Escolar Documentos
Profissional Documentos
Cultura Documentos
PERFORMANCE MANAGEMENT
REVISION PACK
2016
F5 Performance Management 2016
Contents
Page 2 of 147
F5 Performance Management 2016
Direct Cost: A cost that can be traced back in full to a product, service or department.
Indirect Production Cost: Also known as Overheads. It is a cost that cannot be directly linked in full to the
actual production of goods/ provision of services. Example: Rent of factory where five different products
are manufactured.
Indirect Non Production Cost: Also referred to as Overheads. It is a cost incurred in a support function that
is not directly involved in the manufacturing process or provision of the main service. Example: Marketing
expenses of a television sets manufacturer.
Absorption Costing: a form of costing in which the costs of products are calculated by adding an amount
for indirect production costs (overheads) to the direct costs of production.
Marginal Costing: a form of costing where only the direct costs are considered relevant for the cost of a
product. Fixed costs are treated as Period Costs.
Page 3 of 147
F5 Performance Management 2016
Helpful in cases where companies attempt to set selling prices based on the full cost of production or sales
of each product.
Best practice in case of a company selling multiple products, to determine profitability of each product.
Provides more useful information for managers in decision making process as contribution calculated
under this system is directly proportionate to the sales volume; which gives a more accurate picture of the
impact of sales volume on cashflows and profits.
Page 4 of 147
F5 Performance Management 2016
Introduction:
The simplest method of dealing with the fixed production costs is to assume that all of the
production overheads can be treated together and a single overhead absorption rate per labour
hour, or cost per machine hour, derived.
With production processes becoming highly automated the conventional way of treating fixed
overheads, using an over-simplified base is not good enough, especially for organisations
manufacturing multiple products. Companies need to know the causes of overhead and they need
to try to assign costs to products or services on the basis of the resources they consume.
To get a more accurate estimate of what each unit costs to produce, it is necessary to examine
what activities are necessary to produce each unit, because activities usually have a cost attached.
This is the basis of Activity Based Costing (ABC).
Production overheads
Allocated/apportioned to
Product costs
Allocated/apportioned to
Page 5 of 147
F5 Performance Management 2016
Example:
An organisation manufactures 3 different products. In a year, its Fixed Production Overheads comprise of:
Cost Pool Cost Driver
Machine Handling Costs $20,000 500 machine hours
Production Scheduling Costs $14,000 100 production runs
Total Fixed Overheads $34,000 100 labour hoours
Under the traditional Absorption costing method, Fixed Overheads cost for Product A will be:
$34,000 x 20 labour hours = $6,800
100 labour hours
Under the ABC method, the working will change to:
Machine Handling $20,000 x 15 machine hours = $600
500 machine hours
Based on the information made available, the following types of decision making processes will be
supported:
Pricing on mark-up basis for individual products will become fair as the cost of production is
assessed more accurately.
Promoting or discontinuing products, activities or parts of business as there will be better
indication of where cost savings can be made.
Developing new ways or products to do business.
Page 6 of 147
F5 Performance Management 2016
Page 7 of 147
F5 Performance Management 2016
3. Target Costing
Introduction:
Traditionally the selling price of a product is determined by adding a profit mark-up to the Product cost.
But an organisation may not be able to find customers who might want to buy at that price as the product
may not have the features customers value or the competitors products might be cheaper, or at least
offer better value for money. This flaw is addressed by target costing.
Target Costing:
Target costing is very much a marketing approach to costing as it involves setting a selling price for the
product by reference to the market. From this the desired profit margin is deducted to arrive at a target
cost.
Page 8 of 147
F5 Performance Management 2016
For example, if you are selling perfume, the design of its packaging is important. The perfume
could be sold in a plain glass bottle, and although there will be no damage to the use value, the
esteem value will be damaged. The company would be unwise to try to reduce costs by
economising too much on packaging.
Because of the characteristics and information requirements, it is difficult to use Target Costing in service
industries. Examples of service businesses include:
(a) Mass service e.g. the banking sector, transportation (rail, air), mass entertainment
(b) Either / or e.g. fast food, teaching, hotels and holidays, psychotherapy
(c) Personal service e.g. pensions and financial advice, car maintenance
There are five major characteristics of services that distinguish services from manufacturing.
Intangibility Unlike goods there is no substantial material or physical aspects to a
service.
Inseparability/simultaneity. Many services are created at the same time as they are consumed. (Think of
dental treatment.) No service exists until it is actually being experienced/
consumed by the person who has bought it.
Perishability Services are time bound. The services of a dentist are purchased for a
period of time.
No transfer of ownership. Services do not result in the transfer of property but only access to or a
right to use a facility.
Challenges:
Services do not have any material content (tangibility) making it difficult to reduce target cost gap
through material cost reduction.
Services vary each time resulting in there being an estimated average cost for each service but not
a specific standard cost that can be reduced.
Page 9 of 147
F5 Performance Management 2016
Introduction:
Under traditional costing methods, only the current costs, comprising of marginal costs plus a share
of fixed costs, are considered. But other costs, without which the goods could not have been made,
such as Research & Development costs, are ignored.
When seeking to make a profit on a product it is essential that the total revenue arising from the
product exceeds total costs, whether these costs are incurred before, during or after the product is
produced. This is addressed by lifecycle costing.
Lifecycle Costing:
The development stage The product has a research and development stage where costs are incurred
but no revenue is generated.
The introduction stage The product is introduced to the market. The organisation will spend on
advertising to bring the product or service to the attention of the potential
customers.
The growth stage At this stage, the product becomes well-known in the market. Due to increase
in demand, it captures a bigger market and starts to make a profit. At this
stage, cost of the initial investment is progressively recovered.
The maturity stage At this stage, demand for the product stabilises or the rate of growth slows
Page 10 of 147
F5 Performance Management 2016
The decline / saturation A point comes where large / adequate quantities of the product have been
stage sold in the market and the product, therefore, reaches a saturation point. At
this stage the demand for the product starts to fall and marketing costs are
cut down. The product may start making loss at this stage. The organisation
may decide to discontinue the production and to develop a new product.
Cost reduction at the planning, design and development stage of a product's life cycle, rather than during
the production process, is one of the most important ways of reducing product cost.
The potential profitability of product can be assessed before major development of the product is
carried out and costs incurred and non-profit-making products can be abandoned.
Techniques can be used to reduce costs over the life of the product
Pricing strategy can be determined before the product enters production.
Page 11 of 147
F5 Performance Management 2016
Attention can be focused on reducing the research and development phase to get the product to
market as quickly as possible.
By monitoring the actual performance of products against plans, lessons can be learnt to improve the
performance of future products.
Support to Management:
An understanding of the product life cycle can also assist management with decisions about:
Pricing: As a product moves from one stage in its lifecycle to the next, a change in pricing strategy
might be necessary to maintain the market share and recover the costs incurred over the lifecycle.
Performance management: Understanding the changes in the financial performance of the product
as it moves from one stage to another and being prepared for the changes.
Decision-making: Helps with decision about making new investments in the product (new capital
expenditure) or withdrawing a product from the market.
In Service lifecycles, the R & D stages do not exist in the same way and will not have the same impact on
subsequent costs. However consideration should be given in advance about how to carry out the services
and arrange them so as to minimise cost.
Products that take years to produce are usually called projects, and discounted cash flow calculations are
invariably used to cost them over their life cycle in advance. They are monitored very carefully over their
life to make sure that they remain on schedule and that cost overruns are not being incurred.
Customers also have life cycles, and an organisation will wish to maximise the return from a customer over
their life cycle. The aim is to extend the life cycle of a particular customer by encouraging customer loyalty.
The initial cost is high but once customers get used to a supplier they tend to use them more frequently,
bringing in the benefit to the company.
The projected cash flows over the full lives of customers or customer segments can be analysed to
highlight the worth of customers and the importance of customer retention.
Page 12 of 147
F5 Performance Management 2016
5. Throughput Accounting
The theory of constraints is applied within an organisation by following what are called the five focusing
steps. These are a tool developed to help organisations deal with constraints, otherwise known as
bottlenecks, within the system as a whole (rather than any discrete unit within the organisation.) The steps
are as follows:
Often, in exam questions, you will be told what the bottleneck resource is. If not, it is usually quite simple
to work out. For example, lets say that an organisation has market demand of 50,000 units for a product
that goes through three processes: cutting, heating and assembly. The total time required in each process
for each product and the total hours available are:
The total time required to make 50,000 units of the product can be calculated and compared to the time
available in order to identify the bottleneck.
It is clear that the heating process is the bottleneck. The organisation will in fact only be able to produce
40,000 units (120,000/3) as things stand.
This involves making sure that the bottleneck resource is actively being used as much as possible and is
producing as many units as possible. So, productivity and utilisation are the key words here.
The main point here is that the production capacity of the bottleneck resource should determine the
production schedule for the organisation as a whole? Idle time is unavoidable and needs to be accepted if
the theory of constraints is to be successfully applied. To push more work into the system than the
constraint can deal with results in excess work-in-progress, extended lead times, and the appearance of
Page 13 of 147
F5 Performance Management 2016
what looks like new bottlenecks, as the whole system becomes clogged up. By definition, the system does
not require the non-bottleneck resources to be used to their full capacity and therefore they must sit idle
for some of the time.
Normally, elevation will require capital expenditure. However, it is important that an organisation does not
ignore Step 2 and jumps straight to Step 4, and this is what often happens. There is often untapped
production capacity that can be found if you look closely enough. Elevation should only be considered once
exploitation has taken place.
Step 5: If a new constraint is broken in Step 4, go back to Step 1, but do not let inertia become the
systems new bottleneck
When a bottleneck has been elevated, a new bottleneck will eventually appear. This could be in the form
of another machine that can now process less units than the elevated bottleneck. Eventually, however, the
ultimate constraint on the system is likely to be market demand. Whatever the new bottleneck is, the
message of the theory of constraints is: never get complacent. The system should be one of ongoing
improvement because nothing ever stands still for long.
In the context of an exam question,, you are more likely to be asked to show how a bottleneck can be
exploited by maximising throughput via the production of an optimum production plan. This requires an
application of the simple principles of key factor analysis, otherwise known as limiting factor analysis or
principal budget factor.
Once an organisation has identified its bottleneck resource, as demonstrated in Step 1 above, it then has to
decide how to get the most out of that resource. Given that most businesses are producing more than one
type of product (or supplying more than one type of service), this means that part of the exploitation step
involves working out what the optimum production plan is, based on maximising throughput per unit of
bottleneck resource.
In key factor analysis, the contribution per unit is first calculated for each product, then a contribution per
unit of scarce resource is calculated by working out how much of the scarce resource each unit requires in
its production. In a throughput accounting context, a very similar calculation is performed, but this time it
is not contribution per unit of scarce resource which is calculated, but throughput return per unit of
bottleneck resource.
Throughput is calculated as selling price less direct material cost. This is different from the calculation of
contribution, in which both labour costs and variable overheads are also deducted from selling price. It is
an important distinction because the fundamental belief in throughput accounting is that all costs except
direct materials costs are largely fixed therefore, to work on the basis of maximising contribution is
flawed because to do so is to take into account costs that cannot be controlled in the short term anyway.
Page 14 of 147
F5 Performance Management 2016
One cannot help but agree with this belief really since, in most businesses, it is simply not possible, for
example, to hire workers on a daily basis and lay workers off if they are not busy. A workforce has to be
employed within the business and available for work if there is work to do. You cannot refuse to pay a
worker if he is forced to sit idle by a machine for a while.
Example 1
Beta Co produces 3 products, E, F and G, details of which are shown below:
E F G
$ $ $
Selling price per unit 120 110 130
Direct material cost per unit 60 70 85
Maximum demand (units) 30,000 25,000 40,000
Time required on the bottleneck resource (hours per unit) 5 4 3
There are 320,000 bottleneck hours available each month. Calculate the optimum product mix each
month.
It is worth noting here that you often see another step carried out between Steps 2 and 3 above. This is the
calculation of the throughput accounting ratio for each product. Thus far, ratios have not been discussed,
and while I am planning on mentioning them later, I have never seen the point of inserting this extra step
in when working out the optimum production plan. The ranking of the products using the return per
factory hour will always produce the same ranking as that produced using the throughput accounting ratio,
so it doesnt really matter whether you use the return or the ratio.
E F G
$ $ $
Selling price per unit 120 110 130
Direct material cost per unit 60 70 85
Throughput per unit 60 40 45
Time required on the bottleneck resource (hours per unit) 5 4 3
Return per factory hour $12 $10 $15
Ranking 2 3 1
Page 15 of 147
F5 Performance Management 2016
It is worth noting that, before the time taken on the bottleneck resource was taken into account, product E
appeared to be the most profitable because it generated the highest throughput per unit. However,
applying the theory of constraints, the systems bottleneck must be exploited by using it to produce the
products that maximise throughput per hour first (Step 2 of the five focusing steps). This means that
product G should be produced in priority to E.
In practice, Step 3 will be followed by making sure that the optimum production plan is adhered to
throughout the whole system, with no machine making more units than can be absorbed by the
bottleneck, and sticking to the priorities decided.
When answering a question like this in an exam it is useful to draw up a small table, like the one shown
below. This means that the marker can follow your logic and award all possible marks, even if you have
made an error along the way.
Product No. of units Hrs per unit Total hrs T/put per hr Total t/put
G 40,000 3 120,000 $15 $1,800,000
E 30,000 5 150,000 $12 $1,800,000
F 12,500 4 50,000 $10 $5000,000
$4,100,00
Each time you allocate time on the bottleneck resource to a product, you have to ask yourself how many
hours you still have available. In this example, there were enough hours to produce the full quota for G and
E. However, when you got to F, you could see that out of the 320,000 hours available, 270,000 had been
used up (120,000 + 150,000), leaving only 50,000 hours spare.
Therefore, the number of units of F that could be produced was a balancing figure 50,000 hours divided
by the four hours each unit requires ie 12,500 units.
The above example concentrates on Steps 2 and 3 of the five focusing steps. I now want to look at an
example of the application of Steps 4 and 5. I have kept it simple by assuming that the organisation only
makes one product, as it is the principle that is important here, rather than the numbers. The example also
demonstrates once again how to identify the bottleneck resource (Step 1) and then shows how a
bottleneck may be elevated, but will then be replaced by another. It also shows that it may not always be
financially viable to elevate a bottleneck.
Example 2
Cat Co makes a product using three machines X, Y and Z. The capacity of each machine is as follows:
Machine X Y Z
Capacity per week 800 600 500
Page 16 of 147
F5 Performance Management 2016
The demand for the product is 1,000 units per week. For every additional unit sold per week, net present
value increases by $50,000. Cat Co is considering the following possible purchases (they are not mutually
exclusive):
Purchase 1 Replace machine X with a newer model. This will increase capacity to 1,100 units per week and
costs $6m.
Purchase 2 Invest in a second machine Y, increasing capacity by 550 units per week. The cost of this
machine would be $6.8m.
Purchase 3 Upgrade machine Z at a cost of $7.5m, thereby increasing capacity to 1,050 units.
Required:
Which is Cat Cos best course of action?
Answer
First, it is necessary to identify the systems bottleneck resource. Clearly, this is machine Z, which only has
the capacity to produce 500 units per week. Purchase 3 is therefore the starting point when considering
the logical choices that face Cat Co. It would never be logical to consider either Purchase 1 or 2 in isolation
because of the fact that neither machines X nor machine Y is the starting bottleneck. Lets have a look at
how the capacity of the business increases with the choices that are available to it.
X Y Z Demand
Current capacity per week 800 600 500* 1,000
Buy Z 800 600* 1,050 1,000
Buy Z & Y 800* 1,150 1,050 1,000
Buy Z, Y & X 1,100 1,150 1,050 1,000*
* = bottleneck resource
From the table above, it can be seen that once a bottleneck is elevated, it is then replaced by another
bottleneck until ultimately market demand constrains production. At this point, it would be necessary to
look beyond production and consider how to increase market demand by, for example, increasing
advertising of the product.In order to make a decision as to which of the machines should be purchased, if
any, the financial viability of the three options should be calculated.
Buy Z
Additional sales = 600 - 500 = 100 units $'000
Benefit: 100 x $50,000 5,000
Cost (7,500)
Net cost (2,500)
Page 17 of 147
F5 Performance Management 2016
Buy Z & Y
Additional sales = 800 - 500 = 300 units
Benefit : 300 x $50,000 15,000
Cost ($7.5m + $6.8m) (14,300)
Net benefit 700
Buy Z, Y & X
Additional sales = 1,000 - 500 = 500 units
Benefit: 500 x $50,000 25,000
Cost ($7.5m = $6.8m + $6m) (20,300)
Net benefit 4,700
The company should therefore invest in all three machines if it has enough cash to do so.
The example of Cat Co demonstrates the fact that, as one bottleneck is elevated, another one appears. It
also shows that elevating a bottleneck is not always financially viable. If Cat Co was only able to afford
machine Z, it would be better off making no investment at all because if Z alone is invested in, another
bottleneck appears too quickly for the initial investment cost to be recouped.
RATIOS
There are three main ratios that are calculated: (1) return per factory hour, (2) cost per factory hour and
(3) the throughput accounting ratio.
(3) Return per factory hour/cost per factory hour.(throughput accounting Ratio)
In any organisation, you would expect the throughput accounting ratio to be greater than 1. This means
that the rate at which the organisation is generating cash from sales of this product is greater than the rate
at which it is incurring costs. It follows on, then, that if the ratio is less than 1, this is not the case, and
changes need to be made quickly.
Page 18 of 147
F5 Performance Management 2016
Important:
Products and/or divisions can be ranked according to TPAR. The TPAR should be greater than one for a
product to be viable. Priority should be given to the products generating the highest TPARs.
Alternatively the products generating highest TP contribution per unit of constraint should be given
priority.
Page 19 of 147
F5 Performance Management 2016
6. Environmental Accounting
Environmental accounting is becoming increasingly topical in the modern business environment due to
increased regulation and media coverage
The generation and analysis of both financial and non-financial information in order to support
environmental management processes
Identifying environmental costs associated with individual products and services can assist with
pricing decisions
Ensuring compliance with regulatory standards
Potential for cost savings
Government support
Reputation & goodwill
Important
The majority product or of environmental costs are already captured within accounting systems. it is often
difficult to pinpoint and allocate them to a particular service
1. Input/output analysis
This method operates on the principal that what comes in must go out. Output is split across sold and
stored goods and waste.
Measuring these categories in physical quantities and monetary terms forces businesses to focus on
environmental costs.
