Advanced Management Accounting

CPA
CERTIFIED PUBLIC ACCOUNTANTS
PART III
SECTION 5
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ADVANCED MANAGEMENT ACCOUNTING

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STUDY TEXT
PAPER NO.14 14 ADVANCED MANAGEMENT ACCOUNTING
GENERAL OBJECTIVES
This paper is intended to equip the candidate with knowledge, skills and attitudes that will enable him/her
to apply advanced management accounting techniques in business decision making
14.0 LEARNING OUTCOMES

A candidate who passes this paper should be able to:
 Use cost estimation data in decision making
 Apply inventory management techniques to decision making
 Use financial and non-financial indicators to measure organizational performance
 Apply environmental management accounting concepts in practice
CONCEPT
14.1 Nature of management accounting

- Value of information in decision making; perfect and imperfect information
- Ethical standards of management accountants
14.2 cost estimation and forecasting

- An overview of the methods of cost estimation and prediction; engineering, simulation and
statistical methods, simple and multiple regressions, the statistical properties of regression
- Learning curve and its application
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14.3 short-term planning and decision-making
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- Overview of single product and multiple product cost-volume-profit analysis under conditions of
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uncertainty
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- single product and multiple product cost-volume –profit analysis under conditions of uncertainty
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- risk assessment
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- application of marginal costing: product mix decisions, special orders, make or buy decision,
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pricing decision and other similar short-run decisions, relevant information in decision making
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14.4 budgetary control and advanced variance analysis ea
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- flexible and static budget, purpose of budgetary control; operation of a budgetary control system,
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organization and and coordination of the budgeting function

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- human aspects (motivational aspects) of budgeting, emerging trends in budgetary control; ERPS,
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ABB,ZBB, program budgeting

- advanced variance analysis and performance evaluation; expost variances and opportunity costs in
variances
- variance investigation models
14.5 inventory control decisions

- cost of holding and ordering inventory
- stochastic inventory models
- inventory model for perishable items
- application of simulation models in inventory control
14.6 decision theory

- Decision process
- Decision making environment- certainity, risk, uncertainity and competition
- Decision making under uncertainity-maxmin, maxmax, minimax regret, Hurwicz decision rule,
Laplace decision rule
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- Decision making under risk-expected monetary value, expected opportunity loss, minimizing risk
using coefficient of variation, expected value of perfect information
- Decision trees-sequential decision, expected value of sample information
- Limitations of expected monetary value criteria
- Game theory-non zero sum, two persons zero sum games, dominance, value of the game, saddle
point, mixed strategies
- Limitations of game theory
14.7 performance measurement and evaluation

- Linkage between performance measurement and organizational vision
- Responsibility accounting and responsibility centres, segmented reporting
- Distinction between financial performance measures and non financial performance measures
- Cost of information
- Methods of evaluating responsibility centre performance such as return on investment (ROI) and
residual income (RI) and economic value added (EVA) (importance and limitations of the methods)
- Other financial/non-financial performance measures: balance score card, performance pyramid,
Fitgerald and Moon’s building block model, performance prism
- Managerial incentives schemes
- Performance contracting
- Performance measures in the service industry
14.8 Pricing decisions

- External pricing methods
- Internal pricing methods (transfer pricing)
- Backflush accounting
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- Throughput costing
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- Target costing
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- Life cycle costing
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14.9 Environmental management accounting
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- Role of accountants in environmental management accounting
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- Using environmental accounting to manage costs
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- Opportunities for environmental awareness in management accounting
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14.10 Emerging issues and trends
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TOPIC PAGE
Topic 1: Nature of management accounting……………………………………………………………4
Topic 2: Cost estimation and forecasting………………………………………………………………15
Topic 3: Short-term planning and decision-making……………………………………………………55
Topic 4: Budgetary control and advanced variance analysis………………………………………….103
Topic 5: Inventory control decisions…………………………………………………………………..150
Topic 6: Decision theory………………………………………………………………………………169
Topic 7: Performance measurement and evaluation……………………………………………….….195
Topic 8: Pricing decisions………………………………………………………………………….….235
Topic 9: Environmental management accounting…………………………………………….….……267
Revised on: November 2016

TOPIC 1
NATURE OF MANAGEMENT ACCOUNTING
INTRODUCTION
Management Accounting is the process of identification, measurement accumulation, analysis,

preparation, interpretation and communication of financial information used by management to
plan, evaluate and control within an organization and to ensure appropriate use of and
accountability for its resources.
Management accounting is concerned with providing information to managers – that is, people
inside an organization who direct and control its operations. In contrast, financial accounting is
concerned with providing information to shareholders, creditors and others who are outside an
organization. Management accounting provides the essential data with which organizations are
actually run. Financial accounting provides the scorecard by which a company’s past performance
is judged.
Because it is manager oriented, any study of management accounting must be preceded by some
understanding of what managers do, the information managers need, and the general business
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environment. As the organizations and the business environment changes then the role of
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management accounting changes.
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Management accounting focuses on both monetary and non-monetary information (for example,
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cost drivers such as labor hours and quantities of raw materials purchased) that inform
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management decisions and activities such as planning and budgeting, ensuring efficient use of
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resources, performance measurement and formulation of business policy and strategy. The
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collective goal of all this is to create, protect and increase value for an organization’s stakeholders.
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Thus, Management accounting activities include data collection as well as routine and more
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strategic analysis of the data via various techniques (such as capital investment appraisal) designed
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to address specific management needs.
VALUE OF INFORMATION IN DECISION MAKING: PERFECT AND IMPERFECT

INFORMATION
The uncertainty about the future outcome from taking a decision can be reduced by obtaining more
information first about what is likely to occur.
When a decision-maker is faced with a series of uncertain events that might occur, he or she should
consider the possibility of obtaining additional information about which event is likely to occur.
Perfect information is available when a 100% accurate prediction can be made about the future.
The concept of perfect information is somewhat artificial since, in the real world, such perfect
certainty rarely, if ever, exists.

For example, predictions for future demand may only be 80% reliable. Hence, 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.
The approach to calculate the value of perfect and imperfect information is the same i.e compare
the expected value of a decision if the information is acquired against the expected value with the
absence of the information.
The difference represents the maximum amount it is worth paying for the additional information
The information can be obtained from various sources e.g.

 Market surveys
 Conducting pilot tests
 Building a prototype model
 Use of consultants
Information can be categorized depending on how reliable it is likely to be for predicting what
would happen in the future and for helping managers make better decisions.
Perfect Information
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Perfect information (PI) is information that can be guaranteed to predict the future with 100%
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accuracy, which, although it might be quite good, it could be wrong in its prediction of the future.
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Both perfect and imperfect information is costly and its value must be determined
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The value of perfect information
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In decision theory, the expected value of perfect information (EVPI) is the price that one would be
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willing to pay in order to gain access to perfect information. ea
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CALCULATING THE VALUE OF PERFECT INFORMATION
Value of perfect information (PI) = Expected Profit (value) WITH perfect information LESS
Expected Profit (value) WITHOUT perfect information.
Expected valueis Total of the weighted outcomes (payoffs) associated with a decision, the weights
reflecting the probabilities of the alternative events that produce the possible payoff. It is expressed
mathematically as the product of an event's probability of occurrence and the gain or loss that will
result.
Expected value of perfect information is the maximum amount a decision maker is willing to
pay for perfect information.

Payoff tables
A profit table (payoff table) is a useful way to represent and analyze a scenario where there is a
range of possible outcomes and a variety of possible responses. A payoff table simply illustrates all
possible profits/losses and as such is often used in decision making under uncertainty.
ILLUSTRATION
Constructing a payoff table
Haffen Matena supplies homemade mandazi to various customers in a city. Each mandazi is sold
to a customer for sh.10 and costs sh.8 to prepare. Therefore, the contribution per mandazi is sh.2.
Based upon past demands, it is expected that, during the 250 day working year, the customers will
require the following daily quantities:
 On 25 days of the year, 40 mandazis.
 On 75 days 70 mandazis.
He must provide the mandazis when they are fresh in batches of 10 in advance. He has asked for
assistance to decide how many mandazis he should supply for each day of the forthcoming year.
Constructing a payoff table

If 40 mandazi s will be required on 25 days of a 250 day year, then the probability that demand
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will be 40 mandazis is;-
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P (Demand of 40) is 25 days ÷ 250 days = 0.1
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Likewise,
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 P (Demand of 50) =50 days ÷ 250 days =0 .20;
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 P(Demand of 60) = 60 days ÷ 250 days =0.4 and
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 P(Demand of 70) =70 days ÷ 250 days= 0.30
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The different values of profit or losses depending on how many mandazis are supplied and sold
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can be analyzed as follows;-

For example, if he supplies 40 mandazis and all are sold, his profits amount to 40 x sh.2 = 80.
If however he supplies 50 mandazis but only 40 are bought, profits will amount to 40 × sh.2 - (10
unsold mandazis × sh.8 unit cost) = 80 - 80 = 0.
Similarly, a payoff table can be constructed as follows;-

