 13.00 (f) 39,200 ÷ 9.9 (j) 26,000 ÷ 17
(c) 2000 x 9.90 (g) 39,200 ÷ 17 (k) 19,800 ÷ 19.6
(d) 2000 x 17.00 (h) 26,000 ÷ 19.6 (l) 19,800 ÷13
(m) 19,800 ÷17 (q) 12,670.4 ÷ 19.6

(n) 34,000 ÷ 19.60 (r) 12,760.4 ÷ 13
(o) 34,000 ÷ 13 (s) 12,670.4 ÷ 9.9
(p) 34,000 ÷ 9.9 (t) 12,670.4 ÷ 17.00
Extra contribution gained in Shs.

P Q R S
Contribution per Kg/Sh. 68.80 47 42.70 58.6
2000Kg of P subcontract 0 82,283(i) 118,500(ii) 73,530

2000Kg of Q subcontract 64,954 0 96,070 62,536
2000Kg of R subcontract 48,373 51,788 0 46,307
2000 Kg of S subcontract 73,900 78,843 111,448 0
Workings
Incremental contribution - lost contribution
i.e. (i) { ( 3015 + 974 ) 47 } – { (2000 x 52.6) } = 82,280
(ii) {(3959 + 1280) 42.7)} – {(2000 x 52.6)} = 118,500 etc

Decision
The best profitable contribution is to subcontract 2000kg of P and replace it with
5239kg (3959 + 1280) kg of R leading to the highest contribution of Shs. 118,500.
QUESTION 2
A manufacturer produces and sells two products, A and B. The unit variable cost is sh.12 and
sh.8 for A and B respectively. A review of selling prices is in progress and it has been estimated
that, for each product and increase in the selling price would result in a fall in demand of
Sh.500units per every Sh.1 increase in price and similarly a decrease of Sh.1 in price would result
in an increase in demand of 500 units.
The current sales prices and sales demand are:-
Price (Sh.) Demand (Units)
A 30 15,000
B 58 21,000
Required:
Calculate the profit-maximizing price for reach product.
SOLUTION:
The demand function can be determine as follows:
P = A – bV
Where P is the price per unit
V is the volume of sales at that price
A is the price at which V = O (Maximum price)
b is the rate at which the price falls for volume increases a proportion of sales volume.
Product A
Demand is currently 15,000 units at a price of Sh.30. The demand changes by 500 units for each Sh.1
change in price.
A = 30 + 15,000 x 1 = Sh.60
500
The maximum price = Sh.60
b = 1_
500
The demand function will be
P = 60 - 1 Q
500
Total revenue = PQ = 60Q – 1 Q2
500
Profit is maximized where MR = MC

MR = dTR = 60 – 2Q = 60 – Q
dQ 500 250
MC is the unit variable cost = Sh.12
At Maximum profit MR = MC
60 - Q = 12
250
Q = 12,000 units
Substituting to find P
P = 60 – 12,000 = Sh.36
500
The profit maximizing price is Sh.36 and profit maximizing Quantity is 12,000 units.
Product B
This is solved in the same way as A
A = 58 + 21,000 x 1 = Sh.100
500
P = 100 - 1 Q
500
TR = 100Q - Q2
500
MR = dTR = 100 - Q_
dQ 250
MC = Sh.8
At maximum profit MR = MC
100 - Q_ = 8
250
Q = 23,000 units
Substituting
P = 100 – 23,000 = Sh.54

500
The profit maximizing price is Ksh.54 while the profit maximizing quantity is Sh.23,000 units

QUESTION 3
a) Briefly explain three methods that can be used to analyze uncertainty in cost-volume-profit
(C-V-P) analysis.
b) Aberdares Company Ltd. is a manufacturing company which produces and sells a single
product known as T1 at a price of Sh.10 per unit. The company incurs a variable cost of Sh.6
per unit and fixed costs of Sh.400,000. Sales are normally distributed with a mean of 110,000
units and a standard deviation of 10,000 units. The company is considering producing a
second product, T2 to sell at Sh.8 per unit and incur a variable cost of Sh.5 per unit with
additional fixed costs of Sh.50,000. The demand for T2 is also normally distributed with a
mean of 50,000 units and standard deviation of 5,000 units. If T2 is added to the production
schedule, sales of T1 will shift downwards to a mean of 85,000 units and standard deviation of
8,000 units. The correlation coefficient between sales of T1 and T2 is –0.9.
Required:
i) The company’s break-even point for the current and proposed production schedules.
ii) The coefficient of variation for the two proposals.
iii) Based on your computation’s in (i) and (ii) above advise the company on whether to add T2
to its production schedule.
SOLUTION:
a) Methods used to analyses uncertainty in CV-P analysis
(i) Sensitivity analysis
This is what if analysis that considers the effect of a marginal change on each of the relevant
variables to the decision.
(ii) Point estimate of probability
This approach requires a number of different values for each of the uncertain variables to be
selected. Usually three values are selected: these are the worst possible, most likely and best
possible outcomes. For each of these values a probability of occurrence is estimated. The
expected values and standard deviation can then be computed.
(iii) Continuous probability distribution
(e.g. normal distribution)
The uncertain variables can be estimated as a continuous probability distribution. Estimates are
made of the mean and standard deviation, which can then be used to compute expected profit,
standard deviation of profits and probability that the company will break even.
(iv) Simulation analysis

This is a method of analyzing a system by experimentally duplicating its behaviour. Simulation is
used where analytical techniques are not available or would be very complex.
b) (i) Current production: Ti only
contribution = 10 – 6 = Sh.4
E (Profit) = 4 x 110,000 – 400,000 = Sh.40,000
 profit  4 x 10,000  Sh.40,000
BEP units = Total fixed costs = 400,000

Contribution margin 4
= 100,000 units
BEP sh. = 100,000 (10) = Sh.1,000,000
Coefficient of variation C.V

 40,000
C.V    1
E(profit) 40,000
Proposed production: Ti and T2.

Expected profit = 4(85,000) + 3(50,000) – (400,000 + 50,000)
= Sh.40,000
  CM 12  12  CM 22  22  2 r12  CM 1 CM 2  1  2
 4 ( 800 ) 2  3 2 ( 5000 ) 2  2 (  0 . 9 )( 4 )( 3 )( 8000 )( 5000 )
 19621 . 4
B . E . P units  Total fixed costs

average contributi on margin
AV .CM  4  85   3  50   3 . 62962963
 135   135 
400,000  50,000
BEP units   123980 units
3,62962963
Thing one  85 123980   78061 units

135
Thing two  50 (123980 )  45919 units

135
in sh T1 sh
BEP Sh  78061 x Sh10  780,610
T2
BEP Sh  45919 x 8  367,352
Total BEP Sh 1,147,962
(ii) Coefficient of variation (C.V)

C.V =   19621.4  0.49
E ( profit ) 40,000
(iii) Since the mean demand is greater than breakeven point then BEP is not a good criteria in
making the decision. We should use the coefficient o f variation.
The decision therefore is to add T2 to the production schedule since it r educes the
coefficient of variation from 1 to 0.49.

TOPIC 4
BUDGETARY CONTROL AND ADVANCED VARIANCE

ANALYSIS
INTRODUCTION
A budget is a quantified plan of action for a forthcoming accounting period. A budget is a plan
of what the organisation is aiming to achieve and what it has set as a target whereas a forecast is
an estimate of what is likely to occur in the future:
The budget is 'a quantitative statement for a defined period of time, which may include planned
revenues, expenses, assets, liabilities and cash flows. A budget facilitates planning'.
There is, however, little point in an organisation simply preparing a budget for the sake of
preparing a budget. A beautifully laid out budgeted income statement filed in the cost
accountant's file and never looked at again is worthless. The organisation should gain from both
the actual preparation process and from the budget once it has been prepared.
FLEXIBLE AND FIXED BUDGETS
Fixed budgets
Fixed budgets remain unchanged regardless of the level of activity; flexible budgets are designed
flex with the level of activity.
Comparison of a fixed budget with the actual results for a different level of activity is of little use
for control purposes. Flexible budgets should be used to show what cost and revenues should
have been for the actual level of activity.
A fixed budget is a budget which is designed to remain unchanged regardless of the volume of
output or sales achieved.
The master budget prepared before the beginning of the budget period is known as the fixed
budget
The term 'fixed' has the following meaning;-
a) The budget is prepared on the basis of an estimated volume of production and an estimated
volume of sales, but no plans are made for the event those actual volumes of production and
sales may differ from budgeted volumes.
b) When actual volumes of production and sales during a control period (month or four weeks
or quarter) are achieved, a fixed budget is not adjusted (in retrospect) to the new levels of
activity.
The major purpose of a fixed budget is at the planning stage, when it seeks to define the broad
objectives of the organisation.

Flexible budgets
A flexible budget is a budget which, by recognizing different cost behaviour patterns, is designed
to change as volumes of output change.
Flexible budgets may be used in one of two ways.

a) At the planning stage. For example, suppose that a company expects to sell 10,000 units of
output during the next year. A master budget (the fixed budget) would -be prepared on the
basis of these-expected volumes. However, if the company thinks that output and sales might
be as low as 8,000 units or as high as 12,000 units, it may prepare contingency flexible
budgets, at volumes of, say 8,000, 9,000, 11,000 and 12,000 units. There are-a number of
advantages of planning with flexible budgets.
i) It is possible to find out well in advance the costs of lay-off pay, idle time and so on if
output falls short of budget.
ii) Management can decide whether it would be possible to find alternative uses for spare
capacity if output falls short of budget (could employees be asked to overhaul their own
machines for example, instead of paying for an outside contractor).
iii) An estimate of the costs of overtime, subcontracting work or extra machine hire if sales
volume exceeds the fixed budget estimate can be made'. From this, it can be established
whether there is a limiting factor which would prevent high volumes of output and sales
being achieved.
b) Retrospectively. At the end of each month (control period) or year, flexible budgets can be
used to compare actual results achieved with what results should have been under the
circumstances.
Flexible budgets are an essential factor in budgetary control and overcome the practical
problems involved in monitoring the budgetary control system.
i) Management needs to be informed about how good or bad acti.al performance has been.
To provide a measure of performance, there must be a yardstick (budget or standard)
against which actual performance can be measured.
ii) Every business is dynamic, and actual volumes of output cannot be expected to conform
exactly to the fixed budget. Comparing actual costs directly with the fixed budget costs is
meaningless (unless the actual level of activity turns out to be exactly as planned).
iii) For useful control information, it is necessary to compare actual results at the actual
level of activity achieved against the results that should have been expected at this level of
activity, which are shown by the flexible budget.
ILLUSTRATION 1
Tamu Tamu Foods is a middle class restaurant that is only open in the evenings.
The restaurant has eight staff, who are each paid at the wage rate of Sh.96 per hour on the basis
of hours actually worked. The restaurant also has a restaurant manager and a head chef, each of
whom is paid a monthly salary of Sh.51, 600.

The following data relates to operations for the month of April 2012:
Budgeted Actual
Number of meals 1,200 1,560
Sh. Sh.
Revenue: Food 576,000 730,080
Drinks 144,000 140,400
Total revenue 720,000 870,480
Variable costs: Staff wages 110,592 158,976
Food costs 72,000 86,160
Drink costs 28,800 63,360
Electricity costs 40,644 42,000
Total variable costs 252,036 350,496
Contribution 467,964 519,984
Fixed costs: Manager's and chefs salary 103,200 103,200
Rent and depreciation 54,000 54,000
Total fixed costs 157,200 157,200
Operating profit 310,764 362,784
1. The restaurant is only open six days a week and there are four weeks in a month. The
average number of orders each day is 50 and demand is evenly spread across all the days in
the month.
2. The restaurant offers two meals: Meal A which costs Sh.420 per meal and Meal B, which
costs Sh.540 per meal. In addition to this, irrespective of which meal the customer orders,
the average customer consumes four drinks each at Sh.30 per drink Therefore, the average
spend per customer is either Sh.540 or Sh.660 including drinks, depending on the type of
meal selected. The April budget is based on 50% of customers ordering Meal A and 50% of
customers ordering Meal B.
3. Food costs represent 12.5% of revenue from food sales.
4. Drink costs represent 20% of revenue from drink sales.
5. When the number of orders per day does not exceed 50, each member of the hourly paid
staff is required to work exactly six hours per day. For every increase of five orders in the
average number of orders per day, each member of staff has to work 30 minutes of overtime
for which they are paid at the increased rate of Sh. 144 per hour.
6. Electricity costs are deemed to be related to the total number of hours worked by each of the
hourly paid staff, and are absorbed at the rate of Sh.35:28 per hour worked by each of the
eight staff.
7. Assume that all costs for hourly paid staff are treated wholly as variable costs.
Required:
Flexed budget for the month of April 2012, assuming that the standard mix of customers
remains the same as budgeted.

SOLUTION
Tamu tamu foods
Flexible budget for the month of April 2012
Sh. Sh.
1,560
Revenue: Food ( /1,200 × 576,000) 748,800
Drinks (1,560/1.200×144,000) 187,200
936,000
Variable costs:
Staff wages (110,592 + 8 × 0.5 ×144 × 6 × 4 ×3) 152,064
Food costs ((1,560/1.200 ×72,000) 93,600
Drink costs ((1,560/1.200 ×28,800) 37,600
Electricity costs (8×6×6×4 + 8x6×4×0.5×3) 50,803 (333,907)
602,093
Fixed costs:
Managers' chefs salary 103,200
Rent and depreciation 54,000 (157,200)
Opening profit 444,893
The measure of activity in flexible budgets

The preparation of a flexible budget requires an estimate of the way in which costs (and
revenues) vary with the level of activity.
Sales revenue will clearly vary with sales volume, and direct material costs (and often direct
labour costs) will vary with production volume. In some instances, however, it may be
appropriate to budget for overhead costs as mixed costs (part-fixed, part-variable) which vary
with an 'activity' which is neither production nor sales volume. Taking production overheads in a
processing department as an illustration, the total overhead costs will be partly fixed and partly
variable. The variable portion may vary with the direct labour hours worked in the department, or
with the number of machine hours of operation. The better measure of activity, labour hours or
machine hours, may only be decided after a close analysis of historical results.
ILLUSTRATION
Prepare a budget for 2006 for the direct labour costs and overhead expenses of a production
department at the activity levels of 80%, 90% and 100%, -using the information listed below.
i) The direct labour hourly rate is expected to be Shs.3.75:
ii) 100% activity represents 60,000 direct labour hours,
iii) Variable costs
Indirect labour Shs 0.75 per direct labour hour.
Consumable supplies Shs 0,375 per direct labour hour
Canteen and other welfare services. 6% of direct and indirect labour costs
iv) Semi-variable costs are expected to relate to the direct labour hours in the-same manner
as for the last five years.

Year Direct labour Semi-variable costs “Shs”
hours
20 x 1 64,000 20,800
20 x 2 59,000 19,800
20 x 3 53,000 18,600
20 x 4 49,000 17,800
20 x 5 (estimate) 40,000 16,000
v) Fixed overhead per labour hour at 100% activity

Shs
Depreciation 0.30
Maintenance 0.20
Insurance 0.10
Rates 0.25
Management salaries 0.40
vi) Inflation is to be ignored.

Calculate the budget cost allowance (i.e. expected expenditure) for 20 x 6 assuming that 57,000
direct labour hours are worked.
SOLUTION
80% level 90% level 100% level
48,000 hrs 54,000 hrs 60,000 hrs
Shs ‘000’ Shs ‘000’ Shs‘000’
Direct labour 180.00 202.50 225.0
Other variable costs
Indirect labour 36.00 40.50 45.0
Consumable supplies 18.00 20.25 22.5
Canteen etc 12.96 14.58 16.2
Total variable costs (Sh 5,145 per hour) 246.96 277.83 308.7
Semi-variable costs (W) 17.60 18.80 2.0.0
Fixed costs
Depreciation (60 x sh 0.3) 18.00 18.00 18.0
Maintenance (60 x sh 0.2) 12.00 12.00 12.0
Insurance (60 x sh 0.1) 6.00 6.00 6.0
Rates (60 x Sh 0.25) 15.00 15.00 15.0
Management salaries (60 x sh 0.4) 24.00 24.00 24.0
Budgeted costs 339.56 371.63 403.7
Working
Using the high / low method:
Shs
Total cost of 64,000 hours 20,800
Variable cost of 24,000 hours 4,800

Variable cost per hour (Sh 4,800/24,000)=Sh 0.20
Shs
Variable cost of 64,000 hours (x Shs 0.20) 12,800
Fixed costs 8,000
Semi-variable costs are calculated as follows.

Shs
60,000 hours (60,000 × Shs 0.20) + Shs 8,000 = 20,800
54,000 hours (54,000 × Shs 0.20) + Shs 8,000 = 18,800
48,000 hours (48,000 × Shs 0.20) + Shs 8,000 = 17,600
The budget cost allowance for 57,000 direct labour hours of work would be as follows:
Shs
Variable costs (57,000 x Shs 5,145) 293,265
Semi-variable costs (Shs 8,000 + (57,000 ×Shs 19,400
0.20) 75,000
Fixed costs 384,665
Note that in each case the fixed costs remain the same when the level of activity changes and are
not flexed.
Flexible budgets and budgetary control

A prerequisite of flexible budgeting is knowledge of cost behaviour.
The differences between the components of the fixed budget and the actual results are known as
budget variances.
Budgetary control is the practice of establishing budgets which identify areas of responsibility
for individual managers (for example production managers, purchasing managers and so on) and
of regularly comparing actual results against expected results. The differences between actual
results and expected results are called variances and these are used to provide a guideline for
control action by individual managers.
Correct approach to budgetary control

a) Identify fixed and variable costs.
b) Produce a flexible budget using marginal costing techniques.
In the previous example of Tree, let us suppose that we have tile following information
regarding cost behaviour.
c) Direct materials and maintenance costs are variable.
d) Although basic wages are a fixed cost, direct labour is regarded as variable in order to
measure efficiency/productivity.
e) Rent and rates and depreciation are fixed costs.
f) Other costs consist of fixed costs of shs.1, 600 plus a variable cost of $1 per unit made and
sold.

Factors to consider when preparing flexible budgets
The mechanics of flexible budgeting are, in theory, fairly straightforward. In practice, however,
there are a number of points that must be considered before figures are flexed.
a) The separation of costs into their fixed and variable elements is not always straightforward.
b) Fixed costs may behave in a step-line fashion as activity levels increase/decrease.
c) Account must be taken of the assumptions upon which the original fixed budget was based.
Such assumptions might include the constraint posed by limiting factors, the rate of
inflation,
judgement about future uncertainty, the demand for the organisation's products and so on.
Fixed and flexible budgets differences

A fixed budget will not change to take into account variations in production, sales or expenses
actually experienced. A flexible budget can do this by adjusting expected total costs for the level
of production achieved. The original budget based on a given volume is 'flexed' to the actual
volume by analyzing budgeted costs over budgeted volume and multiplying by actual units
produced.
When fixed and flexible budgets are appropriate

Both sorts of budget are used essentially for cost control, although they also provide management
with a yardstick to measure achievement and may thus encourage the attainment of objectives.
Fixed budgets are useful at the planning stage as they provide a common ground for the
preparation of all the many types of budget. At the end of the period, actual results may be
compared with the fixed budget and analysed for control. However, this analysis may be
distorted by uncorrected errors underlying the estimates on which the fixed budget was
constructed. A flexible budget may be needed at the planning stage to complement the master
budget; output may be budgeted at a number of different possible levels for instance. During the
period the flexible budget may then be updated to the actual level of activity and the results
compared. As a result flexible budgets assist management control by providing more dynamic
and comparable information. Relying only on a fixed budget would give rise to massive
variances; since forecast volume is very unlikely to be matched, the variances will contain large
volume differences, Flexible budgets are more likely to pinpoint actual problem areas on which
control may be exercised.
Purpose of Budgetary Control

The objectives of a budgetary planning and control system are as follows.
 To ensure the achievement of the organisation's objectives
 To compel planning
 To communicate ideas and plans
 To coordinate activities
 To provide a framework for responsibility accounting
 To establish a system of control

 To motivate employees to improve their performance
Budgets are therefore not prepared in isolation and then filed away but are the fundamental
components of what is known as the budgetary planning and control system. A budgetary
planning and control system is essentially a system for ensuring communication, coordination
and control within an organisation. Communication, coordination and control are general
objectives:
more information is provided by an inspection of the specific objectives of a budgetary planning
and control system.
Ensure the achievement of the organisation's objectives

Objectives are set for the organisation as a whole, and for individual departments and operations
within the organisation. Quantified expressions of these objectives are then drawn up as-targets
to be achieved within the timescale at the budget plan.
Compel planning
This is probably the most important feature of a budgetary planning and control system. Planning
forces management to look ahead, to set out detailed plans for achieving the targets for each
department, operation and (ideally) each manager and to anticipate problems. It thus prevents
management from relying on ad hoc or uncoordinated planning which may be detrimental to the
performance of the organisation. It also helps managers to foresee potential
threats or opportunities, so that they may take action now to avoid or minimise the effect of the
threats and to take full advantage of the opportunities.
Communicate ideas and plans

A formal system is necessary to ensure that each person affected by the plans is aware of what he
or she is supposed to be doing. Communication might be one-way, with managers giving orders
to subordinates, or there might be a two-way dialogue and exchange of ideas.
Coordinate activities
The activities of different departments or sub-units of the organisation need to be coordinated to
ensure maximum integration of effort towards common goals. This concept of coordination
implies, for example, that the purchasing department should base its budget on production
requirements and that the production budget should in turn be based on sales expectations,
Although straightforward in concept, coordination is remarkably difficult to achieve, and there is
often 'sub-optimality' and conflict between departmental plans in the budget so that the efforts of
each department are not fully integrated into a combined plan to achieve the company's best
targets.
Provide a framework for responsibility accounting

Budgetary planning and control systems require that managers of budget centres are made
responsible for the achievement of budget targets for the operations under their personal control.
Establish a system of control
A budget is a yardstick against which actual performance is monitored and assessed. Control over
actual performance is provided by the comparisons of actual results against the budget plan.
Departures from budget can then be investigated and the reasons for the departures can be
divided into controllable and uncontrollable factors.
Motivate employees to improve their performance

The interest and commitment of employees can be retained via a system of feedback of actual
results, which lets them know how well or badly they are performing. The identification of
controllable reasons for departures from budget with managers responsible provides an incentive
for improving future performance.
Provide a framework for authorization

Once the budget has been agreed by the directors and senior managers it acts as an authorization
for each budget holder to incur the costs included in the budget centres budget. As long as the
expenditure is included in the formalized budget the budget holder can carry out day to day
operations without needing to seek separate authorization for each item of expenditure.
Provide a basis for performance evaluation

As well as providing a yardstick for control by comparison, the monitoring of actual results
compared with the budget can provi.ie a basis for evaluating the performance of the budget
holder. As a result of this evaluation the manager might be rewarded, perhaps with a financial
bonus or promotion. Alternatively the evaluation process might highlight the need for more
investment in staff development and training.
Operation of a budgetary control system, organization and coordination of the budgeting

function
The co-ordination and administration of budgets is usually the responsibility of a budget
committee (with the managing director as chairman). The budget committee is assisted by a
budget officer who is usually an accountant. Every part of the organisation should be represented
on the committee, so there should be a representative from sales, production, marketing and so
on. Functions of the budget committee include the following
a) Co-ordination of the preparation of budgets, which includes the issue of the budget manual
b) Issuing of timetables for the preparation of functional budgets
c) Allocation of responsibilities for the preparation of functional budgets
d) Provision of information to assist in the preparation of budgets
e) Communication of final budgets to the appropriate managers
f) Comparison of actual results with budget and the investigation of variances
g) Continuous assessment of the budgeting and planning process, in order to improve the
planning and control function

The budget preparation process is as follows.
The procedures involved in preparing a budget will differ from organisation to organisation, but
the step- by-step approach described here is indicative of the steps followed by many
organisations. The preparation of a budget may take weeks or months and the budget committee
may meet several times before an organisation's budget is finally agreed.
Step 1
Communicating details of the budget policy and budget guidelines
The long-term plan is the starting point for the preparation of the annual budget.
Managers responsible for preparing the budget must be aware of the way it is affected by the
long-term plan so that it becomes part of the process of meeting the organisation's objectives. For
example, if the long-term plan calls for a more aggressive pricing policy, the budget must take
this into account. Managers should also be provided with important guidelines for wage rate
increases, changes in productivity and so on, as well as information about industry demand and
output.
Step 2
Determining the factor that restricts output
The principal budget factor (or key budget factor or limiting budget factor is the factor that limits
an organisation's performance for a given period and is often the starting point in budget
preparation.
For example, a company's sales department might estimate that it could sell 1,000 units of
product X, which would require 5,000 hours of grade A labour to produce. If there are no units of
product X already in inventory, and only 4,000 hours of grade A labour available in the budget
period, then the company would be unable to sell 1,000 units of X because of the shortage of
labour hours. Grade A labour would be a limiting budget factor, and the company's management
must choose one of the following options.
a) Reduce budgeted sales by 20%.
b) Try to increase the availability of grade A labour by 1,000 hours (25:1) by recruitment or
overtime working.
c) Try to sub-contract the production of 1,000 units to another manufacturer, but still profit on
the transaction.
In most organisations the principal budget factor is sales demand: a company is usually restricted
from making and selling more of its products because there would be no sales demand for the
increased output at a price which would be acceptable/profitable to the company. The principal
budget factor may also be machine capacity, distribution and selling resources, the availability of
key raw materials or the availability of cash. Once this factor is defined then the rest of the
budget can be prepared. For example, if sales are the principal budget factor then the production
manager can only prepare his budget after the sales budget is complete.
However in the public sector, the principal budget factor will not be profit related. You need to
think
about the limiting factor for these organisations in terms of activity, for insurance consultant
availability, cash budget or accommodation.
Remember that state-run organisations providing services free at the point of consumption often
face almost unlimited demand for their services. Therefore resources available usually comprise
the limiting factor: -
a) Cash from government grants and ministries
b) Trained staff such as nurses and doctors
c) Equipment such as MRI scanners and hospital beds
Step 3
Preparation of the sales budget
For many organisations, the principal budget factor is sales volume. The sales budget is therefore
often the primary budget from which the majority of the other budgets are derived.
Before the sales budget can be prepared a sales forecast has to be made.
Sales forecasting is complex and involves the consideration of a number of factors.
a) Past sales patterns
b) The economic environment
c) Results of market research
d) Anticipated advertising
e) Competition
f) Changing consumer taste
g) New legislation
h) Distribution
i) Pricing policies and discounts offered
j) Legislation
k) Environmental factors
Management can use a number of forecasting methods.

a) Sales personnel can be asked to provide estimates.
b) Market research can be used (especially if an organisation is considering introducing a new
product or service).
c) Various mathematical techniques can be used to estimate sales levels.
d) Annual contracts, under which major customers set out in advance monthly ranges of possible
sales, can be reviewed.
On the basis of the sales forecast and the production capacity of the organisation, a sales budget
will be prepared. This may be subdivided, possible subdivisions being by product, by sales area
or by management responsibility.
Step 4
Initial preparation of budgets
Finished goods inventory budget
Decides the planned increase or decrease in finished inventory levels.
Production budget
Stated in units of each product and is calculated as the sales budget in units plus the budgeted
increase in finished goods inventories or minus the budgeted decrease in finished goods
inventories.
Budgets of resources for production
Materials usage budget is stated in quantities and perhaps cost for each type of material used. It
should take into account budgeted losses in production.
Machine utilization budget shows the operating hours required on each machine or group of
machines. .
Labour budgetor wages budget will be expressed in hours for each grade of labour and in terms
of cost. It should take into account budgeted idle time.
Overhead cost budgets

Production overheads
Administration overheads
Selling and distribution overheads
Research and developmentdepartment overheads
Raw materials inventory budget

Decides the planned increase or decrease of the level of inventories.
Raw materials purchase budget

Can be prepared in quantities and value for each type of material purchased once the raw material
usage requirements and the raw materials inventory budget are known.
Overhead absorption rate

Can be calculated once the production volumes are planned, and the overhead cost centre budgets
prepared.
Step 5
Negotiation of budgets with superiors
Once a manager has prepared his draft budget he should submit it to his superior for approval.
The superior should then incorporate this budget with the others for which he or she is
responsible and then submit this budget for approval to his or her superior.
This process continues until the final budget is presented to the budget committee for
approval.
At each stage of the process, the budget would be negotiated between the manager who
had prepared the budget and his/her superior until agreed by both parties.
Step 6
Co-ordination of budgets
It is unlikely that the above steps will be problem-free. The budgets must be reviewed in relation
to one another. Such a review may indicate that some budgets are out of balance with others and
need modifying. The budget officer' must identify such inconsistencies and bring them to the
attention of the manager concerned. The revision of one budget may lead to the revision of all
budgets. During this process the budgeted income statement and budgeted statement of financial
position and cash budget should be prepared to ensure that all of the individual parts of the
budget combine into an acceptable master budget.
Step 7
Final acceptance of the budget
When all the budgets are in harmony with one another they are summarized into a master budget
consisting of a budgeted income statement, budgeted statement of financial position and cash
budget.
Step 8
Budget review
The budgeting process does not stop once the budgets have been agreed. Actual results should be
compared on a regular basis with the budgeted results. The frequency with which such
comparisons are made depends very much on the organisation's circumstances and the
sophistication of its control systems but it should occur at least monthly. Management should
receive a report detailing the differences and should investigate the reasons for the
differences. If the differences are within the control of management, corrective action should be
taken to bring the reasons for the difference under control and to ensure that such inefficiencies
do not occur in the future.
The differences may have occurred, however, because the budget was unrealistic to begin with or
because the actual conditions did not reflect those anticipated (or could have possibly been
anticipated). This would therefore invalidate the remainder of tile budget.
The budget committee, who should meet periodically to evaluate the organisation's actual
performance, may need to reappraise the organisation's future plans in the light of changes to
anticipate conditions and to adjust the budget to take account of such changes.
The important point to note is that the budgeting process does not end for the current year once
the budget period has begun: budgeting should be seen as a continuous and dynamic process.

HUMAN ASPECTS OF BUDGETING AND EMERGING TRENDS IN BUDGETARY
CONTROL; ERPS, ABB, ZBB, PROGRAM BUDGETING
Behavioural aspects of Budgeting

The attitude of those involved in budgeting towards the budget is crucial to its effectiveness, The
management accountant should study the factors influencing the behaviour of the personnel in an
organization, The aim is to resolve conflicts, motivate employees and unite them in the desired
direction in order to arrive at goal congruence,
Setting the difficulty level of a budget is one of the most important tasks before management The
difficulty level balances the motivation to achieve the budget and the attainability of the budget A
change in either factor will result in a change in the other factor and could lead to a deterioration
in both e.g. if an incredibly high target is set, employees will be demotivated, and the target will
not be achieved.
Introduction
A survey was conducted on behavioral issues relating to budgeting. The survey indicated that the
budget holders (i.e. those who are responsible for its implementation) take part in the process of
setting the budget across the organization. It also revealed that senior management has a greater
influence in setting the budget than the budget holders.
The effectiveness of a budgetary system is dependent on the attitude of those who are
implementing it. A budget influences the behaviour of managers in the following ways:
 One of the objectives of a budget is to motivate. It motivates the people in the organization
to produce high levels of output.
 Higher but achievable targets motivate the personnel, however unachievable targets
demotivate them.
 Participation from lower level management while devising the budget, and transparency in
the budgetary system helps the lower level management to be motivated.
The following are the factors influencing the behaviour of the employees.
Misunderstandings about the objectives of senior management

A budget is often understood as a cost-cutting exercise. The lower and middle level managers,
who prepare the budgets may fear that upper level management may not approve the budget
proposed by them, and instead, will try to cut the costs (and increase the sales target) wherever
possible. Due to this, they may dislike the budgetary exercise and may not take initiative in
making it successful.
Also, due to fear of cost-cutting, they may prepare budgets with slack i.e. the managers may try
to set the budget targets with a margin, so that even if there is cost-cutting, their actual
requirement would be fulfilledTargets set by senior managers
Targets set for the budget affect the behaviour of the personnel. In most cases, the performance
of the manager in a department is evaluated on the basis of budget targets. Nobody likes to be
labeled a poor performer. Accordingly, when unachievable targets are set by senior management,
in order to bring out the best from the subordinates, the subordinates will oppose the targets.
Senior management should consult with their subordinates and try to win their co-operation in
order for the budget to succeed.
If the targets are easily achievable by the subordinates, they will not motivate the employees to
achieve their full potential
Targets should be agreed to by both senior management and subordinates, and should be such
that the subordinates are motivated to perform at their best without any reason to believe that the
budget is unachievable.
Sub-optimal planning
When targets are set by individuals and approved by senior managers, there is the possibility that,
due to conflicts between the organizational and divisional objectives, the targets will need to be
changed. Different limiting factors may restrict an organization from maximizing its goals. Care
should be taken, while devising a budget to ensure optimum achievement. The objectives should
be such that each factor can organizational performance should be utilized optimally.
There are certain issues which must be faced while preparing a budget.
Difficulty level for a budget

An easily attainable budget target may fail to bring the best out of the employees. On the other
hand a budget target that is very difficult to achieve, can discourage managers from even trying
to attain it. Ideally, budget targets should be challenging, yet attainable.
Difficulty level refers to a level of performance where the budget target is achievable as well as
motivating. It really is a difficult task to set a budget target.
Ideally, there should be a balance between the aim to achieve targets and the aim to motivate
employees. Up to this level, there is a potential to increase motivation as well as performance
levels. Beyond this level, the motivation level falls 'sharply, as the target becomes unachievable.
This is based on the fact that if the target is easy to attain, the budget may fail to achieve the
objective of motivating the employees to put in their best efforts
Setting the difficulty level for a budget

A budget serves multiple functions such as planning, controlling, coordinating, motivating etc.
All these functions should be taken into consideration while determining the difficulty level of a
budget. Planning and coordination require that the target should be one which attainable by the
most of the managers, and which is best for the organizational performance as a whole.
However, if a budget is considered to be a motivational tool, then the target set for most of the
managers may fail to take the best from them, since they might be highly efficient, but may lack
motivation.
In order to make the budget successful, the target level should be set by ensuring the participation
of all levels of management in the budget preparation process, and at the same time, making the
process transparent.
Issues surrounding setting the difficulty level of a budget

The following are the issues involved in setting the difficulty level of a budget:
1. Non-participation of the lower level management

The participation of the lower level management is one of the ways of resolving the issues related
to target- setting. However, in many organizations, the lower level management has very little in
involvement in the process of budget setting. In these organizations, top management prepares
budgets for the entire organization, including those for lower level operations. This process is
often referred to as authoritative budgeting. This is one of the issues for setting the difficulty
level.
A participative budget is a good communication device. The process of preparing a participative
budget often gives top management a better grasp of the problems faced by their subordinates
and enables 13mployees to gain a better understanding of the difficulties top management deals
with. A participative budget is more likely to gain the employees' commitment to fulfill the
budget targets.
2. Non-participation of top management

The participation of top management in the process of preparing the budget is of utmost
importance.
It motivates the lower level management. It also helps in identifying any slack, i.e.
overestimation or underestimation in the budget. The active involvement of top management in
budgeting also motivates lower management to believe in the budget, to be candid in budget
preparation and to be dedicated in attaining the budget target, as they know the superior is
concerned about the budget. Too much involvement, however, may turn the budget into an
authoritative budget and alienate lower level managers.
In most organizations, the involvement of the top management is either less or much more than
required.
Ideally, there should be a balance. When the involvement of top management is less than
required, it does not serve the purposes mentioned above. When it is more than required, top
management may not listen to the opinions of lower management. Therefore, the budget target
should be such that it will be agreed to by both.
3. Role of the budget department or controller in budgeting

The budget department or the controller is generally responsible for checking the accuracy and
appropriateness of the budgets prepared by various departments. They are responsible for
coordinating amongst different departments, and also for ensuring that the functional budgets are
prepared according to the guidelines given by the senior managers to achieve goal congruence.
Unfortunately, many of the tasks the budget department has to perform are perceived as negative.
At times, the budget department may have to point out slack, excessive inventory, inefficient
operation, etc. These certainly are not easy tasks, yet they are necessary if an organization is to
follow an efficient and effective budget
The benefits and difficulties of the participation of employees in the negotiation of targets
When functional budgets are prepared, they are reviewed by the budget committee / budget
department to see whether they are in line with the organizational objectives and well-
coordinated with the objectives of the other departments. Sometimes, it is found that there is no
goal congruence between the .Individual objectives and the corporate objectives. In such cases,
modification of the budgets is necessary to achieve goal congruence.
Sometimes, due to sub-optimal goals set by functional managers, the functional budgets do not
fall in line with the corporate objectives of achieving optimum profit. In such cases, It is
necessary to resolve the conflicts between organizational and divisional objectives through a
negotiation process.
This administrative process of budget negotiation and coordination takes place before finalizing
the budget. Participation of all the individuals involved in the process of setting the budgets,
should be mandatory. This will eliminate any doubts or suspicion in the minds of the employees
about the objectives of the budget.
Benefits of employees' participation in the negotiation of budgets

1. Participation of the employees in negotiation enables them to understand the dilemmas faced
by top management while setting the target. This may help to obtain the employees'
commitment to achieve the budget targets.
2. If the employees participate in the process of negotiation, they will be able to communicate
their problems to top management because they are much more aware of problems at the
grass root level. This will result in setting realistic targets.
Difficulties in employees' participation in the negotiation of the targets

1. If the employees are involved in the process of negotiation, some of them may feel cornered
to negotiate with management. They may not able to negotiate / communicate well in front of
top management and may agree with whatever top management proposes. Subsequently the
objective of the negotiation process is defeated.
2. Where the process is highly programmable, i.e. where the input-output relationship is clear,
the negotiation process will only waste time.
3. The personality / attitude of a person may limit the benefits of participation. If a person is
introvert and does not make any suggestions, his participation in the negotiation process will
not contribute anything.
Enterprise resource planning systems (ERPS)

It is also important that the management accounting information does not exist in isolation, but is
also part of the wider information system in an organization. A good illustration of the way
organizations are increasingly using integrated software systems can be seen by looking at
Enterprise Resource Planning Systems and Strategic Enterprise Management Systems.
Enterprise Resource Planning Systems are software systems designed to support and automate
the business processes of medium and large enterprises. ERPS are accounting-oriented
information systems which aid in identifying and planning the enterprise wide resources needed
to resource, make, account for and deliver customer orders. They aid the flow of information
between all business functions within an organization, as well as managing connections to
outside stakeholders (such as suppliers).
ERPS handle many aspects of operations including manufacturing, distribution, inventory,
invoicing and accounting. They also cover support functions such as human resource
management and marketing.
Supply chain management software can provide links with suppliers and customer relationship
management with customers.
ERPS thus operate over the whole organization and across functions. All departments that are
involved in operations or production are integrated into one system. In this way, adopting ERPS
make firms more agile in the way they use information, meaning they can process that
information better and integrate it into business procedures and decision-making more
effectively.
Activity based budgeting (ABB)

It's the use of costs determined using Activity Based Budgeting as a basis of preparing budgets.
It's a method of budgeting based on activities and utilizing cost driver data in budgets
preparation. It's based on the assumption that the business as a whole will need to be managed
with far more reference to activities and cost driver.
Activity Based Budgeting involves defining activities and using the levels of activity to decide
how much would be allocated in budgets preparation. It involves the following principles:-
i) They are activity which drives costs and therefore aims are to control the cause which is the
cost driver.
ii) Not all activities are value adding therefore each activity should be examined according to
its ability to add value.
iii) Traditional financial measures are unable to fulfill the objectives of continuous
improvement therefore additional measures to focus on driver of cost; quality of activity etc.
is needed.
Benefits of Activity Based Budgeting
i) Different activity levels provides a good foundation for Zero Based Budgeting
ii) Ensures that organizations overall strategy is taken into account when determining value
adding activities.
iii) Critical success factors during budgets implementations can be identified as part of
information control
iv) The focus is on the entire activities and therefore it's more likely that the budgets would be
implemented accurately
v) Traditional budgeting focuses on nature of costs while activity based budgeting emphasizes
on activities which causes the output.
Zero Based Budgeting

In traditional budgeting, previous year's budgets only incorporate changes expected in the current
year. This is known as incremental budgeting. Incremental budgeting is concerned mainly with
increments in costs and revenues that will occur in the current year as a result of growth of
inflation.
Although budgets will be easier to prepare, it's an inefficient form of budgeting as it encourages
continuous wasteful spending from year to year as well as budget slacks i.e. extra amounts in
budgets.
The above problems can be addressed through use of Zero Based Budgeting (ZBB). Zero based
budgeting system assumes that budget for each cost item or cost centre will be made from scratch
or zero and each item of expenditure included must be justified in total for it to be included in
next year's budget.
Therefore, the basis of preparing budget is zero base. However, managers normally may not start
from zero but will ensure all items are justified. There are three steps of implementing Zero
Based Budgeting.
Define decision packages

i) These are specific organized activities which management can use to evaluate priorities
for current period. They are of two types:-
a) Mutually exclusive: - they contain alternative methods of getting the same work done.
Select through cost benefit analysis.
b) Incremental packages: - explains the levels of effort needed i.e. explains the minimum
that needs to be done and the additional work to be done and cost-benefit of doing so.
ii. Evaluate and rank each activity
This is for priority purposes. Whatever must be done would be prioritized. What ought to
be done should be ranked after?
iii. Allocate the resources
On the basis of priorities, the available resources would be allocated bonds and
incorporated in the budgets.
Advantages of Zero Based Budgeting

a) It helps identify and remove inefficient or obsolete operations
b) It forces employees to avoid wasteful expenditure
c) It can increase motivation
d) It responds to changes in business environment
e) It helps in continuous appraisal of organizations operations
f) It challenges the status quo
g) It results in more efficient allocation of resources
Disadvantages of Zero Based Budgeting
a) It involves a lot of paperwork
b) Short term benefits might be emphasized ignoring long-term benefits
c) It might give the impression that all decisions have to be made in the budgets ignoring
unforeseen opportunities and threats which may need immediate decision.
d) Lack of management skills- managers may have to be trained 111 Zero Based Budgeting
techniques.
e) Information system may not be capable of providing suitable information
f) Ranking of activities may be difficult. Common problems may include:-
i) A large number of packages may require ranking
ii) Difficult to rank packages which are equally vital
iii) Difficult to rank activities which have qualitative rather than quantitative benefits e.g.
spending on staff welfare and working conditions.
Program budgeting
Program budgeting is a decision-making process that helps an organization consider how
different budget options would affect its performance. Program budgeting focuses on
theefficiencyandresource allocationfunctions of budgeting. It can contribute tocontrolandteam-
buildingas well.
Program Budgeting Data

 “Demand” or “Workload” e.g. number of engine overhauls, staffing needs.
 “Inputs,” “Resources,” or “Expenditure Objects” e.g. personnel, materials, equipment.
 “Outputs” or “Products” e.g., passenger miles of service, buses preventively maintained
 “Outcomes” or “Impacts” e.g., single-occupant vehicle trips averted
Program Budgeting’s Benefits

Compared to conventional incremental budgeting, program budgeting promises:
- more reasoned decisions
- probing of the organization’s “base budget”
- logical connections between budgeting and other key management processes
- improved capacity to explain and defend budget choices
- improved team-building
ADVANCED VARIANCE ANALYSIS AND PERFORMANCE EVALUATION
A variance is the difference between actual performed and planned/ budgeted performance.
At the end of production, actual cost are measured and compared with standard cost which were
set before production and any difference is the variance.

