INTRODUCTION TO MANAGEMENT ACCOUNTING

Learning objectives
After studying this chapter, you should be able to:

▪ Distinguish between management accounting and financial accounting

▪ Identify and describe the elements involved in the decision-making, planning and
control process
▪ Justify the view that a major objective of commercial organizations is to broadly seek
to maximize the present value of future cash flows
▪ Explain the factors that have influenced the changes in the competitive environment
▪ Outline and describe the key success factors that directly affect customer satisfaction
▪ Identify and describe the functions of a management accounting system
▪ Provide a brief historical description of management accounting

There are many definitions of accounting, but the one that captures the theme of this book is
the definition formulated by the American Accounting Association. It describes accounting as
the process of identifying, measuring and communicating economic information to permit
informed judgments and decisions by users of the information.

In other words, accounting is concerned with providing both financial and non-financial
information that will help decision-makers to make good decisions. An understanding of
accounting therefore requires an understanding of the decision-making process and an
awareness of the users of accounting information.

During the past two decades many organizations in both the manufacturing and service sectors
have faced dramatic changes in their business environment. Deregulation combined with
extensive competition from overseas companies in domestic markets has resulted in a situation
where most companies are now competing in a highly competitive global market. At the same
time there has been a significant reduction in product life cycles arising from technological
innovations and the need to meet increasingly discriminating customer demands. To compute
successfully in today’s highly competitive global environment companies have made customer

1
satisfaction an overriding priority. They have also adopted new management approaches,
changed their manufacturing systems and invested in new technologies. These changes have
had a significant influence on management accounting systems. Progression through the book
will reveal how these changes have influenced management accounting systems, but first of all
it is important that you have good background knowledge of some of the important changes
that have occurred in the business environment. This chapter aims to provide such knowledge.

The objective of this first chapter is to provide the background knowledge that will enable you
to achieve a more meaningful insight into the issues and problems of management accounting
that are discussed in the book. We begin by looking at the users of accounting information and
identifying their requirements. This is followed by a description of the decision-making process
and the changing business and manufacturing environment. Finally, the different functions of
management accounting are described.

1.1 The users of accounting information

Accounting is a language that communicates economic information to people who have an

interest organization managers, shareholders and potential investors, employees, creditors and
the government. Managers require information that will assist them in their decision-making
and control activities; for example, information is needed on the estimated selling prices, costs,
demand, competitive position and profitability of various products that are made by the
organization. Shareholders require information on the value of their investment and the income
that is derived from their shareholding. Employees require information on the ability of the
firm to meet wage demands and avoid redundancies. Creditors and the providers of loan capital
require information on a firm’s ability to meet its financial obligations. Government agencies
like the Central Statistical Office collect accounting information and require such information
as the details of sales activity, profits, investments, stocks, dividends paid, the proportion of
profits absorbed by taxation and so on. In addition the Inland Revenue needs information on
the amount of profits that are subject to taxation. All this information is important for
determining policies to manage the economy.

2
Accounting information is not confined to business organizations. Accounting information
about individuals is also important and is used by other individuals; for example, credit may
only be extended to an individual after the prospective borrower has furnished a reasonable
accounting of his private financial affairs. Non-profit-making organizations such as churches,
charitable organizations, clubs and government units such as local authorities, also require
accounting information for decision-making, and for reporting the results of their activities. For
example, a cricket club will require information on the cost of undertaking its various activities
so that a decision can be made as to the amo0unt of the annual subscription that it will charge
to its members. Similarly, local authorities need information on the costs of undertaking specific
activities so that decision can be made as to which activities will be undertaken and the
resources that must be raised to finance them.

The foregoing discussion has indicated that there are many users of accounting information
who require information for decision-making. The objective of accounting is to provide
sufficient information to meet the needs of the various users at the lowest possible cost.
Obviously, the benefit derived from using an information system for decision-making must be
greater than the cost of operating the system.

An examination of the various users of accounting information indicates that they can be
divided into two categories:
1 internal parties within the organization;
2 external parties such as shareholders, creditors and regulatory agencies, outside the
organization

It is possible to distinguish between two branches of accounting that reflect the internal and
external users of accounting information. Management accounting is concerned with the
provision of information to people within the organization to help them make better decisions
and improve the efficiency and effectiveness of existing operations, whereas financial
accounting is concerned with the provisions of information to external parties outside the
organization. Thus, management accounting could be called internal accounting and financial

3
accounting could be called external accounting. This book concentrates on management
accounting.

1.2 Differences between management accounting and financial accounting

The major differences between these two branches of accounting are:

• Legal requirements. There is a statutory requirement for public limited companies to

produce annual financial accounts regardless of whether or not management regards this
information as useful. Management accounting, by contrast, is entirely optional and
information should be produced only if it is considered that the benefits from the use of the
information by management exceed the cost of collecting it.
• Focus on individual parts or segments of the business. Financial accounting reports
describe the whole of the business whereas management accounting focuses on small parts
of the organization, for example the cost and profitability of products, services, customers
and activities. In addition, management accounting information measures the economic
performance of decentralized operating units, such as divisions and departments.
• Generally accepted accounting principles. Financial accounting statements must be
prepared to conform with the legal requirements and the generally accepted accounting
principles established by the regulatory bodies such as the Financial Accounting Standards
Board (FASB) in the USA and the Accounting Standards Board (ASB) in the UK. These
requirements are essential to ensure the uniformity and consistency that is needed for
external financial statements. Outside users need assurance that external statements are
prepared in accordance with generally accepted accounting principles so that the inter-
company and historical comparisons are possible. In contrast, management accountants are
not required to adhere to generally accepted accounting principles when providing
managerial information for internal purposes. Instead, the focus is on the serving
management’s needs and providing information that is useful to managers relating to their
decision-making, planning and control functions.
• Time Dimension. Financial accounting reports what has happened in the past in an
organization, whereas management accounting is concerned with future information as well

4
 as past information. Decisions are concerned with future events and management therefore
required details of expected future costs and revenues.
• Reports frequency. A detailed set of financial accounts is published annually and less
detailed accounts are published semi-annually. Management requires information quickly
if it is to act on it. Consequently management accounting reports on various activities may
be prepared at daily, weekly or monthly intervals.

1.3 The decision-making process

Because information produced by management accountants must be judgment in the light of its
ultimate effect on the outcome of decisions, a necessary precedent to an understanding of
management accounting is an understanding of the decision-making process.

Figure 1.1 presents a diagram of a decision-making model. The first five stages represent the
decision-making or the planning process. Planning involves making choices between
alternatives and is primarily a decision-making activity. The final two stages represent the
control process, which is the process of measuring and correcting actual performance to ensure
that the alternatives that are chosen and the plans for implementing them are carried out. You
should note that the decision-making model specified in Figure 1.1 is a theoretical model based
on the assumption of rational economic behavior. This assumption has been challenged on the
grounds that such behavior does not always reflect actual real world behavior. Let us now
examine each of the items listed in Figure 1.1.

• Identifying objectives
Before good decisions can be made there must be some guiding aim or direction that will enable
the decision-makers to assess the desirability of favouring one course of action over another.
Hence, the first stage in the decision-making process should be to specify the goals or
objectives of the organization.

Considerable controversy exists as to what the objectives of firms are should be. Economic
theory normally assumes that firms seek to maximize profits for the owners of the firm (the

5
ordinary shareholders in a limited company) or, more precisely, the maximization of
shareholders’ wealth. Various arguments have been used to support the profit maximization
objective. There is the legal argument that the ordinary shareholders are the owners of the firm,
which therefore should be run for their benefit by trustee managers. Another argument
supporting the profit objective is that profit maximization leads to the maximization of overall
economic welfare. That is, by doing the best for yourself, you are unconsciously doing the best
for society. Moreover, it seems a reasonable belief that the interests of firms will be better
served by a larger profit than by a smaller profit, so that maximization is at least a useful
approximation.

Some writers (e.g. Simon, 1959) believe that businessmen are content to find a plan that
provides satisfactory profits rather than to maximize profits. Because people have limited
powers of understanding and can deal with only a limited amount of information at a time
(Simon uses the term bounded rationality to describe these constraints), they tend to search
for solutions only until the first acceptable solution is found. No further attempt is made to find
an even better solution or to continue the search until the best solution is discovered. Such
behavior, where the search is terminated on finding a satisfactory, rather than optimal solution,
is known as sacrificing.

Cyert and March (1969) have argued that the firm is a coalition of various different groups –
shareholders, employees, customers, suppliers and the government – each of whom must be
paid a minimum to participate in the coalition. Any excess benefits after meeting these
minimum constraints are seen as being the object of bargaining between the various groups. In
addition, a firm is subject to constraints of a societal nature. Maintaining a clean environment,
employing disabled workers and providing social and recreation facilities are all examples of
social goals that a firm may pursue.

6
Figure 1.1: The decision-making, planning and control process

1. Identify objectives

2. Search for alternative courses of action

Planning 3. Gather data about alternative

process

4. Select alternative courses of action

5. Implement the decisions

6. Compare actual and planned outcomes

Control
process
7. Respond to divergencies from plan

Clearly it is too simplistic to say that the only objective of a business firm is to maximize profits.
Some managers seek to establish a power base and build an empire; another goal is security;
the removal of uncertainty regarding the future may override the pure profit motive.
Nevertheless, the view adopted in this book is that, broadly, firms seek to maximize the value
of future net cash inflows (that is, future cash receipts less cash payments) or to be more precise
the present value of future net cash inflow. This is equivalent to maximizing shareholder value.
The reasons for choosing this objective are as follows:

1 It is unlikely that any other objective is as widely applicable in measuring the ability of the
organization to survive in the future.
2 It is unlikely that maximizing the present value of future cash flows can be realized in
practice, but by establishing the principles necessary to achieve this objective you will learn
how to increase the present value of future cash flows.

7
3 It enables shareholders as a group in the bargaining coalition to know how much the pursuit
of other goals is costing them by indicating the amount of cash distributed among the
members of the coalition.

• The search for alternative courses of action

The second stage in the decision-making model is a search for a range of possible courses of
action (or strategies) that might enable the objectives to be achieved. If the management of a
company concentrates entirely on its present product rage and market, and market shares and
cash flows are allowed to decline, there is a danger that the company will be unable to generate
sufficient cash flows to survive in the future. To maximize future cash flows, it is essential that
management identifies potential opportunities and threats in its current environment and takes
specific steps immediately so that the organization will not be taken by surprise by any
developments which may occur in the future. In particular, the company should consider one
or more of the following courses of action:

1 developing new products for sale in existing markets;

2 developing new products for new markets;
3 developing new markets for existing products.

The search for alternative courses of action involves the acquisition of information concerning
future opportunities and environments; it is the most difficult and important stage of the
decision-making process. Ideally, firms should consider all alternative courses of action, but,
in practice they consider only a few alternatives, with the search process being localized
initially. If this type of routine search activity fails to produce satisfactory solutions, the search
will become more widespread (Cyert and march, 1969).

• Gather data about alternatives

When potential areas of activity are identified, management should assess the potential growth
rate of the activities, the ability of the company to establish adequate market shares, and the
cash flows for each alternative activity for various states of nature. Because decision problems
exist in an uncertain environment, it is necessary to consider certain factors that are outside the

8
decision-maker’s control, which may occur for each alternative course of action. These
uncontrollable factors are called stated of nature. Some examples of possible states of nature
are economic boom, high inflation, recession, the strength of competition and so on.

The course of action selected by a firm using information presented above will commit its
resources for a lengthy period of time, and how the overall place of the firm will be affected
within its environment that is, the products it makes, the markets it operates in and its ability to
meet future changes. Such decisions dictate the firm’s long-run possibilities and hence the type
of decisions it can make in the future. These decisions are normally referred to as long-run or
strategic decisions. Strategic decisions have a profound effect on the firm’s position, and it is
therefore essential that adequate data are gathered about the firm’s capabilities and the
environment in which it operates. Because of their importance, strategic decisions should be
the concern of top management.

Besides strategic or long-term decisions, management must also make decisions that do not
commit the firm’s resources for a lengthy period of time. Such decisions are known as short-
term or operating decisions and are normally the concern of lower-level managers. Short-
term decisions are based on the environment of today, and the physical, human and financial
resources presently available to the firm. These are, to a considerable extent, determined by
the quality of the firm’s long-term decisions. Examples of short-term decisions include the
following.

1 What selling prices should be set for the firm’s products?

2 How many units should be produced of each product?
3 What media shall we use for advertising the firm’s products?
4 What level of service shall we offer customers in terms of the number of days required to
deliver an order and the after-sales service?

Data must also be gathered for short-term decisions; for example, data on the selling prices of
competitors’ products, estimated demand at alternative selling prices, and predicted costs for
different activity levels must be assembled for pricing and output decisions. When the data have
been gathered, management must decide which courses of action to take.

9
 • Select appropriate alternative courses of action
In practice, decision-making involves choosing between competing alternative courses of
action and selecting the alternative that best satisfies the objectives of an organization.
Assuming that our objective is to maximize future net cash inflows, the alternative selected
should be based on a comparison of the differences between the cash flows. Consequently, an
incremental analysis of the net cash benefits for each alternative should be applied. The
alternatives are ranked in terms of net cash benefits, and those showing the greatest benefits are
chosen subject to taking into account any qualitative factors.

• Implementation of the decisions

Once3 alternative courses of action have been selected, they should be implemented as part of
the budgeting process. The budget is a financial plan for implementing the various decisions
that management has made. The budgets for all of the various decisions are expressed in terms
of cash inflows and outflows, and sales revenues and expenses. These budgets are merged
together into a single unifying statement of the organization’s expectations for future periods.
This statement is known as a master budget. The master budget consists of a budgeted profit
and loss account, cash flow statement and balance sheet. The budgeting process communicates
to everyone in the organization the part that they are expected to play in implementing
management’s decisions. Chapter 15 focuses on the budgeting process.

• Comparing actual and planned outcomes and responding to divergences from plan
The final stages in the process outlined in Figure 1.1 of comparing actual and planned outcomes
and responses to divergences from plan represent firm’s control process. The managerial
function of control consists of the measurement, reporting and subsequent correction of
performance in an attempt to ensure that the firm’s objectives and plans are achieved. In other
words, the objective of the control process is to ensure that the work is done so as to fulfill the
original intentions.

To monitor performance, the accountant produces performance reports and presents them to the
appropriate managers who are responsible for implementing the various decisions.
Performance reports consisting of a comparison of actual outcomes (actual costs and revenues)

10
and planned outcomes (budgeted costs and revenues) should be issued at regular intervals.
Performance reports provide feedback information by comparing planned and actual outcomes.
Such reports should highlight those activities that do not conform to plans, so that managers
can devote their scarce time to focusing on these items. This process represents the application
of management by exception. Effective control requires that corrective action is taken so that
actual outcomes. Alternatively, the pans may require modification if the comparisons indicate
that the plans are no longer attainable.

