97 Management Accounting Complete

Management accounting
T. Ahrens
2790097
2005
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This guide was prepared for the University of London External Programme by:
T. Ahrens, BA, MSc, PhD, Professor of Accounting, Warwick Business School, University
of Warwick.
This is one of a series of subject guides published by the University. We regret that due
to pressure of work the author is unable to enter into any correspondence relating to,
or arising from, the guide. If you have any comments on this subject guide, favourable
or unfavourable, please use the form at the back of this guide.
This subject guide is for the use of University of London External students registered for
programmes in the fields of Economics, Management, Finance and the Social Sciences
(as applicable). The programmes currently available in these subject areas are:
Access route
Diploma in Economics
BSc Accounting and Finance
BSc Accounting with Law/Law with Accounting
BSc Banking and Finance
BSc Business
BSc Development and Economics
BSc Economics
BSc (Economics) in Geography, Politics and International Relations, and Sociology
BSc Economics and Management
BSc Information Systems and Management
BSc Management
BSc Management with Law/Law with Management
BSc Mathematics and Economics
BSc Politics and International Relations
BSc Sociology.
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Contents
Contents
Introduction 1
Aims 1
Learning outcomes 1
Why study management accounting? 1
Organising your studies 2
Essential reading 4
Further reading 4
Examination advice 5
Abbreviations 6
Chapter 1: Modern management accounting 7
Essential reading 7
Further reading 7
Aims 7
Learning outcomes 7
Introduction 7
Management accounting, cost accounting and financial accounting – routine
and non-routine information provision 8
From record keeping to problem solving? The strategic turn in management accounting 9
‘Price leadership’ and ‘differentiation’ 10
Calculating success 10
Strategic management accounting 11
Information technology 11
Enterprise Resource Planning Systems (ERP) 12
Planning, controlling and ‘experience’ 13
The budgeting process and ‘beyond’ budgeting 14
Decision-making and organisational goals 15
Stakeholders 15
Sample examination question 16
Suggestions for answering the sample examination question 16
Chapter 2: Decision-making 17
Essential reading 17
Further reading 17
Aims 17
Learning outcomes 17
Levels of decision-making 17
The importance of cash flows 18
Opportunity costs 19
The concept of relevant costs and revenues 20
Identifying relevant costs and revenues 21
Purchased resources 21
Resources already under the organisation’s control 22
Decision-making and current replacement cost 22
Comparing cash flows in the long run 23
Discounting 24
The net present value decision rule 24
Making estimates for project appraisals 25
Problems with the opportunity cost concept 27
Uncertainty and relevant information 28
Characteristics of useful information 28
i
Objective and subjective probabilities 29

Expected value 30
The value of information 30
Chapter 3: Cost behaviour 33
Aims 33
Introduction 33
The elements of total costs and their behaviour 33
Direct and indirect costs 34
Fixed and variable costs 34
Costs in-between 35
The identification of cost drivers 36
Allocation 37
Cost estimation 37
Linear regression 39
Error terms and outliers 39
Cost-volume-profit and break-even analysis 40
Chapter 4: Costing and pricing 43
Aims 43
Costs and pricing 43
Contribution margin pricing 44
Short-term decisions with one scarce resource 45
Contribution per bottleneck resource 46
More than one scarce resource: linear programming (LP) 46
Dual prices (shadow prices) and opportunity costs 48
Dual (shadow) prices 49
Opportunity costs 49
Chapter 5: Budgeting and control 51
Further reading 51
Aims 51
The purposes of budgets 52
Budget organisation 53
Budget frequency 53
Types of budgets 54
Budgeting and control 55
Variance analysis 57
The interpretation of variances 59
Chapter 6: Traditional cost systems 61
Aims 61
ii
Contents
The nature of costing systems and their integration into financial accounting systems 61
Cost centres and control 62
Process costing 63
Example of process costing 63
Job costing 65
Batch and contract costing 66
Allocation of fixed overheads 66
Example of an absorption costing system 67
Variable costing 68
Chapter 7: Activity-based costing (ABC) 71
Further reading 71
Aims 71
‘Overhead creep’ in multi-product firms 71
Instruments Inc. 72
Over- and undercosting 72
Cost drivers 72
Cost pools 73
Cross-subsidisation 74
Towards activity-based management 74
Products and processes 75
Customer focus 75
Service industries 75
ABC adoption 75
The costs of ABC 76
Some problems with ABC 76
Homogeneity of cost pools 76
Homogeneity of cost drivers 77
Outlook 77
Chapter 8: Inventory costing 79
Further reading 79
Aims 79
Learning objectives 79
Introduction 79
The purposes of standard costing 80
How to develop standards 80
When is standard costing recommended? 80
Actual costing 81
Inventory accounting and income measurement 82
Marginal (or direct or variable) costing 83
Absorption (or full) costing 83
Production volume variance 84
Profit impact of different methods 85
The key lies in the inventory 87
How to cheat with inventory accounting 88
iii
Chapter 9: Performance measurement systems 89

Further reading 89
Aims 89
Introduction 89
Main components of performance measurement systems 90
Financial records 90
Responsibility structures 90
The three most common responsibility centres: cost centres, profit centres
and investment centres 91
Transfer prices 91
Transfer-pricing methods 91
Gasoil & Co. 92
Divisional and corporate profit calculations 93
How a transfer price may lead to sub-optimal decisions 94
Financial measures 95
Divisional performance 97
Chapter 10: Strategic management accounting 99
Further reading 99
Aims 99
Target costing 100
Life cycle costing 101
Quality costs and the theory of constraints (TOC) 101
Costs of quality 102
Techniques used to identify quality problems 103
Theory of constraints (TOC) 104
Bottlenecks 104
The balanced scorecard 104
‘Lead’ and ‘lag’ indicators 105
Evidence 106
Outlook 106
Enabling management control systems 107
Appendix: Sample examination paper 109
iv
Introduction
Introduction
Aims
This unit is designed to give students a grounding in the key concepts and
techniques of management accounting, and to prepare them for the use of
recent innovations in the management accounting function. Traditionally
concerned with the recording and measurement of costs, management
accountants have increasingly become concerned with supporting the
management of organisational strategy. This has entailed the inclusion of
non-financial information in management accounting reports that are
becoming increasingly tailored to organisational circumstances. Underlying
this work of providing information is a core of economic principles, to which
I will make reference throughout this subject guide.
Your subject guide is arranged in three main sections. The first section
introduces traditional and contemporary functions of management
accounting and some of the key economic concepts underlying management
accounting. The second section covers costing principles and costing systems,
with some recent managerial applications, such as activity-based
management. The third section puts costing principles and systems into
context by explaining what roles they would play as part of an organisation’s
performance measurement and strategic management accounting systems.
Learning outcomes
Specifically, for this unit you should be able to:
• assess the possible uses of information for different types of decision-
making
• calculate and distinguish between different types of costs and explain the
role of costs for pricing and other business decisions
• prepare budgets and explain the significance of budgets for planning and
control
• explain the functioning of costing systems and analyse, calculate and
interpret variances
• discuss the problems of performance measurement and control
in divisionalised organisations and calculate simple measures
of performance
• explain the changing role of management accounting.
Why study management accounting?

After completing your degree you may want to work in government, for a
firm, or for a non-profit-making organisation. Whatever you do, you will
meet people who are concerned with the resources which you consume to do
your work, and who will ask what the benefits of your activities are. They
will very often want to measure your department’s inputs and outputs in
money. Theirs is the language of cost, revenue and return on investment.
They rely on some form of accounting to evaluate the internal functioning of
your organisation. This is what is called management accounting or
managerial accounting. Whether or not you want to be a specialist in this
1
field, you will become involved in discussions of the uses of resources. This
subject is intended to help you understand the thinking behind management
accounting calculations, devise alternative ways of accounting for
organisational activities and put accounting into perspective relative to other
ways of describing the organisation.
Think back to Elements of accounting and finance (or Principles of
accounting). How would you describe the nature of the accounting
knowledge with which you are now acquainted? Is it a science? Is it an art?
Is it a more or less coherent set of rules for practice? There seem to be
elements of all of those three labels in accounting. You can find theory, for
instance, on the notions of wealth, income and profit. To calculate the profit
of an accounting period you need to rely on experience to carefully balance
somewhat contradictory principles, such as the matching and the prudence
principle. Finally, accounting also contains certain rules, relating, for
example, to depreciation or to the arrangement of financial statements.
Often, those rules are laid down in accounting standards, the law,
government regulation, audit practice statements, etc. You can see that
accountants need to draw on theory and their experience to arrive at
judgements that can be justified within the existing rules of practice.
Organising your studies

If you are following regular instructions at a teaching institution you ought to
read through each chapter of the subject guide once before you attend any
relevant teaching sessions to get the flavour of the topic. Take it as an
opportunity to learn to read faster. Read the introduction of each chapter
completely, then read only the first and the last sentence of each paragraph.
‘Scan’ the lines in between. If you do not get a sense of the argument, read
paragraphs completely. This should not take you longer than 10 or 15
minutes per chapter. After attending the lecture, you should then read the
chapter more slowly. With your newly-gained overview of the topic, you can
probably do that in 30–40 minutes. It is important to take your time to think
about the activities in the chapter. Often things seem clear to you so long as
you just follow my writing. When you are asked to do the activities you have
a chance to express things in your own words and explain things to yourself.
Teaching is the best way of learning!
How should you use the textbook? The reading relevant to each chapter is
listed at the beginning of each chapter. The essential reading consists of one
or more textbook chapters and specified journal articles that are mostly
available online through the University of London online library (see below
‘Reading’). In working with the textbook it is important to remember that
the subject guide is not meant to replace the textbook. The subject guide
provides a framework for your study, contains aims and learning objectives
for each topic, and references to the essential and further reading, acts as
a pointer to the most important issues in each topic, provides additional
explanations where appropriate, and contains additional worked examples,
activities to involve you in the topic and clarify its relevance, and sample
exam questions. Your use of the textbook depends very much on whether
you receive instruction from a teaching institution or whether you study
by yourself.
If you receive instruction, the main role of the textbook is to support what
you have learned at your teaching institution. It can confirm what you have
learned already and present topics in a slightly different light. As you read
the textbook, ask yourself, how do the chapters relate to the subject guide?
Which are useful examples, where does the textbook chapter elaborate
2
Introduction
a concept in more depth, and where does it simplify the argument made in
the subject guide. The many examples in the textbook allow you to become
more secure in your understanding of specific techniques. Depending on how
familiar you are with the topic when you start reading the assigned material,
it might take you between 45 and 90 minutes. I would recommend that you
read the textbook after your instruction – most students prefer this and find
it saves them time. However, some students find that they are not able to
follow the instruction as well as they would like to if they leave the essential
reading until after the instruction. In this case you should read the relevant
sections in the textbook beforehand. But be sure to return to the essential
reading after the relevant teaching session because the instruction often
highlights important aspects of a topic that you did not notice upon first reading.
If you study by yourself, the textbook and the other readings are your main
source of knowledge. This means you will need more time on each topic,
typically between one and a half and two hours. Start always with the
textbook before moving on to journal articles. Make sure you understand the
logic of the learning objectives at the beginning of each chapter. Read
carefully through the assigned material, making sure you understand how
the various exhibits and the summaries in the margins relate to the main
text. As you read, try to relate the text to the learning objectives for this
chapter. After completing a chapter, go over the summaries in the margins
again and make sure they still make sense! In my experience, for checking
that you really understand a chapter, it is useful to wait for a day or two
before attempting the problem for self-study at the end of each chapter. They
have detailed solutions for your guidance. After completing the work for each
topic you should have a sense of how the material integrates with the
previous topics. This subject guide is written in order to support you in this.
Especially if you study by yourself you should benefit from the fact that the
textbook takes a holistic approach to the subject of management accounting.
It does not make artificial distinctions between the main topics of the
individual chapters, but makes reference to relevant issues at different point
in the book. For example, activity-based costing (ABC) has its own chapter
(Chapter 5) but reference to ABC is also made on page 337 because ABC is
relevant to the question of cost behaviour. The advantage of this holistic
approach is that it explains the relevance of certain techniques in relation to
different ideas within management accounting. Therefore, if you seek to find
out more about a particular topic or technique, consult firstly the glossary
and then the index. Follow up the references from the index to find out about
the different ideas in relation to which a topic or technique is explained.
Management accounting is a practice that has developed over a long time
and in response to different demands. As a consequence, it does not always
appear logical at first!
When you have finished your textbook reading, and made such notes as you
consider useful, you should test your understanding of the topics covered by
attempting the sample questions that appear at the end the relevant chapter
of this subject guide or the exercises that appear at the end the relevant
chapter of the textbook.
It is helpful to look back regularly to the earlier chapters of the subject guide,
in order to refresh and reinforce your understanding of the earlier topics.
Also, it is a good idea to follow up some of the references provided in the
textbook together with the suggestions for further reading which I give you
in the subject guide. Even though I have indicated how much time I think is
appropriate for working through the guide and the readings, it is difficult to
predict how much time different students need to spend on this topic. Overall,
you will probably need to devote between three and four and a half hours per
3
week in addition to any time you may have spent in lectures. That should
cover lecture preparation, organisation of lecture notes after the lecture,
reading in the guide, essential reading, further reading and exercises.
Essential reading
Horngren, Charles T., Srikant M. Datar and George Foster Cost accounting: a
managerial emphasis. (Prentice Hall Publishing, 2003) eleventh edition
(international) [ISBN 0-13-099619-X].
This subject guide is largely a commentary on that book and I recommend
that you purchase it. If you find a tenth edition second hand (at a good
price!) it would be equally suitable.
Further reading
It is essential that you support your learning by reading as widely as possible
and by thinking about how those principles apply in the real worlds. To help
you read extensively, all external students have free access to the University
of London online library where you will find either the full text of or an
abstract of many of the journal articles listed in this subject guide. You will
need to have a username and password to access this resource. Details can be
found in your handbook or online at:
www.external.ull.ac.uk/index.asp?id=lse
Ahrens, T. and C.S. Chapman ‘Accounting for flexibility and efficiency: A field
study of management control systems in a restaurant chain’, Contemporary
Accounting Research (2004) 21(2): 271–301.
Ahrens, T. and C.S. Chapman ‘Occupational identity of management
accountants in Britain and Germany’. European Accounting Review (2000)
9(4): 477–498.
Balakrishnan, R. and G.B. Sprinkle ‘Integrating Profit Variance Analysis and
Capacity Costing to Provide Better Managerial Information’, Issues in
Accounting Education (May 2002) Vol. 17 Issue 2: 149–162 [concentrate on
the case study in this paper].
Chapman, C.S. and W.F. Chua ‘Technology-driven integration, automation and
standardisation of business processes: implications for accounting’. In A.
Bhimani (ed.) Management Accounting in the Digital Economy. (Oxford:
Oxford University Press, 2003) pp. 74–94.
Cooper, R. and R.S. Kaplan ‘Measure Costs Right: Make the Right Decisions’,
Harvard Business Review (September–October 1988): 96–103.
Cooper, R. and W.B. Chew ‘Control Tomorrow’s Cost Through “Today’s Design’’,
Harvard Business Review (January–February 1996): 80–97.
Covaleski, M.A., J.H. Evans III, J.L. Luft and M.D. Shields ‘Budgeting Research:
Three Theoretical Perspectives and Criteria for Selective Integration’,
Journal of Management Accounting Research (2003) Vol. 15: 3–51.
Friedman, A.L. and S.R. Lyne ‘Activity-based techniques and the death of the
beancounter’, European Accounting Review (1997) 6(1): 19–44.
Goldratt, E. and J. Cox The Goal. (North River Press, 1992) second edition.
Hayes, R.H. and W.J. Abernathy ‘Managing our way to economic decline’,
Harvard Business Review (1980) 58(4): 67–77.
Hopper, T., T. Koga and J. Goto ‘Cost accounting in small and medium sized
Japanese companies: an exploratory study’, Accounting & Business Research,
(Winter 1999) Vol. 30 Issue 1: 73–87.
Ittner, C. and D. Larcker ‘Moving From Strategic Measurement to Strategic Data
Analysis’, C.S. Chapman (ed.) Controlling Strategy: Management, Accounting
and Performance Measurement. (Oxford: Oxford University Press, 2005).
Ittner, C. and D. Larcker (2003) ‘Coming up Short on Nonfinancial Performance
Measurement’, Harvard Business School Press, 81/11: 88–95.
4
Introduction
Johnson, H. and R. Kaplan Relevance lost: The rise and fall of management
accounting. (Boston: Harvard Business School Press, 1987) [ISBN
0875841384].
Kaplan, R.S. and S.R. Anderson ‘Time-Driven Activity-Based Costing’, Harvard
Business Review (November 2004) Vol. 82 (Issue 11): 131–140.
Kaplan, R.S. and D.P. Norton ‘Transforming the Balanced Scorecard from
Performance Measurement to Strategic Management: Part I’, Accounting
Horizons (2001a) 15(1): 87–105.
Kaplan, R.S. and D.P. Norton ‘Transforming the Balanced Scorecard from
Performance Measurement to Strategic Management: Part II’, Accounting
Horizons (2001b) 15(2): 147–161.
Mouritsen, J. ‘Five aspects of accounting departments’ work’, Management
Narayanan, V.G. and R.G. Sarkar ‘The Impact of Activity-Based Costing on
Managerial Decisions at Insteel Industries – A Field Study’, Journal of
Economics & Management Strategy (Summer 2002) Vol. 11, number 2:
257–288.
Roslender, R. and S.J. Hart ‘In search of strategic management accounting:
theoretical and field study perspectives’, Management Accounting Research
(2003) 14(3): 255–279.
Sahay, S.A. ‘Transfer Pricing Based on Actual Cost’, Journal of Management
Accounting Research (2003) Vol. 15: 177–193.
Simmonds, K. ‘Strategic Management Accounting’, Management Accounting
(1981) 59(4): 26–29.
Simon, H.A. Centralisation Vs Decentralisation in Organizing the Controller’s
Department. (Houston: Scholars Books Co., 1954) third edition.
Spiller Jr., E.A. ‘Return on Investment: A Need for Special Purpose Information’,
Accounting Horizons (June 1988) Vol. 2, Issue 2: 1–10.
Verdaasdonk, P. and M. Wouters ‘A generic accounting model to support
operations management decisions’, Production Planning & Control,
(September 2001) Vol. 12 Issue 6: 605–21.
Examination advice
Important: the information and advice given in the following section are
based on the examination structure used at the time this guide was written.
Please note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Regulations for
relevant information about the examination, and the current Examiners’
reports where you should be advised of any forthcoming changes. You should
also carefully check the rubric/instructions on the paper you actually sit and
follow those instructions.
The subject is examined in a written unseen examination which lasts for
three hours. There are two sections. Section A contains four questions which
require the use of calculations to answer the question. Section B has essay
questions. There are four questions in each section. You must answer four
questions in total and at least one from each section. All questions carry
equal marks, 25 in total. Where the questions require you to answer different
parts, the relative weighting of marks is given. Typically, those questions
which ask you to perform calculations also ask you to interpret your results in
a later part. Some of the essay questions may give you a further choice of two
questions. At the end of each chapter in the subject guide I will be showing
you one or two sample questions. Note that the questions cannot usually be
answered with reference to only one chapter in the subject guide, but require
you to integrate the material with other chapters, textbook and journal
article reading, and also with other subjects, such as Elements of
accounting and finance (or Principles of accounting).
5
Before you are examined, you will be sent past examination papers and
associated Examiners’ reports for this unit. The Examiners’ reports contain
valuable information about how to approach the examination and so you are
strongly advised to read them carefully. Past examination papers and the
associated reports are valuable resources when preparing for the examination.
Both question papers and reports for the last three years are available online
but you should be aware that the syllabus and subject guide were revised for
2005 and bear this in mind as you look at past examination papers. You
should also consult the Examination section of your Student Handbook.
Abbreviations
Following is a list of abbreviations used in this subject guide.
ABC activity-based costing
ABM activity-based management
CVP cost-volume-profit analysis
ERP enterprise resource planning system
JIT just-in-time inventory system
LP linear programming
NPV net present value
OWM owners’ wealth maximisation
R&D research and development
RI residual income
RoI return on investment
SMA strategic management accounting
TOC theory of constraints
WACC weighted average cost of capital
6
Chapter 1: Modern management accounting