A variance report must be computed at the end of each week and investigations done to find the
cause of variances.
The actual results achieved by an organisation during a reporting period (week, month, quarter,
year) will, more than likely, be different from the expected results (the expected results being the
standard costs and revenues). Such differences may occur between individual items, such as the
cost of labour and the volume of sales, and between the total expected profit/contribution and the
total actual profit/contribution.
Management will have spent considerable time and trouble setting standards. Actual results have
differed from the standards. The wise manager will consider the differences that have occurred
and use the results of these considerations to assist in attempts to attain the standards. The wise
manager will use variance analysis as a method of control.
A variance is the difference between a planned, budgeted, or standard cost and the actual cost
incurred. The same comparisons may be made for: revenues. The process by which the total
difference between standard and actual results is analysed is known as variance analysis. I
When actual results are better than expected results, we have a favourable variance (F). If, on the
other hand, actual results are worse than expected results, we have an adverse variance (A).
Variances can be divided into three main groups.
 Variable cost variances
 Sales variances
 Fixed production overhead variances.
Causes of variances
1) Errors in standards set  The standards set may not have taken into account all relevant
factors e.g unanticipated breaks / stoppages in production, discounts no material prices,
bonus on labour etc which makes the actual performance differ with standards set.
2) Errors in measuring actual performance  The standards set may be correct or accurate
but actual figures contain errors in measuring i.e. inaccurate tools of measurement. Errors
can also arise in recording and classifying cost e.g. if we fail to use the correct cost
classification such as recording indirect labour hrs in place of direct labour hrs.
3) Failure to implement standards  Standards se t in advance prescribe the type of
materials, type of labour, machine etc to be used if we fail to follow the prescribed
procedures, there will be deviations.
4) Random factors  A variance can occur even when all requirements are in place. Such
variances whose cause cannot be pinpointed are called random factor variances. e.g.
breakdown of machines, shortage of materials in the market etc.

Material Variances
Introduction
The direct material total variance can be subdivided into the direct material price variance and the
direct material usage variance.
The direct material total variance is the difference between what the output actually cost and
what it should have cost, in terms of material.
The direct material price variance;-This is the difference between the standard cost and the
actual cost for the actual quantity of material used or purchased. In other words, it is the
difference between what the material did cost and what it should have cost.
The direct material usage variance;-This is the difference between the standard quantity of
materials that should have been used for the number of units actually produced, and the actual
quantity of materials used, valued at the standard cost per unit of material. In other words, it is
the difference between how much material should have been used and how much material was
used, valued at standard cost.
Material cost variance
MCV = (S.Q×S.P) – A.Q × A.P)
Mat. Price Variance Mat. Usage Variance

MPV = AQ (S.P – A.P) MUV = SP (S.Q – A.Q)
Mat. Mix Variance Mat. Yield / Quantity variance

MMV = SP 1) MQV = S.P (S.Q in S mix- A. Q in S. mix)
(AQ in S. mix – A.Q in A. mix) 2) MYV = S.C (S. Yield(output) – A. Yield (output)
Where;
MPV is material price variance
MUV is material usage variance
SQ is standard quantity
SP is standard price
AQ is actual quantity
AP is actual price
MMV is material mix variance
MQV is material quantity variance
MYV is material yield variance
ILLUSTRATION
Roasters Limited is a coffee-blending firm. It produces a special blend of coffee known as
“Utopia Blend” by mixing two grades of coffee “AB” and “QP” as follows:
Material Standard mix ratio Standard price per
Kg
AB 40% Sh 120
QP 60% Sh 100
A standard loss of 15% is expected. During the month of March 2002, the company produced
2,500 kg of “Utopia Blend”. The actual quantities blended were as follows:
Quantity used Cost (Sh)
AB 1,400kg 175,000
QP 1,600kg 152,000
Required:
Calculate the following variances
i) Material price variance
ii) Material usage variance
iii) Material mix variance
iv) Material yield variance
v) Material cost variance
SOLUTION
(i). Material Price Variance= Actual Usage in the - Actual usage in the actual
Actual mix at the mix at the standard price
Actual price
Actual Usage in the Actual Mix at the Actual Price
= 175,000 + 152,000 = 327,000
Actual Usage in the Actual Mix at the Standard Price:
AB: 1,400 x 120 = 168,000

QP: 1,600 x 60 = 160,000 328,000
1,000(F)
Alternatively
Material Price Variance = (Actual Price – Standard Price) Actual Quantity
AB: (125 – 120) 1,400 = 7,000(A)
QP: 95 – 100) 1,600 = 8,000 (F)
1,000 (F)
NB: Price per KG: AB = 175,000  1,400 = 125
QP = 152,000  1,600 = 95

(ii). Material Usage variance = Material Mix Variance + Material Yield Variance
= 4,000 (A) + 6,105.84 (F)
= 2,105.84 (F)
See Calculations for yield and mix variance in the parts that follow.
(iii). Material Mix Variance= Actual Usage in Actual Mix – Actual Usage at the Standard Mix
At the standard price
Actual Usage in Actual Mix at Standard Price:
Shs
AB: 1,400 x 120 = 168,000
QP: 1,600 x 100 = 160,000 328,000
Actual Usage at Standard Mix at Standard Price
AB: 3,000 x 40% X 120 = 144,000

QP: 3,000 x 60% X 100 = 180,000 324,000
4,000 (A)
(iv). Material Yield Variance = Actual Usage at the standard – Standard Usage at standard
Mix at standard price mix at the standard price
= Actual Usage in - Standard Usage in Standard Price

Standard mix standard mix
1kg of inputs produces 100% - 15% = 85% of output. Therefore to produce 2,500kg of Utopia
Blend Output, we require total standard inputs of:
2,500kg x 100% = 2,941.18 kg

85%
Standard Usage for the inputs in Standard Mix:
AB: 40%×2,941.18 = 1176.472kg

QP: 60%×2,941.18 = 1764.708kg
Then Yield Variance is computed as follows:
Inputs Actual usage in Standard usage for Difference Standard Variance

standard mix the output in Price
standard
proportion
AB 3,000 x 40% = 1,200 1176.472 23.528 120 2,823.36 (A)

QP 3,000 x 60% = 1,800 1764.708 35.292 100 3,529.20 (A)
3,000 2,941.18 6,352.56(A)

(v). Material Cost Variance = (Actual Cost – Standard Cost)
Standard Cost of Material Used in 1kg of Output (Utopia Blend)

AB: 40% x 120 = Shs 48
QP: 60% x 100 = Shs 60
100% OR 1 kg of inputs = Shs 118
But 1kg of Standard inputs produces 0.85kg of output because of the normal loss of 15%.
 Standard Cost of Inputs per kg of output = 118 x 100% = Shs 138.8235294
85%
We produced 2,500kg of Utopia Blend.
Therefore the standard cost of inputs = Shs. 138.82 ×2,500
= Shs. 347,058.8235
Labour Variances
The direct labour total variance can be subdivided into the direct labour rate variance and the
direct labour efficiency variance.
The direct labour total variance is the difference between what the output should have cost and
what it did cost, in terms of labour.
The direct labour rate variance; - It is the difference between the standard cost and the actual
cost for the actual number of hours paid for.
In other words, it is the difference between what the labour did cost and what it should have cost.
The direct labour efficiency variance is similar to the direct material usage variance. It is tile
difference between the hours that should have been worked for the number of units actually
produced, and the actual number of hours worked, valued at the standard rate per hour.
Labour cost variance
LCV = (S.H x S.R) – A.H x A.R)
Labour rate Variance Labour efficiency Variance

LRV = AH (S.R – A.R) LEV = SR (S.H – A.H)
Labour Mix Variance Labour Quantity / Yield variance

LMV = SR (AH in S. mix – A.H in A mix) 1) LQV = S.R (S.H in S mix- A. H in S. mix)
2) LYV = S.C (S. Yield – A. Yield)
Where;
AH is the actual hour
SR is the standard rate
LQV is the labour quantity variance
LYV islabour yield variance
ILLUSTRATION
Hygiene products limited manufacturers a single product, a melamine kitchen sink with a
standard cost of sh. 8000 made up as follows:-
Sh.
Direct materials (15 square metres at sh. 300 per square 4,500
metre) 2,000
Direct labour (5 hours at sh. 400 per hour) 1,000
Variable overheads’ (5 hours at sh. 200 per hour) 500
Fixed overheads (5 hours at sh. 100 per hour)
8,000
The standard selling price of the kitchen sink is sh. 10,000. The monthly budget projects and
sides of 1,000 units.Actual figures for the month of July 2009 were as follows:-
Sales 1,200 units at sh. 10,200 per unit

Production 1,400 units
Direct materials 22,000 square metres at sh. 400 per square
Direct wages metres
Variable overheads 6,800 hours at sh. 500 per hour
Fixed overheads Sh. 1,100,000
Sh. 600,000
Required:
Computer the following variances
 Material price variance
 Material usage variance
 Labour rate variance
 Labour efficiency variance
 Material cost variance
SOLUTION
Material Price Variance = A.Q (S.P –A.P)
A.Q = = 18,857kg
= 18,657 (300 -400)
= 1,883,714A / 1,885,700A
Material Usage variance = S.P (Sp-AQ)

=300 (1200 x 15)-18,857
= 257,100A
Labour rate Variance = Actual Labour. Hours (Standard rate – Actual rate)

= 5,828.5 (400-500)
= 5,828.5 (100)
582,857A
Labour efficiency = Standard rate (Standard Labour. hours – Actual Labour. hours)
= 400 (6,000 – 5828.5)
= 68,600F
Material cost = Material price V + Material Usage V

= 1,885,700 + 257,100
= 2,142,800
Causes of material and labour variances

The calculation of material and labour variances is not enough; we need to know how the
variance could have typically occurred in the first place, and whether there is any connection
between one cause of the variance to another. For example, a higher price of materials could have
resulted in an unfavorable direct material price variance: but, due to the high quality (though high
priced) input materials; this could have led to a favorable efficiency variance!
The above paragraph leads to an important question. What typically causes variances of direct
labour and direct materials? This question is answered in the sections that follow.
Typical Causes of Material Variances
Price Variances
a) Paying higher or lower prices than planned.
b) Losing or gaining quantity discounts by buying in smaller or larger quantities than planned.
c) Buying lower or higher quality than planned.
d) Buying substitute material due to unavailability of planned material.
Usage (Efficiency) Variances

a) Greater or lower field from material than planned.
b) Gains or losses due to use of substitute or gather/lower quality than planned.
c) Inefficiency or efficient machinery.
d) Grater or lower rate of scrap than anticipated.
e) Poorly trained workers or extremely high quality labour.
Typical Causes of Labour Variances

Labour Rate Variances
a) Higher rates being paid than planned due to wage (increase) awards.
b) Higher or lower grade of workers being used than planned.
c) Payment of unplanned overtime or bonus.

Labour Efficiency Variances
a) Use of incorrect grade of labour e.g. poorly trained personnel.
b) Poor workshop organization or supervision.
c) Incorrect materials or machine problems.
d) Use of better quality labour
e) Increase labour or decrease labour efficiency.
Overhead Variances
Variable production overhead variances
The variable production overhead total variance can be subdivided into the variable production
overhear expenditure variance and the variable production overhead efficiency variance (based
on actual hours
Fixed production overhead variances

Introduction
The fixed production overhead total variance can be subdivided into an expenditure variance and
a
volume variance. The fixed production overhead volume variance can be further subdivided into
an efficiency and capacity variance.
You may have noticed that the method of calculating cost variances for variable cost, items is
essentially the same for labour, materials and variable overheads. Fixed production overhead
variances are very different. In an absorption costing system, they are an attempt to explain tile
under- or over-absorption of fixed production overheads in production costs.
The fixed production overhead total variance (i.e. the under- or over-absorbed fixed production
overhead) may be broken down into two parts as Usual.
 An expenditure variance
 A volume variance. This in turn may be split into two parts
- A volume efficiency variance
- A volume capacity variance
You will find it easier to calculate and understand fixed overhead variances, if you keep in mind
the
whole time that you are trying to 'explain' (put a name and value to) any under- or over-absorbed
overhead.
Under/over absorption
Remember that the absorption rate is calculated as follows.
Overhead absorption rate =
Remember that the budgeted fixed overhead is the planned or expected fixed overhead and the

budgeted activity level is the planned or expected activity level.
If either of the following are incorrect, then we will have an under- or over-absorption of
overhead.
 The 'numerator (number on top) = Budgeted fixed overhead
 The denominator (number on bottom) = Budgeted activity level
The fixed overhead expenditure variance

The fixed overhead expenditure variance occurs if the numerator is incorrect. It measures the
under- or over-absorbed overhead caused by the actual total overhead being different from the
budgeted total
overhead.
Therefore, fixed overhead expenditure variance = budgeted (planned) expenditure –Actual

Expenditure.
The fixed overhead volume variance

As we have already stated, the fixed overhead volume variance is made up of the following sub-
variances.
 Fixed overhead efficiency variance
 Fixed overhead capacity variance
These variances arise if the denominator (i.e. the budgeted activity level) is incorrect.
The fixed overhead efficiency and capacity variances measure the under- or over-absorbed
overhead
caused by the actual activity level being different from the budgeted activity level used in
calculating the absorption rate.
There are two reasons why the actual activity level may be different from the budgeted activity
level
used in calculating the absorption rate.
a) The workforce may have worked more or less efficiently than the standard set. This
deviation is
measured by the fixed overhead efficiency variance.
b) The hours worked by the workforce could have been different to the budgeted hours
(regardless
of the level of efficiency of the workforce) because of overtime and strikes etc. This
deviation from the standard is measured by the fixed overhead capacity variance.
How to calculate the variances

In order to clarify the overhead variances which we have encountered in this section, consider the
following definitions which are expressed in terms of how each overhead variance should be

calculated.
Fixed overhead total variance is the difference between fixed overhead incurred and fixed
overhead
absorbed. In other words, it is the under- or over-absorbed fixed overhead.
Fixed overhead expenditure variance is the difference between the budgeted fixed overhead
expenditure and actual fixed overhead expenditure.
Fixed overhead volume variance is the difference between actual and budgeted (planned) volume
multiplied by the standard absorption rate per unit.
Fixed overhead volume efficiency variance is the difference between the number of hours that
actual
production should have taken, and the number of hours actually taken (that is, worked) multiplied
by-
the standard absorption rate per hour.
Fixed overhead volume capacity variance is the difference between budgeted (planned) hours of
work
and the actual hours worked, multiplied by the standard absorption rate per hour.
Total overhead cost variance

TOCV = Standard OH cost – Actual OH
cost
Variable OH cost variance Fixed OH cost variance

VOCV = std V OH cost – actual V OH cost FOCV = std F OH cost – actual F. OH cost
V. OH expenditure variance
VOEV = A.H (VOAR – A.R) V. OH efficiency F. OH expenditure F. OH volume
productivity variance variance
variance FOEV = B.FOH - AFOH FOW =
VOPV = VOAR S.C (B.V – A.V)
(S.H – A.H)
F. OH efficiency / F. OH capacity
productivity variance
variance
Where;
TOCV isTotal overhead cost variance
OH is overhead
VOH is variable overhead
VOCV is variable overhead cost variance
FOCV is fixed overhead cost variance
VOEV is variable overhead expenditure variance
AH isactual hours
SH is standard hour
VOAR isvariable overhead absorption rate
VOPV is variable overheads productivity variance
FOEV is fixed overheads efficiency variance
BFOH is the budgeted fixed overheads
AFOH is the actual fixed overheads
BV is the budgeted volume
AV is the actual volume
ILLUSTRATION
Variable Production Overhead Variances
Suppose that the variable production overhead cost of product X is as follows.
2 hours at Shs. 1.50 = Shs. 3 per unit
During period 6, 1,000 units of product X were made. The labour force worked 2,020 hours, of
which 60 hours were recorded as idle time. The variable overhead cost was Shs. 3,075.
Calculate the following variances.
a) The variable overhead total variance
b) The variable production overhead expenditure variance
c) The variable production overhead efficiency variance
SOLUTION
Since this example, relates to variable production costs, the total variance is based on actual units
of production. (If the overhead had been a variable selling cost, the variance would be based on
sales volumes.)
Shs.
1,000 units of product × should cost (×Shs. 3)but did 3,000
cost 3,075
Variable production overhead total variance 75 (A)
In many variance reporting systems, the variance analysis goes no further, and expenditure and
efficiency variances are not calculated. However, the adverse variance of Sh 75 may be explained
as the sum of two factors.
a) The hourly rate of spending or variable production overheads was higher than it should
have been, that is, there is an expenditure variance.
b) The labour force worked inefficiently, and took longer to make the output than it should
have done. This means that spending on variable production overhead was higher than it
should,have been, in other words there is an efficiency (productivity) variance. The
variable production overhead efficiency variance is exactly the same, in hours, as the
direct labour efficiency variance, and occurs for the same reasons.
It is usually assumed that variable overheads are incurred during active working hours, but are
not incurred during idle time (for example the machines are not running, therefore power is not
being consumed, and no indirect materials are being used). This means in our example that
although the labour force was paid for 2,020 hours, they were actively working for only 1,960 of
those hours and so variable production overhead spending occurred during 1,960 hours.
The variable production overhead expenditure variance is the difference between the amount of
variable production overhead that should have been incurred in the actual hours actively worked,
and the actual amount of variable production overhead incurred.
a)
Shs
1,960 hours of variable production overhead should cost ( ×Shs 1.50) 2,940
but did cost 3,075
Variable production overhead expenditure variance 135 (A)
The variable production overhead efficiency variance, if you already know the direct labour
efficiency variance, the variable production overhead efficiency variance is exactly the same in
hours, but priced at the variable production overhead rate per hour.
b) In our example, the efficiency variance would be as follows.
1,000 units of product X should take/(×2hrs) 2,000 hours
but did take (active hours) 1,960 hours
Variable production overhead efficiency variance in hours 40 hours (F)
x standard rate per hour ' × Shs 1.50
Variable production overhead efficiency variance in Sh Shs 60 (F)
c) Summary
Shs
Variable production overhead expenditure variance 135 (A)
Variable production overhead efficiency variance 60 (F)
Variable production overhead total variance 75 (A)
ILLUSTRATION
Fixed Overhead Variances
Suppose that a company plans to produce 1,000 units of product E during August 2003. The
expected time to produce a unit of E is five hours, and the budgeted fixed overhead is Sh 20,000.
The standard fixed overhead cost per unit of product E will therefore be as follows.
5 hours at Shs 4 per hour = Shs. 20 per unit

Actual fixed overhead expenditure in August 2003 turns out to be Sh 20,450. The labour force
manages to produce 1,100 units of product E in 5,400 hours of work.
Required;
Calculate the following variances.
a) The fixed, overhead total variance
b) The fixed overhead expenditure variance
c) The fixed overhead volume variance
d) The fixed overhead volume efficiency variance
e) The fixed overhead volume capacity variance
SOLUTION
All of the variances help to assess the under or over absorption of fixed overheads, some in greater
detail than others.
a) Fixed overhead total variance

Shs
Fixed overhead incurred 20,450
Fixed overhead absorbed (1,100 units ×Shs. 20 per unit) 22,000
Fixed overhead total variance 1,550 (F)
(= under-/over-absorbed overhead)
The variance is favourable because more overheads were absorbed than budgeted.
b) Fixed overhead expenditure variance
Shs
Budgeted fixed overhead expenditure 20,000
Actual fixed overhead expenditure 20,450
Fixed overhead expenditure variance 450 (A)
The variance is adverse because actual expenditure was greater than budgeted expenditure.
c) Fixed overhead volume variance

The production volume achieved was greater than expected. The fixed overhead volume
variance measures the difference at the standard rate.
Shs.
Actual production at standard rate (1,100 ×shs 20 per unit) 22,000
Budgeted production at standard rate (1,000 ×shs 20 per unit) 20,000
Fixed overhead volume variance 2,000 (F)
The variance is favourable because output was greater than expected.

i) The labour force may have, worked efficiently, and produced output at a faster rate than
expected. Since overheads are absorbed-at the rate of Shs. 20 per unit, more will be

absorbed if units are produced more quickly. This efficiency variance is exactly the same in
hours as the direct labour efficiency variance, but is valued in Shs. at the standard
absorption rate for fixed overhead.
ii) The labour force may have worked longer hours than budgeted, and therefore produced
more output, so there may be a capacity variance.
d) Fixed overhead volume efficiency variance

The volume efficiency variance is calculated in the same way as the labour efficiency variance.
1,100 units of product E should take (×5 hours) 5,500 hours

but did take 5,400 hours
Fixed overhead volume efficiency variance in hours 100 hours (F)
x standard, fixed-overhead absorption rate per hour × Shs 4
Fixed overhead volume efficiency variance in Sh Shs. 400 (F)
The labour force has produced 5,500 standard hours of work in 5,400 actual hours and so
output is 100 standard hours (or 20 units of product E) higher than budgeted for this reason and
the variance is favourable.
e) Fixed overhead volume capacity variance

The volume capacity variance-is the difference between the budgeted hours of work and the
actual active hours of work (excluding any idle time).
Budgeted hours of work 5,500 hours
Actual hours of work 5,400 hours
Fixed overhead volume capacity variance 400 hours (F)
x standard fixed overhead absorption rate per hour ×Shs 4
Fixed overhead volume capacity variance in Sh Shs 1,600 (F)
Since the labour force worked 400 hours longer than planned, we should expect output to be
400 standard hours (or 80 units of product E) higher than budgeted and hence the variance is
favourable.
The variances may be summarized as follows.
Shs
Expenditure variance 450 (A)
Efficiency variance 400 (F)
Capacity variance 1,600 (F)
Over-absorbed overhead (total variance) Shs 1,550 (A)
Causes of Overhead Variances

Overhead variances arise mainly due to the conventions of the overheads absorption process. The
overhead absorption rates utilized in this process are calculated form two main estimates:
i) Estimates of expenditure levels.
ii) Estimates of the activity levels during the budget period.
Since the two elements are mere estimates, they hardly coincide with reality, and therefore will
almost certainly cause a favorable or unfavorable variance in any given accounting period.
Overhead variances are also caused by efficiency variations. Because overheads are frequently
absorbed into production by means of labour hours, overhead variances arise when labour
efficiency is greater or less than planned.
How Overhead Variances Useful for Control Purposes

Overhead variances are essentially a book balancing exercising providing an arithmetic
reconciliation between the standard costs and actual costs. Apart from the expenditure variance,
the calculation of the other overhead variances provides little real control information, since
they are related more to the conventions of overhead absorption than to the organization’s
operational reality.
Sales Variances
These can be used to analyze the performance of the sales function or revenue centers.
N.B. Sales variance calculations are calculated in terms of profit or contribution margin rather
than sales values. It sales values are used (actual sales compared to budgeted) there’s the risk of
ignoring the impact of the sales effort on profit. When we say profit margins, we assume
absorption costing and contribution margin when we are marginal costing.
Total sales margin variance

It is the total difference between the actual margin and the budgeted margin form sales when cost
of sales is valued at standard cost of production.
Sales margin variance (SMV)

SMV = (B.Q x B. Cont) – (A.Q x A. Con)
Sales margin price variance Sales margin volume variance

SMPV = A.Q (B. Cont – A. cont) SMVV = B. cont (B.Q – A.Q)
Sales margin mix variance Sales margin quantity / yield variance

SMMV = B. cont. (A. Q in S. mix – A.Q in A. mix) SMQV = B. cont. (B.Q – A.Q in S. mix)
Where;
B. cont. is the budgeted contribution
BQ is budgeted quantity
AQ is the actual quantity
A cont. is the actual contribution
SMMV is Sales margin mix variance
SMQV is Sales margin quantity yield variance
S.mix is the actual mix
A.mix is the actual mix
ILLUSTRATION
Sales Volume Profit Variance
Suppose that a company budgets to sell 8,000 units of product J for Shs 12 per unit. The standard
full cost per unit is Shs. 7. Actual sales were 7,700 units, at Shs 12.50 per unit.
SOLUTION
The sales volume profit variance is calculated as follows
Budgeted sales volume 8,000 units
Actual sales volume 7,700 units
Sales volume variance in units 300 units (A)
x standard profit per unit (Shs (12-7)) ×Sh 5
Sales volume variance Sh 1,500 (A)
The variance calculated above is adverse because sales were less than budgeted (planned).
ILLUSTRATION
Jasper Company has the following budget and actual figures for 2004
Budget Actual
Sales units 600 620
Selling price per unit Sh 30 Sh 29
Standard full cost of production = Sh 28 per unit.
Required
Calculate the selling price variance and the sales volume profit variance.
SOLUTION
Sales revenue for 620 units should have been (× Shs 30) 18,600
but was (×Shs 29) 17,980
Selling price variance 620 (A)
Budgeted-sales volume 600 units
Actual sales volume 620 units
Sales volume variance in units 20 units (F)
×standard profit per unit (Shs (30-28)) ×Shs 2
Sales volume profit variance Shs 40 (F)
ILLUSTRATION
Sydney manufactures one product, and the entire product is sold as soon as it is produced. There is
no opening or closing inventories and work in progress is negligible. The company: operates a
standard costing system and analysis of variances is made every month. The standard cost card for
the product, a boomerang, is as follows.
Standard cost card – Boomerang.
Shs
Direct materials 0.5 kilos at Shs. 4 per kilo 2.00
Direct wages. 2 hours at Shs. 2.00 per hour 4.00
Variable overheads 2 hours at Shs. 0.30 per hour 0.60
Fixed overhead 2 hours at Shs. 3.70 per hour 7.40
Standard cost 14.00
Standard profit 6.00
Standing selling price 20.00
Selling and administration expenses are not included in the standard cost, and are deducted from
profit as a period charge.
Budgeted (planned) output for the month of June 2007 was 5,100 units. Actual results for June 2007
were as follows:
Production of 4,850 units was sold for Shs 95,600.
Materials consumed in production amounted to 2,300 kgs at a total cost of Shs 9,800.
Labour hours paid for amounted to 8,500 hours at a cost of Shs 16,800.
Actual operating hours amounted to 8,000 hours.
Variable overheads amounted to Shs 2,600.
Fixed overheads amounted to Shs 42,300.
Selling and administration expenses amounted to Shs 18,000.
Required;
Calculate the variance for the month ended 30 June 2007.
SOLUTION
a)
Shs
2,300 kg of material should cost (×Shs 4) 9,200
but did cost 9,800
Material price variance 600 (A)
b)
Shs
4,850 boomerangs should use (x 0.5 kgs) 2,425 kg
but did use 2,300 kg
Material usage variance in kgs 125 Kg (F)
x standard cost per kg x Shs
Material usage variance in Shs 4
Shs 500
(F)
c)

Shs
8,500 hours of labour should cost (× Shs 2) 17,000
but did cost 16,800
Labour rate variance 200 (F)
d)
4,850 boomerangs should take (×2 hours) 9,700 hours
Labour efficiency variance in hours 1,700 hours
× standard cost per hour × Shs 2
Labour efficiency variance in Shs Shs 3,400 (F)
e)Idle time variance 500 hours (A) × Shs 2 Sh 1,000 (A)

f)
Shs
8,000 hours incurring variable overheads expenditure should
cost (× Shs 0.30) 2,400
but did cost 2,600
Variable overhead expenditure variance 200 (A)
g)
Variable overhead efficiency variance in hours is the
same as the
labour efficiency variance: Shs 510 (F)
1,700 hours (F) × Shs 0.30 per hour
h) Shs
Budgeted fixed overhead (5,100 units x 2hrs x Sh 3.70) 37,740
Actual fixed overhead 42,300
Fixed overhead expenditure variance 4,560 (A)
i) Shs
4,850 boomerangs should take (x 2 hrs) 9,700 hours
Fixed overhead volume efficiency variance in hrs 1,700 hours (F)
x standard fixed overhead absorption rate per hour x Shs 3.70
Fixed overhead volume efficiency variance in Sh 6,290 (F)
j) Shs
Budgeted hours of work (5,100×2 hours) 10,200 hours
Actual hours of work 8,000 hours
Fixed overhead volume capacity variance in hours 2,200 hours (A)
x standard fixed overhead absorption rate per hour × Shs 3.70
Fixed overhead volume capacity variance in Shs 8,140 (A)
k)
Shs
Revenue from 4,850 boomerangs should be (x Shs 97,000
20) 95,600
but was 1,400 (A)
Selling price variance
l)
Budgeted sales volume 5,100 units
Actual sales volume 4,850 units
Sales volume profit variance in units 250 units
× standard profit per unit ×Shs 6 (A)
Sales volume profit variance in Shs Shs 1,500
(F)
NB
There are several ways in which an operating statement may be presented. Perhaps the most
common format is one which reconciles budgeted profit to actual profit. In this example, sales and
administration costs will be introduced at the end of the statement, so that we shall begin with
'budgeted profit before sales and administration costs'.
Sales variances are reported first, and the total of the budgeted profit and the two sales variances
results in a figure for 'actual sales minus the standard cost of sales'. The cost variances are then
reported, and an actual-profit (before sales and administration costs) calculated. Sales and
administration costs are then deducted to reach the actual profit for June 2007.
Planning And Operational Variance

Traditional variance analysis, which we have been studying up to now, has been noted to have a
major weakness. There is the implicit assumption that the whole variance is due to operational
deficiencies and that the planning associated with setting the original standard was perfectly
accurate which is hardly realistic.
The planning process could have been wrong and if the standards are found to be unrealistic, they
can be revised with hindsight and performance compared with the revised standards. The
standards set could be unrealistic due to volatile conditions not envisaged during the preparation
of the original budget. In order to prevent blaming variances on operations alone, the total
variances could be split into planning variances and operational variances.
 Planning variances:these ones try to show us by how should the original budget be
adjusted to reflect the changes in conditions between what was forecasted and what is
current i.e. the budget is updated to make it more relevant in current conditions.
 Operational variances.These are found by comparing actual performance with the
revised more realistic standards.
With the separation of the variances, we now get to see a clearer definition of what is an
attainable current target. The planning and operational variances could be further subdivided into

price and usage or rate and efficiency. The original budget is known as ex-antebudget while the
revised one is the ex-postbudget.
ILLUSTRATION
The standard cost / unit of material was estimated to be sh. 5. The general market price at the
time of purchase was sh. 5.5 unit but the actual price paid was sh. 5. /unit. 10,000 units of
materials were purchased during the period.
Required:
a) Material price variance using conventional method
b) Material price variance using planning & operational variance
SOLUTION
a) Conventional variance
MPV = AQ(S.P –A.P)
= 10 000 (5 – 5.2)
= 2 000A
b) i) Planning variance
MPV = A.Q (S.P – R.P) = 10 000 (5 – 5.5) = 5 000A
ii) Operational variance
MPV = AQ (R.P – A.P) = 10 000 (5.5 – 5.2) = 3,000A
ILLUSTRATION
ABC Ltd budgeted to sell 30 000 units of a model at sh. 100 units with budgeted variable cost is
sh. 40 unit. The actual sales made were 36 000 units. The following information is available:
i) The actual selling price & variable cost are 10% and 5% lower than the original standards
respectively.
ii) General market prices have fallen by 6% from the original standards.
iii) 3% of the variable cost reduction from the original standards is due to an over-estimation
of a wage bonus.
Required:
Prepare a summary reconciling original budget contribution with actual contribution using:
a) Conventional approach
b) Planning and operational variances
SOLUTION
Product Original Revised budget Actual
budget
Model
- S.P Sh. 100 94% 100 = 94.00 90% 100 = 90
- V.C Sh. 40 97% 40 = 38.8 95% 40 = 38
Cont. Sh 60 Sh. 55.2 Sh. 52

a) Conventional approach
Budgeted contribution
B.Q × B. Cont. 30 000 × 60 = 1 800 000
Variances
SPV = AQ (B.P – A.P)=36 000 (100 – 90) = 360 000A
SMVV = B. Cont. (B.Q – A.Q) = 60 (30 000 – 36 000) =360 000F

V. cost variance -AQ (Std. cost – Actual cost) =36 000 (40 – 38)=72 000F
1,872,000
Actual contribution = A.Q × Actual cont. = 36 000 × 52 = 1 872 000
b) i) Planning variances & operational variances

Budgeted contribution (BQ x b. Cont) 1,800,000
Planning variances
SPV = BQ (B.P – R.P)
= 30 000 (100 – 94) 180,000A
V. cost variances = B.Q (S.C – R.C)
= 30 000 (40 – 38.8) 36,000F
Revised contribution 1 656 000
BQ x R. Contribution = 30 000 × 55.2
= 1 656 000
Operational variances
SPV = AQ (R.P – AP)
= 36 000 (94 – 90) 144,000A
V. cost variances = A.Q (R. cost – A. cost)
= 30 000 (38.8 - 38) 28,800F
SMVV = R. Cont. (B.Q – A.Q)
= 55.2 (30 000 – 36 000) 331,200F
Actual contribution 1,872 ,000
Advantages and disadvantages of planning and operational variances
Advantages
 The variances used are more useful and relevant especially in changing environments that are
volatile.
 Using operational variances, we are provided with an up to date guide to the levels of
operating activities since the standards have been revised using up to date information.
 Managers are more likely to accept the variances and be motivated by the reports which
provide a better measure of their performance.
 It emphasizes the importance of the planning function and the relationship between planning
and control and helps to identify planning deficiencies.
 The analysis helps in standard setting learning process which will hopefully result in more
useful standards in future.
Disadvantages
 There’s a high degree of subjectivity involved in setting the ex-post budget. This subjectivity
would cause political pressures within the organization and the managers whose performance
is reported to be poor using such a budget are unlikely to accept them.
 The process involves more clerical and managerial time in first analyzing the traditional
variances and then to decide which ones are controllable and which ones are not.
 Analysis tends to exaggerate the inter-relationship of variances providing managers with a
“pre-packed” list of excuses for below standard performance e.g. badly set budgets.
 If planning and operating functions are carried out in the same responsibility center, there’s
also the tendency of placing much fault on outside and uncontrollable factors rather than
internal controllable actions.
VARIANCE INVESTIGATION MODELS

The final stage of standard costing is the investigation of variances. he management must decide
which variances should be investigated. They could adopt a policy of investigating every
reported variance which may be very expensive & time consuming.
Management may not investigate every reported variance and therefore the control function
would be ignored. The optimal policy lies somewhere between these 2 extremes, therefore the
objective is to investigate only those variances that yield benefits in excess of cost variation.
To avoid excess investigation, management may decide to investigate or not. There are a number
of factors which should be considered when assessing the significance of variances namely:
a) Materiality  investigation should only be done if variation between actual and standard is
significant.
b) Controllability  management would need to determine controllability of cause before
investigation. If variance is caused by factors beyond management control, investigation will
not be helpful e.g. if material price variance of oil is caused by worldwide rise in crude oil
prices, investigation will not be helpful since the reason is known.
c) Type of standard being used
Standards can be classified as:
1) Basic standards  are long term standards designed to remain constant for a long period
of time & therefore don’t reflect current conditions hence are unattainable.
2) Ideal standards  they assume perfect working conditions with no allowance for
machine breakdown, idle time & waste in resources due to normal operations. They are
not attainable.
3) Current standards  these are based on current operating conditions allowing for
normal loss in materials, idle time and machine breakdown. They are attainable and are
extracted from basic standards.

