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Exam
A total of 5 questions, each worth 20 marks = 100 marks.
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Contents
C: Budgeting 27-38
• Objectives
• Budgetary systems
• Types of budget
• Quantitative analysis in budgeting
• Behavioural aspects of budgeting
This topic will not be examined as a full question but its basic knowledge needs to be
understood.
Example: Budgeted overheads are $200000 with labour hours of 100000 hours. The
actual results were 120000 hours and actual overheads are $250000. Calculate the
over or under-absorption of overhead.
Solution: OAR = $200000/100000 = $2 per hours.
Over/(under)-absorption = absorbed overheads – actual overheads = $2 x 120000 -
$250000 = ($10000).
AC and MC compared
Their profit reported will be different only if the inventory level changes. If the
inventory level increases, profit reported under AC will be higher than MC, if the
inventory level decreases, profit reported under MC will be higher than AC.
Therefore, when in reconciling the profit, the following has to be done:
MC profit X
Changes in inventory level x fixed OAR X/(X)
AC profit X
In ABC, there is no fixed overhead, all overheads will be treated as variable in nature.
Instead of using OAR to absorb overheads, ABC allocates overheads to product on the
basis of activities consumed, cost driver which is the cost causer is used to calculate
what we call the cost driver rate instead of OAR. Therefore, cost driver rate is similar
to OAR in concept, it is calculated as budgeted overheads/cost driver. The steps to do
ABC include:
1. Identify the activities, e.g. set-up, quality control etc.
2. Identify the total costs incurred for each activity.
3. Cost driver will be determined for each activity.
4. Cost driver rates are calculated for each activity.
5. Use the cost driver rates to allocate the costs to the product, the activities consumed
by each activity need to be identified and multiply with the cost driver rates.
Example: Cost of goods inwards department totalled $10000. During 2010 there were
1000 deliveries. 200 of these deliveries related to product X. 2000 units of product X
were produced. Calculate the unit cost of product X.
Solution: This is an example which only involve one activity, there will be more in
exam.
Cost driver of the cost of goods inwards is the number of deliveries, therefore cost
driver rate = $10000/1000 = $10 per delivery. Product X needs 200 deliveries,
therefore $2000 ($10 x 200) is allocated to product X. The unit cost of product X =
$2000/2000 = $1 per unit.
Target costing
To reduce the cost gap, the concept of cost reduction is important. Cost reduction is a
planned and positive approach to reducing costs, this must not affect the value of the
product. There are many ways and some are explained here:
1. Reducing material costs – this can be done by reducing costs of wastage, obtain
lower prices for purchases, improve stores control and use alternative materials.
However, company must make sure the quality of the materials remain high enough.
2. Standardisation of product – a range of products may be basically standardised,
costs of producing a standard product are most likely cheaper than costs of producing
wide range of products.
3. Training the staff – this will improve the skills and efficiency of the staff and
wastages can be reduced.
4. Employ cheaper labour – this is not to replace the skilled labour, but to do the
easier work which does not require much skill, then the amount of skilled labour
needed can be reduced.
5. Acquiring new technology – obviously technology helps to speed up the production
process and less labour will be needed, production costs will be reduced.
5. Use cost reduction team – company can bring together the members of marketing,
design, assembly and distribution teams to allow discussion of methods to reduce
costs. Open discussion and brainstorming are useful approaches here.
6. Value engineering (or value analysis) – this is important, value engineering
attempts to design the best possible value at the lowest possible cost into a new
product which can then be used in a target costing system. Value engineering aims to
reduce costs by identifying those parts of a product or service which do not add value.
Value is made up of use value (ability of the product to function) and esteem value
(status, probably related to quality). The aim of value engineering is to maximise use
and esteem values while reducing costs. Techniques of value engineering are actually
the cost reduction techniques identified above except using cost reduction team which
is another good approach.
A service company might deliver a number of different services through the same
delivery system, using the same employees and the same assets. Therefore,
introducing new service will add burden to employees. Target costing is used mainly
for new product/service development.
Life cycle costing is the accumulation of costs over a product’s entire life. That
means, the whole life of the product will be taken into account. Product life cycle is
the life of the product, how long it can be in the market. With life cycle costing, we
can identify the total profitability that a product can generate for the company. Not
only product, service and customer have life cycles as well but let us focus on
product.
Throughput accounting
Throughput (or throughput contribution) is defined as sales less direct material costs.
Throughput accounting (TA) is a product management system which aims to
maximize throughput rather than profit. This is in accordance with theory of
constraints and therefore it focuses on bottleneck resource (resource which limits the
throughput). Bottleneck resource is also referred as binding constraint of throughput.
Conversion costs (costs other than material costs) are excluded because in the short
run, they are fixed, only material cost is considered as variable costs. Therefore,
businesses will become richer provided the sales revenue is more than material costs.
The concept of TA has been developed from theory of constraints as an alternative
system of cost and management accounting in a just-in-time (JIT) environment. In
JIT, factory is highly automated and lesser labours are used, therefore material is the
only truly variable costs.
Example: Company A manufactures product X which has a selling price of $100 per
unit. Material cost per unit for product X is $40 and conversion costs per day are
$144000. The processes of making this product can only be operated 8 hours a day
and 500 units can be produced for every 1 hour, ie. 0.002 hour per unit. Calculate
TPAR and interpret it.
Solution: Throughput per unit = $100 - $40 = $60 and therefore throughput per
factory hour = $60 per unit/0.002 hour per unit = $30000. Conversion cost per factory
hour = $144000/8 hours = $18000. TPAR = $30000/$18000 = 1.67.
Since TPAR is more than 1, the product is worthwhile as earning rate is higher than
spending rate. If other product, let say product Y has TPAR of 2, then company A
should focus on producing product Y first instead of product X.
Solution: X Y
Selling price per unit 100 120
Material cost per unit (40) (50)
Throughput per unit 60 70
÷ Machine hour per unit 2 3
Throughput per machine hour 30 23.3
Ranking 1 2
Based on the above evaluation, product X earns more throughput per machine hour
compared to product Y, therefore company A should produce the maximum number of
product X (demand of the product may be given in exam) then only consider product
Y. Although product Y has the higher throughput per unit, it is not relevant to consider
in this decision.
Defining EMA
Definition given by UNDSD is that EMA is the identification, collection, analysis and
use of two types of information for internal decision making:
1. Physical information on the use, flows and destinies of energy, water and materials
(including wastes).
2. Monetary information on environment-related cost, earnings and savings.
Examiner defines EMA as a specialised part of the management accounts that focuses
on the cost of energy and water and the disposal of waste and effluent.
