Performance Management-P2

KAPP EDGE SOLUTIONS

Syllabus structure
A: Pricing and Product Decisions

(30%)

B. Cost Planning and Analysis for Competitive

Advantage
(30%)
C: Budgeting and Management Control (20%)
D: Control and Performance Measurement of
Responsibility Centres

(20%)

Pricing and
Decision
Making
Budgeting and
Management
Control
Responsibility
Centres

Important Topics
Transfer pricing
Pricing decision

Linear Programming
Budgeting
ROCE and RI
Learning Curve

PERFORMANCE
Management
LINEAR PROGRAMMING

Topics Covered
Meaning

Use
Slack and surplus
Sensitivity Analysis and Shadow price

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Linear Programming
Mathematical programming is used to find the best or optimal solution to a problem that
requires a decision or set of decisions about how best to use a set of limited resources to
achieve a state goal of objectives.
Linear programming requires that all the mathematical functions in the model be linear
functions.
Linear Programming is used where more than one limiting factor is involved.

Two main methods:

Graphical method
Simplex solution

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Example of LP Problem
Product Mix Problem
A manufacturer has fixed amounts of different resources such as raw material, labor, and
equipment.
These resources can be combined to produce any one of several different products.
The quantity of the ith resource required to produce one unit of the jth product is known.
The decision maker wishes to produce the combination of products that will maximize total
income.

Example of LP Problem
A Blending Problem
Blending problems refer to situations in which a number of components (or commodities) are
mixed together to yield one or more products.
Typically, different commodities are to be purchased. Each commodity has known characteristics
and costs.
The problem is to determine how much of each commodity should be purchased and blended
with the rest so that the characteristics of the mixture lie within specified bounds and the total
cost is minimized.

Steps
Determine the objective of the problem and describe it by a criterion function in
terms of the decision variables.
Find out the constraints.

Do the analysis which should lead to the selection of values for the decision
variables that optimize the criterion function while satisfying all the constraints
imposed on the problem.

Example
The N. D. Company produces two products: I and II. The total amount of raw
material available per day for both products is 15751b. The total storage space
for all products is 1500 ft2, and a maximum of 7 hours per day can be used for
production.

All products manufactured are shipped out of the storage area at the end of the day.
Therefore, the two products must share the total raw material, storage space, and
production time. The company wants to determine how many units of each product to
produce per day to maximize its total income.

Solution
The object is to maximize the equation:

Z = 13x1 + 11x2
subject to the constraints on storage space, raw materials, and production time.
Each unit of product I requires 4 ft2 of storage space and each unit of product II requires 5
ft2. Thus a total of 4x1 + 5x2 ft2 of storage space is needed each day. This space must be less
than or equal to the available storage space, which is 1500 ft2. Therefore,
4X1 + 5X2 1500
Similarly, each unit of product I and II produced requires 5 and 3 1bs, respectively, of raw
material. Hence a total of 5xl + 3x2 Ib of raw material is used.

Solution contd.

This must be less than or equal to the total amount of raw material available, which is 1575 Ib.
Therefore,
5x1 + 3x2 1575

Prouct I can be produced at the rate of 60 units per hour. Therefore, it must take I minute or 1/60 of an
hour to produce I unit. Similarly, it requires 1/30 of an hour to produce 1 unit of product II. Hence a
total of x1/60 + x2/30 hours is required for the daily production. This quantity must be less than or
equal to the total production time available each day. Therefore,
x1 / 60 + x2 / 30 7
or x1 + 2x2 420

Finally, the company cannot produce a negative quantity of any product, therefore x1 and x2 must each
be greater than or equal to zero.

Solution Contd.
The linear programming model for this example can be summarized
as:

Solution Contd.

Solution contd.
The shaded area of the figure comprises the area common to all the regions defined by the constraints and
contains all pairs of xI and x2 that are feasible solutions to the problem.
This area is known as the feasible region or feasible solution space. The optimal solution must lie within
this region.
There are various pairs of x1 and x2 that satisfy the constraints such as:

Trying different solutions, the optimal solution will be:

X1 = 270
X2 = 75
This indicates that maximum income of $4335 is obtained by producing 270 units of product I and 75
units of product II.
In this solution, all the raw material and available time are used, because the optimal point lies on the two
constraint lines for these resources.

Slack
Slack- this is the amount of resource which is under utilized when the optimum plan is
implemented.
It occurs when the optimum point does not fall on a given resource line.
It is concerned with less than or equal to constraints.

