Management Accounting

Contents
CONTENTS
Chapter 1: Financial accounting review ........................................................................................ 1
1. Framework for Financial Reporting ....................................................................................................................................... 1
2. Structure and content of Financial Statements ................................................................................................................ 3
3. Consolidated Financial Statements......................................................................................................................................20
Chapter 2: Managing Organisation ............................................................................................. 23

1. The Nature of Limited Companies .......................................................................................................................................23
2. Mission, Objectives and Targets ...........................................................................................................................................24
3. Performance Measurement and Performance Management ...................................................................................25
4. Responsibility Centre .................................................................................................................................................................26
5. Cost Accounting and Management Accounting ............................................................................................................29
6. Organisational Structures ........................................................................................................................................................31
7. Divisionalisation, Departmentation and Decentralisation ..........................................................................................32
Chapter 3: Cost Management ....................................................................................................... 35

1. Costing .............................................................................................................................................................................................35
2. Cost classification in the financial statement ..................................................................................................................36
3. Absorption Costing ....................................................................................................................................................................39
4. Activity-Based Costing ..............................................................................................................................................................44
Chapter 4: Managing Budgets ...................................................................................................... 51

1. Purpose and Functions of a Budget ....................................................................................................................................51
2. Process of preparing budget ..................................................................................................................................................54
3. Types of Budget ...........................................................................................................................................................................57
Chapter 5: Breakeven analysis ...................................................................................................... 72

1. The Breakeven Point ..................................................................................................................................................................72
2. Breakeven Graph .........................................................................................................................................................................75
3. Application of CVP and BEP ....................................................................................................................................................78
Chapter 6: Costing Decisions ........................................................................................................ 81

1. Relevant Costs for Decision Making....................................................................................................................................81
2. Cost behaviour and decision making .................................................................................................................................82
3. Limiting factor analysis .............................................................................................................................................................88
4. Make or buy decisions ..............................................................................................................................................................92
5. Decision making under uncertainty ....................................................................................................................................95
Chapter 7: Price Management ...................................................................................................... 97

1. Pricing Policy .................................................................................................................................................................................97
2. Factors affecting the pricing ...................................................................................................................................................97
3. Pricing methods ...........................................................................................................................................................................99
4. Transfer pricing ......................................................................................................................................................................... 105
Chapter 8: Variance Analysis....................................................................................................... 112

1. Types of Variance ..................................................................................................................................................................... 112
Contents
Chapter 9: Quality Management ................................................................................................ 120

1. Measures of shareholder value .......................................................................................................................................... 120
2. Critical success factors and key performance indicators ......................................................................................... 122
3. Balanced scorecard .................................................................................................................................................................. 124
4. Benchmarking ............................................................................................................................................................................ 127
5. Key elements of operations management..................................................................................................................... 130
6. Operational structures and process-based structures .............................................................................................. 130
7. World-class manufacturing and the re-design of operations ............................................................................... 131
8. Materials requirements planning (MRP I) ...................................................................................................................... 138
9. Manufacturing resource planning (MRP II) ................................................................................................................... 140
10. Optimised production technology (OPT) .................................................................................................................... 141
11. Enterprise resource planning (ERP) systems .............................................................................................................. 143
12. Just-in-time production and purchasing ..................................................................................................................... 144
13. Total quality management (TQM) .................................................................................................................................. 150
14. Value for money (VFM) ....................................................................................................................................................... 154
ii
Chapter 1: Financial accounting review

The relationship between Financial Accounting and Management Accounting (also known as
Managerial Accounting) has been described by International Federation of Accountants (IFAC) in
the International Good Practice Guidance: Evaluation and Improving Costing in Organizations.
Figure 1 Financial Accounting and Management Accounting
1. Framework for Financial Reporting

The primary objective of financial reporting is to provide useful information for decision making
by the user. Investors and creditors needs specific cash flow information for making appropriate
business decisions. International Accounting Standards Council (IASC) developed Framework for
the Preparation and Presentation of Financial Statements in 1989 which was adopted by
International Accounting Standards Board (IASB) in 2001. Later on IASB approved Conceptual
Framework for Financial Reporting 2010 which is widely used by the practitioners.
Page | 1
The IFRS Framework describes the basic concepts that underlie the preparation and presentation
of financial statements for external users. The IFRS Framework serves as a guide to the IASB in
developing future IFRSs and as a guide to resolving accounting issues that are not addressed
directly in an International Accounting Standard or International Financial Reporting Standard or
Interpretation.
In addition, the framework may assist:
Preparers of financial statements in applying international standards and in dealing with

topics that have yet to form the subject of an International Accounting Standard
Auditors in forming an opinion as to whether financial statements conform with IASs and
IFRSs
Users of financial statements in interpreting the information contained in financial

statements prepared in conformity with IFRS
Those who are interested in the work of IASB, providing them with information about its
approach to the formulation of accounting standards.
1.1 Purpose and scope of the Framework

The IFRS Framework addresses:
the objective of financial reporting
the qualitative characteristics of useful financial information
the reporting entity
the definition, recognition and measurement of the elements from which financial
statements are constructed
concepts of capital and capital maintenance
1.2 Underlying assumptions

There are two underlying assumptions for the preparation of financial statements, these are:
Accrual Basis
Page | 2
Under the accrual basis, the effects of transactions and other events are recognised when they
occur, and not as cash is received or paid. Under the accruals basis, events are recorded in the
accounting records and reported in the financial statements of the periods to which they relate.
Financial statements prepared on the accrual basis inform users not only to past transactions
when cash was paid or received but also of obligations to pay cash in the future and of cash or
its equivalents to be received in the future.
Going Concern Basis
The going concern basis of accounting is the assumption in preparing the financial statements
that an entity will continue in operation for the foreseeable future and does not plan to go into
liquidation, and will not be forced into liquidation or to curtail its operations.
If such an intention or need exists, the financial statements may have to be prepared on a different
basis and, if so, the basis used is disclosed. The going concern assumption is very important for
the valuation of assets, as they may require valuation on a break-up basis if the company will
cease trading.
2. Structure and content of Financial Statements

IAS 1 Presentation of Financial Statements sets out the overall requirements for financial
statements, including how they should be structured, the minimum requirements for their
content and overriding concepts such as going concern, the accrual basis of accounting and the
current/non-current distinction. The standard requires a complete set of financial statements to
comprise a statement of financial position, a statement of profit or loss and other comprehensive
income, a statement of changes in equity and a statement of cash flows.
A complete set of financial statements includes:
a statement of financial position (balance sheet) at the end of the period
a statement of profit or loss and other comprehensive income for the period
a statement of changes in equity for the period
a statement of cash flows for the period
notes, comprising a summary of significant accounting policies and other explanatory

notes
Page | 3
comparative information prescribed by IFRSs and IASs.
An entity may use titles for the statements other than those stated above. All financial statements
are required to be presented with equal prominence. Reports that are presented outside of the
financial statements including financial reviews by management, environmental reports, and
value added statements are outside the scope of IFRSs.
Financial statements cannot be described as complying with IFRSs unless they comply with all the
requirements of IFRSs (which includes International Financial Reporting Standards, International
Accounting Standards, IFRIC Interpretations and SIC Interpretations).
IAS 1 requires an entity to clearly identify:
the financial statements, which must be distinguished from other information in a

published document
each financial statement and the notes to the financial statements.
In addition, the following information must be displayed prominently, and repeated as necessary:
the name of the reporting entity and any change in the name
whether the financial statements are a group of entities or an individual entity
information about the reporting period
the presentation currency (as defined by IAS 21 The Effects of Changes in Foreign
Exchange Rates)
the level of rounding used (e.g. thousands, millions).
2.1 Statement of financial position (balance sheet)

Current and non-current classification
An entity must normally present a classified statement of financial position, separating current
and non-current assets and liabilities, unless presentation based on liquidity provides information
that is reliable. In either case, if an asset (liability) category combines amounts that will be received
(settled) after 12 months with assets (liabilities) that will be received (settled) within 12 months,
note disclosure is required that separates the longer-term amounts from the 12-month amounts.
IAS 1 classified Current assets as assets that are:
expected to be realised in the entity's normal operating cycle
Page | 4
held primarily for the purpose of trading
expected to be realised within 12 months after the reporting period
cash and cash equivalents (unless restricted).
All other assets are non-current assets.
IAS1 defined Current liabilities as those:
expected to be settled within the entity's normal operating cycle
held for purpose of trading
due to be settled within 12 months
for which the entity does not have an unconditional right to defer settlement beyond 12
months (settlement by the issue of equity instruments does not impact classification).
Other liabilities are non-current liabilities as per IAS1.

When a long-term debt is expected to be refinanced under an existing loan facility, and the entity
has the discretion to do so, the debt is classified as non-current, even if the liability would
otherwise be due within 12 months.
If a liability has become payable on demand because an entity has breached an undertaking
under a long-term loan agreement on or before the reporting date, the liability is current, even
if the lender has agreed, after the reporting date and before the authorisation of the financial
statements for issue, not to demand payment as a consequence of the breach. However, the
liability is classified as non-current if the lender agreed by the reporting date to provide a period
of grace ending at least 12 months after the end of the reporting period, within which the entity
can rectify the breach and during which the lender cannot demand immediate repayment.
Line items of financial statements:
The line items to be included on the face of the statement of financial position are:
i.
property, plant and equipment
ii.
investment property
iii.
intangible assets
iv.
financial assets (excluding amounts shown under (v), (vii), and (ix))
v.
investments accounted for using the equity method
Page | 5
vi.
biological assets
vii.
inventories
viii.
trade and other receivables
ix.
cash and cash equivalents
x.
assets held for sale
xi.
trade and other payables
xii.
provisions
xiii.
financial liabilities (excluding amounts shown under (xi) and (xii))
xiv.
current tax liabilities and current tax assets, as defined in IAS 12
xv.
deferred tax liabilities and deferred tax assets, as defined in IAS 12
xvi.
liabilities included in disposal groups
xvii.
non-controlling interests, presented within equity
xviii.
issued capital and reserves attributable to owners of the parent.
Additional line items, headings and subtotals may be needed to fairly present the entity's financial
position.
When an entity presents subtotals, those subtotals shall be comprised of line items made up of
amounts recognised and measured in accordance with IFRS; be presented and labelled in a clear
and understandable manner; be consistent from period to period; and not be displayed with
more prominence than the required subtotals and totals.
Further sub-classifications of line items presented are made in the statement or in the notes, for
example:
classes of property, plant and equipment
disaggregation of receivables
disaggregation of inventories in accordance with IAS 2 Inventories
disaggregation of provisions into employee benefits and other items
classes of equity and reserves.
2.2 Format of financial statements

IAS 1 does not prescribe the format of the statement of financial position. Assets can be
presented current then non-current, or vice versa, and liabilities and equity can be presented
current then non-current then equity, or vice versa.
Page | 6
A net asset presentation (assets minus liabilities) is allowed.

The long-term financing approach used in UK and elsewhere fixed assets + current assets short term payables = long-term debt plus equity is also acceptable.
Share capital and reserves
Regarding issued share capital and reserves, the following disclosures are required:
numbers of shares authorised, issued and fully paid, and issued but not fully paid
par value (or that shares do not have a par value)
a reconciliation of the number of shares outstanding at the beginning and the end of the
period
description of rights, preferences, and restrictions
treasury shares, including shares held by subsidiaries and associates
shares reserved for issuance under options and contracts
a description of the nature and purpose of each reserve within equity.
Additional disclosures are required in respect of entities without share capital and where an entity
has reclassified puttable financial instruments.
2.3 Statement of profit or loss and other comprehensive income

Concepts of profit or loss and comprehensive income
Profit or loss is defined as "the total of income less expenses, excluding the components of other
comprehensive income". Other comprehensive income is defined as comprising "items of income
and expense (including reclassification adjustments) that are not recognised in profit or loss as
required or permitted by other IFRSs". Total comprehensive income is defined as "the change in
equity during a period resulting from transactions and other events, other than those changes
resulting from transactions with owners in their capacity as owners".
Comprehensive income
for the period
Profit
or loss
Other
comprehensive income
All items of income and expense recognised in a period must be included in profit or loss unless
a Standard or an Interpretation requires otherwise. Some IFRSs require or permit that some
Page | 7
components to be excluded from profit or loss and instead to be included in other comprehensive
income.
Examples of items recognised outside of profit or loss
Changes
in
revaluation
surplus
where
the
revaluation
method
is
used
under IAS 16 Property, Plant and Equipment and IAS 38 Intangible Assets
Remeasurements of a net defined benefit liability or asset recognised in accordance
with IAS 19 Employee Benefits (2011)

Exchange differences from translating functional currencies into presentation currency
in accordance with IAS 21 The Effects of Changes in Foreign Exchange Rates

Gains and losses on remeasuring available-for-sale financial assets in accordance
with IAS 39 Financial Instruments: Recognition and Measurement

The effective portion of gains and losses on hedging instruments in a cash flow hedge
under IAS 39 or IFRS 9 Financial Instruments

Gains and losses on remeasuring an investment in equity instruments where the entity
has elected to present them in other comprehensive income in accordance with IFRS 9
The effects of changes in the credit risk of a financial liability designated as at fair value
through profit and loss under IFRS 9.

In addition, IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors requires the
correction of errors and the effect of changes in accounting policies to be recognised outside
profit or loss for the current period.
Choice in presentation and basic requirements
An entity has a choice of presenting:
a single statement of profit or loss and other comprehensive income, with profit or loss
and other comprehensive income presented in two sections, or
two statements:
o
a separate statement of profit or loss
a statement of comprehensive income, immediately following the statement of

profit or loss and beginning with profit or loss
The statement(s) must present:
Page | 8
profit or loss
total other comprehensive income
comprehensive income for the period
an allocation of profit or loss and comprehensive income for the period between noncontrolling interests and owners of the parent.
Profit or loss section of statement

The following minimum line items must be presented in the profit or loss section (or separate
statement of profit or loss, if presented):
revenue
gains and losses from the derecognition of financial assets measured at amortised cost
finance costs
share of the profit or loss of associates and joint ventures accounted for using the equity
method
certain gains or losses associated with the reclassification of financial assets
tax expense
a single amount for the total of discontinued items
Expenses recognised in profit or loss should be analysed either by nature (raw materials, staffing
costs, depreciation, etc.) or by function (cost of sales, selling, administrative, etc.). If an entity
categorises by function, then additional information on the nature of expenses at a minimum
depreciation, amortisation and employee benefits expense must be disclosed.
Other comprehensive income section
The other comprehensive income section is required to present line items which are classified by
their nature, and grouped between those items that will or will not be reclassified to profit and
loss in subsequent periods.
An entity's share of OCI of equity-accounted associates and joint ventures is presented in
aggregate as single line items based on whether or not it will subsequently be reclassified to
profit or loss.
When an entity presents subtotals, those subtotals shall be comprised of line items made up of
amounts recognised and measured in accordance with IFRS; be presented and labelled in a clear
and understandable manner; be consistent from period to period; not be displayed with more
Page | 9
prominence than the required subtotals and totals; and reconciled with the subtotals or totals
required in IFRS.
Other requirements
Additional line items may be needed to fairly present the entity's results of operations. Items
cannot be presented as 'extraordinary items' in the financial statements or in the notes.
Certain items must be disclosed separately either in the statement of comprehensive income or
in the notes, if material, including:
write-downs of inventories to net realisable value or of property, plant and equipment to

recoverable amount, as well as reversals of such write-downs
restructurings of the activities of an entity and reversals of any provisions for the costs of
restructuring
disposals of items of property, plant and equipment
disposals of investments
discontinuing operations
litigation settlements
other reversals of provisions
2.4 Statement of cash flows

Rather than setting out separate requirements for presentation of the statement of cash flows,
IAS 1 refers to IAS 7 Statement of Cash Flows.
Statement of changes in equity
IAS 1 requires an entity to present a separate statement of changes in equity. The statement must
show: total comprehensive income for the period, showing separately amounts attributable to
owners of the parent and to non-controlling interests
the effects of any retrospective application of accounting policies or restatements made

in accordance with IAS 8, separately for each component of other comprehensive income
reconciliations between the carrying amounts at the beginning and the end of the period
for each component of equity, separately disclosing:
Page | 10
profit or loss
other comprehensive income
transactions with owners, showing separately contributions by and distributions

to owners and changes in ownership interests in subsidiaries that do not result
in a loss of control
The following amounts may also be presented on the face of the statement of changes in equity,
or they may be presented in the notes:
amount of dividends recognised as distributions
the related amount per share.
Notes to the financial statements

The notes must:
present information about the basis of preparation of the financial statements and the
specific accounting policies used
disclose any information required by IFRSs that is not presented elsewhere in the financial
statements and
provide additional information that is not presented elsewhere in the financial statements
but is relevant to an understanding of any of them
Notes are presented in a systematic manner and cross-referenced from the face of the financial
statements to the relevant note.
IAS 1 suggests that the notes should normally be presented in the following order:
a statement of compliance with IFRSs
a summary of significant accounting policies applied, including:

o
the measurement basis (or bases) used in preparing the financial statements
the other accounting policies used that are relevant to an understanding of the
financial statements
supporting information for items presented on the face of the statement of financial
position (balance sheet), statement(s) of profit or loss and other comprehensive income,
statement of changes in equity and statement of cash flows, in the order in which each
statement and each line item is presented
other disclosures, including:

o
Page | 11
contingent liabilities (see IAS 37) and unrecognised contractual commitments
non-financial disclosures, such as the entity's financial risk management

objectives and policies (see IFRS 7 Financial Instruments: Disclosures)
2.5 Other disclosures

Judgements and key assumptions
An entity must disclose, in the summary of significant accounting policies or other notes, the
judgements, apart from those involving estimations, that management has made in the process
of applying the entity's accounting policies that have the most significant effect on the amounts
recognised in the financial statements.
Examples cited in IAS 1 include management's judgements in determining:
when substantially all the significant risks and rewards of ownership of financial assets
and lease assets are transferred to other entities
whether, in substance, particular sales of goods are financing arrangements and

therefore do not give rise to revenue.
An entity must also disclose, in the notes, information about the key assumptions concerning the
future, and other key sources of estimation uncertainty at the end of the reporting period, that
have a significant risk of causing a material adjustment to the carrying amounts of assets and
liabilities within the next financial year. These disclosures do not involve disclosing budgets or
forecasts.
Dividends
In addition to the distributions information in the statement of changes in equity (see above), the
following must be disclosed in the notes:
the amount of dividends proposed or declared before the financial statements were
authorised for issue but which were not recognised as a distribution to owners during
the period, and the related amount per share
the amount of any cumulative preference dividends not recognised.
Capital disclosures
An entity discloses information about its objectives, policies and processes for managing capital.
To comply with this, the disclosures include:
Page | 12
qualitative information about the entity's objectives, policies and processes for managing
capital, including:
o
description of capital it manages
nature of external capital requirements, if any
how it is meeting its objectives
quantitative data about what the entity regards as capital
changes from one period to another
whether the entity has complied with any external capital requirements and
if it has not complied, the consequences of such non-compliance.
Puttable financial instruments

IAS 1 requires the following additional disclosures if an entity has a puttable instrument that is
classified as an equity instrument:
summary quantitative data about the amount classified as equity
the entity's objectives, policies and processes for managing its obligation to repurchase
or redeem the instruments when required to do so by the instrument holders, including
any changes from the previous period
the expected cash outflow on redemption or repurchase of that class of financial

instruments and
information about how the expected cash outflow on redemption or repurchase was
determined.
Other information
The following other note disclosures are required by IAS 1 if not disclosed elsewhere in
information published with the financial statements:
domicile and legal form of the entity
country of incorporation
address of registered office or principal place of business
description of the entity's operations and principal activities
if it is part of a group, the name of its parent and the ultimate parent of the group
if it is a limited life entity, information regarding the length of the life
Page | 13
2.6 Deferred Taxes

IAS 12 Income Taxes implements a so-called 'comprehensive balance sheet method' of
accounting for income taxes which recognises both the current tax consequences of transactions
and events and the future tax consequences of the future recovery or settlement of the carrying
amount of an entity's assets and liabilities. Differences between the carrying amount and tax base
of assets and liabilities, and carried forward tax losses and credits, are recognised, with limited
exceptions, as deferred tax liabilities or deferred tax assets, with the latter also being subject to a
'probable profits' test.
Deferred tax liabilities is defined as the amounts of income taxes payable in future periods in
respect of taxable temporary differences. Taxable temporary differences are the temporary
differences that will result in taxable amounts in determining taxable profit (tax loss) of future
periods when the carrying amount of the asset or liability is recovered or settled.
Deferred tax assets is the amounts of income taxes recoverable in future periods in respect of:
o
deductible temporary differences
the carry forward of unused tax losses, and
the carry forward of unused tax credits
Deferred tax assets and deferred tax liabilities can be calculated using the following formulae:
Temporary difference
Carrying amount
Tax base
Deferred tax asset or liability
Temporary difference
Tax rate
Where, the tax base of an asset or liability is the amount attributed to that asset or liability for tax
purposes.
The following formula can be used in the calculation of deferred taxes arising from unused tax
losses or unused tax credits:
Deferred tax asset
Unused tax loss or unused tax credits
Tax rate
The general principle in IAS 12 is that a deferred tax liability is recognised for all taxable temporary
differences. There are three exceptions to the requirement to recognise a deferred tax liability, as
follows:
liabilities arising from initial recognition of goodwill
Page | 14
liabilities arising from the initial recognition of an asset/liability other than in a business
combination which, at the time of the transaction, does not affect either the accounting
or the taxable profit
liabilities arising from temporary differences associated with investments in subsidiaries,

branches, and associates, and interests in joint arrangements, but only to the extent that
the entity is able to control the timing of the reversal of the differences and it is probable
that the reversal will not occur in the foreseeable future.
2.6.1 Measurement of deferred tax

Deferred tax assets and liabilities are measured at the tax rates that are expected to apply to the
period when the asset is realised or the liability is settled, based on tax rates/laws that have been
enacted or substantively enacted by the end of the reporting period. The measurement reflects
the entity's expectations, at the end of the reporting period, as to the manner in which the
carrying amount of its assets and liabilities will be recovered or settled.
IAS 12 provides the following guidance on measuring deferred taxes:
Where the tax rate or tax base is impacted by the manner in which the entity recovers its
assets or settles its liabilities (e.g. whether an asset is sold or used), the measurement of
deferred taxes is consistent with the way in which an asset is recovered or liability settled
Where deferred taxes arise from revalued non-depreciable assets (e.g. revalued land),
deferred taxes reflect the tax consequences of selling the asset
Deferred
taxes
arising
from
investment
property
measured
at
fair
value
under IAS 40 Investment Property reflect the rebuttable presumption that the investment
property will be recovered through sale
If dividends are paid to shareholders, and this causes income taxes to be payable at a
higher or lower rate, or the entity pays additional taxes or receives a refund, deferred
taxes are measured using the tax rate applicable to undistributed profits
Deferred tax assets and liabilities cannot be discounted.

The following formula summarises the amount of tax to be recognised in an accounting period:
Tax to recognise for
the period
Page | 15
Current tax for the period
Movement in deferred tax

balances for the period
2.7 Earnings Per Share (EPS)

IAS 33 Earnings Per Share sets out how to calculate both basic earnings per share (EPS) and
diluted EPS. The calculation of Basic EPS is based on the weighted average number of ordinary
shares outstanding during the period, whereas diluted EPS also includes dilutive potential
ordinary shares (such as options and convertible instruments) if they meet certain criteria.
Basic EPS is calculated by dividing profit or loss attributable to ordinary equity holders of the
parent entity (the numerator) by the weighted average number of ordinary shares outstanding
(the denominator) during the period.
=
Net profit or loss attributable to ordinary shareholders

Weighted average number of ordinary shares outstanding during the period
The earnings numerators (profit or loss from continuing operations and net profit or loss) used
for the calculation should be after deducting all expenses including taxes, minority interests (NCI),
and preference dividends.
The denominator (number of shares) is calculated by adjusting the shares in issue at the
beginning of the period by the number of shares bought back or issued during the period,
multiplied by a time-weighting factor.
Diluted EPS is calculated by adjusting the earnings and number of shares for the effects of dilutive
options and other dilutive potential ordinary shares. The effects of anti-dilutive potential ordinary
shares are ignored in calculating diluted EPS.
Diluted EPS = [(net income - preferred dividend) / weighted average number of shares
outstanding - impact of convertible securities - impact of options, warrants and other dilutive
securities]
If EPS is presented, the following disclosures are required:
the amounts used as the numerators in calculating basic and diluted EPS, and a
reconciliation of those amounts to profit or loss attributable to the parent entity for the
period
the weighted average number of ordinary shares used as the denominator in calculating
basic and diluted EPS, and a reconciliation of these denominators to each other
Page | 16
instruments (including contingently issuable shares) that could potentially dilute basic
EPS in the future, but were not included in the calculation of diluted EPS because they
are antidilutive for the period(s) presented
a description of those ordinary share transactions or potential ordinary share transactions

that occur after the balance sheet date and that would have changed significantly the
number of ordinary shares or potential ordinary shares outstanding at the end of the
period if those transactions had occurred before the end of the reporting period.
Examples include issues and redemptions of ordinary shares issued for cash, warrants
and options, conversions, and exercises
Illustration of EPS and Diluted EPS

Consider the income statement and the balance sheet below:
Page | 17
How did we get $3.82 and $3.61 respectively?