Essential reading
(international) [ISBN 013099619X] Chapter 1.
Mouritsen, J. ‘Five aspects of accounting departments’ work’, Management
Further reading
Ahrens, T. and C.S. Chapman ‘Occupational identity of management
accountants in Britain and Germany’, European Accounting Review (2000)
9(4): 477–498.
Chapman, C.S. and W.F. Chua ‘Technology-driven integration, automation and
standardisation of business processes: implications for accounting’, A.
Bhimani (ed.) Management Accounting in the Digital Economy. (Oxford:
Oxford University Press, 2003) pp. 74–94.
Friedman, A.L. and S.R. Lyne ‘Activity-based techniques and the death of the
beancounter’, European Accounting Review (1997) 6(1): 19–44.
Johnson, H. and R. Kaplan Relevance lost: The rise and fall of management
accounting. (Boston: Harvard Business School Press, 1987).
Roslender, R. and S.J. Hart ‘In search of strategic management accounting:
theoretical and field study perspectives’. Management Accounting Research,
(2003) 14(3): 255–279.
Simmonds, K. ‘Strategic Management Accounting’, Management Accounting
(1981) 59(4): 26–29.
Simon, H.A. Centralisation Vs Decentralisation in Organizing the Controller’s
Department. (Houston: Scholars Books Co., 1954) third edition.
Aims
The aim of this chapter is to clarify what the term ‘modern management
accounting’ means and why it has gained currency. It also outlines how
recent changes in the management accounting function have affected the
role of the management accountant in organisational practice.
Learning outcomes
After reading this chapter and the essential reading, you should be able to:
• define the terms ‘modern management accounting’ and ‘strategic
management accounting’
• explain why organisations have become concerned with modern
management accounting
• evaluate the extent to which modern management accounting has
changed the role of the management accountant.
Introduction
Modern management accounting is a term that has become more popular
over the last decade or so. It implies a changing set of preoccupations among
management accountants. In the past the vast majority of management
accountants have been regarded as technical specialists whose expertise lay
7
in the operation of accounting and other information systems. This included

the preparation of reports to support management decision-making. Recently,
more emphasis has been put on giving commercial advice to management.
Management accounting, cost accounting and financial

accounting – routine and non-routine information provision
In contrast with financial accounting, which is concerned with accounting
reports for the external constituents of an organisation, such as banks,
investors, trade unions, suppliers, customers and the government, management
accounting produces the reporting for a key internal constituent, namely
management. The idea is to produce and communicate information that is
relevant to managerial decision-making.
Management accounting is therefore much more detailed and potentially
much more varied than financial accounting because it ought to respond to
specific information requests rather than follow general reporting standards
that are valid for very different types of organisations. This is not to say that
all management accounting reporting is ad hoc. An important distinction
with respect to management accounting work is that between routine and
non-routine reporting.
Routine reports regularly cover defined aspects of organisations, such as
efficiency variances of certain input factors, which allow the charting of
trends over time and structured comparisons between different entities
within the organisation. They can be prepared according to widely-used
principles of calculation or be tailor made for the organisation. Non-routine
reports analyse one-off events or decisions that can benefit from in-depth
studies of their different aspects. It is often said that routine reports concern
ongoing operations and non-routine reports tend to be concerned with
investment decisions. Often this is the case but it is also possible that
non-routine reports are prepared to address specific aspects of operations,
such as the further analysis of unusual production variances. Likewise,
certain kinds of investment decisions may, especially in large organisations
with great investment volumes, be highly routinised.
A typical textbook definition of management accounting is that ‘it measures
and reports financial and non-financial information that helps managers
make decisions to fulfil the goals of an organization’ (Horngren et al., 2003),
which covers routine and non-routine decisions. Management accounting
builds on financial accounting information because it requires measurements
and records of business transactions from diverse systems such as creditors
and debtors records, the payroll, the fixed asset inventory, etc. It also
builds on cost accounting, defined as the provision and communication
of cost information.
In addition, management accountants can create additional ‘fictitious’ or
‘notional’ accounting information, for example, by charging opportunity
costs for uses of capital. Imagine, for example, two manufacturing divisions
engaged in similar activities and producing similar output levels. Imagine
further that one division uses twice as much working capital (debtors,
inventory, cash) as the other. In terms of reported profit, based on financial
accounting records, those two divisions are very similar. But the division that
produces its results with less working capital achieves a preferable result
because it leaves a lot of working capital unused. Thereby, it allows the
organisation to expand activities with the unused working capital, thus
potentially enhancing profitability. Management accountants may therefore
decide to include a notional interest charge on working capital when
8
calculating the financial contribution of the divisions. This incentivises

divisional managers to be economic with working capital by, for example,
seeking to minimise inventory or asking debtors to pay earlier. The overall
financing costs of the organisation would be lower as there would be lower
interest payments on bank overdrafts, loans, bonds, etc.
Cost accounting is more technically oriented than management accounting.
It ‘measures and reports financial and non-financial information relating to
the cost of acquiring or consuming resources in an organisation’ (Horngren
et al., 2003, p.836). Cost management, by contrast, is defined by Horngren et
al. (2003) as ‘the approaches and activities of managers in short-run and
long-run planning and control of decisions that increase value for customers
and lower costs of products and services.’ (p.837). This makes cost
management a key part of the organisation’s general management strategies
and their implementation.
How important is cost reduction for organisations? Is it a relevant strategy for
all organisations? This is probably not the case. Some organisations focus
their management attention on, say, market differentiation strategies,
thereby avoiding price competition. They may not possess the management
capacity to also pursue an elaborate cost reduction strategy (although in
principle price competition and market differentiation strategies do not
preclude each other).
Activity
Fill in the following table based on your understanding of the previous section. Reread
the section if necessary.
Table 1.1: A comparison of financial accounting and management accounting

Characteristics of Characteristics of
financial accounting management accounting
Users of information
Extent of formal regulation
Degree of uniformity across
different organisations
Degree of detail
Likelihood of including
non-financial information
Relevance for managerial
decision-making
From record keeping to problem solving? The strategic turn

in management accounting
The relationship between management accounting and strategic
management has over the last decade or so been undergoing some changes.
By ‘strategic’ management, I mean those aspects of management that are
concerned with the core competencies of the organisation. Typically, those
core competencies are defined with respect to an organisation’s relationships
with customers, suppliers, competitors, and the markets for labour and
capital. The core competencies describe what the organisation can
(uniquely) offer its customers in ways that are superior to the competition,
using its own process capabilities as well as its relationships to suppliers and
its own specific access to labour and capital markets.
9
‘Price leadership’ and ‘differentiation’

Two ‘generic’ strategies that are frequently distinguished are ‘price
leadership’ and ‘differentiation’. ‘Price leadership’ implies low prices
combined with a standardised offering. The strategic effort goes into
developing a customer proposition that appeals to large numbers of
customers and can be provided at low cost. Product variation or even
tailoring products to individual customers’ wishes is then not usually part of
the product offering. Budget airlines are a recent and fairly extreme example
of this strategy.
By contrast, ‘differentiation’ emphasises the satisfaction of individual
customers’ wishes as closely as possible, be it with respect to quality of
manufacture, ease of use, flexibility of application or delivery, product
variety, reliability or any combination of these. An example would be luxury
motor vehicle manufacturers. Product cost is also a concern for organisations
that pursue this strategy but not to the same extent as for those that pursue
price leadership.
Even though the strategy literature often portrays price leadership and
differentiation as strategic opposites, in practice one usually finds combinations
of the two, for example, in the various markets for electronic consumer goods.
There are different reasons for this. In large organisations some divisions
may tend towards one strategy and some towards the other. During their
life cycle, certain products may start out as differentiated products that are
tailored towards the high price segment (perhaps because they are innovative),
and later they may be marketed to compete mainly on price (perhaps because
many competitors have entered this market, production volumes have
increased and high quality is no longer a differentiating factor).
The strategic relevance of management accounting would depend on the
extent to which it supports management in finding out which strategy is
most promising for an organisation. Here one would expect management
accountants to prepare alternative scenarios together with marketing, product,
and production managers who assess the long-term profitability of operating
in different markets, offering different price–value combinations to different
customer segments. In target costing, value engineering and life cycle costing,
for example, which are explained in later chapters, and which you should
look up in your textbook’s glossary, the experience has been that such efforts
are best placed in the development and design stages of a new product because
here a large percentage of a product’s cost is built into its design. The role of
management accountants can be to advise on the cost implications of certain
design choices and calculate the added revenue that can be expected from
additional product attributes (e.g. reliability, functionality, appearance, etc).
Calculating success
Strategic management is, however, also concerned with finding out if certain
strategies have been pursued successfully. Here management accountants
can prepare cost and revenue information by product, product group and
market segment, calculating variances in sales volumes, sales mix and market
shares, and their implications for profitability. Ideally one would want to
calculate the profit impact of pursuing certain strategies. A common problem
in this respect is the isolation of causal factors because the environments of
organisations tend to change in many respects at the same time from one
reporting period to the next.
10
At a more elementary level, strategic cost accounting might calculate the

costs of providing certain product attributes that are important for an
organisation’s strategy. For example, a fast food chain might want to calculate
the cost of providing high levels of cleanliness through its estate, or a vehicle
manufacturer the cost of being able to offer engines with lower emissions
than the competition.
Strategic management accounting

