What is the purpose of costing?

1.To value inventory.

2. To record cost associated with product need to be recorded in income statement.

3. For pricing of product. Eg- CP is 8, so after adding profit of 2 SP 10.

4.Decision making regarding which product should be mfg and of what quality.

A standard cost of a product or service is a pre-determined unit cost set under specified
workinf condition.

Purpose of standard costing,

1. The standard cost can be compared to the actual cost and any differences investigated.

2. Planning – standard costing helps in budgeting.

3. performance measurement – Any d/fces btwn the standard and actual cost can be used
as a basis for assessing the performance of cost centre managers.

4.Inventory Valuation- act as an alternative to LIFO and FIFO.

Standard costing is more suitable to organsiation with:

Organisation with mass production of homogenous products,

Repetitive assembly work.

Note- std costing is less suited for orgn. that mfg non-homonogenous products or where
level of human intervention is more.

Std costing is based on expected price and usage of material, labour and overheads.
Types of std costing

1. Attainable std- considering resources capacity efficiency avail. What can be achieved.

2. Current std- when something exception happens this is used.

3. Basic std- something which is fixed for 5-6 yrs (used for trend analysis).

4. ideal std- has problem that actual will be different.

1. Fixed budget- prepared for single activity.

2. Flexible budget- prepared for D/F possible out comes.

3. Flexed budget- prepared for 2-3 D/F activity no need to prepare if already prepared
inflexible.

Traditional costing methods

1. Absorption costing- means to determine full production cost per unit.

2. Marginal costing is extra cost arising from making and selling one more unit of a
product or service. Or saving of cost in makinf and selling one more unit.

Contribution= sales – variable cost of sale

In MC contribution varies with volume of units sold.

Profit will increase as sales volume rises by extra contribution earned.

NOTE -Since fixed cost expenditure does not alter, marginal costing gives an accurate
picture of how a firm's cash flows and profits are affected by changes in sales volumes.

Advantages of AC and MC

Ac

1.Includes FC OH in inventory value in accordance with IAS

2. under/over absorption is useful in controlling cost.

Disadvantage of AC is that it is very process and is not useful in decision making like MC.

Marginal costing
1. contribution per unit is constant, it is not like profit which changes as change in sales
volume. And it is simple to operate.

2. FC is charged fully.

3.it helps in decision making.

MC does share fc per unit but charged fully,

Closing inventory is not valued as per IAS2.

Example 1

Merlene Company uses a standard cost accounting system. Data for the last fiscal year
are as

follows.

Units

Beginning inventory of finished goods 100

Production during the year 700

Sales 750

Ending inventory of finished goods 50

Per Unit

Product selling price $200

Standard variable manufacturing cost 90

Standard fixed manufacturing cost 20*

Budgeted selling and administrative costs (all fixed) $45,000

*Denominator level of activity is 750 units for the year.

There were no price, efficiency, or spending variances for the year, and actual selling and

administrative expenses equaled the budget amount. Any volume variance is written off
to cost of

goods sold in the year incurred. There are no work-in-process inventories.

The amount of operating income earned by Merlene for the last fiscal year using variable
costing

was

a. $21,500.

b. $22,500.

c. $28,000.

d. $31,000.

Solution:

MC per unit= 90

AC per unit = 90+20=110

FC perunit = 750*20=15000

Only calculate profit for 750 units becoz sales is of 750 units only.

Particular AC MC
Sales 750*200 150000 150000
-Cost of sale
100+700-750=50 50*110 50*90
Contribution - 750*110
Gross profit 750*90
-Fixed mfg cost - 15000
Profit 67500 67500
-Fixed sellinf and admn 45000 45000
Income as per MC - 22500
-Under absorbed (Note1) 1000 -
Income as per AC 21500

Note 1 Under or over absorbed cost calculation

For 700 units FC should 700*20=14000

But actual FC is 15000

So under absorbed = 1000

Opp.stock higher value reduce income

Opp.stock lower value increase income.

Adjustment in F.C

Opp stock and closing both value will be higher in AC because of FC higher value of opp.
Stock will reduce profit and high value of closing stock will increase profit.

Opp stock = 100

Closing stock =50

Therefore 50*FC = 50*20=1000

………………………………………………………………………………………………….

Example 2

Consider the following situation for Weisman Corporation for the prior year.

• The company produced 1,000 units and sold 900 units, both as budgeted.

• There were no beginning or ending work-in-process inventories and no beginning

finished

goods inventory.

• Budgeted and actual fixed costs were equal, all variable manufacturing costs are
affected by

volume of production only, and all variable selling costs are affected by sales volume only.

• Budgeted per unit revenues and costs were as follows.

Per Unit

Sales price $100

Direct materials 30
Direct labor 20

Variable manufacturing costs 10

Fixed manufacturing costs 5

Variable selling costs 12

Fixed selling costs ($3,600 total) 4

Fixed administrative costs ($1,800 total) 2

The operating income for Weisman for the prior year using absorption costing was

a. $13,600.

b. $14,200.

c. $15,300.

d. $15,840.

Solution

Particular MC AC
Sales 90000 90000
(-)Cost of sale (30+20+10)*90054000 58500
Cont/prime(900*40) 36000 31500
(-)Fixed.mfg cost 5000 -
(-)variable selling cost (900*12)
10800 10800
(-)selling and admn. 5400 5400
Income 14800 -
(+) FC of closing stock (100*5)
- 500
Income 14800 15300

Note: under and over absorption is based on estimation and actual, only change in
estimate and actual will come under and over.

………………………………………………………………………………………………….

Example 3

Mill Corporation had the following unit costs for the recently concluded calendar year.

Variable Fixed

Manufacturing $8.00 $3.00

Nonmanufacturing $2.00 $5.50

Inventory for Mill’s sole product totaled 6,000 units on January 1 and 5,200 units on
December 31.

When compared to variable costing income, Mill’s absorption costing income is

a. $2,400 lower.

b. $2,400 higher.

c. $6,800 lower.

d. $6,800 higher.

solution

income in MC and AC both will be exept change in FC of closing whichi will be added in AC
so closing stock is 800 and FC = 3.

Therefore, 800*3=2400 higher in AC as compared to MC.

…………………………………………………………………………………………………

Example 4

Troughton Company manufactures radio-controlled toy dogs. Summary budget financial

data for

Troughton for the current year are as follows.

Sales (5,000 units at $150 each) $750,000

Variable manufacturing cost 400,000

Fixed manufacturing cost 100,000

Variable selling and administrative cost 80,000

Fixed selling and administrative cost 150,000

Troughton uses an absorption costing system with overhead applied based on the
number of units

produced, with a denominator level of activity of 5,000 units. Underapplied or

overapplied
 manufacturing overhead is written off to cost of goods sold in the year incurred. The
$20,000

budgeted operating income from producing and selling 5,000 toy dogs planned for this
year is of

concern to Trudy George, Troughton’s president. She believes she could increase
operating income

to $50,000 (her bonus threshold) if Troughton produces more units than it sells, thus
building up the

finished goods inventory. How much of an increase in the number of units in the finished
goods

inventory would be needed to generate the $50,000 budgeted operating income?

a. 556 units.

b. 600 units.

c. 1,500 units.

d. 7,500 units.

Sales 150 750000

- Var.Cost 80 400000
- Fixed mfg 20 100000
Cont 50 250000
- Fixed.Selling 30 150000
- Var.selling 16 80000
Income 4 20000

AC Note: so in this ques we need to earn profit of 50000 by producing more becoz FC per
unit will be carried forward.

If we produce and sell 5000 units d/f in MC and AC is 0 becoz of no opp and clsing stock
(no d/f in opp and closing stock)

To increase profit to 50000 we need to increase production i.e 50000-20000=30000.

FC of clsng stock should be 30000 and FC per unit is 20 so 30000/20=1500 units

5000+1500=6500 units production will give profit of 50000 and over absorption is 1500
units.
……………………………………………………………………………………………….

Example 5

Bethany Company has just completed the first month of producing a new product but has
not yet

shipped any of this product. The product incurred variable manufacturing costs of
$5,000,000, fixed

manufacturing costs of $2,000,000, variable marketing costs of $1,000,000, and fixed

marketing

costs of $3,000,000.

If Bethany uses the variable cost method to value inventory, the inventory value of the
new product

would be

a. $5,000,000.

b. $6,000,000.

c. $8,000,000.

d. $11,000,000.

Solution: In MC only variable mfg cost is included so inventory value is 500000

…………………………………………………………………………………………………

Example 7

During the month of May, Robinson Corporation sold 1,000 units. The cost per unit for
May was as

follows.

Cost Per Unit

Direct materials $ 5.50

Direct labor 3.00

Variable manufacturing overhead 1.00

Fixed manufacturing overhead 1.50

Variable administrative costs .50

Fixed administrative costs 3.50

Total $15.00

May’s income using absorption costing was $9,500. The income for May, if variable
costing had

been used, would have been $9,125. The number of units Robinson produced during May
was

a. 750 units.

b. 925 units.

c. 1,075 units.

d. 1,250 units.

Solution: difference of 9500-9125=375 is because of FC of closing stock so 375/1.5 = 250

Therefore 1000+250=1250 units

………………………………………………………………………………………………….

Advance Costing Method (ABC)

Or morden costing method

OAR= cost of activity / driver of activity

ABC is lengthy process

ABC is/ should be applied in only those organisation where

1.co. producing D/F prodducts

2.All product consume d/f resource

3.All product overhead exp is high as compared to normal direct cost.

Steps

1.cost pool
2.cost driver

3. calculate OAR

4. calculate OH cost for each product.

5.add full cost and profit.

………………………………………………………………………………………………….Example 1

A company which makes two products, Alpha and Zeta, uses activity-based costing to

absorb its overheads. It has recently identified a new overhead cost pool for inspection

costs and has decided that the cost driver is the number of inspections.

The following information has been provided:

Total inspection costs $250,000

Alpha Zeta

Production volume (units) 2,500 8,000

Machine hours per unit 1 1.5

Units per batch 500 1,000

Inspections per batch 41

What is the inspection cost per unit of product Alpha? Select from the list below.

List options are as follows:

• $23.81

• $17.24

• $71.43

• $80.00

Solution: 250000/28*20=178571.42/2500=71.42.

