APC309 Strategic Management Accounting - Press No Trims UPDATED APRIL13

Strategic Management
Accounting
Published by
The University of Sunderland
© 2011 The University of Sunderland
First published in 2008. Revised in 2011 by Martin Quinn,
Lecturer in Accounting, Dublin City University Business School.
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Contents
Introduction vi
Unit 1 An introduction to strategic management

accounting 1
Introduction 1
1.1 The decision-making process 2
1.2 Users of management accounting information 4
1.3 The purpose of management accounting 6
1.4 The competitive environment 7
1.5 So what is strategic management accounting? 15
Self-assessment questions 17
Feedback on self-assessment questions 18
Summary 19
Unit 2 Relevant costs for decision making 20

Introduction 20
2.1 Relevant cost 21
2.2 Qualitative factors 23
2.3 Relevant costs in various scenarios 23
Summary 40
Unit 3 Activity-based costing 41

Introduction 41
3.1 Costing products and services 42
3.2 Applying absorption costing techniques 43
3.3 Applying ABC techniques 47
Summary 58
Copyright © 2011 University of Sunderland iii

Unit 4 Pricing decisions 60
Introduction 60
4.1 Economic theory and pricing 61
4.2 The role of cost information in pricing decisions 64
4.3 Short- and long-term pricing 64
4.4 Pricing policies for new products 70
Summary 77
Unit 5 Budgets 78
Introduction 78
5.1 Management control systems 79
5.2 The traditional approach to budgeting 82
5.3 Conflicting roles of budgets 83
5.4 Administering budgets 84
5.5 Preparing budgets 85
5.6 Alternatives to traditional budgeting approaches 99
5.7 Behavioural aspects of budgeting 102
Summary 119
Unit 6 Management control systems and performance

management 120
Introduction 120
6.1 Responsibility centres 121
6.2 Profit and investment centres 124
6.3 Managerial or divisional performance measures? 128
Summary 133
iv Copyright © 2011 University of Sunderland

Unit 7 Standard costing and variance analysis 134
Introduction 134
7.1 What is standard costing? 135
7.2 Variance analysis 139
7.3 Performance measures 152
7.4 The standard cost operating statement 154
7.5 Benefits and drawbacks of standard costing 158
Summary 171
Unit 8 Working capital management 172

Introduction 172
8.1 The meaning of working capital 173
8.2 The working capital cycle 175
8.3 The working capital components 185
Summary 201
Unit 9 Transfer pricing 202

Introduction 202
9.1 Transfer pricing 203
9.2 Transfer pricing methods 203
9.3 Negotiated transfer prices 207
9.4 International transfer pricing 211
Summary 219
References 220
Index 222
Copyright © 2011 University of Sunderland v

Introduction
Every organisation, large or small, has managers. What constitutes the precise
role of a manager is often up for debate, but by and large the work of managers
can be classified in three categories; 1) planning, 2) directing and motivating
and 3) controlling. Planning involves selecting a course of action and planning
how the course of action can be achieved. Directing and motivating means
enabling people to carry out the plans, and controlling implies ensuring the
plan is carried out and modified according to changing circumstances.
Managers need information to assist them to make decisions in all three facets
of their roles outlined above. This is where management accounting comes in.
The function of management accounting is to provide information to managers
to help them make decisions. The management accountant may provide
information of a financial nature (for example, product costs) or non-financial
nature (for example, number of customer complaints), or help non-accountants
in the design of planning and control systems. Information provided can be
highly summarised or detailed, very frequent or infrequent, highly accurate or
best estimate. The one common characteristic of management accounting
information is that it is primarily for internal use by managers.
The information provided through management accounting can be used to

make short-term and longer-term decisions. The term strategic management
accounting is often used to describe that part of management accounting which
is more involved with providing information for the longer-term decision
making and controls of an organisation. Such decisions include planning and
budgeting decisions, pricing, investment as well as designing, implementing and
using management control and performance systems. This learning pack will
help you to appreciate some of the basic techniques used in the realm of
strategic management accounting. Units 1 to 5 introduce the basic techniques
like understanding costs and cost allocations, together with planning and price
setting. Units 6 and 7 address management control and performance manage-
ment issues and techniques. Unit 8 looks at the management of working capital
in an organisation, and finally Unit 9 addresses the somewhat complex issue of
transfer pricing. Combining the learning from these units and the recommended
reading from the core text, you will have a firm grasp of management
accounting as used at the strategic level in organisations.
How to use this pack

The learning pack will take you step by step in a series of carefully planned
units and provides you with learning activities and self-assessment questions
to help you master the subject matter. The pack should help you organise and
carry out your studies in a methodical, logical and effective way, but if you
have your own study preferences you will find it a flexible resource too.
Before you begin using this learning pack, make sure you are familiar with any
advice provided by the University of Sunderland on such things as study skills,
revision techniques or support and how to handle formal assessments.
vi Copyright © 2011 University of Sunderland

If you are on a taught course, it will be up to your tutor to explain how to use
the pack in conjunction with a programme of face-to-face workshops and
seminars – when to read the units, when to tackle the activities and questions,
and so on.
If you are on a self-study course, or studying independently with remote tutor

support, you can use the learning pack in the following way:
■ Scan the whole pack to get a feel for the nature and content of the subject
matter.
■ Plan your overall study schedule so that you allow enough time to complete
all units well before your examinations – in other words, leaving plenty of
time for revision.
■ For each unit, set aside enough time for reading the text, tackling all the
learning activities and self-assessment questions and for the suggested
further reading. Your tutor will advise on how they will plan activities
around these materials and opportunities to network with other students.
Now let’s take a look at the structure and content of the individual units.
Overview of the units

The learning pack breaks the content down into nine units, which vary from
approximately eight to ten hours’ duration each. However, we are not advising
you to study for this sort of time without a break! The units are simply a
convenient way of breaking the syllabus into manageable chunks. Most people
would try to study one unit a week, taking several breaks within each unit. You
will quickly find out what suits you best.
You will see that each unit is divided into sections. It is assumed, for the most
part, that you will study the units in the order presented. What is more
important is that you try to study each section of each unit in the order
presented. Each unit is written on the strict assumption that you will understand
the material in each section before moving to the next.
Each unit begins with a brief introduction which sets out the areas of the
syllabus being covered and explains, if necessary, how the unit fits in with the
topics that come before and after.
After the introduction there is a statement of the unit learning objectives. The
objectives are designed to help you understand exactly what you should be able
to do after you’ve studied the unit. You might find it helpful to tick them off as
you progress through the unit. You will also find them useful during revision.
There is one unit learning objective for each numbered section of the unit.
Following this, there are prior knowledge and resources sections. These will let
you know if there are any topics you need to be familiar with before tackling
each particular unit, or any special resources you might need, such as calculator,
graph paper or specific books.
Copyright © 2011 University of Sunderland vii

Then the main part of the unit begins, with the first of the numbered main
sections. At regular intervals in each unit, we have provided you with learning
activities, which are designed to get you actively involved in the learning
process. You should always try to complete the activities before reading on.
You will learn much more effectively if you are actively involved in doing
something as you study, rather than just passively reading the text in front of
you. The feedback or answers to the activities are provided immediately
following the activity. Do not be tempted to skip the activity.
Throughout the unit key terms are highlighted in bold with the definition
appearing in the margin.
Each unit contains recommended reading which also appears in the margin and
which refers you to relevant chapters of supporting textbooks including the
core textbooks. It is essential that you do this reading, since it is not possible
to put everything you need to know in a single learning pack. At level 3 of a
degree, wider reading is key to developing deeper subject learning through a
contemporary, contextual and critical perspective. This is important to consider
when approaching the related assessment of the module.
We provide a number of self-assessment questions at the end of each unit. These

are to help you to decide for yourself whether or not you have achieved the
learning objectives set out at the beginning of the unit. As with the activities,
you should always tackle them. The feedback or answers follow immediately
after at the end of the unit. If you still do not understand a topic having
attempted the self-assessment question, always try to re-read the relevant
passages in the textbook readings or unit, or follow the advice on further
reading given. Your allocated tutor will be available to deal with questions
arising from the material and will assist your study through the unit.
At the end of the unit is the summary. Use it to remind yourself or check off
what you have just studied, or later on during revision.
Finally, where possible, we have made reference to material on the internet since
this is easy to access. You may find that addresses change. This is annoying; but
with a bit of effort you will be able to track the material down (nothing
disappears completely from the web). And by searching you will learn even
more! Good luck and enjoy it.
Core textbook
The essential text is: Management Accounting for Business, Colin Drury, 4th
edition, published by Cengage Learning in 2009. The main strength of this
book is that it covers management accounting subject matter in a manner which
conveys a reasonable level of depth, but at the same time does not over-burden
the reader with complex technicalities. It is thus very suited to a more general
business course at undergraduate level or to postgraduate introductory manage-
ment accounting. The text supports the vast majority of units in this learning
pack, the exception being Unit 8. The text includes a number of case studies,
ample exercises and other assessment material and has further resources
available on an accompanying website. Drury has also published two other
management accounting textbooks and is one of the leading English language
viii Copyright © 2011 University of Sunderland

texts in the discipline. You’ll find more information and resources at
<www.drury-online.com>.
Acknowledgements
We are grateful to the following for permission to reproduce copyrighted
material:
Tesco Stores Ltd, for the use of the ‘Tesco Steering Wheel’ in Unit 1.
The EVA® symbol as used in Unit 6 is a registered trademark of Stern Stewart
& Co.
Copyright © 2011 University of Sunderland ix

x Copyright © 2011 University of Sunderland
Unit 1 An introduction to
strategic management
accounting
‘In real life, strategy is actually very

straightforward. You pick a general
direction and implement like hell.’
Jack Welch (2005)
Introduction
strategic management Strategic management accounting has evolved from management
accounting accounting and has come about as a direct result of the competitive
environment that firms are now facing. Johnson and Kaplan’s 1987
publication, Relevance Lost, ignited a debate on the potential develop-
ment of traditional management accounting, for instance, via ‘new’ and
‘advanced’ management accounting techniques. Johnson and Kaplan
stated that almost all management accounting techniques in use at their
management accounting
time of writing had been in operation for over 60 years (1987: 125). They
also stressed that a ‘financial accounting’ mentality had for many
decades persisted throughout organisations, whereby an organisation’s
principal measurement, control and performance systems have a short-
term perspective. They proposed that performance measurement should
focus on both financial and non-financial aspects. However, Johnson and
Kaplan observed that information systems (at that time) were incapable
of delivering the envisaged and more all-encompassing performance
measurement reports. Otley, in a review of the writings of Johnson and
Kaplan 20 years on, described management accounting as being more
innovative in the 20 years since than in the previous 50 (2008: 230). He
stated that the advent of Relevance Lost subsequently ignited a debate
over the relevance of management accounting, including its ability to
deliver and meet the information requirements of business managers.
The work of Johnson and Kaplan is one factor which prompted a move
from traditional management accounting techniques under management
accounting (for example, absorption costing) to new techniques under
strategic management accounting (like activity-based costing and the
balanced scorecard (BSC) balanced scorecard). The unit starts by looking at management account-
ing in relation to the decision-making process, the users of management
accounting information, and the functions of traditional management
accounting. It then maps the evolution of management accounting and its
techniques through the competitive environment to strategic manage-
ment accounting.
Copyright © 2011 University of Sunderland 1

Strategic Management Accounting
Unit learning objectives

On completing this unit, you should be able to:
1.1 Identify and describe the elements involved in the decision-making,
planning and control processes.
1.2 Identify the users of management accounting information and the
function of management accounting.
1.3 Explain the factors that have influenced the changes in the com-
petitive environment.
1.4 Identify how strategic management accounting helps management
to manage the competitive environment.
1.5 Explain what strategic management accounting is.
Prior knowledge
No prior knowledge is required for this unit, but it may be useful if you can think
of some organisations you are familiar with and relate them to the material in
the unit.
1.1 The decision-making process

Recommended reading: Management accounting information should be judged in the light of its
‘Introduction to Management ultimate effect on the outcome of decisions. A necessary precedent to an under-
Accounting’ in Drury (2009). standing of management accounting is an understanding of the decision-making
process. Below is a traditional decision-making diagram (Figure 1.1).
1. Identify objectives
2. Search for alternative courses of action
3. Gather data about alternatives

Planning
process
4. Select alternative courses of action
5. Implemant the decisions
6. Compare actual and planned outcomes

Control
process
7. Respond to divergences from plan
Figure 1.1: Traditional decision-making diagram.
2 Copyright © 2011 University of Sunderland

Unit 1 An introduction to strategic management accounting
Explanations for the steps in the process, as shown in Figure 1.1, are:
1. Identifying objectives: The first phase in the decision making, plan-

ning and control process is concerned with establishing aims and
objectives – an organisation needs to know where it wants to go.
These objectives may be:
■ maximisation of profit
■ maximisation of shareholders’ wealth
■ satisfactory profit
■ maximisation of sales revenue.
Conflict may occur between other parties of the organisation, such as
various user groups, who will undoubtedly have vested interests of a
different nature compared with those, for example, of shareholders.
2. Identifying strategies: This stage involves asking what strategies a

company must pursue in meeting its objectives. A strategy can be
considered as the matching of the capabilities of an organisation to
the opportunities presented in the market, with the aim of achieving
the objectives of the organisation. Formulating a strategy will involve
gathering information both internally and externally to determine
possible strategic options.
3. Evaluating strategies: The company must review strategies which

have the greatest chance of success.
4. Choosing alternative courses of action and coordinating them into a

long-term plan: This is the implementation of long-term plans through,
for example, budgets.
5. Implementing the decision: This involves taking the actual courses of

action as set out in the longer-term plans and budgets, for example,
cut costs by 10% or increase sales volumes by 20% in the next three
years.
6 and 7. Comparing actual and planned outcomes and responding to diver-

gences from the original plan.
Stages 6 and 7 of the process represent the firm’s control process. The
managerial function of control consists of the measurement, reporting and
subsequent correction of performance in an attempt to ensure that: (a) the firm’s
objectives and plans are achieved, and (b) that the process is dynamic, and
stresses the interdependencies between the various stages in the process. The
feedback loop shown in Figure 1.1 between stages 7 and 2 indicates that the
plans should be regularly reviewed, and if they are no longer attainable then
alternative courses of action should be considered. The loop in Figure 1.1
stresses the corrective actions, taken so that actual outcomes conform to
planned outcomes.
Figure 1.1 reflects the levels of decision making made by managers. Stages 1 to
3 reflect decision making over a long-term, or strategic timeframe. Of course,
strategies for the long term need to be converted to operational plans (for
example, budgets), as reflected in stage 4, which may be more medium term (for
example, 1 to 3 years). These operational plans support the organisational

strategy. In turn, decisions need to be taken on a daily basis to ensure opera-

tional plans are implemented, controlled and corrected if necessary (stages 5–7).
Such regular decisions are referred to as ‘tactical management decisions’. Thus,
a link from strategic management to tactical management via operational plans
should ensure organisational objectives are achieved.
1.2 Users of management accounting

information
Unlike users of financial accounting, those of management accounting infor-
mation are internal, such as employees, trade unions or junior or senior
management.
A table showing the various groups and their interest in management account-
ing information is shown below. As can be seen, each user group has its own
information requirements. The information supplied by management
accounting is primarily for managers’ use.
User group Aims/objectives/vested interests
Customers Reliability of supply of an organisation’s products and/or

services; type of credit facilities available.
Government Collection of taxes and duties; enforcement of legal
requirements.
Employees Trade union activities; wages bargaining/settlements.
Management Personal career ambitions; divorce of ownership from
control; internal departmental struggles/conflicts.
ga
nin ct
How would the presentation of management accounting information vary
Lear
ivit
1a between the user groups of employees, junior/senior management and

y
trade unions?
eedb ac
It is likely that both employees and trade unions (as their representatives)
F
1a would prefer summarised rather than detailed information, perhaps in a

graphic or visual format. Senior managers also tend to want summarised
information. On the other hand, junior managers are more likely to be
dealing with day-to-day matters and require more detailed information.
It can be argued that useful management accounting information should
possess the following attributes:
■ Relevance: the information must have an overall effect on the decision,
and it must be timely.
■ Reliability: the information must be correct and be able to be checked as
correct.
■ Comparability: the information must be able to be compared and
therefore help managers evaluate the performance of the business.

eedb ac
Comparability is achieved by treating items in the same manner for
F
k
1a management accounting purposes.
■ Understandability: management accounts should be clear so that the
continued management may comprehend the information.
■ Materiality: the information provided must be important in terms of the
overall decision. For example, inventory losses which amount to £10,000
might seem a material amount, but if the overall inventory value is
£300m, then this is immaterial.
ga
nin ct
From your knowledge of your own organisation or one with which you are
Lear
ivit
1b familiar, identify which functions of the organisation need to receive

y
accounting information. Give a brief example and assess which of these

functions will, in particular, need to receive this information in an easily
understood form.
eedb ac
F
You could argue that almost any function or department of an organisation

1b will receive accounting information. Here are some examples:
■ Design/engineering department will receive information on costs of
production or the sales price to aim for.
■ Sales department will receive information such as customer profitability,
costs of servicing customer, or product profitability.
■ Production department will receive accounting information such as costs
of production (that is, labour and material costs), costs of running a
production facility or machine.
■ Human resources department will receive data on the cost of employees
(salary and additional costs).
■ Senior management will receive reports on product/segment/region
profitability.
It would normally be assumed that senior management, for example, can
readily understand accounting information and reports. However, other
functions may be less exposed to regular accounting reports. With this in
mind, accounting information should be presented as a summary or in a less
detailed format and be relevant to the purpose of the department in
question. Management accountants may, for example, work closely with
product design engineers to design products at the lowest cost.
Features of management accounting information

Having looked at the users of management accounting information, let’s
summarise the key features of this information:
■ Management accounting reports and models are used to aid management
and to record, plan and control activities.

■ There is no legal requirement to prepare or disseminate management

accounting information.
■ The format of management accounting information is at management
discretion. There are no strict rules that govern the way they are prepared
or presented.
■ Management accounting information can focus on specific areas of an
organisation’s activities at the discretion of the organisation’s management.
■ Management accounting information is both a historical record and a
forward-looking planning tool.
ga
nin ct
As a manager of a company you are presently considering launching a new
Lear
ivit
1c product. What management accounting information do you require?

y
eedb ac
The following accounting information might be relevant to a manager
F
1c launching a new product or service:

■ The intended level of return that will be required for the project to be
considered successful.
■ An accurate costing of the production and delivery of each unit of the
product to the market.
■ The capital investment that will be necessary to enable the business to
produce the product.
■ Financial details of any other project forgone if resources are directed
towards production of this product.
1.3 The purpose of management

accounting
Recommended reading: Drury (2008) argues that management accounting has three key functions:
‘Introduction to Management 1. Allocation of costs between cost of goods sold and stock for internal and
Accounting’ in Drury (2009).
external profit reporting.
2. Providing relevant and important accounts information to help managers
make better decisions.
3. Providing information for planning, control and performance measurement,
and continuous improvement.
CIMA’s (The Chartered Institute of Management Accountants) official termin-

ology prescribes the following definition in explanation of what it perceives to
be the detailed role of management accounting:
‘Management accounting is the application of the principles of accounting and

financial management to create, protect, preserve and increase value for the
stakeholders of for-profit and not-for-profit enterprises in the public and private
sectors. It requires the identification, generation, presentation, interpretation
and use of relevant information to:
■ inform strategic decisions and formulate business strategy
■ plan long, medium and short-run operations
■ determine capital structure and fund that structure
■ design reward strategies for executives and shareholders
■ inform operational decisions
■ control operations and ensure the efficient use of resources.
■ measure and report financial and nonfinancial performance to management
and other stakeholders
■ safeguard tangible and intangible assets
■ implement corporate governance procedures, risk management and internal
controls.’ (CIMA, 2005)
The next section discusses the competitive environment in which the manage-
ment accountant provides information.
1.4 The competitive environment

Firms have always been subjected to competition, and this competition has only
become more dynamic. In particular, the following changes have occurred: (a)
globalisation of world trade; (b) privatisation of government-controlled
companies and deregulation in various industries; (c) changing product life
cycles; (d) changing customer tastes that demand ever-improving levels of
service in cost, quality, reliability, delivery and the choice of new products; and
(e) the continued development of information technology and systems.
As a result of these various changes new management themes have emerged

which in turn have resulted in the development of strategic management
accounting.
Emerging management themes

Management accounting is intended to help managers make better decisions.
Changes in the way managers operate means that the management accounting
systems themselves require re-evaluation. Figure 1.2 illustrates some key
emerging themes in management.
The themes identified in Figure 1.2 are expanded upon below:

■ Innovation: companies must pursue a policy of innovation in their product
so as to create and maintain success.
■ Continuous improvement: this involves a process of the company
continually seeking to reduce costs, eliminate waste and improve quality so
as to eventually lead to an increase in customer satisfaction.

Key success factors

Total Value Chain
Cost, Time, Quality,
Analysis
Innovation
CUSTOMER
SATISFACTION
Dual
Continuous
External/Internal
Improvement
Focus
Figure 1.2: Some key management themes.
■ Benchmarking: this means comparing performance to taken-for-granted or

best-practice performance in the same or another industry. Benchmarks on
cost revenues, quality or time are quite common.
■ Employee empowerment: employees have been provided with information
so as to enable them to make continuous improvement to the output
process.
The value chain

value chain The term value chain was first used by Michael Porter (1985). Coordinating the
individual parts of the value chain together to work as a team creates the
conditions to improve customer satisfaction, particularly in terms of cost
efficiency, quality and delivery. It is also appropriate to view the value chain
from the customer’s perspective, with each link, if each link in the value chain
is designed to meet the needs of its customers.
The aim is to manage the linkages in the value chain better than competitors
and thus create a competitive advantage.
Primary activities:
■ Inbound logistics: receiving goods from suppliers, and storing and handling
them until they are required.
■ Operations: production (may be many departments).
■ Outbound logistics: storage and distribution of the finished product to
customers.
■ Marketing and sales: determining what customers want, advertising
products and selling them.
■ Service: product and customer support.

Secondary activities:
■ Procurement, that is, obtaining resources (materials, finance, and so on).
■ Technology development, that is, research and development (R&D).
■ Human resource management, such as recruitment, training budget, and so
on.
■ The firm infrastructures, such as planning and control, and accounting.
Key questions for assessing strengths and weaknesses in the value chain and
value system are:
■ Where is value added?
■ How effective are the links between primary activities?
■ How effective are the links between secondary activities?
■ How effective are the links between primary and secondary activities?
Businesses can rarely produce without relying on other businesses to provide

inputs, and/or distribute the product to the end-consumer.
Figure 1.3 shows a diagram of a value chain.
Firm infrastructure
Human resource management
Procurement
Support Technology development

activities
Inbound Operations Outbound Marketing Services

logistics and sales and sales
Primary activities
Figure 1.3: A value chain.
Over time, new management themes will emerge. If management accountants

are to remain useful to managers they must keep abreast of changes in manage-
ment and respond accordingly. One area presently drawing attention is the
relevance of traditional management accounting techniques to companies like
Google and Facebook, who don’t offer products for sale in a traditional sense
(see Bromwich and Bhimani, 2010).

ga
nin ct How do you think improved information systems have affected the work of
Lear
ivit
1d management accountants?
y
eedb ac
F
Information systems have, to an extent, taken away the day-to-day

k
1d transaction processing work of management accountants. Enterprise

resource planning (ERP) systems such as SAP (a market leader in ERP
software) can provide many and varied reports and even incorporate newer
management accounting techniques like activity-based costing/budgeting
and balanced scorecards (see later in this unit). This means the role of the
management accountant is more of an information analyst/business advisor
than a traditional ‘bean-counting’ role.
How has management accounting responded to

the changes in business operations?
To answer this question, management accounting has responded by introducing
new techniques that tend to fall under the umbrella of strategic management
accounting. Some of the newer techniques are:
■ activity-based techniques
■ customer account profitability
■ life cycle costing
■ target costing
■ variance/performance measurement
■ balanced scorecard
■ benchmarking
■ just-in-time
■ backflush costing.
Please note that some of these areas will be discussed further later in the
learning pack and you may like to return to this section when you have
completed the final unit.
A brief review of some of the current techniques

and their relevance to the business environment
Traditional overhead apportionment
Traditional overhead apportionment and absorption methods were developed
around the time of the Industrial Revolution when organisations were trying to
determine the cost of their industrial production. Production processes at the
time were labour intensive, had a low level of overheads compared to direct
costs, and were relatively non-competitive.

The characteristics of the modern production environment however are quite

different. They are capital intensive in a machine-paced environment. They
have a higher level of overheads compared to direct costs, and compete in a
highly competitive global market.
Due to the change in the environment, traditional methods have been criticised
as not producing useful or accurate information for decision making.
Activity-based costing (ABC)

Recommended reading: Innes et The inadequacy of traditional absorption costing as practised in the UK and the
al (2000). USA has been known for several years and was the first area to undergo radical
reform. In 1988, Cooper and Kaplan proposed a more refined approach for
assigning overheads to products and computing product costs – activity-based
costing (ABC). It is claimed that ABC provides product cost information that
is useful for decision-making purposes.
A study by Innes et al (2000) reported that 25% of respondents had imple-

mented, or were in the process of implementing, ABC. ABC emphasises the
need to obtain a better understanding of the behaviour of overhead costs and
ascertains what causes these costs and how they relate to products.
ABC causes a change in the product costing of high volume and low volume
products. This is because traditional overhead allocation methods use volume-
related measures (for example, machine hours) to apportion overheads to
products. In reality, many overheads are not volume related – for example set-
up costs and ordering costs.
It has been argued that ABC tries to improve on traditional costing techniques
by looking for better methods of overhead allocation. But to say that it
produces an accurate product cost and that this can be used for pricing and
strategic purposes is an oversimplification of business issues and may result in
poor management decisions. It can be argued that it is this process of ABC that
forces managers to understand cost drivers and thereby manage them better.
Others have argued that ABC is time-consuming and expensive to apply, and
not justified by the possible improvement in the quality of information. Innes
et al (2000), for example, mention that the poor uptake of ABC by British
companies can be attributed more to design, implementation and change issues,
rather than to the technique itself.
Budgeting
Recommended reading: Hope and

The majority of organisations still rely heavily on traditional incremental
Fraser (2003). budgeting. Other traditional methods used include zero-base budgeting, flexible
budgeting, probabilistic budgeting, and so on.
The process of ABC can offer a better understanding of the behaviour of costs
– it is now realised that most costs are not fixed in the long term and fluctuate
in relation to an activity (see Unit 3 for further detail). Activity-based budgeting
may address this issue. The Swedish bank Handelsbanken scrapped its formal
process of budgeting in the 1970s and went on to expand and perform
successfully. Not many accountants appear to have been prepared to accept

this view – probably due to the time and effort already invested in the budgeting
process. However, during the 1990s a number of Swedish companies (IKEA,
Volvo, Scania) followed Handelbanken’s lead. IKEA has since effectively
abolished all control of its managers and now sets managers a ratio of profit to
sales, which they must meet in any way they see fit. Outside of Scandinavia,
Philips, UBS and Siemens are other examples (Hope and Fraser, 2001).
Operating without a traditional budget is often referred to as the ‘Beyond
Budgeting’ debate. Organisations like the Beyond Budgeting Roundtable
(BBRT) promote this approach to performance management.
Performance management
The effect of advanced manufacturing technology is that a greater emphasis is
placed on automation and much less emphasis on direct labour. Traditional
direct labour efficiency variances are therefore of limited use. The overhead
absorption rates on which overhead variances are based are also traditionally
calculated using direct labour hours. This becomes meaningless when labour
hours are an insignificant part of the operation.
Another criticism of traditional variance analysis is the timing. Standards are

set some time prior to the beginning of the budget period. In a dynamic business
these standards may have become outdated by the start of the budget period
and as a consequence incorrect variances may be reported and decisions made
on these. Planning and operational variances take care of this criticism.
Return on investment (ROI) is a popular method of measuring the performance

of a division/investment centre. It is seen as a ratio that is easily understood by
managers. It is a relative measure (unlike residual income) which makes
comparison of divisions easier.
However, in an inflationary situation ROI overestimates the rate of return as it

not only overstates profits but also understates the capital employed. ROI also
discourages investment in new plants and processes, as this would lower the
value of the ratio.
Managers tend to reject investments with a relatively low ROI even when the
return is greater than the cost of capital invested in the division. This leads to
sub-optimisation, which may not be in the interest of the group as a whole.
Traditional performance measurement relies heavily on internally set financial

measures such as ratio analysis, variances, meeting of targets and budgets. For
a business to have sustained competitive advantage it has to be responsive to
its customers, produce a quality product/service, and be flexible, innovative
and competitive. Financial measures alone are insufficient measure of an
organisation’s progress in these areas.
Both financial and non-financial measures are required to give a complete

appraisal of an organisation’s performance. The balanced scorecard is largely
a non-financial performance measurement system which overcomes issues of
using solely financial measures.

The balanced scorecard (BSC)

Recommended reading: Kaplan The need to integrate financial and non-financial measures of performance, and
and Norton (1993,1994). to identify key performance measures that link measurements to strategy, led to
the emergence of the BSC, first mentioned by Kaplan and Norton in the 1990s.
This is an integrated set-up performance measure derived from the company’s
strategy that gives top management a fast but comprehensive view of the
organisational unit.
The BSC philosophy assumes that an organisation’s vision and strategy is best
achieved when the organisation’s performance is viewed from the following
four perspectives:
1. customer
2. internal business process
3. learning and growth
4. financial.
Figure 1.4 shows the BSC in visual form.
Financial
‘To succeed
■ Objectives
■ Initiatives
■ Measures
financially, how
■ Targets
should we
appear to our
shareholders?’
Customer Internal Business Processes

‘To achieve our ‘To satisfy our
■ Objectives
■ Objectives
Vision
■ Initiatives
■ Initiatives
■ Measures
vision, how shareholders and

■ Measures
■ Targets
should we
appear to our
and customers, what
business
■ Targets
Strategy
customers?’ processes must
we excel at?’
Learning and Growth

‘To achieve our
■ Objectives
■ Initiatives
■ Measures
vision, how
■ Targets
should we
sustain our
ability to change
and improve?’
Adapted from Robert S. Kaplan and David P. Norton, “Using the Balanced Scorecard
as a Strategic Management System,” Harvard Business Review (January–February
1996): 76.
Figure 1.4: Kaplan and Norton’s balanced scorecard.

Drury (2009: 383) has argued that the benefits of the BSC approach are that it:
■ brings together, in a single report, different perspectives on a company
performance
■ 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 perspectives and then translating these goals into specific
performance measures
■ helps managers to consider all important operational measures together
■ improves communications within the organisation and prompts the active
formulation and implementation of organised strategy.
The limitations of the BSC approach also include the following:

■ Is there really a cause-and-effect relationship between the various com-
ponents? There needs to be some actual coherence between the metrics used
in each of the four perspectives of the BSC.
■ Is it simply a list of metrics with no guidance or bottom-line score?
ga
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Do you think the four performance perspectives of Kaplan and Norton’s BSC
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1e are suitable for all organisations? Run an online search for the ‘Tesco
y
Steering Wheel’ to help you with this activity.
eedb ac
F
The general idea of a balanced scorecard can be adopted to suit the needs
k
1e of an organisation. For example, if you searched online for Tesco Steering

Wheel, you would have seen that their four perspectives are customer,
operations, finance and people. Each perspective is
sub-divided into several segments. Figure
OPER 1.5 shows the Steering Wheel
ER AT
with some of the objectives listed.
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PE Figure 1.5: The Tesco Steering Wheel.

1.5 So what is strategic management

accounting?
Recommended reading: ‘Strategic These include:
performance management’ in
Drury (2009) ■ The extension of traditional management accounting’s internal focus to
Drury (2009) argues that strategic include external information about competitors.
management accounting has
several strands. ■ The relationship between the strategic position chosen by a firm and the
expected emphasis on management accounting (that is, accounting in
relation to strategic positioning).
■ Gaining competitive advantage by analysing ways to decrease costs and/or
enhance the differentiation of a firm’s products, through exploiting links in
the value chain and optimising cost drivers.
CIMA’s official terminology (2005) defines strategic management accounting as

‘a form of management accounting in which emphasis is placed on information
which relates to factors external to the firm, as well as non-financial information
and internally generated information’. Therefore, strategic management accounting
aims to provide relevant information to an organisation’s management to enable
them to make strategic plans and decisions. The emphasis is on external informa-
tion on competitors, customers, market, environment, and so on.
Organisations cannot rely on financial information alone – non-financial infor-

mation plays an important part. It can be argued that strategic management
accounting has a positive role of supporting the financial needs of management
in their task of directing and controlling the business in the best interest of its
owners and other stakeholders.
The table below summarises the main differences between traditional manage-
ment accounting and strategic management accounting:
Traditional management Strategic management

accounting accounting
Focus Mainly internal Mainly external
Reporting unit Entire organisation More focused on business units
Profitability and cost Individual products or services Products and services, but also
analysis customers, market segments,
regions
Cost allocation and Costs assumed as mainly volume Multiple drivers of costs assumed;
analysis based and focused within the longer-term cost focus; costs along
organisation value chain
Performance appraisal Shorter-term profit based Multi-dimension appraisal
Ownership Typically accountants only Broader management and

organisational ownership

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For an organisation with which you are familiar, identify the range of
Lear
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1f financial and non-financial information that would be required as part of

y
strategic management accounting, and identify the sources of the different

information streams.
eedb ac
Your answer will depend on the organisation you selected. Remember that
F
1f non-financial information may exist inside and outside an organisation, so

you might have to look to information sources such as:
■ internal
– quality information
– customer satisfaction
– industry benchmarks or standards
– operations
– information technology/systems suitability
– management and financial accounting systems
■ external
– competitors (for example, on prices and/or products)
– general economic statistics
– industry averages or benchmarks
– analyst reports
– social and environmental responsibility.
The strategic management accounting system

The following are critical factors that need to be considered/addressed when
designing a strategic management accounting system (that is, a system to
provide management accounting information that supports strategic decision
making):
■ Aiding strategic decisions: two types of information are required:
– One-off information to support and evaluate particular strategic
decisions.
– Information to monitor strategies and the firm’s overall competitive
position.
■ Closing the communication gap between managers and accountants:
financial data is off-putting to most people. Avoid technical jargon. Provide
relevant information only in a user-friendly format.
■ Identifying the type of decision: despite strategic decisions being one-off
decisions, most strategic decisions fall into one of three main types:
– Changing the balance of resource allocation.
– Entering a new business area.
– Exit decisions – either closing down or selling part of the business as an
ongoing concern.

■ Offering appropriate financial indicators – but these alone are not sufficient.
For example, customers drive a business and competitors are the greatest
threat to a business. Monitoring key performance variables on these two
stakeholders is crucial to the success of an organisation.
■ Distinguishing between economic and managerial performance, between
controllable and non-controllable costs, and charging only controllable
costs when measuring managerial performance.
■ Providing relevant information: use management by exception principle.
Only include relevant costs in financial statements. Each report should be
tailored to its recipient/requirement.
■ Separating committed from discretionary costs.
■ Distinguishing discretionary from engineered costs.
■ Using standard costs strategically: engineered standard costs can be useful
for control purposes. Standard costs are a useful way of analysing the cost
structure of the business, particularly in trying to understand the impact of
changes in cost structure in relation to competitor costs.
■ Allowing for changes over time: strategic objectives can change over time.
Relationships between input and output can change as manufacturing
technology changes. Information system should be flexible to cope with
such changes.
It is vital for the strategic management accounting system to use a range of

internal and external sources to gather both financial and non-financial
information to aid strategic decisions and planning.
Self-assessment questions
1.1 Describe what is meant by the following:
■ continuous improvement
■ benchmarking
■ employee empowerment.
1.2 What are the four main areas on which Kaplan and Norton’s balanced
scorecard is based?
1.3 Put the following steps of the planning and control cycle into the correct
order:
■ evaluate strategies
■ feedback from implementation
■ implement the long-term plan
■ identify objectives
■ choose alternative courses of action
■ identify potential strategies.
1.4 What are the main differences between management accounting and
financial accounting?
1.5 Thinking about low-cost airlines like Ryanair and easyJet, and the
dynamic business environment they operate in, what kind of management
accounting information might they use?

1.6 Define strategic management accounting in your own words.

1.7 How can management accounting have a strategic focus?
Feedback on self-assessment questions

1.1 ■ Continuous improvement is an ongoing process to reduce costs,
eliminate waste and improve the quality and performance of activities
that increase the customer value of the sales factor.
■ Benchmarking is a continuous measuring of a firm’s products, services
or activities against best performances, either internal or external to
the firm.
■ Employee empowerment is the process of giving employees relevant
information so that they will be able to react faster to customers,
increase process flexibility, reduce cycle time and improve morale.
1.2 The four main areas in Kaplan and Norton’s balanced scorecard are:
■ Finance: targets for measures such as return on capital employed will
be stated.
■ Customer: the market/customer that the business will aim for is estab-
lished, as are its targets for such things.
■ Internal business process perspective: an organisation must strive to
excel in regard to its internal operations management to ensure maxi-
mum efficiency and effectiveness.
■ Learning and growth perspective: this perspective should be forward
looking, preparing the organisation and its members for the future,
rather than just the present, challenges and opportunities.
1.3 The correct order of the planning and control cycle is:
■ identify objectives
■ identify potential strategies
■ evaluate strategies
■ choose alternative courses of action
■ implement the long-term plan
■ feedback from implementation.
It must be recognised that to be strategically effective the development of
an ongoing strategic plan requires a logical and structured approach
where each of the above steps interconnect and support each other.
Ongoing planning and control requires that the above is operated as a
constant cycle with no end point.
1.4 The differences between management and financial accounting
Financial Management
Focus External – legal Internal – costs, benefits,
requirements evaluation
Accuracy Precise Estimations, less precise
Business Business sectors Individual products,
focus processes, markets

Financial Management
Regulation IFRS, FRS No regulation
Timeline Past, historic Forward looking
Reporting Annual Annual, monthly, weekly,
daily, and so on
1.5 Low-cost airlines like Ryanair and easyJet keep tight control of costs and
want regular reports on underlying running costs. In fact, low-cost airlines
try to standardise as much as possible to reduce costs, for example, using
one aircraft type means holding one set of spare parts. Information on
revenue is also of crucial importance. Complex yield management systems
are in place to ensure revenue per flight is maximised. Regular reports on
flight load factors (that is, percentage of seats sold) would be a vital piece
of information for a low-cost airline’s management.
1.6 Strategic management accounting provides information to support strate-
gic decisions in organisations. This involves alignment with the objectives
detailed by Drury (2009) and CIMA (2005) as noted in this unit, and is
carried out via concepts, models and techniques as detailed in the brief
review of current techniques and throughout the subsequent chapters.
1.7 The objective of strategic management accounting is to provide informa-
tion to managers that will help them run their business in a way to achieve
their strategic objectives. Traditional management accounting is not
necessarily so much different, but lacks the clear focus on the achievement
of strategic objectives. Given its focus, strategic management accounting
necessarily needs to be more outward looking and more competitive. It
must also monitor a firm’s strategies and be concerned with these to find
a successful conclusion.
Summary
In this unit, the basic concepts of how management accounting can assist the
strategic decision making in an organisation have been introduced. You now
have a good appreciation of the reasons why managers need accounting
information to help guide an organisation and you have seen some examples of
techniques often used. In later units you will learn more on some of these topics,
but for now the key points you need to take from this unit are:
■ the decision-making process
■ the user of management accounting information and the function of
management accountants
■ the competitive nature of the business environment
■ the evolution of new management techniques to respond to the strategic
and competitive challenges of organisations.

Unit 21 Relevant costs for
decision making
‘The only relevant test of the validity of

a hypothesis is comparison of prediction
with experience.’
Milton Friedman, Economist
Introduction
In decision making not all costs are relevant. This unit argues that it is the
relevant cost future cost (that is, the relevant cost) that needs to be considered when
decision making. The past can be responded to through our future
actions but it cannot in itself be changed. As such, past costs can provide
useful information but it is the future, as yet uncommitted, costs that
are relevant as these are controllable. That which we cannot control may
inform our decision making by making us aware of the environment in
which we exist but the decisions that managers make must focus on the
controllable to be relevant. To this end, a variety of scenarios are pre-
sented in the unit, as well as the important qualitative factors.
2.1 Distinguish between relevant and irrelevant costs and revenues.
2.2 Explain the importance of qualitative factors in relevant costs.
2.3 Apply relevant costs in various situations, such as:
• direct costs (for example, material and labour costs)
• plant and equipment
• limiting factors
• outsource or in-house
• continue or discontinue
• accept or reject special orders.
Prior knowledge
This unit requires no prior knowledge, but you may find it useful to read the
earlier pages of ‘An introduction to cost terms and concepts’ in Drury (2009).

Unit 2 Relevant costs for decision making
2.1 Relevant cost

One of the main problems facing organisations is how to identify and evaluate
the relevant costs and benefits resulting from alternatives. These must be those
that are affected by the decision. Other non-relevant costs and benefits should
Recommended reading: ‘An therefore be ignored. The first principle is therefore: ‘Only future costs are
introduction to cost terms and
relevant.’
concepts’ in Drury (2009.
Past or committed costs do not affect the decision. This concept is often difficult
to grasp as human nature dictates to us that we should attempt to recover past
costs. This is particularly relevant where someone has purchased an asset in
the past. Note, however, that this principle is not saying that all future costs are
relevant, which is conveyed in the second principle: ‘Only those costs which
differ between the available alternatives are relevant.’
Hence, if you are attempting to decide which is the cheapest to run between two
similar cars, you could ignore motor tax and insurance as these will be incurred
even if you never drive the car. The third principle is thus: ‘Only cash costs are
included.’
Depreciation should be ignored as it is only a book-keeping entry and an

avoidable cost accountant’s attempt to find the value of an asset in the future. It does not
represent the cash paid or received for an asset. There are some additional terms
which you may have come across before, which are useful in discussions of
opportunity cost relevant costs:
■ Avoidable costs: costs that would not occur if the activity they are related
to did not occur.
variable cost
■ Opportunity costs: the benefit which could have been earned, but which
was given up, by choosing one option instead of another.
■ Variable costs will usually be relevant costs.
incremental cost ■ Incremental costs: an additional cost incurred as a result of choosing a
particular course of action.
Irrelevant costs are therefore:

fixed cost
■ Fixed costs: unless directly attributable fixed costs.
■ Depreciation.
■ Any sunk cost (a cost that has already been incurred).
sunk cost
Much will depend upon the circumstances in the decision as to whether a cost
is relevant or irrelevant.
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Julian Ltd was making a machine to order for a customer, but the customer
Lear
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2a has decided it does not want the machine any more. There may be
y
subsequent legal remedies which have not been considered yet. Costs
incurred to date are £60,000. Fortunately, the sales department has found
another company willing to buy the machine for £40,000 once it has been
completed. To complete the work, the following costs would be incurred:
(a) Materials: these have already been bought at a cost of £7,000. They
have no other use, and if the machine is not finished, they will be sold
for scrap for £3,000.

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(b) Further labour costs to complete the machine would be £9,000. Labour
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2a is in short supply and if the machine is not finished, the work force will
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be switched to another job, which will earn £20,000 in revenue, and

continued incur direct costs of £13,000 and an absorbed (fixed) overhead of
£8,000.
(c) There are consultancy fees of £5,000 if the job is to be completed. If the
machine is not completed, the consultant’s contract will be cancelled at
a cost of £1,000.
(d) The company has general overheads of £9,000.
What you need to determine are the relevant costs/revenues and whether
the new customer offer should be accepted. Try to determine whether each
of points a to d are relevant or not, and then bring all relevant costs
together with the revenue to see if a gain or loss occurs.
eedb ac
Note: The costs of £60,000 were incurred in the past and are not relevant
F
2a because they will not affect a decision.