Definition given by BPP is that EMA is the generation and analysis of both financial
and non-financial information in order to support internal environmental management
processes.
2. Flow cost accounting – this is also using input/outflow analysis (material flows),
but instead of applying simply to the business as a whole, it takes into account the
organisation structure. It makes material flows transparent by looking at the physical
quantities involved, their costs and their value. It divides the material flows into three
categories:
• Material – for the purposes of calculating the material values and costs, one
needs detailed knowledge of the physical quantities of materials involved in
the various flows and inventories.
• System – this includes costs that are incurred in the course of in-house
handling of the material flows, e.g. personnel costs, depreciation.
• Delivery and disposal – this includes all costs incurred in ensuring that
material leaves the company, e.g. payment to external third parties.
The values and costs of each material flow are then calculated. The aim of flow cost
accounting is to reduce the quantity of materials, this will have a positive effect on the
environment and also reduce business’ total costs in the long run.
3. Activity-based costing (ABC) – ABC allocates all internal costs to the cost centres
and cost drivers on the basis of the activities that caused the costs. It distinguishes
between environment-related costs (e.g. costs relating to sewage plant or incinerator),
which are attributed to joint environmental cost centres, and environment-driven costs
(e.g. increased depreciation or higher cost of staff), which are allocated to general
overheads. Environment-driven costs do not relate directly to a joint environmental
cost centre. No definition is given for environment-related costs and environment-
driven costs by UNDSD so I will define them so that you know how to differentiate:
• Environment-related costs are the costs that are related to activities in the joint
environmental cost centres
• Environment-driven costs are the additional costs due to the activities in the
joint environmental cost centres.
4. Life cycle costing – environmental costs are considered from the design stage of a
new product right up to the end-of-life costs. The full consideration of whole life
cycle of new product at design stage may influence the design of the product itself,
saving on future costs.
Relevant costing
Example: A company has 100 units of material B which was brought at $20 per unit
one year ago in inventory, the company does not use it regularly. Today, the company
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receives a job which requires 200 units of this material. Current purchase price is $25
per unit, resale value is $15 per unit, calculate the relevant cost of this job.
Solution: the job requires 200 units and the company has only 100 units, so 100 units
will need to be purchased. Then the materials in inventory is not used regularly, so
relevant cost is the higher of resale value and contribution from other use, since there
is no other use, resale value will be relevant.
Relevant cost for this job will therefore = 100 x $20 (buy) + 100 x $15 = $3500
Example: Company A sells two products, XX and YY. XX and YY have contribution
per unit of $4.20 and $9.80 respectively. For every five units of XX sold, six units of
YY are sold. Fixed costs per annum are $43980, budgeted sales revenue for next
period is 700 in standard mix and company A expects a profit of $30000. Calculate
BEP (units), target sales (units) and margin of safety.
Solution: The constant mix is seen from the pattern of sales, XX:YY = 5:6.
Contribution per mix can be calculated by ($4.20 x 5) + ($9.80 x 6) = $79.80, with
this we can calculate the BEP in mixes.
BEP in mixes = fixed cost/contribution per mix = $43980/$79.80 = 550 mixes, with
this calculating BEP in units for both product will be possible.
BEP in units for product XX = 550 x 5 = 2750 units, BEP in units for product YY =
550 x 6 = 3300 units. Therefore, selling 2750 units of XX and 3300 units of YY will
breakeven. (Prove: Profit = contribution – fixed cost = ($4.20 x 2750 + $9.80 x 3300)
- $43980 = 0)
Margin of safety in mixes = 700 – 550 = 150 mixes (to get units, just multiply the mix
of the products).
Target sales in mixes = ($43980 + $30000)/$79.80 = 927 mixes.
Target sales in units for XX = 927 x 5 = 4635 units, target sales in units for YY = 927
x 6 = 5562 units.
Example: Company A produces product X and Y. Product X has sales price of $50 and
variable cost of $30 while product Y has sales price of $60 and variable cost of $45.
Budgeted sales for product X are 20000 units and for product Y 10000 units.
Company A’s fixed costs are $200000. Company aims to achieve profit of $300000.
Calculate average C/S ratio, breakeven point (in $) and target sales (in $).
Solution: Product X has a contribution per unit of $20 ($50 - $30) and product Y has a
contribution per unit of $15 ($60 - $45).
The breakeven chart is not a problem, it is similar to breakeven chart prepared under
CVP analysis for one product. There is something new that you need to be aware of
when you are doing multi-product P/V chart, you have to calculate the cumulative
profit/loss for the cumulative revenues. Example is shown at the next page.
Example: Company A produces product X and Y. Product X has sales price of $50 and
variable cost of $30 while product Y has sales price of $60 and variable cost of $45.
Budgeted sales for product X are 20000 units and for product Y 10000 units.
Company A’s fixed costs are $200000. Company aims to achieve profit of $300000.
The management wants the P/V chart to show the profits starting from the most
profitable product. Prepare the figures necessary for drawing multi-product P/V chart
and draw the chart.
Solution: Product X’s C/S ratio = $20/$50 = 0.4 and product Y’s C/S ratio = $15/$60
= 0.25. Therefore product X has higher C/S ratio and its profit will be shown first in
the graph. Then to avoid confusion, show the following information:
Product Contribution Cumulative profit/loss Revenue Cumulative revenues
$000 $000 $000 $000
Fixed cost 0 (200) - -
X 400 W1 200 1000 W3 1000
Y 150 W2 350 600 W4 1600
W1 = 20000 x $20 = $400000
W2 = 10000 x $15 = $150000
W3 = 20000 x $50 = $1000000
W4 = 10000 x $60 = $600000
The P/V chart can be drawn by using the cumulative figures. The points to plot are at
the coordinate of (0, 200), (1000, 200) and (1600, 350). BEP in $ can also be seen
from the graph.
Linear programming
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Shadow price and slack
Normally this is examined together with linear programming. Shadow price is the
extra contribution due to the 1 extra unit added to the critical scarce resource
(resource that will be finished using). Shadow price is also the maximum premium
that the company will be willing to pay for more critical scarce resource (later you
will understand why by looking at an example).
Example: An optimal solution shows that company will use all the materials and there
will be some labour hour left. Company produces product x and product y. Using the
examples above, equation for material is 0.27x + 0.27y = 5400. From the graph,
optimal point has a coordinate of (5000, 15000), it falls at a line which shows
maximum sales demand for x. Contribution function is 20x + 40y. Company’s current
material cost per unit is $200, it can buy extra materials from other supplier at a price
of $300 per unit. Calculate shadow price and interpret it.