2500/500=5*4=20

8000/1000=8*1=8
Therefore 71.43

………………………………………………………………………………………………….

Example

DRP Ltd has recently introduced an activity-based costing (ABC) system. It manufactures

three products, details of which are set out below:

Product: D R P

Budgeted annual production (units) 100,000 100,000 50,000

Batch size (units) 100 50 25

Machine set-ups per batch 3 4 6

Purchase orders per batch 2 1 1

Processing time per unit (minutes) 2 3 3

Three cost pools have been identified. Their budgeted costs for the year ending 30 June

2003 are as follows:

Machine set-up costs $150,000

Purchasing of materials $70,000

Processing $80,000

What is the budgeted machine set-up cost per unit of product R?

A $6.52

B $0.52

C $18.75

D $1.82

Solution:

D R P

No of Batches 1000, 2000 , 2000.

Machiine -

150000/3000+8000+12000=6.52

6.52*8000/100000=0.52

Therefore B $0.52

………………………………………………………………………………………………

Advantages and disadvantages of ABC

ABC in the public sector

Austerity measures introduced by many governments have meant that the public sector is
under increasing pressure to deliver more services, for less money, and with greater
transparency. Public sector organisations thus need to identify, allocate and control costs
more than ever before. ABC is seen as one possible tool to help with this.

The main drivers for introducing ABC are:

Public responsibility – responsible public organisations must have tight control of running
costs at a time when resources provided by central government are strictly limited.

Public accountability – many organisations are being challenged as to whether or not

they spend taxpayer money wisely and feel a need to demonstrate this when the
questions are asked.
Resource allocation within organisations – there have been concerns in many
organisations as to whether the services provided had an equitable distribution of scarce
resource – or whether those who shouted loudest got the most resource.

Helping managers to manage – managers need a better awareness of what activities

actually cost to provide before they can think which to cut.

– However, many public sector organisations have resisted the introduction of ABC.

– To measure the cost of a service and take into account resource costs, the resource
used must be measured – which often means recording time spent.

– Timesheets allow accountability for what people are actually doing, and for this cost
then to be allocated to services. This is a challenge for the public sector, and for those
that wish to use ABC or take a similar approach, a culture change is definitely required.

…………………………………………………………………………………………………………….

Throughput costing

Or

Theory of constraint

Steps

1. identify bottleneck

2.

Throughput Accounting Ratio (TPAR)

Example 1

X Limited manufactures a product, that requires 1.5 hours of machining. Machine time is
a bottleneck resource, due to the limited number of machines available. There are 10
machines available, and each machine can be used for up to 40 hours per week.

The product is sold for $85 per unit and the direct material cost per unit is $42.50. Total
factory costs are $8,000 each week.

Calculate:

(a) the return per factory hour

Solution

85-42.5/1.5=28.33

(b) the TPAR

Cost per factory hour = 8000/400=20

TPAR = 28.33/20=1.416

………………………………………………………………………………………………………..

Improving the TPAR

Increase SP
Decrease material cost without change in quality (by changing material or supplier)

Reduce operating exps.

……………………………………………………………………………………………………….

Example

Eunice Co produces three products, the Widget, the Fidget and the Bidget. Sales price and
cost details (per unit) are as follows for each of these products:

Eunice Co has a bottleneck resource of labour hours, with only 10,000 hours available per
month due to trade union restrictions and a limited skillset in the labour market. Direct
labour costs are $12 per hour, and other monthly fixed costs amount to $65,000.

Calculate the optimal production plan given the current bottleneck restraint, and the
resulting monthly profit.

Solution: total number of minutes=10000*60=600000

Calculation of t.p contribution

Widget Fidget Bidget

Sales 24 12 6

m.cost 14 4 3

T.P,cont. 10 8 3

Calculation return perfectory

Widget Fidget Bidget

T.P cont. 10 8 3
Lab.per.unit(min) 40 25 5
T.P per min 0.25 0.32 0.6
Rank 3 2 1
Tp per min=10/40=0.25

Or TPAR based ranking

Cost perfectory= 185000/600000=0.31

W=0.25/0.31= <1 3
F= 0.32/0.31= =1 2
B=0.6/0.31= 2 1
Note- Here all 3 product are produced with same resource and facility so cost per
factory will be same 185000/600000= 0.31, T.P will be divided by 0.31 to calculate TPAR.

Optimal production plan

Product Units Minuts T.P per min Total T.P

B 25000 125000 0.6 75000
F 15000 375000 0.32 120000
W 2500 100000 0.25 25000
Total= 600000 220000
- (10000*12)+65000= 185000

Max income 35000

………………………………………………………………………………………………………………

Example 2

The following information is available for a single product:

Units produced 500

Time taken 200 hours

Maximum time available 200 hours

Materials purchased 1,000 kg costing $3,000

Materials used 800 kg

Labour costs $2,000

Overheads $1,500

Sales $9,000

Which of the following is the throughput accounting ratio for this product?

Solution:

Cont.T.P= 9000-3000=6000 6000/500=12

Per unit time= 200/500=0.4

Return perfactory=12/0.4=30

Cost perfectory= 3500/200=17.5

TPAR= 30/17.5=1.71.

Institute answer

The throughput accounting ratio is defined as throughput/total factory costs (these can

both be calculated per hour, but that is, more work for the same answer).

Throughput = sales – all material costs = $9,000 – $3,000 = $6,000

(Note that we use materials purchased instead of materials used.)

Total factory costs 5 all other production costs = $2,000 + $1,500 = $3,500

TA ratio = $6,000/$3,500 = 1.7.

………………………………………………………………………………………………………..

Example 3

Which ONE of the above statements is NOT true of throughput accounting?

A Throughput accounting considers that the only variable costs in the short run are

materials and components.

B Throughput accounting considers that time at a bottleneck resource has value, not

elsewhere.
C Throughput accounting views stock building as a non-value-adding activity, and

therefore discourages it.

D Throughput accounting was designed as a decision-making tool for situations where

there is a bottleneck in the production process.

Solution: D All of these points are true, except D. Throughput accounting was designed as a
performance measurement tool, not a decisionmaking tool. One of its advantages is that it will be
used by managers to make decisions that have outcomes that are goal congruent with corporate
aims. However, it was designed as a performance measurement tool.

…………………………………………………………………………………………………………………………………………………………
………………………….

Example 4

A company has recently adopted throughput accounting as a performance measurement

tool. Its results for the last month are shown below.

Units produced 1,150

Units sold 800

Materials purchased 900 kg costing $13,000

Opening material inventory used 450 kg costing $7,250

Labour costs $6,900

Overheads $4,650

Sales price $35

There was no opening inventory of finished goods or closing inventory of materials.

Which of the following is the throughput accounting ratio for this product.

Solution: C

The throughput accounting ratio is defined as throughput/total factory costs.

Throughput accounting aims to discourage inventory building, so the ratios do not take

account of inventory movements.

Throughput = sales – all material costs = $35 × 800 – $13,000 = $15,000

(Note that we use materials purchased instead of materials used.)

Total factory costs= all other production costs= $6,900 + $4,650 = $11,550

TAPR ratio = $15,000/$11,550 = 1.3

…………………………………………………………………………………………………………..

Throughput accounting

Formula

Throughput accounting aims to make the best use of a scarce resource in a JIT
environment.

Throughput = sales revenue – direct material cost

-The aim of throughput accounting is to maximise this measure of profitability, whilst

simultaneously reducing operating expenses and inventory (money is tied up in
inventory).

-The goal is achieved by determining what factors prevent the throughput from being
higher. This constraint is called a bottleneck; for example, there may be a limited number
of machine hours or labour hours.

-In the short-term the best use should be made of this bottleneck. This may result in some
idle time in non-bottleneck resources, and may result in a small amount of inventory
being held so as not to delay production through the bottleneck.

-In the long-term, the bottleneck should be eliminated. For example, a new, more
efficient machine may be purchased. However, this will generally result in another
bottleneck, which must then be addressed.

Assumptions

-The only totally variable cost in the short-term is the purchase cost of raw materials that
are bought from external suppliers.

-Direct labour costs are not variable in the short-term. Many employees are salaried and
even if paid at a rate per unit, are usually guaranteed a minimum weekly wage.

-Given these assumptions, throughput is effectively the same as contribution.

Theory of constraints
Goldratt and Cox describe the process of identifying and taking steps to remove the
constraints that restrict output as the Theory of constraints.

…………………………………………………………………………………………………………..

Target costing

Steps in target csoting

Target cost gap= estimated product cost – target cost

It is the difference between what an organisation thinks it can currently make a product
for, and what it needs to make it for, in order to make a required profit.

Alternative product designs should be examined for potential areas of cost reduction that
will not compromise the quality of the products.

Questions that a manufacturer may ask in order to close the gap include:

-Can any materials be eliminated, e.g. cut down on packing materials?

-Can a cheaper material be substituted without affecting quality?

-Can labour savings be made without compromising quality, for example, by using lower
skilled workers? Can productivity be improved, for example, by improving motivation?

-Can production volume be increased to achieve economies of scale?

-Could cost savings be made by reviewing the supply chain?

-Can part-assembled components be bought in to save on assembly time?

-Can the incidence of the cost drivers be reduced?

-Is there some degree of overlap between the product-related fixed costs that could be
eliminated by combining service departments or resources?

A key aspect of this is to understand which features of the product are essential to
customer perceived quality and which are not.

This process is known as ‘value analysis’.

Attention should be focused more on reducing the costs of features perceived by the
customer not to add value.

Closing the cost gap by increasing the selling price is not a viable option as the price is
determined by market forces rather than the company.

Example 1

Newstart Co is planning on entering into an existing market, where the sales price of
product Z has been well established at $140. This proposal would

require an initial investment of $100,000, and the investors expect Newstart Co to

achieve an annual profit return of 20%. Sales are expected to be 1,000 units in the first
year.

Newstart Co has estimated it can produce the product for $125.

Calculate:

(a) The target cost per unit

(b) The target cost gap

Solution :

(a) Annual return = 100000*20%= 20000

Profit per unit= 20000/1000=20

Target cost = 140-20=120

(b) target cost gap= 125-120=5

…………………………………………………………………………………………………………

Example 2

The predicted selling price for a product has been set at $56 per unit. The desired mark-up

on cost is 25% and the material cost for the product is estimated to be $16 before allowing

for additional materials to allow for shrinkage of 20% (for every 10 kg of material going in

only 8 kg comes out).

