Professional Documents
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APPLICATION OF MANAGEMENT
ACCOUNTING TECHNIQUES
MAC3701
Semesters 1 and 2
BARCODE
CONTENTS
Page
PURPOSE OF THE MODULE ................................................................................................................. 5
PREREQUISITE AND PRIOR KNOWLEDGE.......................................................................................... 5
OVERVIEW OF THE MODULE ................................................................................................................ 6
STRUCTURE OF THE TUTORIAL LETTERS FOR THE MODULE ......................................................... 7
LECTURERS’ CONTACT DETAILS ........................................................................................................ 7
STRUCTURE OF THIS TUTORIAL LETTER ........................................................................................... 7
PRESCRIBED STUDY MATERIAL .......................................................................................................... 8
ASSESSMENTS AND SCOPE ................................................................................................................ 8
LEARNING UNIT 8: PROCESS COSTING .............................................................................................. 9
8.1 Introduction ................................................................................................................................... 9
8.2 Learning outcomes ....................................................................................................................... 9
8.3 Topic outline ............................................................................................................................... 10
8.4 Losses identified at the inspection point ...................................................................................... 11
8.5 Accounting for the proceeds and costs of normal scrap .............................................................. 11
8.6 The short-cut method for allocating normal losses ...................................................................... 11
8.7 The suitability of process costing in a service organisation ......................................................... 17
8.8 Batch or operation costing .......................................................................................................... 17
8.9 Summary .................................................................................................................................... 18
8.10 Self-review exercises .................................................................................................................. 19
LEARNING UNIT 9: STANDARD COSTING ......................................................................................... 20
9.1 Introduction ................................................................................................................................. 20
9.2 Learning outcomes ..................................................................................................................... 20
9.3 Topic outline ............................................................................................................................... 21
9.4 Sales volume variances: levels to use in MAC3701 .................................................................... 23
9.5 Further illustration of idle time and labour efficiency variances .................................................... 23
9.6 Fixed manufacturing overheads variances .................................................................................. 25
9.7 Sales and distribution cost rate and volume variances ................................................................ 26
9.8 Further aspects in respect of reconciling actual and standard profit ............................................ 27
9.9 General ledger accounts and journal entries ............................................................................... 28
9.10 Summary .................................................................................................................................... 34
9.11 Self-review exercises .................................................................................................................. 34
LEARNING UNIT 10: RELEVANT COSTING ........................................................................................ 35
10.1 Introduction ................................................................................................................................. 35
10.2 Learning outcomes ..................................................................................................................... 35
10.3 Topic outline ............................................................................................................................... 36
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LEARNING UNIT 14: INVENTORY MANAGEMENT AND PLANNING TECHNIQUES ......................... 63
14.1 Introduction ................................................................................................................................. 63
14.2 Learning outcomes ..................................................................................................................... 63
14.3 Background................................................................................................................................. 63
14.4 Three motives for holding inventory ............................................................................................ 64
14.5 Application of the EOQ technique to determine the optimal number of units to order .................. 65
14.6 Applying the EOQ to determine the production run size .............................................................. 67
14.7 Decision making: Quantity discounts and the EOQ ..................................................................... 69
14.8 Decision making: When to place an order ................................................................................... 71
14.9 Calculating elementary safety stock levels .................................................................................. 73
14.10 Just-in-time (JIT) purchasing ...................................................................................................... 74
14.11 Self-review exercises .................................................................................................................. 75
BIBLIOGRAPHY .................................................................................................................................... 76
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This module (MAC3701) is intended to equip you (as a student) with specific competencies in
management decision making and control. The module will enable you to demonstrate integrated
knowledge in these competencies, including pervasive skills, ethics and professional practice,
and other accounting competencies.
This module is designed to facilitate your acquisition of these competencies through knowledge
of and engagement in relevant management accounting topics at the forefront of the field,
including an understanding of the theories, methods and techniques relevant to the field, and of
how to apply this knowledge in a particular context.
The syllabus includes the following main topics: cost accounting, planning and control, and
decision making.
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OVERVIEW OF THE MODULE
TL104
Examination Guidance
Assignment 1 (MCQ)
(Assignment 1 covers Learning units 1–7)
Written Assignment 2
(Assessment based on all the learning units in TL102 and TL103)
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PRESCRIBED STUDY MATERIAL
The prescribed study material for this part of the module (tutorial letter) is as follows:
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8.1 Introduction
In the second-year costing module, you learnt about process costing systems. Specifically, you
learnt how to calculate equivalent units of production in cases where work-in-progress (WIP)
exists at the beginning and/or end of a certain period. You also learnt how to assign an equivalent
cost per unit to inventory, production and abnormal losses, using different inventory valuation
methods. Furthermore, you learnt how to account for normal losses. Many of the principles you
learnt in the second-year module are revised in this learning unit. However, some additional
principles, such as the treatment of scrap values and consecutive processes with WIP, are
presented in this learning unit. Also, a greater degree of integration of this topic with other topics
is prevalent in questions (refer to the question bank).
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8.3 Topic outline
This learning unit builds on the principles and concepts of process costing you learnt in your
second-year studies. It is very important to note that the Principles of management accounting
(3rd edition) textbook uses different terms for the process costing statements than the terms used
in MAC2601. For the purposes of MAC3701, you can continue using the MAC2601
terminology if you prefer. Below is a table depicting the terminology differences between
MAC2601 and Principles of management accounting (3rd edition):
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It should also be noted that units that are both started and completed in the current period will
automatically also pass this wastage point in the current period as they move from 0% completion
to 100% completion in this period. This means that the short-cut method may only be used
when all output units pass the wastage point in the current period (Raath & Berry 2019;
Drury 2015; Coetzee et al. 2012a). What the short-cut method involves is that, in the quantity
statement, only in the equivalent unit columns (for both materials and conversion), normal loss
units are represented by zero values. Refer to the following example:
Physical units Equivalent units
Input Details Output Direct Conversion
units units raw materials costs
Units % Units %
5 000 Opening work-in-progress (WIP)
55 000 Put into production
Completed and transferred 55 000 55 000 55 000
Normal loss 3 600 0 100 0 60
Abnormal loss 400 400 100 240 60
Closing work-in-progress (WIP) 1 000 1 000 100 700 70
60 000 60 000 56 400 55 940
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The implication is that you will still have to calculate the normal loss in units for purposes of the
output column of your quantity statement as you normally would have done. However, the
calculated normal loss units are not transferred to the “equivalent units” columns. As a result, the
equivalent cost per unit will be higher than it would have been. Furthermore, the cost allocation
statement will be affected in that the cost of the normal loss will not have to be directly allocated
to the current period completed and transferred, abnormal loss and/or closing WIP sections (as
applicable). Nevertheless, by virtue of a higher equivalent cost per unit, the cost of the normal
loss is indirectly allocated. Although we will have a different equivalent cost per unit using the
two methods, in the end, the result is the same in terms of the valuation of completed goods and
closing WIP and the amount of the abnormal loss.
Take note: In MAC3701 you must always apply the short-cut method when the conditions
for its application are met. You will lose marks if you apply the normal (longer) method in
MAC3701 if you could have used the short-cut method.