Flow diagrams are often used to illustrate how the input is split across different output such as stored
goods and waste.
Page 20 of 147
F5 Performance Management 2016
Environment -related costs such as costs relating to a sewage plant or an incinerator are attributed to joint
environmental cost centers.
Environmental -driven costs such as increased depreciation or higher staff wages are allocated to general
overheads.
Examples of environmental cost drivers include volume of emissions and the cost of complying with
environmental
Material
System and delivery
Disposal
The values and costs of each material flow are calculated. This method focuses on reducing costs and
having a positive effect on the environment
4. Life-cycle costing
Environmental costs are considered from the design stage right up to the last stage costs such as
decommissioning and waste removal etc.
This may influence the design of the product itself, saving on future costs.
Page 21 of 147
F5 Performance Management 2016
Cost-volume-profit analysis looks primarily at the effects of differing levels of activity on the financial
results of a business
In any business, or, indeed, in life in general, hindsight is a beautiful thing. If only we could look into a
crystal ball and find out exactly how many customers were going to buy our product, we would be able to
make perfect business decisions and maximise profits.
Take a restaurant, for example. If the owners knew exactly how many customers would come in each
evening and the number and type of meals that they would order, they could ensure that staffing levels
were exactly accurate and no waste occurred in the kitchen. The reality is, of course, that decisions such as
staffing and food purchases have to be made on the basis of estimates, with these estimates being based
on past experience.
While management accounting information cant really help much with the crystal ball, it can be of use in
providing the answers to questions about the consequences of different courses of action. One of the most
important decisions that needs to be made before any business even starts is how much do we need to
sell in order to break-even? By break-even we mean simply covering all our costs without making a profit.
This type of analysis is known as cost-volume-profit analysis (CVP analysis) and the purpose of this article
is to cover some of the straight forward calculations and graphs required for this part of the Paper F5
syllabus, while also considering the assumptions which underlie any such analysis.
CVP analysis looks primarily at the effects of differing levels of activity on the financial results of a business.
The reason for the particular focus on sales volume is because, in the short-run, sales price, and the cost of
materials and labour, are usually known with a degree of accuracy. Sales volume, however, is not usually
so predictable and therefore, in the short-run, profitability often hinges upon it. For example, Company A
may know that the sales price for product x in a particular year is going to be in the region of $50 and its
variable costs are approximately $30.
It can, therefore, say with some degree of certainty that the contribution per unit (sales price less variable
costs) is $20. Company A may also have fixed costs of $200,000 per annum, which again, are fairly easy to
predict. However, when we ask the question: Will the company make a profit in that year?, the answer is
We dont know. We dont know because we dont know the sales volume for the year. However, we can
work out how many sales the business needs to make in order to make a profit and this is where CVP
analysis begins.
We know that total revenues are found by multiplying unit selling price (USP) by quantity sold (Q). Also,
total costs are made up firstly of total fixed costs (FC) and secondly by variable costs (VC). Total variable
costs are found by multiplying unit variable cost (UVC) by total quantity (Q). Any excess of total revenue
over total costs will give rise to profit (P). By putting this information into a simple equation, we come up
with a method of answering CVP type questions. This is done below continuing with the example of
Company A above.
Note: total fixed costs are used rather than unit fixed costs since unit fixed costs will vary depending on the
level of output.
It would, therefore, be inappropriate to use a unit fixed cost since this would vary depending on output.
Sales price and variable costs, on the other hand, are assumed to remain constant for all levels of output in
the short-run, and, therefore, unit costs are appropriate.
Continuing with our equation, we now set P to zero in order to find out how many items we need to sell in
order to make no profit, ie to break even:
The equation has given us our answer. If Company A sells less than 10,000 units, it will make a loss; if it
sells exactly 10,000 units, it will break-even, and if it sells more than 10,000 units, it will make a profit.
(USP x Q) (UVC x Q) FC = P
(USP UVC) x Q = FC + P
UCM x Q = FC + P
Q = FC + P
UCM
So, if P=0 (because we want to find the break-even point), then we would simply take our fixed costs and
divide them by our unit contribution margin. We often see the unit contribution margin referred to as the
Page 23 of 147
F5 Performance Management 2016
The contribution margin method uses a little bit of algebra to rewrite our equation above, concentrating
on the use of the contribution margin.
Alternatively, a contribution graph could be drawn. While this is not specifically covered by the Paper F5
syllabus, it is still useful to see it. This is very similar to a break-even chart, the only difference being that
instead of showing a fixed cost line, a variable cost line is shown instead.
Hence, it is the difference between the variable cost line and the total cost line that represents fixed costs.
The advantage of this is that it emphasises contribution as it is represented by the gap between the total
revenue and the variable cost lines. This is shown for Company A in Figure 2.
Finally, a profitvolume graph could be drawn, which emphasises the impact of volume changes on profit
(Figure 3). This is key to the Paper F5 syllabus and is discussed in more detail later in this article.
Page 24 of 147
F5 Performance Management 2016
Figure 1
Figure 2
Page 25 of 147
F5 Performance Management 2016
Figure 3
As well as ascertaining the break-even point, there are other routine calculations that it is just as important
to understand. For example, a business may want to know how many items it must sell in order to attain a
target profit.
Example 1
Company A wants to achieve a target profit of $300,000. The sales volume necessary in order to achieve
this profit can be ascertained using any of the three methods outlined above. If the equation method is
used, the profit of $300,000 is put into the equation rather than the profit of $0:
Page 26 of 147
F5 Performance Management 2016
Q = 200,000 + 300,000
20
Finally, the answer can be read from the graph, although this method becomes clumsier than the previous
two. The profit will be $300,000 where the gap between the total revenue and total cost line is $300,000,
since the gap represents profit (after the break-even point) or loss (before the break-even point.)
A contribution graph shows the difference between the variable cost line and the total cost line that
represents fixed costs. An advantage of this is that it emphasises contribution as it is represented by the
gap between the total revenue and variable cost lines.
Margin of safety
The margin of safety indicates by how much sales can decrease before a loss occurs, ie it is the excess of
budgeted revenues over break-even revenues. Using Company A as an example, lets assume that
budgeted sales are 20,000 units. The margin of safety can be found, in units, as follows:
In multi-product situations, a weighted average C/S ratio is calculated by using the formula:
Page 27 of 147
F5 Performance Management 2016
This weighted average C/S ratio can then be used to find CVP information such as break-even point, margin
of safety etc.
Example 2
As well as producing product x described above, Company A also begins producing product y. The following
information is available for both products:
Product x Product y
Sales price $50 $60
Variable cost $30 $45
Contribution per unit $20 $15
Budgeted sales (units) 20,000 10,000
The weighted average C/S ratio can be once again calculated by dividing the total expected contribution by
the total expected sales:
The C/S ratio is useful in its own right as it tells us what percentage each $ of sales revenue contributes
towards fixed costs; it is also invaluable in helping us to quickly calculate the break-even point in $ sales
revenue, or the sales revenue required to generate a target profit. The break-even point can now be
calculated this way for Company A:
Fixed costs + required profit /contribution to sales ratio = $200,000 + $300,000/0.34375 = $1,454,546.
Of course, such calculations provide only estimated information because they assume that products x and
y are sold in a constant mix of 2x to 1y. In reality, this constant mix is unlikely to exist and, at times, more y
may be sold than x. Such changes in the mix throughout a period, even if the overall mix for the period is
2:1, will lead to the actual break-even point being different than anticipated. This point is touched upon
again later in this article.
Contribution to sales ratio is often useful in single product situations, and essential in multi-product
situations, to ascertain how much each $ sold actually contributes towards the fixed costs.
Product x Product y
Sales price $50 $60
Variable cost $30 $45
Page 28 of 147
F5 Performance Management 2016
Product x Product y
Contribution per unit $20 $15
Budgeted sales (units) 20,000 10,000
C/S ratios 0.4 0.25
Weighted average C/S ratio 0.34375
Product ranking (most profitable first) 1 2
Cumulative Cumulative
Contribution profit/loss Revenue revenue
Product $'000 $'000 $'000 $'000
(Fixed costs) 0 (200) 0 0
X 400 200 1,000,000 1,000,000
Y 150 350 600,000 1,600,000
In order to draw a multi-product/volume graph it is necessary to work out the C/S ratio of each product
being sold.
When discussing graphical methods for establishing the break-even point, we considered break-even
charts and contribution graphs. These could also be drawn for a company selling multiple products, such as
Company A in our example. The one type of graph that hasnt yet been discussed is a profitvolume graph.
This is slightly different from the others in that it focuses purely on showing a profit/loss line and doesnt
separately show the cost and revenue lines. In a multi-product environment, it is common to actually show
two lines on the graph: one straight line, where a constant mix between the products is assumed; and one
bow-shaped line, where it is assumed that the company sells its most profitable product first and then its
next most profitable product, and so on. In order to draw the graph, it is therefore necessary to work out
the C/S ratio of each product being sold before ranking the products in order of profitability. It is easy here
for Company A, since only two products are being produced, and so it is useful to draw a quick table
(prevents mistakes in the exam hall) in order to ascertain each of the points that need to be plotted on the
graph in order to show the profit/loss lines.
See Table 3.
The graph can then be drawn (Figure 3), showing cumulative sales on the x axis and cumulative profit/loss
on the y axis. It can be observed from the graph that, when the company sells its most profitable product
first (x) it breaks even earlier than when it sells products in a constant mix. The break-even point is the
point where each line cuts the x axis.
Page 29 of 147
F5 Performance Management 2016
Page 30 of 147
F5 Performance Management 2016
1. If there is a single limiting factor-Optimal plan is made based on ranking (Contribution per limiting
factor -7 steps)
2. If there are multiple limiting factor-Linear programming approach is used. It is a mathematical
approach and is best understood through an exam question
LINEAR PRGRAMMING
Suppose a profit-seeking firm has two constraints: labour, limited to 16,000 hours, and materials, limited
to 15,000kg. The firm manufactures and sells two products, X and Y. To make X, the firm uses 3kg of
material and four hours of labour, whereas to make Y, the firm uses 5kg of material and four hours of
labour. The contributions made by each product are $30 for X and $40 for Y. The cost of materials is
normally $8 per kg, and the labour rate is $10 per hour.
The first step in any linear programming problem is to produce the equations for constraints and the
contribution function, which should not be difficult at this level.
In our example, the materials constraint will be 3X + 5Y 15,000, and the labour constraint will be 4X + 4Y
16,000.
Plotting the resulting graph (Figure 1, the optimal production plan) will show that by pushing out the
contribution function, the optimal solution will be at point B the intersection of materials and labour
constraints.
Page 31 of 147
F5 Performance Management 2016
The optimal point is X = 2,500 and Y = 1,500, which generates $135,000 in contribution. Check this for
yourself (see Working 1). The ability to solve simultaneous equations is assumed in this article.
The point of this calculation is to provide management with a target production plan in order to maximise
contribution and therefore profit. However, things can change and, in particular, constraints can relax or
tighten. Management needs to know the financial implications of such changes. For example, if new
materials are offered, how much should be paid for them? And how much should be bought? These
dynamics are important.
Suppose the shadow price of materials is $5 per kg (this is verifiable by calculation see Working 2). The
important point is, what does this mean? If management is offered more materials it should be prepared
to pay no more than $5 per kg over the normal price. Paying less than $13 ($5 + $8) per kg to obtain more
materials will make the firm better off financially. Paying more than $13 per kg would render it worse off in
terms of contribution gained. Management needs to understand this.
There may, of course, be a good reason to buy expensive extra materials (those costing more than $13
per kg). It might enable the business to satisfy the demands of an important customer who might, in turn,
buy more products later. The firm might have to meet a contractual obligation, and so paying too much
for more materials might be justifiable if it will prevent a penalty on the contract. The cost of this is rarely
included in shadow price calculations. Equally, it might be that cheap material, priced at under $13 per kg,
is not attractive. Quality is a factor, as is reliability of supply. Accountants should recognise that price is
not everything.
We need to find out how many materials are needed at point D on the graph, the point at which 4,000
units of Y are produced. To make 4,000 units of Y we need 20,000kg of materials. Consequently, the
maximum amount of extra material required is 5,000kg (20,000 15,000). Note: Although interpretation is
important at this level, there will still be marks available for the basic calculations.
WORKINGS
Working 1:
The optimal point is at point B, which is at the intersection of:
3X + 5Y = 15,000 and
4X + 4Y = 16,000
Page 32 of 147
F5 Performance Management 2016
Multiplying the first equation by four and the second by three we get:
12X + 20Y = 60,000
12X + 12Y = 48,000
Substituting Y = 1,500 in any of the above equations will give us the X value:
3X + 5 (1,500) = 15,000
3X = 7,500
X = 2,500
Important Definitions:
1. Shadow price: the amount of contribution generated by having one extra unit of the binding
constraint- its the maximum premium the company could pay by having one extra unit of the
limited resource at optimal point
2. Slack: the best utilization of resource is not the full utilization of resource; if a resource is not
binding at the optimal point it will have slack
3. Surplus: when the resource use is more than the minimum required, it is said to have surplus
Again, multiplying by four for the first equation and by three for the second produces:
12X + 20Y = 60,004
12X + 12Y = 48,000
8Y = 12,004
Y = 1,500.5
The new level of contribution is: (2,499.5 x 30) + (1,500.5 x 40) = $135,005
The increase in contribution from the original optimal is the shadow price:
135,005 135,000 = $5 per kg.
Page 33 of 147
F5 Performance Management 2016
Example 2:
Consider the following past exam paper question in detail to improve on your concepts:
Page 34 of 147
F5 Performance Management 2016
Page 35 of 147
F5 Performance Management 2016
Page 36 of 147
F5 Performance Management 2016
Page 37 of 147
F5 Performance Management 2016
Page 38 of 147
F5 Performance Management 2016
9. Pricing Decisions
Influences on Price: Price of a product is decided after taking into account many factors apart from Cost.
Price Sensitivity If customers of the product can pass on the burden of the cost to someone else, they
will not be price sensitive. E.g. A customer will travel business class if his/ her company
is bearing the expenses but will reconsider if he/ she has to spend own money.
Price Perception E.g. if the price of sugar is increased and the customer perceives that the price will
further increase, they will stock-up on the product.
Quality Customers may consider high prices to be a reflection of the high quality of the product
Competitors Some companies show unified increase in price (e.g. petrol) but in others a change in
price, may start a price war (e.g. mobile network services).
Suppliers If a company increases the price of its products, the suppliers may start providing the
raw material at a higher price too.
Inflation Prices have to reflect the increase in material and labour cost.
Newness Pricing will depend upon reference points and in the case of new products a company
may have to look at other markets where the product/ similar product has been
launched.
Incomes If customers have more income, their focus is quality and accessibility of product but if
income decreases, focus is on price.
Product Range Price can be spread over a complete product range to maintain profitability. E.g. sell ink
pens cheaper but make up for profit in the price of ink.
Ethics Does the company want to exploit the market by increasing prices when there is a
short term shortage of the product in the market?
Market: Price is determined by the type of market, the company operates in:
Perfect
Monopoly
Competition
Monopolistic
Oligopoly
Competition
Page 39 of 147
F5 Performance Management 2016
Competition: If competitors cut prices, a company can react in the following possible ways:
Demand:
Economic theory argues that the higher the price of a good, the lower will be the quantity demanded.
A company is able to sell a fixed quantity (Q) of the A company is able to sell limitless quantity (Q) of
product, regardless of any price (P). This is termed the product at a set price (P). This is termed as
as completely inelastic demand as change in price completely elastic demand as change in price will
does not affect the quantity demanded. substantially affect the quantity demanded.
Price Elasticity of Demand: It is a measure of the change in sales demand that would occur for a given
change in the selling price.
PED > 1 than demand is elastic: impact on quantity demanded is greater due to change in price
PED< 1 than demand is inelastic: impact on quantity demanded due to change in price is nominal
Page 40 of 147
F5 Performance Management 2016
Very Inelastic Demand As price will have no impact on quantity demanded, company should focus on
quality, service, product design etc to attract customers.
Inelastic Demand As price has nominal impact on demand, increase the price so that revenue
increases and costs reduce due to smaller quantity being produced.
Elastic Demand Find right balance to ensure that the revenue earned is greater than the costs
incurred.
Very Elastic Demand Try and control elasticity by creating customer preferences through quality,
service etc.
Demand Influencers:
Price of other goods Substitutes: Increase in price of one product will lead to customers moving
towards the substitute available.
Complements: Increase in demand for one product will give rise to demand of
complementary product.
Tastes or fashion A change in tastes or fashion will alter the demand for a good, or a particular
variety of a good.
Expectations Stock up may occur if customers expect the prices to rise and this will lead to
more demand.
Obsolescence Many products and services have to be replaced periodically because of
obsolescence.
Product Life Cycle: Demand varies over the life cycle of a product.
Introduction Phase: The price has no impact on demand at the initial stage, when there is
little or no competition in the market.
Growth: Prices will have to be reduced as competition increases, to maintain demand.
Maturity: Prices can be stabilised unless the competitors reduce their prices.
Decline: Prices may fall due to lower demand or prices can be increased if the competition
withdraws from the market and you are the only one offering the product.
Quality: If the product is of good quality, the demand may be high regardless of price.
Marketing: The 4 Ps of marketing are demand influencers:
Price
Page 41 of 147
F5 Performance Management 2016
Product
Place: of purchase. If goods are not easily accessible, customers will turn to substitutes.
Promotion: developing a brand name and using a variety of promotional tools will lead to
increased demand for the product.
Demand Equation:
Example:
The current price of a product is $18. At this price the company sells 100 items a month. One month the
company decides to raise the price to $22, but only 75 items are sold at this price.
Solution
Assuming demand is linear, each increase of $4 in the price would result in a fall in demand of 25 units. For
demand to be nil, the price needs to rise from its current level by as many times as there are 25 units in
100 units (100/25 = 4) ie to $18 + (4 x $4) = $34.
Using the formula above, this can be shown as a = $18 + ((100/25) x $4) = $34
Step 2: Calculate b
Step 3: Substitute the known value for b into the demand function to find a
P = a - (0.05Q)
18 = a - (0.05 x 100)
18 =a-5
Page 42 of 147
F5 Performance Management 2016
a = 23
18 = 23 (0.05Q)
0.05Q = 23 18
0.05Q = 5
Q = 5 = 100
0.05
Total Cost (TC) = Fixed Cost (FC) + [Variable Cost (VC) x Quantity sold (Q)]
Assume that fixed costs remain constant when in reality there is a concept of Step Fixed Costs
Assume that Variable Cost per unit remains constant when in reality they change due to
economies/ diseconomies of scale or Volume Based Discounts (discounts given for bulk
transactions)
Profits are maximized when marginal cost (MC) = marginal revenue (MR).
