BAE 322 MA Module

The University of Zambia
©
in association with
The Zambia Centre for Accountancy Studies
BACHELOR OF ACCOUNTING WITH EDUCATION
BAE (322)
MANAGEMENT ACCOUNTING
MODULE
3rd Year
Author: Saidi Kephas
Copyright
ALL RIGHTS RESERVED
No part of this publication may be reproduced, stored in a retrieval system, or
transmitted in any form or by any means, electronic or mechanical, including photocopying,
recording or otherwise without the permission of the Zambia Centre for Accountancy Studies.
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Contents
ALL RIGHTS RESERVED...........................................................................................................................ii
UNIT 1: BUSINESS ENVIRONMENT........................................................................................................8
1.0 INTRODUCTION.......................................................................................................................8
1.1 OPERATING ENVIRONMENT.................................................................................................9
1.2 REMOTE ENVIRONMENT.....................................................................................................13
1.3 PART B - ORGANISATION BACKGROUND AND THEORIES........................................16
1.3.1 AGENCY THEORY...........................................................................................................18
1.4 ACTIVITY................................................................................................................................19
1.5 UNIT SUMMARY....................................................................................................................20
UNIT 2: DECISION MAKING TECHNIQUES............................................................................................21
2.0 RISK AND UNCERTAINTY...............................................................................................................21
2.0.1 INTRODUCTION..................................................................................................................21
2.1 PROBABILITY.........................................................................................................................29
2.2 SENSITIVITY ANALYSIS......................................................................................................31
2.3 SIMULATION..........................................................................................................................35
2.4 UNIT SUMMARY....................................................................................................................40
UNIT 3: COST VOLUME PROFIT ANALYSIS...........................................................................................41
3.0 INTRODUCTION.....................................................................................................................41
3.1 UNIT QUESTIONS...................................................................................................................52
3.2 UNIT SUMMARY....................................................................................................................52
UNIT 4: LIMITING FACTOR ANALYSIS...................................................................................................54
4.0 INTRODUCTION.....................................................................................................................54
4.1 OPTIMUM PRODUCTION USING LINEAR PROGRAMMING DECISIONS.....................56
4.2 THE SIMPLEX METHOD.......................................................................................................63
4.3 THE LEARNING CURVE........................................................................................................69
4.4 UNIT SUMMARY....................................................................................................................75
UNIT 5: RELEVANT COSTS....................................................................................................................81
5.0 INTRODUCTION.............................................................................................................................81
5.1 UNIT QUESTIONS...................................................................................................................86

5.2 UNIT SUMMARY....................................................................................................................87
UNIT 6: BUDGETING AND BUDGETRY CONTROL.................................................................................90
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6.0 INTRODUCTION.............................................................................................................................90
6.1THE PURPOSE OF A BUDGET...............................................................................................91

6.1.2 APPROACHES TO BUDGETING....................................................................................93
6.1.2 DEALING WITH UNCERTAINTY IN BUDGETING.....................................................99
6.2 BEYOND BUDGETING........................................................................................................101
6.3 UNIT QUESTIONS.................................................................................................................104
6.4 UNIT SUMMARY..................................................................................................................105
UNIT 7: ADVANCED INVESTMENT APPRAISAL...................................................................................108
7.0 INTRODUCTION...........................................................................................................................108
7.1 SIMPLE PAYBACK PERIOD................................................................................................109

7.2 DISCOUNTED PAY BACK PERIOD....................................................................................110
7.3 MACAULAY DURATION.....................................................................................................112
7.4 ACCOUNTING RATE OF RETURN (ARR).........................................................................113
7.5 INTERNAL RATE OF RETURN (IRR).................................................................................113
7.6 DISCOUNTED CASH FLOW (DCF).....................................................................................114
7.7 NET PRESENT VALUE.........................................................................................................115
7.8 THE BLACK SCHOLES MODEL.........................................................................................120
7.9 INVESTMENT APPRAISAL AND REAL OPTIONS...........................................................122
UNIT 8: PERFORMANCE MASUREMENT............................................................................................129
8.1 PROFITABILITY...................................................................................................................130
8.2 LIQUIDITY RATIOS.............................................................................................................132
8.3 RETURN ON INVESTMENT (ROI) AT THE DIVISIONAL LEVEL..................................134
8.4 RESIDUAL INCOME (RI).....................................................................................................135
8.5 ECONOMIC VALUE ADDED (EVA)...................................................................................136
8.6 BALANCED SCORECARD...................................................................................................138
8.7 FITZGERALD AND MOON BUILDING-BLOCK MODEL................................................140
8.8 PERFORMANCE EVALUATION FOR NOT-FOR-PROFITS..............................................142
8.9 BENCHMARKING.................................................................................................................143
8.10 UNIT SUMMARY................................................................................................................143
UNIT 9: TRANSFER PRICING IN DIVISIONALISED COMPANIES...........................................................145
9.0 INTRODUCTION...........................................................................................................................145
9.1 CALCULATING A TRANSFER PRICE................................................................................147

9.2 TRANSFER PRICING METHODS........................................................................................149
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9.3 UNIT SUMMARY..................................................................................................................154
METHOD OF TEACHING
Three hours of lectures and one-hour tutorial per week.
ASSESSMENT
Continuous assessment 50%
2 tests of equal weight 30%
2 assignments of equal weight 20%
Final examination 50%

Total 100%
PRESCRIBED READING
1. BPP (2017 Paper P2 Advanced Management Accounting, 1st Edition. London: BPP
Learning Media.
2. BPP (2017) Paper F5 Performance Management, 6th Edition. London: BPP Learning
Media.
3. BPP (2017) Paper F9 Financial Management
RECOMMENDED READING
1. Atkinson, A. A., Kaplan, R. S., Matsumura, M. and Young, S. M. (2011). Management
Accounting: Information for Decision Making and Strategy Execution, 6th edition.
London: FT Prentice Hall.
2. Atrill, P. and McLaney, E. (2009). Management Accounting for Decision Makers, 6th
edition. London: FT Prentice Hall.
3. Drury, C. (2008). Management and Cost Accounting, 7th edition. Cengage Learning
EMEA.
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INTRODUCTION
The syllabus begins by introducing the business environment, both operating and remote for
you to understand factors which would affect an organisation internally or externally. The
module then considers decision making covering risk and uncertainty, sensitivity analysis and
the use of expected values. The module also covers the determination of optimum production
plan using the linear programming either graphical or simplex method. Determination of
relevant costs for one-off projects is also covered for short term decision-making.
Budgeting is an important aspect of many accountants’ lives. The module extensively
explores different budgeting techniques and the problems inherent in them.
Different methods of investment appraisal are well covered for your benefit for decision
making in projects evaluations.
The syllabus concludes with performance measurement and control. Accountants needs to
understand how a business should be managed and controlled. You should be to learn both
financial and non-financial performance measures in management. You should as well be
aware of the difficulties in assessing the performance in divisionalised businesses and the
problems caused by failing to consider external influences.
This is an advanced paper, it tests much more than your ability to perform calculations. It
requires calculations, application and advising on the course of action where necessary.
MODULE AIM
To develop knowledge and skills in the application and evaluation of management accounting
techniques to quantitative and qualitative information for planning, decision-making,
performance evaluation, and control.
OBJECTIVES
By the end of the course, students should be able to:
1. Describe both operating and remote business environment for organisations and the
role of the management accountant in multinational entities.
2. Assess and Evaluate decision-making techniques enhances competitive edge for
organisations to in any business sector.
3. Assess budget models and possible effects on the performance of an organisation.
4. Assess and Evaluate different pricing strategies for performance measurement.
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5. Evaluate capital decision with the use of the appropriate techniques and be in a
position to provide a professional judgment on company finances and possible
returns.
6. Analyse the performance and recommend measures of how best an organisation can
perform in a competitive business environment.
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UNIT 1: BUSINESS ENVIRONMENT
1.0 INTRODUCTION
Any business can be considered to have two environments depending on the
direction of impacts between the business and the elements within them. The two
environments are the operating environment and remote environment. The
distinctions and how the two environments impact on the business is explained below within
this unit.
Unit Aim
To learn the business environment in which the business is expected to be

conducted and properly assess on how the business can be successful.
Objectives
At the end of this unit, you should be able to analyse and differentiate between:
1. Operating environment and remote environments with examples.
2. Explain and discuss the Agency theory.
3. Discuss the concept of maximization of the shareholder’s wealth.
4. Evaluate and assess business models with respect to business dynamics in the industry
environment.
Time
You are expected to take approximately an hour to learn this unit.
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Reflection
In your own words, explain the importance of analysing the environment for
business purposes.
PART A
1.1 OPERATING ENVIRONMENT

In the business world, there is the operating environment, composed of elements that the
organisation can influence and those which influence the business.
Examples of such factors are as follows:
Supplier
A supplier provides raw materials to business. This is one of the significant factors of
business environment because of its direct bearing on business. In an event a supplier delays
to supply raw materials or stop to supply, production could be affected adversely.
So, to control this factor, it is imperative for the company to have good relations with more
than one supplier so that, if one stops or delays at one time, materials can be purchased from
other suppliers.
Customers
It may not be easy to maintain customers with one old product. Customers are those people or
companies which buy goods from our business. But time to time tastes of customers also
change. So, according to the taste of business customers, new products must be supplied by
business or rebranding of the old products to extend the existence of a business. Introducing
new products or adding life to old products would excite customers and trigger more sales.
Market Intermediaries
For promoting sales, it is required to advertise in different ways, so market intermediaries
could be effectively utilised. They include sales men and middle men.
This environment is under control of business because, if business starts selling with more
advertisements, sales will surely increase.
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Competitors
Competitors of an organisation also create internal business environment. According to
competitors, policies, business strategy can easily change in a bid to lure more customers.
Financial Intermediaries
In order to expand a business, more money would be needed for such growth. The company
has options on were to source money. It could be gotten through issuance of new shares or by
borrowing money from financial intermediaries. So, financial intermediaries play a vital role
in business environment. If they give out loans at relatively low rates, organisation could find
it easy to borrow and expand quickly. If interest rates are high, businesses will find it difficult
to borrow for fear of making losses.
1.10 Porter’s Five Forces
Note: diagram above - Adapted from M E porter, competitive strategy, free press, 1980
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While PESTEL (A model used to analyse macro-factors of an environment such as political,
ecological, social, technological, economic and legal) analysis focuses on broad
environmental factors, it ignores the specific industry that a company is operating within,
thus making it very difficult to understand our business position without considering industry
factors such as competitors, suppliers and customers. In this case, you need another model to
do this and that model is Porter's Five Forces. It is a business strategy model ever developed,
and consequently is also one of the key models you need to learn for your examinations.
This model can be used:
 To explain how profitable an industry is and helps to decide whether to enter or exit
the market.
 By firms operating in an industry to explain the forces impacting upon industry
profitability and change how they operate to become more profitable themselves.
Each of the forces is analysed to find the size of the force.
 If on balance the forces are high, the industry profitability is low, and the market
would not be a good one to enter.
 If the forces on balance are low, it is a profitable industry and a good one to enter.
The forces are as follows:
Competitive Rivalry
The force will be high and the industry less profitable when:
 there are a lot of competitors.

 there is little difference between the products.
 Competitors are strong (i.e. big, have financial support, economies of scale).
 there are exit barriers (e.g. high cost of leaving a market). That keep competitors in a
market they might otherwise leave.
Competitor analysis - Competitors can be analysed by asking the following questions:
 What are their objectives?

What are their strategies? (e.g. cost leadership, differentiation, market penetration,
product development etc.).
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 What are their strengths and weaknesses?).
 How will they react to our offensive moves (e.g. price cuts)?
 What threats do they pose?
Ultimately through understanding the competition the company can define a strategy which
will enable them to address any potential threats they may face and take advantage of any
weaknesses to ensure the company continues to be profitable. Competitor intelligence
(gaining information about competitors) and acting upon this is therefore a vital way to
remain profitable in a competitive environment.
Threat of new entrants
This relates to new companies entering the market that are not currently there. The force will
be high and the industry less profitable when:
 New companies can easily enter the market.

 New companies are likely to or intend to enter the market.
 It is harder to enter the market when there are significant barriers to entry
(factors which prevent new companies entering the market). These can include:
1. High costs of entry (e.g. production facilities, Information Technology)
2. Patents
3. Customer contracts in place.
4. Cost advantages of existing competitors are significant (e.g. due to scale of operation)
5. Strong brands amongst competitors.
Buyer Power
This is the ability customers have to drive prices down. The force is high and industry less
profitable when:
 Customers are large and provide a large proportion of company profits

 Customers can switch between competitors easily
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Supplier Power
Reflects how easily suppliers can drive up the price of goods and services. It is high and the
industry less profitable when:
 There are few alternative suppliers.

 Cost of changing suppliers is high.
Substitutes
Substitutes are products which fulfil the same needs as the needs met by the product in the
industry being examined. A substitute of cinema might be the theatre, DVD’s, sport or other
forms of entertainment.
Where customers can have their needs met from many different types of products, it becomes
easy for them to switch, if prices rise for instance.
This makes profitability in the industry low.
1.2 REMOTE ENVIRONMENT

The remote environment is composed of elements on which a separate business has no
significant influence but which may have key effects on operating environment and on the
business. The remote environment covers many factors originating beyond, and usually
notwithstanding of, any single firm’s operating situation—economic, social, political,
technological, and ecological factors.
Examples of remote or external environment

Economic Environment
Economic environment is the main element of business environment as it affects all factors of
business in following ways: -
Economic regulation
Different laws and regulations are at international level and national level. These are all
called economic regulations and organisations have to respect all of these while in operation
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Economic policies
Economic policies related to budget, industrial policy, fiscal policy, export and import policy
and business should see what changes are done in these and business has to change their
business policies according to these changes.
Natural environment
Natural environment is also external factor of business as no business can fully control on
natural environment. Seasons, , floods, earth quake are natural and happen according to
inherent fluctuations in it. Factors listed above have direct bearing on businesses and losses
could arise though, some losses from such factors could be transferred with effective schemes
of insurance.
Demo – graphic factors
Size of population and their growth rate have effect on business. Increasing trend of
population will increase demand of products and support business to produce more products.
But if death rate is increasing or demo graphic factor like religion are preventing to use the
products of business, a company should change strategies to meet such business dynamics.
Technological environment: -
This is fully concerned with changing of technology and its effect on products. Many
technical products are rapidly becoming obsolete with the increasing advent of new
technology. In such instances, a business also has to cover new products according to changes
in technology.
Political environment
Political environment is composition of three factors which are following
a) legislature
b) executive
c) judiciary
Factor listed above affects business. For businesses to be successful, they must come up with
strategies which do not conflict with the rules and regulation formulated by the government,
political rules and other necessary regulations.
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INTERNATIONAL ENVIRONMENT
PESTEL MODEL
To analyse effects of the above-mentioned factors, you can use the PESTEL model as a frame
work to provide an answer to any question on macro factors affecting business.
PESTEL is a mnemonic which stands for political, Economic, Social, Technological,

Environmental and legal. These are areas to consider on how current and future changes will
affect the business. Strategies can then be developed which address any potential
opportunities and threats identified.
Political
Political factors are how and to what extent a government intervenes in the economy, areas to
specifically consider as political factors are tax policy, labour law, environmental law, trade
restrictions, tariffs and political stability.
Political factors may also include goods and services which the government wants to provide
or be provided (merit goods) and those that the government does not want to be provided
(demerit goods). Furthermore, governments have great influence on the health, education,
and infrastructure of a nation.
Economic
Economic factors include economic growth, interest rates, exchange rates and inflation rates.
These factors have major impact on how businesses operate and make decisions. For
example, interest rates affect a firm’s cost of capital and an organization’s growth and
expansion rate.
Exchange rates affect the cost of exporting goods and the supply and price of imported goods
in an economy.
Social
Social factors include cultural aspects and include health consciousness, population growth
rates, age distribution, career attitudes and emphasis on safety. Trends in social factors affect
the demand for a company.
Technological
Technological factors include issues such as Research and Development activity, automation,
technology incentives and the rate of technological change. They can determine barriers to
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entry, minimum efficient production level and influence outsourcing decisions. Furthermore,
technological shifts can affect costs, quality, and lead to innovation.
Environmental
Environmental factors include ecological and environmental aspects such as weather, climate
and climate change, which may affect industries such as tourism, farming, and insurance.
Furthermore, glowing awareness of the potential impact of climate change is affecting how
companies operate and the products they offer, both creating new markets and diminishing or
destroying existing ones.
Legal
Legal factors include consumer law, health and safety law, discrimination law etc. Such
factors could affect how a company operates, and the demand for its products.
Which environment should be considered first?
Any environment could be considered first. The rationale for considering the operating
environment before the remote environment is that many features of the remote environment
are specific to the operating environment-and consequently to the business that’s the focus of
the analysis.
While the rationale for considering the remote environment first is that the analysis shouldn’t
start by concentrating solely on current activities. There are some factors in the remote
environment – Information Technology (IT) is a classic example that would affect all (or
almost all) organisations , and it is only by considering these first that the analysis can be
approached with an open mind enough to capture fully the consequences of these forces for a
business and lead to new thinking.
1.3 PART B - ORGANISATION BACKGROUND AND THEORIES

Strategic management
It would be important for you to learn some terminologies which would help you easily
comprehend the unit. Terminologies under consideration are strategic management, strategic
objective and strategic pathways.
Strategic management is the process of managing the mix of goals and strategic pathways
that serve to define what the organisation is (or wishes to be), where it’s going, when it wants
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to get there and how in general it is to get there. It also includes the processes of monitoring
and controlling the strategy of the organisation
Strategic objective
Where the organisation desires to go and when it needs to get there.
Strategic pathway
A pattern of schedules (the means) used to accomplish a strategic goal (an end).
Outlining the strategic pathways will provide guidance as to how the organisation means to
attain its strategic goals. An organisation might specify that it will proceed through internal
development rather than outsourcing- an important consideration to employees thinking of
spending a significant part of their working life with the company.
There are three classes of information used at different management levels of planning,
control and decision making:
Strategic planning- the process of deciding on objectives of the organisation, on changes on
these objectives, on resources used to attain these objective, and on the policies, that are to
govern the acquisition, used and disposition of these resources.
Management control- A management function aimed at achieving defined goals within an
established timetable, and usually understood to have three components:
(1) Setting standards,
(2) Measuring actual performance, and
(3) Taking corrective action. A typical process for management control includes the
following steps:
The procedure is done as follows:
1. Actual performance is compared with planned performance and the difference
between the two is measured,
2. Causes contributing to the difference are identified, and corrective action is taken to
eliminate or minimize the difference. Operational control- the process of assuring
that specific tasks are carried out effectively and efficiently
Operations
Operational control system is the subdivision of an organisation’s overall management
accounting and control system that focuses on short-term operational performance.
Operational control takes place when mid-level managers screen the activities of operating-
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level managers and employees. There are fundamentally two performance dimensions
covered by operational control systems: financial and non-financial.
Traditionally, financial control is achieved by likening actual to planned financial amounts.
Thus, budgets are useful in the financial-control course because they provide the standard
against which actual financial results are referred to as variances.
1.3.1 AGENCY THEORY
An agency, in general terms, is the relationship between two parties, where one is a principal
and the other is an agent who represents the principal in transactions with a third party.
Agency relationships occur when the principals hire the agent to perform a service on the
principals' behalf. Principals commonly delegate decision-making authority to the agents.
Agency problems can arise because of inefficiencies and incomplete information.
In finance, two important agency relationships are those between stockholders and managers,
and stockholders and creditors.
The theory thrives on assumptions about individuals as agents, listed in “Wilson and Chua”
1993) as follows:
a. They behave rationally in seeking to maximise their own utility
b. They seek financial and non-financial rewards
c. They tend to be risk averse and, hence reluctant to innovate.
d. Their individual interest will not always coincide with those of their principals.
e. They prefer leisure to hard work
f. They have more information about their operating performance and actions than is
available to their principal
Maximization of Shareholder’s Wealthy
This is the primary objective for every profit-making entity. The maximization of shareholder
wealth can be achieved through increase in dividends payable to shareholders and capital
gains arising from an improved share price. The sign of shareholders’ wealth is a company
ordinary share price. Since this reflects hopes about future dividend payments as well as
investor’s opinions about the long-term prospects of the company and its anticipated cash
flows. Therefore, the stand-in objective is to maximise the current market price of the
company’s ordinary shares and hence exploit the market value of the company.
Shareholders’ interests in an organisation are as follows:
I. Current earnings
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Earnings typically refer to after-tax net income. The primary factor that causes stock
prices to increase or decrease is the company's earnings. Investors use the financial earnings
of a company to determine its future value. A company's stock price typically increases when
it reports positive earnings and declines when it experiences a loss in net income. Earnings
are perhaps the single most studied number in a company's financial statements,
because they show a company's profitability compared to analysts estimates and
company guidance.
Earnings Manipulation
While earnings may appear to be the aim of performance measures, they can still be
influenced. Some companies intentionally manipulate earnings higher. Companies
with such inclinations are said to have a reduced or weak class of earnings. Earnings
per share can also be manipulated higher, even when earnings are down, with share
buybacks. Companies do this by repurchasing shares with retained earnings or debt.
II. Forthcoming earnings – earnings likely to be generated in the coming accounting
period.
III. Dividend policy
Dividend policy is the set of rules a company uses to resolve how much of its earnings
should be paid out to shareholders.
IV. The relative risk of investments compared to other investments and the return
available
1.4 ACTIVITY
1. Which environment should be considered first, the operating or the remote
environment?
2. In your own words, define the following terminologies:
a. Strategic management
b. Strategic pathway
c. Agency theory
d. Shareholder maximisation
Answers are provided at the end of the unit.
1.5 UNIT SUMMARY
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1. Business environment is divided into operating environment and remote environment.
Tentatively, remote environment is composed of elements which may not have
influence on a single entity but which may have a key effect on the operating
environment and on the business as a whole.
2. Strategic management is the process of managing the mix of goals and strategic
pathways that serve to define what the organisation is (or wishes to be), where it’s
going, when it wants to get there and how in general it is to get there.
3. In organisations, management play the role of agents on behalf of shareholders. They
are bestowed with the responsibility of managing the affairs of an organisation and
ultimately, through their own discretion, do everything feasible to maximise the
wealth of investors.
ANSWERS
1 In an environmental analysis it is not obvious which of the two environments should
be considered first: the operating environment and then the remote environment, or
vice versa. The rationale for considering the operating environment before the remote
environment is that many features of the remote environment are specific to the
operating environment – and consequently to the business that’s the focus of the
analysis. The logical progression is from the organisation to its operating environment
to the remote environment. This line of reasoning emphasises current activities and
supports a market-led approach to strategy.
The rationale for considering the remote environment first is that the analysis
shouldn’t start by concentrating solely on current activities. There are some factors in
the remote environment such as Information Technology (IT). IT is an obvious
example – that will affect all (or almost all) businesses, and it is only by considering
these first that the analysis can be open-minded enough to capture fully the
consequences of these forces for the business and lead to new thinking.
The next unit covers the consideration of risk and uncertainty in decision
making.
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UNIT 2: DECISION MAKING TECHNIQUES
2.0 RISK AND UNCERTAINTY
2.0.1 INTRODUCTION
Clearly, risk is always a major variable in real-world corporate decision-making,
and managers overlook its chances at their peril. Similarly, do not fall into the
same trap of ignoring its changes, instead, you should have an ability to identify the presence
of risk and incorporate appropriate adjustments into the problem-solving and decision-
making scenarios encountered in the examination.
In this unit, you will learn about:
1. Risk and uncertainty and risk preferences or attitudes towards risk
2. Decision making methods
3. Probability in decision making
4. Independent and conditional events
5. decision trees
6. Sensitivity analysis
7. simulation
Aim
To enable you develop a comprehensive analysis of project evaluation in a more
objective manner and help to budget adequately.
Objectives
At the end of this unit, you should be able to:
1. explain various ways of assessing risk and uncertainty

2. Describe and analyse the use of sensitivity analysis under risk and uncertainty
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3. Explain the use of learning curves in decision making
4. evaluate the effective use of decision trees in decision making.
5. Assessment of projects using probabilities
Time: You are expected to take about 2 hours to study this unit
Reflections
Consider appraising a project without factoring in the risks which could be
expected. Do you think results from such an appraisal could be reliable to
make a decision upon?
Risk
Risk is when the probabilities of the possible outcomes are known (such as when tossing a
coin or throwing a dice). Or you can think of risk as a quantification of probability. In other
words, it is susceptible to measurement, statistically or mathematically.
Example 1
Based on past experience of digging for oil in a particular area, an oil company
may estimate that they have a 70% chance of finding oil and a 30% chance of not
finding oil.
Uncertainty
Uncertainty occurs when there are a number of possible outcomes but the probability of each
outcome is not known.
Example 2
The same oil company may dig for oil in a previously unexplored area. The
company knows that it is possible for them to either find or not find oil, but it
does not know the probabilities of each of these outcomes.
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In the artificial scenarios of examination questions, potential outcomes and probabilities will
generally be provided; therefore, knowledge of the basic concepts of probability and their use
will be expected.
Use of research techniques to reduce uncertainty
Market research is an important means of assessing and reducing uncertainty. For example,
about the likely responses of customers to new products, new advertising campaigns and
price changes.
Below are methods of research techniques available:
Focus groups
Focus groups are a common market research tool involving small groups (typically eight to
ten people) selected from the broader population. The group is interviewed through
facilitator-led discussions in an informal environment in order to gather their opinions and
reactions to a particular subject.
For example, a supermarket may use a focus group before a product launch decision is made
in order to gather opinions on a new range of pizzas.
Problems with focus groups
 Results are qualitative.