(a) £7,000, the price paid in the past for the materials, is irrelevant. £3,000
is the opportunity cost of the revenue from scrap, which would be
forgone, and is therefore relevant.
(b) Labour costs required to complete work £9,000

Opportunity costs: contribution forgone £7,000
by losing other work (£20,000–£13,000)
Relevant cost of labour £16,000
The absorbed overhead is not relevant
(c) £4,000 is an incremental cost. That is, the incremental cost of

consultancy from completing the work is the difference between the
cost of completing the work and the cost of cancelling the contract
(£5,000 – 1,000 = £4,000).
(d) General overheads are irrelevant. Therefore the relevant costs are:
£ £
Revenue from completing work 40,000
Relevant costs
Labour: opportunity costs 7,000
Materials: opportunity costs 3,000
Labour: basic pay 9,000
Incremental cost of consultant 4,000 23,000
Gain from special order 17,000

2.2 Qualitative factors

Qualitative factors are those that cannot be expressed in monetary terms yet are
Recommended reading:
‘Measuring relevant costs and important to a final decision. An example would be a decline in employee
revenues for decision making’ in morale resulting from redundancies, which in turn arose from a closure. It is
Drury (2009). essential that qualitative factors be brought to the attention of a management
team during the decision-making process, otherwise there may be a danger that
a wrong decision will be made. For example, the cost of manufacturing a
component internally may be more expensive than purchasing from an outside
supplier. However, the decision to purchase from an outside supplier could
result in the closing down of the company’s facilities for manufacturing the
component. Some of the examples that follow will consider qualitative factors.
2.3 Relevant costs in various scenarios

Relevant costs for materials
Rule: The relevant cost is the current replacement cost, assuming materials will
be re-purchased. However, if the materials have already been purchased then
the relevant cost is the higher of:
■ the alternative use value, or
■ the current resale value.
Work through the following examples:

Material I
A job requires Material I. The job requires 2,000 units. There are no stocks of
Material I, nor is there a book value or realisable value for the material.
Material I has, however, a replacement cost of £8 per unit. This material will
be used regularly by the company.
Answer: The relevant cost is £16,000. Each unit costs £8, so 2,000 × £8 =
£16,000.
Material J
A job requires 1,500 units of Material J. There are 900 units in stock. The book
value of the material is £3 per unit, the realisable value is £3.50 and its
replacement cost is £7. If used, Material J would need to be replaced. What is
the relevant cost?
Answer: Material J is used regularly by the company. There is existing stock
(900 units) but if this is used on the contract under review a further 900 units
would have to be bought to replace the stock. The relevant cost is £10,500:
1,500 units at the replacement cost of £7 per unit = £10,500.
Material K
A job requires 1,500 units of Material K. Already in stock are 800 units, as a
result of overbuying. These 800 units will not need to be replaced. Material K
has a book value of £4, a realisable value of £2.55 and a replacement cost of
£6 per unit. Material K has no other use. What is the relevant cost?
Answer: If the existing 800 units are used for the contract, a further 700 units
must be bought at £6 each. If the existing stock of 800 (which will not be
replaced) were used for the contract, they could not be sold at £2.55 each. The
realisable value of these 800 units is an opportunity cost of sales revenue
forgone, thus (700 × £6) + (800 × £2.55) = £6,240.

Material M
A job requires 100 units of Material M. There are 100 units already in stock
as a result of overbuying. If used, the existing stock will not be replaced. The
book value of Material M is £5 per unit, the realisable value is £7 per unit and
its replacement cost is £4. Material M could be used in another job as a
substitute for 200 units of Material Z. Material Z currently costs £8 per unit.
There is no stock of Material Z. What is the relevant cost?
Answer: The required units of Material M are already in stock and will not be
replaced. There is an opportunity cost of using M in the contract because there
are alternative opportunities either to sell the existing stock for £7 per unit
(£700) or to avoid other purchases (of Material Z) which would cost 200 × £8
= £1,600. Since substitution for Z is more beneficial, £1,600 is the opportunity
cost.
ga
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Lear
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2b which it paid £1,600 two weeks ago. If this were to be sold as raw material
y
it could be sold today for £2 per kg. You are aware that the material can be
bought on the open market for £4.25 per kg but it must be purchased in
quantities of 1000 kg.
Determine the relevant cost of 600 kg of Material X.
eedb ac The material is in regular use and if used will have to be replaced at a cost
F
of £2,550 (600 × 4.25). Therefore, the relevant cost is £2,550.

2b
Relevant costs for plant and equipment

The following are irrelevant:
■ The purchase price of the plant and equipment, as it is a sunk cost.
■ Depreciation is only a book entry – there is no movement of cash. The
relevant costs will therefore be incremental costs.
Example
A machine which originally cost £13,000 has an estimated life of 10 years and
is depreciated at a rate of £1,300 a year. The machine has been unused for the
last 5 years. James, a young whiz-kid in the sales department, has now won a
special order which requires the use of the machine. The current net realisable
value of the machine is £9,000. If it is used for the job, its value is expected to
fall to £8,500. The net book value of the machine is £6,000.
Calculate the relevant cost of using the machine for the order.
Answer: Loss in net realisable value of the machine by using it on the order is:
(£9,000 – 8,500) = £500.

Limiting factors
limiting factor A limiting factor is a scarce resource which limits the company from maxi-
mising its profit: it could be sales, materials or labour. Profits are maximised
when contribution is maximised per limiting factor. The calculation involves the
determination of the contribution for each product per unit of limiting factor
and then determining the production mix.
Example
Samuel Ltd makes two products, the Ace and the King. Variable costs are as
follows:
Ace King
Direct materials £2 £4
Direct labour (£3 per hour) £6 £3
Variable overhead £2 £2
Total £10 £9
The sales price per unit is £20 for Ace and £15 for King. During August the
available direct labour is limited to 8,000 hours. Sales demand in August is
expected to be 3,000 units for Ace, and 5,000 units for King.
Determine the profit-maximising production levels, assuming that monthly
fixed costs are £25,000 and that opening stocks of finished goods and work in
progress are nil. The calculation involves three steps:
Answer:
Step 1 Confirm what the limiting factor is:
Ace King Total
Labour hours per unit 2 hours 1 hour
Sales demand 3,000 units 5,000 units
Labour hours needed 6,000 hours 5,000 hours 11,000 hours
Less labour hours available 8,000 hours
Shortfall 3,000 hours
Direct labour is the limiting factor on production.

Step 2 Calculate the contribution earned by each product per unit of scarce
resource:
Ace King
Sales price £20 £15
Variable cost £10 £9
Unit contribution £10 £6
Labour hours per unit 2 hours 1 hour
Contribution per labour hour
(= unit of limiting factor) £5 £6
Rank (that is, produce in this order) (2) (1)

Although Ace has a higher unit contribution than King, it is more profitable to
make King because labour is in short supply.
Step 3 Work out the budgeted production and sales. Sufficient King will be
made to meet the full sales demand, and the remaining labour hours available
will then be used to make Ace:
Rank Product Hours Hours Total contribution

required
1 King 5,000 5,000 £30,000
(£6 × 5,000 hours)
2 Ace 6,000 3,000 £15,000
(balancing ((£5 × ,3000 hours) ×
hours) 3,000/6,000 hrs)
Total 11,000 8,000 £45,000
available
Less fixed £25,000
cost
Profit £20,000
Thus, King should be produced first as it maximises contribution per limiting

factor. The balance is the amount of Ace produced. Given that there are only
8,000 hours available, the balance is 3,000.
ga
nin ct ABC Ltd manufactures three products, the selling price and cost details of
Lear
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2c which are given below:

y
Product P Product Q Product R

£ £ £
Selling price per unit 85 105 105
Direct materials (£5/kg) 10 5 15
Direct labour (£4/hour) 15 23 19
Variable overhead 9 13 11
Fixed overhead 24 36 30
In a period when direct materials are restricted in supply, calculate the

contribution per limiting factor and rank the products according to
contribution per limiting factor.

F eedb ac
k
2c Product P Product Q Product R
£ £ £
Selling price per unit 85 105 105
Direct materials (£5/kg) 10 5 15
Direct labour 15 23 19
Variable overhead 9 13 11
Total variable cost per unit 34 41 45
Contribution per unit 51 64 60
Materials kg per unit 2 (10/5) 1 (5/5) 3 (15/5)
Contribution per kg 25.5 64 20
Rank (2) (1) (3)
ga
nin ct
Lear
James Ltd makes two products, A and B, for which there is unlimited
ivit
2d demand at the budgeted selling prices. A takes 3 hours to make and has a
y
variable cost of £23 and a selling price of £35. B takes 2 hours to make and
has a variable cost of £15 and a selling price of £25. Both products use the
same type of labour, which is in short supply.
Determine the product which should be made to maximise profits, and
describe the other considerations which might alter your decision.
eedb ac
F
A B
2d
Sales (£) 35 25
Variable costs (£) 23 15
Contribution per unit (£) 12 10
Labour (hours) 3 2
Contribution per labour hour (limiting factor) (£) 4 5
Rank 2 1
Decision: Produce B, as it maximises contribution per hour of labour.

Other qualitative factors:
■ Will selling price change?
■ Will variable cost change?
■ Who are the competitors?

ga
nin ct
A company has the following costs and revenues relating to a product:
Lear
ivit
2e
y
Cost £
Selling price 63.50
Labour @ £7.50 per hour 22.50
Raw materials @ £4 per kg 20
Variable overhead 6
Fixed cost per unit 3
Profit per unit 12
(a) What is the contribution per labour hour?

(b) What is the contribution per kilogram of raw materials?
eedb ac
F
(a) Cost £
2e
Selling price 63.50
Labour cost 22.50
Materials 20
Variable overhead 6
Total variable costs 48.50
Contribution 15
Labour hours needed: £22.50/£7.50 = 3, therefore £15/3 = £5

contribution per labour hour.
(b) Raw materials £20 / £4 = 5kg
Contribution per kilogram of raw material = £15/5kg = £3.
Outsource or in-house
For various reasons it may suit a manufacturer to make the product itself (in-
house) or to outsource (buy) it. The relevant costs for such a decision are the
differential costs between the two options.
Example
Jameson Ltd makes four components (A, B, C and D) for which costs in the
forthcoming year are expected to be as follows:

A B C D
Production (units) 2,000 3,000 4,000 5,000
Unit variable costs
Direct materials 5 6 3 5
Direct labour 10 11 6 8
Variable production overheads 3 2 2 3
18 19 11 16
Directly attributable fixed (incurred as a direct consequence of buying) costs per

annum are: A: £2,000; B: £7,000; C: £7,000; D: £9,000. Other fixed costs are
£3,000. A subcontractor can supply units of A, B, C and D for £10, £23, £17
and £18, respectively.
Decide whether Jameson Ltd should outsource its product or make it in-house.
Answer: The relevant costs are the differential costs between making and
buying. Subcontracting will result in some fixed cost savings:
A B C D
Unit variable cost of making £18 £19 £11 £16
Unit variable cost of buying £10 £23 £17 £18
Cost difference (£8) £4 £6 £2
Annual requirements (units) 2,000 3,000 4,000 5,000
A B C D
Extra variable cost of buying (16,000) 12,000 24,000 18,000
Fixed cost of buying 2,000 7,000 7,000 9,000
Extra total cost of buying (18,000) 5,000 17,000 1,000
The company would save £18,000 subcontracting to A.
ga
nin ct Which qualitative factors would you consider in this Jameson Ltd decision?
Lear
ivit
2f
y
eedb ac
Spare capacity, how should it be used?
F
2f ■ Could there be an industrial dispute as a result of the company’s action?

■ Quality of buying in.
■ Reliable figures? Estimates may not be accurate.

ga
nin ct Sahai Ltd makes three components: A, B and C. The following costs have
Lear
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2g been recorded:
y
A B C
(unit cost, £) (unit cost, £) (unit cost, £)
Variable cost £2.50 £8 £5
Fixed cost £2.00 £8.30 £3.75
Total cost £4.50 £16.30 £8.75
Buy-in price £4 £7 £5.50
The fixed costs will be present irrespective of the ‘make or buy’ decision.
Which components should Sahai Ltd buy in (if any)?
eedb ac
F
A B C
2g
Variable cost £2.50 £8 £5
Variable cost buy £4 £7 £5.50
Cost difference £1.50 (£1) £0.50
Therefore, Sahai Ltd should choose to buy in Component B as the variable

cost to purchase is less.
Assuming that fixed costs will remain unchanged whether the company
makes or buys the components, the relevant cost of manufacture will be the
variable cost. Under these circumstances the company should only purchase
components if the purchase price is less than the variable cost.
Outsource or in-house with scarce resources

Rule: If a company has to subcontract to make up a shortfall in output, then
the company needs to minimise its total costs of subcontracting. The units
bought must have the lowest extra variable cost of buying per unit of scarce
resource saved.
Example
MR Ltd manufactures products A and B using the same material for each.
Annual demand is 9,000 units for A and 13,000 units for B. The variable
production cost of A is £11 and that of B is £16. A requires 3.5 kg of raw
material per unit, B requires 8 kg of raw material per unit. Supply of raw
material will be limited to 90,000 kg during the year. A subcontractor is willing
to supply the products and has quoted prices of £18 per unit for A and £26 per
unit for B.
How many of each product should MR Ltd manufacture in order to maximise

profits?

Answer:
A, £ per unit B, £ per unit
Variable cost of making 11 16
Variable cost of buying 18 26
Extra variable cost of buying 7 10
Raw material saved by buying 3.5 kg 8 kg
Extra variable cost of buying per kg saved £2 £1.25
Priority for internal manufacture/ranking (1) (2)
Priority for external manufacture (2) (1)
Production plan:
Make 31,500 kg of Product A: (9,000 × 3.5 kg)
Make 58,500 kg of Product B: (7312.5 × 8 kg)
Balancing figure is 90,000 kg
58,500 kg/8 kg per unit of B means 7,313 units of B will be produced.
The remaining 5687 units (13,000 – 7,313 units) of B should be purchased
from the external manufacturer.
ga
nin ct Bronze Ltd manufactures two components in its machine division, in which
Lear
ivit
2h capacity per month is limited to 3,500 machine hours. Production costs are
y
as follows:
A (£) B (£)
Variable cost 20 25
Fixed overhead 10 15
Total cost 30 40
Hours per unit 2 3
Monthly requirement 1,000 units 1,000 units
The fixed costs will be present irrespective of the ‘make or buy’ decision.
Component A can be bought from an external supplier for £31 per unit and
Component B can similarly be bought for £47 per unit.
What are the minimum total costs per month of the machining division and
external purchases, given that all the monthly requirements for units of each
component must be either manufactured or purchased?
eedb ac
F
A B Total
2h
Machine hours per unit 2 3
Total machine hours per month needed 2,000 3,000 5,000
Machine hours available 3,500

eedb ac
F
£ £
2h Variable cost per unit 20 25
continued External purchase cost 31 47
Extra cost of purchase per unit 11 22
Hours saved by purchasing 2 per unit 3 per unit
Extra cost per hour saved 5.5 7.3
The company should therefore buy 750 units of A per month.
In-house production costs £

Variable cost of:
A (1,000 – 750) × £20 5,000
B (1,000 × £25) 25,000
30,000
Fixed costs 3,500 hrs × £5 per hour 17,500
47,500
External purchase costs of A (750 × £31) 23,250
70,750
ga
nin ct Johnson Ltd manufactures three products (A, B and C) using the same direct
Lear
ivit
2i labour force. The budgeted data is as follows:

y
A B C
Sales price per unit £10 £20 £24
Variable cost per unit £6.50 £12 £15
Fixed cost per unit £0.50 £4.50 £4
Total cost per unit £7 £16.50 £19
Profit per unit £3 £3.50 £5
Direct labour per unit 0.5 hours 1.5 hours 2 hours
Budgeted monthly sales 500 units 300 units 400 units
There are 1,200 direct labour hours available in normal working hours each
month. The direct labour employees are paid £4 per hour in normal time.
Confirm that the limiting factor is direct labour, identify the best use of the
direct labour hours, and state which contribution would be earned by this
strategy.

F eedb ac
k
Product (units × hours) Hours
2i
A: 500 × 0.5 250
B: 300 × 1.5 450
C: 400 × 2 800
1500
The direct labour is the limiting factor with 1,200 hours.
A B C
Selling price 10 20 24
Variable cost (labour) 6.5 12 15
Contribution 3.5 8 9
Hours 0.5 1.5 2.0
Contribution per limiting factor 7 5.3 4.5
Ranking (1) (2) (3)
Production plan:
Ranking Hours Contribution Total contribution

(units × contribution) (£)
A 250 500 × £3.50 1,750
B 450 300 × £8 2,400
C (Balance) 500 250 × £9 2,250
1,200 6,400
Continue or discontinue
Whether a company ceases production depends in practice on long-term
decisions. In this type of decision, one should consider the contribution made
to the business as a whole rather than just the contribution of the product/
factory to be discontinued.
Example
A company is concerned about its poor profit performance, and is considering
whether to cease selling YY. It is felt that selling prices cannot be raised or
lowered without adversely affecting net income. Of the fixed costs of YY,
£5,000 are direct fixed costs which would be saved if production ceased. All
other fixed costs, it is considered, would remain the same. A summary of the
overall company performance is:

XX YY ZZ Total
Sales £50,000 £40,000 £50,000 £140,000
Variable costs £30,000 £25,000 £25,000 £80,000
Contribution £20,000 £15,000 £25,000 £60,000
Fixed costs £17,000 £18,000 £20,000 £55,000
Profit/loss £3,000 (£3,000) £5,000 £5,000
By stopping production of YY, the consequences would be a £10,000 fall in

profits:
Loss of contribution (£15,000)

Saving in fixed costs £5,000
Incremental loss (£10,000)
It does not therefore seem a good idea to stop producing YY.
Rule: A company should continue producing a product as long as it contributes

to the overall profitability of the company, that is, while it makes a positive
contribution. Qualitative factors should also be considered.
ga
nin ct What are the qualitative factors in the above decision?
Lear
ivit
2j
y
eedb ac
If the company decided to close, what would be the effect on demand
F
2j for other products?

■ Pricing: is YY a loss leader?
Accept or reject orders (special orders)

Special pricing decisions relate to pricing decisions outside the normal market
of a company. Typically they involve one-time orders or orders at a price below
the prevailing market price.
If a company has spare capacity then the rule is to accept an order if the product
makes a contribution to fixed costs and profit. If there is no spare capacity then
existing business should only be turned away if the contribution from a special
order is greater than the contribution from the business which must be
sacrificed.
Example
Symister Ltd makes a single product for which there is great demand. The
labour force is currently working at full capacity producing the product that
earns a contribution of £4 per labour hour. A customer has approached the

company with a request for the manufacture of a special order and is willing
to pay £5,500. The costs of the order would be £2,000 for direct materials,
and 600 labour hours at £3 per hour will be required. Decide whether the order
should be accepted.
Answer:
Labour is a limiting factor. By accepting the order, work would have to be
diverted – from the standard product – and contribution would be lost. That
is, there is an opportunity cost of 600 hours at £4 per hour = £2,400.
Selling price £5,500

Direct materials £2,000
Direct labour (600 × £3) £1,800
Opportunity cost
600 × £4 (contribution lost) £2,400 £6,200
Profit/loss (£700)
Although accepting the order would earn a contribution of £5,500 – (£2,000

+ £1,800) = £1,700 – this contribution would reduce the contribution earned
elsewhere by £2,400 and so the order should not be accepted.
Essentially, special orders are seen as short-term decisions. It could be argued

that if special-order decisions are always evaluated as short-term decisions, a
situation can arise whereby the decision to reduce capacity is continually
deferred. If demand from normal business is considered to be permanently
insufficient to utilise existing capacity, then a long-term capacity decision is
required. It can also be argued that by utilising unused capacity to increase the
range of products produced, the production process becomes more complex
and thus fixed costs of managing additional complexity will eventually increase.
Long-term considerations should therefore always be taken into consideration
when evaluating special pricing decisions.
ga
nin ct
Northampton has three divisions (A, B and C). Information for the year
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2k ending 30 September is as follows:

y
A (£) B (£) C (£) Total (£)

Sales 350 420 150 920
Variable cost 280 210 120 610
Contribution 70 210 30 310
Fixed cost 262.5
Net profit 47.5
Of the fixed costs, 40% is allocated to each division on the basis of sales
revenue. The other 60% is split equally between each division. Using
relevant costs, determine which divisions should remain open if
Northampton wishes to maximise profits.

eedb ac
F
A B C
2k Contribution 70 210 30
Specific fixed cost 52.5 52.5 52.5
Profit/(loss) 17.5 157.5 (22.5)
The specific avoidable fixed overheads per division = £262.5 × 60%

= 157.5/3
= 52.5.
Only divisions A and B should remain open since they both provide positive
contributions to fixed costs.
2.1 Bevel Ltd is an English company that assembles tables and sells them to
a wholesaler in Europe. It manufactures four different types of table: W,
X, Y and Z. It has a labour-intensive factory where all staff are skilled in
the manufacture of all four types of table. Staff can be moved immediately
from the production of one table to another at no additional cost. The
budgeted figures for the forthcoming month are as follows (all figures are
in £ per unit except for sales volume):
W X Y Z
Selling price 25 30 35 30
Costs:
Direct labour at £10 per hour 5 6 8 10
Raw materials
Brass fittings 1 1 2 4
Nails at £30 per kg 3 6 5 3
Sundries: glue 1 1 2 3
Overheads:
Variable overhead 2 2 2 2
Fixed overhead 12 12 12 12
Estimated demand (units) 10,000 7,000 6,000 8,000
Ceasing to produce any product would mean that its share of the fixed
costs would be transferred to the remaining three products.
(a) Calculate whether the company should drop product Z as it is
currently making a loss.

(b) If the company could only manufacture 20,000 units per month due
to limited total production space being available, show how the
company could maximise its profitability under this constraint.
(c) If the company could only acquire 3,150 kg of nails, show how the
company could maximise its profitability under this constraint.
(d) What other factors would you take into account before finally
making a decision about the production mix?
2.2 Mokia Ltd is currently reviewing its manufacturing operations. Currently,
four products are produced: X1, X2, X3 and X4. It has been suggested
that products X3 and X4 should be dropped from production as they are
creating financial losses. The forecast financial results are detailed below:
X1 X2 X3 X4
Sales £450,000 £550,000 £200,000 £260,000
Variable costs £300,000 £250,000 £210,000 £220,000
Fixed costs: general £60,000 £105,000 £25,000 £50,000
Fixed costs: specific £20,000 £15,000 £5,000 £10,000
Profit/(Loss) £70,000 £180,000 (£40,000) (£20,000)
General fixed costs have been absorbed on a direct labour hour basis.
(a) Based on the information given, advise management whether X3
and X4 should be dropped. Support your advice with appropriate
calculations.
(b) The production manager has informed senior management that
because of skills shortages, she is unlikely to have enough machine
operators to provide all the labour requirements. How would this
affect your analysis?
(c) The purchasing manager is outraged at the suggestion that X3
should be dropped as a special machine with no alternative use was
purchased 12 months ago for £30,000, specifically for the X3
production line. The disposal will result in a book loss of £20,000.
What impact would this information have on your analysis?
2.3 What qualitative factors need to be considered when evaluating a special
order request from a customer?
2.4 Provide four examples of possible limiting factors.
2.5 All future costs are relevant to a decision. Do you agree or disagree?
2.6 In your own words, define what a relevant cost is.
2.7 Define what is meant by a limiting factor. Give an example.
2.8 AVC Partners are a pensions and investment consulting firm to large
multinationals who provide employee and executive pensions as part of
remuneration packages. The firm is quite busy and has a new contract
under consideration which requires 600 consulting hours to complete.
There are 350 hours of spare consulting capacity for which consultants
would be paid their normal rate of pay. The remaining hours for the
contract can be found either by weekend overtime working paid at double
the normal rate of pay or by diverting consultants from other projects.

Currently, other projects are making a contribution, net of labour cost, of

£10 per consulting hour. The normal rate of pay is £18 per consulting
hour.
What is the relevant labour cost for the new contract ?

2.1 (a) Z makes a positive contribution to fixed costs and a profit of £30 –
(10 + 4 + 3 +3 + 2) = £8 per unit. Dropping the product would lose
Bevel Ltd 8,000 × £8 = £64,000 contribution and divert the fixed
costs onto the other 3 products.
(b) Contribution per limiting factor:
Rank
W 25 – (5 + 1 + 3 + 1 + 2) = 13 3
X 30 – (6 + 1 + 6 +1 + 2) = 14 2
Y 35 – (8 + 2 + 5 + 2 + 2) = 16 1
Z 30 – (10 + 4 + 3 + 3 + 2) = 8 4
Manufacture in this order up to 20,000 units:
Product Contribution No. of units Total

per unit × £ contribution
Y 16 6,000 96,000
X 14 7,000 98,000
W 13 7,000 (limit) 91,000
20,000 285,000
Less overheads 372,000
Loss (87,000)
Note: Fixed overheads are calculated as 31,000 units × £12 =

£372,000.
(c) Nails required for full capacity:
Units kg per unit kg required

W 10,000 0.1 1,000
X 7,000 0.2 1,400
Y 6,000 0.1667 1,000
Z 8,000 0.1 800
Available nails = 3,150 kg.

Note: In the table on the facing page, each kg of nails yields multiple
units of product. For example, in product W, 1 kg of nails will yield
10 units (1kg/0.1 kg per unit):

Rank
W 13 × 10 = 130 (1)
X 14 × 5 = 70 (4)
Y 16 × 6 = 96 (2)
Z 8 × 10 = 80 (3)
Profitability kg Total Contribution Contribution

kg Per kg
W 1,000 1,000 130 130,000
Y 1,000 2,000 96 96,000
Z 800 2,800 80 64,000
X 350 3,150 70 24,500
314,500
Fixed overhead 372,000
Profit/(Loss) (57,500)
(d) Usual marketing implications: product range, loss leaders, valued

customers, large orders, company image, and so on.
2.2 (a) General fixed costs are unlikely to be reduced by dropping products
X3 and X4. Directly attributable or specific fixed costs will be
avoided as will variable costs. Sales revenue will obviously be lost.
Lost sales (£200,000)

Variable cost savings £210,000
Specific fixed costs £5,000
Net saving (£15,000)
X3 should be dropped as it is currently yielding a negative

contribution. Possible future sales/demand elasticity should be
considered before a final decision is made.
The effects of dropping X4 would be:
Lost sales (£260,000)

Variable cost savings £220,000
Specific fixed costs £10,000
Net loss of contribution (£30,000)
Therefore, X4 should not be dropped.

(b) Existence of scarce resource: optimal production plan found by
ranking products according to contribution per hour of machine
operator. As X3 has a negative contribution it would still be
dropped.

(c) None, as the sunk cost of a book loss is not a cash flow.
2.3 Qualitative factors to be taken into consideration include, but are not
limited to:
■ Are there any long-run implications, for example, will future price be
affected?
■ How are existing customers and orders affected, that is, are any other
better opportunities available?

■ Are staff available? That is, overtime is necessary or staff need to be
trained.
■ How important is the customer asking for the special order in terms of
overall profitability or revenue?

2.4 Possible limiting factors include:
■ machine/process time
■ labour hours
■ floor space/capacity
■ warehouse space
■ supervision hours
■ investment capital.
2.5 All future costs are not relevant. Only future costs that differ as a result
of taking a decision or course of action are relevant.
2.6 A relevant cost is a future cost. You may have used avoidable incremental
or opportunity cost in your definition. This is perfectly acceptable.
2.7 A limiting factor is any scarce resource that limits the production capacity
of the company. Examples are labour, material and sales levels.
2.8 To answer this question, you need to work out the cost of the two options
for overtime and diverting the consultants from existing work:
■ Overtime cost for 250 hours: 250 hours × (£18 × 2) = £9,000
■ Cost of diverting labour: 250 × (£18 + £10) = £7,000
The relevant cost is the lowest alternative – £7,000. It is assumed that AVC
Partners would logically choose the lower-cost option.
Summary
This unit has introduced you to an important cost classification, that is, relevant
or irrelevant costs. You have learned that only some costs are relevant to
decisions.
In summary, relevant costs are those which are affected by a decision (for
example, variable costs), whereas other costs (for example, fixed or sunk costs)
which are not affected are irrelevant. You have also learned to apply your
knowledge of relevant costs to the following scenarios:
■ plant and equipment purchases
■ limiting factors
■ outsource or in-house
■ continue or discontinue
■ accept or reject special orders.

Unit 31 Activity-based costing
‘Pleasure that is obtained by

unreasonable and unsuitable cost, must
always end in pain.’
Samuel Johnson
Introduction
In calculating the selling price of a product or service, a company must
include both direct and indirect costs. Direct costs are easier to ascertain
as the labour and material costs are readily known. Indirect costs, such as
overheads, are quite different. A question is: how much overhead should
be included in the product or service? The answer we’re not sure of, but
we know that it should be included as to exclude it hinders decisions on,
for example, pricing. In this unit, we will explain a method of attributing
activity-based costing (ABC) overhead cost to products or services, namely activity-based costing
(ABC). This technique evolved as the traditional method – absorption
costing – became less relevant to some modern businesses.

absorption costing On completing this unit, you should be able to:
3.1 Explain the need to ascertain the costs of products and services.
3.2 Understand and apply traditional absorption costing method to
costing products and services.
3.3 Understand and apply activity-based costing to costing products and
services.
Prior knowledge
This unit has no prior knowledge, but you may find it useful to read the earlier
pages of ‘An introduction to cost terms and concepts’ in Drury (2009) to be sure
you are familiar with basic cost terms.

3.1 Costing products and services

Traditional absorption costing and activity-based costing (ABC) methods both
seek to determine how much overhead (that is, indirect cost) should be included
in a product or service cost. Both the traditional system and ABC have an
identical approach to assigning direct costs; but they differ on the treatment of
indirect costs.
Traditionally, we tend to think of overheads as rendering a service to cost units,

the cost of which will be charged to those units. ABC sees overheads as being
activity caused by activity, and it is the cost units that cause the activities that must be
charged.
This unit will introduce absorption costing and then compare it to ABC. The
unit then looks at ABC in more detail by recognising the types of cost drivers,
by designing an ABC system, and, finally, by considering the resource consump-
tion model.
ga
nin ct
List as many direct costs of a furniture manufacturer as you can.
Lear
ivit
3a
y
eedb ac
F
Wood
k
3a ■ glue
■ nails
■ handles
■ hinges, and so on.
What is activity-based costing (ABC)?

ABC involves the identification of the factors that cause the costs of an
Recommended reading: ‘Activity-
based costing’ in Drury (2009). organisation’s major activities. An effort is made to charge all support
overheads to products/services on the basis of their usage of the factor causing
the overheads. Thus, ABC allocates indirect costs to cost centres based on
activities rather than departments.
One major difference between the ABC method and the traditional absorption
costing method of overheads relates to the two-stage allocation process. The
first stage for both allocates indirect costs to cost centres (normally depart-
ments). In the second stage, the traditional costing method uses a limited
number of different types of second-stage volume-based allocation (non-
drivers), whereas ABC systems use many different types of volume-based and
non-volume-based cause-and-effect second-stage drivers. Another difference is
that the absorption approach tends to concentrate more on manufacturing
overhead only, meaning that other overheads, such as selling and administra-
tion, tend to be treated as period costs.

Reasons for the development of ABC

Recommended reading: CIMA The reasons for the development of ABC can be grouped under two broad
(2009); Brierley et al (2006) headings:
.
The modern manufacturing environment
■ An increase in support services, such as production scheduling and customer
service.
■ Support services are unaffected by changes in production volume.
■ The range and complexity of products has increased, thus increasing the
activity and number of support services.
■ An increase in overheads as a proportion of total costs.
Inadequacies of absorption costing

■ It implies all overheads are related to production volume.
■ It originates from a time when organisations produced only a narrow range
of products and when overheads were only a small fraction of total costs.
■ It tends to allocate too great a proportion of overheads to high-volume
products (which cause relatively little diversity), and too small a proportion
to low-volume products (which cause greater diversity and use more
support services).
■ It typically concentrates on manufacturing overhead.
CIMA’s 2009 annual survey of management accounting practices reported that

approximately 45% of respondent organisations still use absorption costing,
with approximately 30% using ABC.
3.2 Applying absorption costing techniques

Absorption costing is the traditional method of product costing which aims to
Recommended reading: ‘Cost include an appropriate share of an organisation’s manufacturing overhead in
assignment’ in Drury (2009).
the total cost of a product or service. Product costs are built up using absorption
costing in a process of allocation, apportionment and overhead absorption.
Absorption costing can be used for non-manufacturing overhead, but as you’ll
see later, choosing a volume-based driver may have no relation to how non-
manufacturing overhead is actually incurred.
As stated earlier, there are two stages to apportioning overheads:

1. Sharing out the overhead to cost centres using a fair basis of apportion-
ment.
2. Apportioning the costs of service cost centres (both directly allocated and
apportioned costs) to product cost centres.
The third and fourth stages of absorption costing include the absorption into
product costs (using overhead absorption rates) of the overheads that have been
allocated and apportioned to the product cost centres.

Example
A company is preparing its production overhead budgets and determining the
apportionment of those overheads to products. The company has three pro-
duction departments (X, Y and Z) and two services departments (stores and
maintenance). Costs and related information have been budgeted as follows:
Total (£) X (£) Y (£) Z (£) Stores (£) Maintenance (£)

Indirect wages 87,560 13,586 9,190 14,674 29,650 20,460
Materials 26,900 11,400 13,700 1,200 600 –
Rents and rates 10,700
Building insurance 2,600
Power 9,600
Heat and light 7,400
Depreciation (machinery) 20,200
Value of machinery 402,000 201,000 179,000 22,000
Power (kWh used) 100 55 40 3 – 2
Direct labour (hours) 35,000 8,000 6,200 20,800 – –
Machine usage (hours) 25,200 7,200 18,000 – – –
Area (sq ft) 45,000 10,000 12,000 15,000 6,000 2,000
Calculate overhead totals for all departments by using direct apportionment as

an appropriate basis. Service department overheads of stores and maintenance
are allocated on the basis of direct labour and machine usage, respectively.
Answer:
Stage 1
1. The indirect expense of materials and indirect wages can be directly
allocated to the production cost centres X, Y and Z and to the service
department’s stores and maintenance (as these are actually incurred in the
departments).
2. The overheads of rent and rates, building insurance, power, light and heat,
and depreciation need to be apportioned (that is, shared out) using a fair
and suitable basis. We could use, respectively:
■ value of machinery
■ power used
■ direct labour hours
■ machine hours
■ area.
From the above list, the most suitable basis for rent and rates is area. Therefore
the calculation is as follows:

Rent and rates = £10,700, which needs apportioning out using the basis of area
X: 10000 ÷ 45000 × 10700 = £2,378
Y: 12000 ÷ 45000 × 10700 = £2,853
Z: 15000 ÷ 45000 × 10700 = £3,567
Stores: 6000 ÷ 45000 × 10700 = £1,427
Maintenance: 2000 ÷ 45000 × 10700 = £475
Total: £10,700.
The same approach can be adopted for the apportionment of building insurance
and heat and light. Power can be apportioned using kilowatt-hours (kWh) as
a basis, and depreciation can be apportioned using the value of machinery. The
first stage of the apportionment can now take place.
Step 1
Total (£) X (£) Y (£) Z (£) Stores (£) Maintenance (£)

Indirect wages 87,560 13,586 9,190 14,674 29,650 20,460
Materials 26,900 11,400 13,700 1,200 600
Rent and rates 10,700 2,378 2,853 3,567 1,427 475
Building insurance 2,600 578 693 867 347 115
Power 9,600 5,280 3,840 288 0 192
Heat and light 7,400 1,644 1,973 2,467 987 329
Depreciation 20,200 10,100 8,995 1,105
Total (£) 164,960 44,966 41,244 24,168 33,011 21,571
This is the end of Step 1.
In the table above it can be seen that the service costs of £33,011 (stores) and
£21,571 (maintenance) still need to be reapportioned to the production cost
centres (that is, X, Y and Z). A suitable basis for reapportioning stores appears
to be direct labour hours. Therefore, using direct labour to reapportion stores:
X: 8000 × 33011 ÷ 35000 = £7,545
Y: 6200 × 33011 ÷ 35000 = £5,848
Z: 20800 × 33011 ÷ 35000 = £19,618
Total: £7,545 + £5,848 + £19,618 = £33,011.
ga
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Now try to reapportion maintenance costs to X, Y and Z based on machine
Lear
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3b usage.
y
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F
7200 × 21571 ÷ 25,200 = £6,163

3b 18000 × 21571 ÷ 25200 = £15,408
£6,163 + £15,408 = £21,571.

Step 2
Total (£) X(£) Y(£) Z(£) Stores (£) Maintenance (£) Basis
Totals (from Step 1) 164,960 44,966 41,244 24,168 33,011 21,571

Reapportion stores 0 7,545 5,848 19,618 (33,011) DL
hours
Reapportion 0 6,163 15,408 (21,571) MC
maintenance hours
Final totals 164,960 58,674 62,500 43,786 0 0
Step 3
We will now calculate separate overhead absorption rates for each production
cost centre. There are a number of different ways in which we could do this, but
we will use either labour or machine hours depending on the characteristics of
each cost centre. Thus, we can now say an overhead absorption rate can be
calculated by using this formula: cost centre overheads ÷ cost centre direct
labour hours or machine hours. Or in a more general sense, this formula can
be written as: budgeted overhead ÷ allocation base.
The choice of an absorption base is a matter of judgement but the management

accountant should choose a basis that reflects the characteristics of a given cost
centre. The absorption of overhead for departments X and Z could be based on
labour hours as this is a dominant factor with 8,000 labour hours used by X
and 20,800 by Z. Department Y is dominated by machine hours, of which there
are 18,000.
Therefore the absorption rates are:
Total X Y Z
Total overhead 164,960 58,674 62,500 43,786
Absorbed
By machine hours 18,000
By labour hours 8,000 20,800
Absorption rate 7.33 3.47 2.11
per lab hr per mc hr per lab hr
Step 4
Assigning cost centre overheads to products: assume that a product requires 1
labour hour and 1 machine hour in each department, and 100 units of the
product are produced. If the direct cost of the product is £120, then the unit cost
is:

Overhead Labour hour Machine hour Total

X 1 £7.33
Y 1 £3.47
Z 1 £2.11
Total £132.91
The cost of 100 products is £13,291.
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Briefly list the types of factors you believe could affect the choice of the
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3c base an organisation uses to apportion service department costs.

y
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The type of service provided.
F
3c ■ The amount of overhead expenditure involved.

■ The number of departments benefitting from the service.
■ The ability to produce realistic estimates of the usage of the service.
■ The resulting costs and benefits.
3.3 Applying ABC techniques

Recommended reading: ‘Activity- Example: ABC system and traditional system
based costing’ in Drury (2009).
Russell Ltd manufacturers four products: A, B, C and D.
Product Output units Number of Material cost Direct labour Machine

runs in the per unit hours per unit hours per unit
period
A 20 4 40 1 1
B 20 4 100 2 2
C 200 5 40 1 1
D 200 5 100 2 2
Direct labour cost per hour is £5.
Overhead costs are scheduling costs of £14,280 and materials handling costs of
£8,800, a total of £23,080.
Absorption rates are calculated using machine hours as a base.
Question:
Calculate costs for using traditional absorption costing and ABC:
Solution for absorption costing method (note that the direct costs for ABC are
exactly the same as for absorption costing):

Direct material cost (1)

A: £40 × 20 = £800
B: £100 × 20 = £2,000
C: £40 × 200 = £8,000
D: £200 × 100 = £20,000
Direct labour cost (2)

A: 20 × 1hr × £5 = £100
B: 20 × 2hr × £5 = £200
C: 200 × 1hr × £5 = £1,000
D: 200 × 2hr × £5 = £2,000
Overhead calculations
Total overheads ÷ machine hours = absorption rate
Machine hours (3)

A: 20 × 1 = 20
B: 20 × 2 = 40
C: 200 × 1 = 200
D: 200 × 2 = 400
Total: 660
Absorption rate
Total overheads ÷ machine hours = 23080 ÷ 660 = £34.97 per machine hour
Overheads (4)
A: 1 hr × 20 units × £34.97 = £699
B: 2 hrs × 20 units × £34.97 = £1,399
C: 1 hr × 200 units × £34.97 = £6,994
D: 2 hrs × 200 units × £34.97 = £13,988
Unit cost
Product Material Labour Overhead Total

(£) (£) (£) (£)
A 40 5 34.97 79.97
B 100 10 69.94 179.94
C 40 5 34.97 79.97
D 100 10 69.94 179.94

Solution for ABC method
Overhead cost driver Production runs in period

Activity rates Cost Runs Per run
Scheduling 14,280 18 793
Handling 8,800 18 489
Production runs A B C D Total

4 4 5 5 18
Scheduling costs
Absorption rate 793 793 793 793
per run
Cost 3,173 3,173 3,967 3,967
Handling costs
Absorption rate 489 489 489 489
per run
Cost 1,956 1,956 2,444 2,444
A B C D Total
Direct materials 800 2,000 8,000 20,000 30,800
Direct labour 100 200 1,000 2,000 3,300
Overheads:
Scheduling 3,173 3,173 3,967 3,967 14,280
Materials handling 1,956 1,956 2,444 2,444 8,800
Total 6,029 7,329 15,411 28,411 57,180
Units 20 20 200 200
Unit cost ABC 301.44 366.44 77.06 142.06
Unit cost traditional 79.97 179.94 79.97 179.94
Differences 221.47 186.51 (2.91) (37.88)
Note that the direct costs for ABC are exactly the same as for absorption
costing. Observe how the overhead rates for scheduling and material handling
are multiplied by the number of runs to obtain the overhead amount for the
products. The term ‘cost driver’ used above is explained in the next section.
Conclusion
The figures suggest that the traditional volume-based absorption costing system
is flawed:
1. It under-allocates overhead costs to low-volume products (A and B) and
over-allocates overheads to higher-volume products (D in particular).

2. It under-allocates overhead costs to smaller-sized products (A and C with

just one hour of work needed per unit) and over-allocates overheads to
larger products (B and D).
Cost drivers
Recommended reading: ‘Activity- A cost driver is a factor that causes a change in the cost of an activity. For
based costing’ in Drury (2009). example, materials handling cost would be a possible driver in the number of
production runs. Cost drivers are a significant part of an ABC system. There are
different types of cost driver.
cost driver
Volume-based and non-volume-based cost drivers

ABC systems rely on a greater number and variety of second-stage cost drivers.
The term ‘variety of cost drivers’ refers to the fact that ABC systems use both
volume-based and non-volume-based cost drivers. In contrast, traditional
systems use only volume-based cost drivers, such as machine or labour hours,
as shown in the earlier examples. Volume-based cost drivers assume that a
product’s consumption of overhead resources is directly related to the units
produced. These cost drivers are appropriate for measuring the consumption of
expenses such as machine energy costs, depreciation related to machine usage,
indirect labour employed in production centres, and inspection costs where
each item produced is subject to final inspection. Volume-based drivers are
appropriate where the activities are performed each time a unit of the product
or service is produced.
In contrast, non-volume-related activities (such as product design) are not

performed each time a unit of the product or service is produced. Using only
volume-based cost drivers to assign non-volume-related overhead costs could
result in the reporting of distorted product costs. If a large proportion of an
organisation’s costs are unrelated to volume there is a danger that inaccurate
product costs will be reported. Similarly, if non-volume-related overhead costs
are only a small proportion of total overhead costs, the distortion of product
costs will not be significant. In these circumstances, traditional product costing
systems are likely to be acceptable.
Activity cost drivers

Activity cost drivers consist of transaction and duration drivers. Transaction
drivers, such as the number of purchase orders processed, number of customer
orders processed, number of inspections performed and the number of set-ups
undertaken, all count the number of times an activity is performed. Transaction
drivers are the least expensive type of cost driver but they are also likely to be
the least accurate because they assume that the same quantity of resources is
required every time an activity is performed. Duration drivers represent the
amount of time required to perform an activity. Examples of duration drivers
include set-up hours and inspection hours.
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Can you think of what might drive costs in a sales/customer service
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3d department of a company?
y

eedb ac
Drivers might include the volume of sales orders processed, number of
F
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3d customers served or number of customer complaints handled.
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Lear
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3e non-volume based?
y
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F
The answers given are all volume-based. An example of a non-volume

3e based driver might be product design time for customer specific or new
products.
Designing an ABC system

Designing an ABC system typically involves the following steps:
1. Identify an organisation’s major activities by carrying out activity analysis.
2. Identify the cost drivers (the factors that determine the size of the costs of
an activity/cause the costs of an activity).
3. Collect the costs associated with each cost driver into what are known as
cost pool cost pools.
In order to assign the costs attached to each activity cost centre to products, a
cost driver must be selected for each activity centre. Cost drivers used at this
stage are called activity cost drivers.
Resource consumption model

Kaplan and Cooper (1998) have argued that an ABC system is really a resource
‘Measuring the cost of resource consumption model. Kaplan argues than an ABC system measures the cost of
capacity’ in Kaplan and Cooper using resources and not the cost of supplying resources.
(1998); ‘Activity-based costing’ in
Drury (2009).
Kaplan and Cooper (1998) used the following equation: cost of resources
supplied = cost of resources used + cost of unused capacity.
We can rearrange this formula to get: cost of resources supplied – cost of unused
capacity = cost of resources used.
Drury (2008) argues that ABC will:

‘measure the cost of using resources and not the cost of supplying
resources. The difference between the cost of resources supplied and the
cost of resources used represents the cost of unused capacity. The cost
of unused capacity for each activity is the reporting mechanism for
identifying the need to adjust the supply of resources to match the usage
of resources. However, to translate the benefits of reduced activity
demands into cash flow savings, management action is required to
remove the unused capacity by reducing the spending on the supply of
resources.’