REQUIRED:
(a) Apply the method taught in MAC2601 (the longer method) and calculate the equivalent
cost per unit.
▪ Show all the calculations.
(b) Prepare the statement of profit or loss and other comprehensive income (income
statement) for the period under review.
(c) Determine if the short-cut method is applicable to self-practice exercise 13.1.
(d) If the short-cut method is applicable, calculate the equivalent cost per unit using the short-
cut method and prepare the accompanying income statement for the period under review.
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Take note: It is not necessary to prepare the allocation statement unless it is specifically required
by the question. If the allocation statement is not required, all the amounts needed for the income
statement can simply be reflected as brief calculations.
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(d) Applying the short-cut method in calculating equivalent cost per unit
Quantity statement
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Income statement
R
Sales (109 250 x R20) 2 185 000
Less: Cost of sales 1 609 141
Opening WIP (given) 229 000
Plus: Current production (W4) 1 380 141
Plus: Closing WIP production (W4) 65 288
Less: Closing WIP (W4) 65 288
Gross profit 575 859
Less: Period costs 94 189
Abnormal loss (W4) 42 196
Selling and administrative costs (given) 52 000
Notes:
Can you see that the cost of current period equivalent production activities, abnormal loss and
closing WIP, as well as the gross and net profits, are the same for the longer method and the
short-cut method, except for some rounding differences?
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According to Williams et al (2020:196), job costing can also be used to cost services in cases
where each service delivered is unique – a job does not necessarily have to be a manufactured
“product”. For example, an accounting advisory firm will perform different jobs for different clients
as well as different jobs for the same client – the individual jobs will not consume the same amount
of resources. Different combinations of inputs will be applicable to different jobs, for example,
certain tasks to be carried out may require more (or less) time from advisory staff, different skills
and so forth.
You may remember from second-year costing that a process costing system is normally used
when products are homogeneous (all the same) (Coetzee et al. 2012a). Certain services,
however, can also be “repetitive” and consume similar resources (Drury 2015). To provide these
services, an organisation can make use of one process, or consecutive processes. In such cases,
a process costing system may be appropriate.
An example would be where the accounting advisory firm that we referred to above assists clients
in applying for the registration of new companies. Unless there is specific additional work to be
done in certain cases, the administrative processes and resources used should probably be
standard for each application for registration. The cost of each unit of this “standard” service may
then be determined by dividing the total cost of all the work done in this regard by the total units
of the service. If, for instance, some extent of unique work needs to be done in addition to the
standard service aspects in order to assist a certain client with the application, a “combination” of
process costing and job costing may be appropriate (Drury 2015). This brings us to the next
section of this learning unit: batch or operation costing.
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8.9 Summary
In this learning unit we revised how a process costing system works and how the statements that
are usually associated with such a system are prepared (also refer to section 8.3 above). We
further looked at how a process costing system differs from a job costing system, but how it is
“closely linked to joint and by-products” (Williams et al 2020:249). You learnt, among other things,
how to calculate and/or treat the following in a process costing system: equivalent production
units and equivalent production cost per unit in terms of a specific period; losses, gains and the
sale of “lost” units; and the value of WIP, finished goods and abnormal losses – all in terms of
both the FIFO method and the weighted average method of inventory valuation. Additionally, the
concept of the short-cut method, as it applies to process costing, was introduced.
As with the other MAC3701 topics, you have to be able to integrate process costing with other
topics. Refer to the section “Conclusion: Process costing and other topics in this book” in the
textbook, Principles of management accounting (3rd edition), for examples of topics that can be
combined with process costing.
Furthermore, process costing is often integrated with direct and absorption costing. Using process
costing statements (quantity statement, production cost statement and/or cost allocation
statement) as a basis, you should also be able to prepare a statement of profit or loss and other
comprehensive income (income statement), applying direct or absorption costing principles, as
applicable.
What you learnt and/or revised in this learning unit is graphically summarised as follows:
Period costs
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LEARNING UNIT 9: STANDARD COSTING
9.1 Introduction
The use of a standard costing system, as you have learnt in the second-year costing module,
could offer several advantages. If it is efficient, such a system could enable its users to perform
effective performance management, to have more control over costs and income and to gather
important information for use in budgeting, decision-making and the valuation of different types
of inventory (Williams et al 2020).
Learning unit 9 elaborates on the standard costing principles you were taught in the second-year
costing module by extending their application to an absorption costing system and scenarios in
which there is a difference between the actual and the budgeted volumes of sales and production.
The learning unit, furthermore, demonstrates the calculation and interpretation of more detailed
variances (e.g., mix and yield variances). Critical to your understanding of these more advanced
or detailed applications of standard costing principles are the basic concepts of flexible budgeting
and the difference between a budget and a standard, both of which were dealt with in the second-
year costing module.
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Chapter 13 SAICA Principles of management accounting
knowledge (3rd edition)
Concepts level Theoretical Revision/prescribed
basis exercises
Balances in the variance 3 Section 13.13 Example 13.12
accounts
Criticisms of standard costing 3 Section 13.14 none
Variance analysis in modern 1 Section 13.15 none
mechanised environments
Standard costing in service 3 Section 13.16 none
organisations
Standard costing and 1 Section 13.17 none
benchmarking
Advanced standard costing 3 Appendix 13.1
concepts
▪ Revenue variances: sales mix Appendix example 13.1
and sales quantity variances
▪ Market share and market size Appendix example 13.2
variances
▪ Production mix and yield Appendix example 13.3
variances
o Direct materials mix and none
yield variances
o Labour variances: mix and Appendix example 13.4
yield
o Labour variances: idle time
You also have to work through the following selected sections of chapter 7 of the prescribed
textbook. Although the larger part of section 7.3 relates to prior learning and may be used for
revision purposes, take specific note of how the subsection called “Standard costs” in section
7.3.1, as well as sections 7.3.2 and 7.3.3, relate to standard costing. You must study these
sections.
Chapter 7 SAICA Principles of management accounting
knowledge (3rd edition)
Concepts level Theoretical basis Revision/prescribed
exercises
The elements of cost in a 3 Section 7.3 none
job-costing system
▪ Determining the cost of Section 7.3.1 Example 7.4
materials (subsection on
“standard costs” only)
▪ Determining the cost of Section 7.3.2 Examples 7.5–7.7
labour
▪ Overhead expenses Section 7.3.3 Example 7.8
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9.5.2 Idle time variance and labour efficiency variance formulae
(a) Formulae: idle time variance
The idle time variance should be calculated by applying either of the following two formulae:
➢ Idle time variance = (Actual productive hours – Standard productive hours allowed for actual
input) x Standard work hour rate
or
➢ Idle time variance = (Actual idle time – standard or normal idle time allowed for actual input)
x Standard work hour rate
(b) Formulae: labour efficiency variance (when there is idle time in the question)
This variance is sometimes referred to as operating labour efficiency variance. (Operating) labour
efficiency variance should be calculated by applying either of the following two formulae:
➢ (Operating) labour efficiency variance = (Actual productive hours – Standard productive
hours allowed for actual output) x Standard work hour rate
or
➢ (Operating) labour efficiency variance = (Actual production at standard cost) – (Actual work
hours x Standard work hour rate)
Idle time variance = (Actual idle time – Standard or normal idle time allowed for actual input) x
Standard work hour rate
= ([2 860 x 0,35] – [2 860 x 0,2]) x R187,50
= (1 001 – 572) x R187,50
= 429 x R187,50
= R80 437,50 Adverse (A)
Why is the variance adverse? The skilled labourers were productive for a smaller-than-expected
proportion of the time that they were on the premises due to the “go-slow”.