NB: If ideal and basic standards are used, variances will always occur as they don’t reflect
actual conditions. In view of this, there is no need for variance investigation. If the current
standards are used and there is a variance, hence investigation should be done.
d) Variance trend  trend provides indication whether the variance is increasing or decreasing.
If a constant trend is identified, investigation should be done. Each type of variance should be
looked at in isolation and the trend should be observed for a number of periods.
e) Cost of investigation  the cost should not be more than benefit (cost benefit analysis should
be done.
To make variance analysis a useful aid to management is the main objective of variance
calculations. But this can only be done if we investigate the variances and the data used to
calculate them. Typical questions that could be asked include:
i) Is there any relationship between the vacancies e.g. did we report an unfavorable material
usage variance because we reported a favorable material price variance as a result of
purchasing low quality materials?
ii) Can further information than merely the variance be provided by the management as to
what could have resulted in the variance? E.g. did the budget use an unrealistic overhead
absorption rate leading to capacity and efficiency variances?
iii) Is the variance significant and worth reporting? (Materiality). It is no point concentrating on
very small variances. Normally the management sets a significance level of variances e.g.
variances are only investigated only if they beyond 20% of the expected value. Thus, a
variance of between 1% and 19% would not be investigated.
iv) Are the variances being reported quickly enough, to the right people, in sufficient or too
much detail, with explanatory notes and is follow-up done to ensure correction of the
situations leading to variances occurring?
Models developed in accounting for investigation

Simple rule for thumb model
This is based on arbitrary criteria such as investigating if the absolute size of a variance greater
than a certain amount of if the ratio of the variance to total standard cost exceeds predetermined
percentage.
In this case, managers apply simple methods based on arbitrary criteria e.g.
a. Fixed size of variance

Investigation is done if the absolute size of the variance is greater than, say 5000. The main
disadvantage of using an absolute figure is that a variance of shs.5000 in a total cost of shs
20,000 would be considered more significant than a variance of shs 5,000 in shs 200,000.
b. Fixed percentage rule

This comes as a remedy for point (a). That a variance will be investigated if it is more than, say
10% of the standard cost. That if a standard output of 1000 is determined, outputs of between 900
and 1100 will need to be investigated.
The main advantage of these simple methods is their simplicity and ease of implementation. The
disadvantages include, they do not adequately take into account the statistical significance of the
reported variances. They also do not consider the costs and benefits of an investigation. They
only rely on managerial judgment and intuition when selecting cutoff values.
Statistical decision model that take into account the cost and benefits of investigation.
This takes into account the cost and benefits of investigation.
Statistical models that do not incorporate costs and benefits of investigation.

This compares a probability that a given variance comes from uncontrolled distribution but
doesn’t take into account the cost and benefits of investigation i.e. use of normal distribution such
as statistical estimation.
ILLUSTRATION
MPV of a certain material has a mean of sh. 50 and a standard deviation of sh. 10. If the current
period’s MPV averaged sh. 64 state whether investigation should be undertaken if the firm’s
policy it to investigate price variables whose probability is at least 2%.
SOLUTION
X U 64  50
z 0.4192  1.4 from tables P = 0.4192
S 10
U = 50
S = 10
Conclusion: the company should investigate the price variance as it exceeds 2% i.e. it is 41.92%.
REVISION EXERCISES
QUESTION 1
Pwani Marine Ltd., a boat construction company, has developed a new type of speed boat called
“Speed Surf.”
The following information has been availed to you:
1. Boat construction is a continous assembling process carried out at the company’s yard.
2. Boat assembling is labour intensive involving the use of two classes of labour namely:
 Skilled labour at a standard rate of Shs. 1,250 per hour.

 Semi-skilled labour at a standard rate of Shs. 950 per hour.
3. Experience on boat construction from other models indicates that the use of skilled labour is
associated with an 80% learning curve effect whereas use of semi-skilled labour is
associated with a 90% learning curve effect.
4. Labour usage for the first speed boat assembled was as follows:
 Skilled labour – 952 hours.
 Semi-skilled labour – 650 hours.
5. In October 2005, the sixth and the seventh speed boats were assembled from start to finish.
During the month, the following labour usage and costs were recorded:
 Skilled labour – 680 hours at a total cost of Shs. 800,400.
 Semi-skilled labour – 1,256 hours at a total cost of Shs. 1,281,200.
The management of Pwani Marine Ltd. is concerned about the cost variances and would like to
learn more on the composition of the variances.
Required:
(i) Calculate the standard labour cost of the month of October 2005.
(ii) Reconcile the standard cost with the actual cost for the month of October 2005 showing the
labour rate and labour efficiency variances.
(iii) Express the labour efficiency variance in terms of labour mix and labour output variances.
(Value the labour mix variances using standard rates).
NB: The value of b in the formula for the learning curve is -0.322 for an 80% learning rate and
-0.152 for a 90% learning rate.
SOLUTION:
(i) Skilled labour: 952 hours: Y = 052X0.678 (Total)
Semi-skilled 650 hours: Y = 650X0.848 (Total)
Labour hours for 6th and 7th boat:
Skilled: 952 (7)0.678 – 952(5)0.678 = 726.4 hours
Semi-skilled 650(7)0.848 – 650 (5)0.848 = 840.3 hours
Standard labour cost of boats assembled in June i.e. (six and seventh)
Skilled: 726.4 x 1250 = 908,000
Semi-skilled: 840.3 x 950 = 798,285
1,706,285
(ii) Reconciliation
Standard Labour Cost 1,706,285
Labour rate variance
Skilled: 800,400 – 680 x 1,250 49,600F
Semi-skilled: 1,281,200 – 1,256 x 950 88,000A 384,000A
Labour efficiency
Skilled: 1,250 (680 – 726.4) 58,000F
Semi-skilled: 950(1,256 – 840.3) 394,915A 336,915A
Actual labour cost (800,400 - 1,281,200) 2,082,600

(iii) Labour Mix variance = SR (Actual Mix – Std mix)
 726.4 
Skilled: 1,250 680  x(680  1256) = 272,032 F
 726.4  840.3 
 840.3 
Semi-Skilled: 950 1256  x(680  1256) = 206,745 A
 726.4  840.3 
Total labour mix variance = 65,287 F
Labour output variance = Std. labour cost (Actual output – std. output)
1,706,285
Std. cost per labour cost = = 853142.5
2
(6  726.4  840.3)
Std. output = (1936 ÷  2.4714
2
 Labour output variance = 853,142.5 (2-2.4714)
= 402,171 A
Labour efficiency variance = Labour Mix + Labour output
= 65,287 F + 402,171 A
= 336,884 A
QUESTION 2
Industrial Chemical Ltd. (ICL) produces chemical Y. the standard ingredients of 1 kilogram of Y
are:
0.65 kilograms of ingredient F @ Sh. 40 per Kg
0.30 kilograms of ingredient D @ Sh. 60 per Kg.
0.20 kilograms of ingredient N @ Sh. 25 per Kg.
The following additional information is provided:
1. Production of 4,000 kilograms of chemical Y was budgeted for October 2004.
2. The production of chemical Y is entirely automated and production costs attributed to its
production comprise only direct materials and overheads.
3. ICL’s production process works on a just-in-time (JIT) inventory system and no ingredients
or inventories of chemical Y are held.
4. Overheads budgeted for the production of Y in the month of October 2004 were as follows:
Activity Total
amount
Sh.
Receipt of deliveries from suppliers (Standard delivery quantity is 460 kilograms) 40,000
Dispatch of goods to customers (Standard dispatch quantity is 100 kilograms) 80,000
120,000
5. In October 2004, 4,200 kilograms of Y were produced and the cost details were as follows:
Materials used

2,840 kilograms of F, 1,210 kilograms of D and 860 kilograms of N at a total cost of Sh.
203,800.
Actual overhead costs

12 supply deliveries at a cost of Sh.48,000 and 38 customer dispatches at a cost of Sh. 78,000
were made.
6. ICL’s budget committee met recently to discuss the preparation of the cost control report for
October 2004 and the following discussion took place:
Chief accountant: “the overheads do not vary directly worth output and are therefore by
definition ‘fixed’. They should be analyzed and reported accordingly”.
Management accountant: “the overheads do not vary with output, but they are certainly not
fixed. They should be analyzed and reported on an activity based basis.”
Required:
Having regard to this discussion,
a) Prepare a variance analysis of the production costs of Y in October 2004. (Separate the
material cost variance into price, mixture and yield components and the overhead cost
variance into expenditure, capacity and efficiency components using consumption of
ingredient F as the overhead absorption base).
b) Prepare a variance analysis of the overhead production costs on Y in October 2004 on an
activity based basis.
SOLUTION:
(a) Standard cost of materials per kilogramme of output = (0.65 kilogrammes x 40) + (0.3
kilogrammes x 60) + 0.2 kilogrammes x 25) = Sh.49
Standard overhead rate = 120,000/Budgeted standard quantity of ingredient F (4000 x 0.65)

= 120,000 = Sh. 46 per kilogramme of F
2,600
Standard overhead rate per kilogramme of Y = 0.65 x 46 = Sh. 30
Sh.
Standard cost of actual output
Material (4,200 × 49) 205,800
Overhead (4,200 ×30) 126,000
331,800
Actual Cost of output
Material 203,800
Overheads (78,000 + 48,000) 126,000
329,800

Variance calculations
Materials price variance = (standard price – actual price) Actual Quantity
= SP X AQ – AC
= (40 × 2840) + (60 × 1210) + (25 × 860) – 203800
= 3900 F
Material yield variance = Actual yield – Standard yield x Standard material cost per unit of output
= (4200 – 4910) x 49 = Sh. 3409A
1.15
Material mix variance = Actual quantity in actual mix at standard price – actual quantity in standard mix
at standard prices
F (4,910 ×0.65/1.15 – 2,840)40 = Sh. 2,591A

D (4,910 × 0.30/1.15 – 1,210)60 = Sh. 4,252F
N (4,910 × 0.20/1.15 – 860)25 = Sh. 152A
1,509F
Overhead efficiency variance = (standard quantity of F – Actual quantity) Standard overhead rate per kg
of F
Overhead efficiency variance = (4200 × 0.65 – 2840) 46 = 5060A
Overhead capacity variance = (Budgeted input of F – Actual input) x Standard overhead rate per kg of F
= (4000 x 0.65 – 2840)46 = 11040F
Overhead expenditure variance = budgeted cost – actual costs
= 120,000 – 126,000 = 6000A
Reconciliation of standard costs and actual cost of output
Sh.
Standard cost of actual production 331,800
Material variances
Material price variance 3900F
Material yield variance 3409A
Material mix variance 1509F 2000F
Overhead variances
Overhead efficiency 5060A
Overhead capacity 11040F
Overhead expenditure 6000A 20A
Actual costs 333,780
(b) Standard number of deliveries (4000 x 1.15)/460 = 10

Standard cost per supplier delivery (40,000/10) = Sh.4,000
Standard number of dispatches to customers (4,000/100) = 40
Standard cost per customer dispatch (80,000/40) = Sh. 2,000
Actual output exceeds budgeted output by 200 = 5%
4,000

Activity-based costing reconciliation statement
Standard cost for actual output Sh. Sh.

Deliveries (1.05×10×4,000) 42,000 126,000
Despatches (1.05×40 ×2,000) 84,000
Activity usage variance
Deliveries (10.5 – 12)4,000 6000A
Despatches (42 – 38) 2,000 8000F 2,000F
Activity expenditure variance
Deliveries (12 × 4,000 – 48,000) 0
Despatches (38 × 2,000 – 78,000) 2000A 2,000A
Actual overheads 126,000

TOPIC 5
INVENTORY CONTROL DECISIONS

DEFINITION
Inventoriesare asset items held for sale in the ordinary course of business or goods that will be
used or consumed in the production of goods to be sold. The description and measurement of
inventory require careful attention because the investment in inventories is frequently the largest
current asset of merchandising (retail) and manufacturing businesses.
Inventory refers to stock of raw materials, work in progress, finished goods etc.
Need for inventory

Inventory is a necessary evil that every organization would have to maintain for various
purposes. Optimum inventory management is the goal of every inventory planner. Over
inventory or under inventory both cause financial impact and health of the business as well as
effect business opportunities.
Inventory holding is resorted to by organizations as hedge against various external and internal
factors, as precaution, as opportunity, as a need and for speculative purposes.
Reasons why organizations maintain Raw Material Inventory
Most of the organizations have raw material inventory warehouses attached to the production
facilities where raw materials, consumables and packing materials are stored and issue for
production on JIT basis. The reasons for holding inventories can vary from case to case basis.
They include;-
1. Meet variation in Production Demand

Production plan changes in response to the sales, estimates, orders and stocking patterns.
Accordingly the demand for raw material supply for production varies with the product plan
in terms of specific SKU as well as batch quantities.
Holding inventories at a nearby warehouse helps issue the required quantity and item to
production just in time.
2. Cater to Cyclical and Seasonal Demand

Market demand and supplies are seasonal depending upon various factors like seasons;
festivals etc. and past sales data help companies to anticipate a huge surge of demand in the
market well in advance. Accordingly they stock up raw materials and hold inventories to be
able to increase production and rush supplies to the market to meet the increased demand.

3. Economies of Scale in Procurement
Buying raw materials in larger lot and holding inventory is found to be cheaper for the
company than buying frequent small lots. In such cases one buys in bulk and holds
inventories at the plant warehouse.
4. Take advantage of Price Increase and Quantity Discounts
If there is a price increase expected few months down the line due to changes in demand and
supply in the national or international market, impact of taxes and budgets etc, the company’s
tend to buy raw materials in advance and hold stocks as a hedge against increased costs.
Companies resort to buying in bulk and holding raw material inventories to take advantage of
the quantity discounts offered by the supplier. In such cases the savings on account of the
discount enjoyed would be substantially higher that of inventory carrying cost.
5. Reduce Transit Cost and Transit Times
In case of raw materials being imported from a foreign country or from a faraway vendor
within the country, one can save a lot in terms of transportation cost buy buying in bulk and
transporting as a container load or a full truck load. Part shipments can be costlier.
In terms of transit time too, transit time for full container shipment or a full truck load is
direct and faster unlike part shipment load where the freight forwarder waits for other loads to
fill the container which can take several weeks.
There could be a lot of factors resulting in shipping delays and transportation too, which can
hamper the supply chain forcing companies to hold safety stock of raw material inventories.
6. Long Lead and High demand items need to be held in Inventory
Often raw material supplies from vendors have long lead running into several months.
Coupled with this if the particular item is in high demand and short supply one can expect
disruption of supplies. In such cases it is safer to hold inventories and have control.
INVENTORY COSTS
1. Ordering costs
This refers to costs incurred in getting an item into the firm’s storage facility
Ordering costs are incurred every time an order is placed and include the following:-
i. Cost of issuing the purchase requisition
ii. Cost of issuing the purchase order
iii. Cost of inspecting inventory items to be purchased
iv. Communication cost e.g. of using telephone, fax, email etc.
v. Clearing charges
2. Purchase costs
This refers to the amount paid to the suppliers of the stock items.
Purchase cost is relevant for inventory control decisions if there are discounts.
3. Holding / carrying costs
These are cost incurred because the firm owns or has decided to maintain inventory items and
include the following:-
i) Opportunity cost of capital e.g. internet foregone
ii) Rent of storage space
iii) Protection costs such as cost of security system, insurance premium
iv) Perishability and obsolescence costs
4. Stock out / shortage cost
These are costs incurred as a result of either a delay in meeting customer demand or inability
to meet the demand due to shortage of stock items
Stock out costs include the following
i) Lost contribution
ii) Loss of idle staff
iii) Back order cost that is cost of dealing with disappointed customers
iv) Cost of having to speed up orders e.g use of faster means of transport, working overtime
etc
Economic Order Quantity (EOQ)

This is that quantity that is most economical to order. It is the quantity that minimizes the total
inventory cost of holding and ordering.
It is that size of an order that gives the maximum consumption.
It is obtaining and maintaining inventory at optimal levels.
NB: purchase cost is part of inventory cost. However under EOQ purchase price is assumed to be
constant irrespective of quantity ordered.
It is also assumed that the company will not experience stock out therefore the purchase cost and
stock-out will be ignored under EOQ
To be able to calculate a basic EOQ certain assumptions are necessary.

a) That there is a known, constant stockholding cost.
b) That there is a known, constant order cost.
c) That rates of demand are known and constant.
d) That there is a known, constant price per unit, i.e. there are no price discounts.
e) That replenishment is made instantaneously, i.e. the whole batch is delivered at once.
NOTE:
a) It will be apparent that the above assumptions are somewhat sweeping and they are good
reason for treating any EOQ calculation with caution.
b) Some of the above assumptions are relaxed later in the chapter.
c) The rationale of EOQ ignores buffer stocks which are maintained to cater for variations in
lead time and demand.
The EOQ Formula

It is possible, and more usual, to calculate the EOQ using a formula. The formula method gives
an exact answer, but do not be misled into placing undue reliance upon the precise figure. The
calculations are based on estimates of costs, demand, etc. which are, of course, subject to error.
The derivation of the EOQ formula is given below ;-
Derivation of EOQ model

a) Graphic method
Total costs
Holding cost
TC Cost
Ordering cost
Q=EOQ Quantity (Q)
Total cost will be minimized when:-

Holding cost = ordering cost
=
2
Q2 =
Therefore EOQ model = =
b) Calculus approach
Total cost = ordering cost + purchase costs + holding costs
TC = 0+ + ℎ
FOC = − = =0
1
=
2
.
Q2 =
=Q=

SOC = =
But D, Co, Q ≥ 0
Thus > 0 (+ve)
TC is minimized when
Q=
ILLUSTRATION
A company had annual demand of 800,000 units the purchase per unit is 80 while the cost of
pressing are order is Sh.4,000. The annual inventory holding cost is 5% of the inventory value.
Currently the company has been purchasing 20000 units time, they place an order.
Required;
i) Calculate the total cost of current inventory policy
ii) Calculate the EOQ
iii) Calculate the cost savings if the company adopts EOQ policy
SOLUTION
i) Total inventory cost = ordering cost + purchasing + holding cost for stocks out cost.
D Q
TC  Co  DC  ch  stockout cos t
Q 2
 800,000   800,000 
 x4000    x5% x80  800,000x80
 80,000   2 
= 40,000 + 160,000 + 64,000,000 = 64,200,000
ii) The EOQ will be;-
2 Dco 2 x800,000 x 400

EQQ  
ch 4
 40,000 units
iii) Cost selling = Total Cost using – Total Cost using

Current policy EOQ

 800,000 x 4000   40,000 
T .C     800,000 x80    x5% x100 
 40 ,000   2 
 64 ,160 ,000
Cost saving = 64,200,000 – 64,160,000

= Sh40,000
STOCHASTIC INVENTORY MODELS

The basic EOQ model assumes that all the parameters (elements) in the model are certain (i.e.
Can be predicted accurately in advance). These parameters are:
i) Demand or usage of stocks
ii) Lead times.
iii) Holding costs per unit, ordering costs per order and costs per unit.
In reality however, stock demand, supplies lead times and cost date are not known with certainty.
Accordingly to make the models applicable to real situations we must consider uncertainty when
planning for inventory levels.
To protect itself from conditions of uncertainty, a firm will maintain a level of safety stocks for
raw materials, work-in-progress and finished goods stocks. Thus safety stocks are the amount of
stocks that are carried in excess of the expected use during the lead time to provide a cushion
against running out of stocks. Thus the reorder point is computed as safety stock plus the average
usage during the lead time
i.e. Reorder point = Average usage during lead time + safety (buffer) stock.
Uncertainty of demand
Demand is the most troublesome variable to predict accurately. Actually, demand may fluctuate
from day to day, from week to week or from month to month. Thus, the firm takes the risk of
running out of stocks if there are sudden increases in demand. Hence safety stock is the extra
inventory held as a buffer of protection against the possibility of stock due to higher demand.
However, a larger inventory of safety stock will involve a higher inventory carrying costs, and on
the other hand, the higher safety stock will decrease stock-out costs. Therefore one has to make a
balance between these two costs in order to find out an optimal safety costs.
Note:
The optimum safety-stock level exists where the costs of carrying an extra unit are exactly
counter balanced by the expected stock-out costs. This would be the level that minimizes the
annual total stock-out and carrying costs.
290 MANAGEMENT ACCOUNTINGS T U D Y T E X T

Stock-out costs
These are the opportunity costs of running out of stock.
They include:
i) The costs of lost customer sales, and therefore lost contribution to fixed costs.
ii) Potential loss of goodwill with customers whose demand cannot be net.
iii) Acquiring emergency supplies at higher prices to meet demand.
iv) Cost production of finished goods, where raw material stock-outs occur.
The computation of safety stocks lingers on demand forecasts. The manager will have some
notion (usually based on past experience) of the range of daily demand. That is the probability
that exists for usage of various quantities.
Hence total inventory costs will be as follows:

Total inventory costs = Purchase price cost + carrying costs + stock-out cost + order costs.
= Purchase price costs + normal~ carrying costs (Q÷2 H) + Buffer Stock holding costs (B x H) +
Stock-out costs + order costs.
Stochastic models when stock out cost is known
Total costs
Additional holding cost

Min TC
Cost
Q=S* Safety stock level

Optimal safety stock level
Data requirements
1. Stock out cost unit which may be reflected by lost contribution, lost goodwill etc
2. ROL without safety stock
3. Probability distribution of demand during lead time
4. Annual number of order
5. Holding cost per unit per annum

Procedure
1. Compute the expected stock out cost for each possible safety stock level
2. Compute the additional holding cost for each possible safety stock level
3. Compute the total cost for each possible safety level
4. Recommend the optimal safety stock level that is the safety stock level will minimize the total
cost computed in step (3) above
ILLUSTRATION
Kiwanda Manufacturing Company Ltd. (KMCL) a small size company is a client Of Town Bank.
The Managing Director of KMCL visited The Town Bank Officers to apply for an additional line
of credit and in the ensuing discussions; the town bank loan offer noticed that KMCL could save
a substantial amount of money by improving on its inventory management.
As part of bank's loan application analysis policy, the loan officer invited the Management.
Accountant of KMCL for further consultation. From the conversation, h emerged that the
company holds a substantial quantity of a particular raw material in its warehouse. The
management accountant provided the following informationon the raw material in its warehouse.
The Management Accountant provided the following information on the raw material:
Invoice cost per unit Sh. 120,000
Shipping charges Sh. 2.50 per unit plus sh. 14,000 per shipment.
Inventory insurance Sh. 1,000 per unit per year.
Annual handling and inspection
Cost of the raw material Sh. 2.60 per unit plus sh. 15,000 per year.
Warehouse utilities Sh. 980,000 per month.
Warehouse rental Sh. 11,500 per month.
Unloading costs for units
Received (paid to shipper) Sh. 0.80 per unit
Receiving supervisor salary Sh. 17,600 month.
Processing invoices and other
Purchase documents Sh. 186 per order
The company policy is lo order 5,000 unity each time and maintain a safety stock of 3,000 units.
The annual demand for the raw material is 45,000 units. The lead time for an order is 10 working
days.
The management accountant has also indicated that if there is a stock-out it would be necessary
to obtain the raw material by a special courier service at an additional cost of sh. 8,100 per stock-
out
The probabilities of a stock-out at various safety stock levels were given as follows:
Safety stock (units) Probability of stock –out
500 0.25
1,000 0.08
1,500 0.02
2,000 0.01

1. The company cost of capital is 10%
2. Yon are advised that there are 250 working days in a year.
3. The raw material is ordered in multiples of 250 units.
4. For analysis purposes a stock out probability of 0.02 would be reasonable for order cost
determination in an optimal inventory policy.
Required:
a) The annual cost of the company's present inventory policy.
b) Recommend an optimal order quantity for the company based on the information provided
c) Recommend an optimal safety stock level.
d) Advise the management of KMCL on the savings to be realized from the optimal order
quantity in (b) above.
e) The reorder level for the company.
SOLUTION
W1: Effective purchase cost per unit (C)
Invoice cost per unit 120
Shipping charges 2.5
Unloading costs per unit 0.8
C 123.3
W2: Holding costs per unit
Insurance cost per unit 1.00
Holding cost per unit 2.60
Opportunity cost of capital 12.33
Ch 15.93
W3: Ordering cost per order (Co)
Shipping charges per order 14000
Processing invoices per order 186
14186
Purchase cost = DC
= 45000 × 123.3 = 5543500
Ordering costs =
= × 14.186 = 127674
Holding costs
Working inventory = ℎ= × 15.93 = 39,825
Safety stock = 3000 x 15.93 = 47,790
5,763,789
New C0 = 14186 + (0.02 × 8100) = sh. 14348

× ×
EOQ = = .
= 9003
EOQ = 9,000 units (materials are ordered in multiple of 250)
9003/250 = 36.01 = 36 ×25 = 9000

Stock out costs per order = sh. 8100
Number of orders p.a = D/Q = 45000/9000 = 5 orders
Analysis of costs
Safety stock Expected stock out costs Additional holding Total costs p.a
(units) p.a costs p.a
500 8100 × 0.25 x 5 = 10125 500 × 15.93 =7965 18090
1000 8100×0.08x 5 = 3240 1000 × 15.93 19170
=15930
1500 8100×0.02 x 5 = 810 1500 × 15.93 24705
=23895
2000 8100 ×0.01 x 5 = 405 2000 × 15.93 = 32265
31860
Optimal safety stock = 500 units

Advice: Purchase cost = DC
= 45000 x 123.3 = sh. 5548500
Ordering cost = D/Q Co = 45000/9000 x 14348 = sh. 71740
Holding cost (working inventory Q/2Ch = 900/2 x 15.93 = 71685
Safety stock = 500 x 15.93 = 7965
Expected stock out cost = 10125
Total cost 5,710,015
Savings = 5763789 – 5710015 = sh. 53774
Current ROL = Demand during lead time = × 10 = 1800
Analysis of costs
Safety Expected stock out costs p.a Additional holding Total cost
stock level costs p.a p.a
0 2×1000 × 0.16×100 + 4 x 100 0.1 ×100 + 6 0 96,000
x 1000 x 0.04 x 100 = 96000
2 2 x 1000 x 0.16 x 100 + 4 x 100 0.04 x 2 x 5000 = 10,000 46,000
100=36000
4 2 x 1000 x 0.04 x 100 =8000 4 x 5000 = 20000 28,000
6 0 6 x 5000 = 30,000 30,000
Optimal safety stock level = 4 drums

Revised ROL = 100 +4 = 104 drums
Inventory policy report

i. EOQ = 100 drums
ii. Number of orders p.a = 100 orders
iii. Frequency of ordering = =3
iv. Lead time = 3 days
v. Revised ROL = 104 drums
vi. Total costs = sh. 50550000 + 28000 = sh. 50,578,000
Other factors to take into consideration

- Negotiate for a higher discount rate in order to minimize total cost
- Seek for cheaper sources of the chemical
- Evaluate the reliability of the supplier etc
INVENTORY MODELS FOR PERISHABLE ITEMS

Successful inventory control is recognized today’s as the key to maintain competitive market
conditions. Although inventory is considered as a waste, the traditional motivation behind
holding products is to ensure compliance with customer demand and to guard against
uncertainties arising in demand fluctuations and delivery lead times.
Benefits obtained from quantity discounts, economies of scale and shipment consolidation are
among other reasons to keep products in stock. Certainly, an effective inventory management
requires maintaining economical quantity while keeping the ability to carry out customer
demand. However, the tradeoff between customer satisfaction and maintaining economical
quantity is rather a proven challenge regarding demand fluctuation and costs induced by
shortage.
In addition to this trade off, one of the implicit assumptions made in research related to inventory
is that products can be stored indefinitely to meet future demand. Such an assumption is not
appropriate for a large wide of commodities which are subject to obsolescence, deterioration and
perishability. Drugs, foodstuff, fruits, vegetables, photographic films, radioactive substances,
gasoline, etc are typical examples of such
ILLUSTRATION
A trader deals in perishable commodities whose daily demand and supply are random variables.
The trader buys the commodity at Ksh 20 per kilogram and sales at Ksh 30 per kilogram. If any
of the commodities remains at end of the day it has no saleable value. However the loss incurred
through unsatisfied demand in Kshs 8 per kilogram.
Records of the first 500 trading days show the following

Supply table
Kg supplied No. of days Probability Cumulative probability Random
number
40
10 40 /500 = 0.08 0.08 00-07
50
20 50 /500 = 0.10 0.18 08-17
190
30 190 /500 = 0.38 0.56 08-55
150
40 150 /500 = 0.30 0.86 56-85
70
50 70 /500 = 0.14 1.00 86-99
500 1.0 1.0
Required;
Given the following random numbers simulate a worksheetindicating profits.
Random numbers are 311863841579073243758127
SOLUTION
Demand table
Kg No. of days Probability Cumulative Random
Demanded probability numbers
50
10 50 /500 = 0.1 0.1 00-09
110
20 110 /500 = 0.22 0.22 10-31
200
30 200 /500 = 0.40 0.40 32-71
100
40 100 /500 = 0.20 0.20 72-91
40
50 40 /500= 0.08 0.08 92-99
500 1.0
Simulation worksheet
Supply Demand Cost Revenue Penalty Profit/Loss
Ksh
RN QTY RN QTY
31 30 18 20 600 600 - -
63 40 84 40 800 1200 - 400
15 20 79 40 400 600 160 40
07 10 32 30 200 300 160 (60)
43 30 75 40 600 900 80 220
81 40 27 20 800 600 - (200)
ILLUSTRATION
Peter Oloo is a fishmonger in Kisumu. As a result of adverse business changes in the region, the
supply and demand for fish are subject to random variations making it difficult to project the next
day's business. Management accounts in relation to the previous 300 days reveal the following
mode of behavior.

Number of fish No. of days Number of fish Number of
purchased from sold to consumer days.
fishermen
100 30 100 45
200 60 200 60
300 90 300 90
400 90 400 75
500 30 500 30
300 300
Peter Oloo buys each fish at sh. 40 and sells it for sh. 60 if sold on the same day; if the fish is
sold the following day it will fetch only sh. 20. If not sold during the second day its value drops
to zero and Peter Oloo donates it to children's home. Peter Oloo's policy is to satisfy the days
demand from the fresh fish first; and any further demand will be satisfied from the stock of fish
from previous day. Failure to satisfy demand costs Peter Oloo sh. 20 for every fish not supplied
to the customer. There are no back orders in the business.
Required:
a) Simulate Peter Oloo's operations for 8 days clearly indicating profits made each day.
b) What are the average daily profits for Peter Oloo? Use the following random numbers:
573423739751483681320931644925928345
SOLUTION
a)
Supply Prob Cumm R.N Demand Prob Cumm R.N
Prob Ranges Prob Ranges
100 0.1 0.1 0 100 0.15 0.15 00-14
200 0.2 0.3 1-2 200 0.20 0.35 15-34
300 0.3 0.6 3-5 300 0.30 0.65 35-64
400 0.3 0.9 6-8 400 0.25 0.90 65-89
500 0.1 1.0 9 500 0.1 1.0 90-99

Day R.N Supply R.N Demand Fresh Previous Unsold Donated shortage Profits
fish sold fish daily fish fish
fish sold
1 5 300 73 400 300 - - - 100 400
2 4 300 23 200 200 - 100 - - 0
3 7 400 39 300 300 - 100 100 - 200
4 7 400 51 300 300 - 100 100 - 200
5 4 300 83 400 300 100 - - - 800
6 6 400 81 400 400 - - - - 0
7 3 300 20 200 200 - - - - -800
8 9 500 31 200 200 - 100 100 -
Totals 16000
Profit = Revenue - costs

Day 1 Profit = Revenue -costs = (300 × 60) –(300×40) - (100 ×20) = 4,000
2 Profit = Revenue -costs = (60×200) - (40 ×300) = 0
3 Profit = Revenue-costs = (60×400) - (40×400) = 200
b) Average daily profits

,
= = sh. 2,000
SIMULATION OF INVENTORY MODELS

Simulation is quantitative technique used to make decisions in the environment of uncertainty.
The values of the uncertain variables are assigned using random numbers.
Total inventory = purchase cost + ordering cost + holding cost + stock out costs
Monte Carlo simulation performs risk analysis by building models of possible results by
substituting a range of values—a probability distribution—for any factor that has inherent
uncertainty. It then calculates results over and over, each time using a different set of random
values from the probability functions. Depending upon the number of uncertainties and the
ranges specified for them, a Monte Carlo simulation could involve thousands or tens of thousands
of recalculations before it is complete. Monte Carlo simulation produces distributions of possible
outcome values.
By using probability distributions, variables can have different probabilities of different
outcomes occurring. Probability distributions are a much more realistic way of describing
uncertainty in variables of a risk analysis.
During a Monte Carlo simulation, values are sampled at random from the input probability
distributions. Each set of samples is called iteration, and the resulting outcome from that sample
is recorded. Monte Carlo simulation does this hundreds or thousands of times, and the result is a

probability distribution of possible outcomes. In this way, Monte Carlo simulation provides a
much more comprehensive view of what may happen. It tells you not only what could happen,
but how likely it is to happen.
ILLUSTRATION
A bakery keeps stock of a popular brand of cake; daily demand based on past experience is given
below.
Daily demand 0 15 25 35 45 50
Probability 0.01 0.15 0.20 0.50 0.12 0.02
Consider the following sequence of random numbers

48,78,09,51,56,77,15,14,68,09
i) Using the sequence, simulate the demand for the next 10 days.
ii) Find the stock situation, if the owner of the bakery decides to make 35 cakes every day.
Also estimate the daily average demand for the cake on the basis of simulated data.
Solution
The simulated demand for the cake for the next 10 days can be obtained from the table below.
Demand Probability Cumulative Radom Random numbers filled

Probability Number
0 0.01 0.01 00
15 0.15 0.16 01-15 09(3), 15(7), 14(8), 09(10)
25 0.20 0.36 16-35
35 0.50 0.86 36-85 48(1), 78(2), 51(4), 56(5), 68(9),
45 0.12 0.98 86-97 77(6)
50 0.02 1.00 98-99
In order to simulate the demand, the number 50 is assigned to 0 demand. Numbers 0 – 15, are
assigned to the demand of 15 cakes, 16-35 are assigned to demand of 25 cakes etc.
The stock situation for various days if the decision is to bake 35 cakes every day is given in the
table below.
Day Demand Supply Stock
1 35 35 0
2 35 35 0
3 15 35 20
4 35 35 20
5 35 35 20
6 35 35 20
7 15 35 40
8 15 35 60
9 35 35 60
10 15 35 80
Average daily demand
[35 + 35 + 15 + 35 + 35 + 35 + 15 + 15 + 35 + 15] = 27 cakes
ILLUSTRATION
A retailer deals in a durable product. After some time he is able to extract the following data from
the firm's records.
Demand No. of days Lead time No. of times
(units per day) (days)
40 12 1 20
50 18 2 25
60 30 3 20
70 50 4 15
80 40 5 10
90 30 6 10
100 20 -
200 100
Thecurrent policy of the retailer is to place orders of 500 units whenever the inventory falls to 60
units or below. All items demanded will be sold unless the inventory is depleted. The short items
are back and supplied when the next stock arrives. Inventory holding costs are sh. 10 per item
held overnight. A shortage of sh, 150 is incurred for each item not supplied on the particular day.
Ordering cost is sh. 5,000 per order.
Required:
a) Simulate the retailers operation for 10 days assuming an initial inventory level of 150 units
and hence estimate the mean daily inventory cost.
b) Discuss how your results in (a) could be improved.
SOLUTION
a)
Demand Prob Cum RN Days Lead Prob Cum R.N
prob Ranges time prob Ranges
40 0.06 0.06 00-05 1 0.20 0.20 00-19
50 0.09 0.15 06-14 2 0.25 0.45 20-44
60 0.15 0.30 15-29 3 0.20 0.65 45-64
70 0.25 0.55 30-54 4 0.15 0.80 65-79
80 0.20 0.75 55- 74 5 0.10 0.90 80-89
90 0.15 0.90 75-90 6 0.1 1.00 90-99
100 0.10 1.0 90-99

Day R.N Demand Initial Quantity Warrant Shortage Back Orders RN Lead
inventory sold stock orders time
1 31 70 150 70 80 - - - - -
2 88 90 80 80 - 10 10  75 4
3 30 70 - - - 70 80 - - -
4 22 60 - - - 60 140 - - -
5 78 90 - - - 90 230 - - -
6 41 70 500 300 200 - - - - -
7 46 70 200 70 130 - - - - -
8 11 50 130 50 80 - - - - -
9 52 70 80 70 10 - -  49 3
10 57 80 10 10 - 70 70 70 - -
500 530 2
Analysis of costs Shs

Ordering costs = 2 × 5000 10,000
Holding costs = 10 × 500 5,000
Shortage costs = 150 ×530 79,500
Relevant costs 94,500
,
Relevant costs per day = = shs. 9,450
b) Improving Simulation Results

i) Run as many simulation trials as possible for each possibility of the decision variables in
order to increase the chances of obtaining a stable average costs.
ii) Perform simulation for as many combinations of the decision variables as possible and then
select combination that minimizes relevant inventory costs.
Combination no. Order R.O.L Average daily

quantity costs
1 500 60 9,450
2 600 60 7,240
3 500 70 8,200
The best combination is No- 2 since it minimizes relevant average daily costs.