Kaplan and Cooper identified that unused capacity consists of:

■ Acquisition of equipment or employment of non-piecework (committed
resources).
■ Materials, unusual labour, power, and so on, continually adjusting to match
the exact demand. (Flexible resources are also known as variable costs.)
Drury (2008) argues:

‘To translate benefits of reduced activity demands into cash flow saving,
management action is required. They must permanently remove the
unused capacity by reducing spending on the supply of resources.’
The following information relates to the purchasing activity in a division of the

Sahai Company for the next year. We will use Kaplan’s formula in our
calculations:
Data:
■ Number of employees = 10. Thus 1,200 purchase orders per year capacity
per employee = 12,000 orders in total
■ Salary of each employee: £24,000 per annum
■ Cost driver is number of purchase orders
■ Estimated number of purchase orders to be processed during the year =
10,000.
Question
Calculate the cost of unused capacity.
Solution
Resources supplied:
10 full-time staff at £24,000 per year (including employment costs) = £240,000
annual activity cost.
Cost driver = number of purchase orders processed.
Quantity of cost driver supplied per year: (each member of staff can process
1,200 orders per year) = 12,000 purchase orders.
Estimated cost driver rate = £20 per purchase order (240,000 ÷ 12,000 orders).
Resources used:
Estimated number of purchase orders to be processed during the year = 10,000.
Estimated cost of resources used assigned to parts and materials = £200,000
(10,000 × £20).
Cost of unused capacity:
Resources supplied (12,000) – resources used (10,000) at £20 per order =
£40,000 (2,000 × £20).
ABC in service organisations

Recommended reading: ‘Activity- Drury (2009) quotes Kaplan and Cooper (1998), who argue that service
based costing’ in Drury (2009); organisations are ideal for ABC since most of service organisations’ costs are
Drury and Tayles (2000). indirect. A UK survey by Drury and Tayles (2000) suggests that service
organisations are more likely to implement ABC systems. They reported that
51% of the financial and service organisations surveyed, compared with 15%
of manufacturing organisations, had implemented ABC.
3.1 Consider the likely benefits and problems of the activity-based costing
system. Make lists of each.
3.2 A company manufactures two products, A and B, using the same equip-
ment and similar processes. An extract of the production data for these
products in one period is shown below:
A B Total
Quantity produced (units) 6,000 7,000 13,000
Direct labour hours per unit 2 3 5
Machine hours per unit 4 2 6
Set-ups in the period 10 40 50
Orders handled in the period 15 60 75
Overhead costs £
Relating to machine activity 320,000
Relating to production run set-ups 40,000
Relating to handling of orders 65,000
Total 425,000
Calculate the production overheads to be absorbed by one unit on each

of the products using the following cost methods:
(a) A traditional costing approach using a direct labour hour rate to
absorb overheads.
(b) An ABC approach, using suitable cost drivers to trace overheads to
products.
3.3 Which of the following is not a feature of ABC?
(a) It improves managers’ understanding of costs.
(b) It is quick and easy to implement.
(c) It identifies the activities that drive costs.
(d) It searches for a better way of overhead cost allocation.
(e) None of the above.
3.4 Traditional absorption costing in a hospital: the following budget
information (see page 54) relates to the general surgery and geriatric
departments, which are two departments of many NHS hospitals, for the
most recent financial year.
The hospital operates a traditional absorption costing system, calculating
total costs per inpatient day as an absorption base.
(a) Calculate the budgeted hospital overhead absorption rate per
inpatient day based on the data on page 54.
(b) Calculate the total cost per inpatient day for the general surgery and
geriatric departments. How could hospital management use these
costs meaningfully?
(c) Is it necessary to determine costs in a hospital?

General surgery Geriatric

Number of inpatients 5,000 100
Average stay per inpatient 10 days 200 days
Cost analysis:
Direct treatment £ £
Consultants 2,000,000 500,000
Junior doctors 500,000 1,000,000
Nurses 2,000,000 3,000,000
Direct medical supplies 500,000 1,500,000
Total hospital overheads: £
Hospital administration 6,000,000
Catering 2,000,000
Cleaning 1,500,000
Maintenance 1,000,000
Utilities/laundry 1,000,000
3.5 Smith Ltd has recently introduced an ABC system. It manufactures three
products, details of which are set out below:
A B C
Budgeted annual production 100,000 100,000 100,000
Batch size (units) 100 50 25
Machine set-ups per batch 3 4 6
Three cost pools have been identified. Their budgeted costs for the year
just ended are as follows:
Machine set-up costs: £150,000.
Purchasing of materials: £70,000.
Processing: £80,000.
Calculate the budgeted set-up cost per unit of product B.
3.6 ABC costs are accumulated by activity using what?
3.7 Why does any organisation need to know the cost of the products it sells
or services it provides?


3.1 Compare your list with those benefits and problems identified below:
Benefits:
■ Greater understanding of customer profitability.
■ Identification of non-value-adding activities; that is, tasks which add
no further value to the product or service, such as manual checking of

customer orders and specifications.
■ Identification and understanding of cost behaviour, and thus the
potential to improve cost estimation.

■ Improved accuracy and utility value of management information, thus
enabling managers to make better-informed decisions at both tactical

and strategic levels.
■ Allowing all managers to understand and control costs in their area.
■ By involvement with ABC, accountants can now contribute to an
organisation’s future, rather than merely reporting on its past.

Problems:
■ Identification of cost drivers is a problem and would need to be
explored with each department manager.
■ Overheads, common to several cost pools, may be required to be
arbitrarily apportioned across all product lines or customers. Examples

are: rent, rates, insurance, depreciation, power, heat and light.
■ Overall time and cost involved in implementation. Data gathering can
be very expensive. Not only is it very labour intensive, it can also take
many hours to extract all the relevant information from the various
managers and staff. Costs will also rise, of course, if external con-
sultants are used.
■ Departmental resistance to change, or to provide information.
■ Reluctance to change traditional accounting methods.
3.2 (a) Traditional costing approach:
Direct labour
(hours)
Product A = 6,000 units × 2 hours 12,000
Product B = 7,000 units × 2 hours 21,000
33,000
Therefore, overhead absorption rate = £425,000/33,000

= £12.88 per hour
Overhead absorbed would be as follows

Product A 2 hours × 12.88 = £25.76
Product B 3 hours × 12.88 = £38.64

(b) ABC approach:
Overhead cost drivers Cost Activity rate Absorption

Machine activity Machine hours 320,000 38,000 8.421
Production set-ups Set-ups 40,000 50 800.00
Materials handling Number of orders 65,000 75 866.67
A B Total
Machine hours 24,000 14,000 38,000
Set-ups 10 40 50
Number of orders 15 60 75
Overheads:
Machine activity 202,105 117,895 320,000
Production set-ups 8,000 32,000 40,000
Materials handling 13,000 52,000 65,000
Total 223,105 201,895
Units 6,000 7,000
Overhead per unit £37.18 £28.84
These figures suggest that Product B absorbs an unrealistic amount

of overhead using a direct labour hour basis. Overhead absorption
should be based on the activities which drive the costs, in this case
machine hours, the number of production run set-ups and the
number of orders handled for each product.
3.3 It is quick and easy to implement.

3.4 (a) and (b):
In-patients Average in-patient

days per patient Inpatient days
General 5,000 10 50,000
Geriatric 100 200 20,000
70,000
Overhead costs:
Administration 6,000,000
Catering 2,000,000
Cleaning 1,500,000
Maintenance 1,000,000
Utilities 1,000,000
Total 11,500,000 70,000
Overhead absorption rate £164.29 per inpatient day

General Geriatric
Inpatient days 50,000 20,000
Overhead absorption rate 164.29 164.29
Overhead cost £ 8,214,286 3,285,714
Absorption costing schedule

Direct treatment: General Geriatric Total
Consultants 2,000,000 500,000 2,500,000
Junior doctors 500,000 1,000,000 1,500,000
Nurses 2,000,000 3,000,000 5,000,000
Direct medical supplies 500,000 1,500,000 2,000,000
Total direct costs 5,000,000 6,000,000 11,000,000
Overheads 8,214,286 3,285,714 11,500,000
Total 13,214,286 9,285,714 22,500,000
Inpatient days 50,000 20,000
Cost per inpatient day £264.29 £464.29
Would one expect geriatric treatment to be more expensive?

Should all departments be allocated the same amount of overhead per inpatient
day?

(c) How could the cost information be used?

■ Attention directing, that is, variances to budget investigated.
■ Cost reduction in general.
■ Cost comparison between departments and other hospitals.
■ Is cost ascertainment necessary?
■ Social versus financial/survival objectives.
■ Emotional/ethical cultural conflict against cost reduction.
■ How can one set averages over such a wide range of treatment?
■ Averages could be meaningless over such a range of patients, such
as age/gender, and so on.
■ What does one mean by controllable expenditure in the NHS?
■ It enhances control/stewardship of scarce resources.
■ Helps to provide value for money.
■ Identifies high- and low-cost activities.
3.5 Budgeted number of batches per product:
A = 1000 (100,000 ÷ 100)
B = 2000 (100,000 ÷ 50)
C = 2000 (50,000 ÷ 25)
Total = 5000
Budgeted machine set-ups:
A = 3,000 (1000 × 3)
B = 8,000 (2000 × 4)
C = 12,000 (2000 × 6)
Total = 23,000
Budgeted cost per set-up = £150,000 ÷ 23,000 = £6.52
Budgeted set-up cost per unit of B = (£6.52 × 4) ÷ 50 = £0.52
3.6 Cost pools.
3.7 Costs need to be known for several reasons:
■ determining a price
■ valuing inventory
■ allocating limited resources
■ decision making.
Summary
In this unit, you have learned how to estimate the full cost of a product or
service by including a portion of overhead in the calculations. You have learned
the more traditional absorption costing techniques and noted several problems
that may make it less useful to some organisations today. These are:
■ It implies overheads are related to production volume.
■ It originates from a time when organisations produced only a narrow range
of products and when overheads were only a small fraction of total costs.
■ It tends to allocate too great a proportion of overheads to high-volume
products and vice versa to low-volume products.
■ It typically concentrates on manufacturing overhead.

You have also learned about an alternative technique: activity-based costing

(ABC). This technique moves away from volume as a cost driver and examines
the activities that drive costs and how much of each activity is consumed by a
product or service. Arguably, ABC has a major advantage over the traditional
method in that it links resources used (activities) to product costs. It may also
be more suitable to service sector organisations that have no manufacturing
overheads, but yet need to include selling and administration overhead in costs.

Unit 41 Pricing decisions
‘What is a cynic? A man who knows the

price of everything and the value of
nothing.’
Oscar Wilde
Introduction
To a business, pricing is important as the correct price for its product will
enable it to compete, survive and be profitable. Price also helps to
differentiate and position a product in the marketplace and thus exploit
business opportunities. While the topic of pricing covers quite a narrow
area, it is key to the strategy of an organisation. The structure of this
unit looks firstly at some economic theory on pricing. Then, the unit
looks at the role of cost information in long- and short-term pricing
(including life cycle costing) and, finally, different pricing policies. This
unit examines the pricing policy of an organisation with regard to the
external market. The topic of transfer or internal pricing, which looks at
notional prices attached to goods and services within an organisation, is
covered Unit 9.

At the end of this unit, you should be able to:
4.1 Explain the role of economic theory in pricing.
4.2 Explain the role of cost information in pricing decisions.
4.3 Explain considerations of long- and short-term pricing.
4.4 Identify and describe various pricing policies.
Prior knowledge
There is no prior knowledge for this unit, but you may find it helpful to relate the
material to products, services or companies you know or are familiar with.

4.1 Economic theory and pricing

Economic theory can assist in determining pricing decisions of a firm by looking
at the demand for the product and also what level of output the firm should
produce. We will now briefly consider each of the above. Demand for a product
elasticity of demand can be elastic or inelastic – in economics this is referred to as the elasticity of
demand.
Elastic demand means that a small increase/decrease in price causes a large

decrease/increase in demand. Demand is typically elastic when there are substitutes
for a product. Inelastic demand means that the quantity demanded falls by a
smaller percentage than the percentage increase in price. An awareness of the
concept of elasticity can assist management with pricing decisions in two ways:
1. If inelastic demand exists, prices could be increased because revenues will
increase, and with stable costs, profits will increase.
2. If elastic demand exists, increases in prices will bring decreases in revenue,
and decreases in price will bring increases in revenue.
Inelastic and elastic demand curves are shown below in Figure 4.1 and Figure
4.2, respectively:
Price
Pb
Pa
Qb Qa Demand
Figure 4.1: Inelastic demand curve.
Price
Pb
Pa
Qb Qa Demand
Figure 4.2: Elastic demand curve.

Looking at Figure 4.1, which depicts an inelastic demand curve, you can see
that an increase in price from Pa to Pb causes a proportionately smaller decrease
in demand (from Qa to Qb). Figure 4.2 depicts an elastic demand curve, so
when price increases from Pa to Pb, you can see how the drop in demand from
Qa to Qb is proportionately greater.
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1. What does price elasticity of demand measure?
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y
2. Distinguish between elastic and inelastic demand.
eedb ac
1. Price elasticity of demand is a measure of the extent of change in market
F
4a demand for a good in response to a change in its price.

2. Where demand is elastic, demand falls by a larger percentage than the
percentage rise in price. Where demand is inelastic the quantity
demanded falls by a smaller percentage than the percentage increase in
price.
At what output will a firm make a profit?

marginal cost Microeconomic theory suggests that as output increases, the marginal cost per
unit might rise (due to the law of diminishing returns) and whenever the firm
is faced with a downward-sloping demand curve, the marginal revenue per unit
marginal revenue will decline. Eventually, a level of output will be reached where the extra cost
of making one extra unit of output is greater than the extra revenue obtained
from its sale. It would then be unprofitable to make and sell that extra unit.
Profits will be maximised to the output level where marginal cost has risen to
be equal to the marginal revenue, or where MC = MR. There are some
difficulties with applying economic theory to management accounting as it
assumes:
■ That a firm can estimate a demand curve for its products. In reality this
may be difficult as most companies may have many different products.
■ Price influences the quantity demanded. In practice, factors other than price
may influence the quantity demanded, such as quality, advertising, and so
on.
Learning Activity 4b tests whether you can deduce the profit-maximising

output by completing a table.
ga
nin ct
An organisation operates in a market where there is imperfect competition,
Lear
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4b so that to sell more units of output, it must reduce the sales price of all the
y
units it sells. The following data is available for prices and costs:

ga
nin ct
Lear
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Total output Sales price per Average cost of
4b
y
(units) unit (AR) (£) output (AC)
(£ per unit)
continued
0 – –
1 504 720
2 471 402
3 439 288
4 407 231
5 377 201
6 346 189
7 317 182
8 288 180
9 259 186
10 232 198
The total cost of zero output is £600.

Complete the table below to determine the output level and price at which
the organisation would maximise its profits, assuming that fractions of units
cannot be made. Remember, you are trying to find where MC = MR.
Units Price (£) Total Marginal Total cost Marginal Profit

revenue revenue (£) cost (£) (£)
1
2
3
4
5
6
7
8
9
10

eedb ac
F
The correct answer is that profit is maximised at 7 units and a price of £317,
4b where MR is nearly equal to MC.
Units Price Total Marginal Total cost Marginal Profit

(£) revenue revenue (£) cost (£) (£)
0 0 0 0 600 (600)
1 504 504 504 720 120 (216)
2 471 942 438 804 84 138
3 439 1,317 375 864 60 453
4 407 1,628 311 924 60 704
5 377 1,885 257 1,005 81 880
6 346 2,076 191 1,134 129 942
7 317 2,219 143 1,274 140 945
8 288 2,304 85 1,440 166 864
9 259 2,331 27 1,674 234 357
10 232 2,320 (11) 1,980 306 340
4.2 The role of cost information in pricing

decisions
Recommended reading: ‘Pricing The role of cost information is one important factor in determining whether
decisions and profitability analysis’ companies are price takers or price setters in the market, that is, whether firms
in Drury (2009). can influence price or whether price is determined for them by the factors in the
markets.
price taker
In general, the competitive nature of an industry or sector will determine

whether a firm is a price taker or price setter. If an industry is highly competitive
price setter and no one organisation can influence price, then price takers prevail. On the
other hand, in a highly differentiated industry where one or a small number of
organisations specialise in products or services, then some discretion on price
setting may occur.
When an organisation is a price taker, cost information is important as the

product cost must be assessed to determine profitability from the market deter-
mined price. Likewise, when a price-setting scenario occurs, cost information
is important so that an appropriate long-term price can be set.
4.3 Short- and long-term pricing

The situation of price taker and price setter is further complicated by the fact
that an organisation needs to consider the short run and long run. The follow-
ing rules can be applied.

Price-setting firm in the short run, and

price-taking firm facing short-run product-mix
decisions
For short-term decisions the incremental costs of accepting an order should be
presented (look back to Unit 2). Short-term pricing decisions should meet the
following conditions:
■ Spare capacity should be available.
■ The bid price should represent a one-off price that will not be repeated.
■ The orders will utilise unused capacity.
Price-setting firm’s long-run pricing decisions

Recommended reading: ‘Strategic There are three approaches to pricing in this scenario:
cost management’ in Drury
1. In pricing customised products, it is important that a firm uses accurate
(2009); Jack (2009).
costs. There is, therefore, a strong argument to use activity-based cost (ABC)
information as it provides a better understanding of cost behaviour (see
Unit 3).
2. In pricing non-customised products, the pricing is based on direct
negotiation with the customer.
target costing 3. In using target costing for non-customised products, the selling price is the
start of the costing process rather than the cost.
Approach of target costing

■ Determine the target price which customers will be prepared to pay for the
product, probably through market research.
■ Deduct a target profit margin from the target price to determine the target
cost.
■ Estimate the actual cost of the product.
■ If estimated actual cost exceeds the target cost, investigate ways of driving
down the actual cost to the target cost. This may mean product design
and/or business process changes.
Target costing can also be useful in scenarios when the market sets the price.
Jack (2009) uses the example of the agriculture sector in the UK, US and
Australia/New Zealand.
Price-taking firm facing long-run product-mix

decisions
A price-taking firm accepts the market price. It will, however, need to use
activity-based profitability analysis to evaluate each product’s long-run
profitability.
ga
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Distinguish between a price taker and a price setter. Can you think of any
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4c organisations/industry sectors you are familiar with that may be price takers
y
and/or price setters?

eedb ac
A price taker is a firm that has little or no influence over the prices of its
F
4c product or service. A price setter is a firm that has some discretion over the
selling price of its products or services.
Examples of price-taking sectors include consumer electronics, agricultural
produce, paper and wood products. Examples of price-setting sectors
include computer software (for example, Microsoft), heavy engineering, and
some utility companies (for example, telephone, water and energy in some
markets).
ga
nin ct Imagine that you need to present to your class on relevant costs for a short-
Lear
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4d run pricing decision. Jot down the costs you would typically associate with
y
such a decision.
eedb ac
Some examples include:
F
4d ■ extra materials
■ extra labour
■ extra energy
■ additional rented plant or equipment
■ additional storage and/or distribution costs.
In other words, these are incremental costs.
Life cycle costing

As mentioned earlier in the unit, the cost of a product or service is an important
factor when calculating a price. Costs are incurred throughout the life of a
product. For example, some products may have high development costs,
implying a lot of cost in the earlier years of the product life. Cars and aircraft
are good examples of products with high development costs. Increasingly,
manufacturers have to consider costs at the end of a product’s life. For example,
many countries impose levies on manufacturers based on how much of a
product can be recycled at the end of its life.
The term ‘product life cycle’ is used to describe the sequence of product sales
over time. Figure 4.3 depicts a typical product life cycle.
Relating the product life cycle to pricing, in the introduction stage price may be
low to generate market share, but it may also be high to recoup development
costs. In the growth stage, pricing will be maintained as competition in the
market may be low. As the product and market matures, competition increases
and price may have to be lowered. Finally, as the market and product decline,
price may be under intense pressure, so costs may need to be reduced to
maintain profitability.

Product Sales
Introduction Growth Maturity Decline
Figure 4.3: A typical product life cycle.
Thinking about a typical product life cycle as shown in Figure 4.3, it is clear
that the total costs of a product over time include costs of research/
development, operations/manufacturing, ongoing maintenance and service,
decommissioning and costs along the product’s value chain. A major advantage
of analysing the life cycle costs is to ensure that all committed costs are kept to
a minimum. Committed costs are those costs which will be incurred in the
product’s life cycle, but are committed prior to production. For example, clever
design can drastically reduce production costs. From a price-setting view, a life
cycle cost analysis is very useful in that an organisation can consider all costs
at the various points in the product’s life cycle and attempt to price accordingly.
This is particularly important at the development and design stage as all costs
committed at this stage cannot be easily altered later on.
ga
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Generating wind energy requires a large initial capital investment cost. Over
Lear
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4e the longer term, can you think of how the costs of generating energy using
y
wind compares to costs of generation using fossil fuels, for example. Can
you compare the life cycle costs? An internet search will help you find an
answer.
eedb ac
You might have found that although the cost of wind power is decreasing,
F
4e the initial outlay costs are still quite high. Wind turbines are costly and a
larger site is typically needed (which implies higher land acquisition and
preparation costs). Indeed, wind turbines constructed at sea are increasingly
popular and costly to construct compared to fossil fuel-based generation
plants. Over the typical life cycles of generation equipment, however, wind
energy costs are more competitive as no fuel is needed and operating
expenses are minimal (for example, no employees are required to run a
wind turbine).

Approaches to pricing
Recommended reading: ‘Pricing Cost-based approaches to pricing
decisions and profitability analysis’ There are a variety of different costing bases, including:
in Drury (2009). ■ total (full) cost + % for profit = selling price
■ variable cost + % for profit = selling price.
Example
The following is an example using full cost-plus pricing:
Bachelor has begun to produce a new product, Product A, for which the
following cost estimates have been made:
£
Direct materials 10
Direct labour: 3 hours at £5 per hour 15
Variable production overhead: machining, 0.5 hours at £6 per hour 3
Total 28
Production fixed overheads are budgeted at £350,000 per month and, because
of the shortage of available machining capacity, the company will be restricted
to 10,000 hours of machine time per month. The absorption rate is a direct
labour rate, and budgeted direct labour hours are 25,000 per month. The
company wishes to make a profit of 20% on full production cost from
Product A.
Question
Ascertain the full cost-plus based price.
Answer
£
Direct materials 10
Direct labour: 3 hours at £5 per hour 15
Variable production overhead 3
Fixed production overheads at £350,000/25,000 = £14 × 3 per
direct labour hour 42
Full production cost 70
Profit mark-up (20%) 14
Selling price per unit of Product A 84

ga
nin ct The only difference with this activity and the previous example is the
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4f introduction of opportunity cost in the calculation of total cost.
y Samson plc has a Product B with the following cost estimates. The company
has no spare productive capacity.
£
Direct materials 30
Direct labour: 1 hour at £6 per hour 6
Variable production overhead: 0.5 hours at £18 per machine hour 9
Total 45
Fixed production overheads are £360,000 per month. The absorption rate
will be a direct labour rate and budgeted direct labour hours are 36,000 per
month. It is estimated that the company could earn a minimum contribution
of £10 per machine hour on producing items other than Product B. Profit
mark-up is 20% on full cost including opportunity cost. Determine the full
cost-plus based price.
eedb ac
F
£
4f
Direct materials 30
Direct labour 6
Variable overheads 9
Fixed overheads (360,000/36,000) 10
Opportunity cost ½ hour @ £10 5
60
Profit mark-up 20% 12
Total/Selling price 72
Problems with full cost-plus pricing

There are some problems with a full cost-plus pricing approach:
■ It fails to recognise that, since demand may be determining price, there will
be a profit-maximising combination of price and demand.
■ There may be a need to adjust prices to market and demand conditions.
■ A suitable basis for overhead absorption must be selected, especially where
a business produces more than one product. In practice, cost is one of the
most important influences on price. Many firms base price on simple cost-
plus rules whereby costs are estimated and then a mark-up is added in order
to set a price.

Marginal cost-plus pricing

This method determines the selling price by adding a profit onto either marginal
cost of production or marginal cost of sales.
Advantages:
■ Simple and easy method to use.
■ The mark-up percentage can be varied.
In practice, mark-up pricing is used in businesses where there is a readily

identifiable basic variable cost.
Disadvantages:
■ It ignores fixed overheads in pricing.
4.4 Pricing policies for new products

For new products or services, there are two main pricing policies: price
Recommended reading: ‘Pricing
decisions and profitability analysis’ skimming and penetration pricing. A price-skimming policy is an attempt to
in Drury (2009). exploit sections of the market that are relatively insensitive to price changes. A
skimming policy should not be adopted when a number of close substitutes are
price skimming already being marketed. Circumstances when skimming is appropriate include:
■ A new or different product.
■ When the firm can identify different market segments for the product.
penetration pricing
■ A short life cycle.
A penetration-pricing policy is based on the concept of charging low prices

initially, with the intention of gaining rapid acceptance of the product. Such a
policy is appropriate when close substitutes are available or when the market
is easy to enter. Circumstances when penetration pricing is appropriate include:
■ Pending new entrants.
■ Firm may want to enter the growth and maturity stage of the product life
cycle and therefore reduces the initial stage.
■ Elastic demand exists.
Pricing policy for existing products

Earlier in the unit you saw how the costs of a product over its life cycle may
affect the price over time. The typical product life cycle may see price decline
as the market matures over time. However, certain products may command a
premium price premium price over time. A premium price can be charged and maintained
when a product offers some distinct uniqueness or competitive advantage over
other products. Typically, luxury products such as high-end cars, luxury hotels,
luxury cruises and first-class flights can command a premium price. Such
premium products tend to be demand inelastic. Retaining a premium price is
dependent on factors such as maintaining high quality and keeping competitors
at bay.

4.1 Smith plc has recently spent some time researching and developing a new
product for which they are trying to establish a suitable price. Previously
they have used cost plus 20% to set the selling price. The standard cost
per unit has been estimated as follows:
Direct materials £
Material 1 20 (8 kg at £2.50/kg)
Material 2 7 (1 kg at £7/kg)
Direct labour 12 (2 hours at £6/hour)
Fixed overhead 7 (2 hours at £3.50/hour)
Total 46
Using the standard costs, calculate two different cost-plus prices using
two different bases and explain an advantage and disadvantage of each
method.
4.2 Explain the limitations of cost-plus pricing.
4.3 Describe the different cost-plus pricing methods for deriving selling prices.
4.4 Justify why cost-plus pricing is widely used.
4.5 Sahai plc, a large labour contractor, supplies contract labour to building
construction companies. Sahai has budgeted to supply 60,000 hours of
contract labour. Its variable cost is £12 per hour and its fixed costs are
£360,000. The general manager has proposed a cost-plus approach for
pricing labour at full cost plus 20%.
(a) Calculate the price per hour that Sahai should charge based on the
manager’s proposal.
(b) The marketing manager has supplied the following information on
demand levels at different prices:
Price per hour (£) Demand (hours)

16 120,000
17 100,000
18 80,000
19 70,000
20 60,000
Sahai can meet any of these demand levels. Fixed costs will remain
unchanged for all the preceding demand levels. On the basis of this
additional information, what price per hour should Sahai plc charge?
4.6 Naushaba plc cans fruit for sale to food distributors. All costs are classi-
fied as either manufacturing or marketing. Naushaba prepares monthly
budgets. The budgeted absorption costing income statement is as follows:

Cost £ %
Sales (1,000 crates × £100 a crate) 100,000 100
Cost of goods sold 60,000 60
Gross profit 40,000 40
Marketing costs 30,000 30
Operating profit 10,000 10
Assume that 1,000 crates will be canned and sold in a month.

Monthly costs are classified as fixed or variable (with respect to the cans
produced for manufacturing costs and with respect to the cans sold for
marketing costs):
Fixed Variable
Manufacturing 22,000 38,000
Marketing 18,000 12,000
Naushaba has the capacity to can 1,500 crates per month. The relevant
range in which monthly fixed manufacturing costs will be fixed is from
500 to 1,500 crates per month.
(a) Calculate the normal mark-up percentage based on total variable
costs.
(b) Assume that a new customer approaches Naushaba to buy 300
crates at £55 per crate. No additional marketing effort will be
required but additional manufacturing costs of £3,000 will be
incurred for this special order. Should this order be accepted?
4.7 Distinguish between cost-plus pricing and target costing.
4.8 A gaming software company has the following income statement for the
last quarter:
£
Sales: 100,000 games × £50 per game 5,000,000
Variable cost per game £12 1,200,000
Contribution 3,800,000
Fixed costs 3,840,000
Net loss (40,000)
The variable costs consist solely of outsourcing costs, which are the costs
of software production, packaging and distribution. Fixed costs consist of
general administration costs and information systems running costs for
game downloads.
The company management are concerned at the loss reported, and this is
not the first loss for the company. Market research suggests lowering the
price of the games may increase sales. The research also shows that a 5%
decrease in selling price results in a 9% increase in sales units. The
marketing manager has started to produce the following table:

Selling price Sales Sales Variable Fixed costs Profit/(loss)

(£) (units) (£) costs (£) (£) (£)
5,000,000
50 100,000 0 1,200,000 3,840,000 (40,000)
47 109,000 5,177,500 1,308,000 3,840,000 29,500
Using the sample above, complete the table for the marketing manager.
When complete, construct a graph which shows profit as a function of
selling price – put price on the x-axis and profit on the y-axis. From the
chart, provide an estimate of the profit-maximising price.

4.1 Variable cost plus 20% = £39 × 1.20 = £46.80
Total cost plus 20% = £46 × 1.20 = £55.20
Advantages of variable cost include that it avoids arbitrary allocations, it
identifies short-term relevant costs, it is simple, and mark-up can be
increased to provide a contribution to fixed costs and profit. The
disadvantages are that it represents only a partial cost, it is short-term
oriented, and it ignores price–demand relationships.
Advantages of total cost include that it attempts to include all costs,
reduces the possibility that fixed costs will not be covered, and it is simple.
The disadvantages are that total cost is likely to involve some arbitrary
apportionments and the price–demand relationship is ignored.
4.2 Cost-plus pricing has three major limitations. Firstly, demand is ignored.
Secondly, the approach requires that some assumptions are made about
future volume prior to ascertaining the cost and calculating the cost-plus
selling prices. This can lead to an increase in the derived cost-plus selling
price when demand is falling, and vice versa. Thirdly, there is no
guarantee that total sales revenue will be in excess of total costs even
when each product is priced above ‘costs’.
4.3 Different cost bases can be used for cost-plus pricing. Bases include direct
variable costs, total direct costs, total direct and indirect costs (excluding
higher-level facility/business sustaining costs) and total cost based on an
assignment of a share of all organisational costs to the product or service.
Different percentage profit margins are added depending on the cost base
that is used. lf direct variable cost is used as the cost base, a high
percentage margin will be added to provide a contribution to cover a
share of all of those costs that are not included in the cost base plus
profits. Alternatively, if total cost is used as the cost base, a lower
percentage margin will be added to provide only a contribution to profits.
Target costing is the reverse of cost-plus pricing. With target costing, the
starting point is the determination of the target selling price – the price
that customers are willing to pay for the product (or service). Next, a
target profit margin is deducted to derive a target cost. The target cost
represents the estimated long-run cost of the product (or service) that
enables the target profit to be achieved. Predicted actual costs are
compared with the target cost and, where the predicted actual cost

exceeds the target cost, intensive efforts are made through value
engineering methods to achieve the target cost. If the target cost is not
achieved the product/service is unlikely to be launched.
4.4 There are several reasons why cost-plus pricing is widely used. First, it
offers a means by which prices can be determined with ease and speed in
organisations that produce hundreds of products. Cost-plus pricing is
likely to be particularly applicable to those products that generate
relatively minor revenues that are not critical to an organisation’s success.
A second justification is that cost-based pricing methods may encourage
price stability by enabling firms to predict the prices of their competitors.
4.5 (a) Sahai plc’s full cost per hour of supplying contract labour:
£
Variable costs 12
Fixed costs, £360,000 ÷ 60,000 hours 6
Full cost per hour 18
Price per hour at full cost + 20% = £18 × 1.2 21.60
(b) Contribution margins for different prices and demand realisations

are as follows:
Price per hour Variable cost Contribution Demand Total

(1) (£) per hour (2) (£) margin per hour in hours (4) contribution
(3) = (1) – (2) (£) (5) = (3) × (4)
16 12 4 120,000 £480,000
17 12 5 100,000 500,000
18 12 6 80,000 480,000
19 12 7 70,000 490,000
20 12 8 60,000 480,000
Fixed costs will remain the same regardless of the demand

realisations.
Fixed costs are therefore irrelevant since they do not differ among
the alternatives. The table above indicates that Sahai plc can
maximise contribution margin and hence operating profit by
charging a price of £17 per hour.

4.6
Units £ £ £
Sales 1,000 100 100,000
Cost of goods sold:

Fixed 22,000
Variable 1,000 38 38,000 60,000
Gross profit 40,000
Marketing:
Fixed 18,000
Variable 1,000 12 12,000 30,000
Operating profit 10,000
Mark-up – full absorption cost basis

Gross profit 40,000
Cost of goods sold 60,000 66.67%
Variable costs:
CGS 38,000
Marketing 12,000
50,000
(a) Mark-up – variable cost basis

Gross contribution (100,000–50,000) 50,000
Variable costs 50,000 100.00%
(b) Special order: Cans

Activity 1,000
Special order 300
1,300
This is within current

capacity SP VC Contribution Total
Sales 300 55 38 17 5,100
One-off manufacturing 3,000
2,100
Job can be accepted

4.7 In cost-plus pricing, the cost is used as the starting point. In target costing,
the start is the selling price.
4.8 The table below is completed sufficiently to draw a chart:
Selling price Unit £ Variable Fixed

£ Sales Sales costs costs Profit
50 100,000 5,000,000 1,200,000 3,840,000 (40,000)
47.50 109,000 5,177,500 1,308,000 3,840,000 29,500
45.13 117,175 5,287,522 1,406,100 3,840,000 41,422
42.87 125,963 5,399,882 1,511,558 3,840,000 48,324
40.73 135,410 5,514,629 1,624,924 3,840,000 49,705
38.69 145,566 5,631,815 1,746,794 3,840,000 45,021
36.75 156,484 5,751,491 1,877,803 3,840,000 33,688
34.92 168,220 5,873,710 2,018,638 3,840,000 15,072
33.17 180,836 5,998,527 2,170,036 3,840,000 (11,510)
31.51 194,399 6,125,995 2,332,789 3,840,000 (46,794)
29.94 208,979 6,256,173 2,507,748 3,840,000 (91,575)
The chart is depicted below:

60
40
20
Profit £000 0
20 25 30 35 40 45 50 55
(20)
(40)
(60)
(80)
(100)
Unit Price
Figure 4.4: Feedback for SAQ 4.8
From the chart above, a price of approximately £41 will maximise profits.

Summary
This unit introduced you to how firms approach setting a price for their
products and services. Setting the right price is a key decision and the basic
laws of supply and demand are a good starting point to appreciate the relevance
of the price decision. You also learned that the nature of the market means that
a firm can set a price (be a price setter) or may have to accept the market-
determined price (be a price taker). You also learned two approaches to setting
prices: cost-plus pricing and target costing.

Unit 51 Budgets
‘It's time we reduced the federal budget

and left the family budget alone.’
Ronald Reagan, 40th US president
Introduction
Recommended reading: ‘The The main focus of this unit is the preparation of budgets. Budgets are
budgeting process’ in Drury not prepared in isolation and are part of a budgeting, planning and
(2009). control system, which is outlined first. Next the unit examines the
various functions of budgets and recognises some potential conflicts
budget
which can arise; looks at the administration and preparation of budgets
and component budgets leading to the formation of overall master
budgets; and then examines other budgetary approaches. Finally, the
unit investigates some behavioural aspects of budgeting.

5.1 Understand and explain the basic concepts of management control.
5.2 Explain the traditional approach to budgeting and various functions
that budgets have in a firm.
5.3 Explain conflicting budget objectives.
5.4 Explain the administration of budgets.
5.5 Prepare and explain budgets at various levels of detail.
5.6 Explain activity-base and zero-base budgeting and alternatives to
formal budgeting.
5.7 Appreciate behavioural aspects of budgets.
Prior knowledge
You may find it useful to have covered Unit 3 in advance of this unit, to ensure
you are familiar with activity-based principles. If you work in an organisation, or
are familiar with one, try to relate the concepts in this unit to the budgeting
process of the particular organisation.

Unit 5 Budgets
5.1 Management control systems

Recommended reading: The aim of a management control system is to influence behaviour in desirable
‘Management control systems’ in ways to increase the probability that an organisation’s objectives will be
Drury (2009). achieved. This is achieved through a vast array of differing controls throughout
an organisation, which comprise the management control system. This section
briefly explains the components of a management control system, with the
remainder of this unit focused on one control tool: budgets.
A management control system is a means of gathering and using information

to aid and coordinate the process of planning and control decisions within an
organisation.
A typical management control system is shown in Figure 5.1 (Flamholtz, 1983).
Evaluation –
Reward
Planning Operations Results
Measurements
Figure 5.1: A typical management control system.
Figure 5.1 portrays a control system as being a loop. The first step is a plan,
perhaps a budget. The plan is then enacted (operations) and results are then
measured against the plan. The results, in turn, are used to evaluate perform-
ance and also to adjust plans and operations. The control system in Figure 5.1
can be referred to as a cybernetic control system, as it involves both control
and communication of results.
Of course, no control system operates in isolation within a firm. External

factors like general economic conditions, legislation and government policy
may affect how controls are put in place or how results are explained. In other
words, there is always the possibility of uncontrollable factors in any control
system.
Control
Recommended reading: ‘Results
Control is the process of ensuring that a firm’s activities conform to plan and
controls’ and ‘Action, personnel its objectives are achieved. As mentioned earlier, the aim of management control
and cultural controls’ in Merchant is to influence employee behaviour. Drury (2009) identifies three types of
and Van der Stede (2007). control:

1. action (or behavioural)

2. personal and cultural (or clan and social)
3. results (or output).
Action control focuses on preventing undesirable behaviour and is an ideal

form of control: it aims to prevent the behaviour from occurring. This type of
control involves observing the actions of individuals as they work. Merchant
and Van der Stede (2007) propose that action control can deal with one or
more of the three control problems: lack of direction, motivational problems
and personal limitations. Action control may take one of four forms:
1. Behavioural constraints: preventing unwanted behaviours.
2. Pre-action reviews: communicating what is desired.
3. Action accountability: holding people responsible for their actions.
4. Redundancy: building in a failsafe control.
Personnel control builds on the natural tendencies of employees to control and

motivate themselves. Typically, personnel control serves one of three purposes.
First, it can clarify the expectations of employees. Second, it may help to ensure
employees have the capability to do the job, for example, adequate training.
Third, it may help employees to self-monitor. Related to personnel control is
cultural and clan control. Cultural control reflects a set of values, social norms
and beliefs that are shared. Cultural control is typically exercised by individuals
over one another. For example, Asian culture may seal a business deal verbally,
whereas the Western business style requires a formal written deal. Clan and
social control is based on the beliefs of fostering a strong sense of solidarity
and commitment towards organisational goals. A main feature of a clan is a
high degree of employee discipline.
Results/output control involves collecting and reporting information about the

outcomes of work effort against a predetermined target. The major advantages
of result control is that managers do not have to be knowledgeable about the
means required to achieve the desired results or be involved in directly observ-
ing the actions of subordinates. Results control involves the following stages:
1. Establishing results (such as performance) measures that minimise un-
desirable behaviour.
2. Establishing performance targets.
3. Measuring performance.
4. Providing rewards or punishment.
Look back at Figure 5.1 and you can clearly see how a typical management
control system incorporates results control. For result measures to work
effectively, the individuals whose behaviours are being controlled must be able
to control and influence the results. In other words, results control can only be
applied to controllable factors.

Unit 5 Budgets
Possible detrimental effects of control

A major detrimental effect of a control is a lack of goal congruence within the
organisation. A lack of goal congruence occurs when the organisational goals
and individual goals are in conflict. It can be argued that controls may motivate
behaviour which is not organisationally desirable. Another harmful side effect
of controls is that they can cause negative attitudes towards the control system,
particularly if applied too rigorously.
ga
nin ct Identify and describe three different types of control mechanism used by
Lear
ivit
5a companies.
y
eedb ac
1. Action control tries to prevent undesirable behaviours/actions.
F
5a 2. Personnel and cultural (clan and social) control encourages employees to

self-control (personnel) and control each other according to accepted
norms (cultural).
3. Results control controls on the basis of comparing results to a set target.
ga
nin ct Can you think of any action controls in your daily life?
Lear
ivit
5b
y
eedb ac
Action controls in your life may include:
F
5b ■ Stopping at a traffic light.

■ Walking on a footpath.
■ Not smoking in a bar or restaurant.
■ Putting your litter in a bin.
■ Not being let into a cinema if you’re late.
Cybernetic control systems

In science, a cybernetic control system consists of the following:
■ A process continually monitored by an automatic regulator.
■ Deviations from a predetermined level are identified by the automatic
regulator.
■ Corrective actions are started if the output is not equal to the predetermined
required output.
A simple everyday example of a cybernetic control system is a central heating

system with a pre-set thermostat as the regulator. Figure 5.2 depicts a cybernetic
control system graphically.

Input Process Output
Automatic
Feedback
Regulator
Figure 5.2: A cybernetic (feedback) control system.
feedback A cybernetic control system always includes feedback, which compares the
output or result to a required target. However, the feedback is only available
after the control parameter has been breached, which means errors occur and
then corrective action is taken. Thinking about a cybernetic control system in
an organisation, certain factors are required:
■ Objectives for the process being controlled must exist.
■ The output of the process must be measurable. Thus there must be a
mechanism for assessing whether the process is attaining its objectives.
■ A predictive purpose of the process being controlled is required so that
causes for non-attainment can be identified and proposed corrective actions
evaluated.
■ There must an ability to take action.
In Unit 7 you will learn about analysing differences between budgets/plans and
actual performance – a technique called ‘variance analysis’. This technique uses
the actual results, and compares them to a plan to take corrective action in the
form of either changing the original budget or taking actions to get
costs/revenues back on target. In other words, feedback occurs.
feed-forward control There may also be feed-forward controls within a management control system.
A feed-forward control can be thought of as more preventive in nature than
feedback. For example, a frost thermostat on a central heating boiler will start
the boiler when the temperature reaches zero degrees Celsius – regardless of
how the home or business owner has planned to operate the heat. In a business,
for example, if costs are showing signs of exceeding plans, then cost-cutting
measures can be taken in advance to prevent overrun. Thus, a budget/plan can
also be a feed-forward control.
5.2 The traditional approach to budgeting

incremental budgeting Traditionally, incremental budgeting is used. This involves basing the next
period’s budget on current results plus an extra amount for estimated growth
or inflation. This is the approach which is assumed in most of this unit.
The multiple functions of budgets

The following are various functions of a budget:

Unit 5 Budgets
■ Planning: Managers will be able to see the day-to-day activities that must
be performed. A budget makes planning of these activities more effective.
■ Coordination: Different parts of an organisation will be able to bring
together and reconcile a common plan. Budgets therefore force management
to examine interfunctional relationships and identify any possible conflicts.
■ Communication: All parties to the budget must be able to communicate and
understand what is expected of them. The budget, in turn, communicates
the expectations of senior managers to other staff.
■ Motivation: A budget influences and encourages managers to perform in
line with the company’s objectives. A budget can be a de-motivating device
if it is perceived as a threat or too difficult to achieve. It may then be resisted
by all concerned.
■ Control: By comparing the actual with the budgeted, control can be exerted
when there is any difference. Managers will pay attention only to the devia-
tions from the planned which are significant and thus need investigating.
management by exception This process is called management by exception.
■ Evaluation: Budgets enable managers to assess performance. The use of
budgets as a method of performance evaluation also influences human
behaviour. Of all the roles served by budgetary information it is its role in
performance evaluation that is likely to be the most crucial, because it is
this that impacts most strongly upon the middle and junior managers being
controlled by the budgetary system.
ga
nin ct
Thinking of an organisation you are familiar with, or even your own
Lear
ivit
5c personal circumstances, how are budgets used?

y
eedb ac
F
Your answer depends on the circumstances you are familiar with. In

k
5c terms of a commercial organisation, you should be able to relate to the

purposes of budgets as given in the section above. You may have
thought that the relative importance of any particular purpose varies by
organisation. For example, some organisations, like public sector
organisations, may place more emphasis on the control role. If you
thought of running your house or lifestyle, you may have thought of
planning your weekly/monthly spend on food, transport,
accommodation, and so on. You would control your expenditure by
referring back to your planned spend and evaluate your performance by
counting how much money you have left in your pocket (or bank
account).
5.3 Conflicting roles of budgets

A budget may be a source of conflict in an organisation, for example:
■ Planning and motivation may conflict; for example, demanding budgets
may not be motivating.

■ Motivation and performance evaluation may conflict; for example,

budgets are set in advance, and the performance evaluation may be
between actual activity and the original budget.
ga
nin ct Think about your own personal spending budget. Have you experienced any
Lear
ivit
5d conflict in how you plan to spend your money versus your motivation, or
y
how you actually spend money?
eedb ac
Your answer will be reflective of your own experience. Here are some
F
5d thoughts:
■ As a student, do you find yourself annoyed (de-motivated) when you
spend money too early in a week or month or buy more expensive, one-
off purchases?
■ Are you de-motivated when you have to buy textbooks instead of
having a night out?
■ Do you plan a certain expenditure on textbooks/class materials and feel
good when you spend less than your planned amount?
■ How do you adjust your budget if the price of textbooks, living
accommodation, and so on, increases to a higher than planned level?
5.4 Administering budgets

Two key areas in the administration of budgets are a budget manual and a
budget committee.
The budget manual

budget manual This is a collection of instructions governing the responsibilities of persons,
procedures, forms and records relating to the preparation and use of budgetary
data. It is an instruction/information manual about the way budgeting operates
in a particular organisation. Such manuals or formal procedures are likely in
larger organisations.
Budget committee
budget committee The coordination and administration of budgets is usually the responsibility of
a budget committee. Every part of the organisation should be represented on
the committee, such as accounting, sales, production, marketing, and so on.
Functions of the budget committee include the following:
■ Coordination of budget preparation, including the issue of the budget
manual.
■ Timing the preparation of functional budgets.
■ Allocation of responsibilities for the preparation of functional budgets.
■ Provision of information to assist in the preparation of budgets.
■ Communication of final budgets to the appropriate managers.