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Based on example 13.8 in the prescribed textbook, the following fixed manufacturing overheads
variances are now calculated for illustrative purposes:
Take note: In example 13.8, the company uses an absorption costing system and the fixed
manufacturing overheads are allocated based on the semiskilled labour hours. Therefore, we will
have all four fixed manufacturing overheads variances, as follows:
1. Fixed manufacturing overheads expenditure variance = R250 000 (U)
2. Fixed manufacturing overheads volume variance = R120 000 (F), made up of:
2.1. fixed manufacturing overheads (volume) capacity variance = R94 000 (F)
2.2. fixed manufacturing overheads (volume) efficiency variance = R26 000 (F)
*Take note: The above demonstrations are based on the assumption that the company uses
direct labour hours as its allocation base. Allocation bases such as units, machine hours, kilowatts
and flying hours can also be used.
The following additional, but related, two variances are now introduced:
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Details Reconciliation F or U
R
Budgeted profit XXXXX
Plus/Less: Sales margin volume variance
- Sales mix variance
- Sales quantity variance
Standard gross profit XXX
Plus/Less: Sales margin price variance
Plus/Less: Direct material variance
- Material purchase price variance
- Material usage variance
o Material mix variance
o Material yield variance
Plus/Less: Direct labour variance
- Direct labour price variance
- Direct labour efficiency variance
o Direct labour idle time variance
o Direct labour efficiency variance
Plus/Less: VMOH variance
- VMOH expenditure variance
- VMOH efficiency variance
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Details Reconciliation F or U
R
Plus/Less: FMOH variance
- FMOH expenditure variance
- FMOH volume variance
o FMOH capacity variance
o FMOH efficiency variance
Plus/Less: Fixed selling and distribution cost spending variance
Plus/Less: Variable selling and distribution cost spending variance
Plus/Less: Variable selling and distribution cost volume variance
Actual profit XXXXX
Adapted from Raath and Berry (2019)
Take note: All the variances in the layout must be shown unless it is not possible to calculate
them, or the specific question requires less detail.
If a direct costing system is in use, it should require the following amendments to the proposed
reconciliation “format” given above:
(i) Calculate standard contribution instead of standard gross profit.
(ii) Remove the fixed overheads volume variance and its subcomponents since they will not
be applicable in a direct costing system (Williams et al 2020).
(iii) The variable selling and distribution cost volume variance will not be shown separately
because it will form part of the sales margin volume variance.
Regarding point (iii) above, theoretically, (standard) contribution is the net of all (standard)
variable costs, including variable non-production costs. Therefore, the sales (margin) volume
variance in a standard direct costing system would effectively have the variable sales and
distribution costs volume variance incorporated in it.
Take note: Non-production costs are never included in inventory valuation, whether in terms of
direct costing principles or absorption costing principles.
The following table provides information on where you can find the accounting treatment for most
of the variances that you will be taught in your undergraduate costing studies:
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Variance Calculation* Journal entry General
reference ledger
reference
Variable sales and distribution cost TL103 n/a n/a
volume variance
Fixed non-manufacturing overheads POMA POMA POMA
spending variance (includes fixed sales
and distribution cost rate variance)
* Resource in which the variance calculation is performed and/or described.
Take note: General ledger account entries are transferred from journal entries. Therefore, in the
following section, only general ledger accounts are illustrated from which you can deduce the
related journal entries.
(a) Direct material purchase price variance if materials inventory is kept at actual price
Materials and consumables can be kept either at actual cost or standard cost (Coetzee et al
2012b; Raath & Berry 2019). In a MAC3701 standard costing question, however, the default
position is that the direct materials and consumable inventories are kept at standard cost unless
the question specifies otherwise. With the default position, the direct material general ledger
account balance will always be at the standard cost and will therefore not include the purchase
price variance.
Now, assume it is specified that direct materials are held at actual cost. The following is an
example of how to prepare a journal entry for the material purchase price variance when direct
materials are held at actual cost (for an example of a journal entry when the materials are held at
standard cost, refer to the textbook):
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Dr Cr
R R
Variances account
DM yield variance – C/fibre 60 000
DM yield variance – Aluminium 30 000
Dr Cr
Work-in-progress account
Variances account 60 000
Variances account 30 000
Take note: The direct material mix variance and yield variance are subvariances of the direct
material efficiency variance. In this example, R180 000 (U) + R90 000 (F) = Direct material
efficiency variance of R90 000 (U). Therefore, if the direct material efficiency variance journal
entry is posted, then, to avoid double-counting, the subvariances (direct material mix variance
and yield variance) must not also be posted.
With respect to the Saneone XXI bicycle from the examples in the textbook, chapter 13 (Williams
et al 2020), assume that a mix of skilled labour and semiskilled labour is used, where the two
types of labour “are interchangeable to some extent” but used in the standard proportion of 2:1.
The standard cost per hour of skilled labour is R80 and the standard cost per hour of semiskilled
labour is R60 in a particular period, and the actual hours of skilled labour (1 485 hours) used
during the period were 495 more than the hours of semiskilled labour used during the period.
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(e) Direct labour mix variances
Labour type Actual hours in Actual hours in Diff. Standard Labour mix
std. mix actual rate per variance
proportions proportions hour
Skilled 2 475 x 2/3 = 1 650 1 485 165 R80 R13 200 (F)
Semiskilled 2 475 x 1/3 = 825 1 485 – 495 = 990 (165) R60 R9 900 (A)
Total 2 475 2 475 R3 300 (F)
Labour type Input allowed for Actual hours in Diff. Standard Labour
actual output std. mix rate per yield
proportions hour variance
Skilled 2 000 x (0,4 x 2) 1 650 (50) R80 R4 000 (A)
= 1 600
Semiskilled 2 000 x 0,4 = 800 825 (25) R60 R1 500 (A)
Total 2 400 2 475 R5 500 (A)
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Take note: The labour idle time variance and (operating) labour efficiency variance are
subvariances of the labour efficiency variance. In this example, using the skilled labour only,
R80 437,50 (U) + R41 437,50 (F) = Total labour efficiency variance of R39 000 (U). Therefore, if
the total labour efficiency variance journal entry is posted, then, to avoid double-counting, the
subvariances (labour idle time variance and (operating) labour efficiency variance) must not also
be posted.
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Take note: The fixed overheads volume capacity variance and the fixed overheads volume
efficiency variance are subvariances of the fixed manufacturing overheads volume (quantity)
variance. In this example, R94 000 (F) + R26 000 (F) = R120 000 (F) fixed manufacturing
overheads volume (quantity) variance. Therefore, if the fixed manufacturing overheads volume
(quantity) variance journal entry is posted, then, to avoid double-counting, the subvariances (the
fixed overheads volume capacity variance and the fixed overheads volume efficiency variance)
must not also be posted.