Page 43 of 147
F5 Performance Management 2016
Profit Maximisation is the process by which a firm determines the price and output level that returns the
greatest profit. There are two common approaches to this problem.
The Total revenue (TR) Total cost (TC) method is based on the fact that profit equals revenue
minus cost.
The Marginal revenue (MR) Marginal cost (MC) method is based on the fact that total profit in a
perfect market reaches its maximum point where marginal revenue equals marginal cost.
The optimal selling price can be determined using equations (ie when MC = MR).
Page 44 of 147
F5 Performance Management 2016
Example:
It has been determined based on research that if a price of $400 is charged for product G, demand will be
12,000 units. Demand will rise or fall by 20 units for every $1 fall/rise in the selling price. The marginal cost
of product G is $120. Calculate the profit-maximising selling price for product G.
Solution:
The following step-by-step approach can be applied to most questions involving algebra and pricing.
Step 1: Establish the demand function (find the values for a and b)
b = change in price = $1 = 0.05
change in quantity 20
a = $400 + [(12,000 /20) x $1] = $1,000
Step 2: Establish MC (the marginal cost). This will simply be the variable cost per unit
MC = $120 (given)
Step 3: State MR, assuming MR = a 2bQ
MR = $1,000 (2 x 0.05) Q = $1,000 0.1Q
Step 4: To maximise profit, equate MC and MR to find Q
$120 = $1,000 0.1Q
Q = ($1,000 - $120) x (10/1) = 8,800 is profit maximising demand
Step 5: Substitute Q into the demand function and solve to find P (the optimum price)
P = a bQ = $1,000 (0.05 x 8,800) = $560
Price Strategies
Full cost plus pricing: Calculate full cost of product and add desired profit to determine selling price.
Example:
Mark-Up Margin
% $ % $
Page 45 of 147
F5 Performance Management 2016
Advantages:
Quick, simple and cheap method to set product price.
As profit % is added to full cost, all the expenses are easily recovered.
Disadvantages:
Ignores profit maximisation combination of price and demand.
In reality the price has to be adjusted to market and demand conditions.
Relies on budgeted output volume to determine appropriate absorption rate for overheads.
Suitable basis for overhead absorption rate has to be selected.
Marginal Cost plus Pricing (Mark-Up Pricing): A mark-up or profit margin is added to the marginal cost in
order to obtain a selling price.
The method of calculating sales price is similar to full-cost pricing, except that marginal cost is used instead
of full cost.
Advantages:
Simple and easy to calculate.
Mark up % can be varied to reflect demand conditions.
Focuses attention on the contribution of the product, which is a key factor in decision
making.
Useful in industries where the Variable cost per unit is easily available.
Disadvantages:
Apart from demand, other relevant market factors, like prices set by competitors etc. are
ignored.
Ignores fixed overheads in pricing decisions.
Market Skimming Prices: Charging a high price when the product is introduced in the market for the first
time, with the hope of skimming the market for profits. The price of the product is adjusted at a later date.
Page 46 of 147
F5 Performance Management 2016
Market Penetration Prices: Introducing a product at low costs to establish its stronghold in the market.
Complementary Products Pricing: Setting a single pricing policy for goods that are complementary i.e. are
normally bought together. E.g. Computer games console and computer games.
Loss Leader: is when a company sells a low price for one product to attract customers and ends up selling
complementary products with high profit margins. This is also termed as Captive Product Pricing.
Product Lines Pricing: Setting a consistent pricing policy for a group of products that are related to each
other. E.g. same policy for shampoos, skin care products etc. of the same brand.
Price Discrimination (Differential Pricing): Charging different prices to different groups of buyers for the
same product.
Relevant Cost Pricing (Minimum Pricing): Calculating a minimum price of the product/ order, at which the
company will neither be better off, nor worse off. If sold at more than the minimum price, the company
will enjoy a profit.
The minimum price calculated must take into account the following:
To earn a profit, the company needs to sell the product/ order at a price higher than the minimum price.
Page 47 of 147
F5 Performance Management 2016
Relevant Costs: Are incremental future cash flows, arising as a direct consequence of a decision.
Sunk costs, Committed costs and non-cash expenses like depreciation are irrelevant costs.
If labour is re-assigned tasks to take up new project or product, the variable cost of labour, variable
overheads and the contribution foregone are relevant for decision making.
Purchase cost of machinery is irrelevant unless specifically bought for a product/ job.
The rent of a machine hired for a job, is relevant.
User Cost: is the fall in resale value of owned assets, due to use of the machinery in a specific job.
Opportunity Costs
The value of a benefit given up, in order to avail the benefit from an alternative.
For example, if a material is in short supply, it may be transferred from the production of one product to
that of another product. The opportunity cost is the contribution lost from ceasing production of the
original product.
Page 48 of 147
F5 Performance Management 2016
Example
A company makes two components F and P, for which costs in the forthcoming year are expected to be as
follows.
F P
Production (units) 1,000 2,000
Unit marginal costs $ $
Direct materials 4 5
Direct Labour 8 9
Variable production overheads 2 3
Directly attributable fixed costs per annum and committed fixed costs:
Incurred as a direct consequence of making F $1,000
Incurred as a direct consequence of making P $5,000
A sub-contractor has offered to supply units of F & P for $12 and $21 respectively.
Should the company make or buy the components?
Solution
F P
$ $
Unit variable cost of making 14 17
Unit variable cost of buying 12 21
2 4
The company would save $3,000 pa 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 pa by subcontracting
component Z (because of the saving in fixed costs of $8,000).
Page 49 of 147
F5 Performance Management 2016
Outsourcing:
This is the use of external suppliers for finished products, components or services. This is also known as
contract manufacturing or sub-contracting.
Reasons for Outsourcing:
Hiring specialists ensures the quality of the end product and efficiency.
Outsourcing leads to spare resources that can be effectively utilised in other core areas.
Companys offering outsourcing services have the capacity and flexibility to meet ad-hoc variations
in the demand.
There isnt enough work to justify the recruitment of resources for a specific function.
Companies rely on outsourcing facilities for administrative and maintenance tasks.
The performance of outsourcers has to be monitored and measured to make sure quality and targets
are not compromised upon.
Joint Products:
Joint products are two or more products which are output from the same processing operation, but
which are indistinguishable from each other up to their point of separation. Each product post
separation has a substantial sales value.
A joint product is regarded as an important saleable item, and so it should be separately costed. The
profitability of each joint product should be assessed in the cost accounts.
The point at which joint products become separately identifiable is known as the split-off point or
separation point.
Costs incurred prior to this point of separation are common or joint costs, and these need to be
allocated (apportioned) in some manner to each of the joint products.
Problems in accounting for joint products are basically of two different sorts.
How common costs should be apportioned between products, in order to put a value to closing
inventory and to the cost of sale (and profit) for each product.
Whether it is more profitable to sell a joint product at one stage of processing, or to process the
product further and sell it at a later stage.
Example
A Company produces two joint products, S and T from the same process.
Joint processing costs of $150,000 are incurred up to split-off point, when 100,000 units of S and 50,000
units of T are produced.
The selling prices at split-off point are $1.25 per unit for S and $2.00 per unit for T.
The units of S could be processed further to produce 60,000 units of a new chemical, Splus, but at an
extra fixed cost of $20,000 and variable cost of 30c per unit of input.
The selling price of Splus would be $3.25 per unit. Should the company sell S or Splus?
Solution
Page 50 of 147
F5 Performance Management 2016
The only relevant costs/incomes are those which compare selling S against selling Splus. Every other cost
is irrelevant: they will be incurred regardless of what the decision is.
S Splus
Selling price per unit $1.25 $3.25
$ $ $
Total sales 125,000 195,000
Post-separation processing costs ___ Fixed 20,000
___ Variable 30,000 50,000
Sales minus post-separation 125,000 145,000
(further processing) costs
Example: Company V makes four products, P, Q, R and S. The budget for next year is as follows:
P Q R S Total
$000 $000 $000 $000 $000
Direct materials 300 500 400 700 1,900
Direct labour 400 800 600 400 2,200
Variable overheads 100 200 100 100 500
800 1,500 1,100 1,200 4,600
Sales 1,800 1,650 2,200 1,550 7,200
Contribution 1,000 150 1,100 350 2,600
Directly attributable fixed costs (400) (250) (300) (300) (1,250)
Share of general fixed costs (200) (200) (300) (400) (1,100)
Profit/(loss) 400 (300) 500 (350) 250
Page 51 of 147
F5 Performance Management 2016
'Directly attributable fixed costs' are cash expenditures that are directly attributable to each individual
product. These costs would be saved if operations to make and sell the product were shut down.
Required: State with reasons whether any of the products should be withdrawn from the market.
Answer
From a financial viewpoint, a product should be withdrawn from the market if the savings from closure
exceed the benefits of continuing to make and sell the product. If a product is withdrawn from the market,
the company will lose the contribution, but -will save the directly attributable fixed costs.
Product P and product R both make a profit even after charging a share of general fixed costs.
On the other hand, product Q and product S both show a loss after charging general fixed costs, and we
should therefore consider whether it might be appropriate to stop making and selling either or both of
these products, in order to eliminate the losses.
Effect of shutdown P Q R S
Although product S makes a loss, shutdown would reduce annual cash flows because the contribution lost
would be greater than the savings in directly attributable fixed costs.
However, withdrawal of product Q from the market would improve annual cash flows by $100,000, and
withdrawal is therefore recommended on the basis of this financial analysis.
Decision recommended: Stop making and selling product Q but carry on making and selling product S.
Page 52 of 147
F5 Performance Management 2016
Risk permeates most aspects of corporate decision-making (and life in general), and few can predict with
any precision what the future holds in store.
Risk can take myriad forms ranging from the specific risks faced by individual companies (such as financial
risk, or the risk of a strike among the workforce), through the current risks faced by particular industry
sectors (such as banking, car manufacturing, or construction), to more general economic risks resulting
from interest rate or currency fluctuations, and, ultimately, the looming risk of recession. Risk often has
negative connotations, in terms of potential loss, but the potential for greater than expected returns also
often exists.
Clearly, risk is almost always a major variable in real-world corporate decision-making, and managers
ignore its vagaries at their peril. Similarly, trainee accountants require an ability to identify the presence of
risk and incorporate appropriate adjustments into the problem-solving and decision-making scenarios
encountered in the exam hall. While it is unlikely that the precise probabilities and perfect information,
which feature in exam questions can be transferred to real-world scenarios, a knowledge of the relevance
and applicability of such concepts is necessary.
The basic definition of risk is that the final outcome of a decision, such as an investment, may differ from
that which was expected when the decision was taken. We tend to distinguish between risk and
uncertainty in terms of the availability of probabilities
Risk is when the probabilities of the possible outcomes are known (such as when tossing a coin or throwing
a dice); uncertainty is where the randomness of outcomes cannot be expressed in terms of specific
probabilities.
However, it has been suggested that in the real world, it is generally not possible to allocate probabilities
to potential outcomes, and therefore the concept of risk is largely redundant. In the artificial scenarios of
exam questions, potential outcomes and probabilities will generally be provided, therefore a knowledge of
the basic concepts of probability and their use will be expected.
Attitudes to risk
Risk seeker
A decision maker interested in the best outcomes no matter how small the chance that they may occur.
Risk neutral
A decision maker concerned with what will be the most likely outcome.
Risk Averse
A decision maker who acts on the assumption that the worst outcome might occur.
Page 53 of 147
F5 Performance Management 2016
PROBABILITY
The term probability refers to the likelihood or chance that a certain event will occur, with potential
values ranging from 0 (the event will not occur) to 1 (the event will definitely occur). For example, the
probability of a tail occurring when tossing a coin is 0.5, and the probability when rolling a dice that it will
show a four is 1/6 (0.166). The total of all the probabilities from all the possible outcomes must equal 1, ie
some outcome must occur.
A real world example could be that of a company forecasting potential future sales from the introduction
of a new product in year one (Table 1).
From Table 1, it is clear that the most likely outcome is that the new product generates sales of
1,000,000, as that value has the highest probability.
An independent event occurs when the outcome does not depend on the outcome of a previous event. For
example, assuming that a dice is unbiased, then the probability of throwing a five on the second throw
does not depend on the outcome of the first throw.
In contrast, with a conditional event, the outcomes of two or more events are related, ie the outcome of
the second event depends on the outcome of the first event. For example, in Table 1, the company is
forecasting sales for the first year of the new product. If, subsequently, the company attempted to predict
the sales revenue for the second year, then it is likely that the predictions made will depend on the
outcome for year one. If the outcome for year one was sales of $1,500,000, then the predictions for year
two are likely to be more optimistic than if the sales in year one were $500,000.
The availability of information regarding the probabilities of potential outcomes allows the calculation of
both an expected value for the outcome, and a measure of the variability (or dispersion) of the potential
outcomes around the expected value (most typically standard deviation). This provides us with a measure
of risk which can be used to assess the likely outcome.
Using the information regarding the potential outcomes and their associated probabilities, the expected
value of the outcome can be calculated simply by multiplying the value associated with each potential
outcome by its probability. Referring back to Table 1, regarding the sales forecast, then the expected value
of the sales for year one is given by:
Page 54 of 147
F5 Performance Management 2016
Expected value
= ($500,000)(0.1) + ($700,000)(0.2)
+ ($1,000,000)(0.4) + ($1,250,000)(0.2)
+ ($1,500,000)(0.1)
= $50,000 + $140,000 + $400,000
+ $250,000 + $150,000
= $990,000
In this example, the expected value is very close to the most likely outcome, but this is not necessarily
always the case. Moreover, it is likely that the expected value does not correspond to any of the individual
potential outcomes. For example, the average score from throwing a dice is (1 + 2 + 3 + 4 + 5 + 6) / 6 or 3.5,
and the average family (in the UK) supposedly has 2.4 children. A further point regarding the use of
expected values is that the probabilities are based upon the event occurring repeatedly, whereas, in
reality, most events only occur once.
In addition to the expected value, it is also informative to have an idea of the risk or dispersion of the
potential actual outcomes around the expected value. The most common measure of dispersion is
standard deviation (the square root of the variance), which can be illustrated by the example given in Table
2, concerning the potential returns from two investments.
Investment
Investment A
B
Returns Probability of return Returns Probability of return
8% 0.25 5% 0.25
10% 0.5 10% 0.5
12% 0.25 15% 0.25
To estimate the standard deviation, we must first calculate the expected values of each investment:
Investment A
Expected value = (8%)(0.25) + (10%)(0.5) + (12%)
(0.25) = 10%
Investment B
Expected value = (5%)(0.25) + (10%)(0.5) + (15%)
(0.25) = 10%
The calculation of standard deviation proceeds by subtracting the expected value from each of the
potential outcomes, then squaring the result and multiplying by the probability. The results are then
totalled to yield the variance and, finally, the square root is taken to give the standard deviation, as shown
in Table 3.
Page 55 of 147
F5 Performance Management 2016
Investment
A
Expected Returns minus expected Column 4 x Column
Returns Squared Probability
return returns 5
8% 10% -2% 4% 0.25 1%
10% 10% 0% 0% 0.5 0%
12% 10% 2% 4% 0.25 1%
Variance 2%
Standard
1.414%
deviation
Investment
B
Expected Returns minus expected Column 4 x Column
Returns Squared Probability
return returns 5
5% 10% -5% 25% 0.25 6.25%
10% 10% 0% 0% 0.5 0%
15% 10% 5% 25% 0.25 6.25%
Variance 12.5%
Standard
3.536%
deviation
In Table 3, although investments A and B have the same expected return, investment B is shown to be
more risky by exhibiting a higher standard deviation. More commonly, the expected returns and standard
deviations from investments and projects are both different, but they can still be compared by using the
coefficient of variation, which combines the expected return and standard deviation into a single figure.
DECISION-MAKING CRITERIA
The decision outcome resulting from the same information may vary from manager to manager as a result
of their individual attitude to risk. We generally distinguish between individuals who are risk averse (dislike
risk) and individuals who are risk seeking (content with risk). Similarly, the appropriate decision-making
criteria used to make decisions are often determined by the individuals attitude to risk.
Page 56 of 147
F5 Performance Management 2016
An ice cream seller, when deciding how much ice cream to order (a small, medium, or large order), takes
into consideration the weather forecast (cold, warm, or hot). There are nine possible combinations of
order size and weather, and the payoffs for each are shown in Table 4.
The highest payoffs for each order size occur when the order size is most appropriate for the weather, ie
small order/cold weather, medium order/warm weather, large order/hot weather. Otherwise, profits are
lost from either unsold ice cream or lost potential sales. We shall consider the decisions the ice cream
seller has to make using each of the decision criteria previously noted (note the absence of probabilities
regarding the weather outcomes).
1 Maximin
This criteria is based upon a risk-averse (cautious) approach and bases the order decision upon maximising
the minimum payoff. The ice cream seller will therefore decide upon a medium order, as the lowest payoff
is 200, whereas the lowest payoffs for the small and large orders are 150 and $100 respectively.
2 Maximax
This criteria is based upon a risk-seeking (optimistic) approach and bases the order decision upon
maximising the maximum payoff. The ice cream seller will therefore decide upon a large order, as the
highest payoff is $750, whereas the highest payoffs for the small and medium orders are $250 and $500
respectively.
3 Minimax regret
This approach attempts to minimise the regret from making the wrong decision and is based upon first
identifying the optimal decision for each of the weather outcomes. If the weather is cold, then the small
order yields the highest payoff, and the regret from the medium and large orders is $50 and $150
respectively. The same calculations are then performed for warm and hot weather and a table of regrets
constructed (Table 5).
Page 57 of 147
F5 Performance Management 2016
The decision is then made on the basis of the lowest regret, which in this case is the large order with the
maximum regret of $200, as opposed to $600 and $450 for the small and medium orders.
Decision Trees
A decision tree is a diagrammatic representation of a problem and on it we show all possible courses of
action that we can take in a particular situation and all possible outcomes for each possible course of
action. It is particularly useful where there are a series of decisions to be made and/or several outcomes
arising at each stage of the decision-making process. For example, we may be deciding whether to expand
our business or not. The decision may be dependent on more than one uncertain variable.
For example, sales may be uncertain but costs may be uncertain too. The value of some variables may also
be dependent on the value of other variables too: maybe if sales are 100,000 units, costs are $4 per unit,
but if sales are 120,000 units costs fall to $3.80 per unit. Many outcomes may therefore be possible and
some outcomes may also be dependent on previous outcomes. Decision trees provide a useful method of
breaking down a complex problem into smaller, more manageable pieces.