In the 1980s management accounting and accountants were criticised for
their failure to recognise organisations’ new strategic priorities (Johnson and
Kaplan, 1987), and from this decade stem many of the initiatives to make
management accounting more strategically relevant. The reproach was
that management accounting was in fact dominated by financial reporting
requirements and took no account of what decision-makers wanted to know.
For example, standard costing systems allocated overhead costs to products
that were not causing them, and standard costs were updated so infrequently
that changes in the design and manufacture of products quickly made them
obsolete.
One of the attempts to correct the shortcomings of traditional standard
costing systems was Activity-based costing (ABC), which sought to allocate
manufacturing overheads depending on the manufacturing activities that
were caused by a product, and which is the subject of Chapter 7. A more
general suggestion to enhance the managerial relevance of management
accounting was Simmonds’ (1981) concept of Strategic Management
Accounting. It focused on the incorporation of marketing knowledge into
management accountants’ roles. A recent study by Roslender and Hart
(2003) suggested that even though the term ‘strategic management
accounting’ itself was not common in practice, on the whole, the management
accountants whom they studied could be said to possess more strategic roles
now than they had in the past.
Studies of the role of the management accountant in organisational
management in different countries have found that commercially aware and
active management accountants distinguish commercial involvement from
the ‘bean counter’ mentality of old (e.g. Friedman and Lyne, 1997). By ‘bean
counting’ they meant an overriding concern with administration, record
keeping, and elementary financial reporting work. In terms of Simon’s
(1954) old distinction between the roles of the management accountant –
namely, record keeping, attention directing and problem solving – this
implies a shift in emphasis from the first to the last two.
Information technology
If the calls for greater strategic relevance have been an important criticism
that led to conceptual changes within management accounting, an important
enabler of those changes has been the technical advances in information
technology. Contemporary accounting and information systems are significantly
more powerful and easier to operate than they were only a few years ago.
Generally speaking, it is now easier to extract information from the systems
that are used in organisations. Management accountants can offer
information that is better tailored to answer the questions of managers. In
some cases, managers can now directly access information. As a consequence,
less effort is needed on the part of management accountants to administer
information systems and serve simply as mediators between an
11
organisation’s management and its information systems. There is now the

potential for management accountants to become much more actively
involved in management decision-making.
That said, a questionnaire survey by Mouritsen (1996) about the accounting
function in the 800 largest Danish firms suggested that reports of the
‘disappearance of the bean counters’ are premature. This was one of the
largest surveys of accountants in industry with a response rate of almost 50
per cent, yielding 370 usable responses. While it is true that many traditional
record keeping and administrative tasks can now be automated and consume
less working time of the management accountants, 50 per cent of respondents
ranked general ledger work and internal controls as ‘important’ or ‘very
important’ aspects of accounting departments’ work. 56 per cent said the
same for record keeping, 63 per cent for work on financial accounts, and 54
per cent for the layout of reports. Thus it would seem that the tasks of
information systems design, the structuring of data capture, watching over
data integrity, etc. are still regarded as central to the tasks of accounting
departments. However, commercial awareness and involvement were also
rated highly. 46 per cent said that internal consulting was an important task,
and about 75 per cent of respondents mentioned the importance of
budgeting and variance analysis. In practice it would appear that good
commercial advice depends on reliably and sensibly structured data. Both
data and advice need to be regarded as priorities.
Activity
Read Mouritsen’s (1996) paper and list the five aspects of the work of the accounting
department that he found in his study. Then write one paragraph explaining if and how
Simon’s three roles can be mapped on Mouritsen’s five aspects.
Enterprise Resource Planning Systems (ERP)

In the discussion on the changing roles of management accountants one
needs to keep in mind that new technology does not automatically mean
less administrative work for management accountants. An interesting case in
point are the implications for record keeping of Enterprise Resource Planning
Systems, also known as ERP. Your textbook discusses them on pages 688–9.
ERP has been a key technological innovation of the past decade and many
large companies have spent very large sums on buying ERP systems from
companies such as SAP, Oracle, PeopleSoft, and many others that are
described on websites such as: http://www.olcsoft.com/top%20ERP%
20vendors.htm.
The basic idea of ERP was to replace the multiple stand-alone information
and accounting systems that had historically evolved in organisations with
one all-encompassing information system that would minimise data
duplication and avoid the need for comparisons of the data between systems.
With ERP, all the reports which needed to draw on, for example, the number
of units in inventory of a certain finished good, would find that information
in just one file, such that the information would not be held in any other file.
So, for example, the material requirement planning systems, the production
planning systems, the sales forecast systems, the customer order and
shipping systems, and the various accounting reports that would use this
inventory number would all be fed the same number from the same file. This
means there would be no need for updating other systems when this number
changed and there could consequently be no confusion due to time lags
between updates of different systems – a common problem within traditional
information technology environments.
12
On the face of it ERP looked like a great example of how unrewarding

manual record keeping and administrative work could be reduced, freeing up
the time of management accountants to concentrate on giving commercial
advice to managers – sometimes referred to as ‘adding value’. While some of
those expectations were met by ERP systems, they did, however, also
generate novel requirements for record keeping and data integrity work.
Because they sought to represent all organisational processes in one system
in real time, ERP systems required many organisational members who used
to provide information on paper or on subsidiary electronic systems to enter
information straight into the ERP system. Often this happened through the
automatic capture of their day-to-day work. However, that day-to-day work
usually contains data errors, which can now enter the new ERP systems
unchecked. So, for example, a mistakenly-entered invoice amount may be fed
directly and immediately into budgets, material ordering systems, creditor
management reports, etc. (Chapman and Chua, 2003). Data entry mistakes
can have greater and more immediate impact in ERP systems. This has
created new threats to organisational data integrity and new record keeping
work for management accountants.
Another important point to bear in mind in the discussion of the
modernisation of management accounting is that traditional record keeping
and modern business advice exist in parallel, and that there are potential
advantages to this. A study by Ahrens and Chapman (2000) suggested that
record keeping work served as an important entry level task for junior
management accountants. Through such work they gained experience of
specific organisational processes and the different ways in which they are
related to accounting and organisational information systems more
generally. Record keeping work can thus be useful experience on the basis of
which management accountants can, later in their career, adopt a more
advisory role that is of greater commercial and strategic relevance. Giving
commercial and strategic advice sounds great as a task for junior
management accountants but in reality it is something that newcomers need
to grow into over time. Entry level work lays the foundation for a more
important role later in the career.
Planning, controlling and ‘experience’

The headings most commonly used to describe management accountants’
work are planning, control and performance evaluation. The more senior the
management accountants who are involved in any of those three roles the
more experience of the detailed workings of the organisation they need.
This is because they are interacting with senior line managers who are
responsible for large arrays of organisational activity and who tend to have
themselves complex insights into the workings of the organisation that they
built up over time. If, as a management accountant, you want to discuss
commercial opportunities and strategic priorities with those managers,
and be in a position to effectively contest their views of what is and is not
realistically possible for the organisation to achieve, you cannot do without
experience – gained either in your organisation or with a competitor, or,
sometimes, in a different industry with similar characteristics.
Planning and control are sequential. Control (defined on page 836 of your
textbook) only makes sense if actual results can be compared against a
benchmark – the plan. In some organisations it makes sense to develop the
plan largely as a continuation of historical performance. Other organisations
13
prefer to question their planning assumptions more rigorously every time

they make a new plan, often because their operations and competitive
environment are subject to greater change.
The budgeting process and ‘beyond’ budgeting

Central to planning is the budgeting process, which is discussed in greater
detail in Chapter 5. The budget is a financial plan of the organisational
future. It typically comprises a budget profit and loss account, a budget
balance sheet, and a budget cash flow statement for the organisation as a
whole as well as for its key sub-units, be they divisions, research laboratories,
factories, sales organisations, etc. Organisations determine on a need-to-know
basis how far down in the organisational hierarchy they want to draw up
complete budget profit and loss statements for organisational sub-units.
Sometimes a factory only budgets costs (especially when it is not involved in
the process of selling and has little influence over revenues), and a sales
office only budgets revenues and the costs of running the office. It would
often not budget the costs of goods sold for the products that it sells, because
those would be controlled by the factories that supply its products. In this
case it would make sense for a larger entity, for example, a division that
controls both the sales office and the supplying factories, to budget profits
because this division is responsible for revenues and costs (and, by implication,
profit and loss).
In the debate around strategic management accounting, budgeting has been
criticised for being too administratively oriented, not producing enough
commercially-relevant information, and being too time consuming. In practice,
budgeting processes that take up nine months prior to the financial year for
which they are meant are not unusual. Typically, it takes a long time to collect
cost and revenue estimates from numerous budget holders, co-ordinate them,
and, finally, communicate a coherent plan.
Budgeting has also been criticised for inducing a culture of complacency with
respect to performance targets. Managers whose departments perform well
against budget may not be willing to push their subordinates to achieve
better than budgeted results because, firstly, budgets tend to reward
fulfilment of expectations, not overfulfilment, and, secondly, overfulfilment
may lead to heightened expectations in subsequent budgeting rounds.
Managers may thus be tempted to initially hide the effects of process
improvements and other cost savings and only use them to improve the
financial results of their units gradually – as and when future budgets
demand such improvements.
At the heart of the detection of organisational slack and similar problems
lie the ways in which budgets are used and the kinds of expectations
organisational members have of them. A diverse group of organisations that
have since 1972 come together in the Consortium for Advanced Manufacturing
International (CAM-I, see web site http://www.cam-i.org/) has formed a
sub-committee, known as the Beyond Budgeting Round Table (www.bbrt.org/),
which is specifically concerned with improving the budgeting process. The
Round Table is exploring ways of using budgets more flexibly in ways that
alleviate budgets’ performance reducing effects, for example, by introducing
‘stretch targets’, and finding ways of overcoming the gaming and creation of
slack that often occurs in the process of agreeing performance targets.
A commentary in the British newspaper The Observer provides an easily-
understandable overview over some other key problems with budgets and
makes reference to the Beyond Budgeting Round Table.
(http://observer.guardian.co.uk/business/story/0,6903,1174315,00.html).
14
Activity
Visit www.bbrt.org and have a good look around the web site, then rank what you
regard as the 10 most important criticisms of traditional budgeting practice. Which
criticisms would you regard as unimportant?
Decision-making and organisational goals

Underlying the difficulties of detecting organisational slack, or even deciding
what counts as organisational slack, is the definition of organisational goals.
Especially when you deal with matters of organisational strategy, one
manager’s slack can be another manager’s strategic resource. How much
money should be budgeted for activities of strategic relevance, such as
research and development (R&D), advertising, sales promotion, process
improvement, the speed of logistics, etc.? The key task in management
accounting is to relate budgets to organisational tasks in ways that enhance
the likelihood that the organisation meets its strategic objectives.
From an economics point of view, those objectives are easily defined. The
organisation should maximise its cash flows over its lifetime. Discounting
those cash flows to the present gives the economic value of the organisation,
or the price that the organisation’s owners can demand when they sell it.
From an economic point of view, therefore, management accounting is
concerned with owners’ wealth maximisation or OWM, which we will discuss
in more detail in the next chapter.
Stakeholders
However, owners are not the only organisational stakeholders. The social
environment of an organisation typically includes employees, customers,
neighbours, and suppliers, to name but a few. Not-for-profit organisations
may, moreover, need to consider much wider concerns. For example,
universities can be held accountable by students, parents and the wider
scientific community. Hospitals are subject to the concerns of patients, their
relatives, the professional associations of doctors, the government’s drug
regulators, etc.
Even when the number of stakeholders is small and there is agreement that
financial success is an important criterion for organisational performance,
there may exist significant differences of opinion as to what concrete actions
to take to achieve financial success. Production engineers tend to have
different solutions to organisational problems from marketing managers.
Both groups have incentives to depict particular organisational problems in
ways that suggest a solution that is designed and implemented by them, thus
increasing their own influence in the organisation.
A behavioural perspective on the organisational uses of management
accounting would take such possibilities into account. An important point
from a behavioural standpoint is that, strictly speaking, organisations have
no goals at all – only individuals have. The expression ‘organisational goal’
could then be taken as a shorthand for some sort of aggregate of the goals of
individual organisational members. Economists would regard OWM as the
measure of aggregate organisational goals. Behaviourists, by contrast, allow
conflicting goals within the organisation. What gets talked about or written
down as ‘the goals of the organisation’ or the ‘organisational mission
statement’ would then appear as a temporary settlement of ongoing dispute
that depends on the shifting powers of organisational sub-groups with
conflicting (and presumably changing) interests.
15
The implications for the role of management accounting in decision-making

are profound. There would be no a priori normatively ‘correct’ answer
because different coalitions within the organisation would prefer different
types of outcomes that cannot be clearly ranked on a scale of payoffs. The
resolution of potential conflict becomes a key task of management.
Management accounting often carries great weight in the formulation of
organisational objectives and the weighing of alternative courses of action.
One can therefore expect senior management as well as the different
organisational coalitions to attempt to use information selectively to present
the management accounting information most suitable for their causes.
Sample examination question