Daily supply
Probability 40 mandazis 50 mandazis 60 mandazis 70 mandazis
40 mandazis 0.10 sh.80 sh.0 sh. (80) sh. (160)
50 mandazis 0.20 sh.80 sh.100 sh.20 sh. (60)
Daily Demand 60 mandazis 0.40 sh.80 sh.100 sh.120 sh.40
70 mandazis 0.30 sh.80 sh.100 sh.120 sh.140

To decide how many mandazis should be made every day, expected valuesof profits could be used
to make a decision.
An expected value is a weighted average of all possible outcomes. It calculates the average return
that will be made if a decision is repeated again and again.
In other words it is obtained by multiplying the value of each possible outcome (x) by the
probability of that outcome (p), and summing the results.
The formula for the expected value is EV = Σpx
Since the expected value shows the long-run average outcome of a decision which is repeated time
and time again,it is a useful decision rule for a risk neutral decision maker. This is because a risk
neutral investor neither seeks risk or avoids it; he is happy to accept an average outcome.
ILLUSTRATION
Continuing with our previous illustration where Haffen Matena supplies homemade mandazi to
various customers in a city. Each mandazi is sold to a customer for sh.10 and costs sh.8 to prepare.
Therefore, the contribution per mandazi is sh.2. At present Haffen must decide in advance how
many mandazis to prepare each day (40, 50, 60 or 70). Actual demand will also be 40, 50, 60 or 70
each day.
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Haffens payoff as determined above is as follows;-
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Daily supply
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Probability 40 mandazis 50 mandazis 60 mandazis 70 mandazis
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40 mandazis 0.10 sh.80 sh.0 sh. (80) sh. (160)
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50 mandazis 0.20 sh.80 sh.100 sh.20 ea sh. (60)
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Daily Demand 60 mandazis 0.40 sh.80 sh.100 sh.120 sh.40
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70 mandazis 0.30 sh.80 sh.100 sh.120 sh.140

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The expected value associated with each choice is as follows:

 If choose to make 40 mandazis, EV = 1×80 = 80
 If choose to make 50 mandazis, EV = 0.10×0 + 0.90×100 = 90
 If choose to make 60 mandazis, EV = 0.10×(-80) + 0.20×20 + 0.70×120 = 80
 If choose to make 70 mandazis, EV = 0.10×(-160) + 0.20×(-60) + 0.40×40 + 0.30×140 = 30
Based on expected values without additional information, he would choose to make 50 mandazis
per day with an EV of sh.90 per day. This is the expected highest payoff or profit.
Suppose a new ordering system is being considered, whereby customers must order their mandazis
online the day before. With this new system he will know with certainty the daily demand 24 hours
in advance. He can adjust production levels on a daily basis.
To find the worth of this system to Mr. Matena we compute the value of perfect information.

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TOPIC 2
COST ESTIMATION AND FORECASTING
INTRODUCTION
Cost estimation is the process of pre-determining the cost of a certain product, job or order. It is a
term used to describe the measurement of historical cost with a view of providing estimates on
which to base the future expectation on cost.
The predetermination of cost may be required for several purposes e.g. budgeting, measurement of
performance efficiency, preparation of financial statements (valuation of stocks), make or buy
decisions and fixation of sales prices of the products.
AN OVERVIEW OF THE METHODS OF COST ESTIMATION AND PREDICTION;

Introduction
Mixed costs have both a fixed portion and a variable portion. There are a handful of methods used
by managers to break mixed costs in the two manageable components--fixed costs and variable
costs. The process of breaking mixed costs into fixed and variable portions allow us to use the
costs to predict and plan for the future since we have a good insight on how these costs behave at
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various activity levels. We often call the process of separating mixed costs into fixed and variable
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components, cost estimation.
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The Goal of Cost Estimation
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The ultimate goal of cost estimation is to determine the amount of fixed and variable costs so that a
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cost equation can be used to predict future costs. You should remember the concept of functions
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from your business calculus class. The function that represents the equation of a line will appear in
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the format of:
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y=mx+b
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Where y = total cost

m = the slope of the line, i.e., the unit variable cost
x = the number of units of activity
b = the y-intercept, i.e., the total fixed costs
Determining a linear function is useful in predicting cost amounts at different levels of activity.
Why do managers need to be able to predict costs? They want to plan for future operations often
through what-if analysis and budgets. A key concept you must remember is that before you employ
any of the estimation methods, you must have already determined the cost is mixed. There is no
need to analyze a cost to break it down into fixed and variable portions if you already know
whether it is variable or fixed. Your goal it to determine the variable cost per unit and total fixed
costs to plug into the cost equation.
The methods involved in cost estimation. Namely;-
- Engineering method

- High low method

- Account analysis
- Visual fit method
- Regression analysis
Engineering Method
This method is used when no previous records of costs exist. It is a very detailed method that goes
into the nitty-gritty of what constitutes a product in terms of how much material or how much
labor. From this a suitable level of activity can be determined. The result of the direct observation
of physical quantities is then converted into a cost estimate. This approach can be lengthy and
expensive. It adopts the element of motion study from the scientific theory of management.
This method is based on a detailed study of each operation where careful specification is made for
materials, labor and equipment necessary to produce a product. It involves identifying the level of
input required of an activity in form of raw material and labor while total cost is based on the cost
of each input. This approach is applicable where no past data exists. The main setback of the
approach is that it requires a complex analysis of all the constituents of an activity and the
requirements of an activity in terms of costs detailed into materials, labor, overheads and time.
High Low Method

In this method the highest and lowest activity together with their corresponding costs is identified.
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High-Low method is one of the several techniques used to split a mixed cost into its fixed and
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variable components. Although easy to understand, high low method is relatively unreliable. This
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is because it only takes two extreme activity levels (i.e. labor hours, machine hours, etc.) from a set
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of actual data of various activity levels and their corresponding total cost figures.
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The two points i.e. the lowest and the highest are used to derive a cost function in the form of
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y = a + bx.
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Variable cost per unit (b) is calculated using the following formula;-
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y2 y1
Variable Cost per Unit =
x2 x1
Where;-
y2 is the total cost at highest level of activity;
y1 is the total cost at lowest level of activity;
x2 are the number of units/labor hours etc. at highest level of activity; and
x1 are the number of units/labor hours etc. at lowest level of activity
The variable cost per unit is equal to the slope of the cost volume line (i.e. change in total cost ÷
change in number of units produced).

ILLUSTRATION
Use the high low method to obtain the cost function of the data given below;-
No. of units (x) Cost of product

(y)
100 895
80 700
200 1,294
400 1,680
450 2,550
Units(x) Cost(y)
High 450 2,550

Low 80 700
Y = a + bx
a  700  80 (5)
2,550 = a + 450b b = 1850 5
370  300
700 = a + 80 b
1,850 = 370 b
Therefore Cost of production y = 300 + 5x
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Estimated cost of producing 430 units
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300 + 5(430) = sh. 2,450
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ILLUSTRATION
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Deco Chemicals Ltd manufactures a single type of liquid chemicals. The company’s production
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overheads vary with volume of production in litres. Volume of production and the amount of
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overheads for 10 months that ended 31st October 2004 are presented below. ea
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Month Volume of production Production overheads

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overheads (litres ‘000’) (shs ‘000’)

January 150 1800
February 120 1400
March 200 2300
April 170 1900
May 120 1600
June 250 3000
July 220 2700
August 90 1100
September 180 2400
October 300 3200
Required:
i) Use the high-low method to determine an equation in the form y = a + bx
ii) Using the equation in (i) above determine the overheads for production of 350,000,000 units.

SOLUTION
Highest production level 300 Total cost = 3200
Lowest production level 90 Total cost = 1100
Difference 210 2100
∴ Variable cost per unit (b) = = Sh 10

y = a + bx
Using the highest production level,

a = y – bx
= 3200 x 10 x 30
a = 200
∴ = 200 + 10x
For production of 350,000 units

Y = 200 + 10 x 350
= 3700
Advantages of high low method

1. Highest and lowest covers the relevant level of operation.
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2. It takes into account possible extreme values of cost thus saving time.
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3. It is not expensive.
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4. It is quite easy to apply.
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Disadvantages of high low method.
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1. It relies on two points to represent all the other points
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2. The estimated cost function may poorly describe the actual cost relationship. ea
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3. It is only useful when we have a single independent variable ( single predictor variable)
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4. The method presumes that the relationship between x and y;-

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i) Exists
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ii) Linear
5. It does not take into consideration occurrence of any un usual situation hence giving in accurate
analysis.
Account Analysis
Under account analysis method, the accountant examines and classifies each ledger account as
variable, fixed or mixed. Mixed accounts are broken down into their variable and fixed
components. They base these classifications on experience, inspection of cost behavior for several
past periods or intuitive feelings of the manager.
This is with a view to develop a cost function in the form y=a +bx

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TOPIC 3
SHORT TERM PLANNING AND DECISION- MAKING
INTRODUCTION
Short term planning isthe process of setting smaller, intermediate milestones to achieve within
closer time frames when moving toward an important overall goal. Many businessoperators will
engage in short term planning that typically covers time frames of less than one year in order to
assist their company in moving gradually toward its longer term goals.
Decision- making is the thought process of selecting a logical choice from the availableoptions.
When trying to make a gooddecision, a person must weigh the positives and negatives of each
option, and considerall the alternatives. For effective decision making, a person must be able to
forecast the outcome of each option as well, and based on all these items, determine which option
is the best for that particular situation.
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DEFINITION OF TERMS
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A CVP analysis is a systematic method of examining the relationship between changes in activity
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(output) and changes in total sales revenue, expenses and net profit.
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Relevant revenue is any revenue that differs among alternatives and will influence the final
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outcome.
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Avoidable costs are costs which will not be incurred if a particular decision is made.
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Incremental costs are extra costs incurred as a result of a decision.