The process of taking corrective action so that actual outcomes conform to planned outcomes,
or the modification of the plans if the comparisons indicate that actual outcomes do not conform
to planned outcomes, is indicated by the arrowed liens in Figure 1.1 linking stages 7 and 5 and
7 and 2. These arrowed lines represent ‘feedback loops’. They signify that the process in
dynamic and stress the interdependencies between the various stages in the process. The
feedback loop between stages 7 and 2 indicates that the plans should be regularly reviewed, and
if they are no longer attainable then alternative courses of action must be considered for
achieving the organization’s objectives. The second loop stresses the corrective action taken so
that actual outcomes conform to planned outcomes.

1.4 Changing competitive environment

Prior to the 1980s many organizations in Western countries operated in a protected competitive
environment. Barriers of communication and geographical distance, and sometimes protected
markets, limited the ability of overseas companies to compete in domestic markets. There was
little incentive for firms to maximize efficiency and improve management practices, or to
minimize costs, as cost increases could often be passed on to customers. During the 1980s,
however, manufacturing organizations began to encounter severe competition from overseas
competitors that offered high-quality products at low prices. By establishing global networks
for acquiring raw materials and distributing goods overseas, competitors were able to gain
access to domestic markets throughout the world. To be successful companies now have to
compete not only against domestic competitors but also against the best companies in the world.

11
Excellence in manufacturing can provide a competitive weapon to compete in sophisticated
world-wide markets. In order to compete effectively companies must be capable of
manufacturing innovative products of high quality at a low cost, and also provide a first-class
customer service. At the same time, they must have the flexibility to cope with short product
life cycles, demands for greater product variety from more discriminating customers and
increasing international competition. World-class manufacturing companies have responded to
these competitive demands by replacing traditional production systems with new just-in-time
production systems and investing in advanced manufacturing technologies (AMTs). The major
features of these new systems and their implications for management accounting will be
described throughout the book.

Virtually all types of service organization have also faced major changes in their competitive
environment. Before the 1980s many service organizations, such as those operating in the
airlines, utilities and financial service industries, were either government-owned monopolies or
operated in a high regulated, protected and non-competitive environment. These organizations
were not subject to any great pressure to improve the quality and efficiency of their operations
or to improve profitability by eliminating services or products that were making losses.
Furthermore, more efficient competitors were often prevented from entering the markets in
which the regulated companies operated. Prices were set to cover operating costs and provide
a predetermined return on capital. Hence cost increases could often be absorbed by increasing
the prices of the services. Little attention was therefore given to developing cost systems that
accurately measured the costs and profitability of individual services.

Privatization of government-controlled companies and deregulation in the 1980s completely

changed the competitive environment in which service companies operated. Pricing and
competitive restrictions were virtually eliminated. Deregulation, intensive competition and an
expanding product range created the need for service organizations to focus on cost
management and develop management accounting information systems that enable them to
understand their cost base and determine the sources of profitability for their products,
customers and markets. Many service organizations have only recently turned their attention to
management accounting.

1.5 Changing product life cycles

12
A product’s life cycle is the period of time from initial expenditure on research and
development to the time at which support to customers is withdrawn. Intensive global
competition and technological innovation combined with increasingly discrimating and
sophisticated customer demands have resulted in a dramatic decline in product life cycles. To
be successful companies must now speed up the rate at which they introduce new products to
the market. Being later to the market than the competitors can have a dramatic effect on product
profitability.

In many industries a large fraction of a product’s life-cycle costs are determined by decisions
made early in its life cycle. This has created a need for management accounting to place greater
emphasis on providing information at the design stage because many of the costs are committed
or locked in at this time. Therefore to compete successfully companies must be able to manage
their costs effectively at the design stage, have the capability to adapt to new, different and
changing customer requirements and reduce the time to market of new and modified products.

1.6 Focus on customer satisfaction and new management approaches

In order to compete in today’s competitive environment companies have has to become more
customer-driven’ and make customer satisfaction an overriding priority. Customers are
demanding ever-improving levels of service in cost, quality, reliability, delivery, and the choice
of innovative new products. Figure 1.2 illustrates this focus on customer satisfaction as the
overriding priority. In order to provide customer satisfaction organizations must concentrate on
those key success factors that directly affect it. Figure 1.2 identifies cost efficiency, quality,
time and innovation as the key success factors. In addition to concentrating on these factors
organizations are adopting new management approaches in their quest to achieve customer
satisfaction. These new approaches are illustrated in Figure 1.2. They are continuous
improvement, employee empowerment and total value-chain analysis. Let us now examine
each of the items shown in Figure 1.2 in more detail.

13
Since customers will buy the product with the lowest price, all other things being equal, keeping
costs low and being cost efficient provides an organization with a strong competitive
advantage. Increased competition has also made decision errors due to poor cost information
more probable and more costly. If the cost system results in distorted product costs being
reported, then overcosted products will lead to higher bid prices and business lost to those
competitors who are able to quote lower prices purely because their cost systems produce more
accurate cost information. Alternatively, there is a danger that undercosted profits will result in
the acceptance of unprofitable business.

These developments have made many companies aware of the need to improve their cost
systems so that they can produce more accurate cost information to determine the cost of their
products, pinpoint loss-making activities and analyse profits by products, sales outlets,
customers and markets.

In addition to demanding low cost products customers are demanding high quality products and
services. Most companies are responding to this by focusing on total quality management
(TQM). The goal of TQM is customer satisfaction. TQM is a term used to describe a situation
where all business functions are involved in a process of continuous quality improvement. TQM
has broadened from its early concentration on the statistical monitoring of manufacturing
processes, to a customer-oriented process of continuous improvement that focuses on delivering

14
products or services of consistently high quality in a timely fashion. The emphasis on TQM has
created fresh demands on the management accounting function to expand its role by becoming
involved in measuring and evaluating the quality of products and services and the activities that
produce them.

Organizations are also seeking to increase customer satisfaction by providing a speedier

response to customer requests, ensuring 100 per cent on-time delivery and reducing the time
taken to develop and bring new products to market. For these reasons management accounting
systems now place more emphasis on time-based measures, which have become an important
competitive variable. Cycle time is one measure that management accounting systems have
begun to focus on. It is the length of time from start to completion of a product or service. It
consists of the sum of processing time, move time, wait time and inspection time. Move time
is the amount of time it takes to transfer the product during the production process from one
location to another. Wait time is the amount of time that the product sits around waiting for
processing, moving, inspecting, reworking or the amount of time it spends in finished goods
inventory waiting to be sold and dispatched. Inspection time is the amount of time making sure
that the product is defect free or the amount of time actually spent reworking the product to
remedy identified defects in quality. Only processing time adds value to the product, and the
remaining activities are non-value added activities in the sense that they can be reduced or
eliminated without altering the product’s service potential to the customer. Organizations are
therefore focusing on minimizing cycle time by reducing the time spent on such activities. The
management accounting system has an important role to play in this process by identifying and
reporting on the time devoted to value added and non – value added activities.

The final key success factor shown in figure 1.2 relates to innovation. To be successful
companies much develop a steady stream of innovative new products and services and have the
capability to adapt to changing customer requirements. It has already been stressed earlier in
this chapter that being later to the market than competitors can have a dramatic effect on product
profitability. Companies have therefore begun to incorporate performance measures that focus
on flexibility and innovation into their management accounting systems. Flexibility relates to
the responsiveness in meeting customer requirements. Flexibility measures include the total

15
launch time for new products, the length of development cycles and ability to change the
production mix quickly. Innovation measures include an assessment of the key characteristics
of new products relative to those of competitors, feedback on customer satisfaction with the
new features and characteristics of newly introduced products, and the number of new products
launched and their launch time.

You can see by referring to figure 1.2 that organizations are attempting to achieve customer
satisfaction by adopting a philosophy of continuous improvement. Traditionally, organizations
have sought to study activities and establish standard operating procedures and materials
requirements based on observing and e4stablishing optimum input/output relationships.
Operators were expected to follow the standard procedures and management accountants
developed systems and measurements that compared actual results with predetermined
standards. This process created a climate where by the predetermined standards represented a
target to be achieved and maintained rather than a policy of continuous improvement. In today’s
competitive environment performance against static historical standards is no longer
appropriate. To compete successfully companies must adopt a philosophy of continuous
improvement, an ongoing process that involve a continuous search to reduce costs, eliminate
waste, and improve the quality and performance of activities that increase value or satisfaction.

Benchmarking is a technique that is increasingly being adopted as a mechanism for achieving

continuous improvement. It is a continuous process of measuring a firm’s products, services or
activities against the other best performing organizations, either internal or external to the firm.
The objective is to ascertain how the processes and activities can be improved. Ideally,
benchmarking should involve an external focus on the latest developments, best practice and
model examples that can be incorporated within various operations of business organizations.
It therefore represents the ideal way of moving forward and achieving high competitive
standards.

In their quest for the continuous improvement of organizational activities managers have found
that they have had to rely more on the people closest to the operating processes and customers
to develop new approaches to performing activities. This has led to employees being provided

16
with relevant information to enable them to make continuous improvements to the output of
processes. Allowing employees to take such action without the authorization by superiors has
come to be known as employee empowerment. It is argued that by empowering employees and
giving them relevant information they will be able to respond faster to customers, increase
process flexibility, reduce cycle time and improve morale. Management accounting is therefore
moving from its traditional emphasis on providing information to managers to monitor the
activities of employees to providing information to employees to empower them to focus on
the continuous improvement of activities.

Increasing attention is now being given to value-chain analysis as a means of increasing

customer satisfaction and managing costs more effectively. The value chain is illustrated in
Figure 1.3 it is the linked set of value-creating activities all the way from basic raw material
sources for component suppliers through to the ultimate end – use or service delivered to the
customer. Coordinating the individual parts of the value chain together to work as a team creates
the conditions to improve customer satisfaction. Particularly in terms of cost efficiency, quality
and delivery. It is also appropriate to view the value chain from the customer’s perspective,
with each link being seen as the customer of the previous link. If each link in the value chain is
designed to meet the needs of its customers, then end customer satisfaction should ensue.
Furthermore, by viewing each link in the value chain as a supplier-customer relationship, the
opinions of the customers can be used to provide useful feedback information on assessing the
quality of service provided by the supplier. Opportunities are thus identified for improving
activities thought the entire value chain. The aim is to manage the linkages in the value chain
better than competitors and thus create a competitive advantage.

Figure 1.3: The Value chain

Suppliers Organization Customers

Strategy and administration

Research Des Produ Custo

And ign ction Marketi Distribut mer
Development ng ion Servic
e

Finally, there are other aspects of customer satisfaction that are not specified in Figure 1.2 –
namely, social responsibility and corporate ethics. Customers are no longer satisfied if
companies simply comply with the legal requirements of undertaking their activities. They

17
expect company managers to be more proactive in terms of their social responsibility. Company
stakeholders are now giving high priority to social responsibility, safety and environmental
issues, besides corporate ethics. In response to these pressures many companies are now
introducing mechanisms for measuring, reporting and monitoring their environmental costs and
activities. A code of ethics has also become an essential part of corporate culture. In addition,
professional accounting organizations play an important role in promoting a high standard of
ethical behaviour by their members. Both of the professional bodies representing management
accountants in the UK (Chartered Institute of Management Accountants) and the USA (Institute
of Management Accountants) have issued a code of ethical guidelines for their members and
established mechanisms for monitoring and enforcing professional ethics. The guidelines are
concerned with ensuring that accountants follow fundamental principles relating to integrity
(not being a party to any falsification), objectivity (not being biased or prejudiced),
confidentiality and professional competence and due care (maintaining the skills required to
ensure a competent professional service).

1.7 The impact of information technology

During the past decade the use of information technology (IT) to support business activities has
increased dramatically with the development of electronic business communication
technologies known as e-business, e-commerce or internet commerce. These developments are
having a big impact on businesses. For example, consumers are becoming more discerning
when purchasing products or services because they are able to derive more information from
the internet on the relative merits of the different product offerings. E-commerce has provided
the potential to develop new ways of doing things that have enabled considerable cost savings
to be made from streamlining business processes and generating extra revenues from the adept
use of on – line sales facilities (e.g. ticketless airline bookings and internet banking). The ability
to use e-commerce more proficiently than competitors provides the potential for companies to
establish a competitive advantage.

One advanced IT application that has had a considerable impact on business information
systems is enterprise resource planning systems.(ERPD). The number of adopters of ERPS has
increased rapidly throughout the world since they were first introduced in the mid-1990s. an
18
ERPS comprises a set of integrated software applications modules that aim to control all
information flows within a company. They cover most business functions (including
accounting). Standard ERPS accounting modules incorporate many menus including
bookkeeping, product profitability analysis and budgeting. All the modules are fully integrated
in a common database and users can access real –time information on all aspects of the business.
A major feature of ERPS systems is that all data are entered only once, typically where the data
originate. There are a number of ERPS packages on the market provided by companies such as
SAP, Baan, Oracle and J. D. Edwards. SAP is the market leader with more than 7500 users in
90 countries (Scapenset.al., 1998).

The introduction of ERPS has the potential to have a significant impact on the work of
management accountants. In particular, ERPS substantially reduce routing information
gathering and the processing of information by management accountants. Instead of managers
asking management accountants for information, they can access the system to derive the
information they require directly by PC. Because ERPS integrate separate business functions
in one system for the whole company co-ordination is usually undertaken centrally by
information specialists who are responsible for both the implementation and operation of the
system. In multinational companies this has standardized the global flow of information, but it
has also limited the ability to generate locally relevant information.

Because ERPS perform the routine tasks that were once part of the accountants’ daily routines,
accountants must expand their roles or risk possible redundancy. ERPS provide the potential
for accountants to use the time freed up from routine information gathering to adapt the role of
advisers and internal consultants to the business. This role will require management accountants
to be involved in interpreting the information generated from the ERPS and to provide business
support for managers.

1.8 International convergence of management accounting practices

This book has become an established text in many different countries throughout the world. It
is therefore assumed that the content is appropriate for use in different countries. This
19
assumption is based on the premise that management accounting practices generally do not
differ across countries. Granlund and Lukka (1998) provide support for this assumption. They
argue that there is a strong current tendency towards global homogenization of management
accounting practices within the industrialized parts of the world.

Granund and Lukka distinguish between management accounting practices at the macro and
micro levels. The macro level relates to concepts and techniques; in other word, it relates mainly
to the content of this book. In contrast, the micro level is concerned with the behavioral patterns
relating to how management accounting information is actually used. Granlund and Lukka
argue that, at the macro level, the forces of convergence have started to dominate those of
divergence. They identify various drivers of convergence but the most important relate to the
intensified global competition, developments in information technology, the increasing
tendency of transnational companies to standardize their practices, the global consultancy
industry and the use of globally applied textbooks and teaching.

Firms throughout the world are adopting similar integrated enterprise resource planning
systems or standardized software packages that have resulted in the standardization of data
collection formats and reporting patterns of accounting information. In multinational companies
this process has resulted in the standardization of the global flow of information, but it has also
limited the ability to generate locally relevant information. Besides the impact of integrated IT
systems, it is common for the headquarters/parent company of a transnational enterprise to force
foreign divisions to adopt similar accounting practices to those of the headquarters/parent
company. A large global consultancy industry has recently emerged that tends to promote the
same standard solutions globally. The consultancy industry also enthusiastically supports
mimetic processes. Granlund and Lukka describe mimetic processes as processes by which
companies, under conditions of uncertainty, copy publicly known and appreciated models of
operation from each other, especially from successful companies that have a good reputation.
Finally, the same textbooks are used globally and university and professional accounting
syllabuses tend to be similar in different countries.