Solution: Remember that shadow price is the extra contribution due to the 1 extra unit
added to the critical scarce resource, therefore you can form a new equation, 0.27x +
0.27y = 5401, as optimal point falls at maximum sales demand line for x, we don’t
need to produce x anymore. Therefore we should put x = 5000 into the equation
instead of putting y = 15000 (we want to increase production units for y), 0.27 (5000)
+ 0.27y = 5401 and therefore y = 15004. New solution is therefore producing 5000
units of x and 15004 units of y. There are extra 4 units for y and this will earn extra
contribution of $160 (4 x $40). This extra contribution of $160 is the shadow price
and it is also the maximum premium that the company is willing to pay for extra
material, now this makes sense because the maximum we want to pay is the extra that
we earned. The supplier offers $300 per unit which is $100 above the normal price, it
is acceptable since it is below than shadow price of $160.
Pricing
For every company, the price that the company offers for the goods or services is very
important as profits come from the sales and different prices set will have an impact
on the sales volumes and also the company’s profits.
For example, price of a good is $1.20 per unit and annual demand is 800000 units. An
increase in price of $0.10 will result in a fall in annual demand to 725000 units.
Calculate PED and comment whether the demand is elastic.
Solution: PED = [(800000 – 725000)/800000] x 100% / [(1.30 – 1.20)/1.20] x 100% =
1.125
The demand for this good is elastic because the price elasticity of demand is greater
than 1. Demand is elastic means that if there is an increase in price, the demand will
change much (sensitive demand).
When a new product is developed, there are two pricing strategies that are frequently
used and each will be used based on the situation.
4. Price skimming – enter the market at a high price to earn as much profits as
possible before competition enters the market. This strategy is used if the new product
is “a unique new product that has not existed in the market before”, a good example
for this is the i-pad, Apple company used price skimming when they first launched i-
pad.
5. Penetration pricing – go in the market at a very low price, this is to gain the market
share. This strategy is used if the new product is “a unique new product that existed in
the market”, a good example is Samsung galaxy, since i-pad is already existed in the
market and people prefer to buy i-pad, Samsung galaxy is priced at much lower price
than i-pad in order to catch customers’ attention.
Make-or-buy decision
Company can choose to make the product themselves or simply buy from external
seller (outsourcing). To decide about this, company has to compare the relevant costs
of making (variable and specific fixed cost) and of buying (normally purchase price).
If the costs of making are cheaper, definitely company will want to make.
For example, company A has variable cost of $20 per unit when making this product
and alternatively company can buy this product from an external seller at $30 per unit.
Company will need to pay a salary of $1000 per month if it wishes to make. Advice
the company whether it should make or buy.
Solution: Without taking into account the specific fixed cost, the company will have a
saving if make of $10 per unit ($30 – $20), but since there is a specific fixed cost if
company chooses to make, then the company cannot simply decide by only looking at
the saving of $10 per unit, $1000/$10 per unit = 100 units, with this, we can conclude
that if company needs less than 100 units, then buy (because the fixed costs cause the
making of 100 units more expensive), if company needs more than 100 units, then
make. (You can check about this by calculating costs for 50 units and 200 units)
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If the company must buy some of the products because of scarce resources, then
additional workings are needed (this only occurred if the company is deciding on
more than one product). This is similar to one limiting factor situation:
1. (Purchase cost – variable cost)/limiting factor for each product.
2. Do ranking for each product, the product with highest value will be ranked first and
will be considered to make first.
3. Produce an optimal production plan, the highest ranked product is made first,
follow by other product until the labour hour is fully utilized.
4. The rest of unmade amount of products will be bought from outsourcer.
Shut-down decision
This involves decision about whether to add or drop a service, product or department.
The key is the proper handling of fixed costs as fixed costs are sometime avoidable
(ie. relevant). When a manager is considering dropping a product line, relevant costs
of dropping the product line should be calculated. If there are savings after dropping
the product line (e.g. Sales of other product will increase), then it is deducted from the
relevant costs. At the end, the product line will be shut down if the benefit exceeds
relevant costs (ie. shutting down result in benefit).
For example, product A and B have been manufactured. Product A and B are able to
be sold for $10 per unit and $8 per unit respectively. Product A and B can be further
processed into product AA and BB respectively. Selling prices of product AA and BB
are expected to be $20 per unit and $14 per unit respectively. Company will incur
further processing costs of $5 per unit for product A and $7 per unit for product B.
Advice the company which products should be further processed and which should be
sold immediately.
Take note that per unit figure can only be used if the input and output quantity are the
same, if let say the product A has 1000 units and after further processed it left with
900 units, then you should not use per unit to make decision, you should for example
multiply $10 to 1000 units and use this $10000 (sales revenue) to compare with sales
revenue after further processed.
Limiting factor
Sometime the production is restricted by labour hours, materials or machine hours.
When only one limited resource is present, a company should focus on products that
have the greatest amount of contribution per limiting factor. You have learnt this, here
is a revision for you, what you have to do is:
1. Identify limiting factor.
2. Calculate contribution per unit for each product.
3. Calculate contribution per limiting factor (contribution per unit/limiting factor per
unit)
4. Rank products (first for product with highest contribution per limiting factor).
5. Prepare an optimal production plan, start with the first ranked product until scarce
resource is used up.
Maximin
Choose the highest contribution among the worst contribution for each possible
decision.
Fee ($) Worst contribution ($)
110 1800000
100 1740000
90 1600000
From here, choose the highest one, ie. $1800000. Therefore set the fee as $110 per
member.
Minimax regret
Prepare a regret table, putting decision factor in the middle and uncertain variable at
the left side:
Variable cost per member Fee per member (decision
(uncertain) factor)
$110 $90
$70 0 (best, so no regret) $60000 (loss)
$65 $5000 (loss) 0 (best, so no regret)
$60 $150000 (loss) $80000 (loss)
Maximum regret $150000 $80000
If you are not sure how to get the amount of loss, let’s pick an example, at variable
cost per member of $70, from the three fee, you can see that charging $110 will earn
$1800000 and charging $100 and $90 will earn $1740000 and $1600000 respectively,
therefore the loss for choosing to set fee at $100 is $60000 (1800000 – 1740000).
The decision is to minimise the maximum regret, so $80000 is the lowest regret,
therefore set the fee as $100 per member.
Objectives of budgeting
Every organizations should try to ensure goal congruence exists in order to avoid
conflicting objectives. Goal congruence is the state which leads individuals or groups
to take actions that are in their self-interest and also the best interest of the
organisation. (ie. manager goals = organisation goals) This is not easy to achieve,
budgetary control system needs to be well designed which should encourage
continuous feedback from employees.