To what extent do you regard the current concerns with the strategic
relevance of management accounting as technologically driven?
Suggestions for answering the sample examination

question
This question can be answered in many different ways. One possibility is to
start by making a list of technological reasons for the emergence of strategic
management accounting. Looking at those reasons more closely, are you sure
that all of them are purely technological? Why were the technologies
introduced? Now you could move on to explaining what other influences
contributed to the emergence of, and demand for, strategic management
accounting.
A different way of answering the question would be to distinguish between
enablers of strategic management accounting and demand factors. Some of
the enablers could be broadly labelled as ‘technological’, but were there
perhaps other enablers, too? And was the demand for strategic management
accounting purely driven by considerations of strategy making?
16
Chapter 2: Decision-making
Essential reading
Horngren, Charles T., Srikant M. Datar and George Foster Cost accounting:
a managerial emphasis. (Prentice Hall Publishing, 2003) eleventh edition
(international) [ISBN 013099619X] Chapter 11 (without appendix on linear
programming) and Chapter 21.
Further reading
Hopper, T., T. Koga and J. Goto ‘Cost accounting in small and medium sized
Japanese companies: an exploratory study’, Accounting & Business Research
(Winter 1999) Vol. 30, Issue 1: 73–87.
Verdaasdonk, P. and M. Wouters ‘A generic accounting model to support
operations management decisions’, Production Planning & Control
(September 2001) Vol. 12 Issue 6: 605–21.
Aims
This chapter covers the economic foundations of management accounting
theory and practice. Specifically, it suggests that management accounting
ought to help in decision-making; indeed, that the support of decision-making
processes is its main purpose. To highlight some of the most important
aspects of decision-making, this chapter introduces you to different levels
and stages of decision-making. The chapter also explains the uses of the
concept of uncertainty and derives from this the concept of the value of
information and how it can be calculated. Throughout, the chapter
emphasises the centrality of the concepts of relevant information and
relevant costs for the unit as a whole and for the examination.
Learning outcomes
• distinguish different types of decision-making
• define the terms ‘opportunity cost’ and ‘relevant information’
• conduct long-term project appraisals using relevant information
• calculate the value of information under uncertainty.
Levels of decision-making
The American Accounting Association defined accounting as:
‘[...] the process of identifying, measuring, and communicating

economic information to permit informed judgements and
decision by users of information.’
This means that accounting plays a role at several levels and in several stages
of organisational processes:
1. Setting the objectives of the organisation.
2. Determining the strategy for achieving the organisation’s objectives,
given the resources available to the organisation, and the environment
in which it operates.
17
3. Determining plans, both long-range and short-range (such as the

annual budget), aimed at achieving the organisation’s strategic goals.
4. Controlling the organisation by comparing actual performance against
that planned, and by reviewing and modifying the organisation’s plans
in the light of experience.
5. Communicating the organisation’s plans and their outcome.
Communication is maybe the most important process in which
management accounting is involved because it is not only related to
spreading the objectives of new plans; more significantly, the language
which is used to deal with processes can have wide-ranging effects on
their outcomes. For example, if you set objectives and strategies with
financial performance measures in mind, you signal different
priorities from someone who plans with reference to, say, new
technologies and market share.
Management accounting’s main role in these processes is the provision of
information to assist in decision-making. Decisions arise at three levels:
strategic planning, management control and operational control. The level
of strategic planning has perhaps the greatest long-term significance for the
organisation, and decisions at this level are likely to be crucial for the
organisation’s survival and growth. Such decisions will relate to the
organisation’s overall goals and the long-term strategy for achieving these
goals. Strategic decisions will be made relatively rarely and after extensive
consideration. Management control is a more frequent and regular process,
and may well follow a weekly, monthly, quarterly or, at most, annual cycle. It is
concerned with the implementation of the organisation’s strategic plan, by
ensuring that the necessary resources have been obtained and are being used
efficiently and effectively. Operational control focuses on specific tasks as they
are carried out, trying to ensure that this happens efficiently and effectively.
As an example of the different levels, consider an organisation’s
manufacturing operations.
At the strategic level, the organisation will determine matters such as:
a. whether to adopt a high technology or a low technology production
method
b. whether to manufacture large volumes of a small range of products or
smaller volumes of a larger product range
c. whether to concentrate production geographically or to disperse it.
The decisions taken at the strategic level will imply certain detailed plans for
the organisation’s manufacturing. Therefore, at the management control
level, decisions will need to be made as to the resources required to put the
strategic manufacturing plan into operation, for example, how much of
which materials to use, and the usage of such materials will need to be
monitored and controlled periodically to ensure that they are being used
efficiently. This might involve the setting of quality criteria for deciding
whether products have been satisfactorily manufactured.
At the level of operational control, decisions will be made about particular
batches of goods produced, for example, whether they meet the criteria of
quality set at the management control level.
The importance of cash flows

In decision-making we distinguish typically between the short and the long
term. In short-term decision-making, we can usually ignore the time value of
money, and therefore avoid the need to discount cash flows. Nonetheless,
18
in making short-term decisions, we still need to focus on the cash flows

involved in our decisions, and we use the goal of owners’ wealth
maximisation to argue that we should assess alternative actions in terms of
the amount by which they are expected to change the future net cash flows
of the organisation.
When we consider any action, we should therefore attempt to identify how,
and by how much, the organisation’s cash balances will change as a result of
taking the action. Cash inflows will arise from revenues generated by selling
goods and providing services, from interest and dividends received, from tax
refunds and subsidies, and from the sale of assets. Cash outflows will arise
from purchasing the resources (goods and services, people and machines)
needed to undertake the course of action. For short-term decision-making,
we need some baseline against which we can identify the cash flows that
change as the result of taking a particular course of action. The baseline can
be defined as the consequence of taking an alternative decision. Given the
baseline, we may then attempt to estimate the changes in cash flow (the
incremental cash flows) that arise from the course of action being
considered. The baseline we normally assume is the total net cash flows
associated with the best available alternative to the action under
consideration. This baseline is chosen because we assume that the actions of
the organisation are determined ‘rationally’, and this implies that the
organisation will always select the best available alternative if the particular
action under consideration is unavailable.
Activity
Read pages 379 (bottom of page)–380 and the ‘concepts in action’ box on page 381 of
your textbook, and write a definition of the term ‘opportunity cost’ in one sentence.
Opportunity costs
Within this framework, we may define cost as any decrease in wealth
(measured in cash terms) brought about by a decision to use a particular
resource or set of resources. By measuring the decrease in wealth by
reference to the next best alternative, we are effectively using the economic
concept of opportunity cost. Economists define opportunity cost as the
benefits foregone by not adopting the next best alternative, where ‘benefits’
can relate to any economic benefit, not only cash.
Examples of opportunity cost are more easily presented as situations of
choice under resource constraint. Suppose you have an amount of money
free to spend at the end of the month. You have been looking forward to a
holiday trip for a long time, but now realise that your house needs some
repair work fairly urgently. The opportunity cost of going on holiday would
be to delay the house repair with all the problems to which this course of
action may give rise. The opportunity cost of having the repairs carried out
would be to forego the enjoyment of the holiday. The example shows that
your personal opportunity costs can be very subjective, depending on the
utility of the benefits which you forego. However, for short-term decision-
making purposes, the most relevant economic benefits are likely to be
expressible in terms of cash.
Activity
What opportunity costs did you incur by enrolling on the University of London’s External
Programme?
19
The concept of relevant costs and revenues

Decision-relevant costs (and benefits) have three essential characteristics.
Although what follows concentrates on costs, analogous arguments apply
for revenues.
1. Only cash costs are relevant. From an economic point of view, anything
that does not bring about a cash change to the organisation (immediate
or future) is irrelevant to the decision. It is important to emphasise the
cash basis for decision-making, as several items are treated as costs
for financial accounting purposes (and, indeed, in certain aspects of
management accounting) that are not directly associated with present
or future cash changes. The classic example is depreciation. This is an
allocation of the cost of a fixed asset (such as a machine) over the periods
during which the asset is used or on some other basis associated with the
usage of the asset. Depreciation is not itself a cash outflow (the cash
outflow was the original cost of the asset) and hence is ignored in cash-
based decision-making. Note that, while only cash costs are relevant,
we must take into account all cash costs, both direct and indirect. It is
sometimes difficult to identify and quantify all the indirect cash costs.
For example, if the organisation chooses a particular action, perhaps to
sell a certain type of product, this might make customers more likely to do
business with the organisation in the future; but how is the cash impact of
this to be estimated? Nonetheless, all cash impacts should be included
where possible in the decision-making process.
2. Only differential cash costs are relevant. This flows from our baseline
of the next best alternative: any cash costs that would be incurred
whether or not the course of action is taken should be ignored, as they
would be incurred under the next best alternative and are thus already
reflected in the baseline. Some care is needed in identifying the costs that
are genuinely differential in the context of a particular decision, especially
where following a particular course of action would use resources that
would otherwise be allocated to the next best alternative. Where the
action under consideration and the next best alternative are mutually
exclusive, and resources already contracted for would be used either for
the action under consideration or for the next best alternative action,
then the cost of those resources cannot be regarded as differential and
should be ignored. An example of this would be an airline’s decision to
provide passenger services from Hong Kong to one of two possible new
locations where ground staff handling additional check-ins and baggage
have already been contracted.
3. Only future cash costs are relevant. The decision can only change future
cash flows, it cannot act retrospectively to change cash flows already
incurred. This could either have been the actual spending of cash
(past costs) or the incurring of an obligation to spend cash that cannot
be avoided (committed costs).
The rule is therefore: for making decisions, only differential future cash
flows should be considered. This principle implies that the costs taken into
consideration for decision-making purposes, and the amounts at which those
costs are measured, will often be quite different from the costs and amounts
used in financial accounting statements. By including only differential costs,
we ignore those costs not changed by the decision. The costs actually affected
by the decision will very much depend on the scope of the decision itself.
For very short-term decisions, most resources to be used will already be
20
contracted for, so that the costs that will change as a result of the decision
will relate to relatively few items. For example, it may be impossible in the
very short term for a business to increase (or decrease) its workforce and its
equipment. If the cost of labour and machinery is effectively fixed, so that the
only cost that could change is that relating to materials, it may well be rational
to accept a contract to manufacture and sell goods whose selling price
exceeds the cost of materials alone. This may be advantageous even though
the selling price is significantly less than the accounting cost including wages
and depreciation of equipment, if the next best alternative leaves the
resources idle that would otherwise be used to fulfil this contract. As the
decision horizon lengthens, fewer costs become unavoidable, and more
become relevant. At the extreme, all future costs become relevant, but past
costs will always remain irrelevant.
Activity
A customer offers to buy from your company 100 electrical engines of a standard design
but with a slight modification to its electricity intake. Both the workers and the
supervisors of your factory are paid fixed monthly salaries. You expect to have some
spare production capacity over the coming weeks. The material cost of one engine is
estimated to be $500. To manufacture the altered design specified in the order, you
would have to modify some of your production machinery. An engineer would have to
work on it for eight hours and use materials worth $3,000. The customer offers to pay
$650 per engine. Your company’s list price for the standard design is $880. What further
information do you require to decide whether you should accept the offer?
Identifying relevant costs and revenues

What general factors are involved in applying the opportunity cost concept to
a concrete decision? The first stage is to identify the resources required for
the action under consideration and incorporate them in alternative budgets.
The resources will typically include materials, labour, machines and other
services. We shall see in Chapter 4 that these are the basic elements of overall
cost. Having identified the resources required, it is then necessary to find out
whether or not the organisation already has each resource in its control. For
example, materials to be used might already form part of the organisation’s
inventory, labour needed to carry out the action under consideration might
already be employed, and so on.
Purchased resources
If the resource is not already controlled by the organisation, then it must be
purchased, and the measure of the cost to the organisation is the current
purchase price of the resource. For many resources, this current price provides
a suitable measure with no need to make adjustments. Problems arise,
however, when it is considered appropriate to acquire some resource
to undertake a particular action, and the resource in question will provide
services over and above those needed for the action under consideration.
For example, in order to accept a contract to manufacture a particular
product, it might be necessary to acquire the services of a special machine.
The organisation might simply hire the machine for the contract, in which
case the cost of the machine is the hire charge. But what if it is decided that
the machine should be bought outright, and the organisation intends to use
the machine on other contracts, as well as the one under consideration? In
these circumstances, to assign the whole cost of the machine to the particular
contract currently under consideration would be misleading, as we would
effectively be ‘overcharging’ this contract for the machine and ‘undercharging’
21
other contracts. It is necessary in such circumstances to somehow allocate

the cost of the machine to the contracts that will benefit from its use. Various
techniques for performing such an allocation have developed, but the methods
that are considered to come closest to a rational economic allocation of cost
are too advanced to address in this subject guide. It is important to realise
that the problem exists, and that the current replacement price for a resource
that must be acquired for an action is not always the straightforward
measure of opportunity cost.
Resources already under the organisation’s control

What if the organisation already controls the resource? In this case, we must
consider how the resource would be used if the organisation were to reject
the action under consideration and were to adopt the next best use for the
resource. By undertaking the action, the next best use cannot be undertaken
with that particular resource. If there is in fact no next best use for the
resource, then the organisation bears no economic cost in using the resource
for the action under consideration. This might be the case where the action
under consideration makes use of the labour services of employees who
would otherwise be paid for doing nothing. However, for most resources,
there will be an alternative use. Bear in mind that the next best use for the
resource could be to sell it immediately. If the resource is used for the action
under consideration, the sales revenue that would otherwise be received will
have to be sacrificed. In these circumstances, the opportunity cost of the
resource is the net realisable value foregone of the resource.
If there is an alternative use for the resource, then it will be necessary,
if the resource is assigned to the action under consideration, to replace the
resource to enable the next best alternative to be carried out. Materials that
would otherwise be used elsewhere will have to be replaced, and the
opportunity cost is therefore the replacement cost of the materials. If labour
is transferred from other jobs, it will be necessary to employ replacement
labour, so the opportunity cost is the pay due to the replacement workers.
So for resources that would have to be replaced, the measure of opportunity
cost is current replacement cost.
Activity
Read the section ‘Insourcing-versus-outsourcing and make-versus-buy decisions’ in your
textbook (pages 375–377) and work through example 2.
Decision-making and current replacement cost

You should note carefully that, for decision-making purposes, the original
historical cost of the resources is not relevant, only current replacement cost
and net realisable value. This reflects the forward-looking nature of decision-
making. What has already happened is no longer relevant for decisions. For
financial accounting purposes, however, historical costs are still important in
practice, because most financial statements are drawn up using the Historical
Cost Convention (i.e. using the actual costs at the time they were incurred).
A common criticism of this accounting convention is that the costs it reports
are not relevant for decision-making. You should also note that costs allocated
to a particular resource or overall opportunity because of a financial accounting
convention or a management decision are normally irrelevant within the
context of opportunity costs. Thus depreciation (as a financial accounting
allocation) and apportioned general overheads (as a management accounting
allocation – see Chapter 4 of this subject guide) are not relevant. However,
specific changes in cash flows, such as an incremental expenditure on
overhead services, are relevant.
22
Activity
A department store considers closing one of its branches. Which of the following list is
relevant information?
Information on… Yes No

Hourly wages for sales assistants
Rent of property
Premium for fire insurance
(one policy for the whole company)
Local authority taxes
Sales revenue
Bulk buy discount which the company
negotiates with suppliers
Renovations of premises which were
carried out last year
Head office overheads which are allocated to
branches based on sales revenue
Salary of branch manager
Trade union relationships
Comparing cash flows in the long run

