MANAGEMENT ACCOUNTING

( MA 300)
LECTURE NOTES
Compiled by
Wachawaseme Mwale
merviswacha@gmail.com
+265 999 335 012
 STUDY TOPICS
1. Costing Methods
2. Process Costing
3. Planning Control and Performance
Management
4. Information for decision making
5. Risk and uncertainty
6. Performance Management

2
 COSTING METHODS
• Traditional costing systems
– Absorption costing
– Marginal Costing
• Back flush Costing
• JIT systems
• ABC, ABM AND ABB
• Life cycle costing, customer profitability
analysis and Target costing.
• Throughput accounting and theory of
constraints
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ABSORPTION COSTING/FULL COSTING
• A method whereby all production costs are
included in the costing of a cost unit ie.
– Direct materials,
– direct labour,
– variable production overheads and
– fixed production overheads.
• IAS 2 Inventories requires an element of fixed
production overhead to be ‘absorbed’ into
product cost for inventory valuation purposes.
• All production costs are charged to units of
production.
4
Calculation of unit cost-absorption costing
method
Direct costs:
Direct materials (5kg @ $3/kg) 15.00
Direct labour (3hrs @ $6/hr) 18.00
33.00
Indirect costs:
Variable overheads 2.00
Fixed overheads(absorption) 3.00
Full product cost 38.00
5
 The process of absorption
Three Step Process:
(1) Allocate/apportion overheads to cost centres
(2) Re-apportion service centre costs to
production cost centres
(3) Absorb into production

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 Under/Over absorption
• Over and under absorption of overheads
occurs because the predetermined overhead
absorption rates are based on estimates.
• The rate of overhead absorption is based on
estimates (of both numerator and
denominator) and it is quite likely that either
one or both of the estimates will not agree
with what actually occurs.
• (a)

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• Over absorption means that the overheads
charged to the cost of sales are greater than
the overheads actually incurred.
• Under absorption means that insufficient
overheads have been included in the cost of
sales.
• It is almost inevitable that at the end of the
accounting year there will have been an over
absorption or under absorption of the
overhead actually incurred.
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 The reasons for under-/over-absorbed overhead

• Actual overhead costs are different from

budgeted overheads
• The actual activity level is different from the
budgeted activity level
• Both actual overhead costs and actual activity
level differ from the budgeted costs and level

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Treatment of under/over absorption
• Under absorption is added to gross profit
• Over absorption is deducted from gross profit

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 Example
A company absorbs overheads based on labour hours.
Data for the latest period are as follows.
Budgeted labour hours 8,500
Budgeted overheads K148,750
Actual labour hours 7,928
Actual overheads K146,200
(a) Based on the data given above, what is the labour
hour overhead absorption rate?
(b) Based on the data given above, what is the amount
of under-/over-absorbed overhead?

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 Example
Pembridge Co has a budgeted production overhead of
K50,000 and a budgeted activity of 25,000 direct labour
hours and therefore a recovery rate of K2 per direct labour
hour.
Required
•Calculate the under-/over-absorbed overhead, and the
reasons for the under-/over-absorption, in the following
circumstances.
•(a) Actual overheads cost K47,000 and 25,000 direct labour
hours are worked.
•(b) Actual overheads cost K50,000 and 21,500 direct labour
hours are worked.
•(c) Actual overheads cost K47,000 and 21,500 direct labour
hours are worked.
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 Advantages of absorption costing
1. It recognizes that selling prices must cover all
costs (Pricing purposes)
2. It complies with IAS 2 on accounting for
inventory, whereby the value of inventory
must include an appropriate amount of fixed
production overhead (Stock valuation).
3. By apportioning overhead to production it is
possible to compare how profitable different
items are.(profitability comparisons)

13
 Disadvantages of absorption costing
1. Profits can be manipulated by simply
changing production levels. This is because
overheads will be carried forward in closing
inventory.
2. It is based on the assumption that overheads
are volume related

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 MARGINAL/VARIABLE COSTING
Marginal cost is the variable cost of one unit of product
or service.
Marginal costing is an alternative method of costing to
absorption costing.
In marginal costing, only variable costs are charged as a
cost of sale and a contribution is calculated (sales
revenue minus variable cost of sales). NB: this will mean that when calculating the
the total cost of the unit, the %ntage share of the fixed O/H will not be included in the cost of the unit.

Closing inventories of work in progress or finished

goods are valued at marginal (variable) production cost.
Fixed costs are treated as a period cost, and are charged
in full to the profit and loss account of the accounting
period in which they are incurred.NB:- This fixed cost are treated as the expense in that
accounting period in the income financial statement / profit & loss account . 15
• The marginal production cost per unit of an item usually
consists of the following.
– Direct materials
– Direct labour
– Variable production overheads
• Contribution is an important measure in marginal
costing, and it is calculated as the difference between
sales value and marginal or variable cost of sales.
• Contribution is of fundamental importance in marginal
costing, and the term 'contribution' is really short for
'contribution towards covering fixed overheads and
making a profit'.
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 Example-Marginal costing
Selling price per unit K10
Variable costs per unit
direct materials K2
direct labour K3
production overhead K1
selling and distribution K1
Fixed costs:
Production: budgeted K8,000
actual K8,500
Selling and distribution: (budgeted and actual) K2,000
Activity levels: Year 1
Units
•Budgeted production 4,000
•Actual sales 4,200
•Actual production 4,400
•There is no opening inventory in Year 1.
•Required
Prepare an income statement under absorption costing
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 Advantages of marginal costing
1. Most appropriate for decision making as it
highlights contribution.
2. Fixed costs are treated in accordance with their
nature, ie as period costs.
3. Profit depends on sales and efficiency not on
production levels. Variable costing removes
from profit the effect of stock changes.
4. Variable costing provides more useful
information for decision-making.
5. Variable costing avoids fixed overheads being
capitalized in unsaleable stocks.
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Disadvantages of marginal costing
• There is a danger that products will be sold on
an ongoing basis at a marginal contribution
which fails to cover fixed costs.
• Does not comply with IAS 2, thus necessitating
year end adjustments for the preparation of
published accounts.
• Necessitates analysis of mixed costs between
fixed and variable.
• Seasonal variations in a year can cause
unnecessary profit variances.
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 Absorption and Marginal Costing Compared
• In marginal costing, fixed production costs are
treated as period costs and are written off as
they are incurred. In absorption costing, fixed
production costs are absorbed into the cost of
units and are carried forward in inventory to
be charged against sales for the next period.
• Inventory values using absorption costing are
therefore greater than those calculated using
marginal costing.

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 Differences
Marginal Costing Absorption Costing

Closing inventories are Closing inventories are valued

valued at marginal at full production cost.
production cost.

Fixed costs are period Fixed costs are absorbed into

costs. unit costs.

Cost of sales does include a

Cost of sales does not share of fixed overheads
include a share of fixed
overheads.

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 Reconciling profits
• Reported profit figures using marginal costing
or absorption costing will differ if there is any
change in the level of inventories in the
period.
• If production is equal to sales, there will be no
difference in calculated profits using the
costing methods.

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 Explanation of the differences
1. If inventory levels increase between the beginning
and end of a period, absorption costing will report
the higher profit. This is because some of the fixed
production overhead incurred during the period will
be carried forward in closing inventory (which reduces
cost of sales) to be set against sales revenue in the
following period instead of being written off in full
against profit in the period concerned.
2. If inventory levels decrease, absorption costing will
report the lower profit because as well as the fixed
overhead incurred, fixed production overhead which
had been carried forward in opening inventory is
released and is also included in cost of sales. 23
Profits are the same for both methods when
production equals sales(no changes in stock levels)
Where production exceeds sales (increasing stock
levels)the absorption costing system produces
higher profits.
Where sales exceed production (declining stock
levels) the variable costing system produces higher
profits.
With an absorption costing system profits can
decline when sales volume increases and costs
remain unchanged
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 Reconciliation formula
Marginal Costing Profit x
Add: differences in closing inventory x
Less: differences in opening inventory (x)
Equals Absorption costing profit x

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 Which one is better?
• Choice depends on the circumstances.
– Volatile sales and changing stock levels favour
variable costing for internal monthly or quarterly
profit measurement.
– Seasonal sales where stocks are built up in advance
favours absorption costing.
• Debate only applies to internal reporting – IAS
2, Inventories requires that absorption costing
is used for external reporting.
• Debate only applies when historical cost
accounting is used.
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 ACTIVITY BASED COSTING
The emergence of ABC systems
Traditional systems were appropriate when:
– Direct costs were the dominant costs
– Indirect costs were relatively small
– Information costs were high
– There was a lack of intense global
competition
– A limited range of products was produced.

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 WEAKNESS OF TRADITIONAL COSTING SYSTEMS
MARGINAL COSTING
The main problem is that
fixed overheads are virtually
ignored.
Ignoring overheads tends to
inflate profits artificially.
The profit is, in effect, the
contribution.
The major danger, therefore,
is that fixed overheads are not
allocated to products and may
not be recovered when
setting a selling price.
As a result, the company may
drift into loss and eventually
go out of business.
ABSORPTION COSTING
The process assumes that overheads
relate directly to the level of
production.
The problem with this approach is
that the allocation of costs is carried
out on an arbitrary basis and may
not reflect accurately on those
activities which are truly responsible
for the costs.
Sometimes, a particular product or
activity may show a loss simply due
to a change in the cost allocation
process.
It is time consuming
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 Weaknesses of traditional costing systems
• They split costs into fixed and variable elements-
this is too simplistic and short termism.
Overtime all costs are variable.
• As businesses grow with time, their complexity
also grows. Costs therefore vary according to
complexity and not volume.
• Selling and administration costs are ignored i.e.
not included in product costs.
• Labour hours are often used as the basis for
absorption, even though direct labour often
forms a relatively small proportion of total cost.
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 Stages in ABC
• Identify those activities that cause overheads to be
incurred.
• Adjust the accounting system so that costs are collected
by activity rather than by cost centre.
• Identify those factors which cause each activity's costs to
change (the cost drivers)
• Establish the volume of each cost driver.
• Calculate the cost driver rates by dividing the activity's
cost by the volume of its cost driver.
• Establish the volume of each cost driver required by each
product.
• Calculate overheads attributable to each product by
multiplying step (e) by step (f).
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Cost pool/activity Possible cost driver