REVISION EXERCISES
QUESTION1
Sola Ltd. is a manufacturing company that requires component XLA20 in one of its production
lines. The components are bought from outside suppliers. Form past experience, the company
has determined that the demand for the component can be approximated by a normal distribution
with a mean of 500 and a standard deviation of 10, over the range 470 to 530.
The unit is an initial stock of 2000 components and the company has decided to order in batches
of 2500 whenever the stock level falls below 1500 components. Again, past experience indicates
that the time between the order being placed and delivery varies as follows:
Lead time distribution

Lead time, weeks 1 2 3 4
Probability 0.02 0.50 0.25 005
The unit cost of holding stock is Sh.5 per week applied to the total stock held at the end of each
week. The cost associated with placing an order is Sh.5.00 and the unit cost of being out of stock
is Sh.200 per week. The company does all its accounting at the end of the week and all ordering
and delivery occur at the beginning of a week.
Required:
Estimate the average cost per week of the above policy, using simulation analysis and the
following random numbers:
For Demand: 034 743 738 636 964 736 614 698 637
162 332 616 804 560 111 410 959 774 246 762
For 95 73 10 76 51 74
Leadtime:
Hint:
 Use 15 trial runs
 Round off the demand probabilities to 3 decimal places. (Estimate these probabilities in
ranges of 5)

SOLUTION:
The variables in the problem are the demand and the lead time. Since the demand is approximated by the
continuous normal distribution we will consider demand insteps of 5 x LA 20
Allocation of random numbers to lead time.
Lead Time Cumulative Random
Week Probability probability number
0.20 0.20 00 –19
2 0.50 0.70 20 – 69
3 0.25 0.95 70 – 94
4 0.05 1.00 95 – 99
Allocation of random numbers ranges to weekly demand

Demand/ Cummulative Random
Week Probability Probability Number
470 0.003 0.003 000 – 002
475 0.009 0.012 003 – 011
480 0.028 0.040 012 – 039
485 0.066 0.106 040 – 105
490 0.121 0.227 106 – 226
495 0.175 0.402 227 – 401
500 0.197 0.599 402 – 598
505 0.175 0.774 599 – 773
510 0.121 0.895 774 – 894
515 0.066 0.961 895 – 960
520 0.028 0.989 961 – 986
525 0.009 0.998 989 – 997
530 0.003 1.000 998 – 999
Simulation of Stock Control

Number Openin Demand Closing Reorder Lead-
Week g RN Amount Stock ? Time Shortag
Stock YES/NO RN e
Weeks
1 2,000 034 480 1,520
2 1,520 743 505 1,015
3 1,015 738 505 510 YES 95 4
4 510 636 505 5
5 5 964 520 0 515
6 0 736 505 0 505
7 2,500 614 505 1,995
8 1,995 698 505 1,490
9 1,490 637 505 985 YES 73 3
10 985 162 490 495
11 495 332 495 0
12 2,500 616 505 1,995

13 1995 804 510 1,485
14 1,485 560 500 985 YES 10 1
15 3,485 111 490 2,995
Total 7,525 15,475 1,020
Mean demand = 7525 = 501.7

15
Mean closing stock = 15,475 = 1,031.6
15
Mean shortage = 1,020 = 68

15
Number of orders placed during the 15 weeks period = 3

Therefore, mean number of orders/week = 3/15 = 0.2
The expected Average cost per week

= (1,031.67 x Shs.5) +(68 x Shs.200) + (0.2 x 500)= Shs.18,858.35

TOPIC 6
DECISION THEORY
INTRODUCTION
Decision theory is a body of knowledge and related analytical techniques of different degrees of
formality designed to help a decision maker choose among a set of alternatives in light of their
possible consequences. Decision theory can apply to conditions of certainty, risk, or uncertainty.
In
It helps operations mangers with decisions on process, capacity, location and inventory, because
such decisions are about an uncertain future.
Types of decisions
There are many types of decision making
1. Decision making under uncertainty
Decision under certainty means that each alternative leads to one and only one consequence and a
choice among alternatives is equivalent to a choice among consequences.
2. Decision making under certainty
Whenever there exists only one outcome for a decision we are dealing with this category e.g.
linear programming, transportation assignment and sequencing etc.
3. Decision making using prior data
It occurs whenever it is possible to use past experience (prior data) to develop probabilities for
the occurrence of each data
4. Decision making without prior data
No past experience exists that can be used to derive outcome probabilities in this case the
decision maker uses his/her subjective estimates of probabilities for various outcomes.
DECISION MAKING ENVIRONMENT - CERTAINTY, RISK, UNCERTAINTY AND

COMPETITION
Every decision is made within a decision environment, which is defined as the collection of
information, alternatives, values, and preferences available at the time of the decision. An ideal
decision environment would include all possible information, all of it accurate, and every
possible alternative. However, both information and alternatives are constrained because the time
and effort to gain information or identify alternatives are limited. The time constraint simply
means that a decision must be made by a certain time. The effort constraint reflects the limits of
manpower, money, and priorities. Since decisions must be made within this constrained
environment, we can say that the major challenge of decision making is uncertainty, and a major
goal of decision analysis is to reduce uncertainty. We can almost never have all information
needed to make a decision with certainty, so most decisions involve an undeniable amount of
risk.

The fact that decisions must be made within a limiting decision environment suggests two
things;-
 First, it explains why hindsight is so much more accurate and better at making decisions that
foresight. As time passes, the decision environment continues to grow and expand. New
information and new alternatives appear--even after the decision must be made. Armed with
new information after the fact, the hindsighters can many times look back and make a much
better decision than the original maker, because the decision environment has continued to
expand.
 The second thing suggested by the decision-within-an-environment idea follows from the
above point. Since the decision environment continues to expand as time passes, it is often
advisable to put off making a decision until close to the deadline. Information and
alternatives continue to grow as time passes, so to have access to the most information and to
the best alternatives, do not make the decision too soon. Now, since we are dealing with real
life, it is obvious that some alternatives might no longer be available if too much time passes;
that is a tension we have to work with, a tension that helps to shape the cutoff date for the
decision.
Delaying a decision as long as reasonably possible, then, provides three benefits:

1. The decision environment will be larger, providing more information. There is also time
for more thoughtful and extended analysis.
2. New alternatives might be recognized or created.
3. The decision maker's preferences might change.
And delaying a decision involves several risks:

1. As the decision environment continues to grow, the decision maker might become
overwhelmed with too much information and either makes a poorer decision or else face
decision paralysis.
2. Some alternatives might become unavailable because of events occurring during the delay.
In a few cases, where the decision was between two alternatives, both alternatives might
become unavailable, leaving the decision maker with nothing.
3. In a competitive environment, a faster rival might make the decision and gain advantage.
Another manufacturer might bring a similar product to market in advance.
Decisions are taken in different types of environment. The type of environment also influences
the way the decision is made.
There are four types of environment in which decisions are made;-
1. Certainty;-
In this type of decision making environment, there is only one type of event that can take place. It
is very difficult to find complete certainty in most of the business decisions. However, in many
routine type of decisions, almost complete certainty can be noticed. These decisions, generally,
are of very little significance to the success of business.
2. Uncertainty;-
In the environment of uncertainty, more than one type of event can take place and the decision
maker is completely in dark regarding the event that is likely to take place. The decision maker is
not in a position, even to assign the probabilities of happening of the events.
Such situations generally arise in cases where happening of the event is determined by external
factors. For example, demand for the product, moves of competitors, etc. are the factors that
involve uncertainty.
3. Risk;-
Under the condition of risk, there are more than one possible events that can take place.
However, the decision maker has adequate information to assign probability to the happening or
non- happening of each possible event. Such information is generally based on the past
experience.
Virtually, every decision in a modern business enterprise is based on interplay of a number of
factors. New tools of analysis of such decision making situations are being developed. These
tools include risk analysis, decision trees and preference theory.
Modern information systems help in using these techniques for decision making under conditions
of uncertainty and risk.
4. Competition
The competitive environment, also known as the market structure, is the dynamic system in
which a business competes. The state of the system as a whole limits the flexibility of a business.
World economic conditions, for example, might increase the prices of raw materials, forcing
companies that supply an industry to charge more, raising the overhead costs. At the other end of
the scale, local events, such as regional labor shortages or natural disasters, also affect the
competitive environment.
DECISION MAKING UNDER UNCERTAINTY

Business decision making is almost always accompanied by conditions of uncertainty. Clearly,
the more information the decision maker has, the better the decision will be. Treating decisions as
if they were gambles is the basis of decision theory. This means that we have to trade off the
value of a certain outcome against its probability. To operate according to the canons of decision
theory, we must compute the value of a certain outcome and its probabilities; hence, determining
the consequences of our choices. The origin of decision theory is derived from economics by
using the utility function of payoffs. It suggests that decisions be made by computing the utility
and probability, the ranges of options, and also lays down strategies for good decisions.
Several methods are used to make decision in circumstances where only the pay offs are known
and the likelihood of each state of nature are known;-

a) MAXIMIN METHOD
This criteria is based on the ‘conservative approach’ to assume that the worst possible is going to
happen. The decision maker considers each strategy and locates the minimum pay off for each
and then selects that alternative which maximizes the minimum payoff
ILLUSTRATION
Rank the products A B and C applying the Maximin rule using the following payoff table
showing potential profits and losses which are expected to arise from launching these three
products in three market conditions
(see table 1 below)
Pay off table in sh.‘000’s

Boom Steady state Recession Mini profits
condition row minima
Product A +8 1 -10 -10
Product B -2 +6 +12 -2
Product C +16 0 -26 -26
Table 1
Ranking the MAXIMIN rule = BAC
b) MAXIMAX METHOD
This method is based on ‘extreme optimism’ the decision maker selects that particular strategy
which corresponds to the maximum of the maximum pay off for each strategy
ILLUSTRATION
Using the above example
Max. profits row maxima
Product A +8
Product B +12
Product C +16
Ranking using the MAXIMAX method = CBA
c) MINIMAX REGRET METHOD
This method assumes that the decision maker will experience ‘regret’ after he has made the
decision and the events have occurred. The decision maker selects the alternative which
minimizes the maximum possible regret.

ILLUSTRATION
Regret table in Sh. ‘ 000’s
Boom Steady state Recession Mini regret row
condition maxima
Product A 8 5 22 22
Product B 18 0 0 18
Product C 0 6 38 38
A regret table (table 2) is constructed based on the pay off table. The regret is the ‘opportunity
loss’ from taking one decision given that a certain contingency occurs in our example whether
there is boom steady state or recession
The ranking using MINIMAX regret method = BAC
d) THE HURWIZ METHOD
This method was the concept of coefficient of optimism (or pessimism) introduced by L.
Hurwicz. The decision maker takes into account both the maximum and minimum pay off for
each alternative and assigns them weights according to his degree of optimism (or pessimism).
The alternative which maximizes the sum of these weighted payoffs is then selected
e) THE LAPLACE METHOD
This method uses all the information by assigning equal probabilities to the possible payoffs for
each action and then selecting that alternative which corresponds to the maximum expected pay
off
ILLUSTRATION
A company is considering investing in one of three investment opportunities A, B and C under
certain economic conditions. The payoff matrix for this situation is economic condition.
Investment 1£ 2£ 3£
opportunities
A 5,000 7,000 3,000
B -2,000 10,000 6,000
C 4,000 4,000 4,000
Determine the best investment opportunity using the following criteria.

i) Maximin
ii) Maximax
iii) Minimax
iv) Hurwicz (Alpha = 0.3

SOLUTION
Economic condition
Investment 1£ 2£ 3£ Minimum Maximum
opportunities £ £
A 5000 7000 3000 3000 7000
B -2000 10000 6000 -2000 10000
C 4000 4000 4000 4000 4000
i) Using the Maximin rule Highest minimum = £ 4000
Choose investment C
ii) Using the Maximax rule Highest maximum = £ 10000
Choose investment B
iii) Minimax Regret rule
1 2 3 Maximum
regret
A 0 3000 3000 3000
B 7000 0 0 7000
C 1000 6000 2000 6000
Choose the minimum of the maximum regret i.e. £3000

Choose investment A
iv) Hurwicz rule: expected values
For A (7000 x 0.3) + (3000 x 0.7) = 2100 + 2100 = £4200

For B (10000 x 0.3) + (-2000 x 0.7) = 3000- 1400 = £ 1600
For C (4000 x 0.3) + (4000 x 0.7) = 1200 + 2800 = £ 4000
Best outcome is £ 4200 choose investment A
DECISION MAKING UNDER RISK

Risk implies a degree of uncertainty and an inability to fully control the outcomes or
consequences of such an action. Risk or the elimination of risk is an effort that managers employ.
However, in some instances the elimination of one risk may increase some other risks. Effective
handling of a risk requires its assessment and its subsequent impact on the decision process. The
decision process allows the decision-maker to evaluate alternative strategies prior to making any
decision. The process is as follows:

1) The problem is defined and all feasible alternatives are considered. The possible outcomes for
each alternative are evaluated.
2) Outcomes are discussed based on their monetary payoffs or net gain in reference to assets or
time.
3) Various uncertainties are quantified in terms of probabilities.
4) The quality of the optimal strategy depends upon the quality of the judgments.
The decision maker should identify and examine the sensitivity of the optimal strategy with
respect to the crucial factors.
Whenever the decision maker has some knowledge regarding the states of nature, he/she may be
able to assign subjective probability estimates for the occurrence of each state.
In such cases, the problem is classified as decision making under risk. The decision maker is able
to assign probabilities based on the occurrence of the states of nature.
The decision making under risk process is as follows:

a) Use the information you have to assign your beliefs (called subjective probabilities)
regarding each state of the nature.
b) Each action has a payoff associated with each of the states of nature.
c) Compute the expected payoff, also called the return (R), for each action.
d) We accept the principle that we should minimize (or maximize) the expected payoff.
e) Execute the action which minimizes (or maximizes) .
Expected Payoff
The actual outcome will not equal the expected value. What you get is not what you expect, i.e.
the “Great Expectations!”
a) For each action, multiply the probability and payoff and then,
b) Add up the results by row,
c) Choose largest number and take that action.
ILLUSTRATION
Pay off matrix
States of nature
Growth Medium No change Low
Growth
(0.4) (0.3) (0.2) (0.1)
Bonds 12 8 7 3
Actions Stocks 15 9 5 -2
Deposits 7 7 7 7

Expected pay off matrix
States of nature
Growth Medium No change Low EOL
Growth
(0.4) (0.3) (0.2) (0.1)
Bonds 0.4(12) 0.3(8) + 0.2(7) + 0.1(3) 8.9
Actions Stocks 0.4(15) 0.3(9) + 0.2(5) + 0.1(-2) 9.5*
Deposits 0.4(7) 0.3(7) + 0.2(7) + 0.1(7) 7
Expected Payoff is 9.5
THE EXPECTED MONETARY VALUE METHOD

The expected pay off (profit) associated with a given combination of act and event is obtained by
multiplying the payoff for that act and event combination by the probability of occurrence of the
given event. The expected monetary value (EMV) of an act is the sum of all expected conditional
profits associated with that act
ILLUSTRATION
A manager has a choice between
i) A risky contract promising shs. 7 million with probability 0.6 and shs. 4 million with
probability 0.4 and
ii) A diversified portfolio consisting of two contracts with independent outcomes each
promising Shs. 3.5 million with probability 0.6 and shs. 2 million with probability 0.4
Can you arrive at the decision using EMV method?
SOLUTION
The conditional payoff table for the problem may be constructed as below.
(Shillings in millions)
Event Probability Conditional pay offs Expected pay off decision
E1 (E1) decision
(i) Contract Portfolio(iii) Contract (i) x Portfolio (i) x
(ii) (ii) (iii)
E1 0.6 7 3.5 4.2 2.1
E2 0.4 4 2 1.6 0.8
EMV 5.8 2.9
Using the EMV method the manager must go in for the risky contract which will yield him a
higher expected monetary value of sh. 5.8 million

EXPECTED OPPORTUNITY LOSS (EOL) METHOD
This method is aimed at minimizing the expected opportunity loss (OEL). The decision maker
chooses the strategy with the minimum expected opportunity loss.
The steps of this method are as follows:

a) Set up a loss payoff matrix by taking largest number in each state of nature column (say L),
and subtract all numbers in that column from it, L - Xij,
b) For each action, multiply the probability and loss then add up for each action,
c) Choose the action with smallest EOL.
ILLUSTRATION
Pay off matrix
States of nature
Growth
(0.4) (0.3) (0.2) (0.1)
Bonds 12 8 7 3
Deposits 7 7 7 7
The Expected Opportunity Loss Matrix

Loss Payoff
Matrix
States of nature
Growth Medium No change Low EOL
Growth
(0.4) (0.3) (0.2) (0.1)
Bonds 0.4(15-12) 0.3(9-8) + 0.2(7-7) + 0.1(7-3) 1.9
Actions Stocks 0.4(15-15) 0.3(9-9) 0.2(7-5) + 0.1(7+2) 1.3*
+
Deposits 0.4(15-7) 0.3(9-7) + 0.2(7-7) + 0.1(7-7) 3.8
The expected opportunity loss (EOL) is 1.3

Comparing a decision outcome to its alternatives appears to be an important component of
decision making. One important factor is the emotion of regret. This occurs when a decision
outcome is compared to the outcome that would have taken place had a different decision been
made. This is in contrast to disappointment, which results from comparing one outcome to
another as a result of the same decision. Accordingly, large contrasts with counterfactual results
have a disproportionate influence on decision making.

Regret results compare a decision outcome with what might have been. Therefore, it depends
upon the feedback available to decision makers as to which outcome the alternative option would
have yielded. Altering the potential for regret by manipulating uncertainty resolution reveals that
the decision making behavior that appears to be risk averse can actually be attributed to regret
aversion. There is some indication that regret may be related to the distinction between acts and
omissions. Some studies have found that regret is more intense following an action, than an
omission. For example, in one study, participants concluded that a decision maker who switched
stock funds from one company to another and lost money would feel more regret than another
decision maker who decided against switching the stock funds but also lost money. People
usually assigned a higher value to an inferior outcome when it resulted from an act rather than
from an omission. Presumably, this is as a way of counteracting the regret that could have
resulted from the act.
MINIMISING RISK USING THE COEFFICIENT OF VARIATION

Coefficient of variation is a measure used to assess the total risk per unit of return of an
investment. It is calculated by dividing the standard deviation of an investment by its expected
rate of return.
Since most investors are risk-averse, they want to minimize their risk per unit of return.
Coefficient of variation provides a standardized measure of comparing risk and return of different
investments. A rational investor would select an investment with lowest coefficient of variation.
Sharpe ratio is a similar statistic which measures excess return per unit of risk.
Formula
Standard Deviation of the Investment
Coefficient of Variation =
Expected Return on the Investment
ILLUSTRATION
Ondego Farms is a family owned business engaged in cultivating their land mass of a hundred
square kilometers. The season is beginning, and Ayoyi the family head, has a critical decision to
make: to cultivate maize or cotton. He tasked his eldest son Musero to gather some data on
expected return on each crop under different scenarios and the variation in those returns.
Musero estimates that if there are enough rains (which has a probability of 0.7), the return on
maize could be as high as 25%. However, in case of low rain, the return could be as low as 5%.
He estimates that standard deviation of return on maize crop is 14%. In case of enough rains,
return on cotton could be only 12%, but in case of low rain, the return could be 20%. Standard
deviation of return on cotton is expected to be 9%.
Required;-
In the risk-return perspective, which crop is better for Akbar?

SOLUTION
Expected return on maize = (0.7 × 25%) + (0.3 × 5%) = 19%
Coefficient of variation of maize cultivation = standard deviation on maize (16%) / expected

return on maize (19%) = 0.74
Expected return on cotton = (0.7 × 12%) + (0.3 × 20%) = 14.4%
Coefficient of variation of cotton cultivation = standard deviation on cotton (9%) / expected

return on cotton (14.4%) = 0.625
Since cotton cultivation has the lower coefficient of variation, it offers less risk per unit of return.
Ayoyi should prefer cotton over maize.
VALUE OF PERFECT INFORMATION

It relates to the amount that we would pay for an item of information that would enable us to
forecast the exact conditions of the market and act accordingly. The Value of perfect information
is the amount by which the expected payoff will improve if the manager knows which event will
occur.
The expected value of perfect information EVPI is the expected outcome with perfect
information minus the expected outcome without perfect information namely the maximum
expected monetary value.
Computation of the Expected Value of Perfect Information (EVPI)

a) Take the maximum payoff for each state of nature.
b) Multiply each case by the probability for that state of nature and then add them up,
c) Subtract the expected payoff from the number obtained as Expected Payoff.
EVPI helps to determine the worth of an insider who possesses perfect information.
ILLUSTRATION
Pay off matrix
States of nature
Growth
(0.4) (0.3) (0.2) (0.1)
Bonds 12 8 7 3
Deposits 7 7 7 7

EVPI Computation Matrix
Growth 15(0.4)= 6.0

Medium Growth 9(0.3) = 2.7
No change 7(0.2) = 1.4
Low 7(0.1) = 0.7
10.8
Therefore, EVPI = 10.8 - Expected Payoff = 10.8 - 9.5 = 1.3. Verify that EOL=EVPI. The
efficiency of the perfect information is defined as 100 [EVPI/ (Expected Payoff)] %.
Therefore, if the information costs more than 1.3 percent of investment, don't buy it.
For example, if you are going to invest Sh.100, 000, the maximum you should pay for the
information is [100,000×1.3%] = Sh.1, 300.
DECISION TREES AND SUB SEQUENTIAL DECISIONS

A decision tree is a graphic display of various decision alternatives and the sequence of events as
if they were branches of a tree. It is the general approach to a wide range of decisions such as,
product planning, process management, capacity, and location. It is particularly valuable for
evaluating different capacity expansion alternatives when demand is uncertain and sequential
decisions art involved. For example, a company may expand a facility in 1996 only to discover in
1998 that demand is much higher than forecasted. In that case, a second decision may be
necessary to determine whether to expand once again or build a second facility.
A decision tree is a schematic model of alternatives available to the decision maker, along with
their possible consequences. The name derives from the tree- like appearance of the model. It
consists of a number of square nodes representing decision points that are left by branches (which
should be read from left to right), representing the alternatives. Branches leaving circular, or
chance, nodes represent the events. The probability of each chance event, P(E), is shown above
each branch. The probabilities for all branches leaving a chance node must sum to 1.0. The
conditional payoff, which is the payoff for each possible alternative event combination, is shown
at the end of each combination. Pay offs are given only at the outset, before the analysis begins,
for the end points of each alternative event combination.
Symbols
- The symbol and indicates the decision point and the situation of uncertainty or
event respectively. The node depicted by a square is a decision node while outcome nodes
are depicted by a circle.
- Decision nodes: points where choices exist between alternatives and managerial decisions is
made based on estimates and calculations of the returns expected.
- Outcome nodes are points where the events depend on probabilities
ILLUSTRATION
A retailer must decide whether to build a small or a large facility at a new location. Demand at
the location can be either small or large with probabilities estimated to be 0.4 and 0.6,
respectively. If a small facility is built and demand proves to be high the manager may choose
not to expand (payoff = Sh223,000) or to expand (payoff = Sh270,000). If a small facility is built
and demand is low, there is no reason to expand and the payoff is Sh200,000. If a large facility is
built and demand proves to be low, the choice is to do nothing (Sh40,000) or to stimulate demand
through local advertising.
The response to advertising may be either modest or sizable, with their probabilities estimated to
be 0.3 and 0.7, respectively. If it is modest, the payoff is estimated to be only Sh20,000; the
payoff grows to Sh220,000 if the response is sizable. Finally, if a large facility is built and
demand turns out to be high, the payoff is Sh800,000.
Draw a decision tree. Then analyze it to determine the expected payoff for each decision and
event node. Which alternatives building a small facility or building a large facility, the higher
expected payoff?
Solution The decision tree in Figure below shows the event probability and the pay-off for each
of the seven alternative event combinations. The first decision is whether to build a small or a
large facility. Its node is shown first, to the left because it is the decision the retailer must make
now. The second decision node - whether to expand at a later date is reached only if a small
facility is built and demand turns out to be high.
Finally the third decision point - whether to advertise- is reached only if the retailer builds a large
facility and demand turns out to be low.
Low demand (Sh200)
High demand Demand expand (Sh223)

Small (0.6)
(Sh242) 2
facility Expand
(Sh270) (Sh270
)
1 Low demand Do (Sh40)
(0.4) nothing Modest response
(Sh544)
Large 3
(Sh40)
facility (Sh160)
(Sh544) Advertise
(Sh160) (Sh220)
Modest response
High demand (Sh800)

(0.6)

ILLUSTRATION
Kauzi Agro mills ltd (KAM) is considering whether to enter a very competitive market. In case
KAM decided to enter this market it must either install a new forging process or pay overtime
wages to the entire workers. In either case, the market entry could result in
i) high sales
ii) medium sales
iii) low sales
iv) no sales
a) Construct an appropriate tree diagram
b) Suppose the management of KAM has estimated that if they enter the market there is a 60%
chance of their stakeholders approving the installation of the new forge. (this means that there
is a 40% chance of using overtime) a random sample of the current market structure reveals
that KAM has a 40% chance of achieving high sales, a 30% chance of achieving medium
sales, a 20% chance of achieving low sales and a 10% chance of achieving no sales. Construct
the appropriate probability tree diagram and determine the joint probabilities for various
branches
c) Market analysts of KAM have indicated that a high level of sales will yield shs 1,000,000
profit; a medium level of sales will result in a shs 600000 profit a low level of sales will result
in a shs 200000 profit and a no sales level will cause KAM a loss of shs 500000 apart from
the cost of any equipment. Entering the market will require a cash outlay of either shs 300000
to purchase and install a forge or shs 10000 for overtime expenses should the second option
be selected.
SOLUTION
a) The tree diagram for this problem is illustrated as follows:
The 1st stage of drawing a tree diagram is to show all decision points and outcome points done
from left to right, concentrate first on the logic of the problem and on probabilities or values
involved. This is called forward pass.
The resultant is the figure below:

Tree diagram
Act Act/event Outcome/event
5 High sales
Install forge
6 Medium sales
3
7 Low sales
1 8 No sales
0
Use overtime 9 High sales
4
10 Medium sales
Sto 11 Low sales

2
p
Do not enter 12 No sales
The entire sample space of act event choices is available to KAM are summarized in the table
shown below
Path Summary of alternative Act event sequence
0–1–3–5 Enter market, install forge, high sales
0–1–3–6 Enter market, install forge, medium sales
0–1–3–7 Enter market, install forge, low sales
0–1–3–8 Enter market, install forge, no sales
0–1–4–9 Enter market, use overtime, high sales
0 – 1 – 4 –10 Enter market, use overtime, medium sales
0 – 1 – 4 – 11 Enter market, use overtime, low sales
0 – 1 – 4 – 12 Enter market, use overtime, no sales
0–2 Do not enter the market
b) The appropriate probability tree is shown in the figure below. The alternatives available to the
management of KAM are identified. The joint probabilities are the result of the path sequence
that is followed. For example, the sequence ‘enter market install forge, low sales’ yields (0.6)
(0.2) = 0.12 = probability to install forge and get low sales.

Pay offs
HS = 0.24 = 1,000,000
0.4
Install forge
(300,000)
0.3 MS = 0.18 = 600,000
3
0.2
Enter Market 0.6
LS = 0.12 =
0.1
1
NS = 0.06 = - 500,000
0 0.4
Use overtime
0.4
(10,000) HS = 0.16 =
4 0.3
MS = 0.12 =
0.2
Don’t enter market
2 0.1 LS = 0.08 =
NS = 0.04 = -
(c) The overall decision is determined after analysis of the expected values at various points
so the correct decision (with the highest expected value is made. The stage is worked
from right to left and is known as the backward pass.
- The expected value for a decision is the highest pay off value where as the E.V for
an outcome is the summation of probability x pay off value of each branch. In both
cases any expenditure incurred due to the selection of the said option is deducted.
- In our case
Node 3 = 0.4  1,000,000  0.3  600,000  0.2  200,000  0.1  50,000
- 300,000
E.V. = 615,000 – 300,000 = 315,000
Node 4 = 0.4  1,000,000  0.3  600,000  0.2  200,000  0.1  50,000

- 10,000
E.V. = 615,000 – 10,000 = 605,000
Node 1 = (0.6 × 315,000) + (0.4 × 605,000)

E.V. = 431,000
Node 0 = The highest of (0;431,000)
Since not entering the market has a 0 expected value = 431,000 = thus the decision should be to
enter the market.

This is represented as below in a tree diagram.
1,000,000
0.4
Install forge
0.3 600,000
3
0.6 0.2
Enter Market EV = 315,000 200,000
0.1
1
- 500,000
EV = 431,000 0.4
0
Use overtime 0.4
1,000,000
4 0.3
Don’t enter market 600,000
0.2
EV = 605,000
0.1 200,000
- 500,000
Advantages of decision trees

1. it clearly brings out implicit assumptions and calculations for all to see question and revise
2. it is easy to understand
Disadvantages
1. it assumes that the utility of money is linear with money
2. it is complicated by introduction of more variables and decision alternatives
3. it is complicated by presence of interdependent alternatives and dependent variables
GAME THEORY
Game theory is used to determine the optimum strategy in a competitive situation
When two or more competitors are engaged in making decisions, it may involve conflict of
interest. In such a case the outcome depends not only upon an individual’s action but also upon
the action of others. Both competing sides face a similar problem. Hence game theory is a
science of conflict
Game theory does not concern itself with finding an optimum strategy but it helps to improve the
decision process.
Game theory has been used in business and industry to develop bidding tactics, pricing policies,
advertising strategies, timing of the introduction of new models in the market etc.

Terminologies in game theory
 Game;- it is an activity between two or more persons involving actions by each one of them
according to a set of rules, which results in some gain for each.
 Player;-each participant or competitor playing a game is called a player.
 Play; - a play of a game is said to occur when each player chooses one of his causes of action
for a strategy.
 Strategy;-it is a predetermined rule by which a player decides his cause of action from his
list of causes of actions during the game.
 Pure strategy;- it is the decision rule to always select a particular cause of action.
 Zero sum game;-it is a game in which the sum of play mate to all the players after the play
is equal to zero. In such a game the gain of players that win is exactly equal to the loss of
players that loose e.g two candidates vying for an electoral sit where the gain of votes by one
candidate is the loss of vote to the other candidate.
 Pay off;- it is the outcome of the game.
 Pay off matrix-it is the table showing the amount received by a player named at the left hand
side after all the possible plays of the game. The payment is made by the player named at the
top of the table.
RULES OF GAME THEORY

i) The number of competitors is finite
ii) There is conflict of interests between the participants
iii) Each of these participants has available to him a finite set of available courses of action
i.e. choices
iv) The rules governing these choices are specified and known to all players
v) While playing each player chooses a course of action from a list of choices available to
him
vi) the outcome of the game is affected by choices made by all of the players. The choices are
to be made simultaneously so that no competitor knows his opponents choice until he is
already committed to his own
vii) the outcome for all specific choices by all the players is known in advance and
numerically defined
viii) When a competitive situation meets all these criteria above we call it a game
NOTE: only in a few real life competitive situation can game theory be applied because all the
rules are difficult to apply at the same time to a given situation.
ILLUSTRATION
Two players X and Y have two alternatives. They show their choices by pressing two types of
buttons in front of them but they cannot see the opponents move. It is assumed that both players
have equal intelligence and both intend to win the game.
This sort of simple game can be illustrated in tabular form as follows:

Player Y
Button R Button T
Player X Button m X wins 2 points X wins 3 points
Button n Y wins 2 points X wins 1 point
The game is biased against Y because if player X presses button m he will always win. Hence Y
will be forced to press button T to cut down his losses
Alternative Illustration
Player Y
Button R Button t
Player X Button m X wins 3 points Y wins 4 points
Button n Y wins 2 points X wins 1 point
In this case X will not be able to press button m all the time in order to win(or button n). similarly
Y will not be able to press button r or button t all the time in order to win. In such a situation each
player will exercise his choice for part of the time based on the probability
Standard conventions in game theory

Consider the following table
Y
3 -4
X -2 1
X plays row I, Y plays columns I, X wins 3 points

X plays row I, Y plays columns II, X looses 4 points
X plays row II, Y plays columns I, X looses 2 points
X plays row II, Y plays columns II, X wins 1 points
3, -4, -2, 1 are the known pay offs to X(X takes precedence over Y)
here the game has been represented in the form of a matrix. When the games are expressed in this
fashion the resulting matrix is commonly known as PAYOFF MATRIX
STRATEGY
It refers to a total pattern of choices employed by any player. Strategy could be pure or a mixed
one
In a pure strategy, player X will play one row all of the time or player Y will also play one of this
columns all the time.
In a mixed strategy, player X will play each of his rows a certain portion of the time and player Y
will play each of his columns a certain portion of the time.