The companys $32.47 million net income is divided by the 8.5 million shares of stock the business
has issued to compute its $3.82 EPS.
Assume that its capital stock is being traded at $70 per share. The Big Board (as it is called)
requires that the market cap (total value of the shares issued and outstanding) be at least $100
million and that it have at least 1.1 million shares available for trading.
With 8.5 million shares trading at $70 per share, the companys market cap is $595 million, well
above the NYSEs minimum. At the end of the year, this corporation has 8.5 million stock shares
outstanding, which refers to the number of shares that have been issued and are owned by its
stockholders. Thus, its EPS is $3.82, as just computed.
The business is committed to issuing additional capital stock shares in the future for stock options
that the company has granted to its executives, and it has borrowed money on the basis of debt
instruments that give the lenders the right to convert the debt into its capital stock.
Under terms of its management stock options and its convertible debt, the business may have to
issue 500,000 additional capital stock shares in the future. Dividing net income by the number of
Page | 18
shares outstanding plus the number of shares that could be issued in the future gives the
following computation of EPS:
$32,470,000 net income 9,000,000 capital stock shares issued and potentially issuable =
$3.61 EPS
2.8 Inventory
Inventories include assets held for sale in the ordinary course of business (finished goods), assets
in the production process for sale in the ordinary course of business (work in process), and
materials and supplies that are consumed in production (raw materials).
However, IAS 2 excludes certain inventories from its scope:
work in process arising under construction contracts (see IAS 11 Construction Contracts)
financial instruments (see IAS 39 Financial Instruments: Recognition and Measurement)
biological assets related to agricultural activity and agricultural produce at the point of
harvest (see IAS 41 Agriculture).
Also, while the following are within the scope of the standard, IAS 2 does not apply to the
measurement of inventories held by:
producers of agricultural and forest products, agricultural produce after harvest, and
minerals and mineral products, to the extent that they are measured at net realisable
value (above or below cost) in accordance with well-established practices in those
industries. When such inventories are measured at net realisable value, changes in that
value are recognised in profit or loss in the period of the change
commodity brokers and dealers who measure their inventories at fair value less costs to
sell. When such inventories are measured at fair value less costs to sell, changes in fair
value less costs to sell are recognised in profit or loss in the period of the change.
IAS 2 Inventories contains the requirements on how to account for most types of inventory. The
standard requires inventories to be measured at the lower of cost and net realisable value (NRV)
and outlines acceptable methods of determining cost, including specific identification (in some
cases), first-in first-out (FIFO) and weighted average cost.
In measuring the value of inventory, the cost should include all:
Page | 19
costs of purchase (including taxes, transport, and handling) net of trade discounts
received
costs of conversion (including fixed and variable manufacturing overheads) and
other costs incurred in bringing the inventories to their present location and condition
IAS 23 Borrowing Costs identifies some limited circumstances where borrowing costs (interest)
can be included in cost of inventories that meet the definition of a qualifying asset.
Inventory cost should NOT include:
abnormal waste
storage costs
administrative overheads unrelated to production
selling costs
foreign exchange differences arising directly on the recent acquisition of inventories

invoiced in a foreign currency
interest cost when inventories are purchased with deferred settlement terms.
The standard cost and retail methods may be used for the measurement of cost, provided that
the results approximate actual cost.
For inventory items that are not interchangeable, specific costs are attributed to the specific
individual items of inventory.
3. Consolidated Financial Statements

Consolidated financial statements is the financial statements of a group in which the assets,
liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries are presented
as those of a single economic entity.
IFRS 10 Consolidated Financial Statements outlines the requirements for the preparation and
presentation of consolidated financial statements, requiring entities to consolidate entities it
controls. Control requires exposure or rights to variable returns and the ability to affect those
returns through power over an investee.
A parent prepares consolidated financial statements using uniform accounting policies for like
transactions and other events in similar circumstances.
Page | 20
However, a parent need not present consolidated financial statements if it meets all of the
following conditions:
it is a wholly-owned subsidiary or is a partially-owned subsidiary of another entity and

its other owners, including those not otherwise entitled to vote, have been informed
about, and do not object to, the parent not presenting consolidated financial statements
its debt or equity instruments are not traded in a public market (a domestic or foreign
stock exchange or an over-the-counter market, including local and regional markets)
it did not file, nor is it in the process of filing, its financial statements with a securities
commission or other regulatory organisation for the purpose of issuing any class of
instruments in a public market, and
its ultimate or any intermediate parent of the parent produces financial statements
available for public use that comply with IFRSs, in which subsidiaries are consolidated or
are measured at fair value through profit or loss in accordance with IFRS 10.
Consolidated financial statements:
combine like items of assets, liabilities, equity, income, expenses and cash flows of the
parent with those of its subsidiaries
offset (eliminate) the carrying amount of the parent's investment in each subsidiary and
the parent's portion of equity of each subsidiary (IFRS 3 Business Combinations explains
how to account for any related goodwill)
eliminate in full intragroup assets and liabilities, equity, income, expenses and cash flows
relating to transactions between entities of the group (profits or losses resulting from
intragroup transactions that are recognised in assets, such as inventory and fixed assets,
are eliminated in full).
A reporting entity includes the income and expenses of a subsidiary in the consolidated financial
statements from the date it gains control until the date when the reporting entity ceases to
control the subsidiary. Income and expenses of the subsidiary are based on the amounts of the
assets and liabilities recognised in the consolidated financial statements at the acquisition date.
The parent and subsidiaries are required to have the same reporting dates, or consolidation based
on additional financial information prepared by subsidiary, unless impracticable. Where
impracticable, the most recent financial statements of the subsidiary are used, adjusted for the
effects of significant transactions or events between the reporting dates of the subsidiary and
Page | 21
consolidated financial statements. The difference between the date of the subsidiary's financial
statements and that of the consolidated financial statements shall be no more than three months.
Page | 22
Chapter 3: Cost Management
Chapter 2: Managing Organisation

Business organisation is an entity formed for the purpose of carrying on commercial enterprise.
Business enterprises customarily take one of three forms: individual proprietorships, partnerships,
or limited-liability companies (or corporations).
In the first form, a single person holds the entire operation as his personal property, usually
managing it on a day-to-day basis. Most businesses are of this type. The second form, the
partnership which may have from 2 to 50 or more members, as in the case of large law and
accounting firms, brokerage houses, and advertising agencies. This form of business is owned by
the partners themselves; they may receive varying shares of the profits depending on their
investment or contribution. Whenever a member leaves or a new member is added, the firm must
be reconstituted as a new partnership.
The third form, the limited-liability company, or corporation, denotes incorporated groups of
personsthat is, a number of persons considered as a legal entity (or fictive person) with
property, powers, and liabilities separate from those of its members. This type of company is also
legally separate from the individuals who work for it, whether they be shareholders or employees
or both; it can enter into legal relations with them, make contracts with them, and sue and be
sued by them. Most large industrial and commercial organisations are limited-liability companies.
1. The Nature of Limited Companies

A company can be defined as an "artificial person", invisible, intangible, created by or under law,
with a discrete legal entity, perpetual succession and a common seal. It is not affected by the
death, insanity or insolvency of an individual member. A limited company is a company in which
the liability of each shareholder is limited to the amount individually invested" with corporations
being "the most common example of a limited company."
The ownership of a limited company is represented by shares. There may be several 'classes' of
shares in a company. Ordinary shares represent the 'real' ownership of a company. Preferred
shares do not convey any right to ownership. They entitle their holders to a dividend each year.
A preferred dividend is usually fixed, and expressed as a percentage amount each year on the
nominal value of the shares. Ordinary shareholders receive dividends out of profits, after
Page | 23
preferred dividends have been paid. The amount of dividend in any year depends on the
profitability of the company.
A company can contract, sue and be sued in its incorporated name and capacity. Shareholders
liability for the losses of the company is limited to their share contribution only. This is what
makes it a separate legal entity from its shareholders. The business can be sued on its own and
not involve its shareholders. The company does not belong to any person since one person can
own only a part of it.
2. Mission, Objectives and Targets

Mission statements are normally short and simple statements which outline what the
organisation's purpose is and are related to the specific sector an organisation operates in.
Mission statements are concerned about the current times and tend to answer questions about
what the business does or what makes them stand out compared to the competition. There is no
standard format for setting a mission statement, but they should possess certain characteristics:
Brevity - easy to understand and remember
Flexibility - to accommodate change
Distinctiveness - to make the firm stand out.
The objectives, unlike the mission statement, are actionable and measurable steps. There are
usually multiple goals and objectives needed to achieve the businesss mission statement. There
is a primary corporate objective (restricted by certain constraints on corporate activity) and other
secondary objectives which are strategic objectives which should combine to ensure the
achievement of the primary corporate objective.
(a) For example, if a company sets itself an objective of growth in profits, as its primary objective,
it will then have to develop strategies by which this primary objective can be achieved.
(b) Secondary objectives might then be concerned with sales growth, continual technological
innovation, customer service, product quality, efficient resource management (e.g. labour
productivity) or reducing the company's reliance on debt capital.
Objectives may be long-term or short-term as well.
Page | 24
(a) A company that is suffering from a recession in its core industries and making losses in the
short term might continue to have a primary objective in the long term of achieving a steady
growth in earnings or profits, but in the short term, its primary objective might switch to survival.
(b) Secondary objectives will range from short-term to long-term. Planners will formulate
secondary objectives within the guidelines set by the primary objective, after selecting strategies
for achieving the primary objective.
Target is a measurement of how successfully the aim is reaching its objective. Targets are the
SMART and precise details of the objectives to be realised in a time frame. Targets can also be
used as standards for measuring the performance of the organisation and departments in it.
3. Performance Measurement and Performance Management

Its the 2012 Olympics. How do you think performance is going to be measured at the games by
the teams involved? The number of gold medals? The number of world records? Their position
in the medals table?
Now come back to the present day as teams are preparing for the games. How do you think
performance is being managed? One thing is for sure, it wont involve counting the number of
medals they hope to win. Instead the focus will be on the type of training being given, the diets
being prepared, and the way in which equipment and facilities are being used. To ensure these
can take place, budgets and other resources will be allocated to the most appropriate activities,
while reporting will look at their progress and whether the athlete has achieved set milestones.
In short, performance management is all about preparing and monitoring the athlete, and not on
measuring the outcomes they hope to achieve.
Performance measurement focuses on results and allows users to analyse those results through
charts, grids, trends, and by drilling-down to even greater depths of detail. However, what they
dont reveal is the process that individual managers went through in setting the initial targets;
the actions that were going to be required; the anticipated state of the business environment for
which those actions were conceived; whether or not the required actions were actually carried
out; and whether those actions actually contributed to success.
Without this knowledge,
measures are at best misleading, and in the worst case will promote responses that are ill
considered and damaging to the long-term prospects of the organisation.
Page | 25
Performance management by contrast is all to do with the business processes and day-to-day
actions that lead to strategic goals. This includes how management choose a particular course
of action in a given business environment, as well as how those actions relate to other
departments and the overall achievement of company strategy. A true performance management
system combines many processes. It starts out by supporting the setting up of an operational
plan that is tied to strategic goals. It allows managers to collaborate with others on developing
initiatives to which resources can be allocated that will eventually form part of a departmental
budget.
Performance management systems allow these initiatives to be assessed in various combinations
so that the best can be selected as part of an agreed plan. The system will then go on to track
the implementation of agreed initiatives and warn users and appropriate managers if activities
have not been completed or if they are not having the desired effect on strategic goals.
Where goals are not being met or are being forecast to miss, a performance management system
will allow mangers to propose changes and try out alternative scenarios to put the plan back on
course. Once these are agreed, the system will adjust any budgets, warn users of those changes
and then track the new version.
4. Responsibility Centre
Responsibility centres are identifiable segments within a company for which individual managers
have accepted authority and accountability. Responsibility centres define exactly what assets and
activities each manager is responsible for. How to classify any given department depends on
which aspects of the business the department has authority over.
Managers prepare a responsibility report to evaluate the performance of each responsibility
centre. This report compares the responsibility centres budgeted performance with its actual
performance, measuring and interpreting individual variances.
Responsibility centres can be classified by the scope of responsibility assigned and decisionmaking authority given to individual managers.
The following are the four common types of respon-sibility centres:
Page | 26
4.1. Cost Centres

A cost or expense centre is a segment of an organisation in which the managers are held
re-sponsible for the cost incurred in that segment but not for revenues. Responsibility in a cost
centre is restricted to cost. For planning purposes, the budget estimates are cost estimates; for
control purposes, performance evaluation is guided by a cost variance equal to the difference
between the actual and budgeted costs for a given period. Cost centre managers have control
over some or all of the costs in their segment of business, but not over revenues. Cost centres
are widely used forms of responsibil-ity centres.
In manufacturing organisations, the production and service departments are classified as cost
centre. Also, a marketing department, a sales region or a single sales representative can be
defined as a cost centre. Cost centre may vary in size from a small department with a few
employees to an entire manufacturing plant. In addition, cost centres may exist within other cost
centres.
For example, a manager of a manufacturing plant organised as a cost centre may treat individual
depart-ments within the plant as separate cost centres, with the department managers reporting
directly to plant manager. Cost centre managers are responsible for the costs that are controllable
by them and their subordinates. However, which costs should be charged to cost centres, is an
important question in evaluating cost centre managers.
4.2. Revenue centres

A revenue centre is a segment of the organisation which is primarily responsible for generating
sales revenue. A revenue centre manager does not possess control over cost, investment in assets,
but usually has control over some of the expense of the marketing department. The performance
of a revenue centre is evaluated by comparing the actual revenue with budgeted revenue, and
actual marketing expenses with budgeted marketing expenses. The Marketing Manager of a
product line, or an individual sales representative are examples of revenue centres.
4.3. Profit Centre

A profit centre is a segment of an organisation whose manager is responsible for both revenues
and costs. In a profit centre, the manager has the responsibility and the authority to make
decisions that affect both costs and revenues (and thus profits) for the department or division.
Page | 27
The main purpose of a profit centre is to earn profit. Profit centre managers aim at both the
production and marketing of a product.
The performance of the profit centre is evaluated in terms of whether the centre has achieved its
budgeted profit. A division of the company which produces and markets the products may be
called a profit centre. Such a divisional manager determines the selling price, marketing
programmes and production policies.
Profit centres make managers more concerned with finding ways to increase the centres revenue
by increasing production or improving distribution methods. The manager of a profit centre does
not make decisions concerning the plant assets available to the centre. For example, the manager
of the sporting goods department does not make the decisions to expand the available floor
space for the department.
Mostly profit centres are created in an organisation in which they (profit divisions) sell products
or services outside the company. In some cases, profit centres may be selling products or services
within the company. For example, repairs and maintenance department in a company can be
treated as a profit centre if it is allowed to bill other production departments for the services
provided to them. Similarly, the data processing department may bill each of companys
administrative and operating departments for providing computer-related services.
An example of profit centres in a super market having different retail departments is displayed in
the figure below.
Figure 2 Super Market Profit Centres
In profit centres, managers are encouraged to take important decisions regarding the activities
and operations of their divisions. Profit centres are generally created in terms of product or
process which has grown in size and has profit responsibility. In some organizations, profit centres
are given complete autonomy on sourcing supplies and making sales.
However, in other organisations, such independence may not be found. Top management does
not allow profit centre divisions to buy from outside sources if there is idle capacity within the
Page | 28
firm. Also, the top management may be hesitant to part with designs and other specifications to
maintain quality and safety of the product and due to fear of losing the market that the firm has
already created for its products.
4.4. Investment Centre

An investment centre is responsible for both profits and investments. The investment centre
manager has control over revenues, expenses and the amounts invested in the centres assets.
He also formulates the credit policy which has a direct influence on debt collection, and the
inventory policy which determines the investment in inventory.
The manager of an investment centre has more authority and responsibility than the manager of
either a cost centre or a profit centre. Besides controlling costs and revenues, he has investment
responsibility too. Investment on asset responsibility means the authority to buy, sell and use
divisional assets.
5. Cost Accounting and Management Accounting

Cost accounting is a task of collecting, analysing, summarising and evaluating various alternative
courses of action. Its goal is to advise the management on the most appropriate course of action
based on the cost efficiency and capability. Cost accounting provides the detailed cost
information that management needs to control current operations and plan for the future.
Since managers are making decisions only for their own organisation, there is no need for the
information to be comparable to similar information from other organisations. Instead,
information must be relevant for a particular environment. Cost accounting information is
commonly used in financial accounting information, but its primary function is for use by
managers to facilitate making decisions. A costing system is designed to monitor the costs
incurred by the business. The system is comprised of a set of forms, processes, controls, and
reports that are designed to aggregate and report to management about revenues, costs, and
profitability. Unlike the accounting systems that help in the preparation of financial reports
periodically, the cost accounting systems and reports are not subject to rules and standards i.e.
IFRS. As a result, there is a wide variety in the cost accounting systems of the different companies
and sometimes even in different parts of the same company or organisation.
Page | 29
Management accounting involves preparing and providing timely financial and statistical
information to business managers so that they can make day-to-day and short-term managerial
decisions.
Management accounting (also known as managerial or cost accounting) is different from financial
accounting, in that it produces reports for a companys internal stakeholders, as opposed to
external stakeholders. The result of management accounting is periodic reports for e.g. the
companys department managers, chief executive officer, etc.
The following table summarises the main differences between management accounting and
financial accounting:
Management accounting
Financial accounting
A management accounting system produces
A financial accounting system produces
information
information that is used by parties external to
that
is
used
within
an
organisation, by managers and employees.
the organisation, such as shareholders, banks

and creditors.
Management accounting helps management
Financial accounting provides a record of the
to record, plan and control activities and aids
performance of an organisation over a
the decision-making process.
defined period and the state of affairs at the

end of that period.
There is no legal requirement for an
Limited companies are required by the law of
organisation to use management accounting.
most countries to prepare financial accounts.
Management
Financial accounting concentrates on the
accounting
can
focus
on
specific areas of an organisation's activities.
organisation
Information may aid a decision rather than be
revenues and costs from different operations.
an end-product of a decision.
Financial accounts are an end in themselves.
Management accounting information may be
Most financial accounting information is of a
monetary or alternatively non-monetary.
monetary nature.
Management accounting provides both an
Financial accounting presents an essentially
historical record and a future planning tool.
historical picture of past operations.
Page | 30
as
whole,
aggregating
No strict rules govern the way in which
Financial accounting must operate within a
management
framework determined
accounting
operates.
The
by law and by
management accounts and information are
accounting standards (e.g., IASs and IFRSs). In
prepared in a format that is of use to
principle the financial accounts of different
managers.
organisations can be easily compared.
6. Organisational Structures
An organisational structure defines how activities such as task allocation, coordination and
supervision are directed toward the achievement of organisational aims.
The way that a companys structure develops often falls into a tall (vertical) structure or a flat
(horizontal) structures. Tall structures are more of what we think of when we visualise an
organisational chart with the CEO at the top and multiple levels of management. Flat
organisational structures differ in that there are fewer levels of management and employees often
have more autonomy.
Tall Organisational Structure
Large, complex organisations often require a taller hierarchy. In its simplest form, a tall structure
results in one long chain of command similar to the military. As an organisation grows, the
number of management levels increases and the structure grows taller. In a tall structure,
managers form many ranks and each has a small area of control. Although tall structures have
more management levels than flat structures, there is no definitive number that draws a line
between the two.
The pros of tall structures lie in clarity and managerial control. The narrow span of control allows
for close supervision of employees. Tall structures provide a clear, distinct layers with obvious
lines of responsibility and control and a clear promotion structure. Challenges begin when a
structure gets too tall. Communication begins to take too long to travel through all the levels.
These communication problems hamper decisionmaking and hinder progress.
Page | 31
Figure 3: Tall Organisational Structure

Figure 4: Flat Organisational
Structure
Flat Organisational Structure
Flat structures have fewer management levels,

with each level controlling a broad area or group. Flat organizations focus on empowering
employees rather than adhering to the chain of command. By encouraging autonomy and selfdirection, flat structures attempt to tap into employees creative talents and to solve problems by
collaboration.
Flat organisations offer more opportunities for employees to excel while promoting the larger
business vision. That is, there are more people at the top of each level. For flat structures to
work, leaders must share research and information instead of hoarding it. If they can manage to
be open, tolerant and even vulnerable, leaders excel in this environment. Flatter structures are
flexible and better able to adapt to changes. Faster communication makes for quicker decisions,
but managers may end up with a heavier workload. Instead of the military style of tall structures,
flat organizations lean toward a more democratic style.
The heavy managerial workload and large number of employees reporting to each boss
sometimes results in confusion over roles. Bosses must be team leaders who generate ideas and
help others make decisions. When too many people report to a single manager, his job becomes
impossible. Employees often worry that others manipulate the system behind their backs by
reporting to the boss; in a flat organisation, that means more employees distrusting higher levels
of authority.
7. Divisionalisation, Departmentation and Decentralisation

Divisionalisation is the division of a business into autonomous divisions, regions or product
businesses, each with its own revenues, expenditures and capital asset purchase programmes,
and therefore each with its own profit and loss responsibility.
Each division of the organisation might be:
A subsidiary company under the holding company
Page | 32
A profit centre or investment centre within a single company
Successful divisionalisation requires certain key conditions.

(a) Each division must have properly delegated authority, and must be held properly accountable
to head office (e.g. for profits earned).
(b) Each unit must be large enough to support the quantity and quality of management it needs.
(c) The unit must not rely on head office for excessive management support.
(d) Each unit must have a potential for growth in its own area of operations.
(e) There should be scope and challenge in the job for the management of each unit.
(f) If units deal with each other, it should be as an 'arm's length' transaction. There should be no
insistence on preferential treatment to be given to a 'fellow unit' by another unit of the overall
organisation.
The benefits and drawbacks of divisionalisation may be summarised as follows.
Advantages
Disadvantages
Focuses the attention of management below
In some businesses, it is impossible to identify
'top level' on business performance.
completely independent products or markets

for which separate divisions can be set up.
Reduces
the
likelihood
of
unprofitable
products and activities being continued.
Divisionalisation is only possible at a fairly

senior management level, because there is a
limit to how much discretion can be used in
the division of work. For example, every
product needs a manufacturing function and
a selling function.
Encourages a greater attention to efficiency,
There may be more resource problems. Many
lower costs and higher profits.
divisions get their resources from head office

in competition with other divisions.
Gives more authority to junior managers, and
Reduces the number of levels of management.
so grooms them for more senior positions in
The top executives in each division should be
the future (planned managerial succession).
able to report directly to the chief executive of

the holding company.
Page | 33
Departmentation is a process of grouping and sub-grouping. This is the first task and does not
directly relate to decentralisation. Organisations can be departmentalised on a functional basis
(with separate departments for production, marketing, finance etc.), a geographical basis (by
region, or country), a product basis (e.g. worldwide divisions for product X, Y etc.), a brand basis,
or a matrix basis (e.g. someone selling product X in country A would report to both a product X
manager and a country A manager). Organisation structures often feature a variety of these types,
as hybrid structures.
Decentralisation, however, is a diffusion of authority within the entire enterprise and also within
a department. It relates to positions characterised by organisation for better management.
Page | 34

Cost management is the process of planning and controlling the budget of a business. Cost
management is a form of management accounting that allows a business to predict impending
expenditures to help reduce the chance of going over budget.
1. Costing
A cost management systems (CMS) is part of an overall management information and control
system. A cost management system consists of a set of formal methods developed for planning
and controlling an organisations cost-generating activities relative to its short-term objectives
and long-term strategies. Business entities face two major challenges: achieving profitability in
the short run and maintaining a competitive position in the long run. An effective cost
management system must provide managers the information needed to meet both of these
challenges. The short-run requirement is that revenues exceed coststhe organization must
make efficient use of its resources relative to the revenues that are generated. Specific cost
information is needed and must be delivered in a timely fashion to an individual who is in a
position to influence the cost. Short-run information requirements are often described as relating
to operational management.
Meeting the long-run objective, survival, depends on acquiring the right inputs from the right
suppliers, selling the right mix of products to the right customers, and using the most appropriate
channels of distribution. These decisions require only periodic information that is reasonably
accurate. Long-run information requirements are often described as relating to strategic
management.
The information generated from the CMS should benefit all functional areas of the entity.
Crossing all functional areas, a cost management system can be viewed as having six primary
goals: (1) develop reasonably accurate product costs, especially through the use of cost drivers
(activities that have direct cause-and-effect relationships with costs); (2) assess product/service
life-cycle performance; (3) improve understanding of processes and activities; (4) control costs;
(5) measure performance; and (6) allow the pursuit of organizational strategies.
Page | 35
2. Cost classification in the financial statement

The statement of financial position (balance sheet) and the statement of comprehensive income
(income statement) are two financial statements prepared by a company. The statement of
financial position is a statement of unexpired costs (assets) and equities (liabilities and owners
capital); the statement of comprehensive income is a statement of revenues and expired costs
(expenses and losses).
Costs can also be classified as either product or period costs. Product costs are related to making
or acquiring the products or providing the services that directly generate the revenues of an
entity; period costs are related to other business functions such as selling and administration.
Product costs are also called inventoriable costs and include the cost of direct material, direct
labour, and overhead. Any readily identifiable part of a product (such as the clay in a vase) is a
direct material. Direct material includes raw materials, purchased components from contract
manufacturers, and manufactured subassemblies. Direct labour refers to the time spent by
individuals who work specifically on manufacturing a product or performing a service. At
Wisconsin Film & Bag, the people handling the polyethylene material for storage bags are
considered direct labour and their wages are direct labour costs. Any factory or production cost
that is indirect to the product or service and, accordingly, does not include direct material and
direct labour is overhead. This cost element includes factory supervisors salaries, depreciation
on the machines producing plastic food storage bags, and insurance on the production facilities.
The sum of direct labour and overhead costs is referred to as conversion cost.
A cost that varies in total in direct proportion to changes in activity is a variable cost. Examples
include the costs of materials, wages, and sales commissions. Variable costs can be extremely
important in the total profit picture of a company, because every time a product is produced
and/or sold or a service is rendered and/or sold, a corresponding amount of that variable cost is
incurred. Because the total cost varies in direct proportion to changes in activity, a variable cost
is a constant amount per unit.
To illustrate how to determine a variable cost, assume that Smith Company makes lawnmowers
with batteries attached to start them electrically. Each battery costs a constant $8 as long as the
company produces within the relevant range of 0 to 3,000 mowers annually. Within this range,
total battery cost can be calculated as $8 multiplied by the number of mowers produced. For
Page | 36
instance, if 2,500 mowers were produced, total variable cost of batteries is $20,000 ($8 x 2,500
mowers).
In contrast, a cost that remains constant in total within the relevant range of activity is considered
a fixed cost. Many fixed costs are incurred to provide a firm with production capacity. Fixed costs
include salaries (as opposed to wages), depreciation (other than that computed under the unitsof-production method), and insurance. On a per-unit basis, a fixed cost varies inversely with
changes in the level of activity: the per-unit fixed cost decreases with increases in the activity
level, and increases with decreases in the activity level. If a greater proportion of capacity is used,
then fixed costs per unit are lower.
To illustrate how to determine the total and unit amounts of a fixed cost, suppose that Smith
Company rents for $12,000 annually manufacturing facilities in which its operating relevant range
is 0 to 8,000 mowers annually.
Figure 5: Comparative Total and Unit Cost Behavior
Other costs exist that are not strictly variable or fixed. For example, a mixed cost has both a
variable and a fixed component. On a per-unit basis, a mixed cost does not fluctuate in direct
proportion to changes in activity nor does it remain constant with changes in activity. An electric
bill that is computed as a flat charge for basic service (the fixed component) plus a stated rate for
each kilowatt-hour of usage (the variable component) is an example of a mixed cost. Figure below
shows a graph for Grand Polymers electricity charge from its power company, which consists of
$500 per month plus $0.018 per kilowatt-hour (kwh) used. In a month when Grand Polymers uses
80,000 kwhs of electricity, its total electricity bill is $1,940 [$500 + ($0.018 x 80,000)]. If 90,000
kwhs are used, the electricity bill is $2,120.
Page | 37
Another type of cost shifts upward or downward when activity changes by a certain interval or
step. A step cost can be variable or fixed. Step variable costs have small steps and step fixed
costs have large steps. For example, a water bill computed as $0.002 per gallon for up to 1,000
gallons, $0.003 per gallon for 1,001 to 2,000 gallons, $0.005 per gallon for 2,001 to 3,000 gallons,
is an example of a step variable cost. In contrast, the salary cost for an airline ticket agent who
can serve 3,500 customers per month is $3,200 per month. If airline volume increases from 10,000
customers to 12,800 customers, the airline will need four ticket agents rather than three. Each
additional 3,500 passengers will result in an additional step fixed cost of $3,200.
Figure 6: Graph of a Mixed Cost
2.1. Separating Mixed Costs

Accountants assume that costs are linear rather than curvilinear. Because of this assumption, the
general formula for a straight line can be used to describe any type of cost within a relevant range
of activity. The straight-line formula is
y = a + bX
where,
y = total cost (dependent variable)
a = fixed portion of total cost
b = unit change of variable cost relative to unit changes in activity
Page | 38
X = activity base to which y is being related (the predictor, cost driver, or independent variable)
If a cost is entirely variable, the a value in the formula will be zero. If the cost is entirely fixed, the
b value in the formula will be zero. If a cost is mixed, it is necessary to determine formula values
for both a and b.
HIGH-LOW METHOD
The high-low method analyses a mixed cost by first selecting two observation points in a data
set: the highest and lowest levels of activity, if these points are within the relevant range. Activity
levels are used because activities cause costs to change and not the reverse. Occasionally,
operations may occur at a level outside the relevant range (a rush special order may be taken
that requires excess labour or machine time) or distortions might occur in a normal cost within
the relevant range (a leak in a water pipe goes unnoticed for a period of time). Such nonrepresentative or abnormal observations are called outliers and should be disregarded when
analysing a mixed cost.
Next changes in activity and cost are determined by subtracting low values from high values.
These changes are used to calculate the b (variable unit cost) value in the y = a + bX formula as
follows:
=
Cost at High Activity Level Cost at Low Activity Level

High Activity Level Low Activity Level
=
Change in the Total Cost

Change in Activity Level
The b value is the unit variable cost per measure of activity. This value is multiplied by the activity
level to determine the amount of total variable cost contained in total cost at either (high or low)
level of activity. The fixed portion of a mixed cost is then found by subtracting total variable cost
from total cost.
Total mixed cost changes with changes in activity. The change in the total mixed cost is equal to
the change in activity times the unit variable cost; the fixed cost element does not fluctuate with
changes in activity.
3. Absorption Costing
Absorption costing is the product-costing systems that included both variable and fixed
manufacturing overhead in the product costs that flow through the manufacturing accounts. This
Page | 39
approach to product costing is called absorption costing (also known as full costing), because all
manufacturing-overhead costs are applied to (or absorbed by) manufactured goods.
Figure 7: Absorption costing
Absorption costing treats the costs of all manufacturing components (direct material, direct
labour, variable overhead, and fixed overhead) as inventoriable or product costs in accordance
with generally accepted accounting principles (GAAP). Under absorption costing, costs incurred
in the nonmanufacturing areas of the organization are considered period costs and are expensed
in a manner that properly matches them with revenues.
Suppose that a company makes and sells 100 units of a product each week. The direct cost per
unit is $6 and the unit sales price is $10. Production overhead costs $200 per week and
administration, selling and distribution overhead costs $150 per week.
The weekly profit could be calculated as follows.
$
Sales (100 units $10)
$
1,000
Direct costs (100 $6)
600
Production overheads
200
Administration, selling, distribution costs
150
950
Profit
50
In absorption costing, production overhead costs will be added to each unit of product
manufactured and sold.
$ per unit
Direct cost per unit
Production overhead ($200 per week for 100 units)
Full factory cost
The weekly profit would be calculated as follows.

