BBMA3203

OUM Business School
BBMA3203
Management Accounting II
Copyright © Open University Malaysia (OUM)

BBMA3203
MANAGEMENT
ACCOUNTING II
Noor Asma Jamaluddin

Project Directors: Prof Dato’ Dr Mansor Fadzil
Prof Dr Wardah Mohamad
Open University Malaysia
Module Writer: Noor Asma Jamaluddin

Universiti Utara Malaysia
Moderator: Noral Hidayah Alwi

Developed by: Centre for Instructional Design and Technology

First Edition, November 2008

Second Edition, February 2011
Third Edition, April 2015
Copyright © Open University Malaysia (OUM), April 2015, BBMA3203

All rights reserved. No part of this work may be reproduced in any form or by any means
without the written permission of the President, Open University Malaysia (OUM).

Table of Contents
Course Guide xiăxvi
Topic 1 Cost Volume Profit Analysis 1

1.1 Importance of Cost Volume Profit Analysis 2
1.1.1 Setting the Selling Price 3
1.1.2 Determining the Sales Mix 3
1.1.3 Choosing the Marketing Strategy 3
1.1.4 Evaluating the Impact of Changing Costs 3
1.2 Assumptions in Cost Volume Profit Analysis 4
1.3 Break Even Point (BEP) 4
1.4 Approaches in Cost Volume Profit Analysis 6
1.4.1 Calculation of the Break Even Point (BEP) 7
1.4.2 Calculation of Sales for a Given Target Profit (If Any) 10
1.5 Applications of Cost Volume Profit Analysis 11
1.5.1 Margin of Safety 11
1.5.2 Changes in Fixed Cost 12
1.5.3 Changes in Contribution Margin 13
1.5.4 Target Profit 14
1.5.5 Changes in Various Factors 16
1.6 Impact of Tax in Cost Volume Profit Analysis 20
Summary 20
Key Terms 21
Appendix: Graphs and Their Meaning 21
Topic 2 Budgeting 24
2.1 Budget 25
2.1.1 Definition of Budget 25
2.1.2 Uses and Advantages of Budgets 25
2.2 Cash Budgets 27
2.3 Master Budget 31
2.3.1 Operating Budget 31
2.3.2 Financial Budget 32
2.4 Preparation of Operating Budget 32
2.4.1 Sales Budget 33
2.4.2 Production Budget 35
2.4.3 Raw Materials Budget 36
2.4.4 Direct Labour Budget 37
2.4.5 Overhead Budget 38
2.4.6 Sales and Administrative Expense Budget 39

iv X TABLE OF CONTENTS
2.5 Preparation of a Pro-Forma Income Statement 42

2.6 Financial Budgets 43
2.6.1 Cash Budget 43
2.7 Preparation of Pro-Forma Balance Sheet 47
2.8 Preparation of Master Budgets for Merchandising Firms 48
2.8.1 Sales Budget 48
2.8.2 Purchases Budget 49
2.8.3 Sales and Administrative Expense Budget 50
2.8.4 Preparation of Pro-Forma Income Statement 50
2.8.5 Cash Budget 51
2.8.6 Preparation of Pro-Forma Balance Sheet 52
2.9 Flexible Budgets 54
2.10 Techniques of Budgeting 58
2.10.1 Incremental Budgeting 58
2.10.2 Zero-Based Budgeting (ZBB) 59
2.10.3 Rolling Budget 62
2.10.4 Activity-Based Budget (ABB) 63
Summary 65
Key Terms 66
References 66
Topic 3 Budgetary Control 67

3.1 The Traditional System 68
3.1.1 Budgetary Control System 68
3.1.2 Types of Controls 72
3.1.3 Feed-Forward and Feedback Control 75
3.2 Fixed and Flexible Budgets 82
3.2.1 Performance Reports and Reconciliation Statement 88
3.3 Motivational, Behavioural and Ethical Issues of Budgeting 92
3.3.1 Motivational and Behavioural Issues 92
3.3.2 Ethical Issues 96
3.4 Limitations of Budget and Budgetary Control 97
Summary 100
Key Terms 101
References 102
Topic 4 Standard Costing and Variance Analysis 103

4.1 Standard Costing and Its Importance 104
4.2 Setting Standard Cost 106
4.3 Types of Standards 108
4.4 Advantages and Disadvantages of Standard Costing 110
4.5 Advanced Variance Analysis 112
4.5.1 Material Mix and Yield Variance 112
4.5.2 Labour Mix and Yield Variance 117

TABLE OF CONTENTS W v
4.5.3 Sales Mix and Sales Quantity Variances 121

4.5.4 Market Share and Market Size Variances 127
4.6 Planning and Operational Variance Analysis 129
4.7 Operating Statement (Variable Costing and Absorption 132
Costing Techniques)
4.8 Interdependence between Variances 135
4.9 Investigating Variance 136
4.9.1 Variance Investigation Models 138
Summary 141
Key Terms 142
References 142
Topic 5 Variance Analysis 143

5.1 Cost Variance Analysis 144
5.2 Direct Materials Variance 147
5.3 Direct Labour Variance 150
5.4 Manufacturing Overheads Variance 152
5.5 Overhead Variance 154
5.6 Uses and Importance of Cost Variance 160
Summary 164
Key Terms 164
Topic 6 Productivity and Cost of Quality: Measurement, Report and 165

Control
6.1 Measuring Cost of Quality 166
6.1.1 Production Quality 166
6.2 Costs of Quality 167
6.3 Measuring Optimal Production Quality 168
6.4 Reporting Cost of Quality Information 171
6.4.1 Cost of Quality Report 171
6.5 Productivity 173
6.5.1 Productivity Measurement 173
6.5.2 Fractional Productivity Measurement 174
Summary 175
Key Terms 176
Topic 7 Accounting Information for Pricing Decisions 177

7.1 Main Factors Influencing Pricing 178
7.2 Economic Pricing Model 180
7.2.1 Problems of Economic Pricing Model 180
7.3 Pricing using Production Cost Information 181
7.3.1 Cost Approach for Companies with Single Product 182
7.3.2 Cost Approach for Companies with Multiple Product 183
7.3.3 Determining the Mark-up Percentage 185

vi X TABLE OF CONTENTS
7.3.4 Limitations on the Use of Cost Approach 187

7.4 Customer Profitability Analysis using Activity-Based 188
Costing
7.5 Target Costing and Pricing 192
Summary 194
Key Terms 195
Topic 8 Performance Evaluation in Decentralised Firms 196

8.1 Responsibility Accounting 197
8.2 Measuring Cost of Quality 199
8.3 Decentralised Firms and Segmented Reporting 201
8.4 Measuring The Performance of Investment Centres 203
8.4.1 Return on Investment 204
8.4.2 Residual Income 207
8.4.3 Economic Value Added 209
8.5 Balanced Scorecard 210
8.6 Benchmarking 212
Summary 213
Key Terms 214
Topic 9 Transfer Pricing in Multi-segment Firms 215

9.1 Purpose of Transfer Pricing 216
9.2 Effect of Transfer Pricing on Profit 217
9.3 General Rules in Transfer Pricing 219
9.4 Approach to Transfer Pricing 224
9.4.1 Market-based Transfer Price 224
9.4.2 Cost-based Transfer Price 226
9.4.3 Negotiated Transfer Price 227
9.5 Transfer Price from an International Perspective 229
Summary 230
Key Terms 230
Topic 10 Short-Term Decision Making 231

10.1 Role of a Management Accountant in Decision Making 232
10.2 Relevant Information 234
10.3 Theory of Constraints 236
10.4 Types of Decision Making 239
10.4.1 Decision to Eliminate or Retain a Product 240
10.4.2 Decision to Produce or Buy 244
10.4.3 Decision to Sell Before or After Additional Process 248
10.4.4 Special Orders 250
Summary 257
Key Terms 257

TABLE OF CONTENTS W vii
Topic 11 Long-Term Decision Making 258

11.1 Capital Investment Appraisal Techniques 259
11.1.1 Accounting Rate of Return (ARR) 260
11.1.2 Payback 262
11.1.3 Discounted Payback 265
11.1.4 Net Present Value (NPV) 268
11.1.5 Internal Rate of Return (IRR) 272
11.1.6 Profitability Index 274
11.2 Capital Rationing 274
11.3 Effects of Inflation and Taxation in Capital 277
Investment Appraisal
11.4 Risk and Uncertainty, and Sensitivity Analysis 284
11.5 Ethical Issues and Other Qualitative Factors in 288
Long-Term Decision Making
11.5.1 Other Qualitative Factors 290
Summary 292
Key Terms 293
References 294

viii X TABLE OF CONTENTS

COURSE GUIDE

COURSE GUIDE W xi
COURSE GUIDE DESCRIPTION

You must read this Course Guide carefully from the beginning to the end. It tells
you briefly what the course is about and how you can work your way through
the course material. It also suggests the amount of time you are likely to spend in
order to complete the course successfully. Please keep on referring to the Course
Guide as you go through the course material as it will help you to clarify
important study components or points that you might miss or overlook.
INTRODUCTION
BBMA3203 Management Accounting II is one of the courses offered by the OUM
Business School at Open University Malaysia (OUM). This course is worth 3
credit hours and should be covered over 8 to 15 weeks.
COURSE AUDIENCE
This is a core course for all OUM students undertaking the Bachelor of
Accounting. As an open and distance learner, you should be acquainted with
learning independently and being able to optimise the learning modes and
environment available to you. Before you begin this course, please confirm the
course material, the course requirements and how the course is conducted.
As an open and distance learner, you should be able to learn independently and
optimise the learning modes and environment available to you. Before you begin
this course, please confirm the course material, the course requirements and how
the course is conducted.
STUDY SCHEDULE
It is a standard OUM practice that learners accumulate 40 study hours for every
credit hour. As such, for a three-credit hour course, you are expected to spend
120 study hours. Table 1 gives an estimation of how the 120 study hours could be
accumulated.

xii X COURSE GUIDE
Table 1: Estimation of Time Accumulation of Study Hours
Study
Study Activities
Hours
Briefly go through the course content and participate in initial discussions 3
Study the module 60
Attend 3 to 5 tutorial sessions 10
Online participation 12
Revision 15
Assignment(s), Test(s) and Examination(s) 20
TOTAL STUDY HOURS 120
COURSE OBJECTIVES
By the end of this course, you should be able to:
1. Explain the basic concept of CVP analysis and its application in business
decision making;
2. Apply various techniques of budgeting and discuss their role in planning,
control and decision making;
3. Use standard costing technique and interpret variances, including planning
and operational variances for control purposes;
4. Illustrate the concept of relevant costs and revenues in decision making;
5. Employ various techniques in capital investment decisions, including
accounting rate of return, payback, discounted payback, discounted cash
flow techniques, and effect of inflation and taxation;
6. Incorporate motivational, behavioural and ethical issues in managerial
planning, and control and decision making; and
7. Utilise appropriate computer software to assist decision making.

COURSE GUIDE W xiii
COURSE SYNOPSIS
This course is divided into 11 topics. The synopsis for each topic is presented
below:
Topic 1 elaborates on profit planning using Cost-Volume-Profit (CVP) Analysis.

The application of CVP analysis helps managers to understand how profits are
affected by sales volume, selling price, unit variable cost, total fixed cost and mix
of products sold. CVP is a powerful and vital tool in many business decisions.
Topic 2 explains how budgets are used as a planning and performance

measurement tool. The first part highlights the budgeting process and
preparation, followed by detailed steps of preparing the master budget
comprising operating budget and financial budget for manufacturing and non-
manufacturing organisations. Finally, preparation of budgets are described.
Topic 3 elaborates on using a budget as a good control system. It also compares

between fixed and flexible budgets and their preparation mechanism. Several
aspects and issues related to budgeting are discussed, including its advantage as
a performance assessment tool, the motivational, behavioural and ethical issues,
as well as the limitations of budgeting.
Topic 4 discusses the importance and use of standard costing. There are detailed
illustrations on variance cost analysis, which is divided into three types: direct
materials variance, direct labour variance and overheads variance. Moreover, the
discussion is extended to include advanced variance analysis, such as mix and
yield variance, mix and quantity variance, market share and market size
variance, as well as operational and planning variances. Other related aspects are
also covered such as the uses, advantages, criteria and steps for further
investigation on variances, interdependence between variances as well as the
limitations.
Topic 5 highlights the variance cost analysis which is divided into three types:
direct materials variance, direct labour variance and overheads variance. The
final part discusses the uses and advantages of variance analysis.
Topic 6 talks about the role of management accounting in measuring

productivity and quality. In this topic, you will be introduced to categories in
costs of quality, which will assist in the preparation of cost of quality report. The
measurement of costs of quality and productivity as well as issues in
productivity control are also discussed.

xiv X COURSE GUIDE
Topic 7 introduces pricing decision methods and issues related to the decisions.
Among those discussed include, economic pricing model and cost-based pricing
methods.
Topic 8 describes the delegation of responsibility in decentralised firms and how

monitoring should be conducted so that the original objectives of the
organisation are retained in all departments or branches even at different
locations. Performance mesurement for investment centres is forwarded and
performance measurement through a balanced scorecard is introduced.
Topic 9 discusses the objective of transfer pricing, emphasis on goal congruence,

methods and the general rule in transfer pricing and transfer pricing in an
international perspective.
Topic 10 focuses on short term decision making. Firstly, it talks about relevant
cost and benefits for decision making and then illustrates how this relevant cost
concept is applied to various situations or decisions. Short term decision making
include decisions that involve making or buying a component, adding or
dropping a product line, using a constrained resource, and accepting or rejecting
a special order. Other related discussion includes limiting factors and pricing
strategies and methods.
Topic 11 is concerned with long term decisions. It focuses on the appraisal

techniques that are used for assessing capital investment decisions. It
demonstrates how managers should evaluate and select amongst potential
investment projects to yield maximum profit to companies. In addition, it also
examines more complex issues relating to capital investment decisions like
capital ration, implication of taxation and inflation, risk and uncertainties, as well
as the sensitivity analysis. Ethical issues and other qualitative factors that could
be affected by capital investment decision are also discussed.
TEXT ARRANGEMENT GUIDE

Before you go through this module, it is important that you note the text
arrangement. Understanding the text arrangement will help you to organise your
study of this course in a more objective and effective way. Generally, the text
arrangement for each topic is as follows:
Learning Outcomes: This section refers to what you should achieve after you
have completely covered a topic. As you go through each topic, you should
frequently refer to these learning outcomes. By doing this, you can continuously
gauge your understanding of the topic.

COURSE GUIDE W xv
Self-Check: This component of the module is inserted at strategic locations

throughout the module. It may be inserted after one sub-section or a few sub-
sections. It usually comes in the form of a question. When you come across this
component, try to reflect on what you have already learnt thus far. By attempting
to answer the question, you should be able to gauge how well you have
understood the sub-section(s). Most of the time, the answers to the questions can
be found directly from the module itself.
Activity: Like Self-Check, the Activity component is also placed at various

locations or junctures throughout the module. This component may require you
to solve questions, explore short case studies, or conduct an observation or
research. It may even require you to evaluate a given scenario. When you come
across an Activity, you should try to reflect on what you have gathered from the
module and apply it to real situations. You should, at the same time, engage
yourself in higher order thinking where you might be required to analyse,
synthesise and evaluate instead of only having to recall and define.
Summary: You will find this component at the end of each topic. This component
helps you to recap the whole topic. By going through the summary, you should
be able to gauge your knowledge retention level. Should you find points in the
summary that you do not fully understand, it would be a good idea for you to
revisit the details in the module.
Key Terms: This component can be found at the end of each topic. You should go
through this component to remind yourself of important terms or jargon used
throughout the module. Should you find terms here that you are not able to
explain, you should look for the terms in the module.
References: The References section is where a list of relevant and useful

textbooks, journals, articles, electronic contents or sources can be found. The list
can appear in a few locations such as in the Course Guide (at the References
section), at the end of every topic or at the back of the module. You are
encouraged to read or refer to the suggested sources to obtain the additional
information needed and to enhance your overall understanding of the course.
PRIOR KNOWLEDGE
Learners of this course are required to pass BBMA3103 Management Accounting
I course.

xvi COURSE GUIDE
ASSESSMENT METHOD
Please refer to myINSPIRE.
REFERENCES
Blocher, E. J., Stout, D. E. & Cokins, G. (2010). Cost management: A strategic
emphasis. New York, NY: McGraw-Hill/Irwin.
CIMA. (2011). CIMA official study text: Paper P2 performance management. UK:
Elsevier Limited and Kaplan Publishing.
Drury, C. (2008). Management and cost accounting. UK: South-Western, Cengage
Learning.
Garrison, R. H., Noreen, E. E., Brewer, P. C., Cheng N. S. & Yuen, K. (2012).
Managerial accounting: An Asian perspective. Singapore: McGraw Hill.
Hansen, D. R. & Mowen, M. M. (2012). Cost management: Accounting and
control. Singapore: Thomson South-Western.
Hermanson, R. H., Edwards, J. D., Herman, D., Sellers, K. F., Thomas, W. B. &
Wetzel, S. T. (1997). Financial Accounting: A business perspective (7th ed.).
Ohio, OH: International Thompson Publishing.
Horngren, C. T., Harrison, W. T. Jr., & Bamber, L. S. (2004). Accounting (6th ed.).
New Jersey, NJ: Prentice Hall.
Larson, K. D., Wild, J. J. & Chiappetta, B. (2004). Fundamental accounting
principles (17th ed.). New York, NY: McGraw Hill.
Weygandt, J. J., Keiso, D. E., & Kimmel, P. D. (2008). Accounting principles
(9th ed.). Hoboken, NJ: John Wiley & Sons, Inc.
TAN SRI DR ABDULLAH SANUSI (TSDAS)

DIGITAL LIBRARY
The TSDAS Digital Library has a wide range of print and online resources for
the use of its learners. This comprehensive digital library, which is accessible
through the OUM portal, provides access to more than 30 online databases
comprising e-journals, e-theses, e-books and more. Examples of databases
available are EBSCOhost, ProQuest, SpringerLink, Books24×7, InfoSci Books,
Emerald Management Plus and Ebrary Electronic Books. As an OUM learner,
you are encouraged to make full use of the resources available through this
library.
Topic X Cost Volume
1 Profit Analysis
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Define Cost-Volume-Profit (CVP) analysis;
2. Explain the significance of cost volume profit analysis;
3. Demonstrate the techniques for calculating break even point
(BEP);
4. Elaborate the approach in cost volume profit analysis; and
5. Identify the impact of tax in cost volume profit analysis.
X INTRODUCTION
There are different management accounting aspects used by management to
determine internal decisions. Various decisions have to be made, depending on
the purpose of such decisions. For instance, the management of a private clinic
often poses several questions regarding the business activities of the clinic, such
as:
(a) How many patients have to be treated to achieve break even point?
(b) What would the impact be on profit if the clinic area is widened?
(c) What are the effects of increasing treatment charges on the profit and
number of clinic patients?
All the above questions are related to changes in the activities of the company
which affect the costs and income. They are the fundamental questions in
business and must be answered to allow the management to see the impact of
each of the changes made, which in turn will assist the management in
conducting systematic and strategic planning, thus arriving at systematic and
sound business decisions.
2 X TOPIC 1 COST VOLUME PROFIT ANALYSIS
Cost volume profit analysis (CVP) is a technique in management accounting

which helps to solve questions, such as those described earlier.
1.1 IMPORTANCE OF COST VOLUME PROFIT

ANALYSIS
Cost volume profit analysis (CVP) can be defined as follows.
Cost volume profit analysis is a method of analysis which determines the

impact of a change in activity levels on the cost, income and profit of the
company.
This analysis can be utilised to see how changes in selling prices, variable costs,
fixed costs, taxes and sales mix affect profits. Generally, cost volume profit
analysis helps the management to obtain an overall perspective of the effects of
different types of short term financial changes on cost and income.
In fact, this analysis plays an important role in helping the management to

construct a more systematic planning for making decisions with respect to:
(a) Setting the selling price;
(b) Determining the sales mix;
(c) Choosing the marketing strategy; and
(d) Evaluating the impact of changing costs.
ACTIVITY 1.1
A shop owner likes to talk about profit whenever he sells ice-cream in

his grocery store. He will calculate his profit by taking into account all
costs incurred. However, he is not aware that the profit calculation can
be simplified by cost volume profit analysis. What is the main
significance of cost volume profit analysis?

TOPIC 1 COST VOLUME PROFIT ANALYSIS W 3
1.1.1 Setting the Selling Price

In a perfect competitive economy, the process of setting a price can be very
difficult compared to that in a monopoly economy. Companies cannot depend
only on internal information, such as costs, capacity and efficiency of the
production, but must also take into consideration the macro factors, which
include competition, demand and materials supplies. Cost volume profit analysis
provides management with useful information for the process of determining
prices.
1.1.2 Determining the Sales Mix

As you are aware, a company will try to increase its profit by producing various
products. Producing a variety of products will, however, create problems to the
management when deciding the quantity of each product to be produced and
sold while ensuring the profit is attained.
By applying the cost volume profit analysis, the management is able to determine
the right sales product A and product B. The company cannot simply assume
that, in order to reach the maximum profit or to be just at the break even point, it
has to sell 2 units of product A and 1 unit of product B. On the contrary, the
company has to perform various analyses, and the simplest analysis is by using
the cost volume profit analysis.
1.1.3 Choosing the Marketing Strategy

Marketing strategy is also important in ensuring the success of a product in the
market. A company has to observe the most effective strategy to obtain
maximum profit. The cost volume profit analysis assists the management in
choosing an effective marketing strategy by providing information on the cost
benefit of each strategy to be used. Cost benefit requires the management to
make decisions in such a manner that each cost incurred will attain its benefits
accordingly (be paid off). For example, to increase its profits, a company may
need to change its marketing strategy, for example by cutting-down the expenses
on promotion or reducing the selling price per unit.
1.1.4 Evaluating the Impact of Changing Costs

In the business environment, changes in cost will directly affect the companyÊs
profit. For example, an increase in the cost of raw materials will reduce the profit
of the company, and vice-versa. By employing the cost volume profit analysis,

the management can evaluate thoroughly the impact of the changes in each cost
on the companyÊs profit.
1.2 ASSUMPTIONS IN COST VOLUME PROFIT

ANALYSIS
In management accounting, the information obtained is based on the future, and
hence requires several assumptions. Even though the information is based on
assumptions, it still has to be as accurate as possible. The cost volume profit
analysis can only be applied effectively if several assumptions are satisfied. Some
of the assumptions used in the cost volume profit analysis include:
(a) Selling price is constant throughout the period;
(b) All costs can be classified as either variable cost or fixed cost;
(c) Variable cost varies in proportion to the changes in volume;
(d) Total fixed cost remains constant regardless of the activity levels;
(e) Efficiency level of the operations remains unchanged, that is no profit or
loss will be incurred due to the efficiency factor;
(f) The total sales is equal to a constant sales mix when more than one product
is sold; and
(g) The contribution margin approach will be used in calculating profit.
1.3 BREAK EVEN POINT (BEP)

Break even point (BEP) is a point at which the profit is equal to zero. A
company is said to achieve the break even point if the total revenue is equal
to total cost.
In other words, it is a level of activity at which a company does not attain any
profit or incur any loss. In economics, this concept is also emphasised to assist the
management in making a decision on whether to continue competing or to exit
from the market.

Fixed Costs
BEP (in units) =
Contribution Margin Per Unit
or
Fixed Costs
BEP (in RM) =
Contribution Margin %
We will then verify the validity of a particular theory by using data we have
collected. If the data analysed verify the validity of the theory, then our economic
theory will become an economic law. This economic law will be embraced until
there is a competing theory that states otherwise.
Example 1.1
Atlis Company has sold 10,000 pairs of earrings throughout the month of May,
2003 at a price of RM20 per pair. The variable cost is RM12 for every pair of
earrings. The total fixed cost is RM80,000. The following income statement shows
that the total net income of the company is zero, which is at the break even level.
RM
Sales (10,000 x RM20) 200,000
Less: Variable Costs (10,000 x RM12) (120,000)
Total Contribution Margin 80,000
Less: Fixed Costs 80,000
Net Income 0
From the above example, we can conclude that the company will reach its break
even point if its sales activity level amounts to 10,000 pairs of earrings.
This information is vital for Atlis Company to plan the companyÊs future
activities and subsequently to answer questions that are usually asked by the
management. The concept of break even point also serves as a basis in the cost
volume profit analysis, where the company neither earns a profit nor incurs a
loss.

1.4 APPROACHES IN COST VOLUME PROFIT

ANALYSIS
For your information, in cost volume profit analysis, the marginal costing
approach will be employed more often than the absorption costing approach.
Absorption costing refers to a costing approach where the manufacturing

overhead cost is considered as part of the product cost and hence included in
the product cost. This implies that the overhead cost is an inventoriable cost.
Marginal (variable) costing refers to a costing approach where only variable

overhead costs are absorbed as product cost, while the fixed overhead costs
are charged as period cost.
A comprehensive understanding of marginal costing will help you better

understand the following discussions. In a nutshell, the format of the marginal
costing approach is as follows:
Sales Revenues ă Variable Costs = Contribution Margin
Contribution ă Fixed Costs = Operating Profit

Margin
There are three approaches which are used in the cost volume profit analysis,
which are:
(a) Contribution margin approach;
(b) Mathematical equation approach; and
(c) Graphic presentation approach.
The main purpose of these approaches is to answer the same kind of questions.
The advantage of this analysis is that it provides us with a wide range of options
to choose from and does not restrict us to only one approach or method in
solving questions such as the ones given at the beginning of this topic.
To simplify your understanding of this topic, we will use Example 1.1 again to
demonstrate how these three approaches solve each of the problems or questions
presented.

1.4.1 Calculation of the Break Even Point (BEP)

(a) Contribution Margin Approach
As mentioned earlier, contribution margin is the difference between the
sales revenues (incomes) and the variable costs.
Contribution Margin = Sales Revenues ă Variable Costs
When the activity level reaches the break even point, the total contribution
margin is equal to the total fixed cost. This means that at the point of
breakeven, the company does not incur any loss or earn any profit. Thus,
the contribution margin is only sufficient to cover the total fixed cost
incurred.
In the cost volume profit analysis, the contribution margin can be derived
in the form of contribution margin per unit or as contribution margin
percentage (ratio). Referring to the example again, the calculation of the
contribution margin is as follows:
(i) Contribution Margin Per Unit
Selling Price Per Unit ă Variable Costs Per Unit = Contribution Margin Per Unit
i.e. RM20 ă RM12 = RM8
(ii) Contribution Margin Percentage
(Contribution Margin Per Unit/Selling Contribution Margin

× 100 =
Percentage
Price Per Unit)
i.e. (RM8/RM20) x 100 = 40%
Once we determine the contribution margin, we can easily perform

the calculation for the breakeven point.
Assuming that X is an activity level (selling or production) in units,

then at the break even point, the fixed cost will be divided by the
contribution margin per unit or percentage, i.e.:

Fixed Costs
BEP (unit) =
RM80,000
=
RM8
= 10,000 units.
Or
Assuming that X is now the activity level (selling or production) in

RM, then the break even point is:
Fixed Costs
BEP (unit) =
Contribution Margin Percentage
= RM80,000 / 40%
= 100
RM80,000 ×
40
= RM200,000
(b) Mathematical Equation Approach

In this approach, the mathematical equation method is employed to obtain
the break even point. The break even point is derived by using the
following equation:
Sales = Variable Costs + Fixed Costs
Next, the equation is converted into a mathematical equation of:
HX = BX + T
where:
H is the selling price per unit,
X is the sales quantity,
B is the variable cost per unit, and
T is the total fixed cost.

Referring to the same example, the break even point, in units, is:
20X = 12X + 80,000

8X = 80,000
80,000
X =
8
= 10,000 units
or in ringgit (RM)
= 10,000 units × price per unit
= 10,000 units × RM20
= RM200,000
(c) Graphic Presentation Approach

Through this approach, we can clearly appreciate the meaning of break
even point. An accurately sketched graph will illustrate correctly the total
units and its value in RM for the company whose activity level has reached
the break even point.
Figure 1.1: Graphic presentation approach
The break even point is determined by a point of intersection between the

total income line and the total cost line. From Figure 1.1, the intersection
point is where the sales equal 10,000 units or RM200,000. The graph above
does not only illustrate the break even point for Atlis Company, but also
allows the management of the company to observe the impact of the
changes in sales volume on profit or loss.

For instance, if the companyÊs sales are less than 10,000 units, then it will
fall in the loss region and on the contrary, if the companyÊs sales are more
than 10,000 units, then it will generate profit.
1.4.2 Calculation of Sales for a Given Target Profit

(If Any)
Furthermore, by using the CVP, a company can easily compute the profit earned at
a specific activity level. It also helps the company to identify the level of activity
that produces the expected or required profit.
Referring to the example above, and assuming that Atlis Company is targeting a
profit of RM20,000, what is the level of sales necessary to achieve this profit? This
question can be easily answered by using the three approaches used previously
in CVP analysis to calculate the break even point.
(a) Contribution Margin Approach

If the management of a company sets a target profit, then we need to add
the previously given formula with the amount of profit required.
Sales (unit) = Fixed Costs + Required Profit

= RM80,000 + RM20,000
RM8
=
12,500 pairs
or,
Sales (RM) = Fixed Costs + Required Profit × 100

Contribution Margin Percentage
= RM80,000 + RM20,000 × 100

40%
=
RM250,000
(b) Mathematical Equation Approach

The amount of profit required must be added on the right side of the break
even point equation to give:
Sales = Variable Costs + Fixed Costs + Required Profit

i.e.
H X (in units) = BX + T +
20X = 12X + 80,000 + 20,000
8X = 100,000
X = 12,500 pairs
Or
X (in RM) = 0.6X + 80,000 + 20,000
0.4X = 100,000
= RM250,000
1.5 APPLICATIONS OF COST VOLUME PROFIT

ANALYSIS
Cost volume profit analysis is not only used to obtain the contribution margin
and sales level at the required target profit, but also for determining:
(a) The margin of safety;
(b) Change in fixed cost;
(c) Changes in contribution margin;
(d) Target profit; and
(e) Changes in various factors.
1.5.1 Margin of Safety

The margin of safety is the difference between the current level of operation,
whether in units or RM, and the break even point. In the case of Atlis Company,
if we assume that the company is operating at an activity level of 12,500 units or
RM250,000, then the margin of safety would be 2,500 units or RM50,000. The total
margin of safety can be determined by making the following calculation:
Margin of Safety = Current Operation Level ă Break even Point
= 12,500 units ă 10,000 units

= 2,500 units
or = RM250,000 ă RM200,000
= RM50,000

The margin of safety is crucial for the management to measure how far the
current operation level is from the break even point. This is illustrated in
Figure 1.2.
Figure 1.2: Margin of safety
The company is operating with a margin of safety of 2,500 units and can further
increase its safety margin if the companyÊs level of sales moves further to the
right from the break even point. The company also cannot reduce its sales
volume by more than 2,500 units if it does not want to incur any losses.
1.5.2 Changes in Fixed Cost

In reality, fixed cost and variable cost usually vary, and are not exactly as
expected or assumed. This may be due to the advancement of technology or
expansion of the business. When a fixed cost changes, the important question for
the management to ask is its impact on the break even point.
ACTIVITY 1.2
If the factoryÊs rental (one of the fixed costs) increases by RM4,000,

what will happen to the companyÊs break even point?
The above question can be directly solved by using the cost volume profit
analysis. You need to replace the fixed cost with a new amount, while other items
stay the same.
Let us look at the solution using the contribution margin approach (the
mathematical equation approach and the graphic presentation approach can also
be used).

Hence, it can be concluded that if the fixed cost increases by RM4,000, Company
Atlis needs to increase its sales volume by 500 units or sales amount by RM10,000
(i.e., 500 units x RM20) to reach the new break even point.
1.5.3 Changes in Contribution Margin

There are two factors that can cause a change in the contribution margin, namely,
a change in variable cost per unit and a change in selling price. One or both of
these factors will affect the business operations, in particular the break even
point. This is illustrated in Figure 1.3.
Figure 1.3: Change in contribution margin
(a) Changes in Per Unit Variable Cost

Assuming that the selling price is unchanged, an increase in variable cost
per unit will cause a fall in contribution margin, or the other way around.
For example, if the variable cost for a pair of Atlis earrings increases to
RM15 from its original cost of RM12, the consequences on the contribution
margin are as shown in Table 1.1.
Table 1.1: Impact of Change in Variable Cost per Unit on Contribution Margin
Original New
Selling Price RM20 RM20
Variable Cost RM12 RM15
Contribution Margin RM8 RM5
BEP (units) 80,000 / 8 = 10,000 80,000 / 5 = 16,000
BEP (RM) 200,000 320,000

The increase of RM3 per unit in variable cost has a significant impact on the
operations of Atlis Company. The company now needs to sell 6,000 pairs of
earrings more than before in order to reach the new break even point. Bear
in mind that the cost volume profit analysis is not a tool to solve the
problem above but rather to assist the company in conducting future
planning.
(b) Changes in Selling Price

A change in selling price will similarly have a significant impact on the
operations of the company. Assuming that the variable cost is unchanged,
an increase in selling price from RM20 to RM22 will affect the BEP in the
following manner, shown in Table 1.2.
Table 1.2: Impact of Change in Selling Price on BEP
Original New
Selling Price RM20 RM22
Variable Cost RM12 RM12
Contribution Margin RM8 RM10
BEP (units) 80,000 / 8 = 10,000 80,000 / 10 = 8,000
BEP (RM) 200,000 176,000
The increase in the selling price of RM2 has caused the BEP to fall by 2,000 pairs
of Atlis earrings. As a result, the company now needs to sell only 8,000 pairs but
at a higher price of RM22 so as to achieve the companyÊs new break even point.
1.5.4 Target Profit

Until now, the focus of our discussion has been on determining the sales volume
that can achieve the break even point or obtain the required profit. In addition to
these, the cost volume profit analysis can also predict the amount of profit to be
generated by a company, provided that information on sales volume,
contribution margin per unit and fixed costs are known. To explain this, let us
proceed by demonstrating the following example:

Example 1.2
It is given that the fixed cost incurred in a year for Atlis Company is RM80,000
while its variable cost is RM12 per unit. Based on research, a change in selling
price will affect the demand for Atlis earrings. The company predicts the impact
on demand if the price changes will be as follows:
Selling Price Per Unit Expected Demand (units)

RM20 15,000
RM22 14,000
The target profit can be calculated for each price set. To simplify the calculations,
the total contribution margin approach is used to subtract the total variable cost
from the total income.
Table 1.3: Target Profit
Price of Earrings
RM20 RM22
Total Income:
15,000 x RM20 RM300,000 RM308,000
14,000 x RM22
Less Variable Costs:
15,000 x RM12 (RM180,000) (RM168,000)
14,000 x RM12
Total Contribution Margin RM120,000 RM140,000
Less: Fixed Costs (RM80,000) (RM80,000)
PROFIT RM40,000 RM60,000
From Table 1.3, we can see that, at the price of RM20 per pair, the company will
earn a profit of RM40,000, but if the price is increased to RM22, the profit will
similarly increase by RM20,000. The difference is due to the increase in the
contribution margin per unit by RM2, exceeding the reduction in contribution
margin due to a decrease in demand.
If the fixed cost remains unchanged, then the difference in total contribution
margin will describe the actual difference in profits to be earned. This type of
information is important to assist companies in the price setting process.

1.5.5 Changes in Various Factors

From the previous example, we have noted that a change in the selling price will
affect the sales volume, hence having an impact on the contribution margin and
the companyÊs profit while the fixed cost remains unchanged. However, a change
in the variable factor will indirectly affect the fixed factor (i.e., fixed cost). This
section will discuss the effects on the companyÊs profit if there are changes in the
variable factor and fixed factor at the same time.
By using the example in section 1.5.4, an increase in the price of a pair of earrings
from RM20 to RM22 has resulted in a decrease in demand by 1,000 pairs. This
suggests that the company has to reduce its production by 1,000 pairs.
Suppose that all the machines used in producing the earrings are acquired by the
company through hire purchase. A reduction in the production will have an
influence on the number of machines used. If the company can save the cost of
hire purchase by RM10,000 per year as a result of reducing the number of
machines used, then the companyÊs profit will be as illustrated in Table 1.4
below:
Table 1.4: Changes in Various Factors
Price of Earrings
RM20 RM22
Total Income:
15,000 x RM20 RM300,000 RM308,000
14,000 x RM22
Less: Variable Costs:
15,000 x RM12 (RM180,000) (RM168,000)
14,000 x RM12
Total Contribution Margin RM120,000 RM140,000
Less: Fixed Costs (RM80,000) (RM70,000)
PROFIT RM40,000 RM70,000
The expected contribution margin is now higher by RM20,000 at the price of

RM22 compared to RM20, while the fixed cost is now lower by RM10,000. This
suggests that Atlis Company will generate an additional profit of RM30,000
(RM20,000 + RM10,000) if the earrings are sold at the price of RM22.

Situation 1.1
Zan Bun Berhad is the sole manufacturer of cakes in the Changlun region. The
company only produces a single type of cake that is sold at the price of RM10 per
piece. The cost of making a cake is RM5 while the fixed cost of the company
amounts to RM50,000 per annum.
You are required to:

(a) Determine the rate of the contribution margin and the contribution margin
for a cake.
(b) Determine the number of cakes which must be sold to achieve the
companyÊs break even point.
(c) Determine the sales income of the cakes required to achieve the break even
point.
(d) Calculate the number of cakes which must be sold to achieve a profit of
RM30,000 per year (use the mathematical equation method).
Solution:
RM
(a) Selling Price 10 100%
Variable Cost 5 50%
Contribution Margin 5 50% @ 0.5
Fixed Cost RM50,00 10,000
(b) Break even Point = = =
Contribution Margin RM5/piece pieces
(c) Break even Point = Fixed Cost = RM50,00
% Contribution Margin % Contribution
Margin
= RM50,000
0.5
= RM100,000
(d) Sales = Variable Cost + Fixed Cost + Profit

10x = 50x + RM50,000 + RM30,000
RM80,000
x =
5
= 16,000 pieces

or
x = 0.5 + RM50,000 + RM30,000

RM80,000
x =
0.5
= RM160,000
Situation 1.2
With reference to the information in Situation 1.1, you are required to solve the
following problems individually.
(a) By expecting the fixed cost to increase by 10% in the coming year, calculate
the new break even point for the company.
Solution:
Original New
RM RM
Fixed Cost = 50,000 55,000
Contribution Margin = 5 5
Break even Point = RM50,000 RM55,000
5 5
= 10,000 pieces 11,000 pieces
(b) During the year, the company managed to sell 15,000 pieces of cake. From
observation, if the company reduces the price of a cake from RM10 to RM9,
the demand for the cakes will increase by 20%. What is the break even point
for the company?
Solution:
Original New
RM RM
Selling Price 10 9
Variable Cost 5 5
Contribution Margin 5 4
Break even Point = RM50,000 RM50,000
5 4
= 10,000 pieces 12,500 pieces

(c) Based on the information in (b) how much total sales is required if the
company wants to earn a profit of RM30,000?
Solution
Sales = Variable Cost + Fixed Cost + Profit

9x = 5x + RM50,000 + RM30,000
x = RM80,000
4
x = 20,000 pieces
x = 0.56x + RM50,000 + RM30,000

x = RM80,000
0.44
= RM180,000
(d) What actions must be taken if the changes in (a) and (b) occur at the same
time? Explain.
Solution:
The answer to the above problem can be illustrated clearly if we prepare an

income statement.
Original (RM) New (RM)

Sales 15,000 units 18,000 units
Total Income:
15,000 x RM10 150,000 162,000
18,000 x RM9
Less: Variable Costs:
(15,000 x RM5) (75,000) (90,000)
(18,000 x RM5)
Total Contribution Margin 75,000 72,000
Less: Fixed Costs (50,000) (55,000)
PROFIT 25,000 17,000
Even though the increase in demand is rather high, i.e., by 3,000 pieces of cakes
as a result of a reduction of RM1 in selling price, the profit of the company
reduces by RM8,000. Thus, the company should not reduce the price as the profit
earned is higher although the sales volume is less.

1.6 IMPACT OF TAX IN COST VOLUME PROFIT

ANALYSIS
For your information, a company usually considers the profit after tax when
making a decision. The expected profit or target profit normally assumes that the
tax has been taken into consideration.
We can obtain the target profit by using the formula below:
Sales Target = Fixed Cost + Target Profit

Contribution Margin Per Unit (CM) @ CM%
If income tax is taken into account, the above formula has to be modified to
become:
Sales Target = Fixed Cost + { (Target Profit After Tax) / (1-Tax Rate) }
Ć Cost volume profit analysis is a useful tool for the company management. It
provides the management with important information which is vital for the
purpose of conducting future planning and business decisions.
Ć This analysis particularly, focuses on the problems of calculating the break

even point and target profit required by the company. It also explains the
effects on the sales volume and profit if there are changes in the cost and
selling price.
Ć To solve the fundamental problems in business, this analysis employs three

approaches:
ă The contribution margin approach;
ă The mathematical equation approach; and
ă The graphic presentation approach.
ă It is then up to the management to use the approach that it considers
suitable and is comfortable with.
Absorption costing Margin of safety

Break even point (BEP) Marginal (variable) costing
Contribution margin approach Mathematical equation approach
Cost volume profit analysis (CVP) Sales target
analysis
Graphic presentation approach
APPENDIX: GRAPHS AND THEIR MEANING

Figure 1.3 until Figure 1.8 show examples of graphs and their meaning.
Figure1.3: Demand curve
Figure 1.4: Supply curve

Figure 1.5: Market equilibrium
Figure 1.6: Indifference curve
Figure 1.7: Budget line

Figure 1.8: Consumer equilibrium ă maximisation of satisfaction

Topic X Budgeting
2
LEARNING OUTCOMES
1. Define budget;
2. Discuss the uses and advantages of budgets;
3. Describe the preparation of budgets; and
4. Identify the techniques of budgeting.
X INTRODUCTION
The word budget is not something new or unfamiliar in our lives. As individuals,
either with full realisation or even without realising it, we do practise some form
of budgeting. With the realisation that our resources are limited, the planning
and control of such resources in an optimum manner becomes a matter of
urgency. It is from here that the concept of a budget becomes apparent.
For a business entity, detailed planning is essential, especially in an increasingly

complex business environment. There are opinions saying that the process of
preparing a budget is a waste of time and irrelevant because we live in a dynamic
business environment and there are too many uncertain occurrences.
However, there are many who still believe that a budget is a good planning tool.
This is because a budget can help a manager to plan for acquisition and use
resources available in the company for a specific period.

TOPIC 2 BUDGETING W 25
2.1 BUDGET
What is meant by a budget? Let us now take a look at the definition of budget as
well as its uses and advantages.
2.1.1 Definition of Budget

A budget is defined as follows.
A budget is a formal statement by the management on its planning in

quantitative form. In other words, any planning made by the management will
be formally stated in the form of figures to be communicated to members of the
organisation.
2.1.2 Uses and Advantages of Budgets

Even though the preparation of budgets is a long-drawn process, it is still
considered as a critical step and is much needed in an organisation, regardless of
its size. This is because budgets provide many advantages to an organisation.
Among the advantages of budgets are shown in Figure 2.1.
Figure 2.1: Advantages of budgets

26 X TOPIC 2 BUDGETING
(a) Planning Tool

Budgets allow managers to think ahead, that is, to forecast and prepare for
issues that may arise in the future. In other words, organisations that do not
have budgets:
(i) Have no clear direction;
(ii) Will not be able to predict any future problems at an earlier time;
(iii) Will have difficulties in analysing results achieved by the organisation
because there is no clear measurement tool; and
(iv) Will not be able to conduct an objective performance measurement.
(b) Communication Tool for the Whole Organisation

Budgets finalised by the management will be circulated to other members
of the organisation. The budgets will provide guidance in planning and
executing activities so that previously determined targets can be achieved.
In addition, a manager will also know the planning made by managers

from other departments.
Therefore, the manager will be able to plan a parallel action to achieve the
overall goals of the organisation. For example, if the production manager
receives accurate information about the sales planning made by the sales
manager, then he will be able to plan the level of production necessary to
achieve the needs of the marketing department.
In other words, the process of coordination and integration in an

organisation is easier to execute with the use of a budget. In short, the
budget becomes a communication tool between various parties in an
organisation.
(c) Resource Allocation Tool

Next, budgets are also used as a resource allocation tool. This is because
limited resources force companies to allocate and use resources effectively.
Companies that do not have budgets often fail to allocate resources
rationally and systematically.
With the assistance of a prepared budget, after taking into account the
views of all parties in the organisation, conflicts related to resource
allocation will be minimised. Budgets that are designed with the workersÊ
views will increase their motivation to work. This is because they feel they
are valued when their views and opinions are taken into account in the
preparation of the budget.

(d) Performance Measurement Tool

Budgets also play an important part in preparing a benchmark in
performance measurement. An achievement which is better than the one
planned marks a performance to be proud of and incentives can then be
given. The responsibility accounting concept can be practised with the
existence of effective budgetary data which function as a basis in evaluating
actual performance.
However, undeniably performance measurement that solely uses the

budget as a measurement tool is not something that is ideal because there
are other external factors which might have contributed to the
aforementioned achievement, for example economic conditions, politics,
technology, competitors and others.
ACTIVITY 2.1
In your opinion, after discovering the uses and advantages of budgets,

is it necessary for a retail business to prepare a budget?
2.2 CASH BUDGETS

A cash budget provides information to a company, among others, cash
received and cash paid.
It will also demonstrate how the cash is used when there is surplus cash in excess
of what is needed in the operations of the company (investment). Conversely, if
receipts are less than the disbursements, a cash budget will also demonstrate
how this deficit is covered (financing).
The cash budget, in general, can be divided into four main parts as demonstrated
in Figure 2.2.
Figure 2.2: Cash budget

(a) Receipt
This will list all cash resources of a company, other than financing. Usually,
the main source of cash receipt is from sales of goods.
(b) Disbursement
This section will list all cash outflow such as purchase of raw materials,
direct labour wage payment, overhead payment, sales and administrative
expenses, and other disbursements made by the company. Purchase of
assets, for example, machines, will also be included in the disbursement
part.
(c) Cash Surplus or Deficit

Cash surplus or deficit can be obtained by deducting parts (a) and (b)
above. If there is a cash deficit, the company need not have to borrow for
the purpose of financing. Conversely, if there is a deficit, the deficit has to
be covered through financing from an external party.
However, sometimes company policy requires a minimum amount of cash

on hand. In such cases, even with a cash surplus, that is cash receipts in
excess of disbursements, financing is still necessary solely to fulfil the
minimum requirement.
There are also cases of company policies requiring investments be made for
excessive cash surplus. For example, a companyÊs policy is to restrict cash
surplus that should be kept in the company to a maximum of RM5,000. In
the event that there is a surplus above the maximum level of RM5,000, the
surplus will be invested to generate returns.
(d) Financing
This option will be used when the company is forced to borrow from an
external party to finance any deficit. In addition to itemising the amount of
financing receipts, it should detail the repayment terms of the loan, which
consists of the principal and interest.
From the previous information and additional information made available

to us, let us try to prepare a Cash Budget for Syarikat Guru Jaya.
Let us say:
(a) Initial cash invested by the company to run the business is RM20,000;
(b) The policy of the company requires RM50,000 minimum cash on hand
at the end of each quarter;

(c) Loans can be made in multiples of a thousand in the early quarter of

the year, if necessary, at an interest rate of 8%;
(d) Loans will be paid at the end of the final quarter of the year if there is
ability to pay; and
(e) In the first quarter, the company also buys a machine in cash which
costs RM25,000.
The Cash Budget can be seen in Table 2.1.
Table 2.1: Cash Budget
1st 2nd 3rd 4th

Total
Quarter Quarter Quarter Quarter
Beginning Balance 20,000 50,242 63,393 137,699 20,000
+ Cash Received from Customers 45,000 90,000 115,000 155,000 405,000
= Cash from Operations (a) 65,000 140,242 178,393 292,699 425,000
(ă) Disbursements:
Raw Materials 3,533 5,586 6,944 9,514 25,577
Direct Labour 4,250 5,125 6,500 9,125 25,000
Factory Overhead 9,075 9,338 9,750 10,538 38,701
Operating Expenses 12,900 15,200 17,500 22,100 67,700
Assets Purchased 25,000 - - - 25,000
Total Disbursement (b) 54,758 35,249 40,694 51,277 181,978
= Balance before Loans
10,242 104,993 137,699 241,422 243,002
(a) - (b)
(ă) Cash Minimum (c) 50,000 50,000 50,000 50,000 50,000
= Surplus / (Deficit) (d) (39,758) 54,993 87,699 191,422 193,022
Loans 40,000 - - - 40,000
Payments:
Principal - (40,000) (40,000)
Interest - (1,600) (1,600)
Surplus / (Deficit) (e) 40,000 (41,600) - - (1,600)
Ending Cash Balance (c) + (d) + (e) 50,242 63,393 137,699 241,422 241,422

ACTIVITY 2.2
The following is the financial information of Syarikat Citra for the
month of January until March 2007:
1. Cash balance as at 31 December 2006 is RM13,840.
2. The finance officer has prepared the following sales information:
Actual Data for the Year Projected Data for the Year
2006 2007
Month November December January February March
Sales RM25,000 RM35,000 RM25,000 RM20,000 RM40,000
Sales and
Administrativ RM12,000 RM13,000 RM12,000 RM11,000 RM12,500
e Expenses
Overheads RM2,500 RM3,500 RM2,500 RM2,500 RM4,000
Raw Materials RM3,200 RM3,500 RM3,000 RM2,500 RM3,500
Direct Labour RM6,000 RM6,200 RM6,800 RM6,800 RM6,800
3. 60% of sales consists of cash sales collected in the current month,

30% collected in the second month and the balance collected in
the third month.
4. Payments for the purchase of raw materials are made in the

month they are bought meanwhile payments for sales and
administrative expenses and overhead are made in the following
month. Direct labour is paid in each of the respective month.
5. The company has a loan amounting to RM12,000 at an interest

rate of 12% per annum and it is paid every month. The principal
for the loan amounting to RM2,000 is payable on 28 February
2007.
6. Tax payable is RM4,550 and is paid on 15 March 2007.
7. Company policy dictates a minimum cash balance of RM10,000

must be made available at the end of every month.
8. Prepare the cash budget for Syarikat Ceria for the period of three
months beginning from January 2007 to March 2007.

2.3 MASTER BUDGET

What is meant by a master budget?
A master budget is a budget that summarises all activities planned by each

respective department in an organisation.
In master budgets, all revenues and expenses will be estimated, which will
enable pro-forma (estimated) statements to be prepared. In short, we can
conclude that the master budget will communicate to us a comprehensive plan
by the management and how those plans can be achieved.
The master budget is also the main output of a budget system, covering all
budgets at all operational levels. Meaning, the master budget will contain all
types of budgets in an organisation which would comprise sales, production,
distribution and finance (refer to Figure 2.3).
Figure 2.3: Types of budgets in an organisation
In general, the master budget can be divided into two groups of budget:
(a) Operating budget; and
(b) Financial budget.
2.3.1 Operating Budget

What is meant by an operating budget?
An operating budget is a budget that outlines the activities of a firm.