Materials handling costs Number of production

runs
Machine set-up costs Number of machine set-
ups

Machine operating costs Number of machine hours

Production scheduling Number of production

costs runs
Despatching costs Number of orders
despatched

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 Example
 A company manufactures two products, L and M, using the same equipment and similar
processes. An extract of the production data for these products in one period is shown
below.
L M
 Quantity produced (units) 5,000 7,000
 Direct labour hours per unit 1 2
 Machine hours per unit 3 1
 Set-ups in the period 10 40
 Orders handled in the period 15 60
 Overhead costs $
 Relating to machine activity 220,000
 Relating to production run set-ups 20,000
 Relating to handling of orders 45,000
285,000
Required
 Calculate the production overheads to be absorbed by one unit of each of the products
using the following costing methods.
(a) A traditional costing approach using a direct labour hour rate to absorb overheads
(b) An activity based costing approach, using suitable cost drivers to trace overheads to
products 32
 Merits of ABC
The complexity of manufacturing has increased, with wider
product ranges, shorter product life cycles and more
complex production processes. ABC recognizes this
complexity with its multiple cost drivers.
In a more competitive environment, companies must be
able to assess product profitability realistically. ABC
facilitates a good understanding of what drives overhead
costs.
In modern manufacturing systems, overhead functions
include a lot of non-factory-floor activities such as product
design, quality control, production planning and customer
services. ABC is concerned with all overhead costs and so it
can take management accounting beyond its 'traditional'
factory floor boundaries. 33
 Uses of ABC
1. It provides accurate and reliable cost information
2. It establishes a long-run product cost
3. It provides cost data which may be used to
evaluate different ways of delivering business.
4. It is particularly suited to the following types of
decision:
– Pricing, where selling prices are derived by adding a profit mark-up to cost
– Promoting or discontinuing products or parts of the business, since ABC
may help management to identify activity costs that may be either
incurred or saved
– Developing new products or new ways to do business, because ABC focuses
attention on the support activities that would be required for the
new product or business procedure.
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 Criticisms of ABC
 Cost apportionment may still be required at the cost pooling stage for shared items
of cost such as rent, rates and building depreciation. Apportionment can be an
arbitrary way of sharing costs.
 A single cost driver may not explain the cost behaviour of all items in a cost pool.
An activity may have two or more cost drivers.
 Unless costs are ‘driven’ by an activity that is measurable in quantitative terms,
cost drivers cannot be used. What drives the cost of the annual external audit, for
example?
 There must be a reason for using a system of ABC. ABC must provide meaningful
product costs or extra information that management will use. If management is not
going to use ABC information for any practical purpose, a traditional absorption
costing system would be simpler to operate and just as good.
 The cost of implementing and maintaining an ABC system can exceed the benefits
of ‘improved accuracy’ in product costs.
 Implementing ABC is often problematic, due to problems with understanding
activities and their costs. It is also complex. We need a lot of information.
 ABC is an absorption costing system. Absorption costing has only limited value for
management accounting purposes.

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 JUST-IN-TIME SYSTEMS(JIT)
• JIT is a modern manufacturing concept with
radical implications for the associated costing
systems.
• It is a method of providing production with the
inputs it requires as and when they are needed.
• A common misconception is that JIT is purely a
form of stock control, whereas it is in effect an
overall management philosophy covering all
aspects of the production process.

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• The first stage in implementing a JIT system involves the rearrangement
of the factory layout.

• In a traditional or functional plant layout similar machines are grouped

together, and the item being manufactured travels from department to
department as the various manufacturing processes occur to the item,
e.g. the item will go to the drilling department, then to the grinding
department, then to the turning department.

• In a JIT system dissimilar machines are arranged, often in a U shape,

around a JIT cell which manufactures the item. Each member of the cell
can operate all the machines and the aim is that the item is manufactured
without ever leaving the cell. The item does not go back to store or sit
around awaiting for the next process. JIT uses what is known as
cellular manufacturing.

• The aim of JIT is to produce the right part at the right time. This results in
the "pull" manufacturing system as opposed to traditional
manufacturing methods, which are called "push" manufacturing
systems because the items push their way from department to
department, often resulting in them waiting in queues for the next
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process.
 Aspects of JIT
ASPECT DETAIL
Quality This is not necessarily quality of the product to the final customer, but
rather quality in the following terms:
•Products should be standardized and easy to produce.
•Processes, e.g. plant layout and tool and machinery design, are of critical
importance.
•Suppliers should consist of a small number, each of whom provides
proven quality in terms of product and delivery deadlines.

Purchasing This is the most well known aspect whereby small numbers of items are
delivered when required, but much more frequently.
Production Final customer demand forms the basis of the determinants of output and
Control therefore materials used.
The speed of production should also be dictated by the needs of the
customer, i.e. how quickly the items are required.
In addition, set-up times do not add value and should therefore be
eliminated or reduced as much as possible.

Employee Employees are expected to be much more flexible in addition to

involvement experiencing greater levels of participation and responsibility. 38
 JIT Goals
Goal Explanation
Elimination of non JIT is dedicated to the elimination of waste, which is defined as anything that does not add value
value adding to a product. In manufacturing, the following activities occur before the item is sold (this is called
activities
the lead time):
•process time/inspection time/move time/queue time/storage time.
Of these five activities only process time adds value to the product.
Zero Inventory JIT as a pull manufacturing system, the idea is that items are only produced as they are required
and thus no large stocks of manufactured goods are accumulated.

Zero Defect JIT is based on "doing it right first time". In a conventional system it is assumed that some items
will become defective and some departments will suffer breakdowns. This results in the
maintenance of stocks of work-in-progress to provide work for departments at all times. It also
results in high stock levels which JIT does not sanction.

Batch sizes of one As JIT works to eliminate set-up time as it is a non-value-adding activity, batch sizes can be
reduced, thus preventing the development of bottlenecks, which occur when long production runs
are used.
Zero break down Zero breakdown is aimed for by planning for preventive maintenance to be carried out within the
cell; all members are trained not only to use but also to maintain their machines. Breakdowns can
thus be reduced significantly and repair carried out more quickly should a breakdown occur.

100% on Can be achieved if the previous aims are achieved

time delivery
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JIT The principles of JIT are applied equally to all outside purchases of components. Suppliers must
 Features of JIT
• Organization production in manufacturing
cells
• Hiring and retaining multi-skilled staff
• Emphasizing total quality management
• Reducing manufacturing lead time and set-up
time
• Building strong supplier relationships

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 Advantages and Disadvantages of JIT
Advantages
Work-in-progress and stock
levels are reduced,
representing cost savings of
working capital requirements.
Much smoother production
flow should lead to increased
productivity.
Improvements in quality
should result in less rework.
Because of shorter production
times, paperwork is reduced,
e.g. the amalgamation of the
Disadvantages
The JIT technique is tailored to situations of regular
demand, relatively unchanging processes and a large
percentage of common components. Thus, it is not
necessarily suitable for all types of production.
Problems can arise if attempts are made to implement JIT
in situations which do not match its requirements.
Implementation is over a very long time-scale and a
large degree of patience is required by those whose
responsibility it is
JIT involves a different cultural approach from that
traditionally to be found in Western manufacturing
industries –particularly in terms of consensus
decision-making.
JIT is considered weak in terms of medium-and long-
term planning.
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 TARGET COSTING
Target costing involves setting a target cost for a
product, having identified a target selling price and a
required profit margin.
The target cost is the target sales price minus the
required profit.
Target costing is concerned with designing a product and
its production process so that it can be made and sold at
a cost that delivers the required profit at the chosen
price. It focuses on getting the expected cost of a product
down to a target cost amount.
Achieving a target cost will usually require some
redesigning of the product and the removal of
unnecessary costs.
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 Implementing target costing
Step 1 Determine a product specification of which an adequate
sales volume is estimated.
Step 2 Decide a target selling price at which the organization will
be able to sell the product successfully and achieve a desired
market share.
Step 3 Estimate the required profit, based on required profit
margin or return on investment.
Step 4 Calculate: Target cost = Target selling price – Target profit.
Step 5 Prepare an estimated cost for the product, based on the
initial design specification and current cost levels.
Step 6 Calculate: Target cost gap = Estimated cost – Target cost.
Step 7 Make efforts to close the gap. This is more likely to be
successful if efforts are made to 'design out' costs prior to
production, rather than to 'control out' costs after ‘live’
production has started.

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 Example
A car manufacturer wants to calculate a target
cost for a new car, the price of which will be
set at K17,950.
The company requires an 8% profit margin on
sales.
Required
What is the target cost?

44
Great Games, a manufacturer of computer games, is in the process of introducing a
new game to the market and has undertaken market research to find out about
customers’ views on the value of the product and also to obtain a comparison with
competitors’ products. The results of this research have been used to establish a
target selling price of K60. This is the price that the company thinks it will have to
sell the product to achieve the required sales volume.
Cost estimates have been prepared based on the proposed product specification.
Manufacturing cost K
Direct material 3.21
Direct labour 24.03
Direct machinery costs 1.12
Ordering and receiving 0.23
Quality assurance 4.60
Non-manufacturing costs
Marketing 8.15
Distribution 3.25
After-sales service 1.30
The target profit margin for the game is 30% of the target selling price.
Required
Calculate the target cost of the new game and the target cost gap.

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 Example
• Projected lifetime sales volume 300 000 units
• Target selling price of the product K800
• Target profit margin (30% of selling price)
• Projected cost £700

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 Closing the target cost gap
The target cost gap is the estimated cost less the target cost.
When a product is first manufactured, its currently-attainable
cost may be higher than the target cost. Management can then
set benchmarks for improvement towards the target cost, by
improving production technologies and processes. Various
techniques can be employed.
Reducing the number of components
 Using cheaper staff
Using standard components wherever possible
Acquiring new, more efficient technology
Training staff in more efficient techniques
Cutting out non-value-added activities
Using different materials
47
 Target costing in service industries
Unlike manufacturing companies, services are
characterized by intangibility, inseparability,
variability, perishability and no transfer of ownership.
Some of the characteristics of services make it difficult
to use target costing, and identify a target cost for a
service having established a target selling price.
Intangibility. Some of the features of a service cannot
be properly specified because they are intangible.
When services do not have any material content, it is
not possible to reduce costs to a target level by
reducing material costs
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• Variability/homogeneity. A service can differ
every time it is provided, and a standard
service may not exist. When services are
variable, it is possible to calculate an
estimated average cost, but this is not specific
and so not ideal for target costing.