Budgetary systems
In paper F5, you will not be required to prepare sales budget, production budget,
material usage budget, material purchase budget and so on, these are all covered in
earlier studies.
4. Zero-based budgeting (ZBB) – as the name suggested, this involves preparing the
budget from zero base. Every item of expenditure has to be justified before it is
included in the budget. There are three steps of ZBB:
(a) Define decision packages – decision package (description of activity) is prepared
at the base level (base package), representing the minimum level of service or support
needed to achieve the organisation’s objectives. Further incremental packages may
then be prepared to reflect a higher level of service or support.
(b) Ranking of decision packages – management will evaluate and rank each activity
(incremental decision package) on the basis of its benefit to the organization This will
help management decide what to spend and where to spend it.
(c) Allocate resource – the resources are then allocated based on the order of priority
up to the spending level. For example, a car manufacturer may choose to allocate
more funds to production processes than service and admin functions, based on the
ranking of each activity.
ZBB is useful for budgeting for discretionary costs (e.g. training costs, research and
development costs), service industries, non-profit-making organisations and support
expenses (expenses to support the essential production function).
5. Activity based budgeting (ABB) – ABB involves defining the activities that
caused the costs and using the level of activity to decide how much resource
should be allocated, how well it is being managed and to explain variances
from budget. ABB involves the use of costs determined using activity based
costing (ABC) as a basis of preparing budgets.
6.
6. Incremental budgeting – this is the traditional approach to budgeting. Budget is
prepared using a previous period’s budget or actual performance as a base, with
incremental amounts then being added for the new budget period. It is known for
encouraging slack and wasteful spending, hence it is particularly unsuitable for public
sector organisations which are aiming to achieve desired results with the minimum
use of resources.
Advantages of ZBB
1. Prevent budgetary slack.
2. It responds to changes in the business environment.
3. Remove inefficient or obsolete operations.
4. More efficient allocation of resources.
Disadvantages of ZBB
1. Take up a lot of time and costs may be more than benefits.
2. Managers may have to be trained in ZBB techniques as it requires skills in
constructing decision packages.
3. Ranking of decision packages can be difficult.
Advantages of ABB
1. A more accurate budget is available.
2. Costs are analyzed into activities, therefore it is easier to identify what cause more
costs.
Disadvantages of ABB
1. Require more time and costs.
2. Costs of preparing ABB could be higher than benefits from it.
3. When there are a lot of activities involved, it will be complicated to prepare ABB.
Example: You are given the following data for output at a factory and costs of
production over the past five months.
Month Output (‘ooo units) (x) Costs ($000) (y)
1 20 82
2 16 70
3 24 90
4 22 85
5 18 73
When we use linear regression analysis, cost function is assumed to be linear. It is still
based on past data and it is not reliable if we don’t know the correlation coefficient.
Forecasting techniques
Management can use a number of forecasting methods such as:
1. Judgement and experience – sales personnel can be asked to provide estimates.
2. Market research can be used (especially for new products or services).
3. Simulation.
4. Simple average growth model – growth rate of sales for example, can be estimated
by looking at the sales revenue of past few years.
5. Assigning probabilities for identifying expected values.
6. Time series – this is a series of figures or values recorded over time, main focus is
on this method.
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Time series analysis
A time series has four components:
1. Trend (T) – the general direction which sales follow.
2. Seasonal variations (S) – the short-term fluctuations in recorded values. For
example, sales of ice cream will be higher in summer than in winter.
3. Cyclical variations (C) – medium-term changes in results caused by events which
repeat in cycles, these are the longer-term version of seasonal variations.
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4. Random variations (R) – fluctuations caused by unforeseen events, it is
unpredictable.
Therefore, actual time series (A) = T + S + C + R, but you can ignore C and R.
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Trend
Trend line can be determined by regression analysis, you could be asked to do this in
exam, you can be given sales of the product for a number of years, you have to find
the y = a + bx and y will be the trend. An example is needed here:
Sales of product B over the seven year period from 20X1 to 20X7 were as follows.
Year 20X1 20X2 20X3 20X4 20X5 20X6 20X7
Sales of B (‘000 units) 22 25 24 26 29 28 30
Calculate the trend line of sales and forecast sales in 20X8.
Solution: Shows the same workings excluding because you don’t need to calculate
correlation coefficient, start the x by numbering from 0 upwards.
Year x y xy
20X1 0 22 0 0
20X2 1 25 25 1
20X3 2 24 48 4
20X4 3 26 78 9
20X5 4 29 116 16
20X6 5 28 140 25
20X7 6 30 180 36
∑x = 21 ∑y = 184 ∑xy = 587 = 91
n=7
b = = = 1.25
a = - = – = 22.5
Trend line, y = 22.5 + 1.25x.
Sales in 20X8 (year 7) will be 22.5 + 1.25 x 7 = 31.25 = 31250 units.
Seasonal variations
There are two types of models to estimate seasonal variations:
1. Additive model, this is based on A = T + S + R (you can ignore R), so for example
the trend of Q1 adds seasonal variation of Q1 = actual time series/forecast sales. It is
more suitable when the trend is constant.
Solution:
Q1 Q2 Q3 Q4 Total
Seasonal variations -50 150 -70 50 80
Adjustment -20 -20 -20 -20 -80
Adjusted seasonal variations -70 130 -90 30 0
x = 0 at 2008 quarter 1, so x = 1 at 2008 quarter 2, x = 4 at 2009 quarter 1, x = 12 at
2011 quarter 1.
Trend for Q1 of 2011 = 21 + 5 (12) = 81, forecast sales for Q1 of 2011 = 81 + (-70) =
$11.
Good news here is that you can ignore the adjustment of seasonal variations in exam
(unless examiner specifically requires it).
Tabular approach
Example: The first unit of output of a new product requires 1 hour. A 90% learning
curve applies. Calculate the total time required to produce 8 units.
Solution: There are three basic things to present using tabular approach, remember the
output doubles each time.
Units Cumulative average time per unit Total time required
1 1 hour 1 hour
2 1 x 0.9 = 0.9 hours 2 x 0.9 hours = 1.8 hours
4 0.9 x 0.9 = 0.81 hours 3.24 hours
8 0.81 x 0.9 = 0.729 hours 5.832 hours
The total time required to produce 8 units are 5.832 hours with learning effect.
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Steady state
Eventually, the learning process will stop when there is nothing more for the labour to
learn, this is probably when a certain amount of units of products had been produced.
Steady state is when it reaches peak efficiency, learning stopped.