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Opportunity costs are costs that measure the opportunity that is lost or sacrificed when the choice
of one course of action requires that an alternate course of action be given up.
Marginal revenue is the increase in total revenue from sale of an additional unit
Marginal cost is the increase in total cost from the production of an additional unit
Break even analysis is mainly used to explain the relationship between the cost incurred, the
volume operated at and the profit earned.
The margin of safety is the amount by which actual output or sales may fall short of the budget
without the company incurring losses.
Demand is the quantity of a good which consumers want and are willing and able to pay for.
104 MANAGEMENT ACCOUNTING
Cost plus pricing system is based on costs and adding some profit margin to it to arrive at the
selling price for the product.
Full cost plus pricing (absorption) involves the use of conventional techniques to come up with
the total cost for a product to which is added a markup to arrive at the selling price.
Minimum price is the price to charge for a job that will be able to cover the incremental costs of
producing and selling the item and the opportunity cost of resources consumed in making and
selling the item.
Market penetration relates to the attempt to break into a market and to establish that market share
which will enable the firm to achieve its revenue and profit targets.
Market skimming involves setting a relatively high price stressing the attractions of new features
likely to appeal to those with a genuine interest in the products or associated attractions.
Differential pricing is the ability of the firms to split the market into segments based on different
characteristics.
OVERVIEW OF SINGLE PRODUCT AND MULTIPLE PRODUCT

COST-VOLUME-PROFIT ANALYSIS UNDER CONDITIONS OF CERTANITY
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Cost volume profit (CVP) analysis
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This is a systematic method of examining relationship between profits at various levels of activity
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It uses many of the principles of marginal cost thus important in short term planning
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It explores relationship existing between cost, revenue, output levels and resulting profits
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In short run, most of the costs and prices of the firm are generally well determined and thus the
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principle course of uncertainty in demand that affects a short run profitability of a product
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CVP may be used to make short term decisions e.g. determinants of break-even point, order,
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acceptance or rejection etc.
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In cost-volume-profit analysis, you:

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 Should consider only short-term operations. The short term may be defined as a period too
short to permit facilities expansion or contraction or other changes that might affect overall
pricing relationships.
 Assume that a straight line can reasonably be used in analysis. While actual price behavior may
not follow a straight line, its use can closely approximate actual cost behavior in the short run.
 If purchase volume moves outside the relevant range of the available data, the straight-line
assumption and the accuracy of estimates become questionable.
 If you know that product variable costs per unit are decreasing as quantity increases, consider
using the log-linear improvement curve concept. Improvement curves are particularly useful in
limited production situations where you can obtain cost/price information for all units sold.
In CVP, output is given more attention in the relationship between it and sales, expenses or
profits since the knowledge of this will enable management to identify critical output levels

such as the level at which neither profit nor loss will occur i.e. break-even point. The
relationship being analyzed is normally the short-run normally being a period of 1 year or less.
In the short run, costs can be of three general types:

 Fixed Cost. Total fixed costs remain constant as volume varies in the relevant range of
production. Fixed cost per unit decreases as the cost is spread over an increasing number of
units. Examples include: Fire insurance, depreciation, facility rent, and property taxes.
 Variable Cost. Variable cost per unit remains constant no matter how many units are made in
the relevant range of production. Total variable cost increases as the number of unit’s increases.
Examples include: Production material and labor. If no units are made, neither cost is necessary
or incurred. However, each unit produced requires production material and labor.
 Semi-variable Cost. Semi-variable costs include both fixed and variable cost elements.
Costs may increase in steps or increase relatively smoothly from a fixed base. Examples include:
Supervision and utilities, such as electricity, gas, and telephone. Supervision costs tend to increase
in steps as a supervisor’s span of control is reached. Utilities typically have a minimum service fee,
with costs increasing relatively smoothly as more of the utility is used.
Basic / certainty CVP models

Assumptions
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i) Revenue, cost of profit function are linear with respect of level of output of relevant range
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ii) All cost can be categorized as either fixed or variable
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iii) Fixed cost remains constant of the relevant activity range
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iv) The price per unit and variable per unit remain constant of activity range
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v) Volume is the only driver to cost and revenue i.e. only factor affecting cost and revenues
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vi) Technology, production methods and efficiency levels remain unchanged
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vii) All units produced are sold i.e. no proceeds for sale ea
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viii) The period of time selected is short and assumed that time value of money is not significant
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ix) There are no demand or restriction e.g. contractual obligations

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x) The model relates to one product and incase of multi-product as constant mix is maintained
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Accountant Model of CVP

A constant VC per unit and selling price will result in a linear relationship. The result is ONE
Breakeven point and profits increase with an increase in volume. The most profitable output is
therefore at the maximum practical capacity. The economist’s point of view however is more
superior and more accurate on this point since the TC line is non-linear

Relevant R
Range
Ra
Rb BEP
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Loss
π
Zone
Xb Xa x
NOTE
i. This model assumes that unit price for unit variable cost are constant, this results to only one
BEP and that profit zone widens as volume increases
ii. The most profitable output is thus the maximum product capacity
iii. BEP is as a point where R=C and profit zero
iv. The usefulness of being able to determine BEP is to compare the planned expected level of
production with the BEP and make judgment concerning riskiness of activity
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v. A level of activity below the BEP will lead to loss while above it leads to π this is known as
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margin of safety (MOS) that is a difference between expected / actual level of activity and the
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BEP
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a) MOS (x) = Xa –Xb
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b) MOS ® = Ra –Rb
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c) MOS (%) = x 100
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d) MOS as profit = (Xa –Xb) P-U ea
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vi. The bigger the MOS the better for a firm since any slight decline will still leave the firm with
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the profit making zone

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Relevant range– Objective of a model is to represent the behavior of cost and revenue over the
range of output at which firms expect to be operating
The range represents the output levels that the firm has experience of operating in the past and for
which information is available

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TOPIC 4
BUDGETARY CONTROL AND ADVANCED VARIANCE

ANALYSIS
INTRODUCTION
A budget is a quantified plan of action for a forthcoming accounting period. A budget is a plan of
what the organisation is aiming to achieve and what it has set as a target whereas a forecast is an
estimate of what is likely to occur in the future:
The budget is 'a quantitative statement for a defined period of time, which may include planned
revenues, expenses, assets, liabilities and cash flows. A budget facilitates planning'.
There is, however, little point in an organisation simply preparing a budget for the sake of
preparing a budget. A beautifully laid out budgeted income statement filed in the cost accountant's
file and never looked at again is worthless. The organisation should gain from both the actual
preparation process and from the budget once it has been prepared.
FLEXIBLE AND FIXED BUDGETS
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Fixed budgets
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Fixed budgets remain unchanged regardless of the level of activity; flexible budgets are designed
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flex with the level of activity.
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Comparison of a fixed budget with the actual results for a different level of activity is of little use
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for control purposes. Flexible budgets should be used to show what cost and revenues should have
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been for the actual level of activity.
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A fixed budget is a budget which is designed to remain unchanged regardless of the volume of
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output or sales achieved.

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The master budget prepared before the beginning of the budget period is known as the fixed budget
The term 'fixed' has the following meaning;-
a) The budget is prepared on the basis of an estimated volume of production and an estimated
volume of sales, but no plans are made for the event those actual volumes of production and
sales may differ from budgeted volumes.
b) When actual volumes of production and sales during a control period (month or four weeks or
quarter) are achieved, a fixed budget is not adjusted (in retrospect) to the new levels of
activity.
The major purpose of a fixed budget is at the planning stage, when it seeks to define the broad
objectives of the organisation.