If labour is the only other cost and 2 hours are needed what is the most the business can

pay per hour if a cost gap is to be avoided?

The maximum rate per hour is (2 d.p)

Solution :

Sp=56 and profit is on cp

Cp- sp

100- 125

? - 56

Cp = 44.8 and profit = 11.2

Mc = 16 but actual Material cost = 16/0.8=20

Therefore 56-11.2=44.8-20=24.8

Therefore labour per hour= 24.8/2=12.40

…………………………………………………………………………………………………………..

Example

The selling price of product Zigma is set to be $250 for each unit and sales for the coming

year are expected to be 500 units. The company requires a return of 15% in the coming

year on its investment of $250,000 in product Zigma.

What is the target cost for each unit of Zigma for the coming year? Select from the list as

appropriate.

solution:

return req.=250000*15%=37500 37500/500=75

250-75=175

Therefore TC=175

………………………………………………………………………………………………………….

Target costing in service organisations

Target costing is as relevant to the service sector as the manufacturing sector.

Key issues are similar in both: the needs of the market need to be identified and
understood as well as its customers and users; and financial performance at a given cost
or price (which does not exceed the target cost when resources are limited) needs to be
ensured.

If a firm of accountants was asked to bid for a new client contract, the partners or
managers would probably have an idea of what kind of price is likely to win the contract.

If staff costs are billed out at twice their hourly salary cost, say, this would help to
determine a staff budget for the contract. It would then be necessary to work out the
hours needed and play around with the mix of juniors/senior staff to get to that target
cost.

Issues in service

1. Inseparability/simultaneity of production and consumption

2. Heterogeneity.

3. Perishability.

4. No transfer of ownership.

……………………………………………………………………………………………………………..

Life cycle costing

A product's costs are not evenly spread through its life.

-Traditional costing techniques based around annual periods may give a misleading impression of
the costs and profitability of a product. This is because systems are based on the financial
accounting year, and dissect the product's lifecycle into a series of annual sections.

-Usually, therefore, the management accounting systems would assess a product's profitability on
a periodic basis, rather than over its entire life.

Lifecycle costing, however, tracks and accumulates costs and revenues attributable to each
product over its entire product lifecycle. Then, the total profitability of any given product can be
determined.

Lifecycle cost of Product A =

Total costs of Product A over its entire lifecycle

Total number of units of A

many industries, a large fraction of the life-cycle costs consists of costs incurred on product design,
prototyping, programming, process design and equipment acquisition.

-This had created a need to ensure that the tightest controls are at the design stage, i.e. before a
launch, because most costs are committed, or 'locked in', at this point in time.

-Management Accounting systems should therefore be developed that aid the planning and
control of product lifecycle costs and monitor spending and commitments at the early stages of a
product's life cycle.

……………………………………………………………………………………………………………..

Example

A manufacturing company, NES Co is considering launching a new product.

This product is budgeted to have total design costs of $200,000, and asset depreciation will be
$350,000 in total.

Over the lifetime of the product, NES Co expects to produce and sell 400,000 units of the product,
which will cost $15 per unit to produce, using 3 hours of labour per product.

The company has total fixed production overheads of $15 million per year, which are absorbed
based on labour hours. Total labour hours for the company are budgeted to be 10 million.
What is the budgeted lifecycle cost per unit for the new product?

Solution:

OAR for fixed production o/h= 1500000/1000000=1.5

Labour hour=400000*3=1200000*1.5=1800000

Cost= 400000*15=6000000

Total lifecycle cost= 200000+350000+6000000+1800000=8350000

Lifecycle cost per unit = 8350000/400000=20.875

…………………………………………………………………………………………………………..

Example 2 A manufacturing company which produces a range of products has developed a

budget for

the life-cycle of a newproduct, P. The information in the following table relates exclusively

to product P:

Lifetime total Per unit

Design costs $800,000

Direct manufacturing costs $20

Depreciation costs $500,000

Decommissioning costs $20,000

Machine hours 4

Production and sales units 300,000

The company’s total fixed production overheads are budgeted to be $72 million each year

and total machine hours are budgeted to be 96 million hours. The company absorbs

overheads on a machine hour basis.

Solution:

Mfg cost= 20*300000=6000000

Machine = 72/96=0.75*4=3 ; 300000*3=900000

Cost= 800000+6000000+500000+20000+900000= 8220000

Lifecycle cost= 8220000/300000=27.4

……………………………………………………………………………………………………………

Example

Company B is about to start developing a new product for launch in its existing market.

They have forecast sales of 20,000 units and the marketing department suggest a selling

price of $43/unit. The company seeks to make a mark-up of 40% product cost. It is

estimated that the lifetime costs of the product will be as follows:

(1) Design and development costs $43,000.

(2) Manufacturing costs $15/unit.

(3) Plant decommissioning costs $30,000.

The company estimates that if it were to spend an additional $15,000 on design,

manufacturing costs/unit could be reduced

What is the life cycle cost per unit of the new product?

Solution:

L.C Cost = 300000+43000+30000=373000/20000=18.65

Therefore 18.65

………………………………………………………………………………………………………….

Costs associated with each stage

-Pre-production/Product development stage

– A high level of setup costs will be incurred in this stage (pre-production costs), including
research and development (R&D), product design and building of production facilities.

-Launch/Market development stage

 – Success depends upon awareness and trial of the product by consumers, so this stage is
likely to be accompanied by extensive marketing and promotion costs.

– Production costs per unit will be extremely high due to the low volumes involved.

-Growth stage

– Marketing and promotion will continue through this stage.

– In this stage sales volume increases dramatically, and unit costs fall as fixed costs are
recovered over greater volumes and variable production costs per unit fall due to economies of
scale.

-Maturity stage

– Initially profits will continue to increase, as initial setup and fixed costs are recovered.

– Marketing and distribution economies are achieved but overall marketing costs may
increase to respond to increased competition.

– Variable production costs per unit fall further due to economies of scale and learning
effects.

……………………………………………………………………………………………………………

Environment management accounting (EMA)

EMA techniques

Example 1
The monthly budget for process X shows the following input/output analysis:

INPUTS

Description Comment Weight (kg) $

Materials 1,000 (50,000)

System costs Labour, utilities and other overheads – (30,000)

––––––

Total 1,000 (80,000)

––––––

OUTPUTS

Description Comment Weight (kg) $

Good output Expected good output is 70% of input

and can be sold for $120 per kg 700 84,000

Waste Expected waste is 10% of input and must be

scrapped at a cost of $10 per kg 100 (1,000)

Scrap Expected scrap is 20% of input and can be sold

for $15 per kg 200 3,000

––––––

Total 1,000 86,000

––––––

Monthly profit is thus expected to be $6,000.

The company is looking at introducing new quality systems that will increase system costs by
$5,000 per month but will reduce waste from 10% to 4% of input. Scrap is expected to stay at 20%
of input.

What would be the impact on monthly profit of implementing the proposal?

Solution 60*120=7200

+ waste exps 60*10= 600

Total 7800

-less new system 5000

Net increase income= 2800

………………………………………………………………………………………………………………………..

Cost Volume Profit Analysis

Breakeven Analysis

It is also knowm as CVP analysis it study of effect of profit in change of FC , VC, sale price, quantity
mix.

Single product breakeven analysis

Example 1

Assume that each unit sells for $200 and contributes $160 towards covering fixed costs of
$600,000: Selling price per unit $200
Less: variable cost per unit ($40)

Contribution per unit $160

Total fixed costs $600,000

Profit ?

Budgeted sales 5,000 units

Profit required $150,000

In order to breakeven, we need to cover our fixed costs.

Solution

Breakeven point = total fixed cost/contribution

600000/160=3750

Level of activity to earn a required profit=

Required profit + fixed cost/contribution per unit.

Margin of safety (units) =

Budgeted level of activity – breakeven level of activity.

Margin of safety expressed as a % =

Budgeted sale – breakeven sale/budgeted sale * 100

Contribution to sales ratio (C/S ratio)=

Contribution/sale

Breakeven point in sales revenue ($)=

Fixed cost /cs ratio

Sales revenue required to earn a target profit ($)

Required profit + fixed cost/ cs ratio.

Example 2

The following data is available to draw the basic breakeven chart next page:
Selling price per unit $50 per unit

Less: variable cost per unit $30 per unit

Fixed costs $20,000 per month

Forecast sales 1,700 units per month

In exam you are not asked to draw graph but u will be asked to interept graph and on that basis
you have questions.

Contribution breakeven chart

In conventional chart it is not possible to read contribution directly from chart.

A contribution breakeven chart shows the variable cost line instead of the fixed cost line.
The same lines for total cost and sales revenue are shown so the breakeven point and
profit can be read off in the same way as with a conventional chart. It is also possible also
to read the contribution for any level of activity.

The profit-volume chart

The profit–volume chart plots a single line depicting the profit or loss at each level of
activity. The breakeven point is where this line cuts the horizontal axis.
The vertical axis shows profits and losses. The horizontal axis is drawn at zero profit or
loss. At zero activity the loss is equal to $20,000, that is, the amount of fixed costs.

The second point used to draw the line could be the calculated breakeven point or the
calculated profit for sales of 1,700 units.

The main advantage of the profit–volume chart is that it clearly depicts the effect on
profit and breakeven point of any changes in the variables.

Multi-product breakeven analysis.

Weighted average C/S ratio = total contribution for all product

Total revenue for all product

Breakeven revenue ($) =

Fixed costs

Weighted average C/S ratio

Example

Company A produces Product X and Product Y. Fixed overhead costs amount to $200,000
every year. The following budgeted information is available for both products for next
year:
In order to calculate the breakeven revenue for the next year, using the budgeted sales
mix, we need the weighted average C/S ratio as follows:

Solution

Weighted average C/S ratio= total contribution for all product

Total revenue for all product

(20000*20) + (10000*15)

(20000*50) + (10000*60)

=34.375

Or

Ratio is 20000:10000=2:1

Avg cont.= 20*2+15*1/2+1= 55/3 = 18.33

Avg cont./sales = 18.33*5/50*2 + 60*1 = 55/160 = 34.375.