However, 1500- [4(270) + 5(75)], or 45 ft2 of storage space, is not used. Thus the storage space is
not a constraint on the optimal solution; that is, more products could be produced before the
company ran out of storage space. Thus this constraint is said to be slack.

Surplus
Surplus- this is utilization of resources over and above minimum.
It is concerned with greater than or equal to constraints.

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Simplex Method
When decision variables are more than 2, it is always advisable to use Simplex Method to avoid
lengthy graphical procedure.
The simplex method is not used to examine all the feasible solutions.
It deals only with a small and unique set of feasible solutions, the set of vertex points (i.e.,
extreme points) of the convex feasible space that contains the optimal solution.

Sensitivity Analysis and Shadow price

Sensitivity Analysis- by considering the value of each limiting factor.

Shadow price- the extra contribution that would arise if one more unit of that scarce resource
became available.

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Performance Management
PRICING DECISION

Topics Covered
Factors affecting profit

Price Elasticity of demand

Price Elasticity Graph
Factors affecting price elasticity
Perfectly Competitive Market
Imperfect Competition
Product Life Cycle
Pricing strategies

Factors affecting profit

Profit is the factor of three components:
Cost - volume -price
Cost
Higher
volume
reduces the
cost per unit
Lower cost
helps in
lower prices

Volume
Volume
increase- per
unit cost
decreases

Price
Lower cost
helps in
setting lower
price

Price Elasticity of demand

The relative response of a change in quantity demanded to a change in price.
Price elasticity

Price

Quantity

An elastic demand means that the quantity demanded is relatively responsive to changes in price.
An inelastic demand means that the quantity demanded is not very responsive to changes in price.

Price Elasticity of demand

Formula:

Price Elasticity of demand

=Percentage change in quantity demanded
Percentage change in price

Price Elasticity Graph

Inelastic Demand

Price Elasticity Graph

Elastic demand

Factors affecting price elasticity

1. Scope of the market

2. Information within the market

3. Availability of substitutes
4. Complementary products
5. Disposable Income
6. Necessities
7. Habit

Perfectly Competitive Market

All the firms and consumers are price takers.
They cannot affect the market price.
Assumptions
Many small firms,
Many individual buyers,
Perfect freedom of entry and exit from the industry.
Homogeneous products
Perfect knowledge
No externalities

Imperfect Competition
Monopoly

Oligopoly
Monopolistic Competition

Product Life Cycle

Introductory phase
Growth

Maturity
Decline

Marginal cost and Marginal Revenue

'Marginal Revenue - MR-The increase in revenue that results from the sale of one additional
unit of output.
'Marginal Cost- MC- variable cost of production
Profit maximized
Price equation =p=a- bx
P= price

X=quantity
A and b are constants

MR=a-2bx

MR=MC

Pricing strategies
Total cost plus

Marginal cost plus

Premium pricing
Market Skimming
Penetration Pricing
Loss leader pricing
Controlled Pricing

Performance Management
TRANSFER PRICING

Topics Covered
Meaning of Decentralization
Meaning of transfer pricing
Purpose
Basis of Transfer Pricing
Objective of Transfer Pricing

A Perfect Intermediate Market

Imperfect Intermediate Market
Decision making
TP and International Taxation

Meaning of Decentralization
Delegation of decision-making to the subunits of an organization.
It is a matter of degree.
The lower the level where decisions are made, the greater is the decentralization.
Decentralization is most effective in organizations where subunits are autonomous and costs and
profits can be independently measured.
The benefits of decentralization include:

(1) decisions are made by those who have the most knowledge about local conditions;
(2) greater managerial input in decision- making has a desirable motivational effect; and
(3) managers have more control over results.

Meaning of Transfer Pricing

A transfer price is the price at which one company buys and sells goods or services or shares
resources with a related affiliate in its supply chain.
A transfer price is what one part of a company charges another part of the same company for
goods or services.

Purpose
Generate separate profit figures for each division and thereby evaluate

the performance of each division separately.

Help coordinate production, sales and pricing decisions of the different
divisions (via an appropriate choice of transfer prices).

Transfer prices make managers aware of the value that goods and services have for other
segments of the firm.
Transfer pricing allows the company to generate profit (or cost) figures
for each division separately.
The transfer price will affect not only the reported profit of each centre,
but will also affect the allocation of an organizations resources.

Guidelines for transfer pricing

The Price Must be Similar to That Sold to Arm's-length Customers
An arm's-length transaction is one between two unrelated entities. If one division of a company normally
sells products to companies that are unrelated to them, then that price should be used for a division that is
related to them. "Related" means two companies that are legally part of the same corporation, LLC or other
recognized business organization.