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 BACK FLUSH COSTING
• Back flush accounting is a costing short cut.
• It relies on a business having immaterial amounts
of work‑in-progress and is therefore particularly
suitable for businesses operating just-in-time
inventory management.
• If the amount of work‑in‑progress is negligible,
what is the point in meticulously valuing it?
• Fretting that some products might be 25%
complete and others 60% complete, and then
adding carefully calculated labour and overheads
to these (immaterial) items, is a complete waste
of time and effort.
50
In back flush accounting, costs are not associated
with units until they are completed or sold.
Back flush accounting is sometimes called delayed
costing, which is a helpful name, as costs are not
allocated to production until after events have
occurred.
Standard costs are then used to work backwards to
flush out manufacturing costs into production,
splitting them between stocks of finished goods (if
any) and cost of sales.
No costs, whether material or conversion costs, are
allocated to work-in-progress. 51
 Variants of back flush accounting
• There are two variants of back flush
accounting and they differ according to what
are called ‘trigger points’. Trigger points are
the events which cause costs to be moved
into inventories.

52
Variant 1
This is the less radical variant. There are two inventory
accounts, raw materials and finished goods, and there are two
trigger points:

1 Purchase of raw materials

Dr Materials account
Cr Creditors
The cost of labour and other manufacturing expenses are
debited to a conversion cost account and credited to cash or
creditors. The conversion cost account can be thought of as a
suspense
account where amounts are placed temporarily.

2 On completion of units
Dr Finished goods account with the standard cost of goods
produced
Cr Materials account with the standard cost of materials
Cr Conversion cost account with the standard cost of
conversion. 53
Variant 2
This is more radical because no records are kept of work-in-
progress raw materials, so if this method is to be used,
stocks of both raw materials and work-in-progress must be
negligible. It has only one
trigger point.

As before, the cost of labour and other manufacturing

expenses are initially debited to a conversion cost account
and credited to cash
or creditors.

Entries into the finished goods inventory account are made

only when goods are completed, and the journal entries will
be:

Dr Finished goods account with the standard cost of goods

produced
Cr Creditors with the standard cost of material used in goods
54
 Back flush and variances
• Note that at some point the creditors account
will have to record correctly what is owing to
them so, from time to time, this will be adjusted
by a cost variance. Thus, if the standard cost of
raw materials used was $50,000, but the actual
cost of materials was $52,000, an adverse
variance of $2,000 has to be recognized and the
creditors account would have two entries Cr
$50,000 (and Dr $50,000 to finished goods),
then Cr $2,000 and (Dr $2,000 to profit and loss
account).
55
So, are there any benefits in adopting backflush accounting other than
avoiding complex recording and calculations to value immaterial amounts of
inventory?
Let’s consider the trigger point found in both variants: costs are transferred
when goods are completed.
What would happen if that trigger point were changed to permit cost transfer
only when goods were sold?
That would mean conversion costs would remain as costs until goods were
sold, rather then being transformed into finished stock when goods were
completed.
Managers would then have no incentive to make goods unless they were
going to be sold imminently, otherwise they would simply
be incurring more expense, and that would make their performance look bad.
The purpose of a manufacturing business is not to make goods; its purpose
is to make and sell goods. Only then is there throughput, and backflush
accounting can be set up so that costing records encourage managers
to adopt this goal-orientated behaviour. 56
Illustration
Purchase of raw materials £1 515 000
Conversion costs £1 010 000
Finished goods manufactured 100 000 units
Sales for the period 98 000 units
No opening stocks
Standard unit cost is £25 (£15 materials and
£10 conversion cost)
Zero material variances
57
 LIFE CYCLE COSTING
• Life cycle costing estimates the costs and
revenues attributable to a product over its
entire expected life cycle.
• The life cycle costs of a product are all the
costs attributable to the product over its
entire life, from product concept and design
to eventual withdrawal from the market.

58
Traditional management accounting procedures have
focused primarily on the manufacturing stage of a
product’s life cycle.
 LCC focuses on costs over the product’s entire life
cycle to determine whether profits earned during the
manufacturing phase will cover the costs incurred
during the pre- and post-manufacturing stages.
 A large proportion of a product’s costs can be
committed or ‘locked in’ during the planning and
design stage.
Cost management can be most effectively exercised
during the planning and design stage.
59
The ‘classical’ life cycle of a product has five phases or
stages.
(a) Development. The product has a research or design and
development stage. Costs are incurred but the product is not yet on
the market and there are no sales revenues.
(b) Introduction. The product is introduced to the market. Potential
customers are initially unaware of the product or service, and the
organization may have to spend heavily on advertising to bring the
product or service to the attention of the market. In addition, capital
expenditure costs may be incurred in order to increase the
production capacity as sales demand grows.
(c) Growth. The product gains a bigger market as demand builds up.
Sales revenues increase and the product begins to make a profit.
(d) Maturity. Eventually, the growth in demand for the product will
slow down and it will enter a period of relative maturity, when sales
have reached a peak and are fairly stable. This should be the most
profitable phase of the product’s life. The product may be modified or
improved, as a means of sustaining its demand and making this
phase of the life cycle as long as possible.
(e) Decline. At some stage, the market will have bought enough of
the product and it will therefore reach 'saturation point'. Demand will
start to fall. Eventually it will become a loss-maker and this is the 60
 Life cycle costs
The component elements of a product's cost over its life cycle could therefore include the
following.
1.Research & development costs
 Design costs
 Cost of making a prototype
 Testing costs
 Production process and equipment: development and investment
•The cost of purchasing any technical data required (for example purchasing the right
from another organization to use a patent)
• Training costs (including initial operator training and skills updating)
•Production costs, when the product is eventually launched in the market
• Distribution costs. Transportation and handling costs
•Marketing and advertising costs
1. Customer service
2. Field maintenance
3. Brand promotion
4. Inventory costs (holding spare parts, warehousing and so on)
5. Retirement and disposal costs. Costs occurring at the end of a product's life. These
may include the costs of cleaning up a contaminated site. 61
 Life cycle costing vs traditional costing systems
• Traditional cost accumulation systems are based
on the financial accounting year and tend to dissect
a product's life cycle into a series of 12-month
periods.
• This means that traditional management accounting
systems do not accumulate costs over a product's
entire life cycle and do not therefore assess a
product's profitability over its entire life. Instead
they do it on a periodic basis.
• Life cycle costing, on the other hand, tracks and
accumulates actual costs and revenues attributable
to each product over the entire product life cycle.
Hence the total profitability of any given product
can be determined.
62
 Benefits of life cycle costing
1. It helps management to assess profitability over the full life of a
product, which in turn helps management to decide whether to
develop the product, or to continue making the product.
2. It can be very useful for organizations that continually develop
products with a relatively short life, where it may be possible
to estimate sales volumes and prices with reasonable
accuracy.
3. The life cycle concept results in earlier actions to generate
more revenue or to lower costs than otherwise might be
considered.
4. Better decisions should follow from a more accurate and
realistic assessment of revenues and costs, at least within a
particular life cycle stage.
5. It encourages longer-term thinking and forward planning, and
may provide more useful information than traditional reports
of historical costs and profits in each accounting period.

63
 Maximizing return over the product life cycle
Design costs out of products
Between 70% to 90% of a product's life cycle costs are determined by decisions
made early in the life cycle, at the design or development stage. Careful design of the
product and manufacturing and other processes will keep cost to a minimum over the
life cycle.

Minimize the time to market

‘Time to market’ is the time from the conception of the product to its introduction
to the market.
Competitors watch each other very carefully to determine what types of product
their rivals are developing. If an organization is launching a new product it is vital to
get it to the market place as soon as possible. This will give the product as long a
period as possible without a rival in the market place, and should mean increased
market share in the long run. Furthermore, the life span of a product may be affected
by delay in its the market introduction. It is not unusual for the product's overall
profitability to fall by 25% if the launch is delayed by six months. This means that it is
usually worthwhile incurring extra costs to keep the launch on schedule or to speed
up the launch.
64
Minimize breakeven time (BET)
A short BET is very important in keeping an organization liquid. The sooner
the product is launched the quicker the research and development costs will
be repaid, providing the organization with funds to develop further products.
In life cycle costing, break even occurs when revenue from the product has
covered all the costs incurred to date including design and development
costs.

Maximize the length of the life span

Product life cycles are not predetermined; they can be influenced by the
actions of management and competitors. For example some products lend
themselves to a number of different uses; this is especially true of materials,
such as plastic, PVC, nylon and other synthetic materials. The life cycle of
these materials can be extended by finding new uses for them. The life cycle
of the material is then a series of individual product curves nesting on top of
each other.

65
 Service and project life cycles
• Services have life cycles. The only difference with the
life cycle of a product is that the R & D stages will not
usually exist in the same way.
• The different processes that go to form the complete
service are important, however, and consideration
should be given in advance as to how to carry them
out and arrange them so as to minimize cost.
• Products that take years to produce or come to fruition
are usually called projects, and discounted cash flow
calculations are invariably used to cost them over their
life cycle in advance.
• The projects need to be monitored very carefully over
their life to make sure that they remain on schedule
and that cost overruns are not being incurred.
66
 Customer life cycles
 Customers also have life cycles, and an organisation will wish to maximise the
return from a customer over their life cycle. The aim is to extend the life cycle
of a particular customer or decrease the 'churn‘ rate, as the Americans say.
 This means encouraging customer loyalty. For example, some supermarkets
and other retail outlets issue loyalty cards that offer discounts to loyal
customers who return to the shop and spend a certain amount with the
organisation.
 As existing customers tend to be more profitable than new ones they should
be retained wherever possible.
 Customers become more profitable over their life cycle. The profit can go on
increasing for a period of between approximately four and 20 years. For
example, if you open a bank account, take out insurance or invest in a pension,
the company involved has to set up the account, run checks and so on. The
initial cost is high and the company will be keen to retain your business so that
it can recoup this cost. Once customers get used to their supplier they tend to
use them more frequently, and so there is a double benefit in holding on to
customers.
67
Solaris specialises in the manufacture of solar panels. It is
planning to introduce a new slimline solar panel
specially designed for small houses. Development of the new
panel is to begin shortly and Solaris is in the
process of determining the price of the panel. It expects the new
product to have the following costs.
Year 1 Year 2 Year 3 Year 4
Units manufactured and sold 2,000 15,000 20,000 5,000
$ $ $ $
R&D costs 1,900,000 100,000 - -
Marketing costs 100,000 75,000 50,000
10,000
Production cost per unit 500 450 400 450
Customer service costs per unit 50 40 40 40
Disposal of specialist equipment 300,000

The Marketing Director believes that customers will be prepared to pay

$500 for a solar panel but the
Financial Director believes this will not cover all of the costs throughout the
lifecycle.
Required
Calculate the cost per unit looking at the whole life cycle and comment on 68
 THROUGHPUT ACCOUNTING
Throughput accounting and back flush accounting have
been developed in response to relatively modern
advances in manufacturing:
•The increased reliance by manufacturing businesses on
sophisticated and expensive facilities and machinery. This
greatly increases the proportion of costs which are fixed.
(This was one reason why activity-based costing has
become more important: if fixed costs are more
significant they should be dealt with more accurately.)
•A recognition that holding inventory is likely to be a
waste of resources.
•The increased use of just-in-time manufacturing, so that
inventory (particularly work-in-progress) is much reduced
and its valuation is therefore less important.