Breakeven = 200000 = 10911

18.33

Breakeven of x = 7274

Breakeven of y = 3637

Or

Pv ratio = 34.375

BE sale value = 200000 = 581734

34.375*100
BE for x = 581734*100/160 = 363584

Units = 363584/50 = 7272 units

BE for y = 581734 * 60/160 = 218150

Units 218150/60 = 3635 units.

Multi product profit volume graph

Limitations of breakeven analysis

The following underlying assumptions will limit the precision and reliability of a given
cost-volume-profit analysis.

-The behaviour of total cost and total revenue has been reliably determined and is linear
over the relevant range.
-All costs can be divided into fixed and variable elements.

-Total fixed costs remain constant over the relevant volume range of the CVP analysis.

-Total variable costs are directly proportional to volume over the relevant range.

-Selling prices are to be unchanged.

-Prices of the factors of production are to be unchanged (for example, material, prices,
wage rates).

-Efficiency and productivity are to be unchanged.

-The analysis either covers a single product or assumes that a given sales mix will be
maintained as total volume changes.

-Revenue and costs are being compared on a single activity basis (for example, units
produced and sold or sales value of production).

-Perhaps the most basic assumption of all is that volume is the only relevant factor
affecting cost. Of course, other factors also affect costs and sales. Ordinary cost-volume-
profit analysis is a crude oversimplification when these factors are unjustifiably ignored.

-The volume of production equals the volume of sales, or changes in beginning and
closing inventory levels are insignificant in amount.

Example

Betis Limited is considering changing the way it is structured by asking its employed staff to

become freelance. Employees are currently paid a fixed salary of $240,000 per annum, but

would instead be paid $200 per working day. On a typical working day, staff can produce

40 units. Other fixed costs are $400,000 per annum.

The selling price of a unit is $60 and material costs are $20 per unit.

What will be the effect of the change on the breakeven point of the business and the

level of operating risk?

A The breakeven point reduces by 6,000 units and the operating risk goes down

B The breakeven point reduces by 4,571 units and the operating risk goes down
C The breakeven point reduces by 4,571 units and the operating risk goes up

D The breakeven point reduces by 6,000 units and the operating risk goes up.

Solution

640000/40 = 16000

New 400000/35 = 11429.

16000 – 11429 = 4571.

Operating risk means if FC is more operating risk is high and if FC is low operating risk is low.

………………………………………………………………………………………………………

Example

P Co makes two products – P1 and P2 – budgeted details of which are as follows:

P1 P2

Selling price 10.00 8.00

Cost per unit:

Direct materials 3.50 4.00

Direct labour 1.50 1.00

Variable overhead 0.60 0.40

Fixed overhead 1.20 1.00

Profit per unit 3.20 1.60

Budgeted production and sales for the year ended 30 November 20X5 are:

Product P1 10,000 units

Product P2 12,500 units

The fixed overhead costs included in P1 relate to apportionment of general overhead costs

only. However P2 also includes specific fixed overheads totalling $2,500.

If only product P1 were to be made, how many units (to the nearest unit) would need to
be sold in order to achieve a profit of $60,000 each year?

Solution

Here 2500 of FC is only charged when P2 is mfg and if not mfg then not charged.

FC = 12000+12500 = 24500 – 2500 = 22000.

22000+60000 / 4.4 = 18636.36 = 18637 units

………………………………………………………………………………………………………..

Example

A company manufactures and sells a single product with a variable cost per unit of $36. It

has a contribution to sales ratio (C/S ratio) of 25%. The company has weekly fixed costs of

$18,000.

Which of the following is the weekly breakeven point in units? Pick from list

List options are as follows:

• 1,500

• 1,600

• 1,800

• 2,000

Solution

Selling price per unit ($36/0.75) = $48

Contribution per unit $48 – $36 = $12

Fixed costs $18,000

Therefore, breakeven point (units) is $18,000/$12 = 1,500

……………………………………………………………………………………………………………
Example

The contribution to sales (C/S) ratio for a business is 0.4 and its fixed costs are $1,600,000.

Budget revenue has been set at 6 times the amount of the fixed costs.

What is the margin of safety % measured in revenue (to 1 decimal place)?

Solution

58.3%

The breakeven revenue is FC/CS = $1,600,000/0.4 = $4,000,000

Budget revenue is FC × 6 = $1,600,000 × 6 = $9,600,000

Margin of safety is = (9,600,000 – 4,000,000)/9,600,000 = 58.3%

……………………………………………………………………………………………………………

Budgeting

Purpose of Budgets

A budget is a quantative plan prepared for a specific time period. It is normally expressed in
financial termsand prepared for one year.

Purpose

1.planning

forces organisation to look into the future and plan ahead

2.Responsibility

should motivate managers and result in better targets

3. Integration – of all parts of the organisation/levels of staff towards common goals

4.Motivation – manager’s rewards based on achievement of budgetary targets

5.Evaluation – of performance by comparing actual to budgeted performance.

Budgets and performance management ( more detail on this in performance evaluation chapters)
Budgets contribute to performance management by providing benchmarks against which to
compare actual results (through variance analysis), and develop corrective measures. They take
many forms and serve many functions, but most provide the basis for:

It is an essential facet of the planning and control process. Without a budget, an

organisation will be highly inefficient and ineffective.

The performance hierarchy

1.Strategic planning is long term, looks at the whole organisation and defines resource
requirements. For example, to develop new products in response to changing customer needs.

2.Tactical planning is medium term, looks at the department/divisional level and specifies how to
use resources. For example, to train staff to deal with the challenges that this new product
presents.

3.Operational planning is very short term, very detailed and is mainly concerned with control.
Most budgeting activities fall within operational planning and control. For example, a budget is set
for the new product to include advertising expenditure, sales forecasts, labour and material
expenditure etc.

The aim is that if a manager achieves short-term budgetary targets (operational plans) then there
is more chance of meeting tactical goals and ultimately success for strategic plans. The
achievement of budgetary plans will impact on the eventual achievement of the tactical and
strategic plans. However, budgets should also be flexible in order to meet the changing needs of
the business.

Behavioural aspect of Budgeting

Individuals react to the demands of budgeting and budgetary control in different ways and their
behaviour can damage the budgeting process. Behavioural problems are often linked to
management styles, and include dysfunctional behaviour and budget slack.

Management styles (Hopwood)

Setting the difficulty level of a budget

Approaches to budgeting

Budgeting and participation

Bottom up budgeting is generally seen as preferable because it leads to improved managerial
motivation and performance. However, there are situations for which top down budgeting is
preferable.

Describe three situations where top down budgeting would be more applicable.

1 Operational managers may not have the knowledge and experience to set a budget. For
example, in a small business only the owner may be involved in all aspects of the business and may
therefore set the budget.

2 In times of crisis there may be insufficient time to set a participative budget and targets may
have to be imposed to ensure survival.

3 Participation has to be genuine for it to result in improved motivation. Pseudo-participation,

where senior managers seek the opinions of the ultimate budget holders but do not act on these
views, may lead to demotivation.

Incremental budgets, zero-based budgets (ZBB) and rolling budgets

Activity-based budgeting (ABB)

Activity-based costing

Let’s begin by recapping our costing knowledge.

Changing a budgetary system

A change in the budgetary system could bring about improved planning, control and decision
making.

However, before a change is made the following issues should be considered:

1.Are suitably trained staff available to implement the change successfully?

2.Will changing the system take up management time which should be used to focus on strategy?

3.All staff involved in the budgetary process will need to be trained in the new system and
understand the procedure to be followed in changing to the new approach. A lack of participation
and understanding builds resistance to change.

4.All costs of the systems change, e.g. new system costs, training costs, should be evaluated
against the perceived benefits. Benefits may be difficult to quantify and therefore a rigorous
investment appraisal of the project may be difficult to prepare.

Spreadsheets
A spreadsheet is a computer package which stores data in a matrix format where the intersection
of each row and column is referred to as a cell. They are commonly used to assist in the budgeting
process.

Advantages of spreadsheets

-Large enough to include a large volume of information.

-Formulae and look up tables can be used so that if any figure is amended, all the figures will be
immediately recalculated. This is very useful for carrying out sensitivity analysis.

-The results can be printed out or distributed to other users electronically quickly and easily.

-Most programs can also represent the results graphically e.g. balances can be shown in a bar
chart.

Disadvantages of spreadsheets:

-Spreadsheets for a particular budgeting application will take time to develop. The benefit of the
spreadsheet must be greater than the cost of developing and maintaining it.

-Data can be accidentally changed (or deleted) without the user being aware of this occurring.

-Errors in design, particularly in the use of formulae, can produce invalid output. Due to the
complexity of the model, these design errors may be difficult to locate.

-Data used will be subject to a high degree of uncertainty. This may be forgotten and the data
used to produce, what is considered to be, an 'accurate' report.

-Security issues, such as the risk unauthorised access

(e.g. hacking) or a loss of data (e.g. due to fire or theft).

-Version control issues can arise.

-Educating staff to use spreadsheets/models and which areas/cells to use as inputs can be time
consuming.

Feedback control

Feedback control is defined as 'the measurement of differences between planned outputs and
actual outputs achieved, and the modification of subsequent action and/or plans to achieve future
required results'. This is the most common type of control system.
Positive feedback is feedback taken to reinforce a deviation from standard. The inputs or
processes would not be altered.

Negative feedback is feedback taken to reverse a deviation from standard. This could be by
amending the inputs or process, so that the system reverts to a steady state. For example, a
machine may need to be reset over time to its original settings.

Feed forward control

• Feed-forward control is defined as the ‘forecasting of differences between actual and planned
outcomes and the implementation of actions before the event, to avoid such differences.

• In simpler terms, feedforward control is where a problem is identified and corrective action
taken, before the problem occurs

• An example would be using a cash-flow budget to forecast a funding problem and as a result
arranging a higher overdraft well in advance of the problem.

Advantages

• It encourages managers to be pro active and deal with problems before they occur.

• Re-forecasting on a monthly or continuous basis can save time when it comes to completing a
quarterly or annual budget.

Disadvantages

• It may be time consuming as control reports must be produced regularly.

• It may require a sophisticated forecasting system, which might be expensive.

Beyond Budgeting v.v.imp

Beyond Budgeting is the idea that companies need to move beyond budgeting because of the
inherent flaws in budgeting, especially when used to set incentive contracts. It is argued that a
range of techniques, such as rolling forecasts and market-related targets, can take the place of
traditional budgets.'