VALUE OF THE GAME
The value of the game refers to the average pay off per play of the game over an extended period
of time
ILLUSTRATION
Player Y
 3 4
Player X  
 6 2 
in this game player X will play his first row on each play of the game. Player y will have to play
first column on each play of the game in order to minimize his looses
so this game is in favour of X and he wins 3 points on each play of the game.
This game is a game of pure strategy and the value of the game is 3 points in favour of X
ILLUSTRATION
Determine the optimum strategies for the two players X and Y and find the value of the game
from the following pay off matrix
Player Y
 3 -1 4 2 
Player X  -1 -3 -7 0 
 
 4 -7 3 -9 
Strategy assume the worst and act accordingly

if X plays first
if X plays first with his row one then Y will play with his 2nd column to win 1 point similarly if X
plays with his 2nd row then Y will play his 3rd column to win 7 points and if x plays with his 3rd
row then Y will play his fourth column to win 9 points
In this game X cannot win so he should adopt first row strategy in order to minimize losses
This decision rule is known as ‘maximum strategy’ i.e. X chooses the highest of these minimum
pay offs
Using the same reasoning from the point of view of y
If Y plays with his 1st column, then X will play his 3rd row to win 4 points
If Y plays with his 2nd column, then X will play his 1st row to lose 1 point
If Y plays with his 3rd column, then X will play his 1st row to win 4 points
If Y plays with his 4th column, then X will play his 1st row to win 2 points
Thus player Y will make the best of the situation by playing his 2nd column which is a ‘Minimax
strategy’
This game is also a game of pure strategy and the value of the game is –1(win of 1 point per
game to y) using matrix notation, the solution is shown below

Player Y
Row Minimum
 3 -1 4 2  1
Player X  -1 -3 -7 0  7
 4 -7 3 -9  9
4 -1 4 2
column maximum
In this case value of the game is –1

Minimum of the column maximums is –1
Maximum of the row is also –1
i.e. X’s strategy is maximim strategy
Y’s strategy is Minimax strategy
SADDLE POINT
The saddle point in a payoff matrix is one which is the smallest value in its row and the largest
value in its column are equal. It is also known as equilibrium point in the theory of games.
Saddle point also gives the value of such a game. In a game having a saddle point, the optimum
strategy for both players is to pay the row or column containing the saddle point.
Note: if in a game there is no saddle point the players will resort to what is known as mixed
strategies.
MIXED STRATEGIES
This is a selection among pure strategies with some fixed probabilities.
Example
Consider the following pay-off matrix for player A
B Row
Minima
20 8 −6 I −6 Minimum
A 1510 2 II 2 gain
3 5 6 III 3 guaranteed to
20 10 6
player A
I II III
Column Maximum Player B selects this Player A selects the strategy so as
Maxima loss strategy so as to to maximise on minium gain i.e.
guaranteed to minimise on maximum (maximin strategy)
player B loss (i.e. minimax
strategy)
In this game, maximin is 3 and minimax is 6, meaning that this game does not possess saddle
point. If for example player A chose strategy 3, player 6 will counter by choosing strategy1 so as
to minimise. In turn player A, choose strategy 1 so as to maximise, and this makes B to minimise
by choosing strategy 3 and the cycle continues. Within this sample of framework of thinking
there is no equilibrium in the game/no saddle point. Therefore the game is a mixed strategy
game, and the major factor is that each player avoids the use of same strategy in repeated player
because same strategy will place one player at a definite disadvantage.
ILLUSTRATION
Find the optimum strategies and the value of the game from the following pay off matrix
concerning two person game
Player Y
1 4 
Player X  
5 3 
In this game there is no saddle point
Let Q be the proportion of time player X spends playing his 1st row and 1-Q be the proportion of
time player X spends playing his 2nd row
Similarly:
Let R be the proportion of time player Y spends playing his 1st column and 1-R be the proportion
of time player Y spends playing his second row
The following matrix shows this strategy

Player Y
R 1 R
Q 1 4 
Player X
1  Q 5 3 
X’s strategy
X will like to divide his play between his rows in such a way that his expected winning or loses
when Y plays the 1st column will be equal to his expected winning or losses when y plays the
second column
Column 1
Points Proportion played Expected winnings
1 Q Q
5 1-Q 5(1-Q)
Total = Q + 5(1 –Q)

Column 2
Points Proportion played Expected winnings
4 Q 4Q
3 1-Q 3(1-Q)

Total = 4Q + 3(1 –Q)
Therefore Q + 5(1-Q) = 4Q +3(1-Q)
Giving Q = 2 5 and (1-Q) = 3 5
This means that player X should play his first row 2 5 th of the time and his second row 3 5 th of
the time
Using the same reasoning

1×R + 4(1-R) = 5R +3(1-R)
Giving R = 1 5 and (1-R) = 4 5
This means that player Y should divide his time between his first column and second column in
the ratio 1:4
Player Y
1 4
5 5
2
5 1 4 
Player X 3 5 3 
5  
Short cut method of determining mixed matrices

Player Y
1 4 
Player X  
5 3 
Step I
Subtract the smaller pay off in each row from the larger one and smaller pay off in each column
from the larger one
1 4  4 -1  3
5 3  5 - 3  2
 
5 1  4 4  3  1
Step II
Interchange each of these pairs of subtracted numbers found in step I
1 4  2
5 3  3
 
1 4
Thus player X plays his two rows in the ratio 2: 3
And player Y plays his columns in the ratio 1:4
This is the same result as calculated before
To determine the value of the game in mixed strategies

In a simple 2 x 2 game without a saddle point, each players strategy consists of two probabilities
denoting the portion of the time he spends on each of his rows or columns. Since each player
plays a random pattern the probabilities are listed under

Pay off Strategies which produce this pay Joint
off probability
1 Row I column I 2  1 2
5 5 25
4 Row I column II 2 4 8
5 5 25
5 Row II column I 3  1 3
5 5 25
3 Row II column II 3  4  12
5 5 25
Expected value (or value of the game)
Pay off Probability p(x) Expected value x

(p(x)
1 2 2
25 25
4 8 32
25 25
5 3 15
25 25
3 12 36
25 25
Ƹx p(x) = 85/25 = 17/5 = 3.4

3.4 is the value of the game
DOMINANCE
Dominated strategy is useful for reducing the size of the payoff table
Rule of dominance
i) If all the elements in a column are greater than or equal to the corresponding elements in
another column, then the column is dominated
ii) Similarly if all the elements in a row are less than or equal to the corresponding elements in
another row, then the row is dominated
Dominated rows and columns may be deleted which reduces the size of the game
NB// always look for dominance and saddle points when solving a game
ILLUSTRATION
Determine the optimum strategies and the value of the game from the following 2xm pay off
matrix game for X and Y
Y
 6 3 1 0 3 
X  
3 2 4 2 1

In this columns I, II, and IV are dominated by columns III and V hence Y will not play these
columns
So the game is reduced to 2×2 matrix, hence this game can be solved using methods already
discussed
Y
 1 3
X  
 4 1
ILLUSTRATION
Determine value of the following game
B
I II III
I 0 -2 7
A II 2 5 6
III 3 -3 8
SOLUTION
B Row Minima
I II III
I 0 -2 7 -2
A II 2 5 6 2 Maximin = 2
III 3 -3 8 -3
Column 3 5 8
Maxima
Minmax = 3
Maximin = 2 ≠ 3 = Minimax
Game has no saddle point
SOLUTION
A game of mixed strategy
⟹Solve by Dominance Rule
From the player B’s points of view strategy I dominate strategy III i.e. B would rather play
strategy I than play strategy III
B
I II
I 0 -2
A II 2 5
III 3 -3
From player A point of view strategy II dominate strategy I

I II
II 2 5 3
III 3 -3 6
1 8
I II
6
2 5 6 ⟹ II 2 5 /9
3
3 -3 3 III 3 -3 /9
8 1
8 1 /9 /9
A (0, 3, 6)
B (1, 8, 0)
V= 2 + 5 + 3 + −3 = + + + = +1= +
NON ZERO SUM GAMES

In this type of game , the gain of one player is necessarily equal to the loss of the other player.
Nigel Howard (1966) developed a method which describes how most people play non zero sum
games involving any number of persons
ILLUSTRATION
Each individual farmer can maximize his own income by maximizing the amount of crops that he
produces. When all farmers follow this policy the supply exceeds demand and the prices fall. On
the other hand they can agree to reduce the production and keep the prices high
This creates a dilemma to the farmer
This is an example of a non-zero sum game
Similarly marketing problems are non-zero sum games as elements of advertising come in. In
such cases the market may be split in proportion to the money spent on advertising multiplied by
an effectiveness factor.
PRISONERS DILEMMA
It is a type of non-zero sum game and derives its name from the following story
The district attorney has two bank robbers in separate cells and offers each a chance of
confession. If one confesses and the other does not then the confessor gets two years and the
other one ten years. If both confess they will get eight years each. If both refuse to confess there
is only evidence to ensure convictions on a lesser charge and each will receive 5 years
ILLUSTRATION
The table below is a pay off matrix for two large companies A and B. initially they both have the
same prices. Each consider cutting their prices to gain market share and hence improve profit

Corporation B Maintain prices Decrease prices
maintain prices 3,3 status quo 1 , 4 B gets market share
and profit
Corporation A Decrease prices 4, 1, A gains market share (2,2) Both retain market
and profit share but lose profit
The entries in the pay off matrix indicate the order of preference of the players i.e. first A then B.
We may suppose that if both player study the situation, they will both decide to play row I
column I (3,3).
However
Suppose A’s reasoning is as follows
- If B plays column I then I should play row 2 because I will increase my gain to 4
- In the same way B’s reasoning may be as follows
- If A plays row I then I should play column 2 to get pay off 4 per play
- If both play 2(row 2 column 2) each two receives a pay off of 2 only
- In the long run pay off forms a new equilibrium point because if either party departs from
it without the other doing so he will be worse off before he departed from it
- Game theory seems to indicate that they should play (2,2) because it is an equilibrium
point but this is not intuitively satisfying. On the other hand (3,3) is satisfying but does not
appear to provide stability. Hence the dilemma.
ADVANTAGES AND LIMITATIONS OF GAME THEORY
Advantage
Game theory helps us to learn how to approach and understand a conflict situation and to
improve the decision making process
Limitations
1. Businessmen do not have all the knowledge required by the theory of games. Most often they
do not know all the strategies available to them nor do they know all the strategies available
to their rivals
2. There is a great deal of uncertainty. Hence we usually restrict ourselves to those games with
known outcomes
3. The implications of the Minimax strategy is that the businessman minimizes the chance of
maximum loss. For an ambitious business man, this strategy is very conservative
4. the techniques of solving games involving mixed strategies where pay off matrices are rather
large is very complicated
5. In non-zero sum games, mathematical solutions are not always possible. For example a
reduction in the price of a commodity may increase overall demand. It is also not necessary
that demand units will shift from one firm to another
TOPIC 7
PERFORMANCE MEASUREMENT AND EVALUATION
INTRODUCTION
Performance measurement is used to establish the performance of an organization or an

individual with respect to budgeted performance or past performance or in relation to other
organizations or individuals.
Performance measurement is a vital part of the control process in any organization.
Factors to consider when setting performance measures of a business organization
i) Resource requirement -
To collect and analyzing information we require people, equipment and time. However, the costs
and benefits of providing resources for producing performance' measures should be carefully
analyzed.
ii) Organizational objectives and plans-
Overall performance should be measured against the objective of the organization and the plans
that result from those objectives.
iii) Relevance of the performance measure
The performance measure should reflect the activities performed by the organization.
iv) Expected short term and long term achievements
Short term targets can be achievable but exclusive use of short term targets may divert the
organization away from opportunities that may help the organization improve its performance in
the long run.
v) Fairness of the measure
The measure should only improve factor which managers can control by their decisions and for
which they can be held responsible e.g. measuring controllable costs, controllable revenues and
controllable assets.
vi) Variety of measures
A variety of measures should be used to measure the performance of a business organization e.g.
the balanced score card provides a method of measuring performance from a number of
perspectives. The approach emphasizes on the need to provide management with a set of
information which covers all relevant measures of performance in an objective and unbiased
fashion. The information provided may be both financial and non-financial and covers areas such
as profitability, customer satisfaction, internal business efficiency and innovation.
vii) The performance measures used should have realistic estimates
Once suitable performance measures have been selected they can be monitored on a regular basis
to ensure that they are providing useful information

Performance measures may be divided into two groups. Namely;-
i) Financial performance measures
ii) Non-financial performance measures
LINKAGE BETWEEN PERFORMANCE MEASUREMENT AND ORGANIZATIONAL

VISION
Vision is the foundation that allows the organizational vision to flourish. Awareness of the
organizational vision provides a directional compass for each contributor within the organization
to follow. Depending on the level of leadership, many leaders are not responsible for creating the
vision for the company.
They are responsible for:
 articulating the vision
 aligning team members to operational strategies
 taking steps necessary to achieve company priorities linked to the vision
For example, leaders may engage team members in activities that correlate to fulfillment of
revenue, growth, and organizational culture goals. Team members may brainstorm methods to
improve the interaction between departments targeting improved organizational culture. This
type of activity allows a team to focus on accomplishing departmental tasks that translates to the
company goals and vision.
The Results-Oriented Performance Culture system focuses on aligning performance with

organizational goals. For this to happen, employees must have a direct line of sight between
performance expectations and recognition systems and the agency mission. These links must be
communicated to and understood by employees, enabling them to focus their work effort on
those activities most important to mission accomplishment. All employees should be held
accountable for achieving results that support the agency’s strategic plan goals and objectives.
To meet the requirements of the Results-Oriented Performance Culture system, agencies can use
eight-step process for developing employee performance plans aligned with organizational goals.
In some organizations, performance plans have traditionally been developed by copying the
activities described in an employee’s position description onto the appraisal form. Even though a
performance plan must reflect the type of work described in the employee’s position description,
the plan does not have to mirror it. Performance plans based on position descriptions generally
describe activities, not accomplishments.
Instead of focusing on activities, it is necessary to develop performance plans based on

established elements and standards that address accomplishments that lead to organizational goal
achievement. Each step in the process builds on the previous step. One cannot skip a step and end
up with good results. The eight steps are:
 Step 1: Look at the overall picture

 Step 2: Determine work unit accomplishments
 Step 3: Determine individual accomplishments that support the work unit goals
 Step 4: Convert expected accomplishments into performance elements, indicating type and
priority
 Step 5: Determine work unit and individual measures
 Step 6: Develop work unit and individual standards
 Step 7: Determine how to monitor performance
 Step 8: Check the performance plan against guidelines.
RESPONSIBILITY ACCOUNTING AND RESPONSIBILITY CENTRES, SEGMENTED

REPORTING
RESPONSIBILITY ACCOUNTING (RA)

Responsibility accounting is a concept that separates a company into responsibility segments to
enable a more efficient way to manage a large organization. It provides incentives to segment
managers and other employees and allows them freedom to make decisions concerning the
segment for which each is responsible. As a result, top management has more time to spend on
strategic planning and making policy. Responsibility accounting holds managers responsible for
controllable costs and revenues.
RA will therefore personalize the accounting system. For it to work the organization must be well
structured and responsibilities clearly defined. Cost and revenues will be accounted on the basis
of responsibilities that is responsibility centres
A responsibility centre is a controlled unit for which a manager is responsible for all activities,
costs avenues as well as investment.
Implementation of RA requires structuring an organization into responsibility centres where
performance can be measured
If a manager is to bear responsibility for the performance of his area of the business he will need
information about its performance. In essence, a manager needs to know three things;
What are his resources?
Finance, inventories of raw materials, spare machine capacity, labour availability, the balance of
expenditure remaining for a certain budget, target date for completion of a job.
At what rate are his resources being consumed?

How fast is his labour force working, how quickly are his raw materials being used up, how
quickly are other expenses being incurred, how quickly is available finance being consumed?
How well are the resources being used?

How well are his objectives being met?

Decisions must also be made as to the level of detail that is provided and the frequency with
which information is provided. Moreover the cost of providing information must be weighed
against the benefit derived from it.
In a traditional system managers are given monthly reports, but there is no logical reason for this
except that it ties in with financial reporting cycles and may be administratively convenient. With
modern systems, however, there is a danger of information overload, since information
technology allows the information required to be made available much more frequently.
The task of the management accountant, therefore, is to learn from the managers of responsibility
centres what information they need, in what form and at what intervals, and then to design a
planning and control system that enables this to be provided.
Responsibility centres can be divided into three types;

 Cost centres.
 Profit centres.
 Investment centres.
Cost centres
A cost centre acts as a collecting place for certain costs before they are analyzed further.
Cost centres may include the following.
(a) A department
(b) A machine or group of machines
(c) A project (e.g. the installation of a new computer system)
(d) A new product (allowing development costs to be identified)
To charge actual costs to a cost centre, each cost centre will have a cost code. Items of
expenditure -
will be recorded with the appropriate cost code. When costs are eventually analyzed there may
well be some apportionment of the costs of one cost centre to other cost centres.
a) The costs of those cost centres which receive an apportionment of shared costs should be
divided into directly attributable costs (for which the cost centre manager is responsible) and
shared costs (for which another cost centre is directly accountable).
b) The control system should trace shared costs back to the cost centres from which the costs
have been apportioned, so that their managers can be made accountable for the costs
incurred.
Information about cost centres might be collected in terms of total actual costs, total budgeted
costs and total cost variances (the differences between actual and budged costs) sub-analyzed
perhaps into efficiency, usage and expenditure variances. In addition, the information might be
analyzed in terms of ratios, such as the following.
a) Cost per unit produced (budget and actual)
b) Hours per unit produced (budget and actual)
c) Efficiency ratio
d) Selling costs per shilling of sales (budget and actual)
e) Transport costs per ton/ kilometer (budget and actual)
Profit centres
A profit centre is any unit of an organization (for example, division of a company) to which both
revenues and costs are assigned, so that the profitability of the unit may tie measured.
Profit centres differ from cost centres in that they account for both costs and revenues and the key
performance measure of a profit centre is therefore profit.
For profit centres to have any validity in a planning and control system based on responsibility
accounting, the manager of the profit centre must have some influence over both revenues and
costs, that is, a say in both sales and production policies.
A profit centre manager is likely to be a fairly senior person within an organisation, and a profit
centre is likely to cover quite a large area of operations. A profit centre might be an entire
division within the organisation, or there might be a separate profit centre for each product,
product range, brand or service that the organisation sells. Information requirements will be
similarly focused, as appropriate.
In the hierarchy of responsibility centres within an organisation, there are likely to be several cost
centres within a profit centre.
Revenue centres
A revenue centre is similar to a cost centre and a profit centre but is accountable for revenues
only.
For revenue centres to have any validity in a planning and control system based on responsibility
accounting, revenue centre managers should normally have control over how revenues are raised.
Investment centres
An investment centre is a profit centre whose performance is measured by its return on capital
employed.
This implies that the investment centre manager has some say in investment policy in his area of
operations as well as being responsible for costs and revenues,
Several profit centres might share the same capital 'items, for example the same buildings, stores
or transport fleet, and so investment centres are likely to include several profit centres, and
provide, a basis for control at a very senior management level, like that of a subsidiary company
within a group.
Control can be exercised by reporting information such as profit/sales ratios, asset turnover
ratios, cost/sales ratios, and cost variances. In addition, the performance of investment centres
can be measured by divisional comparisons.
Traceable and controllable costs

The main problem with measuring controllable performance is in deciding which costs are
controllable and which costs are traceable. The performance of the manager of the division is
indicated by the controllable profit (and it is on this that he is judged) and the success of the
division as a whole is judged on the traceable profit.
Consider, for example, depreciation on divisional machinery, would this be included as a
controllable fixed cost or a traceable fixed cost? Because profit centre managers are only
responsible for the costs and revenues under their control, this means that they do not have
control over the investment in non- current assets, the depreciation on divisional machinery
would therefore be a traceable fixed cost judging the performance of the division, and not of the
individual manager.
Controllable costs and uncontrollable costs

Managers of responsibility centres should only be held accountable for costs over which they
have some influence. From a motivation point of view this is important because it can be very
demoralizing for managers who feel that their performance is being judged on the basis of
something over which they have no influence. It is also important from a control point of view in
that control reports should ensure that information on costs is reported to the manager who is able
to take action to control them.
A controllable cost is 'A cost that can be controlled, typically by a cost, profit or investment
centre manager'
Responsibility accounting attempts to associate costs, revenues, assets and liabilities with the
managers most capable of controlling them. As a system of accounting, it therefore distinguishes
between controllable and uncontrollable costs. Most variable costs ‘within a department are
thought to be controllable in the short term because managers can influence the efficiency with
which resources are used, even if they cannot do anything to raise or lower price levels.
A cost which is not controllable by a junior manager or supervisor might be controllable by a

senior manager. For example, there may be high direct labour costs in a department caused by
excessive overtime working. The supervisor may feel obliged to continue with the overtime in
order to meet production schedules, but his senior may be able to reduce costs by deciding to hire
extra full-time staff, thereby reducing the requirements for overtime.
A cost which is not controllable by a manager in one department may be controllable by a
manager in another department. For example, an increase in material costs may be caused by
buying at higher prices than expected (controllable by the purchasing department) or by
excessive wastage and spoilage (controllable by the production department) or by a faulty
machine producing a high number of rejects (controllable by the maintenance department).
Some costs are non-controllable, such as increases in expenditure items due to inflation. Other
costs are controllable, but in the long term rather than the short term. For example, production
costs might be reduced by the introduction of new machinery and technology, but in the short
term, management must attempt to do the best they can with the resources and machinery at their
disposal.
The controllability of fixed costs

It is often assumed that all fixed costs are non-controllable in the short run. This is not so.
a) Committed fixed costs are those costs arising from the possession of plant, equipment,
buildings and an administration department to support the long-term needs of the business.
These costs (depreciation, rent, administration salaries) are largely non-controllable in the
short term because they have been committed by longer-term decisions affecting longer-term
needs. When a company decides to cut production drastically, the long-term committed fixed
costs will be reduced, but arrangements for settling redundancy terms and the sale of assets
cannot be made quickly and in the short term.
b) Discretionary fixed costs, such as advertising, sales promotion, resea.ch and development,
training costs and consultancy fees are costs which are incurred as a result of a top
management decision, but which could be raised or lowered at fairly short notice (irrespective
of the actual volume of production and sales).
Controllability and apportioned costs

Managers should only be held accountable for costs over which they have some influence. This
may seem quite straightforward in theory, but it is not always so easy in practice to distinguish
controllable from uncontrollable costs. Apportioned overhead costs provide a good example.
Suppose that a manager of a production department in a manufacturing company is made

responsible for the costs of his department. These costs include directly attributable overhead
items such as the costs of indirect labour employed in the department, the cost of metered power
units consumed and indirect materials consumed in the department. However, the department's
overhead costs also include an apportionment of costs from other costs centres, such as the
following.
a) Rent and rates for the building which the department shares with other departments.
b) Share of the costs of the maintenance department
c) A share of the costs of the central data processing department
Should the production manager be held accountable for any of these apportioned costs?
a) Managers should not be held accountable for costs over which they have no control. In this
example, apportioned rent and rates costs would not be controllable by the production
department manager.
b) Managers should be held accountable for costs over which they have some influence. In this
example, it is the responsibility of the maintenance department manager to keep
maintenance costs within budget and of the DP manager to keep central DP costs within
budget. But their costs will be partly variable and partly fixed, and the variable cost element
will depend on the volume of demand for their services (the rate of usage of the service). If
the production department's staff treat their equipment badly we might expect higher repair
costs, and the production department manager should therefore be made accountable for the
repair costs that
his department makes the maintenance department incur on its behalf.

NB;-
Responsibility accounting works well in decentralized operation
Decentralization / divisionalization will lead to distribution of decision making powers to
decision managers who will have freedom to make decision
Decentralization is a matter of degree of control
Total decentralization is where managers in charge have maximum freedom and their units
operate as independent / autonomous units / divisions
For centralization, divisions operate with minimum supervision and decision making is
concentrated at the top management level and therefore R.A may not work
Advantage of decentralization
1. Divisional managers have good knowledge of local conditions and are able to make better
judgment of their units
2. Distribution of decision making burden that is divisional managers make day-to-day
decisions and this relieves top managers who will concentrate on strategic decisions
3. Motivation –a manager is assessed on the basis of control he has on his unit. There is a
clear link between managers power and performance
4. Decision making – Power is spread to lower levels which acts as a good training ground
for future top management
5. Eliminates waste and inefficiency
With high level of autonomy, optimal decision can be made to enhance efficiency and to
make the organization capable of meeting its objectives
6. Speed of decision making is increased. This is because the chain of command is reduced
Disadvantages
1. Lack of goal congruence / harmony
There is no harmonization of goals among divisions with those of the organization. This is
because division act independently as autonomous units and therefore this causes sub
optimization.
2. Increase in information cost that is an organization will require elaborate system of control to
gather information in order to monitor all activities of the organization
3. Duplication of resources, services and managerial skills that is each unit has its own resources
some of which could have been shared throughout centralization of activities
4. Top management may lose control where decentralization is excessive.
5. Divisional managers may make poor investment decision which may affect the overall
performance of the company
SEGMENTAL REPORTING
A segment is a unit of an organization for which a measure is required for performance
evaluation.
A segment can be a department, a process, a product, geographical market etc.

It is usually not possible for a user of financial statements to make judgment about the nature of
the different activities carried out by an enterprise or to understand their contribution to the
overall performance of the company unless some segmental analysis of the company is done.
The objective of segmental reporting is to explain further the profitability of each segment.
Controllability is important such that only those items controllable by the segment should be
charged while common cost should be charged to the parent segment or division.
Effective decentralization requires segmented reporting.
How to Prepare Segmented Income Statements

1) Use contribution approach i.e. sales – Variable costs
2) Less identifiable traceable fixed cost
3) Less common fixed cost
Traceable Fixed Costs

There are fixed costs incurred because of existence of the segment. i.e. fixed cost identified with
the segment such that if the segment is eliminated, the fixed cost will disappear. These are also
known as specific fixed costs.
Common Fixed Costs

Are fixed costs that support more than one segment and not identifiable with any segment.
If a segment is eliminated, the cost will continue to be incurred. They are also known as general
fixed costs charged against total income of the entire company.
ILLUSTRATION
A company has two divisions; the following is a segmented income statement for the last month
Details Total Cloth division Leather division

Sh. Sh. Sh.
Sales 3,500,000 200,000 1,500,000
Variable cost (1,721000) (960,000) (761,000)
Contribution 1 ,779 000 1 040 000 739 000
Less traceable F. cost
Advertising 612 000 300 000 312 000
Administration 427 000 210 000 217 000
Depreciation 229 000 115 000 114 000
Divisional segment 511 000 415 000 96 000
margin
Common Fixed cost (390 000)
Net operating income 121 000

The management questions the low margin in leather division while the division has 25% less
sales than cloth division. The management has directed that leather division be further segmented
into product lines as follows:
Details Garments Shoes Handbags

Sh. Sh. Sh.
Sales 500 000 700 000 300 000
Traceable F. cost
Advertising 80 000 112 000 120 000
Administration 30 000 35 000 42 000
Depreciation 25 000 56 000 33 000
Variable cost as a % of sales 65% 40% 52%
Analysis shows that sh. 110 000 of leather divisions’ admin expenses are common to the product
line.
Required;
Prepare a contribution format segmented income statement for leather division with segment
defined as product lines.
SOLUTION
Contribution income statement
Details Leather Garment Shoes Handbag

division segment segment segment
Shs. Shs. Shs. Shs.
Sales 1 500 000 500 000 700 000 300 000
Less: Variable costs (761 000) (325 000) (280 000) (156 000)
Contribution margin 739 000 175 000 420 000 144 000
Less: traceable F. cost
Advertising 312 000 80 000 112 000 120 000
Administration 107 000 30 000 35 000 42 000
Depreciation 114 000 25 000 56 000 33 000
Segmental margin 206 000 40 000 217 000 (51 000)
Less: common F. cost (110 000)
96 000
a) The management is surprised by handbag product line poor showing and would like to have
the product segmented by market as follows:
Details Domestic Foreign
Sales 200 000 100 000
Traceable F. cost
Advertising 40 000 80 000
Variable cost as % of sales 43% 70%

All the handbags product line administration and depreciation are common to the market
Required: prepare a contribution format segmented income statement for handbag product with
segments defined as markets.
SOLUTION
Contribution income statement
Details Handbags Domestic Foreign
product segment segment
Sales 300 000 200 000 100 000
Less: Variable costs 156 000 43% 200 000 70% 100 000
= 86 000 70 000
Contribution margin 144 000 114 000 30 000
Less: traceable F. (120 000) (40 000) (80 000)
cost
Segmental margin 24 000 74 000 (50 000)
Less: common F. cost
Admin & depreciation (75 000)
Product loss (51 000)
b) Referring to the statement prepared in (a) above the sales manager want to run a special
promotion campaign on one of product line over the next month. A marketing study indicates
such a campaign would increase sales of the garment line by sh. 200 000 or sale of the shoe
product line by sh. 145 000. The campaign would cost sh. 30 000.
Required:
Show computation to determine which product line should be chosen
SOLUTION
Details Garment line Shoe line
Sh. Sh.
Sales 700 000 845 000
Less: Variable costs (455 000) (338 000)
Contribution 245 000 507 000
Less: traceable Fixed cost
Advertising 110 000 142 000
Administration 30 000 35 000
Depreciation 25 000 56 000
Product line contribution 80 000 274 000

Incremental Margin Ratio
Garment 80 000 – 40 000 = 40 000 Absolute term
Shoe 274 000 – 217 000 = 57 000
Relative terms
40 000
Garment x 100  100 %
40 000
57 000
Shoe x 100  26 %
217 000
Advantages of Segmental Reporting

(i) It helps in understanding the past performance and the future performance of each segment
in terms of profitability.
(ii) It helps in assessing the risks and returns of each segment thus enhancing management’s
capability in developing risk mitigation strategies.
(iii) It helps in making informed judgment about each segment in terms of opportunities for
growth.
(iv) Can be used by management for decision making especially in committing more financial
resources to more profitable segments and or cutting down the sizes or shutting down the
non-profitable segments.
Disadvantagesof Segmental Reporting

(i) It is difficult to identify primary segments for reporting especially if the company operates
in both classes of business and geographical segment.
(ii) It is difficult to allocate or apportion the common items among the segments especially
those which relate to the overall corporate strategy e.g. finance cost.
(iii) There is a problem of measuring performance especially if the segments trade with each
other.
(iv) Segment information disclosed for external purposes may be an advantage to the
competitors since they may use the information to harm the business
DISTINCTION BETWEEN FINANCIAL PERFORMANCE MEASURES AND NON-

FINANCIAL PERFORMANCE MEASURES
Financial performance measures

These measures make use of financial statement figures to evaluate the performance of the
organization.

Types of financial measures of performance
i)Monetary and percentage changes analysis
Monetary changes involve the computation of the increased or decreased in amount between two
different periods. If the difference is a negative the change is a decrease and if the difference is
positive the change is an increase. Percentage change involves dividing the monetary change by
the earlier period’s amount and then multiplying the result by 100%.
ILLUSTRATION
Particular 2009 2008 Monetary %
Change Change
Cash 6,950 6,330 620 9.8%
Account 18,567 19,330 (763) (3.9%)
receivable 129,00 10,300 26,000 25.2%
Sales 0 8,000 2,000 25%
Rent expenses 10,000 1,400 6,730 480.7%
Net income 8,130
ii)Trend analysis
This is used to compare the percentage change (%) for one amount item over a period of time
Steps
a) Select thebase period or year
b) For each financial statement item; divide the amount in each non-base year by the amount
in the base year by multiplying the result by 100%.
ILLUSTRATION
Calculation of trend % using 2004 as base year
Year 2008 2007 2006 2005 2004
Particular
Inventory 12 309 12 202 12 102 11973 11743
P & Equipment 74 422 78 93S 64 203 65 239 68 450
C. Liabilities 27 945 30 347 27 670 28 259 26 737
Sales 129 000 97 000 95 000 87 000 81 000
C of good sold 70 950 59740 48100 47200 45 500
O. Expenses 42 600 38 055 32 990 26 690 27 050
N/Income/ Loss 8 130 (1 400) 7 869 5093 3812
Trend analysis %. % % % % %

Inventory 104.8 103.9 103.1 102.0 100.0
P & Equipment 108.7 115,3 93.8 95.3 100.0
C, Liabilities 104.8 113.5 103.4 105.7 100.0
Sides 159.3 119.8 117.3 107.4 100.0
C of good sold 155.9 131.3 105.7 103.7 100.0
0, Expenses 157.5 140.7 121.9 109.8 100.0
N/ Income / Loss 213.3 (36.7) 206 133.6 100.0
iii)Common size analysis

This is also called vertic.al analysis and it is used to express each item in the financial statement
as a percentage of one line item, which is referred to as the base amount. The base amount for
balance sheet items is usually the total asset and for the income statement it is usually the net
sales / revenues.
Year 2008 2007
Particulars Amount % Amount %
Cash 6 950 6.1% 6 330 5.3%
Accounts, renewable 18 567 16.2% 19 230 16.1%
Inventory 12 309 10.7% 12 202 10.27%
Year 2008 2007

Particulars Amount % Amount %
Prepaid expenses 540 0.5% 532 0.48%
Total current assets 38,366 33.5% 38,294 32.15%
Property & Equipment 74, 422 65.0% 78,938 66.5%
Other assets 1 ,750 1.5% 1,500 1.3%
Total assets 114 ,538 100% 118 732 100%
Liabilities & stockholders
Equity
Accounts payable 15 560 13.6% 16 987 14.3%
Salaries payable 9 995 8.7% 9 675 8.1%
Accrued expenses 2 390 2.1% 3 685 3.1%
Total current liabilities 27 945 24.4% 30 347 25.5%
Long term debt 15 000 13.1% 23 000 19.4%
Stock holders 71593 62.5% 65 383 55.1%
Total Liabilities & stockholders’ Equity 114,538 100% 118,732 100%
NOTE:
By comparing two or more years of common size statements, changes in the mixture of assets;
liabilities and equity can be identified.
On the income statement changes in the mix of revenues and in expenses of different types can
be identified.

Non-Financial Measures of Performance
Non-financial performance measures are measures of performance based on non-financial
information which may originate in the operating department and may be used to monitor and
control the activities within the accounting department. Examples of non-financial performance
measures are:-
Area assessed Performance measures

1. Service quality - Number of complains
- Customer waiting times
- Timely delivery of products
- Proportion of repeat bookings
2 Production of performance - Set up times
- Output per employee
- Mature yield percentage
- Number of defective items
3 Marketing effectiveness - Trends in market share
- Growth in sales volume
- Customers visits per sales volume
- Growth in number of customers
- Customers survey response
4 Human resource - Staff turn over
- Number of complains reviewed from
the employer
- Days lost through absenteeism
- Days lost through accidents or sickness
- Training and development of employees
5 Research and development - Frequency of new products
- Success history of previous products
- Trends in innovations on existing
product
- Quantity of product.
COST OF INFORMATION
If companies are to keep pace with this exponential increase in information, they must provide
the employees with the tools to connect with relevant information quickly and efficiently. Firms
cannot afford to overlook poor search as one of the largest wastes of man-hours for knowledge
workers. According to a popularly referenced 2007 IDC study, an average employee spends 9.5
work hours a week searching for pre-existing information. What’s worse is that 6 hours a week
are spent recreating documents that exist, but cannot be found. With this information combined

with the statistic that users are typically successful with their searches only about 40% of the
time, the cost of a poor search solution can quickly compound to quite a large burden on a
company of any size.
Management uses cost information in three distinct management activities: programming,
budgeting, and operating.
Programming and Budgeting

The programming process necessarily involves trade-offs, since there are never enough resources
to satisfy every desire. Such tradeoffs, however, can only be made if both the operational
desirability/effectiveness and the cost of any given program are known. Here, then, is the way
that cost information will be used by management in the programming activity: to ensure that a
given program can be accomplished with available resources and to permit rational, objective
trade-off decisions between program elements. The cost information required for this purpose is
the total actual cost of each of the elements included in the program.
The second management activity that will use cost information is the budgeting activity. In this
context, “budgeting” is used in its generic sense and includes all aspects of the budgeting
process—budget estimates, financial plans, operating budgets, etc. When viewed in this
perspective, budgeting may be considered as a composite of three activities—requesting funds,
justifying requests for funds, and planning the expenditure of funds that have been made
available. These activities necessarily involve the prediction of future costs and substantiation of
the predictions. The accuracy of these predictions determines the effectivenessof any budgeting
activity.
In this regard, management uses historical cost information as a basis for predicting future costs.
This is done through equating costs, extrapolating costs, developing cost estimating relationships,
and similar techniques. For example, if historical data show that it cost $100 to do something last
year, and if the controlling cost parameters (such as pay scales, freight charges, cost of raw
materials, etc.)
Operating—Management Control
The operating activity encompasses all the management functions involved in the day-to-day
performance of organizational tasks and missions. As such, it is primarily a lower-echelon
function and is, therefore, of considerable importance to wing/base level managers. In fact, it can
be said that the preponderant portion of a wing/base-level manager’s efforts are expended in the
operating activity. In this regard, many if not most management actions are concerned primarily
with operational effectiveness, mission accomplishment, and the like—considerations which do
not necessarily require cost data. Nevertheless, there are two areas of operating activity in which
manager’s use cost information: management control and decision-making.
In essence, management control is the function of ensuring that management plans and policies
are implemented as intended. In performing this function, cost information can help in three

important ways: it can serve as a means of communication; it can be used to motivate; and it can
be used as a yardstick of appraisal.
METHODS OF EVALUATING RESPONSIBILITY CENTRE PERFORMANCE

In decentralized organization, manager’s performance wills need to be evaluated, what managers
have to control should form the basis of performance evaluation
Controllable contributions on profit is the appropriate measures of divisional managers
performance
They measure ability of the managers to use resources under his control effectively
Non –controllable costs or revenue should not be included, as managers have no control e.g. cost
allocated to a division from head office
Return on investment (ROI)

This expresses divisional profits as a percentage of capital employed in that division
Capital or assets employed can be defined as the total divisional assets controllable by divisional
managers
It is the most widely used measure as financial measure of performance
ROI = × 100
Or
ROI = × × 100
/
ROI is normally used to apply to investment centers or profit centres. These normally reflect the
existing organization structure of the business.
Evaluation of ROI
You may like to consider the following factors when evaluating the use of ROI as a divisional
performance measure.
a) Comparisons. It permits comparisons to be drawn between investment centres that differ in
their absolute size.
b) Aggregation ROI is a very convenient method of measuring the performance for a division or
company as an entire unit.
c) Using an identical target return. This may not be suitable for many divisions or investment
centers as it makes no allowance for the different risk of each investment centre.
d) Misleading impression of improved performance. If an investment centre maintains the same
annual profit, and keeps the same assets without a policy of regular non-current asset
replacement, its ROI will increase year by year as the assets get older. This can give a false
impression of improving 'real' performance over time.
e) Valuation and classification of assets. Many of the criticisms of ROI arise from the valuation
of assets used in the denominator.
f) Short-term perspective. Since managers will be judged on the basis of the ROI that their
centre earns each year, they are likely to be motivated into taking those decisions, which
increase their center’s short-term ROI. So, in the short term, a desire to increase ROI might
lead to projects being taken on without due regard to their risk.
g) Sub-optimal decisions. Similarly, if ROI is used to evaluate divisional performance it may
encourage managers to make sub-optimal decisions. For example, managers may choose,
incorrectly, not to undertake a project with a return greater than the cost of capital simply
because it has a lower projected ROI than the current ROI for the division as a whole.
h) Lack of goal congruence. An investment might be desirable from the group's point of view,
but would not be in the individual investment centre's 'best interest' to undertake.
Furthermore, any decisions which benefit the company in the long term but which reduce the
ROI in the immediate short term would reflect badly on the manager's reported performance.
Residual income (RI)

This is the amount eft to the firm after providers of capital have been paid. It is the controllable
contribution / profit less cost of capital charged on the investment controllable by divisional
managers
RI = Divisional profit – cost of capital on assets
= operating profit – Inputted interest
Evaluation of RI
You may like to consider the following factors when evaluating the use of RI. Think about how it
compares to ROI as a possible divisional performance measure.
a) Usefulness in decision-making. Residual income increases in the following circumstances.
i) Investments earning above the cost of capital are undertaken
ii) Investments earning below the cost of capital are eliminated
Thus it leads managers to make the correct investment decision to benefit the company as a
whole.
b) Flexibility compared to ROI since a different cost of capital can be applied to investments
with different risk characteristics.
c) Does not allow comparisons between investment centres. RI cannot be used to make
comparisons between investment centres as it is an absolute measure of performance.
d) Difficulty in deciding on an appropriate and accurate measure of the capital employed. As we
discussed above, there can be some difficulty in knowing what values to place on assets.
e) Does not relate the size of a centre's income to the size of the investment, other than
indirectly through the interest charge.
ILLUSTRATION
The company defines ROI as operating income divided by total assets while RI as operating
income less imputed interest charged.
Division Operating income Revenue Total Assets
Newspaper 1100,000 4600,000 4900,000
Television 160,000 6400,000 3000,000
Film 200,000 1650,000 2600,000
The manager of Newspaper division is considering a proposal to invest sh. 200,000 in fast speed
printing press with colour option. The estimated investment will have operating income of sh.
30,000.
The company has a 12% required rate of return for investment in all 3 divisions
Required:
a) Use the dupont method to explain difference among the three division
b) Advice the manager of Newspaper whether he should undertake the investment proposal
(using ROI)
c) Compute the residual income of each division before the proposed investment
d) Would adopting RI basis change the manager’s decision on the acceptance of the proposed
investment in Newspaper division
SOLUTION
a) Use the dupont method to explain difference among the three division
ROI = × × 100
,
Newspaper division = × × 100 = 22.45%
,
Television division = × × 100 = 5.33%
,
Film division = × × 100 = 7.69%
NB: Currently Newspaper division is the best with the highest ROI
b) Advice the manager of Newspaper whether he should undertake the investment proposal
(using ROI)
( , , , ) , ,
ROI = ×( )
= 22.16%
, , , , ,
Conclusion
The manager should not invest in the fast speed printing press as investment reduces ROI by
(22.45 -22.16) by 0.29%

c) Compute the residual income of each division before the proposed investment
RI = operating incomes – cost of capital
Newspaper
RI = 1100000 – (12% 4900000) = 512000
Television
RI = 160,000 (12% 3000000) = (200,000)
Film
RI = 200,000 – (12% 2600000) = (112000)
Conclusion
Where ROI ≥ cost of capital = +ve RI
ROI < cost of capital = -ve RI
d) Would adopting RI basis change the manager’s decision on the acceptance of the proposed
investment in Newspaper division
RI = 1130,000 – 12% 5100000 = 518000
The manager’s decision would change as the investment proposal results to a higher RI by sh.
6000. Therefore he should invest in the new proposal
NOTE;
The rate on return on proposed investment is higher than the required rate of return set by the
company as follows:-
,
Rate of return = = × 100 = 15% > 12%
/ ,
ECONOMIC VALUE ADDED

It is argued that linking performance to profit breeds a short‑termism boom–bust culture. For
instance, a firm might adopt a cost minimization programme to increase profits and, to this end,
make immediate redundancies. This short-term decision would most likely trigger problems in
the medium to long-term for the business. This is one of the concerns that EVA directly
addresses, and the principal success of EVA as a performance metric is the link with long-term
wealth maximization and discount factor techniques. Studies have shown that companies that
adopt EVA as a performance measure outperformed their peers by 8.5% annually, and for those
companies operating in a declining market this jumps to over 12% per annum.
The real benefits are realized when EVA is further linked to management compensation
packages.
In this scenario it was found that companies outperformed their peers by 57% over a five-year
period (Stern Stewart, 2005).
Stern Stewart argues that EVA is the financial performance measure that comes closer than any
other to capturing the true economic profit of an organisation, and is the performance measure
most directly linked to the creation of shareholder wealth over time. EVA is an estimate of the

amount by which earnings exceed or fall short of the required minimum rate of return those
shareholders and debt holders could get by investing in other securities of comparable risk.
The formula is as follows:

EVA = net operating profit after tax - WACC×book value of capital employed
Stern et al (ed 2001) suggest that ‘when fully implemented’ EVA will be ‘the centerpiece of an
integrated financial management system that incorporates the full range of corporate financial
decision making’. It is argued that the following advantages can be gained from the adoption of
an EVA-based approach to performance measurement:
• Profits are shown in the way shareholders count them

• Company decisions are aligned with shareholder wealth
• A financial measure is used that line managers understand
• The confusion of multiple goals is ended.
Aligning decisions with shareholder wealth

Stern et al (2001) argue that the development of EVA coincides with the increased
‘empowerment’ of managers as decision makers, and is a tool to meet the potential agency issues
that are created when ownership and management are separated.
It is argued that EVA helps managers incorporate two basic principles of finance into their
decision making. The first is that the primary financial objective of any company should be to
maximize the wealth of its shareholders. The second is that the value of a company depends on
the extent to which investors expect future profits to exceed or fall short of the cost of capital.
Stern et al argue that a sustained increase in EVA will precipitate an increase in the market value
of an organisation.
They further suggest that the adoption of an EVA approach has proved effective in virtually all
types of organisation, from emerging growth companies to those organisations involved in
‘turnaround’ situations. They believe that the current level of EVA isn’t what really matters since
the current performance of an organisation is already reflected in its share price. It is the
continuous improvement in EVA that brings continuous increases in shareholder wealth.
A financial measure that line managers understand

EVA has the advantage of being conceptually simple and easy to explain to non-financial
managers, since it starts with familiar operating profits and simply deducts a charge for the
capital invested either in the company as a whole, or in a business unit, or even in a single plant,
office, or assembly line. In addition, EVA is closely analogous to the concept of residual income
(RI) which is both widely practiced and well established in literature as a measure of divisional
performance.
By assessing a charge for using capital, EVA raises managerial awareness of the need for care in
the management of the balance sheet as well as the income statement, and helps them to properly
assess the trade‑offs between the two. This broader, more complete view of the economics of a
business can have a profound influence on business performance. Unlike net present value (NPV)
calculations, EVA can be used as an effective performance measure because of its ability to
measure results periodically. Proponents of EVA assert that its use provides a superior measure
of the year-to-year value that the business creates. Moreover, because
EVA™ measures performance in terms of ‘value’; it should be the cornerstone of any financial
management system used to set corporate strategy, or to evaluate potential capital investment
decisions, corporate acquisitions, or performance.
EVA ADJUSTMENTS
ILLUSTRATION
Calculating EVA
A company has reported operating profits of shs. 21million. This was after charging shs 4 million
for the development and launch costs: of: a new product that is expected to generate profits for four
years. Taxation is paid at the rate of 25% of the operating; profit.
The company has-a risk adjusted weighted average cost of capital of 12% per annum and is paying
interest at 9% per annum on a substantial long term loan.
The company's non-current asset value is shs 50 million and the net current assets have a value of
shs 22 million. The replacement cost of the non-current assets is estimated to be shs 64 million.
Required;
Calculate the company's EVA for the period.
SOLUTION
Calculation of NOPAT
Shs million
:
Operating profit 21
Add back development costs 4
Less one year's amortization of development costs (Shs 4 million/4) (1)
24
Taxation at 25% 6
NOPAT 18
Calculation of economic value of net assets

Shs million
Replacement cost of net assets (Shs 22 million + Shs 64 million) 86
Add back investment in new product to benefit future 3
Economic value of net assets 89
Calculation of EVA
The capital charge is based on the weighted average cost of capital which takes account of the cost
of share capital as well as the cost of loan capital. Therefore the correct interest rate to use is 12%.