At the micro level Granlund and Lukka acknowledge that difference in national and corporate
culture can result in management accounting practices differing across countries. For example,
national cultures have been categorized as the extent to which: (1) the inequality between people
is considered to the normal and acceptable; (2) the culture is assertive and competitive as

20
opposed to being modest and caring; (3) the culture feels comfortable with uncertainty and
ambiguity; and (4) the culture focuses on long-term or short-term outcomes. There is evidence
to suggest that accounting information is used in different ways in different national cultures,
such as being used in a rigorous/rigid manner for managerial performance evaluation in cultures
exhibiting certain national traits and in a more flexible way in cultures exhibiting different
national traits. At the macro level Granlund and Lukka argue that the impact of national culture
is diminishing because of the increasing emerging pressures to follow national trends to secure
national competitiveness.

1.9 Functions of management accounting

A cost and management accounting system should generate information to meet the following
requirements. It should:
1. Allocate costs between cost of goods sold and inventories for internal and external profit
reporting;
2. Provide relevant information to help managers make better decisions;
3. Provide information for planning, control and performance measurement

Financial accounting rules require that we match costs with revenues to calculate profit.
Consequently any unsold finished goods inventory or partly completed inventory (work in
progress) will not be included in the cost of goods sold, which is matched against sales revenue
during a given period. In an organization that produces a wide range of different products it will
be necessary, for inventory valuation purposes, to charge the costs to each individual product.
The total inventory value of completed products and work in progress plus any unused raw
materials forms the basis for determining the inventory valuation to be deducted from the
current period’s costs when calculating profit. This total is also the basis for determining the
inventory valuation for inclusion in the balance sheet. Costs are therefore traced to each
individual job or product for financial accounting requirements in order to allocate the costs
incurred during a period between cost of goods sold and inventories. This information is
required for meeting external financial accounting requirements, but most organizations also
produce internal profit reports at monthly intervals. Thus product costs are also required for

21
periodic internal profit reporting. Many service organizations, however, do not carry any stocks
and product costs are therefore not required by these organizations for valuing inventories.

The second requirement of a cost and management accounting system is to provide relevant
financial information to managers to help them make better decisions. This involves both
routing and non-routing reporting. Routine information is required relating to the profitability
of various segments of the business such as products, services, customers and distribution
channels in order to ensure that only profitable activities are undertaken. Information is also
required for making resource allocation and product mix and discontinuation decisions. In some
situations cost information extracted from the costing system also plays a crucial role in
determining selling price, particularly in markets where customized products and services are
provided that do not have readily available market prices. Non – routing information is required
for strategic decisions. These decisions are made at infrequent intervals and include decisions
relating to the development and introduction of new products and services, investment in new
plant and equipment and the negotiation of long-term contracts with customers and suppliers.

Accurate cost information is required in decision-making for distinguishing between profitable

and unprofitable activities. If the cost system does not capture accurately enough the
consumption of resources by products, the reported product (or service) costs will be distorted,
and there is a danger that managers may drop profitable products or continue the production of
unprofitable products. Where cost information is used to determine selling prices the
undercosting or products can result in the acceptance of unprofitable business whereas
overcosting can result in bids being rejected and the loss of profitable business.

Management accounting systems should also provide information for planning, control and
performance measurement. Planning involves translating goals and objectives into the specific
activities and resources that are required to achieve the goals and objectives. Companies
develop both long-term plans and the management accounting function plays a critical role in
this process. Short-term plans, in the form of the budgeting process, are prepared in more detail
than the longer-term plans and are one of the mechanisms used by managers as a basis for
control and performance evaluation. Control is the process of ensuring that the actual outcomes

22
conform with the planned outcomes. The control process involves the setting of targets or
standards (often derived from the budgeting process) against which actual results are measured.
Performance is then measured and compared with the targets on a periodic basis. The
management accountant’s role is to provide managers with feedback information in the form
of periodic reports, suitably analysed, to enable them to determine if operations are proceeding
according to plan and identify those activities where corrective action is necessary. In
particular, the management accounting function should provide economic feedback to
managers to assist them in con trolling costs and improving the efficiency and effectiveness of
operations.

It is appropriate at this point to distinguish between cost accounting and management

accounting. Cost accounting is concerned with cost accumulation for inventory valuation to
meet the requirements of external reporting and internal profit measurement, whereas
management accounting relates to the provision of appropriate information for decision-
making, planning, control and performance evaluation. It is apparent from an examination of
the literature that the distinction between cost accounting and management accounting is
extremely vague with some writers referring to the decision-making aspects in terms of cost
accounting’ and other writers using the term management accounting’; the two terms are often
used synonymously. In this book no attempt will be made to distinguish between these two
terms.

You should now be aware form the above discussion that a management accounting system
serves multiple purposes. The emphasis throughout the book is that costs must be assembled
in different ways for different purposes. A firm can choose to have multiple accounting systems
(i.e. a separate system for each purpose) or one basic accounting system and set of accounts
that serve inventory valuation and profit measurement, decision-making and performance
evaluation requirements. Most firms choose, on the basis of costs versus benefits criteria, to
operate a single accounting system. A single database is maintained with costs appropriately
coded and classified so that relevant cost information can be extracted to meet each of the above
requirements. Where future cost information is required the database may be maintained at
target (standard) costs, or if actual costs are recorded, they are adjusted for anticipated price

23
changes. We shall examine in the next chapter how relevant cost information can be extracted
from a single database and adjusted to meet different user requirements.

1.10 A brief historical review of management accounting

The origins of today’s management accounting can be traced back to the industrial revolution
of the nineteenth century. According to Johnson and Kaplan (1987), most of the of the
management accounting practices that were in use in the mid – 1980s had been developed by
1925, and for the next 60 years there was a slow-down, or even a halt, in management
accounting innovation. They argue that this stagnation can be attributed mainly to the demand
for product cost information for external financial accounting reports. The separation of the
ownership and management of organizations created a need for the owners of a business to
monitor the effective stewardship of their investment. This need led to the development of
financial accounting, which generated a published report for investors and creditors
summarizing the financial position of the company. Statutory obligations were established
requiring companies to publish audited annual financial statements. In addition, there was a
requirement for these published statements to conform to a set of rules known as Generally
Accepted Accounting principles (GAAP), which were developed by regulators.

The preparation of published external financial accounting statements required that costs be
allocated between cost of goods sold and inventories. Cost Accounting emerged to meet this
requirement. Simple procedures were established to allocate costs to products that were
objective and verifiable for financial accounting purposes. Such costs, however, were not
sufficiently accurate for decision-making purposes and for distinguishing between profitable
and unprofitable products and services. Johnson and Kaplan argue that the product costs
derived for financial accounting purposes were also being used for management accounting
purposes. They conclude that managers did not have to yield the design of management
accounting systems to financial accountants and auditors. Separate systems could have been
maintained for managerial and financial accounting purposes, but the high cost of information
collection meant that the costs of maintaining two systems exceeded the additional benefits.
Thus, companies relied primarily on the same information as that used for external financial
reporting to manage their internal operations.
24
Johnson and Kaplan claim that, over the years, organizations had become fixated on the cost
systems of the 1920s. Furthermore, when the information systems were automated in the 1960s,
the system designers merely automated the manual systems that were developed in the 1920s.
Johnson and Kaplan conclude that the lack of management accounting innovation over the
decades and the failure to respond to its changing environment resulted in a situation in the
mid-1980s where firms were using management accounting systems that were obsolete and no
longer relevant to the changing competitive and manufacturing environment.

During the late 1980s, criticisms of current management accounting practice were widely
publicized in the professional and academic accounting literature. In 1987 Johnson and
Kaplan’s book entitled Relevance Lost; The Rise and Fall of Management Accounting, was
published. An enormous amount of publicity was generated by this book as a result of the
authors’ criticisms of management accounting. Many other commentators also concluded that
management accounting was in a crisis and that fundamental changes in practice were required.

Since the mid-1980s management accounting practitioners and academics have sought to
modify and implement new techniques that are relevant to today’s environment and that will
ensure that management accounting regains its relevance. By the mid-1990s Kaplan (1994)
stated that:
The past 10 years have seen a revolution in management accounting theory and
practice. The seeds of the revolution can be seen in publications in the early to mid
1980s that identified the failings and obsolescence of existing cost and performance
measurement systems. Since that time we have seen remarkable innovations in
management accounting; even more remarkable has been the speed with which the
new concepts have become widely known, accepted and implemented in practice e and
integrated into a large number of educational programmes.

25
 COST CONCEPTS, ELEMENTS AND CLASSIFICATION

Learning outcomes
At the end of this chapter, you should be able to:
• explain what is meant by cost
• define and illustrate a cost object
• explain different responsibility centers of an organization including cost centers
• explain the meaning of different cost classifications
• explain why maintaining a cost data base is important and
• explain how costs are estimated using various methods.

2.1 Introduction
The term “cost” is used differently for different purposes. For examples, cost is classified
differently to value inventories finding profit or loss for a period in the financial accounting,
measure the performance of divisions or units of an organization, take a special decision in
short run, control behavior of people, etc. Therefore, it is necessary to understand the cost, its
associated terms and different classifications of costs. Further, maintaining a cost data base is
important to provide information efficiently and effectively to take decisions. As management
accounting focuses more on future, costs are required to be estimated for future periods. In this
case, various methods can be used to estimate costs.

2.2 The cost

The cost refers to the value of resources sacrificed to achieve a specific objective, such as
manufacturing, acquiring a good or providing a service. Usually, cost is measured in monetary
terms.

2.3 Cost object/ cost unit

This refers to a quantitative measurement which is used to calculate costs. In other words, if we
want to know the cost of something, that something is called as a cost object. For example, if
we want to know the cost of a passenger in a bus, the passenger is considered as a cost object.

26
Similarly, if we want to know the cost a travelling hour, hour is the cost object. It should be
noted that the cost object depends according to the requirement of the user.

Activity 1
Write some examples for cost units of a manufacturing and service organization.

2.4 Responsibility centers

In a small scale organization, decision making and management of the business is often done
by single or few individuals. However, in a large scale organization this becomes more difficult.
To overcome this difficulty various responsibility centers can be created and managers of each
center have the authority and responsibility over a given area of operation. Generally, following
types of responsibility centers are found in a large scale organization.
• Cost Centers
• Revenue Centers
• Profit Centers
• Investment Centers
Cost Center is a segment of an organization in which the managers are held responsible for the
cost in that center. Responsibility in a cost center is restricted to cost. The performance of a cost
center is usually evaluated through the comparison of budgeted to actual costs. A cost center
could be a location, person, or item of equipment, activity, process (or group of these) for which
costs are ascertained until those costs are allocated to cost objects. Cost centers are also used
for the purpose of cost control. For example, in an apparel manufacturing organization, various
activities such as cutting, sawing, and ironing are performed. For the purpose of cost
accumulation, each of these activities may be treated as cost centers and thereby costs of these
activities can be evaluated against budgets or targets.

A revenue center is a segment of the organization which is primarily responsible for generating
revenue. It does not have the control over costs and investment in assets. The performance of a
revenue center is evaluated comparing the actual with budgeted revenue.
Profit center is responsible for both revenue and costs. The performance of the profit center is
evaluated in terms profit.

27
Investment center is responsible for both profits and investments. This means that managers in
an investment center are responsible for costs, revenues and the amounts invested in the center’s
assets.

2.5 Classifications of costs

Cost can be classified in different ways according to the purpose for which the cost is used. The
following section shows different classifications of costs.

2.5.1. Direct and indirect costs

Direct and indirect classification of costs is based on the identification and the traceability of
costs with a cost object. Accordingly, direct cost refers to the cost that can be specifically and
exclusively identified with a particular cost object. On the other hand, indirect cost cannot be
specifically and exclusively identified with the cost object. Direct and indirect classification of
costs is presented in the Figure 2.1.

Figure 2.1
Cost

Direct Cost Indirect Cost

Direct Direct Direct Indirect Indirect Indirect

Material Labour Other Material Labour Other
Cost Cost Cost Cost Cost Cost

Source: Author

Activity 2
i. Identify direct and indirect costs of a furniture manufacturing company assuming that
the cost object is chair.
ii. Classify identified direct and indirect costs into material, labour and other.
iii. If the cost object is painting division, how would the answer given in the part 1 change?
In the above diagram, total indirect cost is classified as indirect material, indirect labour and
indirect other. However, indirect cost is widely (particularly for external financial reporting)
28
classified based on the function of the cost. Hence, based on the function, indirect cost can be
classified as follows;

Figure 2.2
Indirect Cost

Manufacturing Overheads Non-manufacturing Overheads

Activity 3
Classify the indirect costs identified in the part 1 of the activity 2.2 into manufacturing and non-
manufacturing overheads.

The summation of the direct costs and manufacturing overheads is termed as total
manufacturing cost and it can be depicted as follows;
Direct material cost xx
Direct labour cost xx
Direct other cost xx
Total direct cost xx
Manufacturing overheads xx
Total manufacturing cost xx

2.5.2. Product cost and period cost

Product and period cost classification is based on whether costs are included in the products
manufactured or purchased or not. This classification is often used for the external financial
reporting purpose. Product costs are those costs that are identified with goods purchased or
produced for resale. In a manufacturing organization all manufacturing costs are regarded as
product costs. In such an organization, product cost is included in the finished goods and work
in progress until they are sold. When inventories are sold, the product costs are then recorded

29
as expenses and matched against revenue to find the profit. In organizations operating in trading
sector, the costs of goods purchased are regarded as product costs.
Period costs are those costs that are not included in the inventory valuation and, as a result, are
treated as expenses in the period in which they are incurred. In a manufacturing organization
all non-manufacturing costs are regarded as period costs. Therefore, administration, selling and
distribution and finance and other expenses are regarded as period costs. In a trading
organization also, these costs are regarded as period costs. Figure 2.3 depicts the treatment of
product and period costs.

Figure 2.3
Manufacturing Costs Product Unsold Recorded as an asset
Cost (inventory) and becomes
an expense when the
product is sold

Sold
Recorded as an expense
in the current financial
Non-manufacturing Costs Period period
Cost
Source: Drury, 2007
Activity 4
Benadic Enterprises produces a special door lock. During the year, 5,000 units were produced
3 500 units were sold at Rs. 450 each. The costs for the year are as follows;
Direct material cost 450,000
Direct labour cost 270,000
Direct other cost 80,000
Manufacturing overheads 200,000
Administration & selling expenses 150,000
There were no opening finished goods and Work-In-Progresses at the beginning of the year.
Required:
a) Calculate the total product cost and period cost to be recognized in the year.
b) The profit or loss statement for the year.