The Price Must be Similar to Prices Other Companies Charge Each Other
Examine the prices other companies charge each other for similar products. This is a good guideline for
setting prices between divisions of your own company. Set the price near what the company-to-company
market dictates.

Set Prices According to What You Have Paid Other Companies

The division acquiring the product may have purchased from outside sources in the past. Use the prices
established in those transactions as a guide. Allow for inflation or other market changes, and set the price
accordingly.

Basis of Transfer Pricing

There are three general methods for establishing transfer prices.
Market-based transfer price: In the presence of competitive and stable external markets for
the transferred product, many firms use the external market price as the transfer price.
Cost-based transfer price: The transfer price is based on the production cost of the upstream
division. A cost-based transfer price requires that the following criteria be specified:
Actual cost or budgeted (standard) cost.
Full cost or variable cost.
The amount of markup, if any, to allow the upstream division to earn a profit on the transferred product.

Negotiated transfer price: Senior management does not specify the transfer price. Rather,
divisional managers negotiate a mutually-agreeable price.

Decision -making
Perfectly competitive market
Optimum TP

=Market price + Any small Adjustments

Where there is surplus capacity

Optimum TP=Marginal Cost

Where there is production constraint

Optimum TP=Marginal Cost + shadow price (opportunity cost)

TP and International Taxation

In order to minimize the tax liability:

1. reduce the profitability of its subsidiaries in high tax countries.

2. Increase the profitability of its subsidiaries in low tax countries.

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Performance Management
RESPONSIBILITY CENTERS

Topics Covered
Cost , profit and Investment Centers

Responsibility accounting
ROCE
Residual Income
Economic Value Added

Cost Centre
A cost centre is a business unit that is only responsible for the costs that it incurs. The manager
of a cost centre is not responsible for revenue generation or asset
Assigning costs to cost centres lets you determine where costs are incurred within the
organization.
If you plan costs at cost centre level, you can check cost efficiency at the point where costs are
incurred.

Profit center
A business unit or department which is treated as a distinct entity enabling revenues and
expenses to be determined so that profitability can be measured.
A large corporation with diversified interests in paper manufacturing, trucking, and fast food
may regard each of these three businesses as a profit centre.

Investment Centre
Department or an area of responsibility, where a manager controls revenues and associated costs,
assets, and liabilities. His or her performance is assessed largely on the basis of return on investment
(ROI) achieved.
The corporate headquarters or division in a large decentralized organization would be an example of
an investment centre.
Return on investment and residual income are two key performance measures of an investment
centre.

Responsibility accounting
Responsibility accounting is an underlying concept of accounting performance measurement systems.
The basic idea is that large diversified organizations are difficult, if not impossible to manage as a
single segment, thus they must be decentralized or separated into manageable parts.
These parts, or segments are referred to as responsibility centres that include: 1) cost centres, 2) profit
centres and 3) investment centres.
These elements include costs for a cost centre, a measure of profitability for a profit centre and return
on investment (ROI) for an investment centre.

ROCE
Return on capital employed establishes the relationship between the profit and the capital
employed.
It indicates the percentage of return on capital employed in the business and it can be used to
show the overall profitability and efficiency of the business.
Return on Capital Employed=(Adjusted net profits*/Capital employed)100
*Net profit before interest and tax minus income from investments.

Residual Income
Net income that an investment can earn over the minimum rate of return (timedeposit interest rate).
Residual income, unlike ROI, is an absolute amount of income rather than a rate
of return.

Average operating assets

(a) Net operating income
(b) ROI,
Minimum required return (15% $100,000)
Residual income

ROI

Residual
income

$100,000
=======
$20,000
20%

$100,000
=======
$20,000

15,000
---------$5,000
=======

Economic Value Added

The fundamental concept of EVA is not whether the business or venture is profitable, but
whether that profit is sufficient to compensate the equity capital invested in the firm at its
opportunity cost and have any revenue remaining after compensating the cost of all resources.
Economic value added asserts that businesses should create returns at a rate above their cost of
capital.
The formula for calculating EVA is as follows:
EVA = Net Operating Profit After Tax - (Capital Invested x WACC)

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PERFORMANCE MANAGEMENT
LEARNING CURVE

Topics Covered
Meaning

Formula
Application

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Learning curve- Meaning

It is a mathematical expression.

It is based on the observation that as complex and labor intensive procedures are repeated , unit
labor times tend to decrease.