Flexible budgets
A flexible budget is a budget which, by recognizing different cost behaviour patterns, is designed
to change as volumes of output change.
Flexible budgets may be used in one of two ways.

a) At the planning stage. For example, suppose that a company expects to sell 10,000 units of
output during the next year. A master budget (the fixed budget) would -be prepared on the basis
of these-expected volumes. However, if the company thinks that output and sales might be as
low as 8,000 units or as high as 12,000 units, it may prepare contingency flexible budgets, at
volumes of, say 8,000, 9,000, 11,000 and 12,000 units. There are-a number of advantages of
planning with flexible budgets.
i) It is possible to find out well in advance the costs of lay-off pay, idle time and so on if
output falls short of budget.
ii) Management can decide whether it would be possible to find alternative uses for spare
capacity if output falls short of budget (could employees be asked to overhaul their own
machines for example, instead of paying for an outside contractor).
iii) An estimate of the costs of overtime, subcontracting work or extra machine hire if sales
volume exceeds the fixed budget estimate can be made'. From this, it can be established
whether there is a limiting factor which would prevent high volumes of output and sales
being achieved.
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b) Retrospectively. At the end of each month (control period) or year, flexible budgets can be
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used to compare actual results achieved with what results should have been under the
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circumstances.
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Flexible budgets are an essential factor in budgetary control and overcome the practical
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problems involved in monitoring the budgetary control system.
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i) Management needs to be informed about how good or bad acti.al performance has been. To
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provide a measure of performance, there must be a yardstick (budget or standard) against
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which actual performance can be measured.
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ii) Every business is dynamic, and actual volumes of output cannot be expected to conform
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exactly to the fixed budget. Comparing actual costs directly with the fixed budget costs is
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meaningless (unless the actual level of activity turns out to be exactly as planned).
iii) For useful control information, it is necessary to compare actual results at the actual
level of activity achieved against the results that should have been expected at this level of
activity, which are shown by the flexible budget.
ILLUSTRATION 1
Tamu Tamu Foods is a middle class restaurant that is only open in the evenings.
The restaurant has eight staff, who are each paid at the wage rate of Sh.96 per hour on the basis of
hours actually worked. The restaurant also has a restaurant manager and a head chef, each of
whom is paid a monthly salary of Sh.51, 600.

The following data relates to operations for the month of April 2012:
Budgeted Actual
Number of meals 1,200 1,560
Sh. Sh.
Revenue: Food 576,000 730,080
Drinks 144,000 140,400
Total revenue 720,000 870,480
Variable costs: Staff wages 110,592 158,976
Food costs 72,000 86,160
Drink costs 28,800 63,360
Electricity costs 40,644 42,000
Total variable costs 252,036 350,496
Contribution 467,964 519,984
Fixed costs: Manager's and chefs salary 103,200 103,200
Rent and depreciation 54,000 54,000
Total fixed costs 157,200 157,200
Operating profit 310,764 362,784
Additional information:
1. The restaurant is only open six days a week and there are four weeks in a month. The average
number of orders each day is 50 and demand is evenly spread across all the days in the
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month.
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2. The restaurant offers two meals: Meal A which costs Sh.420 per meal and Meal B, which
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costs Sh.540 per meal. In addition to this, irrespective of which meal the customer orders, the
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average customer consumes four drinks each at Sh.30 per drink Therefore, the average spend
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per customer is either Sh.540 or Sh.660 including drinks, depending on the type of meal
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selected. The April budget is based on 50% of customers ordering Meal A and 50% of
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customers ordering Meal B.
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3. Food costs represent 12.5% of revenue from food sales.
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4. Drink costs represent 20% of revenue from drink sales.

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5. When the number of orders per day does not exceed 50, each member of the hourly paid staff
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is required to work exactly six hours per day. For every increase of five orders in the average
number of orders per day, each member of staff has to work 30 minutes of overtime for which
they are paid at the increased rate of Sh. 144 per hour.
6. Electricity costs are deemed to be related to the total number of hours worked by each of the
hourly paid staff, and are absorbed at the rate of Sh.35:28 per hour worked by each of the
eight staff.
7. Assume that all costs for hourly paid staff are treated wholly as variable costs.
Required:
Flexed budget for the month of April 2012, assuming that the standard mix of customers
remains the same as budgeted.

SOLUTION
Tamu tamu foods
Flexible budget for the month of April 2012
Sh. Sh.
1,560
Revenue: Food ( /1,200 × 576,000) 748,800
Drinks (1,560/1.200×144,000) 187,200
936,000
Variable costs:
Staff wages (110,592 + 8 × 0.5 ×144 × 6 × 4 ×3) 152,064
Food costs ((1,560/1.200 ×72,000) 93,600
Drink costs ((1,560/1.200 ×28,800) 37,600
Electricity costs (8×6×6×4 + 8x6×4×0.5×3) 50,803 (333,907)
602,093
Fixed costs:
Managers' chefs salary 103,200
Rent and depreciation 54,000 (157,200)
Opening profit 444,893
The measure of activity in flexible budgets

The preparation of a flexible budget requires an estimate of the way in which costs (and revenues)
vary with the level of activity.
Sales revenue will clearly vary with sales volume, and direct material costs (and often direct labour
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costs) will vary with production volume. In some instances, however, it may be appropriate to
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budget for overhead costs as mixed costs (part-fixed, part-variable) which vary with an 'activity'
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which is neither production nor sales volume. Taking production overheads in a processing
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department as an illustration, the total overhead costs will be partly fixed and partly variable. The
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variable portion may vary with the direct labour hours worked in the department, or with the
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number of machine hours of operation. The better measure of activity, labour hours or machine
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hours, may only be decided after a close analysis of historical results. ea
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ILLUSTRATION
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Prepare a budget for 2006 for the direct labour costs and overhead expenses of a production
department at the activity levels of 80%, 90% and 100%, -using the information listed below.
i) The direct labour hourly rate is expected to be Shs.3.75:
ii) 100% activity represents 60,000 direct labour hours,
iii) Variable costs
Indirect labour Shs 0.75 per direct labour hour.
Consumable supplies Shs 0,375 per direct labour hour
Canteen and other welfare services. 6% of direct and indirect labour costs
iv) Semi-variable costs are expected to relate to the direct labour hours in the-same manner as
for the last five years.

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TOPIC 5
INVENTORY CONTROL DECISIONS

DEFINITION
Inventoriesare asset items held for sale in the ordinary course of business or goods that will be used
or consumed in the production of goods to be sold. The description and measurement of inventory
require careful attention because the investment in inventories is frequently the largest current asset
of merchandising (retail) and manufacturing businesses.
Inventory refers to stock of raw materials, work in progress, finished goods etc.
Need for inventory

Inventory is a necessary evil that every organization would have to maintain for various purposes.
Optimum inventory management is the goal of every inventory planner. Over inventory or under
inventory both cause financial impact and health of the business as well as effect business
opportunities.
Inventory holding is resorted to by organizations as hedge against various external and internal
factors, as precaution, as opportunity, as a need and for speculative purposes.
Reasons why organizations maintain Raw Material Inventory
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Most of the organizations have raw material inventory warehouses attached to the production
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facilities where raw materials, consumables and packing materials are stored and issue for
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production on JIT basis. The reasons for holding inventories can vary from case to case basis. They
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include;-
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1. Meet variation in Production Demand
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Production plan changes in response to the sales, estimates, orders and stocking patterns.
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Accordingly the demand for raw material supply for production varies with the product plan in
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terms of specific SKU as well as batch quantities.

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Holding inventories at a nearby warehouse helps issue the required quantity and item to
production just in time.
2. Cater to Cyclical and Seasonal Demand

Market demand and supplies are seasonal depending upon various factors like seasons; festivals
etc. and past sales data help companies to anticipate a huge surge of demand in the market well
in advance. Accordingly they stock up raw materials and hold inventories to be able to increase
production and rush supplies to the market to meet the increased demand.
3. Economies of Scale in Procurement

Buying raw materials in larger lot and holding inventory is found to be cheaper for the
company than buying frequent small lots. In such cases one buys in bulk and holds inventories
at the plant warehouse.

4. Take advantage of Price Increase and Quantity Discounts

If there is a price increase expected few months down the line due to changes in demand and
supply in the national or international market, impact of taxes and budgets etc, the company’s
tend to buy raw materials in advance and hold stocks as a hedge against increased costs.
Companies resort to buying in bulk and holding raw material inventories to take advantage of
the quantity discounts offered by the supplier. In such cases the savings on account of the
discount enjoyed would be substantially higher that of inventory carrying cost.
5. Reduce Transit Cost and Transit Times
In case of raw materials being imported from a foreign country or from a faraway vendor
within the country, one can save a lot in terms of transportation cost buy buying in bulk and
transporting as a container load or a full truck load. Part shipments can be costlier.
In terms of transit time too, transit time for full container shipment or a full truck load is direct
and faster unlike part shipment load where the freight forwarder waits for other loads to fill the
container which can take several weeks.
There could be a lot of factors resulting in shipping delays and transportation too, which can
hamper the supply chain forcing companies to hold safety stock of raw material inventories.
6. Long Lead and High demand items need to be held in Inventory
Often raw material supplies from vendors have long lead running into several months. Coupled
with this if the particular item is in high demand and short supply one can expect disruption of
supplies. In such cases it is safer to hold inventories and have control.
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INVENTORY COSTS
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1. Ordering costs
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This refers to costs incurred in getting an item into the firm’s storage facility
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Ordering costs are incurred every time an order is placed and include the following:-
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i. Cost of issuing the purchase requisition
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ii. Cost of issuing the purchase order
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iii. Cost of inspecting inventory items to be purchased

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iv. Communication cost e.g. of using telephone, fax, email etc.