30
As mentioned above, non-manufacturing costs are treated as period cost and not included in the
inventory valuation. The main reason is that there is no guarantee that the non-manufacturing
costs will generate future economic benefits, because they do not represent value addition to
the product.

2.5.3. Classification of costs based on the cost behavior

Knowledge of how costs will vary with different level of activity/ volume is essential for some
situations in decision making (particularly in short term decision making). Activity or volume
may be measured in terms of units of production or sales, hours worked, number of students
enrolled or any other appropriate measure. Based on the cost behavior, (whether the costs are
varied with different levels of activity) following categories of cost can be identified.
i. Variable cost
ii. Fixed cost
iii. Semi-variable cost
iv. Step fixed cost

i. Variable cost
The costs that vary in direct proportion to the volume of activity are called variable cost. In
other words, the cost is doubled when the level of activity is doubled. Some examples for
variable costs are direct material costs, wages for employees who are paid based on the number
of units produced, sales commission paid to sales force based on the number of units sold, etc.
Total variable costs are varied in direct proportion with the volume of activity. However, the
unit variable cost is constant. Suppose the unit variable cost is Rs. 10. The Figure 2.2 shows
that the total variable cost is increasing as the levels of activity increase from 100 to 300 units.
The Figure 2.3 shows that the unit variable cost of Rs. 10 is constant at the activity levels of
100 and 300.

31
 Figure 2.2 Figure 2.3

Total variable cost (Rs.) Unit variable cost (Rs.)

4000
5000
3000
4000
2000
3000
2000 10
1000
0 Units 0 Units
100 300 100 300

ii. Fixed cost

Fixed costs remain constant over the wide range of activity for a specific time period. Examples
for fixed costs are monthly salary paid to production employees, depreciation charge of the
factory building, etc.
Total fixed costs are constant for all levels of activities whereas unit fixed cost is decreasing
proportionately as the levels of activity increase. Suppose the fixed cost is Rs. 5,000. The Figure
2.4 shows that the total fixed cost is constant at the activity levels of 100 and 300 units. The
Figure 2.5 shows that the unit fixed cost is decreasing as the levels of activity increase from
100 to 300.

Figure 2.4 Figure 2.5

Total fixed cost (Rs.) Unit fixed cost (Rs.)

50
5000
16

0 Units 0 Units
100 300 100 300

iii. Semi-variable cost (Mixed costs)

Semi-variable costs include both fixed and variable costs. Example of a semi-variable cost is
telephone charge which includes fixed rental plus the charges on the usage. Another example
is where sales representatives are paid fixed salary plus commission on sales. The Figure 2.6
shows the behavior of the semi-variable cost.

32
 Figure 2.6

Semi-variable cost (Rs.)

Units

iv. Step fixed cost

In practice it is unlikely that fixed costs will be constant over the full range of activity. The
distinction of fixed and variable costs must be made relative to the time period under
consideration. Over the sufficiently long time period all costs are variable. However, in the long
run, fixed costs will not vary in direct proportion to the level of activity. Instead, up to certain
level of activity the fixed costs remain constant and if that level of activity exceeds, additional
fixed costs would be required. For example, let us assume that the maximum capacity of a
rented factory building is 10,000 units per year. If the rent is Rs. 100,000 for the year, up to
10,000 units one factory building is enough. However, if we want to expand the production
above 15 000 units per year, we have to get another factory building and this costs another Rs.
100,000. Therefore, in the long run, fixed costs may increase in steps in the manner depicted in
Figure 2.7.

Figure 2.7

Semi-fixed cost (Rs.)

Units

33
2.5.4. Relevant and irrelevant costs and revenues
Not all costs or revenues are relevant for decision making. Therefore, in decision making, costs
and revenues are classified as relevant and irrelevant costs. Relevant costs and revenues are
those future costs and revenues that will be changed by a decision. On the other hand, irrelevant
costs and revenues are those that will not be affected by the decision. For example, if you are
going to purchase a mobile phone out of two models, the cost for the sim card is irrelevant for
the purchase decision. Because, you have to buy a Sim card irrespective of the purchase
decision. However, cost of accessories of each phone would be different from each phone and
that cost would be relevant for the purchase decision.

Activity 5
ABC Company purchased Rs. 20,000 worth of raw materials a few years ago. Currently there
is no possibility of selling these materials or using them in future production. Recently a
customer saw these materials at the company premises and requested the company to sell those
materials to him. However, this customer is not prepared to pay more than Rs. 12,000. The
additional cost of Rs. 5,000 would be required to change these materials according to the
customer requirement.
1. What are the relevant costs and revenues in this case?
2. Should company sell these materials to the customer?
Adopted from Drury, 2007

2.5.5. Avoidable and unavoidable costs

Avoidable costs are those costs that may be saved by not adopting a given alternative. For
example, a manufacturer can drop one of the product lines so that associated costs (material and
labour) cost could be eliminated. On the other hand unavoidable costs cannot be saved. For
example, if a manufacturing plant shuts down, its avoidable costs like materials or labour could
be avoided, but it still needs to pay for idle equipment, property taxes, lease payments, etc. Only
avoidable costs are relevant for decision making.

34
Activity 6
XYZ Company was manufacturing a product ‘X’. However, due to the outdated design of the
product, the company had to cease its manufacturing. There is a materials stock which was
purchased at Rs. 32,000 a few months ago for product X. Currently there is no possibility of
selling these materials. If these materials are not used, it requires disposing them at a cost of
Rs 4,500. Further, the company had entered to five year rent agreement at the beginning of the
current year and the monthly rental is Rs 20,000. The company is planning to develop a new
product ‘Y’ and if product Y is manufactured, the available material stock could be used after
these materials are further processed at a cost of Rs 2,000.
Required:
1. What is the avoidable cost in the decision to produce product Y?
2. What is the un-avoidable cost in the decision to produce product Y?
3. What are the relevant costs in the decision to produce product Y?
4. Should company use these materials to produce product Y?

2.5.6. Sunk costs

Based on the reversibility of decisions taken on costs, costs can be classified as sunk costs.
Sunk costs are those costs that have been created by a decision made in the past and that cannot
be changed by any decision that will be made in the future.

Activity 7
S & S Company came into a rent agreement with a building owner on 30th June 2017. As per
the agreement, Rs. 20 000 monthly rent should be paid for a minimum of one year. It further
says that the agreement cannot be cancellable. By end of 2017, company thinks whether to
construct its own building or to continue the rent. What is the sunk cost of this decision?

All sunk costs are irrelevant for decision making. However not all irrelevant costs are sunk
costs. Therefore suck costs should be distinguished from irrelevant cost.

Activity 8
Give an example to a situation where the irrelevant cost is not a sunk cost.

35
2.5.7. Opportunity costs
Based on the economic perspective of costs, costs can be classified as opportunity costs.
Opportunity cost refers to the value of the next best alternative that is foregone due to selecting
one alternative when there are two or more alternatives.

Activity 9
A company has received a special order from a customer to produce 750 units of a customized
product. This special order requires additional variable cost of Rs. 20,000. To produce one unit
of this product, two machine hours are required. Currently machines are working are at their
full capacity. If the special order is accepted, current output of product A (the standard product)
will have to be reduced. To produce one unit of product A 1.5 machine hours are required. The
contribution per unit of product A is Rs. 30.
• Find the opportunity cost of fulfilling the customer’s order
• What is the minimum price that should be charged to the order?
Adopted from Drury, 2007

2.5.8. Incremental and marginal costs

Whether the cost is changed due to a selected alternative against another alternative, is the basis
for the classification of as incremental costs. Incremental costs/ revenues are the difference
between costs/revenues under each alternative being considered. In other words, Incremental
costs/ revenues represent the change of cost or revenue as a consequence of selecting one option
as oppose to another.

Activity 10
Following is the costs and revenue of the machine A and machine B.
Machine A Machine B
Revenue 5,000 3,000
Operating Cost (3,000) (2,000)
Profit 2,000 1,000
a) What is the incremental cost and revenue if A is selected over B?
b) What is the incremental cost and revenue if B is selected over A?

36
Activity 11
a) Do you include fixed cost into the incremental cost?
b) What is the main difference between incremental costs and the marginal costs?

2.5.9. Controllable costs and uncontrollable cost

Based on the controllability of costs, costs can be classified as controllable and uncontrollable
costs. Controllable costs are those costs which can be influenced by the action of a
particular member of an undertaking. Uncontrollable cost cannot be influenced by the action of
a particular member.

Activity 12
a) Identify the factors that affect to the controllability of costs.
b) “The uncontrollable costs at certain level of management may be controllable at another
level of management.” Do you agree with this statement? Justify your answer with
examples.

In order to facilitate you about the key words used in the chapter, let’s brief the chapter as
follows.

The term “cost” has multiple meanings. It varies according to the purpose of using the cost
information. Therefore, it is necessary to understand different cost terms and classifications
which are used in different situations. The cost is usually expressed in terms of money and,
represents the value of resources required to achieve a specific objective such as manufacturing
a product. The cost is calculated to cost objects. The cost object is a quantitative measurement
of costs. Cost center is a responsibility center which is responsible for the costs incurred in the
center. In addition to cost centers, there may be other responsibility centers such as revenue
centers, profit centers and investment centers.

According to the nature of the cost, cost is classified as direct and indirect costs. For external
financial reporting purpose, the cost is classified as product cost and period cost. According to
the behavior of cost, cost is classified as variable, fixed, semi-variable and semi-fixed costs.

37
Relevant costs are future cost and relevant for decision making. Irrelevant costs are not relevant
for decision making.

There are costs that can be avoidable by not adopting a given alternative. On the other hand
unavoidable costs cannot be saved. Only avoidable costs are relevant for decision making.
Sunk costs are those costs that have been created by a decision made in the past and that cannot
be changed by any decision that will be made in the future. Therefore, sunk cost is not a relevant
cost for decision making.

Opportunity cost refers to the value of the next best alternative that is foregone due to selecting
one alternative when there are two or more alternatives. Incremental costs/ revenues represent
the change of cost or revenue as a consequence of selecting one option as oppose to another.

Some costs can be controlled at certain level of management whereas some cannot be
controlled. However, uncontrollable costs at certain level of management may be controllable
at another level of management.

2.6 Maintaining a Cost Database

As explained above, cost and management accounting system should generate information to
meet the following requirements

1. To allocate costs between cost of goods sold and inventories for internal and external
profit measurement and inventory valuation;
2. To provide relevant information to help managers make better decisions;
3. To provide information for planning, control and performance measurement.

A database should be maintained, with costs appropriately coded and classified, so that relevant
cost information can be extracted to meet each of the above requirements. A suitable coding
system enables costs to be accumulated by the required cost objects (such products or services,
departments, responsibility centres, distribution channels, etc.) and also to be classified by
appropriate categories. Typical cost classifications within the database are by categories of
expense (direct materials, direct labour and overheads) and by cost behavior (fixed and
variable). In practice, direct materials will be accumulated by each individual type of material,

38
direct labour by different grades of labour and overhead costs by different categories of indirect
expenses (e.g. rent, depreciation, supervision, etc.).

For inventory valuation, the costs of all partly completed products (work in progress) and
unsold finished products can be extracted from the database to ascertain the total cost assigned
to inventories. The cost of goods sold that is deducted from sales revenues to compute the profit
for the period can also be extracted by summing the manufacturing costs of all those products
that have been sold during the period.

The allocation of costs to products is inappropriate for cost control and performance
measurement, as the manufacture of the product may consist of several different operations, all
of which are the responsibility of different individuals. The overcome this problem, costs and
revenues must be traced to the individuals who are responsible for incurring them. This system
is known as responsibility accounting.

Responsibility accounting involves the creation of responsibility centres. A responsibility

centre may be defined as an organization unit or part of a business for whose performance a
manager is held accountable. Responsibility accounting enables accountability for financial
results and outcomes to be allocated to individuals throughout the organization. The objective
of responsibility accounting is to measure the results of each responsibility centre. It involves
accumulating costs and revenues for each responsibility centre so that deviations from a
performance target (typically the budget) can be attributed to the individual who is accountable
for the responsibility centre.

For cost control and performance measurement the accountant produces performance reports
at regular intervals for each responsibility centre. The reports are generated by extracting from
the database costs analyzed by responsibility centres and categories of expenses. Actual costs
for each item of expense listed on the performance report should be compared with budgeted
costs so that those costs that do not conform to plan can be pinpointed and investigated.

Future costs, rather than past costs, are required for decision-making. Therefore costs extracted
from the database should be adjusted for anticipated price changes. We have noted that
classification of costs by cost behavior is important for evaluating the financial impact of
expansion or contraction decisions. Costs, however, are not classified as relevant or irrelevant
within the database because relevance depends on the circumstances. Consider a situation
where a company is negotiating a contract for the sale of one of its products with a customer in
39
an overseas country which is not part of its normal market. If the company has temporary
excess capacity and the contract is for 100 units for one month only, then the direct labour cost
will remain the same irrespective of whether or not the contract if undertaken. The direct labour
cost will therefore be irrelevant. Let us now assume that the contract is for 100 units per month
for three years and the company has excess capacity. For long-term decisions direct labour will
be a relevant cost because if the contract is not undertaken direct labour can be redeployed or
made redundant. Undertaking the contract will result in additional direct labour costs.

The above example shows that the classification of costs as relevant or irrelevant depends on
the circumstances. In one situation a cost may be relevant, but in another the same cost may
not be relevant. Costs can only be classified as relevant or irrelevant when the circumstances
have been identified relating to a particular decision.

Where a company sells many products or services their profitability should be monitored at
regular intervals so that potentially unprofitable products can be highlighted for a more detailed
study of their future viability. This information is extracted from the database with costs
reported by categories of expenses and divided into their fixed and variable elements. Finally,
you should note that when the activities of an organization consist of a series of common or
repetitive operations, targets or standard product costs, rather than actual costs, may be recorded
in the database. Standard costs are predetermined costs; they are target costs that should be
incurred under efficient operating conditions. They should be reviewed and updated at periodic
intervals. If product standard costs are recorded in the database there is no need continuously
to trace costs to products and therefore a considerable amount of data processing time can be
saved. Actual costs, however, will still be traced to responsibility centres for cost control and
performance evaluation.

2.7 Cost Estimation and Cost Behavior

Determining how costs are calculated with output or other measurable factors of activity is of
vital importance for decision making, planning and controlling. The preparation of budgets,
calculation of standard costs and the provision of relevant costs for pricing and other decisions
all depend on reliable estimation of costs. Unfortunately, costs are not easy to predict, since
costs behave differently under different circumstances. The following section discusses how
costs can be estimated using cost estimating methods.

40
2.7.1 General Principles Applying to Estimating Cost Functions
Before we consider the various methods that are appropriate for estimating costs, we need to
look at some of the terms that will be used. A regression equation identifies an estimated
relationship between a dependent variable (cost) and one or more independent variables (i.e. an
activity measure or cost driver). If there is only one independent variable and the relationship
is liner, the regression line can be described as follows;
y = a + bx
y = total cost for the period at an activity level of x
a = total non-variable (fixed) cost for the period
b = average variable cost per unit of activity
x volume of activity levels or cost driver for the period

Activity 13
Fixed costs for a period are Rs 5000. Total variable cost is Rs 7500. The cost driver for variable
cost is direct labour hours and total direct labour hours are 5000. Derive the total cost function.