Example: Company B estimates that the first chair will take two hours to prepare but
this will be subject to a learning rate (LR) of 95%.
The learning improvement will stop once 128 chairs have been made and the time for
the 128th chair will be the time for all subsequent chairs. The cost of labour is $15 per
hour. Value of b is -0.074000581. Calculate the labour cost of the 128th chair made.
Solution: Be careful, learning stops once 128 chairs have been made, so this is the
steady state, when you are required to calculate labour hour or cost of 128 chairs or
the subsequent chairs, they will be the same. To find out the labour hour for 128th
chair, the only way is by total time taken to produce 128 chairs – total time taken to
produce 127 chairs.
Producing 128 chairs, y = = 1.396674592. Total time taken to produce 128 chairs =
1.396674592 x 128 = 178.77 hours.
Producing 127 chairs, y = = 1.39748546. Total time taken to produce 127 chairs =
1.39748546 x 127 = 177.48 hours.
Labour hour for 128th chair (and subsequent chairs) = 178.77 hours – 177.48 hours =
1.29 hours.
Labour cost of the 128th chair made = 1.29 x $15 = $19.35
Example: Company B expects that the first kitchen will take 24 man-hours to fit but
thereafter the time taken will be subject to a 95% learning rate. If the second kitchen
alone is expected to take 21.6 man-hours to fit, demonstrate how the learning rate of
95% has been calculated.
Solution: This question is different, however it is still easy if you understand. You are
given the time taken to produce the 2nd kitchen, so it is like working backward, use
tabular method to reduce confusion:
Number of kitchens Cumulative average time per unit Total time required
1 24 24
2 (21.6 + 24) = 45.6
The time required to produce 2nd kitchen is 21.6 hours, therefore the total time
required to produce 2 kitchens is 45.6 hours. With this, you can also get the
cumulative average time per unit for producing 2 kitchens:
Budgets can affect people’s behavior. Motivation is the key issue. Budget targets are
normally set with pay as a reward of achieving it, this is hoped to motivate employees
to work harder.
There are four types of standards and each having impact on employee motivation:
1. Ideal standard – standard that is based on perfect working conditions, this has a
demotivating effect as it is unattainable. This could be used for long-term targets.
2. Attainable standard – standard that can be attained if the work is carried out
efficiency, some allowance is made for wastage and inefficiencies. This has
motivating effect and aspirations budgets use it.
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3. Current standard – standard that is based on current working conditions, this is used
in expectations budget, it does not have motivation effect.
4. Basic standard – standard that is unchanged over the years and is used to show
changes in efficiency or performance, it should not be used as a target because it is too
easy for managers.
Ideally budget should be slightly higher than expected performance level, this is
known as aspirations budgets. This is likely to motivate higher levels of performance.
However the budget for planning and decision making should be based on reasonable
expectations (expectations budget).
Therefore, manager can show the employees the targets set under aspirations budgets
but when doing standard costing (next topic), manager should compare the actual
results with the expectations budget.
Participation of employees in the negotiation of targets
This can have motivating effect as the employees have chance to voice out what they
think the targets should be. The budgets will therefore be more realistic to the
employees (they will have a sense of ownership of the budgets) and they will have the
motive to achieve their suggested targets. However do not forget that employees have
lesser experience and they might build budgetary slack to the budget.
It would be better to have a higher level person to negotiate the targets with the
employees so that guidance is provided and avoid budgetary slack.
A business requires 15400 units of production in a period and each unit uses 5kg of
raw materials. The production process has a normal loss of 10% during the production
process. What is the total amount of the raw material required for the period?
Solution: Remember to take into account the normal loss. Originally the production
will require 77000kg (15400 x 5kg) of raw material, but it is anticipated that 10% is
lost in the production process, so you need even more raw materials to be prepared for
the loss. Therefore 77000 is assumed to be 90%, the total amount of raw material
required = 77000/90 x 100 = 85556kg. 8556kg (85556 – 77000) of raw material is
expected as wastage.
Example: A production requires 10 labour hours for each unit. However 10% of
working hours are idle time. How long must an employee be paid for in order to
produce 20 units.
Purchasing manager is normally responsible for the raw material costs, if their
performance is also assessed by looking at the labour costs, then what will happen?
The answer is purchasing manager will feel unfair and de-motivated, and might leave
the company as soon as possible.
However, it is quite often that a particular cost might be the responsibility of two or
more managers. For example, raw material costs might be the responsibility of the
purchasing manager (prices) and the production manager (usage). Sometime if the
production manager needs good quality material, the material price variance may
become adverse because purchasing manager has to buy with higher costs. Problem
may arise to determine who is responsible for the variance. A reporting system must
allocate responsibility appropriately.
(a) Prepare flexible budget for 900 units, 1000 units and 1100 units.
Most of the time, basic variance analysis involves standard vs actual except for the
case of fixed overhead variances, so it is recommended that you understand how to
calculate the variances instead of remembering the formula.
Interdependence of variances
The cause of one variance might be wholly or partly explained by the cause of another
variance, for example one adverse variance may be caused by another favourable
variance. Situation of this normally occurred for:
1. Material price and usage variances – eg. buying cheaper material may result in
more losses in production (poor quality).
2. Material price and labour efficiency variances – eg. buying cheaper material may
result in labour requiring more time to finish the production.
3. Labour rate and efficiency variances – eg. using less skilled labour may cause
inefficiency in production.
4. Sales price and volume variances – eg. reducing the price may increase the sales
volume.
Solution: Sales price variance = ($15 - $15.30) x 2000 = $600 F (price charged was
higher than expected).
Sales volume profit variance = (2200 – 2000) x $3 (standard margin = $15.30 -
$12.30) = $600 A (actual sales were less than budgeted).
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Material price and usage variances
Material price variance can be caused by bulk purchase discount (favourable) or
failing to shop around (adverse).
Material usage variance can be caused by careful usage (favourable) or poor quality
material (adverse).
Example: Material M is used to make product A, 10kg of material M at $10 per kg.
(standard cost per unit = $100). During a period, 1000 units of A were produced using
11700kg of material M, which cost $98600.
Example: Budgeted production for product A is 1000 units. Time required to produce
one unit of product A is 5 hours. Budgeted fixed overhead is $20000 and standard
fixed overhead cost per unit is $20. Actual fixed overhead is $20450, actual
production is 1100 units and actual hours worked are 5400 hours.
Solution: Standard overhead cost per unit is $20, therefore the standard overhead cost
per hour = $20/5 = $4 per hour (important to calculate capacity and efficiency
variances).
Fixed overhead expenditure variance = $20000 - $20450 = $450 A (actual expenditure
was higher than budgeted expenditure).