There are two stages to making decisions using decision trees. The first stage is the construction stage,
where the decision tree is drawn and all of the probabilities and financial outcome values are put on the
tree. The principles of relevant costing are applied throughout ie only relevant costs and revenues are
considered. The second stage is the evaluation and recommendation stage. Here, the decision is rolled
back by calculating all the expected values at each of the outcome points and using these to make
decisions while working back across the decision tree. A course of action is then recommended for
management.
A decision tree is always drawn starting on the left hand side of the page and moving across to the right.
Above, I have mentioned decisions and outcomes. Decision points represent the alternative courses of
action that are available to you. These are within your control it is your choice. You either take one
course of action or you take another. Outcomes, on the other hand, are not within your control. They are
dependent on the external environment for example, customers, suppliers and the economy. Both
decision points and outcome points on a decision tree are always followed by branches. If there are two
possible courses of action for example, there will be two branches coming off the decision point; and if
there are two possible outcomes for example, one good and one bad, there will be two branches coming
off the outcome point. It makes sense to say that, given that decision trees facilitate the evaluation of
different courses of actions, all decision trees must start with a decision, as represented by a .
A simple decision tree is shown below. It can be seen from the tree that there are two choices available to
the decision maker since there are two branches coming off the decision point. The outcome for one of
these choices, shown by the top branch off the decision point, is clearly known with certainty, since there
is no outcome point further along this top branch. The lower branch, however, has an outcome point on it,
Page 58 of 147
F5 Performance Management 2016
showing that there are two possible outcomes if this choice is made. Then, since each of the subsidiary
branches off this outcome point also has a further outcome point on with two branches coming off it,
there are clearly two more sets of outcomes for each of these initial outcomes. It could be, for example,
that the first two outcomes were showing different income levels if some kind of investment is undertaken
and the second set of outcomes are different sets of possible variable costs for each different income level.
Once the basic tree has been drawn, like above, the probabilities and expected values must be written on
it. Remember, the probabilities shown on the branches coming off the outcome points must always add up
to 100%, otherwise there must be an outcome missing or a mistake with the numbers being used. As well
as showing the probabilities on the branches of the tree, the relevant cash inflows/outflows must also be
written on there too. This is shown in the example later on in the article.
Once the decision tree has been drawn, the decision must then be evaluated.
When a decision tree is evaluated, the evaluation starts on the right-hand side of the page and moves
across to the left ie in the opposite direction to when the tree was drawn. The steps to be followed are as
follows:
1. Label all of the decision and outcome points ie all the squares and circles. Start with the ones
closest to the right-hand side of the page, labelling the top and then the bottom ones, and then
move left again to the next closest ones.
2. Then, moving from right to left across the page, at each outcome point, calculate the expected
value of the cashflows by applying the probabilities to the cashflows. If there is room, write these
expected values on the tree next to the relevant outcome point, although be sure to show all of
your workings for them clearly beneath the tree too.
Finally, the recommendation is made to management, based on the option that gives the highest expected
value.
Page 59 of 147
F5 Performance Management 2016
It is worth remembering that using expected values as the basis for making decisions is not without its
limitations. Expected values give us a long run average of the outcome that would be expected if a decision
was to be repeated many times. So, if we are in fact making a one-off decision, the actual outcome may
not be very close to the expected value calculated and the technique is therefore not very accurate. Also,
estimating accurate probabilities is difficult because the exact situation that is being considered may not
well have arisen before.
The expected value criterion for decision making is useful where the attitude of the investor is risk neutral.
They are neither a risk seeker nor a risk avoider. If the decision makers attitude to risk is not known, it
difficult to say whether the expected value criterion is a good one to use. It may in fact be more useful to
see what the worst-case scenario and best-case scenario results would be too, in order to assist decision
making.
Let me now take you through a simple decision tree example. For the purposes of simplicity, you should
assume that all of the figures given are stated in net present value terms.
Example
A company is deciding whether to develop and launch a new product. Research and development costs are
expected to be $400,000 and there is a 70% chance that the product launch will be successful, and a 30%
chance that it will fail. If it is successful, the levels of expected profits and the probability of each occurring
have been estimated as follows, depending on whether the products popularity is high, medium or low:
Probability Profits
High: 0.2 $500,000 per annum for two years
Medium: 0.5 $400,000 per annum for two years
Low: 0.3 $300,000 per annum for two years
If it is a failure, there is a 0.6 probability that the research and development work can be sold for $50,000
and a 0.4 probability that it will be worth nothing at all.
The basic structure of the decision tree must be drawn, as shown below:
Page 60 of 147
F5 Performance Management 2016
Next, the probabilities and the profit figures must be put on, not forgetting that the profits from a
successful launch last for two years, so they must be doubled.
Now, the decision points and outcome points must be labeled, starting from the right-hand side and
moving across the page to the left.
Now, calculate the expected values at each of the outcome points, by applying the probabilities to the
profit figures. An expected value will be calculated for outcome point A and another one will be calculated
for outcome point B. Once these have been calculated, a third expected value will need to be calculated at
outcome point C. This will be done by applying the probabilities for the two branches off C to the two
expected values that have already been calculated for A and B.
These expected values can then be put on the tree if there is enough room.
Page 61 of 147
F5 Performance Management 2016
Once this has been done, the decision maker can then move left again to decision point D. At D, the
decision maker compares the value of the top branch of the decision tree (which, given there were no
outcome points, had a certain outcome and therefore needs no probabilities to be applied to it) to the
expected value of the bottom branch. Costs will then need to be deducted. So, at decision point D compare
the EV of not developing the product, which is $0, with the EV of developing the product once the costs of
$400,000 have been taken off ie $155,000.
Finally, the recommendation can be made to management. Develop the product because the expected
value of the profits is $155,000.
Often, there is more than one way that a decision tree could be drawn. In my example, there are actually
five outcomes if the product is developed:
Therefore, instead of decision point C having only two branches on it, and each of those branches in turn
having a further outcome point with two branches on, we could have drawn the tree as follows:
Page 62 of 147
F5 Performance Management 2016
You can see that the probabilities on the branches of the tree coming off outcome point A are now new.
This is because they are joint probabilities and they have been by combining the probabilities of success
and failure (0.7 and 0.3) with the probabilities of high, medium and low profits (0.2, 0.5, 0.3). The joint
probabilities are found easily simply by multiplying the two variables together each time:
All of the joint probabilities above must, of course, add up to 1, otherwise a mistake has been made.
Whether you use my initial method, which I always think is far easier to follow, or the second method, your
outcome will always be the same.
The decision tree example above is quite a simple one but the principles to be grasped from it apply
equally to a more complex decision resulting in a tree with far more decision points, outcomes and
branches on.
Finally, I always cross off the branch or branches after a decision point that show the alternative I havent
chosen, in this case being the do not develop product branch. Not everyone does it this way but I think it
makes the tree easy to follow. Remember, outcomes are not within your control, so branches off outcome
points are never crossed off. I have shown this crossing off of the branches below on my original, preferred
tree:
Page 63 of 147
F5 Performance Management 2016
Perfect information is said to be available when a 100% accurate prediction can be made about the future.
Imperfect information, on the other hand, is not 100% accurate but provides more knowledge than no
information. Imperfect information is far more difficult to calculate and you would only ever need to do
this in the exam if the numbers were extremely straightforward to start with. In this article, we are only
going to deal with perfect information in any detail. This is because the calculations involved in calculating
the value of imperfect information from my example are more complex than the Paper F5 syllabus would
require you to calculate.
Perfect information
The value of perfect information is the difference between the expected value of profit with perfect
information and the expected value of profit without perfect information. So, in our example, let us say
that an agency can provide information on whether the launch is going to be successful and produce high,
medium or low profits or whether it is simply going to fail. The expected value with perfect information can
be calculated using a small table. At this point, it is useful to have calculated the joint probabilities
mentioned in the second decision tree method above because the answer can then be shown like this.
However, it could also be done by using the probabilities from our original tree in the table below and then
multiplying them by the success and failure probabilities of 0.7 and 0.3:
Page 64 of 147
F5 Performance Management 2016
Profit less
EV of
Demand level Probability development Proceed
info
cost
High 0.2 $600,000 Yes $120,000
Medium 0.5 $400,000 Yes $200,000
Low 0.3 $200,000 Yes $60,000
$380,000
Profit less
EV of
Demand level Probability development Proceed
info
cost
Fail and sell 0.6 $(350,000) No 0
Fail and don't sell 0.4 $(400,000) No 0
Expected value $0
Whichever method is used, the value of the information can then be calculated by deducting the expected
value of the decision without perfect information from the expected value of the decision with perfect
information ie $266,000 $155,000 = $111,000. This would represent the absolute maximum that should
be paid to obtain such information.
Imperfect information
In reality, information obtained is rarely perfect and is merely likely to give us more information about the
likelihood of different outcomes rather than perfect information about them. However, the numbers
involved in calculating the values of imperfect information are rather complex and at Paper F5 level, any
numerical question would need to be relatively simple. You should refer to the recommended text for a
worked example on the value of imperfect information. It is suffice here to say that the value of imperfect
information will always be less than the value of perfect information unless both are zero. This would occur
when the additional information would not change the decision. Note that the principles that are applied
for calculating the value of imperfect information are the same as those applied for calculating the value of
perfect information.
SENSITIVITY ANALYSIS
The essence of sensitivity analysis is to carry out calculations with one set of values for the variables
and then substitute other possible values for the variables to see how this effects the overall
outcome.
Page 65 of 147
F5 Performance Management 2016
This technique can be used in any situation where relationships between key variables can be
identified.
Sensitivity analysis is one form of what-if? Analysis.
Page 66 of 147
F5 Performance Management 2016
Page 67 of 147
F5 Performance Management 2016
Feedback: This is important aspect of control once the plan is being implemented.
Single Loop Feedback: Feedback is used to take corrective action to ensure original plan is met.
Double Loop Feedback: Feedback is used to revise the original plan.
Types of feedback:
a) Negative feedback indicates that results or activities must be brought back on course, as they are
deviating from the plan.
b) Positive feedback results in control action continuing the current course.
c) Feedforward control is based on forecasts. Action can be taken well in advance if issues identified.
Incremental Budgeting: method of budgeting in which adjustments are made to the current year actual
data for inflation and other expected changes to arrive at the budget for the next year.
Advantages:
Quick and easy method of budgeting
Suitable for organisations that operate in a stable environment
Disadvantages:
Previous problems and inefficiencies are automatically included in the upcoming years budget.
Managers may overspend in order to be able to claim the same or more budget for the next year.
Fixed Budget: is a budget which remains unchanged throughout the budget period, regardless of
differences between the actual and the original planned volume of output or sales. E.g. Master Budget.
Flexible Budget: is a budget which is changed as the volume of output and sales changes by using the cost
behaviour patterns.
These can be created at the planning stage, as the organisation may prepare budgets for different
levels of expected activities.
These can also be created retrospectively to reflect the actual level of activity achieved. For example, if
actual activity was of 10,000 units produced, then a flexible budget for 10,000 units is created. This
Page 68 of 147
F5 Performance Management 2016
supports the control element as management will be able to compare the actual performance with a
budget of a corresponding level of activity.
Zero Based Budgeting: involves preparing a budget for each cost centre or activity from a zero base. Every
item of expenditure has then to be justified in its entirety in order to be included in the next year's budget.
Implementation: ZBB is particularly useful for budgeting for discretionary costs and for rationalisation
purposes, in areas of operations where efficiency standards are not properly established, such as
administration work.
1. Define items or activities for which costs should be budgeted, and spending decisions should be
planned: these are 'decision packages'.
a) Mutually exclusive packages. These are alternative methods of getting the same job done. The
best option among the packages must be selected by comparing costs and benefits and the other
packages are then discarded.
(b) Incremental packages. These divide an aspect of operations into different levels of activity. The
'base' package will contain the minimum amount of work that must be done to carry out the
activity and the cost of this minimum level. The other incremental packages identify additional
(incremental) work that could be done, at what cost and for what benefits.
2. Evaluate and rank the packages in order of priority: eliminate packages whose costs exceed their
value.
3. Allocate resources to the decision packages according to their ranking. Where resources such as
money are in short supply, they are allocated to the most valuable activities.
Advantages:
Identification and removal of inefficient or obsolete operations.
Avoidance of wasteful expenditure.
Increases motivation of staff by promoting a culture of efficiency.
It responds to changes in the business environment.
ZBB documentation provides an in-depth appraisal of an organisation's operations.
It challenges the status quo.
In summary, ZBB should result in a more efficient allocation of resources.
Disadvantages:
Extra volume of paperwork created and the extra time required to prepare the budget.
Short-term benefits might be emphasised to the detriment of long-term benefits.
It might give the impression that all decisions have to be made in the budget and discourage innovative
ideas.
Managers may have to be trained in ZBB techniques.
The organisation's information systems may not be capable of providing suitable information.
The ranking process can be difficult.
Page 69 of 147
F5 Performance Management 2016
Activity Based Budgeting: This involves defining the activities that underlie the financial figures in each
function and using the level of activity to decide how much resource should be allocated and how well it is
being managed and to explain variances from budget.
Principles:
Activities drive costs and the aim is to plan and control the causes (drivers) of costs rather than the
costs themselves.
Non value adding activities should be removed.
Most departmental activities are driven by demands and decisions beyond the immediate control
of the manager responsible for the department's budget.
Additional measures apart from traditional financial measures are needed to ensure continuous
improvement.
Advantages:
Critical success factors will be identified and performance measures devised to monitor progress
towards them. (A critical success factor is an activity in which a business must perform well if it is to
succeed.)
Because concentration is focused on the whole of an activity, not just its separate parts, there is
more likelihood of getting it right first time.
Rolling Budget: is a budget which is continuously updated by adding a further accounting period (a month
or quarter) to the end of the budget when the corresponding period in the current budget has ended.
As a result, a number of rolling budgets are prepared each year and each rolling budget covers the next 12-
month period.
Advantages:
Element of uncertainty in budgeting is reduced.
Budgets are reassessed regularly, and up to date budgets produced.
Planning and control will be based on a realistic recent plan.
Realistic budgets are better motivational factors for employees.
There is always a budget which extends for several months ahead.
Disadvantages:
More time, effort and money involved in budget preparation.
Frequent budgeting might put off the managers.
Beyond Budgeting: is a budgeting model which proposes that traditional budgeting should be abandoned.
Adaptive management processes should be used rather than fixed annual budgets.
Criticisms of Budgeting:
Budgets are time consuming and expensive.
Budgets provide poor value to users.
Budgets fail to focus on shareholder value.
Page 70 of 147
F5 Performance Management 2016
Benefits:
The use of external benchmarks can lead to management focus on competitive success.
Motivation. Rewards are team based which fosters cooperation and helps achieve corporate goals.
Faster response to threats and opportunities.
Challenges:
Resistance to change. Managers who consistently meet their annual budget targets may resist the
adoption of beyond budgeting as it threatens their position and bonuses..
Resource constraints. In addition, some public sector organisations may struggle to implement a
beyond budgeting process due to the constraints on their resources.
Page 71 of 147
F5 Performance Management 2016
In practice, it is often found that the resources required to make a product decrease as production
volumes increase. It costs more to produce the first unit of a product than it does to produce the one
hundredth unit. In part, this is due to economies of scale since costs usually fall when products are made
on a larger scale. This may be due to bulk quantity discounts received from suppliers, for example. The
learning curve, effect, however, is not about this; it is not about cost reduction. It is a human phenomenon
that occurs because of the fact that people get quicker at performing repetitive tasks once they have been
doing them for a while. The first time a new process is performed, the workers are unfamiliar with it since
the process is untried. As the process is repeated, however, the workers become more familiar with it and
better at performing it. This means that it takes them less time to complete it.
The specific learning curve effect identified by Wright was that the cumulative average time per unit
decreased by a fixed percentage each time cumulative output doubled. While in the aircraft industry this
rate of learning was generally seen to be around 80%, in different industries other rates occur. Similarly,
depending on the industry in question, it is often more appropriate for the unit of measurement to be a
batch rather than an individual unit.
The learning process starts as soon as the first unit or batch comes off the production line. Since a doubling
of cumulative production is required in order for the cumulative average time per unit to decrease, it is
clearly the case that the effect of the learning rate on labour time will become much less significant as
production increases. Eventually, the learning effect will come to an end altogether. You can see this in
Figure 1 below. When output is low, the learning curve is really steep but the curve becomes flatter as
cumulative output increases, with the curve eventually becoming a straight line when the learning effect
ends.
Figure 1
Page 72 of 147
F5 Performance Management 2016
The learning curve effect will not always apply, of course. It flourishes where certain conditions are
present. It is necessary for the process to be a repetitive one, for example. Also, there needs to be a
continuity of workers and they mustnt be taking prolonged breaks during the production process.
Learning curve models enable users to predict how long it will take to complete a future task. Management
accountants must therefore be sure to take into account any learning rate when they are carrying out
planning, control and decision-making. If they fail to do this, serious consequences will result. As regards its
importance in decision-making, let us look at the example of a company that is introducing a new product
onto the market. The company wants to make its price as attractive as possible to customers but still wants
to make a profit, so it prices it based on the full absorption cost plus a small 5% mark-up for profit. The first
unit of that product may take one hour to make. If the labour cost is $15 per hour, then the price of the
product will be based on the inclusion of that cost of $15 per hour. Other costs may total $45. The product
is therefore released onto the market at a price of $63. Subsequently, it becomes apparent that the
learning effect has been ignored and the correct labour time per unit should is actually 0.5 hours. Without
crunching through the numbers again, it is obvious that the product will have been launched onto the
market at a price which is far too high. This may mean that initial sales are much lower than they otherwise
would have been and the product launch may fail. Worse still, the company may have decided not to
launch it in the first place as it believed it could not offer a competitive price.
Let us now consider its importance in planning and control. If standard costing is to be used, it is important
that standard costs provide an accurate basis for the calculation of variances. If standard costs have been
calculated without taking into account the learning effect, then all the labour usage variances will be
favourable because the standard labour hours that they are based on will be too high. This will make their
use for control purposes pointless.
Finally, it is worth noting that the use of learning curve is not restricted to the assembly industries it is
traditionally associated with. It is also used in other less traditional sectors such as professional practice,
financial services, publishing and travel. In fact, research has shown that just under half of users are in the
service sector.