69
• Throughput accounting has a very direct
relationship with decision making and
performance management.
• It begins by focusing on what an organization’s
purpose is – its goal – and seeks to help
organizations attain their purpose by increasing
their ‘goal units’( those units that help to attain
the goal.
• The approach can be applied to both profit-
seeking and not-for-profit organizations,
provided meaningful goal units can be identified.
70
 Example
Take a not-for-profit organization which
performs a medical screening service in three
sequential stages:
1.Take an X-ray.
2.Interpret the result.
3.Recall patients who need further
investigation/tell others that all is fine.

71
• The ‘goal unit’ of this organization will be to
progress a person through all three stages.
• The number of people who complete all the
stages is the organization’s throughput, and
the organization should seek to maximize its
throughput.
• However, there will always be a limit to
throughput, and the resource which sets that
limit is called the ‘bottleneck resource’.
• Adding more detail to the medical screening
process above:
72
 Process Total hors
time/patient(hours) available/week

Take an X-ray 0.25 40 0.25 40

Interpret the result 0.1 20

Recall patients who need further

investigation/tell others that all is fine 0.2 30

73
• You can easily see from this table that the
maximum number of patients (goal units) who
can be dealt with in each process is:
–X-rays: 40/0.25 = 160
–Interpret results: 20/0.10 = 200
–Recall etc: 30/0.20 = 150

74
• So, the recall procedure is the bottleneck resource.
• Throughput, and thereby the organization’s
performance, cannot be improved until that part of the
process can deal with more people. Therefore, to
improve throughput:
1. Ensure there is no idle time in the bottleneck
resource, as that will be detrimental to overall
performance (idle time in a non‑bottleneck
resource is not detrimental to overall
performance).
2. See if less time could be spent on the bottleneck
activity.
3. Finally, increase the bottleneck resource available.
75
• The traditional approach to decision making in
a profit-seeking organization is to use
contribution analysis.
• The contribution per unit is the difference
between the selling price of a unit and the
marginal cost of a unit, where marginal cost
consists of the material, variable labour and
variable overhead per unit.

76
• The contribution approach is not wrong in
principle, but the assumptions it makes about
cost behaviour often do not accurately reflect
the reality of a modern manufacturing business.
In particular, the notion that there are
significant variable labour and overhead costs is
suspect.
• Many of these businesses rely on sophisticated
automated systems that run continuously with
relatively little manual involvement.

77
• Even when production is slack, provided the
downturn is expected to be short lived, most
employees will still be paid because it is
expensive to dismiss workers and then to
rehire and retrain them.
• For short-term fluctuations in production it
would be more accurate to consider labour
costs and all overheads to be fixed, leaving
material as the only truly variable cost.

78
• If all costs except material are fixed,
businesses will become richer provided the
sales revenue per unit exceeds material price
per unit.
• In effect, sales price less material price is the
new contribution per unit, but to make clear
what we are talking about this is not called
‘contribution’: it is called ‘throughput’.
• In fact, ‘throughput’ is sometimes usefully
known as ‘throughput contribution’:
79
Throughput = selling price – material
per unit per unit per unit

Throughput = sales revenue – cost of

materials

80
 EXAMPLE-use the following information to do some throughput calculations

PRODUCTS A B C

Expected demand/budgeted output

(units) 8,000.00 10,000.00 6,000.00
Selling price per unit (K) 130 100 135
Material cost per unit 33 20 40
Labour cost per unit 30 24 36
Variable overhead cost per unit 25 20 30
Fixed overhead cost per unit 15 12 18
       
Machine hours/unit 0.25 0.2 0.3
Labour hours per unit 0.25 0.2 0.3
Quality control time per unit 0.1 0.1 0.1
81
 Identifying the bottleneck process
 

Needed for full production Available

Machine hours 0.25 x 8,000 + 0.2 x 10,000 + 0.3 x 6,000 = 5,800 5000

Labour hours 0.25 x 8,000 + 0.2 x 10,000 + 0.3 x 6,000 = 5,800 6000

Quality control hours 0.10 x 8,000 + 0.1 x 10,000 + 0.1 x 6,000 =

2,400 2500

82
Calculating throughput( Selling price less Material cost

Selling Material Throughput/u

Product Price(K) cost(K) nit(K)

A 130 33 97
B 100 20 80
C 135 40 95

83
We can’t simply conclude from this that Product A must
be best because it earns more per unit than the other
products.
It is essential to take into account the use that each
product makes of the bottleneck resource. Here, machine
hours have been identified as the bottleneck resource.
These are uniquely precious and must be used up in the
best possible way. This can be done by calculating for
each unit:
Throughput
Time in bottleneck resource
and then using the answers to rank the products. See
next slide 84
 Calculating throughput per unit of the bottleneck resource i.e.
throughput per machine hour

Throughput/ Machine Throughput/

Product unit hrs/unit machine hr Rank

A 97 0.25 388 2

B 80 0.2 400 1

C 95 0.3 317 3
85
• This shows that priority should be given to
making Product B, the highest earner per
machine hour, then to Product A, and finally
to Product C.

86
 Calculation of Profit
machine machine(bottleneck)
Product units hrs/unit hours used throughput  throughput

B 10,000 0.2 200010000 x 80=800000 800,000.00

A 8,000 0.25 20008000 x 97=776000 776,000.00
C(balance) 3,333 0.31000(balance) 3333 x 95=316635 316,635.00
 TOTAL THROUGHPUT
    1,892,635.00

Maximum
machine hours
available     5000   
 

Total expected non-material costs-Factory costs (from the original  

budget) =
 
 
Product A: 8,000 x (30 + 25 + 15) = 560,000
 
Product B: 10,000 x (24 + 20 + 12) = 560,000

Product C: 6,000 x (36 + 30 + 18) = 504,000

Total factory costs-factory expenses 1,624,000 87
 Throughput Accounting Ratio(TAR)
The throughput accounting ratio (TA ratio) is the
ratio of the throughput per unit of bottleneck
resource to the factory cost per unit of bottleneck
resource. The factory cost is usually the total factory
cost. This ratio should be as high as possible, and
certainly more than 1
The TAR should be calculated for each product. The
products should then be ranked in order of TAR.
Start producing the product with the highest TAR.
For our example the TAR has been calculated in the
next slide
88
 Note: factory cost is uniform for all the products and is as calculated in slide
87( K1,624,000.00). Machine hrs are 5000hrs)

Throughput
  accounting ratios    

  Product A Product B Product C

Return/factory
hour 388 400 317
Costs/factory
hour 324.8 324.8 324.8

Throughput
accounting ratio 1.17 1.21 0.93
89
The TAR tells us nothing that we have not worked out
already. Its interpretation is:
The higher the better (but we already knew the ranking of
the products from the return/ factory hour)
The TAR should be greater than 1 if a product is
worthwhile (earning rate greater than spending rate).
Organizations should focus on how they can increase their
TAR. Obvious routes are to increase selling prices,
decrease material costs, or decrease factory costs.
Provided a TAR is greater than 1 it will be worth trying to
increase throughput, and this must be done by eliminating
idle time in the bottleneck resource, increasing the
bottleneck resource (until another resource becomes the
bottleneck), or decreasing the use the product makes of
the bottleneck resource
90
 PROCESS COSTING
Process costing is a costing method used where it is not
possible to identify separate units of production, or jobs,
usually because of the continuous nature of the
production processes involved.
Job costing assigns costs to each individual unit of output
because each unit consumes different quantities of
resources.
Process costing however does not assign costs to each
unit of output because each unit is identical. Instead,
average unit costs are computed.
Examples of industries using process costing include: oil
refining, soap making, paper making, food and drinks
91
 Process costs
Process costs are two fold:
Material costs-relate to the units of materials
coming into a process. If we are in say process 2
then the total material cost will consist of
material cost transferred from the previous
process and the material costs of materials
added in the current process.
Conversion costs-these are costs of Labour
and Overheads. Treatment is similar to material
costs when in process 2.

92
 Features of process costing
The output of one process becomes the input to the next
until the finished product is made in the final process.
There is often a loss in process due to spoilage, wastage,
evaporation and so on.
An expected loss is called a normal loss. If the actual loss
exceeds expectation then the extra loss is called abnormal
loss. Sometimes the actual loss will be less than the
expected loss in which case the difference is called
abnormal gain.
Assuming an expected loss of 10% of process input
compute (a) normal loss (b) abnormal loss ( abnormal gain)
in each of the following circumstances.

93
 Example-Process Losses and gains
Example 1: Assume we are in process 2
– Transfers from process 1(units-materials)=1500
units
– Materials added in process 2= 500 units
– Output to process 3 scenario (i)=1600 units
– Output to process 3 scenario(ii)=1850 units

94
 Dealing with process losses
• The units of normal loss and abnormal loss
may be sold at a scrap value
• Units of abnormal gain however represent lost
sales of scrap since the actual loss is less than
the expected loss.
• Normal loss scrap value is used to reduce
material process costs.
• Abnormal loss scrap value is used to reduce
the cost of abnormal loss in the abnormal loss
account.

95
 Calculating cost per unit
The process cost per unit is calculated as follows:
Total process costs(material cost + conversion costs
Expected output from the process
The expected output from a process is simply:
Input less normal loss
If in a process we have (a) normal loss (b) abnormal
loss ( c) work in progress and (d) fully completed
units, then the expected output is simply:
Fully completed units + Work in progress +
Abnormal loss
96
 Framework for dealing with process costing
Step 1 Determine output and losses. This step involves the following.
Determining expected output
Calculating normal loss and abnormal loss and gain
Calculating equivalent units if there is closing or opening work in
progress( statement of equivalent units)
Step 2 Calculate cost per unit of output, losses and WIP. This step involves
calculating cost per unit or cost per equivalent unit.
Step 3 Calculate total cost of output, losses and WIP. In some examples
this will be straightforward; however in cases where there is closing and/or
opening work-in-progress a statement of evaluation will have to be
prepared.
Step 4 Complete accounts. This step involves the following.
Completing the process account
Writing up the other accounts required by the question

97
 Example
• JJ has a factory which operates two production
processes, cutting and pasting.
• Normal loss in each process is 10%. Scrapped units
out of the cutting process sell for K3 per unit
whereas scrapped units out of the pasting process
sell for K5.
• Output from the cutting process is transferred to the
pasting process: output from the pasting process is
finished output ready for sale.
• Relevant information about costs for control period 7
are as follows:

98
 Example cont’d
  Cutting process Pasting process

  units MK units MK

Input materials 18,000 54,000.00    

Transferred to pasting process 16,000      

Materials from cutting process     16,000  

Added materials     14,000 70,000.00

Labour and overheads   32,400.00   135,000.00

Output to finished goods     28,000   99

 Example cont’d
Required
Prepare accounts for the cutting process, the
pasting process, abnormal loss, abnormal gain
and scrap.