The main focus of the operating budget is the Income Statement and
supplementary tables needed in its preparation. In general, the budget contained
in it (which acts as a supplementary table) comprises sales budget, purchasing
budget, cost of goods sold and operating expenses. From these budgets too, a
pro-forma statement (expected) can be prepared to identify the profit level of the
company if the budget is achieved.
Occasionally, the operating budget is also known as the profit plan. For
manufacturing firms, the operating budget includes the sales budget, production,
marketing, administration and income statement.
2.3.2 Financial Budget

What is meant by a financial budget?
A financial budget is a plan that demonstrates how an organisation will

obtain its financial resources to finance its operations.
The financial budget consists of the Cash Budget and the Budgeted Balance
Sheet.
SELF-CHECK 2.1
1. List four types of budget in the master budget.

2. Explain in detail the operating budget and the financial budget.
2.4 PREPARATION OF OPERATING BUDGET

There are six types of operating budget. See Figure 1.3.

Figure 2.4: Types of operating budget
Let us examine each of the budgets included in an operating budget.
2.4.1 Sales Budget

The sales budget is the basis of an operating budget. It requires the organisation
to estimate its future sales. In other words, the particular budget will provide the
basis or guide for the preparation of other budgets.
Other than illustrating the sales revenue for a period, a sales budget will also
provide information related to cash collections for the particular period. It is the
common practice for a company, not to conduct its sales wholly in cash. Credit
given to customers is still needed to encourage sales even though the company is
exposed to the risks of not being able to collect its dues (bad debt).
Sales budget
Ć Expected sales for the coming period;
Ć Provides the basis for the preparation of other budgets; and
Ć Provides information related to cash collections for the period.
In preparing the sales budget, the following formula is used:
Sales Revenue = Expected Sales Quantity x Expected Sales Price

Example 2.1
Syarikat Guru Jaya has just begun its business of selling sports equipments.
Expected sales for the four quarters of 2004 are projected in Table 1.1.
Table 1.1: Projected Sales
Year 2004 Unit
1st Quarter 3,000
2nd Quarter 4,000
3rd Quarter 5,000
4th Quarter 7,000
Total 19,000
Sale price is RM25.00 per unit. It is expected that 60% of those sales are cash and
the rest will be collected in the following quarter. This means, that all sales
revenue will be collected and no bad debts will be provisioned. From the above
information, the sales budget can be prepared as in the following table..
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Total

Sales:
Unit 3,000 4,000 5,000 7,000 19,000
Revenue 75,000 100,000 125,000 175,000 475,000
Cash collection:
60% current month 45,000 60,000 75,000 105,000 285,000
40% previous month 30,000 40,000 50,000 120,000
Total (RM) 45,000 90,000 115,000 155,000 405,000
Notice that all sales revenue was collected in the quarter the sales are made and
the balance in the following quarter, where it involves only two quarters.
However, there are cases where collections may be made in three quarters of the
year or more. It may also involve cases where not all collections can be made,
which will involve the provision of bad debts.

2.4.2 Production Budget

The next operating budget is the production budget. For manufacturing firms,
products to be sold are self-manufactured. Therefore, after estimating sales units
for each quarter, the production budget must be prepared. The production
budget will assist the company to estimate production so demand can be
fulfilled.
In addition, the production budget will assist the company in controlling its
inventory level so that there will be no excess or shortage. If the inventory level is
not controlled, the problem of excess inventory will arise and this will burden the
company because it has to bear high storage cost.
Production Budget
Ć Assist the company in projecting production needed based on demand;
and
Ć Control inventory levels so that there is no excess or shortage.
Usually, the company keeps a closing inventory at a certain percentage of future

sales to avoid unexpected problems concerning production.
With the existence of closing inventory from the previous period, any production
problems arising during the current period will be easier to solve. The closing
inventory from a previous period will become the beginning inventory for the
current period.
Units to Produce = Sales Unit + Ending Inventory ă Beginning Inventory

Example 1.2
Syarikat Guru Jaya requires its ending inventory for a certain quarter to be
10% of its following quarter sales unit. Projected sales unit for the 1st quarter
of the following year is 10,000 units. From this information, the following
Production Budget can be prepared:
Table 1.3: Production Budget

1st 2nd 3rd 4th
Total
Sales 3,000 4,000 5,000 7,000 19,000
Ending Inventory 400 500 700 1,000 1,000
Total 3,400 4,500 5,700 8,000 20,000
Beginning Inventory - (400) (500) (700) -
Units of Production 3,400 4,100 5,200 7,300 20,000
2.4.3 Raw Materials Budget

After the projection of the unit of production is known, the company will prepare
a plan for the purchase of raw materials which will fulfill the production level for
a certain period.
The relationship between the production budget with the raw materials purchase
budget is extremely critical in manufacturing firms. It is important to ensure that
the manufacturing process is not delayed by the exhaustion of raw material.
Other than that, it is extremely useful in creating efficient inventory
management. The company as a norm, will purchase more than necessary for its
current production period and will keep it as ending raw materials inventory in
the event of any possibilities of unexpected incidences such as the shortage of
raw materials in the market.
Required Raw = Raw Materials + Ending Raw – Beginning

Materials for Current Materials Raw
Production Inventory Materials
Inventory

With reference to the example of Syarikat Guru Jaya, let us say that for each
unit of product to be manufactured, the company uses 0.2 kg raw materials
which can be purchased at RM7.00 per kilogram. Payment will be made through
instalments, that is 70% in the quarter it is purchased, and the balance 30% will
be paid in the following quarter. In addition, the company will stock 5% of its
raw materials requirements for the following quarter as its ending inventory.
From this information, the Raw Materials Purchase Budget is as per Table 2.2:
Table 2.2: Raw Materials Purchase Budget
1st 2nd 3rd 4th

Total
Production Unit 3,400 4,100 5,200 7,300 20,000
Consumption Rate 0.2 kg 0.2 kg 0.2 kg 0.2 kg 0.2 kg
Units Consumed 680 820 1,040 1,460 4,000
Ending Inventory 41 52 73 100 266
721 872 1,113 1,560 4,266
Beginning Inventory - (41) (52) (73) (166)
Purchase Unit 721 831 1,061 1,487 4,100
Purchase Price Per Unit (RM) 7.00 7.00 7.00 7.00 7.00
Total Purchase Price (RM) 5,047 5,817 7,427 10,409 28,700
Payment:
70% Current Period (RM) 3,533 4,072 5,199 7,286 20,090
30% Previous Period (RM) - 1,514 1,745 2,228 5,487
Total Disbursement (RM) 3,533 5,586 6,944 9,514 25,577
* Given the consumption unit needed for raw materials requirement for the
first quarter of the following year is 2,000.
2.4.4 Direct Labour Budget

After identifying the production unit that must be produced for a certain period,
the company can then estimate the incurrance of expected total cost of direct
labour for the particular period. To prepare the direct labour budget, the
information needed by the company is the hours of direct labour utilised for each
unit of product and also the wage rate per hour for each direct labour hour.

Total Cost of Direct Labour = Total Number of Hours x Wage Rate Per Hour
Let us say that each unit of product produced by Syarikat Guru Jaya, requires 15
minutes of direct labour (0.25 hour) with a wage rate of RM5.00 per hour. Thus,
the Direct Labour Budget would be as per Table 2.3.
Table 2.3: Direct Labour Budget
1st 2nd 3rd 4th

Total
Production Unit 3,400 4,100 5,200 7,300 20,000
Usage Rate 0.25 0.25 0.25 0.25 0.25
Hours Used 850 1,025 1,300 1,825 5,000
Wage Rate (RM) 5.00 5.00 5.00 5.00 5.00
Total Cost (RM) 4,250 5,125 6,500 9,125 25,000
2.4.5 Overhead Budget

The third product cost component (after raw materials and direct labour) is
overhead, consisting variable overhead and fixed overhead (Refer Figure 2.4).
For example, indirect labour and indirect raw materials are considered as
variable overheads. Meanwhile, production supervisorÊs salary and machine
depreciation are considered as fixed overheads.
Figure 2.5: Overhead budget

In calculating cash disbursement for overhead, adjustments for expenses that do

not involve the outflow of cash is required, for example, depreciation expenses.
LetÊs say the variable overhead for Syarikat Guru Jaya is RM1.50 for each direct
labour hour used and the fixed overhead for each quarter is RM10,000 (including
machine depreciation of RM2,200). Thus, the overhead budget is as the following
Table 2.4.
Table 2.4: Overhead Budget
1st 2nd 3rd 4th

Total
Direct Labour Hours 850 1,025 1,300 1,825 5,000
Variable OH Rate (RM) 1.50 1.50 1.50 1.50 1.50
Variable OH Cost (RM) 1,275 1,537.50 1,950 2,737.50 7,500
Fixed Overhead (RM) 10,000 10,000 10,000 10,000 40,000
Depreciation (RM) (2,200) (2,200) (2,200) (2,200) (8,800)
Disbursement 9,075 9,337.50 9,750 10,537.50 38,700
2.4.6 Sales and Administrative Expense Budget

Next, sales and administrative expenses are incurrance of expenses in
departments other than the production department. However, these expenses are
supplementary expenses to enable the company to earn profit. Among examples
of these supplementary expenses are the marketing expenses, salesperson
commission and other similar expenses.
For example, let us say that the sales and administrative expenses for Syarikat
Guru Jaya is RM2.30 for each sales unit (variable) and RM6,000 for each quarter
(fixed). All sales and administrative expenses are paid in cash in the quarter
concerned.

Thus, Sales and Administrative Budget (SA) is as the following Table 2.5:
Table 2.5: Sales and Administrative Budget
1st 2nd 3rd 4th

Total
Sales Unit 3,000 4,000 5,000 7,000 19,000
Variable SA Rate RM2.30 RM2.30 RM2.30 RM2.30 RM2.30
Variable SA (RM) 6,900 9,200 11,500 16,100 43,700
Fixed SA (RM) 6,000 6,000 6,000 6,000 24,000
Total SA (RM) 12,900 15,200 17,500 22,100 67,700
ACTIVITY 2.3
1. Syarikat Zullyn is a company that sells rattan-based handicraft

products. The following are the projected sales for their company
from January to April 2007 where the selling price of the product is
RM50 per unit:
Month (2007) Total Sales (RM)

January 90,000
February 120,000
March 155,000
April 195,000
Total 560,000
(a) The management expects the following cash collections from sales:
The customer pays 60% of the total current monthÊs sale by cash,
20% in the second month the sale is made and the rest payable in
the subsequent month. Total sales for November and December are
RM70,000 and RM85,000 respectively.

(b) The company also allocates 10% from the following monthly sales
units as the current requirement for the ending inventory.
Projected unit sales for the month of May is RM210,000. 60%
disbursement for purchase of raw materials is made during the
current month while the balance will be paid in the following
month.
(c) Direct labour wage rate is RM6.50 for each unit produced, where
each unit requires a period of 0.5 hours for completion.
(d) The following information is related to overhead and sales and

administrative expenses:
Fixed Overhead RM15,000
Variable Overhead RM1.50 per hour of
direct labour
Fixed sales and administrative expenses RM4,500
Variable sales and administrative expenses RM3.00 per unit of
sales
Based on the information given above, prepare;

(i) Sales Budget;
(ii) Production Budget;
(iii) Raw Materials Purchases Budget;
(iv) Direct Labour Budget;
(v) Overhead Budget; and
(vi) Sales and Adminstrative Expenses Budget.

2.5 PREPARATION OF A PRO-FORMA INCOME

STATEMENT
After obtaining all relevent information from the budgets contained in the
operating budget, a pro-forma income statement can be prepared. This statement
is shown in the following Table 2.6:
Table 2.6: Pro-Forma Income Statement
RM RM RM
Sales 475,000
Cost of Goods Sold:
Beginning Finished Goods Inventory 0
Cost of Goods Manufactured:
Beginning Raw Materials Inventory 0
+ Purchases 28,700
Materials Available for Used 28,700
- Ending Inventory (700) 28,000
Direct Labour 25,000
Variable Factory Overhead 7,500
Fixed Factory Overhead 40,000
100,500
- Ending Finished Goods Inventory (5,025)
(95,475)
Gross Profit 379,525
Operating Expenses:
Sales and Administrative (67,700)
Other Expenses:
Interest (1,600)
Net Income 310,225
Note: Ending finished goods inventory is 1,000 units (as per the production
budget). Cost per unit of finished goods is RM5.025 per unit (raw materials
RM1.40, direct labour RM1.25, variable overhead RM0.375 and fixed overhead
RM2.00). Thus, the cost of finished goods for 1,000 units is 1,000 x RM5.025,
which is RM5,025.

2.6 FINANCIAL BUDGETS

Now that you know the budgets included under the operating budget, you will
then be exposed to the budgets relating to the financial budget.
2.6.1 Cash Budget

A cash budget provides information to a company, among others, cash received
and cash paid. It will also demonstrate how the cash is used when there is
surplus cash in excess of what is needed in the operations of the company
(investment). Conversely, if receipts are less than the disbursements, cash budget
will also demonstrate how this deficit is covered (financing).
The cash budget, in general, can be divided into four main parts as demonstrated
in Figure 2.4.
Figure 2.6: Cash budget

(a) Receipt
This will list all cash resources of a company, other than financing. Usually,
the main source of cash receipt is from sales of goods.
(b) Disbursement
This section will list all cash outflow such as purchase of raw materials,
direct labour wage payment, overhead payment, sales and administrative
expenses, and other disbursements made by the company. Purchase of
assets, for example machines, will also be included in the disbursement
part.
(c) Cash Surplus or Deficit

Cash surplus or deficit can be obtained by deducting parts (a) and (b)
above. If there is a cash deficit, the company need not have to borrow for

the purpose of financing. Conversely, if there is a deficit, the deficit has to

be covered through financing from an external party.
However, sometimes company policy requires a minimum amount of cash

on hand. In such cases, even with a cash surplus, that is cash receipts in
excess of disbursements, financing is still necessary solely to fulfil the
minimum requirement.
There are also cases of company policies requiring investments be made for
excessive cash surplus. For example, a companyÊs policy is to restrict cash
surplus that should be kept in the company of up to RM5,000 only. In the
event that there is a surplus above the maximum level of RM5,000, the
surplus will be invested to generate returns.
(d) Financing
This option will be used when the company is forced to borrow from an
external party to finance deficit. In addition to itemising the amount of
financing receipts, it should detail out the repayment terms of the loan,
which consists of the principal and interest.
From the previous information and additional information made available

to us, let us try to prepare a Cash Budget for Syarikat Guru Jaya.
Let us say:
(i) Initial cash invested by the company to run the business is RM20,000;
(ii) The policy of the company requires RM50,000 minimum cash on hand
at the end of each quarter;
(iii) Loans can be made in multiples of a thousand in the early quarter of
the year, if necessary, at an interest rate of 8%;
(iv) Loans will be paid at the end of the final quarter of the year if there is
ability to pay; and
(v) In the first quarter, the company also buys a machine in cash which
costs RM25,000.

The Cash Budget will look as follows in Table 2.7.

1st 2nd 3rd 4th

Total
+ Cash Received from Customer 45,000 90,000 115,000 155,000 405,000
(ă) Disbursements:
Raw Materials 3,533 5,586 6,944 9,514 25,577
Direct Labour 4,250 5,125 6,500 9,125 25,000
Factory Overhead 9,075 9,338 9,750 10,538 38,701
Asset Purchased 25,000 - - - 25,000
= Balance before Loans
10,242 104,993 137,699 241,422 243,002
(a) - (b)
(ă) Cash Minimum (c) 50,000 50,000 50,000 50,000 50,000
= Surplus / (Deficit) (d) (39,758) 54,993 87,699 191,422 193,022

Loans 40,000 - - - 40,000
Payments:
Principal - (40,000) (40,000)
Interest - (1,600) (1,600)
Surplus / (Deficit) (e) 40,000 (41,600) - - (1,600)
Ending Cash Balance (c) + (d) + 50,242 63,393 137,699 241,422 241,422

ACTIVITY 2.4
The following is the financial information of Syarikat Citra for the month
of January until March 2007:
1. Cash balance as at 31 December 2006 is RM13,840.
2. The finance officer has prepared the following sales information:
Actual Data for the Year Projected Data for the Year
2006 2007
Month November December January February March
Sales RM40,00
RM25,000 RM35,000 RM25,000 RM20,000
0
Sales and
RM12,50
Administrative RM12,000 RM13,000 RM12,000 RM11,000
0
Expenses
Overheads RM2,500 RM3,500 RM2,500 RM2,500 RM4,000
Raw Materials RM3,200 RM3,500 RM3,000 RM2,500 RM3,500
Direct Labour RM6,000 RM6,200 RM6,800 RM6,800 RM6,800
3. 60% of sales consist of cash sales collected in the current month, 30%
collected in the second month and the balance collected in the third
month.
4. Payments for the purchase of raw materials is made in the month it is
bought meanwhile payments for sales and administrative expenses
and overhead are made in the following month. Direct labour is paid
in each of the respective month.
5. The company has a loan amounting to RM12,000 at an interest rate of
12% per annum and it is paid every month. The principal for the loan
amounting to RM2,000 is payable on 28 February 2007.
6. Tax payable is RM4,550 and is paid on 15 March 2007.
7. Company policy dictates a minimum cash balance of RM10,000 must
be made available at the end of every month.
Prepare the cash budget for Syarikat Ceria for the period of three months
beginning from January 2007 to March 2007.

2.7 PREPARATION OF PRO-FORMA BALANCE

SHEET
Finally, after all the other budgets have been completed, the company can
prepare a Pro-Forma Balance Sheet, which is a statement which describes the
financial situation of the company should all its plans achieve the targets as
expected.
By using the example of Syarikat Guru Jaya, a Pro-Forma Balance Sheet can be
prepared as follows:
Syarikat Guru Jaya

Pro-Forma Balance Sheet as at Quarter of 2004
RM RM RM
Current Asset
Cash 241,422
Finished Goods Inventory 5,025
Raw Materials Inventory 700
Accounts Receivable 70,000 317,147
Fixed Asset
Machines 25,000
Accumulated Depreciation (8,800) 16,200
Total Asset 333,347
Liabilities
Accounts Payable 3,122
OwnerÊs Equity
Capital 20,000
Retained Earning 310,225 330,225
OwnerÊs Liabilities and Equity 333,347

2.8 PREPARATION OF MASTER BUDGETS FOR

MERCHANDISING FIRMS
This section will illustrate the preparation of the master budgets, which
comprises the operating budget and the financial budget. To facilitate your
understanding to differentiate a budget for an manufacturing firm and a
merchandising firm, we will use the same example, but for now, let us assume
that Syarikat Guru Jaya is a merchandising firm.
What is meant by a merchandising firm?
A Merchandising firm is a business that sells goods but the goods are not self-
manufactured. The goods are supplied by an external supplier.
2.8.1 Sales Budget

By using the same example, the sales budget for Syarikat Guru Jaya can be
prepared.
Example 2.2
Syarikat Guru Jaya has just begun business selling sports equipment. Expected
quarterly sales for year 2004 is as follows:
Year 2004 Unit

1st Quarter 3,000
2nd Quarter 4,000
3rd Quarter 5,000
4th Quarter 7,000
Total 19,000
Saleselling price is at RM25.00 per unit. It is expected that 60% of those sales
are in cash and the balance is collected in the following quarter. This means, all
sales revenue can be collected and there is no bad debts are provisioned for
bad debts.

From the above information, the sales budget can be prepared as follows:
1st 2nd 3rd 4th

Total
Sales:
Unit 3,000 4,000 5,000 7,000 19,000
Revenue 75,000 100,000 125,000 175,000 475,000
Cash Collected:
60% Current Month 45,000 60,000 75,000 105,000 285,000
40% Previous Month 30,000 40,000 50,000 120,000

Total 45,000 90,000 115,000 155,000 405,000
2.8.2 Purchases Budget

It is assumed that Syarikat Guru Jaya is a merchandising firm, thus a purchasing
budget must be prepared. Let us say that the purchase price of the product is
RM10.00 per unit and payments to the supplier are made through instalments,
where 80% is made during the current period and the balance of 20% in the
following period. Thus, the purchase budget would look like Table 2.8.
Units to be Purchased = Sales Unit + Ending Inventory ă Beginning Inventory
Table 2.8: Purchases Budget
1st 2nd 3rd 4th

Total
Sales: 3,000 4,000 5,000 7,000 19,000
Ending Inventory 400 500 700 1,000 1,000
Beginning Inventory - (400) (500) (700) -
Purchase Units 3,400 4,100 5,200 7,300 20,000
Purchase Price Per Unit 34,000 41,000 52,000 73,000 200,000
Payment: 80% Current Period 27,200 32,800 41,600 58,400 160,000
20% Previous Period 6,800 8,200 10,400 25,400
Total Payment 27,200 39,600 49,800 68,800 185,400

2.8.3 Sales and Administrative Expense Budget

Sales and administrative expense budget (see Table 2.9) is similar to the example
shown previously:
Table 2.9: Sales and Administrative Expense Budget
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Total

Sales Unit 3,000 4,000 5,000 7,000 19,000
SA Rate RM2.30 RM2.30 RM2.30 RM2.30 RM2.30
Variable SA 6,900 9,200 11,500 16,100 43,700
Fixed SA 6,000 6,000 6,000 6,000 24,000
Total SA 12,900 15,200 17,500 22,100 67,700
2.8.4 Preparation of Pro-Forma Income Statement

A pro-forma income statement that needs to be prepared looks simpler because
not many items are involved in calculating cost of goods sold. It would be as in
Table 2.10.
Table 2.10: Pro-Forma Income Statement
RM RM
Sales 475,00
Cost of Goods Sold:
Beginning Inventory of Finished Goods 0
Purchase 200,000
Cost of Finished Goods Available for Sale 200,000
Ending Inventory (10,000) 190,00

Gross Profit 285,00
Operating Expenses: 67,700
Sales and Administration
Depreciation 8,800 (76,500)
Other Expenses: Interest (1,340)
Net Income 207,160

Note: Ending inventory of finished goods is 1,000 units at a purchase cost of

RM10.00 per unit (as per the purchase budget).
2.8.5 Cash Budget

By using the previous example, the cash budget can be prepared. Let us say the
initial cash invested by the company to run the business is RM20,000. The policy
of the company requires a minimum cash of RM50,000 be made available at the
end of each quarter. Loans can be made in multiples of a thousand during the
early quarter of the year, if necessary, at an interest rate of 8%. Loans will be paid
in the last quarter of the year when there is ability to do so. In the first quarter,
the company also purchases a machine in cash at a cost of RM25,000.
Therefore, the cash budget would be as demonstrated in Table 2.11.
1st 2nd 3rd 4th

Total
+ Cash Received from Customer 45,000 90,000 115,000 155,000 405,000
(ă) Disbursement:
Purchase of Finished Goods 27,200 39,600 49,800 68,800 185,400
Purchase of Assets 25,000 25,000
= Balance before Loans (a) ă (b) (100) 86,100 97,780 145,560 146,900
(ă) Cash Minimum (c) 50,000 50,000 50,000 50,000 50,000
= Surplus/(Deficit) (d) (50,100) 36,100 (47,780) (95,560) (96,900)
Loans 51,000 51,000
Payment: Principal (35,000) (16,000) (51,000)
Interest (1,020) (320) (1,340)
Surplus/(Deficit) from 51,000 (36,020) (16,320) (1,340)
Financing (e)
Ending Cash Balance 50,900 50,080 81,460 (145,560) 145,560
(c) + (d) + (e)

2.8.6 Preparation of Pro-Forma Balance Sheet

Finally, after all other budgets have been completed, the company can prepare a
pro-forma balance sheet, which is a statement that describes the financial
position of the company should all its plans achieve the targets as expected.
Syarikat Guna Jaya

Quarterly Pro-Forma Balance Sheet
as at the Year 2004
RM RM RM
Current Asset
Cash 145,560
Finished Goods Inventory 10,000
Accounts Receivable 70,000 225,560
Fixed Asset
Machine 25,000
Accumulated Depreciation (8,800) 16,200
Total Asset 241,760
Liabilities
Accounts Payable 14,600
OwnerÊs Equity
Capital 20,000
Retained Earning 207,160 227,160
OwnerÊs Liabilities and Equity 241,760
From the examples illustrated, which showed the budgets for a manufacturing
company and a non-manufacturing company, it can be concluded that there are
not that many tangible differences between the two. It can be stated here that the
preparation of budgets for a non-manufacturing firm is easier and simpler
because the number of budgets that need to be prepared is less.

ACTIVITY 2.5
Syarikat Bulan Bintang has prepared the following information to be

budgeted for the month of December:
Syarikat Bulan Bintang

Sales Budget
December 2007
Expected Sales Unit 10,000

X Expected Selling Price RM 12.00
= Expected Total Sales RM 12,000

Budgeted Cost of Goods Sold
December 2007
Expected Sales Unit 10,000

X Expected Cost Per Unit RM 800
Cost of Goods Sold RM 80,000

Sales and Administrative Expenses Budgeted
December 2007
Wage RM 18,500
Commission RM 3,000
Rent RM 9,000
Other Expenses RM 1,500
Sales and Administrative Expenses RM 32,000
Requirement:
Prepare a Pro-Forma Income Statement for the month ended December
2007 for Syarikat Bulan Bintang.

2.9 FLEXIBLE BUDGETS

At the beginning of this topic, we mentioned that budgets can also be used as a
performance measurement tool. Actual performance attained will be compared
with targets set out in the budget. If there is a difference between the two, the
relevant responsibility centre will be questioned for the difference.
However, if a static budget, i.e., one that does not take into account activity
levels, is used as a basis for comparison, it will surely raise prolonged issues. The
comparison made is not accurate as it compares two things that are not
comparable.
For example, let us say that in the sales budget, it is estimated that sales revenue
is RM10,000, for the sale of 5,000 units of goods at a price of RM2.00 per unit.
Actual result shows that sales revenue is RM12,000 for 6,000 units of sales. If a
static budget is used as the basis for performance mesurement, surely the
Marketing Department is deemed efficient for achieving above-target revenue.
However, if a flexible budget is used, the Marketing Department is actually not
efficient for it has achieved revenue of only RM12,000, less RM2,000 than
expected.
From the explanation above, it can be said that the flexible budget is able to offer
a method of performance analysis that is more fair because it takes into account
several levels of activities when the budget is being prepared. The flexible budget
is also more dynamic in nature because it can be adapted to various levels of
activities, as long as it remains at a relevant range.
Based on the assumption that the flexible budget acts as a better performance
measurement tool compared to the static budget, therefore, let us try to learn
how it is prepared.

Example 2.3
Syarikat Putra estimates its variable costs and fixed costs for production at a
relevant range of 5,000 units to 9,000 units are as follows:
Variable Cost:
Production RM2.00 per unit
Sales and Administrative RM0.70 per unit
Fixed Cost:
Production RM3,000
Sales and Administrative RM2,500
Sales price is at RM8.00 per unit.
The flexible budget for Syarikat Putra is illustrated as follows:
Activity Level 5,000 7,000 9,000

Sales Revenue 40,000 56,000 72,000
Variable Cost: Production 10,000 14,000 18,000
Sales and Administrative 3,500 4,900 6,300
Contribution Margin 26,500 37,100 47,700
Fixed Cost: Production 3,000 3,000 3,000
Sales and Administrative 2,500 2,500 2,500
Operating Income 21,000 31,600 42,200
Note that the flexible budget will project operating income at various levels of
activities in similar relevant range. In a similar relevant range, fixed costs are
equal. Bear in mind, the pre-condition of preparing a flexible budget is to know
the cost structure (formula) of the company. You have already learned the
concept of cost in the early topic of this course.
Now, how do you use a flexible budget as a performance measurement tool? Let
us say that the master budget of a company is at an activity level of 9,000 units,
but the actual activity level of the company is at 7,000 units. If the master budget
which is static in nature is made the basis of performance measurement, you will
achieve variances as follows:

Actual Master Budget Variance

Activity Level 7,000 9,000 2,000 (N)
Sales Revenue 70,000 72,000 2,000 (N)
Variable Cost: Production 15,400 18,000 2,600 (N)
Sales and Administrative 4,900 6,300 1,400 (N)
Contribution Margin 49,700 47,700 2,000 (P)
Fixed Cost: Production 4,000 3,000 1,000 (P)
Sales and Administrative 3,200 2,500 700 (P)
Operating Income 42,500 42,200 300 (P)
N = Negative P = Positive
From the above comparison, the variable cost variance is 4,000 (N) (2,600 + 1,400)
and the management may not conduct an investigation on it because the actual
cost is less than the cost budgeted. However, mistakes may have been made
without realising it because the comparison made between the actual rate of
7,000 units with an activity level of 9,000 units in the master budget is not
plausible. This mistake may bring about an adverse impact because the
management is assuming that they are adept at controlling variable costs.
However, the fact is not certain before further analysis is conducted. This is the
reason why it is said that the master budget is not a good performance
measurement tool.
To overcome this problem, a variance analysis table must be prepared to

demonstrate more closely and clearly the said variance, to ascertain whether it is
caused by the flexible budget variance or activity level variance. Flexible budget
variance uses the same activity level when computing variances. The existence of
variances indicates efficiency and inefficiency. Activity level variances use
different activity levels and the existence of variances are only caused by the
differences in activity levels.

Table 2.12: Comparison Table
Actual Budget Budget Flexible Activity

Budget Level Total
Variance Variance Variance
(a) (b) (c) (a-b) (b-c)
Activity Level 7,000 7,000 9,000 - 2,000 (N) 2,000 (N)
Sales Revenue 70,000 56,000 72,000 14,000 (P) 16,000 (N) 2,000 (N)
Variable Cost:
15,400 14,000 18,000 1,400 (P) 4,000 (N) 2,600 (N)
Production
Sales and
4,900 4,900 6,300 - 1,400 (N) 1,400 (N)
Administrative
Contribution
Margin 49,700 37,100 47,700 12,600 (P) 10,600 (N) 2,000 (P)
Fixed Cost:
4,000 3,000 3,000 1,000 (P) - 1,000 (P)
Production
Sales and
3,200 2,500 2,500 700 (P) 700 (P)
Administrative
Operating
42,500 31,600 42,200 10,900 (P) 10,600 (N) 300 (P)
Income
The comparison Table 2.12 demonstrates clearly that the operating income
variance of RM300 (P) is caused by the flexible budget variance RM10,900 (P) and
activity level variance of RM10,600 (N). This analysis demonstrates that the
management of the company, in general, is efficient in operating its business
because of the presence of RM10,900 (P) flexible budget.
Overall sales revenue variance of RM2,000 (N) may result in the management
blaming the Sales Department. However, the flexible budget can avoid the
occurrence of this incident because it clearly shows that the Sales Department is
efficient because it has produced a flexible variance of RM14,000 (P). To
conclude, for the purpose of performance measurement, it is more suitable to use
a flexible budget and not the overall variance.

ACTIVITY 2.6
A firm provided the following information:

Maximum production level 10,000 units
Raw material RM5 per unit
Direct labour RM4 per unit
Fixed Overhead RM20,000
Sales and adminstrative:
Fixed RM1,000
Variable RM0.25 per unit
Prepare a flexible budget for the production levels of 7,000, 9,000 and
10,000 units.
2.10 TECHNIQUES OF BUDGETING

Budgets are detailed plans to coordinate the various activities going on in an
organisation. Managers have choices over which budgeting techniques or
approaches to apply. There are many budgeting techniques available, but for this
topic we will look into four commonly used techniques as follows.
(a) Incremental budget;
(b) Zero-based budget;
(c) Rolling budget; and
(d) Activity-based budget.
2.10.1 Incremental Budgeting
In incremental budgeting, the current budget is the base to prepare the budget
for the coming period by simply making some adjustments.
The process assumes that most of current activities and functions will continue
into the next period. Some adjustments could be made to reflect the changes in
business environment, changes in capacity or resource usage, or changes in
assumptions. For instance, in expectation of increased inflation in the coming
year, a certain percentage will be added to the previous yearÊs budget. In

contrast, a certain percentage will be deducted from the previous budget to allow
for recession. Other adjustments include changes in labour requirement,
additional machines and increased capacity.
An incremental budget is appropriate for many cost centres in big organisations.

It is also commonly used by government agencies. Table 2.13 summarises the
advantages and disadvantages of incremental budgets.
Table 2.13: Advantages and Disadvantages of Incremental Budget
Advantages Disadvantages
• Easy and quick to prepare; and • Justification for each activity is
• Not very costly approach. ignored, will just continue the
activities merely because they have
been undertaken previously;
• Any past inefficiencies will be carried
on to the next period;
• No consideration for different ways of
achieving the objective; and
• Tendency among managers to spend
the whole budgets (regardless of
whether the expenditures are
justifiable) knowing that any
unfinished budget will be reduced for
the coming budget.
2.10.2 Zero-Based Budgeting (ZBB)
Zero-based budgeting (ZBB) starts from afresh, meaning that managers need
to prepare budgets each period from a zero base.
Under ZBB, budgeting teams must review all budget items thoroughly because
managers should be able to justify each of the activities or functions in order to
include them in the budget. This process encourages managers to be more
attentive to activities or functions that have outlived their usefulness, are
inefficient or have been considered as wasteful. ZBB offers a better approach in
overcoming some of the weaknesses in incremental budgeting.
The main downside of this approach is that it requires an enormous amount of

time and effort to prepare a real ZBB. Thus, it is quite impractical to conduct an
in-depth budget review every year. What companies or government agencies or
departments can do is to perform the in-depth review periodically, let us say
every five years or yearly, but based on rotation amongst departments. Every
year only one section or department of a company would perform an in-depth
evaluation, and eventually after five years the whole company will have
completed the process. This allows the company to benefit from ZBB without
going through an excessive amount of work every year.
ZBB is a very useful method for non-production and service departments, which
have support or common expenses with no straightforward relationship to the
output level, for example, public sector organisations and discretionary costs
such as research and development. In addition, budgeting for general overhead
costs is not as simple as budgeting for direct cost, which is quite straightforward.
ZBB offers a better way and establishes greater discipline to the process of
budgeting for overhead activities and costs. Managers need to justify every item
or activity.
Below are some factors to be considered in the review-process of the ZBB:

(a) Determine whether the activity is necessary and the implications if it is
discontinued;
(b) Whether the provision of the activity is at the appropriate level; and
(c) Whether there are other alternatives for achieving the same effect.
Next, we present the steps to implement ZBB:

(a) Managers of each responsibility centre must identify those activities that
can be reviewed and evaluated separately;
(b) Next is to develop the decision package for every individual activity, which
includes the costs and revenues expected from the given activity. The
package should be developed in such a way that enables us to evaluate and
rank it against other packages;
(c) All decision packages will be evaluated and ranked accordingly based on
cost-benefit analysis; and
(d) Lastly is to determine and allocate resources to the various packages.

Table 2.14 outlines the advantages and disadvantages of ZBB.
Table 2.3: Advantages and Disadvantages of Zero-base Budgeting
• Activities are filtered ă any wasteful • Time consuming, very costly, involves
expenditure is prevented; enormous paperwork;
• Any inefficient or outdated activities or • Difficulties in comparing and ranking
operations are eliminated; totally different types of activity;
• Emphasises on outcome and how it • Emphasises short-term benefits over
creates value for money; the long-term benefits;
• Managers always questioning rather • Ranking process of the decision
than assuming that current practices packages may be subjective and the
already create value for money; benefits are difficult to quantify;
• Managers explore for all possible • Company may not respond properly
methods to achieve objectives; to unanticipated opportunities or
• Increases staffÊs participation and threats due to the rigidity of the
commitment at all levels; budgeting process;
• Increases staffÊs motivation and • Lack of certain management skills or
communication; and knowledge in the organisation;
• Increases skills, knowledge and • Managers, staff and unions may feel
understanding of the cost behaviours threatened and stressful; and
and patterns. • Difficult to exactly quantify the
incremental costs and benefits of
alternative courses of action.
SELF-CHECK 2.2
1. Find out the differences between the incremental and ZBB
approaches.
2. List and compare the advantages of the incremental and ZBB
methods.

2.10.3 Rolling Budget
Rolling budget is also known as a continuous budget.
Rolling budget keeps extending the period into the future by adding a month,
quarter, or year in the future as the current month, quarter, or year just ended.
There is always a 12-month budget in place. Rolling budgets constantly force
management to think concretely about the forthcoming 12 months, regardless of
the month at hand. Companies also frequently use rolling budgets when
developing 5-year budgets for long-run planning.
Specifically, managers can break down the budgets by months for the first three
months, and by quarters for the remaining nine months. The quarterly budgets
are then built on a monthly basis as the year progresses. For instance, during the
first quarter, managers will prepare the monthly budgets for the second quarter;
and sequentially during the second quarter, managers will develop the monthly
budgets for the third quarter. The quarterly budgets may also be reviewed as the
year unfolds. For example, during the first quarter, the budget for the next three
quarters may be changed as new information becomes known. In the meantime,
managers also prepare a new budget for a fifth quarter. This on-going process
contributes the name to continuous or rolling budgeting.
A rolling budget is suitable for businesses or departments in which accurate

forecasts cannot be made. For instance, a business division operating in a fast
moving or changing environment, or a business area that needs tight control may
apply a rolling budget.
A typical rolling budget might be prepared as follows:

(a) Managers prepare budgets for the coming period as usual, and these
budgets could be Incremental, ABB or ZBB based budgets. The budgets can
be broken down into suitable control periods like monthly, quarterly, semi-
annually, etc.
(b) Towards the end of the first control period, let us say the first quarter,
managers will review by comparing the first quarter performance with the
budgeted figures. The conclusions drawn from this review are used to
update the budgets for the remaining control periods and to add a budget
for another quarter, so that the company once again has budgets available
for one full year.
(c) The planning process is repeated at the end of each three-month control
period.

The main strength about rolling budgets underlies its assumption that planning
is not a one-shot activity, performed only once when the budgets are being
developed. In fact, budgeting is a continuous process, and managers constantly
look ahead, review and update future plans. Consequently, a more realistic target
is produced, and thus more meaningful comparison with the actual results can
be performed. Nevertheless, a rolling budget can create uncertainty and
confusion amongst managers due to its regular changes. Some of its advantages
and disadvantages are summarised in the Table 2.15.
Table 2.15: Advantages and Disadvantages of Rolling Budgets
• Continuously extends the budget into • More costly and time consuming than
the future (normally 12 months); incremental budget;
• Reduces uncertainty by focusing on the • Possible risk of treating the budget as
short-term, for which smaller the last budget and just add or minus
uncertainty presents; a bit;
• Encourages managers to re-examine • The more the budgeting work, the less
the budget frequently and to produce the control of the actual results would
up-to-date budgets; and be;
• Provides more accurate budgets for • Could demotivate employees if they
planning and control purposes. have to spend so much time on
budgeting;
• Could make employees uncertain and
frustrated if the budgetary targets are
constantly changing;
• Difficult for employees to control
since each month the full year
numbers keep changing; and
• Creates confusion in meeting the
changing targets; this can distract
from the key issues as managers
discuss which numbers to achieve.
2.10.4 Activity-Based Budget (ABB)
Activity-based budgeting (ABB) approach is very much similar and closely

related to activity-based costing.

Activity-based budgeting takes a totally different approach from the budgeting

methods discussed. As discussed earlier, ZBB is based on budgets (decision
packages) prepared by responsibility centre managers, while ABB is based on
budgeting for activities. Indeed, ABB is based on an activity framework and
applying cost driver data in the budget-setting. The comparison between ABB
and the traditional approach is summarised in Table 2.16.
Table 2.16: Comparison between Traditional budgeting and ABB
Traditional Budgeting Activity-Based Budgeting (ABB)

• Budgets for functional areas or • Budgets for activities and cost drivers;
spending categories; • Budgets for high-value-added
• Budgets for input resources; activities;
• Lack of future benefits, more historical • Supports continuous improvement
in nature; and capacity management;
• Rarely considers suppliers and • Coordinates formally with suppliers
customers in budgeting; and customers;
• Encourages managers to maximise • Coordinates activities with level of
their performance; and demand; and
• Provides description accounts in • Provides useful information on value-
departmental budget. added versus non value-added
activities.
ABB is very suitable for departments or organisations whose overhead costs or

general costs constitute the larger portion of the operating costs. Similar to ABC,
it is more practical and economical for large organisations with numerous
activities going on.
Basically, ABB will budget the costs for each activity or cost-pool. General
expenditures like overhead costs that are not activity-driven (i.e., factory rental
and insurance costs) are budgeted separately.
Next, we will discuss the steps in implementing ABB.

(a) First, identify the cost driver for each activity or cost pool. Then estimate or
forecast the number of units of the cost driver that will occur in the budget
period (based on the forecasted output); and
(b) Second, estimate the activity cost, which is based on the activity level for
the cost driver as estimated earlier. A cost per unit of activity can also be
computed wherever applicable.

ABB and ABC share about the same advantages and disadvantages as listed in
Table 2.17.
Table 2.17: Advantages and Disadvantages of ABB
• Provides useful control information, • Time consuming and requires a lot of
considering that whenever the paperwork; and
activity volume can be controlled • Organisations must already apply
then activity costs might be ABC.
controllable as well;
• Emphasises the costs of overhead
activities, especially significant when
overhead costs make up a larger
proportion of total operating costs;
• Good for monitoring and controlling
overhead costs, whereby actual costs
of activities are compared against the
expected cost of those activities; and
• Supports quality initiatives, i.e. it
associates the cost of an activity with
the level of product/service
provided, thus users may evaluate
whether they are getting a cost-
effective service/product.
• A budget is a formal statement by the management on its planning in

quantitative form.
• Advantages of budgets include that budgets act as a planning tool, a
communication tool for the whole organisation, a resource allocation tool and
performance measurement tool.
• A cash budget provides information to a company, among others, about cash
received and cash paid.
• A master budget is a budget that summarises all activities planned by each
respective department in an organisation.
• An operating budget is a budget that outlines the activities of a firm.
• A financial budget is a plan that demonstrates how an organisation will
obtain its financial resources to finance its operations.

• The four techniques of budgeting include incremental budget, zero-based

budget, rolling budget and activity-based budget.
• In fact, budgets too, with certain limitations, can be used as a performance
measurement tool.
• This topic has explained to you the importance of budgets, how it is
prepared, and finally, how a flexible budget can be a better tool for
measuring performance.
Activity-based budget Production budget

Budget Raw material budget
Cash budget Rolling budget
Incremental budget Sales budget
Master budget Zero-based budget
Overhead budget
Blocher, E. J., Stout, D. E., & Cokins, G. (2010). Cost management: A strategic
emphasis. New York: McGraw-Hill/Irwin.
CIMA. (2011). CIMA official study text: Paper P2 performance management. UK:

Topic X Budgetary
3 Control
LEARNING OUTCOMES
1. Explain the concepts of control and budgetary control;
2. Differentiate between feed-forward and feedback control;
3. Prepare fixed and flexible budgets;
4. Construct performance reports and reconciliation statements;
5. Assess the motivational, behavioural and ethical issues of
budgeting; and
6. Evaluate the limitations of budgets and budgetary control.
X INTRODUCTION
Controlling is one of the managerial functions, like planning, organising, staffing
and directing. When we zoom into management control systems, control mainly
refers to the process of monitoring the organisationÊs activities to make sure that
they are according to plan and that objectives are achieved. In the first place, the
organisation must have its own targets, objectives and plans. Otherwise, we will
not have any ideas of what to control if we do not know what we plan to achieve
at the end of the day. Can you imagine living your life without a purpose or
going travelling without a destination?
Objectives and plans help to set the standards and specify desirable goals and
behaviour; and outline the rules and procedures that should be pursued by
members of the organisation. For that reason, control is needed to ensure that a
firm is operated in the desired manner, and any necessary further or corrective
actions are taken appropriately to ensure that all objectives can be achieved.

68 X TOPIC 3 BUDGETARY CONTROL
Do not be confused between „controls‰ and „control‰. They can be defined as

follows.
Controls are measurements used to supply information to assist in

determining the control action to be taken (i.e., information indicates that
unfavourable labour variance due to unskilled labour).
Control is the function to ensure that actual work is done to conform to the
original intention (i.e., the action that is carried out to hire only skilled
labour).
There are different control mechanisms available for organisations to control

their managers and employees. The management accounting control system is
one dimension of the various control mechanisms, and budgetary control is a
widely used management accounting control system.
Therefore, in this topic, you will learn more about budgetary control.
3.1 THE TRADITIONAL SYSTEM

Organisations persistently need to ensure that they can accomplish the goals they
have set for themselves. Those controls are applied to determine whether actual
performance meets expected performance. The main purpose of management
control systems is to influence employeesÊ behaviours in desirable ways as to
increase the chances of achieving the organisationÊs objectives. Budgetary control
is one of the methods that organisations can apply.
3.1.1 Budgetary Control System
Budgetary control is a system that uses budgets as a means of planning and

controlling.
Moreover, budgetary control is a management control technique where actual

results are compared with budgets. Indeed, actual income and expenditure are
compared with budgeted income and expenditure, so that you can tell if plans
are being followed and if those plans should be revised in order to make a profit.
Managers or key individuals who can either implement control action or revise
the original budgets will be held responsible for any differences or variances.
TOPIC 3 BUDGETARY CONTROL W 69
Furthermore, budgetary control is defined by the Institute of Cost and

Management Accountants (CIMA) as follows:
The establishment of budgets relating the responsibilities of executives to the

requirements of a policy, and the continuous comparison of actual with
budgeted results, either to secure by individual action the objective of that
policy, or to provide a basis for its revision.
In brief, budgetary control involves the process of setting standards, receiving

feedback on actual performance, and taking corrective action whenever actual
performance deviates significantly from budgeted performance. Thus, the control
system is designed to measure progress toward planned performance and, if
necessary, to apply corrective measure.
Budgetary control assists the management in performing those managerial

functions such as planning, co-ordinating and controlling.
(a) Planning
Budgeting layouts a thorough plan of action for an organisation covering a
specified period of time.
(b) Co-ordination
Budgetary control co-ordinates the various activities of the organisation
and requires cooperation of all relevant parties towards achieving the
shared goals.
(c) Controlling
Control is essential to make sure that plans and objectives are being met.
Control comes after planning and coordination.
An effective budgetary control should come with prerequisites, amongst others,

as follows:
(a) Objectives and goals are clearly defined and understood;
(b) A budget manual should be prepared, containing all details of plans and
procedures for its implementation, schedule for budget preparation, and
details about responsibility centres, etc.;
(c) Establishment of budget committee responsible for budget preparation and

execution;

(d) Top managementÊs support is essential for getting full support and
cooperation from the whole levels;
(e) Proper delegation of authority and responsibility is crucial for successful

budgetary control;
(f) Development of a proper periodic system for reporting purposes;
(g) A good budgeting system coupled with reasonable accounting system is

necessary to make the budgeting successful;
(h) Employees are well-informed, trained and educated about the benefits of
the budgeting system, and how their commitments contribute to achieving
the goals and objectives; and
(i) All critical and limiting factors and possible constraints have been
evaluated before preparation of the budget.
Budgets could provide the base upon which to compare actual outcomes with
budgeted outcomes, and they can trace operations back on course, if necessary.
Budgetary control creates control by continuously measuring and monitoring
performance against the predetermined targets. Moreover, budgeting can be
applied undoubtedly in any sector, including the public or private sectors of the
economy; for a profit-making business or a non-profit making business; and for
trading, manufacturing, or service providers.
The following list underscores some of the advantages and benefits of budgeting
and budgetary control:
(a) Budget and budgetary control assist planning and policy making
(i) Through a budget, objectives are formalised;
(ii) They function by setting the limits and goals;
(iii) They help to adopt the principles of standard costing;
(iv) They assure maximisation of profits through cost control and
optimum utilisation of resources; and
(v) Thus, an organisation can ensure that its plans are achievable,
resources are well-managed to produce the output, and everything
will be available at the right time.

(b) Budget and budgetary control promote effective communication and

coordination
(i) By having agreed and shared objectives, all the managers and staff
will be working towards the same end; and
(ii) All departments and staff play their roles to accomplish overall goals,
and co-ordinate to clarify any confusion and to resolve any
anticipated problems.
(c) Budget and budgetary control facilitate decision-making

(i) Managers can make decisions on the targets for outputs to be
achieved by planning in advance through budgets;
(ii) Cost of the output also can be planned ahead and changes can be
done if necessary; and
(iii) They improve the allocation of scarce resources.
(d) Budget and budgetary control support monitoring and controlling

(i) Management is able to use budget as a control tool, in order to
monitor and compare the actual results;
(ii) Consequently, actions can be taken to modify the operation or
possibly to revise the budget if it becomes unattainable; and
(iii) They facilitate corrective actions, whenever there are inefficiencies
and weaknesses comparing actual performance with budget.
(e) Budget and budgetary control act as sources of motivation

(i) Budgets can be a motivating factor to pool managers and other staff
together to achieve the objectives of the business;
(ii) Budget motivates employees by participating in the setting of
budgets;
(iii) The way the budget is developed and agreed upon, and whether it is
perceived as fair and achievable will influence the degree of
motivation; and
(iv) Rewards can also be linked to the budget for reinforcement.

(f) Budget and budgetary control provide basis for performance evaluation
(i) A budget is the yardstick against which actual performance is
measured and assessed. Any departures from budget can then be
investigated;
(ii) They enable remedial or corrective action to be taken as variances
emerge;
(iii) They facilitate continuous review of performance of different budget
centres; and
(iv) They economise management time by using the management-by-
exception principle.
(g) Budget and budgetary control force management to look forward

(i) They force management to look into the future, to set out detailed
plans for achieving the targets for each department, operation and
each manager;
(ii) They induce managers to anticipate and give the organisation
purpose and direction; and
(iii) They guide management in research and development.
(h) Budget and budgetary control assist in clarifying areas of responsibility

(i) They clearly define areas of responsibility (i.e., respective
responsibility centres, managers in charge); and
(ii) They require managers of budget centres to take responsibility for the
accomplishment of budget targets for the operations under their
personal control.
Nevertheless, budgeting and budgetary control also have some drawbacks and
limitations, which are discussed in the last section of the topic.
3.1.2 Types of Controls

Managers can apply different types of control mechanisms to cope with the
problem of organisational control, specifically to affect change and fluctuations in
the goals and directions of the organisation. Possibly, many problems and issues
may appear at any time during a process; thus, it is beneficial to have a few
different approaches to manage them.