Unit 5 Budgets
■ Comparison of actual results with budget and the investigation of

variances.
■ Continuous assessment of the budgeting and planning process.
ga
nin ct
Think of an organisation you know or have contacts in. Try to ascertain:
Lear
ivit
5e
y
■ The length of the budget period, and when it starts.

■ When budget negotiations start and end.
■ How useful the process is perceived to be by managers. What might
affect a manager’s perception of usefulness?
eedb ac
F
Your findings on the budget period and negotiations will be individual to

k
5e your organisation. It is likely that any person’s perception of the usefulness

of the budget will be affected by their involvement in the budget-setting
process. Those who are closely involved in the planning stages are likely to
see themselves as having a clearer ‘ownership’ of the final budget and thus
may argue it is more useful.
5.5 Preparing budgets

Recommended reading: ‘The The follow steps show how to prepare a budget for an organisation:
budgeting process’ in Drury
1. Identification of the key budget factor: This is the factor which limits the
(2009).
capabilities of the organisation. For example, sales or production capacity.
2. Sales budget: A budget for the units of each product and sales value is
prepared. This budget must be done first to establish what needs to be
bought or produced. Preparing a sales budget usually means detailed
discussion with sales staff.
3. Finished goods stock budget: This budget decides the planned increase or
decrease in finished stock levels.
4. Preparation of a production budget: Taking the unit sales and finished goods
stock, the required production units are determined.
5. Budgets of resources for production: Using the amount of units to be
produced from the previous step, the following budgets can now be drawn
up:
(a) Material usage budget and material purchase budget (this may include
material stock levels to be maintained).
(b) Machine utilisation.
(c) Labour budget.
(d) Production overhead.
6. Overhead cost budgets: Other overhead costs like selling and administration
overhead are also budgeted for.
7. Cash budget: Cash inflows and outflows can now be budgeted for, using
data from the earlier budgets.

8. Master budget: A budgeted income statement (profit and loss account) and
statement of financial position (balance sheet) are now prepared, based on
all previous data.
Some tips on preparing budgets

When preparing production budgets you will have to calculate closing stock
levels. We know: opening stock + units produced – sales = closing stock.
Depending upon what you are being required to find you may be required to
rearrange formulae. For example, if the opening stock is 40 units, sales is 100
units and closing stock is 60 units, how many units are produced? From
rearranging the equation it is clear that the 120 units are produced. Calculation
of the various budgets can be a little tricky and requires some thought.
When calculating monetary values for budgets, you can usually multiply units
by a price. For example, a sales budget would be: sales units × selling price. Or
a material cost budget might be: units of material needed × price per unit.
ga
nin ct
For this activity, the company information regarding products, costs and
Lear
ivit
5f sales levels is as follows:

y
Product X Product Y
Material 216 (kg) 4 6
Material 314 (litres) 2 8
Labour hours skilled 8 4
Labour hours unskilled 4 10
Sales (units) 2,000 1,500
Open stock of finished goods (units) 100 200
The closing stock of materials and finished goods must be sufficient to meet
10% of demand. The opening stock of Material 216 was 300 kg and for
Material 314 was 1000 litres. Material prices are £20 per kg for Material
216 and £9 per litre for Material 314. Labour costs are £12 per hour for the
skilled workers and £8 per hour for the semi-skilled workers.
Produce the following budgets:

(a) production (units)
(b) materials usage (kg and litres)
(c) materials purchases (kg, litres and £)
(d) labour (hours and £).

Unit 5 Budgets
F eedb ac
k
(a) Production budget in units: This can be solved by rearranging the
5f formula for production units given earlier:
X (units) Y (units)
Sales 2,000 1,500
Required closing stock (10%) 200 150
Total 2,200 1,650
Less opening stock 100 200
Required production 2,100 1,450
(b) Material usage in kg and litres:
Material Material
216 (kg) 314 (litres)
X = 2,100 × 4, Y = 1,450 × 6 17,100
X = 2,100 × 2, Y = 1,450 × 8 15,800
(c) Materials purchases (kg, litres and £):
Material 216 Material 314

Used in production 17,100 15,800
Closing stocks required (10%) 1,710 1,580
Total 18,810 17,380
Opening stocks available 300 1,000
Required to purchase 18,510 16,380
Cost £ per kg or litre 20 9
Total cost £370,200 £147,420
(d) Labour budget (hours and £):
X Y Total
Production required (units) 2,100 1,450
Labour hours skilled 16,800 5,800 22,600
Labour hours semi-skilled 8,400 14,500 20,800
Cost £ per hour £

Skilled 12 271,200
Semi-skilled 8 166,400
Total cost 437,600

ga
nin ct Each unit of the product Echo takes 5 direct labour hours to make. Quality
Lear
ivit
5g standards are high, and 8% of units are rejected as sub-standard after

y
completion. Next month’s budgets are as follows:
Opening stock of finished goods 3,000 units

Planned closing stock of finished goods 7,600 units
Budgeted sales of Echo 36,800 units
All stocks of finished goods must have successfully passed the quality
control check. Can you work out the direct labour hours budget for the
month?
eedb ac
F
Planned increase in stock of finished goods 4,600 units

5g
Budgeted sales 36,800 units
Budgeted production 41,400 units
We are told that 8% of products are rejected, so we need to gross up the

41,400 units, thus:
Budgeted production = 100 ÷ 92 × 41,400 = 45,000 units.
Budgeted direct labour hours ( × 5 hours per unit) = 225,000 hours.
ga
nin ct
For a company that does not have any production resource limitations, can
Lear
ivit
5h you propose in what sequence the budgets would be prepared?

y
eedb ac
A sales budget and budgeted changes in finished goods stocks are needed
F
5h to prepare a production budget. The production budget and budgeted

changes in raw materials stocks are then needed to prepare a purchases
budget for raw materials. A purchases budget is needed to prepare a cash
budget and budgeted income statement.

Unit 5 Budgets
ga
nin ct Each unit of the product Alpha requires 3 kg of raw material. Next month’s
Lear
ivit
5i production budget for product Alpha is as follows:
y Opening stock of materials 15,000 kg

Opening stock of finished Alpha 2,000 units
Budgeted sales of Alpha 60,000 units
Closing stock of materials 7,000 kg
Closing stock of finished Alpha 3,000 units
Calculate the kilograms of raw materials that should be purchased next

month.
eedb ac
F
Required increase in finished goods stock 1,000 units

5i Budgeted sales 60,000 units
Production required 61,000 units
Raw materials required (× 3 kg) 183,000 kg
Decrease in raw materials stock 8,000 kg
Raw materials to be purchased 175,000 kg
The cash budget

Recommended reading: ‘The The purpose of a cash budget is to allow an organisation to identify deficits
budgeting process’ in Drury and surpluses of cash. A typical layout of a cash budget is given in the example
(2009). below, which is based on the following data:
(a) Opening cash balance (including any bank balance): £800.
(b) Cash receipts from debtors: July £2,000, August £2,600, September £5,000,
October £7,000, November £8,000, December £15,000.
(c) Cash payments: July £2,500, August £2,700, September £6,900, October
£7,800, November £9,900, December £10,300.
The cash budget looks like this:
July (£) Aug (£) Sept (£) Oct (£) Nov (£) Dec (£)
Opening cash 800 300 200 (1,700) (2,500) (4,400)
Cash receipts 2,000 2,600 5,000 7,000 8,000 15,000
Cash payments (2,500) (2,700) (6,900) (7,800) (9,900) (10,300)
Net cash flow for month (500) (100) (1,900) (800) (1,900) 4,700
Closing cash 300 200 (1,700) (2,500) (4,400) 300

ga
nin ct Based on the following information, draft a cash budget for the six months
Lear
ivit
5j ended 30 June:
y
(a) Opening cash balance at 1st January, £3,200.

(b) Sales: at £12 per unit: cash is received three months after sale. Sales
units are planned as:
Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep
80 90 70 100 60 120 150 140 120 110 100 160
(c) Production in units is planned as:
70 80 90 100 110 130 140 150 120 160 170 180
(d) Raw materials used in production cost £4 per unit of production. They
are paid for two months in advance of production.
(e) Direct labour is £3 per unit paid for in the same month as units
produced.
(f) Other variable expenses: £2 per unit produced, 75% of the cost being
paid for in the same month as production, the other 25% paid in the
month after production.
(g) Fixed expenses of £100 per month are paid monthly.
(h) Some equipment is to be bought and paid for in April, for £800.
eedb ac
F
5j
Schedule of cash receipts
Sales units 80 90 70 100 60 120 150 140 120 110 100 160
Sales £
960 1080 840 1200 720 1440 1800 1680 1440 1320 1200 1920
(× £12)
Cash received
(3 months 960 1080 840 1200 720 1440
after sale)

Unit 5 Budgets
eedb ac
Schedule of cash payments
F
k
5j Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep
continued Production
70 80 90 100 110 130 140 150 120 160 170 180
units
Raw materials
280 320 360 400 440 520 560 600 480 640 680 720
(£4 per unit)
Cash paid
(2 months in 520 560 600 480 640 680
advance)
Labour (£3 per
unit) – paid 300 330 390 420 450 360
in month
Variable
expenses 180 200 220 260 280 300 240
(£2 per unit)
Cash paid
(75% in
month, 25% 195 215 250 275 295 255
one month
after)
Fixed
expenses – 100 100 100 100 100 100
paid in month
Equipment
800
bought
Cash budget
Jan £ Feb £ Mar £ Apr £ May £ June £

Opening balance 3,200 3,045 2,920 2,420 1,545 780
Cash receipts
Sales 960 1,080 840 1,200 720 1,440
Cash payments
Raw materials (520) (560) (600) (480) (640) (680)
Labour (300) (330) (390) (420) (450) (360)
Variable expenses (195) (215) (250) (275) (295) (255)
Fixed expenses (100) (100) (100) (100) (100) (100)
Equipment (800)
(1,115) (1,205) (1,340) (2,075) (1,485) (1,395)
Net cash flow (155) (125) (500) (875) (765) 45
Closing balance 3,045 2,920 2,420 1,545 780 825

ga
nin ct
On 1 January, the summary statement of the financial position (balance
Lear
ivit
5k sheet) of Smith Ltd was as follows:

y
Non-current assets £ £
Plant, property and equipment 100,000
Current assets
Inventories 35,000
Receivables 80,000 115,000
215,000
Equity
Share capital 60,000
Retained earnings 64,250 124,250
Current liabilities
Bank overdraft 17,000
Loan interest accrued 3,750
Dividend accrued 20,000 40,750
Non-current liabilities
10% loan 50,000
215,000
The following are costs expected during the next three months:
Sales (£) Purchases (£) Expenses (£)
January 90,000 60,000 20,000
February 150,000 120,000 25,000
March 240,000 200,000 25,000
Sales and purchases figures are before deduction of discounts. The expenses
figure includes depreciation on plant of £2,000 per month; the remaining
expenses are all cash items and paid for in the month in which they are
charged. Loan interest for a whole year is payable at the end of March. The
dividend accrued is payable in January. Overdraft interest can be ignored.
50% of sales are on credit, with payment after 1 month. 50% of sales are
for cash, with a discount of 5% given for cash settlement. The receivables
figure in the balance sheet relates to amounts owed from December.
Payments for purchases are made in the month of purchase, to benefit from
a 10% prompt settlement discount. Stock levels are expected to remain
constant throughout the period.
Produce a cash budget for the period January to March.

Unit 5 Budgets
F eedb ac
k
Schedule of cash receipts
5k
Cash received in
Month of sale Sale Jan Feb Mar
Amount
December 80,000
January 90,000 42,750 45,000
February 150,000 71,250 75,000
March 240,000 114,000
122,750 116,250 189,000
Note: cash from sales in month = 50% of sales less 5% discount, balance of
50% received 1 month later
Schedule of cash payments
Jan Feb Mar

Suppliers (–10%) 54,000 108,000 180,000
Expenses (excl deprec) 18,000 23,000 23,000
Dividend 20,000
Loan interest (10% of 5,000
50,000)
92,000 131,000 208,000
Cash budget
Jan (£) Feb (£) Mar (£)

Opening balance (17,000) 13,750 (1,000)
Cash receipts
Per schedule 122,750 116,250 189,000
Cash payments
Per schedule (92,000) (131,000) (208,000)
Net cash flow 30,750 (14,750) (19,000)
Closing balance 13,750 (1,000) (20,000)
Example of a master budget

As stated earlier, the master budget is the process of bringing all budgets
together to obtain a budget income statement (profit and loss account) and
statement of financial position (balance sheet).

Example: Sahai Ltd
Statement of financial position as at 31 December:

Non-current assets £ £
Plant, property and equipment 3,600
Current assets
Inventories 1,400
Receivables 1,350
Cash 650 3,400
7,000
Equity
Share capital (£1 shares) 4,000
Retained earnings 2,600 6,600
Current liabilities
Payables 300
Accrued expenses 100 400
Dividend accrued 7,000
Notes:
■ Inventories consist of £900 (75 units) of finished goods and £500 of raw
materials.
■ Receivables comprise £540 owing from October, £360 from November and
£450 from December.
■ Payables consist of amounts owed for raw materials: £120 from November
and £180 from December. Accrued expenses relate to amounts owed for
fixed expenses from December.
■ The plans for the next six months ended 30 June are as follows: production
will be 60 units per month for the first four months, followed by 70 units
per month for May and June.
■ Production costs will be (per unit):
Direct materials £5
Direct labour £4
Variable overhead £3
Total £12
■ Fixed expenses are £100 per month, payable one month in arrears.
■ Sales, at a price of £18 per unit, are expected to be:
Jan Feb Mar Apr May Jun

Units 40 50 60 90 90 70

Unit 5 Budgets
■ Purchases of raw material will be:

Units 150 200 250 300 400 320
■ Raw materials bought are paid two months after purchase.
■ Customers are expected to pay their accounts three months after they have
bought the goods.
■ Direct labour and variable overhead are paid in the same month as units
produced.
■ Plant and equipment costing £2,000 will be bought and paid for in March.
■ 3,000 shares of £1 each are to be issued at par in May.
■ Depreciation for the six months is £650.
■ Based on the above data, prepare all budgets (including a master budget) for
the six months to 30 June.
Answer to example
We draw up individual budgets and then incorporate them into the master
budget. The first budget is the sales budget, then production units, production
costs, and so on.
Sales budget
Jan Feb Mar Apr May Jun Total
Units 40 50 60 90 90 70
Price (£) 18 18 18 18 18 18
720 900 1,080 1,620 1,620 1,260 7,200
Production budget (units)

Opening stock 75 95 105 105 75 55
Production (given) 60 60 60 60 70 70
Sales (40) (50) (60) (90) (90) (70)
Closing stock 95 105 105 75 55 55
Raw materials budget (£)

Opening stock 500 350 250 200 200 250
Purchases (given) 150 200 250 300 400 320
Used in production (300) (300) (300) (300) (350) (350)
Closing stock 350 250 200 200 250 220

Production budget (£)

Jan Feb Mar Apr May Jun Total
Materials 300 300 300 300 350 350 1,900
Labour (£4/unit) 240 240 240 240 280 280 1,520
Variable OH (£3/unit) 180 180 180 180 210 210 1,140
4,560
Cash budget (£)

Opening balance 650 550 210 (2,010) (2,010) 1,050
Cash receipts
Cash from customers 540 360 450 720 900 1,080
(3 months after sale)
Share issue 3,000
540 360 450 720 3,900 1,080
Cash payments
Material suppliers (2 months after (120) (180) (150) (200) (250) (300)
purchase)
Fixed OH (100) (100) (100) (100) (100) (100)
Labour (240) (240) (240) (240) (280) (280)
Variable OH (180) (180) (180) (180) (210) (210)
Purchase of plant (2,000)
(640) (700) (2,670) (720) (840) (890)
Net cash flow (100) (340) (2,220) 0 3,060 190
Closing balance 550 210 (2,010) (2,010) 1,050 1,240
Receivables budget (£)

Op. balance 1,350 1,530 2,070 2,700 3,600 4,320
Sales 720 900 1,080 1,620 1,620 1,260
Cash received (540) (360) (450) (720) (900) (1,080)
Closing balance 1,530 2,070 2,700 3,600 4,320 4,500

Unit 5 Budgets
Payables budget £ (for materials)

Opening balance 300 330 350 450 550 700
Purchases 150 200 250 300 400 320
Cash paid (120) (180) (150) (200) (250) (300)
Closing balance 330 350 450 550 700 720
Budget income statement

£ £
Sales 7,200
Cost of goods sold
Opening stock 900
Cost of production 4,560
Closing stock (55 units × £12) (660)
4,800
Gross profit 2,400
Expenses
Fixed expenses 600
Depreciation 650
1,250
1,150
Net profit

Budget statement of financial position

£ £
Non-current assets:
Plant, property & equipment
(3600 + 2000 – 650) 4,950
Current assets:
Inventories (660 + 220) 880
Receivables 4,500
Cash at bank 1,240
6,620
11,570
Equity:
Share capital (4000 + 3000)
Retained earnings (2600 + 1150) 7,000
3,750
10,750
Current liabilities:
Payables 720
Accrued expenses 100
820
11,570
Criticisms of traditional budgeting

Recommended reading: ‘The Oft-cited criticisms of traditional budgeting, as seen thus far in this unit, are:
budgeting process’ in Drury ■ Time-consuming and costly.
(2009).
■ A barrier to responsiveness, flexibility and change.
■ Adds little value given the amount of management time required.
■ Rarely strategically focused.
■ May demotivate staff.
■ Reinforces departmental barriers rather than encouraging knowledge
sharing.
■ Based on key assumptions and estimates.
■ Developed and updated infrequently.

Unit 5 Budgets
5.6 Alternatives to traditional budgeting

approaches
Zero-base budgeting (ZBB)
Recommended reading: Pyhrr
Zero-base budgeting involves preparing one budget for each cost centre from
(1970); ‘The budgeting process’ in a zero base, such as the budgets starts at nil. It was first written about by Pyhrr
Drury (2009). (1970) and is typically associated with the public sector or discretionary
expenditure. Expenditure options or ‘decision packages’ are considered and
ranked by managers according to importance or organisational objectives.
Higher-ranking expenditure is included in the budget first.
Advantages of ZBB
■ It avoids waste.
■ It can be motivational.
■ It removes inefficient or obsolete operations.
■ It challenges the status quo.
Disadvantages of ZBB
■ Requires a degree of skill in its construction. Managers may need to be
trained.
■ Requires a lot of the management’s time and effort.
■ All decisions will need to be made in the budgets.
■ Can cause suspicion when introduced.
■ Costs and benefits of different alternative courses of action can be difficult
to quantify.
■ Ranking can prove problematic: short-term vs long-term trade-off.
Applications of ZBB
■ support expenses
■ service industries
■ not-for-profit organisations, including the public sector
■ discretionary costs
■ rationalisation measures.
ga
nin ct
Identify areas in an organisation you are familiar with where a ZBB approach
Lear
ivit
5l would be useful.
y
eedb ac
F
The areas you identified may include: any area where the pattern of
k
5l spending changes regularly; any area where the incremental approach has
been taken over a long time; any area where there are large changes in the
budget; or any area where the manager is new.

Kaizen budgeting
Recommended reading: The Japanese word ‘kaizen’ means ‘continuous improvement’. The concept of
‘Motivation, budgets and kaizen is used in several Japanese management techniques, including budgeting.
responsibility accounting’ in The idea is that continuous improvement targets are built into budgets.
Bhimani et al 2008.
Consider the following example of a labour budget:
Quarter Labour hours needed for Product A

Jan–Mar 3
Apr–June 2.8
July–Sep 2.75
Oct–Dec 2.7
In the example above, you can see how the number of labour hours required
decreases. This continuous improvement, if achieved, reduces variable costs.
The major advantage of a Kaizen approach to budgeting is that it strives for
continuous improvement, which is something the traditional incremental
approach does not too. A disadvantage is the additional effort required to seek
out ways to improves tasks and processes – however, this would most likely be
outweighed by constantly improved ways of doing things.
Activity-based budgeting (ABB)

Recommended reading: Activity-based budgeting (ABB) uses the basic principles of activity-based
‘Motivation, budgets and costing (ABC) (see Unit 3) as a basis for preparing budgets. That is, it attempts
responsibility accounting’ in to plan for the consumption of activities by products and services. ABB involves
Bhimani et al (2008); ‘The the following steps:
budgeting process’ in Drury
(2009). 1. Estimate the production and sales volume for individual products,
customers and so on.
activity-based budgeting 2. Estimate the demand for organisational activities based on the predicted
volumes from step 1.
3. Determine the resources that are required to perform organisational
activities.
4. Estimate for each resource the quantity that must be supplied to meet the
demand for the activity.
5. Take action to adjust the capacity of resources to match the projected
supply.
Advantages of using ABB

■ The organisation’s overall strategy and any actual or likely changes in that
strategy will be taken into account because ABB attempts to manage the
business as the sum of its interrelated parts.
■ Critical success factors (an activity in which a business must perform well
if it is to succeed) will be identified and performance measures devised to
monitor progress towards them.

Unit 5 Budgets
■ The focus is on the whole of an activity, not just its separate parts, and so
there is more likelihood of getting it right first time. For example, what is
the use of being able to produce goods in time for their despatch date if the
budget provides insufficient resources for the distribution manager who has
to deliver them?
■ Budgets are more realistic.
Like activity-based costing, a major disadvantage of ABB is the time required

to understand the business activities and make changes to the organisation to
ensure it focuses on activities rather than functions or departments solely.
However, if the work is already done for activity-based costing, extending this
to ABB may be less effort.
Beyond budgeting
The term ‘beyond budgeting’ was mentioned in Unit 1. The term is used to
Recommended reading: Hope and
Fraser (2003). describe several techniques used in place of traditional budgeting techniques.
Some of the techniques used are:
■ Target setting: beat your competitors, not a budget.
■ Strategy: open and continuous process.
■ Growth and improvement: think radically, not incrementally.
■ Resource management: manage resources over the longer term.
■ Coordination: manage cause and effect across responsibility centres, not by
use of departmental budgets.
■ Cost management: challenge all costs on basis of added value, not increase
or decrease.
■ Forecasting: use rolling forecasts.
■ Measurement and control: use key performance indicators, not mass detail.
■ Rewards: base rewards on unit level performance, not personal.
■ Delegation: give managers the freedom to act.
ga
nin ct
Above, it is proposed that costs should be viewed in terms of added value,
Lear
ivit
5m not just as an increase or decrease in the budget. Can you provide an

y
example of a cost which should be thought of in this way?
eedb ac
Two of the most obvious costs are advertising and training. These costs are
F
5m often axed or reduced when budgets are tight. But surely training of staff
adds and retains value over time? And possibly advertising too?

5.7 Behavioural aspects of budgeting

Recommended reading: There are two main behavioural aspects of the budgeting process, namely
‘Management control systems’ in motivation and participation.
Drury (2009).
Budgets and motivation
There are well-known theories of motivation such as those proposed by
Maslow (hierarchy of needs) and Hertzberg (motivating and hygiene factors),
which focus on the factors that motivate people.
Maslow’s hierarchy of needs depicts the growth and development needs of an

individual. The pyramid below reflects the five levels of needs set out by
Maslow.
morality,
creativity,
spontaneity,
problem solving,
lack of prejudice,
Self-actualisation acceptance of facts
self-esteem, confidence,
achievement, respect of others,
Esteem respect by others
Love/belonging friendship, family, sexual intimacy
security of: body, employment, resources,

Safety morality, the family, health, property
Physiological breathing, food, water, sex, sleep, homeostasis, excretion
Figure 5.3: Maslow’s hierarchy of needs.
Hertzberg’s two-factor theory mentions hygiene factors and motivating factors.

He argues that hygiene factors (for example, salary, job security, status, fringe
benefits, physical work environment) must be satisfied for motivating factors
to be effective (for example, challenging targets, responsibility, participation,
recognition).
Some other motivation theories may be more relevant to management account-

ing as they focus on behaviour. These are process theories, including theories
of equity, expectancy and goal setting:
■ Equity theory is where individuals compare themselves to others in terms of
the effort that they have put into a task or the loyalty that they have shown
to a firm and the rewards for that effort in terms of pay or status. If others
receive greater rewards for the same or less effort, then the situation is unfair
and acts to demotivate.

Unit 5 Budgets
■ Expectancy theory relates motivation to the strength of desire for

something; there is an expectancy of performance if effort is put into the
task, and there is expectancy of a result if a task is performed.
■ Goal-setting theory proposes that individuals will be committed to achieving
a goal if the goal is achievable, specific and acceptable.
Budgets, as they are plans, are intended to affect the behavioural attitudes of
managers and staff of an organisation. Attitudes can be affected when:
■ setting budgets
■ implementing budgets
■ comparing results to the budget.
Thus, when management accountants and managers set budgets, the effect of
the budget on the motivation of organisational members needs to be considered.
For example, research by Hofstede (1968) indicated that if a budget were to be
set too easy, actual performance would be better than the budget but worse
than if no budget had been set at all. If the level was too difficult, Hofstede
(1968) found that performance would be worse than if no budget had been set.
Organisational culture
Targets, budgets and organisational change of any kind will often reflect
organisational culture. If the culture is more autocratic, there is likely to be
resistance to change, especially if it involves radical changes to the plans or
budgets. Traditional management accounting practices, as presented in this unit
of the learning pack, make certain assumptions about an organisation, such as:
■ Objectives exist for the organisation.
■ They are clearly communicated to staff.
■ Financial data is transmitted in a two-way process.
If we consider this from the standpoint of the organisation’s culture, we need

to ask:
■ Who sets the objectives?
■ How are the objectives interpreted?
■ How are they checked and corrected?
Douglas McGregor’s X and Y theories of management (McGregor, 1960)

suggest that managers may be of two types. He proposes that managers hold
assumptions about their employees. On the one hand (Theory X), managers
may think people are:
■ motivated by rewards and punishment
■ lazy and need supervision
■ have goals that conflict with those of the organisation.
On the other hand (Theory Y), managers may assume that people are:
■ self-motivated
■ mature and responsible, needing little supervision
■ ambitious.

A manager who subscribes to Theory X will want to keep employees at a

distance, exerting strong control actions. Such managers will be given personal
responsibility for meeting financial targets, which will be imposed without
consultation. These managers will be subject to sanctions if budget targets are
not met.
The Theory Y manager will adopt a far more democratic style, encouraging
participation in the budget formulation, with budget targets less of a control
tool.
A budget may motivate, but not if it is poorly designed or implemented. An

effective budget will allow managers to fail without fear of recrimination. Much
of management is a balancing act between freedom and scarce resources, and
aspirations will be low if the budget is slack, or high if it is tight, as we have seen
in Hofstede’s research (1968).
Some of the less desirable behavioural aspects of budgets might be:

■ Projection of blame onto other people, the computer, the system, and so on.
■ Short-termism.
■ Disputes and confrontations.
■ Budgetary slack, where managers react against the pressure of tight targets
budgetary slack
by introducing slack as a cushion against future budget cuts.
■ Empire building, where a larger budget indicates prestige.
■ Evasion, where the importance of the budget is relegated.
■ Lack of goal congruence, such as when the budget, as a control system,
encourages behaviour which is not desirable and/or in line with organisa-
tional objectives.
So what is appropriate? What factors influence a manager’s approach to

budgeting? There are three broad possible approaches that a management
accountant can adopt in relation to budgets: participatory, imposed or
negotiated. Participatory budgets are seen as motivating and are developed by
lower-level managers who then submit the budgets to their superiors. In
contrast, imposed budgets are developed from senior managers and then
submitted to the junior managers. Negotiated budgets are usually agreed upon
by different levels of management, with information flowing up and down
various levels of authority before final agreement is reached.
According to Drury (2009) there are three approaches that can be used to set
financial targets (such as budgets):
1. Engineered targets: used when there are clearly defined and stable input and
output relationships.
2. Historical targets: defined directly from the results of previous periods. The
disadvantage of using historical targets is that they may include past
inefficiencies.
3. Negotiated targets: targets are set based on negotiation between superiors
and subordinates.

Unit 5 Budgets
Targets will have differing levels of difficulty and, therefore, have a significant
effect on motivation and performance. There are thus arguments for setting an
achievable target:
■ They can be motivating.
■ There is a sense of achievement and self-esteem.
The disadvantages of setting achievable targets are:

■ Rewards such as bonuses, promotions, and so on, are often linked to budget
achievement. There is, therefore, a possibility that management will be
tempted to distort their behaviour so as to achieve rewards.
■ Aspirations and performance may not be maximised.
In an effort to create achievable targets which are less likely to be manipulated,

participation in the budgeting and target-setting process should be encouraged.
More detail on participatory and imposed budgets is given below.
Participatory budgeting
Allowing participation in the budgeting process may bring benefits such as:
■ Better coordination.
■ The spread of work may mean less time is taken in drawing up budgets.
■ Strategic plans are better identified in planned activities by those allowed to
participate.
■ Greater ownership of the final budget.
■ A greater assumption of responsibility from the recipients of the budget.
■ The input of the expertise of the participants (who are often closest to the
detail of the budgeted activity).
However, participation in the budgeting process has some potential problems.

Participation might not be effective if:
■ It is pseudo-participation, where nothing can be achieved without approval
from the top.
■ The situation does not permit it, for example, in an organisation where
decisions have to be made instantly.
■ People do not want it.
■ There are cost implications of poorer performance if managers participate,
and incorporate slack into budgets.
In general the advantages of participation in the budgeting process are:

■ Better morale and motivation.
■ More coordination.
■ Managers have both strategic and operational views of the organisation.
The disadvantages of participation in the budgeting process are:

■ It may take a lot of time.
■ Some employees may engage in empire building.

Vroom (1960) showed that personality variables can have an influence on the
effectiveness of participation. Vroom found that highly authoritarian indivi-
duals (people who obey the structure of authority) had a low need for
participation and were unaffected by it. Conversely, high participation was
more effective for individuals who tended to be less compliant with the
structures of authority.
While personality traits of the individuals may lower the benefits of participa-
tion, participation itself may not be enough to ensure commitment to achieving
a target. The level of difficulty is important too.
The conflicting purposes of budgeting
Budgeted
performance
Expectations
budget Aspirations
budget
Performance
Actual
performance
An easy A budget of A very difficult

budget intermediate budget
difficulty
Figure 5.4: The conflicting purposes of budgeting.

Source: Hofstede (1962)
Figure 5.4, from the work of Hofstede, depicts graphically how actual perform-
ance decreases as the level of difficulty of achieving a target increases. On the
vertical axis the performance of the individual is shown and on the horizontal
axis the level of difficulty. From the graph there comes a point where the level
of difficulty makes the performance difficult to achieve and the aspirational
level and performance level decline. In contrast, the budget that is expected to
be achieved motivates a lower level of performance. Therefore, the conclusion
is that to motivate the best level of performance, demanding budgets should be
set and small variances should be regarded as a good sign.

Unit 5 Budgets
ga
nin ct
Lear
Thinking about your own country, can you think about how the
ivit
5n government could improve its annual budgeting process by involving
y citizens?
eedb ac
F
As with a business, participation of citizens (perhaps through means of

k
5n citizens representatives) would be likely to increase the acceptance of the

budget. Some developed and developing economies engage in social
partnership arrangements to help fix things like wage rates at a national
level, which would help a government to plan its own payroll bill. Arguably
too, politicians may get more detailed information on the effects of plans on
poorer segments of society, which may improve the focus of limited budget
resources.
ga
nin ct Assume you are the managing director of a business. You are trying to
Lear
ivit
5o encourage as many staff as possible to be involved in the budgeting process

y
in the business. A staff meeting has been organised for next week and you
have to present the advantages of participation in setting budgets. List
some of the advantages that you would include in your presentation.
eedb ac
Your list might include:
F
5o ■ An informed budget-setting process, in which the management are

aware of the detail of budgeted activities as provided by the people who
work daily within the budgeted activity.
■ Reducing the adverse effect of budget imposition when difficult
management decisions have to be made (for example, staff reduction).
■ Employees become aware and more involved in the management
activities of the organisation.
■ Coordination within an activity might be improved.
■ Budgetary slack may be reduced as management become more aware of
the operations of activities.
■ Budgets are more achievable.
■ Less likely that budgets will be undermined by subordinate managers
and/or other staff.
■ Motivation may improve.
Imposed budgeting
Sometimes, participation in the budgeting process may not be as effective as
imposing a budget. An imposed budget has been derived by senior management
with little input from junior staff.

There are times when imposed budgets may be more effective:

■ newly formed organisations
■ smaller businesses
■ when operational managers have little budgeting skill.
The main disadvantage of imposed budgets is that they affect motivation in the
company, through low morale and no sense of involvement or control.
The impact of accounting information on

management performance
Recommended reading: The impact of a management accounting system on management performance
Hopwood (1972); ‘Management was studied by Hopwood (1972) who said there are three ways of using
control systems’ in Drury (2009). budgeting information to evaluate management performance:
1. A budget-constrained style: The manager’s performance is primarily
evaluated upon the basis of his ability to continually meet the budget on a
short-term basis.
2. A profit-conscious style of evaluation: The manager’s performance is
evaluated on the basis of his ability to increase the general effectiveness of
his unit operations in the long-term purpose of the organisation.
3. A non-accounting style of evaluation: The budgeting information plays a
relatively unimportant point in a superior’s evaluation of a manager’s
performance.
Hopwood’s (1972) results are summarised in the following table:
Budget-constrained Profit-conscious Non-accounting

style style style
Involvement with costs HIGH HIGH LOW
Job-related tension HIGH MEDIUM MEDIUM
Relations with the superior POOR GOOD GOOD
Relations with colleagues POOR GOOD GOOD
ga
nin ct
Try to think of an organisation or business where funds are limited, but
Lear
ivit
5p many options are available to consume these same funds, for example, a
y
public sector organisation, a charity or a local community organisation. Now

try to place yourself as a manager or employee on the budget committee in
this organisation. If ZBB were used, can you think how it might motivate
managers and staff in the organisation?
eedb ac
In this respect, ZBB has the following advantages:
F
5p ■ It ensures that only forward-looking objectives are addressed. This limits

the potential for historical abuses in budget setting to be established.

Unit 5 Budgets
eedb ac
Employees can be set targets that are consistent with the future
F
k
5p objectives of the organisation.
■ Building budget slack is minimised because, in principle, the entire costs
continued of an activity are reviewed at each budget-setting stage. Employees are
then set realistic targets that relate to activity levels that are the most
efficient.
■ Managers understand the activity itself as part of the ZBB process. This
reduces tension between those who decide (management) and those
who have to implement decisions (staff). Claims that management do
not really understand the nature of an activity are thus reduced.
■ ZBB encourages flexibility in employees since they know that, potentially,
activities may be stopped. Flexibility induces goal consistency by enabling
incentive schemes to reflect activity. In other words, employees are more
likely to be responsive to management directives if they are aware and
trust that the budget-setting process encourages and supports payments
that are responsive to flexibility.
Contingent factors for budgeting and control

The degree of motivation and the incidence of participation are two contingent
factors in the usefulness of a budgeting and/or control system. The factors
which influence the usefulness of a budget will vary from one organisation to
another, and as there are contingent and varying factors, it is impossible to say
that there is any one best style or method of budgeting.
The number of contingent factors for budget preparation, implementation and

use is likely to be quite large. Merchant and Van der Steede (2007) provide a
useful summary of factors that affect management control systems, which
includes budgets and other planning and control techniques. The factors are
described briefly below, and in summary give some indication of what
management accountants and managers need to consider when setting up and
operating control systems. Please note, the three factors below are not an
exhaustive list, and others may arise depending upon the type of organisation,
country of operation, business sector, and so on.
Environmental uncertainty
Environmental uncertainty refers to the general unpredictability of the business
and economic environment. Uncertainty creates several control problems. A
main problem is that action controls may be less useful as the course of action
to be taken may not be clear. Thus, result controls may be used in place of
action controls (for example, measure sales volumes or profit). This creates a
problem in itself, as result controls are only effective if it is known how to
generate the required result. Generating the required result may be more
difficult in uncertain times.
Organisational strategy
The way in which an organisation pursues its strategic goals can also affect
control systems. In a large organisation, where corporate headquarters may

not have sufficient knowledge of the intricate nature of a business unit, controls
and results may become mainly financial in nature. This can drive managers to
be more short term in their orientation to deliver results. At the business level,
a business could pursue a cost leadership or differentiation strategy, which
would affect how planning, budgeting and control happens.
Multinationality
A global organisation will have to adapt its management practices, including
budgeting and control systems, to national culture, local customs, local laws,
local ways of doing business, and so on. Operating as a multinational also
exposes an organisation to more risk and uncertainty, as both can vary by
country.
5.1 A product manager has responsibility for a single product and is in the
process of submitting data to be compiled for the 2009 annual budget.
The manager has performance targets set in relation to sales volume,
profitability levels and a target cash surplus from the product. Shown
below are the agreed budgeted sales for the product for December to May
2009:
Dec Jan Feb Mar Apr May
Units 14,000 16,000 22,000 17,000 20,000 24,000
The company policy is that closing stock of finished goods at each month
end should be 25% of the following month’s forecast sales and the stock
of raw material should be sufficient for 10% of the following month’s
production. Stock levels currently conform to this policy. One unit of raw
material makes one unit of finished stock.
Raw material purchases are paid for during the month following the
month of purchase. All other expenses are paid for as incurred. All sales
are made on credit and the company expects receipts for 50% of sales in
the month of sale and 50% in the following month.
The company operates an absorption costing system which is computed
on a monthly basis. That is, in addition to variable costs, it recovers each
month’s fixed manufacturing overhead expenses in product costs using
the budgeted production and budgeted expenditure in the month to
establish an absorption rate. This unit cost is used to place a value on the
stocks.
Opening stock is valued at the unit cost which was established in the
previous month. At 1 January, finished stock should be assumed at £40
per unit. Raw materials are assumed to be consumed on a FIFO basis.
The sales price is £58 per unit. Estimated costs to be used in the budget
preparation for the product are:
■ Manufacturing costs:
– Material: £10.00 per unit produced.
– Variable overhead and labour: £16.00 per unit produced.
■ Fixed overhead costs: £210,000 per month (including depreciation of
£54,000 per month).

Unit 5 Budgets
■ Selling costs:
– Variable: £7.00 per unit sold.
– Fixed: £164,000 per month.
(a) Compute the monthly budgeted production and material purchases
for January to March.
(b) Prepare a budgeted income statement and a statement of cash receipts
and payments for January.
5.2 Identify four purposes of budgets.
5.3 Explain behavioural factors that should be considered in budgeting and
budgetary control.
5.4 You are part of the management team of a group of companies and your
managing director has asked you to explore the possibilities of
introducing a ZBB system in one of the operating companies in place of
its existing system. You are required to prepare notes for a paper for
submission to the board that sets out what problems might be faced in
introducing ZBB.
5.5 Of the various functions of budgets, do you think any of them conflict
with each other?
5.6 The following data relates to the business of Antwan Cox for the quarter
beginning in July:
Data at the end of the previous

quarter: Stock of finished goods (units) 61
Stock of raw materials £ 1,341
Amounts owed by customers £ 3,309 (all payable in July)
Amounts due to material suppliers £ 3,838
Balance in bank £ 4,213
You have also been provided with the following projections for the
quarter:
1. Sales are estimated at:
Month Units Price/Unit £
July 157 59.00
August 239 65.00
September 187 71.00
October 213 79.00
78% of sales are on credit. Credit sales are normally paid 10% in the
month of sale and 90% in the following month.
2. Closing stock units are to be maintained at 20% of the sales units for
a month.

3. Production costs per unit are predicted to be:
£
Materials 8.90
Labour 8.20
Variable overhead 5.10
October 213
Materials and variable overheads are paid for one month after being
incurred and labour is paid for in the month incurred.
4. Purchases of raw materials are predicted as follows:
Month Price/Unit £
July 2,251
August 1,241
September 1,391
October 2,431
5. Fixed production overheads are £111 per month for the first two
months increasing by 50% in the third month.
6. Plant and equipment valued at £2,500 will be sold in July. New plant
is to be purchased in October costing £6,500.
Prepare the following budgets on a month by month basis and in total
for the four months ended October:
■ Sales budget.
■ Production budget in units.
■ Production cost budget.
■ Materials budget in money values, showing all stocks, usages and
purchases.
■ Cash budget.
5.7 The information below relates to a special purpose section of a local
authority. One function of the special purpose section is to provide library
and cultural services to the elderly and children with special needs. The
council has a total of £75,000 to spend and has identified the three
decision packages below using a ZBB process:
Decision package 1: book mobile
Level of service Activity level Total cost

(hours per week) (£)
Base 25 40,000
Current 30 48,500
Enhanced 35 50,000

Unit 5 Budgets
Decision package 2: in-school programmes
Level of service Activity level Total cost

(hours per week) (£)
Base 8 (1 school) 22,500
Current 10 (2 schools) 25,000
Enhanced 12 (3 schools) 27,500
Decision package 3: foreign film series
Level of service Number of films per year Total cost

(£)
Base 10 3,000
Current 12 3,500
Enhanced 15 4,000
The local authority has a strategy to provide as broad a range of services

as possible, but with emphasis placed on providing the greatest possible
level of in-school programmes, then a book mobile, and finally a film
service.
You are required to set out a table ranking how the local authority can
best spend its £75,000 budget to support its stated strategy.
5.8 Fairgal County Council (FCC) is a local authority responsible for the
normal range of services expected of a local authority. The council is
organised into departments, each responsible for a specific activity, for
example, roads, water, parks, public amenities. Each department has an
annual budget.
After finalising the budget for the current year, the finance committee of
FCC found that central government have planned to place restrictions on
the amount of levies imposed on new building developments in the
council’s area. Building contractors must pay a levy for each square metre
of floor space they build to the local council. As the economy is booming,
this levy on the construction sector is a major source of income for local
authorities. The finance committee have estimated that all expenditure
will need to be cut by 9% as a result of this restriction.
In a radio interview, the finance committee chairperson made the follow-
ing statement:
‘We do not like what has happened, but we have to deal with it. It
seems the fairest thing to do is cut all current year expenditures by
9%. In this manner, all departments will suffer equally. The details
of how this cutback affects the services offered by each department
will be left to the individual department heads to decide.’
You are to write a report to the finance committee chairperson explaining
why you agree or disagree with the approach he advocates. Suggest any
possible change in practice which may help the council deal with such
situations while formulating its budgets and allocating resources.


5.1 (a) Production budget (units):
Dec Jan Feb Mar Apr

Sales 14,000 16,000 22,000 17,000 20,000
Closing stock 4,000 5,500 4,250 5,000 6,000
18,000 21,500 26,250 22,000 26,000
Opening stock 3,500 4,000 5,500 4,250 5,000
Production 14,500 17,500 20,750 17,750 21,000
Material purchases budget (units):
Dec Jan Feb Mar

Production 14,500 17,500 20,750 17,750
Closing stock 1,750 2,075 1,775 2,100
16,250 19,575 22,525 19,850
Opening stock 1,450 1,750 2,075 1,775
Purchases 14,800 17,825 20,450 18,075
(b) Product unit manufacturing cost for January:
£
Material 10
Labour and variable overheads 16
Fixed overheads 12
Total 38
Note: The fixed overhead rate for January is calculated using the budgeted
monthly overhead and production: £210,000 ÷ 17,500 = £12/unit.
Income statement for January:
£000 £000
Sales (16,000 × £58) 928
Cost of sales
Opening stock (4,000 × £40) 160
Cost of goods produced (17,500 × £38) 665
825
Closing stock (5,500 × £38) (209)
616
Gross profit 312
Selling costs – variable (16,000 × £7) 112
Selling costs – fixed 164
276
Net profit 36

Unit 5 Budgets
Cash receipts and payments for January:
Inflow: cash from debtors 870,000

Outflows:
Cash for materials 148,000
Cash for variable overhead and labour 280,000
Fixed overhead costs 156,000
Variable selling costs 112,000
Fixed selling costs 164,000
Total outflows (860,000)
Net inflow of cash £10,000
5.2 Your answer should cover four purposes from the six provided below:
■ Planning: The budget is a major short-term planning device placing
the overall direction of the company into a quarterly, monthly and,

perhaps, weekly focus. It ensures that managers have thought ahead
about how they will utilise resources to achieve company policy in their
area.
■ Control: Once a budget is formulated a regular reporting system can
be established so that the extent to which plans are, or are not, being
met can be established. Some form of management by exception can be
established so that deviations from plans are identified and reactions
to the deviation developed, if desirable.
■ Coordination: As organisations grow, the various departments benefit
from the coordination effect of the budget. In this role, budgets ensure
that no one department is out of line with the action of others. They
may also prevent sub-optimal behaviour.
■ Communication: The construction of the budget can be a powerful aid
to defining or clarifying the lines in horizontal or vertical communica-

tion within the enterprise. Managers should have a clearer idea of what
their responsibilities are, what is expected of them, and are likely to
work better with others to achieve it.
■ Performance evaluation: Budgets are useful tools for evaluating
whether a manager or department is performing well. If sales targets

are met or satisfactory service provided within reasonable spending
limits then bonus or promotion prospects are enhanced.
■ Motivation: The value of a budget is enhanced still further if it only
states expectations but motivates managers to strive towards those

expectations. This is more likely to be achieved if a manager has had
some involvement in the budget construction, understands its
implications and agrees it is fair and controllable.
5.3 ■ Targets: It is generally agreed that the existence of some form of target
or expected outcome is a greater motivation than no target at all. The
establishment of a target, however, raises the question of the degree of
difficulty or challenge of the target. If the performance standard is set
too high or too low then sub-optimal performance could be the result.