$
Page | 40
Sales
1,000
Less factory cost of sales (100 $8)
800
Gross profit
200
Less administration, selling, distribution costs
150
Net profit
50
If an organisation produced a single standard product (or provided a single standard service)
then the overhead cost per unit would be calculated by dividing the total overhead costs among
the total units produced.
In practice, firms produce a variety of products or services, or single products in different sizes,
and a fair method of sharing overhead costs between the products or services needs to be
established.
3.1. Advantages of Absorption Costing System

Following are the main advantages of absorption costing system:
Absorption costing recognizes fixed costs in product cost. As it is suitable for determining
price of the product. The pricing based on absorption costing ensures that all costs are covered.
Absorption costing will show correct profit calculation than variable costing in a situation
where production is done to have sales in future (e.g. seasonal production and seasonal sales).
Absorption costing conforms to accrual and matching accounting concepts which
requires matching costs with revenue for a particular accounting period.
Absorption costing has been recognized for the purpose of preparing external reports
and for stock valuation purposes.
Absorption costing avoids the separating of costs into fixed and variable elements.
The allocation and apportionment of fixed factory overheads to cost centres makes
manager more aware and responsible for the cost and services provided to others.
3.2. Absorption Costing Steps

The steps required to complete a periodic assignment of costs to produced goods is:
Page | 41
i.
Assign costs to cost pools: This is comprised of a standard set of accounts that are always
included in cost pools, and which should rarely be changed.
ii.
Calculate usage: Determine the amount of usage of whatever activity measure is used to
assign overhead costs, such as machine hours or direct labor hours used.
iii.
Assign costs: Divide the usage measure into the total costs in the cost pools to arrive at
the allocation rate per unit of activity, and assign overhead costs to produced goods
based on this usage rate.
3.3. Overhead Absorption

Absorbed overhead is manufacturing overhead that has been applied to products or other cost
objects. Overhead is usually applied based on a predetermined overhead allocation rate.
Overhead is overabsorbed when the amount allocated to a product or other cost object is higher
than the actual amount of overhead, while the amount is underabsorbed when the amount
allocated is lower than the actual amount of overhead.
For example, Higgins Corporation budgets for a monthly manufacturing overhead cost of
$100,000, which it plans to apply to its planned monthly production volume of 50,000 widgets at
the rate of $2 per widget. In January, Higgins only produced 45,000 widgets, so it allocated just
$90,000. Also, the actual amount of manufacturing overhead that the company incurred in that
month was $98,000. Therefore, Higgins experienced $8,000 of under-absorbed overhead.
In February, Higgins produced 60,000 widgets, so it allocated $120,000 of overhead. Also, the
actual amount of manufacturing overhead that the company incurred in that month was
$109,000. Therefore, Higgins experienced $11,000 of over-absorbed overhead.
3.4. Absorption Costing Problems

Since absorption costing requires the allocation of what may be a considerable amount of
overhead costs to products, a large proportion of a product's costs may not be directly traceable
to the product. Direct costing or constraint analysis do not require the allocation of overhead to
a product, and so may be more useful than absorption costing for incremental pricing decisions
where you are more concerned with only the costs required to build the next incremental unit of
product.
It is also possible that an entity could generate extra profits simply by manufacturing more
products that it does not sell. This situation arises because absorption costing requires fixed
Page | 42
manufacturing overhead to be allocated to the total number of units produced - if some of those
units are not subsequently sold, then the fixed overhead costs assigned to the excess units are
never charged to expense, thereby resulting in increased profits. A manager could falsely
authorize excess production to create these extra profits, but it burdens the entity with potentially
obsolete inventory, and also requires the investment of working capital in the extra inventory.
3.5. Illustration: overhead apportionment

A simplified example might help to illustrate the absorption costing method.
A manufacturing company produces a range of electronic products at a plant. The plant has two
production departments, department A and department B, and most products are worked on in
both departments before despatch to customers.
Production overheads for a particular period are as follows:
Item of cost
Total cost
$
43,700
60,300
3,000
15,000
22,000
24,000
5,000
4,000
21,000
198,000
Directly attributable to department A

Directly attributable to department B
Factory depreciation
Repairs and maintenance
Stores
Factory office
Equipment insurance
Heating and lighting
Canteen
Total
Department A
Other information is as follows.
Value of plant and machinery
Machine hours worked
Direct labour hours worked
Number of employees
Value of materials requisitioned from stores
Floor area (square metres)
$200,000
3,600
6,000
40
$150,000
18,000
Department B
$300,000
900
18,000
80
$50,000
27,000
How might the production overhead costs be charged to units of production?

In this example, some overhead costs have been directly allocated to each production
department, but other costs are 'shared' by the two departments, and cannot be allocated in full
to either department. These costs must be apportioned between the two departments on a fair
basis.
Page | 43
There are no rules about selecting a basis for apportionment. In this example, it would seem 'fair'
to apportion the cost of depreciation of the factory building on the basis of floor area taken up
by each department, and to apportion the costs of the canteen on the basis of the number of
employees in each department. Other costs might be apportioned in any of several ways. Possible
apportionments are shown in the table below.
Cost item
Basis of apportionment
Allocated costs
Factory depreciation
Repairs and maintenance
Stores
Factory office
Equipment insurance
Heating and lighting
Canteen
Total dept overhead
Floor area
Machine hrs worked
Materials required
Direct labour hours
Value of plant
Floor area
Employee numbers
Total cost
$
104,000
3,000
15,000
22,000
24,000
5,000
4,000
21,000
198,000
Dept A
$
43,700
1,200
12,000
16,500
6,000
2,000
1,600
7,000
90,000
Dept B
$
60,300
1,800
3,000
5,500
18,000
3,000
2,400
14,000
108,000
The calculations are not set out in detail. As an example, the repairs and maintenance cost of
$15,000 has been shared between the departments on the basis of machine hours worked. The
ratio of machine hours is 3,600:900 or 4:1, and the overhead cost has been apportioned between
the two departments on this basis, i.e. $12,000: $3,000.
4. Activity-Based Costing
In keeping with the focus on activities, managerial accountants have developed a system for
determining the cost of producing goods or services called activity-based costing (ABC). In an
ABC system, the costs of the organizations significant activities are accumulated and then
assigned to goods or services in accordance with how the activities are used in the production of
those goods and services. An ABC system helps management understand the causal linkages
between activities and costs.
ABC is a cost allocation method in which costs begin with tracing of activities and then to
producing the product. In other words, it is the process of costing system which focuses on
activities performed to produce products. This system assumes that activities are responsible for
the incurrence of costs and products creates the demand for activities. Costs are charged to
products based on individual product's use of each activity.
ABC systems follow a two-stage procedure to assign overhead costs to products. The first stage
identifies significant activities in the production of the products and assigns overhead costs to
each activity in accordance with the cost of the organizations resources used by the activity. The
Page | 44
overhead costs assigned to each activity comprise an activity cost pool. After assigning overhead
costs to activity cost pools in stage one, cost drivers appropriate for each cost pool are identified
in stage two. Then the overhead costs are allocated from each activity cost pool to each product
line in proportion to the amount of the cost driver consumed by the product line.
The two-stage cost-assignment process of activity-based costing is depicted in the figure below.
In the first stage of the Activity-Based Costing activities are identified and classified into different
categories or segments of the production process. The grouping of activities is preferably done
using the different levels at which activities are performed. Broadly, activities are classified into:
(1) Unit Level Activities
(2) Batch Level Activities
(3) Product Level Activities
(4) Facility Level Activities
(1) Unit Level Activities:
Unit Level Activities are those activities which are performed each time a single product or unit is
produced. These activities are repetitive in nature. For example, direct labour hours, machine
hours, powers etc. are the activities used for each time for producing a single unit. Direct materials
and direct labour activities are also unit level activities, although they do not overhead costs. Cost
of unit level activity vary with the number of units produced.
Page | 45
(2) Batch Level Activity:

These activities which are performed each time a batch of products or group of identical products
are produced. All the units of a particular batch are uniform in nature and in size. The cost of
batch level activities vary with the number of batches are ascertained. Machine setups,
inspections, production scheduling, materials handling are examples of batch level activities
which are related to batches.
(3) Product Level Activities:
These activities which are performed to support the production of each different type of product.
Maintenance of equipment, engineering charges, testing routines, maintaining bills of materials
etc. are the few examples of product level activities.
(4) Facility Level Activities:
Facility Level Activities are those which are needed to sustain a factory's general manufacturing
process. These activities are common to a variety of products and are most difficult to link to
product specific activities. Factory management, maintenance, security, plant depreciation are the
few examples of facility level activities.
For each activity pool or cost pool, a cost per unit of cost driver is then calculated. The costs in
an activity pool are then assigned to products and services on the basis of:
Units of cost driver Cost per unit of cost driver.
4.1 Different Stages in Activity-Based Costing

There are different activities in ABC costing. The following are the important stages of ActivityBased Costing:
(1) Identify the different activities within the organisation
(2) Relate the overhead cost to the activities
(3) Support activities are then spread across the primary activities
(4) Determine the activity cost drivers
(5) Calculate the activity cost drivers rate, i.e., the quantity of cost driver used by each product
Page | 46
4.2 ABC and Cost Drivers

In Activity-Based Costing, activities are identified and classified into different categories that have
relationship with the different stages or parts of the production process. The factors that influence
the cost of a particular activity are known as "Cost Drivers." A Cost Driver is literally the factors,
forces or events that determine the cost of activities. The process of activity-based costing is
based on the assumption that cost behaviour is influenced by cost drives. It should be understood
that direct costs do not need cost drivers because direct costs are themselves cost drivers. They
can be traced by direct relationship with the different parts of product.
However, all other factory, office and administrative overheads need cost drives.
Examples of Cost Drivers
In order to trace overhead costs to manufacturing a product, suitable Cost Drivers should be
identified. The following are the few examples of Cost Drivers in Activity-Based Costing:
Activity
Cost Drivers
Ordering
Number of receiving order
Delivery
Number of deliveries;
Number of physical delivery and receipt of goods;
Kilometres travelled per delivery
Order Taking
Number of Purchase orders
Customer Visit
Number of customers' visits
Placing Orders
Number placing orders for purchase
Bottles Returns
Number of returning or empty bottles
Product Handling
Number Material handling hours
Materials handling
Number of materials receipts
Labour Transactions
Amount of labour cost incurred
Inspection
Number of inspections
There are no standard rules about what the cost driver should be for a particular activity, and an
organisation should select the cost driver that seems most appropriate for each of its activity
pools.
Page | 47
4.3 Difference between Activity-Based Costing and Conventional Costing

Activity-Based Costing
Conventional
Costing
(or)
Traditional
Costing
(1) It begins with identifying activities and
(1) It begins with identifying cost and then to
then to producing the products
producing the products
(2) It mainly focuses on activities performed to
(2) It emphasises mainly on ascertainment of
produce products
costs after they have been incurred
(3) Cost Drivers used for identifying the
(3) Cost unit is used for allocation and
factors that influence the cost of particular
accumulation of costs
activity
(4) Overhead costs are assigned to Cost
(4) Overhead costs are assigned to production
Centre or Cost Pools
departments or service departments
(5) Overhead costs are assigned to products
(5) Overheads allocated on the basis of
using Cost Drivers Rates
departmental overhead allocation rate
(6)
Variable
overhead
is
appropriately
(6) Costs may be allocated or assigned either
identified to individual products
on actual cost incurred or on standard cost
(7) In ABC many activity based on Cost Pools
(7) Overheads are pooled and collected
or Cost Centres are created
department wise
(8) There is no need to allocate and
(8) The process of allocation and re-
redistribution
distribution of the costs of the service
of
overhead
of
service
departments to production departments
departments to production department is

essential to find out total cost of production
(9) It assumes that fixed overhead costs vary
(9) It assumes that fixed overheads do not vary
in proportion to changes in the volume of
with changes in the volume of output.
output.
4.4 Illustration: ABC Costing

A company manufactures two products, P and Q. The manufacturing process is highlyautomated. The following information relates to production in one year.
Number of units produced
Number of batches
Page | 48
Product P
500,000
500
Product Q
20,000
200
Batch size
Average number of orders per batch
Direct materials cost per unit
Direct labour time per unit
Direct labour cost per hour
Machine hours per unit
Number of set-ups per batch
1,000 units
2
$5
0.05 hours
$10
0.08 hours
2
100 units
3
$10
0.05 hours
$10
0.25 hours
4
Annual overhead costs:

$
900,000
880,000
630,000
450,000
Annual volume
1,800 set-ups
1,600 orders
700 batches
45,000 machine hours
26,000 direct labour hours
The total production overhead costs for the year are $2,860,000.
Set-up costs
Order processing costs
Handling costs
Other production overheads
A system of ABC is used.

Set-up costs are charged to products on the basis of a cost per set-up.
Order processing costs are charged on the basis of a cost per order.
Handling costs are charged on the basis of a cost per batch.
Other production overheads are assigned to product costs on a machine hour basis.
The cost per unit for each cost driver is calculated as follows.
Cost pool
Set-up
Order processing
Handling
Other costs
Total cost
$
900,000
880,000
630,000
450,000
Activity level
Cost per unit of cost

driver
1,800 set-ups
1,600 orders
700 batches
45,000 machine hours
$500 per set-up

$550 per order
$900 per batch
$10 per m/c hour
Product costs are now calculated as follows:

Activity
Set-ups
Orders
Batches
Machine hours
Direct materials
Direct labour
Set-up costs
Page | 49
Total
1,800
1,600
700
45,000
Product P
1,000
1,000
500
40,000
Product Q
800
600
200
5,000
Total
Product P
500,000 units
$
2,500,000
250,000
500,000
Product Q
20,000 units
$
200,000
10,000
400,000
$
2,700,000
260,000
900,000
Order processing costs

Handling costs
Other overheads
Total costs
Cost per unit
880,000
630,000
450,000
5,820,000
550,000
450,000
400,000
4,650,000
$9.30
330,000
180,000
50,000
1,170,000
$58.50
If this company had used traditional absorption costing instead of ABC, the production overheads
would possibly have been absorbed into production costs on a direct labour hour basis. The
overhead recovery rate per direct labour hour would have been $110 per direct labour hour
(2,860,000/26,000 hours). The production overhead cost for one unit of each product would have
been 0.05 hours $110 per hour = $5.50.
The costs of each product would then have been as follows:
Direct materials
Direct labour
Production overhead
Units produced
Total cost
Product P
$
5.0
0.5
5.5
11.0
500,000
$5,500,000
Product Q
$
10.0
0.5
5.5
16.0
20,000
$320,000
$5,820,000
The total production costs would have been the same as with ABC, $5,820,000, but the costs have
been assigned to the two products differently. With ABC, Product Q receives a higher charge for
overhead costs, because of the smaller batch sizes, the larger number of orders per batch, the
larger number of setups per batch and the larger number of machine hours required for each
unit.
Page | 50
Chapter 4: Managing Budgets

Budgeting is an important part of an organisations entire planning process. As with other
planning activities, budgeting helps provide a focused direction or a path chosen from many
alternatives. Management generally indicates the direction chosen through some accounting
measure of financial performance, such as net income, earnings per share, or sales level expressed
in dollars or units. Such accounting-based measures provide specific quantitative criteria against
which future performance (also recorded in accounting terms) can be compared. Thus, a budget
is a type of standard, allowing variances to be computed.
Budgets are the financial culmination of predictions and assumptions about achieving not only
financial but also nonfinancial goals and objectives. Nonfinancial performance goals and
objectives may include throughput, customer satisfaction, defect minimisation, and on-time
deliveries. Budgets can help identify potential problems in achieving specified organizational
goals and objectives. By quantifying potential difficulties and making them visible, budgets can
help stimulate managers to think of ways to overcome those difficulties before they are realized.
Cross-functional teams are often used to balance the various agendas of functional management
throughout the firm.
A well-prepared budget can also be an effective device to communicate objectives, constraints,
and expectations to all organizational personnel. Such communication promotes understanding
of what is to be accomplished, how those accomplishments are to be achieved, and the manner
in which resources are to be allocated. Determination of resource allocations is made, in part,
from a process of obtaining information, justifying requests, and negotiating compromises.
The budget sets the resource constraints under which managers must operate for the upcoming
budget period. Thus, the budget becomes the basis for controlling activities and resource usage.
1. Purpose and Functions of a Budget

Budgeting in its general sense is the act of quantifying objectives in financial terms. Budgeting
assists managers in decision making process in an organization. It is the function of the
management accountant to provide information needed in budgeting process. A management
accountant must be happy with the functions of budgeting described here.
Broadly speaking, budgeting performs the following functions in a company:
Page | 51
FORECASTING: this entails making at calculated attempt into knowing what the future holds.
Forecasting may not be perfect as evidence has shown but it is better to have a forecast to work
with than not having any as this will help get prepared. There are many statistical tools developed
over the years to help managers and accountants make better forecast.
Forecasting is a complex exercise that requires to consider many variables in the light of; the
action of competitors, government actions, economic outlook, relationship between price and
demands, etc.
PLANNING: generally speaking, planning depends on forecast that has been made in the past
to make decision about the future. The estimated data generated by forecasting are used to make
plans.
Government agencies, for example health authorities use forecast from estimated population to
plan on the number of health centres to open in a community and the number of beds and other
health equipment that will be put in that hospital.
Business also use forecast figure to estimate the use of materials and make plans to ensure that
they are provided as and when due.
Financial models on computers makes the mixture of variables on an what if scenario possible
so that the best possible mix of variables are achieved. Spreadsheet is one of the most popular
financial models to use for planning and forecasting.
COMMUNICATION: budgeting in an organisation acts as a communication tool in the following
ways:
Gathering information: information about a company and the activities of its competitors are
gathered during the process of making all kinds of budget. It is quite impossible for a single
individual to gather all these information that are needed to make a functional budget.
Managers and other non-managerial staff will need to be consulted and information
obtained from them. This information will then be analysed, challenged and criticised in order
to come up with filtered information.
Disseminating information: budgets when not acted upon are useless, so, the budgetary
system has an inbuilt information dissemination ability that ensures that responsible
managers actually got the budget which they will work with.
Page | 52
Budgeting committee is usually formed to act as a forum where representatives from different
parts of the business will assemble to iron out issues that relates to resource planning of the
business.
MOTIVATION: motivation is the driving force that makes people to run towards their goals rather
than trudge towards it. Motivation is a relative and subjective term, we are not here to discuss
motivation but, to see how budgeting affects the motivation of staff.
Two factors needs to be considered here: how to make people follow a budget, and setting the
difficulty level of budgeting. There are two main approaches that companies can employ to make
their staff heed towards a budget, each having its advantages and disadvantages. They are
Authoritarian method and participatory method, these two approaches represent two extremes.
The ideal method that is actually used in practice is the one that strive to achieve a balance
between the two extremes.
Again, budgets can either be made so difficult or so easy. For a budget to motivate staff, its level
of difficulty must be somewhere around the middle of difficulty and easiness.
EVALUATION: evaluation means to judge something with a sort of standard. The budget
represents that target performance which will then be compared with actual performance. And
this will then lead to corrective action being taken.
If not handled with, evaluation can encourage actions that will harm the organisation in the long
run.
Again, there are some non-quantifiable aspects of a business that is hard to measure. Examples
are; customer services, staff morale, innovation, environmental friendliness, etc.
There are non-financial factors that have effects on investment appraisal that must be considered
before judging a manager as to whether he or she properly managed the investment under his
or jurisdiction. Other business success factors equally needs to be considered.
CONTROL/ CO-ORDINATION: Budgeting is very important for an organisation to grow with
proper coordination.
Co-ordination simply means ensuring that different parts of the business work in congruence.
For example, it will be useless employing sales force that can sell 2,000,000 units of an item when
all that your company has the capacity of producing is 1,200,000 units of that product. This is not
to say that plans cannot be made to get the remaining 800,000 units from an alternative source,
Page | 53
in fact, this is one of the functions of budgeting- to expose weakness so that plans can be made
to cover for it.
AUTHORISATION: budgeting helps to minimise misappropriation and embezzlement that
would have characterise corporations if a system of authorisation does not exist. Through
authorisation, managers are made more accountable for their spending. A manager that has been
authorised to spend $5,000 dollars in a way will be looking for trouble if she or he spends $5,001
without further authorisation. In fact, budgeting helps to prevent fraud.
2. Process of preparing budget

The procedures involved in preparing a budget will differ from organisation to organisation, but
the step-by-step approach described here is indicative of the steps followed by many
organisations. The preparation of a budget may take weeks, possibly months, and the
management committee responsible for co-ordinating and approving the budget (the 'budget
committee') may meet several times before an organisation's budget is finally agreed.
Step 1
Communicating details of the budget policy and budget guidelines

The long-term plan is the starting point for the preparation of the annual budget. Managers
responsible for preparing the budget must be aware of how their plans for the budget period
should be consistent with the organisation's objectives and strategies. For example, if the
organisation's current strategy calls for a more aggressive pricing policy, the budget must
take this into account. Managers should also be provided with important guidelines for wage
rate increases, changes in productivity and so on, as well as information about industry
demand and output.
Step 2
Determining the factor that restricts output

The principal budget factor (also known as the key budget factor or limiting budget factor) is
the factor that sets a limit on what the organisation can do within the budget period. Activity
might be restricted by limited sales demand, in which case sales are the limiting factor.
Alternatively, activity levels may be restricted by a shortage of a key resource, such as skilled
labour, capital equipment or cash.
For example, suppose that a company's sales department estimates that it could sell 1,000
units of product X, which would require 5,000 hours of grade A labour to produce. If there
Page | 54
are no units of product X already in inventory, and only 4,000 hours of grade A labour
available in the budget period, then the company would be unable to sell 1,000 units of X
because of the shortage of labour hours. Grade A labour would be a limiting budget factor,
and the company's management must choose one of the following options.
Reduce budgeted sales by 20%.
Try to increase the availability of grade A labour by 1,000 hours (25%) by recruitment or
overtime working.
Try to sub-contract the production of 1,000 units to another manufacturer at a cost which
will generate a profit on the transaction.
Step 3
Prepare the sales budget

In most organisations the principal budget factor is sales demand: a company is usually
restricted from making and selling more of its products because there would be no sales
demand for the increased output at a price which would be acceptable/profitable to the
company. The sales budget is therefore normally the primary budget from which the majority
of the other 'functional' budgets are derived.
Step 4
Initial preparation of budgets

After the sales budget has been drafted, other functional budgets can be prepared. The
functional budgets for a manufacturing organisation are likely to be as follows.
Budget
Detail
Finished goods
Decides the planned increase or decrease in inventory levels of
inventory budget
finished goods.
Production
Stated in units of each product and is calculated as the sales budget
budget
in units plus the budgeted increase in finished goods inventory or

minus the budgeted decrease in finished goods inventories.
Budgets of
Materials usage budget. This is a budget for the quantities of
resources for
materials and components required for production. It is stated in
production
quantities and cost for each type of material used. It should take
into account any budgeted losses or materials wastage in
production.
Page | 55
Machine utilisation budget. This is the budget for the operating

hours required on each machine or group of machines.
Labour budget or wages budget. This is a budget for the
quantities of direct labour needed to achieve the production
budget. It will be expressed in hours for each grade of labour and
in terms of cost. It should take into account any budgeted idle time.
Overhead cost
Production overheads
budgets
Administration overheads
Selling and distribution overheads
Research and development department overheads
Raw materials
Decides the planned increase or decrease of the level of inventories
inventory budget
of raw materials.
Raw materials
Can be prepared in quantities and value for each type of material
purchase budget
purchased. This budget can be prepared once the raw material

usage requirements are known, and a decision has been taken on
planned increases or decreases in the levels of raw materials
inventory.
Overhead
When the organisation uses absorption costing, predetermined
absorption rate
overhead absorption rates can be calculated once the production

budget and the overhead cost centre budgets have been prepared.
Step 5
Negotiation of budgets with superiors

Budgets are prepared in draft form, discussed with senior managers, and (usually) revised. A
functional budget might go through several drafts until it is eventually approved.
Step 6
Co-ordination of budgets
It is unlikely that the above steps will be problem-free. The functional budgets must be
reviewed in relation to one another. Such a review may indicate that some budgets are out
of balance with others and need modifying. Inconsistencies should be identified by a senior
manager and brought to the attention of the manager or managers concerned, with a request
to revise the budget. The revision of one budget may lead to the revision of all budgets.
Step 7
Final acceptance of the budget
Page | 56
When all the budgets are in harmony with one another they are summarised into a master
budget consisting of a budgeted income statement, budgeted statement of financial position
and cash budget.
Step 8
Budget review
The budgeting process does not stop once the budgets have been agreed. Actual results
should be compared on a regular basis with the budgeted results. The frequency with which
such comparisons are made depends very much on the organisation's circumstances and the
sophistication of its control systems but it should occur at least monthly. Management should
receive a report detailing the differences and should investigate the reasons for the
differences. If adverse differences are within the control of management, corrective action
should be taken to bring the reasons for the difference under control and to ensure that such
inefficiencies do not occur in the future.
3. Types of Budget
Different types of budgets serve different purposes. A master budget, or profit plan, is a
comprehensive set of budgets covering all phases of an organizations operations for a specified
period of time.
We classify budget in three ways:
On the basis of functionality
On the basis of flexibility
On the basis of period
3.1. Functional Budget

The master budget, the principal output of a budgeting system, is a comprehensive profit plan
that ties together all phases of an organizations operations. The master budget comprises many
separate budgets, or schedules, that are interdependent. Following figure portrays these
interrelationships in a flowchart.
Page | 57
Figure 8: Components of a Master Budget
3.1.1. Sales budget

The starting point for any master budget is a sales revenue budget based on a sales forecast for
services or goods. Airlines forecast the number of passengers on each of their routes. Banks
forecast the number and dollar amount of consumer loans and home mortgages to be provided.
Hotels forecast the number of rooms that will be occupied during various seasons. Manufacturing
and merchandising companies forecast sales of their goods.
Various procedures are used in sales forecasting, and the final forecast usually combines
information from many different sources. Many firms have a top-management-level market
research staff whose job is to coordinate the companys sales forecasting efforts.
Typically, everyone from key executives to the firms sales personnel will be asked to contribute
sales projections.
Page | 58
The starting point in the sales forecasting process is generally the sales level of the prior year.
Then the market research staff considers the information discussed above along with input from
key executives and sales personnel. In many firms, elaborate econometric models are built to
incorporate all the available information systematically. Statistical methods, such as regression
analysis and probability distributions for sales, are often used. All in all, a great deal of effort
generally goes into the sales forecast, since it is such a critical step in the budgeting process.
Making a sales forecast is like shooting an arrow. If the archers aim is off by only a fraction of an
inch, the arrow will go further and further astray and miss the bulls eye by a wide margin.
Similarly, a slightly inaccurate sales forecast, coming at the very beginning of the budgeting
process, will throw off all of the other schedules comprising the master budget.
The first step in developing Buzinuss Ltd.s 20x2 master budget is to prepare the sales budget,
which is displayed as schedule 1. This budget displays the projected sales in units for each quarter
and then multiplies the unit sales by the sales price to determine sales revenue. Notice that there
is a significant seasonal pattern in the sales forecast, with the bulk of the sales coming in the
spring and summer.
Buzinuss Ltd.
Figure 9: Schedule 1-Sales Budget
3.1.2. Production budget

A manufacturing company develops a production budget, which shows the number of product
units to be manufactured. Coupled with the production budget are ending-inventory budgets for
raw material, work in process, and finished goods. Manufacturers plan to have some inventory
on hand at all times to meet peak demand while keeping production at a stable level. From the
production budget, a manufacturer develops budgets for the direct materials, direct labor, and
overhead that will be required in the production process. A budget for selling and administrative
expenses also is prepared.
Page | 59
The operational portion of the master budget of merchandising firm is similar in a

merchandising firm, but instead of a production budget for goods, a merchandiser develops a
budget for merchandise purchases. A merchandising firm will not have a budget for direct
material, because it does not engage in production. However, the merchandiser will develop
budgets for labor (or personnel), overhead, and selling and administrative expenses.
Based on the sales budget for its services, a service industry firm develops a set of budgets that
show how the demand for those services will be met. An airline, for example, prepares the
following operational budgets: a budget of planned air miles to be flown; material budgets for
spare aircraft parts, aircraft fuel, and in-flight food; labor budgets for flight crews and
maintenance personnel; and an overhead budget.
The production budget shows the number of units of services or goods that are to be produced
during a budget period. Buzinuss Ltd.s production budget, displayed as schedule 2, determines
the number of tents to be produced each quarter based on the quarterly sales projections in the
sales budget. Schedule 2-Production budget is based on the following formula.
Sales in Units + Desired ending inventory of finished goods
= Totals units required Expected beginning inventory of finished goods
= Units to be made
Focus on the second-quarter column in the figure below, which is shaded. Expected sales are
15,000 tents, and Edwards desires to have 2,000 finished units on hand at the end of the quarter.
This is 10 percent of the expected sales for the third quarter. However, 1,500 tents are expected
to be in inventory at the beginning of the second quarter. Thus, only 15,500 tents need to be
produced.
Buzinuss Ltd.
Page | 60
Figure 10: Schedule 2- Production Budget
3.1.3. Material budget