Fixed overhead volume variance = (1000 – 1100) x $20 = $2000 F (output is greater
than expected).
Fixed overhead capacity variance = (5 x 1000 – 5400) x $4 = $1600 F (actual hours
worked are greater than budgeted hours of work, ie. workers are capable).
Fixed overhead efficiency variance = (5 x 1100 – 5400) x $4 = $400 F (actual hours
worked are lesser than the expected hours to produce 1100 units, ie. efficient).
Fixed overhead total variance = ($20 x 1100) - $20450 = $1550 F (absorbed overhead
is higher than actual overhead, therefore over-absorption occurred). (Check: fixed
overhead total variance = $450 A + $2000 F = $1550 F).
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How learning curve affects on labour variances
With learning effect the hours worked will be reduced. This affects the calculation of
labour efficiency variance, labour rate variance is not affected because it is calculated
based on hours paid. You have to adjust the standard hour per unit.
Example: A new product has been introduced for which an 80% learning curve is
expected to apply. The standard labour information has been based on estimates of the
time needed to produce the first unit which is 200 hours at $50 per hour. The first 4
units took 700 hours to produce at a cost of $37500.
Solution: Remember only labour efficiency variance is affected, you can use the
formula method to calculate the average time per unit required for 4 units.
Labour rate variance = ($50 x 700) - $37500 = $2500 A (actual cost is higher than the
expected cost for 700 units).
Learning curve formula: y = 200 x 4^(log 0.8/log 2) = 128 hours, total time required
for 4 units = 128 x 4 = 512 hours. The standard shows that to produce 4 units it will
take 800 hours (200 x 4), but now we should use 512 hours as standard time required
to produce 4 units.
Labour efficiency variance = (512 – 700) x $50 = $9400 A (actual hours worked are
longer than expected hours to produce 4 units).
Example: Product A needs grade A labour, 2 hours of grade A labour at $5 per hour
(standard cost per unit = $10). During a period, 1500 units of product A were
produced, direct labour cost of grade A was $17500 for 3080 hours of work of which
100 hours were idle time.
Solution: Be careful when there is idle time, actual hours used in efficiency variance
are hours worked and actual hours used in rate variance are hours paid.
Labour rate variance = ($5 x 3080) - $17500 = $2100 A
Labour efficiency variance = (2 x 1500 – 2980) x $5 = $100 F
Idle time variance = 100 x $5 = $500 A (always adverse if idle time is not allowed in
budget).
The additions of all three variances are equal to labour total variance.
Let say 200 hours of idle time had been budgeted, if so then the idle time variance =
(200 – 100) x $5 = $500 F, the actual idle time is lower than the budgeted.
Waste is the same case, company may allow for waste in the budget. Wastage could
occur due to evaporation, spillage and natural wastage. The variance will need to be
calculated by comparing actual results with the adjusted standard for expected
wastage. To reduce the wastage, company should plan carefully and not buying too
many materials, they may spoil if kept too long without using.
Example: Material M is used to make product A, 10kg of material M at $10 per kg.
(standard cost per unit = $100). Waste of 5% is expected. During a period, 1000 units
of A were produced using 11700kg of material M, which cost $98600.
Solution: Standard kg before adjusted = 10 x 1000 = 10000kg, standard kg after
adjusted for waste = 10000/95 x 100 = 10526kg.
Material price variance (no effect) = ($10 x 11700) - $98600 = $18400 F
Material usage variance = (10526 – 11700) x $10 = $11740 A
ABC-based variances
All overheads within an ABC system are treated as variable costs. Therefore only
expenditure and efficiency variances are calculated. Cost driver rate is important, it is
like the standard cost per unit, will be used to calculate variances. The calculation of
variances is similar to variable overhead variances.
Material usage variance can be subdivided into material mix and yield variances when
more than one material is used in the product. This will involve the use of standard
mix, the ratio will depend on how much quantity of materials from each types of
materials are expected to be used.
For yield variance, we need standard yield from actual input and also standard cost
per unit. Standard cost per unit = $40 + $30 = $70. Standard yield is the standard
expected output from actual input. Standard yield = 195/(5 + 10) = 13 units.
Material yield variance = (13 – 12) x $70 = $70 A (actual output is less than standard
expected output).
Example: Simply Soup Limited manufactures and sells soups in a JIT environment.
The standard cost card is as follows for the period under review:
$
0.90 litres of liquidised vegetables @ $0.80/ltr 0.72
0.05 litres of melted butter @$4/ltr 0.20
1.10 litres of stock @ $0.50/ltr 0.55
Total cost to produce 1 litre of soup 1.47
The board has asked that the variances be calculated for Month 4. In Month 4 the
production department data is as follows:
Quality – the quality of the final product may change when there is changes in mix,
customers may not accept the change in quality unless it has became better. The
decreasing of quality can then lead to reduced yield (adverse material yield variance),
more labour hours required (adverse labour efficiency variance) and lower sales
volume (adverse sales volume variance).
Relationship of material price variance with the material mix and yield variances
As you know, when cheaper materials are brought, material price variance becomes
favourable, however the usage variance could become adverse because the quality is
lower. With the lower quality material, yield variance will be affected because it is
measured by comparing the standard quantity with the actual quantity used. However
mix variance is not affected because we are only interested to compare standard mix
with actual mix in mix variance.
After you knew how to do the mix and yield variances, this will not be a problem, in
fact this will be easier as there is no such thing as standard yield from actual input.
Example: Company A makes and sells two products, X and Y. The budgeted sales and
profit are as follows.
Sales units Revenue ($) Costs ($) Profit ($)
X 400 8000 6000 2000
Y 300 12000 11100 900
700 2900
Actual sales were 280 units of X and 630 units of Y.
(Favorable if actual mix generates higher revenue than standard mix, adverse if actual
mix generates lower revenue than standard mix).
Standard profit per unit = $2900/700 = 4.143
Sales quantity variance = (budgeted quantity – actual quantity) x standard profit per
unit = (700 – 910) x $4.143 = $870 F (actual quantity sold had increase the profit)
Interpret: In sales mix variance, there is a $480 A variance, this shows that actual way
of selling the products are not as good as the budgeted way, ie. 4:3, the profit would
be $480 higher if 910 units had been sold in standard mix of 4:3. In sales quantity
variance, $870 F variance represents the extra profit generated from the actual volume
of sales. The sales volume variance will be equal to $480 A + $870 F = $390 F.
If you are good in basic variances, then this topic will be easier. If you calculate basic
variances by using my way, then it is very similar when calculating planning and
operational variances.
