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FILE 20220108 101529 Management Information Study Manual 2019
FILE 20220108 101529 Management Information Study Manual 2019
MANAGEMENT
INFORMATION
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
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© ICAEW 2018
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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.
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
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.
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.
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.
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.
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.
Board of directors
Definition
Cost object: Anything for which we are trying to ascertain the cost.
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.
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.
Cost elements can be classified as direct costs or indirect costs as far as cost units are
concerned.
Definition
Direct cost: A cost that can be traced in full to the cost unit.
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.
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.
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.
£
Cost
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
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.
£
Cost
Variable part
Fixed part
Volume of output
(or, say, value of sales)
Figure 1.5: Semi-variable cost
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
(3) (4)
(a)
(b)
(c)
(d)
(e)
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.
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.
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,
– 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
(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
Yes No
Telephone bill
Total
Total cost
cost
Total Total
cost cost
Suitable Unsuitable
Sales commission
Order obtained
Total Total
cost cost
Room/night
Meal served
Conference delegate
Conference room/day
Answer to Interactive question 2
(a) Semi-variable
(b) Fixed
(c) Variable
Answer to Interactive question 3
(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
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
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.
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.
Introduction
Examination context
TOPIC LIST
1 Identifying direct and indirect costs for cost units
2 Inventory valuation
Summary and Self-test
Answers to Interactive questions
Answers to Self-test
Introduction
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.
In the examination, students may be required to:
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.
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
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.
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.
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.
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)
Receipt 9 May 300 300
Issue 11 May (300) (100) (400)
Receipt 18 May 100 100
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.
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.
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.
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.
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
* A new inventory value per unit is calculated whenever a new receipt of materials occurs.
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 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.
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.
(£200 + £1,716)
=
(100 + 800)
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).
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.
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)).
Summary
True False
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
£........................................
Now go back to the Learning outcomes in the introduction. If you are satisfied you have
achieved these objectives, please tick them off.
(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
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
Introduction
Examination context
TOPIC LIST
1 Absorption costing
2 Activity based costing
3 Costing methods
4 Other approaches to cost management
Summary and Self-test
Answers to Interactive questions
Answers to Self-test
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.
In the examination, students may be required to:
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.
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.
There are three stages in determining the share of overhead to be attributed to a cost unit.
Overhead allocation
Overhead apportionment
Overhead absorption
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
Rent
Heating costs
Insurance of machinery
Cleaning costs
Canteen costs
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
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
Solution
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
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.
Department 2
– The department 2 absorption rate will be based on units of output.
5,000
= £5 per unit produced
1,000 units
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
(delete as appropriate)
(c) The assembly department rate is £ per direct labour hour/machine hour
(delete as appropriate)
See Answer at the end of this chapter.
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
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.
* Delete as applicable
See Answer at the end of this chapter.
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.
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.
Step 1
Identify an organisation's major
activities.
Step 2
Identify the factors (cost drivers) which
cause the costs of the activities.
WORKINGS
(1) £3,080 ÷ 440 machine hours = £7 per machine hour
(2) £10,920 ÷ 14 production runs = £780 per run
(3) £9,100 ÷ 14 production runs = £650 per run
(4) £7,700 ÷ 14 production runs = £550 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).
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.
Job Number
XXXX
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.
Fitting kitchens
Manufacturing components
Manufacturing chemicals
Building offices
See Answer at the end of this chapter.
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.
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.
Determine Determine
unit cost target cost
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
Summary
2 A company has two production departments and two service departments with production
overheads as shown in the following table.
Production Production Service Service
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: £
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.
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 of apportionment:
1 Floor area
2 Effective horsepower
3 Plant value
4 Fixtures and fittings value
£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
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
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
Production Production Service Service
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
= £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.
Introduction
Examination context
TOPIC LIST
1 Marginal cost and marginal costing
2 Marginal costing and absorption costing compared
Summary and Self-test
Answers to Interactive questions
Answers to Self-test
Introduction
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.
In the examination, students may be required to:
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
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.
1.2 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
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.
£ £
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)
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.
£
Sales 16,000
Production costs
Variable 6,400
Fixed 1,600
Sales and distribution costs
Variable 3,200
Fixed 2,400
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
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
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
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
Solution
(a) Absorption costing: the absorption rate for fixed production overhead is:
£1,500
= £1 per unit
1,500 units
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
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
March £
April £
(b) Calculate the total value of the closing inventory for each month under absorption costing.
March £
April £
(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
Summary
Alternative costing
systems
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
If inventories
If inventories increase: If inventories do not alter:
decrease:
mc profit < ac profit mc profit = ac profit
mc profit > ac profit
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
Luxury Standard
Marginal costing: £ £
Absorption costing: £ £
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?