The degree of budget difficulty is not easy to establish. It is influenced

by the nature of the task, the organisational culture and personality
factors. Some people respond positively to a difficult target; others, if
challenged, tend to withdraw their commitment.
■ Budgets and performance evaluation: The emphasis on achievement of
budget targets can be increased, but also the potential for dysfunctional
behaviour, if the budget is subsequently used to evaluate performance.
This evaluation is frequently associated with specific rewards such as
remuneration increases or improved promotion prospects. In such
cases it is likely that individuals will concentrate on those items which
are measured and rewarded, neglecting aspects on which no measure-
ment exists. This may result in some aspects of the job receiving
inadequate attention because they are not covered by goals or targets
due to the complexity of the situation or the difficulty of measurement.
■ Managerial style: The use of budgets in evaluation and control is also
influenced by the way they are used by the superior. Different
management styles of budget use have been observed, for example:
– Budget constrained – placing considerable emphasis on meeting
budget targets.
– Profit conscious – where a balanced view is taken between budget
targets, long-term goals and general effectiveness.
– Non-accounting – where accounting data is seen as relatively un-
important in the evaluation of subordinates.
■ The style is suggested to influence, in some cases, the superior/
subordinate relationship, the degree of stress and tension involved and
the likelihood of budget attainment. The style adopted and its implica-
tions are affected by the environment in which management is taking
place. For example, the degree of interdependency between areas of
responsibility, the uncertainty of the environment and the extent to
which individuals feel they influence results are all factors to consider
in relation to the management style adopted and its outcomes.
■ Participation: It is often suggested that participation in the budget
process and discussion over how results are to be measured has benefits
in terms of budget attitude and performance. Views on this point are
varied, however, and the personality of the individuals participating, the
nature of the task (narrowly defined or flexible) and the organisation
structure influence the success of participation. However, a budget when
carefully and appropriately established can yield better performance
from staff than one in which these considerations are ignored.
■ Bias: Staff who are involved in the budgeting process are more likely
to accept it as legitimate. However, they may also be tempted to seize
the opportunity to manipulate the desired performance standard in
their favour. That is, they may make the performance easier to achieve
and hence be able to satisfy personal goals rather than organisational
goals. This is referred to as incorporating ‘slack’ into the budget.
5.4 Problems that might be faced in introducing a ZBB system are:
■ Implementation of ZBB might be resisted by staff. Traditional incre-
mental budgeting tends to protect the ‘empire’ that a manager has

built. ZBB challenges this empire, and so there is a strong possibility
that managers might resist the introduction of such a system.

Unit 5 Budgets
■ There is a need to combat a feeling that current operations are efficient.

■ The introduction of ZBB is time-consuming, and management may
lack the necessary expertise.
■ There may be lack of support from the top management.
5.5 Your discussion might include motivation versus control, or performance
evaluation versus planning.
5.6 Sales budget
Units Price £
July 157 59 9,263
August 239 65 15,511
September 187 71 13,350
October 213 79 16,727
54,851
Production budget (units)

July Aug Sept Oct Total
Sales 157 239 187 213 796
– Opening stock 61 31 48 37 61
+ Closing stock 31 48 37 43 43
= Prod 127 255 177 218 778
Production cost budget (£)

U/cost July Aug Sept Oct Total
Materials 8.90 1,134 2,273 1,572 1,942 6,921
Labour 8.20 1,045 2,094 1,448 1,789 6,376
Variable OH 5.10 650 1,303 901 1,113 3,967
Fixed OH 111 111 167 167 556
2,940 5,781 4,088 5,011 17,820
Materials budget (£)

Opening stock 1,341 2,458 1,426 1,245 1,341
Purchases 2,251 1,241 1,391 2,431 7,314
3,592 3,699 2,817 3,676 8,655
– used in prodn (1,134) (2,273) (1,572) (1,942) (6,930)
Closing stock 2,458 1,426 1,245 1,734 1,734

Cash budget (£)

Receipts
Sales of plant 2,500 2,500
Cash sales (22%) 2,038 3,412 2,937 3,680 12,067
Credit sales (W1) 4,032 7,712 11,930 10,676 34,350
6,069 13,625 14,867 14,356 48,918
Payments
Materials 3,838 2,251 1,241 1,391 8,721
Labour 1,045 2,094 1,448 1,789 6,376
Variable OH – 650 1,303 901 2,853
Fixed OH 111 111 167 167 555
New plant 6,500 6,500
4,994 5,106 4,158 10,747 25,005
Net cash in/(out) 1,076 8,519 10,709 3,609 23,912
Opening balance 4,213 5,289 13,808 24,517 4,213
Closing balance 5,289 13,808 24,517 28,125 28,125
Working 1:
July August September October

Cr sales 78% 7,225 12,099 10,413 13,047
Cash received from
previous quarter Given 3,309
From July 10% 723 90% 6,503
August 10% 1,210 90% 10,889
September 10% 1,041 90% 9,372
October 10% 1,305
4,032 7,712 11,930 10,676

Unit 5 Budgets
5.7 Rank £
1 Base level in-school service 22,500
2 Current level in-school service 2,500
3 Enhanced level in-school service 2,500
4 Base level book mobile 40,000
5 Base level film 3,000
6 Current level book mobile 4,500
Total 75,000
5.8 You should identify and briefly discuss that the approach suggested by
the finance committee chairman emphasises inputs and ignores outputs
and objectives. The answer should identify and discuss ZBB as opposed
to incremental budgeting. Points such as the following could be raised
and discussed:
■ Incremental budgeting seeks to look at past budget patterns as a basis
for future spending.

■ Incremental budgeting takes little account of the expected outputs/
objectives.
■ Incremental budgeting does not force planners/managers to examine
activities in detail.
■ The suggested across-the-board cut takes no account of any social
needs, which may be cross-department dependent. The end result could

be cut in the order of a much higher percentage than the 9%. An
example would be care of the elderly.
■ ZBB would be a more proactive approach to budgeting and could help
resolve the council’s issues with lesser impact on essential services.
Summary
This unit introduced the budgeting process, which is an essential short-term
planning tool and part of a management control system. You now know how
budgets are administered and how to prepare various budgets for costs, revenues
and cash, as well as preparing a master budget (budgeted income statement and
balance sheet). There are alternative ways to the traditional method of preparing
budgets, namely activity-based and zero-base budgeting. You have also learned
that budgets can affect the behaviour of people in the organisation. For example,
the effectiveness of a budget may be determined by the level of participation in
formulating the budget and by employee motivation.

Unit 61 Management control
systems and performance
management
‘If everything seems under control,

you’re not going fast enough.’
Mario Andretti, racing driver
Introduction
This unit covers performance measurement, following on from Unit 5.
In order to measure operational performance, first a plan (or budget) is
necessary. In addition, performance management needs to assess the
efficacy of the management system in achieving goals and targets within
broader parameters, such as a division or region. As you may imagine,
the larger and more complex the organisation, the more complex the
performance measurement system, but there are some commonly used
divisional performance measurements which you will learn in this unit.

6.1 Explain responsibility centres and articulate the need for
performance management.
6.2 Evaluate the strategic importance of profit and investment centres.
6.3 Apply measures of divisional and managerial performance.
Prior knowledge
You should have covered Unit 5 in advance of starting this unit.

Unit 6 Management control systems and performance management
6.1 Responsibility centres

Drury (2009) suggests that management accounting control systems have two
‘Management control systems’ in core elements. The first is a formal planning process such as budgeting (see
Drury (2009). Unit 5) and long-term planning. The second is responsibility accounting, which
involves the accountability around the concept of responsibility centres. The
responsibility centre latter enables accountability for financial results/outcomes to be allocated to
individuals throughout the organisation. Responsibility accounting involves:
■ Distinguishing between those items which managers can control and are
held accountable for, and uncontrollable items for which they are not held
accountable.
■ Determining how challenging financial targets should be.
■ Determining how much influence managers should have in the setting of
financial targets.
The table below shows that responsibility centres can be of four types:
Type Manager can control… Performance based on…

Cost All controllable costs Variances from planned
costs
Revenue Pricing policy, sales volumes Variances from planned
revenues
Profit Controllable costs, sales Profit
pricing, sales volume
Investment As profit centre plus capital Return on investment
investment (ROI), residual income (RI)
The definitions of each type responsibility centre are as follows:

■ Cost centres are responsibility centres where managers are normally
accountable for only those costs under their direct control.
■ Revenue centres are responsibility centres where managers are accountable
only for revenues.
■ A profit centre is a responsibility centre where managers are held
accountable for both costs and revenues.
■ Investment centres are responsibility centres where managers are responsible
for profits and capital investment decisions.
As you may have guessed, the managers of cost centres are likely to be more
junior than managers of profit centres, who, in turn, are likely to be more junior
than investment centre managers.
The idea of responsibility accounting is thus based around what is often called
controllability principle the controllability principle. This simple principle implies that any responsibility
centre manager should only be assigned and held accountable for controllable
factors. This can be achieved by removing uncontrollable factors from
performance management reports. It may be difficult to apply the control-
lability concept because there may be areas that are both controllable and
uncontrollable. Examples of uncontrollable factors include:

■ economic and competitive (such as changes in customer tastes)

■ acts of nature (such as fire or flood)
■ interdependencies
■ commodity prices (such as oil).
ga
nin ct What is meant by responsibility accounting? Think of an organisation you
Lear
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6a are familiar with. Can you identify the four types of responsibility centre in
y
this organisation?
eedb ac
The objective of responsibility accounting is to accumulate costs and
F
6a revenues for each individual responsibility centre so that the deviations from
a performance target can be attributed to the individual who is accountable
for the responsibility centre. Thus, responsibility accounting involves:
■ Distinguishing between those items which managers can control and are
held accountable for, and uncontrollable items for which they are not
held accountable.
■ Determining how challenging financial targets should be.
■ Determining how much influence managers should have in the setting
of financial targets.
The four types of responsibility centre are listed below. Your answer will
depend on the organisation you have chosen. Here, the answer makes
some guesses about a large organisation like Hewlett Packard (HP):
■ In cost centres, managers are normally accountable for only those costs
that are under their control. At HP a cost centre might be the production
section of an inkjet printer manufacturing plant.
■ In revenue centres, managers are accountable only for financial outputs
in the form of generating sales revenues. At HP, a revenue centre might
be a product line at regional level, for example, inkjet printers, netbooks,
notebooks, servers, and so on, in the UK or Europe.
■ In profit centres, managers are accountable for both revenues and costs.
At HP, a profit centre might be an entire manufacturing facility as this
would encompass both cost and revenue centres.
■ In investment centres, managers are responsible for both profits and
capital investments. At large organisations like HP, investment is normally
controlled at regional level. So, an investment centre might consist of
multiple profit centres, for example, all European operations.
The need for performance management

Recommended reading: Businesses have adopted various organisational structures to manage the global
‘Divisional financial performance competitive environment more effectively. Typically, a divisional structure is
measures’ in Drury (2009). adopted. With such a structure comes the need for the head office to assess the
performance of the division and of the divisional management.

This unit therefore examines three common financial measures used to assess
divisional performance. These are:
return on investment (ROI) ■ return on investment (ROI), and some related measures
■ residual income (RI)
■ economic value added (EVA®).
residual income (RI)
Each of these measures is examined in detail in the section below, ‘Measurement
of divisional performance’.
Divisionalisation and responsibility accounting

economic value added (EVA®)
The overall aim of divisionalisation is the improvement of group operational
efficiency through increasing corporate profitability and attaining overall
organisation objectives. Managing organisations in a divisional way has advan-
divisionalisation tages and disadvantages.
Advantages of divisionalisation
■ Market information is more localised through divisional contact know-how
and specialist knowledge. The division will have its ear to the ground and
will therefore know the current market information.
■ Management motivation: Divisional managers are likely to be more
motivated as they have ‘ownership’ of the problems.
■ Specialist knowledge: The divisional manager is likely to have built up
specialist knowledge of the division.
■ Timely decisions: Because the division is close to the decision it will not take
unduly long to arrive at the decision which benefits the organisation most.
Disadvantages of divisionalisation
■ Goal conflict: There may be goal conflict between the division and the wider
organisation as a whole, or with other divisions.
■ Risk avoidance: The managers of the division may decide on not pursuing
a course of action as the risk is too high for the division which, if pursued,
would substantially increase the profits of the wider organisation.
■ Competition: Divisions within the same business offering similar or sub-
stitute products may find themselves in competition with each other.
ga
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According to Fortune, Walmart was the world’s largest company in 2010.
Lear
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6b Go to Walmart’s website to see if you can determine any divisionalisation

y
within the company. Here’s a hint: start with the investors’ section of the
website.
eedb ac
F
You may find some information at investors.walmart.com. For example, in

6b the annual reports in the ‘Our Businesses’ section the company seems to
have three divisions, namely, Walmart US, Walmart International and Sam’s
Club.

6.2 Profit and investment centres

Divisions tend to be categorised into either a profit centre or an investment
centre.
Profit centre
A profit centre is an area of responsibility to which both costs and revenues
are attributed for purposes of assessing profit performance. Divisionalisation
within an organisation requires that profit centres are established, and that
divisional managers be held responsible for both the costs and benefits resulting
from their planning and control activities.
A simple but key performance measure used at the profit centre level is EBITDA
(earnings before interest, tax, depreciation and amortisation). EBITDA
eliminates varying items (tax, interest, and so on) from the income statement,
to give an approximation of the operating profit generated by a business or
profit centre. As these items have been removed, EBITDA can be used to
compare a profit centre’s performance with other profit centres.
Investment centre
An investment centre is an area of responsibility in which a divisional manager
is held responsible not solely for profits, but also for the extent to which they
reflect the efficient use of capital invested in the division. Investment centres
represent the greatest degree of devolution of responsibility within division-
alised organisations. Divisional managerial performance appraisal within
investment centres is, therefore, based upon the two elements of profit and
investment.
Measuring performance of an investment centre must take into account the

assets/investment as well as earnings/profits. The section below, ‘Measurement
of divisional performance’, provides more detail on some of the more common
measures used.
ga
nin ct Thinking of Walmart (Learning Activity 6b), or any other organisation you
Lear
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6c know, are there benefits of giving autonomy to divisional managers?

y
eedb ac
The benefits of allowing divisional managers autonomy include:
F
6c ■ Better use of market information. For example, Walmart operates in 15

countries, so local managers are likely to know more about local
conditions.
■ Increase in management motivation.
■ Providing opportunities for management development.
■ Making full use of specialist and/or local knowledge.
■ Giving central managers time to focus on strategic issues. For example,
Walmart has nearly 9,000 stores (as of the end of 2010). Central
managers must delegate to manage such a business effectively.
■ Permitting a more rapid response to changes in market conditions.

Measurement of divisional performance

As already mentioned, there are three main techniques used to measure and
assess divisional performance:
■ return on investment (ROI)
■ net residual income (RI)
■ economic value added (EVA®).
Return on investment (ROI)

Return on investment (ROI), which is also referred to as ‘return on capital
employed (ROCE)’ is a commonly used technique in accounting. It can be
calculated as follows: net profit before interest and taxes ÷ assets (capital)
employed × 100. Net profit is profit before taxes and interest, which for
divisional performance measurement would usually mean profits controllable
by divisional management. Assets employed can be one of several possible bases
for measuring the level of capital employed in an organisation/division:
■ controllable assets (by divisional manager)
■ total divisional assets
■ net assets (such as assets less liabilities).
To further assess performance, the ROI can be disaggregated into two subsid-
iary or secondary measures of divisional performance: profit margin and asset
turnover. The profit margin is sometimes referred to as ‘return on sales’, while
asset turnover is sometimes termed the ‘asset utilisation ratio’.
■ Profit margin (%) = net profit before interest and taxes ÷ turnover ×
100.
■ Asset turnover (times) = turnover ÷ assets employed.
Profit margin shows the percentage of the profit made on each unit sold, which
is a reflection of the operational efficiency of a business. Asset turnover shows
the number of times per annum the asset base generates sales, which reflects
how well assets are used to generate turnover. The profit margin multiplied by
the asset turnover equals the ROI.
Example
Calculate the ROI from the following data:
Net profit: £180,000
Asset investment: £1.5 million
Turnover: £2.25 million
Answer to example
ROI = 180,000 ÷ 1,500,000 × 100 = 12%.
This can be further analysed into profit margin and asset turnover:
Profit margin = 180,000 ÷ 2,250,000 × 100 = 8%.
Asset turnover = 2,250,000 ÷ 1,500,000 = 1.5 times.
Note: 8% × 1.5 times = 12% ROI.

Advantages of ROI
■ Return on the investment is a percentage, which makes the ROI a useful
comparative tool for businesses and/or divisions.
■ It is commonly used and understood by managers.
■ The data required is readily available.
Disadvantages of ROI
■ The principal drawback connected with the use of ROI is that it can allow
sub-optimal planning decisions to be taken by divisional managers. A
manager whose performance is appraised on the basis of ROI will be
unwilling to accept projects and opportunities which do not realise a rate
of return at least equal to the current ROI being earned by that division. In
order to maintain divisional performance levels, managers will reject
investment opportunities that fall short of the required ROI because the
effect of their acceptance would be to dilute or reduce the divisional
manager’s overall ROI.
■ Generally, ROI does not encourage goal congruence.
■ There is no universally accepted formula for ROI, although the one given
here is commonly used. For example, should the assets or capital used be the
figure at year end or an average?
Return on shareholders’ funds

A variation on ROI is return on shareholders’ funds (RoSF). This measure is
particularly useful to shareholders of limited companies, as, unlike ROI, it
shows the return on the capital (equity) owned by the shareholders – such as
share capital and retained earnings. The RoSF can be calculated as: net profit
after interest and taxes ÷ shareholders’ funds × 100.
Note how the profit after interest is used, as interest must be paid with any
remaining profits available to shareholders. Shareholders’ funds consist of all
share capital and reserves. Preference share capital may be excluded as some
companies treat this form of capital as debt rather than equity.
Residual income (RI)

Residual income (RI) can be defined as controllable contribution (or profit) less
a cost of capital charge on the investment controllable by divisional manage-
ment. The RI technique is an absolute income measure. Its basic decision rule
is that all new investment opportunities which generate a positive return in
excess of the organisational cost of capital should be accepted by divisions.
Effectively, the RI technique works by charging divisions with an imputed
(notional) interest charge, equal to the organisation’s cost of capital, for their
use of capital. Thus, any new projects realising a surplus of income after being
charged interest should be accepted for the financial benefit of the organisation
as a whole.
Examples of residual income

If a division produced a profit of £200,000 and there was a divisional invest-
ment of £700,000 with a cost of financing this investment of 12% per year, the
residual income would be as follows:

£
Divisional profit 200,000
Less charge for capital
Invested 12% × 700,000 84,000
Residual income 116,000
An advantage of RI over ROI is that managers will be encouraged to make

investment once RI is positive. Using ROI, they may reject profitable invest-
ments which do not have a high enough ROI. Consider the following example:
Assume a business division has assets of £100,000 and net operating profits of
£20,000. The minimum required return from all divisions is 15%. The division
is considering purchasing a machine. The machine would cost £25,000 and is
expected to generate additional operating income of £4,500 a year. From the
standpoint of the overall company, this would be a good investment since it
promises a rate of return of 18% [(£4,500 ÷ £25,000) × 100], which is in excess
of the company’s minimum required rate of return of 15%. However, if the
divisional manager’s performance is based on ROI, the 18% is less than the
current 20% achieved and this machine purchase might be rejected. If RI were
used, the following table shows the performance:
Present (£) New machine (£) Overall (£)

Average operating assets 100,000 25,000 125,000
Net operating income 20,000 4,500 24,500
Minimum required return 15,000 3,750 18,750
Residual income 5,000 750 5,750
As shown in the table above, the RI is positive for the new machine and thus
will increase overall performance.
RI does have some disadvantages though:

■ It is an absolute measure.
■ It is difficult to compare investments of different sizes.
In general, ROI is preferable to RI because:

■ It can be used for inter-divisional and inter-firm comparisons.
■ ROI is understood more readily by external investors.
■ Managers may prefer percentage measures as they are more easily under-
stood.
Economic value added (EVA®)

Economic value added (EVA®) is an extension of the RI method in that it
removes distortions to divisional performance contained in the operating profits
as per the accounts. It can be defined as follows:
EVA = conventional divisional profit +/– accounting adjustments – cost of
capital charge on divisional assets.

You can see that EVA® is much like RI. The key difference is that it attempts
to remove any accounting treatments which do not contribute to overall share-
holder value. For example, accounting standards may require the capitalisation
of research and development costs, spreading costs over multiple years although
the expenditure has actually been incurred. Another example is a one-off charge
like restructuring costs. If accounting adjustments are minimal, the EVA® result
will be very similar to RI. EVA® is more likely to encourage goal congruence
in terms of asset acquisition decisions and thus is preferable to ROI (as was the
case for RI, above).
economic profit A variation on EVA® is economic profit. From Unit 2, you know what an
opportunity cost is. Economic profit begins with accounting profit and then
deducts any opportunity costs. It thus takes into account how much a business
could make by pursuing other courses of action. Calculating an economic profit
is a rather difficult task as it may not be possible to know the lost returns from
other ventures or investment opportunities.
ga
nin ct
Assume a sole trader has revenue of £200,000 and costs of £160,000. If the
Lear
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6d sole trader were employed, they could earn a salary of £30,000. What is the
y
economic profit of the business?
eedb ac
F
The profit of the business is £40,000. If the salary forgone is deducted, the
6d economic profit is thus £10,000.
6.3 Managerial or divisional performance

measures?
All three financial measures – ROI, RI and EVA® – can be used to evaluate
either managerial or divisional performance. The following guidance is useful:
■ If the purpose is to evaluate the divisional manager then only those items
directly controllable by the manager should be in the profitability measure.
■ If, however, the purpose is to evaluate overall divisional or organisational
performance, many of the items that divisional managers cannot influence
(for example, interest expenses, taxes and the allocation of central
administrative staff expenses) need to be included in the calculations.
ga
nin ct
The following information applies to the budgeted operations of the
Lear
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6e Goodman Division of the Telling Company:

y

ga
nin ct
Lear
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£
6e
y
Sales revenue (50,000 units at £8) 400,000
continued Variable costs (50,000 units at £6) (300,000)
Fixed costs (75,000)
Divisional profit 25,000
Divisional investment 150,000
The minimum desired ROI is the cost of capital of 20% a year.

Calculate:
1. The ROI.
2. The RI.
eedb ac
F
1. ROI = division profit ÷ divisional investment (asset employed) × 100%

k
6e = 25,000 ÷ 150,000 × 100%

= 16.7%.
2. Divisional profit = £25,000
Required return 20% × £150,000 = (30,000)
Residual income (loss) = (5,000).
The results show that the ROI is less than the required return of 20%
and the RI is negative. The results must therefore be considered
unsatisfactory.
ga
nin ct
Explain each of the following:
Lear
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6f
y
■ controllable profit
■ ROI.
eedb ac
F
Controllable profit deducts all expenses (variable and fixed) within the
k
6f control of the divisional manager when arriving at a measure of

performance. This is viewed by many as the best measure of
performance for divisional managers as they will be in a position to
determine the level of expenses incurred. However, in practice, it may be
difficult to categorise expenses as being either controllable or non-
controllable. This measure also ignores the investment made in assets.
For example, a manager may decide to hold very high levels of
inventories, which may be an inefficient use of resources.

eedb ac
Return on investment (ROI) is a widely used method of evaluating the
F
6f profitability of divisions. The ratio is calculated in the following way: net

profit before interest and taxes ÷ assets (capital) employed × 100. The
continued ratio is seen as capturing many of the dimensions of running a division.
When defining divisional profit for this ratio, the purpose for which the
ratio is to be used must be considered. When evaluating the
performance of a divisional manager, the controllable contribution is
likely to be the most appropriate, whereas for evaluating the
performance of a division, the divisional contribution is likely to be more
appropriate. Different definitions can be employed for divisional
investment. The net assets or total assets figure may be used. Additional
assets may be shown at original cost or some other basis such as current
replacement cost.
6.1 Describe three different types of an uncontrollable factor.
6.2 Outline possible problems which may be encountered as a result of the
introduction of a performance and control system into an organisation.
6.3 Identify and explain the essential elements of an effective management
control system.
6.4 Write the formula for EVA®.
6.5 Division A makes a single product. Information for the division for the
year just ended is:
Sales 30,000 units
Fixed costs £500,000
Depreciation £360,000
Residual income £47,200
Net assets £1,250,000
Head office assesses divisional performance by the residual income

achieved. It uses a cost of capital of 12% a year.
Calculate Division A’s average contribution (gross profit) per unit. (Note,
work backwards from residual income towards gross profit in order to
derive divisional contribution.)
6.6 Samson uses residual income to appraise its divisions using a cost of
capital of 12%. It gives the managers of these divisions considerable
autonomy although it retains the cash control function at head office. The
following information was available for one of the divisions:
Net profit after Profit before Divisional net Cash £000

tax £000 interest and tax assets including
£000 cash £000
Division 47 69 104 21
Calculate the controllable residual income.

6.7 Compare and contrast EVA®and RI, and briefly discuss their merits as
divisional performance measures.
6.8 From the data below calculate the ROI and RoSF for X Ltd and Y Ltd for
2011. Use all given data.
Statement of X Ltd X Ltd Y Ltd Y Ltd

financial position 2010 (£) 2011 (£) 2010 (£) 2011 (£)
at 31 Dec
Net assets 16,000 18,000 20,000 24,000
Ordinary share 6,000 6,000 10,000 10,000
capital
Reserves 10,000 12,000 7,600 11,600
10% long-term 2,400 2,400
debt
Total 16,000 18,000 20,000 24,000
The profit from 4,400 7,600
income statement
after tax/interest

6.1 Three uncontrollable factors are:
■ economic and competitive factors
■ acts of nature
■ interdependencies with other organisations.
6.2 Possible problems encountered as a result of the introduction of a

performance and control system into an organisation include:
■ Difficulties in setting standards for non-repetitive work.
■ Non-acceptance of budgets/plans by staff if they view the system as a
punitive device to judge their performance.

■ Isolating variances where interdependencies exist.
6.3 The essential elements of an effective management control system are:

■ The need for a system of responsibility accounting based on a clear
definition of a manager’s authority and responsibility.

■ The production of performance reports at frequent intervals comparing
actual and budget costs for individual expense items. Variances should
be analysed according to whether they are controllable or non-
controllable by the manager.
■ Managers should participate in the setting of budgets and targets.
■ The system should ensure that variances are investigated, causes found
and remedial action is taken.

■ An effective control system must not be used as a punitive device, but
should be seen as a system that helps managers to control their costs

more effectively.
6.4 EVA® = conventional divisional profit +/– accounting adjustments – cost
of capital charge on divisional assets.

6.5 Working backwards to determine the divisional contribution:
£
Cost of capital (12% × £1.25m) 150,000
Residual income 47,200
Depreciation 360,000
Fixed costs 500,000
Total 1,057,200
Therefore contribution per unit = £1,057,200 ÷ 30,000 = £35.24.
6.6 Divisional managers do not control the cash function. Therefore, control-
lable net assets are £104,000 – £21,000 = £83,000.
£
Profit before interest and tax 69,000
Less cost of capital (12% × £83,000) (9,960)
Controllable residual income 59,040
6.7 Your answer should define RI and EVA®:

■ RI = controllable contribution (profit) – cost of capital charge.
■ EVA
® = conventional divisional profit +/– accounting adjustments –
cost of capital charge on divisional assets.
Both measures are similar but EVA® considers any accounting adjust-
ments. If accounting adjustments are few, EVA® and RI will give similar
results.
6.8 As this exercise gives two statements of financial position, the answer can
use an average capital figure.
ROI
X Ltd
4,400 × 100 ÷ ((16,000 + 18,000) ÷ 2) = 25.88%.
Y Ltd
7,600 + 240 ÷ ((20,000 + 24,000) ÷ 2) = 35.63%.
Note the interest on debt is added back to profit.
RoSF
X Ltd
The answer is the same as ROI, as X Ltd has no debt.
Y Ltd
7,600 × 100 ÷ ((17,600 + 21,600) ÷ 2) = 38.77%.

Summary
This unit has introduced you to the importance of management control.
Control, as a general concept, means the measuring of an outcome against a
target. In Unit 5, you learned about one such target – a budget – and in the
next unit, you will learn some techniques to compare budget to actual
performance. You also learned the importance of managerial responsibility for
performance and how responsibility centres are used for the accountability of
managers. In the latter half of the unit you learned about divisional perform-
ance, and some useful techniques to assess this performance – ROI, RI and
EVA® (including some derivatives of these measures).

Unit 71 Standard costing and
variance analysis
‘Set exorbitant standards, and give your

people hell when they don’t live up to
them. There is nothing so demoralising as
a boss who tolerates second-rate work.’
David Ogilvy, military intelligence officer and advertising executive (1911–99)
Introduction
Unit 5 explained the preparation of budgets and Unit 6 introduced you
to management control. As you might expect, budget costs are com-
pared to actual cost and this is a form of control. To make sense of
differences between budget costs and actual costs, it is useful to have
more detail than just the difference. Therefore, it is useful to look at unit
costs rather than total costs. This means we need a budgeted unit cost,
standard cost which is called a standard cost. This unit explains standard costs and
how they are used.

7.1 Explain the nature and purpose of standard costing.
7.2 Calculate and interpret a variety of cost variances.
7.3 Calculate and interpret performance measures.
7.4 Prepare a basic standard cost operating statement.
7.5 Identify the benefits and the disadvantages of a standard costing
system.
Prior knowledge
You should have covered Unit 5 in advance of starting this unit.

Unit 7 Standard costing and variance analysis
7.1 What is standard costing?

Recommended reading for the In earlier units you encountered absorption and marginal costing, which are
entire unit: ‘Standard costing and methods of calculating the actual cost of the production of goods or services.
variances analysis’ in Drury (2009). Standard costing is not a costing method in the sense of product costing, but a
type of control system, often found in conjunction with budgetary control.
Standard costing has its origins in the traditional manufacturing sector, but is
also useful in the service sector. Despite the business world being much less
standardised in terms of product and service delivery, it is a commonly used
technique. CIMA’s 2009 annual survey of management accounting practice
reported that nearly 50% of respondents use standard costing techniques.
A standard cost is the budgeted cost of a single unit of production. Standard

costing works by comparing the standard, predetermined costs with actual
costs, and then analysing the reason for any variances, but in a more detailed
way than with budgetary control. In this unit, we will use an absorption costing
approach, but standard costs can be equally applied in a marginal costing
system.
Traditionally, standard costs of a product/service were written on cards,

standard cost card referred to as standard cost cards. The cost card would include not only costs,
but also standard resources used (such as materials and labour time).
According to Drury (2009), the purposes of a standard costing are to:

■ Provide a basis for setting targets and measuring performance.
■ Provide useful information for decision making.
■ Act as a control device, for example, by exception reporting.
■ Provide a method for valuing inventory (stock).
■ Provide a means for establishing the selling price of goods.
Why ‘standard’?
The predetermined costs of materials and labour are standard costs which are
derived from technical specifications of products and work studies. There are
two types of standard:
ideal standard ■ The ideal standard, which is attained under the most favourable conditions
with no allowance for normal losses, waste and/or downtime.
■ The attainable standard, which is attained when work is carried out under
attainable standard normal efficiency, a machine is properly operated or a material properly
used. Allowances are made for normal losses, waste and downtime.
The attainable standard is a more realistic one, since ideal conditions rarely
prevail. Attainable standards may be set by using averages of past performance
or by detailed studies of work tasks.
ga
nin ct
A factory produces 800 units in a day, and works 8 hours. How many units
Lear
ivit
7a are produced in 1 hour?

y

eedb ac
This is a simple calculation since in 1 (standard) hour 800 ÷ 8 = 100 units
F
7a are produced. However, this calculation shows that in standard costing, a

standard hour is not a measure of time but a measure of performance or
production. It is a period during which a set amount of work is to be
completed.
The standard cost of a unit of production (assuming absorption costing)

consists of four elements, which, together with their bases of calculation, are:
■ direct materials = usage × price
■ direct labour = hours (or other time period) × rate of pay
■ variable overheads = hours × variable overhead rate per hour
■ fixed overheads = hours × fixed absorption rate per hour.
Note that variable overheads can be spread across labour hours or units in a
similar way to fixed overheads, as covered in Unit 3.
ga
nin ct
You are trying to determine standards for a costing system. Which
Lear
ivit
7b individuals do you think would provide details of the following:

y
■ amounts of materials needed for production

■ pay rates
■ materials prices
■ hours required for a particular task
■ overhead absorption rates.
eedb ac
F
A lot of people could be involved, as shown in the table below. This shows
k
7b that non-accountants need to be involved in both setting standards and

keeping them up to date.
Amounts of materials The production manager would supply this information.

needed for production
Pay rates The personnel department or human resources director would supply these.
Materials prices The purchasing department would supply this information, although of
course many firms may not be large enough to have a separate purchasing
department, and the function may be carried out by the production manager.
Hours required for a In a large organisation the works study engineer will provide this
particular task information.
Absorption rates This is the area where you would expect the management accountant to
provide the information.

ga
nin ct
A manufacturer of overcoats is trying to determine the standard cost of one
Lear
ivit
7c overcoat. The details of the coat and typical materials required are:
y ■ 2.5 metres fabric at £10 per metre
■ 0.5 metres of lining at £4 per metre
■ 4 buttons at 50p each
■ 10 metres of thread at 20p per metre
The coat normally takes 3 hours to make and the average rate of pay is £8
per hour. Fixed overheads are absorbed at a rate of £2 per labour hour.
Calculate the standard cost of an overcoat.
eedb ac
F
The standard cost of the overcoat is as follows:

k
7c Cost £
2.5 metres fabric at £10 per metre 25
0.5 metres of lining at £4 per metre 2
4 buttons at 50p each 2
10 metres of thread @ 20p per metre 2
3 hours of labour at £8 per hour 24
Fixed overhead, 3 hours at £2 6
Standard cost 61
Links between budgets, control and variance

analysis
Recommended reading: So far, the key points of a standard costing system are:
‘Management control systems’ in
Drury (2009).
1. It is not a costing method per se, but a type of control system often found
in conjunction with budgetary control.
2. A standard cost is the budgeted cost of a single unit of production, and the
standard used is typically attainable rather than ideal.
3. The standard cost will include elements of direct materials, direct labour,
variable and fixed overheads.
4. A standard costing system will use the concept of the standard hour which
is a measure of performance or production. It is a period during which a set
amount of work is to be completed.
If an organisation uses standard costing, it will typically compare the expected

variance analysis standard costs with actual costs. This process is called variance analysis and is
described in some detail in the section below. Before looking at more detailed
variances, let’s first consider the links between budgets, control and variance
analysis. You learned in Unit 6 that performance of managers is affected by

factors such as motivation and participation. Linking your knowledge of

budgeting from Unit 5 to control, one important point is that managers or
employees should not be held to account for issues outside their control, for
example, a downturn in business. However, when a budget is formulated, it
cannot be a perfectly accurate picture of the future. Thus, when comparing
actual outcomes with the planned outcomes (the budget), any uncontrollable
factors should be eliminated. The solution to this problem is to re-draft the
flexed budget budget to reflect the actual level of activity. This is called a flexed budget. A
simple example is given below:
The standard material and labour costs per unit of a product are £5 and £10,
respectively. At the beginning of the year, the management accountant prepared
a budget based on production of 5,000 units each month. Actual production for
the month of January was 5,450 units. Using the given data, the original budget
would have been:
£
Material cost (£5 × 5,000) 25,000
Labour cost (£10 × 5,000) 50,000
75,000
Had the management accountant known that the output for January would be
5,450 units, the budget would have looked like this:
£
Material cost (£5 × 5,450) 27,250
Labour cost (£10 × 5,450) 54,500
81,750
This is the flexed budget. Now let’s assume actual material costs were £26,160
and actual labour costs were £55,045. If a manager were to be held responsible
for these costs on the basis of the original budget, then the difference from the
original budget would have been as follows:
Actual (£) Budget (£) Difference (£)

Material cost 26,160 25,000 1,160 overspend
Labour cost 55,045 50,000 5,045 overspend
However, this comparison would not be correct as the manager probably has
no control over what is sold (and thus produced). Comparing the flexed budget
to actual costs is more useful, as shown:
Actual (£) Budget (£) Difference (£)

Material cost 26,160 27,250 1,090 underspend
Labour cost 55,045 54,500 545 overspend

Using this comparison, the material costs are actually better than budget, and
the labour costs are not as much over target as in the previous table. The
difference between actual costs and budget costs is called a variance, and you’ll
learn more about this in the section below. The comparison of actual costs to
a flexed budget is the first step in trying to find reasons for variances from
standard. This difference highlights the need for further investigation of
variances by managers. When more detail is required, more information on
standards is needed to give a clear answer. For example, are material costs lower
in the example above because they were bought more cheaply or used more
efficiently? The answer to this type of question is outlined in the following
sections, but to make comparisons of actual costs to budget, the first step is
always to flex the budget.
7.2 Variance analysis

cost variance A cost variance is the difference between a standard cost and the actual cost
incurred in a period. You have already encountered the idea of a variance in the
previous section but here we are going to develop it by looking at the four
standard cost elements in turn. First, let’s consider the implications of a
variance.
ga
nin ct In Learning Activity 7a, you saw how a standard hour produced 100 units.
Lear
ivit
7d Now assume the company works a 7.5-hour day, and, according to the
y
production department records for last week:

■ 800 units were produced on Monday.
■ 740 units were produced on Tuesday.
Calculate and comment on the variances for each day.
eedb ac A standard hour should produce 100 units so in a 7.5-hour day the
F
company should produce 750 units (7.5 × 100).

7d
On Monday, 800 units were produced, so a variance of 800 – 750 = 50
units. The company produced 50 units more than standard so this is a
favourable variance.
On Tuesday, 740 units were produced, so a variance of 740 – 750 = (10)
units. The company produced 10 units less than standard so this is an
adverse variance.
favourable variance
Favourable and adverse variances

The terms favourable and adverse should be thought of in terms of the effect
on the firm’s profits. A favourable variance will increase profit, so produces
adverse variance more than the standard output, incurs costs less than standard or realises
greater revenues than the standard. An adverse variance reduces profit so
produces less than the standard output, incurs greater costs than standard or
realises less revenue than standard.

Direct material cost variance

The direct material cost variance is, as you might expect, the difference between
the standard cost of materials required for the output achieved (that is, the
flexed budget cost) and the actual cost of those materials.
ga
nin ct
Bearing in mind the elements of the cost of direct materials, what do you
Lear
ivit
7e think a cost variance consists of?

y
eedb ac
F
The elements of the cost of direct materials were noted earlier as usage
k
7e multiplied by price, so a cost variance can consist of a variance in usage, a

variance in price, or both. For example: A product has been costed to
require 100 kg of a raw material costing £10 per kg. Thus the standard cost
of material is: usage × price = 100 × £10 = £1,000.
ga
nin ct
From the example in Learning Activity 7e, assume that in production 110 kg
Lear
ivit
7f of the raw material were used at a cost of £9 per kg. What is the direct
y
materials cost variance? Is it favourable or adverse?
eedb ac
We can use a formula to work out a total material cost variance:
F
7f (SQ × SP) – (AQ × AP)

where S = standard, Q = quantity, P = price and A = actual.
In this case, therefore, the variance is calculated as:
(100 × £10) – (110 × £9) = £1,000 – £990 = £10 favourable.
The variance is favourable as the actual cost is less than the standard. Thus, a
formal definition of a material cost variance is: (standard usage × standard
price) – (actual usage × actual price).
The material cost variance is, however, made up of two elements: price and
usage. The cost of the material was £9 per kg instead of £10, and 110 kg were
price variance
used instead of 100. The above formal definition of the total variance can thus
be split into a price variance and usage variance.
The usage variance measures usage at the standard price and is given by: usage
variance = (standard usage for actual production – actual usage) × standard
usage variance price.
The price variance measures price at the actual usage and is given by: price
variance = (standard price – actual price) × actual usage.

ga
nin ct
Check that the price and usage variances, when added together, do give the
Lear
ivit
7g total material cost variance.
y
eedb ac
F
You should have the following:

7g usage variance + price variance = [(standard usage – actual usage) ×
standard price] + [(standard price – actual price) × actual usage] = (standard
usage × standard price) – (actual usage × standard price) + (standard price ×
actual usage) – (actual price × actual usage) = (standard usage × standard
price) – (actual price × actual usage)
= direct materials cost variance.
Do not worry if you found this manipulation a bit tricky. Try to follow the
workings and establish for yourself that the total variance is made up of the
usage and price variance. For the rest of this unit we will abbreviate price and
usage variances as follows (where SQ is the standard usage for actual
production, AQ is actual usage, SP is standard price and AP is actual price):
■ usage variance = (SQ – AQ) × SP
■ price variance = (SP – AP) × AQ.
ga
nin ct In Learning Activity 7f, there was a favourable direct materials cost variance
Lear
ivit
7h of £10. Calculate the individual variances and show how the £10 is made
y
up.
eedb ac
F
Usage variance = (standard usage for actual production – actual usage) ×

k
7h standard price
= (100 – 110) × £10
= (£100).
Price variance = (standard price – actual price) × actual usage
= (£10 – £9) × 110
= £110.
The total favourable variance of £10 is made up of an adverse usage
variance (£100) and a favourable price variance of £110, making a total of
£10.
The importance of this analysis lies in the different responsibilities within an

organisation. Variances in price will be the responsibility of the purchasing
manager, while variances in usage are the responsibility of the production
manager. Thus, using standard costing as a control method allows management
accountants to determine whether more or less raw material has been used
compared to standard, or whether a different price has been paid from

standard. Managers can then investigate why there has been a difference in
material usage or price paid. Linking back to the earlier section on flexed
budgets, in all cases the variances thus far have been calculated based on
standards as applied to actual output, that is, the flexed budget figures. This is
the case for other variances too, as you’ll learn in the following sections.
ga
nin ct Fashion Fabrics Ltd makes curtains. A pair of curtains uses 6 metres of fabric
Lear
ivit
7i that costs £3.10 per metre. On a production run, 50 pairs are made using
y
330 metres of fabric costing £2.50 per metre. Calculate the material cost
variances and suggest why these might have occurred.
eedb ac The production run of 50 pairs should have used 6 metres per pair so the
F
7i standard usage is 50 × 6 = 300 metres. The calculations are as follows:

Material cost variance = (standard usage × standard price) – (actual usage ×
actual price)
= (300 × £3.10) – (330 × £2.50)
= £930 – £825
= £105.
This is an overall favourable variance. This is made up of:
usage variance = (SQ – AQ) × SP
= (300 – 330) × £3.10
= (£93).
price variance = (SP – AP) × AQ
= (£3.10 – £2.50) × 330
= £198.
So the overall favourable variance of £105 comprises an adverse usage
variance of £93, indicating that more fabric has been used than standard,
and a favourable price variance of £198, indicating that the fabric was
purchased at a cheaper price. We do not have enough information to form
a conclusion but it could be that the fabric was cheaper because it was
inferior, which in turn contributed to the adverse usage variance since more
fabric was wasted in the production process. This is something that would
then be investigated by the management.
Learning Activity 7i illustrates one of the key functions of management

accounting. The information provided from the variances shows the production
and purchasing managers that there is a problem. They can now investigate
this in order to arrive at a solution. The reasons for material cost variances
will, in part, depend on the nature of the industry but some common reasons
are:

■ inferior materials causing wastage

■ an inexperienced production team, also causing wastage
■ theft or loss through damage of materials
■ poorer quality materials
■ a change in supplier affecting quality or price
■ bulk orders reducing the price.
Direct labour cost variances

The principles that we have applied above to material variances are also applied
to calculating and investigating labour cost variances. This time the elements of
the cost are the time period and the pay rate. For convenience, we will refer to
the time period in hours. Thus, the starting point is: direct labour cost variance
= (standard hours × standard rate) – (actual hours × actual rate). We can also
use the following again:
The ‘price’ this time is the rate of pay, and the ‘quantity’ the labour hours. For
labour, the usage variance is called the labour efficiency variance and the price
variance is called the labour rate variance.
ga
nin ct
The standard cost of a job is 5 hours at a wage rate of £4 per hour. The job,
Lear
ivit
7j however, takes 4 hours to complete and the rate paid was £4.50 per hour.
y
What is the total labour cost variance?
eedb ac
F
Using the formula above:

k
7j direct labour cost variance = (standard hours × standard rate) – (actual

hours × actual rate)
= (5 × £4) – (4 × £4.50)
= £20 – £18
= £2.
There is an overall favourable variance of £2.
ga
nin ct
Analyse the favourable labour cost variance from Learning Activity 7j into
Lear
ivit
7k the labour efficiency and rate variances.

y
eedb ac
F
Labour efficiency variance = (SQ – AQ) × SP

k
7k = (5 – 4) × £4
= £4.

eedb ac
Labour rate variance = (SP – AP) × AQ
F
7k = (£4 – £4.50) × 4
= (£2).
continued
The favourable efficiency variance means that the job took less time than
anticipated, but the adverse rate variance means that it cost more.
The causes of these variances would have to be investigated, but some of the
more usual reasons for efficiency and rate variances are:
■ unforeseen circumstances that cause delays
■ use of more highly skilled labour, causing an adverse rate variance but may
mean that output is higher or faster
■ use of less highly skilled labour, having the opposite effect: favourable rate
variance, but the job may take longer
■ pay rate rises
■ unforeseen overtime being worked.
Also, the causes of labour and material variances can be related. For example,
poor quality materials may cause more wastage or scrappage, which in turn
may lead to a longer time taken to produce a product, that is, cause an adverse
labour efficiency variance.
Variable production overhead variance

The elements of this cost are the hours and the overhead absorption rate. It
could be argued that variable overhead costs cannot be further analysed, since
expenditure varies directly with output. There can, therefore, be no efficiency
variance. However, it is possible to analyse variable overhead cost into
expenditure and efficiency variances. The starting point is: variable production
overhead variance = (standard hours for the actual production × overhead
absorption rate) – actual variable overheads.
ga
nin ct
A company has budgeted for 10 standard hours to produce 1 unit. Its
Lear
ivit
7l variable overhead absorption rate is £1 per direct labour hour. In 1,600

y
actual hours, 180 units were produced and the variable production
overhead costs incurred were £2,000. Calculate the variable production
overhead variance.
eedb ac
F
The actual production of 180 units should take 180 × 10 = 1,800 hours:
7l Variable production overheads variance = (standard hours for the actual
production × overhead absorption rate) – actual variable overheads
= (1,800 × £1) – £2,000
= £1,800 – £2,000
= (£200). There is an adverse variance of £200.