Beyond Budgeting – 6 principles

A BB implementation should incorporate the following six main principles:

1.

An organisation structure with clear principles and boundaries; a manager should have no doubts
over what he/she is responsible for and what he/she has authority over; the concept of the
internal market for business units may be relevant here.

2.

Managers should be given goals and targets which are based on relative success and linked to
shareholder value; such targets may be based on key performance indicators and benchmarks
following the balanced scorecard principle.

3.

Managers should be given a high degree of freedom to make decisions; this freedom is consistent
with the total quality management and business process reengineering concepts.

4.

Responsibility for decisions that generate value should be placed with ‘front line teams’; again, this
is consistent with Total Quality Management (TQM) and Business Process Re-engineering (BPR)
concepts.

5.

Front line teams should be made responsible for relationships with customers, associate
businesses and suppliers; direct communication between all the parties involved should be
facilitated; this is consistent with the Supply Chain Management concept.

6.

Information support systems should be transparent and ethical; an activity-based accounting

system which reports on the activities for which managers and teams are responsible is likely to be
of use in this regard.

…………………………………………………………………………………………………………..

Quantative techniques
High-low analysis

The high-low method of analysing a semi-variable cost into its fixed and variable elements based
on an analysis of historical information about costs at different activity levels.

The fixed and variable costs can then be used to forecast the total cost at any level of activity.

Example

(a) Find the variable cost per unit:

Variable cost/unit =

Cost at high level of activity – Cost of low level activity

High level activity – Low level activity

Variable cost = (9000 - 7000)/(400-200)

Variable cost per unit = 10

(b) Find the total fixed cost

Using high activity level:

Total cost = $9,000

Total variable cost = 400 × $10 = $4,000

Therefore, fixed costs = $5,000

(c) Estimate the total cost if output is 350 units

Variable cost = 350 × $10 = $3,500

Fixed costs = $5,000

Total cost = $8,500

(d) Estimate the total cost if output is 600 units

Variable cost = 600 × $10 = $6,000

Fixed costs = $5,000

Total cost = $11,000

Advantages/disadvantages of the high-low method

Learning curves

It has been observed in some industries that there is a tendency for labour time per unit to reduce
in time: as more of the units are produced, workers become more familiar with the task and get
quicker per unit.

Wright's Law

Wright's Law states that as cumulative output doubles, the cumulative average time per unit falls
to a fixed percentage (the 'learning rate') of the previous average time.

The learning curve is 'The mathematical expression of the commonly observed effect that, as
complex and labour-intensive procedures are repeated, unit labour times tend to decrease'.

Limitations of the learning curve model

The learning curve model has its limitations. Learning effects are most likely to be seen if:

The process is labour intensive

-Modern manufacturing environments may be very capital intensive (i.e. machine intensive) and
the labour effect cannot apply if machines limit the speed of labour.

The product is new

-This may be the case in the modern environment as products have short lives and therefore new
products will be introduced on a regular basis.

The introduction of a new product makes it more probable that there will not be a learning effect.
The product is complex

-The more complex the product the more likely that the learning curve will be significant, and the
longer it will take for the learning curve to reach a steady state or 'plateau' (beyond which no
more learning can take place).

Production is repetitive and there are no breaks in production

-The learning effect requires that production is repetitive with no major breaks in which the
learning effect may be lost. JIT production has moved towards multi-skilled and multi-tasked
workers. It is possible that some of the benefits of the learning effect in a single tasking
environment may be lost. The production of small batches of possible different products in
response to customer demand may also lead to the loss of some of the learning effect.

Example

Example

Consider the following example of the time taken to make the first four units of a new product:

A pattern emerges when we look at the cumulative average time per unit:

The process demonstrates a 90% learning rate.

Algebraic approach

For intermediate output levels

Where:

X = cumulative number of units

Y = cumulative average time per unit to produce X units

a = time required to produce the first unit of output

b = index of learning = log r/log 2, where r = the learning rate expressed as a decimal.

…………………………………………………………………………………………………….

Example

The first unit of a new product is expected to take 100 hours. An 80% learning curve is known to
apply.

Calculate:

(a) The average time per unit for the first 16 units

Y= a * x ^b

a= 100 , b=-0.3219 , x=16

Y=100 * 16^-0.3219

Y=40.96

Or 100*80%*80%*80%*80%= 40.96

(b) The average time per unit for the first 25 units

Y=100*25^-0.3219 = 35.48

(c) The time it takes to make the 20th unit

Upto 19 units Y= 100*19^-0.3219 = 38.76

19*38.76= 736.44
For 20th unit Y= 100*20^-0.3219 = 38.12

20*38.12 = 762.4

So to make 20th unit 762.4 – 736.4 = 26 hours

……………………………………………………………………………………………………………

Example

A company has started production of a new product and has found the first 10 units of production
took 120 hours. The next 30 units produced took a further 150 hours.

What was the learning rate?

Total 4 batch , total time = 120+150 = 270

So 270/4 = 67.5

67.5 = 120 * r^2

R^2 = 67.5/120 = 0.5625

R = 0.75; learning rate = 75%

……………………………………………………………………………………………………….

Example

SCW Co has budgeted for a learning rate of 95% on the production of its new product Q, which is
still at the development stage.

Actual results were as follows:

• Time to make the first unit of Q = 40 minutes

• Time to make the first 8 units = 233 minutes

Required:

(a) Calculate the actual learning rate, assuming a steady state has not

been reached.

My solution 40 *95%*95%*95%= 34.295

40*92%*92%*92%= 31.14

40*90%*90%*90%= 29.16*8 = 233.2 (learning rate is 90%)

Example A Swiss watch making company wishes to determine the minimum price it should charge
a customer for a special order of watches. The customer has requested a quotation for 10 watches
(1 batch), but might subsequently place an order for a further 10. Material costs are $30 per
watch. It is estimated that the first batch of 10 watches will take 100 hours to manufacture and an
80% learning curve is expected to apply.

Labour plus variable overhead costs amount to $3 per hour. Setup costs

are $1,000 regardless of the number of watches made.

Required:

(a) What is the minimum price the company should quote for the initial

order if there is no guarantee of further orders?

(b) If the company was then to receive the follow-on order, what would

the minimum price of this order be?

(c) What would be the minimum price if both orders were placed

together?

(d) Having completed the initial orders for a total of 20 watches (price

at the minimum levels recommended in (a) and (b)), the company

thinks that there would be a ready market for this type of watch if it

brought the unit selling price down to $45. At this price, what would

be the profit on the first 140 ‘mass-production’ watches (i.e. after

the first 20 watches) assuming that marketing costs totalled $250?

(A)

Material cost 10*30 300

Labour + V.C 100 * 3 300
Setup cost 1000 1000
Total = 1600
1600/10 = 160

………………………………………………………………………………………………………………

(B)
 Material cost 10*30 300
Labour + V.C 60 * 3 180
Setup cost 1000 1000
Total = 1480
1480/10= 148

………………………………………………………………………………………………………………

(C)

Material cost 20*30 600

Labour + V.C 160 * 3 480
Setup cost 1000 1000
Total = 1180
1180/20 = 59

………………………………………………………………………………………………………………

(D) 100*80%*80%*80%*80% = 40.96 (because of 140+20= 160 or 16 batches)

Material cost 140*30 4200

Labour + V.C 656-160 * 3 1488
Marketing cost (only on140 units) 250 250
Total = 5938
Cp = 4200+1488 + 250/140 = 42.41

Profit = 42.41 – 45 * 140 = 362.6

………………………………………………………………………………………………………….

Learning curve and steady state

The learning curve effect will only apply for a certain range of production. For example, machine
efficiency may restrict further improvements or there may be go-slow arrangements in place.

Once the steady state is reached the direct labour hours will not reduce any further and this will
become the basis on which the target is produced.

Eventually, the learning effect will cease and the time to make each successive unit stabilises at a
constant time per unit.

Other quantitative analysis techniques or forecasting technique

Linear regression

Linear regression performs a similar role to that of the high low method, but it uses mathematical
equations that examine all data in the series in order to improve accuracy.

Consider the equation of a straight line:

Correlation

Regression analysis attempts to find the straight-line relationship between two variables.
Correlation is concerned with establishing how strong the straight-line relationship is. Correlation
can be positive or negative:

Positive correlation means that high values of one variable are associated with high values of the
other and that low values of one are associated with low values of the other.
Negative correlation means that low values of one variable are associated with high values of the
other and vice versa.

The coefficient of determination

This squares the correlation in order to express the strength of the relationship between the
variables as a percentage.

The coefficient of determination, r^2, gives the proportion of changes in y that can be explained
by changes in x, assuming a linear relationship between x and y.

For example:

If a correlation coefficient r = +0.9, then r^2 = 0.81 and we could state that 81% of the observed
changes in y can be explained by the changes in x and that 19% of the changes must be due to
other factors.

Limitations of linear regression analysis

-Assumes a linear relationship between the variables.

-Only measures the relationship between two variables. In reality the dependent variable is
affected by many independent variables.

-Only interpolated forecasts tend to be reliable. The equation should not be used for
extrapolation.

-Regression assumes that the historical behaviour of the data continues into the foreseeable
future.

-Interpolated predictions are only reliable if there is a significant correlation between the data.

Time series analysis

Time series analysis uses moving averages to create a trend line over time, established from
historical data, that, when adjusted for seasonal variations, can then be used to make predictions
for the future.

Components of a time series

The trend is the long-term general movement of the data.

Cyclical variations are economic cycles of booms and slumps.

Season variations are a regular variation around the trend over a fixed time period, usually one
year.

Residual variations are irregular, random fluctuations in the data usually caused by factors specific
to the time series.

Calculating the trend and seasonal variation

The trend

There are three ways to calculate the trend:

The seasonal variation

Seasonal variations can be estimated by comparing an actual time series with the trend line values
calculated from the time series.

-For each ‘season’ the seasonal variation is the difference between the trend line value and the
actual historical value for the same period.

A seasonal variation can be calculated for each period in the trend line. When the actual value is
higher than the trend line value, the seasonal variation is positive. When the actual value is lower
than the trend line value, the seasonal variation is negative.