Future differential cash flows are relevant in the short and the long run. In
the long run you need, however, to be aware of what is known as the time
value of money. The time value of money is the result of the existence of
investment, lending and borrowing opportunities and of people’s preference
for immediate rather than future uses of money. The time value of money
concept recognises that holding on to money, rather than using it now
presents an opportunity cost in itself. By holding on to money you forego
profitable investment opportunities. At a minimum, you could, for example,
deposit money in a savings account and receive interest (or, if receiving
interest is forbidden, lend the money for a fee or for a profit share). The
interest rate on the capital markets therefore determines the opportunity
cost, also known as the cost of capital.
Management accounting uses the cost of capital (or ‘i’ for rate of interest)
to express future cash receipts and payments in terms of their present value.
This is necessary because the receipt of $100 in a year’s time is worth less to
you than the receipt of £100 now.
Activity
Before showing you the relevant equations, see if you can understand the principle of
comparing cash flows at different points in time intuitively, through an example. Suppose
you are selling a piece of land today. The selling price is $1,000. As you sign the contract, the
buyer offers you to pay you $1,100 in a year’s time instead of $1,000 now. Assume that
i, the cost of lending and borrowing (you can also think about it as the cost of capital) is
9 per cent per year (also often expressed as ‘p.a.’ = per annum). Would you rather be
paid now or in one year? Hint: compare the difference between the cash flow now and
in one year with the opportunity cost of delaying payment (i.e. how much do you ‘lose’
by accepting payment in one year’s time?)
23
An individual will be indifferent between receiving an amount of capital C

now and C(1+i)n in n years’ time because he or she could lend C (the $1,000
for which the land is sold) at the market rate of interest i (which would be
$1,000 x 9 per cent for the year). For this to hold, we need to assume perfect
capital markets with identical lending and borrowing rates, no transaction
costs and no single individual able to affect the equilibrium interest rate by
the amounts he or she chooses to lend or borrow.
Note that the reason why an individual is indifferent to an amount paid now
and a greater amount paid in the future is not the inflation rate. The
examples that we use in this subject guide ignore inflation. The reason is that
an amount paid now contains opportunities for investment. That makes it
more valuable than the same amount paid in the future. The difference, C x i,
is the opportunity cost of deferring receipt of C by one year.
Discounting
Calculating the present value of a future cash flow is usually called discounting.
The present value approach allows us to reduce all the various cash flows
associated with a project to one figure, the net present value (NPV). We
calculate the discounted present values of the various cash flows associated
with the project, and add them up (remembering that cash inflows are
usually taken to be positive and cash outflows negative). The total we arrive
at is the NPV of the project. For example, assume a project that involves an
outflow of £5,000 immediately, and that will produce inflows of £1,000 at
the end of the first year, £2,000 at the end of the second year and £4,000 at
the end of the third year. The NPV of the project, assuming an interest rate of
10 per cent (i=0.1) is:
−Cash outflow + [cash inflow year 1/(1+i)1] + [CF year 2/(1+i)2] + [CF
year 3/(1+i)3]
= −5000 + 1000/1.1 + 2000/1.21 + 4000/1.33
= −5000 + 909 + 1653 + 3005
= 567.
The actual calculation of NPVs is often made more straightforward by the use
of discounting tables, which is explained in your textbook.
The net present value decision rule

The NPV rule simply states that a business should accept any project that
yields an NPV that is positive, as acceptance of such projects will increase
(or, in the case of a zero NPV project, not decrease) the value of the business.
The NPV of a project is effectively its value in cash terms at the time of
decision, that is, the NPV is the amount of cash that the business would be
indifferent between accepting immediately and undertaking the project, with
its associated cash flows. The business could in principle borrow not only the
cash needed to invest in the project but also the NPV of the project; it could
then pay the NPV to the owners of the business, and be able (just!) to repay
its loan and the related interest out of the cash inflows from the project, so
long as the interest rate of the loan is equal to the rate of discount used to
determine the NPV.
In practice, there are three stages in a project appraisal:
1. estimate the date and amount of the relevant cash inflows and outflows
associated with the project
2. discount the cash flows at an appropriate discount rate
24
3. assess the project using the NPV rule.

The relevant cash flows are those that would change as a result of accepting
the project. Some care is needed here, as it is necessary to include not only
the initial cost of the project and any ultimate realisable value but also any
relevant operating cash receipts and payments and any indirect benefits and
costs such as capital investment grants, tax allowances and tax payments on
operating profits that would arise from accepting the project. If the
acceptance of the project would involve the commitment of working capital,
which will require cash to fund it, then this should also be taken into account
in the appraisal. Conversely, it is important not to confuse the appraisal of
the investment decision by including cash flows relating to the way in which
the project is to be financed (such as interest charges). One important point
to note is that, because we are interested in cash flows, accounting
allocations such as depreciation, which do not represent cash flows, should
not be taken into account in calculating NPV. Thus the NPV should reflect the
net cash flow from year to year associated with the project and not the
accounting profit.
Activity
Now read the section ‘Discounted cash flow’ (pages 720–722) in your textbook, paying
particular attention to exhibit 21-2.
Making estimates for project appraisals

If we are appraising a project whose associated cash flows are known and
certain, the calculation of NPV is a fairly mechanical exercise in identifying
the dates and amounts of the various relevant cash flows and performing the
appropriate discounting exercise. However, where the cash flows are
uncertain, they must be estimated, and this is reflected in appraisals in
practice either by calculating a range of NPVs, usually for the worst likely
cash flows, the best likely cash flows, and some average value of cash flows,
or by calculating expected cash flows using probability estimates (sometimes
called certainty equivalents) and discounting these. There are problems with
the latter approach, as it is strictly only valid where the cash flows forecast in
any one year are independent of those forecast in any other year. For many
projects, however, there is likely to be a strong association between the levels
of cash flow achieved from one year to another. Calculation of a range of
NPVs (and perhaps using these together with overall probability estimates to
calculate an expected NPV for the project) overcomes this problem.
The second stage of the appraisal involves the choice of an appropriate
discount rate. In a certain world, given perfect capital markets, this will
simply be the equilibrium market rate of interest. In an uncertain world,
however, matters are more complicated, and it is usual for a business to use
its cost of capital – the rate of interest it has to pay for its long-term finance –
for discounting purposes. Calculating the cost of capital is a difficult
procedure in practice. First of all, it is necessary to determine what should be
included as ‘capital’. This is usually taken as the long-term finance of the
business, and is classified into debt capital (long-term loans) and equity
capital (shares or other ownership interests). It is then necessary to identify
the cost (usually measured as the rate of return) of the various components
of capital. Here it is important to note that the true rate of return must be
used, not the nominal rate of return offered by a component of capital. For
example, the dividend paid on an equity share might be expressed as 10 per
25
cent of the nominal value of the share, but the true return is given by
expressing the monetary amount of the dividend as a percentage of the
current market value of the share.
Appreciations in share price are another source of returns to the shareholder,
but they are more difficult to incorporate in the cost of capital. They are not
paid in cash by the company, but they can be seen as an opportunity cost. If
the company had not already issued a share in the past, it could issue it now
(after its share price went up) and obtain more money from the buyer of the
newly-issued share. Share price appreciations for all shares should be
expressed as a percentage of the market value of the company because they
constitute an opportunity cost of having used shares to finance the company
in the past and not, say, bonds.
Another problem in estimating the cost of a component of capital is deciding
whether to use a pre-tax or post-tax rate of return. Certain types of capital
are often taxed differently from other types, and the tax treatment depends
on the tax laws of the country in which the business operates. Usually,
however, interest on debt capital is deductible from the profits of the business
before they are assessed to whatever tax is levied on profits, while dividends
and other payments to owners are not deductible. If after-tax rates of return
are used in calculating the NPV of a project, the after-tax cash flows should
be discounted.
The final problem comes in combining the rates of return for the various
components of capital into one overall cost of capital (the weighted average
cost of capital – WACC). The rates of return for the various components
should be weighted by the market values of the components (not their book
values), in the same way that the rates of return are themselves based on
market values. One important point to note is that care must be taken in
appraising projects which it is intended will be financed out of a new issue
of a particular type of capital. It is sometimes suggested that, in these
circumstances, the appropriate cost of capital to use is the cost of the new
specific finance, the marginal cost of capital. This would indeed be correct if
the new issue of capital had no impact on the overall capital structure of the
business, but this is seldom the case. For example, if the business were to
choose to finance the project by debt capital (the cost of which is usually less
than WACC), this would increase the ‘gearing’ (i.e. the relative importance of
loans in the overall capital structure; this is sometimes called the ‘leverage’)
of the business as a whole. The greater the gearing of a company, the more
risky becomes its equity capital, and holders of equity capital would require
a greater return than before to compensate them for the additional risk that
they are forced to bear. The true marginal cost of capital should incorporate
not only the direct cost of the incremental capital issued to finance the new
project but also any indirect costs arising in respect of other components of
capital. I include the ideas mentioned in this paragraph because you will find
them useful for making connections for your study of Finance. They are not
examined as part of Management accounting.
Activity
You receive a proposal to invest in energy-saving light bulbs in your factory. How do you
determine the relevant costs? Outline the decision-making process.
26
Problems with the opportunity cost concept

Central to the decision-making concept is the notion of opportunity costs.
You should understand several problems of the opportunity cost approach.
1. The approach assumes that decision-makers are able to identify the next
best action in any given circumstances. But this might imply an evaluation
and ranking of all conceivable alternatives. In practice, the examination
of alternative actions is likely to be limited to those immediately obvious
to the decision-maker. For example, it might be assumed by the decision-
maker that materials already in inventory will be replaced, even though
the actual next best use of the materials is left unspecified.
2. The determination of opportunity cost in a complex organisation becomes
complicated, as it is not always obvious at which level the cash changes
caused by the decision should be analysed. For example, the decision
might be analysed at the level of an operating division of the organisation,
so that only those cash changes that may be observed at divisional level
are identified. The problem with this from the perspective of the
organisation as a whole is that, first, indirect cash changes elsewhere in
the organisation might be omitted and, secondly, many of the cash
changes identified at divisional level will reflect cash transfers with other
divisions of the organisation, so that the net cash flow for the
organisation as a whole is zero. This might lead to the taking of decisions
that are optimal for the division in isolation but sub-optimal for the
organisation as a whole. (We return to this problem in Chapter 9.)
3. Opportunity costs are forward looking, but in practice they are often
estimated on the basis of past experience of costs and revenues associated
with similar actions; however, it is not always straightforward to estimate
future cash flows from past data.
4. Traditional accountants often have difficulty in understanding and
accepting the basis of opportunity costs, particularly the treatment of past
costs. To the traditional accountant, past costs are actual costs that have
been incurred, so how can they be irrelevant? Moreover, much traditional
management accounting has emphasised the need to ‘recover’ costs that
have been incurred, through the earning of sales revenues. These attitudes
have some validity, in that the costs that have already been incurred are
likely to determine the range of possible future actions for the organisation,
allowing some options and ruling out others. Also, for the organisation to
survive in the long run, it is necessary for revenues to cover costs. In the
short term, however, the relevant costs to be covered by revenues are not
those that the traditional management accountant calculates but rather
the opportunity costs.
5. The opportunity cost concept implies a model of rational decision-making,
yet it is not obvious that this model is an appropriate description of reality
within organisations. People working in organisations have many other
concerns besides rational decision-making.
Activity
What might those other concerns be?
27
Uncertainty and relevant information

Those other concerns notwithstanding, the assumption of rational decision-
making enables us to calculate the value of information under uncertainty.
Take Yassin, for example, who sells cheap umbrellas outside an underground
train station on Singapore’s Orchard Road. On rainy days, he sells many
umbrellas to people who have forgotten theirs and do not want to get wet.
On sunny days, no one buys umbrellas, and Yassin would prefer to stay at
home and work in his garden. Every day, Yassin must decide whether to go to
work or stay at home. If he stays at home and the day is rainy, Yassin loses a
day’s sales, but if the day is fine, he can enjoy his garden. If he goes to work
and the day is rainy, Yassin can sell his umbrellas, but if the day is fine, he
makes no sales, has to pay his fares to central Singapore, and wastes the day.
Activity
What is Yassin’s opportunity cost of travelling from his house in the suburbs to the centre
of Singapore to sell umbrellas?
We may express the possibilities for Yassin in terms of the ‘satisfaction’ that
he gains from the various outcomes. (These ‘satisfaction’ values are arbitrary,
for the purposes of illustration, and the units are unspecified.) Have a look at
the following table.
Table 2.1: Example of outcomes from decision under uncertainty

State of weather
Fine Rainy
Yassin’s Stay at home +10 0
action Go to work −10 +30
From the table, you can see that, if it is going to rain, Yassin would prefer to
go to work. If it is going to be fine, Yassin would prefer to stay at home.
Information about the likely state of the weather would help Yassin in
deciding what action he should take at the start of the day. Can you imagine
how valuable that information would be for Yassin? What is at stake? What
does he stand to gain or lose from not knowing whether it will rain or not?
Characteristics of useful information

Let us now examine the characteristics of the information that Yassin needs.
1. Relevance. The crucial factor for Yassin’s decision is the state of the
weather, so only information about the weather will be relevant. Facts
such as yesterday’s football scores will be irrelevant, and would not
constitute relevant information for Yassin’s decision.
2. Significance. Yassin wants information about today’s weather in
Singapore. Information about today’s weather in New York or yesterday’s
weather in Singapore are unlikely to be significant. (They might be
significant if they are related in some way to today’s weather, so in certain
circumstances information about yesterday’s weather will be significant if
it is a good predictor of today’s weather.)
3. Reliability. Yassin will place greater value on weather forecasts that give
good predictions than on those that do not. A weather forecaster who is
biased in some way (perhaps he or she is an optimist, and tends to predict
better weather on average than actually occurs) will be less reliable than
28
one who is free from bias. Weather forecasts based on forecasting

procedures that can be verified are likely to be more reliable than those
based on unverifiable procedures.
4. Understandability. Yassin simply wants a forecast of whether the day will
be rainy or fine. A complicated forecast, complete with obscure charts and
diagrams, might not be of much use to Yassin, particularly if he needs to
spend a lot of time trying to understand what the complicated forecast
is saying.
5. Sufficiency. Yassin wants a forecast covering all the day, so a forecast
relating only to the morning would be insufficient. Similarly, Yassin wants
a clear-cut forecast implying either that it will be rainy or that it will be
fine: sometimes weather forecasters try to cover both alternatives in
a vague statement, but this would not tell Yassin anything.
6. Practicality. Yassin wants the forecast at the time he has to make the
decision, so a ‘forecast’ available to Yassin only at the end of the day
would be too late. It would have no value for Yassin.
In Singapore, weather forecasts are usually ‘free’: they are obtained from
radio, television or newspapers and not paid for separately. If Yassin was
prepared to pay for a weather forecast, how much do you think he would be
prepared to pay for it? In general terms, it would have to be no more than the
value which the information has for him. From this example, we can see that
not every fact represents information for a particular decision. Facts or data
are usually regarded as information only if they are likely to change the
expectations of the person receiving them. Moreover, information will be
significant only if it is likely to change the outcome of the decision under
consideration. In some circumstances, the outcome of a particular choice of
action might be such as to dominate all other alternative choices, whatever
might be the true data about unknown matters. (For example, if Yassin were
able to sell his umbrellas regardless of the weather, he would decide to go to
work every day.) In such cases, data about the unknown matters will not
change the dominant action implied by the decision. But where facts will
make a difference to the action chosen, we will call those facts ‘information’,
and the information has value. We can often quantify the value of
information, as we do in the section below. Conversely, information will often
have a cost, and it is not sensible to pay more for information than it is worth.
Activity
Read the Appendix to Chapter 3 ‘Decision models and uncertainty’ on pages 80–82 of
your textbook and solve problem 3-47 on page 92.
Objective and subjective probabilities