100
 Valuation of closing work in progress
The continuous nature of production in many
processes means that there will usually be
closing work in progress which must be
valued.
When units are partly completed at the end of
a period (and hence there is closing work in
progress), it is necessary to calculate the
equivalent units of production in order to
determine the cost of a completed unit.

101
 Cont’d
How do we value the finished goods and closing work in
process?
With any form of process costing involving closing WIP,
we have to apportion costs between output and closing
WIP.
To apportion costs 'fairly' we make use of the concept of
equivalent units of production.
Equivalent units are notional whole units which
represent incomplete work, and which are used to
apportion costs between work in process and completed
output
Note that normal loss units are not valued hence they
have a zero equivalent unit
102
 Different rates of input
• In many industries, materials, labour and overhead may be added at
different rates during the course of production.
– Output from a previous process (for example the output from process
1 to process 2) may be introduced into the subsequent process all at
once, so that closing inventory is 100% complete in respect of these
materials.
– Further materials may be added gradually during the process, so that
closing inventory is only partially complete in respect of these added
materials.
– Labour and overhead may be 'added' at yet another different rate.
When production overhead is absorbed on a labour hour basis,
however, we should expect the degree of completion on overhead to
be the same as the degree of completion on labour.
• When this situation occurs, equivalent units, and a cost per equivalent
unit, should be calculated separately for each type of material, and also
for conversion costs.

103
 Example-valuation of closing WIP
Suppose that Columbine Co is a manufacturer of processed goods, and that results in
process 2 for April
20X3 were as follows.
Opening inventory NIL NIL
Material input from process 1 4000 units
Costs of input:
Normal loss is 2.5% of input K
Material from process 1 5850
Added materials in process 2 1050
Conversion costs 1670

Output of 3000 units is transferred into the next process, process 3.

Closing work in process amounted to 800 units, complete as to:
Process 1 material 100%
Added materials 50%
Conversion costs 30%
Required
Prepare the account for process 2 for April 20X3. 104
 Exercise-valuing closing WIP
During January the following costs were incurred in a
process:  
Materials (1,000 units) K5000
Labour K2760
Overheads K3440
During the month, 800 units were finished and transferred to
the next process.  
The remaining 200 units were WIP and were complete as
follows:  
Materials 100%
Labour 60%
Overheads 30%
(a) calculate the cost per unit;  
(b) value the finished output and the WIP;  
(c) prepare Process Account.  
105
 Valuing opening work in progress
• When there is opening W-I-P,
there are two alternative
approaches to the costings.
–First-in-first-out (FIFO)
–Weighted Average

106
 Valuing Opening WIP-FIFO method
• The FIFO method of valuation deals with
production on a first in, first out basis.
• The assumption is that the first units completed
in any period are the units of opening inventory
that were held at the beginning of the period.
• Under this approach it is assumed that the
opening W-I-P is the first to be finished. All the
costs brought forward for the W-I-P are treated
as costs of these specific units, and the current
period’s expenditure is allocated over the work
done in the current period.

107
 Valuing opening WIP using FIFO example
The following information relates to process 3 of a three-stage production process for the month of
January 20X4.
Opening inventory
300 units complete as to: K

materials from process 2 100% 4,400.00

added materials 90% 1,150.00

labour 80% 540.00
production overhead 80% 810.00
6,900.00

In January 20X4, a further 1,800 units were transferred from process 2 at a valuation of K27,000. Added
materials amounted to K6,600 and direct labour to K3,270. Production overhead is absorbed at the rate
of

150% of direct labour cost. Closing inventory at 31 January 20X4 amounted to 450 units, complete as to:
process 2 materials 100%
added materials 60%
labour and overhead 50%
108
Required
 Framework for dealing with FIFO
• The statement of equivalent units would be as
follows:
– Opening WIP
– Fully worked units
– Output to finished goods
– Closing inventory
• Note that the fully worked units (work started
and completed in the current period) is
calculated as follows: Units transferred from
previous process less closing WIP.
109
 Valuing opening WIP-weighted average cost method
An alternative to FIFO is the weighted average cost
method of inventory valuation which calculates a
weighted average cost of units produced from both
opening inventory and units introduced in the current
period.
By this method no distinction is made between units
of opening inventory and new units introduced to the
process during the accounting period. The cost of
opening inventory is added to costs incurred during the
period, and completed units of opening inventory are
each given a value of one full equivalent unit of
production.

110
 Example-valuing opening WIP using weighted cost method
Magpie produces an item which is manufactured in two consecutive processes. Information relating to
process 2 during September 20X3 is as follows.
Opening inventory 800 units 800 units
Degree of completion: K
process 1 materials 100% 4,700.00
added materials 40% 600.00
conversion costs 30% 1,000.00
6,300.00

During September 20X3, 3,000 units were transferred from process 1 at a valuation of $18,100. Added

materials cost K9,600 and conversion costs were K11,800.

Closing inventory at 30 September 20X3 amounted to 1,000 units which were 100% complete with

respect to process 1 materials and 60% complete with respect to added materials. Conversion cost work
was 40% complete.
Magpie uses a weighted average cost system for the valuation of output and closing
inventory.
Required 111
 Example FIFO and AVCO
Summarized below are data for two production processes in a factory for the month just
ended.
Process 1
Materials K6335. Conversion cost K7,677.00. 5% of inputs are expected to be rejected. 190
units failed inspection and were rejected. After inspection, units are immediately
transferred to the next process.
Process 2
Opening work in progress, 500 units: K3576(materials K3042; labour and overheads K534.
Completed output from process 1: 4110 units
Additional materials K11,672
Labour and overheads K9485
Closing work in progress 400 units
There are no losses in process. Work in process is 100% complete as to material and both
opening and closing work in progress were 50% complete as to labour and overhead.
Prepare process 1 account
Prepare process 2 account using both the FIFO method and the weighted average method.

112
 Exercise
The following information relates to process 2 of a three-stage production process for the month of
January 20X4:

Opening inventory 100 kilograms complete as to:

K
Direct materials 100% 235.00
Conversion costs 60% 520.00
 
In January 20X4, 3500kgs were introduced in the process at a valuation of K8405.00. Conversion
costs in the period amounted to K6,200.00
Closing inventory at 31 January 20X4 amounted to 500 kilograms complete as to:

Direct materials 100%

Conversion costs 20%  
Required
Prepare process 2 account valuing opening work in progress using FIFO method
Prepare process 2 account valuing opening work in progress using the Weighted average cost
method

113
 Joint products and by-products
• Joint products are two or more products which
are output from the same processing
operation, but which are indistinguishable from
each other up to their point of separation.
• A by-product is a supplementary or secondary
product (arising as the result of a process)
whose value is small relative to that of the
principal product.

114
 Cont’d
Joint products have a substantial sales value.
Often they require further processing before
they are ready for sale. Joint products arise, for
example, in the oil refining industry where
diesel fuel, petrol, paraffin and lubricants are all
produced from the same process.
The distinguishing feature of a by-product is its
relatively low sales value in comparison to the
main product. In the timber industry, for
example, by-products include sawdust, small
offcuts and bark.
115
 Cont’d
What exactly separates a joint product from a by-
product?
– A joint product is regarded as an important
saleable item, and so it should be separately
costed. The profitability of each joint product
should be assessed in the cost accounts.
– A by-product is not important as a saleable item,
and whatever revenue it earns is a 'bonus' for the
organisation. Because of their relative
insignificance, by-products are not separately
costed.

116
 Problems in accounting for joint products
The point at which joint products and by-products
become separately identifiable is known as the split-
off point or separation point. Costs incurred up to this
point are called common costs or joint costs.
The problems are two fold:
How common costs should be apportioned
between products, in order to put a value to closing
inventories and to the cost of sale (and profit) for
each product.
 Whether it is more profitable to sell a joint
product at one stage of processing, or to process
the product further and sell it at a later stage.

117
 Dealing with common costs
• The main methods of apportioning joint costs,
each of which can produce significantly
different results are as follows.
– Physical measurement
– Relative sales value apportionment method; sales
value at split-off point

118
 Limitations of physical measurement

• Where the products separate during the

processes into different states, for example
where one product is a gas and another is a
liquid, this method is unsuitable.
• This method does not take into account the
relative income-earning potentials of the
individual products, with the result that one
product might appear very profitable and
another appear to be incurring losses.
119
 PERFORMANCE MANAGEMENT
• Why measure performance
• Responsibility and Controllability
• Benchmarking
• Financial and non-financial performance measures
• Short-termism and Manipulation
• Improving Performance
• Balanced scorecard
• Building blocks model by Fitzgerald and Moon
• Divisional performance assessment using Residual
Income and Return on Investment
• Transfer Pricing
120
 Reasons for measuring performance
inform individuals whether the planning
targets or standards (for which they are
responsible) are being met
inform senior managers about the
performance of each of their subordinates,
as well as their own performance
indicate the risk that targets will not be
met, so that action to correct the situation
can be considered
121
 Cont’d
• indicate poor performance, so that individuals
and their managers can take whatever
corrective action seems appropriate
• reward the successful achievement of targets or
standards, for example by means of cash
bonuses or other incentives.
A business entity must have management
information systems that are capable of providing
reliable and relevant information about all the
important aspects of performance.
122
 Responsibility and controllability
These are the two essential features of a
performance reporting system
Responsibility. Performance reports should be
provided to the individuals (and their managers) who
are actually responsible for the performance.
Controllability. Performance reports should distinguish
between aspects of performance that should be
controllable by the individual who is made responsible
and accountable. There is no sensible purpose in
judging the performance of an individual by looking at
factors that are outside the individual’s control.
123
 Long-term, medium-term and short-term performance

Performance measurement should cover the long-term,

medium-term and short-term.
Long-term performance
Long-term performance measures should be linked to the
long-term objectives and the strategies of the
organization. The most significant long-term objectives are
called critical success factors or CSFs. In order to achieve
its long-term and strategic objectives, the critical success
factors must be achieved.
For each critical success factor, there should be a way of
measuring performance, in order to check whether the
CSF targets are being met. Performance measurements
for CSFs might are called key performance indicators
(KPIs) or possibly key risk indicators (KRIs).
124
 Cont’d
Medium-term performance
• Medium-term performance measurement is
associated with the annual budget, and
meeting budget targets.
• Targets, whether financial or non-financial,
can be set for a planning period such as the
financial year, and actual results should be
compared against the planning targets.