Moving averages

Moving averages is a set of calculations used to smooth out the variations in a time series to
identify a trend.
Calculate the 3 point moving total and the trend for the set of data below.
Extrapolating the trend

If the trend is constant, then extrapolation is easy to calculate as the increase between each value

is the same.
Seasonal variations

Once the trend has been identified it is possible to calculate the seasonal variations from the
trend. This is how much the data varies from the trend line.

There are two methods:

Additive model:

Using an additive model, variations are expressed in absolute terms with above and below average
figures shown by using a plus or minus sign respectively.

Example

Calculate the seasonal variation for the following set of data using the additive model.

Multiplicative model:

Using a multiplicative or proportional model, the variations are shown as a percentage of the
trend.

Example

Calculate the seasonal variation for the following set of data using the multiplicative model.
Forecasting

Once the seasonal variations have been calculated they can be used to forecast future values.

The trend line is extrapolated and the variations are applied to the trend.

Additive model forecast = T + S (where T = the trend line and S = the seasonal variation).

Multiplicative model forecast = T × S (S is normally represented as a percentage).

Limitations of time series analysis

-There is an assumption that what has happened in the past is a reliable guide to the future.

-There is an assumption that a straight-line trend exists.

-There is an assumption that seasonal variations are constant, either in actual values using the
additive model (such as dollars of sales) or as a proportion of the trend line value using the
multiplicative model.
Advance Variance

Revision of basic variance analysis

Variance analysis is the process by which the total difference between standard and actual results
is analysed.

A number of basic variances can be calculated. If the results are better than expected the variance
is favourable. If the results are worse than expected, the variance is adverse.

Example

Arby Ltd makes sandwiches and other bread-based snacks, which it sells in bulk to delicatessen
shops. The only variable cost is raw material, which consists mainly of bread and other, lower
value ingredients. The standard cost of the materials used in the manufacture of each kg of
product is $4.00.

In preparing its budget for 2017, Arby Ltd assumed a selling price of $6 per kilogram for its
products and sales of 48,000 kilograms.

However, during 2017, Arby and its competitors were adversely affected by diminishing consumer
confidence in bread-based products. Arby sold only 37,000 kilograms of its products.

Arby’s managing director recently explained how his company attempted to respond to the
difficulties it faced in 2017: ‘First, we reduced our selling price from $6 to $5.95 per kg; this was a
modest price reduction in comparison with those of our smaller competitors. Second, we took
advantage of falling market prices for some of the types of filling we use as a raw material for our
product.

Calculate:

(a) The sales price variance

Actual quantity sold 37,000 × actual price $5.95 = $220,150

Price variance $1,850 A

Actual quantity sold 37,000 × standard price $6 = $222,000

(b) The sales volume variance

Actual quantity sold 37,000 × standard margin $2.00 = $74,000

Volume variance $22,000 A

Budget quantity sold 48,000 × standard margin $2.00 = $96,000

Causes of sales variances

Causes of sales variances

The sales price and volume variances may be linked. For example, an increase in the price of a
product will result in a favourable sales price variance but may also result in an adverse sales
volume variance, due to a fall in demand.

Materials variances
Example

Standard cost 2 kg at $10 per kg

Actual output 1,000 units

Materials purchased and used 2,250 kg

Material cost $20,500

Calculate
The materials price and usage variances may be linked. For example, the purchase of poorer
quality materials may result in a favourable price variance but an adverse usage variance.

Labour variances

Example

Actual production 700 units

Standard wage $4 per hour

Standard time allowed per unit 1.5 hours

Actual hours worked 1,000 hours

Actual wages paid $4,200

Calculate
The labour rate and labour efficiency variances may be linked. For example, employing more
highly skilled labour may result in an adverse rate variance but a favourable efficiency variance.

NOTE – IT MAY BE POSSIBLE THAT ACTUAL MATERIAL PURCNASED AND USED ARE DIFFERENT.
CALCULTE PRICE VARIANCE BY PURCHASE QUANTITY AND USAGE VARIANCE BY CONSUMPTION
QUANTITY. IN THIS CASE TOTAL MATERIAL VARIANCEV WILL BE PRICE + USAGE. SIMILARLY IN
LABOUR ACTUAL HOURS WORKED AND PAID MAY BE DIIFERENT. DUE TO ABNORMAL IDLE
TIME.CALCULATE LRV BY HOURS PAID < EFFICIENCY VARIANCE BY HOURS WORKED AND
SEPERATELY CALCULATE IDLE TIME VARIANCE(IDLE TIME * SR)

……………………………………………………………………………………………………………………………
Material mix and Yield variances

Material mix and yield variances are calculated if:

– A product contains more than one type of material

– These materials are interchangeable.

Mix variance

A mix variance is used to monitor the cost of material.

For instance, if more of an expensive material has been used and less of a cheap material, the cost
will be higher – and the variance adverse.

Example 1

Hondru operates a standard costing system.

The standard direct materials to produce 1,000 units of output is as follows:

Solution:

Material variance is calculated only when more than 1 type of material is used

Yield variance

1000 – 1200 600:240:360 = 5:2:3

21000 - ?

So 21000 = 25200

Actual used 25000

To be used 25200 , so 200 less used

A = 200*5/10 = 100 * 1.1 = 110 F

B = 200* 2/10 = 40 * 2.4 = 96 F

C = 200* 3/10 = 60 * 1.5 = 90 F

Total Yield variance = 296 F

Or

600* 1.1 + 240*2.4 + 360*1.5 / 1200 = 1776/1200 = 1.48

1.48 * 200 = 296 F

Or

1000/600+240+360 * 25000 = 20833 units but actually 21000

20833 – 21000 = 167 * 1776/1000 = 296 F

Material usage variance

Mat Std mat Actual mat A/F Std rate Total

A 600*21= 12600 14000 1400A 1.1 1540 A
B 240*21= 5040 5500 460A 2.4 1104 A
C 360*21 = 7560 5500 2060 1.5 3090 F
Total = 446F
Total usage variance = 446 F

……………………………………………………………………………………………………………………………………

Yield variances

A yield variance measures the efficiency of turning the inputs into outputs. If the yield variance is
adverse, it suggests that actual output is lower than the expected output.

This could be due to labour inefficiencies, higher waste, inferior materials, or using a cheaper mix
with a lower yield.

Method 1: The ‘total’ method

Method 2: The ‘individual’ method

MCV:

A 21000 *600/1000 *1.1 -14000*AR

B 21000 *240/1000 *2.4 -5500 *AR

C 21000 *360/1000 *1.5 – 5500 *AR

a)MPV – not available in this ques.

b) MUV

A = ( 1.1- AP ) *14000 A = (21000 *600/1000-14000)1.1

i)Material Mix – 150F

ii)Material Yield - 296F

Problems when calculating mix and yield variances

-Should only be used when the mix is controllable.

-It is often found that the mix and yield variances are interdependent.

-The standard may be obsolete.

-The analysis ignores any potential impact on quality of output.

-The calculations can be complicated.

Sales mix and quantity variances

Sales volume variance

Sales mix variance

A sales mix variance indicates the effect on profit of changing the mix of actual sales from the
standard mix.

The difference between the actual quantity sold in the standard mix and the actual quantities sold,
valued at the standard profit per unit:
Sales quantity variance

A sales quantity variance indicates the effect on profit of selling a different total quantity from the
budgeted total quantity. Like the mix variance, it can be calculated in one of two ways:

Method 1

The difference between actual sales volume in the standard mix and budgeted sales valued at the
standard profit per unit:

Method 2
The difference between actual sales volume and budgeted sales valued at the weighted average
profit per unit:

Example

A furniture company manufactures high quality dining room furniture that is sold to major retail
stores.

Extracts from the budget for last year are given below:
Solution
We will calculate Mat mix and Mat yields when more than 1 raw materials are used. In the above
example only 1 material is used in 3 output. So mat mix variance is not there. Sales mix variance is
possible as 3 products are there.

Calculation of Variable overhead variance

Standard variable overhead rate = 400/20 = 20hrs , 40/20 = $2

It is same for all 3 products

Actual variable O/H = $2.5

AH = 450/18.75 * 7200 + 60/18.75 * 31000 + 600/18.75 * 7800 = 521600 hrs.

SH = 400/20 * 7200 + 60/20 * 31000 + 600/20 * 7800 = 491000 hrs.

Variable O/H rate variance = 2 – 2.5 = 0.5 * 521600 = 260800 A

Variable overhead efficiency = 491000 – 521600 * 2 =101200 A

Variable overhead cost variance = 471000 *2 - 521600 *2.5

Or 7200 * 40 - 7200 860

31000 *6 – 31000 *8

7800 *60 - 7800 *80

Planning and operational variances

Planning and operational variances for sales

The sales volume variance is split into a planning variance and an operational variance.

Example

Hudson has a sales budget of 400,000 units for the coming year based on 20% of the total market.
On each unit, Hudson makes a profit of $3. Actual sales for the year were 450,000 units, but
industry reports showed that the total market had been 2.2 million units.

(a) Find the traditional sales volume variance

Traditional sales volume variance

= (actual units sold – budgeted sales) × standard profit per unit

450000 – 400000 * 3 = 150000

(b) Split this into planning and operational variances (market size and market share). Comment on
your results.

The revised (ex-post) budget would show that Hudson Ltd should expect to sell 20% of 2.2 million
units = 440,000 units.

Planning =

Original sales × standard margin = 400,000 × $3 = $1,200,000

Market size = $120,000 F

Operational =

Revised sales × standard margin = 440,000 × $3 = $1,320,000

Market share = $30,000 F

Actual sales × standard margin = 450,000 × $3 = $1,350,000

Total sales volume variance = $120,000 F + $30,000 F = $150,000 F

………………………………………………………………………………………………………………………………

Planning and operational variances for materials and labour

Example The standard cost per unit of raw material was estimated to be $5.20 per kg.

However, due to subsequent improvements in technology, the general market price at the time of
purchase was $5.00 per kg.

The actual price paid was $5.18 per kg. 10,000 kgs of the raw materials were purchased during the
period.

Calculate the planning and operational materials price variances.

Comment on the results.