The variable production overhead variance can be subdivided into efficiency

and expenditure variances. Again we can use:
The ‘price’ this time is the overhead rate, the ‘quantity’ the hours used to absorb
overhead.
ga
nin ct
Analyse the adverse variance of £200, found in Learning Activity 7l, into the
Lear
ivit
7m efficiency and expenditure variances.

y
eedb ac
Your calculations should be as follows:
F
7m Efficiency variance = (SQ – AQ) × SP

= (1,800 – 1,600) × £1
= £200,
which is favourable as fewer hours were worked to produce the 180 units
than were budgeted for.
Expenditure variance = (SP – AP) × AQ
= (1,600 × £1) – £2,000
= (£400).
The overall adverse variance arises because the absorption rate of £1 per
direct labour hour was predetermined and, since fewer units were produced
than budgeted for, there is an under-recovery.
Fixed production overhead variances

Fixed overhead variances do not follow the pattern set by the variable pro-
duction costs seen thus far. This time the starting point is: Total fixed
production overhead variance = (standard hours for the actual production ×
fixed overhead absorption rate) – actual fixed overheads. You might notice that
the first portion of the formula is the absorbed overhead. Thus, we can shorten
the formula to read: Total fixed production overhead variance = absorbed
overhead – actual fixed overheads.
ga
nin ct
If the production process referred to in the last activity used a fixed
Lear
ivit
7n overhead absorption rate of £2 per direct labour hour, and fixed overheads
y
were £3,200, calculate the total fixed production overhead variance.

eedb ac
The calculation is as follows:
F
7n Total fixed production overhead variance = absorbed overhead – actual fixed

overheads
= (1,800 × £2) – £3,200
= £3,600 – £3,200
= £400.
This is a favourable variance because too much overhead has been absorbed
into actual production.
The total fixed overhead variance can be analysed into:

■ fixed overhead expenditure variance
■ fixed overhead volume variance
which can be further analysed into:

■ volume capacity variance
■ volume efficiency variance.
You might find it easier to visualise the relationships of the fixed overhead
variances as shown in Figure 7.1.
Fixed OH Total
FOH Expenditure FOH Volume
Volume Capacity Volume Efficiency
Figure 7.1
Fixed overhead expenditure variance

This is simply the budgeted fixed overheads less the actual fixed overheads:
FOH expenditure variance = budgeted fixed overheads – actual fixed
overheads.
If, in Learning Activity 7n, the budgeted fixed overheads had been £4,000, the
expenditure variance would be:
FOH expenditure variance
= budgeted fixed overheads – actual fixed overheads
= £4,000 – £3,200
= £800.
Since actual expenditure was less than budget, the overhead absorption rate
was higher than necessary, and thus the variance was favourable. Note that in

this case, the budget overhead figure is the original budget figure – it is not
flexed in any way. This is because a budgeted absorption rate is set in advance,
based on budgeted costs and absorbed accordingly during the year.
Fixed overhead volume variance

The volume variance is: FOH volume variance = (standard hours for actual
production × overhead absorption rate) – budgeted overhead. This variance
explains the portion of the variance caused by actual volume being different
from budget volume.
ga
nin ct Write down whether you think the volume variance for the previous
Lear
ivit
7o activities (7m and 7n) will be favourable or adverse, and then do the
y
calculation to check your answer.
eedb ac
F
The overall fixed overhead variance is a favourable one of £400, and since the
7o expenditure component is also a favourable one of £800, we would expect
the volume variance to be an adverse one of £400. The calculation is:
FOH volume variance = (standard hours for actual production × overhead
absorption rate) – budgeted overhead
= (1,800 × £2) – £4,000
= £3,600 – £4,000
= (£400) as predicted.
The volume variance is adverse because fewer units have been produced
than budget, so less overhead has been absorbed by these fewer units.
The volume variance can be further analysed into the volume capacity and
volume efficiency variances.
The volume capacity variance is calculated as: Volume capacity variance =

(actual hours worked × overhead absorption rate) – budgeted fixed overhead.
This variance measures the under/over-absorption due to working fewer/more
hours than budget.
ga
nin ct
Using the figures from Learning Activity 7o, calculate the volume capacity
Lear
ivit
7p variance.
y
eedb ac
You should have:
F
7p Volume capacity variance = (actual hours worked × overhead absorption

rate) – budgeted fixed overhead
= (1,600 × £2) – £4,000
= £3,200 – £4,000
= (£800).

eedb ac
The volume capacity variance is adverse because fewer hours than budgeted
F
7p were worked. If the situation is the other way round, and more hours are
worked, a capacity variance will be favourable because a firm has been able
continued to use more hours than budgeted and should therefore be capable of
producing more units.
The volume efficiency variance is calculated as: Volume efficiency variance =

(standard hours for actual production – actual hours worked) × overhead
absorption rate. This variance measures the under/over-absorption due to
working fewer/more hours than expected for actual output.
ga
nin ct
Write down whether you think the productivity variance of Learning Activity
Lear
ivit
7q 7p will be favourable or adverse, then do the calculation to check your

y
answer.
eedb ac
The volume variance is an adverse one of £400, and since the capacity
F
7q component is also an adverse one of £800, we would expect the efficiency

variance to be a favourable one of £400. The calculation is:
volume efficiency variance = (standard hours for actual production –
actual hours worked) × overhead absorption rate
= (1,800 –1,600) × £2
= £400 as predicted.
The variance is favourable as fewer hours were taken than expected for actual
output.
Figure 7.2 is a visual representation of the fixed overhead variances in the

previous examples.
Total £400
Expenditure £800 Volume (£400)
Capacity (£800) Efficiency £400
Figure 7.2
A final point on the variable and fixed overhead variances is that, unlike the
material and labour variances, they only provide an analysis of cost. No
additional information on efficiencies is given, which arguably makes these
variances less useful to managers. Try applying what you have learned so far
to Learning Activity 7r.
ga
nin ct
A company has budgeted for the following costs in manufacturing 1,000
Lear
ivit
7r units during the first quarter of the current year:
y £ per pair
Direct materials (3 m at £5 per m) 15
Direct labour (4 hours at £4 per hour) 16
Variable overheads (£5 per direct labour hour) 20
Fixed overheads (£5.50 per direct labour hour) 22
Total budgeted cost per unit 73
During the quarter 1,100 units were produced. The following actual data is
also available:
■ Direct materials used were 4 metres per unit at £4 per metre.
■ Direct labour was 3 hours per unit at £5 per hour.
■ Variable overheads were £20,000.
■ Fixed overheads were £25,000.
Calculate as many variances as the above data permits.
eedb ac
The calculations are as follows:
F
7r Materials cost variance = (actual usage × standard price) – (actual usage ×

actual price)
= (3 × 1,100 × £5) – (4 × 1,100 × £4)
= £16,500 – £17,600
= (£1,100).
Remember to calculate the standard usage of the actual units produced,
that is, 3 m × 1,100 units.
This adverse variance is made up of:
Usage variance = (SQ – AQ) × SP
= (3,300 – 4,400) × £5
= (£5,500).
Price variance = (SP – AP) × AQ
= (£5 – £4) × 4,400
= £4,400.
Direct labour cost variance = (standard hours × standard rate) – (actual
= (4 × 1,100 × £4) – (3 × 1,100 × £5)
= £17,600 – £16,500
= £1,100.

eedb ac
This is a favourable variance that can be analysed into:
F
7r labour efficiency variance = (SQ – AQ) × SP

= (4,400 – 3,300) × £4
continued = £4,400.
Labour rate variance = (SP – AP) × AQ
= (£4 – £5) × 3,300
= (£3,300).
Variable production overhead variance = (standard hours for the actual
production × overhead absorption rate) – actual variable overheads
= (1,100 × 4 × £5) – £20,000
= £22,000 – £20,000
= £2,000.
This favourable variance can be analysed into:
efficiency variance = (SQ – AQ) × SP
= (4,400 – 3,300) × £5
= £5,500.
Expenditure variance = (SP – AP) × AQ
= (3,300 × £5) – £20,000
= £16,500 – £20,000
= (£3,500).
Total fixed production overhead variance = (standard hours for the actual
production × overhead absorption rate) – actual fixed overheads
= (4 × 1,100 × £5.50) – £25,000
= £24,200 – £25,000
= (£800).
This adverse variance can first of all be analysed into:
Expenditure variance = budgeted fixed overheads – actual fixed overheads
= (4 × 1,100 × £5.50) – £25,000
= £22,000 – £25,000
= (£3,000).
Volume variance = (standard hours for actual production × overhead
= (4,400 × £5.50) – £22,000
= £24,200 – £22,000
= £2,200.
The favourable volume variance comprises:
Capacity variance = (actual hours worked × overhead absorption rate) –
budgeted fixed overhead
= (3,300 × £5.50) – £22,000
= £18,150 – £22,000
= (£3,850).

eedb ac
Efficiency variance = (standard hours for actual production – actual hours
F
k
7r worked) × overhead absorption rate
= (4,400 – 3,300) × £5.50
continued = £6,050.
We can summarise the variances as follows:
£
Direct materials cost variance (1,100)
Direct labour cost variance 1,100
Variable production overheads variance 2,000
Fixed production overheads variance (800)
Total overall variance £1,200
The overall favourable variance can be determined in a single calculation

by comparing the standard and actual cost of the units produced:
Standard Actual cost

cost of
1,100 units
Direct materials £15 per unit 16,500 £16 per unit 17,600
Direct labour £16 per unit 17,600 £15 per unit 16,500
Variable overheads £5 per 22,000 actual 20,000
direct labour hour (4,400)
Fixed overheads £5.50 24,200 actual 25,000
per direct labour hour
Total costs of 1,100 units 80,300 79,100
This confirms the overall favourable variance of £1,200.
Fixed overhead variances when marginal costing is used

Many businesses use marginal (variable) costing techniques for decision
making and internal reporting. In marginal costing, fixed overheads are not
absorbed into products. Instead, they are deducted as a period cost from
contribution (sales less variable costs) to determine profit.
When marginal costing is adopted, most of the fixed overhead variances you
have just learned are not used, as no fixed overhead is absorbed. Only the
fixed overhead expenditure variance (that is, budget fixed overhead less actual
fixed overhead) is typically calculated when marginal costing is used for
internal reporting and control. You’ll also learn later in this unit that sales
variances are calculated in a different way in marginal costing.

7.3 Performance measures

Recommended reading: ‘Standard The information that we have used to calculate variances can also be used to
costing and variance analysis 1’ in calculate three measures of a firm’s efficiency in its production. All are based
Drury (2008). on the direct labour hours and the standard hour. In fact, the ratios shown
below are non-monetary representations of the fixed overhead volume variance
and its two sub-variances (capacity and efficiency).
efficiency ratio Efficiency ratio

This is the basic ratio that compares standard hours for the actual production
with the hours worked, but expresses it as a percentage: efficiency ratio =
standard hours of actual output × 100 direct hours worked.
ga
nin ct
In Learning Activity 7d a firm had a standard hour of 100 units of
Lear
ivit
7s production, and on two particular days, 800 and 740 units were produced,
y
respectively. If, on both days, 7.5 hours were actually worked, what is the
efficiency ratio for each day?
eedb ac
F
On the first day 800 ÷ 100 = 8 standard hours are produced, so the
k
7s efficiency ratio is: 8 ÷ 7.5 × 100 = 106.67%.

On the second day, 740 ÷ 100 = 7.4 standard hours are produced, so the
efficiency ratio is: 7.4 ÷ 7.5 × 100 = 98.67%.
The efficiency ratio measures whether the firm has produced units in more or
less hours than were budgeted for. On the first day the firm has been more
efficient by producing more units that the time allowed for, whereas on the
second day, the efficiency rate has fallen to below 100% because fewer units
than would be expected in the time allowed have been produced.
capacity ratio Capacity ratio

This compares the actual hours with the budgeted hours, to see whether all of
the budgeted hours have been utilised. Capacity ratio = actual hours worked ÷
budgeted hours of input × 100.
ga
nin ct
If the firm in Learning Activity 7s is budgeted to work 8 standard hours per
Lear
ivit
7t day, calculate the capacity ratio for each day.

y
eedb ac
F
The capacity ratios are the same for each day:

7t Capacity ratio = actual hours worked ÷ budgeted hours of input × 100
= 7.5 ÷ 8 × 100
= 93.75%.
The capacity ratio measures whether all the budgeted labour hours have been used
in the actual production. In this case not all the budgeted hours have been used.

production volume ratio Production volume ratio

The third ratio compares the standard hours produced with the budgeted hours,
giving a measure of whether the firm has been effective in utilising the budgeted
hours:
Production volume ratio = standard hours produced ÷ budgeted hours of
output × 100.
ga
nin ct
Calculate the production volume ratio for each day using the information
Lear
ivit
7u from Learning Activities 7s and 7t.

y
eedb ac
F

k
7u output × 100.
First day = 8 ÷ 8 × 100 = 100%.
Second day = 7.4 ÷ 8 × 100 = 92.5%.
This ratio is a measure of how effective the firm has been in using the
budgeted direct labour hours.
ga
nin ct
Calculate the three performance measures for the firm referred to in
Lear
ivit
7v Learning Activity 7r and comment on the results.

y
eedb ac
F
Your results should be as follows:

k
7v Efficiency ratio = standard hours of actual output ÷ direct hours worked

× 100
= 4,400 ÷ 3,300 × 100 = 133.33%.
Capacity ratio = actual hours worked ÷ budgeted hours of input × 100
= 3,300 ÷ 4,400 × 100 = 82.5%.
output × 100
= 4,400 ÷ 4,000 × 100 = 110%.
The budget level of production was 1,000 units, each expected to take 4
hours of direct labour, and so the total budget for direct labour hours was
4,000, but 1,100 units were produced each taking 3 hours, so the actual
direct labour hours were 3,300. Thus the units were produced with greater
efficiency, as shown by the 133.33% efficiency ratio, and not all the
budgeted hours were needed, as shown by the capacity ratio.

7.4 The standard cost operating statement

The information that you have been working on up to now might seem as
though it consists of an unconnected series of arithmetical calculations. The
operating statement calculations are used to prepare an operating statement, which summarises all
variances that you have seen in order to present information to management.
This statement will also include sales variances, which we will examine before
learning about the operating statement.
Sales variances
You may think it odd to talk about sales variances in a section about standard
costing, but their inclusion in an operating statement is essential to give
managers more information about the whole business of the firm – not just its
production costs side. The standard unit cost in this unit has been calculated on
an absorption costing basis, with elements of direct materials and labour costs,
variable and fixed overheads. First, we will calculate sales variances on an
absorption costing basis using the standard profit per unit, and a marginal
costing basis is shown later.
Example
A firm had budgeted to produce 1,000 units, but actually produced 1,100.
Suppose that the budgeted selling price was £100 with a standard cost per unit
of £70, while the actual selling price was £95.
This time we will build up the formula for the sales variances. There are two
sub-variances: sales price and sales volume profit.
Price variance = (actual selling price – budgeted selling price) × actual quantity
produced.
ga
nin ct
Calculate the selling price variance for the example above.
Lear
ivit
7w
y
eedb ac
Price variance = (actual selling price – budgeted selling price) × actual
F
7w quantity produced.
= (£95 – £100) × 1,100
= (£5) × 1,100
= (£5,500).
The sales volume profit variance uses the standard profit as follows: Sales
volume profit variance = (actual sales volume – budgeted sales volume) ×
standard profit.
Note the term sales volume ‘profit’ variance is typically used to distinguish the
fact that fixed costs are included in the profit calculations. The word ‘margin’
would be used only if variable costs were used, that is, in a marginal costing
system – see Learning Activity 7z.

The standard profit is obtained by deducting the standard unit cost from the
budgeted selling price. Do not worry about using the standard cost at this point
because if there are any cost variances they will show up in the analysis of the
cost variances that form part of the operating statement.
ga
nin ct
Using the same information as in the last activity, calculate the sales volume
Lear
ivit
7x profit variance.
y
eedb ac
Standard profit = budgeted selling price – standard cost
F
7x = £100 – £70
= £30.
Sales volume profit variance = (actual volume – budgeted volume) ×
standard profit
= (1,100 – 1,000) × £30
= £3,000.
The sales variance, combining the two sub-variances, is given by the formula:
Sales variance = [(actual selling price per unit – standard cost per unit) ×
actual sales volume] – (budgeted quantity × standard profit per unit).
ga
nin ct
Write down what you expect the sales variance to be, then check it using
Lear
ivit
7y the above formula.

y
eedb ac
The selling price variance was an adverse variance of £5,500 and the sales
F
7y volume profit variance was a favourable variance of £3,000 so you would

expect the sales variance to be an adverse variance of £2,500. The formula
is:
actual sales volume] – (budgeted quantity × standard profit per unit)
= [(£95 – £70) × 1,100] – (1,000 × £30)
= [£25 × 1,100] – £30,000
= £27,500 – £30,000
= (£2,500) as anticipated.
Sales variances in a marginal costing system

In a marginal costing system, the sales variances are calculated in a slightly
different way to those presented above. The primary difference is that instead
of profit, contribution is used. Try Learning Activity 7z.

ga
nin ct
Above, we derived a formula for a sales variances and the sales price/sales
Lear
ivit
7z volume profit margin. If profit is replaced by contribution in a marginal

y
costing system, see if you can write down the formulae you think would be
used when marginal costing is used.
eedb ac
The sales price variance will remain as before:
F
7z Price variance = (actual selling price – budgeted selling price) × actual

sales volume.
The formula for sales volume margin variance – the word margin is used to
identify that marginal costing is used – is as follows:
Sales volume margin variance = (actual volume – budgeted volume) ×
standard contribution.
Combining the above formulae, the total sales variance in a marginal
costing system – usually termed the total sales margin variance – can be
calculated as:
Sales margin variance = [(actual selling price per unit – standard variable
cost per unit) × actual quantity] – (budgeted quantity × standard
contribution per unit).
Operating statements
An operating statement simply brings together both the sales and the cost
variances in order to reconcile the budgeted profit with the actual profit. There
is no prescribed layout as there is with a set of financial accounts, but the
proforma in Learning Activity 7aa should serve to explain the idea to you.
Example
In Learning Activity 7r, you were given information about a company from
which you calculated a series of cost variances. You now have the following
additional information about sales:
■ All 1,100 units of production were sold for £130 per unit.
■ The budgeted selling price was £120 per unit.
ga
nin ct
Lear
ivit
Use the following proforma to calculate the actual profit on sales:

7aa
y
£ Comments
Budgeted profit
Sales volume profit variance
Standard margin of actual sales
Selling price variance
Actual margin

eedb ac
Your proforma should look like this:
F
k
7aa £ Comments
Budgeted profit 47,000 (£120 – £73) × 1,000
Sales volume profit variance 4,700 (1,100 – 1,000) × £47.
Standard margin of actual sales 51,700
Selling price variance 11,000 (£130 – £120) × 1,100.
Again favourable, so added.
Actual margin £62,700
The full operating statement will then extend this by summarising the
variances.
ga
nin ct
Look back to the series of activities in which you calculated the variances,
Lear
ivit
7bb and use them to complete the operating statement shown below:
y
£
Budgeted profit 47,000
Sales volume profit variance 4,700
Selling price variance 11,000
Favourable Adverse £
Material price
Material usage
Labour rate
Labour efficiency
Variable expenditure
Variable efficiency
Fixed expenditure
Fixed capacity
Fixed efficiency
Totals

eedb ac
F
£
7bb Budgeted profit 47,000
Favourable Adverse £
Material price 4,400
Material usage 5,500
Labour rate 3,300
Labour efficiency 4,400
Variable expenditure 3,500
Variable efficiency 5,500
Fixed expenditure 3,000
Fixed capacity 3,850
Fixed efficiency 6,050
Totals 20,350 19,150 1,200
7.5 Benefits and drawbacks of standard

costing
The benefits of standard costing are:
■ It establishes standards with which the actual costs of production can be
compared.
■ In order to establish and maintain a standard costing system, an organisa-
tion’s operation must be examined. This examination may reveal existing
problems that can be corrected.
■ It enables management by exception or investigation of areas where
variances occur, which ought to lead to greater efficiencies. The analysis of
the variances highlights the problem areas.
■ It should enable cost control and ease inventory valuation.
■ It presents a series of production and cost targets at which employees and
managers can aim.

ga
nin ct
What disadvantages do you think there might be with a standard costing
Lear
ivit
7cc system?
y
eedb ac
Some of the disadvantages are similar to those of budgetary control
F
7cc systems, so you may have thought of the following:

■ It may be difficult and expensive to set up and maintain. A standard
costing system certainly requires a great deal of record keeping.
■ It will need regular updating. Costs rarely remain constant for very long,
so costing periods are usually quite short. This has particular application
if the firm is basing its selling price on its costs, as it would be foolish to
base a selling price on out-of-date information.
■ The information provided in a costing system needs to be easily
understood by non-accountants, and this can often be difficult, as you
have probably realised from calculating the above variances!
7.1 Which of these four statements best describes a standard cost?
(a) The ideal cost that a firm should pay.
(b) The budgeted cost of total production.
(c) The budgeted cost of a unit of production.
(d) The amount of work that should be produced under standard
conditions.
7.2 What does the standard cost of a unit of production include?
(a) Direct materials and labour only.
(b) Direct costs and variable overheads only.
(c) Selling price less all budgeted costs.
(d) Direct costs and variable and fixed production overheads.
7.3 A firm produces 30 units a day, working 7.5 standard hours. Use this
information to explain the meaning of a standard hour.
7.4 A standard costing system has budgeted for the production of 2,000 units
per month. Each unit uses 4 metres of wood at 50p per metre and 20
screws at 20p for 10. According to the actual results, 2,100 units were
produced using 8,400 metres of wood at 52p per metre and 41,000
screws at 21p for 10. Calculate the direct materials cost variance, and
show the analysis into the usage and price variances.
7.5 The same costing system referred to in SAQ 7.4 also budgeted for 4 hours
of cutting at £4.50 per hour and 6 hours of finishing at £5 per hour, for
each unit. The actual results showed that production of the 2,100 units
required 8,800 hours cutting at £4.65 per hour and 12,100 hours of
finishing at £5.25 per hour. Calculate the direct labour cost variance, and
show the analysis into the rate and efficiency variances.

7.6 Using the same system as SAQs 7.4 and 7.5, the budgeted variable
overheads are £3 per unit, while the budgeted fixed overheads, based on
direct labour hours, are £3 per hour for cutting and £4 per hour for
finishing. The actual results showed the variable overheads to be £6,400
and the fixed overheads to be £24,700 for cutting and £50,500 for
finishing. What are the variable and fixed production overhead variances?
7.7 Calculate the fixed overhead expenditure and volume variances using the
information from SAQ 7.6.
7.8 Based on SAQs 7.3 to 7.7, assume all production is sold. The estimated
selling price was £150 per unit and the actual selling price was £160 per
unit. Calculate the sales variance and the subdivisions of this variance.
7.9 From the variances that you have calculated over SAQs 7.4 to 7.8, draw
up an operating statement to show the effect on the firm’s budgeted profit.
(You might find it helpful to work out the budgeted and the actual profit
before you begin, as a check.)
7.10 Calculate the performance ratios of the firm above, and use them to
advise the management concerning its investigations into the firm’s
problems.
7.11 Hama Ltd operates a standard costing system in their production facility.
The following data is available for the month ended 30 June:
Standard cost data:
Materials cost: 6 kg per unit at £20 per kg
Labour cost: 4 hours at £12 per hour
Overhead: All production overheads are regarded as variable
and related to direct labour. They are budgeted at
£160,000 based on expected output of 10,000 units
Selling price: A price of £200 per unit is expected
Actual data:
Sales revenue: £2,640,000
Units sold: 11,000
Material: 82,500 kg at a cost of £1,732,500
Labour: 49,500 hours at a cost of £643,500
Overhead: £220,000
Complete the following tasks:
(a) Prepare a standard cost card showing the cost and profit per unit
and the overall budgeted profit for the month of June.
(b) Calculate the actual profit for June.
(c) Prepare a statement reconciling the budget and actual profit. In
doing so, calculate relevant variances for material, labour and
overhead in as much detail as the information above permits.
7.12 Superfit Ltd is a large nationwide car servicing organisation. The company
specialises in quick-fit solutions offering rapid tyre fitting, exhaust fitting
and regular car servicing to customers at over 50 locations. The typical
service offered to customers consists of a set of standard tasks – the
company does not offer any specialised car servicing or products.

The management accountant at Superfit’s head office has prepared a

standard cost card for a typical car service as follows:
Standard cost card for car service:
Materials (oil, brake pads, £120 per service

filters, and so on)
Mechanics labour 2.5 hours at £20.00 per hour
Variable overhead 2.5 hours at £12.50 per hour
Fixed overhead 2.5 hours at £16.00 per hour
Fixed overheads are based on the assumption that 60,000 services per
annum will be undertaken. Services are performed evenly throughout the
year. The price of a car service is £290.
During the month of March, 5,000 standard car services were performed,
and 4,800 of these were at the normal price, with 200 being conducted
at a 20% discount during a Spring promotion. A summary of the actual
costs for March are given as:
Materials At standard cost and usage except:

40 sets of brake pads which were £2
more expensive
100 litres more motor oil than standard
were used at a cost of £30 per litre
Labour Labour hours worked were equal to
standard. Due to the employment of a new
apprentice mechanic, 150 hours were
worked at a lower rate of £18 per hour
Variable overhead Total cost: £148,700
Fixed overhead Total cost: £197,800
(a) Prepare the original budget for March, using the standard selling
price.
(b) For the month of March, reconcile the budget to actual results,
calculating all necessary variances. (Note: your solution must
include a calculation of actual profit.)
7.13 AB Systems assembles PCs and uses flexible budgeting and a standard
costing system. Fixed overhead is allocated based on the number of
material parts used. A performance report for June was produced as
follows:

Static budget Actual results

(10,000 PCs) (11,000 PCs)
Sales (£400 budget, £420 actual) £4,000,000 £4,620,000
Materials (parts) 100,000 107,100
Materials (cost £) £1,000,000 £1,049,580
Labour (hours) 20,000 21,250
Labour (cost £) £280,000 £310,250
Variable manufacturing overhead
(£4 per part budgeted, actual
£4.10 per part) £400,000 £439,110
Fixed manufacturing overhead (£) £450,000 £465,000
Profit £1,870,000 £2,356,060
Based on the above performance report:

(a) Determine the standard cost of one PC.
(b) Prepare a flexed budget for June based on the actual number of PCs
sold.
(c) Calculate price and efficiency (usage) variances for materials and
labour.
(d) Calculate the total variance (that is, variable plus fixed) for
manufacturing overhead.
(e) Calculate the production volume variance for total manufacturing
overhead.
7.14 A company sold 40,000 units last month when budgeted sales were 36,000
units. Using absorption costing, the sales volume profit variance was
£20,000. The fixed overhead absorption rate was £8 per unit. Work out
what the sales volume margin variance would be if the company were
using marginal costing.

7.1 The correct answer is c: the standard cost is the budgeted cost of a unit
of production.
7.2 The correct answer is d: the standard cost of a unit of production includes
direct costs, and variable and fixed production overheads.
7.3 In standard costing a standard hour is not a measure of time but of
performance, being the period during which a set amount of work is to
be completed. If the firm in question produces 30 units in a 7.5-hour day,
then its standard hour is 4 units of production.

7.4 The variances, calculated with reference to actual output of 2,100 units, are:
Direct materials cost variance = (standard usage × standard price) –
(actual usage × actual price)
= [(2,100 × 4 × £0.50) + (2,100 × 20 × £0.02)] – [(8,400 × £0.52)
+ (41,000 × £0.021)]
= [£4,200 + £840] – [£4,368 + £861]
= £5,040 – £5,229
= (£189).
Usage variance = (SQ – AQ) × SP
= [(8,400 – 8,400) × £0.50] + [ (42,000 – 41,000) × £0.02]
= 0 + £20
= £20.
Price variance = (SP – AP) × AQ
= [(£0.50 – £0.52) × 8,400] + [ (£0.02 – £0.021) × 41,000]
= (£168) + (£41)
= (£209).
You may have calculated the variances for the wood and the screws
separately, in which case you should have:
Wood Screws
Materials cost variance (£168) (£21)
Usage variance Nil £20
Price variance (£168) (£41)
7.5 The variances, again calculated with reference to actual output of 2,100
units, are:
Direct labour cost variance = (standard hours × standard rate) – (actual
= [(2,100 × 4 × £4.50) + (2,100 × 6 × £5)] – [(8,800 × £4.65)
+ (12,100 × £5.25)]
= [£37,800 + £63,000] – [£40,920 + £63,525]
= £100,800 – £104,445
= (£3,645).
Efficiency variance = (SQ – AQ) × SP
= [(8,400 – 8,800) × £4.50] + [(12,600 – 12,100) × £5]
= (£1,800) + £2,500
= £700.
Rate variance = (SP – AP) × AQ
= [(£4.50 – £4.65) × 8,800] + [(£5 – £5.25) × 12,100]
= (£1,320) + (£3,025)
= (£4,345).
Again, you may have calculated the variances for cutting and finishing
separately, in which case you should have:
Cutting Finishing
Labour variance (£3,120) (£525)
Efficiency variance (£1,800) £2,500
Rate variance (£1,320) (£3,025)

7.6 The usual calculation using an absorption rate is:

Variable production overheads variance = (standard hours for the actual
production × overhead absorption rate) – actual variable overheads.
In this question you are told that the variable overheads are simply £3
per unit so you should have:
Variable production = (actual production × overheads variance overhead
absorption rate) – actual variable overheads
= (2,100 × £3) – £6,400
= £6,300 – £6,400
= (£100).
Fixed production = (standard hours for the overheads variance actual
production × overhead absorption rate) – actual fixed overheads
= [(8,400 × £3) + (12,600 × £4)] – (£24,700 + £50,500)
= [£25,200 + £50,400] – £75,200
= £75,600 – £75,200
= £400.
7.7 The fixed production overheads variance was a favourable one of £400.
This can be subdivided into the expenditure and volume variances as
follows:
Expenditure variance = budgeted fixed overheads – actual fixed overheads
= (4 × £3 × 2,000) + (6 × £4 × 2,000) – £75,200
= £24,000 + £48,000 – £75,200
= (£3,200).
Remember that the budgeted fixed overheads are based on production of
2,000 units.
Volume variance = (standard hours for actual production × overhead
= (4 × £3 × 2,100) + (6 × £4 × 2,100) – £72,000
= £75,600 – £72,000
= £3,600.
The volume variance can be further subdivided into:
Capacity variance = (actual hours worked × overhead absorption rate) –
budgeted fixed overhead
= (8,800 × £3) + (12,100 × £4) – £72,000
= £26,400 + £48,400 – £72,000
= £2,800.
Efficiency variance = (standard hours for actual production – actual hours
worked) × overhead absorption rate
= [(8,400 – 8,800) × £3] + [(12,600 – 12,100) × £4]
= (£1,200) + £2,000
= £800.

7.8 The standard profit per unit is given as follows:
£ £
Selling price 150
4 m wood at 50p 2
20 screws at 20p for 10 0.4
4 hours at £4.50 18
6 hours at £5 30 50.4
99.6
Variable overheads 3
Fixed overheads, 4 hours at £3 12
6 hours at £4 24 39
Profit 60.6
actual quantity] – (budgeted quantity × standard profit per unit)
= [(£160 – £89.40) × 2,100 – (2,000 × £60.60)
= [£70.60 × 2,100] – £121,200
= £148,260 – £121,200
= £27,060.
This is made up of:
selling price variance = (actual selling price – budgeted selling price) ×
actual quantity
= (£160 – 150) × 2,100
= £21,000; and
sales volume profit variance = (actual quantity – budgeted quantity) ×
standard profit
= (2,100 – 2,000) × £60.60
= £6,060.

7.9 The budgeted and actual profits are as follows:
Budget Actual
£ £ £ £
Sales 2,000 at £150 300,000 2,100 at £160 336,000
Less material costs
4 m wood at 0.50p 4,000 8,400 m at 0.52p 4,368
20 screws at 20p/10 800 (4,800) 41,000 at 21p/10 861 (5,229)
Labour
4 hours at £4.50 36,000 8,800 at £4.65 40,920
6 hours at £5 60,000 (96,000) 12,100 at £5.25 63,525 (104,445)
Variable overheads (6,000) (6,400)
Fixed overheads
Cutting (24,000) (24,700)
Finishing (48,000) (50,500)
Profit £121,200 £144,726
The operating costs statement should look like this:
£
148,260
Favourable (£) Adverse (£) £

Materials wage 20
Material price 209
Labour rate 4,345
Labour efficiency 700
Variable overhead 100
Fixed expenditure 3,200
Fixed volume 3,600
4,320 7,854 3,534 A
Actual profit 144,726

7.10 You need to calculate the standard hours produced before working out
the ratios. In the budget, each unit was allowed 4 hours cutting plus 6
hours finishing so the standard hours of the actual production are: (6 +
4) × 2,100 = 21,000. The actual hours worked are: 8,800 cutting plus
12,100 finishing, a total of 20,900.
The performance ratio calculations are:
Efficiency ratio = standard hours of actual output ÷ direct hours
worked × 100
= 21,000 ÷ 20,900 × 100 = 100.48%.
Capacity ratio = actual hours worked ÷ budgeted hours of input × 100
= 20,900 ÷ 20,000 × 100 = 104.5%.
Production volume ratio = standard hours produced ÷ budgeted hours
of output × 100
= 21,000 ÷ 20,000 × 100 = 105%.
Although there is an overall adverse variance of £3,534 on costs, these
ratios demonstrate that the firm is working at average levels of efficiency
and capacity, producing more than was budgeted for in less time. There
is an adverse expenditure variance on fixed overheads that would repay
investigation although this is balanced out by a favourable volume
variance. The most pressing problem is the £4,345 adverse labour rate
variance, which suggests that the firm is using a higher grade of labour
than might be necessary for this production. The favourable labour
efficiency variance does not compensate for this.
7.11 (a) Standard cost card:
£ £
Selling price 200
Material cost (6 kg × 20) 120
Labour cost (4 × 12) 48
Overhead (4 hrs × £4) 16
Standard profit per unit 16
Budgeted profit = £16 × 10,000 units = 160,000

(b) Actual profit
£000 £000
Sales 2,640
Materials 1,732.5
Labour 643.5
Overhead 220 2,596
Actual profit 44

(c)
£ £
Variances:
Sales price (240 – 200 × 11,000) 440,000
Sales volume (11,000 – 10,000 × 16) 16,000
Material price (1732.5 – (82.5 × 20) (82,500)
Material usage (82.5 – (11,000 × 6) × £20)) (330,000)
Labour rate (643.5 – (49.5 × 12) (49,500)
Labour efficiency (49.5 – (11,000 × 4) × £12) (66,000)
Variable OH rate (220 – (49.5 × 4)) (22,000)
Variable OF efficiency (49.5hrs – 44.0hrs) × £4 (22,000) (116,000)
7.12 (a) Budget for March
£
Sales 5,000 services × £290 1,450,000
Labour 5,000 × £50 250,000
Material 5,000 × £120 600,000
Variable overhead 5,000 × £31.25 156,250
Fixed overhead 5,000 × £40 200,000
(b) Actual results calculation:
£
Sales (4,800 × 290 + 200 × 232) 1,438,400
Material ((5,000 × 120) + (40 × 2) + (100 × 30)) 603,080
Labour (250,000 – (150 × 2)) 249,700
Variable overhead 148,700
Fixed overhead 197,800

Calculation of variances and reconciliation of budgeted to actual

results:
£
Sales price variance:
20% loss on promotion (200 × 290 × 20%) 11,600 A
Material price variance (40 × £2) 80 A
Material usage variance (100 × £30) 3,000 A
Labour efficiency variance N\A as standard hours = actual hours
Labour rate variance (150 × £2) 300 F
Variable OH rate (156,250 – 148,700) 7,550 F
Fixed OH volume N/A as budget = actual
Fixed OH expenditure (200,000 – 197,800) 2,200 F
7.13 (a) Standard cost of one PC:
£
Materials (1,000,000/10,000) 100
Labour (280,000/10,000) 28
Variable OH (400,000/10,000) 40
Fixed OH (450,000/10,000) 45
Standard cost 213
(b) Flexible budget for June:
£
Sales (11,000 × £400) 4,400,000
Materials (11,000 × £100) 1,100,000
Labour (11,000 × £28) 308,000
Variable OH (11,000 × £40) 440,000
Fixed OH 450,000
Gross profit 2,102,000

(c) Workings:
Parts per unit:
100,000 parts for 10,000 units = 10 parts per unit
20,000 labour hours for 10,000 units = 2 hours per unit.
Materials variances:
A×A A×S S×S

107100 × £10/part 11,000 units × 10 parts × £10
1,049,580 1,071,000 1,100,000
(21,420) (29,000)
Favourable Favourable
Labour variances:
A×A A×S S×S

21,250 × £14 11,000 units × 2 hours × £14
310,250 297,500 308,000
12,750 (10,500)
Adverse Favourable
(d) Total overhead variance:

Actual overhead: (439,110 + 465,000) = 904,110.
Standard overhead allocated to actual production:
Variable OH (11,000 × 10 parts × £4) 440,000

Fixed OH (11,000 × 10 parts × £4.50) 495,000
935,000
30,890
Favourable
(e) Production volume variance:
Flexed budget for actual units from 890,000

part b (450,000 + 440,000)
Standard overhead allocated to 935,000
actual production (part d)
Volume variance 45,000
Favourable
7.14 The sales volume profit variance per unit can be calculated as: £20,000 ÷
(40,000 units – 36,000 units) = £5. Adding the fixed overhead per unit to
this, the contribution per unit is thus £5 + £8 = £13 per unit. Therefore,
the sales volume margin variance will be: 4,000 units × £13 = £52,000.

Summary
This unit has introduced the concepts of standard costing. You now know what
a standard cost is and how standards are determined. You also know how
standard costs of actual output can be compared to actual costs in a process
called variance analysis. You have learned several cost and usage variances
(material, labour, variable and fixed overhead) as well as some sales variances.
These variances can be summarised on an operating statement, which shows the
difference between actual and budgeted profit. This operating statement is a
useful control report for managers, who can examine the exceptional variances.
While standard costing is a relatively simple technique to adopt, one of its
major drawbacks is that standards need to be updated on a regular basis and
thus it may not be suitable for all organisations.

Unit 81 Working capital
management
‘It is only the poor who pay cash, and

that not from virtue, but because they
are refused credit.’
Anatole France, French writer (Nobel Prize for Literature, 1921)
Introduction
This unit introduces the nature of working capital, which in simple terms,
is the amount of money tied up in short-term assets (such as inventories
or receivables) and the amount owed to suppliers. In this unit you will
learn how working capital follows a cycle, and how managing the com-
ponents of this cycle affects the liquidity and profitability of a business.

8.1 Differentiate the working capital from the permanent capital of a
business.
8.2 Critically explain the effect of the cyclical flow of working capital.
8.3 Assess the balance between liquidity and profitability by analysing
the components of the working capital cycle using ratios.
Prior knowledge
It is assumed you have basic knowledge of the statements of financial position
(balance sheets) from earlier studies.
Resources
Some of the learning activities ask you to look up the financial statements of
companies on the internet, so it would be good to work through those activities
with an internet connection.

Unit 8 Working capital management
8.1 The meaning of working capital

Recommended reading: The capital of a typical company is represented by the amount invested in it.
‘Managing working capital’ in The term ‘capital’ covers not just share capital but also reserves, debentures
McLaney (2010). and long-term loans. The capital of a company can be invested (or used) in two
ways:
■ As permanent capital, employed in non-current assets such as buildings,
plants or vehicles.
working capital ■ As working capital, required because the company has to pay for goods and
services before recovering the money from customers, and represented by
the difference between current assets and current liabilities.
The assets and liabilities of a business can be seen in the statement of financial
position (or balance sheet) of a business. The statement of financial position is
a snap-shot (usually at year-end) of the assets, liabilities and capital of a
business.
ga
nin ct
Here is a simple statement of financial position:
Lear
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8a
y
£000 £000
Non-current assets 145
Current assets 840
985
Equity
Share capital 100
Reserves 235 335
Non-current liabilities 310
Current liabilities 340
985
1. Use these figures to show that:

Non-current assets + current assets = total claims (that is, liabilities +
capital).
2. How are the total claims on the business made up?
eedb ac
1. From the statement of financial position:
F
8a Non-current assets + current assets = £145 + £840 = £985.

Total liabilities = current liabilities + non-current liabilities + share capital
+ reserves = £340 + £310 + £100 + £235 = £985.
So non-current assets + current assets = total liabilities + capital.

eedb ac
2. The total claims are made up of:
F
8a ■ Current liabilities.
■ Non-current liabilities such as long-term loans and debentures.
continued ■ Owners’ equity which includes share capital and reserves.
ga
nin ct
Using the figures from the statement of financial position in learning activity
Lear
ivit
8b 8a, see if you can show how the net assets are equal to capital employed.
y
eedb ac
You should have:
F
8b Net assets = non-current assets + current assets – current liabilities = £145 +

£500 = £645.
Note that the latter two elements of the net assets equation above is
working capital (that is, current assets – current liabilities).
Capital employed = share capital + reserves + non-current liabilities = £100
+ £235 + £310 = £645.
You can now clearly see from Learning Activity 8b how the capital of a business
can be represented, either in non-current assets that enable the business to trade
and generate profit, or in the working capital equation of:
working capital = inventory + trade receivables + cash – trade payables.
Working capital represents the amount invested in assets expected to be realised

within a year. As the name suggests, it is not permanent and will be turned over
many times during the year. It is used to finance production, invest in goods for
re-sale (inventory) and provide credit for customers. It is financed by current
liabilities or long-term capital such as shares and debentures.
The essential difference between non-current assets and current assets is their
level of permanence. Non-current assets are bought for use in the business, to
enable it to trade, while current assets are less permanent. Goods are sold and
become cash, or trade receivables if sold on credit. Cash is used to pay current
liabilities (such as trade payables). This change in the nature of current assets
is constant during the day-to-day running of the business, and part of a
management accountant’s task is to ensure that this flow change happens with
consistency. This change or flow can be represented as a cycle, which we will
now explore in some detail.