The learning curve effect has regularly been examined in Paper F5. For example, in December 2011, it was
examined in conjunction with life cycle costing. Candidates were asked to calculate a revised lifecycle cost
per unit after taking into account the learning effect. This involved working out the incremental labour
Page 73 of 147
F5 Performance Management 2016
time taken to produce the final 100th unit made before the learning effect ended. This is a fairly common
exam requirement which tests candidates understanding of the difference between cumulative and
incremental time taken to produce a product and the application of the learning curve formula. It is worth
mentioning at this point that you should never round learning curve calculations to less than three decimal
places. In some questions, where the learning effect is small, over-rounding will lead to a candidate wiping
out the entire learning effect and then the question becomes pointless.
The learning curve formula, as shown below, is always given on the formula sheet in the exam.
b
Y = ax
While a value for b has usually been given in past exams there is no reason why this should always be the
case. All candidates should know how to use a scientific calculator and should be sure to take one into the
exam hall.
In June 2013, the learning effect was again examined in conjunction with lifetime costing. Again, as has
historically been the case, the learning rate was given in the question, as was the value for b.
Back in June 2009, the learning curve effect was examined in conjunction with target costing. Once again,
the learning rate was given, and a value for b was given, but this time, an average cost for the first 128
units made was required. It was after this point that the learning effect ended, so the question then went
on to ask candidates to calculate the cost for the last unit made, since this was going to be the cost of
making one unit going forward in the business.
It can be seen, just from the examples given above, that learning curve questions have tended to follow a
fairly regular pattern in the past. The problem with this is that candidates dont always actually think about
the calculations they are performing. They simply practise past papers, learn how to answer questions, and
never really think beyond this. In the workplace, when faced with calculations involving the learning effect,
candidates may not be able to tackle them. In the workplace, the learning rate will not be known in
advance for a new process and secondly, even if it has been estimated, differences may well arise between
expected learning rates and actual learning rate experienced. Therefore, it seemed only right that future
questions should examine candidates ability to calculate the learning rate itself. This leads us on to the
next section of the article.
Obviously, the learning effect could be examined exactly as it has been in past exams, with candidates
being asked to calculate the time taken to produce an individual unit or a number of units of a product
either when the learning curve is still in effect or when it has ended. This objective of the syllabus has not
changed. As mentioned earlier, historically, questions have required the use of the algebraic method and a
Page 74 of 147
F5 Performance Management 2016
value for b has usually been given in the exam. Moving forward, since calculations of the learning rate
itself may be required in future exams, it becomes even more important that candidates are familiar with
both the tabular method and using their scientific calculators. The following question is an example of the
kind of question that may appear in future exams. Here, the tabular method is the simplest way to answer
the question.
Example 1
P Co operates a standard costing system. The standard labour time per batch for its newest product was
estimated to be 200 hours, and resource allocation and cost data were prepared on this basis.
The actual number of batches produced during the first six months and the actual time taken to produce
them is shown below:
Required
(a) Calculate the monthly learning rate that arose during the period.
(b) Identify when the learning period ended and briefly discuss the implications of this for P Co.
Solution
Page 75 of 147
F5 Performance Management 2016
Learning rate:
176/200 = 88%
154.88/176 = 88%
136.29/154.88 = 88%
P Co could try and improve its production process so that the learning period could be extended. It may be
able to do this by increasing the level of staff training provided. Alternatively, it could try to incentivise
staff to work harder through payment of bonuses, although the quality of production would need to be
maintained.
Example 2
The first batch of a new product took six hours to make and the total time for the first 16 units was 42.8
hours, at which point the learning effect came to an end.
Solution
Again, the easiest way to solve this problem and find the actual learning rate is to use a combination of the
tabular approach plus, in this case, a little bit of maths. There is an alternative method that can be used
that would involve some more difficult maths and use of the inverse log button on the calculator, but this
can be quite tricky and candidates would not be expected to use this method. Should they choose to do so,
however, full marks would be awarded, of course.
Using algebra:
Page 76 of 147
F5 Performance Management 2016
Step 2: Divide each side by 16 in order to get rid of the 16 x on the right hand side of the equation:
4
2.675 = (6 x r )
Step 3: Divide each side by 6 in order to get rid of the 6 x on the right hand side of the equation:
4
0.4458333 = r
4
Step 4: take the fourth root of each side in order to get rid of the r on the right hand side of the equation.
4 1/y
You should have a button on your calculator that says r or x . Either of these can be used to find the
fourth root (or any root, in fact) of a number. The key is to make sure that you can use your calculator
properly before you enter the exam hall rather than trying to work it out under exam pressure. You then
get the answer:
r = 0.8171
Example 3:
Solution:
= 100 (500)
= 38.88 / unit
Page 77 of 147
F5 Performance Management 2016
Example
$
Direct Materials:
aterial A: 2 litres at $4.50 per litre 9
Material B: 3 kilos at $4 per Kilo 12
Direct Labour:
Grade 1 labour: 0.5 hours at $20 per hour 10
Grade 2 labour: 0.75 hours at $16 per hour 12
Variable production overheads: 1.25 hours at $4 per hour 5
Fixed production overheads: 1.25 hours at $40 per hour 50
Standard ( production) cost per unit 95
Used to prepare budgets When standard costs are established for products, they can
be used to prepare the budget.
Management can therefore use variance reports to identify whether control measures might be
needed, to improve poor performance or continue with good performances.
Types of Standards:
Ideal Standards The ideal standard cost is the cost that would be achievable if operating conditions
and operating performance were perfect. In practice, the ideal standard is not
achievable. Will demotivate employees if enforced.
Attainable standard These assume efficient but not perfect operating conditions. An allowance is made
for waste and inefficiency. However the attainable standard is set at a higher level
of efficiency than the current performance standard, and some improvements will
therefore be necessary in order to achieve the standard level of performance. This
can be a basis of motivating employees.
Current standards These are based on current working conditions and what the entity is capable of
achieving at the moment. Current standards do not provide any incentive to make
significant improvements in performance, which may cause employee performance
to slack.
Basic Standards These are standards which remain unchanged over a long period of time. Cause
employees to lose interest.
So if an organisation had originally budgeted for an activity level of 5,000 units but ended up producing/
selling 7,000 units, the following steps will have to be carried out to carry out an effective variance
analysis:
Step 1: Use the standard cost card to determine flexible budget for 7,000 units. If the cost card is not
available, information from the fixed budget of 5,000 units can be picked up to create a budget for the
7,000 units. This will depend on following knowledge points:
Total Budgeted Fixed Costs (unless Step Fixed) will not change regardless of level of activity
Budgeted Variable Cost Per Unit will not change regardless of level of activity
Step 2: Compare the actual revenue and costs of 7,000 units with the flexed budget created in Step 1.
Step 3: Identify the differences between the actual and budget as positive (Favourable) or negative
(Adverse).
Step 4: Carry out an investigation to determine causes of the variances (if material). Remember both
favourable and adverse variances may require investigation.
Page 79 of 147
F5 Performance Management 2016
During Variance Analysis, the performance of various managers will be put to question but they
should only be held accountable for controllable aspects.
The principle of controllability is that managers should only be held accountable for costs over
which they have some influence.
Controllable costs: Controllable costs are expenses which can be directly influenced by a given
manager.
Variable costs are considered controllable in the short term.
Committed fixed costs are uncontrollable.
Discretionary fixed costs can be controlled by the relevant authority.
Managers should not be held accountable for apportioned overhead costs.
Page 80 of 147
F5 Performance Management 2016
Example: A unit of product P123 has a standard cost of five liters of material A at $3 per liter. The standard
direct material cost per unit of product 123 is therefore $15.
In a particular month, 2,000 units of product 123 were manufactured. These used 10,400 liters of material
A, which cost $33,600.
$
2,000 units of product P123 should cost (x$15) 30,000
2,000 units of product P123 did cost 33,600
Total direct materials cost variance (3,600) (A)
The total direct materials cost variance is adverse, because actual costs were higher than the standard
cost.
Page 81 of 147
F5 Performance Management 2016
Example: A unit of product p123 has a standard cost of five liters of material A at $3per liter. The standard
direct material cost per unit of product 123 is therefore $15. In a particular month, 2,000 units of product
123 were manufactured. These used 10,400 liters of Material A, which cost $33,600.
The total direst material cost variance is $3,600 (A), as calculated earlier, in the previous example.
$
10,400 liters of materials should cost (x$3) 31,200
10,400 liters of materials did cost 33,600
Material price variance 2,400 (A)
The price variance is adverse because the materials cost more to purchase than they should have.
Example: Using the same example above that was used to illustrate the material price variance; the usage
variance should be calculated as follows:
kilos
2,000 units of Product P123 should use (x 5 kilos) 10,000
2,000 units of Product P123 did use 10,400
Material usage variance in kilos 400 (A)
Standard price per kilo of Material A $3
Material usage variance in $ $1,200 (A)
The usage variance is adverse because more materials were used than expected, and this has added to
costs.
Page 82 of 147
F5 Performance Management 2016
Example: Product P123 has a standard direct labour cost per unit of: 1.5 hours x $12 per direct labour hour
= $18 per unit.
During a particular month, 2,000 units of Product 123 were manufactured. These took 2,780 hours to make
and the direct labour cost was $35,700.
$
2,000 units of product P123 should cost (x $18) 36,000
2,000 units of product P123 did cost 35,700
Total direct labour cost variance 300 F
The variance is favourable, because actual costs were less than the standard cost.
The direct labour total cost variance can be analysed into a rate variance and an efficiency variance. The
calculations are similar to the calculations for the materials price and usage variances.
Example: Using the same example that was used previously to calculate the total labour cost variance,
calculate the direct labour rate variance.
Page 83 of 147
F5 Performance Management 2016
$
2,730 hours should cost (x $12) 33,360
2,730 hours did cost 35,700
Direct labour rate variance 2,340 (A)
The rate variance is adverse because the labour hours worked cost more than they should have.
Example: Using the same example above that was used to illustrate the total direct labour cost variance
and the direct labour rate variance; the efficiency variance should be calculated as follows:
hours
2,000 units of Product P123 should take (x 1.5 hours) 3,000
2,000 units of Product P123 did take 2,780
Efficiency variance in hours 220 F
Standard direct labour rate per hour $12
Direct labour efficiency variance in $ $2,640 F
The efficiency variance is favourable because production took less time than expected, which has reduced
costs.
Efficient or inefficient working by the work The grade or level of labour actually used is
force. different from the grade of labour in the
New workforce due to high labour standard cost
turnover. New workforce due to high labour turnover.
Quality of supervision good or bad, Wage rates have been altered (usually,
resulting in favourable or unfavourable raised).
efficiency variance
The effect of a new incentive scheme.
Problems in the production process, for
example machine breakdowns, reducing
efficiency
Page 84 of 147
F5 Performance Management 2016
Example: Product P123 has a standard variable production overhead cost per unit of 1.5hours x $2 per
direct labour hour= $3 per unit. During a particular month, 2,000 unit of a product 123 were manufactured.
These took 2,780 hours to make and the variable production overhead cost was 46,550.
Required: Calculate for the month the total variable production overhead cost variance.
(Note: this same example will be used to illustrate the variable overhead expenditure and efficiency
variances.)
Answer
$
2,000 units of output should cost (x$3) 6,000
2,000 units of output did cost 6,550
Total variable production overhead cost variance 550 (A)
The variance is adverse, because actual costs were more than a standard cost.
Page 85 of 147
F5 Performance Management 2016
Example: Using the same example that was used previously to calculate the total variable production
overhead cost variance, calculate the variable production overhead expenditure variance.
$
2,780 hours should cost (x$2) 5,560
2,789 hours did cost 6,550
Variable production overhead variance 990 (A)
The expenditure variance is adverse because the expenditure on variable overhead is the hours worked
was more than it should have been.
hours
2,000 units of Product P123 should take (x 1.5 hours) 3,000
2,000 units of Product P123 did take 2,780
Efficiency variance in hours 220 F
Standard variable production overhead rate per hour $2
Variable production overhead efficiency variance in $ $440 F
The efficiency variance is favourable because production took less time than expected, which has reduced
costs.
The causes of variable overhead efficiency variances are the same as the causes of labour efficiency
variances, when variable overhead expenditure is assumed to vary with the number of direct labour
hours worked.
The causes of variable overhead expenditure variances maybe:
Efficient or inefficient spending on overhead items of cost
Inaccurate estimates of the variable overhead expenditure rate per hour.
Page 86 of 147
F5 Performance Management 2016
Page 87 of 147
F5 Performance Management 2016
Example: A company budgeted to make 5,000 units of a single standard product in Year 1. Budgeted direct
labour hours are 10,000 hours. Budgeted fixed production overhead is $40,000. Actual production in Year 1
was 5,200 units and fixed production overhead was $40,500.
Standard fixed overhead cost per unit = $8 (2 hours per unit x $4 per hour).
The variance is favourable, because fixed overhead costs have been over-absorbed.
This variance is adverse because actual expenditure exceeds the budgeted expenditure.
This variance is favourable because actual production volume exceeded the budgeted volume.
Summary $
Fixed overhead expenditure variance 500 (A)
Fixed overhead volume variance 1,600 F
Fixed overhead total cost variance 1,100 F
Example: A company budgeted to make 5,000 units of a single standard product in Year 1. Budgeted direct
labour hours are 10,000 hours. Budgeted fixed production overhead is $40,000. Actual production in Year 1
was 5,200 units in 10,250 hours of work, and fixed production overhead was $40,500.
The capacity variance is favourable because actual hours worked exceeded the budgeted hours (therefore
more units should have been produced).
Summary $
Sales Variances
Page 89 of 147
F5 Performance Management 2016
Example: A company budgets to sell 7,000 units of Product P456. The standard sales price of Product P456
is $50 per unit and the standard cost per unit is $42.
Actual sales were 7,200 units, which sold for $351,400. The sales price variance and sales volume variance
would be calculated as follows:
Page 90 of 147
F5 Performance Management 2016
Operating Statements:
Fav Adv
000 000 000
Budgeted profit xxx
Sales margin
variances
Price xxx (xxx)
Volume xxx (xxx)
xxx/(xxx)
XXX
Cost variances
Materials Price xxx (xxx)
Usage xxx (xxx)
Labour Rate xxx (xxx)
Idle time (xxx)
Efficiency xxx (xxx)
Variable Overhead Expenditure xxx (xxx)
Efficiency xxx (xxx)
Fixed Overhead Expenditure xxx (xxx)
Capacity xxx (xxx)
Efficiency xxx (xxx)
xxx (xxx)
xxx/(xxx)
Actual profit XXX
When a company uses standard marginal costing rather than standard absorption costing: finished goods
inventory is valued at the standard variable production cost, not the standard full production cost
variances are calculated and presented in the same way as for standard absorption costing, but with two
important differences:
Fixed production overhead variances: In standard marginal costing, there is a fixed production overhead
expenditure variance, but no fixed production overhead volume variance.
Sales volume variances: In standard marginal costing, the sales volume variance is calculated using
standard contribution.
Page 91 of 147
F5 Performance Management 2016
Fav Adv
000 000 000
Budgeted contribution xxx
Sales margin variances
Price xxx (xxx)
Volume xxx (xxx)
xxx (xxx) xxx/(xxx)
XXX
Cost variances
Materials Price xxx (xxx)
Usage xxx (xxx)
Labour Rate xxx (xxx)
Idle time (xxx)
Efficiency xxx (xxx)
Variable Overhead Rate xxx (xxx)
Efficiency xxx (xxx)
xxx (xxx)
xxx(xxx)
Actual contribution XXX
Fixed overheads
Budgeted overhead xxx
Expenditure variance xxx (xxx)
xxx(xxx)
Actual profit XXX
Factor Description
Size of the variance. As a general rule, the larger the variance, the greater the potential
benefit from investigation and control measures.
Probability that the cause of the Whether or not to investigate the cause of a variance -will also
variance will be controllable. depend on the expectation of management that the cause of the
variance will be controllable.
Costs and benefits of control Investigating a variance has a cost in terms of both management
action. time and expenditure. A variance should not be investigated unless
the expected benefits exceed the costs of investigation and control.
Page 92 of 147
F5 Performance Management 2016
Random variations in reported Management might take the view that a favourable or adverse
variances. variance in one month is due to random factors that will not recur
next month. If the variance is due to random factors, it should not
happen again next month, and management can probably ignore it
without risk.
Reliability of budgets and Management might have a view about whether the variance is
measurement systems. caused by poor planning and poor measurement systems, rather
than by operational factors. If so, investigating the variance would
be a waste of time and would be unlikely to lead to any cost savings.
Mix Variance: A mix variance occurs when the materials are not mixed or blended in standard proportions
and it is a measure of whether the actual mix is cheaper or more expensive than the standard mix.
Yield Variance: A yield variance arises because there is a difference between what the input should have
been for the output achieved and the actual input.
When standard costing is used for products which contain two or more items of direct material, the total
materials usage variance can be calculated by calculating the individual usage variances in the usual way
and adding them up (netting them off).
Example: Product N is produced front three direct materials, A, B and C that are mixed together in a
process. The following information relates to the budget and output for the month of January
Budget Actual
Material Quantity Standard price Standard Quantity
per kilo cost used
kg $ $
A 1 20 20 160
B 1 22 22 I80
C 8 6 48 1,760
10 90 2,100
Output 1 unit 200 units
Page 93 of 147
F5 Performance Management 2016
The materials mix variance measures how much of the total usage variance is attributable to the fact that
the actual combination or mixture of materials that was used was more expensive or less expensive than
the standard mixture for the materials.
The mix component of the usage variance therefore indicates the effect on costs of changing the
combination (or mix or proportions) of material inputs in the production process.
The materials mix variance is calculated as follows (making reference to the example above):
Step 1: Take the total quantity of all the materials used and divide this into a standard mix for the materials
used.
Step 2: The difference between the quantity of material used and the quantity hat should have been used
according to the standard mix; is the mix variance.
Material Actual Standard Mix variance Std. cost per Mix variance
mix mix (kgs) kg (Standard)
The materials yield variance is the difference between the actual yield from a given input and the yield that
the actual input should have given in standard terms. It indicates the effect on costs of the total materials
inputs yielding more or less output than expected.
The standard cost of each unit (kg) of input = $90/10kg = $9 per kilo
Method 1: This compares the actual yield to the expected yield from the material used. The difference is
then valued at the standard cost of output.
Page 94 of 147
F5 Performance Management 2016
In the above example 10 kg of material in should result in 1 unit of output. Therefore, 2,100 kg of material
in should result in 210 units of output.