The direct-material budget shows the number of units and the cost of material to be purchased
and used during a budget period. Buzinuss Ltd.s direct-material budget, which is displayed as
schedule 3, has two sections: one for tent fabric and one for tent poles. As is true for almost all
manufacturers, Buzinuss Ltd.s direct-material cost is a unit-level cost. Each tent requires 12 yards
of fabric and one tent pole kit. The tent poles required for each tent are prepackaged in a kit by
the vendor in Kansas City and delivered to Cozycamp.com on a just-in-time basis. The top section
of Buzinuss Ltd.s direct-material budget shows the total amount of tent fabric needed to make
tents during each quarter. This part of the budget is based on the following formula:
Raw material required for production + Desired ending inventory of raw materials
= Total material required Expected beginning inventory of raw material
= Raw material to be procured
3.1.4 Labour budget

The direct-labour budget shows the number of hours and the cost of the direct labour to be used
during the budget period. Buzinuss Ltd.s direct-labour budget is displayed as schedule 4. Based
on each quarters planned production, this schedule computes the amount of direct labour
needed each quarter and the cost of the required labour. Buzinuss Ltd. is a relatively small
company, and owner Mary Edwards hires all of her direct-labour production employees on a parttime basis only. This allows Buzinuss Ltd. to meet the labour demands of a given time period,
which vary significantly with the seasonal pattern of demand and production. Thus, Buzinuss Ltd.s
Page | 61
direct labour may be adjusted up or down to meet short-term needs. As a result, direct labour
for this company is a unit-level cost. As schedule 4 shows, each tent manufactured requires half
an hour of direct labour.
It is useful to use the standard labour hour in preparing budget for labour requirements. A
standard labour hour is the quantity of work achievable at standard performance (the standard
rate of efficiency), expressed in terms of a standard unit of work done in a standard period of
time.
Budgeted output of different products or jobs in a period can be converted into standard hours
of production, and a labour budget constructed accordingly.
Standard hours are particularly useful when management wants to monitor the production levels
of a variety of dissimilar units. For example product A may take five hours to produce and product
B, seven hours. If four units of each product are produced, instead of saying that total output is
eight units, we could state the production level as: (4 5) + (4 7) standard hours = 48 standard
hours.
Page | 62
Buzinuss Ltd.
Figure 11: Schedule 3- Material Budget
Page | 63
Buzinuss Ltd.
Figure 12: Schedule 4- Labour Budget
3.1.5 Manufacturing overhead budget

The manufacturing-overhead budget shows the cost of overhead expected to be incurred in the
production process during the budget period. Buzinuss Ltd.s manufacturing overhead budget,
displayed as schedule 5, lists the expected cost of each overhead item by quarter. At the bottom
of the schedule, the total budgeted overhead for each quarter is shown. Then each quarters
depreciation is subtracted to determine the total cash disbursements to be expected for overhead
during each quarter.
3.1.6 Selling, general, and administrative expense budget

The selling, general, and administrative (SG&A) expense budget shows the planned amounts of
expenditures for selling, general, and administrative expenses during the budget period. This
budget lists the expenses of administering the firm and selling its product.
3.1.7 Cash budget

Every business prepares a cash budget. This budget shows expected cash receipts, as a result of
selling goods or services, and planned cash disbursements, to pay the bills incurred by the firm.
The cash budget details the expected cash receipts and disbursements during a budget period.
A cash budget is a statement in which estimated future cash receipts and payments are tabulated
in such a way as to show the forecast cash balance of a business at defined intervals. For example,
in December 20X2 an accounts department might wish to estimate the cash position of the
business during the three following months, January to March 20X3. A cash budget might be
drawn up in the following format.
Page | 64
Jan
Feb
Mar
14,000
16,500
17,000
3,000
4,000
4,500
17,000
22,700
21,500
To suppliers of goods
8,000
7,800
10,500
To employees (wages)
3,000
3,500
3,500
Estimated cash receipts

From credit customers
From cash sales
2,200
Proceeds on disposal of non-current assets

Total cash receipts
Estimated cash payments
16,000
Purchase of non-current assets
1,000
Rent and rates

1,200
1,200
14,700
28,500
16,200
Net surplus/(deficit) for month
2,300
5,800
5,300
Opening cash balance
1,200
3,500
2,300
Closing cash balance
3,500
2,300
3,000
Other overheads
Repayment of loan
1,200
2,500
In this example, the accounts department has calculated that the cash balance at the beginning
of the budget period, 1 January, will be $1,200. Estimates have been made of the cash that is
likely to be received by the business (from cash and credit sales, and from a planned disposal of
non-current assets in February). Similar estimates have been made of cash due to be paid out by
the business (payments to suppliers and employees, payments for rent, rates and other
overheads, payment for a planned purchase of non-current assets in February and a loan
repayment due in January).
From these estimates of cash receipts and payments, it is a simple step to calculate any excess of
cash receipts over cash payments in each month. In some months cash payments may exceed
cash receipts and there will be a deficit for the month; this occurs during February in the above
example because of the large investment in non-current assets in that month.
The last part of the cash budget shows how the business's estimated cash balance can then be
rolled along from month to month. Starting with the opening balance of $1,200 at 1 January, a
cash surplus of $2,300 is generated in January. This leads to a closing January balance of $3,500,
which becomes the opening balance for February. The deficit of $5,800 in February throws the
business's cash position into overdraft and the overdrawn balance of $2,300 becomes the
opening balance for March. Finally, the cash surplus of $5,300 in March leaves the business with
a favourable cash position of $3,000 at the end of the budget period.
Page | 65
What to include in a cash budget

A cash budget shows the expected receipts of cash and payments of cash during a budget period.
Receipts of cash may come from one or more of the following:
Cash sales
Payments by debtors (credit sales)
The sale of non-current assets
The issue of new shares or loan stock and less formalised loans
The receipt of interest and dividends from investments outside the business
Although all of these receipts would affect a cash budget, some of them would not appear in the
income statement.
(a) The issue of new shares or loan stock is an item in the statement of financial position.
(b) The cash received from an asset affects the statement of financial position, and the profit or
loss on the sale of an asset, which appears in the income statement, is not the cash received
but the difference between cash received and the written-down value of the asset at the time
of sale.
Payments of cash may be for one or more of the following:
Purchase of inventories
Payroll costs or other expenses
Purchase of capital items
Payment of interest, dividends or taxation
Not all cash payments are income statement items. For example, payments for the purchase of
capital equipment and the payment of sales tax are not items that appear in the income
statement.
There are several reasons why the profit or loss made by an organisation during an accounting
period does not reflect its cash flow position:
Not all cash receipts affect income as reported in the income statement.
Not all cash payments affect expenditure as reported in the income statement.
Some costs in the income statement such as the depreciation of non-current assets are not
cash items but are costs derived from accounting conventions.
The timing of cash receipts and payments may not coincide with the recording of income
statement transactions. For example, a sale might be made on credit in November, and the
customer might not pay until February. The sale is treated as an income statement item in
November, but it only becomes a cash flow in February, three months later. Similarly, a
company might buy an item for re-sale in March and pay for it in April, but the item might
not be re-sold (for cash) until July. The cash payment would be in April, but the item will not
be a 'cost of goods sold' in the income statement until July.
Page | 66
3.2. Fixed vs Flexible budget

Fixed budgets and flexible budgets both are forms of budgeting that are essential for any
business that wishes to exercise control, induce proper decision making and coordinate business
activities. Fixed budgets are more suitable for businesses that operate in a less dynamic business
environment, whereas flexible budget are best for firms that operate in a turbulent market. A
fixed budget is much easier to prepare than a flexible budget since it does not require constant
revision, whereas flexible budgets are much more complex since the scenarios considered are
greater in number. The accuracy of a flexible budget can be easily affected owing to the variability
of the business environment the firm is in. Flexible budgets are mostly preferred by firms because
they allow the firm to conduct scenario planning and better adjust for unexpected situations.
Flexible budgets are, as their names suggest variable and flexible depending on the variability in
the results expected in the future. Such budgets are most useful for businesses that operate in
an ever changing business environment, and have the need to prepare budgets that are able to
reflect the many outcomes that are possible. The use of a flexible budget ensures that a firm is
prepared to some extent to deal with the unexpected turn around in events, and able to better
guard itself against losses arising from such scenarios. A possible disadvantage of this form of
budgeting is known to be the fact that they may be complicated to prepare, especially when the
scenarios being considered are numerous in number, and complex in nature.
Fixed budgets are used in situations where the future income and expenditure can be known,
with a higher degree of certainty, and have been quite predictable over time. These types of
budgets are commonly used by organisations that do not expect much variability in the business
or economic environment. Fixed budgets are simpler to prepare and less complicated. In addition,
keeping track is easier with fixed budgets, since the budget will not vary from time to time. One
significant disadvantage of using a fixed budget is that it does not account for changes in
expenditure and income over time. Thus, during times of unexpected economic changes the
actual scenario may turn out to be different from what is laid out in a fixed budget.
Flexible budgets apply the principles of marginal costing, and recognise the distinction between
fixed and variable costs.
(a) For some items of expense, it might be necessary to recognise semi-variable costs, and split
these into their variable cost and fixed cost elements.
Page | 67
(b) Some variable unit costs might change if the level of activity rises above a certain level or falls
below a certain level. For example, if output rises above a certain level, it might be necessary
to pay overtime to some employees, or to recruit casual labour at a different rate of pay.
Similarly, if output rises above a certain level, it might be possible to benefit from bulk
purchases of materials or supplies, and so pay a lower unit cost.
(c) Some fixed cost items might show 'step cost' characteristics, and rise by a certain amount as
the level of activity rises above a particular level.
3.3. Long term vs short term budget

Budgets are developed for specific time periods. Short-range budgets cover a year, a quarter, or
a month, whereas long-range budgets cover periods longer than a year. Rolling budgets are
continually updated by periodically adding a new incremental time period, such as a quarter, and
dropping the period just completed.
Rolling budgets are also called revolving budgets or continuous budgets.
The advantages of rolling budgets are as follows:
(a) By producing budgets more frequently than once a year, there is a better likelihood that the
budgets will provide an effective link between strategic planning and operational planning.
They reduce the element of uncertainty in budgeting. Rolling budgets concentrate detailed
planning and control on short-term prospects where the degree of uncertainty is smaller.
(b) They force managers to reassess the budget regularly, and to produce budgets that are upto-date in the light of current events and expectations. For example, if annual budgets are
formulated by adding an allowance for inflation to last year's figures, there is a danger that
the annual rate of inflation will be over-estimated so that the budgets will be too high and
thus encourage overspending by departments. In contrast, quarterly budgets prepared on a
rolling basis are likely to predict inflation rates more accurately because shorter-term
forecasts are used.
(c) Planning and control will be based on a recent plan instead of a fixed annual budget that
might have been made many months ago and which is no longer realistic.
(d) Realistic budgets are likely to have a better motivational influence on managers.
(e) There is always a budget which extends for several months ahead. For example, if rolling
budgets are prepared quarterly there will always be a budget extending for the next 9 to 12
Page | 68
months. If rolling budgets are prepared monthly there will always be a budget for the next
11 to 12 months. This is not the case when fixed annual budgets are used.
The disadvantages of rolling budgets are as follows.
(a) A system of rolling budgets calls for the routine preparation of a new budget at regular
intervals during the course of the one financial year. This involves more time, effort and
money in budget preparation.
(b) Frequent budgeting might have an off-putting effect on managers who doubt the value of
preparing one budget after another at regular intervals, even when there are major
differences between the figures in one budget and the next.
(c) Revisions to the budget might involve revisions to standard costs too, which in turn would
involve revisions to inventory valuations. This could mean that a large administrative effort is
required in the accounts department every time a rolling budget is prepared to bring the
accounting records up to date.
3.4. Zero-based budgeting

Zero-based budgeting is an approach to planning and decision-making that reverses the working
process of traditional budgeting. In traditional incremental budgeting, departmental managers
justify only variances versus past years based on the assumption that the "baseline" is
automatically approved. By contrast, in zero-based budgeting, every line item of the budget,
rather than only the changes, must be approved. Zero-based budgeting requires that the budget
request be re-evaluated thoroughly, starting from the zero-base; this involves preparation of a
fresh budget every year without reference to the past. This process is independent of whether
the total budget or specific line items are increasing or decreasing.
There is a three-step approach to ZBB is:
Define decision packages
Evaluate and rank packages
Allocate resources
3.4.1. Advantages
Efficient allocation of resources, as it is based on needs and benefits rather than history.
Drives managers to find cost effective ways to improve operations.
Detects inflated budgets.
Page | 69
Increases staff motivation by providing greater initiative and responsibility in decisionmaking.
Increases communication and coordination within the organization.
Identifies and eliminates wasteful and obsolete operations.
Identifies opportunities for outsourcing.
Forces cost centers to identify their mission and their relationship to overall goals.
Facilitates more effective delegation of authority
Zero-based budgeting helps in identifying areas of wasteful expenditure, and if desired, can also
be used for suggesting alternative courses of action.
Disadvantages:
More time-consuming than incremental budgeting.
Justifying every line item can be problematic for departments with intangible outputs.
Requires specific training, due to increased complexity vs. incremental budgeting.
In a large organisation, the amount of information backing up the budgeting process

may be overwhelming.
3.5. Activity based budget

Activity-based budgeting (ABB) is a method of budgeting based upon an activity framework,
using cost driver data in budget setting and variance analysis.
Activity-based budgeting is an approach to budgeting that applies many of the concepts of
activity-based costing. It might be particularly relevant, therefore, to high-technology industries,
in which processes are more complex, and quality issues are often important.
Like ZBB, activity-based budgeting is particularly applicable to 'support functions', away from the
factory floor, such as product design, order handling, quality control, customer service and
production planning. It is also applicable to administrative functions, such as personnel and
facilities management.
The approach taken in ABB is to recognise that an organisation consists of a number of activities
rather than a number of departments, and that costs are incurred by activities. Cost drivers can
also be identified for activities. Even within a single department, costs are caused by activities,
and vary with the level of that activity.
Page | 70
For example, within the HR department, some costs might be driven by recruitment numbers (the
costs of setting up personnel records, medical checks, training arrangements, and so on). If so, a
part of the budget for the HR department might be prepared on the basis of the expected number
of employees to be recruited in the budget period.
ABB is an alternative to 'traditional' volume-based models for budgeting, in which costs are either
fixed or vary with the volume of production and sales. It is an approach to planning aimed
primarily at understanding the reason why costs are incurred, and giving planners the opportunity
to manage those costs.
Cost budgets can be prepared on the basis of:
(a) the activities performed in the support areas of the organisation
(b) recognising the cost driver for each of those activities
(c) analysing costs as either variable or fixed in relation to changes in the level of that activity
(d) budgeting what the level of activity will be, and
(e) preparing a cost budget for the activity accordingly.
ABB therefore brings a better analysis of costs into budgeting for overhead operations, compared
with traditional budgeting systems, where overheads are all treated as fixed unless they vary with
output volume.
A further consequence of an activity-based approach might be to identify wasteful spending, i.e.
spending incurred that has no value or purpose in relation to the activities of the organisation. It
might also help managers to identify limiting factors, and constraints on activities.
By focusing on activities, activity-based budgeting encourages managers to think about the most
economical or efficient way of getting something done. For example, suppose that a resources
manager states that he or she needs a new building in which to re-locate a particular operation
that is growing in size. It might well be that obtaining an additional building is the best solution.
However, by looking at the activity, it might be seen that a better solution is to employ more
efficient technology, or to use a more distributive form of doing the work, so that the operation
can be performed without the need for the extra space.
Page | 71
Chapter 5: Breakeven analysis

Breakeven analysis (also known as Cost volume and profit-CVP analysis) is the study of the
interrelationships between costs, output volume and profit at various levels of activity. This
techniques focuses on how selling prices, sales volume, variable costs, fixed costs and the mix of
product sold affects profit. Understanding some of the basic tenets of breakeven analysis can
help analyse these factors in business and make better business decisions. More specifically
breakeven analysis examines the resulting effects on profit due to the shifts in costs and volume.
This analysis is applicable in all economic sectors, including manufacturing, wholesaling, retailing,
and service industries. Breakeven analysis can be used by managers to plan and control more
effectively because it allows them to concentrate on the relationships among revenues, costs,
volume changes, taxes, and profits. The breakeven model can be expressed through a formula or
graphically. All costs, regardless of whether they are product, period, variable, or fixed, are
considered in the breakeven analysis model. The analysis is usually performed on a companywide
basis. The same basic breakeven analysis model and calculations can be applied to a single- or
multiproduct business.
1. The Breakeven Point

Break-even point (BEP) is that level of activity, in units or dollars, at which total revenues equal
total costs. At breakeven, the companys revenues simply cover its costs; thus, the company incurs
neither a profit nor a loss on operating activities. Companies, however, do not wish merely to
break even on operations. The break-even point is calculated to establish a point of reference.
Knowing BEP, managers are better able to set sales goals that should generate income from
operations rather than produce losses. CVP analysis can also be used to calculate the sales volume
necessary to achieve a desired target profit. Target profit objectives can be stated as either a fixed
or variable amount on a before- or after-tax basis. Because profit cannot be achieved until the
break-even point is reached, the starting point of CVP analysis is BEP. Over time, the break-even
point for a firm or even an industry changes.
Finding the break-even point first requires an understanding of company revenues and costs. A
short summary of revenue and cost assumptions is presented at this point.
Relevant range: Relevant range is the range of activity over which a variable cost will remain
constant per unit and a fixed cost will remain constant in total. A primary assumption is that the
Page | 72
company is operating within the relevant range of activity specified in determining the revenue
and cost information used in each of the following assumptions:
Revenue: Revenue per unit is assumed to remain constant; fluctuations in per unit
revenue for factors such as quantity discounts are ignored. Thus, total revenue fluctuates
in direct proportion to level of activity or volume.
Variable costs: On a per-unit basis, variable costs are assumed to remain constant.
Therefore, total variable costs fluctuate in direct proportion to level of activity or volume.
Note that assumed variable cost behaviour is the same as assumed revenue behaviour.
Variable production costs include direct material, direct labour, and variable overhead;
variable selling costs include charges for items such as commissions and shipping.
Variable administrative costs may exist in areas such as purchasing.
Fixed costs: Total fixed costs are assumed to remain constant and, as such, per unit fixed
cost decreases as volume increases. (Fixed cost per unit would increase as volume
decreases.) Fixed costs include both fixed manufacturing overhead and fixed selling and
administrative expenses.
Mixed costs: Mixed costs must be separated into their variable and fixed elements
before they can be used in CVP analysis. Any method (such as regression analysis) that
validly separates these costs in relation to one or more predictors can be used. After
being separated, the variable and fixed cost components of the mixed cost take on the
assumed characteristics mentioned above.
An important amount in break-even and CVP analysis is contribution margin (CM), which can be
defined on either a per-unit or total basis. Contribution margin per unit is the difference between
the selling price per unit and the sum of variable production, selling, and administrative costs per
unit. Unit contribution margin is constant because revenue and variable cost have been defined
as remaining constant per unit. Total contribution margin is the difference between total revenues
and total variable costs for all units sold. This amount fluctuates in direct proportion to sales
volume. On either a per-unit or total basis, contribution margin indicates the amount of revenue
remaining after all variable costs have been covered. This amount contributes to the coverage of
fixed costs and the generation of profits.
The formula approach to break-even analysis uses an algebraic equation to calculate the exact
break-even point. In this analysis, sales, rather than production activity, are the focus for the
Page | 73
relevant range. The equation represents the variable costing income statement and shows the
relationships among revenue, fixed cost, variable cost, volume, and profit as follows:
R(X) - VC(X) - FC = P
Where,
R = revenue (selling price) per unit
X = volume (number of units)
R(X) = total revenue
VC = variable cost per unit
VC(X) = total variable cost
FC = total fixed cost
P = profit
Because the above equation is simply a formula representation of an income statement, P can be
set equal to zero so that the formula indicates a break-even situation.
At the point where P = $0, total revenues are equal to total costs and breakeven point (BEP) in
units can be found by solving the equation for X.
R(X) - VC(X) - FC = $0
R(X) - VC(X) = FC
(R - VC)(X) = FC
X = FC (R - VC)
Comfort Valve Company Income Statement, 20X2
Sales (30,000 units)
Variable Costs:
Production
Selling
Total Variable Cost
Contribution Margin
Fixed Costs:
Production
Selling and administrative
Page | 74
Total
$180,000
$111,600
7,200
(118,800)
$ 61,200
$ 16,020
2,340
Per Unit
$ 6.00
%
100
$ 3.72
0.24
$(3.96)
$ 2.04
62
4
(66)
34
Total Fixed Cost

Income before Income Taxes
(18,360)
$ 42,840
Break-even point volume is equal to total fixed cost divided by (revenue per unit minus the
variable cost per unit). Using the operating statistics shown above for Comfort Valve Company
($6.00 selling price per valve, $3.96 variable cost per valve, and $18,360 of total fixed costs), breakeven point for the company is calculated as:
$6.00(X) - $3.96(X) - $18,360 = $0
$6.00(X) - $3.96(X) = $18,360
($6.00 - $3.96)(X) = $18,360
X = $18,360 ($6.00 - $3.96)
X = 9,000 valves
Revenue minus variable cost is contribution margin. Thus, the formula can be shortened by using
the contribution margin to find BEP.
Hence, breakeven point is fixed cost divided by contribution margin per unit.
2. Breakeven Graph
The breakeven point can also be shown graphically using a breakeven chart.
A breakeven graph is a chart showing levels of profit or loss at different sales volume levels.
A breakeven chart has the following axes:
A horizontal axis showing the sales/output (in value or units)
A vertical axis showing $ for sales revenues and costs
The following lines are drawn on the breakeven chart.
The sales line
Starts at the origin
Ends at the point signifying expected sales
The fixed costs line
Runs parallel to the horizontal axis
Meets the vertical axis at a point which represents total fixed costs
The total costs line
Page | 75
Starts where the fixed costs line meets the vertical axis
Ends at the point which represents the following
Anticipated sales on the horizontal axis
Total costs of anticipated sales on the vertical axis
The breakeven point is the intersection of the sales line and the total costs line.
The distance between the breakeven point and the expected (or budgeted) sales, in units,
indicates the margin of safety.
Illustration: a breakeven graph
The budgeted annual output of a factory is 120,000 units. The fixed overheads amount to $40,000
and the variable costs are 50c per unit. The sales price is $1 per unit.
Construct a breakeven chart showing the current breakeven point and profit earned up to the
present maximum capacity.
We begin by calculating the profit at the budgeted annual output.
$
Sales (120,000 units)
120,000
Variable costs
60,000
Contribution
60,000
Fixed costs
40,000
Profit
20,000
Page | 76
(a) The vertical axis represents money (costs and revenue) and the horizontal axis represents the
level of activity (production and sales).
(b) The fixed costs are represented by a straight line parallel to the horizontal axis (in our
example, at $40,000).
(c) The variable costs are added 'on top of' fixed costs, to give total costs. It is assumed that fixed
costs are the same in total and variable costs are the same per unit at all levels of output.
The line of costs is therefore a straight line and only two points need to be plotted and joined
up. Perhaps the two most convenient points to plot are total costs at zero output, and total costs
at the budgeted output and sales.
At zero output, costs are equal to the amount of fixed costs only, $40,000, since there are
no variable costs.
At the budgeted output of 120,000 units, costs are $100,000.

$
Fixed costs
40,000
Variable costs 120,000 50c
60,000
Total costs
100,000
(d) The sales line is also drawn by plotting two points and joining them up.
Page | 77
i.
At zero sales, revenue is nil.
ii.
At the budgeted output and sales of 120,000 units, revenue is $120,000.
The breakeven point is where total costs are matched exactly by total revenue. From the chart,
this can be seen to occur at output and sales of 80,000 units, when revenue and costs are both
$80,000. This breakeven point can be proved mathematically as:
Required contribution=fixed costs
Contribution per unit
$40,000
50c per unit
= 80,000
Breakeven graphs are used as follows.
To plan the production of a company's products
To market a company's products
To give a visual display of breakeven arithmetic
Breakeven graphs can also be used to show variations in the possible sales price, variable costs
or fixed costs.
3. Application of CVP and BEP

The cost-volume-profit relationships that underlie break-even calculations and CVP graphs have
wide-ranging applications in management. We will look at several common applications:
Safety Margin
The safety margin of an enterprise is the difference between the budgeted sales revenue and the
break-even sales revenue. Suppose Comfort Valve Ltds business manager expects all valves to
be sold out. Then budgeted monthly sales revenue is $180,000 (30,000 valve x $6 per valve). Since
break-even sales revenue is $54,000, the organisations safety margin is $126,000 ($180,000 $54,000). The safety margin gives management a feel for how close projected operations are to
the organisations break-even point.
Profit and Loss Areas
The CVP graph discloses more information than the breakeven calculation. From the graph, a
manager can see the effects on profit of changes in volume. The vertical distance between the
lines on the graph represents the profit or loss at a particular sales volume. As shown in Figure
13, if Seattle Capital Institute sells fewer than 8,000 tickets in a month, the organisation will suffer
Page | 78
a loss. The magnitude of the loss increases as ticket sales decline. The institute will have a profit
if sales exceed 8,000 tickets in a month.
Target Profit
The board of trustees for Seattle Capital Institute would like to run free workshops and classes
for young investors. This programme would cost $3,600 per month in fixed expenses, including
teachers salaries and rental of space at a local college. No variable expenses would be incurred.
If Seattle Capital Institute make a profit of $3,600 per month on its programme, the Seattle
Training Centre could be opened. The board has asked Andrew Lloyd, the organisations business
manager and producer, to determine how many tickets must be sold during each programmes
one-month run to make a profit of $3,600.
The desired profit level of $3,600 is called a target net profit (or income). The problem of
computing the volume of sales required to earn a particular target net profit is very similar to the
problem of finding the break-even point. After all, the break-even point is the number of units of
sales required to earn a target net profit of zero.
Figure 13: Profit-Volume Graph, Seattle Capital Institute
Each ticket sold by Seattle Capital Institute has a unit contribution margin of $6 (sales price of
$16 minus unit variable expense of $10). Eight thousands tickets of these $6 contributions will
Page | 79
contribute just enough to cover fixed expenses of $48,000. Each additional ticket sold will
contribute $6 toward profit.
Required contribution+fixed costs

= Number of Sales required to earn target net profit
Contribution per unit
$48,000 + $3,600
= 8,600
$6
Page | 80
Chapter 6: Costing Decisions

1. Relevant Costs for Decision Making
Managers are charged with the responsibility of managing organizational resources effectively
and efficiently relative to the organizations goals and objectives. Making decisions about the use
of organizational resources is a key process in which managers fulfil this responsibility.
Accounting and finance professionals contribute to the decision-making process by providing
expertise and information.
Accounting information can improve, but not perfect, managements understanding of the
consequences of decision alternatives. To the extent that accounting information can reduce
managements uncertainty about economic facts, outcomes, and relationships involved in various
courses of action, such information is valuable for decision-making purposes.
Relevant costing focuses managerial attention on a decisions relevant (or pertinent) facts.
Relevant costing techniques are applied in virtually all business decisions in both short-term and
long-term contexts. In making a choice among the alternatives available, managers must consider
all relevant costs and revenues associated with each alternative.
A relevant cost or benefit is a cost or benefit that differs between alternatives. Differential costs
are relevant costs. Any cost or benefit that does not differ between alternatives is irrelevant and
can be ignored in a decision. To identify which costs are relevant in a particular situation, take
this three step approach:
1.
Eliminate sunk costs
2.
Eliminate costs and benefits that do not differ between alternatives]
3.
Compare the remaining costs and benefits that do differ between alternatives to
make the proper decision
Five separate types of decisions are discussed in as follows:
Adding and Dropping Product Lines and Other Segments
Make or Buy Decisions
Special Orders
Utilization of a Scarce Resources
Sell or Process further Decisions
Page | 81
2. Cost behaviour and decision making

Cost can be classified into (i) fixed, (ii) variable and (iii) mixed and (iv) step costs, in terms of their
variability or changes in cost behaviour in relation to changes in output, or activity or volume.
Activity may be indicated in any forms such as units of output, hours worked, sales, etc. The
concept of predictable cost behaviour based on volume is very important to the effective use of
accounting information for managerial decision making.
2.1. Fixed Cost

Fixed cost is a cost which does not change in total for a given time period despite wide
fluctuations in output or volume of activity.
Fixed costs are costs that remain the same in total but vary per unit when production volume
changes. Facility-level costs, such as rent, depreciation of a factory building, the salary of a plant
manager, insurance, and property taxes, are likely to be fixed costs. Summarizing this cost
behaviour, fixed costs stay the same in total but vary when expressed on a per unit basis.
Rent is a good example. If the cost to rent a factory building is $10,000 per year and 5,000 units
of product are produced, the rent per unit is $2.00 ($10,000/5,000). If production volume
decreases to 2,500 units per year, the cost per unit will increase to $4.00 ($10,000/2,500). If
production volume increases to 7,500 units, the cost per unit decreases to $1.33 ($10,000/7,500)
per unit. However, the total rent remains $10,000 per year (see Figure 14 below).
Figure 14: The Behaviour of Fixed Costs
Page | 82
2.2. Variable Cost:

Variable costs vary in direct proportion to changes in production volume but are constant when
expressed as per unit amounts. As production increases, variable costs increase in direct
proportion to the change in volume; as production decreases, variable costs decrease in direct
proportion to the change in volume. Examples include direct material, direct labour (if paid per
unit of output), and other unit-level costs, such as factory supplies, energy costs to run factory
machinery, and so on.
Figure 15: The behaviour of Variable Costs
Consider the behaviour of direct material costs as production increases and decreases. If the
manufacture of a standard classroom desk requires $20 of direct material (wood, hardware, etc.),
the total direct material costs incurred will increase or decrease proportionately with increases
and decreases in production volume. If 5,000 desks are produced, the total direct material cost
will be $100,000 (5,000 x $20). If production volume is increased to 7,500 units (a 50 percent
increase), direct material costs will also increase 50 percent to $150,000 (7,500 x $20). However
the cost per unit is still $20. Likewise, if production volume is decreased to 2,500 desks, direct
material costs will decrease by 50 percent to $50,000. But once again, the cost per unit remains
$20 (see Figure 15 above).
2.3. Step Costs

Classification of costs is not always a simple process. Some costs vary but only with relatively
large changes in production volume. Batch-level costs related to moving materials may vary with
Page | 83
the number of batches of product produced but not with every unit of product. Product-level
costs associated with quality control inspections may vary when new products are introduced.
Costs like these are sometimes referred to as step costs. In practice, step costs may look like and
be treated as either variable costs or fixed costs.
Although step costs are technically not fixed costs, they may be treated as such if they remain
constant within a relatively wide range of production. Consider the costs of janitorial services
within a company. As long as production is below 7,500 desks, the company will hire one janitor
with salary and fringe benefits totaling $25,000. The cost is fixed as long as production remains
below 7,500 units. However, if desk production exceeds 7,500, which increases the amount of
waste and cleanup needed, it may be necessary to hire a second janitor at a cost of another
$25,000. However, within a relevant range of production between 7,501 and 15,000 units, the cost
is essentially fixed ($50,000). A graphical representation of a step cost is shown in the figure
below.
Figure 16: The behaviour of step costs
Page | 84
2.4. Mixed costs

Mixed costs present a unique challenge because they include both a fixed and a variable
component. Consequently, it is difficult to predict the behavior of a mixed cost as production
changes unless the cost is first separated into its fixed and variable components. A good example
of a mixed cost is the cost of a delivery vehicle for KenCor. Lets assume that KenCor enters into
a lease agreement that calls for a lease payment of $400 per month for a new delivery van. Every
month, KenCor is required to make the $400 payment, regardless of whether any deliveries are
made; hence, $400 of the cost is fixed. However, KenCor also incurs costs related to driving the
vehicle (gasoline, oil, maintenance costs, etc.) that vary with the number of deliveries made (and
miles driven). If these costs average $1.50 per delivery and 200 deliveries are made during the
month, KenCor will incur an additional $300 of variable costs for a total cost of $700. If 100
deliveries are made, the additional cost will be
$150. Although the variable portion of the cost of the delivery van varies in total as the number
of deliveries increases or decreases, it remains fixed when expressed per unit ($1.50 per delivery).
On the other hand, the fixed portion of the cost remains constant in total ($400) but varies when
expressed per unit.
Although the fixed and variable components of a cost are obvious, they may be difficult to
identify. For example, KenCor has incurred the following overhead costs over the last 7 weeks:
Week
1 (Start-up)
2
3
4
5
6
7
Pizzas
0
423
601
347
559
398
251
Total Overhead Costs

$ 679
1,842
2,350
1,546
2,250
1,769
1,288
Cost per Unit

N/A
$4.35
3.91
4.46
4.03
4.44
5.13
Table 1: Overhead costs of KenCor
Is the overhead cost a fixed, variable, or mixed cost? Clearly, the cost is not fixed, because it
changes each week. However, is it a variable cost? Although the cost changes each week, it does
not vary in direct proportion to changes in production. In addition, remember that variable costs
remain constant when expressed per unit. In this case, the amount of overhead cost per pizza
changes from week to week. A cost that changes in total and also changes per unit is a mixed
cost. As you can see in the figure below, a mixed cost looks somewhat like a variable cost.
However, the cost does not vary in direct proportion to changes in the level of production (you
Page | 85
cant draw a straight line through all the data points) and if a line were drawn through the data
points back to the y-axis, we would still incur overhead cost at a production volume of zero. Like
a fixed cost, a mixed cost has a component that is constant regardless of production volume.
Figure 17: Behaviour of mixed costs
Once we know that a cost is mixed, we are left with the task of separating the mixed cost into its
fixed and variable components.
A variety of tools can be used to estimate the fixed and variable components of a mixed cost.
When we separate a mixed cost into its variable and fixed components, what we are really doing
is generating the equation for a straight line, with the y-intercept estimating the fixed cost (and
the slope estimating the variable cost per unit.
= + ()
Where,
= Total overhead costs
= Fixed costs
= Variable cost per unit
= number of pizzas
A statistical technique used to estimate the fixed and variable components of a mixed cost is
called least squares regression. Regression analysis uses statistical methods to fit a cost line
(called a regression line) through a number of data points. Note that although the data points in
our example do not lie along a straight line, regression analysis statistically finds the line that
Page | 86
minimises the sum of the squared distance from each data point to the line (hence the name
least squares regression).
If we did not have access to a computer regression program or for some reason did not want to
use this tool, we could estimate the regression equation using a simpler technique called the
high/low method. The high/low method uses only two data points (related to the high and low
levels of activity) and mathematically derives an equation for a straight line intersecting those
two data points. Though technically inferior to regression analysis (which uses all the data points),
from a practical perspective, the high/low method can often provide a reasonable estimate of the
regression equation.
In the table above, the high level of activity occurred in week 3, when 601 pizzas were produced
and $2,350 of overhead cost was incurred. The low level of activity occurred in week 7, when only
251 pizzas were produced and overhead costs totalled $1,288.
The slope of the line connecting those two points can be calculated by dividing the difference
between the costs incurred at the high and low levels of activity by the difference in volume
(number of pizzas at those levels). Remember, the slope of a line is calculated as the change in
cost over the change in volume, in this case the difference in cost to produce pizzas over the
difference in volume of pizzas made. As with the regression equation, the slope of the line is
interpreted as the variable-cost component of the mixed cost:
Variable cost per unit=
Changes in cost
Changes in volume
Inserting the data for KenCor Pizza Emporium, the variable cost is $3.03 per unit ($2,350 $1,288)/(601 - 251).
We then solve for the fixed-cost component by calculating the total variable cost incurred at
either the high or the low level of activity and subtracting the variable costs from the total
overhead cost incurred at that level.
Fixed costs = Total overhead costs - Variable costs
At the high level of activity, total overhead costs are $2,350 and variable costs equal $1,821 (601
pizzas x $3.03 per pizza). Therefore, the fixed-cost component of overhead costs is estimated to
be $529 (total overhead costs of $2,350 less variable costs of $1,821).
Hence, the total overhead cost is estimated to be $529 + ($3.03 x (number of pizzas produced)).
Page | 87
3. Limiting factor analysis

If an organisation manufactures more than one product and faces a shortage in the supply of a
single resource (e.g. labour hours, machine hours or a material) that is required in the production
of its multiple products, what quantities of its various products should be produced to maximize
profits?
One option would be to determine production quantities on the basis of contribution per unit of
the different products (i.e. products with higher contribution per unit shall be given preference
over products with lower contribution per unit).
Prioritising production on the basis of contribution per unit however would not maximize profits
as the approach fails to take into account the contribution of various products relative to their
usage of the limiting resource which shall ultimately determine the overall profit. Therefore, when
facing a situation involving a single limiting factor, products should be prioritized in the
production plan according to their contribution per unit of the limiting resource.
Six Step Approach

Single limiting factor problems can be solved by adopting the following six-step approach.
Step 1: Determine the maximum sales
In order to calculate whether a limiting factor exists (Step 2), we need to ascertain the maximum
sales that the business can achieve ignoring any limiting factors that affect production of
multiple
products.
In most cases, Maximum Sales will equal to sales demand of the respective products of the
company.
However, if there is any limiting factor specific to a product (i.e. the limiting factor only affects
production of one product rather than multiple products) the Maximum Sales of that product
should not exceed the units of production that will be achievable subject to such limitation.
Step 2: Determine the limiting factor
Here we need to establish which factor is responsible for limiting the production of its various
products.
This can done by simply comparing:
a) Available units of factors
b) Units of factors required to achieve the Maximum Sales calculated in Step 1
If there is however a shortfall in more than one units of resource (i.e. multiple limiting factors),
then the problem can only be solved using linear programming techniques.
Step 3: Calculate contribution per unit of output of each product
Page | 88
Contribution is simply selling price less variable costs. As with most short term decisions in
managerial accounting, fixed costs are non-relevant which is why the limiting factor analysis uses
contribution per unit rather than profit per unit.
Step 4: Calculate contribution per unit of limiting factor for each product
This represents the contribution earned from a product for every unit of scarce resource
consumed.
Step 5: Rank products in order of priority
The product with highest contribution per unit of limiting factor calculated in Step 4 shall be
ranked first whereas the second highest shall be ranked second and so on.
Step 6: Calculate production quantities
Product ranking first in Step 5 would be produced up to the maximum sales subject to the
availability of the limiting resource. Lower ranked products shall only be produced if the entire
production requirement of higher ranked products have been met.
Following example illustrates how the 6 Steps Approach can be applied in a given scenario.
Illustration: Limiting Factor
ABC Watches is a manufacturer of premium hand-crafted watches.
Estimated watch sales, production and usage for the next period are as follows:
Available
Units
ABC
Platinum
Labour
200,000 hours $500

(50 hours)
Platinum
220 Kg
Gold
300 Kg
Silver
200 Kg
Stainless Steel
2200 Kg
ABC
Gold
ABC
Silver
$400
(40 hours)
$300
(30 hours)
$5,000
(200 grams)
$4,000
(150 grams)
$1,000
(100 grams)
$500
(500 grams)
$400
(400 grams)
$600
(600 grams)
Variable Overheads
$300
$100
$200
Total Variable Overheads
$6,300
$4,900
$2,100
Fixed Overheads Absorption
$100
$80
$60
Total Cost Per Unit
$6,400
$4,980
$2,160
Selling Price
$10,000
$8,000
$5,000
Page | 89
Sales Demand
1,000 Units
2,000 Units
2,500 Units
Calculate the production quantities that will maximize profits of ABC Watches in the following
period.
Step 1: Determine the Maximum Sales
Platinum, Gold & Silver are not potential limiting factors for the purpose of this analysis as they
do not affect the production of other products unlike steel and labour which are required in the
production of all watches.
However, we need to ensure that any shortage in the availability of Platinum, Gold or Silver is
accounted for when calculating the resource requirements of potential limiting factors (i.e. steel
and labour) in Step 2 based on the maximum sales.
Factor
Available Units
Maximum Output Sales Demand
Maximum Sales
Lower of A & B
Platinum
200 KG
1100 units (W1)
1000 Units
1000 Units
Gold
300 KG
2000 units (W2)
2000 Units
2000 Units
Silver
200 KG
2000 units (W3)
2500 Units
2000 Units
W1 : Platinum Watches: 220 KG / 0.2 KG* = 1100 units

*200 grams = 0.2 KG
W2: Gold Watches: 300 KG / 0.15 KG* = 2000 units
*150 grams = 0.15 KG
W3: Silver Watches: 200 KG / 0.10 KG* = 2000 units
*100 grams = 0.10 KG
Step 2: Determine the Limiting Factor
Factor
Available Units
Required units
Shortfall
Steel
2200 KG
2500 KG
Yes
Labour
200,000 hours
190,000 hrs (W2)
(W1)
No
Steel is the limiting factor.

W1: Steel Units required to produce maximum sales units
Page | 90
Platinum:
500 grams x 1000 units
500 KG
Gold:
800 KG
Silver:
1200 KG
Total Steel Units: 2500 KG

W2: Labour hours required to produce maximum sales units
Platinum:
50 hours x 1000 units
50,000 hours
Gold:
80,000 hours
Silver:
60,000 hours
Total Labour hours: 190,000 hours
Step 3: Calculate the Contribution Per Unit of each product

Product
Revenue
Variable cost
Contribution per Unit
A-B
Platinum
$10,000
$6,300
$4,700
Gold
$8,000
$4,980
$3,020
Silver
$5,000
$2,160
$2,840
Step 4: Calculate the Contribution Per Unit of Limiting Factor of each product
Contribution per
Unit
Stainless Steel per Contribution

of
products
Unit
per unit of limiting factor
A/B
Platinum
$4,700
500 grams
$9.4 per gram
Gold
$3,020
400 grams
$7.55 per gram
Silver
$2,840
600 grams
$4.73 per gram
Product
Step 5: Rank products in their order of priority in the production plan

Product
Contribution of Products
per unit of limiting factor
Rank
Platinum
$9.40 per gram
Gold
$7.55 per gram
Silver
$4.73 per gram
Page | 91
Since Platinum Watches earn the highest contribution for every gram of stainless steel used, it
is given first priority in the production plan followed by Gold and Silver Watches.
Step 6: Calculate the production quantities
Product
Rank
Steel Units
Available
Steel Units
Required
Units to be
Produced
Platinum
2200 KG
500 KG (W3)
1000
Gold
1700 KG (W1)
800 KG (W4)
2000
Silver
900 KG (W2)
900 KG (W4)
1500 (W5)
1000 Platinum Watches, 2000 Gold Watches and 1500 Silver Watches should be produced to
maximize profit.
Platinum and gold watches can be produced up to the level of their maximum sales. However,
only 1500 Silver watches can be produced from the steel units available after the production of
platinum and gold watches.
W1: 2200 KG - 500 KG = 1700 KG
W2: 1700 KG - 800 KG = 900 KG
W3: 1000 units x 500 grams per unit = 500 KG
W4: 2000 units x 400 grams per unit = 800 KG
W5: 900 KG / 0.6 KG* = 1500 units
*600 grams = 0.6 KG
4. Make or buy decisions

The act of choosing between manufacturing a product in-house or purchasing it from an external
supplier. In a make-or-buy decision, the two most important factors to consider are cost and
availability of production capacity.
An enterprise may decide to purchase the product rather than producing it, if is cheaper to buy
than make or if it does not have sufficient production capacity to produce it in-house. With the
phenomenal surge in global outsourcing over the past decades, the make-or-buy decision is one
that managers have to grapple with very frequently.
Factors that may influence a firm's decision to buy a part rather than produce it internally include
lack of in-house expertise, small volume requirements, desire for multiple sourcing, and the fact
that the item may not be critical to its strategy. Similarly, factors that may tilt a firm towards
Page | 92
making an item in-house include existing idle production capacity, better quality control or
proprietary technology that needs to be protected.
4.1. Factors favouring in-house manufacture
Wish to integrate plant operations
Need for direct control over manufacturing and/or quality
Cost considerations (costs less to make the part)
Improved quality control
No competent suppliers and/or unreliable suppliers
Quantity too little to interest a supplier
Design secrecy is necessary to protect proprietary technology
Control of transportation, lead time, and warehousing expenses
Political, environmental, or social reasons
Productive utilization of excess plant capacity to assist with absorbing fixed overhead
(utilizing existing idle capacity)
Wish to keep up a stable workforce (in times when there are declining sales)
Greater guarantee of continual supply
4.2. Factors favouring purchase from outside
Suppliers specialized know-how and research are more than that of the buyer
Lack of expertise
Small-volume needs
Cost aspects (costs less to purchase the item)
Wish to sustain a multiple source policy
Item not necessary to the firms strategy
Limited facilities for a manufacture or inadequate capacity
Brand preference
Inventory and procurement considerations
4.3. Costs for the make analysis
Direct labour expenses
Incremental inventory-carrying expenses
Incremental capital expenses
Incremental purchasing expenses
Page | 93
Incremental factory operating expenses
Incremental managerial expenses
Delivered purchased material expenses
Any follow-on expenses resulting from quality and associated problems
4.4 Cost factors for the buy analysis
Transportation expenses
Purchase price of the part
Incremental purchasing expenses
Receiving and inspection expenses
Any follow-on expenses associated with service or quality
Illustration: Make or buy

Starfish makes four components, W, X, Y and Z, for which costs in the forthcoming year are
expected to be as follows.
Production (units)
Unit marginal costs
Direct materials
Direct labour
Variable production overheads
W
1,000
$
4
8
2
14
X
2,000
$
5
9
3
17
Y
4,000
$
2
4
1
7
Z
3,000
$
4
6
2
12
Directly attributable fixed costs per annum and committed fixed costs are as follows.
Incurred as a direct consequence of making W
Incurred as a direct consequence of making X
Incurred as a direct consequence of making Y
Incurred as a direct consequence of making Z
Other fixed costs (committed)
$
1,000
5,000
6,000
8,000
30,000
50,000
A sub-contractor has offered to supply units of W, X, Y and Z for $12, $21, $10 and $14
respectively.
We have to decide whether Starfish should make or buy the components.
The relevant costs are the differential costs between making and buying, and they consist of
differences in unit variable costs plus differences in directly attributable fixed costs.
Page | 94
Unit variable cost of making

Unit variable cost of buying
Annual requirements (units)
Extra variable cost (saving) of buying p.a.

Fixed costs saved by buying
Extra total cost (saving) of buying
W
$
14
12
(2)
1,000
X
$
17
21
4
2,000
Y
$
7
10
3
4,000
Z
$
12
14
2
3,000
$
(2,000)
(1,000)
(3,000)
$
8,000
(5,000)
3,000
$
12,000
(6,000)
6,000
$
6,000
(8,000)
(2,000)
The company would save $3,000 per annum by sub-contracting component W (where the
purchase cost would be less than the marginal cost per unit to make internally) and would save
$2,000 p.a. by subcontracting component Z (because of the saving in fixed costs of $8,000).
In this example, relevant costs are the variable costs of in-house manufacture, the variable costs
of subcontracted units, and the saving in fixed costs.
5. Decision making under uncertainty

Uncertainty is a state of having limited knowledge of current conditions or future outcomes. It is
a major component of risk, which involves the likelihood and scale of negative consequences.
Managers often deal with uncertainty in their work; to minimize the risk that their decisions will
lead to undesired outcomes, they must develop the skills and judgment necessary for reducing
this uncertainty. Managing uncertainty and risk also involves mitigating or even removing things
that inhibit effective decision-making or adversely affect performance.
A risk-averse manager might opt for the option that offers the best 'worst result' (the maximin
criterion).
Some of the assumptions that are typically made in relevant costing are as follows.
Cost behaviour patterns are known; if a department closes down, for example, the
attributable fixed cost savings would be known.
The amount of fixed costs, unit variable costs, sales price and sales demand are known with
certainty.
The objective of decision making in the short run is to maximise 'satisfaction', which is often
regarded as 'short-term profit'.
The information on which a decision is based is complete and reliable.
Page | 95
In reality, the future outcome from taking any particular course of action can be estimated. A
future outcome might even be probable. However, the future can rarely be predicted with
certainty. Managers must recognise that when they make a decision, there will often be an
element of risk or uncertainty.
Page | 96
Chapter 7: Price Management

1. Pricing Policy
Price is the only element of marketing mix that helps in generating income. Therefore, a marketer
should adopt a well-planned approach for pricing decisions. The marketer should know the
factors that influence the pricing decisions before setting the price of a product.
2. Factors affecting the pricing

Let us discuss the factors affecting the pricing decisions briefly:
2.1. Organizational Objectives:

Affect the pricing decisions to a great extent. The marketers should set the prices as per the
organizational goals. For instance, an organization has set a goal to produce quality products,
thus, the prices will be set according to the quality of products. Similarly, if the organization has
a goal to increase sales by 18% every year, then the reasonable prices have to be set to increase
the demand of the product.
2.2. Costs:
Influence the price setting decisions of an organization. The organization may sell products at
prices less than that of the competitors even if it is incurring high costs. By following this strategy,
the organization can increase sales volumes in the short run but cannot survive in the long
run.Thus, the marketers analyze the costs before setting the prices to minimize losses. Costs
include cost of raw materials, selling and distribution overheads, cost of advertisement and sales
promotion and office and administration overheads.
2.3. Legal and Regulatory Issues:

Persuade marketers to change price decisions. The legal and regulatory laws set prices on various
products, such as insurance and dairy items. These laws may lead to the fixing, freezing, or
controlling of prices at minimum or maximum levels.
Page | 97
2.4. Product Characteristics:

Include the nature of the product, substitutes of the product, stage of life-cycle of the product,
and product diversification.
2.5. Competition:
Affects prices significantly. The organization matches the prices with the competitors and adjusts
the prices more or less than the competitors. The organization also assesses that how the
competitors respond to changes in the prices.
2.6. Pricing Objectives:

Help an organization in determining price decisions. For instance, an organization has a pricing
objective to increase the market share through low pricing. Therefore, it needs to set the prices
less than the competitor prices to gain the market share. Giving rebates and discounts on
products is also a price objective that influences the customers decisions to buy a product.
2.7. Price Elasticity of Demand:

Refers to change in demand of a product due to change in price.
There are three situations that arise under it:
a. Products that have inelastic demand will be highly priced
b. Products that have more than elastic demand will be priced low
c. Products that have elastic demand will be reasonably priced.
2.8. Competitors pricing Policies:

Influence the pricing policies of the organizations. The price of a product should be determined
in such a way that it should easily face price competition.
2.9. Distribution Channels:

Implies a pathway through which the final products of manufacturers reach the end users. If the
distribution channel is large, price of the product will be high and if the distribution channel is
Page | 98
short, the price of the product will be low. Thus, these are the major factors that influence the
pricing decisions.
3. Pricing methods
Pricing is the process whereby a business sets the price at which it will sell its products and
services, and may be part of the business's marketing plan. In setting prices, the business will take
into account the price at which it could acquire the goods, the manufacturing cost, the market
place, competition, market condition, brand, and quality of product. There is no "one right way"
to calculate pricing. Once you've considered the various factors involved and determined the
objectives for the pricing strategy, now you need some way to crunch the actual numbers. Here
are different ways to calculate prices:
3.1. Demand-based approach to pricing

Demand-based pricing uses consumer demand (and therefore perceived value) to set a price of
a good or service.
Price theory or demand theory is based on the idea that there is a connection between price, the
total quantity demanded by customers, and total revenue and profits. Demand varies with price,
and so if an estimate can be made of demand at different price levels, it should be possible to
derive either a profit-maximising price or a revenue-maximising price.
To apply this approach to pricing in practice, it is necessary to have realistic estimates of demand
at different price levels. Making accurate estimates of demand is often difficult, since price is only
one of many variables that influence demand. Even so, some larger organisations (e.g. oil
companies) go to considerable effort to estimate the demand for their products or services at
differing price levels.
Illustration: demand-based pricing
For example, a large transport authority might be considering an increase in bus fares or
underground fares. The effect on total revenues and profit of the increase in fares could be
estimated from a knowledge of the demand for transport services at different price levels. If an
increase in the price per ticket caused a large fall in demand, total revenues and profits would
fall. However, if a fares increase would cause relatively little change in demand (e.g. possibly, on
commuter routes) a price increase would boost total revenue. Since a transport authority's costs
Page | 99
are largely fixed in relation to sales volume (passenger miles), a rise in revenues from fares would
boost total profits too.
Many businesses enjoy something akin to a monopoly position, even in a competitive market.
This is because they develop a unique marketing mix, for example a unique combination of price
and quality. The significance of a monopoly situation is:
(a) The business does not have to 'follow the market' on price; in other words it is not a 'pricetaker', but has more choice and flexibility in the prices it sets.
At higher prices, demand for its products or services will be less.
At lower prices, demand for its products or services will be higher.
(b) There will be a selling price at which the business can maximise its profits.
3.2. Full cost plus pricing

Full cost plus pricing is a price-setting method under which you add together the direct material
cost, direct labor cost, selling and administrative costs, and overhead costs for a product, and add
to it a markup percentage (to create a profit margin) in order to derive the price of the product.
The pricing formula is:
Total production costs + Selling and administration costs + Markup
Number of units expected to sell
This method is most commonly used in situations where products and services are provided
based on the specific requirements of the customer; thus, there is reduced competitive pressure
and no standardized product being provided. The method may also be used to set long-term
prices that are sufficiently high to ensure a profit after all costs have been incurred.
The Full Cost Plus Calculation
ABC International expects to incur the following costs in its business in the upcoming year:
Total production costs = $2,500,000
Total sales and administration costs = $1,000,000
The company wants to earn a profit of $100,000 during that time. Also, ABC expects to sell
200,000 units of its product. Based on this information and using the full cost plus pricing method,
ABC calculates the following price for its product:
Page | 100
$2,500,000 Production costs + $1,000,000 Sales/admin costs + $100,000 markup

200,000 units
= $18 Price per unit
Advantages of Full Cost Plus Pricing
The following are advantages to using the full cost plus pricing method:
Simple. It is quite easy to derive a product price using this method, since it is based on a
simple formula. Given the use of a standard formula, it can be derived at almost any level
of an organization.
Likely profit. As long as the budget assumptions used to derive the price turn out to be
correct, a company is very likely going to earn a profit on sales if it uses this method to
calculate prices.
Justifiable. In cases where the supplier must persuade its customers of the need for a
price increase, the supplier can show that its prices are based on costs, and that those
costs have increased.
Disadvantages of Full Cost Plus Pricing

The following are disadvantages of using the full cost plus pricing method:
Ignores competition. A company may set a product price based on the full cost plus
formula and then be surprised when it finds that competitors are charging substantially
different prices.
Ignores price elasticity. The company may be pricing too high or too low in comparison
to what buyers are willing to pay. Thus, it either ends up pricing too low and giving away
potential profits, or pricing too high and achieving minor revenues.
Product cost overruns. Under this method, the engineering department has no incentive
to prudently design a product that has the appropriate feature set and design
characteristics for its target market (see the target costing method). Instead, the
department simply designs what it wants and launches the product.
Budgeting basis. The pricing formula is based on budget estimates of costs and sales
volume, both of which may be incorrect.
Page | 101
Too simplistic. The formula is designed to calculate the price of only a single product. If
there are multiple products, then you need to adopt a cost allocation methodology to
decide on which costs are to be assigned to which product.
3.3. Variable cost plus pricing

A pricing method in which the selling price is established by adding a mark-up to total variable
costs. The expectation is that the mark-up will contribute to meeting all or a part of fixed costs,
and generate some level of profit. Variable cost-plus pricing is especially useful in competitive
scenarios such as contract bidding, but is not suitable in situations where fixed costs are a major
component of total costs.
For example, assume total variable costs for manufacturing one unit of a product are $10 and a
mark-up of 50% is added. The selling price as determined by this variable cost-plus pricing
method would be $15. If contribution to fixed costs per unit is estimated at $4, then profit per
unit would be $1.
3.4. Marginal pricing

Marginal-cost pricing also known as opportunity cost approach to pricing is the practice of
setting the price of a product to equal the extra cost of producing an extra unit of output. By this
policy, a producer charges, for each product unit sold, only the addition to total cost resulting
from materials and direct labour. This is the practice of setting the price of a product at or slightly
above the variable cost to produce it. This approach typically relates to short-term price setting
situations. This situation usually arises in one of two circumstances:
A company has a small amount of remaining unused production capacity available that
it wishes to use; or
A company is unable to sell at a higher price
The first scenario is one in which a company is more likely to be financially healthy - it simply
wishes to maximize its profitability with a few more unit sales. The second scenario is one of
desperation, where a company can achieve sales by no other means. In either case, the sales are
intended to be on an incremental basis; they are not intended to be a long-term pricing strategy,
since prices set this low cannot be expected to offset the fixed costs of a business.
Page | 102
The variable cost of a product is usually only the direct materials required to build it. Direct labor
is rarely completely variable, since a minimum number of people are required to crew a
production line, irrespective of the number of units produced.
For example, ABC International has designed a product that contains $5.00 of variable expenses
and $3.50 of allocated overhead expenses. ABC has sold all possible units at its normal price point
of $10.00, and still has residual production capacity available. A customer offers to buy 6,000 units
at the company's best price. To obtain the sale, the sales manager sets the price of $6.00, which
will generate an incremental profit of $1.00 on each unit sold, or $6,000 in total. The sales
manager ignores the allocated overhead of $3.50 per unit, since it is not a variable cost.
3.5. Fixed price tenders