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v. Clearing charges
2. Purchase costs
This refers to the amount paid to the suppliers of the stock items.
Purchase cost is relevant for inventory control decisions if there are discounts.
3. Holding / carrying costs
These are cost incurred because the firm owns or has decided to maintain inventory items and
include the following:-
i) Opportunity cost of capital e.g. internet foregone
ii) Rent of storage space
iii) Protection costs such as cost of security system, insurance premium
iv) Perishability and obsolescence costs

4. Stock out / shortage cost

These are costs incurred as a result of either a delay in meeting customer demand or inability to
meet the demand due to shortage of stock items
Stock out costs include the following
i) Lost contribution
ii) Loss of idle staff
iii) Back order cost that is cost of dealing with disappointed customers
iv) Cost of having to speed up orders e.g use of faster means of transport, working overtime
etc
Economic Order Quantity (EOQ)

This is that quantity that is most economical to order. It is the quantity that minimizes the total
inventory cost of holding and ordering.
It is that size of an order that gives the maximum consumption.
It is obtaining and maintaining inventory at optimal levels.
NB: purchase cost is part of inventory cost. However under EOQ purchase price is assumed to be
constant irrespective of quantity ordered.
It is also assumed that the company will not experience stock out therefore the purchase cost and
stock-out will be ignored under EOQ
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To be able to calculate a basic EOQ certain assumptions are necessary.
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a) That there is a known, constant stockholding cost.
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b) That there is a known, constant order cost.
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c) That rates of demand are known and constant.
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d) That there is a known, constant price per unit, i.e. there are no price discounts.
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e) That replenishment is made instantaneously, i.e. the whole batch is delivered at once.
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NOTE:
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a) It will be apparent that the above assumptions are somewhat sweeping and they are good reason
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for treating any EOQ calculation with caution.

b) Some of the above assumptions are relaxed later in the chapter.
c) The rationale of EOQ ignores buffer stocks which are maintained to cater for variations in lead
time and demand.
The EOQ Formula

It is possible, and more usual, to calculate the EOQ using a formula. The formula method gives an
exact answer, but do not be misled into placing undue reliance upon the precise figure. The
calculations are based on estimates of costs, demand, etc. which are, of course, subject to error.
The derivation of the EOQ formula is given below ;-

Derivation of EOQ model
a) Graphic method
Total costs
Holding cost
TC Cost
Ordering cost
Q=EOQ Quantity (Q)
Total cost will be minimized when:-

Holding cost = ordering cost
=
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2
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Q2 =
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Therefore EOQ model = =
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b) Calculus approach
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Total cost = ordering cost + purchase costs + holding costs ea
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TC = 0+ +
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FOC = = =0
1
=
2
.
Q2 =
=Q=
SOC = =

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TOPIC 6
DECISION THEORY
INTRODUCTION
Decision theory is a body of knowledge and related analytical techniques of different degrees of
formality designed to help a decision maker choose among a set of alternatives in light of their
possible consequences. Decision theory can apply to conditions of certainty, risk, or uncertainty. In
It helps operations mangers with decisions on process, capacity, location and inventory, because
such decisions are about an uncertain future.
Types of decisions
There are many types of decision making
1. Decision making under uncertainty
Decision under certainty means that each alternative leads to one and only one consequence and a
choice among alternatives is equivalent to a choice among consequences.
2. Decision making under certainty
Whenever there exists only one outcome for a decision we are dealing with this category e.g. linear
programming, transportation assignment and sequencing etc.
3. Decision making using prior data
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It occurs whenever it is possible to use past experience (prior data) to develop probabilities for the
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occurrence of each data
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4. Decision making without prior data
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No past experience exists that can be used to derive outcome probabilities in this case the decision
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maker uses his/her subjective estimates of probabilities for various outcomes.
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DECISION MAKING ENVIRONMENT - CERTAINTY, RISK, UNCERTAINTY AND ea
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COMPETITION
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Every decision is made within a decision environment, which is defined as the collection of
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information, alternatives, values, and preferences available at the time of the decision. An ideal
decision environment would include all possible information, all of it accurate, and every possible
alternative. However, both information and alternatives are constrained because the time and effort
to gain information or identify alternatives are limited. The time constraint simply means that a
decision must be made by a certain time. The effort constraint reflects the limits of manpower,
money, and priorities. Since decisions must be made within this constrained environment, we can
say that the major challenge of decision making is uncertainty, and a major goal of decision
analysis is to reduce uncertainty. We can almost never have all information needed to make a
decision with certainty, so most decisions involve an undeniable amount of risk.
The fact that decisions must be made within a limiting decision environment suggests two things;-
 First, it explains why hindsight is so much more accurate and better at making decisions that
foresight. As time passes, the decision environment continues to grow and expand. New
information and new alternatives appear--even after the decision must be made. Armed with

new information after the fact, the hindsighters can many times look back and make a much
better decision than the original maker, because the decision environment has continued to
expand.
 The second thing suggested by the decision-within-an-environment idea follows from the
above point. Since the decision environment continues to expand as time passes, it is often
advisable to put off making a decision until close to the deadline. Information and alternatives
continue to grow as time passes, so to have access to the most information and to the best
alternatives, do not make the decision too soon. Now, since we are dealing with real life, it is
obvious that some alternatives might no longer be available if too much time passes; that is a
tension we have to work with, a tension that helps to shape the cutoff date for the decision.
Delaying a decision as long as reasonably possible, then, provides three benefits:

1. The decision environment will be larger, providing more information. There is also time for
more thoughtful and extended analysis.
2. New alternatives might be recognized or created.
3. The decision maker's preferences might change.
And delaying a decision involves several risks:

1. As the decision environment continues to grow, the decision maker might become
overwhelmed with too much information and either makes a poorer decision or else face
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decision paralysis.
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2. Some alternatives might become unavailable because of events occurring during the delay.
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In a few cases, where the decision was between two alternatives, both alternatives might
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become unavailable, leaving the decision maker with nothing.
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3. In a competitive environment, a faster rival might make the decision and gain advantage.
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Another manufacturer might bring a similar product to market in advance.
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Decisions are taken in different types of environment. The type of environment also influences the
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way the decision is made.
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There are four types of environment in which decisions are made;-

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1. Certainty;-
In this type of decision making environment, there is only one type of event that can take place. It
is very difficult to find complete certainty in most of the business decisions. However, in many
routine type of decisions, almost complete certainty can be noticed. These decisions, generally, are
of very little significance to the success of business.
2. Uncertainty;-
In the environment of uncertainty, more than one type of event can take place and the decision
maker is completely in dark regarding the event that is likely to take place. The decision maker is
not in a position, even to assign the probabilities of happening of the events.
Such situations generally arise in cases where happening of the event is determined by external
factors. For example, demand for the product, moves of competitors, etc. are the factors that
involve uncertainty.

3. Risk;-
Under the condition of risk, there are more than one possible events that can take place. However,
the decision maker has adequate information to assign probability to the happening or non-
happening of each possible event. Such information is generally based on the past experience.
Virtually, every decision in a modern business enterprise is based on interplay of a number of
factors. New tools of analysis of such decision making situations are being developed. These tools
include risk analysis, decision trees and preference theory.
Modern information systems help in using these techniques for decision making under conditions
of uncertainty and risk.
4. Competition
The competitive environment, also known as the market structure, is the dynamic system in which
a business competes. The state of the system as a whole limits the flexibility of a business. World
economic conditions, for example, might increase the prices of raw materials, forcing companies
that supply an industry to charge more, raising the overhead costs. At the other end of the scale,
local events, such as regional labor shortages or natural disasters, also affect the competitive
environment.
DECISION MAKING UNDER UNCERTAINTY

Business decision making is almost always accompanied by conditions of uncertainty. Clearly, the
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more information the decision maker has, the better the decision will be. Treating decisions as if
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they were gambles is the basis of decision theory. This means that we have to trade off the value of
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a certain outcome against its probability. To operate according to the canons of decision theory, we
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must compute the value of a certain outcome and its probabilities; hence, determining the
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consequences of our choices. The origin of decision theory is derived from economics by using the
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utility function of payoffs. It suggests that decisions be made by computing the utility and
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probability, the ranges of options, and also lays down strategies for good decisions.
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Several methods are used to make decision in circumstances where only the pay offs are known
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and the likelihood of each state of nature are known;-

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a) MAXIMIN METHOD
This criteria is based on the ‘conservative approach’ to assume that the worst possible is going to
happen. The decision maker considers each strategy and locates the minimum pay off for each and
then selects that alternative which maximizes the minimum payoff
ILLUSTRATION
Rank the products A B and C applying the Maximin rule using the following payoff table showing
potential profits and losses which are expected to arise from launching these three products in three
market conditions
(see table 1 below)

Pay off table in sh.‘000’s

Boom Steady state Recession Mini profits
condition row minima
Product A +8 1 -10 -10
Product B -2 +6 +12 -2
Product C +16 0 -26 -26
Table 1
Ranking the MAXIMIN rule = BAC
b) MAXIMAX METHOD
This method is based on ‘extreme optimism’ the decision maker selects that particular strategy
which corresponds to the maximum of the maximum pay off for each strategy
ILLUSTRATION
Using the above example
Max. profits row maxima
Product A +8
Product B +12
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Product C +16
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Ranking using the MAXIMAX method = CBA
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c) MINIMAX REGRET METHOD
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This method assumes that the decision maker will experience ‘regret’ after he has made the
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decision and the events have occurred. The decision maker selects the alternative which
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minimizes the maximum possible regret.