Solution:

AQ × RSP = 10,000 × $5.00 = $50,000

AQ × SP = 10,000 × $5.20 = $52,000 or 5.2 – 5 * 10k = 2000F

Planning variance $2,000 favourable

Operational
AQ × AP = 10,000 × $5.18 = $51,800

AQ × RSP = 10,000 × $5.00 = $50,000 or 5 – 5.18 * 10000 = 1800A

Operational variance $1,800 adverse

Operational variance: the cost per kg was higher than the revised budgeted cost resulting in the
adverse variance. This variance is controllable by management and should be linked to their
performance evaluation.

Planning variance: the improvement in technology resulted in a lower price per kg and hence a
favourable variance. This is a planning difference and is therefore uncontrollable by management.

………………………………………………………………………………………………………………………………..

Example

The standard hours per unit of production for a product is 5 hours. Actual production for the
period was 250 units and actual hours worked were 1,450 hours. The standard rate per hour $10.
Because of a shortage of skilled labour it has been necessary to use unskilled labour and it is
estimated that this will increase the time taken by 20%.

Calculate the planning and operational efficiency variances.

Solution : std hrs = 5 (1250) production units = 250 std rate = 10

Actual hrs = 1450

RSH = 1250 + 20% = 1500 hrs

Operational = 1500 – 1450 * 10 = 500 F

Planning = 1250 – 1500 * 10 = 2500 A

Or

AH × SR = 1,450 × $10 = $14,500

RSH × SR = 1,500 × $10 = $15,000 Operational variance $500 F

SH × SR = 1,250 × $10 = $12,500 Planning variance $2,500 A

……………………………………………………………………………………………………………………………..

Fixed Overhead Variance

Fixed overhead in a month Budgeted 2 lakh

Actual fixed overhead in the month 2.1 lakh.

Adverse = 10000 A = Marginal

If we will follow absorption costing

1000 units

1200 units

FOH rate = Budgeted overhead / budgeted output

= 2 lakh/ 1000 = 200 per unit

Foh volume variance = 1000-1200 *200

= 40000 F

= 200 - 200/1000 *1200 *1000

= BH - SH

SH> BH ( only 1 reason actual production more)

= 40000 F

Calender = days

Capacity = hours worked

Efficiency = for any reason

In January Budgeted days 25

Every day 8 hours

Actual days worked 26 days

Actual hours worked 210 hours

Calender = (1000 - 1000/25 *26) *200

= 8000 F

(200 hours - 200/25 *26) *2Lakh/200

= BH - Revised Budgeted hours

 = 8000 F

Capacity = 208 - 210 +2 lakh/200

= Revised Budgeted hour – AH

= 2000 F

Efficiency =

200 hours /1000 *1200 – 210 * 2 lakh/200

= SH – AH

= 30000 F

Total Fixed overhead variance

= standard for actual output – actual fixed overhead

= 1200 *200 -210000

= 30000 F

= 1200*200/1000 *1000 - 210000

= 30000 F ( over applied )

I) FOH var. = 30000F (under or over applied)

1) Expenditure variance = 10000A

2) Volume variance = 40000F

a) calender – 8000F

b) capacity – 2000F a,b,c – all are under or over absorbed

c) efficiency – 30000F

…………………………………………………………………………………………………………..

1.Budgeted overhead = BH * OAR

2.Standard or applied overhead = SH * OAR

3.Absorbed overhead = AH * OAR

4.Actual overhead = AH * AR

Difference between 1 and 2 is volume var.

Difference between 2 and 3 is efficiency var.

……………………………………………………………………………………………………………………

Budget Ratios ( greater then 1 is better)

Volume ratio = SH/BH = 240/200 = 1.2

Capacity ratio = AH/BH = 210/208 = 1.

Efficiency ratio = SH/AH = 240/210 = 1..

Capacity utilization ratio =

budgeted hours to work/ total hours available = always lower than 1

…………………………………………………………………………………………………………………………..

Reconcilation

From budget to actual or vice versa

From Budget to actual or vice versa.

Question

The following information is available for J Ltd for Period 4:

Budget

Fixed production overheads $22,960

Units 6,560

The standard time to produce each unit is 2 hours

Actual

Fixed production overheads $24,200

Units 6,460
Labour hours 12,600 hrs

Required:

If J Ltd uses an absorption costing system, calculate the following:

(a) FOAR per labour hour = 22960/6560*2 =1.75 per hour

(b) Fixed overhead expenditure variance =

22960-24200 = 1240 A

(c) Fixed overhead capacity variance

= 6560*2 - 12600 * 1.75 = 910 A

(d) Fixed overhead efficiency variance

6460 *2 - 12600 *1.75 = 560 F

(e) Fixed overhead volume variance.

6560 -6460 * 22960/6560

Or

6560 *2 - 6460 *2 * 1.75 = 350 A

Fixed overhead cost variance

= 6460 *2 *1.75 - 24200 = 1590 A

……………………………………………………………………………………………………………………….

Example

Chapel Ltd manufactures a chemical protective called Rustnot. The following standard costs
apply for the production of 100 cylinders:

Materials 500 kgs @ $0.80 per kg 400

Labour 20 hours @ $1.50 per hour 30

Fixed overheads 20 hours @ $1.00 per hour 20

450
The monthly production/sales budget is 10,000 cylinders.

Selling price = $6 per cylinder.

For the month of November the following production and sales information is available:

Produced/sold 10,600 cylinders

Sales value $63,000

Materials purchased and used 53,200 kgs $42,500

Labour 2,040 hours $3,100

Fixed overheads $2,200

Required:

You are required to prepare an operating statement in a marginal costing format for November
detailing all the variances.

MPV = 0.8 - 42500/53200 * 53200 = 60 F

MUV = 10600 *5 - 53200 *0.8 = 160 A

LRV = 1.5 - 3100/2040 * 2040 = 40 A

LEV = 10600 *0.2 - 2040 * 1.5 = 120 F

Fixed overhead exp variance = 20/100 *10000 -2200

= 200 A

SPV = 6 - 63000/10600 *10600 = 600 A

SVV = 10000 -10600 * ( 6- 450-20/100 )

= 1020 F

Budgeted contribution ( 10000 *1.7) = 17000

Less Budgeted FC 2000

Budgeted profit 15000

Adjustment of variances

A F
MPV 60

MUV 160

LRV 40

LEV 120

FOEXP 200

SPV 600

SVV 1020

1000 1200 200

Actual profit (63000-42500-3100-2200) 15200

Absorption

FIXED VOL VARIANCE

= 10000-10600 * 20/100 = 120 F

SVV = 10000-10600 ( 6 - 450/100) = 900 F

Budgeted profit (10000*1.5) 15000

Adjustment of variances

A F

MPV 60

MUV 160

LRV 40

LEV 120

FOEXP 200

FOH VOL 120

SPV 600

SVV 900
 1000 1200 200

Actual profit (63000-42500-3100-2200) 15200

Capacity = 10000 *0.2 - 2040 * 20/20 = 40 F

Efficiency = 10600 0.2 - 2040 *1 = 80 F

Standard and budget difference =

Standard profit = 10600 *1.5 = 15900

For reconciliation don’t calculate sales volume variance.

……………………………………………………………………………………………………………………………

When considering setting standards for costing, which of the following would NOT be
appropriate?

A The normal level of activity should always be used for absorbing overheads

B Average prices for materials should be used, encompassing any discounts that are regularly
available

C The labour rate used will be the rate at which the labour is paid

D Average material usage should be established based on generally-accepted working Practices

Solution The standard labour rate should be the expected rate/hour, but allowing for standard
levels of idle time. For example, if the work force is paid $9 per hour but idle time of 10% is
expected, the standard labour rate will be $10 per hour, not $9.

………………………………………………………………………………………………………………………..

An organisation has recorded a favourable labour rate planning variance for the year of
$40,000.On investigation it has discovered that, whilst actual labour rates were $60 per hour, a
revised standard rate for labour should have been $70 per hour for the actual hours worked of
20,000.What was the original planned labour rate per hour for the year (to the nearest $)?

Solution $72

The planning variance was $40,000 Favourable. This amounts to $2 per hour. If the revised
standard rate per hour was $70 then, for a favourable variance, the original planned rate must
have been $2 higher than this. The original standard rate per hour must have been $72.
Example Mr. Green makes salads. The standard plate of salad has 30 g of lettuce (L), 50 g of
peppers (P) and 80 g of beetroot (B). The standard prices of the three ingredients are $0.2/kg,
0.4/kg and 0.8/kg respectively. The actual prices were $0.22/kg, $0.38/kg and $0.82/kg. Mr.
Green has been experimenting and so in July he changed the mix of vegetables on the plate
thus: 1,500 plates contained 62,000 grams of lettuce, 81,000 grams of peppers and 102,000
grams of beetroot. What is the cost difference between the actual mix and the standard mix (to
the nearest cent)?

Solution
Actual mix Std mix SP × Act mix SP × Std mix

Lettuce 62,000 45,937.5 12.400 9.1875

Peppers 81,000 76,562.5 32.400 30.6250

Beetroot 102,000 122,500.0 81.600 98.0000

245,000 245,000.0 126.400 137.78125

Difference 11.41250

……………………………………………………………………………………………………………………………………………..

Example

Operation B, in a factory, has a standard time of 15 minutes. The standard rate of pay for
operatives is $10 per hour. The budget for a period was based on carrying out the operation 350
times. It was subsequently realised that the standard time for Operation B included in the
budget did not incorporate expected time savings from the use of new machinery from the start
of the period. The standard time should have been reduced to 12 minutes.Operation B was
actually carried out 370 times in the period in a total of 80 hours. The operatives were paid
$850.The operational labour efficiency variance was:

A $60 adverse B $75 favourable C $100 adverse D $125 adverse

Solution: 370 * 3.5 = 4440

80* 60 = 4800 so 4440-4800 = 360 hrs ; 360/60 = 6* 10 = 60 A

…………………………………………………………………………………………………………………………………………..

Which of the following statements are true regarding material price planning variances?

(1) The publication of material price planning variances should always lead to automatic updates
of standard costs.
(2) The causes of material price planning variances do not need to be investigated by managers
at any level in the organisation.

A (1) only

B (2) only

C Neither (1) nor (2)

D Both (1) and (2)

C Statement 1 is not true: the publication of material price planning variances should not always lead to automatic
updates of standard costs. There must be a good reason for deciding that the original standard cost is unrealistic.
Statement 2 is not true either. Although planning variances are not usually the responsibility of operational managers,
these variances do need to be investigated by senior management when they are substantial, so that lessons may be
learned for the future.