A fixed-price contract is a contract where the contract payment does not depend on the amount
of resources or time expended by the contractor, as opposed to cost-plus contracts. These
contracts are often used in military and government contractors to put the risk on the side of the
vendor, and control costs.
Historically, when fixed-price contracts are used for new projects with untested or developmental
technologies, the programs may fail if unforeseen costs exceed the ability of the contractor to
absorb the overruns. In spite of this, such contracts continue to be popular. Fixed-price contracts
tend to work when costs are well known in advance.
A special order is a one-off revenue earning opportunity. These may arise in the following
situations.
(a) When a business has a regular source of income but also has some spare capacity allowing it
to take on extra work if demanded. For example a brewery might have a capacity of 500,000
barrels per month but only be producing and selling 300,000 barrels per month. It could therefore
consider special orders to use up some of its spare capacity.
(b) When a business has no regular source of income and relies exclusively on its ability to
respond to demand. A building firm is a typical example as are many types of sub-contractors. In
the service sector consultants often work on this basis.
The reason for making the distinction is that in situation (a) above, a firm would normally attempt
to cover its longer-term running costs in its prices for its regular products. Pricing for special
orders need therefore take no account of unavoidable fixed costs. This is clearly not the case for
Page | 103
a firm in situation (b), where special orders are the only source of income for the foreseeable
future.
The basic approach in both situations is to determine the price at which the firm would break
even if it undertook the work; that is, the minimum price that it could afford to charge.
3.6. Target cost pricing

A target cost is the maximum amount of cost that can be incurred on a product and with it the
firm can still earn the required profit margin from that product at a particular selling price.
Target costing, and target cost pricing, is an approach to pricing that combines an awareness of
market demand conditions and the need for profitability.
Target cost means a product cost estimate derived by subtracting a desired profit margin from a
competitive market price. This may be less than the planned initial product cost, but will be
expected to be achieved by the time the product reaches the mature production stage.
Target cost = Market price Desired profit margin
This approach to pricing and costs requires managers to change the way they think about the
relationship between cost, price and profit.
(a) Traditionally, the approach has been to develop a new product, determine what it costs to
make, and set a selling price. The product will be profitable if its selling price exceeds its cost.
(b) The target costing approach to new product development is to determine what the market
selling price will be at each stage of its life cycle and what the desired profit margin should
be. As a result, it is then possible to calculate what the cost of the product must be at each
stage of its life cycle, to ensure that the desired profits will be achieved.
The target cost for a product is likely to change over its life cycle. Typically, in the early stages of
its life, a higher sales price will be achievable, and so a higher unit production cost is acceptable.
However, as the price of a product falls, its target cost must also come down. Decisions made at
the planning and design stage for a product can be crucial in making the target cost achievable
(e.g. decisions affecting the choice of materials for making the item, or in the choice of the
number of product features to build into the product).
The steps for implementing a target costing approach are as follows.
Page | 104
Step 1
Determine a product specification for which an adequate sales volume is expected.
Step 2
Set a selling price at which the organisation will be able to achieve a desired market
share.
Step 3
Estimate the required profit based on return on sales or return on investment.
Step 4
Calculate the target cost = target selling price target profit.
Step 5
Compile an estimated cost for the product based on the anticipated design
specification and current cost levels.
Step 6
Calculate the cost gap. This is the difference between the product cost that is
currently estimated and the target cost that needs to be achieved. Cost gap =
estimated cost target cost.
Step 7
Make efforts to close the cost 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
during the production phase.
Step 8
Negotiate with the customer before making the decision about whether to go
ahead with the project.
When a product is first manufactured, its target cost may well be much lower than its currentlyattainable cost, which is determined by current technology and processes. Management can then
set benchmarks for improvement towards the target costs, by improving technologies and
processes.
4. Transfer pricing
Transfer pricing is the setting of the price for goods and services sold between controlled (or
related) legal entities within an enterprise. For example, if a subsidiary company sells goods to a
parent company, the cost of those goods paid by the parent to the subsidiary is the transfer price.
Legal entities considered under the control of a single corporation include branches and
companies that are wholly or majority owned ultimately by the parent corporation. Transfer
pricing can be used as a profit allocation method to attribute a multinational corporation's net
profit (or loss) before tax to countries where it does business. Transfer pricing results in the setting
of prices among divisions within an enterprise.
Page | 105
In principle, a transfer price should match either what the seller would charge an independent,
arm's length customer, or what the buyer would pay an independent, arm's length supplier. While
unrealistic transfer prices do not affect the overall enterprise directly, they become a concern for
government taxing authorities when transfer pricing is used to lower profits in a division of an
enterprise located in a country that levies high income taxes and raise profits in a country that is
a tax haven that levies no (or low) income taxes.
4.1. Transfer pricing methods

4.1.1. Transfers at market price
If an external market price exists for transferred goods or services, profit centre managers will be
aware of the price they could charge or the price they would have to pay for their goods on the
external market, and so will compare this price with the internal transfer price.
It might therefore be agreed that transfers at market price are 'fair' and appropriate.
Illustration: transferring goods at market value
A company has two profit centres, A and B. Centre A sells half of its output on the open market
and transfers the other half to centre B. Costs and external revenues in an accounting period are
as follows.
Centre A
$
8,000
12,000
External sales
Costs of production
Company profit
Centre B
$
24,000
10,000
Total
$
32,000
22,000
10,000
What are the consequences of setting a transfer price at market value?

If the transfer price is at market price, centre A would be happy to sell the output to centre B for
$8,000, which is what centre A would get by selling it externally instead of transferring it.
A
$
Market sales
Transfer sales
Transfer costs
Own costs
Profit
Page | 106
B
$
8,000
8,000
16,000
12,000
$
24,000
24,000
8,000
10,000
(12,000)
4,000
Total
$
32,000
(22,000)
(18,000)
6,000
10,000
The consequences, therefore, are as follows.

(a) Centre A earns the same profit on transfers as on external sales. Centre B must pay a
commercial price for transferred goods, and both divisions will have their profit measured
fairly.
(b) Centre A will be indifferent about selling externally or transferring goods to centre B because
the profit is the same on both types of transaction. Centre B can therefore ask for and obtain
as many units as it wants from centre A.
A market-based transfer price might therefore seem to be the ideal transfer price.
4.1.2. Adjusted market price

However, internal transfers are often cheaper than external sales, with savings in selling and
administration costs, bad debt risks and possibly transport/delivery costs. It would therefore seem
reasonable for the buying division to expect a discount on the external market price.
The transfer price might therefore be set at an amount slightly below market price, so that both
profit centres can share the cost savings from internal transfers compared with external sales. It
should be possible to reach agreement on this price and on output levels with a minimum of
intervention from head office.
The disadvantages of market value transfer prices
Market value as a transfer price does have certain disadvantages.
(a) The division receiving the internal transfer might decide that an external supplier would be
more convenient, or might do the job better or more quickly. There is no incentive for the
division to 'buy' the goods or services internally, because it would be just as cheap to buy
outside. From the point of view of the organisation as a whole, however, it might be very
desirable that internal transfers should be preferred to external market purchases.
(b) The market price may be a temporary one, induced by adverse economic conditions, or
dumping, or the market price might depend on the volume of output supplied to the external
market by the profit centre.
(c) A transfer price at market value might, under some circumstances, act as a disincentive to
use up any spare capacity in the divisions. A price based on incremental cost, in contrast,
might provide an incentive to use up the spare resources in order to provide a marginal
contribution to profit.
(d) Many products do not have an equivalent market price so that the price of a similar, but not
identical, product might have to be chosen. In such circumstances, the option to sell or buy
on the open market does not really exist.
Page | 107
4.1.3. Cost-based approaches to transfer pricing

Fixed costs in the supplying division can be accounted for in a number of ways to ensure that it
at least breaks even.
Standard costs should be used for transfer prices to avoid encouraging inefficiency in the
supplying division.
Cost-based approaches to transfer pricing are often used in practice, particularly where the
following conditions apply.
(a) There is no external market for the product that is being transferred.
(b) Alternatively, although there is an external market it is an imperfect one because the market
price is affected by such factors as the amount that the company setting the transfer price
supplies to it, or because there is only a limited external demand.
In either case there will not be a suitable market price upon which to base the transfer price.
4.1.4. Transfer prices based on full cost

Under this approach, the full cost (including fixed overheads absorbed) incurred by the supplying
division in making the 'intermediate' product is charged to the receiving division. If a full cost
plus approach is used, a profit margin is usually added to cost to reach the transfer price. An
intermediate product is one that is used as a component of another product, for example car
headlights or food additives.
Illustration: transfers at full cost (plus)
A company has two profit centres, P and Q. Centre P assembles a product which it then transfers
to Centre Q. Centre Q does the finishing work on the product, after which it is sold on the external
market.
Budgeted production costs for the year are as follows.
Centre P
30,000
$5
$210,000
Centre Q
30,000
$2
$180,000
Units produced
Variable cost per unit incurred
Fixed costs
The finished item sells for $25 per unit.
If a profit centre organisation did not exist, the budgeted profit would be as follows.
$
Sales (30,000 $25)
Variable costs (30,000 $7)
Fixed costs
Page | 108
210,000
390,000
$
750,000
Total costs
Profit
600,000
150,000
If a profit centre structure were to operate, what would be the profits of centre P and centre Q if
units were transferred between the divisions:
(a) at full cost
(b) at full cost plus a margin of 25%?
Transfer price at full cost
The full cost of output from centre P is the variable cost of $5 plus a fixed cost per unit of $7
($210,000/30,000). If the transfer price is at full cost ($12), centre P would have sales to centre Q
of $360,000 (30,000 units at $12), and the profits of each centre would be as follows.
Centre P
$
External market sales
Internal transfers
Total sales
Costs
Transfers
Own variable costs
Own fixed costs
Total costs
Profit
360,000
360,000
150,000
210,000
Centre Q
$
$
750,000
750,000
360,000
60,000
180,000
360,000
0
Company
$
$
750,000
210,000
390,000
600,000
150,000
600,000
150,000
The transfer sales of centre P are self-cancelling with the transfer costs of centre Q so that total
profits are unaffected by the transfer items. The transfer price simply spreads the total profit of
$150,000 between P and Q. Since the transfers are at full cost, the budgeted profit of centre P is
nil. The only ways in which centre P can make a profit would be:
(a) to produce more units than budgeted, and so make a profit because fixed costs will remain
unchanged, and a contribution of $7 per unit will be earned on every unit in excess of 30,000
(b) keep actual costs below budget.
The obvious drawback to a transfer price at cost is that division P needs a profit on its transfers
in order to be motivated to supply division Q; and transfer pricing at cost is therefore inconsistent
with the use of a profit centre accounting system.
Transfer price at full cost plus
If the transfers are at cost plus a margin of 25%, transfers by division P to division Q will be at
$12 plus 25%, i.e. $15 per unit, or $450,000 in total. Divisional profits will be as follows.
Centre P
Page | 109
Centre Q
Company
$
External market sales
Internal transfers
Total sales
Costs
Transfers
Own variable costs
Own fixed costs
Total costs
Profit
450,000
450,000
150,000
210,000
$
750,000
750,000
450,000
60,000
180,000
360,000
90,000
$
750,000
210,000
390,000
690,000
60,000
600,000
150,000
The total profit is now shared between the two divisions. However, the choice of 25% as a profit
mark-up was arbitrary and unrelated to any external market conditions. If the profit centre
managers cannot agree on the size of the mark-up, a transfer pricing decision would have to be
imposed by head office. If this were to happen, the degree of autonomy enjoyed by the profit
centres would be weakened.
A potential weakness with transfers at cost plus is that the division making the transfers might
not be sufficiently motivated to control costs. On the contrary, if transfers are priced at actual
cost plus, the transferring division would make bigger profits by spending more.
To provide an incentive to control costs, transfers at cost plus should therefore be at a budgeted
cost plus or a standard cost plus.
4.1.5. Transfer price at variable cost

A variable cost approach entails charging the variable cost that has been incurred by the
supplying division to the receiving division, probably with a profit mark-up. In the above example,
centre P might transfer its output to centre Q at variable cost plus, say, 200%. This would give a
transfer price of $15 per unit ($5 plus 200%).
A problem with variable cost plus transfer prices is that unless a transfer price is sufficiently high
(i.e. the mark-up is sufficiently large) the supplying division will not cover its fixed costs and make
a profit. There are ways in which this problem could be overcome.
(a) Each division can be given a share of the overall contribution earned by the organisation, but
it would probably be necessary to decide what the shares should be centrally, thereby
undermining divisional autonomy. Alternatively central management could impose a range
within which the transfer price should fall, and allow divisional managers to negotiate what
they felt was a fair price between themselves.
Page | 110
(b) An alternative method is to use a two-part charging system: transfer prices are set at variable
cost (or variable cost plus some mark-up) and once a year there is a transfer of a fixed fee to
the supplying division, representing an allowance for its fixed costs. Care is needed with this
approach. It risks sending the message to the supplying division that it need not control its
fixed costs because the company will subsidise any inefficiencies. On the other hand, if fixed
costs are incurred because spare capacity is kept available for the needs of other divisions it
is reasonable to expect those other divisions to pay a fee if they 'booked' that capacity in
advance but later failed to utilise it. The main problem with this approach, once again, is that
it is likely to conflict with divisional autonomy.
4.1.6. Negotiated transfer prices

In practice, negotiated transfer prices, market-based transfer prices and full cost-based transfer
prices are the methods normally used.
A transfer price based on opportunity cost is often difficult to identify, for lack of suitable
information about costs and revenues in individual divisions. In this case it is likely that transfer
prices will be set by means of negotiation. The agreed price may be finalised from a mixture of
accounting arithmetic, politics and compromise.
The process of negotiation will be improved if adequate information about each division's costs
and revenues is made available to the other division involved in the negotiation. By having a free
flow of cost and revenue information, it will be easier for divisional managers to identify
opportunities for improving profits, to the benefit of both divisions involved in the transfer.
Page | 111
Chapter 9: Quality Management
Chapter 8: Variance Analysis

Variance analysis, in budgeting (or management accounting in general), is a tool of budgetary
control by evaluation of performance by means of variances between budgeted amount, planned
amount or standard amount and the actual amount incurred/sold.
Variance analysis is usually associated with explaining the difference (or variance) between actual
costs and the standard costs allowed for the good output. For example, the difference in materials
costs can be divided into a materials price variance and a materials usage variance. The difference
between the actual direct labour costs and the standard direct labour costs can be divided into a
rate variance and an efficiency variance. The difference in manufacturing overhead can be divided
into spending, efficiency, and volume variances. Mix and yield variances can also be calculated.
Variance analysis helps management to understand the present costs and then to control future
costs.
1. Types of Variance
A managerial accountants budgetary-control system works like a thermostat. First, a
predetermined or standard cost is set. In essence, a standard cost is a budget for the production
of one unit of product or service. It is the cost chosen by the managerial accountant to serve as
Cost Variance
the benchmark in the budgetary-control system. When the firm produces many units, the
Material Cost
Variance
Labour Cost
Variance
Overhead Cost
Variance
managerial accountant uses the standard unit cost to determine the total standard or budgeted
Page | 112
cost of production. For example, suppose the standard direct-material cost for one unit of
product is $5 and 100 units are manufactured.
The total standard or budgeted direct-material cost, given an actual output of 100 units, is $500
($5 x 100).
Second, the managerial accountant measures the actual cost incurred in the production process.
Third, the managerial accountant compares the actual cost with the budgeted or standard cost.
Any difference between the two is called a cost variance.
In cost accounting, variance is very important to evaluate the performance of company for
increasing its efficiency. In variance analysis, we compare actual and standard cost and revenue
to know whether it is favourable or unfavourable. Favourable variance (F) shows that standard
cost is less than actual cost or standard revenue is more than actual revenue. But unfavourable
or adverse (U or A) variance shows that actual cost is more than standard cost or actual revenue
is less than standard revenue. Types of variance are the steps to deep study of variance. We
classify variance with following ways:
1.1. Direct Material Variance

Direct material variance shows the difference between the actual cost of material of actual units
and standard cost of material of standard units. It is also the total of material price variance,
material quantity variance. If there is favourable material quantity variance and unfavourable
material price variance or vise-versa, direct material cost may be either favourable or
unfavourable because it is total of material price and material quantity variance.
The standard quantity and price of ingredients for one multilayer fancy cake, such as a
Black Forest cake, are shown in the following table:
Standard quantity:
Ingredients in finished product...................................................................................................
Allowance for normal waste...........................................................................................................
Total standard quantity required per multilayer fancy cake..............................................
4.75 pounds
.25 pound
5.00 pounds
Standard price:
Purchase price per pound of ingredients (net of purchase discounts)............................
Transportation cost per pound.....................................................................................................
Total standard price per pound of ingredients.......................................................................
$1.30
.10
$1.40
Page | 113
The standard quantity of ingredients needed to produce one cake is 5 pounds, even though only
4.75 pounds actually remain in the finished product. One-quarter pound of ingredients is wasted
as a normal result of the production process. Therefore, the entire amount of ingredients needed
to produce a fancy cake is included in the standard quantity of material.
The standard price of ingredients reflects all of the costs incurred to acquire the material and
transport it to the plant. Notice that the cost of transportation is added to the purchase price.
Any purchase discounts would be subtracted out from the purchase price to obtain a net price.
To summarise, the standard direct-material quantity is the total amount of direct material
normally required to produce a finished product, including allowances for normal waste or
inefficiency. The standard direct-material price is the total delivered cost, after subtracting any
purchase discounts.
During September, DCdesserts.com produced 2,000 multilayer fancy cakes. The total standard or
budgeted costs for direct material are computed as follows:
Direct material:
Standard direct-material cost per cake (5 pounds x $1.40 per pound)...........................
Actual output..........................................................................................................................................
Total standard direct-material cost.................................................................................................
$7
x 2,000
$14,000
During September, DCdesserts.com incurred the following actual costs for direct material in the
production of multilayer fancy cakes.
Direct material purchased: actual cost 12,500 pounds at $1.42 per pound.................................. $17,750
Direct material used: actual cost 10,250 pounds at $1.42 per pound............................................ $14,555
What caused DCdesserts.com to spend more than the anticipated amount on direct material?
First, the company purchased ingredients at a higher price ($1.42 per pound) than the standard
price ($1.40 per pound). Second, the company used more ingredients than the standard amount.
The amount actually used was 10,250 pounds instead of the standard amount of 10,000 pounds,
which is based on actual output of 2,000 multilayer fancy cakes. The managerial accountant can
show both of these deviations from standards by computing a direct-material price variance (or
purchase price variance) and a direct-material quantity variance. The computation of these
variances is depicted in the figure below:
Page | 114
The formula for the direct-material price variance is as follows:

Direct-material price variance = (PQ X AP) - (PQ X SP) = PQ(AP - SP)
Where,
PQ = Quantity purchased
AP = Actual price
SP = Standard price
DCdesserts.coms direct-material price variance for Septembers production of multilayer fancy
cakes is computed as follows:
Direct-material price variance
= PQ(AP - SP)
= 12,500($1.42 - $1.40)
= $250 Unfavourable
This variance is unfavourable, because the actual purchase price exceeded the standard price.
Notice that the price variance is based on the quantity of material purchased (PQ), not the
quantity actually used in production.
Above figure shows, the following formula defines the direct-material quantity variance.
Direct-material quantity variance = (AQ - SP) X (SQ - SP) = SP(AQ - SQ)
Where,
AQ = Actual quantity used
SQ = Standard quantity allowed
Page | 115
DCdesserts.coms direct-material quantity variance for Septembers production of multilayer

fancy cakes is computed as follows:
Direct-material quantity variance = SP(AQ - SQ)
= $1.40(10,250 - 10,000)
= $350 Unfavourable
This variance is unfavourable, because the actual quantity of direct material used in September
exceeded the standard quantity allowed, given actual September output of 2,000 multilayer fancy
cakes. The quantity variance is based on the quantity of material actually used in production (AQ).
1.2. Labour Variance

Labour variance shows the variance of labour cost. It is the difference between standard cost of
labour for actual production and the actual cost of labour for actual production.
The standard quantity and rate for direct labour for the production of one multilayer fancy cake
are as follows:
Standard quantity:
Direct labour required per multilayer fancy cake..............................................................
Standard rate:
Hourly wage rate............................................................................................................................
Fringe benefits (25% of wages)................................................................................................
Total standard rate per hour.....................................................................................................
.5 hour
$16
4
$20
The standard direct-labour quantity is the number of direct-labour hours normally needed to
manufacture one unit of product. The standard direct-labour rate is the total hourly cost of
compensation, including fringe benefits.
The total standard or budgeted costs for direct labour are computed as follows (for production
of 2,000 multilayer fancy cakes):
Direct labour:
Direct-labour cost per cake (.5 hour x $20.00 per hour)..........................................................
Actual output.............................................................................................................................................
Total standard direct-labour cost........................................................................................................
$ 10
x 2,000
$20,000
Notice that the total standard cost for the direct-material and direct-labour inputs is based on
DCdesserts.coms actual output. The company should incur costs of $34,000 for direct material
and direct labour, given that it produced 2,000 multilayer fancy cakes. The total standard costs
for direct material and direct labour serve as the managerial accountants benchmarks against
which to compare actual costs.
Page | 116
During September, DCdesserts.com incurred the following actual costs for direct labour in the
production of multilayer fancy cakes.
Direct labour: actual cost 980 hours at $21 per hour ........................................................................... $20,580
Why did DCdesserts.com spend more than the anticipated amount on direct labor during
September? First, the division incurred a cost of $21 per hour for direct labor instead of the
standard amount of $20 per hour. Second, the division used only 980 hours of direct labor, which
is less than the standard quantity of 1,000 hours, given actual output of 2,000 multilayer fancy
cakes. The managerial accountant analyzes direct-labor costs by computing a direct-labor rate
variance and a direct-labor efficiency variance. Following figure depicts the computation of these
variances.
The formula for the direct-labour rate variance is shown below:

Direct-labour rate variance = (AH - AR) X (AH - SR) = AH(AR - SR)
Where,
AH = Actual hours used
AR = Actual rate per hour
SR = Standard rate per hour
DCdesserts.coms direct-labour rate variance for Septembers production of multilayer fancy
cakes is computed as follows:
Direct-labour rate variance
= AH(AR - SR)
= 980($21 - $20) = $980 Unfavourable
Page | 117
This variance is unfavourable because the actual rate exceeded the standard rate during
September.
As the figure above shows, the formula for the direct-labour efficiency variance is as follows:
Direct-labour efficiency variance = (AH - SR) X (SH - SR) = SR(AH - SH)
Where,
SH = Standard hours allowed
DCdesserts.coms direct-labour efficiency variance for September is computed as follows:
Direct-labour efficiency variance = SR(AH - SH)
= $20(980 - 1,000)
= $400 Favourable
This variance is favourable, because the actual direct-labour hours used in September were less
than the standard hours allowed, given actual September output of 2,000 multilayer fancy cakes.
Notice that the direct-labour rate and efficiency variances add up to the total direct labour
variance. However, the rate and efficiency variances have opposite signs, since one variance is
unfavourable and the other is favourable.
1.3. Overhead Variance

Overhead Variance shows the variance of all indirect cost. It is the difference between standard
cost of overhead for actual output and actual cost of overhead for actual output.
The reasons for variances
Standard cost variances help management to assess actual performance, and to identify
situations where actual results are significantly better or worse than planned. Variances might
also provide clues as to why actual results have been better or worse than expected.
There are many possible reasons for cost variances arising, including efficiencies and inefficiencies
of operations, errors in budgeting and standard setting and changes in exchange rates. There
now follows a list of a few possible causes of cost variances. This is not an exhaustive list and in
an examination question you should review the information given and use your imagination and
common sense to suggest possible reasons for variances.
Variance
Material price
Page | 118
Favourable
Unforeseen discounts received
Greater care in purchasing
Change in material quality standard
Adverse
Price increase
Careless purchasing
Change in material quality standard
Material
usage
Labour rate
Labour
efficiency
Idle time
Fall in market price of materials

Material used of higher quality than
standard
More effective use made of material
Errors in allocating material to jobs
Use of workers at a rate of pay lower

than standard
Output produced more quickly than
expected,
because
of
work
motivation,
better
quality
of
equipment or materials
Errors in allocating time to jobs
Idle time
adverse
variances
are
always
Overhead
expenditure
Savings in costs incurred

More economical use of services
Overhead
volume
Selling price
Production or level of activity greater

than budgeted
Unplanned price increase
Sales volume
Additional demand
Low price offer attracting higher
demand
Page | 119
Defective material
Excessive waste
Theft
Stricter quality control
Errors in allocating material to jobs
Wage rate increase
Lost time in excess of standard
allowed
Output lower than standard set

because of lack of training, substandard material etc.
Efficiency standard set at an ideal
level
Errors in allocating time to jobs
Bottlenecks in the production system
Illness or injury to worker
Problems with machines
Non-availability of materials
Increase in cost of services
Excessive use of services
Change in type of services used
Production or level of activity less
than budgeted
Unplanned price reduction
Discounts given to customers to win
sales
Unexpected fall in demand
Production difficulties

1. Measures of shareholder value
The shareholder value concept is that a company should have as its main objective the aim of
maximizing shareholder value, and should therefore develop strategies for increasing
shareholder value. Measures of shareholder value include profit, return on assets and economic
value added.
Companies are owned by their ordinary shareholders, who invest in their company in the
expectation of obtaining returns, in the form of dividends and a higher share value. The
shareholder value concept is that the main objective of a company should be to maximise the
wealth of its shareholders, and that all other objectives are subordinate to this.
This concept is not universally accepted. It can be argued that there are many different
'stakeholders' in a company, in addition to the shareholders. Stakeholder groups include the
senior management, other employees, customers, suppliers and the general public. Each
stakeholder group has expectations of what a company should provide for them. For example,
employees might want to earn a good income, be rewarded for efforts made on behalf of the
company and job satisfaction. Customers might expect a company to supply products or services
that satisfy their needs at a reasonable price.
Even so, there is general acceptance that companies should aim to create shareholder value, and
in doing so, other stakeholders are likely to benefit from the company's success. If a company
earns bigger profits, it can afford better wages or salaries for the people it employs and reward
individuals for their achievements. By providing better value to customers, in the form of
improved products or lower prices, companies should be successful in their markets: customer
satisfaction is essential for achieving commercial success.
If the shareholder value concept is accepted, it follows that performance measures should focus
on the creation of shareholder value. Any of several different measures might be used as the
main measure or measures of performance.
(a) Profit. Profit is either paid out to shareholders as a dividend, or reinvested in the business
for future growth. A company might therefore establish a profit target as its key objective.
Shareholders will have expectations of what the company's profits and dividends should be,
Page | 120
and will be disappointed if actual profit turns out less than expected. Lower profits are likely
to result in a fall in the share price, and a loss of shareholder value. Targets for profit will
therefore normally include an element for profit growth.
(b) Earnings per share. A company might issue new shares to raise fresh capital, for investment
in future growth. When new shares are issued for cash, total profits should increase, but the
profit per share (i.e. earnings per share or EPS) might fall. If a company increases its share
capital by 10% but profits increase only by 5%, it would be argued that existing shareholders
have suffered some loss in value, due to a fall in the earnings per share. The main performance
measure for a company might therefore be expressed in terms of a target for earnings per
share and growth in earnings per share.
(c) Return on assets. To earn profits, capital has to be invested. A larger investment should
provide a larger profit. For example, it can be argued that a return of $10,000 on an
investment of $100,000 (10%) is much better than a return of $20,000 on an investment of
$1 million (2%). Performance should therefore be judged in terms of the size of the profit
relative to the size of the capital investment, and the main performance measure might be
return on assets employed or return on investment (ROI).
(d) Profit margin. Some companies might measure overall performance in terms of their
profit/sales ratio, or return on sales. However, although return on sales is a useful secondary
measure, it is not a reliable guide to the creation of shareholder value. Return on sales might
be improved, but sales volume might fall as a result. For example, a company might increase
its profit/sales ratio from 5% to 7% by increasing its prices, but if sales volume falls
substantially as a result of the price rise, the overall result could be a fall in total profit and a
lower return on assets.
(e) Economic value added or EVA. Profit and return on assets are based on accounting
measurements of profitability and asset values. It can be argued that accounting
measurements are unreliable guides to true economic value. Economic value added or EVA
is a measure of performance, developed by consultants Stern Stewart, that addresses this
problem. Adjustments are made to items of expense and asset values, in order to convert
reported accounting profits into a measure that represents the economic value created for
shareholders during the period.
Performance measurement should consider the long-term rather than the short-term.
Maximising shareholder value means having to achieve certain performance levels over a long
Page | 121
period of time, not just over a 12-month time frame. Companies should therefore set targets over
a time period longer than the budget period.
2. Critical success factors and key performance indicators