(i) Variable sales and distribution costs volume and rate variances
Journal entry and general ledger accounts
Not applicable.
Why? “[B]ecause standard costing is essentially an inventory valuation technique” and variable
sales and distribution costs are non-inventoriable costs. Therefore, similar to the sales variances
that are only calculated for “informational purposes” (Williams et al 2020:406 and 427) – to
analyse performance, perform budgetary control and for decision-making purposes – the variable
sales and distribution costs variances are also for “informational purposes” and thus not adjusted
for in the accounting records.
9.10 Summary
In this learning unit you learnt how to calculate detailed variances in a standard costing system,
whether combined with direct (variable) costing or absorption costing and whether the actual and
budgeted sales and production volumes are equal or different. You also learnt how these
variances can be used to reconcile actual profit with budgeted profit and how they are dealt with
in the accounting records of an organisation. In addition, you learnt about criteria that
organisations use to decide when such variances need to be investigated, as well as how to
interpret and analyse them so that appropriate corrective action, if applicable, can be taken.
Ultimately, if used correctly, standard costing can be a helpful performance management tool for
organisations (Williams et al. 2020).
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10.3 Topic outline
Some of the sections outlined below, were already covered in your second-year costing module
and, therefore, comprise revision material. The remainder of the learning unit, however, builds
further on what you have learnt in second year. Study the following sections in chapters 10 and
11 of the prescribed textbook:
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Take note: Simplex tableaus (section 11.8 in the textbook) fall outside the scope of this module.
Excel® also enables you to compare various scenarios through the ‘What-if analysis’ tool, to
support the decision-making process regarding the determination of optimal product mix. Both
these tools can be used in conjunction with other software to help visualise problems in, and
solutions to, scenarios.
While the use of technology can be an efficient way to perform linear programming exercises, one
should also be cognisant of both the advantages and issues associated with using software in
this regard. These include the following:
37
▪ A visual display of information may make it easier for users to understand problems and
solutions.
▪ Software may be helpful in conducting sensitivity analysis because formulae and lookup tables
may be used to perform underlying calculations. This means that if any figure is amended, all
relevant figures will be updated and recalculated automatically.
▪ The results can be distributed to other decision-makers and users easily and efficiently, either
in printed or electronic format.
The following resources are recommended for further reading relating to section 10.4:
https://www.excel-easy.com/data-analysis/what-if-analysis.html
https://www.excel-easy.com/data-analysis/solver.html
10.5 Summary
Let us summarise what you learnt in this learning unit. First, you learnt how to apply relevant
costing principles in advanced decision-making scenarios. In some of these scenarios, conditions
of uncertainty existed. You also learnt how to apply linear programming, using the graphical and
algebraic (simultaneous equation) methods, to optimise the use of two or more limited resources
when contribution per limiting factor calculations do not provide a unanimous ranking.
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11.1 Introduction
In learning unit 9, “Standard costing”, we mentioned that a standard costing system could provide
information that is useful in performance management. Thereafter, in learning unit 10, “Relevant
costing”, we recommended appropriate decisions for management to make under specific
conditions. If managers and divisions make the right decisions, this could influence the
organisation that they form part of in a positive way so that performance can be maintained or
improved. The questions that now arise are: How should the performance of managers and
divisions be measured and rewarded? Should they be held accountable for that which is not under
their control? Will an organisation without separate and autonomous divisions necessarily perform
better than its counterparts that delegate their decisions to those on “lower organisational levels”
(Williams et al. 2020:480)? Learning unit 11 explores these and other potential questions about
performance management.
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11.3 Topic outline
Most of the learning outcomes covered in this topic were not addressed in the second-year costing
module. It is therefore important that you pay careful attention when studying the following
sections in chapter 14 of the prescribed textbook:
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Furthermore, the “point in time” paragraph states that, in determining ‘investment’, average
balances of controllable items should be used. However, for this module, the default position is
to always use closing balances of controllable items unless otherwise stated.
The table below provides an overview of some of the characteristics of these two types of
organisational structures:
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Aspect Organisational structure
Divisionalised Functional
Responsibility Generally, there is a head office or a There is one investment centre
centre type(s) similar central administrative section (the entity as a whole) and cost
(investment centre) and several centres on the level below this
investment and profit centres below investment centre.
the head office.
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UNIqueSA Head
Office
Investment centre
Adapted from Drury and EL-Shishini (2005), Drury (2015) and Raath and Berry (2019)
In this highly simplified divisionalised structure, UNIqueSA has four divisions (MAC, FAC,
AUD and TAX), which are all investment centres. Each division has its own marketing manager,
HR manager, finance manager and despatch manager, who report to the divisional manager.
UNIqueSA
Investment centre
Adapted from Drury and EL-Shishini (2005), Drury (2015) and Raath and Berry (2019)
In this highly simplified functional structure, UNIqueSA has four functions (Marketing, Finance,
Human Resources and Despatch), which are all cost centres. Each function services all four
modules.
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11.6 Applying the principle of controllability to performance management
It is generally argued that the evaluation of managerial and/or divisional performance is only fair
to an extent that the evaluation is based on aspects that the manager and/or division can control.
In this regard, for MAC3701, two financial performance measures are noteworthy, namely,
(i) return on investment (ROI) and (ii) residual income (refer to sections 14.4.1 and 14.4.2 of the
textbook). The textbook outlines the ROI formula as: Income/Investment and further outlines the
residual income formula as: Income less (Required rate of return X Investment). It is important
to note that in these two formulae, the principle of controllability must be taken into account in the
calculation of “income” and “investment” (refer to section 14.2.1). It is for this reason that in the
MAC3701 question banks, questions that relate to performance management, where applicable,
reference is made to “controllable profit” and “controllable investment” instead of “income”
and “investment”. Although you can use the terms “income” and “investment”, calculations
thereof must always be based on the controllability principle (Williams et al. 2020:479).
Furthermore, in this module, we expect from you to use the book values of “controllable
assets” and “controllable liabilities” at the end of the period under review in the calculation
of “controllable investment”, unless specifically required otherwise. Take note that some of
the suggested solutions to exercises in the textbook and/or the question book might follow a
slightly different approach to the approach we require in MAC3701.
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Take note: The above list is not meant to be exhaustive but intends to give you an idea of the
difference between financial and non-financial performance measures. Furthermore, not all non-
financial measures will necessarily apply in all circumstances and/or scenarios. In this regard,
you should guard against verbosity and “memory dump”. You are expected to address non-
financial performance measures with reference to the scenario and the circumstances in question.
11.8 Summary
In summary, this learning unit taught you about divisionalisation and how it can, on the one hand,
benefit organisations and, on the other hand, lead to increased risks and other issues (Williams
et al 2020). You learnt about the different types of responsibility centres that a divisionalised
organisation can consist of and, furthermore, how the performance of the individual centres
(“units”) and their managers and/or other staff members (“individuals”) can be managed. As part
of the process of managing performance, performance needs to be evaluated using financial
performance measures, such as return on investment and residual income, and interpreted.
However, the use of short-term financial measures should be combined with the use of other,
longer-term measures, as well as non-financial measures. If the performance targets and the
reward structure of an organisation are fair and appropriate, they are likely to encourage better
performance by individuals and units and to lead to a better-performing organisation on the whole.