Shs. million
NOPAT 18.00
Capital charge (12% x $89 million) (10.68)
EVA 7.32
ILLUSTRATION
B division of Z Co has operating profits and assets as below:
Shs million
Gross profit 156
Less: Non-cash expenses (8)
Amortization of goodwill (5)
Interest @ 10% (15)
Profit before tax 128
Tax @ 30% (38)
Net profit 90
Total equity 350
Long-term debt 150
500
Z Co has a target capital structure of 25% debt/75% equity. The cost of equity is estimated at 15%.
The capital employed at the start of the period amounted to Shs. 450,000. The division had non-
capitalized leases of Shs. 20,000 throughout the period. Goodwill previously written off against
reserves in acquisitions in previous years amounted to Shs. 40,000.
Required;
Calculate EVA for B division and comment on your results.
SOLUTION
Shs ‘000’ Shs ‘000’
NOPAT
Net profit 90
Add back:
Non-cash expenses 8
Amortization of goodwill 5
Interest (net of 30% tax) 15 x 10.5 23.5
0.7 113.5
Assets 450
At start of period 20
Non-capitalized leases 40
Amortized goodwill 510

WACC
Equity 15% ×75% Debt 0.1125
(10% x 0.7) ×25% 0.0175
VVACC 0.13
EVA Shs “000”

NOPAT 113.5
Capital charge
13%×Shs 510 66.3
47.2
RI Shs “000”
Net profit 90
Capital charge;
13% x Shs 500 65
25
The EVA for B division is Shs 47.2k, higher than its RI. This is despite the higher net asset value
and is caused by treating expenses, such as amortization, in line with economic, not accountancy,
principles. The business is creating value as its return (however calculated) is greater than the
group's WACC. The division's ROI is 18% vs. WACC of 13% (based on target not actual capital
structure).
Its "economic" ROI is 22.3%.
EVA does have some drawbacks.

a) Dependency on historical data. EVA is based on historical accounts, which may be of limited
use as a guide to the future. In practice, the influences of accounting policies on the starting
profit figure may not be completely negated by the adjustments made to it in the EVA model.
b) Number of adjustments needed to measure EVA. Making the necessary adjustments can be
problematic as sometimes a large number of adjustments are required.
c) Comparison of like with like. EVA is an absolute measure, so larger companies in size, may
have larger EVA figures than smaller companies, simply because they are bigger, not
because they are performing better. Allowance for relative size must be made when
comparing the relative performance of companies. In this respect, return on investment
(which shows a percentage measure) may be better for comparing performance between
companies of different size.
d) Difficulty in estimating WACC. Many organization use models such as the CAPM for
estimating WACC. However, this is not a universally accepted method of determining the
cost of equity.

OTHER FINANCIAL/NON-FINANCIAL PERFORMANCE MEASURES
BALANCED SCORECARD
Balance Scorecard
It’s an integrated set of performance measures derived from the company’s strategies that gives
the top management a fast but comprehensive view of the organizational unit. (i.e. a division or a
strategic business unit (S.B.U)
The balanced scorecard philosophy assumes that an organizations vision and strategy is best
achieved when the organization is viewed from the following four perspectives.
1) Customer perspectives (How customers do see us?)

This gives rise to targets that matter to customer’s perspectives.
2) Internal business process (What must we excel in?)
This aims to improve internal processes and decision making quality control.
3) Learning and growth perspective (Can we continue to improve and create value?
This considers an organization’s capacity to maintain its competitive position through
acquisition of new skills.
4) Financial perspective (How do we look to shareholders?)
This covers traditional measures such as profitability, R. O. I etc.
Financial
To succeed financially how

should we appear to shareholders
Internal business
process
Vision
Customer and To satisfy our
strategy shareholders &
To achieve our vision
how should we appear customers, what
to our customers? business process must
Learning & growth we excel at?
To achieve our vision, how

will we sustain our ability to
change & improve?

By implementing the balanced scorecard, the major objectives for each of the four perspectives
should be articulated.
These objectives should be translated into specific performance measures and targets for
achievements.
This method integrates traditional financial measures with operations, customer and staff issues
vital in long run competitiveness.
ILLUSTRATION
ABC Ltd has in the past produced just one fairly successful product. Recently, however, a new
version of this product has been launched .Development work continues to add a related product
to the product list. Given below are some details of the activities during the months of November
2009
Units produced Existing product - 25,000units

New product - 5,000units
Cost of units produced Existing product = Sh. 375,000
New product = Sh. 70,000
Sales revenue Existing product - Sh. 550,000
New product = Sh. 125,000
Hours worked Existing product = 5,000 hrs
New product = 1,250 hrs
` Development cost Sh. 47,000
Required:-
Suggest and calculate performance indicators that could be calculated for each of the four
perspectives on the balanced scored card.
1)Customer perspective
,
Percentage of sales by new products = ×100 = 18.5%
, ,
2) Internal business perspective

i) Productivity:
,
Existing product = = 5hours per unit
,
New product = = 4hours per unit
ii) Unit cost:
,
Existing product = = sh. 15 per unit
,
3) Financial perspectives
, ,
Gross profit; Existing product = ×100 =32%
,

, ,
New product = ×100= 44%
,
4)Learning curve and growth perspective

,
Development costs as a percentage of sales = × 100 = 7%
,
Balanced Scorecard as a Strategic Management System

1) Clarifying and translating vision and strategy into specific strategic objectives and identifying
the critical drives of the strategic objectives.
2) Communicating & linking strategic objectives &measures.
Once employees understand the high level objectives and measures, they should establish
local objectives that support the business unit’s global strategy.
3) Plan, set targets & align strategic initiatives. Such targets should be over a 3 – 5 year period
broken down on a yearly basis so that progression targets can be set for assessing the progress
being made towards achieving the long term targets.
4) Enhancing strategic feedback and learning so that managers can monitor and adjust the
implementation of their strategy and if necessary make fundamental changes to the strategy
itself.
Benefits of Balanced Scorecard

1) It brings together in a single report four different perspectives on a company’s performance
that relate to many of the dispersed elements of the company’s competitive agenda such as
becoming customer oriented, shortening response time, improving quality, emphasizing team
work, reducing new product launch times and managing for the long term.
2) It provides a comprehensive framework for translating a company’s strategic goals into a
coherent set of performance measures by developing the major goals for the four perspectives
and translating these goals into specific performance measures.
3) It helps managers to consider all the important operational measures together i.e. to enables
mangers see whether improvements in one area may have been at the expense of another.
4) It improves communication within the organization and promotes the active formulation and
implementation of organizational strategy by making it highly visible through the linkage
performance measures to business unit strategy.
Limitations of Balanced Scorecard

1) The assumption of the course and effect is too ambitious and lack a theoretical underpinning r
empirical support.
The empirical studies undertaken have failed to provide evidence on the underlying
linkages between non-financial data and future financial performance.
2) There is an omission of important perspective most notable being the environmental impact
on society perspective and an employee perspective. There is nothing to prevent companies
adding additional perspectives to meet their own requirements but they must avoid the
temptation of creating too many perspectives and performance measures as a major benefit of
performance measure is the consciousness and clarity of presentation.
PERFORMANCE PYRAMID
The performance pyramid was developed by Lynch and Cross, includes a hierarchy of financial
and non-financial performance measures.
The diagram below shows actions to assist in the achievement of corporate vision may be
cascaded down through a number of levels, i.e. it shows the link between strategy and day to day
operations.
Level 1: At the top of the organisation is the corporate vision or mission through which the
organisation describes how it will achieve long-term success and competitive advantage.
Level 2: This focuses on the achievement of an organization’s critical success factors (CSFs) in
terms of market-related measures and financial measures. The marketing and financial success of
a proposal is the initial focus for the achievement of corporate vision.
Level 3: The marketing and financial strategies set at level 2 must be linked to the achievement
of customer satisfaction, increased flexibility and high productivity at the next level. These are
the guiding forces that drive the strategic objectives of the organisation.
Level 4: The status of the level 3 driving forces can be monitored using the lower level
departmental indicators of quality, delivery, cycle time and waste.
The left hand side of the pyramid contains measures which have an external focus and which are
predominantly non-financial. Those on the right are focused on the internal efficiency of the
organisation and are predominantly financial.

The one drawback of the performance pyramid is that it does tend to concentrate on two groups
of stakeholders, i.e. shareholders and customers. It is necessary to ensure that measures are
included which relate to other stakeholders as well.
FITZGERALD AND MOON'S BUILDING BLOCK MODEL

The building block model is an analysis that aims to improve the performance measurement
systems of service businesses. It suggests that the performance system should be based on three
concepts of
Dimensions/TARGET, standards and rewards.
Dimensions/Targets(WHAT)fall into two categories: downstream results(competitive and

financial performance) and upstream determinants(quality of service, flexibility, resource
utilization and innovation) of those results. These are the areas that yield specific performance
metrics for a company.
Standards(HOW)are the principlesset for the metrics chosen from the dimensions measured.
These must be such that those being measured take ownership of them, possiblyby participating
in the process of setting the standard. The performance measuresmust be achievable in order to
motivate the employee or partner. The performance measuresmust be fairly set, based on the
environment for each business unit so that those in the lower growth areas of, say, audit do not
feel prejudiced when compared to the growing work in business advisory.
Rewardsare the motivators for the employees to work towards the standards set. The reward
system should be clearly understood by the staff and ensure their motivation. The rewards should
be related to areas of responsibility that the staff member controls in order to achieve that
motivation.
They suggested that the following dimensions need measures of performance:
Performance area Possible measures

Financial performance • Profitability
• Sales growth
• ROI
• Cash flow/liquidity
• EVA
Competitive performance • Sales growth
• Proportion of contracts won
• Customer assessment/feedback
• Market share
Quality • Rejects/reworks
• Customer complaints/feedback

• Claims for compensation
• Peer review assessments
Flexibility • Spare capacity
• Time order to delivery
• Set-up time
• Percentage of work declined
Resource utilization • Idle time
• Non-chargeable time
• Machine utilization
• Wastage
Innovation • New products brought to market
• Patents files
• R&D spend
PERFORMANCE PRISM
The Performance Prism is an approach to performance management which aims to effectively
meet the needs and requirements of all stakeholders. This is in contrast with the performance
pyramid which tends to concentrate on customers and shareholders and is also in contrast with
value based management, which prioritizes the needs of shareholders.
 It takes stakeholder requirements as the start point for the development of performance
measures rather than the strategy of the organisation.
 It recognizes the need to work with stakeholders to ensure that their needs are met.
The Performance Prism aims to manage the performance of an organisation from five interrelated
‘facets’:
1. Stakeholder satisfaction: who are they and what do they want?
For example, shareholders want profits and customer want high quality and value for money.
2. Stakeholder contribution: what does the organisation need and want from its
stakeholders?
For example, large orders, prompt payment, large amounts invested, loyalty. If stakeholders
re not providing what the organisation wants, perhaps they should be dropped.
3. Strategies: what strategies are needed to satisfy both stakeholders’ requirements and the
organization’s?
For example, cost leadership or differentiation.
4. Processes: what is needed to enable the strategies?
For example, cost leadership would require processes that allow cheap, efficient
manufacturing to be carried out. Differentiation would require innovation and tailoring.
5. Capabilities: what capabilities are needed to allow the processes to be carried out?
For example, for cost leadership, high automation, good purchasing skills, right first time.

The Prism is designed to be a flexible tool – it can be used for commercial or non-profit
organisations, big and small. When light is shined into a prism, it is refracted, thus the Prism
shows the hidden complexity of white light. According to Neely and Adams, the Performance
Prism illustrates the true complexity of performance measurement and management.
Stakeholder satisfaction;-the first facet of the Prism focuses on the stakeholders, and what do
they want. Here, the importance of stakeholder mapping is recognised. Stakeholder mapping
means identifying the key stakeholders, and determining how important each of them are to the
organisation. This may be based in how much power they have, and on whether or not they are
likely to use it. If the majority of employees are members of a trade union, for example, then it is
likely that the trade union will hold significant influence over the organisation.
If organisations do not keep the most influential stakeholder groups happy, then this will impact
on financial performance in the long run. Dissatisfied employees, for example, will be less
motivated or may leave the organisation, causing expenses of hiring and training new employees.
Organisations need to identify the most important stakeholders, and what they want from the
organisation. They must then identify performance measures to monitor how well the
organisation is meeting these needs.
Stakeholder contribution;-Organisations are becoming more demanding in what they expect

from their own stakeholders. In the second facet of the Performance Prism, users need to identify
exactly what it is that the organisation wants from those stakeholders, and then come up with
ways to measure whether or not the stakeholders are providing it.
Strategies;-many performance management frameworks start with strategy, and there is a myth
that having identified the strategy of an organisation, selecting appropriate performance measures
is easy. This is largely because many people confuse strategy and goals. In the Performance
Prism, strategy means how the goal will be achieved. It is the route the organisation takes to
reach the goal, not the goal itself. The goals are defined in the first two facets of the Prism.
In the strategies facet of the Performance Prism, therefore, we ask ‘what strategies should the
organisation be adopting to ensure that the wants and needs of its stakeholders are satisfied, while
ensuring that its own requirements are satisfied too?’
Processes;-after identifying the strategies, organisations need to find out if they have the right
business processes to support the strategies.
Many organisations classify four business processes as follows:

 Develop products and services
 Generate demand
 Fulfil demand
 Plan and manage the enterprises.
These processes can then be sub-divided into more detailed processes. Each process and sub
process will have to have a process owner who is responsible for the functioning of that process.
One sub process of ‘plan and manage the enterprise’, for example, might be ‘recruitment’, and it
is likely that the head of human resources would be responsible for this process.
Measures will then be developed to see how well these processes are working. Management will
have to identify which are the most important processes, and focus attention on these, rather than
simply measuring the functioning of all processes. Business process reengineering may be used
at this stage to identify any redundant processes.
Capabilities;-capabilities are the people, practices, technologies and infrastructure required to

enable a process to work. It is important that the right capabilities exist within an organisation in
order to support the processes identified in the processes facet of the Performance Prism.
Neely and Adams provide the example of an order to cash fulfilment process in an electronics
business. This particular process may require the following capabilities:
 Customer order handling
 Planning and scheduling
 Procurement
 Manufacturing
 Distribution
 Credit management
In the capabilities facet of the Performance Prism, the organisation needs to identify which
capabilities are required, and identify performance measures to see how well these capabilities
are being performed.

MANAGERIAL INCENTIVE SCHEMES
Decentralization always involves the question of how the top division managers are rewarded or
penalized. Compensation, contracts particularly incentives and bonuses plans provide important
direction and motivation for top manager.
Executive incentive schemes should be competitive to attract and retain high quality
managers.
i. Communicate and reinforce key priorities in firms by linking bonuses to key performance
measures.
ii. Encourage performance evaluation by rewarding good performance of managers.
Forms of bonuses
They vary from one organization to the other and payments can be made in:-
a) Cash
b) Shares of the company
c) Stock options
d) Performance shares
e) Stock appreciation rights
Bonuses can also be made:-

i) Contingent to corporate result or divisional profits.
ii) Be based on annual performance or performance over a number of years.
A. Cash /Shares
Company profit and individual performance forms the basis used to determine the amounts of
bonuses.
These are current bonuses paid in cash (monetary consideration or shares i.e. ownership
consideration). They reward executive on short term performance therefore there is a risk of
promoting a pre-occupation with short term results which will affect long term interest.
Normally they are based on fixed percentages if corporate or divisional profits exceed a
certain amount e.g. a bonus of 5% if profits exceed shs 10 million etc.
Advantages
i. Bonus can be reduced or eliminated during periods of poor performance.
ii. Share compensation creates a good relationship between manager and shareholders.
iii. Good performance will be encouraged since rewards are related to performance.
Disadvantages
i. Bonuses will bring tax issues and therefore if given in shares, managers will have to
look for money to pay taxes
ii. Significant share ownership by managers may lead to risk averse behaviors.

B. Stock options
A stock option gives managers the right to purchase company shares at a future date and at a
price
established when the option was granted. With stock options it will be assumed that managers
will attempt to influence long term performance rather than short term. Managers will want
share price to appreciate so that they make capital gains when they exercise their option.
Advantages
i. Managers are encouraged to make long term decisions that will maximize value of the
firm
ii. It encourages managers to reduce risks behavior and undertake riskier projects with
higher payoffs.
Disadvantages
i. Some events not directly under control of managers may affect share prices eg political
climate, competition etc.
ii. They have no apparent tax benefits to the company or managers.
C. Performance share.
Are shares given by the company to managers/ employees if they attain a specific level of
performance. The main target is to attain a certain level of performance for a number of years.
Executives receive rewards for maintaining a consistent performance or exceeding the
performance
level. Performance shares are also referred to as executive share ownership plans (ESOPS)
They have same advantages and disadvantages as stock options. However, they have an
additional
problem of basing performance on profit measures which may promote creative accounting or
short
term decisions which may not improve value of the firm.
D. Stock Appreciation Rights
These are deferred cash payments based on the increase in stock price from the time of their
award to the time of payment. Managers will be rewarded for appreciation in share price.
Therefore the value/ the amount of business will be a function of future share price.
Managers will be encouraged to make decisions that maximize share price and hence their
bonuses.
Executive compensation and agent relationship

Managers fire agents of shareholders. The shareholders delegate decision making authority to
managers. Managers are hired by top management or directors to manage the firm or
divisions for decentralized units. In agency relationship there is assumption, that managers look
at financial compensation and wealth maximization as well as other items that will come with the
job e.g. rewards. Managers will not prefer hard work and will therefore require
incentives to reduce agency conflicts. Incentive compensation is designed to harmonize
interest of owners and managers; however divergence of interest will always occur due to;
 risk attitude of managers;
 Existence of private information available to managers etc.
Owners need to monitor manager’s actions by incurring agency costs. Agency cost is the sum
of the costs of incentive compensation i.e. cost of monitoring managers behavior etc.
PERFORMANCE CONTRACTING
Performance Based Contracting is a results-oriented contracting method that focuses on the
outputs, quality, or outcomes that may tie at least a portion of a contractor's payment, contract
extensions, or contract renewals to the achievement of specific, measurable performance
standards and requirements.
PERFORMANCE MEASURES IN THE SERVICE INDUSTRY

Service industries often rely on exceptional customer service to ensure strong operations and to
attract repeat business. Continually setting goals and measuring performance in these key areas
helps the business remain competitive, profitable and successful. Helping staffers understand
expectations through goal-setting can increase productivity and empower staffers to higher levels
of performance.
The focus of competition is changing in many cases has long since changed from simply
competing on price to competing on a range of other factors such as quality, product and service
innovation and flexibility of response to customer needs. The service sector is diverse, embracing
such things as tourism, financial services, health care, catering and communications. Variety of
business and have distinct the categories of service as follow;-
 Distribute services include transportation, communication and trade.
 Producer services involve services such as investment banking, insurance engineering,
accounting, bookkeeping and legal services.
 Social services include health care, education, non-profit organizations and government
agencies.
 Personal services include tourism, dry cleaning, recreational services and domestic services.
Therefore performance measurement is a key factor in ensuring the successful implementations
of company’s strategy. The need for an alternative and more comprehensive performance
measurement system has encouraged several researchers to explore the alternative possibilities.
Measures and indicators refer to the numerical information the results from measurement and
suggest a business performance scorecard often consists of five key categories as follows:
 Customer satisfaction measures;-customer satisfaction measure includes measures of
perceived value, rates of complaint, customer retention, gain and losses of customers, and
recognitions from customers and independent organization.
 Financial and market performance measures;-generally tracked by senior leadership to
gauge overall company performance and are often used to determined incentive compensation
for senior executives. Measures may include return on equity, return on investment, operating

profit, pre-tax profit margin, earnings per share, and other liquidity measure. A key
financial performance indicator is the cost of quality. Marketplace performance could include
market share measures of business growth, new product and geographic markets entered and
percentage of new product sales as appropriate.
 Human resources measure;-HR measures can relate to employee well-being, satisfaction,
development, work system performance and effectiveness.
 Supplier and partner performance measures;-supplier refers to providers of good and
services. Key measures of supplier performance re quality, delivery and service and price.
 Company-specific measures that support company strategy: most company-specific
measures relate to product and service quality, process performance and other factors that
drive the organization from strategic view point.
REVISION EXERCISES
QUESTION 1
Kanorer Enterprises Ltd has two divisions Mugaa and Gwashati. Mugaa division manufactures
an intermediate product for which there is no external market. Gwashati division incorporates
the intermediate product into a final product, which it sells. One unit of the intermediate product
is used in the production of the final product. The expected units of the final product which
Gwashati division estimates it can sell at various selling prices are as follows:
Net selling Price Quantity sold

Sh. Units
100 1000
90 2000
80 3000
70 4000
60 5000
50 6000
The variable and fixed costs of each division are as follows:

Mugaa Gwashati
Sh. Sh.
Variable cost per unit 11 7
Fixed cost per annum 60,000 90,000
The transfer price is Sh.35 for the intermediate product, and is determined on a full cost-plus
basis.

Required:
a) Profit statements for each division and the company as a whole for the various selling prices
b) Which selling prices maximize the profits of Gwashati division and the company as a whole?
Comment on why the selling price (which is selected by the company) is not selected by
Gwashati division.
c) It has been argued that full cost is an inappropriate basis for selling transfer prices. Outline
the objections which can be raised against this basis.
SOLUTION:
(a) Contributions for each division and the company as a whole for the various selling prices are as
follows:
Mugaa Division
Output Total Variables Total
Units Revenue Costs Contribution
Shs. Shs. Shs.
1,000 35,000 7,000 24,000
2,000 70,000 22,000 48,000
3,000 105,000 33,000 72,000
4,000 140,000 44,000 96,000
5,000 175,000 55,000 120,000
6,000 210,000 66,000 144,000
Gwashati Division
Output Total Variables Total Total
Units Revenue Costs Cost Transfers Contribution
Shs. Shs. Shs. Shs.
1,000 100,000 7,000 35,000 58,000
2,000 180,000 14,000 70,000 96,000
3,000 240,000 21,000 105,000 114,000
4,000 280,000 28,000 140,000 112,000
5,000 300,000 35,000 175,000 90,000
6,000 300,000 42,000 210,000 48,000
Whole Company
Output Total Company Total
Units Revenue Variables Costs Contribution
Shs. Shs. Shs.
1,000 100,000 18,000 82,000
2,000 180,000 36,000 144,000
3,000 240,000 54,000 186,000
4,000 280,000 72,000 208,000
5,000 300,000 90,000 210,000

6,000 300,000 108,000 192,000
(b) Based on the statements in (a) Gwashati division should select a selling price of Shs.80 per unit.
This selling price produces a maximum divisional contribution of shs.114,000. it is in the best
interest of the company as a whole if the selling price of Shs.60 per unit is selected. If Gwashati
division selects a selling price of shs.60 per unit instead of shs.80 per unit, it’s overall marginal
revenue would increase by shs.60,000 but it’s marginal cost would increase by shs.84,000.
Consequently, Gwashati Division will not wish to lower the price.
(c) Where there is no market for the intermediate product and the supplying division has no capacity
constraints, the correct transfer price is the marginal cost of the supply division for that output at
which marginal revenue received from the intermediate product. When unit variable cost is
constant and fixed cost remains unchanged, this rule will result in a transfer price that is equal to
the supplying division’s unit variable cost. Therefore the transfer price will be set at shs.11 per
unit when the variable cost transfer pricing rule is applied. Gwashati division will be faced with
the following revenue schedules:
Output units Marginal cost (NOTE) Marginal Revenue

Shs. Shs.
1,000 18,000 100,000
2,000 18,000 80,000
3,000 18,000 60,000
4,000 18,000 40,000
5,000 18,000 20,000
6,000 18,000 NIL
Note:
 Marginal cost = transfer price of shs.11 per unit plus conversion variable cost of shs.7 per unit.
 Gwashati will select the optimum output level for the group as a whole (i.e. 5,000 units)
 And the optimal selling price of shs.60 will be selected. A transfer price equal to the variable cost
per unit of the supplying division will result in the profits of the group being allocated to
Gwashati, and Mugaa will incur a loss equal to the forced costs. Consequently, a divisional profit
incentive cannot be applied to the supplying division.
QUESTION 2
Nairobi Enterprise Ltd. (NEL) is a divisionalised enterprise. Among its divisions, are South and
North. Both of these divisions have a wide range of independent activities. One product, Xcel, is
made by South division for North division. South division does not have any external customers
for the product.
The central management of NEL delegates all pricing decisions to divisional managers and the
pricing of Xcel has been a contentious issue. It has been suggested that South division should
give a transfer price schedule for the supply of Xcel based on South division’s own production
costs and that all goods transferred would be made at South division’s marginal costs. The North

division would then order the quantity it requires each month. South estimates its monthly total
costs (TC) in shillings for producing Xcel using the following equation:
TCS = 1,000,000 + 550QS + 0.002QS2

Where Qs is the quantity of Xcel manufactured.
North division total costs (TCN) in shillings using Xcel, excluding transfer price are:
TCN = 1,500,000 + 1100QN + 0.001Q2S

Where QN is the quantity produced by the North division which incorporates one unit of Xcel.
The North division estimates that the demand function for its product incorporating Xcel is:
PN = 4,500 – 0.0008QN
Where PN is the price per unit of the product incorporating Xcel.
Neither division holds any stocks of Xcel.
Required:
(a)
i) The quantity of Xcel which would maximize profits for NEL.
ii) The transfer price in shillings corresponding to the maximum production in (i) above if
South division’s marginal cost are adopted for transfer pricing. Show the resulting profit
for each division.
(b)
i) The quantity of Xcel which North division would take (at South division’s marginal costs)
if it wanted to maximize its own profits.
ii) The transfer price in shillings corresponding to the quantity of Xcel that would maximize
the profits of North division, and the resulting profit for each division.
SOLUTION:
(a) (i) Profits for the group as a whole will be maximized where the marginal cost of South division is
equal to the marginal revenue of North division.
Price = 4,500 – 0.0008QN
Therefore total revenue = 4,500QN – 0.0008Q²N
dTR
Therefore: MRN = = 4,500 – 0.0016QN
dQ N

dTC
MCN = N = 1,100 + 0.002QN
dQ N
NMRN = MRN - MCN = 3,400 – 0.0036QN
dTC
MCS = S = 550 + 0.004QS
dQ S
So profits are maximized where 550 + 0.004QS = 3,400 – 0.0036QN

Since there is no intermediate market both divisions must agree on the output level so that QS =
QD = Q
Therefore 0.0076Q = 2,850

Q = 375,000
(ii) The optimum transfer price is the marginal cost of South division for that output at which the
marginal cost equals North division’s net marginal revenue from processing the intermediate
product (at output level of 375,000 units).
The marginal cost of South division at an output level of 375,000 units is:
550 + (0.004 x 375,000) = 550 + 1500 = Sh.2,050
At 375,000 units the price that North division would charge for selling the final product is:
4,500 – 0.0008 x 375,000 = Sh.4,200.
The resulting profit from each division would be:
South division Sh.’000’ North division Sh.’000’

Revenue 375,000 x 768,750 Revenue 375,000 x 1,575,000
2,050 488,500 4,200 554,625
Costs (W1) _____ Conversion costs (W2) 768,750
Profit 280,250 Transferred costs 476,625
Profit
W1 TCS = 1,000,000 + 550 x 375,000 + 0.002(375,000)² = Sh.487,500,000
W2 TCN = 1,500,000 + 1,100 x 375,000 + 0.001(375,000)² = Sh.554,625,000
Group profit = Sh.281,250,000 + Sh.476,625,000 = Sh.757,975,000
(b) (i) In (a) the marginal cost for South division at different output levels were equated to the NMR of
North division. It is assumed that the question implies that South division would quote transfer
prices based on its marginal costs would at a given output levels, so that North would regard these

transfer prices (550 + 0.004QS) to be constant per unit for all output levels. Drink’s net profit
(NP) will be as follows:
NP = (4,500Q – 0.0008Q²) – (1,500,000 + 1,100Q + 0.001Q²) – Q(550 + 0.004Q)
OR
Profit = Revenue – Total Costs

= 2,850Q – 0.0038Q² - 2,500,000
dπ
= 2850 – 0.0076Q = 0
dQ
Q = 375,000 units
= 2,850Q – 0.0058Q² - 1,500,000
dNP
Profit is maximized where 0
dQ
That is, where:2,850 – 0.0116Q = 0

Q = 245,690 units
An alternative approach is to equate the net marginal revenue with the marginal cost of the transfers.
South division will transfer out at a marginal cost of 550 + 0.004QS and North division will treat this
price at a constant sum per unit. Therefore the total cost of transfers to North division will be:
QS(550 + 0.004QS) = 550QS + 0.004QS
Therefore the marginal cost of transfer will be 550 + 0.008QS
The transfer price for North division that maximized its profits is where NMR = MC i.e. where 3,400
– 0.0036Q = 550 + 0.008Q
Q = 245,690 units
(ii) The level that maximizes profit for North division determines the transfer price. At an output level
of 245,690 units the transfer price will be:
550 + (0.004 x 245,690) = Sh.1,533
At 245,690 units the price that North division would charge for selling the fund product is 4,500 –
0.0008 x 245,690 = Sh.4,303

South division Sh.’000’ North division Sh.’000’
Revenue 245,690 x 376,642.77 Revenue 245,690 x 1,057,204.07
1533 256,856.65 4,303 332,122.576
Costs (W1) 2 Conversion costs (W2) 1
Transferred costs 376,642.77 _
Profit 119,785.11 Profit 348,438.664
8
W1 = TCS = 1,000,000 + 550 x 245,690 + 0.002(245,690)² = Sh.256,856,652.2
W2 = TCN = 1,500,000 + 1,100 x 245,690 + 0.001(245,690) = Sh.332,122,576.1

TOPIC 8
PRICING DECISIONS
INTRODUCTION
Organizations producing goods and services need to set the price for their product. Setting the
price for an organization's product is one of the most important decisions a manager faces. It is
one of the most crucial and difficult decisions a firm's manager has to make. Pricing is a profit
planning exercise. Cost is one of the major considerations in price determination of the product.
It is one of the three major factors which influence pricing decision. The two other factors are
customers and competitors.
Customer: In a situation where the product has many substitutes, customers decide the price.
That is, the demands of customers are the paramount importance in setting the price of the
product. In such a situation, the firm should try to deliver the value, in the form of product and/or
service, at the target cost so that a reasonable profit can be earned. Similarly, under competitive
condition, price is determined by market forces and an individual firm or an individual customer
cannot influence the price.
Competitors: When there are only few players in the market, competitors usually, react to the
price changes and, therefore, pricing decisions are influenced by the possible reaction of
competitors. As such management must keep watchful eye on the firm's competitors. That is,
knowledge of competitors' strategy is essential for pricing decision in an oligopoly situation.
Cost: Cost is the third major factor. Its role in price setting varies widely among industries. Some
industries determine price by market forces and in some industries, managers set prices a on the
basis of production costs. Firms want to charge a price that covers its costs like production costs,
distribution costs and costs relate with selling the product and also including a fair return for its
effort.
Factors Affecting Pricing Product
A. Internal Factors:
1. Cost:
While fixing the prices of a product, the firm should consider the cost involved in producing the
product. This cost includes both the variable and fixed costs. Thus, while fixing the prices, the
firm must be able to recover both the variable and fixed costs.
2. The predetermined objectives:
While fixing the prices of the product, the marketer should consider the objectives of the firm.
For instance, if the objective of a firm is to increase return on investment, then it may charge a

higher price, and if the objective is to capture a large market share, then it may charge a lower
price.
3. Image of the firm:
The price of the product may also be determined on the basis of the image of the firm in the
market. For instance, HUL and Procter & Gamble can demand a higher price for their brands, as
they enjoy goodwill in the market.
4. Product life cycle:
The stage at which the product is in its product life cycle also affects its price. For instance,
during the introductory stage the firm may charge lower price to attract the customers, and during
the growth stage, a firm may increase the price.
5. Credit period offered:
The pricing of the product is also affected by the credit period offered by the company. Longer
the credit period, higher may be the price, and shorter the credit period, lower may be the price of
the product.
6. Promotional activity:
The promotional activity undertaken by the firm also determines the price. If the firm incurs
heavy advertising and sales promotion costs, then the pricing of the product shall be kept high in
order to recover the cost.
B.External factors
1. Competition:
While fixing the price of the product, the firm needs to study the degree of competition in the
market. If there is high competition, the prices may be kept low to effectively face the
competition, and if competition is low, the prices may be kept high.
2. Consumers:
The marketer should consider various consumer factors while fixing the prices. The consumer
factors that must be considered includes the price sensitivity of the buyer, purchasing power, and
so on.
3. Government control:
Government rules and regulation must be considered while fixing the prices. In certain products,
government may announce administered prices, and therefore the marketer has to consider such
regulation while fixing the prices.
4. Economic conditions:
The marketer may also have to consider the economic condition prevailing in the market while
fixing the prices. At the time of recession, the consumer may have less money to spend, so the
marketer may reduce the prices in order to influence the buying decision of the consumers.
5. Channel intermediaries:
The marketer must consider a number of channel intermediaries and their expectations. The
longer the chain of intermediaries, the higher would be the prices of the goods.