The difference between this figure and the actual output is the yield variance as a number of units. This is
then multiplied by the expected cost of a unit of output.
Units
2,100 kgs of input should yield (@10 kg per unit) 210
did yield 200
Yield variance in units 10 (A)
Standard cost of output $90
Materials yield variance $900 (A)
Method 2: This compares the actual usage to achieve the yield to the expected usage to achieve the actual
yield. The difference is then valued at the standard cost of input.
In the above example 1 unit should use 10 kg of input, therefore, 200 units should use 2,000 kg of input.
The difference between this figure and the actual output is the yield variance as a number of units. This is
then multiplied by the expected cost of a unit of output.
kg
200 units of product N should use (x 10 kilos) 2,000
did use 2,100
Yield variance in quantities 100 (A)
Standard cost of input $9/kg
Yield variance in money value = $900 (A)
Summary
$
Mix variance 1,180 (F)
Yield variance 900 (A)
Usage variance (= mix + yield variances) 280 (F)
Analysis of the material usage variance into the mix and yield components is worthwhile if
management have control of the proportion of each material used. Management will seek to find the
optimum mix for the product and ensure that the process operates as near to this optimum as possible.
Page 95 of 147
F5 Performance Management 2016
Quality. Using a cheaper mix may result in a lower quality product and the customer may not be
prepared to pay the same price. A cheaper product may also result in higher sales returns and loss
of repeat business.
It measures the increase or decrease in the standard profit or contribution as a result of the sales volume
being higher or lower than budgeted.
It is calculated as the difference between actual sales units and budgeted sales units, multiplied by the
standard profit per unit.
If a company sells more than one product, it is possible to analyse the overall sales volume variance into a
sales mix variance and a sales quantity variance.
Sales mix variance: The sales mix variance occurs when the proportions of the various products sold are
different from those in the budget.
Sales quantity variance: The sales quantity variance shows the difference in contribution/profit because of
a change in sales volume from the budgeted volume of sales.
The sales mix variance is calculated as the difference between the actual quantity sold in the standard mix
and the actual quantity sold in the actual mix, valued at standard margin per unit.
The sales quantity variance is calculated as the difference between the actual sales volume in the budgeted
proportions and the budgeted sales volumes, multiplied by the standard margin.
Example: The following information relates to the sales budget and actual sales volume results for X Inc for
the month of March.
Product X Y Z Total
Budgeted sales (units) 2,400 1,400 1,200 5,000
Unit contribution $5 $7 $6
Total contribution $12,000 $9,800 $7,200 $29,000
Working
Average contribution per unit $5.80
Actual sales (units) 2,000 2,200 1,800 6,000
Page 96 of 147
F5 Performance Management 2016
The sales quantity variance indicates the effect on profits of the total quantity of sales being different front
that budgeted, assuming that they are sold in the budgeted sales mix.
If this was the case the average standard contribution per unit would be the same as budgeted at:
Units
of sale
Budgeted sales in total 5,000
Actual sales in total 6,000
Sales quantity variance in units 1,000 (F)
Weighted average standard contribution per unit $5.80
Sales quantity variance in $ of standard contribution $5,800 (F)
The sales mix variance is calculated as follows (making reference to the example above):
Sum up the budgeted sales of each individual product and calculate the percentage that each bears to the
total (Product X: 2,400/5,ooo = 48%; Product Y: 1,400/5,000 = 28%; Product Z: 1,200/5,000 = 24%).
Apply the percentages to the actual total sales to give the actual number of each that would have been
sold if the actual sales were made in the standard mix. (For product X this figure is 48% of 6,000 = 2,880
units).
The mix variance (in units) for each product is the difference between this number and the actual sales of
that product. (For product X this is 2,400 - 2,880 = 480 units. Thus the company has sold 480 units of X less
than it would have if the actual sales were made in the standard mix)
The variance for each product expressed as units is multiplied by the standard contribution per unit of that
product to give the impact on contribution.
Page 97 of 147
F5 Performance Management 2016
In this illustration the total mix variance is favourable because the company has sold more high
contribution items and less low contribution items.
Summary
$
Mix variance 1,400 (F)
Quantity variance 5,800 (F)
Volume variance 7,200 (F)
Page 98 of 147
F5 Performance Management 2016
Introduction:
Sometimes based on circumstances the budget and the standard cost established by an organisation turns
out to be inaccurate and this contributes towards the variances. Under the circumstances, the budgets/
standard costs should be revised based on the new information available and the variances should be split
into Planning or Operational variances.
Planning Variance: Variance arising as a result of error in planning. This is the difference between the
original budget and the revised budget. Strategic level management is responsible for these.
Operational Variance: This is a result of the operational performance: favourable or adverse. These are calculated
by looking at the difference between the actual result and the revised budget/ standard. Operational level managers
are responsible for these.
Revising Budgets:
Budgets should be revised when it is confirmed beyond reasonable doubt that the original budget is
redundant or ineffective under the circumstances.
The changes have to be approved by the senior management.
However care needs to be taken as there is a possibility of management manipulating the budget
revision so that the end result is favourable variances.
MATERIAL
Material Price Planning Variance Original Standard Price
Less: Revised Standard Price
Price Planning Variance ($) .
Material Price Operational Variance Revised standard cost for material actually used
Less: Actual cost for material actually used .
Price Operational Variance ($) .
Material Usage Planning Variance Quantity of material to be used as per original standard
Less: Quantity of material to be used as per revised standard
Usage Planning Variance .
Page 99 of 147
F5 Performance Management 2016
Material Usage Operational Variance Quantity of material to be used as per revised standard
Less: Quantity of material actually used for the actual
production
Usage Operational Variance
.
LABOUR
Labour Rate Planning Variance Original Standard Rate
Less: Revised Standard Rate
Rate Planning Variance ($) .
Labour Rate Operational Variance Revised standard rate for hours actually worked
Less: Actual rate for hours actually worked .
Rate Operational Variance ($) .
SALES
Sales Price Planning Variance Original budgeted sales price
Less: Revised budgeted sales price
Price Planning Variance ($) .
Sales Price Operational Variance Revised budgeted sales price for units actually sold
Less: Actual sales price for units actually sold
Price Operational Variance ($) .
Advantages
They identify variances due to poor planning and put a realistic value to variances resulting from
operations.
Planning variances can be used to update standard costs and revise budgets.
The performance of managers is assessed on 'realistic' variance calculations.
Disadvantages
It takes time and effort to revise budgets and prepare revised standard costs.
Managers might try to blame poor results on poor planning and not on their operational
performance.
Manipulation issues in revising budgets
Variance Analysis is a measure of control. Managers responsible for the variances should be asked
to account for them. Senior Management/ people involved in the planning aspect should be made
accountable for the Planning Variances. And managers/ people given responsibility for
implementing the budget, should only be held accountable for Operational Variances.
The monetary value of the variances also gives an indication of the profit or loss suffered in a
period.
Variances not only identify the possible areas of concern but can be used to improve future
performances. The analysis could highlight areas where efficiency needs to be improved etc.
The concept of Total Quality Management (TQM) is an approach to management based on the
principle that all aspects of quality in an entity's operations should be managed so as to improve
value for the customer.
The concept of 'continuous improvement' is a view that in order to manage quality it is essential to
keep looking for and identifying ways of improving quality in procedures, systems, products and
services.
Variance analysis and variance reporting becomes inconsistent with TQM. This is because:
Variances are calculated by comparing actual results with a fixed standard: performance is
considered 'good' if actual results are better than the standard
In a system of TQM, the aim is to improve continually. Therefore it would be disappointing if
actual results are ever worse than the standard.
Variance reporting in a TQM environment may lead to dysfunctional behaviour if managers
ignore aspects of performance where the variance is close to $0, because in TQM any aspect of
performance should be considered capable of improvement.
Just in time (JIT) management involves purchasing raw materials and producing output 'just in time'
for when they are needed.
In principle, in a JIT environment there will be no inventory of raw materials or finished goods, (in
practice the aim is to keep these inventories as low as possible).
This approach to management may possibly be inconsistent with some variance reporting,
especially if a system of absorption standard costing is used.
In a system of absorption costing, there will be favourable fixed production overhead
variances if actual output exceeds budgeted output. In other words, favourable variances
are obtained and profit is improved by increasing finished goods inventory levels. But in JIT
output is produced when and according to what is needed.
A consequence of JIT purchasing and production is that sometimes the purchase price for
raw materials or the production cost for finished goods may be higher than they might
otherwise be, because a supplier may charge a higher unit price for a small quantity.
Production costs per unit may also be higher when batch sizes are smaller. This will be an
adverse factor from Standard costing perspective.
Standard costs may be incompatible with rapid change, for similar reasons to those of TQM.
In a rapidly-changing environment, it should be expected that the original standard or budget may
get out of date, and action to try to eliminate an adverse variance may in fact be inappropriate
because operating conditions have now changed.
Many companies produce nonstandard products and try to customise their products according to
needs of particular customers. Even where companies do not customise products for individual
customers, there is extensive fragmentation of markets into segments or niches, with different
product designs manufactured for each separate segment. It is extremely difficult to establish a
standard in such an environment.
Variance analysis concentrates on only a narrow range of costs, and does not give sufficient
attention to issues such as quality and customer satisfaction.
Standard costing places too much emphasis on direct labour costs. Direct labour is only a small
proportion of costs in the modern manufacturing environment and so this emphasis is not
appropriate.
Many of the variances in a standard costing system focus on the control of short-term variable
costs. But in most organisations the majority of costs, including direct labour costs, tend to be fixed
in the short run.
The use of standard costing relies on the existence of repetitive operations and relatively
homogeneous output. Nowadays many organisations are forced continually to respond to
customers changing requirements, with the result that output and operations are not so repetitive.
Most standard costing systems produce control statements weekly or monthly. The modern
manager needs much more prompt control information in order to function efficiently in a dynamic
business environment
Management Accounting Information: Information that is used to support strategic planning, control and
decision making.
Strategic Planning: Long term planning decisions that define the objectives of the organisation.
Management Accounting information is primarily used for strategic level planning i.e. plans for long
periods of the future and so relies on forecasts and estimates.
Management accounting information also therefore incorporates some risk and uncertainty analysis.
The management accountant requires information for:
Project assessments: at the time of decision making and post implementation feedback.
Handling cash and operational matters
Management accounting information is primarily derived from internal sources but also takes into
impact of external factors.
Management Accounting information has the following limitations:
It may provide misleading information, leading to ineffective decisions.
It is internally focused as it focuses on performance targets and ignores market competition and
demand.
Data is inflexible as it is often just based on historical performance, so the challenge lies in
providing more relevant information for strategic planning, control and decision making.
Strategic Management Accounting: focuses on external factors, non-financial and internally generated
information. It takes into account the following:
Competitive edge by understanding customer demands and competitors USP (unique selling point).
Input from many different areas of the organisation to ensure that the goals and targets link
together smoothly.
Brings together comparable information regarding different strategies.
Ensures business operations are focused on meeting shareholders needs.
It provides information about: pricing of product, product profitability, cashflows; customer
analysis; market analysis etc.
Management Control: The process of utilising resources, efficiently and effectively with the aim of
achieving the strategic objectives of the organisation. Also known as Tactical Planning.
Efficiency in the use of resources means that optimum output is achieved from the input resources used.
Effectiveness in the use of resources means that the outputs obtained are according to set objectives or
targets.
The time horizon involved in management control will be shorter than at the strategic decisions level.
Management control activities are short-term non-strategic activities.
Features of management control information
Primarily generated internally
Covers the entire organisation
Summarised at a relatively low level
Relevant to the short and medium terms
Collected in a standard manner
Commonly expressed in money terms
Operational Control: Routine processing of transactions as per directions laid down in the Tactical plans.
Scheduling of unexpected or 'ad hoc' work must be done at short notice. These are termed as short-
term non-strategic activities.
Information requirements:
Operational information includes transaction data which is needed for the conduct of day-to-day
implementation of plans.
Detail of information provided depends upon the purpose, it is required for.
Operational information, although quantitative, is expressed in terms of units, hours, quantities of
material, and so on.
Transaction Processing Systems (TPS) collect, store, modify and retrieve the transactions of an
organisation.
Batch transaction processing (BTP) collects transaction data as a group and processes it after a time
delay. Information is entered in batches.
Real time transaction processing (RTTP) is the immediate processing of data.
Management information systems (MIS) convert data from mainly internal sources into information,
which enables managers to make timely and effective decisions for planning and controlling the activities.
Support structured decisions at operational and management control levels and is internally
focused.
Designed to report on existing operations rather than analyse data.
Executive information systems (EIS) provides a quick and efficient computing and communication
environment for senior managers to support strategic decisions.
Executive information systems draw data from the MIS and allow communication with external sources of
information.
Executive resource planning systems (ERP systems) are modular software packages designed to integrate
the key processes in an orgnanisation so that a single system can serve the information needs of all
functional areas.
ERP systems have the principal benefit that the same data can easily be shared between different
departments. ERP systems work in real time.
Benefits of ERP
Closed system is isolated and shut off from the environment. Information is not received from or provided
to the environment. Social systems cannot be part of closed system.
Open system is connected to and interacts with the environment and is influenced by it.
An open system accepts inputs from its surroundings, processes the inputs in some manner and then
produces an output.
Advantages:
Strong communication which leads to effective decision making.
Adaptable. Keeps pace with the dynamic environment.
It helps managers focus on the external factors that affect the organisation.
Types of Data:
Secondary data: data not directly collected from the source by the user.
Primary data: market research is more tailored to the user's exact needs.
Internal Sources:
Formal communication channels
Informal communication between management and staff
Communication between managers
The financial accounting records
External Sources:
Legal/ Tax expert
Research & Development and Marketing departments
Directories & other published sources
Associations and Government agencies
Information from customers
Information from suppliers (product details, pricing etc.)
Internet & online databases
Database information
Data warehouses
Cost of Information:
Management costs
Recording, processing and dissemination of external information
Infrastructure costs
Installation and maintenance of systems communication, internet etc. to facilitate flow of
information.
Time theft
Wasted time caused by abuse of internet and email access facilities
Information overload
Benefits of Information:
Improvement in the quality of the decisions made based on the information available.
Reduction in risk and uncertainties.
Limitation: Quality of information may not be up to mark because of limitations in the parameters defined
for collecting the information, the method of collecting the data and age of the data etc.
Advantages: Cost savings can be substantial because secondary external data is cheaper than gathering
primary data.
Disadvantages:
The data may not be relevant to the research objectives as it has originally been collated by
someone else.
Some external information is expensive to access and may not be easily accessible.
The accuracy of the data is questionable.
Generating Information:
Determine if the benefits of the information generated will be higher than the costs incurred to
prepare it.
Ensure that the desired information will be of use to the decision makers before the information is
gathered.
Standardised formats for the information to be prepared should be set, especially if there are
multiple prepares of the information. The formats should ideally focus on being user friendly for the
ultimate users.
The limitations of the information gathered should be communicated to the users as well as the
details of the preparer/ originator, so that any queries can be directly forwarded.
Distributing Information:
A procedures manual should be in place. This would indicate what reports are to be prepared and
issued to whom.
Confidential information should be highlighted as such and users guided on how to deal with
sensitive information.
E-mail policy should be established specifying the dos and donts for on-line communication.
Physical computer security
Internal security should be established. Senior management should specify which user can
have access to which assets and information.
External security through firewalls should be established, as they can be used to protect
data and databases from being accessed by unauthorised people.
Security and confidential information
A number of procedures can be used to ensure the security of highly confidential information that
is not for external consumption.
Passwords
Logical access systems
Database controls
Firewalls
Personnel security planning
Anti-virus and anti-spyware software
Performance Measurement
Performance measurement is a vital part of control and aims to establish how well something or somebody
is doing in relation to a planned activity.
Responsibility. Performance reports should be provided to the individuals (and their managers) who are
actually responsible for the performance. Performance reports are irrelevant if they are sent to individuals
with no responsibility.
Controllability. Performance reports should distinguish between aspects of performance that should be
controllable by the individual who is made responsible and accountable. There is no sensible purpose in
judging the performance of an individual by looking at factors that are outside the individual's control.
Performance measurement should cover the long-term, medium-term and short- term.
Long-term performance: Measures should be linked to the long-term objectives and the strategies of the
organisation. The most significant long-term objectives might be called critical success factors or CSFs. in
order to achieve its long-term and strategic objectives, the critical success factors must be achieved.
For each critical success factor, there should be a way of measuring performance, in order to check
whether the CSF targets are being met. Performance measurements for CSFs might be called key
performance indicators (KPIs) or possibly key risk indicators (KRIs).
Medium term performance: Medium-term performance measurement is perhaps most easily associated
with the annual budget, and meeting budget targets. Targets, whether financial or non- financial, can be
set for a planning period such as the financial year, and actual results should be compared against the
planning targets.
Financial performance indicators are the tools used by financial analysts for making decisions
regarding credit and investments. This method utilises the data found in financial statements to
determine a companys standing.
Analysts will compare the companys ratios to its past performance, as well as to industry statistics
to determine risks, trends and to identify any peculiarities. This analytical tool facilitates inter-
company as well as intra company comparisons.
Percentage annual growth in sales = (Current Year Sales / Previous Year Sales) x 100%
If a company wishes to increase its annual profits, it will probably want to increase its annual sales
revenue. Sales growth is usually necessary for achieving a sustained growth in profits over time.
Sales growth (or a decline in sales) can usually be attributed to two causes: Sales prices and sales volume.
Profitability Indicators
Profitability ratios are good indicators of the operating efficiency of an organisation. The management of
an organisation is usually keen to measure its operating efficiency. Again, the owners/ shareholders invest
their funds in the expectation of reasonable returns. The operating efficiency of a firm and its ability to
ensure ample returns to its owners/ shareholders depends basically on the profits earned by it.
It is wrong to conclude, without further analysis, that a high profit margin means 'good performance' and a
low profit margin means 'bad performance'. To assess performance by looking at profit margins, it is
necessary to look at the circumstances in which the profit margin has been achieved.
Some companies operate in an industry or market where profit margins are high, although sales volume
may be low. Other companies may operate in a market where profit margins are low but sales volumes are
much higher.
Any change in profit margin front one year to the next will be caused by: changes in selling prices, or
changes in costs as a percentage of sales, or a combination of both.
Cost/sales ratios
Performance may be assessed by looking at changes in these ratios over time. A large increase or reduction
in any of these ratios would have a significant effect on profit margin.
This ratio indicates the efficiency with which company is able to use all its (net) assets to gearing $1 sales.
Generally, the higher a companys total net asset turnover, the more efficiently its assets have been used.