8.2 The working capital cycle

Recommended reading: Before looking at the detail of the working capital cycle, let’s first consider how
‘Managing working capital’ in important cash is to a business. A business raises most of its cash from sale of
McLaney (2010). goods or provision of services. However, unless a business sells for cash, the
amount of cash held by a business is to some extent determined by how well
working capital cycle
working capital is managed. Cash is needed on a daily basis to pay business
expenses, salaries, and so on. Cash is also needed to buy goods for re-sale
and/or supplies needed to provide services. If enough cash is not available, then
a business runs into serious problems such as not being able to buy goods or
pay wages. Cash should typically follow a cycle, whereby goods bought on
credit for re-sale are held in inventory and are sold to customers on credit (and
are thus receivables), who in turn pay cash. The cash can then be used to pay
suppliers (that is, payables). When parts of the cycle get delayed, or the timing
is not correct, cash can run out fast. Thus, managing inventory, receivables and
payables is essential to ensuring a business has ample cash.
ga
nin ct
Lear
ivit
8c
y
Who supply Is sold to
Which is paid to Who pay
Figure 8.1: Working capital cycle of a business selling goods on credit.
Figure 8.1 depicts the working capital cycle of a business selling goods on
credit, but with the components omitted. Complete the diagram by writing
in the appropriate component from the following list:

ga
nin ct ■ inventories
Lear
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8c
y
■ customers (trade receivables)
continued ■ cash
■ suppliers (trade payables).
eedb ac
F
Your completed diagram should look like the one below.

k
8c
Inventory
Who supply Is sold to
Suppliers Customers
Which is paid to Who pay
Cash
Figure 8.2: Feedback on Learning Activity 8c.
In describing the working capital cycle you can start at any point. If you take
inventory as the starting point, then the cycle is as follows:
■ inventory is held by the company until sold on credit to
■ customers who after a period of time will pay (that is, they are trade
receivables)
■ cash, which will remain in the bank until used to pay
■ suppliers, who are owed money for the inventory (that is, they are trade
payables) they supplied on credit.

ga
nin ct A business has £11,000 in inventory, is owed £5,000 in trade receivables,
Lear
ivit
8d has £9,000 in the bank and owes £25,000 in trade payables. It now ceases
y
to trade, so no more inventory is bought. The working capital cycle
therefore looks like this, with no more inventory being supplied:
Inventory
£11,000
Trade Trade
Payables Receivables
£25,000 £5,000
Bank
£9,000
Figure 8.3: Working capital cycle for Learning Activity 8d.
Now, redraw the diagram after each of the following events:

The remaining inventory has been sold, on credit, at its book value of
£11,000.
Then, the remaining receivables are paid.
Finally, the suppliers are paid.

eedb ac
You should have two diagrams as follows:
F
8d Trade Trade
£25,000 £16,000
Bank
£9,000
Figure 8.4: Feedback on Learning Activity 8d.
All remaining inventory is sold, and trade receivables have risen to £16,000.
Trade
Payables
£25,000
Bank
£25,000
Figure 8.5: Feedback on Learning Activity 8d.
All receivables have been paid to the company, and there is now £25,000 in
the bank.
When this is paid to suppliers, there is no diagram to draw as the cycle has
been extinguished.
Learning Activity 8d used an ideal situation as an example. There was a

decision to cease trading, inventory was sold, debts collected and payables were
paid off. Such a situation is not typical. The effective management of working
liquidity capital depends on achieving a balance between liquidity and successful (that
is, profitable) trading. There must be enough cash in the cycle to pay wages,
suppliers and expenses, and enough inventory to enable a smooth flow of
production to satisfy the needs of customers. So, how much working capital
does a firm need?

ga
nin ct If a business had unlimited working capital, so that there was plenty of
Lear
ivit
8e inventory to meet production needs, finished goods to meet customer
y
needs and cash in the bank to pay trade payables, how would this affect
profitability? Try to think about additional costs which may be incurred.
eedb ac
F
The firm may be keeping a larger holding of inventory than necessary,

k
8e incurring extra holding costs. It would pay off the trade payables promptly,
losing potential bank interest. It may have encouraged receivables to be
cleared promptly by giving generous discounts. These will all reduce the
profitability of the firm.
A crude method of determining how much working capital a firm needs is to

look at the ratio of its annual sales to the amount of working capital, at a point
in time.
ga
nin ct
A company’s year-end statement of financial position shows the following:
Lear
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8f
y
Inventories: £60,000
Trade receivables: £50,000
Cash: £10,000
Trade payables: £40,000
The income statement shows the turnover was £400,000. How many
times did the working capital circulate round this firm during the year?
eedb ac
F
The working capital was:

8f inventories + trade receivables + cash – trade payables
= £60,000 + £50,000 + £10,000 – £40,000 = £80,000.
This circulated:
£400,000 ÷ £80,000 = 5 times during the year.
In other words, working capital represented 20% of turnover.
The company in Learning Activity 8f could say that it required working capital
equivalent to 20% of its turnover, but the problem with this method is that the
working capital situation at the year-end may not be typical of the situation
throughout the year. Also, the calculation only works if there are net current assets.
There are a number of more useful accounting ratios used to analyse set
financial statements with a view to assessing liquidity. Two common ratios are
the current and acid-test ratios. These are defined as follows:

Current ratio = current assets ÷ current liabilities

Acid-test ratio = (current assets – inventory) ÷ current liabilities.
The acid-test ratio is also called the ‘quick ratio’ or the ‘liquidity ratio’.
Both the current ratio and acid-test ratio are used to help assess whether the
short-term assets of a business cover its short-term liabilities. The acid-test ratio
is a more strenuous test as it excludes inventory, which may take some time to
convert to cash.
Example
Look again at the figures in Learning Activity 8f.
1. What was the current ratio?
2. What did this ratio mean?
3. How would your answers have differed if the firm had owed trade payables
of £130,000?
Answer to example
1. In this case the current assets are:
Inventory + receivables + cash = £60,000 + £50,000 + £10,000 = £120,000.
The current liabilities are £40,000, so the current ratio is £120,000 :
£40,000 = 3 : 1.
2. A current ratio of 1:1 or above indicates that in the event of a company
ceasing to trade, it can repay its current liabilities out of its current assets.
You saw how this happens in Learning Activity 8e.
3. If the company had owed £130,000 its current ratio would have been
£120,000 : £130,000 = 0.92 : 1. This is, of course, less than 1:1. A current
ratio of less than 1:1 indicates that in the event of cessation a company may
not be able to pay all its creditors from its current assets, especially if it
cannot sell its inventory or collect all trade receivables. In the above case,
the company may have realised in excess of £120,000 (if it were able to sell
inventory at a profit and collect all its receivables) but unless it received at
least £130,000 it would be unable to pay its trade payables in full.
The current ratio and the acid-test ratio give some indication of whether
there is sufficient working capital in a company. The latter may be a more
accurate measure, as by excluding inventory (the least liquid asset), a better
view of liquidity is given. A typical yardstick for the current ratio is 2 : 1,
allowing for up to half the current assets to be held as inventory and not
turned quickly into cash, leaving a yardstick acid-test ratio of 1 : 1.
However, many companies operate profitably with a ratio below this,
especially those where inventory can be turned into cash before trade
payables need to be paid.
ga
nin ct
Go to the websites of companies like Tesco, Sainsbury’s or Morrisons (or any
Lear
ivit
8g other large retailer). Find their most recent annual accounts, go to the
y
statement of financial position (balance sheet) and calculate both the

current and acid-test ratio. See if you can explain why these ratios are less
than the yardsticks mentioned above.

eedb ac
Your answer will depend on which website you visited. Here are some
F
k
8g figures based on Tesco’s figures (in £m) for 2010 (see
http://www.tescoplc.com/plc/ir/).
Current ratio = 11,392 ÷ 16,015 = 0.71.
Acid-test ratio = (11,392 – 2,729) ÷ 16,015 = 0.54.
The major factor in lower than yardstick figures in businesses like Tesco can
be explained by how the business operates. For example, inventories are
sold quickly, kept as low as possible and may not be paid for 30 or 60 days.
Also, a large retailer like Tesco is likely to have relatively low receivables.
However, trade payables are likely to be similar to any other business. This
combination of business factors produces relatively low ratios as seen above.
Thus, the yardsticks might not be applicable to all businesses.
The ideal situation depicted earlier in Learning Activities 8c and 8d rarely
happens in reality; that is, elements of the working capital cycle may not be
in sequence.
ga
nin ct
Look at the figures from Learning Activity 8f shown as a working capital
Lear
ivit
8h cycle diagram:
y
Inventory
£60,000
Trade Trade
£40,000 £50,000
Bank
£10,000
Figure 8.6: Figures from Learning Activity 8f shown as a working capital cycle
diagram.

ga
nin ct
Suppose that trade receivables are allowed 40 days to pay their debts, while
Lear
ivit
8h trade payables must be paid after 30 days. Redraw the cycle, as it would
y
look on day 30, assuming there are no movements in inventory. The

continued business is currently not permitted to overdraw its bank account. What
problems arise?
eedb ac
Your diagram should look like this:
F
8h
Inventory
£60,000
Trade Trade
£30,000 £50,000
Bank
£0
Figure 8.7: Feedback on Learning Activity 8h.

You can see that there is a problem. The amount of working capital has not
changed, but its nature has. We now have:
Inventories + trade receivables – trade payables = £60,000 + £50,000 –
£30,000 = £80,000.
The problem is that there is no cash with which to pay the remaining
£30,000 trade payables who want their money immediately. The receivables
will not be paid for another 10 days.
A number of questions arise from this situation:
■ Can the payables wait?
■ Will interest be charged on late payment?
■ In such a situation how do you choose which payables to pay?
■ Will the trade receivables be paid on time?

The management of the cycle is further complicated if the time taken for
inventory to turn around is introduced. In the simple example in Learning
Activity 8h, the cycle lasted 10 days, that is:
Receivables payment period – payables payment period = 40 – 30 = 10 days.
The true length of the working capital cycle is given by the following:
Working capital cycle = period goods held in inventory + trade receivables
payment period – trade payables payment period.
If the company is a manufacturer then the term ‘goods held in inventory’ will
expand to include the length of time raw materials are held, the production
time and the length of time finished goods are held before sale. The problem of
timing is one of balancing the ideal situation against reality:
Ideally… But…
Low amounts of inventories This is not always practicable

should be held
Trade receivables will pay on time They may delay payment
There is enough cash to clear There isn’t, and the company

trade payables requires an overdraft
Payables can cleared late Interest may be charged on late

payment
The basic problem within working capital management is, therefore, ensuring
that there is enough cash available to clear payables out of current assets
(liquidity) without having an adverse effect on profitability.
Look at the working capital cycle again: Inventory, bought on credit, is held by
the company until sold on credit to trade receivables, who after a period of
time will pay cash, which will remain in the bank until used to pay trade
payables, who are owed money for the inventory they supplied.
There are costs and income involved in this cycle apart from the value of the
components themselves.
ga
nin ct Complete the table overleaf to show an example of income or expenditure
Lear
ivit
8i potentially involved at each stage of the cycle which would affect

y
profitability. The first one has been done for you.

ga
nin ct
Lear
ivit
Component Potential effect on profitability

8i
y
Inventories Costs of storage and deterioration of

continued
inventories, but sales may be lost if there
are insufficient inventories.
Trade receivables
Cash
Trade payables
eedb ac
F
Component Potential effect on profitability

8i
Inventories Costs of storage and deterioration of
inventories, but sales may be lost if there
are insufficient inventories.
Trade receivables If trade receivables are collected late,

potential bank interest on the sums owed is
lost, but interest on the debts can be
charged.
Cash Interest paid to bank if the account

becomes overdrawn, but if receivables pay
promptly, bank interest can be earned.
Trade payables Interest may be charged on trade payables,

but there may be discounts for prompt
payment.
Thus, there is a dilemma at each stage of the working capital cycle:

■ If the company invests in inventory it will incur storage costs, but if it
doesn’t it may lose business through being unable to satisfy customers.
■ If customers are allowed generous credit terms, there is more chance of
further business but the company has to wait for its money.
■ Cash at the bank can earn interest if the account is not overdrawn, but the
sums may not be significant.
■ If the company pays suppliers promptly its cash resources are reduced but
it ensures continuation of supply. If it lags behind in its payments to trade
payables, cash is retained but the company’s reputation may be harmed,
discounts lost and interest incurred.
The current ratio and its more stringent form, the acid-test ratio, measure
whether there is enough cash to clear payables at one point in time, but working
capital management is an ongoing concept. We will now look at each of the
components of working capital in turn, and at these dilemmas in more detail.

8.3 The working capital components

Recommended reading: In the case of each component of the working capital cycle there is a ratio that
‘Managing working capital’ in can be used as a starting point to assess how effectively it is being managed. You
McLaney (2010). may know these from your previous studies, but it is useful to revisit.
Inventory
Inventory refers to goods available for re-sale in a business. These goods may
have been bought from a supplier, or in the case of a manufacturing concern,
made through the manufacturing process. Regardless of business type, goods
available for re-sale are referred to as finished goods inventory. In the
manufacturing concern, there are two other types of inventory. Raw materials
inventory refers to components, parts or some other material bought from
suppliers. The raw materials need to be assembled or processed to become
finished goods. At any point in time, some products may be part assembled/
processed, and these are referred to as work-in-progress inventory. Thus, the
management of inventory in a manufacturing concern is more complex than a
re-seller type business as each of the three components needs consideration.
Part of the assessment of working capital efficiency is a consideration of its

inventory turnover ratio, which is:
Inventory turnover ratio = cost of goods sold ÷ average inventory.
You could use the closing inventory figure, if you did not have enough data to
calculate an average. This ratio is used primarily to measure the efficiency with
which finished goods inventory is managed. Work-in-progress inventory turn-
over could also be assessed using this formula, with the inventory value being
the work-in-progress inventory value. Work-in-progress is valued to include
material, labour and a portion of overhead costs. This value is comparable to
cost of goods sold, implying the formula is still useful.
To measure the efficiency with which raw materials inventory is managed, the
inventory turnover ratio would be amended as follows:
Inventory turnover ratio (raw materials) = Material purchases ÷ average raw
materials inventory.
Cost of goods sold could not be used when assessing the turnover of raw
materials inventory as the former includes labour and overhead costs, thus
making the figures non-comparable.
Example
During the year, a clothing manufacturer sold goods costing £80,000. The
opening inventory was £18,000 and the closing inventory was £22,000.
1. What is the inventory turnover ratio?
2. How many weeks worth of inventory does the company hold at any one
time?
3. Why is the figure for cost of goods sold used in the calculation and not the
sales value?

Answer to example
1. The ratio is:
Inventory turnover ratio = cost of goods sold ÷ average inventory
= £80,000 ÷ £20,000 = 4 times.
The average inventory is the average of the opening and closing inventory
figures.
2. The ratio indicates that in January the company turned its inventories over
four times, so at any one point it held one week’s worth of inventories
(assuming four weeks in a month).
3. The sales figure contains the profit element on trading, so its use would be
inconsistent with the cost values used for the inventories.
Alternatively, the ratio can be expressed in terms of the average age of the
inventories, which is typically termed ‘average days inventory held’:
average days inventory = average or closing inventory ÷ cost of goods sold
× 365.
In the above example the cost of goods sold is £80,000, so the average days
inventory is (£20,000 ÷ £80,000) × 365 = 92.15 days.
This simple ratio provides a lot of food for thought. The company in the
example was making clothes, so a turnover of four times a year might be
reasonable, but you would expect the inventory turnover ratio to be higher,
that is, a faster turnover of inventory, in a firm involved in, say, food
retailing. Successful inventory management consists of keeping a balance
between the holding of enough inventory to avoid risks of running short
and the costs of holding that same inventory.
ga
nin ct In Learning Activity 8g, you were asked to calculate some ratios for a large
Lear
ivit
8j retailer. Go back to their financial statements and calculate the inventory

y
turnover. Also, compare your findings to the inventory ratio of Siemens,

whose accounts you can find here:
http://www.siemens.com/investor/en/financials/annual_reports.htm
eedb ac
Your answer will depend on which website you visited. Again, Tesco’s
F
8j figures for 2010 (in £m) are used here as an example (see
http://www.tescoplc.com/plc/ir/).
Inventory turnover ratio = cost of goods sold ÷ average inventory = 52,303
÷ 2,729 = 19.1 times.
This means that Tesco has a relatively high inventory turnover, which is what
you might expect of such a retailer.
In comparison, the figures (in €m) for Siemens, using their 2009 accounts are:
Inventory turnover ratio = cost of goods sold ÷ average inventory = 55,941
÷ 14,129 = 3.95 times.
While Siemens do make some consumer electronic products, their main
business is in industrial control systems and components, which you would
expect to sell less frequently.

ga
nin ct
Think about the balance between risk and cost of holding inventory and
Lear
ivit
8k write down at least three reasons why:
y 1. Inventories, whether raw materials or finished goods, should be held.
2. Inventories should not be held.
Relate your answers to the two earlier companies, Tesco and Siemens.
eedb ac
1. Some reasons for holding inventory, several of which are risk avoidance
F
8k strategies, are:
■ To ensure a smooth production process.
■ Lead times may be long.
■ To avoid inventory-outs, that is, having no inventory left!
■ Holding enough finished goods to satisfy customer orders.
■ It may be cheaper to buy raw materials in bulk, especially to beat a price
increase.
■ Tesco might like to hold inventory as customers may shop elsewhere if
products are not available. On the other hand, many of the products
Siemens make are likely to be specialised and expensive, and thus they
would try to avoid holding such items.
2. However, the costs involved in holding large amounts of inventory
include:
■ Tying up part of the working capital and possibly causing cash-flow
problems.
■ Storage costs.
■ Insurance.
■ Risk of obsolescence or deterioration.
■ Order and delivery costs.
■ Risk of theft from warehouses.
This means that both the time at which inventory is ordered, and the
amount ordered, are crucial to the management of working capital. Tesco,
for example, would hold as little inventory as possible, and most of this is in
their stores. In the case of Siemens, the sheer cost of materials in some of
their products (for example, public transport systems) would be quite
prohibitive.

ga
nin ct If you consider the benefits of holding inventory against the costs, you may
Lear
ivit
8l decide that the best time to order inventory is at one of the points shown
y
below. Think about what the dangers are, if any, of each course of action.
Order point Dangers
When inventory runs

out
When you can obtain a

discount
When storage becomes

available
When inventory levels

look low
In order to top up to a
required level
When remaining
inventory is sufficient
to cover production
until a new delivery is
made
eedb ac
F
You would have to consider several factors such as the nature of the firm
8l and the ease of obtaining supplies, but possible problems are:
Order point Dangers
When inventory runs This may disrupt production, and would be a disaster if
out further supplies could not be obtained easily.
When you can obtain a This would mean that orders were placed reactively and
discount indiscriminately. The firm could end up with too many
inventories in one period and no inventories at all in
another.
When storage becomes This is also a purely reactive response.

available

F eedb ac
k
Order point Dangers
8l
When inventory levels A subjective opinion of the state of a firm’s inventories
continued look low may be an incorrect one. The low inventory level may be
adequate for production needs. Inventory records are
more reliable.
In order to top up to a Traditionally, inventory levels can be set for

required level manufacturing industries, but there are cost implications
for holding the unused quantities.
When remaining Here, you are covering the anticipated production level
inventory is sufficient and building in the time factor. Although these
to cover production estimates may prove to be incorrect, this is probably the
until a new delivery is best method, but it is complicated by factors such as
made minimum order quantities required to obtain discounts.
Achieving a balance between holding inventory and the cost of holding it is

essential to good inventory management. With modern management techniques
it is possible to carry very little inventory if a ‘just-in-time’ approach is used.
This approach means inventory is delivered by suppliers just when it is needed
to manufacture products or when it is to be sold to customers. Another option
is to track inventory in detail. For example, retailers like Tesco use Electronic
Point of Sale (EPOS) systems to control inventory. If neither of these options
applies, and a company does have to store inventory of raw materials, work-
in-progress or finished goods, then concepts of buffer inventory and economic
order quantities must be considered, which are not covered in detail in this
learning pack.
The underlying principles of inventory management in working capital terms

is to balance two factors:
■ The need for continued production and customer satisfaction, both of which
require inventory to be carried.
■ The costs of tying up working capital.
Or in other words, increased profitability in terms of production and selling

has to be balanced against the expenses involved.
There are some techniques and management concepts which help in the efficient
management of inventory. Three of these, namely the economic order quantity
(EOQ), material requirements planning (MRP) and the just-in-time (JIT)
philosophy, are now described.
Economic order quantity (EOQ)

Two costs associated with inventory levels are the cost of ordering and the cost
of holding inventory. Frequent orders with the objective of reducing the cost of
holding inventory (for example, tying up cash) will increase administrative costs
and other costs like delivery costs. Holding too much inventory increases the
amount of cash tied up and other costs like storage, insurance, and so on.

The EOQ model attempts to provide the order quantity for inventory which
keeps the costs of ordering and holding to a minimum. The EOQ is defined as
follows:
2OD
√ H
O = the cost of placing one material order.
D = annual demand/usage for materials.
H = annual cost of holding one unit of material.
The EOQ model assumes all costs are easily calculated, which may not be so.
It also assumes that annual demand is constant, which is also unlikely to hold.
Perhaps, most importantly, it ignores the delivery lead-time on materials which
can vary dramatically.
Materials requirements planning (MRP)

The concepts underpinning MRP were formalised by Oliver Wight and Joseph
Recommended reading: ‘Has MRP
run its course? A review of Orlicky (Wight, 1984). Orlicky and Wight’s work focused on developing a
contemporary developments in method for the procurement of raw materials needed in the manufacturing
planning systems’ in Kumar and process. The primary basis for such a system is a sales forecast, which triggers
Meade (2002). the flow of materials through the manufacturing process, so that manufacturing
capacity does not suffer any shortage of materials.
A key component of MRP is the bill of materials. This contains all material
components of a product, which combined with sales forecasts, provides useful
plans for the acquisition of materials and components.
During the ‘baby boom’ era of the 1960s and 1970s, demand for consumer
products was at a peak. Manufacturing, particularly in post-war USA, was at
full capacity and global competition was not a prominent feature of the
business environment. A captive audience with increasing demand existed and
when demand exceeded supply, lead times were extended. In this environment,
MRP was a useful tool. In today’s manufacturing environment, with immediate
deliveries and increasingly complex products, MRP in its basic form has
become somewhat obsolete. It concepts are, however, embedded within most
enterprise resource planning systems.
Just-in-time (JIT)
Recommended reading: ‘Strategic JIT stems from Japanese management philosophy. Its objective is to provide
cost management’ in Drury required items, in the right quantity and quality, just when customers want
(2009). them. As a broader management philosophy, JIT endeavours to achieve a
number of goals:
■ Zero, or near-zero, inventory.
■ Zero defects.
■ No machine or process breakdowns.
■ Elimination of non-value-adding processes.
■ 100% on-time delivery.
In reality, these goals may not be achieved precisely. However, JIT concepts can
be applied to reduce inventory levels as much as possible. To achieve reduced
inventory goals, frequent deliveries and close supplier relationships are

necessary. Arguably, the increased cost of more deliveries is balanced by lower

holding costs. Additionally, closer supplier relationships increases quality, which
in turn reduces defects and increases production efficiency.
Trade receivables
In the modern-day business environment, few non-retail sectors have sales of
any volume in cash. Supermarkets, small high-street retailers and service
providers such as greengrocers and hairdressers may still have a sizeable portion
of sales paid in cash or by debit/credit cards. For the majority of the commercial
and industrial sectors, where sales are still made on credit, the management of
monies owed by customers (that is, trade receivables) will form part of the
management of working capital.
Trade receivables, unlike inventory, are not excluded from the acid-test ratio,
as they are traditionally perceived as more easily and quickly convertible to
cash. However, any business selling goods on credit will need to encourage
customers to pay promptly in order to keep the working capital cycle flowing.
The debt collection period ratio gives an idea of how well the credit control of
the company is being managed.
The debt collection period in days is given by the formula:

Debt collection period (in days) = (average trade receivables ÷ total credit
sales) × 365.
The debt collection period can of course be expressed in months by using a

multiplier of 12 instead of 365 in the formula above.
ga
nin ct
In Learning Activity 8j, we used some data from the accounts of Siemens,
Lear
ivit
8m which you can find here

y
http://www.siemens.com/investor/en/financials/annual_reports.htm
Go to the Siemens website and, from their accounts, determine the debt
collection period. For this activity, you can use the year-end receivables
figure rather than the average. Take the total receivables figure from the
statement of financial position and the total revenue figure from the income
statement. Do you think the collection period is reflective of the type of
business Siemens is in?
eedb ac
Using the figures (in €m) from Siemens 2009 accounts, the debt collection
F
8m period is as follows:
Debt collection period (in days) = (average trade receivables ÷ total credit
sales) × 365 = (14,129 ÷ 76,651) × 365 = 67 days.
This seems to be an acceptable collection period, representing
approximately 9.5 weeks, and would seem to be efficient for a business that
deals mainly with large industrial and public sector customers.
There are two broad aspects to the management of trade receivables: granting
the credit and collecting the debts.
Granting credit
ga
nin ct Imagine that you are in charge of the accounts department of a
Lear
ivit
8n manufacturer of sports goods. A company called SportTops & Co Ltd

y
contacts you saying that they are about to open a sports goods shop in
London and they wish to buy inventory from you on credit. What would you
want to know about SportTops & Co Ltd before you made any decision?
How might you find out this information?
eedb ac
F
You need to know whether the company will be able to pay its debts, so
k
8n you would want to know:

■ How long the company had been established.
■ Whether it was a profitable company.
■ How much it already owed to trade payables, including its bank.
■ Whether it paid its other trade payables promptly.
The information can be obtained by asking SportTops & Co Ltd for trade
and bank references, and by using the services of a credit agency to carry
out a check. If the company was an established one then past accounts
would be filed at the Registrar of Companies.
The period of credit may be a matter of form in the particular industry, to

prevent competitors gaining advantage, but 30 days would be typical for many
industries. A further point is the amount of credit to be given in money terms.
This is called the credit limit, for example £5,000. It is normal to start with a
lower credit limit, which can be increased as the customer’s payment history
unfolds.
When considering granting credit to a customer, a business should consider the

five ‘c’s of credit:
■ character (integrity of the customer)
■ capacity (sufficient cash flow to service the debt)
■ capital (for example, net assets)
■ collateral (assets to secure the debt)
■ conditions (of the borrower and the overall economy).
Collecting the debts

Debt collection can be managed by strategies designed to persuade customers
to pay promptly or early. Disputes on quality of goods and other similar matters
should also be resolved promptly to ensure payment is not delayed. Most
businesses will send statements and reminders to customers by post or email.
It would also be normal practice to telephone customers as a matter of course
to request payment when due. Credit is usually granted to customers from the
date of invoice, for example, 30 days, 60 days, and so on. Typically, accounting
software produces an ‘aged receivables’ report or ‘days past due’ report. The
former shows how old customer debts are, allowing staff to concentrate on

older debts first. A ‘days past due’ report would similarly provide a snapshot
of customer debts which are unpaid and beyond agreed credit terms. This is
particularly useful when the period of credit given to customers can vary. If the
period of credit given is standardised for all customers, the ‘aged receivables’
report is a sufficient aid to credit control staff.
If payment is not forthcoming from a customer, then a business may seek the
return of goods (if this is feasible) or pursue legal action to recover the amounts
factoring owing. Factoring debts, passing on their collection to a factoring company who
make a charge but provide instant funds with the trade receivables as security,
can be seen as a way of ensuring a flow of cash into the business. However,
this is a very expensive option and is normally a sign of poor cash flow in a
business.
ga
nin ct How might a business you are familiar with persuade customers to pay
Lear
ivit
8o more promptly?
y
eedb ac
Your answer will be dependent on the business you chose. The debt
F
8o collection period might be improved by offering discounts for prompt

payment. However, the offer of discounts brings us back to the problem of
balance that we saw when managing inventories. Additionally, further
customer orders might not be processed until previous amounts owing are
cleared. The effectiveness of offering a discount will depend on the nature
of the market of the business you chose. For example, will competitors be
willing to extend credit, causing customers to shift to them?
ga
nin ct
If you have just started a business, what is the effect of offering discounts
Lear
ivit
8p for early payment? How would you decide whether it was economic to
y
offer cash discounts?
eedb ac
Cash discounts are an expense of the business, to be charged to the income
F
8p statement, and therefore they will reduce profitability. The effect of cash
discounts on profits could be compared with the cost of financing the bank
overdraft facilities that could well be the alternative. Regardless of whether
discounts are offered, every company must come to terms with the fact
some trade receivables are going to take some time to collect and some
may never be paid. They may dispute the debt or they may have gone out
of business. An effective credit control system will help this aspect of
customer debt management with a system of regular reminders and a clear
strategy for action when it becomes apparent that a debt looks doubtful.

ga
nin ct Assume your business has two customers whose accounts are long overdue.
Lear
ivit
8q In the case of A, the terms of the original sale contract are in dispute. In the
y
case of B, you are aware that they cannot pay the debt. What options
would you consider in these cases regarding the debt?
eedb ac
F
In the case of A, you might consult with your company’s solicitors as to

8q whether legal action could be taken. This would, of course, involve further
expense and you would have to balance this carefully against the likelihood
of recovering the debt. In the case of B, you have the option of writing the
debt off as an expense (to the income statement) or taking legal action to
wind the debtor company up in court. In either case, profitability would be
affected and in the case of a winding-up you would have to consider
whether any of the debt would be recoverable.
The management of trade receivables presents a business with the same tension
as the management of inventory. There is the ongoing dilemma of management
wishing to increase sales, and thus profitability, by offering better credit terms
than competitors, but at the potential cost of the effect on cash flow. A good
credit control policy in granting credit and collecting outstanding debts will
help ensure that extending credit to customers will result in higher sales and
profits.
Cash
A business needs to hold some cash as part of its working capital, and as you
have seen in earlier examples, its sudden absence may cause problems. Cash is
needed to pay trade payables, and some expenses that must be met immediately,
such as wages. It may also be needed as a safety measure, to guard against
potential problems in the event of bad debts or an uncertain economic climate.
In finance, the reasons for holding cash are threefold:
■ Transaction motive: holding cash to pay debts and expenses.
■ Precautionary motive: holding cash for a ‘rainy day’.
■ Speculative motive: holding cash for deposit or investment purposes.
But how much cash should a business hold?
ga
nin ct Thinking of a business you know, what might determine the amount of
Lear
ivit
8r cash it holds? Think of the problem of profitability versus costs.

y
eedb ac
F
Some points to consider are as follows:

8r ■ There may be an opportunity cost of holding cash in a bank account,
compared with the investment opportunities elsewhere.
■ The speed with which the other current assets can be turned into cash is
a factor. Reference has been made to the food-retailing sector, for

eedb ac
example, Tesco, where inventory is turned over very rapidly. A business
F
k
8r of this nature will need to hold less cash than a manufacturing
enterprise.
continued ■ There are costs in not being able to meet supplier demands for
payments, in terms of interest that may be charged and of loss of
reputation resulting in cessation of supply.
■ The state of the economy is a factor, and whether there is a period of
recession or inflation.
■ The interest rates charged by banks are relevant in the event of the firm
having to borrow funds. You have already encountered one technique
for managing cash in Unit 5: a budget showing cash flows. A monthly
analysis of all cash inflows and outflows, showing the state of the bank
account at the month end, is a vital source of information.
There is no accounting ratio directly concerned with the period that cash is
held, but remember the working capital cycle from earlier:
Period goods held in inventory + trade receivables payment period – trade
payables payment period.
cash conversion cycle In effect, this is also the period of the cash flow, which is often called the cash
conversion cycle. The shorter the cash conversion cycle, the less working capital
finance needed, that is, longer credit from suppliers and/or bank overdraft.
Figure 8.8 depicts the cash conversion cycle for a typical manufacturing
business.
Inventory-conversion cycle
Raw material Work-in-progress Finished goods Customer-

inventory period period inventory period conversion period
Credit period
granted by Cash-conversion cycle
suppliers
Input purchased
Supplier paid
Production starts
Output sold
Production complete
Customer pays
Figure 8.8: Cash conversion cycle for a typical manufacturing business.

Source: Arnold (2009).

The cash conversion cycle shown in Figure 8.8 depicts typical day-to-day cash
flow associated with the components of working capital. Of course, other cash
outflows occur too, like payment of wages, rent and taxes. Thus, when cash is
received from customers, payment of these expenses occurs too.
A business will ideally have a cash surplus. While the management of a cash
surplus may not present much of a problem since the funds could be invested
in the short term, a cash deficit may be difficult to manage. Thus, it is important
for a business to budget/forecast its cash requirements and try to eliminate any
deficits in advance – perhaps by arranging extended credit from suppliers or
collecting cash faster from customers.
Cash generated from operations (that is, sales) is of course not the only source
of cash. As mentioned earlier, cash can be held for a speculative motive.
However, when a business wishes to invest in new equipment, premises or in
another business, it may not have sufficient cash. It then has to raise cash from
its owners, investors or borrow funds from banks. This cash, once invested
well, should generate enough profit to pay any borrowing costs (for example,
interest or dividends), repay the debt if borrowed, and still have a surplus. This
cash, in turn, may be used for re-investment in working capital, in further
capital items, or held as a surplus. Thus, there is also a possible cash cycle with
permanent capital, whereby cash is invested and then re-paid to lenders with
interest from profits.
ga
nin ct
In the global recession from 2007 to 2010, you may have heard of/read
Lear
ivit
8s about many businesses facing cash problems. Thinking of one of these,

y
what advice would you give them to resolve a short-term cash deficit? Try to
write down at least three possibilities.
eedb ac
You may have thought of some of the following:
F
8s ■ An extension of overdraft facilities at the bank.

■ Reduction in inventory levels.
■ Delaying expenditure on capital items.
■ Applying to trade payables for extended credit terms.
■ Reducing the periods of credit given to trade receivables.
■ Reducing selling prices to attract customers.
The last one of these is a dangerous strategy since it will affect profitability
and may send out the wrong signals to customers and competitors.

Trade payables
The management of trade payables can be understood by thinking about the
management of trade receivables the other way round. If a supplier offers no
discount for prompt payment then it makes sense to wait until the full credit
period is up before making the payment. But if a discount is offered, consider
whether it is worth taking. Many businesses do, however, regard trade credit
as a source of finance in the short term without considering the real costs.
The trade payables payment period is similar to what we have already covered
for receivables. It is:
Average trade payables ÷ total credit purchases × 365.
You need to be careful in any calculations to exclude cash purchases. Also, the
figure for credit purchases is normally not available in published financial
statements, so the costs of sales figure is often used as a substitute.
ga
nin ct Go back to the accounts of the retailer used in the earlier learning activities
Lear
ivit
8t (Tesco is used here) and Siemens. Work out the trade payables payment
y
period for each. In both cases use the figures from the income statement
and statement of financial position – you may use cost of sales as a
substitute for credit purchases. Why do you think they are similar/different?
Also, for Siemens relate the answer to the debt collection period and
inventory turnover ratio calculated earlier in Learning Activities 8j and 8m
and work out the cash conversion period (Hint: convert the inventory
turnover to days). How do you think the cash conversion period affects the
amount of cash held?
eedb ac
F
Tesco (2010 accounts, €m):

8t average trade payables ÷ total credit purchases × 365
= 9,442 ÷ 52,303 × 365 = 66 days.
Siemens (2009 accounts, €m):
average trade payables ÷ total credit purchases × 365
= 7,593 ÷ 55,941 × 365 = 49 days.
Looking at the figures above, the first point is that we cannot be certain
they are fully reflective of the payables period as we have used some
substitute figures. While cognisant of this, the figures seem to indicate what
we might perceive of the businesses. Taking Tesco first, the retail sector is
known for extended credit from suppliers, which seems to be reflected in
the 66 days payment period. On the other hand Siemens would seem to be
less so, and more reflective of industry in general.
For Siemens, from Learning Activity 8m, we know the debt collection period
is 67 days, and from Learning Activity 8j, we can work out the average days
inventory is held:
365 days ÷ 3.95 times = 92 days.
Using these figures, the cash conversion period is:
92 days + 67 days – 49 days = 110 days.

eedb ac
This might suggest that Siemens would need to hold a relatively large
F
8t amount of cash, as it could be argued they need to be able to pay all

expenses for 110 days. Their 2009 accounts show a cash balance in excess
continued of €10 billon, which should be ample to cover the transaction motives for
holding cash.
The first three SAQs are based on the statement of financial position (balance
sheet) shown below. All the figures are in thousands:
£000 £000
Non-current assets 350
Current assets
Inventories 135
Trade receivables 170 305
655
Equity
Share capital 150
Reserves 110 260
Non-current liabilities 110
Current liabilities
Trade payables 155
Bank overdraft 130 285
655
8.1 Work out the amount of:

(a) permanent capital
(b) working capital
(c) current ratio
(d) acid-test ratio.
8.2 Assume the statement of financial position (balance sheet) is that of a
small hardware wholesaler. Comment on the liquidity.
8.3 Using the following information, calculate the length of the working
capital cycle:
■ Opening inventory for the year was £145,000.
■ Sales of £450,000 were all on credit.
■ Cost of sales was £303,000.
■ Purchases were £293,000 (£3,000 for cash).
8.4 What effect will the following have on the need for working capital?
(a) Taking credit from suppliers.
(b) Expanding sales.

8.5 How might a firm reduce the risk of bad debts?

8.6 What is the annual cost of foregoing a discount of 2% for cash in favour
of an extra 35 days credit?
8.7 Seele plc is experiencing tightening cash flows and has asked you to
investigate some possible ways of increasing cash flows to the business
through good working capital management. The sales manager has
suggested a discount is offered if customers pay in 10 days. It is envisaged
that 50% of credit customers would avail of the discount. The current
average collection period is 45 days. Sales total £1,500,000 of which 60%
are on credit. It is estimated that administrative costs of £4,500 would be
saved and that sales levels would remain constant. The current cost of
short-term finance (that is, a bank overdraft) is 10%. Based on this data,
calculate the total cost of savings of the policy.
8.8 Explain the costs and risks associated with granting credit. Explain factors
to be considered when deciding whether to grant credit to customers.
8.9 Alverno Ltd produces 4,000 units of product 56T each month. Each unit
of product 56T requires an input of 2 kg of Material X, which the
company purchases from suppliers at a cost of £20 per kg. The estimated
cost of holding 1 kg of Material X in stock for one year is £2. The cost
of ordering one unit of Material X is £1.20.
■ Calculate the EOQ for Material X.
■ Explain why the EOQ may be considered the optimum order size.
■ Outline the assumptions implicit in the EOQ formula.

8.1 (a) The permanent capital is that invested in non-current assets, that is
£350,000.
(b) The working capital is current assets less current liabilities, which is
£20,000.
(c) The current ratio is current assets : current liabilities, or 305 : 285
( approx. 1.07 : 1).
(d) The acid-test ratio is current assets less inventory : current liabilities
or 170 : 285 (approx. 0.6 : 1).
8.2 While the current ratio may be acceptable at just over 1 : 1, the acid-test
ratio is rather low at 0.6 : 1, which, given that the company is not
involved in a sector where inventory is turned into cash rapidly, is a source
of concern. The overdraft is also high in relation to the trade payables,
which is a further indication of problems.
8.3 The working capital cycle is:
Period goods held in inventories + debt collection period – payables
payment period.
Period goods held in inventories = average inventory ÷ cost of sales × 365
= 140 ÷ 303 × 365
= 169 days.
Debt collection period = trade receivables ÷ credit sales × 365
= 170 ÷ 450 × 365 = 138 days.

Payables payment period = trade payables ÷ credit purchases × 365

= 155 ÷ 290 × 365 = 195 days.
So the working capital cycle is 169 + 138 – 195 = 112 days.
8.4 (a) Taking credit from suppliers will reduce the need for working
capital because this is, effectively, borrowing in the short term from
trade payables in order to finance working capital.
(b) A company wanting to expand its sales will have to increase its
investment in working capital, because selling is more likely to
require a higher level of inventory to meet increased customer
requirements. It will also result in higher trade receivables.
8.5 The risk of bad debts may be reduced by any of the following:
■ Factoring debts.
■ Obtaining credit references before granting credit.
■ Setting sensible credit limits.
■ Offering discounts.
■ Sending regular statements and reminders with clear terms, invoicing
promptly, using aged trade receivables lists to monitor debts.

■ Penalties: interest on the debt, refusing supply.
■ Threat of legal action.
8.6 The annual cost would be:

365 ÷ 35 × 2% = 20.86%.
8.7 Current receivables: 1,500,000 × 60 % × (45 ÷ 365) =110,958.
Proposed level:
Not taking discount: 1,500,000 × 60% × 50% × (45 ÷ 365) = 55,479.
Taking discount: 1,500,000 × 60% × 50% × (10 ÷ 365) = 12,328
Subtotal: 66,807.
Change in receivables level: 44,151.
Savings in finance costs: 44,151 × 10% = 4,415.
Administrative savings: 4,500.
Total savings: 9,415.
8.8 The following points might be included in your answer:
■ lost interest – on ‘free’ loans to customers
■ administration costs
■ risk of assessing creditworthiness
■ bad debts
■ discounts.
Denying credit also has costs:

■ Loss of customers and/or goodwill.
■ Problems with taking cash payments – for example, segregation of
duties.
Factors to be considered when granting credit:
■ consistent policy on credit applications
■ character (integrity)
■ capacity (sufficient cash flow to service the debt)
■ capital (net worth)
■ collateral (assets to secure the debt)

■ conditions (of the borrower and the overall economy).

8.9 (a) 2OD
EOQ =
√ H
D = 4000 × 12 × 2 kg = 96,000 kg
O = £1.20
H = £2.
2*96,000*£1.20
EOQ =
√ 2
= 339 kg.
(b) Points could include:
■ EOQ considers two main stock-related costs – holding and
ordering.
■ The best order quantity is a trade-off between holding and
ordering costs.
■ EOQ is based on assumptions, which, if held, yield a good
optimum order size.

(c) ■ Demand is certain and continuous.
■ All costs are constant and can be determined.
■ Lead time is constant and certain.
Summary
The key points from this unit can be summarised as follows:
1. The capital of a company can be invested or used in two ways, as:
■ Permanent capital, employed in non-current assets such as buildings,
plants or vehicles.
■ Working capital represented by the difference between current assets
and current liabilities.
2. Working capital flows in a cyclical manner from inventory through to
trade payables, encompassing cash and trade receivables. The length of
the working capital cycle is given by the following:
Period goods held in inventory + trade receivables payment period – trade
payables payment period.
3. The basic goal of working capital management is that of ensuring that
there is enough cash available to pay trade payables out of current assets
(liquidity) without having an adverse effect on profitability.
4. A number of ratios are useful in assessing working capital management:
Current ratio = current assets ÷ current liabilities.
Acid-test ratio = (current assets – inventory) ÷ current liabilities.
Inventory turnover ratio = cost of goods sold ÷ average inventory.
Debt collection period = average trade receivables ÷ credit sales × 365.
Payables payment period = average trade payables ÷ credit purchases ×
365.

Unit 91 Transfer pricing
’
William Shakespeare
Introduction
Transfer prices create a mini economy within an organisation and spread
the ultimate profit or value added throughout the production or service
chain. They may be used to determine production levels, help with
internal activity versus outsource decisions, and, as transfer prices affect
the profitability of each division, they can influence our perception of
divisional and managerial performance.

9.1 Explain the nature and purpose of transfer pricing.
9.2 Apply various transfer pricing methods.
9.3 Explain issues in negotiated transfer prices.
9.4 Explain international perspectives on transfer pricing and calculate
taxation effects of international transfer prices.
Prior knowledge
You may find it useful to revise Unit 2 and Unit 4 of this learning pack in advance
of completing this unit.

9.1 Transfer pricing

Recommended reading: ‘Transfer The selling and buying of goods by divisions within a single organisation is
pricing in divisionalised often done with a price attached to the good or service being transferred – the
companies’ in Drury (2009). price may or may not be the open market price. The price used for such buying
and selling is called the transfer price.
transfer price
Drury (2009) states that:
‘goods transferred from the supplying division to the receiving division are
known as intermediate products. The products sold by a receiving division
to the outside world are known as final products. The objective of the
receiving division is to subject the intermediate product to further
processing before it is sold as a final product to the outside world.’
Transfer pricing has a number of possible advantages:

■ It enhances independence of divisional managers. This encourages and
motivates managers.
■ It may improve the assessment of divisional performance and improve
performance evaluation.
■ It may promote optimisation of profits and divisional autonomy.
■ Allocation of divisional resources can be improved.
■ Tax minimisation: Where a business has operations in various countries, it
may be beneficial to set transfer prices such that the bulk of profits are
reported in divisions where the host country has low corporation tax.
ga
nin ct
Can you think of a company that might use transfer pricing?
Lear
ivit
9a
y
eedb ac
F
Large multinationals like Coca-Cola, Pepsi, GlaxoSmithKline and Dell are the
9a types of companies using transfer pricing. This is because they may have
manufacturing operations in many countries and/or they want to take
advantage of lower tax rates.
9.2 Transfer pricing methods

Recommended reading: ‘Transfer These are several different ways to derive a transfer price, which are detailed
pricing in divisionalised below.
companies’ in Drury (2009).
Market-based transfer price
market-based transfer price A market-based transfer price means the price of a similar product or service
available externally is used.
Advantages of market-based transfer price

To the buying division:
■ Better quality of service, as it would expect the same quality as products
available on the market.