EXTERNAL PRICING METHODS
Psychological pricing
Psychological pricing (also price ending, charm pricing) is a pricing/marketing strategy based on
the theory that certain prices have a psychological impact. Retail prices are often expressed as
"odd prices": a little less than a round number, e.g. sh.1999 or sh. 298. Consumers tend to
perceive “odd prices” as being significantly lower than they actually are, tending to round to the
next lowest monetary unit. Thus, prices such as sh.199 are associated with spending sh.100 rather
than sh.200. The theory that drives this is that lower pricing such as this institutes greater demand
than if consumers were perfectly rational. Psychological pricing is one cause of price points.
Time-based pricing
Time-based pricing is a pricing strategy where the provider of a service or supplier of a
commodity, may vary the price depending on the time-of-day when the service is provided or the
commodity is delivered. The rational background of time-based pricing is expected or observed
change of the supply and demand balance during time. Time-based pricing includes fixed time-of
use rates for electricity and public transport, dynamic pricing reflecting current supply-demand
situation or differentiated offers for delivery of a commodity depending on the date of delivery
(futures contract). Most often time-based pricing refers to a specific practice of a supplier.
Suggested retail price

The manufacturer's suggested retail price (MSRP), list price or recommended retail price (RRP)
of a product is the price at which the manufacturer recommends that the retailersell the product.
The intention was to help to standardize prices among locations. While some stores always sell
at, or below, the suggested retail price, others do so only when items are on sale or
closeout/clearance.
Suggested pricing methods may conflict with competition theory, as they allow prices to be set
higher than would otherwise be the case, potentially negatively affecting consumers. However,
resale price maintenance goes further than this and is illegal in many regions.
Much of the time, stores charge less than the suggested retail price, depending upon the actual
wholesale cost of each item, usually purchased in bulk from the manufacturer, or in smaller
quantities through a distributor.
Suggested prices can also be manipulated to be unreasonably high, allowing retailers to use
deceptive advertising by showing the excessive price and then their actual selling price, implying
to customers that they are getting a bargain. Game shows have long made use of suggested retail
prices both as a game element, in which the contestant must determine the retail price of an item,
or in valuing their prizes.
Additionally, the use of MSRP and SRP has been confused. In certain supply chains, where a
manufacturer sells to a wholesale distributor and the distributor in turn sells to a reseller, the use
of SRP is used to denote suggested reseller price. In that case MSRP is used to convey
manufacturer suggested retail price.

Value-based pricing
Value-based pricing (also value optimized pricing) is a pricing strategy which sets prices
primarily, but not exclusively, on the value, perceived or estimated, to the customer rather than
on the cost of the product or historical prices. Where it is successfully used, it will improve
profitability due to the higher prices without impacting greatly on sales volumes.
The approach is most successful when products are sold based on emotions (fashion), in niche
markets, in shortages (e.g. drinks at open air festival at a hot summer day) or for indispensable
add-ons (e.g. printer cartridges, headsets for cell phones). Goods that are very intensely traded
(e.g. oil and other commodities) or that are sold to highly sophisticated customers in large
markets (e.g. automotive industry) usually are sold using cost-plus pricing.
Penetration pricing
Penetration pricing is a pricing strategy where the price of a product is initially set low to rapidly
reach a wide fraction of the market and initiate word of mouth The strategy works on the
expectation that customers will switch to the new brand because of the lower price. Penetration
pricing is most commonly associated with marketing objectives of enlarging market share and
exploiting economies of scale or experience
Price penetration is most appropriate where:

 Product demand is highly price elastic.
 Substantial economies of scale are available.
 The product is suitable for a mass market (i.e. enough demand).
 The product will face stiff competition soon after introduction.
 There is not enough demand amongst consumers to make price skimming work.
 In industries where standardization is important. The product that achieves high market
penetration often becomes the industry standard (e.g. Microsoft Windows) and other
products, whatever their merits, become marginalized. Standards carry heavy momentum.
The advantages of penetration pricing to the firm are:

 It can result in fast diffusion and adoption. This can achieve high market penetration rates
quickly. This can take the competitors by surprise, not giving them time to react.
 It can create goodwill among the early adopters segment. This can create more trade
through word of mouth.
 It creates cost control and cost reduction pressures from the start, leading to greater
efficiency.
 It discourages the entry of competitors. Low prices act as a barrier to entry
 It can create high stock turnover throughout the distribution channel. This can create
critically important enthusiasm and support in the channel.
 It can be based on marginal cost pricing, which is economically efficient.
The main disadvantage with penetration pricing is that it establishes long term price expectations
for the product, and image preconceptions for the brand and company. This makes it difficult to
eventually raise prices. Some commentators claim that penetration pricing attracts only the
switchers (bargain hunters), and that they will switch away as soon as the price rises. There is
much controversy over whether it is better to raise prices gradually over a period of years (so that
consumers don’t notice), or employ a single large price increase. A common solution to this
problem is to set the initial price at the long term market price, but include an initial discount
coupon .In this way, the perceived price points remain high even though the actual selling price is
low.
Another potential disadvantage is that the low profit margins may not be sustainable long enough
for the strategy to be effective.
INTERNAL PRICING METHODS (TRANSFER PRICING)
COST PLUS PRICING

Cost plus pricing is a cost-based method for setting the prices of goods and services.
Using cost-plus pricing, the selling price is calculated by estimating the cost per unit of a product
and adding an appropriate percentage mark-up.
A primary consideration will be as to what is to be regarded as the cost – full cost, marginal cost,
or opportunity cost.
Cost plus pricing can also be used within a customer contract, where the customer reimburses the
seller for all costs incurred and also pays a negotiated profit in addition to the costs incurred
FULL COST PLUS

Full cost includes a share of overheads and also often includes non-production costs.
Full cost plus pricing is a price-setting method under which you add together the direct material
cost, direct labor cost, selling and administrative costs, and overhead costs for a product, and add
to it a markup percentage (to create a profit margin) in order to derive the price of the product.
The pricing formula is:
Total production costs + Selling and administration costs + Markup

Number of units expected to sell
Advantages of Full Cost plus Pricing

The following are advantages to using the full cost plus pricing method:
 Simple. It is quite easy to derive a product price using this method, since it is based on a
simple formula. Given the use of a standard formula, it can be derived at almost any level of
an organization.
 Likeliness of profits. As long as the budget assumptions used to derive the price turn out to
be correct, a company is very likely going to earn a profit on sales if it uses this method to
calculate prices.

 Justifiable. In cases where the supplier must persuade its customers of the need for a price
increase, the supplier can show that its prices are based on costs, and that those costs have
increased.
Disadvantages of Full Cost plus Pricing

The following are disadvantages of using the full cost plus pricing method:
 Ignores competition. A company may set a product price based on the full cost plus formula
and then be surprised when it finds that competitors are charging substantially different
prices.
 Ignores price elasticity. The company may be pricing too high or too low in comparison to
what buyers are willing to pay. Thus, it either ends up pricing too low and giving away
potential profits, or pricing too high and achieving minor revenues.
 Product cost overruns. Under this method, the engineering department has no incentive to
prudently design a product that has the appropriate feature set and design characteristics for
its target market (see the target costing method). Instead, the department simply designs what
it wants and launches the product.
 Budgeting basis. The pricing formula is based on budget estimates of costs and sales volume,
both of which may be incorrect.
 Too simplistic. The formula is designed to calculate the price of only a single product. If
there are multiple products, then you need to adopt a cost allocation methodology to decide
on which costs are to be assigned to which product.
Evaluation of Full Cost plus Pricing

This method is not acceptable for deriving the price of a product that is to be sold in a
competitive market, for several reasons:
 It does not factor in the prices charged by competitors
 It does not factor in the value of the product to the customer
 It does not give management an option to reduce prices if it wants to gain market share
 It is more difficult to derive if there are multiple products, since the costs in the pricing
formula must now be allocated among multiple product
MARGINAL COST PLUS

The price of the product is determined by calculating the marginal (or incremental) cost of
producing a unit and adding a mark-up.
Marginal cost-plus pricing/ mark- up pricing is a method of determining the sales price by adding
a profit margin on to either marginal cost of production or marginal cost of sales.
Whereas a full cost- plus approach to pricing draws attention to net profit and the net profit
margin, a variable cost-plus approach to pricing draws attention to gross profit and the gross
profit margin, or contribution.

Advantages of Marginal cost plus pricing
 It is a simple and easy method to use.
 The mark-up percentage can be varied, and so mark- up pricing can be adjusted to reflect
demand conditions.
 It draws management attention to contribution and the effects of higher or lower sales
volumes on profit. In this way, it helps to create better awareness of the concepts and
implications of marginal costing and cost –volume-profit analysis. For example, if a product
costs Sh. 10 per unit and a mark –up of 150 % is added to reach a price of Sh.25 per unit,
management should be clearly aware that every additional Rs.1 of sales revenue would add 60
pence to contribution and profit.
 In practice, mark-up pricing is used in businesses where there is a readily identifiable basic
variable cost. Retail industries are the most obvious example, and it is quite common for the
prices of goods in shops to be fixed by adding a mark- up (20% or 33.3%,say ) to the
purchase cost
Disadvantages of Marginal cost plus pricing
 Although the size of the mark-up can be varied in accordance with demand conditions, it does
not ensure that sufficient attention is paid to demand conditions, competitors’ prices and
profit maximization.
 It ignores fixed overheads in the pricing decision, but the sales price must be sufficiently high
to ensure that a profit is made after covering fixed costs
Opportunity cost plus

This is a marginal cost approach but also includes within the cost any opportunities foregone. It is
a relevant costing approach.
ILLUSTRATION
A new product is being launched, and the following costs have been estimated:
Materials Sh.10 per unit

Labour Sh.8 per unit
Variable overheads Sh.5 per unit
Fixed overheads have been estimated to be Sh.50, 000 per year, and the budgeted production is
10,000 units per year.
Calculate the selling price based on:
(a) Full cost plus 20%
(b) Marginal cost plus 40%

SOLUTION
a) Full cost plus 20%
Sh.
Materials 10
Labour 8
Variable o/h 5
Fixed o/h (50,000 ÷ 10,000) 5
Full cost 28
Profit 5.60
Selling price 33.60
b) Marginal cost plus 40%

Sh.
Materials 10
Labour 8
Variable o/h 5
Marginal cost 23
Profit 9.20
Selling price 32.20
OPTIMAL PRICING – TABULAR APPROACH

One major disadvantage of a cost plus approach to pricing is that it completely ignores the
possible effect of the selling price on the level of demand.
For many products (but not all) it is the case that a higher selling price will result in lower
demand, and vice versa.
It could therefore be worthwhile to reduce the selling price and sell more – provided of course
that this resulted in a higher total profit.
ILLUSTRATION
Tamim ltd. has established that the price demand relationship is as follows:
Selling price per Demand
unit
16 100
15.5 200
15 300
14.5 400
14 500
13.5 600
13 700
They have also established that the cost per unit for production of jars of coffee is as follows:

Quantity Cost per unit
100 14.0
200 13.9
300 13.8
400 13.7
500 13.6
600 13.5
700 13.4
800 13.3
900 13.2
Required;-
Determine the optimal selling price in order to maximise profit
SOLUTION
Selling Demand Cost Total Total Total Marginal Marginal
price per Revenue cost profit Revenue Cost
per unit unit
16 100 14.0 1,600 1,400 200 1,600 1,400
15.5 200 13.9 3,100 2,780 20 1,500 1,380
15 300 13.8 4,500 4,140 360 1,400 1,360
14.5 400 13.7 5,800 5,480 320 1,300 1,340
14 500 13.6 7,000 6,800 200 1,200 1,320
13.5 600 13.5 8,100 8,100 - 1,100 1,300
13 700 13.4 9,100 9,380 (280) 1,000 1,280
TRANSFER PRICING
A transfer price is the price at which goods or services are transferred from one department to
another or from one member of a group to another.
Where there are transfers of goods or services between divisions of a divisionalised organization,
the transfers could be made 'free' or 'as a favor' to the division receiving the benefit. For example,
if a garage and car showroom has two divisions, one for car repairs and servicing and the other
for car sales, the servicing division will be required to service cars before they are sold and
delivered to customers.
There is no requirement for this service work to be charged for: the servicing division could do
its work for the car sales division without making any record of the work done.
Unless the cost or value of such work is recorded, however, management cannot keep a proper
check on the amount of resources like labour time) being used up on new car servicing. It is
necessary for control purposes that some record of the inter-divisional services should be kept,
and one way of doing this is through the accounting system. Inter-divisional work can be given a
cost or charge: a transfer price.
Criteria for designing a transfer pricing policy
Transfer prices are a way of promoting divisional autonomy, ideally without prejudicing
divisional performance measurement or discouraging overall corporate profit maximization (goal
congruence).
When transfer pricing is required

It is necessary for control purposes that some record of the market in inter-divisional goods or
services should be kept. One way, of doing this is through the accounting system. Inter-divisional
work can be given a cost or a charge a transfer price.
Divisional autonomy
Transfer prices are particularly appropriate for profit centers because if one profit centre does
work for another the size of the transfer price will affect the costs of one profit centre and the
revenues of another.
However, a danger with profit centre accounting is that the business organization will divide into
a number of self-interested segments, each acting at times against the wishes and interests of
other segments. A profit centre manager might take decisions in the best interests of his own part
of the business, but against the best interests of other profit centers and possibly the organization
as a whole.
A task of head office is therefore to try to prevent dysfunctional decision making by individual
profit centres. To do this, it must reserve some power and authority for itself and so profit centres
cannot be allowed to make entirely autonomous decisions.
Just how much authority head office decides to keep for itself will vary according to individual
circumstances. A balance ought to be kept between divisional autonomy to provide incentives
and motivation, and retaining centralized authority to ensure that the organization’s profit centres
are all working towards the same target, the benefit of the organization as a whole (in other
words, retaining goal congruence among the organization’s separate divisions).
Divisional performance measurement

Profit centre managers tend to put their own profit performance above everything else. Since
profit centre performance is measured according to the profit they earn, no profit centre will want
to do work for another and incur costs without being paid for it. Consequently, profit centre
managers are likely to dispute the size of transfer prices with each other, or disagree about
whether one profit centre should do work for another or not. Transfer prices affect behaviour and
decisions by profit centre managers.
Corporate profit maximization (goal congruence)

When there are disagreements about how much work should be transferred between divisions,
and how many sales the division should make to the external market, there is presumably a
profit-maximizing level of output and sales for the organization as a whole. However, unless
each profit centre also maximizes its own profit at this same level of output, there will be inter-
divisional disagreements about output levels and the profit-maximizing output will not be
achieved.
The ideal solution

Ideally a transfer price should be set at a level that overcomes these problems.
a) The transfer price should provide an 'artificial' selling price that enables the transferring
division to earn a return for its efforts, and the receiving division to incur a cost for benefits
received.
b) The transfer price should be set at a level that enables profit centre performance to be
measured ‘commercially’ (that is, it should be a fair commercial price).
c) The transfer price, if possible, should encourage profit centre managers to agree on the
amount of goods and services to be transferred, which will also be at a level that is consistent
with the organization’s aims as a whole such as maximizing company profits.
In practice it is very difficult to achieve all three aims.
The ‘general rule’

We shall see eventually that the ideal transfer price should reflect the opportunity cost of sale to
the supplying division and the opportunity cost to the buying division. However, this 'general
rule' needs to be measured against the three criteria we looked at in the previous
section. When setting a transfer price, management must always seek to reconcile the three
criteria of goal congruence, managerial effort, and divisional autonomy simultaneously. As we
work through the different methods of transfer pricing we will consider how each method meets
the three criteria
Objectives of transfer pricing

Transfer price should be set in a manner which should help to fulfill the three objectives
1. Goal congruence /harmony – Price should be set with the objective of maximizing divisional
profit as well as company’s profit that is should discourage sub-optimal decision
2. Performance appraisal – it should enable reliable assessment to be made on divisional
performance
3. Divisional autonomy/ independence –Transfer price should seek to maintain maximum
divisional independent so that the benefit of decentralization can be achieved
Methods of determining transfer price

Economic theory suggest that profits are maximized where MC=MR
Optimal transfer price will be the price where MC of the selling division equals MR of the
buying division. However, because of information imperfection, transfer price in practice does
not follow economic theory and therefore the following methods are used;-
Market Based Transfer Price

Where there is market for intermediate product, it is optimal for both decision making and
optimal performance evaluation to set transfer price at competitive market price
The selling division would therefore be indifferent on selling externally or transferring the
product to the other division since the price is the same
Market price will give the manager freedom to negotiate the price which the other division
(buying) will pay treating both as speared entities
Transfer prices may be based on market price (or an adjusted market price) where there is an
external market for the item being transferred.
ILLUSTRATION 1
Transferring Goods At Market Value

A company has two profit centres, A and B. Centre A sells half of its output on the open market and
transfers the other half to B. Costs and external revenues in an accounting period as follows:
A B Total
Shs Shs Shs
External sales 8,000 24,000 32,000
Cost of production 12,000 10,000 22,000
Company profits 10,000
Required;-
What are the consequences of setting a transfer price at market value?
SOLUTION
If the transfer price is at market price, A would be happy to sell the output to B for shs.8, 000,
which, is what A would get by selling it externally instead of transferring it.
A B Total
Shs Shs Shs Shs Shs
Market sales 8,000 24,000
Transfer sales 8,000 -
16,000 24,000 32,000
Transfer costs - 8,000
Own costs 12,000 10,000 22,000
12,000 18,000
Profit 4,000 6,000 10,000
The consequences, therefore, are as follows:
a) A earns the same- profit on transfers as on external sales. B must pay a commercial price for
transferred goods, and both divisions will have their; profit measured fairly.
b) A will be indifferent about selling externally or transferring-goods to B because the profit is the
same on both types of transaction. B can therefore ask for and obtain as many units as it wants
from A.
A market-based transfer price therefore seems to be the ideal transfer price.

Adjusted market price
However, internal transfers are often cheaper than external sales, with savings in selling and
administration costs, bad debt risks and possibly transport/delivery costs. It would therefore seem
reasonable for the buying division to expect a discount on the external market price.
The transfer price might be slightly less than market price, so that A and B could share the cost
savings from internal transfers compared with external sales. It should be possible to reach
agreement on this price and on output levels with a minimum of intervention from head office.
The merits of market value transfer prices

Divisional autonomy
In a decentralized company, divisional managers should have the autonomy to make output,
selling and buying decisions, which appear to be in the best interests of the division's
performance. (If every division optimizes its performance, the company as a whole must
inevitably achieve optimal results.) Thus a transferor division should be given the freedom to sell
output on the open market, rather than to transfer it within the company.
'Arm's length' transfer prices, which give profit centre managers the freedom to negotiate prices
with other profit centres as though they were independent companies, will tend to result in a
market-based transfer price
Corporate profit maximization

In most cases where the transfer price is at market price, internal transfers should be expected,
because the buying division is likely to benefit from a better quality of service, greater flexibility,
and dependability of supply. Both divisions may benefit from cheaper costs of administration,
selling and transport. A market price as the transfer price would therefore result in decisions,
which would be in the best interests of the company or group as a whole.
Divisional performance measurement

Where a market price exists, but the transfer price is a different amount (say, at standard cost
plus), divisional managers will argue about the volume of internal transfers.
The disadvantages of market value transfer prices

Market value as a transfer price does have certain disadvantages.
a) The market price may be a temporary one, induced by adverse economic conditions, or
dumping, or the market price might depend on the volume of output supplied to the external
market by the profit centre.
b) A transfer price at market value might, under some circumstances, act as a disincentive to
use up any spare capacity in the divisions. A price based on incremental cost, in contrast,
might provide an incentive to use up the spare resources in order to provide a marginal
contribution to profit.
c) Many products do not have an equivalent market price so that the price of a similar, but not
identical, product might have to be chosen. In such circumstances, the option to sell or buy
on the open market does not really exist.
d) The external market for the transferred item might be imperfect, so that if the transferring
division wanted to sell more externally, it would have to reduce its price.
Cost Based Transfer Price

Cost-based approaches to transfer pricing are often used in practice, because in practice the
following conditions are common.
a) There is no external market for the product that is being transferred.
b) Alternatively, although there is an external market it is an imperfect one because the market
price is affected by such factors as the amount that the company setting the transfer price
supplies to it, or because there is only a limited external demand.
In either case there will not be a suitable market price upon which to base the transfer price.
When a transfer price is based on cost, standard cost should be used, not actual cost.
These are the commonly used methods because conditions for setting ideal market price may not
exist
1. Full cost transfer price

Under this approach, the full cost (including fixed overheads absorbed) incurred by the supplying
division in making the 'intermediate' product is charged to the receiving division. An intermediate
product is one that is used as a component of another product, for example car headlights or food
additives.
This involves production cost and functional such as administration and selling cost
All these are included in the transfer price. The product is transferred at this cost, the problem
being that the transferring division does not make profit
2. Full cost plus transfer price

Transfer price is determined by adding profit markup / margin to full cost incurred
If a full cost plus approach is used a profit margin is also included in this transfer price.
ILLUSTRATION 2
Example: Transfers at Full Cost (Plus)
Consider the illustration 1above but with the additional complication of imperfect intermediate and
final markets. A company has 2 profit centres, A and B. Centre A can only sell half of its maximum
output externally because of limited demand. It transfers the other half of its output to B, which also
faces limited demand. Costs and revenues, in an-accounting period are as follows.
A B Total
Shs Shs Shs
External sales 8,000 24,000 32,000
Cost of production in the 12,000 10,000 22,000
division 10,000
Company profits

There are no opening or closing, inventories. It does not matter here whether marginal or absorption
costing is used and we shall ignore the question of whether the current output levels are profit
maximizing and congruent with the goals of the company as a whole.
Transfer Price at Full Cost Only

If the transfer price is at full cost, A in our example would have 'sales' to B of Shs 6,000 (costs of
Shs12,000 ×50%). This would be a cost to B, as follows;-
A B Company as a
whole
Shs Shs Shs Shs Shs
Open Market sales 8,000 24,000 32,000
Transfer sales 6,000 _____
Total sales, with transfers 14,000 24,000
Own costs 12,000 10,000 22,000
Total costs, with transfers 12,000 16,000 _____
Profit 2,000 8,000 10,000
The transfer sales of A are self-cancelling with the transfer costs of B so that total profits are
unaffected by the transfer items. The transfer price simply spreads the total profit of $10,000
between A and B.
The obvious drawback to the transfer price at cost is that A makes no profit on its-work, and the
manager of division A would much prefer to sell output on the open market to earn a profit, rather
than transfer to B, regardless of whether or not transfers to B would be in the best interests of the
company as a whole.
Division A needs a profit on its transfers in.orderto.be motivated to supply B; therefore transfer
pricing at cost is inconsistent with the use of a profit centre accounting system.
Transfer Price At Full Cost Plus

If the transfers are at cost plus a margin of, say, 25%, A's sales to B would be Shs 7,500 (Sh12,000
×50%×1.25).
A B Total
Shs Shs Shs Shs Shs
Open market sales 8,000 24,000 32,000
Transfer sales 7,500 _____
15,500 24,000
Own costs 12,000 12,000 10,000 17,500 22,000
Profit 3,500 6,500 10,000

Compared to a transfer price at cost, A gains some profit at the expense of B. However, A makes a
bigger profit on external sales in this case because the profit mark-up of 25% is less than the profit
mark-up on-open market sales. The choice of 25% as a profit mark-up was arbitrary and unrelated
to external market conditions.
Divisional autonomy, divisional performance measurement and corporate profit

maximization
In the above case the transfer price fails on all three criteria for judgments.
a) Arguably, it does not give A fair revenue or charge B a reasonable cost, and so their profit
performance is distorted. It would certainly be unfair, for example, to compare A's profit with
B's profit.
b) Given this unfairness it is likely that the autonomy of each of the divisional managers is under
threat. If they cannot agree on what is a fair split of the external profit a decision will have to
be imposed from above.
c) It would seem to give A an incentive to sell more goods externally and transfer less to B.
Thismay or may not be in the best interests of the company as a whole.
Variable Cost/ Marginal Cost Transfer Price

This involves changing variable costs that have been incurred by the supplying division i.e.
transfer price is at variable cost
The problem is that the transferring division does not cover the fixed cost
A marginal cost approach entails charging the marginal cost that has been incurred by the supplying
division to the receiving division.
ILLUSTRATION 3
Variable Cost/ Marginal Cost Transfer Price
As above, we shall suppose that A's cost per unit is Shs 15, of which Shs 6 is fixed and Shs 9
variable.
A B Company as a
whole
Shs Shs Shs Shs Shs Shs
Market sales 8,000 24,000 32,000
Transfer sales (Sh 6,000 x 9/5) 3,600 _____
11,600 24,000
Transfer costs - 3,600 13,200
Own variable costs 7,200 6,000 8,800
Own fixed costs 4,800 4,000
Total costs and transfers 12,000 13,600 22,000
(Loss)/Profit (400) 10,400 10,000

Divisional autonomy, divisional performance measurement and corporate profit
maximization.
a) This result is deeply unsatisfactory for the manager of division A who could make an
additional Shs. 4,400 (Shs (8,000 - 3,600)) profit if no goods were transferred to division B.
b) Given that the manager of division A would prefer to transfer externally, head office are likely
to have to insist that internal transfers are made.
c) For the company overall, external transfers only would cause a large fall in profit, because
division B could make no sales at all.
The problem is that with a transfer price at marginal cost the supplying division does not cover its
fixed costs.
Negotiated transfer price

Transfer price is set through the process of negotiations between the buying and selling divisions
This may result in a transfer price which is of best interest of the company and acceptance to all
parties concerned.
In practice, negotiated transfer prices, market-based transfer prices and full cost-based transfer
prices are the methods normally used.
A transfer price based on opportunity cost is often difficult to identify, for lack of suitable
information about costs and revenues in individual divisions. In this case it is likely that transfer
prices will be set by means of negotiation. The agreed price may be finalized from a mixture of
accounting arithmetic, politics and compromise.
The process of negotiation will be improved if adequate information about each division's costs
and revenues is made available to the other division involved in the negotiation. By having a free
flow of cost and revenue information, it will be easier for divisional managers to identify
opportunities for improving profits, to the benefit of both divisions involved in the transfer.
A negotiating system that might enable goal congruent plans to be agreed between profit centres
is:
a) Profit centres submit plans for output and sales to head office, as a preliminary step in
preparing the annual budget.
b) Head office reviews these plans, together with any other information it may obtain.
Amendments to divisional plans might be discussed with the divisional managers.
c) Once divisional plans are acceptable to head office and consistent with each other, head office
might let the divisional managers arrange budgeted transfers and transfer prices.
d) Where divisional plans are inconsistent with each other, head office might try to establish a
plan that would maximize the profits of the company as a whole. Divisional managers would
then be asked to negotiate budgeted transfers and transfer prices on this basis.
e) If divisional managers fail to agree a transfer price between them, a head office 'arbitration'
manager or team would be referred to for an opinion or a decision.
f) Divisions finalize their budgets within the framework of agreed transfer prices and resource
constraints.
g) Head office monitors the profit performance of each division.
Limitations of negotiated transfer price.

1) The intermediate product may not have market price which forms the basis of negotiated price
2) It may crate divisional conflicts during the process of negotiation.
3) It may not encourage divisional autonomy since divisions may not make independent
decisions.
ILLUSTRATION 4
Multi calls ltd. Operates two divisions namely, A and B Division. A produces an intermediate
product x that has no external market. The product is then transferred to division B where it is
used as it is used as an input in the production of product Z.
The following information relates to the demand schedule of product z.

Quantity sold Selling prices
(units) Sh.
1,000 120
2,000 110
3,000 100
4,000 90
5,000 80
6,000 70
7,000 60
Divisional costs are as shown in the table below;

Divisional cost
A B
Sh. Sh.
Variable cost per unit 15 10
Fixed costs attributable to the products 70,000 100,000
1. Product x is transferred to division at sh. 35 per unit.
2. Assume that production of both x and z is in batches of 1,000 units.
Required;-
i) The profit maximizing output level for division B at the current transfer price.

ii) The optimal output level for the overall company given that the variable cost of division
A is sh. 11per unit.
SOLUTION
Division A
Quantity T. price V. cost Cont. Total cost
1,000 35 15 20 20,000
2,000 35 15 20 40,000
3,000 35 15 20 60,000
4,000 35 15 20 80,000
5,000 35 15 20 100
6,000 35 15 20 120,000
(7,000) 35 15 20 (140,000)
Division B
1,000 120 (10+35)=45 75 75,000
2,000 110 (10+35)=45 65 130,000
3,000 100 (10+45)=45 55 165,000
(4,000) (90) (10+45)=45 45 (180,000)
5,000 80 (10+45)=45 35 175,000
6,000 70 (10+45)=45 25 150,000
7,000 60 (10+45)=45 15 105,000
Whole company (multi-calls limited)

1,000 120 25 95 95,000
2,000 110 25 85 170,000
3,000 100 25 75 225,000
4,000 90 25 65 260,000
(5,000) (80) 25 5 (275,000)
6,000 70 25 45 270,000
7,000 60 25 35 245,000
NOTE:
From the company’s perspective transfer price is irrelevant. For the transferring division A , it is
a revenue while a cost to the receiving division B
For performance evaluation the objective of division’s B manager is to maximize profit and
therefore would select a selling price of sh. 90 selling 4000 units. However, this leads to sub-
optimal decision from the company’s perspective as the company will make a contribution of sh.
260,000 as follows:-

Division A 80,000
Division B 180,000
Divisional profits 260,000
Less: Optimal profit (275,000)
Shortfall / deficit (15,000)
This means the transfer price is not optimal as there is lack of goal congruence
Transfer Pricing With Capacity Constraints

With idle capacity
The division will not give up any outside sales (eternal demand) so that it can transfer goods to
other division.
The acceptable transfer price should cover variable cost and earn the manufacturing division
some contribution
However the transfer price should not exceed the external supplier’s price being offered
At full capacity
For the division to be able to transfer goods it will give up sales to external customers since the
capacity is not enough.
Acceptable transfer price should cover the variable cost plus the contribution lost from external
sales but should not exceed the external price offered by external supplier
Transfer pricing when intermediate products are in short supply
When an intermediate resource is in short supply and acts as a limiting factor on production in
the supplying division, the cost of transferring an item is the variable cost of production plus the
contribution obtainable from using the scarce resource in its next most profitable way.
ILLUSTRATION
Scarce Resources
Suppose, for example, that division A is a profit centre that produces three items, X, Y and Z. Each
item has an external market.
X Y Z
External market price, per unit Shs 48 Shs 46 Shs 40
Variable Cost of production in division A Shs 33 Shs 24 Shs 28
Labour hours-required per unit In division A 3 4 2
Product Y can be transferred to division B, but the maximum quantity that might be required for
transfer is 300 units of Y.
The maximum-external sales are 800 units of X, 500 units of Y and 300 units of Z.
Instead of receiving transfers of product Y from division A, division B could buy similar units of
product Y on the open-market at a slightly cheaper price of Shs 45 per unit.
What should the transfer price be for each unit if the total labour hours available in division A are
3,800 hours or 5,600 hours?
SOLUTION
Hours required meeting maximum demand
External sales Hours
X(3×800) 2,400
Y (4×500) 2,000
Z (2×300) 600
5,000
Transfers of Y (4 ×300) 1,200
6,200
Contribution from external sales:

X Y Z
Contribution per unit Shs. 15 Shs. 22 Shs. 12
Labour hours per unit 3 hrs 4 hrs 2 hrs
Contribution per labour hour Sh 5.00 Sh 5.50 Sh 6.00
Priority for selling 3rd 2nd 1st
Total-.hours needed. 2,400 2,000 600
a) If only 3,800 hours of labour are available, division A would choose, ignoring transfers to B, to
sell:
Hours
300 Z (maximum) 600
500 Y (maximum) 2,000
2,600
400 X (balance) 1,200
3,800
To transfer 300 units of Y to division B would involve forgoing the sale of 400 units of X because
1,200 hours would be needed to make the transferred units.
Opportunity cost of transferring-.units of Y, and the appropriate transfer price:
Shs per unit
Variable cost of making Y 24
Opportunity cost (contribution of Shs 5 per hour available from
selling T externally): benefit forgone (4 hours x Shs.5). 20
Transfer price for Y. 44

The transfer price for Y should, in this case, be less than-the external market price.
b) If 5,600 hours are available, there is enough time to meet the full demand for external sales (5,000)
and still-have 600hours:of spare capacity, before consideration of transfers. However, 1,200 hours
are needed to produce- the full amount of Y for transfer: (300: units), and so 600 hours need to be
devoted to producing Y for transfer instead .of producing: X for external sale.
This means that the opportunity cost of transfer is:
i) The variable cost of 150 Units of Y produced in the 600 'spare' hours (Shs 24/unit);
ii) The variable cost of production of the remaining. 150 units of Y (Shs 24 per unit), plus the
contribution forgone from the external sales of X that could have been produced in the 600
hours now devoted- to producing Y for transfer (Shs. 5 per labour hour). An average transfer
price per unit could be negotiated for the transfer of the full 300 units- (see below), which
works out at Shs. 34 per unit.
Shs
150 units × Shs 24 3,600
150 units × Shs 24 3,600
600 hours × Shs 5 per hour 3,000
Total for 300 units 10,200
In both cases, the opportunity-cost of receiving transfers for division B is the price it would have
to pay to" purchase Y externally- Shs 45 per unit Thus:
Maximum labour Opportunity cost Opportunity cost

hours in A to A of transfer to B of transfer
Shs Shs
3,800 44 45
5,600 34 (average) 45
In each case any price between the two opportunity costs would be sufficient to persuade B to order
300 units of Y from division A and for division A to agree to transfer them.
Optional transfer pricing using economic theory

The optional transfer price will be the price where marginal cost of selling divisions equals
marginal revenue of buying divisions.
Therefore, profits are maximized where marginal cost (MC) = marginal revenue (MR).
Where MC  dC i.e. change in cost as per change in quantity of each unit and MR 
dR
i.e.
dQ dQ
change in revenue as per change in quantity of each unit.
Note: MC & MR are first order conditions derivatives, therefore the prove their optimality, a
second order condition is derived as follows:

Second order condition
d 2C d 2R
MC  MR 
dQ 2 dQ2
ILLUSTRATION
ABC Ltd is a manufacturing company located in Mombasa. The company comprises two
departments. Namely M and N. Department M produces X which is sold to external customers as
a final product and also used as an input in department N which produces Y.
The external demand forecast for the two products for the months of July 2009 is as follows;-
Product External demand Unit selling

forecast price
X Shs. Shs.
Y 2,000 40
1,000 100
Additional information;
1. Each unit of product Y produced requires 1 unit of product X as input. There is 40 units
change in demand of product X for every shs. 1 change in its selling price.
2. The marginal cost of producing product YX is shs. 20 while that of producing product Y is
shs. 25 exclusive of the transfer cost of product X.
3. Departmental Managers are paid in an incentive bonus based on each department’s respective
performance.
Required;
a) The unit selling price and output of products X and Y that should maximize the profit of the
company.
b) The unit selling price and output of products X and Y that would maximize the profit of the
company given that product X is transferred to department N at the market price.
SOLUTION
Dept M Dept N Customers

x y
P = 200 – 0.1y
External mkt
P= 90 – 0.025x

Department M producing and selling X
P = a + bx
 p 1
b   0.025
 x  40
DD forecast
40 = a – 0.025 (2 000)
40= a + -50
a = 90
 P = 90 – 0.025 z

MC = MR
Where TR = Px
= (90 – 0.025x)x
= 90 x – 0.025x2
MR = 90 – 0.05x
MC = 20
20 = 90 – 0.05x
0.05x = 70
Output X = 1 400 units
P = 90 – 0.025 (1 400) = sh. 55
Department N producing and selling y from x

Ignore transfer price
Demand function
P = a + by
p 1
b   0.1
 y  10
DD forecast
100 = a – 0.1 (1 000)
100 + a – 100
a + 200
 P = 200 – 0.1 y

MC = MR
Where TR = PY
= (200 – 0.1y)y
= 200y – 0.1y2
 MR = 200 – 0.2y
MC = 20 + 25 = 45
200 – 0.2 y = 45
0.2y = 155
Output Y = 775 units
P = 200 – 0.1 (775)

P = 200 – 77.5
Price (P) = shs.122.5
Summary of output
Department M = 1 400
Department N = 775 units
Summary of contribution for whole company

Contribution = revenue – V. cost
Product x sold externally
= (90 x – 0.025x2) – 20x
= 70x – 0.025x2
Where x = 1 400
= 70 (1 400) – 0.025 (1 4002)

= sh. 49 000
Product y (from x)
Contribution = 200y – 0.1y2) – 45y

= 155y – 0.1y2
= 155 (775) – 0.1 (7752)
= 60062.5
Total contribution= 49 000 + 60062.5

= 109,062.5
b) Note: The demand function for product x is based on external demand for intermediate
Product x the internal demand by Department N.
Marginal cost (MC) in department N for y using x
MC = 25 + Transfer price(T.P) (unknown)

i.e. MC = 25 + P
MR for product y
MR = 200 – 0.2y
 MC = MR
25 + P = 200 – 0.2y
0.2y = 200 – 25 – P
175  P
y
0.2
Y = 875 – 5P  internal demand for x
 Rewritten as x = 875 – 5P
External demand for x

DD function
P = 90 – 0.025x
= 90 – 0.025x
Make x the subject
90 – P = 0.025x
90  P
x
0.025
x = 3 600 – 40P (external demand for x)
 Total demand = internal dd + external dd
= (875 – 5P) + (3 600 – 40P)

x = 4 475 – 45 P (total dd)
Profit maximizing output is where MC = MR
Where MC = 20 and MR = dR and R = Px

dQ
DD function; P = a + bx
x = 4,475 – 45P
P the subject

45P = 4 475 – x
4475  x
P=
45
P = 99.4 – 0.02x
MR = 99.4 – 0.04x
MC = 20
20 = 99.4 – 0.04x
x = 1 805 units
P = 99.4 – 0.022 (1 805)
Sh. 60 (market price)
Recall product x was to be transferred at market price, therefore at this price, dept N will
determine its optimal output as follows:
MC = 25 + P
= 25 + 60 = sh. 85
MR = 200 – 0.2y
85 = 200 – 0.2y
0.2y = 115
y = 575 units
Selling price of y
P = 200 – 0.1y
= 200 – 0.1 (575)
= sh. 142.5
Summary
Dept M x = 575 units Dept N Customers

