FILE 20220108 101529 Management Information Study Manual 2019

The Institute of Chartered Accountants in England and Wales
MANAGEMENT
INFORMATION
For exams in 2019
Study Manual
www.icaew.com
Management Information
The Institute of Chartered Accountants in England and Wales
ISBN: 978-1-50972-000-2
Previous ISBN: 978-1-78363-884-0
First edition 2007

Twelfth edition 2018
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© ICAEW 2018
ii Contents ICAEW 2019

Welcome to ICAEW
As the future of our profession, I’d like to personally welcome you to ICAEW.
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ambitions, develop insights that matter and maintain a competitive edge.
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Chief Executive
ICAEW
ICAEW 2019 iii

Contents
 Key resources v
1 The fundamentals of costing 1
2 Calculating unit costs (Part 1) 27
3 Calculating unit costs (Part 2) 49
4 Marginal costing and absorption costing 85
5 Pricing calculations 109
6 Budgeting 131
7 Working capital 167
8 Performance management 203
9 Standard costing and variance analysis 241
10 Breakeven analysis and limiting factor analysis 273
11 Investment appraisal techniques 303
 Appendix 341
 Glossary of terms 345
 Index 355
The Management Information module enables you to prepare essential financial information for
the management of a business.
Questions within the Study Manual should be treated as preparation questions, providing you
with a firm foundation before you attempt the exam-standard questions. The exam-standard
questions are found in the Question Bank.
iv Contents ICAEW 2019

Key resources
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Be sure to visit the specific area for your qualification.
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qualification via your dashboard at icaew.com/dashboard.
ICAEW CFAB students, you can find everything you need at icaew.com/cfabstudents.
Syllabus and technical knowledge grids
This gives you the full breakdown of learning outcomes for each module and how your technical
knowledge will grow throughout the qualification.
Study guide
This guides you through your learning process, putting each chapter and topic of the Study
Manual into context and showing what learning outcomes are attached to them.
Exam webinars
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ICAEW 2019 Management Information v

vi Management Information ICAEW 2019
CHAPTER 1
The fundamentals of
costing
Introduction
Examination context
TOPIC LIST
1 What is cost accounting?
2 Basic cost accounting concepts
3 Cost classification for inventory valuation and profit measurement
4 Cost classification for planning and decision making
5 Cost classification for control
6 Ethics
Summary and Self-test
Answers to Interactive questions
Answers to Self-test
Introduction
Learning outcomes Tick off
 Recognise the use of cost information for different purposes
 Classify costs as fixed, variable, direct or indirect

 Identify and explain ethical issues relating to the preparation, presentation and
interpretation of financial information for the management of a business
The specific syllabus references for this chapter are: 1a, b, 5a.
Syllabus links
An understanding of how costs may be classified in different ways according to the purpose of
the information being prepared is fundamental to this syllabus and underpins many of the
learning outcomes. It also has links to the Accounting syllabus in the context of understanding
how costs are classified for the purposes of inventory valuation and profit measurement.
Examination context
Many of the fundamental aspects of costing covered in this chapter do not lend themselves
easily to numerical objective test questions.
Therefore, you are more likely to see the majority of these subjects in narrative questions. For
example, you might be required to pick out correct definitions or statements from a number of
statements supplied in a question, or you might have to identify an appropriate cost unit from a
number of suggestions for a particular organisation to use as the basis of its accounting system.
In the examination, students may be required to:
 understand the purpose of a cost unit
 classify costs as fixed, variable and semi-variable (or semi-fixed)
 understand what is meant by the elements of cost
 understand the difference between a direct cost and an indirect cost, between a
controllable cost and an uncontrollable cost and between a product cost and a period cost
 identify ethical issues relating to the preparation, presentation and interpretation of
financial information
Knowing the various definitions is fundamental to answering questions in this area. For example,
it is essential to determine the 'cost object' in a question (ie, the thing being costed), in order to
determine whether costs are direct or indirect as regards that cost object.
2 Management Information ICAEW 2019

1 What is cost accounting? C
H
A
Section overview P
T
 The management information system provides information to help management with E
planning, control and decision making. R
 In general terms, financial accounting is for external reporting whereas cost and 1
management accounting is for internal reporting.
 The financial accounting and cost accounting systems both record the same basic data but
each set of records may analyse the data in a different way. Ultimately, financial results
from both systems can, and should be, reconciled with each other.
1.1 The cost accountant

The cost accountant or a person having access to cost information should be able to provide the
answers to questions such as the following.
 What was the cost of goods produced or services provided last period?
 What was the cost of operating a department last month?
 What revenues were earned last week?
Knowing about costs incurred or revenues earned enables management to do the following.
 Assess the profitability of a product, a service, a department, or the whole organisation.
 Determine appropriate selling prices with due regard to the costs of sale and target profit
margins.
 Put a value on inventory (whether raw materials, work in progress, or finished goods) that is
still held at the end of a period, for preparing a balance sheet of the company's assets and
liabilities, and determining the cost of materials (goods) used or sold in a period.
These are all historical questions. The cost accountant also needs to provide information to help
provide forecasts or estimates for the future, such as:
 What are the future costs of goods and services likely to be?
 What information does management need in order to make sensible decisions about future
profits and costs?
 What financial resources will be needed to fund future growth or activities?
1.2 Cost accounting and management accounting

Originally cost accounting dealt with ways of accumulating historical costs and of charging these
costs to units of output, or to departments, in order to establish inventory valuations, profits or
losses and balance sheet items. It has since been extended into planning, control and decision
making, so that the cost accountant is now able to answer both sets of questions in section 1.1
above. In today's environment the role of cost accounting in the provision of management
information is therefore almost indistinguishable from that of management accounting, which is
basically concerned with the provision of information to help management with planning,
control and decision making.
ICAEW 2019 The fundamentals of costing 3

1.3 Cost accounting systems
The managers of a business have responsibility for planning and controlling the resources used.
To carry out this task effectively they must be provided with sufficiently accurate and detailed
information, and the cost accounting system should provide this. Indeed, a costing system
provides the foundations for an organisation's internal financial information system for
managers.
Cost accounting systems are not restricted to manufacturing operations.
 Cost accounting information is also used in service industries, government departments
and not-for-profit organisations, including charities.
 Within a manufacturing organisation itself, the cost accounting system should be applied
not only to manufacturing operations but also to administration, selling and distribution,
research and development and so on.
Cost accounting is concerned with providing information to help the following.
 Establishing inventory valuations, profits or losses and balance sheet items
 Planning (for example, the provision of forecast costs at different activity levels)
 Control (such as the provision of actual and standard costs (see Chapter 9) for comparison
purposes)
 Decision making (for example, the provision of information about actual unit costs for the
period just ended for pricing decisions)
1.4 Financial accounting versus cost accounting

The financial accounting and cost accounting systems in a business both record the same basic
data for income and expenditure, but each set of records may analyse the data in a different
way. This is because each system has a different purpose.
 Financial accounts are usually prepared for stakeholders external to an organisation, eg,
shareholders, banks, customers, suppliers, HMRC and employees.
 Management accounts are usually prepared for internal managers of an organisation.
The data used to prepare financial accounts and management accounts are the same. The
differences between the financial accounts and the management accounts arise because the
data is usually analysed differently.
Financial accounts Management accounts
Financial accounts detail the performance of Management accounts are used to aid
an organisation over a defined period, management to record, plan and control the
including its cash flows and the state of affairs organisation's activities and to help the
at the end of that period. decision-making process.
In the UK, limited companies must, by law, There is no legal requirement to prepare
prepare financial accounts. management accounts.
The format of published financial accounts is The format of management accounts is entirely
determined by law (mainly the Companies at management discretion: no strict rules
Acts), by Statements of Standard Accounting govern the way they are prepared or
Practice and by Financial Reporting Standards. presented. Each organisation can devise its
In theory the accounts of different own management accounting system and
organisations can therefore be easily format of reports.
compared.

Financial accounts Management accounts
C
H
Financial accounts often concentrate on the Management accounts can focus on specific A
business as a whole, aggregating revenues areas of an organisation's activities such as P
and costs from different operations, and are operating departments, individual sites or T
wholly historical. business streams. Information may be produced E
R
to aid a decision rather than to be an end
product of a decision. 1
Most financial accounting information is of a Management accounts incorporate non-

monetary nature. monetary measures. Management may need
to know, for example, tonnes of product
produced, monthly machine hours, or miles
travelled by sales representatives. These are
often called 'Key Performance Indicators'.
Financial accounts present an essentially Management accounts are both a historical
historical picture of past operations. record and a future planning tool, linking to
budgets and forecasts.
IAS 1 changes the titles of financial statements as they will be used in IFRSs.
 'Balance sheet' will become 'statement of financial position'
 'Income statement' will become 'statement of comprehensive income'
 'Cash flow statement' will become 'statement of cash flows'
Entities are not required to use the new titles in their financial statements. Consequently this
Study Manual may use these terms interchangeably.
2 Basic cost accounting concepts
Section overview
 A cost object is anything for which we are trying to ascertain the cost.
 Cost units are the basic control units for costing purposes.
 The term 'cost' can be used as a noun or as a verb.
 Costs need to be arranged into logical groups or classified in order to facilitate an efficient
system for collecting and analysing costs.
2.1 Functions and departments

An organisation, whether it is a manufacturing company, a provider of services (such as a bank
or a hotel) or a public sector organisation (such as a hospital), may be divided into a number of
different functions, within which there are a number of departments. A manufacturing
organisation might be structured as follows.

Board of directors
Production Administration Marketing
Mixing Baking Stores
Figure 1.1: Manufacturing organisation structure

Suppose the organisation above produces chocolate cakes for a number of supermarket chains.
The production function is involved with the making of the cakes, the administration department
with the preparation of accounts and the employment of staff and the marketing department
with the selling and distribution of the cakes.
Within the production function there are three departments, two of which are production
departments (the mixing department and the baking department), which are actively involved in
the production of the cakes, and one of which is a service department (stores department),
which provides a service or back-up to the production departments.
A service business, such as a hotel, may be structured as follows.
Board of directors
Service Administration Marketing

personnel
Front Housekeeping Maintenance Catering

office
Figure 1.2: Service organisation structure
2.2 Cost objects
Definition
Cost object: Anything for which we are trying to ascertain the cost.
Examples of cost objects include:

 a unit of product (eg, a car)
 a unit of service (eg, a valet service of a car)
 a department or function (eg, the accounts department)
 a project (eg, the installation of a new computer system)
 a new product or service (eg, to enable the cost of development to be identified)
In the example above, cost objects could include:
 individual chocolate cakes
 the administration function or mixing department

2.3 Cost units
C
H
A
Definition
P
Cost unit: The basic measure of product or service for which costs are determined. T
E
R
Businesses are often interested in one particular cost object – the cost unit – and the cost per 1
cost unit. Determining the cost per cost unit can help with pricing decisions, which you will study
in more detail in Chapter 5.
Organisation Possible cost unit

Steelworks Tonne of steel produced
Tonne of coke used
Hospital Patient/day
Operation
Out-patient visit
Freight organisation Tonne/kilometre
Passenger transport organisation Passenger/kilometre
Accounting firm Audit performed
Chargeable hour
Restaurant Meal served
2.4 Composite cost units

Notice that some of the cost units in the above table are made up of two parts; for example, the
patient/day cost unit for the hospital. These two-part cost units are known as composite cost
units and they are used most often in service organisations.
Composite cost units help to improve cost control. For example, the measure of 'cost per
patient' might not be particularly useful for control purposes. The cost per patient will vary
depending on the length of the patient's stay, therefore monitoring costs using this basis would
be difficult.
The cost per patient/day is not affected by the length of the individual patient's stay. Therefore it
would be more useful for monitoring and controlling costs. Similarly, in a freight organisation
the cost per tonne/kilometre (the cost of carrying one tonne for one kilometre) would be more
meaningful for control than the cost per tonne carried, which would vary with the distance
travelled.
Interactive question 1: Cost units

Identify which of the following cost objects would be suitable cost units for an hotel. Tick the
boxes to indicate which would be suitable.
Suitable cost unit Suitable cost unit
Bar Conference delegate

Restaurant Fitness suite
Room/night Conference room/day
Meal served
See Answer at the end of this chapter.

2.5 The concept of cost
The term 'cost' can be used as a noun when describing the amount of money incurred in
producing a product: 'The cost to produce 100 units of product X last period was £3,400'.
Alternatively, 'cost' can be used as a verb, for example when describing the act of determining
the amount of money incurred in operating a department: 'Please gather the information
necessary to cost the quality control activity'.
You will rarely see the word 'cost' used alone. Costs need to be classified in some way so that
they can be arranged into logical groups in order to facilitate an efficient system for collecting
and analysing costs.
As you work through this Study Manual you will encounter many different types of cost, each of
which has its usefulness and limitations in various circumstances.
2.6 Direct v indirect costs and cost objects

Direct costs are costs identified with a cost object. Indirect costs cannot be identified with a
particular cost object. For example if a chair is a cost object then certain costs such as materials
and the labour required to assemble the chair would be classed as direct costs for an individual
chair. Factory rent could not be associated with an individual chair so would be classed as an
indirect cost of the chair. However, if the cost object were the factory itself then the rent is a
direct cost of the factory.
3 Cost classification for inventory valuation and profit

measurement
Section overview
 The total cost of a cost unit is usually made up of three cost elements: materials, labour
and other expenses. Each of these cost elements can be classified as direct costs or
indirect costs.
 A direct cost can be traced in full to the cost unit that is being costed.
 The total direct cost (or 'prime cost') is the sum of the direct material cost + direct labour
cost + direct expenses.
 An indirect cost (or overhead) cannot be traced directly and in full to the cost unit that is
being costed.
 Types of indirect cost (or overhead) include production overhead, administration
overhead, selling overhead and distribution overhead.
 Product costs are costs identified with goods produced or purchased for resale. These
costs are allocated to the value of inventory until the goods are sold.
 Period costs are costs deducted as expenses during a particular period. These costs are
not regarded as part of the value of inventory.
In this section we are only concerned with cost units (ie, an individual job or unit of product or
unit of service) as the cost object.

3.1 Cost elements
C
For the purposes of inventory valuation and profit measurement, the cost of one unit must be H
determined. The total cost of a cost unit of product or service is made up of the following three A
P
elements of cost. T
E
 Materials R
 Labour
 Other expenses (such as rent and rates, interest charges and so on) 1
Cost elements can be classified as direct costs or indirect costs as far as cost units are
concerned.
3.2 Direct cost and prime cost
Definition
Direct cost: A cost that can be traced in full to the cost unit.
There are three types of direct cost.

 Direct material costs are the costs of materials that are known to have been used in making
and selling a unit of product (or providing a service). Examples are components and
packing materials.
 Direct labour costs are the specific costs of the workforce used to make a unit of product or
provide a service. Direct labour costs are established by quantifying the cost of the time
taken for a job, or the time taken in 'direct production work'. For example, the wages paid
to an employee sewing buttons on a coat is a direct cost of that cost unit.
 Other direct expenses are those expenses that have been incurred in full as a direct
consequence of making a unit of product, or providing a service, or running a department.
For example, the cost of hiring a special machine for a job is a direct cost of that job.
Another term used to describe the total direct cost is prime cost.
Prime cost = total direct cost = direct material cost + direct labour cost + direct expenses
3.3 Indirect cost and overhead
Definition
Indirect cost (or overhead): A cost that is incurred which cannot be traced directly and in full to
the cost unit.
Examples of indirect costs, where the cost object is a unit of output, might be the cost of
supervisors' wages on a production line or cleaning materials and buildings insurance for a
factory. These costs cannot be traced directly and in full to the cost unit in question.

Total expenditure may therefore be analysed as follows.
Materials cost = Direct materials cost + Indirect materials cost

+ + +
Labour cost = Direct labour cost + Indirect labour cost
+ + +
Expenses = Direct expenses + Indirect expenses
Total cost = Direct cost/prime cost + Indirect cost/overhead
3.3.1 Production overhead

Production (or manufacturing or factory) overhead includes all indirect material costs, indirect
wages and indirect expenses incurred in the factory from receipt of the order until its
completion, including:
 Indirect materials, which cannot be traced to units of the finished product.
– Consumable stores, eg, material used in negligible amounts or across several different
products
 Indirect wages, meaning all wages not charged directly to a unit of product.
– Salaries of non productive personnel in the production department, eg, supervisor
 Indirect expenses (other than material and labour) not charged directly to units of
production.
– Rent, rates and insurance of a factory
– Depreciation, fuel, power and maintenance of plant and buildings
3.3.2 Administration overhead

Administration overhead is all indirect material costs, wages and expenses incurred in the
direction, control and administration of an undertaking, including:
 depreciation of office equipment
 office salaries, including the salaries of secretaries and accountants
 rent, rates, insurance, telephone, heat and light cost of general offices
3.3.3 Selling overhead

Selling overhead is all indirect materials costs, wages and expenses incurred in promoting sales
and retaining customers, including:
 printing and stationery, such as catalogues and price lists
 salaries and commission of sales representatives
 advertising and sales promotion, market research
 rent, rates and insurance for sales offices and showrooms
3.3.4 Distribution overhead

Distribution overhead is all indirect material costs, wages and expenses incurred in making the
packed product ready for despatch and delivering it to the customer, including:
 cost of packing cases
 wages of packers, drivers and despatch clerks
 depreciation and running expenses of delivery vehicles

3.4 Product costs and period costs
C
For the preparation of financial statements, costs are often classified as either product costs or H
A
period costs. Product costs are costs identified with goods produced or purchased for resale.
P
Period costs are costs deducted as expenses during a particular period. T
E
Consider a retailer who acquires goods for resale without changing their basic form. The only R
product cost is therefore the purchase cost of the goods. Any unsold goods are held as
inventory. The inventory is valued at the lower of purchase cost and net realisable value, which is 1
the valuation basis stipulated in accounting standards, and included as an asset in the balance
sheet. As the goods are sold, their cost becomes an expense in the form of 'cost of goods sold'.
A retailer will also incur a variety of selling and administration expenses. Such costs are period
costs because they are deducted from revenue without ever being regarded as part of the value
of inventory.
Now consider a manufacturing firm in which direct materials are transformed into saleable
goods with the help of direct labour and factory overheads. All these costs, even the factory
overheads, are product costs because they are allocated to the value of inventory until the
goods are sold (see Chapter 3). As with the retailer, selling and administration expenses are
regarded as period costs.
4 Cost classification for planning and decision making
Section overview
 Costs can be classified according to how they vary in relation to the level of activity.
 A knowledge of how the cost incurred varies at different activity levels is essential to
planning and decision making.
 A fixed cost is not affected by changes in the level of activity.
 A variable cost increases or decreases as the level of activity increases or decreases.
 A semi-variable cost is partly fixed and partly variable and is therefore partly affected by a
change in the level of activity.
 The relevant range is the range of activity levels within which assumed cost behaviour
patterns occur.
4.1 Cost behaviour patterns

A different way of classifying costs is in terms of their behaviour patterns. This means grouping
costs according to how they vary in relation to the level of activity.
The level of activity can be measured in a variety of different ways depending on the
circumstances. Examples of possible ways of measuring the level of activity are as follows.
 The volume of production in a period
 The number of items sold
 The number of invoices issued
 The number of units of electricity consumed
Planning and decision making are concerned with future events and so managers require
information on expected future costs and revenues. A knowledge of how the cost incurred
varies at different levels of activity is essential to planning and decision making.
For our purposes in this chapter, the level of activity will generally be taken to be the volume of
production/output or sales.

4.2 Fixed costs
Definition
Fixed cost: A cost that, within a relevant range of activity levels, is not affected by increases or
decreases in the level of activity.
Fixed costs are a period charge, in that they relate to a span of time; as the time span increases,
so too will the fixed costs. Figure 1.3 shows a sketch graph of a fixed cost.
Graph of fixed cost
£
Cost
Volume output (level of activity)
Figure 1.3: Fixed cost

Examples of fixed costs include the following.
 The salary of the managing director (per month or per annum)
 The rent of a single factory building (per month or per annum)
 Straight-line depreciation of a single machine (per month or per annum)
4.3 Variable costs
Definition
Variable cost: A cost that increases or decreases as the level of activity increases or decreases.
A variable cost tends to vary directly with the level of activity. The variable cost per unit is the
same amount for each unit produced whereas total variable cost increases as volume of output
increases. Figure 1.4 shows a sketch graph of a variable cost.
Graph of variable cost
£
Cost
Volume of output
Figure 1.4: Variable cost

Examples of variable costs include the following.
C
 The cost of raw materials (where there is no discount for bulk purchasing, since bulk H
purchase discounts reduce the unit cost of purchases). A
P
 Direct labour costs, which are usually classed as a variable cost even though basic wages T
are often fixed. E
R
 Sales commission that is variable in relation to the volume or value of sales.
1
4.4 Semi-variable costs (or semi-fixed costs or mixed costs)
Definition
Semi-variable, semi-fixed or mixed costs: Costs that are part-fixed and part-variable and are
therefore partly affected by changes in the level of activity.
Examples of semi-variable costs include the following.

 Electricity and gas bills. There may be a 'standing' basic charge plus a charge per unit of
consumption.
 Sales representative's salary. The sales representative may earn a basic monthly amount
plus a commission based on the value of sales made.
The behaviour of a semi-variable cost can be presented graphically as shown in Figure 1.5.
£
Cost
Variable part
Fixed part
Volume of output
(or, say, value of sales)
Figure 1.5: Semi-variable cost
4.5 Cost behaviour and total and unit costs

If the variable cost of producing a unit is £5 per unit then it will remain at that cost per unit no
matter how many units are produced (within the relevant range).
However, if the business's fixed costs are £5,000 then the fixed cost per unit will decrease the
more units are produced: for example, one unit will have fixed costs of £5,000 per unit; if 2,500
are produced the fixed cost per unit will be £2; if 5,000 are produced the fixed cost per unit will
be only £1. Thus as the level of activity increases the total costs per unit (fixed cost plus variable
cost) will decrease.

In sketch graph form this may be illustrated as shown in Figure 1.6.
Variable cost Fixed cost Total cost
Cost Cost Cost
per per per
unit unit unit
£ £ £
Number of units Number of units Number of units
Figure 1.6: Cost behaviour

Interactive question 2: Fixed, variable or semi-variable cost?
Tick the appropriate box for each cost.
Fixed Variable Semi-variable
(a) Telephone bill
(b) Annual salary of the chief accountant
(c) Cost of materials used to pack 20 units of

product X into a box
4.6 The relevant range
Definition
The relevant range: The range of activity levels within which assumed cost behaviour patterns
occur.
For example, a fixed cost is only fixed for levels of activity within the relevant range, after which it
could 'step up'.
The relevant range also broadly represents the activity levels at which an organisation has had
experience of operating in the past and for which cost information is available. It can, therefore,
be dangerous to attempt to predict costs at activity levels that are outside the relevant range
(extrapolation).
For example, the rent of a factory is generally assumed to be a fixed cost. However, if the volume
of activity increases beyond the relevant range then it may be necessary to rent an extra factory.
The rent cost will then increase to a new, higher level. This is called a step increase in fixed cost
and can be represented graphically as shown in Figure 1.7.
£
Cost
Relevant
range
Level of activity
Figure 1.7: Step increase

Interactive question 3: Activity levels
C
Select the correct words in the following sentence. H
A
In general, as activity levels rise within a relevant range, the variable cost per unit will (a) P
rise/fall/stay the same, the fixed cost per unit will (b) rise/fall/stay the same and the total cost T
E
per unit will (c) rise/fall/stay the same.
R
1
Interactive question 4: Cost behaviour graphs

Match the sketches (1) to (4) below to the listed items of expense. In each case the vertical axis
relates to total cost, the horizontal axis to activity level. Each graph may be used more than once.
Write the graph number in the space provided.
(a) Electricity bill: a standing charge for each period plus a charge for each unit of electricity
consumed.
(b) Supervisory labour, which is paid as a monthly salary.
(c) Sales commission, which amounts to 2% of sales revenue.
(d) Machine rental cost of a single item of equipment. The rental agreement is that £10 should
be paid for every machine hour worked each month, subject to a maximum monthly charge
of £480.
(e) Photocopier rental costs. The rental agreement is that £80 is paid each month, plus £0.01
per photocopy taken.
(1) (2)
(3) (4)

Expense description Graph number
(a)
(b)
(c)
(d)
(e)
5 Cost classification for control
Section overview
 For control purposes the most effective classification of costs is by responsibility, ie,
according to whether the costs are controllable or uncontrollable by a particular manager.
 A system of responsibility accounting segregates costs and revenues into areas of
personal responsibility in order to monitor and assess the performance of each part of the
organisation.
 A responsibility centre is a part of a business whose performance is the direct
responsibility of a specific manager.
 An uncontrollable cost is a cost that cannot be influenced by a manager within a given
time span.
5.1 Responsibility accounting

Allocating costs to products is not always useful for the purposes of control, as the production of
a product, say, may consist of a number of operations, each of which is the responsibility of a
different person. A product cost does not therefore provide a link between costs incurred and
areas of responsibility. So costs (or revenues) must be traced in another way to the individuals
responsible for each cost or revenue. This 'other way' is known as responsibility accounting.
Definitions
Responsibility accounting: A system of accounting that segregates revenue and costs into areas
of personal responsibility in order to monitor and assess the performance of each part of an
organisation.
A responsibility centre: A department or function whose performance is the direct responsibility
of a specific manager.
Managers of responsibility centres should only be held accountable for costs over which they
have significant influence. From a motivation or incentivisation point of view this is important
because it can be very demoralising for managers to have their performance judged on the
basis of something over which they have no influence. It is also important from a control point of
view that management reports should ensure that information on costs is reported to the
manager who is able to take action to control them.

Responsibility accounting attempts to associate costs, revenues, assets and liabilities with the
managers most capable of controlling them. As a system of accounting, it therefore C
H
distinguishes between controllable and uncontrollable costs. A
P
T
5.2 Controllable and uncontrollable costs E
R
Definitions 1
Controllable cost: A cost that can be influenced by management decisions and actions.
Uncontrollable cost: A cost that cannot be affected by management within a given time span.
Most variable costs within a department are thought to be controllable in the short term
because managers can influence the efficiency with which resources are used, even if they
cannot do anything to raise or lower price levels.
A cost that is not controllable by a junior manager might be controllable by a senior manager.
For example, there may be high direct labour costs in a department caused by excessive
overtime working. The junior manager may feel obliged to continue with the overtime to meet
production schedules, but his senior may be able to reduce costs by hiring extra full-time staff,
thereby reducing the requirements for overtime.
A cost that is not controllable by a manager in one department may be controllable by a
manager in another department. For example, an increase in material costs may be caused by
buying at higher prices than expected (controllable by the purchasing department) or by
excessive wastage (controllable by the production department) or by a faulty machine
producing rejects (controllable by the maintenance department).
Some costs are non-controllable, such as increases in expenditure due to inflation. Other costs
are controllable, but in the long term rather than the short term. For example, production costs
might be reduced by the introduction of new machinery and technology, but in the short term,
management must attempt to do the best they can with the resources and machinery at their
disposal.
6 Ethics
Section overview
 What are the ethical issues relating to the preparation, presentation and interpretation of
financial information?
6.1 Introduction
Cost accountants are often involved in the preparation and reporting of information to help
management with planning, control and decision making. Such information may include
forecasts, budgets and variance analysis which we will consider in detail in later chapters.
6.2 ICAEW ethical guidance for accountants involved in the preparation and
reporting of information
6.2.1 Fundamental principles
ICAEW defines a professional accountant as 'an individual who is a member of an IFAC member
body'. A professional accountant in business is defined as 'a professional accountant employed
or engaged in an executive or non-executive capacity in such areas as commerce, industry,

service, the public sector, education, the not for profit sector, regulatory bodies or professional
bodies, or a professional accountant contracted by such entities.'
ICAEW provides ethical guidance that will ensure professional accountants in business prepare
and report information fairly, honestly and in accordance with relevant professional standards
so that the information will be understood in its context. The guidance is also designed to
ensure that professional accountants in business take reasonable steps to maintain information
for which they are responsible in a manner that:
 describes clearly the true nature of business transactions, assets or liabilities
 classifies and records information in a timely and proper manner
 represents the facts accurately and completely in all material respects
The guidance can be found at icaew.com and much of this is dealt with in the certificate level
Business, Technology and Finance syllabus.
The guidance is applicable to both members in practice and members in business (eg,
professional accountants involved in the preparation and reporting of information to help
management).
Fundamental Principle 1 – 'Integrity'
A member should behave with integrity in all professional and business relationships.
Integrity implies not only honesty but fair dealing, truthfulness and being straightforward. A
member's advice and work must be uncorrupted by self-interest and not be influenced by the
interests of other parties. A member should not be associated with information that is false or
misleading or supplied recklessly.
Fundamental Principle 2 – 'Objectivity'
A member should strive for objectivity in all professional and business judgements.
Objectivity is the state of mind which has regard to all considerations relevant to the task in hand
but no other. There should be no bias, conflict of interest or undue influence of others.
Fundamental Principle 3 – 'Professional competence and due care'
When providing professional services 'professional competence and due care' therefore mean:
 having appropriate professional knowledge and skill
 having a continuing awareness and an understanding of relevant technical, professional
and business developments
 exercising sound and independent judgement
 acting diligently, that is:
– carefully
– thoroughly
– on a timely basis
– in accordance with the requirements of an assignment
 acting in accordance with applicable technical and professional standards
 distinguishing clearly between an expression of opinion and an assertion of fact
Fundamental Principle 4 – 'Confidentiality'
The professional accountant should assume that all unpublished information about a
prospective, current or previous client's or employer's affairs, however gained, is confidential.
Information should then:
 be kept confidential (confidentiality should be actively preserved)
 not be disclosed, even inadvertently such as in a social environment
 not be used to obtain personal advantage

Fundamental Principle 5 – 'Professional behaviour'
C
Behaving professionally means: H
A
 complying with relevant laws and regulations P
T
 avoiding any action that discredits the profession (the standard to be applied is that of a E
reasonable and informed third party with knowledge of all relevant information) R
 conducting oneself with: 1
– courtesy; and
– consideration.
When marketing themselves and their work, professional accountants should:
 be honest and truthful
 avoid making exaggerated claims about:
– what they can do
– what qualifications and experience they possess
 avoid making disparaging references to the work of others
6.2.2 Threats and safeguards
Threats to compliance with the fundamental principles, such as self-interest or intimidation
threats to objectivity or professional competence and due care, are created where a
professional accountant in business is pressured (either externally or by the possibility of
personal gain) to become associated with misleading information or to become associated with
misleading information through the actions of others.
Accordingly, professional accountants should take steps to ensure they are not associated with
reports, returns, communications or other information where they believe that the information:
 contains a materially false or misleading statement
 contains statements or information furnished recklessly
 omits or obscures information required to be included where such omission or obscurity
would be misleading
The significance of such threats depends on factors such as the source of the pressure and the
degree to which the information is, or may be, misleading. The significance of the threat should
be evaluated and safeguards applied where necessary to eliminate them or reduce them to an
acceptable level. Such safeguards include consultation with superiors within the employing
organisation (such as a line manager), the audit committee, or those charged with governance
of the organisation, or ICAEW.
Where it is not possible to reduce the threat(s) to an acceptable level, the professional
accountant in business should refuse to be or remain associated with any information they
determine to be misleading.
Sometimes, a professional accountant in business may be unknowingly associated with
misleading information. Upon becoming aware of this, the professional accountant in business
should take steps to be disassociated from the information.
In determining whether there is a requirement to report, the professional accountant in business
may consider obtaining legal advice. In addition, the professional accountant my consider
whether to resign.

Summary
Financial information
Financial accounting Management accounting

Aggregate information Internal management information
for external reporting for planning, control and decision
making
Classification for planning Classification for control

Cost objects
and decision making System of responsibility
Requires knowledge of cost accounting segregates
behaviour patterns controllable costs and
uncontrollable costs
Cost units
Basic control unit for
costing purposes Fixed cost Variable cost Semi-variable
Not affected Changes in cost
by changes line with level Partly affected
in activity of activity by changes in
Classification for inventory
activity
valuation and profit
measurement
Cost elements = materials,
labour and other expenses
Direct cost or Indirect cost or Product cost Period cost

prime cost can be overhead cannot Allocated to value Deducted as
traced in full to be traced in full to of inventory until expenses in a
cost object being cost object being sold particular period
costed costed

Self-test
C
Answer the following questions. H
A
1 Which of the following statements about a direct cost are correct? P
T
(a) A direct cost can be traced in full to the product, service or department that is being E
costed. R
(b) A particular cost can be a direct cost or an indirect cost, depending on what is being 1
costed.
(c) A direct cost might also be referred to as an overhead cost.
(d) Expenditure on direct costs will probably vary every period.
A (a) and (b) only
B (a) and (c) only
C (a), (b) and (d) only
D (a), (b), (c) and (d)
2 Which one of the following items might be a cost unit within the management accounting
system of a university or college of further education?
A Business studies department
B A student
C A college building
D The university itself
3 Identify whether the statements shown below are true or false.
True False
A cost unit is a unit of product that has costs attached
A cost object is always a unit of product or service
Costs can be divided into three elements: materials, labour and

expenses
An overhead is another name for an indirect cost
4 Which of the following are likely to be classed as variable costs?
Yes No
Telephone bill
A royalty payment for each unit produced
Direct materials for production
Annual salary of chief accountant
Annual salary of factory supervisor

5 A company hires its vehicles under an agreement where a constant rate is charged per mile
travelled, up to a maximum monthly payment regardless of the miles travelled.
This cost is represented by which of the following graphs?
A B
Total
Total cost
cost
Level of activity Level of activity

C D
Total Total
cost cost
Level of activity Level of activity
6 Cost units are:

A Units of a product or service for which costs are ascertained
B Amounts of expenditure attributable to a number of different products
C Functions or locations for which costs are ascertained
D Things for which we are trying to ascertain the cost
7 Which of the following items might be a suitable cost unit within the sales department of a
manufacturing company?
Suitable Unsuitable
Sales commission
Order obtained
Unit of product sold

8 In a factory one supervisor is required for every five employees. Which one of the following
graphs depicts the cost of supervisors? C
H
A B A
P
T
Total Total
E
cost cost
R
Number of employees Number of employees

C D
Total Total
cost cost
Number of employees Number of employees

9 Which of the following might describe a cost unit?
A A unit of production or service to which costs can be related
B A cost incurred in selling a product or service
C A cost that can be traced in full to the product, service or department that is being
costed
D A cost identified with the goods produced or purchased for resale
10 Prime cost is:
A All cost incurred in manufacturing a product
B The total of direct costs
C The material cost of a product
D The cost of operating a department
Now go back to the Learning outcomes in the introduction. If you are satisfied you have
achieved these objectives, please tick them off.

Answer to Interactive question 1

Suitable cost unit
Room/night 
Meal served 
Conference delegate 
Conference room/day 
(a) Semi-variable 
(b) Fixed 
(c) Variable 
(a) Stay the same
(b) Fall; because the same amount of fixed cost is spread over more units
(c) Fall; because the fixed cost per unit included within the total cost will reduce
Expense description Graph number Discussion
(a) (1) A semi-variable cost that has both a fixed element

and a variable element that changes with the level
of activity
(b) (4) A fixed cost that remains constant within the
relevant range
(c) (2) A variable cost that varies in direct proportion to
the level of activity
(d) (3) Graph passes through origin because at zero
activity no cost is incurred. Variable cost pattern
until maximum cost is reached. Thereafter cost is
fixed
(e) (1) A semi-variable cost that has both a fixed element
and a variable element that changes with the level
of activity

Answers to Self-test C
H
A
1 C The correct answer is: (a), (b) and (d) only. P
T
Statement (a) is correct. Direct costs are specific and traceable to the relevant product, E
service or department. R
Statement (b) is correct. For example, a departmental manager's salary is a direct cost 1
of the department but it is an indirect cost of the individual cost units passing through
the department.
Statement (c) is incorrect. An indirect cost (not a direct cost) might also be referred to
as an overhead cost.
Statement (d) is correct. It is likely that activity will change from period to period, in
which case so will the expenditure on direct costs, as direct costs are traced directly to
cost units.
2 B A student is likely to be a cost unit (cost per student per course). The others are all cost
objects but not the most basic unit of product or service for which costs are
determined.
3 The correct answers are:
True False
A cost unit is a unit of product that has costs attached


A cost object is always a unit of product or service

Costs can be divided into three elements: materials, labour and
expenses

An overhead is another name for an indirect cost

A cost object is anything for which we are trying to ascertain the cost. It could be a unit
of product or service but it could also be other items such as a department, a function
or an item of equipment.
4
Yes No
Telephone bill

A royalty payment for each unit produced

Direct materials for production

Annual salary of chief accountant

Annual salary of factory supervisor

The royalty payments described and the cost of direct materials for production are
likely to increase in line with output levels and are therefore classed as variable costs.
A telephone bill is a typical example of a semi-variable cost, with a fixed line rental and
a variable cost element that relates to the number of telephone calls made.
Salaries are a typical example of a fixed cost.

5 C The correct graph is:
Total
cost
Level of activity
The cost described begins as a linear variable cost, increasing at a constant rate in line
with activity. After a certain level of activity is reached, the total cost reaches a
maximum as demonstrated by the horizontal line on the graph. The cost becomes
fixed regardless of the level of activity.
6 A Amounts of expenditure attributable to a number of products (option B) are classed as
overheads.
Functions or locations for which costs are ascertained (option C) are cost objects.
Option D is the definition of a cost object.
7
Suitable Unsuitable
Sales commission

Order obtained

Unit of product sold

Either calculating the cost of each order obtained or the cost of each unit of product
sold would be suitable cost units within the sales department.
Sales commission is an expense of the business, and therefore not suitable to use as a
cost unit.
8 A The correct graph is:
Total
cost
Number of employees
9 A Cost units are the basic units for costing purposes. Different organisations would use
different cost units, such as patient/day in a hospital or meals served in a restaurant.
A cost incurred in selling a product or service (option B) describes a period cost.
A cost that can be traced in full to the product, service or department that is being
costed (option C) describes a direct cost.
A cost identified with the goods produced or purchased for resale (option D) describes
a product cost.
10 B Prime cost is the total of direct material, direct labour and direct expenses.
Option A describes total production cost, including a share of production overhead.
Option C is only a part of prime cost. Option D is an overhead or indirect cost.

CHAPTER 2
Calculating unit costs

(Part 1)
Introduction
Examination context
TOPIC LIST
1 Identifying direct and indirect costs for cost units
2 Inventory valuation
Introduction
 Classify costs as fixed, variable, direct or indirect

 Calculate unit costs and profits/losses from information provided, using:
– marginal costing
– absorption costing and reconcile the differences between the costs and
profits/losses obtained
The specific syllabus references for this chapter are: 1b, c.
Syllabus links
A thorough understanding of the valuation of materials inventory will underpin your
understanding of inventory valuation for the Accounting syllabus.
Examination context
The context of much of this chapter provides scope for a range of numerical questions.
However, you should also be prepared to deal with narrative questions that examine your
understanding of the implications of the techniques you are using.
Narrative questions on the pricing of materials issues and on the classification of costs have
been popular in past examinations.
 classify costs as direct or indirect
 calculate the prime cost of a cost unit
 calculate the price of materials and the value of inventory using ('first in, first out') FIFO,
('last in, first out') LIFO and average pricing methods
It is important to realise that in this chapter and the next, ideas from Chapter 1 are being applied
in determining the cost of a unit of output. The cost object is, therefore, the unit of output and all
terms such as direct and indirect are used in that context. It is also essential to appreciate that
direct and variable costs and indirect and fixed costs are not the same thing. The narrative is as
important as the calculations for FIFO, LIFO and weighted average inventory valuations.

1 Identifying direct and indirect costs for cost units
Section overview
 Direct costs are those that can be specifically identified with the cost unit being costed.
 Direct material cost is all material becoming part of the cost unit, unless used in negligible
amounts.
 Direct labour cost is all wages paid to labour that can be identified with a specific cost unit.
 Direct expenses are expenses incurred on a specific cost unit, other than direct material
and direct labour costs.
C
 Indirect costs are those that cannot be identified directly with the cost unit being costed. H
A
P
For the purposes of this chapter and Chapter 3 the cost object is a cost unit (eg, a unit of T
product, a job, a batch, a unit of service). E
R
1.1 Direct material cost 2
Direct material is all material becoming part of the cost unit (unless used in negligible amounts
and/or having negligible cost).
Direct material costs are charged to the cost unit as part of the prime cost. Examples of direct
material are as follows.
 Component parts or other materials purchased for a particular product, service, job, order
or process
 Primary packing materials like cartons and boxes
Materials used in negligible amounts and/or having negligible cost can be grouped under
indirect materials as part of overhead.
1.2 Direct wages or direct labour costs

Direct wages are all wages paid for labour (either as basic hours or as overtime) that can be
identified with the cost unit.
Direct wages costs are charged to the cost unit as part of the prime cost.
Examples of groups of labour receiving payment as direct wages are as follows.
 Workers engaged in altering the condition, conformation or composition of the product
 Inspectors, analysts and testers specifically required for such production
1.3 Direct expenses

Direct expenses are any expenses that are incurred on a specific cost unit other than direct
material cost and direct wages.
Direct expenses are charged to the product as part of the prime cost. Examples of direct
expenses are as follows.
 The cost of special designs, drawings or layouts for a particular job.
 The hire of tools or equipment for a particular job.
ICAEW 2019 Calculating unit costs (Part 1) 29

1.4 Indirect costs
Indirect costs or overheads are those costs that cannot be traced in full to a specific cost unit.
For example, a garage carries out a repair job on a customer's car.
 The direct material cost of the job will include the replacement parts used.
 The direct labour cost will be wages paid to the mechanics who carried out the work. The
labour is treated as a direct cost in this case, even if the mechanics are paid a fixed amount
each period. This is because it is possible to measure exactly how long each person worked
on the repair, and their hourly rate of pay.
 The indirect costs of the repair job will include a share of the overhead costs incurred in the
garage, such as the rent, the buildings insurance, the depreciation of the garage equipment
and so on. These costs cannot be traced to any single job worked on during the period.
For example, a beauty salon carries out a treatment for a customer.
 The direct material cost of the treatment will include the treatment materials, such as a face
mask.
 The direct labour cost will be wages paid to the beauticians who carried out the treatment.
The labour is treated as a direct cost in this case, even if the beauticians are paid a fixed
amount each period. This is because it is possible to measure exactly how long each person
worked on the treatment, and their hourly rate of pay.
 The indirect costs of the treatment will include a share of the overhead costs incurred in the
salon, such as the rent, the buildings insurance, the salon cleaning costs and so on. These
costs cannot be traced to any single treatment worked on during the period.
Try the interactive question below to ensure you have understood the principle of how to
distinguish a direct cost from an indirect cost.
Interactive question 1: Direct cost or indirect cost?

Indicate whether each of the following costs would be classified as a direct cost or an indirect
cost of a particular car repair in a garage. The repair was worked on in overtime hours due to an
unusually large number of repairs being booked into the garage that day.
Cost incurred Direct or indirect?
The salary of the garage's accountant

The cost of heating the garage
A can of engine oil used in the repair
A smear of grease used in the repair
An overtime premium paid to the mechanic
carrying out the repair
An idle time payment made to the mechanic
while waiting for a delivery of parts for a
number of jobs
The wages of the supervisor overseeing the
mechanic carrying out the repair

1.5 Direct and indirect costs: some further points
There are a few possible misconceptions about direct and indirect costs that should be clarified
at this stage.
(a) Direct costs are not necessarily bigger in size than indirect costs. In highly-automated
service industries, direct materials and direct labour costs are likely to be very small, relative
to overhead costs. The relative size of direct and indirect costs per unit of output varies
according to the type of output, the industry, the technology, etc.
(b) Indirect costs are not less important than direct costs. Although they cannot be directly
attributed to individual units of output or to individual jobs, they represent expenditure on
resources that are essential for the units to be made or the jobs to be done. In the example
of the garage repair job, the rent of the garage is an indirect cost, but the rental cost C
represents a share of the use of the garage space, without which the job could not have H
been done. A
P
(c) It is easy to confuse fixed and variable costs with indirect and direct costs. A direct cost is T
E
often also a variable cost: for example, the cost of raw materials that goes into making a unit R
of product is both a direct cost and a variable cost. However, a direct cost may be a fixed
cost rather than a variable cost. For example, the direct cost of the labour employed to do a 2
certain type of work is a fixed cost to the business if the employees are paid a fixed amount
of wages or salary regardless of the amount of work they do. Similarly, an indirect cost may
a variable cost. For example, the cost of heating in a manufacturing plant may rise as more
hours are worked. The cost of heating cannot be directly attributed to an individual job or
unit of output. But, it is a cost that rises with the level of activity, and is a variable cost.
Variable indirect costs are more commonly referred to as variable overheads.
2 Inventory valuation
Section overview
 The pricing of issues of inventory items and the valuation of closing inventory have a direct
effect on the calculation of profit. Several different methods can be used in practice.
 With FIFO all issues are priced at the cost of the earliest delivery remaining in inventory.
 With LIFO all issues are priced at the cost of the most recent delivery remaining in inventory.
 The cumulative weighted average pricing method calculates a weighted average price for
all units in inventory whenever a new delivery of materials is received into store.
 The periodic weighted average pricing method calculates a single weighted average price
at the end of the period. The average is based on the opening inventory plus all units
received in the period.
 Each method of inventory valuation usually produces different figures for the value of
closing inventories and the cost of material issues. Therefore, profit figures using the
different inventory valuations are usually different.
2.1 Valuing inventory in financial accounts

You may be aware from your studies of Accounting that, for financial accounting purposes,
inventories are valued at the lower of cost and net realisable value. In practice, inventories will
probably be valued at cost in the stores records throughout the course of an accounting period.
Only when the period ends will the value of the inventory in hand be reconsidered so that items
with a net realisable value below their original cost will be revalued downwards, and the inventory
records altered accordingly.

2.2 Charging units of inventory to cost of production or cost of sales
It is important to be able to distinguish between the way in which the physical items in inventory
are actually issued and the way in which inventory is costed. In practice a storekeeper may issue
goods in the following way.
 The oldest goods first
 The latest goods received first
 Randomly
 Those that are easiest to reach
By comparison, the cost of goods issued must be determined on a consistently applied basis,
and must ignore the likelihood that the materials issued will be costed at a price different from
the amount paid for them.
This may seem a little confusing at first, and it may be helpful to explain the point further by
looking at an example.
2.3 Example: Inventory valuation

Suppose that there are three units of a particular material in inventory.
Units Date received Purchase cost
A June 20X1 £100
B July 20X1 £106
C August 20X1 £109
In September, one unit is issued to production. As it happened, the physical unit actually issued
was B. The accounting department must put a value or cost on the material issued, but the value
would not be the cost of B, £106. The principles used to value the materials issued are not
concerned with the actual unit issued, A, B, or C. However, the accountant may choose to make
one of the following assumptions.
 The unit issued is valued as though it were the earliest unit received into inventory, ie, at the
purchase cost of A, £100. This valuation principle is called FIFO, or first in, first out.
 The unit issued is valued as though it were the most recent unit received into inventory, ie,
at the purchase cost of C, £109. This method of valuation is LIFO, or last in, first out.
 The unit issued is valued at an average price of A, B and C. The three units cost a total of
£315, an average of £105 each.
2.4 Pricing methods in inventory valuation

In the following sections we will consider each of the pricing methods detailed above, using the
following transactions to illustrate the principles in each case.
Transactions during May 20X6
Market value
per unit on
date of
Quantity Unit cost Total cost transaction
Units £ £ £
Opening balance, 1 May 100 2.00 200
Receipts, 3 May 400 2.10 840 2.11
Issues, 4 May 200 2.11
Receipts, 9 May 300 2.12 636 2.15
Issues, 11 May 400 2.20
Receipts, 18 May 100 2.40 240 2.40
Issues, 20 May 100 2.42
Closing balance, 31 May 200 2.45
1,916

2.5 FIFO (first in, first out)
Definition
FIFO (first in, first out): Defined by CIMA as a method 'used to price issues of goods or materials
based on the cost of the oldest units held, irrespective of the sequence in which the actual issue
of units held takes place.'
FIFO assumes that materials are issued out of inventory in the order in which they were
delivered into inventory: issues are priced at the cost of the earliest delivery remaining in
inventory.
C
H
Worked example: FIFO A
P
Using FIFO, the cost of issues and the closing inventory value of the transactions in section 2.4 T
would be as follows. E
R
Date of issue Quantity Value
issued 2
Units £ £
4 May 200 100 b/f at £2 200
100 at £2.10 210
410
11 May 400 300 at £2.10 630
100 at £2.12 212
842
20 May 100 100 at £2.12 212
Cost of issues 1,464
Closing inventory 200 100 at £2.12 212
value
100 at £2.40 240
452
1,916
Using a tabular format, as below, is a practical way of tracking items when carrying out a FIFO
calculation:
£2.00 £2.10 £2.12 £2.40 Total
b/f 100 100
Receipt 3 May 400 400
Issue 4 May (100) (100) (200)
Issue 11 May (300) (100) (400)
Issue 20 May (100) (100)
– – 100 100 200
Points to note
1 The cost of materials issued plus the value of closing inventory equals the cost of purchases
plus the value of opening inventory (£1,916).
2 The market price of purchased materials is rising dramatically. In a period of inflation, there
is a tendency with FIFO for materials to be issued at a cost lower than the current market
value, although closing inventories tend to be valued at a cost approximating to current
market value.

2.6 Advantages and disadvantages of the FIFO method
Advantages Disadvantages
It is a logical pricing method, which probably FIFO can be cumbersome to operate because
represents what is physically happening: in of the need to identify each batch of material
practice the oldest inventory is likely to be separately.
used first.
It is easy to understand and explain to Managers may find it difficult to compare costs
managers. and make decisions when they are charged
with varying prices for the same materials.
The inventory valuation can be near to a In a period of high inflation, inventory issue
valuation based on replacement cost. prices will lag behind current market value.
Interactive question 2: FIFO

Complete the table below in as much detail as possible using the information from the last
worked example.
Receipts Issues Inventory
Date Unit Unit Unit
Quantity price Amount Quantity price Amount Quantity price Amount
£ £ £ £ £ £
2.7 LIFO (last in, first out)
Definition
LIFO (last in, first out): Defined by CIMA as a method 'used to price issues of goods or materials
based on the cost of the most recently received units.'
LIFO assumes that materials are issued out of inventory in the reverse order from that in which
they were delivered: the most recent deliveries are issued before earlier ones, and issues are
priced accordingly.

Worked example: LIFO
Using LIFO, the cost of issues and the closing inventory value of the transactions in section 2.4
would be as follows.
Date of issue Quantity issued Valuation
Units £ £
4 May 200 200 at £2.10 420
11 May 400 300 at £2.12 636
100 at £2.10 210
846
20 May 100 100 at £2.40 240
Closing inventory 200 100 at £2.10 210 C
value H
100 at £2.00 200 A
410 P
T
1,916 E
R
A tabular format similar to that in section 2.5 can also be used in section 2.7.
2
Points to note
2 In a period of inflation there is a tendency with LIFO for the following to occur.
– Materials are issued at a price that approximates to current market value.
– Closing inventories become undervalued when compared to market value.
2.8 Advantages and disadvantages of the LIFO method

Inventories are issued at a price which is close to The method can be cumbersome to
current market value. operate because it sometimes results in
several batches being only part-used in the
inventory records before another batch is
received.
Managers are continually aware of recent costs LIFO is often the opposite of what is
when making decisions, because the costs being physically happening and can therefore be
charged to their department or products will be difficult to explain to managers.
current costs.
As with FIFO, decision making can be
difficult because of the variations in prices.
2.9 Cumulative weighted average pricing
Definition
Average cost: Defined by CIMA as a method 'used to price issues of goods or materials at the
weighted average cost of all units held.'
The cumulative weighted average pricing method calculates a weighted average price for all
units in inventory. Issues are priced at this average cost, and the balance of inventory remaining

would have the same unit valuation. The average price is determined by dividing the total cost
by the total number of units.
A new weighted average price is calculated whenever a new delivery of materials is received
into store. This is the key feature of cumulative weighted average pricing.
Worked example: Cumulative weighted average pricing

Using cumulative weighted average pricing, issue costs and closing inventory values of the
transactions in section 2.4 would be as follows.
Total
Inventory
Date Received Issued Balance value Unit cost
Units Units Units £ £ £
Opening inventory 100 200 2.00
3 May 400 840 2.10
* 500 1,040 2.08
4 May 200 (416) 2.08 416
300 624 2.08
9 May 300 636 2.12
* 600 1,260 2.10
11 May 400 (840) 2.10 840
200 420 2.10
18 May 100 240 2.40
* 300 660 2.20
20 May 100 (220) 2.20 220
Closing inventory value 200 440 2.20 440
1,916
* A new inventory value per unit is calculated whenever a new receipt of materials occurs.
Points to note
2 In a period of inflation, using the cumulative weighted average pricing system, the value of
material issues will rise gradually, but will tend to lag a little behind the current market value
at the date of issue. Closing inventory values will also be a little below current market value.
2.10 Advantages and disadvantages of cumulative weighted average pricing

Fluctuations in prices are smoothed out, The resulting issue price is rarely an actual price
making it easier to use the data for decision that has been paid, and can run to several
making. decimal places.
It is easier to administer than FIFO and LIFO, Prices tend to lag a little behind current market
because there is no need to identify each values when there is gradual inflation.
batch separately.

Interactive question 3: Inventory valuation methods
Shown below is an extract from records for inventory item number 988988.
Receipts Issues Balance
Date Qty Value Total Qty Value Total Qty Value Total
£ £ £ £ £ £
5 June 30 2.50 75
8 June 20 3.00 60
10 10 A
June
14 20 B
June
18 40 2.40 96
C
June H
20 6 C D A
June P
T
(a) The values that would be entered on the stores record for A, B, C and D in a cumulative E
R
weighted average pricing system would be:
2
A £ ........................................
B £ ........................................
C £ ........................................
D £ ........................................
(b) The values that would be entered on the stores record for A, B, C and D in a LIFO system
would be:
A £ ........................................
B £ ........................................
C £ ........................................
D £ ........................................
2.11 Periodic weighted average pricing

This average method differs from the cumulative weighted average method. Instead of
calculating a new inventory value per unit whenever a receipt occurs, a single average is
calculated at the end of the period based on all purchases for the period. Unless stated to the
contrary, assume the cumulative method is required in an exam question.
Worked example: Periodic weighted average pricing

Using periodic weighted average pricing, the issue costs and closing inventory of the
transactions in section 2.4 would be as follows.
Cost of opening inventory + Total cost of receipts in period
Periodic weighted average price =
Units in opening inventory + Total units received in period
(£200 + £1,716)
=
(100 + 800)
= £2.129 per unit

This average price is used to value all the units issued and the units in the closing inventory.
£
Cost of issues = 700 units  £2.129 1,490
Closing inventory value = 200 units  £2.129 426
1,916
Notice that once again the cost of materials issued plus the value of closing inventory equals the
cost of purchases plus the value of opening inventory (£1,916).
2.12 Inventory valuation and profitability

Each method of inventory valuation usually produces different figures for the value of closing
inventories and the cost of material issues. A summary of the valuations based on the
transactions in section 2.4 is as follows.
Valuation method Closing
inventory Cost
value of issues Total
£ £ £
FIFO (section 2.5) 452 1,464 1,916
LIFO (section 2.7) 410 1,506 1,916
Cumulative weighted average (section 2.9) 440 1,476 1,916
Periodic weighted average (section 2.11) 426 1,490 1,916
Since material costs affect the cost of production, and the cost of production works through
eventually into the cost of sales (which is also affected by the value of closing inventories), it
follows that different methods of inventory valuation will provide different profit figures.
The following example will help to illustrate the point.
Worked example: Inventory valuation and profitability

On 1 November 20X2, Delilah's Dresses Ltd held three pink satin dresses with orange sashes,
designed by Freda Swoggs. These were valued at £120 each. During November 20X2, 12 more
of the dresses were delivered as follows.
Date Dresses received Purchase cost per dress
10 November 4 £125
20 November 4 £140
25 November 4 £150
A number of the pink satin dresses with orange sashes were sold during November as follows.
Date Dresses sold Sales price per dress
14 November 5 £200
21 November 5 £200
28 November 1 £200
Requirements
Calculate the gross profit from selling the pink satin dresses with orange sashes in November
20X2, applying the following principles of inventory valuation.
(a) FIFO
(b) LIFO
(c) Cumulative weighted average pricing
Calculate gross profit using the formula: gross profit = (sales – (opening inventory + purchases –
closing inventory)).

Solution
(a) FIFO
Cost Closing
Date of sales Total inventory
£ £
14 November 3 units  £120
+ 2 units  £125
610
+ 3 units  £140
670
28 November 1 unit  £140 140
C
Closing inventory 4 units  £150 600 H
1,420 600 A
P
(b) LIFO T
E
Cost of Closing R
Date sales Total inventory
2
£ £
+ 1 unit  £120
620
+ 1 unit  £120
680
28 November 1 unit  £150 150
Closing inventory 3 units  £150
+ 1 unit  £120
570
1,450 570
(c) Cumulative weighted average pricing

Balance in Cost of Closing
Units Unit cost inventory sales inventory
£ £ £ £
1 November 3 120.00 360
10 November 4 125.00 500
7 122.86 860
14 November 5 122.86 614 614
2 246
20 November 4 140.00 560
6 134.33 806
21 November 5 134.33 672 672
1 134
25 November 4 150.00 600
5 146.80 734
28 November 1 146.80 147 147
30 November 4 146.80 587 1,433 587

Profitability Weighted
FIFO LIFO average
£ £ £
Opening inventory 360 360 360
Purchases 1,660 1,660 1,660
2,020 2,020 2,020
Closing inventory 600 570 587
Cost of sales 1,420 1,450 1,433
Sales (11  £200) 2,200 2,200 2,200
Gross profit 780 750 767
2.13 Profit differences

In this example, different inventory valuation methods produced different costs of sale and
hence different gross profits. As opening inventory values and purchase costs are the same for
each method, the different costs of sale are due to different closing inventory valuations. The
differences in gross profits therefore equal the differences in closing inventory valuations.
The profit differences are only temporary. In the example, the opening inventory in December
20X2 will be £600, £570 or £587, depending on the inventory valuation method used. Different
opening inventory values will affect the cost of sales and profits in December, so that in the long
run, inequalities in costs of sales each month will even themselves out.

Summary
Direct costs Indirect costs

Can be traced in full to cost Cannot be traced in full to
unit being costed cost object being costed C
H
A
P
T
E
Direct material cost Direct labour cost Direct expenses R
All material becoming part Wages that can be identified Non-material and labour cost
of the cost unit with a specific cost unit that can be identified with a 2
specific cost unit
FIFO LIFO Weighted average

Issues priced at oldest prices Issues priced at latest prices Issues priced at a calculated
in inventory in inventory weighted average
Cumulative weighted average Periodic weighted average

New average calculated whenever Single average calculated at
a delivery is received end of each period

Self-test
Answer the following questions.
1 Which two of the following are cost objects?
A A packing machine
B The factory canteen
C Direct materials for production
D Annual salary of the chief accountant
E A telephone bill
2 Which two of the following are classified as indirect costs of individual units of output or of
individual projects?
A The cost of overtime worked specifically to complete a one-off project
B The depreciation of a machine on an assembly line
C Primary packing materials, eg, cartons and boxes
D The hire of maintenance tools or equipment for a factory
3 Which one of the following would be classified as an indirect cost of individual batches of
output, units of service or of individual projects of the organisation concerned?
A The cost of sugar used for a batch of cakes in a bakery
B The lease rental cost of a leased car used by a site foreman travelling to a specific
construction project
C The accountant's salary in a factory
D The cost of drinks served on an intercity train journey
4 When costing cost units, wage payments for idle time within a production department are
classified as:
A Direct labour cost
B Prime cost
C Administration overhead
D Factory overhead
5 A retailer currently uses the LIFO method to value its inventory of goods for sale.
If the retailer decides instead to use the FIFO method, in a period of rising prices:
A The closing inventory value will be lower and the gross profit will be lower
B The closing inventory value will be lower and the gross profit will be higher
C The closing inventory value will be higher and the gross profit will be lower
D The closing inventory value will be higher and the gross profit will be higher
6 A wholesaler had an opening inventory of 750 units of geronimos valued at £80 each on
1 March.
The following receipts and sales were recorded during March.
4 March Received 180 units at a cost of £85 per unit
18 March Received 90 units at a cost of £90 per unit
24 March Sold 852 units at a price of £110 per unit
Using the weighted average cost method of valuation, what was the cost of geronimos sold
on 24 March? (to the nearest £)
A £35,320
B £38,016
C £38,448
D £69,660

7 At the beginning of week 10 there were 400 units of component X held in the stores. 160 of
these components had been purchased for £5.55 each in week 9 and 240 had been
purchased for £5.91 each in week 8.
On day 3 of week 10 a further 120 components were received into stores at a purchase cost
of £5.96 each.
The only issue of component X occurred on day 4 of week 10, when 150 units were issued
to production.
Using the FIFO valuation method, what was the value of the closing inventory of component
X at the end of week 10?
A £1,980.45
B £2,070.15
C £2,135.10 C
D £2,200.55 H
A
8 A wholesaler had an opening inventory of 330 units of product T valued at £168 each on P
1 April. T
E
The following receipts and sales were recorded during April. R
4 April Received 180 units at a cost of £174 per unit 2
18 April Received 90 units at a cost of £186 per unit
24 April Sold 432 units at a price of £220 per unit
Using the LIFO valuation method, what was the gross profit earned from the units sold on
24 April?
A £16,350
B £18,120
C £18,520
D £19,764
9 Which of the following statements is/are true?
True False
Using LIFO, managers are continually aware of recent costs when

making decisions, because the costs being charged to their
departments or products will be current costs
FIFO lets managers value issues at current prices in a period of high
inflation
The use of the cumulative average pricing method of inventory
valuation is easier to administer than FIFO and LIFO because there is
no need to identify each batch separately
10 A business buys and sells boxes of item J. The transactions for the latest quarter are shown
below.
Opening inventory 400 boxes valued at £1,000
Purchases Sales
Boxes Value Boxes
£
July 1,000 2,600 1,100
August 1,200 3,300 900
September 1,000 3,000 800
The business values its inventories using a periodic weighted average price calculated at
the end of each quarter.
To the nearest £, the value of the inventory at the end of September is
£........................................

Cost incurred Direct or indirect?
The salary of the garage's accountant Indirect

The cost of heating the garage Indirect
A can of engine oil used in the repair Direct. This cost can be directly attributed to
this particular repair.
A smear of grease used in the repair Indirect. This cost is negligible and would not
be recorded separately as a direct cost.
An overtime premium paid to the mechanic Indirect. The overtime is being worked due to
carrying out the repair a generally heavy work load. This particular
repair has not caused the overtime premium to
be incurred. The cost is indirect and must be
shared over all the repair jobs carried out.
An idle time payment made to the mechanic Indirect. The cost cannot be identified with any
while waiting for a delivery of parts for a particular repair job.
number of jobs
The wages of the supervisor overseeing the Indirect. The supervisor is overseeing all repair
mechanic carrying out the repair jobs being undertaken.