11.9.1 Review the performance management video that can be found on myUnisa.
11.9.2 Attempt BQ2, BQ3 and BQ7 in chapter 14 of the prescribed textbook.
11.9.3 Attempt LQ1 in chapter 14 of the prescribed textbook.
11.9.4 Attempt LQ3 in chapter 14 of the prescribed textbook.
▪ Ignore all references to EVA®.
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LEARNING UNIT 12: PRICE SETTING
12.1 Introduction
In learning unit 11 you learnt about how to manage performance in organisations. Many of the
financial performance measures described made use of profit figures in their calculations. Profit,
in turn, is dependent on several and diverse factors. Selling prices of products (or services) are
important determinants of these factors. If an organisation sets its selling prices too low, it may
lose out on contribution and be less profitable than it potentially could. However, if it sets its selling
prices too high, customers may choose to buy from competitors (if its product is price elastic), it
could lose out on sales volumes and thereby contribution and, again, it may be less profitable
than it potentially could. This learning unit deals with the setting of prices when products or
services are transferred between divisions of the same organisation (internally), as well as
external pricing in the long term. Short-term external pricing has already been addressed in
learning unit 10 in the discussion of “special orders”.
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47
Raath and Berry (2019) note that it “is important to understand the difference between an
intermediate and a final product, as this determines who the transferring(selling) and the
receiving(buying) divisions are. The costs incurred by the receiving division to complete the final
product are called further processing costs. Further processing costs are incurred irrespective of
whether the intermediate product is sourced from another division in the group or from an external
source.”
Take note that transfer pricing could also apply within the context of a group of companies, where
one company transfers a product to another company in the same group (Williams et al.
2020:510).
What further complicates the cost-plus method is the question of what to use as a cost base.
Should the cost base be direct variable costs alone, both variable and fixed direct costs, or a
combination of both direct and indirect costs (which we refer to as “full cost” or “long-term cost”)?
The answer to this question depends on the extent of detail that an organisation’s costing system
can provide and, therefore, how accurately costs can be allocated to products. The more
comprehensive the cost base, the smaller the mark-up that the organisation needs to add. On the
contrary, the larger the demand for a customised product, the higher the mark-up that the
organisation can add (Raath & Berry 2019; Drury 2015).
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for a given volume”. With this approach, the target selling price per unit is thus determined by
adding the target mark-up to the total manufacturing costs per unit.
Based on the target rate of return on invested capital approach, the selling price is determined
as follows:
= Target mark-up per unit plus total manufacturing costs per unit:
= The target mark-up for the MaZe-Ndal is R24: ((R5 million x 12%) ÷ 25 000)).
The target selling price per unit of MaZe-Ndal is therefore, R824 (R800 + R24).
In reassessing whether it is still useful to sell a product, one should also consider whether a direct
costing system or an absorption costing system has been used to determine profitability. The
costing system will influence the profitability perspective since the amount (or level) of fixed costs
allocated to a specific product will differ and some of the fixed costs may simply have been
assigned to the product arbitrarily and not because there is a cause-and-effect relationship
between the product and the cost (Coetzee et al 2012a; Drury 2015).
Furthermore, some of the costs are assigned to products for purposes of decision-making even
if they would not form part of the inventory valuation under International Financial Reporting
Standards (IFRS) (Coetzee et al. 2012a).
49
12.8 Price elasticity: further aspects
A number of additional aspects that you should be aware of in respect of price elasticity are
outlined below.
Take note: In MAC3701 we use the terms “price elasticity” (Williams et al. 2020:314), “demand
elasticity” (Raath & Berry 2019) and “(price) elasticity of demand” interchangeably.
Price elasticity refers to the sensitivity of demand to factors such as price and buying power, as
well as supply sensitivity (Inglesi-Lotz & Blignaut 2011; Breytenbach & De Villiers 2012). However,
for MAC3701, the focus is on the sensitivity of demand to price changes only.
Bread is used as an example of an elastic product in the textbook (refer to section 10.6.2).
However, bread is often seen as a necessary food item for which demand is usually inelastic
(Raath & Berry 2019). For this reason, we would rather like to use chocolate as an example of a
product for which the demand could be expected to be elastic. If the price of chocolate increases,
customers are likely to buy significantly less chocolate. They might decide to buy chips or other
sweets instead or they might simply eat less chocolate. If it is only the price of a specific make of
chocolate that increased, customers might decide to buy a different make of chocolate.
In general terms, when an increase in selling price leads to a significant decrease in demand,
such demand is deemed elastic (Williams et al. 2020:314). In this instance, the demand is
deemed to be sensitive to the change in price, in that a relatively small change in price will result
in a higher percentage change in the demand. In contrast, if the percentage change in quantity
demanded is less than the percentage change in price, we deem the demand to be inelastic for
purposes of this module (Raath & Berry 2019). Refer to the graphs below, where P1, P2 and P3
are different price levels while Q1, Q2 and Q3 are different demand levels:
Williams et al. (2020:316) refer to several pricing strategies (refer to section 10.6.6). One of these
strategies is price skimming, which involves charging a “high initial price”. Price skimming is
more suitable when the initial demand for a product is inelastic (Drury 2015). However, if the
demand for the product is elastic in the early stages, penetration pricing is more suitable. Based
on the explanations of these strategies in the textbook, why would you say this is the case? (Hint:
compare how the pricing of the following two cell phone apps is, for example, likely to differ when
each app is originally released:
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1. App A is based on an innovative, fresh idea. Currently, no similar app is available for
download. Market research shows that the app could create quite a hype among cell phone
users.
2. App B is introduced a year later than App A by a rival developer and is an adaptation of
the idea or concept used in App A. Although the concept is still popular, when one searches
for the keyword that used to identify App A only, several apps now appear among the
search results.
12.9 Summary
In this learning unit you learnt about the principles of transfer pricing that may have to be applied
when a transferring division (or company) transfers a product to a receiving division (or company)
within the same company (or group of companies). You learnt that the minimum transfer price
that should be set by a transferring division (or company) is often the sum of (i) the total
opportunity cost of losing contribution on forfeited external sales and (ii) the total of all incremental
costs associated with transferring the units, divided by (iii) the total number of units transferred.
Furthermore, you learnt about different approaches that organisations could follow in respect of
external selling prices in the long term, which may differ from the short-term approaches followed
when a special order is applicable, as well as between price-setting and price-taking
organisations.
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LEARNING UNIT 13: OTHER ANCILLARY TOPICS
13.1 Introduction
One of the techniques that you learnt about in learning unit 10 was optimisation when resources
are constrained. Often, you would use the contribution per limiting factor to rank products in the
order that they should be produced to maximise profits. However, in learning unit 13, you will
learn about the theory of constraints as an alternative “management accounting system” (Raath
& Berry 2019) that can be used to address constraints, specifically by maximising throughput
when bottlenecks exist (Williams et al 2020). The concepts of throughput (and throughput
accounting) and bottlenecks will be explained in this learning unit.
In addition, you will be introduced to various concepts, techniques, philosophies, practices and
systems of management accounting, most of which emanate from the continuous developments
in the field of management accounting. The world of business is dynamic and ever-changing.