(1805 units 575 units @ 142.5
External market
1,805 – 575
= 1,230 units @ 60

Summary of profits
Product x = (60 – 20) 1,230 = 49,200

Y = (142.5 – 45) 575 = 560,621.5
105,262.5
BACK FLUSH ACCOUNTING

Back-flush accounting is a costing short-cut. It relies on businesses having immaterial amounts of
work-in-progress and it is therefore particularly suitable for businesses operating just-in-time
inventory management. If the amount of work-in-progress is negligible, what is the point in
meticulously valuing it? Fretting that some products might be 25% complete and others 60%
complete, and then adding carefully calculated labour and overheads to these (immaterial) items
is a complete waste of time and effort. That type of accounting is perhaps the modern-day
equivalent of alleged ancient arguments about how many angels could dance on the point of a
needle.
In back-flush accounting costs are not associated with units until they are completed or sold.
Back-flush accounting is sometimes called delayed costing, which is a helpful name, as costs are
not allocated to production until after events have occurred.
Standard costs are then used to work backwards to flush out manufacturing costs into production,
splitting them between stocks of finished goods (if any) and cost of sales. No costs, whether
material or conversion costs, are allocated to work-in-progress.
Basically, backflush accounting is when you wait until the manufacture of a product has been
completed, and then record all of the related issuances of inventory from stock that were required
to create the product. This approach has the advantage of avoiding all manual assignments of
costs to products during the various production stages, thereby eliminating a large number of
transactions and the associated clerical labor.
Backflush accounting is entirely automated, with a computer handling all transactions. The
backflushing formula is:
Number of units produced × unit count listed in the bill of materials for each component
= Number of raw material units removed from stock
Backflushing is a theoretically elegant solution to the complexities of assigning costs to products

and relieving inventory, but it is difficult to implement. Backflush accounting is subject to the
following problems:
 Requires an accurate production count. The number of finished goods produced is the
multiplier in the backflush equation, so an incorrect count will relieve an incorrect amount of
components and raw materials from stock.
 Requires an accurate bill of materials. The bill of materials contains a complete itemization
of the components and raw materials used to construct a product. If the items in the bill are
inaccurate, the backflush equation will relieve an incorrect amount of components and raw
materials from stock.
 Requires excellent scrap reporting. There will inevitably be unusual amounts of scrap or
rework in a production process that are not anticipated in a bill of materials. If you do not
separately delete these items from inventory, they will remain in the inventory records, since
the backflush equation does not account for them.
 Requires a fast production cycle time. Backflushing does not remove items from inventory
until after a product has been completed, so the inventory records will remain incomplete
until such time as the backflushing occurs. Thus, a very rapid production cycle time is the
best way to keep this interval as short as possible. Under a backflushing system, there is no
recorded amount of work-in-process inventory.
Backflushing is not suitable for long production processes, since it takes too long for the
inventory records to be reduced after the eventual completion of products. It is also not suitable
for the production of customized products, since this would require the creation of a unique bill
of materials for each item produced.
The cautions raised here do not mean that it is impossible to use backflush accounting. Usually, a
manufacturing planning system allows you to use backflush accounting for just certain products,
so you can run it on a compartmentalized basis. This is useful not just to pilot test the concept,
but also to use it only under those circumstances where it is most likely to succeed. Thus,
backflush accounting can be incorporated into a hybrid system in which multiple methods of
production accounting may be used.
THROUGHPUT COSTING
Throughput accounting has a very direct relationship with decision-making and performance
management. It begins by focusing on what an organisation’s purpose is –its goal – and seeks to
help organisations attain their purpose by increasing their ‘goal units’. The approach can be
applied in both profit-seeking and not-for-profit organisations, provided meaningful goal units
can be identified.
For example, take a not-for profit organisation which performs a medical screening service in
three sequential stages:
1. Take an X-ray.
2. Interpret the result.
3. Recall patients who need further investigation/tell others that all is fine.
The ‘goal unit’ of this organisation will be to progress a person through all three stages.
The number of people who complete all the stages is the organisation’s throughput, and the
organisation should seek to maximise its throughput. However, there will always be a limit to
throughput, and the resource which sets that limit is called the ‘bottleneck resource’.
Adding more detail to the medical screening process above:

Process Time/patient Total hours
(hours) available/week
Take an X-ray 0.25 40
Interpret the result 0.10 20
Recall patients who need further 0.20 30
investigation/tell others that all is fine
You can easily see from this table that the maximum number of patients (goal units) who can be
dealt with in each process is:
X – rays: 40/0.25 = 160
Interpret results: 20/0.10 = 200
Recall etc: 30/0.20 = 150
So, the recall procedure is the bottleneck resource. Throughput and the organization’s
performance cannot be improved until that part of the process can deal with more people.
Therefore, to improve throughput:
1. Ensure there is no idle time in the bottleneck resource, as that will be detrimental to overall
performance (idle time in a non-bottleneck resource is not detrimental to overall
performance).
2. See if less time needs to be spent on the bottleneck activity.
3. Finally, increase the bottleneck resource available.
In the example above, increasing the bottleneck resource or the efficiency with which it is used
might be relatively cheap and easy to do because this is a simple piece of administration whilst
the other stages employ expensive machinery or highly skilled personnel. There is certainly no
point in improving the first two stages if things grind to a halt in the last stage; patients are helped
only when the whole process is completed and they are recalled id necessary.
TARGET COSTING
Target costing is a pricing method used by firms. It is defined as "a cost management tool for
reducing the overall cost of a product over its entire life-cycle with the help of production,
engineering, research and design".
Target costing is a system under which a company plans in advance for the price points, product
costs, and margins that it wants to achieve for a new product. If it cannot manufacture a product
at these planned levels, then it cancels the design project entirely. With target costing, a
management team has a powerful tool for continually monitoring products from the moment they
enter the design phase and onward throughout their product life cycles. It is considered one of the
most important tools for achieving consistent profitability in a manufacturing environment.
The primary steps in the target costing process are:
1. Conduct research. The first step is to review the marketplace in which the company wants to
sell products. The design team needs to determine the set of product features that customers
are most likely to buy, and the amount they will pay for those features. The team must learn
about the perceived value of individual features, in case they later need to determine what
impact there will be on the product price if they drop one or more features. It may be
necessary to later drop a product feature if the team decides that it cannot provide the feature
while still meeting its target cost. At the end of this process, the team has a good idea of the
target price at which it can sell the proposed product with a certain set of features, and how it
must alter the price if it drops some features from the product.
2. Calculate maximum cost. The company provides the design team with a mandated gross
margin that the proposed product must earn. By subtracting the mandated gross margin from
the projected product price, the team can easily determine the maximum target cost that the
product must achieve before it can be allowed into production.
3. Engineer the product. The engineers and procurement personnel on the team now take the
leading role in creating the product. The procurement staff is particularly important if the
product has a high proportion of purchased parts; they must determine component pricing
based on the necessary quality, delivery, and quantity levels expected for the product. They
may also be involved in outsourcing parts, if this results in lower costs. The engineers must
design the product to meet the cost target, which will likely include a number of design
iterations to see which combination of revised features and design considerations results in
the lowest cost.
4. Ongoing activities. Once a product design is finalized and approved, the team is reconstituted
to include fewer designers and more industrial engineers. The team now enters into a new
phase of reducing production costs, which continues for the life of the product. For example,
cost reductions may come from waste reductions in production (known as kaizen costing), or
from planned supplier cost reductions. These ongoing cost reductions yield enough additional
gross margins for the company to further reduce the price of the product over time, in
response to increases in the level of competition.
The design team uses one of the following approaches to more tightly focus its cost reduction
efforts:
 Tied to components. The design team allocates the cost reduction goal among the various
product components. This approach tends to result in incremental cost reductions to the same
components that were used in the last iteration of the product. This approach is commonly
used when a company is simply trying to refresh an existing product with a new version, and
wants to retain the same underlying product structure. The cost reductions achieved through
this approach tend to be relatively low, but also result in a high rate of product success, as
well as a fairly short design period.
 Tied to features. The product team allocates the cost reduction goal among various product
features, which focuses attention away from any product designs that may have been inherited
from the preceding model. This approach tends to achieve more radical cost reductions (and
design changes), but also requires more time to design, and also runs a greater risk of product
failure or at least greater warranty costs.

Of these methods, companies are more likely to use the first approach if they are looking for a
routine upgrade to an existing product, and the second approach if they want to achieve a
significant cost reduction or break away from the existing design.
ILLUSTRATION
Upendo Ltd. are considering whether or not to launch a new product. The sales departments have
determined that a realistic selling price will be Sh.20 per unit.
Packard have a requirement that all products generate a gross profit of 40% of selling price.
Required;-
Calculate the target cost.
SOLUTION
Selling price = Sh.20 per unit.
Target return = 40% of selling price
Target Cost = 100% - 40% = 60%
= 60 % × Sh.20 = Sh.12per unit
ILLUSTRATION
Urembo Ltd. is about to launch a new product on which it requires a pre-tax ROI of 30% per
annum.
Buildings and equipment needed for production will cost sh.5, 000,000.
The expected sales are 40,000 units per annum at a selling price of sh.67.50 per unit.
Required;-
Calculate the target cost.
SOLUTION
Target return = 30% × 5,000,000 = Sh.1, 500,000 per unit.
Expected revenue = 40,000 × Sh.67.50 = Sh.2, 700,000
, , , ,
Target cost = =Sh.30
,
LIFE CYCLE COSTING

The costs involved in making a product, and the sales revenues generated, are likely to be
different at different stages in the life of a product. For example, during the initial development

of the product the costs are likely to be high and the revenue minimal – i.e. the product is likely
to be loss-making.
If costing (and decision based on the costing) were only to be ever done over the short term it
could easily lead to bad decisions.
Life-cycle costing identifies the phases in the life-cycle and attempts to accumulate the costs over
the entire life of the product.
The cost phases of a product can be identified as;-
Phase Examples of types of cost

Design Research, development, design and tooling
Material, labour, overheads, machine set up, inventory, training, production
Manufacture
machine maintenance and depreciation
Operation Distribution, advertising and warranty claims
End of life Environmental clean-up, disposal and decommissioning
There are four principal lessons to be learned from lifecycle costing:

 All costs should be taken into account when working out the cost of a unit and its
profitability.
 Attention to all costs will help to reduce the cost per unit and will help an organisation
achieve its target cost.
 Many costs will be linked. For example, more attention to design can reduce manufacturing
and warranty costs. More attention to training can machine maintenance costs. More attention
to waste disposal during manufacturing can reduce end-of life costs.
 Costs are committed and incurred at very different times. A committed cost is a cost that will
be incurred in the future because of decisions that have already been made. Costs are incurred
only when a resource is used.
ILLUSTRATION
A company is planning a new product. Market research suggests that demand for the product
would last for 5 years. At a selling price of Sh.10.50 per unit they expect to sell 2,000 units in the
first year and 12,000 units in each of the other four years.
The company wishes to achieve a markup of 50% on cost.

It is estimated that the lifetime costs of the product will be as follows:
1. Manufacturing costs – Sh.6.00 per unit
2. Design and development costs - Sh.60, 000
3. End of life costs - Sh.30, 000
Required to:
(a) Calculate the target cost for the product.
(b) Calculate the lifecycle cost per unit and determine whether or not the product is worth
making.
It has been further estimated that if the company were to spend an additional Sh.20,000 on
design, then the manufacturing costs per unit could be reduced.
(c) If the additional amount on design were to be spent, calculate the maximum manufacturing
cost per unit that could be allowed if the company is to achieve the required mark-up.
SOLUTION
(a) Cost (100%) 7.00 plus: Mark-up (50%) 3.50 equals: Selling price (150%) 10.50
Cost (100%) 7.00 + Mark-up (50%) 3.50 = Selling price (150%) 10.50
The target cost is sh.7.00 per unit
(b) Estimated total sales = 2,000 + (4 × 12,000) = 50,000 units

Total lifecycle cost = (50,000 ×6) + 60,000 + 30,000 = sh.390, 000
Lifecycle cost per unit = 390,000 / 50,000 = sh.7.80
This is above the target cost per unit, and therefore it would not be worthwhile making the
product.
(c) The maximum lifecycle cost per unit = the target cost = sh.7.00
The part caused by the design and end of life costs:
(60,000 + 20,000 + 30,000) / 50,000 = sh.2.20
Therefore, the maximum manufacturing cost per unit would have to fall from sh.6.00 to
(sh.7.00 - sh.2.20) = sh.4.80 per unit

TOPIC 9
ENVIRONMENTAL MANAGEMENT ACCOUNTING
INTRODUCTION
Environmental Management Accounting (EMA) is a relatively new tool in environmental
management. Decades ago environmental costs were very low, so it seemed wise to include them
in the overhead account for simplicity and convenience. Recently there has been a steep rise in all
environmental costs, including energy and water prices as well as liabilities. In Europe the
Pollution Prevention Pays program me played a crucial role in the spread of the EMA concept,
while in the United States the high level of potential liabilities pushed companies to better
evaluate their environmental costs. Now, especially transition economies are going through a fast
change that will impose a requirement for more accurate control of production inputs and
outputs.
Environmental costs are no longer a minor cost item that can be pooled together with other costs:
the use of EMA saves money and improves control.
Still, many companies need external help in creating or improving their EMA, as those skills are
not widespread and rarely available internally. EMA has to be tailored to the special needs of the
company rather than be applied as a generic system. The costs and benefits of building such a
system have to be considered and the scope of the EMA properly selected.
DEFINITION
Environmental Management Accounting has no single, universally accepted definition.
According to IFAC’s Statement Management Accounting Concepts, EMA is “the management of
environmental and economic performance through the development and implementation of
appropriate environment-related accounting systems and practices. While this may include
reporting and auditing in some companies, environmental management accounting typically
involves life-cycle costing, full-cost accounting, benefits assessment, and strategic planning for
environmental management.”
A complementary definition is given by the United Nations Expert Working Group on EMA,
which more distinctively highlights both the physical and monetary sides of EMA. This
definition was developed by international consensus of the group members, representing 30+
nations. According to the UN group:
EMA is broadly defined to be the identification, collection, analysis and use of two types of
information for internal decision making:
 physical information on the use, flows and destinies of energy, water and materials
(including wastes) and
 Monetary information on environment-related costs, earnings and savings.

These two definitions highlight the broad types of information organizations typically consider
under EMA, as well as some common EMA data analysis techniques and uses.
The benefits and uses of EMA also are discussed in more detail below.
In the real world, EMA ranges from simple adjustments to existing accounting systems to more
integrated EMA practices that link conventional physical and monetary information systems.
But, regardless of structure and format, it is clear that both MA and EMA share many common
goals. And it is to be hoped that EMA approaches eventually will support the IFAC proposals in
Management Accounting Concepts that, in leading-edge MA, “inattention to environmental or
social concerns are likely to be judged ineffective,” and that “resource use is judged effective if it
optimizes value generation over the long run, with due regards to the externalities associated with
an organization’s activities.”
Types of Information included under EMA

Physical Information under EMA
To assess costs correctly, an organization must collect not only monetary data but also
nonmonetary data on materials use, personnel hours and other cost drivers. EMA places a
particular emphasis on materials and materials-driven costs because: (1) use of energy, water and
materials, as well as the generation of waste and emissions, are directly related to many of the
impacts organizations have on their environments and (2) materials purchase costs are a major
cost driver in many organizations.
Most organizations purchase energy, water and other materials to support their activities. In a
manufacturing setting, some of the purchased material is converted into a final product that is
delivered to customers. Most manufacturing operations also produce waste – materials that were
intended to go into final product but became waste instead because of product design issues,
operating inefficiencies, quality issues, etc. Manufacturing operations also use energy, water and
materials that are never intended to go into the final product but are necessary to manufacture the
product (such as water to rinse out chemical tanks between product batches or fuel use for
transport operations). Many of these materials eventually become waste streams that must be
managed. Non-manufacturing operations (for example, agriculture and livestock, resource
extraction sector, service sector, transport, the public sector) can also use a significant amount of
energy, water and other materials to help run their operations, which, depending on how those
materials are managed, can lead to a significant generation of waste and emissions.
Thus, the most obvious example of materials-related environmental impacts is the generation of
waste and emissions, which can affect the health of both humans and natural ecosystems,
including plants and animals. Air, water or land can end up polluted or even contaminated.
The second broad area of materials-related environmental impact is the potential impact of the
physical products (including by-products and packaging) produced by a manufacturer. These
final products have environmental impacts when they leave the company, for example, when a
product ends up in a landfill at the end of its useful life. Some of the potential environmental
impacts of products can be reduced by changes in product design, such as decreasing the volume
of paper used in packaging or replacing a physical product with an equivalent service, etc. In
many manufacturing plants, most of the materials used become part of a final product rather than
part of waste or emissions. As a result, the potential environmental impact of products is high,
and the potential environmental benefit of product improvements is correspondingly high.
Tracking and reducing the amount of energy, water and materials used by manufacturing, service
and other companies can also have indirect environmental benefits upstream, because the
extraction of almost all raw materials has environmental impacts. For example, activities such as
forestry and the extraction of materials such as coal, oil, natural gas, oil, as well as gold and other
minerals, can have extreme impacts on the environment surrounding extraction sites. These
impacts include not only the pollution and waste generated during extraction operations, but also
the erosion or outright removal of topsoil and vegetation, sedimentation of nearby water bodies
and the disruption of wildlife feeding, reproduction and migration habitat. As well, there are
impacts on the local human populations that depend on the affected ecosystem for food and clean
water. The depletion of non-renewable or slowly renewable natural resources is also a cause for
concern.
To effectively manage and reduce the potential environmental impacts of waste and emissions, as
well as of any physical products, an organization must have accurate data on the amounts and
destinies of all the energy, water and materials used to support its activities. It needs to know
which and how much energy, water and materials are brought in, which become physical
products and which become waste and emissions. This physical accounting information does not
provide all of the data needed for effectively managing all potential environmental impacts, but is
essential information that the accounting function can provide.
Monetary Information under EMA

Monetary environmental management accounting is a sub-system of environmental accounting
that deals only with the financial impacts of environmental performance. It allows management
to better evaluate the monetary aspects of products and projects when making business decisions.
Environmental Management Accounting (EMA) serves business managers in making capital
investment decisions, costing determinations, process/product design decisions, performance
evaluation and a host of other forward-looking business decisions. Thus,EMA has an internal
company-level function and focus, as opposed to being a tool used for reporting environmental
costs to external stakeholders.
It is not bound by strict rules as is financial accounting and allows space for taking into
consideration the special conditions and needs of the company concerned.

ROLE OF ACCOUNTANTS IN ENVIRONMENTAL MANAGEMENT ACCOUNTING
An accountant is a Person who has the requisite skill and experience in establishing and
maintaining accurate financial records for an individual or a business. The duties of an
accountant may include designing and controlling systems of records, auditing books, and
preparing financial statements. An accountant may give tax advice and prepare tax returns.
The following list encompasses the major aspects of environmental accounting which can be
handled by an accountant;-
 Recognising and seeking to mitigate the negative environmental effects of conventional
accounting practices
 Separately identifying environmentally related costs and revenues within the conventional
accounting systems
 Devising new forms of financial and non-financial accounting systems, information systems
and control systems to encourage more environmentally benign management decisions
 Developing new forms of performance measurement, reporting and appraisal for both internal
and external purposes
 Identifying, examining and seeking to rectify areas in which conventional (financial) criteria
and environmental criteria are in conflict
 Experimenting with ways in which, sustainability may be assessed and incorporated into
organisational orthodoxy.
The whole environmental agenda is constantly changing and businesses therefore need to
monitor the situation closely.
Environmental audit
Environmental auditing is exactly what it says: auditing a business to assess its impact on the
environment or the systematic examination of the interactions between any business operation
and its surroundings.
The audit will cover a range of areas and will involve the performance of different types of
testing. The scope of the audit must be determined and this will depend on each individual
organisation.
There are, however, some aspects of the approach to environmental auditing, which are worth
mentioning especially within the European Countries.
 Environmental Impact Assessment (EIAs) are required, under EC directive, for all major
projects which require planning permission and have a material effect on the environment.
The EIA process can be incorporated into any environmental auditing strategy.
 Environmental surveys are a good way of starting the audit process, by looking at the
organisation as a whole in environmental terms. This helps to identify areas for further
development, problems, potential hazards and so forth.

 Environmental SWOT analysis. A ‘strengths, weaknesses, opportunities, threats’ analysis is
useful as the environmental audit strategy is being developed. This can only be done later in
the process, when the organisation has been examined in much more detail.
 Environmental quality management. This is seen as part of TQM (Total Quality
Management) and it should be built in to an environmental management system.
 Eco-audit. The European commission has adopted a proposal for a regulation for a
voluntary community environmental auditing scheme, known as the eco-audit scheme. The
scheme aims to promote improvements in company environmental performance and to
provide the public with information about these improvements. Once registered, a company
will have to comply with certain on-going obligations involving disclosure and audit.
 Eco-labelling. Developed in Germany, this voluntary scheme will indicate those EC
products, which meet the highest environmental standards, probably as the result of an
EQM system. It is suggested that eco-audit must come before an eco-label can be given.
 BS 7750 environmental management systems. BS 7750 also ties in with eco-audits and eco-
labelling and with the quality BSI standard BS 5750. achieving BS 7750 is likely to be a
first step in the eco-audit process.
 Supplier audits, to ensure that goods and services bought in by an organisation meet the
standards applied by that organisation.
Financial reporting
There are no international disclosure requirements relating to environmental matters, so any
disclosures tend to be voluntary unless environmental matters happen to fall under standard
accounting principles (e.g. recognising liabilities).
 In most cases disclosure is descriptive and unquantified
 There is little motivation to produce environmental information and many reasons for not
doing so, including secrecy.
 The main factor seems to be apathy on the part of businesses but more particularly on the part
of shareholders and investors. The information is not demanded, so it is not provided.
Environmental matters may be reported in the accounts of companies in the following areas:
 Contingent liabilities
 Exceptional charges
 Operating and financial review comments
 Profit and capital expenditure forecasts
The voluntary approach contrast with the position in the United States, where the SEC/FASB
accounting standards are obligatory.

USING ENVIRONMENTAL MANAGEMENT ACCOUNTING TO REDUCE COSTS
Companies and managers usually believe that environmental costs are not significant to the
operation of their businesses. However, often it does not occur to them that some production
costs have an environmental component.
For instance, the purchase price of raw materials: the unused portion that is emitted in a waste is
not usually considered an environmentally related cost. These costs tend to be much higher than
initial estimates (when estimates are even performed) and should be controlled and minimized by
the introduction of effective cleaner production initiatives whenever possible. By identifying and
controlling environmental costs, EMA systems can help environmental managers justify these
cleaner production projects, and identify new ways of saving money and improving
environmental performance at the same time.
The systematic use of EMA principles will assist managers in identifying environmental costs
often hidden in a general accounting system. When hidden, it is impossible to know what share
of the costs is related to any particular product or process or is actually environmental. Without
the ability to isolate and separate this portion of the overall cost from that of production, product
pricing will not reflect the true costs of its production.
Polluting products will appear more profitable than they actually are because some of their
production costs are hidden, and they may be sold underpriced. Cleaner products that bear some
of the environmental costs of more polluting products (through the overhead), may have their
profitability underestimated and be overpriced. Since product prices influence demand, the
perceived lower price of polluting products maintains their demand and encourages companies to
continue their production, perhaps even over that of a less polluting product.
Finally, implementing environmental accounting will multiply the benefits gained from other
environmental management tools. Besides the cleaner production assessment, EMA is very
useful for example in evaluating the significance of environmental aspects and impacts and
prioritizing potential action plans during the implementation and operation an environmental
management system (EMS). EMA also relies significantly on physical environmental
information. It therefore requires a close cooperation between the environmental manager and the
management accountant and results in an increased awareness of each other's concerns and
needs.
As a tool, EMA can be used for sound product, process or investment project decision-making.
Thus, an EMA information system will enable businesses to better evaluate the economic
impacts of the environmental performance of their businesses.
1. Product/process related decision-making

Correct costing of products is a pre-condition for making sound business decisions. Accurate
product pricing is needed for strategic decisions regarding the volume and choices of products to
be produced. EMA converts many environmental overhead costs into direct costs and allocates
them to the products that are responsible for their incurrence.

The results of improved costing by EMA may include:
 Different pricing of products as a result of re-calculated costs;
 Re-evaluation of the profit margins of products;
 Phasing-out certain products when the change is dramatic;
 Re-designing processes or products in order to reduce environmental costs;
 Improved housekeeping and monitoring of environmental performance.
The purchase value of materials and processing costs of non-product outputs play an important
role in EMA. They include the cost for buying and processing that portion of production inputs
that goes into the waste or is discarded as scrap such as raw materials, auxiliary materials or
water, energy and the labour cost of processing. These costs are often on an average ten to twelve
times greater than the waste and emissions treatment costs. Savings associated with this category
of environmental costs into project evaluations will make a larger number of cleaner production
projects more profitable.
2. Investment projects and decision-making

Investment project decision-making requires the calculation of different profitability indicators
like net present value (NPV), payback periods (PBP) and internal rates of return (IRR) or benefit-
cost ratios. Recognizing and quantifying environmental costs and benefits is both invaluable and
necessary for calculating the profitability of environment-related projects.
Without these calculations, management may arrive at a false and costly conclusion.
Companies should take into account hidden, contingent and image costs for project appraisals.
The costs recorded in bookkeeping by conventional accounting systems are insufficient to
provide an accurate projection of the profitability and risks of an investment. Many cost items
that may arise from long-term operations or projects must be included in the project appraisal.
These environmental costs have been grouped into five categories as follows:
 Raw materials, utilities, labour and capital costs are conventional costs always considered in
project appraisals and cost accounting, however the environmental portion of these costs, e.g.
non-product raw material costs, are not isolated and recognized as environmental.
 Administrative costs buried in the overhead costs and hidden.
Examples include monitoring, reporting or training costs
 Contingency costs that may or may not be incurred in the future, such as potential clean-up
costs from an accident, compensations or fines: the inherent difficulty in predicting their
likelihood, magnitude or timing often results in their omission from the costing process.
However, these costs very often represent a major business risk for the company.
 Image benefits and costs, often called intangible or “good-will" benefits and costs, arise from
the improved or impaired perception of stakeholders (environmentalists, regulators,
customers, etc.). Changes in these intangible benefits are often not felt until they are impaired.
For example, a bad relationship with regulators may result in prolonged licensing process or
stricter monitoring.

 External costs represent a cost to external stakeholders (communities, customers, etc.) rather
than to the company itself. Most accountants agree that these costs should not be taken
directly into account when making project decisions. The company should be aware,
however, that high levels of external costs may eventually become internalized through
stricter environmental regulation, taxes or fees. A good example of this type of cost would be
costs of environmental degradation (through “acid rain”), due to sulphur dioxide (SO2)
pollution, which later standards strictly regulating SO2 emissions would internalize, as the
costs of purchasing and operating a scrubbing and neutralizing system.
A profitability analysis should be done using appropriate time-lines and indicators that do not
discriminate against long-term savings and benefits.
Net present value and benefit cost ratios are suggested as better investment criteria than simple
paybacks or internal rates of return to reflect real costs and benefits. An accurate analysis of the
investment's sensitivity to environmental costs should also be carried out, which takes into
consideration the impact of input price changes and future changes in the regulatory regime (fees,
fines and penalties). Different scenarios can be examined, also evaluating contingency and
external environmental costs reflecting the joint impact of changing several variables at the same
time.
Thus, EMA is an important tool for integration of environmental considerations into financial
appraisals and decision-making for new investments: environmentally friendly investments will
show increased profitability in the long term if all these factors are included in the model.
Integration of EMA with other environmental management tools

Environmental accounting will produce the most benefits when it is integrated with other
environmental management tools. In particular, EMA will increase the advantages that a
company can gain through the implementation of EMS. Linking EMA with cleaner production
and environmental reporting show the financial gain which can be achieved by applying these
tools, since contingent liabilities represent major environmental, business and financial risks for
companies. EMA is a good supplement for risk management programmes as well.
The TEST project has the major advantage of applying different tools within an integrated
framework. Below is a brief discussion on how the different tools support each other and can be
integrated with EMA.
1. Environmental Management Systems (EMS) according to the ISO standard

The ISO14001 standard requires the evaluation of environmental aspects during the planning
phase of the environmental management system. In ISO 14001 environmental aspects are
“elements of an organization's activities, products and services that can interact with the
environment.” The company shall:
 Identify the aspects which have an impact on the environment and
 Assign a level of significance to each environmental aspect

“When establishing and reviewing its objectives, an organization shall consider the legal and
other requirements, its significant environmental aspects, its technological options and its
financial, operational and business requirements, and the views of interested parties”.
Experience shows that financial implications play a very important role in companies decisions
about significant environmental aspects they choose to tackle first. Measures that will bring
higher savings will most likely be implemented first. By clarifying the environmental cost
structure of a process or of a product, EMA will allow managers to have an accurate
understanding of where to focus to make processes more cost efficient.
When EMA is in place, environmental costs are calculated and traced back to the source of their
generation within the production process. In this way, environmental costs can be associated to
specific environmental aspects, and can provide additional quantitative criteria for the setting of
priorities, targets and objectives within an EMS. Thus, having an EMA system in place will help
managers to effectively implement the EMS.
2. Cleaner production
When cleaner production is combined with an EMA system, significant synergies can be reached.
The optimum time to build up the EMA is just after completing a cleaner-production detailed
analysis, where the input/output analysis and the material flows analysis can provide basic
information on the amount of production inputs physically lost. These data are essential for
assessing the non-product output costs.
A cleaner-production assessment (CPA) can be a major source of data during the design of an
EMA information system: especially in companies that do not have a well-established
management accounting system and environmental controlling system to provide information on
material flows and the costs associated with them. This is especially true for small and medium
sized companies. If neither a CPA nor EMA exists, it is recommended a company perform the
CPA before the EMA, especially if the company does not have accurate data on the process.
Regardless of whether any of these systems have been implemented or assessments performed,
the adoption of an EMA would immediately result in the adoption of tools like CPA to identify
measures to reduce environmental costs on a continual basis.
3. Environmental performance evaluation and sustainability reporting

The calculation of the financial impacts of environmental performance has recently been
introduced within the environmental performance evaluation and reporting.
According to ISO 14031 financial costs and benefits are a sub-group of management
performance indicators. Examples for financial indicators in the standard include: costs that are
associated with environmental aspects of a product or process, return on environmental
investment, savings achieved through reductions in resource usage, prevention of pollution or
waste recycling, etc. While most companies have an estimate of their environmental costs, it is
usually underestimated. Moreover, savings and profitability of waste reduction programmes
cannot be reliably estimated without a proper EMA in place.
An EMA system can separate end-of-pipe costs from prevention costs. It also helps in calculating
the savings gained through the reduced use of raw materials and energy. Without these data from
environmental programmes, companies will continue to think of environmental management as a
strictly non-profit-generating part of business that always costs money. Cleaner production can
save money and thereby increase profits.
With an EMA these savings can be captured and reported.
EMA generated data improves the bargaining power of environmental managers with a
company's top managers and shareholders, to create or obtain funding for environmental
programmes, CP projects and EST investments. It will also provide precise numbers on
environmental costs, when required by external stakeholders. While shareholders are concerned
about their liabilities, external stakeholders (authorities, civil societies, NGOs, etc.) are interested
in seeing the company's efforts toward environmental management supported by substantial
environmental expenditures. Data generated by an EMA will help demonstrate these efforts.
OPPORTUNITIES FOR ENVIRONMENTAL AWARENESS IN MANAGEMENT

ACCOUNTING
Environmental Accounting (EA) is a broad term used in a number of different contexts, such
as:
 assessment and disclosure of environment-related financial information in the context of
financial accounting and reporting;
 assessment and use of environment-related physical and monetary information in the context
of Environmental Management Accounting (EMA);
 estimation of external environmental impacts and costs, often referred to as Full Cost
Accounting (FCA);
 accounting for stocks and flows of natural resources in both physical and monetary terms, that
is, Natural Resource Accounting (NRA);
 aggregation and reporting of organization-level accounting information, natural resource
accounting information and other information for national accounting purposes; and
 Consideration of environment-related physical and monetary information in the broader
context of sustainability accounting.
At the organization level, EA takes place in the context of both management accounting
(assessment of an organization’s expenditures on pollution control equipment; revenues from
recycled materials; annual monetary savings from new energy-efficient equipment) and financial
accounting (evaluation and reporting of the organization’s current environment-related
liabilities). As mentioned in the Foreword to this document, numerous books and guidance
documents have been published on the topic of Environmental Management Accounting.

Guidance documents and requirements regarding the reporting of environmental issues in the
annual accounts and reports of companies are also available.
Just as there are typically many links between an organization’s MA and FA practices and
activities, there are potentially many links between EMA and the inclusion of environment
related information in financial reports. For example, as requirements for environmental content
in financial reports increase, organizations can draw on information originally collected for
internal EMA purposes to help fulfill their external reporting requirements.
There are other types of EA that go beyond the issues typically considered by an organization’s
financial and management accounting functions.
For example, most environmental regulations allow some legal level of pollutant emissions,
which can have an impact on the health of both ecosystems and humans. Because the emissions
are legal, however, the emitting organizations do not have to manage those impacts or pay any
associated costs. Regardless of the level of pollution permitted by law, however, emissions have
detrimental external effects. As most organizations are not the sole contributor to such impacts,
such as the water quality of a river or the quality of air in a city, most organizations do not
estimate their contribution in monetary terms.
While numerous organizations account for and report physical information on their external
environmental impacts (for example, the quantities of different types of pollutant emissions per
year), accounting for and reporting the external economic impacts is much less common. An EA
initiative that attempts to take such external costs into account is often referred to as Full Cost
Accounting (FCA). FCA has been developed mainly as a means of ensuring that business
decisions take full account of an organization’s wider environmental impacts.
At the geographic and geopolitical levels, EA information is collected, typically by government,
to assess the health of a particular ecosystem (such as a watershed), a particular political entity
(such as a nation) or even the entire world. This type of National Environmental Accounting can
include not only aggregated information from individual organizations (for example, total annual
expenditures on environmental remediation by industry and government within a country) and,
possibly, externalities information, but also information provided by Natural Resource
Accounting (NRA). NRA provides information on the stocks and flows, actual and potential uses
and potential value of natural resources such as forestl and, clean water and mineral deposits. For
example, forestland might be valued for purposes such as helping provide a source of clean water
to nearby communities and/or identifying the potential value of the timber on the market.
The management accounting of some organizations that own large amounts of property (timber
companies, oil companies, mining operations, agricultural operations) may actually be a type of
natural resource accounting, for example, a timber company keeping track of its timber stock.
Due to space limitations, this type of physical accounting information is not discussed further in
this document.

There is certainly some overlap among the broad types of EA described above. For example,
national governments may aggregate organization-level information (including EA information)
for national-level statistical accounting. Conversely, the information collected by individual
organizations primarily for statistical reporting to government is potentially quite valuable for
internal management decision making at the organization level. Unfortunately, the communities
that practice organization level accounting do not seem to be well coordinated.

Advanced Management Accounting - Study Text

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Advanced Management Accounting - Study Text

Uploaded by

Copyright:

Available Formats

CERTIFIED PUBLIC ACCOUNTANTS

www.someakenya.com Contact: 0707 737 890 Page 1

14.0 LEARNING OUTCOMES

14.1 Nature of management accounting

14.2 cost estimation and forecasting

14.3 short-term planning and decision-making

14.4 budgetary control and advanced variance analysis

14.5 inventory control decisions

14.6 decision theory

www.someakenya.com Contact: 0707 737 890 Page 2

14.7 performance measurement and evaluation

14.8 Pricing decisions

14.9 Environmental management accounting

14.10 Emerging issues and trends

Revised on: June 2016

www.someakenya.com Contact: 0707 737 890 Page 3

Management Accounting is the process of identification, measurement accumulation, analysis,

VALUE OF INFORMATION IN DECISION MAKING: PERFECT AND IMPERFECT

www.someakenya.com Contact: 0707 737 890 Page 4

The information can be obtained from various sources e.g.

The value of perfect information

CALCULATING THE VALUE OF PERFECT INFORMATION

www.someakenya.com Contact: 0707 737 890 Page 5

Constructing a payoff table

P (Demand of 40) is 25 days ÷ 250 days = 0.1

www.someakenya.com Contact: 0707 737 890 Page 6

The formula for the expected value is EV = Σpx

Haffens payoff as determined above is as follows;-

The expected value associated with each choice is as follows:

www.someakenya.com Contact: 0707 737 890 Page 7

If supply = demand Pay off (profit) Probability Px

Options Demand outcome

www.someakenya.com Contact: 0707 737 890 Page 8

Expected value without perfect information is Shs 800

The value IPI = EV with IPI – EV without IPI

EV is the expected value.

www.someakenya.com Contact: 0707 737 890 Page 9

EV ('Drill') = (sh.190, 000 × 0.1) + (- sh.10, 000× 0.9) = sh.10, 000.

(b) Calculating the Expected Value of profits if the geologist is employed;-

www.someakenya.com Contact: 0707 737 890 Page 10

Working from right to left:

www.someakenya.com Contact: 0707 737 890 Page 11

Oil = 0.704 60 x 0.74 = 42.24

The expected value without perfect information is 4m

www.someakenya.com Contact: 0707 737 890 Page 12

ETHICAL STANDARDS OF MANAGEMENT ACCOUNTANTS

Resolution of Ethical Conflict

www.someakenya.com Contact: 0707 737 890 Page 14

www.someakenya.com Contact: 0707 737 890 Page 15

COST ESTIMATION AND FORECASTING

AN OVERVIEW OF THE METHODS OF COST ESTIMATION AND PREDICTION;

The Goal of Cost Estimation

Where y = total cost

www.someakenya.com Contact: 0707 737 890 Page 16

High Low Method

www.someakenya.com Contact: 0707 737 890 Page 17

No. of units (x) Cost of product

High 450 2,550

Therefore Cost of production y = 300 + 5x

Month Volume of production Production overheads

www.someakenya.com Contact: 0707 737 890 Page 18

∴ Variable cost per unit (b) = = Sh 10

Using the highest production level,