Receipts Issues Inventory
Date Unit Unit Unit
Quantity price Amount Quantity price Amount Quantity price Amount
£ £ £ £ £ £
1.5.X6 100 2.00 200.00
3.5.X6 400 2.10 840.00 100 2.00 200.00

400 2.10 840.00
500 1,040.00
4.5.X6 100 2.00 200.00

100 2.10 210.00 300 2.10 630.00
9.5.X6 300 2.12 636.00 300 2.10 630.00

300 2.12 636.00
600 1,266.00
11.5.X6 300 2.10 630.00

100 2.12 212.00 200 2.12 424.00
18.5.X6 100 2.40 240.00 200 2.12 424.00

100 2.40 240.00
300 664.00
20.5.X6 100 2.12 212.00 100 2.12 212.00

100 2.40 240.00
31.5.X6 200 452.00

(a) A £27
B £54
C £15
D £135
WORKINGS
£
8 June Inventory balance = 30 units  £2.50 75
20 units  £3.00 60
50 135
Weighted average price = 135/50
= 2.70 C
H
10 June Issues = 10 units  £2.70 £27 A
14 June Issues = 20 units  £2.70 £54 P
18 June Inventory balance = remaining 20 units  £2.70 54 T
E
receipts 40 units  £2.40 96
R
60 150
Weighted average price = 150/60 2
= 2.50
20 June Issues = 6 units  £2.50 £15
Inventory balance = 54 units  £2.50 135
(b) A £30
B £55
C £14.40
D £131.60
WORKINGS
£
10 June 10 units  £3.00 30.00
4 June Issues 10 units  £3.00 30.00
10 units  £2.50 25.00
55.00
20 June Issues: 6 units  £2.40 14.40
Balance: 34 units  £2.40 81.60
20 units  £2.50 50.00
54 131.60

1 A, B It is possible to ascertain the cost of these two cost objects.
The other three items are costs that might be attributed to a particular cost object, but
they are not cost objects in themselves.
2 B, D The cost of overtime worked specifically to complete a one-off project (option A) is
direct labour.
Primary packing materials, eg, cartons and boxes, (option C) are direct materials.
3 C The accountant's salary is an indirect cost because it cannot be traced to a specific cost
unit.
It would be classified as an administration overhead.
All of the other costs can be traced to a specific cost unit.
The cost of sugar would be a direct ingredients cost of a specific batch of cakes.
The lease rental cost would be a direct cost of a construction project.
The cost of drinks served would be a direct cost of a particular train journey.
4 D Idle time is usually treated as an overhead; in this case it is within the production
department and is therefore a factory overhead.
5 D The FIFO method prices issues from inventory at the cost of the earliest delivery
remaining in inventory.
The closing inventory will therefore be valued at the higher prices paid.
The charge to cost of sales will be lower than with LIFO, therefore the gross profit will
be higher.
6 D
Weighted average cost per unit:
£
750 units  £80 60,000
180 units  £85 15,300
90 units  £90 8,100
1,020 83,400
Weighted average cost per unit = £83,400/1,020

= £81.76
Cost of units sold on 24 March = £81.76 × 852 units
= £69,660
7 C Components issued on day 4 = 150 from week 8 receipts
Closing inventory week 10:
£
Remaining 90 Components from week 8  £5.91 531.90
160 Components from week 9  £5.55 888.00
120 Components from week 10  £5.96 715.20
370 2,135.10

8 D The LIFO method uses the cost of the most recent batches first.
Cost of units sold on 24 April:
£
90 units  £186 16,740
180 units  £174 31,320
162 units  £168 27,216
432 75,276
Sales revenue = 432 units  £220 95,040

Less cost of units sold 75,276
Gross profit 19,764
9 C
H
True False
A
P
Using LIFO, managers are continually aware of recent costs when T
making decisions, because the costs being charged to their  E
R
departments or products will be current costs
FIFO lets managers value issues at current prices in a period of 2
high inflation 
The use of the cumulative average pricing method of inventory
valuation is easier to administer than FIFO and LIFO because there 
is no need to identify each batch separately
FIFO lets managers value issues at current prices in a period of high inflation is incorrect.
Under FIFO, inventory issues are valued at the cost of the earliest delivery remaining in
inventory. In times of inflation, this will mean that issue prices will be lower than current
prices.
10 To the nearest £, the value of the inventory at the end of September is £2,200.
Total inventory available during quarter:
Boxes Value
£
Opening inventory 400 1,000
Purchases: July 1,000 2,600
August 1,200 3,300
September 1,000 3,000
3,600 9,900
Periodic weighted average price = £9,900/3,600

= £2.75 per box
Closing inventory = 3,600 – (1,100 + 900 + 800)
= 800 boxes
Value of closing inventory = 800  £2.75
= £2,200

CHAPTER 3

(Part 2)
Introduction
Examination context
TOPIC LIST
1 Absorption costing
2 Activity based costing
3 Costing methods
4 Other approaches to cost management
Introduction

 Select the most appropriate method of costing for a given product or service
The specific syllabus references for this chapter are: 1c, d.
Syllabus links
A knowledge of the method of determining a full unit cost will underpin your understanding of
inventory valuation for the Accounting syllabus.
Examination context
Numerical questions on the calculation of overhead absorption rates and of over and under
absorption of overheads have been popular in past exams.
You should also be prepared to tackle narrative questions on overhead absorption as well as on
the selection of the most appropriate costing method in specific circumstances.
You will not be required to answer numerical questions about activity based costing but you
should be able to demonstrate a general understanding of the underlying principles of this
costing system.
 calculate the full cost of a cost unit using absorption costing
 demonstrate an understanding of the basic principles of activity based costing
 identify the most appropriate costing method in specific circumstances
 demonstrate an understanding of the general principles of target costing, life cycle costing
and just in time
It is essential to appreciate the difference between the allocation and apportionment of
overheads, which links back to the ideas about direct and indirect cost covered earlier.
A common difficulty is failing to allow for under/over absorption when predetermined overhead
rates are used.

1 Absorption costing
Section overview
 In absorption costing the full cost of a cost unit is equal to its prime cost plus an absorbed
share of overhead cost.
 The three stages in determining the share of overhead to be attributed to a cost unit are
allocation, apportionment and absorption.
 Overheads are absorbed into product or service costs using a predetermined overhead
absorption rate, usually set annually in the budget.
 The absorption rate is calculated by dividing the budgeted overhead by the budgeted
level of activity. For production overheads, the level of activity is often measured in terms
of direct labour hours or machine hours.
 Over- or under-absorption of overhead arises because the absorption rate is based on
estimates.
1.1 Calculating the absorption cost of a cost unit

To calculate the full cost of an item using absorption costing (sometimes referred to as full
costing) it is necessary first to establish its direct cost or prime cost and then to add a fair share
of indirect costs or overhead. C
H
The full or absorption cost per unit is therefore made up as follows. A
P
£ T
Direct materials X E
Direct labour X R
Direct expenses (if any) X 3

Total direct cost (prime cost) X
Share of indirect cost/overhead X
Absorption (full) cost X
There are three stages in determining the share of overhead to be attributed to a cost unit.
 Overhead allocation
 Overhead apportionment
 Overhead absorption
1.2 Overhead allocation

The first step in absorption costing is allocation. Allocation is the process by which whole cost
items are charged direct to a cost centre. A cost centre acts as a collecting place for costs before
they are analysed further.
Cost centres may be one of the following types.
 A production department, to which production overheads are charged.
 A production service department, to which production overheads are charged.
 An administrative department, to which administration overheads are charged.
 A selling or a distribution department, to which sales and distribution overheads are
charged.
 An overhead cost centre, to which items of expense which are shared by a number of
departments, such as rent and rates, heat and light and the canteen, are charged.

The following are examples of costs that would be charged direct to cost centres via the process
of allocation.
 The cost of a warehouse security guard will be charged to the warehouse cost centre.
 Paper on which computer output is recorded will be charged to the computer department.
Worked example: Overhead allocation

Consider the following costs of a company.
£
Wages of the supervisor of department A 200
Wages of the supervisor of department B 150
Indirect materials consumed in department A 50
Rent of the premises shared by departments A and B 300
The cost accounting system might include three cost centres.
Cost centre: 101 Department A
102 Department B
201 Rent
Overhead costs would be allocated directly to each cost centre, ie, £200 + £50 to cost centre
101, £150 to cost centre 102 and £300 to cost centre 201. The rent of the factory will be
subsequently shared between the two production departments, but for the purpose of day to
day cost recording in this particular system, the rent will first of all be charged in full to a
separate cost centre.
1.3 Overhead apportionment

The next step in absorption costing is overhead apportionment. This involves apportioning
general overheads to cost centres (the first stage) and then reapportioning the costs of service
cost centres to production departments (the second stage).
1.3.1 First stage: apportioning general overheads

Overhead apportionment follows on from overhead allocation. The first stage of overhead
apportionment is to identify all overhead costs as production department, production service
department, administration or selling and distribution overhead. This means that the costs for
heat and light, rent and rates, the canteen and so on (that is, costs which have been allocated to
general overhead cost centres) must be shared out between the other cost centres.
Overhead costs should be shared out on a fair basis. You will appreciate that because of the
complexity of items of cost it is rarely possible to use only one method of apportioning costs to
the various cost centres of an organisation. The bases of apportionment for the most usual cases
are given below.
Overhead to which the basis applies Basis
Rent, rates, heating and light, repairs and Floor area occupied by each cost centre
depreciation of buildings
Depreciation, insurance of equipment Cost or book value of equipment
Personnel office, canteen, welfare, wages and Number of employees, or labour hours
cost offices, first aid worked in each cost centre
Heating, lighting (see above) Volume of space occupied by each cost centre

Interactive question 1: Bases of apportionment
The following bases of apportionment are used by a factory.
A Volume of cost centre
B Value of machinery in cost centre
C Number of employees in cost centre
D Floor area of cost centre
Requirement
Complete the table below using one of A to D to show the bases on which the production
overheads listed in the table should be apportioned.
Production overheads Basis
Rent
Heating costs
Insurance of machinery
Cleaning costs
Canteen costs

C
H
A
Worked example: Overhead apportionment P
T
McQueen Co has incurred the following overhead costs.
E
£'000 R
Depreciation of factory 100
3
Factory repairs and maintenance 60
Factory office costs (treat as production overhead) 150
Depreciation of equipment 80
Insurance of equipment 20
Heating 39
Lighting 10
Canteen 90
549
Information relating to the production and service departments in the factory is as follows.
Department
Production Production Service Service
1 2 100 101
Floor space (square metres) 1,200 1,600 800 400
Volume (cubic metres) 3,000 6,000 2,400 1,600
Number of employees 30 30 15 15
Book value of equipment £30,000 £20,000 £10,000 £20,000
The overhead costs are apportioned using the following general formula.
Total overhead cost
 Value of apportionment base of cost centre
Total value of apportionment base
£39,000
For example, heating for department 1 = ×3,000 = £9,000
13,000

Total To department
Item of cost Basis of apportionment cost 1 2 100 101
£ £ £ £ £
Factory depreciation (floor area) 100 30.0 40 20.0 10.0
Factory repairs (floor area) 60 18.0 24 12.0 6.0
Factory office costs (number of employees) 150 50.0 50 25.0 25.0
Equipment (book value) 80 30.0 20 10.0 20.0
depreciation
Equipment insurance (book value) 20 7.5 5 2.5 5.0
Heating (volume) 39 9.0 18 7.2 4.8
Lighting (floor area) 10 3.0 4 2.0 1.0
Canteen (number of employees) 90 30.0 30 15.0 15.0
Total 549 177.5 191 93.7 86.8
Interactive question 2: Allocating and apportioning overheads

Rose Ceramics Ltd rents office premises and owns a factory and a warehouse. There are four
cost centres in the factory, the offices are the fifth cost centre, and the warehouse forms a sixth.
On 25 January, several invoices were received for overheads. For each of these, decide:
(a) whether the cost would be allocated or apportioned
(b) the cost centre(s) to be charged
(c) a suitable basis if apportionment is required
(a) Allocate or (b) Cost centre(s) (c) Basis of

Overhead
apportion? charged? apportionment
Factory light and heat

Rent
Factory rates
Office stationery
Cleaning of workers' overalls
Roof repair to warehouse
Interactive question 3: Apportioning overheads

Pippin Co has three production departments (forming, machining and assembly) and two
service departments (maintenance and general).
The following is an analysis of budgeted overhead costs for the forthcoming 12-month period.
£ £
Rent and rates 8,000
Power 750
Light, heat 5,000
Repairs, maintenance:
Forming 800
Machining 1,800
Assembly 300
Maintenance 200
General 100
3,200

£ £
Departmental expenses:
Forming 1,500
Machining 2,300
Assembly 1,100
Maintenance 900
General 1,500
7,300
Depreciation:
Plant 10,000
Fixtures and fittings (F&F) 250
Insurance:
Plant 2,000
Buildings 500
Indirect labour:
Forming 3,000
Machining 5,000
Assembly 1,500
Maintenance 4,000
General 2,000
15,500
52,500
These overheads are to be allocated and apportioned as fairly as possible to the five
departments using the following information: C
Effective H
A
Floor Plant horse-
P
area value F&F power T
2
m £ £ E
Forming 2,000 25,000 1,000 40 R
Machining 4,000 60,000 500 90
3
Assembly 3,000 7,500 2,000 15
Maintenance 500 7,500 1,000 5
General 500 – 500 –
10,000 100,000 5,000 150
Requirement
Allocate and apportion the budgeted overheads to the five departments.
Forming Machining Assembly Maint'nce General
£ £ £ £ £
Rent, rates
Power
Light, heat
Repairs, maintenance
Departmental expenses
Dep'n of plant
Dep'n of F&F
Insurance of plant
Insurance of buildings
Indirect labour

1.3.2 Second stage: service cost centre cost apportionment
The second stage of overhead apportionment concerns the treatment of service cost centres.
For example, a factory is divided into several production departments and also a number of
service departments, but only the production departments are directly involved in the
manufacture of the units. In order to be able to add production overheads to unit costs, it is
necessary to have all the overheads charged to (or located in) the production departments. The
next stage in absorption costing is, therefore, to apportion the costs of service cost centres to
the production cost centres. Examples of possible apportionment bases are as follows.
Service cost centre Examples of possible bases of apportionment
Stores Number of materials requisitions

Maintenance Hours of maintenance work done for each cost centre
Production planning Direct labour hours worked in each production cost centre
Interactive question 4: Production and service cost centres

Which of the following are production cost centres and which are service cost centres?
Production cost centre Service cost centre

Cost centre
( ) ( )
Finished goods warehouse

Canteen
Machining department
Offices
Assembly department
Worked example: Service centre cost apportionment

JPE Ltd is divided into five departments that are also cost centres. These are departments A, B
and C (through which cost units physically pass), an administrative department and a canteen.
Some details of the business are as follows:
A B C Canteen Admin
Floor area (sq metres) 5,000 5,000 4,000 4,000 2,000
Personnel (persons) 10 20 10 10 5
Remuneration per month
Direct (£) 1,920 3,600 2,240 – –
Indirect (£) 360 480 240 320 870
Direct materials consumed (£) 5,500 250 400 – –
Machine hours per month 600 2,400 200 – –
Power costs per month (£) 50 500 20 80 –
General overheads per month (£) 1,000 2,000 1,200 650 1,230
The monthly takings of the canteen are £600. Food bills for the canteen totalled £470. None of
the administrative staff use the canteen.
The monthly electricity charge for heat and light is £1,000. The monthly rent of the company's
premises is £6,000.
The administration costs are made up mainly of personnel-related costs.

Requirement
Apportion all overheads to the production cost centres.
Solution
Step 1: Primary allocation and apportionment

Where possible, costs should be allocated directly to each cost centre. Where costs are shared,
a fair basis of apportionment should be selected. Remember that the analysis is concerned only
with overheads. Direct material and direct wages costs are not included.
Basis of
Cost item apportionment A B C Canteen Admin
£ £ £ £ £
Indirect labour Allocation 360 480 240 320 870
Power Allocation 50 500 20 80 0
General overhead Allocation 1,000 2,000 1,200 650 1,230
Canteen takings Allocation (600)
Food Allocation 470
Rent Floor area 1,500 1,500 1,200 1,200 600
Electricity Floor area 250 250 200 200 100
3,160 4,730 2,860 2,320 2,800
Note: The apportionment of rental costs and electricity costs have been made on the basis of
floor area, because this seems 'fair'. The choice of the fairest basis, however, in practice, is a C
matter for judgement. H
A
P
Step 2: Re-apportion the service centre costs T
The next step is to apportion the costs of the service cost centres to the production cost centres. E
R
The method illustrated here is as follows.
3
 The first apportionment is for the service cost centre with the largest costs. These costs are
shared between all the other cost centres, including the other service cost centre, on a fair
basis.
 The costs of the second service cost centre, which will now include some of the first service
cost centre's costs, are apportioned between the production cost centres, on a fair basis.
This is illustrated below.
Basis of
Cost item apportionment A B C Canteen Admin
£ £ £ £ £
Costs allocated
and apportioned 3,160 4,730 2,860 2,320 2,800
Apportion admin Number of
employees
excluding admin 560 1,120 560 560 (2,800)
3,720 5,850 3,420 2,880 0
Apportion Number of
canteen employees
in A, B and C 720 1,440 720 (2,880) –
4,440 7,290 4,140 0 0

Points to note
1 The costs of the administration department were taken first because these are the largest
service centre costs. The basis of apportionment selected is number of employees, since
administration costs are largely personnel-related.
2 The costs of the canteen have also been apportioned on the basis of number of employees,
because canteen work is primarily employee-related.
3 Service centre costs must ultimately be apportioned to the production cost centres;
otherwise there will be no mechanism for absorbing the costs into the cost of output units.
4 WORKING: Apportionment of administration department costs
£2,800
= £56.00 per employee
(10 + 20 +10 +10)
The apportionment of costs is therefore (10 × £56) = £560 to Department A, (20 × £56) =
£1,120 to Department B, (10 × £56) = £560 to Department C, and (10 × £56) = £560 to the
canteen.
5 WORKING: Apportionment of canteen costs
£2,880
= £72.00 per employee
(10 + 20 +10)
The apportionment of costs is therefore (10 × £72) = £720 to Department A, (20 × £72) =
£1,440 to Department B, and (10 × £72) = £720 to Department C.
Interactive question 5: Reapportioning overheads

Shah Co has two production departments (machining and assembly) and two service
departments (maintenance and canteen). The accountant has already completed the initial
allocation and apportionment of budgeted overheads to the four departments and now wishes
to reapportion the service department overheads to the production departments. She has
provided the following information.
Machining Assembly Maintenance Canteen
Total overhead (£) 520,000 600,000 200,000 70,000
Number of employees 50 40 30 15
Maintenance works 40% of the time for Machining, 10% for Canteen and 50% for Assembly.
Requirement
Reapportion the service department overheads to the production departments, rounding to the
nearest £.
Machining Assembly Maintenance Canteen
£ £ £ £
Total overhead 520,000 600,000 200,000 70,000
First reapportionment
Revised total overheads
(enter figures in all 4 boxes)
Second reapportionment
Revised total overheads
(enter figures in all 4 boxes)

1.4 Overhead absorption
Having allocated and/or apportioned all overheads, the next stage in absorption costing is to
add them to, or absorb them into, the cost of production or sales.
 Production overheads are added to the prime cost (direct materials, labour and expenses),
the total of the two being the factory cost, or full cost of production. Production overheads
are therefore included in the value of inventories of finished goods.
 Administration, selling and distribution overheads are then included. The aggregate of the
factory cost and these non-production overheads is the total cost of sales. These
non-production overheads are therefore not included in the value of closing inventory.
1.4.1 Predetermined absorption rates

In absorption costing, it is usual to add overheads into product costs by applying a
predetermined overhead absorption rate. The predetermined rate is usually set annually in
advance, as part of the budgetary planning process.
Overheads are not absorbed on the basis of the actual overheads incurred but on the basis of
estimated or budgeted figures (calculated before the beginning of the period). There are
several reasons why the rate at which overheads are included in production costs (the
absorption rate) is determined before the accounting period begins.
 Goods are produced and sold throughout the year, but many actual overheads are not
known until the end of the year. It would be inconvenient to wait until the year end in order
to decide what overhead costs should be included in production costs. C
H
 An attempt to calculate overhead costs more regularly (such as each month) is possible, A
although estimated costs must be added for periodic expenditure such as rent and rates P
(usually incurred quarterly). The difficulty with this approach would be that actual overheads T
E
from month to month could fluctuate therefore overhead costs charged to production R
would be inconsistent. For example, a unit made in one week might be charged with £4 of
overhead, in a subsequent week with £5, and in a third week with £4.50. Only units made in 3
winter would be charged with the heating overhead. Such charges are considered
misleading for costing purposes and administratively inconvenient.
 Similarly, production output might vary each month. For example, actual overhead costs
might be £20,000 per month and output might vary from, say, 1,000 units to 20,000 units
per month. The unit rate for overhead would be £20 and £1 per unit respectively, which
would again lead to administration and control problems.
1.4.2 Calculating predetermined overhead absorption rates

The absorption rate is calculated by dividing the budgeted overhead by the budgeted level of
activity. For production overheads the level of activity is often budgeted direct labour hours or
budgeted machine hours.
Overhead absorption rates are therefore predetermined as follows.
 The overhead likely to be incurred during the coming period is estimated.
 The total hours, units, or direct costs on which the overhead absorption rates are to be
based (the activity level) are estimated.
 The estimated overhead is divided by the budgeted activity level to arrive at an absorption
rate for the forthcoming period.
1.4.3 Selecting the appropriate absorption base

Management should try to establish an absorption rate that provides a reasonably 'accurate'
estimate of overhead costs for jobs, products or services.

There are a number of different bases of absorption (or 'overhead recovery rates') that can be
used. Examples are as follows.
 A rate per machine hour
 A rate per direct labour hour
 A rate per unit
 A percentage of direct materials cost
 A percentage of direct labour cost
 A percentage of prime cost
The choice of an absorption basis is a matter of judgement and common sense. There are no
strict rules or formulae involved, although factors that should be taken into account are set out
below. What is required is an absorption basis that realistically reflects the characteristics of a
given cost centre and avoids undue anomalies, for example:
 A direct labour hour basis is most appropriate in a labour intensive environment.
 A machine hour rate would be used in departments where production is controlled or
dictated by machines. This basis is becoming more appropriate as factories become more
heavily automated.
 A rate per unit is only effective if all units are identical in terms of the resources used in their
manufacture in each cost centre.
Worked example: Overhead absorption bases

The budgeted production overheads and other budget data of Calculator Co are as follows.
Production Production
Budget dept 1 dept 2
Production overhead cost £36,000 £5,000
Direct materials cost £32,000
Direct labour cost £40,000
Machine hours 10,000
Direct labour hours 18,000
Units of production 1,000
The production overhead absorption rates using the various bases of apportionment would be
as follows.
 Department 1
£36,000
– Percentage of direct materials cost = × 100% = 112.5%
£32,000
£36,000
– Percentage of direct labour cost = × 100% = 90%
£40,000
£36,000
– Percentage of prime cost = × 100% = 50%
£72,000
£36,000
– Rate per machine hour = = £3.60 per machine hour
10,000 hrs
£36,000
– Rate per direct labour hour = = £2 per direct labour hour
18,000 hrs
 Department 2
– The department 2 absorption rate will be based on units of output.
5,000
= £5 per unit produced
1,000 units

The choice of the basis of absorption is significant in determining the cost of individual units, or
jobs, produced. In this example, suppose that an individual product has a material cost of £80, a
labour cost of £85, and requires 36 labour hours and 23 machine hours to complete. The
production overhead cost of the product would vary, depending on the basis of absorption
used by the company for overhead recovery.
 As a percentage of direct materials cost, the overhead cost would be 112.5%  £80 = £90.00
 As a percentage of direct labour cost, the overhead cost would be 90%  £85 = £76.50
 As a percentage of prime cost, the overhead cost would be 50%  £165 = £82.50
 Using a machine hour basis of absorption, the overhead cost would be 23 hrs  £3.60 = £82.80
 Using a labour hour basis, the overhead cost would be 36 hrs  £2 = £72.00
In theory, each basis of absorption would be possible, but the company should choose a basis
for its own costs that seems to be 'fairest'. In our example, this choice will be significant in
determining the cost of individual products, as the following summary shows, but the total cost
of production overheads is the budgeted overhead expenditure, no matter what basis of
absorption is selected. It is the relative share of overhead costs borne by individual products and
jobs that is affected by the choice of overhead absorption basis.
A summary of the product costs is shown below.
Basis of overhead recovery
Percentage Percentage Percentage Direct
of materials of labour of prime Machining labour
cost cost cost hours hours
£ £ £ £ £ C
H
Direct material 80.00 80.00 80.00 80.00 80.00
A
Direct labour 85.00 85.00 85.00 85.00 85.00 P
Production overhead 90.00 76.50 82.50 82.80 72.00 T
Total production cost 255.00 241.50 247.50 247.80 237.00 E
R
3
Interactive question 6: Overhead absorption rates
Use the following information to determine suitable overhead absorption rates for a company's
three production cost centres.
Forming Machining Assembly
Budgeted cost centre overheads £13,705 £28,817 £9,978
Budgeted direct labour hours per annum 5,482 790 4,989
Budgeted machine hours per annum 1,350 5,240 147
(a) The forming department rate is £ per direct labour hour/machine hour
(delete as appropriate)
(b) The machining department rate is £ per direct labour hour/machine hour
(c) The assembly department rate is £ per direct labour hour/machine hour

1.4.4 Important note for the exam
It is usual to use predetermined absorption rates as described in 1.4.1 to 1.4.3. However, using
estimates for a predetermined rate may lead to an incorrect overhead charge (called over- or
under-absorption in section 1.6) which leads to an adjustment. In order to avoid this type of
adjustment, you may see actual absorption rates used in certain situations in the scenario-based
questions. This will make more sense when you start to practise some questions.
1.5 Blanket absorption rates and departmental absorption rates

A blanket or single factory overhead absorption rate is an absorption rate used throughout a
factory and for all jobs and units of output irrespective of the department in which they were
produced.
For example, if total overheads were £500,000 and there were 250,000 machine hours during
the period, the blanket overhead rate would be £2 per machine hour and all units of output
passing through the factory would be charged at that rate.
Such a rate is not appropriate, however, if there are a number of departments and units of
output do not spend an equal amount of time in each department.
Worked example: Absorption rates

AB plc has two production departments, for which the following budgeted information is
available.
Department 1 Department 2 Total
Budgeted overheads £360,000 £200,000 £560,000
Budgeted direct labour hours 200,000 40,000 240,000
If a single factory overhead absorption rate is applied, the rate of overhead recovery would be:
£560,000
= £2.33 per direct labour hour
240,000 hours
If separate departmental rates are applied, these would be:
Department 1 Department 2
£360,000 £200,000
= £1.80 per direct labour hour = £5 per direct labour hour
200,000 hours 40,000 hours
Department 2 has a higher overhead cost per hour worked than department 1.
Now let us consider two separate products.
 Product A has a prime cost of £100, takes 30 hours in department 2 and does not involve
any work in department 1.
 Product B has a prime cost of £100, takes 28 hours in department 1 and 2 hours in
department 2.
Requirements
What would be the production cost of each product, using the following rates of overhead
recovery?
(a) A single factory rate of overhead recovery
(b) Separate departmental rates of overhead recovery

Solution
Product Product
A B
(a) Single factory rate £ £
Prime cost 100.00 100.00
Production overhead (30  £2.33) 70.00 70.00
Production cost 170.00 170.00
(b) Separate departmental rates £ £
Prime cost 100.00 100.00
Production overhead: Department 1 (0  £1.80) 0.00 (28  £1.80) 50.40
Department 2 (30  £5) 150.00 (2  £5) 10.00
Production cost 250.00 160.40
Using a single factory overhead absorption rate, both products would cost the same. However,
since product A is produced entirely within department 2 where overhead costs are relatively
higher, and product B is produced mostly within department 1, where overhead costs are
relatively lower, it is arguable that product A should cost more than product B. This can be seen
to be the case if separate departmental overhead recovery rates are used to reflect the work
done on each job in each department separately.
Interactive question 7: Calculating the overhead to be absorbed

In relation to calculating total absorption cost, label the following descriptions in the correct C
H
order as Steps 1–5.
A
P
Description Step T
E
A Apportion fixed costs over cost centres R
B Establish the overhead absorption rate 3
C Choose fair methods of apportionment

D Apply the overhead absorption rate to products
E Reapportion service cost centre costs
1.6 Over and under absorption of overheads

The overhead absorption rate is based on estimates (of both numerator and denominator) and it
is quite likely that either one or both of the estimates will not agree with what actually occurs.
Actual overheads incurred are unlikely to be equal to the overheads absorbed into the cost of
production.
(a) Over absorption means that the overheads charged to the cost of production are greater
than the overheads actually incurred.
(b) Under absorption means that insufficient overheads have been included in the cost of
production.

Worked example: Over and under absorption of overheads
Suppose that the budgeted production overhead in a production department is £80,000 and
the budgeted activity is 40,000 direct labour hours. The overhead recovery rate (using a direct
labour hour basis) would be £2 per direct labour hour.
Actual production overheads in the period are, say, £84,000, and 45,000 direct labour hours are
worked.
£
Overhead incurred (actual) 84,000
Overhead absorbed (45,000  £2) 90,000
Over absorption of overhead 6,000
In this example, the cost of produced units or jobs has been charged with £6,000 more than was
actually spent. An adjustment to reconcile the overheads charged to the actual overhead is
necessary and the over absorbed overhead will be written as a credit to the income statement at
the end of the accounting period. By making this adjustment the total overhead in the income
statement would be reduced to £84,000, matching the overhead cost actually incurred.
1.6.1 The reasons for under/over absorbed overheads

The overhead absorption rate is predetermined from budget estimates of overhead cost and
the expected volume of activity. Under or over recovery of overhead will occur in the following
circumstances:
 actual overhead costs are different from budgeted overheads; or
 the actual activity level is different from the budgeted activity level.
It is mathematically possible, but unlikely, that if both variations occur together they could cancel
each other out so that no over or under absorption occurs.
Interactive question 8: Under and over absorption of overheads

Using your answer to Interactive question 4 and the following information, determine whether
the overhead in each of the three production departments is under or over absorbed and by
how much for the year.
Forming Machining Assembly
Actual direct labour hours 5,370 950 5,400
Actual machine hours 1,300 6,370 100
Actual overhead £13,900 £30,300 £8,500
Requirement
(a) The overhead in the forming department is under/over* absorbed by £

(b) The overhead in the machining department is under/over* absorbed by £
(c) The overhead in the assembly department is under/over* absorbed by £
* Delete as applicable

2 Activity based costing
Section overview
 Activity based costing (ABC) is a development of absorption costing.
 ABC involves the identification of the factors (cost drivers) that cause the costs of an
organisation's major activities.
 Activity costs are assigned to products or services on the basis of the number of the
activity's cost drivers that each product or service generates.
 The resulting product costs provide more accurate information for cost management and
control.
2.1 The problem with traditional absorption costing

We have seen that the traditional absorption costing system relies on subjective judgement
concerning the basis of apportionment of overheads to cost centres. To a greater or lesser
extent, all methods of apportionment and absorption are arbitrary in nature. Where overheads
form a relatively low proportion of the total costs of a business, the arbitrary nature of overhead
apportionment and absorption may not be a serious issue. However, a significant feature of
many modern businesses is the relatively high level of overhead costs in relation to total costs.
In this situation, the traditional absorption costing system can create a problem for management C
seeking to accurately identify unit costs and exert control over these costs. This problem has H
particular significance given the highly competitive environment faced by many businesses. A
P
T
E
Worked example: The problem with traditional absorption costing R
A business sells 20,000 coffee mugs per year comprising large mugs (10,000), medium size
3
mugs (8,000) and small mugs (2,000). The time spent by direct labour is the same for each mug
and the time spent on the machines is also the same for each mug. This will mean that, using
either the direct labour hour method or the machine hour method of apportionment, the
overheads absorbed by each mug will be the same. Thus, assuming the total overheads are
£15,000, each mug will bear £0.75 (ie, £15,000/20,000) of the total overheads.
Overall, the large mugs will absorb 50% of the total overheads (ie, 10,000/20,000), the medium
size mugs will absorb 40% of the total overheads (ie, 8,000/20,000) and the small mugs will
absorb 10% (ie, 2,000/20,000). However, this may not be an equitable apportionment of
overhead costs. For example, where there are high set up costs or there are demanding
requirements concerning a particular product, the volume of output may be an unreliable guide
to the time and effort expended by the service departments on each product. It may be that
each type of mug produced places equal demands on the support departments such as
administration, distribution, packaging, etc. If this situation occurs, it can be argued that the
large mugs and medium size mugs, which are the higher volume items, will bear too high a
proportion of the total overheads and the small mugs, which have a lower volume of output, will
bear too low a proportion of the total overheads if the traditional approach is followed.
2.2 The activity based costing approach

Activity based costing (ABC) provides an alternative to the traditional method of absorption
costing. The objective of this method is to establish a better means of relating overheads to
output. It is claimed that the ABC method provides managers with a better basis for both cost
control and for the analysis of profitability.

The major concepts underlying ABC can be demonstrated as follows.
Traditional absorption costing

assigns a large share of overhead
This is because overheads are usually absorbed using an hourly rate.
to large volume items and a small
share to small volume items.
In high-technology production and

in service operations there are
Activities include setting up machines and order processing.
many 'support' activities that are
not related to output.
Products create a demand for the activities, but not necessarily in

Activities cause costs. relation to the volume manufactured.
The costs of an activity are caused The cost of the ordering activity might be driven by the number of
or driven by factors known as orders placed, the cost of the despatching activity by the number of
cost drivers. despatches made.
The costs of an activity are If product A requires five orders to be placed, and product B
assigned to products on the basis 15 orders, ¼ (ie, 5/(5 + 15)) of the orde ring cost will be assigned to
of the number of cost drivers. product A and ¾ (ie, 15/(5 + 15)) to product B.
Figure 3.1: Activity based costing
2.2.1 Cost drivers

For those costs that vary with production levels in the short term, ABC uses volume-related cost
drivers such as labour hours or machine hours. The cost of oil used as a lubricant on machines
would therefore be added to products on the basis of the number of machine hours, since oil
would have to be used for each hour the machine ran.
For costs that vary with some other activity and not volume of production, ABC uses
transaction-related cost drivers such as the number of production runs for the production
scheduling activity.
2.2.2 Calculating product costs using ABC
Step 1
Identify an organisation's major
activities.
Step 2
Identify the factors (cost drivers) which
cause the costs of the activities.
Step 3 Cost pools are equivalent to cost centres used

Collect the costs associated with each
with traditional absorption costing.
activity into cost pools.

Step 4 Suppose the cost pool for the ordering activity
Charge the costs of activities to totalled £100,000 and that there were 10,000
products on the basis of their usage of orders (orders being the cost driver). Each
the activities. A product's usage of an product would therefore be charged with £10 for
activity is measured by the quantity of each order it required. A batch requiring five
the activity's cost driver it generates. orders would therefore be charged with £50.
Although you will not be required to perform numerical calculations using ABC in your exam,
the following example will help to clarify the differences between ABC and traditional
absorption costing.
Worked example: Comparing ABC with traditional absorption costing

Suppose that Cooplan plc manufactures four products, W, X, Y and Z. Output and cost data for
the period just ended are as follows.
Number
of production Direct Total machine
runs in the Material cost labour hours Machine or labour
Output period per unit per unit hours per unit hours
Units £
W 10 2 20 1 1 10
X 10 2 80 3 3 30
Y 100 5 20 1 1 100
Z 100 5 80 3 3 300 C
H
14 A
P
Direct labour cost per hour is £10. Overhead costs are as follows. T
£ E
Short-run variable costs 3,080 R
Set-up costs 10,920
3
Production and scheduling costs 9,100
Materials handling costs 7,700
30,800
Traditional absorption costing

Using absorption costing and an absorption rate based on either direct labour hours or machine
hours, the product costs would be as follows.
W X Y Z Total
£ £ £ £ £
Direct material 200 800 2,000 8,000 11,000
Direct labour 101 100 300 111,000 3,000 44,400
Overheads * 700 2,100 7,000 21,000 30,800
1,000 3,200 10,000 32,000 46,200
Units produced 10 10 100 100
Cost per unit £100 £320 £100 £320
* £30,800 ÷ 440 hours = £70 per direct labour or machine hour

Activity based costing
Using activity based costing and assuming that the number of production runs is the cost driver
for set up costs, production and scheduling costs and materials handling costs and that machine
hours are the cost driver for short run variable costs, unit costs would be as follows.
W X Y Z Total
£ £ £ £ £
Direct material 200 800 2,000 8,000 11,000
Direct labour 100 300 1,000 333,000 4,400
Short-run variable overheads (W1) 70 210 700 2,100 3,080
Set-up costs (W2) 1,560 1,560 3,900 3,900 10,920
Production and scheduling costs (W3) 1,300 1,300 3,250 3,250 9,100
Materials handling costs (W4) 1,100 1,100 2,750 2,750 7,700
4,330 5,270 13,600 23,000 46,200
Units produced 10 10 100 100
Cost per unit £433 £527 £136 £230
WORKINGS
(1) £3,080 ÷ 440 machine hours = £7 per machine hour
(2) £10,920 ÷ 14 production runs = £780 per run
Summary
Absorption
Product costing ABC
Unit cost Unit cost Difference
£ £ £
W 100 433 + 333
X 320 527 + 207
Y 100 136 + 36
Z 320 230 – 90
The figures suggest that the traditional volume based absorption costing system is flawed.
 It under allocates overhead costs to low volume products (here, W and X) and over
allocates overheads to higher volume products (here Z in particular).
 It under allocates overhead costs to less time consuming products (here W and Y with just
one hour of work needed per unit) and over allocates overheads to more time consuming
products (here X and particularly Z).

3 Costing methods
Section overview
 An organisation's costing method will depend on the nature of its operations.
 Specific order costing methods are appropriate when each cost unit is separately
identifiable.
 Types of specific order costing method are job, batch and contract costing.
 Job and batch costing are appropriate when jobs are of relatively short duration. Each
batch is a separate job consisting of a number of identical units.
 Contract costing is appropriate when cost units are of relatively long duration. Contracts
are usually undertaken away from the organisation's own premises.
 The process costing method is appropriate when output consists of a continuous flow of
identical units.
 In a process costing environment unit costs are determined on an averaging basis.
Regardless of the materials pricing method that is selected by management or whatever basis is
used to absorb overheads into cost units, the overall costing method used by an organisation
will ultimately depend on the nature of the organisation's operations.
C
H
3.1 Specific order costing A
P
Some organisations produce 'one off' products or services to a customer's specific T
requirements, where each cost unit is separately identifiable from all others. The operations of E
R
these organisations can range from providing plumbing services, repairing vehicles or
manufacturing a custom-made garden bench, to building a school or a hospital or a block of 3
flats.
3.1.1 Job costing

Job costing is appropriate where each separately identifiable cost unit or job is of relatively
short duration, such as the plumbing services and the garden bench in the examples above.
Each job would be allocated a separate job number and costs would be accumulated against
this number in order to determine the total cost of the job.
 Issues of direct material would be charged to each job using FIFO or LIFO, etc.
 Direct labour charges would be determined from detailed time records kept for each
employee.
 Overhead costs would be absorbed into the total cost of each job using the predetermined
overhead absorption rate for each cost centre through which the job passes.

Direct material issues Direct labour costs
FIFO, LIFO etc Based on time records
Job Number
XXXX
Production overhead costs

Absorbed from cost centre A,
cost centre B, etc
Figure 3.2: Job costing
3.1.2 Contract costing

Contract costing is appropriate where each separately identifiable cost unit is of relatively long
duration, such as the building of the school or hospital in the examples above. Contracts are
often undertaken away from the organisation's own premises.
Each contract would be allocated a separate number and costs would be accumulated against
this number in order to determine the total cost of the contract.
 Many direct materials would be delivered straight to the contract but issues of direct
material from stores would be charged to each contract using FIFO or LIFO, etc.
 Many direct employees would be permanently employed on the contract site but direct
labour charges for those employees travelling between sites would be determined from
detailed time records kept for each employee.
 Many overhead costs can be allocated directly to the contract but administrative overhead
might be absorbed into contract costs using some form of absorption basis.
3.1.3 Batch costing

Batch costing is similar to job costing except that each separately identifiable cost unit would
be a batch of identical items. For example, batch costing can be applied when production takes
the form of separately identifiable batches of shoes or batches of printed advertising leaflets.
Each batch would be allocated a number to identify it and costs would be accumulated for the
batch in the same way as for a job in job costing. The cost per unit manufactured in a batch is the
total batch cost divided by the number of units in the batch.
3.2 Process (continuous operation) costing

Some organisations have a continuous flow of operations and produce a large number of
identical products. Food processing is one example and oil refining is another.
Such operations often consist of a number of consecutive processes where the output of one
process becomes the input of the subsequent process and so on until the finished output is
produced.

For example, the processes involved in making bottled sauces might be as follows.
Mixing Cooking Bottling Packing Output to

Process Process Process Process finished
d
Each process usually acts as a cost centre and material, labour and overhead costs are collected
to derive a total cost for each process for each period. The cost per unit of output from each
process is determined by dividing the total process cost by the number of units produced each
period. This unit cost then becomes an input cost for the subsequent process and so on until the
final cost of a completed unit is accumulated.
Additional materials
and labour
Materials Average total unit
Process 1 Process 1 input Process 2
Labour cost to finished
Overhead goods
Additional overhead
Process costing can also be applied in a service environment. For example, in an organisation
that provides a shirt laundering service the processes involved might be as follows.
Washing Drying Pressing Packing Finished

Process Process Process Process output
C
H
The cost per shirt laundered would be determined by the same averaging process as described A
earlier. P
T
E
R
Interactive question 9: Costing methods
3
Tick one costing method that would be appropriate in each of the following industries.
Process Job Contract Batch
Fitting kitchens   
Manufacturing components    
Manufacturing chemicals    
Building offices    

4 Other approaches to cost management
Section overview
 Life cycle costing tracks and accumulates the costs and revenues attributable to each
product over its entire life cycle.
 Life cycle costs include those incurred in developing the product and bringing it to
market, as well as the costs incurred after sales of the product have ceased.
 Target costing begins with a concept for a new product for which a required selling price
is determined after consideration of the market conditions.
 The required profit margin is deducted from the selling price to determine the target cost
for the product.
 The costs to be incurred over the product's entire life cycle are then examined to ensure
that the target cost is achieved.
 Just-in-time (JIT) is an approach to operations planning and control based on the idea that
goods and services should be produced only when they are needed.
4.1 Life cycle costing

A product incurs costs over the whole of its life cycle, from the design stage through
development to market launch, production and sales, and its eventual withdrawal from the
market.
Component elements of a product's costs over its life cycle include the following.
 Research and development costs: design, testing and so on
 Training costs: including initial operator training
 Production costs: materials, labour and so on
 Distribution costs: transportation, handling, inventory cost
 Marketing costs: advertising, customer service
 Retirement and disposal costs: dismantling specialised equipment
Costs Costs incurred during production

incurred and sales stage, eg, direct materials,
marketing costs
Costs incurred before

production and sales
begin, eg, R&D Costs incurred once
production has ceased,
eg, disposal costs
Time
Figure 3.3: Costs incurred during the life cycle of a product or service
Traditional management accounting systems are based on the accounting year and tend to
dissect the product's life cycle in a series of annual sections. This means that a product's
profitability over its entire life is not assessed, but rather its profitability is assessed on a periodic
basis.

In contrast, life cycle costing tracks and accumulates actual costs and revenues attributable to
each product over its entire life cycle, hence the total profitability of any given product can be
determined.
4.2 Target costing

We have seen how the full cost of a product can be determined using some form of absorption
costing. This full cost is often used as the basis of the selling price decision: a desired profit
mark-up is added to the full cost to determine the product's selling price.
Target costing works the other way round. It begins with a concept for a new product and, after
considering the situation in the potential market for the product, a required selling price is
determined.
From this price is deducted the desired profit margin, and the resulting acceptable cost
becomes the target cost. Thus the selling price determines the cost rather than the other way
round.
Determine Determine
unit cost target cost
Add desired Deduct

profit margin desired profit
C
H
Determine Determine A
selling price selling price P
T
E
Traditional Target R
pricing costing
3
The costs to be incurred over the product's entire life cycle are then examined and engineered
in order to ensure that the target cost is achieved.
Of particular importance is the initial design of the product. This is because many of the costs to
be incurred over the product's entire life cycle are built into the product at the design stage.
4.3 Just-in-time
Just-in-time (JIT) is an approach to operations planning and control based on the idea that
goods and services should be produced only when they are needed. They should not be
produced too early, so that inventories build up, nor too late, so that the customer has to wait.
JIT consists of JIT purchasing and JIT production.
 JIT production is driven by demand for a product so that no items are produced until they
are needed by a customer or by the next stage in a production process.
 JIT purchasing requires that material is delivered by the supplier just as it is needed in the
production process.
JIT systems are often referred to as 'pull' systems, whereby demand from a customer pulls
products through the production process. This is in contrast to traditional manufacturing
systems, which are 'push' systems because a delivery from a supplier pushes products through
production into inventory.
'Pus h' sy stems ' Pull ' sys tems
Supplier Production Customer Supplier Production Customer

4.3.1 Operational requirements for JIT
A number of operational requirements are vital to the success of a JIT system.
 High quality. Production must not be disrupted by quality failures.
 Speed. Throughput in the operation must be fast so that customer orders can be met by
production rather than out of inventory.
 Reliability. Supplies and production must be reliable, to avoid hold-ups.
 Flexibility. To respond immediately to customer orders, production must be flexible and in
small batch sizes.
 Efficient production planning. To ensure that goods are ready just when they are needed
and that overproduction does not occur.
 Reliable sales forecasting. More accurate sales forecasts ensure that sales and production
are better coordinated. This helps to avoid the build-up of inventories when forecasts are
over-optimistic, or delays when production is not ready in time to meet sales requirements
which exceed forecasts.
4.3.2 JIT and cost management

An efficient JIT system enables managers to control and reduce costs in a number of areas,
including the following.
 Warehousing costs. Reduced storage costs result from holding lower inventories.
 Improved capacity utilisation. Efficient production planning enables capacity to be used in
the most effective way with a faster throughput, thus reducing unit costs.
 Reduction in waste. The focus on high quality reduces the incidence of costs due to rejects.
 Reduction in write-offs due to obsolescence. Since goods are produced only as customers
need them there is a reduction in obsolescence costs due to unexpected changes in
customer requirements.

Summary
Determining unit costs
Traditional Activity Costing Other

absorption based method approches
costing costing
Depends on nature
of operations
to cost
management
Continuous
Overhead allocation operation Life cycle
Identify cost drivers costing costing
that cause costs of Identical cost units Tracks costs and
the major activities revenues over entire
Overhead life cycle
apportionment Process
costing
Unit costs determined C
Target
Overhead Assign activity costs
by averaging
costing
H
A
absorption according to number Determines target P
Ussually using a time of cost drivers cost by working T
based method generated E
Each costs unit backwards from
R
different selling price
3
Use of estimates Job costing Batch Contract Just In Time

may lead to under/
over absoption
Each unit of short costing costing Goods and services
duration Separate batches of Each unit of long produced/received
identical units duration, often only when needed
constructional

Self-test
1 The direct materials involved in the manufacture of a Whoopie cost £2 per unit and the
direct labour cost is £2.50 per unit. There are also direct expenses of £0.50 per Whoopie.
Fixed costs allocated to one Whoopie amount to £3.15.
Calculate the prime cost of a Whoopie.
The prime cost of a Whoopie is £
2 A company has two production departments and two service departments with production
overheads as shown in the following table.
dept W dept X dept Y dept Z
Production overheads (£'000) 500 600 600 800
Service department Y divides its time between the other departments in the ratio 3:2:1 (for
W, X and Z respectively).
Department Z spends 40% of its time servicing department W and 60% of its time servicing
department X. If all service department overheads are apportioned to production
departments, the total fixed overhead cost of department W is: £
3 An overhead absorption rate is used to:

A share out common costs to benefiting cost centres
B find the total overheads for a cost centre
C charge overheads to products
D control overheads
4 A company produces two products, Bubble and Squeak, in two production cost centres.
The initial allocation and apportionment of budgeted production overheads has been
completed. Extracts from the budget are as follows.
Machining Finishing
cost cost
centre centre
Production overheads £38,000 £10,350
Machine hours per unit:
product Bubble 6 2
product Squeak 4 1
Production overheads are absorbed on a machine hour basis. Budgeted production is 800
units of Bubble and 700 units of Squeak.
The budgeted production overhead cost per unit of Bubble is:
A £39.00
B £45.00
C £45.20
D £54.00

5 ABC Co has been using an overhead absorption rate of £6.25 per labour hour in its packing
department throughout the year.
During the year the overhead expenditure amounted to £257,500, and 44,848 labour hours
were used.
Which of the following statements is correct?
A Overheads were under absorbed by £27,600.
B Overheads were under absorbed by £22,800.
C Overheads were over absorbed by £27,600.
D Overheads were over absorbed by £22,800.
6 Budgeted and actual data for the year ended 31 December 20X1 is shown in the following
table.
Budget Actual
Production (units) 5,000 4,600
Fixed production overheads £10,000 £10,000
Sales (units) 4,500 4,000
Fixed production overheads are absorbed on a per unit basis, based on a normal capacity
of 5,000 units per annum.
Why did under-absorption of fixed production overheads occur during the year ended
31 December 20X1?
C
A The company sold fewer units than it produced. H
B The company sold fewer units than budgeted. A
C The company produced fewer units than budgeted. P
T
D The company budgeted to sell fewer units than produced. E
R
7 A management consultancy absorbs overheads on chargeable consulting hours. Budgeted
overheads were £615,000 and actual consulting hours were 32,150. Overheads were 3
under-absorbed by £35,000.
If actual overheads were £694,075, what was the budgeted overhead absorption rate per
hour?
A £19.13
B £20.50
C £21.59
D £22.68
8 Which two of the following statements about traditional absorption costing and ABC are
correct?
A Traditional absorption costing tends to assign too small a proportion of overheads to
high volume products.
B ABC costing systems will provide accurate unit costs because cost drivers are used to
trace overhead costs to products and services.
C An ABC system does not use volume-related cost drivers.
D Cost pools in an ABC system are equivalent to cost centres used in traditional
absorption costing.
E A cost driver is the factor that influences the cost of an activity.

9 Which two of the following statements are correct?
A Process costing is the most appropriate costing method when a continuous flow of
identical units is produced.
B Job costing and contract costing can only be applied where work is undertaken on the
organisation's own premises.
C In process costing the cost per unit is derived using an averaging calculation.
D Process costing cannot be applied in a service environment.
E For batch costing to be applied each unit in the batch must be separately identifiable.
10 Which two of the following statements are correct?
A Life cycle costing is the profiling of cost over a product's production life.
B The aim of target costing is to reduce life cycle costs of new products in order to
achieve a cost that will produce the target profit.
C Once a product's target cost has been determined, the desired profit mark up is added
to derive the product's selling price.
D JIT systems are referred to as 'push' systems because they push products through the
production process as quickly as possible.
E JIT purchasing requires small, frequent deliveries from suppliers as near as possible to
the time the raw materials and parts are needed.

Production overheads Basis Production overheads Basis
Rent D Cleaning costs D

Heating costs A Canteen costs C
Insurance of machinery B
Overhead (a) Allocate or (b) Cost centre(s) (c) Basis of

apportion? charged? apportionment?
Factory light and heat Apportion The four factory Floor area or
cost centres volume occupied
Rent Allocate Office (this is the
only cost centre
rented) C
H
Factory rates Apportion The four factory Floor area A
cost centres P
T
Office stationery Allocate Offices E
R
Cleaning of workers' Apportion The four factory Number of workers
3
overalls cost centres and the using overalls
warehouse
Roof repair to warehouse Allocate Warehouse

Basis Forming Machining Assembly Maint'nce General
£ £ £ £ £
Rent, rates 1 1,600 3,200 2,400 400 400
Power 2 200 450 75 25 0
Light, heat 1 1,000 2,000 1,500 250 250
Repairs, maintenance 800 1,800 300 200 100
Departmental expenses 1,500 2,300 1,100 900 1,500
Dep'n of plant 3 2,500 6,000 750 750 0
Dep'n of F&F 4 50 25 100 50 25
Insurance of plant 3 500 1,200 150 150 0
Insurance of buildings 1 100 200 150 25 25
Indirect labour 3,000 5,000 1,500 4,000 2,000
Basis of apportionment:
1 Floor area
2 Effective horsepower
3 Plant value
4 Fixtures and fittings value

Cost centre Production cost centre Service cost centre
Finished goods warehouse  

Canteen  
Machining department  
Offices  
Assembly department  
Only the machining department and assembly department are directly involved in the
manufacture of units. The other cost centres support the production activity and are therefore
service cost centres.

Machining Assembly Maintenance Canteen WORKINGS
£ £ £ £
Total overhead 520,000 600,000 200,000 70,000
First reapportionment 80,000 100,000 (200,000) 20,000 Maintenance
is larger cost
4:5:1
Revised total overheads 600,000 700,000 0 90,000
(enter figures in all 4
boxes)
Second reapportionment 50,000 40,000 0 (90,000) No of
employees
5:4
Revised total overheads 650,000 740,000 0 0
(enter figures in all 4
boxes)

The relative proportions of labour hours and machine hours in each cost centre can be used to
identify whether the cost centre is labour intensive or machine intensive.
£13,705
(a) Forming (labour intensive) = £ 2.50 per direct labour hour
5,482
£28,817
(b) Machining (machine intensive) = £ 5.50 per machine hour
5,240
£9,978
(c) Assembly (labour intensive) = £ 2 per direct labour hour
4,989

Description Step
A Apportion fixed costs over cost centres 2

B Establish the overhead absorption rate 4
C Choose fair methods of apportionment 1
D Apply the overhead absorption rate to 5
products
E Reapportion service cost centre costs 3
(a) The overhead in the forming department is Under absorbed by £ 475
(b) The overhead in the machining department is Over absorbed by £ 4,735
(c) The overhead in the assembly department is Over absorbed by £ 2,300
WORKINGS
(1) Forming £
Overhead absorbed (£2.50  5,370) 13,425 C
Overhead incurred 13,900 H
Under absorbed overhead 475 A
P
(2) Machining £ T
Overhead absorbed (£5.50  6,370) 35,035 E
R
Overhead incurred 30,300
Over absorbed overhead 4,735 3
(3) Assembly £
Overhead absorbed (£2  5,400) 10,800
Overhead incurred 8,500
Over absorbed overhead 2,300
Process Job Contract Batch
Fitting kitchens (Note 1)  

Manufacturing
components
   (Note 2)
Manufacturing chemicals (Note 3)   
Building offices   (Note 4) 
Notes
1 Each fitted kitchen would be a separately identifiable cost unit of relatively short duration,
hence job costing is most appropriate.
2 A number of identical components would be manufactured in each separately identifiable
batch.
3 Chemical manufacture involves a continuous flow of processes.
4 Each office building would be a separately identifiable cost unit of relatively long duration.
Therefore contract costing is most appropriate.

1 £5
Whoopie prime cost £ per unit
Direct materials 2.00
Direct labour 2.50
Direct expenses 0.50
Prime cost 5.00
Remember that prime cost is the total of all direct costs. The fixed cost of £3.15 per unit is
excluded from the prime cost calculation.
2 £1,160,000
dept W dept X dept Y dept Z
£'000 £'000 £'000 £'000
Production overheads 500 600 600 800
Apportion Y (3:2:1) 300 200 (600) 100
900
Apportion Z (40:60) 360 540 – (900)
1,160
3 C A is incorrect because this is overhead apportionment.

B is incorrect because total overheads are found for cost centres by analysing cost
information.
D is incorrect because overheads are controlled using budgets and other management
information.
4 A
Machining Finishing
Budgeted machine hours:
Bubble (6  800) 4,800 (2  800) 1,600
Squeak (4  700) 2,800 (1  700) 700
7,600 2,300
Production overhead absorption rate
per machine hour (£38,000/7,600) £5.00 (£10,350/2,300) £4.50
Production overhead per unit of Bubble = (6 hours  £5.00) + (2 hours  £4.50)

= £39.00
5 D Actual overheads were £257,500. Absorbed overheads = £6.25 × 44,848 = £280,300

Actual overheads – Absorbed overheads = £257,500 – £280,300
= £22,800 over absorbed
Overheads were therefore over absorbed by £22,800.
6 C Options A and B are incorrect because it is the levels of production that bring about
under/over absorption.
Option D is incorrect because the company was budgeting to produce the normal
capacity on which the absorption rate is based. This would have led to zero under or
over absorption, whatever the level of sales achieved.

7 B
£
Actual overheads 694,075
Under absorbed overheads 35,000
Overheads absorbed by 32,150 hours 659,075
Overheads absorbed = Consulting hours  Budgeted absorption rate

£659,075 = 32,150  Budgeted absorption rate
£659,075
Budgeted absorption rate =
£32,150
= £20.50
8 D,E Statement A is incorrect because traditional absorption costing tends to assign too
large a proportion of overheads to high volume products, because it uses volume-
related cost drivers.
Statement B is incorrect. ABC costing systems tend to provide more accurate unit costs
than traditional absorption costing systems. However, some arbitrary apportionments
and absorptions will still be necessary, therefore the unit costs are not accurate.
Statement C is incorrect. An ABC system uses volume-related cost drivers such as
labour hours or machine hours for costs that vary with production levels in the short
term, such as machine power costs.
C
Statement D is correct. Cost pools are used as collecting places to accumulate the H
costs associated with each activity. A
P
Statement E is correct. The cost of an activity increases in line with the number of cost T
E
drivers. R
9 A,C Statement A is correct. Process costing is a form of continuous operation costing. 3
Statement B is incorrect. Both job costing and contract costing can be applied where
work is undertaken on the customer's premises, for example, a decorating job (job
costing) and building an extension on a school (contract costing).
Statement C is correct because process costs are divided by the number of units
produced to derive an average unit cost for the period.
Statement D is incorrect because process costing can be applied in a service
environment where there is a continuous flow of identical units.
Statement E is incorrect. Each batch must be separately identifiable but the units within
each batch will be identical.
10 B,E Statement A is incorrect because life cycle costing includes development costs and
other cost incurred before production as well as any costs such as dismantling costs
incurred after production has ceased.
Statement B is correct. The target cost is calculated by deducting the target profit from
a predetermined selling price based on the market situation.
Statement C is incorrect. The target cost is derived by deducting the desired profit
margin from a competitive market price.
Statement D is incorrect. JIT systems are 'pull' systems because demand from a
customer pulls products through production.
Statement E is correct. JIT relies heavily on reliable, high quality suppliers.

CHAPTER 4
Marginal costing and

absorption costing
Introduction
Examination context
TOPIC LIST
1 Marginal cost and marginal costing
2 Marginal costing and absorption costing compared
Introduction

The specific syllabus reference for this chapter is: 1c.
Syllabus links
A knowledge of marginal costing and absorption costing will underpin your understanding of
inventory valuation for the Accounting syllabus.
Examination context
The calculation of the different profits reported under marginal costing and absorption costing
is likely to be a popular examination topic. You are also likely to be asked to reconcile the
difference between the profits reported under the two systems.
 calculate the profit reported under marginal costing and under absorption costing using
the same basic set of data
 reconcile the difference between the profits reported under the two systems
 derive the marginal costing profit from data provided that is prepared using absorption
costing, and vice versa

1 Marginal cost and marginal costing
Section overview
 In a marginal costing system only variable production costs are included in the valuation of
units.
 All fixed costs are treated as period costs and are charged in full against the sales revenue
for the period.
 Contribution towards fixed costs and profit is calculated as sales revenue less variable cost
of sales.
 Marginal costing profit for the period = contribution less fixed costs.
1.1 Marginal costing

Marginal costing is an alternative costing system to absorption costing. With marginal costing,
only variable production costs are included in the valuation of units. All fixed costs are treated
as period costs and are charged in full against the sales revenue for the period.
The marginal production cost per unit usually consists of the following:
 Variable materials
 Variable labour
 Variable production overheads
1.2 Contribution
Contribution is an important measure in marginal costing, and it is calculated as the difference
between sales value and marginal cost.
The term 'contribution' is really short for 'contribution towards fixed overheads and profit'.
The contribution per unit can be calculated as follows.
£ per unit £ per unit
C
Selling price X
H
Variable materials X A
Variable labour X P
Variable production overheads X T
E
Marginal production cost X
R
Variable selling, distribution and administrative cost X
Total marginal cost (X) 4
Contribution X
Interactive question 1: Contribution

A particular dining experience is sold for £1,009.99. The variable ingredients (materials) cost per
experience is £320, the variable labour cost per experience is £192 and the variable overhead
cost per experience is £132. Fixed overheads per annum are £100,000.
The contribution per dining experience is £
ICAEW 2019 Marginal costing and absorption costing 87

Worked example: Marginal costing
Water Ltd makes a product, the Splash, which has a variable production cost of £6 per unit and a
sales price of £10 per unit. At the beginning of September 20X0, there was no opening
inventory and production during the month was 20,000 units. Fixed costs for the month were
£45,000 (production, administration, sales and distribution). There were no variable marketing
costs.
Requirements
Calculate the contribution and profit for September 20X0, using marginal costing principles, if
sales were as follows.
(a) 10,000 Splashes
(b) 15,000 Splashes
(c) 20,000 Splashes
Solution
The first stage in the profit calculation must be to identify the variable costs, and then the
contribution. Fixed costs are deducted from the total contribution to derive the profit. All closing
inventories are valued at marginal or variable production cost (£6 per unit).
10,000 Splashes 15,000 Splashes 20,000 Splashes
£ £ £ £ £ £
Sales (at £10) 100,000 150,000 200,000
Opening inventory 0 0 0
Variable production cost 120,000 120,000 120,000
120,000 120,000 120,000
Less value of closing
inventory (at marginal cost) 60,000 30,000 –
Variable cost of sales 60,000 90,000 120,000
Contribution 40,000 60,000 80,000
Less fixed costs (45,000) (45,000) (45,000)
Profit/(loss) (5,000) 15,000 35,000
Profit/(loss) per unit £(0.50) £1 £1.75
Contribution per unit £4 £4 £4
1.3 Conclusions
The conclusions that may be drawn from this example are as follows.
(a) The profit per unit varies at differing levels of sales, because the average fixed overhead
cost per unit changes with the volume of sales.
(b) The contribution per unit is constant at all levels of output and sales. Total contribution,
which is the contribution per unit multiplied by the number of units sold, increases in direct
proportion to the volume of sales.
(c) Since the contribution per unit does not change, the most effective way of calculating the
expected profit at any level of output and sales would be as follows.
(1) First calculate the total contribution.
(2) Then deduct fixed costs as a period charge in order to find the profit.

This calculation method is much quicker and is therefore useful for certain types of multiple
choice questions in the exam. The contribution and profit figures would be calculated as follows,
arriving at the same answers as above.
10,000 15,000 20,000
Splashes Splashes Splashes
£ £ £
Total contribution at £4 per unit 40,000 60,000 80,000
Less fixed costs (45,000) (45,000) (45,000)
Profit/(loss) (5,000) 15,000 35,000
However, in the scenario-based questions you will be required to calculate the sales figures and
cost figures separately so this method is not appropriate for the scenario-based questions.
Interactive question 2: Marginal costing principles

Plumber plc makes two products, the Loo and the Wash. Information relating to each of these
products for April 20X1 is as follows.
Loo Wash
Opening inventory Nil Nil
Production (units) 15,000 6,000
Sales (units) 10,000 5,000
£ £
Sales price per unit 20 30
Unit costs
Variable materials 8 14
Variable labour 4 2
Variable production overhead 2 1
Variable sales overhead 2 3
Fixed costs for the month £
Production costs 40,000
Administration costs 15,000
Sales and distribution costs 25,000
Requirements
Using marginal costing principles and the approach in section 1.3, calculate the profit in April C
H
20X1. A
P
Then calculate the profit again using the format shown below.
T
Loo Wash Total E
R
£ £ £ £ £
Sales 4
Variable production
costs
Opening inventory
Closing inventory
Production cost of
sales
Variable selling
overhead
Contribution
Fixed production
costs
Profit/(loss)

2 Marginal costing and absorption costing compared
Section overview
 In a marginal costing system inventories are valued at marginal or variable production
cost; all fixed overhead is charged against sales for the period in which it is incurred.
 In an absorption costing system an amount of absorbed fixed production overhead is
included in the inventory valuation.
 Reported profit figures using marginal and absorption costing will differ if there is any
change in the level of inventories during the period.
 If the fixed production overhead absorption rate per unit is the same each period, the
difference in reported profit is calculated as the change in inventory units  fixed
production overhead absorption rate per unit.
 If the fixed production overhead absorption rate is not the same each period, the difference
in reported profit is equal to the change in the fixed production overhead in the inventory.
 In the long run the total reported profit will be the same whether marginal costing or
absorption costing is used.
 Each of the costing systems has a number of advantages.
2.1 Summarising the differences between the two costing methods

The differences between the two costing systems can be summarised as follows:
 In marginal costing
– Closing inventories are valued at marginal or variable production cost.
– Fixed costs are charged in full against the profit of the period in which they are incurred.
– No fixed costs are included in the inventory valuation.
 In absorption costing (sometimes referred to as full costing)
– Inventories are valued at full production cost, and include a share of fixed production
costs.
– This means that the cost of sales in a period will include some fixed overhead incurred
in a previous period (in opening inventory values) and will exclude some fixed
overhead incurred in the current period which is carried forward in the closing
inventory value. This will be a charge to a subsequent accounting period.
With these differences in mind, work through the following example.
Worked example: Marginal and absorption costing compared

TLF plc manufactures a single product, the Claud. The following figures relate to the Claud for a
one-year period.
Sales and production (units) 800
£
Sales 16,000
Production costs
Variable 6,400
Fixed 1,600
Sales and distribution costs
Variable 3,200
Fixed 2,400

The normal level of activity for the year is 800 units. Fixed costs are incurred evenly throughout
the year, and actual fixed costs are the same as budgeted. A predetermined overhead
absorption rate is used for the year.
There were no inventories of Claud at the beginning of the year.
In the first quarter, 220 units were produced and 160 units sold.
Requirements
For the first quarter:
(a) calculate the fixed production costs absorbed by Clauds if absorption costing is used
(b) calculate inventory values per unit using both absorption costing and marginal costing
(c) calculate the under/over absorption of overheads
(d) calculate the profit using absorption costing
(e) calculate the profit using marginal costing
(f) explain why there is a difference between the answers to (d) and (e)
Solution
The requirements provide useful steps for analysing the example.
Budgeted fixed production costs £1,600
(a) =
Budgeted output (normal level of activity) 800 units
Absorption rate = £2 per unit produced.