Example: Standard selling price of A is $50 each and B $100 each. In period 1, there
was a special promotion on B with a 5% discount being offered. Sales of A and B are
2000 and 500 units respectively.
Solution: Original budgeted sales = $50 x 2000 + $100 x 500 = $150000. Revised
budgeted sales = $50 x 2000 + $100 x 95% x 500 = $147500.
Factors that could and could not be allowed to revise an original budget
A budget revision should be allowed if something has happened which is beyond the
control and which makes the original budget unsuitable for use in performance
management. For example, increase in market price of raw material cannot be
controlled and therefore the standard can be revised to allow for it. These adjustments
should be approved by senior management who should attempt to take an objective
and independent view. Any item that is within the operational control of an
organisation should not be adjusted. However, it can be very difficult to identify what
is due to operational problems (controllable) and what is due to planning error
(uncontrollable).
Now you know that planning variance is not controllable, the cause of it could be
inaccurate planning or faulty standards. Operational variance is controllable by
operational manager, the cause of it is probably the favourable or adverse operational
performance.
Remember that the way of calculating the variances is the same, the difference is that
for example, if you use my way to calculate material price variance it is (standard
price – actual price) x actual kg purchased, now material price planning variance will
be (original price – revised price) x revised kg purchased. Now can you see the
difference? If not then have a look at some examples:
Example: The market for leather bound diaries has been shrinking as the electronic
versions become more widely available and easier to use. Spike Co has produced the
following data relating to leather bound diary sales for the year to date:
Budget
Sales volume 180,000 units
Sales price $17·00 per unit
Standard contribution $7·00 per unit
The total market for diaries in this period was estimated in the budget to be 1·8m
units. In fact, the actual total market shrank to 1·6m units for the period under review.
Actual results for the same period
Sales volume 176,000 units
Sales price $16·40 per unit
(a) Calculate total sales price and total sales volume variance.
(b) Analyse the total sales volume variance into components for market size and
market share.
(c) Comment on the sales performance of the business.
Solution:
(a) Sales price variance = ($17 - $16.40) x 176000 = $105600 A
Sales volume variance = (180000 – 176000) x $7 = $28000 A
(b) Market size variance = (180000 – 160000) x $7 = $140000 A
Market share variance = (160000 – 176000) x $7 = $112000 F
(c) When you are asked to comment, you should try to identify the reason why the
variances occurred, answer:
Sales price variance show a significant variance, the business reduced the price,
probably this was to sustain the sales of leather bound diaries.
There are some recognized problems of using standard costing in the modern
environment such as organisation running just-in-time (JIT) and total quality
management (TQM) system. Variance analysis can also impact the behavior of people
just like budgets.
Just-in-time (JIT)
JIT aims to hold as little inventory as possible and production systems need to be very
efficient to achieve this. Deliveries will be small and frequent rather than in bulk.
Company needs to have a reliable supplier as that supplier will guarantee to deliver
raw materials components of appropriate quality always on time. Workforce must also
be flexible and multi-skilled in order to minimize delay and eliminate poor quality
production. JIT is often associated with TQM. In summary, order inventory only when
needed.
Although standard costing has been criticised for using in modern business
environment, it is still widely used by many organisations. As with information
technology (IT), standards can be updated rapidly to keep up with the changing
environment. Therefore with the assistant of IT, standard costing system becomes
possible in rapidly changing environment.
These ratios, however, are subject to limitations as they are calculated based on past
information and people are able to manipulate it. Therefore, there is an increasing use
of NFPIs.
Balanced scorecard
This is one of the most widely used models in organisation. Instead of looking at
profitability, risk or other areas, balanced scorecard (by Kaplan and Norton) approach
to performance measurement focuses on four different perspectives and uses FPIs and
NFPIs. It takes a long-term perspective of business performance. The four
perspectives are:
1. Financial
2. Customer
3. Internal business process
4. Innovation and learning
For each perspective, you should identify the CSFs before talking about the KPIs,
KPIs are based on CSFs. The following example demonstrates how balanced
scorecard can be used by college.
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You do not need to show the CSFs in exam if you are required to use balanced
scorecard unless CSFs are required. CSFs are normally mentioned as goals.
Standards (SOAE)
The three key words to keep in mind:
1. Ownership
2. Achievability
3. Equity (fairness)
Fitzgerald and Moon suggested that that employees should participate in the setting of
standards/targets since this would encourage ownership of the target and a
commitment to it. They said that the target should be achievable after putting in effort
and all targets should be seen to be fair by the employees. To achieve fairness,
adjustments might have to be made, for example when the divisions operate in
different countries, some divisions have advantages in other country such as cheaper
rental, we have to allow for the cheaper overseas rents. In this way all divisions could
be compared fairly.
Rewards (RCMC)
The three key words to keep in mind:
1. Clarity (clear and understandable)
2. Motivation
3. Controllability
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Dimensions
Fitzgerald and Moon proposed six dimensions or areas that service organisations
should set standards. As each business is different, some organisations would
concentrate on the areas that they felt were important to them.
1. Financial performance – most of the non-financial performance models recognise
that businesses cannot entirely focus on the future and so suggest measuring short-
term financial performance in some way such as profitability, liquidity and risk.
2. Competitive performance – setting standards on market share and sales growth is
sensible as competitors will almost always present.
3. Flexibility – an organisation needs to be flexible and punctual in the way it deals
with its customers. The more it is able to say ‘yes’ to a customer request, the more
customers it will have. However, before saying ‘yes’, make sure the organisation is
able to cope with demand. For example in the context of a restaurant, range of items
on the menu, overtime worked, times of booking and so on can be used as KPIs.
4. Resource utilisation – organisation has to consider how efficiently the
resources/assets are being utilised. Asset turnover is normally used, but other NFPIs
are possible as well depending on the type of business. For example a hotel, rooms
occupied can be compared to rooms available.
5. Innovation – organisation that can find innovative ways of satisfying customers’
needs has an important competitive advantage. Standards can be set for the number of
new ideas it generates and the successfulness of the new ideas (eg. sales from new
products).
6. Quality of service – an organisation has to decide what quality means for it. For
example, a restaurant’s quality might be based around standards for waiting times,
taste of food, service level and so on.
The dimensions can be divided into two sets: the results (measured by financial and
competitive performance) and the determinants (the remainder). Improvement of
determinants should lead to improvement in results. You may find that mnemonic
FRIQ is useful to remember the determinants.