Critical success factors (CSFs) are the few key areas of a business that must go right if success is
to be achieved. They are of vital importance for achieving the organisation's objectives, and the
organisation cannot afford non-achievement for any CSF.
There will usually be just a small number of critical success factors, and at a departmental level,
they might be expressed in financial terms (e.g. keeping costs under control), and perhaps also
in terms of productivity and quality. At the organisational level, critical success factors might be
expressed in financial terms (e.g. growth in shareholders' wealth) but also in terms of market
share or technological innovation.
Critical success factors might be identified, for example, in terms of:
(a) Profitability
(b) Market share
(c) Productivity
(d) Product leadership
(e) Personnel development
(f) Employee attitudes
(g) Public responsibility
(h) Balance between long-term and short-term goals
It might be a useful exercise to look at a specific example.
A food manufacturer has the crucial marketing tasks of persuading shops and supermarkets to
stock their produce, and persuading customers to buy it. It has therefore been suggested that
the critical success factors for a manufacturer of processed food products are:
(a) New product development
(b) Good distribution, and
(c) Effective advertising.
New product development is necessary to create products that customers want to buy. Good
distribution is essential to persuade supermarket chains and other retailers to buy the goods of
the manufacturer, rather than similar goods of rival producers. Effective advertising is essential to
create demand from consumers, who will then expect to see the manufacturer's products in the
places they buy their food. Good distribution provides marketing 'push' and effective advertising,
by stimulating consumer demand, creates a marketing 'pull'.
Page | 122
2.1 Key performance indicators

Having established what its critical success factors are, the company must then identify targets
and measures of performance. These are key performance indicators. For a food manufacturer,
the key performance indicator might be:
(a) The number of new products developed during the period. For example, a target might be to
launch four new products on the market, of which one should be an organic food product.
(b) The amount of revenue earned from sales of new products. For example, a target might be
for 20% of annual sales to be achieved from new products launched since the previous year.
Key performance indicators for good distribution could be a target for the time from receipt of a
customer's order to delivery. The target might be that distribution time should be no longer than,
say, 24 hours, and actual performance can be measured against this target.
2.2 CSFs and non-profit-making organisations

Critical success factors can be used by non-profit-making institutions. For example, a university
might see its objectives as to carry out academic research and to teach students to a high
standard. The critical success factors for a university might be:
(a) The availability of funding, for both research and teaching
(b) Student recruitment, to obtain students of a suitable calibre
(c) The skills of the academic team, in both research and teaching
(d) Course design
(e) Responding to external needs, for example the needs of employers and the demand from
other organisations (e.g. companies) for research
(f) The exploitation of technology.
For each critical success factor, targets and key performance indicators could be set.
An approach to establishing performance measures in both profit-making and non-profit making
organisations might therefore be to:
(a) Identify the organisation's corporate objectives
(b) Determine the critical success factors, at the organisational level, and also at divisional,
departmental or other operating level within the organisation
(c) Determine a small number of key performance indicators for each factor.
Page | 123
3. Balanced scorecard
There could be a risk that short-term financial performance will take prominence over longerterm objectives, including non-financial objectives, and the organisation's strategy. One approach
to linking performance target setting and performance measurement to strategy is the balanced
scorecard.
Measures of shareholder value, and responsibility accounting measures of performance within an
organisation, focus on financial issues. It has already been suggested that the objectives of an
organisation, and targets for achievement, will be non-financial as well as financial.
Unless an organisation has clear targets for its non-financial objectives, and measures actual
performance in achieving those objectives, there is a severe risk that an organisation's
performance management systems will focus on financial targets, to the exclusion of nonfinancial factors.
One approach to target setting and performance measurement is the balanced scorecard. Since
it was first proposed by Kaplan and Norton in the early 1990s it has been successfully
implemented by a number of commercial and not-for-profit organisations. While it has been
successful for many organisations, the approach is not universally accepted.
A balanced scorecard establishes non-financial as well as financial targets, and measures actual
performance in relation to all these targets. Areas covered include profitability, customer
satisfaction, internal efficiency and innovation.
The balanced scorecard approach focuses on four different aspects of performance.
Perspective
The key question
Customer
What do existing customers and targeted new customers value from us?
Focusing on this issue gives rise to targets that matter to customers, such
as cost (value for money), quality or place of delivery.
Internal
What processes must we excel at to achieve our financial and customer

objectives? Focusing on this issue should lead to improvements in
internal processes and decision making.
Page | 124
Innovation and
learning
Can we continue to improve and create value? Focus on this issue draws
attention to the ability of the business to maintain its competitive
position, through the acquisition of new skills and the development of
new products. Suitable measures of performance might include the
percentage of sales derived from new products compared to the
percentage derived from longer-established products, and the time
required to bring a new product to market.
Financial
How do we create value for our shareholders? Financial measures of

performance include share price growth, profitability and return on
investment, and market value added.
For organisations that adopt a balanced scorecard approach, targets are set for a range of critical
financial and non-financial areas, and the main monthly performance report for management is
a balanced scorecard report, not budgetary control reports. In other words, with a balanced
scorecard, the budget 'takes a back seat' to the balanced scorecard.
Typical measures of outcomes for each of the four aspects of performance are as follows.
Perspective
Core financial
measures
Core customer
measures
Internal business
measures
Core learning and

growth measures
Page | 125
Outcome measures
Return on investment, or economic value added/market value added
Profitability
Revenue growth/ revenue mix
Cost reduction/ productivity
Cash flow
Market share
Customer profitability
Attracting new customers
Retaining existing customers
Customer satisfaction
On-time delivery
These will vary according to the nature of the business, but might
include:
Success rate in winning contract orders
Production cycle time
Level of re-works
The percentage of total revenue generated by new products
Time to develop new products
Employee productivity
Employee satisfaction
Employee retention
Revenue per employee
Important benefits of a balanced scorecard approach are that:

(a) It looks at both internal and external factors affecting the organisation
(b) It is related to key elements of the organisation's strategy, and is a strategy-focused
performance management system
(c) Financial and non-financial measures are included, and (short-term) financial performance
measures do not take precedence over the others.
3.1 Implementing a balanced scorecard approach

Robert Kaplan and David Norton, originators of the balanced scorecard approach in the 1990s,
recommend that:
(a) A firm should start by translating its strategy into a balanced set of key objectives. This will
probably include setting a high-level financial objective, such as increasing the return on
capital employed from its current level to a higher target level
(b) These key objectives should then be converted into operational targets
(c) These operational targets should be communicated to employees
The focus of attention is therefore on strategic objectives and the success factors necessary for
achieving them.
3.2 The need for care when adopting a balanced scorecard approach
Supporters of the balanced scorecard approach to performance measurement are amongst those
who doubt the value of budgets and budgetary control as a system of planning and control and
performance management.
However, implementing a balanced scorecard approach can have its problems. The argument
originally put forward by Kaplan and Norton to support a balanced scorecard approach was that
financial indicators of performance on their own were inadequate.
(a) Accounting figures are unreliable and can be manipulated.
(b) Changes in the business and in market conditions facing a company do not show up in the
financial results until much later. Accounting results therefore do not provide early warning
indicators of change.
Performance measures should ideally be difficult to manipulate, and should provide advance
warning of what could happen in the future. They should also relate to factors that management
can do something about. In other words, performance indicators should act as pointers to what
should be done to improve matters.
Page | 126
4. Benchmarking
Another way of measuring performance, that should encourage strategic thinking, is
benchmarking against the world's best.
Benchmarking has been described as 'the formalisation of the basic notion of comparing
practices. It is a systematic analysis of one's own performance against that of another
organisation . The overall objective of benchmarking is to improve performance by learning
from the experience of others' (Smith).
Benchmarking therefore aims to achieve competitive advantage by learning from others'
experiences and mistakes, finding best practice and translating this best practice into use in the
organisation.
4.1. Types of benchmarking

External benchmarking involves:
(a) Comparing the performance of an organisation with that of a direct competitor - ideally one
that is acknowledged to be the 'best in class' (competitive benchmarking), or
(b) Comparing the performance of an internal function with those of the best external
practitioners of those functions, regardless of the industry within which they operate
(functional benchmarking).
Given that the benchmark is the 'best' in a particular field ('the world's best'), it provides a
meaningful target towards which the organisation should aim.
Internal benchmarking, on the other hand, involves comparing the performance of one part of a
business with that of a different part of the same business with the aim of establishing best
practice throughout an organisation. Some external benchmarking is still required, however, in
order to establish best practice.
Although any process can be benchmarked, studies indicate that the business functions most
subjected to benchmarking are customer services, manufacturing, human resources and
information services.
4.2. Why benchmark?

Performance measurements within an organisation should help it to achieve its aims and
objectives. However, there is often a tendency for performance measurements to become an end
Page | 127
in themselves, instead of a way of helping management to achieve their goals. Managers might
even take measures that are harmful to the organisation, in order to produce good results 'on
paper'.
'Perhaps performance measures, when done correctly, help everyone in the company focus on
the right things in the right place at the right time. However ... there are many stories of
dysfunctional behaviour - the telephone company which pledged to have at least 90% of
payphones working, then achieving this figure by simply removing all public payphones from
those areas most often vandalised. Or the bus operator which, plagued by delays, decided to pay
bonuses to drivers who arrived at the terminus on time.
As a result, most buses arrived at the terminus on time - however, drivers no longer tended to
stop for passengers along the way!
Measuring performance by itself has no meaning. Meaning can only be achieved through
comparison, either against poor performance, which usually provides no true indication of future
or competitive position, or through benchmarking.' (Management Accounting, November 1996)
4.3. Limitations and advantages of benchmarking

Both approaches to benchmarking suffer from a number of limitations.
(a) Limitations of external benchmarking
Deciding which activities to benchmark
Identifying which organisation is the 'best in class' at an activity
Persuading that organisation to share information
Successful practices in one organisation may not transfer successfully to another.
(b) The principal limitation of internal benchmarking centres on the relevance of the other part
of the business.
The amount of resources devoted to the units may differ
There may be local differences (use of different computer hardware)
Inputs and outputs may be difficult to define.
Benchmarking works, it is claimed, for the following reasons.

(a) The comparisons are carried out by the managers who have to live with any changes
implemented as a result of the exercise.
Page | 128
(b) Benchmarking focuses on improvement in key areas and sets targets which are challenging
but 'achievable'. What is really achievable can be discovered by examining what others have
achieved: managers are thus able to accept that they are not being asked to perform miracles.
Benchmarking can also provide early warning of competitive disadvantage (i.e. helps an
organisation to identify key areas where competitors are performing better) and should lead to
a greater incidence of team-working and cross-functional learning within an organisation,
through joint efforts to achieve improvements in performance standards to 'world-class' levels.
4.4. Relationship between balanced scorecard and benchmarking

The balanced scorecard and benchmarking are similar in that they both involve identifying key
areas of a business and the selection of performance measures to monitor how the areas are
performing.
The balanced scorecard identifies four specific areas (financial, customer, internal and learning),
whereas benchmarking is not so prescriptive and benchmarks any areas of the business but
typically customer services, manufacturing, human resources and information systems.
Both techniques set targets against which to assess performance. The balanced scorecard will set
a target that will typically be taken from the strategic plan for the business; benchmarking will
usually take the targets either from external competitors or use comparisons from internal
divisions.
One of the main differences between the two techniques is that the balanced scorecard (as its
name suggests) does not rank any performance measure as more important than another e.g. it
does not attribute more importance to financial measures than non-financial. The whole point of
the system is the recognition that for long term growth a business has to move forward on all
fronts exceptional strength in one area may not compensate in the long run for a serious
weakness in others. For example, a strong profit performance may not be sufficient to mask
under-investment in skills training or research and development. A company using the balanced
scorecard would consider that it was failing if the scores were unbalanced.
Benchmarking does not necessarily concern itself with balance, although the benchmarks may be
interpreted to use the balanced scorecard concept to assess overall performance.
Page | 129
5. Key elements of operations management

Operations management is the management of procurement, production, logistics, quality and
related aspects of business operations.
The focus of operations management is on how to achieve standards of performance that will
enable the company to succeed in highly-competitive global markets.
The main elements of operations management should be familiar to you.
(a) Procurement. An organisation buys many products and services from other suppliers.
Procurement involves processing procurement orders, placing orders with suppliers and (if
necessary) chasing up late deliveries. There have been significant developments in recent
years in procurement over the internet ('e-commerce' or 'e-procurement'), with large
reductions in the amount of paperwork needed to place orders.
(b)
Production. Production management is concerned with how items are produced. An

objective of production management should be to produce items more quickly and more
cheaply, and to a higher quality. Flexibility in production methods, for example customising
products to customer specifications, might also be an important objective.
(c) Logistics. Logistics is concerned with transportation and warehousing. Items purchased from
suppliers have to be delivered to the buyer's premises and stored. Finished output might
have to be held in a warehouse until it is delivered to a customer, and then delivered to the
customer. The aim of logistics management should be to achieve a cost-efficient and reliable
way of transporting and storing purchased items and finished goods.
(d) Quality management. Quality is not just a production issue. Quality issues arise in
procurement and logistics operations. The aim of quality management is to improve the
quality of operations and production, both as a way of increasing customer satisfaction and
reducing costs.
6. Operational structures and process-based structures

Traditionally, operations within a manufacturing organisation have been organised on a
functional basis, with a separate department for each major operational function. For example,
there might be separate departments in a factory for making metal products, for machining,
grinding, assembly and finishing. In an old-fashioned factory for making towels, there might have
Page | 130
been departments for carding, dyeing, spinning, weaving and warehousing. Within an operational
or functional structure, every product manufactured by the company goes through every
department, and emerges as a finished product at the end of all the processes.
There are different types of manufacturing process.
(a) Project processes are production processes that usually deal with discrete, customised orders.
The time to complete individual projects can be long, and the work is characterised by low volume
and high variety. Examples of project processes include construction projects and the making of
a film.
(b) Jobbing processes also deal with low-volume and high-variety work. Jobs are essentially small
projects. However, whereas in project processes, each individual project has its own dedicated
resources, for example its own labour force and its own equipment, in jobbing processes, different
jobs share the same resources.
(c) A batch process is one in which products are made several at a time, in discrete batches, but
are not made continuously.
(d) Mass processes produce goods of a fairly standard type in large volumes. Some variations in
product design are possible: for example, car production is a mass process, but it allows for cars
to have different colours of paint and other differing features.
(e) Continuous processes are an extreme form of mass production, in which the volumes of
output are larger than in mass production, and product variety is less. Typically, output is in an
endless, continuing flow, and the process is highly capital-intensive. Examples of continuous
processes might be chemicals production and baked beans manufacture.
The most efficient methods of managing production are likely to vary according to the process
type.
7. World-class manufacturing and the re-design of operations

To be a world class manufacturing business, many companies have re-organised their operations,
perhaps based on focus factories, work flow production or customising orders.
Operations management strategy for a company might be to become a 'lean' manufacturer. Lean
manufacturing is based on flow production, continuous improvement, the elimination of waste,
inventory reduction, work cells etc.
Page | 131
The general term 'world class manufacturing' refers to manufacturing systems that achieve a high
level of performance, allowing the manufacturer to compete on a global stage against rival
producers. It is also associated with changes to manufacturing methods, away from traditional
mass production and batch production systems.
There are a number of production concepts, many of them closely related and compatible with
each other.
7.1. Focus factories

A focus factory can be defined as a collection, within a large manufacturing plant, of a group of
people and machines dedicated to the production and assembly of a specific product, often for
a specific customer. Each focus factory has its own management team, which is responsible for
output and performance.
In 'traditional' manufacturing systems, all the items produced within a single plant go through
the same production departments. Each department deals with one stage in the overall
production process (for example, machining, assembly, finishing). Production is often carried out
in large batches, so that at each stage in the overall process, there are batches of part-finished
items waiting to go into the next process. In practice, production delays occur regularly, and as a
result, the overall production process is often slow, and the quantities and cost of part-finished
work in process scattered around the factory floor is very high. Since items are produced in
batches, some items are made in expectation of demand that does not yet exist, so that finished
goods go into storage in a warehouse until a customer order materialises.
With focus factories, the manufacturing plant is divided into smaller units (known as focus
factories) and each unit concentrates on the manufacture of a single product or product line,
replacing the large all-purpose production departments. The entire production of an item goes
through its focus factory, with the work carried out by 'work cells'.
Experience has shown that a focus factory based arrangement can lead to very large reductions
in work-in-process, thereby saving inventory holding costs, including the interest cost of the
working capital investment in the WIP.
Page | 132
7.2. Flow production

With traditional manufacturing, the emphasis is on making efficient use of plant and machinery.
With flow production, the emphasis is on the responsiveness of the manufacturer to customer
orders.
Flow manufacturing is a production methodology aimed at achieving fast response to customer
demand, by pulling items from suppliers and taking it through a synchronised manufacturing
process to make the item the customer has asked for. The terms one-piece flow and continuous
flow manufacturing are also used.
One-piece flow means a flow of work one unit at a time through production, at a pace
determined by the needs of customers and without the need for building up inventories of partfinished items at each stage in the production process.
Continuous flow manufacturing is similar to flow manufacturing, but refers to a manufacturing
philosophy that is demand led such that its proponents talk of the manufacturing process being
part of the demand chain rather than the supply chain.
The entire manufacturing operation is reconfigured and based on customer requirements. Rather
than manufacturing quantities of products that are then pushed into the marketplace, the
manufacturing process is pulled by the customers requirements. Computer systems are in place
to receive customer needs and organise the supply from external suppliers of the parts needed
and also organise the companys manufacturing cells to produce the required parts and final
goods. The system is a mixture of JIT and Kanban systems, with zero inventories and the customer
as the ultimate pull that initiates the production process.
7.3. Work cell production

Work cell production has similarities to focus factories. With this type of production, the factory
is divided into a number of different work cells or units.
A work cell is a group of equipment or workstations within the same small area of the factory
floor, arranged in processing sequence. Each work cell is capable of making one or more products
with similar characteristics, and is designed to support a smooth flow of production with minimal
transportation of part-finished items and minimal delays. The team in the work cell has the entire
production process under its control.
Page | 133
By putting into a work cell the employees and equipment needed to make similar products, it is
possible to obtain some of the benefits of flow manufacturing (one-piece flow) faster
production, simpler production scheduling, reduced set-up times and lower inventories of work
in progress.
Within a work cell, the machines and other equipment are operated by multi-skilled workers. Each
person can work on any of the machines, and does not specialise in just one type. This allows for
much greater flexibility than in traditional manufacturing systems, where each type of machine
has its own specialist handlers.
Work cell production also makes possible high variety production, because it is a flexible and
adaptable system of working. Members of the team are all in the same small area of the factory
floor, and so can communicate easily. This allows them to adapt readily to variations in customer
specifications, so that the production system is capable of customising orders. An ability to
customise orders has become an essential factor for success in many product markets.
7.4. Flexible manufacturing systems

The reorganisation of manufacturing processes into smaller units focus factories and work cells
an be accompanied by a high degree of computerisation. A flexible manufacturing system (FMS)
is a cluster of machine tools, a robot to change the work pieces and a system of conveyor belts
that shuttle them from one tool to another, all controlled by computers.
The system gets its name from its flexibility in being able to be programmed to produce a number
of different ranges of machined parts, and to switch from one to another quickly and
economically.
In addition to this flexibility, the other main benefits to be derived from such a system include:
(a) The ability to continuously repeat the same operations to the same accuracy and quality
(b) Reduced lead times from design to marketing
(c) Reduced labour costs
(d) Production stability even in the case of disruption, e.g. due to machine breakdown, as the unit
can be reprogrammed to adapt to changes in work scheduling
Page | 134
7.5. Empowered work teams

The changes in operational process organisation and technology that modern manufacturing
systems bring, along with a changing workforce profile, have led many businesses to consider
moving from a traditional hierarchical management structure to a team-based organisation.
Empowered work teams are groups of employees who work together to achieve a particular task
or set of tasks, who will often interact with other groups to achieve the overall business plan.
Being competitive in a marketplace that values quality, flexibility and response times requires
manufacturers to hire or develop employees who can demonstrate these same characteristics.
It's no longer possible to take people off the street, train them in half an hour and expect them
to make a profit, as it was in the days of mass production. Employees must be able to measure
and manage the quality of their jobs to very high standards, be able to switch flexibly from one
task or product to another, and to assist in product and process innovations that can keep their
business at the cutting edge. And in addition to these high skill levels, the employee must also
be able to interact and share information in a time efficient manner, as they will be operating in
one area of the business that will be interdependent with others. Such communication is
facilitated by the use of specialised work teams.
An additional motivator towards the team-based approach is the changing nature of today's
workforce. Over the last forty years or so, the proportions of women and older people in the
workplace have increased, bringing increased demand for more flexible working structures flexitime, job shares, career breaks etc. This requires employees to be able to support and fill in for
each other, a need best fulfilled by the use of work teams. The workforce is also growing more
slowly than in the past, which makes hiring new staff more difficult. New skills therefore need to
be acquired by re-training existing employees, with cross training to provide flexibility. This is
also best accomplished within a team environment.
The particular structure and characteristics of the teams will be dictated by the particular ends
they are designed to achieve, with the underlying principle that a team should be organised in a
way that will maximise its chances of goal attainment.
For example, task forces are teams that are organised as cross-functional units. They may come
together around a single project, issue or problem, and disappear once the project has ended.
Work teams are teams whose members rely on each other every day to meet production
schedules.
Page | 135
Whatever their format, teams need some kind of organisation a charter to determine their
roles and limits of responsibilities.
For example, it might be considered business sense to delegate the daily production scheduling
responsibility to a work team to free up a manager for more important tasks.
When setting the charter, consideration must be made of the extent to which team members can,
for example, rotate jobs, manage suppliers, redesign workflow, monitor quality, deal with
substandard performance, remove team members etc.
7.6. Lean manufacturing

The concept of lean manufacturing began in Japan after 1945, with a number of companies
(notably Toyota) and subsequently found its way into the US. 'Lean' means using less human
effort, a smaller investment of capital, less floor space, fewer materials and less time in production.
Lean manufacturing also has a customer-oriented focus, concentrating on the production and
delivery of items that a customer has asked for, rather than on large-scale batch production of
standard items.
It applies a systematic approach to identifying and eliminating waste in production. Waste is any
activity that does not add value for the customer, and costs more to perform than the value of
any benefit it provides.
Two aspects of lean manufacturing are:
(a) Achieving a flow of production in response to the demands of customers, and
(b) An embedded process of continuous improvement in manufacturing (known in Japanese as
'kaizen'), in search of 'perfection'.
At the centre of lean production is an attack on waste. Several categories of waste can be
identified.
(a) Over-production creates waste. Over-production means making more of an item than there
is demand from customers. If the demand never materialises, the items will have to be discarded,
or possibly sold at a heavily-discounted price. Even when the items are eventually sold, there will
be a period of time during which they are held as inventory, for which there is a holding cost.
Holding inventories of any kind is unnecessarily wasteful because it has a cost but adds no value.
Page | 136
(b) Part-finished work-in-process is also wasteful. This is work going through the production
process, that has completed one stage of the overall process and is waiting to be taken through
the next stage. Work-in-process tends to build up when production processes have a long lead
time, so there can be a long delay for production items between completion of one process and
starting the next.
(c) The transportation of material items does not add value. Any form of motion is waste, whether
it involves the movement of people, materials, part-finished items or finished goods. The
reduction of movement is one of the concepts underlying work cell production.
(d) There is often waste in the production process itself. Any activities within processing that do
not add value should be eliminated.
(e) Time spent by workers waiting for a machine to complete processing is wasteful. The aim
should be to maximise the use of the worker, not the machine.
(f) The manufacture of defective items is wasteful. Defective items must be either scrapped or reworked if they are identified before they leave the factory. After defective items have been
delivered to a customer, there are costs of handling the complaint and making good to the
customer. Poor-quality output also risks the loss of customer goodwill.
There follows a list of concepts commonly associated with lean production
The elimination of waste
Lower inventory levels
Reducing defective output
Continuous improvement (kaizen)
A stop-the-line quality system, whereby any defect in production brings the entire production
line to a halt
Achieving a level production of items, rather than manufacturing in occasional large batches
Continuous flow
Point of use storage of materials and components, to reduce materials flow, rather than
having a centralised storage area
Reduction in production lead times and in set-up times
Improvement in equipment reliability
Teamwork within work cells
7.7. Continuous improvement kaizen

Kaizen is a Japanese term for the philosophy of continuous improvement in performance in all
areas of a business's operations.
Page | 137
Continuous improvement, or kaizen, calls for ever-continuing efforts of finding ways to make
small improvements in production, and is an integral part of the just-in-time philosophy. The
concepts underlying continuous improvement are:
(a) The organisation should always seek perfection. Since perfection is never achieved, there must
always be scope for improving on the current methods.
(b) The search for perfection should be ingrained into the culture and mindset of all employees.
Improvements should be sought all the time.
(c) Individual improvements identified by the work force will be small rather than far-reaching.
The philosophy of continual small-scale improvements is in stark contrast to business process reengineering, which seeks to make radical one-off changes to improve an organisation's
operations and processes.
8. Materials requirements planning (MRP I)

There are various systems for improving operations management. Materials requirements
planning (MRP I) is a computerised system for planning and ordering materials, based on a
master production schedule, bills of materials and inventory level records.
The concepts described above relate to manufacturing methods and the re-design of
manufacturing systems. Another aspect of manufacturing is planning. Within traditional
manufacturing
systems,
the
planning
process
has
been
improved
enormously
by
computerisation.
Illustration: MRP I
The potential benefits of MRP I can perhaps be understood with a simple example. Suppose that
a company manufactures product X, which consists of two units of sub-assembly A and one unit
of sub-assembly B. The company makes the sub-assemblies. One unit of sub-assembly A needs
six units of component C and three units of component D, and one unit of sub-assembly B needs
four units of component D and five units of component E.
In a traditional materials procurement system, new orders are generated for finished goods, subassemblies, components or raw materials when the inventory level for the item falls to a re-order
level. A new batch is then ordered. In the example above, the production of a new batch of
Page | 138
product X could result in new production orders for sub-assembly A or B, and these in turn could
generate new orders for any of the components, depending on inventory levels.
Where a manufacturing process uses many sub-assemblies, components and raw materials items,
it could be difficult to keep check on materials requirements and the re-ordering process, and
there would be a risk of stock-outs of key items, or possibly overstocking of key items to reduce
the likelihood of stock-outs.
A further complication is that each sub-assembly, component or raw material item has its own
production lead time (if manufactured in-house) or supply lead time (if purchased externally). The
task in planning materials requirements is therefore not just a matter of what to order and in
what quantities, but when to order to ensure that deliveries occur in time.
MRP I dates back to the 1960s, and the introduction of computers into business. It is a
computerised information, planning and control system. It can be used in a traditional
manufacturing environment as well as with advanced manufacturing technologies, but is most
commonly used with batch manufacturing. The main advantage of MRP I is that it can process a
large amount of data, and so simplifies what would otherwise be a complex and time-consuming
operation.
The elements of an MRP I system are as follows.
(a) The system has access to inventory records, for all items of inventory (finished goods, subassemblies, components, raw materials) and so is aware of current inventory levels. For each
inventory item, there are also records for the production lead time or purchase lead time.
(b) The system has access to a bill of materials for each item of production. A bill of materials is
simply a detailed list of the sub-assemblies, components and raw materials, including the
quantities of each, needed to make the item.
(c) The system also has access to a master production schedule. This is a production schedule,
detailing the quantities of each item that need to be produced, and the time by which completed
output is required. The master production schedule is produced from firm sales orders and
current estimates of future sales demand within the planning period.
(d) Taking the production schedule, the bills of materials and inventory records, the system
computes what quantities of materials are required, and by when. In the case of items purchased
externally, the system will report when the purchase orders must be placed. Where items are
Page | 139
produced in-house, the system will provide a schedule for the commencement of production for
each item.
(e) The system can produce works orders and materials plans and automatic purchase orders for
use by the purchasing department.
(f) As information about sales orders changes, the production schedule can be altered quickly,
and a new materials procurement programme prepared automatically.
The aims of MRP I are to:
(a) Minimise inventory levels by avoiding over-stocking and earlier-than-necessary materials
requisitions
(b) Avoid the costs of rush orders
(c) Reduce the risk of stock-outs and resulting disruptions to the flow of production.
9. Manufacturing resource planning (MRP II)

Manufacturing resource planning (MRP II) is an extension of MRP I, that integrates the
manufacturing, materials requirements planning, engineering, finance and possibly marketing
databases into a single planning control system database.
Manufacturing Resource Planning, known as MRP II, evolved out of MRP I in the 1970s.
MRP II is a computerised system for the planning of all resources in a manufacturing company,
and materials requirements planning is a core element in MRP II.
The difference between MRP II and MRP I is principally that MRP II extends the computer system
beyond manufacturing operations, and provides a common database for all functions in the
organisation, such as sales and marketing, finance and distribution and transportation (logistics).
It attempts to integrate materials requirement planning, factory capacity planning, shop floor
control, production design, management accounting, purchasing and even marketing into a
single complete (and computerised) control system.
Without an MRP II system, each separate function within the company would need its own standalone database, even though some of the information they use is common to each.
Page | 140
9.1. Example: MRP II