Concepts, techniques, systems and so on relating to the field of management accounting ought
to develop on a continuous basis to keep abreast of changes in the business environment.
After you have studied learning unit 13, you should be able to
▪ explain the operation of a just-in-time (JIT) system and to apply JIT principles to a particular
scenario
▪ describe how the principles of JIT purchasing differ from those of traditional purchasing
▪ explain the concept of benchmarking and to apply it to a particular scenario
▪ explain the concepts of materials requirement planning (MRP) and enterprise resource
planning (ERP) and to apply them to a particular scenario
▪ explain and to apply the concepts and steps associated with the theory of constraints and
to apply them to a particular scenario
▪ compare the theory of constraints with activity-based costing (ABC)
▪ explain and to apply the concept of throughput accounting and to apply it to a particular
scenario
▪ describe Porter’s generic strategies from a management accounting perspective
▪ describe activity-based management (ABM) from a management accounting perspective
▪ describe total quality management (TQM) from a management accounting perspective
▪ describe target costing from a management accounting perspective
▪ describe life-cycle costing (LCC) from a management accounting perspective
▪ describe supply chain management (SCM) from a management accounting perspective
▪ describe value chain analysis from a management accounting perspective
▪ understand the basic aspects of big data and digitisation from a management accounting
perspective
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53
Chapter 17 SAICA Principles of management
knowledge accounting (3rd edition)
Concepts level Theoretical Revision/prescribed
basis exercises
Life-cycle costing 1 Section 17.6 none
▪ Pre-production costs Section 17.6.1
▪ Production costs Section 17.6.2
▪ Marketing, service and support Section 17.6.3
costs
Supply chain management 1 Section 17.7 none
▪ How supply chain management Section 17.7.1
confers competitive advantage
Value chain analysis 1 Section 17.8 none
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In determining the life-cycle budget of product, an organisation should also consider the different
stages of the life of that product. As mentioned earlier, regarding the life-cycle of a product, the
majority of costs are incurred in the development and design phase. As such, only having
products in the growth phase could be costly since the organisation’s cash resources may be
‘locked’ in the product’s early development or design stages. On the flip side, only commencing
with the development of a new product once an old product’s life-cycle has ended, may result in
cash inflow constraints. Therefore, from a costing perspective, an organisation needs to ensure
that its products are in various phases of the life-cycle to stagger costs and plan cash flow.
Therefore, the organisation needs to introduce new products as old products are nearing the end
of their life-cycles, this to ensure a healthy balance between cash outflow and cash inflow.
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13.5 Big data
Organisations rely on the availability of and access to information to make decisions about their
entities. Although various sources of information are available, a growing phenomenon within
business environments is the use of big data analytics to source information.
What is big data
“Big data is used to refer to the large volume of data, both structured and unstructured, that is
available to organisations on a day-to-day basis. This information is often in digital form and
created outside the organisation and available to everyone. Big data can be analysed in order
to provide insights that lead to better decisions based on more informed knowledge. Big data
analytics has become the catch-all term for gathering, analysing, and using massive amounts
of digital information to improve business operations. Big data analytics enable organisations
to make decisions based on data instead of business instinct.” CIMA P1 (Kaplan Publishing,
2020:256).
In the following few subsections, we look at big data as source of information for budgeting,
sources of big data, features of big data, benefits of big data, and as well as problems associated
with big data.
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▪ Databases: The organisation may utilise software to structure its internal unstructured and
unanalysed data from its own databases such as customers and suppliers, in such a way
that it turns into useful information.
1
An American multinational retail corporation that operates a chain of hypermarkets, discount department stores, and grocery
stores, headquartered in Bentonville, Arkansas. (Source: https://en.wikipedia.org/wiki/Walmart)
2
An American microblogging and social networking service on which users post and interact with messages known as "tweets".
(Source: https://en.wikipedia.org/wiki/Twitter)
57
60% of adults in the United States of America. However, there are some issues which need to be
overcome by big data users. These are explained through revisiting the features of big data,
namely the 3V’s:
▪ Volume: The amount of data is often too much to analyse. All of the data may not be relevant
to the organisation, which means someone in the organisation will need to decide what data
to collect and store, and how to analyse and structure the often-messy data into useful
information.
▪ Variety: The data comes in various forms such as tweets, texts and pictures. It makes it
difficult to compare and analyse the data, since it is presented in an inconsistent format and
therefore needs to be organised and interpreted first.
▪ Velocity: The data is created and changed at great speed, calling for it to be uploaded and
updated on a second-by-second basis. Software plays a key role in collecting, organising
and changing data at a great speed to enable organisations to analyse the data.
▪ The data is freely available and may therefore also be analysed by rivals, bringing an early
end to the organisation’s competitive edge.
▪ A significant investment in IT is required to store, organise and manage these vast amounts
of data.
▪ The fourth V (“veracity”) which is often listed as one of the features of big data (see section
13.5.3 above), also comes into play in the form of users questioning the accuracy of the data
and whether it can be trusted.
▪ The data may be distorted by data outliers, presenting users with a very different impression
of the overall data.
“Data outliers are pieces of information that do not appear to fit into the pattern of normal
results. Outliers are often more easily spotted through the use of data graphs. Data outliers
give a very different impression of the overall data, but should not be ignored. The outliers
themselves could contain valuable data.” (CIMA P1, Kaplan Publishing, 2020:260).
3
The Fourth Industrial Revolution (or Industry 4.0) is the ongoing automation of traditional manufacturing and industrial
practices, using modern smart technology. (Source: https://en.wikipedia.org/wiki/Fourth_Industrial_Revolution)
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(refer to section 13.4); and (iii) budgeting in conjunction with the use of big data (refer to
section 13.5). However, business environment has many complexities which require solutions
that goes beyond the basic use of technology. Technological solutions range from basic solutions
such as digitisation (conversion of the traditional physical information into virtual content) to more
advanced solutions such as digitalisation (delivering solutions via the application of digital
technologies). In many instances, both digitisation and digitalisation often use digital product(s).
Organisations are therefore expected to understand how to cost digital products.
“A digital product typically refers to a product that is stored, delivered and consumed in an
electronic format. The products can be delivered in many ways such as through a website, a
mobile phone application or email. One digital product may be offered in various forms. For
example, a company may release a game that can be played on its website or via IOS or
Android apps. A digital product can also refer to digital media that will be distributed such as a
television programme or music album. Digital products can sometimes be seen as a gathering
together of individual product features. Features can be added and changed by individual
consumers giving each user a bespoke experience through choosing the features that they
want and don’t want.” (CIMA P1, Kaplan Publishing, 2020:100).
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13.6.2 Typical costs and cost patterns associated with digital products
▪ Staff costs: Many costs will be specific to a digital project or product. For example, when
developing an app, the majority of the staff costs will be incurred upfront before the app is
launched, with almost no costs incurred once the app has been launched.
▪ Infrastructure, platform and payment types: This typically includes costs associated with
the platform on which the product is launched, infrastructure services such as where the app
is hosted, where the data is stored and the number of payment methods accepted.
▪ Functionality: Individual product functions may be costed separately, especially where
functionalities may be used separately in other products as well.