In the following section, we present a brief explanation of several control

mechanisms as follows:
(a) Three categories of controls (Drury, 2006; Ouchi, 1979; and Merchant, 1998):
(i) Action or behavioural controls;
(ii) Personnel and cultural (clans and social) controls; and
(iii) Results or output controls.
(b) Cybernatic control systems.
(c) Feedback and feed-forward controls.
For the purpose of this topic, only feed-forward and feedback controls will be
discussed in detail.
Budgetary control systems are so dependent on internal and external factors

which affect the organisation and changes in those factors must have impact on
the budget. External, political, social and economic changes tend to have a slow
effect on organisations as such changes are often unpredictable and organisations
tend to act reactively rather than proactively. For example in the public sector,
changes in the vision of a government from vision 2020 to vision 2015 will have
an impact on their budget. Economic changes such as the rate of inflation will
affect the predictive value of budgets. If these changes occur frequently then
organisations will increasingly need to use techniques such as flexible budgeting
and sensitivity analysis to the effect of these changes.
(a) Action or behavioural controls

(i) Behavioural controls involve observing and guiding the actions of
subordinates at work;
(ii) They are effective where cause-and-effect relationships are well
understood and desirable actions or behaviours are known;
(iii) Merchant categorises action controls into three forms: behavioural
constraints, pre-action reviews and action accountability; and
(iv) Action controls focusing on preventing undesirable behaviour is
preferable to detection controls.

(b) Personnel, cultural, clan and social controls

(i) Clan controls are quite similar to corporate cultures or a special form
of social controls which include the selection of people who have
already been socialised into adopting desired norms and patterns of
behaviour to perform particular tasks;
(ii) While personnel controls include encouraging employees do a good
job by building on employeesÊ natural tendencies to control
themselves; and
(iii) In addition, cultural controls represent shared values, social norms
and beliefs that would influence and determine employeesÊ actions.
(c) Results or output controls

(i) Results or output controls involve collecting and reporting about the
outcomes of processes or activity;
(ii) Result measures are normally in monetary terms, including both
financial and nonfinancial measures;
(iii) Management accounting control systems, such as budgetary control,
is a form of output control; and
(iv) There are four stages of result controls:
Ć Establish results or performance measures that minimise
undesirable behaviours;
Ć Establish performance targets;
Ć Measure performance (comparisons between actual and targets);
and
Ć Provide rewards or punishment.
(d) Cybernatic control systems (see Figure 3.1)

(i) A traditional approach that views results controls as a simple
cybernatic system;
(ii) The output of the process is monitored regularly, the input will be
automatically adjusted whenever the output level is different from the
predetermined level;
(iii) Result controls and budgetary control share same features of this
cybernatic or thermostat control model; and

(iv) The stages include to initially determine the standards of

performance, monitor performance, then compare between the
standard and actual performance, and provide feedback on the
variances.
Figure 3.1: Cybernatic control system
SELF-CHECK 3.1
1. Explain why control is needed.
2. List down the types of controls.
3. What is budgetary control?
3.1.3 Feed-Forward and Feedback Control

In order to be effective, control must be future-oriented, which is able to prevent
problems before they occur. Getting feedback from the output of a system and
knowing about deviations in performance long after they have occurred are not
very helpful for control. The control system should also be proactive instead of
responsive. Thus, managers need a control system that will alert them just in
time for corrective action and that problems will most likely occur if there is no
action taken now. Luckily, the feed-forward control system can provide those
features.
In budgetary control, a feed-forward control system compares the budgeted

results against a forecast. The aim is to anticipate errors or variances before they
actually occur and to take necessary actions to prevent or minimise them. Control
action is initiated whenever there is a significant difference between budgeted
and forecasted results.

Furthermore, feed-forward control can be considered as the most proactive and

preventative control which involves identifying and preventing problems in an
organisation and ensuring goals will be accomplished. Indeed, it is a preparatory
control like our body. For instance, smelling food leads to salivation and
production of stomach acid in preparation of food. In a similar way, feed-
forward controls allow managers to plan work effectively. They can monitor
resources like employees, raw materials and capital in advance. Consequently,
possible future problems can be prevented.
Under feed-forward control, appropriate actions can be taken ahead in order to

avoid problems later on. Let us examine some situations below:
(a) Background checking and drug testing on employees are very critical.
Mistakenly recruiting a drug user can result in poor job performance,
higher social problems, liability claims and absenteeism;
(b) Training programmes are essential for quality maintenance. Employee

accidents and injuries at workplace can be avoided by training employees
on job safety; and
(c) Providing employees with good health insurance plan would definitely
reduce absenteeism and sick-leave.

The following case illustrates the feed-forward control:
Case: Prima Hospital
Each function of the emergency room must be fully operational and run
smoothly. Many different employees, ranging from highly-skilled to
minimally-skilled employees, are needed to properly treat patients.
As preventive measures, it is important that Prima Hospital management

hires the right people, inspects and tests equipment regularly and has
enough capital resources to manage any medical emergency that may occur.
Focusing on inputs, or things, the organisation can put into the planning can
ensure objectives are met and problems are avoided in the emergency room.
A closer look at the members of the management team of the emergency

room will reveal that feed-forward controls are always in action. In fact, we
will find that a very detailed human resource plan, an equipment
maintenance plan and a well-funded budget plan are in place.
Feed-forward control planning can be used in planning for the Human

Resource Department. A human resource plan ensures that the hiring
managers are recruiting the right people for every position.
However, there is a downside. Hiring the right people can be costly and time
consuming. Time and money are spent on placing job-vacancy ads in the
right newspapers and right online job sites, interviewing candidates, running
background checks and drug testing, training and health benefits. Without a
strong human resource plan, the emergency room may not be appropriately
staffed. There may not be enough medical staff to operate the emergency
room. This can cause countless problems later on.
In order to have an effective and workable feed-forward control system, the

following steps or actions are required:
(a) Carry out a thorough and well thought-out analysis of the planning and
control systems;
(b) Design and develop a good model of the system;
(c) Evaluate the model frequently to observe whether the assumptions and
variables continue to represent realities;

(d) Gather relevant data regularly and place them into the system;
(e) Review the variations of actual input data from planned, for inputs, and
assess the impact on the expected end result on a regular basis; and
(f) Select and take appropriate action to solve problems.
Although feed-forward controls may cost a lot and may delay or hold back the
planning process, they are able to avoid numerous problems afterwards. The
additional cost, time and effort invested in implementing the system are
positively justified by the substantial benefits of feed-forward control. Table 3.1
outlines some advantages and disadvantages of feed-forward control.
Table 3.1: Advantages and Disadvantages of Feed-Forward Control
• Managers are encouraged to be • May require a sophisticated and
proactive and take preventive measures expensive forecasting system;
ahead before the problems occur; and
• May take the focus off the day-to-day
• Reforecasting on a monthly or organisation; and
continuous basis can save time when it
comes to completing a quarterly or • May be labour and time consuming
annual budget. as control reports must be produced
regularly.
Generally feedback helps organisations to make necessary adjustments to

improve performance. Feedback functions by identifying and correcting
problems in an organisation after they already happen. In other words, feedback
control analyses processes are carried out after the activity to determine whether
goals have been fulfilled. Positive feedback enhances performance, while
negative feedback inhibits performance that may require corrective action.
Feedback also serves as motivation for many people in the workplace in
increasing their performance.
Feedback is a very simple method, and often used whenever the other controls
like feed-forward and concurrent would be too costly and time consuming.
Moreover, some organisational objectives cannot have a preventative measure or
cannot be measured in real-time. Thus, sales goals should take a feedback
approach.

The following case illustrates the use of feedback control.
Prima Hospital uses feedback controls for things like customer satisfaction
surveys, accounting collection goals, gift shop sales goals and food sales goals.
Feedback controls focus on outputs, or things the organisation may obtain out of
the planning to be sure the objectives can be fulfilled.
Using the reactive approach, it can help to analyse problems after an activity has
been completed. Prima Hospital's Accounting Department sets goals for
employees to collect on outstanding hospital bills. The Collections Department
employees must make 200 collection calls to patients each day who owe
outstanding balances to the hospital. The Accounting Manager will evaluate call
reports and collection reports to determine whether each employee is coming
close to or meeting the collection goals. If the report states that the total calls
required are being made, no corrective action is needed. Feedback will be
positive. If the goals are not met, this could mean that the goals will need to be
re-formulated to be more effective.
In contrast to feed-forward control, a feedback system would basically compare

the actual historical results with the budgeted results. Indeed, a feedback control
system measures the differences between planned and actual results. In
responding to the resulting variances, managers can take succeeding actions to
obtain the required results. Figure 3.2 shows the difference between feed-forward
and feedback controls.
Figure 3.2: Feed-forward and feedback control

Source: Voss, Brignall, Fitzgerald, Johnston and Silvestro (1992)

For illustration, we will look at a sample of feedback control report for a sales
manager (see Table 3.2). A sales manager will normally receive monthly control
reports about sales. The following feedback control report was prepared at the
end of July, assuming it is already in the middle of the year. The budgeted sales
for the year to 31 December were estimated at RM300,000 in total.
Table 3.2: Performance Report for Sales using Feedback Control
Month of July Cumulative

Product Budget Actual Variance Budget Actual Variance
RM RM RM RM RM RM
A120 10,000 11,500 1,500 F 68,000 72,000 4,000 F
B100 8,000 6,500 1,500 A 55,000 45,500 9,500 A
C110 7,000 8,500 1,500 F 47,000 49,500 2,500 F
Total 25,000 26,500 1,500 F 170,000 167,000 3,000 A
If the Sales Department uses feed-forward control, then the sales manager would
receive monthly or periodic feed-forward control report, as shown in Table 3.3.
Table 3.3: Performance Report for Sales Using Feed-forward Control
Sales Report, July

Budget Latest forecast Expected
Product
for the year Variance
RM RM RM
A120 120,000 125,000 5,000 F
B100 95,000 89,500 5,500 A
C110 85,000 80,500 4,500 A
Total 300,000 295,000 5,000 A
Based on the feedback sales report in Table 3.2, the sales manager can only
acknowledge that there were variances: favourable sales variance for the month
of July but cumulatively for the first six months of the year the sales value was
slightly below target (with RM3,000 adverse variance). Nothing much can be
done by the sales manager as those are historical data, which already occurred.
Sales manager may think of something to increase the sales of product B100 in
the coming months, since B100 sales were below target.
On the other hand, if we refer to Table 3.3, the feed-forward sales report indicates
that as at the middle of the year, there is expected adverse variance of the amount

RM5,000 for the year. Since there is another six-month period to go, the sales
manager should proactively consider some actions or initiatives like conducting
sales campaign to boost up the sales in order to avoid the expected adverse sales
variance. In brief, a feed-forward control system allows managers to proactively
consider corrective actions that can be preventive measures against the expected
adverse variances.
Internal and external factors have great influence on the budgetary control
system. External factors such as movement in the market place and business
environment, plus political, social and economic factors would most likely affect
the budget and organisational performance. Anyhow, some changes in those
factors tend to have a slow impact on organisations as such changes are often
unpredictable and thus organisations have no preventive measures and tend to
be reactive rather than proactive. So, feedback control is more feasible in this
situation.
Furthermore, changes in the vision or policy of a government or organisations,

and economic changes such as the change in inflation rate will affect not only the
actual performance but also the predictive value of budgets. If these changes
happen frequently then organisations may need to use proper techniques such as
flexible budgeting and sensitivity analysis to better account for the effect of these
changes. For that reason, in the next section we will discuss these two types of
budget: fixed and flexible budgets.
ACTIVITY 3.1
Write down your answers to the following questions and publish or post
them in the MyVLE forum and respond to some of the postings by your
coursemates.
(a) How does budgetary control system work?
(b) Distinguish between feed-forward and feedback controls in terms
of how they function?
(c) What are the strengths of feed-forward and feedback control?

3.2 FIXED AND FLEXIBLE BUDGETS

Budgets are detailed financial planning which is prepared prior to the beginning
of the period being budgeted. In addition, the comparison of the budget with
actual results provides valuable information about organisational financial
performance. For that reason, a budget is a good planning tool, control tool and
performance evaluation tool as well.
Developing appropriate budgets for your business is vital to keep operations

running smoothly and to have meaningful performance evaluation at the end of
the day. Normally, companies are more conducive to fixed budgets, which
clearly define company costs and income streams. Nevertheless, some businesses
operate in a more turbulent or volatile economic environment, which require
advance planning for multiple economic realities or scenarios. In this case, a
flexible budget seems more practical.
Control is the function to ensure that actual work is done to conform to the
original intention (i.e., the action that is carried out to hire only skilled
labour).
Normally, fixed budget is prepared in advance before the beginning of the

financial year. Fixed budgets are simpler to prepare and to understand if
compared to Flexible budgets. A fixed budget is suitable under static or stable
conditions in which the levels of income and expense are not expected to
fluctuate very much through the duration of the budgeting period. Since it is
created for a particular level of activity, it is not going to highlight the cost
variances due to the difference in the levels of activity.
The ICWA London defines a fixed budget as follows:
A flexible budget, also known as variable or sliding scale budget, is designed

to change according to the level of activity actually attained.
Fixed budgets are often used by firms which rely on their forecasts. Hence, once
made and accepted, the fixed budget cannot be changed for whatever reason
being that fixed cost is incurred and still persists irrespective of sales volume.
Since a fixed budget is developed to remain unchanged irrespective of the
volume of output or turnover attained, a comparison between actual results and
this budget will be meaningful only when the actual level of activity matches
with the budgeted level of activity.

Flexible budget is the contrary of fixed budget that indicates the expected cost at
a single level of activity. Flexible budget reflects the effect of changes in the
business environment which affect the performance of the budget. It is
developed for several levels of activity or volume of output, and thus actual
results do not have to be compared against budgeted costs at the original activity
level.
The flexible budget combines a series of fixed budgets for different levels of
activity. It presents the budgeted expenses against each item of cost
corresponding to the different levels of activity. This budget is used to overcome
the limitation or problem caused by the application of the fixed budget. The
following are some of the advantages and benefits of flexible budgets.
(a) In a flexible budget, all possible volumes of output or level of activity can
be covered;
(b) Overhead costs are analysed into fixed, variable and semi-variable costs;
(c) Expenditure can be forecasted at different levels of activity;
(d) It facilitates at all times the comparison of related factors which are
essential for intelligent decision making;
(e) A flexible budget facilitates ascertainment of costs at different levels of
activity, price fixation, placing tenders and quotations;
(f) A flexible budget can be prepared with standard costing or without
standard costing, depending upon what the company opts for; and
(g) It helps in assessing the performance of all departmental heads as the same
can be judged by terms of the level of activity attained by the business.
Next, we will examine the differences between fixed and flexible budgets. The
differences are summarised in Table 3.4.
Table 3.4: Distinction between Fixed Budget and Flexible Budget
Fixed Budget Flexible Budget

Remains constant irrespective of Changes according to the activity level
changing volumes of activity. and can be recast on the basis of volume
of cost.
Determines costs for one level of Able to determine cost by behaviour and
activity only. variable costs, as per activity attained.
Cost ascertainment does not provide Able to fix the selling price at different
a correct picture if budget and actual levels of activity or output.
activity levels do not match.

Difficult and not quite possible to Can easily determine costs at different
ascertain costs in Fixed cost. levels of activity.
Offers little or limited application for Offers many applications and serves as
cost control. an effective tool for cost control.
Assumes that conditions would Able to reflect the effects of changed
remain constant, and become a rigid conditions.
budget.
Difference in volume of production Offers meaningful and realistic
causes comparison of actual and comparisons according to the change in
budgeted performance to be incorrect the level of activity.
and unrealistic.
Cannot categorise costs according to Variability of costs can be classified into
their variability. fixed, variable and semi-variable
according to their nature.
Big corporations can use flexible budgets within smaller departments to keep
shortcomings of one branch of business operations from affecting the entire
company. Seasonal businesses, businesses affected heavily by weather conditions
and companies frequently introducing new products also develop flexible
budgeting practices.
For example, say a seasonal retail store traditionally does about RM70,000 worth
of business during the holiday months and only RM35,000 during off-season
months. Plotting in different figures for holiday and off-season sales will help the
business owner develop contingency plans in the event of a surplus or budgetary
shortcomings.
In preparing a flexible budget, it starts with identifying the relevant factors that
are most likely to vary during the budgetary period. Then select a range of levels
of activity or output. When a fixed budget is adjusted to account for variable
results, it can be referred to as a flexible budget. The following steps are used to
prepare a flexible budget:
(a) Determine the budgeted variable cost per unit of output. Also, determine
the budgeted sales price per unit of output, if the entity to which the budget
applies generates revenue (e.g., the retailer or the hospital);
(b) Determine the budgeted level of fixed costs;
(c) Determine the actual volume of output achieved (e.g., units produced for a
factory, units sold for a retailer, patient days for a hospital); and
(d) Develop the flexible budget based on the budgeted cost information from
steps (a) and (b), and the actual volume of output from step (c).

For illustration, let us follow through the case below, whereby we will prepare a
fixed budget and flexible budget, and prepare a performance report.
Double A Sdn Bhd has forecasted sales of RM200,000 for January and had
budgeted production of 10,000 units to support the estimated sales. Let us suppose
that demand for the product has increased recently, thus sales of RM350,000 were
made in the month. The increased sales activity has caused the production level to
exceed the budgeted level. Actual production was 17,500 units. The estimated
production costs are as follows:
Production Variable cost Production Fixed Costs

Costs per unit Costs
Direct material RM4.00 Supervision RM16,000
Direct labour RM2.00 Depreciation RM20,000
Indirect labour RM0.40 Others fixed RM12,000
Indirect material RM0.60
Other variable costs RM0,20
Using the above information, a performance report comparing the actual

production costs for the month with the original planned production costs can be
prepared, as depicted in Table 3.5.
Based on the performance report in Table 3.5, most of the production costs have
unfavourable variances (with total unfavourable variance of RM26,800). Of
course, when production unit increases, all variable costs (direct material, direct
labour and variable overheads) will automatically increase as well, even if cost
control is perfect for the production of 17,500 units. So what is wrong with the
report? The mistake is where we compare the actual cost of production of 17,500
units with budgeted cost of production of 10,000 units. Thus, to create a more
meaningful performance report, actual costs and expected costs must be
compared at the same level of activity. Hence, we are able to perform this with a
flexible budget.

Table 3.5: Performance Report: Monthly Production Costs

(under Fixed Budget)
Actual Budgeted Variance

Units produced 17,500 10,000 7,500 F
RM RM RM
Direct material 52,000 40,000 12,000 U
Direct labour 30,000 20,000 10,000 U
Overhead:
Variable:
Indirect labour 7,500 4,000 3,500 U
Indirect material 8,500 6,000 2,500 U
Other variable costs 1,800 2,000 200 F
Fixed:
Supervision 17,000 16,000 1,000 U
Depreciation 20,000 20,000 0.0
Other fixed costs 10,000 12,000 2,000 F
Total production costs RM146,800 RM120,000 RM26,800 U
Note: All variable costs for budgeted amounts were obtained by

multiplying the unit cost with 10,000 units
Flexible budgets are prepared at the end of the period, when actual output is
known. However, the same steps described above for creating the flexible budget
can be used prior to the start of the period to anticipate costs and revenues for
any projected level of output, where the projected level of output is incorporated
at step (c). If these steps are applied to various anticipated levels of output, the
analysis is called pro-forma analysis. Pro-forma analysis is useful for planning
purposes. For example, if next yearÊs sales are double this yearÊs sales, what will
be the companyÊs cash, materials and labour requirements in order to meet
production needs? However, pro-forma analysis will not be explained in detail
here as it is beyond the coverage of the course.
Next, we will prepare a flexible budget for three levels of production using the
data from the same case of Double A Sdn Bhd. If you follow the steps as
described earlier, firstly you need to know the cost behaviour pattern of each
budget item. As for variable cost items, you need to multiply the cost per unit by
activity level. While the fixed costs stay at the same amount as long as the levels
of activity are still in relevant range. Table 3.6 presents the production budget
under flexible budgeting.

Table 3.6: Flexible Production Budget
Range of Production (Units)

Variable
Cost per 10,000 14,000 17,500
Unit
RM RM RM
Production costs:
Variable:
Direct material RM4.00 40,000 56,000 70,000
Direct labour RM2.00 20,000 28,000 35,000
Variable Overhead:
Indirect labour RM0.40 4,000 5,600 7,000
Indirect material RM0.60 6,000 8,400 10,500
Other variable costs RM0.20 2,000 2,800 3,500
Total variable costs RM7.20 RM72,000 RM100,800 RM126,000
Fixed overhead:
Supervision 16,000 16,000 16,000
Depreciation 20,000 20,000 20,000
Other fixed costs 12,000 12,000 12,000
Total fixed costs RM48,000 RM48,000 RM48,000
Total production costs RM120,00 RM148,800 RM174,000
Notice that the total budgeted production costs will increase as the activity level
increases. Budgeted costs change mainly due to the variable costs, while the fixed
costs stay the same. The above table shows what the costs should have been for
the actual level of activity, let us say for 17,500 units. So, next let us revise the
performance report to compare the actual and the budgeted production costs at
the 17,500 unit level (refer to Table 3.7).

Table 3.7: Actual versus Flexible Performance Report: Monthly Production Costs
Actual Budgeted# Variance

Units produced 17,500 17,500 --
RM RM RM
Direct material 52,000 70,000 18,000 F
Direct labour 30,000 35,000 5,000 F
Overhead:
Variable:
Indirect labour 7,500 7,000 500 U
Indirect material 8,500 10,500 2,000 F
Other variable costs 1,800 3,500 1,700 F
Fixed:
Supervision 17,000 16,000 1,000 U
Depreciation 20,000 20,000 0.0
Other fixed costs 10,000 12,000 2,000 F
Total production costs RM146,800 RM174,000 RM27,200 F
A fixed budget is a common mainstay in many businesses, but flexible budgets

do have many applications where they are preferable to fixed budgets. The
flexible budget is considered as a performance evaluation tool. The motivation
for the flexible budget is to compare apples to apples. If the manufacturer
actually produced 10,000 units, then management should compare actual
production costs for 10,000 units to what the manufacturer should have spent to
make 10,000 units, not to what the manufacturer should have spent to make 9,000
units or 11,000 units or any other production level.
3.2.1 Performance Reports and Reconciliation

Statement
Performance report basically describes the results of some activity, operations or
individual performance for a specific period of time. For example, an academic
report received by a student every semester or every year is also a performance
report. As a student, when you receive your carrying mark prior to your final
examination (normally you may assess your mark or grade via your universityÊs
portal system), it would tell you about your current performance and how much
more you need to get from your final examination in order to reach whatever
target grade that you set for that particular paper. Likewise, for businesses,
variety of performance reports are issued for divisions, departments, units and

individual employees. Performance report contains detailed results that might

help management assess the success of a project or product, the efficiency of
operation or processes, and how well resources were used and managed.
On the other hand, reconciliation statement is the result of comparing two sets of
records to ensure the figures are in agreement and are accurate. Reconciliation is
an accounting process to determine whether the money leaving an account
matches the amount spent, ensuring the two values are balanced at the end of the
recording period. Account or statement reconciliation is very important for
businesses to check for fraud or misuse of funds and to prevent balance sheet
errors. Accounting software and applications are available to help them perform
account reconciliations. For publicly traded companies, material mistakes can
have serious implications.
Generally, performance report contains performance indicators which are known

as key performance indicators (KPIs) that measure the achievements of the entity
and its activities. For instant, for a hospital, the report may disclose the number
of patients warded and discharged, number of treatments given by illness
category, and the change in the patient flow. Comparisons between the actual
results and the targeted figures for each KPIs would give some indication of level
of achievement, e.g., outstanding or underperformed. As for financial
performance indicators, the reports might show the cost variances for various
treatments, medicines, nursing services, operations, maintenance and etc. Such a
report might be useful for management to assess the efficiency of each
operations and treatments provided by individual units or departments of the
hospital and how well they adhered to budgetary constraints. Table 3.2, Table 3.3
and Table 3.5 are examples of performance reports. How often should the
performance report be produced? Generally, it depends upon several factors as
follows:
(a) Short term objectives

If the report contains perfomance indicators that measure short term
objectives, and involve operational level (or day-to-day operations), the
report should be prepared more frequent like for weekly, monthly or
quarterly basis. This periodic reporting is called as interim performance
reports. They serve as a measure of progress achieved on periodic basis to
help managers identify operational, administrative or technical problems
that may need to be resolved immediately.
(b) Extent of the impact

Frequency of reporting also depends on the extent of the impact if no
corrective action was taken. The severe the impact, the regular the report

should be produced. Some processes or activities are critical to the

company then regular reporting would be necessary.
(c) Long term objectives

Performance reports with regard to shareholding, investment performance,
and fixed assets position are more towards long term objectives and
involving corporate level, are normally prepared on annual basis. Ask
yourself ă how often do you prefer your progress or performance in the
courses taken in the semester be released?
Table 3.5 as shown in the previous section is an example of performance report,

prepared on monthly basis, showing the variances for production costs. In
addition to budgets, companies often use performance reports to provide owners
or managers with additional information relevant to budget variances. This
additional information could be financial or non-financial issues that cause the
budget to go beyond its allowable range. Non-financial factor such as unskilled
or inferior labors may increase the consumption of resources. In addition,
resource cost like raw materials may also increase due to inflation, thus would
create variances.
In budgetary control system, small business owners or managers will track

spending variances through the use of budgets. Although most financial budget
processes are completed on an annual basis, tracking budget variances typically
is done on regular basis, like every month. This monthly spending performance
report helps the owners understand where money was spent each month
compared to the amount of sales generated on financial statements. Excessive
budget variances may entail immediate attention and force the owners or
managers to thoroughly review their budget process.
There are plenty of software applications available for preparing budgets and
performance reports. Companies may use software packages which include a
budgeting module that allows companies to funnel information electronically
into a pre-set budget format. Computerised budgets limit the companyÊs time
and money spent during the development or planning phase of the budget. The
biggest advantage of such application is that it links these budgets to specific
financial accounts and tracks information on a real-time basis.
If you have current account and are using credit card or debit card, you are
strongly advisable to reconcile your checkbook and card accounts by comparing
your check copies, debit card receipts and credit card receipts with your bank
and credit card statements. This account reconciliation can reveal if your money
was being fraudulently or mistakenly withdrawn, if financial institutions have
made any errors impacting your accounts, provide you an overall picture of your

spending, help you review whether you were overspending and show whether
you were paying too much on banking and credit card fees.
Therefore, what do we mean by reconciliation statement? Reconciliation

statement is a document that begins with the company's own record of an
account balance, adds and subtracts to adjust for reconciling items, and then uses
these adjustments to arrive at the record of the same account held by a third
party. The main goal of the reconciliation statement is to provide an independent
verification of the trueness of the balance in the company account, as well as to
clarify the differences between the two versions of the account. The differences
between the two accounts are detailed in the reconciliation statement, which
makes it easier to determine which of the reconciling items may be invalid and in
need of adjustment. Reconciliation statements are extremely useful for both
internal and external auditors.
For example, when a bank account is reconciled, the statementÊs transactions and
ending balance should tally with the account holderÊs records. For a checking
account, it is important to be aware of reconciling items such as any pending
deposits or checks outstanding and bank charges that may affect the statement
balance, that is the amount of money that you really have available to spend.
External auditors will normally use internally-prepared reconciliation statements

as part of their auditing procedures, since the statements allow them to focus on
reconciling items, especially in large-balance accounts that are materially
significant components of the financial statements.
Reconciliation statements are commonly prepared for the following items:

(a) Bank accounts ă The bank reconciliation compares the balances between a
company's version of its cash balance and the bank's version, typically
involving many reconciling items such as deposits in transit and uncashed
checks.
(b) Debt accounts ă The debt reconciliation compares the outstanding balances
of debts and loans according to the companyÊs and its lenderÊs records.
There can be differences requiring reconciliation when the company pays
the lender, and the lender has not yet recorded the payment in its books.
(c) Accounts receivable ă The receivables reconciliation is usually constructed
for individual customers, by comparing their version of outstanding
receivable balances to the company's version.
(d) Accounts payable ă The payables reconciliation is normally prepared for
individual suppliers, by comparing their version of outstanding payable
balances to the company's version.

3.3 MOTIVATIONAL, BEHAVIOURAL AND

ETHICAL ISSUES OF BUDGETING
A successful budgeting process can be realised only if those responsible for its
implementation make it really happen. Management must be aware of and
consider a number of behavioural issues related to budgeting and budgetary
control in order to have a successful budgeting process. The next section will
discuss in detail about the behavioural aspect of budgeting and budgetary
control system.
3.3.1 Motivational and Behavioural Issues

An effective organisational control depends upon the communication and
coordination amongst the top management and the rest of the employees.
Moreover, management accountants through the budget process can motivate
managers and employees and improve their attitudes and perceptions towards
budgetary control.
Motivation can be regarded as the fuel that drives employees to direct their effort
towards achieving the organisational goals. It is about how to align the
individual managerÊs goals with the organisational goals, which is referred to as
goal congruence. Goal congruence refers to the degree of consistency between the
goals of the organisation, and that of its sub-units and employees. Obtaining goal
congruence is essentially a behavioural issue. Managers especially need to be
motivated in such a way that they will pursue the same shared goals. Here are
some suggestions for motivating employees, which in turn would result in goal
congruence.
(a) Employees involvement in the budgeting process

By participating in the budgeting process from the beginning, employees
and managers would be motivated to accomplish the organisational goals
because they feel a sense of belonging and sense of purpose. If they meet
their targets regularly, they may be motivated to go for a higher target.
On the contrary, if the budgets are determined by those above and imposed
on those who are to implement the plan, it will not motivate workers but
may invite resistance instead.
(b) Budget difficulty level

In the budgeting process, targets have been set. The perception of
employees on the difficulty of achieving the target would determine

whether employees will perform better. There are different perceptions of

targets, such as:
(i) If targets are very low, easy to attain, then actual performance can be
pulled down from where it might naturally have been since no extra
effort is needed to achieve the targets; and
(ii) If targets are very high, then employees might give up and feel
discouraged, then performance decreases since they know that they
will never meet the target no matter how hard they try. Thus, it is
easy to conclude that they might as well not try at all.
Figure 3.3 displays research findings on the relationship between the level
of employee effort and level of difficulty of budget targets. It seems that the
higher the difficulty level of achieving the target, the lower the effort or
performance would be. Ideally, budget targets should be challenging yet
attainable.
Figure 3.3: Relationship between budget difficulty and performance

Source: Drury (2008)
In short, an easy budget target may discourage employees from giving their
best efforts while a very difficult budget target may restrain managers
from even trying to attain it. Thus, our focus is to set the targets that are
perceived as realistic and reasonable and would stimulate employees to put
more effort than they otherwise might have done. Research by Merchant
and Manzoni (1989) suggests that a "highly achievable target", that is, one
achievable by most managers 80% to 90% of the time, serves quite well in
the vast majority of organisations, especially when accompanied by extra
rewards for performances exceeding the target.
(c) Tying rewards or compensation to budget

Attaching rewards to budget can serve as a motivator. The reward gained
on accomplishing the required budget level is important for motivating
lower level managers and employees. Consequently, the management style,
culture and attitude towards employees will determine the approach to
budgeting within the organisation. According to Banham (1999), FujitsuÊs
system of linking 40% of managersÊ compensation to successful execution
of departmental plans and budgets motivates them.
Adopting appropriate budgeting approaches would significantly affect future

support and cooperation expected from employees, and may influence certain
behaviours or may cause certain dysfunctional behaviours. Generally, there are
three main approaches that can be employed in collecting and developing data
for the final budgets.
(a) Imposed budget (top-down or authoritative budgeting)

This type of budget is often employed by organisations with an
autocratic style of leadership, where top management alone decides
on the budget and lower level management is only responsible for
the execution. This approach is suitable for small to medium
businesses, and it reduces decision making time. It is preferable
where a process is highly programmable, and there are clear and
stable input-output relationships, so that engineered studies can be
used to set the targets. There is no need for negotiation of targets
using a bottom-up process.
This top-down budgeting offers better decision-making control than

participative budgeting does. Nevertheless, it does not have the
commitment and support of lower-level managers and employees
responsible for executing it.
(b) Participative budget (bottom-up)

A participative budget is a bottom-up approach that requires participation
of all the people affected by the budget from all levels in the budgeting
process. It can be a good communication device and is more likely to gain
employee commitment to fulfil budgetary goals. The budgeting process
offers employees a better understanding of the conflicts and dilemmas
confronting the top management and reciprocally provides top
management a better awareness and comprehension of the problems their

employees cope with. However, without proper control a participative

budget may turn into an easy budget target, induce budget slacks or targets
not aligned with the organisation's overall strategy.
This budget is suitable for big organisations, supportive of the democratic

style of leadership where lower level management is empowered through
their contribution to the budget. It requires a lot of effort and longer time,
but would gain support and cooperation from all levels. Participation by
itself is not sufficient in gaining commitment to standards. Indeed, the
manager must also believe that he or she can significantly influence the
results and be given the necessary feedback about them. In addition,
personality traits of the participants may hinder the benefits of
participation.
(c) Negotiated budget

This budget is in the middle, adopting both the top-down and bottom-up
styles of budgeting and creating an environment where there is shared
responsibility for budget preparation. It can be employed by businesses of
all sizes, and support from employees may also be obtained. Basically, the
budget committee will issue budget guidelines for the divisions or
departments to develop their initial budgets. Next, the budgets will be
reviewed and commented on by senior managers before passing them back
to the divisions for amendments. After several rounds of negotiations and
revisions, the budget will finally be approved.
In brief, leadership style and the nature or size of the organisation would
determine which approaches to be adopted. It is commonly observed that
budgeting systems using the participative or negotiated approaches would bring
out greater support from workers and managers in all aspects ă system design,
target level setting, analysis of budget variances and corrective action. When
there are little or no opportunities for employees and managers to participate in
the budgeting process, it may lead to dysfunctional behaviours.
In addition, budgetary controls that are too rigid or inflexible may also create
dysfunctional behaviours such a managerial short-term orientation and slack
creation. Slack (cushion) or also known as padding the budget is the practice of
managers in purposely including a higher amount of expenditures or lower
amount of revenue in the budget than the figures most likely to occur. If the slack
is created during the budgeting process, then it is commonly called budget slack.
Normally, slacks are created either by overestimating expenditures or

underestimating revenues. Managers justify their practices for several reasons,
including to cope with uncertainties, to protect from budget slashes or cuts by

the top management, or simply to impress others or have a good feeling for being
able to beat the budgets. Actually budget slack represents wasted resources and
induces employees to make minimal efforts to meet or exceed the budget. Putting
positive or negative slacks is considered dysfunctional behaviour because
managers are not giving a true and fair budget as they are supposed to do, and
this may have long-term effects on the performance of the organisation.
Managerial short-term orientation is defined as the extent to which the managers

focus on business matters that will affect their performance within the current
budgeting period (one year). For instance, managers may create fraudulent
reporting to achieve immediate financial targets, which may affect the long-term
plan. Managers may make decisions for the benefit of their department, which
would negatively affect the others.
SELF-CHECK 3.2
1. What are reconciliation statements and performance reports?

2. Briefly explain the three types of budgeting approaches.
3.3.2 Ethical Issues

How might ethical issues arise in the budgeting process? In order to understand
the ethical issues associated with budgeting, and to demonstrate how ethical
dilemmas might arise, assume you are a manager and that you help upper
management establish the master budget during the planning phase. In addition,
you are being evaluated based on achieving budgeted profit on a quarterly basis
(this is the control phase). Moreover, you will receive RM10,000 as a quarterly
bonus, in addition to your base salary, if you meet or exceed the budgeted profit.
Obviously, there is an inherent conflict between the planning and control phases
of this process. You help to set the company plan, but you also desire the
budgeted profit to be as low as possible so that you can beat the target and claim
the RM10,000 bonus.
Setting a sales and profit budget that is considerably lower than what will
probably happen (creating a budget slack here) is likely to cause problems for the
entire organisation. Why is this so? A lower sales budget will cause production to
be short of materials and labour, causing inefficiencies in the production process.
Selling and administrative support may be lacking due to an underestimation of
sales. Customers will not be satisfied if they have to wait long for the product.
The dilemma you face as a manager in this situation is whether to do what is best

for you, that is to set a low profit estimate to earn the bonus (an example of
managerial short-term orientation favouring immediate benefit/reward at the
expense of long-term benefit). Alternatively, you can do what is best for the
company, that is to estimate accurately so the budget reflects true sales and
production needs (an example of pursuing goal congruence).
Top management must acknowledge this conflict and have measurement in place
to ensure both the interests of individual employees and the interests of the
organisation as a whole are served. For example, employees can be rewarded not
just for meeting goals but also for providing accurate estimates. Perhaps a long-
term stock option incentive system instead of immediate bonus would motivate
managers to do what is best for the organisation, thereby increasing shareholder
value. Whatever incentive system is implemented, organisations must promote
honest employees.
3.4 LIMITATIONS OF BUDGET AND

BUDGETARY CONTROL
Budgets are widely accepted and used by various types of organisations for
planning, controlling and performance evaluation purposes due to their
practicality and numerous benefits. Whilst most organisations will benefit from
the use of budgets and budgetary control, there are a number of limitations and
problems to be aware of. Further, the traditional budgeting process was criticised
for taking so much effort but offering low value. Moreover, the typical
characteristics of the budget itself have created limitations and constraints to the
budget. These limitations, constraints and problems related to budget and
budgetary control are outlined below.
(a) Benefits of using budget and budgetary control must go beyond the cost
(i) Budget preparation consumes a lot of time and resources, sometime
whole departments are dedicated to budget setting and control;
(ii) Some small businesses in particular may find budgeting a
cumbersome, somewhat complex process, a burden in terms of time
and other resources required, with only limited benefits;
(iii) However many fund providers, like banks often require the financial
plan, i.e., budget, as part of the business plan;
(iv) The budgeting cycle is too long as multiple levels of approval are
required; and
(v) As the rule of thumb, the benefit of generating the budget must
exceed its cost.

(b) Information from budget and budgetary control may not be precise
(i) Budgets are as good as the data being input to create them. Inaccurate
or unreasonable assumptions may make budgets unrealistic;
(ii) Budgeting calls for estimates and forecasting, which are subject to
uncertainties and risks. Inaccurate forecasts lead to inaccurate and
ineffective budget plans;
(iii) The more inaccurate a budget is, the less use it is to the business as a
planning and control mechanism; and
(iv) Great care needs to be taken in forecasting sales, which is the starting
point of the budgeting process.
(c) Budget and budgetary control may demotivate

(i) Employees who are not involved in budgeting from the beginning
may feel they do not own it, and they may be demotivated;
(ii) Responsibility versus controlling, i.e., some costs are under the
influence of more than one person, e.g., power costs;
(iii) Employees may perceived budgets as either a „carrot‰ or a „stick‰,
i.e., as a form of encouragement or punishment;
(iv) Employees may see budgets as pressure devices imposed by
management, thus budgets can cause bad labour relations and
inaccurate record-keeping;
(v) May create departmental conflict due to disputes over resource
allocation and departments blaming each other if targets are not
attained; and
(vi) Difficulty in reconciling personal/individual and corporate goals.
(d) Budget and budgetary control may lead to dysfunctional management

(i) Employees or departments of a business may over-achieve against
their budget, but create problems elsewhere (i.e., extra output
produced by production department may not be saleable by the sales
department);
(ii) This kind of dysfunctional management can be prevented by setting
budgets at realistic levels, linking and coordinating them across all
levels within the business;
(iii) Budgets can lead to inflexibility in decision-making depending on the
extent of the flexible budget used;
(iv) Budgets support more short-term than long-term decisions;

(v) No clear connection or linkage between strategy, budgeting and

performance management as no line ownership for budgets existed;
(vi) Managers may become too preoccupied with setting and reviewing
budgets, and thus forget to focus on the real issue of winning
customers;
(vii) Managers may overestimate costs so that they will not be blamed in
the future should they overspend;
(viii) Too much focus is given to data collection rather than synthesis,
analysis and interpretation of the budgets; and
(ix) Effective implementation of budgetary control depends upon
willingness, cooperation and understanding among employees.
(e) Budget and budgetary control may be set at too low a level
(i) If the budget is set too low, it will be too easy to achieve without extra
effort, thus it will be of no benefit to the business; and
(ii) Budgets should be set at realistic levels, which make the best use of
the resources available.
(f) Budget and budgetary control have no connection to corporate strategy

(i) Budgets are criticised for not being strategically focused and are often
contradictory;
(ii) In fact, they focus on cost reduction and not on value creation;
(iii) They inhibit responsiveness and flexibility and add little value. In
fact, they can be rather bureaucratic and discourage creative thinking,
causing them to often be a barrier to change;
(iv) Sometimes they are based on unsupported assumptions and
guesswork, therefore encouraging gaming and unreasonable or
dysfunctional behaviour;
(v) They reinforce vertical command and control and do not reflect the
emerging network structures that organisations are adopting; and
(vi) They strengthen departmental barriers rather than promote
knowledge sharing, and they make people feel undervalued.
Budgets and budgetary control may also create some constraints from the
perspective of behavioural challenges in a business as listed below:
(a) Budgets may demotivate rather than motivate if they are imposed rather
than negotiated;

(b) A culture of „finger-pointing‰ may develop; however, managers should be

answerable only for variations that were under their control;
(c) Setting unrealistic targets, either too low or too -high, adds to de-
motivation;
(d) Budgets may indirectly encourage departmental rivalry or battles over
resource allocation;
(e) Budgets can encourage a negative mentality of „use it or lose it‰, where
managers would spend up to the budget to preserve it for next year; and
(f) Budget game or budgetary slack occurs if targets are set too low.
Despite these limitations and problems, budgeting and budgetary control are
widely accepted as a tool to promote corporate accountability and effectiveness,
rather than merely as an approach for allocating resources and controlling
expenditures. Faced with constraints and demands for improved services, thus,
modern organisations look forward to new ways of budgeting and improved
budgetary control systems by considering all these limitations and criticisms.
ACTIVITY 3.2
Mr Zulkifli is a partner in a newly-established, medium-sized company,

which trades in local and imported mobile phones and applications. He
has approached your accounting firm for some consultation on
budgetary control. Your task is to write a memo to Mr Zulkifli,
explaining about the budgetary control system, including how it
functions, its benefits and limitations, types of budget suitable for the
control system and other related information.
Ć Controlling is an important managerial function because it helps to monitor

and take corrective action so that deviation from standards are minimised,
and ensures that organisational goals and objectives are achieved in the
desired manner.
Ć Control in management principally means setting standards, measuring

actual performance, and taking corrective action.
Ć Budgetary control uses budget as a means of planning and controlling,

whereby actual results are compared with budgets.

Ć To meet their planning and controlling needs, organisations may apply two
types of control: the feedback and feed-forward controls.
Ć Feed-forward control is a proactive approach with preventive measures,

while feedback control is a reactive or responsive approach.
Ć A fixed or static budget is prepared at one level of activity or output. It is

simpler to prepare and suitable for businesses operating under stable
conditions.
Ć In contrast a flexible budget is developed at several levels of activity to reflect

changes in the business environment that may influence the business activity.
A flexible budget requires more effort but offers a more meaningful
performance evaluation than a fixed budget.
Ć A performance report is a detailed statement that measures the results of

some activity in terms of its success over a specific time frame.
Ć A reconciliation statement provides an independent verification of the

veracity of the balance in the company account, and clarifies the differences
between the two versions of the account.
Ć It is important to recognise and be aware of the behavioural implications of

budgeting and budgetary control with regard to motivation, ethical issues
and dysfunctional behaviours.
Ć Despite being widely accepted and applied for their realised benefits, there
are also some important limitations to and criticisms of budgets and
budgetary control.
Budget slack Fixed budget

Budgetary control Flexible budget
Control system Managerial short-term orientation
Dysfunctional behaviour Performance report
Feedback control Reconciliation statement
Feed-forward control

Banham, R. (1999). The revolution in planning. In CFO Magazine, August, 44-56.
Drury, C. (2000). Management and cost accounting (5th ed.). London, UK:
Thomson Learning.
Drury, C. (2006). Management accounting for business. London, UK: Thomson

Learning.
Drury, C. (2008). Management and cost accounting. London, UK: South-Western.
Merchant, K. (1998). Modern management control systems: Text and cases.

Scarborough: Prentice Hall.
Merchant, K., & Manzoni, J. F. (1989). The achievability of budget targets in

profit centers: A field study. In The Accounting Review, 539-558.
Ouchi, W. (1977). The relationship between organizational structures and

organizational control. In Administrative Science Quarterly, 22, 95-113.
Voss, C. A., Brignall, T. J., Fitzgerald, L. Johnston, R., & Silvestro, R. (1992).
Measurement of innovation and design performance in services. In Design
Management Journal, 40-46.

Topic X Standard
4 Costing and
Variance
Analysis
LEARNING OUTCOMES
1. Explain the importance and use of standard costing;
2. Discuss variance cost analysis;
3. Compute advanced variances, including mix and yield variances
for materials, labour and sales, market share and size variances,
operating and planning variances, and operating statement; and
4. Identify the investigation of variances, the interdependence
between variances and the variance investigating approaches.
X INTRODUCTION
In this topic, you will be introduced to standard costing as a measurement of
productivity and quality in an organisation.
You will also be exposed to the importance and uses of standard costing and
approaches in determination of standard cost. Students will need to identify
types of standards and following that, the advantages and disadvantages of
standard costing will be explained.

104 X TOPIC 4 STANDARD COSTING AND VARIANCE ANALYSIS
4.1 STANDARD COSTING AND ITS

IMPORTANCE
Usually, at the end of a budget period, managers will analyse business
performance by comparing actual achievement against the budget. The manager
will want to know if the company has reached the targeted level of profitability.
From the aspect of cost control, the manager will ensure that all expenses and
costs incurred are within the budget.
To evaluate the achievement level of the company, these three main elements
must be made available:
(a) Standard or pre-determined achievement level;
(b) Actual achievement; and
(c) Comparison between standard achievement and actual achievement.
These three elements usually exist in any control system.
What is meant by standard costing?
Standard costing is a method of cost formulation or standard achievement

level to be made a benchmark or measurement level.
Among the main uses of standard costing is for the purpose of planning and
control such as management and cost control, preparation of budgets,
determining cost of product and performance evaluation (refer to Figure 4.1).
Figure 4.1: Main uses of standard costing
Hence, it is used as a benchmark for comparison to the performance or actual

level of operational development of a business.

TOPIC 4 STANDARD COSTING AND VARIANCE ANALYSIS W 105
In a budget control system, a management accountant will determine a standard

cost which will be the benchmark. With that, the management accountant will
use standard cost per unit to determine the total standard production cost or the
budgeted cost. Next, an accountant will measure the actual cost incurred in the
production process.
Early measures for cost control are done by comparing the actual production cost
and budgeted production cost. This comparison is called variance analysis.
What is meant by variance analysis?
Variance analysis is the process of calculating and interpreting the difference

between actual production cost and budgeted production cost.
Any difference between the two is known as a variance. The result of variance
analysis will provide an illustration pertaining to the performance level of an
activity, unit, department or even a manager whether it is favourable or not, in
comparison to the standard performance determined. Cost variance is an
indication where cost control measures need to be initiated, given due attention
or action taken if deemed reasonable.
Standard costing is often used for two main reasons, which are for planning,
control and product costing. Standard costing is extremely useful for the purpose
of product costing and for the process that follows it, that is, setting the price of
the product. It is not realistic to wait for manufacturing of the product to
complete before identifying the product cost to determine sales price. Standard
cost information is used to estimate cost of product and in turn set product
pricing at an earlier stage without waiting for the completion of production.
Standard costing simplifies the process of preparing a budget. The standard cost
per unit determined is subsequently used to obtain the amount budgeted for
each componentÊs cost of production. This budget is used as a guide to plan
requirement for materials, labour, overhead and other expenses.
From the aspect of cost control, this standard cost functions as a benchmark to
compare against the actual cost incurred. This comparison process is executed
through variance analysis which you will study in this topic. Significant cost
variance will be given due attention and its causes examined. Following that, the
manager will analyse and take control and corrective actions to improve the
production process as a whole.

SELF-CHECK 4.1
Explain what is meant by standard costing and its importance.
4.2 SETTING STANDARD COST

In determining standard cost, involvement from various parties will guarantee
accuracy, credibility, acceptance and compliance with the determined standard.
It requires a combination of expertise from various parties responsible for the
price of input and the effective use of input in production. They include
management accountants, engineers, purchase managers, production managers,
supervisors and production operators. Old records related to price and the use of
input can be used to determine standard.
The determination of standard cost is rather a difficult process. The management

accountant has to ensure that the standard cost determined is reasonable,
realistic, illustrates the production capacity level of the company, and is not too
low or too high, making it impossible or too easy to attain.
In general, there are two approaches that are usually used by the management
accountant to determine the standard cost, which is through task analysis and
historical data analysis as shown in Figure 4.2.
Figure 4.2: The two approaches used by

management accountant to determine standard cost

Standard cost can be formulated based on experience or historical cost

information.
What is historical cost information?
Historical cost information which are relevant can be used as a basis to

forecast or estimate future costs, especially for production processes that have
matured, for example, companies with extensive experience on production.
Even though historical cost is relevant, accountants have to be cautious and not
rely too much on it. It should be reminded that standards are supposed to be
designed to encourage operations efficiency in the future and not to repeat past
inefficiencies.
Therefore, accountants will always have to make adjustments on forecasts or

estimates to illustrate movements in price level or changes in technology in the
production process. Sometimes, small changes in the production process may
deem historical cost information irrelevant.
To be realistic and effective, new products require new standard costs. New
products based on genetic engineering, for example will surely do not have
historical costs. Therefore, accountants have to move on to a different approach
to determine its standard cost.
Using an alternative method, that is, task analysis, standard cost is determined
by studying and analysing the production processes, one step after another.
The focus of the management accountant is to determine what costs must be

incurred. In this process, the accountant will cooperate with skilled engineers in
the production process to study and determine the amount of direct materials to
be used and how machines should be utilised in the production process and so
on. Engineering methods such as marketing and movement research must be
executed to determine how long, for instance, it would take for direct labour or
machines to execute the work at each step of the production process. In certain
situations, the result from a combination of both approaches can be used.

Example 4.1
As an example, assume that there is a change in technology involving just one

step in the production process. The management accountant can then
cooperate with the engineer to determine standard cost in that particular
section only. Meanwhile, standard cost for other steps can be determined
based on historical cost information.
4.3 TYPES OF STANDARDS

The determination of a suitable level of standard cost in a business depends on
the requirements of management and the purpose for which the relevant
standard is used for. A suitable standard will become a stimulus factor to
efficiency, effectiveness and productivity. Meanwhile, an unsuitable standard
may give rise to other unexpected issues.
In general, there are two categories of standards, which are shown in Figure 4.3.
Figure 4.3: Types of standard

The first standard we will elaborate on is the ideal standard followed by the
practical standard.
(a) Ideal Standard

What is meant by an ideal standard?
The ideal standard is a standard set at a perfect level and is the most
difficult to attain.