Cost estimation begins with past relationship between cost and cost drivers. However, cost
function should not be taken solely on the basis of past relationships as past data may not reflect
the future relationships between costs and cost drivers.

2.7.2 Cost Estimation Methods

Following methods can be used to estimate costs.
1. Engineering Methods
2. Inspection of the Accounts Method
3. Graphical or Scatter-graph Method
4. High-low method
5. Least squares method (will not be discussing in this course)
1. Engineering Methods

This method is based on the use of engineering analyzes of technological relationships between
inputs and outputs. Method study, work sampling and time and motion study are examples for
Engineering Methods. The procedure when undertaking and engineering study is to make an

41
analysis based on direct observations of the underlying physical quantities required for an
activity and then to convert the final results into cost estimates. This approach is appropriate
when there is a physical relationship between cost and the cost driver (cost driver is any factor
whose change causes a change in the total costs of an activity). However, this method is not a
method that can be used for separating semi-variable costs into their fixed and variable
elements.

2. Inspection of Accounts

The inspection of accounts method requires that the departmental manager and the accountant
inspect each item of expenditure within the accounts for a particular period, and then classify
each item of expense as a wholly fixed, wholly variable or a semi-variable costs. A single
average unit cost figure is selected for the items that are categorized as variable, whereas a
single total cost for the period is used for the items that are categorized as fixed. For semi-
variable items the departmental manager and the accountant agree on a cost function that
appears to be best describe the cost behavior.

42
Activity 14
Following cost information has been obtained from the latest monthly accounts for an output
level of 10 000 units for a cost centre.
Rs.
Direct materials 100 000
Direct labour 140 000
Indirect labour 30 000
Depreciation 15 000
Repairs and maintenance 10 000
The departmental manager and the accountant inspected each item of expenditure and came to
the following conclusions.
▪ Direct material and direct labour costs are varying with direct proportion of units.
▪ Indirect labour and depreciation costs are fixed.
▪ The fixed element of the repairs and maintenance is Rs 5 000.

Required: Classify above costs into variable and fixed

3. Graphical or Scatter-graph Method

This method involves plotting on a graph the total costs for each activity level. The total cost is
represented on the vertical (Y axis) and the activity levels are recorded on the horizontal (X
axis). A straight line is fitted on the scatter of plotted points by visual approximation.

43
Activity 15
The total maintenance costs and the machine hours for the past ten four weekly accounting
periods were as follows;
Period Machine hours (X) Maintenance cost (Y)
1 400 960
2 240 880
3 80 480
4 400 1200
5 320 800
6 240 640
7 160 560
8 480 1200
9 320 880
10 160 440
You are required to estimate the regression equation using the graphical method.

4. High-low Method
The high low method consists of selecting the periods of highest and lowest activity levels and
comparing the changes in costs that results from the two levels. Though this method is simple
and easy, this has disadvantages. This method ignores all cost observations other than the
observations for the lowest and highest activity levels. Cost observations at the extreme ranges
of activity levels are not always typical of normal operating conditions and therefore may reflect
abnormal cost relationships.
Activity 16
The monthly recordings for outputs and maintenance costs for the past 12 months have been
examined and the following information has been extracted.
Month Volume (Units) Maintenance costs (Rs)
January 6000 25 500
February 6200 27 000
March 7000 30000
April 8000 31500
May 5000 22000
June 5500 23000
July 5800 24200
August 5500 24000
September 5800 25000
October 6000 26300
November 7900 29000
December 10000 32000

44
Estimate the variable cost and fixed cost using high-low method.

2.8 Summary
This chapter focused on what is meant by cost and cost object. Accordingly, the cost is defined
as the value of resources required to achieve a specific objective such as manufacturing a
product. The cost object is a quantitative measurement of costs. Further, the chapter explained
the different responsibility centers that could be in an organization for their different purposes.
Moreover, different cost classifications were explained in the chapter including direct and
indirect costs, product and period costs, variable, fixed, semi-variable and step fixed costs,
relevant and irrelevant costs, avoidable and unavoidable costs, sunk costs, opportunity costs,
Incremental costs and controllable and uncontrollable costs. Further, maintaining a cost data
base is important to provide information effectively and efficiently to facilitate decision
making. Hence, this chapter discussed the importance of maintaining a cost data base as well.
Determining how costs are calculated with output or other measurable factors of activity is of
vital importance for decision making, planning and controlling. In this case, costs are to be
estimated and various methods that can be used to estimate costs were discussed at last in this
chapter.

45
 Tutorial Questions
Question 1
A company manufactures and retails clothing. You are required to group the costs which are
listed below and numbered (1)–(20) into the following classifications (each cost is intended to
belong to only one classification):
(i) Direct materials
(ii) Direct labour
(iii) Direct expenses
(iv) Manufacturing overheads
(v) Selling and distribution costs
(vi) Administration costs
(vii) Finance costs

(1) Lubricant for sewing machines

(2) Compact disks (CDs) for general office computer
(3) Maintenance charges for general office photocopying machinery
(4) Cost of raw materials damaged by a fire
(5) Interest on bank overdraft
(6) Cost to broadcast music throughout the factory
(7) Salary of security guards for factory
(8) Carriage on purchase of basic raw material
(9) Royalty payable on number of units of product XY produced
(10) Revenue licence fees for delivery vehicles
(11) Cost of samples sent to customers
(12) Cost of advertising products on television
(13) Audit fees
(14) Chief accountant’s salary
(15) Wages of operatives in the cutting department
(16) Cost of painting advertising slogans on delivery vans
(17) Wages of storekeepers in materials store
(18) Wages of fork lift truck drivers who handle raw materials
(19) Cost of launching a new product in the market
(20) Royalty payable on number of units of product XY sold

46
Question 2
For the relevant cost data in items (1) – (7), indicate which of the following is the best
classification.
(a) Sunk Cost (d) Fixed Cost (g) Controllable Cost
(b) Incremental Cost (e) Semi-variable Cost (h) Non-controllable Cost
(c) Variable Cost (f) Semi-fixed Cost (i) Opportunity cost

(1) A company is considering selling an old machine. The machine has a book value of
Rs.200 000. In evaluating the decision to sell the machine, the Rs.200 000 is a ...

(2) As an alternative to the old machine, the company can rent a new one. It will cost Rs.30
000 a year. In analyzing the cost–volume behavior the rental is a ...

(3) To run the firm’s machines, here are two alternative courses of action. One is to pay the
operator a base salary plus a small amount per unit produced. This makes the total cost
of the operators a ...
(4) As an alternative, the firm can pay the operators a flat salary. It would then use one
machine when volume is low, two when it expands, and three during peak periods. This
means that the total operator cost would now be a ...
(5) The machine mentioned in (1) could be sold for Rs.80 000. If the firm considers
retaining and using it, the Rs.80 000 is a ...

(6) If the firm wishes to use the machine any longer, it must be repaired. For the decision
to retain the machine, the repair cost is a ...

(7) The machine is charged to the foreman of each department at a rate of Rs.30 000 a year.
In evaluating the foreman, the charge is a ...
Adopted from Drury, 2007

47
Question 3
Ganga Enterprises produces dolls. The following information is provided for the month of
January 2018.
To produce one unit of doll,
Plastic - 2 kgs at Rs. 50 per kilogram
Cloths - 1 metre at Rs. 30 per metre
Machine operators are paid at Rs. 30 per doll produced plus Rs.4,000 fixed monthly allowance
per operator.
No. of machine operators - 5
Supervisor’s salary is Rs.1,000 per working day.
No. of working days - 25
No. of supervisors - 1
During the month, 10,000 dolls were produced and 8,500 dolls were sold.
Normal production of dolls of a month is 9,000 units.
Designing is outsourced and designers are paid at Rs. 2 for each doll produced.
Machinery maintenance expenses Rs. 45,000
Purchases of materials during the month
Plastic - 25,000 kg
Cloth - 12,500 m
There were no opening inventory of raw materials and finished goods.
Assume that there are no opening and closing work-in-progresses.
Distribution costs - Rs. 30,000
Stationery expenses at the general administration office - Rs. 3,000
Other administration costs - Rs.15,000
Selling price of a doll is decided by adding 40% on the unit production cost.
Required;
1. Calculate the product cost and the period cost of the month.
2. Prepare the statement of profit or loss for the month

48
 COST VOLUME AND PROFIT ANALYSIS (CVP ANALYSIS)
AND SHORT-TERM DECISION MAKING

This chapter consists of two parts. Part I is CVP analysis and the Part II is short-term
decision making.

Learning outcomes
At the end of this chapter, you will be able to:
▪ Explain what is CVP analysis, and how is it used for decision making
▪ Explain how are CVP calculations performed for a single product
▪ Explain how are CVP calculations performed for multiple products
▪ Determine the breakeven point and other related applications
▪ Explain how income taxes affect CVP analysis
▪ Explain the graphical approach to CVP analysis
▪ Explain the assumptions of CVP analysis
▪ Explain how CVP analysis can be use for short-term decisions making

3.1 Introduction
Managers are concerned about the impact of their decisions on profit to plan and
monitor operations in their organizations. The decisions they usually make are about
volume, pricing, or incurring cost. Therefore, managers require an understanding of the
relations among revenue, cost, volume, and profit. Cost-Volume-Profit (CVP) analysis
is a technique used to examine the relationships among the total volume of an
independent variable, total cost, total revenue, and profit for a time period. In CVP
analysis, volume refers to a single unit-level activity cost driver, such as unit sales, that
is assumed to correlate with changes in revenues, costs, and profits.

It is a short term decision making technique used by managers in organizations, when

compared with long term decision making techniques like investment appraisal and
budgeting. Its most common application is break-even analysis. Further, managers use
CVP analysis to identify the levels of operating activity needed to avoid losses, achieve
targeted profits, plan future operations, and monitor organizational performance. They

49
also analyze operational risk as they choose an appropriate cost structure. CVP analysis
is useful in the early stages of planning because it provides an easily understood
framework for discussing planning issues and organizing relevant data.

3.2 The accountant’s cost-volume-profit model

The diagram for the accountant’s model is presented in Figure 5.1. The diagram
assumes a variable cost and a selling price that are constant per unit; this result in a
linear relationship (i.e. a straight line) for total revenue and total cost as volume
changes. The effect is that there is only one break-even point in the diagram, and the
profit area widens as volume increases. The most profitable output is therefore at
maximum practical capacity.

3.3 Relevant range

The relevant range is used to refer to the output range at which the firm expects to be
operating within a short-term planning horizon. This relevant range also broadly
represents the output levels which the firm has had experience of operating in the past
and for which cost information is available. The range of output is represented by the
output range between points X and Y in Figure 5.1.

50
3.4 Understanding cost behavior
Cost structures differ widely among industries and among firms within an industry.
Understanding the relationships between costs, volume and selling price as well as
comprehending cost behaviour can help to steer a company better in any economic
conditions. Therefore, in short term decision-making situations, when making a
decision it is vital to analyze the cost behaviour and the relationship among cost, volume
and profit. As we studied in cost concepts chapter, an organization’s cost structureis the
proportion of fixed and variable costs to total costs. Variable costs are those that vary
with sales volume. The more you sell, the more such costs you will incur. Fixed costs
are costs that do not vary with sales volume within a certain output range. In business,
a company can make a profit, suffers a loss or just breakeven-where it neither makes a
profit or loss. The following sections depict how to arrive at break-even point while
explaining the basic terms used in CVP analysis.

3.5 Profit equation

Every organization’s financial operations can be stated as a simple relation among total
revenues (TR), total costs (TC) and operating profit. The key relation for CVP analysis
is the profit equation.
Profit = Total revenue - Total costs
Separating costs into variable and fixed categories, we express profit as:
Profit = Total revenue – Total variable costs - Total fixed costs

3.6 Contribution margin

Contribution margin is the difference between the total revenue and the total variable
costs.
Total Contribution margin = Total Revenue – Total Variable Cost

Total contribution margin can be termed as total contribution.

Similarly, the contribution margin per unit is the selling price per unit minus the
variable cost per unit.
Contribution margin per unit= selling price per unit - variable cost per unit

51
Both contribution margin and contribution margin per unit are valuable tools when
considering the effects of volume on profit. Contribution margin per unit tells us how
much revenue from each unit sold can be applied toward fixed costs. As the number of
units manufactured and sold increases, the contribution is also increases
proportionately. Once enough units have been sold to cover all fixed costs, then the
contribution margin per unit from all remaining sales becomes profit.

If we assume that the selling price and variable cost per unit are constant, then total
revenue is equal to price times quantity, and total variable cost is variable cost per unit
times quantity. We then rewrite the profit equation in terms of the contribution margin
per unit.
Profit = (P x Q) – (V x Q) - F
= (P –V)Q- F
where ; P = Selling price per unit
V = Variable cost per unit
(P - V) = Contribution margin per unit
Q = Quantity of product sold (units of goods or services)
F = Total fixed cost

Contribution margin ratio

The contribution margin ratio (also known as the profit volume ratio) is the ratio
between contribution and sales. In other words it is the contribution margin as a
percentage of sales.
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
Contribution margin ratio = =
𝑠𝑎𝑙𝑒𝑠 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒

52
 Activity 1
When Janith first opened his photo developing shop “J-Develop”, he offered one service
only, i.e. developing prints. He charged an average price of Rs.60. The average variable cost
of each print was Rs.36, computed as follows:
Rs
Cost of processing (materials and labor) . . . . . . . . . . . . . . . . . . . . . 30
Other costs (sales and support). . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Average variable cost per print. . . . . . . . . . . . . . . . . . . . . . . . . . . 36
The fixed costs to operate the store for March, a typical month, were Rs 150,000.
In March, “J-Develop” processed 12,000 prints.
I. Compute the total contribution and contribution margin ratio.
II. Find out the operating profit of “J-Develop” for the month of March.

3.7 Break Even Point (BEP)

Managers often want to know the level of activity required to break even. The break-
even point is the level of activity where an organization neither enjoys any profit nor
incurs any loss. In other words, when its total revenue equals total cost or the level of
output whose contribution margin just covers the fixed costs. This is a very crucial
decision for any organization as this would indicate the minimum number of units to
be sold to cover the fixed cost of the organization. Beyond the break-even point every
unit sold brings in contribution which in turned profit to the company. Managers might
want to know the break-even point expressed either in units or in sales value. If the
company makes many products, it is often much easier to think of volume in terms of
sales value; if the company dealing with only one product, it’s easier to work with units
as the measure of volume.
Break-even point in units
We can calculate the breakeven point from profit formula, setting profit to zero.
Profit = (P –V) Q- F
0 = (P –V) Q- F
Q= F
(P-V)
BEP (Units) = Total fixed cost
Contribution margin per unit

53
Break-even point in sales value (Rs)
To find the break-even point in terms of sales value, we must first know about a new
term, contribution margin ratio. As stated earlier the contribution margin ratio is the
contribution margin as a percentage of sales revenue. In some books contribution
margin ratio is named as contribution to sales ratio (C/S ratio) or profit volume ratio
(P/V ratio).