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 £ .
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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.
Budgeted overheads
(c) Overhead absorption rate =
Budgeted output
Budgeted overheads
£5 =
36,000 units
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.
£
sales volume 24,500 units 215,600
Less fixed selling and administration costs 49,000
Absorption costing net profit 166,600
Inventories increased during the period, therefore the marginal costing net profit will be
lower.
£
Absorption costing net profit 166,600
Difference in profits (change in inventory 1,500 units £3.50) (5,250)
Marginal costing net profit 161,350
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
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
Summary and Self-test
Answers to Interactive questions
Answers to Self-test
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.
In the examination, students may be required to:
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
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.
Step 1
Calculate the fixed overhead absorption rate.
£69,000
Overhead absorption rate =
17,250
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
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.
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
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.
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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.
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
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.
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.
Summary
Pricing calculations
Optimal price
in perfectly Fixed and
competitive variable
market charges
separated
Different
Mark-up may price used
be derived to for receiving
earn a required and supplying
return on division
investment
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 %
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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%
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
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.
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.
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
Summary and Self-test
Answers to Interactive questions
Answers to Self-test
Introduction
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.
In the examination, students may be required to:
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
• To be useful for planning and control purposes a budget must be quantified, but not
necessarily only in financial terms.
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.
'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.
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.
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.
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
Sales budget
Production budget
Inventory budget
(raw materials)
Recruitment or Production
redundancy budgets overhead budget
Raw materials
purchase budget
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
Requirement
Sales quantity
Sales value £ £ £ £
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.
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
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.
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.
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.
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.
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
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
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).
X X
Figure 6.4: Perfect 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.
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.
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
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
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
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
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
Now go back to the Learning outcomes in the introduction. If you are satisfied you have
achieved these objectives, please tick them off.
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
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
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.
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
Summary and Self-test
Answers to Interactive questions
Answers to Self-test
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.
In the examination, students may be required to:
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.
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.
Section overview
All businesses face a trade off between being profitable (providing a return) and being
liquid (staying in business).
Section overview
Ratios can be used to assess a business's liquidity position.
Liquidity can be assessed using the current and quick ratios.
Solution
Step 1
Calculate the annual sales revenue
Average receivables
Receivables collection period (in days) = × 365
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 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
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
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.
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
RAW MATERIALS
RECEIVABLES INVENTORY
Production
Sales
Where averages cannot be calculated or are not available then period-end balances should be
used.
Cost of sales =
Days
Raw materials in inventory =
WIP in inventory =
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
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.
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
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
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
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.
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
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.
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.
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
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.
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.
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
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.
Summary
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
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
Now go back to the Learning outcomes in the introduction. If you are satisfied you have
achieved these objectives, please tick them off.
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.
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
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.
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
= £326,400
£256,000 + £326,400
Current ratio =
£192,000
= 3:1
£720,000
15 =
Inventory
Inventory = £48,000
Trade receivables
73 = × 365
£900,000
Performance
management
Introduction
Examination context
TOPIC LIST
1 Performance evaluation
2 Responsibility centres
3 Performance measures
4 The balanced scorecard
5 Budgetary control
Summary and Self-test
Answers to Interactive questions
Answers to Self-test
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.
In the examination, students may be required to:
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
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)
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.
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.
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.'
Research has shown no clear preference for one style over another.
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.
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
Non-current assets
Trade receivables
Trade payables
Inventory
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.
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.
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)?
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.
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.
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.
Solution
£'000
Divisional RI without the project:
Divisional profit 300
Imputed interest charge (20% £1m) 200
100
RI of the project
Profit 25
Imputed interest charge (20% £100,000) 20
5
Solution
(a) Residual income
Division 1 Division 2
£'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
Division 1 Division 2
Year 1 £200,000/£1,000,000 20%
£20,000/£100,000 20%
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.
ROI RI
Without investment % £
With investment % £
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.
Perspective Measures
Financial 1
2
3
Customer 1
2
3
Innovation and learning 1
2
3
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.
(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.
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.
Ignoring inflation, the cost of factory power which will be incurred is estimated to be £ .
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
* 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?
£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.
(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)
Summary
Decentralisation
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
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
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
achieved these objectives, please tick them off.
Non-current assets
Trade receivables
Trade payables
Inventory
ROI RI
RI
£ £
Profit 119,700 128,200
Imputed interest charge:
£570,000 15% 85,500
£620,000 15% 93,000
34,200 35,200
(g) (1) The total expenditure variance for period 6 was £ 2,600 favourable
£480,000 + £200,000
Investment R only = = 22.7%
£2,400,000 + £600,000
= 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
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
Summary and Self-test
Answer to Interactive question
Answers to Self-test
Introduction
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.