▪ Design and development: Similar to functionality, design elements may also be shared
amongst products. This should be taken into consideration in the costing of the product in
the form of overheads. Design and development costs unique to the individual product would
be a direct cost which would probably be incurred during the pre-launch phase.
▪ Marketing: Marketing costs may be incurred during all phases of the lifespan of the product.
A fixed marketing budget may also be allocated to a digital product.
▪ IT support services and testing: This typically include costs such as ongoing technical
support, IT specific maintenance costs for infrastructure, and testing before the product is
launched, but also post-launch to provide application programming interfaces (API) and fix
bugs.
▪ Royalty and licencing costs: Royalties may be difficult to budget for since it is often based
on sales, whereas licence fees may be a fixed amount incurred before the launch of the
product.
▪ Inventory costs: There is no inventory holding cost associated with a digital product and
therefore no need to perform an inventory valuation for accounting purposes.
▪ Administrative services: The organisation will need to administer the developed apps
through an administration dashboard. The dashboard will, amongst others, serve to manage
the content of the apps, update the apps, manage functional services and manage user
profiles. Costs associated with administration are difficult to determine since it is based on
individual apps.
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therefore, not repeat the information here but would like you to take note of how closely integrated
this area is with many, if not most, of the learning units in the study material. In the main, non-
financial performance indicators can measure various aspects, such as the quality of products or
services provided, environmental impacts, societal impacts, how satisfied customers are,
governance and how ethically an organisation is managed (Raath & Berry 2019; Drury 2015).
Furthermore, note that, technically, there is a difference between the following two comparisons:
(1) financial versus non-financial measures and (2) quantitative versus qualitative measures. A
non-financial measure is not necessarily qualitative; for example, the number of customer
complaints is a non-financial performance indicator but is still a quantitative measure (Raath &
Berry 2019; Williams et al 2020).
13.9 Summary
In this learning unit you were introduced to contemporary management accounting concepts, and
“techniques, practices and philosophies” that “support competitive advantage” (Williams et al
2020). Many, if not all, of these could assist an organisation with planning and control, decision-
making and strategy. Furthermore, in line with the Fourth Industrial Revolution, this learning unit
highlighted the importance of technology from a management accounting perspective. In this
regard, you were introduced to concepts such as big data, digital products, and digital costing
systems.
Lastly, take note that in MAC3701 you should not use throughput accounting or the theory of
constraints unless you are specifically instructed to do so.
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14.3 Background
First, let us briefly discuss inventory in general, as EOQ and JIT purchasing or production are all
about planning and controlling inventory.
63
Keeping in mind the different types of inventory, for which reasons, do you think, do companies
hold inventory?
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or when we are unsure as to whether our suppliers will be able to provide sufficient finished goods
or raw materials as and when we require these, we might want to keep some extra inventory as
a "backup". Here the key term is "uncertainty", which was also addressed in more detail in your
MAC2601 topic 12: Sensitivity Analysis. Conditions of uncertainty compels us to keep safety
stocks (Drury 2015:660-661), which we will be addressing a little bit later in this document. We
will not expect you to apply probabilities in calculating safety stock in this module; however, what
you have learnt in MAC2601 about uncertainty (including Study unit 30: Probabilities in Study
guide two of two for MAC2601 (Coetzee, Ntuli & Verster 2012b)) is still relevant and is examinable.
At this point, we have briefly outlined some key concepts within inventory management and
planning, including the different types of inventory and the reasons, or motives, why companies
keep inventory. The next section of this document deals with the mechanism of the EOQ
technique as an inventory management tool.
As a recap, you should be aware that the formula to use in calculating EOQ is:
65
• C, in turn, represents the variable costs of placing an order, thus the incremental costs we
incur each time that we place one additional order. Based on the cost behaviour of a
variable cost that you have learnt about, this means that the variable costs per order – or C
in your EOQ formula – remains constant, but the total (ordering) costs will increase if we
place more orders.
• H represents the variable holding costs of carrying one unit in inventory for a period of one
year, but excludes the interest portion (P x i) of the holding costs if the above formula is
used. We then go and also include in the total variable inventory holding costs, the return
or interest that we expect on the purchase price of the inventory item. Holding costs, in
principle, therefore include both the required return on the purchase price ((P x i) in the
above formula) and “other” holding costs (H if the above formula is used). See below for
clarification of using H as denominator versus using H + (P x i) as denominator in the EOQ
formula.
• Remember that the EOQ is rounded up because generally items cannot be purchased in
partially-completed units and if rounded down we will then not have sufficient inventory.
It is important to note that although the symbol H is often used to represent “other variable
inventory holding cost (excl. interest) per annum per unit” (Coetzee, Jordaan, Sithole & Verster
2012:70, own emphasis), “H” can also be used to represent the total variable inventory holding
costs per annum per unit, i.e., including interest or the required return, if applicable. We mostly
follow the convention of using H for the total variable inventory holding costs per annum per
unit in this document, but both depictions of the denominator are correct as long as the
principles are applied correctly.
The principle is that the denominator in the EOQ formula should be the total variable inventory
holding costs per annum per unit, i.e., including interest (or required annual return on
investment in inventories).
This implies that the following two EOQ formulae should result in the same answer:
Formula 1
Formula 2
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The two formulae are the same in principle, it is just the symbols used that differ slightly.
Please refer to activity 4.5 in Study unit 4: Material of your Study guide one of two for MAC2601
for an example of where “H” is used without the “+ (P x i)”. Students often enquire about this
example.
In activity 4.5, the H already includes the interest. As you will see, the “interest” has already
been added to the other holding costs to arrive at the total holding costs (per annum per unit)
of R6. The principle remains that annual interest per unit + other annual variable inventory
holding costs (excluding interest) per unit = total annual variable inventory holding costs
(including interest) per unit and that interest (if applicable) will be part of the total holding costs.
It is important for you to understand what we are calculating when using the EOQ formula: we are
calculating how many units of a specific inventory item we will have to order at a time so that we
will minimise the total of ordering costs plus holding costs for the year.
Remember, the less units we order at a time, the more the number of orders that we will have
to place during the year and, therefore, the higher our total ordering costs will be. C (variable
cost of placing an order), however, remains constant as it relates only to the ordering costs of a
single order.
Also, the less units we order at a time, the less our average inventory in store will be, which, in
turn, will lead to lower holding costs in total. EOQ thus seeks to find an order size at which the
total ordering costs added to the total holding costs are as little as possible.
This brings us to a recap of how to calculate the number of orders that we need to place during
a year:
Number of orders = Annual demand (in units) ÷ EOQ
For example, if our EOQ is 100 units and our planned usage of the associated inventory item is
2 000 units for the year, we will need to place 20 orders per year, that is, 2 000 divided by 100.
In the next section of this document we will discuss how the same EOQ principles that we use for
inventory purchases can be applied to calculate the optimal size of a production run.
Previously, we used the EOQ technique to determine how many units (e.g. of materials, to meet
our manufacturing requirements) we had to order each time – now we use the same formula to
calculate how many product units we need to manufacture at a time. To do this, we replace the
67
C ("variable cost of placing an order") in the EOQ formula by the set-up costs per batch (Drury
2015:658). Take note that although more complex models for batch size optimisation also exist,
such as the extended model discussed by Berlec, Kušar, Zerovnik & Starbek (2014:37), the
following basic formula will suffice for purposes of MAC3701:
In the formula above, the set-up costs per batch are represented by an “S”, and the “U” and “H”
remain the annual demand and the holding costs per unit per annum, respectively.