On the assumption that the weather in the future will be similar to that in the
past, historic frequencies of rain and sunshine may be used to estimate the
probabilities of the weather in the future. Our records might show rain on six
days out of every 10. We could use this frequency to estimate the probability
of rain as 0.6 or 60 per cent or 3/5. Where probabilities are derived from
frequencies, we often describe them as objective probabilities. While many
management decisions arise in circumstances where the past is a good guide
to the future, it is often necessary to take decisions where the future is
uncertain but there is no past data on which to base estimates of future
probabilities. In such cases, involving ‘one off’ decisions, it is impossible to lay
down rules for estimating future probabilities, and we often talk of the
decision-maker using subjective probabilities in his or her decision-making
process.
29
Expected value
The expected value of an outcome is found by adding together the value of
each possible outcome multiplied by the probability that the outcome will
occur. For example, suppose that we estimate that a project will earn a profit
of £1,000 with probability 0.3, £2,000 with probability 0.5, and £3,000 with
probability 0.2. Then the expected value of the profit is:
(£1,000 x 0.3) + (£2,000 x 0.5) + (£3,000 x 0.2) = £1,900.
You should note that the expected value is not necessarily equal to one of the
possible outcomes. It measures the average profit that would be expected if
the project were to be repeated many times under the same conditions.
Returning to the example of Yassin, there are two possible states of the
world: ‘fine’ and ‘rainy’. Suppose that our decision-maker, Yassin, believes
that the probability that it will be fine is 0.4 and that it will be rainy is 0.6.
(Note that these probabilities add up to 1.0, as it is certain that one of the
two states will occur.) We can work out the expected value of each of Yassin’s
possible actions in terms of units of ‘satisfaction’:
stay at home (+10 x 0.4) + (0 x 0.6) = 4
go to work (−10 x 0.4) + (+30 x 0.6) = 14.
Yassin maximises the expected value of his satisfaction by going to work
every day.
The value of information

Given an uncertain world, the expected value rule enables us to choose
between alternative actions, so long as we are able to assign probabilities to
the various possible states of the world. Are there circumstances in which
decision makers can improve the expected outcome? Can they refine the
decision making process? If Yassin knew at the start of the day what the
weather was going to be, he could choose to stay at home if it was going to
be fine (achieving 10 units of satisfaction) or go to work if it was going to rain
(achieving 30 units). What, however, is his best choice without this
information? At present, given the uncertainty about the weather, his best
choice is to go to work every day. How would certain information about the
weather change his choices? Assume that the probability of a fine day is still
0.4 and of a rainy day 0.6. If Yassin has perfect knowledge of the weather, he
will stay at home on average four days out of 10 and go to work on average
six days out of 10. The expected value of his satisfaction will therefore be:
(10 x 0.4) + (30 x 0.6) = 22
This is greater than Yassin’s expected satisfaction if he always goes to work,
regardless of the weather. That means that perfect knowledge of the weather
improves Yassin’s decision making by 22 – 14 = 8. If Yassin were able to
acquire a weather forecast that was correct every time he could pay up to
eight units for the forecast and still be no worse off than if he did not use the
forecast at all.

‘The notion of relevant costs is impractical for management practice because
it ignores past cash flows.’ Critically discuss this statement.
30

question
It might be worth pointing out that the relevant cost definition seeks to
establish a theoretical yardstick for identifying how organisations can
identify the most profitable courses of action. Insofar as this theoretical
yardstick presents problems in practice it is useful to explain in what ways
practice differs from the assumptions on which theoretical concepts are
founded. In practice accountants may be uncomfortable with the idea that
past cash flows are irrelevant. They often suggest that investments made in
the past should be utilised. For theoretical economists, by contrast, ‘bygones
are bygone.’ Just because money was spent on a certain project does not
mean for them that more money should be spent on it, for example, to
complete it.
One of the reasons why they think like this is that they assume perfect capital
markets. If another, more promising project can be identified, they assume
that capital can be raised for it. In reality, organisations face credit limits and
may not possess the option of raising large amounts of fresh capital.
Accountants realise that past cash flows produce dependencies as well as
expectations that often make it attractive to stay with an ongoing project,
even if new opportunities open up.
31
Notes
32
Chapter 3: Cost behaviour

Essential reading
(international) [ISBN 0-13-099619-X] Chapters 2, 10 and 3.
Aims
This chapter introduces the cost terminology used in this guide. It explains
cost behaviour as fundamental to costing systems and shows how to chart
fixed and variable costs. Cost-volume-profit analysis (CVP) is introduced
as a key management accounting technique for diverse decision-making
situations. Cost estimation is mentioned as an important topic for
management accounting practice even though it is of minor theoretical
relevance for the unit.
Learning outcomes
• distinguish different types of costs
• structure problems in ways that lend themselves to the application of CVP
• explain the differences between cost estimation techniques.
Introduction
The basic framework of the decision-making approach to management
accounting may still seem somewhat abstract, but you will find that it is an
important basis for approaching the remainder of this subject. It will also
help you structure your thinking when you come into contact with
management accounting in your future career.
You have by now spent some time thinking about how to approach ‘what if’
questions; what will be the effect on resources if we do X? This chapter stays
with the ‘what if’ question but focuses in more detail on the daily work of
management accountants. It looks at costs, specifically, at what happens to
costs if organisational activity varies. This is called ‘cost behaviour’. Cost
behaviour depends on activities which cause costs to occur. Those activities
are called ‘cost drivers’. The chapter also considers how costs can be
estimated. Also, you will learn about cost-volume-profit (CVP) analysis
which is a technique linking organisational activity to cost and profit that
allows us to determine the minimum level of activity for profitability: the
so-called ‘break-even point’.
The elements of total costs and their behaviour

Probably the biggest part of management accounting in practice is cost
accounting. It measures and reports financial and non-financial information
that helps managers make decisions to fulfil the goals of an organisation. The
component elements of total cost may be presented as follows (sums in bold):
33
Direct material cost X

Direct labour cost X
Direct expenses X
Prime cost X
Production (or factory) overhead X
Production (or factory) cost X
Administrative overhead X
Selling and distribution overhead X
Total cost X
It should be noted that this analysis of total cost is similar to the overall
analysis that might appear in a profit and loss account: the difference is that
the profit and loss account reflects all the costs attributable to a particular
period while the cost statement above relates to a particular product or
service. Also management accounts tend not to include the detailed expenses
for financing and taxation.
Direct and indirect costs

Costs are traditionally classified in a number of different ways. The first
important distinction is that between direct and indirect costs. Direct costs
are those that can be directly related to a cost object. A cost object can be any
product or service. Direct costs include, for example, the cost of materials
specifically used in manufacturing a product or providing a service, specific
labour costs that can be identified with the work involved in manufacturing
a product or providing a service and other expenses that can be specifically
identified with a product or service. Indirect costs are those costs that cannot
be specifically attributed to a good or service. Indirect costs are also known
as ‘overheads’. They are often classified into:
1. production overhead: all indirect material cost, indirect labour and
indirect expenses incurred in the factory from receipt of an order for
goods to be produced until completion of production
2. administration overhead: all indirect material, labour and expense costs
incurred in the direction, control and administration of the organisation
3. selling overhead: all indirect materials, labour and expenses involved in
promoting sales
4. distribution overhead: all indirect materials, labour and expenses
incurred in preparing the finished product for despatch and in
distributing the product to its destination.
Fixed and variable costs

The second important way of classifying costs is as fixed or variable costs.
Fixed costs are those that arise in relation to the passage of time and which,
within certain output and turnover limits, tend to be unaffected by
fluctuations in the level of output or turnover. Fixed costs tend to be
overheads such as rent, insurance and the cost of managerial staff. It is
important to remember that costs are, strictly speaking, only fixed in relation
to a particular time horizon: in the very long run, no costs are truly fixed, in
the sense that they cannot be altered. They will vary with large variations in
production output, for example, when a second factory is built next to the
original one. It is also important to note that costs may be fixed over a
particular range of output levels but start to vary outside that range.
34
The converse of a fixed cost is a variable cost, which is a cost that tends to
follow (in the short term) the level of activity of the organisation.
Traditionally, examples of variable costs have been taken as materials used,
labour directly employed on production, and selected overheads such as
power used to drive machines. However, with the exception of materials
used, many costs are in practice (at least in the short term) effectively fixed:
for example, if production workers are paid wages independent of the
volume of production, and it is difficult to increase or decrease the size of the
workforce, labour costs behave as if they are fixed in the short term. Variable
costs are usually taken as varying linearly with the level of activity (that is,
a graph of cost against activity level is an upward-sloping straight line, like
exhibit 2–3 in your textbook), and this implies that the variable cost per unit
of output is constant at all levels of output. However, in practice variable
costs might not be linearly related: for example, unit variable costs might
gradually decrease relative to the level of output (as would be the case where
there are economies of scale available from production), gradually increase
(if there are diseconomies of scale) or exhibit a more complex relationship.
However, it may be possible to regard variable costs as approximately linear
over a relevant range of output.
Costs in-between
Some costs do not fit neatly into either the fixed or variable categories. One
important type of cost is the step fixed cost. This is a cost that is fixed over
relatively short activity ranges, but which increases dramatically as the level
of activity moves from one range to another. For example, for a particular
range of outputs, a business may need to employ only one production
supervisor on a fixed salary. However, to increase production beyond this
range will require the employment of a second supervisor. The fixed cost of
supervisory salaries increases suddenly and then continues at the new level
until output is such that a third supervisor needs to be employed. This is
graphically illustrated in exhibit 2-4 of your textbook.
Another important cost category is that of semi-variable costs. These are
costs that reflect both a fixed and a variable component. An example of a
semi-variable cost would be a charge for electricity based on a fixed monthly
charge (paid whatever quantity of electricity is consumed) and a charge per
unit of electricity actually consumed (which will therefore vary with the level
of activity). There are other, more complicated, relationships that might exist
between activity levels and costs, but for many purposes we can assume that
(at least over the range of output that interests us) total cost may be divided
into a fixed element, which does not vary over the range of output, and a
variable element, related linearly to output. Expressed algebraically, we can
define total cost using the following equation:
y = a + bx
where y = total cost, a = fixed cost
b = unit variable cost, x = units of output.
An example of a total cost curve is represented by line AB in exhibit 3-2 of
your textbook.
35
Activity
From your own experience, think of three examples of each of the costs discussed above.
Don’t forget to specify with regard to which cost object you define direct and indirect costs.
1 2 3
Direct
Indirect
Fixed
Variable
Step-fixed
Semi-variable
Some students mistakenly equate variable costs with direct costs and fixed costs with
indirect costs (overheads). Often variable costs are direct (e.g. direct material costs) and
fixed costs are indirect (e.g. rent), but this is not always the case. Importantly, what is
classified as direct and indirect depends on the cost object!
Activity
Carefully study exhibit 2-5 in your textbook and explain all four combinations given in
the diagram.
The identification of cost drivers

Much of the work of the cost accountant is involved in dividing up overall
costs for particular expense items and assigning these to particular products
or services, so that the total cost of each product or service may be
ascertained. Sometimes, it is possible to identify whole items of cost that are
specifically attributable to a particular product, in which case we are said to
‘allocate’ the cost to the product. In other cases, a cost may be incurred on
behalf of two or more products, and we must therefore apportion the total
cost to the relevant products. We often speak in more general terms of
allocation or apportionment of costs to cost objects. Those cost objects are
anything for which we wish to ascertain a cost. Typically, we are interested in
knowing the costs of two types of cost objects: cost units and cost centres.
What do we mean by these terms?
A cost unit is an arbitrary unit of production, service or time in relation to
which costs may be ascertained or expressed. The unit selected must be
appropriate to the organisation, be it a business or a not-for-profit-
organisation, and one with which expenditure may be readily associated.
Typical cost units might be physical units of production, such as a can of
baked beans or a motor car, or some unit of quantity or volume, such as a
kilogram of sugar or a tonne of steel. In some cases, the cost unit might be a
unit of time, for example, an hour of time charged to a client by a
professional (so your lawyer knows how much to bill you), or a unit of
service, for example, a share purchase made by a stockbroker.
A cost centre is a location, person, or item of equipment (or group of these)
for which costs may be ascertained. In a factory, cost centres might be
departments such as stores, maintenance, personnel or design; operational
cost centres such as the machines or operators performing a particular
operation; particular salespeople, departmental supervisors or managers;
or particular contracts or customers.
Activity
Think of five further examples of cost centres.
36
Allocation
To calculate total costs for particular cost objects, it is necessary to allocate or
apportion costs first to cost centres and cost units. The overall criterion used
for this is cost causation. If you are to calculate the economic resource
consumption of cost objects it is advisable to follow the lines of causality from
the cost object to the consumed resource and then to ascertain its value. The
link between the two is called cost driver. Cost drivers are variables the
occurrence of which ‘drives’ or causes costs.
Activity
Study exhibits 2-1 and 2-2 in your textbook and read pages 30–31.
In practice this is usually not as straightforward as it sounds, particularly in