 The small sample size means that results may not be representative.
 Individuals may feel under pressure to agree with other members or to give a 'right'
answer.
 Their cost and logistical complexity is frequently cited as a barrier, especially for
smaller companies. On-line focus groups are becoming more popular and help to
address this issue.
Desk research
The information is collected from secondary sources.
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 It obtains existing data by studying published and other available sources of
information. For example, press articles, published accounts, census information.
 It can often eliminate the need for extensive field work.
Factors to consider when using desk research:
1. It may not be exactly what the researcher wants and may not be totally up to date or
accurate.
2. However, it is quicker and cheaper than field research.
Field research
Information is collected from primary sources by direct contact with a targeted group.
1. Although it is more expensive and time consuming than desk research. The results
should be more accurate, relevant and up to date.
2. There are two types of field research:
Motivational research
- Measurement research.
RISK PREFERENCES
Managers have different attitudes towards risk. The direction for decision making will
depend on the decision-makers attitude to risk.
(a) A risk seeker will be interested in the best possible outcome, no matter how small the
chance of occurring.
(b) Risk neutral will be concerned with the most likely or ‘average’ outcome.
(c) A risk averse manager makes decisions on the basis of the worst possible outcomes
that may occur.
DECISION METHODS
(a) Maximin decisions.
This is a decision rule which maximise the minimum return of each decision and is usually
utilised by a manager who is risk averse.
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(b) Criticisms of Maximin
• Ignores the probability of each outcome occurring.
• Is conservative (doesn’t try to maximise profit).
Follow the steps outlined below to evaluate Maximin decisions

1. Find out the minimum payoff for each of the strategies.
2. Select the maximum out of the minimum payoffs for each strategy as identified in
step 1 the payoff thereby selected is the maximum out of the minimum payoffs i.e.
Maximin.
3. Identify the strategy corresponding to the Maximin payoff.
Example
The following information is given
The committee of a new golf club is setting the annual membership fee. The
number of members depends on the membership fee charged and economic
conditions. The forecast annual cash inflows from membership fees are shown below.
Membership level Membership level Membership level
Membership fee Low Average High
K6000 360,000 480,000 540,000
K8000 400,000 440,000 480,000
K9000 360,000 405,000 495,000
K1000 320,000 380,000 420,000
If the maximin criterion is applied the fee set by the committee would be:
A K600
B K800
CK900
D K1, 000
Answer is B
This is looking at the best of the worst-case scenarios.
The minimum outcome for a fee of K600 is K360, 000
25
The minimum outcome for a fee of K1, 000 is K320, 000
Therefore, if the committee wants to maximise the minimum cash inflow it will set a fee of
K800.
Maximax decisions
Aim for the best possible return and this decision rule is utilized by risk seeking decision
maker.
(a) Criticisms of Maximax

 Ignores the probability of each outcome occurring.
 Is overly optimistic.
(b) Follow the steps outlined below
 Find out the maximum payoff for each of the strategies.
 Select the maximum out of the maximum payoffs for each strategy as identified in
step 1. The payoff thereby selected is the maximum out of the maximum payoffs i.e.
Maximax.
4. Identify the strategy corresponding to the Maximin payoff.
Example
MICMAR Co is a manufacturer of baby equipment and is planning to launch a
revolutionary new style of sporty pushchair. The company has commissioned
market research to establish possible demand for the pushchair and the following
information has been obtained.
If the price is set at K425, demand is expected to be 1,000 pushchairs, at K500 it will be 730
pushchairs and at K600 it will be 420 pushchairs. Variable costs are estimated at K170, K210
or K260. A decision needs to be made on what price to charge.
Required
(a) Produce a table showing the expected contribution for each of the nine possible outcomes.
(4 marks)
(b) Explain what is meant by Maximax and Maximin rules, using the information in the
scenario to illustrate your explanations. (10 marks)
26
Answer
Price Price Price

Variable costs K425 K500 K600
K170 K255,000 K240,900 K180,600
K210 K215,000 K211,700 K163,800
K260 K165,000 K175,200 K142,800
Workings
(1) (425 - 170) ×1,000 = K255, 000
(2) (425 - 210) × 1,000 = K215, 000
(3) (500 - 170) × 730 = K240, 900
2.20 (b) Maximax
The Maximax criterion looks at the best possible results. Maximax means 'maximise the
maximum profit'.
In this case, we need to maximise the maximum contribution.
Demand/price Maximum contribution
1,000/K425 K255, 000
730/K500 K240, 900
420/K600 K180, 600
MICMAR would therefore set a price of K425.

Minimax regret decision rule
'Regret' means opportunity cost from making the wrong decision.
27
The decision rule chooses the option which minimises the maximum opportunity cost from
making the wrong decision.
2.22 Follow the steps outlined below
1. For each of the strategies of nature find out the regret.

2. Regret = maximum payoff for a state of nature – (minus) payoff for the
strategy
3. From the regret table, find out the maximum regret for each strategy
4. Select the minimum from the maximum regret selected above – Minimax regret
5. Select the strategy corresponding to the Minimax regret rule.
Minimax regret rule
Variable costs Price price Price
K425 K500 K600
K170 K0 K14,100 K74,400

K210 K0 K3, 300 K51, 200
K260 K10, 200 K0 K32, 400
Minimax regret K10, 200 K14, 100 K74, 400

Minimax regret strategy (price of K425) is that which minimises the maximum regret (K10,
200).
Workings
1 At a variable cost of K170 per day, the best strategy would be a price of K425. The
opportunity loss from setting a price of K600 would be K (255,000 – 180,600) = K74, 400.
2 At a variable cost of K210 per day, the best strategy would be a price of K 425. The
3 At a variable cost of K260 per day, the best strategy would be a price of K500. The
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2.1 PROBABILITY
The term ‘probability’ refers to the likelihood or chance that a certain event will occur, with
potential values ranging from 0 (the event will not occur) to 1 (the event will definitely
occur). For example, the probability of a tail occurring when tossing a coin is 0.5, and the
probability when rolling a dice that it will show a four is 1/6. The total of all the probabilities
from all the possible outcomes must equal 1, that is, some outcome must occur.
Independent and conditional events

An independent event occurs when the outcome does not depend on the outcome of a
previous event. For example, assuming that a dice is unbiased, then the probability of
throwing a five on the second throw does not depend on the outcome of the first throw.
In contrast, with a conditional event, the outcomes of two or more events are related,
that is, the outcome of the second event depends on the outcome of the first event.
For example, in the Table below, the company is forecasting sales for the first year of the
new product. If, subsequently, the company attempted to predict the sales revenue for the
second year, then it is likely that the predictions made will depend on the outcome for year
one.
If the outcome for year one was sales of K1,500,000, then the predictions for year two are
likely to be more optimistic than if the sales in year one was K500,000.
Sales 800, 000 1000, 000 1,300,000 1,550, 000 1, 800,000

probability 0.1 0.2 0.4 0.2 0.1
From the table above, it is clear that the most likely outcome is that the new product
generates sales of K1,300,000, as that value has the highest probability.
Illustration
A company is considering investing in a new project. The following table shows

the project’s estimated cash inflows and cash outflows, together with their
associated probabilities. The cash inflows and cash outflows are totally
independent.
Cash Inflows Cash Outflows
29
K Probability K Probability
120,000 0.30 50,000 0.25
140,000 0.45 60,000 0.35
160,000 0.25 70,000 0.40
Calculate the probability of net cash flows being K90, 000 or greater.
Answer is 36.25%
You need to work out the probability of earning net cash flows K90, 000 or more. Therefore,
select those outcomes which will yield this and select their respective probabilities. The
combinations which will comply are:
Cash inflow Probability Cash outflow Probability Combined

probability
K140, 000 0.45 50, 000 0.25 0.45 ×0.25 =
0.1125
K160, 000 0.25 50, 000 0.25 0.25× 0.25 =
0.0625
K160, 000 0.25 60, 000 0.35 0.25 × 0.35
= 0.0875
K160, 000 0.25 70, 000 0.40 0.25 × 0.40
= 0.1
TOTAL 0.36.25
P (earning net cash flows of K90,000 or more) = 0.3625 or 36.25%
Quantitative methods of incorporating risk and uncertainty
In addition to the research techniques discussed, the following methods can be used to
address risk or uncertainty.
30
2.2 SENSITIVITY ANALYSIS.
Sensitivity analysis is a method used to incorporate uncertainty in decision making by taking
each uncertain factor in turn, and calculates the change that would be necessary in that factor
before the original decision is reversed. Typically, it involves posing 'what-if' questions.
By using this technique, it is possible to know which estimates (variables) are more critical
than others in affecting a decision.
The process is as follows:
1. Best estimates for variables are made and a decision arrived at.
2. Each of the variables is analysed in turn to see how much the original estimate can
change before the original decision is reversed. For example, it may be that the
estimated selling price can fall by 5% before the original decision to accept a project
is reversed.
3. Estimates for each variable can then be reconsidered to assess the likelihood of the
estimate being wrong. For example, what is the chance of the selling price falling by
more than 5%?
4. The maximum possible change is often expressed as a percentage. This formula only
works for total cash flows. It cannot be used for individual units, selling prices,
variable cost per unit, etc.
The aim of this component is to:
1. Analyze risks surrounding capital projects.

2. Assess the responsiveness of project’s NPV to changes amongst the variables
involved in the calculation of NPV.
Use the formulas below to calculate the sensitivity
31
Sensitivity analysis = NPV of a project X 100%
PV of the variable
Example
A company is considering a project with the following cash flows:

Year initial investment variable costs cash inflows net cash flows
K’000 K’000 K’000 K’000
0 15,000
1 (4,500) 9,300 4,800
2 (4,500) 9,300 4,800
Cash flows arise from selling 1,030,000 units at K10 per unit. The company has a cost of
capital of 10%
Required
(a) Calculate the NPV of the project.
(b) Measure the sensitivity of the project to changes in selling price.
Solution
1. NPV calculation
Year Cash flows Cash Discount factor PV of PV of cash PV of net/C-

Flows
In flows @10% V/ costs inflows
0 (8, 000) 1.000

(8,000)
1. 4,500 9,300 0.909 4,091 8454 4,363
2. 4,500 9300 0.826 3717 7,682 3,965
7808 16136 328

(B) Sensitivity to variable cost
Sensitivity analysis = NPV of a project × 100%
PV of the variable
= 328
32
7,808 × 100% = 4.2%
Calculating sensitivity to cost of capital uses the following formula.

Sensitivity analysis = IRR – Cost of capital
Cost of capital
Where;
IRR is the internal rate of return. This is the rate at which net present value would be zero
(0)
The calculation is done through trial and error. It can either be by interpolation or by
extrapolation. With interpolation, your intention is to capture the rate that might give you
zero net present value (NPV). You have to guess two different rates hoping one would give
you a positive NPV and the other a negative NPV. If it happens that you have both positive
and negative net present values, the approach will be called interpolation because you have
managed to work with a range within which IRR would be expected to be falling. If both
rates you guessed to discount cashflows, give you both positive NPV’s, the approach
becomes extrapolation and you just have to proceed with the formula given below.
The steps in linear interpolation are:
(1) Calculate two NPVs for the project at two different costs of capital
(2) Use the following formula to find the IRR:
Where:
L = Lower rate of interest
H = Higher rate of interest
NL = NPV at lower rate of interest
NH = NPV at higher rate of interest.
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Task 1
A project with a five-year life requires an initial investment of K120, 000 and
generates a net present value (NPV) of K50, 000 at a discount rate of 10% pa.
The project cash flows are as follows:
K000 pa
Variable material cost 30
Variable labour cost 10
Incremental fixed cost 5
The costs and activity levels are expected to remain the same for each year of the project. The
sensitivity of the investment decision to changes in the variable costs is:
A 131.9%
B 44.0%
C 33.0%
D 29.3%
Answer
K40, 000 x 3.791 = K151, 640
K50, 000 / K151, 640 = 0.3297 = 33.0%
The correct answer is C.

Advantages
1. Simple to understand
2. It identifies areas which are crucial to the success of the project. If the project is
chosen, those areas can be carefully monitored.
3. It influences management to make contingent plans, if the project is highly
susceptible to change for a factor critical to it.
Disadvantages
1. It assumes that changes to variables can be made independently, e.g. material prices
will change independently of other variables
2. It only identifies how far a variable need to change; it does not look at the probability
of such a change.
3. It provides information on the basis of which decision can be made but it does not
point to the correct decision directly
34
2.3 SIMULATION
This is a quantitative technique that uses computerized mathematical models for decision-
making under conditions of uncertainty, by evaluating alternative courses of action based on
the facts and assumptions. It shows the effect of more than one variable changing at the same
time.
It is often used in capital investment appraisal.
1. It is not a technique for making decision, only for obtaining more information about
the possible outcome.
2. Models can become extremely complex.
3. Probability distributions may be difficult to formulate.
Example
The Mutale Organisation is an independent film production company. It has a

number of potential films that it is considering producing. One of which is the
subject of a management meeting next week.
The expected revenues from the film have been estimated as follows: there is a
 30% chance it may generate total sales of K254, 000;

 50%chance sales may reach K318, 000 and
 20% chance they may reach K382, 000.
Expected costs (advertising, promotion and marketing) have also been estimated as follows:
there is a
 20% chance they will reach approximately K248,000;

 60% chance they may get to K260,000 and
 20 %chance of totalling K272, 000.
In a Monte Carlo simulation, these revenues and costs could have random numbers assigned
to them as follows:
Sales Revenue Probability Assign Random Numbers

(Assume integers)
K254, 000 0.30 00-29
35
K318,000 0.50 30-79
K382, 000 0.20 80-99
Costs
K248,000 0.20 00-19
K260, 000 0.60 20-79
K272,000 0.2 80-99
A computer could then generate 20-digit random numbers such as 98125602386617556398.
These would then be matched to the random numbers assigned to each probability and values
assigned to 'Sales Revenues' and 'Costs' based on this.
The random numbers generated give 5 possible outcomes in our example:
Random sales revenue in Random costs in Profit
Number K’000 Number K’000
98 382 12 248 134
56 318 02 248 70
38 318 66 260 58
17 254 55 260 (6)
63 318 98 272 46
Note that simulation has not generated a decision, but has given management more
information.
Making a decision
36
Suppose a business is choosing between two projects, project A and project B.
It uses simulation to generate a distribution of profits for each project as follows.
Which project should the business invest in?
 Project A has a lower average profit but is also less risky (less variability of possible
profits).
 Project B has a higher average profit but is also riskier (more variability of possible
profits).
 There is no correct answer. All simulation will do is give the business the above
results. It will not tell the business which is the better project.
 If the business is willing to take on risk, they may prefer project B since it has the
higher average return.
 However, if the business would prefer to minimise its exposure to risk, it would take
on project A. This has a lower risk but also a lower average return.
Disadvantages of simulation
There are major drawbacks of simulation:
 It is not a technique for making a decision, only for obtaining more information about
the possible outcomes.
37
 Models can become extremely complex.
 The time and costs involved in their construction can be more than is gained from the
improved decisions.
 Probability distributions may be difficult to formulate.
EXPECTED VALUES
Definition.
An expected value is a weighted average of all possible outcomes. It calculates the average
return that will be made if a decision is repeated again and again.
In other words, it is obtained by multiplying the value of each possible outcome (x) by the
probability of that outcome (p), and summing the results.
Where there is uncertainty and a range of possible future outcomes has been quantified (for
example, best, worst and most likely) probabilities can be assigned to these outcomes and a
weighted average (expected value) of those outcomes calculated.
The formula for the expected value is EV = ∑ PX where
p is the probability of the outcome occurring and
x is the value of the outcome (profit or cost).
When you are faced with a number of alternative decisions, chose the one with the highest
EV.
Example
A company is considering whether to develop and market a new product. The cost
of developing the product is estimated to be K150, 000. There is a 70%
probability that the development will succeed and a 30% probability that the
development will be unsuccessful.
If the development is successful the product will be marketed. There is a 50% chance that the
marketing will be very successful and the product will make a profit of K250, 000. There is a
30% chance that the marketing will be reasonably successful and the product will make a
profit of K150, 000 and a 20% chance that the marketing will be unsuccessful and the
product will make a loss of K80, 000. The profit and loss figures stated are after taking
account of the development costs of K150, 000.
The expected value of the decision to develop and market the product is:
A K154, 000
38
B K4, 000
C K107, 800
D K62, 800
The expected value of the decision:
EV of development succeeding + EV of development not succeeding
If development is successful then the company will market the product and therefore we need
to work out the EV of marketing success.
Marketing success rate EV
Very (250,000 x 0.7 x 0.5) = K87,500

Reasonably (150,000 x 0.7 x 0.3) = K31,500
Unsuccessful (-80,000 x 0.7 x 0.2) = -K11,200
Total EV of marketing K107,800
If development is unsuccessful then we need to work out the EV of development costs only.
This is because there will be no expenditure on marketing for an unsuccessful development.
The expected value of the development costs = -K150, 000 x 0.3 = -K45, 000
The EV of the decision = K107, 800 + -K45, 000 = K62, 800
2.4 UNIT SUMMARY

• Risk is where a decision-maker has past experience. With uncertainty,
there is no past experience.
• There are three types of risk preference.
(a) Risk seeker – optimist, (b) Risk verse – pessimist and (c) Risk neutral –
uses expected values
 Expected values are calculated as Σ px.
 An independent event occurs when the outcome does not depend on the outcome
of a previous event.
 Sensitivity analysis is a “what-if” technique that measures how the expected values in
a decision model will be affected by changes in the critical data inputs.
39
 Simulation is a quantitative technique that uses computerized mathematical models
for decision-making under conditions of uncertainty, by evaluating alternative courses
of action based upon the facts and assumptions.
The next unit you are expected to read deals with the analysis of the inter-relationship which
exist between costs, quantity and expected profits, popularly known as CVP analysis.
UNIT 3: COST VOLUME PROFIT ANALYSIS
3.0 INTRODUCTION
Cost volume profit (CVP) analysis is often used when providing information in
financial reports for management. It is a relatively easy technique used to
estimate profits and make decisions about the best course of action to take. CVP involves
calculating break-even point which is the activity level at which there is neither profit nor
loss. Therefore, CVP is often referred to as break-even analysis.
Aim:
To use CVP tools and enhance decision making in a business setting.
Objectives:
1. Calculate Break-even point.
2. Calculate Contribution/sales ratio.
3. Calculate Margin of safety.
4. Calculate sales volume were Target profit is expected to be achieved.
5. Apply CVP to situations involving both single and multiple products.
6. Prepare and interpret break-even and profit/volume charts.
7. Describe the assumptions upon which break-even analysis thrives.
40
Time
8. You should take at least 2 hours to read this unit.
Reflection
In your own words, explain how you can know the number of units to be
sold for you to recover your fixed costs.
Explain the inter-relationship that exist between costs volume and profit.
Cost volume profit (CVP) Break-even analysis is the study of the interrelationships
between costs, volume and profit at various levels of output. Managers need to estimate
future revenues, costs, and profits to help them plan and monitor operations. They use cost-
volume-profit (CVP) analysis to identify the levels of operating activity needed to avoid
losses, achieve targeted profits, plan future operations, and monitor organizational
performance. Invariably, cost volume profit analysis is break-even analysis.
Basic computations on break-even analysis
Contribution per unit = unit selling price – unit variable costs.
Break-even point = activity level at which there is neither profit nor loss and is calculated as
BEP = Total fixed cost
Contribution per unit
Example 1
GK Limited has fixed costs of K60, 000 per annumn. It manufactures a single
product which it sells for K20 per unit. Its contribution to sales ratio is 40%. GK’s
break-even point in units is:
A 1200
B 1800
C 3000
D 7500
Solution to example 1
41
Contribution per unit = 40% × K20 = 8
BEP = Fixed cost 60
Contribution per unit 8 = 7,500 units
Contribution to sales ratio (C/S) ratio = profit = Contribution

Volume Sales x 100%
Sales revenue at break-even point = fixed costs

C/S ratio
Example
Trade kings makes a product which sells for K50 a unit and has a contribution to
sales ratio of 60%. Given that overhead is K400, 000, the volume (to the nearest
unit) to achieve a target profit of K200,000 would be:
400,000 + 200,000 = 1000 units.
0.6
= 1000, 000/0.6 = 20,000 units.
Sales volume to achieve a target profit = Fixed cost + target profit
Contribution per unit
Margin of Safety.
The margin of safety is the excess of an organization’s expected future sales (in either
revenue or units) above the break-even point. The margin of safety indicates the amount by
which sales could drop before profits reach the break-even point
Margin of safety in units = Actual or estimated units of activity - Units at break-even
Point.
Margin of safety in revenues = Actual or estimated revenue - Revenue at break-even
Point.
3.16 Assume for example that the company budgets to sell 15,000 units of Product M.
Its margin of safety would be calculated as follows:
Margin of safety = 15,000 - 10,000 = 5,000 units;
42
In terms of sales revenue, this is 5,000 x K25 = K125, 000;
As a percentage of the budget, this is (5,000 units / 15,000 units) x 100 %, i.e. 33.3%
Contribution to sales ratio.
The C/S ratio (also confusingly known as the PV ratio) is normally expressed as a percentage.
It is constant at all levels of activity. The C/S ratio reveals the amount of contribution that is
earned for every K1 worth of sales revenue. The following formula is therefore used:
Contribution to sales ratio (C/S) ratio = profit = Contribution

Volume Sales x 100%
For Product ‘M’ above, the C/S ratio can be calculated as K5/K25, or 20%.
TASK 1 Company F makes a single product which it sells for K2 per unit. Fixed costs are
K13, 000 per month. The C/S ratio is 40%. Sales revenue is K62, 500
What is the Margin of Safety?
Assumptions
 Can only apply to one product or constant mix.