An ideal standard can be attained in certain conditions or operating

situations that is almost perfect. The situations include:
(i) Efficiency at an optimal level;
(ii) The input price is at the lowest possible;
(iii) Materials are of the best quality; and
(iv) No disturbance or breakdown in the production process.
Some managers believe that the ideal standard will motivate workers to
attain the lowest cost possible or closest to the standard. On the other hand,
there are some with the opinion that an ideal standard will frustrate
workers because it is quite impossible to attain. Moreover, an unrealistic
standard will drive workers to neglect or sacrifice product quality in the
process of attaining lower cost.
(b) Practical Standard

What is meant by a practical standard?
A practical standard or attainable illustrates the attainable level

according to the companyÊs or industryÊs best practices.
A practical standard assumes the production process is efficient in normal

operating conditions. It takes into account situations such as normal machine
breakdown, and normal amount of wastage or surplus of raw materials. It is
attainable at an efficient and a high level of initiativeness by workers. Due to
this, many are confident that practical standard encourages positive attitude
among workers and productivity in comparison to the ideal standard.
To summarise, an entity that uses standard costing must always update

and improve its standard costing by holding on to its principles or
continuous improvement goals. This will ensure that the company will be
able to control costs and plan the operations of the company more
efficiently and effectively.

4.4 ADVANTAGES AND DISADVANTAGES OF

STANDARD COSTING
Standard cost is used by most industries including manufacturing industries,
service sectors, catering and non-profit organisations.
Example 4.2
Hospitals for example, have daily standard costs (for food, laundry, treatment
and others) for each bed. It is the same for fast food businesses such as
McDonaldÊs, which determines an accurate standard for the quantity of meat
that goes into each of its burgers, as well as a standard for the time taken to
fulfil each order from its customers.
In short, wherever we go, we can witness the use of standard costs by all types of
businesses. Standard costing is practised because of its advantages, especially
from the aspect of cost control and planning as discussed earlier. It assists
managers in controlling business operations by making the standard cost as the
operationsÊ achievement target.
Thus, when actual performance does not reach the target level, an examination or
inspection will be conducted to identify its causes and following that, identify the
problem so that the same problem will not recur. Management by exception
proposes that the manager concentrates fully on the activities or operations that
are very much different from the determined standard.
Standard cost is also used for the purpose of performance evaluation. The
performance of workers including the manager can be evaluated or measured by
comparing it with achievement standard. Achievement standard is one of the
motivating factors for workers. Workers will strive to attain or increase their
performance to a level that they have agreed upon as the expected level of
achievement standard.
As previously explained, standard cost determined according to cost per unit is

useful in the pricing process of products sold or services offered. By using
standard cost, the management will roughly know the cost of each unit
manufactured.
This makes it easier for the manager to set a selling price after determining the
mark-up rate required by the company. The standard cost can be reviewed or
changed according to current conditions. However, in general, standard cost is

quite stable, therefore the cost of product which was determined using the
standard cost is also stable. This also applies to the selling price.
Even though standard costing system is rather expensive to develop, it saves the
cost of processing information. Standard cost is able to simplify and facilitate the
process of record-keeping, and thus reduces the costs related to administration.
However, the standard costing system has its disadvantages. Extra emphasis on
cost reduction factor may neglect the aspect of product quality. For example, the
purchasing manager may purchase cheaper materials to reduce cost. As a result,
the quality of goods may be compromised, more so if the purchasing manager in
question, is only evaluated based on his efficiency and not on the purchase of
materials.
Standard cost may not be a suitable practice in a modern manufacturing

environment. Changes in the manufacturing environment such as the intensive
use of robots and machines and fully automated systems will reduce cost and the
use of labour. As such, the importance of related standard cost and the analysis
of labour cost will be correspondingly less.
It is neither practical nor profitable to apply standard costing in a flexible

manufacturing operation where the life span of the product is much shorter.
Standard cost is quite expensive to develop, therefore it is not economical to use
standard cost that constantly has to be renewed or updated every time a new
product emerges.
A comparison between the advantages and disadvantages of standard costing is

shown in Table 4.1.
Table 4.1: Advantages and Disadvantages of Standard Costing
Is an important element in Âmanagement by The Âmanagement by exceptionÊ approach
exceptionÊ. As long as cost is within the is said to give more focus on negative
standard, managers can focus on other matters. Workers should also receive
issues. Conversely, if the cost deviates far positive encouragement for work
from the standard, it is a possible sign that completed. If the manager is not careful in
there may be a problem that would require using variances report, this will cause
the managerÊs attention. subordinates to take actions that are not in
the best interest of the company by
ensuring that the variances are at a
satisfactory level.

Assists the manager in controlling Extra emphasis on the adherence of

business operations by making the standard cost may neglect other important
standard cost as a target in operations objectives such as improving quality,
attainment. prompt delivery and customer satisfaction.
Evaluate performance of worker/ manager Not suitable for practice in a modern
by comparing it with achievement manufacturing environment. For example,
standard. Indirectly providing motivation in a manufacturing industry that uses
to workers to attain the level of robots and machines intensively. Thus, the
achievement standard determined and to importance of standard cost relating to
evaluate oneÊs own performance. labour cost analysis will lessen.
Standard cost determined according to Expensive to develop and not economical
cost per unit assists in the product pricing to use standard cost if there is a need to
of products sold/offered. constantly renew/update every time a new
product is manufactured.
Saves costs in processing information,
able to simplify and facilitate record
keeping process. Indirectly reduces
administrative costs.
4.5 ADVANCED VARIANCE ANALYSIS

Variance analysis allows us to find where deviations have occurred between
planned and actual results, assists us in inspecting the reasons for the differences,
and supports managerial actions in improving the companyÊs planning
processes. In the following sections, we shall continue and extend our
discussions on variance analysis to include several more advanced variances.
4.5.1 Material Mix and Yield Variance

A finished product may require blending of several types of raw material inputs.
Imagine a cheese cake; well, you can easily identify the main ingredients used to
make it. Or think about a more complex production; can you list the raw
materials needed to produce a car? So, it is normal in production that the
materials used are sometimes interchangeable or substitutable for each other.
This raw material mix may change, which will directly affect the quantities and
prices of the mix accordingly. Thus, these changes would have an impact on the
overall costs, which will result in cost variances.
In this case, materials quantity or usage variance can be broken-up into mix and
yield variances as shown in Figure 4.4. If material inputs are not interchangeable
then conventional materials quantity or usage variance should be computed for
each input.
Total raw material variance = [raw material price variance (RMPV)

+ raw material usage variance (RMUV)]
Raw material usage variance (RMUV) = [raw material mix variance (RMMV)
+ raw material yield variance (RMYV)]
(if more than one material input)
Figure 4.4: Raw material variance breakdown
Material mix refers to the proportion of material inputs used in a particular

production. The standard mix is the expected proportion of materials to be used
in a given mix while the actual mix is the actual proportion of materials used. A
material mix variance measures the cost of material. Thus, the mix variance
calculated represents the cost difference between the actual proportion and the
standard mix. If the amount of expensive material used is more than the amount
of cheap material, then the overall cost will be higher and the variance adverse.
Material yield refers to the relationship of inputs in total to the outputs. A yield
variance measures the efficiency of turning the inputs into outputs. For instance,
an adverse yield variance indicates that actual output is lower than the expected
output. The reasons for adverse yield variance include excess waste, sub-quality
materials, labour inefficiencies, and cheaper mix with a lower yield. Any changes
in material mix would affect the overall total materials variance.
Those two variances may be interrelated. A favourable mix variance may lead to
an unfavourable yield variance and vice versa. A favourable mix variance
indicates that cheaper mix materials are used, thus the overall average cost per
unit is lower. However, it could have an adverse effect on yield variance,
whereby total input in volume is more than expected for the output achieved.
Here is the formula for those variances:

Abbreviation for the following terms can be used to facilitate the variance
formula as follows.
AQAM = actual quantity at actual mix

AQSM = actual quantity at standard mix
SQSM = standard quantity at standard mix
Illustration: Computation of mix and yield variance.

Consider Case 1 of Dali Frozen Meat Sdn Bhd (DFM), as presented in the
following section, we shall calculate the raw material price, raw material mix
and raw material yield variances respectively.
Raw materials price variance (RMPV) is the basic variance that you have learnt in
the earlier part of this topic.
Actual Standard Actual

Material Price- Price-SP Quantity (AP-SP) * AQ
AP AQ
Grade A RM14 RM16 12,000 (RM14-16)*12,000 = RM24,000
Grade B RM11 RM12 8,000 (RM11-12)*8,000 = RM8,000
Grade C RM10 RM10 4,000 Nil
Total RMPV = (Favourable) RM32,000
The raw materials price variance is favourable (RM32,000) meaning that the
purchased cost is lower than the standard cost. This is mainly due to the falling
market price of meat caused by the mad cow epidemic.
Case 1: Dali Frozen Meat Sdn Bhd (DFM)

DFM processes raw meat into burger meat, sausages, meat balls and other frozen
meat products. The highest selling item is burger meat, which is made of three
grades of raw meat. The standard cost of the raw materials used in the
manufacture of each 100 kilograms of burger meat is as follows:
Raw Meat Kilograms-KG Standard Price per KG

Grade A 40 RM16
Grade B 70 RM12
Grade C 15 RM10
Total Input 125
Normal loss (20% of input) (25)
Output 100

In preparing its budget for 2013, DFM forecasted that there would be demand for
100,000 kilograms of burger meat and that represents a 50% share of this market.
The estimated selling price for the burger meat is RM20 per kilogram.
Unfortunately, during 2013 the fast food industry worldwide was adversely
affected by diminishing consumer confidence in meat products, which was
mainly due to the mad cow epidemic rooted in the USA. Consequently, the
actual total market size was only 80,000 kilograms of burger meat (instead of the
estimated 100,000 kilograms). DFM was able to sell only 20,000 kilograms of its
product.
The actual raw materials used by DFM in 2013 were as follows:
Raw Meat Kilograms-KG Actual Price per KG

Grade A 8,000 RM14
Grade B 10,500 RM11
Grade C 5,500 RM10
Total 24,000
Initially, in preparing the budget those three raw materials were estimated to be
used in a certain proportion or mix. However, if the actual mix differs from the
budgeted mix, then this will result in cost variance. The effect of a change in
material mix can be captured by computing the raw material mix variance
(RMMV), a subcomponent of RMUV. Here are the steps to calculate raw
material mix variance:
(a) Step 1: The standard raw materials mix is:
Materials Grade A Grade B Grade C Total

Standard input quantities (kg.) 40 kg 70 kg 15 kg 125 kg
Standard input quantities (%) 32% 56% 12% 100%
(b) Step 2: Calculation of raw material mix variance:
Material Actual Actual Quantity Standar [AQ in actual mix ă AQ

Quantity (24,000 kg) d price in standard mix] * SP
(24,000 kg) in standard mix per (AQAM ă AQSM)* SP
in actual [32%:56%:12%] kilogra
mix m
Grade A 8,000 [32% * 24,000] RM16 [8,000 ă 7,680] * RM16

= 7,680 kg = RM5,120 U

Grade B 10,500 [56% * 24,000] RM12 [10,500 ă 13,440] * RM12

= 13,440 kg = RM35,280 F
Grade C 5,500 [12% * 24,000] RM10 [5,500 ă 2,880] * RM10

= 2,880 kg = RM26,200 U
24,000 24,000 RMMV = RM3,960 F
The RMMV shows favourable variance (RM3,960), which is because DFM

has changed the standard mix to take advantage of the decreased price, and
at the same time maintained the quality of its product. Please remember to
use the standard price in the calculations of RMMV because we want to
examine the effect of the change in material mix alone (while assuming the
price variable as constant by ignoring price changes). It is also because
RMMV is a sub-component of the raw materials usage variance (RMUV),
which is computed based on standard price as well.
The formula for RUMV:
RMUV = (Actual Quantity ă Standard Quantity) * Standard Price
Raw materials yield variance (RMYV) is the second subcomponent of the RMUV.
The RMYV compares between total input (ignoring the question of „mix‰) and
total output. In DFM case, the budget assumed that every 125 kilograms of input
will yield 100 kilograms of output. Thus, a non-zero RMYV (either extra yield or
loss yield) would indicate that the actual input/output ratio differed from this
budgetary assumption. Next, let us compute the RMYV:
(a) 24,000 kg of raw materials were used, so if the standard yield (SY) had been
achieved, then the output would have been:
[24,000 kg * (100 / 125) ] = 19,200 kilograms.
(b) Luckily, the actual yield (AY) achieved was 20,000 kilograms of output,
meaning that there were 800 kilograms more than the standard yield. This
„extra‰ yield (when actual output is larger than expected output) indicates
the efficiency in turning the inputs into outputs.
(c) The financial benefit of this extra yield is calculated as below

RMYV = (AY ă SY) * Standard RM Cost per kg of output #
= (20,000 kg ă 19,200 kg) * RM16.30 = RM13,040 Favourable
# Standard RM Cost per kg of output:
(40kg × RM16 ) + (70kg × RM12 ) + (15kg × RM10)

= RM16.30 per kg of output
100 kg of output
Both favourable RMMV and RMYV represent cost saving. However, sometimes
this cost saving also means lower quality of product because a cheaper mix of
materials has been used instead. This could also have an effect on the market
share and market size variances.
In brief, material mix and yield variances are computed when there is more than one
type of materials being used to produce a product. The mix is assumed to be
controllable by the management. If management cannot control the mix, then the
usage or efficiency variance should not be broken down into mix and yield variance.
Instead, compute only the usage variance for each of the individual materials.
SELF-CHECK 4.2
Explain the breakdown of raw material variances and write down the
formula for each of the variances.
4.5.2 Labour Mix and Yield Variance

Similar to material usage, labour usage may also involve more than one type of
labour such as professional labour, unskilled labour, or different grades of
labour. The mixture of labour employed in producing a product or providing a
service may not be fixed all the time, the mixture could be changed due to several
reasons like capacity, availability, and market factors (demand and supply
condition, price changes, etc.). Likewise, you can calculate labour mix and yield
variance in exactly the same way as material mix and yield variance. Again we
are assuming that the mix of labour utilised is controllable by and known to the
management. Otherwise, only the labour efficiency variance is computed for
each individual labour type. The subcomponents of labour variances are as
shown in Figure 4.5, and look at how they are interrelated.

Figure 4.5: Labour variance breakdown

Labour mix refers to the combination of different types or grades of labour used
in production. Whenever the standard or predetermined mix is changed, then the
total labour cost would be affected as well because they are interrelated as shown
in the above Figure 4.3. Labour mix variance (LMV), which is also known as
gang-composition variance, measures the cost of labour. It captures the amount
of labour cost which is due to changes in the labour mix. The labour mix will
show adverse variance whenever a larger than standard proportion of a higher
grade of labour is used. On the other hand, a favourable labour mix variance can
occur when a larger than standard mix of a lower grade of labour is included in
the mix.
Labour yield describes the relationship of labour inputs in total to the outputs.
Labour yield variance (LYV) exists when there is a difference between the
standard output and the actual output attained for a given level of input
(measured in terms of hours). Adverse variance or loss yield implies inefficiency
in turning the input into output, and vice versa.
Illustration: Computation of labour mix variance (LMV)
There could be several ways to calculate those variances. Here we will look at
one of the ways. Consider the following Case 2 for computing the variances:
Case 2:
Data for standard and actual usage of two types of labour are presented below:
Standard Actual
Skilled Labour 300 hrs RM40 per hr 280 hrs RM44 per hr
Semi-Skilled Labour 600 hrs RM20 per hr 700 hrs RM18 per hr
Production Volume 12,000 units of a product 11,500 units of a product
Labour Mix / Proportion 300 hrs : 600 hrs = 1:2 260 hrs : 650 hrs = 2:5

Around 20 hours of Skilled Labour time and 50 hours of Semi-Skilled Labour

time were lost due to breakdown which is abnormal.
Next, let us calculate the total cost of labour at standard mix and actual mix as
shown below:
Standard Actual
(Production- 12,000 (Production: 11,500 units)
units)
Total Gross Total Net Abnormal
Rate Time Cost Rate
(RM Time Cost Time Cost Time Cost
(RM/hr) (Hr) (RM)
/hr) (Hr) (RM) (Hr) (RM) (Hr) (RM)
Skilled 40 300 12,000 44 280 12,320 260 11,440 20 880
Semi 20 600 12,000 18 700 12,600 650 11,700 50 900
Skilled
Total 900 24,000 980 24.920 910 23,140 70 1,780
The total labour mix variance is the sum of the variances measured for each
labour type separately. The basic formula for labour mix variance ă LMV is:
= [Standard Cost (SR) of Standard Time (ST) for Actual Mix (AM)
î Standard Cost (SR) of Actual Time(AT)]
LMV = SC of ST for AM î SC of AT
AT(N)Mix
LMV = ({ ï ST} ă AT(N)) ï SR
STMix
Please note that AT(actual time) must always be the net time used after
considering the abnormal loss.
Using the above formula, let us calculate the LMV:

(a) Firstly we need to calculate the mix variance for each type of labour
separately; and
(b) Then we sum-up the variances of all types of labour to arrive at the total
LMV.

Skilled = ({910 hrs × 300 hrs} - 260 hrs) × RM40 /hr

900 hrs
= ({1.011 ï 300 hrs) î 260 hrs) ï RM40 /hr
= (303.33 hrs î 260 hrs) ï RM40 /hr
= (+ 43.33 hrs) ï RM40 /hr
= RM1,733.20 Favourable
Semi- = ({910 hrs × 600 hrs} - 650 hrs) × RM20 /hr
Skilled 900 hrs
= ({1.011 ï 600 hrs) î 650 hrs) ï RM20 /hr
= (606.67 hrs î 650 hrs) ï RM20 /hr
= (- 43.33hrs) ï RM20 /hr
= (-RM866.67) Adverse
Therefore, adding together all the variances to arrive at the Total LMV
= RM1,733.20 - RM866.67 = RM866.53 Favourable.
Since this is labour cost variance, thus any favourable variance means cost
saving. This LMV captures the effect of actual proportion being different from
the standard mix. Accordingly, the people or department responsible for
authorising the work time usage and mixing of component labourers for
production can be held responsible for this variance.
Illustration: Computation of labour yield variance (LYV).
There could be several ways to calculate these variances. Here we will look at one
of the ways. Using Case 2 from the previous illustration, next we will compute
the LYV. This variance cannot be computed separately for each labour type;
instead it must be in total for all types of labour used. The basic formula for
LMV:
=[Standard Cost (SC) of Actual Output (AO) î Standard Cost (SC) of

Standard Output (SO) for Actual Time (AT)]

LYV = SC of AO î SC of SO for AT(N)
AT(N)
= (AO ï SR(SO)) î ï SO ï SR(SO)
ST
AT(N)
= (AO î ï SO) ï SR(SO)
ST
Using this formula, let us compute the LYV:
Total LYV = (11,500 units ă {910 hrs × 12,000 unit} ) × RM24,000

900 hrs 7,500 units
= ({11,500 units ă 12,133 units) ï RM2 /unit
= (- 633.33 units) ï RM2 /unit
= (- RM1,266) Adverse
This labour yield shows the relationship between the total input (labour hours)
and the total output produced. Thus, unfavourable variance means less efficiency
in using the input. Since this variance measures whether there is more or less
yield, or output, for the labour time used, the manager or department responsible
for production, possibly the manufacturing department, would be held
responsible for this variance.
SELF-CHECK 4.3
What do the unfavourable labour mix and yield variances mean?
4.5.3 Sales Mix and Sales Quantity Variances

Sales variance is also known as marketing variance. Sales variance is normally
used by non-manufacturing organisations for decision making and control
purposes. Nowadays, many companies sell more than one product. In fact, most
of those companies sell a combination or variety of products and these products
could be either from the same product line or different ones, and sell to the same
or different markets. Some sales of certain products depend very much on the
sales of another product. This proportion of different products on sale is known

as the sales mix. This pre-determined sales mix or the budgeted mix may change
over the time due to several reasons such as changing in customersÊ taste and
needs, new products or substitute products, change in fashion and trend. Any
change in sales mix will directly affect sales volume and total sales, which will
result in contribution margin or profit variances. The breakdown of sales
variance is as shown in Figure 4.6.
Figure 4.6: Sales variance breakdown
In order to have a valid analysis for sales variances, it is very crucial to note that
these variances must be computed for products which are sold into the same
market. Furthermore, it is important to distinguish between competing and
complementary products. Competing products are similar to substitute products,
which are sold to the same market and they are competing against each other
and rivalsÊ products. On the other hand, complementary products are products
whose sales are depending on or very much influenced by sales of the other
products. Thus, it is invalid to compute these variances in relation to products
sold to different markets because demands and preferences are determined by
different factors for different markets.
There are three bases for computing sales variances, namely profit margin,
contribution margin and sales price. So which basis is to be used? Well, it
depends on a companyÊs cost structure. If a company has a high level of variable
costs and the remainder of its costs are largely fixed over its expected range of
activity, then contribution will probably give a satisfactory analysis. On the other
hand, if a company has a relatively low level of variable costs and a significant
level of semi-fixed costs, gross profit should be used.
Sales mix variance (SMV) refers to contribution margin or profit difference as an

effect of changing the mix, whereby the mix of actual sales differs from the
standard mix. Similar to material mix, there are several ways to compute sales

mix variance. For simplicity, only one formula for each variance will be
illustrated here.
SMV = (AM% ă SM%) × AQ sold x SCM
SQV = (AQ sold ă SQ) × SM% x SCM
Abbreviation for the following terms can be used to facilitate the variance
formula as follows.
(a) AQ = actual quantity sold;
(b) ACM = actual contribution margin;
(c) SQ = standard quantity for sales;
(d) SCM = standard contribution margin;
(e) AM% = actual mix percentage; and
(f) SM% = standard mix percentage.
Sales quantity variance (SQV) measures the effect on contribution margin of

selling a different total quantity from the budgeted total quantity. It indicates
how much more (less) contribution margin or profit would have been made if
sales were above (below) budget for a competing range of products since it
calculates what should have been sold of each product if total actual sales were in
line with the budget sales mix %. For simplicity, the illustration will be based on
the above formula. For illustration, contribution margin (selling price ă variable
cost) will be used as the basis for sales variances.
For illustration, let us consider the following case:
Case 3: Magic Clean Sdn Bhd (MC)

Magic Clean supplies liquid detergent in one litre containers and one litre refill
bags to Mr Dobi laundry chains. Containers and refill bags are sold by the case. A
case of containers contains about the same amount of liquid as a case of refill
bags. Below is the information on the budgeted and actual sales:
Budgeted Actual
Quantity Price Variable Quantity Price
Cost
Container 2,000 RM140 RM50 2,250 RM125
Refill bags 3,000 RM100 RM30 3,050 RM110

Total sales variance : Actual CM ă Budgeted CM

= (AQ × ACM) ă (SQ × SCM)
= [(2,250 × RM(125-50) + (3,050 × RM(110-30)]
ă [(2,000 × RM(140-50) + (3,000 × RM100-30)]
= RM412,750 ă RM 390,000
= RM22,750 Favourable
It is important to recognise that containers and refill bags are competing products
and substitutable. Based on the above Magic Clean case, the total sales variance
was RM22,750, favourable. This variance can be broken down into various
subcomponents (as in Figure 4.6 ă sales variance breakdown) in order to better
analyse and understand customer profitability, set more reasonable prices, and
create better marketing campaigns. Firstly, let us break it down into price
variance and volume variance in Table 4.2.
Figure 4.6: Sales variance breakdown

Table 4.2: Computation of Price Variance and Volume Variance
Containers Refill Bags Total

Actual CM RM75 RM80
Standard CM ă RM90 ă RM70
CM difference U RM15 F RM10
Actual quantity X 2,250 X 3,050
Price Variance U RM33,750 F RM30,500 U RM3,250
Actual quantity 2,250 3,050

Standard quantity 2,000 3,000
Quantity difference F 250 F 50
Standard CM X RM90 X RM70
Volume Variance F RM22,500 F RM3,500 F RM26,000
Total Variance U RM11,250 F RM34,000 F RM22,750
Based on the above table, we would be interested to know what caused the
favourable volume variance. Firstly, you can observe that the total units sold
(5,300 units) was more than the budgeted amount (5,000 units). Secondly, a
higher fraction of containers was sold than budgeted. Both containers and refill
bags are substitutes, meaning that customers can substitute one for the other.
This volume variance of RM22,500 for containers and RM3,500 for refill bags can
be broken down into two more variances: the SMV and SQV. These variances are
very beneficial especially when the company offers multiple and substitutable
products. The mix variance measures the effect of substitution among the
products, while the quantity variance captures the differences in total actual and
standard quantities sold.
The computations are as in the following table. For mix variance, the higher
fraction of containers sold brought about an additional contribution margin of
RM11,700, but at the same time reduced the refill bags sales contribution margin
by RM9,100. Combining both mix variances, we get a total of RM2,600,
favourable. This increase in contribution margin represents how much of the
volume variance is due to the change in product mix, while the number of units
sold is kept constant.
The additional cases sold of 300 generated additional contribution margins of

RM23,400 (RM10,800 and RM12,600 combined), which is shown as quantity
variance. In doing this, the mix is kept constant at the standard mix percentages
(40%:60%). Therefore, quantity variance represents how much of the volume
variance is due to increase in actual sales (see Table 4.3). We could conclude that
most of the favourable volume variance of RM26,000 comes from the additional

300 cases sold, not from the shift of demand from refill bags to containers. Mix
variance is not necessary for products which do not have competing products.
Table 4.3: Computation of Sales Mix Variance and Quantity Variance
Container Refill Bags Total

Actual mix % 42.45% 57.55%
Standard mix % 40.00% 60.00%
% difference 2.45% 2.45%

Total actual units sold X 5,300 X 5,300
Difference in units 130 130

Mix Variance F RM11,700 U RM9,100 F RM2,600
Total actual units sold 5,300 5,300

Total standard unit sold 5,000 5,000
Difference in units sold F 300 F 300
Standard mix % 40% 60%
Additional sales 120 180

Quantity Variance F RM10,800 F RM12,600 F RM23,400
Volume Variance F RM22,500 F RM3,500 F RM26,000
In brief, sales quantity and mix variances offer valuable information to managers
about market movements. In case total sales are above budget the sales quantity
variance would specify how much more contribution margin or profit should
have been made as a result of increased demand. Whereas, the sales mix variance
determines which products customers bought relatively more or less of at the
increased level of demand. After clarifying the reasons for the variances then
appropriate decision and actions can be executed such as:
(a) Changing advertising strategy;
(b) Replacing or improving products;
(c) Amending policies on mix, price etc.; and
(d) Understanding and recognising changing customersÊ preferences.

SELF-CHECK 4.4
How is sales mix variance related to total sales variance?
4.5.4 Market Share and Market Size Variances

The sales quantity variance can be further divided into market size and market
share variances. Market share and market size variances can be added to the
breakdown of sales variance as shown below. If reliable market data can be
obtained, then these market variances would offer more insight into product
performance. Market data can be obtained from trade associations, which collect
data from their members and make it available to them on an anonymous basis.
Market size variance (MSZV) examines the relationship between a company or

organizationÊs percentage of a market and the overall size of that market. Market
size variance measures how much more/less profit would have been made if
budget market share was maintained. It represents the portion of the sales
activity variance attributable to changes in industry volume.
Market share variance (MSHV) arises when there is a difference between the
actual market share of a company and the expected or budgeted market share.
For example, if a company budgets for a 20% market share but eventually obtains
only a 15% market share, this represents a market share variance. It measures the
effect on profitability of actual market share being different from budget market
share.
For illustration: Computing the MSZV and MSHV

We will be using the previous Case 3 on Magic Clean Sdn Bhd (MC) as shown
below. In addition, the last two columns contain data obtained from the trade
association that represents companies which supply household products,
specifically laundry detergent:
Budgeted Actual Market data

Budget Actual
Variable
Quantity Price Quantity Price Demand Demand
Cost
Quantity Quantity
Containers 2,000 RM140 RM50 2,250 RM125 10,000 14,000
Refill bags 3,000 RM100 RM30 3,050 RM110 12,000 15,000

To calculate MSZV, firstly we need to calculate the expected % of market share

from the budget market data, then multiply the differences between expected
and budget sales by standard price, as shown in Table 4.4.
Table 4.4: Computation of Price Variance and Volume Variance
Container Refill Bags Total

Budget quantity 2,000 3,000
Budget demand quantity ÷ 10,000 12,000
Budget sales mix % 20% 25%

Actual demand quantity X 14,000 X 15,000
Expected quantity 2,800 3,750

Budget quantity – 2,000 – 3,000
Difference in quantity F 800 F 750

Standard CM RM90 RM70
Market Size Variance F RM72,000 F RM52,500 RM124,500
The calculations indicate that an additional contribution margin of RM124,500

would have been made if the budget market share was achieved. Although the
actual demand from the industry has increased the increase in sales for both
products was not big enough to retain the budgeted market share percentage.
To calculate MSHV, the first step is to compare actual sales with expected sales.
Then multiply the differences between actual and expected sales by the standard
price to arrive at market share variance. The calculation of a market share
variance reflects the effect on contribution margin of actual market share being
different from budget market share.
Containers Refill Bags Total

Actual quantity 2,250 3,050
Expected quantity ă 2,800 ă 3,750
Difference in quantity (500) (700)

Market Share Variance UF RM45,000 UF RM49,000 (RM94,000)

The calculations indicate that a loss of RM94,000 was made as a result of not
maintaining its market share for all its products. The budgeted market share
percentages were 20% (containers) and 25% (refill bags) and the actual market
share percentages were reduced to 16%-containers (2,250/14,000) and 20.3%-refill
bags (3,050/15,000).
In conclusion, this sales or marketing variances helps especially non-

manufacturing organisation to identify and understand why budgeted
contribution margins or profits differ from actual contribution margins. These
variances largely reflect the impact of external factors. The breakdown of sales
variance into sub-variances provides very useful data in making decisions for
marketing and selling purposes and policy setting.
4.6 PLANNING AND OPERATIONAL

VARIANCE ANALYSIS
In the standard setting process, managers make their best estimates and
forecasts. Indeed, most of the standards are set on a forecast basis, which is
known as ex ante or before the event. Thus their estimations and forecast of costs
and revenues at the budgeting or planning stage may not be accurate or close to
actual results. This will result in planning variance.
Standards and budgets could possibly be revised once more information

becomes visible and observable after the event or also known as ex post. But the
differences between the revised budget and the actual performance may still exist
and be called operational variance, as depicted in Figure 4.7.
Figure 4.7: Planning and operating variances
Planning variances reflect the difficulties and errors in setting the original
standards. Normally, standards are revised due to change in condition,
assumptions or environment. Managers may not be held responsible because
those causes are regarded as beyond their control. Basically, a planning variance
is the difference between the ex ante and the ex post standards. Using similar
concept of other variances ă „actual versus budget‰, planning variance compares

original standards with revised standards. A favourable variance means the ex

post standard cost is lower than the original ex ante standard cost. In contrast, an
adverse variance shows that the ex post standard cost is higher than the ex ante
standard cost.
Operational variances compare revised standards with actual performance. It is

assumed that these variances occur due to operational factors. Hence, these
variances are within management control, thus relevant managers or
departments can be held responsible. The variances include material, labour,
overhead and sales variances. They are computed by comparing the actual
results with the ex post standard, instead of the original standard.
For illustration: Computing the planning and operational variances

Consider Case 4 as shown below.
Case 4: The following data concerns material A:

Original standard price RM20 per litre
Revised standard price RM23 per litre
Actual price RM22
Standard usage 100 litres
Actual usage 95 litres
Based on the traditional approach, material price and usage variances are
computed as shown in Figure 4.8:
SQSP AQSP AQAP

(100 litres × RM20) (95 litres × RM20) (95 litres × RM22)
= RM2,000 = RM1,900 = RM2,090
Usage Variance Price Variance

RM100 F RM190 A
SQSP AQSP AQAP

(100 litres × RM23) (95 litres × RM23) (95 litres × RM22)
= RM2,300 = RM2,185 = RM2,090
Usage Variance Price Variance

RM115 F RM95 F
Figure 4.8: Traditional approach

Favourable (F) material usage variance indicates operating efficiency, while

favourable price variance may reflect good bargaining skills, etc.
Some variances will appear due to factors that are practically or completely
within the control of management, for instance, the material usage variance that
reflects manufacturing efficiency in material consumption. These controllable
variances are known as operational variances. Variances that arise as a result of
changes in environment external to the business are known as planning variances
like price variance. Since planning variances are beyond the control of
operational management, managers cannot be charged for these variances.
Significant planning variances may lead to standard revision. Management

should have valid reasons to decide on revising the standards. Some possible
reasons for revising the standards are:
(a) Unexpected change in the rate or compensation for workforce;
(b) Unexpected increase in material prices in the market;
(c) Change in materials used in production; and
(d) Change in production setting, policies or procedures that alter the
consumption of resources.
Planning and operational variances are very useful for dynamic and volatile
environments. They help in determining planning deficiencies, offer up-to-date
information about degree of efficiency, make standard costing more acceptable
and become a motivating factor. Nevertheless, they are also subject to criticism
and have potential drawbacks. It is said that they are time consuming, create
conflict between planning and operational staff, and generate temptation to shift
the blame on the external factors.
SELF-CHECK 4.5
Explain the difference between planning and operational variances?
Figure 4.9 summarises the common variances. As mentioned in the previous

section, the sales variances could be measured based on selling price,
contribution margin or gross profit.

Figure 4.9: Chart of common variances

Source: Lucey (1996)
4.7 OPERATING STATEMENT (VARIABLE

COSTING AND ABSORPTION COSTING
TECHNIQUES)
Standard costing has long been used as a control system, whereby the budgeted
or planned cost and revenues are compared with the actual results. The resulting
variances will be reported to management as part of performance measurement
and control. Managers will prepare a report called cost reconciliation statement
disclosing all cost variances. The operating statement is another reconciliation
report that summarises both sales variances and cost variances. The format of the
reconciliation or the operating statement is different under variable (marginal)
and absorption costing. Table 4.5 shows the format of operating statement under
absorption costing.

Table 4.5: Operating Statement under Absorption Costing
RM
Budgeted profit xxx
Sales volume profit variance xx/(xx)
Standard profit on actual sales (= flexed budget profit) xxx
Selling price variance xx/(xx)
xxxx
Cost Variances: Favour. Adverse

RM RM
Material price xx (xx)
Material usage xx (xx)
Labour rate xx (xx)
Labour efficiency xx (xx)
Variable overhead expenditure xx (xx)
Variable overhead efficiency xx (xx)
Fixed production overhead expenditure variance xx (xx)
Fixed production overhead capacity variance Fixed xx (xx)
production overhead efficiency variance xx (xx)
Total xx/(xx)
Actual Profit xxxx
The operating statement under variable or marginal costing is quite similar to the
one under absorption costing, but with several differences as listed below (also
see Table 4.6).
(a) A sales volume contribution variance is used in place of a sales volume
profit variance;
(b) Only fixed overhead expenditure variance is included; and
(c) The reconciliation is from budgeted to actual contribution then fixed
overheads are deducted to arrive at a profit.

Table 4.6: Operating Statement under Variable Costing
RM
Budgeted contribution
(budgeted production x budgeted contribution/unit) xxx
Sales volume profit variance xx/(xx)
Standard contribution on actual sales
(= flexed budget contribution) xxx
Selling price variance xx/(xx)
xxxx
Variable Cost Variances
Favour. Adverse
RM RM RM
Material price xx (xx)
Material usage xx (xx)
Labour rate xx (xx)
Labour efficiency xx (xx)
Variable overhead expenditure xx (xx)
Variable overhead efficiency xx (xx)
Total xx/(xx)
Actual contribution xxx
Budgeted fixed production overhead xxx
Fixed overhead expenditure variance xx/(xx)
Actual Profit xxxx
Please remember that adverse variances increase actual cost whereas favourable
variances reduce actual cost. Variable costing distinguishes between fixed and
variable cost. Under variable costing, the sales volume variance would be based
upon contribution per unit rather than profit per unit. In brief, for absorption
costing, it is important to distinguish between the sales volume and the rate and
efficiency causes of deviations from budget. On the other hand, for variable
costing it is crucial to separate the effects on contribution, fixed and variable
costs. If you have a computerised accounting package, this will be a very simple
task.

4.8 INTERDEPENDENCE BETWEEN VARIANCES

Normally, the people in the accounting department are the ones who prepare
and calculate all variances, but those performing the accounting function are less
likely to know the causes of the variances. Actually, it is operational managers
who should determine the causes and only they should provide input into the
management report on the figures. Effective management decisions on the
appropriate course of action can be made possible only if we know the true
cause.
We need to recognise the inter-relationships among variances. For instance, the

purchase of low quality materials by a purchase manager may cut the cost a bit
and result in a favourable materials price variance. However, these poor quality
materials may cause production employees to use more materials than expected
and they may have to spend more time working with the materials, and
eventually this may result in an adverse materials efficiency variance and an
adverse labour efficiency variance. Furthermore, if labour hours are the cost-
allocation base for variable overhead, then most probably overhead efficiency
variance will also be an unfavourable variable. Now, think about who is going to
be held responsible for those variances. Do you think it is fair for production
managers to be charged for all those adverse variances which were entirely due
to poor quality materials?
Therefore, understanding and recognising the interdependence between

variances are very crucial especially in determining the true underlying cause of
the variances so that proper corrective action can be taken. Secondly, no
managers should be wrongly held responsible or be blamed for variances which
were caused by others.
Variance analysis which is not supported by effective planning processes may

adversely create dysfunctional behaviour among managers. Consider the
following example. Normally, the human resource (HR) manager takes full
charge of unfavourable variance in labour costs, whereas the production
manager is held responsible for fully utilising manufacturing capacity. This
arrangement encourages the production manager to keep production running at
full capacity all the time. Whenever demand increases, the production manager
would contract more labour rather than expanding capacity. This short-term
measure is costly for the company and it is the HR manager who is going to be
responsible for this variance, not the production manager. These kinds of
dysfunctional behaviours that favour short-term measures at the expense of long-
term organisational goals are not healthy for the survival of the company.
Therefore, acknowledging the reliance of variances upon each other, individual
managers should consider the implications of their decisions on others before

taking further action. In order to guide managers, or even to prevent them from
focusing on the interest of their departments/sections alone in isolation from
others, variance analysis should be aligned to and focused on achieving the
strategic goals of an organisation.
In many situations, like in the above scenario, the misallocation of

responsibilities, off-track focus and penalties for unfavourable variances may
create a culture of fear, blame and frustration. The focus is not on achieving
strategic goals. One way to alleviate this issue is to link advanced variance
analysis to the companyÊs planning and budgeting processes. By reviewing
which managers should be responsible for common types of variances, you can
make any necessary adjustments. You can then determine which variances are
critical to strategic performance. By linking variance analysis to a target-based
budget derived from the firmÊs business plan, you create an effective tool to
improve the firmÊs strategic performance.
4.9 INVESTIGATING VARIANCE

Why do we need to investigate a variance? Of course, the purpose is to determine
the underlying cause of the variance so that proper corrective action can be
taken. Companies often establish criteria to determine which variances to focus
on rather than simply investigating all variances. Some may apply what we call
management by exception (MBE), whereby managers focus exclusively on
variances that are significant. Management decision to take further investigation
depends on many factors. Some of the factors that should be considered are as
follows:
(a) Reliability and accuracy of the figures ă Possibility of mistakes in
calculating budget figures, or in recording actual costs and revenues.
(b) Materiality ă A company may predetermine the size of the variance that
reflects the magnitude of the problem and its potential benefits gained from
its correction.
(c) Interdependencies between variances ă Any interdependent variances
should be considered jointly before making an investigation decision.
(d) Natural variability in costs and revenues ă Some variances are considered
normal like oil prices of high volatility in nature, but some other variances
are quite stable thus a small variance may signal a problem.
(e) Adverse or favourable ă Normally adverse variances get all the attention
because they reflect problems. However, do not just ignore favourable
variances because they may signal that the standards are too low and thus

need revision. Alternatively, favourable variances should be highlighted so

that a business can learn from its successes.
(f) Trends and patterns ă Occurrence of variances is either at random or
persistent. A series of adverse variances usually indicates a problem.
(g) Controllability and probability of correction ă No corrective action is
necessary for uncontrollable variances.
(h) Costs and potential benefits of correction ă If the cost of corrective action
outweighs its potential benefits from the correction, there is no need for
further investigation.
Next, let us learn more about cause and controllability issues. Variances can be
divided into two classifications: random and systematic. Random variances are
uncontrollable, either from technical or financial aspects. For instant, price
fluctuations in the open market at the time of acquisition and the time allowed to
acquire the goods or services are definitely beyond the control of management.
Thus, no further action from the management is needed since these variances are
basically random variances.
In contrast, systematic variances are persistent, and most likely to reappear if

they are not corrected. Normally, they are controllable, in which management
can take corrective actions to remove or reduce them. Immediate action is
required if the variances are material. Causes for these systematic variances
include inaccuracy or errors in prediction, modelling, measurement and
implementation. Each cause requires different further investigation and effective
managerial action to rectify the variance. Next, we will look at the different types
of errors and the necessary corrective action.
(a) Prediction errors refer to inaccurate estimation of variables in the standard-
setting process, such as increases in materials price are faster or higher than
estimated. Corrective action for prediction errors would be to modify the
standard and the standard setting process.
(b) Modelling errors occur when management has failed to include all relevant
variables or has included wrong or irrelevant ones in the standard-setting
process. For instant, a modelling error occurs when a firm fails to consider
for normal material lost or waste. The unfavourable material usage variance
that the firm experiences is a result of modelling error, not because of
inefficient operations. Setting the standard at 1,000 kgs of input materials to
produce 1,000 kg of output is a modelling error, knowing that the
manufacturing process has 10% normal waste. Corrective actions for
modelling errors include the firm changing its standard and the standard-
setting process.

(c) Measurement errors refer to using wrong numbers due to improper or

inaccurate accounting systems or procedures. For example, allocating
overhead incurred for setups based on machine hours rather than the
number of setups is a measurement error. Corrective actions for
measurement errors would be to redesign the firm's accounting system or
procedures.
(d) Implementation errors occur when operators deviate from the standard in
performing their jobs. Examples of implementation errors include setting a
cutting machine to cut plywood in lengths of 2 x 3.97 feet, instead of 2 x 4
feet, and using material of low or lesser quality than those specified that has
resulted in unfavourable materials usage variance. Some errors are
temporary and disappear in subsequent periods in the normal course of
operations like excessive or wrong use of materials in production may
occur only in one or a few production runs. However, some errors could be
continuing and reappear until the firm takes proper corrective action, i.e.
resetting the length of the cutting machine. Proper immediate actions are
very crucial for this type of implementation error.
Investigation of variances involves time and money. In brief, companies,

therefore, need to determine whether the benefits of investigating the variance
outweigh the costs, how important the item is to the production process or
service experience, whether there has been a trend in the variance over a period
of time, whether the variance is persistently or repeatedly occurring and whether
someone in the organisation has the ability to control a particular cost or revenue,
before deciding on further investigation of the variances.
4.9.1 Variance Investigation Models

There are a number of variance investigation models available. These models can
be as simple as consisting of set of rules or procedures for investigating
variances. A simple control chart or the statistical model-control chart is quite a
popular and widely used method. Alternative methods involve more
sophisticated models such as probability-based approach, and stochastic
processes such as dynamic programming model.
(a) Percentage of standard cost approach

The percentage of standard cost approach is a simple method to apply. This
method allows certain variances within a fixed percentage of standard cost.
Thus, any variance larger than this percentage will require investigation.
Nevertheless, the main limitation of this approach is that it does not
consider most of the issues related to making decisions on investigating
variance as mentioned in the investigating variance section. Such issues like

reliability of the figures, interdependence between variances, the natural

variability of the costs involved, recent trends in variances, or the costs and
potential benefits of investigation are not taken into consideration.
(b) Control chart

Random and systematic variances can be identified by using a control chart.
Control charts offer a visual representation of the variation of actual costs
around standard and clearly portray trends in variance. A control chart has
a horizontal axis, a vertical axis, a horizontal line at the level of the
desirable characteristic, and one or two additional horizontal lines for the
allowable range of variation (see Figure 4.10). The horizontal line represents
time intervals, batch numbers or production runs. The vertical line denotes
scales for the characteristic of interest, such as the amount of the cost
variance. Upper and lower borders limit the allowable range of the
variance. If actual costs fall outside the warning limits, this signals close
monitoring is necessary. If actual costs shift towards outside the action
limits, this would call for corrective action.
Figure 4.10: Variance control chart

Source: www2.accaglobal.com
The management is responsible for setting the upper and lower control
limits in control charts. Managers may set the warning and action limits
based on their past experience, or a standard normal distribution. When the
control limits are established using a statistical model, the chart is called a
statistical control chart as depicted in Figure 4.11.

Figure 4.11: Statistical model-control chart

Source: http://dl.groovygecko.net
In the above statistical control chart, the control limits are set at two
standard deviations from the mean. This means that 95% of the variance
amounts should lie within the control limits. A control chart is very useful
in the case where an average cost can be established, but its use is
commonly limited to efficiency variances.
(c) Probability based and dynamic programming methods

A probability-based model appears very rational; however, it requires
accurate estimation of probabilities. Another complex method is the
dynamic programming method, which was suggested by Kaplan in 1969
for making cost variance investigation decisions. This model tries to
minimise the expected total cost (or the expected present value of total
costs) over a specified time frame or horizon and does include a
consideration of decisions in future periods.
Previous studies have reported that there is lack of application of more complex
cost investigation models, which could be due to several reasons, including that
the added costs may outweigh the potential benefits, lack of awareness, and
choice of simple over complicated models.

• Advanced variance offers further analysis by breaking down the basic

variances into several compositions that enable us to understand more about
those variances in improving overall financial performance.
• This topic discusses the evaluation of the achievement level of a company

from the aspect of planning and control by using standard costing as a
benchmark.
• Standard costing can be used in management activities and cost control,

budget preparation, product pricing and performance evaluation.
• At the end of this topic, students will have learned cost control through
variance analysis and following that, the approach used in the formulation of
standard cost and types of standard costs.
• The effectiveness of the use of standard costing, among others, will assist
managers in controlling business operations other than assisting in the
process of pricing products for sale. Manufacturing-based organisations that
produce products using multiple or many types of raw materials and labours
may find advanced variances like material mix and yield variances, and
labour mix and yield variances very useful in evaluating their resource
management and performance management in general.
Ć Sales or marketing variances such as sales mix and quantity variances,

market share and size variances are very beneficial for non-manufacturing or
service organisations in investigating their sales performance and market
movement.
Ć Variances may require further investigation for several reasons that may lead
to revision of standard setting. A number of models or approaches for
investigating variances are available.

Ideal standard Operating statement

Labour mix variance Practical standard
Labour yield variance Standard costing
Market share variance Sales mix variance
Market size variance Sales quantity variance
Material mix variance Variance analysis
Blocher, E. J., Stout, D. E., & Cokins, G. (2010). Cost management: A strategic
emphasis. New York: McGraw-Hill/Irwin.
CIMA. (2011). CIMA official study text: Paper P2 Performance Management. UK:

Topic X Variance
5 Analysis
LEARNING OUTCOMES
1. Interpret cost variance analysis result;
2. Explain the uses and importance of direct material variance
and direct labour varience;
3. Calculate direct material varience and direct labour varience;
4. Compute overhead variance; and
5. Examine the uses and importance of cost variance in decision
making.
X INTRODUCTION
The previous topic exposed students to standard costing as a measurement of
productivity and quality in an organisation. Productivity and quality can be
measured by comparing actual cost and standard cost. It then becomes
information that can be used by the management to conduct a performance
evaluation during a specific period.
However, in this topic, you will be exposed to variance analysis which is one of
the tools used in standard costing in conducting performance evaluation.
Following that, students will also be exposed to the uses and advantages of cost
variance other than examining in further detail, types of variance including price
variance and efficiency variance (quantity).

144 X TOPIC 5 VARIANCE ANALYSIS
5.1 COST VARIANCE ANALYSIS

As explained, standard cost is often used as a benchmark for analysing or
evaluating the performance of an organisation. In cost control, actual cost will be
compared with standard cost in evaluating the performance of an organisation.
This can be achieved by conducting a variance analysis. From the result of this
analysis, we can conclude in general whether the achievement of the organisation
is satisfactory or otherwise.
This section will discuss cost variance analysis, specifically for the manufacturing
industry. In general, cost variance analysis for production cost is divided into
two types, which are price variance and efficiency variance or quantity variance.
It is calculated by multiplying the price difference with actual of input quantity.
Refer to Figure 5.1.
Figure 5.1: Two types of variance cost analysis
What is meant by price variance?
Price variance measures the extent a business can afford to maintain the price
of one unit of raw material input and labour within the standard price.
If a company pays less than the standard price, thus the price variance is
favourable. Conversely, if the company pays more than the standard price, the
price variance is regarded as unfavourable.
Price Variance = (Actual Price ă Standard Price) x Actual Quantity

TOPIC 5 VARIANCE ANALYSIS W 145
What is meant by efficiency variance?
Efficiency variance measures whether the quantity of material or labour used

to produce actual output is within the standard quantity allowed to produce
the amount of actual output.
Efficiency variance refers to the difference in quantity multiplied by the price of

one unit of input.
Efficiency Variance (Quantity) = (Actual Quantity ă Standard Quantity) x

Standard Price
If a company uses input quantity less than the standard input allowed, therefore
the efficiency variance is said to be favourable. Conversely, if a company uses
input more than the standard input, efficiency variance is regarded as
unfavourable.
Therefore, efficiency variance is calculated based on standard price. This is to

enable the company to view how the use of materials and labour affects the
profitability of the company. The efficiency aspect in using materials and labour
is within the control of the company.
Meanwhile, price variance illustrates how changes in the price of materials and
labour wage rate affects the profitability of the company. However, change in
price of materials and labour wage rate caused by changes in the current market
are beyond the control of the company.
Next, let us apply variance analysis. For the purpose of illustration, we will focus
on an example of a company that produces school uniforms.

Example 5.1
Uniform Expert Sdn. Bhd. takes orders and supplies school uniforms to most
supermarkets and clothing stores throughout Malaysia. The production
process is divided into two stages, which are the cutting process and the
stitching process. The production section supervisor together with the
management accountant have set the standards for direct materials and direct
labour as demonstrated in Table 5.1.
Table 5.1: Uniform Expert: Material and Direct Labour Standards
Standard Material Price:

Purchase Price Per Metre Cloth....................................... RM4.00
Carriage Cost Per Metre............................................... RM0.20
Total Standard Price Per Metre Cloth.............................. RM4.20
Standard Material Quantity:
Cloth in Finished Product..............................................
2.7 metres
Surplus of Material (normal)..........................................
0.3 metres
Total Standard Quantity Needed Per Unit Product..........
3.0 metres
Standard Wage Rate:

Wage Rate Per Hour................................................... RM4.00
Additional Allowance (15% of wage)........................ RM0.60
Total Standard Wage Rate Per Hour............................... RM4.60
Standard Quantity of Direct Labour Hours:
Direct Labour Required Per Unit Product......................... 4 hour
Standard quantity of direct materials constitutes the normal amount of direct

materials needed to produce one unit of the finished product. It also takes into
account or allows inefficiency and normal materials surplus.
Standard price of direct materials has taken into account all incurrable costs in
obtaining materials and transporting them to the factory. Material purchase
price is derived after deducting purchase discount, if any. Whereas carriage
inward cost will be added to the purchase price.
Standard quantity of direct labour hours refers to the normal direct labour
hours required to produce one unit of the final product. Meanwhile, the
standard rate of direct labour is the amount of wage and salary costs,
including additional allowances.