a large complex operation with hundreds and thousands of machines,
people, and products. Often, management accountants therefore employ a
two-stage process of allocating and apportioning costs to cost objects. Firstly,
costs might be assigned to cost centres on a particular basis and, secondly,
the cost per cost centre further assigned to individual cost units. Several
different cost drivers (they are sometimes called ‘bases’ of apportionment or
allocation) are used in practice, and cost accountants often attempt to select
a ‘suitable’ driver in the light of the cost being apportioned. Some drivers,
with examples of costs for which they could be used, are:
1. capital values for insurance and depreciation of plant and machinery
2. relative area of floor space for rent, cleaning expenses, light and heat,
depreciation of buildings
3. number of employees for personnel office, canteen, safety and first aid
4. number of set-ups for machines or production lines for engineering
overheads, production planning overheads
5. number of purchase orders for purchase department overheads
6. number of warehouse orders for overheads for the organisation’s internal
logistics
7. number of orders to change product design for design engineering
overheads.
You can see that there are different drivers available for the same costs,
and the cost accountant must, in the end, select an arbitrary basis
of apportionment.
Activity
Consider an organisation which you know well. (Take the institution where you are
studying if you have little work experience.) What are its most significant cost
components? Labour? Materials? Process improvement? Different forms of administration?
What causes those costs? What are their drivers? How could you allocate cost to those
managers or administrators who should be held responsible for them?
Cost estimation
Complete allocation and apportionment of costs may be carried out only at
the end of a period, when the total costs to be assigned have been determined.
If the purpose of cost attribution is simply to achieve an ex post measure of
the cost of the organisation’s products, for the purposes of control or
otherwise, then this retrospective cost attribution will be acceptable. For
37
many purposes, however, the end of the period is too late: estimates of cost
will be needed for planning, pricing and control purposes at the time when
goods are produced and services provided, and indeed before such a time.
Different techniques exist for estimating costs, some of which rely on the
classification of costs into fixed and variable categories to estimate a cost
function of the form y = a + bx, as discussed in the previous section. In such
a function, the independent variable x is sometimes units of output, but
could be a measure of input such as machine hours or labour hours.
Sometimes there might be circumstances in practice where total cost is
better expressed as a function of two or more variables rather than one, but
for expository purposes, textbooks usually assume that total cost is a linear
function of a single variable, normally output.
Cost estimation usually involves two aspects: estimation of the usage of
factors of production such as materials, labour and overheads, and
estimation of the cost of such factors. The first method of cost estimation is
the engineering method, which gets its name from estimates determined by
engineers of the materials, labour and overheads required to manufacture
a product or provide a service. Materials needed will be estimated from the
specification of the product, labour from time and motion studies and
estimates of the operations needed to make the product, and overheads from
estimates of capital equipment needed and other costs to be incurred. The
engineering method is particularly relevant where there is little past
information on which to base a cost function, but it is costly to operate, and
not always easy to carry out. However, the use of the engineering method is
often associated with a standard costing system (described in more detail in
Chapter 8), which helps to integrate the cost estimates into the overall
control system of the organisation. Where past data exist relating to the
product in question, these may be used to estimate a cost function. Past data
may be used to obtain directly a cost function expressed in monetary terms
or indirectly to estimate how production inputs are related to production
outputs. To estimate a cost function, it is necessary for us to be satisfied that
the relationship between costs and output shown in the past will give us
reliable information about the relationship at present and in the future.
There are three important factors to take into account when using historical
data.
1. Choice of independent variable: we usually select output level, although
the total cost for an item may depend on many factors, such as level of
output, total machine hours, total labour hours, volume and quality of
materials and so on. While cost estimates might be more accurate if a
multivariate cost function were used, it is likely that the various variables
selected will themselves depend to a great extent on the level of output. If
the ‘independent’ variables are not truly independent, there is little extra
benefit from a multivariate function in comparison with a univariate one,
where the independent variable is level of output.
2. Selection of time period: the period covered by past data should be
reasonably long, so as to allow for a large number of observations, but
circumstances during the period should be comparable to the current and
future environment, so that it is reasonable to use cost functions based on
past data for future cost estimations. In this context the learning curve
effect may assist in the estimation. This effect arises because
organisations tend to become more efficient at the production of an item
as time passes. Initially, the product is new, the workforce has to learn
how to make it, the specification of the product may need to be modified
in the light of manufacturing experience, and, overall, unit costs will be
relatively high. As time passes, the organisation becomes more
38
experienced and efficient at manufacturing the product, and unit costs

fall. The graph of unit costs over time shows a curve which falls rapidly to
begin with and then starts to level off. This is called the learning curve. In
order to estimate future costs, it is necessary either to exclude or to adjust
observations where the learning curve effect is likely to be significant.
3. Examination of accounting data: it is important to make sure that any
biases, which might be induced in the data by the methods by which the
data are compiled, are identified and adjusted for. Where data cover a
long time period, allowance must be made for inflation so that the cost
function reflects current prices. When the data have been collected and,
where necessary, adjusted to reflect inflation and accounting biases, they
may be used to estimate a cost function. This estimation may be carried
out using approximate methods, such as basing the function on the
highest and lowest values of total cost or plotting the observations on a
graph of output against total cost and fitting a line to the observations
visually.
Linear regression
A different approach uses the statistical technique of linear regression. This
approach determines a line of best fit using the ‘method of least squares’.
Your textbook describes the mechanics of calculating the least squares line of
best fit (see exhibits 10-6 and 10-8), but it is worth pointing out that the
actual calculations would usually be carried out in practice using appropriate
computer programs. The linear regression approach has two important
advantages over less sophisticated methods. First, we can estimate how good
is our line of best fit, using the correlation coefficient. The closer r2
approaches 1, the closer our line of best fit explains the variation in total cost
(or other dependent variable) in terms of output (or whatever other
independent variable we use). Second, the linear regression method can be
easily extended to cope with several independent variables, using multiple
regression analysis (although this makes a computer almost essential). The
computer programs used for multiple regression analysis are sophisticated,
and are capable of identifying situations of multicollinearity, where the
‘independent’ variables are in fact interdependent, so that a cost function
based on the smallest number of significant variables may be derived.
Although regression analysis is a valuable tool in cost estimation, it must be
remembered that, as a statistical method, it makes various assumptions
about the data that might not be true in practice. For example, it may classify
data in one category despite underlying differences.
Error terms and outliers

Before discussing these, it is necessary to introduce the expression error
term. The regression equation derived from the method of least squares
allows us to calculate an estimated value of our dependent variable (such as
total cost) for any value of the independent variable (such as total output).
If we compare the estimated value with the observed value y for that level of
activity x, the error term is simply the difference in y. Now, the method of
least squares mathematically forces the mean of the error terms for all the
observations to equal zero. This means that the regression equation derived
is very sensitive to isolated observations lying far from the line of best fit,
which are called outliers. If outliers were not included, the regression
equation could be quite different (and the value of r2, measuring goodness of
fit, would almost certainly be higher). It is often the case that there are
special factors explaining the occurrence of specific outliers, which can be
39
adjusted for, and it is useful to try to identify potential outliers visually before
the regression calculations are performed. There are two further technical
problems.
1. The method of least squares assumes that the error terms are
independent of each other, but in some cases they are not: this is referred
to as autocorrelation. An example arises where the observations are
affected by seasonal factors, which should have been adjusted for before
performing the regression. The seasonal factors will leave the
observations subject to a particular underlying pattern in addition to any
fundamental trend.
2. The method of least squares assumes that the likely size of the error terms
is independent of the value of the independent variable: that is, the error
term does not grow larger as the level of output increases. Where the size
of the error term does increase (referred to as heteroscedasticity), the
regression equation becomes less reliable. The existence of
heteroscedasticity is often an indication that there is an underlying
growth or inflation factor that has not properly been adjusted for.
Standard statistical regression computer programs often determine
whether autocorrelation and heteroscedasticity are significant problems.
The use of regression analysis to estimate a cost function is a useful
technique, but it is more of a blunt instrument than the engineering method,
as it breaks total cost down only into fixed and variable elements. For many
purposes, this is enough, but where detailed estimates of all the elements of
total cost are needed, something like the engineering method must be used.
As already mentioned, standard costing is likely to be based on engineering
cost estimates, but any other detailed costing will also need such an
approach.
Activity
Define the following:
• autocorrelation
• error term
• heteroscedasticity
• the learning curve effect
• linear regression
• multicollinearity
• outliers.
Check that you know how to use these terms appropriately before continuing.
Cost-volume-profit and break-even analysis

The division of total costs into fixed and variable components lies at the heart
of cost-volume-profit analysis (CVP), which focuses on four key business
variables: costs, revenues, volume of output and profits.
CVP looks at changes in total costs and in profits arising through changes in
the volume of output, and may be used in decisions about pricing, the best
balance (or ‘mix’) of sales from several products, and many other short-term
decisions.
An important concept in CVP analysis is that of the contribution margin
(sometimes referred to simply as contribution). If we are able to divide total
costs into a component which is fixed and independent of output over a
particular range and a component which is variable and proportionate to
40
output over that range, then the contribution margin is calculated by

deducting variable costs from revenue. Over the output range, the
contribution margin will itself be proportionate to the volume of output
(assuming that the unit selling price of output is independent of volume). We
may compare the contribution margin at a particular output level with the
fixed costs to see whether a net profit or loss will be made at that level:
where the contribution margin exceeds the fixed costs, a net profit arises,
and vice versa. The point at which contribution margin is equal to fixed costs
is called the break-even point at this level of output, the net profit is zero, and
total costs equal total revenues.
Calculating the break-even point indicates the minimum output level needed
for sales of a product to be profitable. Remember that several assumptions
underlie the determination of the break-even point:
1. fixed costs are constant
2. variable costs vary linearly with output
3. sales revenues per unit of output are constant
4. volume of output is the only factor affecting total cost.
These assumptions are often unrealistic in practice, so break-even analysis
must be regarded as a rough guide rather than a precise one. The break-even
chart is the most common way of presenting the relationship between total
costs and total revenues at different output levels, and finding the break-even
point. The break-even point occurs where the profit line (the line
representing profit as a function of output) cuts the output axis: at this point,
profit is zero.
If you look closely at the break-even chart you notice that it fails to show net
profit or loss clearly at different output levels. To remedy this, the profit
volume chart has been developed. This is a graph of volume against profit (or
loss) at each level of output. Profit volume charts and break-even charts may
be used to illustrate what happens when changes occur in key variables, such
as fixed costs, variable costs and selling price.
Activity
Compare the CVP chart in exhibit 3-2 with the profit-volume graph in exhibit 3-3 and
explain how the latter is derived from the former.

What are the principle ideas underlying cost-volume-profit analysis, what are
possible applications, and what are its limitations?

question
This question can be answered by rereading this chapter and the textbook.
41
Notes
42
Chapter 4: Costing and pricing

Essential reading
(international) [ISBN 0-13-099619-X] Chapter 12, appendix to Chapter 11
on linear programming.
Cooper, R. and W.B. Chew ‘Control Tomorrow’s Cost Through Today’s Design’,
Harvard Business Review (January–February 1996) 80–97.
Aims
Once you have calculated product cost, what price should you charge? The
link between costs and prices depends on the kind of product market in
which your organisation operates and the marketing strategy which it
pursues. Given those contexts, management accounting can attempt to
provide information on optimal prices as well as bounds for the lowest price.
Typical methods that are used include cost-plus and contribution margin
pricing. This chapter also deals with the question of the optimal allocation of
scarce resources. It shows how linear programming can be used for
allocation decisions, and how linear programming techniques can produce
dual or ‘shadow’ prices which simulate for decision-makers an internal
market for the organisation’s resources.
Learning outcomes
• outline the distinction between different types of pricing and explain
under what circumstances they might be appropriate
• conduct Linear Programming Analysis
• explain the how the consideration of scarce resources affects the notion of
opportunity costs.
Costs and pricing

One of the justifications for costing is that it assists in setting selling prices.
In some situations, producers are faced with a selling price determined by
the market, and any individual producer cannot materially affect the market
price. Even so, a producer will wish to know whether to enter or remain in
the market for a particular product, and this will require a comparison of unit
costs and selling prices. In other situations, market prices are not available
(for example, for a new product) or an individual producer might have a
significant effect on the determination of price. Many businesses operate in
an environment where the quantities of products demanded by customers
depend in some way on selling price. Economists refer to such markets as
exhibiting high elasticity of demand. Demand responds to price changes.
In such a case, given the desire to maximise net cash flows accruing to the
business, it will be necessary to determine the optimal price and level of
production so as to maximise net cash flow. In these circumstances, the profit
volume chart may be used to help determine maximum profit.
43
Such use of the profit volume chart hinges on your ability to estimate the
price elasticity of demand (i.e. the sensitivity of demand to changes in price).
Where it is difficult to estimate demand at various prices, many businesses
use a cost-plus approach to pricing, either as the sole basis for price setting or
as an indication of the minimum acceptable price (the actual price then
being determined by taking into account marketing considerations). To
determine a cost-plus price, the total cost, including allocated fixed overheads,
of a cost unit is determined, and a pre-set profit percentage (the ‘mark-up’) is
added to arrive at the selling price. For example, if total direct costs per unit
are £12, allocated fixed overheads are £8, and the required mark-up is 50 per
cent, the cost-plus price is:
(12 + 8) x 150 per cent = £30.
Activity
Recall Elements of accounting and finance (or Principles of accounting): How
much is the margin in this example?
Cost-plus pricing is simple to operate, but the prices obtained depend on the
basis of allocating fixed costs, and on the profit percentage applied. Both of
these are ultimately arbitrary, so the use of cost-plus pricing could lead to
sub-optimal pricing decisions.
For instance, assume that an organisation sells one kind of product for $10.
Variable costs are $2 per unit, period fixed costs are $500. The per unit fixed
cost would depend on volume. If volume was 100 units, it would be
$500/100 = $5.
Table 4.1: Contribution margin per unit and for the organisation
Per unit in $ For the
organisation in $
price 10 1000
− variable costs 2 200
= contribution 8 800
− fixed costs varies with volume, 500
therefore of limited
usefulness
= net profit often not calculated 300
Contribution margin pricing

Contribution margin pricing does not insist on covering long-term fixed
costs. (Remember that their allocation to particular product lines is
problematic.) Instead it is based on the difference between sales price and
variable costs. If variable cost measures resource consumption accurately,
then any sales price greater than variable costs gives the business a
contribution towards its fixed costs and profit requirements. In that sense,
variable costs are the minimum price in the short run. Why in the short run?
Because in the long run you need to be profitable. What should you consider
before accepting an order which would cover variable but not fixed costs?
You need to be cautious about a general deterioration of sales prices for your
product. (Will other customers also demand lower prices?) A point of
caution: most students think that it is okay to accept an order which covers
only variable costs (because this would generate a positive contribution),
but only if you have already covered your fixed costs. To connect the issues
of contribution and the covering of fixed cost in this manner is nonsense.
Whether or not you have covered your fixed costs for the current period,
44
such an order would help you cover them. So, as long as you have idle
capacity and the market price for your product will not generally deteriorate,
you should accept the order which gives a contribution.
How then do you find out about, and manage, scarce resources? Suppose
a soft drinks producer obtains an order from overseas offering £10 per case.
If the producer has idle capacity and the overseas market has no knock-on
effects on its core markets, the producer should accept the offer so long as
the variable cost per case including transport is less than £10. Whether fixed
period costs have already been covered at the time of the order is irrelevant.
Any contribution earned from this and other orders will be used to help cover
fixed costs and profits. Once fixed costs are covered, the remaining
contribution adds to profits.
Short-term decisions with one scarce resource

Many decisions will need to be taken in circumstances where resources are
in short supply. It may be that resources are externally rationed, so that
a business is restricted in the amount of a resource that can be acquired.
Alternatively, it may be impossible for the amount of resource to be increased
over the time horizon relevant to a decision. For example, workers might
take time to recruit and train, so that they are available for production only
after a certain period. If an order comes in that needs immediate attention,
then the labour required must be transferred from that already employed
elsewhere in the business. Thus acceptance of a new order might mean that
existing products must be curtailed or dropped altogether. When a decision
is assessed using incremental costs, and resources are scarce, then it is
necessary to take into account not only the incremental cash outflows
arising, but also any contribution sacrificed by transferring scarce resources
from other productive uses.
Some decisions will not be of an incremental nature. They concern ‘lumpy’
items. These are items which cannot be divided. For example, production
capacity may need to be dedicated to one product and not be halved. The
most important of lumpy items are encountered in resource allocation
decisions, where the business must decide how to allocate a scarce resource
to the various available products, so as to achieve the best overall outcome.
Various assumptions are normally made about the business and its
production processes:
1. the business seeks to maximise its cash contribution
2. costs are linearly related to output
3. all the products of the business may be produced and sold independently
of each other
4. all production processes are perfectly divisible, as regards both inputs and
outputs
5. there are no hidden costs associated with non-production such as loss
of reputation
6. all inputs and all production processes are known with certainty.
For many businesses, these assumptions (except perhaps assumption 6.) are
reasonably good approximations to reality. However, the assumption of
perfect divisibility is questionable where the business manufactures large
individually identifiable items, and caution must be used in such cases in
applying the techniques of this chapter.
45
Contribution per bottleneck resource