 Fixed costs are same in total and unit variable costs same at all levels of output.
 Sales prices are constant at all levels of activity.
 Production = sales.
You should learn how to draw break even chart from both traditional point of view and from
the marginal point of view.
The accountant’s model.
Make reference to the diagram below:
43
I. Draw the axes (“x” and “y”) and label them.
II. Draw the fixed cost line and label it. This will be a straight-line parallel to the
horizontal axis.
III. Draw the total costs and label it. The best way to do this is to calculate the total costs
for the maximum sales.
IV. Draw the revenue line and label it (start by plotting the revenue at the maximum
activity level and join it to the origin.
V. Mark any required information on the chart and read off solutions as required.
VI. Check the accuracy of your readings using arithmetic.
3.22 Break-even point graph from the Accountants point of view
The economist‘s break-even chart
The economist’s break-even chart employs non-linear relationships and shows two break-
even points. More correctly this is a chart showing the point of profit maximisation.
 The 2nd BEP is at a point where declining total revenues equal increasing combined
costs.
 BEP No 1 is similar, but not exactly equivalent, to the single BEP.
 The cost line shows economies of scale at first, then turns upwards as diminishing
returns set in.
 The revenue line curves downwards on the assumption that selling prices will have to
be reduced to increase sales volume.
44
3.24
3.25 Profit /volume

(P/V) Chart
The intercept K40 indicated on the graph is the fixed cost. When you start selling and
increase sales, you be coming out of losses to meeting a point where you will neither make
losses nor a profit (break-even point). When you sell more, than what can break-even, you
start making profits.
45
Calculation of break-even point for multiple products
The break-even point (in number of mixes) for a standard mix of products is calculated as
Fixed costs
Average Contribution per unit.
Consider the following steps.

Calculate:
1. contribution per unit and the weighted average per unit.
2. Break-even point in units.
3. breakeven point in terms of revenue.
Example
Saidi K. produces and sells two products. The G sells for K10 per unit and has a
total variable cost K4.00 per unit, while the H sells for K15 per and has total
variable cost of K5.00 per unit. The marketing department has estimated that for
every 3 units of G sold, 1 unit of H will be sold. The organisation’s fixed cost total K50, 000
Calculate the break-even point for SK.
Solution
Step 1
Calculate weighted average contribution per unit.
G H
K per unit K per unit
Sales price 10. 00 15. 00
Variable cost 4. 00 5. 00
Contribution 6.00 10.00
Contribution from sale of 3 units of G (6 ×3) = 18.00
Contribution from sale of 1 unit of H (10 ×1) = 10.00
Contribution from sale of 7 units in standard sales mix 28.00
Weighted average contribution per unit = K28.00 /4 = 7
Step 2
Calculate break-even point in units.
Fixed costs/ weighted average contribution per unit.
46
= K50, 000/7
7143 units; these are in the ratio 3: 1 therefore break-even is at the point where ¾ ×7143 =
5357 unit of G are sold and ¼ ×7143 = 1786 units of H are sold.
Step 3
Calculate the break-even point in sales revenue.
G - 5357 ×10 = K53, 570
H - 1786 ×15 = K26, 790
Total K80, 360
Contribution to sales (C/S) ratio.

Alternatively, you can use contribution to sales ratio C/S ratio for multiple
products.
Using the same information from the question above, BEP can be calculated as
follows:
Calculate:
 Calculate weighted average contribution per unit.
 Calculate break-even point (total).
 Step 3 calculate break-even sales for each product.

Step 1
Calculate revenue and contribution per mix of 3 units of G and I unit of H
Contribution Revenue
Per unit Total Per unit Total
K K K K
Product G (3 units) 6.00 18.00 10 30
Product H (1 units) 10 10.00 15 15
28.00 45.00
Weighted average C/S ratio = K 28.00/ 45.00 = 0.6222222
Step 2
Calculate break-even point (total).
= fixed cost / weighted C/S ratio = K50, 000/ 0.6222222 = K80, 357 in sales revenue.
Step 3 calculate break-even sales for each product
G = ¾ × 80, 357 = K60, 268
47
In units 60,268/ 10 = 6, 026 units
H = ¼ × 80, 357 = K 20, 089
In units = K20, 089/ 15 =1339 Units
Note: the difference on the BEP in total from the two approaches is as a result of rounding
offs.
Graphical CVP Analysis (Multiple – product)

Our analysis so far has assumed a single – product setting. However, most firms produce and
sell many products or services. You need to learn how to determine the number of each
product or service to be sold for you to break even.
Two assumptions can be used to draw break-even chart.
1. If a company could be able to sale first a product with the highest contribution to sales
ratio.
2. Constant mix (Whenever X units of product A are sold, Y units of product B and Z units of
product C are sold also.
By assuming a constant sales mix for the products, we can calculate a weighted average
contribution per unit sold. The weighting is based on the quantities or proportions of each
product in the constant sales mix.
When considering output decisions (e.g. how many units to make and sell) in the short term,
then decision making often focuses on contribution. This component considers how to apply
cost volume profit analysis to scenarios with more than one product.
STEP 1: Calculate the C/S ratio of each product being sold, and rank the products in order of
profitability.
STEP 2: Draw the graph, showing cumulative sales on the x-axis. For example, if we assume
3 products X, Y and Z, then the following graph could be drawn, with 'V' representing the
total sales. At an output of 0, the profit earned will amount to the company's fixed costs,
represented by point k on the chart.
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STEP 3: Draw the line km, that represents the profit earned by product X. The slope of the
line is determined by the contribution per unit earned on sales of that product.
STEP 4: Draw the line mn, that represents the profit earned by product y, which has a lower
contribution per unit than product X. The line nj is the profit earned by the least profitable
product, product Z.
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STEP 5: Draw the line joining points k and j:
3.35 It reflects the average profitability of the three products, and each point on that line
represents the profit earned for the associated output, assuming that the three products are
sold in the standard product mix, i.e. the mix implied in the construction of the chart.
Accordingly, the indicated break-even point only applies if the products are sold in the
standard product mix.
It can also be seen that break-even can also occur at lower levels of output, provided the
proportions of the products are changed. For example, the point B where the
line kmnj crosses the horizontal axis indicates a possible break-even point.
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The multi-product PV chart therefore helps to identify the following:
1. the overall company break-even point.
2. Which products should be expanded in output and which, if any, should be discontinued.
3. What effect changes in selling price and sales volume will have on the company’s break-
even point.
3.1 UNIT QUESTIONS

Company YZ manufactures Products L, M and N. These products are always sold
in the ratio 9L:6M:5N.
The budgeted sales volume for December is a total of 14,000 units. The budgeted
sales volumes,
selling price per unit and variable cost per unit for each of the products are shown below:
L M N
Sales budget (units) 6,300 4,200 3,500
K K K
Selling price per unit 300 600 230
Contribution per unit 200 300 180
The budgeted fixed costs of the company for December are K2.7 million and the total
budgeted profit after fixed costs is K450,000.
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Calculate the number of units of each product that must be sold for Company YZ to break
even in December given the current sales mix ratio.
3.2 UNIT SUMMARY

There are many ways of calculating BEP. Different formulas to calculate
break-even point could be used depending on the information provided. Both
in a single product environment set-up and multiple product environment set-
up, it is important to know how to determine BEP either using formulas or
through graphical illustrations as presented in this unit.
ANSWERS
Unit task 1
Consider a ‘bundle’ of products in the mix 9L:6M:5N
L M N TOTAL
Sales mix 9 6 5 1 Bundle
Selling price per unit 300 600 230
Contribution per unit 200 300 180
Total contribution in bundle 1,800 1,800 900 4,500
Number of bundles needed to break even = 2,700,000/4,500 = 600
Therefore, the sales plan to break even = (600 ×9) = 5,400 L, (600 × 6) = 3,600M (600 ×5) =
3000N.
The next unit you will be learning will equip you with knowledge on how to produce the
best combination of products from limited resources.
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UNIT 4: LIMITING FACTOR ANALYSIS
4.0 INTRODUCTION
Marginal costing supports other management accounting techniques. Limiting-
factor analysis, for example, is used when a company has a short-term internal
constraint, such as lack of skilled labour, in order to determine the short-term
profit-maximising sales mix. It identifies the short-term contribution in terms of the limiting
factor for each product affected by that constraint. Absorption costing cannot be used for this
analysis, since it comprises production overheads – i.e., costs that are fixed in the short term.
Although limiting-factor analysis will indicate which products should be made to maximise
short-term profits, other factors – i.e., contractual obligations and long-term strategic
considerations – must be taken into account in order to reach an informed decision. Most
companies operate in complex, dynamic environments and are under pressure to achieve
objectives in the short, medium and long term.
Under this unit you will learn:
1. How to Calculate optimum production plan when you have limited quantities in one of
your
resources.
2. How to Calculate or determine optimum production plan when you have limited quantities
in many of your resources using either linear programing or simplex method.
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3. Inclusion of learning curve in decision making.
Unit Aim
 To maximise returns through prudent utilization of limited resource.
Objectives
 Calculate and analyse the Optimum production plan which can give
higher contribution in situations where a resource is limited.
 Using linear programming, Plot and analyse the optimum production plan
 Calculate and comment on shadow price and slack.
 Evaluate the optimum production plan using simplex method.
Time
You are expected to take about 2 hours to finish studying this unit.
Reflection.
Evaluate the best production plan If you have limited resources, and you
need to maximise profit.
Calculation of optimum production plan where one of your resources is limited.
In such an instance, you are expected to use limiting factor analysis.

Example
Zulu & Bwalya has just changed its cake mix and is struggling to cope with
increased demand for its cakes. Machine time available is 300 hours per week.
Fairy Butterfly Pixie
Information per batch:
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K K K
Sales price 150 120 100
Variable cost 100 80 70
Fixed cost 20 20 20
Profit 30 20 10
Machine time per batch 5hrs 2hrs 1hr
Demand per week 50 50 50
Required
What is the optimal production plan?
Answer
Production plan F B P
Contribution/unit K50 K40 K30
Contribution/machine hour K10 K20 K30
Rank 3rd 2nd 1st
Production schedule Hrs. / unit hrs. available K contribution
300 /hour
Produce maximum P 50 1 (50) 30
Produce maximum B 50 2 (100) 20
Produce F with (150/5) 30 5 (150) 10
4.1 OPTIMUM PRODUCTION USING LINEAR PROGRAMMING DECISIONS

Linear programming is a mathematical technique used for selecting the optimum decision
variable in circumstances where a business problem contains a number of constraints i.e.
scares resources (e.g. money, manpower, material, machine and other facilities).
Assumptions made in linear programming techniques include:

(a) Fixed costs are unchanged by decision.
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(b) Unit variable cost is constant.
(c) Estimates of demand and resource requirements are known with certainty.
(d) Units of output are divisible.
(e) Total amount of each scarce resource is known with certainty.
(f) No interdependence between demand for products.
Graphical approach
You can estimate the maximum production plan and ultimately maximum contribution out of
the limited resources using the graphical approach. The following steps are relevant to sort
out the problem graphically:
1. Define variables;
Since you will be using the graph paper where you will draw the X- axis (horizontal
line) and the Y axis (vertical line). Riding on the assumption of having two products,
one product should represent x- axis and the other product y- axis.
2. Establish the objective function. For example, if the contribution from one product
(x) is K6 per unit and the other product (y) has 5 as contribution per unit.
Establishment of the objective function will be as follows:
C = 6x +5y. This is the function which would give you the maximum contribution
depending on the mix.
3. Formulate the constraints (inequalities) including the non-negativity ones.
The usage of material to produce each of the products involved could be as follows;
for example, 3kg to make one unit of X and 2kgs to make one unit of Y where the
material available could be limited to 500kg only. Therefore, the constraint would be
as follows; 3x +2y ≤ 2000.
4. Convert inequalities into equations and use the table of values to calculate the
intercepts (coordinates) which you will use to plot the graph. E.g. 3x +2y ≤ 2000
could be converted as follows: 3x+2y = 2000.
If x is zero (0) what would be the value of y
X 0 1667
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Y 1, 000 0
Use the coordinates (0, 1000) and (1667, 0) to plot and show the linear limitation.
5. Establish the feasible region and determine the optimum production point using the
ISO- contribution line.
6. Find the value of x and y using simultaneous equations and find the maximum
contribution.
7. Test the inequalities if there is slack or they are binding. If the inequality is binding, it
is possible to calculate the shadow price which is the extra contribution if one extra
unit of a limited resource could be found. Follow the example below.
Example
A company produces two products in three departments. Details are shown below
regarding the time per unit required in each department, the available hours in
each department and the contribution per unit of each product:
Product X: Product Y: Available hours
Hours per unit Hours per unit
Department A 8 10 11, 000
Contribution per unit K4 K8
A step-by-step approach to determine what the optimum production plan is can be presented

as follows:
Step 1: Define the variables.
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Let 'x' be the number of units of X to produce; Let 'y' be the number of units of Y to produce.
Step 2: Define and formulate the objective function
Objective function: to maximise contribution C = K4x + K8y.
Step 3: Formulate the constraints.
Subject to:
In Department A, 8x + 10y ≤ 11,000 hours
In Department B, 4x + 10y ≤ 9,000 hours
In Department C, 12x + 6y ≤ 12,000
x, y ≥ 0
Step 4: Draw a graph identifying the feasible region
To draw Constraint 1 (constraint in Department A), we take the inequality '8x + 10y ≤ 11,000
hours' and turn it into an equation: 8x+ 10y = 11,000.
To draw this constraint, we need two points. If X = 0, Y = 11,000· 10 so Y = 1,100.

Likewise, if Y = 0, X = 11,000 so X = 1,375.
To draw Constraint 2 (Department B): If X = 0, Y = 900 and if Y = 0, X = 2,250.
To draw Constraint 3 (Department C): If X = 0, Y = 2,000 and if Y = 0, X = 1,000
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Step 5: Finding the optimum solution - Using the iso-contribution line.
We do not know the maximum value of the objective function; however, we can draw an Iso-
contribution (or 'profit') line that shows all the combinations of x and y that provide the same
total value for the objective function.
If, for example, we need to maximise contribution K4x + K8y, we can draw a line on a graph
that shows combination of values for x and y that give the same total contribution, when x
has a contribution of K4 and y has a contribution of K8.
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Any total contribution figure can be picked, but a multiple of K4 and K8 is easiest.
 For example, assume 4x + 8y = 4,000. This contribution line could be found by

joining the points on the graph x = 0, y = 500 and x = 1,000 and y = 0.
Instead, we might select a total contribution value of 4x + 8y = K8, 000.
This contribution line could be found by joining the points on the graph x = 0, y =
1,000 and x = 2,000 and y = 0.
 When drawing both of these contribution lines on a graph, you will find that the two
lines are parallel and the line with the higher total contribution value for values x and
y (K8, 000) is further away from the origin of the graph (point 0).
 This can be used to identify the solution to a linear programming problem. Draw the
Iso-contribution line showing combinations of values for x and y that give the same
total value for the objective function.
 Look at the slope of the contribution line and, using a ruler, identify which
combination of values of x and y within the feasible area for the constraints is furthest
away from the origin of the graph. This is the combination of values for x and y where
an Iso-contribution line can be drawn as far to the right as possible that just touches
one corner of the feasible area. This is the combination of values of x and y that
provides the solution to the linear programming problem.
Optimum corner is Corner C, the intersection of:
8x + 10y = 11,000 and 4x + 10y = 9,000

At this corner, x = 500 and y = 700.
The optimum production plan is to produce 500 units of Product X and700 units of Product
Y; The contribution at this point is maximised C = (500 x K4) + (700 x K8) = K7,600.
Assumptions
 There is a single quantifiable objective, e.g. maximise contribution. In reality, there

may be multiple objectives such as maximising return while simultaneously
minimising risk.
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 Each product always uses the same quantity of the scarce resource per unit. In reality,
this may not be the case. For example, learning effects may be enjoyed.
 The contribution per unit is constant. In reality, this may not be the case:
- The selling price may have to be lowered to sell more

- There may be economies of scale, for example a discount for buying in
bulk.
 Products are independent - in reality:
- Customers may expect to buy both products together.

- The products may be manufactured jointly together.
 The scenario is short term. This allows us to ignore fixed costs.
The assumptions apply to the analysis used when there is one limiting factor or if there are
multiple limiting factors.
Slack
Slack is the amount by which a resource is under-utilised. It will occur when the optimum
point does not fall on a given resource line.
Slack is important because unused resources can be put to another use, e.g. hired out to
another manufacturer.
Shadow price
The shadow price of a resource can be found by calculating the increase in value (usually
extra contribution) which would be created by having available one additional unit of a
limiting resource at its original cost. It therefore represents the maximum premium that the
firm should be willing to pay for one extra unit of each constraint. This aspect is discussed in
more detail below. Non-critical constraints will have zero shadow prices as slack exists
already.
Calculating shadow prices.
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The simplest way to calculate shadow prices for a critical constraint is as follows:
Step 1: Take the equations of the straight lines that intersect at the optimal point. Add one
unit to the constraint concerned, while leaving the other critical constraint unchanged.
Step 2: Use simultaneous equations to derive a new optimal solution.
Step 3: Calculate the revised optimal Contribution The increase is the shadow price for the
constraint under consideration.
Linear programming (LP)can be useful in the following situations:

1. Budgeting – subject to the budget constraint, a combination of investment proposals that
would provide the highest net present value would be selected. Where there is multi-period
capital rationing, you use linear programming techniques to maximise the net present value.
2. Calculation of relevant costs – When more than one scarce resource exists, the opportunity
cost should be established using linear programming techniques.
3. Production decisions.
4 Payment for scarce resources.
5 Control – Opportunity costs are also important for cost control. For example, materials
wasted are recorded in an adverse material usage variance. The responsibility Centre should
not only be identified with the acquisition cost, but also with the opportunity cost.
6 Capital budgeting – Where there is multi-period capital rationing, you should use linear
programing techniques to maximise the net present value.
4.2 THE SIMPLEX METHOD

The simplex method is used to solve problems with three or more decision variables. This
section focuses on the main principles of problem solving using this method. Most real-world
problems are too complex to solve graphically. They have too many variables to evaluate,
and the algebraic solutions are lengthy. A simplex tableau is a way to systematically evaluate
variable mixes in order to find the best one.
Simplex usually starts at the corner that represents doing nothing. It moves to the neighboring
corner that best improves the solution. It does this over and over again, making the greatest
possible improvement each time. When no more improvements can be made, the most
attractive corner corresponding to the optimal solution has been found.
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For example
A furniture manufacturer produces wooden tables and chairs. Unit profit for tables
is K6, and unit profit for chairs is K8. The company uses two resources to produce
tables and chairs. These are wood (board feet) and labor (hours).
Table Chair
Material 30 kg 20kg
Labour 5 hours 10 hours
There are 300 kg of wood available and 110 hours of labor available. The company wishes to
maximize profit.
In this case, profit maximization becomes the objective function (The criterion for
selecting the best values of the decision variables).
The resources (wood and labor) are the decision variables (The resources
Available). The limitations on resource availability (300 kg of wood and 110 hours of labor)
form the constraint set (The limitations on resource availability), or operating rules that
govern the process. Using Linear Programming, management can decide how to allocate the
limited resources to maximize profits.
Define variables
Let x be tables
Let y be chairs
Objective function.
Z = 6x + 8y
Subject to:
30x+ 20y < 300 (wood constraint: 300 kg available)
5x + 10y < 110 (labor constraint: 110 hours available)
x, y > 0 (non-negativity conditions)
The first step is to convert the inequalities into equalities by adding slack variables to the two
constraint inequalities. With S1 representing surplus wood, and S2 representing surplus labor,
the constraint equations can be written as:
30x + 20y + S1 = 300 (wood constraint: 300kg)
5x + 10y + S2 = 110 (labor constraint: 110 hours)
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All variables need to be represented in all equations. Add slack variables to the other
equations and give them coefficients of 0 in those equations. Rewrite the objective function
and constraint
equations as:
Maximize: Z = 6x + 8y + 0S1 + 0S2 (objective function)
Subject to: 30x + 20y + Sx + 0Sy = 300 (wood constraint: 300kg)
5x + 10y + 0Sx + Sy = 110 (labor constraint: 110 hours)
x, y, Sx, Sy > 0 (non-negativity conditions)
Note: We can think of slack or surplus as unused resources that don’t add any value to the
objective function. Thus, their coefficients are 0 in the objective function equation.
Draw a simplex tableau
Unit 6 8 0 0 solution
profit
Basic mix x y Sx Sy Exchange
ratio
0 Sx 30 20 1 0 300 300/20=15
0 Sy 5 10 0 1 110 110/10=11
sacrifice 0 0 0 0 0 Current
profit
Improvement 6 8 0 0 -
Second simplex table

Unit profit 6 8 0 0 solution
Basic mix X y sx sy
0 sx
8 y 0.5 1 0 0.1 11
sacrifice
improvemen
t
2. Fill in the new Sx row.

Now we’ll find the values for the Sx row. Referring to above table, find the value in the S x
row in the old tableau in the pivot element column (20). Multiply it times the first value in the
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new y row (0.5 from the table above). Subtract your answer from the value in the first
position of the old y row.
Thus, for the first value (to replace the 30 in the first tableau):
(20 × 0.5) = 10
30 - 10 = 20
For the second value (to replace 20 in the first tableau):
(20 × 1) = 20
20 - 20 = 0
For the third value in this row:
20 × 0 = 0
1 - 0 = 1 (Stays the same in the new tableau.)
For the fourth value in this row:
20 × 0.1 = 2
0 - 2 = -2
For the solution column value for this row:
20 × 11 = 220
300 - 220 = 80

Basic mix X y sx sy
0 sx 20 0 1 -2 80
8 sy 0.5 1 0 0.1 11
Sacrifice
improvemen
t
3. Find the sacrifice and improvement rows.

Find the sacrifice and improvement rows using the same method
as in the first tableau.
Second simplex tableau—sacrifice and improvement rows.
Basic mix X y S1 S2
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0 sx 20 0 1 -2 80
8 sy 0.5 0 0.1 0.1 11
Sacrifice 4 8 0 0.8 88
Improvement 2 0 0 -0.8 -
You now see that profit has been improved from 0 to K88.
4. Complete the pivot operation (entering and exiting variables).
Recall that the pivot operation results in new entering and exiting variables. The greatest per-
unit improvement is 2 (under x column). The others offer no improvement (either 0 or a
negative number). x becomes the new entering variable. Mark the top of its column with an
arrow as shown in the table below. Remember, when no improvement can be found at this
step, the current tableau represents the optimal solution.
Basic mix x y sx sy
0 x 20 0 1 -2 80
8 y 0.5 1 0 -1 11
Sacrifice 4 8 0 0.8 88
Improvem 2 0 0 -0.8 -
ent
Now determine the exiting variable. To do so, first determine the exchange ratios:
80/20 = 4
and 11/0.5 = 22
Now choose the smallest non-negative exchange ratio (4 versus 22). x becomes the exiting
variable. Mark that row with an arrow.
Draw a circle around the pivot element, 20.
Construct the third tableau from the second tableau.
Replace the entering variable in the basic mix where the exiting variable left. Bring over the
unit profit from the top row of the old table to the new table. Fill in the pivot element row by
dividing through by the pivot element (20).
Third simplex tableau x row.
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Unit profit 6 8 0 0 Solution
Basic mix x y sx sy
6 x 1 0 0.05 -0.1 4
8 y
Sacrifice
Improvement
Fill in the first value in the ‘y’ row as follows. First, multiply the previous tableau’s “y” pivot
value (0.5) times the first value in the new tableau’s “x” row (1): 0.5 × 1 = 0.5 Now subtract
this number from the first value in the previous tableau’s “y” row (0.5): 0.5 - 0.5 = 0
Place this value in the first position of the new tableau’s “y” row.
Repeat this process to fill in the remaining values in the new ‘y’ row.
Third simplex tableau- y -row

Basic mix x y S1 S2
6 X 1 0 0.05 -0.1 4
8 y 0 1 -0.025 0.15 9
Sacrifice
Improvement
Fill in the sacrifice row. The first value is (6 × 1) +(8 × 0) = 6.