Earnings per share (EPS) = Profits available to ordinary shareholder / Number of ordinary shares
EPS is widely used as a measure of a company's performance, especially in comparing results over a period
of several years. A company must be able to sustain its earnings in order to pay dividends and reinvest in
the business so as to achieve future growth. Investors also look for growth in the EPS from one year to the
next.
EPS is a figure based on past data, and it is easily manipulated by changes in accounting policies and by
mergers or acquisitions. The use of the measure in calculating management bonuses makes it particularly
liable to manipulation.
Return on capital employed (ROCE) = (Capital Employed / Profit Before Interest & Tax) x 100%
Capital employed = Shareholders' funds plus 'payables: amounts falling due after more than one year' plus
any long-term provisions for liabilities = Total assets less current liabilities.
The change in ROCE from one year to the next
The ROCE being earned by other companies, if this information is available
A comparison of the ROCE with current market borrowing rates
We may analyse the ROCE, to find out why it is high or low, or better or worse than last year. There are
Page 113 of 147
F5 Performance Management 2016
two factors that contribute towards a return on capital employed, both related to turnover.
Profit margin. A company might make a high or a low profit margin on its sales.
Asset turnover. Asset turnover is a measure of how well the assets of a business are being used to
generate sales.
Profit margin and asset turnover together explain the ROCE, and if the ROCE is the primary profitability
ratio, these other two are the secondary ratios. The relationship between the three ratios is as follows
Financial Risk
Financial risk is the risk to a business entity that arises for reasons related to its financial structure or
financial arrangements.
There are several major sources of financial risk, such as credit risk (= the risk of bad debts because
customers who are given credit will fail to pay what they owe) and foreign exchange for companies that
import or export goods or services (= the risk of an adverse movement in an important currency exchange
rate).
The risk is that if an entity borrows very large amounts of money, it might fail to generate enough cash
front its business operations to pay the interest or repay the debt principal.
Debt ratios
Debt ratios can be used to assess whether the total debts of the entity are within control and are not
excessive.
Gearing ratio (leverage) = (Long term debt/ Share capital and reserves) x 100%
Or (Long term debt/ Share capital and reserves plus long term debts) x 100%
When there are preference shares, it is usual to include the preference shares within long-term debt, not
share capital.
A company is said to be high-geared or highly-leveraged when its debt capital exceeds its share capital and
reserves. This means that a company is high-geared when the gearing ratio is above either 50% or 100%,
depending on which method is used to calculate the ratio.
A company is said to be low-geared when the amount of its debt capital is less than its share capital and
reserves. This means that a company is low-geared when the gearing ratio is less than either 50% or 100%,
depending on which method is used to calculate the ratio.
The gearing ratio can be used to monitor changes in the amount of debt of a company over time. It can
also be used to make comparisons with the gearing levels of other, similar companies, to judge whether
the company has too much debt, or perhaps too little, in its capital structure.
Interest cover ratio = Profit before interest and tax / Interest charges in the year
Interest cover measures the ability of the company to meet its obligations to pay interest.
An interest cover ratio of less than 3.0 times is considered very low, suggesting that the company could be
at risk from too much debt in relation to the amount of profits it is earning.
The risk is that a significant fall in profitability could mean that profits are insufficient to cover interest
charges, and the entity will therefore be at risk from any legal action or other action that lenders might
take.
Financial risk, as we have seen, can be measured by financial gearing. Business risk refers to the risk of
making only low profits, or even losses, due to the nature of the business that the company is involved in.
One way of measuring business risk is by calculating a company's operating gearing or 'operational
gearing'.
Liquidity Ratios
Liquidity for a business entity means having enough cash, or having ready access to additional cash, to
meet liabilities when they fall due for payment. The most important sources of liquidity for non-bank
companies are:
Cash may also come front other sources, such as the sale of a valuable non-current asset (such as land and
buildings), although obtaining cash front these sources may need some time.
Liquidity is important for a business entity because without it, the entity- may become insolvent even
though it is operating at a profit. If the entity is unable to settle its liabilities when they fall due, there is a
risk that a creditor will take legal action and this action could lead on to insolvency proceedings.
On the other hand a business entity may have too much liquidity, when it is holding much more cash than
it needs, so that the cash is 'idle', earning little or no interest. Managing liquidity is often a matter of
ensuring that there is sufficient liquidity, but without having too much.
It is sometimes suggested that there is an 'ideal' current ratio of 2.0 times (2:1). However, this is not
necessarily true and in some industries, much lower current ratios are normal. It is important to assess a
current ratio by considering:
changes in the ratio over time
the liquidity ratios of other companies in the same industry.
The quick ratio or acid test ratio is the ratio of 'current assets excluding inventory' to current liabilities.
Inventory is excluded from current assets on the assumption that it is not a very liquid item.
It is sometimes suggested that there is an 'ideal' quick ratio of 1.0 times (1:1). However, this is not
necessarily true and in some industries, much lower quick ratios are normal. As indicated earlier, it is
important to assess liquidity- by looking at changes in the ratio over time and comparisons with other
companies and the industry norm.
Accounts Receivable Payment Period: (Trade Receivables/ Credit Sales Turnover) x 365
This is a rough measure of the average length of time it takes for a company's accounts receivable to pay
what they owe.
This indicates the average number of days that items of inventory are held for. As with the average
accounts receivable collection period, this is only an approximate figure, but one which should be reliable
enough for finding changes over time.
The accounts payable payment period often helps to assess a company's liquidity; an increase in accounts
payable days is often a sign of lack of long-term finance or poor management of current assets, resulting in
the use of extended credit from suppliers, increased bank overdraft and so on.
Non-financial performance refers to every aspect of operations within a business except the financial
aspect, and performance targets can be set for every- department throughout the entity. Some indicators
are:
Non Financial Performance indicators are adequately covered through different models covered later.
Analysing NFPIs
You need to explain the significance of the ratio - What does it mean? Does it indicate good or bad
performance, and why?
Look at the background information given in the exam question and try- to identify a possible cause or
reason for the good or bad performance.
Possibly, think of a suggestion for improving performance. What might be done by management to make
performance better?
Performance measures - both financial and non-financial - are needed for service industries, but the key
measures that are best suited to service industries are often very different from the key NFPIs in
manufacturing.
Customer Satisfaction informal listening by calling a certain number of customers each week
number of customer visit to the factory or workplace
Total Quality Management embraces every activity of a business so performance measures cannot be
confined to the production process but must also cover the work of sales and distribution departments and
administration departments, the efforts of external suppliers, and the reaction of external customers.
In many cases the measures used will be non-financial ones. They may be divided into three types.
Measuring the quality of incoming supplies. Quality control should include procedures for
acceptance and inspection of goods inwards and measurement of rejects.
Monitoring work done as it proceeds. 'In-process' controls include statistical process controls and
random sampling, and measures such as the amount of scrap and reworking in relation to good
production.
Measuring customer satisfaction. This may be monitored in the form of letters of complaint,
returned goods, penalty discounts, claims under guarantee, or requests for visits by service
engineers.
Short-termism is when there is a bias towards short-term rather than long-term performance.
Organisations often have to make a trade-off between short-term and long-term objectives. Decisions
which involve the sacrifice of longer-term objectives include the following.
Balanced Scorecard
A useful approach for a complete strategic performance evaluation is to include both financial and non-
financial factors for an organisation, using the balanced scorecard. The balanced scorecard measures an
organisations performance in four key areas:
Customer satisfaction
Financial performance
The justifications of balanced scorecard over the traditional measures are that:
Accounting figures are easily manipulated and as such unreliable changes in the business and
market environment do not show in the financial results of a company until much later.
Factors other than financial performance must therefore be targeted.
Customer perspective
This focuses on the analysis of different types of customers, their degree of satisfaction and the processes
used to deliver products and services to customers.
Customer service.
New products.
New markets.
Customer retention.
Customer satisfaction.
Quality performance.
Quality.
Motivated workforce.
Product diversification.
% sales from new products.
Amount of training.
Number of employee suggestions.
Extent of employee empowerment.
Financial perspective
This is concerned with the shareholders view of performance. Shareholders are concerned with many
aspects of financial performance.
Market share.
Profit ratio.
Return on investment.
Economic value added.
Return on capital employed.
Cash flow.
Share price.
Criticism
The targets for each of the four perspectives might often conflict with each other. When this happens,
there might be disagreement about what the priorities should be.
This problem should not be serious, however, if it is remembered that the financial is the most important
of the four perspectives for a commercial business entity. The term 'balanced' scorecard indicates that
some compromises have to be made between the different perspectives.
Fitzgerald and Moon (1996) suggested that a performance management system in a service organisation
can be analysed as a combination of three building blocks:
dimensions
standards, and
rewards.
These are shown in the following diagram, which is known as the 'building block model'.
Dimensions of Performance
Dimensions of performance are the aspects of performance that are measured. To establish a performance
measurement system for a service industry, a decision has to be made about the dimensions of
performance that should be used for measuring performance.
Research by Fitzgerald and others (1993) and by Fitzgerald and Moon (1996) concluded that there are six
aspects to performance measurement that link performance to corporate strategy. These are:
resource utilisation
flexibility
innovation.
Performance measures should be established for each of these six dimensions. Some performance
measures that might be used for each dimension are set out in the following table.
Standards of performance
The second part of the framework for performance measurement suggested by Fitzgerald and Moon
relates to setting expected standards of performance, once the dimensions of performance have been
selected. This considers behavioral aspects of performance targets.
To what extent do individuals feel that they own the standards that will be used to assess their
performance? Do they accept the standards as their own, or do they feel that the standard shave
been imposed on them by senior management?
Page 122 of 147
F5 Performance Management 2016
Do the individuals held responsible for achieving the standards of performance consider that these
standards are achievable, or not?
Are the standards fair ('equitable') for all managers in all business units of the entity?
It is recognised that individuals should 'own' the standards that will be used to assess their performance,
and managers are more likely to own the standards when they have been involved in the process of setting
the standards.
It has also been argued that if an individual accepts or 'owns' the standards of performance, better
performance will be achieved when the standard is more demanding and difficult to achieve than when
the standard is easy to achieve.
This means that the standards of performance that are likely to motivate individuals the most are
standards that will not be achieved successfully all the time. Budget targets should therefore be
challenging, but not impossible to achieve.
Finding a balance between standards that the company thinks are achievable and standards that the
individual thinks are achievable can be a source of conflict between senior management and their
subordinates.
The third aspect of the performance measurement framework of Fitzgerald and Moon is rewards. This
refers to the structure of the re-wards system, and how individuals will be rewarded for the successful
achievement of performance targets. This aspect of performance also has behavioral implications.
One of the main roles of a performance measurement system should be to ensure that strategic objectives
are achieved successfully, by linking operational performance with strategic objectives.
According to Fitzgerald, there are three aspects to consider in the reward system.
The system of setting performance targets and rewarding individuals for achieving those targets
must be clear to everyone involved. Provided that managers accept their performance targets,
motivation to achieve the targets will be greater when the targets are clear (and when the
managers have participated in the target-setting process).
Employees may be motivated to work harder to achieve performance targets when they are
rewarded for successful achievements, for example with the payment of an annual bonus.
Individuals should only be held responsible for aspects of financial performance that they can
control. This is a basic principle of responsibility accounting. A common problem, however, is that
some costs are incurred for the benefit of several divisions or departments of the organisation. The
costs of these shared services have to be allocated between the divisions or departments that use
them. The principle that costs should be controllable therefore means that the allocation of shared
costs between divisions must be fair, in practice; arguments between divisional managers often
arise because of disagreements as to how the shared costs should be shared.
Decentralisation of authority
Decentralisation involves the delegation of authority within an organisation. Within a large organisation,
authority is delegated to the managers of cost centres, revenue centres, profit centres and investment
centres.
A divisionalised structure refers to the organisation of an entity in which each operating unit has its own
management team which reports to a head office. Divisions are commonly set up to be responsible for
specific geographical areas or product lines within a large organisation. The term 'decentralised
divisionalised structure' means an organisation structure in which authority has been delegated to the
managers of each division to decide selling prices, choose suppliers, make output decisions, and so on.
Benefits of decentralisation
Decision-making should improve, because the divisional managers make the tactical and
operational decisions, and top management is free to concentrate on strategy and strategic
planning.
Decision-making at a tactical and operational level should improve, because the divisional
managers have better 'local' knowledge.
Decision-making should improve, because decisions will be made faster. Divisional managers can
make decisions 'on the spot' without referring them to senior management.
Managers may be more motivated to perform well if they are empowered to make decisions and
rewarded for performing well against fair targets
Divisions provide useful experience for managers who will one day become top managers in the
organisation.
Within a large multinational group, there can be tax advantages in creating a divisional structure, by
locating some divisions in countries where tax advantages or subsidies can be obtained.
Disadvantages of decentralisation
The divisional managers might put the interests of their division before the interests of the
organisation as a whole. Taking decisions that benefit a division might have adverse consequences
for the organisation as a whole. When this happens, there is a lack of 'goal congruence'.
Top management may lose control over the organisation if they allow decentralisation without
accountability. It may be necessary to monitor divisional performance closely. The cost of such a
monitoring system might be high.
It is difficult to find a satisfactory measure of historical performance for an investment centre that
will motivate divisional managers to take the best decisions. For example, measuring divisional
performance by Return 011 Investment (ROI) might encourage managers to make inappropriate
long-term investment decisions. This problem is explained in more detail later.
Economies of scale might be lost. For example, a company might operate with cute finance
director. If it divides itself into three investment centres, there might be a need for four finance
directors - one at head office and one in each of the investment centres. Similarly there might be a
duplication of other systems, such as accounting system and other IT systems.
Page 124 of 147
F5 Performance Management 2016
Controllable profit is used to assess the manager and is therefore sometimes called the managerial
evaluation.
Traceable profit is used to assess the performance of the division and is sometimes called the economic
evaluation.
Profit is a key measure of the financial performance of a division. However, in measuring performance, it is
desirable to identify:
costs that are controllable by the manager of the division, and also
costs that are traceable to the division. These are controllable costs plus other costs directly
attributable to the division over which the manager does not have control.
There may also be an allocation of general overheads, such as a share of head office costs.
In a divisionalised system, profit centres and investment centres often trade with each other, buying and
selling goods and services. These are internal sales, priced at an internal selling price (a 'transfer price').
Reporting systems should identify external sales of the division and internal sales as two elements of the
total revenue of the division.
Responsibility Accounting
Responsibility accounting is the term used to describe decentralisation of authority, with the performance
of the decentralised units measured in terms of accounting results.
With a system of responsibility accounting there are five types of responsibility centre: cost centre;
revenue centre; profit centre; contribution centre; investment centre.
Transfer Pricing
When goods are sold or transferred by one division to another, the sale for one division is matched by a
purchase by the other division, and total profit of the company as a whole is unaffected. It is an internal
transaction within the company, and a company cannot make a profit from internal transfers.
A decision has to be made about what the transfer price should be. A transfer price maybe:
the cost of the item (to the selling division), or
a price that is higher than the cost to the selling division, which may be cost plus a profit margin or
related to the external market price of the item transferred.
Transfers at cost
The transfer price may be the cost of making the item (goods) or cost of provision (services) to the selling
division. A transfer at cost maybe at either:
marginal cost (variable cost), or
full cost.
Example
An entity has to divisions, Division A and Division B, Division A makes a component X which is transferred
to Division B. Division B uses component X to make end-product Y.
Details of budgeted annual sales and costs in each division are as follows:
Division A Division B
Answer
Transfers at marginal cost: budgeted performance:
By transferring goods at variable cost, the transferring division earns revenue equal to its variable cost of
production. It therefore bears the full cost of its fixed costs, and its records a loss (or a net cost) equal to
its fixed costs.
On the other hand, the buying division (Division B) reports a profit. Because te fixed costs of Division A are
not included in the transfer price, the profit of Division B exceeds the total profit of the company as a
whole.
Since the transfer price includes the fixed costs of the selling division, Division A is able to cover all its
costs, but it reports neither a profit nor a loss. It covers its costs exactly.
The buying division (Division B) has to pay for the fixed costs of division A in the transfer price. It still
reports a profit, but this profit is now equal to the profit earned by the company as a whole.
Costs of production
Internal transfers (11,000 x $15) - 165,000 0
Other variable costs 77,000 33,000 110,000
Fixed costs (incurred) 80,000 90,000 170,000
Total costs 157,000 288,000 280,000
One way of arranging for each division to make a profit on transfers is to set the transfer price at an
amount above cost, to provide the selling division with a profit margin. However the transfer price should
not be so high that the buying division makes a loss on the items it obtains from the selling division.
Divisional autonomy
Autonomy is freedom of action and freedom to make decisions. Divisional managers should be free to
make their own decisions. Autonomy should improve motivation of divisional managers.
For example, when transfer prices have been decided, the managers of all divisions within the entity
should be free to decide:
whether to sell their output to other divisions (internal transfers) or -whether to sell them to external
customers, if an external market exists for the output
whether to buy their goods from another division (internal transfers) or whether to buy them from
external suppliers, if an external market exists.
The main problems arise when there is an external market for the goods (or services) that one division
transfers to another. When an external market exists for goods or services that are also transferred
internally, the market might be called an external intermediate market.
The selling division can sell its goods into this market, instead of transferring them internally.
Similarly the buying division can buy its goods from other suppliers in this market, instead of buying
them internally from another division.
Divisional managers will put the interests of their division before the interests of the company. When there
is an external intermediate market, divisional managers will decide between internal transfers and using
the external market in a way that maximises the profits of their division.
Market-based and cost-based transfer prices, and transfer prices based on opportunity cost
As a general rule:
when an external intermediate market does not exist for transferred goods, the transfer price will be
based on cost
when an external intermediate market does exist for transferred goods, the transfer price will be based
on the external market price.
However, the situation is more complicated when:
there is a limit to production capacity in the selling division, or
there is a limit to sales demand in the external intermediate market.
In these circumstances, we need to consider the opportunity costs for the selling division of transferring
goods internally instead of selling them externally.
Ideal transfer prices must therefore take opportunity costs into consideration.
Transfers at cost do not provide any profit for the selling division; therefore transfer prices at cost are
inappropriate for a divisional structure where the selling division is a profit centre or an investment centre,
with responsibility for making profits.
Transfers at cost are appropriate only if the selling division is treated as a cost centre, with responsibility
for controlling its costs but not for making profit.
If the selling division is a profit centre or an investment centre, and there is 110 external intermediate
market for the transferred item, transfers should therefore be at a negotiated 'cost plus' price, to provide
some profit to the selling division.