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ILLUSTRATION
Regret table in Sh. ‘ 000’s
Boom Steady state Recession Mini regret row
condition maxima
Product A 8 5 22 22
Product B 18 0 0 18
Product C 0 6 38 38
A regret table (table 2) is constructed based on the pay off table. The regret is the ‘opportunity
loss’ from taking one decision given that a certain contingency occurs in our example whether
there is boom steady state or recession
The ranking using MINIMAX regret method = BAC

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TOPIC 7
PERFORMANCE MEASUREMENT AND EVALUATION
INTRODUCTION
Performance measurement is used to establish the performance of an organization or an

individual with respect to budgeted performance or past performance or in relation to other
organizations or individuals.
Performance measurement is a vital part of the control process in any organization.
Factors to consider when setting performance measures of a business organization
i) Resource requirement -
To collect and analyzing information we require people, equipment and time. However, the costs
and benefits of providing resources for producing performance' measures should be carefully
analyzed.
ii) Organizational objectives and plans-
Overall performance should be measured against the objective of the organization and the plans
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that result from those objectives.
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iii) Relevance of the performance measure
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The performance measure should reflect the activities performed by the organization.
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iv) Expected short term and long term achievements
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Short term targets can be achievable but exclusive use of short term targets may divert the
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organization away from opportunities that may help the organization improve its performance in
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the long run. ea
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v) Fairness of the measure
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The measure should only improve factor which managers can control by their decisions and for
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which they can be held responsible e.g. measuring controllable costs, controllable revenues and
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controllable assets.
vi) Variety of measures
A variety of measures should be used to measure the performance of a business organization e.g.
the balanced score card provides a method of measuring performance from a number of
perspectives. The approach emphasizes on the need to provide management with a set of
information which covers all relevant measures of performance in an objective and unbiased
fashion. The information provided may be both financial and non-financial and covers areas such
as profitability, customer satisfaction, internal business efficiency and innovation.
vii) The performance measures used should have realistic estimates
Once suitable performance measures have been selected they can be monitored on a regular basis
to ensure that they are providing useful information
Performance measures may be divided into two groups. Namely;-
i) Financial performance measures
ii) Non-financial performance measures
LINKAGE BETWEEN PERFORMANCE MEASUREMENT AND ORGANIZATIONAL

VISION
Vision is the foundation that allows the organizational vision to flourish. Awareness of the
organizational vision provides a directional compass for each contributor within the organization to
follow. Depending on the level of leadership, many leaders are not responsible for creating the
vision for the company.
They are responsible for:
 articulating the vision
 aligning team members to operational strategies
 taking steps necessary to achieve company priorities linked to the vision
For example, leaders may engage team members in activities that correlate to fulfillment of
revenue, growth, and organizational culture goals. Team members may brainstorm methods to
improve the interaction between departments targeting improved organizational culture. This
type of activity allows a team to focus on accomplishing departmental tasks that translates to the
company goals and vision.
The Results-Oriented Performance Culture system focuses on aligning performance with

organizational goals. For this to happen, employees must have a direct line of sight between
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performance expectations and recognition systems and the agency mission. These links must be
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communicated to and understood by employees, enabling them to focus their work effort on those
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activities most important to mission accomplishment. All employees should be held accountable
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for achieving results that support the agency’s strategic plan goals and objectives.
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y a.
To meet the requirements of the Results-Oriented Performance Culture system, agencies can use
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eight-step process for developing employee performance plans aligned with organizational goals.
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In some organizations, performance plans have traditionally been developed by copying the
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activities described in an employee’s position description onto the appraisal form. Even though a
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performance plan must reflect the type of work described in the employee’s position description,
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the plan does not have to mirror it. Performance plans based on position descriptions generally
describe activities, not accomplishments.
Instead of focusing on activities, it is necessary to develop performance plans based on established

elements and standards that address accomplishments that lead to organizational goal achievement.
Each step in the process builds on the previous step. One cannot skip a step and end up with good
results. The eight steps are:
 Step 1: Look at the overall picture
 Step 2: Determine work unit accomplishments
 Step 3: Determine individual accomplishments that support the work unit goals
 Step 4: Convert expected accomplishments into performance elements, indicating type
and priority
 Step 5: Determine work unit and individual measures
 Step 6: Develop work unit and individual standards
 Step 7: Determine how to monitor performance

 Step 8: Check the performance plan against guidelines.
RESPONSIBILITY ACCOUNTING AND RESPONSIBILITY CENTRES, SEGMENTED

REPORTING
RESPONSIBILITY ACCOUNTING (RA)

Responsibility accounting is a concept that separates a company into responsibility segments to
enable a more efficient way to manage a large organization. It provides incentives to segment
managers and other employees and allows them freedom to make decisions concerning the
segment for which each is responsible. As a result, top management has more time to spend on
strategic planning and making policy. Responsibility accounting holds managers responsible for
controllable costs and revenues.
RA will therefore personalize the accounting system. For it to work the organization must be well
structured and responsibilities clearly defined. Cost and revenues will be accounted on the basis of
responsibilities that is responsibility centres
A responsibility centre is a controlled unit for which a manager is responsible for all activities,
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costs avenues as well as investment.
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Implementation of RA requires structuring an organization into responsibility centres where
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performance can be measured
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If a manager is to bear responsibility for the performance of his area of the business he will need
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information about its performance. In essence, a manager needs to know three things;
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What are his resources?
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Finance, inventories of raw materials, spare machine capacity, labour availability, the balance of
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expenditure remaining for a certain budget, target date for completion of a job.
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At what rate are his resources being consumed?

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How fast is his labour force working, how quickly are his raw materials being used up, how
quickly are other expenses being incurred, how quickly is available finance being consumed?
How well are the resources being used?

How well are his objectives being met?
Decisions must also be made as to the level of detail that is provided and the frequency with which
information is provided. Moreover the cost of providing information must be weighed against the
benefit derived from it.
In a traditional system managers are given monthly reports, but there is no logical reason for this
except that it ties in with financial reporting cycles and may be administratively convenient. With
modern systems, however, there is a danger of information overload, since information technology
allows the information required to be made available much more frequently.
The task of the management accountant, therefore, is to learn from the managers of responsibility
centres what information they need, in what form and at what intervals, and then to design a
planning and control system that enables this to be provided.
Responsibility centres can be divided into three types;

 Cost centres.
 Profit centres.
 Investment centres.
Cost centres
A cost centre acts as a collecting place for certain costs before they are analyzed further.
Cost centres may include the following.
(a) A department
(b) A machine or group of machines
(c) A project (e.g. the installation of a new computer system)
(d) A new product (allowing development costs to be identified)
To charge actual costs to a cost centre, each cost centre will have a cost code. Items of expenditure
-
will be recorded with the appropriate cost code. When costs are eventually analyzed there may
well be some apportionment of the costs of one cost centre to other cost centres.
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a) The costs of those cost centres which receive an apportionment of shared costs should be
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divided into directly attributable costs (for which the cost centre manager is responsible) and
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shared costs (for which another cost centre is directly accountable).
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b) The control system should trace shared costs back to the cost centres from which the costs
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have been apportioned, so that their managers can be made accountable for the costs incurred.
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Information about cost centres might be collected in terms of total actual costs, total budgeted costs
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and total cost variances (the differences between actual and budged costs) sub-analyzed perhaps
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into efficiency, usage and expenditure variances. In addition, the information might be analyzed in
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terms of ratios, such as the following.

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a) Cost per unit produced (budget and actual)

b) Hours per unit produced (budget and actual)
c) Efficiency ratio
d) Selling costs per shilling of sales (budget and actual)
e) Transport costs per ton/ kilometer (budget and actual)
Profit centres
A profit centre is any unit of an organization (for example, division of a company) to which both
revenues and costs are assigned, so that the profitability of the unit may tie measured.
Profit centres differ from cost centres in that they account for both costs and revenues and the key
performance measure of a profit centre is therefore profit.
For profit centres to have any validity in a planning and control system based on responsibility
accounting, the manager of the profit centre must have some influence over both revenues and
costs, that is, a say in both sales and production policies.
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TOPIC 8
PRICING DECISIONS
INTRODUCTION
Organizations producing goods and services need to set the price for their product. Setting the
price for an organization's product is one of the most important decisions a manager faces. It is one
of the most crucial and difficult decisions a firm's manager has to make. Pricing is a profit planning
exercise. Cost is one of the major considerations in price determination of the product. It is one of
the three major factors which influence pricing decision. The two other factors are customers and
competitors.
Customer: In a situation where the product has many substitutes, customers decide the price. That
is, the demands of customers are the paramount importance in setting the price of the product. In
such a situation, the firm should try to deliver the value, in the form of product and/or service, at
the target cost so that a reasonable profit can be earned. Similarly, under competitive condition,
price is determined by market forces and an individual firm or an individual customer cannot
influence the price.
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Competitors: When there are only few players in the market, competitors usually, react to the
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price changes and, therefore, pricing decisions are influenced by the possible reaction of
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competitors. As such management must keep watchful eye on the firm's competitors. That is,
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knowledge of competitors' strategy is essential for pricing decision in an oligopoly situation.
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Cost: Cost is the third major factor. Its role in price setting varies widely among industries. Some
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industries determine price by market forces and in some industries, managers set prices a on the
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basis of production costs. Firms want to charge a price that covers its costs like production costs,
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distribution costs and costs relate with selling the product and also including a fair return for its
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effort.
Factors Affecting Pricing Product
A. Internal Factors:
1. Cost:
While fixing the prices of a product, the firm should consider the cost involved in producing the
product. This cost includes both the variable and fixed costs. Thus, while fixing the prices, the firm
must be able to recover both the variable and fixed costs.
2. The predetermined objectives:
While fixing the prices of the product, the marketer should consider the objectives of the firm. For
instance, if the objective of a firm is to increase return on investment, then it may charge a higher
price, and if the objective is to capture a large market share, then it may charge a lower price.