Fill in the improvement row. The first value is 6 - 6 = 0.
Third simplex tableau—sacrifice and improvement rows
Unit profit 6 8 0 0 Solution
Basic mix x y S1 S2
6 x 1 0 0.05 -0.1 4
8 y 0 1 -0.025 0.15 9
Sacrifice 6 8 0.1 0.6 96
Improvement 0 0 -0.1 -0.6 -
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There are no positive numbers in the new improvement row. Thus, we no longer can improve
the solution to the problem. This simplex tableau represents the optimal solution to the LP
problem and is interpreted as:
x = 4, y = 9, Sx = 0, Sy = 0, and profit or Z = K96
The optimal solution (maximum profit to be made) is to manufacture
four tables and nine chairs for a profit of K96.
Exercise 1
Solve the linear programming problem below, using simplex method.
Maximize Z= x+3y (objective function)
Subject to –x + y ≤ 20 (constraints)
-2x + y ≤ 50
The solution is provided at the end of the unit.
4.3 THE LEARNING CURVE

In practice, it is often found that the resources required to make a product decrease as
production volumes increase. It costs more to produce the first unit of a product than it does
to produce the one hundredth unit.
It is a human phenomenon that occurs because of the fact that people get quicker at
performing repetitive tasks once they have been doing them for a while. The first time a new
process is performed, the workers are unfamiliar with it since the process is untried. As the
process is repeated, however, the workers become more familiar with it and better at
performing it. This means that it takes them less time to complete it.
The learning process starts as soon as the first unit or batch comes off the production line.
Since a doubling of cumulative production is required in order for the cumulative average
time per unit to decrease, it is clearly the case that the effect of the learning rate on labour
time will become much less significant as production increases. Eventually, the learning
effect will come to an end altogether.
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It is necessary for the process to be a repetitive one, for example. Also, there needs to be a
continuity of workers and they mustn’t be taking prolonged breaks during the production
process.
The learning rate: cumulative average time
In learning theory, the cumulative average time per unit produced is assumed to decrease by a
constant percentage every time total output of the product doubles.
Considering an example where an 95% learning effect occurs, the cumulative average time
required per unit of output is reduced to 95% of the previous cumulative average time when
output is doubled.
1. By cumulative average time, we mean the average time per unit for all units
produced so far, back to and including the first unit made.
2. The doubling of output is an important feature of the learning curve measurement.
Example: an 80% learning curve
The first unit of output of a new product requires 100 hours. An 80% learning
curve applies. The production time would be as follows:
Number of units cumulative avg time total time incremental time

produced Required per unit required for additional units
1* 100 (x1) 100
2* (80%) 80.0 (x2) 160.0 60.0 (for 1 extra unit)
4* (80%) 64.0 ((x4) 256 96.0 (for2 extra units)
8* (80%) 51.2 (x8) 409.6 153.6 (for 4 extra units)
* Output is being doubled each time
Algebraic method-Formula
Y= axb
Where
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Y is the cumulative average time per unit taken to produce X units.
a is the time taken to produce the first unit.
X is the cumulative number of units.
b is the index of learning (calculated as Log r in decimal/ Log 2 where r is the learning rate in
decimal place).
You need to know when the Steady state reaches
Eventually, the time per unit will reach a steady state where no further improvement can be
made.
The practical application of learning curve
You need to know costs which get affected by learning curve.
1. direct labour time and costs.
2. variable costs if they vary with direct labour hours worked.
3. material costs are usually unaffected by learning among the workforce, although it is
conceivable that materials handling might improve, and so wastage costs be reduced.
4. fixed overheads should be unaffected by the learning curve.
The relevance of learning curve effects in management accounting
The theory can be used to:
1. calculate the marginal (incremental) cost of making extra units of a product.

2. quote selling prices for a contract.
3. prepare realistic production budgets and more efficient production schedules.
4. prepare realistic standard costs for a cost control purpose.
Limitations of learning curve theory
1. The learning curve phenomenon is not always present.

2. It assumes stable conditions at work which will enable learning to take place, this is
not practicable.
3. It must assume a certain degree of motivation amongst employees.
4. Breaks between repeating production of an item must not be too long, or workers.
would forget and the learning process would start all over again.
Example 1
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The first batch of 100 units of a new product will take 1, 500 labour hours to
produce. There will be an 85% learning curve that will continue until 6, 400 units
have been produced.
Calculate average time per batch for the first batches to the nearest hour.
Answer
The average time for 64 batches (i.e 6, 400 units) is
Y = axb
Y = 1, 500 × 64-0.2345
Y = 565.64 hours
Example 2
SK has discovered that it employs a new engineer. There is a learning curve with
a 75% rate of learning that exists for the first 12 customer assignments. A new test
engineer completed her first customer assignment in 6 hours.
Calculate the time that she should take for her 7th assignment to the nearest 0.01 hours.
Note: the index for a 75% learning curve is -0.415
Solution
Average time for 7 assignments = 6 ×7-0.415 = 2.6757hours
Total time for 7 assignments = 7× 2.6757 hours = 18.730 hours
Average time for 6 assignments = 6× 6-0.415 = 2.8525 hours
Total time for 6 assignments 6 × 2.8525 hours = 17.115 hours
Time for the 7th assignment = 18.730 hours – 17.115 hours = 1.615 hours.
Calculating the learning rate.
The following example should provide you with a step by step process on how to do this.
Example
Company A is currently producing product X. The time it took them to produce

the 32nd batch was 63 hours, whereas it took them 120 hours to produce the first
batch. The company is hoping for a rate of learning of 75%.
71
Step 1
How many ‘doubles’ in output have there been Rates of learning always change such that as
output doubles from 1 to 2, then 2 to 4, 4 to 8 and so on there is a set relationship.
Batch 1 2 4 8 16 32 64 128 256
- 1 2 3 4 5 6 7 8
In our case, batch 32 is 5 doubles. If your question asks for 256 th batch, the number of
doubles is 8.
Step 2
Use the formula:
Time for first batch (rdoubles) = time for latest batch
Where r is the rate of learning. Here then: 120(r5) = 63. This can be rearranged as:
5
r= √ 63/120 . Therefore, r = 0.88 = 88%. As you can see this is well off their expected
target of 75%!
Task 2
SK is an electronic company that has developed a new product for the video
conferencing market. The product has successfully completed its testing phase
and FH has now produced the first four production units. The first unit took 3 hours of labour
time and the total time for the first 4 units was 8. 3667 hours.
Calculate the learning curve improvement rate (rate of learning) to the nearest 0.1%.
Answer is provided at the end of this unit.
Task 3
Marco Limited is a new firm specialising in producing and selling energy saving
bulbs for domestic use. There has been significant venture capital finance invested
in the company and the board of directors is made up of the promoter and
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representatives from the venture capital finance companies. Currently the managing director
is the promoter. The promoter is a medical doctor by profession and has no extensive
experience working in this sector. The promoter has recently undertaken research and has
been granted a patent for the new energy saving bulbs. This has helped to attract the capital
investment. However, there have been two recent fractious board meetings with the venture
capitalists unhappy with the pace of development and the lack of financial information being
presented to the board. The board has recently engaged a consulting accountant to help with
pricing and financial information. Following discussions with staff and potential customers,
the accountant has put together the following pricing information.
Price Demand (units)
K4,000 1,000
K3,500 1,500
K3,000 2,000
The cost of producing each bulb is expected K850 per unit

to be as follows: Variable production costs
Fixed production costs K1, 000 per unit based on an annual demand
of 1,000 units.
Variable selling costs K200 per unit
Non-production fixed costs K500, 000 per annum.
The managing director has stated that the company should sell at the highest price point of
K4, 000 in order to maximise profits but this has been questioned by the other board
members.
Following production of the first four models it has become apparent that there is a learning
curve in operation that has reduced variable costs through time and material savings.
Units Produced Cumulative Production
Time (Hrs.)
1 120
2 216
4 388.8
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The managing director knows from previous experience that this learning will cease after
completion of 16 units and will result in a variable production cost saving of approximately
15%.
The accountant has detailed these findings in her report to the board and a board meeting has
been scheduled in order to discuss the report and make some decisions.
The Learning coefficient:
Learning co-efficient for 95% = -0.074
Required:
(a) Establish the rate of learning that applies to the production of the energy saving bulbs and
calculate the length of time that each unit will take once learning ceases. Explain how this
information should be used. [10 Marks]
(b) Calculate the number of energy saving bulbs that the company must sell in order to
achieve a target profit of K400, 000 for the first full year of trading allowing for the learning
curve effect reduction in variable cost and a set selling price of K2, 000 per unit. [3
Marks]
(c) The sales director has recommended increasing the sales commission that will increase
variable selling cost by 10% but will also reduce fixed non-production costs by 20%. State
the effect on the annual break-even sales revenue if this proposal is implemented (assume
selling price and unit variable costs as per part b). [3
Marks]
(d) Discuss situations where the learning curve is best applied, how it may assist management
accountants and explain any weaknesses associated with it. [4 Marks]
[Total marks 20]
Answers are provided at the end of this unit.
4.4 Unit summary
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Marginal costing supports other management accounting techniques. Limiting
factor analysis, for example, is used when a company has a short-term internal
constraint, such as lack of skilled labour, in order to determine the short-term
profit-maximising sales mix. It identifies the short-term contribution in terms
of the limiting factor for each product affected by that constraint. Absorption costing cannot
be used for this analysis, since it comprises production overheads – i.e., costs that are fixed in
the short term. Although limiting-factor analysis will indicate which products should be made
to maximise short-term profits, other factors – i.e., contractual obligations and long-term
strategic considerations – must be taken into account in order to reach an informed decision.
Most companies operate in complex, dynamic environments and are under pressure to
achieve objectives in the short, medium and long term.
Solutions
Task 1
To solve the above Linear Programming problem, you will need to follow the following
simplex steps:
A slack variable represents the amount of a constraint that is unused. In most real-life
problems, it’s unlikely that all resources (usually a large mix of many different resources)
will be used completely. While some might be used completely, others will have some
unused capacity.
1 Turn the inequalities into equations then standardize them by adding slack variables
(S). i.e. slack variables are added to a linear programming problem to account for any
constraint that is unused at the point of optimality, and one slack variable is
introduced for each constraint.
-x + y + 0S1 =20
-2x + y + 0S2 =50
Rewrite the objective function, add both slack variables and equate to zero
0 = Z –x -3y -0S1 -0S2
3 Draw the simplex table and fill in with all the variables as shown below
Basis Z X Y S1 S2 RHS Ratio

S1 0 1 1× 1 0 20 20/1=20
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S2 0 2 1 0 1 50 50/1=50
Z 1 -1 -3 0 0 0 0
Determination of the Pivoting element is quite significant on your journey to sort out a
problem using simplex method. The intersection of the column and row is where your
pivoting element is (×). The procedure goes as follows:
Step 2. Find the sacrifice and improvement rows.

Values in the sacrifice row indicate what will be lost in per-unit profit by making a change in
the resource allocation mix. Values in the improvement row indicate what will be gained in
per-unit profit by making a change.
First you need to determine the basis entering variable. Pick the most negative variable in Z
row (which in this case is -3) to have a pivoting column.
Then for you to have the pivoting row, divide the pivoting column variables by the right
hand side (RHS) values. After which you get the smallest non-negative ratio. This then means
that Y is the entering variable into the basis and S1 will be the leaving variable.
NB: your pivoting element should always be 1, if it’s not, say it’s a 4, divide the whole
pivoting row by 4. Then ensure that all the values below and above it in that column are
equal to zero.
However, in the table above, our pivoting element is already equal to 1. Therefore, we now
need to aim at turning the 1 and -3 into zeros.
To find S2 values we multiply the pivoting row by -1 so as to have a zero below the pivot
element. Then add the initial S2 values;
Pivot row by -1 -1 -1 0 -20

-1
Initial S2 2 1 0 1 50
Final S2 1 0 -1 1 30
To find Z row values we multiply the pivoting row by 3 so as to have a zero below the pivot
element. Then add the initial Z values.
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Pivot row by 3 3 3 0 60
3
Initial z row -1 -3 0 0 0
Final Z row 2 0 3 0 60
Then put the calculated values in the simplex table
Basis Z X Y S1 S2 RHS
Y 0 1 1 1 0 20
S2 0 1 0 -1 0 30
Z 1 2 0 3 0 60
The solution is optimal because we no longer have any negative values in the z row.
Therefore, the solution is optimal when Z= 60, X =0 (its 0 because it did not enter the basis
column) and Y=20.
NB: the solution can be proved by inserting the calculated values into the objective function
i.e.
Max Z= (0) + 3(20) =60
Task 2
Average time per unit for 4 units = 8.3667/4 = 2.0917
Rate of improvement is 83.5%
Note: Next topic is still under decision making. You are expected to learn how to determine
relevant costs which could be as a result of a decision taken.
Solution three
(a) learning curve
energy saving bulb cum time average time per unit %learning
1 120 120
2 216 108 108/120 = 90%
4 388.8 97.2 97.2/108 = 90%
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(a) (ii) learning effect is 90% with learning stopping after the first 16 units
(b) Time for 16 units: Y = axb
Y = 120 ×16-0.152 = 78.73
Cumulative time for 16 units = 16× 78.73 = 1,259.72
Time for 15 units = Y = 120(15) -0.152 = 79.51

Cumulative for 15 units = 79.51 × 15 = 1,192.63
Time for the 16th unit and each unit thereafter (1,259.72 – 1,192.63) = 67.09 hours per unit.
(b)
Total fixed cost
Total fixed production costs 1000 × K1000 1,000,000
Total fixed non-production O/Heads 500,000
Total fixed costs 1,500,000
Selling price 2000
Variable costs 850 + 200 (1050)
Contribution per unit 950
Target profit + TFC (K1,500,000+400000) 1,900,000/950 = 2000
Number of energy saving bulbs = K1,900,000/950 = 2000
Old Proposal
K K
Selling price 2,000 2,000
Variable costs (850 +200) (1050) (850 ×200 ×110%) (1070)
Contribution per unit 950 930
B/E in units (1,500/K950 = 1, 579 units (1,400,00/930 = 1,505units
B/E in terms of revenue
1,579 ×2000 = K3,158,000 1,505 × 2000 = K3,010,000
d) How it might assist management.

1. Enable management to set up a Standard Costing system.
2. A budget will need to incorporate a learning cost factor until the plateau is reached.
3. A budgetary control system incorporating labour variances will have to make
allowances for the anticipated time changes.
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4. Identification of the learning curve will permit the company to better plan its
marketing, work scheduling, recruitment and material acquisition activities.
5. The decline in labour costs will have to be considered when estimating the overhead
apportionment rate.
6. As the employees gain experience they are more likely to reduce material wastage.
Weaknesses/ Limitations:
1. The stable conditions necessary for the learning curve to take place may not be
present – unplanned changes in production techniques or labour turnover will cause
problems and affect the learning rate.
2. The employees need to be motivated, agree to the plan and keep to the learning
schedule, these assumptions may not hold.
3. Accurate and appropriate learning curve data may be difficult to estimate.
4. Inaccuracy in estimating the initial labour requirement for the first unit.
5. Inaccuracy in estimating the output required before reaching a ‘steady state’ time rate.
6. It assumes a constant rate learning factor.
You need to learn how to determine relevant costs, say for a one-off project and coming
up with a decision as to either accepting or rejecting a project. Such knowledge is
important in business and you will find it from the next topic.
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UNIT 5: RELEVANT COSTS
5.0 INTRODUCTION
The relevant cost concept is fundamental to decision making. Relevant cost must
be influenced by a decision that may have been taken.
Under this unit, you will learn about
1. Definition of relevant costs and other terminologies.
2. Determination of relevant costs in materials.
3. Determination of relevant cost in labour.
4. How to calculate the total tender price.
Aim
 Make use of relevant costs for a fair and reasonable assessment

of a project, a company would wish to undertake.
Objectives At the end of this unit, you should be able to:
1 . Calculate the relevant cost for a one-off project.
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2 Calculate the tender price.
3 Assess and evaluate either to take up the one-off project on offer or not
Reflection
In your own words,
1. Define relevant costs and revenues?
2. Explain the significance of knowing relevant costs in decision
making.
Time. You are expected to take about 2 hours to finish studying this unit.
Relevant cost Definition

A relevant cost is a future cash flow arising or stopped as a result of the decision under
review.
They are future costs and revenues – as it is not possible to change what has happened in the
past, then relevant costs and revenues must be future costs and revenues.
They are incremental – relevant costs are incremental costs and it is the increase in costs and
revenues that occurs as a direct result of a decision taken that is relevant. Common costs can
be ignored for the purposes of decision making. In examination questions look out for costs
detailed as differential, specific or avoidable.
They are cash flows – in addition, future costs and revenues must be cash flows arising as a
direct consequence of the decision taken. Relevant costs do not include items which do not
involve cash flows (depreciation and notional costs for example).
Terminologies to note
Sunk costs – costs already incurred. Not relevant in decision making and are therefore
ignored.
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Example:
Previously spent research, development, and advertising dollars are sunk costs and
are unavoidable.
Opportunity cost – the value of a benefit sacrificed when one course of action is chosen in
preference to an alternative. The opportunity cost is represented by the potential benefit
forgone from the best rejected course of action.
Opportunity costs are relevant for decision making and are likely to arise when there are a
number of possible uses of a scarce resource.
Example:
Bupe makes K500 an hour as a consultant and is considering paying someone
K3000 to paint his house. If he decides to do it himself, it will take four hours. His
opportunity cost for doing it himself is the lost wages for four hours, or K2000.
Avoidable costs – the specific costs of an activity or sector of a business which would be
avoided if that activity or sector did not exist.
For example, if you choose to close a production line, then the cost of the building in
which it is housed is now an avoidable cost, because you can sell the building. The
avoidable cost concept is crucial when engaging in cost reduction activities.
Avoidable costs are relevant for decision making and are usually associated with shutdown
decisions.
Fixed costs may be avoided if they are specific to a department or product. Allocated fixed
costs are unlikely to change.
Costing projects
It is a standard management accounting practice to determine the relevant costs of a new
project in order to come up with a price quotation. Setting a price without having an accurate
understanding of costs can put a company at a competitive disadvantage, particularly if there
is intense competition.
Determination of relevant costs

 RELEVANT COST OF MATERIALS
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Any historic cost given for materials is always a sunk cost and never relevant unless it
happens to be the same as the current purchase price.
RELEVANT COST OF LABOUR
The following flow chart can help you understand to determine relevant costs to do with
labour.
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Relevant cost of non-current assets
The relevant costs associated with non-current assets, such as plant and machinery, are
determined in a similar way to the relevant costs of materials.
 If plant and machinery is to be replaced at the end of its useful life, then the relevant
cost is the current replacement cost.
 If plant and machinery is not to be replaced, then the relevant cost is the higher of the
sale proceeds (if sold) and the net cash inflows arising from the use of the asset (if not
sold)
Costing projects
It is standard management accounting practice to determine the relevant costs of a new

project in order to come up with a price quotation. Setting a price without having an accurate
understanding of costs can put a company at a competitive disadvantage, particularly if there
is intense competition.
Example
A company currently produces fire hydrants with the following per unit data:
K K
Selling price 100

Direct material 50
Direct labour 15
Fixed overhead 25
This company has been asked to supply a one-time contract supplying fire hydrants with the
following conditions:
K
• Contract revenue is 750
• 10 hours of labour are required
• Materials specific to this contract are valued at 200

Required
1. Should the company accept or reject the order?
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2. What would be the impact on your decision if labor was at full capacity?
5.1 UNIT QUESTIONS

Question 1
X plc intends to use relevant costs as the basis of the selling price for a special
order: the printing of a brochure. The brochure requires a particular type of paper
that is not regularly
used by X plc although a limited amount is in X plc’s inventory which was left over from a
previous job. The cost when X plc bought this paper last year was K15 per ream and there are
100 reams in inventory. The brochure requires 250 reams. The current market price of the
paper is K26 per ream, and the resale value of the paper in inventory is K10 per ream.
The relevant cost of the paper to be used in printing the brochure is:
A. K2,500
B. K4,900
C. K5,400
D. K6,500
Question 2
Mwando Limited (ML) is a construction company that has been in existence for
three years. The construction industry has been growing very rapidly and
competitive. A potential customer, Newton Ltd (NL), a housing company, has
asked for a quotation to build ten basic one bed roomed houses in the newly opened free
economic zone. NL is not a current customer of ML, but the directors of ML are keen to try
and win the contract as they believe that this may lead to more contracts in the future. As a
result, they intend to quote the minimum possible price.
The following information has been obtained:
(i) The manager for this contract is paid an annual salary equivalent to K26, 400 per month.
(ii) 10,000 bags of cement will be required. This is a material that is essentially used in all
construction works by ML and there are 4,000 bags currently in inventory. These were
bought at a cost of K65 per bag two months ago. Its current replacement cost is K72 per bag.
(iii) 300 litres of Termkill, a material used to treat the foundation will be required. This
material will have to be purchased for the contract because it is not otherwise used by ML.
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The minimum order quantity from the supplier is 400 litres at a cost of K45 per litre. ML
does not expect to have any use for any of this material that remains after this contract is
completed.
(iv) 1200 metres of conforce wire will be required. These will be purchased from Hamudili
Hardware, a well-known building materials supplier. The purchase price is K30 per metre.
(v) A total of 4,700 direct labour hours will be required. The current wage rate for the
appropriate grade of direct labour is K11 per hour. Currently ML has 1500 direct labour
hours of spare capacity at this grade that is being paid under a guaranteed wage agreement.
The additional hours would need to be obtained by either (i) overtime at a total cost of K14
per hour; or (ii) recruiting temporary staff at a cost of K12 per hour. However, if temporary
staff is used they will not be as experienced as ML’s existing workers and will require 100
hours supervision by an existing supervisor who would be paid overtime at a cost of K18 per
hour for this work.
(vi) 50 machine hours will be required. The block making machine to be used is already
leased for a weekly cost of K1,200. It has a capacity of 80 hours per week. The machine has
sufficient available capacity for the contract to be completed. The variable running cost of the
machine is K14 per hour.
(vii) The company absorbs its fixed overhead costs using an absorption rate of K40 per direct
labour hour.
Required:
Prepare a cost schedule, using relevant costing principles, showing the minimum price
Mwando Limited (ML) would charge for the contract. You should also explain each 6
relevant cost value included in your schedule and why the values you have excluded are not
relevant. (14 marks)
Note: The solution is provided at the end of the unit.
5.2 UNIT SUMMARY

Relevant costs are future, incremental, cash flows.
The relevant cost for labour depends on the capacity utilization of
labor:
 If there is spare labor capacity, then the relevant cost is zero;
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 If labor is at full capacity, then the relevant cost is either:
 its variable market cost, if additional labor can be hired, or
 The value sacrificed as a result of diverting labor from another activity already
performed within the firm.
The relevant cost for materials depends on the following:

 If the material is not owned, then it must be bought at the current replacement
(market) price;
 If the material is already in stock, then the relevant cost is either:
- Its current replacement cost, if it is to be replaced in the regular course of business, or
- Its current scrap (resale) value, if it is no longer in use, or its value (if greater than scrap) if
it can be applied as a substitute for another product.
 If the material is scarce (i.e. cannot be purchased externally) and must be diverted
from another activity already performed at the company, then its opportunity cost
must be ascertained in order to arrive at an accurate relevant cost.
Answers
Question 1
K
100 reams @ resale value of K10 1,000
150 reams @ market price of K26 3,900
Total relevant cost 4,900
Question 2
(a) Note K
Production director – meeting 1 NIL
Cement 2 72,000
Termkill 3 18,000
Floor tiles 4 36,000
Direct labour 5 40,200
Machine hours 6 700
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Fixed overhead 7 NIL
Total relevant cost 166,900
Notes:
1. The Manager salary is a fixed cost; therefore, the relevant cost is NIL. Even if it were
future
the manager’s annual salary is not incremental cost to ML.
2. Cement is in regular use by ML and consequently its relevant value is its replacement cost.
The historical cost is not relevant because it is a past cost and the resale value is not
relevant
since ML is not going to sell it since the material is in regular use and therefore must be
replaced.
3. Termkill is to be purchased for the contract therefore its purchase cost is relevant.
Although
only 300 litres are required for the work the minimum order quantity is 400 litres and as
ML
has no other use for this material and there is no indication that the unused 100 litres can
be
sold, the full cost of purchasing the 400 litres is the relevant cost.
4. The conforce wire is to be purchased from Hamudili at a cost of K30 each. This is a
relevant
cost because it is future expenditure that will be incurred as a result of the work being
undertaken.
5. Since, 1500 hours of spare capacity are available which have a zero-relevant cost, the
relevant
cost relates only to the other 3200 hours. ML has two choices: either use its existing
employees and pay them overtime at K14 per hour which is a total cost of K44,800; or
engage the temporary staff which incurs their cost of K38,400 plus a supervision cost of
K1,800 which equals K40,200. The relevant cost is the cheaper of these alternatives which
is to use the temporary employees.
6. The machine is currently being leased and it has spare capacity so it will either stand idle
or
be used on this work. The lease cost will be incurred regardless so the only relevant cost is
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the incremental running cost of K14 per hour.
7. Fixed overhead costs are incurred whether the work goes ahead or not so it is not a relevant
cost.
Under unit six, you will learn about budgeting and budgetary control theories and
techniques.
UNIT 6: BUDGETING AND BUDGETRY CONTROL
6.0 INTRODUCTION
Budgeting is the method of communicating the goals of organisation to the appropriate
managers in order to facilitate, coordinate and control various sections of the
organisation so that the desired outcomes are achieved.
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It is important for managers to develop attitudes and strategies that cultivate and maintain
supportive and co-operative relationships with subordinates.
Under this unit, you will have a recap of what you studied in cost and management
accounting module and then you will upgrade your evaluation skills of budget models taking
account of issues such as beyond budgeting and behavioral issues. You will also consider
advanced variances.
Aim
The use of budgets is vital if the organisation is
1.To correctly perform necessary management functions.
2 Expected to plan properly.
3 To facilitate communication for the benefit of an organisation.