■ Greater flexibility, as it provides a sound basis for decision making.
To both divisions:
■ Lower costs of administration, selling and transport may arise as the
transfer price must be competitive to ensure profitability.
■ Better decisions that will be in the interest of the whole company as
decisions are based on prices reflective of actual markets.
Disadvantages of market-based transfer price

■ The market price may be temporary, or fluctuate frequently.
■ There may not be an external market price available.
■ There may be an imperfect external market for the transferred item, so that
if the transferring division tried to sell more externally it would have to
reduce its selling price.
■ Internal transfers are often cheaper than external sales. Therefore the buying
division could expect a discount on the external market price.
In practice, a market-based transfer price may be reduced to take account of

common or shared costs. For example, intra-company transfers may benefit
from lower packaging, transport or advertising costs.
Full cost transfer price

This method is widely used in practice. It is based on the product or services
costs determined by the organisation’s costing systems (see Unit 3). This is in
fact a major problem with full cost transfer prices, in that these costing systems
may provide poor estimates of long-run marginal costs.
Full cost transfer does not promote an incentive for the supplying division to
transfer goods and services internally because they do not include a profit mark-
up. It may be useful when it is difficult to determine the actual amount of a
profit mark-up. On the other hand, a full cost approach does not provide any
incentive for divisional managers to keep costs down, since they can pass the
costs onto the buying divisions.
A transfer price based on full cost plus a mark-up is also possible. However,
such a price may lead to sub-optimal decisions because it leads the ‘buying’
division to regard the fixed costs and the mark-up of the selling division as
variable costs.
ga
nin ct Think about the types of companies mentioned in Learning Activity 9a. Do
Lear
ivit
9b you think they could use market-based transfer pricing?

y
eedb ac
In general, the answer is no. Typically, companies transfer partially
F
9b completed products between divisions and there might be no ready market

for these products. This would make estimating a market price more
difficult. For example, Coca-Cola ship cola concentrate around the globe,
for which no market as such exists.

ga
nin ct Sahai has two divisions, X and Y, which manufacture calculators. Division X
Lear
ivit
9c produces and manufactures the frame and Division Y assembles the
y
components. There is a market for both the sub-assembly and the final
product. Each division has been designated as a profit centre. The transfer
price for the sub-assembly has been set at the long-run average market
price. The following data is available to each division:
£
Estimated selling price for final product 305
Long-run average selling price for intermediate product 205
Incremental costs for completion in Division Y 155
Incremental costs in Division X 125
The manager of Division Y has made the following calculation:
£
Selling price for final product 305
Transferred in costs (market) 205
Incremental costs for completion 155
Total 360
Contribution on product (55)
(a) Should transfers be made to Division Y if there is no excess capacity in

Division X? Is the market price the correct transfer price?
(b) Assume that Division X’s maximum capacity for this product is 1,005
units per month and sales to the intermediate market are now 805
units. Should 200 units be transferred to Division Y? At what transfer
price? Assume that for a variety of reasons, X will maintain the £205
selling price indefinitely; that is, X is not considering lowering the price
to outsiders even if idle capacity exists.
eedb ac
F
(a) No, transfers should not be made to Division Y if there is no excess

k
9c capacity in Division X. An incremental (outlay) cost approach shows a

positive contribution for the company as a whole:
£
Selling price for final product 305
Incremental costs in Division X 125
Incremental costs in Division Y 155
Total 280
Contribution 25

eedb ac However, if there is no excess capacity in Division X, any transfer will result
F
in diverting products from the market for the intermediate product. Sales in
9c this market result in a greater contribution for the company as a whole.
Division Y should not assemble the calculators since the incremental revenue
continued
Sahai can earn, £100 per unit (£305 from selling the final product, £205
from selling the intermediate product), is less than the incremental costs of
£155 to assemble the calculator in Division Y.
£
Selling price for intermediate product 205
Incremental (outlay) costs in Division X 125
Contribution 80
Correct transfer price

Minimum transfer price = additional incremental costs per unit incurred up
to the point of transfer + opportunity costs per unit to the supplying division
= £125 + (£205 – £125)
= £205, which is the market price.
Market price is the transfer price that leads to the correct decision; that is,
do not transfer to Division Y unless there are extenuating circumstances for
continuing to market the final product. Therefore, Y must either drop the
product or reduce the incremental costs of assembly from £155 per
calculator to less than £105.
(b) If X has excess capacity, there is intermediate external demand for only
805 units at £205, and the £205 price is to be maintained, then the
opportunity costs per unit to the supplying division are £0.
A minimum transfer price would be: £125 + £0 = £125, which is the
incremental or outlay costs for the first 200 units.
Y would buy 200 units from X at a transfer price of £125 because Y can
earn a contribution of £25 per unit [£305 – (£125 + £155)]. In fact, Y would
be willing to buy units from X at any price up to £155 per unit because any
transfers at a price of up to £155 will still yield Y a positive contribution
margin.
Note, however, that if Y wants more than 200 units, the minimum transfer
price will be £205 as calculated in the answer to Learning Activity 9c (a),
because X will incur an opportunity cost in the form of lost contribution of
£80 (market price of £205 – outlay costs of £125) for every unit above 200
units that are transferred to Y. The following schedule summarises the
transfer prices for units transferred from X to Y.
Units Transfer price

0–200 £125–155
200–1000 £205

9.3 Negotiated transfer prices

Negotiated transfer prices are most appropriate in situations where some
Recommended reading: ‘Transfer
pricing in divisionalised market imperfections exist for the intermediate product, that is, where goods
companies’ in Drury (2009). cannot be delivered in an arm’s-length fashion or where information is not
available to all market participants. Negotiated transfer pricing works best
where there is an external market for the goods supplied by the buying and
selling divisions. When there is excess capacity, the transfer range for
negotiations generally lies between the minimum price at which the selling
division is willing to sell (its variable costs) and the maximum price the buying
division is willing to pay (the price at which the product is available from
outside suppliers).
Advantages of negotiated transfer pricing are:

■ An organisation’s strategies and goals are supported by ‘realistic’ transfer
prices.
■ Goal congruence of the overall organisation is promoted, as managers of
divisions agree prices in the interest of the organisation as a whole.
■ Divisional autonomy is promoted as divisional managers may be motivated
to maximise profits.
The limitations of negotiated transfer pricing are:

■ The outcome of negotiated transfer prices may not be optimal. For example,
there may be power imbalance between divisions and/or managers.
■ Conflict may exist between divisions, as divisional managers may be pitted
against one another in terms of performance measurement, or managers
may not understand each other’s divisions.
■ The negotiation process may be time-consuming for managers.
Comparing negotiated transfer prices to the other types described in the

previous section, let’s consider which might be best in practice:
■ Market prices are usually best because they tend to represent the
opportunity cost, but a market may not exist in practice.
■ Full cost, usually plus a profit, rarely reflects the opportunity costs and tends
to pass on inefficiencies.
■ Negotiated prices enable a division to act as an independent business but
can be unfair.
Resolving transfer pricing conflicts

In the absence of a perfect market for an intermediate product, a number of
possible conflicts arise with transfer prices. And, if a negotiation process is
followed to determine a transfer price, this too raises the possibility of conflict.
To resolve conflicts, two possible transfer pricing methods can be adopted:
■ A dual rate transfer pricing system.
■ A transfer at marginal cost plus a fixed lump-sum fee.
Dual transfer price

A dual rate transfer pricing system uses two separate transfer prices to price
each inter-divisional transaction. Therefore, the receiving division should

choose the output level at which the marginal cost of the intermediate product
is equal to the net marginal revenue. The main purpose of dual transfer prices
is to encourage divisions to participate in the transfers.
The following example shows how a dual transfer price works by showing how
a transfer is recorded in the accounting records:
The Spring Water Company uses a dual transfer price in which Division A sells
at the market price of £19 per case to Division B, who pays £17 per case. The
production cost to Division A is £16 per case. Assuming Division A transfers
500 cases to Division B, the following will be recorded in the books of account
of each division and the corporate headquarters:
Division A:
Dr (£) Cr (£)
Receivable from Division B 9,500
Revenue 9,500
Cost of goods sold 6,000
Finished goods inventory (£16 × 500 cases) 6,000
Division B:
Dr (£) Cr (£)
Finished goods inventory 8,500
Division A payable (£17 × 500 cases) 8,500
Corporate headquarters:
Dr (£) Cr (£)
Inter-company account A 8,500
Corporate subsidy 1,000
Inter-company account B 9,500
Most of the transactions above are eliminated when the accounts of the group
are prepared. The exception is the cost of goods sold (£6,000). In other words,
the transfer pricing has no effect on the cost of finished goods or on the group
as a whole.
Some problems with dual rate transfer prices in practice include:

■ The use of different dual transfer prices causes confusion.
■ Dual rate transfer prices are considered to be artificial.
■ Dual rate transfer prices reduce divisional incentives to compete effectively.
Marginal costs plus a fixed lump-sum fee

This method may be best used when an imperfect/non-existent market occurs.
It is also known as the two-part transfer pricing system. This involves transfers
being made at the marginal cost per unit of output of the supplying division plus
a lump-sum fixed fee.

The advantages are:

■ Transfers are made at the marginal cost of the supplying division and both
divisions should also be able to report profits from inter-divisional trading.
■ Receiving divisions are made aware and are charged for the full cost of
obtaining intermediate products.
Which is the best transfer price?

There is probably no one ideal transfer price that leads to optimal decisions in
all cases. This is because the three criteria of goal congruence, management
effort and divisional autonomy are difficult to achieve simultaneously. The
following three points can, however, act as a guide in determining the best
transfer price:
1. If a perfectly competitive market exists and there is no idle capacity in an
intermediate market, then: minimum transfer price = marginal cost per unit
+ opportunity costs per unit.
2. If the market is not perfectly competitive, and an intermediate market exists,
then: minimum transfer price = marginal cost per unit.
3. If no market exists for the intermediate product, then: the transfer price
should be the marginal cost.
Just to remind you, marginal cost represents the additional costs that are
directly associated with production and transfer of the product. Opportunity
costs are the maximum contribution forgone by the supplying division of the
products if transferred internally. In all three cases above, a cost-based transfer
price is assumed. The minimum transfer price can be affected by capacity
constraints of the selling division. If there are no limits on production capacity,
then the selling division will be indifferent towards external customers and the
buying division. If, however, a capacity constraint exists in the selling division,
the selling division must consider the opportunity cost of lost sales to external
customers. In this instance, the opportunity cost must include the cost of lost
sales to external customers.
Drury (2009) argues that in a perfectly competitive market, the supplying

division should supply as much as the receiving division requires at the current
market price. If the supplying division produces more of the intermediate
product than the receiving division requires, the excess can be sold to the
market at the current market price. The following learning activity requires
you to think about what transfer price might be used.
ga
nin ct
Johnson Ltd has been offered supplies of Z at a transfer price of £18 per kg
Lear
ivit
9d by Hampstead Ltd, which is part of the same group of companies.

y
Hampstead Ltd processes and sells Z to external customers at £18 per kg.
Hampstead Ltd bases its transfer price on cost plus 25% profit mark-up.
Total cost has been estimated as 75% variable and 25% fixed.
Discuss and propose the transfer prices at which Hampstead Ltd should
offer to transfer Z to Johnson Ltd in order that group profit-maximising
decisions may be taken on financial grounds in each of the following
situations:

ga
nin ct
1. Hampstead Ltd has an external market for all its production of Z at a
Lear
ivit
9d selling price of £18 per kg. Internal transfers to Johnson Ltd would
y
enable £1.50 per kg of variable packing cost to be avoided.

continued 2. Conditions are as point 1, but Hampstead Ltd has production capacity
for 3,500 kg of Z for which no external market is available.
3. Conditions are as per point 2, but Hampstead Ltd has an alternative use
for some of its spare production capacity. This alternative use is
equivalent of 2,000 kg of Z and would earn a contribution of £6,000.
eedb ac
F
1. The method to adopt here is marginal cost + opportunity cost.

k
9d The proposed transfer price is £18.

We know that cost × 1.25 = £18 (25% profit mark-up).
Thus cost = £18 ÷ 1.25 = £14.40.
Variable costs are thus £14.40 × 75% = £10.80.
Fixed costs are thus £14.40 × 25% = £3.60.
Now work out any lost contribution.
Contribution = transfer price £18 – variable cost £10.80 = £7.20.
Marginal cost of the transfer is:
Variable cost – packaging = marginal cost = £10.80 – £1.50 = £9.30.
Transfer price is thus:
Marginal cost + opportunity cost (that is, lost contribution) = £9.30 +
£7.20 = £16.50.
This is equivalent to using the market price rule, that is, the external
market price, saving: £18 – £1.50 = £16.50.
2. For 3,500 kg, where no external market is available, the opportunity cost
is the variable cost of £10.80 and this is the transfer price. The
remaining output should be transferred at £16.50.
3. The lost contribution for 2,000 kg is £3 per kg (£6,000 ÷ 2000 kg) giving
a transfer price of £3 + £10.80 = £13.80. The remaining 1,000 kg would
be transferred at £10.80 variable cost and the balance for which there is
an external market transferred at £16.50.
ga
nin ct
Think about some companies you may know or have worked for that use
Lear
ivit
9e transfer pricing. If you were a divisional manager, why do you think you
y
would not like to use marginal cost transfer prices?
eedb ac
F
Marginal cost is normally interpreted as being equivalent to variable cost.

9e Thus, it does not support profit or investment centre structures because it
provides poor information for evaluating the performance of either the
supplying or receiving divisions. As a divisional manager, you would
probably prefer to make decisions that will increase the performance of
your division.

9.4 International transfer pricing

Recommended reading: ‘Transfer International transfer pricing is concerned with the prices that an organisation
pricing in divisionalised uses to transfer products between divisions in different countries. As you might
companies’ in Drury (2009). imagine, global companies like Coca-Cola, Intel and Apple have operations in
many different countries and intermediate products are transferred between
countries on a regular basis.
When the supplying and receiving divisions are located in different countries
with different taxation rates, transfer pricing becomes quite interesting. If the
taxation rates in one country are much lower than another, it would be in the
company’s interest to ‘locate’ most of the profits in a division operating in the
low-tax country.
ga
nin ct
Ireland’s low corporation tax rate of 12.5% has been used by successive
Lear
ivit
9f governments to attract much foreign direct investment. Do a web search to

y
see if you can find some multinational companies based in Ireland and
whether they save tax by using transfer pricing on intermediate products
there.
eedb ac
F
Your answer will depend on your search results, but here are a few
k
9f examples of global firms operating in Ireland. These firms are some of those
who use transfer pricing for intermediate products/services into (and
possibly out of) Ireland:
■ Coca-Cola
■ Pfizer
■ GlaxoSmithKline
■ Elan
■ Apple
■ Deutsche Bank
■ Google
■ PayPal.
Your web search may have yielded many results, so the following represents
one possible case you may have found. On 21 October 2010, Bloomberg
reported that Google saved a total of $2.4 billion in taxes by routing the
vast majority of its non-US income through an Irish subsidiary (Drucker,
2010).This news story reports how the lower Irish corporation tax rate of
12.5% (compared to 28% in the UK and 35% in the US) is very attractive
to transfer pricing arrangements.
In an international context, a further complication may be double taxation

relief. When a subsidiary company receives dividends (that is, transferred
profits) from another business in a different tax jurisdiction, the profits
underpinning those dividends will already have been taxed. The subsidiary
company, though, will be taxed on the dividend income, thus effectively bearing
a double taxation load. In such circumstances, ‘double taxation relief’ may be

available, depending on the tax regimes involved, whereby some or all of the
foreign tax suffered may be recoverable.
Some countries also have a ‘withholding tax’. This is a tax applied to dividend
payments. The paying company retains (withholds) an element of tax from the
dividend payment and the receiving company, therefore, receives a dividend
after withholding tax. It is normal in such circumstances for the paying
company to remit the withholding tax to its own taxation authorities and for
the receiving company to reclaim this tax from its tax authorities. We will now
look at an example of the impact of transfer pricing strategies designed to take
advantage of low tax rates. In this example we ignore withholding tax.
Example
Jason is a multinational holding company (H) based in Beland. It has one
wholly owned subsidiary in Celand (S1) and another, also 100% owned, in the
UK (S2). The UK subsidiary manufactures machinery parts which are sold to
the Celand subsidiary for 250 Beland dollars (B$250). These parts cost B$190
each. 200,000 units are sold annually.
The Celand subsidiary incurs further costs of B$200 per unit and sells the goods
for B$625.
All after-tax profits are remitted, in the form of dividends, by the subsidiaries
to Jason. No withholding tax applies to any of the dividend transactions.
The following rates of corporation tax apply:
UK 25%, Beland 35% and Celand 40%. No double taxation treaties apply.

Scenario A:
Produce the income statements to indicate the overall profitability of this
venture.
Solution:
Scenario A After-tax profits of S1 and S2 are remitted to H. No offset of

foreign tax
Jason
Beland Celand UK
H S1 S2 Group
B$000 B$000 B$000 B$000
Sales to Outsiders 0 125,000 125,000
Sales S2 to S1 50,000
Costs S2 40,000
Costs S1 from S2 50,000
Cost of Sales 0 90,000 38,000 78,000
Operating profit 0 35,000 12,000 47,000

Dividends received 30,000 0
30,000 47,000
Tax 35% 10,500 40% 14,000 25% 3,000 27,500
After Tax 19,500 21,000 9,000 19,500
Dividends paid 0 21,000 9,000 0
Retained 19,500 0 0 19,500
As can be seen, the retained profit is B$19,500,000 and taxation suffered by the
group is B$27,500,000.

Scenario B:
Let us now consider the impact on group retained profit if the transfer price
between UK (S2) and Celand (S1) is increased by 25%. In this case S2’s income
(and S1’s costs in this respect) will increase from B$50,000 to B$62,500. Again
we will assume no double taxation relief.
Solution:
Scenario B After-tax profits of S1 and S2 are remitted to H. No offset of

foreign tax transfer price S2 to S1 increases by 25%
Jason
Beland Celand UK
H S1 S2 Group
B$000 B$000 B$000 B$000
Costs S2 40,000
Cost of Sales 0 102,500 38,000 78,000

31,875 47,000
Tax 35% 11,156 40% 9,000 25% 6,125 26,281
After Tax 20,719 13,500 18,375 20,719
Retained 20,719 0 0 20,719
As can be seen the impact of this is to increase group retained profits by

B$1,219,000 which is as a result of taxation falling from B$27,500,000 to
B$26,281,000.

Scenario C:
To complete this section, Scenario B has been amended to permit H to reclaim
the tax paid by the UK and Celand subsidiaries S1 and S2. In reality, the tax
regulations for such ‘double taxation relief’ arrangements can be complex. In
this case we will assume that:
(a) Jason (H) will be taxed based on the operating profits of S1 and S2 (rather
than the dividends received).
(b) The overseas tax of S1 and S2 will be reclaimed by Jason.
The following would be the result:
Solution:
Scenario C After-tax profits of S1 and S2 are remitted to H. Simple offset of

foreign tax. Transfer price S2 to S1 increased by 25%
Jason
Beland Celand UK
H S1 S2 Group
B$000 B$000 B$000 B$000
Costs S2 40,000
Cost of Sales 0 38,000 78,000

Add back foreign tax 15,125
H taxable profit 47,000
Tax 35% 16,450 40% 9,000 25% 6,125 31,575
Tax recovered by H 15,125
Group tax 16,450
After Tax 30,550 13,500 18,375 30,550

Retained 30,550 0 0 30,550

Note that, under scenario C, if H is now to be taxed on the operating profits

of S1 and S2 (B$47,000) then this can be achieved by adding back the foreign
tax of S1 and S2 (B$15,125) to the dividends received by H (B$31,875).
Group tax is now B$16,450 instead of B$26,281, a saving of B$9,831 as

compared to scenario B.
This results from:
£
Saving of tax, S1 6,125
Saving of tax, S2 9,000
15,125
Additional tax (47,000 – 31,875*) = 15,125 at 35% 5,294
Net saving 9,831
*B$31,875 was already taxed under Scenario B.
As the example above shows, taxation can be saved through transfer pricing
arrangements. Naturally, tax authorities try to prevent such transactions. The
Organisation for Economic Cooperation and Development (OECD) has looked
into international transfer pricing in some depth and international guidelines
now require transactions to be on an arm’s-length principle. In this respect,
transfer pricing should assume that, within groups, transactions are being
undertaken by two independent corporations rather than as businesses within
the same corporate structure. The main objective of these guidelines is to limit
taxation losses to economies. The arm’s-length principle is typically adopted
by tax authorities.
Ernst & Young, a leading accounting firm, regularly undertakes a global survey
on transfer pricing and its taxation effects on economies. The most recent
edition of the survey from 2009 highlights the increasing number of countries
that are taking a more regulated approach to international transfer pricing. The
survey also reports divergent approaches to establishing a transfer price across
countries. Key trends identified by the survey are as follows:
■ An increased level of resources in many tax authorities to investigate the
legitimacy of transfer pricing arrangements.
■ Increased inspections by tax officials and increased penalties on companies.
■ A greater degree of investigation of companies using known tax havens.
■ More enforcement of the ‘arm’s-length’ principle.
■ As taxation is a relatively important feature of transfer pricing, and the
regulation of transfer pricing is increasingly present, companies may enter
into an Advance Pricing Agreement (APA). This agreement sets out how
transfer prices are determined and is approved by all relevant tax
authorities, meaning two or more tax authorities may be involved. APAs
are in common use in countries such as Canada, the United States, the
United Kingdom and most EU member states.

9.1 Jojoba Industries makes two component parts, A and B. It supplies A to
the division to be used in the manufacture of car engines, and B to the
division to be used in the manufacture of car gearboxes. When transfers
are made in-house, Jojoba Industries transfers products at full cost
(calculated using an activity-based cost system) plus 10%. The unit cost
information for A and B is as follows:
A B
Variable cost (£) 13 6
Fixed cost (£) 17 15
The division receiving A feels that the price is too high and has told Jojoba
that it is trying to locate an outside vendor to supply the part at a lower
price. Jojoba argues that to reduce the transfer price they will have to
change the fixed cost allocation in order to decrease the transfer price to
£27.99.
(a) Calculate the transfer prices for A and B.
(b) Calculate the fixed cost per unit that Jojoba would have to allocate
to A to enable Jojoba to transfer A at £27.99 per unit.
9.2 If an external, perfectly competitive market exists for an intermediate
product, what should the transfer price be?
9.3 Explain four purposes for which transfer pricing can be used.
9.4 Distinguish between intermediate products and final products.
9.5 JBC plc has two divisions: Division X and Division Y. Division X
produces a product which it transfers to Division Y and also sells
externally. Division Y has been approached by another company which
has offered to supply 3,000 units of the product for £35 each.
The following details for Division X are available:
Sales revenue:
Sales to Division Y at £50 per unit = £500,000
External sales at £45 per unit = £270,000.
Less:
Variable cost at £20 per unit = £320,000
Fixed costs = £100,000
Profit = £350,000.
(a) If Division Y decides to buy from the other company, what is the
impact of the decision on the profits of Division X?
(b) What is the impact on the whole company?
9.6 Nana Ltd has been offered supplies of Y at a transfer price of £20 per kg
by Help Ltd, which is part of the same group of companies. Help Ltd
processes and sells Y to customers external to the group at £20 per kg.
Help Ltd bases its transfer price on cost plus 24% profit mark-up. Total
cost has been estimated as 75% variable and 25% fixed.

Calculate the transfer price under each case below in order to maximise
group profit:
(a) Help Ltd has an external market for all of its production of Y, at a
selling price of £20 per kg. Internal transfers to Nana Ltd would
enable £1.50 per kg of variable packing costs to be avoided.
(b) Conditions as per point a, but Help Ltd has production capacity for
2500 kg of Y for which no external market is available.
(c) Conditions as per point b, but Help Ltd has an alternative use for
some of its spare production capacity. This alternative use is
equivalent to 2000 kg of Y and would earn a contribution of
£4,000.

9.1 (a) Transfer prices for A and B are as follows:
A (£) B (£)
Variable cost per unit 13 6
Allocated fixed costs per unit 17 15
Total costs per unit 30 21
10% of total cost 3 2
Transfer price per unit 33 23
(b) For A to have a transfer price of £27.99 per unit, its full cost would
have to be £27.99 ÷ 1.10 = £25.45, because the transfer price per
unit is determined by adding 10% to the full cost per unit.
Fixed costs per unit that the management accountant would have to
allocate to A can be calculated as follows:
£
Full cost per unit of A 25.45
Less variable costs 13
Fixed costs 12.45
9.2 In most cases, where a perfectly competitive market for an intermediate

product exists, the transfer price will be set at the market price.
9.3 ■ To provide information to motivate divisional managers.
■ To evaluate the managerial and economic performance.
■ To move profits between divisions.
■ To ensure divisional autonomy.
9.4 Goods transferred from the supplying division to the receiving division are
known as intermediate products. Products sold by a receiving division to
the outside world are known as final products.

9.5 The loss of contribution in Division X from lost internal sales is 3,000 ×
(£50 – £20) = £90,000.
Y spends externally 3,000 × £35 = £105,000
X saves 3,000 × £20 variable cost = £60,000
Company worse off by £45,000.
9.6 (a) £20 transfer price is based on cost, therefore:
Cost × 1.24% = £20.
Cost = £20 ÷ 1.24.
Cost before mark-up = £16.13.
Variable cost is £16.13 × 0.75 = £12.10.
Fixed cost is £16.13 × 0.25 = £4.03.
Therefore there is a lost contribution of £20 – £12.10 = £7.90 from
transferring internally (this is the opportunity cost).
The marginal cost of the transfer is (external variable cost –
packaging):
12.10 – 1.50 = £10.60
10.60 + 7.90 = £18.50
(that is, MC + opportunity cost).
An alternative approach would be:
Market price – selling costs
20 – 1.50 = £18.50.
(b) For the 2500 kg, where no external market is available, the
opportunity cost will not apply and transfers should be at the
variable cost of £12.10. The remaining output should be transferred
at the transfer price of £18.50.
(c) The lost contribution for the output of 2000 kg is £2 per kg, that is,
(£4,000 ÷ 2000 kg) giving a transfer price of £14.10 (£12.10
variable cost + £2 opportunity cost). The remaining 500 kg for
which there is no external market should be transferred at £12.10
variable cost and the balance for which there is an external market
at £18.50.
Summary
This unit has introduced you to the concepts of transfer pricing, which is
typically the realm of multinational companies. Transfer pricing applies to
intermediate products and is normally used to create a degree of divisional
autonomy and, in turn, improve the performance evaluation of divisionalised
organisations. You learned two basic methods of transfer pricing, namely,
market-based prices and full cost pricing. Another possibility is a negotiated
transfer price, which is useful when some market imperfections exist, which is
normally the case. Negotiations can of course be problematic, and in general,
conflicts may be resolved using either a dual rate transfer pricing system or
transfer at marginal cost plus a fixed lump-sum fee. There may be no best fit
transfer price, but you have learned how a combination of unit marginal costs
and opportunity costs is useful. Finally, you have also learned that transfer
pricing is complicated by differing taxation rates between countries. This may
encourage transfer pricing to be organised around lower tax economies, but
the OECD have issued guidelines recommending all transfers should be
undertaken at arm’s length.

References
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Performance Evaluation’, The Accounting Review, 49 (3), 485–95.
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References
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Kaplan, RS, and DP Norton (1992) ‘The Balanced Scorecard: Measures That
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Kaplan, RS, and DP Norton (1993) ‘Putting the Balanced Scorecard to Work’,
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Book Press.

Index
ABB see activity-based budgeting budgeting process 102–10, 115–16
ABC see activity-based costing benchmarking 8
absorption costing 10–11 definition 18
definition 41 ‘beyond budgeting’ 12, 101
inadequacies 43 budget committee 84–5
techniques 43–7 budget income statement 93, 97, 114
versus activity-based costing (ABC) budget manual 84
42, 47–50, 55–6 budget statement of financial position
accountability 121 93, 98
accounting ratios 179–81 budgetary slack 104, 116
see also acid–test ratios; current ratios budgeting 11–12
acid-test ratios 179–81, 184, 199, 201 activity-based budgeting (ABB) 11,
action controls 80, 81, 109 100–1
activity alternatives to traditional budgeting
definition 42 99–101
identification 51 behavioural aspects 102–10, 115–16
activity cost drivers 50, 51 ‘beyond budgeting’ 12, 101
activity-based budgeting (ABB) 11, criticisms of traditional budgeting 98
100–1 incremental budgeting 82–3
advantages 100–1 incremental versus zero-base
definition 100 budgeting (ZBB) 119
disadvantage 101 Kaizen budgeting 100
procedure 100 traditional approach 82–3
activity-based costing (ABC) 11, 41–3, zero-base budgeting (ZBB) 99, 108–9,
47–59 116–17
benefits 55, 59 see also budgets
cost drivers 11, 49, 50–1, 59 budgets 78–119
definition 41 administration 84–5
designing the system 51 behavioural aspects 102–10, 115–16
features 53, 56 conflicting roles 83–4, 117
problems 11, 55 definition 78
reasons for development 43 flexed budget 138–9
resource consumption model 51–2 functions 82–3, 115
service organisations 52 imposed 104, 107–8
versus traditional absorption costing links with control and variance
42, 47–50, 55–6 analysis 137–9
adverse variance: definition 139 negotiated 104
attainable standard: definition 135 organisational culture 103–8
avoidable costs 21 participatory 104, 105–7, 116
preparation 85–98
bad credit: reducing risk 200 sequence of preparation 88
balanced scorecard (BSC) 12–14 see also budgeting
benefits and limitations 14 business environment
definition 1 competitive challenges 7
four main components 13, 18 impact of uncertainty on control
Tesco Steering Wheel 14 systems 109
behaviour
action control 80, 81 capacity ratio 150, 152, 153, 167

Index
definition 152 definition 121

capital uncontrollable factors 121–2, 131
permanent 173, 199, 201 controllable profit 129
see also working capital coordination: function of a budget 83,
cash 174 115
amount to hold 194–5 cost centres 121, 122
importance 175 cost drivers 11, 49, 50–1, 59
period for holding 195–6 activity 50, 51
reasons for holding 194–5 definition 50
working capital component 175–6, identification 51
184, 194–6 non-volume-based 50
cash budget 85, 89–93, 96, 118 volume-based 50, 51
cash conversion cycle 195–6 cost pool: definition 51
definition 195 cost variance
cash deficit 196 definition 139
solution 196 direct labour 143–4, 149–50, 151,
cash discounts 193 163
cash receipts statement 90, 93, 115 direct materials 140–3, 149, 151, 163
cash surplus 196 fixed production overheads 145–52,
cease production: decision-making 33–4 164
Chartered Institute of Management variable production overheads 144–5,
Accountants (CIMA) 150, 151, 164
management accounting definition cost-plus pricing
6–7 distinct from target costing 73–4, 76
strategic management accounting full cost-plus 68–9, 73
definition 15 full cost-plus pricing including
committed costs 21 opportunity cost 69
communication: function of a budget justification for using 74
83, 115 limitations 73
comparability: management accounting marginal cost-plus pricing 70
information 4–5 methods used for deriving prices 73
competition 7 problems with full cost-plus pricing
competitive advantage: value chain 8 69
continue production: decision-making variable cost-plus 68, 73
33–4 credit control 191–4
continuous improvement 7 debt collection 192–4
definition 18 discounts 193
employee empowerment 8 factoring 193
Kaizen budgeting 100 granting credit 192, 200–1
control reducing risk of bad credit 200
action/behavioural 80, 81, 109 credit references 191
cybernetic control systems 81–2 cultural control 80, 81
detrimental effects 81 current assets 173–4
environmental uncertainty factor 109 current liabilities 173–4
function of a budget 83, 115 current ratios 179–81, 184, 199, 201
links with budgets and variance customer satisfaction
analysis 137–9 continuous improvement 7
personnel and cultural control 80, 81 value chain 8
process 2–4, 18, 79–80 customers
results/output 80, 81, 109 users of management accounting
see also management control systems information 4
controllability principle 121–2 working capital component 176

cybernetic control systems 81–2 economic uncertainty: impact on control

systems 109
debt collection 192–4 economic value added (EVA®) 128
factoring 193 comparison with RI 132
debt collection period 191, 201 definition 123
decision-making divisional performance measurement
accept or reject orders (special orders) 127–8
34–6 formula 127, 131
continue or discontinue decision 33–4 efficiency ratio 151, 152, 153, 167
in-house or outsource (make or buy) definition 152
28–30 elasticity of demand 61–2
in-house or outsource with scarce definition 61
resources 30–3 Electronic Point of Sale (EPOS):
limiting factors 25–8 inventory tracking 189
decision-making process 2–4 employee control 80, 81
qualitative factors 23, 27, 29, 34, 40 employee empowerment 8
see also pricing decisions; relevant definition 18
costs employees: users of management
depreciation 21 accounting information 4
design department: relevant management engineered targets 104
accounting information 5 engineering department: relevant
direct cost 10–11, 20, 41, 42 management accounting information 5
see also labour; materials enterprise resource planning (ERP)
discontinue production: decision- systems 10
making 33–4 EPOS (Electronic Point of Sale):
discounts for prompt payment 193, 197 inventory tracking 189
divisional performance measurement Ernst & Young transfer pricing survey
123, 128 216
comparison between EVA® and RI EVA® see economic value added
132
economic value added (EVA®) 127–8 factoring 193
investment centres 124 favourable variance: definition 139
profit centres 124 feed-forward controls 82
residual income (RI) 126–7, 128–9 feedback 82
return on investment (ROI) financial accounting: distinct from
125–6, 128–9, 130 management accounting 18–19
divisionalisation financial measures
advantages and disadvantages 123 return on shareholders' funds (RoSF)
autonomy to divisional managers 124 126
see also international transfer pricing; see also economic value added (EVA®);
transfer pricing residual income (RI); return on
double taxation relief: international investment (ROI)
transfer pricing 211–12 finished goods stock budget 85
fixed costs 21
easyJet: relevant management fixed production overhead variances
accounting information 19 145–52, 164
EBITDA (earnings before interest, tax, marginal costing 151
depreciation and amortisation) 124 flexed budget 138–9
economic order quantity (EOQ): definition 138
inventory management 189–90, 201 full cost transfer price 204
economic profit 128 future costs see relevant costs
economic theory of pricing 61–4

Index
government: users of management labour budget 85, 86, 87, 88

accounting information 4 labour cost variance 143–4, 149–50,
151, 163
Handelsbanken 11–12 causes 144
historical targets 104 life cycle costing 66–7
human resources department: relevant limiting factors 25–8
management accounting information 5 definition 25, 40
example 40
ideal standard: definition 135 outsource or in-house with scarce
IKEA 12 resources 30–3
imposed budgets 104, 107–8 liquidity
incremental budgeting 82–3 assessment 179–81, 199
definition 82 definition 178
versus zero-base budgeting (ZBB) 119 liquidity ratios see acid-test ratios
incremental costs 21–2 low cost airlines: relevant management
definition 21 accounting information 19
short-run pricing decision 65, 66
indirect cost 41, 42 make or buy decision
see also absorption costing; activity- relevant costs 28–30
based costing (ABC); overheadcosting scarce resources 30–3
information systems 10 management
innovation 7 key themes 7–8
international transfer pricing 211–16 users of management accounting
Advanced Pricing Agreement (APA) information 4
216 management accounting
double taxation relief 211–12 CIMA definition 6–7
key trends 216 decision-making process 2–4
taxation aspects 211–16 definition 1
inventory distinct from financial accounting
control and tracking 189 18–19
economic order quantity (EOQ) new techniques 10
approach 189–90, 201 purpose 6–7
‘just-in-time’ (JIT) approach 189, traditional versus new techniques 1,
190–1 10–14
management 185–91 traditional versus strategic
materials requirement planning management accounting 15
(MRP) approach 190 see also strategic management
raw materials 185, 189 accounting
work-in-progress 185, 189 management accounting information
working capital component 176, attributes 4–5
177–8, 181–91 features 5–6
inventory turnover ratio 185–6, 201 format 6
investment centres 121, 122 impact on management performance
divisional performance measurement 108
124 low cost airlines, relevant to 19
irrelevant costs 20, 21 new product launch, relevant to 6
‘just-in-time’ (JIT) inventory no legal requirement for 6
management 189, 190–1 users 4–6
management by exception 83
Kaizen budgeting 100 management control systems 79–82
cybernetic control systems 81–2
labour: limiting factors 25–8 environmental uncertainty factor 109

essential elements 131 non-financial information 15, 16, 17

feed-forward controls 82
----multinationality factor 110 OECD (Organisation for Economic
organisational strategy factor 109–10 Cooperation and Development) 216
performance management and operating statement 154, 156–8, 166,
120–33 171
types of control 79–80 sales variances 154–6, 165
management styles 108, 116 opportunity costs 21–2
marginal cost 62–4 definition 21
definition 62 economic profit 128
transfer pricing 208–10 Organisation for Economic Cooperation
marginal costing and Development (OECD) 216
fixed overhead variances 151 organisational culture: effect of
sales variances 155–6, 170 budgeting process 103–8
marginal revenue 62–4 organisational strategy: impact on
definition 62 control systems 109–10
market-based transfer price 203–4 outsourcing
definition 203 make or buy decision with scarce
master budget 86, 93–8 resources 30–3
materiality: management accounting relevant in-house or outsource (make
information 5 or buy) costs 28–30
materials overhead cost budget 85
limiting factors 25–8 overhead costing 10–11
relevant costs 23–4 absorption costing techniques 43–7
see also raw materials inventory criticism 12
materials cost variance 140–3, 149, 151, traditional versus activity-based
163 costing (ABC) 42, 47–50, 55–6
causes 142–3 see also absorption costing; activity
materials purchases budget 85, 86, 87, based costing (ABC); fixed
89, 114 production overhead variances;
materials requirement planning (MRP): variable production overhead
inventory management 190 variance
materials usage budget 85, 86, 87, 95,
117 participatory budgets 104, 105–7, 116
motivation past costs 20, 21
effect of budgeting process 102–10 payables payment period 197, 201
function of a budget 83–4, 115 penetration pricing
multinationals 203, 211 appropriateness 70
management control systems 110 definition 70
see also international transfer pricing; performance evaluation: impact of
transfer pricing budgets 83, 84, 116, 108, 115, 116
performance management 12–14
negotiated budgets 104 management control systems and
negotiated targets 104 120–33
new products need for 122–3
accounting information relevant to performance measurement 128
launch 6 balanced scorecard (BSC) 12–14
penetration pricing 70 capacity ratio 150, 152, 153, 167
price skimming 70 economic value added (EVA®) 123,
pricing policies 70 127–8
non-current assets 173–4 efficiency ratio 151, 152, 153, 167
non-current liabilities 173–4 investment centres 124

Index
production volume ratio 153, 167 price over time 70

profit centres 124 production budget 85, 86–7, 95, 96,
residual income (RI) 123, 126–7 114, 117
return on investment (ROI) 12, 123, production department: relevant
125–6, 130 management accounting information 5
see also divisional performance production volume ratio 153, 167
measurement definition 153
permanent capital 173, 199, 201 profit centres 121, 122
personality: participatory budgeting divisional performance measurement
106, 116 124
personnel control 80, 81 EBITDA performance measure 124
planning profit maximisation 62–4
function of a budget 83, 115
process 2–4, 18 quick ratios see acid-test ratios
plant and equipment: relevant costs 24
premium price 70 raw materials inventory 185
price elasticity of demand 61–2 control 189
price setters relevance: management accounting
definition 64 information 4
long-term pricing 65 relevant costs 20–40
role of cost information 64 accept or reject orders (special orders)
sector examples 66 34–6
short-term pricing 65 continue or discontinue 33–4
versus price takers 65–6 definition 20, 40
price skimming in-house or outsource (make or buy)
appropriateness 70 decision 28–30
definition 70 in-house or outsource with scarce
price takers resources 30–3
definition 64 limiting factors 25–8
long-term pricing 65 materials 23–4
role of cost information 64 plant and equipment 24
sector examples 66 qualitative factors 23, 27, 29, 34, 40
short-term pricing 65 reliability: management accounting
versus price setters 65–6 information 4
price variance 140–3 residual income (RI) 128
definition 140 comparison with EVA® 132
pricing decisions 60–77 definition 123
cost-based approaches see cost-plus divisional performance measurement
pricing 126–7, 128–9
economic theory 61–4 responsibility accounting 121–2
existing products 70 divisionalisation 123
life cycle costing 66–7 responsibility centres 121–2
marginal cost-plus pricing 70 definition 121
new products 70 types 121, 122
role of cost information 64 see also cost centres; investment
short- and long-term 35, 64–6 centres; profit centres; revenue
special orders 34–6 centres
product costing 42–3 results control 80, 81
absorption costing techniques 43–7 environmental uncertainty factor 109
activity-based costing (ABC) 11 return on capital employed (ROCE) see
life cycle costing 66–7 return on investment (ROI)
product life cycle 66–7 return on investment (ROI) 12, 128

advantages and disadvantages 126 purpose 135

definition 123, 130 sales variances 154–6, 165
divisional performance measurement variable overheads element 136,
125–6, 128–9, 130 144–5
return on shareholders’ funds (RoSF) statement of financial position 173–4
126 assessing liquidity 179–81
revenue centres 121, 122 strategic management accounting 15–16
RI see residual income CIMA definition 15
ROCE see return on investment (ROI) definition 1, 19
ROI see return on investment (ROI) design of the system 16–17
RoSF (return on shareholders’ funds) techniques 10
126 versus traditional management
Ryanair: relevant management accounting 15
accounting information 19 subcontracting
make or buy decision with scarce
sales: limiting factors 25–8 resources 30–3
sales budget 85, 95, 117 relevant in-house or outsource (make
sales department: relevant management or buy) costs 28–30
accounting information 5 sunk cost 21
sales variances 154–6, 165 suppliers: working capital component
marginal costing 155–6, 170 176
SAP enterprise resource planning system
10 target costing
scarce resource see limiting factors approach to 65
senior management: relevant definition 65
management accounting information 5 distinct from cost-plus pricing 73–4,
service costing 42–3 76
absorption costing techniques 43–7 targets
life cycle costing 66–7 achievability 105, 106, 115–16
service organisations: activity-based engineered 104
costing (ABC) 52 historical 104
short-term pricing 65, 66 negotiated 104
special orders 35 taxation: international transfer pricing
social control 80, 81 211–16
special orders Tesco Steering Wheel 14
accept or reject decision 34–6 trade payables 174, 176, 177–8, 181–4
qualitative factors 40 management 197–8
standard cost payment period 197, 201
definition 134 trade receivables 174, 176, 177–8,
see also operating statement 181–4
standard cost card 167 management 191–4
definition 135 trade unions: users of management
standard costing 167–70 accounting information 4
benefits 158 transfer price: definition 203
direct labour element 136, 143–4 transfer pricing 202–19
direct materials element 136, 140–3 advantages 203
disadvantages 159, 171 best price 209–10
fixed overheads element 136, 145–51 decisions 204–6
key points of system 137 dual rate transfer price method 207–8
meaning 135–7 final and intermediate products 203,
people involved in standard setting 218
136 full cost transfer price 204

Index
international 211–16 favourable and adverse variances 139

marginal cost 208–10 links with budgets and control 137–9
marginal costs plus a lump sum fee sales variances 154–6, 165
method 208–9 traditional 12
market-based transfer price 203–4 see also cost variance
methods 203–6
negotiated transfer prices 207–9 withholding tax 212
purpose 218 work-in-progress inventory 185, 189
resolving conflicts 207–9 working capital 172–201
two-part system 208–9 amount necessary 178–9
cash component 175–6, 184, 194–6
uncontrollable factors 121–2, 131, 138 components 176, 185–98
understandability: management customer component 176
accounting information 5 definition 173
usage variance 140–3 inventory component 176, 177–8,
definition 140 181–91
users: management accounting meaning 173–4
information 4–6 supplier component 176
trade payables component 174, 176,
value chain 8–10 177–8, 181–4, 197–8
definition 8 trade receivables component 174,
variable costs 21 176, 177–8, 181–4, 191–4
variable production overhead variance working capital cycle 175–84, 201
144–5, 150, 151, 164 definition 175
variance analysis 82, 139–51 length 183, 199–200
definition 137

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Strategic Management

Unit 1 An introduction to strategic management

Unit 2 Relevant costs for decision making 20

Unit 3 Activity-based costing 41

Copyright © 2011 University of Sunderland iii

Unit 6 Management control systems and performance

iv Copyright © 2011 University of Sunderland

Unit 8 Working capital management 172

Unit 9 Transfer pricing 202

Copyright © 2011 University of Sunderland v

The information provided through management accounting can be used to

How to use this pack

vi Copyright © 2011 University of Sunderland

If you are on a self-study course, or studying independently with remote tutor

Overview of the units

Copyright © 2011 University of Sunderland vii

We provide a number of self-assessment questions at the end of each unit. These

viii Copyright © 2011 University of Sunderland

Copyright © 2011 University of Sunderland ix

‘In real life, strategy is actually very

Copyright © 2011 University of Sunderland 1

Unit learning objectives

1.1 The decision-making process

2. Search for alternative courses of action

3. Gather data about alternatives

4. Select alternative courses of action

5. Implemant the decisions

6. Compare actual and planned outcomes

7. Respond to divergences from plan

Figure 1.1: Traditional decision-making diagram.

2 Copyright © 2011 University of Sunderland

1. Identifying objectives: The first phase in the decision making, plan-

2. Identifying strategies: This stage involves asking what strategies a

3. Evaluating strategies: The company must review strategies which

4. Choosing alternative courses of action and coordinating them into a

5. Implementing the decision: This involves taking the actual courses of

6 and 7. Comparing actual and planned outcomes and responding to diver-

Copyright © 2011 University of Sunderland 3

strategy. In turn, decisions need to be taken on a daily basis to ensure opera-

1.2 Users of management accounting

User group Aims/objectives/vested interests

Customers Reliability of supply of an organisation’s products and/or

1a between the user groups of employees, junior/senior management and

1a would prefer summarised rather than detailed information, perhaps in a

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1b familiar, identify which functions of the organisation need to receive

accounting information. Give a brief example and assess which of these

You could argue that almost any function or department of an organisation

Features of management accounting information

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■ There is no legal requirement to prepare or disseminate management

1c product. What management accounting information do you require?

1c launching a new product or service:

1.3 The purpose of management

CIMA’s (The Chartered Institute of Management Accountants) official termin-

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1.4 The competitive environment

As a result of these various changes new management themes have emerged

Emerging management themes

The themes identified in Figure 1.2 are expanded upon below:

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Key success factors

Figure 1.2: Some key management themes.