In the examination, students may be required to:
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.
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.
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'.
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.'
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.
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).
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.
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
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
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)
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.
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)
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 expenditure variance 532 (A)
Variable overhead efficiency variance 60 (F)
Variable overhead total variance 472 (A)
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.
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.
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.
There are several ways in which an operating statement may be presented. A common format is
one which reconciles budgeted profit to actual profit.
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.
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)
Actual profit 24,100
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
Actual sales volume 4,850 units
9
Sales volume variance in units 250 units (A)
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)
(7) £
8,500 hours incurring variable o/hd expenditure should cost
( £0.30) 2,550
but did cost 2,600
Variable overhead expenditure variance 50 (A)
(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
Actual fixed overhead 42,300
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.
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.
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
4.3 Deriving actual data from standard cost details and variances
Variances can be manipulated to derive actual data from standard cost details.
(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
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:
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
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
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
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
Actual sales volume 2,800 units
Sales volume variance in units 200 units (A)
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
Sales price variance 1,120 (F)
4 Material usage
Material P
2,800 units of SK should use ( 8 kg) 22,400 kg
but did use 19,000 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
but did use 14,000 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
but did take 8,300 hrs
Labour variance in hrs 100 hrs (F)
Standard rate per hour £7.50
Labour efficiency variance in £ £750 (F)
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
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
C
H
A
P
T
E
R
Breakeven analysis
and limiting factor
analysis
Introduction
Examination context
TOPIC LIST
1 Breakeven analysis and contribution
2 Breakeven charts
3 Limiting factor analysis
Summary and Self-test
Answers to Interactive questions
Answers to Self-test
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.
In the examination, students may be required to:
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.
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.
If the selling price is £10 per unit, the number of units of W that must be sold is .
See Answer at the end of this chapter.
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.
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)
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 contribution £5,600
Required sales = = = 40,000 cakes per month
Contribution per unit £0.14
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
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.
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
(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
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
The margin of safety can be seen on the chart as the difference between the budgeted level of
activity and the breakeven level.
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.
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
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.
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.
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
Requirement
Indicate, by placing ticks where relevant in the table below, which resource or resources
represent a limiting factor for LF Ltd.
Materials
Labour
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
*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.
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.
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
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
Contribution per unit £40 £64 £12
Labour hours 4 8 1
10
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
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
Summary
Contribution =
Sales price – Variable cost
Breakeven chart
Depicts the profit or
loss over a range of activities
C
H
A
P
T
E
R
10
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
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
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
Now, go back to the Learning outcomes in the introduction. If you are satisfied you have
achieved these objectives, please tick them off.
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
(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
The remaining 5,000 units of E should be purchased from the sub contractor.
C
H
A
P
T
E
R
10
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
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
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
* 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
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
Summary and Self-test
Answers to Interactive questions
Answers to Self-test
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.
In the examination, students may be required to:
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.
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.
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.
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.
Requirement
Calculate the payback period to the nearest month.
(120 93)
Payback period = 3 years + ×12 months
49
= 3 years 7 months
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.
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.
Solution
Using initial investment
11
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.
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.
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.
1/(1.10)
2
After 2 years £12,100 10,000
1/(1.10)
3
After 3 years £13,310 10,000
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.
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.
4.7 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.
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
0
1
2
3
4
Net present value
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.
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
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
Solution
£6m £8m
NPV = (£10m) + + = £1.52m
1.10 1.10 ×1.20
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.
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.
NPV
Positive IRR
0
Cost of capital %
Negative
True IRR
Negative
P
Q
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%.
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.
30
20
Positive
10
0
Cost of
5 10 20 30 40 capital %
–10
Negative
–20
–30
–40
NPV +
600 D
Discount rate
0%
25% 400%
NPV –
4,000
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?
NPV
250
200
100
0
10 20 30 40 50 Discount
rate %
–50
Investment appraisal
Discounted
Allowing for the
payback Accounting
time value of money period Payback rate of
method return (ARR)
Inconsistency between
NPV and IRR as
decision tools
Superiority of NPV
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?
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
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?
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?
Proj
ect Y
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.
1
2 40,000 = 0.797 31,880
(1.12)2
1
3 30,000 = 0.712 21,360
(1.12)3
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
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%.
= 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
= 2.54 years
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
Discount tables
340 Management Information ICAEW 2019
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
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
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Study Manual.