1. Describe the purpose of budgeting system.
2. Explain the role of budgeting as a means of planning and control.
3. Discuss the use of budgets in performance measurement.
4. Prepare budgets.
5. Discuss the use of budgets as a motivational tool.
Reflection
In your own words, what is the significance of budgeting and budgetary
control in an organisation?
Time
You are expected to take about three hours to finish studying this unity.
You are expected to take about four hours to understand all the methods together with their
decision rules.
The role of budgets in planning and control
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Budgeting is an integral part of management function of planning, organizing, motivating and
controlling. A budget is one of the central tools used to carry out the management function.
6.1THE PURPOSE OF A BUDGET

Forecasting.
Inevitably, if an organisation is going to draft a budget which will be of any use whatsoever,
it will have to make forecasts. These forecasts will not always be correct, but at least the
organisation has had to look ahead. It won’t see every danger or opportunity, but looking
ahead must be better than moving forward with eyes closed.
Budgeting serves a number of purposes:
 Planning
A budgeting process forces a business to look to the future. This is essential for
survival since it stops management from relying on ad hoc or poorly co-ordinated
planning.
 Control
Actual results are compared against the budget and action is taken as appropriate.
 Communication
The budget is a formal communication channel that allows junior and senior managers
to converse.
 Co-ordination
The budget allows co-ordination of all parts of the business towards a common
corporate goal.
 Evaluation
Responsibility accounting divides the organisation into budget centres, each of which
has a manager who is responsible for its performance. The budget may be used to
evaluate the actions of a manager within the business in terms of the costs and
revenues over which they have control.
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 Motivation
The budget may be used as a target for managers to aim for. Reward should be given
for operating within or under budgeted levels of expenditure. This acts as a motivator
for managers.
 Authorisation
The budget acts as a formal method of authorisation to a manager for expenditure,

hiring staff and the pursuit of plans contained within the budget.
 Delegation
Managers may be involved in setting the budget. Extra responsibility may motivate
the managers. Management involvement may also result in more realistic targets.
How to set a budget

Broadly, when setting a budget, there are two choices:
1 Top-down imposition
2 Bottom-up participation.
Organisations should look for the most effective way of setting their budgets.
Questions below beg for answers for the success of an organisation:
 How do they get employees to pay heed to a budget and to take it seriously?
 How can they get accurate budgets?
 How can they motivate employees to try hard?
Participation usually increases motivation and commitment as it is very difficult subsequently
to ignore the decisions or targets which one has helped develop.
However, It is important to realise that the budget setting approach adopted for one
department, for one set of employees, or for one economic or competitive environment, is
unlikely to be universally acceptable and managers must be prepared to vary their approach
to match the situation.
6.1.2 APPROACHES TO BUDGETING
There are a number of different approaches to budgeting, including the following:
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Incremental budgeting
This a budgeting approach where the current or previous budget is used as a starting point for
a forth coming budget and just add inflation and growth rates to the existing budget. If there
is no growth, inflation will then be the only adjustment to be made to the existing budget.
Such budgets are based on what went on during the period before. Typically, this approach
results in modest changes and adjustments to the earlier budget. At worst, they retain and
perpetuate inefficiencies and old assumptions. This might be termed the “lazy man’s budget”.
Zero- based budgeting (ZBB).
 Each year, budget owners must justify the entire budget (build it from zero). The
budget is prepared from the scratch without making any reference from a previous
budget
 At odds with incremental budgeting (where only changes need justification, hence
encouraging the “spend it or lose it” mentality).
A three-step approach to ZBB:
1. Define “decision packages” (i.e. activities that result in costs or revenues), distinguishing
between “mutually exclusive packages” (alternative activities to achieve the same result) and
“incremental packages” (base level of input needed + additional inputs).
2. Evaluate and rank packages (based on the benefit to the organisation).
3. Allocate resources across packages, considering ranking and seniority of responsible
managers
Rolling budgets
A rolling budget is one which is revised on an on-going basis by comparing actual results
with the original budget when one period has expired, while simultaneously adding a new
period to the budget period.
Example
An annual budget which is kept rolling on a quarterly basis, for example, may
start with an (original) January – December forecast. At the end of March, the
entire budget is revised on the basis of the first quarter, and a new set of forecasts
relating to April (current year) – March (next year) are prepared, i.e. always with a 12-month
range into the future.
Selecting a suitable budgetary system is dependent on a number of factors such as;
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 Type of industry.
 Type and size of organisation.
 Type of product and product range.
 Culture of the organisation.
Fixed Budget
A fixed budget is not adjusted to the actual volume of output (activity level). What you
planed is what you are going to work with.
Preparation of functional budgets
Mwaiseni is a newly formed company manufacturing two components used in automobile
industry namely Kasili and Watu. Sales volumes for the first four months of the forthcoming
year have been forecast to be as follows:
Component January February March April
Kasili 1300 1380 900 1500
Watu 860 640 780 800
The budgeted selling price for Component Wagon is K372 per unit, while Component Van is
budgeted to sell for K410 per unit. 13% of sales are for cash, with the balance being on one
month’s credit. All purchases of materials made by the company are paid for in the month
after purchase.
The following opening balances are expected to be included in Mwaiseni Ltd’s ledger at the
start of January:
Bank 100,000 CR
Creditors/ trade payables 126,000 CR
Debtors/ trade receivables component Kasili 132,000 DR
Debtors/trade payables component Watu 113,000 DR
The company’s inventory policy requires that sufficient stock of Component Wagon and
Component Van be held at the end of every month to cover 35% of the following month’s
sales. It is expected that at the start of January, 455 units of Component Wagon and 301 units
of Component Van will be in stock.
The inputs required for the production of one unit of each of the products are budgeted to be
as follows:
Material Component Kasili Component Watu
Material A 3.5 4.1
Material B 6.6 6.5
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Material A is budgeted to cost K13 per kg. It is expected that 800 kg of Material A will be in
inventory at the start of January. Management requires that the quantities of Material A in
inventory at the end of each of the first three months of the year should be:
Quantity January February March

765kg 820kg 900kg
Material B is expected to cost K17 per kg. It is expected that 1,600 kg of Material B will be
in inventory at the beginning of January. Management requires that the quantities of Material
B in inventory at the end of each of the first three months of the year should be:
January February March
Quantity 1702kg 1800kg 1965kg
Every month fixed production overheads of K100,000 are incurred. These are paid for in the
month in which they are incurred.
The Labour inputs required for the production of one unit of each of the products are
budgeted to be as follows:
Labour grade Component Kasili Component Watu
Skilled hours 2 3
Unskilled hours 4 5
Skilled labour is budgeted to cost K7 per hour while unskilled labour is projected to cost K3
per hour. These are paid for in the month in which they are incurred.
Required:
a. Prepare production budgets (in units) for Component Kasili and Component
Watu for each of the first three months of the forthcoming year. (4 marks)
b. Prepare material usage budgets (in kg) for Material 1 and Material 2 for each
of the first three months of the forthcoming year. (3 marks)
B. Prepare material purchase budgets (in kg and in K) for Material A and
Material 2 for each of the first three months of the forthcoming year.
(4 marks)
c. Prepare Labour budgets (in hours and K) for all the Labour grades for each of
the first three months of the forthcoming year. (4 marks)
d. Prepare a cash budget for Mwaiseni Ltd. for each of the first three months of
the year which shows receipts and payments for each month and in total for
the period (9 marks)
Solution
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The production budget calculates the number of units of products that must
be manufactured, and is derived from a combination of the sales forecast and
the planned amount of finished goods inventory to have on hand (usually as
safety stock to cover for unexpected increases in demand)
(a) Production budget
Component Kasili
Jan Feb March
Sales 1300 1380 900
Add closing inventory 483 315 525
Less opening inventory (455) (483) (315)
Production 1,328 1,212 1,110
Now you can try on your own to prepare the production budget for
Component Watu. The answer is at the end of the unit.
(b) Material usage budget

A Raw Materials Usage Budget shows the expected quantity of each raw
material needed in the manufacturing process and where/how the raw material
is used.
Material A
Jan Feb
March
Component Kasili units 1,328 1,212 1,110
Material A (Kg)/unit 3.50 3.50 3.50
Material A (kg) 4,648.30 4,242.00 3,885.00
Component Watu (units) 783 689 787

Material A (kg)/unit 4.10 4.10 4.10
Material A (Kg) 3,210.30 2,824.90 3,226.70
Total material A 7,858.30 7,066.90 7,111.70
On your own, try to prepare material usage budget for material B. The
answer is provided at the end of the unit
(c) Material purchases Kg and Kwacha

MATERIAL A
Jan Feb
March
Required 7,858.30 7,066.90 7, 111.70

Add closing stock (Kg) 765 820 900
Less opening stock (Kg) (800) (765) (820)
Purchases Kg 7,823.30 7121.90 7,

191.70
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Price per Kg K 13 K13 K13
Purchases (K) 101,702.90 92,584.70

93,492.10
Material B
Jan Feb March
Required 13, 854.30 12,477.70
12,441.50
Add closing stock (Kg) 1,702 1,800
1,965
Less opening stock (Kg) (1,600) (1,702)
(1,800)
Purchases Kg 13,956.30 12.575.70 12,606.50

Price per Kg K 17 K17 K17
Purchases (K) 237,257.10 213,786.90

214.310.50
d) Component Kasili
Jan Feb March
Production 1,328 1,212 1,110
Skilled labour hr/unit 2 2 2
Skilled labour hour 2,656 2,424 2,220
Labour rate per hour K7 K7 K7
Total skilled labour cost 18,592 16,968 15,540
Unskilled labour hr/unit 4 4 4

Unskilled labour hours 5,312 4,848 4,440
Labour rate per hour K3 K3 K3
Total unskilled labour cost 15,936 14,544 13,320
Component Watu
Jan Feb March
Production 783 689 787
Skilled labour hr/unit 3 3 3
Skilled labour hour 2,349 2,067 2,361
Total skilled labour cost 16,443 14,469 16,527
Unskilled labour hr/unit 5 5 54

Unskilled labour hours 3,915 3,445 3,935
Total unskilled labour cost 62,716 56,316 57,192
e) Cash Budget
Jan Feb March
Total
Receipts
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Sales 353,706 828,343 760,009
1,942,058
Payments
Material purchases 126,000 *338,960 306,372
771,332
Fixed production overhead 100,000 100,000 100,000 300,000
Labour cost 62,716 56,316 57,192 176,224
Total Payments 288,716 495,276 463,564 1,247,556
Receipts less payments 64,990 333,067 296,446 694,502

Opening bank balance (110,000) (45,010) 288,057
(110,000)
Closing bank balance (45,010) 288,057 584,502 584,502
*Add purchases material A and purchases material @ in part (c) above.

Workings (I & ii) for the opening inventory (units)
Jan Feb March April

Component Kasili
Sales 1300 1380 900 1500
Inventory policy 35% 35% 35% 35%
Opening inventory 455 483 315 525
Component Watu
Sales 860 640 780 800
Inventory policy 35% 35% 35% 35%
Opening inventory 301 224 273 280
Workings
W1 Jan Feb March April
Cash sales 13%
Component Kasili *62,868 66,737 43,524 72,540
Component Watu 45,838 34,112 41,574 42,640
Total cash sales 108,706 100,849 85,098 115,180
Credit sales 87%

Component Kasili 132,000 420,732 446,623 291,276
Component Watu 113,000 306,762 228,288
278,226
Total credit sales 245,000 727,494 674,911 569,502
Total sales 353,706 828,343 760,009 684,682
Units sold X selling price X 13%cash sales.
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6.1.2 DEALING WITH UNCERTAINTY IN BUDGETING
Budgets are open to uncertainty. Due to non-controllable factors such as a recession or a
change in prices charged by suppliers will contribute to uncertainty in the budget setting
process.
To deal with uncertainty, the use of the following can help.
Flexible budgets: designed to change according to actual volumes of output; usually done
before the start of the budgetary period as a sort of scenario planning;
These are budgets which, by recognising different cost behaviour patterns, are
designed to change as the volume of activity changes.
Flexible budgets are prepared under marginal costing principles, and so mixed costs
are split into their fixed and variable components. This is useful at the control stage: it
is necessary to compare actual results to the actual level of activity achieved against
the results that should have been expected at this level of activity - which are shown
by the flexible budget.
Rolling budgets: the budget is updated regularly and, as a result, uncertainty is reduced.
Sensitivity analysis: variables can be changed one at a time and a large number of budgets
produced. For example, what would happen if the actual sales volume was only 60% of the
budgeted amount?
Simulation: similar to sensitivity analysis but it is possible to change more than one variable
at a time.
Activity-based (ABB): No budget owners (departments, functions), but budgeted activity

cost (ABC costing) Budgeted activity cost = demand for activity × unit cost of activity. More
detailed and accurate than traditional budgets, especially regarding indirect costs.
BEHAVIORAL ASPECTS
Budgets must not only be used as a computational tool to control costs: the behavioral aspects
such as staff having a sense of ownership of the budget as a result of participating in its
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formulation must be considered. This then translates in them being motivated enough to
achieve the budget’s goals.
The balanced scorecard approach of Kaplan and Norton, and the building block approach of
Fitzgerald and Norton can be a great help in ensuring that objectives (or targets), or budgets
are set for a very wide range of factors, both financial and non-financial.
The balanced scorecard
The balanced scorecard considers four perspectives comprehensively to analyse the
performance of an organisation. The four perspectives are analysed in turns below:
Financial perspective.
Ultimately, businesses must perform well financially and there should be budgets and
objectives set for measures such as return on capital employed, profit, growth, gross profit
percentages and so on.
Customer perspective.
However, complete financial success is dependent on pleasing customers and you should take
care that budgets and objectives take account of factors such as customer satisfaction, repeat
business, or market growth.
Internal business perspective.
To achieve customer perspective the organisation needs to pause questions such as:
Why do customers like us?
Presumably because we are good at what we do, in terms of adequate stockholding, quality,
efficient production, flexible responses to customer requests. Budgets should be set for these
because they are important.
Innovation and learning perspective.
Finally, you ask, how can we keep up with competitors and customer demands? Only through
continual innovation, improvement and learning.
So, the organisation’s financial success (easily and frequently measured by budgets)
ultimately depends on more unclear matters such as innovation, quality, style, and flexibility.
Therefore, it is essential that budgets are set for these as well, otherwise they will be ignored
as employees strive to meet the often more superficial and short-term conventional budget
elements.
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6.2 BEYOND BUDGETING
Beyond budgeting (BB) is a specific idea which regards the abolition of the traditional budget
process as a trigger for improving management control within organisations by a fundamental
re-examination of how they might be managed better. The Beyond Budgeting Round Table
(BBRT) solution is radical and believes that the shortcomings of the budgeting process can
only be overcome by abandoning budgeting altogether.
The source of all Beyond Budgeting ideas is the Beyond Budgeting Round Table (BBRT) an
independent industry led research consortium. The BBRT was established in the UK in 1998,
but now has members in mainland Europe, the US and Australia.
Beyond budgeting becomes a good and effective practice if the market changes rapidly
triggering the need for real-time response to events.
Aim of beyond budgeting

To eliminate redundant elements of the traditional budgetary process, that is, elements
performed at least as effectively and rigorously within other strategic management processes
(e.g. communication and control).
The pre-requisites of the “beyond budgeting” model, as alternative to traditional budgeting
1. Decentralization and divisional management empowerment within leaner
organisational structure.
2. Clear communication of company goals, of performance targets and of boundaries
within which local/divisional managers have the freedom to act.
3. Strong management performance evaluation system, based on self-indulgent
responsibility, authority and accountability across responsibility centres.
4. Head-office acts as provider of internal support services to responsibility centres,
with most of co-ordination among centres achieved through market forces.
Implementation.
For a successful BB implementation, Hope and Fraser argue that the following criteria are
necessary:
1. There needs to be a clear case for change, with the benefits fully explained.
2. Managers should consider carefully the degree of decentralisation that might be
possible within their organisation.
3. There must be a governance framework with clear priorities and boundaries.
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4. A high-performance ethos based on visible and relative success at all levels will be
necessary.
5. Front line teams need the freedom to take decisions within agreed parameters.
6. Trust and openness at all levels of the organisation will be paramount.
Implementation of a Beyond Budgeting capability has decisive organisational implications.
These include:
 Decentralisation – it is not obvious that decentralisation can be adopted by all
organisations squarely for all organisations. Every organisation is unique and it may
be impossible to change the company culture to provide the necessary
decentralisation. Successful decentralisation also depends on a great deal of trust
being invested in teams throughout the organisation.
 Customer focus
This leads to greater accountability, as well as more satisfied and profitable customers.
Management philosophy
The Beyond Budgeting Round Table proposes an alternative management model which they
feel supports the needs of modern business. They feel that a new set of coherent management
processes and a new leadership style are essential to achieving the full potential of an
organisation and its people.
Managing without budgets requires consideration of the following:
Planning
All along, many organisations, planning had been driven by top management. Then they
decentralised responsibility for strategy assessment to business units or front-line teams.
These are responsible for reviewing the medium-term outlook (goals, strategies, action plans
and value drivers) annually and the short-term outlook (actual and forecast performance
indicators) every quarter.
Beyond Budgeting argues that this continuous and open process allows teams to create value.
They can respond to changing demand and anticipate business threats and opportunities.
Coordination
Previously plans were centrally administered through central co-ordination of annual
departmental and business unit budgets.
Co-ordination now occurs through cross-company interaction.
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Operating capacity rises and falls according to demand. There is less waste as fewer items are
made for stock. The organisation acts like an integrated unit.
Target setting
Under Beyond Budgeting, targets are based on high level key performance indicators (Kips)
unlike in the time past when targets were solely dependent on financial figures such as return
on capital, cost to income ratios, free cash flows or cost to income ratios. Goals are set to
maximise short and medium-term profit potential.
The BBRT claims that this is much faster than budgeting. The benchmarking bar is
constantly raised to encourage maximum profit potential.
Performance management
Beyond Budgeting offers an implicit performance contract to managers, with reward based
on relative performance achieved. The targets which replace budgets must be aligned with
incentives to support a new culture of accountability within the organisation.
Rewards
In traditional budgeting, rewards were linked to a fixed outcome agreed in advance. Beyond
Budgeting rewards team success based on relative performance, not fixed annual targets.
Reported benefits: The best performers are recognised and rewarded, not just the skilled
budget negotiators.
Advantages
 It is a more adaptive process than traditional budgeting.
 It is a decentralised process, unlike traditional budgeting where leaders plan and
control organisations centrally.
Disadvantages
 No clear-cut road map which details where a business is and where it wants to go.
 Budgets may be very deeply ingrained in an organisation’s fabric and operating
culture.
 It might be difficult for organisations to adopt the culture of delegation on which
successful Beyond Budgeting thrives.
Apparently, when Beyond Budgeting Round Table (BBRT) use the term budget, they mean
the entire performance management process.
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6.3 UNIT QUESTIONS
Question 1.
Which of the following is a disadvantage of a participative budget?
(a) It does not reflect local resource requirements.
(b) It is time consuming to prepare.
(c) Morale and motivation will be adversely affected.
(d) It will decrease communication between different levels of management.
Question 2.
Which of the following are advantages of a bottom-up process of budgeting?
Select ALL that
apply.
(a) It reduces the amount of budgetary slack.
(b) It increases the co-ordination between the plans of different divisions.
(c) Budgets are based on input from employees who are familiar with day-to-day
activities.
(d) It enhances motivation of managers who are familiar with day to day activities.
6.4 UNIT SUMMARY.