Look at Table 5.2. This table demonstrates actual costs incurred by the
production department throughout the month of March. Throughout the month
of March, the company has produced 4,000 school uniforms. Now, let us
compare the total actual cost with the total standard cost by applying variance
analysis.
Table 5.2: Uniform Expert: Actual Cost for the Month of March
Quantity of Direct Materials Bought................................15,000 metres

Price of Direct Materials Per Metre...................................RM3.90
Quantity of Direct Materials Used ...................................14,500 metres
Direct Labour Hours Used.................................................11,400 hours Wage Rate
Direct Labour Per Hour .....................................................RM4.40
SELF-CHECK 5.1
Elaborate what you have understood in relation to cost variance and

its functions.
5.2 DIRECT MATERIALS VARIANCE

You will want to know the value of what has been spent by the purchasing
manager for materials and most importantly, whether the manager has spent
more than necessary. The answer will be known by applying the variance
formulas as follows. Abbreviation for the following terms can be used to facilitate
the variance formula as follows.
QP = Quantity Purchased
AP = Actual Price
SP = Standard Price
AQ = Actual Quantity Used
SQ = Standard Quantity
Direct Materials Quantity Variance Direct Materials Price Variance

(AQ x SP) ă (SQ x SP) (QP x AP) ă (QP x SP)
= SP (AQ ă SQ) = QP (AP ă SP)

The calculation of direct material variance for the production of uniforms for the
month of March can be calculated by adding relevant information from Table 5.1
and Table 5.2 as follows:
Direct Materials Price Variance Direct Materials Quantity Variance

QP (AP ă SP) SP (AQ ă SQ)
= 15,000 (RM3.90 ă RM4.20) = RM4.20 [14,500 ă (4,000 x 3)]
= (RM4,500) Favourable = RM10,500 Unfavourable
A positive variance amount means that the actual cost exceeds the standard cost,
therefore, is unfavourable. Conversely, a variance amount that is negative means
the actual cost is less than the standard cost, therefore is said to be favourable.
Direct material price variance is said to be favourable because the actual
purchase price is less than the standard price.
This price variance explains why revenue from the operations of the company
will be RM4,500 higher because the company has paid less than the standard
price. This can be explained further by comparing the total actual cost with
standard cost for raw materials in the following calculations.
Standard Cost Actual Cost

Total Cost of Direct Materials Purchased RM63,000a RM58,000b
Total Cost of Direct Materials Used RM50,400c RM56,550d
Calculation:
(a) RM4.20 x 15,000 metres (b) RM3.90 x 15,000 metres

(c) RM4.20 x (3 metres x 4,000 units) (d) RM3.90 x 14,500 metres
You can observe that the standard cost amount above is calculated based on
actual output (4,000 units). With that, the purchasing department is estimated to
incur cost amounting RM63,000 only to produce 4,000 units of uniforms. But the
actual cost of direct material purchased is much lower, that is RM58,500. This
means that the purchase of materials was managed efficiently, that is without
spending more than is budgeted.
Meanwhile, direct materials quantity or efficiency variance is unfavourable. This

means that income from the operations of the company will be RM10,500 lower
because workers have used amount of cloth in excess of the standard. The
comparison information shows that the total actual cost of direct materials used
(RM56,550) is higher than the amount budgeted, which is RM50,400. As a whole,

the total variance for direct materials is not favourable, amounting to

RM6,000 (- 4,500 + 10,500).
Variance analysis does not provide related information on the cause of a

particular variance. It only states whether the variance is favourable or
unfavourable. The variances derived must be translated so that we will know
the causes of such variances. Thus, the managers involved must sit down to
discuss and take steps to investigate the causes of significant variances.
For material price variance, it is usually the manager or purchasing clerk who
will be responsible because they should know what causes the change in price. In
the previous example, a favourable price variance may be due to factors such as a
lower price offered by suppliers, purchase of materials per specifications,
company obtaining trade discount or cash discount for buying wholesale or
paying within the credit period, and perhaps carriage cost has fallen.
The production manager is usually the one responsible for material quantity
variance. Unfavourable quantity variance means that the company has used
more materials than required. This could be caused by machine failure, unskilled
labour or worker, materials that do not meet specification or are low in quality
and weak preparation. Sometimes, the purchasing manager has to be responsible
for the material quantity variance. This may be caused by the purchasing
manager buying poor quality materials to save cost.
ACTIVITY 5.1
Through your readings, explain what you have understood if the result of
the analysis showed a positive variance for direct material efficiency and
who will be held responsible for it.
Note that price variance is based on quantity purchased (QP) and quantity
variance is calculated using standard price (SP). For price variance, the
purchasing manager purchases materials not only for what is supposed to be
used, but for the actual amount used. So the price variance is the difference in
price multiplied by the actual quantity purchased.
Price Variance = Price Difference x Actual Quantity Purchased (AQ)

More so, based on the quantity bought, the purchasing manager will know at an
earlier stage, when purchasing, the difference between actual price and standard
price. Therefore, corrective or improvement measures can be identified
immediately for subsequent purchases.
Whereas the purchasing manager would prioritise production efficiency, thus

efficiency variance is calculated by multiplying the difference in quantity with
standard price. With that, the efficiency level of materials used will be known
after the completion of production, that is, after the actual amount of material
used is known.
Efficiency Variance (Quantity) = Quantity Difference x Standard Price (SP)
Often in the manufacturing industry, it involves various types of direct material.

In cases like this, price variance and direct material quantity is calculated for each
material. After that, the amount of variances will be combined to derive the
overall total variance.
5.3 DIRECT LABOUR VARIANCE

The calculation of Actual Cost and Standard Cost of Direct Labour for Uniform
Expert is shown in Table 5.3.
Table 5.3: Calculation of Actual Cost and Standard Cost of Direct Labour for
Uniform Expert
Type of Cost Cost Evaluation

Actual Cost of Direct Material RM4.40 x 11,400 hours
= RM50,160
Standard Cost of Direct Labour RM4.60 x (4 hours x 4,000 units)

= RM73,600
Based on Table 5.3, a comparison of the total actual cost of direct labour used,
that is RM50,160 (RM4.40 x 11,400 hours) is far much lower than the standard
cost for direct labour amounting RM73,600 (RM4.60 x (4 hours x 4,000 units). This
is due to two factors, the actual wage rate is lower than the standard rate and the
number of actual labour is only 11,400 hours. This is much lower than the
standard labour quantity of 16,000 hours. Both these factors will be shown more
clearly by calculating the direct labour rate variance and direct labour efficiency
variance. The formulas are as follows:

Direct Labour Efficiency Variance Direct Labour Rate Variance

(AH x SR) ă (SH x SR) (AH x AR) ă (AH x SR)
= SR (AH ă SH) = AH (AR − SR)
Abbreviation for the following terms will be used to facilitate the variance
formula.
AH = Actual hours used
AR = Actual rate per hour
SR = Standard rate per hour
SH = Standard hours allowed
Direct labour rate and efficiency variance for the production of uniforms in the
month of March can be calculated as follows based on the information in Table
5.1 and Table 5.2.
Direct Labour Rate Variance - RM 2,280 Favourable

Direct Labour Efficiency Variance - RM21,160 Favourable
Total Direct Labour Variance - RM23,440 Favourable
This means that the operating income of the company will be RM23,440 higher
because the company has paid a lower wage compared to the standard rate. This
is also caused by skilled workers which enabled labour hours needed for
production to be lower than the standard labour hours.
Normally, it is the personnel or human resources department which is responsible

in recruiting workers, providing industrial training and determining the workersÊ
wage and salary rates.
A favourable wage rate variance may be due to factors such as the recruitment of
unskilled workers, surplus of skilled workforce in the particular field in the
employment market and efficient supervision. The factors mentioned may result in
lower wages, or it may still be under control.
Efficiency variance is favourable as the direct labour hours used are lower than
standard hours. Rate variance is also favourable because the company pays
labourers at a lower wage rate compared to the standard rate. Both variances if
combined, will become the total variance for direct labour.

Try to recall the type of conditions which create positive or unfavourable direct
labour efficiency variance.
Should the production process involves several categories of labour or workers,

the labour rate and efficiency variance must be calculated for each category
separately. Following that, the variances amounts will be combined to derive the
overall total variance.
ACTIVITY 5.2
The following information was obtained from Syarikat Mila:

Actual direct labour hours 1,275
Actual direct labour cost RM16,605
Actual units produced 1,255 units
Direct labour standard rate RM12
Direct labour efficiency standard rate 1 hour per unit
Budgeted production 1,200 units
Required:
1. Determine direct labour rate variance.
2. Determine direct labour efficiency variance.
5.4 MANUFACTURING OVERHEADS

VARIANCE
Next, we will discuss the third variance, namely the manufacturing overhead
variance.
What is meant by overhead cost?
Overhead cost comprises expenses other than direct materials and direct
labour, such as indirect materials, supplies, utilities, wages of plant managers
and supervisors etc.
Because there is no relationship or direct involvement between the use of

overhead and product, the process of determining the standard cost for overhead
is quite complicated. So is the process of allocating overhead cost to production.

Before we continue our discussion on overhead variance, let us first examine

how manufacturing overhead is divided or allocated to production. For the same
reason, which is the absence of direct relation between input and output for
overhead cost, it is unreasonable to use only one basis to distribute all overhead
expenses. Alternatively, the company can distribute overhead cost to products
using basic activities such as direct labour hours, machine hours, actual output
units and others.
Assuming direct labour hours is made the basis of allocation, the requirement on
overhead is similar to the requirement towards direct labour hours. As soon as
the basis for allocation is chosen, the pre-determined rate or overhead standard
cost can be set for direct labour per hour and those similar to it. This standard
overhead is then used as a benchmark to monitor actual overhead expenses.
In general, you should know that there are two types of variance overheads:
(a) Flexible Budget Variance or Spending Variance

Shows how a manager can control or maintain total overhead expenses within
the amount budgeted, with or based on the total of actual output in the
corresponding period.
(b) Production Volume Variance (or Efficiency)
Is found when the actual quantity of output is different from the quantity of
expected output as noted in the master budgets or static budgets.
Both variances for this overhead is then combined to explain the difference
between standard overhead cost and actual overhead cost.
For the purpose of illustration of overhead variance analysis, you can refer to the
information for Uniform Expert Sdn. Bhd., a school uniform manufacturer. This
company allocates overhead cost based on the machine hours used. Standard
cost information, budgeted cost and actual cost of fixed and variable overheads
for the month of March, and production units are as demonstrated in Table 5.4.

Table 5.4: Uniform Expert: Overhead Cost Information
Standard Machine Hours Per Unit Product................................. 3.5 hours

Total Standard Machine Hours
(based on actual output = 3.5 x 4,000)........................................... 14,000 hours
Budgeted Variable Overhead Cost................................................ RM22,500
Budgeted Fixed Overhead Cost..................................................... RM16,400
Estimated Machine Hours.............................................................. 12,000 hours
Actual Machine Hours Used.......................................................... 13,800 hours
Actual Variable Overhead Cost..................................................... RM20,300
Actual Fixed Overhead Cost.......................................................... RM15,050
Normal Production Capacity Per Month..................................... 6,000 units
Actual Production (March)............................................................ 4,000 units
5.5 OVERHEAD VARIANCE

We will discuss in detail about overhead variance. Overhead variance can be
divided into two, namely:
Rajah 5.2: Two types of overhead variance
(a) Variable Overhead Variance (VOV)

Variable overhead variance can be described in detail as expense variance
and efficiency variance. The formula for the calculation for both variances
are as follows:
Spending Variance = Actual VOV ă (Budgeted VOV x Actual Basis)

= Actual Basis (Actual Rate ă Standard Rate)

Efficiency Variance = Standard Rate (Actual Basis ă Standard Basis on Actual

Output)
Variable overhead spending variance is the difference between variable

overhead cost and standard variable overhead cost at actual basis.
What is meant by actual basis?
Actual basis is the basis that is used to allocate overhead and for the stated
illustration, actual basis is the actual machine hours utilised.
Variable overhead efficiency variance meanwhile refers to the difference

between standard variable overhead cost at an actual basis and standard
variable overhead cost at a standard basis (based on actual output).
To understand further, let us calculate the variance for variable overhead

by adding the relevant Uniform Expert information (refer to Table 5.4) in
the formula provided.
Variance = Actual VOV ă (Budgeted VOV x Actual Basis)

= RM20,300 ă (RM1.07* x 13,800 hours)
= RM20,300 ă RM14,766
= + RM5,534 (Unfavourable)
Efficiency = Standard Rate (Actual Basis ă Standard Basis at

Variance Actual Output)
= RM1.07* [ 13,800 ă (3.5 hours x 4,000 units) ]
= RM214 (Favourable)
* Standard variable overhead rate per machine hour = RM22,500/(6,000 units

x 3.5 hours)
= RM1.07
Unfavourable expense variance illustrates that the actual rate of variable
overhead, that is RM1.47 per machine hour (RM20,300/13,800 hours)
exceeds the standard rate (RM1.07 machine hours). While efficiency
variance is favourable due to actual basis (13,800 machine hours) being
lower than the allowed basis at actual output (14,000 machine hours).
Variance analysis for variable overhead can be illustrated in the chart
shown in Figure 5.3.
Figure 5.3: Variable overhead variance analysis
If you would like to examine the causes of differences in the rates for
variable overhead, you will need to examine the price or rate for each item
combined in the variable overheads such as electricity supply, telephone,
water, indirect materials, indirect labour and so on. A higher rate may be
caused by surplus or wastage in using these items or there is a price
increase.
For a favourable variable overhead efficiency variance, it is directly related

to the basis used to absorp overhead. In the Figure 5.3 illustration, actual
machine hours used is said to be efficient or favourable, thus the company
is regarded as efficient in using its variable overheads. Because both
variances have a direct relationship, the company has to be careful in its
choice of basis activities for the allocation of overhead cost to production.
(a) Fixed Overhead Variance (FOV)

Now, let us look at the second variance overhead, which is the fixed
overhead variance. Fixed overhead variance can be divided into two types,
namely:
(i) Budget variance; and
(ii) Production volume variance.
Calculation for both variances is by using the following formula.
Budget Variance = Actual FOV ă Budgeted FOV
Production Volume Variance = Budgeted FOV ă Absorbed FOV
= Standard Rate (pre-determined) x

(Forecast Basis ă Standard Basis)
= Budgeted FOV ă (Standard Rate x

Standard Basis at Actual Output)
Fixed overhead budget variance is the difference between the total of actual fixed
overhead and budgeted fixed overhead. Whereas production volume variance
will exist due to total fixed overhead budgeted, is not the same as total overhead
absorbed into product. Overhead will be absorbed to the product at standard
basis based on actual output. In the illustration before this, the standard basis is
standard machine hours (5.5 hours per product unit) at actual output which is
4,000 units.
Returning to Uniform Expert, we will calculate fixed overhead variance by taking

the relevant information from Table 5.4 and incorporating it into the following
formula. Absorbed FOV
Budget Variance = Actual FOV ă Budgeted FOV

= RM15,050 ă RM16,400
= ă RM1,350 (Favourable)
Production Volume V a r i a n c e = Estimated FOV ă Absorbed FOV

= RM16,400 ă (RM1.37* x 3.5 hours x 4,000 units)
= RM16,400 ă RM19,180
= ă RM2,780 (Favourable)
* Standard fixed overhead rate (pre-determined) = RM16,400/12,000 = RM1.37.

This analysis can be demonstrated in Figure 5.4. Analysis results demonstrate

both variances as favourable. Fixed overhead budget variance is almost the same
as variable overhead expenses variance, of which actual overhead expenses is
usually difficult to control by managers.
Figure 5.4: Fixed overhead analysis variance
Production volume variance demonstrates how a company uses existing facilities

and amenities in a factory or manufacturing plant. Therefore, it bears no relation
to expenses. A favourable production volume variance means the company is
operating at its capacity. On the other hand, if the variance is unfavourable, this
means the company is operating below its existing capacity.
Based on the corresponding discussion with regard to both variances mentioned,

we can summarise the following. First, there are two categories of cost variance,
namely:
(a) Price variance; and
(b) Efficiency variance (quantity).
The separation between these two variances is important because different
managers are responsible for purchase and input usage and both of these two
activities occur at different times.
Second, price variance and efficiency variance (quantity) can be calculated for all
three cost elements (materials, direct labour and variable overhead), even though
this variance is not known by the same term. For example, for direct materials, it
is known as direct materials price variance, but it is called direct labour rate
variance for direct labour cost and is known as variable overhead expense
variance for variable overhead cost.
Third, even though price variance is known by a different term, it is calculated in

the same way. The same goes for efficiency variance (quantity).
Fourth, actual cost variance analysis is an analysis in the form of input-output.

Input stands for actual quantity of direct materials, direct labour and
overheads.Whereas, output represents product manufactured during that period.
This output is stated in terms of standard quantity allowed based on actual
output, which means amount of materials, labour and overheads that should
have been used to produce actual output for that period.
ACTIVITY 5.3
1. Syarikat Ebi adopts variable overhead for its production at a basis of

RM22 per direct labour hour. Standard labour efficiency rate is 0.5
hours per unit. Last month, the company produced 14,500 units and
used 7,300 direct labour hours. Actual variable overhead cost is
RM162,000.
Required:
(a) Determine the variable overhead expense variance.
(b) Determine the variable overhead efficiency variance.
2. Syarikat Manjalara uses fixed overhead at a rate of RM4.60 per direct

labour hour. Fixed overhead is budgeted at RM910,800 per month.
Direct labour efficiency rate is 3 hours per unit. Even though the unit
budgeted is 66,000, the company has managed to produce 67,800
units. Actual direct labour hours for production is 203,000 and
overhead cost incurred is RM920,000.
Required:
(a) Determine fixed overhead budget variance.
(b) What is the difference between planned units and actual units
produced.
(c) Determine fixed overhead volume variance.

5.6 USES AND IMPORTANCE OF COST

VARIANCE
You must remember that cost variances do not identify the source of the
problem, but rather raise questions and direct attention or focus of the manager.
As such, the source for the existence of variance probably may or may not be
controlled by the manager. In your opinion, would it be approriate for all
variances found be given attention and investigated for its causes?
Variances can occur all the time. Small variances are usually regarded as normal
and managers will not conduct further investigation. Significant and
unfavourable amount of variances are probably indicating that there are
problems which may obstruct the company from achieving its targets as per
budgeted. While significant and favourable variances may illustrate that there is
space and opportunity to implement continuous cost reduction methods.
However, there are cases where favourable variances can indicate a situation
which is worse than that attributed to unfavourable variances. For example, a
favourable variance for the amount of meat in a slice of burger means that a
lesser amount of meat is used compared to what is determined by the standard.
The effect, complaints may come from customers who are not satisfied with the
quality of the burger.
A summary of categories of variances can be seen in Figure 5.5.
Figure 5.5: Categories of variances and its importance

When is a variance considered large or significant? The significance of a variance

depends on the judgement of the management. No specific rules interpret how a
variance is considered to be significant. Normally, a company will set their own
criteria whether the source of the said variance should be investigated or not.
After setting the criteria, the manager will investigate all variances included in
the significant category, not counting whether the variances are favourable or
otherwise.
When should a variance be brought to the attention of the management?
Before significant variances are investigated further, the manager must also
compare between the expected benefit and incurrable cost of the investigation
(cost-benefit analysis). Assuming the cost of investigating is larger than its
benefit, it will not be profitable to continue with the investigation. Following that,
after the investigation is conducted, it will be evaluated and corrective measures
and improvement actions will be taken. Figure 5.6 simplifies the steps that must
be taken by a company when conducting an investigation on any variance.
Figure 5.6: Steps that must be taken by a company when conducting variance
investigation

A variance which is significant can be measured through its relative size, that is
in the amount of RM or in the form of percentages. A basis value will be used to
measure the size of variance, for instance, standard cost or targetted profit.
For example, a manager may neglect a variance which is less than 8% of standard
cost, because he believes that such variances are normal. Among the normal
practices of a company is to invetigate all variances exceeding RM10,000 or
investigate all similar variances or those exceeding 8% of standard cost.
In a previous illustration, Uniform Expert incurred only 11,400 direct labour

hours compared to 16,000 standard hours allowed. The labour hours
consumption variance which is favourable, almost 29% [(11,400 ă 16,000)/16,000]
less than standard hours may be due to trained and skilled workers. This
variance or difference of 29% can be considered as significant and the
management should investigate further.
There is a probability that the standard labour hour rates determined is too low,
while in normal conditions, a worker can prepare a product in faster time than
the standard time. If this actually occurs, a revision in standard labour hours
must be made to realistically demonstrate the capacity of workers.
You must understand that favourable labour efficiency variance can also occur
when the manager recruits workers that are too skilled or possess qualifications
beyond the required level. Surely workers such as these are more efficient, but
the wage rate may exceed the standard rate. The impact is, the company will face
wage rate variance that is unfavourable.
Materials of good quality and machines that runs smoothly also contributes to
favourable labour efficiency variance. Quality materials may be acquired at a
much higher price, which will be demonstrated in the materials price variance. In
short, we must carefully understand variance because variances that are
favourable sometimes give an adverse effect to other variances and also to the
profitability of the company as a whole.
You should also know repeated variances may need further investigation. With
variance, we can study its trend or direction. Variances that constantly occur and
can be forecasted probably shows that the standard cost which was determined is
not suitable or realistic. If that is the reason, the manager must revise the
standard cost used.

When and How Often Should Variances be Calculated?
Usually, variance analysis is conducted at the end of a certain period, for

example monthly, quarterly or daily according to requirement. If the company
has a business contract with suppliers, and has a good relationship and
understanding with the workers union, the tendency for significant price
variances are less.
Thus comparison between actual cost and standard cost is performed monthly or
quarterly is sufficient. On the other hand, if efficiency variance occurs repeatedly,
the manager may monitor the use of raw materials and direct labour hours every
day, perhaps even every hour. Continuous monitoring is not burdensome, in fact
it is an easy process if systems such as computerised input of data and a bar
coding system are available.
Senior management has to be very careful when using cost variance in evaluating
performance. This is because some source of variances are beyond the control of
managers, for example price increase in the market. You must also understand
that price and efficiency variances are inter-related. For example, a personnel
manager may decide to only employ skilled workers to guarantee the quality of
the product produced. Surely then, wage and salary rate will be more costly. In a
case like this, price variance which is unfavourable may not be balanced wholly
by an efficiency variance which is favourable.
Senior management too must not evaluate the performance of managers based
on one benchmark only. Evaluation based on a single variance will encourage
managers to take actions towards making the relevant variance look good, but
this may lead to an adverse impact on the company in the long-term.
Example 5.5
For example, to reduce cost, the purchasing manager may buy poor quality
materials. As a result, more expenses may be incurred when more products
are defective or returned. The purchasing manager may have bought a large
quantity, more than is needed for the purpose of obtaining a good price and a
discount. The impact is that the company will have to bear a higher inventory
storage cost, and the possibility of materials becoming obsolete, defective and
pilfering will also increase. Due to this, performance evaluation must be based
on several basis or other factors including financial and non-financial
methods.
In addition, the managers also have to shift their focus from positive matters and
to be wary of unexpected impacts or consequences.

ACTIVITY 5.4
Based on your understanding, when should a cost variance be

investigated further?
• From the topic that we have discussed, it can be summarised that a variance
analysis can assist in controlling costs.
• Variances for direct materials, direct labour and overheads can be calculated
through variance analysis using the formulas given.
• Moreover, the manager will also be able to identify significant variances

guided by company and industryÊs best practices, and following their own
respective judgements and criteria.
• Significant variances are usually investigated to pinpoint its causes.
• The following factors are taken into account in determining whether a

variance requires further investigation or not; size of variance, frequency of
varience occurence, trend or direction of variance and controllability of
variances.
• The senior management must exercise caution when using variances for
whatever purposes to prevent any unexpected negative consequences.
Direct materials quantity standard Price variance

Efficiency variance Variable overhead efficiency variance
Fixed overhead budget variance Variable overhead spending variance
Overhead cost

Topic X Productivity
6 and Cost of
Quality:
Measurement,
Report and
Control
LEARNING OUTCOMES
1. Explain the meaning of quality and the concept of production
quality;
2. Identify the categories of cost of quality;
3. Examine the methods of measuring cost of quality;
4. Analyse the cost of quality report; and
5. Discuss the importance of productivity and measurement of
productivity.

166 X TOPIC 6 PRODUCTIVITY AND COST OF QUALITY: MEASUREMENT,
REPORT AND CONTROL
X INTRODUCTION
This topic will discuss the role of management accounting in the measurement of
productivity and quality. Quality is important to all types of organisations,
whether manufacturing or service, whether big or small, because an increase in
quality will increase productivity which in turn increases profitability.
Improvement in quality will increase productivity in two ways, namely:
(a) By increasing customers demand; and
(b) Through cost reduction.
In this topic, you will be introduced to categories of costs of quality which will
assist in the preparation of the cost of quality report. Following that, the
measurement of cost of quality and productivity will be explained.
6.1 MEASURING COST OF QUALITY

In this segment, we will study about measuring cost of quality. Do you know
what is meant by quality?
Quality is defined as compliance to customersÊ expectations. A successful

organisation is one that knows how to fulfill their customersÊ expectations
towards the quality of its products or services.
Organisations will execute activities to overcome poor quality that may or may
not exist. Costs of running these activities are called costs of quality. Before we
examine the costs of quality, it will be good if we first understand the meaning of
production quality. Other than that, we will also be discussing how to measure
optimal production quality.
6.1.1 Production Quality

Previously, we have defined the meaning of quality. Now, we will be discussing
about production quality. There are two concepts of production quality which
sets the level of suitability of a product according to the original purpose it is
meant to be used for.

TOPIC 6 PRODUCTIVITY AND COST OF QUALITY: MEASUREMENT, ◄ 167
REPORT AND CONTROL
(a) Design quality

Design quality refers to the level of compliance between customersÊ
expectations towards a product or services and the specification of that
product or services. For instance, a bicycle that has a seat which is too small
for its user is regarded as not having a precise design quality. This design
quality refers to the product characteristics that differentiate it from other
products with the same function.
(b) Compliance quality
Compliance quality refers to the level of productivity mentioned that meets
the design specification. For instance, a bicycle with a suitable seat will
meet the design specification, but if the seat is broken because the
production process is poor, it becomes useless. The bicycle fails to meet its
compliance quality.
Therefore, both the design and compliance qualities are necessary to attain high
quality of end products.
6.2 COSTS OF QUALITY

Next, we will discuss costs of quality. What do you know about costs of quality?
Costs of quality are costs that arise as a result of a possible occurrence or

actual occurrence of poor quality.
Most managers find that financial information related to quality is useful in

determining the importance of quality problems and in formulating a
comprehensive strategy to improve quality. There are four categories of costs of
quality that are usually monitored see Figure 6.1.
Figure 6.1: Four categories of costs of quality

REPORT AND CONTROL
What is meant by costs of quality? To learn about it, please read the following
explanations.
Costs of Quality Categories

(a) Prevention Cost
This is a cost incurred in avoiding the production of poor quality products or
services. For example, costs of quality training programmes, quality reporting,
evaluation and selection of suppliers, quality planning, quality audit and design
checking.
(b) Evaluation Cost
This is a cost incurred in determining whether products and services comply with
the requirements it was made for or whether it meets the customersÊ needs. For
example, inspection and testing of materials, packaging inspection, supervisory
evaluation activities, product approval, inspection and testing of equipments and
external verification.
(c) Internal Failure Cost
This is a cost incurred when products do not meet specification or customersÊ
needs. Failure to meet specification is identified before the product is delivered to
the customers. For instance, scrap cost, reexamination, retesting and design
changes.
(d) External Failure Cost
This is a cost incurred when products and services fail to meet the requirements or
customersÊ satisfaction after it is delivered to the customer. For example, warranty
cost, cost of product recall, legal fees for product liability and customer complaints.
6.3 MEASURING OPTIMAL PRODUCTION

QUALITY
We have discussed costs of quality in the earlier segment. Next, we will learn
how to measure optimal product quality. Let us recall cost of quality. Costs of
quality are available costs in the accounting records. Hidden costs of quality are
opportunity costs, the result of poor quality products.
According to traditional views, the optimal level of production quality is a

balance between the incurrance of prevention and evaluation costs in one part
and the incurrance of failure costs (internal and external) in other parts. When
the percentage of damaged products fall, prevention and evaluation costs fall.
Following that, internal and external failure costs also fall. Total maintenance,
evaluation, internal and external failure costs are costs of quality. The optimal
level of production quality is at the point where the total costs of quality is at the
most minimum.

REPORT AND CONTROL
Costs of quality discussed before this are costs that can be observed. However, a
few costs of quality incurred by an organisation have a hidden nature. For
example, when there is poor quality products in the market, the customer will
not be satisfied. Consequently, the company may lose sales. The opportunity cost
of losing sales and the reduction of market share are hidden costs to the
organisation and these could be significant. Such costs are difficult to estimate
and report.
However, there are three recommended methods to estimate costs of quality,

namely, as shown in Figure 6.2.
Figure 6.2: Methods for estimating costs of quality
(a) Multiplier Method

The multiplier method assumes that total failure cost is the multiplier of
measurable failure costs.
Total external failure cost = k (measured external failure cost)
Where k is the multiplier effect. The value of k is usually derived from past
experience of the organisation. For example, if the external failure cost is
RM1 million and based on the k experience, k is 3 and 4, thus the total
external failure cost is between RM3 million to RM4 million where this cost
is the external failure cost which also takes into account hidden costs. By
taking into account this hidden costs, it is expected to assist the
organisation in determining with greater accuracy the level of resources
which will be spent on prevention and evaluation activities.

REPORT AND CONTROL
(b) Marketing Research Method

This method is used to evaluate the effect of poor quality on sales and
market share. Among others, questionnaires to customers and interviews
with sales personnel will provide a view on hidden costs and following
that, it can help to project loss of profits as a result of poor quality.
(c) Taguchi Loss Function

The Taguchi loss function assumes that any deviation from the targetted
value of quality features which will result in hidden costs of quality.
L(y) = k(y-T)2
Where,
k = Proportional constant based on the organisationÊs external failure

cost structure
y = Actual value of quality features
T = Targetted value of quality features
L = Quality Loss
To apply the Taguchi loss function, k must be estimated as follows:
k = c/d2
c = Loss at the lowest or highest specification limit

d = Limit distance from targetted value
This means that loss may still need to be estimated for any deviation from
targetted value. When known, hidden quality cost can be estimated.
Let us say that k is RM200 and T is 20cm diameter for the product of which
quality is to be measured. If the actual diameter of the product is 20.4cm,
therefore the quality loss is,
L(y) = k(y-T)2
L(20.4cm) = RM200(20.4cm-20cm)2
L(20.4cm) = RM32
REPORT AND CONTROL
This means, if the product diameter is different by 0.4cm from targetted, loss
incurred is RM32 for each unit.
SELF-CHECK 6.1
1. What is the balance that must be taken into consideration in

preparing information for the purpose of cost of quality
management when part of the cost of quality has to be estimated?
2. How does the improvement in quality reduce the cost of quality?
6.4 REPORTING COST OF QUALITY

INFORMATION
In this section, we will discuss about reporting cost of quality information. Have
you ever thought why cost of quality need to be reported?
As a first step in the programme towards improving quality, an organisation will

usually formulate a cost of quality report. A detailed list of current actual costs
according to categories will assist managers in evaluating the financial impact, at
the same time evaluate the relative importance of each category of cost.
6.4.1 Cost of Quality Report

Cost of quality report lists costs of quality according to categories; prevention
cost, evaluation cost, internal cost failure and external cost failure. The financial
impact from cost of quality is easier to evaluate when it is stated as a percentage
of sales. The following Table 6.2 demonstrates an illustration of a cost of quality
report.

REPORT AND CONTROL
Table 6.2: Cost of Quality Report

SYARIKAT PLASTIK JINGGA
Cost of Quality Report
For the year ended 31 December 2007
Total Sales
(RM) Percentage (%)
Prevention Costs:
Systems development 405,000 0.54
Quality training 195,000 0.26
Supervision of prevention activities 60,000 0.08
Quality improvement project 315,000 0.42
Total prevention costs 975,000 1.30
Evaluation Costs:
Inspection 840,000 1.12
Endurance test 630,000 0.84
Supervision of test and inspection 120,000 0.16
Depreciation of test machine 210,000 0.28
Total evaluation cost 1,800,000 2.40
Internal Failure Costs:

Net scrap cost 1,125,000 1.50
Labour rework and overhead 1,215,000 1.62
Downtime due to poor quality 150,000 0.20
Disposal of poor quality product 510,000 0.68
Total internal failure costs 3,000,000 4.00
External Failure Costs:

Repair warranty 1,350,000 1.80
Replacement warranty 3,450,000 4.60
Allowance 945,000 1.26
Field services cost 1,980,000 2.64
Total external failure costs 7,725,000 10.30
TOTAL COST OF QUALITY 13,500,000 18.00
Note that in Table 4.2, the percentage cost of quality failure from sales is high. At
the same time, the percentage cost of prevention and evaluation costs from sales
are low. In this situation, the company can improve quality management if the
incurred failure cost is reduced whereas focus on the incurrance of prevention
and appraisal costs are given in the best manner possible so that cost of quality as
a whole, can be reduced.

REPORT AND CONTROL
6.5 PRODUCTIVITY
What is meant by productivity?
Productivity refers to the production of output in an efficient manner by

looking at the relationship between input used compared to the output
produced.
Comprehensive productive efficiency is the level where two conditions are met
namely:
(a) For any combination of inputs that will produce output, there is no one
input that will be used exceeding the requirement for production of the
said output; and
(b) With combination of inputs that meets condition (i), the combination which
has the lowest cost will be chosen. Condition (i) is referred to as technical
efficiency, whereas condition (ii) is input balance efficiency. Any
productivity improvement programme is aimed at achieving a
comprehensive productive efficiency.
6.5.1 Productivity Measurement

What is meant by productivity measurement?
Productivity measurement is an evaluation of change in productivity that is,

to see whether productivity efficiency has increased or otherwise.
If actual productivity measurement is made, it will enable the managers to

evaluate, monitor or control changes.
If prospective productivity measurement is made, it will be a form of

measurement for the future and becomes an input to strategic decision-making.
Prospective measurement enables managers to compare the advantages of input

combinations, to choose input and a combination of input that will give the best
advantage. Productivity measurements can be formed for each input for
example, materials or labour measured and separately be called fractional
productivity measurement. This measurement can also be made for all inputs
simultaneously and is called a comprehensive productivity measurement.

REPORT AND CONTROL
However, in practice, not all inputs can be measured, the impact being, only
measurements deemed relevant as the organisation performance and success
indicator may be measured. This is because index in an aggregate and
comprehensive form is complex and difficult to measure. Therefore, in this
section, only fractional productivity measurement will be discussed in detail.
6.5.2 Fractional Productivity Measurement

The measurement of one input is calculated by the ratio of output to input as
follows:
Productivity Ratio = Output/Input
Productivity ratio can be calculated by quantity value or financial value. For

operational purposes, this measurement will be compared with the productivity
measurement figure in the nearest previous period, for instance, previous
production batchÊs measurement or previous weekÊs productivity measurement.
But for the purpose of strategic evaluation, usually the previous years
measurement figures are used as the basis of measurement.
For instance, in the year 2007, the number of units produced is 100,000 units
using 25,000 direct labour hours. This means that the productivity ratio is 4 units
per direct labour hour. The year before, in the year 2006, production is 75,000
units using 25,000 direct labour hours that is 3 units per direct labour hour.
Therefore, in the period of one year, productivity has increased by 1 unit per
direct labour hour.
Fractional productivity measurement assists managers in focusing its attention to

the use of certain input. It is easy to understand and is used to evaluate
performance of operations staff.
For example, a labourer can easily relate the meaning of number of units
produced per hour for the purpose of evaluating his performance. Though in a
higher learning institution, the measurement of lecturersÊ productivity is the
number of articles published in journals in a year.
However, fractional measurement if evaluated on its own can also give an

inaccurate or deviated meaning. This is because the reduction of a certain input
may be needed to increase the measurement of other productivity inputs. For
example, if the measurement of number of articles published in a journal in a
year is added for a lecturer, the focus on effective teaching time will decrease.

REPORT AND CONTROL
Also, if direct labour hour is reduced to produce the same number of output,
perhaps raw materials input may be wasted because the worker has to work faster
and eventually the total output compared with the end input remains the same.
Therefore, fractional measurement must be used with care and with clear
understanding about the actual critical success factor of an organisation.
ACTIVITY 6.1
1. What is the capability of the fractional productivity information

contribution when used for the purpose of strategic planning?
2. Is productivity something that can be measured quantitatively?
Discuss.
• Products and services quality is now the main factor in determining the
success or failure of a firm in the global market.
• Many firms now monitor the costs of maintaining the quality of their
products.
• Costs of quality are usually classified into categories: prevention cost,

evaluation cost, internal failure cost and external failure cost.
• Other than observed costs of quality, firms may also face hidden costs of quality.
• Contemporary perspective on product quality maintains the view that the

optimal level of quality production will occur at zero damage level where
both costs of quality can be observed and hidden costs of quality will be
considered.
• Productivity is related to how far input efficiency (for example materials and
labour) is used to produce output (products or services).
• Fractional productivity measurement evaluates efficient usage of a singular

input.
• The measurement of comprehensive productivity evaluate efficiency for all

simultaneous inputs.

REPORT AND CONTROL
• Improving quality may increase productivity and vice versa. This is because
most improvement in quality will reduce the amount of resources used to
produce and sell the output of the company.
• With that, productivity will increase. For instance, if less defective units are
produced, less reworking will be done.
• Following that, measurement of productivity will increase because less inputs

are used to produce output (because there is no need for reworking).
• However, a firm may produce a good product but may still have an
inefficient process. It has quality products but do not have high measurement
of productivity.
Compliance quality Productivity

Design quality Productivity measurement
Faulty product Quality products or services

Topic X Accounting
7 Information
for Pricing
Decisions
LEARNING OUTCOMES
1. Identify the main factors that influence pricing;
2. Analyse economic pricing model;
3. Calculate pricing using cost-based formula;
4. Apply activity-based costing in evaluating customersÊ
profitability; and
5. Discuss the importance of target costing and pricing.
X INTRODUCTION
You may be used to haggling prices when making purchases at the market or
making price comparisons before deciding to buy your essential goods. Actually,
pricing decisions are important to some organisations because a high price may
deter customers from making purchases, while a very low price may result in the
organisation having to bear the cost. Manufacturers determine the price for the
goods they produce, the retailer determines the price of the goods they sell, while
service organisations determine the price for plane tickets or legal services
offered.
However, for some organisations that sell a product which has a pre-determined
price in the market, pricing becomes much easier. For example, raw palm oil has
a set market price. Customers will not pay more for the product, and the seller,
rationally will not want to sell it at a lower price. In this topic, you will be

178 X TOPIC 7 ACCOUNTING INFORMATION FOR PRICING DECISIONS
exposed to pricing methods and issues related with pricing decisions such as the
ones faced by the management of an organisation.
7.1 MAIN FACTORS INFLUENCING PRICING

Many people will surely complain when price of goods in the market increase.
But do you know that there are many factors that influence pricing? Among the
main factors include:
(a) Demand and supply;

(b) Competitors and customers behaviour;
(c) Cost; and
(d) Political and image issues.
CustomersÊ demands for a product can influence the price of the product, and in
the case of some goods, the government has to intervene and control the price of
such goods because it is the basic necessity of the community. High demand for
certain goods or services is associated with high price, and when demand falls,
the price will also be set lower.
You will notice that low-peak season room rates are offered by the hotel
management during non-school term breaks or weekends. The hotel
management realises this low demand thus makes an effort to attract customers
by offering a lower price to ensure their services can continue to operate.
Therefore, the management has to understand and continuously project customer

demand because it is extremely critical to the continuance of their operations.
This can be done through market research and obtaining feedback from
questionnaires completed by customers.
Supply of certain goods will also influence price where, a high supply is
associated with low price and vice versa. You may still remember the sugar
shortage in the market in mid-2006 which resulted in sugar being sold at a higher
price in some supermarkets in Malaysia.
Apart from demand and supply in the market, competitor behaviour can
influence the price of a particular product. During the Âshopping monthÊ period,
certain products sold in the supermarket can be obtained at a lower price because
the supermarketÊs management must ensure that they can maintain their market
share.

TOPIC 7 ACCOUNTING INFORMATION FOR PRICING DECISIONS W 179
At the same time, customer reaction in obtaining high quality goods can also
influence high pricing, for example, treatment cost in a private hospital is much
higher than that in government hospitals because the services are for those who
can afford to pay such a price in return for guaranteed satisfactory services.
Therefore, the management must practise due care in identifying their products
and market.
Cost is another factor that can influence price even though the cost advantage in
this case may be different according to the type of industry. In some industries,
price is solely determined by market forces. However, to earn profits, production
cost must be below the market price, if not, the company will incur losses. In
general, the balance between the market price that the customer is willing to pay
and the costs incurred by the company will determine the price of the particular
product.
Another factor just as important in influencing price other than market forces
and costs is political and image factor. The image of a brand often influences
price because of publicÊs perception associates it with quality. For example, the
public do not expect any car models from Mercedes will be sold at a comparable
price as a Nissan.
Meanwhile, political influence plays a part when the public realises that an
industry is excessively profiting through their pricing. A ceiling price will be set
to counter some problems, for example a ceiling price will be set when the price
of dressed chickens increases, even though the price increase can be attributed to
reduced supply. Political influence may also possibly allow certain industries to
increase the price of their products or services even though the public may not
agree with this increase, for example, price increase for petrol and tolls.
ACTIVITY 7.1
Do you still remember the increase in world petrol price in the early
20th century? The impact of this price increase was felt by all level of
society in Malaysia until now. Why do you think this happened?
Discuss.

7.2 ECONOMIC PRICING MODEL

Many economists have devoted their careers studying the core theory of pricing.
According to economic models, the goal of an organisation is to maximise profit,
while revealing the function of cost and revenue. The increase in quantity of sales
is followed by the reduction of selling price, causing marginal revenue to
decrease with the increase in sales. Following that, the increase in production will
result in the increase in marginal cost.
What is meant by marginal revenue?
Marginal revenue is the change in the increase of total revenue due to the sale
of one additional unit of product. Marginal cost is the incremental change in
total cost needed to produce and sell an additional unit of product.
In an economic model, maximum profit can be attained when the sales volume is
at a level where marginal revenue equals marginal cost and at this point the ideal
price is achieved.
7.2.1 Problems of Economic Pricing Model

Even though the economic model for pricing will provide a useful framework in
determining price, a survey has shown that the managers, in practice, do not use
it. Among the limitations of this economic model is the difficulty in determining
accurately the ideal price where marginal revenue equals marginal cost. Perfect
information is needed in an unending time period. Many profit-oriented
organisations will try to achieve target profit and not maximum profit.
This is because it is difficult to determine a set of actions that will lead to

maximum profits. When sourcing for information, the management accountant
will often consider the question of cost and benefit from that information.
Therefore, for the purpose of making pricing decisions, they will also consider
the question of production cost itself.

Figure 7.1: Marginal revenue and marginal cost curve
SELF-CHECK 7.1
Why is pricing using the economic model not used widely in practice?
7.3 PRICING USING PRODUCTION COST

INFORMATION
Many managers weigh into consideration the product cost in determining price.
The use of product cost in pricing becomes important because a price based on
this is easy to defend. The price of products or sevices determined based on cost
is said to provide justified profit to producers.
In addition, information about cost is readily available. This is because, for

organisations that produce various types of products and services, they will need
a long period of time to conduct a market analysis for all of their products.
Therefore, cost information will provide them a quick and easily defended basis
in determining pricing.
Traditionally, the basis of pricing for a new product is initiated through a market
survey on customers needs, followed by product design, pricing and adding
mark-up on costs.

Figure 7.2: The basis of pricing for a new product
Using cost as a basis, the price for products and services cost is added with
sufficient mark-up to bear costs that are not allocated and to earn profits.
7.3.1 Cost Approach for Companies with Single

Product
Here, we will discuss the cost approach for companies with a single product. If a
company only produces one type of product, pricing is easier as long as all costs
incurred, the amount of units sold and profit desired are known.
Example 1
Perkilangan Ubi Sedap produces flavoured potato crisps with a fixed cost of
RM10,000 per year. The management requires RM5,000 profit for 5,000 packets of
potato crisps. The variable cost for a packet of crisp is RM1. Assume all flavours
have similar costs. Using the profit calculation formula, the price of one packet of
potato crisp is RM4.00 which is calculated as follows:
Profit = Total Revenue ă Total Cost

RM5,000 = (Price per unit X 5,000 units) ă (RM1 X 5,000 + RM10,000)
5,000 x Price = RM5,000 + RM15,000
Price = RM4

Even though the price can be calculated based on available cost information,
pricing has to be done by taking into account market conditions such as the
readiness of customers to pay that price or the behaviour of the competitor.
7.3.2 Cost Approach for Companies with Multiple

Products
We have discussed the cost approach for companies with single product. Now,
we will discuss the cost approach for companies with multiple products. Before
this, have you ever thought how companies ensure that price determined for
each type of product produced will be profitable?
Products and services pricing for companies that produce multiple products will
take into account the profit required for the whole company and the price for
each different types of product. For this cost approach, this will generally be
done by taking into account costs incurred in producing the products and
suitable mark-up to bear unallocated costs for the product and at the same time
earn profits as desired by the company.
Price = Cost + (Mark-up Percentage X cost)
Using the price formula as stated, you may ask, what is the best basis to calculate
cost and how is the mark-up calculated? For the purpose of cost calculation,
actually there is not one definition for the purpose of pricing. It depends on
whether price estimated is for the short-term or long-term. Product cost of a
company can be defined using:
(a) Absorption cost, or
(b) Variable cost.
Most companies find it easier to justify cost by using an absorption cost-based

formula where all manufacturing costs are taken into account as product cost.
Perhaps, a wider definition is used where product cost takes into account all
manufacturing costs and sales and administrative costs. One weakness in using
this absorption cost approach is, it does not describe the behaviour pattern of
companyÊs cost.
This means, it is not clear how the total cost of the company will change with the
change in the production or sales volume because the fixed cost element is also
taken into account in the calculation of cost. (You can refer to the absorption and
variable costs approach explanation before this to see how the effect of fixed cost
is taken into account in the calculation of product cost).
If variable cost is used, product cost takes into account all variable manufacturing
costs or all variable costs including variable sales and administrative cost. Using
the variable cost to calculate consistent product cost through profit volume cost
analysis can be used by managers to evaluate the implication on profits when
there is a change in price or volume. The use of this variable cost approach does
not require allocation of fixed cost on production cost which may be done
arbitrarily.
Following that, this fixed cost is usually calculated on per unit basis until it is
treated as variable cost and this can confuse the behaviour pattern of cost. In the
short-term, variable cost may be suitable for use, especially if the company needs
to determine price of a specially ordered product from a customer.
However, in the long run, the approach of taking into account only variable cost
can cause the company to set a low price and the company having to bear the
whole production cost to remain sustainable. Because of this, the company has to
be clear about using a higher mark-up if the variable cost approach is to be used.
To make it easier to understand the use of absorption cost and variable cost in
pricing, try and follow the following example:
Example 2
Syarikat Jaya is a producer of leather handbags. The company would like to set
the price of a newly-introduced handbag model. The Accounting Department
has prepared information for the new product with estimated costs as follows:
Cost Per Unit Total
Raw materials 3
Direct labour 2
Variable manufacturing overhead 5
Fixed manufacturing overhead 30,000
Sales and administrative expenses (variable) 2
Sales and administrative expenses (fixed) 40,000
The company produces 10,000 units of bags and RM5,000 profit is required
above the cost for the bag.

If Syarikat Jaya uses the absorption cost approach where it takes into account the
manufacturing costs (raw materials cost, direct materials cost, fixed and variable
manufacturing overheads) in the calculation of product cost, the price can be
determined as follows:
Price = Cost + (Mark-up percentage X

cost)
= RM13 + (50% X RM13)
= RM19.50
If Syarikat Jaya uses the variable cost approach where it takes into account the
variable manufacturing costs (raw materials cost, direct materials cost, fixed and
variable manufacturing overheads) in the calculation of product cost, the price
can be determined as follows:
Price = Cost + (Mark-up percentage X

cost)
= RM10 + (95% X RM10)
= RM19.50
Notice that in the pricing example above, Syarikat Jaya will set the same price for
the product produced even though different cost-basis are used. This is because
the mark-up percentage used is different. Assuming that the mark-up percentage
used is the same, surely the price is lower if the variable manufacturing cost is
used. Here, we can see how important it is for the company to understand what
costs should be covered, determining mark-up on different cost-basis so that the
company can continue enjoying profits.
7.3.3 Determining the Mark-up Percentage

Next, we will learn how to determine the mark-up percentage. Look at the
statement as follows.
There are situations that make it possible for a company to give a special price to
a certain customer where not all costs are borne in pricing. Think of how fitting
this decision is and whether this situation will cause losses to the company.
In general, if the manufacturing cost is made the basis for calculating product
cost, mark-up calculated must be able to cover non-manufacturing cost and
generate profit as required by the company. If variable manufacturing cost is

used, the mark-up calculated will cover fixed manufacturing cost, non-
manufacturing costs and generate profit to the company.
The general formula for calculating mark-up is as follows:
Cost not included in basic cost + Required profit

Mark-up cost =
Basic cost
Using the above example, the mark-up charged is derived as follows:
When product cost is calculated based on manufacturing cost:

Mark-up cost =
Basic cost
RM60,000 + RM5,000
=
RM130,000
= 0.50
When product cost is calculated based on variable manufacturing cost:

Mark-up cost =
Basic cost
RM90,000 + RM5,000
=
RM100,000
= 0.95
You may also like to know how a company determines the amount of profit that
it requires, in the example of Syarikat Jaya, how the amount RM5,000 determined
as the profit required? What is considered normal or reasonable profit margin?
Even though managers usually use their judgement and experience in
determining the most appropriate mark-up, a more formal method is usually
based on target profit on the capital invested.