An example of setup costs per batch may be the incremental cost of labour (wages) of the
employees getting the production machinery ready for a new batch (Berlec et al 2014:35).
“Inventory carrying or holding costs” have already been discussed in MAC2601 (Coetzee et al
2012a:66) and can apply in both the context of keeping inventory of materials for use in production
and the context of keeping finished goods inventory for sale.
Although no marks will be allocated to the EOQ formula in your third-year module, we always
write down the formula we are using.
R330
2 𝑥 [3 000 x 12] x [(0,5 x 3 x R40)+(3 x )]
5
=√ [R50+R1+R149]
= √92 880
= 304,76
Let's look at an example (take note that the example given below is, henceforth, further expanded
to explain and illustrate some of the concepts of this tutorial letter):
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For this example, you may assume the following:
• The supplier charges an administrative fee of R120 per order placed.
• Brezie needs 22 500 units of the raw material to meet its production requirements for the
year.
• Brezie’s holding costs per unit of the raw material per annum is R21,60. This amount is
relatively high due to specific temperature and humidity requirements for the material to be
safely stored.
Step 1: Calculate the current economic order quantity (if not already given).
= √250 000
= 500 units
Step 2: Apply relevant costing to calculate the net relevant cost or income
* The 45 orders that we have used in the answer is the total annual demand of 22 500 units
divided by the EOQ of 500 units per order. If we now place orders of 750 units per order instead
of 500 units, it will mean that we will have to place only 30 orders (22 500 ÷ 750) instead of the
original 45. Therefore, at a level of 750 units per order, we are placing 15 less orders than we
would have placed if we used the original economic order quantity of 500 units.
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# The increase in total holding costs amount to the holding costs per unit of R21,60, multiplied by
the increase in average inventory level. The average inventory levels are calculated as EOQ (or
simply the order size where EOQ is not used) divided by two.
We will now move on to a discussion of deciding when to place an order and how to calculate
safety stock, and then conclude with a section on the Just-In-Time (JIT) approach, specifically
focusing on JIT purchasing.
In the following examples, let's extend on the Brezie’s example that was used earlier in this
document. We will outline the logic of the re-order point and show you how this fits in with some
of the formulas you need to know.
Brezie will require 22 500 ÷ 360 = 63 units (rounded) of the raw material per day. If the lead time
is five days, it means that Brezie will have to place its next order for 500 units when inventory
levels hit 5 x 63 = 315 units. If, instead, Brezie waits until the 500 units are all used up before the
next order is placed, it will be too late, as Brezie will only receive the next batch of 500 units five
days later. The inventory level (315 units in this example) that is available at the point in time
when you have to place the next order, is called the "re-order point".
At an order size of 500 units, Brezie will have to place 22 500 ÷ 500 = 45 orders per year. This
means that an order will have to be placed every 360 ÷ 45 = 8 days.
Let us now have a look at how this explanation fits in with some of the formulas you need to study
and be able to apply.
Note that you also need to know how to calculate the number of orders for the year as well as the
order interval:
• Number of orders placed per year
= Annual usage ÷ EOQ
= 22 500 ÷ 500
= 45 orders
Brezie will thus have to place 45 orders during the year if its annual usage is
22 500 units and its EOQ is 500 units.
• Order interval
= Number of days in a year ÷ Number of orders placed per year
= 360 ÷ 45
= 8 days
The “order interval” is the time lapse between orders.
In this question, our lead time is measured in days, so we need to determine the daily usage
requirements of the inventory item. If the lead time was measured in weeks, one would have
calculated the average usage per week, order interval in weeks, etcetera.
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The current example also assumes that no uncertainty exists in terms of any of the information
regarding the inventory (Drury 2015:660). What now if some uncertainty exists about how many
units of the raw material Brezie will actually use during the year, how long the supplier will take
before it delivers, etcetera?
In calculating Brezie’s re-order point, one will also have to take into account the safety stock level
that is required. In other words, should Brezie decide to keep a backup of, say 25 units of raw
materials inventory, Brezie will have to place its orders even earlier (at a higher inventory level
than the 315 units in example 2B) use the following formula to calculate the re-order point:
Formula: Re-order point = Daily* requirement x Lead time in days* + Safety Stock4
As soon as an inventory level of 340 units (315 + 25) is reached, Brezie will have to place its next
order. Brezie’s re-order point is thus 340 units in the current scenario.
4 * Can replace “daily” and “days” with other time period, e.g. “monthly” and “months”, as applicable. Consistency is,
however, required – do not mix time periods, such as days and months. We can also refer to the “Daily requirement
x Lead time in days” (or “Weekly requirement x Lead time in weeks”, etc.) as the “average usage during lead time”.
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using 5 x 63 = 315 units as its re-order point as before, Brezie will now use 7 x 70 = 490 units as
its re-order point.
Our safety stock can be calculated as the difference between our re-order point under conditions
of uncertainty (490 units) and our re-order point under conditions of certainty (315 units), which
amounts to 175 units.
Brezie may also choose not to work with the worst-case scenario (maximum usage and maximum
lead time) as illustrated above but to only keep some safety stock, taking the risk that it might not
be enough and it may result in an opportunity cost. However, the scenario will guide you in terms
of which scenario is applicable.
In other words, safety stock (if not given) can be calculated as:
Re-order point under conditions of uncertainty less re-order point under conditions of
certainty
As mentioned, the calculation will depend on whether the company is willing to take risk, and if
so, how much risk:
We would still refer to the 63 units as the average usage rate and the five days (not the seven
days) as our lead time.
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JIT purchasing involves, amongst other aims, the following (Drury 2015:664-665; Berry & Raath
2019:9; Williams et al 2020:548-551):
• Keeping as little inventory as possible – for this to realise, suppliers need to be reliable in
delivering inventories just before the entity needs them. If they deliver late, the entity
may have stock-out costs (Drury 2015:661) and not be able to meet demand (we discussed
the transaction motive and precautionary motive for holding inventory earlier on in this
document).
• Minimising the number of suppliers – this could possibly be done by channelling business
to those suppliers that are the most reliable in terms of timeous delivery and that are the
most willing to ensure that the goods delivered are of impeccable quality so that they can be
used immediately and without any further checking. In the process, longstanding
relationships with suppliers may be created.
JIT purchasing could have advantages like the following (Drury 2015:664-667; Berry & Raath
2019:9; Williams et al 2020:549-551):
• A reduction in inventory holding costs.
• Better relationships with suppliers over the long-term.
• A reduction in ordering costs, possibly due to better relationships with suppliers leading to
more bargaining power for the entity, or automation.
In a similar way, JIT principles may be applied to the manufacturing process to reduce, for
example, set-up times and costs, as well as batch sizes due to more frequent production runs
(Drury 2015:665-666).
Techniques similar to those used in “Step 2” of Example 2A: Deciding about a quantity discount
above may also be used to determine the net relevant saving or cost associated with
implementing JIT purchasing or manufacturing.
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