Contribution margin ratio = Unit contribution margin

Selling price per unit

Using the contribution margin ratio, the formula to find the break-even sales volume
is as follows:

Break-even point in sales value (Rs) = Total fixed cost

Contribution margin ratio

Activity 2
Using the information provided in Activity 5.1 find out BEP both in units and sales value.

Besides deciding the minimum number of units to be sold to cover the fixed cost of the
organization, breakeven analysis facilitates the managers with a quantity which can be
used to evaluate the future demand. If, in case, the break-even point lies above the
estimated demand, reflecting a loss on the product, the manager can use this information
for taking various decisions. He might choose to discontinue the product, or improve
the advertising strategies, or even re-price the product to increase demand. Another
important usage of the break-even point is that it is helpful in recognizing the relevance
of fixed and variable cost. The fixed cost is less with a more flexible personnel and
equipment thereby resulting in a lower break-even point. On the other hand, if a
company has higher fixed cost due to heavy usage of newly adopted sophisticated
automated systems, leads to higher break-even points. Therefore, the break-even point
would depend on the nature of the industry as there are characteristic features associated
with each industry. However, the applicability of break-even analysis is affected by
numerous assumptions (which will be discussed at the end of the chapter). A violation
of these assumptions might result in erroneous conclusions.

54
 Activity 3
“Tasty foods” is a Sri Lankan restaurant which serves mid-price food to customers. Its
strategy is to provide quality food at reasonable prices. Hence, its variable costs are high
due to the usage of high quality ingredients. Selling price is fixed to cater the mass market.
As such, its contribution margin is not high. To cover its fixed costs and make a profit, it
has to compensate with high volume.
Required: Explain what does “Tasty foods” do to achieve this task?

3.8 Required sales to achieve a target profit

To find the required sales, to earn the target profit we use the profit equation with the
target profit specified. The formula to find the target sales in units and value (Rs) is
given below. If the target profit is X the total contribution should be equal to the total
of fixed cost and x
If target profit is π
Target Profit = (P –V)Q- F
X = (P –V)Q- F
Q = F+X
(P –V)
Target sales (units) = Fixed costs + Target profit
Contribution margin per unit

Target sales value (Rs) = Fixed costs + Target profit

Contribution margin ratio

Activity 4
A manufacturing firm provides the following information.
Selling price 80
Variable cost per units Rs.60
Total fixed cost Rs.120 000
The firm is expecting to earn Rs.80 000 profit in the next year.
Required; calculate the required sales to earn the target profit.

55
3.9 Margin of safety
The margin of safety is the excess of projected (or actual) sales over the break-even
sales level. This tells managers the margin between current sales and the break-even
point. In a sense, margin of safety indicates the risk of losing money that a company
faces, that is, the amount by which sales can fall before the company is in the loss area.
The margin of safety formula is;

Margin of safety (in units) = sales volume - break-even sales volume

In practice, the margin of safety also may be expressed in sales value or as a percent of
current sales. The excess of the projected or actual sales volume expressed as a
percentage of the break-even volume is the margin of safety percentage. It acts as a
measure of safety towards a possible fluctuation of sales about the budgeted value. If
the margin of safety is high it amounts to a low risk situation as output (or sales) could
drop relatively more than when the margin of safety is low before losses begin to incur.
At break-even point all the fixed costs have been recovered. Therefore contribution
included in margin of safety will become profit. On this ground, following formulas
can be used to calculate the profit.

Margin of safety in units × contribution per unit = profit

Margin of safety rupee value × Contribution margin ratio = profit
Total sales × Margin of safety ratio × contribution margin ratio = profit

Activity 5
Use the information given in Activity 6.1 and following as well.
If “J-Develop” sells 8000 prints, calculate margin of safety in units and as a percentage of
current sales. Explain the meaning of margin of safety percentage and calculated it.

56
3.10 Income taxes
We can incorporate the effects of income taxes by modifying the profit equation to
include taxes. If the target profit is given as after tax profit it should be converted into
before tax profit.
Profit after tax
Profit before tax =
1−tax rate
Assuming that operating profits before taxes and taxable income are the same, income
taxes may be incorporated into the basic model as follows:

Target sales volume (units) = Fixed costs + [Target profit / (1- t)]
contribution margin per unit

Target profit after tax

fixed cost+ 1−tax rate
Target sales volume (Rs) =
contribution margin ratio

Activity 6
Use the information given in Activity 6.1 and following as well.
Suppose that the owner of “J-Develop” wants to find the number of prints required to generate
after-tax operating profits of Rs.180,000. “J-Develop” has a 25 percent tax rate.
Determine the sales volume required to earn an after-tax operating profit of Rs. 180,000.

3.11 Multi-product CVP analysis

CVP analysis is fairly simple in the single-product setting. However, most firms
produce and sell a number of products or services. Even though CVP analysis becomes
more complex with multiple products, the operation is reasonably straightforward.

Without some assumptions, there are an infinite number of combinations of the two
services that would achieve a given level of profit. To simplify matters, managers often
assume a particular product mix and compute break-even or target volumes using either
of two methods, a fixed product mix or weighted-average contribution margin, both of
which give the same result.

57
Fixed product mix
Using the fixed product mix method, managers define a package or bundle of products
in the typical product mix and then compute the breakeven or target sales for the
package.

Weighted-average contribution margin

The weighted-average contribution margin also requires an assumed product mix, (for
an example, as explained in Activity 5.7, 90% prints and 10% enlargements). The
problem can be solved by using a weighted average contribution margin per unit. When
a company assumes a constant product mix, the contribution margin is the weighted-
average contribution margin of all of its products.

Breakeven in sales in value (Rs)

To find the breakeven in sales value (Rs), divide the fixed costs by the weighted-
average contribution margin percent. The weighted-average contribution margin
percent is the ratio of the weighted-average contribution margin divided by the
weighted-average revenue. To find the weighted-average revenue, multiply the
proportion of sales by the sales prices per unit.

58
 Activity 7
When “J-Develop” started, it provided only one service, print processing. After a short time,
a second service, enlargements of photos, was offered. The prices and costs per product of
the two products are as follows:
Prints (Rs) Enlargements (Rs)
Selling price 60 100
Variable cost 36 56
Contribution margin 24 44

When these two services were offered, monthly fixed costs totaled to Rs.182,000. Suppose
that the owner of “J-Develop” is willing to assume that the prints and enlargements will sell
in a 9:1 ratio (assumed product mix is 90% prints and 10% enlargements).
How many prints and enlargements must “J-Develop” sell to break even? (use both fixed
product mix and weighted-average contribution margin methods)

The complexity of determining the break-even point in units increases dramatically as

the number of products increases. Imagine performing this analysis for a firm with
several hundred products. Anyway computers can easily handle a problem with so
much data. Furthermore, many firms simplify the problem by analyzing product groups
rather than individual products. Another way to handle the increased complexity is to
switch from the units sold to the sales revenue approach. This approach can accomplish
a multiple-product CVP analysis using only the summary data found in an
organization’s income statement.

3.12 Graphical approach to CVP analysis

The graphical approach may be preferred when a simple overview is sufficient or when
greater visual impact is required. e.g. A report given for a manager. Such a graph is a
helpful aid in presenting cost-volume-profit relationships. Using the graphical approach
we can indicate the same information (i.e. BEP, margin of safety, values of profits and
losses at different level of activity) in a graph. Various types of graphs could be drawn
to indicate this information and those are shown below. The basic chart is known as a
break-even chart and can be drawn in two ways.

59
 • Using traditional approach
• Using contribution approach

Traditional break-even chart

This is prepared by drawing the following lines.
Fixed cost line
Total cost line
Total revenue line

Activity 8
Shehan Entertainments operate in the leisure and entertainment industry and one of its
activities is to promote concerts at locations throughout the country. The company is
examining the viability of a concert in Kandy. Estimated fixed costs are Rs.600,000.
These include the fees paid to performers, the hire of the venue and advertising costs.
Variable costs consist of the cost of pre-packed buffet which will be provided by a firm
of caterers at a price, which is currently being negotiated, but it is likely to be in the area
of Rs. 100 per ticket sold. The proposed price for the sale of a ticket is Rs.200. Assume
that the relevant range is sales volume of 4,000-12,000 tickets. (Adopted from Drury,
2007)
Using the information given above, construct the traditional break-even chart for Shehan
Entertainments. You are required to identify BEP, profit and loss areas, relevant activity
range in the graph.

Even though the above graph provides various information, it does not show the
contribution. Therefore, by modifying the traditional break-even chart we can show the
contribution in the contribution break-even chart.

Contribution break-even chart

In order to prepare the contribution chart, following lines should be drawn.
Total cost line
Variable cost line
Total revenue line

60
 Activity 9
Using the information given in the Activity 5.8, develop the contribution break-even chart.

Profit chart
The traditional break-even and contribution charts do not highlight the profit or loss at
different volume levels. The profit volume chart is more convenient method of showing
the impact of changes in volume on profits. Under this method of CVP analysis, only
the profit or loss line is drawn in order to identify the break-even level.

Activity 10
Using the same information in Activity 5.8, develop a profit chart.

Profit chart and product range

In reality it is very common fact that an organization manufactures and sells a wide
verity of products. Therefore a single product situation is more a hypothetical case than
a reality. The simple break-even analysis can be extended to cope with the multi-
product situation provided the assumption that the organization sells its products in a
constant mix. It follows that break-even analysis can be carried out assuming that the
average contribution to sales ratio is maintained right throughout its range of sales.

When a company is producing more than a single product, the profit line illustrated
above is not valid. In other words such a line will have different shapes depending on
different cost and revenue structures. In such an instance the profit line should be drawn
using following steps.
1. Calculate C/S ratio
2. Determine the priority ranking
3. Draw a graph according to the priority

61
 Activity 11
A firm is producing three products namely X, Y and Z. It has a fixed cost of
Rs.50,000.

Product Sales (Rs.’000) Variable costs (Rs.’000)

X 150 120
Y 40 20
Z 60 25

Prepare a profit chart and calculate BEP if the company is producing in most
profitable way.

3.13 Assumptions in CVP analysis

CVP analysis relies on several assumptions to simplify the complex relationship among
costs, revenues, and activity levels. Key assumptions are:
1. All other variables remain constant
2. A single product or constant sales mix
3. Profits are calculated on a variable-costing basis
4. Total costs and total revenues are linear functions of output
5. The analysis applies to the relevant range only
6. Cost can be accurately divided into fixed and variable elements
7. The analysis applies to short-term horizon
8. Complexity related fixed costs do not change
(Note: Read Management and Cost Accounting, Drury, 2007 for further explanations
for each assumption)

62
 Short-term Decision Making

3.14 Marginal costing and management decisions in short run

Concept of Marginal Costing is very useful in making managerial decisions in the short
run.
Determining the appropriate sales mix
a) When there are limiting factors the firm should select the best sales mix by
considering those factors.
Factors which limits indefinite expansion of on organization or earning of profit are
called limiting factors.
e.g. Finance, Sales, Row material, Skilled labour etc.
Steps:
i. Ascertain the contribution
ii. Ascertain the contribution per limiting factor
iii. List the order of preferences

Activity 12
A Company is producing 4 products and planning it’s production mix for the next period.
Estimated cost, sales and production data are given below.
Product W X Y Z
Selling price per unit 20 30 40 36
Labour (2/= per hour) 6 4 14 10
Material (1/= per kg) 6 18 10 12
Maximum demand (units) 5,000 5,000 5,000 5,000

Based on the above data, what is the most appropriate sales mix if;
I. Labour hours are limited to 50,000 hours in a period
II. Materials are limited to 110,000 Kg in a period.

b) Acceptance of a special order

Special order is an order, under terms different from terms for normal sales. Such
an order can be considered only if the organization has not utilized its capacity to
the fullest extent. In this decision the fundamental criteria whether to accept or
not, is based on the comparison of the variable cost with the price in the special

63
 offer. If proposed selling price of the special offer is higher than the variable cost
per unit, the order can be accepted.

Activity 13
X Ltd manufacture & market a drink which they sell at Rs.20 per bottle. Current output is
400,000 bottles per month, which represent 80% of capacity. They have the opportunity to
utilize their surplus capacity by selling the drink at Rs.13 per bottle to a super market, which
will sell it as an own labeled product. Total cost for the last month was Rs.5,600,000 out of
which 1,600,000were fixed cost.

Based on the above data, write a report to the Board of Directors stating whether to accept this
special order and the other factors that has to be considered in making the decision.

c) Dropping a loss making product

When a company is producing a range of products, which include a product
incurring losses, business will have to decide whether such product to be
discontinued. This decision can also be taken by comparing variable cost and the
selling price. In other words, by determining whether the product is having a
contribution. If the loss making product is having a contribution, it is profitable
to continue the product.

Activity 14
X Company has a range of products of which revenue and cost data are as follows
X (Rs.) Y (Rs.) Z (Rs.)
Sales 32,000 50,000 45,000
Total cost 36,000 38,000 34,000

The total cost comprises of 1/3 of the fixed cost. The Marketing manager of the
Company argues that product X is making losses and hence it should be discontinued.
The Managing Director of the organization seeks your advice on the issue.

64
d) Make or Buy Decisions
Frequently the management is faced with the decision whether to make a
particular product or component or whether to buy it from outside. A part from
over riding the technical reason the decision is usually based on an analysis of the
cost indicators. Under these types of decisions the most important factor is that
the costs are divided into fixed and variable cost. Any purchase price payable to
an outsider may be compared with any cost which can be saved unless the
production is made.

Activity 15
A firm manufactures component “XL 200” and the cost for the production at current level
of 50,000 units are as follows
Cost per unit (Rs.)
Raw material 2.50
Labour 1.25
Variable O/H 1.75
Fixed O/H 3.50

Component “XL 200” could be bought for Rs.7.75 and if so, the production capacity
utilized at present would be unused. Decide whether “XL 200” to be manufactured or
purchased. Show the effect on profit based on your calculations.

3.15 Summary
CVP analysis is a short term planning technique that is used by managers in varied
decision making situations. The chapter commences with break-even analysis and it
emphasized the importance of both mathematical and graphical approach to break-even
analysis for both single and multi product situations. It discussed how sensitivity
analysis helps managers to cope with uncertainty. Further, the chapter indicated the
fundamental assumptions of CVP analysis. Finally, it explained how CVP analysis used
in short-term decision making.
It is important to note that the CVP results are only one input into business decisions.
There are many other qualitative factors that may bear on decisions to choose one type
of product or service over another.

65
 Tutorial Questions

Question 1
Chandana PLC manufactures a product which has a selling price of Rs. 14 and 9
variable cost of Rs.6 per unit with an annual fixed cost of Rs. 24,400. Annual sales
demand is 8,000 units.
A new production method is currently being considered for introduction. This will
increase the fixed costs by 30%, but would reduce the variable cost to Rs. 5 per unit.
The superior quality of the finished product would enable sales rise to 8,500 units per
annum at a price of Rs. 15 each.