Assuming Syarikat Jaya invested a capital of RM25,000 for the purpose of

producing a new model of leather handbag. The company hopes to attain 20
percent return from total assets invested. The target profit of RM5,000 is shown
in setting the mark-up above is calculated as follows:
Average Investment of Capital X Target Return on

Investment = Target Profit
= RM25,000 X 20%
= RM5,000
Whatever basic cost is used, a manager who is rational will determine the
percentage of mark-up to be able to bear the comprehensive product cost
produced and simultaneously generate profit for the company.
7.3.4 Limitations on the Use of Cost Approach

If the product life span is long and relatively, the market is not as competitive,
the cost approach can provide a starting point in setting price. However, current
competitiveness in the business world limits purely cost-based formula and
requires the manager to consider a lot of other factors. Among the limitations of
cost approach in determining price are:
(a) Pricing using basic cost requires accurate calculation of product cost.
Mistakes in cost calculation can cause setting a too high price resulting in
loss of market share or too low price will result in reasonable profit will not
be enjoyed by the company;
(b) Costs must be allocated to the product accurately. The more parts of costs not
allocated, the higher the possibility of lower pricing than is reasonable; and
(c) Pricing using cost approach assumes that customers are willing to pay for
that price. This assumption can be questioned especially when there exists
intense competition for that product in the market.
Even though relative pricing is easier by taking into account available
information in companyÊs records (that is total product cost and adding it with
target profit), the use of basic cost in pricing for a less competitive product and
services, especially when the difference in price is minimal for the same product
can determine the success of a company.

ACTIVITY 7.2
What happens when a price determined by a company is not accepted

in the market? Can you imagine the pricing situation that is faced by
managers? Discuss.
7.4 CUSTOMER PROFITABILITY ANALYSIS

USING ACTIVITY-BASED COSTING
In the Management Accounting I course, you were introduced to the concept of
activity-based costing (ABC). You can refer to that topic on how the ABC
approach is able to give a more accurate view in the calculation of product cost
when the activities are classified according to the levels of units, batches and
facilities.
Indirectly, limitations in the use of cost approach stated in section 7.3.4 can be
overcome when cost allocation, especially costs classified as indirect in
traditional costing can be done accurately using ABC. This will simultaneously
assist managers in determining price and following that calculate profits with
confidence. ABC will also provide a more accurate information on profit
generated from different lines of products and identify the presence of activities
that do not add value to the customer.
Something which is apparent is the importance of customers in contributing to

the profit of the company. However, some customers can be more profitable
compared to others and it is not surprising that there are customers who can
cause losses to the company. The rationale is, by making an assessment on the
potential of their customers, the company can accurately target their required
profit and following that increase their overall profits. However, how does a
company identify these groups?
ABC assists in the preparation of information for managers to conduct an

evaluation on their clients through customer profitability analysis.

Example 3
Serama Inds receives an order from its customer, Syarikat Sedili, for the supply
of two products, namely Standard Bricks and Special Bricks. Serama Inds uses
ABC to calculate its production costs.
Activity cost level as calculated by the companyÊs accountant is as follows:
Customer order RM31.50 per order
Product design RM128.50 per design
Order size RM1.90 per labour hour
Customer relations RM367.50 per customer
Information related to product ordered by Sedili is shown below:
Standard Bricks Special Bricks
(no design activity (new design activity
required) required)
Price per unit RM3.40 RM65
Order unit 400 units Per unit
Number of orders 2 orders Once a year
Raw material cost RM211 RM1.30
Labour cost RM185 RM5.00
Delivery cost RM 18 RM2.50
Labour hours required 0.5 hours 4 hours
Required:
The company would like to know the margin for both of its products and the
sales margin for Sedili.

Calculation:
Product Margin
Standard Bricks
Sales RM1,360
Cost:
Raw materials RM211
Direct labour 185
Delivery cost 18
Customer order (RM31.50 X 2) 63
Product design -
Order size (RM1.90 X 400 units X 0.5 hours) 380 857
Product margin RM503
Special Bricks
Sales RM65.00
Cost:
Raw materials RM1.30
Direct labour 5.00
Delivery cost 2.50
Customer order (RM31.50 X 1) 31.50
Product design 128.50
Order size (RM1.90 X 1 units X 4 hours) 7.60 176.40
Product margin (RM111.40)
Customer Margin:
Syarikat Sedili
Product Margin:
• Standard Bricks RM503.00
• Special Bricks (111.40)
Total Product Margin 391.60
Less: Customer Relations 367.50
Customer Margin RM24.10

Example 4
Serama Inds receives an order from its customer, Syarikat Sedili, for the
supply of two products, namely Standard Bricks and Special Bricks. Serama
Inds uses ABC to calculate its production costs.
Activity cost level as calculated by the companyÊs accountant is as follows:
Customer order RM31.50 per order
Product design RM128.50 per design
Order size RM1.90 per labour hour
Customer relations RM367.50 per customer
Information related to product ordered by Sedili is shown below:
Standard Bricks Special Bricks
(no design activity (new design activity
required) required)
Price per unit RM3.40 RM65
Order unit 400 units Per unit
Number of Orders 2 orders Once a year
Raw material cost RM211 RM1.30
Labour cost RM185 RM5.00
Delivery cost RM 18 RM2.50
Labour hours required 0.5 hours 4 hours
Required:
The company would like to know the margin for both of its products and the
sales margin for Sedili.
Calculation:
Product Margin
Standard Bricks
Sales RM1,360
Cost:
Raw materials RM211
Direct labour 185
Delivery cost 18
Customer order (RM31.50 X 2) 63
Product design -
Order size (RM1.90 X 400 units X 0.5 hours) 380 857
Product margin RM503

Special Bricks
Sales RM65.00
Cost:
Raw materials RM1.30
Direct labour 5.00
Delivery cost 2.50
Customer order (RM31.50 X 1) 31.50
Product design 128.50
Order size (RM1.90 X 1 units X 4 hours) 7.60 176.40
Product margin (RM111.40)
Customer Margin:
Syarikat Sedili
Product Margin:
• Standard Bricks RM503.00
• Special Bricks (111.40)
Total Product Margin 391.60
Less: Customer Relations 367.50
Customer Margin RM24.10
From the example above, the product margin calculated shows that Special
Bricks is causing a loss to Serama Inds. Following that, when wanting to know
whether it would be profitable or otherwise to retain its customer, Sedili, Serama
Inds calculates the customer margin and finds that the loss can be absorbed with
the order for Standard Bricks. Note that the incurred cost from customer relations
activities was deducted from the margin at this level. What the management can
probably act upon is the pricing set for Special Bricks, which is low compared to
its production cost.
7.5 TARGET COSTING AND PRICING

In the previous section, it was explained that pricing begins with the calculation
of product cost and the determination of mark-up to attain a suitable price. The
discussion assumes that the product has already been developed, costs have
already been calculated and is ready to be marketed when the price is set.
However, in the current business environment that focuses on customers needs,
these pricing steps may not necessarily be followed. Especially for companies
that produce new products, market research will be conducted to survey
marketability and price the customer is willing to pay if the product is produced.
At times, for some products and services, the price has been agreed upon and the

managementÊs task is to develop the products or services that can be marketed at

the desired price.
Target costing is the process of determining the maximun cost allowed for a new
product designed and manufactured in a profitable way. The target cost is
calculated by estimating the sale price less the desired profit.
Target Cost = Target Sale Price ă Desired Profit
Assuming that Syarikat Jaya feels that there is market for leather handbags with
a distinctive handle. Through a market survey, the company finds that the price
of RM60 is suitable for that bag. At that price, the company expects to sell 4,000
units of bags per year. To design, develop and produce the bag, capital
investment of RM200,000 is needed. The company requires a 15% return on the
investment. The target cost can be calculated as follows:
Expected sales (4,000 X RM60) RM240,000

Less: Required profit (15% X RM200,000) 30,000
Target cost for 4,000 bags 210,000
Target cost per unit 52.50
This cost of RM52.50 will then be further divided according to the various
functions, among others, production, marketing and distribution. Each function
will be responsible for ensuring that their costs remain as targetted.
ACTIVITY 7.3
How does ABC assist companies in using target costing in pricing?

• Decision-making in setting price requires careful consideration and would

have to take into account many factors that can be controlled by the company
internally, such as costs, and external factors, such as consumer needs and
competitor situation.
• According to economic theory, under certain assumptions, the price that

generates maximum profit is determined by the meeting point between the
marginal revenue and marginal cost curves.
• However, the economic pricing model is too restricted by its assumption and
the need for information that is difficult to acquire.
• Most companies set price by using cost as a foundation.
• Price formula based on additional mark-up needs a clear definition of

production cost and justification in the calculation of mark-up.
• Mark-up calculated must be sufficient to enable the price attained to bear

incurred costs and generate profits to the company.
• Using cost information from activity-based costing approach (ABC) increases

accuracy for the setting of price in most situations.
• Customer profitability analysis can be conducted to provide information to

the organisation whether to retain or proceed with an action towards their
profitable or unprofitable customers.
• However, one thing that must be given due attention is the role of the market
in determining price.
• Target costing focuses on the customer and the price they are willing to pay.
This is different from cost-based costing.
• Target costing sets price first before working backwards to ensure that the
production cost incurred is less than the price and the organisation can still
gain profit. This is especially necessary for new products to be marketed.
• Indirectly, the organisation can ensure that the product produced will be
accepted in the market.

Cost-based pricing Mark-up

Marginal cost curve Production cost
Marginal revenue curve Target costing

T op i c X Performance
8 Evaluation in
Decentralised
Firms
LEARNING OUTCOMES
1. Explain responsibility accounting and types of responsibility
centres;
2. Discuss the reasons why firms choose decentralised structure;
3. Elaborate the need for segmented reporting;
4. Calculate return on investment, residual income and economic
value added;
5. Apply balanced scorecard for performance measurement; and
6. Identify the steps that must be considered for a benchmarking.
X INTRODUCTION
In a small business that is a solely owned and run by its proprietor, the question
of monitoring staff is usually done directly by the proprietor because he is
physically close to the operationÊs premise. However, imagine a huge
supermarket like Jaya Jusco which has a network that spans throughout
Malaysia. Every Jaya Jusco supermarket for example, will have its own manager
with various departments under its management. There will also be various
levels of management, for instance, in the Jaya Jusco Seremban 2, that are needed
to run the daily operations of the supermarket. How does a firm that has many
branches like Jaya Jusco, monitor each outlet and manage every one of these
outlets? How do they ensure that each outlet will operate towards attaining the
TOPIC 8 PERFORMANCE EVALUATION IN DECENTRALISED FIRMS W 197
same Jaya Jusco goals? Is there a possibility of the existence of competitiveness

among outlets and the spirit of Âwe-nessÊ among outlets?
Actually, when an organisation expands and has many staff, it is impossible for
senior management to directly monitor all their staff or to make all decisions
related to business operations at different locations. It is appropriate for the
senior management to delegate authority for decision-making to their immediate
staff or managers at branch level. This topic will discuss the delegation of
responsibility and how monitoring needs to be done so that the original goals of
the organisation is maintained at all departments or branches, even though at
different locations.
8.1 RESPONSIBILITY ACCOUNTING

In this section, we will learn about responsibility accounting. How does an
organisation determine type of responsibilities of a department or its branch?
In general, a company can be arranged according to its responsibility. The

organisational chart usually begins with its chief executive officer, middle
managers and junior managers and flows down to its other staff. The
management system often conforms to this line of responsibility and formulates
responsibility centres so that a set of certain activities can be made accountable to
certain managers to facilitate monitoring and control.
A responsibility centre is one part or segment in an organisation where the

manager will be responsible for activities of that segment. Responsible
accounting is therefore a system that measures revenue for each responsibility
centre according to the information needed by the managers to run the
operations at the centre.
In general, ther are four types of responsibility centres practised by an

organisation, as shown in Figure 8.1.
Figure 8.1: Four types of responsibility centres

198 X TOPIC 8 PERFORMANCE EVALUATION IN DECENTRALISED FIRMS
To know further about each type of responsibility centres, please refer to

Table 8.1.
Table 8.1: Types of Responsibility Centres
Types of Responsibility Centres

(a) Cost Centres
This is a responsibility centre where its manager is responsible for the incurrence of
costs. For example, the Assembly Department at a factory is a cost centre. The
supervisor will be able to control the incurrence of cost in the assembly of goods at
the factory but has no authority in setting the price of those goods. For the puprose
of performance evaluation, the supervisor will be evaluated on how far costs are
controlled.
(b) Revenue Centres
This is a responsibility centre where its manager is responsible only for the revenue
or sales attained. For example, the Marketing Department manager has the
authority only in setting price and planning sales. It is a revenue centre and for the
purpose of performance evaluation. The manager will be evaluated based on total
sales achieved and direct costs from the Marketing Department.
(c) Profit Centres
This is a responsibility centre where its manager is responsible for both incurrance
of costs and the revenue achieved. For example, the manager of a hotel is made
accountable for revenue and incurred costs of the hotel. Usually, they will be
evaluated by comparing target profits and the actual profit achieved.
(d) Investment Centres
This is the responsibility centre where its manager is responsible for revenue, costs
and investments made. For example, the manager of a multinational subsidiary is
usually responsible for the profit achieved by the subsidiary and has the authority to
make capital investment decisions such as the closure of factory or the termination of
a production line. They will be evaluated based on the responsibility given. Among
the usual measurement used is the return on investment or residual income. Both
measurements will be discussed in this topic in the following sections.
ACTIVITY 8.1
If the marketing manager makes a decision to offer frequent price
discounts to customers and sales continues to increase, what is the
impact on the Production Department?

8.2 MEASURING COST OF QUALITY

An organisation that has many responsibility centres will usually choose to
manage their many and perhaps complex activities by making either centralised
or decentralised decisions. If the decision is centralised, only top level managers
will make the decision whereas middle and lower level managers will execute
that decision. Conversely, in a decentralised firm structure, decison-making
empowerment is not centralised to several top managers only but is spread
throughout the organisation.
The authority for decision-making is delegated to the lower levels. A very

decentralised structure will empower the managerial level and lower, or even the
workers themselves to make decisions. Conversely, an extremely centralised
structured organisation gives minimum decision-making powers to the lower
level managers. Most organisations will lie between these two extremes although
the current trend favours a more decentralised structure. Why is this so?
There are several reasons that would lead an organisation to choose this
structure. Among the advantages of a decentralised structure are as shown in
Table 8.2.
Table 8.2: Advantages of Decentralised Structure
Advantages of Decentralised Structure
(a) Senior managers will be able to focus on decision-making at a higher level because
they are less burdened by daily matters. Therefore, focus can be given to strategic
matters and not on operations.
(b) Junior managers often possess latest and more detailed information about local or
localised conditions compared to senior managers. Decision-making related to
operations is usually done better by managers at the lower level.
(c) Enables speedier feedback to customers when empowerment of decision-making is

delegated to junior managers.
(d) Decentralised structure gives opportunity to junior managers to gain experience in

decision-making as a preparation when they are promoted to higher level posts.
(e) Giving or delegating responsibility to lower level managers will increase

motivation of the said managers and following that, will increase job satisfaction
and encourage better performance in the future.

Even though the advantages of a decentralised system is very obvious, a few

factors have to be considered by management in executing their tasks because a
decentralised system too has a few disadvantages. Among them are as shown in
Table 8.3.
Table 8.3: Disadvantages of Decentralised Structure
Disadvantages of Decentralised Structure
(a) Junior managers may possess an advantage in acquiring more detailed information
on local operations or their job scope. However, senior managers have more
information and understanding about the organisation as a whole and the strategies
to be executed. Therefore, junior managers may make decisions without a clear
understanding of the overall picture. The effect being, decisions made may not be in
line with the organisationÊs needs.
(b) The junior managerÊs objective may differ from the overall objective of the
organisation. They may want to strengthen their department or branch to the
detriment of other departments or branches.
(c) For example, Syarikat Maju JayaÊs branch in Johor would like to increase the size of
their market to extend to the whole of southern of Peninsular Malaysia. Because
Syarikat Maju Jaya already has a branch in Melaka, this planned expansion by the
Johor branch will be considered as a threat to the Melaka branch. What is being
planned by the Johor branch may not increase the overall profit of the company,
whilst creating unwarranted conflict among these two branches.
(d) In an extremely decentralised system, coordination among department and branch

managers will be less.
(e) In general, it is difficult to pull off an extremely decentralised system because there
may be an individual in the organisation who is a great thinker and may contribute
for the benefit of all. If an order is not centralised, these ideas may not be channeled
systematically and benefit other sections in the organisation.
The disadvantages outlined in Table 8.3 can be overcome if the companyÊs

strategies are outlined clearly and communicated throughout the organisation.
Effective information system among branches will also give room to the
channeling of creative thinking to everyone in the same organisation.
Other than that, managers must be rewarded to motivate them to achieve the
overall goals of the organisation so that the objectives of the department or
branch do not deviate from the organisationÊs desires.

Goal congruence occurs when managers in a sub-unit in an organisation are

commited in achieving the goals of the organisation and at the same time fulfill
personal goals. This is what should be achieved by the organisation to ensure
management efficiency. One of the ways in ensuring that the manager of the
responsibility centre is still executing objectives that are in line with the
objectives of the organisation as a whole or to achieve this congruence is through
the formulation of an effective performance evaluation system.
SELF-CHECK 8.1
How does a multinational organisation benefit from a decentralised
firm structure of its management?
8.3 DECENTRALISED FIRMS AND SEGMENTED

REPORTING
We have learned about the structure of a decentralised firm. Now, we will learn
about decentralised firms and segmented reporting. In ensuring effective
disemination of information, decentralised firms require segmented reporting in
addition to the firmsÊ comprehensive report. The segment meant here may be
certain sections of the organisation or specific activities where information on
costs, revenue or profit be made known to the manager.
In this section, you can see how an income statement for a segment is presented.
This statement is useful in assisting managers in analysing profit for each
segment and measure performance of the segment managers.
To form an income statement according to segments, costs must be separated

between the firmsÊ general costs allocated to that segment and costs that can be
trace directly to the segment.
For example, in a supermarket consisting of stationery and childrensÊ clothes

departments. The cost of managerÊs wage for the stationery department can be
trace directly to the department, whereas the wage of the supermarket manager
is a general cost that is allocated for both the stationery and childrenÊs clothes
departments. The segmentÊs direct cost is a controllable cost from the decision-
making angle of a segment, whereas the general cost allocated cannot be
controlled easily when a decision is to be made about the reported segment.
For example, if the supermarket decides to close the stationery department, the
department managerÊs wage can be eliminated. However, the supermarket

managerÊs wage is still incurred because he continues to manage other

departments in the supermarket.
Income statement for a segment is usually prepared according to the contribution

margin format which separates fixed and variable costs in its presentation. This is
because, most indirect costs that must be separated from the profit segment report
are fixed costs. Information from the contribution margin format is easier to pass on,
compared to an income statement prepared using the absorption approach.
Table 8.4 shows an example of segmented income statement of a supermarket.
Table 8.4: Example of a Segmented Income Statement

ChildrensÊ
Stationery
Clothes Supermarket
Department
Department
Sales RM150,000 RM100,000 RM250,000
Variable cost
• Cost of variable goods sold 60,000 30,000 90,000
• Other variable expenses 15,000 10,000 45,000
Total variable cost 75,000 40,000 115,000
Contribution margin 75,000 60,000 135,000
Direct fixed cost 45,000 40,000 85,000
Segment margin 30,000 20,000 50,000
General expenses 42,500
Net income RM7,500
In reference to Table 8.5, fixed cost is differentiated between direct fixed cost
(that is cost that can be trace directly to the segment) and the general fixed cost
(that is cost allocated to the segment). Fixed costs which can be trace directly to
the segment is the fixed costs incurred as a result of the existence of that segment.
For example, wage expense of the stationery department manager as explained
before this. That is the reason why, if the segment is closed, the expense is
avoidable.

However, general fixed costs are those that support the operations of more than
one segment, for example, the supermarket managerÊs wage expense. This total
expense will not reduce even though the stationery segment is closed.
The separation of both elements of fixed costs is important to allow the segment
margin to be calculated effectively for each segment in the company. Information
on this segment margin will assist the manager in evaluating long-term profits of
a segment and is more meaningful for the purpose of future performance
evaluation of that segment.
8.4 MEASURING THE PERFORMANCE OF

INVESTMENT CENTRES
Next, we will discuss how to measure the performance of investment centres.
What is the most suitable measurement to describe the performance of
investment centres?
There are three performance measurements for investment centre that are usually
used, namely:
(a) Return on investment;
(b) Residual income; and
(c) Economic value added.
However, you will have to differentiate between performance evaluation of

departments or branches with performance evaluation of the department or
branch manager. This is because, a department may be showing satisfactory
performance even though it has an inefficient manager due to market conditions
or business locations.
However, there is a possibility that an efficient manager will be moved to a

problematical branch to initiate changes. The branch performance may not
change in the short-term, but it is not due to the poor performance of the
manager. In this section, what will be explained is related to the performance of
responsibility centres and not their managers. Each one is explained as follows.

8.4.1 Return on Investment

The first performance measurement of investment centres is return on
investment. Investment centres are accountable for profit and capital invested to
generate profit. Therefore, the performance of the investment centre should be
measured by relating the two. One method is by calculating profit generated for
each amount of capital invested through the measurement of return on
investment. It can be calculated using the following formula:
Operating income
Return on investment =
Average operating asset
Operating income refers to earnings before deducting interest and tax expenses.
The calculation of operating income is used so that it is consistent with the
denominator in this formula, which is operating assets.
Operating assets are all assets obtained to generate operating income including
cash, accounts receivable, inventory, land, building and equipment. Non-
operating assets are not taken into account in the calculation, for example, land
owned for future use, building rented to others or investment in other
companies.
Example 1
Syarikat Cikucomel is a producer of local toys. The Southern Branch which

produces remote control toys reports its revenue for the year 20X6 as follows:
Operating income RM300,000

Sales revenue 2,000,000
Average operating asset 3,000,000
Average balance in current liabilities 20,000
CikucomelÊs weighted average cost of investment is 9 percent, tax rate is 30

percent and minimum required return on investment is 9 percent.

Using the formula shown in Example 1, you can calculate the return on
investment:
Operating income
Return on investment =
Average operating asset
RM300,000
=
RM3,000,000
= 10%
From the above example, CikucomelÊs return on investment is 10 percent. You

will see how the calculation can be easily done. However, this formula, when
separated to margin ratio and turnover, will provide additional information.
Margin is the operating income ratio to sales. It shows available sales for interest
expenses, tax and profit. Meanwhile, turnover is sales divided by average
operating asset. It shows how productive an asset is when used to generate sales.
Using Example 1, we can recalculate the return on investment with the margin
and turnover formula.
Return on investment = Margin x Turnover

Operating income Sales
=
Sales Average operating asset
RM300,000 x RM2,000,000
=
RM2,000,000 RM3,000,000
= 15% x 67%
= 10%
Even though the figure on return for fixed investment is the same as the calculation
before this, additional information such as how productive an asset is used can be
shown clearly by this formula. This information will assist the manager in
understanding change or maintaining the performance of a branch or department.
For instance, the return on fixed investment is set for two years, but the actual
margin increases. How does this happen? This is because a decreasing return may be
due to assets such as the increasing amount of inventory held by the company.

Matters such as this must be taken into consideration by the manager to remain
efficient in his management and not just to provide aggregate information that is
not as meaningful in certain situations.
Next, the manager can plan how to increase the return on investment through
margin increase or turnover or both.
The measurement of performance using the measurement of return of

investment has a few advantages, among others:
Advantages of Return on Investment
(a) It encourages the manager to focus on the relationship among sales, expenses and
investment, as should be done by an investment centre manager.
(b) It encourages the manager to focus on cost efficiency.
(c) It encourages the manager to focus on operating asset efficiency.
However, extreme emphasis on return of investment figures can cause myopic

behaviour. Among the disadvantages of this measurement are:
Return on investment = Margin x Turnover

Operating income Sales
=
Sales Average operating
asset
Disadvantages of Return on Investment
(a) It can result in limited focus on the profit of the branch which may sacrifice the
interest of the organisation as a whole.
(b) It results in the manager focusing on the short term performance sacrificing the
long term interest.
You can refer to the return on investment formula where the denominator is the
operating asset. There is a possibility where the result of an investment in asset to
increase the efficiency of a branch can only be seen in the long-term.
However, in the short-term, the investment will result in an increase in the total
operating asset and following that, reduce return on investment. If bonus given

to a branch depends on the return on investment figure, would a rational

manager let this figure fall?
The return on investment measurement may be used mostly in evaluating

performance, but it is not a perfect tool. The manager may try to increase this
measurement without taking into account the companyÊs strategy.
ACTIVITY 8.2
Is it appropriate for a corporate asset of which the amount is allocated to
the branch, be taken into account in the total operating asset of the
branch for the purpose of calculating return on investment for that
branch?
8.4.2 Residual Income

Another approach in measuring performance of an investment centre is through
the use of residual income figures.
Residual income is the operating income that can be derived by an investment

centre in excess of the minimum returns required by its operating asset.
Formula-wise, residual income is:
Residual = Operating ă ( Average operating x Minimum rate of )

income income asset required returns
Residual income shows a figure in ringgit total and not in the form of a ratio such
as return on investment. While the rate of minimum return required is an
estimated rate by the management accountant, the rate among others, rely on the
risks of capital invested to generate income.
Using Example 1, Syarikat Cikucomel, you can calculate the residual income of
the Southern Branch by using the above formula.
Residual = Operating ă ( Average operating x Minimum rate of )

income income asset required returns

= RM300,000 ă ( RM3,000,000 x 9% )
= RM300,000 ă RM270,000
= RM30,000
Even though the calculation of residual income takes into account the rate of
required return by the firm for investment in its assets, one apparent weakness is
when this measurement cannot be used to compare performance among different
sizes of investment centres.
Assuming that Syarikat Cikucomel has a Northern Branch that produces toy cars.
The Northern BranchÊs operating income is RM600,000 and average operating
asset is RM5,000,000. The minimum rate of return required is 9 percent. The
residual income is calculated as follows:
Residual = Operating ă ( Average x Minimum rate of )

income income operating asset required returns
= RM600,000 ă ( RM5,000,000 x 9% )
= RM600,000 ă RM450,000
= RM150,000
Can it be said that the performance of the Northern Branch is better than the
Southern Branch? If you examine it, the difference is caused by the bigger size of
the Northern Branch and appropriately the return from the use of asset is
similarly large.
In short, performance measurement using the return on investment or residual

income cannot provide a perfect evaluation. Perhaps due to this reason, most
companies use both measurements for the purpose of performance evaluation of
investment centres.

8.4.3 Economic Value Added

The final approach is the economic value added. An adaptation from the
measurement of residual income is the measurement of economic value added
which is the operating profit after tax, less the total annual cost of capital. It is
different from residual income through two aspects; current liability will be
deducted from the total assets of investment centres and the weighted average
cost of capital is used in the calculation. The formula of calculating the economic
value added can be illustrated as follows:
Economic Operating Total assets of Current liability Weighted

value
added
= income ă
after tax
[( investment
centre
ă of investment
centre
) X average cost
of capital
]
Using Example 1, Syarikat Cikucomel, you can calculate the economic value
added of South Branch using the above formula.
Economic Total assets Current liability

value
added
=
Operating income
after tax
ă
[( of investment
centre
ă
of investment
centre
) Weighted
× average cost
of capital
]
= [RM300,000 × (1-0.3)] ă [ (RM3,000,000 ă RM20,000) × 9% ]
= RM210,000 ă [ (RM2,980,000) X 9% ]
= (RM58,200)
From the calculation, it shows that the Southern Branch does not contribute to
the economic incremental value of Cikucomel.
SELF-CHECK 8.2
What are the differences and similarities between calculations of

performance measurement using residual income and economic
incremental value added?

8.5 BALANCED SCORECARD

In this section, we will discuss about the balanced scorecard. Have you ever
thought about the impact on a managerÊs behaviour when the measurement of
performance evaluation uses only accounting figures?
Performance measurements such as return on investment, residual income and

economic value added are frequently used and are important to the organisation.
However, to look at performance from a purely financial angle does not provide
a complete picture of the organisationÊs overall performance. You may have
heard of non-financial performance measurement which was formulated to take
this into account. For example, at a factory, the number of defective units during
the production process must be monitored for the purpose of efficiency in cost
and quality management.
Therefore, records must be kept and measurement created to monitor the

number of defective units at a certain period of time. Other than that, service
organisations such as hotels, for example, have to know whether the customers
using their services are satisfied or otherwise because it can affect the
profitability of the hotel in the future. Thus, a measurement of customer
satisfaction is created and measured through feedbacks and questionnaires
usually placed in hotel rooms.
Moreover, measuring only financial performance hardly motivates junior

managers. They generally do not see direct effect of their actions on the change in
overall profits of the company. Therefore, non-financial measurement such as the
number of defective units can be monitored directly by the factory supervisor,
while the measurement of employee turnover ratio will be monitored
continuously by the personnel manager of an organisation.
In 1990, Kaplan and Norton formulated the Balanced Scorecard (BS) through an
intensive research project. BS provides a system to measure and manage all
aspects of performance of a company, among others providing a balanced
measurement of the financial and non-financial performance. It translates the
organisationÊs mission and strategies to operating objectives and measurement of
performance through four perspectives:
(a) Financial
To see how far success is measured by shareholders.
(b) Customer Satisfaction
To see how we created value for customers.

(c) Internal Process

To see how we can make ourselves more prominent to satisfy customers
and shareholders.
(d) Learning and Development
To see the capacity of staff, information system and the environment of the
organisation required to continually improve internal processes and
customer relationships.
How is strategy related to measurements of performance from these four

perspectives? Let us imagine a strategy at a manufacturing company ă assume it
is executing a quality improvement strategy. If the design engineer receives
quality training (learning and development perspective), they can design a
product that minimises defective units (internal process perspective). If the
number of defective units is reduced, customers satisfaction will increase
(customer satisfaction perspective) and when customer satisfaction increases,
market share will increase and following that, increases profit (financial
perspective).
The following Table 8.5 shows the operating objectives to be achieved through
each of the perspectives above and the related performance measurement.
Table 8.5: Performance Measurement of Balanced Scorecard
Perspective Objective Measurement
Financial Return on expenses Income/total expenses

Return on investment Operating income/operating asset
Customer Retain existing customers % of return customers

% of business development from
existing customers
Internal Process Increase process efficiency Per unit cost movement

Output/input
Development Increase staff ability % of staff turnover

The four perspectives contain performance measurement in financial and non-

financial forms. Each measurement perspective or category that is to be
monitored has information from the past and standard measurement related to
the category. However, attention must be given to the suitability of each
measurement according to the type of business or organisation executing it.
ACTIVITY 8.3
How does the emphasis on the importance of intangible assets in
current organisations increase interest in the performance
measurement of BS (Balanced Scorecard)?
8.6 BENCHMARKING
Before we begin discussing this heading in detail, do you know the type of
information that can assist a firm in competing in terms of cost, quality and
services with other firms in the same industry?
Each firm in the business will face stiff competition among themselves until it
forces them to find a benchmark to compete in terms of cost, quality and services.
Benchmarking is a systematic appproach in identifying best practices in the
industry to assist the organisation in executing steps towards increasing
performance. In a globalised era, benchmarking can be done formally and
openly.
Six steps that must be taken to execute benchmarking are:

(a) Identifying what will undergo benchmarking;
(b) Plan benchmarking projects;
(c) Understand own performance;
(d) Research other parties;
(e) Learn the data obtained; and
(f) Take necessary actions.
Through benchmarking practice, it will assist organisations in dealing with the

problem of rejecting changes by staff. This is because the staff can see for
themselves what the organisation would like to achieve that can be achieved by
other organisations.

• Most organisations are structured into units that run operations and have
their own responsibilities.
Ć For the purpose of evaluating performance, the responsibility units are

divided into cost centre, revenue centre, profit centre and investment centre.
Ć Cost centres are usually evaluated with standard cost deviation analysis or
flexible budgets.
Ć The profit centre is evaluated by looking at the profit generated in the income
statement prepared.
Ć Segmented income statement provides information to evaluate profit and

performance of a segment which may be a branch, production line or sales
area of a company.
Ć To enable contribution margin from a segment to be presented effectively,

general fixed costs allocated is not deducted from the segmentÊs profit.
Ć The contribution margin income statement format is regarded as more

suitable for the purpose of preparing segmented income statement.
Ć An investment centre is usually evaluated by looking at returns generated by

the investment centre compared to the capital invested.
Ć The three measurements usually advanced are return on investment, residual

income and economic value added.
Ć Residual income is a measurement that can avoid this problem, though

residual income absolute figure derived from it cannot be used to compare
performance among different investment centres of different sizes.
Ć One weakness of measurement using this accounting figure, though, is its

tendency to encourage managers to adopt a myopic view.
Ć Another current performance measurement tool prepares a framework that

balances the use of measurements using accounting figures and other
information.
Ć The Balanced Scorecard (BS) is a tool designed to encourage the management

to focus its attention to current goals, when, if achieved, will assist in the long
term goals of the organisation.

Ć In evaluating performance, the organisation often would like to obtain

information about their competitors.
Ć Benchmarking make what is usually executed informally as a systematic

approach and can be executed openly.
Balanced scorecard Goal cogruence

Benchmarking Residual income
Common fixed cost Responsibility centre
Decentralised structure Return on investment
Economic value added Segment

Topic X Transfer
9 Pricing in
Multi-segment
Firms
LEARNING OUTCOMES
1. Explain the purpose of transfer pricing;
2. Examine the impact of transfer pricing on the profits of the
division and the company as a whole;
3. Identify the general rule in transfer pricing;
4. Discuss the approaches in setting transfer pricing;
5. Calculate transfer price; and
6. Elaborate transfer price from an international perspective.
X INTRODUCTION
Multi-segment firms comprise of several divisions where each one runs its
business in its own way. Usually, output of one division in the same firm will be
used as input for another division. For example, a circuit board produced by the
electronics division is used by the video games division as one of its many inputs
in the production of its video games. Transfer price is the price that is charged on
the product transferred from one division to another. The transferred item is
known as an intermediary product (in the example before this, the intermediary
product is the electronic circuit board). Although most of the items transferred
are raw materials, components or finished goods, they also include services.

216 X TOPIC 9 TRANSFER PRICING IN MULTI-SEGMENT FIRMS
Transfer pricing is very important and constitutes a degree of complexity to the

firmÊs management. Transfer prices charged becomes revenue to the producing
division (known as the selling division) and to the receiving division (known as
the buying division) the price becomes a cost to them. Because revenue and cost
are used to determine profit, the transfer price charged affects the performance
evaluation of both divisions when performance measurement such as profit
margin and return on investment (ROI) are used.
Operating autonomically, division managers are more inclined to achieve higher

profits for their divisions and will take actions towards achieving that as well as
their own personal goals. At the same time, senior management of the firm has to
ensure that the goals of division managers are congruent to or in line with the
goals of the firm.
This topic will discuss transfer pricing goals, goal congruence emphasis, methods
and general rules in setting transfer prices and transfer pricing from an
international perspective.
9.1 PURPOSE OF TRANSFER PRICING

Have you ever thought about the purpose of having a transfer price? There are
various purposes of having it. Among them are:
(a) To prepare information that would motivate division managers to make
decisions in the interests of the division and the company as a whole;
(b) To prepare suitable information for performance evaluation of divisions;
(c) To transfer profits among divisions or locations; and
(d) To ensure the divisionÊs autonomy is maintained.
Transfer prices are used to create a performance measurement system to ensure
that managers make decisions to improve the performance of the segment and
also the performance of the organisation while maintaining the autonomy of
their divisions.
SELF-CHECK 9.1
Recall the previously discussed measurements of responsibility

centres, such as return on investment (ROI) and residual income (RI).
What financial statement information are used in these performance
measurements?

TOPIC 9 TRANSFER PRICING IN MULTI-SEGMENT FIRMS W 217
9.2 EFFECT OF TRANSFER PRICING ON PROFIT

What is the effect of transfer pricing on profit? Transfer pricing affect profits,
following that, to performance evaluation of both divisions, and also the overall
performance of the company. This can be explained using Example 1.
Example 1: Syarikat Alpha
Syarikat Alpha has two divisions executing internal transfers. Division A

produces components which are sold to Division C at a price of RM50 per unit.
The transfer price of RM50 per unit becomes the revenue for Division A and this
will increase the profit of the division. Because each division is an investment
centre, the performance measurement used is return on investment (ROI).
Therefore, the manager of Division A would want a high transfer price to achieve
higher profit so that the ROI of his division would also be high. Conversely, the
transfer price of RM50 per unit is cost to Division C and this will decrease the
profit of Division C.
Thus, the manager of Division C will favour a lower transfer price so that the
divisionÊs profit and ROI are not jeopordised. However, the overall profit of the
company is zero because revenue earned by Division A is a cost for Division C.
This illustration is simplified in Table 9.1.
Table 9.1: The Effect of Transfer Pricing on the Profits of

Divisions and the Company as a Whole
Syarikat Alpha
Division A Division C
Produces components and transfers them Buys components from Division A at a

to Division C at a transfer price of RM50 price of RM50 per unit and uses it in the
per unit production of final goods
Transfer price is RM50 per unit Transfer price is RM50 per unit
Revenue to Division A Cost to Division C
Profit increases Profit decreases
ROI increases ROI decreases

Transfer price revenue = Transfer price cost

Zero impact on Syarikat Alpha
Autonomous operation and performance measurement based on profit figures

will cause division managers to take actions solely in the interests of their own
division and neglect the interests of other divisions or the company as a whole.
Return to the example of Syarikat Alpha. Division C can source components from
an outside supplier at a price of RM48 per unit. Division C is expected to reject
the transfer price offered by Division A because Division C will save on purchase
cost from RM50 to RM48 (that is a saving for purchase of component at RM2 per
unit).
This decision will result in a profit increase for Division C. Assuming the
componentÊs production cost at Division A is RM44 per unit and Division A
cannot substitute the internal sales with external sales, Division A will lose a
revenue of RM6 per unit (that is RM50 ă RM44). As a whole, surely the
CompanyÊs profit will be reduced by RM4 per unit. The reduction in the overall
companyÊs profit of RM4, can be explained as an external cost of RM48 that
exceeds the internal cost of RM44. The impact on the overall companyÊs profit is
illustrated in Table 9.2.
Table 9.2: The Impact of Transfer Price on the Profit of Syarikat Alpha
Alternative Answer 1 Alternative Answer 2
Division C:
Cost savings
(RM50ăRM48) RM2 per unit External purchasing cost RM48 per unit
Division A: Internal purchasing cost RM44 per unit

Loss in revenue
(RM50ăRM44) RM6 per unit Increase in cost @
Reduction in profit RM4 per unit
Overall impact
Reduction in profit RM4 per unit
The action of Division C has compromised the interests of another division and
the company as a whole. In this case, goal congruence is not achieved because the
goal of the division is at odds with the goals of the firm. This condition is known
as sub-optimal. Actually, the ideal transfer price allows each division manager to

maximise the profit of the firm while striving to maximise the profit of each
division respectively to achieve goal congruence.
ACTIVITY 9.1
What is meant by sub-optimal? Illustrate how transfer price can
influence the profits of divisions resulting in a sub-optimal
condition.
The following sub-topic discusses the use of general rule in transfer pricing to
encourage goal congruence among the division managers.
9.3 GENERAL RULES IN TRANSFER PRICING

Usually, there is no such thing as a single optimal transfer price. But there is a
transfer price range that can encourage optimal behaviour among managers. This
price range refers to the minimum and and maximum transfer prices.
What is meant by minimum transfer price and maximum transfer price?
Minimum transfer price refers to the transfer price where the selling division
does not incur losses if the product is sold to an internal party compared to if
sold to an external party.
Maximum transfer price, meanwhile, refers to the transfer price where the
buying division does not incur losses if the input is bought internally
compared to if bought in the external market.
Several methods or rules can be used to set the actual transfer price. Transfer
pricing methods are discussed in the following section. This section will discuss
the general rule of transfer pricing.
General rule in transfer pricing will ensure that goal congruence between
division managers involved in the transfer. This general rule is used for
minimum transfer pricing.
Transfer price = Additional cost + Opportunity cost

The general rule above states that transfer price comprises two cost components.
The first component is additional cost. Additional cost is the additional amount
that must be paid by the selling division to produce products or services and
transfer products or services to another segment. Additional cost include variable
cost and other costs incurred specifically for internal transfer.
The second component of the general rule is opportunity cost. Opportunity cost
is the contribution margin foregone by the selling division when transferring the
item internally. For example, when the selling division has a capacity limitation,
that is production of products is insufficient to fulfill both internal and external
demands, the opportunity cost for internal transfer is the contribution margin
(selling price ă variable cost) given up for the external market. We will use
Syarikat Mekar as an example.
Example 2: Syarikat Mekar
The Electronics Division of Syarikat Mekar produces electronic circuit boards.

The following information are provided.
Production capacity 120,000 units

Selling price to external market RM30
Variable cost per unit circuit board RM15
Fixed cost per unit circuit board (based on production RM6
capacity)
Syarikat Mekar also has a Video Games Division which can use the circuit
boards in its video games. At the moment, the Video Games Division buys
10,000 units of circuit boards from the external market at a price of RM29.
The general rule can be differentiated in two scenarios.
Scenario A: No excess capacity
When all 120,000 units of circuit boards produced are sold to the external market,
the Electronics Division is said to have no excess capacity.
Assuming that you are the manager of the Electronics Division, what is the
minimum price you are willing to accept that will not jeopardise the profit of the
division and your previous performance evaluation?

If the Electronics Division is to fulfill an internal transfer, the Division has to

sacrifice 10,000 units of circuit boards meant for sale to the external market. To
replace the loss in revenue of RM30 per unit from the external market foregone
as a result of the internal transfer, the minimum transfer price willing to be
accepted by the Electronics Division is also RM30 per unit so that the Division
will not incur losses compared to the previous period.
If you use the general rule:
Transfer price = Additional cost + Opportunity cost (i.e. margin

contribution margin per unit for loss of sales)
= RM15 + {(RM30 ă RM15)/10,000}/10,000

= RM30
Now, as the manager of the Video Games Division, what is the maximum price
you are willing to pay without jeopardise the profits of the division and your
performance evaluation?
Meanwhile, the manager of the Video Games Division is willing to pay the
maximum price of RM29 per unit which is the purchase price of the circuit board
in the external market. If he accepts purchase price of more than RM29 per unit
of circuit board, the Video Games Division will experience a reduction in profit
compared to the purchase of circuit board in the external market because the cost
of internal purchase price is much higher. The purchase of 10,000 units of circuit
board from the external market provides more saving compared to buying from
the Electronics Division.
Transfer pricing at RM30 per unit will result in the none-execution of internal
transfer. At the same time, it will also optimise behaviour of managers to
maximise the profits of their respective divisions and also the firm as a whole
where goal congruence is achieved.
Assuming variable cost is RM2 which is the sales commision that can be avoided
should an internal transfer be executed. In a scenario where there is no excess
capacity, if internal transfer is executed, the Electronics Division will lose sales
revenue of 10,000 units of circuit boards to the external market. As a result, the
Electronics Division will lose sales revenue of RM30 per unit, but the variable
cost of RM2 per unit can be saved. This means that to bear the whole cost of loss
of sales in the external market, the minimum price willing to be accepted by the
Electronics Division is RM28 per unit (RM30-RM28) without incurring losses.

If you use the general rule, the minimum transfer price is:

= RM15 + {(RM30 ă RM15 ă RM2)/10,000}/10,000

= RM28
The price of RM28 per unit circuit board is the net transfer cost from the
perspective of the company as whole. The maximum price the manager of the
Video Games Division is willing to pay is RM29, which is the purchasing cost in
the external market. Because the transfer cost of RM28 is much lower than the
purchase cost of circuit board from the external market of RM29, the manager of
the Video Games Division is motivated to buy internally to save cost and
following that increase the profit of the Division. Therefore, the ideal transfer
price is between RM28 and RM29.
Ideal transfer price

RM28 RM29
Scenario B: Excess Capacity
Excess capacity exists when units that can be sold are less than those that can be
produced. Assuming that Syarikat Mekar now sells 110,000 units of circuit
boards to the external market. This means that the company has excess capacity
of 10,000 units of circuit board to fulfill the demand for internal transfer.
As before, imagine you are the manager of the Electronics Division. What is the
minimum price that you are willing to pay so as not to jeopardise the profits of
the division and your previous performance evaluation?
If 10,000 units of circuit board is transferred from the Electronics Division to the
Video Games Division, there is no loss in sales for the Electronics Division
because there is excess capacity. Conversely, variable cost of RM15 is incurred for
each additional unit of circuit board produced. The cost of producing circuit
boards at the Electronics Division can be fully borne when the transfer price is at
least, or at its minimum, RM15 per unit. Thus, the cost to the firm (and
Electronics Division) is RM15 per unit.

If you use the general rule, minimum transfer price is:

= RM15 + RM0
= RM15
As the manager of the Video Games Division, what is the maximum price you
are willing to pay so as not to jeopardise the profits of the division and your
performance evaluation?
Whereas for the Video Games Division, the maximum price it is willing to pay is
RM29 per unit, which is the purchase price in the external market. Considering
that the minimum transfer price is less than the purchase cost, internal transfer
has to be executed. To encourage the behaviour of the division managers, the
ideal transfer price is between RM15 and RM29 per unit, where a price in this
range will increase profits of both divisions.
Ideal transfer price

RM15 RM29
The general rule of transfer price usually generates decisions that are goal
congruent if the rule is implemented. Nonetheless, the rule is difficult to
implement because of the difficulty in measuring opportunity cost. The problem
of measuring opportunity cost are due to the following reasons:
(a) The external market is not perfect where a producer or a group of
producers can affect market price by offering various amounts of products
in the market. In this case, the external market price depends on the
manufacturing decisions of producers. Hence, the opportunity cost as a
result of internal transfer relies on the units sold in the external market.
This interaction can cause difficulties in measuring accurately the
opportunity cost caused by the transfer of products.
(b) Uniqueness of products and services transferred.
(c) Producing companies have to invest in special equipments to enable
products to be transferred.
(d) Reliance on several products or services transferred.

Even so, the general rule of transfer pricing provides a good conceptual model
for management accounting in setting transfer price. This rule can be
implemented in most cases. If this cannot be implemented, the firm can use
another method of transfer pricing discussed in the next section.
SELF-CHECK 9.2
State the minimum transfer price in the following situations:

(a) Excess capacity; and
(b) No excess capacity.
9.4 APPROACH TO TRANSFER PRICING

A firm can choose from three approaches commonly used to set transfer prices
which are:
(a) Market-based transfer price;
(b) Cost-based transfer price; and
(c) Negotiated transfer price.
9.4.1 Market-based Transfer Price

Market price is suitable for use as the basis for transfer pricing when there is
external market for intermediary products or services and there is perfect
competition. Perfect market competition exists when the product is
homogeneous and no individual seller or buyer can influence the market price.
In other words, both divisions can sell or buy intermediary products or services
in the external market at the same price and the profit of the firm as a whole is
not affected.
Syarikat Malbex is used as an example to show the impact of market-based

transfer price on the profit of the firm when the intermediary product is sold in
the internal and external markets.

Example 3: Syarikat Malbex
The Mirror Division of Syarikat Malbex produces standard size mirrors. Over
1,000 units are produced and can be sold either to the Furniture Division of
Syarikat Malbex or the external market. Every mirror costs RM8.00 per unit to
produce. The market price of the mirror is RM15.00 per unit and the mirror
market is a perfect market. The Furniture Division will use this mirror as one of
its production imputs to produce vanity tables. Other variable costs to produce
the table is RM200.00. The selling price for the vanity table is RM280.00 per unit.
Figure 9.1 shows the impact on profit of Syarikat Malbex with the sale of 1,000
units of mirror in two scenarios (1) external market; and (2) Furniture Division.
Figure 9.1: The impact on profit if using market-based transfer price

Figure 9.1 shows that whether the intermediary product is sold either internally
or externally, the profit of each division and the firm as a whole has not changed.
The advantage of market-based transfer price is that it represents the divisionÊs

actual economic contribution to the overall profit of the firm. If there is no buying
division, the intermediary product can be obtained from the external market at
market price. Also, if there is no buying division, the intermediary product can
be sold in the external market at market price. Therefore, the profit of the
division is the same as the profit it would have obtained if the division happens
to be a different company. Following that, the profit of the division can be
compared to the profit of a similar company operating in the same type of
industry.
One of the main problem of using market-basis for the setting of transfer price is
that market of intermediary products is often not perfect. The intermediary
product may have special features that differentiate it from other similar
products. The use of market price for intermediary products is only suitable
when quality, delivery, discount and services are equal. Division too have an
alternative to buy intermediary products from the external market when the
supplier offers a ÂdistressÊ market price, where price is less than the total cost but
exceeds variable cost. Also, sub-optimal decisions occur when the selling division
has excessive capacity if the market-based transfer price is strictly applied.
In using market price as the basis of transfer pricing, the firm has to ensure that
the market of the intermediary product must be nearing a perfect market. If the
market of the intermediary product is nearing the perfect market, the transfer
price of intermediary product is the market price and whatever excess demand
on supply in the external market or where supply exceeds demand can be solved
by buying and selling intermediary products in the external market.
9.4.2 Cost-based Transfer Price

If the product or services transferred do not have an external market, one
alternative that can be used is cost-based transfer price. The basis often used is
variable cost or full cost.
Cost-based transfer price is preferred because it is easy to understand and use.

However, there are a few disdvantages:

Disadvantages of Cost-based Transfer Price
(a) The use of cost especially full cost as the basis for transfer price can result in subă
optimal conditions. Back to Example 2, Syarikat Mekar. If the full cost is used, the
transfer price per unit of circuit board is RM21, of which variable cost is RM15 +
fixed cost RM6. Assume the cost of purchasing circuit boards from the external
market is less than RM21, for example, RM20. The Video Games Division will not
purchase circuit boards from the Electronics Division because the buying cost is
higher compared to that in the external market.
From the persective of the firm as a whole, is it necessary for the circuit boards to
be transferred from the Electronics Division to the Video Games Division when
the Electronics Division has excess capacity? When operating at excess capacity,
cost to the firm to produce one unit of circuit board is only RM15 compared to
RM20 when bought from an external supplier.
(b) If cost is used as the basis of setting transfer price, the selling division will not
show any profit on any transfer price. The division that will show profit is the
division that sells the end product to customers.
(c) Cost-based transfer price provides no incentive to control cost.