125
 Cont’d
Short-term performance
• Short-term performance should be monitored
by means of operational performance
measures. E.g.
• Quality might be measured by the percentage
of rejected units in production, or the rate of
customer returns or customer complaints.
• Speed might be measured by the average time
required to meet a customer order.

126
 Benchmarking
It may be useful to be aware of benchmarking as a
method of assessing performance.
Benchmarking involves comparing performance with
the performance of another, similar organization or
operation. In other words, another organization or
department is used as a ‘benchmark for comparison’.
Performance can be assessed in terms of whether it
has been better or worse than the selected
benchmark. By making such comparisons, it should be
possible to identify strengths and weaknesses in
performance.
127
 Types of benchmarking
Type of Explanation
benchmarking

Internal An entity may have many similar operations, such as regional or area
benchmarking branches. For example, a bank may have a network of branches, and a
retail company may have a network of retail stores. The best-
performing branches or departments can be used as a benchmark, and
the performance of other branches compared against it.

Competitive This involves comparing the performance of the organization against

benchmarking the performance of its most successful competitors. In this way, the
areas of performance where the competitor is better can be identified,
and measures can then be planned for reducing the gap in
performance. How?

Operational A company might use benchmarking to assess the performance of a

benchmarking particular aspect of its operations, such as customer order handling,
handling e-commerce orders from the Internet, or warehousing and
despatch operations. It might be able to identify a company in a
completely different industry that carries out similar operations 128
 Financial and non-financial performance
measures
• Performance measures can be:
– financial performance measures or
– non-financial performance measures
• Performance measurement is a vital part of the
planning and control process.
• Traditionally, performance reporting by
management accountants was restricted to
financial performance measures, or ‘financial
performance indicators’ (FPIs).

129
 Cont’d
• However, the performance of a business in both the short term
and the longer term depends on factors other than financial
results.
• Profits are earned by delivering products or services to
customers that customers want to buy, and by operating in an
efficient and effective manner.
• Non-financial aspects of performance are the main reason why
a business is financially successful (or performs badly in
financial terms) and profits follow on from ‘getting the business
right’.
• It is therefore recognized that non-financial aspects of
performance are important and that these should also be
measured and monitored (using non-financial performance
indicators or NFPIs).
130
 Financial and non-financial performance measures
Type of measure
Financial performance measures
Non-financial performance
measures
Examples
Financial measures are typically measures relating to
revenues, costs, profits, return on capital, asset values
or cash flows.
Actual performance is often measured against a
financial plan, such as a budget.
Non-financial measures may relate to a number of
different aspects of performance, such as:
• Product or service quality
•Reliability
•Speed of performance
•Risk
•Flexibility
•Customer attitudes
•Innovation
•Capability
•Pollution 131
 Financial performance indicators
• Financial performance indicators analyse return on
capital, profitability, liquidity and financial risk, often
in relation to a plan or budget, or in relation to
performance in preceding time periods.
• Financial indicators (or monetary measures) include:
– Profit (both gross profit and net profit)
– Revenue
– Costs
– Cash flows
– Debt and gearing

132
 Cont’d
• The two most common ways of using financial
measures to assess performance are:
– Comparing actual results with the budget or
another financial plan
– Comparing performance in the most recent time
period with performance in a corresponding
previous time period (or analysing a trend over
time)

133
 Cont’d
• Financial measures may be presented as ratios, such as gross
profit margin (gross profit/sales), and return on capital employed
(net profit/capital employed).
• Monetary amounts have meaning only only in relation to
something else. Financial results should be compared against a
benchmark such as:
– Budgeted sales, costs and profits
– Standards in a standard costing system
– The trend over time (last year/this year, say)
– The results of other parts of the business
– The results of other businesses
– Future potential (for example the performance of a new
business may be judged in terms of nearness to breaking
even).
134
 Cont’d
Type of Ratio Examples
Profitability •% annual growth in sales
•Gross profit margin
•Net profit margin
•Cost/sales ratio
•Return on capital employed
•Earnings per share(EPS)
Liquidity and •Monitor changes in the cash balance or bank overdraft balance
cashflow •Current ratio
•Acid test or quick ratio
•Accounts receivable period
•Inventory turnover period
•Accounts payable period
Debt and gearing •Financial gearing ratio
•Interest cover ratio
•Operating gearing ratio-Contribution/PBIT

135
 Limitations of accounting ratios for measuring
performance
• Financial statements are published infrequently. If
ratios are used to study trends and developments
over time, they are only useful for trends or changes
over one year or longer, and not changes in the
short-term.
• Ratios can only indicate possible strengths or
weaknesses in financial position and financial
performance. They might raise questions about
performance, but do not provide answers. They are
not easy to interpret, and changes in financial ratios
over time might not be easy to explain.
136
• Using financial ratios to measure performance can lead
managers to focus on the short-term rather than the
long-term success of the business.
• There is some risk that managers may decide to
‘manipulate’ financial performance, for example by
delaying a large item of expenditure or bringing forward
the date of a major business transaction, in order to
increase or reduce profitability in one period (and so
reduce or increase the profit for the next financial
period). The risk of manipulating financial results is
particularly significant when managers are paid annual
bonuses on the basis of financial performance.

137
 Non-financial performance indicators
• Reasons for growing emphasis on NFPIs
– FPIs concentration on too few variables.
This may lead to managers concentrate on
only those variables and ignore other
important variables that cannot be
expressed in monetary terms.
– Lack of information on quality. Traditional
responsibility accounting systems fail to
provide information on the quality or
importance of operations.
138
– Changes in cost structures. Modern technology
requires massive investment and product life cycles
have got shorter. A greater proportion of costs are
sunk and a large proportion of costs are planned,
engineered or designed into a product/service before
production/delivery. At the time the product/service
is produced/delivered, it is therefore too late to
control costs.
– Changes in competitive environment. Financial
measures do not convey the full picture of a
company's performance, especially in a modern
business environment.

139
– NFPIs are a better indicator of future prospects.
Financial performance indicators tend to focus on
the short term. They can give a positive impression
of what is happening now but problems may be
looming. For example, falling quality will ultimately
damage profitability.

140
 Which NFPIs should be measured?
As a general guide, NFPIs may be measurements of the following aspects
of
performance.
• (a) Quality of production: wastage rates or percentage of rejects in
production
• (b) Speed or efficiency, such as output per hour; average time taken
per unit of activity
• (c) Delivery: average time between taking an order and delivery to
the customer
• (d) Reliability: percentage of calls answered within a given target
time; number of equipment failures or amount of ‘down time’
• (e) Customer satisfaction: number of complaints
• (f) Innovation: number of new products developed and launched on
to the market
With non-financial indicators, anything can be measured and
compared if it
is meaningful to do so. The measures should be tailored to the
circumstances of the business.
141
 Different NFPIs
Type of NFPI Examples

NFPIs in relation •Attitudes and Morale( through surveys)

to employees •Education and skills levels, promotion and training,
absenteeism and labour turnover( monitoring)
Performance •Measuring the quality of incoming supplies. Quality control
measurement in should include procedures for acceptance and inspection of
a TQM goods inwards and measurement of rejects.
environment •Monitoring work done as it proceeds. 'In-process' controls
include statistical process controls and random sampling, and
measures such as the amount of scrap and reworking in
relation to good production. Measurements can be made by
product, by worker or work team, by machine or machine type,
by department, or whatever is appropriate.
Measuring customer satisfaction. This may be monitored in
the form of letters of complaint, returned goods, penalty
discounts, claims under guarantee, or requests for visits by
service
engineers.
142
 Measures of customer satisfaction
• Market research information on customer preferences
and customer satisfaction with specific product
features
• Number of defective units supplied to customers as a
percentage of total units supplied
• Number of customer complaints as a percentage of
total sales volume
• Percentage of products which fail early or excessively
• On-time delivery rate
• Average time to deal with customer queries
• New customer accounts opened
• Repeat business from existing customers

143
 Short-termism and manipulation
• Short-termism is when there is a bias towards short-
term rather than long-term performance.
• It is often due to the fact that managers' performance is
measured on short-term results.
• Organisations often have to make a trade-off between
short-term and long-term objectives.
• Decisions which involve the sacrifice of longer-term
objectives include the following.
– Postponing or abandoning capital expenditure projects, which
would eventually contribute to growth and profits, in
order to protect short term cash flow and profits.

144
– Cutting R&D expenditure to save operating costs,
and so reducing the prospects for future product
development.
– Reducing quality control, to save operating costs
(but also adversely affecting reputation and
goodwill).
– Reducing the level of customer service, to save
operating costs (but sacrificing goodwill).
– Cutting training costs or recruitment (so the
company might be faced with skills shortages).

145
• Managers may also manipulate results,
especially if rewards are linked to
performance.
• This can be achieved by changing the timing
of capital purchases, building up inventories
and speeding up or delaying payments and
receipts.

146
 Improving performance
• Performance is measured to asses show well or
badly an organisation has performed over a
given period of time. When performance is
measured, the objectives should be to:
– identify aspects of performance that may be a
cause for concern(analyse performance)
– explain differences between actual performance
and the plan or expectation, or deteriorating
performance over time
– consider ways of taking control measures to
improve performance.
147
 Example: Improving performance
Aspect of performance Possible reasons Possible measures to
improve performance
Increase in rejection Using relatively Hire more experienced
rates for faulty inexperienced staff to do staff
products the work Provide training Switch
Using cheaper materials back to better-quality
(to ‘save money’) material
Increase in Reduction on amount of Increase routine
frequency of routine maintenance of
machine maintenance work machines
breakdowns
Longer average time Reduction in number of Employ more staff
to answer customer call
calls in a call centre centre staff
Declining labour Increase in complexity of Hire more experienced
productivity the staff
work Provide training
Use of inexperienced staff Give the most complex
Hire more experienced tasks to specialist staff
staff 148
Structured approaches to performance measurement
• Some structured approaches to performance
measurement have been developed, which
combine measurements of financial and non-
financial performance.
• Two of these are:
– The balanced score card
– The building blocks model

149
 The balanced scorecard
• The balanced scorecard approach to
performance measurement focuses on four
different perspectives of performance, and
uses both financial and non-financial indicators
to set performance targets and monitor
performance.

150
• A balanced scorecard is a performance
measurement system in which:
– Objectives and targets are set for four different
aspects or perspectives of performance: a financial
perspective; customer perspective; internal
perspective; and innovation and learning
perspective. All four perspectives are important for
the long-term success of the organisation. Three of
these perspectives are non-financial in nature.
– There should be a small number of targets for each of
the four perspectives.