3. Image of the firm:

The price of the product may also be determined on the basis of the image of the firm in the
market. For instance, HUL and Procter & Gamble can demand a higher price for their brands, as
they enjoy goodwill in the market.
4. Product life cycle:
The stage at which the product is in its product life cycle also affects its price. For instance, during
the introductory stage the firm may charge lower price to attract the customers, and during the
growth stage, a firm may increase the price.
5. Credit period offered:
The pricing of the product is also affected by the credit period offered by the company. Longer the
credit period, higher may be the price, and shorter the credit period, lower may be the price of the
product.
6. Promotional activity:
The promotional activity undertaken by the firm also determines the price. If the firm incurs heavy
advertising and sales promotion costs, then the pricing of the product shall be kept high in order to
recover the cost.
B.External factors
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1. Competition:
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While fixing the price of the product, the firm needs to study the degree of competition in the
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market. If there is high competition, the prices may be kept low to effectively face the competition,
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and if competition is low, the prices may be kept high.
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2. Consumers:
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The marketer should consider various consumer factors while fixing the prices. The consumer
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factors that must be considered includes the price sensitivity of the buyer, purchasing power, and
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so on.
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3. Government control:
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Government rules and regulation must be considered while fixing the prices. In certain products,
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government may announce administered prices, and therefore the marketer has to consider such
regulation while fixing the prices.
4. Economic conditions:
The marketer may also have to consider the economic condition prevailing in the market while
fixing the prices. At the time of recession, the consumer may have less money to spend, so the
marketer may reduce the prices in order to influence the buying decision of the consumers.
5. Channel intermediaries:
The marketer must consider a number of channel intermediaries and their expectations. The longer
the chain of intermediaries, the higher would be the prices of the goods.

EXTERNAL PRICING METHODS
Psychological pricing
Psychological pricing (also price ending, charm pricing) is a pricing/marketing strategy based on
the theory that certain prices have a psychological impact. Retail prices are often expressed as "odd
prices": a little less than a round number, e.g. sh.1999 or sh. 298. Consumers tend to perceive “odd
prices” as being significantly lower than they actually are, tending to round to the next lowest
monetary unit. Thus, prices such as sh.199 are associated with spending sh.100 rather than sh.200.
The theory that drives this is that lower pricing such as this institutes greater demand than if
consumers were perfectly rational. Psychological pricing is one cause of price points.
Time-based pricing
Time-based pricing is a pricing strategy where the provider of a service or supplier of a
commodity, may vary the price depending on the time-of-day when the service is provided or the
commodity is delivered. The rational background of time-based pricing is expected or observed
change of the supply and demand balance during time. Time-based pricing includes fixed time-of
use rates for electricity and public transport, dynamic pricing reflecting current supply-demand
situation or differentiated offers for delivery of a commodity depending on the date of delivery
(futures contract). Most often time-based pricing refers to a specific practice of a supplier.
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Suggested retail price
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The manufacturer's suggested retail price (MSRP), list price or recommended retail price (RRP) of
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a product is the price at which the manufacturer recommends that the retailersell the product. The
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intention was to help to standardize prices among locations. While some stores always sell at, or
co.
below, the suggested retail price, others do so only when items are on sale or closeout/clearance.
a.
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Suggested pricing methods may conflict with competition theory, as they allow prices to be set
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higher than would otherwise be the case, potentially negatively affecting consumers. However,
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resale price maintenance goes further than this and is illegal in many regions.
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Much of the time, stores charge less than the suggested retail price, depending upon the actual
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wholesale cost of each item, usually purchased in bulk from the manufacturer, or in smaller
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quantities through a distributor.

Suggested prices can also be manipulated to be unreasonably high, allowing retailers to use
deceptive advertising by showing the excessive price and then their actual selling price, implying
to customers that they are getting a bargain. Game shows have long made use of suggested retail
prices both as a game element, in which the contestant must determine the retail price of an item,
or in valuing their prizes.
Additionally, the use of MSRP and SRP has been confused. In certain supply chains, where a
manufacturer sells to a wholesale distributor and the distributor in turn sells to a reseller, the use of
SRP is used to denote suggested reseller price. In that case MSRP is used to convey manufacturer
suggested retail price.
Value-based pricing
Value-based pricing (also value optimized pricing) is a pricing strategy which sets prices primarily,
but not exclusively, on the value, perceived or estimated, to the customer rather than on the cost of

the product or historical prices. Where it is successfully used, it will improve profitability due to
the higher prices without impacting greatly on sales volumes.
The approach is most successful when products are sold based on emotions (fashion), in niche
markets, in shortages (e.g. drinks at open air festival at a hot summer day) or for indispensable
add-ons (e.g. printer cartridges, headsets for cell phones). Goods that are very intensely traded (e.g.
oil and other commodities) or that are sold to highly sophisticated customers in large markets (e.g.
automotive industry) usually are sold using cost-plus pricing.
Penetration pricing
Penetration pricing is a pricing strategy where the price of a product is initially set low to rapidly
reach a wide fraction of the market and initiate word of mouth The strategy works on the
expectation that customers will switch to the new brand because of the lower price. Penetration
pricing is most commonly associated with marketing objectives of enlarging market share and
exploiting economies of scale or experience
Price penetration is most appropriate where:

 Product demand is highly price elastic.
 Substantial economies of scale are available.
 The product is suitable for a mass market (i.e. enough demand).
 The product will face stiff competition soon after introduction.
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 There is not enough demand amongst consumers to make price skimming work.
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 In industries where standardization is important. The product that achieves high market
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penetration often becomes the industry standard (e.g. Microsoft Windows) and other
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products, whatever their merits, become marginalized. Standards carry heavy momentum.
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The advantages of penetration pricing to the firm are:
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 It can result in fast diffusion and adoption. This can achieve high market penetration rates
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quickly. This can take the competitors by surprise, not giving them time to react.
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 It can create goodwill among the early adopters segment. This can create more trade
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through word of mouth.

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 It creates cost control and cost reduction pressures from the start, leading to greater
efficiency.
 It discourages the entry of competitors. Low prices act as a barrier to entry
 It can create high stock turnover throughout the distribution channel. This can create
critically important enthusiasm and support in the channel.
 It can be based on marginal cost pricing, which is economically efficient.
The main disadvantage with penetration pricing is that it establishes long term price expectations
for the product, and image preconceptions for the brand and company. This makes it difficult to
eventually raise prices. Some commentators claim that penetration pricing attracts only the
switchers (bargain hunters), and that they will switch away as soon as the price rises. There is
much controversy over whether it is better to raise prices gradually over a period of years (so that
consumers don’t notice), or employ a single large price increase. A common solution to this
problem is to set the initial price at the long term market price, but include an initial discount
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TOPIC 9
ENVIRONMENTAL MANAGEMENT ACCOUNTING
INTRODUCTION
Environmental Management Accounting (EMA) is a relatively new tool in environmental
management. Decades ago environmental costs were very low, so it seemed wise to include them
in the overhead account for simplicity and convenience. Recently there has been a steep rise in all
environmental costs, including energy and water prices as well as liabilities. In Europe the
Pollution Prevention Pays program me played a crucial role in the spread of the EMA concept,
while in the United States the high level of potential liabilities pushed companies to better evaluate
their environmental costs. Now, especially transition economies are going through a fast change
that will impose a requirement for more accurate control of production inputs and outputs.
Environmental costs are no longer a minor cost item that can be pooled together with other costs:
the use of EMA saves money and improves control.
Still, many companies need external help in creating or improving their EMA, as those skills are
not widespread and rarely available internally. EMA has to be tailored to the special needs of the
company rather than be applied as a generic system. The costs and benefits of building such a
system have to be considered and the scope of the EMA properly selected.
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DEFINITION
Environmental Management Accounting has no single, universally accepted definition.
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According to IFAC’s Statement Management Accounting Concepts, EMA is “the management of
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environmental and economic performance through the development and implementation of
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appropriate environment-related accounting systems and practices. While this may include
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reporting and auditing in some companies, environmental management accounting typically
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involves life-cycle costing, full-cost accounting, benefits assessment, and strategic planning for
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environmental management.”
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A complementary definition is given by the United Nations Expert Working Group on EMA,
which more distinctively highlights both the physical and monetary sides of EMA. This definition
was developed by international consensus of the group members, representing 30+ nations.
According to the UN group:
EMA is broadly defined to be the identification, collection, analysis and use of two types of
information for internal decision making:
 physical information on the use, flows and destinies of energy, water and materials
(including wastes) and
 Monetary information on environment-related costs, earnings and savings.
These two definitions highlight the broad types of information organizations typically consider
under EMA, as well as some common EMA data analysis techniques and uses.