……………………………………………………………………………………………

Examle

Leaf Limited has had a mixed year. Its market share has improved 2% to 20% but the

overall market had contracted by 5% in the same period. The budgeted sales were 504,000

units and standard contribution was $12 per unit.

What is the level of actual sales?

A Two percentage points up on budget at 510,080 units

B Three percent down overall on budget at 488,880 units

C Three percent up on budget at 519,120 units

D Up by a little over five and a half percent to 532,000 units

solution

Budget units Actual units Change

Sales 504,000 532,000 Up 5.55%

Market share 18% 20% Up 2%

Market size 2,800,000 2,660,000 Down 5%

So D is correct
Example

A company manufactures a specific clinical machine used in hospitals. The company holds a

2% share of the market and the total market demand has been constant at 250,000

machines for the last few years. The budgeted selling price for each machine is $10,000 and

standard contribution is equivalent to 10% of the budgeted selling price.

An initial performance review of the company’s actual results showed a sales volume of

5,600 machines had been achieved. The total market demand for the machines, though,

had risen to 300,000 units.

What is the market share variance for the clinical machines?

A $200,000 favourable

B $400,000 adverse

C $600,000 favourable

D $1,000,000 adverse

solution

Market share variance compares revised sales volume to actual sales volume.

Revised sales volume (300,000 units × 2%) = 6,000 units Actual sales volume = 5,600 units

Difference = 400 units adverse

Valued at standard contribution of $1,000

Variance = $400,000 adverse

……………………………………………………………………………………………………………………………………….

Example

A profit centre manager claims that the poor performance of her division is entirely due to

factors outside her control. She has submitted the following table along with notes from a

market expert, which she believes explains the cause of the poor performance:
Category Budget this Actual this Actual last Market expert notes

Year year year

Sales volume (units) 500 300 400 The entire market has decreased by 25% compared
. to last year. The product will be obsolete in four years

Sales revenue $50,000 $28,500 $40,000 Rivalry in the market saw selling prices fall by 10%

Total material cost $10,000 $6,500 $8,000 As demand for the raw materials is decreasing, .
. suppliers lowered their prices by 5%.

After adjusting for the external factors outside the manager’s control, in which

category/categories is/are there evidence of poor performance?

A Material cost only

B Sales volume and sales price

C Sales price and material cost

D Sales price only

Solution

The material price when flexed is higher than budget whilst the external environment

shows that prices are reducing. This indicates that although suppliers lowered their prices,

the manager has still overspent which indicates poor performance.

When sales volumes and prices are flexed, it can be seen that the manager has performed

better.

………………………………………………………………………………………………………………………………………………………………………..

Performance measurement and control

Introduction

The calculation of a particular indicator of performance will probably mean very little, unless it is
set in some context.

Establishing the value of a particular indicator will add little benefit until it is:

-compared with a budget

-set in a trend
-and/or set against a best practice benchmark.

Financial performance and ratio analysis

Profitability ratios

Gross profit margin = Gross profit × 100

Turnover (revenue sales)

A high gross profit margin is desirable. It indicates that either revenue is high, or that production
costs are being kept well under control.

Operating profit margin = Operating profit × 100

Turnover

A high operating profit margin is desirable. It indicates that either revenue is high, or that all
costs are being kept well under control.

Return on Capital Employed (ROCE) =

Operating profit × 100

Capital employed

This is a key measure of profitability. It is the operating profit as a percentage of the capital
employed. The ROCE shows the operating profit that is generated from each $ of assets
employed.

Asset turnover = Turnover

Capital employed

The asset turnover shows the turnover that is generated from each $ of assets employed and
therefore how well the assets are being utilised in the business.

More on the ROCE

Liquidity ratios

Current ratio = Current assets

Current liabilities

The ratio measures the company’s ability to meet its short-term liabilities as they fall due. A
ratio in excess of 1 is desirable but the expected ratio varies between the type of industry the
business is operating in.

Quick ratio (acid test) = Current assets – inventory

Current liabilities

The ratio is similar to the current ratio but inventory is removed from the current assets due to
its poor liquidity in the short term.
Inventory holding period = Inventory × 365

Cost of sales

This indicates the average number of days that inventory items are held for.

Receivables collection period = Receivables × 365

Turnover

This is the average period it takes for a company’s receivables to pay what they owe.

Payables Period = Payables × 36

Purchases

This is the average period it takes for a company to pay for its credit purchases.

Measuring risk

Financial gearing = Debt × 100 Debt× 100

Equity or Debt + equity

This is the long -term debt as a percentage of equity. A high level of gearing indicates that the
company relies heavily on debt to finance its long- term needs.

Interest cover = Operating profit

Finance cost

A decrease in the interest cover indicates that the company is facing an increased risk of not
being able to meet its finance payments as they fall due.

Dividend cover = profit

Dividend

A decrease in the dividend cover indicates that the company is facing an increased risk of not
being able to meet its dividends payments as they fall due.

Non-financial performance indicators Issues with financial performance indicators

The use of traditional financial performance metrics is widespread, but the practice has its
problems:

-They only tell what has happened over a limited period in the immediate past.

-They give no indication of what is going to happen in the future.

-They are vulnerable to manipulation and to the choice of accounting policy on matters such as
depreciation and inventory valuation.

-They do not relate to the strategic management of the business and may induce ‘short-
termism’ at the expense of motivation, quality and efficiency.

The Balanced Scorecard

Example

Faster Pasta is an Italian fast food restaurant that specialises in high quality, moderately priced
authentic Italian pasta dishes and pizzas. The restaurant has recently decided to implement a
balanced scorecard approach and has established the following relevant goals for each
perspective:

The following information is also available for the year just ended and for the previous year:

Using appropriate performance measures, calculate and comment on whether or not Faster
Pasta has achieved its goals.

Customer perspective

-Goal: To increase the number of new and returning customers.

-Measure: The number of new customers has increased year on year from 4,400 to 4,750. This is
an 8.0% increase. The number of returning customers has also increased slightly from 7,200 to
7,250, i.e. a 1.0% increase.

-Comment: The company has achieved its goal of increasing the number of new and existing
customers. It is worth noting that the proportion of customers who are returning customers has
fallen slightly from 62.1% to 60.4% of the total customers. This could indicate a small drop in the
level of customer satisfaction.

-Goal: To decrease the % customer complaints.

-Measure: The percentage of customer complaints has increased from 4% (464 ÷ 11,600) to 7%
(840 ÷ 12,000).

-Comment: This increase in complaints may be due to the longer time between order and
delivery of the meals, or could be as a result of the customer experience deteriorating due to
poorly trained/new staff. If customer complaints continue to increase, Faster Pasta may see a
reduction in customer retention going forward, reducing profitability.

Internal perspective

-Goal: To reduce the time taken between taking the customer's order and delivering the meal to
the customer.

-Measure: The time taken has more than tripled from an average of 4 minutes in 20X8 to an
average of 13 minutes in 20X9.

-Comment: Customers may place a high value on the fast delivery of their food. The increase in
time may be linked to the increased number of customer complaints. If this continues customer
satisfaction, and therefore profitability, will suffer in the long-term. The restaurant should take
steps now in order to ensure that this goal is achieved going forward.

-Goal: To reduce staff turnover.

-Measure: This has risen significantly from 12% to 40% and hence the business has not achieved
its goal.

-Comment: The increase in staff turnover suggests staff are dissatisfied. This may be due to poor
pay or working conditions, perhaps arising from growth in customer numbers leading to higher
workloads. Also, staff may be disappointed at the limited training they are receiving. The staff
turnover may be contributing to longer waiting times and the increase in customer complaints.
This will impact long-term profitability.

Innovation and learning perspective

-Goal: To increase the proportion of revenue from new dishes.

-Measure: This has increased year on year from 20% ($22,000 ÷ $110,000) in 20X8 to 30%
($39,600 ÷ $132,000) in 20X9. Therefore, the restaurant has achieved its goal.

-Comment: This is a favourable increase and may have a positive impact on long-term
profitability if the new products meet the needs of the customers. This will hopefully lead to
attracting and retaining customers in the future.

-Goal: To increase the % of staff time spent on training.

-Measure: This has fallen significantly from 5% to only 2% and hence the company is not
achieving its goal.

-Comment: Staff may be unsatisfied if they feel that their training needs are not being met. This
may contribute to a high staff turnover. In addition, staff may not have the skills to do the job
well and this would impact the level of customer satisfaction.

Financial perspective

-Goal: To increase spend per customer.

-Measure: Spend per customer has increased from $9.48 ($110,000 ÷ 11,600) to $11.00
($132,000 ÷ 12,000), i.e. a 16.0% increase.

-Comment: This is a favourable increase. However, the issues discussed above must be
addressed in order to ensure that this trend continues.

-Goal: To increase gross profit margin.

-Measure: The GP margin has increased year on year from 20% ($22,000 ÷ $110,000) to 23%
($30,360 ÷ $132,000).

-Comment: This is a favourable increase. However, the issues discussed above must be
addressed to ensure that this trend continues.

Evaluation of the Balanced Scorecard as a performance

measurement tool
 The Building Block model
A performance measurement system for the service sector based
on three building blocks
Example

Which of the following statements regarding Fitzgerald and Moon’s Building Blocks model are
correct?

1 The determinants of upstream performance are quality, innovation, resource utilisation and
competitiveness.

This statement is not correct. The determinants of performance are quality, innovation,
resource utilisation and flexibility. Competitiveness is a result of the determinants.

2 Standards are targets for performance and should be fair, achievable and controllable.

This statement is not correct. Standards should be fair, achievable and staff should have
ownership of them. Controllability is a feature of the rewards block.
3 Rewards encourage staff to work towards the standards and should be clear, motivating and
controllable.

Rewards should be clear, motivating and controllable, so this is correct.

4 It is a performance measurement framework particularly suitable for service organisations.

This statement is correct. Fitzgerald and Moon’s Building Blocks model is a framework designed
to attempt to overcome the problems associated with performance management in service
companies.

Evaluation of the building block model as a performance

measurement tool

External considerations

Performance measures provide useful information to management which aid in the control of
the business. However, they need to be considered in the context of the environment external
to the business to gain a full understanding of how the business has performed and to develop
actions which should be taken to improve performance.