During the quarter, the fixed production overhead absorbed would be 220 units × £2 =
£440.
(b) Inventory values per unit
Absorption Marginal
costing costing
Variable production cost (£6,400/800) 8 8
Fixed production cost (£1,600/800) 2 –
Inventory value per unit 10 8
C
(c) £ H
Actual fixed production overhead 400 (1/4 of £1,600) A
P
Absorbed fixed production overhead 440 T
Over absorption of fixed production overhead 40 E
R
(d) Profit for the quarter, absorption costing
4
In a scenario-based question the layout would be similar to the following:
£ £
Sales (160  £20) 3,200
Production costs
Variable (220  £8) 1,760
Fixed (absorbed overhead (220  £2)) 440
Total (220  £10) 2,200
Less closing inventories (60  £10) 600
Production cost of sales 1,600
Adjustment for over absorbed overhead 40
Total production costs 1,560
Gross profit 1,640

£ £
Less sales and distribution costs
Variable (160  £4) 640
Fixed (1/4 of £2,400) 600
1,240
Net profit 400
Using the 'short-cut' calculation method (suitable for multiple choice questions) this answer
can be derived as follows.
£ per unit £
Sales price 20
Less: Full absorption cost (10)
Variable sales and distribution cost (4)
6
 sales volume 160 units 960
Less fixed sales and distribution costs (600)
360
Adjust for over absorbed overhead 40
Net profit 400
(e) Profit for the quarter, marginal costing

In a scenario-based question the layout would be similar to the following:
£ £
Sales 3,200
Variable production costs 1,760
Less closing inventories (60  £8) 480
Variable production cost of sales 1,280
Variable sales and distribution costs 640
Total variable costs of sales 1,920
Total contribution 1,280
Less: Fixed production costs 400
Fixed sales and distribution costs 600
1,000
Net profit 280
Using the 'short-cut' calculation method (suitable for multiple choice questions) this answer
can be derived as follows.
£ per unit £
Sales price 20
Less: Variable production cost (8)
Variable sales and distribution cost (4)
Contribution per unit 8
 sales volume 160 units = contribution 1,280
Less: Fixed production costs (400)
Fixed sales and distribution costs (600)
Net profit 280

(f) The difference in profit is due to the different valuations of closing inventory. In absorption
costing, the 60 units of closing inventory include absorbed fixed overheads of £120 (60 ×
£2), which are therefore costs carried over to the next quarter and not charged against the
profit of the first quarter. In marginal costing, all fixed costs incurred in the period are
charged against profit.
£
Absorption costing profit 400
Fixed production costs carried forward in inventory values (60 units × £2)* 120
Marginal costing profit 280
* Change in inventory units  fixed production cost per unit
2.2 Conclusions
We can draw a number of conclusions from this example.
(a) Marginal costing and absorption costing are different techniques for assessing profit in a
period.
(b) If there are changes in inventories during a period, marginal costing and absorption
costing give different results for profit obtained.
Assuming that the variable cost per unit and the fixed cost per unit are constant:
(1) if inventory levels increase, absorption costing will report a higher profit because
some of the fixed production overhead incurred during the period will be carried
forward in closing inventory. This reduces cost of sales and carries forward cost to be
set against sales revenue in the following period.
(2) if inventory levels decrease, absorption costing will report a lower profit because as
well as the fixed overhead incurred, fixed production overhead which had been
brought forward in opening inventory is released and is included in cost of sales.
(c) If the opening and closing inventory levels are the same, marginal costing and absorption
costing will give the same profit figure if unit costs remain constant.
C
(d) In the long run, total profit for a company will be the same whether marginal costing or H
absorption costing is used as all inventory is sold. Different accounting conventions merely A
affect the profit of individual accounting periods. P
T
E
R
Interactive question 3: Reconciling the difference in reported profits
4
The overhead absorption rate for product X is £10 per machine hour. Each unit of product X
requires five machine hours.
Production of product X last period was 4,800 units and the sales volume achieved was 4,750
units.
Requirement
(a) The absorption costing profit would be (tick one box):
Greater than
The same as
Less than
the marginal costing profit.

(b) The differences between the reported profits would be £
Worked example: Comparison of total profits

To illustrate the point in conclusion 2.2(d) above, let us suppose that a company makes and sells
a single product. At the beginning of period 1, there are no opening inventories of the product,
for which the variable production cost is £4 per unit and the sales price £6 per unit. Fixed costs
are £2,000 per period, of which £1,500 are fixed production costs.
Period 1 Period 2
Sales 1,200 units 1,800 units
Production 1,500 units 1,500 units
Requirements
What profit would be reported in each period and in total using the following costing systems?
(a) Absorption costing. Assume normal output is 1,500 units per period.
(b) Marginal costing.
Solution
(a) Absorption costing: the absorption rate for fixed production overhead is:
£1,500
= £1 per unit
1,500 units
Period 1 Period 2 Total

£ £ £ £ £ £
Sales 7,200 10,800 18,000
Production costs
Variable 6,000 6,000 12,000
Fixed absorbed 1,500 1,500 3,000
7,500 7,500 15,000
Add opening inventory b/f – 1,500 –
7,500 9,000 15,000
Less closing inventory c/f 1,500 – –
Production cost of sales 6,000 9,000 15,000
(Under)/over absorbed
overhead – – –
Total production costs 6,000 9,000 15,000
Gross profit 1,200 1,800 3,000
Other costs 500 500 1,000
Net profit 700 1,300 2,000
Using the 'short-cut' method of calculation the profit figures can be calculated as follows.
Period 1 Period 2
£ per unit £ £
Sales price 6
Full absorption cost:
Variable production cost (4)
Absorbed fixed production cost (1)
1
 sales volume 1,200 1,800
Other costs 500 500
Net profit 700 1,300

(b) Marginal costing
Period 1 Period 2 Total
£ £ £ £ £ £
Sales 7,200 10,800 18,000
Variable production cost 6,000 6,000 12,000
Add opening inventory b/f – 1,200 –
6,000 7,200 12,000
Less closing inventory c/f 1,200 – –
Variable production cost
of sales 4,800 7,200 12,000
Contribution 2,400 3,600 6,000
Fixed costs 2,000 2,000 4,000
Profit 400 1,600 2,000
Using the 'short-cut' method of calculation the profit figures can be calculated as follows.
Period 1 Period 2
£ per unit £ £
Sales price 6
Less variable production costs (4)
Contribution per unit 2
 sales volume = total contribution 2,400 3,600
Less fixed costs 2,000 2,000
Profit 400 1,600
Points to note
The total profit over the two periods is the same for both costing systems, but the profit in each
period is different.
It is important to notice that although production and sales volumes in each period are different
(and therefore the profit for each period using absorption costing is different from the profit
reported by marginal costing), over the full period, total production equals sales volume, the
total cost of sales is the same, and therefore the total profit is the same using either system of
accounting.
C
H
A
Interactive question 4: Marginal and absorption costing P
X plc started business on 1 March making one product only. Unit cost information for the T
E
product is as follows. R
£
4
Variable labour 5
Variable material 8
Variable production overhead 2
Fixed production overhead 5
Standard production cost 20
The fixed production overhead figure has been calculated on the basis of a budgeted normal
output of 36,000 units per annum.
You are to assume that all the budgeted fixed expenses are incurred evenly over the year. March
and April are to be taken as equal period months.
Selling, distribution and administration expenses are as follows.
Fixed £120,000 per annum
Variable 15% of the sales value

The selling price per unit is £35 and the number of units produced and sold was as follows.
March April
Units Units
Production 2,000 3,200
Sales 1,500 3,000
Requirements
(a) Calculate the total value of the closing inventory for each month under marginal costing.
March £
April £
(b) Calculate the total value of the closing inventory for each month under absorption costing.
March £
April £
(c) Calculate the budgeted annual fixed production overhead. £
(d) Calculate the profit or loss for March using both absorption costing and marginal costing.
March
Absorption Marginal
£ £ £ £
Sales
Variable production
costs
Fixed production
cost absorbed
Opening inventory
Closing inventory
Production cost of
sales
Under/over
absorption
Variable selling,
distrib'n and admin
Fixed selling,
distrib'n and admin
Fixed production
costs
Profit/(loss)
(e) Calculate the profit or loss for April using both absorption costing and marginal costing
April
Absorption Marginal
£ £ £ £
Sales
Variable production
costs
Fixed production
cost absorbed
Opening inventory
Closing inventory

Absorption Marginal
£ £ £ £
Production cost of
sales
Under/over
absorption
Variable selling,
distrib'n and admin
Fixed selling,
distrib'n and admin
Fixed production
costs
Profit/(loss)
2.3 Marginal costing and absorption costing compared

(a) Advantages of absorption costing
(1) Fixed production costs are incurred in order to make output; it is therefore 'fair' to
charge all output with a share of these costs.
(2) Closing inventory values, by including a share of fixed production overhead, will be
valued on the principle required by accounting standards for the financial accounting
valuation of inventories for external reporting purposes.
(3) A problem with calculating the contribution of various products made by a company is
that it may not be clear whether the contribution earned by each product is enough to
cover fixed costs, whereas by charging fixed overhead to a product it is possible to
ascertain whether or not it is profitable.
(b) Advantages of marginal costing
(1) It is simple to operate.
C
(2) There are no apportionments of fixed costs, which are frequently done on an arbitrary H
basis. Many costs, such as the managing director's salary, are indivisible by nature. A
P
(3) Fixed costs will be the same regardless of the volume of output, because they relate to T
a period of time and are period costs. It makes sense, therefore, to charge them in full E
R
as a cost to the period.
(4) The cost to produce an extra unit is the variable production cost. It is realistic to value 4
closing inventory items at this directly attributable cost.

(5) Under or over absorption of overheads is avoided.
(6) Marginal costing information can be more useful for decision making since it focuses
on the variable costs that are most likely to be altered as the result of a decision.

Summary
Alternative costing
systems
Marginal costing (mc) Absorption costing (ac)
Highlights contribution
= sales value less
variable costs
Fixed production
overhead absorbed
Fixed costs charged in into unit production
full against revenue for costs
period
Inventories valued at
full production cost, ie,
Inventories valued at including a share of
variable production cost fixed production costs
Different inventory valuation may
result in different profit results in
short term
Assuming that variable costs per

unit and fixed costs per unit are
constant
If inventories
If inventories increase: If inventories do not alter:
decrease:
mc profit < ac profit mc profit = ac profit
mc profit > ac profit
Difference in profit = change in

inventory units × fixed
production overhead per unit

Self-test
1 The following cost card relates to one unit of Product EZ.
£
Variable materials 20
Variable labour 40
Production overheads
Variable 10
Fixed 5
Sales and distribution overheads
Variable 5
Fixed 10
Total cost 90
The marginal production cost of one unit of Product EZ is £
2 A new product has a variable material cost of £5.50 per unit, a variable labour cost of £2 per
unit and a fixed overhead absorption rate of £3.50 per unit.
Production during the first month was 23,000 units and sales were 21,000 units.
Calculate to the nearest £ the inventory valuation under both marginal costing and
absorption costing.
Marginal costing: £ (to the nearest £) Absorption costing: £ (to the nearest £)
3 A company manufactures Luxury and Standard items. The following information relates to
period 1.
Luxury Standard
Variable materials £16 per unit £12 per unit
Variable labour £21 per unit £9 per unit
Variable production overhead £10 per unit £8 per unit
Budgeted production 3,500 units 3,300 units

Actual production 3,500 units 3,300 units
C
Closing inventory 290 units 570 units H
A
Variable labour is paid £6 per hour. P
T
Fixed costs totalled £120,400 and are recovered on the basis of variable labour hours. E
R
Calculate to the nearest £ the inventory valuation under both marginal and absorption
costing. 4
Luxury Standard
Marginal costing: £ £
Absorption costing: £ £

4 A company has just completed its first year of trading. The budgeted production volume of
26,000 units was achieved and the sales volume was 24,500 units at £40 each.
The following actual cost information is available.
£
Variable cost per unit
Manufacturing 18.50
Selling and administration 9.20
Fixed costs (as budget)
Manufacturing 91,000
Selling and administration 49,000
Calculate the net profit figures using both absorption and marginal costing.
Absorption net profit £ Marginal net profit £
5 When opening inventories were 8,500 litres and closing inventories 6,750 litres, a firm had a
profit of £62,100 using marginal costing.
Assuming that the fixed overhead absorption rate was £3 per litre, what would be the profit
using absorption costing?
A 41,850
B 56,850
C 67,350
D 82,350
6 Which of the following are arguments in favour of marginal costing?
Closing inventory is valued in accordance with financial reporting standards.

It is simple to operate.
There is no under or over absorption of overheads.
Fixed costs are the same regardless of activity levels.
The information from this costing system may be more useful for decision making.
7 Which two of the following statements are correct assuming that unit costs are constant?
A product showing a positive contribution under marginal costing will always show a
profit under absorption costing.
If inventory levels increase, marginal costing will report a lower profit than absorption
costing.
If inventory levels decrease, marginal costing will report a lower profit than absorption
costing.
If inventory levels increase, marginal costing will report a higher profit than absorption
costing.
If opening and closing inventory levels are the same, marginal costing and absorption
costing will report the same profit figure.
8 Last period a company reported absorption costing profits of £36,000. Actual fixed
production overheads were £42,000 and the actual production volume of 6,000 units
resulted in over absorbed fixed production overhead of £6,000.
A sales volume of 7,100 units was achieved during the period.
The marginal costing profit for the period would have been £ .

9 Last period 17,500 units were produced at a total cost of £16 each. Three quarters of the
costs were variable and one quarter fixed. 15,000 units were sold at £25 each. There were
no opening inventories.
By how much will the profit calculated using absorption costing principles differ from the
profit if marginal costing principles had been used?
A The absorption costing profit would be £10,000 less
B The absorption costing profit would be £10,000 greater
C The absorption costing profit would be £30,000 greater
D The absorption costing profit would be £40,000 greater
10 In a period, a company had opening inventory of 31,000 units and closing inventory of
34,000 units. Profits based on marginal costing were £850,500 and on absorption costing
were £955,500.
If the budgeted total fixed costs for the company were £1,837,500 what was the budgeted
level of activity in units?
A 32,500
B 52,500
C 65,000
D 105,000
C
H
A
P
T
E
R


The contribution per experience is £ 365.99 .
WORKING
£ £
Selling price per experience 1,009.99
Marginal cost per experience
Variable material 320
Variable labour 192
Variable overhead 132
644.00
Contribution per experience 365.99
Absorbed fixed overheads are not included in the calculation of marginal cost per unit or
contribution per unit.

£
Contribution from Loos (unit contribution = £20 – £16 = £4  10,000 units) 40,000
Contribution from Washes (unit contribution = £30 – £20 = £10  5,000 units) 50,000
Total contribution 90,000
Fixed costs for the period 80,000
Profit 10,000
Loo Wash Total

£ £ £ £ £
Sales 200,000 150,000
Variable production 210,000 102,000

costs
Opening inventory 0 0
Closing inventory (70,000) (17,000)
Production cost of (140,000) (85,000)
sales
Variable selling (20,000) (15,000)
overhead
Contribution 40,000 50,000 90,000
Fixed production (80,000)
costs
Profit/(loss) 10,000

(a) The absorption costing profit would be greater than the marginal costing profit.
This is because production exceeded sales, therefore the inventory level increased. Some
of the fixed production overhead incurred during the period would be carried forward in
the inventory value with absorption costing, thus reducing the charge to cost of sales.

(b) The difference between the reported profits would be £2,500.
This is calculated as follows.
Difference in profit = Change in inventory levels × Fixed overhead absorption rate per unit
= 50 units  (£10 × 5 hours)
= £2,500
(a) March £7,500 (500 units  £15)
April £10,500 (700 units  £15)
(b) March £10,000 (500 units  £20)
April £14,000 (700 units  £20)
Budgeted overheads
(c) Overhead absorption rate =
Budgeted output
Budgeted overheads
 £5 =
36,000 units
 Budgeted overheads = £180,000

(d) March
Absorption Marginal
£ £ £ £
Sales 52,500 52,500

costs
Fixed production cost 10,000 0
absorbed
Opening inventory 0 0
Production cost of (30,000) (22,500) C
sales H
A
Under/over (5,000) 0 P
absorption T
Variable selling, (7,875) (7,875) E
R
distrib'n and
admin 4
Fixed selling, distrib'n (10,000) (10,000)
and admin
Fixed production 0 (15,000)
costs
Profit/(loss) (375) (2,875)
WORKING
Sales revenue = 1,500  £35 = £52,500
Variable production costs = 2,000  (£5 + £8 + £2) = £30,000
Fixed production cost absorbed = 2,000  £5 = £10,000
Closing inventory = see (a) and (b)

Under absorption:
£
Overhead incurred (£5  36,000  1/12) 15,000
Under/(over) 5,000
absorbed
Variable selling, distribution and admin = £52,500  15% = £7,875

Fixed selling, distribution and admin = £120,000/12 months = £10,000
Fixed production cost = (36,000  £5)/12 = £15,000
(e) April
Absorption Marginal
£ £ £ £
Sales 105,000 105,000

costs
Fixed production cost 16,000 0
absorbed
Opening inventory 10,000 7,500
Production cost of (60,000) (45,000)
sales
Under/over 1,000 0
absorption
Variable selling, (15,750) (15,750)
distrib'n and
admin
Fixed selling, distrib'n (10,000) (10,000)
and admin
Fixed production 0 (15,000)
costs
Profit/(loss) 20,250 19,250
WORKING
Sales revenue = 3,000  £35 = £105,000
Variable production costs = 3,200  (£5 + £8 + £2) = £48,000
Fixed production cost absorbed = 2,000  £5 = £10,000
Opening inventory = March closing inventory – see (a) and (b)
Closing inventory – see (a) and (b)
Over absorption:
£
Overhead incurred (£5  36,000  1/12) 15,000
Under/(over) absorbed (1,000)
Variable selling, distribution and admin = £105,000  15% = £15,750

Fixed selling, distribution and admin = £120,000/12 months = £10,000
Fixed production cost = (36,000  £5)/12 = £15,000

1 The correct answer is: £70.
Marginal production cost is the total of all variable production costs.
WORKINGS
Marginal production cost of product EZ
£ per unit
Variable materials 20
Variable labour 40
Variable production overheads 10
70
2 The correct answers are: marginal costing: £15,000 and absorption costing: £22,000.
WORKINGS
(1) Marginal cost of product = Variable material cost + Variable labour cost
= £5.50 + £2
= £7.50 per unit
In marginal costing, closing inventories are valued at marginal production cost, which
includes the variable material cost of £5.50 and the variable labour cost of £2 for 2,000
units.
Therefore inventory valuation = £7.50  2,000
= £15,000
(2) Absorption cost of product = Marginal cost + Fixed production overheads
= £7.50 + £3.50
= £11 per unit
In absorption costing, closing inventories are valued at £11 each (this includes a share
of fixed production overheads).
Therefore inventory valuation = £11  2,000
= £22,000 C
H
3 A
P
Luxury Standard T
Marginal costing £13,630 £16,530 E
R
Absorption costing £20,735 £22,515
4
WORKINGS
(1) Marginal costing
In marginal costing, closing inventories are valued at marginal production cost
(variable materials, variable labour and variable production overhead).
Luxury = £16 + £21 + £10 = £47 per unit.
There are 290 of them, so closing inventory value = 290  £47 = £13,630.
Standard = £12 + £9 + £8 = £29 per unit.
There are 570 of them, so closing inventory value = 570  £29 = £16,530.
(2) Absorption costing basis
Absorption costing includes fixed production overheads in inventory values rather than
charging them against profit.

Based on the labour costs, the number of hours to produce each item is Luxury 3.5
(£21/£6), Standard 1.5 (£9/£6).
Luxury = The overhead absorption rate is £120,400/((3,500  3.5) + (3,300  1.5)) = £7
per direct labour hour.
Absorption costing inventory values of luxury items are therefore £7  3.5 hours  290
units greater than marginal costing inventory values, ie, £13,630 + £7,105 = £20,735.
Standard = The overhead absorption rate is £7 per direct labour hour. Absorption
costing inventory values are therefore £7  1.5 hours  570 units greater than marginal
costing inventory values, ie, £16,530 + £5,985 = £22,515.
4 Absorption net profit £ 166,600 Marginal net profit £ 161,350
WORKING
Absorption net profit
£91,000
Fixed manufacturing cost per unit = = £3.50
26,000
Budgeted production = actual production, therefore no under or over absorption of

overhead occurred.
£ £
Sales revenue 24,500  £40 980,000
Manufacturing cost of sales 24,500  £(18.50 + 3.50) (539,000)
Gross profit 441,000
Less selling and administration costs
Variable 24,500  £9.20 225,400
Fixed 49,000
(274,400)
Absorption costing net profit 166,600
Using the 'short-cut' method:

£ per unit
Sales price 40.00
Less: Variable manufacturing cost per unit (18.50)
Variable selling and administration cost per unit (9.20)
Fixed manufacturing cost per unit (3.50)
8.80
£
 sales volume 24,500 units 215,600
Less fixed selling and administration costs 49,000
Inventories increased during the period, therefore the marginal costing net profit will be
lower.
£
Difference in profits (change in inventory 1,500 units  £3.50) (5,250)
Marginal costing net profit 161,350
Check using the 'short-cut' method: £

Marginal costing contribution = 24,500  £(40 – 18.50 – 9.20) 301,350
Less fixed costs (£91,000 + £49,000) (140,000)
Marginal costing profit 161,350

5 B
Difference in profit = (8,500 – 6,750)  £3 = £5,250
Absorption costing profit = £62,100 – £5,250 = £56,850
Since inventory levels reduced, the absorption costing profit will be lower than the marginal
costing profit. You can therefore eliminate options C and D.
6 The following statements are arguments in favour of marginal costing.
 It is simple to operate.
 There is no under or over absorption of overheads.
 Fixed costs are the same regardless of activity levels.
 The information from this costing system may be more useful for decision making.
The first statement is incorrect. A marginal costing system does not value inventory in
accordance with financial reporting standards because it does not include absorbed fixed
production overheads. The information from an absorption costing system is therefore
more useful for external reporting purposes.
7 The correct statements are as follows.
 If inventory levels increase, marginal costing will report a lower profit than absorption
costing.
 If opening and closing inventory levels are the same, marginal costing and absorption
costing will report the same profit figure.
The first statement is incorrect because a positive contribution will not always show a profit
under either costing system. The level of reported profit will depend on the magnitude of
fixed overheads.
The remaining statements can be assessed using the following rules:
 if inventory levels increase, absorption costing profit is higher than marginal costing
profit (because of the fixed overhead carried forward in inventory)
C
 if inventory levels decrease, absorption costing profit is lower than marginal costing H
profit (because of the fixed overhead 'released' from inventory) A
P
 if inventory levels remain the same then both costing systems will report the same T
profit figure E
R
8 The marginal costing profit for the period would have been £ 44,800 .
4
WORKING
£
Actual fixed production overhead 42,000
Over absorbed overhead 6,000
Absorbed fixed production overhead 48,000
£48,000
Therefore absorption rate per unit = = £8 per unit
6,000
Inventory decrease = 7,100 units – 6,000 units = 1,100 units

£
Absorption costing profit 36,000
Profit difference (1,100 units × £8) 8,800
Marginal costing profit 44,800

9 B
Fixed costs per unit = £16/4 = £4
Units in closing inventory = 17,500 – 15,000 = 2,500 units
Profit difference = Inventory increase in units × Fixed overhead per unit
= 2,500 × £4 = £10,000
Inventories increased, therefore fixed overhead would have been carried forward in
inventory using absorption costing and the profit would be higher than with marginal
costing.
10 B
Inventory levels increased by 3,000 units and absorption costing profit is £105,000 higher
(£955,500 – £850,500).
Therefore fixed production cost included in inventory increase = £105,000/3,000 = £35 per
unit of inventory.
Budgeted fixed costs £1,837,500
= = 52,500 units
Fixed cost per unit 35

CHAPTER 5
Pricing calculations
Introduction
Examination context
TOPIC LIST
1 Full cost-plus pricing
2 Marginal cost-plus pricing
3 Mark-ups and margins
4 Transfer pricing
Introduction
 Calculate the sales price for a given product or service using cost based pricing
 Calculate transfer prices for specified sales to internal customers which take
account of appropriate costs
The specific syllabus references for this chapter are: 1e, f.
Syllabus links
An understanding of the use of cost information as a basis for pricing decisions will underpin
your studies of strategic choice within the Business Strategy and Technology syllabus.
Examination context
Pricing decisions could feature as a narrative question or as a calculation question.
The content of this chapter is deceptively straightforward. A thorough knowledge of this, and
earlier topics such as fixed and variable costs, is required to answer questions in this area.
 calculate a selling price using full cost-plus pricing
 calculate a selling price using marginal cost-plus pricing
 demonstrate an understanding of the difference between mark-up and margin and of the
relationship between them
 derive the mark up percentage that will achieve a desired return on the investment in a
product
 calculate a transfer price that will achieve profit maximisation and encourage an alignment
of the goals of groups or individuals with the goals of the organisation as a whole

1 Full cost-plus pricing
Section overview
 In full cost-plus pricing the sales price is determined by calculating the full cost of the
product or service and then adding a percentage mark-up for profit.
 The full cost may be a fully absorbed production cost only, or it may include some
absorbed selling, distribution and administration overheads. In the former case the mark-
up on costs must be greater in order to recover the other costs.
 The most important criticism of full cost-plus pricing is that it fails to recognise that since
sales demand may be determined by the sales price, there will be a profit-maximising
combination of price and demand.
1.1 Cost-plus pricing

In practice cost is one of the most important influences on price. While in economic theory it is
possible to set a sales price that will maximise profit, in reality there is a lack of precise
information about cost behaviour patterns and the effect of price on sales demand.
This will lead some organisations to base their selling price decision on simple cost-plus rules,
whereby costs are estimated and then a percentage mark-up is added in order to set the price.
1.2 Setting full cost-plus prices

The full cost may be a fully absorbed production cost only, or it may include some absorbed
selling, distribution and administration overhead.
Therefore there are two options for calculating a full cost-plus price.
Option 1
Manufacturing: Unit sales price = Total production cost per unit + Percentage mark-up
Service: Unit sales price = Service cost per unit + Percentage mark-up
Option 2
Manufacturing: Unit sales price = Total production cost per unit + Other costs* per unit +
Percentage mark-up
Service: Unit sales price = Service cost per unit + Other costs* per unit + Percentage mark-up
*Other costs include selling, distribution and administration costs
Clearly, to achieve the same sales price, the mark-up on cost must be greater under Option 1
than under Option 2 in order to recover the other costs.
Worked example: Calculating a cost-plus selling price

XY Ltd has begun to supply service S, for which the following cost estimates have been
C
prepared.
H
£ per unit A
Variable materials 14.00 P
T
Variable labour at £12 per hour 54.00
E
Variable overheads at £3 per hour 13.50 R
Variable service cost per unit 81.50
5
Fixed production overheads are budgeted to be £69,000 each period. The overhead absorption
rate will be based on 17,250 budgeted direct labour hours each period.
The company wishes to add 20% to the full service cost in order to determine the selling price
per unit for service S.
ICAEW 2019 Pricing calculations 111

Solution
Step 1
Calculate the fixed overhead absorption rate.
£69,000
Overhead absorption rate =
17,250
= £4 per direct labour hour
Step 2
Calculate the full service cost per unit.
Direct labour hours per unit = £54/£12 = 4.5 hours
£ per unit
Variable production cost per unit 81.50
Fixed overhead absorbed (4.5 hours  £4) 18.00
Full service cost per unit 99.50
Step 3
Add the required mark-up to determine the selling price.
£ per unit
Full service cost per unit 99.50
Mark-up 20% 19.90
Full cost-plus selling price 119.40
Interactive question 1: Adjusting the mark-up percentage

The full cost of providing a service is £40 per hour and its selling price is currently determined as
full cost plus 60%.
Requirement
In each of the following separate situations, calculate the required profit mark-up percentage.
Situation Write your answer here

%
1 A competitor launches a similar service for £60 per

hour. In order to sell the service at the same price as
the competitor the percentage mark-up must be
reduced to:
2 The full cost of providing the service increases to £50
per hour. The required mark-up percentage to
achieve the same absolute value of mark-up per
hour of service provided is:

1.3 Determining the mark-up percentage
A business may have an idea of the percentage profit mark-up it would like to earn, and so may
decide on an average profit mark-up as a general guide for pricing decisions. This would be
particularly useful for businesses that carry out a large amount of contract or jobbing work, for
which individual job or contract prices must be quoted regularly to prospective customers.
However, the percentage profit mark-up does not have to be rigid and fixed. It can be varied to
suit the circumstances. In particular, the percentage mark-up can be varied to suit anticipated
supply and demand conditions in the market.
1.4 Determining the mark-up to achieve a required return on investment

A business might calculate the mark-up percentage for a product in order to achieve a required
return on the investment in the product.
Worked example: Pricing to generate a return on investment

ZZ Ltd requires an annual return of 30% on the investment in all of its products. In the
forthcoming year £800,000 will be invested in non-current assets and working capital to produce
and sell 50,000 units of product Z. The full cost per unit of product Z is £100.
The annual return required on the investment in product Z = £800,000 × 30%
= £240,000
Total cost to be incurred on product Z = 50,000 units × £100 = £5m
Mark-up as a percentage of full cost = (£240,000/£5m) × 100% = 4.8%
The selling price can now be calculated as follows.
£ per unit
Full cost 100.00
Mark-up 4.8% 4.80
Selling price of product Z 104.80
1.5 Allowing for inflation when setting selling prices

We have seen that the mark-up added to total cost must be sufficient to earn the required profit,
or in the case of adding a mark-up to total production cost, the mark-up must be sufficient to
recover all non-production costs in addition to earning the required profit.
Therefore managers must estimate costs as accurately as possible and must decide whether to
include allowances for anticipated inflation. Even if some sort of allowance is added for inflation
the seller bears the risk of inflation when a selling price is determined before delivery of the
goods or services.
However, if the buyer agrees to prices based on actual cost incurred plus a profit mark-up then
C
all of the cost increases caused by inflation can be passed to the buyer. Thus all of the inflation H
risk is borne by the buyer. The following points about this pricing policy should be noted. A
P
(a) The buyer is likely to require some form of assurance that costs are adequately controlled. T
Otherwise the supplier's cost inefficiencies will be passed directly to the buyer and there is E
R
no incentive for the supplier to control costs. The principle of 'Open book accounting' can
be introduced, where the buyer is given open access to the cost information contained in 5
the accounts of the seller.
(b) Moreover the supplier actually has an incentive to overspend, since all costs will be passed
to the buyer and a profit mark-up will also be earned on all expenditure by the supplier.

(c) If a credit period is offered to the buyer then the supplier will bear the inflation risk from
the date that the final price is agreed until payment is received from the customer.
However in low inflation economies this extra inflation risk is likely to be acceptable to a
supplier.
1.6 Advantages and disadvantages of full cost-plus pricing

The advantages of full cost-plus pricing are as follows.
 The price is quick and easy to calculate.
 Pricing decisions can be delegated to more junior employees. This is particularly important
with jobbing work where many prices must be established and quoted each day.
 A price in excess of full cost should ensure that an organisation working at normal capacity
will cover all its costs.
 Price increases can be justified as costs rise.
However, full cost-plus pricing does have a number of disadvantages.
 It fails to recognise that since demand may be determining price, there will be a profit-
maximising combination of price and demand.
 It reduces incentives to control costs.
 It requires arbitrary absorption of overheads into product costs.
 If full cost-plus pricing is applied strictly the organisation may be caught in a vicious circle
like the one shown in Figure 5.1.
Price is set using total

cost per unit based on
budgeted sales volume
Resulting price may be

too high to achieve the
budgeted demand
Reduced output volume

increases the fixed cost
per unit
Higher selling price

results from full cost-plus
formula
Figure 5.1: Application of cost-plus pricing

2 Marginal cost-plus pricing
Section overview
 Marginal cost-plus pricing involves adding a profit mark-up to the marginal or variable
cost of production or sales.
 The chief advantage of marginal cost-plus pricing is that it avoids the arbitrary
apportionment and absorption of fixed costs.
2.1 Setting marginal cost-plus prices

Marginal cost-plus pricing is a method of determining sales prices whereby a profit mark-up is
added to either the marginal cost of production or the marginal cost of sales.
In practice, marginal cost-plus pricing is used in businesses where there is a readily identifiable
basic variable cost. The most obvious example is retail organisations, where the price of goods
in shops is often determined by adding a mark-up to the purchase price of the item.
Worked example: Calculating a marginal cost-plus price

Product Y incurs direct variable production costs of £7 per unit. Fixed production costs amount
to £17,900 each period.
Variable selling and distribution costs are £3.80 per unit and fixed selling, distribution and
administration costs amount to £24,800 each period.
Selling prices are determined on a marginal cost-plus basis, using a mark-up of 30% of the
marginal cost of sales.
Requirement
Calculate the selling price per unit of product Y and the profit that will result from sales of 26,800
units each period.
Solution
Step 1
Calculate the total marginal or variable cost of sales per unit.
£ per unit
Variable production cost 7.00
Variable selling and distribution cost 3.80
Total marginal cost 10.80
Step 2
Add the required mark-up to determine the selling price.
£ per unit
Total marginal cost 10.80
C
Mark-up 30% 3.24
H
Marginal cost-plus selling price 14.04 A
P
T
E
R

Step 3
Determine the total contribution and deduct the fixed costs to derive the period profit.
The mark-up per unit is the same as the contribution earned per unit. It contributes towards the
fixed costs and profit for the period.
£ £
Total mark-up/contribution (26,800  £3.24) 86,832
Less fixed costs:
Production 17,900
Selling, distribution and administration 24,800
42,700
Profit 44,132
2.2 Advantages and disadvantages of marginal cost-plus pricing

The advantages of marginal cost-plus pricing are as follows.
 It is a simple method to use.
 It avoids the arbitrary apportionment and absorption of fixed costs that is necessary with
absorption costing.
 It is more useful than total cost-plus pricing for short-term management decision making.
This is because it draws management's attention to contribution and the effect on profit of
higher or lower sales volumes. The level of contribution will vary in direct proportion to the
sales volume.
The disadvantages of marginal cost-plus pricing are as follows.
 The full costs might not be recovered in the long term.
 Although the size of the mark-up can be varied in accordance with demand conditions, the
pricing method does not ensure that sufficient attention is paid to demand conditions,
competitors' prices or profit maximisation.
3 Mark-ups and margins
Section overview
 The mark-up is the profit expressed as a percentage of the marginal cost, total production
cost or total cost.
 The margin is the profit expressed as a percentage of the sales price.
3.1 The difference between mark-up and margin

When sales prices are being determined on a cost-plus basis it is extremely important to be
clear about whether the profit to be added to unit costs is calculated as a percentage of costs or
as a percentage of selling price.

Cost-plus
pricing
Mark-up percentage Margin percentage

Profit expressed as a Profit expressed as a
percentage of cost percentage of sales
price
Figure 5.2: Mark-up percentage v margin percentage
Worked example: The difference between mark-up and margin

Product Q incurs a total cost of £80 per unit and its selling price is set at £100 per unit.
The mark-up applied to product Q = (£20/£80) × 100%
= 25% of total cost
The margin earned by product Q = (£20/£100) × 100%
= 20% of sales price
Interactive question 2: Mark-ups and margins
Question Write your answer here
1 If the full cost is £14 per unit, calculate the price to

achieve a margin of 20% of the selling price.
2 The selling price is £27 per unit, determined on the
basis of full cost-plus. If the full cost is £18 per unit,
calculate the mark-up percentage.
3 A selling price of £165 per unit earns a mark-up of
106.25% of the full cost. What is the full cost per unit?
4 A product's selling price is determined by adding
33.33% to its full cost. What percentage margin on
sales price does this represent?
C
H
A
P
T
E
R

4 Transfer pricing
Section overview
 A transfer price is the amount charged by one part of an organisation for the provision of
goods or services to another part of the same organisation.
 A transfer pricing system has a number of aims, which may conflict with each other.
 Inappropriate transfer prices may lead to sub-optimal decisions and a lack of alignment of
corporate goals (called goal congruence).
 In a perfectly competitive market the optimum transfer price is the market price. This
should be reduced for savings in costs that are not incurred on internal transfers, such as
distribution costs, advertising and marketing costs, and bad debts.
 A problem with cost-plus pricing is that the receiving division will perceive the transfer
price to be a wholly variable cost, whereas it includes some costs which are fixed from the
point of view of the company as a whole. This could lead to sub-optimal decision making.
 With two part transfer prices, all transfers are charged at a predetermined standard
variable cost. A periodic charge for fixed costs would also be made by the supplying
division to the receiving division.
 In a dual pricing system the receiving division is charged with the standard variable cost of
all transfers. The supplying division is credited with the market value or a cost-plus price in
order to provide a profit incentive to make the transfer.
4.1 What is a transfer price?

Transfer pricing is used when divisions of an organisation need to charge other divisions of the
same organisation for goods or services that they provide to them. For example, subsidiary A
might manufacture a component that is used as part of a product made by subsidiary B of the
same company. The component can also be bought on or sold to the external market. Therefore
there will be two sources of revenue for subsidiary A:
 external sales revenue from sales made to other organisations
 internal sales revenue from the transfer prices charged for components supplied to
subsidiary B
4.2 Aims of a transfer pricing system

 To enable the realistic measurement of divisional profit.
 To provide the supplier with a realistic profit and the receiver with a realistic cost.
 To give autonomy to managers.
 To encourage goal congruence, whereby individual managers' own goals are the same as
the goals of the company as a whole.
 To ensure profit maximisation for the company as a whole.
It may be difficult to reconcile all of these aims.

4.3 Practical methods of transfer pricing
PRACTICAL METHODS
OF TRANSFER PRICING
MARKET COST- TWO PART DUAL

PRICE PLUS TRANSFER PRICING
PRICE PRICE
Figure 5.3: Practical methods of transfer pricing
4.3.1 Market price

If a perfectly competitive market exists for a product, then the external market price is the
optimum transfer price if the supplying division is operating at full capacity.
The market price should be adjusted for savings in certain costs that may not be incurred on
internal transfers, such as:
 packaging costs
 advertising costs
 distribution costs
 bad debts
Care must be taken to ensure that the division's product is the same as that offered by the
external market (for example in terms of quality, delivery terms etc).
Using market price can, however, lead to problems. Interactive question 3 illustrates this.
Interactive question 3: Using market value as the transfer price

Division A Division B
Variable cost 10 15
Transfer price at market value – 20
Fixed costs 5 10
Profit 5 25
Transfer price/selling price 20 70
Division A can sell externally at £20 per unit or transfer internally to division B at £20 per unit.
Division B receives an offer from a customer of £30 per unit for its final product.
Requirements
(a) Would division B accept the offer of £30 per unit given the existing transfer price?
Yes No
C
H
(b) Is this the correct decision from the company's point of view if:
A
P
(1) division A has surplus capacity? Yes No T
E
(2) division A is operating at full capacity? Yes No
R
See Answer at the end of this chapter. 5

4.3.2 A cost-plus approach to transfer pricing
This transfer pricing method works in the same way as cost-plus pricing, discussed earlier in this
chapter. The supplying division determines the transfer price by adding a profit mark-up to the
cost of the product or service. Some form of cost-based transfer pricing method will usually be
necessary where there is no external market for the product or service. A number of issues arise
with this transfer pricing method.
 A pre-determined standard cost should be used rather than actual cost. A standard cost is
a predetermined unit cost which is calculated by taking account of the expected price and
usage of resources to produce one unit of product or service. If standard costs are not used
then all efficiencies and inefficiencies are transferred from one division to another and
divisional profit measurement is distorted.
 To ensure that overheads are recovered the supplying division will wish to base the
transfer price on total cost. However, the supplying division's fixed costs will then be
perceived as variable costs from the point of view of the receiving division. This could lead
to sub-optimal decisions.
Worked example: Sub-optimal decision making

A company has two divisions, S and R. Both divisions manufacture multiple products. Division S
transfers its output of component C to division R at full cost plus 10%. Division R then incurs
further costs to convert component C into finished product P for sale on the external market at
£40 per unit.
Costs incurred are as follows.
Division S Division R
Variable cost 20 15
Fixed cost absorbed 10
Full cost 30
Requirements
Would the transfers be recommended from the point of view of:
(a) the company as a whole?
(b) the manager of division R?
Solution
(a) The transfers would be recommended from the point of view of the company as a whole.
The variable cost incurred by the company as a whole for each unit of product P is £35.
£ per unit
Variable cost – Division S 20
– Division R 15
35
The fixed costs are irrelevant to this analysis because they would be incurred even if the
transfers are not made.
Therefore from the point of view of the company as a whole the transfers are worthwhile
because product P earns a contribution of £5 per unit (£40 – £35).
(b) The transfers would not be recommended from the point of view of the manager of division R.
Transfer price per unit of component C = £30 + 10% = £33
The manager of division R would view the transfer price of component C as a variable cost,
since it is an extra cost incurred by division R for every unit of product P manufactured.

Therefore, from the point of view of the manager of division R the variable cost of each unit
of product P is £48.
£ per unit
Variable cost – Component C (perceived variable cost) 33
– Extra cost incurred 15
48
Division R would not recommend the transfer of component C and the manufacture of
product P since the division would record a negative contribution of £8 for each unit
manufactured.
£ per unit of P
External market price 40
Division R perceived variable cost (48)
Contribution (8)
In this example the use of a full cost-plus transfer price has led to sub-optimal decision making.
There is a lack of goal congruence because the manager of division R, in pursuing the division's
own goals, was not at the same time automatically pursuing the goals of the company as a
whole.
In the situation depicted in Interactive question 3 (b)(i) there was also a lack of goal congruence.
The divisional manager's own goals were not congruent with those of the company as a whole.
The transfer pricing system was leading the manager of division B to make a sub-optimal
decision from the point of view of the company as a whole when division A had spare capacity.
4.3.3 Two-part transfer price

To avoid the sub-optimal decisions that may occur when the fixed costs of one division are
perceived as variable costs by another division, a two-part transfer price might be used.
Transfers are charged at a predetermined standard variable cost. A periodic charge for fixed
costs would also be made by the supplying division to the receiving division.
This helps to ensure goal congruence, since the receiving division would be fully aware of the
cost behaviour patterns of the company as a whole.
4.3.4 Dual pricing

In dual pricing the supplying division is credited with a different price from that which is charged
to the receiving division.
This transfer pricing method charges the receiving division for all transfers at variable or
marginal cost. This may lead to improved decision making.
The supplying division is credited with the market value or with a cost-plus transfer price in order
to provide a profit incentive to make the transfer.
C
The dual pricing method can be effective in avoiding sub-optimal decisions but it can be H
administratively cumbersome. A
P
T
E
R

Summary
Pricing calculations
Full cost- Market cost- Transfer pricing

plus pricing plus pricing for internal sales
Based on total Market Cost- Two Dual

cost or on price plus part pricing
total production price price
cost
Optimal price
in perfectly Fixed and
competitive variable
market charges
separated
Mark-up Margin May lead to

percentage percentage sub-optiomal
Profit expressed Profit expressed decisions
as a percentage as a percentage
cost of sales price
Different
Mark-up may price used
be derived to for receiving
earn a required and supplying
return on division
investment

Self-test
1 The following variable costs are incurred producing each unit of product F.
£ per unit
Variable material 8.00
Variable labour at £14 per hour 42.00
Variable production overheads are incurred at the rate of £4 per hour. Fixed production
overheads of £60,000 are absorbed on the basis of 25,000 budgeted direct labour hours.
Other overheads are recovered at 5% of total production cost.
If selling prices are set to recover the full cost plus 50% the selling price per unit of product
F is:
A £72.66
B £99.62
C £103.80
D £108.99
2 The marginal cost per unit of a product is 70% of its full cost. Selling prices are set on a full
cost-plus basis using a mark-up of 40% of full cost.
Which percentage mark-up on marginal cost would produce the same selling price as the
full cost-plus basis described?
A 70%
B 90%
C 100%
D 200%
3 Jay operates a car valeting service and charges £16 per car. He incurs a total cost of £10 per
car valeted.
Calculate the mark-up and margin earned per car valeted.
Mark-up %
Margin %
4 Which of the following statements is correct?

A A full cost-plus sales price will always be higher than a marginal cost-plus sales price
B If the selling price is agreed at the point of sale then the seller bears the inflation risk
during any credit period offered to the buyer
C A selling price in excess of the full cost per unit will always result in an overall profit for
the organisation
D A cost-plus selling price takes account of the effect of price on the quantity demanded
C
5 A company requires a 20% annual return on the investment in product F. H
A
The budgeted investment in non-current assets and working capital for product F for the P
next year is £90,000. The full cost per unit of product F is £5.00 and budgeted production T
and sales for next year is 36,000 units. E
R
The profit margin as a percentage of the sales price of product F is:
5
A 9.1%
B 10.0%
C 20.0%
D 50.0%

6 When goods are transferred from division A to division B a charge is made to division B at
standard variable cost. Each quarter division B is also charged with a lump-sum as a share of
A's fixed costs. This type of transfer pricing system is a:
A marginal cost-plus system
B dual pricing system
C two-part transfer pricing system
D standard cost transfer pricing system
7 Which two of the following are advantages of marginal cost-plus pricing?
A It is simple to use.
B The percentage mark-up can be varied.
C It pays attention to profit maximisation.
D It ignores fixed overheads in the pricing decision.
8 Division U makes components which it sells to external customers at a price of £24 per unit,
earning a mark-up of 20% of total cost. Variable costs account for 40% of Division U's total
cost.
Division U also transfers components at market value to Division V within the same
company. Division V incurs extra total costs of £8 per unit to convert and pack the
component for international sales. Variable costs account for 70% of Division V's total cost.
Both divisions currently have surplus capacity.
Division V has an opportunity to sell a batch of components to a customer for £15 per unit.
Which of the following statements is correct with regard to this potential order?
A The order is not acceptable from the company's point of view and the manager of
division V will make a sub-optimal decision.
B The order is not acceptable from the company's point of view and the manager of
division V will not make a sub-optimal decision.
C The order is acceptable from the company's point of view and the manager of division
V will make a sub-optimal decision.
D The order is acceptable from the company's point of view and the manager of division
V will not make a sub-optimal decision.
9 Division M manufactures product R incurring a total cost of £30 per unit. Fixed costs
represent 40% of the total unit cost.
Product R is sold to external customers in a perfectly competitive market at a price of £50
per unit. Division M also transfers product R to division N. If transfers are made internally
then division M does not incur variable distribution costs, which amount to 10% of the
variable costs incurred on external sales.
The total demand for product R exceeds the capacity of division M.
From the point of view of the company as a whole, enter the optimum price per unit at
which division M should transfer product R to division N.
Transfer price per unit = £

10 The following data relate to the Columba group, a company with several divisions. Division
D produces a single product, which it sells to Division R and also to organisations outside
the Columba group.
Division D sales to Division R Division D external sales
£ £
Sales revenue at £70 per unit 700,000
Sales revenue at £60 per unit 300,000
Variable costs at £36 per unit (180,000) (360,000)
Contribution 120,000 340,000
Fixed costs (100,000) (240,000)
Profit 20,000 100,000
The Columba group profit is £550,000.

A supplier offers to supply 3,000 units at £50 each to Division R.
Divisional managers of Columba are given freedom of choice for selling and buying
decisions, and their performance is judged solely according to divisional profitability.
Calculate the profit for Division D and for Columba if Division D does not match the lower
price offered by the external supplier and cannot increase its external sales, and Division R
chooses to purchase from the external supplier.
C
H
A
P
T
E
R

Write your answer here

Situation
%
1 A competitor launches a similar service for £60 per 50%

hour. In order to sell the service at the same price
as the competitor the percentage mark-up must be
reduced to:
2 The full cost of providing the service increases to 48%
£50 per hour. The required mark-up percentage to
achieve the same absolute value of mark-up per
hour of service provided is:
WORKINGS
(1) Situation 1
Absolute mark-up per hour of service sold = £(60 – 40) = £20
Mark-up percentage = (20/40) × 100% = 50%
(2) Situation 2
Current absolute value of mark-up per hour of service sold = 60% × £40 = £24
Mark-up percentage required = (£24/£50) × 100% = 48%
Question Write your answer here
1 If the full cost is £14 per unit, calculate the price to £17.50
achieve a margin of 20% of the selling price.
2 The selling price is £27 per unit, determined on the 50%
basis of full cost-plus. If the full cost is £18 per unit,
calculate the mark-up percentage.
3 A selling price of £165 per unit earns a mark-up of £80
106.25% of the full cost. What is the full cost per
unit?
4 A product's selling price is determined by adding 25%
33.33% to its full cost. What percentage margin on
sales price does this represent?
WORKINGS
(1) Cost and selling price structure:
%
Cost 80
Profit 20
Price 100
 Price = 100/80 × £14 = £17.50 per unit

(2) Profit per unit = £27 – £18 = £9
Mark-up percentage = £9/£18 = 50% of full cost
%
Cost 100.00
Profit 106.25
Price 206.25
 Full cost = (100.00/206.25) × £165 = £80 per unit

%
Cost 100.00
Profit 33.33
Price 133.33
Percentage margin on sales price = (33.33/133.33) × 100% = 25%

(a) No
Division B would reject the offer as there is a negative contribution of –£5 (£30 – £20 transfer
price – £15 variable cost).
(b) (1) No
If division A has surplus capacity then no full-price external sales would be forgone as a
result of transferring an extra unit to division B. Since the fixed costs are an arbitrary
apportionment of costs that would be incurred anyway, the only marginal cost to be
incurred within division A to provide another unit to B is £10 per unit.
From the point of view of the company as a whole, all the apportioned fixed costs can
be ignored because they will be incurred anyway. The sale of a unit from B to a
customer for £30 would earn a contribution of £5 as follows.
£30 – £10 variable cost in A – £15 variable cost in B = £5
Therefore division B's decision to reject the offer of £30 per unit would not be the
correct decision from the company's point of view if division A has surplus capacity.
(2) Yes
If division A is operating at full capacity then the transfer of an extra unit to division B
would mean that a full price external sale at £20 per unit is displaced, thus forgoing
contribution of:
£10 (£20 – £10 variable cost)
Therefore from the point of view of the company as a whole, the sale of a unit from B to
a customer for £30 would generate a negative contribution of – £5 as follows.
C
£ per unit H
Selling price 30 A
P
Variable cost in division A (10) T
Forgone contribution in division A (10) E
Variable cost in division B (15) R
Contribution (5)
5
Therefore division B's decision to reject the offer of £30 per unit would be the correct
decision from the company's point of view if division A is operating at full capacity. In
this situation there would be goal congruence and the manager of division B would not
make a sub-optimal decision.

1 D
Labour hours per unit = £42/£14 = 3 hours
Fixed production overhead absorption rate = £60,000/25,000
= £2.40 per hour
£ per unit
Variable material 8.00
Variable labour 42.00
Variable production overhead (3 hrs at £4) 12.00
Fixed production overhead (3 hrs at £2.40) 7.20
Total production cost 69.20
Other overhead at 5% 3.46
Full cost 72.66
Mark-up at 50% 36.33
Selling price 108.99
2 C
%
Marginal cost 70
Absorbed fixed cost 30
Full cost 100
Mark-up 40
Selling price 140
(30 + 40)
Required mark up on marginal cost = × 100%
70
= 100%
3 Mark-up = 60.0%
Margin = 37.5%
WORKINGS
£(16 – 10)
Mark-up % = × 100%
£10
= 60.0%
£(16 – 10)
Margin % = × 100%
£16
= 37.5%
4 B
A is incorrect because both prices will depend on the mark-up percentage that is added to
cost. If a very large mark-up percentage is added to marginal cost then a higher selling
price may result than with a full-cost plus sales price.
C is incorrect because the full cost includes fixed costs per unit which have been derived
based on estimated or budgeted sales volumes. If the budgeted volumes are not achieved
then the actual fixed cost per unit will be higher than estimated and the selling price might
be lower than the actual cost per unit.
D is incorrect because one of the major criticisms of cost-plus pricing is that it fails to
recognise that sales demand may be determined by the sales price.

5 A
Required annual return from product F = £90,000 × 20%
= £18,000
Total cost incurred = 36,000 × £5 = £180,000
 Required percentage mark-up on cost = (£18,000/£180,000) × 100%
= 10%
Product F selling price = £5 + 10%
= £5.50
Profit margin as a percentage of sales price = (£0.50/£5.50) × 100%
= 9.1%
6 C A marginal cost-plus system would involve adding a percentage to marginal cost in
order to provide the selling division with a contribution towards its fixed costs and profit.
A dual pricing system operates by charging the buying division for transfers at
marginal cost and crediting the selling division with either the market value or with a
cost-plus transfer price.
The description of a standard cost transfer pricing system is imprecise because it does
not specify whether marginal or full cost is used.
7 A,B The method is simple to use and the mark-up can be adjusted to reflect demand
conditions.
Option C is not an advantage. Although the size of the mark-up can be varied in
accordance with demand conditions, it is not a method of pricing which ensures that
sufficient attention is paid to demand conditions, competitors' prices and profit
maximisation.
Option D is not an advantage. Although there is no arbitrary apportionment and
absorption of fixed overheads, these costs are not ignored. They are taken into account
in ensuring that the mark-up is large enough to make a profit after covering fixed costs.
8 C Since both divisions have surplus capacity no full-price sales will be forgone as a result
of accepting this order. The fixed costs will not alter, therefore provided the order
covers the variable costs and earns a contribution it will be acceptable.
Division U total cost = 100/120 × £24 = £20 per unit
Division U variable cost = 40% × £20 = £8
From the point of view of the company as a whole:
Sales price per component 15.00
Variable cost incurred:
Division U 8.00
Division V (£8  70%) 5.60
13.60
Contribution 1.40 C
H
The order earns a contribution therefore it is acceptable from the company's point of view. A
P
From the point of view of Division V: T
E
£ per unit £ per unit R
Sales price per component 15.00
Variable cost incurred: 5
Transfer price 24.00
Own variable cost 5.60
(29.60)
Negative contribution (14.60)

The manager of Division V will perceive the transfer price to be a variable cost which is
incurred for each component sold. Therefore, this order will not be accepted. The
decision will be sub-optimal because the profit of the company as a whole will not be
maximised.
9 Transfer price per unit = £48.20
The total demand for product R exceeds the capacity of division M therefore internal
transfers will displace external sales. The optimum transfer price can be calculated as
follows.
Optimum transfer price = External market price – Cost savings with internal transfer
Cost savings with internal transfer = 10% × Variable costs
Fixed costs represent 40% of the total unit cost therefore variable costs are equal to 60% of
the total unit cost.
Cost savings with internal transfer = 10% × (£30 × 60%)
= £1.80
 Optimum transfer price = £50 – £1.80
= £48.20
10 The correct answer is profit for Division D = £48,000; profit for Columba Group = £508,000
Division R will buy the 3,000 units externally at a price of £50 per unit, leaving it with only
2,000 units to buy from Division D at £60 per unit.
Profits of Division D
£'000
Contribution from external sales 340
Contribution from sales to Division R 48
388
Fixed costs 340
Profit 48
The group as a whole will be paying £(50 – 36) = £14 per unit extra for each unit that
Division R purchases externally, thus reducing Columba's profits by 3,000 × £14 = £42,000.
Columba's profit will therefore reduce to £550,000 – £42,000 = £508,000.

CHAPTER 6
Budgeting
Introduction
Examination context
TOPIC LIST
1 Why do organisations prepare budgets?
2 A framework for budgeting
3 Steps in the preparation of a budget
4 The master budget
5 Preparing forecasts
6 Alternative approaches to budgeting
Introduction
 Apply forecasting techniques to help management in performance measurement

and planning
 Identify how data analytics can be used in budgeting and forecasting
 Prepare budgets, or budget extracts from information supplied

 Select the most appropriate of the following budgeting approaches and methods,
taking into account their advantages and disadvantages for planning, control and
motivation:
– bottom-up and top-down approaches to generating and managing budgets
– activity-based, responsibility-based and product-based structures
– zero-based and incremental budgeting
The specific syllabus references for this chapter are: 2a, b, c, d.
Syllabus links
You will need an understanding of how the annual budgeting exercise acts as a step towards the
achievement of an organisation's longer-term plans when you study the Business Strategy and
Technology syllabus.
Examination context
Numerical questions will be limited in scope (eg, individual budgets). Narrative questions need
to be read very carefully, particularly those that ask whether statements are true or false.
 demonstrate an understanding of the:
– objectives of a budgetary planning and control system
– difference between a budget and a forecast
– administrative process of budget preparation
 prepare functional budgets and the income statement and balance sheet elements of a
master budget from data supplied
 calculate the effect on budget outcomes of changes in specified variables
 demonstrate an understanding of a range of budgeting approaches and methods
 demonstrate an understanding of how data analytics can be used in forecasting

1 Why do organisations prepare budgets? C
H
A
Section overview P
T
• An organisation's budgets fulfil many roles. E
R
• A forecast is a prediction of what is likely to happen, whereas a budget is a plan of what
the organisation intends should happen. 6
• To be useful for planning and control purposes a budget must be quantified, but not
necessarily only in financial terms.
1.1 Reasons for preparing budgets

An organisation's budget fulfils many roles. Here are some of the reasons why budgets are used.
Function Detail
Compel planning Budgeting forces management to look ahead, to set out

detailed plans for achieving the targets for each department,
each operation and (ideally) each manager and to anticipate
problems.
Communicate ideas and A formal system is necessary to ensure that each person affected
plans by the plans is aware of what he or she is supposed to be doing.
Communication might be one-way, with managers giving orders
to subordinates, or there might be two-way communication.
Coordinate activities The activities of different departments need to be coordinated
to ensure everyone in an organisation is working towards the
same goals. This means, for example, that the purchasing
department should base its budget on production requirements
and that the production budget should in turn be based on
sales expectations.
Means of allocating It can be used to decide how many resources are needed (cash,
resources labour and so on) and how many should be given to each area
of the organisation's activities. Resource allocation is particularly
important when some resources are in short supply. Budgets
often set ceilings or limits on how much administrative
departments and other service departments are allowed to
spend in the period. Public expenditure budgets, for example,
set spending limits for each government department or other
public body.
Authorisation A formal budget delegates authority to budget holders to take
action and, within specified control limits, to incur expenditure
on the organisation's behalf.
Provide a framework for Budgets require that managers are made responsible for the
responsibility accounting achievement of budget targets for the operations under their
personal control.
Establish a system of control Control over actual performance is provided by the comparison
of actual results against the budget plan. Departures from
budget can then be investigated and the reasons can be divided
into controllable and uncontrollable factors.
ICAEW 2019 Budgeting 133

Function Detail
Provide a means of Budgets provide targets that can be compared with actual
performance evaluation outcomes in order to assess employee performance. They also
provide a means to establish a personal incentive and bonus
scheme.
Motivate employees to The interest and commitment of employees can be retained if
improve their performance there is a system that lets them know how well or badly they are
performing. The budget can act as a target for achievement, and
the identification of controllable reasons for departures from
budget with managers responsible provides an incentive for
improving future performance.
1.2 Budgets compared with forecasts

A forecast is a prediction of what is likely to happen in the future, given a certain set of
circumstances. This is different from a budget, which is a quantified plan of what the
organisation intends should happen in the future.
The budget is based on the forecast, therefore the two are connected, but they are not the same
thing. Measures might be taken to ensure that budgeted targets are achieved, thus a budget
forces management into decision making and taking action. For example, a gap between
forecast sales revenue and the sales budget could force sales promotions or an increase in
advertising.
1.3 Quantified budgets

To fulfil the range of purposes for which it is prepared, a budget must be quantified. For
example, the following two statements would not be particularly useful for planning and control
purposes.
'We plan to use fully all the available hours of semi-skilled labour next period.'
'We plan to minimise expenditure on advertising next period.'
Without quantification these are merely general statements of purpose. The following quantified
budgets are more useful for planning and control.
'We plan to use 24,800 hours of semi-skilled labour next period.'

'We plan to spend £107,000 on advertising next period.'
These budgets provide definite plans, as well as yardsticks for control purposes. Notice that the
labour hours budget is not expressed in financial terms. It still fulfils the role of a budget because
it is quantified. Therefore a budget does not necessarily need to be expressed in financial terms.
Of course the semi-skilled labour hours budgeted can be converted into a budget expressed in
financial terms by applying a rate of pay per hour to the budgeted number of labour hours.
An important feature of any quantified budget is the fact that it is time bound. Just to say, 'We
plan to spend £107,000 on advertising' without specifying a period over which this amount is to
be spent would render the 'budget' useless.

2 A framework for budgeting C
H
A
Section overview P
T
 The budget committee is the coordinating body in the preparation and administration of E
budgets. R
 The budget period is the period covered by the budget, which is usually one year. The 6
budget is divided into a number of control periods, typically calendar months.
 The budget manual is a collection of instructions relating to the preparation and use of
budgetary data.
2.1 Budget committee

The budget committee is the coordinating body in the preparation and administration of
budgets. The budget committee is usually headed up by the managing director (as chairman)
who is helped by a budget officer, who is usually the finance director or another accountant.
Every part of the organisation should be represented on the committee, so there should be a
representative from sales, production, marketing and so on.
Functions of the budget committee include the following.
 Coordination and allocation of responsibility for the preparation of budgets
 Issuing of the budget manual
 Timetabling
 Provision of information to help with the preparation of budgets
 Communication of final budgets to the appropriate managers
 Monitoring the budgeting process by comparing actual and budgeted results
Often the budget committee is the senior management team of an organisation or the board of
directors itself.
2.2 The budget period

The budget period is the period covered by the budget, which is usually one year. However,
budgets can be prepared and used for longer periods, for example capital expenditure
budgets. Budgets can also be prepared for shorter periods, for example in an environment
where technology or other factors are rapidly changing with the result that annual budgets
quickly become out of date.
In the common situation where a budget is prepared for a year it will usually be divided into
monthly control periods so that regular comparisons can be made of the actual and budgeted
results.
Some organisations divide the annual budget into 13 periods of 4 weeks. Others have 12
budget periods but they are not calendar months, but periods of 4, 4 and 5 weeks for each
quarter of the year.
2.3 The budget manual

The budget manual is a collection of instructions governing the responsibilities of persons and
the procedures, forms and records relating to the preparation and use of budgetary data.

A budget manual may contain the following.
(a) An explanation of the objectives of the budgetary process
 The purpose of budgetary planning and control
 The objectives of the various stages of the budgetary process
 The importance of budgets in the long term planning of the business
(b) Organisational structures
 An organisation chart
 A list of individuals holding budget responsibilities
(c) An outline of the principal budgets and the relationship between them
(d) Administrative details of budget preparation
 Membership and terms of reference of the budget committee
 The sequence in which budgets are to be prepared
 A timetable
(e) Procedural matters
 Specimen forms and instructions for their completion
 Specimen reports
 Account codes (or a chart of accounts)
 The name of the budget officer to whom enquiries must be sent
3 Steps in the preparation of a budget
Section overview
 The principal budget factor is that factor which limits an organisation's activities. The
budget for the principal budget factor must be prepared first.
 If sales volume is the limiting factor then the sales budget should be prepared first.
 The production budget will then be prepared by adjusting the sales budget for planned
changes in finished goods inventory.
 The next stage will be the preparation of budgets for production resources such as direct
materials usage and direct labour.
 The direct materials purchases budget is prepared by adjusting the direct materials usage
budget for planned changes in raw materials inventory.
 Overhead cost budgets will be prepared, taking account of the level of activity to be
achieved and the support needed to be given to the 'direct' operations. A budgeted
income statement can then be produced.
 A number of budgets such as the capital expenditure budget, the working capital budget
and the cash budget must be prepared in order to provide the necessary information for
the budgeted balance sheet.
 Standard costs provide the basic unit rates to be used in the preparation of a number of
functional budgets.
The procedures for preparing a budget will differ from organisation to organisation but the
steps described below will be typical of those followed by many organisations. The preparation
of a budget may take weeks or months and the budget committee may meet several times
before the master budget (budgeted income statement, budgeted balance sheet and budgeted
cash flow) is finally agreed. Functional budgets (sales budgets, production budgets, direct

labour budgets and so on), which are combined into the master budget, may need to be
amended many times because of discussions between departments, changes in market C
H
conditions and so on during the course of budget preparation. A
P
Ideally, a master budget should be finished before the start of the period to which it relates.
T
E
R
3.1 Identifying the principal budget factor
6
The budget for the principal budget factor must be prepared first. The principal budget factor is
that factor which limits an organisation's activities. This factor is usually sales demand. A
company is usually restricted from making and selling more of its products or services because
there would be no sales demand for the increased output at a price that would be
acceptable/profitable to the company. The principal budget factor may alternatively be machine
capacity, distribution and selling resources, the availability of key raw materials or the availability
of cash. Once this factor is defined then the remainder of the budgets can be prepared. For
example, if sales are the principal budget factor then the production manager can only prepare
the production budget after the sales budget is complete.
3.2 The order of budget preparation

Assuming that sales has been identified as the principal budget factor, the stages involved in the
preparation of a budget for a manufacturing business can be summarised as follows.
(a) The sales budget is prepared in terms of units of product or service, unit selling price and
total sales value. The finished goods inventory budget can be prepared at the same time.
This budget decides the planned increase or decrease in finished goods inventory levels.
(b) With the information from the sales and inventory budgets, the production budget can be
prepared. This is, in effect, the sales budget in units plus (or minus) the increase (or
decrease) in finished goods inventory. The production budget will be stated in terms of
units.
(c) This leads on logically to budgeting the resources for production. This involves preparing a
materials usage budget, machine usage budget and a labour budget.
(d) In addition to the materials usage budget, a materials inventory budget will be prepared,
to decide the planned increase or decrease in the level of inventory held. Once the raw
materials usage requirements and the raw materials inventory budget are known, the
purchasing department can prepare a raw materials purchases budget in quantities and
value for each type of material purchased. Similarly warehousing and distribution budgets
can be prepared.
(e) During the preparation of the sales and production budgets, the managers of the cost
centres of the organisation will prepare draft budgets for their department overhead costs.
Such overheads will include maintenance, stores, administration, selling and research and
development.
(f) From the above information a budgeted income statement can be produced.
(g) In addition, several other budgets must be prepared in order to arrive at the budgeted
balance sheet. These are the capital expenditure budget (for non-current assets), the
working capital budgets (for budgeted increases or decreases in the level of receivables
and accounts payable as well as inventories), and a cash budget.

The following diagram shows the major budgets and their inter-relationships.
Sales budget
Inventory budget Other cost budgets: Receivables

(finished goods) Sales and distribution costs budget
Administration costs
R&D
Production budget
Raw materials Direct labour Machine usage

usage budget budget Budget
Inventory budget
(raw materials)
Recruitment or Production
redundancy budgets overhead budget
Raw materials
purchase budget
Payables budget Cash budget

Capital
expenditure
budget
Budget income
statement and
balance sheet
Figure 6.1: Inter-relationships between major budgets

A similar flow chart could be prepared for a service based business.
Interactive question 1: The order of budget preparation
For the following pairs of budgets use the table to identify, under normal circumstances,
whether the first budget should be produced before or after the second or whether it does not
matter. Tick one box for each row. Assume that sales demand is the principal budget factor.
Before After Doesn't matter
Sales revenue; sales quantities
Finished goods inventories; production

volume
Materials usage; labour hours
Materials usage; materials purchases

3.3 Preparing functional budgets
C
Functional/departmental budgets include budgets for sales, production, purchases, labour and H
A
administration. Having seen the theory of budget preparation, let us look at functional (or
P
departmental) budget preparation, which is best explained by an example. T
E
R
Worked example: Preparing a materials purchases budget
6
ECO Co manufactures two products, S and T, which use the same raw materials, D and E. One
unit of S uses 3 litres of D and 4 kilograms of E. One unit of T uses 5 litres of D and 2 kilograms of
E. A litre of D is expected to cost £3 and a kilogram of E £7.
Budgeted sales for 20X2 are 8,000 units of S and 6,000 units of T; finished goods in inventory at
1 January 20X2 are 1,500 units of S and 300 units of T, and the company plans to hold
inventories of 600 units of each product at 31 December 20X2.
Inventories of raw material are 6,000 litres of D and 2,800 kilograms of E at 1 January and the
company plans to hold 5,000 litres and 3,500 kilograms respectively at 31 December 20X2.
The warehouse and stores managers have suggested that a provision should be made for
damages and deterioration of items held in store, as follows.
Product S : loss of 50 units
Product T : loss of 100 units
Material D : loss of 500 litres
Material E : loss of 200 kilograms
Requirement
Prepare a material purchases budget for the year 20X2.
Solution
To calculate material purchases requirements it is first necessary to calculate the material usage
requirements. That in turn depends on calculating the budgeted production volumes.
Product S Product T
Units Units
Production required
To meet sales demand 8,000 6,000
To provide for inventory loss 50 100
For closing inventory 600 600
8,650 6,700
Less inventory already in hand (1,500) (300)
Budgeted production volume 7,150 6,400
Material purchases budget Material D Material E

Litres kg
Usage requirements
To produce 7,150 units of S 21,450 28,600
To produce 6,400 units of T 32,000 12,800
To provide for inventory loss 500 200
For closing inventory 5,000 3,500
58,950 45,100
Less inventory already in hand (6,000) (2,800)
Budgeted material purchases 52,950 42,300
Unit cost £3 £7
Cost of material purchases £158,850 £296,100
Total cost of material purchases £454,950

The basic principles for the preparation of each functional budget are similar to those above.
Work carefully through the following question, which covers the preparation of a number of
different types of functional budget.
Interactive question 2: Preparing functional budgets

XYZ company produces three products, X, Y and Z. For the coming accounting period budgets
are to be prepared based on the following information.
Budgeted sales
Product X 2,000 at £100 each
Product Y 4,000 at £130 each
Product Z 3,000 at £150 each
Budgeted usage of raw material
RM11 RM22 RM33
Product X 5 2 –
Product Y 3 2 2
Product Z 2 1 3
Cost per unit of material £5 £3 £4
Finished inventory budget

Product X Product Y Product Z
Opening 500 800 700
Closing 600 1,000 800
Raw materials inventory budget

RM11 RM22 RM33
Opening 21,000 10,000 16,000
Closing 18,000 9,000 12,000
Expected hours per unit 4 6 8
Expected hourly rate (labour) £9 £9 £9
Requirement
Fill in the blanks.

(a) Sales budget
Product X Product Y Product Z Total
Sales quantity
Sales value £ £ £ £
(b) Production budget

Units Units Units
Budgeted production
(c) Material usage budget

RM11 RM22 RM33
Units Units Units
Budgeted material usage

(d) Material purchases budget
C
RM11 RM22 RM33 H
A
Budgeted material purchases £ £ £ P
T
(e) Labour budget E
R
Budgeted total wages £
6
3.4 The link between budgeting and standard costing

In the practical exercises in section 3.3 involving the preparation of budgets you used data
about the expected price and usage of the resources required to manufacture one unit of
product in the budget. For example, to prepare the labour cost budget you were provided with
information about the expected labour hours for each unit of product to be manufactured, as
well as the expected rate to be paid for each hour of labour.
This information about the expected price and usage of resources is provided by a standard
costing system. A standard cost is a predetermined unit cost that details the price and quantity
of resources (material, labour and so on) required for each unit of product or service. This unit
cost is multiplied by the budgeted activity level to determine the budgeted total cost for each of
the relevant cost elements.
Thus standard costs provide the basic unit rates to be used in the preparation of a number of
functional budgets. The detailed standard cost also enables control to be exercised over actual
performance. The departures from budgets, or variances, can be analysed in detail using the
standard cost information about the price and quantity of resources that should have been used
for each unit of production or service.
In Chapter 8 you will study the use of budgets for control purposes, and in Chapter 9 the
analysis of standard costing variances will be explored in detail.
4 The master budget
Section overview
 The master budget consists of the budgeted income statement, the budgeted balance
sheet and the cash budget.
 The master budget provides a consolidation of all the subsidiary budgets and is likely to
be of most interest to senior managers and directors.
 A sensitivity analysis might be carried out on the master budget to show the effect on the
budgeted outcome of changes in the budgeted assumptions.
4.1 The content of the master budget

The master budget provides a consolidation of all the subsidiary budgets and normally consists
of a budgeted income statement, a budgeted balance sheet and a cash budget.
Cash budgeting will be discussed in detail in Chapter 7. In this chapter we will focus on the
budgeted income statement and budgeted balance sheet.

Worked example: Preparing a budgeted income statement and balance sheet
Use the following information to prepare a budgeted income statement for the six months ended
30 June and a budgeted balance sheet at that date.
A new business is to be started and details of budgeted transactions are as follows.
 Non-current assets will be purchased for £12,000. Depreciation will be charged on a
straight line basis, assuming that the assets will have a useful life of five years after which
they will have no residual value.
 Month-end inventories will be maintained at a level sufficient to meet the forecast sales for
the following month.
 Forecast monthly sales are £4,000 for January to March, £5,000 for April to June and £6,000
per month for July onwards.
 The gross profit margin is budgeted to be 20% of sales value.
 Two months' credit will be allowed to customers and one month's credit will be received
from suppliers of inventory.
 Operating expenses (excluding depreciation) are budgeted to be £350 each month.
 The budgeted closing cash balance as at 30 June is £16,700.
Solution
Budgeted income statement for six months ended 30 June
£ £
Revenue ((£4,000  3) + (£5,000  3)) 27,000
Cost of sales (£27,000  80/100) 21,600
Gross profit 5,400
Operating expenses (£350  6) 2,100
Depreciation ((£12,000/5)  6/12) 1,200
3,300
Budgeted profit 2,100
Budgeted balance sheet as at 30 June

£ £
Non-current assets (£12,000 – £1,200 depreciation) 10,800
Current assets
Inventories (July cost of sales = £6,000 × 80/100) 4,800
Receivables (May and June sales) 10,000
Cash 16,700
31,500
Current liabilities
Trade payables (June purchases = July cost of sales) 4,800
Net current assets 26,700
37,500
Owner's capital 37,500

4.2 Performing a sensitivity analysis
C
Since the master budget provides a summary of all the subsidiary budgets it is likely to be of H
A
most interest to senior managers and directors who may not need to be concerned with the
P
detail of budgets outside their own areas of responsibility. T
E
Of particular interest to senior managers will be the sensitivity of the budget outcomes to R
changes in the budget assumptions. For example, they might like to know the answers to
questions such as the following. 6
 What will be the budgeted profit if sales revenue is 5% higher or lower than the budget?
 What will be the total budgeted costs if direct material costs are 10% higher or lower than
the budget?
A sensitivity analysis (sometimes called a 'what if?' analysis) might be performed to show the
effect of changes such as these, and to assess the impact on critical areas such as cash
resources.
Worked example: 'What if?' analysis

R Ltd manufactures and sells a single product. The budgeted income statement contained in the
master budget for the forthcoming year is as follows.
£ £
Sales revenue (20,000 units) 640,000
Variable materials cost 190,000
Variable labour cost 172,000
Variable overhead 13,000
Fixed overhead 155,000
530,000
Budgeted net profit 110,000
The directors wish to know what the budgeted profit will be if a higher quality material is used.
This will increase material costs per unit by 10% but sales volume will be increased by 5%. There
will be no change in the unit selling price.
Assumptions
The budgeted sales volume will increase to 21,000 units and, in the absence of information to
the contrary, we will assume there will be no changes in the total fixed overhead cost incurred
and no changes in the variable labour and overhead costs per unit.
The revised budgeted income statement will look like this.
£ £
Sales revenue (£640,000/20,000) × 21,000 672,000
Variable materials cost (£190,000/20,000) × 1.1 × 21,000 219,450
Variable labour cost (£172,000/20,000) × 21,000 180,600
Variable overhead (£13,000/20,000) × 21,000 13,650
Fixed overhead 155,000
568,700
Budgeted net profit 103,300
The proposed changes are not worthwhile since the contribution from the increase in sales
volume is not sufficient to compensate for the increase in material costs.

5 Preparing forecasts
Section overview
 Techniques that use past data to forecast future events assume that the past will provide a
good indication of what will happen in the future.
 The high-low method is a technique for analysing the fixed and variable elements of a
semi-variable cost and thus predicting the cost to be incurred at any activity level within
the relevant range.
 A major disadvantage of the high-low method is that it takes account of only two sets of
data.
 Linear regression analysis establishes a straight line equation to represent cost or revenue
and activity data. It takes account of all sets of data that are available.
 Correlation is the degree to which one variable is related to another.
 The coefficient of correlation, r, can take any value between –1 (perfect negative correlation)
and +1 (perfect positive correlation). If r = 0 then the variables are uncorrelated.
 The coefficient of determination, r², is a measure of the proportion of the change in one
variable that can be explained by variations in the value of the other variable.
5.1 Forecasting using historical data

Numerous techniques have been developed for using past costs as the basis for forecasting
future values. These techniques range from simple arithmetic to advanced computer-based
statistical systems. With all these techniques the important presumption is made that the past
will provide guidance to the future.
The forecasting methods that we will review in this section of the chapter are based on the
assumption that a linear relationship links levels of cost and levels of activity.
5.2 Linear relationships

A linear relationship can be expressed in the form of an equation that has the general form y = a
+ bx, where:
y is the dependent variable, depending for its value on the value of x
x is the independent variable, whose value helps to determine the corresponding value of y
a is a constant, a fixed amount
b is a constant, being the coefficient of x (that is, the number by which the value of x should
be multiplied to derive the value of y)
For example, if there is a linear relationship between total costs and the level of activity, y = total
costs, x = level of activity, a = fixed cost and b = variable cost per unit.
5.3 The high-low method

The high-low method is a technique for analysing the fixed and variable cost elements of a semi-
variable cost and thus predicting the cost to be incurred at any activity level within the relevant
range.
The steps taken to prepare a forecast using the high-low method are as follows.

Step 1
C
Records of costs in previous periods are reviewed and the costs of the following two periods are
H
selected. A
P
 The period with the highest volume of activity ie, the high/low values of the independent T
 The period with the lowest volume of activity variable E
R
The difference between the total cost of these two periods will be the total variable cost of the
difference in activity levels (since the same fixed cost is included in each total cost). 6
Step 2
The variable cost per unit may be calculated from this as (Difference in total costs/Difference in
activity levels).
Step 3
The fixed cost may then be determined by substitution.
Step 4
The linear equation y = a + bx can be used to predict the cost for a given activity level.
Worked example: The high-low method

The costs of operating the maintenance department of a computer manufacturer, Bread and
Butter Ltd, for the last four months have been as follows.
Month Cost Production volume
£ Units
1 110,000 7,000
2 115,000 8,000
3 111,000 7,700
4 97,000 6,000
Requirement
Calculate the costs that should be expected in Month 5 when output is expected to be 7,500
units. Ignore inflation.
Solution
Step 1
Units £
High output 8,000 Total cost 115,000
Low output 6,000 Total cost 97,000
Total variable cost 2,000 18,000
Step 2
Variable cost per unit £18,000/2,000 = £9
Step 3
Substituting in either the high or low volume cost:
High Low
£ £
Total cost 115,000 97,000
Variable costs (8,000  £9) 72,000 (6,000  £9) 54,000
Fixed costs 43,000 43,000

Step 4
Estimated maintenance costs when output is 7,500 units:
£
Fixed costs 43,000
Variable costs (7,500  £9) 67,500
Total costs 110,500
Interactive question 3: High-low method

The Valuation Department of a large firm of surveyors wishes to develop a method of predicting
its total costs in a period. The following past costs have been recorded at two activity levels.
Number of valuations Total cost
(V) (TC)
Period 1 420 £82,200
Period 2 515 £90,275
Requirement
Write the appropriate figures in the boxes below to derive an equation that can be used to
represent the total cost model for a period.
TC = £ +£ V
A major disadvantage of the high-low method is that it takes account of only two sets of data,
which may not be representative of all the data available. In particular, one of them could be a
rogue set of data.
For example, the pattern of data might be as follows.
Cost
£
Level of activity
Figure 6.2: Example data set

The straight-line equation derived using the high-low method, as shown in the diagram above
using points H and L, would be inaccurate. It does not take into account all of the recorded
combinations and fails to allow for the fact that the majority of points lie below the line joining
the highest and lowest activity.

5.4 Linear regression analysis
C
Linear regression analysis is a statistical technique for establishing a straight line equation to H
A
represent a set of data. Linear regression analysis is superior to the high-low method because it
P
takes account of all sets of recorded data, rather than only the highest and lowest activity. T
E
However, even though the linear regression technique is more accurate than the high-low R
method, it is important to remember that its use in forecasting is still based on the presumption
that past events are a good guide to what will happen in the future. 6
A further issue with the use of both the high-low method and linear regression analysis is that
the quality or reliability of the linear equation derived will depend upon the correlation
between the variables.
5.5 Correlation
Correlation is the degree to which one variable is related to another, ie, the degree of
interdependence between the variables.
(a) (b)
Y Y
X X
Figure 6.3: Correlation
In the scatter diagrams above, you should agree that the straight line equation is more likely to
reflect the 'real' relationship between X and Y in (b) than in (a). In (b), the pairs of data are all
close to the line of best fit, whereas in (a), there is much more scatter around the line.
In the situation represented in diagram (b), forecasting the value of Y from a given value for X
would be more likely to be accurate than in the situation represented in (a). This is because there
would be greater correlation between X and Y in (b) than in (a).
5.5.1 Degrees of correlation

Two variables might be perfectly correlated, partly correlated, uncorrelated or subject to non-
linear correlation.
Perfect correlation
Y Y
X X
Figure 6.4: Perfect correlation

All the pairs of values lie on a straight line. An exact linear relationship exists between the two
variables.
Partial correlation
Y Y
X X
Figure 6.5: Partial correlation
In the left-hand diagram, although there is no exact relationship, low values of X tend to be
associated with low values of Y, and high values of X with high values of Y.
In the right-hand diagram, there is no exact relationship, but low values of X tend to be
associated with high values of Y and vice versa.
No correlation
X
Figure 6.6: No correlation
The values of these two variables are not correlated with each other.
Non-linear or curvilinear correlation
Y
X
Figure 6.7: Non-linear or curvilinear correlation
There is a relationship between X and Y since the points are on an obvious curve but it is not a
linear relationship.

5.5.2 Positive and negative correlation
C
Correlation, whether perfect or partial, can be positive or negative. H
A
 Positive correlation is the type of correlation where low values of one variable are P
associated with low values of the other, and high values of one variable are associated with T
E
high values of the other. R
 Negative correlation is the type of correlation where low values of one variable are
6
associated with high values of the other, and high values of one variable with low values of
the other.
5.6 Measures of correlation

5.6.1 The coefficient of correlation, r
The degree of correlation between two variables can be measured using the coefficient of
correlation, r.
r has a value between –1 (perfect negative correlation) and +1 (perfect positive correlation). If r
= 0 then the variables are uncorrelated.
5.6.2 The coefficient of determination, r2

2
The coefficient of determination, r , is a measure of the proportion of the change in one variable
that can be explained by variations in the value of the other variable.
Worked example: The coefficient of determination

The coefficient of correlation, r, between vehicle maintenance costs and vehicle running hours
has been calculated to be 0.96.
This indicates that there is a fairly high degree of positive correlation between x (vehicle running
hours) and y (vehicle maintenance cost) because r is quite close to +1. The coefficient of
2 2
determination, r , is equal to (0.96) = 0.9216. This means that 92% of variations in the value of y
(cost) can be explained by a linear relationship with x (running hours). This leaves only 8% of
variations in y to be predicted from other factors.
Therefore it is likely that vehicle running hours could be used with a high degree of confidence
to predict vehicle running costs during a period.
Interactive question 4: The coefficient of determination

Tick the boxes to indicate whether the following statements about the coefficient of
determination are true or false.
True False
(a) It is the square of the coefficient of correlation

(b) It can never quite equal 1
(c) If it is high, this proves that variations in one variable cause variations in the other

5.7 Big data, data analytics and data mining
Definitions
Big data: The term that describes those 'datasets whose size is beyond the ability of typical
database software to capture, store, manage and analyse.' (McKinsey Global Institute, Big data:
The next frontier for innovation, competition and productivity)
An alternative definition is provided by Gartner.
Big data: It concerns 'high-volume, high-velocity and high-variety information assets that
demand cost-effective, innovative forms of information processes for enhanced insight and
decision making.' (Gartner)
Data analytics: The process of collecting, organising and analysing large sets of data to discover
patterns and other information which an organisation can use for its future business decisions.
Closely linked to the term data analytics is data mining.
Data mining: The process of sorting through data to identify patterns and relationships between
different items. Data mining software, using statistical algorithms to discover correlations and
patterns, is frequently used on large databases. In essence, it is the process of turning raw data
into useful information. Predictive analytics is a type of data mining that aims to predict future
events.
Structured data: Data that is contained within a field in a data record or file (eg, databases and
spreadsheets).
Unstructured data: Data that is not easily contained within structured data fields, such as
pictures, videos, webpages, PDF files, emails or blogs.
5.7.1 Big data – what is it?

In a commercial setting 'big data' is used to identify trends that may exist in vast quantities of
data in the pursuit of value creation. Historically, organisations have been restricted as to the
amount of data that they can process due to the storage limitations of existing computer
systems.
The main characteristics of big data are volume, velocity, variety and veracity.
(a) Volume. The scale of information which can now be created and stored is staggering.
Advancing technology has allowed embedded sensors to be placed in everyday items such
as cars, video games and refrigerators. Mobile devices have led to an increasingly
networked world where people's consumer preferences, spending habits, and even their
movements can be recorded.
Advances in data storage technology as well as a fall in price of this storage has allowed for
the captured data to be stored for further analysis.
(b) Velocity. Timeliness is a key factor in the usefulness of financial information to decision
makers, and it is no different for the users of big data. One source of high-velocity data is
Twitter, users of which are estimated to generate nearly 100,000 tweets every 60 seconds.
(c) Variety. Big data consists of both structured and unstructured data. While the sources of
data have grown, the software tools for interpreting the data have not kept pace with this
change. The challenge is bringing together both structured and unstructured information to
reveal new insights.
(d) Veracity. Another challenge to users of big data is keeping the information 'clean' and free
from so-called noise, or bias. Due in part to the other three factors, it is not possible to
'cleanse' the data. While even unstructured data such as tweets can give an accurate view
as to how an event or product is perceived, it may not be useful in predicting sales of a
product. The age profile and location of the average Twitter user may act as a bias,
therefore distorting the data collected.

Big data management is a term relating to the storage and administration of large volumes of
data in all forms. Once stored, big data analytics are used to analyse the data to identify C
H
relationships, patterns and other correlations in order to improve profitability. Big data analytics A
are often developed using Hadoop – an open source programming tool which is designed to P
process vast amounts of data held on multiple servers. T
E
There is potential to analyse big data for patterns and trends to provide improved forecasting. R
However, this isn't always easy to do. Big data has potential benefits but also some problems.
6
5.7.2 Big data benefits

Businesses can use data analytics programs for many purposes including marketing
measurement, pricing, fraud detection and so on, but the most popular use of analytics tools
appears to be for budgeting and forecasting. Data analytics allow managers to make informed
decisions based on the latest information.
(a) Forecasting demand. Big data from sources such as website traffic, online trends, customer
feedback, promotions and microeconomic factors specific to the business's industry can be
processed and an accurate model of future demand can be generated. Such analysing uses
data correlations alongside other known demand trends to predict customer demand
responses to new products and marketing campaigns and this information can be fed into
the sales forecast. The information will also be passed on to the operations so that the
supply side of the business can be balanced with the demand.
(b) Identifying customer preferences. A key benefit of big data is the ability to understand the
preferences and desires of each customer. Consumers are increasingly happy to share
information about themselves with a business, but only if they trust the organisation first.
Once this trust is built, data will come from the customer because they see the benefit of a
more personal experience that is created. This saves the customer time in finding what they
want (because the website knows the products they are interested in) and more relevant
promotions can be created.
Sources of information on customer preferences include past transactions, website data
cookies, responses to emails and online promotions and adverts, and data contained about
them on social networks. This data about a specific person can also be combined with more
general demographic data and trends to generate predictions about the products the customer
might be interested in but no preference has yet been determined through the available data.
5.7.3 Big data problems

(a) Lack of forecasting tools. The sheer volume, complexity and speed of big data means that
traditional forecasting tools cannot cope.
(b) Privacy. While big data can be a valuable 'asset' to a company, there are certain risks
associated with big data. In addition to being beneficial for companies and customers, big
data has the potential to harm individuals. The link between online and offline identity and
who should control our data is a key question. Big data is borderless, but cultural attitudes
towards privacy are very different across the world. Concerns about whether or not
governments are also gathering big data about individuals, including their own citizens,
raises questions about the balance between the benefits and the infringement of rights.
(c) Security. Companies using big data should ensure that they are not infringing the security
of other organisations and their customers.
This also relates to people who are unaware of the security risks posed by their own actions,
such as people who post their location on social media, revealing that they are on holiday,
and are then targeted by robbers.

(d) Incorrect data. If the data is incorrect then it is worthless and potentially harmful if incorrect
conclusions are reached as a result.
(e) Lack of skilled data analysts. Big data requires data analysts and therefore a business needs
to be able to recruit suitable employees to make full use of the data.
5.7.4 Big data examples

Retail
Many retailers now issue customers with loyalty cards which they swipe with each purchase. This
provides the retailer with details of each customer's buying habits and allows them to send
marketing information and discounts which are specific to the customer.
Case example: Tesco Clubcard

The Tesco supermaket's Clubcard loyalty card provides a good example of how big data can be
useful in some circumstances but does not necessarily provide a solution for all difficulties faced.
Tesco's Clubcard loyalty card was launched in 1995 and it very quickly gave Tesco an insight
into how its customers behaved. After only three months, the chief executive claimed that the
Clubcard database knew more about Tesco's customers than he did after 30 years. This new
understanding initially allowed Tesco to become the market leader in the UK as it was able to
predict customer needs and desires.
More recently however, customers appear to be favouring more basic discount supermarkets
such as Aldi and Lidl. This is perhaps because they feel they can buy what they want rather than
what Tesco suggests they should be buying via promotions and vouchers. Big data was initially
very useful to Tesco but more recently it has been unable to solve Tesco's problems.
Source:
www.telegraph.co.uk/finance/newsbysector/retailandconsumer/10577685/Clubcard-built-the-
Tesco-of-today-but-it-could-be-time-to-ditch-it.html
Worked example: Predictive analytics

Predictive analytics may be used by hotels to try to predict the number of customers for
particular nights, in order to set prices.
Case example: Student.com

Student.com is a company which helps students find residential accommodation in 400 cities
worldwide. It uses data analytics to spot trends and monitor performance.

6 Alternative approaches to budgeting C
H
A
Section overview P
T
 An organisation's budgeting style can be participative (bottom-up) or imposed (top-down). E
R
 Participative budgeting tends to have the most favourable motivational impact but it does
have its disadvantages. 6
 Budget slack is the intentional overstating of costs or understating of revenues in a

budget, in order to set an 'easy' budget target.
 Incremental budgeting involves basing the next year's budget on the current year's
results, with adjustments for known changes and inflation.
 Zero based budgeting requires all budgets to be prepared from the very beginning or zero.
 Rolling budgets, also known as continuous budgets, are continuously updated by adding
a further month or quarter to the end of the budget as each month or quarter comes to a
close.
 The structure of budgets may be designed around one of a number of frameworks,
including product based budgets, responsibility based budgets and activity based budgets.
6.1 Participation in the budgeting process

It has been argued that participation in the budgeting process will improve motivation and so
will improve the quality of budget decisions and the efforts of individuals to achieve their
budget targets.
There are basically two ways in which a budget can be set: from the top down (imposed budget)
or from the bottom up (participatory budget).
6.1.1 Imposed or top-down style of budgeting

In this approach to budgeting, top management prepare a budget with little or no input from
operating personnel, which is then imposed upon the employees who have to work to the
budgeted figures.
The times when imposed budgets are effective are:
 in newly-formed organisations
 in very small businesses
 during periods of economic hardship
 when operational managers lack budgeting skills
 when the organisation's different units require precise coordination
There are, of course, advantages and disadvantages to this style of setting budgets.
(a) Advantages
 Strategic plans are likely to be incorporated into planned activities.
 They enhance the coordination between the plans and objectives of divisions.
 They use senior management's awareness of total resource availability.
 They decrease the input from inexperienced or uninformed lower-level employees.
 They decrease the period of time taken to draw up the budgets.

(b) Disadvantages
 Dissatisfaction, defensiveness and low morale amongst employees. It is hard for
people to be motivated to achieve targets set by somebody else, particularly if
managers consider the budget targets to be unrealistic.
 The feeling of team spirit may disappear.
 The acceptance of organisational goals and objectives could be limited.
 The budget may be viewed as a punitive device.
 Managers who are performing operations on a day to day basis are likely to have a
better understanding of what is achievable.
 Unachievable budgets could result if consideration is not given to local operating and
political environments. This applies particularly to overseas divisions.
 Lower-level management initiative may be stifled.
6.1.2 Participative or bottom-up style of budgeting

In this approach to budgeting, budgets are developed by lower-level managers who then
submit the budgets to their superiors. The budgets are based on the lower-level managers'
perceptions of what is achievable and the associated necessary resources.
Advantages of participative budgets
 They are based on information from the employees most familiar with the department.
 Knowledge spread among several levels of management is pulled together (ie, information
asymmetry is reduced).
 Morale and motivation is improved.
 They increase operational managers' commitment to organisational objectives.
 In general they are more realistic.
 Coordination between units is improved.
 Specific resource requirements are included.
 Senior managers' overview is mixed with operational level details.
 Individual managers' aspiration levels are more likely to be taken into account.
Disadvantages of participative budgets
 They consume more time.
 Changes implemented by senior management may cause dissatisfaction.
 Budgets may be unachievable or much too soft if managers are not qualified to participate.
 They may cause managers to introduce budget slack (overstating costs or understating
revenues) and budget bias.
 They can support 'empire building' by subordinates.
 An earlier start to the budgeting process could be required.
6.2 Incremental budgeting

The traditional approach to budgeting is to base the forthcoming year's budget on the current
year's results modified for changes in activity levels, for example by adding an extra amount for
estimated growth or inflation next year. This approach is known as incremental budgeting since
it is concerned mainly with the increments in costs and revenues which will occur in the coming
period.

Incremental budgeting is a reasonable approach if the current operations are as effective,
efficient and economic as they can be. C
H
In general, however, it is an inefficient form of budgeting. It encourages slack, which is A
P
unnecessary expenditure built into the budgets. Past inefficiencies are perpetuated because
T
cost levels are rarely subjected to close scrutiny. E
R
6.3 Zero based budgeting 6
Zero based budgeting (ZBB) is an approach to budgeting that attempts to ensure that
inefficiencies are not concealed.
The principle behind ZBB is that, instead of using the current year's results as a starting point,
each budget should be prepared from the very beginning or zero. Every item of expenditure
must be justified separately to be included in the budget for the forthcoming period.
Increments of expenditure are compared with the expected benefits received, to ensure that
resources are allocated as efficiently as possible.
ZBB can be particularly useful when applied to discretionary costs such as marketing and
training costs. This type of cost is not vital to the continued existence of an organisation in the
way that, say, raw materials are to a manufacturing business.
A major disadvantage of ZBB is that it is a time-consuming task that involves a great deal of
work.
6.4 Rolling budgets

Rolling budgets are sometimes called continuous budgets. They are particularly useful when an
organisation is facing a period of uncertainty so that it is difficult to prepare accurate plans and
budgets. For example, it may be difficult to estimate the level of inflation for the forthcoming
period.
Rolling budgets are an attempt to prepare targets and plans that are more realistic and certain,
particularly with a regard to price levels, by shortening the period between preparing budgets.
Instead of preparing a periodic budget annually for the full budget period, budgets would be
prepared, say, every one, two or three months (4, 6, or even 12 budgets each year). Each of
these budgets would plan for the next 12 months so that the current budget is extended by an
extra period as the current period ends: hence the name rolling budgets. Cash budgets, which
are the subject of the next chapter, are usually prepared on a rolling basis.
Suppose, for example, that a rolling budget is prepared every three months. The first three
months of the budget period would be planned in great detail, and the remaining nine months
in lesser detail, because of the greater uncertainty about the longer term future.
(a) The first continuous budget would show January to March Year 1 in detail, and April to
December Year 1 in less detail.
(b) At the end of March, the first three months of the budget would be removed and a further
three months would be added at the end for January to March Year 2.
(c) The remaining nine months for April to December Year 1 would be updated in the light of
current conditions, adding more detail to the earliest three months, April to June Year 1.
The detail in the first three months would be principally important for the following.
 Planning working capital and short-term resources (cash, materials, labour and so on).
 Control: the budget for each control period should provide a more reliable yardstick for
comparison with actual results.

The advantages of rolling budgets are as follows.
(a) They reduce the element of uncertainty in budgeting. If a high rate of inflation or major
changes in market conditions or any other change that cannot be quantified with accuracy
is likely, rolling budgets concentrate detailed planning and control on short-term prospects
where the degree of uncertainty is much smaller.
(b) They force managers to reassess the budget regularly, and to produce budgets that are up
to date in the light of current events and expectations.
(c) Planning and control will be based on a recent plan instead of an annual budget that might
have been prepared many months ago and is no longer realistic.
(d) There is always a budget that extends for several months ahead. For example, if rolling
budgets are prepared quarterly there will always be a budget extending for the next 9 to 12
months. If rolling budgets are prepared monthly there will always be a budget for the next
11 to 12 months. This is not the case when annual budgets are used.
The disadvantages of rolling budgets can be a deterrent to using them.
(a) A system of rolling budgets calls for the routine preparation of a new budget at regular
intervals during the course of the one financial year. This involves more time, effort and
money in budget preparation.
(b) Frequent budgeting might have an off putting effect on managers who doubt the value of
preparing one budget after another at regular intervals, even when there are major
differences between the figures in one budget and the next.
6.5 Alternative budget structures

The structure of budgets may be designed around one of a number of frameworks, including
the following.
6.5.1 Product based budgets

Product based budgets are drawn up by preparing separate budgets for each product. For
example a separate production budget would be established for product A, for product B and
for product C as well as a separate marketing cost budget, a separate distribution cost budget, a
separate sales revenue budget and so on.
This structure is appropriate when the cost and revenue responsibilities differ for each product,
or when a single manager is responsible for all aspects of one product.
The individual product budgets might also be aggregated across products, for example where a
distribution manager has overall responsibility for all product distribution costs.
The separate product budgets and the possibility for aggregation across products enables
senior managers to look both down and across the whole organisation in terms of budgets.
6.5.2 Responsibility based budgets

Responsibility based budget systems segregate budgeted revenues and costs into areas of
personal responsibility in order to monitor and assess the performance of each part of an
organisation.
Budgetary control is based around a system of budget centres. Each budget centre will have its
own budget, and an individual manager (a budget holder) will be responsible for managing the
budget centre and ensuring that the budget is met.
Responsibility based budgets can have a positive motivational impact, as long as the budget
holder is not held responsible for costs and revenues over which they have no control.

6.5.3 Activity based budgets
C
Activity based budgets are based on a framework of activities, and cost drivers are used as a H
basis for preparing budgets. A
P
The budget for each activity is derived from the quantity of the activity's cost driver  the T
E
appropriate cost driver rate. R
6
Worked example: Activity based budget
An organisation expects to place 500 orders with suppliers during the forthcoming budget
period. The rate per cost driver has been established as £100. The budgeted cost of the
ordering activity is therefore 500 × £100 = £50,000.
Activity based budgeting (ABB) involves defining the activities that underlie the financial figures
in each function. The level of activity in terms of cost drivers is used to decide how much
resource should be allocated and how well the activity is being managed, and to explain
differences between the budget and actual results.
Implementing ABB leads to the realisation that the business as a whole needs to be managed
with more reference to the behaviour of activities and cost drivers identified.
(a) Traditional budgeting may make managers 'responsible' for activities that are driven by
factors beyond their control: the cost of setting up new personnel records and of induction
training would traditionally be the responsibility of the personnel manager even though
such costs are driven by the number of new employees required by managers other than
the personnel manager.
(b) The budgets for costs not directly related to production are often traditionally set using an
incremental approach because of the difficulty of linking the activity driving the cost to
production level. However, this assumes that all of the cost is unaffected by any form of
activity level, which is often not the case in reality. Some of the costs of the purchasing
department, for example, will be fixed (such as premises costs) but some will relate to the
number of orders placed or the volume of production, say. In an ABB framework the
budget for the purchasing department can take account of the expected number of orders.

Summary
Budgets
Fulfil many
objectives/roles
Must be quantified but

not necessarily in
financial terms
Organisational Budgets are Alternative

Alternative
procedures based on approaches
structures
forecast
Forecasts based Bottom up

Budget period Product or
on historical
based Top down
data
Establishing
Budget Responsibility Incremental
linear
committee based budget
relationships
Linear
High-low Activity Zero based
Budget manual regression
method based budget
analysis
Functional
Correlation Rolling budgets
budgets
Master Coefficient of
budget determination
Sensitivity
analysis may
be performed

Self-test
C
A
1 Which of the following is the budget committee not responsible for? P
T
A Preparing functional budgets E
B Timetabling the budgeting operation R
C Allocating responsibility for the budget preparation
6
D Monitoring the budgeting process
The following data relate to questions 2 and 3.
Budgeted sales revenues for R Ltd, a wholesaler, are as follows.
July August September October
£ £ £ £
180,000 150,000 165,000 210,000
One month's credit is allowed to credit customers, who account for 50% of all sales. Other
customers pay cash in the same month the sale occurs.
One month's credit is received from suppliers.
Month-end inventories are maintained at a level sufficient to meet 50% of the forecast sales for
the next month.
R Ltd adds a profit mark-up of 20% to the cost of purchases in order to derive the selling price.
2 The budgeted balance sheet as at the end of September will show a receivables balance of:
A £75,000
B £82,500
C £150,000
D £165,000
3 The budgeted balance sheet as at the end of September will show a payables balance of:
A £118,750
B £137,500
C £150,000
D £156,250
4 Which of the following is unlikely to be contained in a budget manual?
A Organisational structures
B Objectives of the budgetary process
C Selling overhead budget
D Administrative details of budget preparation
5 Cassius Ltd manufactures two products, P and Q, from the same material, S.
A finished unit of product P contains three litres of material S and a finished unit of product Q
contains five litres. However, there is a high wastage rate of materials and 25% of the input
materials are lost in production.
The budgeted production volumes for next year are 6,000 units of P and 8,100 units of Q.
At the beginning of the year the company expects to have 20,000 litres of material S in
inventory but intends to reduce inventory levels to 5,000 litres by the end of the year.
The purchase cost of material S is £1.60 per litre.
The purchases budget for material S is:
A £63,000
B £93,000
C £100,800
D £148,800

6 A retailing company is preparing its annual budget. It plans to make a profit of 25% on the
cost of sales. Inventories will be maintained at the end of each month at 30% of the
following month's sales requirements.
Details of budgeted sales are as follows.
Credit sales – gross Cash sales
£ £
December 1,900,000 400,000
January 1,500,000 250,000
February 1,700,000 350,000
March 1,600,000 300,000
(a) Budgeted inventory levels at the end of December are £
(b) Budgeted inventory purchases for January are £
7 The coefficient of correlation between advertising expenditure and the number of theatre
tickets sold is 0.97. Which two of the following statements are correct?
A 97% of the variation in ticket sales can be explained by variations in advertising
expenditure
B 94% of the variation in ticket sales can be explained by variations in advertising
expenditure
C A 97% increase in advertising expenditure will result in a 97% increase in ticket sales
D There is a fairly high degree of positive correlation between advertising expenditure
and ticket sales
8 A transport company has recorded the following maintenance costs for the last two periods.
Period 7 Period 8
Miles travelled 30,000 50,000
Maintenance cost per mile £1.90 £1.30
The forecast maintenance cost for period 9, when 38,000 miles will be travelled, is
£
9 Big data analytics typically involves the analysis of unstructured data. Which of the following
is an example of unstructured data?
A Data tables showing monthly sales figures
B Spreadsheet analysis of fixed asset purchases
C Email communications between a customer and the sales department
D A table of supplier names and addresses
10 In what circumstances might participative or bottom-up budgets not be effective?
A In centralised organisations
B In well-established organisations
C In very large businesses
D During periods of economic affluence

Answers to Interactive questions C
H
A
P
T
Answer to Interactive question 1 E
R
Before After Doesn't matter
6
Sales revenue; sales quantities

Finished goods inventories; production
volume

Materials usage; labour hours

Materials usage; materials purchases

The sales revenue budget is derived by multiplying the budgeted sales quantities by the
standard selling price. Therefore the sales revenue budget must be prepared after the budget
for sales quantities.
The production volume budget is derived by adjusting the budgeted sales quantities for
budgeted changes in finished goods inventories. Therefore the budget for finished goods
inventories must be prepared before the production volume budget.
The materials usage budget and the labour hours budget are derived from the production
volume budget, independently of each other.
The materials purchases budget is derived by adjusting the materials usage budget for
budgeted changes in materials inventories. Therefore the material usage budget must be
prepared before the materials purchases budget.

(a) Sales budget
Product X Product Y Product Z Total
Sales quantity 2,000 4,000 3,000

Sales price £100 £130 £150
Sales value £200,000 £520,000 £450,000 £1,170,000
(b) Production budget
Sales quantity 2,000 4,000 3,000
Closing inventories 600 1,000 800
2,600 5,000 3,800
Less opening inventories (500) (800) (700)
Budgeted production 2,100 4,200 3,100
(c) Material usage budget

Production RM11 RM22 RM33
Units Units Units Units
Product X 2,100 10,500 4,200 –
Product Y 4,200 12,600 8,400 8,400
Product Z 3,100 6,200 3,100 9,300
Budgeted material 29,300 15,700 17,700
usage

(d) Material purchases budget
RM11 RM22 RM33

Units Units Units
Budgeted material usage 29,300 15,700 17,700
Closing inventories 18,000 9,000 12,000
47,300 24,700 29,700
Less opening inventories (21,000) (10,000) (16,000)
Budgeted material purchases 26,300 14,700 13,700
Cost per unit of material £5 £3 £4
Budgeted material purchases £131,500 £44,100 £54,800
(e) Labour budget

Hours
required Labour Rate per
Product Production per unit budget hour Cost
Units Total hours £ £
X 2,100 4 8,400 9 75,600
Y 4,200 6 25,200 9 226,800
Z 3,100 8 24,800 9 223,200
Budgeted total wages 525,600

TC = £ 46,500 + £ 85 V
Although we only have two activity levels in this question we can still apply the high-low method.
WORKINGS
Valuations Total cost
£
Period 2 515 90,275
Period 1 420 82,200
Change due to variable cost 95 8,075
 Variable cost per valuation = £8,075/95 = £85.

Period 2: fixed cost = £90,275 – (515 × £85)
= £46,500

2
Statement (a) is true. The coefficient of determination is r .
2
Statement (b) is false. r can reach 1 or –1, therefore r can reach 1.
Statement (c) is false. A high coefficient of determination means it is very likely that variations in
one variable cause variations in the other. The high degree of correlation may, however, be due
to chance (ie, spurious correlation).

Answers to Self-test C
H
A
1 A The budget committee is not responsible for preparing functional budgets. The manager P
T
responsible for implementing the budget must prepare it, not the budget committee.
E
Since the committee is a coordinating body it is definitely responsible for timetabling R
and allocating responsibility for budget preparation. It is also responsible for 6

monitoring the whole budgetary planning and control process.
2 B The budgeted receivables balance at the end of September is £82,500.
Since one month's credit is given to credit customers, the outstanding receivables
balance at the end of each month is equal to the credit sales for that month.
Credit sales for September = 50% × £165,000 = £82,500
If you answered £165,000 you did not allow for the fact that only 50% of sales are made
on credit.
If you answered £75,000 or £150,000 you based your answer on the sales revenue for
August, all of which will have been received from customers by the end of September.
3 D The budgeted payables balance at the end of September is £156,250.
Since one month's credit is received from suppliers the payables balance at the end of
each month is equal to the credit purchases for that month.
The budgeted cost of goods sold in each month is derived by multiplying each sales
figure by (100/120) to remove the profit mark-up.
September
£
Budgeted cost of goods sold (£165,000  100/120) 137,500
Budgeted closing inventory (£210,000  100/120  50%) 87,500
225,000
Less budgeted opening inventory (£165,000  100/120  50%) (68,750)
Budgeted purchases = budgeted payables 156,250
If you answered £118,750 you reversed the budgeted opening and closing inventory.
The option of £137,500 is incorrect because the purchases are not equal to the cost of
goods sold since there are budgeted changes in inventory.
If you answered £150,000 you treated the 20% profit as a margin on the sales price
rather than as a mark-up on the cost of purchases.
4 C The selling overhead budget is unlikely to be contained in a budget manual. All of the
other items are concerned with the organisation and coordination of the budgetary
process, therefore they would be included in the budget manual.
5 C Material S
litres
Material S required for production:
Product P: 6,000 units  3  100/75 24,000
Product Q: 8,100 units  5  100/75 54,000
Total material S required for production 78,000
Plus budgeted closing inventory 5,000
83,000
Less budgeted opening inventory (20,000)
Budgeted material purchases in litres 63,000
 purchase cost per litre  £1.60
Budgeted material purchases in £ £100,800

If you answered £63,000 you selected the figure for purchases in litres rather than the
value of the budgeted purchases.
If you answered £93,000 you did not deal correctly with the losses. The 25% loss is
based on the input materials. You calculated a 25% loss based on the output.
If you answered £148,800 you reversed the opening and closing inventory.
6 (a) Budgeted inventory levels at the end of December are £420,000.
(b) Budgeted inventory purchases for January are £1,472,000.
WORKINGS
(1) Sales in January = £1,500,000 + £250,000
= £1,750,000
Cost of sales (×100/125) = £1,400,000
End of December inventory = 30% × £1,400,000
= £420,000
(2) Sales in February = £1,700,000 + £350,000
= £2,050,000
Cost of sales (×100/125) = £1,640,000
End of January inventory = 30% × £1,640,000
= £492,000
January
£
Cost of goods sold 1,400,000
Budgeted closing inventory 492,000
1,892,000
Less budgeted opening inventory (420,000)
Budgeted purchases 1,472,000
2 2
7 B,D A is incorrect and B is correct. The coefficient of determination (r ) = (0.97) = 0.9409,
therefore 94% of the variation in the value of y (ticket sales) can be explained by a
linear relationship with x (advertising expenditure).
C is incorrect because it misinterprets the meaning of the coefficient of correlation.
D is correct. There is a fairly high degree of positive correlation because r, the
coefficient of correlation, is close to 1.

8 The forecast maintenance cost for period 9 is £60,200.
C
WORKINGS H
A
To use the high-low method we need to know the total cost incurred at each activity level. P
T
Miles Total cost E
travelled incurred R
£
Period 8 50,000 ( £1.30) 65,000 6
Period 7 30,000 ( £1.90) 57,000
Variable cost 20,000 8,000
Variable cost per mile = £8,000/20,000 = £0.40

Fixed cost = £65,000 – (50,000 miles  £0.40) = £45,000
Forecast maintenance cost for 38,000 miles: £
Variable cost (38,000  £0.40) 15,200
Fixed cost 45,000
60,200
9 C Structured data refers to any data that is contained within a field in a data record or file.
This includes data contained in databases and spreadsheets. Therefore, A, B and D are
examples of structured data. Unstructured data is data that is not easily contained
within structured data fields: pictures, videos, webpages, PDF files, emails, blogs etc. C
is therefore an example of unstructured data.
10 A Participative (bottom-up) budgets might not be effective in centralised organisations.

An imposed or top-down budgeting system is likely to be most effective in this
situation.

CHAPTER 7
Working capital
Introduction
Examination context
TOPIC LIST
1 What is 'working capital'?
2 Balancing liquidity and profitability
3 Assessing the liquidity position via ratios
4 The cash operating cycle
5 Managing inventory
6 Managing trade payables
7 Managing trade receivables
8 Treasury management
9 Cash budgets
Introduction
 Prepare and/or comment upon a cash budget for a business which highlights the
quantity and timing of cash surpluses and deficits
 Calculate the cash cycle for a business and recognise its significance
 Identify the constituent elements of working capital and treasury and specify the
methods by which each element can be managed to optimise working capital and
cash flows
 Recognise how a business manages surpluses and deficits predicted in cash
budgets
The specific syllabus references for this chapter are: 2e, f, g, h.
Syllabus links
As with Chapter 6, this chapter will underpin your study of planning within the Business Strategy
and Technology syllabus. You will study working capital again in the Strategic Business
Management syllabus at Advanced level.
Examination context
You could be asked to prepare a full cash budget in the exam in a scenario-based question.
Alternatively, you could be asked to prepare an extract from information provided in a shorter
question. For example, you may be asked to calculate the budgeted receipts from customers or
the budgeted payments made to suppliers, taking account of the budgeted activity and planned
credit periods.
 use data supplied to prepare cash budgets or extracts from cash budgets
 select appropriate actions to be taken in the light of information provided by a cash budget
 calculate and interpret the cash cycle for a business
 assess the liquidity of a business using current and quick ratios
Questions on working capital and treasury management could easily appear in the exam. They
are likely to be set in an application context. Knowledge-type questions are also likely, set on
particular principles or definitions.

1 What is 'working capital'?
Section overview
 The components of working capital are inventory, receivables, cash and payables.
Definition
Working capital: The total of the current assets of a business less its current liabilities.
Net working capital is made up of current assets less current liabilities: C

H
Receivables + Inventory + Cash – Payables A
P
Investment in working capital is needed to 'oil the wheels' of business. T
E
It is essential to consider working capital as a whole and how the components all fit together. R
The management of working capital is concerned with the liquidity position of the company, so
7
the main aim is to turn the cash round as quickly as possible while ensuring that profitability is
not thereby undermined: it is a trade-off.
2 Balancing liquidity and profitability
Section overview
 All businesses face a trade off between being profitable (providing a return) and being
liquid (staying in business).
Alternative policies in working capital management need to be reviewed in terms of their

relative risk and return. An important aspect of the risk associated with various options is the
effect it has on the company's liquidity position. Liquidity is obviously of crucial importance to
the financial stability of a business; mismanagement of a firm's liquidity position may result in it
being unable to pay its debts which, in turn, may result in corporate insolvency. A business's
liquidity determines its ability to survive. This can be illustrated by looking at each component of
working capital in turn.
 Cash. A business requires a particular level of cash (or overdraft facility) in order to pay
debts when they fall due, and particularly to take advantage of any generous discounts
offered for prompt payment. However, a better return could be earned by investing any
cash surplus in a high-yielding investment. By ensuring that it has sufficient liquid assets
(cash), therefore, a business is reducing its chance of owning more profitable assets.
 Receivables. A business could decide that it does not want to offer credit to customers,
because the delay in payment jeopardises its liquidity position. If it tried to adopt this policy
however, customers would be driven away, revenue would fall and profits would fall.
 Inventory. In order to satisfy customer demand, manufacturing and retailing firms need to
maintain finished goods inventory; to keep production runs moving without disruption, raw
materials inventories also need to be maintained. This means that a business will have money
tied up in inventories that, again, it might feel it could use more profitably elsewhere.
However, if inventories were not available when required, a potential sale might be lost; the
cost of a broken production facility may be higher than the cost of holding inventory.
ICAEW 2019 Working capital 169

 Payables. To improve its cash position a business might decide not to pay suppliers until
after two or three months, rather than after the normal one month. Apart from the obvious
cost of lost discount opportunities, the business runs the risk of alienating its suppliers and
even losing sources of supply.
In each of the above instances the business must weigh up profitability versus liquidity. Since
ultimately a business aims to maximise profits, it must establish the financial costs and benefits of
different liquidity positions. Inevitably all working capital decisions reduce to decisions over cash
levels, since current assets should eventually be turned into cash.
Remember that profit and cash flows are not the same. It is possible to make accounting profits
while suffering a dramatic decline in the cash balance (and vice versa). There are many cases of
companies becoming insolvent while reporting accounting profits. Since the consequences of
compulsory liquidations are invariably catastrophic for all concerned, it is crucial for a business
to maintain a sound liquidity position. Cash budgeting and performance measurement are key
techniques in monitoring and controlling that position.
3 Assessing the liquidity position via ratios
Section overview
 Ratios can be used to assess a business's liquidity position.
 Liquidity can be assessed using the current and quick ratios.
It is important for a business to monitor its liquidity position on a regular basis.

A secure liquidity position is desirable. The business's liquidity position can be assessed in two
ways: by ratios, and via the cash operating cycle.
Ratios
Inventory Receivables Payables Liquidity

turnover collection payment ratios
period period
Inventory Payables
365 Receivables Current assets
Cost of sales 365 365
Revenue Purchases Current liabilities
(Inventory turnover
(current ratio)
period)
Cost of sales Current assets – inventory
Inventory Current liabilities
(Inventory turnover (quick ratio or
ratio) liquidity ratio)
Figure 7.1: Ratios

These can be compared with:
 the same company in previous periods
 other companies in the same industry
to see whether they are getting better or worse, and how they look against industry averages.
For an individual business, we can gain a better understanding of the effects of funding and
operational decisions on its liquidity position by manipulating its ratios.

For the following ratios averages should be used where they are available, but the year-end
figure should be used if not.
3.1 Inventory turnover period

This measure shows the average length of time that inventory is held for.
Inventory
Inventory turnover period = × 365
Cost of sales
If the inventory is held for a shorter period, the costs of holding the stock will decrease. A similar
insight is obtained by calculating the inventory turnover ratio – see below.
3.2 Rate of inventory turnover C

H
The rate of inventory turnover monitors how many times inventory turns over during the trading A
P
period. T
Cost of sales E
Rate of inventory turnover = R
Average inventory
7
In general the rate of turnover should be as high as possible since this means that the inventory
is lower, thus reducing costs such as space costs, insurance, obsolescence write-offs and the
cost of capital being tied up. However, potential sales might be forgone if inventory is so low
that customers' needs cannot be met.
3.3 Receivables collection period

This monitors how long on average it takes to collect debts.
Average receivables
Receivables collection period (in days) = × 365
Annual sales revenue
The collection period can also be measured in months, in which case the ratio calculation would
be multiplied by 12 instead of by 365.
The lower this period, the lower the capital cost of the money invested in receivables balances
and the lower the risk of bad debts. However, customers may go elsewhere if the credit period
offered is too low.
3.4 Payables payment period

This monitors how long on average the company waits before paying its suppliers.
Average payables
Payables payment period = × 365
Annual purchases
In general this period should be as high as possible. However, supplier goodwill may be lost if
the period of credit taken is too long. Continuity of supply could also be disrupted if suppliers
place overdue accounts on stop.
The payment period can also be measured in months, in which case the ratio calculation would
be multiplied by 12 instead of by 365.
The purchases figure should be used where this is available. If not then cost of sales should be
used as an alternative.

Worked example: Working capital ratios
Division S is a retail operation. Its year-end working capital consists of inventory valued at cost,
trade receivables of £90,000, cash and trade payables. Its financial performance ratios include
the following.
Gross profit margin (gross profit/turnover) 25%
Current ratio 2.3:1
Receivables collection period 30 days
Payables payment period 40 days
Rate of inventory turnover 18 times
The opening inventory, receivables and payables balances are the same as the closing balances.
Requirement
Calculate the division's year-end cash balance.
Solution
Step 1
Calculate the annual sales revenue
Average receivables
Sales revenue
£90,000
Sales revenue = × 365
30
= £1,095,000
Step 2
Calculate the cost of sales/purchases
Since the opening and closing inventories are equal, the cost of sales is equal to the purchases.
Cost of sales = £1,095,000 × 0.75
= £821,250
Step 3
Calculate the inventory balance
Cost of sales
Rate of inventory turnover =
Average inventory
£821,250
Inventory =
18
= £45,625
Step 4
Calculate the trade payables balance
Average payables
Payables payment period = × 365
Purchases
40 ×£821,250
Trade payables =
365
= £90,000

Step 5
Calculate the current assets balance
Current assets
Current ratio =
Current liabilities
Current assets = 2.3 × £90,000
= £207,000
Step 6
Calculate the cash balance
£ £
Total current assets 207,000 C
H
Less: Inventory 45,625
A
Receivables 90,000 P
135,625 T
Cash balance 71,375 E
R
3.5 Current ratio

This ratio measures the ability to meet short-term liabilities from easily or quickly realisable
current assets. It is calculated as follows.
Current assets
Current ratio =
Current liabilities
A higher value for the ratio indicates that the business is more liquid and is able more easily to
meet its current liabilities from its available current assets.
In general a higher ratio is preferable to a lower one. However, if a business has a very high
ratio this may indicate that funds are tied up in current assets, such as inventory and cash that
may be used more productively elsewhere in the business.
The most appropriate level for the current ratio will depend on the type of business. For
example, a supermarket will have a relatively low current ratio because it does not hold
inventories of raw materials and work in progress and a large proportion of its sales to
customers are made for cash, with consequently a low investment in receivables.
On the other hand a manufacturer will have a relatively high current ratio because of the need to
invest in inventories of raw materials and work-in-progress and to provide credit to customers.
3.6 Quick (liquidity) ratio

The nature of the inventory in some types of business means that it cannot be easily or quickly
converted into cash. This inventory cannot be relied upon as a liquid asset when it is necessary
to meet short-term liabilities.
The quick ratio therefore excludes inventory from the current assets as follows.
Current assets less inventories
Quick (liquidity) ratio =
Current liabilities
Worked example: Manipulating working capital ratios 1

Right Ltd currently has inventory and payables of £15,000 and receivables of £30,000. It pays its
suppliers one month after receiving goods from them but allows its customers two months'
credit.

Right Ltd does not expect any change to its level of business, but it now proposes to reduce its
receivables credit period to one month to bring it in line with its payables payment period. It
also proposes an increase in its inventory levels, such that its inventory turnover period will
increase from 30 days to 60 days.
Requirement
What will be the effect of these decisions on Right Ltd's ratios?
Solution
Current policy Proposed policy
days days
£ £
Inventory turnover/Inventory 30 15,000 60 30,000
Payables period/Payables (30) (15,000) (30) (15,000)
Receivables period/Receivables 60 30,000 30 15,000
Cash operating cycle/Net current assets 60 30,000 60 30,000
Current ratio 3:1 3:1

Quick ratio 2:1 1:1
Interactive question 1: Risk in working capital decisions

Is Right Ltd's proposal more or less risky than its current operation?
See Answer at end of this chapter.
Interactive question 2: Calculating ratios to assess the liquidity position

The following balances were recorded for a business at the end of last week.
£'000
Inventories 982
Receivables 648
Cash 78
Payables 653
Requirement
Complete the table below to compare the current ratio and quick (liquidity) ratio with the
average for businesses in the industry. Comment on the results.
Ratio for this business Industry average

Current ratio 2.5:1
Quick (liquidity) 1.4:1
ratio
Comments on the results:

4 The cash operating cycle
Section overview
 The cash operating cycle is the length of time between paying out cash for raw materials
and other input costs and receiving the cash for goods or services supplied.
 The length of each element of working capital (receivables, payables and so on) can be
calculated in days and then summed to determine the length of the cash operating cycle.
 Liquidity problems can be caused if the cash cycle becomes too long. The forecasting and
control of working capital requirements is critical to the management of the cash
operating cycle. C
H
A
4.1 What is the cash operating cycle? P
T
It is important to note that movements in working capital will have an impact on an E
organisation's cash balance. The efficient control of working capital is therefore vital in the R
management of an organisation's cash. 7

The measurement of the cash operating cycle focuses on the length of time between an
organisation paying out cash for its raw materials and other input costs and receiving the cash
for goods or services supplied.
The cash operating cycle is normally measured in days and it may be referred to as the working
capital cycle. It can be depicted in Figure 7.2 below.
Cash payment
PAYABLES
CASH
Cash
collection Purchases
RAW MATERIALS
RECEIVABLES INVENTORY
Production
Sales
FINISHED GOODS WORK-IN-PROGRESS

INVENTORY INVENTORY
Production
Figure 7.2: The cash operating cycle

4.2 Calculating the length of the cash operating cycle
The length of the cash cycle and its component parts can be calculated as follows:
Days
Average inventory of raw materials
Raw materials holding period × 365 = X
Annual usage
Average trade payables
Average payables payment period × 365 = (X)
Annual purchases
Average inventory of work in progress
Average production period × 365 = X
Annual cost of sales
Average inventory of finished goods
Average inventory-holding period × 365 = X
Annual cost of sales
Average receivables
Average receivables collection period × 365 = X
Annual sales revenue
Length of cycle X
Where averages cannot be calculated or are not available then period-end balances should be
used.
Interactive question 3: Calculating the cash operating cycle

Marlboro Ltd has the following estimated figures for the coming year:
Sales £3,600,000
Average receivables £306,000
Gross profit margin 25% on sales
Average inventories
Finished goods £200,000
Work in progress £350,000
Raw materials £150,000
Average payables £130,000
Inventory levels are constant.

Raw materials represent 60% of total production cost.
Requirement
Complete the table to calculate the company's cash operating cycle. Use the space provided in
the table for your workings.
Cost of sales =
Days
Raw materials in inventory =
Credit taken from suppliers = ( )
WIP in inventory =
Finished goods in inventory =
Credit given to customers =
Number of days between payment and receipt

Worked example: Manipulating working capital ratios 2
A profitable business's inventory turnover ratio of 20 rises by 20%. Its number of receivables
days rises by 10% from 70 days, but its cost of goods sold and payables days remain the same.
The effect on its cash operating cycle is as follows:
Period 1 Period 2
Days Days
Inventory Cost of 365/20 18 365/(20  1.2) 15
turnover period sales/Inventory
Receivables Receivables/Revenue 70 70  1.1 77
days C
H
88 92 A
P
The cash operating cycle will therefore lengthen. T
E
R
7
4.3 Investment in working capital
The level of investment in working capital increases considerably over the period of the cycle,
as seen in Figure 7.3, which highlights the situation where raw materials are bought, processed
into work in progress, then finally into finished goods. Cash paid out for labour and overheads
during this time increases the investment.
Investment
£
Finished Receivables
WIP goods
Raw materials (work in progress)
Payables
Purchase Manufacture Sell
Figure 7.3: Investment in working capital

Business A with inventory days of 50 and receivables days of 60 might appear to have the same
working capital investment (110 days) as Business B with 90 days' inventory and 20 days'
receivables. In practice, the level of investment in Business B is lower, as less capital is tied up in
inventories (particularly raw materials) than in receivables.
The total investment is also influenced by:
 growth (see overtrading below)
 inflation. As the price of raw material inputs rises, together with labour and overhead costs
in production, a firm is likely to put up its selling prices. Thus, the monetary investment in
inventory + receivables – payables increases

4.4 Variations between businesses
Different types of business have different working capital requirements.
A civil engineering firm with

many large projects, eg,
A large national supermarket constructing buildings for Manufacturer of school
chain 2012 Olympics uniforms
 High investment in  Relatively low investment  Customers usually buy

inventory (for example in raw material inventory school uniforms at the start
non-food items such as as each job is unique and of a school year and so
clothing and electrical supplies may be bought working capital
goods) in shops and when needed. requirements will fluctuate
warehouses. significantly during the
year.
 Low investment in  Long WIP and receivables  Receivables will increase

receivables (as most sales days. Progress payments as customers (retailers)
are in cash). are used to offset outflows stock up for the new
but there may be money school year but will be
held back by the customer much lower later in the
until the job is deemed year.
satisfactory.
 Ability to take long credit  The manufacturer is likely

terms from suppliers by to spread its production
applying various sorts of process over the year to
pressure. Cash operating smooth production, with
cycle may be negative ie, inventory building in the
cash comes in before it is run-up to the peak period.
paid out to suppliers.
 Cash operating cycle  Cash flow is likely to be

relatively stable as there is disjointed – outflows while
not that much seasonal inventory is built up with
activity. Non-food may the majority of inflows
have a longer cycle where concentrated at the start of
items spend longer in the school year. Cash
inventory (turnover is less operating cycle therefore
frequent) ie, overall cycle likely to vary significantly
may be made up of depending on the time of
distinct elements. year.
4.5 Limitations of working capital performance measures

The measures must be used with care, because:
 the balance sheet values at a particular point in time may not be typical
 balances used for a seasonal business will not represent average levels, eg, summer
holiday travel business
 such measures concern the past not the future
Therefore, measures should not be considered in isolation. Trends and industry averages are
important.

4.6 Overtrading
The amount of cash required to fund the cash operating cycle will increase as:
 the cycle gets longer
 sales (and hence purchases of inventory required) increase
This can often happen at the start of a new business, since:
 there is no trading record, so suppliers are likely to insist on a very short credit period
 there is no reputation to draw in customers, so a long credit period is likely to be extended
to customers in order to break into the market
 if the business has found a 'niche market', rapid sales expansion may occur
C
This can lead to the cycle being 'out of balance', so short-term financing may be necessary to H
get over the initial period. If this finance is unavailable it may be necessary to sell non-current A
P
assets to pay debts or, at the extreme, to go into insolvent liquidation. The forecasting of T
working capital so as to avoid overtrading is thus of particular importance for new businesses. E
R
4.7 Solutions to short-term liquidity problems 7
The aim must be to reduce the length of the cash operating cycle by:
 reducing the inventory-holding period
 reducing the production period – not easy to do but it might be worth investigating
different machinery or different working methods
 reducing customers' credit period and tightening up on cash collection
 extending the period of credit taken from suppliers – again, not easy to do as the business
has to comply with their terms, but it is worth considering the advantages and
disadvantages of taking early settlement discounts
5 Managing inventory
Section overview
 There are many, usually non-financial, reasons for a business to hold inventory, but it does
so at considerable cost.
 As a result, businesses try to keep inventory levels down as far as possible, using a variety
of inventory control systems: re-order level, periodic review, ABC, economic order
quantity (EOQ), just-in-time (JIT) and perpetual inventory.
5.1 Why hold inventory?

Reasons for holding inventory include:
 to meet demand by acting as a buffer in times of unusually high consumption, to reduce
the risk of stockouts or where supplier delivery times (lead times) are uncertain
 to ensure continuity of production
 to take advantage of quantity discounts or special promotions by ordering more at a time
 to buy in ahead of a shortage or ahead of a price rise
 for technical reasons, such as maturing whisky or keeping oil in pipelines
 to reduce ordering costs by ordering more items on fewer occasions
 because suppliers insist on minimum order quantities

5.2 Costs associated with holding inventory
 Purchase price, ie, the cost of the inventory itself
 Holding costs:
– Opportunity cost of capital tied up
– Cost of insurance
– Risk of deterioration, obsolescence and pilferage
– Cost of the warehousing function
– Cost of stores administration
 Re-order costs:
– Transport costs
– Clerical and administrative expenses
– Batch set-up costs for goods produced internally
These costs vary with the number of orders which will increase as inventory levels are
reduced.
 Shortage costs:
– Production stoppages caused by lack of raw materials
– Stockout costs for finished goods – anything from a delayed sale to a lost customer
– Emergency re-order costs
The benefits of holding inventory must outweigh the costs.
5.3 Inventory control systems

For both finance and operational reasons it is therefore very important to control inventory levels
effectively. There is a wide range of inventory control systems available.
 Re-order level system. A fixed quantity (the optimum order quantity – see economic order
quantity below) will be ordered whenever inventory falls to a pre-determined level (the
re-order level).
 Periodic review system. Inventory levels are reviewed at fixed time intervals to fit in with
production schedules, and variable quantities are ordered as appropriate. This is a very
simple method of inventory control.
 ABC system. The aim here is to reduce the work involved in inventory control in a business
which may have several thousand types of inventory item. Inventory is categorised into
classes A, B or C according to the annual cost of the usage of that inventory item, or the
difficulty of replacements, or the importance to the production process. Class A will then
take most of the inventory control effort, Class B less and Class C less still.
 Economic order quantity system (EOQ). The EOQ model for inventory control addresses
the problem of when to order inventory and how much to order. The formula is:
2cd
EOQ =
h
where c = cost of placing one order
d = estimated usage of the inventory item over a particular period
h = cost of holding one unit of inventory for that period

Worked example: Economic order quantity (EOQ)
Material X costs £100 per kg. 2,000 kg are to be used per year, and holding costs per kg per
year are £5. Each order placed costs £200 in administration time.
2×200×2,000
EOQ for material : = 400 kg
5
Annual usage is 2,000 kg, so 2,000/400 = 5 orders per year will be placed.
While EOQ appears to be a satisfactorily precise model, it has some serious limitations:
– It is cumbersome to apply.
C
– Some simplifying assumptions are made about usage and a constant purchase price H
A
that may be unjustified.
P
– It ignores the potential benefit of taking advantage of bulk discounts because it does T
E
not consider whether the best price is being obtained. R
– It can be very difficult in practice to estimate holding costs and the cost of placing each 7
order.
 Just-in-time (JIT) manufacturing systems. Production and purchasing are linked closely to
sales demand on a week-to-week basis. This means that negligible inventories of raw
materials and finished goods need to be held. Features of JIT systems include:
– the need for flexibility of both suppliers and the workforce to expand and contract
output at short notice
– guaranteed quality of raw materials. There are no inventories in reserve should one
batch of raw materials prove to be faulty, so production would stop until a further
delivery can be made
– close working relationship between suppliers and users including geographical
proximity in order to be able to make immediate deliveries
– willingness of the workforce to increase or decrease working hours from one period to
another; This could be done by having a core workforce with a group of part-time or
freelance workers
– rationalised factory layout systems to minimise movements between stages
 Perpetual inventory methods. This is a system whereby the inventory records are updated
for each receipt and issue of inventory as it occurs. One advantage of such a system is the
data it provides to management to determine which product lines are moving rapidly.
Marketing managers may also use the data to make tactical decisions on special prices and
promotions to sell slow-moving items.
 Other ways to manage inventory include:
– sub-contracting (outsource) non-core processes, passing on the inventory holding
problem to another business
– obtaining progress payments from customers, thus reducing the net capital required
to finance inventory
– reducing the number of product lines, eg, drop products near the end of their product
life cycle

6 Managing trade payables
Section overview
 Trade credit is generally a cheap source of finance.
Credit periods for the buyer are a source of short-term finance. For example, if a buyer decides
not to pay its trade debts for a further month, it has obtained a further month's use of its cash.
Trade payables are not, however, without cost.
 Credit status may be lost so the supplier gives low priority to the buyer's future orders, with
consequent disruption of activities.
 The supplier may raise prices in order to compensate for the finance which they are
involuntarily supplying.
 The buyer will lose any cash discount for prompt payment; the cost of the lost discount
should be compared with other short-term sources of finance, eg, overdrafts.
The advantages of trade credit are that:
 it is convenient and informal (ie, it is unusual to tell your suppliers that you do not intend to
pay them on time, though after a while they will realise anyway)
 it can be used by businesses which do not qualify for credit from a financial institution
 it does not prevent advantage being taken of settlement discounts (which can result in a very
cheap source of financing) because a period of time is still allowed before payment has to be
made
 trade credit can represent a virtual subsidy or sales promotion device offered by the seller –
for example, favourable terms may be offered when a new company is set up
 it can be used on a very short-term basis to overcome unexpected cash flow crises
Because of these advantages, a business should:
 consider switching suppliers if better credit terms are available or if better terms exist for
sole supplier relationships
 negotiate better terms for buying large quantities
 reconcile statements (make sure that what the supplier says a company owes agrees with
what the company thinks it owes)
 pay only on completion of correct delivery
7 Managing trade receivables
Section overview
 The cost of granting credit to customers has to be balanced against the benefits of doing so.
 Proper management of trade receivables should ensure an adequate level of collections.
 Trade receivables may be financed by invoice discounting or factoring.

7.1 What is the ideal level of trade receivables?
The management of trade receivables involves the business trading-off:
 the costs of extending credit to customers – these include finance costs, irrecoverable
debts and administrative costs of the credit control department
 the benefits of granting credit – in their simplest form these are larger profits due to the
increased sales generated because of the credit terms offered
Managing the level of trade receivables involves some very practical issues, usually undertaken
by the receivables ledger and credit control sections of the business's finance function.
7.2 Credit control and collection policies C

H
Credit control and collection policies should be set at board level. Implementation of the A
policies may fall outside the remit of the finance function itself, but the treasury management P
section could certainly be involved in credit control. T
E
R
7.2.1 Credit terms and settlement discounts
7
Credit terms will be influenced largely by trade custom which may, for example, be payment
within 60 days.
Settlement discounts are again influenced largely by custom and practice within the industry.
The business must ensure the cost does not outweigh the benefit, and should compare it with
the cost of other sources of short-term finance, eg, overdraft. Offering discounts can be
expensive. For example, if it costs a company 2% discount per month to get receipts early from
customers, the annual cost is 1.0212 – 1 = 26.8%.
Worked example: Settlement discount

Left Ltd has monthly sales of £20,000. 25% of receivables are paid within one month of a sale,
and 70% are paid within two months, but 5% of receivables are never paid. Left Ltd proposes
offering a 3% discount to receivables settling invoices within one month of the invoice date. As a
result, monthly sales are predicted to rise to £25,000, and 50% of trade receivables will pay
within one month. 44% will pay within 2 months but irrecoverable debts will rise to 6%. All sales
are invoiced at the end of each month. The discount will be offered for all invoices issued from
Month 1.
Requirement
By how much will total cash inflows from trade receivables in Months 1 and 2 change as a result,
and what will be the effect on profit?
Solution
Cash received
Irrecoverable Discount
Sales Month 1 Month 2 debts allowed
£ £ £ £ £
Current policy 25% 70% 5%
Sales M1 20,000 5,000 14,000 1,000 0
Sales M2 20,000 0 5,000 0 0
Total cash 5,000 19,000 1,000 0
Proposed policy 50% × 97% 44% 6% 50% × 3%

Sales M1 25,000 12,125 11,000 1,500 375
Sales M2 25,000 0 12,125 0 0
12,125 23,125 1,500 375

There is a large cash flow benefit of £7,125 in Month 1, and a benefit of £4,125 per month once
the normal pattern is established. The reduction in monthly profits caused by increased
irrecoverable debts is £500, while profits are further reduced by £375 with respect to the
discount allowed.
The company must communicate its terms to customers clearly on:

 orders
 invoices
 statements
The settlement discount policy must be enforced, otherwise most customers will continue to
take the settlement discount as a matter of course, whether or not they pay on time.
7.2.2 Credit rating
The risk that a customer will not pay its debts can be indicated by giving each customer a credit
rating. Some customers may be refused credit altogether, so supplies are only made against
cash.
Credit ratings should be based on:
 an assessment of the ability of the customer to meet the liabilities
 an assessment of financial statements, particularly for major customers
 the use of credit-rating agencies (eg, Dun and Bradstreet) who rate the customer according
to a number of factors related to its ability to pay
 an analysis of ongoing trading experience with each customer
 the practice in some industries whereby credit managers liaise regularly to exchange
information with other businesses; this is very useful, since members will alert each other as
soon as problems are identified
 credit limits on how much can be outstanding on a customer's account at any time; these
should be reviewed frequently and reported immediately if exceeded so that necessary
action can be taken
 trade and bank references, although these may be so bland as to be of limited value; these
references may provide valuable corroboration of other sources of information, however
credit ratings should be reviewed regularly.
Interactive question 4: Collection procedures

You are employed in the receivables ledger section of Kott plc. Your manager has asked you to
help in a project to improve the cash operating cycle of Kott plc.
Requirement
Identify three ways in which collection of amounts owed by customers could be speeded up.
7.3 Financing trade receivables

Receivables are an asset, and so can be 'sold' like any other asset by invoice discounting or
factoring.
7.3.1 Invoice discounting

This involves selling the invoices to a discounting company for a cash sum, then repaying the
discounter when the debtor pays the invoice. Note that the business retains full responsibility for

sales ledger, credit control and collection functions. However, the discounting company may
perform certain credit checks and ratings before entering the agreement. This form of
discounting is effectively a form of overdraft facility as the discounter makes a charge for lending
the money.
7.3.2 Receivables factoring

This contains three closely integrated elements:
 Accounting and collection – the business is paid by the factor as customers settle their
invoices or after an agreed settlement period. The factor maintains the sales ledger
accounting function.
 Credit control – the factor is responsible for chasing the customers and speeding up the
collection of debts. Recourse factoring means that any bad debts are passed back to the C
client company. Non-recourse factoring provides 100% bad debt insurance, that is the H
A
client does not suffer from the cost of bad debts. P
 Finance against sales – the factor advances, say, 80% of the value of sales immediately on T
E
invoicing. R
The major disadvantage is the loss of immediate contact with the customer, who may see
7
factoring as a sign of financial problems.
7.4 Good practice in receivables management

Good practice can be summarised as: look after key accounts and manage time scales.
7.4.1 Look after key accounts

It frequently happens that 20% of customers represent 80% of the debts. These customers, and
their debts, must receive special attention.
7.4.2 Manage time scales

Attempt to reduce all time scales between placement of an order and receipt of cash from the
customer, and eliminate any causes of disputes or non-payments. This should serve to tighten
up the cash operating cycle in general.
Worked example: Total receivables ageing

November December
20X1 20X1
out- % of out- % of
standing total standing total
£ £
0–30 days 10,000 86.2 12,000 80.5
31–60 days 1,000 8.6 2,000 13.4
61–90 days 500 4.3 750 5.0
90+ days 100 0.9 150 1.1
11,600 100.0 14,900 100.0
The changes from November to December show customers taking longer to pay. It might be a
normal seasonal pattern. If not, the customers who are responsible need to be identified.

Worked example: Customer aging, December 20
Customer 0 – 30 31 – 60 61 – 90 90+
days days days days
£ £ £ £
Sid plc 200 – – –
Snow plc 150 20 – –
Gizzard Ltd 120 80 60 40
: : : : :
: : : : :
: : : : :
12,000 2,000 750 150
Gizzard Ltd appears to be one of the problem customers; perhaps it is time to start more
aggressive collection procedures?
7.5 Trade credit insurance

Trade credit insurance insures a business against the possible default and insolvency of its
credit customers and, where exports are involved, political risk. It is therefore a useful tool in
credit management, helping to minimise possible problems from late payment and bad debts.
Credit insurance means a business can:
 insure all or part of its receivables ledger against default by a customer
 include a 'first loss' (or excess) on its accounts to be insured
 be insured only up to a ceiling ('credit limit')
The premium paid will vary in accordance with the above factors.
The insurer invariably sets a credit limit on the maximum amount that can be insured. Policies
cost between 0.20% and 0.50% of annual revenue on accounts to be insured. However,
premiums are also influenced by factors such as effectiveness of credit control systems, length of
credit given and previous experience of irrecoverable debts. The policyholder will have to
accept part of any loss; credit insurers will typically accept 75% to 95% of any loss, the balance
being taken by the policyholder. Insurance brokers or insurance intermediaries usually arrange
policies.
8 Treasury management
Section overview
 The risks of running out of cash have to be balanced against the costs of holding cash, just
like with inventory.
 Short term surpluses of cash should be invested; short term shortages of cash need to be
funded.
8.1 The basic trade-off: cost of holding v cost of running out of cash
To manage its cash position successfully the business must trade off the cost of holding cash
against the cost of running out of cash.
The cost of holding cash, either as a cash float or in a current account, is the opportunity cost of
what else could be done with the money. Cash is an idle asset and earns little or no return. If the
funds were put to work elsewhere (ie, invested) they could generate profits.

The costs of running out of cash vary, depending upon the circumstances of the business. Cash
shortages result in the business not being able to pay its payables on time, and this could have
many implications. Examples include:
 loss of settlement discounts from trade suppliers
 loss of supplier goodwill, eg, refusal of further credit, higher prices, poor delivery
 poor industrial relations if wage payments are delayed
 creditors petitioning for winding up the business
Although the above costs may be difficult to quantify the business must at all times ensure that it
has sufficient liquidity, in the form of cash balances or overdraft/loan facilities, to maintain its
solvency.
C
8.2 Aim of good cash management H
A
The primary aim of good cash management is to have the right amount of cash available at the P
right time. This involves: T
E
 accurate cash budgeting/forecasting, so that shortfalls and surpluses can be anticipated R
 planning short-term finance when necessary
7
 planning investment of surpluses when necessary
 cost-efficient cash transmission
8.3 Short-term finance

 Receivable factoring and invoice discounting;
 Bank overdrafts:
– may be used to fund fluctuating working capital
– are technically repayable on demand, so carry some risk
– normally carry a flat charge for the facility and variable interest on the balance, eg,
1-5% above base rate
– are flexible in that the business borrows only when it needs to (unlike a fixed term loan)
 Short-term bank loans:
– should ideally match the term of the loan with the duration of the project
– can have fixed or variable rates of interest
 Operating leases allow the business to have use of long-term assets such as plant or
vehicles without paying the full amount of their cost. Instead, a regular amount is paid out
each month to give use of the asset, while the risks of ownership remain with the lessor.
8.4 Investing surplus funds

Surplus funds can be invested in various financial products:
 Treasury bills issued by the Bank of England on behalf of the government, which have a
minimum investment of £50,000+, run for three months and are highly secure and liquid,
but offer low returns.
 Deposits, which offer investment periods ranging from overnight to five years. They are
available from banks, local authorities and building societies with yields exceeding that of
Treasury bills.
 Gilts (longer-term government debt), which offer a large range of maturities and rates
based on money market rates; they can have capital gains tax advantages.

 Bonds, which are debentures and loans of companies quoted on the stock market; rates
fluctuate with general interest rates and there is good liquidity.
 Equities dealt on the Stock Exchange offer good marketability and liquidity but relatively
high risk.
When choosing investments from the list above the following factors should be considered:
 The amount of funds available
 The length of time for which the funds are available (invest short-term funds in the short-
term and longer-term funds in longer-term projects)
 The likelihood of needing early withdrawal (consider liquidity)
 The notice period for withdrawal, and penalties
 The risk and the return of the investment
9 Cash budgets
Section overview
 A cash budget shows the cash effect of all the decisions taken in the budgetary planning
exercise.
 It is a statement tabulating future cash receipts and payments to show the forecast cash
balance of a business at defined intervals.
 The appropriate management action to be taken in response to forecast cash deficits or
surpluses will depend on whether the situation is expected to be short term or longer
term.
 Certain non-cash items such as depreciation are not included in a cash budget.
A cash budget is a statement in which estimated future cash receipts and payments are
tabulated in such a way as to show the forecast cash balance of a business at defined intervals.
9.1 Preparing cash budgets

For example, in December 20X2 an accounts department might wish to estimate the cash
position of the business during the three following months, January to March 20X3. A cash
budget might be drawn up in the following format.
Jan Feb Mar

£ £ £
Estimated cash receipts
From accounts payable 14,000 16,500 17,000
From cash sales 3,000 4,000 4,500
Proceeds on disposal of non-current assets 2,200
Total cash receipts 17,000 22,700 21,500
Estimated cash payments
To suppliers of goods 8,000 7,800 10,500
To employees (wages) 3,000 3,500 3,500
Purchase of non-current assets 16,000
Rent and rates 1,000
Other overheads 1,200 1,200 1,200
Repayment of loan 2,500
14,700 28,500 16,200

Jan Feb Mar
£ £ £
Net surplus/(deficit) for month 2,300 (5,800) 5,300
Opening cash balance 1,200 3,500 (2,300)
Closing cash balance 3,500 (2,300) 3,000
In this example the accounts department has calculated that the cash balance at the beginning
of the budget period, 1 January, will be £1,200. Estimates have been made of the cash that is
likely to be received by the business (from cash and credit sales, and from a planned disposal of
non-current assets in February). Similar estimates have been made of cash due to be paid out by
the business (payments to suppliers and employees, payments for rent, rates and other
overheads, payment for a planned purchase of non-current assets in February and a loan
C
repayment due in January).
H
From these estimates it is a simple step to calculate the net cash movement in each month. In A
P
some months the budgeted cash payments may exceed cash receipts and there will be a deficit T
for the month; this occurs during February in the above example because of the large E
investment in non-current assets in that month. R
The last part of this cash budget shows how the business's estimated cash balance can then be 7
rolled along from month to month. Starting with the opening balance of £1,200 at 1 January a
cash surplus of £2,300 is generated in January. This leads to a closing January balance of
£3,500, which becomes the opening balance for February. The deficit of £5,800 in February
throws the business's cash position into overdraft and the overdrawn balance of £2,300
becomes the opening balance for March. Finally, the cash surplus of £5,300 in March leaves the
business with a favourable cash position of £3,000 at the end of the budget period.
9.2 The usefulness of cash budgets

Cash budgets enable management to make any forward planning decisions that may be
needed, such as advising their bank of estimated overdraft requirements or strengthening their
credit control procedures to ensure that customers pay more quickly.
The cash budget can also give management an indication of potential problems that could arise
and allows them the opportunity to take action to avoid such problems. A cash budget can show
potential cash positions as explored in section 9.3 below. Management will need to take
appropriate action depending on the potential position.
Interactive question 5: Cash budget

Tick to show which of the following should be included in a cash budget.
Include Do not include
Funds from the receipt of a bank loan

Revaluation of a non-current asset
Receipt of dividends from outside the business
Depreciation of distribution vehicles
Bad debts written off
Share dividend paid

Worked example: Preparing a cash budget
Penny operates a retail business. Purchases are sold at cost plus 33 1/3%.
(a) Budgeted sales Labour cost Expenses incurred
in month in month in month
£ £ £
January 40,000 3,000 4,000
February 60,000 3,000 6,000
March 160,000 5,000 7,000
April 120,000 4,000 7,000
(b) It is management policy to have sufficient inventory in hand at the end of each month to
meet half of next month's sales demand.
(c) Suppliers for materials and expenses are paid in the month after the purchases are
made/expenses incurred. Labour is paid in full by the end of each month.
(d) Expenses include a monthly depreciation charge of £2,000.
(e) (1) 75% of sales are for cash.
(2) 25% of sales are on one month's credit.
(f) The company will buy equipment costing £18,000 for cash in February and will pay a
dividend of £20,000 in March. The opening cash balance at 1 February is £1,000.
Requirement
Prepare a cash budget for February and March.
You should make an entry in every box in the cash budget. Enter a zero or a dash where
applicable. Do not leave any boxes blank.
Solution
Cash budget
February March
£ £
Receipts
Receipts from cash sales 45,000 (W1) 120,000 (W2)
Receipts from credit sales 10,000 (W1) 15,000 (W2)
Payments
Payments to suppliers 37,500 (W3) 82,500 (W3)
Expenses 2,000 (W4) 4,000 (W4)
Labour 3,000 5,000
Equipment purchase 18,000 0
Dividend 0 20,000
Total payments 60,500 111,500
Receipts less payments (5,500) 23,500
Opening cash balance b/f 1,000 (4,500)
Closing cash balance c/f (4,500) 19,000
WORKINGS
(1) Receipts in February £
Cash 75% of Feb sales (75%  £60,000) 45,000
Credit 25% of Jan sales (25%  £40,000) 10,000
(2) Receipts in March £
Cash 75% of Mar sales (75%  £160,000) 120,000
Credit 25% of Feb sales (25%  £60,000) 15,000

(3) Purchases
January February
£ £
For Jan sales (50% of £30,000) 15,000
For Feb sales (50% of £45,000) 22,500 (50% of £45,000) 22,500
For Mar sales – (50% of £120,000) 60,000
37,500 82,500
These purchases are paid for in February and March.

(4) Expenses
Cash expenses in January (£4,000 – £2,000) and February (£6,000 – £2,000) are paid in
February and March respectively. Depreciation is not a cash item.
C
H
A
P
Interactive question 6: Cash budget
T
You are presented with the budgeted data shown in Annex A for the period November 20X1 to E
R
June 20X2 by your firm. It has been extracted from the other functional budgets that have been
prepared. 7
You are also told the following.

(a) Sales are 40% cash, 60% credit. Credit sales are paid two months after the month of sale.
(b) Purchases are paid in the month following purchase.
(c) 75% of wages are paid in the current month and 25% the following month.
(d) Overheads are paid the month after they are incurred. The overhead figures include
monthly depreciation of £2,000.
(e) Dividends are paid three months after they are declared.
(f) Capital expenditure is paid two months after it is incurred.
(g) The opening cash balance is £15,000.
Annex A
Nov X1 Dec X1 Jan X2 Feb X2 Mar X2 Apr X2 May X2 June X2
£ £ £ £ £ £ £ £
Sales 80,000 100,000 110,000 130,000 140,000 150,000 160,000 180,000
Purchases 40,000 60,000 80,000 90,000 110,000 130,000 140,000 150,000
Wages 10,000 12,000 16,000 20,000 24,000 28,000 32,000 36,000
Overheads 12,000 12,000 17,000 17,000 17,000 22,000 22,000 22,000
Dividends 20,000 40,000
declared
Capital
expenditure 30,000 40,000
Requirement
Use the following framework to prepare the cash budget.
You should make an entry in every box in the cash budget. Enter a zero or a dash where
applicable. Do not leave any boxes blank.

January February March April May June
£'000 £'000 £'000 £'000 £'000 £'000
Receipts
Cash sales
Credit sales
Payments
Purchases
Wages:
75%
25%
Overheads
Dividends
Capital
expenditure
Net
surplus/(deficit)
Opening balance
Closing balance
9.3 Potential cash positions
9.3.1 Short term surplus

 Pay suppliers early in return for settlement discount
 Increase receivables and inventories
 Invest short term (see Section 8.4)
9.3.2 Short term deficit
 Increase payables by delaying payments to suppliers
 Reduce receivables and inventories
 Arrange overdraft
9.3.3 Long term surplus
 Invest long term
 Expand
 Diversify
 Replace non-current assets
 Increase dividends
 Buy back shares
9.3.4 Long term deficit
 Raise long term finance
 Consider divestment
 Consider selling non-current assets
 Plan a controlled shutdown

Summary
Need to weigh up profitability vs liquidity
WC = Receivables + Inventory + Cash – Payables

C
H
A
Working capital and P
T
cash planning E
R
Cash budget Cash operating cycle
Length of time between

paying for inputs and
receipt of cash from
Forecast surpluses Forecast deficits customers
Can be calculated for

Short term each element
surplus • Increase payables (receivables, payables,
• Pay suppliers by delaying etc) in days
early in return for payments to
settlement suppliers
discount • Reduce Liquidity problems
• Increase receivables and caused if cycle too long
receivables and inventories
inventories • Arrange overdraft
• Invest short term Important to assess
liquidity
• Current ratio
• Quick (liquidity) ratio
Long term
surplus
• Invest long term • Raise long term
• Expand finance
• Diversify • Consider
• Replace non- divestment
current assets • Consider selling
• Increase non-current
dividends assets
• Buy back shares • Plan a controlled
shutdown

Self-test
1 X will begin trading on 1 January 20X3. The following sales revenue is budgeted for
January to March 20X3.
January February March
£13,000 £17,000 £10,000
5% of sales will be for cash. The remainder will be credit sales. A discount of 5% will be
offered on all cash sales. The payment pattern for credit sales is expected to be as follows.
Invoices paid in the month after sale 75%
Invoices paid in the second month after sale 23%
Bad debts 2%
Invoices are issued on the last day of each month.
The amount budgeted to be received from customers in March 20X3 is:
A £15,428
B £15,453
C £15,618
D £16,215
2 The amount of working capital is most likely to increase when:
A work-in-progress falls
B selling prices increase
C the credit period allowed to customers is reduced
D the credit period taken from suppliers is increased
3 A retailing company earns a gross profit margin of 37.5% on its monthly sales of £20,000. In
order to generate extra cash, the following changes are proposed:
Present Proposed
Inventory holding period 1.5 months 1.0 month
Trade payable payment period 1.0 month 1.3 months
How much extra cash will be generated at the end of the month in which these changes
take place?
A £2,500
B £3,750
C £6,250
D £10,000
4 Selected figures from a firm's budget for next month are as follows:
Sales £450,000
Gross profit on sales 30%
Decrease in trade payables over the month £10,000
Increase in cost of inventory held over the month £18,000
What is the budgeted payment to trade payables?
A £343,000
B £323,000
C £307,000
D £287,000

5 A company's cash budget for next year shows a cash deficit for the months of April and
May. For the remaining months there will be a cash surplus.
Which two of the following management actions would be most appropriate in response to
the expected cash position in April and May?
A Increase inventories of raw materials
B Arrange a bank overdraft
C Delay the payment of suppliers as much as possible
D Issue extra share capital
E Offer extra credit to customers
6 The following are items from APC Ltd's opening and closing balance sheet and income
statements for the year 20X8.
C
1 January 31 December H
A
£'000 £'000
P
Receivables 800 900 T
Inventory 600 700 E
Payables 200 250 R
Credit sales £10m 7

Cost of goods sold £6m
What is the approximate length of the cash operating cycle?

A 54 days
B 57 days
C 61 days
D 84 days
7 Gemstrong Ltd is a retail company that has average sales of £14.6 million per annum and
earns a mark-up of 25%. Inventory averages £2 million, receivables average £0.9 million
and trade payables £0.6 million.
If all sales and purchases are on credit, how long is the company's cash operating cycle (to
the nearest day)?
A 58 days
B 66 days
C 69 days
D 104 days
8 A company sells inventory at a profit to a customer on credit. How will this transaction affect
each of the following ratios immediately after the transaction?
Current ratio Increase Decrease Stay the same
Quick (liquidity) ratio Increase Decrease Stay the same
9 A subsidiary which sells goods wholesale has a year-end trade payables balance of £192,000.
The remainder of the working capital items consist of trade receivables, inventories and cash.
The inventory, receivables and payables balances were the same at the year end as at the
beginning of the year.
Relevant financial ratios for the year are as follows:
Quick (liquidity) ratio 1.7:1
Rate of inventory turnover 6 times p.a.
Payables payment period 1.5 months
The current ratio to the nearest whole number at the year end is

10 A retailing company's working capital consists of inventory, trade receivables, cash and
trade payables. All working capital balances were the same at the beginning and the end of
the year. The sales revenue for the year was £900,000.
The financial ratios for the year include the following.
Current ratio 3.4:1

Rate of inventory turnover 15 times p.a.
Receivables collection period 73.0 days
Payables payment period 36.5 days
Gross profit margin 20.0%
The closing cash balance was £


While liquidity as seen in the current ratio is unaffected by the decisions, when we look at the
quick ratio, which treats inventory as non-current in the short term, we can clearly see that Right
Ltd's short-term liquidity will decrease as a result of the proposed changes, so it is a riskier
policy.

C
H
Ratio for this business Industry average A
P
(982 + 648 +78) 1,708 T
Current ratio = = 2.6:1 2.5:1
653 653 E
R
Quick (liquidity) (1,708 – 982) 1.4:1
= 1.1:1 7
ratio 653
Comments on the results:

The current ratio is close to the industry average, which appears to suggest an adequate level of
liquidity. However, when inventory is deducted from the current assets the quick ratio is below
the industry average. This business is more reliant than average on liquidating its inventory in
order to meet its current liabilities. The importance of this will depend upon how quickly the
inventory can be turned into cash, ie, the length of the cash operating cycle. Moreover, the
business has relatively little cash and its liquidity as measured by the quick ratio relies on the
quality of its receivables, ie, how likely customers are to pay their debts and how quickly they will
pay.

Cost of sales = 75% × £3,600,000 = £2,700,000
Days
150,000
Raw materials in inventory = × 365 34
2,700,000×60%
130,000
Credit taken from suppliers = × 365 (29)
*2,700,000× 60%
350,000
WIP in inventory = × 365 47
2,700,000
200,000
Finished goods in inventory = × 365 27
2,700,000
306,000
Credit given to customers = × 365 31
3,600,000
Number of days between payment and receipt 110
* Since inventory levels are constant, annual purchases = annual usage.

You may have thought of three of the following:
 Set clearly defined procedures to be followed. Establish timings for issuing letters of
demand and the point when further deliveries should stop.
 Ensure the receivables ledger section liaises with marketing management to see if the latter
can help.
 Consider creating a stop list ie, suspending supplies, etc.
 Decide whether outside assistance, such as solicitors, trade associations and debt collection
agencies are needed earlier in the cycle to collect overdue debts.
 Assess whether it may be cheaper to collect debts through the court system than through
outside help.

Any item that is a cash flow will be included. Non-cash items are excluded from a cash budget.
Include Do not include
Funds from the receipt of a bank loan 
Revaluation of a non-current asset 
Receipt of dividends from outside the business 
Depreciation of distribution vehicles 
Bad debts written off 
Share dividend paid 

January February March April May June
£'000 £'000 £'000 £'000 £'000 £'000
Receipts
Cash sales 44 52 56 60 64 72
Credit sales 48 60 66 78 84 90
Payments
Purchases 60 80 90 110 130 140
Wages:
75% 12 15 18 21 24 27
25% 3 4 5 6 7 8
Overheads 10 15 15 15 20 20
Dividends 0 0 20 0 0 0
Capital
expenditure 0 0 30 0 0 40
Net surplus/(deficit) 7 (2) (56) (14) (33) (73)
Opening balance 15 22 20 (36) (50) (83)
Closing balance 22 20 (36) (50) (83) (156)

1 A
Received in March
£
Cash sales (5%  £10,000)  95% 475.00
February sales (£17,000  95%)  75% 12,112.50
January sales (£13,000  95%)  23% 2,840.50
15,428.00
If you answered B you forgot to allow for 5% discount on cash sales.

C
If you selected C as the correct answer you have included the bad debts for March as a H
cash receipt. A
P
If you answered D you forgot that credit sales amounted to only 95% of each month's T
budgeted sales revenue. E
R
2 B A, C and D will cause a fall. B may increase receivables.
7
3 D
Monthly cost of sales = £20,000  62.5%
= £12,500
£ £
Existing inventory level 1.5  £12,500 18,750
New inventory level 1  £12,500 (12,500)
Change in inventory level 6,250
Existing payables 1  £12,500 12,500
New payables 1.3  £12,500 16,250
Change in payables 3,750
Total change in working capital 10,000
If you answered A you treated the change in payables as a cause of a reduction in cash.
However, if payables increase this will increase their cash inflow. The other two
incorrect options considered each of the changes separately, but their effects must be
combined to derive the correct answer.
4 A
£'000
Cost of sales for month = £450,000  70% 315
Decrease in trade payables 10
Increase in inventory 18
Budgeted payment to trade payables 343
If you selected an incorrect option you did not treat the change in trade payables and
inventory balances correctly.
An increase in inventory indicates that budgeted purchases are greater than the
budgeted cost of goods to be sold in the month, which would increase the amount
payable to suppliers. Since the balance owed to suppliers is budgeted to decrease,
this further increases the amount budgeted to be paid to suppliers.

5 B,C The budget forewarns of a short term deficit and these are the two most appropriate
responses to this situation.
Action taken to increase inventories or to offer extra credit to customers will result in
cash outflows. These are not appropriate actions in the light of a short term deficit.
Although the issue of extra share capital would help to reduce or eliminate a cash
deficit, this would be a more appropriate action to take if the predicted deficit were
expected to continue in the longer term.
6 B
Average inventory = £650,000
650×365
Inventory period = = 39.54 days
6,000
Average receivables = £850,000
850×365
Receivables period = = 31.03 days
10,000
Average payables = £225,000
Purchases = cost of goods sold
plus increase in inventory
= £6m + £100,000
= £6.1m
225×365 (13.46) days
Payables period = =
6,100
Cash operating cycle 57 days
If you selected 84 days you added together the days for each element of working capital.
However, the payable period, during which the company takes credit from suppliers,
reduces the length of the cycle and hence should be deducted.
7 B
Days
Receivable days (0.9/14.6)  365 22.5
Payable days (0.6/(14.6 ÷ 1.25))  365 (18.8)
Inventory days (2.0/(14.6 ÷ 1.25))  365 62.5
66.2
If you selected 58 days you based your calculations of payables days and inventory
days on the sales revenue rather than on the cost of sales.
If you arrived at an answer of 69 days you performed your calculations using a margin
of 25% of sales, rather than a mark up of 25% of cost.
If you selected 104 days you added together the days for each element of working
capital. The payables days should be subtracted, since credit from suppliers reduces
the cash operating cycle.
8
Current ratio
 Increase Decrease Stay the same
Quick (liquidity) ratio

 Increase Decrease Stay the same
Both ratios will increase. The current liability figure used as the denominator will stay the
same in both cases. The total of the current assets will increase because of the profit
element in receivables, therefore the current ratio will increase. The total of the liquid assets
will also increase therefore the quick (liquidity) ratio will increase.

9 The current ratio at the year end is 3:1
WORKINGS
Average payables
Payables payment period (in months) = ×12
Purchases
£192,000
1.5 = ×12
Purchases
Purchases = £1,536,000
Inventory = unchanged  cost of sales = Purchases
Cost of sales
Rate of inventory turnover = C
Average inventory H
A
£1,536,000 P
6 =
Inventory T
E
Inventory = £256,000 R
From the quick ratio, receivables and cash = 1.7 × £192,000 7
= £326,400
£256,000 + £326,400
 Current ratio =
£192,000
= 3:1
10 The closing cash balance was £ 16,800

WORKINGS
Since gross profit margin = 20%
Cost of sales = 80% × £900,000
= £720,000
Inventory = unchangedcost of sales = purchases

Average trade payables
Payables payment period (in days) = × 365
Purchases
Trade payables
36.5 =  365
£720,000
Trade payables = £72,000

Current assets
Since current ratio = = 3.4:1
Current liabilities
Current assets = 3.4 × £72,000
= £244,800
Cost of sales
Rate of inventory turnover =
Average inventory
£720,000
15 =
Inventory
Inventory = £48,000

Average trade receivables
Sales revenue
Trade receivables
73 = × 365
£900,000
Trade receivables = £180,000

Current assets = Inventory + Receivables + Cash
£244,800 = £48,000 + £180,000 + Cash
Cash = £16,800

CHAPTER 8
Performance
management
Introduction
Examination context
TOPIC LIST
1 Performance evaluation
2 Responsibility centres
3 Performance measures
4 The balanced scorecard
5 Budgetary control
Introduction
 Identify the reasons for and key features of effective performance management
systems
 Select appropriate financial and non-financial performance measures which
effectively encourage the business as a whole to meet its objectives
 Identify the features of cloud accounting and their associated risks and benefits
 Identify the features of shared service centres and their relative merits for the
provision of management information
The specific syllabus references for this chapter are: 3a, b, d and e.
Syllabus links
Decentralisation and an understanding of responsibility centres also feature in the Business,
Technology and Finance syllabus, in the context of appreciating how these structures help to
achieve business objectives. You will also study internal controls in more depth in the context of
your Assurance syllabus and some of the performance measures covered in this chapter will be
met again when you are studying the interpretation of financial information for the Financial
Accounting and Reporting syllabus.
Examination context
It is important to appreciate that both numerical and written questions will be set on
performance measures and a thorough understanding of flexed budgets is required as a basis
for variance analysis in the next chapter.
 identify the most appropriate performance measure in a given situation
 demonstrate an understanding of the effect of management actions on specific
performance measures
 demonstrate an understanding of the purpose and operation of a responsibility accounting
system
 interpret the information provided by specific performance measures
 calculate the flexed cost budget for a given level of activity
 interpret the information provided by a flexed budget comparison
 identify the features, risks and benefits of cloud accounting
 identify the features and benefits of shared service centres

1 Performance evaluation
Section overview
 The term 'feedback' is used to describe both the process of reporting back control
information to management and the control information itself.
 Effective feedback information should have the following features.
– Clear and comprehensive
– Use an exception reporting format
– Identify separately the controllable costs and revenues
– Prepared on a regular basis
– Timely
– Sufficiently accurate for the purpose intended (not containing irrelevant detail)
– Communicated to the manager who has authority and responsibility to act on the
information
 Inappropriate performance measures can lead to a lack of goal congruence and may
introduce budget bias.
 Hopwood identified three styles of evaluation: budget constrained; profit conscious; non- C
accounting. H
A
P
T
1.1 Feedback control E
R
The term 'feedback' is used to describe both the process of reporting back control information
to management and the control information itself. In a business organisation, it is information 8
produced from within the organisation (management control reports) with the purpose of
helping management and other employees with control decisions.
The feedback loop can be depicted as follows.
INPUT
RESOURCES
Plan, target
or budget Compare OPERATIONS
actual results Control
with plan action
OUTPUTS
Feedback of Measure
(eg, actual output
information outputs
revenues, costs)
Figure 8.1: Feedback loop in the control cycle

The elements in the control cycle, illustrated in Figure 8.1, are as follows.
ICAEW 2019 Performance management 205

Step 1
Plans and targets are set for the future. These could be long, medium or short term plans.
Examples include budgets, profit targets and standard costs (which we will learn more about in
the next chapter).
Step 2
Plans are put into operation. Then, resources are consumed and costs are incurred.
Step 3
Actual results are recorded and analysed.
Step 4
Information about actual results is fed back to the management concerned, often in the form of
accounting reports. This reported information is feedback.
Step 5
The feedback is used by management to compare actual results with the plan or targets (what
should be or should have been achieved).
Step 6
By comparing actual and planned results, management can then do one of three things,
depending on how they see the situation.
(1) They can take control action. By identifying what has gone wrong, and then finding out
why, corrective measures can be taken.
(2) They can decide to do nothing. This could be the decision when actual results are going
better than planned, or when poor results were caused by something which is unlikely to
happen again in the future.
(3) They can alter the plan or target if actual results are different from the plan or target, and
there is nothing that management can do (or nothing, perhaps, that they want to do) to
correct the situation.
It may be helpful at this stage to relate the control system to a practical example, such as
monthly sales.
Step 1
A sales budget or plan is prepared for the year.
Step 2
Management organises the business's resources to achieve the budget targets.
Steps 3 and 4
At the end of each month, actual results are reported back to management.
Step 5
Managers compare actual results against the plan.
Step 6
Where necessary, they take corrective action to adjust the workings of the system, probably by
amending the inputs to the system.
 Sales people might be asked to work longer hours
 More money might be spent on advertising
 Some new price discounts might be decided
 Delivery periods to customers might be reduced by increasing output
Where appropriate the sales plan may be revised, up or down.

1.2 Features of effective feedback
(a) Reports should be clear and comprehensive.
(b) The 'exception principle' should be applied so that significant differences between the
target and the actual results are highlighted for investigation. Areas that are conforming to
plan should be given less prominence in the management control reports.
(c) The controllable costs and revenues should be separately identified. These are the items
that can be directly influenced by the manager who receives the report. It can be
demotivating if managers feel that they are being held responsible for items which are
outside their control and which they are unable to influence. Uncontrollable items might be
included for information (rather than action).
(d) Reports should be produced on a regular basis to ensure that continual control is exercised.
(e) Reports should be made available to managers in a timely fashion. This means they must
be produced in good time to allow the manager to take control action before any adverse
results get much worse.
(f) Information should be sufficiently accurate for the purpose intended.
(g) Irrelevant detail should be excluded from the report.
(h) Reports should be communicated to the manager who has responsibility and authority to
act on the information.
C
1.3 The behavioural impact of performance measurement H
A
Research evidence suggests that all too often performance measures lead to a lack of goal
P
congruence. Managers seek to improve their performance on the basis of the indicator used, T
even if this is not in the best interests of the organisation as a whole. E
R
For example, a production manager may be encouraged to achieve and maintain high
production levels and to reduce costs, particularly if his or her bonus is linked to these factors. 8
Such a manager is likely to be highly motivated. However, the need to maintain high production
levels could lead to high levels of slow-moving inventory, resulting in an adverse effect on the
company's cash flow. Thus the manager's behaviour has been distorted by the control system.
The impact of an accounting system on managerial performance depends ultimately on how the
information is used. Research by Hopwood has shown that there are three distinct ways of using
budgetary information to evaluate managerial performance.
Style of evaluation Comment
Budget constrained 'The manager's performance is primarily evaluated upon the basis of his
ability to continually meet the budget on a short term basis. This criterion
of performance is stressed at the expense of other valued and important
criteria and the manager will receive unfavourable feedback from his
superior if, for instance, his actual costs exceed the budgeted costs,
regardless of other considerations.'
Profit conscious 'The manager's performance is evaluated on the basis of his ability to
increase the general effectiveness of his unit's operations in relation to
the long term purposes of the organisation. For instance, at the cost
centre level one important aspect of this ability concerns the attention
which he devotes to reducing long run costs. For this purpose, however,
the budgetary information has to be used with great care in a rather
flexible manner.'
Non accounting 'The budgetary information plays a relatively unimportant part in the
superior's evaluation of the manager's performance.'

A summary of the effects of the three styles of evaluation is as follows.
Style of evaluation
Budget Profit Non-
constrained conscious accounting
Involvement with costs High High Low
Job-related tension High Medium Medium
Manipulation of the accounting reports (bias) Extensive Little Little
Relations with the supervisor Poor Good Good
Relations with colleagues Poor Good Good
Research has shown no clear preference for one style over another.
1.4 Budget bias

In the table above we have indicated that bias or manipulation of accounting reports is more
likely to occur if the manager is under pressure to achieve short-term budget targets.
In the process of preparing budgets, managers might introduce budget slack into their
estimates. This is when a manager deliberately overestimates costs and/or underestimates
revenues, so that they will not be blamed in the future for overspending and/or poor results.
In controlling actual operations, managers might ensure that their spending rises to meet their
inflated budget, otherwise they will be 'blamed' for careless budgeting.
A typical situation is for a manager to pad the budget and waste money on non-essential
expenses so that all budget allowances are used. The reason behind the manager's action is the
fear that unless the allowance is fully spent it will be reduced in future periods, thus making the
manager's job more difficult as the future reduced budgets will not be so easy to attain. Because
inefficiency and slack are allowed for in budgets, achieving a budget target means only that
costs have remained within the accepted levels of inefficient spending.
Budget bias can work in the other direction too. It has been noted that, after a run of mediocre
results, some managers deliberately overstate revenues and understate cost estimates, no
doubt feeling the need to make an immediate favourable impact by promising better
performance in the future. They may merely delay problems, however, as the managers may
well be censured when they fail to hit these optimistic targets.
This is another example of management's reaction to control systems distorting the processes
that the control systems are meant to serve.

2 Responsibility centres
Section overview
 Divisionalisation involves splitting the organisation into separate divisions, for example
according to location or the product or service provided.
 In a decentralised organisation the authority for certain decisions is delegated to less
senior managers. The most appropriate degree of decentralisation depends on a range of
factors.
 There are a number of advantages and disadvantages of decentralisation.
 Responsibility accounting is the term used to describe decentralisation of authority, with
the performance of the decentralised units measured in terms of accounting results.
 With a system of responsibility accounting there are four types of responsibility centre:
cost centre, revenue centre, profit centre, investment centre.
 An investment centre manager has responsibility for capital investment in the centre.
 The performance of the responsibility centre manager should be monitored and based
only on those items over which the manager can exercise control:
– Controllable costs and revenues should be separated from non-controllable costs and
revenues.
C
– Controllable elements of divisional investment should be separated from non- H
controllable elements. A
P
T
E
2.1 Divisionalisation R
As companies grow, and possibly also spread geographically, it is likely that they will consider
8
some form of divisionalisation. This involves splitting the company into divisions, for example
according to location or according to the product or service provided. Divisional managers are
then given the authority to make decisions concerning the activities of their divisions.
2.2 Decentralisation
In general, a divisional structure will lead to decentralisation of the decision-making process.
Divisional managers may have the freedom to set selling prices, choose suppliers, make output
decisions and so on. Later in this section we will see that the degree of decentralisation depends
on how much freedom managers are given to make decisions.
2.2.1 Factors affecting the degree of decentralisation

 Management style. An authoritarian style is likely to mean that decision making is
centralised.
 The size of the organisation. Decentralisation tends to increase as an organisation grows.
 The extent of activity diversification. A greater diversification of activities will lead to more
decentralisation.
 Effectiveness of communications. Decentralisation can only operate if information is
communicated effectively both up and down the organisation.
 The ability of management. The more able the management team, the more
decentralisation is likely to result.

 The speed of technological advancement. Managers lower down the organisation are more
likely to be familiar with changing technology, therefore decentralisation would be more
appropriate.
 The geography of locations and the extent of local knowledge needed. If an organisation
is spread over a wide range of locations then decentralisation is likely to be most effective.
Local managers would make more effective decisions based on their knowledge of local
markets.
2.2.2 The advantages of decentralisation

 Senior managers are freed from detailed involvement in day to day operations and can
devote more time to strategic issues.
 The quality of decisions is likely to improve because local managers may be able to make
more informed judgements based on local knowledge.
 The increased responsibility should motivate managers in decentralised organisations.
 Decisions should be taken more quickly in response to changing conditions.
 Decentralised operations provide valuable training grounds for future senior managers by
giving them experience of managerial skills in what may be a less complex environment
than that faced by more senior managers.
2.2.3 The disadvantages of decentralisation

 It can be difficult to coordinate the activities of the organisation since several people are
making decisions rather than just a few.
 The organisation might effectively divide into a number of self-interested segments,
leading to a lack of goal congruence in decision making.
 Senior managers lose control over day to day activities.
 Evaluating the performance of managers and their area of responsibility becomes difficult.
 There may be a duplication of some roles, for example administration, with consequent
increased costs.
2.3 Responsibility accounting

We have already discussed responsibility accounting in outline in the context of cost
classification in the first chapter of this Study Manual.
Responsibility accounting is the term used to describe decentralisation of authority, with the
performance of the decentralised units or responsibility centres measured in terms of
accounting results.
Within a system of responsibility accounting there are four main types of responsibility centre:
cost centre, revenue centre, profit centre and investment centre.
Decentralisation is a matter of degree, depending on how much freedom and authority is given
to managers. In the weakest form of decentralisation a system of cost centres or revenue centres
might be used. As decentralisation becomes stronger the responsibility accounting framework
will be based around profit centres. Decentralisation in its strongest form means that investment
centres are used.

Type of responsibility Manager has control over Principal performance
centre measures
Cost centre Controllable costs Variance analysis

Efficiency measures
Revenue centre Revenues only Revenues
Profit centre Controllable costs Profit
Sales prices (including transfer prices) Profit margins
Investment centre Controllable costs Return on investment
Sales prices (including transfer prices) Residual income
Output volumes Other financial ratios
Investment in non-current assets and
working capital
2.4 Cost centres

A cost centre manager is responsible for, and has control over, the costs incurred in the cost
centre. The manager has no responsibility for earning revenues or for controlling the assets and
liabilities of the centre.
C
Functional departments such as production and personnel might be treated as cost centres and H
A
made responsible for their costs.
P
It is important that control reports for a cost centre show a clear distinction between controllable T
E
costs, over which the cost centre manager can exercise some control, and uncontrollable costs, R
which cannot be controlled by the cost centre manager.
8
2.5 Revenue centres

The manager of a revenue centre is responsible only for raising revenue but has no
responsibility for forecasting or controlling costs. An example of a revenue centre is a sales
centre where a sales manager might be responsible for achieving a budgeted level of sales
revenue.
2.6 Profit centres

A profit centre is a part of a business accountable for both costs and revenues.
For a profit centre organisation structure to be established it is necessary to identify units of the
organisation to which both revenues and costs can be separately attributed. Revenues might
come from sales of goods and services to external customers, or from goods and services
provided to other responsibility centres within the organisation. These internal 'sales' are
charged at a transfer price, which you learned about in Chapter 5.
A profit centre's performance report, in the same way as that for a cost centre, would identify
separately the controllable and non-controllable costs as well as the controllable and non-
controllable revenues. A profit centre performance report might look like the example below.

Profit Centre Y
Income Statement for the Period
Budget Actual Variance
£'000 £'000 £'000
Sales revenue X X
Variable cost of sales (X) (X)
Contribution X X
Directly attributable/controllable fixed costs
Salaries (X) (X)
Stationery costs (X) (X)
etc etc
Gross profit (directly attributable/controllable) X X
Share of uncontrollable costs (eg, head office costs) (X) (X)
Net profit X X
The budget for the sales revenue and variable cost of sales will be flexed according to the
activity level achieved. You will learn how to do this later in this chapter.
The variances (differences between budgeted and actual results) could be analysed in further
detail for the profit centre manager.
Notice that three different 'profit levels' are highlighted in the report.
(a) Contribution, which is within the control of the profit centre manager
(b) Directly attributable gross profit, which is also within the manager's control
(c) Net profit, which is after charging certain uncontrollable costs and which is therefore not
controllable by the profit centre manager
2.7 Investment centres

Where a manager of a division is allowed some discretion about the amount of investment
undertaken by the division, assessment of results by profit alone (as for a profit centre) is clearly
inadequate. The profit earned must be related to the amount of capital invested. Such divisions
are sometimes called investment centres for this reason.
Performance can be measured by return on capital employed (ROCE), often referred to as return
on investment (ROI) and other subsidiary ratios, or by residual income (RI).
The amount of capital employed attributed to an investment centre should consist only of
directly attributable non-current assets and working capital (net current assets).
(a) Subsidiary companies that are treated as investment centres are often required to remit
spare cash to the central treasury department at group head office. In this situation the
directly attributable working capital would normally consist of inventories and receivables
less payables, but minimal amounts of cash.
(b) If an investment centre is apportioned a share of head office non-current assets, the amount
of capital employed in these assets should be recorded separately because it is not directly
attributable to the investment centre or controllable by the manager of the investment
centre.
Interactive question 1: Controllable investment in division

The manager of division D has complete autonomy regarding the purchase and use of non-
current assets and inventory but the payment of all suppliers is undertaken by head office which
maintains a central bank account. The manager also has authority to establish the division's own
credit policy with regard to its customers. The division operates a credit control department but
all cash received from customers is remitted immediately to head office.

Requirement
Classify the following assets and liabilities to indicate whether or not they are a part of the
divisional investment that is within the control of the manager of division D.
Part of controllable Not part of controllable

Item divisional investment divisional investment
Non-current assets
Trade receivables
Trade payables
Inventory
2.8 Shared service centres (SSC)

Basic processing tasks are now often carried out in shared service centres. Shared service
centres consolidate the transaction-processing activities of many operations within a company.
Functions such as human resources, payroll, accounting and IT may be carried out in a shared
C
service centre. The aim of a shared service centre is to achieve significant cost reductions while H
improving service levels through the use of standardised technology and processes and service A
level agreements. For example, a multinational business may use shared servicing in its head P
T
office to process all transactions incurred by its overseas operations. E
R
A fair transfer pricing policy (covered in Chapter 5) is vital to ensure that client divisions value the
SSC and that the SSC provides efficient services. 8
Advantages to using a shared service centre include:

(a) reduced headcount due to economies of scale resulting from the single location centre
(b) associated reduction in premises and other overhead costs
(c) knowledge sharing should lead to an improvement in quality of the service provided
(d) allows standard approaches to be adopted across the organisation leading to more
consistent management of business data
Disadvantages might include:
(a) loss of business specific knowledge. For example, creating a consolidated finance function
which broadly handles financial matters for the entire organisation may lack an
understanding of specific finance issues affecting individual departments or business units.
(b) removed from decision making. Building on from the point above, an SSC finance function is
unlikely to be able to provide meaningful financial information for decision making if
finance personnel are removed from the day to day realities facing a particular department
or business unit.
(c) weakened relationships. Geographical distance between the site of the SSC and the
respective business areas it serves may weaken the relationships between the two.
(d) cost inefficiencies. Cost inefficiencies within the SSC could potentially be passed on to the
client division and this is likely to lead to friction between the two parties.
Another difficulty for shared service centres is performance measurement. In the 1990s the focus
was on lowering costs by increasing processing speed, reducing labour costs and having

economies of scale. More recently the focus has shifted towards quality of service and qualitative
measures such as error rates and efficiency rates have become important. However, qualitative
measures are often difficult to implement and subjective and some organisations abandon these
measures.
Case example: Nestle and Burberry

In 2011 Nestle opened a shared service centre in L'viv, Ukraine, offering services to divisions in
over 20 countries in Europe.
Fashion retailer Burberry is to open a shared service centre in Leeds, UK in late 2017, covering
the UK, Europe, Middle East, India and Africa shared service teams from finance, HR, IT and
customer services.
2.9 Cloud accounting
Definitions
Cloud computing: "Is a model for enabling ubiquitous, convenient, on-demand network access
to a shared pool of configurable computing resources (eg, networks, servers, storage,
applications, and services) that can be rapidly provisioned and released with minimal
management effort or service provider interaction". (US Department of Commerce, National
Institute of Standards and Technology)
Cloud accounting: An application of cloud computing where accountancy software is provided
in the cloud by a service provider.
Cloud accounting applications can be hosted applications or software as a service (SaaS).
Hosted applications involve using your own desktop or server accounting application and
accessing the accounting software using the internet. Using SaaS involves using a cloud
accounting supplier's server where the accounting software and data are stored.
2.9.1 Benefits of cloud accounting

 Accounting information can be accessed from anywhere, at any time, from a browser or
mobile device, as long as internet access is available. Information can therefore be
accessed quickly by management and employees can be deployed anywhere.
 The security systems in place will often be better than a small business can provide.
 The software updates are managed by the cloud accounting supplier.
 Back ups are made automatically by the cloud accounting supplier.
 Applications are usually rented rather than purchased meaning that there are no upfront
costs.
 Overhead costs, such as in-house technical experts costs, can be reduced.
 There is no need to worry about whether PCs are powerful enough as the software is
running in the cloud, not on the PC.
 Collaboration between users is easier as files can shared via invitations rather than
physically exchanging files.
 If the business grows then more cloud accounting licences can be purchased. There is no
need to upgrade servers and so on.

2.9.2 Risks of cloud accounting
 The supplier could fail and so a contingency plan is required.
 There is a permanent need for internet access. Operations could be hampered if there is a
problem with internet access.
 There is a risk of security breaches, including data loss or theft and privacy issues.
 There are legislation risks if the cloud supplier operates from a jurisdiction where the laws
are different from the country in which the data is being used (particularly privacy laws).
 Unannounced changes or upgrades to software could be disruptive.
Case example: Cloud accounting

Examples of businesses that provide cloud accounting software include Sage, Xero and Intuit.
3 Performance measures
Section overview
 Effective performance measures should promote goal congruence, incorporate only
C
controllable factors and encourage the pursuit of longer term as well as short-term H
objectives. A
P
 Inappropriate performance measures may lead to sub-optimal behaviour. T
E
 Two performance measures for investment centres that relate the profit earned to the R
capital invested are Return on Investment (ROI) and Residual Income (RI).
8
 In certain circumstances the use of ROI as a performance measure might not lead to goal
congruent decisions.
 ROI tends to focus attention on short-term performance.
 RI is a measure of an investment centre's profits after deducting a notional or imputed
interest cost of the capital invested in the centre.
 RI is less useful as a comparative measure because it is absolute.
 RI will encourage marginally profitable investments because it will increase if a proposed
project earns a return which is higher than the cost of capital.
3.1 General requirements for effective performance measures

One or more performance measures, or key performance indicators (KPIs), might be used to
monitor the performance of each responsibility centre. Before going on to consider some of the
individual measures in detail it will be useful to summarise the features of effective performance
measures.
 They should promote goal congruence by providing an incentive to promote the
responsibility centre's performance in line with overall company objectives.
 The measures should incorporate only those factors over which the responsibility centre
manager has control.
 They should encourage the pursuit of longer term objectives as well as short-term, budget-
constrained objectives.

3.2 Potential problems with inappropriate performance measures
Problems that may arise through the use of inappropriate measures include the following.
 Managers may manipulate information in order to ensure achievement of the KPIs.
 The measures might cause demotivation and stress-related conflict between a manager
and the manager's subordinates, superiors or fellow managers.
 The measures might promote excessive concern for the control of short-term costs,
possibly at the expense of longer term profitability.
 They may lead to the assessment of a responsibility centre as an isolated unit, rather than
as an integral part of the whole organisation.
3.3 Performance measures for a cost centre

Since the manager of a cost centre has responsibility for the costs incurred within the centre,
appropriate performance measures could be as follows.
 Cost variances, which are the differences between the budgeted or standard costs and the
actual costs
 Cost per unit
 Cost per employee
 Other non-financial measures such as the rate of labour turnover or staff absenteeism
3.4 Performance measures for a revenue centre

Appropriate performance measures would be related to the revenue earned.
 Revenue variances, which are the differences between the budgeted or standard revenue
and the actual revenue achieved
 Revenue earned per employee
 Percentage market share achieved
 Growth in revenue
3.5 Performance measures for a profit centre

Since the manager of a profit centre has responsibility for the revenue earned and the costs
incurred within the centre all of the above performance measures would be suitable. Extra
measures might include the following.
 Gross profit margin, which is the difference between the selling price and the direct costs
incurred, often expressed as a percentage of the selling price
 Operating profit margin, which is the gross profit less indirect costs incurred such as
administrative salaries, often expressed as a percentage of the selling price
3.6 Performance measures for an investment centre

All of the measures appropriate for a cost, revenue and profit centre would be suitable for
monitoring the performance of an investment centre. In addition, certain measures related to
the management of the investment in the division would also be useful. Such measures might
include a number of working capital ratios.
 Liquidity measures such as the current ratio and the quick (liquidity) ratio
 Rate of inventory turnover
 Receivables and payables periods

Two other measures monitor the return achieved in the division. These concern the level of
investment.
 Return on investment (ROI)
 Residual income (RI)
We studied the working capital ratios in detail in Chapter 7. Now we will go on to look at ROI
and RI.
3.7 Return on investment (ROI)

ROI is often used as a measure to monitor the performance of an investment centre. It shows
how much profit has been earned in relation to the amount of capital invested in the centre.
Controllable divisional profit
ROI =  100%
Divisional capital employed
The main reason for the widespread use of ROI is that it ties in directly with the accounting
system and is identifiable from the income statement and balance sheet.
Use of the ROI facilitates comparisons but ranking is difficult as the measure is a relative
percentage. For example, is a 5% return on £1 (20p) really better than a 1% return on £1 million
(£10,000)?
Worked example: Ranking using ROI C

H
Suppose that a company has two investment centres, A and B, which show results for the year as
A
follows. P
T
A B E
£ £ R
Profit 60,000 30,000
Capital employed 400,000 120,000 8
ROI 15% 25%
Investment centre A has generated double the profits of investment centre B, and in terms of
profits alone has therefore been more 'successful'. However, B has achieved its profits with a
much lower capital investment, and so has earned a much higher ROI. This suggests that B has
been a more successful investment than A.
3.7.1 Capital employed

A decision needs to be taken on which assets to include in capital employed. Leased assets,
shared assets, idle assets and goodwill need to be given careful consideration. Centrally-
controlled assets are excluded because the investment centre manager cannot exercise control
over their use.
Usually, opening capital employed or an average of opening and closing capital is used, on the
grounds that this has been generating the year's profits.
The use of historical cost/carrying amount may lead to problems as shown below.

Worked example: The effect of changing the capital employed base
An asset costs £100,000, has a life of four years, and its scrap value is nil. The asset generates
annual cash flows of £34,000 and straight line depreciation is used.
Requirements
(a) Calculate annual ROI using opening carrying amount (ie, depreciation is deducted from the
asset value).
(b) Calculate annual ROI using historical cost (ie, no depreciation is deducted from the asset
value).
(c) Comment on any problems identified by these calculations.
Solution
ROI using opening carrying amount
Year 1: (34 – 25) ÷ 100 = 9%
Year 2: (34 – 25) ÷ 75 = 12%
Year 3: (34 – 25) ÷ 50 = 18%
Year 4: (34 – 25) ÷ 25 = 36%
ROI improves despite constant annual profits. Consequently divisional managers may hold
assets for too long.
ROI using historical cost
Years 1 – 4: (34 – 25) ÷ 100 = 9%
ROI using historical cost overcomes the increasing return problem of using the carrying amount.
However, it is not perfect.
Using the historical cost/carrying amounts may be misleading, particularly when comparing
divisions, if:
 assets have been bought at different points in time and prices have changed due to
inflation
 assets of one division are older than those of another and have been written down to a
lower value
 different depreciation policies are applied by different divisions
To resolve this, one solution would be to use a replacement cost valuation.
3.7.2 Profit
Usually the profit figure taken as the numerator in the ROI calculation is after depreciation, but
this may lead to distortion, as discussed above.
It is common for divisions and managers to be assessed on pre-tax profit, since the company's
ultimate tax charge is likely to be significantly affected by central decisions and is therefore not
controllable by divisional managers.
However, it is important that managers are made aware of the tax implications of their
operational decisions.
3.7.3 ROI and goal congruence

In certain circumstances the use of ROI as a performance measure might not lead to goal
congruent decisions.

Worked example: ROI and goal congruence
Data for an investment centre are as follows.
Target ROI (= cost of capital) 20%
Divisional profit £300,000
Capital employed £1m
Requirement
Would the division manager accept a project requiring capital of £100,000 and generating
profits of £25,000, if the manager were paid a bonus based on ROI?
Solution
£300,000
Divisional ROI without the project = ×100%
£1m
= 30.0%
Divisional ROI with the project = £325,000
×100%
£1.1m
= 29.5%
ROI of the project = 25.0%
Although the project ROI is acceptable to the company (25%), the manager would not be
motivated to accept a project which lowers divisional ROI.
C
H
A limitation of ROI is that it tends to focus attention on short-term performance, whereas A
investment decisions should be evaluated over their full life. P
T
E
3.8 Residual income (RI) R
An alternative way of measuring the performance of an investment centre is residual income (RI). 8
RI is a measure of the centre's profits after deducting a notional or imputed interest cost of the
capital invested in the centre.
RI can avoid some of the behavioural problems of dysfunctionality that arise with the use of ROI.
Worked example: Residual income and goal congruence

Returning to the data in the previous example, would the division manager accept the proposed
project if the manager's bonus was based on RI?
Solution
£'000
Divisional RI without the project:
Divisional profit 300
Imputed interest charge (20%  £1m) 200
100
Divisional RI with the project:

Divisional profit 325
Imputed interest charge (20%  £1,100,000) 220
105
RI of the project
Profit 25
Imputed interest charge (20%  £100,000) 20
5

The RI would increase therefore the manager would accept the project. In this particular
circumstance, RI would lead to the correct decision since the project ROI of 25% is acceptable to
the company.
Note that the ROI and the RI are both based on the same figures for profits and capital
employed. The difference is that ROI is a relative measure whereas RI is an absolute measure.
3.8.1 RI and comparisons

RI is less useful as a comparative measure because it is absolute.
Worked example: Using ROI and RI to measure comparative performance

A company has a target ROI and an imputed interest charge of 20% for each of its investment
centres. Which of the two divisions is performing better, using the following performance
measures?
(a) Residual income
(b) Return on investment
Division 1 Division 2
Capital employed £1,000,000 £100,000
Controllable profits:
Year 1 £200,000 £20,000
Year 2 £220,000 £40,000
Solution
(a) Residual income
£'000 £'000
Year 1
Divisional profit 200 20
Imputed interest charge
(£1,000,000  20%) 200
(£100,000  20%) 20
RI – –
Year 2
Divisional profit 220 40
Imputed interest charge 200 20
20 20
Using RI the relative performance of the two divisions appears to be the same. Both divisions
have increased the annual RI by £20,000.
(b) Return on investment
Year 1 £200,000/£1,000,000 20%
£20,000/£100,000 20%
Year 2 £220,000/£1,000,000 22%

£40,000/£100,000 40%
Return on investment shows that division 2 is out performing division 1. Despite earning the
same absolute increase in RI it is much easier for the larger division to generate a further
£20,000 of RI. Hence using RI to compare divisions of different sizes is misleading.

Interactive question 2: ROI and RI
An investment centre with capital employed of £570,000 is budgeted to earn a profit of
£119,700 next year. A proposed non-current asset investment of £50,000, not included in the
budget at present, will earn a profit next year of £8,500 after depreciation. The company's cost
of capital is 15%.
Requirement
Complete the boxes to show the budgeted ROI and RI for next year, both with and without the
investment.
ROI RI
Without investment % £
With investment % £
3.8.2 The advantages and disadvantages of RI compared with ROI

The advantages of using RI
(a) Residual income will increase when investments earning above the cost of capital are C
undertaken and investments earning below the cost of capital are eliminated. H
A
(b) Residual income is more flexible since a different cost of capital can be applied to P
investments with different risk characteristics. T
E
The disadvantages of RI are that it does not facilitate comparisons between investment centres R
nor does it relate the size of a centre's income to the size of the investment.
8
3.8.3 RI versus ROI: marginally profitable investments

Residual income will increase if a new investment is undertaken which earns a profit in excess of
the imputed interest charge on the value of the asset acquired. Residual income will go up even
if the profit from the investment only just exceeds the imputed interest charge, and this means
that 'marginally profitable' investments are likely to be undertaken by the investment centre
manager.
In contrast, when a manager is judged by ROI, a marginally profitable investment would be less
likely to be undertaken because it would reduce the average ROI earned by the centre as a
whole.
4 The balanced scorecard
Section overview
 The balanced scorecard approach to the provision of information focuses on four different
perspectives: customer, innovation and learning, financial and internal business.
 The information provided in the balanced scorecard includes both financial and
non-financial elements.
 As with all techniques, problems can arise when the balanced scorecard approach is
applied.

4.1 Introduction
The balanced scorecard was developed to help companies manage the multiple objectives they
have to satisfy to compete in today's markets. Traditional accounting measures have a number
of weaknesses that make them less relevant today.
 They tend to concentrate on a single factor, eg, profit, revenue, ROI or RI
 They are primarily historical, eg, how have we done compared with last year
 They are capable of distortion
 There is often confusion between measures and objectives
 Traditional accounting performance measures are of little use as a guide to action
4.2 The balanced scorecard approach

The balanced scorecard involves the following steps:
 Identify the critical success factors for the business from four perspectives:
– Financial perspective – how do we create value for our shareholders?
– Customer perspective – what do new and existing customers value from us?
– Innovation and learning perspective – can we continue to improve and create value?
– Internal business perspective – at what must we excel?
 Identify the core competences and resources required to achieve them
• Develop the key performance indicators (financial and non-financial – see below) to best
measure progress towards achieving the necessary competences and resources
 Set targets
 Monitor performance
4.3 Non-financial performance measures

It is important to realise that financial measures will only tell part of the story. To minimise the
risk of suboptimal decisions, a company should use as broad a range of measures as possible,
both quantitative and qualitative.
Other measures to consider could include:
 the number of new products developed
 the rate of employee turnover
 customer praise/complaints
 the number of outstanding orders
 the number of warranty claims
 health and safety incident statistics
4.4 Potential measures

A selection of potential measures is detailed below. These would obviously need adapting for
the circumstances of the individual company concerned.
Financial perspective
Possible financial measures include:
 survival, eg, cash flows
 growth, eg, sales revenue
 cost reduction, eg, unit costs
 asset utilisation, eg, working capital ratios
 risk, eg, order books

Customer perspective
Possible customer perspective measures include:
 time, eg, product delivery lead times
 quality, eg, defect rates
 price, eg, compared with the prices of competitors
 satisfaction, eg, repeat purchases
Innovation and learning perspective
Possible measures include:
 employees, eg, the rate of staff turnover
 learning, eg, the number of days spent on staff training
 products and services, eg, the percentage of revenue generated by new products and
services
Internal business perspective
Possible measures include:
 the number or percentage of quality control rejects
 the average set-up time
 the speed of producing management information
The scorecard is 'balanced' in the sense that managers are required to think in terms of all four
C
perspectives, to prevent improvements being made in one area at the expense of another. H
A
Note that the balanced scorecard approach can also be used to measure performance in shared
P
service centres. The focus on performance measurement of a shared service centre is not just T
cost reduction but also quality such as responses to queries, error rates and so on. E
R
Interactive question 3: Balanced scorecard evaluation 8

Radlan & Dunne are a firm of High Street solicitors. They have traditionally measured their
success in terms of ROI. They have decided to modernise their approach and plan to use the
Balanced Scorecard to measure performance.
Requirement
Suggest three measures they could use under each of the four balanced scorecard perspectives.
Perspective Measures
Financial 1
2
3
Customer 1
2
3
Innovation and learning 1
2
3

Perspective Measures
Internal business 1
2
3
4.5 Problems
As with all techniques, problems can arise when the balanced scorecard is applied.
Problem Explanation
Conflicting measures Some measures in the scorecard such as research funding and cost
reduction may naturally conflict. It is often difficult to determine the
balance which will achieve the best results.
Selecting measures Not only do appropriate measures have to be devised but the number
of measures used must be agreed. Care must be taken that the impact
of the results is not lost in a sea of information.
Expertise Measurement is only useful if it initiates appropriate action. Non-
financial managers may have difficulty with the usual profit measures.
With more measures to consider this problem will be compounded.
Interpretation Even a financially-trained manager may have difficulty in putting the
figures into an overall perspective.
Too many measures The ultimate objective for commercial organisations is to maximise
profits or shareholder wealth. Other targets should offer a guide to
achieving this objective and not become an end in themselves.
5 Budgetary control
Section overview
 A fixed budget is a budget which is set for a single activity level.
 A flexible budget recognises different cost behaviour patterns and is designed to change
as the volume of activity changes.
 Effective budgetary control involves comparing a flexible budget (based on the actual
activity level) with the actual results. The differences between the flexible budget figures
and the actual results are called budget variances.
5.1 Effective budgetary control

We have seen that the performance of all types of responsibility centres may be monitored by
the comparison of actual costs and revenues with the budget for the period.
However, if activity levels fluctuate then the comparison of the actual results with a budget
prepared for a different activity level might not be valid for control purposes.
To be more meaningful, the actual results should be compared with a realistic budget for the
actual activity level achieved.

5.2 Fixed budgets
The master budget prepared before the beginning of the budget period is known as the fixed
budget. By the term 'fixed', we do not mean that the budget is kept unchanged. Revisions to a
fixed master budget will be made if the situation so demands. The term 'fixed' means the
following.
(a) The budget is prepared on the basis of an estimated volume of production or output and
an estimated volume of sales, but no plans are made for the event that actual volumes of
production and sales may differ from budgeted volumes.
(b) When actual volumes of production and sales during a control period (month or four weeks
or quarter) are achieved, a fixed budget is not adjusted (in retrospect) to represent a new
target for the new levels of activity.
The major purpose of a fixed budget lies in its use at the planning stage, when it seeks to define
the broad objectives of the organisation.
Fixed budgets (in terms of a pre-set expenditure limit) are also useful for controlling any fixed
cost, and particularly non-production fixed costs such as advertising, because such costs should
be unaffected by changes in activity level (within a certain range).
5.3 Flexible budgets

A flexible budget recognises different cost behaviour patterns and is designed to change as the
volume of activity changes. C
A flexible budget has two advantages. H
A
(a) At the planning stage, it may be helpful to know what the effects would be if the actual P
outcome differs from the prediction. For example, a company may budget to sell 10,000 T
E
units of its product, but may prepare flexible budgets based on sales of, say, 8,000 and R
12,000 units. This would enable contingency plans to be drawn up if necessary, and is an
example of sensitivity analysis which we discussed in Chapter 6. 8
(b) At the end of each month or year, actual results may be compared with the relevant activity
level in the flexible budget as a control procedure.
5.4 Preparation of flexible budgets
Step 1
The first step in the preparation of a flexible budget is the determination of cost behaviour
patterns, which means deciding whether costs are fixed, variable or semi-variable.
 Fixed costs are easy to spot. They remain constant as activity levels change.
 For non-fixed costs, divide each cost figure by the related activity level. If the cost is a
variable cost, the cost per unit will remain constant. If the cost is a semi-variable cost, the
unit rate will reduce as activity levels increase.
Step 2
The second step in the preparation of a flexible budget is to calculate the budget cost allowance
for each cost item.
Budget cost allowance = Budgeted fixed cost + (Number of units  Variable cost per unit)
Semi-variable costs therefore need splitting into their fixed and variable components so that the
budget cost allowance can be calculated.

Interactive question 4: Analysing semi-variable costs
One method for splitting semi-variable costs is the high/low method, which we covered in
Chapter 6. Attempt the following question to make sure you remember how to do this.
The cost of factory power has behaved as follows in past years.
Units of Cost of
output factory
produced power
£
20X1 7,900 38,700
20X2 7,700 38,100
20X3 9,800 44,400
20X4 9,100 42,300
Budgeted production for 20X5 is 10,200 units.
Ignoring inflation, the cost of factory power which will be incurred is estimated to be £ .
Worked example: Preparing a flexible budget

(a) Prepare a budget for 20X6 for the variable direct labour costs and overhead expenses of a
production department flexed at the activity levels of 80%, 90% and 100%, using the
information listed below.
 The variable direct labour hourly rate is expected to be £7.50
 100% activity represents 60,000 direct labour hours
 Variable costs
Indirect labour £0.75 per direct labour hour
Consumable supplies £0.375 per direct labour hour
Canteen and other welfare services 6% of direct and indirect labour costs
 Semi variable costs are expected to relate to the direct labour hours in the same
manner as for the last five years.
Direct labour Semi-variable
Year hours costs
£
20X1 64,000 20,800
20X2 59,000 19,800
20X3 53,000 18,600
20X4 49,000 17,800
20X5 40,000 (estimate) 16,000 (estimate)
 Fixed costs
£
Depreciation 18,000
Maintenance 10,000
Insurance 4,000
Rates 15,000
Management salaries 25,000
 Inflation is to be ignored.
(b) Calculate the budget cost allowance (ie, expected expenditure) for 20X6 assuming that
57,000 direct labour hours are worked.

Solution
(a) 80% level 90% level 100% level
48,000 hrs 54,000 hrs 60,000 hrs
£'000 £'000 £'000
Variable direct labour 360.00 405.00 450.00
Other variable costs
Indirect labour 36.00 40.50 45.0
Consumable supplies 18.00 20.25 22.5
Canteen etc 23.76 26.73 29.7
Total variable costs (£9.12 per hour) 437.76 4492.48 547.2
Semi-variable costs (W) 17.60 18.80 20.0
Fixed costs
Depreciation 18.00 18.00 18.0
Maintenance 10.00 10.00 10.0
Insurance 4.00 4.00 4.0
Rates 15.00 15.00 15.0
Management salaries 25.00 25.00 25.0
Budgeted costs 527.36 583.28 639.2
WORKING
Using the high-low method:
£
Total cost of 64,000 hours 20,800
C
Total cost of 40,000 hours 16,000 H
Variable cost of 24,000 hours 4,800 A
P
Variable cost per hour (£4,800/24,000) 0.20 T
E
£ R
Total cost of 64,000 hours 20,800
Variable cost of 64,000 hours ( £0.20) 12,800 8
Fixed costs 8,000
Semi variable costs are calculated as follows.

£
60,000 hours (60,000  £0.20) + £8,000 = 20,000
54,000 hours (54,000  £0.20) + £8,000 = 18,800
48,000 hours (48,000  £0.20) + £8,000 = 17,600
(b) The budget cost allowance for 57,000 direct labour hours of work would be as follows.
£
Variable costs (57,000  £9.12) 519,840
Semi-variable costs (£8,000 + (57,000  £0.20)) 19,400
Fixed costs 72,000
611,240

5.5 Flexible budgets and control
Suppose W Co manufactures a single product, the CL. Budgeted results and actual results for
June 20X2 are shown below.
Actual
Budget results Variance*
Production and sales of the CL (units) 2,000 3,000
£ £ £
Sales revenue (a) 20,000 30,000 10,000 (F)
Direct materials 6,000 8,500 2,500 (A)
Direct labour 4,000 4,500 500 (A)
Maintenance 1,000 1,400 400 (A)
Depreciation 2,000 2,200 200 (A)
Rent and rates 1,500 1,600 100 (A)
Other costs 3,600 5,000 1,400 (A)
Total costs (b) 18,100 23,200 5,100 (A)
Profit (a) – (b) 1,900 6,800 4,900 (F)
* The variance is the difference between the budget and the actual results. A favourable variance
(F) indicates that the difference would result in a higher profit (higher sales revenue or lower
cost). An adverse variance (A) indicates that the difference would result in a lower profit (lower
sales revenue or higher cost).
(a) In this example, the variances are meaningless for purposes of control. Costs were higher
than budget because the volume of output was also higher; variable costs would be
expected to increase above the budgeted costs in the fixed budget. There is no information
to show whether control action is needed for any aspect of costs or revenue.
(b) For control purposes, it is necessary to know the answers to questions such as the following.
 Were actual costs higher than they should have been to produce and sell 3,000 CLs?
 Was actual revenue satisfactory from the sale of 3,000 CLs?
5.5.1 The correct approach to control

The correct approach to control is as follows.
 Identify fixed and variable costs.
 Produce a flexible budget based on the actual activity level.
In the previous example of W Co, let us suppose that we have the following estimates of cost
behaviour.
(a) Direct materials, direct labour and maintenance costs are variable.
(b) Rent and rates and depreciation are fixed costs.
(c) Other costs consist of fixed costs of £1,600 plus a variable cost of £1 per unit made and
sold.

The control analysis should therefore be based on a flexible budget as follows.
Fixed Flexible Actual Budget
budget budget results variance
(a) (b) (c) (c)–(b)
Production & sales (units) 2,000 3,000 3,000
£ £ £ £
Sales revenue 20,000 30,000 30,000 0
Variable costs
Direct materials 6,000 9,000 8,500 500 (F)
Direct labour 4,000 6,000 4,500 1,500 (F)
Maintenance 1,000 1,500 1,400 100 (F)
Semi-variable costs
Other costs 3,600 4,600 5,000 400 (A)
Fixed costs
Depreciation 2,000 2,000 2,200 200 (A)
Rent and rates 1,500 1,500 1,600 100 (A)
Total costs 18,100 24,600 23,200 1,400 (F)
Profit 1,900 5,400 6,800 1,400 (F)
£3,500 (F) £1,400 (F)

Volume variance Expenditure variance
£4,900 (F)
Total variance C
H
Notice that the total variance has not altered. It is still £4,900 (F) as before. The flexible budget A
comparison merely analyses the total variance into two separate components. P
T
E
5.5.2 Interpretation of the control statement R
We can analyse the above as follows.
8
(a) In selling 3,000 units the expected profit is shown by the flexible budget. This is not the
fixed budget profit of £1,900, but the flexible budget profit of £5,400. Instead, actual profit
was £6,800, ie, £1,400 more than we should have expected. This is the £1,400 favourable
expenditure variance. The reason for this £1,400 improvement is that, given output and
sales of 3,000 units, overall costs were lower than expected (and sales revenue was exactly
as expected). For example, the direct material cost was £500 lower than expected.
(b) Another reason for the improvement in profit above the fixed budget profit is the sales
volume.
W Co sold 3,000 units of CL instead of 2,000, with the following result.
£ £
Budgeted sales revenue increased by 10,000
Budgeted variable costs increased by:
Direct materials 3,000
Direct labour 2,000
Maintenance 500
Variable element of other costs 1,000
6,500
Budgeted fixed costs are unchanged –
Budgeted profit increased by 3,500
Budgeted profit was therefore increased by £3,500 because sales volume increased. This is
the £3,500 favourable volume variance.

(c) A full variance analysis statement would be as follows.
£ £ £
Fixed budget profit 1,900
Variances
Sales volume 3,500 (F)
Direct materials cost 500 (F)
Direct labour cost 1,500 (F)
Maintenance cost 100 (F)
Other costs 400 (A)
Depreciation 200 (A)
Rent and rates 100 (A)
Total expenditure variance 700 (A) 2,100 (F) 1,400 (F)
Actual profit 6,800
If management believes that any of these variances are large enough to justify it, they will
investigate the reasons for them to see whether any corrective action is necessary.
Interactive question 5: Budget cost allowances

WL Co manufactures and sells a single product, R. Since the R is highly perishable, no
inventories are held at any time. WL Co's management uses a flexible budgeting system to
control costs. Extracts from the flexible budget are as follows.
Output and sales (units) 4,000 5,500
Budget cost allowances £ £
Direct material 16,000 22,000
Direct labour 20,000 24,500
Variable production overhead 8,000 11,000
Fixed production overhead 11,000 11,000
Selling and distribution overhead 8,000 9,500
Administration overhead 7,000 7,000
Total expenditure 70,000 85,000
Production and sales of product R amounted to 5,100 units during period 5.
Requirements
The total budget cost allowances in the flexible budget for period 5 will be:
(a) Direct material £

(b) Direct labour £
(c) Variable production overhead £
(d) Fixed production overhead £
(e) Selling and distribution overhead £
(f) Administration overhead £
(g) Production and sales of product R in period 6 amounted to 5,500 units. Budgeted output
for the period was 4,000 units. Actual total expenditure was £82,400.
(1) The total expenditure variance for period 6 was £ favourable/adverse (delete
as necessary)
(2) The volume variance for period 6 was £ favourable/adverse (delete as

necessary)

Summary
Performance management systems
Effective feedback information
• Clear and comprehensive

• Exception principle
• Highlight controllable items Hopwood’s three
• Regular and timely
• Sufficiently accurate styles of evaluation
• Exclude irrelevant detail
• Communicated to correct manager • Budget constrained
• Profit conscious
• Non-accounting
Decentralisation
• The authority for

certain decisions is C
delegated to less H
A
senior managers
P
T
E
Responsibility centres R
Cost centre Revenue centre Profit centre Investment centre

Responsible for
Responsible for Responsible for Responsible for • Costs incurred
• Costs incurred • Revenues earned • Costs incurred
• Revenues earned
• Revenues earned
• Capital invested
Performance
Balanced scorecard measures related to
capital employed
Perspectives:
• Financial
• Customer
• Internal business Return on Residual
• Innovation and learning investment (ROI) income (RI)
Budgetary control
• Dysfunctional focus • Reduces
on short-term dysfunctional
performance behaviour
Fixed budget Flexible budget • Most useful as a • Encourages
comparative marginal
For a single Realistic budget measure investments
activity level cost allowance for
actual activity level

Self-test
1 Which of the following items would be excluded in the calculation of controllable divisional
profit?
A Sales to external customers
B Head office costs
C Variable divisional expenses
D Controllable divisional fixed costs
2 Slack Ltd is based in Beeland, and it has recently decided to adopt cloud accounting in its
finance function. It is looking at a range of suppliers and is considering using a well-
established and reputable international provider of cloud accounting services, Distant Inc,
based in Ceeland.
Which of the following is a significant consideration for Slack Ltd when deciding whether to
use Distant Inc’s cloud accounting services?
A Slack Ltd will need to make some of its accounts staff redundant
B Applicable accounting standards in Ceeland will be different
C The monthly fee charged by Distant Inc will be in Ceeland’s local currency
D Data protection legislation in Ceeland may be less strict than in Beeland
3 Division Y is considering a project which will increase annual profit by £45,000 but will
require average inventory levels to increase by £180,000. The current return on investment
for the division is 28% and the imputed interest cost of capital is 20%.
Would the performance measures of ROI and RI motivate the manager of division Y to act in
the interest of the company as a whole?
ROI RI
A No No
B No Yes
C Yes No
D Yes Yes
4 Which of the following is not a perspective which is monitored using the balanced
scorecard approach to performance measurement?
A Financial
B Innovation and learning
C Internal business
D Sales
5 A division has a residual income of £750,000 and a net profit before imputed interest of
£1,850,000.
If it uses a rate of 11% for computing imputed interest on its invested capital, what is its
return on investment?
A 7.5%
B 11%
C 18.5%
D 26%

6 A division currently has an investment base of £2,400,000 and annual profits of £480,000.
The following extra investments are being considered.
Annual
Outlay profit
£'000 £'000
Investment Q 1,400 350
Investment R 600 200
Investment S 400 88
Which combination of investments will maximise the division's return on investment?
A Investment Q only
B Investment R only
C Investments Q and R
D Investments Q, R and S
7 On the last day of the financial year an investment centre has net assets with a total carrying
amount of £1.2 million, with a return on investment (ROI) of 15%.
The manager of this division is considering selling one of its non-current assets immediately
before the year end. The non-current asset has a carrying amount of £105,000 and a net
realisable value of £80,000.
What would be the division's ROI immediately after the sale of the asset at the end of the
year?
A 13.2% C
B 14.2% H
A
C 15.3% P
D 16.4% T
E
8 A divisionalised company uses return on investment (ROI) and residual income (RI) to assess R
the performance of its divisions. Straight-line depreciation is used and assets are valued at
net book value. If the cash flows from a new investment in a depreciable non-current asset 8
are likely to be constant over the life of the investment, what will be the effect of the
investment on the ROI and RI over the life of the asset?
ROI RI
A Increase Increase
B Increase No change
C No change No change
D Decrease Decrease
9 What is a budget cost allowance?
A A budget of expenditure applicable to a particular function
B A budget allowance which is set without permitting the ultimate budget manager the
opportunity to participate in setting the budget
C The budgeted cost expected for the actual level of activity achieved during the period
D A fixed budget allowance for expenditure which is expected every period, regardless
of the level of activity

10 BF Limited manufactures and sells a single product. An extract from the flexed budget for
production costs is as follows.
Activity level
80% 90%
£ £
Direct material 3,200 3,600
Direct labour 2,800 2,900
Production overhead 5,400 5,800
Total production cost 11,400 12,300
The total production cost in a budget that is flexed at the 88% level of activity will be
£
Now, go back to the Learning outcomes in the introduction. If you are satisfied you have

Part of controllable Not part of controllable

Item divisional investment divisional investment
Non-current assets

Trade receivables

Trade payables

Inventory

ROI RI
Without investment 21.0 % £ 34,200

C
With investment 20.7 % £ 35,200 H
A
P
WORKINGS T
E
Without With R
investment investment
ROI 8
£119,700/£570,000 21.0%
£128,200/£620,000 20.7%
RI
£ £
Profit 119,700 128,200
Imputed interest charge:
£570,000  15% 85,500
£620,000  15% 93,000
34,200 35,200

Many answers are possible. They could include:
Financial perspective
All the standard measures plus:
 proportion of income from legal aid
 regularity of income paid in prolonged cases
 net fee income from 'No Win, No Fee' litigation
Customer perspective
 Number of cases won
 Number of new clients won through recommendations
 Cost of key services (eg, conveyancing) compared to other local firms

Innovation and learning
 Continuing Professional Development (CPD) courses attended
 New services offered
 New methods of service delivery introduced (eg, online Wills)
Internal business perspective
 Time taken to process key services (eg, to draft and type Wills)
 Administration cost (eg, courier services, website maintenance)
 Speed of accessing archives
 Ease of access to legislative and case law databases

The cost of factory power is estimated to be £ 45,600 .
WORKINGS
Units £
20X3 (highest output) 9,800 44,400
20X2 (lowest output) 7,700 38,100
2,100 6,300
The variable cost per unit is therefore £6,300/2,100 = £3.

The level of fixed cost can be calculated by looking at any output level.
£
Total of factory power in 20X3 44,400
Less variable cost of factory power (9,800  £3) 29,400
Fixed cost of factory power 15,000
An estimate of costs in 20X5 is as follows.

£
Fixed cost 15,000
Variable cost of budgeted production (10,200  £3) 30,600
Total budgeted cost of factory power 45,600

(a) Direct material £ 20,400
(b) Direct labour £ 23,100
(c) Variable production overhead £ 10,200
(d) Fixed production overhead £ 11,000
(e) Selling and distribution overhead £ 9,100
(f) Administration overhead £ 7,000
(g) (1) The total expenditure variance for period 6 was £ 2,600 favourable
(2) The volume variance for period 6 was £ 15,000 adverse

WORKINGS
(a) Direct material is a variable cost of £16,000/4,000 = £4 per unit.
Budget cost allowance for 5,100 units = 5,100  £4 = £20,400.
(b) Direct labour is a semi-variable cost which can be analysed using the high-low method.
Output
units £
High 5,500 24,500
Low 4,000 20,000
Change 1,500 4,500
Variable cost per unit = £4,500/1,500 = £3

Substituting in high output, fixed cost = £24,500 – (5,500 × £3)
= £8,000
Budget cost allowance for 5,100 units:
£
Variable cost = 5,100  £3 15,300
Fixed cost 8,000
23,300
(c) Variable production overhead per unit = £8,000/4,000 = £2 per unit.

Budget cost allowance for 5,100 units = 5,100  £2 = £10,200.
C
(d) Fixed production overhead cost allowance is fixed at £11,000. H
A
(e) Selling and distribution is a semi-variable cost which can be analysed using the high-low P
T
method.
E
Output R
units £
8
High 5,500 9,500
Low 4,000 8,000
Change 1,500 1,500
Variable cost per unit = £1,500/1,500 = £1

Substituting in high output, fixed cost = £9,500 – (5,500  £1)
= £4,000
Budget cost allowance for 5,100 units:
£
Variable cost = 5,100  £1 5,100
Fixed cost 4,000
9,100
(f) Administration overhead cost allowance is fixed at £7,000.

(g) The budgeted and actual output volumes correspond to the two activity levels provided in
the question data. The total budget cost allowance for each activity level can be used as the
basis for the variance calculations.
(1) Expenditure variance = Budget cost allowance for 5,500 units – actual
expenditure for 5,500 units
= £85,000 – £82,400
= £2,600 favourable
(2) Volume variance = budget cost allowance for original budget of 4,000 units – budget
cost allowance for actual volume of 5,500 units
= £70,000 – £85,000 = £15,000 adverse

1 B Head office costs are not controllable by the divisional manager and should be
excluded from the calculation of controllable divisional profit.
2 D The use of cloud accounting applications is not aimed at reducing staff costs; accounts
staff will still be required so option A is not correct. As a well established and reputable
international supplier, it is to be expected that Distant Inc can support the
requirements of overseas customers so any questions over accounting standards is
unlikely to be a significant consideration (option B). We do not know in which currency
Distant will charge its subscription fee, but again this would not represent a major
consideration in the decision as to which supplier to use (option C) as Slack Ltd could
choose to manage any exposure to foreign currency risk. The major consideration for
Slack Ltd is the fact that data protection legislation may vary between Beeland and
Ceeland (option D); if Ceeland is less strict then Slack Ltd needs to make sure that its
company and customer data is properly protected.
3 B ROI on marginal investment = £45,000/£180,000

= 25%
This is higher than the cost of capital therefore it would be acceptable to the company
as a whole. However, the manager would reject the project based on ROI because it is
lower than the current divisional ROI.
Incremental RI = £45,000 – (£180,000  20%)
= £9,000
Therefore the manager would accept the project if performance was assessed on the
basis of residual income. This would be acting in the interest of the company as a whole.
4 D The sales perspective is not one of the four perspectives of the balanced scorecard
approach. The four perspectives are financial, innovation and learning, internal
business and customer.
5 C Imputed interest is £1,850,000 – £750,000 = £1,100,000. With interest at 11%, capital
must be £10m. ROI = £1,850,000/£10,000,000 = 18.5%.
£480,000 + £350,000
6 C Investment Q only = = 21.8%
£2,400,000 + £1,400,000
£480,000 + £200,000
Investment R only = = 22.7%
£2,400,000 + £600,000
£480,000 + £350,000 + £200,000

Investments Q and R = = 23.4%
£2,400,000 + £1,400,000 + £600,000
£480,000 + £350,000 + £200,000 + £88,000

Investments Q, R and S = = 23.3%
£2,400,000 + £1,400,000 + £600,000 + £400,000

7 A
£
Original profits = 15%  £1.2m 180,000
Loss on sale of asset = £105,000 – £80,000 25,000
Revised profits 155,000
Revised investment base = £(1,200,000 – 105,000 + 80,000)

= £1,175,000
£155,000
Revised ROI =
£1,175,000
= 13.2%
8 A If returns are constant and the value of the asset base is falling, both ROI and RI will
increase.
9 C A budget cost allowance is the expected expenditure in a budget which has been
flexed to the actual level of activity. It includes a basic, unchanged allowance for fixed
costs and an amount for variable costs according to the level of activity.
Option A describes a functional budget and option B is an imposed or top-down
budget. A budget cost allowance includes an amount for variable overhead therefore
option D is not correct.
10 The total production cost in a budget that is flexed at the 88% level of activity will be £ 12,120 . C
H
WORKING A
P
Direct material cost per 1% activity = £40 T
E
Direct labour cost per 1% activity is not a constant amount at both activity levels, so this R
must be a semi-variable cost. Since production overhead is also a semi-variable cost the two
8
costs can be analysed together, to save time (since the question asks only for a total cost in
the answer).
£
Direct labour and production overhead
At 80% activity 8,200
At 90% activity 8,700
Change 10% 500
£500
Variable cost per 1% change in activity = = £50
10%
Substituting in 80% activity:
£
Variable cost = 80  £50 4,000
Total cost 8,200
Fixed cost 4,200
Flexed budget cost at 88% level of activity is as follows.

£
Direct material (88  £40) 3,520
Direct labour and production overhead: Variable (88  £50) 4,400
Fixed 4,200
12,120

CHAPTER 9
Standard costing and

variance analysis
Introduction
Examination context
TOPIC LIST
1 Standard costing and standard costs
2 Cost variances
3 Sales variances and operating statements
4 Interpreting variances and deriving actual data from variance detail
Answer to Interactive question
Introduction
 Calculate differences between actual performance and standards or budgets in

terms of price and volume effects and identify possible reasons for those
differences
The specific syllabus reference for this chapter is: 3c.
Syllabus links
An understanding of variance analysis as a part of the work of the finance function will be
necessary for your Business, Technology and Finance syllabus and as a part of performance
measurement within that syllabus.
Examination context
The calculation and analysis of variances lends itself well to numerical exam questions. However,
you are also likely to be presented with narrative questions, perhaps testing your understanding
of the meaning of calculated variances.
The examiner is also likely to ask you to 'work backwards' from variance information to derive
extracts from the actual results or the original standards. This requires a thorough understanding
of the methods of variance calculation and of the meaning of the results of the calculations.
 calculate and interpret variances for variable costs
 calculate and interpret contribution-based variances for sales
 derive actual cost and standard cost data from calculated variances
 demonstrate an understanding of the meaning and use of standard cost operating
statements
Traditionally students find variances a difficult area. They can be approached in a tabular
manner or using formulae – find the one that suits you best. Understanding the meaning can
help with understanding and remembering the calculations.

1 Standard costing and standard costs
Section overview
 Standard costing is the preparation of standard costs to use in variance analysis, a key
management control tool.
 Standards for each cost element are made up of a monetary component and a resources
requirement component.
 Standard costing enables the principle of management by exception to be practised.
 If they are to continue to be useful for control purposes, standard costs must be revised
whenever there are changes in required resource inputs or in the price of resources.
1.1 Standard costing
Definition
Standard costing: Defined by the Chartered Institute of Management Accountants as a 'control
technique that reports variances by comparing actual costs to pre-set standards so facilitating
action through management by exception'.
Standard costing (for control) therefore involves the following.

 The establishment of predetermined estimates of the costs of products or services.
 The collection of actual costs.
 The comparison of the actual costs with the predetermined estimates.
1.2 Standard costs

A standard cost per unit is the expected, or normal, cost per unit, based on expectations
(standards) for:
C
 the usage of resources; and H
 the price per unit of resource. A
P
A simple standard cost card, taking account of only variable costs, is shown below. T
E
Standard cost: Widget Price per
R
unit of
Units of resource 9
resource £ £
Material 6 kg 5 30
Labour 2.5 hours 8 20
Variable production overhead 2.5 hours 2 5
Standard variable production cost 55
Standards provide an expected cost for one unit of output. A budget is a financial plan for a
period of time. However, standard costs can be used in the preparation of budgets.
When standard costs are used, budgetary control variance analysis is based on a comparison
between actual results and a flexed budget that uses standard costs. The particular advantage of
standard costs is that the cost information consists of a quantity of resources (units of raw
material, hours of direct labour and variable overheads) and a price per unit of resource (cost
per kilogram of material or cost per hour for labour, etc).
As a result of this extra information, the analysis of the cost variances can be more detailed, and
so can provide more control information to management.
ICAEW 2019 Standard costing and variance analysis 243

1.3 Standard costing and management by exception
Standard costs, when established, are average expected unit costs. Because they are only
averages and not a rigid specification, actual results will vary to some extent above or below the
average. Standard costs can therefore be viewed as benchmarks for comparison purposes, and
variances should only be reported and investigated if there is a significant difference between
actual and standard. The problem is in deciding whether a variation from standard should be
considered significant and worthy of investigation. Tolerance limits can be set and only
variances that exceed such limits would require investigation.
Standard costing therefore enables the principle of management by exception to be practised.
Definition
Management by exception: Defined by CIMA as the 'practice of concentrating on activities that
require attention and ignoring those which appear to be conforming to expectations. Typically
standard cost variances or variances from budget are used to identify those activities that
require attention.'
1.4 Setting standard costs

Standards for units of production or service should be based on careful investigation and
research, and standards should be continually monitored to ensure that they are reasonable
and reliable. If there is an inaccuracy in the standard cost, a comparison of actual results against
the standard will provide meaningless and unhelpful variance information.
A possible reason for a variance may be that the standard is unreliable or inaccurate, rather than
that actual results were worse or better than they should have been. Companies that use
standard costs therefore try to make their standard costs as reliable as possible, and will revise
the standard whenever there are changes in resource inputs required or in the price per unit of
resource.
1.5 The advantages of standard costing

 Carefully planned standards are an aid to more accurate budgeting.
 Standard costs provide a yardstick against which actual costs can be measured.
 The setting of standards involves determining the most appropriate materials and methods
which may lead to economies.
 A target of efficiency is set for employees to reach and cost consciousness is stimulated.
 Variances can be calculated which enable the principle of 'management by exception' to
be operated. Only the variances which exceed acceptable tolerance limits need to be
investigated by management with a view to control action.
 Standard costs simplify the process of bookkeeping in cost accounting, because they are
easier to use than LIFO, FIFO and weighted average costs.
 Standard times simplify the process of production scheduling.
 Standard performance levels might provide an incentive for individuals to achieve targets
for themselves at work.

1.6 Difficulties in applying standard costing in service environments
Standard costing was originally used in manufacturing environments and a criticism levelled at
standard costing was its apparent lack of applicability in service industries.
The application of standard costing in service industries does have its problems.
 It can be difficult to establish a measurable cost unit for some services.
 In some service organisations every cost unit will be different (heterogeneous). For
example each haircut provided in a salon will be different.
 Since the human influence is so great in many services it can be difficult to predict and
control the quality of the output and the resources used in its production.
To overcome these problems and enable the application of standard costing for planning and
control in service industries it is therefore necessary to do the following.
 Establish a measurable cost unit. This is relatively easy in some service organisations. For
example cost units for transport companies, such as a passenger-mile or a tonne-mile, or for
hotels, such as a guest-night. (You might recall that these are referred to as composite cost
units.)
 Attempt to reduce the heterogeneity of services. If every service provided to the customer
is the same as the last then it will be possible to set a standard cost for the service and use
this to maximise efficiency and reduce waste.
 Reduce the element of human influence. This can be achieved by swapping machines for
humans wherever possible.
2 Cost variances
Section overview
 Variances measure the difference between actual results and expected results. The
process by which the total difference between standard and actual results is analysed is
known as variance analysis.
C
 The material total variance can be divided into the material price variance and the material H
usage variance. A
P
 Since material inventories are usually valued at standard cost in a standard costing system, T
E
material price variances are usually extracted at the time of purchase of the materials,
R
rather than at the time of usage.
9
 The labour total variance can be divided into the labour rate variance and the labour
efficiency variance.
 The variable overhead total variance can be divided into the variable overhead
expenditure variance and the variable overhead efficiency variance.
 If the variable overhead rate is stated in terms of a rate per labour hour, then the variable
overhead efficiency variance, in hours, is exactly the same as the labour efficiency variance
in hours, and it occurs for the same reasons.
 The fixed overhead expenditure variance is the difference between the budgeted and
actual fixed overhead expenditure in the period.

2.1 Variances
Definitions
Variance: Defined by CIMA as 'the difference between a planned, budgeted, or standard cost
and the actual cost incurred. The same comparisons may be made for revenues.'
Variance analysis: Defined as the 'evaluation of performance by means of variances, whose
timely reporting should maximise the opportunity for managerial action'.
As we saw in Chapter 8, when actual results are better than expected results, we have a
favourable variance (F). If, on the other hand, actual results are worse than expected results, we
have an adverse variance (A).
2.2 Material variances
Definition
Material total variance: 'Measures the difference between the standard material cost of the
output produced and the actual material cost incurred' (CIMA).
The material total variance can be divided into the material price variance and the material
usage variance.
(a) The material price variance
This is the difference between the standard cost and the actual cost for the actual quantity
of material used or purchased. In other words, it is the difference between what the material
did cost and what it should have cost.
(b) The material usage variance
This is the difference between the standard quantity of materials that should have been
used for the number of units actually produced, and the actual quantity of materials used,
valued at the standard price per unit of material. In other words, it is the difference between
how much material should have been used and how much material was used, valued at
standard price.
Worked example: Material variances

Product X has a standard material cost as follows.
10 kg of material Y at £10 per kilogram = £100 per unit of X.
During Period 4, 1,000 units of X were manufactured, using 11,700 kg of material Y which cost
£98,631.
Requirement
Calculate the following variances.
(a) The material total variance
(b) The material price variance
(c) The material usage variance

Solution
(a) The material total variance
This is the difference between what 1,000 units should have cost and what they did cost.
£
1,000 units should have cost ( £100) 100,000
but did cost 98,631
Material total variance 1,369 (F)
The variance is favourable because the units cost less than they should have cost.
Now we can break down the material total variance into its two constituent parts: the
material price variance and the material usage variance.
(b) The material price variance
This is the difference between what 11,700 kg should have cost and what 11,700 kg did cost.
£
11,700 kg of Y should have cost ( £10) 117,000
but did cost 98,631
Material Y price variance 18,369 (F)
The variance is favourable because the material cost less than it should have.
(c) The material usage variance
This is the difference between how many kilograms of Y should have been used to produce
1,000 units of X and how many kilograms were used, valued at the standard cost per
kilogram.
1,000 units should have used ( 10 kg) 10,000 kg
but did use 11,700 kg
Usage variance in kg 1,700 kg (A)
 Standard price per kilogram  £10
Usage variance in £ £17,000 (A)
The variance is adverse because more material was used than should have been used.
C
(d) Summary
H
£ A
P
Price variance 18,369 (F)
T
Usage variance 17,000 (A) E
Total variance 1,369 (F) R
2.2.1 Using formulae to calculate materials variances

You may prefer to use formulae to calculate standard cost variances. The formulae for the
material cost variances are as follows.
Material price variance = (Standard price per unit of materials – Actual price per unit of
materials)  Actual quantity of materials
(SP – AP)  AQ
Material usage variance = (Standard quantity of materials for actual output – Actual quantity
used)  Standard price per unit of material
(SQ – AQ)  SP

The total material cost variance in formula terms is:
(Standard price per unit of materials  Standard quantity of materials)
less
(Actual price per unit of materials  Actual quantity of materials)
Ie, (SP  SQ) – (AP  AQ)
Algebraically, material price variance + material usage variance
= (SP – AP)  AQ + (SQ – AQ)  SP
= (SP  AQ) – (AP  AQ) + (SQ  SP) – (AQ  SP)
= (SP  SQ) – (AP  AQ)
(as above)
Worked example: Using formulae to calculate material variances

Using the data in the last example the formulae would be applied as follows.
Materials price variance = (SP – AP)  AQ
= [£10 – (£98,631/11,700)]  11,700
= £18,369 (F)
Materials usage variance = (SQ – AQ)  SP
= [(1,000  10 kg) – 11,700 kg]  £10
= £17,000 (A)
2.2.2 Materials variances and opening and closing inventory

Suppose that a company uses raw material P in production, and that this raw material has a
standard price of £3 per metre. During one month 6,000 metres are bought for £18,600, and
5,000 metres are used in production. At the end of the month, inventory will have been
increased by 1,000 metres. In variance analysis, the problem is to decide the material price
variance. Should it be calculated on the basis of materials purchased (6,000 metres) or on the
basis of materials used (5,000 metres)? The answer to this problem depends on how closing
inventories of the raw materials will be valued.
(a) If closing inventories of raw materials are valued at standard cost, (1,000 units at £3 per
unit) then the price variance is calculated on material purchases in the period.
(b) If closing inventories of raw materials are valued at actual cost (FIFO) (1,000 units at £3.10
per unit) then the price variance is calculated on materials used in production in the period.
2.2.3 When to calculate the material price variance

A full standard costing system is usually in operation and therefore the price variance is usually
calculated on purchases in the period. The variance on the full 6,000 metres will be written off to
the costing income statement, even though only 5,000 metres are included in the cost of
production.
There are two main advantages in extracting the material price variance at the time of purchase.
(a) If variances are extracted at the time of purchase they will be brought to the attention of
managers earlier than if they are extracted as the material is used. If it is necessary to
correct any variances then management action can be more timely, such as negotiating the
price down with the supplier.

(b) Since variances are extracted at the time of purchase, all inventories will be valued at
standard price. This is administratively easier and it means that all issues from inventories
can be made at standard price. If inventories are held at actual cost it is necessary to
calculate a separate price variance on each batch as it is issued. Since issues are usually
made in a number of small batches this can be a time-consuming task, especially with a
manual system.
The price variance would be calculated as follows.
£
6,000 metres of material P purchased should cost ( £3) 18,000
but did cost 18,600
Price variance 600
2.3 Labour variances

The calculation of labour variances is very similar to the calculation of material variances.
Definition
Labour total variance: Measures the difference between the standard labour cost of the output
produced and the actual labour cost incurred.
The labour total variance can be divided into the labour rate variance and the labour efficiency
variance.
(a) The labour rate variance
This is similar to the material price variance. It is the difference between the standard cost
and the actual cost for the actual number of hours paid for.
In other words, it is the difference between what the actual labour used did cost and what it
should have cost.
(b) The labour efficiency variance
This is similar to the material usage variance. It is the difference between the hours that
C
should have been worked for the number of units actually produced, and the actual H
number of hours worked, valued at the standard rate per hour. A
P
T
Worked example: Labour variances E
R
The standard labour cost of product X is as follows.
9
2 hours of grade Z labour at £10 per hour = £20 per unit of product X.
During period 4, 1,000 units of product X were made, and the labour cost of grade Z labour was
£17,825 for 2,300 hours of work.
Requirement
Calculate the following variances.
(a) The labour total variance
(b) The labour rate variance
(c) The labour efficiency variance

Solution
(a) The labour total variance
This is the difference between what 1,000 units should have cost and what they did cost.
£
1,000 units should have cost ( £20) 20,000
but did cost 17,825
Labour total variance 2,175 (F)
The variance is favourable because the units cost less than they should have done.
Again we can analyse this total variance into its two constituent parts.
(b) The labour rate variance
This is the difference between what 2,300 hours should have cost and what 2,300 hours did
cost.
£
2,300 hours of work should have cost ( £10) 23,000
but did cost 17,825
Labour rate variance 5,175 (F)
The variance is favourable because the labour cost less than it should have cost.
(c) The labour efficiency variance
1,000 units of X should have taken ( 2 hours) 2,000 hrs
but did take 2,300 hrs
Efficiency variance in hours 300 hrs (A)
 Standard rate per hour × £10
Efficiency variance in £ £3,000 (A)
The variance is adverse because more hours were worked than should have been worked.
Summary
£
Rate variance 5,175 (F)
Efficiency variance 3,000 (A)
Total variance 2,175 (F)
2.3.1 Using formulae to calculate labour variances

The formulae that you may wish to use to calculate the labour cost variances are as follows.
Labour rate variance = (Standard rate of pay per hour – Actual rate of pay per hour) 
Actual labour hours
= (SR – AR)  AH
Labour efficiency variance = (Standard labour hours for actual output – Actual labour hours ) 
Standard rate of pay per hour
= (SH – AH)  SR
As with the materials variances, the total labour cost variance can be shown algebraically to be
(SR  SH) – (AR  AH).

Worked example: Using formulae to calculate labour variances
Labour rate variance = (SR – AR)  AH
= [£10 – £17,825/2,300)]  2,300
= £5,175 (F)
Labour efficiency variance = (SH – AH)  SR
= [(1,000  2 hours) – 2,300]  £10
= £3,000 (A)
2.4 Variable production overhead variances
Definitions
Variable production overhead total variance: Measures the difference between the variable
production overhead that should be used for actual output and the variable production
overhead actually used.
Variable production overhead expenditure variance: Measures the actual cost of any change
from the standard variable overhead rate per hour.
Variable production overhead efficiency variance: The standard variable production overhead
cost of any change from the standard level of efficiency.
The variable overhead total variance can be subdivided into the variable overhead expenditure
variance and the variable overhead efficiency variance.
Worked example: Variable overhead variances

Suppose that the variable overhead cost of product X is as follows.
C
2 hours at £1.50 = £3 per unit H
A
During the latest period, 400 units of product X were made. The labour force worked 760 hours. P
T
The variable overhead cost was £1,672.
E
Requirement R
Calculate the following variances. 9
(a) The variable overhead total variance

(b) The variable overhead expenditure variance
(c) The variable overhead efficiency variance
Solution
(a) The variable overhead total variance
This is similar to the labour total variance. It is the difference between the standard variable
overhead cost of 400 units and the actual variable overhead cost incurred.
£
400 units of product X should cost ( £3) 1,200
but did cost 1,672
Variable overhead total variance 472 (A)

(b) The variable overhead expenditure variance
This is the difference between the amount of variable overhead that should have been
incurred in the actual hours worked, and the actual amount of variable overhead incurred.
£
760 hours of variable overhead should cost ( £1.50) 1,140
but did cost 1,672
Variable overhead expenditure variance 532 (A)
(c) The variable overhead efficiency variance

400 units of product X should take ( 2 hrs) 800 hrs
but did take 760 hrs
Variable overhead efficiency variance in hours 40 hrs (F)
 Standard rate per hour  £1.50
Variable overhead efficiency variance in £ £60 (F)
If the variable overhead rate is stated in terms of a rate per labour hour, the variable
overhead efficiency variance is exactly the same, in hours, as the labour efficiency variance,
and occurs for the same reasons.
However, the variable overhead rate is sometimes stated in terms of a rate per machine
hour, in which case the difference must be calculated between the actual machine hours
and the standard machine hours for the output achieved.
The difference in hours, whether expressed in terms of labour hours or in terms of machine
hours, is evaluated at the standard variable overhead rate per hour.
Summary
£
Variable overhead efficiency variance 60 (F)
Variable overhead total variance 472 (A)
2.4.1 Using formulae to calculate variable overhead variances

The formulae that you may wish to use to calculate the variable overhead cost variances are as
follows.
Variable overhead expenditure variance = (Standard variable overhead rate per hour –
Actual variable overhead rate per hour)  Actual
hours
= (SR – AR)  AH
Variable overhead efficiency variance = (Standard hours for actual output – Actual hours)
 Standard variable overhead rate per hour
= (SH – AH)  SR
The standard rate per hour, and the actual and standard hours, can be expressed in terms of
labour or in terms of machine hours.
The same algebraic breakdown of variable overhead variances can be derived as for materials
and labour variances.

Worked example: Using formulae to calculate variable overhead variances
Using the data from the last example the formulae would be applied as follows.
Variable overhead expenditure variance = (SR – AR)  AH
= [£1.50 – (£1,672/760)]  760
= £532 (A)
Variable overhead efficiency variance = (SH – AH)  SR
= [(400  2) – 760]  £1.50
= £60 (F)
2.5 Fixed overhead expenditure variance

The fixed overhead expenditure variance is simply the difference between the budgeted and
actual fixed overhead expenditure in the period. By definition, fixed overheads should remain
the same, regardless of the volume of production and sales. Any difference between budget
and actual spending must be due to higher-than-expected or lower-than-expected spending,
and can have nothing to do with differences in volume of activity.
The fixed overhead expenditure variance is (Budgeted fixed overhead cost – Actual fixed
overhead cost).
3 Sales variances and operating statements
Section overview
 The sales price variance is a measure of the effect on expected contribution of charging a
different selling price from the standard selling price.
 The sales volume variance measures the increase or decrease in standard contribution as
a result of the actual sales volume being higher or lower than budgeted.
C
 Operating statements used in a standard marginal costing system show how the H
combination of variances reconcile the budgeted contribution and the actual contribution A
P
for a period.
T
E
3.1 Sales variances R
Just as it is possible to set predetermined standards for cost, so it is also possible to set 9
predetermined standards for sales: the unit sales price and the sales volume. This enables
variances to be calculated to monitor and control the actual sales price and the actual sales
volume achieved.
3.1.1 Sales price variance

The sales price variance is a measure of the effect on expected contribution of charging a
different selling price from the standard selling price. It is calculated as the difference between
what the sales revenue should have been for the actual quantity sold, and what it actually was.
3.1.2 Sales volume variance

The sales volume variance is the difference between the actual units sold and the budgeted
quantity, valued at the standard contribution per unit. In other words, it measures the increase or
decrease in standard contribution as a result of the sales volume being higher or lower than
budgeted.

Worked example: Calculating sales variances
A company budgets to sell 8,000 units of product J for £12 per unit. The standard variable cost
per unit is £7. Actual sales were 7,700 units, at a price of £12.50 per unit.
The sales price variance is calculated as follows.
£
Sales revenue from 7,700 units should have been ( £12) 92,400
but was (7,700  £12.50) 96,250
Sales price variance 3,850 (F)
The variance is favourable because the actual price was higher than standard.
The sales volume variance is calculated as follows.
Budgeted sales volume 8,000 units
Actual sales volume 7,700 units
Sales volume variance in units 300 units (A)
 Standard contribution £(12 – 7)  £5
Sales volume variance 1,500 (A)
The variance is adverse because actual sales volume was less than budgeted.
3.1.3 Using formulae to calculate sales variances

The formulae that you may wish to use to calculate the sales variances are as follows.
Sales price variance = (Actual selling price per unit – Standard selling price per unit) 
Actual sales quantity
= (AP – SP)  AQ
Sales volume variance = (Actual sales quantity – Budgeted sales quantity)  Standard
contribution per unit
= (AQ – BQ)  SC
Worked example: Using formulae to calculate sales variances

Sales price variance = (AP – SP)  AQ
= (£12.50 – £12.00)  7,700
= £3,850 (F)
Sales volume variance = (AQ – BQ)  SC
= (7,700 – 8,000)  £(12 – 7)
= £1,500 (A)
3.2 Operating statements

So far, we have considered how variances are calculated in a standard marginal costing system
without considering how they combine to reconcile the difference between budgeted
contribution and actual contribution during a period. This reconciliation is usually presented as a
report to senior management at the end of each control period. The report is called an
operating statement or statement of variances.

An operating statement might look like this.
Operating statement for Period 8 £
Budgeted contribution 928,000
Sales volume variance 17,320 (A)
Actual sales less standard variable cost of sales 922,510
Variable cost variances Favourable Adverse
£ £
Material price 7,120
Material usage 6,190
Labour rate 5,340
Labour efficiency 4,140
Variable overhead expenditure 4,920
Variable overhead efficiency 2,870
Total variable cost variances 12,040 18,540 6,500 (A)
Actual contribution 916,010
£
Budgeted fixed overhead 400,470
Fixed overhead expenditure variance 15,010 (A)
Actual fixed overhead 415,480
Actual profit 500,530
Note that favourable variances are added to the budgeted contribution and adverse variances
are subtracted, in reaching the actual profit figure.
However, in the case of the adverse fixed overhead expenditure variance, this is added to the
budgeted expenditure because the actual expenditure was higher than budgeted.
Interactive question 1: Operating statement

NN Co manufactures a single product, the SK. The standard variable cost for this item is as
follows.
£ £
Materials:
P (8 kg at £0.40 per kg) 3.20 C
H
Q (4 kg at £0.70 per kg) 2.80 A
6.00 P
Labour (3 hours at £7.50) 22.50 T
Variable overhead (3 labour hours at £0.50) 1.50 E
R
30.00
9
Budgeted fixed overhead expenditure is £8,600.
The standard sales price per unit is £40. The budgeted production and sales for Period 7 were
3,000 units.
Actual results for Period 7 were as follows.
Sales and production 2,800 units
Sales revenue £113,120
Materials purchased and used:
P 19,000 kg Cost £7,410
Q 14,000 kg Cost £10,220
Labour 8,300 hours Cost £64,740
Variable overhead £4,067
Fixed overhead £8,250

Requirement
Complete the operating statement for Period 7 shown below. For the cost variances, make one
entry (adverse or favourable) for each variance and enter a zero or a dash in the other column.
For the sales variances, indicate in the box whether they are adverse (A) or favourable (F).
Operating statement for Period 7
£
(a) Sales volume variance
(b) Sales price variance
Actual sales less standard variable cost of sales

Favourable Adverse
Variable cost variances £ £
(c) Material price
(d) Material usage
(e) Labour rate
(f) Labour efficiency
(g) Variable overhead expenditure
(h) Variable overhead efficiency
Total variable cost variances

£
(i) Fixed overhead expenditure variance
Actual fixed overhead
There are several ways in which an operating statement may be presented. A common format is
one which reconciles budgeted profit to actual profit.
Worked example: Reconciling budgeted profit to actual profit

Sydney manufactures one product, and the entire product is sold as soon as it is produced.
There are no opening or closing inventories and work in progress is negligible. The standard
cost card for the product, a boomerang, is as follows.
Standard cost card – boomerang
£
Direct materials 0.5 kg at £4 per kg 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 selling price 20.00
Budgeted output for the month of June Year 7 was 5,100 units. Actual results for June Year 7
were as follows.
Production of 4,850 units was sold for £95,600.

Materials consumed in production amounted to 2,300 kg at a total cost of £9,800.
Labour hours paid for amounted to 8,500 hours at a cost of £16,800.
Variable overheads amounted to £2,600.
Fixed overheads amounted to £42,300.
Requirement
Complete the table to generate a marginal costing operating statement for the month ended
30 June Year 7. Make one entry (adverse or favourable) for each variance and enter a zero or a
dash in the other column. Enter the net total of adverse and favourable variances as either a
positive number (favourable total) or negative number (adverse total) in the fourth column.
Solution
Operating statement for June
Favourable Adverse
£ £ £
Budgeted profit 30,600
Sales volume variance 0 3,350
Sales price variance 0 1,400
Cost variances
Materials price 0 600
Materials usage 500 0
Labour rate 200 0
Labour efficiency 2,400 0
Variable overhead rate 0 50
Variable overhead efficiency 360 0
Fixed overhead expenditure 0 4,560
Total variances 3,460 9,960 (6,500)
WORKINGS
£
(1) Revenue from 4,850 boomerangs should be ( £20) 97,000 C
but was 95,600 H
Selling price variance 1,400 (A) A
P
T
(2)
E
Budgeted sales volume 5,100 units R
9
 standard contribution per unit  £13.40
Sales volume contribution variance in £ £3,350 (A)
(3) £
2,300 kg of material should cost ( £4) 9,200
but did cost 9,800
Material price variance 600 (A)
(4) 4,850 boomerangs should use ( 0.5 kg) 2,425 kg

Material usage variance in kg 125 kg (F)
 standard cost per kg  £4
Material usage variance in £ £ 500 (F)

(5) £
8,500 hours of labour should cost ( £2) 17,000
but did cost 16,800
Labour rate variance 200 (F)
(6) 4,850 boomerangs should take ( 2 hrs) 9,700 hrs

Labour efficiency variance in hours 1,200 hrs (F)
 standard cost per hour  £2
Labour efficiency variance in £ £2,400 (F)
(7) £
8,500 hours incurring variable o/hd expenditure should cost
( £0.30) 2,550
but did cost 2,600
(8) Variable overhead efficiency variance in hours is the same as the labour efficiency variance:
1,200 hours (F)  £0.30 per hour £360 (F)
(9) £
Budgeted fixed overhead (5,100 units  2 hrs  £3.70) 37,740
Fixed overhead expenditure variance 4,560 (A)
Note: If you use the formula approach to calculate variances in a scenario-based question, make
sure that you do not round your calculations. Leave the figures unrounded in your calculator. For
example, using the formula approach, the variable overhead expenditure variance above would
be calculated like this:
Variable overhead expenditure variance = (SR – AR)  AH
= [£0.30 – (£2,600/8,500)]  8,500
= £50 (A)
If you rounded £2,600/8,500 to say, three decimal places, you would get 0.306 and you would
end up with a variance of £51 instead of £50. As these questions are computer marked, it is
important to leave the figures in your calculator.
4 Interpreting variances and deriving actual data from

variance detail
Section overview
 There is a wide range of possible reasons for the occurrence of sales and cost variances.
 Individual variances should not be looked at in isolation. It is possible that one variance is
inter-related with one or more other variances.
 Variances can be manipulated to derive actual data from standard cost details.

4.1 The reasons for variances
There is a wide range of reasons for the occurrence of adverse or favourable sales and cost
variances.
The following list is not exhaustive but it should give you an idea of the type of circumstance that
could give rise to each of the variances.
Variance Favourable Adverse
Material price  Unforeseen discounts received  Price increase in the market

 More care taken in purchasing  Careless purchasing
 Material standard price set too  Material standard price set too
high low
Material usage  Material used of higher quality  Defective material
than standard
 Excessive waste
 More effective use made of
 Theft
material
 Stricter quality control
 Errors in allocating material to
jobs  Errors in allocating material to
jobs
Labour rate  Use of apprentices or other  Wage rate increase
workers at a rate of pay lower than
 Use of higher grade labour
standard
Labour efficiency  Output produced more quickly  Lost time in excess of standard
than expected because of work allowed
motivation, better quality of
 Output lower than standard set
equipment or materials, or better
because of deliberate
methods
restriction, lack of training, or
 Errors in allocating time to jobs sub-standard material used
 Errors in allocating time to jobs C
H
Variable  Change in types of overhead or  Change in types of overhead or A
P
overhead their cost their cost T
expenditure E
R
Variable  As for labour efficiency (if based  As for labour efficiency (if based
overhead on labour hours) on labour hours) 9
efficiency
Fixed overhead  Fixed overheads include a wide range of different items of expense. Any
expenditure of these might be higher or lower than budgeted. For example rent,
rates or insurance for the period might be higher or lower than
budgeted

Variance Favourable Adverse
Sales price  Supply shortages meant  Supply surplus meant customers

customers prepared to pay higher wished to pay lower price
prices
 Quantity discounts given to
 Quantity discounts given to customers were higher than
customers were lower than expected
expected
 Original standard selling price
 Original standard selling price set set too high
too low
Sales volume  Efficient sales force  Demotivated sales force
 Successful advertising campaign  Competitor increased
advertising effort
 Potential market was larger than
expected  Original budgeted sales were
too optimistic
 Original budgeted sales were
very conservative
4.2 Inter-relationships between variances

Quite possibly, 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, inter
related, variance occurred too.
Here are some examples of inter-related variances.
(a) Materials price and usage
It may be decided to purchase cheaper, lower quality materials for a job in order to obtain a
favourable price variance, possibly with the consequence that materials wastage is higher
and an adverse usage variance occurs. If the cheaper materials are more difficult to handle,
there might also be an adverse labour efficiency variance and an adverse variable overhead
efficiency variance.
If a decision is made to purchase more expensive materials, which perhaps have a longer
service life, the price variance will be adverse but the usage variance might be favourable.
(b) Labour rate and efficiency
If employees are paid higher rates for experience and skill, using a highly skilled team to do
some work would incur an adverse rate variance, but should also obtain a favourable
efficiency variance. In contrast, a favourable rate variance might indicate a larger than
expected proportion of inexperienced workers in the workforce, which could result in an
adverse labour efficiency variance, and perhaps poor materials handling and high rates of
wastage or product rejections (adverse material usage variance).
(c) Sales price and sales volume
The inter-relationship between sales price and sales volume variances should (hopefully) be
obvious to you. A reduction in the sales price might stimulate bigger sales demand, so that
an adverse sales price variance might be offset by a favourable sales volume variance.
Similarly, a price rise would give a favourable price variance, but possibly at the cost of a fall
in demand and an adverse sales volume variance.

(d) Cost and sales variances
(1) If there are favourable cost variances (perhaps cheaper labour or material have been
used, say, so that there are favourable labour rate or material price variances), the
possible drop in quality of the product could lead to an adverse sales volume variance
because customers don't wish to buy the lower quality product.
(2) If product quality is improved this might result in an adverse cost variance.
 If more expensive material is used (adverse material price variance)
 If labour are more careful in production of the product and hence take longer than
standard (adverse labour efficiency variance)
 If more skilled labour is used (adverse labour rate variance)
But the change in quality might result in a favourable sales volume variance because
customers want to buy more of the higher-quality product or a favourable sales price
variance as a higher price could be charged for the better quality product.
(3) If costs have risen (resulting in adverse labour rate, material price and variable
overhead expenditure variances), the sales price might have to be increased to cover
the extra costs. This would result in a favourable sales price variance, but could lead to
an adverse sales volume variance.
4.3 Deriving actual data from standard cost details and variances
Variances can be manipulated to derive actual data from standard cost details.
Worked example: Deriving actual data

The standard marginal cost card for the TR, one of the products made by P Co, is as follows.
£
Material 16 kg  £6 per kg 96
Labour 6 hours  £12 per hour 72
168
P Co reported the following variances in control period 13 for the TR. C

H
Material price: £18,840 favourable A
Material usage: £480 adverse P
T
Labour rate: £10,598 adverse E
Labour efficiency: £8,478 favourable R
Actual wages cost £171,320. P Co paid £5.50 for each kg of material. There were no opening or
9
closing inventories of the material.
Requirements
Calculate the following.
(a) Actual output
(b) Actual hours worked
(c) Average actual wage rate per hour
(d) Actual number of kilograms purchased and used

Solution
(a)
£
Total wages cost 171,320
Adjust for variances:
Labour rate (10,598)
Labour efficiency 8,478
Standard wages cost 169,200
 Actual output = Total standard cost/unit standard cost

= £169,200  £72
= 2,350 units
(b)
£
Total wages cost 171,320.0
Less rate variance (10,598.0)
Standard rate for actual hours 160,722.0
 Standard rate per hour ÷ £12.0
Actual hours worked 13,393.5 hrs
(c) Average actual wage rate per hour = Actual wages/actual hours = £171,320/13,393.5 =
£12.79 per hour.
(d) Number of kg purchased and used = x
£
x kg should have cost ( £6) 6.0x
but did cost ( £5.50) 5.5x
Material price variance 0.5x
 £0.5x = £18,840
 x = 37,680 kg
Alternatively the formula for the material price variance could be used as follows.
Price variance = (SP – AP)  AQ
£18,840 = £(6 – 5.50)  AQ
AQ = £18,840/£0.50
= 37,680 kg

Summary
C
H
A
P
T
E
R

Self-test
1 Gough Ltd manufactures a product with a standard material cost of £11. This is made up as
follows.
£
Material X 2 kg at £1.00 2
Material Y 6 kg at £1.50 9
11
Actual production of 1,010 units required the following material purchases.

Material X 2,200 kg £2,530
Material Y 6,080 kg £8,512
There were no opening and closing inventories, and materials X and Y are not substitutable.
Using the table identify the total material price variance and whether it is adverse or
favourable.
Adverse Favourable
A £150
B £162
C £210
D £278
2 Based on the same data as for question 1, using the table identify the total materials usage
variance and whether it is adverse or favourable.
Adverse Favourable
A £150
B £162
C £210
D £278
3 S Limited has extracted the following details from the standard cost card of one of its
products.
Labour standard 4.5 hours @ £6.40 per hour
During March, S Limited produced 2,300 units of the product and incurred wages costs of
£64,150. The actual hours worked were 11,700.
The labour rate and efficiency variances were:
Rate (£) Efficiency (£)
A 10,730 (F) 8,640 (F)

B 10,730 (F) 8,640 (A)
C 10,730 (A) 8,640 (A)
D 10,730 (F) 7,402 (A)

4 The following diagram represents the standard and actual material costs incurred in
manufacturing a product.
R
Actual Z V
Standard Y U
T
Material
prices
0 Material W X
quantities Standard Actual
Using the table identify the areas corresponding to the conventional price and usage
variances. Tick one box for each variance.
Area
WXRV WXTU YZVU YZRT
A Price variance
B Usage variance
5 A firm incurred a total adverse labour variance of £750. The standard pay rate was £7.50
per hour, while the actual pay rate was £8 per hour. The labour rate variance was £2,250.
What are the flexed budgeted hours for labour?
A 4,300 hours
B 4,500 hours
C 4,600 hours
C
D 4,700 hours H
A
6 Using the table identify the most likely labour variance to arise under each of the P
circumstances described. Tick one box for each circumstance. T
E
Adverse Adverse Favourable Favourable R
rate efficiency rate efficiency 9
A Labour more skilled than expected
B More machine breakdowns than

expected
C Pay increase less than expected

7 Using the table identify the most likely impact of the following on the fixed overhead
expenditure variance. Tick one box for each item.
Adverse Favourable No impact
A Volume of activity up marginally
B Supervisors' salaries increase less than

expected
C Higher energy consumption
8 The budgeted sales revenue of Thorold Ltd for August was £210,000 with an estimated
selling price of £84 and estimated variable cost per unit of £70. Actual sales in August were
2,650 units, amounting to £219,950 revenue with a total resultant profit of £35,775.
Using the table below indicate the monetary value of the sales volume variance and
whether it is adverse or favourable.
Adverse Favourable
A £2,025
B £2,100
C £12,450
D £12,600
9 A company had budgeted contribution of £26,700 for the latest period. The variances
reported to managers at the end of the period were as follows.
£
Material price 3,020 (A)
Labour efficiency 310 (A)
Variable overhead efficiency 217 (A)
Variable overhead total 149 (F)
Sales volume 2,700 (F)
The actual contribution for the period was £........................................
10 The following sales data are available for product P for the last period.
Budget Actual
Sales revenue £69,000 £79,530

Sales volume (units) 4,600 4,820
The sales price variance for the period was:

A £3,300 (F)
B £6,900 (F)
C £7,230 (F)
D £10,530 (F)

Answer to Interactive question

Operating statement for period 7
£
(a) Sales volume variance 2,000 (A)
(b) Sales price variance 1,120 (F)
Actual sales less standard variable cost of 29,120

sales
Favourable Adverse
Variable cost variances £ £
(c) Material price 0 230
(d) Material usage 0 600
(e) Labour rate 0 2,490
(f) Labour efficiency 750 0
(g) Variable overhead expenditure 83 0
(h) Variable overhead efficiency 50 0
Total variable cost variances 2,437 (A)

£
(i) Fixed overhead expenditure variance 350 (F)
Important point. In an exam, read the requirement carefully to make sure that you are entering C
your answers in the correct format. For example, this type of question may require you to enter H
A
zeros in boxes that you don't use. (The reason for this is so that the computer programme can P
tell whether you have completed the question or not.) T
E
R
WORKINGS
9
1 Sales volume
Budgeted sales volume 3,000 units
 Standard contribution per unit (£(40 – 30))  £10
Sales volume variance in £ £2,000 (A)
2 Sales price
£
Revenue from 2,800 units should have been ( £40) 112,000
but was 113,120

3 Material price
£ £
19,000 kg of P should cost ( £0.40) 7,600
but did cost 7,410
Material P price variance 190 (F)
14,000 kg of Q should cost ( £0.70) 9,800
but did cost 10,220
Material Q price variance 420 (A)
Total material price variance 230 (A)
4 Material usage
Material P
2,800 units of SK should use ( 8 kg) 22,400 kg
Material P usage variance in kg 3,400 kg (F)
 Standard price per kg  £0.40
Material P usage variance in £ £1,360 (F)
Material Q
2,800 units of SK should use ( 4 kg) 11,200 kg
Material Q usage variance in kg 2,800 kg (A)
 Standard price per kg  £0.70
Material Q usage variance in £ £1,960 (A)
Total material usage variance (£1,960 – £1,360) £600 (A)
5 Labour rate
£
8,300 hours of labour should cost ( £7.50) 62,250
but did cost 64,740
Labour rate variance 2,490 (A)
6 Labour efficiency
To make 2,800 units of SK should take ( 3 hrs) 8,400 hrs
Labour variance in hrs 100 hrs (F)
Labour efficiency variance in £ £750 (F)
7 Variable overhead expenditure

£
8,300 worked hours should cost ( £0.50) 4,150
but did cost 4,067
Variable overhead expenditure variance 83 (F)
8 Variable overhead efficiency (same as labour hours)

£
100 hrs (F)  Standard rate (£0.50) 50 (F)
9 Fixed overhead expenditure

£
Budgeted expenditure 8,600
Actual expenditure 8,250
Fixed overhead expenditure variance 350 (F)

1 D Favourable
£ £
Material X
2,200 kg should cost ( £1.00) 2,200
but did cost 2,530
Materials price variance 330 (A)
Material Y
6,080 kg should cost ( £1.50) 9,120
but did cost 8,512
Materials price variance 608 (F)
Total materials price variance 278 (F)
2 C Adverse
kg £
Material X
1,010 units produced should use ( 2 kg) 2,020
but did use 2,200
Variance in kg 180 (A)
 Standard price per kg ( £1.00) 180 (A)
Material Y
1,010 units produced should use ( 6 kg) 6,060
but did use 6,080
Variance in kg 20 (A)
 Standard price per kg ( £1.50) 30 (A)
Total materials usage variance 210 (A)
3 B
£
11,700 hours should cost ( £6.40) 74,880 C
but did cost 64,150 H
A
Labour rate variance 10,730 (F) P
T
2,300 units should take ( 4.5 hrs) 10,350 hrs E
but did take 11,700 hrs R
Variance in hours 1,350 hrs (A) 9

Labour efficiency variance £8,640 (A)
If you selected options A or C you calculated the correct monetary values of the
variances but misinterpreted their direction.
If you selected option D you valued the efficiency variance in hours at the actual rate
per hour instead of the standard rate per hour.
4 A = YZVU
The material price variance is based on the actual quantity purchased
B = WXTU
The usage variance is evaluated at the standard price

5 D
The flexed budgeted hours for labour are the standard hours allowed for the actual
production.
Labour rate variance = Actual hours worked  difference in labour rate
2,250 = Actual hours worked  (£8.00 – £7.50)
Actual hours worked = 4,500
Since total labour variance = Efficiency variance + rate variance
 £750 (A) = Efficiency variance + £2,250 (A)
Efficiency variance = £1,500 (F)
1,500 (F) = Saving in labour hours compared with standard 
standard rate per hour
Saving in labour hours = £1,500/£7.50
= 200 hours
Standard hours for actual production = 4,500 hours worked + 200 hours saved
= 4,700 hours
6 A Favourable efficiency. More skilled workers would work at a faster rate
B Adverse efficiency. Labour hours would still be recorded but there would be no output
C Favourable rate. The hourly rate of pay would be lower than that used in the standard
cost calculation
7 A No impact. Fixed overhead expenditure would not be affected by a marginal increase
in the volume of activity
B Favourable
C No impact. Energy costs related to consumption are variable overheads
8 B Favourable
Budgeted sales volume (£210,000/£84) 2,500 units
Sales volume variance in units 150 units (F)
 Standard contribution per unit (£84 – £70)  £14
Sales volume variance £2,100 (F)
9 The actual contribution for the period was £ 26,219

£
Variances
Material price (3,020)
Labour efficiency (310)
Variable overhead total 149
(Excluding variable overhead efficiency because included within the –
total variance)
Sales volume variance 2,700

10 C
Standard sales price per unit = £69,000/4,600
= £15
£
4,820 units should sell for ( £15) 72,300
but did sell for 79,530
C
H
A
P
T
E
R

CHAPTER 10
Breakeven analysis
and limiting factor
analysis
Introduction
Examination context
TOPIC LIST
1 Breakeven analysis and contribution
2 Breakeven charts
3 Limiting factor analysis
Introduction
 Calculate the breakeven point, contribution and margin of safety for a given
product or service
 Allocate scarce resource to those products and services with the highest
contribution per limiting factor
The specific syllabus references for this chapter are: 4a, b.
Syllabus links
You will study the identification and management of limiting factors in more depth in the context
of the Business Strategy and Technology syllabus.
Examination context
Examination questions about breakeven analysis and limiting factor analysis can be quite
complicated but there are strict decision rules which can be applied in every question of this
type. For example, unless otherwise stated, the absolute amount of expenditure on fixed costs
and the variable cost per unit remain the same for every level of activity.
Questions on this area of the syllabus will usually involve some calculations.
 calculate the breakeven point, margin of safety and contribution ratio for a product or
service
 calculate the volume of sales or level of activity required to achieve a target profit for the
period
 calculate the effect on profit, breakeven point, etc, of changes in the major decision
variables
 identify the optimum production plan or similar when a resource is in limited supply, and
when:
– there is a maximum and/or minimum limit on the demand for individual products or
services; and/or
– it is possible to alleviate the resource restriction by subcontracting work to parties
outside the business.
This area involves students following a logical series of steps (or rules) which must be learned.
The most difficult type of question in this area normally involves consideration of the possibility
of sub contracting or outsourcing work.

1 Breakeven analysis and contribution
Section overview
 Breakeven analysis or cost-volume-profit (CVP) analysis is the study of the
interrelationships between costs, volume and profit at various levels of activity.
 Contribution = selling price less variable costs; profit = contribution less fixed costs.
 The breakeven point occurs when there is neither a profit nor a loss and so fixed costs
equal contribution.
 Breakeven point in units = total fixed costs ÷ contribution per unit.
 The contribution ratio is a measure of how much contribution is earned per £1 of sales
revenue. It is usually expressed as a percentage.
 Breakeven point (in £) = total fixed costs ÷ contribution ratio.
 The margin of safety is the difference between the budgeted sales volume and the
breakeven sales volume. It is sometimes expressed as a percentage of the budgeted sales
volume.
 The contribution required for a target profit is equal to the fixed costs plus the target profit.
1.1 Contribution
Breakeven analysis or cost-volume-profit (CVP) analysis is the study of the interrelationships
between costs, volume and profit at various levels of activity.
Contribution, a concept we encountered in Chapter 4, is fundamental to CVP analysis. As you
know, contribution per unit is the difference between the selling price per unit and the variable
costs per unit. The total contribution from the sales volume for a period can be compared with
the fixed costs for the period. Any excess of contribution is profit, any deficit of contribution is a
loss.
1.2 Breakeven point

The management of an organisation usually wishes to know the profit likely to be made if the
aimed for production or activity and sales for the year are achieved. Management may also be
interested to know the activity level at which there is neither profit nor loss. This is known as the
breakeven point.
The breakeven point (BEP) can be calculated as:
Breakeven point = Number of units of sale required to break even
Total fixed costs
=
Contribution per unit
Contribution required to break even C

= H
A
P
T
Worked example: Breakeven point E
R
Expected sales 10,000 units at £8 = £80,000
Variable cost £5 per unit 10
Fixed costs £21,000
Requirement
Compute the breakeven point.
ICAEW 2019 Breakeven analysis and limiting factor analysis 275

Solution
The contribution per unit is £(8 – 5) = £3
Contribution required to break even = fixed costs = £21,000
Breakeven point (BEP) = £21,000 / £3
= 7,000 units
In revenue, BEP = (7,000  £8) = £56,000
Sales above £56,000 will result in profit of £3 per unit of extra sales and sales below £56,000 will
mean a loss of £3 per unit for each unit by which sales fall short of 7,000 units. In other words,
profit will improve or worsen per unit of sales by the level of contribution per unit.
7,000 units 7,001 units
£ £
Revenue 56,000 56,008
Less variable costs 35,000 35,005
Contribution 21,000 21,003
Less fixed costs 21,000 21,000
Profit 0 (= breakeven) 3
1.3 The contribution ratio

The contribution ratio is a measure of how much contribution is earned from each £1 of sales
revenue.
An alternative way of calculating the breakeven point to give an answer in terms of sales revenue
and using the contribution ratio is as follows.
Breakeven point = Sales revenue required to break even
Contribution required to break even
=
Contribution ratio
Fixed costs
=
Contribution ratio
Worked example: Contribution ratio

£3
Using the data in the last worked example the contribution ratio is = 37.5%
£8
£21,000
Breakeven is where sales revenue equals = £56,000. At a price of £8 per unit, this
0.375
represents 7,000 units of sales, as calculated earlier.
Interactive question 1: Contribution ratio

The contribution ratio of product W is 20%. IB, the manufacturer of product W, wishes to make a
contribution of £50,000 towards fixed costs.
If the selling price is £10 per unit, the number of units of W that must be sold is .

1.4 The margin of safety
As well as being interested in the breakeven point, management may also be interested in the
amount by which actual sales can fall below anticipated sales without a loss being incurred. This
is the margin of safety.
The margin of safety is the difference in units between the budgeted or expected sales volume
and the breakeven sales volume. It is sometimes expressed as a percentage of the budgeted
sales volume. Alternatively the margin of safety can be expressed as the difference between the
budgeted sales revenue and breakeven sales revenue, expressed as a percentage of the
budgeted sales revenue.
Worked example: Margin of safety

Mal de Mer Co makes and sells a product which has a variable cost of £30 and which sells for
£40. Budgeted fixed costs are £70,000 and budgeted sales are 8,000 units.
Requirement
Calculate the breakeven point and the margin of safety.
Solution
Total fixedcosts £70,000
Breakeven point = =
Contribution per unit £(40 – 30)
= 7,000 units
Margin of safety = 8,000  7,000 units = 1,000 units
1,000 units
which may be expressed as × 100% = 12½% of budget
8,000 units
The margin of safety indicates to management that actual sales can fall short of budget by 1,000
units or 12½% before the breakeven point is reached and no profit is made.
1.5 Cost-volume-profit analysis and profit targets

Once the selling price and cost structure have been established for a product or service it is
possible to manipulate the data to provide a variety of information for management decisions.
Worked example: CVP analysis

Butterfingers Company makes a product which has a variable cost of £7 per unit.
Requirement
If fixed costs are £63,000 per annum, calculate the selling price per unit if the company wishes to C
break even with a sales volume of 12,000 units. H
A
P
Solution T
E
Contribution required to break even (= fixed costs) = £63,000 R
Volume of sales = 12,000 units
10
£
Required contribution per unit = £63,000/12,000 = 5.25
Variable cost per unit = 7.00
Required sales price per unit = 12.25

Worked example: Target profits
RB Co makes and sells a single product, for which variable costs are as follows.
£ per unit
Materials 10
Labour 8
Production overhead 6
24
The sales price is £30 per unit, and fixed costs per annum are £68,000. The company wishes to
make a profit of £16,000 per annum.
Requirement
Determine the sales required to achieve this profit.
Solution
Since the contribution earned in a period is literally the contribution towards fixed costs and
profit, in order to achieve a certain target profit the contribution required is equal to the fixed
costs plus the target profit.
Required contribution = fixed costs + profit = £68,000 + £16,000 = £84,000
Required sales can be calculated in one of two ways.
Required contribution £84,000
(a) = = 14,000 units, or £420,000 in revenue
Contribution per unit £(30 – 24)

(b) = = £420,000 of revenue, or 14,000 units.
Contribution ratio 20% *
£30 – £24 £6
* Contribution ratio = = = 0.2 = 20%.
£30 £30
Interactive question 2: Target profits

SLB Limited wishes to sell 14,000 units of its product, which has a variable cost of £15 to make
and sell. Fixed costs are £47,000 and the required profit is £23,000.
The required sales price per unit is £ .

1.5.1 Variations on breakeven and profit target calculations

You may come across variations on breakeven and profit target calculations in which you will be
expected to consider the effect of altering the selling price, variable cost per unit or fixed cost.
Worked example: Change in selling price

Stomer Cakes Ltd bake and sell a single type of cake. The variable cost of production is £0.15
per cake and the current sales price is £0.25 per cake. Fixed costs are £2,600 per month, and the
annual profit for the company at the current sales volume is £36,000. The volume of sales
demand is constant throughout the year.
The sales manager wishes to raise the sales price to £0.29 per cake, but considers that a price
rise will result in some loss of sales.

Requirement
Ascertain the volume of sales required each month to maintain current profitability, if the selling
price is raised to £0.29.
Solution
The volume of sales required is one which would leave total profit the same as before, ie, £3,000
per month. Required profit should be converted into required contribution, as follows.
£
Monthly fixed costs 2,600
Monthly profit required 3,000
Current monthly contribution 5,600
The volume of sales required after the price rise will be an amount which earns a contribution of
£5,600 per month, the same as before. The contribution per cake at a sales price of £0.29 would
be (£0.29 – £0.15) = £0.14.
Required sales = = = 40,000 cakes per month
Contribution per unit £0.14
Worked example: Change in production costs

Close Brickett Ltd makes a product which has a variable production cost of £8 and a variable
selling cost of £2 per unit. Fixed costs are £40,000 per annum, the sales price per unit is £18,
and the current volume of output and sales is 6,000 units.
The company is considering whether to hire an improved machine for production. Annual hire
costs would be £10,000 and it is expected that the variable cost of production would fall to £6
per unit.
Requirements
(a) Determine the number of units that must be produced and sold to achieve the same profit
as is currently earned, if the machine is hired.
(b) Calculate the annual profit with the machine if output and sales remain at 6,000 units per
annum.
Solution
(a) The current unit contribution is £(18  (8 + 2)) = £8
£
Current contribution (6,000 × £8) 48,000
Less current fixed costs 40,000
Current profit 8,000
C
H
With the new machine fixed costs will increase by £10,000 to £50,000 per annum. The
A
variable cost per unit will reduce to £(6 + 2) = £8, and the contribution per unit will increase P
to £10. T
E
£ R
Required profit (as currently earned) 8,000
Fixed costs 50,000 10
Required contribution 58,000
Contribution per unit £10

Sales required to earn £8,000 profit = £58,000/£10 = 5,800 units

(b) If sales are 6,000 units
£
Profit at 5,800 units of sale (see (a)) 8,000
Contribution from sale of extra 200 units (× £10) 2,000
Profit at 6,000 units of sale 10,000
2 Breakeven charts
Section overview
 A breakeven chart is a chart that indicates the profit or loss at different levels of sales
volume within a limited range.
 A traditional breakeven chart has a line for sales revenue, for fixed costs and for total costs.
 The breakeven point is at the intersection of the sales line and the total costs line.
 A contribution breakeven chart depicts variable costs, so that contribution can be read
directly from the chart.
 Despite the usefulness of breakeven analysis, the technique has some serious limitations.
2.1 Breakeven charts

The breakeven point can be determined graphically using a breakeven chart. A breakeven chart
is a chart that indicates the profit or loss at different levels of sales volume within a limited range.
A breakeven chart has the following axes.
 A horizontal axis showing the sales/output (in value or units).
 A vertical axis showing £ for sales revenues and costs.
2.2 Lines on a breakeven chart

The following lines are drawn on the breakeven chart.
(a) The sales line:
 starts at the origin
 ends at the point signifying expected sales volume and sales value
(b) The fixed costs line
 runs parallel to the horizontal axis
 meets the vertical axis at a point which represents the value of total fixed costs
(c) The total costs line
 starts where the fixed costs line meets the vertical axis
 ends at the point which represents anticipated sales volume on the horizontal axis and
the total costs of anticipated sales on the vertical axis
The breakeven point is the intersection of the sales line and the total costs line.
The distance between the breakeven point and the expected (or budgeted) sales, in units,
indicates the margin of safety at that level of sales.

Worked example: A breakeven chart
The budgeted annual output of a factory is 120,000 units. The fixed overheads amount to
£40,000 and the variable costs are 50p per unit. The sales price is £1 per unit.
Requirement
Construct a breakeven chart showing the current breakeven point and profit earned up to the
present maximum capacity of 120,000 units.
Solution
We begin the construction of the breakeven chart by calculating the profit at the budgeted
annual output.
£
Sales (120,000 units) 120,000
Variable costs 60,000
Contribution 60,000
Fixed costs 40,000
Profit 20,000
The breakeven chart is shown on the following page.

The chart is drawn as follows.
(a) The vertical axis represents money (costs and revenue) and the horizontal axis represents
the level of activity (production and sales).
(b) The fixed costs are represented by a straight line parallel to the horizontal axis (in our
example, at £40,000).
(c) The variable costs are added 'on top of' fixed costs, to give total costs. It is assumed that
fixed costs are the same in total and variable costs are the same per unit at all levels of
output.
The line of costs is therefore a straight line and only two points need to be plotted and
joined up. Perhaps the two most convenient points to plot are total costs at zero output,
and total costs at the budgeted output and sales.
 At zero output, costs are equal to the amount of fixed costs only, £40,000, since there
are no variable costs.
 At the budgeted output of 120,000 units, total costs are £100,000.
£
Fixed costs 40,000
Variable costs 120,000 × 50p 60,000
Total costs 100,000
(d) The sales line is also drawn by plotting two points and joining them up.
 At zero sales, revenue is nil. C
 At the budgeted output and sales of 120,000 units, revenue is £120,000. H
A
P
T
E
R
10

£'000
120 s
le
Sa Budgeted profit
100
Breakeven point
80
Budgeted variable costs
sts
60 tal co
To
Fixed costs
40
Margin
20 of safety Budgeted fixed costs
0
0 20 40 60 80 100 120 '000 Units
Figure 10.1: Breakeven chart
2.3 Interpreting the breakeven chart

The breakeven point is where total costs are matched exactly by total revenue. From the chart,
this can be seen to occur at output and sales of 80,000 units, when revenue and costs are both
£80,000. This breakeven point can be calculated as:
Required contribution (= fixed costs) £40,000
= = 80,000 units
Contribution per unit £0.50 per unit
The margin of safety can be seen on the chart as the difference between the budgeted level of
activity and the breakeven level.
2.4 The contribution breakeven chart

The main problem with the traditional breakeven chart is that it is not possible to read
contribution directly from the chart.
The contribution breakeven chart remedies this by drawing the variable cost line instead of the
fixed cost line. This line will always run parallel to the total cost line. A contribution breakeven
chart for the last worked example would include the variable cost line passing through the origin
and the total variable cost of £60,000 for 120,000 units. The contribution breakeven chart is
shown on the next page.

£'000
120
Budgeted
les
100 Sa profit
Breakeven point Budgeted
contribution
80
s
60 l cost
ta
To
s
40
c ost
ble
ria
20 Va
0
0 20 40 60 80 100 120 '000 Units
Figure 10.2: Contribution breakeven chart
If you look back at the traditional breakeven chart shown in Figure 10.1 you will see that the
breakeven point is the same, but that the budgeted contribution can now be read more easily
from the chart.
Interactive question 3: Breakeven chart

Match the following labels to (a), (b), (c) and (d) marked on the breakeven chart below.
Budgeted fixed Margin of safety Budgeted Budgeted variable

costs profit costs
s
le b
Sa
Breakeven point
c
co sts
tal
To
Fixed costs
d C
a H
A
P
Budgeted sales Units T
E
See Answer at the end of this chapter. R
10

2.5 Limitations of breakeven or CVP analysis and breakeven charts
CVP analysis is a useful technique for managers. It can provide simple and quick estimates, and
breakeven charts provide a graphical representation of breakeven arithmetic. It does, however,
have a number of limitations.
 It can only apply to a single product or a constant mix of a group of products.
 A breakeven chart may be time-consuming to prepare.
 It assumes fixed costs are constant at all levels of output.
 It assumes that variable costs are the same per unit at all levels of output.
 It assumes that sales prices are constant at all levels of output.
 It assumes production and sales are the same (inventory levels are ignored – effectively
marginal costing is used).
 It ignores the uncertainty in the estimates of sales prices, fixed costs and variable cost per
unit.
3 Limiting factor analysis
Section overview
 A limiting factor is anything which limits the activity of an entity.
 If a specific resource is a limiting factor, contribution will be maximised by earning the
highest possible contribution per unit of limiting factor.
 To establish the contribution-maximising product or service mix the products or services
must be ranked in order of their contribution-earning ability per unit of limiting factor.
 When there is a maximum potential sales demand for an organisation's products or
services the contribution-maximising decision is to produce the top-ranked products (or to
provide the top-ranked services) up to the sales demand limit.
 If there is a minimum demand for particular products or services, the optimum plan must
first take into account the minimum requirements. The remaining resource must then be
allocated according to the ranking of contribution per unit of limiting factor.
 In a situation where a company must sub-contract work to make up a shortfall in its own in-
house capabilities, total costs will be minimised if those units bought in have the lowest
extra variable cost of buying per unit of limiting factor saved by buying.
3.1 Limiting factors

One of the more common problems faced by management is a situation where there are
insufficient resources to meet the potential sales demand. In this situation a decision has to be
made about what mix of products to manufacture or services to provide, using the available
resources as effectively as possible. The resource that limits the organisation's ability to meet
sales demand is called a limiting factor or key factor.
A limiting factor or key factor is 'anything which limits the activity of an entity'. An entity seeks to
optimise the benefit it obtains from the limiting factor. Examples are a shortage of supply of a
resource or a restriction on sales demand at a particular price.
A limiting factor could be sales if there is a limit to sales demand but any one of the
organisation's resources (labour, materials and so on) may be insufficient to meet the level of
production demanded.

It is assumed in limiting factor analysis that management wishes to maximise profit and that since
there is no change in the fixed cost incurred profit will be maximised when contribution is
maximised.
3.2 Limiting factor situations

For example if grade A labour is the limiting factor, contribution will be maximised by earning
the highest contribution from each hour of grade A labour worked.
The limiting factor decision therefore involves the determination of the contribution earned by
each different product or service from each unit of the limiting factor.
Worked example: Limiting factor

AB Ltd makes two products, the Ay and the Be. Unit variable costs are as follows.
Ay Be
£ £
Materials 1 3
Labour (£9 per hour) 18 9
Overhead 1 1
20 13
The sales price per unit is £26 per Ay and £17 per Be. During July 20X2 the available labour is
limited to 8,000 hours. Sales demand in July is expected to be 3,000 units for Ays and 5,000
units for Bes.
Requirement
Determine the profit-maximising production mix, assuming that monthly fixed costs are £20,000,
and that no inventories are held.
Solution
Step 1
Confirm that the limiting factor is something other than sales demand.
Ay Be Total
Labour hours per unit 2 hrs 1 hr
Sales demand 3,000 units 5,000 units
Labour hours needed 6,000 hrs 5,000 hrs 11,000 hrs
Labour hours available 8,000 hrs
Shortfall 3,000 hrs
Labour is the limiting factor on production
Step 2
Identify the contribution earned by each product per unit of limiting factor, that is per labour
hour worked. C
Ay Be H
A
£ £ P
Sales price 26 17 T
Variable cost 20 13 E
Unit contribution 6 4 R
10
Labour hours per unit 2 hrs 1 hr
Contribution per labour hour (= unit of limiting factor) £3 £4
Although Ays have a higher unit contribution than Bes, two Bes can be made in the time it takes
to make one Ay. Because labour is in short supply it is more profitable to make Bes than Ays.

Step 3
Determine the optimum production plan. Sufficient Bes will be made to meet the full sales
demand, and the remaining labour hours available will then be used to make Ays.
Hours Hours Priority of
Product Demand required available manufacture
Bes 5,000 5,000 5,000 1st
Ays 3,000 6,000 3,000 (bal) 2nd
11,000 8,000
Hours Contribution
Product Units needed per hour Total
£ £
Bes 5,000 5,000 4 20,000
Ays 1,500 3,000 3 9,000
8,000 29,000
Less fixed costs 20,000
Profit 9,000
Interactive question 4: Limiting factors

LF Ltd makes a single product for which the standard cost details are as follows.
£
Variable material (£3 per kg) 12
Variable labour (£8 per hour) 72
Production overhead 48
Total production cost 132
Demand for next period will be 20,000 units. No inventories are held and only 75,000 kg of
material and 190,000 hours of labour will be available.
Requirement
Indicate, by placing ticks where relevant in the table below, which resource or resources
represent a limiting factor for LF Ltd.
Limiting factor Not a limiting factor
Materials
Labour
Interactive question 5: Limiting factor analysis

POV Ltd manufactures three products – X, Y and Z – that use the same machines. The budgeted
income statements for the three products are as follows.
X Y Z
£'000 £'000 £'000
Sales 1,000 1,125 625
Variable material and labour costs (500) (563) (438)
Variable overheads (250) (187) (62)
Fixed overheads (200) (315) (130)
Profit/(loss) 50 60 (5)
Annual sales demand (units) 5,000 7,500 2,500
Machine hours per unit 20 21 26

However, after the budget had been formulated, an unforeseen condition has meant that during
the next period the available machine capacity has been limited to 296,500 hours.
Requirement
(a) The shortfall in available machine hours for next period is …………… hours
(b) The contribution earned per machine hour used on product X is £ ……………
The contribution earned per machine hour used on product Y is £ ……………
The contribution earned per machine hour used on product Z is £ ……………
(c) The number of units of each product that should be manufactured next period is:
(1) Product X …………… units
(2) Product Y …………… units
(3) Product Z …………… units
Worked example: Extra supply of limiting factor

HMF Ltd makes three products, the X1, Y2 and the Z3. Materials are expected to be in short
supply in May and the budget for May is as follows:
X1 Y2 Z3
Maximum demand (units) 10,000 12,000 8,000
Optimum planned production (units) 7,000 12,000
Contribution (per unit) £15 £20 £10
Material cost per unit (@ £3 per kg) £9 £6 £7.5
The planned production is based on optimising the use of the current supply of materials at £3
per kg. A new supplier has offered to supply an additional 25,000 kg of material.
Requirement
Calculate the maximum total price that HMF Ltd should pay for the extra 25,000 kg of materials.
Solution
Step 1
Identify the contribution earned by each product per unit of limiting factor, that is per kg of
material, and rank products.
In this case, the question states that the planned production is based on the optimal use of
materials. We can therefore conclude that Y2 has the highest contribution per kg as 12,000 units
are produced to meet the maximum demand. We can also conclude that Z3 has the lowest
contribution per kg as no units are produced.
Step 2
Determine the optimum production plan using the extra resource. 12,000 units of Y2 and 7,000 C
H
units of X1 will be made from the existing materials available. The additional materials A
purchased from the new supplier will be used to make the outstanding demand of X1s and Z3s. P
T
Demand Kg Kg Priority of Optimum E
Product Units required available manufacture units R
X1 (10,000 – 7,000) 3,000 9,000 9,000 1st 3,000
Z3 8,000 20,000 16,000 2nd 10
6,400
(bal)
29,000 25,000

Step 3
Determine the contribution earned from the extra resource and add back resource cost already
accounted for within the contribution per unit.
Optimum Contribution
Product Units per unit Total
£ £
X1 3,000 15 45,000
Z3 6,400 10 64,000
109,000
Add material cost already included in
contribution per unit (25,000 kg @ £3) 75,000*
Maximum that should be paid: 184,000
*This is the cost from the old supplier. The cost was included in the contribution calculation but
will no longer be paid due to purchasing materials from the new supplier.
3.3 Limiting factor analysis and restricted freedom of action

In certain circumstances an organisation faced with a limiting factor on production and sales
might not be able to produce the profit-maximising product mix because the mix and/or
volume of products that can be produced and sold is also restricted by a factor other than a
scarce resource.
(a) A contract to supply a certain number of products to a customer which cannot be cancelled.
(b) Production/sales of a minimum quantity of one or more products to provide a complete
product range and/or to maintain customer goodwill.
(c) Maintenance of a certain market share of one or more products.
In each of these cases, the organisation might have to produce more of a particular product or
products than the level established by ranking according to contribution per unit of limiting
factor.
If an organisation has to produce more of a particular product or products than the level
established by ranking according to contribution per unit of limiting factor, the products should
be ranked in the normal way but the optimum production plan must first take into account the
minimum production requirements. The remaining resource must then be allocated according
to the ranking.
Worked example: Restricted freedom of action

Harvey is currently preparing its budget for the year ending 30 September 20X2. The company
manufactures and sells three products, Beta, Delta and Gamma.
The unit selling price and cost structure of each product is budgeted as follows.
Beta Delta Gamma
£ £ £
Selling price 100 124 32
Variable costs:
Labour 24 48 6
Materials 26 7 8
Overhead 10 5 6
60 60 20
The labour rate is budgeted at £6 per hour, and fixed costs at £1,300,000 per annum. The
company has a maximum production capacity of 228,000 labour hours.

A meeting of the board of directors has been arranged to discuss the budget and to resolve the
problem as to the quantity of each product which should be made and sold. The sales director
presented the results of a recent market survey which reveals that market demand for the
company's products will be as follows.
Product Units
Beta 24,000
Delta 12,000
Gamma 60,000
The production director proposes that since Gamma only contributes £12 per unit, the product
should no longer be produced, and the surplus capacity transferred to produce extra quantities
of Beta and Delta. The sales director does not agree with the proposal. Gamma is considered
necessary to complement the product range and to maintain customer goodwill. If Gamma is
not offered, the sales director believes that sales of Beta and Delta will be seriously affected.
After further discussion the board decided that a minimum of 10,000 units of each product
should be produced. The remaining production capacity would then be allocated so as to
achieve the maximum profit possible.
Requirement
Prepare a budget statement which clearly shows the maximum profit which could be achieved in
the year ending 30 September 20X2.
Solution
Step 1
Ascertain whether labour hours are a scarce resource
Units demanded Labour hours per Total labour
unit hours
Beta 24,000 4 (£24/£6) 96,000
Delta 12,000 8 (£48/£6) 96,000
Gamma 60,000 1 (£6/£6) 60,000
252,000
Labour hours are a limiting factor.
Step 2
Rank the products
Since only 228,000 hours are available we need to establish which product earns the greatest
contribution per labour hour.
Beta Delta Gamma
Labour hours 4 8 1
Contribution per labour hour £10 £8 £12 C

H
A
Ranking 2nd 3rd 1st P
T
E
R
10

Step 3
Determine a production plan
The optimum production plan must take into account the requirement that 10,000 units of each
product are produced, and then allocate the remaining hours according to the above ranking.
Hours
Beta 10,000 units  4 hours 40,000
Delta 10,000 units  8 hours 80,000
Gamma 10,000 units  1 hour 10,000
130,000
Gamma 50,000 units  1 hour (full demand) 50,000
Beta 12,000 units  4 hours (balance) 48,000
228,000
Step 4
Draw up a budget.
Budget statement
£
Contribution
Beta (22,000 units  £40) 880,000
Delta (10,000 units  £64) 640,000
Gamma (60,000 units  £12) 720,000
Total contribution 2,240,000
Fixed costs 1,300,000
Profit 940,000
3.4 Make or buy decisions and scarce resources

An organisation might want to do more things than it has the resources for, and so its
alternatives would be as follows.
(a) Make the best use of the available resources and ignore the opportunities to buy help from
outside.
(b) Combine internal resources with subcontracting externally so as to do more and increase
profitability.
Buying help from outside is justifiable if it adds to profits. A further decision is then required on
how to split the work between internal and external effort. What parts of the work should be
given to suppliers or subcontractors so as to maximise profitability?
In a situation where a company must subcontract work to make up a shortfall in its own
in-house capabilities, its total costs will be minimised if those units bought have the lowest extra
variable cost of buying per unit of scarce resource saved by buying.

Worked example: Make or buy decisions with scarce resources
MM manufactures three components, S, A and T using the same machines for each and
assembles them into a single product. The budget for the next year calls for the production and
assembly of 4,000 of each component. The variable production cost per unit of the final product
is as follows.
Machine hours Variable cost
£
1 unit of S 3 20
1 unit of A 2 36
1 unit of T 4 24
Assembly 100
Only 24,000 hours of machine time will be available during the year, and a subcontractor has
quoted the following unit prices for supplying components: S £29; A £40; T £34.
Requirement
Advise MM on its most profitable plan.
Solution
The organisation's budget calls for 36,000 hours of machine time, if all the components are to
be produced in-house. Only 24,000 hours are available, and so there is a shortfall of 12,000
hours of machine time, which is therefore a limiting factor. The shortage can be overcome by
subcontracting the equivalent of 12,000 machine hours' output to the subcontractor.
The assembly costs are not relevant costs because they are not affected by the decision.
The decision rule is to minimise the extra variable costs of subcontracting per unit of scarce
resource saved (that is, per machine hour saved).
S A T
£ £ £
Variable cost of making 20 36 24
Variable cost of buying 29 40 34
Extra variable cost of buying 9 4 10
Machine hours saved by buying 3 hrs 2 hrs 4 hrs
Extra variable cost of buying per hour saved £3 £2 £2.50
This analysis shows that it is cheaper to buy A than to buy T and it is most expensive to buy S.
The priority for making the components in-house will be in the reverse order: S, then T, then A.
There are enough machine hours to make all 4,000 units of S (12,000 hours) and to produce
3,000 units of T (another 12,000 hours). 12,000 hours' production of T and A must be
subcontracted.
The cost-minimising and so profit-maximising make and buy schedule is as follows.
Machine hours Unit Total
Component used/saved Number of units variable cost variable cost
£ £
C
Make: S 12,000 4,000 20 80,000 H
T 12,000 3,000 24 72,000 A
24,000 152,000 P
T
E
Buy: T 4,000 1,000 34 34,000 R
A 8,000 4,000 40 160,000
12,000 10
Total variable cost of components, excluding assembly costs 346,000

Interactive question 6: Make or buy and limiting factors
TW manufactures two products, the D and the E, using the same material for each. Annual
demand for the D is 9,000 units, while demand for the E is 12,000 units. The variable production
cost per unit of the D is £10, and that of the E £15. The D requires 3.5 kg of raw material per unit,
the E requires 8 kg of raw material per unit. Supply of raw material will be limited to 87,500 kg
during the year.
A sub contractor has quoted prices of £17 per unit for the D and £25 per unit for the E to supply
the product. How many of each product should TW manufacture in order to maximise profits?
Requirement
Fill in the boxes in the sentence below.
TW should manufacture units of D and units of E to maximise profits.


Summary
Contribution =
Sales price – Variable cost
Breakeven point (BEP) Contribution ratio Limiting factor

= No profit and no loss = Contribution analysis
Sales
Fixed cost Fixed costs Maximise the

BEP in units = BEP in £ = contribution per
Contribution per unit Contribution ratio
unit of limiting
factor
Margin of safety Make or buy

Budgeted sales – BEP decision
= × 100%
Budgeted sales
Breakeven chart
Depicts the profit or
loss over a range of activities
Contribution breakeven chart

Includes the variable cost line so
that contribution is highlighted
C
H
A
P
T
E
R
10

Self-test
The following information relates to questions 1 to 3.
Information concerning K Limited's single product is as follows.
£ per unit
Selling price 6.00
Variable production cost 1.20
Variable selling cost 0.40
Fixed production cost 4.00
Fixed selling cost 0.80
Budgeted production and sales for the year are 10,000 units.
1 What is the company's breakeven point, to the nearest whole unit?
A 8,000 units
B 8,333 units
C 10,000 units
D 10,909 units
2 How many units must be sold if K Limited wants to achieve a profit of £11,000 for the year?
A 2,500 units
B 9,833 units
C 10,625 units
D 13,409 units
3 It is now expected that the variable production cost per unit and the selling price per unit
will each increase by 10%, and fixed production costs will rise by 25%. Other costs are
expected to remain the same.
What will be the new breakeven point, to the nearest whole unit?
A 8,788 units
B 11,600 units
C 11,885 units
D 12,397 units
The following information relates to questions 4 to 6.
W Limited sells one product for which data is given below:
£ per unit
Selling price 10
Variable cost 6
Fixed cost 2
The fixed costs are based on a budgeted level of activity of 5,000 units for the period.
4 How many units must be sold if W Limited wishes to earn a profit of £6,000 for one period?
A 1,500
B 1,600
C 4,000
D 8,000

5 What is W Limited's margin of safety for the budget period if fixed costs prove to be 20%
higher than budgeted?
A 29%
B 40%
C 50%
2
D 66 %
3
6 If the selling price and variable cost increase by 20% and 12% respectively by how much
must sales volume change compared with the original budgeted level in order to achieve
the original budgeted profit for the period?
A 24.2% decrease
B 24.2% increase
C 39.4% decrease
D 39.4% increase
7
£
s
le
Sa A
D ts
l cos C
T ota
B
s
ost
ec
i abl
Var
x Units
In the above breakeven chart, the contribution at level of activity x can be read as:
A Distance A
B Distance B
C Distance C
D Distance D
8 R Limited manufactures three products, the selling price and cost details of which are given
below.
Product P Product Q Product R C
£ £ £ H
Selling price per unit 150 190 190 A
P
Costs per unit
T
Variable materials (£5/kg) 20 10 30 E
Variable labour (£8/hour) 32 48 40 R
Variable overhead 16 24 20
10
Fixed overhead 48 72 60

In a period when materials are restricted in supply, the most and least profitable uses of
materials are:
Most profitable Least profitable
A R P
B Q R
C Q P
D R Q
9 JJ makes two products, the K and the L. The K sells for £50 per unit, the L for £70 per unit.
The variable cost per unit of the K is £35, that of the L £40. Each unit of K uses 2 kg of raw
material. Each unit of L uses 3 kg of material.
In the forthcoming period the availability of raw material is limited to 2,000 kg. JJ is
contracted to supply 500 units of K. Maximum demand for the L is 250 units. Demand for
the K is unlimited.
What is the profit-maximising product mix?
K L
A 250 units 625 units
B 1,250 units 750 units
C 625 units 250 units
D 750 units 1,250 units
10 B has insufficient workshop capacity to carry out all the repair work currently required on its
fleet of delivery vehicles. In such circumstances certain repair jobs will be sub-contracted to
local garages.
Set out below are the routine repair jobs scheduled for the coming week.
Job A B C D E F
Cost of parts £1,200 £1,375 £1,450 £500 £375 £690
Labour hours 150 100 200 50 150 100
Equipment hours 170 30 70 30 70 70
Sub-contract cost (including £3,950 £2,700 £4,900 £1,800 £2,700 £2,400
parts)
Labour is paid £6 per hour. Overtime is not worked on routine jobs. Labour-related variable
overheads are £2 per labour hour. Equipment-related variable overheads are £1 per
equipment-hour. Depreciation on workshop equipment is £960 per week. Other workshop
fixed overheads are £1,540 per week.
Tick the boxes to indicate which jobs should be subcontracted if the amount of workshop
labour available in the week is fixed at 400 hours and there is no restriction on equipment
availability.
Job A
Job B
Job C
Job D
Job E
Job F


The number of units that must be sold is 25,000
WORKINGS
= = £250,000
Contribution ratio 20%
 Number of units = £250,000 ÷ £10 = 25,000.

The required sales price per unit is £ 20
WORKINGS
Required contribution = fixed costs plus profit
= £47,000 + £23,000
= £70,000
Required sales 14,000 units
Required contribution per unit = £70,000/14,000 = £5 per unit
£
Required contribution per unit sold 5
Variable cost per unit 15
Required sales price per unit 20

(a) = Margin of safety
(b) = Budgeted profit
(c) = Budgeted variable costs
(d) = Budgeted fixed costs
Limiting factor Not a limiting factor
Materials
 
Labour
 
WORKINGS
C
(1) Material required = 20,000 units  (£12/£3) = 80,000 kg H
A
Material is therefore a limiting factor, since 75,000 kg are available. P
T
(2) Labour required = 20,000 units  (£72/£8) = 180,000 hours E
R
Labour is not a limiting factor, since 190,000 labour hours are available.
10

(a) The shortfall in available machine hours for next period is 26,000 hours.
WORKINGS
Machine hours required to satisfy annual sales demand:
Hours
Product X 5,000 units  20 hrs 100,000
Product Y 7,500 units  21 hrs 157,500
Product Z 2,500 units  26 hrs 65,000
Total machine hours required 322,500
Machine hours available 296,500
Shortfall in available machine hours 26,000
(b) The contribution earned per machine hour used on product X is £ 2.50
The contribution earned per machine hour used on product Y is £ 2.38
The contribution earned per machine hour used on product Z is £ 1.92
WORKINGS
X Y Z
£'000 £'000 £'000
Sales revenue 1,000 1,125 625
Variable material and labour costs (500) (563) (438)
Variable overheads (250) (187) (62)
Contribution 250 375 125

Contribution per machine hour £2.50 £2.38 £1.92
(c) (1) Product X 5,000 units

(2) Product Y 7,500 units
(3) Product Z 1,500 units
WORKINGS
Demand Hours Hours Production
Ranking Product units required available units
1st X 5,000 ( 20) 100,000 100,000 5,000
2nd Y 7,500 ( 21) 157,500 157,500 7,500
3rd Z 2,500 ( 26) 65,000 39,000* 1,500
296,500
* Balance (296,500 – 100,000 – 157,500)

TW should manufacture 9,000 units of D and 7,000 units of E.
WORKINGS
D E
Variable cost of making 10 15
Variable cost of buying 17 25
Extra variable cost of buying 7 10
Raw material saved by buying 3.5 kg 8 kg
Extra variable cost of buying per kg saved £2 £1.25
Priority for internal manufacture 1 2

Production plan Material used
kg
 Make D (9,000  3.5 kg) 31,500
E (7,000  8 kg) 56,000
87,500
The remaining 5,000 units of E should be purchased from the sub contractor.
C
H
A
P
T
E
R
10

Fixed costs
1 D Breakeven point =
10,000×(£4.00 +£0.80) £48,000

= = = 10,909 units
(£6.00  (£1.20 +£0.40)) £4.40
If you selected option A you divided the fixed cost by the selling price, but the selling
price also has to cover the variable cost. Option B ignores the selling costs, but these
are costs that must be covered before the breakeven point is reached. Option C is the
budgeted sales volume, which happens to be below the breakeven point.
2 D Contribution required for target profit = Fixed costs + Profit
= £48,000 + £11,000
= £59,000
 Contribution per unit (from question 1) = £4.40
£59,000
 Sales units required = = 13,409 units
£4.40
If you selected option A you divided the required profit by the contribution per unit,
but the fixed costs must be covered before any profit can be earned. If you selected
option B you identified correctly the contribution required for the target profit, but you
then divided by the selling price per unit instead of the contribution per unit. Option C
ignores the selling costs, which must be covered before a profit can be earned.
3 C
£ per unit
New selling price (£6 × 1.1) 6.60
New variable cost (£1.20 × 1.1) + £0.40 1.72
Revised contribution per unit 4.88
New fixed costs (£40,000 × 1.25) + £8,000 £58,000

£58,000
Revised breakeven point = = 11,885 units
£4.88
If you selected option A you divided the fixed cost by the selling price, but the selling
price also has to cover the variable cost. Option B fails to allow for the increase in
variable production cost and option D increases all of the costs by the percentages
given, rather than the production costs only.
4 C
£
Target profit 6,000
Fixed costs (5,000 × £2) 10,000
Target contribution 16,000
Contribution per unit (£10 – £6) £4

Units required to achieve target profit = £16,000 = 4,000
£4
If you selected option A you divided £6,000 target profit by the £4 contribution per
unit, but the fixed costs must be covered before any profit can be earned. If you
selected option B you divided by the selling price, but the variable costs must also be
taken into account. If you selected option D you divided by the profit per unit instead

of the contribution per unit, but the fixed costs are taken into account in the calculation
of the target contribution.
5 B
Fixed costs (£10,000 × 120%) £12,000
Units required now to break even = £12,000 = 3,000

£4 (contribution)
Budgeted units of sales 5,000
Margin of safety (units) 2,000
2,000
In percentage terms, margin of safety = × 100% = 40%
5,000
Option A increases the variable cost by 20% and option C increases the activity by
20%. If you selected option D you calculated the margin of safety as a percentage of
the breakeven volume, but it should be expressed as a percentage of budgeted sales.
6 A
£
Original budgeted profit:
Contribution (5,000 × £4) 20,000
Fixed costs 10,000
Profit 10,000
£ per unit
New sales price (£10 × 1.20) 12.00
New variable cost (£6 × 1.12) 6.72
New contribution 5.28
Contribution required (as above) £20,000

£20,000 3,788 units
Sales volume now needed = =
£5.28
This is 1,212 units or 24.24% less than the original budgeted level of 5,000 units of
sales.
If you selected option B you identified the correct percentage change but you
misinterpreted it as a required increase. If you selected options C or D you took £6,000
as your figure for the original budgeted profit. However, the budgeted profit would be
based on the budgeted level of activity of 5,000 units for the period.
7 C Contribution at level of activity x = Sales value less variable costs, which is indicated by
distance C. Distance A indicates the profit at activity x, B indicates the fixed costs and D
indicates the margin of safety in terms of sales value.
8 B
Product P Product Q Product R C
Contribution per unit £82 £108 £100 H
A
kg required per unit 4 2 6
P
Contribution per kg of material £20.50 £54 £16.67 T
Ranking 2 1 3 E
R
Therefore Q is the most profitable and R is the least profitable.
10
If you selected option A you ranked the products according to their profit per unit, but
this takes no account of the limiting factor and is distorted by the fixed costs.

9 C
K L
Contribution per unit £15 £30
Contribution per unit of limiting factor £15/2 = £7.50 £30/3 = £10
Ranking 2 1
Raw materials
used
kg
Contracted supply of K (500 × 2 kg) 1,000
Meet demand for L (250 × 3 kg) 750
Remainder of resource for K (125 × 2 kg) 250
2,000
10 Jobs B, E and F should be subcontracted

WORKINGS
(1)
A B C D E F
Extra cost of subcontracting (W2) £1,380 £495 £1,780 £870 £1,055 £840
Labour hours required 150 100 200 50 150 100
Cost per labour hour saved by
subcontracting £9.20 £4.95 £8.90 £17.40 £7.03 £8.40
Ranking of jobs to subcontract 5 1* 4 6 2* 3*
* Subcontracted jobs
As labour capacity is restricted to 400 hours per week there is only enough capacity for jobs
C, A and D. Jobs B, E and F should therefore be subcontracted as they have the lowest
incremental cost per labour hour saved.
(2)
A B C D E F
Cost of doing work in-house £ £ £ £ £ £
Parts 1,200 1,375 1,450 500 375 690
Labour (labour hours  £6 per hour) 900 600 1,200 300 900 600
Labour-related overhead
(labour hours  £2 per hour) 300 200 400 100 300 200
Equipment-related overhead
(equipment hours  £1 per hour) 170 30 70 30 70 70
Total cost of doing work in-house 2,570 2,205 3,120 930 1,645 1,560
Cost of subcontracting (including 3,950 2,700 4,900 1,800 2,700 2,400
parts)
Extra cost of subcontracting 1,380 495 1,780 870 1,055 840

CHAPTER 11
Investment appraisal
techniques
Introduction
Examination context
TOPIC LIST
1 Making investment appraisal decisions
2 The payback method
3 The accounting rate of return method
4 The net present value method
5 The internal rate of return method
Introduction
 Calculate the net present value, internal rate of return, payback period or
accounting rate of return for a given project
 Identify and comment upon the advantages and disadvantages of the investment
appraisal techniques specified above
The specific syllabus references for this chapter are: 4c, d.
Syllabus links
You will be using the techniques you learn in this chapter when you study the Financial
Management syllabus. In that syllabus you will explore further the investment decision-making
process and associated issues.
Examination context
Since most of this part of your syllabus is concerned with calculation techniques you can expect
to encounter predominately numerical questions about these topics.
 calculate the net present value, internal rate of return, payback period or accounting rate of
return from data supplied
 interpret information about the net present value, internal rate of return, payback or
accounting rate of return for a project or projects
 demonstrate an understanding of the advantages and disadvantages of the investment
appraisal techniques specified above
 manipulate simple data involving annuities, perpetuities and non-conventional cash flows
 demonstrate an understanding of the derivation and meaning of the net terminal value of a
project
While most of the questions in this area of the syllabus will be numerical (where such issues as
the timing of cash flows will be critical) it is vital to understand what each of the techniques
involves (and their weaknesses) in order to be able to tackle narrative questions.

1 Making investment appraisal decisions C
H
A
Section overview P
T
 A typical model for investment decision making has a number of distinct stages. E
R
 These stages are typically: the origination of proposals, project screening, analysis and
acceptance, and monitoring and review. 11
1.1 The investment decision-making process

You will study the investment decision-making process in more detail in your Financial
Management syllabus so we will review the process in outline only here, to set the financial
investment appraisal techniques in context.
A typical model for investment decision making has a number of distinct stages.
 Origination of proposals. It has been suggested that good ideas for investment are likely to
occur in environments in which staff feel free to present and develop ideas. Some
alternatives will be rejected early on. Others will be more thoroughly evaluated.
 Project screening. Before a detailed financial analysis is undertaken a qualitative evaluation
of the project will be made. For example, questions will be asked such as whether the
project 'fits' with the organisation's long-term objectives and whether all possible
alternatives have been considered. Only if the project passes this initial screening will more
detailed financial analysis begin.
 Analysis and acceptance. This will include a financial analysis, using the organisation's
preferred investment appraisal techniques. You will be studying the most common
techniques in the remainder of this chapter. Qualitative issues will also be considered
before a decision is made whether to proceed and the project is implemented.
 Monitoring and review. During the project's progress it will be necessary to ensure that
capital spending does not exceed the amount authorised, that the implementation of the
project is not delayed and that the anticipated benefits are eventually obtained.
2 The payback method
Section overview
 The payback period is the time it takes for a project's net cash inflows to equal the initial
cash investment.
 The payback period is often used as an initial screening process.
 If a project's payback period is shorter than a defined maximum period then the project
should be evaluated further using a more sophisticated project appraisal technique.
 A major disadvantage is that the timing of cash flows within the payback period are
ignored and therefore no account is taken of the time value of money.
ICAEW 2019 Investment appraisal techniques 305

2.1 The payback period
Definition
Payback: Defined by The Chartered Institute of Management Accountants as 'The time required
for the cash inflows from a capital investment project to equal the initial cash outflow(s)'.
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 that target payback period.
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, such as those presented later
in this chapter.
You should note that when payback is calculated, we use profits before depreciation in the
calculation, 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.
2.2 Why is payback alone an inadequate project appraisal technique?

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 (one quarter of the way through Year 3). Project Q pays back
halfway through Year 2. Using payback alone to judge projects, project Q would be preferred.
But the returns from project P total £200,000 over its life and are much higher than the returns
from project Q which totals just £85,000.
Worked example: Payback period

An asset costing £120,000 is to be depreciated over 10 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
Requirement
Calculate the payback period to the nearest month.

Solution
C
Cash flows, ie, profits before depreciation should be used. H
A
Profit after Cash Cumulative P
Year depreciation Depreciation flow cash flow T
E
£'000 £'000 £'000 £'000 R
1 12 12 24 24
11
2 17 12 29 53
3 28 12 40 93
4 37 12 49 142
5 8 12 20 162
 (120  93) 
 Payback period = 3 years +  ×12 months 
 49 
= 3 years 7 months
2.3 Disadvantages of the payback method

There are a number of serious drawbacks to the payback method.
 It ignores the timing of cash flows within the payback period.
 It also ignores the cash flows after the end of the payback period and therefore the total
project return.
 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. This is because an investor who has £1 today can
either 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.
 The method is unable to distinguish between projects with the same payback period.
 The choice of any cut-off payback period by an organisation is arbitrary.
 It may lead to excessive investment in short-term projects.
 It takes account of the risk of the timing of cash flows but does not take account of the
variability of those cash flows.
2.4 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.
 Focus on early payback can enhance liquidity.
 Investment risk is increased if payback is longer.
 Shorter-term forecasts are likely to be more reliable.
 The calculation is quick and simple.
 Payback is an easily understood concept.

3 The accounting rate of return method
Section overview
 The Accounting Rate of Return (ARR) expresses the average accounting profit as a
percentage of the capital outlay.
 The capital outlay (the denominator in the ARR calculation) may be expressed as the initial
investment or as the average investment in the project.
 The decision rule is that projects with an ARR above a defined minimum are acceptable;
the greater the ARR, the more desirable the project.
 The main advantage of the ARR is that it is simple to calculate and understand. However it
does have a number of major disadvantages.
 The main disadvantage of the ARR is that it does not take account of the timing of the
profits from a project.
3.1 Calculating the accounting rate of return

The accounting rate of return (ARR) method of appraising a project involves estimating the
accounting rate of return that a project should yield. If it exceeds a target rate of return then the
project is acceptable.
There are two different ways of calculating the ARR.
Average annual accounting profit
ARR =  100%
Initial investment

ARR =  100%
Average investment
1
The average investment is calculated as (initial investment + final or scrap value).
2
An examination question will always make it clear whether you are to calculate the ARR based on
the average investment or based on the initial investment.
Note that this is the only appraisal method that we will be studying that uses accounting profits
instead of cash flow.
Worked example: The accounting rate of return

A project involves the immediate purchase of plant at a cost of £110,000. It would generate
annual profits before depreciation of £24,000 for five years. Scrap value will be £10,000 at the
end of the fifth year.
Requirement
Calculate the ARR using the initial and average investment.
Solution
Using initial investment
Profits before depreciation – Depreciation

Average profit =
5
(£24,000 × 5) – (£110,000 – £10,000)

=
5
= £4,000 p.a.

£4,000
ARR = ×100% = 3.6% C
£110,000
H
A
Using average investment
P
£4,000 T
×100% = 6.7% E
£(110,000 + 10,000)/2 R
11
3.2 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).
Interactive question 1: The ARR and mutually exclusive projects

Arrow wants to buy a new item of equipment. Two models of equipment are available, one with
a slightly higher capacity and greater reliability than the other. The expected costs and profits of
each item are as follows.
Equipment Equipment
item item
X Y
Capital cost £100,000 £175,000
Life 5 years 5 years
Profits before depreciation £ £
Year 1 50,000 50,000
Year 2 50,000 50,000
Year 3 30,000 60,000
Year 4 20,000 60,000
Year 5 10,000 60,000
Disposal value for equipment 20,000 25,000
ARR is measured as the average annual profits divided by the average investment.
Fill in the boxes below to determine which equipment item should be purchased, if the
company's target ARR is 25%.
Item X Item Y
£ £
Total profit over life of equipment:
Before depreciation
After depreciation
Average investment
ARR, based on average investment % %

Requirement
The equipment that should be purchased is item .

3.3 The advantages and disadvantages of the ARR method of project appraisal
The ARR method has the serious disadvantage 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
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 other disadvantages.
 It is based on accounting profits rather than cash flows, which are subject to a number of
different accounting policies.
 It is a relative measure rather than an absolute measure and hence takes no account of the
size of the investment.
 It takes no account of the length of the project.
 Like the payback method, it ignores the time value of money.
There are, however, advantages to the ARR method.
 It is quick and simple to calculate.
 It involves a familiar concept of a percentage return.
 Accounting profits can be easily calculated from financial statements.
 It looks at the entire project life.
 Managers and investors are accustomed to thinking in terms of profit, and so an appraisal
method which employs profit may be more easily understood.
 It allows more than one project to be compared.
4 The net present value method
Section overview
 The terminal value of an investment is its value at some point in the future, including an
allowance for interest.
 Discounting converts a sum of money receivable or payable in the future to its present
value, which is the cash equivalent now of the future value.
 Discounted cash flow (DCF) techniques discount all the forecast cash flows of an
investment proposal to determine their present value.
 The net present value (NPV) of a project is the difference between its projected
discounted cash inflows and discounted cash outflows.
 The decision rule is to accept a project with a positive NPV.
 An annuity is a constant cash flow for a number of years.
 The net terminal value (NTV) is the cash surplus remaining at the end of a project after
taking account of interest and capital payments.
 One of the principal advantages of the DCF appraisal method is that it takes account of the
time value of money.
 The payback method can be combined with DCF to calculate a discounted payback period.
£a
 A perpetuity is a constant cash flow forever. The present value of a perpetuity is ,
r
where a is the constant annual amount and r is the discount rate.

4.1 Compounding: calculating the terminal value
C
Suppose that a company has £10,000 to invest, and wants to earn a return of 10% (compound H
A
interest*) on its investments. This means that if the £10,000 could be invested at 10%, the value
P
of the investment with interest would build up as follows. T
E
(a) After 1 year £10,000  (1.10) = £11,000 R
(b) After 2 years £10,000  (1.10) = £12,100
2
(c) After 3 years £10,000  (1.10) = £13,310

3 11
and so on.
* This means that interest is earned each year on the previous years' interest.
This is compounding. The formula for the future value or terminal value of an investment plus
n
accumulated interest after n time periods is V = X(1 + r)
where V is the future value or terminal value of the investment with interest
X is the initial or 'present' value of the investment
r is the compound rate of return per time period, expressed as a decimal (so 10% =
0.10, 5% = 0.05 and so on)
n is the number of time periods.
Usually r is an annual rate of return and n is the number of years.
Worked example: Terminal value

What is the terminal value of £200 invested today at an interest rate of 7% per annum in 10
years' time?
Solution
10
Terminal value = £200 × (1.07) = £393
Terminal values can cause difficulties when trying to compare or choose between projects
because:
 the projects may not end on the same future date (or may not end at all)
 decision makers are more likely to be interested in the effect of the project on shareholder
wealth now, rather than in the future
It is therefore more common to look at present values. The present value of a future sum shows
what that future sum is worth today. This is in effect the reverse of compounding.
4.2 Discounting
Discounting starts with the future value (a sum of money receivable or payable at a future date),
and converts the future value to a present value, which is the cash equivalent now of the future
value.
For example, if a company expects to earn a (compound) rate of return of 10% on its
investments, how much would it need to invest now to have the following investments?
(a) £11,000 after 1 year
(b) £12,100 after 2 years
(c) £13,310 after 3 years
The answer is £10,000 in each case, and we can calculate it by discounting.

The discounting formula to calculate the present value (X) of a future sum of money (V) at the
n
end of n time periods is X = V/(1+r)
(a) After 1 year, £11,000/1.10 = £10,000
2
(b) After 2 years, £12,100/1.10 = £10,000
3
(c) After 3 years, £13,310/1.10 = £10,000
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.
The discount rate (r) used when calculating the present value is the relevant interest rate (or cost
of capital) to the entity in question. In the exam this will always be made clear.
4.2.1 Discount factors
In the calculations above we were converting each cash flow into its present value by effectively
n
multiplying by a discount factor. This discount factor is calculated as 1/(1 + r) .
The calculations could be presented as follows.
Multiply by 10% discount factor Present value £
After 1 year £11,000  1/1.10 10,000
 1/(1.10)
2
After 2 years £12,100 10,000
 1/(1.10)
3
After 3 years £13,310 10,000
Interactive question 2: Present value calculation

Spender expects the cash inflow from an investment to be £40,000 after two years and another
£30,000 after three years. Its target rate of return is 12%.
Use the table below to calculate the present value of these future returns.
Cash flow Multiplied by 12% Present value

Year
£ discount factor £
Total present value
4.3 Net present value (NPV)

Discounted cash flow (DCF) techniques are used in calculating the net present value of a series
of cash flows. This measures the change in shareholder wealth now as a result of accepting a
project.
NPV = present value of cash inflows less present value of cash outflows

 If the NPV is positive, it means that the cash inflows from a project will yield a return in
excess of the cost of capital, and so the project should be undertaken if the cost of capital is C
H
the organisation's target rate of return. A
P
 If the NPV is negative, it means that the cash inflows from a project will yield a return below T
the cost of capital, and so the project should not be undertaken if the cost of capital is the E
organisation's target rate of return. R
 If the NPV is exactly zero, the cash inflows from a project will yield a return which is exactly 11
the same as the cost of capital, and so if the cost of capital is the organisation's target rate of
return, the project will have a neutral impact on shareholder wealth and therefore would
not be worth undertaking because of the inherent risks in any project.
Worked example: NPV

Slogger 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
Requirement
Calculate the NPV of the project, and assess whether it should be undertaken.
Solution
Present
Year Cash flow Discount factor 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
Point to note
The discount factor for any cash flow 'now' (time 0) is always 1, whatever the cost of capital.
The present value (PV) of cash inflows exceeds the PV of cash outflows by £56,160, which
means that the project will earn a discounted cash flow (DCF) yield in excess of 15%. It should
therefore be undertaken.
4.4 Timing of cash flows: conventions used in DCF

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 may be
applied.
 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.

 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.
 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.
4.5 Cash flows, not accounting profits

It is important to remember that DCF techniques are based on 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
benefits 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.
4.6 Discount tables for the PV of £1

Instead of having to calculate the discount factor every time we can use tables. Discount tables
for the present value of £1, for a range of integer values of r and n, are shown in the third
column of the discount table in the Appendix at the back of this Study Manual. These tables
will be provided in the exam.
4.7 Annuities
An annuity is a series of constant cash flows for a number of years. For example, a college might
enter into a contract to provide training courses for a firm for a fixed annual fee of £30,000
payable at the end of each of the next three years. This would be a three-year annuity.
Worked example: Calculating the present value of an annuity

In the example of the college training course, the present value of the fees, assuming a 20% cost
of capital, could be calculated as follows.
Present value
Year Cash flow Present value factor of cash values
£ 20% £
1 30,000 0.833 24,990
2 30,000 0.694 20,820
3 30,000 0.579 17,370
2.106 63,180
Where there is a constant cash flow from year to year (in this case £30,000 per annum for Years
1–3) it is quicker to calculate the present value by adding together the discount factors for the
individual years. These total factors could be described as 'same cash flow per annum' factors,
'cumulative present value' factors or 'annuity' factors. They are shown in the final column of the
discount tables in the Appendix at the back of this Study Manual (2.106, for example, is in the
final column for 20% per annum and the row for Year 3).
The calculation could then be performed in one step:
£30,000  2.106 = £63,180
4.8 Net terminal value

Net terminal value (NTV) is the cash surplus remaining at the end of a project after taking
account of interest and capital repayments.

The NTV discounted at the cost of capital will give the NPV of the project.
C
H
Worked example: The net terminal value A
P
A project has the following cash flows.
T
Year £ E
R
0 (5,000)
1 3,000 11
2 2,600
3 6,200
The project has an NPV of £4,531 at the company's cost of capital of 10% (workings not shown).
Requirement
Calculate the net terminal value of the project.
Solution
The net terminal value can be determined directly from the NPV, or by calculating the cash
surplus at the end of the project.
Assume that the £5,000 for the project is borrowed at an annual interest rate of 10% and that
cash flows from the project are used to repay the loan.
£
Loan balance outstanding at beginning of project 5,000
Interest in Year 1 at 10% 500
Repaid at end of Year 1 (3,000)
Balance outstanding at end of Year 1 2,500
Interest Year 2 250
Repaid Year 2 (2,600)
Balance outstanding Year 2 150
Interest Year 3 15
Repaid Year 3 (6,200)
Cash surplus at end of project 6,035
The net terminal value is £6,035.

Check
NPV = £6,035 × 0.751 (10% discount factor for year 3) = £4,532
Allowing for the rounding errors caused by three figure discount tables, this is the correct figure
for the NPV.
4.9 Advantages of NPV

The advantages of NPV are as follows.
 It is directly linked to the assumed objective of maximising shareholder wealth as it
measures, in absolute (£) terms, the effect of taking on the project now, ie, Year 0.
 It considers the time value of money, ie, the further away the cash flow the less it is worth in
present terms.
 It considers all relevant cash flows, so that it is unaffected by the accounting policies which
cloud profit-based investment appraisal techniques such as ARR.
 Risk can be incorporated into decision making by adjusting the company's discount rate.
 It provides clear, unambiguous decisions, ie, if the NPV is positive, accept; if it is negative,
reject.

Interactive question 3: Non-standard discount factors
A project has the following forecast cash flows.
Year £
0 (280,000)
1 149,000
2 128,000
3 84,000
4 70,000
Requirement
Using two decimal places in all discount factors, complete the following table to calculate the
net present value of the project at a cost of capital of 16.5%.
Cash flow Present value

Year 16.5% discount factor
£ £
0
1
2
3
4
Net present value
4.10 The time value of money

DCF is a project appraisal technique that is based on the concept of the time value of money,
that £1 earned or spent sooner is worth more than £1 earned or spent later. Various reasons
could be suggested as to why a present £1 is worth more than a future £1.
 Uncertainty. The business world is full of risk and uncertainty, and although there might be
the promise of money to come in the future, it can never be certain that the money will be
received until it has actually been paid. This is an important argument, and risk and
uncertainty must always be considered in investment appraisal. But this argument does not
explain why the discounted cash flow technique should be used to reflect the time value of
money.
 Inflation. Because of inflation it is common sense that £1 now is worth more than £1 in the
future. It is important, however, that the problem of inflation should not confuse the
meaning of DCF, and the following points should be noted.
– If there were no inflation at all, discounted cash flow techniques would still be used for
investment appraisal.
– Inflation, for the moment, has been completely ignored.
– It is obviously necessary to allow for inflation.
 An individual attaches more weight to current pleasures than to future ones, and would
rather have £1 to spend now than £1 in a year's time. Individuals have the choice of
consuming or investing their wealth and so the return from projects must be sufficient to
persuade individuals to prefer to invest now. Discounting is a measure of this time
preference.

 Money is invested now to make profits (more money or wealth) in the future. Discounted
cash flow techniques can therefore be used to measure either of two things. C
H
– What alternative uses of the money would earn (NPV method) (assuming that money A
P
can be invested elsewhere at the cost of capital). T
E
– What the money is expected to earn (IRR method – this is to be covered in the next
R
section of this chapter).
11
4.11 Advantages of DCF methods of appraisal
Taking account of the time value of money (by discounting) is one of the principal advantages of
the DCF appraisal method. Other advantages include the following.
 the method uses all cash flows relating to the project.
 it allows for the timing of the cash flows.
 there are universally accepted methods of calculating the NPV and IRR.
4.12 A comparison of the ROI and NPV methods

In Chapter 8 we saw that managers are often judged on the return on investment (ROI) of their
division or responsibility centre which is very similar in principle to the ARR. Managers will only
want to invest in projects that increase divisional ROI but sometimes such a strategy may not
correspond with the decision that would be arrived at if NPV were used to appraise the
investment.
For example, suppose that Division M is considering an investment of £200,000 which will
provide a net cash inflow (before depreciation) of £78,000 each year for the four years of its life.
It is group policy that investments must show a minimum return of 15%.
As the working below shows, using net book value (NBV) at the start of each year and
depreciating on a straight line basis to a nil residual value, in Year 1 the ROI would be below the
target rate of return of 15%. If management were to take a short-term view of the situation, the
investment would be rejected if the ROI measure were to be used, despite the fact that the
investment's NPV is positive and that in Years 2 to 4 the ROI is greater than the target rate of
return.
Years
1 2 3 4
£ £ £ £
NBV of investment at start of year 200,000 150,000 100,000 50,000
Cash flow (before depreciation) 78,000 78,000 78,000 78,000

Less depreciation (50,000) (50,000) (50,000) (50,000)
Net profit 28,000 28,000 28,000 28,000
ROI 14.00% 18.67% 28.00% 56.00%
Net present value = – £200,000 + (£78,000 × 2.855) = £22,690.
4.13 Discounted payback

The payback method can be combined with DCF to calculate a discounted payback period.
The discounted payback period (DPP) is the time it will take before a project's cumulative NPV
turns from being negative to being positive.

Worked example: Discounted payback
If we have a cost of capital of 10% and a project with the cash flows shown below, we can
calculate a discounted payback period.
Discount Present Cumulative
Year Cash flow factor value NPV
£ 10% £ £
0 (100,000) 1.000 (100,000) (100,000)
1 30,000 0.909 27,270 (72,730)
2 50,000 0.826 41,300 (31,430)
3 40,000 0.751 30,040 (1,390)
4 30,000 0.683 20,490 19,100
5 20,000 0.621 12,420 31,520
NPV = 31,520
The DPP is early in Year 4.

A company can set a target DPP, and choose not to undertake any projects with a DPP in excess
of a certain number of years, say five years.
4.13.1 Advantages and disadvantages of discounted payback period

The approach has all the perceived advantages of the payback period method of investment
appraisal: it is easy to understand and calculate, and it provides a focus on liquidity where this is
relevant. In addition, however, it also takes into account the time value of money. It therefore
bridges the gap between the theoretically superior NPV method and the regular payback period
method.
Because the DPP approach takes the time value of money into consideration, it produces a
longer payback period than the non-discounted payback approach, and takes into account
more of the project's cash flows.
Another advantage it has over traditional payback is that it has a clear accept-or-reject criterion.
Using payback, acceptance of a project depends on an arbitrarily determined cut-off time. Using
DPP, a project is acceptable if it pays back within its lifetime (because it has a positive NPV).
DPP still shares one disadvantage with the payback period method: cash flows which occur after
the payback period are ignored (although as the DPP is longer than the payback period, fewer
of these are ignored).
4.14 The discount rate

Throughout our study of DCF techniques we have been using the same discount rate across all
years of the project under consideration, on the assumption that the cost of capital will remain
the same over the life of the project. There are a range of factors that influence the cost of
capital, however, including inflation and interest rates, and these can fluctuate widely over fairly
short periods of time. An organisation may therefore wish to use different discount rates at
different points over the life of a project to reflect this. This is possible if NPV and discounted
payback methods of appraisal are being used, but IRR (see section 5) and ARR methods are
based on a single rate.
Another problem is deciding on the correct rate in the first place. This is difficult enough in year
one of a project's life, but even more problematic five years later, say, because of economic
changes and so on.

4.15 Other aspects of discounting
C
Now that we have learned about the basics of the discounted cash flow technique we can move H
A
on to consider some of the complications that might arise.
P
T
4.15.1 Delayed annuities E
A company may take out a loan, agreeing to repay it in equal annual instalments (ie, an annuity) R
but starting at the end of Year 2, so that the first cash flow does not occur until after Year 1. As 11
annuity factor tables work on the assumption that the first cash flow occurs at the end of Year 1,
care will be needed when using the tables. Remember that if an annuity factor from the table is
used, the present value of the annuity stream is being found one period before the first annuity
flow, so further discounting will be needed to find the present value at Year 0.
4.15.2 Annuities in advance
When, for example, a firm leases vans for its business, the lease payments are usually paid in
advance, ie, the first cash flow occurs in Year 0. This is a combination of a normal annuity starting
at Year 1 plus an extra sum now which does not need to be discounted.
Worked example: Annuities in advance and delayed annuities

What is the present value of £1,000 received annually for five years if the first receipt is:
(a) in one year's time?
(b) now?
(c) in three years' time?
Use a discount rate of 15%.
Solution
(a) Present value = £1,000 × annuity factor for five years at 15%
= £1,000 × 3.352 = £3,352
(b) Only the cash flows at the end of Years 1 to 4 need discounting.
Present value = £1,000 received now + (£1,000 × annuity factor for four years at 15%)
= £1,000 + (£1,000 × 2.855)
= £3,855
(c) This can be solved in two possible ways.
(1) Present value = £1,000 × (annuity factor for seven years – annuity factor for two
years)
This leaves the cash flows for Years 3, 4, 5, 6 and 7 being discounted.
= £1,000 × (4.160 – 1.626)
= £2,534
(2) Present value of annuity at end of Year 2 = £1,000 × 3.352
= £3,352
Now this must be discounted again to bring it back to the present value at year 0 (now).
Present value = £3,352 × PV factor for Year 2 at 15%
= £3,352 × 0.756
= £2,534

4.15.3 Annual cash flows in perpetuity
A perpetuity is an equal annual cash flow forever, ie, an annuity that lasts forever.
£a
The present value of a perpetuity of £a per annum forever is calculated as , where r is the
r
annual discount rate. This formula finds the present value of the perpetuity stream one year
before the first cash flow.
Worked example: Perpetuities

(a) What is the present value of £3,000 received in one year's time and forever if the annual
interest rate is 10%?
(b) What would be the present value if the first receipt is in four years' time?
Solution
(a) Present value = £3,000/0.10
= £30,000
(b) Present value one year before the first cash flow = at end of Year 3
= £3,000/0.10
= £30,000
Present value at year 0 = £3,000 × Year 3 10% discount factor
= £30,000 × 0.751
= £22,530
4.15.4 Changing discount rates

If the discount rate changes over time the net present value is calculated as follows
Year 0 Year 1 Year 2
NPV = outflow + inflow/(1+r1) + inflow/(1+r1)(1+r2) etc
Where r1 = interest rate for Year 1

r2 = interest rate for Year 2
Worked example: Changing discount rates

A project's estimated cash flows are as follows.
Year 0 Year 1 Year 2
£m £m £m
Cash flow (10) 6 8
Requirement
Calculate the NPV if the cost of capital is 10% for the first year and 20% for the second year.
Solution
£6m £8m
NPV = (£10m) + + = £1.52m
1.10 1.10 ×1.20

5 The internal rate of return method C
H
A
Section overview P
T
 The internal rate of return (IRR) is the DCF rate of return that a project is expected to E
achieve. It is the discount rate at which the NPV is zero. R
 If the IRR exceeds a target rate of return, the project would be worth undertaking. 11
 The IRR can be estimated from a graph of the project's NPV profile. The IRR can be read
from the graph at the point on the horizontal axis where the NPV is zero.
NPVa
 The IRR interpolation formula is IRR = a + (b  a)
NPVa  NPVb
 The IRR method has a number of disadvantages compared with the NPV method.
– It ignores the relative size of the investments.
– There are problems with its use when a project has non-conventional cash flows or
when deciding between mutually exclusive projects.
– Discount rates which differ over the life of a project cannot be incorporated into IRR
calculations.
5.1 The internal rate of return

Another discounted cash flow (DCF) technique for appraising capital projects involves
calculating the internal rate of return (IRR). The IRR is a relative measure (%) in contrast to the
absolute (£) measure resulting from NPV calculations.
The IRR is the DCF rate of return (DCF yield) that a project is expected to achieve, in other words
the discount rate at which the NPV is zero.
If the IRR exceeds a target rate of return, the project would be worth undertaking.
5.2 Graphical approach

The easiest way to estimate the IRR of a project is to find the project's NPV at a number of costs
of capital and sketch a graph of NPV against discount rate. The graph can be used to estimate
the discount rate at which the NPV is equal to zero (the point where the curve cuts the axis).
Worked example: Graphical approach

A project might have the following NPVs at the following discount rates.
Discount rate NPV
% £
5 5,300
10 700
15 (1,500)
20 (3,200)
This could be sketched on a graph as follows.

NPV
£’000 6
Discount
0
rate %
5 10 15 20
–
–2
–3
–4
The IRR can be estimated as 13%. The NPV should then be recalculated using this interest rate.
The resulting NPV should be equal to, or very near, zero. If it is not, extra NPVs at different
discount rates should be calculated, the graph resketched and a more accurate IRR determined.
5.3 Interpolation method

If we are appraising a 'typical' capital project, with a 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. It would look like this.
NPV
Positive IRR
0
Cost of capital %
Negative
Figure 11.1: NPV at different costs of capital

If we determine a cost of capital where the NPV is (slightly) positive, and another cost of capital
where it is (slightly) negative, we can estimate the IRR – where the NPV is zero – by drawing a
straight line between the two points on the graph that we have calculated.

C
NPV Q H
A
P A P
Positive T
B E
R
0
Cost of capital % 11
True IRR
Negative
P
Q
Figure 11.2: Estimating the IRR

 If we establish the NPVs at the two points P, we would estimate the IRR to be at point A.
 If we establish the NPVs at the two points Q, we would estimate the IRR to be at point B.
The closer our NPVs are to zero, the closer our estimate will be to the true IRR.
The interpolation method assumes that the NPV rises in linear fashion between the two NPVs
close to zero. The real rate of return is therefore assumed to be on a straight line between the
two points at which the NPV is calculated.
The IRR interpolation formula to apply is:
NPVa
IRR = a + (b  a)
NPVa  NPVb
where a is the first discount rate giving NPVa
b is the second discount rate giving NPVb
Worked example: The IRR method and interpolation

A company is trying to decide whether to buy a machine for £80,000 which will save costs of
£20,000 per annum for five years and which will have a resale value of £10,000 at the end of
Year 5.
Requirement
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 using the IRR method whether this project should be undertaken.
Solution
The first step is to calculate two net present values, both as close as possible to zero, using rates
for the cost of capital which are whole numbers. Ideally one NPV should be positive and the
other negative although the formula will work with two positive or two negative NPVs
(extrapolation).
Choosing rates for the cost of capital which will give an NPV close to zero (that is, rates which
are close to the actual rate of return) is a hit and miss exercise, and several attempts may be
needed to find satisfactory rates. As a rough guide, try starting at a return figure which is about
two thirds or three quarters of the ARR.
Annual depreciation would be £(80,000 – 10,000)/5 = £14,000.
The ARR would be (£20,000 – depreciation of £14,000)/(½ of £(80,000 + 10,000)) =
£6,000/£45,000 = 13.3%.

Two thirds of this is 8.9% and so we can start by trying 9%. The discounted tables do not provide
discount factors for an interest rate of 9% therefore we need to calculate our own factors.
Using the formula provided at the top of the final column in the tables:
1 1 
PV of an annuity = 1–
r  (1+r)n 
1  1 
PV factor for 5 years at 9% = 1 – 
0.09  (1.09)5 
= 3.89
1
PV factor at 9% for year 5 =
(1.09)5
= 0.65
We can use these factors to discount the cash flows.
Try 9% Year Cash flow PV factor PV of cash flow
£ 9% £
0 (80,000) 1.00 (80,000)
1–5 20,000 3.89 77,800
5 10,000 0.65 6,500
NPV 4,300
This is fairly close to zero. It is also positive, which means that the internal rate of return is more
than 9%. We can use 9% as one of our two NPVs close to zero, although for greater accuracy, we
should try 10% or even 11% to find an NPV even closer to zero if we can. As a guess, it might be
worth trying 12% next, to see what the NPV is. Again we will need to calculate our own discount
factors.
1  1 
PV factor for 5 years at 12% = 1

0.12  (1.12)5 
= 3.605
1
PV factor at 12% for year 5 = = 0.567
(1.12)5
Try 12% Year Cash flow PV factor PV of cash flow
£ 12% £
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 internal rate of return is therefore greater than 9%
(positive NPV of £4,300) but less than 12% (negative NPV of £2,230).
Note: If the first NPV is positive, choose a higher rate for the next calculation to get a negative
NPV. If the first NPV is negative, choose a lower rate for the next calculation.
 4,300 
So IRR = 9 +  × (12  9)  % = 10.98%, say 11%
 4,300 + 2,230 
If it is company policy to undertake investments which are expected to yield 10% or more, this
project would be undertaken. An alternative approach would be to calculate the NPV at 10%. As
it would be positive it would tell us that the IRR is greater than 10% and therefore the project
should be accepted.

Interactive question 4: IRR
C
Calculate the IRR of the project below and complete the box at the end of the question. H
A
Time £ P
0 Investment (4,000) T
1 Receipts 1,200 E
R
2 Receipts 1,410
3 Receipts 1,875 11
4 Receipts 1,150
The project IRR is %

5.4 NPV and IRR compared

The IRR method has a number of advantages and disadvantages when compared with the NPV
method.
5.4.1 Advantages of IRR method
 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%'.
 A discount rate does not have to be specified before the IRR can be calculated. A hurdle
discount rate is simply required which is then compared with the IRR.
5.4.2 Disadvantages of IRR method
 If managers were given information about both ARR and IRR, it might be easy to get their
relative meaning and significance mixed up.
 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 (10 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.
 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.
 There are problems with using the IRR when the project has non-conventional cash flows
(see section 5.5) or when deciding between mutually exclusive projects (see section 5.6).

5.5 Non-conventional cash flows
The projects we have considered so far have had conventional or normal cash flows (an initial
cash outflow followed by a series of inflows) and in such circumstances the NPV and IRR
methods give the same accept or reject decision. When flows vary from this they are termed
non-conventional. The following project has non-conventional cash flows.
Year Project X
£'000
0 (1,900)
1 4,590
2 (2,735)
Project X has two IRRs as shown by the diagram which follows.
NPV
£'000 40
30
20
Positive
10
0
Cost of
5 10 20 30 40 capital %
–10
Negative
–20
–30
–40
Figure 11.3: Non-conventional cash flows

Suppose that the required rate of return on project X is 10% but that the IRR of 7% is used to
decide whether to accept or reject the project. The project would be rejected since it appears
that it can only yield 7%. The diagram shows, however, that between rates of 7% and 35% the
project should be accepted. Using the IRR of 35% would produce the correct decision to accept
the project. Lack of knowledge of multiple IRRs could therefore lead to serious errors in the
decision of whether to accept or reject a project.
In general, if the sign of the net cash flow changes in successive periods (inflow to outflow or
vice versa), it is possible for the calculations to produce up to as many IRRs as there are sign
changes.
The use of the IRR is therefore not recommended in circumstances in which there are non-
conventional cash flow patterns (unless the decision maker is aware of the existence of multiple
IRRs). The NPV method, on the other hand, gives clear, unambiguous results whatever the cash
flow pattern.
Before moving on to the worked example you might like to check that the IRRs of project X are
indeed 7% and 35%. Apply the relevant discount factors to the project cash flows and on both
occasions you should arrive at an NPV of approximately zero.

Worked example: Sketching an NPV graph with non-conventional cash flows
C
Two projects have estimated cash flows as follows. H
A
Year 0 Year 1 Year 2 IRR P
£ £ £ T
Project C (4,000) 25,000 (25,000) 25% and 400% E
R
Project D 1,000 (1,600) 1,200 –
11
To clear up the confusion about whether the projects are acceptable when using IRR draw a
graph. To find the starting point on the vertical axis find the NPV at 0% (ie, add up the cash flows).
NPV +
600 D
Discount rate
0%
25% 400%
NPV –
4,000
Project C is acceptable for discount rates between 25% and 400%.

The graph for project D starts at +600 on the vertical axis (the NPV at 0% = the sum of the cash
flows). The graph does not cut the horizontal axis at all because there is no IRR. Therefore, the
IRR decision rule cannot be used for project D.
5.6 Mutually exclusive projects

The IRR and NPV methods can give conflicting rankings when assessing which project should be
given priority. Let us suppose that a company with a cost of capital of 16% is considering two
mutually exclusive options, option A and option B. The cash flows for each are as follows.
Year Option A Option B
£ £
0 Capital outlay (10,200) (35,250)
1 Net cash inflow 6,000 18,000
1
The NPV of each project is calculated below. Use the formula to calculate the discount
(1+r)n
factors.

Option A Option B
Cash Present Cash Present
Year Discount factor
flow value flow value
16% £ £ £ £
0 1.000 (10,200) (10,200) (35,250) (35,250)
1 0.862 6,000 5,172 18,000 15,516
2 0.743 5,000 3,715 15,000 11,145
3 0.641 3,000 1,923 15,000 9,615
NPV = + 610 NPV = + 1,026
The IRR of option A is 20%, while the IRR of option B is only 18% (workings not shown).
On a comparison of NPVs, option B would be preferred, but on a comparison of IRRs, option A
would be preferred.
The preference should go to option B because with the higher NPV it creates more wealth than
option A.
Interactive question 5: Sketching NPV profiles
Use the working table below to deduce the data required to sketch the NPV profiles of projects
A and B on the scales provided. At what discount rate do the two projects earn the same NPV?
Cash flows NPV at NPV at NPV at

Project Year 0 Year 1 IRR 0% 10% 30%
£ £ £ £ £
A (1,000) 1,250 25%
B (100) 140 40%
Sketch of the NPV profiles
NPV
250
200
100
0
10 20 30 40 50 Discount
rate %
–50

5.7 Reinvestment assumption
C
An assumption underlying the NPV method is that any net cash inflows generated during the life H
A
of the project will be reinvested elsewhere at the cost of capital (that is, the discount rate). The
P
IRR method, on the other hand, assumes these cash flows can be reinvested elsewhere to earn a T
return equal to the IRR of the original project. E
R
In the example in section 5.6, the NPV method assumes that the cash inflows of £6,000, £5,000
and £3,000 for option A will be reinvested at the cost of capital of 16% whereas the IRR method 11
assumes they will be reinvested at 20%. If the IRR is considerably higher than the cost of capital
this is an unlikely assumption. In theory, a firm will have accepted all projects which provide a
return in excess of the cost of capital and any other funds which become available can only be
reinvested at the cost of capital. (This is the assumption implied in the NPV rule.) If the
assumption is not valid the IRR method overestimates the real return.

Summary
Investment appraisal
Discounted cash Non-discounting

flow techniques techniques
Discounted
Allowing for the
payback Accounting
time value of money period Payback rate of
method return (ARR)
Net present Internal rate Uses

value (NPV) of return (IRR) Uses cash accounting
flows profits
Inconsistency between
NPV and IRR as
decision tools
Superiority of NPV

Self-test
C
A
1 The payback period takes some account of the time value of money by: P
T
A placing greatest value on £1 receivable in the first year and progressively less on £1 E
received in each subsequent year R
B placing least value on £1 receivable in the first year and progressively more on £1 11
received in each subsequent year
C placing the same value on £1 receivable up to the payback period and no value on
subsequent receipts
D placing the same value on each £1 receivable over the life of a project
2 A project has the following cash flows.
Year £
0 (40,000)
1 15,000
2 15,000
3 15,000
4 15,000
If the company were to discover that the cash inflow in year 4 had been overestimated, what
would be the effect on the project's internal rate of return (IRR) and payback period if the
error were corrected?
IRR Payback period
A Decrease No change
B Decrease Increase
C Increase No change
D Increase Increase
3 A project requires an initial investment in equipment of £100,000 and will produce eight
equal annual cash flows of £40,000. The investment has no scrap value and straight line
depreciation is used.
What are the payback period and accounting rate of return (ARR), based on the initial
investment?
Payback ARR
A 2 years 6 months 27.5%

B 2 years 6 months 40%
C 3 years 6 months 27.5%
D 3 years 6 months 40%

4 £50,000 is to be spent on a machine having a life of five years and a residual value of
£5,000. Operating cash inflows will be the same each year, except for Year 1 when the
figure will be £6,000. The accounting rate of return on the initial investment has been
calculated at 30% pa.
What is the payback period?
A 2.75 years
B 2.55 years
C 2.54 years
D 2.33 years
5 A firm has two projects available. Project 1 has two internal rates of return of 15% and 30%,
and project 2 has two internal rates of return of 10% and 20%. At a zero discount rate
project 1 has a positive NPV and project 2 has a negative NPV. The appropriate discount
rate for both projects is 25%.
Which of the following decisions about projects 1 and 2 should be taken?
Project 1 Project 2
A Accept Accept
B Accept Reject
C Reject Accept
D Reject Reject
6 A project has a normal pattern of cash flows (ie, an initial outflow followed by several years
of inflows).
What would be the effects of an increase in the company's cost of capital on the internal
rate of return (IRR) of the project and its payback period?
IRR Payback period
A Increase Increase
B Increase No change
C No change Increase
D No change No change
7 Which two of the following statements about the use of IRR as an investment appraisal
method are incorrect?
A It always establishes if a single project is worthwhile
B It always establishes which of several projects to accept
C It ignores the relative size of the investment

8 Consider the following graph.
C
NPV H
A
P
T
Pro E
jec R
tX
11
Proj
ect Y
0 15% Discount rate

Which of the following statements is true?
A Project Y has a higher internal rate of return than project X
B At a discount rate of less than 15%, project Y is preferred to project X
C Project X is preferred to project Y irrespective of the discount rate
D Project Y is preferred to project X irrespective of the discount rate
9 A firm is evaluating the following four mutually-exclusive projects. All four projects involve
the same initial outlay and have positive net present values. The projects generate the
following cash inflows during their lives:
Year 1 Year 2 Year 3 Year 4
£ £ £ £
Project A 500 400 600 300
Project B 300 600 500 400
Project C 500 300 600 400
Project D 300 500 600 400
Which project should be chosen?
A Project A
B Project B
C Project C
D Project D
10 An investment of £100,000 now is expected to generate equal annual cash flows to
perpetuity of £15,000 pa, commencing in five years' time.
If the discount rate is 10% pa, what is the net present value of the investment (to the nearest
£10)?
A – £15,330
B – £6,860
C + £2,450
D + £50,000

Item X Item Y
£ £
Total profit over life of equipment:
Before depreciation 160,000 280,000
After depreciation 80,000 130,000
Average annual accounting profit 16,000 26,000
Average investment = (capital cost + disposal value)/2 60,000 100,000
ARR, based on average investment 26.7% 26%
The equipment that should be purchased is item X .
Both projects would earn a return in excess of 25%, but since item X would earn a bigger ARR, it
would be preferred to item Y, even though the profits from Y would be higher by an average of
£10,000 a year.

Year Multiplied by 12% discount factor
£ £
1
2 40,000 = 0.797 31,880
(1.12)2
1
3 30,000 = 0.712 21,360
(1.12)3
Total present value 53,240

Year 16.5% discount factor
£ £
0 (280,000) 1.00 (280,000)
1
1 149,000 = 0.86 128,140
(1.165)
1
2 128,000 = 0.74 94,720
(1.165)2
1
3 84,000 = 0.63 52,920
(1.165)3
1
4 70,000 = 0.54 37,800
(1.165) 4
Net present value 33,580

C
The project IRR is 15% . H
A
The total receipts are £5,635 giving a total profit of £1,635 and average profits of £409. The P
average investment is £2,000. The ARR is £409  £2,000 = 20%. Two thirds of the ARR is T
E
approximately 14%. The initial estimate of the IRR that we shall try is therefore 14%. R
Try 14% Try 16%
11
Discount Discount
Time Cash flow factor PV factor PV
£ 14% £ 16% £
0 (4,000) 1.000 (4,000) 1.000 (4,000)
1 1,200 0.877 1,052 0.862 1,034
2 1,410 0.769 1,084 0.743 1,048
3 1,875 0.675 1,266 0.641 1,202
4 1,150 0.592 681 0.552 635
NPV 83 NPV (81)
The IRR must be less than 16%, but higher than 14%. The NPVs at these two costs of capital will
be used to estimate the IRR.
Using the interpolation formula
 83 
IRR = 14% +  × (16% – 14%)  = 15.01%
 83 + 81 
The IRR is, in fact, exactly 15%.
Cash flows NPV at NPV at NPV at

Project Year 0 Year 1 IRR 0% 10% 30%
£ £ £ £ £
A (1,000) 1,250 25% 250 136 (38)
B (100) 140 40% 40 27 8
NPV
250
200
100
40
0
10 20 30 40 B 50 Discount
A rate %
–50
The two projects earn the same NPV at the point where the lines intersect, which is at a discount
rate of approximately 23%.

1 C Statement A describes how DCF methods account for the time of money. Statement B
is the reverse of statement A and is incorrect because it is not taking account of the
time value of money at all.
Statement D is incorrect because the payback method ignores cash flows after the
payback period.
2 A The payback period is not affected because the Year 4 cash flow occurs after the
payback period, however the IRR would be reduced because of the lower cash inflow
in Year 4.
£100,000
3 A Payback period =
£40,000
= 2.5 years
£100,000
Annual depreciation =
8
= £12,500
Annual profit = £40,000 – £12,500
= £27,500
£27,500
ARR = × 100%
£100,000
= 27.5%
Average profit
4 C ARR = × 100
Initial investment
Average profit
0.3 =
£50,000
Average profit = 0.3 × £50,000

= £15,000
Total profit for five years = 5 × £15,000
= £75,000
Total cash inflows equals total
profit plus total depreciation = £(75,000 + 45,000)
= £120,000
Cash inflow for year 1 = £6,000
Cash flow, years 2 to 5 = £114,000
Annual inflow, years 2 to 5 = £28,500
£(50,000 – 6,000)
Payback period = 1+
£28,500
= 2.54 years

5 D The NPV profiles can be sketched as follows.
C
Project 1 Project 2 H
NPV NPV
A
P
T
E
R
11
15 30 i 10 20 i
At a discount rate of 25%, both projects have a negative NPV therefore they should be
rejected.
6 D Both the internal rate of return and the payback period are independent of the cost of
capital.
7 A, B
A is not true because IRR cannot be used to assess projects that do not have an IRR.
B is not true because NPV is used for mutually exclusive projects.
8 A Statement A is correct because the NPV profile of project Y crosses the horizontal axis
at a higher discount rate than that for project X.
Statement B is incorrect because at discount rates less than 15% project X has a higher
NPV and is therefore preferred.
Statements C and D are incorrect because at discount rates less than 15% project X is
preferred, whereas at rates greater than 15% project Y is preferred.
9 A By a comparison of the cash flows A is better than C (it gives the same inflows in Year 1
and Year 3, but returns £100 higher in Year 2 and £100 lower in Year 4).
B is also better than D (same flows in Years 1 and 4, but returns £100 more in Year 2,
and £100 less in Year 3).
By a similar argument A is better than B; therefore A is the preferred project.
 £15,000 
10 C –£100,000 +  × 0.683 (Year 4 factor at 10%) = £2,450
 0.1 

APPENDIX
Discount tables
DISCOUNT TABLES
Interest Number of Present value of Present value of £1
rate years £1 receivable at receivable at the end
p.a. n the end of n years of each of n years
1 1 
r 1 – 
r  (1+r) n 
1% 1 0.990 0.990
2 0.980 1.970
3 0.971 2.941
4 0.961 3.902
5 0.951 4.853
6 0.942 5.795
7 0.933 6.728
8 0.923 7.652
9 0.914 8.566
10 0.905 9.471
5% 1 0.952 0.952
2 0.907 1.859
3 0.864 2.723
4 0.823 3.546
5 0.784 4.329
6 0.746 5.076
7 0.711 5.786
8 0.677 6.463
9 0.645 7.108
10 0.614 7.722
10% 1 0.909 0.909

2 0.826 1.736
3 0.751 2.487
4 0.683 3.170
5 0.621 3.791
6 0.564 4.355
7 0.513 4.868
8 0.467 5.335
9 0.424 5.759
10 0.386 6.145
15% 1 0.870 0.870

2 0.756 1.626
3 0.658 2.283
4 0.572 2.855
5 0.497 3.352
6 0.432 3.784
7 0.376 4.160
8 0.327 4.487
9 0.284 4.772
10 0.247 5.019
20% 1 0.833 0.833

2 0.694 1.528
3 0.579 2.106
4 0.482 2.589
5 0.402 2.991
6 0.335 3.326
7 0.279 3.605
8 0.233 3.837
9 0.194 4.031
10 0.162 4.192
ICAEW 2019 Appendix: Discount tables 341

Glossary of terms
Absorption costing The direct (or prime) cost of an item plus a fair share of the indirect
(overhead) costs. Also called full costing.
Accounting rate of A measure of the expected average annual accounting profits from an
return investment expressed as a percentage of the value of that investment.
Either the initial or average value of the investment can be used. Also
called return on investment (ROI) or return on capital employed (ROCE).
Activity based An approach to budgeting which uses cost drivers as a basis for
budgeting (ABB) preparing budgets.
Activity based costing An alternative to traditional absorption costing where overheads are
(ABC) related to output using multiple cost drivers (activities which cause the
overheads).
Allocation The process by which overheads are charged directly to cost centres.
Annuity A constant annual cash flow, for a number of years.
Apportionment A procedure where indirect (overhead) costs are spread fairly between
cost centres.
Avoidable costs Costs which would not be incurred if the activity to which they relate did
not exist.
Balanced scorecard An approach to the provision of information to management to help
approach strategic policy formulation and achievement. It emphasises the need to
provide the user with a set of information which addresses all relevant
areas of performance in an objective and unbiased fashion. The
information provided may include both financial and non-financial
elements, and cover areas such as profitability, customer satisfaction,
internal efficiency and learning and growth.
Batch costing A costing method applied where a group (batch) of identical items is
treated as a cost unit. The cost per item = total batch cost ÷ number of
items in the batch.
Big data Very large volumes of data too big for usual software to manage.
Blanket absorption An absorption rate used throughout a factory for all products
rate irrespective of the department in which they were produced.
Bottom-up budgeting See participative budgeting.
Breakeven analysis See cost-volume-profit analysis.
Breakeven point Number of units sold at which neither a profit nor a loss is made.
Budget A quantitative statement, for a defined period of time, which may
include planned revenues, expenses, assets, liabilities and cash flows.
Budget manual A collection of instructions governing the responsibilities of persons
and the procedures, forms and records relating to the preparation and
use of budgetary data.
Budget slack Deliberately underestimating revenues or overestimating costs in order
to ensure that achieving the budget is easy.
Capital expenditure Expenditure which results in the acquisition of long-term assets or an
improvement in their earning capacity.
Cash budget A statement in which estimated future cash receipts and payments are
tabulated in such a way as to show the forecast cash balance of a
business at defined intervals.
ICAEW 2019 Glossary of terms 345

Cash operating cycle The period of time which elapses between the point at which cash
begins to be spent on the production of a product and the collection of
cash from the customer who purchases it.
Cloud accounting An application of cloud computing where accountancy software is
provided in the cloud by a service provider.
Cloud computing Using a network of remote servers rather than a local server.
Coefficient of Measures the degree to which one variable is related to another.
correlation r
2
Coefficient of The square of the correlation coefficient, r . This measures the amount
2
determination r of the total variation in the value of one variable that can be explained
by variations in the value of the other variable.
Contract costing A form of specific order costing where costs are attributed to contracts.
Contribution The difference between the selling price and all of the variable costs of
a product.
Controllable costs Items of expenditure which can be directly influenced by a given
manager within a given time span.
Cost behaviour The way in which costs are affected by changes in the level of activity
where 'activity' can be volume of output, number of production runs
etc.
Cost centre Any part of an organisation which incurs costs.
Cost driver Something which causes costs to change eg, volume of output, number
of production runs etc.
Cost object Something (eg, product, service, activity) in relation to which costs are
determined.
Cost plus pricing A desired profit mark-up is added to total costs to arrive at the selling
price.
Cost pool A grouping of costs relating to a particular activity in an activity-based
costing system.
Cost unit A unit of product or service in relation to which costs are ascertained.
Cost-volume-profit An analysis of costs, volume and profit at various levels of activity. Also
(CVP) analysis known as breakeven analysis.
Cumulative weighted An inventory valuation method that calculates a weighted average cost
average pricing from both opening inventory and units introduced in the current period.
The average is calculated whenever a new delivery occurs.
Current ratio Current assets ÷ current liabilities.
Curvilinear correlation A relationship between variables which appears as a curve when drawn
on a graph.
Data analytics The process of collecting, organising and analysing large sets of data to
discover patterns and other information which an organisation can use
for its future business decisions
Data mining The process of sorting through data to identify patterns and
relationships between different items.

Decentralisation When managers of divisions have freedom to make certain decisions
relating to their division (as opposed to decisions being made centrally
by a head office).
Development costs The costs incurred between the decision to produce a new or improved
product and the commencement of full manufacture of the product.
Differential cost The difference in total cost between alternatives.
Direct cost A cost that can be traced in full to the product, service, or department
that is incurring the cost.
Direct labour cost The specific costs of the workforce used to make a product or provide a
service. Direct labour costs are established by measuring the time taken
for a job, or the time taken in 'direct production work'.
Direct labour The difference between the hours that should have been worked for the
efficiency variance number of units actually produced, and the actual number of hours
worked, valued at the standard labour rate per hour.
Direct labour rate The difference between the standard cost and the actual cost for the
variance actual number of hours paid for.
Direct labour total The difference between what the output actually cost and what it should
variance have cost, in terms of labour.
Direct material costs The costs of materials that are known to have been used in making and
selling a product, or providing a service.
Direct material price The difference between the standard cost and the actual cost for the
variance actual quantity of material used or purchased.
Direct material total The difference between what the output actually cost and what it should
variance have cost, in terms of material used.
Direct material usage The difference between the standard quantity of materials that should
variance have been used for the number of units actually produced, and the
actual quantity of materials used, valued at the standard cost per unit of
material.
Discounted cash flow Converting future sums of money to their present value, which is the
cash equivalent now of those future sums.
Discounted payback How long it will take for a project to pay back the capital outlay on a
method discounted cash flow basis.
Economic order The order quantity which minimises inventory costs. The EOQ can be
quantity (EOQ) calculated using a table, graph or formula.
Extrapolation Predicting costs at activity levels outside the relevant range.
Factoring organisation Takes over the management of the trade debts owed to its client (a
business customer) on the client's behalf. The factor company collects
the debts and provides an immediate cash advance of a proportion of
the money it is due to collect.
FIFO (first in, first out) A method of pricing materials based on the cost of the oldest units held
regardless of the sequence in which the issue of the materials takes
place.
Financing costs Costs incurred to finance a business such as loan interest.
Fixed budget A budget which is set for a single activity level.

Fixed cost A cost which is incurred for a particular period of time and which, within
certain activity levels (the relevant range), is unaffected by changes in
the level of activity.
Fixed overhead The difference between the budgeted fixed overhead expenditure and
expenditure variance actual fixed overhead expenditure.
Flexible budget A budget which, by recognising different cost behaviour patterns, is
designed to change as volume of activity changes.
Full cost-plus pricing A method of determining the sales price by calculating the full
(absorption) cost of the product and adding a percentage mark-up for
profit.
Functional budgets The budgets for the various functions of the business eg, production,
marketing, sales, purchasing budgets.
Goal congruence When individuals' goals and company goals coincide.
Incremental Basing this year's budget on last year's budget with adjustments for
budgeting changes and inflation.
Imposed budget A budget set without allowing the budget holder to participate in the
budgeting process.
Indirect cost or A cost that is incurred in the course of making a product, providing a
overhead service or running a department, but which cannot be traced directly
and in full to the product, service or department.
International States that the cost of all inventories should comprise those costs which
Accounting Standard have been incurred in the normal course of business in bringing the
2 (IAS 2) inventories to their 'present location and condition'.
Internal rate of return The discount rate at which a project has a zero NPV.
(IRR)
Investment centre A section of an organisation whose manager has some say in
investment policy in their area of operations as well as being
responsible for costs and revenues.
Invoice discounting The purchase (by the provider of the discounting service) of a
company's trade debts, at a discount. Invoice discounting enables a
company to raise finance based on their expected invoice receipts. The
invoice discounter does not take over the administration of the client's
sales ledger so the client remains in control of debt collection.
Job costing The costing method used where work is undertaken to customers'
special requirements and each order is of comparatively short duration.
Just-in-time (JIT) 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 inventory. A JIT system is a 'pull' system, which responds to demand,
in contrast to a 'push' system, in which inventories act as buffers
between the different elements of the system, such as purchasing,
production and sales.
Just-in-time A system which is driven by demand for finished products whereby
production each component on a production line is produced only when needed
for the next stage.
Just-in-time A system in which material purchases are contracted so that the receipt
purchasing and usage of material coincide to the maximum extent possible.

Life cycle costing A costing method that takes into account the costs and revenues of a
product over its entire life span.
LIFO (last in, first out) A method of pricing materials based on the cost of the newest units
held regardless of the sequence in which the issue of the materials
takes place.
Limiting factor Anything which limits the activity of a company.
Linear regression A technique for estimating the equation of a line of best fit.
analysis
Liquidity How quickly an asset can be converted to cash determines its liquidity.
Cash is the most liquid asset.
Management Provide information specifically for the use of managers within an
accounting systems organisation.
Management by Only paying attention to results that are substantially different from
exception expected.
Management control The process by which managers assure that resources are obtained and
used effectively and efficiently in the accomplishment of the
organisation's objectives
Margin of safety The difference in units between the budgeted sales volume and the
breakeven sales volume. It is sometimes expressed as a percentage of
the budgeted sales volume.
Marginal cost The variable cost of one unit of product or service.
Mutually exclusive If two events are mutually exclusive, it means that they cannot occur at
the same time.
Net present value The sum of the present value of the benefits (revenues or savings) from
an investment, less the present value of expenditures. Uses discounted
cash flows (see above).
Operating statement A regular report for management of actual costs and revenues, usually
showing variances from budget.
Opportunity cost The value of the benefit sacrificed when one course of action is chosen
in preference to an alternative.
Outsourcing The use of external suppliers as a source of finished products,
components or services. This is also known as contract manufacturing or
sub-contracting.
Overhead absorption The process whereby overhead costs allocated and apportioned to
production cost centres (in traditional costing systems) or cost pools (in
activity based costing systems) are added to unit, job or batch costs.
Overhead absorption is sometimes called overhead recovery.
Participative Budgeting style which allows all budget holders to participate in setting
budgeting their own budget.
Payback period The time required for the cash inflows from a capital investment project
to equal the cash outflows.
Period cost A cost relating to a period of time.
Perpetuity A constant annual cash flow that continues forever (a perpetual annuity).
Prime costs The sum of all the direct costs.

Principal budget The budgeted factor which limits the activities of an organisation.
factor
Process costing A form of costing applicable to continuous processes where process
costs are attributed to the number of units produced.
Production costs The costs which are incurred by the sequence of operations beginning
with the supply of raw materials, and ending with the completion of the
product ready for warehousing as a finished goods item.
Profit centre Any section of an organisation, for example, a division of a company,
which earns revenue and incurs costs. The profitability of the section
can therefore be measured.
Quick ratio Current assets less inventories ÷ current liabilities
Residual income (RI) Profit less a notional interest charge for invested capital.
Residual value The disposal value of equipment at the end of its life, or its disposal
cost.
Responsibility A system of accounting that makes revenues and costs the
accounting responsibility of particular managers so that the performance of each
part of the organisation can be monitored and assessed.
Responsibility centre A section of an organisation that is headed by a manager who has direct
responsibility for its performance.
Return on capital Also called Return on investment (ROI). Is calculated as (profit/capital
employed (ROCE) employed)  100% and shows how much profit has been made in
relation to the amount of resources invested.
Revenue centre A section of an organisation which creates revenue but has no
responsibility for production. A sales department is an example.
Revenue expenditure Expenditure which is incurred for the purpose of the trade of the
business or to maintain the existing earning capacity of non-current
assets.
Rolling budget A budget continually updated to add a new budget period as the most
recent one has finished.
Sales price variance A measure of the effect on expected profit of a different selling price to
standard selling price. It is calculated as the difference between what
the sales revenue should have been for the actual quantity sold, and
what it actually was.
Sales volume variance The difference between the actual units sold and the budgeted
(planned) quantity, valued at the standard contribution per unit. In other
words, it measures the increase or decrease in standard contribution as
a result of the sales volume being higher or lower than budgeted
(planned).
Scrap Discarded material having some value.
Selling costs Sometimes known as marketing costs, are the costs of creating demand
for products and securing firm orders from customers.
Semi-variable/mixed A cost which contains both fixed and variable components and so is
cost partly affected by changes in the level of activity.
Sensitivity analysis Assesses how sensitive a budget is to changes in the budget
assumptions.

Step fixed cost A cost that is fixed for a certain range of activity but increases to a new
fixed level once a critical level of activity is reached.
Shared service centre A centre responsible for operational tasks such as accounting, for
(SSC) multiple parts of the same organisation.
Structured data Data that is contained within a field in a data record or file (eg,
databases and spreadsheets).
Target costing A process that begins with the development of a product concept and
approach then determination of the price customers would be willing to pay for
that concept. The desired profit margin is deducted from the price,
leaving a figure that represents total cost. This is the target cost.
Time value of money Recognises that £1 today is worth more than £1 at a future time,
because money can be reinvested today to earn more money over time.
Top down budget See imposed budget.
Total quality A philosophy that means that quality management is the aim of every
management part of the organisation. The aim is to 'get it right first time' which means
that there is a striving for continuous improvement in order to eliminate
faulty work and prevent mistakes.
Transfer price The amount charged by one part of an organisation for the provision of
goods or services to another part of the same organisation.
Unstructured data Data that is not easily contained within structured data fields, such as
pictures, videos, webpages, PDF files, emails or blogs.
Variable cost A cost which varies with the level of activity.
Variable production The difference between the hours that should have been worked and
overhead efficiency those actually worked, evaluated at the standard variable overhead rate
variance per hour.
Variable production The difference between the amount of variable production overhead
overhead expenditure that should have been incurred in the actual hours worked, and the
variance actual amount of variable production overhead incurred.
Variable production The difference between what the output actually cost and what it should
overhead total have cost, in terms of variable overheads.
variance
Variance The difference between a planned, budgeted, or standard cost and the
actual cost incurred.
Working capital Current assets less current liabilities (the value of raw materials, work-in-
progress, finished goods inventories, accounts receivable and cash less
accounts payable and overdraft).
Zero-based budgeting Involves preparing a budget for each cost centre from a zero base.
(ZBB) Every item of expenditure has to be justified in its entirety in order to be
included in the next year's budget.

Index
A Contribution ratio, 276
ABC system, 180 Control, 133
Absorption, 59 Control cycle, 205
Absorption costing, 90, 97 Controllable cost, 17, 207
Absorption rate, 59 Coordination, 154
Accounting rate of return, 308 Correlation, 147
Activity based budgets, 157 Cost behaviour patterns, 11
Administration overhead, 10 Cost centres, 51, 210, 211, 216
Annuity, 314, 319 Cost drivers, 66
Assessing the liquidity position via ratios, Cost elements, 9
170 Cost object, 6
Authorisation, 133 Cost of holding cash, 186
Average cost, 35 Cost pools, 66
Cost unit, 7
B Cost-plus pricing, 111
Costs associated with holding inventory,
Balanced scorecard, 222
180
Bank overdrafts, 187
Costs of running out of cash, 187
Batch costing, 70
Cost-volume-profit (CVP) analysis, 275
Big data, 150
Credit control and collection policies, 183
Blanket absorption rates, 62
Credit insurance, 186
Bottom-up style of budgeting, 154
Credit rating, 184
Breakeven analysis, 275
Credit terms, 183
Breakeven charts, 280
Cumulative weighted average pricing, 35
Breakeven point, 275
Current ratio, 173, 216
Budget, 133
Curvilinear correlation, 148
Budget bias, 155, 208
Budget committee, 135
D
Budget constrain, 207
Budget cost allowance, 225 Data analytics, 150
Budget manual, 135 Data mining, 150
Budget officer, 135 DCF yield, 321
Budget period, 135 Decentralisation, 209
Budget preparation, 136 Department budget, 137
Budget slack, 155, 208 Direct cost, 8, 9
Direct expenses, 29
C Direct material, 29
Direct wages, 29
Cash, 169
Discount factors, 312
Cash budget, 156, 188
Discounted cash flow (DCF), 312
Cash budgeting, 187
Discounted payback period, 317
Cash float, 186
Discounting, 311
Cash operating cycle, 175
Distribution overhead, 10
Cash shortages, 187
Divisionalisation, 209
Cloud accounting, 214
Dual pricing, 121
Cloud computing, 214
Coefficient of correlation r, 149, 150, 151,
E
152
Coefficient of determination r2, 149 Economic order quantity system (EOQ), 180
Communication, 133 Exception principle, 207
Composite cost units, 7 Extrapolation, 14
Compounding, 311
Continuous budgets, 155 F
Contract costing, 70 Factoring, 187
Contribution, 87, 275 Feedback, 205, 206
Contribution breakeven chart, 282 FIFO (first in, first out), 33
ICAEW 2019 Index 355

Financial accounting versus cost K
accounting, 4 Key factor, 284
Financing current assets, 170 Key performance indicators (KPIs), 215
Financing trade receivables, 184
Finished goods inventory budget, 137 L
Fixed budgets, 225
Labour budget, 137
Fixed cost, 12 , 87, 97, 225
Labour efficiency variance, 249
Fixed overhead expenditure variance, 253
Labour rate variance, 249
Fixed production overhead, 97
Labour total variance, 249
Flexible budget, 225
Life cycle costing, 72
Forecast, 134
LIFO (last in, first out), 34
Forecasting, 144
Limitations of working capital performance
Full costing, 51, 90
measures, 178
Full cost-plus pricing, 114
Limiting factor, 284
Functional budgets, 136, 139
Linear regression analysis, 147
Fundamental principles, 17, 19
Linear relationship, 144
G
M
Goal congruence, 121, 207, 215, 218
Machine usage budget, 137
Make or buy decisions, 290
H
Management by exception, 244
High-low method, 144, 226 Managerial performance, 207
Holding costs, 180 Margin, 116
Holding inventory, 179 Margin of safety, 277
Hopwood, 207 Marginal costing, 87, 97
Mark-up, 111, 116
I Master budget, 136
ICAEW ethical guidance, 17 Material price variance, 246
Imposed budget, 153 Material total variance, 246
Incremental budgeting, 154 Material usage variance, 246
Indirect costs, 8, 9, 30 Materials inventory budget, 137
Inflation, 113, 177 Materials usage budget, 137
Internal rate of return, 321 Mixed costs, 13
Internet of things, 214 Motivation, 154
Interpolation method, 322 Motivation and budgets, 134
Inter-relationships between variances, 260 Multiple IRRs, 326
Inventory, 169 Mutually exclusive projects, 306, 327
Inventory control systems, 180
Inventory turnover period, 171 N
Inventory valuation and profitability, 38 Net present value, 312
Inventory-holding period, 176 Net terminal value (NTV), 314
Investing surplus funds, 187 Non accounting, 207
Investment centre, 211, 216, 221 Non-conventional cash flows, 326
Investment in working capital, 177 Non-financial performance measures, 222
Invoice discounting, 184, 187 Non-linear correlation, 148
J O
Job costing, 69 Open book accounting, 113
Just in time, 73 Operating leases, 187
Just-in-time (JIT) manufacturing systems, Operating statement, 254
181 Opportunity cost, 186
Outsource, 181
Overhead, 9, 30
Overhead absorption, 59

Overhead absorption rate, 59 Residual income, 211, 212, 219
Overhead allocation, 51 Resource allocation, 133
Overhead apportionment, 52 Responsibility accounting, 16, 133, 210
Overhead recovery rates, 60 Responsibility based budgets, 156
Overtrading, 179 Responsibility centre, 16, 210, 215
Return, 169
P Return on capital employed, 212
Participation, 153 Return on investment, 211, 217
Participative budgets, 154 Revenue centre, 211, 216
Payables, 170 Risk, 169
Payables payment period, 171, 176 Risk in working capital decisions, 174
Payback, 306 Rolling budgets, 155
Payback period, 306
Performance evaluation, 134 S
Period costs, 11, 87 Sales budget, 137
Periodic review system, 180 Sales price variance, 253
Periodic weighted average pricing, 37 Sales volume variance, 253
Perpetual inventory methods, 181 Second stage: service cost centre cost
Perpetuity, 320 apportionment, 56
Planning, 133 Selling overhead, 10
Present value, 311 Semi-fixed costs, 13
Prime cost, 9, 29 Semi-variable costs, 13, 225
Principal budget factor, 137 Sensitivity analysis, 143
Process costing, 71 Service cost centres, 56
Product based budgets, 156 Settlement discounts, 183
Product costs, 11 Shared service centres (SSC), 213
Product life cycle, 181 Shortage costs, 180
Production budget, 137 Short-term bank loans, 187
Production overhead, 10 Solutions to liquidity problems, 179
Production overheads, 59 Specific order costing, 69
Production period, 176 Standard cost, 243
Profit and cash flows, 170 Standard costing, 141, 243
Profit centre, 211, 216 Strategic plans, 154
Profit centres, 210 Structured data, 150
Profit conscious, 207 Subcontracting, 290
Progress payments, 181 Sub-optimal decisions, 120
Project screening, 305
Pull systems, 73 T
Push systems, 73 Target costing, 73
Terminal value, 311
Q Time value of money, 307, 310, 316
Quick (liquidity) ratio, 173, 216 Top-down style of budgeting, 154
Trade credit, 182
R Trade credit insurance, 186
Rate of inventory turnover, 171 Trade payables, 182
Raw materials holding period, 176 Trade receivables, 183
Raw materials purchases budget, 137 Transaction-related cost drivers, 66
Receivables, 169 Transfer price, 211
Receivables collection period, 171, 176 Two part transfer price, 121
Receivables factoring, 185
Receivables management, 185 U
Relevant range, 14 Uncontrollable cost, 17
Re-order costs, 180 Unstructured data, 150
Re-order level system, 180
ICAEW 2019 Index 357

V Volume-related cost drivers, 66
Variable cost, 12, 225
Variable overheads, 31 W
Variable production overhead efficiency Weighted average pricing, 36
variance, 251 'What if?' analysis, 143
Variable production overhead expenditure Working capital, 169, 175
variance, 251 Working capital ratios, 172
Variable production overhead total
variance, 251 Z
Variance, 228, 246 Zero based budgeting (ZBB), 155
Variance analysis, 246

ICAEW 2019 Notes
Management Information Notes
ICAEW 2019 Notes
ICAEW 2019 Notes
ICAEW 2019 Notes
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ICAEW 2019 Notes
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The Institute of Chartered Accountants in England and Wales

For exams in 2019

First edition 2007

All rights reserved. No part of this publication may be reproduced, stored

Originally printed in the United Kingdom on paper obtained from

The International Accounting Standards Board (IASB)

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Copyright © IFRS Foundation

ii Contents ICAEW 2019

ICAEW 2019 iii

iv Contents ICAEW 2019

ICAEW 2019 Management Information v

Learning outcomes Tick off

 Recognise the use of cost information for different purposes

 Classify costs as fixed, variable, direct or indirect

2 Management Information ICAEW 2019

1.1 The cost accountant

1.2 Cost accounting and management accounting

ICAEW 2019 The fundamentals of costing 3

1.4 Financial accounting versus cost accounting

Financial accounts Management accounts

4 Management Information ICAEW 2019

Most financial accounting information is of a Management accounts incorporate non-

2 Basic cost accounting concepts

2.1 Functions and departments

ICAEW 2019 The fundamentals of costing 5

Production Administration Marketing

Mixing Baking Stores

Figure 1.1: Manufacturing organisation structure

Service Administration Marketing

Front Housekeeping Maintenance Catering

Figure 1.2: Service organisation structure

2.2 Cost objects

Examples of cost objects include:

6 Management Information ICAEW 2019

Organisation Possible cost unit

2.4 Composite cost units

Interactive question 1: Cost units

Bar Conference delegate

See Answer at the end of this chapter.

ICAEW 2019 The fundamentals of costing 7

2.6 Direct v indirect costs and cost objects

3 Cost classification for inventory valuation and profit

8 Management Information ICAEW 2019

3.2 Direct cost and prime cost

There are three types of direct cost.

3.3 Indirect cost and overhead

ICAEW 2019 The fundamentals of costing 9

Materials cost = Direct materials cost + Indirect materials cost

3.3.1 Production overhead

3.3.2 Administration overhead

3.3.3 Selling overhead

3.3.4 Distribution overhead

10 Management Information ICAEW 2019

4 Cost classification for planning and decision making

4.1 Cost behaviour patterns

ICAEW 2019 The fundamentals of costing 11

Graph of fixed cost

Volume output (level of activity)

Figure 1.3: Fixed cost

4.3 Variable costs

12 Management Information ICAEW 2019

4.4 Semi-variable costs (or semi-fixed costs or mixed costs)