Learning rate:
When cumulative output doubles, the cumulative average time per unit falls to a fixed percentage
of the previous average time.
This is called learning rate.

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Example
Consider a product with the following data about the hours of labor required to produce
a unit:
Hours required to produce

1-st unit:

100

Hours required to produce 10-th unit:

48

Hours required to produce 25-th unit:

35

Hours required to produce 75-th unit:

25

Hours required to produce 200-th unit:

18

As more and more units are produced, the hours of labor required to produce
the most recent unit is lower and lower.

57

Graph for Example

Cumulative
Production

Hours Required
to Produce
Most Recent Unit

1
10
25
75
200

100
48
35
25
18

Hours Required
to Produce
Most Recent Unit

Learning Curve
110
100
90
80
70
60
50
40
30
20
10
0

25

50

75

100

125

150

175

200

225

Cumulative Production

58

What happens when cumulative production

doubles?
The concept of a Learning Curve is motivated by the observation (in
many diverse production environments) that, each time the cumulative
production doubles, the hours required to produce the most recent unit
decreases by approximately the same percentage.
For example, for an 80% learning curve,
If cumulative production doubles from 50 to 100, then the hours required to
produce the 100-th unit is 80% of that for the 50-th unit.
If cumulative production doubles from 100 to 200, then the hours required
to produce the 200-th unit is 80% of that for the 100-th unit.

59

Learning curve-Example
Incremental Qty.

Cumulative
Qty.

Avg. time per

unit

Cumulative
Time taken

100

100

80

160

64

256

51

408

16

41

656

The time taken for 2nd unit is 80% of time taken for 1st unit as 80% learning rate is applicable.

Learning Ratio
Learning curve ratio
= Average labour cost of first 2N units
Average labour cost of first N units

If the average labour cost for the first 500 units is $25 and first 1000 units is $20, the ratio is:
$20 x 100

$25
=80%
Every time output doubles, the average cost declines to 80% of the previous amount.

Calculation Of Learning Rate

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

Month

Incremental number
of batches produced
each month

Incremental labour
hours taken to
produce the batches

June

200

July

152

August

267.52

September

470.8

October

1,090.32

November

16

2,180.64

Solution - Monthly rates of learning

Month
June
July
August
Septembe
r
October
Novembe
r

1
1
2

200
152
267.52

1
2
4

200
352
619.52

Cumulative
average
hours per
batch
200
176
154.88

470.8

1090.32

136.29

1090.32

16

2180.64

136.29

16

2180.64

32

4361.28

Incremental
Cumulative
Incremental
Cumulative
number of
number of
total hours
total hours
batches
batches

Learning rate:
176/200 = 88%
154.88/176 = 88%
136.29/154.88 = 88%
Therefore the monthly rate of learning was 88%

Functional Form of a Learning Curve

To model the behavior described in the previous slides, we proceed as follows:
Let

x = cumulative production
y = hours required to produce the x-th unit

Then, y = ax-b
where a and b are parameters defined as follows:

a = hours required to produce the 1-st unit

b = a value related to the percentage associated with the Learning Curve
b= log learning curve rate
log 2

64

An 80% Learning Curve

Assume that production of the first unit required 100 hours and that there is an 80%
Learning Curve.
Again, let

x = cumulative production
y = hours required to produce the x-th unit
Then, mathematicians can show that the Learning Curve is
y = 100x-0.322

65

An 80% Learning Curve

(continued)
Cumulative
Production

Hours Required
to Produce
Most Recent Unit

y = 100x -0.322

1
2
--4
--8
--16
--25
--32
--50
--64
--100
--128
--200

100.000
80.000
--64.000
--51.200
--40.960
--35.478
--32.768
--28.383
--26.214
--22.706
--20.972
--18.165

66

Application
1.

Budgeting and standard costing

2.

Pricing

3.

Work scheduling

4.

Steady rate

5.

Experience curves

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Application
1.

Budgeting and standard costing

2.

Pricing

3.

Work scheduling

4.

Steady rate

5.

Experience curves

KAPP Edge Solutions

Study Tips
Be regular in studies. Study at least 11 hours per week.
Attempt at least two mock papers to timed conditions before the exam including reading time
of 20 minutes (Total 3 hrs and 20 minutes to complete).
Students have performed worse in calculating and explaining variances. Try to concentrate on
this topic specifically.
Timed conditions it is 1.8 minutes per mark (18 minutes for 10 mark, 45 minutes for 25 marks).
Dont forget to carry your scientific calculator in exam.

KAPP Edge Team wishes you all the best.

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