[Actually, cost is only transferred to another party and this results in less
incentive to reduce transfer price.]
9.4.3 Negotiated Transfer Price

Negotiated transfer price is suitable for use when there exists no perfect market
for the intermediary product, that is, the internal and external selling price are
different or there are various market prices. To facilitate the involvement of
division managers in the negotiation process, they must have freedom to buy
and sell in the external market.
It is believed that in certain situations, if the division managers are allowed to

negotiate freely, they will often decide on maximising the profit of the company
as a whole with the assumption that they are qualified and know how to use
accounting information.
Negotiated transfer price will be effective if there is equal negotiating power

among division managers. If the selling division has many resources to source
intermediary goods but the buying division has limited selling space, the
negotiation power of the division managers becomes unequal.
This inequality in negotiating power can happen when the internal transfer is a
small part of the business of a division and a large part of the other division. The

division manager where the internal transfer constitutes a small part of the
business has more negotiation power because he will not be seriously affected if
the negotiation does not yield the desired internal transfer price. The
disadvantages of negotiated transfer price are as follows:
Disadvantages of Negotiated Transfer Price
(a) Because negotiated transfer price relies on the expertise and negotiation power of
the division managers involved, there is a possibility that the final revenue of the
transfer price will not achieve optimal level;
(b) It can lead to conflict between divisions and the resolution to this conflict may
require intervention from senior management resulting in the non-conformance of
the decentralisation rules;
(c) The measurement of profit of the division relies on the negotiating expertise of
division managers who may not have equal negotiating powers; and
(d) It takes a long time especially if many transactions are involved.
Even though negotiated transfer price will not yield optimal levels, it motivates
the managers who have full freedom in making decisions. This may lead to an
increase in profit and balance out the loss from non-optimal transfer price. The
general rule on transfer pricing can be used to set ceiling and bottom transfer
prices as a guide in negotiations between divisions.
ACTIVITY 9.2
Explain the advantages and disadvantages of the following transfer

pricing methodologies:
1. Market price
2. Variable cost of production
3. Absorption cost of production
4. Negotiated price

9.5 TRANSFER PRICE FROM AN

INTERNATIONAL PERSPECTIVE
Transfer price from an international perspective is related to the price used by
firms to transfer their products intra-division in different countries. Different tax
rates among countries influence transfer pricing. Countries with high tax rates
result in higher total taxable profit compared to countries with lower tax rates.
Assuming that a European international company has a division in Asia. A

division in Europe produces components that are transferred to a division in
Asia for end product assembly. Assuming that the rate of tax in Europe is higher
compared to that in the Asian country, what is the reaction of the international
firmÊs management in setting the transfer price?
The management of the international firm is more inclined to set the lowest
transfer price for the said component. The division in Europe which is the selling
division will report a lower profit with a low transfer price because it is a
revenue to the division. Conversely, the buying division which is the division in
Asia reports a higher profit because the purchasing cost of the component is low.
The firm as a whole will save on tax payable because the tax rate in Asia is much
lower than that in Europe. By setting a lower transfer price, the firm will transfer
part of its tax to the country which has a lower tax rate.
Other than the tax rate, the import duty also bears an impact on the transfer
pricing policy. Import duty is the amount charged by importers on the value of
the imported goods. LetÊs revert to the previous example. Assuming that the
Asian country charges import duty on the goods transferred from the division in
Europe. How would the management of the international firm react in setting the
transfer price?
Management of the firm also has the incentive to set a lower price for the
transferred goods. This will minimise duty fees and maximise profit of the firm
as a whole.
To avoid the use of transfer pricing as an alternative to manipulating profits for

the purpose of taxation and import duty, some countries have created laws to
limit the flexibility of firms in setting transfer price.

ACTIVITY 9.5
Explain how transfer pricing between divisions at different country

locations is used to reduce tax payments.
• Transfer pricing is a mechanism used by firms to control the behaviour of

division managers so that their decisions in setting transfer price lead to the
overall well-being of the firm in addition to the well-being of their divisions
respectively.
• Also, the execution of effective transfer pricing will maintain the autonomous
power of the divisions.
• There are various basis for transfer pricing such as market price, cost-basis or
negotiation-basis and its suitability of use depends on the market situation.
• The general rule of transfer pricing i.e. additional cost + opportunity cost is
used as a guide by firms to achieve the ideal price to encourage division
managers to work towards goal congruence.
• For international transfer pricing, the tax and duty rates influence the transfer
pricing process.
Buying division Opportunity cost

Goal congruence Selling division
Intermediary product Sub-optimal
Maximum transfer price Transfer price
Minimum transfer price

Topic X Short-Term
10 Decision
Making
LEARNING OUTCOMES
At the end of this topic, you should be able to:
1. Identify the roles of the management accountant in the decision
making process;
2. Recognise the relevant information for decision making;
3. Describe the constraints faced by organisations; and
4. Examine and apply five types of decision making.
X INTRODUCTION
Making decisions is one of the roles and functions of a manager. In performing
these daily tasks, the manager is often faced with problems in decision-making,
such as:
(a) How many units of products need to be sold for every existing product
line;
(b) What method of production to be used;
(c) Will the company be producing the components or acquiring them from
suppliers;
(d) Should the existing production lines be maintained or closed down; and
(e) Many other decisions related to the daily operations of the company.
Making decisions is not a simple task and therefore needs to be performed by

highly skilled and knowledgeable managers. In the process of decision making,
cost has always been an important factor which needs to be considered. The cost
for each alternative has to be considered as one of the steps in making decisions.
232 X TOPIC 10 SHORT-TERM DECISION MAKING
The problem is, not all costs are relevant for decision making. Therefore, a
manager has to be quick in evaluating the cost information so that only relevant
information is taken into account when making decisions.
This topic will discuss the roles of management accountants in decision making,
identifying the relevant cost information and employing the relevant cost in the
process of making the following decisions: the decisions whether to produce or
buy, retain or remove the product, make special orders, sell at a split-off point or
perform additional processes as well as decisions regarding product mix.
10.1 ROLE OF A MANAGEMENT ACCOUNTANT

IN DECISION MAKING
One of the most significant roles of management accounting is to prepare
information which satisfies the requirements specified by managers and
employees who make every effort to achieve the objectives of the organisation.
As you are aware, the key role of a manager involves making decisions. The
question now is what type of information must the management accountant
provide to the managers?
There are three main features of good accounting information for making
decisions, namely relevancy, accuracy and timeliness.
(a) Relevancy
The information is said to be relevant if it is useful for making a

decision. The information given by the accountant must be in
conformity with the type of decision making which must be made by
the managers.
This is due to the fact that, the type or structure of decision making may
differ from one manager to another. For instance, managers of marketing,
production and purchasing require different accounting information to
make decisions in their fields.
Marketing managers may be interested in knowing the cost of advertising.

Production managers, on the other hand, will be interested in knowing the
cost of setting up the machines. Thus, only relevant information needs to be
provided by the management accountant to be used in making decisions.
Nevertheless, at the managerial level, managers need to understand the
financial implication of each decision made. The management accountants
TOPIC 10 SHORT-TERM DECISION MAKING W 233
are responsible for obtaining and analysing the relevant information while
individual managers are responsible for acquiring the information,
analysing them and making final decisions.
(b) Accuracy
Accuracy of information refers to the information given to the

managers which must be accurate in terms of its facts, calculations and
so on.
Accurate information is necessary in decision making to ensure the

usefulness of the information.
(c) Timeliness
Besides the above criteria, relevant and accurate information needs to be
provided on time in order for it to be useful to the decision makers when
making decisions.
A management accountant must understand the need for different types of

information within the organisation. For example, the top management
may only require monthly summary reports from every department or
section. An engineer responsible for hourly production schedules may
require current and continuous information as well as comprehensive
information on alternative costs for various methods of producing a
product.
The information provided by the accountant has its own costs associated
with it, which may be difficult to measure at times. The cost of obtaining
such information increases with increases in the degree of its accuracy,
volume requested and urgency of its delivery. Moreover, it is also common
for managers to request for additional information to reduce any
uncertainties arising from various actions taken. However, some managers
may request for information without being aware of the additional cost
associated with it. Thus, the decision makers often have to balance the costs
against the benefits of the information. The information is said to be
beneficial if the managers cannot perform the decision making without it.

ACTIVITY 10.1
Assuming that you are an accountant in company A, what roles should
you assume in helping your company to make sound business
decisions? What information needs to be prepared as reference materials
for the company?
Example 10.1
For instance, a sales manager requests for information regarding all the
overhead costs involved in producing a product. Assuming that one of the costs
is related to the consumption of glue, if the manager only wants the complete
and accurate costs, the management accountant then has to spend a lot of time
in allocating the cost of glue incurred to the product, even though the total cost
of the glue is only RM200, compared to the overall overhead cost of RM5
million.
Then again, if the management accountant is consuming too much time to

obtain accurate information regarding the cost of glue incurred, then the cost of
obtaining the information will be higher and possibly cause a delay in its
delivery to the sales manager. Subsequently, the information may not be useful
if a decision has been made before it arrives.
10.2 RELEVANT INFORMATION

One of the criteria of quality information is the relevancy of the information.
Relevance here refers to different information for different alternatives which
will be useful for making decisions.
In previous topics, you have studied various concepts of costs, such as variable
costs, fixed costs, and opportunity costs, incremental or differential costs as well
as sunk costs. Which of these costs do you think is the relevant cost?
Any avoidable cost can be defined as a cost which could be eliminated

(entirely or partially) resulting from choosing an alternative over other
available alternatives in the process of making decisions.

All costs can be considered as avoidable costs except for sunk costs and future
costs, which are indifferent between available alternatives.
Example 10.2
Suppose you wish to trade in your old car for a new car. The relevant
information is the cost of a new car and the selling price of the old car. On the
other hand, the cost of the old car is irrelevant and is considered as sunk cost as
it has been incurred in the past and cannot change any future decisions. Sunk
costs are the costs that have been incurred in the past and cannot be avoided
no matter which course of action is taken. Thus, the sunk cost is irrelevant to
future events and has to be disregarded in the decision making process.
To identify avoidable costs, the following steps can be taken:
Step 1: Obtain all costs related to the alternatives under consideration.

Step 2: Identify sunk costs and ignore these costs.
Step 3: Identify which of the costs are indifferent between alternatives and
ignore them.
Step 4: Make decisions based on the remaining costs after performing Step 2
and Step 3. The remaining cost information is called differential cost
or incremental cost.
In management accounting, terms like differential cost, incremental cost,

avoidable cost and relevant cost are often used alternately but ultimately mean
the same, that is, relevant cost.
To carry out the above steps, consider this example. Suppose you have an old
car. The book value for the old car is:
Cost of Acquiring The Old Car RM90,000

Less: Accumulated Depreciation Value RM50,000
Book Value RM40,000
The old car can be resold at a price of RM15,000. Apart from the annual
depreciation value of RM10,000, you also have variable operating costs (petrol,
maintenance, etc.) which amount to RM10,000 per annum. You are considering
purchasing a new car that costs RM120,000, has 10 years of lifespan and an

expected variable operating cost of RM6,000 in a year. To perform this decision

making, consider the following:
(a) Gather the cost information: The costs involved are the cost of acquiring the
old car, accumulated depreciation value, book value, price of the new car,
depreciation of the new car, operating cost for the old and new car,
respectively and the selling price of the old car;
(b) The sunk costs are the book value and the depreciation of the old car;
(c) There are no future costs which are indifferent; and
(d) Relevant costs are the selling price of the old car, depreciation of the new
car and annual operating costs.
Therefore, we can perform analysis as illustrated in Table 10.1.
Table 10.1: Decision to Replace a Car
Retaining Old Acquiring New Differential Cost

Car Car (RM)
(RM) (RM)
Income from Selling Old Car - (15,000) 15,000
Depreciation of New Car - 12,000 (12,000)
Operating Cost 10,000 6,000 4,000
Total 10,000 3,000 7,000
The differential cost column shows the difference in each item of costs incurred
between the two alternatives. From the analysis shown in Table 5.1, it is
evidently better that you buy a new car than retaining the old car.
We can now conclude that for a cost to be relevant, it has to satisfy two
requirements, i.e. it must be cost-effective in the future and must provide
different cost-effectiveness between alternatives.
10.3 THEORY OF CONSTRAINTS

Constraints theory is a theory developed by Dr Eliyah Goldratt for the purpose
of managing constraints faced by an organisation. The theory of constraints states
that:

Every process is said to have constraints or resources bottlenecks and thus

production cannot move as fast due to the existence of the constraints.
The purpose of the constraints theory is to maximise the throughput, which is the
selling income minus the direct raw materials cost.
This theory can be associated with decision making since every organisation will
face at least one constraint. Thus, in performing decision making analysis, the
accountant should take into account the constraint factors faced by the
organisation. Moreover, the managers have to be smart in determining the best
manner to use limited resources in order to achieve the objectives of the
organisation.
Constraint refers to anything that hinders an organisation from achieving its

objectives. Constraints can be divided into internal constraints and external
constraints, as illustrated in Table 10.2.
Table 10.2: Two Types of Constraints
Constraints Type Explanation

Internal Constraint Internal constraints refer to the constraints which can be
managed and controlled by organisations, for example,
insufficiency in labour force, machines, raw materials, storage
areas and others.
External Constraint External constraints refer to the constraints which cannot be
managed or controlled by the organisations, for example,
inadequacy in raw materials as a result of reduction in its
supply in the market.
In the short term, managers will not be able to overcome the constraints easily.
The reason is that, in order to overcome a constraint, the companyÊs long term
financial condition will be affected. For instance, a company is short of machines
in the production process. The decision to buy machines is a long-term decision
as it involves high cost and the company must therefore perform a thorough
analysis on the costs and benefits of purchasing such machines.

ACTIVITY 10.2
What are the constraints that you can think of, which are normally faced
by managers when making decisions in an organisation?
How can we identify a constraint? Consider Example 10.3.
Example 10.3
Puteri Idaman Sdn. Bhd. is a well-known company that produces school

uniforms in the northern region of Malaysia. The demand for the school
uniforms is 350 pairs per month. Puteri Idaman has four production
departments, namely the Cutting Department, Sewing Department, Finishing
Department and Packaging Department. Every department has its own capacity
that differs from the others, as illustrated:
Department Monthly Capacity

Cutting 200 pairs
Sewing 300 pairs
Finishing 400 pairs
Packaging 500 pairs
Determine the process which constitutes a constraint to Puteri Idaman Sdn. Bhd.
Based on the information given in Example 5.3, it is obvious that the process
which constitutes a production constraint is the process in the Cutting
Department, which is only able to complete 200 pairs in a month. That means
Puteri Idaman will not be able to meet all of its customersÊ demands as its
maximum production capacity is only 200 pairs per month.
In general, a company will have more than one constraint. Nevertheless,

discussions in this topic will be focused on single constraint only. The application
of the theory of constraints will be demonstrated later when we discuss decision
making issues related to product mix.

10.4 TYPES OF DECISION MAKING

In this topic, we will discuss several types of decision-making (refer to
Figure 10.1).
Figure 10.1: Types of decision making
Discussions on decision making in this topic will focus on short-term decision

making, which is usually known as tactical decision making.
Tactical decision making means the process of choosing from among a

selection of alternatives, which is performed with urgency or under limited
consideration.
In making tactical decisions, we will be using relevant data and cost information
which will best benefit the organisation.
Before we proceed to look at each of the types of decision making, we will

observe the steps to be taken in the decision making process, as illustrated below
in Figure 10.2.

Figure 10.2: Steps in the decision making process
10.4.1 Decision to Eliminate or Retain a Product

Sometimes, some of the products we produce do not receive good response from
customers, thus incurring losses to the company. In this situation, the company
will decide whether to retain or remove the product from the production lines. In
addition, this decision may include closing business segments, branches or
departments related to the product within the organisation. A decision to
eliminate or continue a product often leads to another decision of whether or not
the company will introduce new products or add business segments.
Useful information that will assist in making such decisions can be obtained from
the income statements by segments, which are prepared according to products or
business segments, depending on the type of decision required.

Income statement by segment refers to condensed income statements

prepared for each type of product or segment.
Example 10.4
For example, Kaya Company has three product lines, namely, product A, B and
C. Therefore, the accountant of Kaya Company needs to prepare income
statements by segment, specifically for product A, B and C. From these income
statements (by segments), the accountant will be able to see clearly the profits
generated by each product.
Bear in mind, however, that the income statements by segments must be

prepared in the marginal income statement format. Why? The reason is that, as
previously discussed; only variable costs are relevant in decision making as fixed
costs are irrelevant and must be ignored. Hence, income statements based on the
marginal format can provide the type of information required above.
Problems which may arise in making decisions are usually related to fixed costs.
Note that fixed costs can be divided into two categories, namely direct fixed costs
and joint fixed costs.
(a) Direct Fixed Costs
Direct fixed costs refer to fixed costs that can be traced or assigned
directly to each product.
For example, the salary of a supervisor can be traced directly to product A,

B and C. It is often assumed, when a product is eliminated, that the related
costs can be avoided (whether totally or partially, depending on the given
situation). In this case, we assume that the direct fixed cost satisfies both
criteria of relevant cost and thus must be taken into account when making
decisions. However, if the direct fixed cost cannot be avoided, then the cost
is said to be irrelevant and must be ignored.

(b) Joint Fixed Costs
Joint fixed costs refer to fixed costs which are shared between the
existing products.
For instance, the salary of a general manager of a company which cannot be

allocated directly to each product will be considered as a joint cost.
Example 10.5
Puteri Idaman is a company producing a variety of school essentials, such as

school uniforms, school bags and shoes. For the past two years, the sales of
school uniforms have been quite poor, which have resulted in losses in the last
two consecutive years. The management of the company is worried about this
situation and is thinking of discontinuing the product. The management
accountant has been asked to prepare an analysis to help in making a decision.
Following is the information which has been collected successfully:
1. Condensed Income Statement by Segment.
Bags Shoes Uniforms Total

Sales 90,000 120,000 100,000 310,000
Less: Variable Expenses 48,000 60,000 48,000 156,000
Contribution Margin 42,000 60,000 52,000 154,000
Less: Direct Fixed Expenses
SupervisorÊs Salary 12,000 10,800 24,000 46,800
Warehouse Rent 3,000 1,800 9,000 13,800
Insurance 1,900 2,100 2,400 6,400
Promotion 3,500 4,200 7,100 14,800
Transportation 10,950 7,000 12,750 30,700
Total 31,350 25,900 55,250 112,500
Product Margin 10,650 34,100 (3,250) 41,500
Less: Joint Fixed Cost 27,950
Net Profit 13,550

2. Additional Information:
(a) The supervisor for uniform products has been transferred to another
section with the same salary.
(b) There are two warehouses storing clothing products; one of them is
owned by the company while the other warehouse is rented from a
tenant under a revocable lease contract (RM750 per month). The
storage warehouse owned by the company can be rented out to other
parties at a rental rate of RM350 per month.
(c) Insurance taken is based on the number of products and can be
revoked without incurring additional costs.

Determine whether the company should discontinue the uniform product or
retain the product from its manufacturing lines as shown in Table 10.3.
Table 10.3: Decision Whether to Retain or Discontinue the Production of Uniform

Product
Retain (RM) Discontinue (RM)
Sales 100,000 -0-
Less: Variable Expenses 48,000 -0-
Contribution Margin 52,000 -0-
Other Income (Warehouse Rental) 4,200
Less: Direct Fixed Expenses
SupervisorÊs Salary 24,000 24,000
Warehouse Rent 9,000 -0-
Insurance 2,400 -0-
Promotion 7,100 -0-
Transportation 12,750 -0-
Total 55,250 24,000
Increment (Reduction) in Income (3,250) (19,800)
The purpose of the analysis illustrated in Table 5.3 is to compare the income
received if the product is retained and if the product is discontinued. Based on
this analysis, we can observe that continuing the product will cause the company
to incur a loss of RM3,250 per year. On the other hand, discontinuing the product
will result in an increase in losses of RM16,550 (that is, the difference between the
two losses of RM3,250 and RM19,800). Thus, the company should not
discontinue the uniform product.

Supposing a detailed analysis is not performed and the management depends

totally on the information from the income statements by segments to decide, the
management may actually arrive at the wrong decision by discontinuing the
production of the uniform product. A negative profit margin of the uniform
product does not necessarily imply that its production must be discontinued.
This is because the information provided in the segmental income statements do
not take into account other information which are related to avoidable costs and
opportunity costs.
Based on the analysis above, the avoidable costs that will result from
discontinuing the uniform product include the cost of supervisorÊs salary,
warehouse rental, insurance, promotion and transportation. On the other hand,
the opportunity cost for discontinuing the uniform product is the warehouse
rental income from an outside party. At this juncture, cost analysis can also be
carried out, as shown in Table 10.4.
Table 10.4: Cost Analysis if Production of Uniform Product is Discontinued
(RM) (RM)
Avoidable Cost (Cash In-Flows):
Variable Costs 48,000
Warehouse Rent 9,000
Insurance 2,400
Promotion 7,100
Transportation 12,750 79,250
(+) Warehouse Rental Income 4,200
(-) Opportunity Cost (Cash Out-Flows):
Sales Income (100,000)
Reduction in Income (16,550)
10.4.2 Decision to Produce or Buy

Deciding whether to produce or buy is a common type of decision faced by an
organisation. To produce or to buy here refers to the companyÊs choice between
producing in-house components required to produce the product and buying
from external parties.

For example, in the process of producing computers, the components required

are the mouse, monitor, processor, disc and many others. Some of these
components are produced in-house by the company manufacturing computers
while other components are bought from external suppliers.
In fact, in some cases, it will be more profitable to buy components from external
suppliers than to produce them while in other cases it will be more profitable to
produce than to buy the components. Hence, the managers need to perform a
more comprehensive analysis before deciding on whether to produce or buy the
components.
Similar to the types of decision making that have been discussed previously,
there are two types of analyses which can be carried out in the produce or buy
decision.
(a) The first step in the analysis is to look at the differential cost between the
buying alternative and the alternative of producing in-house. The
alternative which provides the best benefits will be selected.
(b) The second analysis to be performed is to look at avoidable costs.
Avoidable costs refer to the savings made by the company. If an alternative
results in higher savings than the cost, then the alternative will be chosen.
Example 10.6
Mercury Berhad is a company that produces washing machines. One of the

components required in producing the washing machines is called SPF-10.
Currently, the company produces 20,000 units of SPF-10 at the following
production costs:
Direct Materials RM100,000

Variable Overheads 20,000
Fixed Overheads 80,000
Total Manufacturing Cost RM240,000
Manufacturing Cost Per Unit RM12.00
Income from Sales of Washing Machines RM300.00
Recently, a company known as Techno Company offers to sell SPF-10 components

at the price of RM9.00 per unit. If Mercury decides to purchase the components
from an outsider, a fixed overhead cost of RM5,000 can be eliminated. The
question is, should Mercury Berhad accept the offer?

At a glance, we can see that Mercury should buy the components from Techno
Company since the offer price of RM9.00 per unit is lower than the per unit
manufacturing price of RM12.00. Nonetheless, we cannot just compare the per
unit costs but must also perform some analyses related to relevant costs.
Table 10.5 provides all costs incurred regardless of whether or not they are
relevant for decision-making.
Table 10.5: Relevant and Irrelevant Cost Information
Relevant Irrelevant
Direct Materials Selling Price
Direct Labour
Variable Overheads
Fixed Overheads (Partial)
Purchase Cost
After identifying the relevant and irrelevant costs, we have to perform relevant
cost analysis, as shown in Table 10.6.
From the analysis given in Table 10.6, it is obvious that Mercury Berhad will incur
an additional loss of RM15,000 if purchases are made from an external party. This
is in contrast with our earlier perception that buying from an external party is
cheaper than producing the components. Based on the analysis, Mercury should
continue producing the component SPF-10 and reject the offer from Techno
Company.
Table 10.6: Relevant Cost Analysis (for 20,000 units) to Determine Whether to Produce or
Buy Component SPF-10
Produce Buy Net Income Increase

(Decrease)
Direct Materials RM100,000 - RM100,000
Direct Labour 40,000 - 40,000
Variable Overhead 20,000 - 20,000
Fixed Overhead 80,000 75,000 5,000
Purchase Cost SPF-10
(RM9 × 20,000) - 180,000 (180,000)
Total Cost RM240,000 RM255,000 RM(15,000)

The second form of analysis to be conducted by Mercury involves identifying

avoidable costs and additional costs as shown in Table 10.7.
Table 10.7: Relevant Cost Analysis (for 20,000 units) to Determine Whether to Produce or
Purchase Component SPF-10
Avoidable Cost Approach: (If component SPF-10 is purchased)

Cost Savings/Avoidable Costs:
Direct Materials RM100,000
Variable Overheads 20,000
Fixed Overhead s 5,000 RM165,000
Incremental Costs:
Purchasing Cost 180,000
Net Incremental Cost RM(15,000)
Occasionally, the company has to consider opportunity cost. As we discussed

earlier, opportunity cost is a type of relevant cost. Referring to Mercury Berhad,
we assume that the company has decided to purchase the component from
Techno Company. The capacity that was previously used to produce component
SPF-10 can now be used to produce other products, which can generate an
additional income of RM20,000. Letting go of this income is an additional cost to
produce the component in-house in the „produce or purchase‰ decision making
process. Accordingly, this opportunity cost has to be included in the „buy‰
column for the purpose of comparison. Thus, the new relevant cost analysis will
be as follows:
Table 10.8: Relevant Costs analysis (for 20,000 units) to Determine Whether to Produce or
Buy Component SPF-10
Produce Buy Net Income

Increase (Decrease)
Total Cost RM240,000 RM255,000 RM(15,000)
Opportunity Cost 20,000 - 20,000
New Total Cost RM260,000 RM255,000 RM5,000

From the analysis in Table 5.8, we can see that after taking into account the
opportunity cost, the cost of producing the component in-house is now higher
than the cost of buying it from an external party. Therefore, Mercury Berhad
should choose to purchase the component from an external party in order to
attain an additional net income of RM5,000.
The company must also consider other qualitative factors in making decisions,
such as releasing employees whose work involves producing the SPF-10
component. Besides, the company must evaluate the ability of the external party
to produce the components in the long run and ensure that the quality of the
component if produced by the supplier is better than if it is produced in-house.
ACTIVITY 10.3
After studying the earlier sections, if you are a manager in Company X

who is considering whether to produce or to buy a product from
Company Y, what are the factors which must be considered apart from
the relevant costs?
10.4.3 Decision to Sell Before or After Additional

Process
A joint production process produces two or more products called a joint product.
For example, processing a raw pineapple can produce canned pineapples and
natural pineapple juices. Thus, pineapple serves as the input for the joint
production process, which produces two joint products, namely, canned
pineapple and natural pineapple juice. In this example, the pineapple is
processed through the joint production process which cannot be allocated until it
reaches a point known as the split-off point. The two different products can only
be identified at the split-off point. Please refer to Figure 5.3 that illustrates the
joint process for producing pineapples.

Figure 10.3: Joint process for pineapple production
From Figure 5.3, we can see that the joint cost of RM1,000 consists of the raw
materials cost of RM200 and the conversion cost of RM800. The output from the
joint process cost is 1,000 kg of canned pineapple and 1,800 kg of pineapple juice.
It is quite common for managers in a manufacturing company to have joint

production processes, hence facing a situation which involves deciding whether
to sell the products at the split-off point or to carry on with an additional process
before selling the products to customers. Assume that at the split-off point, a
manager of Ros Company is considering whether to proceed with the additional
process of converting natural pineapple juice into cordial juice. In other words,
should the company perform an additional process to produce cordial pineapple
juice? Referring to Figure 5.3, we can also see that by converting natural
pineapple juice into cordial juice, the company will generate sales value of
RM800. Given the information above, what should the manager do? What costs
and benefits need to be considered?
Let us consider each of the costs involved carefully. First, the company has
incurred a joint production cost of RM1,000. Is this cost relevant for making the
aforementioned decision? The joint production cost is actually irrelevant and
must be ignored in this decision making since it does not change regardless of
the decision made by the manager. If the manager decides to sell at the split-off
point, the cost of RM1,000 will be incurred and similarly, if the manager decides
to proceed with the additional process, the cost of RM1,000 will still be incurred.
That is what we mean by the cost is unchanged and is therefore, irrelevant.

The question now is, what are the relevant costs and benefits involved here?
Only different costs and income arising from different alternatives will be
considered here, as shown in Table 5.9.
Table 5.9: Analysis of Income and Cost for Determining Whether to Sell at the Split-off
Point or After Additional Process
Sales Income from Cordial Pineapple Juice RM800

Sales Income from Natural Pineapple Juice (400)
Increment in Income from Additional Process 400
Separate Process Cost (100)
Net Benefit from Additional Process RM300
The analysis shown in Table 5.9 is performed by comparing between the

additional income arising from the additional process and the separate process
cost, which is the cost involved at the split-off point. From this analysis, if the
company gains net benefit from the additional cost, then it should proceed with
the additional process. Conversely, if the additional income from the additional
process is less than the cost of the additional process, then the company should
sell the product at the split-off point and should not proceed with the additional
process which will incur loss to the company.
Based on the above analysis, we can conclude that the company should perform
the additional process on the natural pineapple juice and sell cordial pineapple
juice as the company can raise its income by RM300.
10.4.4 Special Orders
A special order refers to an order received from customers which is outside

the companyÊs ordinary production or expected orders.
It has been a common practice for companies to undertake early planning

regarding production level, which is done through a production budget.
Nonetheless, there are situations where the company receives orders other than
the normal orders. This kind of order is known as a special order. Usually,
special orders are orders made specifically according to customersÊ requirements
where the products may need to be modified to suit the customersÊ needs.

There are several decisions which must be made by managers regarding special
order products.
(a) First of all, is it reasonable to accept this special order?
(b) Secondly, the setting of the price for the special order.
To answer the first question, that is whether or not to accept the special order, the
company should first consider its capacity. If the company has extra capacity,
then it can accept the order as long as that order provides an increase in the
companyÊs operating income. On the other hand, if the company does not have
additional capacity (that is, the company is already operating under full
capacity), then it should consider the opportunity cost and the increase in cost in
order to decide whether to accept the special order or not. In the above situation,
the company will accept the order as long as the increase in the companyÊs
operating income is more than the opportunity cost plus the increase in cost. We
will first discuss special orders for a company which has additional capacity.
Later on under the setting of price section, we will explore the situation where a
company receives a special order when it is already operating at full capacity.
Consider Example 10.7 for a discussion on the decision to accept a special order.
Example 10.7
IndahSari Company is a manufacturer of ready-made clothing. The companyÊs

practical production level is 20,000 pairs per year. However, currently the
company only produces 15,000 pairs. Recently, the company received a special
order of 500 pairs of clothing from a manager of Kolej Utara for the selling price
of RM120.00 for each pair. The manager has requested the clothing be altered to
suit the corporate image of the college. The alteration will involve an additional
cost of RM5.00 per pair. The company also has to hire a designer, which involves
an additional cost of RM1,000.00. In addition to the above, two more machines
must be rented to cater for this special order with the total rental costing
RM800.00 for the two machines.
Normally, the ready-made clothes produced by IndahSari Company are sold at a

price of RM150.00 per pair. The costs involved in getting each of the pair ready
are:

Direct Materials RM15.00

Direct Labour 20.00
Variable Manufacturing Overheads 25.00
Fixed Manufacturing Overheads 40.00
Per Pair Cost RM100.00
What type of analysis should be carried out to assist IndahSari Company in this
decision making? Like any other decision making, we will consider once again
the relevancy of its costs and benefits. Therefore, we need to first identify the
relevant costs and benefits for the above special order. The difference or increase
in operations is illustrated in Table 10.10.
Table 10.10: Income and Cost Analysis for Decision Making with Respect to the Special
Order
Per Pair Total

Increase in Income RM120.00 RM60,000
Increase in Costs:
Direct Materials RM15.00 7,500
Direct Labour 20.00 10,000
Variable Overheads 25.00 12,500
Alteration 5.00 2,500
Machine Rental 800
Total Increase in Costs: 33,300

Increase in Operating Income RM26,700
The calculation above suggests that the new order must be accepted as it
provides a total profit of RM 26,700, even though the selling price of the special
order is lower (RM120) than the normal selling price (RM150). If we observe the
above analysis carefully, it does not take into account the fixed overhead cost in
the analysis. This is due to the fact that the fixed cost does not increase with the
increased number of orders. The reason is that it remains unchanged whatever
alternatives we choose, and thus it is irrelevant and should be ignored in this
analysis.

Example 10.8
Rasa Sayang Berhad is a company that manufactures ice-cream. Currently, the

company produces two flavours of ice-cream: namely vanilla and strawberry.
The capacity of its factory is limited to the number of existing machine hours. A
total of 600 machine hours is available for usage every month. Rasa Sayang
Company can sell as many ice-creams it produces in both flavours. Thus, the
production is only restricted to one capacity, that is machine hours.
Data on the costs of producing and selling (per box) are given below:
Vanilla Strawberry
Direct Materials RM1.50 RM2.80
Direct Labour 2.00 3.00
Variable Manufacturing Overhead 2.50 1.20
Selling Price 10.00 9.50
Required Labour Hour Per Box 0.5 1
Required Machine Hours Per Box 0.08 0.04
Monthly Demand (in boxes) 10,000 12,000
Table 10.11 illustrates the calculation of the contribution margin per box for both
products of Rasa Sayang Company.
Table 5.11: Contribution Margin Per Box
Vanilla Strawberry
Sales 10.00 9.50
Less: Variable Expenses
Direct Materials RM1.50 RM2.80
Direct Labour 2.00 3.00
Variable Manufacturing Overheads 2.50 1.20
Total Variable Cost 6.00 7.00
Contribution Margin 4.00 2.50
At a glance, the analysis seems to imply that the vanilla flavour ice-cream is more
profitable than the strawberry flavour. It is true that vanilla ice-cream has a
higher contribution margin which helps to cover the companyÊs fixed costs as
well as contributing towards its profit. Nevertheless, there is an important factor

to be considered in Table 10.11. Recall that the companyÊs capacity is limited to
600 machine hours per month. This information needs to be taken into account in
the analysis.
To maximise the companyÊs total contribution which can cover the fixed cost and
profit, managers of the company must use every machine hour efficiently. The
relevant question here is no longer which product gives the maximum
contribution margin per box but rather which product gives the maximum
contribution margin per machine hour. The answer to this question is provided
in Table 10.12.
Table 10.12: Contribution Margin Per Machine Hour
Vanilla Strawberry
(a) Contribution Margin RM4.00 RM2.50
(b) Required Machine Hours Per Box 0.08 0.04
(a) ÷ (b) Contribution Margin Per Machine Hour RM50.00 RM62.50
From the calculation in Table 10.12, we can see that every machine hour used to
produce vanilla ice-cream will provide a contribution of RM50.00 to cover the
fixed costs and consequently contribute towards the companyÊs profit. On the
other hand, the machine hours used to produce strawberry ice-cream will
provide a contribution of RM62.50. Therefore, as soon as we take into account the
limited resources of Rasa Sayang Company, the product which contributes most
towards the companyÊs profit is the strawberry flavoured ice-cream.
After knowing which product is profitable, the next question is how many boxes
of strawberry and vanilla flavoured ice-cream can be produced? Table 10.13
illustrates the best use of the limited resources based on the contribution margin
per limited capacity as previously computed in Table 10.12.
Table 10.13: Sales Mix
Product Machine Hours Required Production Units

Strawberry 12,000 boxes × 0.04 machine hours = 480 hours 12,000
Vanilla 1,500 boxes × 0.08 machine hours = 120 hours 1,500*
Computation Steps*
(600 hours ă 480 hours) / 0.08 hours = 1,500 boxes.

From the analysis in Table 10.13, the company will give priority to all demands
for strawberry ice-creams as it is the most profitable product. Therefore, out of
600 available machine hours, 480 hours will be used to produce strawberry ice-
cream. The remaining machine hours of 120 hours (that is, 600 hours ă 480 hours)
will be fully utilised to produce the less profitable product per limited capacity,
which is the vanilla ice-cream.
It is evident here that the company can only produce 1,500 boxes of vanilla ice-
cream, that is by using the remaining capacity of the available machine hours.
Thus, the sales mix per month of Rasa Sayang Company is 12,000 boxes of
strawberry flavoured ice-cream and 1,500 boxes of vanilla flavoured ice-cream,
which results in the maximum contribution margin of RM36,000 [i.e. (RM2.50 ×
12,000 boxes) + (RM4.00 × 1,500 boxes)].
How does a special order affect this sales mix? In the previous section, we
discussed special order under excess capacity. Now, we will explore what will
happen when a company accepts a special order under full capacity.
Supposing that an officer of the Malaysian National Service Centre (MNSC) has
requested that Rasa Sayang Company supply 500 boxes of strawberry flavoured
ice-cream to the centre. Should the company accept or reject this special order?
Bear in mind that the company has fully utilised its existing capacity for the
normal production of both of its products. In other words, if the company agrees
to accept this special order, then it has to sacrifice its existing production. Which
product should be sacrificed? Obviously, it has to be the product with the lowest
contribution margin per limited capacity, which is the vanilla flavoured ice-
cream. Table 10.14 provides calculations that help the company to arrive at this
decision.
Table 10.14: Machine Hours Required for Special order
Required Machine Hours for Special Order:

500 boxes × 0.04 hours 20 machine hours
Number of Sacrificed Boxes of Vanilla Ice-Cream:
(20 hours Á 0.08 hours) 250 boxes
From the above analysis illustrated in Table 10.14, we will first need to determine
the required number of machine hours for the special order; i.e., 20 machine
hours are required to produce 500 boxes of strawberry flavoured ice-cream. The
20 required machine hours will be taken from the existing machine hours used to
produce vanilla ice-creams.

This means Rasa Sayang Company must reduce the production of vanilla ice-
cream by 250 boxes to allow the company to complete the special order. The total
amount of the contribution margin belonging to the sacrificed production is
considered an opportunity cost which equals to the loss of potential income to be
obtained by the company as a result of no longer producing the product. Thus in
this situation, the opportunity cost for Rasa Sayang is RM1000 (that is, 250 boxes
× contribution margin per unit of RM4.00).
With the new decision to accept the special order, the sales mix will be affected.
The new sales mix is given by Table 10.15.
Table 10.15: New Sales Mix
Product Production Units Machine Hours Required

Strawberry 12,000 + 500 = 12,500 500 hours
Vanilla 1,500 ă 250 = 1250 100 hours
The production of strawberry ice-cream will be increased to 12,500 boxes

including the special order and 500 machine hours will be used to produce this
product. On the other hand, the production of vanilla ice-cream will be decreased
to 1250 boxes which will only use up 100 machine hours after letting go 250
boxes of this product to cater for the special order. Hence, the whole machine
hour capacity of 600 hours is fully utilised again.
Now, what about the price setting of the special order? In setting the price for the
special order, we must take into consideration the increase in cost as well as the
opportunity cost (in the case of full capacity). Please refer to Table 10.16.
Table 10.16: Manufacturing Costs of the Special Order
Cost Per Unit Total

Variable Cost RM7.00 RM3,500
Opportunity Cost RM2.00 RM1,000
Total Increment in Costs RM9.00 RM4,500
* RM1000 Á 500 boxes = RM2.00
Based on the calculations in Table 10.16, the total increase in cost to be incurred if
the company accepts the special order is RM4,500, which consists of RM3,500 of
variable manufacturing cost and RM1,000 of opportunity cost. In other words,
the lowest (minimum) price for the special order that is acceptable to the
company is RM9.00 per box since it provides a similar profit as the profit lost
from the vanilla product by choosing the special order over the vanilla product.
In conclusion, the special order can be accepted provided that the price of the
special order is no less than RM9.00 per box, otherwise it will be a loss to the
company.
Ć Relevant information is crucial in the decision making process. The relevant

information can be quantitative or qualitative. Whatever form the relevant
information takes, be it quantitative or qualitative, it is a vital source to those
involved in the process of decision making. Every piece of relevant
information will usually have an effect on the decision made for each
alternative.
Ć In the decision making process, the information required as well as the

analysis for the information provided will differ according to the type of
decisions made. Since daily operations involve different types of information,
then separating between the relevant and irrelevant information is a difficult
but an important process to perform. As soon as the relevant information is
separated from the irrelevant information, the subsequent process of
analysing the relevant information can be performed, thus helping the
management to obtain more accurate and sound decisions. The decisions
made will affect the profitability of the company, both in the short and long
term.
Accuracy Joint fixed cost

Avoidable cost Opportunity cost
Constraints/resources bottlenecks Relevancy
Decision making Sales mix
Direct fixed cost Special order
External constraint Split-off point
Income statement by segment Tactical decision making
Internal constraint Timeliness

Topic X Long-Term
11 Decision
Making
LEARNING OUTCOMES
At the end of this topic, you should be able to:
1. Explain capital investment;
2. Apply various capital investment appraisal techniques;
3. Examine the effects of inflation and taxation in capital investment
appraisal;
4. Identify risks and uncertainty, sensitivity analysis and capital
rationing; and
5. Analyse ethical issues and other qualitative factors in long-term
decision making.
X INTRODUCTION
Apart from short-term planning, managers also need to do long term planning.
Managers often make decisions involving an investment today with the hope to
get returns in the future. Hypermarkets Tesco and MyDin made an investment
when they decided to open a branch in another town. PETRONAS was making a
huge investment when it decided to explore for gas and oil in an African country.
All of these investments require significant initial capital or fund outlay with the
hope of getting a return of extra cash flows in the future. These significant
investment decisions in projects that have long-term implications and benefits
are known as capital budgeting or capital investment decisions. There could be
many potential projects but the availability of funds is a major constraint.
Therefore, managers must thoroughly evaluate and choose projects with the
highest future returns. In this topic, you will learn various appraisal techniques
TOPIC 11 LONG-TERM DECISION MAKING W 259
for capital investment, and about several issues related to capital investment like
the effects of inflation, taxation, risks and uncertainty, sensitivity, capital ration
and ethical issues.
11.1 CAPITAL INVESTMENT APPRAISAL

TECHNIQUES
What is a capital investment decision? In our lifetime, we have made small and
big decisions like going to boarding school, entering university or college, getting
a job, purchasing our first car, getting in love and married, and so on. All of these
decisions require some rational thoughts and justifications due to their long-term
implications in our lives. Similarly, as managers, they frequently have to make
choices and decisions which involve utilisation of limited resources. Generally,
any decision that requires an outlay (initial investment) now in expectation of
future benefit or return is a capital budgeting decision. Below are some examples
of capital budgeting or investment decisions, which demand thorough and well
thought planning.
(a) Lease or purchase decision ă Whether a new machine should be leased or
purchased;
(b) Expansion decision ă Whether a new building, warehouse or any facility
should be acquired to increase capacity and sales;
(c) Equipment replacement decision ă Whether outdated machine should be
replaced now or later; and
(d) Cost-reduction decision ă Whether a new piece of equipment should be
acquired to reduce costs.
These capital investment decisions would involve planning, setting targets and
priorities, arranging financing and using a set of criteria for making the selection
of long-term assets and commitments. Poor capital investment decisions can be
very costly because they affect the long-run profitability of a company since huge
amounts of resources are invested and at risk for long period of time. This whole
process of making capital investment decisions is normally called capital
budgeting.
Managers sometimes have to choose among competing capital budgeting

projects or investment alternatives. In this case, if one project is accepted then the
other projects must be excluded. These competing projects are known as
mutually exclusive projects. On the other hand, independent projects are projects
that are either accepted or rejected; they do not affect the cash flows of other
projects.

260 X TOPIC 11 LONG-TERM DECISION MAKING
Capital investment involves long-term assets. The initial investment fund will be
used to employ assets. As we know, long-term assets (except land) will
depreciate over their lives. Hence, it is very crucial for us to make a correct
assessment of each of the alternative projects to determine its economic returns,
whether the capital investment will earn back its initial outlay and provide a
reasonable return.
You may wonder how we assess a capital investment. What aspects should we
consider?
In making a capital investment decision, we need to consider the impact of the

project on the companyÊs profitability. Thus, we must assess the risk of the
investment, estimate and project the quantity and timing of cash flows, and
forecast for potential cost savings, benefits and profit generation. Goals or targets
and priorities must be determined for capital investments. Companies also need
to identify some set of criteria for accepting or rejecting any proposed
investment. In the following section, you will learn several appraisal techniques
to assess potential investments. They include the following:
(a) Accounting rate of return;
(b) Payback;
(c) Discounted payback;
(d) Net present value;
(e) Internal rate of return; and
(f) Profitability index.
SELF-CHECK 11.1
1. Explain the process of capital investment decisions.
2. Identify available methods for assessing capital investment

decisions.
11.1.1 Accounting Rate of Return (ARR)

Accounting rate of return and payback are two techniques that ignore the time
value of money. These methods which do not consider the effect of time value of
money (also known as non-discounting models) are considered as weak or

inferior. In spite of this, these two techniques are frequently used in practice;
thus, it would be worthwhile for you to know about these methods.
Accounting rate of return (ARR) is also known as the return on investment,
simple rate of return and the return on capital employed. The formula for
computing ARR is as follows.
ARR = Average annual profit or Average income

Average investment
Note:
Average income/profit = Total of income/profit
Estimated life of investment-year
Average investment = (Original investment + Salvage value)

2
ARR measures the return on a project in terms of income or profit instead of cash
flows. Income or profit is different from cash flows because the computation of
income statement uses the accrual basis. Average income can be approximated
by subtracting average depreciation from average cash flow (equivalent to net
cash flow). Average investment includes one-half of the original investment plus
one-half of the scrap value at the end of the projectÊs life.
For illustration, let us examine the three alternative investment projects as shown
in Table 11.1.
Table 11.1: Three Potential Capital Investment Projects

Project X Project Y Project Z
RM RM RM RM RM RM
Initial cost 100,000 100,000 100,000
Net cash inflows:
Year 1 25,000 20,000 20,000
Year 2 25.000 40,000 40,000
Year 3 25,000 40,000 40,000
Year 4 40,000 40,000 5,000
Year 5 50,000 20,000 5,000
Year 6 50,000 - 5,000
Year 7 50,000 265,000 - 160,000 5,000 120,000
Scrap value - - -
NPV at a 10% discount rate 74,420 21,031 (6,800)

Let us assume that there is no scrap value and the straight-line depreciation
method is used, then the average investment for each project will be RM50,000.
Next, we may compute the ARR for each of these projects as follows:
ARR = Average annual profit or Average income

Average investment
Project X = (RM265,000-100,000)/7 years = RM23,571 = 47%

(RM100,000 + 0) / 2 RM50,000
Project Y = (RM160,000-100,000)/5 years = RM12,000 = 24%

(RM100,000 + 0) / 2 RM50,000
Project Z = (RM110,000-100,000)/7 years = RM1,429 = 3%

(RM100,000 + 0) / 2 RM50,000
As for ARR, the rule of thumb is to accept projects with high returns. If project X,
Y and Z are competing (mutually exclusive) projects, then project X with the
highest returns should be selected. In addition, companies sometimes might set
the target returns or specify the minimum required returns for potential projects.
Assuming a company looks for any potential projects that will provide minimum
returns of 20%, then project X and Y will be accepted.
ARR considers the profitability of projects and allows projects with different
useful lives of the assets to be compared. For instance, in the above calculation,
although project Y has a shorter life, project X is preferred to project Y due to its
high earnings over the whole life of the project. The only major flaw of ARR is
that it ignores the time value of money.
11.1.2 Payback
The payback method is very popular, widely used, and can be considered as the
easiest and most straightforward method. Payback period refers to the time
required for a firm to recover its original investment. When the stream of cash
flow is even every year, then the payback period can be calculated using the
following formula:

Payback period = Original investment

Annual cash flow
Cash flow = (Cash inflows ă Cash outflows)
For instance, assume a caterer invests in a new grinder costing RM100,000 and it
is expected to generate an annual cash flow of RM25,000 for 6 years. Then the
payback period will be 4 years (which is computed as RM100,000 divided by
RM25,000). However, if the cash flow is not constant from year to year, then the
payback period is calculated by adding the annual cash flows until the total is
equal to the original investment. Now let us refer back to Table 11.1; there are 3
projects with uneven annual cash flows. If you add up the cash flows for each
project, then you will get payback periods for project X, Y and Z as 3.6 years, 3
years and 3 years respectively. If a fraction occurs like for project X, it is
computed as follows:
RM25,000 (1 year)
RM25,000 (1 year)
RM25,000 (1 year)
RM25,000 (0.625 year = 25,000/40,000)
RM100,000 (3.625 years)
The rule of thumb says the shorter the payback period the better. Thus, from the
above calculation, using the payback method, project Y and Z are equally
desirable because they pay back their initial investment costs in three years, the
fastest amongst all projects. Sometimes, companies may set a maximum payback
period that will determine whether to accept or reject a project.
Before we proceed to the next appraisal model, let us evaluate this payback
model further. Please compare projects Y and Z again, by referring to Table 11.1.
According to their payback periods alone, you may accept either project Y or Z
(assuming they are mutually exclusive). Now, by knowing their rates of return
and payback periods, which project would you choose between Y and Z? The
answer is definitely project Y because Y gives higher returns. Although project Y
has the same payback period as project Z, the ARR method correctly identifies
project Y (with 24% return and positive NPV) is preferable to project Z (with only
3% returns and negative NPV). (We will discuss net present value (NPV) in more
detail in the following section.) This is because ARR does consider a projectÊs
profitability unlike the payback method. Therefore, if you use the payback model
solely, you may end up incorrectly accepting project Z in spite of its lowest

returns (and negative NPV), while project X with the highest returns will be
rejected. In addition, the payback model does not consider the timing and pattern
of the cash flows earned before the payback period, and also fails to take into
account the cash flows earned after the payback period.
To illustrate further, please consider the following two capital investments ă A

and B. Both projects require the same amount of initial investment of RM300,000
and have a 4-year life. The expected cash flows for A and B are as follows.
Investment Year 1 Year 2 Year 3 Year 4

A RM80,000 RM80,000 RM140,000 RM100,000
B RM150,000 RM100,000 RM50,000 RM100,000
If you compute and compare the payback periods for A and B, you will get the
same period of 3 years. So both investments are equally attractive since they can
recover the initial outlay within 3 years. If you were to choose between
investments A and B, which one is your choice? By looking at the timing and
pattern of the cash flows, investment B is preferable because it offers greater
ringgit return at the early stage of its life. For the first 2 years, A may generate
RM250,000 of cash flow while B generates only RM160,000. The extra cash flow
of RM70,000 (RM150,000-RM80,000) that B supplies in the first year could be
used productively like financing another potential project. Getting extra cash one
year earlier is better than a year later since the extra cash can be reinvested and
may provide additional returns in the following year.
Despite being criticised on its deficiencies for ignoring the time value of money
and projectsÊ total profitability, the payback period method is very helpful to
managers by providing information related to risk, liquidity and obsolescence.
The longer a company takes to recover its investment, the riskier it is. Projects
with riskier cash flows might require a shorter payback period than the average
period. Moreover, some industries have high risk of obsolescence, thus
companies in those industries may want to recover funds quickly. In addition,
companies who are facing liquidity problems would also be more interested in
projects with speedy paybacks. Managers are more likely to choose projects with
a quick payback period due to pressure to produce short-term results as well as
for self-interest (in cases whereby managersÊ performance appraisal is based on
short-term criteria like profit).
This simple payback method can be easily understood by all levels of

management. It simply indicates to you how quickly a project will recover itself.
In spite of its straightforward and simple approach, it is not wise and could be
misleading to use the payback model alone in making capital investment

decisions. Indeed, both the ARR and payback models ignore the time value of
money which could cause a critical deficiency and may lead managers to select
projects that do not maximise profits.
ACTIVITY 11.1
Analyse the following four (4) mutually exclusive capital investment

projects using ARR and payback methods. Give your suggestion on
which project to accept and justify your answer. During tutorial class,
discuss and exchange your answers.
Projects Red Yellow Green Blue

ARR 30% 25% 33% 15%
Payback period 4 years 4 years 4.5 years 5 years
11.1.3 Discounted Payback

In order to overcome a deficiency of the payback model with regard to the time
value of money, as mentioned in the previous section, we may adjust the
computation of the payback period by using cash flows that are discounted first
to their present values. This will make the payback period a valid indicator of the
time required for an investment to recover itself. This adjustment on the cash
flows is referred to as adjusted or discounted payback method.
To illustrate, let us compute the present value of cash flows for each project X, Y
and Z as in Table 11.1. To calculate the present value of the cash flows, you can
use the following formula or you may refer to the table of present value as
provided in this module. Assuming a discount rate of 10%, the present values of
those cash flows are computed in Table 11.2. The formula for present value is as
follows:
Fn 25, 000
PV = Example: PV = = RM22,727.27
(1 + i ) ( 1 + 0.10 )
n 1
F = future cash flow

n = number of years in the future
i = annual interest rate or discount rate

If we use the present value table, we need to get the discount factor at 10%
discount rate. To illustrate, let us compute the present values of the cash flows of
project X using the discount factors retrieved from the present value table.
Table 11.2: Discounted Cash Flows for Project X Using Discount Factors
Year Cash flow (RM) Present Value

Discount Factor
n Project X (RM)
1 25,000 0.9091 22,727
2 25.000 0.8264 20,660
3 25,000 0.7513 18,783
4 40,000 0.6830 27,320
5 50,000 0.6209 31,045
6 50,000 0.5645 28,225
7 50,000 0.5132 25,660
Table 11.3 below compares the discounted cash flows of those three projects: X, Y
and Z. We use the same discount factors (as in Table 11.2) to calculate the present
value of cash flows for projects Y and Z.
Table 11.3: Discounted Cash Flows for Three Potential Capital Investment Projects

RM RM RM RM RM RM
Net cash inflows:
Year 1 22,727 18,182 18,182
Year 2 20,660 33,056 33,056
Year 3 18,783 30,052 30,052
Year 4 27,320 27,320 3,415
Year 5 31,045 12,418 3,106
Year 6 28,225 - 2,823
Year 7 25,660 - 2,566
Sub-total 174,420 121,031 93,200
NPV at a 10% discount rate 74,420 21,031 (6,800)
Note: You may get slightly different present values when using the formula due to
rounding effects, which is equally acceptable.