The production engineering department needs information about bills of materials. If it makes a
change to a product specification, the bill of materials for the product must be changed. In the
absence of an MRP II system, the same changes would have to be made to the databases of both
the production department and the production engineering department. There would also be
the risk of one database being updated but not the other.
The finance department uses information from a production budget and bills of materials to
produce budgets and reports on product costs and product profitability. When a bill of materials
is changed, the accounts department needs to know so that product costs can be re-calculated.
When the production schedule is amended, the accounts department needs to know in order to
prepare revised production cost estimates. Without an MRP II system, any changes to the
production schedule would have to be fed into the production database and the accounting
database separately.
MRP II therefore offers the advantages of a common database easier updating and a common
set of data for all departments to use.
MRP I and MRP II systems have their critics, particularly from advocates of just-in-time production
and lean production. A problem with the MRP approach is that it creates a model of what
currently happens in the manufacturing plant, not what perhaps ought to happen. It builds in bad
habits and waste. It allows for long lead times, bottlenecks in production, large batch sizes.
Management will not be motivated to achieve improvements and eliminate waste when poor
productivity and poor quality are built into the MRP II planning system.
10. Optimised production technology (OPT)

An optimised production technology (OPT) system is another type of system for planning
manufacturing and materials resource requirements. Whereas MRP plans requirements to a given
production schedule, OPT plans production schedules to known capacity constraints in the
production process. The OPT approach is based on the theory of constraints.
OPT is an alternative computer system to MRP II. Like MRP II, it can be used to plan manufacturing
and materials requisition requirements. Unlike MRP II, however, it plans production schedules to
known capacity constraints within the production process.
Page | 141
Optimised production technology (OPT) has making money as its primary goal, progress towards
which can be measured by three criteria: production rate (throughput), inventory and operating
expenses. The aim of OPT is to maximise throughput whilst minimising inventory levels and
operating expenses.
10.1. How OPT works

Essentially, an OPT system simulates the factory or workshop and its current workload.
A production process consists of a sequence of tasks, each carried out with a different group of
workers and on a different group of machines. There are resources for each task (for example, a
given number of workers or machines) and the volume of output achievable will be restricted by
the quantity of those resources available. There will be one point in the process where output
capacity is lower than at any other point in the process. In other words, there must always be a
bottleneck. An OPT system identifies the bottleneck (or bottlenecks) in production. This could be
a particular machine or group of machines, or available skilled labour time.
When a bottleneck has been identified, management can look for ways of overcoming it and
reducing the limitation on output and optimising work flow. When one bottleneck has been
alleviated, another stage in the production process will become the new bottleneck, and
management can switch its attention to the new restriction on output. By focusing on the
bottleneck, management should optimise production throughput.
Once a plan has been prepared for maximising work flow through the bottleneck, the remainder
of the production facility should be organised for supplying parts to the bottleneck or for dealing
with the production processes after the bottleneck point. The manufacturer might try to ensure
that there is always some inventory (work in progress) waiting to go through the bottleneck
operation, so that this operation is never brought to a halt by a stock-out. Management should
also avoid any unnecessary build-up of part-finished work in other parts of the manufacturing
operation, which cannot be completed because of the bottleneck. A benefit of OPT, in addition
to optimising throughput, should also be to reduce inventory levels in other parts of the
operation, away from the bottleneck.
Page | 142
10.2. Rationale for OPT

Although OPT is a computer system, it had its origins in a 1992 love story thriller book, The Goal.
This book was co-written by Eli Goldratt, who became a management consultant. The ideas of
Goldratt led to the Theory of Constraints, which states that any system consists of multiple steps,
where the output of one step depends on the output of one or more previous steps. The output
of these previous steps will be limited (constrained) by the least productive of those steps.
The aim of a company should be to maximise profits. Higher profits can be achieved to some
extent by reducing costs and reducing inventory levels. Goldratt suggested, however, that the
greatest opportunities for improving profits will come from optimising the flow through the
system. Optimum throughput is achieved by focusing on existing constraints, and:
(a) Identifying what they are
(b) Deciding how best to optimise the work flow, given the existing constraint
(c)
Seeking ways to overcome the constraint, for example by working overtime on the
constraining operation, or buying more machines or hiring more labour.

Once one constraint has been 'elevated' (i.e. overcome, so that it is no longer a constraint) the
next task is to identify the new constraint in the system and seek ways to overcome that.
11. Enterprise resource planning (ERP) systems

An ERP system can be defined in its widest sense as any software system designed to support
and automate the business processes of medium and large businesses. This may include
manufacturing, distribution, personnel, project management, payroll and finances.
ERP systems are accounting-oriented information systems for identifying and planning the
enterprise-wide resources needed to take, make, distribute and account for customer orders. For
example, they help track the flow of raw materials into an organisation, the integration of those
components into final products, the cost and processes associated with running the business,
and the delivery of the products to the customer.
The benefits to be derived from this detailed and accurate tracking of such operational data
include:
Enabling informed business process decisions to reduce costs
Speeding product delivery times through shortened cycle times
Page | 143
Increasing customer satisfaction
Increasing shareholder value
Twenty years ago these automated systems were custom projects which were only attempted at
significant cost by large organisations. There are now a number of independent software vendors
who have developed common underlying systems that can be adapted to each business's needs,
enabling a larger number of organisations to automate ERP functions.
The central feature of any ERP system is a large and powerful database, that incorporates all the
information systems necessary to plan and track resource utilisation throughout the business.
ERP systems employ highly developed technology in both their software and hardware to achieve
the aims of speedy and accurate processing of data to provide relevant up to date information
for management control.
For example, one outcome of the ERP development has been the increased availability of up to
date and accurate information to employees, management and customers wherever and
whenever needed, by the use of hand held and pocket PCs. These bypass the traditional paperbased systems by the use of computerised forms on mobile PCs, allowing data to be entered
directly into the system at its point of origin, resulting in faster and higher quality data entry (lines
cannot be left blank, data can be pre-checked for validity etc.).
Microsoft used such devices to track inventory of the company's products on store shelves, and
saw a 50% reduction in the time it took to collect the data when paper forms were converted to
electronic forms.
12. Just-in-time production and purchasing

Just-in-time purchasing and production seek to minimise inventory levels, by acquiring raw
materials or producing goods only when they are needed. JIT purchasing calls for close cooperation between an organisation and its suppliers.
Just-in-time is an approach to operations planning and control based on the idea that goods and
services should be produced only when they are needed, and neither too early (so that inventories
build up) nor too late (so that the customer has to wait). JIT is also known as 'lean operations',
'stockless production' and 'fast throughput manufacturing'. It contrasts with the 'traditional'
approach to purchasing and production, in which an organisation seeks to maintain sufficient
inventories of all key supply items and finished goods to meet foreseeable demand.
Page | 144
Definitions of JIT are:

(a) 'JIT aims to meet demand instantaneously, with perfect quality and no waste.' (Bicheno,
Implementing Just-in-time)
(b) 'Just-in-time is a disciplined approach to improving overall productivity and eliminating
waste. It provides for the cost-effective production and delivery of only the necessary quantity of
parts at the right quality, at the right time and place, while using a minimum amount of facilities,
equipment, materials and human resources. JIT is dependent on the balance between the
supplier's flexibility and the user's flexibility. It is accomplished through the application of
elements which require total employee involvement and teamwork. A key philosophy of JIT is
simplification.' (Voss, Just-in-Time Manufacture).
Just-in-time (JIT) is a system whose objective is to produce or to procure products or
components as they are required (by a customer or for use) rather than for inventory. A justin-time system is a 'pull' system, which responds to demand, in contrast to a 'push' system, in
which inventories act as buffers between the different elements of the system, such as
purchasing, production and sales.
Just-in-time production is a production system which is driven by demand for finished
products whereby each component on a production line is produced only when needed for the
next stage.
Just-in-time purchasing is a purchasing system in which material purchases are contracted so
that the receipt and usage of material, to the maximum extent possible, coincide. (CIMA Official
Terminology)
In 'traditional' manufacturing, where there is a production process with several stages,
management seek to insulate each stage in the process from disruption to another stage, by
means of producing for inventory and holding inventory. For example, a manufacturing process
consists of four consecutive stages. In a traditional manufacturing system, there would be
inventories of raw materials and finished goods, and also inventories of part-finished items
between stage 1 and stage 2, between stage 2 and stage 3 and between stage 3 and stage 4. If
there is disruption to production at, say, stage 2, the other stages would not be immediately
affected. Stages 3 and 4 would continue to operate, using the inventories of part-finished items
from stages 2 and 3. Stage 1 would also continue to operate, producing inventory for stage 2.
Page | 145
The responsibility for resolving the disruption would fall mainly on the managers of the stage
affected, which in this example would be the management of stage 2.
In contrast, in its extreme form, a JIT system seeks to hold zero inventories. In the same fourstage process described above, a disruption at any stage would immediately have an impact on
all the other stages. For example, if a disruption occurs at stage 2, stages 3 and 4 will have to stop
working because they have no output from stage 2. Stage 1 will also have to stop working,
because it will only produce when stage 2 is ready to receive and use its output.
In JIT a disruption at any part of the system becomes a problem for the whole operation to
resolve. Supporters of JIT management argue that this will improve the likelihood that the
problem will be resolved, because it is in the interest of everyone to resolve it. They also argue
that inventories are a 'blanket of obscurity' that help to hide problems within the system, so that
problems go un-noticed for too long.
12.1. Requirements of JIT

The operational requirements for JIT are as follows.
(a) High quality. Disruption in production due to errors in quality will reduce throughput and
reduce the dependability of internal supply.
(b) Speed. Throughput in the operation must be fast, so that customer orders can be met by
production rather than out of inventory.
(c) Reliability. Production must be reliable and not subject to hold-ups.
(d) Flexibility. To respond immediately to customer orders, production must be flexible, and in
small batch sizes.
(e) Lower cost. As a consequence of high quality production, and with a faster throughput and
the elimination of errors, costs will be reduced.
A consequence of JIT is that if there is no immediate demand for output, the operation should
not produce goods for inventory. Average capacity utilisation could therefore be low (lower than
in a 'traditional' manufacturing operation). However, with a traditional manufacturing system, a
higher capacity utilisation would only be achieved by producing for inventory at different stages
of the production process.
Page | 146
Supporters of JIT argue that there is no value in producing for inventory, and, as suggested above,
it could damage the overall efficiency of an operation.
12.2. The JIT philosophy

JIT can be regarded as an approach to management that encompasses a commitment to
continuous improvement and the search for excellence in the design and operation of the
production management system. Its aim is to streamline the flow of products through the
production process and into the hands of customers.
The JIT philosophy originated in Japan in the 1970s, with companies such as Toyota. At its most
basic, the philosophy is:
(a) To do things well, and gradually do them better (continuous improvement), and
(b) To squeeze waste out of the system.
Three key elements in the JIT philosophy are:
(a) Elimination of waste. Waste is defined as any activity that does not add value. Examples of
waste identified by Toyota were:
(i) Overproduction, i.e. producing more than was immediately needed by the next stage in the
process
(ii) Waiting time. Waiting time can be measured by labour efficiency and machine efficiency.
(iii) Transport. Moving items around a plant does not add value. Waste can be reduced by
changing the layout of the factory floor so as to minimise the movement of materials.
(iv) Waste in the process. There could be waste in the process itself. Some activities might be
carried out only because there are design defects in the product, or because of poor maintenance
work.
(v) Inventory. Inventory is wasteful. The target should be to eliminate all inventory by tackling the
things that cause it to build up.
(vi) Simplification of work. An employee does not necessarily add value by working. Simplifying
work is an important way of getting rid of waste in the system (the 'waste of motion') because it
eliminates unnecessary actions.
Page | 147
(vii) Defective goods are 'quality waste'. This is a significant cause of waste in many operations.
(b) The involvement of all staff in the operation. JIT is a cultural issue, and its philosophy has to
be embraced by everyone involved in the operation if it is to be applied successfully. Critics of JIT
argue that management efforts to involve all staff can be patronising.
(c) Continuous improvement. The ideal target is to meet demand immediately with perfect
quality and no waste. In practice, this ideal is never achieved. However, the JIT philosophy is that
an organisation should work towards the ideal, and continuous improvement is both possible
and necessary. The Japanese term for continuous improvement is 'kaizen'.
12.3. JIT techniques

JIT is not just a philosophy, it is also a collection of management techniques. Some of these
techniques relate to basic working practices.
(a) Work standards. Work standards should be established and followed by everyone at all times.
(b) Flexibility in responsibilities. The organisation should provide for the possibility of expanding
the responsibilities of any individual to the extent of his or her capabilities, regardless of the
individual's position in the organisation. Grading structures and restrictive working practices
should be abolished.
(c) Equality of all people working in the organisation. Equality should exist and be visible. For
example, there should be a single staff canteen for everyone, without a special executive dining
area; and all staff including managers might be required to wear the same uniform.
(d) Autonomy. Authority should be delegated to the individuals responsible directly in the
activities of the operation. Management should support people on the shop floor, not direct
them. For example, if a quality problem arises, an operative on the production line should have
the authority to bring the line to a halt ('line stop authority'). Gathering data about performance
should be delegated to the shop floor and the individuals who use it. Shop floor staff should also
be given the first opportunity to solve problems affecting their work, and expert help should only
be sought if it is needed.
(e) Development of personnel. Individual workers should be developed and trained.
(f) Quality of working life. The quality of working life should be improved, through better work
area facilities, job security, involvement of everyone in job-related decision-making and so on.
Page | 148
(g) Creativity. Employees should be encouraged to be creative in devising improvements to the

way their work is done.
Aspect
Explanation
JIT purchasing
Small, frequent deliveries, rather than bulk supply orders. This requires
close integration of suppliers with the company's manufacturing process.
Machine cells
The grouping of machines or workers by product or component instead

of by type of work performed. For example, instead of having a single
machining department and a single assembly or finishing department for
all products made by the organisation, there is a small area on the factory
floor (a 'cell') for the machining and assembly or finishing for each
product or group. The entire production process for the product is
carried out within the cell.
Set-up time
The recognition of machinery set-ups as non 'value-adding' activities,
reduction
which should be reduced or even eliminated.
Uniform loading
The operating of all parts of the production process at a speed that

matches the rate at which the customer demands the final product.
Pull system
The use of a Kanban, or signal, to ensure that products/components are
(Kanban)
only produced when needed by the next process. Nothing is produced for
inventory, in anticipation of need.
Total quality
The design of products, processes and vendor quality assurance

programmes to ensure that the correct product is made to the
appropriate quality level on the first pass through production.
Employee
JIT involves major cultural change throughout an organisation. This can
involvement
only be achieved if all employees are involved in the process of change

and continuous improvement inherent in the JIT philosophy.
There are other JIT techniques and methodologies.

(a) Design for manufacture. In many industries, the way that a product is designed determines a
large proportion of its eventual production costs. Production costs can therefore be significantly
reduced at the design stage, for example by reducing the number of different components and
sub-assemblies required in the product (i.e. achieving greater simplicity).
(b) Use several small, simple machines, rather than a single large and more complex machine.
Small machines can be moved around more easily, and so offer greater flexibility in shop floor
Page | 149
layout. The risk of making a bad and costly investment decision is reduced, because relatively
simple small machines usually cost much less than sophisticated large machines.
(c) Work floor layout and work flow. Work can be laid out to promote the smooth flow of
operations. Work flow is an important element in JIT, because the work needs to flow without
interruption in order to avoid a build-up of inventory or unnecessary down-times. The movement
of materials and part-finished work is wasteful because it does not add value, which means that
waste can be reduced by laying out the work floor and designing the work flow so as to minimise
movements.
(d)
Total productive maintenance (TPM). Total productive maintenance seeks to eliminate
unplanned breakdowns and the damage they cause to production and work flow. Staff operating
on the production line are brought into the search for improvements in maintenance, and are
encouraged to 'take ownership' of their machines and carry out simple repairs on them. This frees
up maintenance specialists to use their expertise to look for 'higher level' ways of improving
maintenance systems, instead of spending their time on 'fire fighting' repairs and maintenance
jobs.
(e) Visibility. The work place and the operations taking place in it are made more visible, through
open plan work space, visual control systems, information displays in the work place showing
performance achievements, and signal lights to show where a stoppage has occurred.
13. Total quality management (TQM)

Total quality management is an approach to quality improvements that seeks to eliminate
waste entirely and to achieve perfect quality standards.
Quality means 'the degree of excellence of a thing' how well it is made, or how well it is
performed (if it is a service), how well it serves its purpose, and how it measures up against its
rivals.
The management of quality is the process of:
(a) Establishing standards of quality for a product or service
(b) Establishing procedures or production methods which ought to ensure that these required
standards of quality are met in a suitably high proportion of cases
(c) Monitoring actual quality
Page | 150
(d) Taking control action when actual quality falls below standard
Quality management becomes total when it is applied to everything a business does.
TQM has been described as a 'natural extension' of previous approaches to quality management,
which were:
(a) Inspection, i.e. inspecting output in order to detect and rectify errors.
(b) Quality control, i.e. using statistical techniques to establish quality standards and monitor
process performance.
(c) Quality assurance. This extended quality management to areas other than direct operations,
and uses concepts such as quality costing, quality planning and problem solving.
13.1. Get it right first time

One of the basic principles of TQM is that the cost of preventing mistakes is less than the cost of
correcting them once they occur. The aim should therefore be to get things right first time.
'Every mistake, every delay and misunderstanding directly costs a company money through
wasted time and effort, including time taken in pacifying customers. Whilst this cost is important,
the impact of poor customer service in terms of lost potential for future sales has also to be taken
into account'.
13.2. Continuous improvement

A second basic principle of TQM is dissatisfaction with the status quo: the belief that it is always
possible to improve and so the aim should be to 'get it more right next time'.
13.3. The requirements of quality

There are nine elements in a TQM approach.
(a) Accept that the only thing that matters is the customer.
(b) Recognise the all-pervasive nature of the customer-supplier relationship, including internal
customers: passing sub-standard material to another division is not satisfactory or acceptable.
(c) Move from relying on inspecting to a predefined level of quality to preventing the cause of
the defect in the first place.
Page | 151
(d) Each operative or group of operatives must be personally responsible for defect-free
production or service in their domain. TQM requires an awareness by all personnel of the quality
requirements compatible with supplying the customer with products of the agreed design
specification.
(e) Move away from 'acceptable' quality levels. Any level of defects is unacceptable. TQM aims
towards an environment of zero defects at minimum cost.
(f) It also aims towards the elimination of waste, where waste is defined as anything other than
the minimum essential amount of equipment, materials, space and workers' time.
(g) All departments should try obsessively to get things right first time: this applies to misdirected
telephone calls and typing errors as much as to production.
(h) Quality certification programmes should be introduced.
(i) The cost of poor quality should be emphasised: good quality generates savings.
When quality improvements are achieved by introducing new technology or new practices, then
training to show people how to use the new technology or implement the new practices will be
required.
However, workers themselves are frequently the best source of information about how (or how
not) to improve quality. 'Training' means training workers to want to improve things: it is matter
of changing attitudes.
(a) Workers can be motivated by a positive approach to quality: producing quality work is a
tangible and worthwhile objective. Where responsibility for quality checking has been given to
the worker (encouraging self-supervision), job satisfaction may be increased: it is a kind of job
enrichment, and also a sign of trust and respect, because imposed controls have been removed.
(b) Cultural orientation (the deep 'belief' in quality, filtered down to all operatives) and work
group norms and influence can be used. Competition to meet and beat quality standards, for
example, might be encouraged. Quality circles may be set up, perhaps with responsibility for
implementing improvements which they identify.
Page | 152
13.4. Involvement of all parts of the organisation

In a TQM approach, all parts of the organisation are involved in quality issues, and need to work
together. Every person and every activity in the organisation affects the work done by others.
TQM promotes the concept of the internal customer and internal supplier. The work done by an
internal supplier for an internal customer will eventually affect the quality of the product or service
to the external customer. In order to satisfy the expectations of the external customer, it is
therefore also necessary to satisfy the expectations of the internal customer at each stage of the
overall operation. Internal customers are therefore linked in quality chains. Internal customer A
can satisfy internal customer B who can satisfy internal customer C who in turn can satisfy the
external customer.
The management of each 'micro operation' within an overall operation has the responsibility for
managing its internal supplier and internal customer relationships. They should do this by
specifying the requirements of their internal customers, for example in terms of quality, speed,
dependability and flexibility, and the requirements for the operation itself (for example, in terms
of cost).
The concept of internal supplier-customer relationships in a series of micro-operations helps to
focus attention on the 'up-stream' activities in an operation, several stages removed from the
external customer. Failure at an early stage on the operation, for example in new product design,
has an adverse impact on all the supplier-customer relationships down the line to the external
customer. The cost of rectifying an error becomes more expensive the further it goes down the
'supply chain' without rectification.
Some organisations formalise the internal supplier-internal customer concept by requiring each
internal supplier to make a service level agreement with its internal customer. A service level
agreement is a statement of the standard of service and supply that will be provided to the
internal customer and will cover issues such as the range of services supplied, response times,
dependability and so on. Boundaries of responsibility and performance standards might also be
included in the agreement.
Service level agreements have been criticised, however, for over-formalising the relationship
between the internal supplier and internal customer, and so creating barriers to the development
of a constructive relationship and genuine co-operation between them.
Page | 153
14. Value for money (VFM)

Value for money (VFM), as the term suggests, means giving or getting good value for the money
spent. The management of VFM means trying to ensure that value for money is obtained, or
improved.
There are three elements in getting value for money, sometimes called the 'three Es'.
(a) Economy
(b) Efficiency
(c) Effectiveness
Economy. Economy means obtaining the appropriate quantity and quality of input resources
(labour, materials, machinery and equipment, finance, etc.) at the lowest cost.
Efficiency. Efficiency describes the relationship between the utilisation of resources (inputs) and
the output produced with those resources. Improving efficiency means getting more output from
each unit of input, or getting the same amount of output with fewer input resources.
Effectiveness. Effectiveness is concerned with whether an activity or output succeeds in fulfilling
the purpose for which it was intended.
VFM management can be applied in any organisation, but VFM is more usually associated with
not-for-profit organisations. The results of a not-for-profit organisation cannot be measured in
terms of profits or return on investment. Instead, results can be measured in terms of whether
the organisation has succeeded in achieving what it intended (effectiveness) at the lowest cost,
through economic purchasing and efficient use of resources.
14.1. Studying and measuring the three Es

Economy, efficiency and effectiveness can be studied and measured with reference to inputs,
outputs and impacts.
(a)
Inputs. Inputs are resources used by an organisation or activity. Resources are labour,
materials and supplies, capital equipment and money. In a school, for example, inputs include the
teaching staff and administrative staff, the school buildings, teaching equipment and books.
Page | 154
(b) Outputs. Outputs are the results of an activity, which are measurable as the services actually
provided, and the quality of those services. In a school, outputs would include the number of
pupils taught, the number of subjects taught per pupil, the number of examinations taken by
pupils, the number of examinations passed and the grades obtained, the number of sixth-form
pupils going on to higher education, and so on.
(c) Impacts. Impacts are the effect that the outputs of an activity or programme have in terms of
achieving policy objectives. For example, in a school system, policy objectives might include
providing a minimum level of education up to the age of sixteen, and for a target percentage of
sixteen year olds to continue with their education and then go on to further education.
Economy is concerned with the cost of inputs, and obtaining the desired quality of resources at
the lowest cost. Economy does not mean straightforward cost-cutting, because resources must
be of a suitable quality to provide the service to the desired standard. However, economy is an
important element in performance in not-for-profit organisations, such as government services.
Efficiency is concerned with maximising output with a given quantity of resources, or achieving a
target output with the minimum quantity of resources. Examples of improving efficiency might
be to increase the number of cases handled by members of the police force or a hospital service.
14.2. Problems with value for money

14.2.1. Evaluation of VFM
When a value for money programme is established, an important element in the system should
be review and evaluation. Managers need to know whether the intended value for money has
actually been achieved.
There are various ways of assessing VFM.
(a)
Through benchmarking an activity against similar activities in other organisations. For
example, hospitals can compare what they do with practices in other hospitals.
(b) Through performance indicators. Actual performance can be monitored against targets.
(c) By seeking out recognised good practice and seeing whether this can be applied to the
organisation's own situation.
(d) Internal audit.
Page | 155
(e) By retaining documentation to show how an operation or activity has been planned, as
evidence that good practice has been adopted.
(f) By examining the results or outcomes of an activity or operation.
Economy, efficiency and effectiveness should seem desirable targets for management to achieve,
but in practice, there can be problems in performance measurement, particularly in the public
sector.
These problems relate to:
(a) How to identify objectives, and then state them in quantifiable terms
(b) How to measure outputs and impacts.
A further problem is that there may be several totally different ways of meeting the service needs
of the public. If so, a government cannot easily compare the alternatives using VFM. For example,
suppose that the government's transport ministry is considering ways of easing congestion on
the roads.
(a) It could build more roads.
(b) It could encourage the public to switch from using cars to other forms of transport, by
increasing the tax on petrol or imposing motorway tolls.
These alternatives cannot be compared in quantifiable terms, and so VFM could not be used as
a technique for reaching a policy decision.
14.2.2. Barriers to value for money

Value for money is improved by making changes that reduce costs, increase efficiency or make
an operation more effective in achieving its desired target. However, a willingness to make
changes calls for:
(a) Management that is willing to innovate and take serious steps to improve performance
(b) Generating ideas for improving VFM, and the ability to evaluate these ideas and put them
into practice
(c) The co-operation of employees, and a general motivation to improve VFM
Page | 156

Management Accounting

Enviado por

Dados do documento

Direitos autorais

Formatos disponíveis

Compartilhar este documento

Compartilhar ou incorporar documento

Opções de compartilhamento

Você considera este documento útil?

Este conteúdo é inapropriado?

Direitos autorais:

Formatos disponíveis

Management Accounting

Enviado por

Direitos autorais:

Formatos disponíveis

Contents

Chapter 2: Managing Organisation ............................................................................................. 23

Chapter 3: Cost Management ....................................................................................................... 35

Chapter 4: Managing Budgets ...................................................................................................... 51

Chapter 5: Breakeven analysis ...................................................................................................... 72

Chapter 6: Costing Decisions ........................................................................................................ 81

Chapter 7: Price Management ...................................................................................................... 97

Chapter 8: Variance Analysis....................................................................................................... 112

Chapter 9: Quality Management ................................................................................................ 120

Chapter 1: Financial accounting review

Chapter 1: Financial accounting review

Figure 1 Financial Accounting and Management Accounting

1. Framework for Financial Reporting

Chapter 1: Financial accounting review

Preparers of financial statements in applying international standards and in dealing with

Users of financial statements in interpreting the information contained in financial

1.1 Purpose and scope of the Framework

the objective of financial reporting

the qualitative characteristics of useful financial information

the reporting entity

concepts of capital and capital maintenance

1.2 Underlying assumptions

Chapter 1: Financial accounting review

Going Concern Basis

2. Structure and content of Financial Statements

a statement of financial position (balance sheet) at the end of the period

a statement of changes in equity for the period

a statement of cash flows for the period

notes, comprising a summary of significant accounting policies and other explanatory

Chapter 1: Financial accounting review

comparative information prescribed by IFRSs and IASs.

the financial statements, which must be distinguished from other information in a

each financial statement and the notes to the financial statements.

whether the financial statements are a group of entities or an individual entity

information about the reporting period

the level of rounding used (e.g. thousands, millions).

2.1 Statement of financial position (balance sheet)

expected to be realised in the entity's normal operating cycle

Chapter 1: Financial accounting review

held primarily for the purpose of trading

expected to be realised within 12 months after the reporting period

cash and cash equivalents (unless restricted).

All other assets are non-current assets.

IAS1 defined Current liabilities as those:

expected to be settled within the entity's normal operating cycle

held for purpose of trading

due to be settled within 12 months

Other liabilities are non-current liabilities as per IAS1.

property, plant and equipment

investments accounted for using the equity method

Chapter 1: Financial accounting review

trade and other receivables

cash and cash equivalents

assets held for sale

trade and other payables

financial liabilities (excluding amounts shown under (xi) and (xii))

current tax liabilities and current tax assets, as defined in IAS 12

deferred tax liabilities and deferred tax assets, as defined in IAS 12

liabilities included in disposal groups

non-controlling interests, presented within equity

issued capital and reserves attributable to owners of the parent.

classes of property, plant and equipment

disaggregation of inventories in accordance with IAS 2 Inventories

disaggregation of provisions into employee benefits and other items