The benefits and uses of EMA also are discussed in more detail below.
In the real world, EMA ranges from simple adjustments to existing accounting systems to more
integrated EMA practices that link conventional physical and monetary information systems.
But, regardless of structure and format, it is clear that both MA and EMA share many common
goals. And it is to be hoped that EMA approaches eventually will support the IFAC proposals in
Management Accounting Concepts that, in leading-edge MA, “inattention to environmental or
social concerns are likely to be judged ineffective,” and that “resource use is judged effective if it
optimizes value generation over the long run, with due regards to the externalities associated with
an organization’s activities.”
Types of Information included under EMA

Physical Information under EMA
To assess costs correctly, an organization must collect not only monetary data but also
nonmonetary data on materials use, personnel hours and other cost drivers. EMA places a
particular emphasis on materials and materials-driven costs because: (1) use of energy, water and
materials, as well as the generation of waste and emissions, are directly related to many of the
impacts organizations have on their environments and (2) materials purchase costs are a major cost
driver in many organizations.
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Most organizations purchase energy, water and other materials to support their activities. In a
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manufacturing setting, some of the purchased material is converted into a final product that is
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delivered to customers. Most manufacturing operations also produce waste – materials that were
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intended to go into final product but became waste instead because of product design issues,
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operating inefficiencies, quality issues, etc. Manufacturing operations also use energy, water and
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materials that are never intended to go into the final product but are necessary to manufacture the
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product (such as water to rinse out chemical tanks between product batches or fuel use for
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transport operations). Many of these materials eventually become waste streams that must be
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managed. Non-manufacturing operations (for example, agriculture and livestock, resource

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extraction sector, service sector, transport, the public sector) can also use a significant amount of
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energy, water and other materials to help run their operations, which, depending on how those
materials are managed, can lead to a significant generation of waste and emissions.
Thus, the most obvious example of materials-related environmental impacts is the generation of
waste and emissions, which can affect the health of both humans and natural ecosystems, including
plants and animals. Air, water or land can end up polluted or even contaminated.
The second broad area of materials-related environmental impact is the potential impact of the
physical products (including by-products and packaging) produced by a manufacturer. These final
products have environmental impacts when they leave the company, for example, when a product
ends up in a landfill at the end of its useful life. Some of the potential environmental impacts of
products can be reduced by changes in product design, such as decreasing the volume of paper
used in packaging or replacing a physical product with an equivalent service, etc. In many
manufacturing plants, most of the materials used become part of a final product rather than part of

waste or emissions. As a result, the potential environmental impact of products is high, and the
potential environmental benefit of product improvements is correspondingly high.
Tracking and reducing the amount of energy, water and materials used by manufacturing, service
and other companies can also have indirect environmental benefits upstream, because the
extraction of almost all raw materials has environmental impacts. For example, activities such as
forestry and the extraction of materials such as coal, oil, natural gas, oil, as well as gold and other
minerals, can have extreme impacts on the environment surrounding extraction sites. These
impacts include not only the pollution and waste generated during extraction operations, but also
the erosion or outright removal of topsoil and vegetation, sedimentation of nearby water bodies and
the disruption of wildlife feeding, reproduction and migration habitat. As well, there are impacts on
the local human populations that depend on the affected ecosystem for food and clean water. The
depletion of non-renewable or slowly renewable natural resources is also a cause for concern.
To effectively manage and reduce the potential environmental impacts of waste and emissions, as
well as of any physical products, an organization must have accurate data on the amounts and
destinies of all the energy, water and materials used to support its activities. It needs to know
which and how much energy, water and materials are brought in, which become physical products
and which become waste and emissions. This physical accounting information does not provide all
of the data needed for effectively managing all potential environmental impacts, but is essential
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information that the accounting function can provide.
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Monetary Information under EMA
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Monetary environmental management accounting is a sub-system of environmental accounting that
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deals only with the financial impacts of environmental performance. It allows management to
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better evaluate the monetary aspects of products and projects when making business decisions.
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Environmental Management Accounting (EMA) serves business managers in making capital
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investment decisions, costing determinations, process/product design decisions, performance
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evaluation and a host of other forward-looking business decisions. Thus,EMA has an internal
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company-level function and focus, as opposed to being a tool used for reporting environmental
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costs to external stakeholders.
It is not bound by strict rules as is financial accounting and allows space for taking into
consideration the special conditions and needs of the company concerned.
ROLE OF ACCOUNTANTS IN ENVIRONMENTAL MANAGEMENT ACCOUNTING
An accountant is a Person who has the requisite skill and experience in establishing and
maintaining accurate financial records for an individual or a business. The duties of an accountant
may include designing and controlling systems of records, auditing books, and preparing financial
statements. An accountant may give tax advice and prepare tax returns.
The following list encompasses the major aspects of environmental accounting which can be
handled by an accountant;-

 Recognising and seeking to mitigate the negative environmental effects of conventional

accounting practices
 Separately identifying environmentally related costs and revenues within the conventional
accounting systems
 Devising new forms of financial and non-financial accounting systems, information systems
and control systems to encourage more environmentally benign management decisions
 Developing new forms of performance measurement, reporting and appraisal for both internal
and external purposes
 Identifying, examining and seeking to rectify areas in which conventional (financial) criteria
and environmental criteria are in conflict
 Experimenting with ways in which, sustainability may be assessed and incorporated into
organisational orthodoxy.
The whole environmental agenda is constantly changing and businesses therefore need to monitor
the situation closely.
Environmental audit
Environmental auditing is exactly what it says: auditing a business to assess its impact on the
environment or the systematic examination of the interactions between any business operation and
its surroundings.
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The audit will cover a range of areas and will involve the performance of different types of testing.
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The scope of the audit must be determined and this will depend on each individual organisation.
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There are, however, some aspects of the approach to environmental auditing, which are worth
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mentioning especially within the European Countries.
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 Environmental Impact Assessment (EIAs) are required, under EC directive, for all major
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projects which require planning permission and have a material effect on the environment.
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The EIA process can be incorporated into any environmental auditing strategy.
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 Environmental surveys are a good way of starting the audit process, by looking at the
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organisation as a whole in environmental terms. This helps to identify areas for further
development, problems, potential hazards and so forth.
 Environmental SWOT analysis. A ‘strengths, weaknesses, opportunities, threats’ analysis is
useful as the environmental audit strategy is being developed. This can only be done later in
the process, when the organisation has been examined in much more detail.
 Environmental quality management. This is seen as part of TQM (Total Quality
Management) and it should be built in to an environmental management system.
 Eco-audit. The European commission has adopted a proposal for a regulation for a voluntary
community environmental auditing scheme, known as the eco-audit scheme. The scheme
aims to promote improvements in company environmental performance and to provide the
public with information about these improvements. Once registered, a company will have to
comply with certain on-going obligations involving disclosure and audit.

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CPA

CERTIFIED PUBLIC ACCOUNTANTS

PAPER NO.14 14 ADVANCED MANAGEMENT ACCOUNTING

14.0 LEARNING OUTCOMES

14.1 Nature of management accounting

14.2 cost estimation and forecasting

organization and and coordination of the budgeting function

ABB,ZBB, program budgeting

14.5 inventory control decisions

14.6 decision theory

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14.7 performance measurement and evaluation

14.8 Pricing decisions

Revised on: November 2016

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Management Accounting is the process of identification, measurement accumulation, analysis,

to address specific management needs.

VALUE OF INFORMATION IN DECISION MAKING: PERFECT AND IMPERFECT

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The information can be obtained from various sources e.g.

CALCULATING THE VALUE OF PERFECT INFORMATION

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Constructing a payoff table

can be analyzed as follows;-

Similarly, a payoff table can be constructed as follows;-

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The formula for the expected value is EV = Σpx

70 mandazis 0.30 sh.80 sh.100 sh.120 sh.140

The expected value associated with each choice is as follows:

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COST ESTIMATION AND FORECASTING

AN OVERVIEW OF THE METHODS OF COST ESTIMATION AND PREDICTION;

Where y = total cost

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- High low method

High Low Method

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No. of units (x) Cost of product

High 450 2,550

Therefore Cost of production y = 300 + 5x

Month Volume of production Production overheads

overheads (litres ‘000’) (shs ‘000’)

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∴ Variable cost per unit (b) = = Sh 10

Using the highest production level,

For production of 350,000 units

Advantages of high low method

4. The method presumes that the relationship between x and y;-

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Pass on first attempt

Sample/preview is NOT FOR SALE

SHORT TERM PLANNING AND DECISION- MAKING

Incremental costs are extra costs incurred as a result of a decision.

OVERVIEW OF SINGLE PRODUCT AND MULTIPLE PRODUCT

In cost-volume-profit analysis, you: