FACULTY OF COMMERCE

DEPARTMENT OF ACCOUNTING & FINANCE

MANAGEMENT ACCOUNTING [COAF 4105]

STUDY GUIDE

MR. B DLAMINI

2016 EDITION
 Management Accounting (COAF 4105)

For Accounting and finance students

Lecturer: Mr. B Dlamini

Contact: 0772 476 323/ bdlamini@lsu.ac.zw

Course Overview
Chapter one: Introduction to Management accounting

 Nature and scope of Management Accounting

 Objectives of Management Accounting
 Features of Management Accounting
 Cost Accounting vs. Management Accounting

Chapter two: Standard Costing

 Various Types of Standards
 Variance analysis for Materials, Labour , Overheads and Sales
 Variance Reporting to Management
 Reconciliation of budgeted and actual profit
 Investigating variances
 Benchmarking

Chapter three: Transfer pricing

 Transfer Pricing Methods
 Objectives and concept of Transfer Pricing
 practical problems involved in Transfer Pricing

Chapter four: Uniform costing

 Objective Of Uniform Costing
 Merits and demerits of Uniform Costing
 Requisites for Uniform Costing
 Uniform Cost-manual

Chapter five: The modern business environment

 The changing business environment
 Just-in-time (JIT) systems
 Total quality management (TQM)
 Costs of quality and cost of quality reports

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Chapter six: Modern costing techniques -Throughput and Back-flush accounting

 The theory of constraints (TOC)
 Throughput accounting
 Back-flush accounting

Chapter seven: Activity Based Costing

 Objectives of Activity Based Costing
 Activity Based Costing vs. Traditional Costing System
 Application of Activity Based Costing
 Limitations of Activity Based Costing

Chapter eight: Project appraisal- Investment decision making

 The process of investment decision making
 Post audit
 Method: payback, accounting rate of return, net present value and internal rate of return.
 NPV and IRR compared
 Discounted payback and taking account of Taxation and Inflation

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Chapter one:

Introduction to Management Accounting

Introduction:-
The scope of Management Accounting is broader than the scope of cost accounting.
In cost accounting, as we have seen, the primary emphasis is on cost and it deals with collection,
analysis, relevance, interpretation and presentation for various problems of management.
Management Accounting is an accounting system which will help the Management to improve
its efficiency. The main thrust of Management Accounting is towards determining policy and
formulating plans to achieve desired objectives of management. It helps the Management in
planning, controlling and analyzing the performance of the organization in order to follow the
path of continuous improvement. Management Accounting utilizes the principle and practices of
financial accounting and cost accounting in addition to other modern management techniques for
effective operation of a company. In fact there is an overlapping in various areas of cost
accounting and management accounting. However, the distinguishing features of Management
Accounting are given below.

Management Accounting is the presentation of accounting information in such a way as to

assist management in the creation of policy and the day – to – day operation of an undertaking.
Thus, it relates to the use of accounting data collected with the help of financial accounting and
cost accounting for the purpose of policy formulation, planning, control and decision – making
by management.

Objectives of Cost and Management Accounting: -

1. To ascertain the cost of production on per unit basis, for example, cost per kg, cost per meter,
cost per litre, cost per ton etc.
2. Cost accounting helps in the determination of selling price. Cost accounting enables to
determine the cost of production on a scientific basis and it helps to fix the selling price.
3. Cost accounting helps in cost control and cost reduction.
4. Ascertainment of division wise, activity wise and unit wise profitability becomes possible
through cost accounting.
5. Cost accounting also helps in locating wastages, inefficiencies and other loopholes in the
production processes/services offered.

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6. Cost accounting helps in presentation of relevant data to the management which helps in
decision making. Decision making is one of the important functions of Management and it
requires presentation of relevant data. Cost accounting enables presentation of relevant data in a
systematic manner so that decision making becomes possible.
7. Cost accounting also helps in estimation of costs for the future.
8. Planning is an important function of management accounting which is most effectively
performed by the preparation of budgets and forecasts.

9. Management accounting facilitates the provision of financial information to management for

decision making.

10. Management accounting also involves the evaluation of alternative strategies and actions by
the application of techniques and concepts such as relevant costing, cost-volume-profit analysis,
limiting factor analysis, investment appraisal techniques and client / product profitability
analysis.

11. Management accounting lays great emphasis on accountability through effective

performance measurement. By setting targets for strategic business units and as well as for
departments, management accounting assists in the assignment of responsibility for the
achievement of business targets by individual managers.

The scope of Management Accounting

The scope of Management Accounting is broader than the scope of cost accounting.
In cost accounting, as we have seen, the primary emphasis is on cost and it deals with collection,
analysis, relevance, interpretation and presentation for various problems of management.
Management Accounting is an accounting system which will help the Management to improve
its efficiency. The main thrust of Management Accounting is towards determining policy and
formulating plans to achieve desired objectives of management. It helps the Management in
planning, controlling and analyzing the performance of the organization in order to follow the
path of continuous improvement. Management Accounting utilizes the principle and practices of
financial accounting and cost accounting in addition to other modern management techniques for
effective operation of a company. In fact there is an overlapping in various areas of cost
accounting and management accounting. However, the distinguishing features of Management
Accounting are given below.

Features of Management Accounting

The features of Management Accounting are given below.

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1. The Management Accounting data are derived from both, the financial accounting and cost
accounting.
2. The main thrust in management accounting is towards determining policy and formulating
plans to achieve desired objectives of management.
3. Management Accounting makes corporate planning and strategy effective and meaningful.
4. It is concerned with short and long range planning and uses highly sophisticated techniques
like sensitivity analysis, probability techniques, decision tree, ratio analysis etc for planning,
control and evaluation.
5. It is futuristic in approach and predictive in nature.
6. Management accounting system cannot be installed without proper cost accounting system.

Management Accounting Information and their use

In the above paragraphs, we have seen the utility of Management Accounting. One of the
distinguishing factors between the financial accounting and management accounting is that the
management accounting does not have a unified structure. The format in which it is prepared
varies widely according to the circumstances in each case and the purpose for which the
information is being summarized. The management accounting generates information, which is
used for three different purposes. I] Measurement II] Control and III] Decision making
[Alternative choice problems] for each of these purposes, management accounting generates vital
information. The uses of information for each of the three purposes of management accounting
are explained below:

I. Measurement: For measurement of full costs, the management accounting system focuses on
the measurement of full costs. Full costs are the total costs required for producing goods or
offering services. These costs are divided into A] Direct costs and B] Indirect costs. Direct costs
are identifi able or traceable to the products or services offered while indirect costs are not
traceable to the products or services. Full cost accounting measures not only the total costs
[direct plus indirect costs] required for producing products or services but also the full costs
required to run other activity like conducting a research project or running a welfare scheme and
so on. Thus full cost accounting is not restricted to solely to measure the cost of manufacturing.

II. Control: An important aspect of the management accounting information is to provide

information, which can be used for ‘Control’. The management accounting system is structured
in such a manner that information is generated for each ‘Responsibility Centre’. A responsibility
centre is an organization unit headed by a manager who is responsible for its operations and
performance. Management accounting helps to prepare budget for each responsibility centre and
also facilitates comparison between the budgeted and actual results. A report is prepared for each
responsibility centre, which shows the budgeted and actual performance and also the difference

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between the two. This enables the performance analysis of each responsibility centre so that
proper corrective action can be taken in this respect.

III. Decision Making: Management accounting generates useful information for decision
making.
Management has to take several decisions in the course of business. Some of the major decisions
are Make or Buy Accepting or rejecting of an Export Order, Working of second shift, Fixation of
selling price, Capital expenditure decisions, increasing production capacity, Optimizing of
Product Mix and so on. For all these decisions, providing of information is necessary and the
management accounting generates this information, which enables the management to take such
decisions.

Role of Management Accountancy

The role of management accounting and financial accounting is quite different from each other
as they have different goals altogether. Management accounting measures analyzes and reports
financial and non financial information that helps managers to take decisions to fulfill the goals
of an organization. Managers use management accounting information to choose, communicate
and implement strategy. They also use management accounting information to coordinate
product design, production and marketing decisions. Management accounting focuses on internal
reporting. The following points highlight the role played by Management Accounting in the
business organization.

I. Implementing Strategy: Managers implement strategies by translating them into actions.

Creating value for customers is an important part of planning and implementation of strategies.
Strategic planning and implementation will include decisions regarding the design of products,
services or processes, research and development, production, marketing, distribution and
customer services.
Each of this area is important for satisfying customers and keeping them satisfied. Management
accounting will help to track the costs of each of the activity mentioned above. The ultimate
target is to reduce costs in each category and to improve efficiency. Cost information also helps
managers make cost benefit analysis. For example, managers can find out that is it cheaper to
buy products from outside vendors or to do manufacturing in-house? Is it worthwhile to invest
more resources in design and manufacturing if it reduces costs in marketing and customer
service?

II. Supply Chain Analysis: Companies can also implement strategy, cut costs and create value
by enhancing their supply chain. The term ‘Supply Chain’ describes the flow of goods, services
and information from the initial sources of materials and services to the delivery of products to

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customers regardless of whether those activities occur in the same organization or in other
organization. Customers expect improved performance from companies through the supply
chain. They expect that the companies should perform all these activities in an efficient manner
so as to reduce costs and also maintain quality of the products and the products be available
easily for them. This is no doubt a daunting task and the management accounting plays a vital
role in ensuring value for money for the customers. Tools like standard costing and target costing
can be used effectively for cost control and cost reduction and thus ensure reasonable prices for
customers. A system of budgets and budgetary control will ensure continuous planning and
monitoring various functions and thus provide for introspection. Continuous improvement in
these activities will help in creating value for customers.

III. Decision Making: One of the important functions of management is decision making.
Management Accounting helps in this crucial area by providing relevant information to the
management. Techniques like marginal costing helps to generate information, which will be
useful for taking decisions. Decisions include make or buy decisions, adding or dropping a
product line, working of additional shift, shut down or continue operations, capital expenditure
decisions and so on. Decisions based on information are expected to be more rational and
objective rather than subjective.

IV. Performance Measurement: Management accounting helps immensely for the measurement
of performance of the organization. The main aspect of performance measurement is comparison
between the targets and actual. There are several tools and techniques like budgets and budgetary
control, standard costing and marginal costing, which are used in measuring the actual
performance against the target performance. This will facilitate introspection and corrective
action can be taken for further improving the performance.

Cost Accounting vs. Management Accounting

Cost Accounting and management accounting both have the same objectives of helping
management in planning, control and decision making. Both are internal to the organization and
use common tools and techniques like standard costing, variable costing, budgetary control etc.
in spite of these similarities there are certain differences between these two.

The Main distinctions between cost accounting and management accounting are given
below:

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Cost Accounting Management Accounting

The main objective of cost accounting is to The primary objective of management accounting
assist the management in cost control and is to provide necessary information to the
decision-making. management in the process of its planning,
controlling, and performance evaluation, and
decision-making.

Cost accounting system uses quantitative cost Management accounting uses both quantitative and
data that can be measured in monitory terms. qualitative data. It also uses those data that cannot
be measured in terms of money.

Determination of cost and cost control are the Efficient and effective performance of a concern is
primary roles of cost accounting. the primary role of management accounting.

Success of cost accounting does not depend Success of management accounting depends on
upon management accounting system. sound financial accounting system and cost
accounting systems of a concern.

Cost-related data as obtained from financial Management accounting is based on the data as
accounting is the base of cost accounting. received from financial accounting and cost
accounting.

Provides future cost-related decisions based on Provides historical and predictive information for
the historical cost information. future decision-making.

Cost accounting reports are useful to the Management accounting prepares reports
management as well as the shareholders and exclusively meant for the management.
creditors of a concern.

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Only cost accounting principles are used in it. Principals of cost accounting and financial
accounting are used in management accounting.

Statutory audit of cost accounting reports are No statutory requirement of audit for reports.
necessary in some cases, especially big
business houses.

Cost accounting is restricted to cost-related Management accounting uses financial accounting

data. data as well as cost accounting data.

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Chapter two:
Standard Costing and variance analysis

Definitions
Standard Cost is the planned unit cost of the products, components or services produced in a
period. The standard cost may be determined on a number of bases. The main uses of standard
costs are in performance measurement, control, inventory valuation and in the establishment of
selling prices, (CIMA, 2005).
Standard Costing is a control technique which compares standard costs and revenues with actual
results to obtain variance, which are used to stimulate improved performance, (CIMA, 2005).

Standard costing consists of the following STEPS:

1. Setting the estimates i.e., standard costs (both for the items of costs as well as for revenues).
2. Comparing the actual cost with the standard cost (and also actual revenue with standard
revenue).
3. Calculating the variance if any (i.e. identifying whether or not actual performance deviates
from the desired level).
4. Analyzing and investigating the reasons for the variance
5. Taking corrective action - either by improving the actual performance or by revising the
standards. The steps involved in a standard costing system are presented by means of the
following diagram:

Type of Standard:

I. Ideal Standard: An ideal standard is a standard, which can be attained under the most
favourable conditions. The expected performance can be achieved only if all factors, such as
material and labour prices, level of performance of employees, highest output with best possible
equipment and machinery, highest level of efficiency and so on.

II. Normal Standard: These are such standards which are expected if normal circumstances
prevail. Term normal represents the normal conditions of the business in the absence of any
unexpected fluctuations (either favourable or unfavourable). Even through normal standards are
more of theoretical in nature as reality cannot be sufficiently predicted with all its fluctuations in
advance
III. Basic standard: This is standard established considering those factors that are basic in nature
and remain unchanged over a long period of time and are altered only when the business

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operations change significantly affecting the very basic foundations of the entity and nature of
business.
IV. Attainable Standard: An Attainable Standard is a standard, which, it is anticipated, can be
attained during a future specified standard period. This standard is quite attainable; it is
consistent and hence fulfils all the purposes of a good standard. It provides incentive to improve
performance and get the better of the adverse conditions. These standards are formulated after
making allowance for the cost of normal spoilage, cost of idle time due to machine breakdowns,
and the cost of other events, which are unavoidable in normal efficient operations. Thus all the
normal losses are taken into consideration.

Setting of Standard Costs

Direct Material Cost Standard
The establishment of standard cost for direct materials involves the determination of:
standard quantity of raw materials and
Standard price of raw material consumed.
Direct Labour:
Two factors need to be taken into consideration while fixing the standard labour cost:
the standard time and
The standard rate.
Factory Overhead Standards:
Setting of standard for overhead costs, there is a need to determine:
standard capacity and
Standard overhead cost for that capacity.

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Variance Analysis

Variance Analysis refers to the investigation of deviations in financial performance from the
standards defined in organizational budgets.

Material Variances:
In the material variances, the main objective is to find out the difference between the standard
cost of material used for actual production and actual cost of material used. Thus the main
variance in this category is the cost variance, which is thereafter broken down into other
variances. These variances are given below.

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Material Cost Variance: As mentioned above, this variance shows the difference between the
standard cost of material consumed for actual production and the actual cost. The following
formula is used for computation of this variance.

 Standard Cost of Material Consumed for Actual Production – Actual Cost

Material Price Variance: One of the reasons for difference between the standard material cost
and actual material cost is the difference between the standard price and actual price. Material
Price Variance measures the difference between the standard price and actual price with
reference to the actual quantity consumed. The computation is as shown below:

 Material Price Variance: Actual Quantity [Standard Price – Actual Price]

Material Quantity [Usage] Variance: This variance measures the difference between the
standard quantity of material consumed for actual production and the actual quantity consumed
and the same is multiplied by standard price.
 Material Quantity [Usage] Variance: Standard Price [Standard Quantity – Actual
Quantity]

Material Mix Variance:

Material Mix Variance is the measure of difference between the cost of standard proportion of
materials and the actual proportion of materials consumed in the production process during a
period. While material usage variance illustrates the overall efficiency of raw material
consumption during a period (in terms of the difference between the amount of materials which
should have been used and the actual usage), material mix variance focuses on the aspect of
proportion of raw materials used in the production process. Material mix variance is only
suitable for performance measurement and control where the proportion of inputs to the

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production process can be altered without reducing the effectiveness of the final product. In case
of several products, two or more types of raw materials are mixed to produce the final product.
In such cases, standard proportion of mixture is decided in advance. For example, in
manufacturing one unit of product ‘P’, material A and B may have to be mixed in a standard
proportion of 3:2. This is called as a standard mix. However, when the actual production begins,
the actual proportion of mix may have to be changed due to several reasons like non-availability
of a particular material etc. In such cases material mix variance arises. The mix variance is
computed in the following manner.

 Material Mix Variance = Standard Price (Actual Mix Quantity - Standard Mix
Quantity)

Example

Cement PLC manufactured 10,000 bags of cement during the month of January. Consumption of
raw materials during the period was as follows:

Material Quantity Used Standard Mix Per Bag Actual Price Standard Price

Limestone 100 tons 11 KG $75/ton $70/ton

Clay 150 tons 14 KG $21/ton $20/ton

Sand 250 tons 26 KG $11/ton $10/ton

Material Mix Variance will be calculated as follows:

Step 1: Calculate the total consumption of raw materials

Total Raw Materials Consumption (100 + 150 + 250) = 500 tons

Step 2: Calculate the Standard Mix

We need to calculate the quantity of each raw material which would have been consumed had the
total usage of raw materials (500 tons) been based on the standard mix.

Limestone: 500 tons units x 11 / 51* = 108 tons

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Clay: 500 tons units x 14 / 51* = 137 tons

Sand: 500 tons units x 26 / 51* = 255 tons

* Total Quantity under Standard Usage (11 + 14 + 26) = 51 KG per bag

Note that the sum of the standard mix of raw materials calculated above equals the actual total
consumption of 500 tons. This is because in material mix variance, we are not concerned about
the efficiency of raw material consumption but rather their relevant proportions.

Step 3: Calculate the Variance

Material Usage Variance = [Actual Mix - Standard Mix (Step 2)] x Standard Price

Limestone: (100 - 108) x $70 = ($560) Favourable

Clay: (150 - 137) x $20 = $260 Adverse

Sand: (250 - 255) x $10 = ($50) Favourable

Total Usage Variance ($350) Favourable

Note: Actual price paid for the acquisition of materials shall be ignored since any variation
between standard prices is already accounted for in the material price variance..

Analysis

A favourable material mix variance suggests the use of a cheaper mix of raw materials than the
standard. Conversely, an adverse material mix variance suggests that a more costly combination
of materials have been used than the standard mix.

A change in the material mix must also be analyzed in the context of other organization wide
implications that may follow. Some of the effects a change in direct material mix include:

Change in the quality, performance and durability of the final product

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Price offered by customers may vary as a result of a change in perceived quality of the product

 Change in material mix may affect the workability of materials which may in turn affect
labour efficiency

Exercise 1:

A product T is produced by mixing three materials: P, Q and R in a standard mix ratio of 1:2:2.
Actual materials consumed during the month ended May 31, 20X2 were 4,670g, 8,450g and
8,390g respectively. Standard prices are $0.04/g $0.03/g and $0.02/g per gram respectively.
Calculate the direct material mix variance.

Material Yield Variance:

In any manufacturing process, some unavoidable loss always takes place. Thus if the input is
100, output may be 95.5 units being normal or unavoidable loss. The normal loss is always
anticipated and taken into consideration while determining the standard quantity. Yield variance
arises when the actual loss is more or less than the normal loss. The computation of yield
variance is as given below.
Material Yield Variance = SYR [Actual Yield – Standard Yield]
SYR = Standard Yield Rate, i.e. standard cost per unit of standard output.

Reconciliation: Quantity Variance = Mix Variance + Yield Variance.

Example

Cement PLC manufactured 10,000 bags of cement during the month of January. Consumption of
raw materials during the period was as follows:

Material Quantity Used Standard Mix Per Bag Actual Price Standard Price

Limestone 100 tons 11 KG $75/KG $70/KG

Clay 150 tons 14 KG $21/KG $20/KG

Sand 250 tons 26 KG $11/KG $10/KG

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Material Yield Variance shall be calculated as follows:

Step 1: Calculate the Standard Yield for the total materials input

500 tons of materials should have yielded 9,804 bags

Standard Yield = 500 tons x 1000 / 51 KG = 9,804 bags

Step 2: Calculate the Standard Cost of materials per bag

Total material cost of 1 bag of cement:

Limestone: 11 KG x $70 = $770

Clay: 14 KG x $20 = $280

Sand: 26 KG x $10 = $260

Total $1,310 per bag

Actual material price should be ignored since the variance between actual and standard price is
accounted for in the material price variance.

Step 3: Calculate the Total Yield Variance

Material Usage Variance = [Actual Yield - Standard Yield (Step 1)] x Standard Cost / Unit
(Step 2)

Actual Yield - Standard Yield = 10,000 - 9,804 (Step 1) = 196 bags

Total Material Yield Variance = 196 bags x $1,310 (Step 2)

= $256,760 Favourable

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As the actual output achieved during the period is higher than the standard yield, the variance is
favourable. Favourable material yield variance indicates the amount of savings in material costs
as a result of better output yield than the standard.

Step 4: Calculate the Material Wise Yield Variances

Individual material yield variance can be calculated in a similar way to the total yield variance.

Actual Yield - Standard Yield Standard Cost per bag

Materials: x = Yield Variance
(Step 3) (Step 2)

Limestone: 196 bags x $770 = $150,920

Clay: 196 bags x $280 = $54,880

Sand: 196 bags x $260 = $50,960

$256,760

Note that sum of individual material yield variances equals the total yield variance calculated in
step 3.

Analysis

A favourable material yield variance indicates better productivity than the standard yield
resulting in lower material cost. Conversely, an adverse material yield variance suggests lower
production achieved during a period for the given level of input resulting in higher material cost.

Exercise 2:

Using the same example which we used in calculating the direct material mix variance:
A product T is produced by mixing three materials: P, Q and R in a standard mix ratio of 1:2:2.
Actual materials consumed during the month ended May 31, 20X2 were 4,670g, 8,450g and
8,390g respectively. Standard prices are $0.04/g $0.03/g and $0.02/g per gram respectively
whereas standard quantities allowed are 4,310g, 8,620g and 8,620g respectively.

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Calculate the direct material yield variance.

Exercise 3:
The standard material cost to produce a ton of chemical X is given below:
300 kg of material A @ $10 per kg
400 kg of material B @ $5 per kg
500 kg of material C @ $6 per kg
During a particular period, 100 tons of mixture X was produced from the usage of
35 tons of material A @ $9, 000 per ton
42 tons of material B @ $6, 000 per ton
53 tons of material C @ $7, 000 per ton

Calculate material cost, price, and usage and mix variances.

Exercise 4:

For 500 Kg of a finished product, the standard material inputs required are given below:

Material Quantity (in Kg) Standard rate per kg (in $)

A 225 40.00
B 200 80.00
C 125 30.00
550
Standard Loss 50
Standard Output 500

10000 kg of the finished product has been actually produced during the period for which the
actual quantities of material used & the prices paid there for are as under:

Material Quantity used (in Kg) Purchase rate per kg (in $)

A 5000 38.00
B 4250 84.00
C 2250 32.50

Calculate:

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(a) Material Cost variance;

(b) Material price variance;

(c) Material usage variance;

(d) Material mix variance;

(e) Material yield variance.

Also make reconciliation among the variances.

Exercise 5:

From the following data,:

Material Standard Actual
X 3500 kg @ $ 2.10 3750 kg @ $ 2.40
Y 1500 kg @ $ 4.30 1650 kg @ $ 4.60
Z 1000 kg @ $ 6.60 1200 kg @ $ 7.00

Calculate:

(a) Material Cost Variance,

(b) Material Price Variance,

(c) Material Usage Variance,

(d) Material mix variance

Exercise 6:

S.V. Ltd. manufactures a single product, the standard mix of which is as follows:
Material A 60% at $20 per kg
Material B 40% at $10 per kg

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Normal loss in the production is 20% of input. Due to shortage of material A, the standard mix
was changed and the actual mix was as follows:
Material A 105 kg at $20 per kg
Material B 95 kg at $9 per kg
Actual loss was 35 kg, while the actual output was 165 kg

Calculate all material variances.

Labour Variances:
Like the material variances, labour variances arise due to the difference between the standard
labour cost for actual production and the actual labour cost. The following variances are
computed in case of direct labour.

The following chart will show the relationships between various labour variances.

Labour Cost Variance

|
--------------------------------------------------------------------------
| | |
Rate Variance Efficiency Variance Idle Time Variance
|
--------------------------------------
| |

Mix Variance Yield Variance

I] Labour Cost Variance: This variance is the main variance in case of labour and arises due to
the difference between the standard labour cost for actual production and the actual labour cost.
The following formula is used for computation of this variance.

 Labour Cost Variance = Standard Labour Cost for Actual Production – Actual
Labour Cost

II] Labour Rate Variance: One of the reasons for labour cost variance is the difference between
the standard rate of wages and actual wages rate. The labour rate variance indicates the

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difference between the standard labour rate and the actual labour rate paid. The formula for
computation is as under.

 Labour Rate Variance: Actual Hours [Standard Rate – Actual Rate]

Labour Efficiency Variance:

It is of paramount importance that efficiency of labour is measured. For doing this, the actual
time taken by the workers should be compared with the standard time allowed for the job. The
standard time allowed for a particular job is decided with the help of time and motion study. The
efficiency variance is computed with the help of the following formula.

 Labour Efficiency Variance = Standard Rate [Standard Hours for Actual Output –
Actual Hours worked]

IV] Labour Mix Variance or Gang Composition Variance: This variance is similar to the
material mix variance and is computed in the same manner. In doing a particular job, there may
be a particular combination of labour force, which may consist of skilled, semi skilled and
unskilled workers. However due to some practical difficulties, this composition may have to be
changed. How much is the loss caused due to this change or how much is the gain due to this
change is indicated by this variance. The computation is done with the help of the following
formula.
Labour Mix Variance = Standard Cost of Standard Mix – Standard Cost of Actual Mix.
Or
Labour Mix Variance = (Revised Standard – Actual Hours Worked) X Standard Rate

Exercise 7:

The following information is available from the records of a Company:

Standard wages Actual wages
Skilled : 90 workers @ $2 per hour 80 workers @ $2.50 per hour
Unskilled: 60 workers @ $3 per hour 70 workers @ $2 per hour
Budgeted hours: 1000 Actual hours: 900

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Required
Calculate the following Variance:
i)Labour Cost Variance
ii)Labour Rate Variance
iii)Labour Efficiency Variance
iv)Labour Mix Variance

Labour Yield Variance: This variance indicates the difference between the actual output and the
standard output based on actual hours. In other words, a comparison is made between the actual
production achieved and the production that should have been achieved in actual number of
working hours. The variance will be favourable is the actual output achieved is more than the
standard output. The computation is done in the following manner.

Labour Yield Variance = (AY - SY) x SC

AY = Actual yield or output
SY = Standard Yield or output for actual input
SC = Standard cost per unit

Exercise 8:

The following information is available from the records of a Company:

4 hours of skilled labour @$15 per hour
6 hours of unskilled labour @$10 per hour

The standard total labour input associated with production of one unit is 10 hours at an average
hourly rate of $12. During the period:
250 units where produced
950 hours of skilled labour where used
1750 hours of unskilled labour where used
$32675 wages where paid

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Required:
Calculate: Labour Yield Variance

VI] Idle Time Variance: This variance indicates the loss caused due to abnormal idle time.
While fixing the standard time, normal idle time is taken into consideration. However if the
actual idle time is more than the standard/normal idle time, it is called as abnormal idle time.
This variance will be always adverse and will be computed as shown below.

Idle Time Variance = number of Idle hours X Standard Rate/hour

Example

DM manufactured and sold 10,000 pairs of jeans during a period.

Information relating to the direct labour cost and production time per unit is as follows:

Actual Hours Standard Hours Actual Rate Standard Rate

Per Unit Per Unit Per Hour Per Hour
Direct Labour 0.65 0.6 $12 $10

During the period, 800 hours of idle time was incurred. In order to motivate and retain
experienced workers, DM has devised a policy of paying workers the full hourly rate in case of
any idle time.

Note: 0.65 hours per unit of actual time includes the idle time.

Calculation of idle time variance and Labour Efficiency Variance

(a) Idle Time Variance:

(b) Labour Efficiency Variance:

Exercise 9:

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The standard output of production EXE is 25 units per hour in a manufacturing department of a
company employing 100 workers. The standard wage rate per labour hour is $6.
In a 42 hours week, the department produced 1040 units of the product despite 5% of the time
paid were lost due to an abnormal reason. The hourly wage rate actually paid were $6.20, $6 and
$5.70 respectively to 10, 30 and 60 of the workers.

Compute various relevant labour variances.

Overhead Variances:
The overhead variances show the difference between the standard overhead cost and the actual
overhead cost. In case of direct material and direct labour variances, there is no question of
dividing them into fixed and variable as the direct material and direct labour costs are variable.
However, in case of overheads, it is necessary to divide them into fixed and variable for
computation of variances. We will take up the fixed overhead variances first and then the
variable overhead variances.

A. Fixed Overhead Cost Variance: This variance indicates the difference between the standard
fixed overheads for actual production and the actual fixed overheads incurred. Actually this
variance indicates the under/over absorbed fixed overheads. If the actual overheads incurred are
more than the standard fixed overheads, it indicates the under absorption of fixed overheads and

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the variance is favourable. On the other hand, if the actual overheads incurred are more than the
standard fixed overheads, it indicates the over absorption of fixed overheads and the variance is
adverse. The following formula is used for computation of this variance.
 Fixed Overhead Cost Variance: Standard Fixed Overheads for Actual Production –
Actual Fixed Overheads.

B. Fixed Overhead Expenditure/Budget Variance: This variance indicates the difference

between the budgeted fixed overheads and the actual fixed overhead expenses. If the actual fixed
overheads are more than the budgeted fixed overheads, it is an adverse variance as it means
overspending as compared to the budgeted amount. On the other hand, if the actual fixed
overheads are less than the budgeted fixed overheads, it is a favourable variance. This variance is
computed with the help of the following formula.

 Fixed Overhead Expenditure Variance: Budgeted Fixed Overheads – Actual Fixed

Overheads

C] Fixed Overheads Volume Variance: This variance indicates the under/over absorption of
fixed overheads due to the difference in the budgeted quantity of production and actual quantity
of production. If the actual quantity produced is more than the budgeted one, this variance will
be favourable but it will indicate over absorption of fixed overheads. On the other hand, if the
actual quantity produced is less than the budgeted one, it indicates adverse variance and there
will be under absorption of overheads. The formula for computation of this variance is as shown
below:

 Fixed Overhead Volume Variance: Standard Rate [Budgeted Quantity – Actual

Quantity]

 Fixed Overhead Cost Variance = Expenditure Variance + Volume Variance

D] Fixed Overhead Efficiency Variance: It is that portion of volume variance which arises
due to the difference between the output actually achieved and the output which should have
been achieved in the actual hours worked. This variance will be favourable it the actual
production is more than the standard production in actual hours. The formula for computation
of this variance is as follows:
 Fixed Overhead Efficiency Variance: Standard Rate [Standard Production –
Actual Production]

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E] Fixed Overhead Capacity Variance: This variance is also that portion of volume
variance, which arises due to the difference between the capacity utilization, i.e. the capacity
actually utilized and the budgeted capacity. If the capacity utilization is more than the
budgeted capacity, the variance is favourable, otherwise it will be adverse. The formula is as
follows:

 Fixed Overheads Capacity Variance: Standard Rate [Standard Quantity –

Budgeted Quantity]

 Volume Variance = Efficiency Variance + Capacity Variance

F] Fixed Overhead Revised Capacity Variance: This variance indicates the difference in
capacity utilization due to working for more or less number of days than the budgeted one.
The computation of this variance is done by using the following formula.

 Fixed Overhead Revised Capacity Variance = Standard Rate [Standard Quantity –

Revised Budgeted Quantity]

G] Fixed Overheads Calendar Variance: This variance indicates the difference between the
budgeted quantity of production and actual quantity of production achieved arising due to the
difference in the number of days worked and budgeted. The formula for computation of this
variance is as follows:

 Fixed Overheads Calendar Variance = Standard Rate [Budgeted Quantity –

Revised Budgeted Quantity]

Exercise 10:

From the following information extracted from the books of a manufacturing company,
Details Budgeted Actual
Production – Units 22, 000 24, 000
Fixed Overheads $44, 000 $49, 000
Variable Overheads $33, 000 $39, 000
Number of Days 25 26
Number of man hours 25, 000 27, 000

Calculate Fixed and Variable Overhead Variances.

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Exercise 11:

The following information is available from the records of a manufacturing

company using standard costing system.

Particulars Standar Actual

Production 4,000 units d 3,800 units
Working days 20 21
Fixed overhead $40, 000 $39, 000
Variable overheads $12, 000 $12, 000

Calculate the following overhead variances

I] Variable overhead variance

II] Fixed overhead cost variance

III] Fixed overhead expenditure variance

IV] Fixed overhead volume variance

V] Fixed overhead efficiency variance

VI] Fixed overhead calendar variance

Sales Price Variance:

Is the measure of change in sales revenue as a result of variance between actual and standard
selling price. The calculation of the variance is in fact very simple if you just remember the
objective of finding the variance, i.e. how much change in sales revenue is attributable to the
change in selling price from the standard? It is calculated by comparing the actual selling price
per unit and the budgeted selling price per unit; each price variance is multiplied by the number
of units for each type of product.

 Sales Price Variance =Actual Units Sold (Actual Price - Standard Price)

Sales volume variance:

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Is the difference between the actual number of units sold, and the budgeted number. Each
difference is multiplied by the budgeted profit per unit. It is the measure of change in profit or
contribution as a result of the difference between actual and budgeted sales quantity.

Formula

Sales Volume Variance (where absorption costing is used):

(Actual Unit Sold - Budgeted Unit Sales) Standard Profit per Unit

Sales Volume Variance (where marginal costing is used):

(Actual Unit Sold - Budgeted Unit Sales) Standard Contribution per Unit

Sales Mix Variance

Sales Mix Variance measures the change in profit or contribution attributable to the variation in
the proportion of the different products from the standard mix. The difference in the quantity of
customer purchases of each product or service compared to the quantities that a business
expected to sell. Sales mix variance compares the actual mix of sales to the budgeted mix. The
metric can be used for analyzing the company's profitability since some products and services
usually have higher profit margins than others. Sales mix variance is the sum of all product line
calculations as follows:

Sales Mix Variance = (actual sales at the expected mix - expected sales at expected mix) *
expected contribution margin per unit.

or

Sales Mix Variance = total units actually sold * (actual sales mix % - expected sales mix %)
* expected contribution margin per unit

Sales Mix Variance (where standard costing is used):

= (Actual Unit Sold - Unit Sales at Standard Mix) x Standard Profit Per Unit

Sales Mix Variance (where marginal costing is used):

= (Actual Unit Sold - Unit Sales at Standard Mix) x Standard Contribution Per Unit

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Sales Mix Variance is one of the two sub-variances of sales volume variance (the other being
sales quantity variance). Sales mix variance quantifies the effect of the variation in the
proportion of different products sold during a period from the standard mix determined in the
budget-setting process. Sales mix variance, as with sales volume variance, should be calculated
using the standard profit per unit in case of absorption costing and standard contribution per
unit in case of marginal costing system.

Example

ABC Inc. is a small company that specializes in the manufacture and sale of gaming computers.
Currently, the company offers two models of gaming PCs:

TR - A professional gaming PC with a water-cooling system priced at $2,500

SD - An entry level gaming PC with standard fan cooling priced at $1,000

ABC budgeted sales of 1,600 units of TR and 2,400 units of SD in the last year. The standard
variable costs of a single unit of TR and SD were set at $1,500 and $750 respectively.

The sales team at ABC managed to sell 1,300 units of TR and 3,700 units of SD during the last
year.

Step 1: Calculate the standard mix ratio

40% TR* and 60% SD** Standard mix ratio:

1,600 / (1,600 + 2,400) % = 40% TR *

** 100% - 40% = 60% SD

Step 2: Calculate the sales quantities in proportion to the standard mix

Total sales during the period: 1,300 TR + 3,700 SD = 5,000 units

Unit Sales at Standard Mix:

Sales of TR in standard mix @ 40% of 5,000 = 2,000 units

Sales of SD in standard mix @ 60% of 5,000 = 3,000 units

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Step 3: Calculate the difference between actual sales quantities and the sales quantities in
standard mix

TR SD
Units Units

Actual sales quantities (as per question) 1,300 3,700

Unit sales at standard mix (Step 2) (2000) (3000)

Difference (700) Adverse 700 Favourable

Step 4: Calculate the standard contribution per unit

TR SD
$ $

Revenue 2,500 1,000

Variable cost (1,500) (750)

Standard contribution per unit 1,000 250

Step 5: Calculate the variance for each product

TR SD

Standard contribution per unit (Step 4) $1,000 $250

Actual quantity - Standard mix (Step 3) x (700 units) x 700 units

Variance $700,000 Adverse $175,000 Favourable

Step 6: Add the individual variances

$525,000 Adverse = ($700,000 - $175,000) = Sales Mix Variance

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Sales mix variance is adverse in this example because a lower proportion (i.e. 26%) of TR
(which is more profitable than SD) were sold during the year as compared to the standard mix
(i.e. 40%).

Analysis

Sales mix variance is only a relative measure of the variation in performance of an organization
and should be interpreted with care. For instance, an adverse sales mix variance may be perfectly
fine where a company is able to earn extra revenue through sale of lower margin products if such
sales are in addition to high sales of the products with higher margins.

Favourable sales mix variance suggests that a higher proportion of more profitable products
were sold during the period than was anticipated in the budget.

Reasons for favourable sales mix variance may include:

 Concentration of sales and marketing efforts towards selling the more profitable products
 Increase in the demand for the higher margin products (where demand is a limiting
factor)
 Increase in the supply of the more profitable products due to for example addition to the
production capacity (where supply is a limiting factor)
 Decrease in the demand or supply of the less profitable products

Adverse sale mix variance suggests that a higher proportion of the low margin products were
sold during the period than expected in the budget.

Reasons for adverse sales mix variance may include:

 Demand for the more profitable products being lower than anticipated
 Decrease in the production of the high margin products due to supply side limiting factors
(e.g. shortage of raw materials or labour)
 Sales team not focusing on selling products with higher margins due to for example lack
of awareness or misaligned performance incentives (e.g. uniform sales commission on
the entire product range may not motivate sales staff to compete for high margin sales)
 Increase in demand or supply of the less profitable products

Operating statements
An operating statement is a regular report for management which compares actual costs and
revenues with budgeted figures and shows variances. There are several ways in which an

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operating statement may be presented. Perhaps the most common format is one which reconciles
budgeted profit to actual profit. Sales variances are reported first, and the total of the budgeted
profit and the two sales variances results in a figure for 'actual sales minus the standard cost of
sales'. The cost variances are then reported, and an actual profit calculated.

Exercise 10:
A company manufactures one product, and the entire product is sold as soon as it is produced.
There is no opening or closing inventories and work in progress is negligible. The company
operates a standard costing system and analysis of variances is made every month. The standard
cost card for the product, a widget, is as follows.

STANDARD COST CARD – WIDGET

$
Direct materials 0.5 kilos at $4 per kilo 2.00
Direct wages 2 hours at $2.00 per hour 4.00
Variable overheads 2 hours at $0.30 per hour 0.60
Fixed overhead 2 hours at $3.70 per hour 7.40
Standard cost 14.00
Standard profit 6.00
Standing selling price 20.00
Budgeted output for January was 5,100 units. Actual results for January were as follows.
Production of 4,850 units was sold for $95,600
Materials consumed in production amounted to 2,300 kilos at a total cost of $9,800
Labour hours paid for amounted to 8,500 hours at a cost of $16,800
Actual operating hours amounted to 8,000 hours
Variable overheads amounted to $2,600
Fixed overheads amounted to $42,300

Required
Calculate all variances and prepare an operating statement for January.

Operating statements in a marginal cost environment

There are two main differences between the variances calculated in an absorption costing system
and the variances calculated in a marginal costing system. In a marginal costing system the
only fixed overhead variance is an expenditure variance and the sales volume variance is valued
at standard contribution margin, not standard profit margin.

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Exercise 11:
Returning to the question above, now assume that the company operates a marginal costing
system.
Required
Recalculate any variances necessary and produce an operating statement.

Investigating variances
Materiality, controllability, the type of standard being used, variance trend, interdependence
and costs should be taken into account when deciding on the significance of a variance.
The decision whether or not to investigate
Before management decide whether or not to investigate the reasons for the occurrence of a
particular variance, there are a number of factors which should be considered in assessing the
significance of the variance.

Materiality
Because a standard cost is really only an average expected cost, small variations between actual
and standard are bound to occur and are unlikely to be significant. Obtaining an 'explanation' of
the reasons why they occurred is likely to be time consuming and irritating for the manager
concerned. The explanation will often be 'chance', which is not, in any case, particularly helpful.
For such variations further investigation is not worthwhile since such variances are not
controllable.

Controllability
This must also influence the decision about whether to investigate. If there is a general
worldwide increase in the price of a raw material there is nothing that can be done internally to
control the effect of this. If a central decision is made to award all employees a 10% increase in
salary, staff costs in division A will increase by this amount and the variance is not controllable
by division A's manager. Uncontrollable variances call for a change in the plan, not an
investigation into the past.

The type of standard being used

The efficiency variance reported in any control period, whether for materials or labour, will
depend on the efficiency level set. If, for example, an ideal standard is used, variances will
always be adverse. A similar problem arises if average price levels are used as standards. If
inflation exists, favourable price variances are likely to be reported at the beginning of a period,
to be offset by adverse price variances later in the period.

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Variance trend
Although small variations in a single period are unlikely to be significant, small variations that
occur consistently may need more attention. Variance trend is probably more important that a
single set of variances for one accounting period. The trend provides an indication of whether
the variance is fluctuating within acceptable control limits or becoming out of control.
(a) If, say, an efficiency variance is $1,000 adverse in month 1, the obvious conclusion is that the
process is out of control and that corrective action must be taken. This may be correct, but what
if the same variance is $1,000 adverse every month? The trend indicates that the process is in
control and the standard has been wrongly set.
(b) Suppose, though, that the same variance is consistently $1,000 adverse for each of the first
six months of the year but that production has steadily fallen from 100 units in month 1 to 65
units by month 6. The variance trend in absolute terms is constant, but relative to the number of
units produced, efficiency has got steadily worse.
Individual variances should therefore not be looked at in isolation; variances should be
scrutinised for a number of successive periods if their full significance is to be appreciated.

Interdependence between variances

Individual variances should not be looked at in isolation. One variance might be inter-related
with another, and much of it might have occurred only because the other variance occurred too.
When two variances are interdependent (interrelated) one will usually be adverse and the
other one favourable. Here are some examples.

Interrelated variances Explanation

Materials price and usage
If cheaper materials are purchased for a job in order to obtain a favourable price variance,
materials wastage might be higher and an adverse usage variance may occur.
If the cheaper materials are more difficult to handle, there might be an adverse labour efficiency
variance too. If more expensive materials are purchased, the price variance will be adverse but
the usage variance might be favourable if the material is easier to use or of a higher quality.

Labour rate and efficiency

If employees are paid higher rates for experience and skill, using a highly skilled team might
lead to an adverse rate variance and a favourable efficiency variance (experienced staff are
less likely to waste material, for example).
In contrast, a favourable rate variance might indicate a larger-than-expected proportion of
inexperienced workers, which could result in an adverse labour efficiency variance, and
perhaps poor materials handling and high rates of rejects too (and hence an adverse materials
usage variance).

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Selling price and sales volume

A reduction in the selling price might stimulate bigger sales demand, so that an adverse selling
price variance might be counterbalanced by a favourable sales volume variance.
Similarly, a price rise would give a favourable price variance, but possibly cause an adverse
sales volume variance.

Costs of investigation
The costs of an investigation should be weighed against the benefits of correcting the cause of a
variance. When asked to provide a commentary on variances you have calculated, make sure that
you interpret your calculations rather than simply detail them.

Management signals from variance trend information

Variance analysis is a means of assessing performance, but it is only a method of signalling to
management areas of possible weakness where control action might be necessary. It does not
provide a ready-made diagnosis of faults, nor does it provide management with a ready-made
indication of what action needs to be taken. It merely highlights items for possible
investigation.
Signals that may be extracted from variance trend information
(a) Materials price variances may be favourable for a few months, then shift to adverse variances
for the next few months and so on. This could indicate that prices are seasonal and perhaps
inventory could be built up in cheap seasons.
(b) Regular, perhaps fairly slight, increases in adverse price variances usually indicate the
workings of general inflation. If desired, allowance could be made for general inflation when
flexing the budget.
(c) Rapid large increases in adverse price variances may suggest a sudden scarcity of a resource.
It may soon be necessary to seek out cheaper substitutes.

Exercise:
A production department has experienced an improving trend in reported labour efficiency
variances but a worsening trend in machine running expenses. Suggest possible reasons for these
trends and comment on the management action that may be necessary.

Why might actual and standard performance differ?

Here are some common reasons.
Reason Comment

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Measurement errors Scales may be misread. Pilfering or wastage

may go unrecorded.
Out of date standards Price standards may become out of date during
periods of high inflation.
Standards may also become out of date due to
technological development.
Efficient or inefficient operations Spoilage, idle time, better quality material or
more highly skilled labour may all affect
efficiency of operations.
Random or chance fluctuations A standard is an average figure. Individual
measurements are likely to deviate from the
standard.

Summary
Variance Favourable Adverse
Material price Unforeseen discounts received Price increase
Greater care in purchasing Careless purchasing
Change in material standard Change in material standard
Material usage Material used of higher quality than Defective material
standard Excessive waste or theft
More efficient use of material Stricter quality control
Errors in allocating material to jobs Errors in allocating material to jobs
Labour rate Use of workers at a rate of pay lower Wage rate increase
than standard
Idle time Idle time was build into budget to Machine breakdown, illness or
allow for bad weather, say, but none injury to worker
occurred
Labour Output produced more quickly than Lost time in excess of standard
efficiency expected because of worker Output lower than standard set
motivation, better quality materials because of lack of training,
etc substandard materials etc
Errors in allocating time to jobs Errors in allocating time to jobs

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Benchmarking
We have seen how standard costing achieves control by the comparison of actual results with a
predetermined standard. Benchmarking is another type of comparison exercise through
which an organisation attempts to improve performance. The idea is to seek the best
available performance against which the organisation can monitor its own performance.

BENCHMARKING is 'The establishment, through data gathering, of targets and comparators,

that permit relative levels of performance (and particularly areas of underperformance) to be
identified. Adoption of identified best practices should improve performance.' (CIMA Official
Terminology)

CIMA lists four types of benchmarking.

Type Description
Internal A method of comparing one operating unit or function with another within
benchmarking the same organisation
Functional Internal functions are compared with those of the best external practitioners
benchmarking of those functions, regardless of the industry they are in (also known as
operational or generic benchmarking)
Competitive Information is gathered about direct competitors, through techniques such as
benchmarking reverse engineering*[Reverse engineering: buying a competitor's product
and dismantling it, in order to understand its content and configuration]
Strategic A type of competitive benchmarking aimed at strategic action and
benchmarking organisational change

From this list you can see that a benchmarking exercise does not necessarily have to involve
the comparison of operations with those of a competitor. Indeed, it might be difficult to
persuade a direct competitor to part with any information which is useful for comparison
purposes. Functional benchmarking, for example, does not always involve direct competitors.
For instance a railway company may be identified as the 'best' in terms of on-board catering, and
an airline company that operates on different routes could seek opportunities to improve by
sharing information and comparing their own catering operations with those of the railway
company.

Obtaining information
Financial information about competitors is easier to acquire than non-financial information.
Information about products can be obtained from reverse engineering, product literature,
media comment and trade associations. Information about processes (how an organisation

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deals with customers or suppliers) is more difficult to find. Such information can be obtained
from group companies or possibly non-competing organisations in the same industry (such
as the train and airline companies mentioned above).

Why use benchmarking?

for setting standards

Benchmarking allows attainable standards to be established following the examination of both
external and internal information. If these standards are regularly reviewed in the light of
information gained through benchmarking exercises, they can become part of a programme of
continuous improvement by becoming increasingly demanding.

Other reasons
(a) Its flexibility means that it can be used in both the public and private sector and by people at
different levels of responsibility.
(b) Cross comparisons (as opposed to comparisons with similar organisations) are more likely to
expose radically different ways of doing things.
(c) It is an effective method of implementing change, people being involved in identifying and
seeking out different ways of doing things in their own areas.
(d) It identifies the processes to improve.
(e) It helps with cost reduction.
(f) It improves the effectiveness of operations.
(g) It delivers services to a defined standard.
(h) It provides a focus on planning.
(i) It can provide early warning of competitive disadvantage.
(j) It should lead to a greater incidence of team working and cross-functional learning.
Benchmarking works, it is claimed, for the following reasons.
(a) The comparisons are carried out by the managers who have to live with any changes
implemented as a result of the exercise.
(b) Benchmarking focuses on improvement in key areas and sets targets which are challenging
but 'achievable'. What is really achievable can be discovered by examining what others have
achieved.
Managers are therefore able to accept that they are not being asked to perform miracles.
Care must be taken, however, to ensure that benchmarking exercises are comparing like with
like. For example, different accounting policies may produce different results for different
businesses. It might be unfair to suggest that one business is more efficient than the other
because of a particular figure in a benchmarking report.

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Exercise 12:
What are the advantages and disadvantages of benchmarking?

Other approaches
(a) Metric benchmarking. This involves comparing appropriate metrics (quantitative data) to
identify possible areas for improvement.
(b) Process benchmarking. This involves comparing processes with a partner as part of an
improvement process.
(c) Diagnostic benchmarking. This involves reviewing the processes of a business to highlight
those which have a problem and offering possible areas for improvement.

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Chapter three:
Transfer pricing

Introduction
Transfer pricing has assumed lot of importance today. It is one of the important tools in the
hands of management for performance evaluation of a division or department. Transfer pricing
has become necessary in highly decentralized companies where number of divisions/departments
are created as a part and parcel of the decentralized organization. In the modern days, production
is on the mass scale due to technological advancement and up gradation. Organizations grow in
course of time and for such growing organizations, decentralization becomes absolutely
necessary. It becomes inevitable for such organizations to establish separate divisions and
departments to ensure smooth working. However it is also necessary to evaluate the performance
of these departments/divisions. Transfer pricing is one of the tools in the hands of management
for measuring the performance.

A ‘Transfer Price’ is that notional value at which goods and services are transferred between
divisions in a decentralized organization. Transfer prices are normally set for intermediate
products, which are goods, and services that are supplied by the selling division to the buying
division. As explained in the above paragraph, in large organizations, each division is treated as a
‘profit centre’ as a part and parcel of decentralization. Their profitability is measured by fixation
of ‘transfer price’ for inter divisional transfers. A question arises as to how the transfer of goods
and services between divisions should be priced. The transfer price can have impact on the
division’s performance and hence lot of care is to be taken in fixation of the same.
The following factors should be taken into consideration before fixing the transfer prices.
 Transfer price should help in the accurate measurement of divisional performance.
 It should motivate the divisional managers to maximize the profitability of their
divisions.
 Autonomy and authority of a division should be ensured.
 Transfer Price should allow ‘Goal Congruence’ which means that the objectives of
divisional managers match with those of the organization.

Transfer Pricing Methods

In the previous paragraph, we have seen that the transfer prices are fixed basically for the
evaluation of divisional performance. It is the notional value of goods and services transferred
from one division to other division. In other words, when internal exchange of goods and
services take place between the different divisions of a firm, they have to be expressed in
monetary terms. The monetary amount for those inter divisional exchanges is called as ‘transfer
price’. However the determination of transfer prices is an extremely difficult and delicate task as

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lot of complicated issues are involved in the same. Inter division conflicts are also possible.
There are several methods of fixation of ‘Transfer Price’. They are discussed below.
Cost Based Pricing: - In these methods, ‘cost’ is the base and the following methods fall under
this category.

Actual Cost of Production: - This is in fact the simplest method of fixation of transfer price. In
this method, the actual cost of production is taken as transfer price for inter divisional transfers.
The actual cost of production may consist of only variable costs or total costs including fixed
cost.

Full Cost Plus: - In this method, the total cost of sales plus some percentage of profit is charged
by the transferring division to the transferee division. The percentage of profit may be on the
capital employed or on the cost of sales. The benefit of this method is that the profit
measurement becomes possible.

Standard Cost: - Standard cost is ‘predetermined cost’ based on technical analysis for material,
labour and overhead. Under this method, transfer price is fixed based on standard cost. The
transferring unit absorbs the variance, i.e. difference between standard cost and actual cost. This
method is quite simple for operation once the standards are set. However it becomes essential to
revise the standards at regular intervals, otherwise the standard cost may become outdated.

Marginal Cost Pricing: - Under this method, only the marginal cost is charged as ‘transfer
prices’.
The logic used in this method is that fixed costs are in any case unavoidable and hence should
not be charged to the buying division. Therefore only marginal cost should be taken as transfer
price.

Market Based Pricing: - Under this method, the transfer price will be determined according to
the market price prevailing in the market. It acts as a good incentive for efficient production to
the selling division and any inefficiency in production and abnormal costs will not be borne by
the buying division. The forces of demand and supply will determine the market price in the long
run and profit generated will be a very good parameter for measuring efficiency. The logic used
in this method is that if the buying division would have purchased the goods/services from the
open market, they would have paid the market price and hence the same price should be paid to
the selling division. One of the variation of this method is that from the market price, selling and
distribution overheads should be deducted and price thus arrived should be charged as transfer
price. The reason behind this is that no selling efforts are required to sale the goods/services to
the buying division and therefore these costs should not be charged to the buying division.

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Market price based transfer price has the following advantages.

 Actual costs are fluctuating and hence difficult to ascertain. On the other hand market
prices can be easily ascertained.
 Profits resulting from market price based transfer prices are good parameters for
performance evaluation of selling and buying divisions.
However, the market price based transfer pricing has the following limitations.
 There may be resistance from the buying division. They may question buying from the
selling division if in any way they have to pay the market price?
 Like cost based prices, market prices may also be fluctuating and hence there may be
difficulties in fixation of these prices.
 Market price is a rather vague term as such prices may be ex-factory price, wholesale
price, retail price etc.
 Market prices may not be available for intermediate products, as these products may not
have any market.
 This method may be difficult to operate if the intermediate product is for captive
consumption.
 Market price may change frequently.
 Market prices may not be ascertained easily.

Negotiated Pricing: - In the above two methods, transfer prices are fixed on the basis of either
the cost price or market price. However the transfer prices may be fixed on the basis of
‘Negotiated Prices’ that are fixed through negotiations between the selling and the buying
division. Sometimes it may happen that the concerned product may be available in the market at
a cheaper price than charged by the selling division. In this situation the buying division may be
tempted to purchase the product from outside sellers rather than the selling division.
Alternatively the selling division may notice that in the outside market, the product is sold at a
higher price but the buying division is not ready to pay the market price. Here, the selling
division may be reluctant to sell the product to the buying division at a price, which is less than
the market price. In all these conflicts, the overall profitability of the firm may be affected
adversely. Therefore it becomes beneficial for both the divisions to negotiate the prices and
arrive at a price, which is mutually beneficial to both the divisions. Such prices are called as
‘Negotiated Prices’. In order to make these prices effective care should be taken that both, the
buyers and sellers should have access to the available data including about the alternatives
available if any.

Similarly buyers and sellers should be free to deal outside the company, but care should be taken
that the overall interest of the organization is not jeopardized.

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 The main limitation of this method is that lot of time is spent by both the negotiating
parties in fixation of the negotiated prices.
 Negotiating skills are required for the managers for arriving at a mutually acceptable
price, otherwise there is a possibility of conflicts between the divisions.

Opportunity Cost Pricing: - This pricing recognizes the minimum price that the selling division
is ready to accept and the maximum price that the buying division is ready to pay. The final
transfer price may be based on these minimum expectations of both the divisions. The most ideal
situation will be when the minimum price expected by the selling division is less than the
maximum price accepted by the buying division. However in practice, it may happen very rarely
and there is possibility of conflicts over the opportunity cost.

Conclusion: - From the above discussion, it is very clear that fixation of transfer prices is a very
delicate decision. There might be clash of interests between the selling and buying division and
hence while fixing the transfer price, overall interests of the organization should be taken into
consideration. As mentioned in the introduction, ‘Goal Congruence’ should be given highest
importance rather than interests of the selling or buying division alone.

Exercise 1:
(a) Explain the potential benefits of operating a transfer pricing system within a divisionalised
company. (3 marks)

(b) A company operates two divisions, Able and Baker. Able manufactures two products X and
Y. Product X is sold to external customers for $42 per unit. The only outlet for product Y is
Baker.

Baker supplies an external market and can obtain its semi-finished supplies (product Y) from
either Able or an external source. Baker currently has the opportunity to purchase product Y
from and external supplier for $38 per unit. The capacity of division Able is measured in units of
output, irrespective of whether X or Y, or a combination of both is manufactured.

The associated product costs are as follows:

X Y

Variable costs per unit ($) 32 35

Fixed overhead per unit ($) 5 5

Total unit costs ($) 37 40

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Required:

For each of the following conditions and using the information above, explain how optimum
transfer prices will lead the manager of the Baker division to make goal congruent decisions;

(i) When division Able has spare capacity and limited external demand for product X. (3
marks)
(ii) When division Able is operating at full capacity with unsatisfied external demand for
product X. (4 marks)

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Chapter four:
Uniform Costing

Introduction
In ideal competition, there should be availability of reliable data and information about the
competitions. Such data may be absolute form or in coded form. But data must be reliable and
information derived should be on equal or uniform bases and principles. In modern business
where the competition is very tough, it is very much important to know the strength and
weakness of the rival as well as the business unit itself. It makes call to inter firm comparison
like rate of return on capital, rate of profit on sales and on cost, cost per unit, etc. it can be
possible if the all concerned uniform principles and methodology for computation of the
necessary data. This was the origin of evolution of inter firm comparison and uniform costing.

Meaning of Uniform Costing

Uniform costing is not a distinct method of cost accounting, but it is probably the latest
technique of costing and cost control. It is the acceptance and adherence of identical costing
principles and procedures by all or several units in a same industry by mutual agreement. ICMA
London defines Uniform Costing as, “the use by several undertakings of the same costing
systems, i.e. the same basic costing methods and superimposed principles and techniques.”
Another good definition is available by Prof. Glover – “A system of uniform application of the
principles of a costing method agreed upon and adopted by the whole or majority of the
manufacturer or executives, in any specific industry.” Thus uniform costing simply denotes that
a number of undertakings in a same industry may use same costing principles and procedures to
arrive to cost, so that mutual comparison may be possible among them.

Objective of Uniform Costing

The important objectives of the uniform costing can be stated as follows –
1. To help for meaningful and valid cost comparison among the members.
2. To locate and eliminate inefficiencies in the firm by measuring own efficiency in terms of
industry in general and in terms of close rivals in particular.
3. To stop cut-throat competition and create healthy competition.
4. To improve the productivity of men, machine production technology and methodology.
5. To provide uniform data and information to Government for different purposes like tax policy,
subsidies, concessions, restrictions, etc.

Areas of Uniform Costing

The more important areas where uniformity is to be achieved can be listed as follows –
1. Determination and adoption of the ‘cost unit’, ‘cost centres’ and ‘departments’.

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2. Costing method to be used and cost treatment of the items in the costs.
3. System of Costing.
4. Cost control techniques.
5. Cost and accounts classification.
6. Methods of Valuation of different stocks.
7. Bases of apportionments and absorption of costs.
8. Depreciation methods and rates.
9. Treatments of waste, spoilage, defectives, scrap.
10. Costing period and reporting periods.
11. Treatment of interest on capital and on long-term loans.
12. Cost treatment of overtime, holiday pay, etc. items of Labour cost.
13. Treatment of R & D costs.
14. Formats of the cost reports and statements.
15. Codification of cost accounts and reports, statements, etc.
The different areas to be covered are depends on need of uniformity in the reporting and
accuracy of the comparison required by the different units participated in the uniform costing
system. So above is only an illustrative list of areas and not a comprehensive one.

Advantages of Uniform Costing

The benefits of the uniform costing to various interested groups can be summarized as follows –
To the Member Units –
These are the natural claimants to the advantages of the system. Such advantages are –
1. High standards –
Either highly qualified experienced professional and consultants or the experienced members in
the industry design uniform costing system. So it ensures high standard of operation.
2. Cost comparisons –
It is the basic object of the system. A successful system of uniform costing always helps of the
member units to locate the points of inefficiencies in comparison to industry in general and with
close rival in particular. It results in improvement of work and establishing standards and
benchmarking for achievements.
3. Healthy competition –
Uniform costing helps to create belief among the member units and stops the price-cutting or any
other cut-throat competitions measures and tactics. It ensures to adopt all policies that give
reasonable and fair rate of return on the investment.
4. Automation of data –
Uniform costing needs computerization of accounting, data collection, classification and
reporting.
So automation of data becomes necessary. It ensures reliability of data and information.

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5. Benefits to Smaller Units –

The smaller units get benefits of R & D of large units and improve their competitiveness.
To the Workers –
1. Uniform, just and fair wage structure in the industry.
2. Reduced Labour turnover.
3. Higher productivity ensures higher wages and bonus.
To Consumers –
1. Cost reduction results into price reduction.
2. Fair prices.
3. Improved product and services.
4. Improved quality and assurance of after sales services.
To industry –
1. Reliable data and information can be supplied to the government and fair government policies
can be adopted.
2. Introducing improved methodologies and technologies can eliminate all types wastages.
3. Industrial activities can be planned and directed in most meaningful way.

Disadvantages of Uniform Costing

Being a joint activity, the uniform costing suffers many limitations. Some of them are listed
below –
1. It creates monopoly at end because the large units may manipulate the available data for their
benefit and small units have to surrender to them.
2. The difference in the size of member units generally may not allow to adopt all rules and
forms of the uniform costing, because many time such data is not available or is not affordable to
make it available to some weak units.
3. Implementation and execution of this system needs utmost good faith among all members. So
lethargy or unrealistic or ambiguous data supply by any one or more units creates confusion and
defeats the objects of the system failure.
4. Many times it is observed that members are eager to receive the information of other units but
hardly gives their own information clearly. So it creates operational hindrances in the system.
If we closely observe these limitations it can be understood that these are the operational
problems and not basic difficulties in the system. The main point is the mutual understanding and
belief. If that is built in good sense it certainly brings all benefits to the concerned parties.

Requisites for Uniform Costing

The success of the uniform costing is based on the following requisites -

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1. Mutual belief and understanding –

The success or failure of the uniform costing is entirely depends on mutual trust and confidence
among the all participants members in the system. It is primarily need for this system.
2. Accounting policies and principles –
The details of the method of the costing, various treatments of the cost items, the terminologies
to be accepted, principles to be implemented, etc. are to be agreed and accepted by all members
in the system.
3. Classification and codification –
The bases of classification of accounts to be used for recording and reporting, the codification of
the accounts used should have to be as per the need of the object of the uniform costing. It should
be acceptable for large and small units also. It should take care of operational difficulties of all
members accounting traditions and customs.
4. Bases of allocation and apportionment –
The difference in cost calculation among different concerns is basically due to two things –
classification of the cost items into direct and indirect costs and thereafter application of the
different bases for allocation and apportionment of the overheads. The uniform costing is the
good answer for such problem. So carefully equitable bases should be selected and be applied in
cost treatment of the members.
5. Absorption of overheads –
The selection of the absorption method for the departmental overheads and its uniform
application is prerequisite of the uniform costing. It is only capable to give correct comparable
cost among the members.
6. Areas to be covered –
The areas to be covered under uniform costing depend on the object and depth of the system.
All these areas to report must be ascertained in clear terms by the all members to avoid further
misunderstanding and disputes. Actually the success of mutual confidence is depending on this
factor. We have already listed such areas in section 3.4 of this chapter.

Uniform Cost-manual
Under uniform costing techniques, numbers of the units of different sizes and peculiarities are
participated. On such background, the adoption of a uniform cost plan presupposes the existence
of the uniform cost manual.
It can be defined as, “the set of instructions to be followed in cost ascertainment and cost control
and it is the evidence of existence of the uniform cost plan among the member unit.”
The uniform cost manual describes the nature and scope of the cost plan. It also lays down the
procedure for implementing and operating such cost plan. It is a operating guide to the

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participants who have to bring about uniformity in costing principles and procedures in
accordance with the statement of the objectives.
The United States Chamber of Commerce observes the prime objectives of such manual as
follows –
1. Selling appeal, i.e. they should present in an interesting way the compelling reasons for the
desirability of making use of uniform methods.
2. Serving as a comprehensive reference book on accounting procedures.
3. Usefulness to the executives and accountants in solving problems of installation of the
recommended uniform methods.

Contents of the cost manual –

An explanatory cost manual may include the following contents in it however such contents are
always depends on the numbers of the units, depth of the system and object of the system.
A. Introduction –
This part discusses the object, depth scope, of the system. It also highlights the advantages that
accrue to the members and clears the limitations also.
B. Accounting systems and procedures –
In this part the areas covered under the system are clearly mentioned. In addition general
principles of accounting, conventions to be followed, nature of classification and codification,
terminology to be used etc. are discussed in length. The method of costing, relation with the
financial accounting, treatment of different items of cost which need special attention etc. are
discussed in detail to clear all doubt of the user of the members.
C. Reporting and statements –
The cost manual gives detailed instructions about the presentation of data and information. It
also prescribes use of uniform forms for various statements to be prepared and reports to be
made. Even the periodicities of reports are also mentioned to the extent possible. The ratios to be
calculated obligatory and mandatory, the graphs and diagrams to be prepared, etc. are also given
in the manual.
D. Other information –
In this section different aspects such as tax impacts, interest on capital, depreciation, wastage,
by-product costing, etc. are discussed. In addition in this part the doubts raised by the users,
suggest remedies to the difficulties, and suggest optional areas for the uniformity, etc. are
cleared. This part is many times prepared in the form of Bulletin. It may be published by regular
time interval.

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Inter Firm Comparison

Meaning: Inter firm comparison can be defined as, ” a management technique by the use of
which it is made possible for an organization to compare its performance with that of the other
units engaged in the same activity.”
Thus, it is a technique of evaluation and is based upon comparison of productivity, efficiency,
cost, and profit as yardstick among the different business units in a same industry.

There are ways available for such comparison –

1. Where such comparison is made from freely available published information and
2. Where there is voluntary and authentic exchange of information among the different units
systematically and scientifically.
The first type of comparison is a general one and can be carried out with reference to the data
and information freely available such as published annual accounts, and reports, industrial
bulletins, speeches or statements made by the key persons in the business, financial journals,
newspapers, etc. However it is not inert firm comparison in its true sense. It has first limitation of
the size of the units and thereafter there are numbers of other limitations such as lack of
explanation of accounting policies, methods of treatments, pricing policy, methods and
techniques of the productions etc.
The second comparison referred above is the point of our discussion at present. Such comparison
helps the management to solve many problems such as to locate the bottlenecks in the operating
efficiencies, the reasons of less productivity and profitability, lacunas in the organization, etc.
Budgetary control and standard costing helps the management to understand and to control the
internal inefficiencies and wastages in the business units but the inter firm comparison goes
further. It reveals the veil over the external uncontrollable factors and shows the clear face of the
organization in comparison with the external world.

It focuses the position where the unit stands in comparison to the other units. It compels the
management to challenge the standards accepted and adopted by the external world. The
management has to improve the performances in the light of the current information gathered
from efficient members of the industry.

The scheme of the internal comparison consists of two phases –

a. Voluntary collection and exchange of information concerning costs, prices, profits,
productivity and overall efficiency among the participating firms engaged in a similar types of
the operation.
b. Making systematic inter firm comparison of the available data for the purpose of improvement
in efficiency and indicating the weaknesses and the strong points.

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Of course such exchange poses certain threats to the secrecy and confidential information of
individual firms. So there is a systematic exchange of information not in absolute fi gure but in
processed forms like ratios, ranks, grades, so that the individual secrecy should be maintained
and privacy of the firm should not be disturbed.

For this purpose a central organization is established. A code number is allotted to every member
unit. All units require providing of data to this organization honestly and regularly. The team of
professional accountants and consultants generally employed to look after the administration and
processing of collected data the results out of the processed data is made available in the form of
ratio, grades, ranks in respect of code number of unit and not in any absolute form with specific
name of the individual firm. The results are commented and supplied to all members at request.
Such results are in respect of entire industry as well as individual units (but in code numbers). Of
course for effective execution of such scheme there should be uniform costing accepted by all
concerned member units. Inter firm comparison without uniform costing has no relevance and
effectiveness in its true meaning.

Essentials: While installing an inter firm comparison scheme, following requirements should be
considered in detail –

1. Existence of uniform costing –

As pointed out earlier acceptance of uniform costing only makes such scheme successful, so all
requirements for a good uniform costing system should have to fulfill.
2. Scope of data collection –
It is nothing but ascertaining the areas of such comparison. This depends on needs of the member
units, value and usefulness of the information, efficiency of the central organization, etc.
3. Central Organization –
For effective operation of the scheme there is need of a central organization. Collection, analysis
and representation of data are the primary responsibility of the organization. However
maintenance of secrecy of absolute data of individual firm is the top function of the organization.
Secrecy and confidentiality of the codification of the members and their absolute data should be
at top priority.
Only the analyzed and proceed data should be published to the use of members.
4. Methodology –
Normally the data is to be supplied by the firms by regular interval in the prescribed forms only.
The general published data may be taken directly from such publication. While interpreting the
analyzed data ratio analysis is resorted. The absolute data except that of the published data is
never supplied to the other firms. It increases the confidence and utility of the comparison. The

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results of the comparison may be provided in the form of journals, articles, etc. through regular
publications by the central organization.

Advantages of Inter Firm Comparison

The important benefits from the scheme can be listed as follows –
1. Improvement in efficiency –
Fixation of performance standards makes meaningful comparison. It helps to reveal the internal
inefficiencies and helps to convert them into efficiency.
2. Increased productivity –
Inter firm comparison compels to accept new production methods, technical know-how. As a
result the productivity of the individual firm and the industry also increases.
3. Reliable information –
Inter firm comparison is based on the uniform costing. So it is reliable information for decision
making process.
4. R & D –
Inter firm comparison facilitates research and development. Individual firms as well as the group
of them undertake different R & D projects to increase the competitiveness. So it more R & D is
possible.
5. Assistance to Government –
Inter firm comparison helps Government to know true fact of industry in general and in
particular to a firm also. The Government can design just and fair industrial policies, tax police is
with help of the data available from the Inter firm comparison.
6. Other benefits –
Other benefits from the Inter firm comparison can be traced as follows –
a. Creation of cost consciousness.
b. Introduction of standardization of materials, Labor operation, equipments, etc.
c. Elimination of unfair competition.
d. Acts as tool of cost control and cost reduction.
e. Facilitates export promotion.
f. Optimum utilization of available resources.

Disadvantages of Inter Firm Comparison

Actually these are the limitations and difficulties faced by the Inter firm comparison because
Inter firm comparison in its honest use and since cannot be disadvantageous to any segment in it.
The important limitations can be listed as follows.
1. Any misuse of the collected information by any influential firm may be possible.
2. Participant members do not provide timely and accurate data.

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3. It is difficult to find out bases of comparison as there are differences in the size of the firms,
their productivity, financial conditions, etc. so many times it renders meaningless comparison.
4. Lack of uniform costing renders difficulty in comparison.
5. The top management feels secrecy of absolute data as the top preference and may not render
full cooperation.
Although these limitations and operational difficulties are in existence, there are success stories
of Inter firm comparison in Europe e.g. “Centres for Inter firm comparison” at regional chambers
of commerce in different parts of U.K., Germany, etc.

Revision questions
1. Write short note on uniform costing or define uniform costing?
2. Enumerate the points on which uniformity is essential before introducing uniform costing
system?
3. what are the requisites for installation of a uniform costing system?
4. Explain the advantages of uniform costing system?
5. Explain the disadvantages of uniform costing system?
6. Write short note on uniform cost manual?
7. Write short note on interfirm comparison?
8. What are the pre- requisites of an inter firm comparison system?
9. Write four advantages & limitations of interfirm comparison?

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Chapter five:
The modern business environment

The changing business environment

Before the 1970s, barriers of communication and geographical distance limited the extent to
which overseas organisations could compete in domestic markets. Cost increases could often be
passed on to customers and so there were few efforts to maximise efficiency and improve
management practices, or to reduce costs. During the 1970s, however, overseas competitors
gained access to domestic markets by establishing global networks for acquiring raw materials
and distributing high-quality, low-priced goods. To succeed, organisations had to compete
against the best companies in the world.

The changing competitive environment for service organisations

Prior to the 1980s, many service organisations (such as the utilities, the financial services and
airlines industries) were either government-owned monopolies or were protected by a highly-
regulated, non competitive environment. Improvements in quality and efficiency of
operations or levels of profitability were not expected, and costs increases were often covered by
increasing service prices. Cost systems to measure costs and profitability of individual services
were not deemed necessary. The competitive environment for service organisations changed
radically in the 1980s, however, following privatisation of government-owned monopolies and
deregulation. The resulting intense competition and increasing product range has led to the
requirement for cost management and management accounting information systems which
allow service organisations to assess the costs and profitability of services, customers and
markets.

Changing product life cycles

Today's competitive environment, along with high levels of technological innovation and
increasingly discriminating and sophisticated customer demands, constantly threaten a product's
life cycle. Diverse product ranges and demand for ever better products means that product life
cycle have dramatically reduced.

Product life cycle is the 'Period which begins with the initial product specification and ends with
the withdrawal from the market of both the product and its support. It is characterised by defined
stages including research, development, introduction, maturity, decline and abandonment.'
(CIMA Official Terminology) Organisations can no longer rely on years of high demand for
products and so, to compete effectively, they need to continually redesign their products and to
shorten the time it takes to get them to the market place.

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In many organisations today, up to 90% of a product's life cycle cost is determined by decisions
made early within the cycle, at the design stage. Management accounting systems that monitor
spending and commitment to spend during the early stages of a product's life cycle are therefore
becoming increasingly important.

Changing customer requirements

Successful organisations in today's competitive environment make customer satisfaction their
priority and concentrate on the following key success factors.

Key success factor Detail

Cost efficiency Not wasting money
Quality Focusing on total quality management (TQM)
Providing a speedier response to customer requests,
ensuring 100% on-time. delivery and reducing the time
Time taken to develop and bring new products to market
Developing a steady stream of innovative new products and
Innovation having the flexibility to respond to customer requirements

They are also taking on board new management approaches.

Approach Detail
A facet of TQM, being a continuous search to reduce costs, eliminate
Continuous waste and improve the quality and performance of activities that increase
improvement customer satisfaction or value

Employee Providing employees with the information to enable them to make

empowerment continuous improvements without authorisation from superiors

Ensuring that all the factors which add value to an organisation's products
– the value chain of research and development, design, production,
Total value-chain marketing, distribution and customer service – are coordinated within the
analysis overall organisational framework

Changing manufacturing systems

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Traditionally, manufacturing industries have fallen into a few broad groups according to the
nature of the production process and materials flow.

Type of production

Job industries: Industries in which items are produced individually, often for a specific
customer order, as a 'job'. Such a business requires versatile equipment
and highly skilled workers to give it the flexibility to turn its hand to a
variety of jobs. The jobbing factory is typically laid out on a functional
basis with, say, a milling department, a cutting department, finishing, and
assembly.

Batch processing: Involves the manufacture of standard goods in batches. 'Batch

production is often carried out using functional layouts but with a greater
number of more specialised machines. With a functional layout batches
move by different and complex routes through various specialised
departments travelling over much of the factory floor before they are
completed.
Mass production: Involves the continuous production of standard items from a sequence
of continuous or repetitive operations. This sort of production often uses a
product based layout whereby product A moves from a milling machine
to a cutting machine to a paint-spraying machine, product B moves from a
sewing machine to a milling machine to an oven and then to finishing and
so on.

The point is that there is no separate 'milling department' or 'assembly

department' to which all products must be sent to await their turn on the
machines: each product has its own dedicated machine.

In recent years, however, a new type of manufacturing system known as group technology (or
repetitive manufacturing) has emerged. The system involves a flexible or cellular arrangement of
machines which manufacture groups of products having similar manufacturing requirements. By
grouping together facilities required to produce similar products, some of the benefits associated
with flow production systems (lower throughput times, easier scheduling, reduced set-up times
and reduced work in progress) are possible to achieve. Moreover, the increase in customer
demand for product diversity can be satisfied by such a manufacturing system.

Dedicated cell layout

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The modern development in this sphere is to merge the flexibility of the functional layout with
the speed and productivity of the product layout. Cellular manufacturing involves a U-shaped
flow along which are arranged a number of different machines that are used to make products
with similar machining requirements.

The machines are operated by workers who are multi-skilled (can operate each machine within
the cell rather than being limited to one operation such as 'lathe-operator', 'grinder', or whatever)
and are able to perform routine preventative maintenance on the cell machines. The aim is to
facilitate just-in-time production and obtain the associated improvements in quality and
reductions in costs.

Cost reduction and value analysis

In today’s environment, businesses are under pressure to offer an increased choice of quality
products at a cost traditionally associated with mass production.
Cost reduction is a planned and positive approach to reducing expenditure. Cost reduction
measures should be planned programmes to reduce costs rather than crash programmes to cut
spending levels. Value analysis is an example of a cost reduction technique. It is a planned,
scientific approach to cost reduction which reviews the material composition of a product and the
product’s design so that modifications and improvements can be made which do not reduce the
value of the product to the customer or user.

Waste
Part of cost reduction may look at elimination of waste. Waste, in this context, results from
activities which do not add value. Examples of activities which do not add value include
continuing production when there is no demand resulting in the build up of unnecessary

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inventory, or waiting time, or unnecessary movement of materials or staff. These are all waste
activities because they are unnecessary actions.

Just-in-time (JIT) systems

'Traditional' responses to the problems of improving manufacturing capacity and reducing unit
costs of production might be described as follows.
• Longer production runs
• Fewer products in the product range
• Economic batch quantities
• More overtime
• Reduced time on preventive maintenance, to keep production flowing
In general terms, longer production runs and large batch sizes should mean less disruption, better
capacity utilisation and lower unit costs. Just-in-time systems challenge such 'traditional' views
of manufacture.

Key terms
Just-In-Time (JIT) is a 'System whose objective is to produce or to procure products or
components as they are required by a customer or for use, rather than for stock. A JIT system is a
pull system, which responds to demand, in contrast to a push system, in which stocks act as
buffers between the different elements of the system, such as purchasing, production and sales.'

Just-In-Time Production is a 'Production system which is driven by demand for finished

products whereby each component on a production line is produced only when needed for the
next stage.'

Just-In-Time Purchasing is a 'Purchasing system in which material purchases are contracted so

that the receipt and usage of material, to the maximum extent possible, coincide.' (CIMA Official
Terminology)

Although described as a technique in the Official Terminology, JIT is more of a philosophy or

approach to management since it encompasses a commitment to continuous improvement
and the search for excellence in the design and operation of the production management system.

JIT has the following essential elements.

Element Detail
JIT Parts and raw materials should be purchased as near as possible to the time they

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purchasing are needed, using small frequent deliveries against bulk contracts.
Close In a JIT environment, the responsibility for the quality of goods lies with the
relationship supplier. A long-term commitment between supplier and customer should
with therefore be established. The supplier is guaranteed a demand for products
suppliers because of being the sole supplier and the supplier can plan to meet the
customer's production schedules. If an organisation has confidence that
suppliers will deliver material of 100% quality, on time, so that there will be no
rejects, returns and hence no consequent production delays, usage of materials
can be matched with delivery of materials and inventories can be kept at near
zero levels. Suppliers are also chosen because of their close proximity to an
organisation's plant.
Uniform All parts of the productive process should be operated at a speed which matches
loading the rate at which the final product is demanded by the customer. Production runs
will therefore be shorter and there will be smaller inventories of finished goods
because output is being matched more closely to demand (and so storage costs
will be reduced).
Set-up time Machinery set-ups are non-value-added activities (see below) which should be
reduction reduced or even eliminated.
Machine Machines or workers should be grouped by product or component instead of by
cells the type of work performed. The non-value-added activity of materials
movement between operations is therefore minimised by eliminating space
between work stations. Products can flow from machine to machine without
having to wait for the next stage of processing or returning to stores. Lead times
and work in progress are thus reduced.
Quality Production management should seek to eliminate scrap and defective units
during production, and to avoid the need for reworking of units since this stops
the flow of production and leads to late deliveries to customers. Product quality
and production quality are important 'drivers' in a JIT system.
Pull system A Kanban, or signal, is used to ensure that products/ components are only
(Kanban) produced when needed by the next process. Nothing is produced in anticipation
of need, to then remain in inventory, consuming resources.
Preventative Production systems must be reliable and prompt, without unforeseen delays and
maintenanc breakdowns. Machinery must be kept fully maintained, and so preventative
e maintenance is an important aspect of production.
Employee Workers within each machine cell should be trained to operate each machine
involvement within that cell and to be able to perform routine preventative maintenance on
the cell machines (i.e. to be multi-skilled and flexible).

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4.1 Value added

JIT aims to eliminate all non-value-added costs. Value is only added while a product is actually
being processed. Whilst it is being inspected for quality, moving from one part of the factory to
another, waiting for further processing and held in store, value is not being added. Non value-
added activities (or diversionary activities) should therefore be eliminated.

'A value-added cost is incurred for an activity that cannot be eliminated without the customer's
perceiving deterioration in the performance, function, or other quality of a product. The cost of a
picture tube in a television set is value-added. The costs of those activities that can be eliminated
without the customer's perceiving deterioration in the performance, function, or other quality of a
product are non-value-added. The costs of handling the materials of a television set through
successive stages of an assembly line may be non-value-added.

Problems associated with JIT

JIT should not be seen as a panacea for all the endemic problems associated with Western
manufacturing. It might not even be appropriate in all circumstances.
(a) It is not always easy to predict patterns of demand.
(b) JIT makes the organisation far more vulnerable to disruptions in the supply chain.
(c) JIT, originated by Toyota, was designed at a time when all of Toyota's manufacturing was
done within a 50 km radius of its headquarters. Wide geographical spread, however, makes this
difficult.

Standard costing and JIT

Some commentators have argued that traditional variance analysis is unhelpful and
potentially misleading in the modern organisation, and can make managers focus their attention
on the wrong issues. Here are just two examples.

(a) Efficiency variance. Traditional variance analysis emphasises that adverse efficiency
variances should be avoided, which means that managers should try to prevent idle time and
keep up production. In an environment where the focus is on improving continuously, JIT should
be used.
In these circumstances, manufacturing to eliminate idle time could result in the production of
unwanted products that must be held in store and might eventually be scrapped. Efficiency
variances could focus management attention on the wrong problems.

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(b) Materials price variance. In a JIT environment the key issues in materials purchasing are
supplier reliability, materials quality, and delivery in small order quantities. Purchasing managers
should not be shopping around every month looking for the cheapest price. Many JIT systems
depend on long-term contractual links with suppliers, which mean that material price variances
are not relevant for management control purposes.

Total quality management (TQM)

Quality means 'the degree of excellence of a thing' - how well made it is, or how well
performed if it is a service, how well it serves its purpose, and how it measures up against its
rivals. These criteria imply two things.
• That quality is something that requires care on the part of the provider.
• That quality is largely subjective - it is in the eye of the beholder, the customer.

The management of quality

The management of quality is the process of:
(a) Establishing standards of quality for a product or service
(b) Establishing procedures or production methods which ought to ensure that these required
standards of quality are met in a suitably high proportion of cases
(c) Monitoring actual quality
(d) Taking control action when actual quality falls below standard
Take the postal service as an example. The postal service might establish a standard that 90% of
first class letters will be delivered on the day after they are posted, and 99% will be delivered
within two days of posting.
(a) Procedures would have to be established for ensuring that these standards could be met
(attending to such matters as frequency of collections, automated letter sorting, frequency of
deliveries and number of staff employed).
(b) Actual performance could be monitored, perhaps by taking samples from time to time of
letters that are posted and delivered.
(c) If the quality standard is not being achieved, management should take control action (employ
more postal workers or advertise the use of postcodes again).

NOTE: Quality management becomes total (Total Quality Management (TQM)) when it is
applied to everything a business does.

Total Quality Management (TQM) is an 'Integrated and comprehensive system of planning

and controlling all business functions so that products or services are produced which meet or
exceed customer expectations. TQM is a philosophy of business behaviour, embracing principles

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such as employee involvement, continuous improvement at all levels and customer focus, as well
as being a collection of related techniques aimed at improving quality such as full documentation
of activities, clear goal setting and performance measurement from the customer perspective.'
(CIMA Official Terminology)

Exam skills
As you learn the mechanics of these new management approaches, try not to view each one in
isolation. For example, a question may require you to give reasons why the adoption of TQM is
important in a JIT environment.

Get it right, first time

One of the basic principles of TQM is that the cost of preventing mistakes is less than the cost of
correcting them once they occur. The aim should therefore be to get things right first time. Every
mistake, delay and misunderstanding, directly costs organisation money through wasted time and
effort, including time taken in pacifying customers. The lost potential for future sales because of
poor customer service must also be taken into account.

Continuous improvement
A second basic principle of TQM is dissatisfaction with the status quo: the belief that it is
always possible to improve and so the aim should be to 'get it more right next time'.

Quality assurance procedures

Because TQM embraces every activity of a business, quality assurance procedures cannot be
confined to the production process but must also cover the work of sales, distribution and
administration departments, the efforts of external suppliers, and the reaction of external
customers.

Area Procedure
Quality assurance of goods inwards Suppliers' quality assurance schemes are being
used increasingly. This is where the supplier
guarantees the quality of goods supplied.
Inspection of output The aim of carrying out inspection samples is
to satisfy management that quality control in
production is being maintained.
Monitoring customer reaction Customer complaints should be monitored.
Some companies survey customers on a
regular basis

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Employees and quality To ensure that employees have a positive

attitude towards quality
• Responsibility for quality checking could be
given to the worker himself
• Inter-group competition to meet and beat
quality standards could be introduced

Problems can therefore be overcome by changing people's attitudes rather than teaching them
new tricks. The key issue is to instil understanding of, and commitment to, working practices
that lead to quality.

Empowerment
Workers themselves are frequently the best source of information about how (or how not) to
improve quality. Empowerment therefore has two key aspects.
(a) Allowing workers to have the freedom to decide how to do the necessary work, using the
skills they possess and acquiring new skills as necessary to be an effective team member.
(b) Making workers responsible for achieving production targets and for quality control.

Design for quality

A TQM environment aims to get it right first time, and this means that quality, not faults, must
be designed into the organisation's products and operations from the outset.
Quality control happens at various stages in the process of designing a product or service.
(a) At the product design stage, quality control means trying to design a product or service so
that its specifications provide a suitable balance between price and quality (of sales and delivery,
as well as manufacture) which will make the product or service competitive.
(b) Production engineering is the process of designing the methods for making a product (or
service) to the design specification. It sets out to make production methods as efficient as
possible, and to avoid the manufacture of sub-standard items.
(c) Information systems should be designed to get the required information to the right person
at the right time; distribution systems should be designed to get the right item to the right
person at the right time; and so on.

Quality control and inspection

A distinction should be made between quality control and inspection.
(a) Quality control involves setting controls for the process of manufacture or service delivery.
It is an aimed at preventing the manufacture of defective items or the provision of defective
services.

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(b) Inspection is a technique of identifying when defective items are being produced at an
unacceptable level. Inspection is usually carried out at three main points.
(i) Receiving inspection – for raw materials and purchased components
(ii) Floor or process inspection for WIP
(iii) Final inspection or testing for finished goods

Standard costing and TQM

Standard costing concentrates on quantity and ignores other factors contributing to an
organisation's effectiveness. In a total quality environment, however, quantity is not an issue,
quality is. Effectiveness in such an environment therefore centres on high quality output
(produced as a result of high quality input); the cost of failing to achieve the required level of
effectiveness is not measured in variances, but in terms of the internal and external failure
costs which would not be identified by traditional standard costing analysis.
Standard costing might measure, say, labour efficiency in terms of individual tasks and the
level of output. In a total quality environment, labour is most likely to be viewed as a number
of multi-task teams who are responsible for completion of a part of the production process. The
effectiveness of such a team is more appropriately measured in terms of re-working required,
returns from customers, defects identified in subsequent stages of production and so on.
In a TQM environment there are likely to be minimal rate variances if the workforce are paid a
guaranteed weekly wage. Fixed price contracts, with suppliers guaranteeing levels of quality, are
often a feature, especially if a JIT system is also in place, and so there are likely to be few, if
any, material price and usage variances.
So can standard costing and TQM exist together? Or do we need to SCRAP standard costing
in a TQM environment?

Standard costing v TQM

Standard costs often incorporate a planned level of scrap in material
standards. This is at odds with the TQM aim of 'zero defects' and there is no
Scrap motivation to 'get it right first time'.

Continual improvements should alter quantities of inputs, prices and so on,

Continual whereas standard costing is best used in a stable, standardised, repetitive
changes environment.
Standard costing systems make individual managers responsible for the
variances relating to their part of the organisation's activities. A TQM
programme, on the other hand, aims to make all personnel aware of, and
Responsibility responsible for, the importance of supplying the customer with a quality

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product.

Attainable standards, which make some allowance for wastage and

Attainable inefficiencies, are commonly set. The use of such standards conflicts with the
standards elimination of waste which is a vital ingredient of a TQM programme.
Predetermine Predetermined standards conflict with the TQM philosophy of continual
d standards improvement.

Problems implementing TQM in an organisation

(a) It can be de-motivating because ‘perfection’ is hard to achieve.
(b) It relies heavily on the quality of suppliers.
(c) Change management can be difficult depending on the culture of the business.

Criticisms of TQM
The operation of TQM in practice has not always worked as intended:
● Empirical studies suggest that ‘empowerment’ often amounts to the delegation of additional
duties to employees. Limits have to be placed on what employees can do, so empowerment is
often associated with rules, bureaucracy and form-filling. That apart, many employees find most
satisfaction from outside work activities and are quite happy to confine themselves to doing what
they are told while at work. The proponents of TQM are often very work-centred people
themselves and tend to judge others by their own standards. Teams do not always contribute to
organisational effectiveness? Just calling a group of people who work in the same office ‘ a team
’ does not make it a team. A team requires a high level of cooperation and consensus. Many
competitive and motivated people find working in a team environment to be uncongenial. It
means that every time you want to do anything you have to communicate with and seek approval
from fellow team members.

In practice, this is likely to involve bureaucracy and form-filling.

Many organisations that have attempted TQM have found that it involves a great deal of
additional bureaucracy. When the attempt is anything less than fully committed, then the results
can be unfortunate. Some organisations have found themselves with two parallel structures. A
new TQM structure is set up complete with committees and teams – but the old hierarchical
structure remains in existence which actually amounts to ‘the real organisation’. One UK study
(A.T. Kearney) reporter found that only 20 per cent of organizations who had tried TQM
reported positive results from it.

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Kaizen Costing:
A philosophy that sees improvement in productivity as a gradual and methodical process. Kaizen
is a Japanese term meaning “change for the better”. The concept of Kaizen encompasses a wide
range of ideas; it involves making the work environment more efficient and effective by creating
a team atmosphere, improving everyday procedures, ensuring employee satisfaction and making
a job more fulfilling, less tiring and safer.
A method of costing that involves making continual, incremental improvements to the
production process during the manufacturing phase of the product/service lifecycle, typically
involving setting targets for cost reduction. Some of the key objectives of the Kaizen philosophy
include the elimination of waste, quality control, just-in-time delivery, standardized work and the
use of efficient equipment.
An example of the Kaizen philosophy in action is the Toyota production system, in which
suggestions for improvement are encouraged and rewarded, and the production line is stopped
when a malfunction occurs.

Costs of quality and cost of quality reports

Cost of quality reports highlight the total cost to an organisation of producing products or
services that do not conform to quality requirements. Four categories of cost should be reported:
prevention costs, appraisal costs, internal failure costs and external failure costs.

Costs of quality
When we talk about quality-related costs you should remember that a concern for good quality
saves money; it is poor quality that costs money.

Key terms
The cost of quality is the 'Difference between the actual cost of producing, selling and
supporting, products or services and the equivalent costs if there were no failures during
production or usage.'
The cost of quality can be analysed into:
Cost of conformance – 'Costs of achieving specified quality standards'
Cost of prevention – 'Costs incurred prior to or during production in order to prevent
substandard or defective products or services from being produced'
Cost of appraisal – 'Costs incurred in order to ensure that outputs produced meet required
quality standards' (CIMA Official Terminology)
Cost of non-conformance is 'The cost of failure to deliver the required standard of quality.'
Cost of internal failure – 'Costs arising from inadequate quality which are identified before the
transfer of ownership from supplier to purchaser'

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Cost of external failure – 'Costs arising from inadequate quality discovered after the transfer of
ownership from supplier to purchaser.' (CIMA Official Terminology)

Quality-related cost Example

Prevention costs Quality engineering
Design/development of quality control/inspection equipment
Maintenance of quality control/inspection equipment
Administration of quality control
Training in quality control
Appraisal costs Acceptance testing
Inspection of goods inwards
Inspection costs of in-house processing
Performance testing
Internal failure costs Failure analysis
Re-inspection costs
Losses from failure of purchased items
Losses due to lower selling prices for sub-quality goods
Costs of reviewing product specifications after failures

External failure costs Administration of customer complaints section

Costs of customer service section
Product liability costs
Cost of repairing products returned from customers
Cost of replacing items due to sub-standard products/marketing errors

The cost of conformance is a discretionary cost which is incurred with the intention of
eliminating the costs of internal and external failure. The cost of non-conformance, on the other
hand, can only be reduced by increasing the cost of conformance. The optimal investment in
conformance costs is when total costs of quality reach a minimum (which may be below 100%
quality conformance). To achieve 0% defects, costs of conformance must be high. As a greater
proportion of defects are accepted, however, these costs can be reduced. At a level of 0% defects,
costs of non-conformance should be nil but these will increase as the accepted level of defects
rises. There should therefore be an acceptable level of defects at which the total costs of quality
are at a minimum. This is illustrated in the following diagram

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$
Total costs
Cost of non conformance

Cost of conformance
0 1 2 3 4 % defects

Cost of quality reports

Shown below is a typical cost of quality report. Some figures in the report, such as the
contribution forgone due to sales lost because of poor quality, may have to be estimated, but it is
better to include an estimate rather than omit the category from the report.
The report has the following uses.
(a) By expressing each cost category as a percentage of sales revenue, comparisons can be made
with previous periods, divisions within the group or other organisations, thereby highlighting
problem areas. A comparison of the proportion of external failure costs to sales revenue with the
figures for other organisations, for example, can provide some idea of the level of customer
satisfaction.
(b) It can be used to make senior management aware of how much is being spent on quality-
related costs.
(c) It can provide an indication of how total quality costs could be reduced by a more sensible
division of costs between the four categories. For example, an increase in spending on
prevention costs should reduce the costs of internal and external failure and hence reduce total
spending.

Exercise 1:
ABC is a food producer that makes low cost processed food that it sells to supermarkets. ABC
produces only one type of processed food product and production techniques have remained
largely unchanged for a number of years.
Over recent months, sales have been falling steadily. Consumer tastes are changing to favour
natural ingredients and supermarkets have reflected this in the products that they offer for sale.
ABC is keen to address the decline in sales and recently held a meeting to discuss the
performance of the organisation. The Management Accountant suggested to the Managing
Director that the performance of ABC could be improved by implementing Total Quality

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Management (TQM) principles and adopting Kaizen costing concepts. Currently the control
systems of ABC focus on material price and usage.
The Managing Director is sceptical of the Management Accountant’s suggestions and is unclear
as to whether they are suitable for the company.

Required:

(a) Explain TWO concepts of Kaizen costing.

(b) Explain THREE conditions that must exist for TQM to be successfully implemented at
ABC.

Exercise 2:
One of your clients is concerned that the management and control of stocks is not receiving
sufficient attention within her organisation and is keen to learn more about it.

Required:
Draft a report which:
(a) Describes the costs associated with holding stock.
(b) Outlines the advantages and disadvantages of the following methods of valuing stock:
(i) FIFO method;
(ii) AVCO method.
(c) Describes the key features of a Just-in-Time system.
(d) Explain the potential benefits for a company from using a just-in-time (JIT) production
system.

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Chapter six:
Modern costing techniques

The theory of constraints (TOC)

Theory of constraints is a set of concepts developed in the USA which aim to identify the
binding constraints in a production system and which strive for evenness of production flow so
that the organisation works as effectively as possible. No inventories should be held, except prior
to the binding constraint. Its key financial concept is to turn materials into sales as quickly as
possible, thereby maximizing throughput and the net cash generated from sales. This is to be
achieved by striving for balance in production processes, and so evenness of production flow
is an important aim.

Key terms
Theory of constraints (TOC) is a 'Procedure based on identifying bottlenecks (constraints),
maximising their use, subordinating other facilities to the demand of the bottleneck facilities,
alleviating bottlenecks and re-evaluating the whole system.'

A constraint (or bottleneck resource) is an 'Activity, resource or policy that limits the ability to
achieve an objective.

Managing constraints
One process will inevitably act as a bottleneck (or limiting factor) and constrain throughput.
This is known as a binding constraint in TOC terminology. In order to manage constraints
effectively, Goldratt has proposed a five-step process of ongoing improvement. The process
operated as a continuous loop.

Step 1: Identify the binding constraint/bottleneck

Step 2: Exploit
The highest possible output must be achieved from the binding constraint. This output
must never be delayed and as such a buffer inventory should be held immediately before
the constraint.

Step 3: Subordinate
Operations prior to the binding constraint should operate at the same speed as it so that
WIP does not build up.

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Step 4: Elevate the system bottleneck. Steps should be taken to increase resources or
improve its efficiency.

Step 5: Return to Step 1

The removal of one bottleneck will create another elsewhere in the system.

Throughput contribution = sales revenue – direct material cost

Conversion cost (in TOC) = all operating costs except direct material cost (ie all costs except
totally variable costs)
Investment cost = inventory, equipment, building costs and so on

Throughput contribution
The aim of TOC is to maximise throughput contribution while keeping conversion and
investment costs to a minimum. If a strategy for increasing throughput contribution is being
considered it will therefore only be accepted if conversion and investment costs increase by a
lower amount than contribution. It is important to realise that TOC is not an accounting system
but a production system.

Throughput accounting
Throughput accounting is the accounting system developed in the UK, based on the theory of
constraints and JIT. It measures the throughput contribution per factory hour. It is very similar to
marginal costing but can be used to make longer-term decisions about production
equipment/capacity. The concept of throughput accounting has been developed from TOC as an
alternative system of cost and management accounting in a JIT environment.

Throughput accounting (TA) is an approach to accounting which is largely in sympathy with

the JIT philosophy. In essence, TA assumes that a manager has a given set of resources
available. These comprise existing buildings, capital equipment and labour force. Using these
resources, purchased materials and parts must be processed to generate sales revenue. Given this
scenario the most appropriate financial objective to set for doing this is the maximisation of
throughput (Goldratt and Cox, 1984) which is defined as: sales revenue less direct material cost.'
(Tanaka, Yoshikawa, Innes and Mitchell, Contemporary Cost Management)
The Official Terminology's definition of throughput accounting (TA) is 'Variable cost
accounting presentation based on the definition of throughput (sales minus material and
component costs).'
TA is different from all other management accounting systems because of what it emphasises.
• Firstly throughput

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• Secondly inventory minimisation

• Thirdly cost control
TA is based on three concepts.

Concept 1
In the short run, most costs in the factory (with the exception of materials costs) are fixed.
Because TA differentiates between fixed and variable costs it is often compared with marginal
costing and some people argue that there is no difference between marginal costing and
throughput accounting. For this reason TA is sometimes referred to as super variable costing
and indeed there are some similarities in the assumptions underlying the two methods. However,
on marginal costing direct labour costs are usually assumed to be variable costs. Years ago this
assumption was true, but employees are not usually paid piece rate today and they are not laid off
for part of the year when there is no work, and so labour cost is not truly variable. If this is
accepted the two techniques are identical in some respects, but marginal costing is generally
thought of as being purely a short-term decision-making technique while TA, or at least TOC,
was conceived with the aim of changing manufacturing strategy to achieve evenness of flow.
It is therefore much more than a short-term decision technique.
Because TA combines all conversion costs together and does not attempt to examine them in
detail it is particularly suited to use with activity based costing (ABC), which examines the
behaviour of these costs and assumes them to be variable in the long run.

Concept 2
In a JIT environment, all inventories are a 'bad thing' and the ideal inventory level is zero.
Products should not be made unless there is a customer waiting for them. This means
unavoidable idle capacity must be accepted in some operations, but not for the operation that
is the bottleneck of the moment. There is one exception to the zero inventory policy, being that a
buffer inventory should be held prior to the bottleneck process.

Concept 3
Profitability is determined by the rate at which 'money comes in at the door' (that is, sales are
made) and, in a JIT environment, this depends on how quickly goods can be produced to satisfy
customer orders. Since the goal of a profit-orientated organisation is to make money, inventory
must be sold for that goal to be achieved.
The buffer inventory and any other work in progress or finished goods inventory should be
valued at material cost only until the output is eventually sold, so that no value will be added and
no profit earned until the sale takes place. Producing output just to add to work in progress or
finished goods inventory creates no profit, and so should not be encouraged.

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Bottleneck resources
The aim of modern manufacturing approaches is to match production resources with the demand
for them. This implies that there are no constraints, termed bottleneck resources in TA, within an
organisation. The throughput philosophy entails the identification and elimination of these
bottleneck resources. Where they cannot be eliminated production must be limited to the
capacity of the bottleneck resource in order to avoid the build-up of work in progress. If a
rearrangement of existing resources or buying-in resources does not alleviate the bottleneck,
investment in new equipment may be necessary.

The elimination of one bottleneck is likely to lead to the creation of another at a previously
satisfactory location, however. The management of bottlenecks therefore becomes a primary
concern of the manager seeking to increase throughput.
(a) There is nothing to be gained by measuring and encouraging the efficiency of machines that
do not govern the overall flow of work.
(b) Likewise, there is little point in measuring the efficiency of production staff working on non-
bottleneck processes.
(c) Bonuses paid to encourage faster working on non-bottleneck processes are wasted and could
lead to increased storage costs and more faulty goods.

Other factors that might limit throughput other than a lack of production resources
(bottlenecks)
(a) The existence of an non-competitive selling price.
(b) The need to deliver on time to particular customers, which may disrupt normal production
flow.
(c) The lack of product quality and reliability, which may cause large amounts of rework or an
unnecessary increase in production volume.
(d) Unreliable material suppliers, which will lead to poor quality products that require rework.

Identifying the bottleneck resource

It may not always be obvious which the bottleneck resource is and a process of trial and error for
a few periods can be an expensive and inefficient way of attempting to identify it.
If the resource constraint is machine capacity, it is possible to identify the constrained machine
through the calculation of machine utilisation rates.

Exercise 1:
A company produces three products using three different machines. The following data is
available for the latest period.

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Product L Product M Product N

Machine hours Hours per Hours per Hours per
required: unit unit unit
Mixing machine 2 5 3
Cutting machine 3 4 2
Finishing machine 1 2 2
Sales demand 2,700 units 1,200 units 2,500 units

Maximum capacity is as follows.

Hours available
Mixing machine 22,000
Cutting machine 15,400
Finishing machine 7,300
Example: machine utilisation rates
Required:
(a) Calculate the machine utilisation rate for each machine
(b) Identify which of the machines is the bottleneck resource

Throughput measures
Return per time period
In a throughput accounting environment, the overall focus of attention is the rate at which the
organisation can generate profits. To monitor this, the return on the throughput through the
bottleneck resource is monitored using:

Return per time period = [sales revenue −material costs]/time period

This measure shows the value added by an organisation during a particular time period. Time
plays a crucial role in the measure, so managers are strongly encouraged to remove
bottlenecks that might cause production delays.

Return per time period on bottleneck resource

In throughput accounting, the limiting factor is the bottleneck. The return per time period
measure can be adapted and used for ranking products to optimise production in the short term.
Product return per minute = [sales price −material costs]/minutes on key/bottleneck resource

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Ranking products on the basis of throughput contribution per minute (or hour) on the bottleneck
resource is similar in concept to maximising contribution per unit of limiting factor. Such
product rankings are for short-term production scheduling only. In throughput accounting,
bottlenecks should be eliminated and so rankings may change quickly. Customer demand can, of
course, cause the bottleneck to change at short notice too.
Solution
Rankings by TA product return and by contribution per unit of limiting factor may be different.
Which one leads to profit maximisation? The correct approach depends on the variability or
otherwise of labour and variable overheads, which in turn depends on the time horizon of the
decision. Both are short-term profit maximisation techniques and given that labour is nowadays
likely to be fixed in the short term, it could be argued that TA provides the more correct solution.
An analysis of variable overheads would be needed to determine their variability.

Bear in mind that the huge majority of organisations cannot produce and market products based
on short-term profit considerations alone. Strategic-level issues such as market developments,
product developments and stage reached in the product life cycle must also be taken into
account.

TA ratio
Products can also be ranked according to the throughput accounting ratio (TA ratio).

TA ratio = throughput contribution or value added per time period/conversion cost per
time period

= [(sales- material costs) per time period]/ (labour + overhead) per time period

This measure has the advantage of including the costs involved in running the factory. The
higher the ratio, the more profitable the company.
A profitable product should have a ratio greater than one. If a product's ratio is less than one the
organisation is losing money every time that product is produced.
Here's an example. Note the figures are in $ per hour.

Product A Product B
$ per hour $ per hour
Sales price 100 150
Material cost (40) (50)
Throughput 60 100

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Conversion cost (50) (50)

Profit 10 50
TA ratio 60/50=1.2 100/50=2.0

Profit will be maximised by manufacturing as much of product B as possible.

Exercise 2:

Each unit of product B requires 4 machine hours. Machine time is the bottleneck resource, there
being
650 machine hours available per week.
B is sold for$120 per unit and has a direct material cost of$35 per unit. Total factory costs are
$13,000 per week.

Required

Calculate the return per factory hour and the TA ratio for product B.

Effectiveness measures and cost control

Traditional efficiency measures such as standard costing variances and labour ratios are
unsuitable in a TA environment because traditional efficiency should not be encouraged (as the
labour force should not produce just for inventory).
Effectiveness is a more important issue. The current effectiveness ratio compares current levels
of effectiveness with the standard.
Current effectiveness ratio = standard minutes of throughput achieved/minutes available

Is it good or bad?
TA is seen by some as too short term, as all costs other than direct material are regarded as fixed.
This is not true. But it does concentrate on direct material costs and does nothing for the control
of other costs. These characteristics make throughput accounting a good complement for activity
based costing (ABC), as ABC focuses on labour and overhead costs. TA attempts to maximise
throughput whereas traditional systems attempt to maximise profit. By attempting to maximise
throughput an organisation could be producing in excess of the profit-maximising output.

Where TA helps direct attention

• Bottlenecks • Reducing the response time to customer demand
• Key elements in making profits • Evenness of production flow

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• Inventory reduction • Overall effectiveness and efficiency

Exercise 3:
Corrie produces three products, X, Y and Z. The capacity of Corrie's plant is restricted by
process alpha. Process alpha is expected to be operational for eight hours per day and can
produce 1,200 units of X per hour, 1,500 units of Y per hour, and 600 units of Z per hour.
Selling prices and material costs for each product are as follows.

Product Selling price Material cost Throughput contribution

$ per unit $ per unit $ per unit
X 150 70 80
Y 120 40 80
Z 300 100 200
Conversion costs are $720,000 per day.

Required:
(a) Calculate the profit per day if daily output achieved is 6,000 units of X, 4,500 units of Y and
1,200 units of Z.
(b) Determine the efficiency of the bottleneck process given the output in (a).
(c) Calculate the TA ratio for each product.
(d) In the absence of demand restrictions for the three products, advise Corrie's management on
the optimal production plan.

Exercise 4:
A company’s binding constraint is the capacity of machine M. The throughput accounting (TA)
ratio for product P on machine M is 1.4.

Explain how the TA ratio is calculated and state FOUR actions that management could consider
to improve the TA ratio for product P.

Throughput accounting in service and retail industries

Sales staff has always preferred to use a marginal costing approach so that they can use their
discretion on discounts, and retail organisations have traditionally thought in terms of sales
revenue less the bought in price of goods. The throughput accounting approach is therefore
nothing new to them. Throughput accounting can be used very effectively in support departments
and service industries to highlight and remove bottlenecks. For example, if there is a delay in

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processing a potential customer's application, business can be lost or the potential customer may
decide not to proceed. Sometimes credit rating checks are too detailed, slowing the whole
procedure unnecessarily and delaying acceptance from say 24 hours to eight days.
A similar problem could occur in hospitals where work that could be done by nurses has to be
carried out by doctors. Not only does this increase the cost of the work but it may well cause a
bottleneck by tying up a doctor's time unnecessarily.

Back-flush accounting
Back-flush accounting is a method of accounting that can be used with JIT production systems.
It saves a considerable amount of time as it avoids having to make a number of accounting
entries that are required by a traditional system. Back-flush accounting is the name given to the
method of keeping cost accounts employed if back-flush costing is used. The two terms are
almost interchangeable.

Traditional costing systems use sequential tracking (also known as synchronous tracking) to
track costs sequentially as products pass from raw materials to work in progress, to finished
goods and finally to sales. In other words, material costs are charged to WIP when materials are
issued to production, direct labour and overhead costs are charged in a similar way as the cost is
incurred or very soon after. If a production system such as JIT is used, sequentially tracking
means that all entries are made at almost the same moment and so a different accounting system
can be used. In back-flush costing/accounting, costs are calculated and charged when the product
is sold, or when it is transferred to the finished goods store.

Back-flush costing is 'A method of costing, associated with a JIT production system, which
applies cost to the output of a process. Costs do not mirror the flow of products through the
production process, but are attached to the output produced (finished goods inventory and cost of
sales), on the assumption that such back-flushed costs are a realistic measure of the actual costs
incurred.' The CIMA definition above omits the fact that budgeted or standard costs are used
to work backwards to 'flush' out manufacturing costs for the units produced. (Hence the rather
unattractive name for the system!) The application of standard costs to finished goods units, or to
units sold, is used in order to calculate cost of goods sold, thereby simplifying the costing system
and creating savings in administrative effort. In a true back-flush accounting system, records of
materials used and work in progress are not required as material cost can be calculated from
either finished goods or goods sold.

Back-flush costing runs counter to the principle enshrined in IAS 2, and the staple of cost
accounting for decades, that inventory and WIP should be accounted for by calculating cost and
net realisable value of 'specific individual items of inventory'. The substantial reduction in

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inventories that is a feature of JIT means that inventory valuation is less relevant, however,
and therefore the costing system can be simplified to a considerable extent. Back-flush costing
is therefore appropriate for organisations trying to keep inventories to the very minimum. In
such circumstances, the recording of every little increase in inventory value, as each nut and
bolt is added, is simply an expensive and non-value-added activity that should be eliminated.

Possible problems with back-flush costing

(a) It is only appropriate for JIT operations where production and sales volumes are
approximately equal. It is not appropriate for manufacturing businesses which have high
inventory levels.
(b) Some people claim that it should not be used for external reporting purposes. If, however,
inventories are low or are practically unchanged from one accounting period to the next,
operating income and inventory valuations derived from back-flush accounting will not be
materially different from the results using conventional systems. Hence, in such
circumstances, back-flush accounting is acceptable for external financial reporting.
(c) It is vital that adequate production controls exist so that cost control during the production
process is maintained.
(d) Traditional costing systems provide more detailed management information than back-flush
costing systems.

Advantages of back-flush costing

(a) It is much simpler, as there is no separate accounting for WIP.
(b) Even the finished goods account is unnecessary.
(c) The number of accounting entries should be greatly reduced, as are the supporting
vouchers, documents and so on. Accounting costs will be reduced.
(d) The system should discourage managers from producing simply for inventory since
working on material does not add value until the final product is completed or sold.
(e) When inventory levels are low or constant, it gives the same results as traditional costing
methods.

Variants of back-flush costing

(a) Trigger points determine when the entries are made in the accounting system. There will
be either one or two trigger points that trigger entries in the accounts.
(i) Triggered when materials are purchased or received (can be used if suppliers’ deliveries are
unpredictable)
(ii) Triggered when goods are completed (can be used when unpredictability in demand) or when
they are sold (used to motivate staff to focus on sales)

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In a true JIT system where no inventories are held the first trigger, when raw materials are
purchased, is unnecessary.
(b) Actual conversion costs are recorded as incurred, just as in conventional recording systems.
Conversion costs are applied to products at the second trigger point based on a standard cost. It is
assumed that any conversion costs not applied to products are carried forward and disposed of at
the period end.
(c) Direct labour is included as an indirect cost in conversion cost with overheads.
(Production is only required when there is demand for it in a JIT system, and so production
labour will be paid regardless of the level of activity.)
(d) All indirect costs are treated as a fixed period expense.

Exercise 5:
A company operates a throughput accounting system. The details per unit of Product C are:
Selling price $28.50
Material cost $9.25
Labour cost $6.75
Overhead costs $6.00
Time on bottleneck resource 7.8 minutes

What is the throughput contribution per hour for Product C?

Exercise 6:
A company manufactures two products A and B. The budget statement below was produced
using a traditional absorption costing approach. It shows the profit per unit for each product
based on the estimated sales demand for the period

Product A $ Product B $
Selling price per unit 46 62
Production costs per unit:
Material costs 18 16
Labour costs 4 10
Overhead costs 8 12
Profit per unit 16 24
Additional information:
Estimated sales demand 6,000 8,000
(units)

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Machine hours per unit 0.5 0.8

It has now become apparent that the machine which is used to produce both products has a
maximum capacity of 8,000 hours and the estimated sales demand cannot be met in full. Total
production costs for the period, excluding direct material cost, are $248,000. No inventories are
held of either product.

Required:
(i) Calculate the return per machine hour for each product if a throughput accounting approach
is used.
(ii) Calculate the profit for the period, using a throughput accounting approach, assuming the
company prioritises Product B.

Exercise 7:
CH Ltd operates a throughput accounting system. Product B sells for$27.99, has a material cost
of
$7.52 and a conversion cost of$1.91. The product spends 27 minutes on the bottleneck resource.
What is the return per factory hour for product B?
A$45.49 B$20.47 C$26.08 D$57.96

Exercise 8:
A company produces three products D, E and F. The statement below shows the selling price and
product costs per unit for each product, based on a traditional absorption costing system

Product D Product E Product F

$ $ $
Selling price per 32 28 22
unit
Variable costs per unit
Direct material 10 8 6
Direct labour 6 4 4
Variable 4 2 2
overhead

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Fixed cost per unit

Fixed overhead 9 6 6
Total product 29 20 18
cost
Profit per unit 3 8 4
Additional information:
Demand per 3,000 4,000 5,000
period (units)
Time in Process 20 25 15
A (minutes)

Each of the products is produced using Process A which has a maximum capacity of 2,500 hours
per period.

Required:
a) If a traditional contribution approach is used, the ranking of products, in order of priority,
for the profit maximising product what will be mix?
b) If a throughput accounting approach is used, the ranking of products, in order of priority,
for the profit maximising product what will be mix?

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Chapter six:
Activity Based Costing

Introduction
We have already discussed the concepts of cost, costing, cost accounting in the previous
chapters. The accounting of overheads is also discussed in detail in the chapter of ‘overheads’.
The main objective of any costing system is to determine scientifically the cost of a product or
service. For facilitating the calculation, costs are divided into direct and indirect. Direct costs are
the costs which are traceable to the products/services offered. On the other hand, indirect costs
which are also called as ‘overheads’ are not traceable to the products/services. Hence these costs
are first identified, classified, allocated, apportioned wherever allocation is not possible,
reapportioned and finally absorbed in the products/services. Charging the direct costs to the
products is comparatively a simple procedure and can be done with remarkable accuracy.

However, the indirect costs present problems in charging them to the products and there is a
possibility of distortion of costs though the basis of charging them is quite logical. This is one of
the limitations of the traditional costing system. For example, one of the methods of absorption
of overheads is direct labour cost and this method is quite satisfactory when the overhead costs
of indirect activities is a small percentage compared to direct labour component in actual making
of products. However, the increased technology and automation has reduced the direct labour
considerably and so the indirect activities have assumed greater importance. Therefore, using the
direct labour as a basis for absorbing the overheads can lead to distortions in the costs.
Distortions in the costs resulting into incorrect cost calculations may lead to following wrong
decisions.
 Errors in fixation of selling prices.
 Wrong decisions regarding deciding of product mix.
 Ignoring customer orientation.
 Missing of profitable opportunities.
In order to overcome the limitations of traditional costing systems Activity Based Costing has
been introduced. Before we proceed to the other aspects of Activity Based Costing, let us see the
limitations of traditional costing system. A brief mention of the same has already been made in
the above paragraph. Some more points are discussed below.

Limitations of Traditional Costing System

The following are the limitations of traditional costing system.

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 In a traditional costing system, overheads i.e. indirect costs are allocated, apportioned and
finally absorbed in the cost units. There can be distortion in computing costs due to the
basis selected for absorption. The following example will clarify the situation.
Suppose a manufacturing company is producing two products, A and B. The direct material cost
for the products is $100,000 and $200,000 respectively. The total overheads are $150,000 and
the company adopts direct material cost as the basis for absorption. The absorption percentage of
overheads will be 50% of the direct material. [150,000/300,000 X 100 = 50%] Thus the
overheads absorbed in the product A will be $50,000 and for B, they will be $100,000 [50% of
the overheads] Product B has a larger share of the overhead costs as the material costs are higher
than that of A. However, actually product B may be requiring lesser efforts in the indirect
activities than A, but only because it has a higher material costs, it will be charged with larger
amount of overheads. Thus there is a distortion in the total cost. This distortion in costs may lead
to wrong decisions in several areas like make or buy, pricing decisions, acceptance of export
offer etc.

 Another limitation of traditional costing system is the division between fixed and variable
may not be realistic as there are many complications due to the complexity of the modern
business.
 There should be linkage between the activities and the costs. Similarly the information
should be available simultaneously which means that information should be made
available while the activities are going on. Information available after the activity is over
will not be of much use.
As mentioned above, the Activity Based Costing system is developed due to the limitations of
the traditional costing system. The limitations of the traditional costing system have been
discussed above. Now, in the following paragraphs, we will proceed to discuss the various
aspects of Activity Based Costing.

Activity Based Costing – Various Issues

Meaning: - CIMA defines Activity Based Costing as, ‘cost attribution to cost units on the basis
of benefit received from indirect activities e.g. ordering, setting up, assuring quality.’
One more definition of Activity Based Costing is, ‘the collection of financial and operational
performance information tracing the significant activities of the firm to product costs.’
The following are the objectives of Activity Based Costing.

Objectives of Activity Based Costing

The objectives of Activity Based Costing are discussed below.

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 To remove the distortions in computation of total costs as seen in the traditional costing
system and bring more accuracy in the computation of costs of products and services.
 To help in decision making by accurately computing the costs of products and services.
 To identify various activities in the production process and further identify the value
adding activities.
 To distribute overheads on the basis of activities.
 To focus on high cost activities.
 To identify the opportunities for improvement and reduction of costs.
 To eliminate non value adding activities.

Working of Activity Based Costing

The working of Activity Based Costing is explained below.
• Understanding and analyzing manufacturing process :- For installation of any costing
system, study of manufacturing process is essential. For Activity Based Costing system also, it is
necessary to study the manufacturing process and ascertain various stages involved in the same
so that ‘activities’ involved in the same can be identified.
• Study of the Activities involved :- The next step is to study the activities involved in the
manufacturing process. This step is very crucial as the entire Activity Based Costing is based on
identification of activities. In this step, the activities involved in a process are identified. For
example, in a bank, opening of an account is one of the services offered to customers. In this
service, activities involved are studied. It may be revealed that opening of a new account
involves activities like issuing the application form, verification of the same and accepting the
initial amount required for opening of an account. Similarly in case of a manufacturing company,
purchase procedure may involve activities like receiving of purchase requisition for concerned
department or the stores department, inviting quotations from various suppliers, placing of an
order, follow up of the same and finally receiving and inspection of the goods. In case of an
educational institute, activities in a library may include activities like issue of books, receipt of
books, ordering new books, giving accession numbers, stock taking, removing obsolete and
outdated books, identification of slow moving and fast moving items etc. In this manner, whether
in manufacturing or in service sector, activities are identified and the next step is to divide the
activities into value adding and non value adding. The objective behind this is that attention can
be focused on the value adding activities while non value adding activities can be eliminated in
the future.

• Activity Cost Pool: - Cost pool is defined by CIMA as, ‘the point of focus for the costs relating
to a particular activity in an activity based costing system.’ For example, in case of a library, the
cost of issue and receipts cost of ordering, stock taking costs etc. can be identified with ‘Library

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Cost’. In other words, ‘Library’ will the cost pool in which all the costs mentioned above may be
clubbed. In case of a manufacturing organization, as regards to stores, cost of classification, cost
of issue of stores requisitions, inspection costs etc. can be pooled under the heading ‘stores’.
Thus cost pool concept is similar to the concept of cost centre. The cost pool is the point of focus
or in other words, it is the total cost assigned to an activity. It is the sum of all the cost elements
assigned to an activity.

Cost Drivers :- According to CIMA, ‘cost driver is any factor which causes a change in the cost
of an activity, e.g. the quality of parts received by an activity is a determining factor in the work
required by that activity and therefore affects the resources required. An activity may have
multiple cost drivers associated with it.’ In other words, cost driver means the factors which
determine the cost of an activity. For example, if we repeat the example of library, the number of
receipts and issue of books will be cost drivers, in a store, no. of stores requisitions will be cost
drivers, in customer order processing the no. of customers as well as no. of orders will be cost
drivers. Thus a cost driver is an activity which generates cost. Activity Based Costing is based on
the belief that activities cause costs and therefore a link should be established between activities
and product. The cost drivers thus are the link between the activities and the cost.

Identification of costs with the products: - The final stage in Activity Based Costing is to
identify the cost with the final products which can also be called as cost objects. Cost objects
include, products, services, customers, projects and contracts. As mentioned earlier, direct costs
can be identified easily with the products but the indirect costs can be linked with the products
by identifying activities and cost drivers. Thus Activity Based Costing is the process of tracing
costs first from resources to activities and then from activities to specific products.

Conclusion: - It can be concluded that the Activity Based Costing is a costing system which tries
to charge the indirect costs to the products and services fairly accurately. However for effective
implementation there is a need of involvement of the staff and their training on continuous basis.
Similarly there is a need to review the working of the system at periodic intervals and keep a
follow up of the feedback received. These actions will ensure effective implementation of the
system. Support of top management is also required for effective implementation of this system.
Activity Based Costing system is definitely a better system but much depends on the
implementation of the same.

Limitations of Activity Based Costing

Though this system is quite effective, it suffers from some limitations. These limitations are
given below.

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_ Activity Based Costing is a complex system and requires lot of records and tedious
calculations.
_ For small organizations, traditional cost accounting system may be more beneficial than
Activity Based Costing due to the simplicity of operation of the former.
_ Sometimes it is difficult to attribute costs to single activities as some costs support several
activities.
_ There is a need of trained professionals who are limited in number.
_ This system will be successful if there is a total support from the top management.
_ Substantial investment of time and money is required for the implementation of this system.

Activity Based Budgeting

A budget is a statement expressed in quantitative/monetary/both terms prepared prior to a
defined period of time for the policy to be pursued during that period for the purpose of
achieving a given objective. In other words, a budget is always prepared ahead of time, it is
expressed either in quantitative terms or monetary terms or both, it reflects the objective to be
achieved during that period and hence the policy to be followed during that period is put in the
budget. Budget helps in planning for the future. It also helps in controlling as there is a
continuous comparison of actual with budget. Any deviation between the two is identified for
taking suitable action.
The traditional budgeting is based on traditional cost accounting i.e. on the basis of allocation,
apportionment and absorption of overheads in the products. However, the Activity Based
Budgeting is different from the traditional budgeting in the sense that it provides a strong link
between the objectives of organization and objectives of a particular activity. In other words, it
involves identification of activities and dividing them in value adding and non value adding
activities. The non value adding activities are eliminated in due course of time. Activity Based
Budgeting, thus requires identification of activities of the organization, establishing the factors
which cause costs, the cost drivers and then collecting the costs of the activities in cost pools.
The following are the features of Activity Based Budgeting.
_ It uses the activity analysis to relate costs to activities.
_ It identifies cost improvement opportunities.
_ There is a clear link between strategic objectives and planning and the tactical planning of the
ABC process.

Activity Based Accounting

Activity Based Accounting is a broader term which involves in, ‘collection, recording, analysis,
controlling and reporting of activity related costs rather than departmental or cost centres related
costs.’ It involves several activities like Activity Based Budgeting, Cost management based on

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activities, performance measurement of activity, reducing the costs through elimination of non
value adding activities and also initiating innovative measure for reduction of costs.

Activity Based Management

The Activity Based Management is a tool of management that involves analyzing and costing
activities with the goal of improving efficiency and effectiveness. Though it is closely related to
the Activity Based Costing, still it differs from the same in its primary goal. The Activity Based
Costing focuses on activities with the object of measuring the cost of products/services. It tries to
compute the cost as accurately as possible. On the other hand Activity Based Management
focuses on managing the activities themselves. In Activity Based Costing resources are traced to
the activities for the purpose of computing the costs while in Activity Based Management,
resources are traced to activities for evaluation of the activities themselves.
In other words, efforts are made to improve the activities further. Thus Activity Based
Management is a set of actions that management can take, based on information from an Activity
Based Costing system, to increase/improve profitability.
For continuous improvement, Activity Based Management attempts the following analysis.
• Cost Driver Analysis: - The factors that cause activities to be performed need to be identified in
order to manage activity costs. Cost driver analysis identifies these casual factors. For example,
in a stores department, it may be observed that slow moving and obsolete stock is not disposed of
in time, the reason being the staff in the stores is not trained properly in this area. Managers have
to address this cost driver to correct the root cause of this problem and take proper action.
• Activity Analysis: - Activity Analysis identifies value added and non value added activities.
This analysis identifies the activities in the organization and the activity centres that should be
used in Activity Based Costing system. In Activity Based Management, as said above,
identification of activities into value adding and non value adding is made and efforts are made
to eliminate the non value adding activities.
• Performance Analysis: - Performance analysis involves the identification of appropriate
measures to report the performance of activity centres or other organizational units consistent
with each units goals and objectives. Performance Analysis aims to identify the best ways to
measure the performance of factors that are important to organizations in order to stimulate
continuous improvement.

Difference between Activity Based Costing And Activity Based Management: -

Activity Based Costing is logical distribution of overheads, i.e. overheads are distributed on the
basis of the consumption of resources. It helps to avoid distortion of costs of products/services.
On the other hand, Activity Based Management, on the other hand, is a discipline that focuses on
efficient management so as to value of services rendered to customers. This focus on activities is
being used effectively for cost reduction, business process re-engineering, benchmarking and

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performance measurement. Activity Based Management brings about a change in viewing at the
objective by incorporation of financial perspective, internal business perspective, innovation and
learning perspective.

Exercise 1:
You are the Trainee Management Accountant with N Ltd, a company involved in the production
of a large number of products for the sport and leisure industry in Iceland. The Managing
Director of N Ltd, Mrs. Dube, has just returned from a conference in London where the theme of
the conference was “Activity Based Costing (ABC) in the modern environment”. Mrs. Dube
would like to develop a better understanding of ABC before deciding on whether or not to
implement it into N Ltd.

Required:
Prepare a memorandum for Mrs. Dube explaining the following factors:
(a) The factors that led to the emergence of ABC.
(b) The advantages and disadvantages of adopting ABC in N Ltd.

Exercise 2:
Squash Ltd manufactures 2 products: Product S and Product T and sells these products at a price
which provides a 20% mark-up on absorption cost. Although Squash operates in a highly
competitive environment with intense price competition, sales of Product S regularly surpass
budget expectations. The sales volumes achieved for Product T are less satisfactory and in recent
years the actual sales volume achieved for this product has consistently been below the budgeted
level.
The company currently calculates absorption costs using a traditional volume based approach in
which overheads are absorbed on the basis of direct labour hours. Squash Ltd produces 6,000
units of Product S and 4,000 units of Product T every year. The following cost information is
currently available in respect of the most recent reporting period:
Product S Product T
Direct material cost per unit $68 $72
Direct labour cost per unit (@ $10 per hour) $30 $40
Budgeted fixed production overheads amount to $680,000 for the year.
A recent examination of production overheads led to the identification of the following activities,
activity costs and cost drivers.

Activity Cost Driver Cost Cost Driver Volumes Per Annum

Product S Product T Total
Purchasing No. of requisitions $120,000 600 200 800

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Setting-up No. of set-ups $180,000 310 140 450

Machining No. of machine hrs $240,000 4,200 3,800 8,000
Quality control No. of inspections $140,000 200 150 350

Required:
(a) Calculate the absorption cost per unit for Product S and for Product T using the overhead
absorption approach currently employed within Squash Ltd.
(b) Calculate the absorption cost per unit for Product S and for Product T if, on the basis of the
information provided above, an Activity Based Costing (ABC) approach was adopted.
(c) Discuss the appropriateness of introducing ABC to Squash Ltd given the company’s
particular circumstances.

Exercise 3:
Liboza Ltd. manufactures and sells components used in the computer hardware industry. The
company currently charge overheads to products using a plant-wide rate based on direct labour
hours. This method was introduced in 1988 when the company was established and the company
only produced one product. Since 1988, the company has invested heavily in advanced
manufacturing technologies and has increased their product range. Liboza Ltd. operates in a very
competitive market and due to current economic conditions they are coming under increasing
pressure by their customers to reduce their prices. The company is considering the introduction
of an Activity Based Costing (ABC) system and has provided the following information in
relation to their three products:
Product A Product B Product C
Direct materials per unit $100 $120 $150
Direct labour hours per unit 10 hours 8 hours 9 hours
Machine hours per unit 4 hours 6 hours 3 hours
Production/sales in units 10,000 4,000 6,000

Direct labour is paid at $14 per labour hour. The company calculates selling price by applying a
mark-up on cost of 25%.

Details of the overheads of Liboza Ltd. are as follows:

$
Machine related costs 246,000
Set-up costs 180,000
Delivery costs 68,000
Quality related costs 64,000

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Further information in relation to all three products is given as follows:

Product A Product B Product C
Number of set-ups 100 30 20
Number of deliveries 1,000 550 450
Number of inspections 200 100 100

Required:
(a) Calculate the unit production cost and unit profit using the traditional approach to
costing. (3 marks)
(b) Calculate the unit production cost and unit profit based on Activity Based Costing
principles. (12 marks)
(c) Identify three reasons why Liboza Ltd. should implement an Activity Based Costing
system. (3 marks)
(d) How ABC can be used to eliminate non-value added costs in Liboza Ltd (3 marks)
[Note: Figures to be rounded to two decimal places]

Exercise 4:

a) Discuss the different stages in activity based costing?

b) Explain the concept of cost driver?

Exercise 5:
P Co. produces two products, X and Y, both made from the same material. Until now, it has
used traditional absorption costing to allocate overheads to its products. The company is now
considering an activity based costing system. Information for the two products for the last year
is as follows:

X Y
Production and sales volumes (units) 30,000 50,000
Selling price per unit $20 $30
Raw material usage (kg) per unit 4 6
Direct labour hours per unit 0·6 0·44
Machine hours per unit 1.0 1.4
Number of production set ups per annum 24 36

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Number of purchase orders per annum 46 54

Number of deliveries to retailers per annum 20 25

The price for raw materials remained constant throughout the year at $2 per kg. Similarly, the
direct labour cost for the whole workforce was $15 per hour. The annual overhead costs were
as follows:

$
Machine set up costs 30,000
Machine running costs 40,000
Ordering costs 45,000
Delivery costs 45,000
Total Overhead cost 160,000

Required:
(a) Calculate the full cost and profit per unit for products X and Y under traditional
absorption costing, using direct labour hours as the basis for absorption.

(b) Calculate the full cost and profit per unit for each product using activity based costing.

Exercise 6:
JS Products Limited is a leading manufacturer of silver picture frames. The company used a
traditional costing system to allocate production overheads to products using machine hours.

The newly appointed financial controller believes that activity based costing would provide a
better allocation of production overheads to products than the current system. You are provided
with the following total production overheads for the last period recorded by the cost accounting
system.

$
Utility costs related to machine hours 189,000
Production set up costs 120,000
Cost of ordering materials 18,000
Cost of handling materials 33,000

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Details of the three models of products and relevant actual information for the last period are also
provided as follows.

Model1 Model2 Model3

Number of production runs 17 25 18
Number of material orders 20 30 40
Number of material requisitions 30 100 70
Units produced 1,000 2,000 2,500
Machine hours per unit 1 1.5 2
Direct labour hours per unit ($60 per hour) 0.5 hour 1 hour 2 hours
Direct material per unit $10 $12 $15

Required:

(a) Calculate the unit production cost of each of the three products using

(i) The traditional absorption costing, and

(ii) The activity based costing approach respectively. (20 marks)

(b) Comment o n the calculations in part (a) above and explain w h y the a c t i v i t y
based costing approach is superior to traditional absorption costing. (5 marks)

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Chapter seven:
Project appraisal- Investment decision making

Investment
Investment can be divided into capital expenditure and revenue expenditure and can be made
in noncurrent assets or working capital.
Investment is any expenditure in the expectation of future benefits. We can divide such
expenditure into two categories: capital expenditure, and revenue expenditure.

Suppose that a business purchases a building for $30,000. It then adds an extension to the
building at a cost of $10,000. The building needs to have a few broken windows mended, its
floors polished and some missing roof tiles replaced. These cleaning and maintenance jobs cost
$900. The original purchase ($30,000) and the cost of the extension ($10,000) are capital
expenditure because they are incurred to acquire and then improve a non-current asset. The
other costs of $900 are revenue expenditure because they merely maintain the building and thus
the earning capacity of the building.
Capital expenditure is expenditure which results in the acquisition of non-current assets or an
improvement in their earning capacity. It is not charged as an expense in the income statement;
the expenditure appears as a non-current asset in the statement of financial position.
Revenue expenditure is charged to the income statement and is expenditure which is incurred:
(a) For the purpose of the trade of the business - this includes expenditure classified as selling
and distribution expenses, administration expenses and finance charges
(b) To maintain the existing earning capacity of non-current assets

Non-current asset investment and working capital investment

Investment can be made in non-current assets or working capital.
(a) Investment in non-current assets involves a significant elapse of time between commitment
of funds and recoupment of the investment. Money is paid out to acquire resources which are
going to be used on a continuing basis within the organisation.
(b) Investment in working capital arises from the need to pay out money for resources (such as
raw materials) before it can be recovered from sales of the finished product or service. The funds
are therefore only committed for a short period of time.

Investment by the commercial sector

Investment by commercial organisations might include investment in:
Plant and machinery

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Research and development

Advertising
Warehouse facilities
The overriding feature of a commercial sector investment is that it is generally based on
financial considerations alone. The various capital expenditure appraisal techniques that we
will be looking at assess the financial aspects of capital investment.

Investment by not-for-profit organisations

Investment by not-for-profit organisations differs from investment by commercial organisations
for several reasons.
(a) Relatively few not-for-profit organisations' capital investments are made with the intention
of earning a financial return.
(b) When there are two or more ways of achieving the same objective (mutually exclusive
investment opportunities), a commercial organisation might prefer the option with the lowest
present value of cost.
Not-for-profit organisations, however, rather than just considering financial cost and financial
benefits, will often have regard to the social costs and social benefits of investments.
(c) The cost of capital that is applied to project cash flows by the public sector will not be a
'commercial' rate of return, but one that is determined by the government. Any targets that a
public sector investment has to meet before being accepted will therefore not be based on the
same criteria as those in the commercial sector.

The process of investment decision making

Capital budgeting is the process of identifying, analysing and selecting investment projects
whose returns are expected to extend beyond one year.

Creation of capital budgets

The capital budget will normally be prepared to cover a longer period than sales, production
and resource budgets, say from three to five years, although it should be broken down into
periods matching those of other budgets. It should indicate the expenditure required to cover
capital projects already underway and those it is anticipated will start in the three to five year
period (say) of the capital budget. The budget should therefore be based on the current
production budget, future expected levels of production and the long-term development of the
organisation, and industry, as a whole.

Budget limits or constraints might be imposed internally or externally.

(a) The imposition of internal constraints, which are often imposed when managerial resources
are limited, is known as soft capital rationing.

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(b) Hard capital rationing occurs when external limits are set, perhaps because of scarcity of
financing, high financing costs or restrictions on the amount of external financing an
organisation can seek.
Projects can be classified in the budget into those that generally arise from top management
policy decisions or from sources such as mandatory government regulations (health, safety and
welfare capital expenditure) and those that tend to be appraised using the techniques covered in
this chapter and the next.
Cost reduction and replacement expenditure
Expenditure on the expansion of existing product lines
New product expenditure
The administration of the capital budget is usually separate from that of the other budgets.
Overall responsibility for authorisation and monitoring of capital expenditure is, in most large
organisations, the responsibility of a committee. For example:
Expenditure up to $75,000 may be approved by individual divisional managers.
Expenditure between $75,000 and $150,000 may be approved by divisional management.
Expenditure over $150,000 may be approved by the board of directors.

The investment decision-making process

We have seen in the introduction to this chapter that capital expenditure often involves the outlay
of large sums of money, and that any expected benefits may take a number of years to
accrue. For these reasons it is vital that capital expenditure is subject to a rigorous process of
appraisal and control.
A typical model for investment decision making has a number of distinct stages.
Origination of proposals
Project screening
Analysis and acceptance
Monitoring and review
We will look at these stages in more detail below.

Origination of proposals
Investment opportunities do not just appear out of thin air. They must be created.
An organisation must therefore set up a mechanism that scans the environment for potential
opportunities and gives an early warning of future problems. A technological change that
might result in a drop in sales might be picked up by this scanning process, and steps should be
taken immediately to respond to such a threat.
Ideas for investment might come from those working in technical positions. A factory manager,
for example, could be well placed to identify ways in which expanded capacity or new

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machinery could increase output or the efficiency of the manufacturing process. Innovative
ideas, such as new product lines, are more likely to come from those in higher levels of
management, given their strategic view of the organisation’s direction and their knowledge of
the competitive environment.

The overriding feature of any proposal is that it should be consistent with the organisation’s
overall strategy to achieve its objectives. For example, an organisation’s strategy could be to
increase revenue by introducing new products, or targeting new customers or markets.
Employees from across the organisation can be involved in the evaluation of alternative
technologies, machines and project specifications. Some alternatives will be rejected early on.
Others will be more thoroughly evaluated.

Project screening
Each proposal must be subject to detailed screening. So that a qualitative evaluation of a
proposal can be made, a number of key questions such as those below might be asked before any
financial analysis is undertaken. Only if the project passes this initial screening will more
detailed financial analysis begin.
What is the purpose of the project?
Does it 'fit' with the organisation's long-term objectives?
Is it a mandatory investment, for example to conform with safety legislation?
What resources are required and are they available, eg money, capacity, labour?
Do we have the necessary management expertise to guide the project to completion?
Does the project expose the organisation to unnecessary risk?
How long will the project last and what factors are key to its success?
Have all possible alternatives been considered?

Analysis and acceptance

The analysis stage can be broken down into a number of steps.
Step 1 Complete and submit standard format financial information as a formal investment
proposal.
Step 2 Classify the project by type (to separate projects into those that require more or less
rigorous financial appraisal, and those that must achieve a greater or lesser rate of return
in
order to be deemed acceptable).
Step 3 Carry out financial analysis of the project.
Step 4 Compare the outcome of the financial analysis to predetermined acceptance criteria.
Step 5 Consider the project in the light of the capital budget for the current and future operating
periods.

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Step 6 Make the decision (go/no go).

Step 7 Monitor the progress of the project.

Financial analysis
The financial analysis will involve the application of the organisation's preferred investment
appraisal techniques. We will be studying these techniques in detail in this chapter and the
next. In many projects some of the financial implications will be extremely difficult to quantify,
but every effort must be made to do so, in order to have a formal basis for planning and
controlling the project.
Here are examples of the type of question that will be addressed at this stage.
What cash flows/profits will arise from the project and when?
Has inflation been considered in the determination of the cash flows?
What are the results of the financial appraisal?
Has any allowance been made for risk, and if so, what was the outcome?
Some types of project, for example a marketing investment decision, may give rise to cash
inflows and returns which are so intangible and difficult to quantify that a full financial
appraisal may not be possible. In this case more weight may be given to a consideration of the
qualitative issues.

Qualitative issues
Financial analysis of capital projects is obviously vital because of the amount of money involved
and the length of time for which it is tied up. A consideration of qualitative issues is also relevant
to the decision, however (ie factors which are difficult or impossible to quantify). We have
already seen that qualitative issues would be considered in the initial screening stage, for
example in reviewing the project's 'fit' with the organisation's overall objectives and whether it is
a mandatory investment. There is a very wide range of other qualitative issues that may be
relevant to a particular project.
(a) What are the implications of not undertaking the investment, eg adverse effect on staff
morale, loss of market share?
(b) Will acceptance of this project lead to the need for further investment activity in future?
(c) What will be the effect on the company's image?
(d) Will the organisation be more flexible as a result of the investment, and better able to
respond to market and technology changes?

Go/no go decision
Go/no go decisions on projects may be made at different levels within the organisational
hierarchy, depending on three factors.
The type of investment

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Its perceived riskiness

The amount of expenditure required
For example, a divisional manager may be authorised to make decisions up to $25,000, an area
manager up to $150,000 and a group manager up to $300,000, with board approval for greater
amounts. Once the go/no go (or accept/reject) decision has been made, the organisation is
committed to the project, and the decision maker must accept that the project’s success or failure
reflects on his or her ability to make sound decisions.

Monitoring the progress of the project

During the project's progress, project controls should be applied to ensure the following.
Capital spending does not exceed the amount authorised.
The implementation of the project is not delayed.
The anticipated benefits are eventually obtained.
The first two items are probably easier to control than the third, because the controls can
normally be applied soon after the capital expenditure has been authorised, whereas monitoring
the benefits will span a longer period of time.

Post audit
The post completion audit is a forward-looking rather than a backward-looking technique. It
seeks to identify general lessons to be learned from a project. A POST-COMPLETION
AUDIT (PCA) is 'An objective independent assessment of the success of a capital project in
relation to plan. Covers the whole life of the project and provides feedback to managers to aid
the implementation and control of future projects.' (CIMA Official Terminology)

Why perform a post-completion appraisal (PCA) or audit?

(a) The threat of the PCA will motivate managers to work to achieve the promised benefits
from the project.
(b) If the audit takes place before the project life ends, and if it finds that the benefits have
been less than expected because of management inefficiency, steps can be taken to
improve efficiency. Alternatively, it will highlight those projects which should be
discontinued.
(c) It can help to identify managers who have been good performers and those who have
been poor performers.
(d) It might identify weaknesses in the forecasting and estimating techniques used to evaluate
projects, and so should help to improve the discipline and quality of forecasting for
future investment decisions.

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(e) Areas where improvements can be made in methods which should help to achieve better
results in general from capital investments might be revealed.
(f) The original estimates may be more realistic if managers are aware that they will be
monitored, but post-completion audits should not be unfairly critical.

Which projects should be audited?

A reasonable guideline might be to audit all projects above a certain size, and a random
selection of smaller projects. A PCA does not need to focus on all aspects of an investment, but
should concentrate on those aspects which have been identified as particularly sensitive or
critical to the success of a project. The most important thing to remember is that post-
completion audits are time-consuming and costly and so careful consideration should be given
to the cost-benefit trade-off arising from the post-completion audit results.

When should projects be audited?

If the audit is carried out too soon, the information may not be complete. On the other hand, if
the audit is too late then management action will be delayed and the usefulness of the
information is greatly reduced.
There is no correct answer to the question of when to audit, although research suggests that in
practice most companies perform the PCA approximately one year after the completion of the
project.

Who performs a PCA?

Because it can be very difficult to evaluate an investment decision completely objectively, it is
generally appropriate to separate responsibility for the investment decision from that for the
PCA. Line management involved in the investment decision should therefore not carry out the
PCA. To avoid conflicts of interest, outside experts could even be used.

Problems with PCA

(a) There are many uncontrollable factors which are outside management control in long-
term investments, such as environmental changes.
(b) It may not be possible to identify separately the costs and benefits of any particular
project.
(c) PCA can be a costly and time-consuming exercise.
(d) Applied punitively, post-completion audit exercises may lead to managers becoming
over cautious and unnecessarily risk averse.
(e) The strategic effects of a capital investment project may take years to materialise and it
may in fact never be possible to identify or quantify them effectively.

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Despite the growth in popularity of post-completion audits, you should bear in mind the possible
alternative control processes.
(a) Teams could manage a project from beginning to end, control being used before the
project is started and during its life, rather than at the end of its life.
(b) More time could be spent choosing projects rather than checking completed projects.

Relevant cash flows

Relevant costs of investment appraisal include opportunity costs, working capital costs and
wider costs such as infrastructure and human development costs. Non-relevant costs include
past costs and committed costs.

Relevant cash flows in investment appraisals

The cash flows that should be considered in investment appraisals are those which arise as a
consequence of the investment decision under evaluation. Any costs incurred in the past, or any
committed costs which will be incurred regardless of whether or not an investment is
undertaken, are not relevant cash flows. They have occurred, or will occur, whatever
investment decision is taken. This includes centrally-allocated overheads that are not a
consequence of undertaking the project.

The annual profits from a project can be calculated as the incremental contribution earned
minus any incremental fixed costs which are additional cash items of expenditure (that is,
ignoring depreciation and so on). There are, however, other cash flows to consider. These might
include the following.

Opportunity costs
These are the costs incurred or revenues lost from diverting existing resources from their best
use.

Example: opportunity costs

If a salesman, who is paid an annual salary of $30,000, is diverted to work on a new project and
as a result existing sales of $50,000 are lost, the opportunity cost to the new project will be the
$50,000 of lost sales.
The salesman's salary of $30,000 is not an opportunity cost since it will be incurred however the
salesman's time is spent.

Residual value
The residual value or disposal value of equipment at the end of its life, or its disposal cost.

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Working capital
If a company invests $20,000 in working capital and earns cash profits of $50,000, the net cash
receipts will be $30,000. Working capital will be released again at the end of a project's life, and
so there will be a cash inflow arising out of the eventual realisation into cash of the project's
inventory and receivables in the final year of the project.

Other relevant costs

Costs that will often need to be considered include:
Infrastructure costs such as additional information technology or communication systems
Marketing costs may be substantial, particularly of course if the investment is in a new
product or service. They will include the costs of market research, promotion and branding and
the organisation of new distribution channels
Human resource costs including training costs and the costs of reorganisation arising from
investments

Relevant benefits of investments

Relevant benefits from investments include not only increased cash flows, but also savings and
better relationships with customers and employees.

Types of benefit
The benefits from a proposed investment must also be evaluated. These might consist of benefits
of several types.
(a) Savings because assets used currently will no longer be used. The savings should
include:
(i) Savings in staff costs
(ii) Savings in other operating costs, such as consumable materials
(b) Extra savings or revenue benefits because of the improvements or enhancements that the
investment might bring:
(i) More sales revenue and so additional contribution
(ii) More efficient system operation
(iii) Further savings in staff time, resulting perhaps in reduced future staff growth
(c) Possibly, some one-off revenue benefits from the sale of assets that are currently in use,
but which will no longer be required.
Some benefits might be intangible, or impossible to give a money value to.
(a) Greater customer satisfaction, arising from a more prompt service (eg because of a
computerised sales and delivery service).
(b) Improved staff morale from working with higher-quality assets.
(c) Better decision making may result from better information systems.

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Example: Relevant cash flows

Elsie is considering the manufacture of a new product which would involve the use of both a
new machine (costing $150,000) and an existing machine, which cost $80,000 two years ago and
has a current net book value of $60,000. There is sufficient capacity on this machine, which has
so far been under-utilised.
Annual sales of the product would be 5,000 units, selling at $32 per unit. Unit costs would be as
follows.
$
Direct labour (4 hours at $2 per hour) 8
Direct materials 7
Fixed costs including depreciation 9
24
The project would have a five-year life, after which the new machine would have a net residual
value of $10,000. Because direct labour is continually in short supply, labour resources would
have to be diverted from other work which currently earns a contribution of $1.50 per direct
labour hour. The fixed overhead absorption rate would be $2.25 per hour ($9 per unit) but actual
expenditure on fixed overhead would not alter.
Working capital requirements would be $10,000 in the first year, rising to $15,000 in the second
year and remaining at this level until the end of the project, when it will all be recovered. The
company's cost of capital is 20%. Ignore taxation.
You are required to identify the relevant cash flows for the decision as to whether or not the
project is worthwhile.

Solution
The relevant cash flows are as follows.
(a) Year 0 Purchase of new machine $150,000
(b) Years 1-5 $
Contribution from new product (5,000 units x $(32 – 15)) 85,000
Less contribution foregone(5,000 x (4 $1.50)) 30,000
55,000
(c) The project requires $10,000 of working capital at the end of year 1 and a further $5,000 at
the start of year 2. Increases in working capital reduce the net cash flow for the period to which
they relate. When the working capital tied up in the project is 'recovered' at the end of the
project, it will provide extra cash inflow (for example debtors will eventually pay up).
(d) All other costs, which are past costs, notional accounting costs or costs which would be
incurred anyway without the project, are not relevant to the investment decision.

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The payback method

Now that we have discussed all the stages involved in the capital budgeting process, we will
return to study in detail the stage that many managers consider to be the most important: the
financial appraisal. We will begin with what is probably the most straightforward appraisal
technique: the payback method. PAYBACK is 'The time required for the cash inflows from a
capital investment project to equal the cash outflows'. (CIMA Official Terminology)

When deciding between two or more competing projects, the usual decision is to accept the
one with the shortest payback. Payback is often used as a 'first screening method'. By this,
we mean that when a capital investment project is being subjected to financial appraisal, the first
question to ask is: 'How long will it take to pay back its cost?' The organisation might have a
target payback, and so it would reject a capital project unless its payback period was less than a
certain number of years.
However, a project should not be evaluated on the basis of payback alone. Payback should be a
first screening process, and if a project gets through the payback test, it ought then to be
evaluated with a more sophisticated project appraisal technique.
You should note that when payback is calculated, we take profits before depreciation, because
we are trying to estimate the cash returns from a project and profit before depreciation is likely
to be a rough approximation of cash flows.

Why is payback alone an inadequate project appraisal technique?

The reason why payback should not be used on its own to evaluate capital investments should
seem fairly obvious if you look at the figures below for two mutually exclusive projects (this
means that only one of them can be undertaken).
Project P Project Q
Capital cost of asset $60,000 $60,000
Profits before depreciation
Year 1 $20,000 $50,000
Year 2 $30,000 $20,000
Year 3 $40,000 $5,000
Year 4 $50,000 $5,000
Year 5 $60,000 $5,000
Project P pays back in year 3 (about one quarter of the way through year 3). Project Q pays back
half way through year 2. Using payback alone to judge projects, project Q would be
preferred. But the returns from project P over its life are much higher than the returns
from project Q. Project P will earn total profits before depreciation of $200,000 on an
investment of $60,000, whereas Project Q will earn total profits before depreciation of only
$85,000 on an investment of $60,000.

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Example:
An asset costing $120,000 is to be depreciated over ten years to a nil residual value. Profits after
depreciation for the first five years are as follows.
Year $
1 12,000
2 17,000
3 28,000
4 37,000
5 8,000
How long is the payback period to the nearest month?
A 3 years 7 months
B 3 years 6 months
C 3 years
D The project does not payback in five years

Advantages of the payback method

The use of the payback method does have advantages, especially as an initial screening device.
(a) Long payback means capital is tied up
(b) Focus on early payback can enhance liquidity
(c) Investment risk is increased if payback is longer
(d) Shorter-term forecasts are likely to be more reliable
(e) The calculation is quick and simple
Payback is an easily understood concept

Disadvantages of the payback method

There are a number of serious drawbacks to the payback method.
(a) It ignores the timing of cash flows within the payback period, the cash flows after the
end of the payback period and therefore the total project return.
(b) It ignores the time value of money (a concept incorporated into more sophisticated
appraisal methods). This means that it does not take account of the fact that $1 today is
worth more than $1 in one year's time. An investor who has $1 today can consume it
immediately or alternatively can invest it at the prevailing interest rate, say 10%, to get a
return of $1.10 in a year's time.

There are also other disadvantages.

(a) The method is unable to distinguish between projects with the same payback period.
(b) The choice of any cut-off payback period by an organisation is arbitrary.

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(c) It may lead to excessive investment in short-term projects.

(d) It takes account of the risk of the timing of cash flows but does not take account of the
variability of those cash flows.

The accounting rate of return method

The accounting rate of return (ARR) method (also called the return on capital employed (ROCE)
method or the return on investment (ROI) method) of appraising a project is to estimate the
accounting rate of return that the project should yield. If it exceeds a target rate of return, the
project will be undertaken.
The CIMA Official Terminology definition is [Average annual profit from investment / Average
investment] ×100
Unfortunately there are several different definitions of ARR.
ARR = [Estimated total profits/Estimated initial investment] × 100%
OR
ARR = [Estimated average profits/Estimated initial investment] × 100%

Note:
There are arguments in favour of each of these definitions. The most important point is, however,
that the method selected should be used consistently. For examination purposes we
recommend the first definition (CIMA's definition) unless the question clearly indicates that
some other one is to be used. Note that this is the only appraisal method that we will be studying
that uses profit instead of cash flow. If you are not provided with a figure for profit, assume
that net cash inflow minus depreciation equals profit.

Example:
A company has a target accounting rate of return of 20% (using the CIMA definition above), and
is now considering the following project.
Capital cost of asset $80,000
Estimated life 4 years
Estimated profit before depreciation
Year 1 $20,000
Year 2 $25,000
Year 3 $35,000
Year 4 $25,000
The capital asset would be depreciated by 25% of its cost each year, and will have no residual
value.

Required

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Assess whether the project should be undertaken.

Solution
The annual profits after depreciation, and the mid-year net book value of the asset, would be as
follows.
Year Profit after Mid-year net book ARR in the year
depreciation $ value $ %
1 0 70000 0
2 5000 50000 10
3 15000 30000 50
4 5000 10000 50

As the table shows, the ARR is low in the early stages of the project, partly because of low
profits in Year 1 but mainly because the NBV of the asset is much higher early on in its life. The
project does not achieve the target ARR of 20% in its first two years, but exceeds it in years 3
and 4. Should it be undertaken?
When the ARR from a project varies from year to year, it makes sense to take an overall or
'average' view of the project's return. In this case, we should look at the return over the four-
year period.
$
Total profit before depreciation over four years 105,000
Total profit after depreciation over four years 25,000
Average annual profit after depreciation 6,250
Original cost of investment 80,000
Average net book value over the four year period ((80,000 + 0)/2) 40,000
The project would not be undertaken because its ARR is 6,250/40,000 = 15.625% and so it
would fail to yield the target return of 20%.

The ARR and the comparison of mutually exclusive projects

The ARR method of capital investment appraisal can also be used to compare two or more
projects which are mutually exclusive. The project with the highest ARR would be selected
(provided that the expected ARR is higher than the company's target ARR).

The drawbacks and advantages to the ARR method of project appraisal

The ARR method has the serious drawback that it does not take account of the timing of the
profits from a project. Whenever capital is invested in a project, money is tied up until the
project begins to earn profits which pay back the investment. Money tied up in one project

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cannot be invested anywhere else until the profits come in. Management should be aware of the
benefits of early repayments from an investment, which will provide the money for other
investments.

There are a number of advantages.

(a) It is quick and simple to calculate
(b) It involves a familiar concept of a percentage return
(c) Accounting profits can be easily calculated from financial statements
(d) It looks at the entire project life
(e) Managers and investors are accustomed to thinking in terms of profit, and so an appraisal
method which employs profit may therefore be more easily understood

There are, however disadvantages to the ARR method.

(a) It is based on accounting profits which are subject to a number of different
accounting Treatments
(b) It is a relative measure rather than an absolute measure and hence takes no account of
the size of the investment
(c) It takes no account of the length of the project
(d) Like the payback method, it ignores the time value of money

Exercise:
A company is considering two capital expenditure proposals. Both proposals are for similar
products and both are expected to operate for four years. Only one proposal can be accepted.
The following information is available.
Profit/(loss) after depreciation
Proposal A Proposal B
$ $
Initial investment 46,000 46,000
Year 1 6,500 4,500
Year 2 3,500 2,500
Year 3 13,500 4,500
Year 4 (1,500) 14,500
Estimated scrap value at the end of year 4 4,000 4,000
Depreciation is charged on the straight line basis.
Required
(a) Calculate the following for both proposals.
(i) The payback period to one decimal place
(ii) The return on capital employed on initial investment, to one decimal place

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(b) Give two advantages for each of the methods of appraisal used in (a) above.

Discounted cash flow

There are two methods of using DCF to evaluate capital investments, the NPV method and the
IRR method. Discounted cash flow, or DCF for short, is an investment appraisal technique
which takes into account both the timings of cash flows and also total profitability over a
project's life.
Two important points about DCF are as follows.
(a) DCF looks at the cash flows of a project, not the accounting profits. Cash flows are
considered because they show the costs and benefits of a project when they actually occur
and ignore notional costs such as depreciation.
(b) The timing of cash flows is taken into account by discounting them. The effect of
discounting is to give a bigger value per $1 for cash flows that occur earlier: $1 earned
after one year will be worth more than $1 earned after two years, which in turn will be
worth more than $1 earned after five years, and so on.

Discounted cash flow is 'The discounting of the projected net cash flows of a capital project to
ascertain its present value. The methods commonly used are:
yield, or internal rate of return (IRR), in which the calculation determines the return in
the form of a percentage;
net present value (NPV), in which the discount rate is chosen and the present value is
expressed as a sum of money;
Discounted payback, in which the discount rate is chosen, and the payback is the number
of years required to repay the original investment.' (CIMA Official Terminology)

DCF looks at the cash flows of a project, not the accounting profits. Like the payback
technique of investment appraisal, DCF is concerned with liquidity, not profitability. Cash flows
are considered because they show the costs and benefit of a project when they actually occur. For
example, the capital cost of a project will be the original cash outlay, and not the notional cost of
depreciation which is used to spread the capital cost over the asset's life in the financial accounts.
The net present value (NPV) method
Net Present Value (NPV) is 'The difference between the sum of the projected discounted cash
inflows and outflows attributable to a capital investment or other long-term project'. (CIMA
Official Terminology)

The NPV method therefore compares the present value of all the cash inflows from a project
with the present value of all the cash outflows from a project. The NPV is thus calculated as
the PV of cash inflows minus the PV of cash outflows.

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(a) If the NPV is positive, it means that the present value of the cash inflows from a
project is greater than the present value of the cash outflows. The project should
therefore be undertaken.
(b) If the NPV is negative, it means that the present value of cash outflows is greater than
the present value of inflows. The project should therefore not be undertaken.
(c) If the NPV is exactly zero, the present value of cash inflows and cash outflows are
equal and the project will be only just worth undertaking.

Example:
ABC has a cost of capital of 15% and is considering a capital investment project, where the
estimated cash flows are as follows.
Year Cash flow $
0 (ie now) (100,000)
1 60,000
2 80,000
3 40,000
4 30,000

Required
Calculate the NPV of the project, and assess whether it should be undertaken.

Solution:
Year Cash flow Discount factor Present value
$ 15% $
0 (100,000) 1.000 (100,000)
1 60,000 1/(1.15)= 0.870 52,200
2 80,000 1/1.152 = 0.756 60,480
3 40,000 1/1.153 = 0.658 26,320
4 30,000 1/1.154 = 0.572 17,160
NPV = 56,160
(Note: The discount factor for any cash flow 'now' (time 0) is always 1, whatever the cost of
capital.)
The PV of cash inflows exceeds the PV of cash outflows by $56,160, which means that the
project will earn a DCF yield in excess of 15%. It should therefore be undertaken.

Timing of cash flows: conventions used in DCF

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Discounting reduces the value of future cash flows to a present value equivalent and so is clearly
concerned with the timing of the cash flows. As a general rule, the following guidelines should
be applied.
(a) A cash outlay to be incurred at the beginning of an investment project ('now') occurs in
time 0. The present value of $1 now, in time 0, is $1 regardless of the value of the
discount rate r. This is common sense. (Note that it is usual to assume that Year 0 is a
day, ie the first day of a project. Year 1 is the last day of the first year.)
(b) A cash flow which occurs during the course of a time period is assumed to occur all at
once at the end of the time period (at the end of the year). Receipts of $10,000 during
time period 1 are therefore taken to occur at the end of time period 1.
(c) A cash flow which occurs at the beginning of a time period is taken to occur at the end of
the previous time period. Therefore a cash outlay of $5,000 at the beginning of time
period 2 is taken to occur at the end of time period 1.

Assumptions in the NPV model

(a) Forecasts are assumed to be certain.
(b) Information is assumed to be freely available and costless.
(c) The discount rate is a measure of the opportunity cost of funds which ensures wealth
maximisation for all individuals and companies.

Question:
A project has the following forecast cash flows.
Year $
0 (280,000)
1 149,000
2 128,000
3 84,000
4 70,000
Using two decimal places in all discount factors, what is the net present value of the project
at a cost of capital of 16.5%?
A $27,906 B $29,270 C $32,195 D $33,580

The internal rate of return method

The IRR method of project appraisal is to calculate the exact DCF rate of return which the
project is expected to achieve, in other words the rate at which the NPV is zero.

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If the expected rate of return (the IRR yield or DCF yield) exceeds a target rate of return,
the project would be worth undertaking (ignoring risk and uncertainty factors).

The Internal Rate of Return (IRR) is 'The annual percentage return achieved by a project, at
which the sum of the discounted cash inflows over the life of the project is equal to the sum of
the discounted cash outflows'. (CIMA Official Terminology)
Without a computer or calculator program, an estimate of the internal rate of return is made
using either a graph or using a hit-and-miss technique known as the interpolation method.

The IRR method of investment appraisal is to accept projects whose IRR (the rate at which the
NPV is zero) exceeds a target rate of return. The IRR is calculated using interpolation.
Using the NPV method of discounted cash flow, present values are calculated by discounting at a
target rate of return, or cost of capital, and the difference between the PV of costs and the PV of
benefits is the NPV. In contrast, the internal rate of return (IRR) method is to calculate the
exact DCF rate of return which the project is expected to achieve, in other words the rate at
which the NPV is zero. If the expected rate of return (the IRR or DCF yield) exceeds a target
rate of return, the project would be worth undertaking (ignoring risk and uncertainty factors).
Without a computer or calculator program, the calculation of the internal rate of return is made
using a hit-and-miss technique known as the interpolation method.

Step 1 Calculate the net present value using the company's cost of capital.
Step 2 Having calculated the NPV using the company's cost of capital, calculate the NPV using
a second discount rate.
(a) If the NPV is positive, use a second rate that is greater than the first rate
(b) If the NPV is negative, use a second rate that is less than the first rate
Step 3 Use the two NPV values to estimate the IRR. The formula to apply is as follows.

IRR = [[A/(A-B)]( b – a)]%

Where a = the lower of the two rates of return used
b = the higher of the two rates of return used
A = the NPV obtained using rate a
B = the NPV obtained using rate b
Note. Ideally A will be a positive value and B will be negative. (If B is negative, then in the
equation above you will be subtracting a negative, i.e. treating it as an added positive).
Do not worry if you have two positive or two negative values, since the above formula will
extrapolate as well as interpolate. In the exam you will not have time to calculate NPVs using
more than two rates.

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Example: the IRR method

A company is trying to decide whether to buy a machine for $80,000 which will save costs of
$20,000 per annum for 5 years and which will have a resale value of $10,000 at the end of year
5. If it is the company's policy to undertake projects only if they are expected to yield a DCF
return of 10% or more, ascertain whether this project be undertaken.

Solution
Step 1 Calculate the first NPV, using the company's cost of capital of 10%
Year Cash flow PV factor 10% PV of cash flow
$ $
0 (80,000) 1.000 (80,000)
1–5 20,000 3.791 75,820
5 10,000 0.621 6,210
NPV = 2,030
This is positive, which means that the IRR is more than 10%.

Step 2 Calculate the second NPV, using a rate that is greater than the first rate, as the first
rate gave a positive answer.
Suppose we try 12%.
Year Cash flow PV factor12% PV of cash flow
$ $
0 (80,000) 1.000 (80,000)
1–5 20,000 3.605 72,100
5 10,000 0.567 5,670
NPV = (2,230)
This is fairly close to zero and negative. The IRR is therefore greater than 10% (positive
NPV of $2,030) but less than 12% (negative NPV of $2,230).
Step 3 Use the two NPV values to estimate the IRR.
The interpolation method assumes that the NPV rises in linear fashion between the two
NPVs close to 0. The IRR is therefore assumed to be on a straight line between NPV =
$2,030 at 10% and NPV = –$2,230 at 12%.
Using the formula
IRR = [[A/(A-B)]( b – a)]%
= [[2030/(2030+2230)](12-10)]%
=10.95%, say 11%
If it is company policy to undertake investments which are expected to yield 10% or more, this
project would be undertaken. If we were to draw a graph of a 'typical' capital project, with a

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negative cash flow at the start of the project, and positive net cash flows afterwards up to the end
of the project, we could draw a graph of the project's NPV at different costs of capital.

NPV and IRR compared

Unfortunately there are several disadvantages as well as advantages to the IRR method.
Managers should always bear these in mind.

Advantages of IRR method

(a) The main advantage is that the information it provides is more easily understood by
managers, especially non-financial managers. 'The project will be expected to have an initial
capital outlay of $100,000, and to earn a yield of 25%. This is in excess of the target yield of
15% for investments' is easier to understand than 'The project will cost $100,000 and have an
NPV of $30,000 when discounted at the minimum required rate of 15%'.
(b) A discount rate does not have to be specified before the IRR can be calculated. A hurdle
discount rate is simply required to which the IRR can be compared.

Disadvantages of IRR method

(a) If managers were given information about both ROCE (or ROI) and IRR, it might be easy
to get their relative meaning and significance mixed up.

(b) It ignores the relative size of investments. Both projects below have an IRR of 18%.
Project A Project B
$ $
Cost, year 0 350,000 35,000
Annual savings, years 1–6 100,000 10,000
Clearly, project A is bigger (ten times as big) and so more 'profitable' but if the only information
on which the projects were judged were to be their IRR of 18%, project B would be made to
seem just as beneficial as project A, which is not the case.
(c) When discount rates are expected to differ over the life of the project, such variations can be
incorporated easily into NPV calculations, but not into IRR calculations. And an adjustment can
be made to the discount rate used in NPV calculations to include an allowance for project risk.
(d) There are problems with using the IRR when the project has non-conventional cash flows or
when deciding between mutually exclusive projects.

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FACULTY OF COMMERCE

DEPARTMENT OF ACCOUNTING AND FINANCE

BACHELOR OF COMMERCE HONOURS DEGREE IN ACCOUNTING AND

FINANCE

PART IV FIRST SEMESTER EXAMINATION

MANAGEMENT ACCOUNTING [COAF 4105]

OCTOBER/NOVEMBER 2015

DURATION: 3 HOURS PLUS 15 MINUTES READING TIME

INSTRUCTIONS

1. Answer All Questions.

2. Begin each question on a new page.
3. Please indicate your study format (Conventional/Block/Parallel) on the cover of your
answer script.

INFORMATION
1. Questions may be attempted in any order.
2. Show all your workings.

This paper consists of five printed pages

QUESTION 1 [30 Marks]

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FX Corporation produces a single product RG. The company operates a standard absorption
costing system and a just-in-time purchasing system.
Standard production cost details per unit of product RG are:
$
Materials (5 kg at $20 per kg) 100
Labour (4 hours at $10 per hr) 40
Variable overheads (4 hours at $5 per hr) 20
Fixed overheads (4 hours at $12.50 per hr) 50

Fixed and variable overheads are absorbed on the basis of labour hours.
Budget data for product RG for July are detailed below: Production and sales 1,400 units
Selling price $250 per unit
Fixed overheads $70,000

Actual data for product RG for July are as follows: Production and sales 1,600 units

Selling price $240 per unit

Direct materials 7,300 kg costing $153,300
Direct labour 5,080 hours at $9 per hour
Variable overheads $25,400
Fixed overheads $74,000

Required:
(a) Prepare a statement that reconciles the budgeted and actual gross profit for product RG for
July showing the variances in as much detail as possible. [20 Marks]

b) GRV is a subsidiary of FX which processes chemical that produce sprays used by farmers to
protect their crops. One of these sprays is made by mixing three chemicals. The standard
material cost details for 1 litre of this spray is as follows:

$
0.4 litres of chemical A @ $30 per litre 12
0.3 litres of chemical B @ $20 per litre 6
0.5 litres of chemical C @ $15 per litre 7.50
Standard material cost of 1 litre of spray 25.50

During July GRV produced 1,000 litres of this spray using the following chemicals:

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600 litres of chemical A costing $18,000

250 litres of chemical B costing $8,000
500 litres of chemical C costing $8,500

You are the Management Accountant of GRV and the Production Manager has sent you the
following e-mail:

I was advised by our purchasing department that the worldwide price of chemical B had risen by
50%. As a result, I used an increased proportion of chemical A than is prescribed in the
standard mix so that our costs were less affected by this price change.

Required:

(a) Calculate the following operational variances:

(i) Direct material mix and [3 marks]

(ii) Direct material yield [2 marks]
(b) Discuss the decision taken by the Production Manager. [5 marks]

QUESTION 2 [30 Marks]

XYZ Ltd manufactures 2 products: Product S and Product T and sells these products at a price
which provides a 20% mark-up on absorption cost. Although XYZ operates in a highly
competitive environment with intense price competition, sales of Product S regularly surpass
budget expectations. The sales volumes achieved for Product T are less satisfactory and in recent
years the actual sales volume achieved for this product has consistently been below the budgeted
level.
The company currently calculates absorption costs using a traditional volume based approach in
which overheads are absorbed on the basis of direct labour hours. XYZ Ltd produces 6,000 units
of Product S and 4,000 units of Product T every year. The following cost information is currently
available in respect of the most recent reporting period:

Product S Product T
Direct material cost per unit $68 $72
Direct labour cost per unit (@ $10 per hour) $30 $40
Budgeted fixed production overheads amount to $680,000 for the year.

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A recent examination of production overheads led to the identification of the following activities,
activity costs and cost drivers.
Activity Cost Driver Cost Cost Driver Volumes Per Annum
Product S Product T
Purchasing No. of requisitions $120,000 600 200
Setting-up No. of set-ups $180,000 310 140
Machining No. of machine hrs $240,000 4,200 3,800
Quality control No. of inspections $140,000 200 150

Required
(a) Calculate the absorption cost per unit for Product S and for Product T using
the overhead absorption approach currently employed within XYZ Ltd. [7 marks]
(b) Calculate the absorption cost per unit for Product S and for Product T if, on
the basis of the information provided above, an Activity Based Costing (ABC) approach
was adopted. [15 marks]
(c) Discuss the appropriateness of introducing ABC costing to XYZ Ltd given the
company’s particular circumstances. [8 marks)

Question 3 [15 marks]

ABC is a food producer that makes low cost processed food that it sells to supermarkets. ABC
produces only one type of processed food product and production techniques have remained
largely unchanged for a number of years.
Over recent months, sales have been falling steadily. Consumer tastes are changing to favour
natural ingredients and supermarkets have reflected this in the products that they offer for sale.
ABC is keen to address the decline in sales and recently held a meeting to discuss the
performance of the organisation. The Management Accountant suggested to the Managing
Director that the performance of ABC could be improved by implementing Total Quality
Management (TQM) principles and adopting Kaizen costing concepts. Currently the control
systems of ABC focus on material price and usage.
The Managing Director is sceptical of the Management Accountant’s suggestions and is unclear
as to whether they are suitable for the company.

Required:

(e) Explain TWO concepts of Kaizen costing. [6 marks]

(f) Explain THREE conditions that must exist for TQM to be successfully implemented
at ABC. [9 marks]

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QUESTION 4 [15 Marks]

Liboza produces three products, X, Y and Z. The capacity of Liboza's plant is restricted by
process alpha. Process alpha is expected to be operational for eight hours per day and can
produce 3000 units of X per hour, 3750 units of Y per hour, and 1500 units of Z per hour.
Selling prices and material costs for each product are as follows.

Product Selling price Material cost

$ per unit $ per unit
X 375 175
Y 300 100
Z 750 250
Conversion costs are $1 800 000 per day.

Required:
(a) Calculate the profit per day if daily output achieved is 15 000 units of X, 11250 units
of Y and 3000 units of Z. [3 marks]
(b) Determine the efficiency of the bottleneck process given the output in (a). [5 marks]
(c) Calculate the TA ratio for each product. [4 marks]
(d) In the absence of demand restrictions for the three products, advise
Liboza's management on the optimal production plan. [3 marks]

ALL THE BEST!!

* END OF EXAMINATION PAPER*

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