Beyond budgeting is a set of guiding principles that, if followed, will enable
an organisation to manage its performance and decentralise its decision-
making process without the need for traditional budgets. Its purpose is to
enable the organisation to meet the success factors of the information economy (e.g. being
adaptive in unpredictable conditions).
Answers
Example 1
Production budget
Component Watu
Jan Feb March
Sales 860 640 780
Add closing inventory 224 273 280
Less Opening inventory (wii) (301) (224) (274)
Production 783 689 787
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Material usage budget B
Jan Feb Mar
Component Kasili (units) 1,328 1,212 1,110
Material B (kg) /unit 6.6 6.6 6.6
Material B 8,764.80 7,999.20 7,326.00
Component Watu (units) 783 689 787
Material B (kg) /unit 6.5 6.5 6.5
Material B (kg) 5, 089. 50 4, 478.70 5, 115.50
Total material B 13, 854.30 12,477.70 12,441.50
Question 1
The answer is A. It is time consuming to prepare.
Question 2
Budgets are based on input from employees who are familiar with day-to-day activities.
It enhances motivation of managers who are familiar with day to day activities
Advanced investment appraisal is the topic you have to learn in the next unit. You are
expected to know different methods of appraising projects and learn to make decisions from
the outcome.
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UNIT 7: ADVANCED INVESTMENT APPRAISAL
7.0 INTRODUCTION
There are many methods used to evaluate projects. It is vital that you acquaint
yourself with many methods for you to be successful both in examinations and
workplace. The methods available as far this syllabus is concerned are as follows:
Net present value, Internal Rate of Return IRR, Pay back and Discounted payback periods,
Accounting Rate of Return (ARR), Macaulay duration, sensitivity analysis in project
appraisals and consideration of real options in investment appraisal.
Aim
To evaluate potential profitability of projects before a final decision as to which
one could be implemented can be arrived at.
1. Calculate the prospective projects outcome using different appraisal

methods and be able to advise.
2. evaluate projects and consider possible benefits from real options.
Time.
You are expected to take about four hours to finish this unit.
Reflection
In your own words, what would inspire you to pursue a project?
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7.1 SIMPLE PAYBACK PERIOD
The simplest appraisal method, works out how long it will take a project to recoup the
investment, though doesn’t account for cash flows occurring after that time. As a result, its
users may still choose unprofitable projects or those yielding low returns as the decision rule
requires choosing a project which gives back initial outlay within the shortest possible period
of time.
This approach assumes that cash flows occur equally throughout a year.
In practice, of course, they may vary according to the seasonal nature of the business.
Payback cannot evaluate mutually exclusive projects because it doesn’t consider the whole
project period. While payback does not calculate a return for a project, it does provide a
simple measure of risk. Most people instinctively feel that the longer the payback period, the
greater the risk.
Advantages
As an initial screening device, payback period has the following advantages:
1. It is simple to calculate and easy to understand, as it does not involve complex
calculations.
2. Payback period method can also be used as a basic screening device at the first stage
for short list projects.
3. It considers cash flows rather than accounting profits, that’s why chances of
manipulation are very low.
4. Payback period method indirectly avoids risk as it gives favor to those investments
which have short payback periods.
5. This method helps the company to grow, minimize risk and maximize liquidity.
6. In the situation of capital rationing, it can be used to identify the projects which
generate additional cash for investment quickly.
Disadvantages
1 It does not consider the time value of money; hence the outcome may not be accurate
and reliable.
2 It does not consider the whole life of the project. It might be possible that it will favor
the projects, giving high cash inflows in the starting years only and giving very low
cash inflows in the remaining years.
3 There is no specific criteria or rule which can justify that company’s target payback
period is measured accurately that is why it is difficult to measure target payback
period.
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4 It may lead to excessive investment in short term projects.
5 It does not consider the risk and uncertainty in the projects. Uncertainty of cash
inflows can deteriorate the results.
6 It does not focus on shareholders wealth maximization because of the decision rule of
picking the project which recoups the initial investment in the shortest possible time.
7 Life expectancy of a project is ignored.
Below is an oil production project with a cash outflow at the end of its life. The
cash flow in year five is negative, since it includes the cost of decommissioning
the oil rig. To estimate the payback period, we divide the last cumulative cash
outflow, which occurs at the end of year two (K55m), by the cash inflow expected in year
three (K60m). You then add this figure (0.92) to the number of years (two) associated with
the last negative cumulative cash flow to obtain.
Year annual cash flow cumulative cash flows

0 -K125m -K125m
1 K20m -K105m
2 K50m -K55m
3 K60m K5m
4 K40m K45m
5 -K15m K30m
Payback: 2.92 years
Payback = 2yrs + 55/60 = 2.92yrs or [2yrs + 11 months]
7.2 DISCOUNTED PAY BACK PERIOD

Discounted payback period is used to evaluate the time period needed for a project to bring in
enough profits to recoup the initial investment.
Example
An initial investment of K2, 324,000 is expected to generate K600, 000 per year
for 6 years. Calculate the discounted payback period of the investment if the
discount rate is 11%.
Step 1:
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Prepare a table to calculate discounted cash flow of each period by multiplying the actual
cash flows by present value factor. Create a cumulative discounted cash flow column.
Year Cash Flow Prese Value Discounted Cash Cumulative

n CF FactorDF @11% Flow Discounted
CF×PV K1 Cash Flow
0 K 1.0000 (K2, 324,000) (K 2,324,000)
(2,324,000)
1 600,000 0.9009 540,541 (1,783, 459)
2 600,000 0.8116 486, 973 (1,296, 486)
3 600,000 0.7312 438, 715 (857,771)
4 600,000 0.6587 395, 239 (462, 533)
5 600,000 0.5935 356,071 (106, 462)
6 600,000 0.5346 320,785 214, 323
Step 2:
Discounted Payback Period = 5 + -106, 462 = 5.32 years
320, 785
Advantage:
Discounted payback period is more reliable than simple payback period since it accounts for
time value of money. It is interesting to note that if a project has negative net present value it
won't pay back the initial investment.
Disadvantage:
It ignores the cash inflows from project after the payback period.
7.3 MACAULAY DURATION

The weighted average length of time to the receipt of a bond’s benefit (Coupon and
redemption value), the weights being the present value of the benefits involved. It is a
composite measure of the risk expressed in years.
Calculating duration steps
1. Multiply the present value of cash flows for each time period by the time period and
add together
2. Add the present value of the cash flows in each time period together
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3. Divide the result of step 1 by the result of step 2
Assumptions
1. Macaulay Duration measures interest rate risk only for bonds where cashflows do not
change
with change in the yield (i.e. for plain vanilla bonds and not for bonds with embedded
options)
2. Macaulay Duration assumes yield curve is flat and so cashflows are reinvested at constant
YTM rate over the bond period.
3. Macaulay Duration does not consider the fact that duration does not remain constant and
duration changes with level of YTM rates.
Note that the total present value of the bond’s flow of 97.26 is equal to the price, as would
be expected
Example
What is the Macaulay duration and modified duration of a 10% interest-only 5-year loan with
annual payments and a balloon in year 5?
There are three parts to solving this problem.

Part 1 – write out the cash flows.
Part 2 – determine the weight on each cash flow, where the weight is the percent of the
present value of that particular cash flow.
Part 3 –compute the duration.
Here are the cash flows assuming a K100,000 mortgage (the dollar amount of the mortgage
does not matter).
Year 1 2 3 4 5
K10,000 K10,000 K10,000 K10,000 K110,000
Present value of the cash flows

Year 1 PV = K10,000/1.1 = 9090.91
Year 2 PV = K10,000/ (1.1)2 = 8264.463
Year 3 PV = K10,000/ (1.1)3 = 7513.148
Year 4 PV = K10,000/ (1.1)4 = 6830.135
Year 5 PV = K10,000/ (1.1)5 = 68301.35
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You can verify the sum of these PVs is equal to K100,000
Here are the weights associated with each cash flow (weight = PV / K100,000, you can verify
that the weights sum to 1.0)
Year 1 2 3 4 5
0.0909 0.0826 0.0751 0.0683 0.6830
And finally, here is the sum of each year’s weight times the year
1× 0.0909 + 2×0.0826 + 3×0.0751 + 4×0.0683 + 5×0.683 = 4.17 = Macaulay Duration
The modified duration is the Macaulay duration divided by 1 + the interest rate
= 4.17 / 1.10 = 3.79
Properties of duration
 Duration is always less than the bond maturity
 Duration increases coupon decreases
 Duration increases as yield to maturity increases
 Duration increases as maturity increases.
7.4 ACCOUNTING RATE OF RETURN (ARR)

Unlike payback which provides a simple measure of risk, ARR computes a project’s return.
ARR is calculated by dividing the average annual profit flow by the average value of the
investment.
It is possible to apply the same principles to two mutually exclusive projects to calculate an
ARR for each. Using ARR to choose between them, you must pick a project that offers a
higher return. That is the decision rule for ARR
The CIMA Official terminology definition is Average annual profit from investment x 100
Average investment
7.5 INTERNAL RATE OF RETURN (IRR)

The IRR is the discount rate that produces a net present value (NPV) of zero for a project’s
cash flows. The simple decision rule is to accept projects with an IRR that’s greater than the
cost of capital and reject those with an IRR that’s less than the cost of capital.
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Advantages
1. Information provided by IRR is easily understood by managers.
2. There is no specification of a discount rate before the IRR can be calculated.
3. It ignores the relative size of investment.
Disadvantages of IRR
1. It assumes that money earned from a potential investment will be reinvested at the
project’s IRR. But is this a realistic assumption, particularly if a project has a high
potential return? The answer is NO! it has to be at the cost of capital.
2. It is possible to calculate multiple rates of return for a project if it has irregular or
unusual cash flows. Which one is right?
3. IRR produces multiple answers in case of non-conventional cash flows.
4. IRR is not helpful in choosing the best answer in case of mutually exclusive projects.
5. IRR is a relative measure therefore it does not consider the size of the project.
IRR by interpolation, two sets of calculations must be performed for a project’s cash flows.
Ideally, one set will calculate a positive NPV and the other a negative NPV. Then use the
formula
6. IRR = A% + NPVa
(NPVa +NPVb) x (B% - A%)
Where: A% is the lower rate
NPVa is the net present value calculated using the lower rate.
NPVb is the net present value calculated using the higher rate.
B% is the higher rate.
7.6 DISCOUNTED CASH FLOW (DCF)

DCF methods are based on a simple idea: today’s money is worth more than the same amount
received in future, because today’s money can be invested – eg, put in a deposit account at a
fixed interest rate. Future cash flows from an alternative investment are discounted at the
opportunity cost of capital – eg, the interest lost by taking money out of the deposit account
to fund a project – in order to determine whether it provides a better return. Another way of
looking at this concept, if the investor needs to borrow money, is to consider what future
money would be worth now after taking account of the cost of borrowing. ARR cannot take
account of the time value of money, since it uses profit flows rather than cash flows.
Discount factors are calculated as follows:
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1 ÷ (1 + r) n, where r is the rate of interest and n is the year for which the factor is being
calculated. The discount factor for an interest rate of 10 per cent for year one, for example,
would be: 1 / (1 + 0.1)1 = 0.909. The factor for year two would be 1/ (1 + 0.1) 2 = 0.826. For
your examinations, these factors will be given them. You have to use appropriate discount
factors to discount cash flows.
Discounting is all about bringing expected future cash flows to current economic terms for
easier comparison with the initial investment and ultimately judge if at all there is value
addition or losses. NPV does give an absolute return rather than a percentage. Using this
approach, you should apply discount factors to future cash flows to determine their present
value. You then add up the present values of the cash flows for each year of the project to
find its NPV.
The simple decision rule is to accept projects with a positive NPV and reject those with a
negative NPV.
7.7 NET PRESENT VALUE

The net present value (NPV) is 'The difference between the sum of the projected discounted
cash inflows and outflows attributable to a capital investment or other long-term project'.
(CIMA Official Terminology).
The NPV method therefore compares the present value of all the cash inflows from a project
with the present value of all the cash outflows from a project. The NPV is thus calculated as
the PV of cash inflows minus the PV of cash outflows.
This method does give an absolute return rather than a percentage.
Decision Rule: -
(a) If the NPV is positive, it means that the present value of the cash inflows from a project is
greater than the present value of the cash outflows. The project should therefore be
undertaken.
(b) If the NPV is negative, it means that the present value of cash outflows is greater than the
present value of inflows. The project should therefore not be undertaken. (c) If the NPV is
exactly zero, the present value of cash inflows and cash outflows are equal and the project
will be only just worth undertaking.
Capital allowances/writing down allowances (WDAS)
Capital allowances/writing down allowances (WDAs). Remember that depreciation is a way
of charging the cost of plant and machinery against financial accounting profits over a
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number of periods (thereby reducing profits). Similarly, writing down allowances (WDAs) or
capital allowances (sometimes called tax allowable depreciation) are a way of charging the
cost of plant and machinery against taxable profits over a number of periods, thereby
reducing taxable profits and hence the tax payable. The reduction in tax payable (to be
included in the DCF analysis) = amount of WDA × tax rate.
As half the tax on profit is paid in the year to which the profits relate, and half in the
following year, the benefit of the WDA is also felt half in the year to which it relates and half
in the following year.
Taxation in capital projects
(a) Compute the total cost of any new asset.
(b) Compute WDA for each year and multiply by the tax rate to give the tax saving.
(c) Half of tax saving is a benefit in the year in question, half in the following year.
(d) Calculate a balancing allowance or charge on the sale of the asset
(i) If sales price is bigger than the reducing balance, you will have the balancing charge
(increases taxable profit)
(ii) If sales price is less than the reducing balance, the balancing allowance (reduces taxable
profit) results.
(e) Effect of the balancing charge/allowance (which is calculated as amount × tax rate) is felt
half in the year in which the asset is sold and half in the following year.
(f) Include in the appraisal: tax on WDAs and balancing allowance/charge, net cash inflows
due to project (i.e. taxable profits) and tax on these net cash inflows.
Note that the net cash flows from a project should be considered as the taxable profits
arising from the projects (unless an indication is given to the contrary)
Example
7.24 Mwamba has a cost of capital of 15% and is considering a capital investment
project, where the estimated cash flows are as follows.
Year Cash flow K
0 (i.e. now) (100,000)
1 60,000
2 80,000
3 40,000
4 30,000
Required Calculate the NPV of the project, and assess whether it should be undertaken.
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Year Cash flow Discount factor Present value
K 15% K
0 (100,000) 1.000 (100,000)
1 60,000 1/(1.15)= 0.870 52,200
2 80,000 1/1.152 = 0.756 60,480
3 40,000 1/1.153 = 0.658 26,320
4 30,000 1/1.154 = 0.572 17,160
NPV = 56,160
(Note. The discount factor for any cash flow 'now' (time 0) is always 1.000, whatever the cost
of capital.) The PV of cash inflows exceeds the PV of cash outflows by K56,160, which
means that the project will earn a DCF yield in excess of 15%. It should therefore be
undertaken.
Example
Scores Co is evaluating the purchase of a new machine to produce product called
Top star decoder, which has a short product life-cycle due to rapidly changing
technology. The machine is expected to cost K1 million. Production and sales of
top star are forecast to be as follows:
Years 1 2 3 4
Production and sales (units/year) 35,000 53,000 75,000
36,000
The selling price of Top star decoder (in current price terms) will be K20 per unit, while the
variable cost of the product (in current price terms) will be K12 per unit. Selling price
inflation is expected to be 4% per year and variable cost inflation is expected to be 5% per
year. No increase in existing fixed costs is expected since Scores Co has spare capacity in
both space and labour terms.
Producing and selling Top star decoder will call for increased investment in working capital.
Analysis of historical levels of working capital within Scores Co indicates that at the start of
each year, investment in working capital for Top star decoder will need to be 7% of sales
revenue for that year.
Scores Co pays tax of 30% per year in the year in which the taxable profit occurs. Liability to
tax is reduced by capital allowances on machinery (tax-allowable depreciation), which Scores
Co can claim on a straight-line basis over the four-year life of the proposed investment. The
new machine is expected to have no scrap value at the end of the four-year period.
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Scores Co uses a nominal (money terms) after-tax cost of capital of 12% for investment
appraisal purposes.
Required:
(a) Calculate the net present value of the proposed investment in Top star decoder. (10 marks)
(b) Calculate the internal rate of return of the proposed investment in Top star decoder.
(3 marks)
(c) Advise on the acceptability of the proposed investment in Top star decoder and discuss
the limitations of the evaluations you have carried out. (3
marks)
(d) Discuss how the net present value method of investment appraisal contributes towards the
objective of maximising the wealth of shareholders. (4 marks)
SOLUTION
Calculation of net present value
Year 0 1 2 3 4
K K K K K
Sales revenue 728,000 1,146,390 1,687,500 842,400
Variable costs (441,000) (701,190) (1,041,750) (524,880)
Contribution 287,000 445,200 645,750 317,520
Capital (250,000) (250,000) (250,000) (250,000)
allowances
Taxable profit 37,000 195,200 395,750 67,520
Taxation (11,100) (58,560) (118,725) (20,256)
After-tax profit 25,900 136,640 277,025 47,264
Capital 250,000 250,000 250,000 250,000
allowances
After-tax cash 275,900 386,640 527,025 297,264
flow
Initial investment (1,000,000)
Working (50,960) (29,287) (37,878) 59,157 58,968
capital
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Net cash (1,050,960) 246,613 348,762 586,182 356,232
flows
Discount at 1·000 0·893 0·797 0·712 0·636
12%
Present (1,050,960) 220,225 277,963 417,362 226,564
values
NPV = K91, 154
Advantages of Net Present Value:

1. Net Present Value method takes into account the time value of money and this is
giving a better picture of the projects viability.
2. It considers the whole life of the project because all cash flows relating to the project
life is incorporated in its calculations.
3. It gives an indication about the increase or decrease in the wealth of shareholders. Its
decisions rule is consistent with the objective of maximization of shareholders wealth.
4. It focuses on cash flows rather than accounting profit, so it takes into account the
relevancy and irrelevancy of cash flows.
5. Change in cost of capital can be incorporated in it.
6. It can also be used for projects with non-conventional cash flows.
7. It gives a better ranking of mutually exclusive projects.
8. It assumes that cash flows are reinvested at the company’s cost of capital.
9. NPV is technically more superior method to IRR because of its less rigid assumptions.
Disadvantages’ of Net Present Value:

1. It involves complex calculations as compared to other techniques. Resultantly, it is
difficult to calculate and difficult to understand.
2. Managers feel it difficult to explain the calculations of Net Present Value method.
3. It does not take into account the risk and uncertainty of estimates and scarcity of
resources.
4. Cost of capital used in NPV calculation is difficult to calculate and gets subjective
when we incorporate risk and uncertainty within companies cost of capital.
5. Changing technology may render the product obsolete before the natural end of the
project life.
6. It fails to relate the return of the project to the size of the cash outlay.
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Question 1
A washing machine manufacturer is considering the replacement of existing
equipment with new equipment for its production of the new range of industrial
washing machines. The new equipment will cost K1, 620,000 and installation will
cost another K73, 000. The new equipment’s salvage value is estimated to be K315, 000 at
the end of its useful life, which is 7 years. The old equipment was acquired 8 years ago for
K1, 230,000. The company can sell the old equipment immediately for K255, 000.
With the new equipment, the manufacturer expects to reduce variable costs by 7% for the
first 5 years and by 12% for the last 2 years. The company uses straight-line depreciation.
The company’s before-tax cost of capital is 20%, and the tax rate is 40%. The company sells
20 washing machines per year at K275, 000 each. The costs per washing machine are as
follows:
Costs per washing machine.
Direct materials K160, 000
Direct labour K55, 000
Direct labour K30, 000
total cost K245, 000
Capital allowances are available on the purchase of washing machines, excluding the cost of
installation, at 20% per annum on a reducing balance basis. Tax is payable in the year in
which the liability arises.
Required:
Compute the net present value of the new equipment. Provide your calculations to the nearest
Kwacha. Should the company acquire the new machine? [15 Marks]
Solution is provided at the end this unit
Taxation and DCF
The effect of taxation on capital budgeting is simple. Organisation must pay tax and the effect
of undertaking a project will be to increase or decrease tax payment each year. These
incremental tax cash flows should be included in the cash flows of the project for discounting
to arrive at the project’s NPV.
7.8 THE BLACK SCHOLES MODEL

This is a model used to calculate the value of an option. It uses the formula to calculate the
value of the call option. Options are either traded or real options.
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For traded options, the formula is as follows:
C= Pa N(d1)- Pe N(d2) e–rt

Where pa = current market share price
Pe = Exercise price.
T = time to maturity.
R = risk free.
S = volatility.
First you have to calculate d1, then d2 and insert them into the formula above.
d1 = In (Pa / Pe ) + (r + 0.5s2 )t
s√ t
N(d1) is gotten from the normal distribution table. If the answer for d 1 is positive, (e.g. d1 =
0.95, from the first column of the normal distribution table, check for 0.9 and look for 0.05
along the topmost row and find the intersection off the two directions on the area under the
curve. Add 0.5 to the value from normal distribution table to calculate N(d 1). However, if the
answer for d1 is negative, subtract the value from the normal distribution table from 0.5 to
arrive at N(d1)
d2 = d1 - s√ t
N(d2) is gotten from the normal distribution table just like N(d1)
Value of the put option is calculated using the Put-Call Parity formula
p = c − Pa + Pe e-rt
where; C is the value of call option
pa is the share’s current market value
Pe = Exercise price
Application of Black Scholes in real options
There are differences between the application of Black Scholes model to financial options
and real options. The main practical problem is the estimation of volatility. As the underlying
asset is not traded, it is very difficult to establish the volatility of the value. The main method
to overcome this problem is to use simulation method to estimate volatility.
For real options to calculate the call option the formula is the same though there are changes
(pa) and (pe) variables.
C= Pa N(d1)- Pe N(d2) e –rt
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Where:
Pa = is the value of the project [the PV of future cash inflows]
Pe = is the additional investment involved in expansion
The formula is based on 5 principal drivers of value.
1. The underlying asset value (Pa), which is the present value of future cash flows arising
from the project.
2. The exercise price (Pe), which is the amount paid when the call option is exercised or
amount received if the put option is exercised.
3 Risk-free rate (r): the continuously compounded annual rate of interest – in practical terms,
this means that K1 invested for one year in a riskless asset will equal e r (where e is 2.7183 –
the base of natural logarithms).
4. The volatility (s), which is the risk attached to the project or underlying asset, measured by
the standard deviation.
5. Time to expiry (t): the validity period of the option (expressed as a fraction of a year)
When using the formula, there is need to learn the dynamics involved if one of the
variables increases:
1. When the exercise price (Pe) increases, it results in decrease in the call value and
increase in the put value.
2. When the Underlying asset (Pa) increases, the call value increases too and the put
value goes down.
3. When the Volatility (s) increases, an increase in the Call value is automatically
triggered and put value goes up.
4. When the Time to expiry (t) increases, it results in an increase in the Call value and an
increase in the Put value.
5. When the Risk-free rate (r) increases, there is an increase in the Call value and the put
value decreases.
6. The time (t), which is the time, in years, that is left before the opportunity to exercise
ends.
Assumptions
There are a number of assumptions relating to Black-Scholes:
1. Taxes are zero.
2. Transaction costs are zero.
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3. Constant risk-free rate.
4. Continuously functioning market.
5. Stock prices can be plotted as a continuous function.
6. No penalties in the event of short selling of the stock.
7. Option is exercisable only at expiry date (European-style).
8. No cash dividends are paid on the shares.
EXAMPLE
Chilanga Co is undertaking a due diligence investigation of Ndola Lime Co and is

reviewing the potential bid price for an acquisition. You have been appointed as a consultant
to advise the company’s management on the financial aspects of the bid.
Chilanga Co is a fully listed company financed wholly by equity. Ndola Lime is listed on an
alternative investment market. Both companies have been trading for over 10 years and have
shown strong levels of profitability recently.
However, both companies’ shares are thinly traded. It is thought that the current market value
of Ndola Lime’s shares at 33 1/3% higher than the book value is accurate, but it is felt that
Chilanga Co shares are not quoted accurately by the market.
The following information is taken from the financial statements of both companies at the
start of the current year:
Chilanga Ndola Lime

K000 K’000
Assets less current liabilities 4400 4200
--------- ---------
Capital Employed
Equity 4400 1200
5-year floating rate loan at yield rate plus 3% 3000
--------- ---------
Total capital employed 4400 4200
--------- ---------
Net operating profi t after tax (NOPAT) 580 430
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Net amount retained for reinvestment in assets 180 150
It can be assumed that the retained earnings for both companies are equal to the net
reinvestment in assets.
The assets of both companies are stated at fair value. Discussions with the Stadard Chartered
Bank have led to an agreement that the floating rate loan to Ndola Lime can be transferred to
the combined business on the same terms.
The current yield rate is 5% and the current equity risk premium is 6%. It can be assumed
that the risk free rate of return is equivalent to the yield rate. Chilanga’s beta has been
estimated to be 1•26. Chilanga’s Co wants to use the Black-Scholes option pricing (BSOP)
model to assess the value of the combined business and the maximum premium payable to
Ndola Lime shareholders. Chilanga has conducted a review of the volatility of the NOPAT
values of both companies since both were formed and has estimated that the volatility of the
combined business assets, if the acquisition were to go ahead, would be 35%. The exercise
price should be calculated as the present value of a discount (zero-coupon) bond with an
identical yield and term to maturity of the current bond.
Required:
Prepare a report for the management of Chilanga on the valuation of the combined business
following acquisition and the maximum premium payable to the shareholders of Ndola lime.
Your report should, explain the circumstances in which the Black-Scholes option pricing
(BSOP) model could be used to assess the value of a company, including the data required
for the variables used in the model. (5 marks)
Solution
Date: 28/11/2017
From: Finance Manager
To: Management of Chilanga
Subject; Valuation of the combined business
Introduction
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Using the BSOP model in company valuation rests upon the idea that equity is a call option,
written by the lenders, on the underlying assets of the business. If the value of the company
declines substantially then the shareholders can simply walk away, losing the maximum of
their investment. On the other hand, the upside potential is unlimited once the interest on debt
has been paid.
BSOP model can be helpful in circumstances where the conventional methods of valuation
do not reflect the risks fully or where they can not be used. Given the gearing of the two
companies, the low levels of trading in each company’s equity, and their future growth
potential, including its volatility, it is appropriate to handle the valuation by focusing upon
the real option value attributable to the post-acquisition business.
There are five variables which are input into the BSOP model to determine the value of the
option. Proxies need to be established for each variable when using the BSOP model to value
a company. The five variables are:
1 The value of the underlying asset