Required:
a) Calculate the break-even output level with the current production method is
introduced.
b) If the envisaged production method is introduced calculate the new break-even
output level.
c) At what level of sales would the annual profit be the same with both production
methods?

Question 2
a) From the following information calculate the break-even point
Fixed overhead Rs.210,000
Variable cost Rs.20 per unit
Selling price Rs.50 per unit

b) If the company is earning a profit of Rs.300,000 express the margin of safety

available to it.
c) Assuming that the company is operating in full capacity and income tax rate
applicable to it is 35%, find the no of units that the company should sell to earn
an after tax target profit of Rs. 300,000.

66
Question 3
Zigma Ltd produces two products, X and Y. The company’s management accountant
have prepared the following monthly budget.
Product X Product Y
Sales units 5,000 2,000
Sales revenue (Rs.) 100,000 80,000
Variable cost (Rs.) 40,000 60,000
Fixed production overhead (Rs.) Rs.32,000/-
Fixed administration overheads (Rs.) Rs.22,000/-
The fixed overhead can only be avoided if neither product is manufactured.
Required:
a) Calculate number of units to be sold of each product to reach the Break-even point;
i. If product X alone is sold,
ii. If product X and Y are sold in the ratio of 4:1

b) As an alternative to the manual production process assumed in the budget, Zigma

Ltd. has the option of adopting a computer-aided process. The process would cut
variable cost of production by 10% and increase fixed cost by Rs.5,072/- per month.
How will this affect the answer given to (a) i. above?

67
Question 4
A profit-volume or P/V graph is sometimes used in place of or along with the break-
even chart. An example of such a graph is given here.

(+) I
N
e
t
P
r
o
0 D F B J
f
i
t
(-) G

A H E K

Required:
Answer the associated questions and be precise.
a) What does JK represent?
b) What is represented by the point E?
c) What is represented by the IJ? (be precise)
d) What is represented by
e) What does IK  AK represent?
f) What does IJ  DJ represent?
g) If variable cost per unit decreases (other factors constant) what would happen
to the ratio IJ/DJ? Why?
h) If fixed costs were to increase but sales prices were also increased to the extent
necessary to retain the prior break-even, what would be the effect on profits at
a level of output (sales) K and how would this appear on the graph?
i) Order the following in terms of their absolute effect on the slope of the line ABC
(Give a 1 to the greatest change and a 3 to the smallest change.)
68
 i Variable cost per unit declines 10 per cent.
ii. Selling price per unit declines 10 per cent
iii Fixed costs decline 10 percent
j) What, in your opinion, is the most significant limitation to traditional break-
even analysis and why do you think so?

Question 5
Cost-volume-profit analysis helps managers evaluate the impact of alternative product
pricing strategies on profits. It can also be useful for evaluating competitors’ pricing
strategies and efforts to grow market share. Discuss.

Question 6
Alpah Ltd. Manufacturers market a special brand of soap which they sell for Rs.50/=
per price.
Current output is 22,500 pieces per month, which represents 75% of full capacity. The
total cost for the last month were Rs.800,000/= out of which Rs.125,000 were fixed
cost.
Required:
a) If the average selling price remains the same as it has been in the past, at
what level of activity will the company break-even?
b) Assume that a new customer offers the Alpha Ltd. Rs.35/= per piece for its
product. Provided that there are no effects on sales to old customers and no
legal complications. Should the Alpha Ltd. accept an order for 7,000 pieces
of soap. State two other factors to be considered in making the above
decision.

69
 CAPITAL INVESTMENT DECISIONS

Learning Objectives
After studying this chapter, you should be able to:
• Understand Stages of capital investment decisions
• Calculate the net present value
• Calculate the internal rate of return
• Identify relevant cash flows
• Understand Timing of cash flows
• Calculate Payback
• Calculate Accounting Rate of Return
• Explain the concepts of net present value (NPV), internal rate of return (IRR),
payback method and accounting rate of return (ARR)
• Calculate the incremental taxation payments arising from a proposed
investment
• Explain the effect of performance measurement on capital investment
decisions
• Explain the importance of qualitative factors

4. 1 Introduction
The process of allocating or capital investment decisions is usually more involved than
just deciding whether to buy a particular fixed asset. We frequently face broader issues
like whether we should launch a new product or enter a new market. Decisions such as
these determine the nature of a firm’s operations and products for years to come,
primarily because fixed asset investments are generally long-lived and not easily
reversed once they are made.

The most fundamental decision a business must make concerns its product line. What
services will we offer or what will we sell? In what markets will we compete? What
new products will we introduce? The answer to any of these questions will require that
the firm commit its scare and valuable capital to certain types of assets. As a result, all
of these strategic issues fall under the general heading of capital budgeting. The process
of capital investment decisions could thus be given a more descriptive name: strategic
asset allocation.

Any firm possesses a huge number of possible investments. Each possible investment
is an option available to the firm. Some options are valuable and some are not. The
essence of successful financial management, of course, is learning to identify which are

70
which. The major objective this chapter is to provide you with an understanding of
capital investment appraisal methods that should generally result in the maximizing of
shareholder value. In addition, those appraisal methods that are also widely used by
firms and that cannot be guaranteed to maximize shareholder value are explained.

These capital investment decisions are considered to be very important for a

firm/financial manager due to the following reasons;
▪ The capital investment decisions involve a considerable amount of time. Hence,
a firm loses flexibility once invested.
▪ Capital investment decisions typically involve substantial expenditures.
▪ An erroneous capital budgeting decision can have serious consequences. Due to
above reasons, it is extremely difficult to reverse a decision once invested.

Activity 1
Identify some examples for the above different types of capital investment decisions.

4.2 Steps in capital investment decisions making process

As highlighted in the previous section, capital budgeting decisions are very important
for any firm. It is, therefore, necessary that these decisions follow a well thought-out
decision making process in reaching the optimum decisions. The steps in a capital
budgeting decision making process can be given as follows;
1. Identify possible investment opportunities necessary to accomplish
organizational objectives.
2. Investigate alternative capital investments which will achieve the objectives of
an organization.
3. Evaluate these various alternatives based on expected costs and benefits.
4. Select the most suitable and feasible project/s for implementation.
5. Finance the project/s.
6. Implement of project/s.
7. Control and review the project/s.

4.3 Capital budgeting techniques

There are various capital budgeting techniques which can be used to evaluate the
financial viability of projects. These techniques can be categorized as non-discounted
cash flow techniques and discounted cash flow techniques (refer Figure 6.1).

71
Figure 4.1: Categorization of various capital budgeting techniques

Capital budgeting techniques

Non-discounted cash flow techniques Discounted cash flow techniques

▪ Payback period ▪ Discounted payback period

▪ Accounting rate of return ▪ Net present value
▪ Internal rate of return
Source: Author

4.3.1 Non-discounted cash flow techniques

Non-discounted cash flow techniques ignore the time value of money. There are two
widely used techniques that do not consider the time value of money principle. They
are payback and accounting rate of return method. These methods are not theoretically
sound methods and will not maximize the shareholder wealth. However, as these
methods are widely used in practice it is necessary to understand these methods and
their merits and limitations.

Payback (PB) method

Payback period is the length of time required for a stream of cash flows from an
investment to recover the original cash outlay (capital). The payback period can be
expressed in days, weeks, months or years. A project will be selected if it has a lower
payback period than the hurdle payback period of the company. When there are
mutually exclusive projects, the project with the lower payback period will be selected
given it is above the hurdle rate.

Activity 2
ABC Plc is planning to buy a new solar panel system with an initial capital of Rs.
2,800,000. The annual electricity bill savings is expected to be Rs. 800,000 per year for
five years due to the installation of the new system. Calculate the payback period.

Let’s look at the following activity with uneven cash flows.

72
 Activity 3
ABC Plc is planning to buy a new solar panel system with an initial capital of Rs.
3,000,000. The annual electricity bill savings is expected to be as follows due to the
installation of the new system.
Year Savings per annum Rs.
1 500,000
2 700,000
3 850,000
4 950,000
5 800,000
Calculate the payback period.

Payback period method is widely used due to the following reason;

▪ It is simple to understand.
▪ It is appropriate where liquidity constraints exist. A project with shorter payback
period will ensure a firm recovers its capital quickly leading to a better liquidity
position.
▪ It is appropriate for risky investments in uncertain markets. When selecting a
project with a shorter payback period, the risks involved in projects with longer
payback are automatically avoided. Hence, the payback method assumes the
risk is time related.
▪ Payback is often used as an initial screening device to identify whether the
investment allows a recovery of capital injected before the other advanced
techniques are used.

Despite the wide usage showcasing the popularity of this method, payback method
suffers from the following limitations;
▪ Simple payback method ignores the time value of money. However, Discounted
Payback Period (DPP) method can be used to overcome this limitation.
▪ It ignores cash flows after the payback period. Hence, the cash flows of the
entire life of a project are not considered.
▪ Payback method assumes that the cash flows are constant/uniform throughout a
year. Thus, it ignores the seasonality of the cash flows.

73
Accounting Rate of Return (ARR)
This method is also known as the return on investment or return on capital employed.
The accounting rate of return of a project is usually calculated by dividing the average
annual profits from a project by the average investment of the project. It is therefore
different from other techniques as it uses profits rather than cash flows. The average
annual profit is calculated by dividing the incremental profit of the investment by the
estimated life of the investment. The average investment is the initial investment and
the scrap sales value of the investment divided by two. The formula for the calculation
of the accounting rate of return can be expressed as follows:

Accounting Rate of Return = Average annual incremental profit x 100

Average investment

A project will be selected if it has a higher accounting rate of return than the hurdle
accounting rate of return of the company. When there are mutually exclusive projects,
the project with the highest accounting rate of return will be selected given it is above
the hurdle rate.

Activity 4
ABC Plc is planning to invest in a new project with an initial capital of Rs. 4,000,000. The
annual incremental profit of the project is expected to be Rs. 1,500,000 per year for four
years. The disposal value of the machines used in the projects is Rs. 1,000,000 and it is
expected that no other initial investment is recoverable. Calculate the accounting rate of
return of the project.

Let’s look at the following more complex activity.

74
 Activity 5
XYZ Plc is in the process of evaluating two capital expenditure proposals of four years.
However, only one proposal can be accepted. The initial capital outlay of both projects is Rs.
2,600,000 with an estimated disposal value of Rs. 400,000. Depreciation is charged on the
straight line basis. The following information is available.
Profit/(loss)
Year
Proposal X Proposal Y
1 500,000 450,000
2 650,000 700,000
3 700,000 800,000
4 500,000 300,000
Evaluate the above proposals using;
▪ Payback period method
▪ Accounting rate of return

Accounting rate of return has the following advantages;

▪ It is quick and simple to calculate as accounting profits can be easily identified
from financial statements/feasibility reports.
▪ It looks at the entire project life.
▪ As the accounting rate of return involves a familiar concept of a percentage
return easy comparisons can be made.

However, the accounting rate of return has the following limitations

▪ It ignores the time value of money.
▪ It is based on accounting profit rather than the cash flow. In appraising the
investments cash flow is generally regarded as a better indicator mainly due to
the difficulty in manipulation and various other reasons.
Nevertheless, accounting rate of return is widely used due to the wide use of return on
investment measure in financial statement analysis. Managers are generally interested
in understanding a projects’ impact on external reporting indicators.

75
4.3.2 Discounted cash flow techniques
These methods are based on the time value of money principle. . The discounted
payback method, net present value and internal rate of return are the commonly used
discounted cash flow techniques. These methods are based on the concept that Rs. 1,000
now is worth more than Rs. 1,000 received in the future. In other words, this principle
suggests that a certain amount of money today has a different buying power than the
same amount of money in the future. Under this method, the objective to calculate and
compare return on an investment in a capital project with an alternative equal risk
investment in securities traded in the financial markets. This comparison is made using
a technique called discounted cash flow (DFC) analysis. The rates of return that are
available from investments in securities in financial markets such as ordinary shares
and government gilt-edged securities represent the opportunity cost of investment in
capital projects; that is, if cash is invested in the capital project, it cannot be invested
elsewhere to earn a return. A firm should therefore invest in capital projects only if they
yield a return in excess of the opportunity cost of the investment. The opportunity cost
of the investment is also known as the minimum required rate of return, cost of capital,
discounted rate or interest rate.

Discounted Payback method

This method is similar in concept to the payback method discussed earlier except that
for the fact that discounted cash flows are used. One main limitation of the pay back
method, i.e. not considering the time value of money can be overcome in this method.

Activity 6
Same data as Activity 7.3. Calculate the discounted payback period assuming the cost of
capital rate of the company is 12% and the initial investment is Rs.2,000,000.

Net Present Value (NPV)

The NPV is the surplus funds earned on the project after financing an investment. In
calculating the NPV, all incremental cash inflows and outflows from a project are
discounted to their present values using the company’s cost of capital. When the NPV
is positive, the project should be accepted and when the NPV is negative, it should be
rejected. If the NPV is zero the project is breaking even. Further, If two projects are
mutually exclusive, the one with the highest positive NPV should be selected.
76
 Activity 7
Office Marts is a retail chain selling fast moving consumer goods in 35 locations
throughout Colombo. The company is now considering replacing its CFL bulbs with
power saving LED bulbs. In addition to long-term cost savings, this investment would
reduce the company’s carbon footprint.

Cash Outflows In Rs ‘000

Year 0 2,700
Year 1 100
Year 2 60

Cash Inflows
Electricity cost savings:
Year 1 540
Year 2 580
Year 3 640
Year 4 780
Year 5 840
Year 6 420
Year 7 200
Evaluate whether the investment in LED bulbs is worthwhile assuming the company’s cost
of capital.

NPV is a discounted cash flow based technique which considers the whole life of a
project. Theoretically, a project with a positive NPV is supposed to create shareholder
wealth. Thus, it is supposed to be the best method in appraising investments. However,
in applying NPV the following limitations/problems will be encountered.
▪ It is difficult for non-financial managers to understand the NPV.
▪ In order to calculate the NPV, it is require have a knowledge of the cost of
capital in advance. This poses a challenge for medium and small businesses who
are privately owned
▪ The speed of repayment of the original investment is not highlighted in NPV.

77
Activity 8
Alis is evaluating the introduction of a new product to which would involve the use of both
a new machine costing Rs. 3,000,000 and an existing machine which cost Rs. 1,600,000
four years ago. This existing machine has a current net book value of Rs. 1,200,000. As
the machine is currently under utilized there is sufficient capacity to produce the new
product. After carrying out a market research the company has identified that the demand
for the new product will last for five years. The annual demand will be 5,000 units per
annum in the first two years at a unit selling price of Rs. 640 and the demand will be 6,000
per annum in the next three years at a unit selling price of Rs. 600.

Having analysed the prototype of the product the engineering department has estimated
that the direct materials cost of a product is Rs. 140 and the conversion cost of the product
is Rs. 200. This includes a depreciation charge of Rs. 40 per unit. The production of the
new product will incur additional fixed overhead cost of Rs. 500,000 per annum.

After the five year life of the project, the new machine would have a disposal value of
value of Rs. 1,100,000. The required working capital would be Rs. 200,000 in the first
year, rising to Rs. 450,000 in the second year and remaining at this level until the end of
the project.

Evaluate whether the project is worthwhile, given that the company’s cost of capital is
15%.

Internal Rate of Return (IRR)

The IRR is the project’s expected rate of return. In other words IRR is the discount rate
at which the present value of expected cash inflows from a project equals the present
value of its expected cash outflows, making the NPV of a project zero. When applying
IRR technique, the project with the highest IRR is selected given it is greater than the
company’s cost of capital. Further, when selecting between mutually exclusive projects
the project with the highest IRR is selected given it is greater than the company’s cost
of capital.
78
 Activity 9
Calculate the IRR of the project given in Activity 7.

The main advantage of IRR is that the information it provides is more easily understood
by managers, especially non-financial managers as it is expressed as a percentage. In
order to calculate the IRR the cost of capital rate of a company is not needed in advance.
Most of the time a project selected based on IRR will be the same as selected in the
NPV. However, IRR has the following limitations.
▪ In calculating the IRR all future cash flows are assumed to be reinvested at the
IRR. There can be some projects with very high IRR (very profitable) or even
very less or negative IRR (very unprofitable). A company will not get projects
with very high level of profitability always. Neither a company will reinvest
money in a loss making projects. Thus, the reinvestment rate assumption in IRR
is not always practical. On the other hand, NPV assumes that the future cash
flows are reinvested at the cost of capital which is more practical.

▪ There can be projects in which an IRR may not exist or there may be multiple
IRR. This situation typically happens when dealing with projects with non-
conventional cash flows. Conventionally, a project’s cash flows are initially
negative and then become positive. However, there can be projects with initial
negative cash flows, next positive cash flows which are then followed by
negative cash flows again towards the end of a project. These projects are
deeded to be projects with non-conventional cash flows which will create this
problematic situation.

Activity 10
Identify some real life examples for the projects with non-conventional cashflows.

Let’s look at the following activity with non-conventional cash flows.

79
 Activity 11
ABV is planning to invest in a project with the following cash flows.
Year 0 Investment outlay (400,000)
Year 1 Net cash flows 1,200,000
Year 2 Environmental and disposal costs (895,000)

Calculate the NPV values at the following cost of capital rates and plot these NPV values
on a graph.
▪ 2% 5% 30% 50% 60%

▪ When dealing with mutually exclusive investments, it is sometimes possible for

NPV and IRR methods to lead to different decisions. Mutually exclusive
projects exist when the acceptance of one project excludes the acceptance of
another project. When the NPV profiles of two mutually exclusive projects
intersect, the investment decision arrived at based on the IRR technique is
correct if the cost of capital rate is less than the cross over rate.

Activity 12
The following information is given.
Year Expected cash flow ‘000
Project A Project B
0 (2,000) (2,000)
1 1,000 200
2 800 600
3 600 800
4 200 1,200
Requirements:
a) Draw the NPV profiles at different cost of capital rates (ranging from 5%, 8%, 10%,
14% and 18%).
b) Calculate the IRR of the projects.
c) Identify which project is selected based on IRR and NPV techniques, if the cost of
capital rate is 14% and 5%

80
4.4 Taxation and Investment Decision

Companies rarely pay tax on the profits that are disclosed in their published profit and
loss accounts, since certain expenses which are deducted during the preparation of the
accounts are not allowable deductions for taxation purposes. For example, depreciation
is not an allowable deduction; instead, taxation legislation enables capital allowances
to be claimed on capital expenditure that is incurred on plant and machinery and other
fixed assets.

Example: A company is considering whether to purchase some machinery that will

cost Rs. 100,000 but that is expected to give rise to additional cash inflows of Rs. 50,000
per annum for four years. The cost of capital is 10% and taxation is at the rate of 35%.
The machinery is eligible for 25% annual writing down allowances. It is anticipated
that the machinery will be sold at the end of year 4 at its written down value for taxation
purposes. Calculate the net present value.
The first stage is to calculate the annual writing down allowances (i.e. the capital
allowances.) the calculations are as follows:
End of year Annual writing down allowance Written down value
(Rs.) (Rs.)
0 0 100 000
1 25000 (25% x Rs. 100,000) 75 000
2 18750 (25% x Rs. 75000) 56 250
3 14063 (25% x Rs. 56250) 42 187
4 10547 (25% x Rs. 42187) 31 640

Next we calculate the additional taxable profits arising from the project. The
calculations are as follows:
Year 1 Year 2 Year 3 Year 4
(Rs. ) (Rs. ) (Rs. ) (Rs. )
Incremental annual profits 50 000 50 000 50 000 50 000
Less writing down allowance 25 000 18 750 14 063 10 547
Incremental taxable profits 25 000 31 250 35 947 39 453
Incremental tax at 35% 8 750 10 937 12 578 13 809

81
You can see that for each year the incremental tax payment is calculated as follows:
Corporate tax rate x (incremental cash flows – capital allowance).

Note that depreciation charges should not be included in the calculation of incremental
cash flows. We must now consider the timing of the taxation payments. It is assumed
that tax is paid one year after the end of the company’s accounting year. This means
that the tax payment of Rs. 8750 for year 1 will be paid at the end of year 2, Rs. 10937
tax will be paid at the end of year 3 and so on.

The incremental tax payments are now included in the NPV calculation:
Year Cash flow Taxation Net cash Discount Present
(Rs.) flow (Rs.) factor value (Rs.)
0 -100 000 0 -100 000 1.0000 -100 000
1 +50 000 0 +50 000 0.9091 +45 455
2 +50 000 -8 750 +41 250 0.8264 +34 809
3 +50 000 -10 937 +39 063 0.7513 +29 348
4 +50 000 -12 578 +69 062 0.6830 +47 169
+31 640a
5 0 -13 809 -13 809 0.6209 -8 574
Net present value +48 207

a
Sale of machinery for written down value of Rs. 31 640.

82
 Activity 13
A company is considering whether to purchase some machinery that will cost Rs. 100,000 but
that is expected to give rise to additional cash inflows of Rs. 50,000 per annum for four years.
The cost of capital is 10% and taxation is at the rate of 35%. The machinery is eligible for 25%
annual writing down allowances. It is anticipated that the machinery will be sold at the end of
year 4 Rs 25,000. Calculate the net present value.

Activity 14
A company is considering whether to purchase some machinery that will cost Rs. 100,000 but
that is expected to give rise to additional cash inflows of Rs. 50,000 per annum for four years.
The cost of capital is 10% and taxation is at the rate of 35%. The machinery is eligible for 25%
annual writing down allowances. It is anticipated that the machinery will be sold at the end of
year 4 at Rs 45,000. Calculate the net present value.

When taxation is included in the capital investment decision the cash flows from a
project must be reduced by the amount of taxation paid on these cash flows. In addition,
the investment cost must be reduced by the taxation saving arising from the capital
allowances. Because taxation payments do occur at the same times as the associated
cash inflows or outflows, the precise timing of the taxation payment must be identified.

4.5 The effect of performance measurement on capital investment decisions

The way that performance of a manager is measured is likely to have a product effect
on the decisions he or she will make. There is a danger that, because of the way
performance is measured, a manager may be motivated take the wrong decision and not
follow the NPV rule. For instance, a company is required to report on its performance
externally at annual intervals and managerial performance is also often evaluated on an
annual or more frequent basis. Evaluating managerial performance at the end of the five
year project lives is clearly too long a time scale since managers are unlikely to remain
in the same job for such lengthy periods. Therefore, if a manager’s performance is
measured using short-term criteria, such as annual profits, she or he may choose
projects that have a favorable impact on short-term financial performance.

83
 Activity 15

The cash flows and NPV calculation for project C are as follows:
Initial cost (50000)
Net cash inflows
1 10,000
2 20,000
3 20,000
4 3,500
5 3,500
6 3,500
7 3,500
Total cash inflows 64,000
NPV at 10% -1,036

4.6 Qualitative/non-monetary factors in capital budgeting decisions

The aforementioned techniques would assist a firm in evaluating the financial aspects
of capital budgeting decisions. However, there are many other factors that are difficult
to expresses in terms of monetary costs and benefits. These factors include impact on
customers and employees, externalities created on environment and society, etc. Before
a project is undertaken or rejected, it is necessary to analyse these non-monetary aspects
involved in the decision. Sometimes, even a financially viable project will not be
undertaken due to its negative impacts on environment.

Activity 16
Identify non-monetary aspects in the following capital budgeting decisions.
- Installation of a solar panel system
- Opening up a new cafeteria for employees
- Installation of safety equipment in factory
-

84
4.7 Summary
The chapter discussed capital budgeting decisions, an important financial management
decision that every organization makes. In order to evaluate various types of capital
budgeting decisions, discounted and non-discounted cash flow techniques are used.
These techniques have their own merits and limitations. Therefore, it is necessary a
combination of these methods is used when evaluation various investments. Further,
taxation matter was discussed in calculating net present value. However, these
techniques only take into consideration the monetary aspects of the decisions. It is also
imperative to consider non-monetary aspects before arriving at a final capital budgeting
decision.

85
 Tutorial Questions

Question No. 01
(i) Explain two problems associated with the discounted cash flow technique in
relation to Capital Budgeting.
(ii) “Weighted Average Cost of Capital (WACC) would be a good measure to
discount cash flows in capital budgeting “. Do you agree with the above
statement? Give reasons.
(iii) Managers over weigh qualitative factors over financial calculations in making
capital budgeting decisions. State four (4) such qualitative factors.
(iv) Explain the meaning of Irrelevant cash flows in capital budgeting. Give one
example of such a cash flow.
(v) Two mutually exclusive projects namely A and B are under review for
investment by a firm. IRRs of project A and B are 30% and 50% respectively.
Hurdle IRR of the firm is 25%.

(a) Explain with reasons which project should be accepted, based on given
information.
(b) State two problems that you will face in making a decision to invest,
assuming that the given information is not adequate.

(vi) A company is planning to build a production line to manufacture a new product.

Following information is given with respect to the project.

Rs.
• Cost of new machine to acquire 200,000

• Replacement of spare parts at the end of year 2 50,000

• Value of existing machines which are used in another

production line at present but expected to be shifted to the 75,000
new line

• Scrap value of the new machine after 3 years 20,000

• Value of existing machines which are idling at present in

another production line and expected to be shifted to the new 50,000
production line

86
 • Other impact due to new products.

Impact Year
1 2 3
Drop in sales of other products 25,000 40,000 30,000
Sales from new product 300,000 450,000 230,000
Increase in Operating expenses 80,000 150,000 110,000

Additional information:
• Company is liable to pay income tax at 30% per annum and tax liability of
a year is paid in the following year.

• Acquisition of new machines is allowed for depreciation allowance for tax

at the rate 50% per annum

• Cash flow discounting rate of the company is 20% per annum

• Assume that cash flows of a year take place at the end of each year

Required:
Evaluate the project and give your recommendations on accepting the project.

Question No. 02
A.
Outline two advantages of payback method over Net Present Value (NPV) method
when appraising investments.
B.
• Sillicon Valley Plc is considering an investment to produce chips for mobile phones
using one of its existing factories. It is expected that these chips can be sold for 4
years after which they will be replaced by a completely new technologically
advanced chip.
• The initial investment required is estimated to be Rs. 30 mn to buy the new plant
which will be depreciated on straight line basis over 4 years. It is also estimated
that the pre-tax salvage value of the plant is Rs. 1 mn at the end of the project. As
the new plant is qualified for a special investment promotion scheme, the company
can claim a 100% capital allowance in the first year.

87
• The existing plant in the factory will have to be dismantled at a cost of Rs. 1.4 mn
which has a net book value of Rs. 250,000. However, there is no scrap sales value
of this existing plant.
• The working capital requirement is Rs.6.5 mn at the beginning of the project.
• Annual fixed costs of running the factory will be Rs. 4.5 mn. The variable cost of
making one chip is Rs. 1,000 in the first two years. However, due to increasing
energy and direct labour costs, the variable cost per chip is expected to increase to
Rs. 1,500 in the next two years.
• The demand for the chip will be 10,000 units in every year. The marketing
department estimates that the selling price per chip will be Rs. 4,000 in the first year
and in the subsequent years the price will have to be reduced by Rs. 1,000 each
year.
• This type of investment is subject to a special tax rate of 10% which is paid in the
same year.

Required:
Determine whether project is financially feasible, using the NPV technique, if the
required rate of return is 12%. Show workings.

Question No. 03
You are the Financial Controller of Shanghi Express Ltd. which is an overseas company
engaged in highway constructions in Sri Lanka. You have been requested by the board
of directors of the company to assess the financial viability of the proposed Kandy-
Colombo highway construction project. You are provided with the following
information.

• The project will require an unspecified initial cash outlay of Rs. 1,000 million (mn.)
followed by further investment of cash outlays in four (04) phases.
• Construction of the highway is expected to be completed within three (03) years and
will pass through the following four (04) phases

88
Phase Activity Distance Cost
Rs. mn
I Surveys, land clearance, dispute handling and compensation - 4,000
II Kadawatha – Ambepussa, Highway construction 40 km 7,000
III Ambepussa – Kurunegala, Highway construction 30 km 4,300
IV Kurunegala – Kandy, Highway construction 30 km 5,700

• Phase I is expected to be completed during the first year(Y-1). Phases II and III
are to be completed during the second year (Y-2) and Phase IV is to be completed
in the third year (Y-3)
• In addition to the construction cost that appears in the above table, an additional
landscaping cost of Rs.10mn per kilometre is to be incurred.

• 75% of the construction cost (including survey and landscaping cost but excluding
initial unspecified cash outlay) incurred by the company each year will be paid by
the government of Sri Lanka in the same year.

• As per the agreement, Shanghi Express Ltd can operate the highway for 7 years
after completing the construction. After seven years of operation (i.e. after 10 years
from the commencement of the construction), management of the highway should
be transferred to the government of Sri Lanka.

• Estimated annual operating and maintenance cost of the highway for the first three
years after opening is Rs.100mn per year and thereafter it will remain constant at
Rs.200 mn per year.

• A flat toll of Rs.400 per vehicle is charged for the use of the road irrespective of the
distance travelled and types of vehicles for first three (03) years and Rs.500 per
vehicle is charged thereafter. Estimated number of vehicles that are expected to use
the highway per annum is given below.

Year 1 2 3 4 5 6 7
No. of Vehicles 4mn 5mn 6mn 7mn 7mn 8mn 8mn

• The average cost of capital is 12% per annum.

89
 • It is noted that some environmental activists and social and religious pressure
groups have protested against similar highway constructions due to environmental
footprints and social issues of such projects.

• Shanghi Express is exempted from tax.

Year 1 2 3 4 5 6 7 8 9 10
Discounting 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322
Factor @ 12%

Required:
(i) Estimate net cash flow for the ten (10) years of the project.
(ii) Assess the financial viability of the project based on NPV.
(iii) State four (04) non-financial factors to be considered before arriving at the
final decision.

90