Using the discounted cash flows, let us now calculate the payback period for
each project X, Y and Z, as shown in the following table.
Based on the calculation in the following table, the payback periods under the
discounted payback model are longer than the payback model. The rule of
thumb is still the same, to accept project with the shortest payback period. Thus,
by using discounted cash flows, project Y (payback period of 3.68 years) is
preferred to project X (payback period of 4.34 years). What is happening to
project Z? Remember, under the payback method Y and Z are equally desirable.
Now, after considering the time value of the cash flows, it seems that the total
cash flow of project Z generated along its asset life is not sufficient to recover its
original investment (which is clearly indicated by its negative NPV). The whole
cash flows (RM93,200) generated for 7 years of project Z are not enough to pay
back its initial investment of RM100,000. Therefore, the discounted payback
method somehow indicates whether the project is likely to be profitable, but it is
not able to estimate how profitable the project will be.

(RM) (RM) (RM)
Cash 22,727 1 year 18,182 1 year 18,182 1 year
Flows 20,660 1 year 33,056 1 year 33,056 1 year
18,783 1 year 30,052 1 year 30,052 1 year
27,320 1 year 18,710 0.68 year2 3,415 1 year
10,510 0.34 year1 3,105 1 year
2,823 1 year
2,566 1 year
Total 100,000 (4.34 years) 100,000 (3.68 years) (93,199) (>7 years)
Note: 1 = RM10,510 / RM31,045 = 0.34 year

2 = RM18,710 / RM27,320 = 0.68 year
Although the adjustment has been made, the discounted payback model cannot
be used solely and it cannot measure the profitability of an investment. Thus, this
method is normally used together with the net present value (NPV) and internal
rate of return (IRR) methods. Preferably, after you identify projects with positive
NPV, then you might want to know which one would recover its investment the
fastest by computing their payback periods using discounted cash flows.
Alternatively, managers may use payback period as a first screening test that
would shortlist projects for further rigorous evaluation. Previous studies show
that larger organisations prefer the IRR method, followed by the payback and

NPV method, while smaller organisations favour payback first, then IRR and
other methods.
11.1.4 Net Present Value (NPV)

Net present value (NPV) and internal rate of return (IRR) are classified as
discounting models that fully take into account the time value of money. Similar
to discounted payback model, all cash inflows and outflows will be discounted to
their present values.
NPV measures the profitability of an investment by looking at the difference in

the present value of the cash inflows and outflows associated with the capital
investment. Again to calculate the present value of cash flows, we can use either
the present value table or the formula, which would give the same result
(rounding effect may be observed). Business calculators have the functions for
calculating present and future values as well as NPV. You may also turn to
spreadsheets like Excel to compute NPV. Below is the formula for NPV.
NPV = (PV of cash inflows ă PV of cash outflows) ă Investment Outlay

NPV = PV of net cash flows - Investment Outlay
FV1 FV 2 FV n
NPV = + +L + n −I0
(1 + i ) (1 + i ) (1 + i )
1 2
FV = future cash flows

i = required rate of return from the investment
n = number of years (project life)
I = investment outlay
In order to apply the NPV method, we need to identify the required rate of
return (the i). It is the minimum acceptable rate of return, which is commonly
referred to as the discount rate or hurdle rate. Companies frequently choose a
discount rate which is a bit higher than the cost of capital. Sometimes company
may obtain funding from different sources, and of course at different costs of
capital. There is more discussion on cost of capital toward the end of this sub-
topic of NPV. Next, we will use the above formula to calculate the NPV for
project Y:

FV1 FV 2 FV n
NPV = + +L + n −I0
(1 + i ) (1 + i ) (1 + i )
1 2
RM20, 000 RM40, 000 RM40, 000 RM20, 000

NPV = + + + − RM100, 000 = + RM21, 031
(1 + 0.10 ) ( 1 + 0.10 ) (1 + 0.10 ) (1 + 0.10 )
1 2 4 5
The rules related to making this type of decision are to accept investments with
positive NPV, and reject investments with negative NPV. However, a zero NPV
indicates that managers should be indifferent to whether the investment is
accepted or rejected. Zero NPV means the investment just breaks even. A
positive NPV means there is potential increase in wealth and market value, also
indicates that the initial investment and required rate of return have been
recovered, and an excess of return is to be received. Thus investments with NPV
greater than zero are profitable and should be accepted. Investments with zero
NPV should be rejected because their earnings or expected return is less than the
required rate of return. Now, let us compare the NPVs for these three projects
(see Table 11.4). We may use the information in Table 11.3 to further compute
individual NPV.
Table 11.4: NPV for the Three Potential Capital Investment Projects

RM RM RM RM RM RM
Net cash flows:
Year 1 22,727 18,182 18,182
Year 2 20,660 33,056 33,056
Year 3 18,783 30,052 30,052
Year 4 27,320 27,320 3,415
Year 5 31,045 12,418 3,106
Year 6 28,225 - 2,823
Year 7 25,660 - 2,566
Sub-total 174,420 121,031 93,200
Investment outlay (100,000) (100,000) (100,000)
NPV 74,420 21,031 (6,800)

If they are mutually exclusive projects, then project X with the highest NPV will
be accepted. On the other hand, if they are independent projects both projects X
and Y are accepted for having positive NPVs.
Let us try to calculate NPV one more time. Consider the following case.
Suppose Amanah Bhd received an investment proposal to purchase a new

piece of machinery that will bring in a stream of cash flows for five consecutive
years at the amount of RM600,000, RM800,000, RM1,000,000, RM500,000 and
RM500,000 respectively. The initial outlay requirement is RM2 million, and an
additional investment of RM200,000 at year three is needed. Assume the
discount rate is 10%. This investment requires a working capital of RM800,000,
which will be recovered at the end of year five. The machinery is expected to
have a salvage value of RM300,000 at the end of year five.
Firstly, we need to determine the cash flow for each year; then we need to
compute the present value of those cash flows.
Year Cash flows Net cash flows Discount factor Present value
(RM) (RM) at 10% (RM)
0 (2,000,000 + 800,000) (2,800,000) (2,800,000)
1 600,000 600,000 0.9091 545,460
2 800,000 800,000 0.8264 661,120
3 1,000,000-200,000 800,000 0.7513 601,040
4 500,000 500,000 0.6830 341,500
5 500,000 + 300,000+800,000 1,600,000 0.6209 993,440
NPV 342,560
Please note that the salvage value of the asset is part of cash inflow. The working
capital is assumed as cash outflow at the early stage, similar to initial investment
(but they are not expenses), but later it will be treated as cash inflow when it is
recovered.
There are capital investments that pay back a fixed sum each period for a specific
number of periods. These even cash flows represent an annuity. To compute the
NPV for even cash flows, we should refer to the present value table for annuity,
which is simpler. Consider a project that requires an investment outlay of
RM100,000 with a series of cash inflows of RM50,000 each year for 5 years.
Assume that the rate of return is 10%. You may use the following formula or get

the discount factor from the annuity present value table. The calculation is
simpler than the ones for uneven cash flows.
A⎛ 1 ⎞
PV annuity = ⎜1− ⎟
r ⎜⎝ ( 1 + r ) n ⎟
⎠
RM50, 000 ⎛ 1 ⎞ RM50, 000

PV annuity = ⎜1−
⎜ 5 ⎟
= ( 0.3791) = RM189, 550
0.10 ⎝ ( 1 + 0.10 ) ⎟⎠ 0.10
NPV = RM189,550 ă RM100,000 = RM89,550
The funds or capitals available to finance capital investments may be in the form
of loan (debt) or stock (equity) and they come from various sources. So the cost of
capital for these blended funds will be the weighted average of the costs from the
various sources. This is also known as the weighted average cost of capital
(WACC). For illustration, assume that Alis Bhd may finance its capital
investment in two ways:
(a) By getting a loan for RM400,000 with an after-tax cost of 8%; and
(b) By issuing stocks to shareholders with expected return of 12%,to raise
another RM600,000.
Both sources contribute at a proportion of 40% and 60% (for loan and stock
respectively) to the total capital raised. These relative weights of 0.4 for the loan
and 0.6 for the stock will be used to calculate WACC as follows:
Source Amount of Relative Cost of capital Cost of capital

capital weight (%) (RM)
Loan RM400,000 0.4 8% RM32,000
Stock RM600,000 0.6 12% RM72,000
RM1,000,000 1.0 10.4% * RM104,000
WACC = 104,000/1,000,000 = 10.4% or

WACC = (0.4 × 0.08) + (0.6 × 0.12) = 10.4%

This WACC of 10.4% shall be used as the discount rate in calculating the NPVs.
SELF-CHECK 11.2
Using formulas and an Excel spreadsheet, calculate the NPVs for

projects X and Z. Then compare your answers with the ones in Table 6.4
(which are computed based on present value table).
11.1.5 Internal Rate of Return (IRR)

Similar to NPV, internal rate of return considers the time value of money. The
internal rate of return is the interest (represented by i or K) rate or the discount
rate (also known as discounted rate of return) that will make the NPV of an
investment zero. At this point, the present value of cash receipts is equal to the
present value of cash outlays. In other words, IRR specifies the maximum cost of
capital that can be committed to finance a capital investment without negatively
affecting the value to the shareholders. Using the following formula, we need to
solve for i in order to find the IRR.
FV 1 FV 2 FV n
I0 = + +L+
(1 + i ) (1 + i ) (1 + i )
1 2 n
Basically, we need to solve for IRR by trial and error, and it is easier to find it
using the present value table. Let us try to find the IRR for project Y. Given the
discount factor 10%, X has positive NPV of RM21,031 (refer to Table 11.4). Now
we need to increase the discount factor, let us say to 19%. Using an Excel
spreadsheet is very much helpful, so at 19%, we will get a negative NPV of
RM2,880. Recalculate by applying 17%, this will give a positive NPV of RM1,756.
So now you may estimate that the IRR should lie between 17% and 18% but
closer to 18%. Let us compute the NPV using discount factors at 17%.

Year Cash Flow Discount factor PV of cash flow

(RM) at 17% (RM)
1 20,000 0.855 17,100
2 40,000 0.731 29,240
3 40,000 0.624 24,960
4 40,000 0.534 21,360
5 20,000 0.456 9,120
Net PV of cash flow 101,780
Initial outlay (100,000)
NPV 1,780
The rule of thumb is that if the IRR is greater than the cost of capital, the
investment is considered profitable with positive NPV. On the other hand, if the
IRR is smaller than the cost of capital then the investment will have negative
NPV indicating it is unprofitable. To enable us to compare, we need to estimate
the cost of capital as well. As for project X, the IRR is around 17.740%. If the
estimated cost of capital is around 12%, then project X will be accepted, meaning
that as long as the cost of capital is lower than the IRR, the project will be
accepted.
Let us compare and discuss further those two discounting methods, the IRR and
NPV. In most cases especially for independent investments whereby accepting
one project will not disqualify the others, the IRR and NPV models will come to
the same accept/reject decisions. Nevertheless, in other cases the NPV model is
superior to the IRR model due to several reasons. As for mutually exclusive
projects like choosing one of many possible locations or assets, the NPV model is
preferable to the IRR model in terms of giving a correct ranking of these possible
investments. The IRR may incorrectly rank and prioritise projects due to its
reinvestment assumptions. Its implicit assumption is that cash flows generated
from a project can be reinvested immediately to earn a return equal to the IRR of
the previous project. Whereas, the NPV model is more conservative, it assumes
that all the proceeds from a project can be reinvested immediately only at the
cost of capital, which is more realistic.
Moreover, the IRR model has a technical deficiency in evaluating projects with
unconventional cash flows that give rise to multiple rates of returns. This
deficiency could result in the incorrect rejection of profitable projects. Another
limitation is the use of percentage of return (instead of in monetary terms) in
comparing potential investments this can sometimes be misleading. All of these
limitations and deficiencies explain why NPV is preferred to IRR in assessing
capital investments, especially for mutually exclusive projects.

11.1.6 Profitability Index

In some scenarios, there are several potential projects with positive NPVs but
there are limited funds available to finance those projects. Thus, we need to rank
and prioritise the projects according to their profitability. How do we rank
potential capital investments? One way to do it is by ranking them according to
their NPVs. Alternatively, we may rank them by their profitability index.
Profitability index is computed as follows:
Profitability Index = Present value of project

Investment outlay
The decision rule is to accept only those projects with a profitability index of
more than 1.0 since they have positive NPVs. For illustration, let us consider the
three projects X, Y and Z as displayed in Table 11.5.
Table 11.5: Comparison of Profitability Index
Projects Investment Present Net Present Profitability

Outlay-(RM) Value-(RM) Value-(RM) Index
X 100,000 174,420 74,420 1.74
Y 100,000 121,031 21,031 1.21
Z 100,000 93,200 (6800) 0.93
Project X, with the highest profitability index, also indicates that it has the
highest NPV. If they are mutually exclusive projects, only project X will be
accepted. On the other hand, if they are independent projects both projects X and
Y with a profitability index exceeding 1.0 will be accepted. Conversely, project
09iZ with a profitability index of less than 1.0 also indicates that it has a negative
NPV. Thus, ranking of projects according to profitability index will result in the
highest NPV.
11.2 CAPITAL RATIONING

Although sometimes a company has many potential capital investment projects
with positive NPVs, whether the company can take up all the projects is subject
to availability of funds to finance those investments. There are situations where
funds are limited or insufficient to finance all projects. These situations are
depicted as capital rationing, which occur due to various reasons. Top

management may impose a budget ceiling (for various reasons), limiting the
amount of funds available for investments in any particular period. Companies
may set such policies upon all capital investments that are financed by internal
funds. This internal limitation on fund availability is referred to as soft capital
rationing. However, funds may also be insufficient or limited due to external
constraints, such as difficulty in getting funds from the financial markets. Then
this situation is called as hard capital rationing.
So how do we allocate such limited funds to those potential projects? When there
is capital rationing, managers have to carefully select the projects that will
maximise the NPVs of the firm. In order to select, it is very crucial to rank those
potential projects, so that we can maximise the NPVs given the limited amount of
funds available. As mentioned in the previous section, ranking can be done
according to NPVs or profitability index. Using an absolute amount of NPVs in
ranking may result in incorrect decisions because this approach will choose only
large projects with high individual NPVs. These high individual NPVs in total
can be lower than the combined NPVs of a group of smaller projects (with lower
individual NPVs). To illustrate, consider the following information for three
projects:
Projects Investment Net Present

Outlay-(RM) Value-(RM)
A 50,000 14,000
B 30,000 10,000
C 20,000 8,000
If the fund is restricted to RM50,000, based on the NPV ranking approach which
project would you choose? Ranking the projects by their NPVs, you will end up
selecting project A with the highest NPV, which is not really a correct decision.
Actually, it is better to accept B and C, smaller projects with combined NPVs of
RM18,000.
To overcome this shortcoming, we may use the profitability index instead. To

illustrate, Axis Bhd have seven potential capital investments, M, N, O, P, Q, R
and S. The company has allocated RM50 million fund for capital investment for
the period. The ranking of those investments by NPV and profitability index are
computed as in Table 11.6.

Table 11.6: Ranking of Capital Investments

Investment Present Net Present Ranking
Profitability Ranking
Projects Outlay Value Value Profitability
Index NPV
(RM m) (RM m) (RM m) Index
M 10.0 11.8 1.8 1.18 6 5
N 25.0 26.90 1.9 1.08 5 7
O 20.0 24.7 4.7 1.24 1 4
P 10.0 13.15 3.15 1.32 2 2
Q 5.0 6.5 1.5 1.30 7 3
R 15.0 17.0 2.0 1.13 4 6
S 5.0 7.5 2.5 1.50 3 1
In order to select, we need to rank the projects in descending order. If we select

the projects based on NPV, then projects O, P, S and R will be accepted with a
total NPV of RM12.35 million as shown below:
Projects selected Investment Outlay Net Present Value

(NPV ranking) (RM m) (RM m)
O 20 4.7
P 10 3.15
S 5 2.5
R 15 2.0
Total NPV 12.35
On the other hand, if we rank and select the projects based on profitability index,
then projects S, P, O, Q and M will be accepted with a total NPV of RM13.65
million.
Projects selected Investment Outlay Net Present Value

(Profitability index (RM m) (RM m)
ranking)
S 5 2.5
P 10 3.15
Q 5 1.5
O 20 4.7
M 10 1.8
Total NPV 13.65

Comparing the two rankings, you can see that selection of projects according to
profitability index gives the highest NPV.
11.3 EFFECTS OF INFLATION AND TAXATION

IN CAPITAL INVESTMENT APPRAISAL
Capital investment decision making is in fact a complex topic. Therefore, it is
better for you to learn about it in small doses so that you may digest the topic
better. All previous discussion and illustration ignore the effects of inflation and
taxation for simplicity. Next, we will explore the topic in more depth by taking
into account those effects in our discussion and illustration. Indeed, you may find
many related textbooks discussing this sub-topic toward the end or in the
appendix to the respective chapter.
How does inflation affect capital investment decisions? Fundamentally, inflation

affects both the future cash flows and the required return on the investment,
which is the discount rate. To understand the inflation effect, firstly we need to
distinguish between nominal cash flows and real cash flows, and nominal rate of
return and real rate of return.
In terms of cash flows, expected inflation may increase your future cash flows
but it does not mean you are better off, and your purchasing power will remain
the same. How could it be? Let us say you expect to receive cash of RM300 in one
yearÊs time, assuming there is no inflation. With the money you intend to buy 3
decorated lamps at RM100 each for your new house. Now, let us assume that
there is an anticipated annual inflation rate of 10%. This anticipated inflation will
cause your future cash to increase to RM330 (RM300 × 1.10). At the same time,
generally inflation triggers the price of goods to increase as well. Therefore, the
cost of the lamps will increase to RM110 each (RM100 × 1.10). With your
expected cash of RM330 and the increased price, you will still only afford to buy
3 units, which explains why your purchasing power remains unchanged. The
RM330 cash flow is also known as a nominal cash flow, but if it is stated in
todayÊs purchasing power it will be called a real cash flow of RM300. The
relationship between the two can be expressed as follows:
Nominal cash flow = Real cash flow (1 + Expected inflation rate)n
Alternatively,
Real cash flow = Nominal cash flow / (1 + Expected inflation rate)n
Note: n = number of periods that the cash flow is subject to inflation

As discussed earlier, taking the example of a real cash flow of RM300 expressed
in todayÊs purchasing power, with an expected rate of inflation of 10%, then the
nominal cash flow at the end of year 4 would be: RM300 (1+ 0.10)4 =
RM439.23.Alternatively, a nominal cash flow of RM439.23 receivable at the end
of year 4 will be equivalent to a real cash flow of: RM439.23 / (1.1)4 = RM300.
The general rate of inflation is the average rate of inflation for all goods and
services traded in an economy and it varies amongst countries. Hence, from the
above discussion we could expect the adjusted NPV to be the same as the NPV in
the absence of inflation, given that the projectÊs cash flows increase at the same
rate as the general rate of inflation.
Next, we will examine the difference and relationship between nominal rate and
real rate of return. The rates of return quoted on financial securities already
reflect expected inflation, and they are known as nominal or money rates of
return. On the other hand, real rates of return are the rates when there is no
inflation. Their relationship can be represented in an equation as proposed by
Fisher (1930) as follows:
⎛ 1 + nominal rate ⎞ = ⎛ 1 + real rate ⎞ × ⎛ 1 + expected rate ⎞

⎜ of return ⎟ ⎜ of return ⎟ ⎜ of inflasion ⎟
⎝ ⎠ ⎝ ⎠ ⎝ ⎠
For instance, if the quoted rate on financial securities is 15% (this is the nominal
rate), and expected inflation is at a rate of 8%, then we can compute the real rate
of return as follows.
(1+0.15) = (1+ real rate) × (1+0.08)

(1+ real rate) = (1.15) / (1.08)
(1+ real rate) = 1.0648
Real rate = 1.0648 ă 1 = 6.48%
For illustration, consider the capital investment decision by Bagus Bhd as

follows:

Bagus Bhd is evaluating an investment proposal that requires an initial outlay

of RM1 million and is expected to generate a series of cash flows as follows:
Year 1 ă RM500,000
Year 2 ă RM800,000
Year 3 ă RM300,000
Year 4 ă RM300,000
The required rate of return is 10%. Initially assume zero inflation, and later
assume an annual inflation rate of 6% is anticipated during the four years of
the project. Ignore taxation effect.
Assuming there is zero inflation, we may calculate the NPV using the same
formula shown earlier, as follows:
FV1 FV 2 FV n
NPV = + +L + n −I0
(1 + i ) (1 + i ) (1 + i )
1 2
NPV = RM500, 000 +

RM800, 000 RM300, 000 RM300, 000
+ + − RM1, 000, 000 = + RM546, 000
( 1 + 0.10 ) ( 1 + 0.10 ) ( 1 + 0.10 ) ( 1 + 0.10 )
2 2 2 4
Now let us consider the inflation effect on our calculation of NPV. Whenever
there is expected inflation, the calculated rate of return required by investors
should include a premium for anticipated inflation. Next we need to revise the
required rate of return (RRR) to reflect the impact of inflation. Using FisherÊs
formula, the revised RRR is computed as follows:
1 + nominal RRR = [1 + real RRR] × [1 + rate of inflation]

= [1+0.10] × [1+0.06]
= 1.166
Thus, the nominal RRR equals to 16.6% (1.166-1.0). This nominal rate is used to
adjust the cash flows as well as the discount factor (16.6%). The revised NPV by
incorporating the inflation effect is computed as follows:

RM500, 000 ( 1.06 ) RM800, 000 ( 1.06 ) RM300, 000 ( 1.06 )

2 2 2
NPV = + + +
( 1.10 ) ( 1.06 ) ( 1.10 ) ( 1.06 ) ( 1.10 ) ( 1.06 )
2 2 2 2 2 2
RM300, 000 ( 1.06 )

4
− RM1, 000, 000 = RM546, 000

( 1.10 ) ( 1.06 )
4 4
The inflation effect is incorporated in the cash flows (in the numerator) and in the
required rate of return (in the denominator) using the same expected inflation
rate of 6%. As a result, the effect of inflation is cancelled out, whereby the
adjusted NPV (RM546,000) is the same as the previous NPV (without inflation
adjustment). To recap, the capital investmentÊs NPV is unaffected if the cash
flows and the required rate of return are exposed to the same rate of expected
inflation. In the above computation of NPV, we use nominal cash flows and
nominal discount rate. Alternatively, you may also calculate the NPV using real
cash flows and real discount rate.
What impact does taxation have on capital investment decision? Many

organisations do not pay or are exempted from income taxes, such as not-for-
profit organisations and government agencies. In addition, tax rules and codes
vary significantly amongst countries and could be very complicated. Thus, we
need to simplify the tax computations so that this sub-topic is within a
reasonable level for our absorption. Whenever taxes are applicable, we need to
identify which cash flows are subject to the tax rate. Let us examine each of the
capital investment items. In Table 11.7, we summarise how taxation affects the
capital budgeting cash flows:
Table 11.7: How Taxation Affects the Capital Budgeting Cash Flows
Effects of Taxation
Initial investment cash No adjustment required because cash flow does not affect the
outflow taxable net income (since it is not an expense).
Working capital cash No adjustment required because cash flow does not affect the
outflow and inflow taxable net income.
Revenue cash inflows Requires adjustment because cash flow affects the taxable net
income.
After tax cash flow =Before tax cash inflow (1-tax rate)
Expense cash outflows Requires adjustment because cash flow affects the taxable net
income.
After tax cash flow = Before tax cash outflow (1-tax rate)
Depreciation Requires adjustment in the form of tax saving/tax shield.

Another implication of taxation on capital investment is the capital allowance on

depreciation of assets. Certain expenses deducted from the income statement are
not allowable deductions for tax computation. Instead, a capital allowance can be
claimed on these expenses, like capital expenditure. For instance, depreciation on
plant, machines and other fixed assets is considered as a capital expenditure,
which will get capital allowance or also known as depreciation tax shields or tax
saving. The taxation laws and rules of individual countries will specify the
amount allowable for capital expenditure, the period over which the capital
allowance can be claimed, and the allowable depreciation method. Currently in
Malaysia, companies are eligible to claim capital allowance on their qualifying
capital expenditures. The capital allowances comprises initial capital allowance
of 20% on the outlay and annual capital allowance rates of 20%, 14% or 10% of
the outlay, depending on the nature of the capital expenditures or assets.
For illustration, consider the following case.
Jaya Bhd owns the mineral rights to land that has tin reserves. It is uncertain
if it should purchase equipment and start mining activities on the property.
The company has collected the following data for further analysis:
Cost of equipment........................................................ RM1,500,000

Required working capital ............................................ RM 600,000
Estimated annual cash inflows from sales of tin ......... RM1,000,000
Estimated annual cash expenses for salaries,
insurance, utilities and other cash expense ................. RM 550,000
Cost of road repairs in year 6 ...................................... RM 200,000
Salvage value of the equipment in 10 years ................ RM 500,000
Assume the tin reserves become exhausted after 10 years of mining, and thus
the mine will be closed that year. The equipment would then be sold at its
salvage value. The companyÊs after tax cost of capital is 12% and its tax rate is
25%. The company uses the straight line method, assuming no salvage value
for computing tax-shield purposes.
First we need to determine the annual net cash inflows, which are RM450,000
(RM1,000,000 – RM550,000). The detailed computation of the NPV is provided in
Table 11.8.

Table 11.8: NPV Computation with Tax Effect

Items Year Amount Tax After-Tax Discount PV of Cash
(1) Effect Cash Flows Factor at Flows
(2) (1)×(2) 12%
Cost of new equipment 0 (1,500,000) - (1,500,000) 1.000 (1,500,000)
Working capital 0 (600,000) - (600,000) 1.000 (600,000)
Annual net cash inflows 1-10 450,000 1-0.25 337,500 5.650 1,906,875
Road repairs 6 (200,000) 1-0.25 (150,000) 0.507 (76,050)
Annual depreciation 1-10 150,000 0.25 37,500 5.650 211,875
Salvage value of equipment 10 500,000 1-0.25 375,000 0.322 120,750
Release of working capital 10 600,000 - 600,000 0.322 193,200
NPV = 256,650
Next, we shall discuss each item in the table above for a better understanding
(see Table 11.9).
Table 11.9: Explanation on NPV Computation with Tax Effect
Cost of new The initial investment of RM1.5 million in the new equipment is included
equipment in full with no reductions for taxes. This represents an investment, not an
expense, so no tax adjustment is made. (Only revenues and expenses are
adjusted for the effects of taxes.) However, this investment does affect
taxes through the depreciation deductions that are considered below.
Working Observe that the working capital needed for the project is included in full
capital with no reductions for taxes. Like the cost of new equipment, working
capital is an investment and not an expense so no tax adjustment is
made. Also observe that no tax adjustment is made when the working
capital is released at the end of the project's life. The release of working
capital is not a taxable cash flow because it is a return of investment
funds to the company.
Annual net The annual net cash receipts from sales of tin are adjusted for the effects
cash receipts. of income taxes, as discussed earlier in the chapter. Note that the annual
cash expenses are deducted from the annual cash receipts to obtain the
net cash receipts. This simplifies computations.
Road repairs Because the road repairs occur just once (in the sixth year), they are treated
separately from other expenses. Road repairs are a tax-deductible cash
expense, and therefore they are adjusted for the effects of income taxes.
Depreciation The tax savings provided by depreciation deductions are essentially an
deductions annuity that is included in the present value computations in the same
way as other cash flows.

Salvage value Because the company does not consider salvage value when computing
of equipment depreciation deductions, book value will be zero at the end of the life of
an asset. Thus, any salvage value received is taxable as income to the
company. The after-tax benefit is determined by multiplying the salvage
value by (1 - Tax rate). Refer to Figure 11.1.
Figure 11.1: Salvage value of equipment
Since the NPV is positive, the company may purchase equipment and start
mining operations. Many countries have taxation rules that allow capital
allowances to be claimed on the net cost of the asset. Moreover, some countries
may allow similar types of assets to be combined into asset pools and purchases
and sales of assets are added to the pool. Therefore, there is no individual asset
capital allowance and tax charge. Thus, it is very crucial to be aware of specific
tax legislation that applies when appraising investment proposals. In many cases,
taxation is more likely to have significant impact on the NPV computation.

SELF-CHECK 11.3
Please compute the following:

(a) The nominal cash flow receivable at the end of year 3, if the real
cash in todayÊs purchasing power is RM500 and the anticipated
inflation rate is 8%.
(b) The real cash flow, if the nominal cash flow receivable at the end of
year 5 is RM4,000 and the anticipated inflation rate is 8%.
(c) The nominal rate of return, if the real rate of return is 5% and the
anticipated inflation rate is 8%.
(d) The real rate of return if the nominal rate is 12% and the
anticipated inflation rate is 8%.
(e) The expected inflation rate, if the nominal cash flow receivable at
the end of year 5 is RM1469.33 and the real cash flow is RM1,000.
(f) The expected inflation rate, if the real rate of return is 2% and the
nominal rate of return is 10.16%.
11.4 RISK AND UNCERTAINTY, AND

SENSITIVITY ANALYSIS
Making investment decisions entails careful analysis and evaluation because
various types of investments carry different degrees of risk and uncertainty.
Studies of past returns show that investors require higher expected returns for
investing in risky securities, and the safest investment has the lowest average
rate of return. Previous studies also indicate that investing in securities (in the
USA and UK) yields an average return of 4% for treasury bills (nearly risk-free)
and 13% for ordinary shares. In evaluating potential investments, managers need
to incorporate the risk and uncertainty into the discount rate. They need to come
up with a discount rate that reflects the risks of such an investment.
Some projects may be risk-free, and some others may have a risk equivalent to
the other group of listed share securities (also known as market portfolio).
However, for projects that do not belong to these two groups, a risk-adjusted
discount rate (expected return) has to be calculated. One approach is to study the
relationship between risk and return.
This relationship is described in a model called capital asset pricing model

(CAPM). The relationship between expected returns and risk (measured in terms
of beta) is represented by a sloping line, called the security market line. CAPM
describes an equation for the security market line. This security market line can
be used to establish the expected return on any security. Here is the formula:
⎛ Expected ⎞
⎜ return on ⎟ = ⎛⎜ Risk free ⎞⎟ + ( Risk Premium ) × beta
⎜ a security ⎟ ⎝ rate ⎠
⎝ ⎠
⎛ Expected ⎞ ⎛ Expected return ⎞
⎜ return on ⎟ = ⎛⎜ Risk free ⎞⎟ + ⎜ on the market − Risk Premium ⎟ × beta
⎜ a security ⎟ ⎝ rate ⎠ ⎜ portfolio ⎟
⎝ ⎠ ⎝ ⎠
For illustration, consider the following three securities ă the ordinary shares of
Companies X, Y and Z.
Security X Its risk is identical with the market portfolio

Security Y Its risk is half of the market portfolio
Security Z Its risk is twice of the market portfolio
Using the above formula, the expected returns for each security are computed as
follows:
Security X = 4% + (13% - 4%) × 1.0 = 13%

Security Y = 4% + (13% - 4%) × 0.5 = 8.5%
Security Z = 4% + (13% - 4%) × 2.0 = 22%
This is how the required rate of return for an individual firmÊs securities is
computed. Similarly, the cost of capital can be determined for an individual
company or for an entire industry. Figure 11.2 displays the cost of capital for
some industries. You do not have to worry how to get or compute for beta
because the figures for beta are published, especially in risk measurement
publications.

New York UniversityÊs Stern School of Business determines cost of

capital figures by industry. Almost 7,000 firms were included in
accumulating this information. The following sampling of industries
compares the cost of capital across industries. Notice that high-risk
industries (e.g., computer, e-commerce, Internet and semiconductor)
have relatively high costs of capital.
Air transportation 11.48% E-commerce 15.65%

Auto and truck 11.04% Grocery 9.79%
Auto parts 9.56% Internet 15.98%
Beverage (soft drinks) 8.16% Retail store 9.30%
Computer 14.49% Semiconductor 19.03%
Figure 11.2: Cost of capital by industry

Source: http://pages.stern.nyu.edu
Next we shall focus on sensitivity analysis. As we calculate the NPV of projects,

we include several independent factors or variables. These variables include
estimated cost of capital (the i), estimated life of the project (the n), estimated
initial outlay (the I), and estimated stream of cash flows that can be broken up
into selling price, sales volume, and operating costs. All of these variables have
different degrees of uncertainty, thus they are estimated with certain conditions
or assumptions. Sensitivity analysis can be performed to evaluate how
responsive or sensitive the NPV is to changes in those variables. It is also refers to
what if analysis. We might want to know what will happen to NPV if sales
volume drops (reduced cash inflow), if cost of capital increases, or if initial
investment is reduced. To perform sensitivity analysis, we need to recalculate
NPVs under alternative assumptions or scenarios to determine how far NPV will
respond to different conditions.
By performing the analysis, we can be aware of the variables that the NPV is
most sensitive to, and the extent of their impact on NPV. It also provides some
clues on why a particular project might not be successful. Once the decision has
been made, the company should control and monitor closely any critical
variables to which the NPV is most sensitive that most likely will cause NPV to
be negative. Remember, the decision rule is to accept projects with positive NPV,
whereas zero NPV means the investment is just going to break even (neither gain
nor loss).
There are many forms of sensitivity analysis. We may look at the impact on NPV
of a specified percentage change in a selected variable, for example, to examine
the change in NPV if the cost of capital increases by 5% (the discount rate).
Another form of analysis is by examining the extent to which each variable could
change until NPV becomes zero. We may also analyse the impact on NPV of best
situation (optimistic), most likely situation and the worst situation (pessimistic).
For illustration, consider the following capital investment by Cekap Bhd:
Cekap Bhd plans to purchase a new piece of machinery. Assume the cost of
capital is 18%. The estimated cash flows are as follows:
Year 0 Year 1 Year 2 Year 3

(RM) (RM) (RM) (RM)
Initial outlay -1,000,000
Cash inflows
(10,000 units at RM100 per unit) 1000000 1000000 1000000
Variable costs
(45% of selling price) 450000 450000 450000
Net cash flows -1,000,000 550000 550000 550000
NPV 195,850
Next we will perform sensitivity analysis on some of the variables in the above
case. We shall examine the extent of the change in the selected variables that will
lead the NPV towards zero (see Table 11.10). It will be very helpful if you
perform the analysis using a spreadsheet programme such as Excel in which
such analysis is available.
Table 11.10: Sensitivity Analysis of Variables
Variable Scenarios
Initial The initial outlay can be increased depending on the amount of NPV, the
outlay maximum amount it can increase is the amount of the NPV- RM195,850, by
which the investment breaks even (zero NPV). It is equivalent to an
increase of 19.59% (195,850/1,000,000). If it increases more than that, the
NPV will become negative.
Cost of You can calculate manually (by trial and error) to get the internal rate of
capital return for the project (at which the NPV is zero). Using Excel, the internal
rate of return is close to 29.92% (rounded up). Thus, the cost of capital can
increase by 66.22% (29.92-18/18) before the NPV turns negative.
Sales Using Excel, a sales volume of 8,363 will cause the NPV to approach zero.
volume That represents a decrease in sales volume of 1,637 units. Alternatively, we
can say that the sales volume may decline by 16.37% before the NPV
becomes negative.

Selling Using Excel, the NPV is close to zero when the selling price drops to
price RM83.70 per unit (rounded up), assuming sales volume is at 10,000 units
per annum and other variables remain the same. This represents a 16.3%
reduction in the selling price.
Variable Again, you may calculate using trial and error. We calculate (using Excel)
cost that when the variable cost is about 54% of the selling price, the NPV
becomes close to zero. Thus, the variable costs per annum can increase by
only 9% (54-45) of the selling price or by RM90,000 before the NPV
becomes nearly zero.
So, which variable(s) does the NPV seem to be most sensitive to? They are the
ones with the smallest percentages, like variable cost (9%), followed by sales
volume and selling prices (16.3%). Accordingly, the company needs to carefully
monitor these variables.
A major limitation of this sensitivity analysis is that it ignores the linkages

between the variables. For example, there is the expectation that sales volume
will increase whenever selling price is reduced. Managers would be more
interested in assessing the impact on NPV due to changes in the combination of
variables rather than treating each variable in isolation. Despite its limitations,
sensitivity analysis is widely used for formal risk management techniques.
11.5 ETHICAL ISSUES AND OTHER

QUALITATIVE FACTORS IN LONG-TERM
DECISION MAKING
From our preceding discussion, managers can easily make sound capital
investment decisions after considering quantitative factors like the NPV, IRR,
and profitability index, as well as the qualitative factors. Nevertheless, sometimes
managers may not make investment decisions in the best interest of the
company. What might cause or motivate managers to do that?
(a) Modifying figures for getting approval

Managers may encounter conflict in making decisions, especially when
they are deeply involved and have vested interest in a so-called pet project.
They are more inclined to get approval for the project even though the
projectÊs NPV and IRR may not meet the minimum requirement set by the
company. For instance, a manager may have invested significant efforts
and resources for several years to develop the project proposal. His
tendency is to ensure that the project is approved regardless of its
profitability. As a result, the manager would modify the relevant figures to

inflate projected cash inflows to get a positive NPV, and the project is
approved. His action is clearly unethical and may also be illegal.
To alleviate this conflict, some companies offer managers incentives like

part ownership in the company (via stock options), thus motivating
managers to accept only those projects that will increase the value of the
company over the long run. In addition, a post-audit can be conducted,
whereby the original capital budget is compared to the actual results.
Misleading or faulty capital budget analyses are identified through this
process, and the committed managers should be held responsible. This
post-audit may encourage managers to provide accurate estimates and
analysis.
(b) Pressure over short-term results

Managers are pressured for producing short-term results. This could be in
conflict with the companyÊs goal to improve long-term results. Certain
projects may have negative cash flows in the early stage. For instance, in
the first two years, revenues are low and depreciation charges are high,
resulting in significantly lower overall company net income than if the
project were rejected. Thus, managers have a strong tendency to reject this
kind of project even though it has positive NPV.
The conflict becomes worse when managers are evaluated and

compensated based on annual financial performance. This could cause the
managers to make decisions which are not in the best interest of the
company whenever their own interest may be at stake. Again, by offering
managers part ownership in the company may create an incentive for
managers to increase the value of the company over the long run.
(c) Myopic Behaviour

Managers might also be responsible and pressured to improve their
divisionÊs performance. Thus, managers are inclined to reject some
potential projects because those projects may lower their divisional
required rate of return. This kind of improper action is known as myopic
behaviour. Suppose the divisionÊs required rate of return is 15%, and the
companyÂs return is 10%. Assume there is a potential investment with a
positive NPV and the required rate of return of 12%. This investment
should be accepted since it will increase the companyÊs overall rate of
return; however, at the same time this investment will lower the divisionÊs
rate of return. Therefore, in this situation, the divisionÊs manager would
most likely act in the interest of his division at the expense of the company
as a whole.

To conclude, the above conflicts and pressures would cause managers to commit
unethical, and possibly illegal, behaviours in making capital investment
decisions. Top management should consider offering incentives or establishing
formal procedures or guidelines with regard to capital investment decisions in
order to avoid such unethical behaviour.
ACTIVITY 11.2
During the tutorial session, divide the class into two groups. Study the
following case, then after some time call upon members of the two groups
to debate on the ethical issues or behaviours in this case.
Case:
Assume the manager of Cergas Trading earns an annual bonus based on
meeting a certain level of net income. The company is currently
considering expanding by adding a second retail store. The second store is
expected to become profitable three years after opening. The manager is
responsible for making the final decision as to whether the second store
should be opened and would be in charge of both stores.
(a) Why might the manager refuse to invest in the new store even
though the investment is projected to achieve a return greater than
the companyÊs required rate of return?
(b) What can the company do to mitigate the conflict between the
managerÊs interest in achieving the bonus and the companyÊs desire
to accept investments that exceed the required rate of return.
11.5.1 Other Qualitative Factors

Despite those quantitative measurements like NPV, payback period and IRR,
qualitative factors are equally important when making capital investment
decisions. Some of the qualitative factors include company culture, ethics, safety
and environmental concerns. Awareness of the implications of these types of
qualitative factors is critical in making a well-informed capital-investment
decision. The following are some of the qualitative factors for consideration.
(a) Environmental Considerations

Managers must take into account the impact that any capital investment
will have on the environment. Capital investments may have various
degrees of effect on the environment. Normally, projects that are financially
attractive would have greater impact than projects that cost a lot. Thus,
managers need to seek a balance between affordability and

environmentally-friendly design. Even though quantitative analysis such as
NPV and IRR do not approve of investing in pollution control devices for a
company in the chemical industry, the investment may provide social
benefits. Unfortunately, it is very challenging to quantify the social benefits.
(b) Ethical Concerns

Capital investments may affect employee safety, local employment, local
lifestyle, local cost of living and local air quality in spite of their financial
benefits. For example, changing from manual processes to automation may
cause severe reduction in labour force, although it promotes greater cost
efficiency at the same time. In addition, providing low-quality safety
equipment may unnecessarily endanger employees on the job.
(c) Company Culture

Prior to making a capital-investment decision, managers should anticipate
the impact of the investment on the company's culture with regard to the
way people work together, the team spirit, the things people value and
believe in, the overall morale and the staff motivation. For instance,
establishing a second office abroad may change the communication
approach and information flow between teams. Team spirit and team
dynamics on the production floor may also be eroded due to investment in
machine-intensive production.
(d) Balance between cost and quality

The quality of goods or services can be directly affected by the quality of
capital resources. Sometimes, quantitative and qualitative factors can be on
opposing sides, because frequently the less expensive options will generally
yield lower quality. Thus, managers should seek a balance between cost
and quality in capital resources to maximise cost efficiency. For example,
acquiring low-quality kitchen equipment in a restaurant may reduce the
consistency of prepared food. Capital investments should be made to
improve a company's capacity to produce goods or deliver services.
(e) Image and reputation

Sometimes companies must invest in long-term assets even though NPV
and IRR analyses indicate otherwise. For instance, investing in new
technology may be crucial to maintaining a reputation as the industry
leader in innovation, even though the quantitative analysis does not
support the investment. Again it is quite challenging to measure the
benefits of being the industry leader in innovation.

Undeniably, quantitative measurements must be undertaken prior to making

capital investment decisions. However, qualitative factors sometimes may
outweigh quantitative factors in making investment decision. Thus, it is critical
for managers to evaluate and understand the impact of capital investment on
various qualitative factors prior to making investment decisions.
SELF-CHECK 11.4
1. What is sensitivity analysis?

2. Briefly describe two scenarios of capital investment in which
qualitative factors may outweigh quantitative factors.
3. AA Bhd produces chemical products. The company recently
decided to invest in expensive pollution control devices even
though the negative NPV pointed toward rejecting this
investment. What qualitative factor likely led the company to
make the investment in spite of the negative NPV?
Ć Capital investments require initial capital or fund outlay with the hope of
getting a return of extra cash flows in the future. These significant investment
decisions in projects that have long-term implications and benefits are known
as capital budgeting or capital investment decisions.
Ć The payback method and the accounting rate of return (ARR) are appraisal
techniques that ignore the effect of time value of money. The payback period
is the number of periods that are required to fully recover the initial
investment in a project. The ARR is determined by dividing a project's
accounting net operating income by the initial investment in the project.
Ć Investment decisions should consider the time value of money because a

dollar today is more valuable than a dollar received in the future. Both the
net present value (NPV) and internal rate of return (IRR) methods fully apply
the time value of money.
Ć In computing NPV, future cash flows are discounted to their present value.
The decision rule is to accept projects with positive NPV. The discount rate in
the NPV method is usually based on a minimum required rate of return such
as a company's cost of capital.

Ć The IRR is the rate of return that will cause the NPV to become zero. The
decision rule is to accept projects for which the IRR is higher than the
company's minimum required rate of return (cost of capital).
Ć In the case of capital rationing (fund constraint), only a few projects can be
selected. All potential projects can be ranked using either the project
profitability index, the NPV or the IRR. The project profitability index is
computed by dividing the NPV of the project by the required initial
investment. Ranking using profitability index will result in the highest total
NPV of potential projects.
Ć Taxation and anticipated inflation have an impact on the evaluation of capital

investments. Managers should identify which variables or items are affected
by taxation and inflation, and know how to incorporate the effects in the
analysis.
Ć Sensitivity analysis allows managers to be aware of the variables that the

NPV is most sensitive to, and the extent of their impact on NPV. It also
provides some clues as to why a particular project might fail. Once the
decision has been made, the company should control and monitor closely any
critical variables to which the NPV is most sensitive that most likely will
cause the NPV to be negative.
Ć Besides quantitative analysis, managers should also consider other

qualitative factors such as ethical issues, environmental concerns, safety and
company culture in making capital investment decisions. Sometimes,
qualitative factors may outweigh quantitative measures.
Accounting rate of return Investment outlay

Annuity Mutually exclusive projects
Capital budgeting Net present value
Capital investment decision Payback model
Discounted payback model Payback period
Independent projects Profitability index
Internal rate of return Weighted average cost of capital

Drury, C. (2008). Management and cost accounting. UK: South-Western, Cengage

Learning.
Fisher, I. (1930). The theory of interest. New York: Macmillan
Garrison, R. H., Noreen, E. E., Brewer, P. C., Cheng N. S., & Yuen, K. (2012).
Managerial accounting: An Asian perspective. Singapore: McGraw Hill.

MODULE FEEDBACK
MAKLUM BALAS MODUL
If you have any comment or feedback, you are welcome to:
1. E-mail your comment or feedback to modulefeedback@oum.edu.my
OR
2. Fill in the Print Module online evaluation form available on myINSPIRE.
Thank you.
Centre for Instructional Design and Technology

(Pusat Reka Bentuk Pengajaran dan Teknologi )
Tel No.: 03-27732578
Fax No.: 03-26978702


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Copyright © Open University Malaysia (OUM)

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Module Writer: Noor Asma Jamaluddin

Moderator: Noral Hidayah Alwi

Developed by: Centre for Instructional Design and Technology

First Edition, November 2008

Copyright © Open University Malaysia (OUM), April 2015, BBMA3203

Copyright © Open University Malaysia (OUM)

Topic 1 Cost Volume Profit Analysis 1

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2.5 Preparation of a Pro-Forma Income Statement 42

Topic 3 Budgetary Control 67

Topic 4 Standard Costing and Variance Analysis 103

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4.5.3 Sales Mix and Sales Quantity Variances 121

Topic 5 Variance Analysis 143

Topic 6 Productivity and Cost of Quality: Measurement, Report and 165

Topic 7 Accounting Information for Pricing Decisions 177

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7.3.4 Limitations on the Use of Cost Approach 187

Topic 8 Performance Evaluation in Decentralised Firms 196

Topic 9 Transfer Pricing in Multi-segment Firms 215

Topic 10 Short-Term Decision Making 231

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Topic 11 Long-Term Decision Making 258

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COURSE GUIDE DESCRIPTION

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Table 1: Estimation of Time Accumulation of Study Hours

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Topic 1 elaborates on profit planning using Cost-Volume-Profit (CVP) Analysis.

Topic 2 explains how budgets are used as a planning and performance

Topic 3 elaborates on using a budget as a good control system. It also compares

Topic 6 talks about the role of management accounting in measuring

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Topic 8 describes the delegation of responsibility in decentralised firms and how

Topic 9 discusses the objective of transfer pricing, emphasis on goal congruence,

Topic 11 is concerned with long term decisions. It focuses on the appraisal

TEXT ARRANGEMENT GUIDE

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Self-Check: This component of the module is inserted at strategic locations

Activity: Like Self-Check, the Activity component is also placed at various

References: The References section is where a list of relevant and useful

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TAN SRI DR ABDULLAH SANUSI (TSDAS)

Cost volume profit analysis (CVP) is a technique in management accounting

1.1 IMPORTANCE OF COST VOLUME PROFIT

Cost volume profit analysis is a method of analysis which determines the

In fact, this analysis plays an important role in helping the management to

A shop owner likes to talk about profit whenever he sells ice-cream in

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1.1.1 Setting the Selling Price

1.1.2 Determining the Sales Mix

1.1.3 Choosing the Marketing Strategy

1.1.4 Evaluating the Impact of Changing Costs

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1.2 ASSUMPTIONS IN COST VOLUME PROFIT

1.3 BREAK EVEN POINT (BEP)

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1.4 APPROACHES IN COST VOLUME PROFIT