Example
A company has two divisions, Division A and Division B. Division A makes a component X which is
transferred to Division B.
Division B uses component X to make end-product Y. Both divisions are profit centres within the company.
Details of costs and selling price are as follows:
Division A $
Cost of component X
Variable cost 10
Fixed cost 8
Total cost 18
Division B
Further processing costs
Variable cost 4
Fixed cost 7
11
The further processing costs of Division B do not include the cost of buying component X from Division A.
One unit of component X goes into the production of one unit of Product Y. Fixed costs in both divisions
will be the same, regardless of the volume of production and sales.
Required: What is the ideal transfer price, or what is a range of prices that would be ideal for the transfer
price?
Step 2: What will motivate the buying division to buy as many units of component X as possible?
Division B will want to buy more units of component X provided that the division earns additional
contribution from every unit of the component that it buys.
Division B $
Selling price of Product Y, per unit 40
Variable further processing costs in Division B 4
36
Page 132 of 147
F5 Performance Management 2016
The opportunity cost of not buying units of component X, ignoring the transfer price, is $36 per unit.
Division B should therefore be willing to pay up to $36 per unit for component X. Any transfer price below
$36 but above $4 per unit -will increase its contribution and profit
Step 3: What will motivate the selling division to make and transfer as many units of component X as
possible?
Division A will want to make and sell more units of component X provided that the division earns
additional contribution from every unit of the component that it sells. The marginal cost of making and
transferring a unit of component X is $10. Division A should therefore be willing to transfer as many units
of component X as it can make (or Division B has the capacity to buy) if the transfer price is at least $10.
Finding the ideal transfer price: An external intermediate market and no production limitations
When there is an external intermediate market for the transferred item, a different situation applies. If
there are no production limitations in the selling division, the ideal transfer price is usually the external
market price.
Example
A company has two divisions P and Q. Division P makes a component X which it either transfers to Division
Q or sells in an external market. The costs of making one unit of component X are:
Component X $
Variable cost 60
Fixed cost 30
Total cost 90
Division Q uses one unit of component X to make one unit of product Y, which it sells for $200 after
incurring variable further processing costs of $25 per unit.
Required What is the ideal transfer price or range of transfer prices, if the price of component X in the
external intermediate market is:
$140
$58?
If component X is not transferred by Division P to Division Q, Division Q will have to buy units of component
X in the external market. Every unit of component X transferred internally therefore reduces the need to
purchase a unit externally.
The additional contribution for the company from making and selling one unit of product Y is $115
($200 - $60 - $25).
The additional contribution from making one unit of component X and selling it externally is $80 ($140 -
$60) when the external price is $140.
When the external market rice is $58 for component X, Division P would make an incremental loss of $2
per unit ($58 - $60) by selling the component externally.
A profit-maximising plan is therefore to maximise the sales of Division Q, and transfer component X from
Division P to Division Q rather than sell component X externally. This is the optimum plan if the external
price for component X is either $140 or $58.
Step 2: What will motivate the buying division (Division Q) to buy as many units of component X as possible
from Division P?
Division Q will be prepared to buy component X from Division P as long as it is not more expensive than
buying in the external market from another supplier. Division Q will be willing to buy internally if the
transfer price is:
a) not more than $140 when the external market price is $140
b) not more than $58 when the external market price is $58.
If the external market price and transfer price are both $140, Division Q will make an incremental
contribution of $35 ($200 - $140 - $25) from each unit of component X that it buys and uses to make and
sell a unit of product Y.
If the external market price and transfer price are both $58, Division Q will make an incremental
contribution of $117 ($200 - $58 - $25) from each unit of component X that it buys and uses to make and
sell a unit of product Y.
It the transfer price is higher than the external market price, Division Q will choose to buy component X in
the external market, which would not be in the best interests of the company as a whole.
Step 3: What will motivate the selling division to make and transfer to Division Q as many units of
component X as possible?
Division P should be prepared to transfer as many units of component X as possible to Division Q provided
that its profit is no less than it would be if it sold component X externally.
Units transferred to division Q are lost sales to the external market; therefore there is an opportunity cost
of transfer that Division P will wish to include in the transfer price.
Variable cost 60
Opportunity cost of lost external sale (58 -60) (2)
Total cost = minimum transfer price 58
Finding the ideal transfer price: An external intermediate market and production limitations
When there is an external intermediate market for the transferred item, and the selling division has a
limitation on the number of units it can produce, the ideal transfer price should allow for the opportunity
cost of the selling division. Every unit transferred means one less external sale.
Example
A company consists of two divisions, Division A and Division B. Division A is working at full capacity on its
machines, and can make either Product Y or Product Z, up to its capacity limitation. Both of these products
have an external market.
The costs and selling prices of Product Y and Product Z are:
Product Y Product Z
$ $
Selling price 15 17
The variable cost of sale is incurred on external sales of the division's products. This selling cost is not
incurred for internal sales/transfers from Division A to Division B.
To make one unit of Product Y takes exactly the same machine time as one unit of Product Z.
Division B buys Product Y, which it uses to make an end product.
The profit of the company as a whole will be maximised by making and selling as many units as possible of
Division Bs end product.
This is stated in the example. The company wants to make and sell as many units of the end product of
Division B as possible. It is not clear, however, whether it is better for Division B to buy Product Y externally
or to buy internally from Division A.
If Division A does not make Product Y, it can make and sell Product Z instead. Product Z earns a higher
contribution per unit of machine time, the limiting factor in Division A.
Step 2: What would motivate the buying division to buy as many units of Product Y as possible from
Division A?
Division B will be prepared to buy Product Y from Division A as long as it is not more expensive than buying
in the external market from another supplier.
Division B will be willing to buy Product Y internally if the transfer price is $15 or less.
Step 3: What would motivate the selling division to make and transfer as many units of Product Y as
possible?
The selling division will only be willing to make Product Y instead of Product Z if it earns at least as much
contribution as it would front making Z and selling it externally, (in this situation, the division can make as
many units of Z as it can make of Y, and Product Z earns a higher contribution).
Product Y $
Variable cost of making Product Y (the variable cost of sale is
not relevant for internal transfers) 10
Opportunity cost of lost external sale of Product Z (17 - 7 - 2 ) 8
Total cost = minimum transfer price 18
In practice, transfer prices may be agreed and expressed in one of the following ways.
If the selling division would incur some extra costs if it sold its output externally rather than transferred it
internally to another division, the transfer price may be reduced below market price, to allow for the
variable costs that would be saved by the selling division. This is very common as the selling division may
save costs of packaging and warranties or guarantees. Distribution costs may also be cheaper and there
will be no need for advertising.
It may also be difficult to identify exactly what the external market price is. Products from rival companies
may be different in quality, availability may not be so certain and there may be different levels of service
back-up.
Standard full costs should be used, not actual full costs. This will prevent the selling division from
increasing its profit by incurring higher costs per unit.
Full cost plus might be suitable when there is no external intermediate market.
However, there are disadvantages in using full cost rather than variable cost to decide a transfer price.
The fixed costs of the selling division become variable costs in the transfer price of the buying division.
This might lead to decisions by the buying division manager that are against the best interests of the
company as a whole. This is because a higher variable cost may lead to the buying division choosing to
set price at a higher level which would lose sales volume.
The size of the profit margin or mark-up is likely to be arbitrary.
Standard variable costs should be used, not actual variable costs. This will prevent the selling division from
increasing its profit by incurring higher variable costs per unit.
Variable cost plus might be suitable when there is no external intermediate market. It is probably more
suitable in these circumstances than full cost plus, because variable cost is a better measure of opportunity
cost. However, as stated earlier, when transfers are at cot, the transferring division should be a cost
centre, and not a profit centre.
The fixed charge is a lump stun charge at the end of each period. The fixed charge would represent a share
of the contribution front selling the end product, which the selling/transferring division has helped to earn.
Alternatively, the charge could be seen as a charge to the buying division for a share of the fixed costs of
the selling division in the period.
The fixed charge could be set at an amount that provides a 'fair' profit for each division, although it is an
arbitrary amount.
Dual pricing
In some situations, two divisions may not be able to agree a transfer price, because there is no transfer
price at which the selling division will want to transfer internally or the buying division will want to buy
internally. However, the profits of the entity as a whole would be increased if transfers did occur.
These situations are rare. However, when they occur, head office might find a solution to the problem by
agreeing to dual transfer prices.
the selling division sells at one transfer price, and
the buying division buys at a lower transfer price.
There are two different transfer prices. The transfer price for the selling division should be high enough to
motivate the divisional manager to transfer more units to the buying division. Similarly, the transfer price
for the buying division should be low enough to motivate the divisional manager to buy more units from
the selling division.
In the accounts of the company, the transferred goods are:
sold by the selling division to head office and
bought by the buying division from head office.
Page 138 of 147
F5 Performance Management 2016
The loss from the dual pricing is a cost for head office, and treated as a head office overhead expense.
However, dual pricing can be complicated and confusing. It also requires the intervention of head office
and therefore detracts from divisional autonomy.
These profit measures can be used with variance analysis, ratio analysis, return on investment, residual
income and non-financial performance measurements to evaluate performance.
Return on investment (ROI) is a measure of the return on capital employed for an investment
centre. It is also called the accounting rate of return (ARR).
It is often used as a measure of divisional performance for investment centres because:
the manager of an investment centre is responsible for the profits of the centre and also the assets
invested in the centre, and
ROI is a performance measure that relates profit to the size of the investment.
Profit is not a suitable measure of performance for an investment centre. It does not make the manager
accountable for his or her use of the net assets employed (the investment in the investment centre).
Measuring ROI
Performance measurement systems could use ROI to evaluate the performance of both the manager and
the division. ROI is the profit of the division as a percentage of capital employed.
Profit
ROI =
Capital employed (size of investment)
Profit. This should be the annual accounting profit of the division, without any charge for interest on
capital employed. This means that the profit is after deduction of any depreciation charges on non-current
assets.
Capital employed/investment.
This should be the stun of the non-current assets used by the division plus the working capital that it uses.
Working capital = current assets minus current liabilities, which for a division will normally consist of
inventory plus trade receivables minus trade payables.
The performance of the manager of an investment centre may be judged on the basis of ROI.
A divisional manager may receive a bonus on the basis of the ROI achieved by the division.
When an investment centre manager's performance is evaluated by ROI, the manager will probably
be motivated to make investment decisions that increase the division's ROI in the current year, and
reject investments that would reduce ROI in the current year.
The problem is that investment decisions are made for the longer term, and a new investment that
reduces ROI in the first year may increase ROI in subsequent year.
An investment centre manager may therefore reject an investment because of its short-term effect
on ROI, without giving proper consideration, to the longer term.
As explained above, investment decisions might be affected by the divisions ROI short term effect
and this is inappropriate for making investment decisions.
There are different ways of measuring capital employed. Comparison of performance between
different organisations is therefore difficult.
When assets are depreciated, ROI will increase each year provided that annual profits are constant.
The division's manager might not want to get rid of ageing assets, because ROI will fall if new
(replacement) assets are purchased.
Divisional profit is an accounting measurement of profit, after depreciation charges are subtracted. It is
the same figure for profit that would be used to measure ROI.
Imputed interest (notional interest) and the cost of capital: The interest charge is calculated by applying a
cost of capital to the division's net investment (net assets).
Imputed interest (notional interest) is the division's capital employed, multiplied by:
One reason for using residual income instead of ROI to measure a division's financial performance is that
residual income has a monetary value, whereas ROI is a percentage value.
It relates the profit of the division to the capital employed, by charging an amount of notional
interest on capital employed, and the division manager is responsible for both profit and capital
employed.
Residual income is a flexible measure of performance, because a different cost of capital can be
applied to investments with different risk characteristics.
Residual income is an accounting-based measure, and suffers from the same problem as ROI in
defining capital employed and profit.
Its main weakness is that it is difficult to compare the performance of different divisions using
residual income.
Page 141 of 147
F5 Performance Management 2016
Residual income is not easily understood by management, especially managers with little
accounting knowledge.
ROI/ROCE Dec 08 Q 1
June 11 Q 4b
June 12 Q 5
June 14 Q 3a
The public sector refers to the sector of the economy that is owned or controlled by the government in
the interests of the general public.
Not-for-profit organisations are entities that are not government-owned or in the public sector, but
which are not in existence to make a profit. They include charitable organisations and professional
bodies.
A common feature of public sector organisations and not-for-profit organisations is that their main
objective is not financial.
A not-for-profit organisation will nevertheless have some financial objectives:
State-owned organisations must operate within their spending budget.
Charitable organisations may have an objective of keeping running costs within a certain limit, and
of raising as much funding as possible for their charity work.
Although the main objective of not-for-profit and public sector organisations is not financial, they need
good management, and their performance should be measured and monitored as the directors or senior
managers of public sector bodies are accountable to the public. In practice, this usually means
accountability to the government, which in turn should be accountable to the public.
The leaders of not-for-profit organisations outside the public sector should also be accountable to the
people who provide the finance to keep them in existence.
Performance measurement should be related to achieving targets that will help the organisation to achieve
its objectives, whatever these may be.
The selection of appropriate targets will vary according to the nature and purpose of the organisation. The
broad principle, however, is that any not-for-profit organisation should have:
operational targets, which may be either financial (often related to costs and keeping costs under
control) or non-financial (related to the nature of operations).
To identify suitable performance targets for Not for Profit organisations and Public sector organisations,
focus on:
A good performance measurement system seeks to monitor the success of an organisation in achieving its
objectives.
However, there are several reasons why the problems with performance measurement in the public sector
are greater than those in commercial business organisations.
Multiple objectives: An organisation in the public sector (and also not-for-profit organisations) may
have a number of different 'main objectives', and they are required to achieve all these objectives
within the constraint of limited available finance. This will also lead to conflict and it becomes difficult
to prioritise.
Measuring outputs: Outputs can seldom be measured in a way that is generally agreed to be
meaningful. \Data collection can be problematic. For example, unreported crimes are not included in
data used to measure the performance of a police force.
Lack of profit measure: If an organisation is not expected to make a profit, or if it has no sales,
indicators such as ROI and RI are meaningless.
Nature of service provided: Many not-for-profit organisations provide services for which it is difficult to
define a cost unit.
Financial constraints: Although every organisation operates under financial constraints, these are more
pronounced in not-for-profit organisations.
Political, social and legal considerations: Unlike commercial organisations, public sector organisations
are subject to strong political influences. The public may have higher expectations of public sector
organisations than commercial organisations. The performance indicators of public sector
organisations are subject to far more onerous legal requirements than those of private sector
organisations.
Economy means spending within limits, and avoiding wasteful spending. It also means achieving the
same purpose at a lower expense.
Efficiency means getting more output from available resources. Applied to employees, efficiency is
often called 'productivity'.
Effectiveness refers to success in achieving end results or success in achieving objectives. Whereas
efficiency is concerned with getting more outputs from available resources, effectiveness is concerned
with achieving outputs that meet the required aims and objectives.
Management accounting systems and reporting systems may provide information to management about
value for money.
Value for money audits may be carried out to establish how much value is being achieved within a
particular department and whether there have been improvements to value for money.
Value for money is an objective that can be applied to any organisation whose main objective is non-
financial but which has restrictions on the amount of finance available for spending. It could therefore
be appropriate for all organisations within the public sector.
The objective of economy focuses on the need to avoid wasteful expenditure on items, and to keep
spending within limits. It also helps to ensure that the limited finance available is spent sensibly.
Targets could be set for the prices paid for various items from external suppliers. Audits by the
government's auditors into departmental spending may be used to identify:
any significant failures to control prices, and
unnecessary expense.
Efficiency relates the quantity of resources to the quantity of output. This can be measured in a variety of
ways
External considerations are factors that arise or exist outside an organisation, and within its external
environment, that could have an impact on the objectives that the organisation should try to achieve and
the targets that it sets for those objectives, or its actual performance.
The external factors that affect an organisation vary according to the type of organisation and the
environment in which it operates. Broad categories of external factors include:
Political and legal developments: new laws may affect what a company is allowed to do or is not
permitted to do, and this change could affect its performance
Economic conditions and economic developments
Changes in public attitudes and behaviour
Technological changes
Competition in the market.
Stakeholders:
Stakeholders of a company are any organisations, individuals or groups with an interest in what the
company does and how it performs. It is often convenient to group stakeholders into categories, such
as shareholders, lenders, suppliers, customers, employees, the government and the general public.
Public sector entities and not-for-profit organisations also have different stakeholder groups.
The interests of each stakeholder group differ, and each group has different expectations about what
the organisation should do. They also judge its performance in different ways.
Shareholders in a company have invested money by buying shares. Their main expectation is likely
to be that the company should provide good returns on investment, in the form of dividends or
share price growth.
Lenders to a company expect to make a profit or return in the form of interest. Lenders will want
the company to have a secure business, and will not want the company to take risks that could
threaten its ability to make the interest payments and repay the lending at maturity.
Major suppliers to a company may depend on the company for a large proportion of their profits.
They will expect honest and fair dealing from the company, and they will expect to be paid on time.
Customers of a company expect to receive value for the money they pay to buy the goods or
services that the company provides. If they think they are receiving poor value, they are likely to
switch to buying the products of competitors, or to finding an alternative product.
Employees are stakeholders in a company because the company provides them with a job and
possibly also career opportunities. They also have an interest in working conditions.
The government and the general public. Some large companies can have a major influence on the
national economy. They provide work for large numbers of people, and they produce the goods or
services that many people buy and rely on. In addition, companies are major users of natural
resources, and are a cause of much pollution in the environment. Public expectations of what
particular companies should or should not be doing may become quite strong, and in some cases a
company may come under severe criticism from protest groups.
For each company, some stakeholders are likely to be more influential than others. However, when
there are several influential stakeholder groups the company may need to take their conflicting
interests into consideration, and set their objectives and performance targets accordingly.
Market conditions
Market conditions are any factors that influence the state of the market or markets in which a company
operates. These include:
Companies will usually hope to achieve growth in sales and profits, and economic conditions may be either
favourable or adverse.
Other financial conditions may affect a company's performance, such as changes in rates of taxation,
interest rates or foreign exchange rates.
The targets that a company sets, and the performance that it achieves, are also affected the by nature of
competition in the market. When the size of a market is fixed, and competition is strong, the rival firms will
compete for market share.
The performance of a company in a competitive market may be measured by the size of market share that
it obtains.
The performance of a company may also be affected by the actions taken by competitors. For example if a
major competitor has reduced its sales prices, a company may feel obliged to respond by cutting its own
prices.