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Difficulties of target setting in qualitative areas
It is not easy to set target in qualitative areas as sometimes we don’t know what target
is the most suitable one and qualitative information is not in numbers. A single target
can easily be abused, for example when the chef is asked to cook as fast as possible,
the chef can do it but the taste of food could be ignored. But too many targets can
confuse people as well. There are no rules guiding you how many targets/measures to
be set in qualitative areas, qualitative measures are by nature subjective. Therefore,
the organisation has to be clear on what it considers to be important and targets must
be set there. For example, instead of asking the chef to cook faster, the restaurant can
keep the customers waiting for a while and in return providing them a fresh cooked
delicious food. With this, the target is set at a right area.
Performance measures which are suitable to the division will depend on which
responsibility centre is the division. Principle of controllability is very relevant. Most
organisations are divisionalised where managers of business areas are given a degree
of autonomy to make decision such as set selling prices, choose suppliers and so on
without referring to senior management.
Responsibility centres
We have four types of responsibility centres as part of the organisation structure:
1. Cost centre – managers are responsible for cost only and do not generate revenues.
2. Revenue centre – managers are responsible for raising revenue without any link to
associated costs.
3. Profit centre – managers are responsible for both costs and revenues.
4. Investment centre – managers are responsible for capital investment and also the
responsibilities of the profit centre.
According to principle of controllability, managers are only accountable for what they
can control, therefore we should measure the performance based on the responsibility
of the managers in different responsibility centres.
Advantages of ROI
1. It is a relative measure and so it facilitates comparison of performance between the
divisions.
2. Easy to understand as the amount is in percentage.
3. Information needed to calculate ROI is readily available in income statement and
statement of financial position.
Advantages of RI
1. It makes divisional managers aware of the cost of financing their divisions, this is
because the cost of capital is used as part of the calculation.
2. It is an absolute measure of performance, positive figure means good.
3. All divisions will be motivated to take projects which have a higher return than the
company’s cost of capital, this will avoid sub-optimal decisions made by managers.
4. In the long run it supports the NPV approach to investment appraisal (present value
of a project’s RI equals net present value of that project).
Disadvantages of RI
1. Residual income gives the symptoms not the causes of problems. If residual income
falls the figures give little clue as to why.
2. Problems exist in comparing the performance of different sized divisions (large
divisions will earn larger residual incomes simply due to their size). This is because
RI is an absolute measure.
3. RI when applied on a short term basis is a short term measure of performance and
may lead to short-termism.
4. Require an estimate of the cost of capital which can be difficult to calculate.
5. Some managers may be unfamiliar with RI.
Transfer pricing
It is common that one division (selling division) produces immediate product (one
that is used as a component of another product) and sells it to another division (buying
division), then buying division will incur some extra costs to come out with the final
product. Transfer price is the sales of selling division and is a variable cost to the
buying division.
Transfer pricing when there is perfect market exists for immediate good
In this case, transfer prices may be based on the market price of the immediate good.
With this, the selling division will be motivated to sell internally (since it is the same
price as selling externally) and it can make a fair profit. A market price as the transfer
price can result in decisions which would be in the best interests of the company as a
whole. However there are some disadvantages of market price based transfer price:
1. A comparable product might not be available to establish the price.
2. Prices are not always consistent and stable.
3. An internal transfer of goods may involve savings in advertising, packaging and
delivery costs, so market price would not be entirely appropriate.
Transfer pricing when there is imperfect or no market exists for immediate good
When there is imperfect market (market in which some of the producers and/or
consumers are significant enough to affect the price and quantity of goods by their
actions alone) or no market for the immediate good, market price is not suitable as a
transfer price. Other methods such as cost-based or cost-plus will be common, note
that standard costs instead of actual costs should be used for transfer prices to avoid
encouraging inefficiency in the selling division.
Example: Selling division has a variable cost of $18 and fixed cost of $12. The
transfer price is $30 (full cost), buying division has its own variable cost of $10 and
market price of immediate product is $35.
Not-for-profit organisations (NFPOs) are those organisations that are not formed
primarily to make profit but probably to serve public interest. NFPOs are normally
under public sector. Examples of NFPOs include schools, public hospitals, public
universities and so on.
External considerations are factors that arise outside an organisation which can have
impact on the objectives and actual performance of the organisation. We have to allow
for external considerations in performance management.
Stakeholders
Stakeholders are a group of people who have interest in the company’s activities.
There are three types of stakeholders:
1. Internal stakeholders – employees and management.
2. Connected stakeholders – shareholders, customers, suppliers and lenders.
3. External stakeholders – community, government and pressure groups.
Stakeholders will influence the activities of an organisation, the level of influence
depends on the power and interest of the stakeholders. When there are several
influential stakeholder groups, the company may need to take their conflicting
interests into consideration and set objectives and performance targets accordingly.
Market conditions
Market conditions are factors that influence the state of market. These include
political, economy, social and technological factors (PEST).
1. Political – investors would not like to invest in a company operating in an unstable
political environment unless the returns are high enough to compensate the risks.
2. Economy – inflation, interest rates, exchange rates, tax rates and so on can have a
very serious influence on business.
3. Social – changes in populations such as social structure and the wealth of people
can influence the sales of the business.
4. Technological – the technology level of the business will decide the
competitiveness of it and different countries have different technology level.
These four factors will affect the market conditions and the performance of the
organization can be affected by them.
Competitors
Performance of an organisation will also be affected by the nature of competition in
market and also actions taken by competitors. This is especially in the case of pricing,
company cannot set a price without taking competitors’ price into account.
Performance of the company in a competitive market may be measured by the size of
market share that it obtains.
We can alter the objectives to allow for external considerations, set performance
targets by making assumptions about external factors and assess actual performance
by taking into consideration unexpected developments in the external environment.
With this, the true performance of the organisation can be seen and the comparison of
performance between divisions in different countries will be possible.
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Interpreting performance in the light of external considerations
In the exam, if one division is being affected by the external consideration, do not
directly compare the performance of it with the other division and comment on the
performance, same goes to the comparison of the performance of the organisation as a
Many organisations have systems for linking the achievement of performance targets
with rewards for successful individuals. But there are also behavioural problems with
rewards systems. The problems include:
1. Manager may take decisions that increase his divisional performance at the expense
of other divisions and group’s performance, eg. transfer pricing decision.
2. High level of output may be achieved at the expense of quality.
3. Managers may revise the budget so that they can get favourable operational
variances to get rewards.
4. Purchase managers may buy raw materials at cheaper price to get favourable
material price variance without considering the quality.
5. Managers may not wish to make investments if their performance is measured by
ROI so that ROI will not reduce.
It is very important that the top management set up a good reward system so that it
will not affect the performance measurement. A good reward system should be fair,
motivational, understandable, consistently applied and objective.
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