151
– The different targets for the four perspectives
should be consistent with each other: the four
perspectives are sometimes in conflict with each
other and it is necessary to establish an acceptable
balance between the different perspectives and
targets. (Hence, a ‘balanced’ scorecard.)
– Actual performance is measured regularly and
compared with the targets for all of the perspectives.
– Differences between the target and actual
performance are investigated, and where appropriate
measures are taken to improve performance.

152
Features of the balanced scorecard
• The scorecard is 'balanced' as managers are required
to think in terms of all four perspectives, to prevent
improvements being made in one area at the expense
of another.
• Important features of this approach are as follows.
– It looks at both internal and external matters
concerning the organization.
– It is related to the key elements of a company's
strategy.
– Financial and non-financial measures are linked
together. 153
 Perspectives of the balanced scorecard
Perspective Basic question Identifying performance targets
What do existing and
Gives rise to targets that matter to customers: cost,
Customer new customers value
quality, delivery, inspection, handling and so on.
from us?
What processes must we
excel at to achieve our Aims to improve internal processes and decision
Internal
financial and customer making.
objectives?
Can we continue to Considers the business's capacity to maintain its
Innovation
improve and create competitive position through the acquisition of
and learning
future value? new skills and the development of new products.

Covers traditional measures such as growth,

How do we create value
Financial profitability and shareholder value but set through
for our shareholders?
talking to the shareholder or shareholders direct.

154
Performance targets: examples

155
156
157
158
 Example

• Spotlight Productions has in the past produced

just one fairly successful product. Recently,
however, a new version of this product has
been launched. Development work continues to
add a related product to the product list. Given
below are some details of the activities during
the month of November.

159
• Units produced – existing product 25,000
– new product 5,000
• Cost of units produced – existing product $375,000
– new product $70,000

• Sales revenue – existing product $550,000

– new product $125,000
• Hours worked – existing product 5,000
– new product 1,250
• Development costs $47,000

160
• Required
• (a) Suggest and calculate performance
indicators that could be calculated for each of
the four perspectives on the balanced
scorecard.
• (b) Suggest how this information would be
interpreted.  

161
 Example 2: Non profit making orgn
A non profit making organization might set the following
Goals for each of the four perspectives:
Financial perspective
– Increase income from charitable donations
– Improve margins
Internal business perspective
– Reduce overheads
– Claim back tax on gift aid
Customer perspective
– Continued donor support
– Donor involvement in initiatives
 
162
Innovation and learning perspective
– More projects supported
– More fundraisers
– More money pledged
Required
Suggest some performance measures for each
of the goals outlined above.

163
 Solution
Perspective Goal Measures
Internal Reduce overheads Lower overheads measured
by monitoring and accounts
Claim back tax on Improved reclaim times for
business gift aid gift aided donation

Income from Donations received

Financial charitable
donations Lower costs and/or increased
Improved margins income from all sources

Innovation More projects

supported
Number of projects given
support
Number of fundraisers
and learning More fundraisers

More money
recruited
Amount of donations
pledged promised

Continued donor
Pledges given and direct
Customer support
Donor
debits set up
Fundraising and charity
involvement in
dinners 164
initiatives
 The Building Block Model
• Performance measurement in service businesses
has sometimes been perceived as more difficult
than in manufacturing businesses.
• Fitzgerald and Moon (1996) suggested that a
performance management system in a service
organisation can be analysed as a combination
of three building blocks:
– dimensions of performance
– standards
– rewards.
165
 The Model

Dimensions of performance
Profit
Competitiveness
Quality
Resource utilisation
Flexibility
Innovation

Standards Rewards
Ownership Clarity
Achievability Motivation
Equity Controllability

166
 Dimensions of performance
• Dimensions of performance are the aspects of
performance that are measured. Fitzgerald and Moon
suggested that there are six aspects to performance
measurement that link performance to corporate
strategy.
• These include: profit, competitiveness, quality,
resource utilization, flexibility and innovation.
• Some performance measures that might be used for
each of these dimensions are as follows.

167
Dimension of Performance
performance measures
Profitability
Financial performance (profit) Profits growth
Gross profit margin, net profit margin
Growth in sales
Competitiveness Retention rate for customers
Success rate in converting enquiries into sales
Number of complaints
Service quality Customer satisfaction, as revealed by customer opinion
surveys
Mix of different types of work done by employees
Flexibility
Speed in responding to customer requests
Efficiency/productivity measures
Resource utilisation
Capacity utilisation rates
Number of new services offered within the previous year or
Innovation
two years
168
 Example
• A service business has collected some figures relating to its year just
ended.
Budget Actual
• Customer enquiries:
 New customers 6,000 9,000
 Existing customers 4,000 3,000
• Business won:
 New customers 2,000 4,000
 Existing customers 1,500 1,500
• Types of services performed:
 Service A 875 780
 Service B 1,575 1,850
 Service C 1,050 2,870
• Employees:
 Service A 5 4
 Service B 10 10
 Service C 5 8

169
Required
• Calculate figures that illustrate
competitiveness and resource utilisation.

170
 Solution
• Competitiveness can only be measured from these
figures by looking at how successful the organisation
is at converting enquiries into firm orders. Percentage
of enquiries converted into firm orders
Budget Actual
• New customers (W1) 33% 44%
• Existing customers (W1) 37.5% 50%

Workings
– 1 For example 2,000/6,000 = 33%

171
 Solution
• Resource utilisation can be measured by
looking at average services performed per
employee.
Budget Actual Rise
• Service A (W2) 175 195 +11.4%
• Service B (W2) 157.5 185 +17.5%
• Service C (W2) 210 358.75 +70.8%
Workings
– 2 For example 875/5 = 175

172
 Standards of performance
• The second part of the framework for
performance measurement suggested by
Fitzgerald and Moon relates to setting expected
standards of performance, once the dimensions
of performance have been selected. This
considers behavioural aspects of performance
targets.

173
 Cont’d
There are three aspects to setting standards of
performance:
• To what extent do individuals feel that they own the standards
that will be used to assess their performance? Do they accept
the standards as their own, or do they feel that the standard
shave been imposed on them by senior management?
• Do the individuals held responsible for achieving the standards
of performance consider that these standards are achievable,
or not?
• Are the standards fair (‘equitable’) for all managers in all
business units of the entity?

It is recognised that individuals should ‘own’ the standards that

will be used to assess their performance, and managers are more
likely to own the standards when they have been involved in
the process of setting the standards.
174
 Rewards for performance
• The third aspect of Fitzgerald and Moon’s performance
measurement framework is rewards. This refers to the
structure of the rewards system, and how individuals
will be rewarded for the successful achievement of
performance targets.
• There are three aspects to consider in a reward system.
– The system of setting targets and rewarding individuals for
achieving the targets should be clear. Clarity will improve the
motivation to achieve the targets.
– Achievement of performance targets should be suitably
rewarded.
– Individuals should be made responsible only for aspects of
performance that they are in a position to control.

175
 DIVISIONAL PERFORMANCE
• Divisionalisation is a term for the division of an
organisation into divisions. Each divisional
manager is responsible for the performance of
the division.
• A division may be a cost centre (responsible for
its costs only), a profit centre (responsible for
revenues and profits) or an investment centre
or Strategic Business Unit (responsible for costs,
revenues and assets).
• There are a number of advantages and
disadvantages to divisionalisation. 176
• In general, a large organisation can be structured in
one of two ways:
– functionally (all activities of a similar type within a
company, such as production, sales, research, are under
the control of the appropriate departmental head) or
– divisionally (split into divisions in accordance with the
products or services made or provided).
• Divisional managers are therefore responsible for all
operations (production, sales and so on) relating to
their product, the functional structure being applied
to each division. It is possible, of course, that only
part of a company is divisionalised and activities such
as administration are structured centrally on a
functional basis with the responsibility of providing
services to all divisions.

177
 Decentralisation
• In general, a divisional structure will lead to
decentralisation of the decision-making
process and divisional managers may have
the freedom to set selling prices, choose
suppliers, make product mix and output
decisions and so on.
• Decentralisation is, however, a matter of
degree, depending on how much freedom
divisional managers are given.

178
 Advantages of divisionalisation/decentralisation
1) Divisionalisation can improve the quality of
decisions made because divisional managers (those
taking the decisions) know local conditions and are
able to make more informed judgements.
2) Decisions should be taken more quickly because
information does not have to pass along the chain of
command to and from top management. Decisions
can be made on the spot by those who are familiar
with the product lines and production processes and
who are able to react to changes in local conditions
quickly and efficiently.
3) The authority to act to improve performance should
motivate divisional managers

179
• Divisional organisation frees top
management from detailed involvement in
day-to-day operations and allows them to
devote more time to strategic planning.
• Divisions provide valuable training grounds
for future members of top management by
giving them experience of managerial skills
in a less complex environment than that
faced by top management.
• In a large business organisation, the central
head office will not have the management
resources or skills to direct operations
closely enough itself. Some authority must
be delegated to local operational managers
180
 Disadvantages of divisionalisation
• The business organisation will divide into a number of self-
interested segments, each acting at times against the wishes
and interests of other segments.
• A task of head office is therefore to try to prevent
dysfunctional decision making by individual divisional
managers. To do this, head office must reserve some power
and authority for itself so that divisional managers cannot be
allowed to make entirely independent decisions. A balance
ought to be kept between decentralisation of authority to
provide incentives and motivation, and retaining centralised
authority to ensure that the organisation's divisions are all
working towards
• the same target, the benefit of the organisation as a whole (in
other words, retaining goal congruence among the
organisation's separate divisions).
181
• It is claimed that the costs of activities that
are common to all divisions such as running
the accounting department may be greater
for a divisionalised structure than for a
centralised structure.
• Top management, by delegating decision
making to divisional managers, may lose
control since they are not aware of what is
going on in the organisation as a whole.
(With a good system of performance
evaluation and appropriate control
information, however, top management
should be able to control operations just as
effectively.)
182
 Responsibility accounting
• Responsibility accounting is the term used to
describe decentralisation of authority, with the
performance of the decentralised units
measured in terms of accounting results.
• With a system of responsibility accounting there
are five types of responsibility centre: cost
centre; revenue centre; profit centre;
contribution centre; investment centre

183
• The creation of divisions allows for the operation of a
system of responsibility accounting. There are a
number of types of responsibility accounting unit, or
responsibility centre that can be used within a system
of responsibility accounting.
• In the weakest form of decentralisation a system of
cost centres might be used.
• As decentralisation becomes stronger the
responsibility accounting framework will be based
around profit centres.
• In its strongest form investment centres are used.

184
Type of Manager has control over Principal
responsibility … performance
centre measures
Variance analysis
Cost centre Controllable costs
Efficiency measures

Revenue centre Revenues only Revenues

Controllable costs
Profit centre Profit
Sales prices (including transfer prices)
As for profit centre except that
Contribution centre expenditure is reported on a marginal cost Contribution
basis

Controllable costs
Sales prices (including transfer prices) Return on investment
Investment centre Output volumes Residual income
Investment in non-current assets and Other financial ratios
working capital

185
 Controllable profit and traceable profit
• Profit is a key measure of the financial
performance of a division. However, in
measuring performance, it is desirable to
identify:
– costs that are controllable by the manager of the
division, and also
– costs that are traceable to the division. These are
controllable costs plus other costs directly
attributable to the division over which the manager
does not have control.  
• There may also be an allocation of general
overheads, such as a share of head office costs.
186
• In a divisionalised system, profit centres and
investment centres often trade with each
other, buying and selling goods and services.
• These are internal sales, priced at an internal
selling price (a ‘transfer price’).
• Reporting systems should identify external
sales of the division and internal sales as two
elements of the total revenue of the division.
• We will look at transfer pricing later.

187
Performance measures for Investment
Centres(Divisions)
• The performance of an investment centre is
usually monitored using either or both of
return on investment (ROI) and residual
income (RI).
• We will look at each of the two measures in
turn.

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 Return on Investment(ROI)
• Return on investment (ROI) shows how much
profit has been made in relation to the amount
of capital invested and is calculated as
(profit/capital employed) x100%
• ROI is generally regarded as the key
performance measure. The main reason for its
widespread use is that it ties in directly with
the accounting process, and is identifiable from
the income statement and balance sheet.

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 Example
• A company has two divisions which are treated as investment
centres for the purpose of performance reporting. Centre 1 has
net assets of $5 million and made a profit of $250,000. Centre 2
has net assets of $1 million and made a profit of $150,000.
• If the performance of the centres is compared on the basis of
profits, the performance of Centre 1 ($250,000) is better than
the performance of Centre 2 ($150,000).
• However Centre 1 employed assets of $5 million to earn its profit
and its ROI was just 5% ($350,000/$5 million).
• Centre 2 employed assets of just $1 million and its ROI was 15%.
• Comparing performance on the basis of ROI, Centre 2 performed
better.

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 Measuring ROI
• There is no generally agreed method of
calculating ROI and it can have behavioural
implications and lead to dysfunctional decision
making when used as a guide to investment
decisions.
• It focuses attention on short-run performance
whereas investment decisions should be
evaluated over their full life.

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General formula for measuring ROI is as follows:
•Profit of the division as a percentage of capital
employed.
•Profit. This should be the annual accounting profit
of the division, without any charge for interest on
capital employed.
•This means that the profit is after deduction of
depreciation.

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Capital employed/investment.
This should be the sum of the non-current assets
used by the division plus  the working capital that
it uses.
Working capital = current assets minus current
liabilities, which for a division will normally consist
of inventory plus trade receivables minus trade
payables.  

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• Non-current assets could be measured at their
initial cost.
• However, it is more usual to measure non-
current assets at their carrying value.
• The capital employed is usually an average of
the capital employed at the beginning of the
year and at the end of the year.
• All these bases have their limitations as
follows:

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Profit after depreciation as a % of net assets
employed
• If an investment centre maintains the same
annual profit, and keeps the same assets without
a policy of regular replacement of non-current
assets, its ROI will increase year by year as the
assets get older.
• This can give a false impression of improving
performance over time. See example on next
slide

195
 Non- Deprecia Workin
  current tion NBV g Capital Profit ROI
in the (mid emplo
  assets year year) capital yed    
Year at cost            
  K'000 K'000 K'000 K'000 K'000 K'000  
0 100    10 110   
1 100 20 90 10 100 10 10%
2 100 20 70 10 80 10 13%
3 100 20 50 10 60 10 17%
4 100 20 30 10 40 10 25%
5 100 20 10 10 20 10 50%
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• This table of figures is intended to show that an
investment centre can improve its ROI year by
year, simply by allowing its non-current assets
to depreciate, and there could be a disincentive
to investment centre managers to reinvest in
new or replacement assets, because the
centre's ROI would probably fall.
• This example has used a mid year NBV but a
year end or start of year NBV can also be used.

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 Example
• A new company has non-current assets of
$460,000 which will be depreciated to nil on a
straight line basis over 10 years. Net current
assets will consistently be $75,000, and annual
profit will consistently be $30,000. ROI is
measured as return on net assets.
Required
Calculate the company's ROI in years 2 and 6.
Solution: Year 2: 6.8%; Year 6: 11.6%

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• A further disadvantage of measuring ROI as
profit divided by net assets is that, for similar
reasons, it is not easy to compare fairly the
performance of investment centres.
  Investment centre P Investment centre Q
  K K K K
Working capital   20,000.00   20,000.00
Non current assets at cost 230,000.00   230,000.00  
Accumulated Depreciation 170,000.00   10,000.00  
Net book value   60,000.00   220,000.00
Capital employed   80,000.00   240,000.00
Profit   24,000.00   24,000.00
ROI   30%  10%

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• Investment centres P and Q have the same amount of
working capital, the same value of non-current assets
at cost, and the same profit. But P's non-current assets
have been depreciated by a much bigger amount
(presumably P's non-current assets are much older
than Q's) and so P's ROI is three times the size of Q's
ROI. The conclusion might therefore be that P has
performed much better than Q. This comparison,
however, would not be 'fair', because the difference in
performance might be entirely attributable to the age
of their non-current assets.

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• The arguments for using net book values for
calculating ROI
• (a) It is the 'normally accepted' method of
calculating ROI.
• (b) Organisations are continually buying new
non-current assets to replace old ones that
wear out, and so on the whole, the total net
book value of all non-current assets together
will remain fairly constant (assuming nil
inflation and nil growth).
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 Profit after depreciation as a % of gross assets
employed
• Instead of measuring ROI as return on net assets, we
could measure it as return on gross assets ie before
depreciation. This would remove the problem of
ROI increasing over time as non-current assets get
older.
• If a company acquired a non-current asset costing
$40,000, which it intends to depreciate by $10,000
pa for 4 years, and if the asset earns a profit of
$8,000 pa after depreciation, ROI might be
calculated on net book values or gross values, as
follows.
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• The ROI based on net book value shows an
increasing trend over time, simply because the
asset's value is falling as it is depreciated. The ROI
based on gross book value suggests that the asset
has performed consistently in each of the four years,
which is probably a more valid conclusion.
    NBV ROI based Gross ROI based

Year Profit (Mid year value) on NBV Value on gross value

1 8000 35,000.00 22.90% 40,000.00 20%

2 8000 25,000.00 32.00% 40,000.00 20%

3 8000 15,000.00 53.30% 40,000.00 20%

4 8000 5,000.00 160.00% 40,000.00 20%

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• However, using gross book values to measure ROI has its
disadvantages. Most important of these is that measuring ROI as
return on gross assets ignores the age factor, and does not
distinguish between old and new assets.
• (a) Older non-current assets usually cost more to repair and
maintain, to keep them running. An investment centre with old
assets may therefore have its profitability reduced by repair costs,
and its ROI might fall over time as its assets get older and repair
costs get bigger.
• (b) Inflation and technological change alter the cost of non-current
assets. If one investment centre has non-current assets bought ten
years ago with a gross cost of $1 million, and another investment
centre, in the same area of business operations, has non-current
assets bought very recently for $1 million, the quantity and
technological character of the non-current assets of the two
investment centres are likely to be very different. 204
Massaging the ROI
• If a manager's large bonus depends on ROI
being met, the manager may feel pressure to
massage the measure. The asset base of the
ratio can be altered by increasing/decreasing
payables and receivables (by speeding up or
delaying payments and receipts).

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 ROI and new investments
• If investment centre performance is judged by ROI, we should
expect that the managers of investment centres will probably
decide to undertake new capital investments only if these new
investments are likely to increase the ROI of their centre.
• Suppose that an investment centre, A, currently makes a return
of 40% on capital employed. The manager of centre A would
probably only want to undertake new investments that promise
to yield a return of 40% or more, otherwise the investment
centre's overall ROI would fall.
• For example, if investment centre A currently has assets of
$1,000,000 and expects to earn a profit of $400,000, how would
the centre's manager view a new capital investment which would
cost $250,000 and yield a profit of $75,000 pa?

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• The new investment would reduce the investment centre's ROI from 40% to 38%,
and so the investment centre manager would probably decide not to undertake
the new investment.
• If the group of companies of which investment centre A is a part has a target ROI
of, say, 25%, the new investment would presumably be seen as beneficial for the
group as a whole. But even though it promises to yield a return of 75,000/250,000
= 30%, which is above the group's target ROI, it would still make investment centre
A's results look worse. The manager of investment centre A would, in these
circumstances, be motivated to do not what is best for the organisation as a
whole, but what is best for his division.
Without new With new
  investment investment
Profit 400,000.00 475,000.00
Capital
Employed 1,000,000.00 1,250,000.00
ROI 40% 38%
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 Residual income (RI)
An alternative way of measuring the performance of an
investment centre, instead of using ROI, is residual income (RI).
•Residual income is a measure of the centre's profits after
deducting a notional or imputed interest cost.
(a) The centre's profit is after deducting depreciation on capital
equipment.
(b) The imputed cost of capital might be the organisation's cost
of borrowing or its weighted average cost of capital.
•RI can sometimes give results that avoid the behavioural
problem of dysfunctionality. Its weakness is that it does not
facilitate comparisons between investment centres nor does it
relate the size of a centre's income to the size of the investment

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 Example
• A division with capital employed of $400,000
currently earns an ROI of 22%. It can make an
additional investment of $50,000 for a 5 year
life with nil residual value. The average net
profit from this investment would be $12,000
after depreciation. The division's cost of
capital is 14%.
• What are the residual incomes before and
after the investment?

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  Before investment After investment

  K K

Divisional profit ($400,000 ×

22%) 88,000.00 100,000.00

Imputed interest    

(400,000*0.14) 56,000.00  

(450,000*0.14)   63,000.00

Residual income 32,000.00 37,000.00

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 The advantages and weaknesses of RI compared
with ROI
The advantages of using RI
•(a) Residual income will increase when investments earning
above the cost of capital are undertaken and investments
earning below the cost of capital are eliminated.
•(b) Residual income is more flexible since a different cost of
capital can be applied to investments with different risk
characteristics.
The weakness of RI is that it does not facilitate comparisons
between investment centres nor does it relate the size of a
centre's income to the size of the investment.

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