Let us further suppose that one resource is scarce. It might be material that
cannot be easily replaced or whose supply is rationed, or labour hours, for
example, where the workforce and the time worked by each employee is
limited and cannot be easily expanded, or some other constraining factor.
In the absence of the constraint, the business would produce all goods
generating a positive incremental contribution, but given the scarce resource,
this must be utilised in the most efficient way. We can achieve efficient
utilisation of the scarce resource by calculating the contribution per unit of
the scarce resource for each product, and producing the product that yields
the maximum contribution per unit of scarce resource. Where the demand
for products is limited, the various products should be ranked in order of
contribution per unit of scarce resource.
The product yielding the greatest contribution per unit of scarce resource
should be produced up to the maximum output demanded, then the product
yielding the next highest level of contribution per unit of scarce resource,
and so on until the scarce resource is fully utilised. You should note that the
ranking of products by contribution per unit of scarce resource will not
necessarily correspond to the ranking of contribution per unit of product,
as products yielding high unit contributions might use the scarce resource to
a greater relative extent than products yielding low unit contributions. In
other words, you work out how much of a bottleneck resource each product
would consume and decide to make those that give you the highest benefit
(contribution) per ‘bottleneck unit’ (e.g. time spent in a final spraying booth
or a drying oven).
More than one scarce resource: linear programming (LP)

Where the business faces more than one scarce resource, the technique
outlined above does not always work. If the products are ranked by
contribution per unit of each scarce resource, it is likely that the rankings will
differ, as a product that uses one scarce resource relatively extensively might
not use another scarce resource to the same relative extent. Where the
rankings differ, there is no clear-cut answer to the problem of what
combination of goods should be produced to maximise total contribution,
unless a more sophisticated technique is used. One such technique is linear
programming (LP). This is a mathematical technique that, given the
assumptions stated above, gives the theoretically-optimal solution to the
problem of allocating scarce resources to maximise contribution.
Although the LP technique is conceptually simple, it is difficult to apply in
practice, and many real world LP problems require a computer to obtain a
solution quickly (there is a method of solving LP problems manually called
the ‘Simplex Algorithm’, but this is time-consuming to apply). Where there
are only two products, however, it is possible to solve the LP problem using
a graph (because the problem is two dimensional and a graph exists in two
dimensions), and two product problems are usually to be found in
management accounting textbooks.
Now take a look at the appendix on LP in Chapter 11 of your textbook.
Exhibit 11-14 is a graphic solution to an LP problem. Keep the graph by you
while you read the following. Here are various stages in applying the LP
technique to a problem.
1. Identify the objective function. This is an expression that shows in
algebraic terms what is to be maximised (or minimised). For example,
46
where the LP problem involves maximisation of total contribution, the

objective function will be an expression defining the contribution and
showing how it would be made up of the contributions from each unit of
the various products that could be produced. (The LP technique may also
be used where we wish to minimise rather than maximise, for example
to calculate the minimum cost to produce certain given combinations
of output.)
2. Identify the constraints. For each scarce resource, there will be a constraint,
which is an algebraic expression in the form of an inequality. This implies
that the total of the scarce resource used in production cannot be exceeded,
but that it is possible for some of the scarce resource not to be used.
Additionally, there will be non-negativity constraints, which state that the
production of each good must be greater than or equal to zero, as we
cannot produce negative quantities of any good. There could also be
demand constraints, where there is a maximum demand for any good.
Alternatively, powerful customers who buy large portions of your output
may require you to keep output of certain products over a specified level.
This would be a minimum demand constraint.
3. Plot the constraints on a graph and determine the feasible region. This is
the area of the graph such that all points within the feasible region satisfy
all the inequalities. (On a two-axis graph, any point within the feasible
region would indicate a production combination of your two products.)
Any point outside the feasible region must break at least one of the
constraints, and cannot be a possible solution. Note that the feasible
region normally includes points lying on the boundary of the feasible
region, as the constraints are normally of the form ‘less than or equal to’
or ‘greater than or equal to’ rather than strict inequalities.
4. Identify on the graph the optimal solution. This is given by the point lying
‘furthest away’ from the origin of the graph. The ‘furthest away’ point in
this context depends on the objective function (i.e. in exactly which
direction – a bit more to the top, or a bit more to the right – do you aim to
move away from the origin of the graph?). The solution to a maximisation
problem is achieved when the objective function takes its highest value
within the feasible region. We can draw on our graph various parallel
lines representing the graph of the objective function for various values of
the objective function. As these lines (sometimes called iso-profit or iso-
contribution lines, because they join all combinations of output of the
goods that yield the same profit or contribution) move out from the
origin, the value of the objective function increases, and the highest value
will be reached at the last line to just touch the feasible region. In LP, the
optimal solution will lie on the boundary of the feasible region, and will
be either a point where two constraints intersect (the more typical
outcome, giving a unique solution) or, where the objective function has
the same slope as one of the constraints, a segment of that constraint
between the points where it intersects with two other constraints (in
which case there is no unique solution). Given a unique solution, the
co-ordinates of the point represented by the solution may be determined
either directly from the graph or alternatively by solving the two constraints
defining the point of intersection as simultaneous equations.
The LP approach is useful when we can be sure that our underlying
assumptions represent reasonable approximations of the reality of the
situation. Even where some of the assumptions do not hold, it might be
possible to employ non-linear techniques to overcome the problems
47
(although these almost inevitably require computers even in simple settings).

For example, LP assumes perfect divisibility of inputs and outputs, and it is
not unlikely that the solution obtained will involve fractions of units.
If, however, the products are such that fractional units are not sensible, then
a solution in terms of integers is required. This could be approximated by
rounding down the precise solution to the nearest whole number, but in
certain situations the more advanced technique of integer programming is
needed to deal with a requirement for an integer solution. Similarly, where
certain constraints are non-linear, and where there are interdependencies
between inputs or outputs (for example, certain products can be produced
only jointly), the LP formulation needs extra constraints and it may be
necessary to utilise a non-linear approach such as quadratic programming.
Note that non-linear techniques are beyond the scope of this unit.
Activity
Work through the example in the LP appendix of Chapter 11 in your textbook and write
a brief paragraph on the limitations of LR.
Dual prices (shadow prices) and opportunity costs

One of the most important assumptions of LP is that the constraints are given
externally and cannot be affected by the decision-maker. However, this
assumption might be incorrect in two ways.
1. There might be some uncertainty about a particular constraint. For
example the total quantity of a particular scarce resource might be
uncertain, although estimates may be made in formulating the LP
problem. To overcome this, it is possible to perform a sensitivity analysis
by reformulating the LP problem with different quantities of the scarce
resource in the relevant constraint, and finding the new solution. Many
computer programs for LP do this automatically. One important situation
arises when a constraint is non-binding, that is, it is not one of the
constraints that define the optimal solution. Graphically, this means that
the constraint line does not touch the point which represents the optimal
solution on the edge of your feasible region. In this case, the constraint is
not actually effective in limiting production (this is achieved by other
constraints), and it is irrelevant to the solution. Where a constraint is
non-binding, the optimal solution implies that there are unused quantities
of the resource involved, so that small changes in the quantity available
will not change the optimal solution. We say that there is ‘slack’ in respect
of this resource. The resource becomes significant only if the quantity
available changes so much that the constraint becomes a binding one,
in which case it starts to define the optimal solution.
2. The second way in which the assumption that constraints are given
externally might be incorrect is where the quantity of a scarce resource
could be changed, by increasing or decreasing it. Although this might
seem inconsistent with the assumption that the resource is scarce, in
some cases it is possible to increase resources at a price. For example,
labour hours might be limited, but it might be possible to increase them
by paying higher overtime rates. Machine hours might be increased by
hiring time elsewhere, even if this is relatively expensive. Emergency
supplies of materials could be purchased at a higher price than usual. The
decision-maker will want to know when it is worthwhile to pay over the
normal price to overcome a resource scarcity, and the maximum that can
be paid while still increasing the net contribution to the business. Rather
than a strictly optimal solution, LP would give management a tool for
thinking about its options!
48
Dual (shadow) prices

In order to provide such information, the technique of calculating the dual
price (sometimes called the shadow price) of a scarce resource is used. The
dual price represents the additional contribution that will be obtained from
one more unit of scarce resource, or the contribution loss that will be
incurred if one unit of scarce resource is removed. We calculate (or a suitable
computer programme gives) the dual price of a scarce resource by:
1. adding one unit to the constraint corresponding to the scarce resource
2. solving a new LP problem with the revised constraint in place of the
previous constraint
3. calculating the value of the objective function at the solution to the new
LP problem
4. finding how much this new value exceeds the value of the objective
function at the optimal solution to the old LP problem: this is the dual
price of the scarce resource.
The dual price of a scarce resource, then, is the incremental contribution,
after taking into account changes in the quantities of each good produced
and consequent changes in the usage of slack resources, from an incremental
unit of the scarce resource. The dual price therefore represents the maximum
extra amount that the business will be prepared to pay (in excess of the
normal unit price) to acquire an extra unit of the scarce resource.
Activity
For example, if a unit of a scarce resource normally costs £10, but buying an extra unit
will increase total contribution by £4 (remember that the objective function reflects
contribution figures that already take account of the normal price of the scarce resource),
then how much would the business be willing to pay for it?
Up to £14 for an extra unit is correct, as any amount less than that would still
generate a positive incremental contribution, after paying for the scarce
resource and amending the optimal business plan to allow for the availability
of the extra unit of the scarce resource.
Opportunity costs
Where a resource is scarce, its use in producing one good means that it is not
available for other goods. In many situations with scarce resources, it may be
assumed that the business has already determined its optimal production
plan. Suppose that an alternative arises, and the business wishes to consider
whether it should be accepted. In Chapter 2, we saw that such an
incremental opportunity should be assessed by calculating the net
incremental cash contribution that the business would earn if this new
opportunity is accepted. The basis for calculating this is the opportunity costs
of the resources used. Where resources are not scarce, acceptance of an
opportunity does not imply a rearrangement of the other activities of the
business: these may be carried on in any event. The opportunity cost of a
resource is in general its current replacement cost, which we can refer to as
its external opportunity cost.
Where a resource is scarce, however, its use for a new alternative action
means that it must be transferred from existing activities, so that these must
be rearranged. Contribution will be foregone through this, and the foregone
contribution is just as much an incremental cost for the new activity as the
49
replacement price of the resource. We call such a cost the internal

opportunity cost, and measure it by the dual price of the resource. In our
decision-making process, then, the total opportunity cost of a scarce resource
will be the sum of the external and internal opportunity costs. Thus the dual
price of a scarce resource represents part of the economic cost that must be
borne if the resource is allocated to another use.
What happens with slack resources? These correspond to non-binding
constraints, which do not enter into the solution to the LP problem. Thus
adding or subtracting extra units of a slack resource will not change the
solution (at least for small additions or subtractions). Therefore the value of
the objective function remains unchanged. The dual price of a slack resource
is therefore zero. You should note that constraints are likely to remain
binding or non-binding only over certain ranges of resource supply, and the
dual price is valid only so long as the binding constraints remain effective.
A final point relating to dual prices arises when one of the binding
constraints is a demand constraint (specifying the maximum number of units
of a particular good that will be demanded). In this situation, the good in
question will have a dual price, in that an extra unit of demand for the good
will increase the total contribution (this occurs because a binding demand
constraint can arise only in respect of the good with the highest unit
contribution, unless several demand constraints bind simultaneously). What
is the interpretation of this dual price? Just as the dual price for a scarce
resource represents the maximum extra amount over normal price that it is
rational to pay for an extra unit of the resource, so the dual price for a unit of
output represents the maximum amount that the business will be willing to
pay (in the form of a reduction of the normal selling price or through a
greater marketing effort) in order to achieve an extra unit of demand. Note
that the extra payment or discount applies only to incremental units, not to
the total units bought or sold.
Activity
What is the opportunity cost of your current management accounting studies? How can
you measure it? In what way would it make sense to distinguish between internal and
external opportunity costs in your case?

How does the introduction of scarce resources affect the notion of
opportunity costs?

question
The main point for this question is that with scarce resources management
stops considering opportunity costs in the abstract and begins to relate the
contributions to be earned from different activities to the resources used for
pursuing those activities. This means that contribution is calculated as
contribution per unit of scarce resource, thus changing the relative ranking
of possible actions, depending on their projected resource consumption.
50

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Management accounting

The External Programme

Published by: University of London Press

Objective and subjective probabilities 29

Chapter 9: Performance measurement systems 89

Why study management accounting?

Organising your studies

Chapter 1: Modern management accounting

in the operation of accounting and other information systems. This included

Management accounting, cost accounting and financial

calculating the ﬁnancial contribution of the divisions. This incentivises

Table 1.1: A comparison of financial accounting and management accounting

From record keeping to problem solving? The strategic turn

‘Price leadership’ and ‘differentiation’

At a more elementary level, strategic cost accounting might calculate the

Strategic management accounting

organisation’s management and its information systems. There is now the

Enterprise Resource Planning Systems (ERP)

On the face of it ERP looked like a great example of how unrewarding

Planning, controlling and ‘experience’

prefer to question their planning assumptions more rigorously every time

The budgeting process and ‘beyond’ budgeting

Decision-making and organisational goals

The implications for the role of management accounting in decision-making

Sample examination question

Suggestions for answering the sample examination

‘[...] the process of identifying, measuring, and communicating

3. Determining plans, both long-range and short-range (such as the

The importance of cash flows

in making short-term decisions, we still need to focus on the cash ﬂows

The concept of relevant costs and revenues

Identifying relevant costs and revenues

other contracts. It is necessary in such circumstances to somehow allocate

Resources already under the organisation’s control

Decision-making and current replacement cost

Information on… Yes No

Comparing cash flows in the long run

An individual will be indifferent between receiving an amount of capital C

The net present value decision rule

3. assess the project using the NPV rule.

Making estimates for project appraisals

Problems with the opportunity cost concept

Uncertainty and relevant information

Table 2.1: Example of outcomes from decision under uncertainty

Characteristics of useful information

one who is free from bias. Weather forecasts based on forecasting

Objective and subjective probabilities

The value of information

Sample examination question

Suggestions for answering the sample examination

Chapter 3: Cost behaviour

The elements of total costs and their behaviour

Direct material cost X

Direct and indirect costs

Fixed and variable costs

The identification of cost drivers

In practice this is usually not as straightforward as it sounds, particularly in

experienced and efﬁcient at manufacturing the product, and unit costs

Error terms and outliers

Cost-volume-profit and break-even analysis

output over that range, then the contribution margin is calculated by

Sample examination question

Suggestions for answering the sample examination