2 The exercise price,
3 The time to expiry
4 The volatility of the underlying asset value and
5 The risk-free rate of return.
For the exercise price, the debt of the company is taken. In its simplest form, the assumption
is that the borrowing is in the form of zero coupon debt, i.e., a discount bond. In practice such
debt is not used as a primary source of company finance and so we calculate the value of an
equivalent bond with the same yield and term to maturity as the company’s existing debt.
The exercise price in valuing the business as a call option is the value of the outstanding debt
calculated as the present value of a zero-coupon bond offering the same yield as the current
debt. The proxy for the value of the underlying asset is the fair value of both the companies’
assets less current liabilities on the basis that if the company is broken up and sold, then that
is what the assets would be worth to the long-term debt holders and the equity holders.
The time to expiry is the period of time before the debt is due for redemption. The owners of
the company have that time before the option needs to be exercised, that is when the debt
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holders need to be repaid. The proxy for the volatility of the underlying asset is the volatility
of the business’ assets. The risk-free rate is usually the rate on a riskless investment such as a
short-term government bond.
Should you need further information, please do not hesitate to contact me.
Yours
FM.
7.9 INVESTMENT APPRAISAL AND REAL OPTIONS

These are choices an organisation would make over a project which may have given a
negative NPV or marginal positive NPV for it to turn profitable due to the additional value
that may be imbedded in the real option. Real options build on net present value in situations
where uncertainty exists and, for example:
(i) When the decision does not have to be made on a now or never basis, but can be delayed,
(ii) When a decision can be changed once it has been made, or
(iii) When there are opportunities to exploit in the future contingent on an initial project being
undertaken. Therefore, where an organisation has some flexibility in the decision that has
been, or is going to be made, an option exists for the organisation to alter its decision at a
future date and this choice has a value.
With conventional NPV, risks and uncertainties related to the project are accounted for in the
cost of capital, through attaching probabilities to discrete outcomes and/or conducting
sensitivity analysis or stress tests.
Options, on the other hand, view risks and uncertainties as opportunities, where upside
outcomes can be exploited, but the organisation has the option to disregard any downside
impact.
Real options methodology takes into account the time available before a decision has to be
made and the risks and uncertainties attached to a project. It uses these factors to estimate an
additional value that can be attributable to the project.
The choices (options) could be;

1. Decision to delay the implementation of the project.
2. Decision to expand the project.
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3. Decision to follow on.
4. Decision to withdraw/Abandonment.
Estimating the Value of Real Options.
You are expected to explain and compute an estimate of the value attributable to three
types of real options:
(i) The option to delay a decision to a future date (which is a type of call option).
(ii) The option to abandon a project once it has commenced if circumstances no
longer justify the continuation of the project (which is a type of put option), and
(iii) The option to exploit follow-on opportunities which may arise from taking on an
initial project (which is a type of call option).
In addition to this, candidates are expected to be able to explain (but not compute the
value of) redeployment or switching options, where assets used in projects can be
switched to other projects and activities.
Examples
Carter B Ltd is planning to invest in the expansion of its production facilities. The
company has estimated K20m as the initial investment for the expansion. The
expansion is expected to generate K5m after tax cash inflows each year for the
next five years. Assuming a discount rate of 10%, calculate the NPV of the project. Also
calculate the value of the option to delay the project assuming the risk-free rate is 7% and the
standard deviation of the project cash flows is 30%.
Answer
4 NPV of the new project = (20) + 5×3.79
= (20) + 18.95
= - K1.05m
5 evaluation of the option to delay
value of underlying asset (Pa) = 18.95
strike price (Pe) K 20m
time to expiry (t) 5 years
standard deviation (s) 30%
risk-free rate 7%
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Step 1 calculate the values of d1 and d2
d1 = In (Pa / Pe ) + (r + 0.5s2 )t
s√ t
d1 = [18.95/20] + [0.07 +0.5(0.3)2] ×5

0.30√5
d1 = 0.779
d2 = 0.779 – 0.67
d2 = 0.779 – 0.67
= 0.109
Step 2 calculate the values of N(d1) and N(d2) from the normal distribution table.
N(d1) = 0.2794 + 0.5 = 0.7794
N(d2) = 0.0438+0.5 = 0.5438
Step 3 substitute the values of N(d1) and N(d2) in the option pricing formula.
Value of the call option = 18.95 × 0.7794 – 20 (0.5438) e-0.07×5
= 14.77 – 7.66
= K7.11m
Task 2
Option to delay
A company is considering bidding for the exclusive rights to undertake a project,
which will initially cost K35m.
The company has forecast the following end of year cash flows for the four-year project.
Year 1 2 3 4
Cash flows (Km) 20 15 10 5
The relevant cost of capital for this project is 11% and the risk-free rate is 4.5%. The likely
volatility (standard deviation) of the cash flows is estimated to be 50%.
Using Black Scholes model, calculate the value of the call option
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7.40 Unit summary
Project evaluation can be done in different ways. Decision rules tend to differ;
therefore, you are expected to learn and be able to give a sound advice with
regards to the best and appropriate approach. It is important to consider real
options in appraising new projects because of the value imbedded in real
options which can easily change the total outcome of a project.
Answers
Unit Activities
Task 1
(a) Year 0 1 2 3 4 5 6
Initial outlay (1,620,000)
Installation Costs (73,000)
Old machine scrap 255,000
Sales 5,500,000 5,500,000 5,500,000 5,500,000 5,500,000 5,500,000
Revenue
(K275,000 x
20)
Variable costs (4,194,300) (4,194,300) (4,194,300) (4,194,300) (4,194,300) (3,968,80

(w.1)
Fixed costs (390,000) (390,000) (390,000) (390,000) (390,000) (390,000)
Pre-tax 915,700 915,700 915,700 915,700 915,700 1,141,200
cashflow
Tax at 40% (366,280) (366,280) (366,280) (366,280) (366,280) (456,480)
Scrap value 315,000
Tax savings 129,600 103,680 82,944 66,355 53,084 42,467
(w.2)
Net cash (1,438,000) 679,020 653,100 632,364 615,775 602,504 727,1
flow
DF @ 12% 1.0 0.892 0.797 0.712 0.636 0.567 0.507
PV (1,438,000) 605,686 520,521 450,243 391,633 341,620 368,6
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NPV= K1,712,090
Decision: Yes. The company should acquire the machine on a financial basis because it gives
a positive NPV.
Workings
(w1)
K
Variable costs
Direct materials 160
Direct labour 55
V/overheads (35% × K30) 10.5
Variable cost per unit 225.5
X
Total machines per annum 20
Total variable costs (K000) 4510
Net costs
Years 1-5 (93% ×K4510) = 4194.3
Years 6-7 (88% x 4510) = 3968.8
@20% @40%
Year 0 K1620,000
Year 1, WDA 20% × 1620,000 = 324,000
Tax savings @40% 324,000 = 129,600
Year 1 Balance b/d (1620,000 – 324,000) = K1296000

Year 2 WDA 20% × K1,296,000 = 259,200
Tax savings 40%×259,200 = 103,680
Year 2 b/d (1,296,000 – 259,200) = 1,036,800

Year 3 WDA @ 20% × 1,036,800 = 207360
Tax savings 82,944
Year 3 Balance b/d 829440

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Year 4 WDA@20% = 165888
Tax savings 66365

Year 5 WDA @ 20% 132710
Tax savings 53084

Year 6WDA @ 20% 106168
Tax savings @ 40% 42467

Year 7 sales 315000
109677
Bala Allowance 109674 × 40% = 43870
Activity
Task 2
Variables to be used in the BSOP model

Asset value (Pa) = K14.6m + K9.9m + K5.9m + K2.7m = K33.1m
Exercise price (Pe) = K35m
Exercise date (t) = Two years
Risk free rate (r) = 4.5%
Volatility (s) = 50%
Using the BSOP model
d1 0.401899
d2 -0.30521
N(d1) 0.656121
N(d2) 0.380103
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Call value K9.6m
Based on the facts that the company can delay its decision by two years and a high volatility,
it can bid as much as K9.6m instead of K5.8m for the exclusive rights to undertake the
project. The increase in value reflects the time before the decision has to be made and the
volatility of the cash flows.
The next unit is about measuring the performance either for departments, divisions or a
company as a whole.
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UNIT 8: PERFORMANCE MASUREMENT
8.0 INTRODUCTION
This unit begins by explaining the terminology performance measurement and
description of various performance measures that are used by private sector
organisations (other than variances).
It is important that the performance of an organisation is monitored; this is mostly done by
calculating a number of ratios.
The unit concludes by considering alternative views of performance measurement such as
balanced score card, building blocks and benchmarking.
Aim
Performance measurement aim to establish how well something or somebody is
doing in relation to a plan. The ‘thing’ may be a machine, a factory, a subsidiary
company or an organisation as a whole. ‘The body’ may be an individual
employee, a manager, or a group of people.

1. Describe, calculate and interpret financial performance indicators (KPI)s
for profitability, liquidity and risk in both manufacturing and service
businesses
2. Describe, calculate and interpret non-financial performance indicators (NFPIs)
methods to improve these measures.
3. Explain and interpret the balanced scorecard, and the building block model proposed
by Fitzgerald and moon and the concept of benchmarking.
4. Evaluate Economic Value Added (EVA) and interpret the results.
Time: you are expected to take two hours studying this unit
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Reflection
In your own words, how would you evaluate or rather explain the
performance of a manager or an organisation as a whole?
Financial measures are typically measures relating to revenues, costs profits, return on
capital, asset values or cashflows. Ratios will often help you analyse financial statements for
the year under consideration and to compare them with the results of say, a prior period,
another entity, or against industry averages.
When interpreting, it is important that you carefully consider information provided in the
scenario and incorporate it into your assessment for your answer to be grounded.
8.1 PROFITABILITY
8.04 (a) Return on capital employed (ROCE) =
ROCE = Profit before interest and tax

Shareholders' equity + debt
ROCE is the primary profitability ratio as it shows how well a business has generated profit
from its long-term financing. A rise in ROCE is usually considered to be an improvement.
Movements in return on capital employed are best interpreted by examining profit margins
and asset turnover in more detail (often referred to as the secondary ratios) as ROCE is made
up of these component parts.
For example, an improvement in ROCE could be due to an improvement in margins or more

efficient use of assets.
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Asset turnover.
Asset turnover = Revenue

Total assets - current liabilities
Asset turnover shows how efficiently management have utilised assets to generate revenue.
When looking at the components of the ratio a change will be linked to either a movement in
revenue, a movement in net assets, or both.
There are many factors that could both improve and deteriorate asset turnover. For example, a
significant increase in sales revenue would contribute to an increase in asset turnover or, if
the business enters into a sale and operating lease agreement, then the asset base would
become smaller, thus improving the result.
Profit margins
Profit margins = Gross or Operating profit

Revenue
The gross profit margin looks at the performance of the business at the direct trading level.
Typically differences in this ratio are as a result of changes in the selling price/sales volume
or changes in cost of sales.
For example, cost of sales may include inventory write downs that may have occurred during
the period due to damage or obsolescence, exchange rate fluctuations or import duties.
The operating profit margin (or net profit margin) is generally calculated by comparing the
profit before interest and tax of a business to revenue, but, beware in the exam as sometimes
the examiner specifically requests the calculation to include profit before tax.
Analysing the operating profit margin enables you to determine how well the business has
managed to control its indirect costs during the period.
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When interpreting operating profit margin, it is advisable to link the result back to the gross
profit margin. For example, if gross profit margin deteriorated in the year then it would be
expected that operating margin would also fall.
However, if this is not the case, or the fall is not so severe, it may be due to good indirect cost
control or perhaps there could be a one-off profit on disposal distorting the operating profit
figure.
8.2 LIQUIDITY RATIOS
Current ratio
Current ratio = Current assets

Current liabilities
The current ratio considers how well a business can cover the current liabilities with its
current assets. It is a common belief that the ideal for this ratio is between 1.5 and 2 to 1 so
that a business may comfortably cover its current liabilities should they fall due.
However, this ideal will vary from industry to industry. For example, a business in the service
industry would have little or no inventory and therefore could have a current ratio of less than
1. This does not necessarily mean that it has liquidity problems so it is better to compare the
result to previous years or industry averages.
Quick ratio (sometimes referred to as acid test ratio) =
Quick ratio = Current assets - inventory

Current liabilities
The quick ratio excludes inventory as it takes longer to turn into cash and therefore places
emphasis on the business's 'quick assets' and whether or not these are sufficient to cover the
current liabilities. Here the ideal ratio is thought to be 1:1 but as with the current ratio, this
will vary depending on the industry in which the business operates.
When assessing both the current and the quick ratios, look at the information provided within
the question to consider whether or not the company is overdrawn at the year-end. The
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overdraft is an additional factor indicating potential liquidity problems and this form of
finance is both expensive (higher rates of interest) and risky (repayable on demand).
Receivables collection period (in days)
Receivables collection period (in days) = Receivables x 365

Credit sales
It is preferable to have a short credit period for receivables as this will aid a business's cash
flow. However, some businesses base their strategy on long credit periods. For example, a
business that sells sofas might offer a long credit period to achieve higher sales and be more
competitive than similar entities offering shorter credit periods.
If the receivables days are shorter compared to the prior period it could indicate better credit
control or potential settlement discounts being offered to collect cash more quickly whereas
an increase in credit periods could indicate a deterioration in credit control or potential bad
debts.
Payables collection period (in days).
Payables collection period = Payables x 365

Credit purchases*
*(or cost of sales if not available)
An increase in payables days could indicate that a business is having cash flow difficulties
and is therefore delaying payments using suppliers as a free source of finance. It is important
that a business pays within the agreed credit period to avoid conflict with suppliers. If the
payables days are reducing this indicates suppliers are being paid more quickly. This could be
due to credit terms being tightened or taking advantage of early settlement discounts being
offered.
Inventory days
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Inventory days = Closing (or average) inventory x 365 days.
Cost of sales
Generally, the lower the number of days that inventory is held the better as holding inventory
for long periods of time constrains cash flow and increases the risk associated with holding
the inventory. The longer inventory is held the greater the risk that it could be subject to theft,
damage or obsolescence. However, a business should always ensure that there is sufficient
inventory to meet the demand of its customers.
Gearing.
Gearing = Debt or Debt

Equity Debt + equity
The gearing ratio is of particular importance to a business as it indicates how risky a business
is perceived to be based on its level of borrowing. As borrowing increases so does the risk as
the business is now liable to not only repay the debt but meet any interest commitments under
it. In addition, to raise further debt finance could potentially be more difficult and more
expensive.
If a company has a high level of gearing it does not necessarily mean that it will face
difficulties as a result of this. For example, if the business has a high level of security in the
form of tangible non-current assets and can comfortably cover its interest payments (interest
cover = profit before interest and tax compared to interest) a high level of gearing should not
give an investor cause for concern.
8.3 RETURN ON INVESTMENT (ROI) AT THE DIVISIONAL LEVEL

Earnings can be measured at the divisional level in relation to the financial resources they
use. The ROI measure is very similar to ROCE (return on capital employed) with the only
exception being the use of profit in the formula:
ROI = Net Profit ×100%

Capital Employed
ROI as defined above is commonly used for investment appraisal and for business sector
(divisional) performance, whereas ROCE is common at the overall corporate level.
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Advantages of Return on Investment
1. It is widely used and accepted since it is line with ROCE which is frequently used to
assess overall business performance.
2. As a relative measure it enables comparisons to be made with divisions or companies

of different sizes.
3. It can be broken down into secondary ratios for more detailed analysis, i.e. profit
margin and asset turnover.
Disadvantages of Return on Investment
1. It may lead to dysfunctional decision making, e.g. a division with a current ROI of
20% would not wish to accept a project offering a ROI of 15%, as this would dilute its
current figure. However, the 15% ROI may meet or exceed the company's target.
2. ROI increases with the age of the asset if Net Book Values (NBV) are used, thus
giving managers an incentive to hang on to possibly inefficient, obsolescent
machines.
3. It may encourage the manipulation of profit and capital employed figures to improve
results, e.g. in order to obtain a bonus payment.
4. Different accounting policies can confuse comparisons (e.g. depreciation policy).
8.4 RESIDUAL INCOME (RI)

Convert results into monetary magnitudes:
Residual Income = Divisional EBIT xxx
Less (minus) Imputed interest (xx)
Residue Income xxx
Where;
Imputed interest = Capital Employed X Capital charge (or cost of capital)
A positive result adds profits to the division beyond the incremental capital cost. An
investment should be accepted if the RI is positive.
Advantages of Residue Income
1. Residue income encourages managers for investment centers to make new

investments if such investments would add to RI. A new investment might add to RI
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but reduce ROI. In such a situation, measuring performance by RI would not result in
dysfunctional behavior, i.e. the best decision will be made for the business as a whole.
2. Making a specific charge for interest helps to make investment centre managers more
aware of the cost of the assets under their control.
Disadvantages of Residue Income
1. It does not facilitate comparisons between divisions since the RI is driven by the size
of divisions and of their investments.
2. It is based on accounting measures of profit and capital employed which may be

subject to manipulation, e.g. in order to obtain a bonus payment.
8.5 ECONOMIC VALUE ADDED (EVA)

Economic Value Added (EVA) is the financial performance measure that comes closer than
any other to capturing the true economic profit of an enterprise. It is the performance measure
most directly linked to the creation of shareholders wealth over time. The very logic of using
EVA is to maximize the value for the shareholders. More explicitly, EVA measure gives
importance on how much economic value is added for the shareholders by the management
for which they have been entrusted with. EVA is exceptional from other traditional tools in
the sense that all other tools mostly depend on information generated by accounting.
Undoubtedly, accounting, more often produces historical data or distorted data that may have
no relation with the real status of the company. But, EVA goes for adjustments to accounting
data to make it economically viable. The EVA method involves extensive adjustments to be
made to the financial statements of a company in order to determine whether the company
has created (or destroyed) value during the year.
EVA is arrived at by calculating two values based on a company’s financial statements:
(i) The amount of capital employed in a business during the year (or period):
Capital Employed = Assets – non-interest bearing current liabilities
(ii) The (cash) profits (called “net operating profit after tax” -- NOPAT) that the company is
able to generate during the year (or period).
The EVA formula also requires the company’s WACC (r) such that:
EVA = (NOPAT – r) x Capital Employed
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In other words, the formula says: Economic value is created at the firm when the
management is able to generate sufficient returns (NOPAT) to cover the charge on capital
which represents the expected return by capital providers.
If the NOPAT fails to reach the required cost of using the capital employed, then economic
value is being destroyed.
EVA Adjustments
The company’s financial statements need to be adjusted in order to calculate the Capital
Employed and NOPAT.
Capital Employed
The resources that a company uses come from its capital providers – debt and equity. In order
to keep track of such resources provided, the following items need to be “capitalized” by
including them in the economic book value at the start of each period being measured:
Items to be included/added back:
1. All off-balance sheet debt (e.g. operating leases);
2. Cumulative goodwill/(accounting) depreciation (previously written off);
3. Provisions for bad debts/deferred taxes;
4. Intangibles (e.g. R & D, advertising, training)
Income Statement
The income statement needs to be adjusted in order to reveal the actual operating profit of the
company. To achieve this, a number of “distortions” caused by the application of accounting
conventions need to be removed.
The following items (typically) need to be added back to income:
1. Goodwill and accounting depreciation written off during the period, net of economic
depreciation.
2. Provisions for bad debt expenses and deferred taxes (for the period).
3. Other non-cash expenses.
4. Intangibles (e.g. advertising, R&D, training expenses).
5. Interest expense on debt (net of tax).
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Question 1
SKT Ltd has reported annual operating profits for the year of K89.2m after
charging K9.6m for the full development costs of a new product that is expected
to last for the current year and two further years. The cost of capital is 13% per
annum. The statement of financial position for the company shows non-current assets with a
historical cost of K120m. A note to the statement of financial position estimates that the
replacement cost of these non-current assets at the beginning of the year is K168m. The
assets have been depreciated at 20% per year.
V Ltd has a working capital of K27.2m
Ignore the effects of taxation.
The Economic Value Added® of V Ltd is closest to:
A. K64.16m
B. K70.56m
C. K83.36m
D. K100.96m
Non-financial performance measurement
There are additional models which provide perspective on performance measurement. One of
them is the:
8.6 BALANCED SCORECARD

The first balanced scorecard (BSC) was developed in 1987 by US firm Analog Devices. Its
progress was followed by a number of academics, with the most famous study resulting in a
1992 article in Harvard Business Review by Kaplan and consultant David Norton called “The
balanced scorecard measures that drive performance”. Because of its rapid adoption, the BSC
has become the best-known model of multi-dimensional performance measurement.
The balance scorecard addresses a number of parameters (or “perspectives”) in monitoring
business performance by asking the following questions:
i. Financial perspective: “To succeed financially how should we appear to our
shareholders?”
ii. Customer perspective: “To achieve our vision how should we appear to our
customers?”
iii. Internal business processes: “To satisfy our shareholders and customers what
business processes must we excel at?”
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iv. Learning and growth: “To achieve our vision how will we sustain our ability to
change and improve?”
Advantages
The benefits of using a BSC are that it:
1 Enables senior managers to monitor and communicate all aspects of the

strategy and how goals should be achieved, without being limited to
monitoring only the financial results.
2 Discourages managers from focusing too much on short-term financial results.
3 Can be used to influence strategic changes by communicating a new strategy
as objectives for all functions.
4 Enables performance measures to be derived for non-financial activities.
Disadvantages.
Problems achieving congruence between performance measures can be a particular weakness
of the BSC. For example, does a commitment to improvements in learning and growth
support the objective of improving the financials?
Question 2
G Restaurants owns 50 restaurants in its home country. Each restaurant is
organised as a profit centre. The board has previously focused on financial
performance but it has been suggested that some non-financial performance
measures may help provide valuable insights.
Which of the following statements are valid for G Restaurants? (Select ALL that apply.)
A. Restaurants cannot be expected to achieve 100% customer satisfaction.
B. Customer satisfaction can be measured by the amount of repeat business that the
restaurants achieve.
C. The time taken to serve the customer can be used as an indication of customer
satisfaction and the efficiency of internal business processes.
D. A high level of customer satisfaction is the most important factor in determining
whether a restaurant should continue to trade.
E. The time taken to serve the customer will always be the most important factor in
determining customer satisfaction.
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8.7 FITZGERALD AND MOON BUILDING-BLOCK MODEL
This emerged from a 1996 CIMA-funded research report entitled “Performance measurement
in service industries: making it work”. Its authors, Philip Moon and Lin Fitzgerald, proposed
a model based on dimensions, measures and standards. The dimensions are the six things to
be measured. These are subdivided into results – the summary measures of success – and
determinants – the factors behind those results. They are:
Competitiveness (result): measures such as market share and relative cost.
Financial performance (result).

Quality of service (determinant).
Flexibility (determinant):
ability to alter volumes or specifications quickly.
Resource utilization (determinant):
the percentage of full capacity in each process or asset that’s being used.
Innovation (determinant):
product and process improvements, and the time it takes to implement these.
The measures are the three qualities of effective performance metrics. These are:
Clarity
Measures should be under-stood by the people responsible for them.
Motivation
Measures should encourage people to act in a way that is congruent with the organisation’s
goals.
Controllability
Managers should have authority over all factors affecting the measures for which they are
responsible.
Ownership
Those responsible for achieving the measures should feel they had some involvement in
setting them.
Achievability
Targets should be realistic so as to avoid demotivating people.
Fairness
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People must feel that the overall system is equitable and applies equally to everyone in the
organisation.
The standards are the three characteristics of an effective performance management system.
This model addresses itself to service companies.
The Dimensions refer to what is measured; among them, one must distinguish between:
 Results (Profit; Competitiveness) and
 Determinants (Quality; Resource utilization; Flexibility and Innovation).
The Standards define the “rules” by which business performance is judged and
the Rewards are available to those achieving good performance. Notice that
much emphasis is given to human motivational factors:
Standards must be achievable and fair (equity); employees must “buy-in” to
the
rules.
Rewards must be clear and within the possibility (controllability) of the
employee to be motivating.
8.8 PERFORMANCE EVALUATION FOR NOT-FOR-PROFITS

Unlike most organisations, the primary objective of a not-for-profit (NFP) is not to generate
wealth. Instead, it exists to provide a social or community service, which cannot be measured
by traditional financial metrics. As a result, evaluating the performance of a NFP is a slightly
more complicated task.
Efficiency.
Efficiency is important in Not-For-Profits because they are typically forced to operate with
limited resources. For example, a public organisation will only be provided a certain amount
of funding by the government, and it will be up to them to use that funding to achieve the
maximum possible output.
Efficiency is measured based on productivity; the amount of output achieved per resources
consumed. A good example may be a government education department being measured on
the metric of cost per student.
Effectiveness.
Effectiveness relates to how well an Non-For-Profit has achieved its objectives. For example,
a public education department will be tasked with providing the best possible education for
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students. One might measure performance based on percentage of children graduating from
high school, or percentage of A level passes.
‘Good’ performance consists of a balance between efficiency and effectiveness. A Non-For-
Profit might be able to keep the cost per student at an extremely low level, but this would
mean nothing if half the students in the country fail to graduate from high school. In this case,
the departments ‘efficiency’ in educating children has an unacceptable trade-off with the
‘effectiveness’ of their learning.
Question 3
M Ltd had profits of K90m for the current year after charging for development
costs of K8 million. The new product is expected to last for five years, including
the current year.
The cost of capital is 10% per annum. Non-current assets have a historical cost of K120m and
a replacement cost of K150m. They have been depreciated at 12% per annum. The company
has working capital of K25m.
Ignoring taxation, what is the economic value added of M Ltd in K million to 2 decimal
places
8.9 BENCHMARKING
Benchmarking can be used in the Non-For-P sector just as it is in the private sector. By
singling out processes to be benchmarked, NFPs can then secure suitable benchmark partners
and use them to compare and evaluate their processes.
It should be noted that benchmarking in the NFP sector is more suited to measuring
efficiency than effectiveness. Metrics such as ‘cost per student’ or ‘cost per patient’ can
easily be compared to similar private sector organisations, but benchmarking provisions of
public services isn’t as easily comparable.
Question 4
The member of staff responsible for grounds maintenance of the area surrounding
F Limited's premises is engaged in a benchmarking exercise. He is comparing his
operations with those of grounds maintenance in a nearby school. He hopes to
improve the performance of his operations by adopting the best practices of the other
operations. This type of benchmarking is known as:
A. internal benchmarking.
B. Functional bench marking.
C. Competitive bench marking.
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D. Strategic benchmarking.
Question 5
A manufacturing business compares the operational efficiency of all its other
factories against its best performing factory. This is an example of what type of
benchmarking?
A. Functional
B. Strategic
C. Competitive
D. Internal
8.10 UNIT SUMMARY

Performance measures may be divided into two groups;
1 financial performance indicators.
2 Non-financial performance indicators.
Financial performance indicators analyse profitability, liquidity and risk, and
include measurements of profits, costs, share price, costs and cash flow.
The performance of an investment Centre is usually monitored using either or both of return
on capital employed and residue income.
ANSWERS
Question 1
K
Profit 89.2
Current depreciation (K120 × 20%) 24.00
Development costs (K9·60 × 2/3) 6.40
Replacement depreciation (K168 × 20%) (33.60)
Adjusted profit 86.00
Less cost of capital charge (Working) (21.84)
EVA 64.16
Question 2
A. Restaurants cannot be expected to achieve 100% customer satisfaction.
B. Customer satisfaction can be measured by the amount of repeat business that the
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restaurants achieve.
C. The time taken to serve the customer can be used as an indication of customer
satisfaction and the efficiency of internal business processes.
Question 3
K
Profit 90.00
Add: Current depreciation (K120m × 12%) 14.40
Add: Development costs (K8m × 4/5) 6.40
Less: Replacement depreciation (K150m × 12%) (18.00)
92.80
Less cost of capita charge (16.40)
EVA 76.46
Workings
Non-current assets (150 – 18) 132.00
Working capital 25.00

Development costs 6.40
163.4
Cost of capital charge ×10% (16.34)
76.46
Question 4
A. Functional benchmarking.
This involves comparing internal functions with how they are carried out externally,
in different industries as well as the same industry.
The next topic you need to learn is transfer pricing in divisionalised companies.
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UNIT 9: TRANSFER PRICING IN DIVISIONALISED COMPANIES
9.0 INTRODUCTION
Divisional performance can be evaluated using different financial measures. When
divisions transfer goods and services to each other, financial measure outcomes get
affected. The established transfer price is a cost to the receiving division and
revenue to the supplying division, which means that whatever transfer price is set, will affect
the profitability of each division. In addition, this transfer price will also significantly
influence each division’s input and output decisions, and thus total company profits.
Aim
. A good transfer pricing system should aim to achieve the following:
1. The autonomy and independence of each division is necessary.
2. Motivate managers.
3. Goal congruence.
4. Best allocation of resources.
5. Provide fair outcomes with regards to performance measurement.
6. Be simple to understand and not require frequent revisions.
Objectives.
After learning this unit, you should be able to:
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1. Describe different purposes of transfer pricing system
2. Identify and describe the five different transfer pricing methods
3. Explain why cost-plus transfer prices will not result in the optimum output being
achieved.
4. Explain why the correct transfer price is the external market price when there is
perfectly competitive market for the intermediate product
5. Describe additional factors that must be considered when setting transfer prices for
multinational transactions
6. Calculate optimum output and transfer prices when there is no external market or an
imperfect external market for the intermediate product.
Time:
This unit should at least take you three hours of studying.
Reflection
In your own words, is there a way of how the performance of managers can
be assessed? Explain.
Definition of transfer price.

A transfer price is the price at which goods or services are sold by one division within a
company to another division in the same company. Internal sales are referred to as transfers,
so the internal selling and buying price is the transfer price.
Purpose of Transfer Pricing.
Whenever divisions within the same organisation transfer goods to one another, they must
come up with a value for the goods for reporting purposes. This value is known as the
transfer price, which, is not always an easy value to agree upon. Every manager wishes to
send or receive transfers at the best price possible to enhance his/her division’s performance.
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The method to be used will often depend on the organisation’s transfer pricing policy and the
goals of the organisation.
9.1 CALCULATING A TRANSFER PRICE.

As a general rule, transfer prices will fall within two limits:
Minimum transfer price – The minimum that a division will sell a unit for should amount to
cost price plus any opportunity cost for selling the unit internally. if an engine cost K3000 to
manufacture, and transferring it internally will result in profits foregone of a further K1000,
the minimum transfer price would amount to K4000.
Maximum transfer price – The maximum price a division will pay for an internal transfer
will amount to the lowest price that the unit could be acquired for from other suppliers.
If an engine was available to be bought on the open market for K7000, then the maximum
Jim would pay for engines internally would also be K7000.
In the above scenario, the transfer price would then need to fall between K4000 and K7000.
This is because you would not sell an engine for less than 4000, as you could receive a higher
price selling elsewhere.
Cost-based transfer pricing
To illustrate the different cost calculations, we’ll refer to the following example:
Variable cost per engine K40
Fixed overhead cost per engine K10.
Total cost per engine K50
Normal mark-up K20
Market price K70
Production Capacity 100,000 units.
Marginal cost
We can assume that marginal cost amounts to the variable cost of a unit. In this case, the
transfer price would be K40.
Divisions will supply goods at marginal cost if there is no opportunity cost in doing so.
Usually this will only occur when a division has excess capacity.
Using the example above, you have the capacity to produce 100,000 units. If your demand
only amounted to 60,000, there would be no opportunity cost to you if you were to supply
Jim the remaining 40,000 engines at marginal cost. No sales would be lost, the cost of the
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extra units would be covered and Bwalya would get his supply at an attractive rate. If,
however, your demand was at or over your 100,000 unit capacity, you would have a strong
disincentive to supply Jim at anything less than the market price.
Absorption cost
In this case the transfer price would be K5000 per engine (variable cost plus fixed overhead
per unit). You would be happy to sell units at this price, but only if there was excess capacity
to spare. However, your incentive to sell in this situation is a little higher than before, as you
will receive at least some contribution towards fixed costs.
Regardless, the market will still give you a higher selling price.
If absorption cost is used as a transfer price, there is also the possibility that the buying
division can find a cheaper price from an outside supplier. For example, if a manager for
another division (we can call him, say Musonda) could purchase an engine elsewhere for
K4500 he would do it, as it’s cheaper than the transfer price of K5000.
From a big picture perspective, this is a poor use of company resources - a division is paying
an external party K4500 for a product which can be produced internally for K4000.
One of the conditions of a good transfer pricing system is optimal resource allocation, and in
this scenario, that is not being achieved. While Musonda is saving money, the organisation is
losing money as a whole.
One must also remember that this is only true in the event of spare capacity. If the selling
division is selling its full capacity at market price (K7000), the K2000 profit it would earn per
unit would outweigh the K500 loss described above, which leads to an overall positive
outcome for the group as a whole.
9.2 TRANSFER PRICING METHODS

Standard cost
One problem with using marginal cost or absorption cost as a transfer price is that the
transferor is able to pass on cost overruns to the transferee. There is little incentive to keep
costs down, as the marginal cost, however high it turns out to be, is paid for in full anyway by
the buying party.
Using standard cost as a transfer price is therefore considered one of the more equitable
options.
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Standard cost does not take into account what actual costs are. Any adverse variance rests on
the shoulders of the transferor, meaning that the transfer price is fixed at a fair level for both
parties.
Marginal cost transfer price (Two-part tariff)
Under this method, the buying division is also required to pay a fixed annual fee. This fee
represents a contribution towards the selling divisions fixed costs, as well as a payment for
the privilege of receiving transfers at the lowest possible price. It is assumed that marginal
cost can be approximated by short-run variable cost interpreted as direct costs plus variable
indirect costs.
This approach works well because both divisions are able to receive some benefit from the
intra-company transfer.
Example 1
Division A transfers 100,000 units of a component to Division B each year. The
market price of the component is K25. Division A's variable cost is K15 per unit.
Division A's fixed costs are K500,000 each year.
What price would be credited to Division A for each component that it transfers to Division B
under
1 Dual pricing (based on marginal cost and market price

2 two party tariff pricing (where the divisions have agreed that the fixed fee will be
K200,000?
A Dual pricing K15 Two part-tariff pricing K15
B Dual pricing K25 Two part-tariff pricing K15
C Dual pricing K15 Two part-tariff pricing K17
D Dual pricing K25 Two part-tariff pricing K17
Solution to example 1
Dual pricing K25 Two part-tariff pricing K15
The dual pricing scheme here credits the supply division with market price and debits the
receiving division with marginal cost. Under a two-part tariff system, transfers are at variable
cost.
Question 1
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WX has two divisions, Y and Z. The following budgeted information is available
Division Y manufactures motors and budgets to transfer 60,000 motors to
Division Z and to sell 40,000 motors to external customers.
Division Z assembles food mixers and uses one motor for each food mixer produced.
The standard cost information per motor for division Y is as follows:
Direct materials 70
Direct labour 20
Variable production overhead 10
Fixed production overhead 40
Fixed selling and administration overhead 10
Total standard cost 150
In order to set the external selling price, the company uses a 33·33% mark up on total
standard cost.
Calculate the budgeted profit/(loss) for Division Y if the transfer price is set at marginal cost
Market-based transfer pricing.

When an organisation is decentralised it is encouraged that they operate as standalone
business units, with managers in charge.
e of all aspects of the operation. Under this reasoning, market-based transfer prices would be
the most suitable. After all, if the division really was an autonomous business unit, the open
market is where they would need to go to for supply.
The key issue with this approach is determining a true ‘market cost’. This can prove difficult
for the following reasons:
 Different suppliers quote different prices.
 Different buyers command different prices (including discounts, credit terms etc).
 Current market prices may fluctuate or be seasonal.
 Internal transfers reduce the need for advertising, sales staff and delivery costs,
therefore the market price may benefit the transferor more than expected.
 The product may not be available on the open market Dual pricing.
Negotiating a transfer price
A transfer price based on opportunity cost is often difficult to identify, for lack of suitable
information about costs and revenues in individual divisions. In this case, it is likely that
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transfer prices will be set by means of negotiation. The agreed price may be finalised from a
mixture of accounting arithmetic, politics and compromise.
a. A negotiated price might be based on market value, but with some reductions
to allow for the internal nature of the transaction, which saves external selling
and distribution costs.
b. Where one division receives near-finished goods from another, a negotiated
price might be based on the market value of the end product, minus an amount
for the finishing work in the receiving division.
Alternative budgeting models.
Behavioral implications. Even so, inter-departmental disputes about transfer prices are likely
to arise and these may need the intervention or mediation of head office to settle the problem.
Head office management may then impose a price which maximises the profit of the
company as a whole. On the other hand, head office management might restrict their
intervention to the task of keeping negotiations in progress until a transfer price is eventually
settled. The more head office has to impose its own decisions on profit Centre’s, the less
decentralisation of authority there will be and the less effective the profit Centre system of
accounting will be for motivating divisional managers.
Question 2
At the request of the Board, ZMAT a company based in Lusaka recently
purchased 100% of the share capital of BEST Ltd. This request was made to
ensure a steady supply of BEST designer jackets to Lusaka, where they are an
extremely popular, but ZMAT has no plans to sell the jackets in Chipata.
Following the acquisition, BEST Ltd. retained its existing profit centre structure.
Division A manufactures lengths of tweed and operates at its full capacity of 6,000 lengths
per month. Of this amount, 25% is sold to Division B (which produces one jacket from each
length of tweed) and the other 75% is sold to other garment manufacturers. Variable costs in
Division A are K24 per length, and variable costs in Division B are K28 per jacket (plus the
transfer price paid to Division A for the length of tweed). Fixed costs per month are K30,000
in Division A and K25,000 per month in Division B.
Division B sells all of its output to ZMAT for K80 per jacket.
At present, it purchases all of its lengths of tweed from Division A, but it has recently been
approached by an external supplier which has offered to supply lengths of tweed of the same
quality at a price of K44 each. Division A has been approached by another garment
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manufacturer which has offered 7 to purchase (under a long-term supply arrangement) the
1,500 lengths of tweed which are at present sold to Division B. The price offered by this
garment manufacturer is K50 per length, although the manager of Division A estimates that
the incremental cost of transporting these lengths of tweed to the garment manufacturer
would be K10 each (payable by Division A).
Required:
(a) Explain as to whether Division B should continue buying tweed from Division A. (3
marks)
(b) Calculate the optimal transfer price. (4
marks)
(c) Calculate how much net profit from the sale of 1,500 jackets will be included in each
division’s monthly performance report using the transfer price in part (b) above. (5 marks)
(d) Comment on whether the results in your answer to part (c) provide a fair reflection of the
performance of each division, and respond to the suggestion that Division B should be closed
down.
(8 marks)
[Total: 20 marks]
Question 3
R plc has a fittings division that manufactures light fittings. R plc also has an
electric light
division that manufactures electric lights.
The fittings division sells fittings to external customers and to the electric lights division. It
sells a fitting for K900. It incurs a variable manufacturing cost of K400 and a shipping charge
of K150 on external sales and K80 on sales to the electric lights division.
The electric lights division can buy elements from external suppliers for K800.
Select which of the following statements apply to this situation.
A. Both divisions are likely to prefer to trade internally because internal delivery charges
are lower than external delivery charges.
B. The optimal transfer price between the divisions is K900
C. The minimum transfer price that will satisfy the fittings division is K830.
D. There is a range of prices within which a transfer price can be set that will satisfy both
divisions.
Question 4
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division produces one product, Y, which it sells in equal proportions to B and C
divisions,
where it is incorporated into a variety of products. There is no external market for
Y.
The standard variable cost of Y is K10 per litre. Division A's budgeted annual overhead is
K300,000 and annual capacity is 300,000 litres.
L plc sets its divisions a target ROI of 20% p.a. Capital employed at A division is K1.5
million.
Which of the following is the optimum transfer price for Y?
A. K10 per litre
B. K11 per litre
C. K10 per litre plus head office subsidy of K600,000
D. K12 per litre
9.3 UNIT SUMMARY

Transfer pricing aims at achieving Goal congruence, equitable performance
measurement, retain divisional autonomy motivate divisional managers and
ultimately achieve divisional and group profitability.
Market based transfer price being the best transfer price should result in:
1. Goal congruent behavior.
2. Selling division gets same profit on internal and external sales.
3. Buying division pays a commercial price (possibly less savings in selling and
distribution).
4. Equitable performance measurement for both divisions
Cost plus based may lead to dysfunctional behavior. It covers all costs and the seller is
encouraged to make transfer though the buyer may wish to buy externally.
Variable cost based
Such a transfer price may lead to dysfunctional behavior.
Most likely the selling division does not cover all costs while the buyer is encouraged to
make transfer.
Finally, in some instances, it is likely that transfer prices will be set by means of negotiations.
The agreed price may be finalised from a mixture of accounting arithmetic, politics and
compromise.
155
ANSWERS
Question 1
K’000
Sales:
Internal (60,000 100) 6000
External (40,000 × (K150 × 1·3333)) 8000
14,000
Variable costs (100,000 × K100) 10, 000
Contribution 4,000
Fixed costs:
Production (100,000 × K40) 4,000
Administration (100,000 × K10) 1, 000
Loss 1,000
Question 2
(a) Opportunity cost of transfer from Division A = (K50 - K10) = K40.

Price quoted by external supplier = K44.
156
Hence, it is preferable if the sheets of tweed are sourced from Division A.
(b) Marginal cost + Opportunity cost of making the transfer = K40.
Division A:
This is the same as the price offered by the garment manufacturer, so Division A will have no
objection to making the transfer.
Division B:
K40 < K44 ⇒ will prefer to source internally rather than externally. 20
Also: Division B:
Net marginal revenue K80 - K28 = K52 > K40 ⇒ will prefer to source internally rather than
not produce jackets at all.
(c) Division A Division B
External Sales 1,500 × 80 120,000
Transfer price 1,500× 40 60,000 (60,000)
Variable cost 1,50× 0 24 36,000 1,500 × 28 42,000
(excluding
transfer price)
Fixed costs 25% ×30,000 7,500 25,000
Profit(loss) 16,500 7,000
(d) The transfer price is based on an external market price, which is sustainable over the long
run because it is being offered as part of a long-term supply agreement. Therefore, even
though it results in Division B having to pay a price which results in a net loss, it is
unrealistic to argue that the transfer price does not result in profit figures which reflect fairly
the economic performance of each division.
• There is no way of knowing whether the figures reflect fairly the managerial performance of
each division, since there is no distinction made between controllable and uncontrollable
costs.
• Given the poor economic performance of Division B, there is a good case for shutting it
down. Assuming that fixed as well as variable costs would be avoided, the profits of Cavan
Tweed Ltd. (and therefore of its parent company Vixen Ltd.) would be K7,000 per month
higher. The sales which Division A currently makes to Division B would be made to the
garment manufacturer instead.
157
• There is a strategic reason for keeping Division B open, however. BEST Ltd was acquired
for the specific purpose of securing the supply of tweed jackets to ZMART’s parent
company, MOVIA Ltd. If Division B is closed then this objective will no longer be served.
Question 3
A. Both divisions are likely to prefer to trade internally because internal delivery charges
are lower than external delivery charges.
B. The minimum transfer price that will satisfy the fittings division is K830
Question 4
K10 per litre plus head office subsidy of K600,000
Price at variable cost means compensation is required to cover fixed costs (K300,000) and
make positive return on investment (K1.5m × 0.2 = a further K300,000)
158

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The University of Zambia

The Zambia Centre for Accountancy Studies

BACHELOR OF ACCOUNTING WITH EDUCATION

Author: Saidi Kephas

UNIT 1: BUSINESS ENVIRONMENT........................................................................................................8

2.0 RISK AND UNCERTAINTY...............................................................................................................21

5.1 UNIT QUESTIONS...................................................................................................................86

6.1THE PURPOSE OF A BUDGET...............................................................................................91

7.1 SIMPLE PAYBACK PERIOD................................................................................................109

9.1 CALCULATING A TRANSFER PRICE................................................................................147

Final examination 50%

To learn the business environment in which the business is expected to be

1. Operating environment and remote environments with examples.

2. Explain and discuss the Agency theory.

3. Discuss the concept of maximization of the shareholder’s wealth.

You are expected to take approximately an hour to learn this unit.

1.1 OPERATING ENVIRONMENT

Examples of such factors are as follows:

1.10 Porter’s Five Forces

This model can be used:

Each of the forces is analysed to find the size of the force.

The forces are as follows:

 there are a lot of competitors.

Competitor analysis - Competitors can be analysed by asking the following questions:

 What are their objectives?

Threat of new entrants

 New companies can easily enter the market.

1. High costs of entry (e.g. production facilities, Information Technology)

3. Customer contracts in place.

5. Strong brands amongst competitors.

 Customers are large and provide a large proportion of company profits

 There are few alternative suppliers.

This makes profitability in the industry low.

1.2 REMOTE ENVIRONMENT

Examples of remote or external environment

PESTEL is a mnemonic which stands for political, Economic, Social, Technological,

1.3 PART B - ORGANISATION BACKGROUND AND THEORIES

1.3.1 AGENCY THEORY

1.5 UNIT SUMMARY

2.0 RISK AND UNCERTAINTY

At the end of this unit, you should be able to:

1. explain various ways of assessing risk and uncertainty

Use of research techniques to reduce uncertainty

Below are methods of research techniques available:

Problems with focus groups

 Results are qualitative.

The information is collected from secondary sources.

Factors to consider when using desk research:

Follow the steps outlined below to evaluate Maximin decisions

(a) Criticisms of Maximax

Price Price Price

2.20 (b) Maximax

MICMAR would therefore set a price of K425.

2.22 Follow the steps outlined below

1. For each of the strategies of nature find out the regret.

K170 K0 K14,100 K74,400

Minimax regret K10, 200 K14, 100 K74, 400

Independent and conditional events

Sales 800, 000 1000, 000 1,300,000 1,550, 000 1, 800,000

A company is considering investing in a new project. The following table shows

Cash Inflows Cash Outflows

Cash inflow Probability Cash outflow Probability Combined

Quantitative methods of incorporating risk and uncertainty

The process is as follows: